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+Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.​Management’s Discussion and Analysis of Financial Condition and Results of Operations (MD&A) is designed to provide a reader of 3M’s financial statements with a narrative from the perspective of management. 3M’s MD&A is presented in eight sections:​●Overview●Results of Operations●Performance by Business Segment●Performance by Geographic Area●Critical Accounting Estimates●New Accounting Pronouncements●Financial Condition and Liquidity●Financial Instruments​Forward-looking statements in Item 7 may involve risks and uncertainties that could cause results to differ materially from those projected (refer to the section entitled “Cautionary Note Concerning Factors That May Affect Future Results” in Item 1 and the risk factors provided in Item 1A for discussion of these risks and uncertainties).​Additional information about results for year end 2018 and certain year-on-year comparisons between 2019 and 2018 can be found in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” sections in the Company’s Annual Report on Form 10-K for the year ended December 31, 2019.​OVERVIEW​3M is a diversified global manufacturer, technology innovator and marketer of a wide variety of products and services. As more fully described in both the Performance by Business Segment section in MD&A and in Note 19, effective in the first quarter of 2020, the Company changed its business segment reporting in its continuing effort to improve the alignment of businesses around markets and customers. Additionally, the Company consolidated the way it presents geographic area net sales by providing an aggregate Americas geographic region (combining former United States and Latin America and Canada areas). Also, effective in the second quarter of 2020, the measure of segment operating performance used by 3M’s chief operating decision maker changed and, as a result, the Company’s disclosed measure of segment profit/loss has been updated. Business segment information presented herein reflects the impact of these changes for all periods presented. ​3M manages its operations in four operating business segments: Safety and Industrial; Transportation and Electronics; Health Care; and Consumer. From a geographic perspective, any references to EMEA refer to Europe, Middle East and Africa on a combined basis.​Consideration of COVID-19:​3M is impacted by the global pandemic and related effects associated with the coronavirus (COVID-19). The Company updated its risk factors with respect to COVID-19, which can be found in Item 1A “Risk Factors” in this document. ​Public and private sector policies and initiatives to reduce the transmission of COVID-19, such as the imposition of travel restrictions and the adoption of remote working, have impacted 3M’s operations. 3M continues to work to protect its employees and the public, maintain business continuity and sustain its operations, including ensuring the safety and protection of people who work in its plants and distribution centers across the world, many of whom support the manufacturing and delivery of products that are critical in response to the global pandemic. COVID-19 has impacted 3M’s supply chains relative to global demand for products like respirators, surgical masks and commercial cleaning solutions. As this situation continues, 3M also closely monitors and responds to potential impacts to the Company’s broader supply chain associated with other products. COVID-19 has also affected the ability of suppliers and vendors to provide products and services to 3M. Furthermore, COVID-19 has impacted the broader economies of affected countries, including negatively impacting economic growth.The Company has taken steps to help employees lead safe and productive lives during the outbreak including remote working; escalated procedures in factories related to personal safety, cleaning and medical screening measures; and pandemic leave policies. 3M closely monitors how the spread of COVID-19 is affecting employees and business operations and has preparedness plans to help protect the safety of employees around the world while safely continuing business. While nearly all of our manufacturing locations and distribution centers are fully or partially operational, the Company 18 Table of Contentsimplemented plant and/or line shutdowns during 2020 related to certain markets due to weaker customer demand or government mandates. Some of the above factors have increased the demand for 3M products, while others have decreased demand or made it more difficult for 3M to serve customers. Serving 3M customers is a priority and teams continue to communicate with individual customers about potential disruptions. ​3M’s total sales increased 0.1% for the full year 2020 when compared to 2019. Organic local-currency sales decreased 1.7% for the full year 2020 when compared to 2019. Given the diversity of 3M’s businesses, the impact of COVID-19 varied across the Company throughout 2020. 3M experienced strong sales growth in personal safety, as well as in other areas such as home improvement, general cleaning, semiconductor, data center, and biopharma filtration. COVID-related respirator sales are estimated to have impacted year-on-year organic local-currency sales growth by approximately 3 percent for the year ending December 31, 2020. At the same time, weakness in several end markets, while improving, contributed in part to sales declines in a number of 3M’s businesses with the biggest year-on-year total sales decreases in oral care (down 19 percent), advanced materials (down 17 percent), automotive and aerospace (down 16 percent), commercial solutions (down 14 percent), stationery and office (down 11 percent), closure and masking (down 11 percent), automotive aftermarket (down 10 percent), and businesses aligned to general industrial applications such as abrasives (down 15 percent) and industrial adhesives and tapes (down 5 percent).​3M’s operating income margins increased 3.1 percentage points year-on-year for the year ending December 31, 2020. Factoring out the impact on operating income of special items as described in the Certain amounts adjusted for special items - (non-GAAP measures) section below, operating income margins increased 0.1 points to 21.3 percent for the year ending December 31, 2020 when compared to 2019. Various COVID-19 implications contributed in part to these results.​Overall, the impact of the COVID-19 pandemic on 3M’s consolidated results of operations was primarily driven by factors related to changes in demand for products and disruption in global supply chains as described above. While it is not feasible to identify or quantify all the other direct and indirect implications on 3M’s results of operations, below are factors that 3M believes have also affected its 2020 results:​Factors contributing to charges:●Period expenses of unabsorbed manufacturing costs and increased expected credit losses on customer receivables.●Restructuring actions addressing structural enterprise costs and operations in certain end markets as a result of the COVID-19 pandemic and related economic impact resulting in a second quarter 2020 charge of $58 million (as further discussed in Note 5).●Committed financial support to various COVID-relief and medical research initiatives.●Charge of $22 million related to equity securities as discussed in the “Assets and Liabilities that are Measured at Fair Value on a Nonrecurring Basis” section of Note 15 that use the measurement alternative described therein in addition to an immaterial pre-tax charge related to impairment of certain indefinite lived tradenames in the first quarter of 2020. 3M continues to regularly consider if COVID-19 and other related market implications could indicate it is more likely than not the carrying amount of various applicable assets may be impaired and assess whether certain investments without readily determinable fair values may have been impacted. ​Factors providing benefits or other impacts:●Decreased discretionary spending in areas such as travel, professional services, and advertising/merchandising as well as cost reduction efforts, hiring freezes, and maintaining only essential contract workers. 3M continues to monitor discretionary spending and deploy cost control efforts as the situation continues.●Government-sponsored COVID-response stimulus and relief initiatives, including certain employment retention benefits under the Coronavirus Aid, Relief and Economic Security (CARES) Act in the United States.●Lower self-insured medical visit/instance expense during 2020.●Instituted accelerated vacation usage policies which benefited the second quarter of 2020 year-on-year, but provided a penalty in comparison to prior year in the second half of 2020.​As previously disclosed, in light of circumstances, 3M took actions to ensure sources of cash may remain strong, including the March 2020 issuance of $1.75 billion of registered notes, suspension of share repurchases, and the decrease of its 2020 capital spending to approximately $1.5 billion. While capital spending decreased, it included additional expansion of respirator production capacity. 3M continues to have access to its commercial paper program and undrawn committed credit facility. Refer to the Financial Condition and Liquidity section below for more information on the Company’s liquidity position.19 Table of ContentsThe Company also continues to evaluate the extent to which it may avail itself of various government-sponsored COVID-response stimulus, relief, and production initiatives around the world, such as under the Defense Production Act (DPA) and CARES Act in the United States. During 2020 and into January 2021, 3M reached certain agreements with governments in the U.S. and other countries involving just over $250 million of asset funding to expand capacity to supply N-95 respirators. ​Due to the speed with which the COVID-19 situation is developing and evolving and the uncertainty of its duration and the timing of recovery, 3M is not able at this time to predict the extent to which the COVID-19 pandemic may have a material effect on its consolidated results of operations or financial condition.​Earnings per share (EPS) attributable to 3M common shareholders – diluted:​The following table provides the increase (decrease) in diluted earnings per share for 2020 compared to the same period last year, in addition to 2019 compared to 2018. As applicable, certain items in the table reflect specific income tax rates associated therewith.​​​​​​​​​​ Year ended December 31, (Earnings per diluted share) 2020​2019 Same period last year​$ 7.81​$ 8.89​Significant litigation-related charges/benefits​​ 1.01​​ 1.28​TCJA measurement period adjustment​​ —​​ 0.29​Loss on deconsolidation of Venezuelan subsidiary​​ 0.28​​ —​Gain/loss on sale of businesses​​ (0.22)​​ (0.73)​Divestiture-related restructuring actions​​ —​​ 0.18​Same period last year, excluding special items​$ 8.88​$ 9.91​Increase/(decrease) in earnings per share - diluted, due to:​​​​​​​Organic growth/productivity and other​​ (0.06)​​ (0.60)​Non divestiture-related restructuring actions​​ 0.12​​ (0.41)​Acquisitions/divestitures​​ (0.10)​​ (0.24)​Foreign exchange impacts​​ (0.11)​​ —​Income tax rate​​ (0.03)​​ —​Shares of common stock outstanding​​ 0.04​​ 0.22​Current period, excluding special items​$ 8.74​$ 8.88​Significant litigation-related charges/benefits​​ 0.07​​ (1.01)​Loss on deconsolidation of Venezuelan subsidiary​​ —​​ (0.28)​Gain/loss on sale of businesses​​ 0.52​​ 0.22​Divestiture-related restructuring actions​​ (0.08)​​ —​Current period​$ 9.25​$ 7.81​​Year 2020 EPS:​For year ended December 31, 2020, net income attributable to 3M was $5.384 billion, or $9.25 per diluted share basis, compared to $4.570 billion, or $7.81 per diluted share, for year ended December 31, 2019, an increase of 18.4 percent on a per diluted share basis.​The Company refers to various “adjusted” amounts or measures on an “adjusted basis”. These exclude special items. These non-GAAP measures are further described and reconciled to the most directly comparable GAAP financial measures in the Certain amounts adjusted for special items - (non-GAAP measures) section below.​On an adjusted basis, net income attributable to 3M was $5.088 billion, or $8.74 per diluted share for 2020 compared to $5.193 billion, or $8.88 per diluted share in December 31, 2019, a decrease of 1.5 percent on a per diluted share basis. ​Additional discussion related to the components of the year-on-year change in earnings per diluted share follows:​Organic growth/productivity and other: ●Lower organic volume growth in 2020 as a result of significant COVID-19 related impacts, in addition to COVID-related net factors described in the preceding Overview—Consideration of COVID-19 section, decreased earnings per diluted share year-on-year. 3M also experienced year-over-year increased costs as a result of the regular review of its respirator mask 20 Table of Contentsliabilities and certain follow-on accelerated depreciation following some of the restructuring described below. Partially offsetting this net decrease in earnings per share were year-on-year net gains related to certain property sales (in 2020 within Safety and Industrial and in 2019 within Corporate and Unallocated) in addition to benefits recognized in 2020 related to the restructuring and other actions taken in 2019 (and the adjustments thereto in 2020) along with continued cost management and productivity efforts. ●On a combined basis, higher defined benefit pension and postretirement service cost increased expense year-on-year.●Interest expense (net of interest income) increased in 2020, as a result of higher U.S. average debt balances and lower year-on-year interest income driven by lower average interest rates on cash balances. 2020 interest expense also included an early debt extinguishment charge in conjunction with the repayment of notes in December 2020.​Non divestiture-related restructuring actions:●3M recorded non divestiture-related restructuring pre-tax charges aggregating $195 million in 2020. These included charges in the second quarter of 2020 to address certain COVID-related impacts and in the fourth quarter as 3M initiated actions to further enhance its operational and marketing capabilities. In 2019, charges included $282 million as the Company committed to actions in light of slower than expected 2019 sales and associated with realigning its organizational structure and operating model. See Note 5 for additional details. ●The year-on-year impact of the non divestiture-related restructuring actions taken in 2020 and 2019 increased earnings per diluted share by 12 cents.​Acquisitions/divestitures:●Acquisition impacts, which are measured for the first twelve months post-transaction, relate to the acquisitions of M*Modal (first quarter 2019), and Acelity (fourth quarter 2019). These items collectively decreased earnings per diluted share by 7 year-on-year for 2020. The net impacts related to these acquisitions included income from operations, more than offset by transaction and integration costs. Financing costs related to these acquisitions is also included. ●Divestiture impacts include the lost operating income from divested businesses, which decreased earnings per diluted share by 3 cents year-on-year for 2020. This was primarily related to the divestiture of the Company’s drug delivery business.​Foreign exchange impacts:●Foreign currency impacts (net of hedging) decreased pre-tax earnings year-on-year by approximately $81 million in 2020, which decreased earnings per diluted share by 11 cents, excluding the impact of foreign currency changes on tax rates. ​Income tax rate:●Certain items above reflect specific income tax rates associated therewith. Overall, the effective tax rate for 2020 was 19.6 percent, a decrease of 0.2 percentage points versus 2019. On an adjusted basis (as discussed below), the effective tax rate increased 0.1 percentage points year-on-year for 2020.●Factors that decreased the effective tax rate for 2020 included geographical income mix and adjustments to uncertain tax positions. These decreases were partially offset by decreased benefit from stock options. Refer to Note 10 for additional details.​Shares of common stock outstanding:●Lower shares outstanding increased earnings per share year-on-year by 4 cents per diluted share for 2020. Weighted-average diluted shares outstanding in 2020 declined 0.5 percent year-on-year, which benefited earnings per share. The decrease in the outstanding weighted-average diluted shares relates to the Company’s purchase of $368 million of its own stock, prior to suspension of share repurchases under its board-approved stock repurchase program in late March 2020 with other repurchase activity limited to 3M’s stock compensation plans.​Year 2019 EPS:​Organic growth/productivity and other: ●Negative organic local-currency sales growth as a result of softness in certain end markets and channel inventory adjustments, along with actions taken by 3M in response to lower sales volumes and high inventory levels, which resulted in lower manufacturing and inventory absorption, reduced earnings per diluted share. Partially offsetting these impacts were benefits from restructuring actions taken in the second quarter of 2019.21 Table of Contents●Defined benefit pension and postretirement service cost expense decreased expense year-on-year, which benefited earnings per diluted share.●Lower income related to non-service cost components of pension and postretirement expense, increased expense year-on-year.●Interest expense (net of interest income) increased in 2019, as a result of higher U.S. average debt balances, partially offset by the increase in interest income driven by higher balances in cash, cash equivalents and marketable securities during the year resulting from the proceeds from debt issuances in advance of the October 2019 Acelity acquisition.​Non divestiture-related restructuring actions:●During the second quarter of 2019, in light of slower than expected 2019 sales, and additionally in the fourth quarter to realign 3M’s organizational structure and operating model, management approved and committed to undertake certain restructuring actions. In aggregate, the Company recorded a full year 2019 combined pre-tax charge of $282 million, or 41 cents per diluted share. See Note 5 for additional details.​Acquisitions/divestitures:●Acquisition impacts, which are measured for the first twelve months post-transaction, relate to the acquisitions of M*Modal (first quarter 2019), and Acelity (fourth quarter 2019). These items collectively decreased earnings per diluted share by 19 cents year-on-year for 2019. The net impacts related to these acquisitions included income from operations, more than offset by transaction and integration costs. Interest expense related to financing costs of these acquisitions is also included. Expenses related to the October 2019 acquisition of Acelity also include financing costs and the tax effect of repatriating funds in advance of the close of the acquisition.●Divestiture impacts collectively decreased earnings per diluted share by 5 cents year-on-year for 2019. They include remaining stranded costs and lost operating income related to the 2018 divestiture of the Communication Markets Division, which decreased earnings per diluted share by 4 cents year-on-year, and lost operating income from other divested businesses (primarily the Company’s gas and flame detection business), which decreased earnings per diluted share by 1 cent year-on-year.​Foreign exchange impacts:●Foreign currency impacts (net of hedging) were essentially flat year-on-year, excluding the impact of foreign currency changes on tax rates. ​Income tax rate:●Certain items above reflect specific income tax rates associated therewith. Overall, the effective tax rate for 2019 was 19.8 percent, a decrease of 3.6 percentage points versus 2018. On an adjusted basis (as discussed below), the effective tax rate increased 0.2 percentage points year-on-year for 2019.●Factors that decreased the effective tax rate on a GAAP basis for 2019 included prior year measurement period adjustments related to 2017 Tax Cuts and Jobs Act (TCJA), prior year resolution of the NRD lawsuit (as described in Note 16) and geographical income mix. These decreases were partially offset by the deconsolidation of the Venezuelan subsidiary, adjustments to uncertain tax positions, and significant litigation-related charges. Refer to Note 10 for additional details.​Shares of common stock outstanding:●Lower shares outstanding increased earnings per share year-on-year by 22 cents per diluted share for 2019. Weighted-average diluted shares outstanding in 2019 declined 2.8 percent year-on-year which benefited earnings per share. The decrease in the outstanding weighted-average diluted shares relates to the Company’s purchase of $1.4 billion of its own stock in 2019.​​22 Table of ContentsCertain amounts adjusted for special items - (non-GAAP measures): ​In addition to reporting financial results in accordance with U.S. GAAP, the Company also provides non-GAAP measures that adjust for the impacts of special items. For the periods presented, special items include the items described below. Beginning in 2020, the Company includes gain/loss on sale of businesses and divestiture-related restructuring actions as special items due to their potential distortion of underlying operating results. Information provided herein reflects the impact of this change for all periods presented. Operating income (measure of segment operating performance), income before taxes, net income, earnings per share, and the effective tax rate are all measures for which 3M provides the reported GAAP measure and a measure adjusted for special items. The adjusted measures are not in accordance with, nor are they a substitute for, GAAP measures. The Company considers these non-GAAP measures in evaluating and managing the Company’s operations. The Company believes that discussion of results adjusted for these items is meaningful to investors as it provides a useful analysis of ongoing underlying operating trends. The determination of these items may not be comparable to similarly titled measures used by other companies. Special items include:​Significant litigation-related charges/benefits:●In 2020, 3M recorded a net pre-tax charge of $17 million ($13 million after tax) related to PFAS (certain perfluorinated compounds) matters. The charge was more than offset by a reduction in tax expense of $52 million related to resolution of tax treatment with authorities regarding the previously disclosed 2018 agreement reached with the State of Minnesota that resolved the Natural Resources Damages lawsuit. These items, in aggregate, resulted in a $39 million after tax benefit. ●In 2019, the Company recorded significant litigation-related charges of $762 million ($590 million after tax) related to PFAS matters and coal mine dust respirator mask lawsuits of which $214 million ($166 million after tax) occurred in the fourth quarter. The aggregate 2019 pre-tax charge was reflected in cost of sales ($328 million) and selling, general and administrative expense ($434 million). These charges are further discussed in Note 16.●In 2018, the Company recorded significant litigation-related charges of $897 million ($770 million after tax) for PFAS matters related to the previously disclosed agreement reached with the State of Minnesota that resolved the Natural Resource Damages lawsuit. Essentially all of the aggregate 2018 pre-tax charge was reflected in selling, general and administrative expense.​Gain/loss on sale of businesses:●In the first quarter of 2020, 3M recorded a pre-tax gain of $2 million ($1 million loss after tax) related to the sale of its advanced ballistic-protection business and recognition of certain contingent consideration. In the second quarter of 2020, 3M recorded a pre-tax gain of $387 million ($304 million after tax) related to the sale of its drug delivery business. Refer to Note 3 for further details.●In the first quarter of 2019, 3M recorded a gain related to the sale of certain oral care technology comprising a business in addition to reflecting an earnout on a previous divestiture, which together resulted in a net gain of $8 million ($7 million after tax). In the second quarter of 2019, as a result of a “held for sale” tax benefit related to the legal entities associated with the pending divestiture of the Company’s gas and flame detection business, 3M recorded an after-tax gain of $43 million. In the third quarter of 2019, 3M recorded a gain related to the divestiture of the Company’s gas and flame detection business and an immaterial impact as a result of measuring a disposal group at the lower of its carrying amount or fair value less cost to sell, which in aggregate resulted in a pre-tax gain of $106 million ($79 million after tax).●In the first quarter of 2018, 3M recorded a gain related to the sale of certain personal safety product offerings primarily focused on noise, environmental, and heat stress monitoring, the sale of its polymer additives compounding business, and a gain on final closing adjustments from a prior divestiture which, in aggregate, resulted in a net pre-tax gain of $24 million ($19 million after tax). In the second quarter of 2018, 3M recorded a pre-tax gain of $12 million ($10 million after tax) related to the sale of its abrasive glass products business. In the fourth quarter of 2018, 3M recorded a gain of $2 million related to an earnout from a previous divestiture. Additionally, in 2018, 3M completed the sale of substantially all of its Communication Markets Division and reflected a pre-tax gain of $509 million ($410 million after tax).​Divestiture-related restructuring actions:●In the second quarter 2020, following the divestiture of substantially all of the drug delivery business (see Note 3) management approved and committed to undertake certain restructuring actions addressing corporate functional costs and manufacturing footprint across 3M in relation to the magnitude of amounts previously allocated/burdened to the divested business. As a result, 3M recorded a second quarter 2020 pre-tax charge of $55 million ($46 million after tax) and made a subsequent immaterial adjustment thereto. Refer to Note 5 for further details.23 Table of Contents●During 2018, management approved and committed to undertake certain restructuring actions as further described in Note 5, related to addressing corporate functional costs following the Communication Markets Division divestiture resulting in a 2018 pre-tax charge of $127 million ($110 million after tax), net of adjustments for reductions in cost estimates of $10 million.​Loss on deconsolidation of Venezuelan subsidiary:●In the second quarter of 2019, 3M recorded a pre-tax charge of $162 million related to the deconsolidation of the Company’s Venezuelan subsidiary as further discussed in Note 1.​Measurement period accounting for TCJA:●3M recorded a net tax expense of $176 million in 2018 as a measurement period adjustment to the enactment of the 2017 Tax Cuts and Jobs Act (TCJA). See Note 10 for additional information.​​​​​​​​​​​​​​​​​​​​​​​(Dollars in millions, except per share amounts)​​Operating Income​Operating Income Margin​​Income Before Taxes​​Provision for Income Taxes​Effective Tax Rate​​Net Income Attributable to 3M​​Earnings Per Diluted Share​Earnings per diluted share percent change​Year ended December 31, 2018 GAAP​$ 7,207​ 22.0%$ 7,000​$ 1,637​ 23.4%$ 5,349​$ 8.89​​​Adjustments for special items:​​​​​​​​​​​​​​​​​​​​​​Significant litigation-related charges/benefits​​ 897​​​​ 897​​ 127​​​​ 770​​ 1.28​​​Gain/loss on sale of businesses​​ (547)​​​​ (547)​​ (107)​​​​ (440)​​ (0.73)​​​Divestiture-related restructuring actions​​ 127​​​​ 127​​ 17​​​​ 110​​ 0.18​​​Measurement period accounting for TCJA ​ —​​​​ —​​ (176)​​​​ 176​​ 0.29​​​Year ended December 31, 2018 adjusted amounts (non-GAAP measures)​$ 7,684​ 23.5%$ 7,477​$ 1,498​ 20.0%$ 5,965​$ 9.91​​​​ ​​​​​​​​​​​​​​​​​​​​​Year ended December 31, 2019 GAAP​$ 6,174​ 19.2%$ 5,712​$ 1,130​ 19.8%$ 4,570​$ 7.81​ (12.1)%Adjustments for special items:​​​​​​​​​​​​​​​​​​​​​​Significant litigation-related charges/benefits​​ 762​​​​ 762​​ 172​​​​ 590​​ 1.01​​​Gain/loss on sale of businesses​​ (114)​​​​ (114)​​ 15​​​​ (129)​​ (0.22)​​​Loss on deconsolidation of Venezuelan subsidiary ​ —​​​​ 162​​ —​​​​ 162​​ 0.28​​​Year ended December 31, 2019 adjusted amounts (non-GAAP measures)​$ 6,822​ 21.2%$ 6,522​$ 1,317​ 20.2%$ 5,193​$ 8.88​ (10.4)%​ ​​​​​​​​​​​​​​​​​​​​​Year ended December 31, 2020 GAAP $ 7,161​ 22.3%$ 6,711​$ 1,318​ 19.6%$ 5,384​$ 9.25​ 18.4%Adjustments for special items:​​​​​​​​​​​​​​​​​​​​​​Significant litigation-related charges/benefits​​ 17​​​​ 17​​ 56​​​​ (39)​​ (0.07)​​​Gain/loss on sale of businesses​​ (389)​​​​ (389)​​ (86)​​​​ (303)​​ (0.52)​​​Divestiture-related restructuring actions​​ 55​​​​ 55​​ 9​​​​ 46​​ 0.08​​​Year ended December 31, 2020 adjusted amounts (non-GAAP measures) $ 6,844​ 21.3%$ 6,394​$ 1,297​ 20.3%$ 5,088​$ 8.74​ (1.5)%​​​​24 Table of ContentsYear 2020 sales and operating income by business segment:​The following tables contain sales and operating income results by business segment for the years ended December 31, 2020 and 2019. Refer to the section entitled “Performance by Business Segment” later in MD&A for additional discussion concerning 2020 verses 2019 results, including Corporate and Unallocated. Refer to Note 19 for additional information on business segments, including Elimination of Dual Credit.​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​2020 vs 2019 ​​​2020​2019​% change ​ ​Net % of Oper. Net % of Oper. Net Oper. (Dollars in millions)​​Sales​Total​Income​Sales​Total​Income​Sales​Income Business Segments​​​​​​​​​​​​​​​​​​​​​​Safety and Industrial​​$ 11,767 36.6% $ 3,054​$ 11,514 35.8% $ 2,510 2.2% 21.7%Transportation and Electronics​​ 8,827 27.4​ 1,927​ 9,591 29.8​ 2,221 (8.0)​ (13.3)​Health Care​​ 8,345 25.9​ 1,828​ 7,431 23.1​ 1,858 12.3​ (1.6)​Consumer​​ 5,336 16.6​ 1,249​ 5,151 16.0​ 1,124 3.6​ 11.2​Corporate and Unallocated ​​ (1) —​ (363)​ 110 0.3​ (1,130) —​ —​Elimination of Dual Credit ​​ (2,090) (6.5)​ (534)​ (1,661) (5.0)​ (409) —​ —​Total Company ​​$ 32,184 100.0% $ 7,161​$ 32,136 100.0% $ 6,174 0.1% 16.0%​​​​​​​​​​​​​​​​Year ended December 31, 2020 Worldwide Sales Change​Organic local-​​​​​​​Total sales By Business Segment​currency sales​Acquisitions​Divestitures​Translation​change Safety and Industrial 3.5% —% (0.6)% (0.7) % 2.2%Transportation and Electronics (7.1)​ —​ (1.1)​ 0.2​ (8.0)​Health Care 1.0​ 15.5​ (4.1)​ (0.1)​ 12.3​Consumer 4.1​ —​ —​ (0.5)​ 3.6​Total Company (1.7)% 3.5% (1.4)% (0.3)% 0.1%​​25 Table of ContentsYear 2020 sales results by geographic area/business segment: ​Percent change information compares the year ended December 31, 2020 with the same period last year, unless otherwise indicated. Additional discussion of business segment results is provided in the Performance by Business Segment section.​​​​​​​​​​​​​​​​​​​​Year ended December 31, 2020 ​​​​​​​​Europe,​​​​​​ ​​​​Asia​Middle East​Other​​​ ​ Americas Pacific & Africa Unallocated Worldwide Net sales (millions) $ 16,525 $ 9,569 $ 6,109 $ (19) $ 32,184​% of worldwide sales​ 51.3% 29.7% 19.0% —​ 100.0%Components of net sales change:​​​​​​​​​​​​​​​​Volume — organic​ (1.2)% (2.9)% (4.0)% —​ (2.3)%Price​ 1.0​ (0.5)​ 1.2​ —​ 0.6​Organic local-currency sales​ (0.2)​ (3.4)​ (2.8)​ —​ (1.7)​Acquisitions​ 5.5​ 0.7​ 2.8​ —​ 3.5​Divestitures​ (1.5)​ (0.2)​ (2.9)​ —​ (1.4)​Translation​ (1.3)​ 0.6​ 1.0​ —​ (0.3)​Total sales change​ 2.5% (2.3)% (1.9)% —​ 0.1%​​​​​​​​​​​​​​​​​Total sales change:​​​​​​​​​​​​​​​​Safety and Industrial​​ 2.8%​ (1.4)%​ 4.7%​ —​​ 2.2%Transportation and Electronics​​ (15.4)%​ (2.4)%​ (12.9)%​ —​​ (8.0)%Health Care​​ 20.5%​ (0.8)%​ 3.8%​ —​​ 12.3%Consumer​​ 5.2%​ (1.3)%​ 1.5%​ —​​ 3.6%​​​​​​​​​​​​​​​​​Organic local-currency sales change:​​​​​​​​​​​​​​​​Safety and Industrial​​ 5.0%​ (1.5)%​ 5.6%​ —​​ 3.5%Transportation and Electronics​​ (11.4)%​ (2.8)%​ (13.8)%​ —​​ (7.1)%Health Care​​ 3.9%​ (6.0)%​ 0.2%​ —​​ 1.0%Consumer​​ 6.3%​ (2.2)%​ 0.1%​ —​​ 4.1%​Additional information beyond what is included in the preceding table is as follows:​●In the Americas geographic area, U.S. total sales increased 6 percent and organic-local currency sales increased 1 percent. Total sales in Mexico decreased 14 percent while organic local-currency sales decreased 12 percent. In Canada, total sales decreased 1 percent as organic local-currency sales decreases of 4 percent were partially offset by acquisition-related sales growth. In Brazil, total sales decreased 17 percent while organic local-currency sales increased 7 percent, as organic sales growth was more than offset by foreign currency translation impacts. ●In the Asia Pacific geographic area, China total sales increased 4 percent and organic local-currency sales increased 3 percent. In Japan, total sales decreased 3 percent and organic local currency sales decreased 7 percent. ​Foreign currency translation decreased year-on-year sales by 0.3 percent, while selling prices increased by 0.6 percent year-on-year for 2020, with price growth in EMEA and Americas, while Asia Pacific decreased.​​26 Table of ContentsYear 2019 sales results by geographic area/business segment: ​Percent change information compares the full year 2019 with the full year 2018, unless otherwise indicated. Additional discussion of business segment results is provided in the Performance by Business Segment section.​​​​​​​​​​​​​​​​​​​​Year ended December 31, 2019 ​​​​​​​​Europe,​​​​​​ ​​​​Asia​Middle East​Other​​​ ​ Americas Pacific & Africa Unallocated Worldwide Net sales (millions) $ 16,124 $ 9,796 $ 6,226 $ (10) $ 32,136​% of worldwide sales​ 50.1% 30.5% 19.4% —​ 100.0%Components of net sales change:​​​​​​​​​​​​​​​​Volume — organic​ (1.5)% (2.8)% (2.2)% —​ (2.1)%Price​ 0.8​ (0.1)​ 1.3​ —​ 0.6​Organic local-currency sales​ (0.7)​ (2.9)​ (0.9)​ —​ (1.5)​Acquisitions​ 3.5​ 0.3​ 1.0​ —​ 2.0​Divestitures​ (0.6)​ (0.2)​ (1.9)​ —​ (0.7)​Translation​ (0.6)​ (1.7)​ (4.6)​ —​ (1.7)​Total sales change​ 1.6% (4.5)% (6.4)% —​ (1.9)%​​​​​​​​​​​​​​​​​Total sales change:​​​​​​​​​​​​​​​​Safety and Industrial​​ (5.3)%​ (7.6)%​ (11.0)%​ —​​ (7.2)%Transportation and Electronics​​ (3.8)%​ (5.3)%​ (6.6)%​ —​​ (5.1)%Health Care​​ 15.5%​ 2.5%​ 0.6%​ —​​ 8.9%Consumer​​ 2.2%​ (2.8)%​ (4.6)%​ —​​ 0.5%​​​​​​​​​​​​​​​​​Organic local-currency sales change:​​​​​​​​​​​​​​​​Safety and Industrial​​ (3.3)%​ (4.7)%​ (2.4)%​ —​​ (3.4)%Transportation and Electronics​​ (3.3)%​ (4.1)%​ (2.2)%​ —​​ (3.6)%Health Care​​ 1.1%​ 3.1%​ 1.4%​ —​​ 1.5%Consumer​​ 2.6%​ (1.1)%​ 0.4%​ —​​ 1.7%​Additional information beyond what is included in the preceding table is as follows:●In the Americas geographic area, U.S. total sales increased 2 percent and organic-local currency decreased 1 percent. Total sales remained flat in Mexico, as organic local-currency sales increases of 1 percent were partially offset by lost sales from divested businesses and foreign currency translation impacts. In Canada, total sales and organic local currency increased 3 percent. In Brazil, total sales decreased 4 percent, as organic local-currency sales growth of 3 percent was more than offset by foreign currency translation impacts.●In the Asia Pacific geographic area, China total sales decreased 7 percent and organic local-currency sales decreased 4 percent. In Japan, total sales decreased 2 percent and organic local currency sales decreased 3 percent. ​Foreign currency translation decreased year-on-year sales by 1.7 percent, while selling prices increased by 0.6 percent year-on-year for 2019, with price growth in EMEA and Americas, while Asia Pacific was flat. ​Managing currency risks:The stronger U.S. dollar had a negative impact on sales in full year 2020 compared to the same period last year. Net of the Company’s hedging strategy, foreign currency negatively impacted earnings for full year 2020 compared to the same period last year. 3M utilizes a number of tools to hedge currency risk related to earnings. 3M uses natural hedges such as pricing, productivity, hard currency and hard currency-indexed billings, and localizing source of supply. 3M also uses financial hedges to mitigate currency risk. In the case of more liquid currencies, 3M hedges a portion of its aggregate exposure, using a 12, 24 or 36 month horizon, depending on the currency in question. For less liquid currencies, financial hedging is frequently more expensive with more limitations on tenor. Thus, this risk is largely managed via local operational actions using natural hedging tools as discussed above. In either case, 3M’s hedging approach is 27 Table of Contentsdesigned to mitigate a portion of foreign currency risk and reduce volatility, ultimately allowing time for 3M’s businesses to respond to changes in the marketplace.​Financial condition: ​3M generated $8.1 billion of operating cash flow in 2020, an increase of $1.0 billion when compared to 2019. This increase was primarily due to cost saving actions taken in response to COVID-19 and lower year-on-year significant litigation-related charges and the timing of associated payments. This followed an operating cash flow increase of $631 million when comparing 2019 to 2018. Refer to the section entitled “Financial Condition and Liquidity” later in MD&A for a discussion of items impacting cash flows. ​In November 2018, 3M’s Board of Directors replaced the Company’s February 2016 repurchase program with a new repurchase program. This new program authorizes the repurchase of up to $10 billion of 3M’s outstanding common stock, with no pre-established end date. In 2020, the Company purchased $0.4 billion of its own stock, compared to purchases of $1.4 billion in 2019. As of December 31, 2020, approximately $7.8 billion remained available under the authorization. In the first quarter of 2020, the Company suspended repurchases under its board-approved share repurchase program with other repurchase activity limited to 3M’s stock compensation plans. The Company plans to resume share purchases in 2021. In February 2021, 3M’s Board of Directors declared a first-quarter 2021 dividend of $1.48 per share, an increase of 1 percent. This marked the 63rd consecutive year of dividend increases for 3M. ​Raw materials:​In 2020, the coronavirus (COVID-19) pandemic caused fluctuations in supply markets. Generally, as demand for certain COVID-related products surged, 3M saw a corresponding tightening in supply and some degree of price inflation in associated markets. Within the supply chain of less essential products, 3M experienced raw material price deflation as economies slowed and certain producers scaled back or idled operations. Conversely, as markets re-opened and demand increased, the Company experienced raw material price inflation with some level of stabilization late in the year.​In response, the Company continued to deploy productivity projects to minimize the impact of raw material inflation and market supply challenges, including input management, reformulations, and multi-sourcing activities. Overall, on a consolidated basis, 3M experienced net raw material deflation in 2020. To date, the Company is receiving sufficient quantities of all raw materials to meet its reasonably foreseeable production requirements. It is difficult to predict future shortages of raw materials or the impact any such shortages would have. 3M has avoided disruption to its manufacturing operations through careful management of existing raw material inventories, strategic relationships with key suppliers, and development as well as qualification of additional supply sources. 3M manages spend category price risks through negotiated supply contracts and price protection agreements. In addition, 3M evaluates suppliers’ conformance with environmental and social compliance requirements.​Pension and postretirement defined benefit/contribution plans:​On a worldwide basis, 3M’s pension and postretirement plans were 87 percent funded at year-end 2020. The primary U.S. qualified pension plan, which is approximately 67 percent of the worldwide pension obligation, was 91 percent funded and the international pension plans were 93 percent funded. The U.S. non-qualified pension plan is not funded due to tax considerations and other factors. Asset returns in 2020 for the primary U.S. qualified pension plan were 13.6%, as 3M strategically invests in both growth assets and fixed income matching assets to manage its funded status. For the primary U.S. qualified pension plan, the expected long-term rate of return on an annualized basis for 2021 is 6.50%. The primary U.S. qualified pension plan year-end 2020 discount rate was 2.55%, down 0.70 percentage points from the year-end 2019 discount rate of 3.25%. The decrease in U.S. discount rates resulted in an increased valuation of the projected benefit obligation (PBO). The primary U.S. qualified pension plan’s funded status decreased 1 percentage point in 2020 due to the higher PBO resulting from the discount rate decrease and partially offset by higher return on assets. Additional detail and discussion of international plan asset returns and discount rates is provided in Note 13 (Pension and Postretirement Benefit Plans).​3M expects to contribute approximately $100 million to $200 million of cash to its global defined benefit pension and postretirement plans in 2021. The Company does not have a required minimum cash pension contribution obligation for its U.S. plans in 2021. 3M expects global defined benefit pension and postretirement expense in 2021 to decrease by approximately $40 million pre-tax when 28 Table of Contentscompared to 2020. Refer to “Critical Accounting Estimates” within MD&A and Note 13 (Pension and Postretirement Benefit Plans) for additional information concerning 3M’s pension and post-retirement plans.​RESULTS OF OPERATIONS​Net Sales:​Refer to the preceding “Overview” section and the “Performance by Business Segment” section later in MD&A for additional discussion of sales change.​Operating Expenses:​​​​​​​​​(Percent of net sales)​2020​2019​2020 versus 2019​Cost of sales 51.6% 53.4% (1.8)% Selling, general and administrative expenses (SG&A) 21.5​ 21.9​ (0.4)​Research, development and related expenses (R&D) 5.8​ 5.9​ (0.1)​Gain on sale of businesses​ (1.2)​ (0.4)​ (0.8)​Operating income margin 22.3% 19.2% 3.1% ​Operating income margins increased year over year for 2020. The increase from 2019 to 2020 was primarily driven by lower significant litigation-related charges and higher gains on divestitures (net of divestiture-related restructuring actions) year-on-year. These items are further described in the Certain amounts adjusted for special items - (non-GAAP measures) section above. A number of factors impact the various income statement line items. Expanded discussion of each of the income statement line items follows in the various sections below. ​In 2020 the Company’s operating expenses were impacted by factors described in the preceding Overview – Consideration of COVID-19 section above. ​In 2020 and 2019, 3M approved and committed to certain restructuring actions that impacted cost of sales, SG&A, and R&D (see Note 5 for additional details). In addition to actions related to divestitures (as discussed earlier in the Certain amounts adjusted for special items - (non-GAAP measures) section), for 2020 these included charges to address certain COVID-related impacts and actions to further enhance its operational and marketing capabilities. In 2019, charges included actions in light of slower than expected 2019 sales and associated with realigning its organizational structure and operating model.​Pension and postretirement service cost expense is recorded in cost of sales, SG&A, and R&D. In total, 3M’s defined benefit pension and postretirement service cost expense increased $31 million in 2020. Refer to Note 13 (Pension and Postretirement Plans) for the service cost components of net periodic benefit costs.​The Company is investing in an initiative called business transformation, with these investments impacting cost of sales, SG&A, and R&D. Business transformation encompasses the ongoing multi-year phased implementation of an enterprise resource planning (ERP) system on a worldwide basis, as well as changes in processes and internal/external service delivery across 3M.​Cost of Sales:​Cost of sales includes manufacturing, engineering and freight costs. ​Cost of sales, measured as a percent of sales, decreased during 2020 when compared to 2019. Decreases were related to lower significant litigation-related charges taken in 2020, which were partially offset by 2020 COVID-related net impacts, including period expenses of unabsorbed manufacturing costs, in addition to higher restructuring action charges taken in 2020 along with certain related follow-on accelerated depreciation. In addition, selling prices increased year-on-year by 0.6 percent for full year 2020, and lower raw material costs reduced cost of sales as a percentage of sales.​​29 Table of ContentsSelling, General and Administrative Expenses:​SG&A in dollars decreased slightly in 2020 when compared to 2019. The decrease was driven by cost saving actions taken in response to COVID-19, in addition to benefits from prior year restructuring (and adjustments thereto in 2020). Additional factors that decreased SG&A in 2020 also include lower year-on-year impact related to significant litigation-related charges. In terms of SG&A as a percent of sales, partially offsetting these decreases was the overall effect of the COVID-19 pandemic on sales that resulted in higher costs as a percent of sales. SG&A was also impacted by increased spending year-on-year related to Acelity, which was acquired in the fourth quarter of 2019.​Research, Development and Related Expenses: ​R&D in dollars decreased slightly in 2020 when compared to 2019 and remained relatively consistent as a percent of sales at 5.8% in 2020 compared to 5.9% in 2019. 3M continued to invest in its key initiatives, including R&D aimed at disruptive innovation programs with the potential to create entirely new markets and disrupt existing markets. Incremental R&D spending in 2020 included activities related to the Acelity business acquired in the fourth quarter of 2019. 3M also experienced lower year-on-year restructuring activities impacting R&D.​Gain on Sale of Businesses:​During the first quarter of 2020, the Company recorded a pre-tax gain of $2 million ($1 million loss after tax) related to the sale of its advanced ballistic-protection business and recognition of certain contingent consideration. During the second quarter of 2020, the Company recorded a pre-tax gain of $387 million ($304 after tax) related to the sale of substantially all of its drug delivery business. ​During the first quarter of 2019, the Company sold certain oral care technology comprising a business and reflected an earnout on a previous divestiture resulting in a pre-tax gain of $8 million ($7 million gain after tax). In the third quarter of 2019, 3M recorded a gain related to the divestiture of the Company’s gas and flame detection business and an immaterial impact as a result of measuring a disposal group at the lower of its carrying amount or fair value less cost to sell, which in aggregate resulted in a pre-tax gain of $106 million ($79 million after tax). Refer to Note 3 for additional details on divestitures.​Operating Income Margin:​3M uses operating income as one of its primary business segment performance measurement tools. Refer to the table below for a reconciliation of operating income margins for 2020 and 2019.​​​​​​​​​Year ended December 31, ​(Percent of net sales) 2020​2019​Same period last year​ 19.2% 22.0%Significant litigation-related charges/benefits​ 2.4​ 2.7​Gain/loss on sale of businesses​ (0.4)​ (1.6)​Divestiture-related restructuring actions​ —​ 0.4​Same period last year, excluding special items​ 21.2% 23.5%Increase/(decrease) in operating income margin, due to:​​​​​Organic volume/productivity and other​ (0.1)​ (1.7)​Non divestiture-related restructuring actions​ 0.2​ (0.8)​Acquisitions/divestitures​ (0.5)​ (0.6)​Selling price and raw material impact​ 0.7​ 0.4​Foreign exchange impacts​ (0.2)​ 0.4​Current period, excluding special items​ 21.3% 21.2%Significant litigation-related charges/benefits​ —​ (2.4)​Gain/loss on sale of businesses​ 1.2​ 0.4​Divestiture-related restructuring actions​ (0.2)​ —​Current period​ 22.3% 19.2%​30 Table of Contents​Year 2020 operating income:​Operating income margins increased 3.1 percentage points in 2020 when compared to 2019. Factoring out the impact on operating income of special items as described in the Certain amounts adjusted for special items – (non-GAAP measures) section above, operating margins increased 0.1 percentage points to 21.3 percent in 2020 when compared to 2019. ​Additional discussion related to the components of the year-on-year change in operating income margins follows:​Organic volume/productivity and other:●Lower organic volume growth in 2020 as a result of significant COVID-19 related impacts, in addition to COVID-related net factors described in the preceding Overview—Consideration of COVID-19 section, decreased operating income margins year-on-year. 3M also experienced year-over-year increased costs as a result of the regular review of its respirator mask liabilities and certain follow-on accelerated depreciation following some of the restructuring described below. Partially offsetting this net decrease were year-on-year net gains related to certain property sales (in 2020 with Safety and Industrial and in 2019 within Corporate and Unallocated) in addition to benefits recognized in 2020 related to the restructuring and other actions taken in 2019 (and the adjustments thereto in 2020) along with continued cost management and productivity efforts.●Operating income margins decreased year-on-year due to higher defined benefit pension and postretirement service cost expense.​Non divestiture-related restructuring actions:●3M recorded non divestiture-related restructuring charges that impacted operating income aggregating $195 million in 2020. These included charges in the second quarter of 2020 to address certain COVID-related impacts and in the fourth quarter as 3M initiated actions to further enhance its operational and marketing capabilities. In 2019, charges included $246 million impacting operating income (and $36 million impacting other expense (income)) as the Company committed to actions in light of slower than expected 2019 sales and associated with realigning its organizational structure and operating model. See Note 5 for additional details. ●The year-on-year impact of the non divestiture-related restructuring charges taken in 2020 and 2019 increased operating income margins.​Acquisitions/divestitures:●Acquisition-related impacts relate to the ongoing integration of M*Modal and Acelity, which decreased operating income margins year-on-year.●Divestiture impacts, which includes lost operating income from divested businesses, increased operating income margins year-on-year.​Selling price and raw material impact:●Higher selling prices in addition to lower raw material cost impacts benefited operating income margins year-on-year for 2020.​Foreign exchange impacts:●Foreign currency effects (net of hedge gains) decreased operating income margins year-on-year.​Significant litigation-related charges:●Operating income margins for 2020 and 2019 included the $17 million and $762 million impact, respectively, of significant litigation-related charges (as discussed earlier in the Certain amounts adjusted for special items - (non-GAAP measures) section).​Gain/loss on sale of businesses:●2020 and 2019 included gains of $389 million and $114 million, respectively, on sale of businesses. See the Certain amounts adjusted for special items - (non-GAAP measures) section for more information.​31 Table of ContentsDivestiture-related restructuring actions:●Operating income margins for full year 2020 included the $55 million second quarter impact as a result of certain restructuring actions following the divestiture of substantially all of the drug delivery business addressing corporate functional costs and manufacturing footprint across 3M in relation to the magnitude of amounts previously allocated/burdened to the divested business. Refer to Note 5 for further details. This item was also discussed earlier in the Certain amounts adjusted for special items - (non-GAAP measures) section.​Year 2019 operating income:​Operating income margins decreased 2.8 percentage points for the full year 2019 when compared to full year 2018. Factoring out the impact on operating income of special items as described in the Certain amounts adjusted for special items – (non-GAAP measures) section above, operating margins decreased 2.3 percentage points to 21.2 percent in 2019 when compared to 2018.​Organic volume/productivity and other: ●Negative organic local sales volume growth as a result of softness in certain end markets and channel inventory adjustments, along with actions taken by 3M in response to lower sales volumes and high inventory levels, which resulted in lower manufacturing and inventory absorption, reduced operating margins. Partially offsetting these impacts were benefits from restructuring actions taken in the second quarter of 2019.●Operating income margins increased year-on-year due to lower defined benefit pension and postretirement service cost expense.​Non divestiture-related restructuring actions:●During the second quarter of 2019, in light of slower than expected 2019 sales, and additionally in the fourth quarter to realign 3M’s organizational structure and operating model, management approved and committed to undertake certain restructuring actions. The resulting charges included $246 million impacting operating income (and $36 million impacting other expense (income)). See Note 5 for additional details.​Acquisitions/divestitures: ●Acquisition-related impacts relate to the on-going integration of M*Modal and Acelity, which decreased operating income margins year-on-year. ●Divestiture impacts include the lost operating income from divested businesses, which increased operating income margins year-on-year and primarily relate to the divestiture of the Communication Markets Division. ●Remaining stranded costs from the 2018 divestiture of the Communication Markets Division also reduced operating margins year-on-year.​Selling price and raw material impact: ●Higher selling prices, partially offset by raw material cost increases, benefited operating income margins year-on-year for 2019.​Foreign exchange impacts: ●Foreign currency effects (net of hedge gains) increased operating income margins year-on-year. ​Significant litigation-related charges: ●Operating income margins for 2018 and 2019 included the $897 million and $762 million impact, respectively, of significant litigation-related charges (as discussed earlier in the Certain amounts adjusted special items - (non-GAAP measures) section.​Other Expense (Income), Net:​See Note 6 for a detailed breakout of this line item.​The decrease in other expense (income) during 2020 was primarily due to the 2019 impact of deconsolidation of the Company’s Venezuelan subsidiary. Refer to Note 1 for additional details. ​32 Table of ContentsInterest expense (net of interest income) increased during 2020 and 2019. The increase in 2020 was due to higher U.S. average debt balances and lower year-on-year interest income driven by lower average interest rates on cash balances. 2020 interest expense also included an early debt extinguishment charge in conjunction with the repayment of notes in December 2020. The increase in 2019 was driven by higher U.S. average debt balances, partially offset by the year-on-year increase in interest income driven by higher balances in cash, cash equivalents and marketable securities during the year resulting from the proceeds from debt issuances in advance of the October 2019 Acelity acquisition. ​In addition, other expense (income) was impacted by lower year-on-year pension and postretirement net periodic benefit non-service benefits for 2020 and 2019, respectively. The lower year-on-year benefit in 2020 was primarily due to the increased expense from lower December 31, 2019 discount rates. The decreases in 2019 was primarily due to the charge associated with the voluntary retirement program taken in the second quarter of 2019 in addition to the pension settlement charges in the fourth quarter of 2019 related to employee retirements. Refer to Note 13 for additional details. ​Provision for Income Taxes:​​​​​​(Percent of pre-tax income)​2020 2019 Effective tax rate ​ 19.6% 19.8% ​The effective tax rate for 2020 was 19.6 percent, a decrease of 0.2 percentage points when compared to 2019. The effective tax rate for 2019 was 19.8 percent, compared to 23.4 percent in 2018, a decrease of 3.6 percentage points. Factors that impacted the tax rates between years are further discussed in the Overview section above and in Note 10.​3M currently estimates its effective tax rate for 2021 will be approximately 20 to 21 percent. ​The tax rate can vary from quarter to quarter due to discrete items, such as the settlement of income tax audits, changes in tax laws, and employee share-based payment accounting; as well as recurring factors, such as the geographic mix of income before taxes. Refer to Note 10 for further discussion of income taxes.​Income from Unconsolidated Subsidiaries, Net of Taxes: ​​​​​​​​(Millions) 2020 2019Income (loss) from unconsolidated subsidiaries, net of taxes​$ (5)​$ —​Income (loss) from unconsolidated subsidiaries, net of taxes, is primarily attributable to the Company’s ownership interest in Kindeva using the equity method of accounting following 3M’s divestiture of the drug delivery business in 2020. See Note 3 for further discussion. ​Net Income Attributable to Noncontrolling Interest:​​​​​​​​​(Millions) 2020 2019 Net income (loss) attributable to noncontrolling interest ​$ 4​$ 12​​Net income (loss) attributable to noncontrolling interest represents the elimination of the income or loss attributable to non-3M ownership interests in 3M consolidated entities. The primary noncontrolling interest relates to 3M India Limited, of which 3M’s effective ownership is 75 percent.​Currency Effects:​3M estimates that year-on-year currency effects, including hedging impacts, decreased pre-tax income by $81 million in 2020 and increased pre-tax income by $1 million in 2019. This estimate includes the effect of translating profits from local currencies into U.S. dollars; the impact of currency fluctuations on the transfer of goods between 3M operations in the United States and abroad; and transaction gains and losses, including derivative instruments designed to reduce foreign currency exchange rate risks. 3M estimates that year-on-year foreign currency transaction effects, including hedging impacts, decreased pre-tax income by approximately $21 million in 2020 and increased pre-tax income by approximately $201 million in 2019. These estimates include transaction gains and 33 Table of Contentslosses, including derivative instruments designed to reduce foreign currency exchange rate risks. Refer to Note 14 in the Consolidated Financial Statements for additional information concerning 3M’s hedging activities. ​PERFORMANCE BY BUSINESS SEGMENT​Item 1, Business Segments, provides an overview of 3M’s business segments. In addition, disclosures relating to 3M’s business segments are provided in Note 19. Effective in the first quarter of 2020, the Company changed its business segment reporting in its continuing effort to improve the alignment of businesses around markets. Also, effective in the second quarter of 2020, the measure of segment operating performance used by 3M’s chief operating decision maker (CODM) changed and, as a result, 3M’s disclosed measure of segment profit/loss (business segment operating income) has been updated for all periods presented. The change to business segment operating income aligns with the update to how the CODM assesses performance and allocates resources for the Company’s business segments.​As discussed in Note 19, 3M discloses business segment operating income as its measure of segment profit/loss, reconciled to both total 3M operating income and income before taxes. Business segment operating income includes dual credit for certain related operating income (as described below in “Elimination of Dual Credit”). Business segment operating income excludes certain expenses and income that are not allocated to business segments (as described below in “Corporate and Unallocated”). Additionally, the following special items are excluded from business segment operating income and, instead, are included within Corporate and Unallocated: significant litigation-related charges/benefits, gain/loss on sale of businesses, and divestiture-related restructuring actions. ​Information provided herein reflects the impact of these changes for all periods presented. 3M manages its operations in four business segments. The reportable segments are Safety and Industrial; Transportation and Electronics; Health Care; and Consumer.​Corporate and Unallocated:​In addition to these four business segments, 3M assigns certain costs to “Corporate and Unallocated,” which is presented separately in the preceding business segments table and in Note 19. Corporate and Unallocated includes a variety of miscellaneous items, such as corporate investment gains and losses, certain derivative gains and losses, certain insurance-related gains and losses, certain litigation and environmental expenses, corporate restructuring charges and certain under- or over-absorbed costs (e.g. pension, stock-based compensation) that the Company determines not to allocate directly to its business segments. Additionally, Corporate and Unallocated operating income includes special items such as significant litigation-related charges/benefits, gain/loss on sale of businesses, and divestiture-related restructuring costs. Corporate and Unallocated also includes sales, costs, and income from contract manufacturing, transition services and other arrangements with the acquirer of the Communication Markets Division following its 2018 divestiture through 2019 and the acquirer of the former drug delivery business following its 2020 divestiture. Because this category includes a variety of miscellaneous items, it is subject to fluctuation on a quarterly and annual basis.​Corporate and Unallocated net operating loss decreased by $767 million in 2020 when compared to 2019. ​Special ItemsRefer to the Certain amounts adjusted for special items - (non-GAAP measures) section and Note 5 for additional details on the impact of significant litigation-related charges/benefits, gain/loss on sale of businesses, and divestiture-related restructuring actions that are reflected in Corporate and Unallocated. ​Other Corporate Expense - NetOther corporate operating expenses increased in 2020. The increases were due to year-over-year increased net costs as a result of the regular review of 3M’s respirator mask liabilities, lower year-on-year gains from certain property sales reflected in Corporate and Unallocated, in addition to transition service and other arrangement costs, net of income, post-divestiture of the Company’s former drug delivery business in 2020, and increased legal expenses. These increases were partially offset by lower year-on-year non divestiture-related restructuring costs reflected in Corporate and Unallocated. ​34 Table of ContentsOperating Business Segments:​Information related to 3M’s business segments is presented in the tables that follow. Organic local-currency sales include both organic volume impacts plus selling price impacts. Acquisition impacts, if any, are measured separately for the first twelve months post-transaction. The divestiture impacts, if any, foreign currency translation impacts and total sales change are also provided for each business segment. Any references to EMEA relate to Europe, Middle East and Africa on a combined basis.​The following discusses total year results for 2020 compared to 2019 and 2019 compared to 2018, for each business segment. Refer to the preceding “Sales and operating income by geographic area” section for organic local-currency sales growth by business segment within major geographic areas.​Safety and Industrial Business (36.6% of consolidated sales):​​​​​​​​​​2020 2019 Sales (millions) ​$ 11,767​$ 11,514​Sales change analysis:​​​​​​​Organic local-currency​ 3.5% (3.4)% Divestitures​​ (0.6)​​ (1.7)​Translation ​ (0.7)​ (2.1)​Total sales change ​ 2.2% (7.2)% ​​​​​​​​Business segment operating income (millions) ​$ 3,054​$ 2,510​Percent change ​ 21.7% (12.2)% Percent of sales ​ 26.0% 21.8% ​Year 2020 results: ​Sales in Safety and Industrial totaled $11.8 billion, an increase of 2.2 percent compared to the same period last year. Organic local-currency sales increased 3.5 percent, divestitures decreased sales by 0.6 percent, and foreign currency translation decreased sales by 0.7 percent.​On an organic local-currency sales basis:●Sales increased in personal safety and roofing granules, while industrial adhesives and tapes, electrical markets, closure and masking systems, automotive aftermarket, and abrasives sales declined year-on-year.●Strong growth related to unprecedented demand for respirators as a result of the COVID-19 pandemic was partially offset by softness that impacted sales growth across most of the Company’s general industrial-related portfolio. ​Divestitures:●2018 divestitures that impacted 2019 results relate to the sale of certain personal safety product offerings primarily focused on noise, environmental, and heat stress monitoring (first quarter 2018), and it’s abrasives glass products business (second quarter of 2018).●Also in 2018, 3M completed the sale of substantially all of its Communication Markets Division.●In August 2019, 3M completed the sale of its gas and flame detection business.​Business segment operating income:●Business segment operating income margins increased 4.2 percentage points, primarily related to strong productivity, continued cost discipline and benefits from certain property sale, 2019 restructuring and other actions.​​35 Table of ContentsYear 2019 results: ​Sales in Safety and Industrial totaled $11.5 billion, down 7.2 percent in U.S. dollars, compared to full year 2018. Organic local-currency sales decreased 3.4 percent, divestitures decreased sales by 1.7 percent, and foreign currency translation decreased sales by 2.1 percent.​On an organic local-currency sales basis:●Sales increased in roofing granules and personal safety, while electrical markets, industrial adhesives and tapes, abrasives, automotive aftermarket, and closure and masking systems declined year-on-year.​Divestitures:●In February 2018, 3M closed on the sale of certain personal safety product offerings primarily focused on noise, environmental, and heat stress monitoring.●In May 2018, 3M divested an abrasives glass products business.●In 2018, 3M completed the sale of substantially all of its Communication Markets Division.●In August 2019, 3M completed the sale of its gas and flame detection business.​Business segment operating income:●Operating income margins decreased 1.2 percentage points, primarily related to sales declines, particularly in Asia Pacific and the U.S, in addition to inventory reductions and restructuring impacts.​Transportation and Electronics Business (27.4% of consolidated sales):​​​​​​​​​​ 2020 2019 Sales (millions) ​$ 8,827​$ 9,591​Sales change analysis:​​​​​​​Organic local-currency​ (7.1)% (3.6)% Divestitures​​ (1.1)​​ —​Translation ​ 0.2​ (1.5)​Total sales change ​ (8.0)% (5.1)% ​​​​​​​​Business segment operating income (millions) ​$ 1,927​$ 2,221​Percent change ​ (13.3)% (16.0)% Percent of sales ​ 21.8% 23.2% ​Year 2020 results: ​Sales in Transportation and Electronics totaled $8.8 billion, down 8.0 percent in U.S. dollars. Organic local-currency sales decreased 7.1 percent, divestitures decreased sales by 1.1 percent, and foreign currency translation increased sales by 0.2 percent.​On an organic local-currency sales basis:●Sales declined in transportation safety, advanced materials, commercial solutions, and automotive and aerospace. Automotive and aerospace was primarily impacted by the decline in global car and light truck builds. Commercial solutions and transportation safety were impacted by soft-end markets such as hospitality, advertising and highway infrastructure due to social distancing and work-from-home protocols as a result of COVID-19.●Sales increased in 3M’s electronics-related businesses. Electronics-related growth was led by demand for semiconductor, data center, and factory automation end-markets, and was partially offset by softness in the consumer electronics end-market.​Divestitures:●In January 2020, 3M completed the sale of its advanced ballistic-protection business. Refer to Note 3 for details.​​36 Table of ContentsBusiness segment operating income:●Business segment operating income margins decreased 1.4 percentage points, primarily related to lower sales and reduced productivity in key end-markets due to COVID-19 related impacts, partially offset by continued cost discipline and benefits from last year’s restructuring actions.​Year 2019 results: ​Sales in Transportation and Electronics totaled $9.6 billion, down 5.1 percent in U.S. dollars. Organic local-currency sales decreased 3.6 percent, and foreign currency translation decreased sales by 1.5 percent.​On an organic local-currency sales basis:●Sales increased in advanced materials and transportation safety, while commercial solutions and automotive and aerospace solutions declined.●Automotive and aerospace was impacted by the decline in global car and light truck builds along with channel inventory reductions within its Automotive OEM business, particularly in China.●Sales decreased 6 percent in 3M’s electronics-related businesses, with decreases in both display materials and systems and electronics materials solutions. Electronics-related growth was impacted by soft consumer electronics and factory automation end markets in addition to channel inventory adjustments.●Sales decreased 4 percent in Asia Pacific, where 3M’s electronics business is concentrated.​Business segment operating income:●Operating income margins decreased 3.0 percentage points, primarily impacted by continued sales declines, particularly in Asia Pacific and the U.S, in addition to inventory reductions. Operating income margins were also impacted by the restructuring charges initiated in 2019.​Health Care Business (25.9% of consolidated sales):​​​​​​​​​ 2020 2019 Sales (millions) ​$ 8,345​$ 7,431​Sales change analysis:​​​​​​​Organic local-currency​ 1.0% 1.5% Acquisitions ​ 15.5​ 9.4​Divestitures​​ (4.1)​​ —​Translation ​ (0.1)​ (2.0)​Total sales change ​ 12.3% 8.9% ​​​​​​​​Business segment operating income (millions) ​$ 1,828​$ 1,858​Percent change ​ (1.6)% (3.1)% Percent of sales ​ 21.9% 25.0% ​Year 2020 results: ​Sales in Health Care totaled $8.3 billion, up 12.3 percent in U.S. dollars. Organic local-currency sales increased 1.0 percent, acquisitions increased sales by 15.5 percent, divestitures decreased sales by 4.1 percent, and foreign currency translation decreased sales by 0.1 percent.​On an organic local-currency sales basis:●Sales increased in medical solutions, separation and purification sciences, and food safety, while sales decreased in health information systems and oral care.●Increases in healthcare volumes benefited both medical solutions and oral care after significant disruptions in the second quarter, with strong pandemic-related demand for disposable respirators resulting in increased sales for medical solutions, while oral care sales decreased year-on-year. In addition, health information systems decreased due to hospitals remaining cautious relative to their information technology investments.​37 Table of ContentsAcquisitions:●In February 2019, 3M acquired M*Modal, a leading healthcare technology provider of cloud-based, conversational artificial intelligence-powered systems that help physicians efficiently capture and improve the patient narrative.●In October 2019, 3M completed the acquisition of Acelity Inc. and its KCI subsidiaries, a leading global medical technology company focused on advanced wound care and specialty surgical applications.​Divestitures:●In the first quarter of 2019, the Company sold certain oral care technology comprising a business.●In May 2020, 3M completed the sale of substantially all of its drug delivery business.​Business segment operating income:●Operating income margins decreased 3.1 percentage points year-on-year, driven by impacts related to the Acelity acquisition in addition to significant sales declines in oral care during the second quarter of 2020, partially offset by continued cost discipline and benefits from 2019 restructuring and other costs. ​Year 2019 results:​Sales in Health Care totaled $7.4 billion, up 8.9 percent in U.S. dollars. Organic local-currency sales increased 1.5 percent, acquisitions increased sales 9.4 percent, and foreign currency translation decreased sales by 2.0 percent.​On an organic local-currency sales basis:●Sales increased in health information systems, food safety, and medical solutions, while separation and purification sciences decreased, and oral care was flat. ●Drug delivery declined year-on-year, as continued softness in the business negatively impacted overall Health Care organic growth.​Acquisitions:●In February 2019, 3M acquired M*Modal, a leading healthcare technology provider of cloud-based, conversational artificial intelligence-powered systems that help physicians efficiently capture and improve the patient narrative.●In October 2019, 3M completed the acquisition of Acelity Inc. and its KCI subsidiaries, a leading global medical technology company focused on advanced wound care and specialty surgical applications. ​Divestitures:●In the first quarter of 2018, 3M completed the sale of its polymer additives compounding business.●In the first quarter of 2019, the Company sold certain oral care technology comprising a business.​Business segment operating income:●Operating income margins decreased 3.1 percentage points year-on-year.​​38 Table of ContentsConsumer Business (16.6% of consolidated sales):​​​​​​​​​​ 2020 2019 Sales (millions) ​$ 5,336​$ 5,151​Sales change analysis:​​​​​​​Organic local-currency​ 4.1% 1.7% Translation ​ (0.5)​ (1.2)​Total sales change ​ 3.6% 0.5% ​​​​​​​​Business segment operating income (millions) ​$ 1,249​$ 1,124​Percent change ​ 11.2% 3.7% Percent of sales ​ 23.4% 21.8% ​Year 2020 results: ​Sales in Consumer totaled $5.3 billion, an increase of 3.6 percent in U.S. dollars. Organic local-currency sales increased 4.1 percent and foreign currency translation decreased sales by 0.5 percent.​On an organic local-currency sales basis:●Sales grew in home improvement and home care, while consumer health care and stationery and office declined.●Stationery and office declined year-on-year as a result of many business offices and schools remaining partially or fully closed due to the pandemic.●Sales showed continued strength in the Company’s CommandTM, FiltreteTM, Scotch BlueTM, Scotch BriteTM, and MeguiarsTM brands.​Business segment operating income:●Operating income margins increased 1.6 percentage points year-on-year as a result of strong organic sales growth and continued cost discipline.​Year 2019 results:​Sales in Consumer totaled $5.2 billion, an increase of 0.5 percent in U.S. dollars. Organic local-currency sales increased 1.7 percent and foreign currency translation decreased sales by 1.2 percent.​On an organic local-currency sales basis:●Sales grew in home improvement, while home care and stationery and office were flat. Consumer health care decreased year on year. ●Geographically, the U.S. showed particular strength in the Company’s FiltreteTM and CommandTM brands, while Asia Pacific was impacted by lower consumer demand for respiratory solutions.​Business segment operating income:●Operating income margins increased 0.7 percentage points year-on-year. Increases in operating income margins were primarily due to benefits from portfolio and footprint actions taken, partially offset by the restructuring charges initiated in 2019. ​PERFORMANCE BY GEOGRAPHIC AREA​While 3M manages its businesses globally and believes its business segment results are the most relevant measure of performance, the Company also utilizes geographic area data as a secondary performance measure. Export sales are generally reported within the geographic area where the final sales to 3M customers are made. A portion of the products or components sold by 3M’s operations to its customers are exported by these customers to different geographic areas. As customers move their operations from one geographic area to another, 3M’s results will follow. Thus, net sales in a particular geographic area are not indicative of end-user consumption in that geographic area. Financial information related to 3M operations in various geographic areas is provided in Note 2 and Note 19.​39 Table of ContentsRefer to the “Overview” section for a summary of net sales by geographic area and business segment.​Geographic Area Supplemental Information​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​Property, Plant and ​​​​​​​​​​​​​​​​​Equipment - net ​​ Employees as of December 31, ​Capital Spending​ as of December 31, (Millions, except Employees) 2020 2019 2018 2020 2019 2018 2020 2019 Americas 56,042 56,027 53,661​$ 943​$ 1,218​$ 1,044​$ 5,752​$ 5,873​Asia Pacific 18,271 18,724 18,971​ 235​ 241​ 238​ 1,662​ 1,637​Europe, Middle East and Africa 20,674 21,412 20,884​ 323​ 240​ 295​ 2,007​ 1,823​Total Company 94,987 96,163 93,516​$ 1,501​$ 1,699​$ 1,577​$ 9,421​$ 9,333​​Employment:​Employment decreased by approximately 1,200 positions in 2020 and increased by approximately 2,600 positions in 2019. The above table includes the impact of acquisitions (which involved approximately 5,500 positions in 2019), net of divestitures and other actions. ​Capital Spending/Net Property, Plant and Equipment:​Investments in property, plant and equipment enable growth across many diverse markets, helping to meet product demand and increasing manufacturing efficiency. In 2020, 63 percent of 3M’s capital spending was within the Americas, followed by Europe, Middle East and Africa, and Asia Pacific. 3M is increasing its investment in manufacturing and sourcing capability in order to more closely align its product capability with its sales in major geographic areas in order to best serve its customers throughout the world with proprietary, automated, efficient, safe and sustainable processes. Capital spending is discussed in more detail later in MD&A in the section entitled “Cash Flows from Investing Activities.”​​CRITICAL ACCOUNTING ESTIMATES​Information regarding significant accounting policies is included in Note 1 of the consolidated financial statements. As stated in Note 1, the preparation of financial statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue and expenses, and related disclosure of contingent assets and liabilities. Management bases its estimates on historical experience and on various assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates.​The Company believes its most critical accounting estimates relate to legal proceedings, pension and postretirement obligations, goodwill and certain long-lived assets, and uncertainty in income tax positions. Senior management has discussed the development, selection and disclosure of its critical accounting estimates with the Audit Committee of 3M’s Board of Directors.​Legal Proceedings:​Assessments of lawsuits and claims can involve a series of complex judgments about future events and can rely heavily on estimates and assumptions. The Company accrues an estimated liability for legal proceeding claims that are both probable and estimable in accordance with Accounting Standard Codification (ASC) 450, Contingencies. Please refer to the section entitled “Process for Disclosure and Recording of Liabilities Related to Legal Proceedings” (contained in “Legal Proceedings” in Note 16) for additional information about such estimates.​Pension and Postretirement Obligations:​The Company makes certain estimates and judgements in relation to its defined benefit pension and postretirement obligations. ​The benefit obligation represents the present value of the benefits that employees are entitled to in the future for services already rendered as of the measurement date. The Company measures the present value of these future benefits by projecting benefit payment cash flows for each future period and discounting these cash flows back to the December 31 measurement date, using the yields of a 40 Table of Contentsportfolio of high quality, fixed-income debt instruments that would produce cash flows sufficient in timing and amount to settle projected future benefits. Service cost and interest cost are measured separately using the spot yield curve approach applied to each corresponding obligation. Service costs are determined based on duration-specific spot rates applied to the service cost cash flows. The interest cost calculation is determined by applying duration-specific spot rates to the year-by-year projected benefit payments. The spot yield curve approach does not affect the measurement of the total benefit obligations as the change in service and interest costs offset in the actuarial gains and losses recorded in other comprehensive income.​Using this methodology, the Company determined discount rates for its plans as follow:​​​​​​​​​​U.S. Qualified Pension International Pension (weighted average) U.S. Postretirement Medical​December 31, 2020 Liability:​​​​​​​Benefit obligation​ 2.55% 1.38% 2.35%2021 Net Periodic Benefit Cost Components:​​​​​​​Service cost​ 2.84% 1.23% 2.71%Interest cost​ 1.93% 1.13% 1.68%​Another significant element in determining the Company’s pension expense is the expected return on plan assets. The expected return on plan assets for the primary U.S. qualified pension plan is based on strategic asset allocation of the plan, long-term capital market return expectations, and expected performance from active investment management. For the primary U.S. qualified pension plan, the expected long-term rate of return on an annualized basis for 2021 is 6.50%, a decrease from 6.75% in 2020. Return on assets assumptions for international pension and other post-retirement benefit plans are calculated on a plan-by-plan basis using plan asset allocations and expected long-term rate of return assumptions. The weighted average expected return for the international pension plans is 4.36% for 2021 compared to 4.70% for 2020. Refer to Note 13 for information on how the 2020 rates were determined.​3M follows ASC 820, Fair Value Measurements and Disclosures in determining the fair value of plan assets within the Company’s pension and postretirement benefit plans. While the Company believes the valuation methods used to determine the fair value of plan assets are appropriate and consistent with other market participants, the use of different methodologies or assumptions to determine the fair value of certain financial instruments could result in a different estimate of fair value at the reporting date. See Note 13 for additional discussion of actuarial assumptions used in determining defined benefit pension and postretirement health care liabilities and expenses.​For the year ended December 31, 2020, the Company recognized consolidated defined benefit pre-tax pension and postretirement service cost expense of $456 million and a benefit of $50 million related to all non-service pension and postretirement net benefit costs (after settlements, curtailments, special termination benefits and other) for a total consolidated defined benefit pre-tax pension and postretirement expense of $406 million, up from $357 million in 2019. ​In 2021, defined benefit pension and postretirement service cost expense is anticipated to total approximately $497 million while non-service pension and postretirement net benefit costs is anticipated to be a benefit of approximately $130 million, for a total consolidated defined benefit pre-tax pension and postretirement expense of $367 million, a decrease of approximately $40 million compared to 2020.​The table below summarizes the impact on 2021 pension expense for the U.S. and international pension plans of a 0.25 percentage point increase/decrease in the expected long-term rate of return on plan assets and discount rate assumptions used to measure plan liabilities and 2020 net periodic benefit cost. The table assumes all other factors are held constant, including the slope of the discount rate yield curves.​​​​​​​​​​​​​​​​​Increase (Decrease) in Net Periodic Benefit Cost​​​Discount Rate​Expected Return on Assets (Millions) -0.25% +0.25% -0.25% +0.25% U.S. pension plans​$ 34​$ (34)​$ 39​$ (39)​International pension plans​ 27​ (28)​ 21​ (17)​​41 Table of ContentsGoodwill and Certain Long-Lived Assets:​The Company makes certain estimates and judgments in relation to goodwill and certain long-lived assets. Those include considerations made in the valuation of certain acquired identifiable definite-lived and indefinite-lived assets as a result of business combinations as well as considerations in the recoverability and impairment assessments of long-lived assets and goodwill.​Acquisition of certain identifiable definite-lived and indefinite-lived assets​In conjunction with an acquisition of a business, the Company records identifiable definite-lived and indefinite-lived intangible assets acquired at their respective fair values as of the date of acquisition. The corresponding fair value estimates for these assets acquired include projected future cash flows, associated discount rates used to calculate present value, asset life cycles, royalty rates, and customer retention rates. The fair value calculated for indefinite-lived intangible assets such as certain tradenames, in addition to intangible assets that are definite-lived such as patents, customer relationships, tradenames and other technology-based assets may change during the finalization of the purchase price allocation, due to the significant estimates used in determining their fair value. As a result, the Company may make adjustments to the provisional amounts recorded for certain items as part of the purchase price allocation subsequent to the acquisition, not to exceed one year after the acquisition date, until the purchase accounting allocation is finalized.​Assessments of long-lived assets and goodwill​As of December 31, 2020, net property, plant and equipment totaled $9.4 billion and net identifiable intangible assets totaled $5.8 billion, of which $0.7 billion related to indefinite-lived tradenames. In addition, 3M goodwill totaled approximately $13.8 billion as of December 31, 2020. Long-lived assets with a definite life are tested for impairment whenever events or circumstances indicate that the carrying amount of an asset (asset group) may not be recoverable. An impairment loss is recognized when the carrying amount exceeds the estimated undiscounted cash flows from the asset’s or asset group’s ongoing use and eventual disposition. If an impairment is identified, the amount of the impairment loss recorded is calculated by the excess of the asset’s carrying value over its fair value. Fair value is generally determined using a discounted cash flow analysis. Intangible assets with an indefinite life, namely certain tradenames, are not amortized. Indefinite-lived intangible assets are tested for impairment annually and are tested for impairment between annual tests if an event occurs or circumstances change that would indicate that the carrying amount may be impaired. An impairment loss would be recognized when the fair value is less than the carrying value of the indefinite-lived intangible asset. Goodwill is tested for impairment annually in the fourth quarter of each year, as further discussed below, and is tested between annual tests if an event occurs or circumstances change that would indicate the carrying amount may be impaired. If future non-cash asset impairment charges are taken, 3M would expect that only a portion of the long-lived assets or goodwill would be impaired. Management makes estimates and assumptions in preparing the consolidated financial statements for which actual results will emerge over long periods of time. This includes the recoverability of long-lived assets employed in the business, including assets of acquired businesses. These estimates and assumptions are closely monitored by management and periodically adjusted as circumstances warrant. For instance, expected asset lives may be shortened or an impairment recorded based on a change in the expected use of the asset or performance of the related asset group. Factors which could result in future impairment charges include, among others, changes in worldwide economic conditions, changes in competitive conditions and customer preferences, and fluctuations in foreign currency exchange rates. These risk factors are discussed in Item 1A, “Risk Factors,” of this document. In addition, changes in the weighted average cost of capital could also impact impairment testing results.​As of December 31, 2020, the $0.7 billion of indefinite-lived tradenames primarily relates to Capital Safety (acquired in 2015), whose tradenames ($520 million at acquisition date) have been in existence for over 60 years (refer to Note 4 for more detail). The primary valuation technique used in estimating the fair value of indefinite lived intangible assets (tradenames) is a discounted cash flow approach. Specifically, a relief of royalty rate is applied to estimated sales, with the resulting amounts then discounted using an appropriate market/technology discount rate. The relief of royalty rate is the estimated royalty rate a market participant would pay to acquire the right to market/produce the product. In the first quarter of 2020, 3M reflected an immaterial charge related to impairment of certain indefinite-lived assets in 2020. Based on annual impairment testing in the third quarter of 2020, no additional impairment was indicated. ​3M goodwill totaled approximately $13.8 billion as of December 31, 2020. 3M’s annual goodwill impairment testing is performed in the fourth quarter of each year. Impairment testing for goodwill is done at a reporting unit level, with all goodwill assigned to a reporting unit. Reporting units are one level below the business segment level, but are required to be combined when reporting units 42 Table of Contentswithin the same segment have similar economic characteristics. At 3M, reporting units correspond to a division. 3M did not combine any of its reporting units for impairment testing. An impairment loss would be recognized when the carrying amount of the reporting unit’s net assets exceeds the estimated fair value of the reporting unit, and the loss would equal that difference. The estimated fair value of a reporting unit is determined using earnings for the reporting unit multiplied by a price/earnings ratio for comparable industry groups, or by using a discounted cash flow analysis. 3M typically uses the price/earnings ratio approach for stable and growing businesses that have a long history and track record of generating positive operating income and cash flows. 3M uses the discounted cash flow approach for start-up, loss position and declining businesses, in addition to using for businesses where the price/earnings ratio valuation method indicates additional review is warranted. 3M also uses discounted cash flow as an additional tool for businesses that may be growing at a slower rate than planned due to economic or other conditions. Where applicable, 3M uses a weighted-average discounted cash flow analysis for certain divisions, using projected cash flows that were weighted based on different sales growth and terminal value assumptions, among other factors. The weighting was based on management’s estimates of the likelihood of each scenario occurring.​As described in Note 19, effective in the first quarter of 2020, the Company changed its business segment reporting. For any product changes that resulted in reporting unit changes, the Company applied the relative fair value method to determine the impact on goodwill of the associated reporting units, the results of which were immaterial. In conjunction with the change in segment reporting, 3M completed an assessment indicating no goodwill impairment existed as a result of this new segment structure. The discussion that follows relates to the separate fourth quarter 2020 annual impairment test and is in the context of the reporting unit structure that existed at that time.​Based on the annual test in the fourth quarter of 2020, no goodwill impairment was indicated for any of the reporting units. As of October 1, 2020, 3M had 22 primary reporting units, with ten reporting units accounting for approximately 93 percent of the goodwill. These ten reporting units were comprised of the following divisions: Advanced Materials, Display Materials and Systems, Electronics Materials Solutions, Health Information Systems, Industrial Adhesives and Tapes, Medical Solutions, Oral Care Solutions, Personal Safety, Separation and Purification Sciences, and Transportation Safety.​3M is a highly integrated enterprise, where businesses share technology and leverage common fundamental strengths and capabilities, thus many of 3M’s businesses could not easily be sold on a stand-alone basis. 3M’s focus on research and development has resulted in a portion of 3M’s value being comprised of internally developed businesses that have no goodwill associated with them. ​3M will continue to monitor its reporting units and asset groups in 2021 for any triggering events or other indicators of impairment.​Uncertainty in Income Tax Positions:​The extent of 3M’s operations involves dealing with uncertainties and judgments in the application of complex tax regulations in a multitude of jurisdictions. The final taxes paid are dependent upon many factors, including negotiations with taxing authorities in various jurisdictions and resolution of disputes arising from federal, state, and international tax audits. The Company recognizes potential liabilities and records tax liabilities for anticipated tax audit issues in the United States and other tax jurisdictions based on its estimate of whether, and the extent to which, additional taxes will be due. The Company follows guidance provided by ASC 740, Income Taxes, a subset of which relates to uncertainty in income taxes, to record these liabilities (refer to Note 10 for additional information). The Company adjusts these reserves in light of changing facts and circumstances; however, due to the complexity of some of these uncertainties, the ultimate resolution may result in a payment that is materially different from the Company’s current estimate of the tax liabilities. If the Company’s estimate of tax liabilities proves to be less than the ultimate assessment, an additional charge to expense would result. If payment of these amounts ultimately proves to be less than the recorded amounts, the reversal of the liabilities would result in tax benefits being recognized in the period when the Company determines the liabilities are no longer necessary.​NEW ACCOUNTING PRONOUNCEMENTS​Information regarding new accounting pronouncements is included in Note 1 to the Consolidated Financial Statements.​43 Table of ContentsFINANCIAL CONDITION AND LIQUIDITY​The strength and stability of 3M’s business model and strong free cash flow capability, together with proven capital markets access, provides financial flexibility and enables the Company to invest through business cycles. Investing in 3M’s business to drive organic growth and deliver strong returns on invested capital remains the first priority for capital deployment. This includes research and development, capital expenditures, and commercialization capability. Organic investments will be supplemented by complementary acquisitions. The Company also continues to actively manage its portfolio to maximize value for shareholders. Given uncertainty arising from COVID-19, the Company suspended repurchases under its board-approved share repurchase program effective March 2020 with other repurchase activity limited to 3M’s stock compensation plans. 3M will continue to return cash to shareholders through dividends and plans to resume share repurchases in 2021. 3M maintains strong liquidity and further added to its liquidity position through the issuance of $1.75 billion in registered notes in March 2020. To fund cash needs in the United States, the Company relies on ongoing cash flow from U.S. operations, access to capital markets and repatriation of the earnings of its foreign affiliates that are not considered to be permanently reinvested. For those international earnings still considered to be reinvested indefinitely, the Company currently has no plans or intentions to repatriate these funds for U.S. operations. See Note 10 for further information on earnings considered to be reinvested indefinitely.​3M’s primary short-term liquidity needs are met through cash on hand and U.S. commercial paper issuances. 3M believes it will have continuous access to the commercial paper market. 3M’s commercial paper program permits the Company to have a maximum of $5 billion outstanding with a maximum maturity of 397 days from date of issuance. At December 31, 2020, there was no commercial paper issued and outstanding.​Total Debt:​The strength of 3M’s credit profile and significant ongoing cash flows provide 3M proven access to capital markets. Additionally, the Company’s debt maturity profile is staggered to help ensure refinancing needs in any given year are reasonable in proportion to the total portfolio. 3M currently has an A1 credit rating with a negative outlook from Moody’s Investors Service and an A+ credit rating with negative outlook from Standard and Poor’s.​The Company’s total debt was $1.5 billion lower at December 31, 2020 when compared to December 31, 2019. Decreases in debt are further described in Note 12 and include the repayment of aggregate $445 million principal amount of Third Lien Notes subject to in-substance defeasance, 650 million euros and $500 million aggregate principal amount of floating-rate medium-term notes that matured, the December 2020 repayment of $1 billion aggregate principal amount of notes related to make-whole-call offers, lower commercial paper balance, and the repayment of the 80 billion Japanese yen and 150 million euro credit facilities. These decreases were partially offset by the March 2020 issuance of $1.75 billion of registered notes. For discussion of repayments of and proceeds from debt refer to the following “Cash Flows from Financing Activities” section.​In July 2017, the United Kingdom’s Financial Conduct Authority announced that it would no longer require banks to submit rates for the London InterBank Offered Rate (“LIBOR”) after 2021. In November 2020, the ICE Benchmark Administration (IBA), LIBOR’s administrator, proposed extending the publication of USD LIBOR through June 2023. The Company has reviewed its debt securities, bank facilities, and derivative instruments and continues to evaluate commercial contracts that may utilize LIBOR as the reference rate. 3M will continue its assessment and monitor regulatory developments during the transition period.​Effective February 10, 2020, the Company updated its “well-known seasoned issuer” (WKSI) shelf registration statement, which registers an indeterminate amount of debt or equity securities for future issuance and sale. This replaced 3M’s previous shelf registration dated February 24, 2017. In May 2016, in connection with the WKSI shelf, 3M entered into an amended and restated distribution agreement relating to the future issuance and sale (from time to time) of the Company’s medium-term notes program (Series F), up to the aggregate principal amount of $18 billion, which was an increase from the previous aggregate principal amount up to $9 billion of the same Series.​As of December 31, 2020, the total amount of debt issued as part of the medium-term notes program (Series F), inclusive of debt issued in February 2019 and prior years is approximately $17.6 billion (utilizing the foreign exchange rates applicable at the time of issuance for the euro denominated debt). Additionally, the August 2019 and March 2020 debt was issued under the WKSI shelf registration, but not as part of the medium-term notes program (Series F). Information with respect to long-term debt issuances and maturities for the periods presented is included in Note 12.44 Table of ContentsThe Company has a $3.0 billion five-year revolving credit facility expiring in November 2024. The revolving credit agreement includes a provision under which 3M may request an increase of up to $1.0 billion (at lender’s discretion), bringing the total facility up to $4.0 billion. In addition, 3M entered into a $1.25 billion 364-day credit facility, which was renewed in November 2020 with an expiration date of November 2021. The 364-day credit agreement includes a provision under which 3M may convert any advances outstanding on the maturity date into term loans with a maturity date one year later. These credit facilities were undrawn at December 31, 2020. Under both the $3.0 billion and $1.25 billion credit agreements, the Company is required to maintain its EBITDA to Interest Ratio as of the end of each fiscal quarter at not less than 3.0 to 1. This is calculated (as defined in the agreement) as the ratio of consolidated total EBITDA for the four consecutive quarters then ended to total interest expense on all funded debt for the same period. At December 31, 2020, this ratio was approximately 17 to 1. Debt covenants do not restrict the payment of dividends.​Apart from the committed credit facilities described above, in September 2019, 3M entered into a credit facility initially expiring in July 2020 that was further extended to August 2021 in the amount of 80 billion Japanese yen. In November 2019, 3M entered into a credit facility expiring in November 2020 in the amount of 150 million euros. During the third quarter of 2020, the Company paid the outstanding balances and closed these credit facilities. The Company also had $273 million in stand-alone letters of credit and bank guarantees issued and outstanding at December 31, 2020. These instruments are utilized in connection with normal business activities.​Cash, Cash Equivalents and Marketable Securities:​At December 31, 2020, 3M had $5.1 billion of cash, cash equivalents and marketable securities, of which approximately $2.8 billion was held by the Company’s foreign subsidiaries and approximately $2.3 billion was held by the United States. These balances are invested in bank instruments and other high-quality fixed income securities. At December 31, 2019, 3M had $2.5 billion of cash, cash equivalents and marketable securities, of which approximately $2.4 billion was held by the Company’s foreign subsidiaries and approximately $100 million was held by the United States. The increase from December 31, 2019 primarily resulted from strong cash flow from operations, reduced capital expenditures, and lower share repurchases. ​Net Debt (non-GAAP measure):​Net debt is not defined under U.S. GAAP and may not be computed the same as similarly titled measures used by other companies. The Company defines net debt as total debt less the total of cash, cash equivalents and current and long-term marketable securities. 3M believes net debt is meaningful to investors as 3M considers net debt and its components to be important indicators of liquidity and financial position. The following table provides net debt as of December 31, 2020 and 2019.​​​​​​​​​​​​​ December 31, ​2020 versus​(Millions)​2020​2019 2019​Total debt​$ 18,795​$ 20,313​$ (1,518)​Less: Cash, cash equivalents and marketable securities​ 5,068​ 2,494​ 2,574​Net debt (non-GAAP measure)​$ 13,727​$ 17,819​$ (4,092)​​Refer to the preceding “Total Debt” and “Cash, Cash Equivalents and Marketable Securities” sections for additional details. ​Balance Sheet:​3M’s strong balance sheet and liquidity provide the Company with significant flexibility to fund its numerous opportunities going forward. The Company will continue to invest in its operations to drive growth, including continual review of acquisition opportunities.​The Company uses working capital measures that place emphasis and focus on certain working capital assets, such as accounts receivable and inventory activity.​45 Table of ContentsWorking Capital (non-GAAP measure):​​​​​​​​​​​​​​December 31, ​​2020 versus​(Millions)​​2020​​2019​​2019​Current assets​$ 14,982​$ 12,971​$ 2,011​Less: Current liabilities​ 7,948​ 9,222​ (1,274)​Working capital (non-GAAP measure)​$ 7,034​$ 3,749​$ 3,285​​Various assets and liabilities, including cash and short-term debt, can fluctuate significantly from month to month depending on short-term liquidity needs. Working capital is not defined under U.S. generally accepted accounting principles and may not be computed the same as similarly titled measures used by other companies. The Company defines working capital as current assets minus current liabilities. 3M believes working capital is meaningful to investors as a measure of operational efficiency and short-term financial health. ​Working capital increased $3.3 billion compared with December 31, 2019. Balance changes in current assets increased working capital by $2.0 billion, driven by increases in cash and cash equivalents and inventory, partially offset by decreases in accounts receivable. Balance changes in current liabilities increased working capital by $1.3 billion, primarily due to decreases in short-term borrowing and the current portion of long-term debt. ​Accounts receivable decreased $86 million from December 31, 2019, primarily due to ongoing collection management and increased expected credit losses on customer receivables related to COVID-19 uncertainty. Inventory increased $105 million from December 31, 2019 primarily as a result of foreign currency impacts. These increases were partially offset by inventory decreases as a result of the divestiture of the drug delivery business.​Return on Invested Capital (non-GAAP measure):​Return on Invested Capital (ROIC) is not defined under U.S. generally accepted accounting principles. Therefore, ROIC should not be considered a substitute for other measures prepared in accordance with U.S. GAAP and may not be comparable to similarly titled measures used by other companies. The Company defines ROIC as adjusted net income (net income including non-controlling interest plus after-tax interest expense) divided by average invested capital (equity plus debt). The Company believes ROIC is meaningful to investors as it focuses on shareholder value creation. The calculation is provided in the below table.​​46 Table of ContentsIn 2020, ROIC of 18.2 percent was higher than 2019. The increase was driven by the lower year-over-year impact of significant litigation-related charges in addition to the non-repeating charge from the 2019 deconsolidation of the Company’s Venezuela subsidiary. 2019 ROIC was also negatively impacted by the increase in cash and cash equivalents in anticipation of the funding of the acquisition of Acelity. ​​​​​​​​​Years ended December 31 ​ ​ (Millions)​2020​2019​​​​​​​​​Return on Invested Capital (non-GAAP measure)​​​​​​​Net income including non-controlling interest​$ 5,388​$ 4,582​Interest expense (after-tax) (1)​​ 425​​ 359​Adjusted net income (Return)​$ 5,813​$ 4,941​​​​​​​​​Average shareholders' equity (including non-controlling interest) (2)​$ 11,500​$ 10,198​Average short-term and long-term debt (3)​ 20,413​ 17,982​Average invested capital​$ 31,913​$ 28,180​​​​​​​​​Return on invested capital (non-GAAP measure)​​ 18.2%​ 17.5%​​​​​​​​(1) Effective income tax rate used for interest expense​​ 19.6%​ 19.8%​​​​​​​​(2) Calculation of average equity (includes non-controlling interest)​​​​​​​Ending total equity as of:​​​​​​​March 31​$ 10,209​$ 9,757​June 30​​ 10,915​​ 10,142​September 30​​ 11,943​​ 10,764​December 31​ 12,931​ 10,126​Average total equity​$ 11,500​$ 10,198​​​​​​​​​(3) Calculation of average debt​​​​​​​Ending short-term and long-term debt as of:​​​​​​​March 31​$ 22,495​$ 16,370​June 30​​ 20,762​​ 15,806​September 30​​ 19,598​​ 19,439​December 31​ 18,795​ 20,313​Average short-term and long-term debt​$ 20,413​$ 17,982​​Cash Flows:​Cash flows from operating, investing and financing activities are provided in the tables that follow. Individual amounts in the Consolidated Statement of Cash Flows exclude the effects of acquisitions, divestitures and exchange rate impacts on cash and cash equivalents, which are presented separately in the cash flows. Thus, the amounts presented in the following operating, investing and financing activities tables reflect changes in balances from period to period adjusted for these effects.​​47 Table of ContentsCash Flows from Operating Activities:​​​​​​​​​Years Ended December 31 ​ ​ (Millions)​2020​2019 Net income including noncontrolling interest​$ 5,388​$ 4,582​Depreciation and amortization​ 1,911​ 1,593​Company pension and postretirement contributions​ (156)​ (210)​Company pension and postretirement expense​ 406​ 357​Stock-based compensation expense​ 262​ 278​Gain on sale of businesses​​ (389)​​ (111)​Income taxes (deferred and accrued income taxes)​ (33)​ (68)​Loss on deconsolidation of Venezuelan subsidiary​ —​ 162​Accounts receivable​ 165​ 345​Inventories​ (91)​ 370​Accounts payable​ 252​ (117)​Other — net​ 398​ (111)​Net cash provided by operating activities​$ 8,113​$ 7,070​​Cash flows from operating activities can fluctuate significantly from period to period, as pension funding decisions, tax timing differences and other items can significantly impact cash flows.​In 2020, cash flows provided by operating activities increased $1.0 billion compared to the same period last year, with this increase primarily due to cost saving actions taken in response to COVID-19 and lower year-on-year significant litigation-related charges and the timing of associated payments. The combination of accounts receivable, inventories and accounts payable improved operating cash flow by $326 million in 2020, compared to an operating cash flow improvement of $598 million in 2019. Additional discussion on working capital changes is provided earlier in the “Financial Condition and Liquidity” section.​Cash Flows from Investing Activities:​​​​​​​​​Years ended December 31 ​ ​ (Millions)​2020​2019 Purchases of property, plant and equipment (PP&E)​$ (1,501)​$ (1,699)​Proceeds from sale of PP&E and other assets​ 128​ 123​Acquisitions, net of cash acquired​ (25)​ (4,984)​Purchases and proceeds from maturities and sale of marketable securities and investments, net​ 232​ (192)​Proceeds from sale of businesses, net of cash sold​ 576​ 236​Other — net​ 10​ 72​Net cash provided by (used in) investing activities​$ (580)​$ (6,444)​​Investments in property, plant and equipment enable growth across many diverse markets, helping to meet product demand and increasing manufacturing efficiency. In 2020, 3M reduced overall spending in light of uncertainty regarding COVID-19, but continued to invest in expanding the Company’s ability to increase production of respiratory products to meet worldwide demand. The Company expects 2021 capital spending to be approximately $1.8 billion to $2.0 billion as 3M continues to invest in growth, productivity and sustainability.​3M records capital-related government grants earned as reductions to the cost of property, plant and equipment; and associated unpaid liabilities and grant proceeds receivable are considered non-cash changes in such balances for purposes of preparation of statement of cash flows.​3M invests in renewal and maintenance programs, which pertain to cost reduction, cycle time, maintaining and renewing current capacity, eliminating pollution, and compliance. Costs related to maintenance, ordinary repairs, and certain other items are expensed. 3M also invests in growth, which adds to capacity, driven by new products, both through expansion of current facilities and new facilities. Finally, 3M also invests in other initiatives, such as information technology (IT), laboratory facilities, and a continued focus on investments in sustainability.48 Table of ContentsRefer to Note 3 for information on acquisitions and divestitures. The Company is actively considering additional acquisitions, investments and strategic alliances, and from time to time may also divest certain businesses. Acquisitions, net of cash acquired, in 2020 primarily relate to the payment made for contingent consideration in regards to the Acelity acquisition. Proceeds from sale of businesses in 2020 primarily relate to the sales of the Company’s advanced ballistic-protection business and its drug delivery business. Acquisitions, net of cash acquired, in 2019 primarily include the purchase of M*Modal and Acelity Inc. Proceeds from sale of businesses in 2019 primarily relate to the sale of certain oral care technology comprising a business and the gas and flame detection business.​Purchases of marketable securities and investments and proceeds from maturities and sale of marketable securities and investments are primarily attributable to certificates of deposit/time deposits, commercial paper, and other securities, which are classified as available-for-sale. In 2020 these included the maturity of the held-to-maturity debt security that was purchased to satisfy the redemption of the Third Lien Notes (which matured in May 2020). Refer to Note 11 for more details about 3M’s diversified marketable securities portfolio. Purchases of investments include additional survivor benefit insurance, plus investments in equity securities.​Cash Flows from Financing Activities:​​​​​​​​​Years ended December 31 ​ ​ (Millions)​2020​2019 Change in short-term debt — net​$ (143)​$ (316)​Repayment of debt (maturities greater than 90 days)​ (3,482)​ (2,716)​Proceeds from debt (maturities greater than 90 days)​ 1,750​ 6,281​Total cash change in debt​$ (1,875)​$ 3,249​Purchases of treasury stock​ (368)​ (1,407)​Proceeds from issuances of treasury stock pursuant to stock option and benefit plans​ 429​ 547​Dividends paid to stockholders​ (3,388)​ (3,316)​Other — net​ (98)​ (197)​Net cash used in financing activities​$ (5,300)​$ (1,124)​​2020 Debt Activity: ​Total debt was approximately $18.8 billion at December 31, 2020 and $20.3 billion at December 31, 2019. Repayment of debt primarily consists of the aggregate $445 million principal amount of Third Lien Notes and the 650 million euros and $500 million aggregate principal amount of floating-rate medium-term notes that matured in May 2020 and August 2020, respectively. During the third quarter of 2020, the Company paid the outstanding balances on their Japanese yen and euro credit facilities. In addition, $1.0 billion aggregate principal amount of notes maturing in September 2021 were repaid in December 2020 via make-whole-call offers. Increases in debt were related to the March 2020 issuance of $1.75 billion in registered notes. There was no outstanding commercial paper at December 31, 2020, as compared to $150 million at December 31, 2019. Net commercial paper issuances in addition to repayments and borrowings by international subsidiaries are largely reflected in “Change in short-term debt – net” in the preceding table. 3M’s primary short-term liquidity needs are met through cash on hand and U.S. commercial paper issuances. Refer to Note 12 for more detail regarding debt.​2019 Debt Activity:​Total debt was approximately $5.7 billion higher at December 31, 2019 when compared to December 31, 2018. Increases in debt related to the first quarter and third quarter 2019 issuances of $2.25 billion of medium-term notes and $3.25 billion of other registered notes, respectively, 69 billion Japanese yen (approximately $632 million at December 31, 2019 exchange rates) outstanding from the 80 billion Japanese yen credit facility established in September 2019, 150 million euros (approximately $168 million at December 31, 2019 exchange rates) outstanding credit facility established in November 2019, and $0.5 billion of debt assumed and not yet repaid as a result of the Company’s acquisition of Acelity Inc. Repayment of debt primarily consists of the June 2019 repayment of $625 million aggregate principal amount of fixed-rate medium-term notes that had matured, in addition to debt assumed and subsequently repaid as a result of the Company’s acquisitions of M*Modal and Acelity Inc. as discussed in Note 3. Outstanding commercial paper decreased $285 million from December 31, 2018 to December 31, 2019. Refer to Note 12 for more detail regarding debt.​​49 Table of ContentsRepurchases of Common Stock:​Repurchases of common stock are made to support the Company’s stock-based employee compensation plans and for other corporate purposes. In November 2018, 3M’s Board of Directors replaced the Company’s February 2016 repurchase program with a new repurchase program. This new program authorizes the repurchase of up to $10 billion of 3M’s outstanding common stock, with no pre-established end date. In 2020, the Company purchased $0.4 billion of its own stock, compared to purchases of $1.4 billion in 2019. As of December 31, 2020, approximately $7.8 billion remained available under the authorization. In the first quarter of 2020, the Company suspended repurchases under its board-approved share repurchase program with other repurchase activity limited to 3M’s stock compensation plans. The Company plans to resume share purchases in 2021. For more information, refer to the table titled “Issuer Purchases of Equity Securities” in Part II, Item 5. The Company does not utilize derivative instruments linked to the Company’s stock.​Dividends Paid to Shareholders:​Cash dividends paid to shareholders totaled $3.388 billion ($5.88 per share) in 2020, $3.316 billion ($5.76 per share) in 2019, and $3.193 billion ($5.44 per share) in 2018. 3M has paid dividends since 1916. In February 2021, 3M’s Board of Directors declared a first-quarter 2021 dividend of $1.48 per share, an increase of 1 percent. This is equivalent to an annual dividend of $5.92 per share and marked the 63rd consecutive year of dividend increases.​Other cash flows from financing activities may include various other items, such as cash paid associated with certain derivative instruments, distributions to or sales of noncontrolling interests, changes in cash overdraft balances, and principal payments for finance leases.​Free Cash Flow (non-GAAP measure):​Free cash flow and free cash flow conversion are not defined under U.S. generally accepted accounting principles (GAAP). Therefore, they should not be considered a substitute for income or cash flow data prepared in accordance with U.S. GAAP and may not be comparable to similarly titled measures used by other companies. The Company defines free cash flow as net cash provided by operating activities less purchases of property, plant and equipment. It should not be inferred that the entire free cash flow amount is available for discretionary expenditures. The Company defines free cash flow conversion as free cash flow divided by net income attributable to 3M. The Company believes free cash flow and free cash flow conversion are meaningful to investors as they are useful measures of performance and the Company uses these measures as an indication of the strength of the company and its ability to generate cash. The first quarter of each year is typically 3M’s seasonal low for free cash flow and free cash flow conversion. Below find a recap of free cash flow and free cash flow conversion. ​Refer to the preceding “Cash Flows from Operating Activities” and “Cash Flows from Investing Activities” sections for discussion of items that impacted the operating cash flow and purchases of PP&E components of the calculation of free cash flow. Refer to the preceding “Results of Operations” section for discussion of items that impacted the net income attributable to 3M component of the calculation of free cash flow conversion.​​50 Table of ContentsFree cash flow conversion grew to 123% in 2020 compared to 118% in 2019 as increases in free cash flow out-paced increases in net income attributable to 3M.​​​​​​​​​Years ended December 31 ​ ​ (Millions)​2020​2019​​​​​​​​​Major GAAP Cash Flow Categories​​​​​​​Net cash provided by (used in) operating activities​$ 8,113​$ 7,070​Net cash provided by (used in) investing activities​​ (580)​​ (6,444)​Net cash provided by (used in) financing activities​​ (5,300)​​ (1,124)​​​​​​​​​Free Cash Flow (non-GAAP measure)​​​​​​​Net cash provided by (used in) operating activities​$ 8,113​$ 7,070​Purchases of property, plant and equipment​ (1,501)​ (1,699)​Free cash flow​$ 6,612​$ 5,371​Net income attributable to 3M​$ 5,384​$ 4,570​Free cash flow conversion​ 123% 118%​​Off-Balance Sheet Arrangements and Contractual Obligations:​As of December 31, 2020, the Company has not utilized special purpose entities to facilitate off-balance sheet financing arrangements. Refer to the section entitled “Warranties/Guarantees” in Note 16 for discussion of accrued product warranty liabilities and guarantees.​In addition to guarantees, 3M, in the normal course of business, periodically enters into agreements that require the Company to indemnify either major customers or suppliers for specific risks, such as claims for injury or property damage arising out of the use of 3M products or the negligence of 3M personnel, or claims alleging that 3M products infringe third-party patents or other intellectual property. While 3M’s maximum exposure under these indemnification provisions cannot be estimated, these indemnifications are not expected to have a material impact on the Company’s consolidated results of operations or financial condition.​Contractual Obligations​A summary of the Company’s significant contractual obligations as of December 31, 2020, follows:​​​​​​​​​​​​​​​​​​​​​​​​​​​​​Payments due by year ​ ​ ​ ​ ​ ​ ​ After (Millions)​Total​2021​2022​2023​2024​2025​2025 Total debt (Note 12)​$ 18,795​$ 806​$ 1,659​$ 1,878​$ 1,100​$ 1,790​$ 11,562​Interest on long-term debt​ 6,540​ 501​ 475​ 449​ 416​ 389​ 4,310​Operating leases (Note 17)​ 930​ 273​ 201​ 141​ 93​ 60​ 162​Finance leases (Note 17)​ 123​ 20​ 18​ 18​ 16​ 10​ 41​Tax Cuts and Jobs Act (TCJA) transition tax (Note 10)​​ 653​​ 69​​ 69​​ 129​​ 172​​ 214​​ —​Unconditional purchase obligations and other​ 1,735​ 1,027​ 330​ 218​ 97​ 48​ 15​Total contractual cash obligations​$ 28,776​$ 2,696​$ 2,752​$ 2,833​$ 1,894​$ 2,511​$ 16,090​​As a result of put provisions associated with certain debt instruments, long-term debt payments due in 2021 include floating rate notes totaling $53 million (classified as current portion of long-term debt).​In conjunction with the 2017 Tax Cuts and Jobs Act (TCJA), the Company has a transition tax liability that is payable over 8 years beginning in 2018. See Note 10 for additional details.​Unconditional purchase obligations are defined as agreements to purchase goods or services that are enforceable and legally binding on the Company. Included in the unconditional purchase obligations category above are certain obligations related to take or pay contracts, capital commitments, service agreements and utilities. These estimates include both unconditional purchase obligations with 51 Table of Contentsterms in excess of one year and normal ongoing purchase obligations with terms of less than one year. Many of these commitments relate to take or pay contracts, in which 3M guarantees payment to ensure availability of products or services that are sold to customers. The Company expects to receive consideration (products or services) for these unconditional purchase obligations. Contractual capital commitments are included in the preceding table, but these commitments represent a small part of the Company’s expected capital spending. The purchase obligation amounts do not represent the entire anticipated purchases in the future but represent only those items for which the Company is contractually obligated. The majority of 3M’s products and services are purchased as needed, with no unconditional commitment. For this reason, these amounts will not provide a reliable indicator of the Company’s expected future cash outflows on a stand-alone basis.​Other obligations, included in the preceding table within the caption entitled “Unconditional purchase obligations and other” include the current portion of the liability for uncertain tax positions under ASC 740, which is expected to be paid out in cash in the next 12 months, when applicable. The Company is not able to reasonably estimate the timing of the long-term payments, or the amount by which the liability will increase or decrease over time; therefore, the long-term portion of the total net tax liability of $933 million is excluded from the preceding table. In addition, the transition tax prescribed under the Tax Cuts and Jobs Act (TCJA) is separately included in the table above. Refer to Note 10 for further details. Additionally, included within the caption entitled “Unconditional purchase obligations and other” are operating lease commitments that have not yet commenced, which as of December 31, 2020, totaled approximately $18 million. These commitments pertain to 3M’s right of use buildings.​As discussed in Note 13, the Company does not have a required minimum cash pension contribution obligation for its U.S. plans in 2021 and Company contributions to its U.S. and international pension plans are expected to be largely discretionary in future years; therefore, amounts related to these plans are not included in the preceding table.​FINANCIAL INSTRUMENTS​The Company enters into foreign exchange forward contracts, options and swaps to hedge against the effect of exchange rate fluctuations on cash flows denominated in foreign currencies and to offset, in part, the impacts of changes in value of various non-functional currency denominated items including certain intercompany financing balances. The Company manages interest rate risks using a mix of fixed and floating rate debt. To help manage borrowing costs, the Company may enter into interest rate swaps. Under these arrangements, the Company agrees to exchange, at specified intervals, the difference between fixed and floating interest amounts calculated by reference to an agreed-upon notional principal amount. The Company manages commodity price risks through negotiated supply contracts and price protection agreements.​Refer to Item 7A, “Quantitative and Qualitative Disclosures About Market Risk”, for further discussion of foreign exchange rates risk, interest rates risk, commodity prices risk and value at risk analysis.​Item 7A. Quantitative and Qualitative Disclosures About Market Risk.​In the context of Item 7A, 3M is exposed to market risk due to the risk of loss arising from adverse changes in foreign currency exchange rates, interest rates and commodity prices. Changes in those factors could impact the Company’s results of operations and financial condition. Senior management provides oversight for risk management and derivative activities, determines certain of the Company’s financial risk policies and objectives, and provides guidelines for derivative instrument utilization. Senior management also establishes certain associated procedures relative to control and valuation, risk analysis, counterparty credit approval, and ongoing monitoring and reporting.​The Company is exposed to credit loss in the event of nonperformance by counterparties in interest rate swaps, currency swaps, and forward and option contracts. However, the Company’s risk is limited to the fair value of the instruments. The Company actively monitors its exposure to credit risk through the use of credit approvals and credit limits, and by selecting major international banks and financial institutions as counterparties. The Company does not anticipate nonperformance by any of these counterparties.​Foreign Exchange Rates Risk:​Foreign currency exchange rates and fluctuations in those rates may affect the Company’s net investment in foreign subsidiaries and may cause fluctuations in cash flows related to foreign denominated transactions. 3M is also exposed to the translation of foreign currency earnings to the U.S. dollar. The Company enters into foreign exchange forward and option contracts to hedge against the 52 Table of Contentseffect of exchange rate fluctuations on cash flows denominated in foreign currencies. These transactions are designated as cash flow hedges. 3M may dedesignate these cash flow hedge relationships in advance of the occurrence of the forecasted transaction. The maximum length of time over which 3M hedges its exposure to the variability in future cash flows of the forecasted transactions is 36 months. In addition, 3M enters into foreign currency contracts that are not designated in hedging relationships to offset, in part, the impacts of changes in value of various non-functional currency denominated items including certain intercompany financing balances. As circumstances warrant, the Company also uses foreign currency forward contracts and foreign currency denominated debt as hedging instruments to hedge portions of the Company’s net investments in foreign operations. The dollar equivalent gross notional amount of the Company’s foreign exchange forward and option contracts designated as either cash flow hedges or net investment hedges was $2.3 billion at December 31, 2020. The dollar equivalent gross notional amount of the Company’s foreign exchange forward and option contracts not designated as hedging instruments was $3.2 billion at December 31, 2020. In addition, as of December 31, 2020, the Company had 3.5 billion Euros in principal amount of foreign currency denominated debt designated as non-derivative hedging instruments in certain net investment hedges as discussed in Note 14 in the “Net Investment Hedges” section.​Interest Rates Risk:​The Company may be impacted by interest rate volatility with respect to existing debt and future debt issuances. 3M manages interest rate risk and expense using a mix of fixed and floating rate debt. In addition, the Company may enter into interest rate swaps that are designated and qualify as fair value hedges. Under these arrangements, the Company agrees to exchange, at specified intervals, the difference between fixed and floating interest amounts calculated by reference to an agreed-upon notional principal amount. The dollar equivalent (based on inception date foreign currency exchange rates) gross notional amount of the Company’s interest rate swaps at December 31, 2020 was $403 million. Additional details about 3M’s long-term debt can be found in Note 12, including references to information regarding derivatives and/or hedging instruments, further discussed in Note 14, associated with the Company’s long-term debt.​Commodity Prices Risk:​The Company manages commodity price risks through negotiated supply contracts and price protection agreements. The related mark-to-market gain or loss on qualifying hedges was included in other comprehensive income to the extent effective, and reclassified into cost of sales in the period during which the hedged transaction affected earnings. ​Value At Risk:​The value at risk analysis is performed annually to assess the Company’s sensitivity to changes in currency rates, interest rates, and commodity prices. A Monte Carlo simulation technique was used to test the impact on after-tax earnings related to debt instruments, interest rate derivatives and underlying foreign exchange and commodity exposures outstanding at December 31, 2020. The model (third-party bank dataset) used a 95 percent confidence level over a 12-month time horizon. The exposure to changes in currency rates model used nine currencies, interest rates related to two currencies, and commodity prices related to five commodities. This model does not purport to represent what actually will be experienced by the Company. This model does not include foreign currency hedges, because the Company believes their inclusion would not materially impact the results. The following table summarizes the possible adverse and positive impacts to after-tax earnings related to these exposures.​​​​​​​​​​​​​​​​​Adverse impact on after-tax​Positive impact on after-tax ​​earnings​earnings (Millions) 2020 2019 2020 2019 Foreign exchange rates​$ (169)​$ (133)​$ 175​$ 137​Interest rates​ (1)​ (11)​ 2​ 10​Commodity prices​ —​ (2)​ —​ 1​​An analysis of the global exposures related to purchased components and materials is performed at each year-end. A one percent price change would result in a pre-tax cost or savings of approximately $70 million per year. The global energy exposure is such that a ten 53 Table of Contentspercent price change would result in a pre-tax cost or savings of approximately $40 million per year. Global energy exposure includes energy costs used in 3M production and other facilities, primarily electricity and natural gas.​
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+ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion should be read in conjunction with our Consolidated Financial Statements and Notes thereto. Discussion regarding our financial condition and results of operations for fiscal 2019 as compared to fiscal 2018 is included in Item 7 of our Annual Report on Form 10-K for the fiscal year ended November 29, 2019, filed with the SEC on January 21, 2020.ACQUISITIONS Subsequent to November 27, 2020, we completed our acquisition of Workfront, a privately held company that provides a work management platform for marketers, for approximately $1.5 billion in cash consideration. Workfront will be integrated into our Digital Experience reportable segment for financial reporting purposes in the first quarter of fiscal 2021.During fiscal 2019, we acquired the remaining interest in Allegorithmic SAS (“Allegorithmic”), a privately held 3D editing and authoring software company for gaming and entertainment, for approximately $106 million in cash consideration, and integrated it into our Digital Media reportable segment.During fiscal 2018, we completed our acquisitions of Marketo, a privately held marketing cloud platform company, for approximately $4.73 billion and Magento, a privately held commerce platform company, for approximately $1.64 billion, and integrated them into our Digital Experience reportable segment.We also completed other immaterial business acquisitions during the fiscal years presented. See Note 3 of our Notes to Consolidated Financial Statements for further information regarding these acquisitions, including pro forma financial information related to the Marketo acquisition. Pro forma information has not been presented for our other acquisitions during the fiscal years presented as the impact to our Consolidated Financial Statements was not material.CRITICAL ACCOUNTING POLICIES AND ESTIMATESIn preparing our Consolidated Financial Statements in accordance with GAAP and pursuant to the rules and regulations of the SEC, we make assumptions, judgments and estimates that affect the reported amounts of assets, liabilities, revenue and expenses, and related disclosures of contingent assets and liabilities. We base our assumptions, judgments and estimates on historical experience and various other factors that we believe to be reasonable under the circumstances. Actual results could differ materially from these estimates under different assumptions or conditions. We evaluate our assumptions, judgments and estimates on a regular basis. We also discuss our critical accounting policies and estimates with the Audit Committee of the Board of Directors.We believe that the assumptions, judgments and estimates involved in the accounting for revenue recognition, business combinations and income taxes have the greatest potential impact on our Consolidated Financial Statements. These areas are key components of our results of operations and are based on complex rules requiring us to make judgments and estimates, and consequently, we consider these to be our critical accounting policies. Historically, our assumptions, judgments and estimates relative to our critical accounting policies have not differed materially from actual results.Revenue Recognition Our contracts with customers may include multiple goods and services. For example, some of our offerings include both on-premise and/or on-device software licenses and cloud services. Determining whether the software licenses and the cloud services are distinct from each other, and therefore performance obligations to be accounted for separately, or not distinct from each other, and therefore part of a single performance obligation, may require significant judgment. We have concluded that the on-premise/on-device software licenses and cloud services provided in our Creative Cloud and Document Cloud subscription offerings are not distinct from each other such that revenue from each offering should be recognized ratably over the subscription period for which the cloud services are provided. In reaching this conclusion, we considered the nature of our promise to Creative Cloud and Document Cloud customers, which is to provide a complete end-to-end creative design or document workflow solution that operates seamlessly across multiple devices and teams. We fulfill this promise by providing access to a solution that integrates cloud-based and on-premise/on-device features that, together through their integration, provide functionalities, utility and workflow efficiencies that could not be obtained from either the on-premise/on-device software or cloud services on their own.Cloud-based features that are integral to our Creative Cloud and Document Cloud offerings and that work together with the on-premise/on-device software include, but are not limited to: Creative Cloud Libraries, which enable customers to access their work, settings, preferences and other assets seamlessly across desktop and mobile devices and collaborate across teams in 42Table of Contentsreal time; shared reviews which enable simultaneous editing and commenting of PDFs across desktop, mobile and web; automatic cloud rendering of a design which enables it to be worked on in multiple mediums; and Sensei, Adobe’s cloud-hosted artificial intelligence and machine learning framework, which enables features such as automated photo-editing, photograph content-awareness, natural language processing, optical character recognition and automated document tagging.Business CombinationsWe allocate the purchase price of acquired companies to tangible and intangible assets acquired and liabilities assumed based upon their estimated fair values at the acquisition date. The purchase price allocation process requires management to make significant estimates and assumptions with respect to intangible assets and deferred revenue obligations. Although we believe the assumptions and estimates we have made are reasonable, they are based in part on historical experience, market conditions and information obtained from management of the acquired companies and are inherently uncertain. Examples of critical estimates in valuing certain of the intangible assets we have acquired or may acquire in the future include but are not limited to:•future expected cash flows from software license sales, subscriptions, support agreements, consulting contracts and acquired developed technologies and patents;•historical and expected customer attrition rates and anticipated growth in revenue from acquired customers;•the acquired company’s trade name and trademarks as well as assumptions about the period of time the acquired trade name and trademarks will continue to be used in the combined company’s product portfolio;•the expected use of the acquired assets; and •discount rates.In connection with the purchase price allocations for our acquisitions, we estimate the fair value of the deferred revenue obligations assumed. The estimated fair value of these obligations is determined utilizing a cost build-up approach. The cost build-up approach determines fair value by estimating the costs related to fulfilling the obligations plus a normal profit margin. Unanticipated events and circumstances may occur which may affect the accuracy or validity of such assumptions, estimates or actual results.Accounting for Income TaxesWe use the asset and liability method of accounting for income taxes. Under this method, income tax expense is recognized for the amount of taxes payable or refundable for the current year. In addition, deferred tax assets and liabilities are recognized for the expected future tax consequences of temporary differences between the financial reporting and tax bases of assets and liabilities, and for operating losses and tax credit carryforwards. Management must make assumptions, judgments and estimates to determine our current provision for income taxes and also our deferred tax assets and liabilities.Our assumptions, judgments and estimates relative to the current provision for income taxes take into account current tax laws, our interpretation of current tax laws and possible outcomes of current and future audits conducted by foreign and domestic tax authorities. We have established reserves for income taxes to address potential exposures involving tax positions that could be challenged by tax authorities. In addition, we are subject to the continual examination of our income tax returns by the U.S. Internal Revenue Service and other domestic and foreign tax authorities. These tax examinations are expected to focus on our intercompany transfer pricing practices, application of tax rules, and other matters. We regularly assess the likelihood of outcomes resulting from these examinations to determine the adequacy of our provision for income taxes and have reserved for potential adjustments that may result from such examinations. We believe such estimates to be reasonable; however, we cannot provide assurance that the final determination of any of these examinations will not have a significant impact on the amounts provided for income taxes in our Consolidated Financial Statements.During fiscal 2020, we completed intra-entity transfers of certain intellectual property rights (“IP rights”) which resulted in the establishment of deferred tax assets, net of valuation allowance, and related tax benefits of $224 million and $1.13 billion, based on the fair value of the IP rights transferred in April and November 2020, respectively. The determination of the fair value involves significant judgment on future revenue growth, operating margins and discount rates. Unanticipated events and circumstances may occur that could affect either the accuracy or validity of such assumptions, estimates or actual results. The sustainability of our future tax benefits is dependent upon the acceptance of the valuation estimates and assumptions by the taxing authorities.43Table of ContentsRecent Accounting Pronouncements See Note 1 of our Notes to Consolidated Financial Statements for information regarding recent accounting pronouncements that are of significance, or potential significance to us. RESULTS OF OPERATIONSOverview of 2020For our fiscal 2020, we experienced strong demand across our Digital Media offerings consistent with the continued execution of our long-term plans with respect to this segment. In our Digital Experience segment, we continued to experience growth in software-based subscription revenue across our portfolio of offerings. During the second quarter of fiscal 2020, we began to discontinue our transaction-driven Advertising Cloud offerings, allowing us to focus our investment on strategic growth initiatives. In the fourth quarter of fiscal 2020, we moved our Advertising Cloud offerings from our Digital Experience segment into our new Publishing and Advertising segment, which combined Advertising Cloud with our previous Publishing segment. This realignment is consistent with how we manage our Digital Experience segment to better reflect the strategic shift related to Advertising Cloud and to align with our overall core value proposition of delivering on customer experience management. Digital MediaIn our Digital Media segment, we are a market leader with Creative Cloud, our subscription-based offering which provides desktop tools, mobile apps and cloud-based services for designing, creating and publishing rich and immersive content. Creative Cloud delivers value with deep, cross-product integration, frequent product updates and feature enhancements, cloud-enabled services including storage and syncing of files across users’ machines, machine learning and artificial intelligence, access to marketplace, social and community-based features with our Adobe Stock and Behance services, app creation capabilities, tools which assist with enterprise deployments and team collaboration, and affordable pricing for cost-sensitive customers.We offer Creative Cloud for individuals, students, teams and enterprises. We expect Creative Cloud will drive sustained long-term revenue growth through a continued expansion of our customer base by acquiring new users as a result of low cost of entry and delivery of additional features and value to Creative Cloud, as well as keeping existing customers current on our latest release. We have also built out a marketplace for Creative Cloud subscribers to enable the delivery and purchase of stock content in our Adobe Stock service. Overall, our strategy with Creative Cloud is designed to enable us to increase our revenue with users, attract more new customers, and grow our recurring and predictable revenue stream that is recognized ratably.We continue to implement strategies that will accelerate awareness, consideration and purchase of subscriptions to our Creative Cloud offerings. These strategies include increasing the value Creative Cloud users receive, such as offering new desktop and mobile applications, as well as targeted promotions and offers that attract past customers and potential users to try out and ultimately subscribe to Creative Cloud. Because of the shift towards Creative Cloud subscriptions and Enterprise Term License Agreements (“ETLAs”), revenue from perpetual licensing of our Creative products has been immaterial to our business.We are also a market leader with our Document Cloud offerings built around our Adobe Acrobat family of products, including Adobe Acrobat Reader DC, and a set of integrated mobile apps and cloud-based document services, including Adobe Scan and Adobe Sign. Acrobat provides reliable creation and exchange of electronic documents, regardless of platform or application source type. Document Cloud, which we believe enhances the way people manage critical documents at home, in the office and across devices, includes Adobe Acrobat DC and Adobe Sign, and a set of integrated services enabling users to create, review, approve, sign and track documents whether on a desktop or mobile device. Adobe Acrobat DC is offered both through subscription and perpetual licenses.44Table of ContentsAnnualized Recurring Revenue (“ARR”) is currently the key performance metric our management uses to assess the health and trajectory of our overall Digital Media segment. ARR should be viewed independently of revenue, deferred revenue, unbilled backlog and remaining performance obligation as ARR is a performance metric and is not intended to be combined with any of these items. We adjust our reported ARR on an annual basis to reflect any material exchange rates changes. Our reported ARR results in the current fiscal year are based on currency rates set at the beginning of the year and held constant throughout the year. We calculate ARR as follows:Creative ARRAnnual Value of Creative Cloud Subscriptions and Services+ Annual Creative ETLA Contract Value Document Cloud ARRAnnual Value of Document Cloud Subscriptions and Services +Annual Document Cloud ETLA Contract ValueDigital Media ARRCreative ARR+ Document Cloud ARRCreative ARR exiting fiscal 2020 was $8.72 billion, up from $7.25 billion at the end of fiscal 2019. Document Cloud ARR exiting fiscal 2020 was $1.46 billion, up from $1.08 billion at the end of fiscal 2019. Total Digital Media ARR grew to $10.18 billion at the end of fiscal 2020, up from $8.33 billion at the end of fiscal 2019. Revaluing our ending ARR for fiscal 2020 using currency rates at the beginning of fiscal 2021, our Digital Media ARR at the end of fiscal 2020 would be $10.26 billion or approximately $77 million higher than the ARR reported above.Our success in driving growth in ARR has positively affected our revenue growth. Creative revenue in fiscal 2020 was $7.74 billion, up from $6.48 billion in fiscal 2019 and representing 19% year-over-year growth. Document Cloud revenue in fiscal 2020 was $1.50 billion, up from $1.22 billion in fiscal 2019 and representing 22% year-over-year revenue growth and reflecting an increase in demand driven by the shift to remote work as well as our continued efforts to transition Document Cloud to a subscription-based model. Total Digital Media segment revenue grew to $9.23 billion in fiscal 2020, up from $7.71 billion in fiscal 2019 and representing 20% year-over-year growth. These increases were driven by strong net new user growth, including those resulting from the current work-from-home environment reflecting expanded digital engagement.Digital ExperienceWe are a market leader in the fast-growing category addressed by our Digital Experience segment. The Adobe Experience Cloud applications, services and platform are designed to manage customer journeys, enable shoppable experiences and deliver intelligence for businesses of any size in any industry. Our differentiation and competitive advantage is strengthened by our ability to use the Adobe Experience Platform to connect our comprehensive set of solutions.Adobe Experience Cloud is focused on delivering solutions for our enterprise customers across the following strategic growth pillars:•Customer data and insights. Our solutions deliver real-time customer profiles and intelligence across the customer journey. Our offerings include Adobe Experience Platform, Adobe Analytics, Adobe Audience Manager, Customer Journey Analytics, Real-time Customer Data Platform and Intelligent Services.•Content and commerce. Our solutions to help customers manage, deliver, test, target and optimize content delivery and enable shopping experiences that scale from mid-market to enterprise businesses. Our offerings include Adobe Experience Manager, Adobe Target and Adobe Commerce.•Customer journey management. Our solutions help businesses manage, personalize and orchestrate campaigns and customer journeys across B2E use cases. Our offerings include Adobe Campaign, Marketo Engage and Journey Orchestration.In addition to chief marketing officers, chief revenue officers and digital marketers, users of our Digital Experience solutions include advertisers, campaign managers, publishers, data analysts, content managers, social marketers, marketing executives and information management and technology executives. These customers often are involved in workflows that utilize other Adobe products, such as our Digital Media offerings. By combining the creativity of our Digital Media business 45Table of Contentswith the science of our Digital Experience business, we help our customers to more efficiently and effectively make, manage, measure and monetize their content across every channel with an end-to-end workflow and feedback loop.We utilize a direct sales force to market and license our Digital Experience solutions, as well as an extensive ecosystem of partners, including marketing agencies, systems integrators and independent software vendors that help license and deploy our solutions to their customers. We have made significant investments to broaden the scale and size of all of these routes to market, and our recent financial results reflect the success of these investments. Digital Experience revenue for all fiscal years presented has been updated to reflect the Advertising Cloud segment move. Digital Experience revenue was $3.13 billion in fiscal 2020, up from $2.80 billion in fiscal 2019 which represents 12% year-over-year growth. Driving this increase was the increase in subscription revenue across our offerings which grew to $2.66 billion in fiscal 2020 from $2.28 billion in fiscal 2019, representing 17% year-over-year growth. COVID-19 UPDATEIn March 2020, the World Health Organization declared the outbreak of a disease caused by a novel strain of the coronavirus (COVID-19) to be a pandemic. This pandemic has had widespread, rapidly-evolving and unpredictable impacts on global societies, economies, financial markets and business practices. Federal and state governments have implemented measures in an effort to contain the virus, including physical distancing, travel restrictions, border closures, limitations on public gatherings, work from home, supply chain logistical changes and closure of non-essential businesses. Our focus remains on promoting employee health and safety, serving our customers and ensuring business continuity. As a result, we have taken action to direct our teams to work from home, suspend travel and replace in-person events such as Adobe Summit and MAX, with digital events through July 2021. During the pandemic, digital has become the primary way for people to connect, work, learn and be entertained, and for businesses to engage with customers. This macro trend towards all things digital has increased the importance and relevance of our solutions and accelerated the tailwinds that benefit our business, which contributed to our continued growth year over year. However, while our revenue and earnings are relatively predictable as a result of our subscription-based business model, the broader implications of the pandemic on our results of operations and overall financial performance remain uncertain. See Risk Factors for further discussion of the possible impact of the pandemic on our business.Financial Performance Summary for Fiscal 2020•Total Digital Media ARR of approximately $10.18 billion as of November 27, 2020 increased by $1.85 billion, or 22%, from $8.33 billion as of November 29, 2019. The increase in our Digital Media ARR was primarily due to new user adoption of our Creative Cloud and Document Cloud offerings. •Creative revenue of $7.74 billion increased by $1.25 billion, or 19%, during fiscal 2020, from $6.48 billion in fiscal 2019. Document Cloud revenue of $1.50 billion increased by $272 million, or 22%, during fiscal 2020, from $1.22 billion in fiscal 2019. The increases were primarily due to subscription revenue growth associated with our Creative Cloud and Document Cloud offerings.•Digital Experience revenue of $3.13 billion increased by $330 million, or 12%, during fiscal 2020, from $2.80 billion in fiscal 2019. The increase was primarily due to subscription revenue growth across our offerings.•Remaining performance obligation of $11.34 billion as of November 27, 2020 increased by $1.52 billion, or 15%, from $9.82 billion as of November 29, 2019, primarily due to new contracts and renewals for our Digital Media and Digital Experience offerings. •Cost of revenue of $1.72 billion increased by $49 million, or 3%, during fiscal 2020, from $1.67 billion in fiscal 2019 primarily due to increases in hosting services and data center costs, offset in large part by decreases in Advertising Cloud media costs.•Operating expenses of $6.91 billion increased by $679 million, or 11%, during fiscal 2020, from $6.23 billion in fiscal 2019 primarily due to increases in base and incentive compensation and related benefits costs, as well as increased marketing spend. These increases were offset in part by decreases in travel-related expenses. •Net income of $5.26 billion increased by $2.31 billion, or 78%, during fiscal 2020 from $2.95 billion in fiscal 2019 primarily due to increases in revenue and the non-recurring benefit from income taxes resulting from intra-entity transfers of certain intellectual property rights. 46Table of Contents•Net cash flows from operations of $5.73 billion during fiscal 2020 increased by $1.31 billion, or 30%, from $4.42 billion during fiscal 2019 primarily due to higher net income adjusted for the net effect of non-cash items.Presentation ChangesIn the fourth quarter of fiscal 2020, we moved our Advertising Cloud offerings from our Digital Experience segment into our new Publishing and Advertising segment, which combined our Advertising Cloud offerings with our previous Publishing segment. This realignment is consistent with how we manage our Digital Experience segment to better reflect the strategic shift related to Advertising Cloud and to align with our overall core value proposition of delivering on customer experience management. Further, we reclassified revenue and related cost of revenue of our Advertising Cloud offerings from subscription to services and other on our Consolidated Statements of Income.Financial information for all fiscal years presented has been updated to reflect these reclassifications. There were no other updates to disclosures included in our prior year report in relation to the reclassifications.RevenueOur financial results for fiscal 2020 and 2019 are presented in accordance with Accounting Standards Update No. 2014-09, Revenue from Contracts with Customers (Topic 606), which was adopted under the modified retrospective method at the beginning of fiscal 2019. Fiscal 2018 results have not been restated which limits its comparability with other fiscal years presented.(dollars in millions)202020192018% Change2020-2019% Change2019-2018Subscription$11,626 $9,634 $7,604 21 %27 %Percentage of total revenue90 %86 %84 % Product507 648 622 (22)%4 %Percentage of total revenue4 %6 %7 % Services and other735 889 804 (17)%11 %Percentage of total revenue6 %8 %9 % Total revenue$12,868 $11,171 $9,030 15 %24 %SubscriptionOur subscription revenue is comprised primarily of fees we charge for our subscription and hosted service offerings, and related support, including Creative Cloud and certain of our Adobe Experience Cloud and Document Cloud services. We primarily recognize subscription revenue ratably over the term of agreements with our customers, beginning with commencement of service. Subscription revenue related to certain offerings, where fees are based on a number of transactions and invoicing is aligned to the pattern of performance, customer benefit and consumption, are recognized on a usage basis.We have the following reportable segments: Digital Media, Digital Experience, and Publishing and Advertising. Subscription revenue by reportable segment for fiscal 2020, 2019 and 2018 is as follows:(dollars in millions)202020192018% Change2020-2019% Change2019-2018Digital Media$8,813 $7,208 $5,858 22 %23 %Digital Experience2,660 2,280 1,600 17 %43 %Publishing and Advertising153 146 146 5 %*Total subscription revenue$11,626 $9,634 $7,604 21 %27 %_________________________________________(*) Percentage is less than 1%.ProductOur product revenue is comprised primarily of fees related to licenses for on-premise software purchased on a perpetual basis, for a fixed period of time or based on usage for certain of our OEM and royalty agreements. We primarily recognize 47Table of Contentsproduct revenue at the point in time the software is available to the customer, provided all other revenue recognition criteria are met.Services and OtherOur services and other revenue is comprised primarily of fees related to consulting, training, maintenance and support and our advertising offerings. We typically sell our consulting contracts on a time-and-materials and fixed-fee basis. These revenues are recognized as the services are performed for time and materials contracts and on a relative performance basis for fixed-fee contracts. Training revenues are recognized as the services are performed. Our maintenance and support offerings, which entitle customers, partners and developers to receive desktop product upgrades and enhancements or technical support, depending on the offering, are generally recognized ratably over the term of the arrangement. Transaction-based advertising revenue is recognized on a usage basis as we satisfy the performance obligations to our customers.Segments In fiscal 2020, we categorized our products into the following reportable segments:•Digital Media—Our Digital Media segment provides tools and solutions that enable individuals, teams and enterprises to create, publish, promote and monetize their digital content anywhere. Our customers include content creators, experience designers, app developers, enthusiasts, students, social media users and creative professionals, as well as marketing departments and agencies, companies and publishers. Our customers also include knowledge workers who create, collaborate on and distribute documents and creative content. •Digital Experience—Our Digital Experience segment provides products, services and solutions for creating, managing, executing, measuring, monetizing and optimizing customer experiences from analytics to commerce. Our customers include marketers, advertisers, agencies, publishers, merchandisers, merchants, web analysts, data scientists, developers, marketing executives, information management and technology executives, product development executives, and sales and support executives. •Publishing and Advertising—Our Publishing and Advertising segment addresses market opportunities ranging from the diverse authoring and publishing needs of technical and business publishing to our legacy type and OEM printing businesses. It also includes our platforms for Advertising Cloud, web conferencing, document and forms, and Primetime.Segment Information(dollars in millions)202020192018% Change2020-2019% Change2019-2018Digital Media$9,233 $7,707 $6,325 20 %22 %Percentage of total revenue72 %69 %70 % Digital Experience3,125 2,795 2,073 12 %35 %Percentage of total revenue24 %25 %23 % Publishing and Advertising510 669 632 (24)%6 %Percentage of total revenue4 %6 %7 % Total revenue$12,868 $11,171 $9,030 15 %24 %Digital MediaRevenue from Digital Media increased $1.53 billion during fiscal 2020 as compared to fiscal 2019, driven by increases in revenue associated with our Creative and Document Cloud offerings due to increased demand and digital engagement amid the work-from-home environment. Revenue associated with our Creative offerings, which includes our Creative Cloud, perpetually licensed Creative and stock photography offerings, increased during fiscal 2020 primarily due to increases in net new subscriptions across our Creative Cloud offerings. Document Cloud revenue, which includes our Acrobat product family and Adobe Sign service, increased during fiscal 2020 primarily due to increases in subscription revenue driven by strong adoption of our Document Cloud offerings including Adobe Sign.48Table of ContentsDigital ExperienceRevenue from Digital Experience increased $330 million during fiscal 2020, as compared to fiscal 2019 primarily due to subscription revenue growth across our offerings of which the largest contributors were our AEM and Marketo Engage offerings. Geographical Information(dollars in millions)202020192018% Change2020-2019% Change2019-2018Americas$7,454 $6,506 $5,117 15 %27 %Percentage of total revenue58 %58 %57 % EMEA3,400 2,975 2,550 14 %17 %Percentage of total revenue26 %27 %28 % APAC2,014 1,690 1,363 19 %24 %Percentage of total revenue16 %15 %15 % Total revenue$12,868 $11,171 $9,030 15 %24 %Overall revenue during fiscal 2020 increased in all geographic regions as compared to fiscal 2019 primarily due to increases in Digital Media revenue and, to a lesser extent, increases in Digital Experience revenue. Within each geographic region, the fluctuations in revenue by reportable segment were attributable to the factors noted in the segment information above. Included in the overall change in revenue for fiscal 2020 and fiscal 2019 were impacts associated with foreign currency as shown below. Our cash flow hedging program is used to mitigate a portion of the foreign currency impact to revenue. (in millions)20202019Revenue impact: Increase/(Decrease)Euro$(24)$(73)Australian Dollar(16)(27)British Pound(5)(27)Japanese Yen14 2 Brazilian Real(14)(2)Other currencies(8)(11)Total revenue impact(53)(138)Hedging impact:Euro8 30 British Pound(2)8 Japanese Yen(2)2 Australian Dollar(1)— Total hedging impact3 40 Total impact$(50)$(98) During fiscal 2020, the U.S. Dollar strengthened largely against EMEA currencies and the Australian Dollar, which decreased revenue in U.S. Dollar equivalents. The foreign currency impact to revenue was partially offset by gains primarily from our Euro cash flow hedging program.See Note 2 of our Notes to Consolidated Financial Statements for additional details of revenue by geography.49Table of ContentsCost of Revenue(dollars in millions)202020192018% Change2020-2019% Change2019-2018Subscription$1,108 $926 $574 20 %61 %Percentage of total revenue9 %8 %6 % Product36 40 46 (10)%(13)%Percentage of total revenue**1 % Services and other578 707 575 (18)%23 %Percentage of total revenue4 %6 %6 % Total cost of revenue$1,722 $1,673 $1,195 3 %40 %_________________________________________(*) Percentage is less than 1%SubscriptionCost of subscription revenue consists of third-party hosting services and data center costs, royalty fees and other expenses related to operating our network infrastructure, including depreciation expense and operating lease payments associated with computer equipment, salaries and related expenses of network operations, implementation, account management and technical support personnel, amortization of certain intangible assets and allocated overhead. Cost of subscription revenue increased due to the following: Components of% Change2020-2019Components of% Change2019-2018Hosting services and data center costs10 %16 %Incentive compensation, cash and stock-based5 5 Royalty costs3 5 Base compensation and related benefits associated with headcount3 5 Software licenses2 2 Amortization of intangibles(2)24 Various individually insignificant items(1)4 Total change20 %61 %Product Cost of product revenue is primarily comprised of third-party royalties, amortization related to purchased intangibles and acquired rights to use technology, excess and obsolete inventory, localization costs and the costs associated with the manufacturing of our products.Services and OtherCost of services and other revenue is primarily comprised of employee-related and other associated costs incurred to provide consulting services, training and product support. Cost of services and other also includes media costs related to impressions purchased from third-party ad inventory sources for our transaction-based Adobe Advertising Cloud offerings, which we began to discontinue in the second quarter of fiscal 2020. Cost of services and other fluctuations were due to the following:Components of% Change2020-2019Components of% Change2019-2018Media costs(9)%10 %Base compensation and related benefits associated with headcount(7)4 Incentive compensation, cash and stock-based(1)6 Professional and consulting fees3 — Various individually insignificant items(4)3 Total change(18)%23 %50Table of ContentsOperating Expenses(dollars in millions)202020192018% Change2020-2019Research and development$2,188 $1,930 $1,538 13 %Percentage of total revenue17 %17 %17 % Sales and marketing3,591 3,244 2,621 11 %Percentage of total revenue28 %29 %29 % General and administrative968 881 745 10 %Percentage of total revenue8 %8 %8 % Amortization of intangibles162 175 91 (7)%Percentage of total revenue1 %2 %1 % Total operating expenses$6,909 $6,230 $4,995 11 %Research and Development Research and development expenses consist primarily of salary and benefit expenses for software developers, contracted development efforts, third party fees for hosting services, related facilities costs and expenses associated with computer equipment used in software development.Research and development expenses increased due to the following: Components of% Change2020-2019Incentive compensation, cash and stock-based11 %Base compensation and related benefits associated with headcount3 Travel(1)Total change13 %We believe that investments in research and development, including the recruiting and hiring of software developers, are critical to remain competitive in the marketplace and are directly related to continued timely development of new and enhanced offerings and solutions. We will continue to focus on long-term opportunities available in our end markets and make significant investments in the development of our subscription and service offerings, applications and tools.Sales and MarketingSales and marketing expenses consist primarily of salary and benefit expenses, amortization of contract acquisition costs, including sales commissions, travel expenses and related facilities costs for our sales, marketing, order management and global supply chain management personnel. Sales and marketing expenses also include the costs of programs aimed at increasing revenue, such as advertising, trade shows and events, public relations and other market development programs.Sales and marketing expenses increased due to the following: Components of% Change2020-2019Marketing spend related to campaigns, events and overall marketing efforts8 %Incentive compensation, cash and stock-based4 Transaction fees2 Base compensation and related benefits associated with headcount1 Professional and consulting fees(1)Travel(3)Total change11 %51Table of ContentsGeneral and AdministrativeGeneral and administrative expenses consist primarily of compensation and benefit expenses, travel expenses and related facilities costs for our finance, facilities, human resources, legal, information services and executive personnel. General and administrative expenses also include outside legal and accounting fees, provision for bad debts, expenses associated with computer equipment and software used in the administration of the business, charitable contributions and various forms of insurance.General and administrative expenses increased due to the following: Components of% Change2020-2019Incentive compensation, cash and stock-based5 %Charges related to cancellation of corporate events, net of recoveries3 Bad debt expense2 Charitable contributions2 Base compensation and related benefits associated with headcount1 Travel(2)Various individually insignificant items(1)Total change10 % During fiscal 2020, we recorded net charges related to the cancellation of our corporate events due to concerns over the pandemic. Certain of these charges were reversed as we successfully negotiated the right to apply certain commitments to other events.Bad debt expense increased during fiscal 2020 primarily due to specific reserves for certain categories of customers that were more impacted by the changes in the macroeconomic environment as a result of the pandemic.Amortization of IntangiblesAmortization expense decreased during fiscal 2020 as compared to fiscal 2019 primarily due to certain intangible assets from previous acquisitions, including from Marketo and Omniture, becoming fully amortized during the year.Non-Operating Income (Expense), Net(dollars in millions)202020192018% Change2020-2019Interest expense$(116)$(157)$(89)(26)%Percentage of total revenue(1)%(1)%(1)%Investment gains (losses), net13 52 3 (75)%Percentage of total revenue*** Other income (expense), net42 42 40 **Percentage of total revenue***Total non-operating income (expense), net$(61)$(63)$(46)(3)%_________________________________________(*) Percentage is less than 1%.(**) Percentage is not meaningful.Interest ExpenseInterest expense represents interest associated with our debt instruments. Interest on our Notes is payable semi-annually, in arrears, on February 1 and August 1. Interest on our Term Loan, which was terminated in the first quarter of fiscal 2020, was payable periodically at the end of each interest period. Floating interest payments on the interest rate swaps, which matured in the first quarter of fiscal 2020, were paid monthly and the fixed-rate interest receivable on the swaps was received semi-annually concurrent with the Notes interest payments.Interest expense decreased during fiscal 2020 as compared to fiscal 2019 primarily due to lower average interest rates on our debt instruments that were refinanced in the first quarter of fiscal 2020.52Table of ContentsInvestment Gains (Losses), NetInvestment gains (losses), net consists principally of unrealized holding gains and losses associated with our deferred compensation plan assets which are classified as trading securities, and gains and losses associated with our direct and indirect investments in privately held companies.Investment gains (losses), net decreased during fiscal 2020 as compared to fiscal 2019 primarily due to the gain recognized upon our acquisition of the remaining interest in Allegorithmic in January 2019.Other Income (Expense), Net Other income (expense), net consists primarily of interest earned on cash, cash equivalents and short-term fixed income investments. Other income (expense), net also includes realized gains and losses on fixed income investments and foreign exchange gains and losses.Other income (expense), remained stable during fiscal 2020 primarily due to decreases in interest income driven by lower average interest rates offset by our change in methodology of accounting for foreign currency cash flow hedges. Effective in the third quarter of fiscal 2019, option premiums, which were previously recorded in other income (expense), net, are recorded in accumulated other comprehensive income (loss).Provision for (Benefit from) Income Taxes (dollars in millions)202020192018% Change2020-2019Provision for (benefit from) income taxes$(1,084)$254 $203 **Percentage of total revenue(8)%2 %2 % Effective tax rate(26)%8 %7 % _________________________________________(**) Percentage is not meaningful.Our effective tax rate decreased by approximately 34 percentage points during fiscal 2020 as compared to fiscal 2019. The change is primarily due to non-recurring tax benefits resulting from the intra-entity transfers of certain intellectual property rights (“IP rights”) completed during fiscal 2020. Our effective tax rate for fiscal 2020 was lower than the U.S. federal statutory tax rate of 21% primarily due to tax benefits resulting from the intra-entity transfers of certain IP rights, a favorable geographic mix of earnings and tax benefits related to stock-based compensation.During fiscal 2020, we completed intra-entity transfers of certain IP rights to our Irish subsidiary in order to better align the ownership of these rights with how our business operates. The transfers did not result in taxable gains; however, our Irish subsidiary recognized deferred tax assets for the book and tax basis difference of the transferred IP rights. As a result of these transactions, we recorded deferred tax assets, net of valuation allowance, and related tax benefits of $224 million and $1.13 billion, based on the fair value of the IP rights transferred in April and November 2020, respectively. The tax-deductible amortization related to the transferred IP rights will be recognized over the period of economic benefit. In years beyond fiscal 2020, the change in the geographic mix of international income resulting from these transfers is anticipated to adversely affect our effective income tax rates and cash flows. However, the adverse impact to effective rates for cash paid for income taxes will be partially offset by future deductions on the transferred IP rights.On December 22, 2017, the U.S. Tax Act was enacted into law, which significantly changed existing U.S. tax law and includes many provisions applicable to us. Certain international provisions of the U.S. Tax Act, such as a tax on global intangible low-tax income, a base erosion and anti-abuse tax and a special tax deduction for foreign-derived intangible income, took effect in fiscal 2019. As the U.S. Treasury releases regulations that impact these provisions, we account for finalized regulations in the period of enactment.We recognize deferred tax assets to the extent that we believe these assets are more likely than not to be realized. In making such a determination, we considered all available positive and negative evidence, including our past operating results, forecasted earnings, future taxable income and prudent and feasible tax planning strategies. On the basis of this evaluation, we continue to maintain a valuation allowance to reduce our deferred tax assets to the amount realizable. The total valuation allowance was $276 million as of November 27, 2020 and is primarily attributable to certain state and foreign credits and foreign intangible assets. 53Table of ContentsWe are a United States-based multinational company subject to tax in multiple U.S. and foreign tax jurisdictions. A significant portion of our foreign earnings for the current fiscal year were earned by our Irish subsidiaries. The current U.S. tax law provides an exemption from federal income taxes for distributions from foreign subsidiaries made after December 31, 2017, including certain earnings that were not subject to the one-time transition or global intangible low-tax income tax. As we repatriate the undistributed foreign earnings for use in the U.S., the distributions will generally not be subject to further U.S. federal tax.In June 2020, California enacted legislation which includes a limitation on the utilization of research and development tax credits for a three-year period beginning in fiscal 2021. The net impact of the legislation is uncertain but is anticipated to increase our California tax and, consequently, adversely impact our effective tax rates for the three-year period beginning in fiscal 2021.See Note 10 of our Notes to Consolidated Financial Statements for further information on our provision for (benefit from) income taxes. Accounting for Uncertainty in Income TaxesThe gross liabilities for unrecognized tax benefits excluding interest and penalties were $201 million, $173 million and $196 million for fiscal 2020, 2019 and 2018, respectively. If the total unrecognized tax benefits at November 27, 2020, November 29, 2019 and November 30, 2018 were recognized, $136 million, $116 million and $136 million would decrease the respective effective tax rates.The combined amount of accrued interest and penalties related to tax positions taken on our tax returns were approximately $26 million and $25 million for fiscal 2020 and 2019, respectively. These amounts were included in long-term income taxes payable in their respective years.The timing of the resolution of income tax examinations is highly uncertain as are the amounts and timing of tax payments that are part of any audit settlement process. These events could cause large fluctuations in the balance sheet classification of our tax assets and liabilities. We believe that within the next 12 months, it is reasonably possible that either certain audits will conclude or statutes of limitations on certain income tax examination periods will expire, or both. Given the uncertainties described above, we can only determine a range of estimated potential decreases in underlying unrecognized tax benefits ranging from $0 to approximately $20 million over the next 12 months.In addition, in countries where we conduct business and in jurisdictions in which we are subject to tax, including those covered by governing bodies that enact tax laws applicable to us, such as the European Commission of the European Union, we are subject to potential changes in relevant tax, accounting and other laws, regulations and interpretations, including changes to tax laws applicable to corporate multinationals such as Adobe. These countries, other governmental bodies and intergovernmental economic organizations such as the Organization for Economic Cooperation and Development, have or could make unprecedented assertions about how taxation is determined in their jurisdictions that are contrary to the way in which we have interpreted and historically applied the rules and regulations described above in such jurisdictions. In the current global tax policy environment, any changes in laws, regulations and interpretations related to these assertions could adversely affect our effective tax rates, cause us to respond by making changes to our business structure, or result in other costs to us which could adversely affect our operations and financial results.Moreover, we are subject to the continual examination of our income tax returns by the U.S. Internal Revenue Service and other domestic and foreign tax authorities. These tax examinations are expected to focus on our intercompany transfer pricing practices, application of tax rules and other matters. We regularly assess the likelihood of outcomes resulting from these examinations to determine the adequacy of our provision for income taxes and have reserved for potential adjustments that may result from these examinations. We cannot provide assurance that the final determination of any of these examinations will not have an adverse effect on our operating results and financial position.54Table of Contents LIQUIDITY AND CAPITAL RESOURCESThis data should be read in conjunction with our Consolidated Statements of Cash Flows.As of(in millions)November 27, 2020November 29, 2019Cash and cash equivalents$4,478 $2,650 Short-term investments$1,514 $1,527 Working capital$2,634 $(1,696)Stockholders’ equity$13,264 $10,530 Working CapitalWorking capital as of November 27, 2020 and November 29, 2019 was $2.63 billion of a surplus and $1.70 billion of a deficit, respectively. During the first quarter of fiscal 2020, we refinanced our 2.25 billion term loan due April 30, 2020 (“Term Loan”) and $900 million 4.75% senior notes due February 1, 2020 (“2020 Notes”). See the section titled “Cash Flows from Financing Activities” below. A summary of our cash flows for fiscal 2020, 2019 and 2018 is as follows:(in millions)202020192018Net cash provided by operating activities$5,727 $4,422 $4,029 Net cash used for investing activities(414)(456)(4,685)Net cash used for financing activities(3,488)(2,946)(5)Effect of foreign currency exchange rates on cash and cash equivalents3 (13)(2)Net increase (decrease) in cash and cash equivalents$1,828 $1,007 $(663)Our primary source of cash is receipts from revenue and, to a lesser extent, proceeds from participation in the employee stock purchase plan. The primary uses of cash are our stock repurchase program as described below, payroll-related expenses, general operating expenses including marketing, travel and office rent, and cost of revenue. Other uses of cash include business acquisitions, purchases of property and equipment and payments for taxes related to net share settlement of equity awards.Cash Flows from Operating ActivitiesFor fiscal 2020, net cash provided by operating activities of $5.73 billion was primarily comprised of net income adjusted for the net effect of non-cash items. The primary working capital sources of cash were net income together with increases in deferred revenue and decreases in trade receivables, which were offset in part by increases in prepaid expenses and other assets. The increase in deferred revenue was primarily driven by Digital Media offerings with cloud-enabled services, and the decrease in trade receivables was largely attributable to strong collections. The primary working capital use of cash was due to increases in prepaid expenses and other assets driven by sales commissions paid and capitalized and, to a lesser extent, increases due to the timing of billings and payments associated with certain vendors.Cash Flows from Investing ActivitiesFor fiscal 2020, net cash used for investing activities of $414 million was primarily due to ongoing capital expenditures. These cash outflows were offset in part by proceeds from sales and maturities of short-term investments, net of purchases.Cash Flows from Financing ActivitiesFor fiscal 2020, net cash used for financing activities of $3.49 billion was primarily due to payments for our treasury stock repurchases and taxes paid related to the net share settlement of equity awards, which were offset by proceeds from re-issuance of treasury stock for our employee stock purchase plan. See the section titled “Stock Repurchase Program” discussed below.In February 2020, we issued $500 million of 1.70% senior notes due February 1, 2023 (“2023 Notes”), $500 million of 1.90% senior notes due February 1, 2025 (“1.90% 2025 Notes”), $850 million of 2.15% senior notes due February 1, 2027 (“2027 Notes”) and $1.30 billion of 2.30% senior notes due February 1, 2030 (“2030 Notes”). We used the proceeds to repay the Term Loan and 2020 Notes concurrently. See Note 17 of our Notes to Consolidated Financial Statements for information regarding our debt refinancing.55Table of ContentsOther Liquidity and Capital Resources ConsiderationsOur existing cash, cash equivalents and investment balances may fluctuate during fiscal 2021 due to changes in our planned cash outlay. Cash from operations could also be affected by various risks and uncertainties, including, but not limited to, the effects of the pandemic and other risks detailed in Part I, Item 1A titled “Risk Factors.” While the pandemic has not negatively impacted our liquidity and capital resources to date, it has led to increased disruption and volatility in capital markets and credit markets which could adversely affect our liquidity and capital resources in the future. However, based on our current business plan and revenue prospects, we believe that our existing cash, cash equivalents and investment balances, our anticipated cash flows from operations and our available credit facility will be sufficient to meet our working capital, operating resource expenditure and capital expenditure requirements for the next twelve months.Our cash equivalent and short-term investment portfolio as of November 27, 2020 consisted of asset-backed securities, corporate debt securities, foreign government securities, money market mutual funds, municipal securities and time deposits. We use professional investment management firms to manage a large portion of our invested cash.We have a $1 billion senior unsecured revolving credit agreement (“Revolving Credit Agreement”) with a syndicate of lenders, providing for loans to us and certain of our subsidiaries through October 17, 2023. As of November 27, 2020, there were no outstanding borrowings under this credit agreement and the entire $1 billion credit line remains available for borrowing. As of November 27, 2020, we have $4.15 billion senior notes outstanding, consisting of the 2023 Notes, 1.90% 2025 Notes, 2027 Notes, 2030 Notes and the $1 billion of 3.25% senior notes due February 1, 2025 (the “3.25% 2025 Notes,” and together with the aforementioned notes, the “Notes”). The Notes rank equally with our other unsecured and unsubordinated indebtedness.We expect to continue our investing activities, including short-term and long-term investments, purchases of computer systems for research and development, sales and marketing, product support and administrative staff, and facilities expansion. As of November 27, 2020, we expect our capital investment to be approximately $550 million to $650 million, primarily to fund our San Jose and Bangalore construction projects through fiscal 2022. Furthermore, cash reserves may be used to repurchase stock under our stock repurchase program and to strategically acquire companies, products or technologies that are complementary to our business.Subsequent to November 27, 2020, we completed our acquisition of Workfront, a privately held company that provides a work management platform for marketers, for approximately $1.5 billion in cash consideration. See Note 3 of our Notes to Consolidated Financial Statements for further information regarding this acquisition.Stock Repurchase ProgramTo facilitate our stock repurchase program, designed to return value to our stockholders and minimize dilution from stock issuances, we may repurchase shares in the open market or enter into structured repurchase agreements with third parties. In May 2018, our Board of Directors granted us an authority to repurchase up to $8 billion in common stock through the end of fiscal 2021.During fiscal 2020, 2019 and 2018, we entered into several structured stock repurchase agreements with large financial institutions, whereupon we provided them with prepayments totaling $3.05 billion, $2.75 billion, and $2.05 billion, respectively. We enter into these agreements in order to take advantage of repurchasing shares at a guaranteed discount to the Volume Weighted Average Price (“VWAP”) of our common stock over a specified period of time. We only enter into such transactions when the discount that we receive is expected to be higher than the foregone return on our cash prepayments to the financial institutions. There were no explicit commissions or fees on these structured repurchases. Under the terms of the agreements, there is no requirement for the financial institutions to return any portion of the prepayment to us. The financial institutions agree to deliver shares to us at monthly intervals during the contract term. The parameters used to calculate the number of shares deliverable are: the total notional amount of the contract, the number of trading days in the contract, the number of trading days in the interval and the average VWAP of our stock during the interval less the agreed upon discount.56Table of ContentsThe following is a summary of our structured stock repurchases executed with large financial institutions during fiscal 2020, 2019 and 2018:(in millions, except average price per share)202020192018Board approval datesSharesAverage per shareSharesAverage per shareSharesAverage per shareJanuary 2017— $— — $— 8.7 $230.43 May 20188.0 $376.38 9.9 $270.23 — $— Total cost$3,024$2,671$2,002For fiscal 2020, 2019 and 2018, the prepayments were classified as treasury stock on our Consolidated Balance Sheets at the payment date, though only shares physically delivered to us by November 27, 2020, November 29, 2019 and November 30, 2018 were excluded from the computation of earnings per share. As of November 27, 2020, $255 million of prepayments remained under the agreement. Subsequent to November 27, 2020, we entered into a structured stock repurchase agreement with a large financial institution whereupon we provided them with a prepayment of $950 million. This amount will be classified as treasury stock on our Consolidated Balance Sheets. Upon completion of the $950 million stock repurchase agreement, $1.1 billion remains under our May 2018 authority. Further, in December 2020, our Board of Directors granted us additional authority to repurchase up to $15 billion in common stock through the end of fiscal 2024. We have not drawn from our new $15 billion authority as of the issuance of these financial statements.See Item 5, Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities for share repurchases during the quarter ended November 27, 2020.Off-Balance Sheet Arrangements and Aggregate Contractual Obligations Our principal commitments as of November 27, 2020 consist of our Notes and obligations under operating leases, royalty agreements and various service agreements. See Notes 16, 17 and 18 of our Notes to Consolidated Financial Statements for additional information regarding our contractual commitments.Contractual ObligationsThe following table summarizes our contractual obligations as of November 27, 2020:(in millions) Payment Due by Period TotalLess than1 year1-3 years3-5 yearsMore than5 yearsNotes, including interest$4,763 $99 $693 $1,659 $2,312 Operating lease obligations657 104 162 119 272 Purchase obligations 1,885 872 1,012 1 — Total$7,305 $1,075 $1,867 $1,779 $2,584 Senior NotesAs of November 27, 2020, the carrying value of our Notes was $4.12 billion. Interest is payable semi-annually, in arrears on February 1 and August 1. At November 27, 2020, our maximum commitment for interest payments was $613 million for the remaining duration of our outstanding Notes.CovenantsOur Revolving Credit Agreement contains a financial covenant requiring us not to exceed a maximum leverage ratio. As of November 27, 2020, we were in compliance with this covenant. We believe this covenant will not impact our credit or cash in the coming fiscal year or restrict our ability to execute our business plan. Our Notes do not contain any financial covenants.Under the terms of our Revolving Credit Agreement, we are not prohibited from paying cash dividends unless payment would trigger an event of default or if one currently exists. We do not anticipate paying any cash dividends in the foreseeable future.57Table of ContentsTransition Taxes LiabilityOur transition tax liability which was accrued as a result of the U.S. Tax Act was approximately $390 million as of November 27, 2020 and is payable in installments through fiscal 2026. The U.S. Tax Act provides an exemption from federal income taxes for distributions from foreign subsidiaries made after December 31, 2017, including certain earnings that were not subject to the one-time transition or global intangible low-tax income tax. As we repatriate the undistributed foreign earnings for use in the U.S., the distributions will generally not be subject to further U.S. federal tax.Accounting for Uncertainty in Income TaxesSee Results of Operations - Provision for (Benefit from) Income Taxes above and Note 10 of our Notes to Consolidated Financial Statements for our discussion on accounting for uncertainty in income taxes.RoyaltiesWe have certain royalty commitments associated with the licensing of certain offerings. Royalty expense is generally based on a dollar amount per unit sold or a percentage of the underlying revenue.IndemnificationsIn the normal course of business, we provide indemnifications of varying scope to customers and channel partners against claims of intellectual property infringement made by third parties arising from the use of our products and from time to time, we are subject to claims by our customers under these indemnification provisions. Historically, costs related to these indemnification provisions have not been significant and we are unable to estimate the maximum potential impact of these indemnification provisions on our future results of operations.To the extent permitted under Delaware law, we have agreements whereby we indemnify our directors and officers for certain events or occurrences while the director or officer is or was serving at our request in such capacity. The indemnification period covers all pertinent events and occurrences during the director’s or officer’s lifetime. The maximum potential amount of future payments we could be required to make under these indemnification agreements is unlimited; however, we have director and officer insurance coverage that limits our exposure and enables us to recover a portion of any future amounts paid. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKAll market risk sensitive instruments were entered into for non-trading purposes.Foreign Currency RiskForeign Currency Exposures and Hedging InstrumentsIn countries outside the United States, we transact business in U.S. Dollars and various other currencies, which subject us to exposure from movements in exchange rates. We may use foreign exchange option contracts or forward contracts to hedge a portion of our forecasted foreign currency denominated revenue. Additionally, we hedge our net recognized foreign currency monetary assets and liabilities with foreign exchange forward contracts to reduce the risk that our earnings and cash flows will be adversely affected by changes in exchange rates. Our significant foreign currency revenue exposures for fiscal 2020, 2019 and 2018 were as follows :(in millions)202020192018Euro€1,887 €1,603 €1,310 Japanese Yen¥88,640 ¥73,158 ¥60,791 British Pounds£562 £503 £423 Australian Dollars$645 $538 $441 As of November 27, 2020, the total notional amounts of all outstanding foreign exchange contracts, including options and forwards, was $2.03 billion, which included the notional equivalent of $923 million in Euros, $385 million in Japanese Yen, $321 million in British Pounds, $212 million in Australian Dollars and $186 million in other foreign currencies. As of November 27, 2020, all contracts were set to expire at various dates through June 2021. The bank counterparties in these contracts could expose us to credit-related losses that would be largely mitigated with master netting arrangements with the same counterparty by permitting net settlement transactions. In addition, we enter into collateral security agreements that 58Table of Contentsprovide for collateral to be received or posted when the net fair value of these contracts fluctuates from contractually established thresholds.A sensitivity analysis was performed on all of our foreign exchange derivatives as of November 27, 2020. This sensitivity analysis measures the hypothetical market value resulting from a 10% shift in the value of exchange rates relative to the U.S. Dollar. For option contracts, the Black-Scholes option pricing model was used. A 10% increase in the value of the U.S. Dollar and a corresponding decrease in the value of the hedged foreign currency asset would lead to an increase in the fair value of our financial hedging instruments by $97 million. Conversely, a 10% decrease in the value of the U.S. Dollar would result in a decrease in the fair value of these financial instruments by $9 million.As a general rule, we do not use foreign exchange contracts to hedge local currency denominated operating expenses in countries where a natural hedge exists. For example, in many countries, revenue in the local currencies substantially offsets the local currency denominated operating expenses. We also have long-term investment exposures consisting of the capitalization and retained earnings in our non-U.S. Dollar functional currency foreign subsidiaries. As of November 27, 2020 and November 29, 2019, this long-term investment exposure totaled an absolute notional equivalent of $598 million and $385 million, respectively, with the year-over-year increase primarily driven by earnings growth. At this time, we do not hedge these long-term investment exposures.We do not use foreign exchange contracts for speculative trading purposes, nor do we hedge our foreign currency exposure in a manner that entirely offsets the effects of changes in foreign exchange rates. We regularly review our hedging program and assess the need to utilize financial instruments to hedge currency exposures on an ongoing basis.Cash Flow Hedges of Forecasted Foreign Currency Revenue We may use foreign exchange purchased options or forward contracts to hedge foreign currency revenue denominated in Euros, British Pounds, Japanese Yen and Australian Dollars. We hedge these cash flow exposures to reduce the risk that our earnings and cash flows will be adversely affected by changes in exchange rates. These foreign exchange contracts, carried at fair value, have maturities of up to twelve months. We enter into these foreign exchange contracts to hedge forecasted revenue in the normal course of business and accordingly, they are not speculative in nature.We record changes in fair value of these cash flow hedges of foreign currency denominated revenue in accumulated other comprehensive income (loss) in our Consolidated Balance Sheets, until the forecasted transaction occurs. When the forecasted transaction affects earnings, we reclassify the related gain or loss on the cash flow hedge to revenue. In the event the underlying forecasted transaction does not occur, or it becomes probable that it will not occur, we reclassify the gain or loss on the related cash flow hedge from accumulated other comprehensive income (loss) to revenue. For the fiscal year ended November 27, 2020, there were no net gains or losses recognized in revenue relating to hedges of forecasted transactions that did not occur.Non-Designated Hedges of Foreign Currency Assets and LiabilitiesOur derivatives not designated as hedging instruments consist of foreign currency forward contracts that we primarily use to hedge monetary assets and liabilities denominated in non-functional currencies to reduce the risk that our earnings and cash flows will be adversely affected by changes in foreign currency exchange rates. These foreign exchange contracts are carried at fair value with changes in fair value of these contracts recorded to other income (expense), net in our Consolidated Statements of Income. These contracts reduce the impact of currency exchange rate movements on our assets and liabilities. At November 27, 2020, the outstanding balance sheet hedging derivatives had maturities of 180 days or less.See Note 6 of our Notes to Consolidated Financial Statements for information regarding our derivative financial instruments.59Table of ContentsInterest Rate RiskShort-Term Investments and Fixed Income SecuritiesAt November 27, 2020, we had debt securities classified as short-term investments of $1.51 billion. Changes in interest rates could adversely affect the market value of these investments. A sensitivity analysis was performed on our investment portfolio as of November 27, 2020. The analysis is based on an estimate of the hypothetical changes in market value of the portfolio that would result from an immediate parallel shift in the yield curve of various magnitudes.The following tables present the hypothetical fair values of our debt securities classified as short-term investments assuming immediate parallel shifts in the yield curve of 50 basis points (“BPS”), 100 BPS and 150 BPS. The analysis is shown as of November 27, 2020 and November 29, 2019: (dollars in millions)-150 BPS-100 BPS-50 BPSFair Value 11/27/20+50 BPS+100 BPS+150 BPS$1,521 $1,520 $1,519 $1,514 $1,507 $1,500 $1,493 -150 BPS-100 BPS-50 BPSFair Value 11/29/19+50 BPS+100 BPS+150 BPS$1,545 $1,539 $1,533 $1,527 $1,521 $1,515 $1,509 Senior NotesFollowing our debt refinancing in February 2020, our outstanding Notes have fixed interest rates. As of November 27, 2020, the total carrying amount of our Notes was $4.12 billion and the related fair value based on observable market prices in less active markets was $4.48 billion.See Note 17 of our Notes to Consolidated Financial Statements for information regarding our senior notes.60Table of Contents
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+Item 7. Management Discussion and Analysis of Financial Condition and Results of Operations (MD&A).The Company is authorized to conduct insurance business in all 50 states, the District of Columbia, several U.S. territories and Japan. The Company’s website is: www.aflac.com. Information included on the Company’s website is not incorporated by reference into this filing. The Company makes available free of charge through its website, its annual report on Form 10-K, its quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports as soon as reasonably practicable after they have been electronically filed with or furnished to the Securities and Exchange Commission (SEC).REVENUE-GENERATING ACTIVITIESThe Company's strategy for growth in the U.S. and Japan has remained straightforward and consistent for many years. The Company develops relevant supplemental insurance products and sells them through expanded distribution channels. To help promote its insurance products, the Company’s marketing campaigns feature the Aflac Duck.LONG-TERM GROWTH STRATEGYIn 1999, the Company had been running commercials for nearly a decade, but its brand awareness was hovering at about 10%. An innovative marketing campaign with something unique and memorable that would build brand awareness was needed. The Aflac Duck’s first commercial in the U.S., “Park Bench,” aired on January 1, 2000 and taught consumers how to pronounce “Aflac.” The Aflac Duck made his international debut in Japan in 2003. In the two decades since his U.S. debut, the Aflac Duck has become one of the most familiar advertising icons in the world, appearing in several 2Item 1. Businesscommercials and countless print ads in both the U.S. and Japan. Today, the Aflac Duck is a helpmate who increases brand knowledge and connection. The Company's insurance business consists of two reporting segments: Aflac Japan and Aflac U.S. The primary insurance subsidiary in the Aflac Japan segment is Aflac Life Insurance Japan Ltd. Aflac U.S includes the insurance subsidiaries American Family Life Assurance Company of Columbus (Aflac); Continental American Insurance Company (CAIC), branded as Aflac Group Insurance (AGI); American Family Life Assurance Company of New York (Aflac New York); and Tier One Insurance Company (TOIC); as well as Argus Dental & Vision, Inc. (Argus), which is licensed as a third party administrator in most U.S. jurisdictions and as a pre-paid limited health service organization in Florida.In November 2020, the Company, through its insurance subsidiaries Aflac and Aflac New York, acquired Zurich North America’s U.S. Corporate Life and Pensions business, which consists of group life, disability and absence management products. Aflac and Aflac New York agreed to reinsure on an indemnity basis Zurich North America’s U.S. in-force group life and disability policies with annualized earned premium of over $100 million. Aflac also acquired assets needed to support the group life and disability business, along with an absence management platform.In November 2019, the Company acquired Argus Holdings, LLC and its subsidiary Argus Dental & Vision, Inc. (Argus), a benefits management organization and national network dental and vision company, which provides a platform for Aflac Dental and Vision. Argus is an addition to the Aflac U.S. segment.Aflac Japan is the principal contributor to the Parent Company’s consolidated earnings. Aflac Japan's revenues, including realized gains and losses on its investment portfolio, accounted for 68% of the Company's total revenues in 2020, compared with 69% in 2019 and 70% in 2018. The percentage of the Company's total assets attributable to Aflac Japan was 83% at both December 31, 2020 and 2019. For information on the Company's results of operations and financial information by segment, see Item 7. MD&A and Note 2 of the Notes to the Consolidated Financial Statements in this report.AFLAC JAPANAflac Japan is the largest insurer in Japan in terms of cancer and medical (third sector insurance products) policies in force. As of December 31, 2020, Aflac Japan exceeded 24 million individual policies in force in Japan. Aflac Japan continued to be the number one seller of cancer insurance policies in Japan throughout 2020, with more than 15 million cancer policies in force as of December 31, 2020. Insurance ProductsAflac Japan's third sector insurance products are designed to help consumers pay for medical and nonmedical costs that are not reimbursed under Japan's national health insurance system. Changes in Japan's economy and an aging population have put increasing pressure on Japan's national health care system. As a result, more costs have been shifted to Japanese consumers, who in turn have become increasingly interested in insurance products that help them manage those costs. Aflac Japan has responded to this consumer need by enhancing existing products and developing new products. The focus at Aflac Japan remains on maintaining leadership in third sector insurance products that are less interest rate sensitive and have strong and stable margins. At the same time, Aflac Japan complements this core business with similarly profitable first sector protection products as outlined below. THIRD SECTOR INSURANCEFIRST SECTOR INSURANCELife insurance products include:▪CancerProtection type:Savings type:▪Medical▪Term Life▪WAYS▪Income Support▪Whole Life▪Child Endowment▪GIFTCancer Insurance Aflac Japan pioneered the cancer insurance market in Japan in 1974, and remains the number one provider of cancer insurance in Japan today. Aflac Japan's cancer insurance products provide a lump-sum benefit upon initial diagnosis of cancer and fixed daily benefits for subsequent hospitalization and outpatient treatments due to cancer, as well as cancer-related surgical and convalescent care benefits.3Item 1. BusinessMedical Insurance Aflac Japan's medical insurance products provide benefits for hospitalization, surgeries and outpatient treatment of various illnesses, as well as lump sum benefits related to three critical illnesses: cancer, heart attack, and stroke.Income Support Insurance Aflac Japan's Income Support Insurance provides fixed-benefit amounts in the event that a policyholder is unable to work due to significant illness or injury and was developed to supplement the disability coverage within Japan’s social security system.Whole Life Aflac Japan launched Prepare Smart Whole-Life Insurance in 2018, a whole life insurance product with low cash surrender value, which offers non-smoking policyholders further discounted premiums, and it provides beneficiaries, typically a designated family member, with a pre-determined benefit payment upon the death of the insured.GIFT GIFT is a term life insurance product that provides a designated family member with a fixed amount of money every month upon a breadwinner’s death or serious disability as family support.WAYS and Child Endowment WAYS is an insurance product which has features that allow policyholders to convert a portion of their life insurance to medical, nursing care or fixed annuity benefits at a predetermined age. Aflac Japan's child endowment insurance product offers a death benefit until a child reaches age 18. This product also pays a lump-sum at the time of the child's entry into high school, as well as an educational annuity for each of the four years during his or her college education. Beginning in 2013, Aflac Japan began to curtail sales of WAYS and Child Endowment, first sector savings-type products, due to persistent low interest rates in Japan and, in particular, the relatively large capital commitment required by such products and their lower profitability, in such an environment.Distribution ChannelsTraditional Sales Channel This distribution channel includes individual agencies, independent corporate agencies and affiliated corporate agencies. Aflac Japan was represented by more than 8,500 sales agencies at the end of 2020, with approximately 112,000 licensed sales associates employed by those agencies, including individual agencies.Banks Consumers in Japan rely on banks to provide not only traditional bank services, but also as one key source to provide insurance solutions and other services. By the end of 2020, Aflac Japan had agreements with approximately 90% of the total number of banks in Japan to sell its products.Dai-ichi Life Aflac Japan's alliance with Dai-ichi Life was launched in 2001, and approximately 40,000 Dai-ichi Life representatives offer Aflac's cancer products.Japan Post Group Aflac Japan's alliance with Japan Post Group was launched in 2008. After the alliance strengthened in 2013, the number of postal outlets of Japan Post Co. Ltd. (JPC) selling Aflac Japan's cancer product increased to more than 20,000 since 2015. Japan Post Insurance Co., Ltd. (JPI) offers Aflac Japan cancer products through its 76 directly managed offices. In 2018, the Company entered a strategic alliance with Japan Post Holdings Co., Ltd. (Japan Post Holdings), the parent company of Japan Post Co. Ltd (JPC) and Japan Post Insurance Co., Ltd. (JPI). See the "Aflac Japan Segment" subsection of MD&A for more about this alliance.Daido Life In 2013, Aflac Japan and Daido Life Insurance entered into an agreement for Daido to sell Aflac Japan's cancer insurance products specifically to the Hojinkai market, which is an association of small businesses. Currently, Daido also sells Aflac Japan's cancer insurance products to the market in the tax payment association, which is a not-for-profit association for small businesses to support tax related matters.Competitive MarketsThe Company competes with other insurance carriers through policyholder service, price, product design and sales efforts, as the number of insurance companies offering stand-alone cancer and medical insurance has more than doubled since the deregulation of the Japan market in 2001. However, based on Aflac Japan's size of annualized premiums in force and diversified distribution network, the Company does not believe that Aflac Japan's market-leading position has been significantly impacted by increased competition. Furthermore, the Company believes the continued development and maintenance of operating efficiencies will allow Aflac Japan to offer affordable products that appeal to consumers. The Company believes Aflac Japan will remain a leading provider of cancer and medical insurance coverage in Japan, principally due to its experience in the market, well-known brand, low-cost operations, expansive marketing system and product expertise.4Item 1. BusinessGovernment RegulationFinancial Services Agency (FSA) The financial and business affairs of Aflac Japan are subject to examination by Japan's FSA. Aflac Japan files annual reports and financial statements for the Japanese insurance operations based on a March 31 fiscal year end, prepared in accordance with Japanese regulatory accounting practices prescribed or permitted by the FSA. Japanese regulatory basis earnings are determined using accounting principles that differ materially from U.S. generally accepted accounting principles (U.S. GAAP). Capital and surplus of Aflac Japan, based on Japanese regulatory accounting practices, was $9.0 billion at December 31, 2020, compared with $7.8 billion at December 31, 2019. Two FSA regulations applicable to Aflac Japan are outlined below. ▪Privacy and CybersecurityWith regard to personal information obtained from policyholders, the insured, or others, Aflac Japan is regulated in Japan by the Act on the Protection of Personal Information (APPI) and guidelines issued by FSA and other governmental authorities. The FSA updated its guidelines regarding cybersecurity in October 2018.•FSA Solvency Standard The FSA maintains a solvency standard, the solvency margin ratio (SMR), which is used by Japanese regulators to monitor the financial strength of insurance companies. Aflac Japan's SMR is sensitive to interest rate, credit spread and foreign exchange rate changes. See the Liquidity and Capital Resources section of Item 7. MD&A for additional information on SMR, including a discussion of measures the Company has taken to mitigate the sensitivity of Aflac Japan's SMR.Japan Companies Act After the conversion of Aflac Japan to a subsidiary structure on April 1, 2018 and starting in the fourth quarter of 2018, Aflac Japan distributes dividends to the Parent Company. Such dividends are subject to permitted dividend capacity under the Japanese Corporate Law.Policyholder Protection The Japanese insurance industry has a policyholder protection corporation that provides funds for the policyholders of insolvent insurers. For additional information, see the policyholder protection section of the MD&A.For additional information regarding Aflac Japan's operations and regulations, see the "Aflac Japan Segment" subsection of the MD&A and Notes 2 and 13 of the Notes to the Consolidated Financial Statements in this report.AFLAC U.S.The Company designs its U.S. insurance products to provide supplemental coverage for people who already have major medical or primary insurance coverage, as Aflac U.S. insurance policies pay benefits regardless of other insurance. Aflac U.S. products are distributed in the individual and group supplemental insurance markets. Aflac's individual policies are portable, meaning that individuals may retain their full insurance coverage upon separation from employment or affiliation with a group, generally at the same premium. Individual policies are typically guaranteed-renewable for the lifetime of the policyholder (to age 75 for short-term disability policies). Insurance Products▪Cancer▪Critical Illness▪Vision▪Accident▪Hospital Indemnity▪Life ▪Disability▪DentalCancer Insurance Aflac U.S.'s cancer insurance products provide a lump-sum benefit upon initial diagnosis of cancer and subsequent benefits for treatment received due to cancer. Aflac U.S. offers cancer insurance on an individual basis.Accident Insurance Aflac U.S. offers accident coverage on both an individual and group basis. These policies pay cash benefits in the event of a covered injury. The accident portion of the policy includes lump-sum benefits for accidental death, dismemberment and specific injuries as well as fixed benefits for hospital confinement. Additional benefits are also available for home modifications, wellness and increased benefits for injuries related to participation in an organized sporting activity.5Item 1. BusinessDisability Insurance Aflac U.S. offers short-term disability benefits on both an individual and group basis and long-term disability benefits on a group basis. The individual short-term disability product offers an Aflac Value Rider that pays a benefit, less claims, for every consecutive five-year term that the policy is in force. Critical Illness Insurance Aflac U.S. offers coverage for critical illness plans on both an individual and group basis. These policies are designed to pay cash benefits in the event of critical illnesses such as heart attack, stroke or cancer. Hospital Indemnity Insurance Aflac U.S. offers hospital indemnity coverage on both an individual and group basis. Hospital indemnity products provide policyholders fixed dollar benefits triggered by hospitalization due to accident or sickness. Indemnity benefits for inpatient and outpatient surgeries, as well as various other diagnostic events, are also available. Aflac U.S. also offers a lump sum rider for a range of critical illness events that can be added to its individual accident, short-term disability and hospital indemnity products.Dental and Vision Insurance Aflac U.S. offers network dental and vision products on a group basis. Aflac U.S. offers fixed-benefit dental coverage on both an individual and group basis. Aflac U.S. offers Vision NowSM, an individually issued policy which provides benefits for serious eye health conditions and loss of sight as well as coverage for corrective eye materials and exam benefits.Life Aflac U.S. offers term- and whole-life policies on both an individual and group basis.SeasonalityIn recent years, new annualized premium sales are generally higher in the fourth quarter for Aflac U.S. group business due to the timing of open enrollment for many employers. As a result, approximately half of total new annualized premium sales for Aflac U.S. are generated in the fourth quarter.Distribution ChannelsIndependent Associates/Career Agents The career agent channel in Aflac U.S. focuses on marketing Aflac to the small business market, defined as employers of between three and 99 employees. Sales associates in the U.S. are independent contractors and are paid commissions and other variable compensation based on first-year and renewal premiums from their sales of insurance products. Brokers The broker channel of Aflac U.S. focuses on selling to the mid- and large-case market, which is comprised of employers with 100 or more employees and typically an average size of 1,000 employees or more. Brokers in the U.S. are independent contractors and are paid commissions based on first-year and renewal premiums from their sales of insurance products.Consumer Markets While Aflac U.S. primarily markets its insurance products at the worksite, Aflac U.S. is also expanding its distribution strategy to directly reach consumers outside of the traditional worksite through digital lead generation. Competitive MarketsAflac U.S. competes against several supplemental insurance carriers on a national and regional basis. Aflac U.S. believes its policies, premium rates, platforms, value-added services and sales commissions are competitive by product type. Moreover, Aflac U.S. believes that its products are distinct from competitive offerings given its product focus (including features, benefits and claims service model), distribution capabilities and brand awareness. Since Aflac products provide an additional level of financial protection for policyholders, the Company believes the increased financial exposure some employees may face creates a favorable opportunity for Aflac U.S. products. However, given the profitability erosion some major medical carriers are facing in their core lines of business, the Company has seen a more competitive landscape as these carriers seek entry into Aflac's supplemental product segments and leverage their core benefit offerings by bundling and discounting products in order to gain market share.Government RegulationInsurance Regulation The Parent Company and its U.S. insurance subsidiaries, Aflac, CAIC, TOIC (Nebraska-domiciled insurance companies), Aflac New York (a New York-domiciled insurance company) are subject to state regulations in the U.S. as an insurance holding company system and Argus, which is licensed as a third party 6Item 1. Businessadministrator in most U.S. jurisdictions and as a pre-paid limited health service organization in Florida. Such regulations generally provide that certain transactions between companies within the holding company system must be fair and equitable. In addition, transfers of assets among such affiliated companies, certain dividend payments from insurance subsidiaries and certain transactions between companies within the system, including management fees, loans and advances are subject to prior notice to, or approval by, state regulatory authorities. These laws generally require, among other things, the insurance holding company and each insurance company directly owned by the holding company to register with the insurance departments of their respective domiciliary states and to furnish annually financial and other information about the operations of companies within the holding company system.Like all U.S. insurance companies, Aflac, CAIC, TOIC and Aflac New York are subject to regulation and supervision in the jurisdictions in which they do business. In general, the insurance laws of the various jurisdictions establish supervisory agencies with broad administrative powers relating to, among other things:•granting and revoking licenses to transact business•regulating trade and claims practices•licensing of insurance agents and brokers•approval of policy forms and premium rates•standards of solvency and maintenance of specified policy benefit reserves and minimum loss ratio requirements•capital requirements•limitations on dividends to shareholders•the nature of and limitations on investments•deposits of securities for the benefit of policyholders•filing of financial statements prepared in accordance with statutory insurance accounting practices prescribed or permitted by regulatory authorities•periodic examinations of the market conduct, financial, and other affairs of insurance companiesThe insurance laws of Nebraska that govern Aflac's activities provide that the acquisition or change of “control” of a domestic insurer or of any person that controls a domestic insurer cannot be consummated without the prior approval of the Nebraska Department of Insurance (NDOI). A person seeking to acquire control, directly or indirectly, of a domestic insurance company or of any person controlling a domestic insurance company (in the case of Aflac, CAIC and TOIC, the Parent Company) must generally file with the NDOI an application for change of control containing certain information required by statute and published regulations and provide a copy to Aflac. In Nebraska, control is generally presumed to exist if any person, directly or indirectly, acquires 10% or more of an insurance company or of any other person or entity controlling the insurance company. The 10% presumption is not conclusive and control may be found to exist at less than 10%. Similar laws apply in New York, the domiciliary jurisdiction of Aflac's New York insurance subsidiary.State insurance departments conduct periodic examinations of the books and records, financial reporting, policy filings and market conduct of insurance companies domiciled in their states, generally once every three to five years. Examinations are generally carried out in cooperation with the insurance departments of other states under guidelines promulgated by the National Association of Insurance Commissioners (NAIC). In 2016, full-scope, risk-focused financial examinations were conducted by the NDOI, New York State Department of Financial Services (NYSDFS), and the South Carolina Department of Insurance (SCDOI) on their state domiciled insurance entities Aflac, Aflac New York, and CAIC, respectively. There were no material findings contained in the final exam reports. CAIC redomiciled to Nebraska as of December 2016 and TOIC redomiciled to Nebraska effective March 11, 2019. The NDOI and NYSDFS are currently conducting full-scope comprehensive financial examinations covering years 2016-2019. The current examinations are expected to close by March 31, 2021.NAIC Risk-Based Capital The NAIC continually reviews regulatory matters, such as risk-based capital (RBC) modernization, group capital calculations and liquidity risk assessment. The NAIC uses an RBC formula relating to insurance risk, business risk, asset risk and interest rate risk to facilitate identification by insurance regulators of inadequately capitalized insurance companies based upon the types and mix of risk inherent in the insurer's operations. The formulas for determining the amount of RBC specify various weighting factors that are applied to financial balances or various levels of activity based on the perceived degree of risk. Regulatory compliance is determined by a ratio of a company's regulatory total adjusted capital to its authorized control level RBC as defined by the NAIC. Companies below specific trigger points or ratios are classified within certain levels, each of which requires specified corrective action. The levels are company action, regulatory action, authorized control, and mandatory control. See Note 13 of the Notes to the Consolidated Financial Statements and the Liquidity and Capital Resources section of MD&A for additional information on RBC.7Item 1. BusinessGuaranty Association and Similar Arrangements Under state insurance guaranty association laws and similar laws in international jurisdictions, the Company is subject to assessments, based on the share of business the Company writes in the relevant jurisdiction, for certain obligations of insolvent insurance companies to policyholders and claimants. In the U.S., some states permit member insurers to recover assessments paid through full or partial premium tax offsets. The Company's policy is to accrue assessments when the entity for which the insolvency relates has met its state of domicile's statutory definition of insolvency, the amount of the loss is reasonably estimable and the related premium upon which the assessment is based is written. In most states, the definition is met with a declaration of financial insolvency by a court of competent jurisdiction. Federal Regulation Federal legislation and administrative policies in several areas, including health care reform legislation, financial services reform legislation, securities regulation, pension regulation, privacy, tort reform legislation and taxation, can significantly and adversely affect insurance companies. Certain federal regulations applicable to Aflac U.S. are outlined below. •Patient Protection and Affordable Care Act The Patient Protection and Affordable Care Act and the Heath Care and Education Reconciliation Act of 2010 (collectively, the ACA), federal health care reform legislation, gave the U.S. federal government direct regulatory authority over the business of health insurance. The ACA, as enacted, does not require material changes in the design of the Company's insurance products. However, indirect consequences of, or changes to, the legislation and regulations could present challenges that could potentially have an impact on the Company's sales model, financial condition and results of operations. Certain provisions of the ACA have been and may continue to be subject to challenge through litigation, the ultimate effects of which on the ACA are uncertain. See the risk factor entitled, "Extensive regulation and changes in legislation can impact profitability and growth" for more information. •Dodd-Frank ActTitle VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank) and regulations issued thereunder, in particular rules to require central clearing for certain types of derivatives, may have an impact on the Company's derivative activity, including activity on behalf of Aflac Japan. The Dodd-Frank Act also established a Federal Insurance Office (FIO) under the U.S. Treasury Department to monitor all aspects of the insurance industry and of lines of business other than certain health insurance, certain long-term care insurance and crop insurance. •Privacy and CybersecurityThe collection, maintenance, use, protection, disclosure and disposal of individually identifiable data by the Company's businesses are regulated at the international, federal and state levels. These laws and rules are subject to change by legislation or administrative or judicial interpretation. Various state laws address the unauthorized access and acquisition of personal information and the use and disclosure of individually identifiable health data to the extent they are more restrictive than those contained in the privacy and security provisions in the federal Gramm-Leach-Bliley Act of 1999 (GLBA) and in the Health Insurance Portability and Accountability Act of 1996 (HIPAA). For example, the California Consumer Privacy Act became effective January 1, 2020 and requires businesses to provide California consumers the right to access, delete, and restrict certain uses of their personal information. HIPAA also requires that the Company imposes privacy and security requirements on its business associates (as such term is defined in the HIPAA regulations). Cybersecurity also continues to be an area of evolving focus for U.S. legislation and regulatory activity. In March 2017, new cybersecurity regulation issued by the NYDFS went into effect that requires covered entities, including Aflac New York, to maintain an information security program meeting certain security, data disposal, audit, activity monitoring, and data encryption requirements. In October 2017, the NAIC adopted an Insurance Data Security Model Law that may be adopted in whole or in part by U.S. states in which the Company’s subsidiaries are licensed. Other states have adopted and, the Company expects, will continue to pass legislation and issue regulations related to cybersecurity. The Company anticipates, assesses and if necessary modifies its information security program to accommodate changes and comply with regulatory regulations concerning privacy and cybersecurity. For further information concerning Aflac U.S. operations, see the "Aflac U.S. Segment" subsection of the MD&A and Notes 2 and 13 of the Notes to the Consolidated Financial Statements in this report.8Item 1. BusinessCORPORATE AND OTHERThe Company's other operations include the Parent Company, Aflac Global Ventures LLC and its subsidiaries, asset management subsidiaries, results of reinsurance retrocession activities and a printing subsidiary. In October 2020, the Company entered into an agreement to purchase approximately $200 million in newly issued common stock of Trupanion, Inc., a provider of medical insurance for pets in the United States and Canada. The Company closed on approximately $60 million of this transaction in October 2020. The Company closed on the remaining approximately $140 million of this transaction in November 2020 which resulted in the Company owning approximately 9% of the outstanding common stock of Trupanion, Inc. The shares were registered for resale and, pursuant to the Shareholder Agreement, subject to certain exceptions, the Company has agreed that it will not transfer its shares of Trupanion, Inc. common stock during a restricted period ending on November 13, 2023.The Company also announced that it has entered into an alliance agreement with Trupanion, Inc. to sell pet insurance in worksites in the U.S., subject to certain exceptions, and to explore on an exclusive basis potential distribution opportunities for pet insurance in Japan.Effective January 1, 2018, investments of Aflac U.S. as well as certain sub-advised assets of Aflac Japan, are managed by the Company’s U.S. asset management subsidiary, Aflac Asset Management LLC (AAM), and investments of Aflac Japan are managed pursuant to an investment advisory agreement between Aflac Japan and the Company's asset management subsidiary in Japan, Aflac Asset Management Japan Ltd. (AAMJ). AAMJ is licensed as a discretionary asset manager under the Japan Financial Instruments and Exchange Act and is subject to rules of the Japan Investment Advisors Association, a self-regulatory organization with mandatory membership for Japan investment managers. Effective January 19, 2021, AAM is registered with the SEC as an investment adviser under the Investment Advisers Act of 1940. AAM and AAMJ are reported in the Corporate and other segment category; however, the assets that they manage are reported in the respective Aflac Japan and Aflac U.S. business segments.For additional information on the Company's other operations, see the "Corporate and Other" subsection of the MD&A and Note 8 in the Notes to the Consolidated Financial Statements. HUMAN CAPITALThe Company’s overarching human capital philosophy is, “If you take care of your employees, your employees will take care of the business.” As of December 31, 2020, Aflac Japan had 6,239 employees, Aflac U.S. had 4,906 employees, and the Company's other operations had 858 employees. The Company's compensation and benefit expense totaled approximately $2.0 billion in 2020 and $1.8 billion in 2019. The Company believes its employee relations are generally satisfactory.TalentThe Company uses internal and external resources to attract, retain and develop talent across a variety of backgrounds and demographics. Aflac Japan seeks diverse talent through annual recruitment of new university graduates as well as mid-career recruitment of those with specialty skills or expertise. For its employees, Aflac Japan implements standard and unified training and development programs focusing on a range of business skills. For example, Aflac Japan’s Leadership Program allows select managers to participate in a comprehensive training program to learn about innovation and the global business environment. Aflac Japan is implementing a human capital management system, beginning in January 2021 with managers and more senior leadership positions. Under the new system, employees will have access to descriptions and necessary skills for all job positions across the Company and will be able to more proactively design their careers.Aflac U.S. recruiting efforts include partnerships with colleges and universities, including historically black colleges and universities, and civic organizations to attract diverse talent. Aflac U.S. also offers a variety of internships, co-operative opportunities and transitional programs to allow emerging talent to develop. Educational opportunities are available for self-development and growth to help employees further enhance their technical and professional skills.CompensationThe Aflac Japan and Aflac U.S. Human Resources divisions operate as centralized internal compensation functions to provide oversight and input to the respective management teams with the objective of providing compensation that is consistent with job scope, duties and responsibilities. The compensation function evaluates new-hire job offers, promotions and compensation adjustments with the goal of consistent and equitable compensation. Defined salary 9Item 1. Businessstructures are reviewed regularly and updated utilizing market data. Job levels and associated compensation are determined based on annually updated market data, job scope, duties and responsibilities. Employee performance reviews are conducted annually and are factored into employee bonuses and salaries.Health and WellnessAflac Japan is certified as a Health and Productivity Management Organization by Japan’s Ministry of Economy, Trade and Industry. This certification is awarded for best practices in employee health management, strategically focused work style and development of a socially appreciative work environment. Aflac Japan has also developed a program to promote healthy lifestyles for employees at home and the office, with benefits including women’s health programs, healthy meal options in the cafeteria, fitness programs and smoking cessation support.Aflac U.S. Health and Wellness, a training and service program works to enhance organizational health, encourage healthy lifestyles among all U.S. employees, provide diverse wellness programs to meet a wide range of personal health needs, recognize employees for participating in healthier lifestyles activities, and support a positive corporate culture that is focused on celebrating and improving the quality of life for all U.S.employees.Diversity & InclusionThe Company’s corporate culture reflects its commitment to diversity and inclusion at all levels of the Company. For example:•As of December 31, 2020, women account for 52% of Aflac Japan employees and 32% of those in leadership positions including managers and assistant managers. Women also held 22.5% of senior officer roles including vice presidents, senior vice presidents and executive vice presidents. Aflac Japan's goal is to further increase the percentage of women in line manager positions by 2025. •As of December 31, 2020, nearly 50% of Aflac U.S. and the Parent Company employees located in the U.S. were minorities and approximately 66% were women. Women also occupied approximately 55% of leadership roles located in the U.S. including officers, directors, senior managers, managers and supervisors, and 30% of officer roles, including vice presidents, senior vice presidents, executive vice presidents and other officer positions. In 2020, 45% of new hires located in the U.S. were minorities and 56% were women.•Established in 2009, Aflac Heartful Services Co., Ltd. (Aflac Heartful Services), a subsidiary of Aflac Japan, promotes the hiring of employees with disabilities. Aflac Heartful Services has established a barrier-free work environment and provides, among other things, specialized training, specially-trained supervisors and development opportunities to support those with disabilities. Of Aflac Heartful Services’ 146 employees as of December 31, 2020, 116 have a disability. Aflac Heartful Services supports these employees with the assistance of advisors for long-term career support.•Both Aflac Japan and Aflac U.S. have created diversity councils that include employees from various levels that meet regularly to discuss activities and initiatives. The councils are designed to create avenues in which employees can communicate and appreciate one another’s cultural differences.•Females and minorities comprise approximately 64% of the Parent Company’s board of directors.Employee Engagement and CultureThe Company strives to have an engaged employee culture by developing programs including career development support and programs emphasizing work life balance. Aflac Japan provides an annual survey to employees to assess their work styles, and in 2021 Aflac Japan plans to conduct a more comprehensive employee survey. Aflac U.S. provides an annual survey to employees to gather their views on company culture, and works with its leadership to monitor continuous improvements and enhance the employee experience. In response to the COVID-19 global pandemic, Aflac Japan is implementing paperless initiatives in order to promote a flexible working style not limited by time or place, and Aflac U.S. announced actions taken for its employees including a commitment to cover the costs of COVID-19 testing and extended paid leave in certain circumstances.For more information on the effects of the COVID-19 global pandemic on the Company’s human capital management, see the Executive Summary section of Item 7. MD&A. 10Item 1. BusinessInformation about the Company's Executive OfficersNAMEPRINCIPAL OCCUPATION(1)AGEDaniel P. AmosChairman, Aflac Incorporated and Aflac, since 2001; Chief Executive Officer, Aflac Incorporated and Aflac, since 1990; President, Aflac, from 2017 until 2018; President, Aflac Incorporated, from 2018 until 2020 69 Steven K. BeaverSenior Vice President, Chief Financial Officer, Aflac U.S., since 2019; Senior Vice President, Financial Planning and Analysis, Aflac Incorporated, from 2018 until 2019; Senior Vice President, Global Strategic Projects, Corporate Financial Planning and Analysis, Aflac Incorporated, from 2017 until 2018; Vice President, Deputy Chief Accounting Officer, Tax Department, Aflac Incorporated, from 2015 until 201656 Max K. BrodénExecutive Vice President, Chief Financial Officer, Aflac Incorporated, since 2020; Senior Vice President and Treasurer, Aflac Incorporated, from 2017 until 2020; Senior Portfolio Manager, Norges Bank, from 2007 until 201742 Frederick J. CrawfordPresident and Chief Operating Officer, Aflac Incorporated, since 2020; Executive Vice President, Chief Financial Officer, Aflac Incorporated, from 2015 until 2020; Executive Vice President, Chief Financial Officer, CNO Financial Group, from 2012 until 201557 J. Todd DanielsExecutive Vice President, Chief Financial Officer, Aflac Japan, since 2018; Executive Vice President, Global Chief Risk Officer and Chief Actuary, Aflac Incorporated, from 2016 until 2018; Senior Vice President, Global Chief Risk Officer and Chief Actuary, Aflac, from 2015 until 2016; Senior Vice President, Deputy Corporate Actuary and Global Chief Risk Officer, Aflac, from 2014 until 201550 June HowardChief Accounting Officer, Aflac Incorporated and Aflac, since 2010; Senior Vice President, Financial Services, Aflac Incorporated and Aflac, since 2010; Treasurer, Aflac, from 2011 until 201554 Eric M. KirschExecutive Vice President, Global Chief Investment Officer, Aflac, since 2012; President, Aflac Asset Management LLC, since 201760 Masatoshi Koide President and Chief Operating Officer, Aflac Japan since 2017; Deputy President, Aflac Japan from 2016 until 2017; Executive Vice President, Aflac Japan from 2015 until 2016; First Senior Vice President, Aflac Japan, from 2013 until 201560 Charles D. Lake, IIPresident, Aflac International, since 2014; Chairman, Aflac Japan, since 200859 Albert A. RiggieriSenior Vice President, Global Chief Risk Officer and Chief Actuary, Aflac Incorporated, since 2018; Senior Vice President, Corporate Actuary, Aflac, from 2016 until 2018; Group Chief Actuary, Unum Group, until 201665 Audrey B. TillmanExecutive Vice President, General Counsel, Aflac Incorporated and Aflac, since 201456 Teresa L. WhitePresident, Aflac U.S., since 201454 (1) Unless specifically noted, the respective executive officer has held the occupation(s) set forth in the table for at least the last five years. Each executive officer is appointed annually by the board of directors and serves until his or her successor is chosen and qualified, or until his or her death, resignation or removal.11Item 1A. Risk FactorsITEM 1A. RISK FACTORS The Company faces a wide range of risks, and its continued success depends on its ability to identify, prioritize and appropriately manage enterprise risk exposures. Readers should carefully consider each of the following risks and all of the other information set forth in this Form 10-K. These risks and other factors may affect forward-looking statements, including those in this document or made by the Company elsewhere, such as in earnings release webcasts, investor conference presentations or press releases. The risks and uncertainties described herein may not be the only ones facing the Company. Additional risks and uncertainties not presently known to the Company or that the Company currently believes to be immaterial may also adversely affect its business. If any of the following risks and uncertainties develops into actual events, there could be a material impact on the Company.Investment and Markets Risk FactorsDifficult conditions in global capital markets and the economy, including those caused by the novel coronavirus COVID-19, could have a material adverse effect on the Company's investments, capital position, revenue, profitability, and liquidity and harm the Company's business. The Company's results of operations are materially affected by conditions in the global capital markets and the global economy generally, including in its two primary operating markets of the U.S. and Japan. Shifts in global trade policies could result in tariffs and a downturn in the global economy that could negatively impact the Company. A new U.S. presidential administration took office in January 2021, which adds further uncertainty around U.S. trade policies. Weak global financial markets impact the value of the Company's existing investment portfolio, influence opportunities for new investments, and may contribute to generally weak economic fundamentals, which can have a negative impact on its results of operations and financial positions.Global capital markets experienced extreme volatility in early 2020 due to the effects of the COVID-19 global pandemic, but have since stabilized due to central bank and government intervention. Initial volatility triggered dramatic declines in investment values, constrained liquidity, and significantly reduced interest rates. The Company's investment portfolio, including the creditworthiness and valuation of investment assets and availability of new investments, has been, and may continue to be, adversely affected as a result of market developments related to the COVID-19 pandemic and uncertainty regarding its ultimate severity and duration. While conditions have improved, the Company's investments remain vulnerable to extreme asset price volatility, lack of market liquidity, credit rating downgrades, payment defaults, asset restructurings, increased losses, and other risks as the world experiences an unprecedented shock to economic activity.The Company has evaluated its holdings and identified those investments most exposed to the negative impacts of an economic downturn as a result of COVID-19, including but not limited to investments in businesses facing an immediate and severe impact such as travel and lodging, leisure, non-emergency medical, energy, and others involving large gatherings of people. These investments are experiencing and may continue to experience higher credit losses, credit rating downgrades and/or defaults and the Company has examined in each case whether a reduction in size of the holding is appropriate. In addition, volatility in oil prices and reduction in global energy demand could have a continued adverse impact on issuers in the energy sector. While the Company has identified assets impacted or expected to be impacted by COVID-19 and its consequences, other investments not identified to date may also be impacted. The availability of new investments in certain private market asset classes, such as middle market loans, commercial mortgages and transitional real estate, has been and may continue to be limited. Interest rates have declined in response to the pandemic, and a prolonged reduction in interest rates globally could result in new investments generating lower yields than in prior periods. The Company may need to adjust its investment strategy and/or be forced to liquidate investments to pay claims. Actions of governments and central banks in response to COVID-19 may not be adequate to fully address its impact. COVID-19 has resulted in unprecedented disruption of markets and business activity globally, and the Company is not able to predict the duration of such disruption or the ultimate impact of COVID-19 on the Company’s investments and hedging programs. See the risk factor below entitled, “The Company is exposed to significant interest rate risk, which may adversely affect its results of operations, financial condition and liquidity” for more information. See the “Investments” and “Results of Operations by Segment” sections of Item 7, MD&A, for more information. As the Company holds a significant amount of fixed maturity securities issued by borrowers located in many different parts of the world, its financial results are directly influenced by global financial markets. Recent weakness in global capital markets could adversely affect the Company's financial condition, including its capital position and overall profitability. Market volatility and recessionary pressures could result in significant realized or unrealized losses due to severe price declines driven by increases in interest rates or credit spreads, defaults in payment of principal or interest, or credit rating downgrades.12Item 1A. Risk FactorsJapan is the largest market for the Company's insurance products, and the Company owns substantial holdings in Japan Government Bonds (JGBs). Government actions to stimulate the economy affect the value of the Company's existing holdings, its reinvestment rate on new investments in JGBs or other yen-denominated assets, and consumer behavior relative to the Company's suite of insurance products. The additional government debt from fiscal stimulus actions could adversely impact the Japan sovereign credit profile, which could in turn lead to volatility in Japanese capital and currency markets.Should investors become concerned with any of the Company's investment holdings, including the concentration in JGBs, its access to market sources of funding could be negatively impacted. It is possible that lenders or debt investors may also become concerned if the Company incurs large investment losses or if the level of the Company's business activity decreases due to a market downturn or there are further adverse economic trends in the U.S. or Japan, specifically, or generally in developed markets. The Company needs liquidity to pay its operating expenses, dividends on its common stock, interest on its debt, and liabilities. See the "Liquidity and Capital Resources" Item 7, MD&A, for more information. In the event the Company's current resources do not meet its needs, the Company may need to seek additional financing. The Company's access to additional financing will depend on a variety of factors such as market conditions, the general availability of credit within the financial services industry and its credit rating. See the risk factor below entitled, “Any decrease in the Company's financial strength or debt ratings may have an adverse effect on its competitive position and access to liquidity and capital” for more information.Broad economic factors such as consumer spending, business investment, government spending, the volatility and strength of the capital markets, and inflation all affect the business and economic environment and, indirectly, the amount and profitability of the Company's business. In an economic downturn characterized by higher unemployment, lower family income, lower corporate earnings, lower business investment and lower consumer spending, the demand for financial and insurance products could be adversely affected. This adverse effect could be particularly significant for companies such as Aflac that distribute supplemental, discretionary insurance products primarily through the worksite in the event that economic conditions result in a decrease in the number of new hires and total employees. Adverse changes in the economy could potentially lead the Company's customers to be less inclined to purchase supplemental insurance coverage or to decide to cancel or modify existing insurance coverage, which could adversely affect the Company's premium revenue, results of operations and financial condition. The Company is unable to predict the course of the global financial markets or the recurrence, duration or severity of disruptions in such markets.See the risk factor entitled "Major public health issues, and specifically the novel coronavirus COVID-19 and any resulting economic effects could have an adverse impact on the Company's financial condition and results of operations and other aspects of its business" for more information.Defaults, downgrades, widening credit spreads or other events impairing the value of the fixed maturity securities and loan receivables in the Company's investment portfolio may reduce the Company's earnings and capital position.The Company is subject to the risk that the issuers and/or guarantors of fixed maturity securities and loan receivables the Company owns may default on principal or interest. A significant portion of the Company's portfolio represents an unsecured obligation of the issuer, including some that may be subordinated to other debt in the issuer’s capital structure. In these cases, many factors can influence the overall creditworthiness of the issuer and ultimately its ability to service and repay the Company's holdings. This can include changes in the global economy, the company's assets, strategy, or management, shifts in the dynamics of the industries in which they compete, their access to additional funding, and the overall health of the credit markets. Factors unique to the Company's securities including contractual protections such as financial covenants or relative position in the issuer's capital structure also influence the value of the Company's holdings.Most of the Company's investments carry a rating by one or more of the nationally recognized statistical rating organizations (NRSROs or rating agencies). Any change in the rating agencies' approach to evaluating credit and assigning an opinion could negatively impact the fair value of the Company's portfolio. Any expected or sustained credit deterioration of the Company's investments will negatively impact the Company's net income and capital position through credit impairment and other credit related losses. Credit related losses that are not temporary in nature would also affect the Company's solvency ratios in the U.S. and Japan. Aflac Japan has certain regulatory accounting requirements for realizing impairments that could be triggered by credit-related losses, which may be different from U.S. GAAP and statutory requirements. These impairment losses could negatively impact Aflac Japan's earnings, and the corresponding dividends and capital deployment.13Item 1A. Risk FactorsThe Company is also subject to the risk that any collateral providing credit enhancement to the Company's investments could deteriorate. The Company is also exposed to the general movement in credit market spreads. A widening of credit spreads could reduce the value of the Company's existing portfolio, create unrealized losses on its investment portfolio, and reduce the Company's adjusted capital position which is used in determining SMR in Japan. A tightening of credit spreads could reduce the net investment income available to the Company on new credit investments. Increased market volatility also makes it difficult to value certain of the Company's investment holdings. For more information, see the "Critical Accounting Estimates" section of Item 7, MD&A, and the "Credit Risk" subsection of Item 7A, Quantitative and Qualitative Disclosures about Market Risk.The Company is exposed to significant interest rate risk, which may adversely affect its results of operations, financial condition and liquidity.The Company has substantial investment portfolios that support its policy liabilities. Interest rate risk is an inherent portfolio, business and capital risk for the Company, and significant changes in interest rates could have a material adverse effect on the Company's consolidated results of operations, financial condition or cash flows through realized losses, impairments, changes in unrealized positions, and liquidity. Changes in interest rates could also result in the Company having to recognize gains or losses because the Company disposes of some or all of its investments prior to their maturity.The Company's exposure to interest rate risk relates primarily to the ability to invest future cash flows to support the interest rate assumption made at the time the Company's products were priced and the related reserving assumptions were established. Low levels of interest rates on investments experienced in Japan and the U.S. over the last decade have also reduced the level of investment income earned by the Company, and the Company's overall level of investment income will continue to be negatively impacted in a persistent low-interest-rate environment. While the Company generally seeks to maintain a diversified portfolio of fixed-income investments that reflects the cash flow and duration characteristics of the liabilities it supports, the Company may not be able to fully mitigate the interest rate risk of its assets relative to its liabilities. Prolonged periods of low interest rates also heighten the risk associated with future increases in interest rates because an increasing proportion of the Company's investment portfolio include investments that bear lower rates of return than the embedded book yield of the investment portfolio. A rise in interest rates could decrease the fair value of the Company's debt securities. A sustained decline in interest rates could hinder the Company's ability to earn the returns assumed in the pricing and the reserving for its insurance products at the time they were sold and issued and may also influence the Company's ability to develop and price attractive new products and could impact its overall sales levels. The Company's first sector products are more interest rate sensitive than third sector products. As discussed in Item 1, Business, beginning in 2013, Aflac Japan began to curtail sales of first sector savings-type products due to persistent low interest rates in Japan. The continuing negative interest rate imposed by the Bank of Japan (BoJ) on excess bank reserves could continue to have a negative impact on the distribution and pricing of these products.Conversely, a rise in interest rates could improve the Company's ability to earn higher rates of return on future investments, as well as floating rate investments held in its investment portfolio. However, an increase in the differential of short-term U.S. and Japan interest rates would also increase the cost of hedging a portion of the U.S. dollar-denominated assets in the Aflac Japan segment into yen, which could have a material adverse effect on the Company's business, results of operations or financial condition. Further, some of the insurance products that Aflac sells in the U.S. and Japan provide cash surrender values, and a rise in interest rates could trigger significant policy surrenders, which might require the Company to sell investment assets and recognize unrealized losses. Rising interest rates also negatively impact SMR because unrealized losses on the available-for-sale investment portfolio factor into the ratio. For regulatory accounting purposes for Aflac Japan, there are also certain requirements for realizing impairments that could be triggered by rising interest rates, negatively impacting Aflac Japan's earnings and corresponding dividends and capital deployment. The Company’s floating rate investments typically bear interest based on the London Interbank Offered Rate (LIBOR). Regulatory and industry initiatives to eliminate LIBOR as an interest rate benchmark may create uncertainty in the valuation of LIBOR-based loans, derivatives, and other financial contracts. The Company is unable to predict with certainty how LIBOR elimination may impact markets, pricing, liquidity and other factors or the Company's activities. See the "Interest Rate Risk" subsection of Item 7A, Quantitative and Qualitative Disclosures about Market Risk for more information. 14Item 1A. Risk FactorsThe Company's concentration of business in Japan poses risks to its operations and financial condition.The Company's operations in Japan, including net investment gains and losses on Aflac Japan's investment portfolio, accounted for 68% of the Company's total revenues in 2020, 69% in 2019 and 70% 2018. The Japanese operations accounted for 83% of the Company's total assets at both December 31, 2020 and 2019.Any potential deterioration in Japan's credit quality or access to markets, the overall economy of Japan, or an increase in Japanese market volatility could adversely impact Aflac Japan's operations and its financial condition and thereby Aflac's overall financial performance. Further, because of the concentration of the Company's business in Japan and its need for long-dated yen-denominated assets, the Company has a substantial concentration of JGBs in its investment portfolio. The NRSROs, credit rating agencies registered with the SEC, have increased scrutiny of JGBs, resulting in downgrades. See the risk factor entitled “Any decrease in the Company's financial strength or debt ratings may have an adverse effect on its competitive position and access to liquidity and capital” for more information. The Company seeks to match investment currency and interest rate risk to its yen liabilities. The low interest rates on yen-denominated securities has a negative effect on overall net investment income. A large portion of the cash available for reinvestment each year is deployed in yen-denominated instruments and subject to the low level of yen interest rates.Lack of availability of acceptable yen-denominated investments could adversely affect the Company's results of operations, financial position or liquidity.The Company aims to match both the duration and currency of its assets with its liabilities. This is very difficult for Aflac Japan due to the lack of available long-dated yen-denominated fixed income instruments beyond JGBs. Aflac Japan’s investment strategy includes U.S. dollar-denominated investments for which a portion of dollar currency risk is mitigated by entering into currency hedges. This program includes public investment-grade bonds as well as U.S. dollar-denominated investment-grade commercial mortgage loans, middle market loans, infrastructure debt, collateralized loan obligations and other loan types, high yield bond and public and private equities. The Company plans to continue adding other instruments denominated in U.S. dollars, including floating rate investments, to improve the portfolio diversification and/or return profile. Some of the U.S. dollar-denominated asset classes that the Company has added, and anticipates continuing to add, have less liquidity than investment-grade corporate bonds. Further, in recent years the Company has reduced the proportion of U.S. dollar-denominated investments that are subject to a currency hedge, and this proportion continues to be subject to change at the Company’s discretion. These strategies will continue to increase the Company's exposure to U.S. interest rates, credit spreads and other risks. The Company has increased U.S. dollar risk exposure in Japan as the comprehensive hedging program may not always correlate to the underlying U.S. dollar-denominated assets, thereby increasing earnings volatility. These risks can significantly impact the Company's consolidated results of operations, financial position or liquidity.Investing in U.S. dollar-denominated investments in Aflac Japan also creates an unmatched foreign currency exposure and related SMR volatility, as Aflac Japan’s insurance liabilities are yen-denominated. Although the Company engages in certain foreign exchange hedging activities to partially mitigate this risk, and such hedged assets may be used to satisfy yen-denominated insurance liabilities and other business obligations, important risks remain.Foreign exchange derivatives used for hedging are periodically settled, which results in cash receipt or payment at maturity or early termination. Cumulative net cash settlements on derivatives hedging currency exposure of Aflac Japan's U.S. dollar-denominated investments are associated with existing U.S. dollar-denominated investments that continue to be hedged, previously hedged investments that continue to be held but are no longer hedged, and investments previously hedged that have since been sold, matured or redeemed and may or may not have not been converted to yen. The Company’s foreign exchange derivatives are typically shorter-dated than the underlying U.S. dollar-denominated investments being hedged, which creates roll-over risks within the hedging program that could increase the cost of such derivatives. If the Company reduces the notional amount of foreign exchange derivatives prior to the maturity of the hedged U.S. dollar-denominated investments, the foreign exchange gains or losses on the U.S. dollar-denominated investments remain economically unrealized. These foreign currency gains or losses on the investments are only economically realized, or monetized, through sale, maturity or redemption of the investments and concurrent conversion to yen. However, the Company may not realize the benefit of offsetting adverse cash settlements on hedging derivatives with cash receipts on the U.S. dollar-denominated investments if the currency exchange rates move in an adverse direction before the investments are converted to yen, or if the investments are never converted to yen. As an example of the latter, if the Company’s actual insurance risk experience in Japan is as expected or more favorable than expected, the need for yen to pay expenses and claims would correspondingly remain at or below expected levels, thereby diminishing operational requirements to convert U.S. dollar-denominated investments to yen. The settlement of the foreign exchange 15Item 1A. Risk Factorsderivatives is reported in the investing activities section of the Company’s consolidated statements of cash flows in the line item “Settlement of derivatives, net.”See the risk factor entitled “The Company is exposed to foreign currency fluctuations in the yen/dollar exchange rate”, the "Hedging Activities" subsection of Item 7, MD&A, and the "Currency Risk" subsection of Item 7A. Quantitative and Qualitative Disclosures about Market Risk for more information.The Company is exposed to foreign currency fluctuations in the yen/dollar exchange rate.Due to the size of Aflac Japan, where functional currency is the Japanese yen, fluctuations in the exchange rate between the yen and the U.S. dollar can have a significant effect on the Company's reported financial position and results of operations. Aflac Japan's premiums and approximately half of its investment income are received in yen, and its claims and most expenses are paid in yen. Aflac Japan purchases yen-denominated assets and U.S. dollar-denominated assets, which may be hedged to yen, to support yen-denominated policy liabilities. Certain unhedged U.S. dollar denominated assets and liabilities held by Aflac Japan are re-measured to yen with the volatility reported in earnings. Furthermore, the yen-denominated balance sheet of Aflac Japan is translated into U.S. dollars for financial reporting purposes with foreign exchange impact reflected in equity. Accordingly, fluctuations in the yen/dollar exchange rate can have a significant effect on the Company's reported financial position and results of operations. Yen weakening has the effect of suppressing current year results in relation to the prior year, while yen strengthening has the effect of magnifying current year results in relation to the prior year. In addition, the weakening of the yen relative to the U.S. dollar will generally adversely affect the value of the Company's yen-denominated investments in U.S. dollar terms. Further, unhedged U.S. dollar-denominated securities held by Aflac Japan are exposed to foreign exchange fluctuations, which impact SMR. As a result, periods of unusually volatile currency exchange rates could result in limitations on dividends available to the Parent Company.The Company engages in certain foreign currency hedging activities to hedge the exposure to yen from its net investment in Japanese operations. These hedging activities are limited in scope, and the Company cannot provide assurance that these activities will be effective. As indicated in the MD&A, the Company has determined that the unhedged U.S. dollar-denominated investment portfolio acts as a natural economic currency hedge of a portion of the Company’s investment in Aflac Japan against erosion of economic value. At the same time, the unhedged U.S. dollar-denominated investment portfolio creates an unmatched foreign currency exposure and subjects Aflac Japan to volatility in regulatory capital, including SMR, and earnings, which may adversely impact Aflac Japan’s ability to pay dividends to the Parent Company. The Company has historically maintained and currently maintains the size of the unhedged portfolio at levels below the economic equity surplus in Aflac Japan, but there can be no assurance that this strategy will be successful.For regulatory accounting purposes, there are certain requirements for realizing impairments that could be triggered by changes in the rate of exchange between the yen and U.S. dollar and could negatively impact Aflac Japan's earnings and the corresponding dividends and capital deployment. Additionally, the Company is exposed to currency risk when yen cash flows are converted into U.S. dollars, resulting in changes in the Company's U.S. dollar-denominated cash flows and earnings when exchange gains or losses, respectively, are realized. This primarily occurs when Aflac Japan pays dividends in yen to the Parent Company, but it also has an impact when cash in the form of yen is converted to U.S. dollars for investment into U.S. dollar-denominated assets. The exchange rates prevailing at the time of dividend payment may differ from the exchange rates prevailing at the time the yen profits were earned. The Parent Company utilizes forward contracts to accomplish a dual objective of hedging foreign currency exchange rate risk related to dividend payments by Aflac Japan, and reducing enterprise-wide hedge costs. However, if the markets experience a significant strengthening of yen, this could cause cash strain at the Parent Company as a result of cash collateral and potentially cash settlement requirements. Based on the timing and severity of exchange rate fluctuations combined with the level of outstanding activity in this program, the cash strain at the Parent Company could be significant. For more information regarding unhedged U.S. dollar-denominated securities, see the risk factor above entitled, “Lack of availability of acceptable yen-denominated investments could adversely affect the Company’s results of operations, financial position or liquidity”. See the "Currency Risk" subsection of Item 7A, Quantitative and Qualitative Disclosures about Market Risk for more information .The valuation of the Company's investments and derivatives includes methodologies, estimations and assumptions that are subject to differing interpretations and could result in changes to investment valuations that may adversely affect the Company's results of operations or financial condition.16Item 1A. Risk FactorsThe Company reports a significant amount of its fixed maturity securities and other financial instruments at fair value. As such, valuations may include inputs and assumptions that are less observable or require greater estimation and valuation methods that are more sophisticated, thereby resulting in values that may be greater or less than the value at which the investments may be ultimately sold. Rapidly changing and unprecedented credit and equity market conditions could materially impact the valuation of securities as reported within the Company's consolidated financial statements and the period-to-period changes in value could vary significantly.Valuations of the Company's derivatives fluctuate with changes in underlying market variables, such as interest rates and foreign currency exchange rates. During periods of market turbulence created by political instability, economic uncertainty, government interventions or other factors, the Company may experience significant changes in the volatility of its derivative valuations. Extreme market conditions can also affect the liquidity of such instruments creating marked differences in transaction levels and counterparty valuations. Depending on the severity and direction of the movements in its derivative valuations, the Company will face increases in the amount of collateral required to be posted with its counterparties. Liquidity stresses to the Company may also occur if the required collateral amounts increase significantly over a very short period of time. Conversely, the Company may be exposed to an increase in counterparty credit risk for short periods of time while calling collateral from its counterparties.Where valuation and interest rates are based on LIBOR, elimination of LIBOR as an interest rate benchmark may create uncertainty in valuation of loans, derivatives and other assets in the pricing of such assets in markets for their sale and disposition.See the "Critical Accounting Estimates" section of Item 7, MD&A, and Notes 1, 3, 4, and 5 of the Notes to the Consolidated Financial Statements for more information.The determination of the amount of expected credit losses recorded on the Company's investments is based on significant valuation judgments and could materially impact its results of operations or financial position.The Company estimates an expected lifetime credit loss on investments measured at amortized cost including held-to-maturity fixed maturity securities, loan receivables and loan commitments. For the Company’s available-for-sale fixed maturity securities, the Company evaluates estimated credit losses only when the fair value of the available-for-sale fixed maturity security is below its amortized cost basis.The Company’s approach to estimating credit losses is complex and incorporates significant judgments. In addition to a security, or an asset class, or issuer-specific credit fundamentals, it considers relevant historical information (e.g. loss statistics), current market conditions and reasonable and supportable micro and macroeconomic forecasts.The Company's management updates its expected credit loss assumptions regularly as conditions change and as new information becomes available and reflects expected credit losses in the Company's earnings when considered necessary. Furthermore, additional credit losses may need to be taken in the future. Historical trends may not be indicative of future expectations of credit losses.See Note 3 of the Notes to the Consolidated Financial Statements in this report for more information.The Company cannot provide assurance that these evaluations will be accurate and effective. If the Company’s estimates of credit losses are not accurate and actual credit losses are higher than the Company’s estimates, the Company’s net income and capital position will be negatively impacted. These higher losses would also negatively affect the Company's solvency ratios in the U.S. and Japan. For regulatory accounting purposes for Aflac Japan, there are certain requirements for realizing impairments that could be triggered by rising interest rates, credit-related losses, or changes in foreign exchange, negatively impacting Aflac Japan's earnings and corresponding dividend and capital deployment. Any decrease in the Company's financial strength or debt ratings may have an adverse effect on its competitive position and access to liquidity and capital.NRSROs may change their ratings or outlook on an insurer's ratings due to a variety of factors including but not limited to competitive position; profitability; cash generation and other sources of liquidity; capital levels; quality of the investment portfolio; and perception of management capabilities. 17Item 1A. Risk FactorsThe ratings assigned to the Company by the NRSROs are important factors in the Company's ability to access liquidity and capital from the bank market, debt capital markets or other available sources, such as reinsurance transactions. Downgrades of the Company's credit ratings could give its derivative counterparties the right to require early termination of derivatives transactions or delivery of additional collateral, thereby adversely affecting the Company's liquidity. Downgrades of the Company's ratings could also have a material adverse effect on agent recruiting and retention, sales, competitiveness and the marketability of its products, all of which could negatively impact the Company's liquidity, operating results and financial condition. Additionally, sales through the bank channel in Japan could be adversely affected as a result of their reliance on and sensitivity to ratings levels.The Company cannot predict what actions rating agencies may take, or what actions the Company may take in response to the actions of rating agencies. As with other companies in the financial services industry, the Company's ratings could be downgraded at any time and without any notice by any NRSRO.A decline in the creditworthiness of other financial institutions could adversely affect the Company.The Company has exposure to and routinely executes transactions with counterparties in the financial services industry, including broker dealers, derivative counterparties, commercial banks and other institutions. The Company uses derivative instruments to mitigate various risks associated with its investment portfolio, notes payable, and subsidiary dividends. The Company's use of derivatives results in financial exposure to derivative counterparties. If the Company's counterparties fail or refuse to honor their obligations under derivative instruments, the Company's hedges of the risks will be ineffective, and the Company's financial condition and results of operations could be adversely affected. The Company engages in derivative transactions directly with unaffiliated third parties under International Swaps and Derivatives Association, Inc. (ISDA) agreements and other documentation. Most of the ISDA agreements also include Credit Support Annexes (CSAs) provisions, which generally provide for two-way collateral postings at the first dollar of exposure. In addition, a significant portion of the derivative transactions have provisions that give the counterparty the right to terminate the transaction upon a downgrade of Aflac’s financial strength rating. The actual amount of payments that the Company could be required to make depends on market conditions, the fair value of outstanding affected transactions, and other factors prevailing at and after the time of the downgrade. If the Company is required to post collateral to support derivative contracts and/or pay cash to settle the contracts at maturity, the Company's liquidity could be strained. In addition, the Company's cleared swaps result in counterparty exposure to clearing brokers and central clearinghouses; while this exposure is mitigated in part by clearinghouse and clearing broker capital and regulation, no assurance can be provided that these counterparties will fulfill their obligations. The Company also has exposure to counterparties to securities lending transactions in the event they fail to return loaned securities. The Company is also exposed to the risk that there may be a decline in value of securities posted as collateral for securities lending programs or a decline in value of investments made with cash posted as collateral for such programs.Further, the Company has agreements with various Japanese financial institutions for the distribution of its insurance products. For example, at December 31, 2020, the Company had agreements with 361 banks to market Aflac's products in Japan. Sales through these banks represented 5.1% of Aflac Japan's new annualized premium sales in 2020. Any material adverse effect on these or other financial institutions could also have an adverse effect on the Company's sales.The Company has entered into significant reinsurance transactions with large, highly rated counterparties. Negative events or developments affecting any one of these counterparties could have an adverse effect on the Company's financial position or results of operations.All of these risks related to exposure to other financial institutions could adversely impact the Company's consolidated results of operations and financial condition.The concentration of the Company's investment portfolios in any particular single-issuer or sector of the economy may have an adverse effect on the Company's financial position or results of operations.Negative events or developments affecting any particular single issuer, industry, group of related industries, asset class or geographic sector may have an adverse impact on a particular holding or set of holdings, which may increase risk of loss from defaults due to non-payment of interest or principal. To the extent the Company has concentrated positions, it could have an adverse effect on the Company's results of operations and financial position. 18Item 1A. Risk FactorsSee the "Investments" section of Item 7, MD&A, and the "Credit Risk" section of Item 7A, Quantitative and Qualitative Disclosures about Market Risk, for more information. Operational-Related Risk FactorsMajor public health issues, and specifically the novel coronavirus COVID-19 and any resulting economic effects could have an adverse impact on the Company's financial condition and results of operations and other aspects of its business.The Company continues to closely monitor developments related to the COVID-19 pandemic to assess its impact on the Company's business. Due to the evolving and highly uncertain nature of this event, including fluctuations in infection and death rates in the United States, Japan and other regions of the world, and global efforts to develop and distribute a vaccine, the COVID-19 pandemic could impact the Company's business, financial condition, results of operations, capital position, liquidity or prospects in a number of ways. The pandemic may cause changes to estimates of future earnings, capital deployment and other guidance the Company has provided to the markets in the "2021 Outlook" section of Item 7, MD&A.There can be no assurance that governmental interventions in the U.S. and Japan will be effective to mitigate adverse impacts on financial markets and the Company’s investment portfolio, and the effects of the pandemic and the response of governmental entities, public health authorities and private entities on the U.S., Japan and global economies cannot be predicted. The pace and magnitude of changes to levels of unemployment, the significant government responses to date, and the continuing effort to contain the impact of COVID-19 in the U.S., among other factors, introduces significant uncertainty about the severity and duration of the pandemic’s effects on the U.S. economy. The Company also cannot predict how legal and regulatory responses to concerns about COVID-19 and related public health issues will affect its business. The extent to which the pandemic will impact the Company's business, results of operations, financial condition, capital position, liquidity or prospects, as well as those of its customers, agents, brokers and other distribution partners, vendors and counterparties, will depend on future developments that are highly uncertain and cannot be predicted, including new information that may emerge concerning the severity of COVID-19 and the actions taken to contain or treat its impact.As a result of the COVID-19 pandemic, the Company may face increased costs associated with claims under its policies, customers experiencing difficulty paying premiums or policies being designated as “no lapse” for periods of time. In particular, Aflac U.S. may experience higher lapses because a higher concentration of its policies in force are associated with small business and the correlation of lapse rates to unemployment. These small businesses may be disproportionately negatively impacted by the economic uncertainty surrounding COVID-19. The cost of reinsurance to the Company for these policies could increase, and the Company may encounter decreased availability of such reinsurance.Policies issued by Aflac Japan and Aflac U.S. are primarily sold and enrolled in person through face-to-face interaction. Likewise, recruiting of new agents and brokers largely occurs through in-person contact. The ability of individual agents and agencies, strategic alliance partners, brokers and other distribution partners to make sales in Japan and the U.S. and the ability to conduct agent and broker recruiting has been significantly reduced by efforts to mitigate the effects of the pandemic, including social distancing guidelines issued by public health authorities and/or other authorities, government shelter in place orders or requirements, and requests or orders by employers that their employees work remotely. Further, in both Japan and the U.S., a significant amount of sales have historically been made to individuals and businesses who may, in light of the economic and social effects of the pandemic and for an indeterminate amount of time, lack the certainty or financial resources to purchase the Company’s products or maintain premium payments on policies already purchased. Further, independent of whether government and public health authorities impose or withdraw shelter in place orders or requirements and social distancing guidelines issued to date, businesses and individuals may voluntarily continue to exercise social distancing techniques, which may hinder sales of the Company’s products in Japan and the U.S. The Company cannot predict with certainty the impact of these events on its distribution channels and financial results, but the impact to date has been more acute for Aflac U.S. due to the higher number of confirmed COVID-19 cases and deaths in the U.S. to date compared with Japan, both in absolute terms and in proportion to national populations, as well as the historically lower rate of persistency in the Aflac U.S. business. The Company also considers that most Aflac U.S. business customers, and most of the independent agents in its agency channel, are small businesses who may lack the financial resources to weather an economic downturn, which may impact sales beyond 2020. For example, as of December 31, 2020, over 400,000 of the Aflac U.S. business accounts are small businesses with under 100 employees. See the risk factors entitled “Sales of the Company's products and services are dependent on its ability to attract, retain and support a network of qualified sales associates, brokers and employees in the U.S. and sales associates and other distribution partners in Japan” and “Difficult conditions in global capital markets and the economy, including those caused 19Item 1A. Risk Factorsby the novel coronavirus COVID-19, could have a material adverse effect on the Company's investments, capital position, revenue, profitability, and liquidity and harm the Company's business” for more information.Further, the Company's operations, as well as those of its vendors, service providers and counterparties, may also be adversely affected by the COVID-19 pandemic or the mitigation efforts outlined above. The business and operational impacts of extended periods of working from home cannot be predicted with certainty and may have an adverse impact on the Company’s ability to conduct its business. In the U.S. and Japan, the Company has approximately 95% and 50%, respectively, of its employees working remotely. The Company expects to ultimately implement return to work plans for Aflac Japan and Aflac U.S. that will be based upon multiple factors including government mandates, guidelines issued by public health authorities, the location and job responsibilities of specific Company personnel, and the availability and efficacy of one or more therapies or vaccines for use by the Company’s workforce. Such plans may be implemented in stages over an extended period of time, but the Company may nevertheless experience operational disruptions when employees return to work. The assumptions and estimates that the Company uses in establishing premiums and reserves depend on the Company's judgment regarding the likelihood of future events and are inherently uncertain, including without limitation in regard to the effects of COVID-19. See the risk factor entitled “If future policy benefits, claims or expenses exceed those anticipated in establishing premiums and reserves, the Company's financial results would be adversely affected” and the "Executive Summary" section of Item 7, MD&A, for more information.For more information on the effects of the COVID-19 pandemic on markets and investments, see the risk factor entitled, “Difficult conditions in global capital markets and the economy, including those caused by the novel coronavirus COVID-19, could have a material adverse effect on the Company's investments, capital position, revenue, profitability, and liquidity and harm the Company's business.”Sales of the Company's products and services are dependent on its ability to attract, retain and support a network of qualified sales associates, brokers and employees in the U.S. and sales associates and other distribution partners in Japan.The Company's sales, results of operations and financial condition could be materially adversely affected if its sales networks deteriorate or if the Company does not adequately provide support, training and education for its existing network of sales associates, brokers, other distribution partners and employees. In the U.S., competition exists for sales associates and brokers with demonstrated ability. In Japan, the Company's sales results are dependent upon its relationship with sales associates and other distribution partners, including its strategic partner, Japan Post. The Company competes with other insurers and financial institutions primarily on the basis of its products, compensation, support services and financial rating. The Company's sales associates, brokers and other distribution partners are independent contractors and may sell products of its competitors. If the Company's competitors offer products that are more attractive, or pay higher commissions than the Company does, any or all of these distribution partners may concentrate their efforts on selling the Company's competitors' products instead of the Company's. In addition to the Company's commissioned sales force in the U.S., Aflac has expanded its sales leadership team to include a salaried sales force of over 200 market directors and broker sales professionals. The Company's inability to attract and retain qualified sales associates, brokers and other distribution partners, including its alliance partners in Japan, could have a material adverse effect on the Company's sales, results of operations and financial condition.Additionally, as the Japan and U.S. employment markets continue to evolve, there is risk that the Company's practices regarding attracting, developing, and retaining employees may not be fully effective. Failure to successfully meet and maintain sufficient levels of employees may diminish the Company's ability to achieve its financial and compliance objectives, both of which are time consuming and personnel-intensive.For more information on the strategic partnership with Japan Post, see the risk factor entitled "Events related to the ongoing Japan Post investigation and other matters regarding sales of Japan Post Insurance products could negatively impact the Company’s sales and results of operations." For more information on the effects of COVID, see the risk factor entitled, “Major public health issues, and specifically the novel coronavirus COVID-19 and any resulting economic effects could have an adverse impact on the Company's financial condition and results of operations and other aspects of its business.”20Item 1A. Risk FactorsIf future policy benefits, claims or expenses exceed those anticipated in establishing premiums and reserves, the Company's financial results would be adversely affected. The assumptions and estimates that the Company uses in establishing premiums and reserves depend on the Company's judgment regarding the likelihood of future events and are inherently uncertain. Many factors can cause actual outcomes to deviate from these assumptions and estimates, such as changes in incidence rates, economic conditions, changes in government healthcare policy, advances in medical technology, changes in treatment patterns, and changes in average lifespan. Accordingly, the Company cannot determine with precision the ultimate amounts that it will pay for, or the timing of payment of, actual benefits and claims or whether the assets supporting the policy liabilities will grow to the level the Company assumes prior to payment of benefits or claims. If the Company's actual experience is different from its assumptions or estimates, the Company's premiums and reserves may prove inadequate. As a result, the Company would incur a charge to earnings in the period in which it determines such a shortfall exists, which could have a material adverse effect on the Company's business, results of operations and financial condition.The success of the Company's business depends in part on effective information technology systems and on continuing to develop and implement improvements in technology.The Company's business depends in large part on its technology systems for interacting with employers, policyholders, sales associates, and brokers, and the Company's business strategy involves providing customers with easy-to-use products to meet their needs and ensuring employees have the technology in place to support those needs. Some of the Company's information technology systems and software are older, legacy-type systems that are less efficient and require an ongoing commitment of significant resources to maintain or upgrade to current standards including adequate business continuity procedures. The Company is in a continual state of upgrading and enhancing its business systems and has increased the pace of such enhancements in recent years, particularly during the COVID-19 pandemic, given the growing importance of virtual sales to both Aflac Japan and Aflac U.S. These changes tend to be accompanied by large expenditures and challenge the Company's complex integrated environment. If the Company does not maintain the effectiveness of its systems and continue to develop and enhance information systems that support its business processes in a cost-efficient manner, the Company's sales, business retention, operations and reputation could be adversely affected and it could be exposed to litigation, regulatory proceedings and fines or penalties.Interruption in telecommunication, information technology and other operational systems, or a failure to maintain the security, confidentiality, integrity or privacy of sensitive data residing on such systems, could harm the Company's business. The Company stores confidential policyholder, employee, agent, and other proprietary information on its information technology systems. The Company also depends heavily on its telecommunication, information technology and other operational systems and on the integrity and timeliness of data it uses to run its businesses and service its customers. The Company’s information technology and other systems, as well as those of third party providers and participants in the Company’s distribution channels, have been and will likely continue to be subject to physical or electronic break-ins, unauthorized tampering, security breaches, social engineering, phishing, web application attacks, computer viruses or other malicious codes, or other cyber-attacks, that may result in the failure to adequately maintain the security, confidentiality, integrity, or privacy of sensitive data, including personal information relating to customers and prospective customers, or in the misappropriation of the Company's intellectual property or proprietary information. Although the Company attempts to manage its exposure to such events through the purchase of cyber liability insurance, such events are inherently unpredictable and insurance may not be sufficient to protect the Company against all losses. As a result, events such as these could adversely affect the Company's financial condition or results of operation. Although the minor data leakage issues the Company has experienced to date have not had a material effect on its business, there is no assurance that the Company's security systems or processes will prevent or mitigate future break-ins, tampering, security breaches or other cyber-attacks. Interruption in telecommunication, information technology and other operational systems, or a failure to maintain the security, confidentiality or privacy of sensitive data residing on such systems, whether due to actions by the Company or others, including third party providers and participants in the company’s distribution channels, could delay or disrupt the Company's ability to do business and service its customers, seriously harm the Company's brand, reputation, and ability to compete effectively, subject it to regulatory sanctions and other claims, lead to a loss of customers and revenues and otherwise adversely affect the Company's business. In addition, the costs to address or remediate system interruptions or security threats and vulnerabilities, whether before or after an incident, could be significant.As a holding company, the Parent Company depends on the ability of its subsidiaries to transfer funds to it to meet its debt service and other obligations and to pay dividends on its common stock.21Item 1A. Risk FactorsThe Parent Company is a holding company and has no direct operations, and its most significant assets are the stock of its subsidiaries. Because the Parent Company conducts its operations through its operating subsidiaries, the Parent Company depends on those entities for dividends and other payments to generate the funds necessary to meet its debt service and other obligations, to pay dividends on and conduct repurchases of its common stock, and to make investments into its subsidiaries or external opportunities. Aflac is domiciled in Nebraska and is subject to insurance regulations that impose certain limitations and restrictions on payments of dividends, management fees, loans and advances by Aflac to the Parent Company. The Nebraska insurance statutes require prior approval for dividend distributions that exceed the greater of the net income from operations, which excludes net realized investment gains, for the previous year determined under statutory accounting principles, or 10% of statutory capital and surplus as of the previous year-end. The Nebraska insurance department also must approve service arrangements and other transactions within the affiliated group of companies. After the Japan branch conversion, the Nebraska insurance department and the FSA approved their respective domiciled insurance company service arrangements and transactions. The FSA does not allow dividends or other payments from Aflac Japan unless it meets certain financial criteria as governed by Japanese corporate law. Under these criteria, dividend capacity at the Japan subsidiary will be defined as retained earnings plus other capital reserve less net after-tax net unrealized losses on available-for-sale securities. The ability of Aflac and Aflac Japan to pay dividends or make other payments to the Parent Company could also be constrained by the Company's dependency on financial strength ratings from independent rating agencies. The Company's ratings from these agencies depend to a large extent on Aflac's capitalization level. Any inability of Aflac to pay dividends or make other payments to the Parent Company could have a material adverse effect on the Company's financial condition and results of operations.For the foregoing reasons, there is no assurance that the earnings from, or other available assets of, the Parent Company's operating subsidiaries will be sufficient to make distributions to enable the Company to operate.The Company's risk management policies and procedures may prove to be ineffective and leave the Company exposed to unidentified or unanticipated risk, which could adversely affect the Company's businesses or result in losses.The Company has developed an enterprise-wide risk management and governance framework to mitigate risk and loss to the Company. The Company maintains policies, procedures and controls intended to identify, measure, monitor, report and analyze the risks to which the Company is exposed.However, there are inherent limitations to risk management strategies because risk may exist, or emerge in the future, that the Company has not appropriately anticipated or identified. If the Company's risk management framework proves ineffective, the Company may suffer unexpected losses and could be materially adversely affected. As the Company's businesses change and the markets in which it operates evolve, the Company's risk management framework may not evolve at the same pace as those changes, and risks may not be appropriately identified, monitored or managed. In times of market stress, unanticipated market movements or unanticipated claims experience resulting from greater than expected morbidity, mortality, longevity, or persistency, the effectiveness of the Company's risk management strategies may be limited, resulting in losses to the Company. Under difficult or less liquid market conditions, the Company's risk management strategies may be ineffective or more difficult or expensive to execute because other market participants may be using the same or similar strategies to manage risk.Many of the Company's risk management strategies or techniques are based upon historical customer and market behavior and all such strategies and techniques are based to some degree on management’s subjective judgment. The Company cannot provide assurance that its risk management framework, including the underlying assumptions or strategies, will be accurate and effective. Management of operational, legal and regulatory risks requires, among other things, policies, procedures and controls to record properly and verify a large number of transactions and events, and these policies, procedures and controls may not be fully effective. The Company's businesses and corporate areas primarily use models to project future cash flows associated with pricing products, calculating reserves and valuing assets, and evaluating risk and determining capital requirements, among other uses. These models are utilized under a risk management policy approved by the Company's executive risk management committees, however, the models may not operate properly and rely on assumptions and projections that are inherently uncertain. As the Company's businesses continue to grow and evolve, the number and complexity of models the Company utilizes expands, increasing the Company's exposure to error in the design, implementation or use of models, including the associated input data and assumptions. 22Item 1A. Risk FactorsPast or future misconduct by the Company's employees or employees of third parties (suppliers which are cost-based relationships and alliance partners which are revenue-generating relationships) could result in violations of law by the Company, regulatory sanctions and/or serious reputational or financial harm, and the precautions the Company takes to prevent and detect this activity may not be effective in all cases. Despite the Company's published Supplier Code of Conduct, due diligence of the Company's alliance partners, and rigorous contracting procedures (including financial, legal, IT security, and risk reviews), there can be no assurance that controls and procedures that the Company employs will be effective. Additionally, the use of third parties also poses operational risks that could result in financial loss, operational disruption, brand damage, or compliance issues. Inadequate oversight of Aflac’s third party suppliers due to the lack of policies, procedures, training and governance may lead to financial loss or damage to the Aflac brand.Regulatory Risk FactorsEvents related to the ongoing Japan Post investigation and other matters regarding sales of Japan Post Insurance products could negatively impact the Company’s sales and results of operations As previously disclosed, in July 2019 Japan Post Insurance Co., LTD (JPI) and Japan Post Co., LTD (JPC), each an affiliate of Japan Post Holdings (together with JPI and JPC, the Japan Post Group) announced that they had established a Special Investigative Committee to determine whether JPC and JPI sales practices with respect to JPI products had caused disadvantages to customers holding such policies that were not otherwise the result of honoring such customers’ intentions.While the sale of Aflac Japan cancer insurance products was not within the scope of the JPI investigation or the business suspension orders, beginning in August 2019 the Company has experienced a material decrease of sales in the Japan Post Group channel. This decline continued into 2020 and the Company believes it was exacerbated by the effects of COVID-19. The Company further believes that sales of Aflac Japan cancer insurance through JPC and JPI are unlikely to return to 2018 levels in the near term. After the issuance of a three month business suspension order by the FSA in December 2019, JPI announced on September 11, 2020 that it would resume operations aimed at regaining customers' trust on October 5, 2020, but the timeline for resumption of normal sales remains unclear. It is uncertain what long-term effect these developments will have on the Company’s results of operations or financial condition, but any such effects could be material. See the "Aflac Japan Segment" section of Item 7. MD&A for more information. Tax rates applicable to the Company may change. The Company is subject to taxation in Japan, and in the U.S. under federal and numerous state and local tax jurisdictions. In preparing the Company's financial statements, the Company estimates the amount of tax that will become payable, but the Company's effective tax rate may be different than estimates due to numerous factors including accounting for income taxes, the mix of earnings from Japan and the U.S., the results of tax audits, adjustments to the value of uncertain tax positions, changes to estimates and other factors. Further, changes in U.S. or Japan tax laws or interpretations of such laws could increase the Company's corporate taxes and reduce earnings.In addition, it remains difficult to predict the timing and effect that future tax law changes could have on the Company's earnings both in the U.S. and in foreign jurisdictions, including in connection with a new presidential administration in the United States in 2021. Any of these factors could cause the Company to experience an effective tax rate significantly different from previous periods or the Company's current estimates. If the Company's effective tax rate were to increase, the Company's financial condition and results of operations could be adversely affected. If the Company fails to comply with restrictions on customer privacy and information security, including taking steps to ensure that its third-party service providers and business associates who access, store, process or transmit sensitive customer information maintain its security, integrity, confidentiality and availability, the Company's reputation and business operations could be materially adversely affected.The collection, maintenance, use, protection, disclosure and disposal of individually identifiable data by the Company's businesses are regulated at the international, federal and state levels. These laws and rules are subject to change by legislation or administrative or judicial interpretation. With regard to personal information obtained from policyholders, the insured, or others, Aflac Japan is regulated in Japan by the APPI and guidelines issued by FSA and other governmental authorities.Various state laws in the U.S. address the unauthorized access and acquisition of personal information and the use and disclosure of individually identifiable health data. HIPAA requires the Company to impose privacy and security requirements on its business associates (as such term is defined in the HIPAA regulations). The U.S. Congress and many 23Item 1A. Risk Factorsstates are considering new privacy and security requirements that would apply to the Company's business. Compliance with new privacy and security laws, requirements, and new regulations may result in cost increases due to necessary systems changes, new limitations or constraints on the Company's business models, the development of new administrative processes, and the effects of potential noncompliance by the Company's business associates. They also may impose further restrictions on the Company's collection, disclosure and use of customer identifiable data that are housed in one or more of the Company's administrative databases. Noncompliance with any privacy laws or any security breach involving the misappropriation, loss, theft or other unauthorized disclosure of sensitive or confidential customer information, whether by the Company or by one of its third parties, could have a material adverse effect on the Company's business, reputation, brand and results of operations, including: material fines and penalties; compensatory, special, punitive and statutory damages; consent orders regarding the Company's privacy and security practices; adverse actions against the Company's licenses to do business; and injunctive relief.In addition, under Japanese laws and regulations, including the APPI, if a leak or loss of personal information by Aflac Japan or its business associates should occur, depending on factors such as the volume of personal data involved and the likelihood of other secondary damage, Aflac Japan may be required to file reports to the FSA; issue public releases explaining such incident to the public; or become subject to an FSA business improvement order, which could pose a risk to the Company's reputation.Although the Company provides for appropriate protections through its contracts and performs information security risk assessments of its third-party service providers and business associates, the Company still has limited control over their actions and practices. In addition, despite the security measures the Company has in place to ensure compliance with applicable laws and rules, the Company's facilities and systems, and those of the Company's third-party providers and participants in its distribution channels may be vulnerable to security breaches, acts of vandalism or theft, computer viruses, misplaced or lost data, programming and/or human errors or other similar events. From time to time, the Company, its third party providers and participants in the Company’s distribution channels have experienced and will likely continue to experience such events. In such cases, notification to affected individuals, state and federal regulators, state attorneys general and media may be required, depending upon the number of affected individuals and whether personal information including health or financial data was subject to unauthorized access.Extensive regulation and changes in legislation can impact profitability and growth.Aflac's insurance subsidiaries are subject to complex laws and regulations that are administered and enforced by a number of governmental authorities, that exercise a degree of interpretive latitude, including the FSA and Ministry of Finance (MOF) in Japan, and state insurance regulators, the SEC, the NAIC, the FIO, the U.S. Department of Justice, state attorneys general, the U.S. Commodity Futures Trading Commission, and the U.S. Treasury, including the Internal Revenue Service (IRS), in the U.S. The Company is subject to the risk that compliance with any particular regulator's or enforcement authority's interpretation of a legal or regulatory issue may result in non-compliance with another regulator's or enforcement authority's interpretation of the same issue, particularly when compliance is judged in hindsight. There is also a risk that any particular regulator's or enforcement authority's interpretation of a legal or regulatory issue may change over time to the Company's detriment. In addition, changes in the overall legal or regulatory environment may, even absent any particular regulator's or enforcement authority's interpretation of an issue changing, cause the Company to change its views regarding the actions it needs to take from a legal or regulatory risk management perspective. This may necessitate changes to the Company's practices that may, in some cases, limit its ability to grow or otherwise negatively impact the profitability of the Company's business. Regulatory authorities periodically re-examine existing laws and regulations applicable to insurance companies and their products. Changes in these laws and regulations, or in interpretations thereof, could have a material adverse effect on the Company's financial condition and results of operations. If the Company's subsidiaries fail to meet the minimum capital or operational requirements established by its respective regulators, they could be subject to examination or corrective action, or the Company's financial strength ratings could be downgraded, or both.Compliance with applicable laws and regulations is time consuming and personnel-intensive, and changes in these laws and regulations may materially increase the Company's direct and indirect compliance and other expenses of doing business, thus having a material adverse effect on the Company's financial condition and results of operations. See the “Government Regulation” subsections of Item 1, Business, for more information. 24Item 1A. Risk FactorsGeneral Risk FactorsCompetition could adversely affect the Company's ability to increase or maintain its market share or profitability.The Company operates in a competitive environment and in an industry that is subject to ongoing changes from market pressures brought about by customer demands, legislative reform, marketing practices and changes to health care and health insurance delivery. These factors require the Company to anticipate market trends and make changes to differentiate the Company's products and services from those of its competitors. The Company also faces potential competition from existing or new companies in the U.S. and Japan that have not historically been active in the supplemental health insurance industry, but some of which have greater financial, marketing and management resources than the Company. Further, some of these potential competitors could introduce new means of product development and delivery that disrupt the Company’s business model. Failure to anticipate market trends and/or to differentiate the Company's products and services can affect the Company's ability to retain or grow profitable lines of business. Further, as employers and brokers are increasingly requesting a full suite of products from one insurance provider, a failure to react and adapt to these demands could result in decreased sales or market share.The insurance market is undergoing rapid changes with frequent introductions of new technology-driven products and services. The Company's future success will depend, in part, on its ability to keep pace with the technological changes and to use technology to satisfy and grow customer demand for the Company's products and services and to create additional efficiencies in its operations. The Company expects that it will need to continue making substantial investments in its technology and information systems to compete effectively and to stay current with technological changes. The Company may not be able to effectively implement new technology-driven products and services or be successful in marketing these products and services to its customers. A failure to meet evolving customer demands through innovative product development, effective distribution channels, and continuous investment in the Company's technology could result in lower revenues and less favorable policy terms and conditions, which could adversely affect the Company's operating results. As a result, the Company's ability to effectively compete to retain or acquire new business may be impaired, and its business, financial condition or results of operations may be adversely affected.Catastrophic events, including as a result of climate change, could adversely affect the Company's financial condition and results of operations as well as the availability of the Company’s infrastructure and systems.The Company's insurance operations are exposed to the risk of catastrophic events including, but not necessarily limited to, epidemics, pandemics, tornadoes, hurricanes, earthquakes, tsunamis, war or other military action, and terrorism or other acts of violence. Claims resulting from natural or man-made catastrophic events could cause substantial volatility in the Company's financial results for any fiscal quarter or year and could materially reduce its profitability or harm the Company's financial condition, as well as affect its ability to write new business. In addition, such events may lead to periods of voluntary or required premium grace periods, which may lead to volatility in lapse rates and premium persistency.Additionally, the Company's business operations may be adversely affected by such catastrophic events to the extent they disrupt the Company's physical infrastructure, human resources or systems that support its businesses and customers. Although the Company has a global crisis management framework to minimize the business disruption from a catastrophic event, such framework may not be effective to avoid an adverse impact to the Company from such an event.Climate change may increase the frequency and severity of natural disasters such as hurricanes, tornadoes, floods and forest fires. Further, the Company cannot predict the effects that any legal or regulatory changes made in response to climate change concerns would have on the Company’s business. In addition, while assessment of risks related to climate change are part of the Company's credit review process, climate change-related risks may adversely impact the value of the securities that the Company holds.Events, including those external to the Company's operations, could damage the Company's reputation.The Company has made significant investments in the Aflac brand over a long period of time. Because insurance products are intangible, the Company's ability to compete for and maintain policyholders relies to a large extent on consumer trust in the Company's business, including its alliance partners, sales associates and other distribution partners. The perception of unfavorable business practices, lack of commitment to sustainability efforts and attention to societal impacts, or financial weakness with respect to the Company, its alliance partners, sales associates or other distribution partners could create doubt regarding the Company's ability to honor the commitments it has made to its policyholders. Such a perception could also negatively impact the Company’s ability to attract and retain qualified sales associates, brokers and other distribution partners, including its alliance partners in Japan, and could have a material adverse effect on the 25Item 1A. Risk FactorsCompany's sales, results of operations and financial condition. Maintaining the Company's stature as a trustworthy insurer and responsible corporate citizen, which helps support the strength of the Company's brand, is critical to the Company's reputation and the failure or perceived failure to do so could adversely affect the Company's brand value, financial condition and results of operations. The Company depends heavily on key management personnel, and the loss of services of one or more of its key executives could harm the Company's business.The Company’s success depends to a significant extent upon the efforts and abilities of its key management personnel. The loss of the services of one or more of the Company's senior executives could significantly undermine its management expertise, and the Company's business could be adversely affected.Changes in accounting standards issued by the Financial Accounting Standard Boards (FASB) or other standard-setting bodies may adversely affect the Company's financial statements.The Company's financial statements are subject to the application of U.S. GAAP, which is periodically revised and/or expanded. Accordingly, from time to time the Company is required to adopt new or revised accounting standards issued by recognized authoritative bodies, including the FASB. Changes to accounting standards could have a material adverse effect on the Company's results of operations and financial condition. See Note 1 of the Notes to the Consolidated Financial Statements for more information.The Company faces risks related to litigation, regulatory investigations and inquiry and other matters.The Company is a defendant in various lawsuits considered to be in the normal course of business. The final results of any litigation cannot be predicted with certainty, and plaintiffs may seek very large amounts in class actions or other litigation. Although some of this litigation is pending in states where large punitive damages, bearing little relation to the actual damages sustained by plaintiffs, have been awarded in recent years, the Company believes the outcome of pending litigation will not have a material adverse effect on its financial position, results of operations, or cash flows. However, a substantial legal liability or a significant federal, state or other regulatory action against the Company, as well as regulatory inquiries or investigations, could harm the Company's reputation, result in changes in operations, result in material fines or penalties, result in significant costs due to legal fees, settlements or judgments against the Company, or otherwise have a material adverse effect on the Company's business, financial condition and results of operations. Without limiting the foregoing, the litigation and regulatory matters the Company is, has been, or may become, subject to include matters related to sales agent recruiting, policy sales practices, claim payments and procedures including denial or delay of benefits, material misstatements or omissions in the Company's financial reports or other public statements, and/or corporate governance, corporate culture or business ethics matters. Further, the Company may be subject to claims of or litigation regarding sexual or other forms of misconduct or harassment, or discrimination on the basis of race, color, national origin, religion, gender, or other bases, notwithstanding that the Company's Code of Business Conduct and Ethics prohibits such harassment and discrimination by its employees, the Company has ongoing training programs and provides opportunities to report claims of noncompliant conduct, and it investigates and may take disciplinary action regarding alleged harassment or discrimination. Any violations of or deviation from laws, regulations, internal or external codes or standards of normative behavior, or perceptions of such violations or deviations, by the Company's employees or by independent sales agents could adversely impact the Company's reputation and brand value, financial condition and results of operations.Allegations or determinations of agent misclassification could adversely affect the Company’s results of operations, financial condition and liquidity.A majority of the Company's U.S. sales force is, and has historically been, comprised of independent agents. While the Company believes that it has properly classified such agents as independent contractors, the Company may be subject to claims, regulatory action by state or federal departments of labor or tax authorities, changes in state or federal law, or litigation asserting that such agents are employees. The laws and regulations governing the classification of workers in the U.S. may be changed or interpreted differently compared to past interpretations, including in states where the Company generates significant sales through independent agents. An allegation or determination that independent agents in the Company’s U.S. sales force have been misclassified as independent contractors could result in changes in the Company’s operations and U.S. business model, result in material fines or penalties, result in significant costs due to legal fees, settlements or judgments against the Company, or otherwise have a material adverse effect on the Company's business, results of operation, financial condition and liquidity.26Item 1B. Unresolved Staff CommentsITEM 1B. UNRESOLVED STAFF COMMENTSNot applicable.ITEM 2. PROPERTIESIn the U.S., the Company owns land and buildings that comprise two primary campuses located in Columbus, Georgia. These campuses include buildings that serve as the Company's worldwide headquarters and house administrative support and information technology functions for U.S. operations. The Company leases office space in Columbia, South Carolina, which houses the Company's CAIC subsidiary (branded as Aflac Group Insurance). The Company also leases office space in New York that houses the Company's Global Investment division. The Company also leases administrative office space throughout the U.S., Puerto Rico and the United Kingdom.In Tokyo, Japan, the Company has two primary campuses. The first campus includes a building, owned by the Company, for the customer call center, the claims department, the information technology departments, and training facility. This campus also includes a leased property, which houses the Company's policy administration and customer service departments. The second campus comprises leased space, which serves as the Company's headquarters and houses administrative and investment support functions. The Company also leases additional office space in Tokyo, along with regional offices located throughout the country. The Company believes its properties are adequate and suitable for its business as currently conducted and are adequately maintained.ITEM 3. LEGAL PROCEEDINGSThe Company is a defendant in various lawsuits considered to be in the normal course of business. Members of the Company's senior legal and financial management teams review litigation on a quarterly and annual basis. The final results of any litigation cannot be predicted with certainty. Although some of this litigation is pending in states where large punitive damages, bearing little relation to the actual damages sustained by plaintiffs, have been awarded in recent years, the Company believes the outcome of pending litigation will not have a material adverse effect on its financial position, results of operations, or cash flows.ITEM 4. MINE SAFETY DISCLOSURESNot applicable.27Item 5. Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity SecuritiesPART IIITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIESMarket InformationAflac Incorporated's common stock is principally traded on the New York Stock Exchange under the symbol AFL. HoldersAs of February 17, 2021, there were 86,569 holders of record of the Company's common stock.DividendsFor a summary of dividends paid to shareholders in 2020 and 2019 and potential restrictions on the Company's ability to pay future dividends, see the Liquidity and Capital Resources section of Item 7. MD&A. 28Item 5. Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity SecuritiesStock Performance GraphThe following graph compares the five-year performance of the Company's common stock to the Standard & Poor's 500 Index (S&P 500) and the Standard & Poor's Life and Health Insurance Index (S&P Life and Health). The Standard & Poor's Life and Health Insurance Index includes: Aflac Incorporated, Globe Life Inc., Lincoln National Corporation, MetLife Inc., Principal Financial Group Inc., Prudential Financial Inc. and Unum Group. Performance Graphic IndexDecember 31,201520162017201820192020Aflac Incorporated100.00 119.11 153.65 163.20 193.48 167.21 S&P 500100.00 111.96 136.40 130.42 171.49 203.04 S&P Life & Health Insurance100.00 124.86 145.37 115.17 141.88 128.43 Copyright© 2021 Standard & Poor’s, a division of S&P Global. All rights reserved.29Item 5. Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity SecuritiesIssuer Purchases of Equity SecuritiesDuring the year ended December 31, 2020, the Company repurchased shares of Aflac common stock as follows:PeriodTotalNumber ofSharesPurchasedAveragePrice PaidPer ShareTotalNumberof SharesPurchasedas Part ofPubliclyAnnouncedPlans orProgramsMaximum Number of Shares that May Yet Be Purchased Under the Plans or Programs January 1 - January 313,906,085 $52.61 3,906,085 33,147,528 February 1 - February 292,870,531 50.93 2,367,300 30,780,228 March 1 - March 313,715,439 33.46 3,710,430 27,069,798 April 1 - April 301,890,000 35.74 1,890,000 25,179,798 May 1 - May 311,721,653 34.95 1,720,900 23,458,898 June 1 - June 301,609,905 37.48 1,597,741 21,861,157 July 1 - July 312,045,100 35.76 2,045,100 19,816,057 August 1 - August 313,929,149 36.98 3,913,300 115,903,549 September 1 - September 304,961,219 36.79 4,957,427 110,946,122 October 1 - October 312,533,700 36.83 2,533,700 108,412,422 November 1 - November 303,206,400 42.72 3,206,400 105,206,022 December 1 - December 316,051,715 44.62 6,050,404 99,155,618 Total38,440,896 (1)$40.72 37,898,787 99,155,618 (1)During the year ended December 31, 2020, 542,109 shares were purchased in connection with income tax withholding obligations related to the vesting of restricted-share-based awards during the period.30Item 6. Selected Financial DataITEM 6. SELECTED FINANCIAL DATAAflac Incorporated and SubsidiariesYears Ended December 31, (In millions, except for share and per-share amounts)20202019201820172016Revenues:Net premiums, principally supplemental health insurance$18,622 $18,780 $18,677 $18,531 $19,225 Net investment income3,638 3,578 3,442 3,220 3,278 Net investment gains (losses)(270)(135)(430)(151)(14)Other income157 84 69 67 70 Total revenues22,147 22,307 21,758 21,667 22,559 Benefits and expenses:Benefits and claims, net11,796 11,942 12,000 12,181 12,919 Expenses6,192 5,920 5,775 5,468 5,573 Total benefits and expenses17,988 17,862 17,775 17,649 18,492 Pretax earnings4,159 4,445 3,983 4,018 4,067 Income taxes(619)1,141 1,063 (586)1,408 Net earnings$4,778 $3,304 $2,920 $4,604 $2,659 Share and Per-Share AmountsNet earnings (basic)$6.69 $4.45 $3.79 $5.81 $3.23 Net earnings (diluted)6.67 4.43 3.77 5.77 3.21 Cash dividends paid1.12 1.08 1.04 .87 .83 Cash dividends declared1.45 1.08 1.04 .87 .83 Weighted-average common shares used for basic EPS (In thousands)713,702 742,414 769,588 792,042 822,942 Weighted-average common shares used for diluted EPS (In thousands)716,192 746,430 774,650 797,861 827,841 Supplemental DataYen/dollar exchange rate at year-end (yen)103.50 109.56 111.00 113.00 116.49 Weighted-average yen/dollar exchange rate (yen)106.86 109.07 110.39 112.16 108.70 31Item 6. Selected Financial DataAflac Incorporated and SubsidiariesDecember 31, (In millions)20202019201820172016Assets:Investments and cash$149,753 $138,091 $126,243 $123,659 $116,361 Other15,333 14,677 14,163 13,558 13,458 Total assets$165,086 $152,768 $140,406 $137,217 $129,819 Liabilities and shareholders’ equity:Policy liabilities$114,391 $106,554 $103,188 $99,147 $93,726 Income taxes4,661 5,370 4,020 4,745 5,387 Notes payable and lease obligations (1)7,899 6,569 5,778 5,289 5,360 Other liabilities4,576 5,316 3,958 3,438 4,864 Shareholders’ equity33,559 28,959 23,462 24,598 20,482 Total liabilities and shareholders’ equity$165,086 $152,768 $140,406 $137,217 $129,819 (1) See Note 1 of the Notes to the Consolidated Financial Statements for the adoption of accounting guidance on January 1, 2019 related to leases.32Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OFOPERATIONS Certain statements included in this section constitute forward-looking statements within the meaning of the U.S. Private Securities Litigation Reform Act of 1995. Forward-looking statements are made based on management’s current expectations and beliefs concerning future developments and their potential effects upon the Company. The Company’s actual results may differ, possibly materially, from expectations or estimates reflected in such forward-looking statements. Certain important factors that could cause actual results to differ, possibly materially, from expectations or estimates reflected in such forward-looking statements can be found in the “Risk Factors” and “Forward-Looking Statements” sections herein.MD&A OVERVIEWThe following financial review provides a discussion of the Company’s results of operations and financial condition, as well as a summary of the Company’s critical accounting estimates. This section should be read in conjunction with Part I - Item 1. Business and the audited consolidated financial statements and accompanying notes included in Part II -
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+Item 7. Management’s Discussion and Analysis of Financial Condition and Results of OperationsThis Management’s Discussion and Analysis of Financial Condition and Results of Operations, or MD&A, should be read in conjunction with our consolidated financial statements and notes thereto that appear elsewhere in this annual report on Form 10-K. See “Risk Factors” elsewhere in this annual report on Form 10-K for a discussion of certain risks associated with our business. The following discussion contains forward-looking statements. The forward-looking statements do not include the potential impact of any mergers, acquisitions, divestitures or other events that may be announced after the date hereof.OverviewWe provide solutions for securing, delivering and optimizing content and business applications over the internet. The key factors that influence our financial success are our ability to build on recurring revenue commitments for our security and performance offerings, increase media traffic on our network, effectively manage the prices we charge for our solutions, develop new products and carefully manage our capital spending and other expenses.22Table of ContentsRevenueFor most of our solutions, our customers commit to contracts having terms of a year or longer, which allows us to have a consistent and predictable base level of revenue. In addition to a base level of revenue, we are also dependent on media customers where usage of our solutions is more variable. As a result, our revenue is impacted by the amount of media and software download traffic we serve on our network, the rate of adoption of gaming, social media and video platform offerings, the timing and variability of customer-specific one-time events and geopolitical, economic and other developments that impact our customers' businesses. Seasonal variations that impact traffic on our network, such as holiday shopping, can cause revenue fluctuations from quarter to quarter. Over the longer term, our ability to expand our product portfolio and to effectively manage the prices we charge for our solutions are key factors impacting our revenue growth.We have observed the following trends related to our revenue in recent years:•Increased sales of our security solutions have made a significant contribution to revenue growth. We plan to continue to invest in this area with a focus on further enhancing our product portfolio and extending our go-to-market capabilities, particularly in certain markets and through our channel partners.•We have experienced increases in the amount of traffic delivered for customers that use our solutions for video, gaming downloads and social media, contributing to an increase in our revenue in 2020 as compared to 2019. In addition, as a result of the COVID-19 outbreak and resultant pandemic-related shutdowns and restrictions in various locations around the world during some of 2020, the rate of growth in traffic in 2020, as compared to prior years, accelerated significantly due to increased consumption of streaming media and games online and online commerce. We expect this year-over-year growth to moderate in 2021, assuming the restrictions experienced in 2020 do not continue.•While we have increased committed recurring revenue from our solutions by upselling incremental solutions to our existing customers and adding new customers, we have also experienced slower revenue growth in recent quarters in our web performance solutions. We expect the trend of slower revenue growth in our web solutions to continue in 2021 as our customers, particularly in the commerce and travel and hospitality industries, continue to experience financial pressure, especially in light of the negative impacts of the COVID-19 pandemic on these customers' operations.•The prices paid by some of our customers have declined, particularly in the context of contract renewals and large media consolidations, reflecting the impact of competition and volume discounts. Our revenue would have been higher absent these price declines.•Revenue from our international operations has been growing at a faster pace than from our U.S. operations, particularly in terms of new customer acquisition and cross-selling of incremental solutions. Because we publicly report in U.S. dollars, if the dollar strengthens, our reported revenue results will be negatively impacted. Conversely, a continuing weaker dollar would benefit our reported results.•We have experienced variations in certain types of revenue from quarter to quarter. In particular, we typically experience higher revenue in the fourth quarter of each year for some of our solutions as a result of holiday season activity. In addition, we experience quarterly variations in revenue attributable to, among other things, the nature and timing of software and gaming releases by our customers; whether there are large live sporting or other events or situations (like the COVID-19 pandemic) that impact the amount of media traffic on our network; and the frequency and timing of purchases of custom solutions or licensed software. ExpensesOur level of profitability is also impacted by our expenses, including direct costs to support our revenue such as bandwidth and co-location costs. We have observed the following trends related to our profitability in recent years:•Our profitability improved in 2020 as compared to 2019 due to higher revenue and the effects of cost savings and efficiency initiatives we have undertaken in recent years, as well as from lower travel and marketing expenses in 2020 due to pandemic-related shutdowns and restrictions. In order to maintain our current levels of profitability, we will need to continue to undertake efforts intended to improve the efficiency of operations and ensure that our expense growth does not exceed our revenue growth.23Table of Contents•Network bandwidth costs represent a significant portion of our cost of revenue. Historically, we have been able to mitigate increases in these costs by reducing our network bandwidth costs per unit and investing in internal-use software development to improve the performance and efficiency of our network. Our total bandwidth costs may increase in the future as a result of expected higher traffic levels and serving more traffic from higher cost regions. We will need to continue to effectively manage our bandwidth costs to maintain current levels of profitability.•Co-location costs are also a significant portion of our cost of revenue. By improving our internal-use software and managing our hardware deployments to enable us to use servers more efficiently, we have been able to manage the growth of co-location costs. We expect to continue to scale our network in the future and will need to continue to effectively manage our co-location costs to maintain current levels of profitability.•We expect to continue to manage our headcount and payroll costs in the future to focus investments on certain areas of the business while maintaining efficient operations in others. We expect to continue to hire employees in support of our strategic initiatives but do not expect overall headcount to increase significantly in 2021.•Depreciation expense related to our network equipment also contributes to our overall expense levels. During the last three quarters of 2020, we accelerated our purchases of servers and other equipment used in our network to help meet the increased traffic demands arising during the COVID-19 pandemic and to make up for supply chain issues we experienced in the first quarter. We expect to see higher depreciation expense in 2021 to reflect the deployment of this equipment. We plan to continue to invest in our network in 2021, although not at the same levels we experienced in 2020, which will further increase our capital expenditures and resulting depreciation expense.We currently report our revenue by division, which is a customer-focused reporting view that reflects revenue from customers that are managed by the division. We report our revenue in two divisions: the Web Division and the Media and Carrier Division. As the purchasing patterns and required account expertise of customers change over time, we may reassign a customer from one division to another. In 2020, we reassigned some of our customers between the Media and Carrier Division and the Web Division and revised historical results in order to reflect the most recent categorization and to provide a comparable view for all periods presented.In March 2021, we will reorganize into two groups: the Edge Technology Group, or ETG, and the Security Technology Group, or STG. The reorganization will align leaders of the two groups around our product offerings, with support from a single global sales organization, and is intended to position us to become more agile in delivering our solutions. Beginning in 2021, we will report revenue from the STG (previously Cloud Security Solutions revenue) and the ETG (revenue from our remaining solutions), separately.Nearly all of our employees are working remotely due to the COVID-19 pandemic, and we are not requiring employees whose roles do not require in-person presence to perform their jobs to return to offices before January 1, 2022. We have implemented a comprehensive evaluation process to determine whether offices in different locations should be open or closed. Our operations have not been significantly disrupted by the shift to remote working. While we expect to incur expenses associated with enabling remote work and reconfiguring work spaces to help ensure the safety and well being of employees accessing our locations, we do not currently believe those costs will materially impact our financial condition or results of operations. 24Table of ContentsResults of OperationsThe following sets forth, as a percentage of revenue, consolidated statements of income data for the years indicated: 202020192018Revenue100.0 %100.0 %100.0 %Costs and operating expenses:Cost of revenue (exclusive of amortization of acquired intangible assets shown below)35.4 34.1 35.1 Research and development8.4 9.0 9.1 Sales and marketing16.0 18.1 19.1 General and administrative17.1 17.8 21.1 Amortization of acquired intangible assets1.3 1.3 1.2 Restructuring charge1.2 0.6 1.0 Total costs and operating expenses79.4 80.9 86.6 Income from operations20.6 19.1 13.4 Interest income0.9 1.2 1.0 Interest expense(2.2)(1.7)(1.6)Other expense, net(0.1)— (0.1)Income before provision for income taxes19.2 18.6 12.7 Provision for income taxes(1.4)(1.8)(1.6)Loss from equity method investment(0.4)— — Net income17.4 %16.8 %11.1 %RevenueRevenue during the periods presented is as follows (in thousands):For the Years Ended December 31,For the Years Ended December 31,20202019% Change% Change at Constant Currency20192018% Change% Change at Constant CurrencyWeb Division$1,666,305 $1,556,252 7.1 %7.2 %$1,556,252 $1,439,772 8.1 %9.4 %Media and Carrier Division1,531,844 1,337,365 14.5 14.5 1,337,365 1,274,702 4.9 6.1 Total revenue$3,198,149 $2,893,617 10.5 %10.6 %$2,893,617 $2,714,474 6.6 %7.8 %The increase in our revenue in 2020 as compared to 2019 was primarily the result of higher media traffic volumes due in part to behavioral changes prompted by the COVID-19 pandemic and continued strong growth in sales of our Cloud Security Solutions. Cloud Security Solutions revenue for the year ended December 31, 2020 was $1,061.6 million, compared to $848.7 million for the year ended December 31, 2019, which represents a 25.1% increase. The increase in our revenue in 2019 as compared to 2018 was primarily the result of higher media traffic volumes, including from our large internet platform customers, and continued strong growth in sales of our Cloud Security Solutions. Cloud Security Solutions revenue for the year ended December 31, 2019 was $848.7 million, compared to $658.7 million for the year ended December 31, 2018, which represents a 28.8% increase.25Table of ContentsThe increase in Web Division revenue for 2020 as compared to 2019, and 2019 as compared to 2018, was primarily the result of increased sales of both new and existing Cloud Security Solutions to this customer base. Customers that have been experiencing financial difficulties as a result of the COVID-19 pandemic, specifically those in the commerce, retail and travel and hospitality verticals, are primarily assigned to our Web Division. Accordingly, Web Division revenue was negatively impacted during 2020 as a result of this pandemic. It is difficult to predict the length of time and amount by which the Web Division will continue to be impacted by the pandemic given its uncertain nature.The increase in Media and Carrier Division revenue for 2020 as compared to 2019 was primarily the result of increased customer traffic volumes from video delivery, gaming and social media usage, due in part to behavioral changes tied to the COVID-19 and higher sales of Cloud Security Solutions. The increase in Media and Carrier Division revenue for 2019 as compared to 2018 was primarily the result of increased customer traffic volumes from video delivery and gaming customers and higher sales of Cloud Security Solutions.Revenue derived in the U.S. and internationally during the periods presented is as follows (in thousands):For the Years Ended December 31,For the Years Ended December 31,20202019% Change% Change at Constant Currency20192018% Change% Change at Constant CurrencyU.S.$1,777,435 $1,694,211 4.9 %4.9 %$1,694,211 $1,683,272 0.6 %0.6 %International1,420,714 1,199,406 18.4 18.5 1,199,406 1,031,202 16.3 19.6 Total revenue$3,198,149 $2,893,617 10.5 %10.6 %$2,893,617 $2,714,474 6.6 %7.8 %The U.S. revenue growth rate for 2020 was positively impacted by the increase in traffic on our network in 2020, including from our U.S.-based large internet platform customers. The U.S. revenue growth rate for 2019 was negatively impacted by a reduction in prices paid by some of our customers, partially offset by an increase in revenue from large internet platform companies, as these companies are based in the U.S.Internationally, during 2020 and 2019, we continued to see strong revenue growth from our operations in the Asia-Pacific region. Changes in foreign currency exchange rates negatively impacted our revenue by $1.2 million in 2020 as compared to 2019, and negatively impacted our revenue by $33.9 million in 2019 as compared to 2018.For the year ended December 31, 2020, approximately 44% of our revenue was derived from our operations located outside of the U.S., compared to 41% for the year ended December 31, 2019 and 38% for the year ended December 31, 2018. No single country outside of the U.S. accounted for 10% or more of revenue during any of these periods.26Table of ContentsCost of RevenueCost of revenue consisted of the following for the periods presented (in thousands): For the Years Ended December 31,For the Years Ended December 31, 20202019% Change20192018% ChangeBandwidth fees$200,167 $165,335 21.1 %$165,335 $154,853 6.8 %Co-location fees156,275 127,024 23.0 127,024 128,082 (0.8)Network build-out and supporting services134,952 101,135 33.4 101,135 88,543 14.2 Payroll and related costs262,972 248,146 6.0 248,146 238,920 3.9 Stock-based compensation, including amortization of prior capitalized amounts52,863 51,607 2.4 51,607 45,765 12.8 Depreciation of network equipment167,017 125,589 33.0 125,589 150,458 (16.5)Amortization of internal-use software158,426 168,788 (6.1)168,788 146,864 14.9 Total cost of revenue$1,132,672 $987,624 14.7 %$987,624 $953,485 3.6 %As a percentage of revenue35.4 %34.1 %34.1 %35.1 %The increase in total cost of revenue for 2020 as compared to 2019 was primarily due to increases in investments in our network to support current and anticipated future traffic growth, which resulted in increases to amounts paid for network build-out and supporting services, higher depreciation costs of our network equipment and higher expenses related to our co-location facilities. Bandwidth fees also increased during this period due to growth in the amount of traffic served on our network.The increase in total cost of revenue for 2019 as compared to 2018 was primarily due to increases in amortization of internal-use software as we continued to release internally-developed software onto our network related to new product launches and significant enhancements to our existing services, network build-out and supporting service costs due to investments in network expansion and bandwidth fees to support the increase in traffic served on our network. These increases were partially offset by lower depreciation expense of network equipment of $31.5 million for the year ended December 31, 2019, due to software and hardware initiatives we implemented to manage our global network more efficiently, resulting in an increase in the expected average useful lives of our network assets, primarily servers, from four to five years effective January 1, 2019.During 2021, we plan to continue to focus our efforts on managing our operating margins, including continuing to manage our bandwidth and co-location costs. We anticipate depreciation of network equipment to increase in 2021 due to increased investments in our network to address expected traffic increases.Research and Development ExpensesResearch and development expenses consisted of the following for the periods presented (in thousands):For the Years Ended December 31,For the Years Ended December 31, 20202019% Change20192018% ChangePayroll and related costs$410,568 $382,084 7.5 %$382,084 $365,713 4.5 %Stock-based compensation48,854 49,685 (1.7)49,685 44,034 12.8 Capitalized salaries and related costs(200,143)(183,282)9.2 (183,282)(174,373)5.1 Other expenses10,036 12,878 (22.1)12,878 10,791 19.3 Total research and development$269,315 $261,365 3.0 %$261,365 $246,165 6.2 %As a percentage of revenue8.4 %9.0 %9.0 %9.1 %The increases in research and development expenses for 2020 as compared to 2019 were due to growth in payroll and related costs as a result of merit increases and headcount growth to support investments in new product development and 27Table of Contentsnetwork scaling. These increases were partially offset by increases in capitalized salaries and related costs due to continued investment in internal-use software deployed on our network.The increases in research and development expenses for 2019 as compared to 2018 were due to increases in payroll and related costs, including stock-based compensation, as a result of headcount growth to support investments in new product development and network scaling, and as a result of employees joining us through acquisitions. These increases were partially offset by increases in capitalized salaries and related costs due to continued investment in internal-use software deployed on our network.Research and development costs are expensed as incurred, other than certain internal-use software development costs eligible for capitalization. Capitalized development costs consist of payroll and related costs for personnel and external consulting expenses involved in the development of internal-use software used to deliver our services and operate our network. For the years ended December 31, 2020, 2019 and 2018, we capitalized $35.7 million, $33.7 million and $31.9 million, respectively, of stock-based compensation. These capitalized internal-use software development costs are amortized to cost of revenue over their estimated useful lives, which is generally two years, but can be up to seven years based on the software developed and its expected useful life.We expect research and development costs to increase in 2021 as we plan to maintain our focus on innovation; however, we do not expect these costs to increase as a percentage of revenue as we continue to manage costs.Sales and Marketing ExpensesSales and marketing expenses consisted of the following for the periods presented (in thousands):For the Years Ended December 31,For the Years Ended December 31, 20202019% Change20192018% ChangePayroll and related costs$393,800 $382,570 2.9 %$382,570 $388,320 (1.5)%Stock-based compensation65,257 62,149 5.0 62,149 64,372 (3.5)Marketing programs and related costs39,272 52,787 (25.6)52,787 41,796 26.3 Other expenses12,076 26,377 (54.2)26,377 22,865 15.4 Total sales and marketing$510,405 $523,883 (2.6)%$523,883 $517,353 1.3 %As a percentage of revenue16.0 %18.1 %18.1 %19.1 %During much of 2020, restrictions associated with the COVID-19 pandemic have resulted in the cancellation or postponement of in-person marketing events and led to a decline in travel expenses such as airfare, lodging and other costs related to in-person customer events and meetings; as a result, we experienced a decrease in sales and marketing expenses in 2020 as compared to 2019.The increase in sales and marketing expenses for 2019 as compared to 2018 was primarily due to increased spending for marketing programs and other expenses, primarily for a customer conference that took place during 2019 that did not take place in 2018, partially offset by a decrease in payroll and related costs and stock-based compensation due to reduced headcount in the marketing organization.We expect the decreased level of marketing and travel related expenditures to continue into 2021 as we continue to be impacted by the COVID-19 pandemic. We also plan to continue to carefully manage costs in our efforts to refine and optimize our go-to-market efforts and manage operating margins.28Table of ContentsGeneral and Administrative ExpensesGeneral and administrative expenses consisted of the following for the periods presented (in thousands):For the Years Ended December 31,For the Years Ended December 31, 20202019% Change20192018% ChangePayroll and related costs$199,992 $194,232 3.0 %$194,232 $188,635 3.0 %Stock-based compensation58,470 52,826 10.7 52,826 53,514 (1.3)Depreciation and amortization82,862 78,587 5.4 78,587 80,014 (1.8)Facilities-related costs98,805 90,674 9.0 90,674 86,107 5.3 Provision for doubtful accounts2,881 1,924 49.7 1,924 2,672 (28.0)Acquisition-related costs5,579 1,920 190.6 1,920 2,868 (33.1)License of patent— (8,855)(100.0)(8,855)(17,146)(48.4)Legal and stockholder matter costs275 10,000 (97.3)10,000 23,091 (56.7)Endowment of Akamai Foundation20,000 — 100.0 — 50,000 (100.0)Professional fees and other expenses79,024 94,785 (16.6)94,785 104,312 (9.1)Total general and administrative$547,888 $516,093 6.2 %$516,093 $574,067 (10.1)%As a percentage of revenue17.1 %17.8 %17.8 %21.1 %The increase in general and administrative expenses for 2020 as compared to 2019 was primarily due to:•an endowment contribution to the Akamai Foundation in 2020, which did not occur in 2019, to support the Foundation's increased initiatives (for additional information see Note 21 to the consolidated financial statements included elsewhere in this annual report on Form 10-K);•expansion of company infrastructure throughout 2019, including moving into our new corporate headquarters in Cambridge, Massachusetts, which increased facilities-related costs and depreciation and amortization in 2020; and•a reduction to license patent fees as a result of our litigation with Limelight Networks, Inc., or Limelight, that did not recur in 2020.The 2020 increases in general and administrative expenses were also partially offset by a decrease in amounts paid to professional service providers for advisory services as well as a legal settlement charge in 2019.The decrease in general and administrative expenses in 2019 as compared to 2018 was primarily due to the 2018 contribution to the Akamai Foundation, a reduction in legal and stockholder matter costs and a decrease in other expenses due to a decrease in non-income tax reserves. These decreases were partially offset by cessation of payments to us under the terms of the litigation settlement agreement with Limelight.General and administrative expenses for 2020 and 2019 are broken out by category as follows (in thousands):For the Years Ended December 31,For the Years Ended December 31,20202019% Change20192018% ChangeGlobal functions$193,719$198,077 (2.2)%$198,077 $197,377 0.4 %As a percentage of revenue6.1 %6.8 %6.8 %7.3 %Infrastructure325,434307,500 5.8 307,500 308,915 (0.5)As a percentage of revenue10.2 %10.6 %10.6 %11.4 %Other28,73510,516 173.3 10,516 67,775 (84.5)Total general and administrative expenses$547,888 $516,093 6.2 %$516,093 $574,067 (10.1)%As a percentage of revenue17.1 %17.8 %17.8 %21.1 %Global functions expense includes payroll, stock-based compensation and other employee-related costs for administrative functions, including finance, purchasing, order entry, human resources, legal, information technology and executive personnel, as well as third-party professional service fees. Infrastructure expense includes payroll, stock-based compensation and other 29Table of Contentsemployee-related costs for our network infrastructure functions, as well as facility rent expense, depreciation and amortization of facility and IT-related assets, software and software-related costs, business insurance and taxes. Our network infrastructure function is responsible for network planning, sourcing, architecture evaluation and platform security. Other expense includes acquisition-related costs, provision for doubtful accounts, legal settlements, non-routine stockholder matter costs, the endowment contribution to the Akamai Foundation, transformation costs and the licensing of a patent.During 2021, we plan to continue to focus our efforts on managing our operating margins.Amortization of Acquired Intangible AssetsFor the Years Ended December 31,For the Years Ended December 31,(in thousands)20202019% Change20192018% ChangeAmortization of acquired intangible assets$42,049 $38,581 9.0 %$38,581 $33,311 15.8 %As a percentage of revenue1.3 %1.3 %1.3 %1.2 %The increase in amortization of acquired intangible assets in 2020 as compared to 2019, as well as 2019 as compared to 2018, was the result of amortization of assets related to our recent acquisitions. Based on acquired intangible assets as of December 31, 2020, future amortization is expected to be $47.4 million, $43.8 million, $36.3 million, $28.4 million and $22.9 million for the years ending December 31, 2021, 2022, 2023, 2024 and 2025, respectively. Restructuring ChargeFor the Years Ended December 31,For the Years Ended December 31,(in thousands)20202019% Change20192018% ChangeRestructuring charge$37,286 $17,153 117.4 %$17,153 $27,594 (37.8)%As a percentage of revenue1.2 %0.6 %0.6 %1.0 %The restructuring charge in 2020 was primarily the result of management actions initiated in the fourth quarter of 2020 to better position us to become more agile in delivering our solutions. The restructuring charge for this action relates to certain headcount reductions and software charges for software not yet placed into service that will not be implemented due to this action. Also included in 2020 is an $8.7 million impairment of lease related assets incurred to exit leased facilities related to the 2019 action.The restructuring charge in 2019 was primarily the result of management actions that focused on investments with the potential to accelerate revenue growth. The restructuring charge relates to certain headcount reductions and software charges for software not yet placed into service that will not be implemented due to this action.The restructuring charge in 2018 was primarily the result of management actions intended to re-balance investments to focus on long-term growth and scale. The restructuring charge relates to certain headcount reductions and software charges for software not yet placed into service that will not be implemented due to this action.In addition to the actions described above, we have also recognized restructuring charges for redundant employees, facilities and contracts associated with completed acquisitions.We expect to incur up to $7.0 million in 2021 for severance and related benefits related to the 2020 action. We do not expect to incur any material additional charges related to previously completed acquisitions.30Table of ContentsNon-Operating Income (Expense)For the Years Ended December 31,For the Years Ended December 31,(in thousands)20202019% Change20192018% ChangeInterest income$29,122 $34,355 (15.2)%$34,355 $26,940 27.5 %As a percentage of revenue0.9 %1.2 %1.2 %1.0 %Interest expense$(69,120)$(49,364)40.0 %$(49,364)$(43,202)14.3 %As a percentage of revenue(2.2)%(1.7)%(1.7)%(1.6)%Other expense, net$(2,454)$(1,428)71.8 %$(1,428)$(3,148)(54.6)%As a percentage of revenue(0.1)%— %— %(0.1)%For the periods presented, interest income primarily consists of interest earned on invested cash balances and marketable securities. The decrease to interest income in 2020 as compared to 2019 was primarily the result of investing in marketable securities having lower rates of return due to lower interest rates in 2020 as compared to 2019. The increase to interest income in 2019 as compared to 2018 was primarily the result of increased cash, cash equivalents and marketable securities balances as a result of our August 2019 issuance of $1,150.0 million in par value of convertible senior notes due 2027.Interest expense is related to our debt transactions, which are described in Note 11 to the consolidated financial statements included elsewhere in this annual report on Form 10-K. The increase to interest expense for 2020 as compared to 2019 was primarily due to the August 2019 issuance of $1,150.0 million in par value of convertible senior notes due 2027, or 2027 Notes, which bear regular interest of 0.375%, but have an effective interest rate of 3.1% due to the conversion feature. The increase to interest expense for 2019 as compared to 2018 was primarily due to the May 2018 issuance of $1,150.0 million in par value of convertible senior notes due 2025, which bear regular interest of 0.125%, but have an effective interest rate of 4.26% due to the conversion feature, and the issuance of the 2027 Notes.Other expense, net for the years ended December 31, 2020, 2019 and 2018 primarily represents net foreign exchange gains and losses mainly due to foreign currency exchange rate fluctuations on intercompany and other non-functional currency transactions. Other expense, net may fluctuate in the future based on changes in foreign currency exchange rates or other events. Other expense, net also includes a $7.2 million gain from the sale of an equity investment in 2020.Provision for Income TaxesFor the Years Ended December 31,For the Years Ended December 31,(in thousands)20202019% Change20192018% ChangeProvision for income taxes$45,922 $53,350 (13.9)%$53,350 $44,716 19.3 %As a percentage of revenue1.4 %1.8 %1.8 %1.6 %Effective income tax rate7.5 %10.0 %10.0 %13.0 %The decrease in the provision for income taxes for 2020 as compared to 2019 was mainly due to a decrease in intercompany sales of intellectual property, a decrease in the valuation allowance recorded against deferred tax assets related to state tax credits and an increase in foreign income taxed at lower rates. These amounts were partially offset by an increase in profit before tax and the release of certain tax reserves related to the expiration of local statues of limitations in 2019.The increase in the provision for income taxes for 2019 as compared to 2018 was mainly due to an increase in profit before taxes and an increase in the valuation allowance recorded against deferred tax assets related to state tax credits. These amounts were partially offset by the composition of income from foreign jurisdictions that is taxed at lower rates and the release of certain tax reserves related to the expiration of local statutes of limitations.For the year ended December 31, 2020, our effective income tax rate was lower than the federal statutory tax rate due to foreign income taxed at lower rates, the impact of the excess tax benefit related to stock-based compensation and the benefit of U.S. federal, state and foreign research and development credits. These amounts were partially offset by non-deductible stock-based compensation, state taxes and the valuation allowance recorded against tax credits and foreign net operating loss carryforwards.31Table of ContentsFor the year ended December 31, 2019, our effective income tax rate was lower than the federal statutory tax rate due to the release of certain tax reserves related to the expiration of local statutes of limitations, foreign income taxed at lower rates, the excess tax benefit related to stock-based compensation and the benefit of the U.S. federal, state and foreign research and development credits. These amounts were partially offset by the valuation allowance recorded against deferred tax assets related to state tax credits, non-deductible executive compensation, an intercompany sale of intellectual property and state income taxes.For the year ended December 31, 2018, our effective income tax rate was lower than the federal statutory tax rate due to foreign income taxed at lower rates, the excess tax benefit related to stock-based compensation, a decrease in the provisional amount of the one-time transition tax that was recorded in 2017, the release of certain tax reserves related to the expiration of local statutes of limitations and the benefit of U.S. federal, state and foreign research and development credits. These amounts were partially offset by an intercompany sale of intellectual property and state income taxes.Our effective income tax rate may fluctuate between fiscal years and from quarter to quarter due to items arising from discrete events, such as tax benefits from the disposition of employee equity awards, tax law changes and settlements of tax audits and assessments. Our effective income tax rate is also impacted by, and may fluctuate in any given period because of, the composition of income in foreign jurisdictions where tax rates differ depending on the local statutory rates.Refer to Note 19 to the consolidated financial statements included elsewhere in this annual report on Form 10-K for additional information regarding unrecognized tax benefits that, if recognized, would impact the effective income tax rate in the next 12 months and the potential impact that current litigation related to an adverse audit finding could have on our results of operations.Loss from Equity Method InvestmentFor the Years Ended December 31,For the Years Ended December 31,(in thousands)20202019% Change20192018% ChangeLoss from equity method investment$13,106 $1,096 1,095.8 %$1,096 $— 100.0 %As a percentage of revenue0.4 %— %— %— %During 2019, we began recognizing our share of earnings from our investment with Mitsubishi UFJ Financial Group in a joint venture, Global Open Network, Inc., or GO-NET. GO-NET intends to operate a new blockchain-based online payment network. For the year ended December 31, 2020, the losses recognized reflect our share of the losses incurred by GO-NET as well as an $11.0 million impairment charge to adjust our carrying value of our investment to fair value, due to a modified business plan and continued negative projected cash flows. We expect to record additional equity method losses in 2021 and beyond as GO-NET continues executing on the early stages of its business plan.Non-GAAP Financial MeasuresIn addition to providing financial measurements based on generally accepted accounting principles in the United States of America, or GAAP, we provide additional financial metrics that are not prepared in accordance with GAAP, or non-GAAP financial measures. Management uses non-GAAP financial measures, in addition to GAAP financial measures, to understand and compare operating results across accounting periods, for financial and operational decision making, for planning and forecasting purposes, to measure executive compensation and to evaluate our financial performance. These non-GAAP financial measures are non-GAAP income from operations, non-GAAP operating margin, non-GAAP net income, non-GAAP net income per share, Adjusted EBITDA, Adjusted EBITDA margin, capital expenditures and impact of foreign currency exchange rates, as discussed below.Management believes that these non-GAAP financial measures reflect our ongoing business in a manner that allows for meaningful comparisons and analysis of trends in the business, as they facilitate comparing financial results across accounting periods and to those of peer companies. Management also believes that these non-GAAP financial measures enable investors to evaluate our operating results and future prospects in the same manner as management. These non-GAAP financial measures may exclude expenses and gains that may be unusual in nature, infrequent or not reflective of our ongoing operating results.The non-GAAP financial measures do not replace the presentation of our GAAP financial measures and should only be used as a supplement to, not as a substitute for, our financial results presented in accordance with GAAP.32Table of ContentsThe non-GAAP adjustments, and our basis for excluding them from non-GAAP financial measures, are outlined below:•Amortization of acquired intangible assets – We have incurred amortization of intangible assets, included in our GAAP financial statements, related to various acquisitions we have made. The amount of an acquisition's purchase price allocated to intangible assets and term of its related amortization can vary significantly and are unique to each acquisition; therefore, we exclude amortization of acquired intangible assets from our non-GAAP financial measures to provide investors with a consistent basis for comparing pre- and post-acquisition operating results. •Stock-based compensation and amortization of capitalized stock-based compensation – Although stock-based compensation is an important aspect of the compensation paid to our employees, the grant date fair value varies based on the stock price at the time of grant, varying valuation methodologies, subjective assumptions and the variety of award types. This makes the comparison of our current financial results to previous and future periods difficult to interpret; therefore, we believe it is useful to exclude stock-based compensation and amortization of capitalized stock-based compensation from our non-GAAP financial measures in order to highlight the performance of our core business and to be consistent with the way many investors evaluate our performance and compare our operating results to peer companies. •Acquisition-related costs – Acquisition-related costs include transaction fees, advisory fees, due diligence costs and other direct costs associated with strategic activities. In addition, subsequent adjustments to our initial estimated amounts of contingent consideration and indemnification associated with specific acquisitions are included within acquisition-related costs. These amounts are impacted by the timing and size of the acquisitions. We exclude acquisition-related costs from our non-GAAP financial measures to provide a useful comparison of our operating results to prior periods and to our peer companies because such amounts vary significantly based on the magnitude of our acquisition transactions and do not reflect our core operations. •Restructuring charges – We have incurred restructuring charges that are included in our GAAP financial statements, primarily related to workforce reductions and estimated costs of exiting facility lease commitments. We exclude these items from our non-GAAP financial measures when evaluating our continuing business performance as such items vary significantly based on the magnitude of the restructuring action and do not reflect expected future operating expenses. In addition, these charges do not necessarily provide meaningful insight into the fundamentals of current or past operations of our business.•Amortization of debt discount and issuance costs and amortization of capitalized interest expense – In August 2019, we issued $1,150 million of convertible senior notes due 2027 with a coupon interest rate of 0.375%. In May 2018, we issued $1,150 million of convertible senior notes due 2025 with a coupon interest rate of 0.125%. In February 2014, we issued $690 million of convertible senior notes due 2019 with a coupon interest rate of 0%. The imputed interest rates of these convertible senior notes were 3.10%, 4.26% and 3.20%, respectively. This is a result of the debt discounts recorded for the conversion features that are required to be separately accounted for as equity under GAAP, thereby reducing the carrying values of the convertible debt instruments. The debt discounts are amortized as interest expense together with the issuance costs of the debt. The interest expense excluded from our non-GAAP results is comprised of these non-cash components and is excluded from management's assessment of our operating performance because management believes the non-cash expense is not representative of ongoing operating performance. •Gains and losses on investments – We have recorded gains and losses from the disposition, changes to fair value and impairment of certain investments. We believe excluding these amounts from our non-GAAP financial measures is useful to investors as the types of events giving rise to them are not representative of our core business operations and ongoing operating performance. •Legal and stockholder matter costs – We have incurred losses related to the settlement of legal matters and costs from professional service providers related to a non-routine stockholder matter. We believe excluding these amounts from our non-GAAP financial measures is useful to investors as the types of events giving rise to them are not representative of our core business operations. 33Table of Contents•Endowment of Akamai Foundation – We have incurred expenses to endow the Akamai Foundation, a private corporate foundation dedicated to encouraging the next generation of technology innovators by supporting math and science education. Our first endowment was in 2018 to enable a permanent endowment for the Akamai Foundation to allow it to expand its reach. In the fourth quarter of 2020 we supplemented the endowment to enable specific initiatives to increase diversity in the technology industry. We believe excluding these amounts from non-GAAP financial measures is useful to investors as these infrequent expenses are not representative of our core business operations. •Transformation costs – We have incurred professional services fees associated with internal changes that are designed to improve operating margins and that are part of a discrete planned transformation program intended to significantly change the manner in which business is conducted. We believe excluding these amounts from our non-GAAP financial measures is useful to investors as the types of events and activities giving rise to them occur infrequently and are not representative of our core business operations and ongoing operating performance. •Income and losses from equity method investment – We record income or losses on our share of earnings and losses from our equity method investment. We exclude such income and losses because we do not direct control over the operations of the investment and the related income and losses are not representative of our core business operations. •Income tax effect of non-GAAP adjustments and certain discrete tax items – The non-GAAP adjustments described above are reported on a pre-tax basis. The income tax effect of non-GAAP adjustments is the difference between GAAP and non-GAAP income tax expense. Non-GAAP income tax expense is computed on non-GAAP pre-tax income (GAAP pre-tax income adjusted for non-GAAP adjustments) and excludes certain discrete tax items (such as recording or releasing of valuation allowances), if any. We believe that applying the non-GAAP adjustments and their related income tax effect allows us to highlight income attributable to our core operations.34Table of ContentsThe following table reconciles GAAP income from operations to non-GAAP income from operations and non-GAAP operating margin for the years ended December 31, 2020, 2019 and 2018 (in thousands): 202020192018Income from operations$658,534 $548,918 362,499 Amortization of acquired intangible assets42,049 38,581 33,311 Stock-based compensation197,411 187,140 183,813 Amortization of capitalized stock-based compensation and capitalized interest expense33,202 34,438 28,603 Restructuring charge37,286 17,153 27,594 Acquisition-related costs5,579 1,920 2,868 Legal and stockholder matter costs275 10,000 23,091 Endowment of Akamai Foundation20,000 — 50,000 Transformation costs— 5,527 7,730 Non-GAAP income from operations$994,336 $843,677 $719,509 GAAP operating margin21 %19 %13 %Non-GAAP operating margin31 %29 %27 %The following table reconciles GAAP net income to non-GAAP net income for the years ended December 31, 2020, 2019 and 2018 (in thousands): 202020192018Net income$557,054 $478,035 $298,373 Amortization of acquired intangible assets42,049 38,581 33,311 Stock-based compensation197,411 187,140 183,813 Amortization of capitalized stock-based compensation and capitalized interest expense33,202 34,438 28,603 Restructuring charge37,286 17,153 27,594 Acquisition-related costs5,579 1,920 2,868 Legal and stockholder matter costs275 10,000 23,091 Endowment of Akamai Foundation20,000 — 50,000 Transformation costs— 5,527 7,730 Amortization of debt discount and issuance costs62,823 45,857 41,958 (Gain) loss on investments(7,228)60 1,481 Loss from equity method investment13,106 1,096 — Income tax effect of above non-GAAP adjustments and certain discrete tax items(103,280)(80,488)(86,391)Non-GAAP net income$858,277 $739,319 $612,431 35Table of ContentsThe following table reconciles GAAP net income per diluted share to non-GAAP net income per diluted share for the years ended December 31, 2020, 2019 and 2018 (shares in thousands): 202020192018GAAP net income per diluted share$3.37 $2.90 $1.76 Adjustments to net income:Amortization of acquired intangible assets0.25 0.23 0.20 Stock-based compensation1.19 1.14 1.09 Amortization of capitalized stock-based compensation and capitalized interest expense0.20 0.21 0.17 Restructuring charge0.23 0.10 0.16 Acquisition-related costs0.03 0.01 0.02 Legal and stockholder matter costs— 0.06 0.14 Endowment of Akamai Foundation0.12 — 0.30 Transformation costs— 0.03 0.05 Amortization of debt discount and issuance costs0.38 0.28 0.25 (Gain) loss on investments(0.04)— 0.01 Loss from equity method investment0.08 0.01 — Income tax effect of above non-GAAP adjustments and certain discrete tax items(0.63)(0.49)(0.51)Adjustment for shares (1)0.04 — — Non-GAAP net income per diluted share (2)$5.22 $4.49 $3.62 Shares used in GAAP diluted per share calculations165,213 164,573 169,188 Impact of benefit from note hedge transactions (1)(873)— — Shares used in non-GAAP diluted per share calculations (1)164,340 164,573 169,188 (1) Shares used in non-GAAP diluted per calculations have been adjusted for the year ended December 31, 2020, for the benefit of our note hedge transactions. During 2020, our average stock price was in excess of $95.10, which is the initial conversion price of our convertible senior notes due in 2025. See further discussion below.(2) May not foot due to rounding.Non-GAAP net income per diluted share is calculated as non-GAAP net income divided by diluted weighted average common shares outstanding. GAAP diluted weighted average common shares outstanding are adjusted in non-GAAP per share calculations for the shares that would be delivered to us pursuant to the note hedge transactions entered into in connection with the issuance of our convertible senior notes. Under GAAP, shares delivered under hedge transactions are not considered offsetting shares in the fully-diluted share calculation until they are delivered. However, we would receive a benefit from the note hedge transactions and would not allow the dilution to occur, so management believes that adjusting for this benefit provides a meaningful view of net income per share. Unless our weighted average stock price is greater than $95.10, the initial conversion price of the convertible senior notes due 2025, or $116.18, the initial conversion price of the convertible senior notes due 2027, there will be no difference between our GAAP and non-GAAP diluted weighted average common shares outstanding.We consider Adjusted EBITDA to be another important indicator of the operational strength and performance of our business and a good measure of our historical operating trends. Adjusted EBITDA eliminates items that we do not consider to be part of our core operations. We define Adjusted EBITDA as GAAP net income excluding the following items: interest income; income taxes; depreciation and amortization of tangible and intangible assets; stock-based compensation; amortization of capitalized stock-based compensation; acquisition-related costs; restructuring charges; gains and losses on legal settlements; costs from professional service providers related to a non-routine stockholder matter; costs incurred related to endowment contributions to the Akamai Foundation; transformation costs; foreign exchange gains and losses; interest expense; amortization of capitalized interest expense; certain gains and losses on investments; gains and losses from equity method investments; and other non-recurring or unusual items that may arise from time to time. Adjusted EBITDA margin represents Adjusted EBITDA stated as a percentage of revenue.36Table of ContentsThe following table reconciles GAAP net income to Adjusted EBITDA and Adjusted EBITDA margin for the years ended December 31, 2020, 2019 and 2018 (in thousands): 202020192018Net income$557,054 $478,035 $298,373 Amortization of acquired intangible assets42,049 38,581 33,311 Stock-based compensation197,411 187,140 183,813 Amortization of capitalized stock-based compensation and capitalized interest expense33,202 34,438 28,603 Restructuring charge37,286 17,153 27,594 Acquisition-related costs5,579 1,920 2,868 Legal and stockholder matter costs275 10,000 23,091 Interest income(29,122)(34,355)(26,940)Endowment of Akamai Foundation20,000 — 50,000 Transformation costs— 5,527 7,730 Amortization of debt discount and issuance costs69,120 49,364 43,202 Provision for income taxes45,922 53,350 44,716 Depreciation and amortization403,160 367,655 372,606 (Gain) loss on investments(7,228)60 1,481 Loss from equity method investment13,106 1,096 — Other expense, net9,682 1,368 1,667 Adjusted EBITDA$1,397,496 $1,211,332 $1,092,115 Adjusted EBITDA margin44 %42 %40 %Impact of Foreign Currency Exchange RatesRevenue and earnings from our international operations have historically been an important contributor to our financial results. Consequently, our financial results have been impacted, and management expects they will continue to be impacted, by fluctuations in foreign currency exchange rates. For example, when the local currencies of our foreign subsidiaries weaken, generally our consolidated results stated in U.S. dollars are negatively impacted.Because exchange rates are a meaningful factor in understanding period-to-period comparisons, management believes the presentation of the impact of foreign currency exchange rates on revenue and earnings enhances the understanding of our financial results and evaluation of performance in comparison to prior periods. The dollar impact of changes in foreign currency exchange rates presented is calculated by translating current period results using monthly average foreign currency exchange rates from the comparative period and comparing them to the reported amount. The percentage change at constant currency presented is calculated by comparing the prior period amounts as reported and the current period amounts translated using the same monthly average foreign currency exchange rates from the comparative period.Liquidity and Capital ResourcesTo date, we have financed our operations primarily through public and private sales of debt and equity securities and cash generated by operations. As of December 31, 2020, our cash, cash equivalents and marketable securities, which primarily consisted of corporate bonds and U.S. government agency obligations, totaled $2.5 billion. Factoring in our outstanding convertible senior notes of $2.3 billion, our net cash at December 31, 2020 was $196.9 million. We place our cash investments in instruments that meet high-quality credit standards, as specified in our investment policy. Our investment policy also limits the amount of our credit exposure to any one issue or issuer and seeks to manage these assets to achieve our goals of preserving principal and maintaining adequate liquidity at all times.Changes in cash, cash equivalents and marketable securities are dependent upon changes in, among other things, working capital items such as accounts receivable, deferred revenue, accounts payable and various accrued expenses, as well as changes in our capital and financial structure due to common stock repurchases, debt repurchases and issuances, purchases and sales of marketable securities and similar events. The events related to the COVID-19 pandemic have not had a material impact to our 37Table of Contentsliquidity in 2020; however, we continue to monitor our customer base, particularly those in industries most impacted by the pandemic, and their ability to pay us for our services or to pay us in a timely manner due to financial stresses the outbreak may have caused them. We believe that, particularly in situations like these, our strong balance sheet and cash position are important competitive differentiators that provide the financial stability and flexibility to enable us to continue to make investments at opportune times.As of December 31, 2020, we had cash and cash equivalents of $278.7 million held in accounts outside the U.S. The U.S. Tax Cuts and Jobs Act establishes a territorial tax system in the U.S., which provides companies with the potential ability to repatriate earnings with minimal U.S. federal income tax impact beginning in 2018. As a result, our liquidity is not materially impacted by the amount of cash and cash equivalents held in accounts outside the U.S.Cash Provided by Operating ActivitiesFor the Years Ended December 31,(in thousands)202020192018Net income$557,054 $478,035 $298,373 Non-cash reconciling items included in net income727,829 683,132 679,648 Changes in operating assets and liabilities(69,883)(102,863)30,306 Net cash flows provided by operating activities$1,215,000 $1,058,304 $1,008,327 The increase in cash provided by operating activities for 2020 as compared to 2019 was primarily due to increased profitability in 2020 and timing of vendor payments. The increase was partially offset by the timing of payments from customers.The increase in cash provided by operating activities for 2019 as compared to 2018 was primarily due to increased profitability in 2019, partially offset by the timing of cash collections from customers, an increase of $28.8 million in cash paid for income taxes and timing of collections and payments of other working capital items.Cash Used in Investing ActivitiesFor the Years Ended December 31,(in thousands)202020192018Cash paid for acquired businesses, net of cash acquired$(127,999)$(165,329)$(79)Cash paid for asset acquisition(36,376)— — Cash paid for equity method investment— (36,008)— Purchases of property and equipment and capitalization of internal-use software development costs(731,872)(562,077)(405,741)Net marketable securities activity(154,848)(904,919)(98,647)Other investing activities8,121 399 (2,066)Net cash used in investing activities$(1,042,974)$(1,667,934)$(506,533)The decrease in cash used in investing activities in 2020 as compared to 2019 was driven by a decrease in purchases of marketable securities. During 2019 we invested some of the proceeds from our August 2019 issuance of convertible senior notes in marketable securities, which increased our purchases in that year and did not recur in 2020. The decrease in cash used in investing activities in 2020 as compared to 2019 was partially offset by an increase in purchases of property and equipment during 2020 to support the increase in traffic we experienced on our network and expect to continue to experience in the future.The increase in cash used in investing activities in 2019 as compared to 2018 was primarily driven by an increase in purchases of marketable securities with the proceeds from our August 2019 issuance of convertible senior notes, cash paid for acquired companies in 2019, increased capital expenditures and cash invested in an equity method investment.38Table of ContentsCash (Used in) Provided by Financing ActivitiesFor the Years Ended December 31,(in thousands)202020192018Activity related to convertible senior notes$— $318,554 $990,390 Activity related to stock-based compensation(30,053)(18,154)(1,697)Repurchases of common stock(193,588)(334,519)(750,000)Other financing activities— (1,558)(5,085)Net cash (used in) provided by financing activities$(223,641)$(35,677)$233,608 The increase in cash used in financing activities in 2020 as compared to 2019 was due to the net proceeds received from our August 2019 issuance of our convertible senior notes and related bond hedge and warrant transaction. The increase was partially offset by the repayment of our convertible senior notes that were due in February 2019 and a decrease in shares repurchased under our repurchase programs.The change in net cash used in or provided by financing activities during 2019 as compared to 2018 was due to our repayment of $690 million of aggregate principal of convertible notes in 2019, partially offset by a decrease in shares repurchased under our repurchase programs.Effective November 2018, the board of directors authorized a $1.1 billion repurchase program through December 2021. Our goal for the share repurchase programs is to offset the dilution created by our employee equity compensation programs and provide the flexibility to return capital to shareholders as business and market conditions warrant. As of December 31, 2020, we have $571.9 million available for future purchases of shares under this repurchase program.During 2020, 2019 and 2018, we repurchased 2.0 million, 4.0 million and 10.2 million shares of our common stock, respectively, at an average price per share of $98.53, $82.90 and $73.54, respectively.Convertible Senior NotesIn August 2019, we issued $1,150.0 million in par value of convertible senior notes due 2027 and entered into related convertible note hedge and warrant transactions. We have used and expect to continue to use the net proceeds of the offering for share repurchases, working capital and general corporate purposes, including potential acquisitions and other strategic transactions.In May 2018, we issued $1,150.0 million in par value of convertible senior notes due 2025 and entered into related convertible note hedge and warrant transactions. We used a portion of the net proceeds to repay at maturity all of our $690.0 million outstanding aggregate principle amount of convertible senior notes due in 2019. In addition, we have used and expect to continue to use the remaining net proceeds of the offering for share repurchases, working capital and general corporate purposes, including potential acquisitions and other strategic transactions.In February 2014, we issued $690.0 million in par value of convertible senior notes due 2019 and entered into related convertible note hedge and warrant transactions. We repaid the full $690.0 million in principal amount of the notes in cash in February 2019, as the notes matured and no conversions occurred.The terms of the notes and the hedge and warrant transactions are discussed more fully in Note 11 to the consolidated financial statements included elsewhere in this annual report on Form 10-K. Revolving Credit FacilityIn May 2018, we entered into a $500.0 million, five-year revolving credit agreement, or the Credit Agreement. Borrowings under the facility may be used to finance working capital needs and for general corporate purposes. The facility provides for an initial $500.0 million in revolving loans. Under specified circumstances, the facility can be increased to up to $1.0 billion in aggregate principal amount.Borrowings under the Credit Agreement bear interest, at our option, at a base rate plus a spread of 0.00% to 0.25% or an adjusted LIBOR rate plus a spread of 0.875% to 1.25%, in each case with such spread being determined based on our 39Table of Contentsconsolidated leverage ratio specified in the Credit Agreement. Regardless of what amounts, if any, are outstanding under the Credit Agreement, we are also obligated to pay an ongoing commitment fee on undrawn amounts at a rate of 0.075% to 0.15%, with such rate being based on our consolidated leverage ratio specified in the Credit Agreement.The Credit Agreement contains customary representations and warranties, affirmative and negative covenants and events of default. Principal covenants include a maximum consolidated leverage ratio and a minimum consolidated interest coverage ratio. There were no outstanding borrowings under the Credit Agreement as of December 31, 2020. Liquidity OutlookBased on our present business plan, we expect our current cash, cash equivalents and marketable securities balances and our forecasted cash flows from operations to be sufficient to meet our foreseeable cash needs for at least the next 12 months. Our foreseeable cash needs, in addition to our recurring operating costs, include our expected capital expenditures, investments in information technology, opportunistic business acquisitions, anticipated share repurchases, lease and purchase commitments and settlements of other long-term liabilities.Contractual Obligations, Contingent Liabilities and Commercial CommitmentsThe following table presents our contractual obligations and commercial commitments, as of December 31, 2020, for the next five years and thereafter (in thousands): Payments Due by PeriodTotalLess than12 Months12 to 36Months36 to 60MonthsMore than60 MonthsOperating lease obligations: (1)Real estate arrangements$854,829 $80,787 $163,308 $137,176 $473,558 Co-location arrangements186,539 73,540 60,201 27,590 25,208 Bandwidth agreements119,495 95,923 23,232 240 100 Open vendor purchase orders266,644 231,059 31,654 3,931 — Convertible senior notes2,300,000 — — 1,150,000 1,150,000 Total contractual obligations$3,727,507 $481,309 $278,395 $1,318,937 $1,648,866 (1) Excludes $13.6 million of obligations for operating leases that have not yet commenced. See Note 12 to our consolidated financial statements included elsewhere in this annual report on Form 10-K for additional information.In accordance with the authoritative guidance for accounting for uncertainty in income taxes, as of December 31, 2020, we had unrecognized tax benefits of $29.5 million, including $7.7 million of accrued interest and penalties. We believe that it is reasonably possible that $9.6 million of our unrecognized tax benefits will be recognized by the end of 2021. The settlement period for the remaining amount of the unrecognized tax benefits is unknown.Letters of CreditAs of December 31, 2020, we had outstanding $5.8 million in irrevocable letters of credit issued by us in favor of third party beneficiaries, primarily related to facility leases. These irrevocable letters of credit, which are not included in the table of contractual obligations above, are unsecured and are expected to remain in effect, in some cases, until 2026. Off-Balance Sheet ArrangementsWe have entered into indemnification agreements with third parties, including vendors, customers, landlords, our officers and directors, shareholders of acquired companies, joint venture partners and third parties to which we license technology. Generally, these indemnification agreements require us to reimburse losses suffered by a third party due to various events, such as lawsuits arising from patent or copyright infringement or our negligence. These indemnification obligations are considered off-balance sheet arrangements in accordance with the authoritative guidance for guarantor’s accounting and disclosure requirements for guarantees, including indirect guarantees of indebtedness of others. See Note 13 to our consolidated financial statements included elsewhere in this annual report on Form 10-K for further discussion of these indemnification agreements. The fair value of guarantees issued or modified during 2020 and 2019 was determined to be immaterial.40Table of ContentsLegal MattersWe are party to litigation that we consider routine and incidental to our business. We do not currently expect the results of any of these litigation matters to have a material effect on our business, results of operations, financial condition or cash flows.Significant Accounting Policies and EstimatesSee Note 2 to the consolidated financial statements included elsewhere in this annual report on Form 10-K for information regarding recent and newly adopted accounting pronouncements. Application of Critical Accounting Policies and EstimatesOverviewOur MD&A is based upon our consolidated financial statements, which have been prepared in accordance with GAAP. These principles require us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue and expenses, cash flow and related disclosure of contingent assets and liabilities. Our estimates include those related to revenue recognition, accounts receivable and related reserves, valuation and impairment of marketable securities, capitalized internal-use software development costs, goodwill and acquired intangible assets, income tax reserves, impairment and useful lives of long-lived assets and stock-based compensation. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances at the time such estimates are made. Actual results may differ from these estimates. For a complete description of our significant accounting policies, see Note 2 to our consolidated financial statements included elsewhere in this annual report on Form 10-K.DefinitionsWe define our critical accounting policies as those policies that require us to make subjective estimates and judgments about matters that are uncertain and are likely to have a material impact on our consolidated financial statements. Our estimates are based upon assumptions and judgments about matters that are highly uncertain at the time an accounting estimate is made and applied and require us to assess a range of potential outcomes.Review of Critical Accounting Policies and EstimatesRevenue RecognitionOur contracts with customers sometimes include promises to transfer multiple services to a customer. Determining whether services are distinct performance obligations often requires the exercise of judgment by management. Advanced features that enhance a main product or service and are highly interrelated are generally not considered distinct; rather, they are combined with the service they relate to into one performance obligation. Different determinations related to combining services into performance obligations could result in differences in the timing and amount of revenue recognized in a period.Determination of the standalone selling price, or SSP, also requires the exercise of judgment by management. SSP is based on observable inputs such as the price we charge for the service when sold separately, or the discounted list price per management’s approved price list. In cases where services are not sold separately or price list rates are not available, a cost-plus-margin approach or adjusted market approach is used to determine SSP. Changes to SSP could result in differences in the allocation of transaction price among performance obligations, which could result in differences in the timing and amount of revenue recognized in a period.From time to time, we enter into contracts to sell services or license technology to unrelated enterprises at or about the same time that we enter into contracts to purchase products or services from the same enterprises. Consideration payable to a customer is reviewed as part of the transaction price. If the payment to the customer does not represent payment for a distinct service, revenue is recognized only up to the net amount of consideration after customer payment obligations are considered. Different determinations on whether a payment represents a distinct service could result in differences in the amount of revenue recognized.We may also resell the licenses or services of third parties. If we are acting as an agent in an arrangement with a customer to provide third party services, the transaction price reflects only the net amount to which we will be entitled, after accounting for payments made to the third party responsible for satisfying the performance obligation. Different determinations on whether we are acting as an agent or a principal could change the amount of revenue recognized.41Table of ContentsAccounts Receivable and Related ReservesTrade accounts receivable are recorded at the invoiced amounts and do not bear interest. In addition to trade accounts receivable, our accounts receivable balance includes unbilled accounts that represent revenue recorded for customers that is typically billed within one month. We record allowance against our accounts receivable balance, primarily for current expected credit losses. Increases and decreases in the allowance for current expected credit losses are included as a component of general and administrative expense in the consolidated statements of income.Estimates are used in determining our allowance for current expected credit losses using historical loss rates for the previous twelve months as well as expectations about the future where we have been able to develop forecasts to supports our estimates. In addition, the allowance for current expected credit losses considers outstanding balances on a customer-specific, account-by-account basis. We assess collectibility based upon a review of customer receivables from prior sales with collection issues where we no longer believe that the customer has the ability to pay for services previously provided. We also perform ongoing credit evaluations of our customers. If such an evaluation indicates that payment is no longer reasonably assured for services provided, any future services provided to that customer will result in the creation of a cash basis reserve until we receive consistent payments. Valuation and Impairment of Marketable SecuritiesWe measure the fair value of our financial assets and liabilities at the end of each reporting period. Fair value is defined as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. We have certain financial assets and liabilities recorded at fair value (principally cash equivalents and short- and long-term marketable securities) that have been classified as Level 1, 2 or 3 within the fair value hierarchy. Fair values determined by Level 1 inputs utilize quoted prices (unadjusted) in active markets for identical assets or liabilities that we can access at the reporting date. Fair values determined by Level 2 inputs utilize data points other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly. Fair values determined by Level 3 inputs are based on unobservable data points for the asset or liability.Marketable securities are considered to be impaired when a decline in fair value below cost basis is determined to be other-than-temporary. We periodically evaluate whether a decline in fair value below cost basis is other-than-temporary by considering available evidence regarding these investments including, among other factors, the duration of the period that, and extent to which, the fair value is less than cost basis; the financial health of, and business outlook for, the issuer, including industry and sector performance and operational and financing cash flow factors; overall market conditions and trends; and our intent and ability to retain our investment in the security for a period of time sufficient to allow for an anticipated recovery in market value. Once a decline in fair value is determined to be other-than-temporary, a write-down is recorded and a new cost basis in the security is established. Assessing the above factors involves inherent uncertainty. Write-downs, if recorded, could be materially different from the actual market performance of marketable securities in our portfolio if, among other things, relevant information related to our investments and marketable securities was not publicly available or other factors not considered by us would have been relevant to the determination of impairment.Impairment and Useful Lives of Long-Lived AssetsWe review our long-lived assets, such as property and equipment and acquired intangible assets, for impairment whenever events or changes in circumstances indicate that the carrying amount of the assets may not be recoverable. Events that would trigger an impairment review include a change in the use of the asset or forecasted negative cash flows related to the asset. When such events occur, we compare the carrying amount of the asset to the undiscounted expected future cash flows related to the asset. If this comparison indicates that impairment is present, the amount of the impairment is calculated as the difference between the carrying amount and the fair value of the asset. If a readily determinable market price does not exist, fair value is estimated using discounted expected cash flows attributable to the asset. The estimates required to apply this accounting policy include forecasted usage of the long-lived assets, the useful lives of these assets and expected future cash flows. Changes in these estimates could materially impact results from operations.42Table of ContentsGoodwill and Acquired Intangible AssetsWe test goodwill for impairment on an annual basis, as of December 31, or more frequently if events or changes in circumstances indicate that the asset might be impaired. We have concluded that we have one reporting unit and that our chief operating decision maker is our chief executive officer and the executive management team. We have assigned the entire balance of goodwill to our one reporting unit. The fair value of the reporting unit was based on our market capitalization as of each of December 31, 2020 and 2019, and it was substantially in excess of the carrying value of the reporting unit at each date. Acquired intangible assets consist of completed technologies, customer relationships, trademarks and trade names, non-compete agreements and acquired license rights. We engaged third party valuation specialists to assist us with the initial measurement of the fair value of acquired intangible assets. Acquired intangible assets, other than goodwill, are amortized over their estimated useful lives based upon the estimated economic value derived from the related intangible assets.Income Taxes Our provision for income taxes is comprised of a current and a deferred portion. The current income tax provision is calculated as the estimated taxes payable or refundable on tax returns for the current year. The deferred income tax provision is calculated for the estimated future tax effects attributable to temporary differences and carryforwards by using expected tax rates in effect in the years during which the differences are expected to reverse or the carryforwards are expected to be realized.We currently have net deferred tax assets, comprised of net operating loss, or NOL, carryforwards, tax credit carryforwards and deductible temporary differences. Our management periodically weighs the positive and negative evidence to determine if it is more-likely-than-not that some or all of the deferred tax assets will be realized. In determining our net deferred tax assets and valuation allowances, annualized effective tax rates and cash paid for income taxes, management is required to make judgments and estimates about domestic and foreign profitability, the timing and extent of the utilization of NOL carryforwards, applicable tax rates, transfer pricing methodologies and tax planning strategies. Judgments and estimates related to our projections and assumptions are inherently uncertain; therefore, actual results could differ materially from our projections.We have recorded certain tax reserves to address potential exposures involving our income tax positions. These potential tax liabilities result from the varying application of statutes, rules, regulations and interpretations by different taxing jurisdictions. Our estimate of the value of our tax reserves contains assumptions based on past experiences and judgments about the interpretation of statutes, rules and regulations by taxing jurisdictions. It is possible that the costs of the ultimate tax liability or benefit from these matters may be more or less than the amount that we estimated.Uncertainty in income taxes is recognized in our consolidated financial statements using a two-step process to determine the amount of tax benefit to be recognized. First, the tax position must be evaluated to determine the likelihood that it will be sustained upon external examination. If the tax position is deemed more-likely-than-not to be sustained based on technical merit, the tax position is then assessed to determine the amount of benefit to recognize in the financial statements. The amount of the benefit that may be recognized is the largest amount that we believe has a greater than 50% likelihood of being realized upon ultimate settlement.Accounting for Stock-Based CompensationWe issue stock-based compensation awards including stock options, restricted stock units and deferred stock units. We measure the fair value of these awards at the grant date and recognize such fair value as expense over the vesting period. We have selected the Black-Scholes option pricing model to determine the fair value of stock option awards and the Monte Carlo simulation model to determine the fair value of market-based restricted stock unit awards. Determining the fair value of stock-based awards at the grant date requires judgment, including estimating the expected life of the stock awards and the volatility of the underlying common stock. Our assumptions may differ from those used in prior periods. Changes to the assumptions may have a significant impact on the fair value of stock-based awards, which could have a material impact on our financial statements. Judgment is also required in estimating the number of stock-based awards that are expected to be forfeited. Should our actual forfeiture rates differ significantly from our estimates, our stock-based compensation expense and results of operations could be materially impacted. In addition, for awards that vest and become exercisable only upon achievement of specified performance conditions, we make judgments and estimates each quarter about the probability that such performance conditions will be met or achieved. Changes to the estimates we make from time to time may have a significant impact on our stock-based compensation expense and could materially impact our result of operations.43Table of ContentsCapitalized Internal-Use Software CostsWe capitalize salaries and related costs, including stock-based compensation, of employees and consultants who devote time to the development of internal-use software development projects, as well as interest expense related to our senior convertible notes. Capitalization begins during the application development stage, once the preliminary project stage has been completed. If a project constitutes an enhancement to previously-developed software, we assess whether the enhancement creates additional functionality to the software, thus qualifying the work incurred for capitalization. Once the project is available for general release, capitalization ceases and we estimate the useful life of the asset and begin amortization. We periodically assess whether triggering events are present to review internal-use software for impairment. Changes in our estimates related to internal-use software would increase or decrease operating expenses or amortization recorded during the period.Item 7A. Quantitative and Qualitative Disclosures About Market RiskInterest Rate Risk Our portfolio of cash equivalents and short- and long-term investments is maintained in a variety of securities, including U.S. government agency obligations, high-quality corporate debt securities, commercial paper, mutual funds, money market funds and municipal securities. The majority of our investments are classified as available-for-sale securities and carried at fair market value with cumulative unrealized gains or losses recorded as a component of accumulated other comprehensive loss within stockholders' equity. A sharp rise in interest rates could have an adverse impact on the fair market value of certain securities in our portfolio. We do not currently hedge our interest rate exposure and do not enter into financial instruments for trading or speculative purposes. Foreign Currency RiskGrowth in our international operations will incrementally increase our exposure to foreign currency fluctuations as well as other risks typical of international operations that could impact our business, including, but not limited to, differing economic conditions, changes in political climate, differing tax structures and other regulations and restrictions.Transaction ExposureForeign exchange rate fluctuations may adversely impact our consolidated results of operations as exchange rate fluctuations on transactions denominated in currencies other than functional currencies result in gains and losses that are reflected in our consolidated statements of income. We enter into short-term foreign currency forward contracts to offset foreign exchange gains and losses generated by the re-measurement of certain assets and liabilities recorded in non-functional currencies. Changes in the fair value of these derivatives, as well as re-measurement gains and losses, are recognized in our consolidated statements of income within other expense, net. Foreign currency transaction gains and losses from these forward contracts were determined to be immaterial during the years ended December 31, 2020, 2019 and 2018. We do not enter into derivative financial instruments for trading or speculative purposes.Translation ExposureTo the extent the U.S. dollar weakens against foreign currencies, the translation of these foreign currency-denominated transactions will result in increased revenue and operating expenses. Conversely, our revenue and operating expenses will decrease when the U.S. dollar strengthens against foreign currencies.Foreign exchange rate fluctuations may also adversely impact our consolidated financial condition as the assets and liabilities of our foreign operations are translated into U.S. dollars in preparing our consolidated balance sheet. These gains or losses are recorded as a component of accumulated other comprehensive loss within stockholders' equity.Credit RiskConcentrations of credit risk with respect to accounts receivable are limited to certain customers to which we make substantial sales. Our customer base consists of a large number of geographically dispersed customers diversified across numerous industries. We believe that our accounts receivable credit risk exposure is limited. As of December 31, 2020 and 2019, no customer had an accounts receivable balance of 10% or more of our accounts receivable. We believe that at December 31, 2020, the concentration of credit risk related to accounts receivable was insignificant.44Table of Contents
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+Item 7. Management’s discussion and analysis of financial condition and results of operations” in this annual report on Form 10-K. Readers of our annual report on Form 10-K should also read our SEC and other publicly filed documents for further discussion regarding such factors.As used in this annual report on Form 10-K, references to the “Company,” “Alexandria,” “we,” “us,” and “our” refer to Alexandria Real Estate Equities, Inc. and its consolidated subsidiaries. The following discussion should be read in conjunction with our consolidated financial statements and notes thereto under “Item 15. Exhibits and Financial Statement Schedules” in this annual report on Form 10-K.ITEM 1. BUSINESSOverviewWe are a Maryland corporation formed in October 1994 that has elected to be taxed as a REIT for federal income tax purposes. We are an S&P 500® urban office REIT and the first, longest-tenured, and pioneering owner, operator, and developer uniquely focused on collaborative life science, technology, and agtech campuses in AAA innovation cluster locations. We consider AAA locations to be highly desirable for tenancy by life science, technology, and agtech entities because of their close proximity to concentrations of specialized skills, knowledge, institutions, and related businesses. Such locations are generally characterized by high barriers to entry for new landlords, high barriers to exit for tenants, and a limited supply of available space. Founded in 1994, Alexandria pioneered this niche and has since established a significant market presence in key locations, including Greater Boston, San Francisco, New York City, San Diego, Seattle, Maryland, and Research Triangle.Alexandria develops dynamic urban cluster campuses and vibrant ecosystems that enable and inspire the world’s most brilliant minds and innovative companies to create life-changing scientific and technological breakthroughs. We believe in the utmost professionalism, humility, and teamwork. Alexandria manages its properties through fully integrated regional teams with real estate, life science, technology, and agtech expertise. Our tenants include multinational pharmaceutical companies; public and private biotechnology companies; life science product, service, and medical device companies; digital health, technology, and agtech companies; academic and medical research institutions; U.S. government research agencies; non-profit organizations; and venture capital firms. Alexandria has a longstanding and proven track record of developing Class A properties clustered in urban life science, technology, and agtech campuses that provide its innovative tenants with highly dynamic and collaborative environments that enhance their ability to successfully recruit and retain world-class talent and inspire productivity, efficiency, creativity, and success. Alexandria also provides strategic risk capital to transformative life science, technology, and agtech companies through its venture capital arm. We believe our unique business model and diligent underwriting ensure a high-quality and diverse tenant base that should result in higher occupancy levels, longer lease terms, higher rental income, higher returns, and greater long-term asset value. As of December 31, 2020, Alexandria’s total market capitalization was $31.9 billion. For the definition of “Total market capitalization,” refer to the “Non-GAAP measures and definitions” section under Item 7 in this annual report on Form 10-K. Our asset base in North America consisted of 49.7 million SF, which includes 31.9 million RSF of operating properties and 3.3 million RSF of Class A properties undergoing construction, 7.1 million RSF of near-term and intermediate-term development and redevelopment projects, and 7.4 million SF of future development projects as of December 31, 2020. These operating properties and development projects include 40 properties that are held by consolidated real estate joint ventures and six properties that are held by unconsolidated real estate joint ventures. The occupancy percentage of our operating properties in North America was 94.6% as of December 31, 2020. Our 10-year average occupancy rate of operating properties as of December 31, 2020, was 96%. Investment-grade or publicly traded large cap tenants represented 55% of our annual rental revenue in effect as of December 31, 2020. Additional information regarding our consolidated and unconsolidated real estate joint ventures is included in “Item 7. Management’s discussion and analysis of financial condition and results of operations” in this annual report on Form 10-K. Additional information regarding risk factors that may affect us is included in “Item 1A. Risk factors” and “Item 7. Management’s discussion and analysis of financial condition and results of operations” in this annual report on Form 10-K.1Business objective and strategiesOur primary business objective is to maximize long-term asset value and shareholder returns based on a multifaceted platform of internal and external growth. A key element of our strategy is our unique focus on Class A properties clustered in urban campuses located in AAA innovation cluster locations. These key urban campus locations are characterized by high barriers to entry for new landlords, high barriers to exit for tenants, and a limited supply of available space. They represent highly desirable locations for tenancy by life science, technology, and agtech entities because of their close proximity to concentrations of specialized skills, knowledge, institutions, and related businesses. Our strategy also includes drawing upon our deep and broad real estate, life science, technology, and agtech relationships in order to identify and attract new and leading tenants and to source additional value-creation real estate.Our tenant base is broad and diverse within the life science, technology, and agtech industries and reflects our focus on regional, national, and international tenants with substantial financial and operational resources. For a more detailed description of our properties and tenants, refer to “Item 2. Properties” in this annual report on Form 10-K. We have an experienced Board of Directors and are led by an executive and senior management team with extensive experience in the real estate, life science, technology, and agtech industries.AcquisitionsWe seek to identify and acquire high-quality properties in our target cluster markets. Critical evaluation of prospective property acquisitions is an essential component of our acquisition strategy. When evaluating acquisition opportunities, we assess a full range of matters relating to the prospective property or properties, including:•Proximity to centers of innovation and technological advances;•Location of the property and our strategy in the relevant market;•Quality of existing and prospective tenants;•Condition and capacity of the building infrastructure;•Physical condition of the structure and common area improvements;•Quality and generic characteristics of the improvements;•Opportunities available for leasing vacant space and for re-tenanting or renewing occupied space;•Availability of and/or ability to add appropriate tenant amenities;•Availability of land for future ground-up development of new space;•Opportunities to generate higher rent through redevelopment of existing space;•The property’s unlevered yields; and•Our ability to increase the property’s long-term financial returns.Development, pre-construction, and redevelopmentA key component of our business model is our value-creation development projects. Our development strategy is primarily to pursue selective projects with significant pre-leasing for which we expect to achieve appropriate investment returns and generally match a source of funds for this use. Our value-creation development projects focus on high-quality, generic, and reusable office/laboratory or tech office space to meet the real estate requirements of our diverse group of tenants.We seek to meet growing demand from our stakeholders and continuously improve the efficiency of our buildings. We have committed to significant building goals to promote wellness and productivity for our buildings’ occupants, including targeting a minimum of LEED® Gold certification on all new ground-up construction projects. Pre-construction activities include entitlements, permitting, design, site work, and other activities preceding commencement of construction of aboveground building improvements, which are focused on reducing the time required to deliver projects to prospective tenants. These critical activities add significant value to our future ground-up development and are required for the vertical construction of buildings. We normally do not commence vertical construction of new projects prior to achieving significant pre-leasing. Another key component of our business model is our value-creation redevelopment of existing office, warehouse, or shell space, or newly acquired properties, into high-quality, generic, and reusable office/laboratory space that can be leased at higher rental rates. Our redevelopment strategy generally includes significant pre-leasing of projects prior to the commencement of redevelopment. 2Non-real estate investmentsWe also hold equity investments in publicly traded companies, limited partnerships, and privately held entities primarily involved in the life science, technology, and agtech industries. We invest primarily in highly innovative entities whose focus on the development of therapies and products that advance health and transform patients’ lives is aligned with Alexandria’s purpose of making a positive and meaningful impact on the health, safety, and well-being of the global community. Our status as a REIT limits our ability to make such non-real estate investments. Therefore, we conduct, and will continue to conduct, our non-real estate investment activities in a manner that complies with REIT requirements. Balance sheet and financial strategyWe seek to maximize balance sheet liquidity and flexibility, cash flows, and cash available for distribution to our stockholders through the ownership, operation, management, and selective acquisition, development, and redevelopment of office/laboratory and tech office space, as well as the management of our balance sheet. In particular, we seek to maximize balance sheet liquidity and flexibility, cash flows, and cash available for distribution to our stockholders by:•Maintaining access to diverse sources of capital, including operating cash flows after dividends, incremental debt, asset sales, and other capital such as the sale of equity or joint venture capital;•Maintaining significant liquidity through borrowing capacity under our unsecured senior line of credit and commercial paper program, marketable securities, issuances of forward equity contracts from time to time, and cash, cash equivalents, and restricted cash;•Continuing to improve our credit profile;•Minimizing the amount of near-term debt maturities in a single year;•Maintaining commitment to long-term capital to fund growth;•Maintaining low to modest leverage;•Minimizing variable interest rate risk;•Generating high-quality, strong, and increasing operating cash flows;•Selectively selling real estate assets, including land parcels and non-core/“core-like” operating assets, and reinvesting the proceeds into our highly leased value-creation development and redevelopment projects;•Allocating capital to Class A properties located in collaborative life science, technology, and agtech campuses in AAA urban innovation clusters;•Maintaining geographic diversity in urban intellectual centers of innovation;•Selectively acquiring high-quality office/laboratory and tech office space in our target urban innovation cluster submarkets at prices that enable us to realize attractive returns;•Selectively developing properties in our target urban innovation cluster submarkets;•Selectively redeveloping existing office, warehouse, or shell space, or newly acquired properties, into high-quality, generic, and reusable office/laboratory space that can be leased at higher rental rates in our target urban innovation cluster submarkets;•Renewing existing tenant space at higher rental rates to the extent possible;•Minimizing tenant improvement costs;•Improving investment returns through the leasing of vacant space and the replacing of existing tenants with new tenants at higher rental rates;•Executing leases with high-quality tenants and proactively monitoring tenant health;•Maintaining solid occupancy while attaining high rental rates;•Realizing contractual rental rate escalations; and•Implementing effective cost control measures, including negotiating pass-through provisions in tenant leases for operating expenses and certain capital expenditures. CompetitionIn general, other office/laboratory and tech office properties are located in close proximity to our properties. The amount of rentable space available in any market could have a material effect on our ability to rent space and on the rental rates we can attain for our properties. In addition, we compete for investment opportunities with other REITs, insurance companies, pension and investment funds, private equity entities, partnerships, developers, investment companies, owners/occupants, and foreign investors. Many of these entities have substantially greater financial resources than we do and may be able to invest more than we can or accept more risk than we are willing to accept. These entities may be less sensitive to risks with respect to the creditworthiness of a tenant or the overall expected returns from real estate investments. In addition, as a result of their financial resources, our competitors may offer more free rent concessions, lower rental rates, or higher tenant improvement allowances in order to attract tenants. These leasing incentives could hinder our ability to maintain or raise rents and attract or retain tenants. Competition may also reduce the number of suitable investment opportunities available to us or may increase the bargaining power of property owners seeking to sell. Competition in acquiring existing properties and land, both from institutional capital sources and from other REITs, has been very strong over the past several years; however, we believe we have differentiated ourselves from our competitors. As the first and only publicly traded urban office REIT to focus primarily on the office/laboratory real estate niche, we provide world-class collaborative life science, technology, and agtech campuses in AAA innovation cluster locations and maintain and cultivate many of the most important and strategic relationships in the life science, technology, and agtech industries.3Financial information about our reportable segmentRefer to Note 2 – “Summary of significant accounting policies” to our consolidated financial statements under Item 15 in this annual report on Form 10-K for information about our one reportable segment.RegulationGeneralProperties in our markets are subject to various laws, ordinances, and regulations, including regulations relating to common areas. We believe we have the necessary permits and approvals to operate each of our properties.Americans with Disabilities ActOur properties must comply with Title III of the Americans with Disabilities Act of 1990 (“ADA”) to the extent that such properties are “public accommodations” as defined by the ADA. The ADA may require removal of structural barriers to permit access by persons with disabilities in certain public areas of our properties where such removal is readily achievable. We believe that our properties are in substantial compliance with the ADA and that we will not be required to incur substantial capital expenditures to address the requirements of the ADA. However, noncompliance with the ADA could result in the imposition of fines or an award of damages to private litigants. The obligation to make readily achievable accommodations is an ongoing one, and we will continue to assess our properties and make alterations as appropriate in this respect.Environmental mattersUnder various environmental protection laws, a current or previous owner or operator of real estate may be liable for contamination resulting from the presence or discharge of hazardous or toxic substances at that property and may be required to investigate and remediate contamination located on or emanating from that property. Such laws often impose liability without regard to whether the owner or operator knew of, or was responsible for, the presence of the contaminants, and the liability may be joint and several. Previous owners may have used some of our properties for industrial and other purposes, so those properties may contain some level of environmental contamination. The presence of contamination or the failure to remediate contamination at our properties may expose us to third-party liability or may materially adversely affect our ability to sell, lease, or develop the real estate or to borrow using the real estate as collateral.Some of our properties may have asbestos-containing building materials. Environmental laws require that asbestos-containing building materials be properly managed and maintained and may impose fines and penalties on building owners or operators for failure to comply with these requirements. These laws may also allow third parties to seek recovery from owners or operators for personal injury associated with exposure to asbestos-containing building materials.In addition, some of our tenants handle hazardous substances and wastes as part of their routine operations at our properties. Environmental laws and regulations subject our tenants, and potentially us, to liability resulting from such activities. Environmental liabilities could also affect a tenant’s ability to make rental payments to us. We require our tenants to comply with these environmental laws and regulations and to indemnify us against any related liabilities. Independent environmental consultants have conducted Phase I or similar environmental site assessments on the properties in our portfolio. Site assessments are intended to discover and evaluate information regarding the environmental condition of the surveyed property and surrounding properties and do not generally include soil samplings, subsurface investigations, or an asbestos survey. To date, these assessments have not revealed any material environmental liability that we believe would have a material adverse effect on our business, assets, or results of operations. Nevertheless, it is possible that the assessments on our properties have not revealed all environmental conditions, liabilities, or compliance concerns that may have arisen after the review was completed or may arise in the future; and future laws, ordinances, or regulations may also impose additional material environmental liabilities.InsuranceWith respect to our properties, we carry commercial general liability, all-risk property, and business interruption insurance, including loss of rental income coverage. We select policy specifications and insured limits that we believe to be appropriate given the relative risk of loss and the cost of the coverage. In addition, we have obtained earthquake insurance for certain properties located in the vicinity of known active earthquake zones in an amount and with deductibles we believe are commercially reasonable. We also carry environmental insurance and title insurance policies on our properties. We generally obtain title insurance policies when we acquire the property, with each policy covering an amount equal to the initial purchase price of each property. Accordingly, any of our title insurance policies may be in an amount less than the current value of the related property. Additional information regarding risk factors that may affect us is included in “Item 1A. Risk factors” in this annual report on Form 10-K.4Available informationCopies of our annual reports on Form 10-K, quarterly reports on Form 10-Q, and current reports on Form 8-K, including any amendments to the foregoing reports, are available, free of charge, through our corporate website at www.are.com as soon as is reasonably practicable after such material is electronically filed with, or furnished to, the SEC. The current charters of our Board of Directors’ Audit, Compensation, and Nominating & Governance Committees, along with our corporate governance guidelines and Business Integrity Policy and Procedures for Reporting Non-Compliance (the “Business Integrity Policy”), are also available on our corporate website. Additionally, any amendments to, and waivers of, our Business Integrity Policy that apply to our Co-Chief Executive Officers or our Chief Financial Officer will be available free of charge on our corporate website in accordance with applicable SEC and NYSE requirements. Written requests should be sent to Alexandria Real Estate Equities, Inc., 26 North Euclid Avenue, Pasadena, California 91101, Attention: Investor Relations. The public may also download these materials from the SEC’s website at www.sec.gov.5Human CapitalAs of December 31, 2020, we had 470 employees. We believe that we have good relations with our employees. We have adopted a Business Integrity Policy that applies to all of our employees, and its receipt and review by each employee is documented and verified annually. In order to promote an exceptional corporate culture, Alexandria continuously monitors employee satisfaction, seeks employee feedback, and seeks opportunities to enhance our offerings. We participate in annual performance reviews with our employees and conduct formal employee surveys, and our talent management team holds annual meetings with employees. The positive employee experience is evidenced by our low voluntary and total turnover rates (averaging 4.1% and 8.1%, respectively, over the last five years, from 2016 to 2020), which are well below the reported median voluntary and total turnover rates of 10% and 18.0%, respectively, in the Nareit 2020 Compensation & Benefits Survey (data for 2019). We have an exceptional track record of identifying highly qualified candidates for promotion from within the Company. Alexandria’s executive and senior management team, represented by our senior vice presidents and above, consists of 47 individuals, averaging 24 years of real estate experience, including 12 years with Alexandria. Our executive management team alone averages 17 years of experience with Alexandria. Alexandria’s executive and senior management team has unique experience and expertise in creating, owning, and operating highly dynamic and collaborative campuses in key urban life science, technology, and agtech cluster locations. Alexandria’s highly experienced management team also includes regional market directors with leading reputations and longstanding relationships within the life science, technology, and agtech communities in their respective urban innovation clusters. We believe that our expertise, experience, reputation, and key relationships in the real estate, life science, technology, and agtech industries provide Alexandria with significant competitive advantages in attracting new business opportunities.At Alexandria, people come first. At the outset of the COVID-19 pandemic, we moved swiftly to support our employees’ medical, mental, emotional, physical, and financial health. Our commitment to our people has always been our primary focus, and we continue to devote extraordinary efforts to hire, develop, and retain a healthy and diverse workforce.Supporting our employees through COVID-19 and beyond In response to COVID-19-related state and local government orders to stay at home, Alexandria immediately issued a $1,000 emergency bonus to each of our non-officer employees, connected employees to LiveHealth Online support, and shared comprehensive resources and tools to help our team members cope with stress, anxiety, isolation, and loss and also balance work and child care obligations. To further support our employees in prioritizing their health and well-being, the Company temporarily enhanced our existing wellness benefit. This enrichment included reimbursement of fitness and mindfulness applications, online classes, and exercise equipment to help our employees reach their individual wellness goals and stay physically and mentally strong. Additionally, Alexandria has been able to leverage our world-class network to curate a series of internal webinars featuring leading experts on COVID-19 to keep our employees informed and address some of their questions or pressing concerns.Providing exceptional benefits to support our employees’ well-being, medical and financial healthWe provide a comprehensive benefits package intended to meet and exceed the needs of our employees and their families. Our highly competitive offering helps our employees stay healthy, balance their work and personal lives, and meet their financial and retirement goals. We pay 100% of the health insurance premiums for our employees and their families and provide an employee assistance program to help them address a wide range of issues. In addition, Alexandria’s Operation CARE program provides the following services to our employees: •Alexandria Access. Alexandria’s unparalleled network in the life science community affords us access to deep medical expertise. Alexandria Access makes this expertise available to our employees and their immediate family members who are experiencing an illness or injury and would benefit from specialized expertise.•Matching Gifts. Alexandria matches each employee’s financial contributions to, or funds raised for, eligible nonprofit organizations on a dollar-for-dollar basis, up to $2,500 per person each calendar year, to double the impact of their charitable gifts.•Volunteer Time Off. Each Alexandria employee receives 16 hours (two days) per calendar year of paid volunteer time off to use at the eligible non-profit(s) of their choice.•Volunteer Rewards. When an Alexandria employee volunteers more than 25 hours in any one quarter at an eligible nonprofit(s), Alexandria donates a total of $2,500 to the eligible non-profit(s) of their choice.Investing in professional development and trainingWe understand that to attract and retain the best talent, we must provide opportunities for our people to grow and develop. Therefore, we invest in training and development programs to enhance our employees’ engagement, effectiveness, and well-being.In-person and virtual training topics include project management, business writing, leadership, change management, interviewing, presentations, productivity, conversations crucial to business results, effective one-on-ones, goal setting, delegation, 6flexibility, self-direction, and feedback. Our annual mentoring program allows employees to partner with senior leaders throughout the organization and receive career guidance. To customize training and development, we conduct needs assessments and design training programs for specific functional teams as well as offer a highly customized coaching program for high-potential executives, leaders, and teams. We provide access to expert panels and cutting-edge information via webinars in order to share information and support our team. We also provide on-demand learning resources such as LinkedIn Learning for employees to take classes that range from creating effective PowerPoint presentations to understanding how the brain reacts to stress.To continuously monitor and improve employee performance and engagement, we issue satisfaction surveys and conduct annual performance reviews. Our talent management team additionally conducts formal surveys and holds regular feedback meetings with our employees. Building a diverse and inclusive workforceWe work every day to create an open and respectful environment where everyone can actively contribute, have equal access to opportunities and resources, be themselves, and realize their potential.Our Corporate Governance Guidelines highlight the Board of Directors’ focus on diversity, which explicitly states the board’s commitment to considering qualified women and minority director candidates, as well its policy of requesting an initial list of diverse candidates of any search firm it retains. As an Equal Opportunity Employer, we emphasize inclusion through hiring and compensation practices and consider a pool of diverse candidates for open positions and internal advancement opportunities. To address issues related to pay discrimination, we do not ask potential candidates about their current or previous compensation during the hiring process, and we incorporate equal and fair pay reviews into every employment compensation decision. To reinforce our corporate culture of respect, diversity, and inclusion, each of our employees completes anti-harassment training annually.(1)As of December 31, 2020.(2)Minorities are defined to include individuals of Asian, Black/African American, Hispanic/Latino, Native American or Pacific Islander, or multiracial background. We determine race and gender based on our employees' self-identification or other information compiled to meet requirements of the U.S. government. (3)Managers and above include individuals who lead others and/or oversee projects.(4)Represents a five-year average from 2016 to 2020.7ITEM 1A. RISK FACTORS OverviewThe following risk factors may adversely affect our overall business, financial condition, results of operations, and cash flows; our ability to make distributions to our stockholders; our access to capital; or the market price of our common stock, as further described in each risk factor below. In addition to the information set forth in this annual report on Form 10-K, one should carefully review and consider the information contained in our other reports and periodic filings that we make with the SEC. Those risk factors could materially affect our overall business, financial condition, results of operations, and cash flows; our ability to make distributions to our stockholders; our access to capital; or the market price of our common stock. The risks that we describe in our public filings are not the only risks that we face. Additional risks and uncertainties not presently known to us, or that we currently consider immaterial, also may materially adversely affect our business, financial condition, and results of operations. Additional information regarding forward-looking statements is included in the beginning of “Part I” in this annual report on Form 10-K.Risk factors summaryAn investment in our securities involves various risks. Such risks, including those set forth in the summary of material risks in this Item 1A, should be carefully considered before purchasing our securities.Risks related to operating factors•We may be unable to identify and complete acquisitions, investments, or development or redevelopment projects or to successfully and profitably operate properties.•We could default on our ground leases or be unable to renew or re-lease our land or space on favorable terms or at all. Our tenants may also be unable to pay us rent.•The cost of maintaining and improving the quality of our properties may be higher than anticipated, and we may be unable to pass any increased operating costs through to our tenants, which can result in reduced cash flows and profitability. •We could be held liable for environmental damages resulting from our tenants’ use of hazardous materials, or from harmful mold, poor air quality, or other defects from our properties, or we could face increased costs in complying with other environmental laws.•The loss of services of any of our senior officers or key employees and increased competition for skilled personnel could adversely affect us and/or increase our labor costs.•We rely on a limited number of vendors to provide utilities and other services at our properties, and disruption in such services may have an adverse effect on our operations and financial condition.•Our insurance may not adequately cover all of our potential losses, or we may incur costs due to the financial condition of our insurance carriers.•We may change business policies without stockholder approval.•Failure to maintain effective internal control over financial reporting could have a material adverse effect on our business.•If we failed to qualify as a REIT, we would be taxed at corporate rates and would not be able to take certain deductions when computing our taxable income.•We may not be able to raise sufficient capital to fund our operations due to adverse changes in our credit ratings, our inability to refinance our existing debt or issue new debt, or our inability to sell existing properties quickly.•We may invest or spend the net proceeds from our equity or debt offerings in ways with which our investors may not agree and in ways that may not earn a profit.•Our debt service obligations may restrict our ability to engage in some business activities or cause other adverse effects on our business.•We face risks and liabilities associated with our investments (including those in connection with short-term liquid investments) and the companies in which we invest (including properties owned through partnerships, limited liability companies, and joint ventures, as well as through our non-real estate venture investment portfolio), which expose us to risks similar to those of our tenant base and additional risks inherent in venture capital investing. We may be limited in our ability to diversify our investments.Risks related to market and industry factors•There are limits on ownership of our stock under which a stockholder may lose beneficial ownership of its shares, as well as certain provisions of our charter and bylaws that may delay or prevent transactions that otherwise may be desirable to our stockholders.•Possible future sales of shares of our common stock could adversely affect its market price.•We are dependent on the health of the life science, technology, and agtech industries, and changes within these industries, increased competition, or the inability of our tenants and non-real estate equity investments within these industries to obtain funding for research, development, and other operations may adversely impact their ability to make rental payments to us or adversely impact their value.•Market disruption and volatility, poor economic conditions in the capital markets and global economy, including in connection with the COVID-19 pandemic, and high unemployment levels could adversely affect the value of the companies in which we hold equity investments or the ability of tenants and the companies in which we invest to raise additional capital or access capital from venture capital investors or financial institutions on favorable terms.8Risks related to government and global factors•Actions, policy, or key leadership changes in government agencies, or changes to laws or regulations, including those related to tax, accounting, debt, derivatives, government spending, or funding (including those related to the FDA, the National Institutes of Health (the “NIH”), the SEC, and other agencies), and drug and healthcare pricing, costs, and programs could have a significant negative impact on the overall economy, our tenants, and our business.•Partial or complete government shutdown resulting in temporary closures of agencies could adversely affect our tenants (some of which are also government agencies) and the companies in which we invest, including delays in the commercialization of such companies’ products, decreased funding of research and development, or delays surrounding approval of budget proposals.•The replacement of LIBOR with an alternative reference rate may adversely affect interest expense related to outstanding debt.•The current outbreak of COVID-19, or the future outbreak of any other highly infectious or contagious diseases, could adversely impact or cause disruption to our financial condition and results of operations, and/or to the financial condition and results of operations of our tenants and non-real estate investments.Risks related to general and other factors•Social, political, and economic instability, unrest, significant changes, and other circumstances beyond our control, including circumstances related to changes in the U.S. presidential administration, could adversely affect our business operations.•Seasonal weather conditions, climate change and severe weather, changes in the availability of transportation or labor, especially in connection with the COVID-19 pandemic, and other related factors may affect our ability to conduct business, the products, and services of our tenants, or the availability of such products and services of our tenants and the companies in which we invest.•We may be unable to meet our sustainability goals.•System failures or security incidents through cyber attacks, intrusions, or other methods could disrupt our information technology networks and related systems, cause a loss of assets or data, give rise to remediation or other expenses, expose us to liability under federal and state laws, and subject us to litigation and investigations, which could result in substantial reputational damage and adversely affect our business and financial condition.•We are subject to risks from potential fluctuations in exchange rates between the U.S. dollar and foreign currencies and downgrades of domestic and foreign government sovereign credit ratings.We attempt to mitigate the foregoing risks. However, if we are unable to effectively manage the impact of these and other risks, our ability to meet our investment objectives would be substantially impaired and any of the foregoing risks could materially adversely affect our financial condition, results of operations, and cash flows, our ability to make distributions to our stockholders, or the market price of our common stock.9Operating factorsWe may be unable to identify and complete acquisitions and successfully operate acquired properties. We continually evaluate the market of available properties and may acquire properties when opportunities exist. Our ability to acquire properties on favorable terms and successfully operate them may be exposed to significant risks, including, but not limited to the following:•We may be unable to acquire a desired property because of competition from other real estate investors with significant capital, including both publicly traded REITs and institutional funds;•Even if we are able to acquire a desired property, competition from other potential acquirers may significantly increase the purchase price or result in other less favorable terms;•Even if we enter into agreements for the acquisition of properties, these agreements are subject to customary conditions to closing, including completion of due diligence investigations to our satisfaction;•We may be unable to complete an acquisition because we cannot obtain debt and/or equity financing on favorable terms or at all;•We may spend more than budgeted amounts to make necessary improvements or renovations to acquired properties;•We may be unable to quickly and efficiently integrate new acquisitions, particularly acquisitions of operating properties or portfolios of properties, into our existing operations;•Acquired properties may be subject to reassessment, which may result in higher-than-expected property tax payments;•Market conditions may result in higher-than-expected vacancy rates and lower-than-expected rental rates; and•We may acquire properties subject to liabilities and without any recourse, or with only limited recourse, with respect to unknown liabilities, such as liabilities for the remediation of undisclosed environmental contamination; claims by tenants, vendors, or other persons dealing with the former owners of the properties; and claims for indemnification by general partners, directors, officers, and others indemnified by the former owners of the properties.The realization of any of the above risks could significantly and adversely affect our ability to meet our financial expectations, our financial condition, results of operations, and cash flows, our ability to make distributions to our stockholders, the market price of our common stock, and our ability to satisfy our debt service obligations.We may suffer economic harm as a result of making unsuccessful acquisitions in new markets.We may pursue selective acquisitions of properties in markets where we have not previously owned properties. These acquisitions may entail risks in addition to those we face in other acquisitions where we are familiar with the markets, such as the risk of not correctly anticipating conditions or trends in a new market and therefore not being able to generate profit from the acquired property. If this occurs, it could adversely affect our financial condition, results of operations, and cash flows, our ability to make distributions to our stockholders, our ability to satisfy our debt service obligations, and the market price of our common stock.The acquisition of new properties or the development of new properties may give rise to difficulties in predicting revenue potential.We may continue to acquire additional properties and/or land and may seek to develop our existing land holdings strategically as warranted by market conditions. These acquisitions and developments could fail to perform in accordance with expectations. If we fail to accurately estimate occupancy levels, rental rates, lease commencement dates, operating costs, or costs of improvements to bring an acquired property or a development property up to the standards established for our intended market position, the performance of the property may be below expectations. Acquired properties may have characteristics or deficiencies affecting their valuation or revenue potential that we have not yet discovered. We cannot assure our stockholders that the performance of properties acquired or developed by us will increase or be maintained under our management.We may fail to achieve the financial results expected from development or redevelopment projects.There are significant risks associated with development and redevelopment projects, including, but not limited to, the following possibilities:•We may not complete development or redevelopment projects on schedule or within budgeted amounts;•We may be unable to lease development or redevelopment projects on schedule or within budgeted amounts;•We may encounter project delays or cancellations due to unavailability of necessary labor and construction materials;•We may expend funds on, and devote management’s time to, development and redevelopment projects that we may not complete;•We may abandon development or redevelopment projects after we begin to explore them, and as a result, we may lose deposits or fail to recover costs already incurred;•Market and economic conditions may deteriorate, which can result in lower-than-expected rental rates;10•We may face higher operating costs than we anticipated for development or redevelopment projects, including insurance premiums, utilities, real estate taxes, and costs of complying with changes in government regulations or increases in tariffs;•We may face higher requirements for capital improvements than we anticipated for development or redevelopment projects, particularly in older structures;•We may be unable to proceed with development or redevelopment projects because we cannot obtain debt and/or equity financing on favorable terms or at all;•We may fail to retain tenants that have pre-leased our development or redevelopment projects if we do not complete the construction of these properties in a timely manner or to the tenants’ specifications;•Tenants that have pre-leased our development or redevelopment projects may file for bankruptcy or become insolvent, which may adversely affect the income produced by, and the value of, our properties or require us to change the scope of the project, which may potentially result in higher construction costs and lower financial returns;•We may encounter delays, refusals, unforeseen cost increases, and other impairments resulting from third-party litigation, natural disasters, or severe weather conditions;•We may encounter delays or refusals in obtaining all necessary zoning, land use, building, occupancy, and other required government permits and authorizations; and•Development or redevelopment projects may have defects we do not discover through our inspection processes, including latent defects that may not reveal themselves until many years after we put a property in service.The realization of any of the above risks could significantly and adversely affect our ability to meet our financial expectations, our financial condition, results of operations, and cash flows, our ability to make distributions to our stockholders, the market price of our common stock, and our ability to satisfy our debt service obligations.We could default on leases for land on which some of our properties are located or held for future development.If we default under the terms of a ground lease obligation, we may lose the ownership rights to the property subject to the lease. Upon expiration of a ground lease and all of its options, we may not be able to renegotiate a new lease on favorable terms, if at all. The loss of the ownership rights to these properties or an increase in rental expense could have a material adverse effect on our financial condition, results of operations, and cash flows, and our ability to satisfy our debt service obligations and make distributions to our stockholders, as well as the market price of our common stock. Refer to “Ground lease obligations” in the “Uses of capital” subsection of the “Capital resources” section under “Item 7. Management’s discussion and analysis of financial condition and results of operations” in this annual report on Form 10-K for additional information on our ground lease obligations.We may not be able to operate properties successfully and profitably.Our success depends in large part upon our ability to operate our properties successfully. If we are unable to do so, our business could be adversely affected. The ownership and operation of real estate is subject to many risks that may adversely affect our business and our ability to make payments to our stockholders, including, but not limited to, the following risks:•Our properties may not perform as we expect;•We may have to lease space at rates below our expectations;•We may not be able to obtain financing on acceptable terms; and•We may underestimate the cost of improvements required to maintain or improve space to meet standards established for the market position intended for that property.The realization of any of the above risks could significantly and adversely affect our ability to meet our financial expectations, our financial condition, results of operations, and cash flows, our ability to make distributions to our stockholders, the market price of our common stock, and our ability to satisfy our debt service obligations.We may not be able to attain the expected return on our investments in real estate joint ventures. As of December 31, 2020, we had several consolidated and unconsolidated real estate joint ventures in which we shared ownership and decision-making power with one or more parties. Our joint venture partners must agree in order for the applicable joint venture to take specific major actions, including budget approvals, acquisitions, sales of assets, debt financing, execution of lease agreements, and vendor approvals. Under these joint venture arrangements, any disagreements between us and our partners may result in delayed decisions. Our inability to take unilateral actions that we believe are in our best interests may result in missed opportunities and an ineffective allocation of resources and could have an adverse effect on the financial performance of the joint venture and our operating results.11We may experience increased operating costs, which may reduce profitability to the extent that we are unable to pass those costs through to our tenants.Our properties are subject to increases in operating expenses, including insurance, property taxes, utilities, administrative costs, and other costs associated with security, landscaping, and repairs and maintenance of our properties. As of December 31, 2020, approximately 94% of our leases (on an RSF basis) were triple net leases, which require tenants to pay substantially all real estate and other rent-related taxes, insurance, utilities, common area expenses, and other operating expenses (including increases thereto) in addition to base rent. Our operating expenses may increase as a result of tax reassessments that our properties are subject to on a regular basis (annually, triennially, etc.), which normally result in increases in property taxes over time as property values increase. In California, however, pursuant to the existing state law commonly referred to as Proposition 13, properties are generally reassessed to market value at the time of change in ownership or completion of construction; thereafter, annual property reassessments are limited to 2% of previously assessed values. As a result, Proposition 13 generally results in significant below-market assessed values over time. From time to time, lawmakers and political coalitions initiate efforts to repeal or amend Proposition 13 to eliminate its application to commercial and industrial properties, including by introducing Proposition 15 on the ballot in California, which failed to pass adoption on November 3, 2020.Our triple net leases allow us to pass through, among other costs, substantially all real estate and rent-related taxes to our tenants in the form of tenant recoveries. Consequently, as a result of our triple net leases, we do not expect potential increases on property taxes as a result of tax reassessments to significantly impact our operating results. We cannot be certain, however, that we will be able to continue to negotiate pass-through provisions related to taxes in tenant leases in the future, or that higher pass-through expenses will not lead to lower base rents in the long run as a result of tenants’ not being able to absorb higher overall occupancy costs. Thus, the repeal of or amendment to Proposition 13 could lead to a decrease in our income from rentals over time. If our operating expenses increase without a corresponding increase in revenues, our profitability could diminish. In addition, we cannot be certain that increased costs will not lead our current or prospective tenants to seek space outside of the state of California, which could significantly hinder our ability to increase our rents or to maintain existing occupancy levels. The repeal of or amendment to Proposition 13 in California may significantly increase occupancy costs for some of our tenants and may adversely impact their financial condition, ability to make rental payments, and ability to renew lease agreements, which in turn could adversely affect our financial condition, results of operations, and cash flows and our ability to make distributions to our stockholders.In addition, we expect to incur higher costs as a result of doing business in California and other states. For example, compliance with various laws passed in California and civil unrest in Washington may result in cost increases due to new constraints on our business and the effects of potential non-compliance by us or third-party service providers. Any changes in connection with compliance could be time consuming and expensive, while failure to timely implement required changes could subject us to liability for non-compliance, any of which could adversely affect our business, operating results, and financial condition.The cost of maintaining the quality of our properties may be higher than anticipated, which can result in reduced cash flows and profitability.If our properties are not as attractive to current and prospective tenants in terms of rent, services, condition, or location as properties owned by our competitors, we could lose tenants or suffer lower rental rates. As a result, we may, from time to time, be required to make significant capital expenditures to maintain the competitiveness of our properties. However, there can be no assurances that any such expenditures would result in higher occupancy or higher rental rates or deter existing tenants from relocating to properties owned by our competitors.Our inability to renew leases or re-lease space on favorable terms as leases expire may significantly affect our business.Our revenues are derived primarily from rental payments and reimbursement of operating expenses under our leases. If our tenants experience a downturn in their business or other types of financial distress, they may be unable to make timely payments under their leases. In addition, because of the impact to business environment due to the civil unrest, high cost of living, taxes, and other increased region specific costs of doing business in certain of our markets and submarkets, such as those located in the states of California and Washington, tenants may choose not to renew or re-lease space. Also, if our tenants terminate early or decide not to renew their leases, we may not be able to re-lease the space. Even if tenants decide to renew or lease space, the terms of renewals or new leases, including the cost of any tenant improvements, concessions, and lease commissions, may be less favorable to us than current lease terms. Consequently, we could generate less cash flows from the affected properties than expected, which could negatively impact our business. We may have to divert cash flows generated by other properties to meet our debt service payments, if any, or to pay other expenses related to owning the affected properties.12The inability of a tenant to pay us rent could adversely affect our business.Our revenues are derived primarily from rental payments and reimbursement of operating expenses under our leases. If our tenants, especially significant tenants, fail to make rental payments under their leases, our financial condition, cash flows, and ability to make distributions to our stockholders could be adversely affected. Additionally, the inability of the U.S. Congress to enact a budget for a fiscal year or the occurrence of partial or complete U.S. government shutdowns may result in financial difficulties for tenants that are dependent on federal funding, which could adversely affect the ability of those tenants to pay us rent.The bankruptcy or insolvency of a major tenant may also adversely affect the income produced by a property. If any of our tenants becomes a debtor in a case under the U.S. Bankruptcy Code, as amended, we cannot evict that tenant solely because of its bankruptcy. The bankruptcy court may authorize the tenant to reject and terminate its lease with us. Our claim against such a tenant for uncollectible future rent would be subject to a statutory limitation that might be substantially less than the remaining rent actually owed to us under the tenant’s lease. Any shortfall in rent payments could adversely affect our cash flows and our ability to make distributions to our stockholders.We could be held liable for damages resulting from our tenants’ use of hazardous materials.Many of our tenants engage in research and development activities that involve controlled use of hazardous materials, chemicals, and biological and radioactive compounds. In the event of contamination or injury from the use of these hazardous materials, we could be held liable for damages that result. This liability could exceed our resources and any recovery available through any applicable insurance coverage, which could adversely affect our ability to make distributions to our stockholders.Together with our tenants, we must comply with federal, state, and local laws and regulations governing the use, manufacture, storage, handling, and disposal of hazardous materials and waste products. Failure to comply with these laws and regulations, or changes thereto, could adversely affect our business or our tenants’ businesses and their ability to make rental payments to us.Our properties may have defects that are unknown to us.Although we thoroughly review the physical condition of our properties before they are acquired, and as they are developed or redeveloped, any of our properties may have characteristics or deficiencies unknown to us that could adversely affect the property’s value or revenue potential.Our properties may contain or develop harmful mold or suffer from other air quality issues, which could lead to liability for adverse health effects and costs to remedy the problem.When excessive moisture accumulates in buildings or on building materials, mold may grow, particularly if the moisture problem remains undiscovered or is not addressed over a period of time. Some molds may produce airborne toxins or irritants. Indoor air quality issues can also stem from inadequate ventilation, chemical contamination from indoor or outdoor sources, and other biological contaminants such as pollen, viruses, and bacteria. Indoor exposure to airborne toxins or irritants above certain levels may cause a variety of adverse health effects and symptoms, including allergic or other reactions. As a result, the presence of significant mold or other airborne contaminants at any of our properties could require us to undertake a costly remediation program to contain or remove the mold or other airborne contaminants from the affected property or increase indoor ventilation. In addition, the presence of significant mold or other airborne contaminants could expose us to liability from our tenants, employees of our tenants, and others if property damage or health concerns arise.We may not be able to obtain additional capital to further our business objectives.Our ability to acquire, develop, or redevelop properties depends upon our ability to obtain capital. The real estate industry has historically experienced periods of volatile debt and equity capital markets and/or periods of extreme illiquidity. A prolonged period in which we cannot effectively access the public debt or equity markets may result in heavier reliance on alternative financing sources to undertake new investments. An inability to obtain debt or equity capital on acceptable terms could delay or prevent us from acquiring, financing, and completing desirable investments and could otherwise adversely affect our business. Also, the issuance of additional shares of capital stock or interests in subsidiaries to fund future operations could dilute the ownership of our then-existing stockholders. Even as liquidity returns to the market, debt and equity capital may be more expensive than in prior years.We may not be able to sell our properties quickly to raise capital.Investments in real estate are relatively illiquid compared to other investments. Accordingly, we may not be able to sell our properties when we desire or at prices acceptable to us in response to changes in economic or other conditions. In addition, the Internal Revenue Code of 1986, as amended (the “Internal Revenue Code”), limits our ability to sell properties held for less than two years. These limitations on our ability to sell our properties may adversely affect our cash flows, our ability to repay debt, and our ability to make distributions to our stockholders.13Adverse changes in our credit ratings could negatively affect our financing ability.Our credit ratings may affect the amount of capital we can access, as well as the terms and pricing of any debt we may incur. There can be no assurance that we will be able to maintain and/or improve our current credit ratings. In the event that our current credit ratings are downgraded or removed, we would most likely incur higher borrowing costs and experience greater difficulty in obtaining additional financing, which in turn would have a material adverse impact on our financial condition, results of operations, cash flows, and liquidity.We may not be able to refinance our debt, and/or our debt may not be assumable.Due to the high volume of real estate debt financing in recent years, the real estate industry may require more funds to refinance debt maturities than are available from lenders. This potential shortage of available funds from lenders and stricter credit underwriting guidelines may limit our ability to refinance our debt as it matures or may adversely affect our financial condition, results of operations, and cash flows, our ability to make distributions to our stockholders, and the market price of our common stock.We may not be able to borrow additional amounts through the issuance of unsecured bonds or under our unsecured senior line of credit or commercial paper program.There is no assurance that we will be able to continue to access the unsecured bond market on favorable terms. Our ability to borrow additional amounts through the issuance of unsecured bonds may be negatively impacted by periods of illiquidity in the bond market. Aggregate borrowings under our unsecured senior line of credit require compliance with certain financial and non-financial covenants. Borrowings under our unsecured senior line of credit are funded by a group of banks. Our ability to borrow additional amounts under our unsecured senior line of credit and commercial paper program may be negatively impacted by a decrease in cash flows from our properties, a default or cross-default under our unsecured senior line of credit and commercial paper program, non-compliance with one or more loan covenants associated with our unsecured senior line of credit, and non-performance or failure of one or more lenders under our unsecured senior line of credit. In addition, we may not be able to refinance or repay outstanding borrowings on our unsecured senior line of credit or commercial paper program.Our inability to borrow additional amounts on an unsecured basis could delay us in or prevent us from acquiring, financing, and completing desirable investments, which could adversely affect our business; and our inability to refinance or repay amounts under our unsecured senior line of credit or commercial paper program may adversely affect our cash flows, ability to make distributions to our stockholders, financial condition, and results of operations.If interest rates rise, our debt service costs will increase and the value of our properties may decrease.Our unsecured senior line of credit bears interest at variable rates, and we may incur additional variable-rate debt in the future. Amounts issued under our commercial paper program typically mature in less than 30 days and no later than 397 days from the date of issuance and require repayment or refinancing upon maturity. Increases in market interest rates would increase our interest expense under these debt instruments and would increase the costs of refinancing existing indebtedness or obtaining new debt. Additionally, increases in market interest rates may result in a decrease in the value of our real estate and a decrease in the market price of our common stock. Accordingly, these increases could adversely affect our financial condition and our ability to make distributions to our stockholders.Our unsecured senior line of credit restricts our ability to engage in some business activities.Our unsecured senior line of credit contains customary negative covenants and other financial and operating covenants that, among other things:•Restrict our ability to incur additional indebtedness;•Restrict our ability to make certain investments;•Restrict our ability to merge with another company;•Restrict our ability to make distributions to our stockholders;•Require us to maintain financial coverage ratios; and•Require us to maintain a pool of qualified unencumbered assets.Complying with these restrictions may prevent us from engaging in certain profitable activities and constrain our ability to effectively allocate capital. Failure to comply with these restrictions may result in our defaulting on these and other loans, which would likely have a negative impact on our operations, financial condition, and ability to make distributions to our stockholders.14Our debt service obligations may have adverse consequences on our business operations.We use debt to finance our operations, including the acquisition, development, and redevelopment of properties. Our use of debt may have adverse consequences, including, but not limited to, the following:•Our cash flows from operations may not be sufficient to meet required payments of principal and interest;•We may be forced to dispose of one or more of our properties, possibly on disadvantageous terms, to make payments on our debt;•If we default on our debt obligations, the lenders or mortgagees may foreclose on our properties that secure those loans;•A foreclosure on one of our properties could create taxable income without any accompanying cash proceeds to pay the tax;•A default under a loan that has cross-default provisions may cause us to automatically default on another loan;•We may not be able to refinance or extend our existing debt;•The terms of any refinancing or extension may not be as favorable as the terms of our existing debt;•We may be subject to a significant increase in the variable interest rates on our unsecured senior line of credit or commercial paper program, which could adversely impact our cash flows and operations; and•The terms of our debt obligations may require a reduction in our distributions to stockholders.If our revenues are less than our expenses, we may have to borrow additional funds, and we may not be able to make distributions to our stockholders.If our properties do not generate revenues sufficient to cover our operating expenses, including our debt service obligations and capital expenditures, we may have to borrow additional amounts to cover fixed costs and cash flow needs. This could adversely affect our ability to make distributions to our stockholders. Factors that could adversely affect the revenues we generate from, and the values of, our properties include, but are not limited to, the following:•National, local, and worldwide economic and political conditions;•Competition from other properties;•Changes in the life science, technology, and agtech industries;•Real estate conditions in our target markets;•Our ability to collect rent payments;•The availability of financing;•Changes to the financial and banking industries;•Changes in interest rate levels;•Vacancies at our properties and our ability to re-lease space;•Changes in tax or other regulatory laws;•The costs of compliance with government regulation;•The lack of liquidity of real estate investments; and•Increases in operating costs.In addition, if a lease at a property is not a triple net lease, we will have greater exposure to increases in expenses associated with operating that property. Certain significant expenditures, such as mortgage payments, real estate taxes, insurance, and maintenance costs, are generally fixed and do not decrease when revenues at the related property decrease.If we fail to effectively manage our debt obligations, we could become highly leveraged, and our debt service obligations could increase to unsustainable levels.Our organizational documents do not limit the amount of debt that we may incur. Therefore, if we fail to prudently manage our capital structure, we could become highly leveraged. This would result in an increase in our debt service obligations that could adversely affect our cash flows and our ability to make distributions to our stockholders. Higher leverage could also increase the risk of default on our debt obligations or may result in downgrades to our credit ratings.Failure to meet market expectations for our financial performance would likely adversely affect the market price and volatility of our stock.Our expected financial results may not be achieved, and actual results may differ materially from our expectations. This may be a result of various factors, including, but not limited to, the following:•The status of the economy;•The status of capital markets, including availability and cost of capital;•Changes in financing terms available to us;•Negative developments in the operating results or financial condition of tenants, including, but not limited to, their ability to pay rent;15•Our ability to re-lease space at similar rates as leases expire;•Our ability to reinvest sale proceeds in a timely manner at rates similar to the rate at which assets are sold;•Regulatory approval and market acceptance of the products and technologies of tenants;•Liability or contract claims by or against tenants;•Unanticipated difficulties and/or expenditures relating to future acquisitions;•Environmental laws affecting our properties;•Changes in rules or practices governing our financial reporting; and•Other legal and operational matters, including REIT qualification and key management personnel recruitment and retention.Failure to meet market expectations, particularly with respect to earnings estimates, funds from operations per share, operating cash flows, and revenues, would likely result in a decline and/or increased volatility in the market price of our common stock or other outstanding securities.The price per share of our stock may fluctuate significantly.The market price per share of our common stock may fluctuate significantly in response to many factors, including, but not limited to, the following:•The availability and cost of debt and/or equity capital;•The condition of our balance sheet;•Actual or anticipated capital requirements;•The condition of the financial and banking industries;•Actual or anticipated variations in our quarterly operating results or dividends;•The amount and timing of debt maturities and other contractual obligations;•Changes in our net income, funds from operations, or guidance;•The publication of research reports and articles about us, our tenants, the real estate industry, or the life science, technology, and agtech industries;•The general reputation of REITs and the attractiveness of their equity securities in comparison to other debt or equity securities (including securities issued by other real estate-based companies);•General stock and bond market conditions, including changes in interest rates on fixed-income securities, that may lead prospective stockholders to demand a higher annual yield from future dividends;•Fluctuations from general market volatility;•Changes in our analyst ratings;•Changes in our corporate credit ratings or credit ratings of our debt or other securities;•Changes in market valuations of similar companies;•Adverse market reaction to any additional debt we incur in the future;•Additions, departures, or other announcements regarding our key management personnel;•Actions by institutional stockholders;•Speculation in the press or investment community;•Terrorist activity adversely affecting the markets in which our securities trade, possibly increasing market volatility and causing the further erosion of business and consumer confidence and spending;•Government regulatory action and changes in tax laws;•Fiscal policies or inaction at the U.S. federal government level that may lead to federal government shutdowns or negative impacts on the U.S. economy;•Global market factors adversely affecting the U.S. economic and political environment;•The realization of any of the other risk factors included in this annual report on Form 10-K; and•General market and economic conditions.Many of the factors listed above are beyond our control. These factors may cause the market price of shares of our common stock to decline, regardless of our financial condition, results of operations, business, or prospects.Possible future sales of shares of our common stock could adversely affect its market price.We cannot predict the effect, if any, of future sales of shares of our common stock or the market price of our common stock. Sales of substantial amounts of capital stock (including the conversion or redemption of preferred stock), or the perception that such sales may occur, could adversely affect prevailing market prices for our common stock. Refer to “Other sources” in the “Sources of capital” subsection of the “Capital resources” section under “Item 7. Management’s discussion and analysis of financial condition and results of operations” in this annual report on Form 10-K.16We have reserved a number of shares of common stock for issuance to our directors, officers, and employees pursuant to our Amended and Restated 1997 Stock Award and Incentive Plan (sometimes referred to herein as our “equity incentive plan”). We have filed a registration statement with respect to the issuance of shares of our common stock pursuant to grants under our equity incentive plan. In addition, any shares issued under our equity incentive plan will be available for sale in the public market from time to time without restriction by persons who are not our “affiliates” (as defined in Rule 144 adopted under the Securities Act of 1933, as amended). Affiliates will be able to sell shares of our common stock subject to restrictions under Rule 144.Our distributions to stockholders may decline at any time.We may not continue our current level of distributions to our stockholders. Our Board of Directors will determine future distributions based on a number of factors, including, but not limited to, the following:•The amount of net cash provided by operating activities available for distribution;•Our financial condition and capital requirements;•Any decision to reinvest funds rather than to distribute such funds;•Our capital expenditures;•The annual distribution requirements under the REIT provisions of the Internal Revenue Code;•Restrictions under Maryland law; and•Other factors our Board of Directors deems relevant.A reduction in distributions to stockholders may negatively impact our stock price.Distributions on our common stock may be made in the form of cash, stock, or a combination of both.As a REIT, we are required to distribute at least 90% of our taxable income to our stockholders. Typically, we generate cash for distributions through our operations, the disposition of assets, including partial interest sales, or the incurrence of additional debt. Our Board of Directors may determine in the future to pay dividends on our common stock in cash, in shares of our common stock, or in a combination of cash and shares of our common stock. For example, we may declare dividends payable in cash or stock at the election of each stockholder, subject to a limit on the aggregate cash that could be paid. Any such dividends would be distributed in a manner intended to count in full toward the satisfaction of our annual distribution requirements and to qualify for the dividends paid deduction. While the IRS privately has ruled that such a dividend would so qualify if certain requirements are met, no assurances can be provided that the IRS would not assert a contrary position in the future. Moreover, a reduction in the cash yield on our common stock may negatively impact our stock price.We have certain ownership interests outside the U.S. that may subject us to risks different from or greater than those associated with our domestic operations.We have three operating properties in Canada and one operating property in China. Acquisition, development, redevelopment, ownership, and operating activities outside the U.S. involve risks that are different from those we face with respect to our domestic properties and operations. These risks include, but are not limited to:•Adverse effects of changes in exchange rates for foreign currencies;•Challenges and/or taxation with respect to the repatriation of foreign earnings or repatriation of proceeds from the sale of one or more of our foreign investments;•Changes in foreign political, regulatory, and economic conditions, including nationally, regionally, and locally;•Challenges in managing international operations;•Challenges in hiring or retaining key management personnel;•Challenges of complying with a wide variety of foreign laws and regulations, including those relating to real estate, corporate governance, operations, taxes, employment, and legal proceedings;•Differences in lending practices;•Differences in languages, cultures, and time zones; •Changes in applicable laws and regulations in the U.S. that affect foreign operations;•Challenges in managing foreign relations and trade disputes that adversely affect U.S. and foreign operations;•Future partial or complete U.S. federal government shutdowns, trade disagreements with other countries, or uncertainties that could affect business transactions within the U.S. and with foreign entities;•Changes in tax and local regulations with potentially adverse tax consequences and penalties; and•Foreign ownership and transfer restrictions.In addition, our foreign investments are subject to taxation in foreign jurisdictions based on local tax laws and regulations and on existing international tax treaties. We have invested in foreign markets under the assumption that our future earnings in each of those countries will be taxed at the current prevailing income tax rates. There are no guarantees that foreign governments will continue to honor existing tax treaties we have relied upon for our foreign investments or that the current income tax rates in those countries will not increase significantly, thus impacting our ability to repatriate our foreign investments and related earnings.17Investments in international markets may also subject us to risks associated with establishing effective controls and procedures to regulate the operations of new offices and to monitor compliance with U.S. laws and regulations, including the Foreign Corrupt Practices Act and similar foreign laws and regulations. The Foreign Corrupt Practices Act and similar applicable anti-corruption laws prohibit individuals and entities from offering, promising, authorizing, or providing payments or anything of value, directly or indirectly, to government officials in order to obtain, retain, or direct business. Failure to comply with these laws could subject us to civil and criminal penalties that could materially adversely affect our results of operations or the value of our international investments. In addition, if we fail to effectively manage our international operations, our overall financial condition, results of operations, and cash flows, and the market price of our common stock could be adversely affected.Furthermore, we may in the future enter into agreements with non-U.S. entities that are governed by the laws of, and are subject to dispute resolution rules of, another country or region. In some cases, such a country or region might not have a forum that provides us an effective or efficient means for resolving disputes that may arise under these agreements.We are subject to risks and liabilities in connection with properties owned through partnerships, limited liability companies, and joint ventures.Our organizational documents do not limit the amount of funds that we may invest in non-wholly owned partnerships, limited liability companies, or joint ventures. Partnership, limited liability company, or joint venture investments involve certain risks, including, but not limited to, the following:•Upon bankruptcy of non-wholly owned partnerships, limited liability companies, or joint venture entities, we may become liable for the liabilities of the partnership, limited liability company, or joint venture;•We may share certain approval rights over major decisions with third parties;•We may be required to contribute additional capital if our partners fail to fund their share of any required capital contributions;•Our partners, co-members, or joint venture partners might have economic or other business interests or goals that are inconsistent with our business interests or goals and that could affect our ability to lease or re-lease the property, operate the property, or maintain our qualification as a REIT;•Our ability to sell the interest on advantageous terms when we so desire may be limited or restricted under the terms of our agreements with our partners; and•We may not continue to own or operate the interests or assets underlying such relationships or may need to purchase such interests or assets at an above-market price to continue ownership.We generally seek to maintain control of our partnerships, limited liability companies, and joint venture investments in a manner sufficient to permit us to achieve our business objectives. However, we may not be able to do so, and the occurrence of one or more of the events described above could adversely affect our financial condition, results of operations, and cash flows, our ability to make distributions to our stockholders, and the market price of our common stock.We could incur significant costs due to the financial condition of our insurance carriers.We insure our properties with insurance companies we believe have good ratings at the time our policies are put into effect. The financial condition of one or more of the insurance companies we hold policies with may be negatively impacted, which can result in their inability to pay on future insurance claims. Their inability to pay future claims may have a negative impact on our financial results. In addition, the failure of one or more insurance companies may increase the cost of renewing our insurance policies or increase the cost of insuring additional properties and recently developed or redeveloped properties.Our insurance may not adequately cover all potential losses.If we experience a loss at any of our properties that is not covered by insurance, that exceeds our insurance policy limits, or that is subject to a policy deductible, we could lose the capital invested in the affected property and, possibly, future revenues from that property. In addition, we could continue to be obligated on any mortgage indebtedness or other obligations related to the affected properties. All properties carry comprehensive liability, fire, extended coverage, and rental loss insurance with respect to our properties, including properties partially owned through joint ventures that are managed by our joint venture partners.We have obtained earthquake insurance for our properties that are located in the vicinity of active earthquake zones in an amount and with deductibles we believe are commercially reasonable. However, a significant portion of our real estate portfolio is located in seismically active regions, including San Francisco, San Diego, and Seattle, and a damaging earthquake in any of these regions could significantly impact multiple properties. As a result, the amount of our earthquake insurance coverage may be insufficient to cover our losses, and aggregate deductible amounts may be material, which could adversely affect our business, financial condition, results of operations, and cash flows. We also carry environmental insurance and title insurance policies for our properties. We generally obtain title insurance policies when we acquire a property, with each policy covering an amount equal to the initial purchase 18price of each property. Accordingly, any of our title insurance policies may be in an amount less than the current value of the related property.Our tenants are also required to maintain comprehensive insurance, including liability and casualty insurance that is customarily obtained for similar properties. There are, however, certain types of losses that we and our tenants do not generally insure against because they are uninsurable or because it is not economical to insure against them. The availability of coverage against certain types of losses, such as from terrorism or toxic mold, has become more limited and, when available, carries a significantly higher cost. We cannot predict whether insurance coverage against terrorism or toxic mold will remain available for our properties because insurance companies may no longer offer coverage against such losses, or such coverage, if offered, may become prohibitively expensive. We have not had material losses from terrorism or toxic mold at any of our properties.The loss of services of any of our senior officers could adversely affect us.We depend upon the services and contributions of relatively few senior officers. The loss of services or contributions of any one of them may adversely affect our business, financial condition, and prospects. We use the extensive personal and business relationships that members of our management have developed over time with owners of office/laboratory and tech office properties and with major tenants and venture investment portfolio companies in the life science, technology, and agtech industries. We cannot assure our stockholders that our senior officers will remain employed with us. In California and certain other regions where we have operations, there is intense competition for individuals with skill sets needed for our business. Moreover, we expect that the high cost of living in California, where our headquarters and many of our properties are located, as a result of high state and local taxes and increased home prices, may impair our ability to attract and retain employees in the future. Due to the long-term nature of our investments and properties, we are unable to predict and may be unable to effectively control such costs. If we do not succeed in attracting new personnel and retaining and motivating existing personnel, our business may suffer, and we may be unable to implement our current initiatives or grow effectively.Failure to maintain effective internal control over financial reporting could have a material adverse effect on our business, results of operations, financial condition, and stock price.Pursuant to the Sarbanes-Oxley Act of 2002, we are required to provide a report by management on internal control over financial reporting, including management’s assessment of the effectiveness of internal control. Changes to our business will necessitate ongoing changes to our internal control systems and processes. Internal control over financial reporting may not prevent or detect misstatement because of its inherent limitations, including the possibility of human error, the circumvention or overriding of controls, or fraud. Therefore, even effective internal controls can provide only reasonable assurance with respect to the preparation and fair presentation of financial statements. If we fail to maintain the adequacy of our internal controls, including any failure to implement required new or improved controls, or if we experience difficulties in their implementation, our business, results of operations, and financial condition could be materially harmed, we could fail to meet our reporting obligations, and there could be a material adverse effect on the market price of our common stock.If we failed to qualify as a REIT, we would be taxed at corporate rates and would not be able to take certain deductions when computing our taxable income.We have elected to be taxed as a REIT under the Internal Revenue Code. If, in any taxable year, we failed to qualify as a REIT:•We would be subject to federal and state income taxes on our taxable income at regular corporate rates;•We would not be allowed a deduction for distributions to our stockholders in computing taxable income;•We would be disqualified from treatment as a REIT for the four taxable years following the year during which we lost qualification, unless we were entitled to relief under the Internal Revenue Code; and•We would no longer be required by the Internal Revenue Code to make distributions to our stockholders.As a result of any additional tax liability, we may need to borrow funds or liquidate certain investments in order to pay the applicable tax. Accordingly, funds available for investment or distribution to our stockholders would be reduced for each of the years involved.Qualification as a REIT involves the application of highly technical and complex provisions of the Internal Revenue Code to our operations and financial results, as well as the determination of various factual matters and circumstances not entirely within our control. There are only limited judicial or administrative interpretations of these provisions. Although we believe that we our current organization and method of operation comply with the rules and regulations promulgated under the Internal Revenue Code to enable us to qualify as a REIT, we cannot assure our stockholders that we are or will remain so qualified.From time to time, we dispose of properties in transactions qualified under Section 1031 of the Internal Revenue Code (“Section 1031 Exchanges”). If a transaction intended to qualify as a Section 1031 Exchange is later determined by the IRS to be taxable or if we are unable to identify and complete the acquisition of a suitable replacement property to effect a Section 1031 Exchange or if the laws surrounding Section 1031 Exchanges are amended or repealed, we may not be able to dispose of properties on 19a tax-deferred basis. In such a case, our earnings and profits and our taxable income would increase, which could increase the dividend income and reduce the return of capital to our stockholders. As a result, we may be required to pay additional dividends to stockholders, or if we do not pay additional dividends, our corporate income tax liability could increase and we may be subject to interest and penalties.We may not be able to participate in certain sales that the IRS characterizes as “prohibited transactions.” The tax imposed on REITs engaging in prohibited transactions is a 100% tax on net income from the transaction. Whether or not the transaction is characterized as a prohibited transaction is a factual matter. Generally, prohibited transactions are sales or other dispositions of property, other than foreclosures, characterized as held primarily for sale to customers in the ordinary course of business. However, a sale will not be considered a prohibited transaction if it meets certain safe harbor requirements. Although we do not intend to participate in prohibited transactions, there is no guarantee that the IRS would agree with our characterization of our properties or that we will meet the safe harbor requirements. Federal income tax rules are constantly under review by the U.S. Congress and the IRS. Changes to tax laws could adversely affect our investors or our tenants, and we cannot predict how those changes may affect us in the future. New legislation, U.S. Treasury Department regulations, administrative interpretations, or court decisions could significantly and negatively affect our ability to qualify as a REIT, the federal income tax consequences of such qualification, or an investment in our stock. Also, laws relating to the tax treatment of investment in other types of business entities could change, making an investment in such other entities more attractive relative to an investment in a REIT.We are dependent on third parties to manage the amenities at our properties. We retain third-party managers to manage certain amenities at our properties, such as restaurants, conference centers, exercise facilities, and parking garages. Our income from our properties may be adversely affected if these parties fail to provide quality services and amenities with respect to our properties. While we monitor the performance of these third parties, we may have limited recourse if we believe they are not performing adequately. In addition, these third-party managers may operate, and in some cases may own or invest in, properties that compete with our properties, which may result in conflicts of interest. As a result, these third-party managers may have made, and may in the future make, decisions that are not in our best interests.We rely on a limited number of vendors to provide utilities and certain other services at our properties, and disruption in these services may have a significant adverse effect on our business operations, financial condition, and cash flows.We rely on a limited number of vendors to provide key services, including, but not limited to, utilities and construction services, at certain of our properties. Our business and property operations may be adversely affected if key vendors fail to adequately provide key services at our properties as a result of natural disasters (such as fires, floods, earthquakes, etc.), power interruptions, bankruptcies, war, acts of terrorism, public health emergencies, cyber attacks, pandemics, or other unanticipated catastrophic events. If a vendor encounters financial difficulty such as bankruptcy or other events beyond our control that cause it to fail to adequately provide utilities, construction, or other important services, we may experience significant interruptions in service and disruptions to business operations at our properties, incur remediation costs, and become subject to claims and damage to our reputation. In addition, difficulties encountered by key vendors in providing necessary services at our properties could result in significant market rate increases for such services. Our triple net leases allow us to pass through substantially all operating expenses and certain capital expenditures to our tenants in the form of additional rent. However, we cannot be certain that we will be able to continue to negotiate pass-through provisions in tenant leases in the future, which could lead to a decrease in our recovery of operating expenses. If our operating expenses increase without a corresponding increase in revenues, our profitability could diminish. Also, we cannot be certain that increased costs will not lead our current or prospective tenants to seek space elsewhere, which could significantly hinder our ability to increase our rents or to maintain existing occupancy levels. Additionally, this may significantly increase occupancy costs for some of our tenants and may adversely impact their financial condition, ability to make rental payments, and ability to renew their lease agreements.Pacific Gas and Electric Company (“PG&E”) is the primary public utility company providing electrical and gas service to residential and commercial customers in northern California, including the San Francisco Bay Area. Most of our properties located in our San Francisco market depend on PG&E for the delivery of these essential services. PG&E initiated voluntary reorganization proceedings under Chapter 11 of the U.S. Bankruptcy Code in January 2019 in response to potential liabilities arising from a series of catastrophic wildfires that occurred in Northern California in 2017 and 2018. While PG&E emerged from bankruptcy in July 2020, there is no guarantee that PG&E will be able to sustain safe operations and continue to provide consistent utilities services. During periods of high winds and high fire danger in recent fire seasons, PG&E preemptively shut off power to areas of Central and Northern California. The shutoffs were designed to help guard against fires ignited in areas with high winds and dry conditions. PG&E has warned that it may have to employ shutoffs while the utility company addresses maintenance issues. Future shutoffs of power may impact the reliability of access to a stable power supply at our properties and, in turn, adversely impact our tenants’ businesses. In addition, there is no guarantee that PG&E’s safety measures mandated by regulators will be timely and sufficient to prevent future catastrophic wildfires.20The realization of any of the above risks could significantly and adversely affect our ability to meet our financial expectations, our financial condition, results of operations, and cash flows, our ability to make distributions to our stockholders, the market price of our common stock, and our ability to satisfy our debt service obligations.We may change our business policies without stockholder approval.Our Board of Directors determines all of our material business policies, with management’s input, including those related to our:•Status as a REIT;•Incurrence of debt and debt management activities;•Selective acquisition, disposition, development, and redevelopment activities;•Stockholder distributions; and•Other policies, as appropriate.Our Board of Directors may amend or revise these policies at any time without a vote of our stockholders. A change in these policies could adversely affect our business and our ability to make distributions to our stockholders.There are limits on the ownership of our capital stock under which a stockholder may lose beneficial ownership of its shares and that may delay or prevent transactions that might otherwise be desired by our stockholders.In order for a company to qualify as a REIT under the Internal Revenue Code, not more than 50% of the value of its outstanding stock may be owned, directly or constructively, by five or fewer individuals or entities (as set forth in the Internal Revenue Code) during the last half of a taxable year. Furthermore, shares of our company’s outstanding stock must be beneficially owned by 100 or more persons during at least 335 days of a taxable year of 12 months or during a proportionate part of a shorter taxable year. In order for us to maintain our qualification as a REIT, among other things, our charter provides for an ownership limit, which prohibits, with certain exceptions, direct or constructive ownership of shares of stock representing more than 9.8% of the combined total value of our outstanding shares of stock by any person, as defined in our charter. Our Board of Directors, in its sole discretion, may waive the ownership limit for any person. However, our Board of Directors may not grant such waiver if, after giving effect to such waiver, we would be “closely held” under Section 856(h) of the Internal Revenue Code. As a condition to waiving the ownership limit, our Board of Directors may require a ruling from the IRS or an opinion of counsel in order to determine our status as a REIT. Notwithstanding the receipt of any such ruling or opinion, our Board of Directors may impose such conditions or restrictions as it deems appropriate in connection with granting a waiver. Our charter further prohibits transferring shares of our stock if such transfer would result in our being “closely held” under Section 856(h) of the Internal Revenue Code or would result in shares of our stock being owned by fewer than 100 persons. The constructive ownership rules are complex and may cause shares of our common stock owned directly or constructively by a group of related individuals or entities to be constructively owned by one individual or entity. A transfer of shares to a person who, as a result of the transfer, violates these limits shall be void or these shares shall be exchanged for shares of excess stock and transferred to a trust for the benefit of one or more qualified charitable organizations designated by us. In that case, the intended transferee will have only a right to share, to the extent of the transferee’s original purchase price for such shares, in proceeds from the trust’s sale of those shares and will effectively forfeit its beneficial ownership of the shares. These ownership limits could delay, defer, or prevent a transaction or a change in control that might involve a premium price for the holders of our common stock or that might otherwise be desired by such holders.In addition to the ownership limit, certain provisions of our charter and bylaws may delay or prevent transactions that may be deemed to be desirable to our stockholders.As authorized by Maryland law, our charter allows our Board of Directors to cause us to issue additional authorized but unissued shares of our common stock or preferred stock and to classify or reclassify unissued shares of common or preferred stock without any stockholder approval. Our Board of Directors could establish a series of preferred stock that could delay, defer, or prevent a transaction that might involve a premium price for our common stock or that might, for other reasons, be desired by our common stockholders, or a series of preferred stock that has a dividend preference that may adversely affect our ability to pay dividends on our common stock.Our charter permits the removal of a director only upon a two-thirds majority of the votes entitled to be cast generally in the election of directors, and our bylaws require advance notice of a stockholder’s intention to nominate directors or to present business for consideration by stockholders at an annual meeting of our stockholders. Our charter and bylaws also contain other provisions that may delay, defer, or prevent a transaction or change in control that involves a premium price for our common stock or that, for other reasons, may be desired by our stockholders.21Market and industry factorsWe face substantial competition in our target markets. The significant competition for business in our target markets could have an adverse effect on our operations. We compete for investment opportunities with:•Other REITs;•Insurance companies;•Pension and investment funds;•Private equity entities;•Partnerships;•Developers;•Investment companies; •Owners/occupants; and•Foreign investors, including sovereign wealth funds.Many of these entities have substantially greater financial resources than we do and may be able to pay more than we can or accept more risk than we are willing to accept. These entities may be less sensitive to risks with respect to the creditworthiness of a tenant or the geographic concentration of their investments. Competition may also reduce the number of suitable investment opportunities available to us or may increase the bargaining power of property owners seeking to sell. If there is no matching growth in demand, the intensified competition may lead to oversupply of available space comparable to ours and result in the pressure on rental rates and greater incentives awarded to tenants. To maintain our ability to retain current and attract new tenants, we may be forced to reduce the rental rates that our tenants are currently willing to pay or offer greater tenant concessions. Should we encounter intensified competition or oversupply, we cannot be certain that we will be able to compete successfully, maintain our occupancy and rental rates, and continue to expand our business. As a result, our financial condition, results of operations, and cash flows, our ability to pay dividends, and our stock price may be adversely affected.Poor economic conditions in our markets could adversely affect our business.Our properties are primarily located in the following markets:•Greater Boston;•San Francisco;•New York City;•San Diego;•Seattle;•Maryland; and•Research Triangle.As a result of our geographic concentration, we depend upon the local economic and real estate conditions in these markets. We are therefore subject to increased exposure (positive or negative) to economic, tax, and other competitive factors specific to markets in confined geographic areas. Our operations may also be affected if too many competing properties are built in any of these markets. An economic downturn in any of these markets could adversely affect our operations and our ability to make distributions to our stockholders. We cannot assure our stockholders that these markets will continue to grow or remain favorable to the life science, technology, and agtech industries.Improvements to our properties are significantly more costly than improvements to traditional office space.Many of our properties generally contain infrastructure improvements that are significantly more costly than improvements to other property types. Although we have historically been able to recover the additional investment in infrastructure improvements through higher rental rates, there is the risk that we will not be able to continue to do so in the future. Typical improvements include:•Reinforced concrete floors;•Upgraded roof loading capacity;•Increased floor-to-ceiling heights;•Heavy-duty HVAC systems;•Enhanced environmental control technology;•Significantly upgraded electrical, gas, and plumbing infrastructure; and•Laboratory benches.22We are dependent on the life science, technology, and agtech industries, and changes within these industries may adversely impact our revenues from lease payments, the value of our non-real estate investments, and our results of operations.In general, our business strategy is to invest primarily in properties used by tenants in the life science, technology, and agtech industries. Through our venture investment portfolio, we also hold investments in companies that, similar to our tenant base, are concentrated in the life science, technology, and agtech industries. Our business could be adversely affected if the life science, technology, and agtech industries are impacted by an economic, financial, or banking crisis, or if the life science, technology, and agtech industries migrate from the U.S. to other countries. Because of our industry focus, events within these industries may have a more pronounced effect on our results of operations and ability to make distributions to our stockholders than if we had more diversified investments. Also, some of our properties may be better suited for a particular life science, technology, or agtech industry tenant and could require significant modification before we are able to re-lease space to another tenant. Generally, our properties may not be suitable for lease to traditional office tenants without significant expenditures on renovations.Our ability to negotiate contractual rent escalations on future leases and to achieve increases in rental rates will depend upon market conditions and the demand for office/laboratory and tech office space at the time the leases are negotiated and the increases are proposed.It is common for businesses in the life science, technology, and agtech industries to undergo mergers or consolidations. Mergers or consolidations of life science, technology, and agtech entities in the future could reduce the RSF requirements of our tenants and prospective tenants, which may adversely impact the demand for office/laboratory and tech office space and our future revenue from lease payments and our results of operations.Some of our current or future tenants may include high-tech companies in their startup or growth phases of their life cycle. Fluctuations in market confidence vested in these companies or adverse changes in economic conditions may have a disproportionate effect on operations of such companies. Deterioration in the financial conditions of our tenants may result in our inability to collect rental payments from them and therefore may negatively impact our results of operations. Our results of operations depend on our tenants’ research and development efforts and their ability to obtain funding for these efforts.Our tenant base includes entities in the pharmaceutical, biotechnology, medical device, life science, technology, agtech, and related industries; academic institutions; government institutions; and private foundations. Our tenants base their research and development budgets on several factors, including the need to develop new products, the availability of government and other funding, competition, and the general availability of resources. Our investments through our venture investment portfolio are also in companies that, similar to our tenant base, are concentrated in the life science, technology, and agtech industries.Research and development budgets fluctuate due to changes in available resources, research priorities, general economic conditions, institutional and government budgetary limitations, and mergers and consolidations of entities. Our business could be adversely impacted by a significant decrease in research and development expenditures by our tenants, our venture investment portfolio companies, or the life science, technology, and agtech industries. Our tenants also include research institutions whose funding is largely dependent on grants from government agencies, such as the NIH, the National Science Foundation, and similar agencies or organizations. U.S. government funding of research and development is subject to the political process, which is often unpredictable. Other programs, such as Homeland Security or defense, could be viewed by the government as higher priorities. Additionally, proposals to reduce or eliminate budgetary deficits have sometimes included reduced allocations to the NIH and other U.S. government agencies that fund research and development activities. Additionally, the inability of the U.S. Congress to enact a budget for a fiscal year or the occurrence of partial or complete U.S. federal government shutdowns may result in temporary closures of agencies such as the FDA or NIH, which could adversely affect business operations of our tenants who are dependent on government approvals and appropriations. Any shift away from funding of research and development or delays surrounding the approval of government budget proposals may adversely impact our tenants’ operations, which in turn may impact their demand for office/laboratory and tech office space and their ability to make lease payments to us and thus adversely impact our results of operations.23Our life science industry tenants and venture investment portfolio companies are subject to a number of risks unique to their industry, including (i) changes in technology, patent expiration, and intellectual property protection, (ii) high levels of regulation, (iii) failures in the safety and efficacy of their products, and (iv) significant funding requirements for product research and development. These risks may adversely affect our tenants’ ability to make rental payments or satisfy their other lease obligations to us or may impact our venture investment portfolio companies’ value and consequently may materially adversely affect our business, results of operations, financial condition, and stock price.Changes in technology, patent expiration, and intellectual property rights and protection•Our tenants and venture investment portfolio companies develop and sell products and services in an industry that is characterized by rapid and significant technological changes, frequent new product and service introductions and enhancements, evolving industry standards, and uncertainty over the implementation of new healthcare reform legislation, which may cause them to lose competitive positions and adversely affect their operations.•Many of our tenants and venture investment portfolio companies, and their licensors, require patent, copyright, or trade secret protection and/or rights to use third-party intellectual property to develop, make, market, and sell their products and technologies. A tenant or venture investment portfolio company may be unable to commercialize its products or technologies if patents covering such products or technologies are not issued or are successfully challenged, narrowed, invalidated, or circumvented by third parties. Additionally, a third party may own intellectual property that limits a tenant’s or venture investment portfolio company’s ability to bring to market its product or technology without securing a license or other rights to use the third-party intellectual property, which may require the tenant to pay an upfront fee or royalty. Failure to obtain these rights from third parties may make it challenging or impossible for a tenant or venture investment portfolio company to develop and commercialize its products or technologies, which could adversely affect its competitive position and operations.•Many of our tenants and venture investment portfolio companies depend upon patents to provide exclusive marketing rights for their products. As their product patents expire, competitors of these tenants or venture investment portfolio companies may be able to legally produce and market products similar to those products of our tenants or venture investment portfolio companies, which could have a material adverse effect on their sales and results of operations.High levels of regulation•Some of our life science industry tenants and venture investment portfolio companies develop and manufacture drugs that require regulatory approval, including approval from the FDA, prior to being made, marketed, sold, and used. The regulatory approval process to manufacture and market drugs is costly, typically takes many years, requires validation through clinical trials and the use of substantial resources, and is often unpredictable. A tenant or venture investment portfolio company may fail to obtain or may experience significant delays in obtaining these approvals. Even if the tenant or venture investment portfolio company obtains regulatory approvals, marketed products will be subject to ongoing regulatory review and potential loss of approvals.•The ability of some of our life science industry tenants and venture investment portfolio companies to commercialize any future products successfully will depend in part on the coverage and reimbursement levels set by government authorities, private health insurers, and other third-party payers. Additionally, reimbursements may decrease in the future.Failures in the safety and efficacy of their products•Some of our life science industry tenants and venture investment portfolio companies developing potential products may find that their products are not effective, or are even harmful, when tested in humans.•Some of our life science industry tenants and venture investment portfolio companies depend upon the commercial success of certain products. Even if a product made by a life science industry tenant or venture investment portfolio company is successfully developed and proven safe and effective in human clinical trials, and the requisite regulatory approvals are obtained, subsequent discovery of safety issues with these products could cause product liability events, additional regulatory scrutiny and requirements for additional labeling, loss of approval, withdrawal of products from the market, and the imposition of fines or criminal penalties.•A drug made by a life science industry tenant or venture investment portfolio company may not be well accepted by doctors and patients, or may be less effective or accepted than a competitor’s drug, even if it is successfully developed.•The negative results of safety signals arising from the clinical trials of the competitors of our life science industry tenants or venture investment portfolio companies may prompt regulatory agencies to take actions that may adversely affect the clinical trials or products of our tenants or venture investment portfolio companies.Significant funding requirements for product research and development•Some of our life science industry tenants and venture investment portfolio companies require significant funding to develop and commercialize their products and technologies, which funding must be obtained from venture capital firms; private investors; public markets; other companies in the life science industry; or federal, state, and local governments. Such funding may become unavailable or difficult to obtain. The ability of each tenant or venture investment portfolio company to raise capital will depend on its financial and operating condition, viability of its products and technology, and the overall condition of the financial, banking, and economic environment, as well as government budget policies.24•Even with sufficient funding, some of our life science industry tenants or venture investment portfolio companies may not be able to discover or identify potential drug targets in humans, or potential drugs for use in humans, or to create tools or technologies that are commercially useful in the discovery or identification of potential drug targets or drugs.•Some of our life science industry tenants or venture investment portfolio companies may not be able to successfully manufacture their drugs economically, even if such drugs are proven through human clinical trials to be safe and effective in humans.•Marketed products also face commercialization risk, and some of our life science industry tenants and venture investment portfolio companies may never realize projected levels of product utilization or revenues.•Negative news regarding the products, the clinical trials, or other business developments of our life science industry tenants or venture investment portfolio companies may cause their stock price or credit profile to deteriorate.We cannot assure our stockholders that our life science industry tenants or venture investment portfolio companies will be able to develop, make, market, or sell their products and technologies due to the risks inherent in the life science industry. Any life science industry tenant or venture investment portfolio company that is unable to avoid, or sufficiently mitigate, the risks described above may have difficulty making rental payments or satisfying its other lease obligations to us or may have difficulty maintaining the value of our investment. Such risks may also decrease the credit quality of our life science industry tenants and venture investment portfolio companies or cause us to expend more funds and resources on the space leased by these tenants than we originally anticipated. The increased burden on our resources due to adverse developments relating to our life science industry tenants may cause us to achieve lower-than-expected yields on the space leased by these tenants. Negative news relating to our more significant life science industry tenants and venture investment portfolio companies may also adversely impact our stock price.Our technology industry tenants and venture investment portfolio companies are subject to a number of risks unique to their industry, including (i) an uncertain regulatory environment, (ii) rapid technological changes, (iii) a dependency on the maintenance and security of the Internet infrastructure, (iv) significant funding requirements for product research and development and sales growth, and (v) inadequate intellectual property protections. These risks may adversely affect our tenants’ ability to make rental payments to us or satisfy their other lease obligations or may impact our venture investment portfolio companies’ value, which consequently may materially adversely affect our business, results of operations, financial condition, and stock price.Uncertain regulatory environment•Laws and regulations governing the Internet, e-commerce, electronic devices, and other services are evolving. Existing and future laws and regulations and the halting of operations at certain agencies resulting from partial or complete U.S. federal government shutdowns may impede the growth of our technology industry tenants and venture investment portfolio companies. These laws and regulations may cover, among other areas, taxation, worker classification, privacy, data protection, pricing, content, copyrights, distribution, mobile communications, business licensing, and consumer protection.Rapid technological changes•The technology industry is characterized by rapid changes in customer requirements and preferences, frequent new product and service introductions, and the emergence of new industry standards and practices. A failure to respond in a timely manner to these market conditions could materially impair the operations of our technology industry tenants and venture investment portfolio companies.Dependency on the maintenance and security of the Internet infrastructure•Some of our technology industry tenants and venture investment portfolio companies depend on continued and unimpeded access to the Internet by users of their products and services, as well as access to mobile networks. Internet service providers and mobile network operators may be able to block, degrade, or charge additional fees to these tenants, venture investment portfolio companies, or users of their products and services.•The Internet has experienced, and is likely to continue to experience, outages and other delays. These outages and delays, as well as problems caused by cyber attacks and computer malware, viruses, worms, and similar programs, may materially affect the ability of our technology industry tenants and venture investment portfolio companies to conduct business.•Security breaches or network attacks may delay or interrupt the services provided by our technology industry tenants and venture investment portfolio companies and could harm their reputations or subject them to significant liability.Significant funding requirements for product research and development•Some of our technology industry tenants and venture investment portfolio companies require significant funding to develop and commercialize their products and technologies, which funding must be obtained from venture capital firms; private investors; public markets; companies in the technology industry; or federal, state, and local governments. Such funding may become unavailable or difficult to obtain. The ability of each tenant or venture investment portfolio company to raise capital will depend on its financial and operating condition, viability of their products, and the overall condition of the financial, banking, governmental budget policies, and economic environment.25•Even with sufficient funding, some of our technology industry tenants and venture investment portfolio companies may not be able to discover or identify potential customers or may not be able to create tools or technologies that are commercially useful.•Some of our technology industry tenants and venture investment portfolio companies may not be able to successfully manufacture their products economically.•Marketed products also face commercialization risk, and some of our technology industry tenants and venture investment portfolio companies may never realize projected levels of product utilization or revenues.•Unfavorable news regarding the products or other business developments of our technology industry tenants or venture investment portfolio companies may cause their stock price or credit profile to deteriorate.Inadequate intellectual property protections•The products and services provided by some of our technology industry tenants and venture investment portfolio companies are subject to the threat of piracy and unauthorized copying, and inadequate intellectual property laws and other inadequate protections could prevent them from enforcing or defending their proprietary technologies. These tenants and venture investment portfolio companies may also face legal risks arising out of user-generated content. •Trademark, copyright, patent, domain name, trade dress, and trade secret protection is very expensive to maintain and may require our technology industry tenants and venture investment portfolio companies to incur significant costs to protect their intellectual property rights. We cannot assure our stockholders that our technology industry tenants and venture investment portfolio companies will be able to develop, make, market, or sell their products and services due to the risks inherent in the technology industry. Any technology industry tenant or venture investment portfolio company that is unable to avoid, or sufficiently mitigate, the risks described above may have difficulty making rental payments or satisfying its other lease obligations to us or may have difficulty maintaining the value of our investment. Such risks may also decrease the credit quality of our technology industry tenants or venture investment portfolio companies or cause us to expend more funds and resources on the space leased by these tenants than we originally anticipated. The increased burden on our resources due to adverse developments relating to our technology industry tenants may cause us to achieve lower-than-expected yields on the space leased by these tenants. Unfavorable news relating to our more significant technology industry tenants and venture investment portfolio companies may also adversely impact our stock price.Our agtech industry tenants and venture investment portfolio companies are subject to a number of risks unique to their industry, including (i) uncertain regulatory environment, (ii) seasonality in business, (iii) unavailability of transportation mechanisms for carrying products and raw materials, (iv) changes in costs or constraints on supplies or energy used in operations, (v) strikes or labor slowdowns or labor contract negotiations, and (vi) rapid technological changes in agriculture. These risks may adversely affect our tenants’ ability to make rental payments or satisfy their other lease obligations to us or may impact our venture investment portfolio companies’ value, which consequently may materially adversely affect our business, results of operations, financial condition, and stock price.Uncertain regulatory environment•Laws and regulations governing the Internet, e-commerce, electronic devices, and other services and products developed by the agtech industry are evolving. Existing and future laws and regulations and the halting of operations at certain agencies resulting from partial or complete U.S. federal government shutdowns may impede the growth of our agtech industry tenants and venture investment portfolio companies. These laws and regulations may cover, among other areas, taxation, privacy, data protection, pricing, content, copyrights, distribution, mobile communications, business licensing, and consumer protection.Seasonality in business•Our agtech industry tenants’ and venture investment portfolio companies’ businesses may fluctuate from time to time due to seasonal weather conditions and other factors out of their control, affecting products and services our agtech industry tenants and venture investment portfolio companies offer.Unavailability of transportation mechanisms for carrying products and raw materials•Some of our agtech industry tenants’ and venture investment portfolio companies’ businesses depend on transportation services to deliver their products or to deliver raw materials to their clients. If transportation service providers are unavailable or fail to deliver our agtech industry tenants’ or venture investment portfolio companies’ products in a timely manner, they may be unable to manufacture and deliver their services and products on a timely basis.Changes in costs or constraints on supplies or energy used in operations•Similarly, if fuel or other energy prices increase, it may increase transportation costs, which could affect our agtech industry tenants’ and venture investment portfolio companies’ businesses.26Strikes or labor slowdowns or labor contract negotiations•Our agtech industry tenants and venture investment portfolio companies may face labor strikes, work slowdowns, labor contract negotiations, or other job actions from their employees or third-party contractors. In the event of a strike, work slowdown, or other similar labor unrest, our agtech industry tenants or venture investment portfolio companies may not have the ability to adequately staff their businesses, which could have an adverse effect on their operations and revenue.Rapid technological changes in agriculture•The agtech industry is characterized by regular new product and service introductions, and the emergence of new industry standards and practices. A failure to respond in a timely manner to these market conditions could materially impair the operations of our agtech industry tenants and venture investment portfolio companies.•Technological advances in agriculture could decrease the demand for crop nutrients, energy, and other crop input products and services our agtech industry tenants and venture investment portfolio companies provide. Genetically engineered crops that resist disease and insects could affect the demand for certain of our tenants’ or venture investment portfolio companies’ products. Demand for fuel could decline as technology allows for more efficient usage of equipment.We cannot assure our stockholders that our agtech industry tenants and venture investment portfolio companies will be able to develop, make, market, or sell their products and services due to the risks inherent in the agtech industry. Any agtech industry tenant or venture investment portfolio company that is unable to avoid, or sufficiently mitigate, the risks described above may have difficulty making rental payments or satisfying its other lease obligations to us. Such risks may also decrease the credit quality of our agtech industry tenants or venture investment portfolio companies or cause us to expend more funds and resources on the space leased by these tenants than we originally anticipated. The increased burden on our resources due to adverse developments relating to our agtech industry tenants may cause us to achieve lower-than-expected yields on the space leased by these tenants. Unfavorable news relating to our more significant agtech industry tenants and venture investment portfolio companies may also adversely impact our stock price.The companies in which we invest through our non-real estate venture investment portfolio expose us to risks similar to those of our tenant base and additional risks inherent in venture capital investing, which could materially affect our reported asset and liability values and earnings, and may materially and adversely affect our reported results of operations.Through our strategic venture investment portfolio, we hold investments in companies that, similar to our tenant base, are concentrated in the life science, technology, and agtech industries. The venture investment portfolio companies in which we invest are accordingly subject to risks similar to those posed by our tenant base, including those disclosed in this annual report on Form 10-K. In addition, the companies in which we invest through our venture investment portfolio are subject to the risks inherent in venture capital investing and may be adversely affected by external factors beyond our control and other risks, including, but not limited to the following:•Risks inherent in venture capital investing, which typically focuses on relatively new and small companies with unproven technologies and limited access to capital and is therefore generally considered more speculative than investment in larger, more established companies;•Market disruption and volatility, which may adversely affect the value of the companies in which we hold equity investments and, in turn, our ability to realize gains upon sales of these investments. •Disruptions, uncertainty, or volatility in the capital markets and global economy, which may impact the ability of the companies in which we invest to raise additional capital or access capital from venture capital investors or financial institutions on favorable terms;•Liquidity of the companies in which we invest, which may (i) impede our ability to realize the value at which these investments are carried if we are required to dispose of them, (ii) make it difficult for us to sell these investments on a timely basis, and (iii) impair the value of such investments;•Changes in the political climate, potential reforms and changes to government negotiation and regulation, the effect of healthcare reform legislation, including those that may limit pricing of pharmaceutical products and drugs, market prices and conditions, prospects for favorable or unfavorable clinical trial results, new product initiatives, the manufacturing and distribution of new products, product safety and efficacy issues, and new collaborative agreements, all of which may affect the valuation, funding opportunities, business operations, and financial results of the companies in which we invest;•Changes in U.S. federal government organizations or other agencies, including changes in policy, regulations, budgeting, retention of key leadership and other personnel, administration of drug approvals or restrictions on drug product or service development or commercialization, or a partial or complete future government shutdown resulting in temporary closures of agencies such as the FDA and SEC, could adversely affect the companies in which we invest, including delays in the commercialization of such companies’ products, decreased funding of research and development in the life science, technology, and agtech industries, or delays surrounding approval of budget proposals for any of these industries;•Impacts or changes in business in connection with the COVID-19 pandemic or for other reasons, including diversion of healthcare resources away from clinical trials, delays, or difficulties enrolling patients or maintaining scheduled appointments in clinical trials, interruptions, and delays in laboratory research due to the reduction in employee resources stemming from social distancing requirements and the desire of employees to avoid contact with people, insufficient 27inventory of supplies and reagents necessary for laboratory research due to interruptions in supply chain, delays or difficulties obtaining clinical site locations or engaging clinical site staff, interruptions on clinical site monitoring due to travel restrictions, delays in interacting with or receiving approval from regulatory agencies in connection with research activities or clinical trials, and disruptions to manufacturing facilities and supply lines;•Reduction in revenue or revenue growth, including in connection with the COVID-19 pandemic, deterioration in the global economy, or other reasons, may impair the value of the companies in which we hold equity investments or impede their ability to raise additional capital; and•Seasonal weather conditions, changes in availability of transportation or labor, especially in connection with the COVID-19 pandemic, and other related factors may affect the products and services or the availability of the products and services of the companies in which we invest in the agtech sector.Many of the factors listed above are beyond our control and, if the venture investment portfolio companies are adversely affected by any of the foregoing, could materially affect our reported asset and liability values and earnings and may materially and adversely affect our reported results of operations. The occurrence of any of these adverse events could cause the market price of shares of our common stock to decline regardless of the performance of our primary real estate business.Market and other external factors may adversely impact the valuation of our equity investments.We hold equity investments in certain publicly traded companies, limited partnerships, and privately held entities primarily involved in the life science, technology, and agtech industries through our venture investment portfolio. The valuation of these investments is affected by many external factors beyond our control, including, but not limited to, market prices, market conditions, the effect of healthcare reform legislation, prospects for favorable or unfavorable clinical trial results, new product initiatives, the manufacturing and distribution of new products, product safety and efficacy issues, and new collaborative agreements. In addition, partial or complete future government shutdowns that may result in temporary closures of agencies such as the FDA and SEC may adversely affect the processing of initial public offerings, business operations, financial results, and funding for projects of the companies in which we hold equity investments. Unfavorable developments with respect to any of these factors may have an adverse impact on the valuation of our equity investments.Market and other external factors may negatively impact the liquidity of our equity investments.We make and hold investments in privately held life science, technology, and agtech companies through our venture investment portfolio. These investments may be illiquid, which could impede our ability to realize the value at which these investments are carried if we are required to dispose of them. The lack of liquidity of these investments may make it difficult for us to sell these investments on a timely basis and may impair the value of these investments. If we are required to liquidate all or a portion of these investments quickly, we may realize significantly less than the amounts at which we had previously valued these investments.Government factorsNegative impact on economic growth resulting from the combination of federal income tax policy, debt policy, and government spending may adversely affect our results of operations.Global macroeconomic conditions affect our tenants’ businesses. Instability in the banking and government sectors of the U.S. and/or the negative impact on economic growth resulting from the combination of government tax policy, debt policy, and government spending, may have an adverse effect on the overall economic growth and our future revenue growth and profitability. Volatile, negative, or uncertain economic conditions could undermine business confidence in our significant markets or in other markets and cause our tenants to reduce or defer their spending, which would negatively affect our business. Growth in the markets we serve could be at a slow rate or could stagnate or contract in each case for an extended period of time. Differing economic conditions and patterns of economic growth and contraction in the geographic regions in which we operate and the industries we serve may in the future affect demand for our services. Our revenues and profitability are derived from our tenants in North America, some of which derive significant revenues from their international operations. Ongoing economic volatility and uncertainty affects our business in a number of other ways, including making it more difficult to accurately forecast client demand beyond the short term and to effectively build our revenue and spending plans. Economic volatility and uncertainty are particularly challenging because it may take some time for the effects and resulting changes in demand patterns to manifest themselves in our business and results of operations. Changing demand patterns from economic volatility and uncertainty could have a significant negative impact on our results of operations. These risks may impact our overall liquidity, our borrowing costs, or the market price of our common stock.28Monetary policy actions by the U.S. Federal Reserve could adversely impact our financial condition and our ability to make distributions to our stockholders.During 2017–2018, the U.S. Federal Reserve gradually increased the target range for the federal funds rate. As of December 31, 2018, the federal funds rate was set at a range from 2.25% to 2.50%. From August 2019 through March 2020, the U.S. Federal Reserve initiated a series of rate cuts. As of December 31, 2020, the federal funds rate was set at a range from 0% to 0.25%. The U.S. Federal Reserve has not indicated any intention to continue to cut the federal funds rate, nor to raise the rate. Should the U.S. Federal Reserve raise the rate in the future, this will likely result in an increase in market interest rates, which may increase our interest expense under our variable-rate borrowings and the costs of refinancing existing indebtedness or obtaining new debt. In addition, increases in market interest rates may result in a decrease in the value of our real estate and a decrease in the market price of our common stock. Increases in market interest rates may also adversely affect the securities markets generally, which could reduce the market price of our common stock without regard to our operating performance. Any such unfavorable changes to our borrowing costs and stock price could significantly impact our ability to raise new debt and equity capital going forward.Changes to the U.S. tax laws could have a significant negative impact on the overall economy, our tenants, and our business.Changes to U.S. tax laws that may be enacted in the future could negatively impact the overall economy, government revenues, the real estate industry, our tenants, and us, in ways that cannot be reliably predicted. Furthermore, any future changes to U.S. tax laws may negatively impact certain of our tenants’ operating results, financial condition, and future business plans. Such changes to the tax laws may also result in reduced government revenues, and therefore reduced government spending, which may negatively impact some of our tenants that rely on government funding. For example, the Tax Cuts and Jobs Act of 2017 was enacted on December 20, 2017, and significantly revised the U.S. corporate income tax law by, among other things, reducing the corporate income tax rate to 21% for tax years beginning in 2018, imposing additional limitations on the deductibility of interest, changing the utilization of net operating loss carryforwards, allowing for the expensing of certain capital expenditures, and implementing a modified territorial system. We are currently unable to predict whether any future changes will occur and any impact such changes could have on our operating results, financial condition, and future business operations.Actual and anticipated changes to the regulations of the healthcare system may have a negative impact on the pricing of drugs, the cost of healthcare coverage, and the reimbursement of healthcare services and products.The FDA and comparable agencies in other jurisdictions directly regulate many critical activities of life science, technology, and healthcare industries, including the conduct of preclinical and clinical studies, product manufacturing, advertising and promotion, product distribution, adverse event reporting, and product risk management. In both domestic and foreign markets, sales of products depend in part on the availability and amount of reimbursement by third-party payers, including governments and private health plans. Governments may regulate coverage, reimbursement, and pricing of products to control cost or affect utilization of products. Private health plans may also seek to manage cost and utilization by implementing coverage and reimbursement limitations. Substantial uncertainty exists regarding the reimbursement by third-party payers of newly approved healthcare products. The U.S. and foreign governments regularly consider reform measures that affect healthcare coverage and costs. Such reforms may include changes to the coverage and reimbursement of healthcare services and products. In particular, there have been judicial and Congressional challenges to the Patient Protection and Affordable Care Act of 2010, as amended by the Health Care and Education Reconciliation Act (collectively, the “ACA”), which could have an impact on coverage and reimbursement for healthcare terms and services covered by plans authorized by the ACA. During 2017 several attempts were made to amend the ACA; however, no amendment proposal gained the 50-vote support from the U.S. Senate needed to pass a repeal bill. As a result, in October 2017, U.S. President Trump issued an executive order, “Promoting healthcare choice and competition across the United States” (the “Executive Order”). It is expected that the Biden administration will repeal the Executive Order, but it is unknown what other changes the new administration will implement through the U.S. Congress or future executive orders and how these would impact our tenants. Government and other regulatory oversight and future regulatory and government interference with the healthcare systems may adversely impact our tenants’ businesses and our business.29U.S. government tenants may not receive anticipated appropriations, which could hinder their ability to pay us.U.S. government tenants are subject to government funding. If one or more of our U.S. government tenants fail to receive anticipated appropriations, we may not be able to collect rental amounts due to us. A significant reduction in federal government spending, particularly a sudden decrease due to the recent tax reform or to a sequestration process, which has occurred in recent years, could also adversely affect the ability of these tenants to fulfill lease obligations or decrease the likelihood that they will renew their leases with us. In addition, recent budgetary pressures have resulted in, and may continue to result in, reduced allocations to government agencies that fund research and development activities, such as the NIH. For example, the NIH budget has been, and may continue to be, significantly impacted by the sequestration provisions of the Budget Control Act of 2011, which became effective on March 1, 2013. Past proposals to reduce budget deficits have included reduced NIH and other research and development budgets. Any shift away from the funding of research and development or delays surrounding the approval of government budget proposals may cause our tenants to default on rental payments or delay or forgo leasing our rental space, which could adversely affect our business, financial condition, or results of operations. Additionally, the inability of the U.S. Congress to enact a budget for a future fiscal year or the occurrence of partial or complete U.S. federal government shutdowns could adversely impact demand for our services by limiting federal funding available to our tenants and their customers. In addition, defaults under leases with U.S. government tenants are governed by federal statute and not by state eviction or rent deficiency laws. As of December 31, 2020, leases with U.S. government tenants at our properties accounted for approximately 1.2% of our aggregate annual rental revenue in effect as of December 31, 2020.Some of our tenants may be subject to increasing government price controls and other healthcare cost-containment measures.Government healthcare cost-containment measures can significantly affect our tenants’ revenue and profitability. In many countries outside the U.S., government agencies strictly control, directly or indirectly, the prices at which our pharmaceutical industry tenants’ products are sold. In a number of European Union (“EU”) Member States, the pricing and/or reimbursement of prescription pharmaceuticals are subject to governmental control, and legislators, policymakers, and healthcare insurance funds continue to propose and implement cost-containing measures to keep healthcare costs down, due in part to the attention being paid to healthcare cost containment and other austerity measures in the EU. In the U.S., our pharmaceutical industry tenants are subject to substantial pricing pressures from state Medicaid programs, private insurance programs, and pharmacy benefit managers. In addition, many state legislative proposals could further negatively affect pricing and/or reimbursement for our pharmaceutical industry tenants’ products. Also, the pricing environment for pharmaceuticals continues to be in the political spotlight in the U.S. Pharmaceutical and medical device product pricing is subject to enhanced government and public scrutiny and calls for reform. Some states have implemented, and other states are considering, pharmaceutical price controls or patient access constraints under the Medicaid program, and some states are considering price-control regimes that would apply to broader segments of their populations who are not Medicaid eligible. We anticipate that pricing pressures from both governments and private payers inside and outside the U.S. will become more severe over time.Changes in U.S. federal government funding for the FDA, the NIH, and other government agencies could hinder their ability to hire and retain key leadership and other personnel, properly administer drug innovation, or prevent new products and services from being developed or commercialized by our life science industry tenants and venture investment portfolio companies, which could negatively impact our business.The ability of the FDA to review and approve new products can be affected by a variety of factors, including budget and funding levels, the ability to hire and retain key personnel, and statutory, regulatory, and policy changes. Average review times at the agency have fluctuated in recent years as a result. In addition, government funding of the NIH and other government agencies that fund research and development activities is subject to the political process, which is inherently fluid and unpredictable.The ability of the FDA, the NIH, and other government agencies to properly administer their functions is highly dependent on the levels of government funding and the ability to fill key leadership appointments, among various factors. Delays in filling or replacing key positions could significantly impact the ability of the FDA, the NIH, and other agencies to fulfill their functions and could greatly impact healthcare and the drug industry.In December 2016, the 21st Century Cures Act was signed into law. This legislation is designed to advance medical innovation and empower the FDA with the authority to directly hire positions related to drug and device development and review. In the past, the FDA was often unable to offer key leadership candidates (including scientists) competitive compensation packages as compared to those offered by private industry. The 21st Century Cures Act is designed to streamline the agency’s hiring process and enable the FDA to compete for leadership talent by expanding the narrow ranges that are provided in prior compensation structures.However, any future government proposals to reduce or eliminate budgetary deficits may include reduced allocations to the FDA, the NIH, and other related government agencies. These budgetary pressures may result in a reduced ability by the FDA and the NIH to perform their respective roles and may have a related impact on academic institutions and research laboratories whose funding is fully or partially dependent on both the level and the timing of funding from government sources.30In October 2020, U.S. President Trump signed a stopgap spending bill in order to extend government funding until December 11, 2020. This bill provided necessary funding to government agencies until more fulsome appropriations were approved to provide funding for the remainder of the 2021 fiscal year. In December 2020, the U.S. Congress passed additional stopgap bills before finally enacting a budget for the 2021 fiscal year on December 27, 2020. It is unclear whether the U.S. federal government will fail to enact a budget in future fiscal years, and if so, it is possible another partial government shutdown similar to the one that took place from December 22, 2018, to January 25, 2019, may occur. If this occurs, the FDA and certain other science agencies may temporarily shut down select non-essential operations. Also, as was the case in the last government shutdown, the FDA may maintain only operations deemed to be essential public health-related functions and halt the acceptance of new medical product applications and routine regulatory and compliance work for medical products and certain drugs and foods during any shutdown.Disruptions at the FDA and other agencies, such as those resulting from a government shutdown, or uncertainty from stopgap spending bills may slow the time necessary for new drugs and devices to be reviewed and/or approved by necessary government agencies and the healthcare and drug industries’ ability to deliver new products to the market in a timely manner, which would adversely affect our tenants’ operating results and business. Interruptions to the function of the FDA and other government agencies could adversely affect the demand for office/laboratory space and significantly impact our operating results and our business.Changes in laws and regulations that control drug pricing for government programs may adversely impact our operating results and our business.The Centers for Medicare & Medicaid Services (“CMS”) is the federal agency within the U.S. Department of Health and Human Services that administers the Medicare program and works in partnership with state governments to administer Medicaid. The Medicare Modernization Act of 2003 that went into effect on January 1, 2006 (which also made changes to the public Part C Medicare health plan program), explicitly prohibits government entities from directly negotiating drug prices with manufacturers. Recently, there has been significant public outcry against price increases viewed to be unfair and unwarranted.Currently, the outcome of potential reforms and changes to government negotiation/regulation to drug pricing is unknown. Changes in policy that limit prices may reduce the financial incentives for the research and development efforts that lead to discovery and production of new therapies and solutions to life-threatening conditions. Negative impacts of new policies could adversely affect our tenants’ and venture investment portfolio companies’ businesses, including life science, technology, and agtech companies, which may reduce the demand for office/laboratory space and negatively impact our operating results and our business.The provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) may subject us to substantial additional federal regulation and may adversely affect our business, results of operations, cash flows, or financial condition.There are significant corporate governance- and executive compensation-related provisions in the Dodd-Frank Act that required the SEC to adopt additional rules and regulations in these areas. For example, the Dodd-Frank Act requires publicly traded companies to give stockholders a non-binding vote on executive compensation and so-called “golden parachute” payments. Our efforts to comply with these requirements have resulted in, and are likely to continue to result in, an increase in expenses and a diversion of management’s time from other business activities. In addition, provisions of the Dodd-Frank Act that directly affect other participants in the real estate and capital markets, such as banks, investment funds, and interest rate hedge providers, could have indirect, but material, impacts on our business. In 2018, several changes were made to the Dodd-Frank Act, including the repeal of certain provisions that eased restrictions on small and medium-sized banks of the Dodd-Frank Act. It is expected that the Biden administration will reverse a number of U.S. President Trump’s policies, includes those that relate to deregulation, and will increase the number of financial regulators as current vacancies in the bureaucracy are prioritized and filled under the new administration.Many of the provisions of the Dodd-Frank Act have extended implementation periods and delayed effective dates and will require extensive rulemaking by regulatory authorities. Given the uncertainty associated with the Dodd-Frank Act itself and the manner in which its provisions are implemented by various regulatory agencies and through regulations, the full extent of the impact such requirements will have on our future operations is unclear. The provisions of the Dodd-Frank Act may impact the profitability of business activities, require changes to certain business practices, or otherwise adversely affect our business in general. The Dodd-Frank Act, including current and future rules implementing its provisions and the interpretation of those rules, along with other legislative and regulatory proposals directed at the financial or real estate industry or affecting taxation that are proposed or pending in the U.S. Congress, may limit our revenues, impose fees or taxes on us, and/or intensify the regulatory framework within which we operate in ways that are not currently identifiable. The Dodd-Frank Act also has resulted in, and is expected to continue to result in, substantial changes and dislocations in the banking industry and the financial services sector in ways that could have significant effects on, for example, the availability and pricing of unsecured credit, commercial mortgage credit, and derivatives, such as interest rate swaps, which are important aspects of our business. Accordingly, new laws, regulations, and accounting standards, as well as changes to, or new interpretations of, currently accepted accounting practices in the real estate industry, may adversely affect our results of operations.31Global factorsChanges in the method of determining LIBOR, or the replacement of LIBOR with an alternative reference rate, may adversely affect interest expense related to outstanding debt.From time to time, we utilize interest rate hedge agreements to manage a portion of our exposure to variable interest rates. Historically, our interest rate hedge agreements primarily related to our borrowings with variable interest rates based on LIBOR. Beginning in 2008, concerns were raised that some of the member banks surveyed by the BBA in connection with the calculation of daily LIBOR across a range of maturities and currencies may have underreported, overreported, or otherwise manipulated the interbank lending rate applicable to them in order to profit on their derivatives positions or to avoid an appearance of capital insufficiency or adverse reputational or other consequences that might have resulted from reporting interbank lending rates higher than those they actually submitted. A number of BBA member banks have entered into settlements with their regulators and law enforcement agencies with respect to alleged manipulation of LIBOR, and investigations have been instigated by regulators and government authorities in various jurisdictions. Other member banks may also enter into such settlements with, or have proceedings brought by, their regulators or law enforcement agencies in the future. If manipulation of LIBOR occurred, it may have resulted in LIBOR having been artificially lower (or higher) than it would otherwise have been. Any such manipulation could have occurred over a substantial period of time.On September 28, 2012, British regulators published a report on the review of LIBOR. The report concluded that LIBOR should be retained as a benchmark but recommended a comprehensive reform of LIBOR, including replacing the BBA with a new independent administrator of LIBOR. Based on this report, final rules for the regulation and supervision of LIBOR by the Financial Conduct Authority (“FCA”) were published and came into effect on April 2, 2013 (the “FCA Rules”). In particular, the FCA Rules include requirements that (i) an independent LIBOR administrator monitor and survey LIBOR submissions to identify breaches of practice standards and/or potentially manipulative behavior and (ii) firms submitting data to LIBOR establish and maintain a clear conflict-of-interest policy and appropriate systems and controls. In response, ICE Benchmark Administration Limited (“IBA”) was appointed as the independent LIBOR administrator, effective in early 2014. On July 27, 2017, the FCA announced that it would phase out LIBOR as a benchmark by the end of 2021. On November 18, 2020, IBA announced it would consult on its intention to cease the publication of all GBP, EUR, CHF, and JPY LIBOR settings and the one-week and two-month USD LIBOR tenors immediately following the LIBOR publication on December 31, 2021. On November 30, 2020, IBA announced an extension of the LIBOR transition deadline to June 30, 2023, rather than December 31, 2021, for the overnight and one-, three-, six-, and twelve-month USD LIBOR. These decisions are subject to consultation, and announcements of the official cessation of any LIBOR settings will be made separately.In addition, in November 2014, the U.S. Federal Reserve established a working group composed of large U.S. financial institutions, the Alternative Reference Rates Committee (“ARRC”), to identify a set of alternative interest reference rates to LIBOR. In a May 2016 interim report, the ARRC narrowed its choice to two LIBOR alternatives. The first choice was the Overnight Bank Funding Rate (“OBFR”), which consists of domestic and foreign unsecured borrowing in U.S. dollars. The U.S. Federal Reserve has been calculating and publishing the OBFR since March 2016. The second alternative rate to LIBOR was the Treasury General Collateral Rate, which is composed of repo transactions secured by treasuries or other assets accepted as collateral by the majority of intermediaries in the repo market.In June 2017, the ARRC selected the Secured Overnight Financing Rate (“SOFR”), a new index calculated by reference to short-term repurchase agreements backed by U.S. Treasury securities, as its preferred replacement for U.S. dollar LIBOR. SOFR is observed and backward looking, which stands in contrast to LIBOR under the current methodology, which is an estimated forward-looking rate and relies, to some degree, on the expert judgment of submitting panel members. Given that SOFR is a secured rate backed by government securities, it does not take into account bank credit risk (as is the case with LIBOR). SOFR is therefore likely to be lower than LIBOR and is less likely to correlate with the funding costs of financial institutions. The first publication of SOFR was released by the Federal Reserve Bank of New York in April 2018. In April 2019, the ARRC published its recommendations on fallback language for syndicated loans, which the ARRC encourages companies to use in new contracts that reference LIBOR in order to minimize market disruptions when LIBOR ceases to exist. The ARRC suggested two alternative fallback language approaches for syndicated loan contracts:•“Hardwired Approach,” which clearly specifies the SOFR-based successor rate and spread adjustment to be used when LIBOR ceases to exist.•“Amendment Approach,” which, unlike the Hardwired Approach, does not reference specific rates or spread adjustments but provides a streamlined amendment approach for negotiating a benchmark replacement and introduces clarity with respect to the fallback trigger events and an adjustment to be applied to the successor rate.In November 2020, the ARRC published best practice recommendations that new LIBOR cash products should have robust fallback language as soon as possible and new use of LIBOR should cease altogether. 32Since 2012, we have been closely monitoring developments related to the transition away from LIBOR and have implemented numerous proactive measures to minimize the potential impact of the transition to the Company, specifically:•We have proactively reduced outstanding LIBOR-based borrowings under our unsecured senior bank term loans and secured construction loans through repayments. From January 2017 to December 2020, we retired approximately $1.5 billion of such debt. •We continue to prudently manage outstanding borrowings under our unsecured senior line of credit, our only LIBOR-based debt (excluding $12.7 million LIBOR-based debt held by one of our unconsolidated joint ventures as of December 31, 2020). As of December 31, 2020, we had no borrowings outstanding under our unsecured senior line of credit. •Our unsecured senior line of credit contains fallback language generally consistent with the ARRC’s Amendment Approach, which provides a streamlined amendment approach for negotiating a benchmark replacement and introduces clarity with respect to the fallback trigger events and an adjustment to be applied to the successor rate.•We continue to monitor developments by the ARRC and other governing bodies involved in LIBOR transition.We continue to be proactive in managing the risk of disruption associated with the cessation of LIBOR; however, it is not possible to predict the effect of the FCA Rules, any changes in the methods pursuant to which LIBOR is determined, the administration of LIBOR by IBA, and any other reforms to LIBOR that will be enacted in the United Kingdom and elsewhere. In addition, any changes announced by the FCA, the BBA, IBA, the ARRC, or any other successor governance or oversight body, or future changes adopted by such body, in the method pursuant to which LIBOR is determined, as well as manipulative practices or the cessation thereof, may result in a sudden or prolonged increase or decrease in reported LIBOR, which could have an adverse impact on the level of the index. Fluctuation or discontinuation of LIBOR would affect our interest expense and earnings and the fair value of certain of our financial instruments. We also have certain joint ventures that may require variable-rate construction loans with interest based upon LIBOR plus a spread. From time to time, we utilize interest rate hedge agreements to mitigate our exposure to such interest rate risk on a portion of our debt obligations. However, there is no assurance these arrangements will be effective in reducing our exposure to changes ininterest rates.It is unclear whether new methods of calculating LIBOR will be established such that it continues to exist after 2021. When LIBOR ceases to exist, we may need to amend the credit and loan agreements with our lenders that utilize LIBOR as a factor in determining the interest rate based on a new standard that is established, if any. The transition to an alternative rate will require careful and deliberate consideration and implementation so as to not disrupt the stability of financial markets. There is no guarantee that a transition from LIBOR to an alternative will not result in financial market disruptions, significant increases in benchmark rates, or borrowing costs to borrowers, any of which could have an adverse effect on our business, results of operations, financial condition, and stock price.The transition to SOFR may present challenges, including, but not limited to, the illiquidity of SOFR derivatives markets, which could make it difficult for financial institutions to offer SOFR-based debt products, the determination of the spread adjustment required to convert LIBOR to SOFR (and the related determination of a term structure with different maturities), and the greater volatility of SOFR compared to that of LIBOR. Although daily pricing resets for SOFR have been noted to be more volatile than that of LIBOR, especially at month end, there is no sufficient evidence to establish how SOFR volatility compares to that of LIBOR. Whether or not SOFR attains market acceptance as a LIBOR replacement tool remains in question. As such, the future of LIBOR and potential alternatives at this time remains uncertain.The current outbreak of the novel coronavirus disease, or COVID-19, or the future outbreak of any other highly infectious or contagious diseases, could adversely impact or cause disruption to our financial condition and results of operations. Further, the spread of COVID-19 has caused severe disruptions in the U.S. and global economies, may further disrupt financial markets, and could create widespread business continuity issues.In recent years, the outbreaks of a number of diseases, including avian influenza, H1N1, and various other “superbugs,” have increased the risk of a pandemic. In December 2019, COVID-19 was reported to have surfaced in Wuhan, China. COVID-19 has since spread around the globe, including the U.S. COVID-19 has been reported in every state in the U.S., including those where we own and operate our properties, have executive offices, and conduct principal operations. On March 11, 2020, the World Health Organization declared COVID-19 a pandemic, and on March 13, 2020, the U.S. declared a national emergency with respect to COVID-19.The potential impact and duration of the COVID-19 pandemic has had, and continues to have, a significant adverse impact across regional and global economies and financial markets. The global impact of the outbreak has been rapidly evolving and as new cases of the virus have continued, particularly in the U.S., countries around the world and states around the U.S., have reacted by instituting quarantines and restrictions on travel.33Almost every state implemented some form of shelter-in-place or stay-at-home directive between March and May 2020, including, among others, the cities of Boston, San Francisco (including five other San Francisco Bay Area counties), and Seattle, and the states of California, Maryland, Massachusetts, and New York, where we own properties. The lockdown restrictions implemented included quarantines, restrictions on travel, shelter-in-place orders, school closures, restrictions on types of business that may continue to operate, and/or restrictions on types of construction projects that could continue. These quarantines generally came with exceptions for essential healthcare/public health operations; health manufacturing; clinical research, development, and testing for COVID-19; research and laboratory activities; essential manufacturing for pharmaceuticals, vaccines, testing materials, laboratory supplies, medical equipment, instruments; and safety products; essential retail, including pharmacies; essential building services, such as cleaning and maintenance; skilled trades, such as plumbers and electricians; and certain essential construction projects. Beginning in early May 2020, parts of the U.S. began to ease the lockdown restrictions and allow for the reopening of businesses. The gradual reopening of retail, manufacturing, and office facilities came with required or recommended safety protocols. Due to the increase in the number of COVID-19 cases subsequent to the reopening, in November 2020, parts of the U.S. have implemented additional stay-at-home and lockdown restrictions. Additionally, in recent months, new COVID-19 variants were discovered in the United Kingdom (“U.K.”), among other countries, which have spread globally, including the U.S. While these strains do not appear to cause more severe symptoms in individuals, they have spread faster and more easily upon contact. As a result, more stringent lockdown restrictions have been implemented in regions globally and within the U.S. It is unknown when easing of these lockdowns and another reopening will occur even as COVID-19 vaccines become available across the U.S. via Emergency Use Authorization (“EUA”) by the FDA. There is no assurance that the reopening of businesses, even if those businesses adhere to recommended safety protocols, will enable us or many of our tenants to avoid adverse effects on our and our tenants’ operations and businesses.As of the date of this report, all our ground-up development projects undergoing construction have resumed construction. New lockdowns instituted by local and state governments may cause our construction projects to have to pause, causing delays on our expected future deliveries. Construction workers are also practicing social distancing and following rules that restrict gathering of large groups of people in close proximity, as well as other appropriate practices, that may slow the pace of construction.Although critical research and development efforts are continuing in our office/laboratory properties, in certain cases such research and development efforts have fewer workers, and non-critical workers in these buildings and most office buildings are working remotely. When appropriate, certain spaces have been and may continue to be subject to temporary closure for quarantine and proper disinfecting. Our properties and tenant base include a small amount of restaurant, conference center, fitness centers, and retail space, which accounts for approximately 0.5% of our annual rental revenues as of December 31, 2020. Retail tenants in particular continue to be severely impacted by stay-at-home and lockdown restrictions and social distancing protocols that remain in place across all of the markets where our properties are located. The COVID-19 outbreak has already had a significant adverse impact on the economies of the world, including that of the U.S., and this pandemic, and future pandemics, could trigger a period of prolonged global economic slowdown or recession.The effects of COVID-19 or another pandemic on our (or our tenants’) ability to successfully operate could be adversely impacted due to, among other factors:•The continued service and availability of personnel, including our executive officers and other leaders that are part of our management team, and our ability to recruit, attract, and retain skilled personnel. To the extent our management or personnel are impacted in significant numbers by the outbreak of pandemic or epidemic disease and are not available or allowed to conduct work, our business and operating results may be negatively impacted;•Our (or our tenants’) ability to operate, generally or in affected areas, or delays in the supply of products or services from our vendors that are necessary for us to operate effectively;•Our tenants’ ability to pay rent on their leases in full and timely and, to the extent necessary, our inability to restructure our tenants’ long-term rent obligations on terms favorable to us or to timely recapture the space for re-leasing (refer to the risk factor on the next page within this Item 1A of this annual report on Form 10-K); •Difficulty in our accessing debt and equity capital on attractive terms, or at all, and a severe disruption and instability in the global financial markets, or deterioration in credit and financing conditions, which may affect our (or our tenants’) ability to access capital necessary to fund business operations or replace or renew maturing liabilities on a timely basis and may adversely affect the valuation of financial assets and liabilities, any of which could affect our (or our tenants’) ability to meet liquidity and capital expenditure requirements or could have a material adverse effect on our business, financial condition, results of operations, and cash flows;•Complete or partial closures of, or other operational issues at, one or more of our offices or properties resulting from government action or directives;•Our (or our tenants’) ability to continue or complete construction as planned for our tenants’ operations, or delays in the supply of materials or labor necessary for construction, which may affect our (or our tenants’) ability to complete construction or to complete it timely, our ability to prevent a lease termination, and our ability to collect rent, which may have a material adverse effect on our business, financial condition, results of operations, and cash flows;•The cost of implementing precautionary measures against COVID-19, including, but not limited to, potential additional health insurance and labor-related costs;34•Governmental efforts (such as moratoriums on or suspensions of eviction proceedings) that may affect our ability to collect rent or enforce remedies for the failure of our tenants to pay rent;•Uncertainty related to whether the U.S. Congress or state legislatures will pass additional laws providing for additional economic stimulus packages, governmental funding, or other relief programs, whether such measures will be enacted, whether our tenants will be eligible or will apply for any such funds, whether the funds, if available, could be used by our tenants to pay rent, and whether such funds will be sufficient to supplement our tenants’ rent and other obligations to us;•Deterioration of global economic conditions and job losses, which may decrease demand for and occupancy levels of our rental properties and may cause our rental rates and property values to be negatively impacted;•Our dependence on short-term and long-term debt sources, including our unsecured senior line of credit, commercial paper program, and senior notes, which may affect our ability to continue our investing activities and make distributions to our stockholders;•Declines in the valuation of our properties, which may affect our ability to dispose of assets at attractive prices or to obtain debt financing secured by our properties and may reduce the availability of debt funding;•Declines in the valuation of our venture investment portfolio, which may (i) impede our ability to realize the value at which these investments are carried if we are required to dispose of them, (ii) make it difficult for us to sell these investments on a timely basis, and (iii) impair the value of such investments;•Refusal or failure by one or more of our lenders under our credit facility to fund their financing commitment to us, which we may not be able to replace on favorable terms, or at all;•To the extent we enter into derivative financial instruments, one or more counterparties to our derivative financial instruments could default on their obligations to us or could fail, increasing the risk that we may not realize the benefits of utilizing these instruments;•Any possession taken of our properties, in whole or in part, by governmental authorities for public purposes in eminent domain proceedings;•Our level of insurance coverage and recovery we receive under any insurance we maintain, which may be delayed by, or insufficient to fully offset potential/actual losses caused by, COVID-19;•Any increase in insurance premiums and imposition of large deductibles;•Our level of dependence on the Internet, as it relates to employees’ working remotely, and increases in malware campaigns and phishing attacks preying on the uncertainties surrounding COVID-19, which may increase our vulnerability to cyber attacks;•Our ability to ensure business continuity in the event our continuity of operations plan is not effective or is improperly implemented or deployed during a disruption; and•Our ability to operate, which may cause our business and operating results to decline or may impact our ability to comply with regulatory obligations and may lead to reputational harm and regulatory issues or fines.While the rapid development and fluidity of the COVID-19 pandemic precludes any prediction as to the ultimate adverse impact of COVID-19, the spread of COVID-19 has resulted in, and may continue to result in, significant disruption of the global financial market and an increase in unemployment in the U.S. Although the FDA has approved certain therapies and two vaccines for emergency use and distribution to certain groups of individuals as of the date of this report, (i) the initial rollout of vaccine distributionhas encountered significant delays, and (ii) there remain uncertainties as to the amount of vaccine available for distribution, the logistics of implementing a national vaccine program, and the overall efficacy of the vaccines once widely administered, especially asnew strains of COVID-19 have been discovered, and the level of resistance these new strains have to the existing vaccines, if any,remains unknown. Until such therapies and vaccines are widely available and effective, the pandemic and public and private responses to the pandemic may lead to deterioration of economic conditions, an economic downturn, and/or a recession, at a global scale, which could materially affect our (or our tenants’) performance, financial condition, results of operations, and cash flows. The current outbreak of the novel coronavirus disease, or COVID-19, or the future outbreak of any other highly infectious or contagious diseases, could adversely impact or cause disruption to our tenants’ financial condition and results of operations, which may adversely impact our ability to generate income sufficient to meet operating expenses or generate income and capital appreciation. Our tenants, many of which conduct business in the life science, technology, or agtech industries, may incur significant costs or losses responding to the outbreak of a contagious disease (such as COVID-19), lose business due to interruption in their operations, or incur other liabilities related to shelter-in-place orders, quarantines, infection, or other related factors. Tenants that experience deteriorating financial conditions as a result of the outbreak of a contagious disease, or the COVID-19 pandemic, may be unwilling or unable to pay rent in full or timely due to bankruptcy, lack of liquidity, lack of funding, operational failures, or other reasons. Our tenants’ defaults and delayed or partial rental payments could adversely impact our rental revenues and operating results. The negative effects of an outbreak of a contagious disease on our tenants in the life science industry may include, but are not limited to:•Delays or difficulties in enrolling patients or maintaining scheduled study visits in clinical trials;•Delays or difficulties in clinical site initiation, including difficulties in recruiting clinical site investigators and clinical site staff;35•Diversion of healthcare resources away from clinical trials, including the diversion of hospitals serving as our tenants’ clinical trial sites and hospital staff supporting the conduct of our tenants’ clinical trials;•Interruptions of key clinical trial or other research activities, such as clinical trial site monitoring, due to limitations on travel imposed or recommended by federal or state governments, employers, and others;•Limitations in employee resources that would otherwise be focused on our tenants’ research, business, or clinical trials, including because of sickness of employees or their families, the desire of employees to avoid contact with large groups of people, or as a result of the governmental imposition of shelter-in-place or similar working restrictions;•Interruptions in supply chain, manufacturing, and global shipping, or other delays that may affect the transport of materials necessary for our tenants’ research, clinical trials, or manufacturing activities;•Reduction in revenue projections for our tenants’ products due to the prioritization of the treatment of COVID-19 patients over other treatments, such as specialty and elective procedures and non-COVID-19 diagnostics;•Delays in necessary interactions with ethics committees, regulators, and other important agencies and contractors due to limitations in employee resources or forced furlough of government employees; •Delays in receiving approval from regulatory authorities to initiate planned clinical trials or research activities;•Delays in commercialization of our tenants’ products and approval by governmental authorities (such as the FDA and the federal and state Emergency Management Agencies) of our tenants’ products caused by disruptions, funding shortages, or health concerns, as well as by the prioritization by the FDA of the review and approvals of diagnostics, therapeutics, and vaccines that are related to COVID-19;•Difficulty in retaining staff or rehiring staff in connection with layoffs caused by deteriorating global market conditions; •Changes in local regulations as part of a response to the COVID-19 outbreak that may require our tenants to change the ways in which their clinical trials are conducted, which may result in unexpected costs or the discontinuation of the clinical trials altogether;•Refusal or reluctance of the FDA to accept data from clinical trials in affected geographies outside the U.S.; •Diminishing public trust in healthcare facilities or other facilities, such as medical office buildings, that are treating (or have treated) patients affected by contagious diseases; and •Inability to access capital on terms favorable to our tenants because of changes in company valuation and/or investor appetite due to a general downturn in economic and financial conditions and the volatility of the market.The negative effects of an outbreak of a contagious disease on our tenants in the technology industry may include, but are not limited to:•Reduction in staff productivity due to business closures, alternative working arrangements, or illness of staff and/or illness in the family;•Reduction in sales of our tenants’ services and products, longer sales cycles, reduction in subscription duration and value, slower adoption of new technologies, and increase in price competition due to economic uncertainties and downturns;•Disruptions to our tenants’ supply chain, manufacturing vendors, or logistics providers to deliver products or perform services;•Limitations on business and marketing activities due to travel restrictions and virtualization, or cancellation of customer and employee events; •Adverse impact on customer relationships and our ability to recognize revenues due to our tenants’ inability to access their clients’ sites for implementation and on-site consulting services;•Inability to recruit and develop highly skilled employees with appropriate qualifications, to conduct background checks on potential employees, and to provide necessary equipment and training to new and existing employees; •Network infrastructure and technology system failures of our tenants, or of third-party services used by our tenants, which may result in system interruptions, reputational harm, loss of intellectual property, delays in product development, lengthy interruptions in services, breaches of data security, and loss of critical data;•Higher employment compensation costs that may not be offset by improved productivity or increased sales; and •Inability to access capital on terms favorable to our tenants because of changes in company valuation and/or investor appetite due to a general downturn in of economic and financial conditions and the volatility of the market.The negative effects of an outbreak of a contagious disease on our tenants in the agtech industry may include, but are not limited to:•Reduction in productive capacity and profitability because of decreased labor availability due, for example, to government restrictions, the inability of employees to report to work, or collective bargaining efforts; •Potential contract cancellations, project reductions, and reduction in demand for our tenants’ products due to the adverse effect on business confidence and consumer sentiments and the general downturn in economic conditions;•Disruption of the logistics necessary to import, export, and deliver products to target companies and their customers, as ports and other channels of entry may be closed or may operate at only a portion of capacity;•Disruptions to manufacturing facilities and supply lines; and •Inability to access capital on terms favorable to our tenants because of changes in company valuation and/or investor appetite due to a general downturn in economic and financial conditions and the volatility of the market.36The potential impact of a pandemic or outbreak of a contagious disease with respect to our tenants or our properties is difficult to predict and could have a material adverse impact on our tenants’ operations and, in turn, on our revenues, business, and results of operations, as well as the value of our stock. The COVID-19 pandemic, or other pandemics, may directly or indirectly cause the realization of any of the other risk factors included in this annual report on Form 10-K.Other factorsWe may incur significant costs if we fail to comply with laws or if laws change.Our properties are subject to many federal, state, and local regulatory requirements and to state and local fire, life-safety, and other requirements. If we do not comply with all of these requirements, we may have to pay fines to government authorities or damage awards to private litigants. We do not know whether these requirements will change or whether new requirements will be imposed. Changes in these regulatory requirements could require us to make significant unanticipated expenditures. These expenditures could have an adverse effect on us and our ability to make distributions to our stockholders.For example, the California Safe Drinking Water and Toxic Enforcement Act, also referred to as Proposition 65, requires “clear and reasonable” warnings be given to persons who are exposed to chemicals known to the State of California to cause cancer or reproductive toxicity. We believe that we comply with Proposition 65 requirements; however, there can be no assurance that we will not be adversely affected by litigation or regulatory enforcement relating to Proposition 65. In addition, there can be no assurance that the costs of compliance with new environmental laws and regulations will not be significant or will not adversely affect our ability to meet our financial expectations, our financial condition, results of operations, and cash flows.We may incur significant costs in complying with the Americans with Disabilities Act and similar laws.Under the ADA, places of public accommodation and/or commercial facilities must meet federal requirements related to access and use by disabled persons. We may be required to make substantial capital expenditures at our properties to comply with this law. In addition, non-compliance could result in the imposition of fines or an award of damages to private litigants.A number of additional federal, state, and local laws and regulations exist regarding access by disabled persons. These regulations may require modifications to our properties or may affect future renovations. These expenditures may have an adverse impact on overall returns on our investments.We face possible risks and costs associated with the effects of climate change and severe weather.We cannot predict the rate at which climate change will progress. However, the physical effects of climate change could have a material adverse effect on our properties, operations, and business. For example, most of our properties are located along the east and west coasts of the U.S. To the extent that climate change impacts changes in weather patterns, our markets could experience severe weather, including hurricanes, severe winter storms, and coastal flooding due to increases in storm intensity and rising sea levels. Over time, these conditions could result in declining demand for space at our properties, delays in construction, resulting in increased construction costs, or in our inability to operate the buildings at all. Climate change and severe weather may also have indirect effects on our business by increasing the cost of, or decreasing the availability of, property insurance on terms we find acceptable, by increasing the costs of energy, maintenance, repair of water and/or wind damage, and snow removal at our properties.Although Congress has not yet enacted comprehensive federal legislation to address climate change, numerous states and municipalities have adopted laws and policies on climate change and emission reduction targets. For example, in July 2019, the Climate Leadership and Community Protection Act was signed into law in New York, establishing a statewide framework to reduce net greenhouse gas emissions to zero by 2050. Also, in May 2019, New York City enacted the Climate Mobilization Act aimed at reducing greenhouse gas emissions and will apply to commercial and residential buildings. In September 2018, SB 100 was signed into law in California, accelerating the state’s renewable portfolio standard target dates and setting a policy of meeting 100% of retail sales from eligible renewables and zero-carbon resources by December 31, 2045. Changes in federal, state, and local legislation and regulation based on concerns about climate change could result in increased capital expenditures on our existing properties and our new development properties (for example, to improve their energy efficiency and/or resistance to severe weather) without a corresponding increase in revenue, which may result in adverse impacts to our net income.There can be no assurance that climate change and severe weather will not have a material adverse effect on our properties, operations, or business.37We may incur significant costs in complying with environmental laws.Federal, state, and local environmental laws and regulations may require us, as a current or prior owner or operator of real estate, to investigate and remediate hazardous or toxic substances or petroleum products released at or from any of our properties. The cost of investigating and remediating contamination could be substantial and could exceed the amount of any insurance coverage available to us. In addition, the presence of contamination, or the failure to properly remediate, may adversely affect our ability to lease or sell an affected property, or to borrow funds using that property as collateral.Under environmental laws and regulations, we may have to pay government entities or third parties for property damage and for investigation and remediation costs incurred by those parties relating to contaminated properties regardless of whether we knew of or caused the contamination. Even if more than one party was responsible for the contamination, we may be held responsible for all of the remediation costs. In addition, third parties may sue us for damages and costs resulting from environmental contamination, or jointly responsible parties may contest their responsibility or be financially unable to pay their share of such costs.Environmental laws also govern the presence, maintenance, and removal of asbestos-containing building materials. These laws may impose fines and penalties on us for the release of asbestos-containing building materials and may allow third parties to seek recovery from us for personal injury from exposure to asbestos fibers. We have detected asbestos-containing building materials at some of our properties, but we do not expect that they will result in material environmental costs or liabilities for us.Environmental laws and regulations also require the removal or upgrading of certain underground storage tanks and regulate:•The discharge of stormwater, wastewater, and any water pollutants;•The emission of air pollutants;•The generation, management, and disposal of hazardous or toxic chemicals, substances, or wastes; and•Workplace health and safety.Many of our tenants routinely handle hazardous substances and wastes as part of their operations at our properties. Environmental laws and regulations subject our tenants, and potentially us, to liability resulting from these activities. Environmental liabilities could also affect a tenant’s ability to make rental payments to us. We require our tenants to comply with these environmental laws and regulations and to indemnify us against any related liabilities.Independent environmental consultants have conducted Phase I or similar environmental assessments at our properties. We intend to use consultants to conduct similar environmental assessments on our future acquisitions. This type of assessment generally includes a site inspection, interviews, and a public records review, but no subsurface sampling. These assessments and certain additional investigations of our properties have not to date revealed any environmental liability that we believe would have a material adverse effect on our business, assets, or results of operations.Additional investigations have included, as appropriate:•Asbestos surveys;•Radon surveys;•Lead-based paint surveys;•Mold surveys;•Additional public records review;•Subsurface sampling; and•Other testing.Nevertheless, it is possible that the assessments on our current properties have not revealed, and that assessments on future acquisitions will not reveal, all environmental liabilities. Consequently, there may be material environmental liabilities of which we are unaware that may result in substantial costs to us or our tenants and that could have a material adverse effect on our business.Environmental, health, or safety matters are subject to evolving regulatory requirements. Costs and capital expenditures relating to the evolving requirements depend on the timing of the promulgation and enforcement of new standards. As discussed in the immediately preceding risk factor, due to concern over the risks of climate change, a more restrictive regulatory framework to reduce greenhouse gas pollution might be implemented, including the adoption of carbon taxes, restrictive permitting, and increased efficiency standards. These requirements could make our operations more expensive and lengthen our project times. The costs of complying with evolving regulatory requirements, including greenhouse gas regulations and policies, could negatively impact our financial results. Moreover, changes in environmental regulations could inhibit or interrupt our operations, or require modifications to our facilities. Accordingly, environmental, health, or safety regulatory matters could result in significant unanticipated costs or liabilities and could have a material adverse effect on our business, financial condition, results of operations, and cash flows, and the market price of our common stock. 38We may be unable to meet our sustainability goals.We seek to make a positive and meaningful impact on the health, safety, and well-being of our tenants, stockholders, employees, and the communities in which we live and work. In support of these efforts, we set specific sustainability goals to reduce the environmental impact of buildings in operation and for new ground-up construction projects. There are significant risks that may prevent us from achieving these goals, including, but not limited to, the following possibilities:•Change in market conditions may affect our ability to deploy capital for projects that reduce energy consumption, greenhouse gas pollution, and potable water consumption and that provide waste savings.•Our tenants may be unwilling or unable to accept potential incremental expenses associated with our sustainability programs, including expenses to comply with requirements stipulated under building certification standards such as LEED, WELL, and Fitwel.The realization of any of the above risks could significantly impact our reputation, our ability to continue developing properties in markets where high levels of LEED certification contribute to our efforts to obtain building permits and entitlements, and our ability to attract tenants who include LEED certification among their priorities when selecting a location to lease.We may invest or spend the net proceeds from the offering of our unsecured senior notes payable due in January 2024 and April 2026 in ways investors may not agree with and in ways that may not earn a profit.The net proceeds from the offering of our unsecured senior notes payable due in January 2024 and our unsecured senior notes payable due in April 2026 (collectively the “Green Bonds”) will be used to fund, in whole or in part, Eligible Green Projects (as defined below), including the development and redevelopment of such projects. The net proceeds from these offerings were initially used to reduce the outstanding balance on our unsecured senior line of credit. We then allocated the funds to recently completed and future Eligible Green Projects.There can be no assurance that the projects funded with the proceeds from the Green Bonds will meet investor criteria and expectations regarding environmental impact and sustainability performance. In particular, no assurance is given that the use of such proceeds for any Eligible Green Projects will satisfy, whether in whole or in part, any present or future investor expectations or requirements regarding any investment criteria or guidelines with which such investor or its investments are required to comply, whether by any present or future applicable law or regulations or by its own bylaws or other governing rules or investment portfolio mandates (in particular with regard to any direct or indirect environmental, sustainability, or social impact of any projects or uses, the subject of or related to, the relevant Eligible Green Projects). Adverse environmental or social impacts may occur during the design, construction, and operation of the projects, or the projects may become controversial or criticized by activist groups or other stakeholders. In addition, although we will limit the use of proceeds from the Green Bonds to Eligible Green Projects, there can be no assurance that one or more development, redevelopment, and tenant improvement projects that we expect will receive a LEED certification will actually receive such certification. Furthermore, from time to time, we may refinance our debt to take advantage of lower market rates or other favorable terms, and we might pursue this strategy in the future in connection with our Green Bonds. If the terms of the refinanced agreements set different or no restrictions on the range of purposes the funds can be allocated to, we can provide no assurance that allocations to future Eligible Green Projects established prior to the refinancing of our Green Bonds will remain unchanged after the refinancing has been completed. ‘‘Eligible Green Projects’’ are defined as:•New class A development properties that have received or are expected to receive Gold or Platinum LEED certification;•Existing class A redevelopment properties that have received or are expected to receive Gold or Platinum LEED certification; and•Tenant improvements that have received or are expected to receive Gold or Platinum LEED certification.Eligible Green Projects include projects with disbursements made in the three years preceding the applicable issue date of the Green Bonds. We intend to spend the remaining net proceeds from the sale of the Green Bonds within two years following the applicable issue date of the Green Bonds. LEED is a voluntary, third party building certification process developed by the U.S. Green Building Council (‘‘USGBC’’), a non-profit organization. The USGBC developed the LEED certification process to (i) evaluate the environmental performance from a whole-building perspective over a building’s life cycle, (ii) provide a definitive standard for what constitutes a ‘‘green building,’’ (iii) enhance environmental awareness among architects and building contractors, and (iv) encourage the design and construction of energy-efficient, water-conserving buildings that use sustainable or green resources and materials.39Changes in U.S. accounting standards may adversely impact us.The regulatory boards and government agencies that determine financial accounting standards and disclosures in the U.S., which include the FASB and the IASB (collectively, the “Boards”) and the SEC, continually change and update the financial accounting standards we must follow. From time to time, the Boards issue ASUs that could have a material effect on our financial condition or results of operations, which in turn could also significantly impact the market price of our common stock. Such potential impacts include, without limitation, significant changes to our balance sheet, significant changes to the timing or methodology of revenue or expense recognition, or significant fluctuations in our reported results of operations, including an increase in our operating expenses or general and administrative expenses related to payroll costs, legal costs, and other out-of-pocket costs incurred in order to comply with the requirements of these ASUs.Furthermore, in January 2018, we adopted an ASU that amended the accounting for certain equity investments. The core principle of the ASU involves the measurement of equity investments at fair value and the recognition of changes in fair value of those investments during each reporting period in net income. Since adoption, this ASU increased the volatility of our earnings, and is expected to continue introducing volatility to our results of operations, as a result of the guidance requiring us to immediately recognize in net income (i) unrealized gains and losses on our equity investments and (ii) impairments deemed not to be other than temporary under the previous guidance. The increased volatility of our earnings could adversely affect investors’ and analysts’ ability to form reliable expectations of our future performance, which could negatively impact analysts’ “buy,” “sell,” or “hold” recommendations for our common stock. Therefore, our share price could be negatively affected by causes beyond our control. Any difficulties in the implementation of changes in accounting principles, including the ability to modify our accounting systems and to update our policies, procedures, information systems, and internal controls over financial reporting, could result in materially inaccurate financial statements, which in turn could harm our operating results or cause us to fail to meet our reporting obligations. Significant changes in new ASUs could cause fluctuations in revenue and expense recognition and materially affect our results of operations. We may also experience an increase in general and administrative expenses resulting from additional resources required for the initial implementation of such ASUs. This could adversely affect our reported results of operations, profitability, and financial statements. Additionally, the adoption of new accounting standards could also affect the calculation of our debt covenants. It cannot be assured that we will be able to work with our lenders to successfully amend our debt covenants in response to changes in accounting standards.Security incidents through cyber attacks, cyber intrusions, or other methods could disrupt our information technology networks and related systems, cause a loss of assets or loss of data, give rise to remediation or other expenses, expose us to liability under federal and state laws, and subject us to litigation and investigations, which could result in substantial reputational damage and materially and adversely affect our business, financial condition, results of operations, and cash flows, and the market price of our common stock.Information technology, communication networks, and related systems are essential to the operation of our business. We use these systems to manage our tenant and vendor relationships, internal communications, accounting and record-keeping systems, and many other key aspects of our business. Our operations rely on the secure processing, storage, and transmission of confidential and other information in our computer systems and networks, which also depend on the strength of our procedures and the effectiveness of our internal controls. A security incident may occur through physical break-ins, breaches of our secure network by an unauthorized party, software vulnerabilities, malware, computer viruses, attachments to emails, employee theft or misuse, social engineering, or inadequate use of security controls. Outside parties may attempt to fraudulently induce our employees to disclose sensitive information or transfer funds via illegal electronic spamming, phishing, spoofing, or other tactics. Additionally, cyber attackers can develop and deploy malware, credential theft or guessing tools, and other malicious software programs to gain access to sensitive data or fraudulently obtain assets we hold.We have implemented security measures to safeguard our systems and data and to manage cybersecurity risk. We monitor and develop our information technology networks and infrastructure, and invest in the development and enhancement of our controls designed to prevent, detect, respond, and mitigate the risk of unauthorized access, misuse, computer viruses, and other events that could have a security impact. We conduct periodic security awareness trainings of our employees to educate them on how to identify and alert management to phishing emails, spoofed or manipulated electronic communications, and other critical security threats. We have implemented monthly phishing tests using a variety of scenarios, including those obtained from phishing samples and intelligence sources. Additionally, we have an internal team and external partners with well-defined processes devoted to responding to threats, including reports of phishing, in real time. We have implemented internal controls around our treasury function, including enhanced payment authorization procedures, verification requirements for new vendor setup and vendor information changes, and bolstered outgoing payment notification process and account reconciliation procedures.40There can be no assurance that our actions, security measures, and controls designed to prevent, detect, or respond to intrusion; to limit access to data; to prevent loss, destruction, alteration, or exfiltration of business information; or to limit the negative impact from such attacks can provide absolute security against a security incident. A significant security incident involving our information systems or those of our tenants, vendors, software creators, cloud providers, cybersecurity service providers, or other third parties with whom we do business could lead to, among other things, the following:•Theft of our cash, cash equivalents, or other liquid assets, including publicly traded securities;•Interruption in the operation of our systems, which may result in operational inefficiencies and a loss of profits;•Unauthorized access to, and destruction, loss, theft, misappropriation, or release of, proprietary, confidential, sensitive, or otherwise valuable information of ours or our tenants, and other business partners, which could be used to compete against us or for disruptive, destructive, or otherwise harmful purposes and outcomes;•Inability to produce financial and operational data necessary to comply with rules and regulations from the SEC, the IRS, or other state and federal regulatory agencies;•Our inability to properly monitor our compliance with the rules and regulations regarding our qualification as a REIT;•Significant management attention and resources required to remedy any damages that result;•Significant exposure to litigation and regulatory fines, penalties, or other sanctions; •Violation of our lease agreements or other agreements; •Damage to our reputation among our tenants, business partners, and investors;•Loss of business opportunities;•Difficulties in employee retention and recruitment; and•Unauthorized access to, and destruction, loss, or denial of service to, the computing systems that manage our buildings.A principal reason that we cannot provide absolute protection from security incidents is that it may not always be possible to anticipate, detect, or recognize threats to our systems, or to implement effective preventive measures against all security incidents due to, among other things, the frequent change in techniques used in cyber attacks, which may not be recognized until launched, and the wide variety of sources from which a cyber attack can originate. We may not be able to immediately address the consequences of a security incident due to a cyber attack. A successful breach of our computer systems, software, networks, or other technology assets due to a cyber attack could occur and persist for an extended period of time before being detected due to, among other things:•The breadth of our operations and the high volume of transactions that our systems process;•The large number of our business partners; and•The proliferation and increasing sophistication of cyber attacks.The extent of a particular cyber attack and the steps that we may need to take to investigate the attack may not be immediately clear. Therefore, in the event of an attack, it may take a significant amount of time before such an investigation can be completed. During an investigation, we may not necessarily know the extent of the damage incurred or how best to remediate it, and certain errors or actions could be repeated or compounded before they are discovered and remediated, which could further increase the costs and consequences of a cyber attack.Even if we are not targeted directly, cyber attacks on the U.S. government, financial markets, financial institutions, or other businesses, including our tenants, vendors, software creators, cloud providers, cybersecurity service providers, and other third parties with whom we do business, have occurred in the past and such events could disrupt our normal business operations and networks in the future. In December 2020, hackers reportedly linked to the Russian government engaged in a massive cyber attack on the U.S. government and major U.S.-based private companies through malware planted in third-party software. As of the date of this report, the full extent of the hack remains unknown, though a number of governmental agencies and private companies, most of which are U.S.-based, have confirmed breaches.We maintain insurance to protect ourselves against certain losses incurred in the event of a security incident or disruption of our information systems. However, we cannot be certain that the coverage is adequate to compensate for all damages that may arise. In addition, we cannot be certain that such insurance options will remain available to us in the future on commercially reasonable terms, or at all.General Risk FactorsWe face risks associated with short-term liquid investments.From time to time, we may have significant cash balances that we invested in a variety of short-term investments that are intended to preserve principal value and maintain a high degree of liquidity while providing current income. These investments may include (either directly or indirectly) obligations (including certificates of deposit) of banks, money market funds, treasury bank securities, and other short-term securities. Investments in these securities and funds are not insured against loss of principal. Under certain circumstances, we may be required to redeem all or part of these securities or funds at less than par value. A decline in the value of our investments, or a delay or suspension of our right to redeem them, may have a material adverse effect on our results of operations or financial condition and our ability to pay our obligations as they become due.41Competition for skilled personnel could increase labor costs.We compete with various other companies in attracting and retaining qualified and skilled personnel. We depend on our ability to attract and retain skilled management personnel who are responsible for the day-to-day operations of the Company. Competitive pressures may require that we enhance our pay and benefits package to compete effectively for such personnel. We may not be able to offset such additional costs by increasing the rates we charge tenants. If there is an increase in these costs or if we fail to attract and retain qualified and skilled personnel, our business and operating results could be adversely affected.Failure to hedge effectively against interest rate changes may adversely affect our results of operations.From time to time, we may enter into interest rate hedge agreements to manage some of our exposure to interest rate volatility. Interest rate hedge agreements involve risks, such as the risk that counterparties may fail to honor their obligations under these arrangements. In addition, these arrangements may not be effective in reducing our exposure to changes in interest rates. These risk factors may lead to failure to hedge effectively against changes in interest rates and therefore could adversely affect our results of operations. As of December 31, 2020, we had no interest rate hedge agreements outstanding.Market volatility may negatively affect our business.From time to time, the capital and credit markets experience volatility. In some cases, the markets have produced downward pressure on stock prices and credit capacity for certain issuers without regard to those issuers’ underlying financial and/or operating strength. If market disruption and volatility occur, there can be no assurance that we will not experience an adverse effect, which may be material, on our business, financial condition, and results of operations. Market disruption and volatility may adversely affect the value of the companies in which we hold equity investments, including through our non-real estate venture investment portfolio, and we may be required to recognize losses in our earnings. Disruptions, uncertainty, or volatility in the capital markets may also limit our access to capital from financial institutions on favorable terms, or altogether, and our ability to raise capital through the issuance of equity securities could be adversely affected by causes beyond our control through extraordinary disruptions in the global economy and financial systems or through other events.Changes in financial accounting standards may adversely impact our compliance with financial debt covenants.Our unsecured senior notes payable contain financial covenants that are calculated based on GAAP at the date the instruments were issued. However, certain debt agreements, including those related to our unsecured senior line of credit, contain financial covenants whose calculations are based on current GAAP, which is subject to future changes. Our unsecured senior line of credit agreement provides that our financial debt covenants be renegotiated in good faith to preserve the original intent of the existing financial covenant when such covenant is affected by an accounting standard change. For those debt agreements that require the renegotiation of financial covenants upon changes in accounting standards, there is no assurance that we will be successful in such negotiations or that the renegotiated covenants will not be more restrictive to us.Extreme weather and natural or other unforeseen disasters may cause property damage or disrupt operations, which could harm our business and operating results.We have properties located in areas that may be subject to extreme weather and natural or other disasters, including, but not limited to, earthquakes, winds, floods, hurricanes, fires, power shortages, telecommunication failures, medical epidemics, explosions, or other natural or manmade accidents or incidents. Our corporate headquarters and certain properties are located in areas of California that have historically been subject to earthquakes and wildfires. Such conditions and disastrous events may damage our properties, disrupt our operations, or adversely impact our tenants’ or third-party vendors’ operations. These events may affect our ability to operate our business and have significant negative consequences on our financial and operating results. Damage caused by these events may result in costly repairs for damaged properties or equipment, delays in the development or redevelopment of our construction projects, or interruption of our daily business operations, which may result in increased costs and decreased revenues.We maintain insurance coverage at levels that we believe are appropriate for our business. However, we cannot be certain that the amount of coverage will be adequate to satisfy damages or losses incurred in the event of another wildfire or other natural or manmade disaster, which may lead to a material adverse effect on our properties, operations, and our business, or those of our tenants.Failure of the U.S. federal government to manage its fiscal matters or to raise or further suspend the debt ceiling, and changes in the amount of federal debt, may negatively impact the economic environment and adversely impact our results of operations.The Budget Control Act of 2011 provided for a reduction of $1.1 trillion of U.S. federal government discretionary spending over the succeeding decade (later extended through 2023) through a series of automatic, across-the-board spending cuts known as sequestration. Sequestration went into effect on March 1, 2013, and will remain in effect in the absence of further legislative action.42The U.S. federal government has established a limit on the level of federal debt that the U.S. federal government can have outstanding, often referred to as the debt ceiling. The U.S. Congress has authority to raise or suspend the debt ceiling and to approve the funding of U.S. federal government operations within the debt ceiling, and has done both frequently in the past, often on a relatively short-term basis. In July 2019, congressional leaders passed a two-year deal to raise the U.S. borrowing limit, which reduced the threat of default and significantly raised federal spending limits. Absent appropriate action to mitigate increasing government spending and provide fiscal discipline, the U.S. federal government may encounter similar issues that result in a partial or complete shutdown and/or default of its existing loans as a result of reaching the debt ceiling. If effective legislation to manage the debt ceiling is not enacted and the debt ceiling is reached, the federal government may stop or delay making payments on its obligations. A failure by the U.S. Congress to raise the debt limit to the extent necessary in future fiscal years would increase the risk of default by the U.S. on its obligations, the risk of a lowering of the credit rating of the U.S. federal government, and the risk of other economic dislocations. If the U.S. government fails to complete its budget process, another federal government shutdown may result. Such a failure, or the perceived risk of such a failure, could consequently have a material adverse effect on the financial markets and economic conditions in the U.S. and throughout the world.An inability of the U.S. federal government to manage its fiscal matters, reduce the duration and scope of sequestration, or manage its debt may result in the loss of economic confidence domestically and globally, reduce investment spending, increase borrowing costs, impact availability and cost of capital, and significantly hinder or reduce economic activity. Furthermore, a failure by the U.S. federal government to enact appropriate fiscal legislation may significantly impact the national and global economic and financial environment and affect our business and the businesses of our tenants. On December 27, 2020, the U.S. federal government was able to enact an appropriations bill for the fiscal year 2021. If, however, the U.S. Congress fails to enact a budget for a given fiscal year’s government operations, it may result in a government shutdown similar to the one that took place from December 22, 2018, to January 25, 2019. The shutdown affected certain key agencies at the federal government level, including the FDA and the SEC, and resulted in partial closures of operations. It is unclear whether the U.S. federal government will fail to enact a budget in future fiscal years, and if so, it is possible another partial government shutdown may occur.The shutdown in early 2019 had affected certain key agencies at the federal government level, including the SEC, which closed partial non-essential operations. The SEC operated limited functions to address emergency situations involving market integrity and investor protection. However, the SEC suspended key functions, such as those related to enforcement actions and review of applications for initial public offerings. Future closures of the SEC could result in uncertainty regarding regulatory actions, issuance of new or clarifications of existing rules and regulations, disruptions in the initial public offerings of companies, including those of our tenants and companies in which we hold equity investments, and investigations and enforcement actions by the SEC. During this period, the FDA and certain other science agencies temporarily shut down select non-essential operations. Also during this period, the FDA maintained only operations deemed to be essential public health-related functions and halted the acceptance of new medical product applications and routine regulatory and compliance work for medical products and certain drugs and foods during the shutdown. The long-term impacts resulting from a prolonged closure of the SEC, the FDA, and other similar agencies are uncertain and may adversely affect our business operations or our tenants and companies in which we hold equity investments. If economic conditions severely deteriorate as a result of government fiscal gridlock, our operations, or those of our tenants, could be affected, which may adversely impact our financial condition and results of operations. These risks may also impact our overall liquidity, our borrowing costs, or the market price of our common stock.Changes in laws, regulations, and financial accounting standards may adversely affect our reported results of operations.As a response, in large part, to perceived abuses and deficiencies in current regulations believed to have caused or exacerbated the recent global financial crisis, legislative, regulatory, and accounting standard-setting bodies around the world are engaged in an intensive, wide-ranging examination and rewriting of the laws, regulations, and accounting standards that have constituted the basic playing field of global and domestic business for several decades. In many jurisdictions, including the U.S., the legislative and regulatory response has included the extensive reorganization of existing regulatory and rule-making agencies and organizations, and the establishment of new agencies with broad powers. This reorganization has disturbed longstanding regulatory and industry relationships and established procedures.The rule-making and administrative efforts have focused principally on the areas perceived as having contributed to the financial crisis, including banking, investment banking, securities regulation, and real estate finance, with spillover impacts on many other areas. These initiatives have created a degree of uncertainty regarding the basic rules governing the real estate industry, and many other businesses, that is unprecedented in the U.S. at least since the wave of lawmaking, regulatory reform, and government reorganization that followed the Great Depression.The global financial crisis and the aggressive reaction of the government and accounting profession thereto have occurred against a backdrop of increasing globalization and internationalization of financial and securities regulation that began prior to the recent financial crisis. As a result of this ongoing trend, financial and investment activities previously regulated almost exclusively at a local or national level are increasingly being regulated, or at least coordinated, on an international basis, with national rule-making and standard-setting groups relinquishing varying degrees of local and national control to achieve more uniform regulation and reduce the ability of market participants to engage in regulatory arbitrage between jurisdictions. This globalization trend has continued, arguably with an increased sense of urgency and importance, since the financial crisis.43This high degree of regulatory uncertainty, coupled with considerable additional uncertainty regarding the underlying condition and prospects of global, domestic, and local economies, has created a business environment that makes business planning and projections even more uncertain than is ordinarily the case for businesses in the financial and real estate sectors.In the commercial real estate sector in which we operate, the uncertainties posed by various initiatives of accounting standard-setting authorities to fundamentally rewrite major bodies of accounting literature constitute a significant source of uncertainty as to the basic rules of business engagement. Changes in accounting standards and requirements, including the potential requirement that U.S. public companies prepare financial statements in accordance with international accounting standards and the adoption of accounting standards likely to require the increased use of “fair value” measures, may have a significant effect on our financial results and on the results of our tenants, which would in turn have a secondary impact on us. New accounting pronouncements and interpretations of existing pronouncements are likely to continue to occur at an accelerated pace as a result of recent Congressional and regulatory actions and continuing efforts by the accounting profession itself to reform and modernize its principles and procedures.Although we have not been as directly affected by the wave of new legislation and regulation as banks and investment banks, we may also be adversely affected by new or amended laws or regulations; by changes in federal, state, or foreign tax laws and regulations; and by changes in the interpretation or enforcement of existing laws and regulations. In the U.S., the financial crisis and continuing economic slowdown prompted a variety of legislative, regulatory, and accounting profession responses.The federal legislative response culminated in the enactment on July 21, 2010, of the Dodd-Frank Act. The Dodd-Frank Act contains far-reaching provisions that substantially revise, or provide for the revision of, longstanding, fundamental rules governing the banking and investment banking industries and provide for the broad restructuring of the regulatory authorities in these areas. The Dodd-Frank Act has resulted in, and is expected to continue to result in, profound changes in the ground rules for financial business activities in the U.S. To a large degree, the impacts of the legislative, regulatory, and accounting reforms to date are still not clear. The ongoing implementation of derivatives regulations could have an adverse impact on our ability to hedge risks associated with our business.Title VII of the Dodd-Frank Act regulates derivatives transactions, which include certain instruments that we use in our risk management activities. It remains impossible at this time to predict the full effects on our hedging activities of the derivatives-related provisions of the Dodd-Frank Act and rules of the Commodity Futures Trading Commission (“CFTC”) and SEC thereunder, or the timing of such effects. While the CFTC has implemented most of its derivatives-related regulations under the Dodd-Frank Act, it has not yet adopted all of those regulations, and it has proposed revisions to certain of its existing derivatives regulations. The impact of any future new or revised CFTC derivatives regulations, or new or revised CFTC interpretations of existing regulations, is unknown, but they could result in, among other things, increases in the costs to us of swaps and other derivatives contracts, and decreases in the number and/or creditworthiness of available hedge counterparties. Furthermore, at this time, the SEC’s regulations for security-based swaps have generally not yet been implemented, and their potential impact on our ability to hedge risks cannot yet be known.In addition, we may enter into hedging transactions with counterparties based in the EU, Canada, or other jurisdictions that, like the U.S., are in the process of implementing regulations for derivatives. Non-U.S. regulations may apply to such derivatives transactions. The potential impact of such non-U.S. regulations is not fully known and may include, among other things, increased costs for our hedging transactions.A global financial stress, high structural unemployment levels, and other events or circumstances beyond our control may adversely affect our industry, business, results of operations, contractual commitments, and access to capital.The COVID-19 pandemic that has taken place in 2020 across the U.S. and worldwide has precipitated widespread structural economic and financial stress. In addition, from 2008 through 2010, significant concerns over energy costs, geopolitical issues, the availability and cost of credit, the U.S. mortgage market, and a declining real estate market in the U.S. contributed to increased volatility, diminished expectations for the economy and the markets, and high levels of structural unemployment by historical standards. These factors, combined with volatile oil prices and fluctuating business and consumer confidence, precipitated a steep economic decline. Since 2011, the U.S. economy has showed significant signs of improvement, but other economies around the world, including Latin America, continue to demonstrate sluggish, stagnant, or slowing growth. Further, severe financial and structural strains on the banking and financial systems have led to significant lack of trust and confidence in the global credit and financial system. Consumers and money managers have liquidated and may liquidate equity investments, and consumers and banks have held and may hold cash and other lower-risk investments, which has resulted in significant and, in some cases, catastrophic declines in the equity capitalization of companies and failures of financial institutions. Although U.S. bank earnings and liquidity have rebounded in recent years, though tapered by the recent COVID-19 pandemic, the potential of significant future bank credit losses creates uncertainty for the lending outlook.44Further downgrades of the U.S. government’s sovereign credit rating and an economic crisis in Europe could negatively impact our liquidity, financial condition, and earnings.Previous U.S. debt ceiling and budget deficit concerns, together with sovereign debt conditions in Europe, have increased the possibility of additional downgrades of sovereign credit ratings and economic slowdowns. There is no guarantee that future debt ceiling or federal spending legislation will not fail.Standard & Poor’s Ratings Services lowered its long-term sovereign credit rating on the U.S. from “AAA” to “AA+” in August 2011, which was affirmed in April 2020. Although Standard & Poor’s Ratings Services maintains a stable outlook on the U.S. credit rating, further fiscal impasses within the federal government may result in future downgrades. Moody’s Investor Services, Inc. affirmed its “Aaa” long-term issuer and senior unsecured ratings in June 2020 and maintains a stable outlook on the U.S. credit rating but has warned that the U.S. fiscal strength has been deteriorating. Fitch Ratings Inc. maintains a “AAA” sovereign rating for U.S. but shifted its outlook from stable to negative in July 2020 to reflect the ongoing deterioration in the U.S. public finances and the absence of a credible fiscal consolidation plan. The impact of any further downgrades to the U.S. government’s sovereign credit rating, or its perceived creditworthiness, is inherently unpredictable and could adversely affect the U.S. and global financial markets and economic conditions.In addition, certain European nations experienced in the recent past varying degrees of financial stress, including Greece, Ireland, Italy, Portugal, and Spain. Although these economies are continuing to recover or have already gone through a gradual recovery, we do not know whether the economic growth will be slowed by the U.K.’s leaving the EU or whether the prior sovereign financial difficulties within the EU governments will reemerge with a higher degree of negative impact to the financial markets. Market concerns over the direct and indirect exposure of European banks and insurers to these EU peripheral nations have resulted in a widening of credit spreads and increased costs of funding for some EU financial institutions. There can be no assurance that government or other measures to aid economic recovery will be effective.These developments, and concerns over the U.S. government’s fiscal policies in general, could cause interest rates and borrowing costs to rise, which may negatively impact our ability to access the debt markets on favorable terms. In addition, the lowered credit rating could create broader financial turmoil and uncertainty, which may exert downward pressure on the market price of our common stock. Continued adverse economic conditions could have a material adverse effect on our business, financial condition, and results of operations.Financial volatility and geopolitical instability outside of the U.S. may adversely impact the U.S. and global economies.In recent years, as global growth has weakened and trade tensions have heightened, the devastating financial and human impacts of COVID-19 are mostly yet to be seen. Many economies, however, have already experienced financial turmoil, high unemployment, soaring inflation and interest rates, and a significant depreciation of their local currencies. Economies of developing countries like Venezuela and Argentina remain in a long-term crisis, with their current political turmoil exacerbating their economic problems and rendering a bleak near-term outlook. Policies of advanced economies have a profound effect on emerging markets, and ramifications of any trade war involving an advanced economy, like of that between the U.S. and China, could further contribute to the adverse economic and political conditions of emerging and other developed economies. In addition, there are ongoing security concerns about North Korea and Iran’s nuclear weapons and ballistic missile capabilities, uncertainty regarding North Korea and Iran’s actions, and their relations with the U.S. and the international community in general, which have created a global security issue that may adversely affect international business and economic conditions.During 2018–2019, disputes on trade policy between the U.S. and China resulted in increased tariffs and escalating tensions between the two countries. On January 15, 2020, the two parties signed a trade deal representing the first phase of trade negotiations between the two countries. The agreement reduced certain existing tariffs, obligated China to purchase additional products from the U.S. in 2020 and 2021, and provided for stronger protection of American intellectual property and trade secrets (the “Phase One deal”). The Phase One deal has not been dismantled despite China’s purchase of products falling behind schedule and escalating tensions and sanctions between the two countries during 2020. Newly elected U.S. President Biden has stated that there are no immediate plans to cancel the Phase One deal, but the administration is expected to make changes to the U.S.-China tariff policies. Future trade disputes may result in the imposition of further tariffs or other retaliatory actions that may affect us, the industry in which we operate, or that of our tenants and vendors.In January 2020, the U.S. imposed new sanctions on Iran after tensions escalated in a U.S. airstrike killing a top Iranian military leader and Iran retaliated with ballistic missile strikes targeted at U.S. bases located in Iraq. The sanctions targeted the construction, mining, manufacturing, and textiles sectors, which are key sectors of Iran’s economy, in an attempt to deny the Iranian government revenues derived from these activities. Tensions with Iran have continued in 2020 under U.S. President Trump, and it is not clear what, if anything, newly elected U.S. President Biden will do in his administration to ease relations between the two countries. If Iran carries out retaliatory actions against the U.S., the U.S. economy, safety, and lives of U.S. residents and businesses may be significantly impacted, resulting in financial volatility and social instability for those affected. This may include, but not be limited to, our company, tenants, employees, investors, and others located in affected communities in which we hold properties.It is not possible to predict to what extent regional economic and political instability of emerging economies or trade conflicts may negatively impact economies around the world, including the U.S. If these macroeconomic and political issues are not managed 45appropriately, they could lead to currency devaluation, sovereign debt increases, banking crises, and other financial and political turmoil and uncertainty. Continued adverse economic conditions could have a material adverse effect on our business, financial condition, and results of operations.We are subject to risks from potential fluctuations in exchange rates between the U.S. dollar and foreign currencies.We have properties and operations in countries where the U.S. dollar is not the local currency, and we thus are subject to international currency risk from the potential fluctuations in exchange rates between the U.S. dollar and the local currency. In particular, a significant decrease or volatility in the value of the Canadian dollar or other currencies in countries where we may have an investment could materially affect our results of operations. We may attempt to mitigate such effects by borrowing in the local foreign currency in which we invest. Any international currency gain recognized with respect to changes in exchange rates may not qualify under gross income tests that we must satisfy annually in order to qualify and maintain our status as a REIT.Adoption of the Basel III standards and other regulatory standards affecting financial institutions may negatively impact our access to financing or affect the terms of our future financing arrangements.In response to various financial crises and the volatility of financial markets, the Basel Committee on Banking Supervision (the “Basel Committee”) adopted the Basel III regulatory capital framework (“Basel III” or the “Basel III Standards”). The final package of Basel III reforms was approved by the G20 leaders in November 2010. In January 2013, the Basel Committee agreed to delay implementation of the Basel III Standards and expanded the scope of assets permitted to be included in certain banks’ liquidity measurements. U.S. banking regulators have elected to implement substantially all of the Basel III Standards, with implementation of Basel III having commenced in 2014 and incrementally implemented through 2020, though progress was limited during 2020 due to the impact of the COVID-19 pandemic.Since approving the Basel III Standards, U.S. regulators also issued rules that impose upon the most systemically significant banking organizations in the U.S. supplementary leverage ratio standards (the “SLR Standards”) more stringent than those of the Basel III Standards. In addition, the Federal Reserve Board has adopted a final rule that establishes a methodology to identify whether a U.S. bank holding company is a global systemically important banking organization (“GSIB”). Any firm identified as a GSIB would be subject to a risk-based capital surcharge that is calibrated based on its systemic risk profile. Under the final rule, the capital surcharge began phasing in on January 1, 2016, and became fully effective on January 1, 2019.On September 3, 2014, U.S. banking regulators issued a final rule to implement the Basel Committee’s liquidity coverage ratio (the “LCR”) in the U.S. (the “LCR Final Rule”). The LCR is intended to promote the short-term resilience of internationally active banking organizations to improve the banking industry’s ability to absorb shocks arising from idiosyncratic or market stress, and to improve the measurement and management of liquidity risk. The LCR Final Rule contains requirements that are in certain respects more stringent than the Basel Committee’s LCR. The LCR measures an institution’s high-quality liquid assets against its net cash outflows. Under the LCR Final Rule, the LCR transition period occurred from 2015 through 2017. U.S. regulators have also issued and proposed rules that impose additional restrictions on the business activities of financial institutions, including their trading and investment activities. For example, with effect in April 2014, U.S. regulators adopted a final rule implementing a section of the Dodd-Frank Act that has become known as the “Volcker Rule.” The Volcker Rule generally restricts certain U.S. and foreign financial institutions from engaging in proprietary trading and from investing in sponsoring or having certain relationships with “covered funds,” which include private equity funds and hedge funds. Amendments effective in January 2020 have provided a certain level of regulatory relief, particularly pertaining to proprietary trading restrictions, by tailoring the Volker Rule’s application, simplifying certain standards and requirements, and reducing compliance burden. Additional amendments related to “covered funds” are expected. The effects of the Volcker Rule are uncertain, but it is in any event likely to curtail various banking activities, which in turn could result in uncertainties in the financial markets.The implementation of the Basel III Standards, the SLR Standards, the GSIB capital surcharge, the LCR Final Rule, the Volcker Rule, and other similar rules and regulations could cause an increase in capital requirements for, and place other financial constraints on, both U.S. and foreign financial institutions from which we borrow, which may negatively impact our access to financing or affect the terms of our future financing arrangements.Changes in the system for establishing U.S. accounting standards may result in adverse fluctuations in our reported asset and liability values and earnings and may materially and adversely affect our reported results of operations.Accounting for public companies in the U.S. has historically been conducted in accordance with GAAP as established by the FASB, an independent body whose standards are recognized by the SEC as authoritative for U.S. publicly held companies. The IASB is a London-based independent board established in 2001 and charged with the development of IFRS. IFRS generally reflects accounting practices that prevail in Europe and in developed nations in other parts of the world.IFRS differs in material respects from GAAP. Among other things, IFRS has historically relied more on “fair value” models of accounting for assets and liabilities than GAAP. “Fair value” models are based on periodic revaluation of assets and liabilities, often 46resulting in fluctuations in such values as compared to GAAP, which relies more frequently on historical cost as the basis for asset and liability valuation.The SEC released a final report on its IFRS work plan, which indicates the SEC still needs to analyze and consider whether IFRS should be incorporated into the U.S. financial reporting system. It is unclear at this time how and when the SEC will propose that GAAP and IFRS be harmonized if the decision to incorporate is adopted. In addition, incorporating a new method of accounting and adopting IFRS will be a complex undertaking. We may need to develop new systems and controls based on the principles of IFRS. Since these are new endeavors, and the precise requirements of the pronouncements ultimately adopted are not now known, the magnitude of costs associated with this conversion is uncertain.We are currently evaluating the impact of the adoption of IFRS on our financial condition and results of operations. Such evaluation cannot be completed, however, without more clarity regarding the specific proposed standards that will be adopted. Until there is more certainty with respect to the standards to be adopted, prospective investors should consider that our conversion to IFRS could have a material adverse impact on our reported results of operations.Significant developments stemming from recent international trade developments or the U.K.’s referendum on membership in the EU could have a material adverse effect on us.During his administration, U.S. President Trump imposed significant increases on tariffs on goods imported into the U.S., particularly from China, Mexico, and Canada. The U.S., Mexico, and Canada negotiated and reached an agreement for a new United States-Mexico-Canada Agreement (USMCA), which replaced the North American Free Trade Agreement. Newly elected U.S. President Biden has committed to focus on domestic investment in jobs and education before entering into any new trade deals. Any changes in U.S. social, political, regulatory, and economic conditions or laws and policies governing the healthcare system and drug prices, foreign trade, manufacturing, and development and investment in the territories and countries where we or our tenants operate could adversely affect our operating results and our business.On January 31, 2020, the U.K. officially withdrew from the EU, but a transitional period was extended through December 31, 2020, to allow for businesses and individuals to adjust to its changes, during which all EU regulations continued to apply to the U.K. A Trade and Cooperation Agreement (“TCA”) was agreed upon by the EU and the U.K. on December 24, 2020, and ratified by the European Council and the U.K. Parliament ahead of the end of the transition period on December 31, 2020. While the TCA has provisions for how both parties will trade, live, and work with one another, financial services are not covered in any detail in the TCA. The nature of much of the future economic and political relationship between the EU and U.K. remains uncertain, and there is no guarantee that both parties will be able to adhere to the terms of the deal effectively. The exit of the U.K. from membership of the EU has created political and economic uncertainty, particularly in the U.K. and the EU, and this uncertainty may last for years. Our business could be affected during this period of uncertainty, and perhaps longer, by the impact of the U.K.’s exit from the EU. In addition, our business could be negatively affected by new trade agreements between the U.K. and other countries, including the U.S., and by the possible imposition of trade or other regulatory barriers in the U.K. These possible negative impacts, and others resulting from the U.K.’s withdrawal from the EU, may adversely affect our operating results and our tenants’ businesses.Social, political, and economic instability, unrest, and other circumstances beyond our control could adversely affect our business operations.Our business may be adversely affected by social, political, and economic instability, unrest, or disruption in a geographic region in which we operate, regardless of cause, including legal, regulatory, and policy changes by a new presidential administration in the U.S., protests, demonstrations, strikes, riots, civil disturbance, disobedience, insurrection, or social and other political unrest. Such events may result in restrictions, curfews, or other actions and give rise to significant changes in regional and global economic conditions and cycles, which may adversely affect our financial condition and operations. In 2020, there were protests in cities throughout the U.S. as well as globally, including in Hong Kong, in connection with civil rights, liberties, and social and governmental reform. While protests have been peaceful in many locations, looting, vandalism, and fires have occurred in cities such as Seattle, Portland, Los Angeles, Washington, D.C., New York City, and Minneapolis that have led to the imposition of mandatory curfews and, in some locations, deployment of the U.S. National Guard. Government actions in an effort to protect people and property, including curfews and restrictions on business operations, may disrupt operations, harm perceptions of personal well-being, and increase the need for additional expenditures on security resources. In addition, action resulting from such social or political unrest may pose significant risks to our personnel, facilities, and operations. The effect and duration of demonstrations, protests, or other factors is uncertain, and we cannot ensure there will not be further political or social unrest in the future or that there will not be other events that could lead to social, political, and economic disruptions. If such events or disruptions persist for a prolonged period of time, our overall business and results of operations may be adversely affected.In addition, a new U.S. President, Joseph R. Biden, was elected in November 2020. On January 6, 2021, a group ofsupporters of President Trump, some of whom were armed and violent, illegally stormed and vandalized the U.S. Capitol as a response to false claims of widespread voter fraud and encouragement from U.S. President Trump to protest the Congressional certification of the U.S. presidential election results. Several people were killed in the incursion. Following the deadly event at the Capitol, on January 13, 2021, the House of Representatives voted to impeach U.S. President Trump for incitement of insurrection. On January4720, 2021, the presidential inauguration of President Biden was carried out with increased security measures but without further majorincident. The aftermath of the November 2020 presidential election, including the January 6, 2021, violent disruption at the Capitol,has left the U.S. in what many consider to be an extremely heightened state of political and social tension, and it is unclear whetherthis tension will dissipate or intensify in coming months and what resulting impacts may occur to adversely affect our business operations or the safety of our employees, our tenants, and the communities in which we operate.Changes in federal policy, including tax policies, and at regulatory agencies occur over time through policy and personnel changes following elections, which lead to changes involving the level of oversight and focus on certain industries and corporate entities. The nature, timing, and economic and political effects of potential changes to the current legal and regulatory frameworks affecting the life science, technology, and agtech industries, as well as the real estate industry in general, remain highly uncertain. For example, any proposals to make changes related to U.S. tax law, such as those involving Section 1031 Exchanges, may have a material adverse effect on our future business, financial condition, results of operations, and growth prospects. From time to time, we dispose of properties in transactions qualified as Section 1031 Exchanges. If certain proposed changes were ultimately effected and the laws surrounding Section 1031 Exchanges amended or repealed, we may not be able to dispose of properties on a tax-deferred basis. In such a case, our earnings and profits and our taxable income would increase, which could increase dividend income and reduce the return of capital to our stockholders. As a result, we may be required to pay additional dividends to stockholders, or if we do not pay additional dividends, our corporate income tax liability could increase and we may be subject to interest and penalties.Terrorist attacks may have an adverse impact on our business and operating results and could decrease the value of our assets.Terrorist attacks such as those that took place on September 11, 2001, could have a material adverse impact on our business, our operating results, and the market price of our common stock. Future foreign or domestic terrorist attacks may result in declining economic activity, which could reduce the demand for, and the value of, our properties. To the extent that any future foreign or domestic terrorist attacks impact our tenants, their businesses similarly could be adversely affected, including their ability to continue to honor their lease obligations.Our business and operations would suffer in the event of information technology system failures.Despite system redundancy, the implementation of security measures, and the existence of a disaster recovery plan for our internal information technology systems, our systems are vulnerable to damages from any number of sources, including computer viruses, unauthorized access, energy blackouts, natural disasters, terrorism, war, and telecommunications failures. Any system failure or accident that causes interruptions in our operations could result in a material disruption to our business. We may also incur additional significant costs to remedy damages caused by such disruptions.Any or all of the foregoing could have a material adverse effect on our financial condition, results of operations, and cash flows, or the market price of our common stock. Additional risks and uncertainties not currently known to us, or that we presently deem to be immaterial, may also have potential to materially adversely affect our business, financial condition, and results of operations.ITEM 1B. UNRESOLVED STAFF COMMENTSNone.48ITEM 2. PROPERTIESGeneralAs of December 31, 2020, we had 338 properties in North America containing approximately 35.2 million RSF of operating properties and development and redevelopment of new Class A properties (under construction), including 40 properties that are held by consolidated real estate joint ventures and six properties that are held by unconsolidated real estate joint ventures. Refer to the definitions of “Annual rental revenue” and “Operating statistics” in the “Non-GAAP measures and definitions” section under “Item 7. Management’s discussion and analysis of financial condition and results of operations” in this annual report on Form 10-K for a description of the basis used to compute the aforementioned measures. The occupancy percentage of our operating properties in North America was 94.6% as of December 31, 2020. The exteriors of our properties typically resemble traditional office properties, but the interior infrastructures are designed to accommodate the needs of life science, technology, and agtech tenants. These improvements typically are generic rather than specific to a particular tenant. As a result, we believe that the improvements have long-term value and utility and are usable by a wide range of tenants. Improvements to our properties typically include:•Reinforced concrete floors;•Upgraded roof loading capacity;•Increased floor-to-ceiling heights;•Heavy-duty HVAC systems;•Enhanced environmental control technology;•Significantly upgraded electrical, gas, and plumbing infrastructure; and•Laboratory benches.As of December 31, 2020, we held a fee simple interest in each of our properties, with the exception of 36 properties in North America that accounted for approximately 11% of our total number of properties. Of these 36 properties, we held 16 properties in the Greater Boston market, 13 properties in the San Francisco market, two properties in the New York City market, two properties in the Seattle market, one property in the Maryland market, and two properties in the Research Triangle market pursuant to ground leasehold interests. During the year ended December 31, 2020, our ground lease rental expense aggregated 1.4% as a percentage of net operating income. Refer to further discussion in our consolidated financial statements and notes thereto in “Item 15. Exhibits and financial statement schedules” in this annual report on Form 10-K.As of December 31, 2020, we had 909 leases with a total of 670 tenants, and 167, or 49%, of our 338 properties were single-tenant properties. Leases in our multi-tenant buildings typically have initial terms of four to 11 years, while leases in our single-tenant buildings typically have initial terms of 11 to 21 years. As of December 31, 2020:•Investment-grade or publicly traded large cap tenants represented 55% of our total annual rental revenue;•Approximately 94% of our leases (on an RSF basis) contained effective annual rent escalations that were either fixed (generally ranging from approximately 3.0% to 3.5%) or indexed based on a consumer price index or other index;•Approximately 94% of our leases (on an RSF basis) were triple net leases, which require tenants to pay substantially all real estate taxes, insurance, utilities, repairs and maintenance, common area expenses, and other operating expenses (including increases thereto) in addition to base rent; and•Approximately 93% of our leases (on an RSF basis) provided for the recapture of capital expenditures (such as HVAC maintenance and/or replacement, roof replacement, and parking lot resurfacing) that we believe would typically be borne by the landlord in traditional office leases.Our leases also typically give us the right to review and approve tenant alterations to the property. Generally, tenant-installed improvements to the properties are reusable generic improvements and remain our property after termination of the lease at our election. However, we are permitted under the terms of most of our leases to require that the tenant, at its expense, remove certain non-generic improvements and restore the premises to their original condition.49Locations of propertiesThe locations of our properties are diversified among a number of life science, technology, and agtech cluster markets. The following table sets forth the total RSF, number of properties, and annual rental revenue in effect as of December 31, 2020, in each of our markets in North America (dollars in thousands, except per RSF amounts):RSFNumber of PropertiesAnnual Rental RevenueMarketOperatingDevelopmentRedevelopmentTotal% of TotalTotal% of TotalPer RSFGreater Boston8,454,396 — 296,489 8,750,885 25 %72 $507,459 36 %$61.20 San Francisco 7,495,390 744,715 92,147 8,332,252 24 61 362,262 25 57.87 New York City1,145,296 — 122,382 1,267,678 3 5 81,185 6 73.68 San Diego6,367,526 146,456 79,945 6,593,927 19 80 233,128 16 39.14 Seattle1,747,332 100,086 213,976 2,061,394 6 22 81,477 6 48.59 Maryland2,821,574 261,096 169,420 3,252,090 9 44 80,429 6 29.97 Research Triangle2,810,670 410,000 652,381 3,873,051 11 35 61,354 4 24.38 Canada256,967 — — 256,967 1 3 4,870 — 23.16 Non-cluster/other markets549,479 — — 549,479 1 12 10,608 1 36.64 Properties held for sale225,849 — — 225,849 1 4 6,257 — N/ANorth America31,874,479 1,662,353 1,626,740 35,163,572 100 %338 $1,429,029 100 %$49.08 3,289,093Summary of occupancy percentages in North AmericaThe following table sets forth the occupancy percentages for our operating properties and our operating and redevelopment properties in each of our North America markets, excluding properties held for sale, as of the following dates: Operating PropertiesOperating and Redevelopment PropertiesMarket12/31/2012/31/1912/31/1812/31/2012/31/1912/31/18Greater Boston98.1 %99.1 %98.7 %94.8 %97.1 %98.2 %San Francisco95.8 (1)98.3 100.0 94.7 93.6 96.2 New York City97.3 99.2 98.3 87.8 88.1 87.3 San Diego93.5 (1)92.3 94.7 92.4 92.3 94.7 Seattle96.0 98.7 97.7 85.5 98.7 97.7 Maryland96.1 96.7 96.8 90.6 95.2 94.7 Research Triangle89.6 (1)96.5 95.4 72.7 96.5 85.9 Subtotal95.5 97.0 97.6 90.7 94.6 95.3 Canada81.8 93.7 95.2 81.8 93.7 95.2 Non-cluster/other markets52.7 80.1 79.0 52.7 80.1 79.0 North America94.6 %(1)96.8 %97.3 %90.0 %94.4 %95.1 %(1)Includes 970,199 RSF, or 3.1%, of vacancy in our North America markets, representing lease-up opportunities that will contribute to growth in cash flows at recently acquired properties (noted below). Excluding these acquired vacancies, occupancy of operating properties in North America was 97.7% as of December 31, 2020. The following table provides vacancy detail for our recent acquisitions: As of December 31, 2020VacantOccupancy ImpactPropertyMarket/SubmarketRSFRegionConsolidatedAlexandria Center® for Life Science – DurhamResearch Triangle/Research Triangle251,465 8.9 %0.8 %601, 611, and 651 Gateway BoulevardSan Francisco/South San Francisco199,895 2.7 %0.6 SD Tech by AlexandriaSan Diego/Sorrento Mesa71,462 1.1 %0.2 Other acquisitionsVarious447,377 N/A1.5 970,199 3.1 %Refer to the “Non-GAAP measures and definitions” section under Item 7 in this annual report on Form 10-K for additional information.50Top 20 tenants85% of Top 20 Annual Rental Revenue From Investment-Grade or Publicly Traded Large Cap Tenants(1)Our properties are leased to a high-quality and diverse group of tenants, with no individual tenant accounting for more than 3.7% of our annual rental revenue in effect as of December 31, 2020. The following table sets forth information regarding leases with our 20 largest tenants in North America based upon annual rental revenue in effect as of December 31, 2020 (dollars in thousands, except average market cap):Remaining Lease Term(1) (in Years)AggregateRSFAnnualRentalRevenue(1)Percentage of Aggregate Annual Rental Revenue(1)Investment-Grade Credit RatingsAverage Market Cap(1)(in billions)TenantMoody’sS&P1 Bristol-Myers Squibb Company7.7 896,867 $52,460 3.7 %A2A+$137.9 2 Takeda Pharmaceutical Company Ltd.8.6 606,249 39,342 2.8 Baa2BBB+$56.7 3 Facebook, Inc.11.0 903,786 38,899 2.7 ——$668.4 4 Illumina, Inc.9.6 891,495 35,907 2.5 —BBB$47.7 5 Sanofi7.5 494,693 33,868 2.4 A1AA$124.0 6 Eli Lilly and Company8.5 531,784 33,527 2.3 A2A+$142.4 7 Moderna, Inc.11.4 615,458 32,147 2.2 ——$24.1 8 Novartis AG7.6 423,914 30,101 2.1 A1AA-$217.7 9 Uber Technologies, Inc.61.9 (2)1,009,188 27,379 1.9 ——$62.3 10 Roche2.7 (3)649,482 24,129 1.7 Aa3AA$295.3 11 bluebird bio, Inc.6.4 312,805 23,142 1.6 ——$3.7 12 Maxar Technologies4.5 478,000 21,577 1.5 ——$1.2 13 Massachusetts Institute of Technology8.0 257,626 21,145 1.5 AaaAAA$— 14 Jazz Pharmaceuticals, Inc.9.7 198,041 20,003 1.4 ——$7.2 15 New York University10.7 204,691 19,531 1.4 Aa2AA-$— 16 Merck & Co., Inc.13.4 311,015 19,392 1.4 A1AA-$204.9 17 Pfizer Inc.4.2 416,979 17,762 1.2 A2A+$203.2 18 Amgen Inc.3.3 407,369 16,838 1.2 Baa1A-$135.9 19 United States Government6.8 284,777 16,601 1.2 AaaAA+$— 20 athenahealth, Inc.12.4 333,956 15,413 1.1 ——$— Total/weighted average11.0 (2)10,228,175 $539,163 37.8 %Annual rental revenue and RSF include 100% of each property managed by us in North America. (1)Based on aggregate annual rental revenue in effect as of December 31, 2020. Refer to the definitions of “Annual rental revenue” and “Investment-grade or publicly traded large cap tenants” in the “Non-GAAP measures and definitions” section under Item 7 in this annual report on Form 10-K for additional information about our methodology on annual rental revenue from unconsolidated real estate joint ventures and average market capitalization. (2)Includes (i) ground leases for land at 1455 and 1515 Third Street (two buildings aggregating 422,980 RSF) and (ii) leases at 1655 and 1725 Third Street (two buildings aggregating 586,208 RSF) owned by our unconsolidated joint venture in which we have an ownership interest of 10%. Annual rental revenue is presented using 100% of the annual rental revenue of our consolidated properties and our share of annual rental revenue for our unconsolidated real estate joint ventures. Refer to footnote 1 for additional details. Excluding the ground lease, the weighted-average remaining lease term for our top 20 tenants was 8.4 years as of December 31, 2020.(3)Includes 197,787 RSF expiring in 2022 at our recently acquired property at 651 Gateway Boulevard in our South San Francisco submarket. Upon expiration of the lease, 651 Gateway Boulevard will be redeveloped into a Class A office/laboratory building. Excluding this 197,787 RSF, the weighted-average remaining term of space occupied by Roche is 3.1 years.51Long-Duration Cash Flows From High-Quality, Diverse, and Innovative TenantsInvestment-Grade or Publicly Traded Large Cap TenantsLong-Duration Lease Terms55%7.6 Yearsof ARE’sWeighted-AverageAnnual Rental Revenue(1)Remaining Term(2)Tenant MixPercentage of ARE’s Annual Rental Revenue(1)(1)Represents annual rental revenue in effect as of December 31, 2020. Refer to the “Non-GAAP measures and definitions” section under Item 7 in this annual report on Form 10-K for additional information.(2)Based on aggregate annual rental revenue in effect as of December 31, 2020. Refer to definition of “Annual rental revenue” in the “Non-GAAP measures and definitions” section under Item 7 in this annual report on Form 10-K for our methodology on annual rental revenue for unconsolidated real estate joint ventures.(3)Represents annual rental revenue currently generated from office space that is targeted for a future change in use. The weighted-average remaining term of these leases is 3.3 years.(4)Represents annual rental revenue from publicly traded tenants with an average daily market capitalization greater than $200 billion for the twelve months ended December 31, 2020.(5)Annual rental revenues from our other tenants, aggregating 3.0%, comprise 2.5% of annual rental revenue from technology, professional services, finance, telecommunications, and construction/real estate companies and only 0.5% from retail-related tenants.52High-Quality Cash Flows From High Quality Tenants andClass A Properties in AAA LocationsIndustry-LeadingTenant RosterAAA Locations85%of ARE’s Top 20Annual Rental Revenue(1)From Investment-Grade orPublicly TradedLarge Cap TenantsPercentage of ARE’s Annual Rental Revenue(1)Solid HistoricalOccupancy(2)Occupancy Across Key Locations(3)96%Over 10 Years(1)Represents annual rental revenue in effect as of December 31, 2020. Refer to the “Non-GAAP measures and definitions” section under Item 7 in this annual report on Form 10-K for additional information.(2)Represents average occupancy of operating properties in North America as of each December 31 for the last 10 years.(3)As of December 31, 2020.(4)Refer to the “Summary of occupancy percentages in North America” section within this Item 2 for additional information on vacancy at acquired properties.53Property listing The following table provides certain information about our properties as of December 31, 2020 (dollars in thousands):Occupancy PercentageRSFNumber of PropertiesAnnual Rental RevenueOperatingOperating and RedevelopmentMarket / Submarket / AddressOperatingDevelopmentRedevelopmentTotalGreater BostonCambridge/Inner SuburbsAlexandria Center® at Kendall Square2,365,487 — — 2,365,487 10$168,794 98.9 %98.9 %50, 60, 75/125(1), 100, and 225(1) Binney Street, 161 and 215 First Street, 150 Second Street, 300 Third Street, and 11 Hurley Street Alexandria Technology Square®1,181,635 — — 1,181,635 7101,943 99.7 99.7 100, 200, 300, 400, 500, 600, and 700 Technology SquareThe Arsenal on the Charles539,799 — 296,489 836,288 1121,914 100.0 64.5 311, 321, and 343 Arsenal Street, 300 and 400 North Beacon Street, 1, 2, and 3 Kingsbury Avenue, and 100, 200, and 400 Talcott AvenueAlexandria Center® at One Kendall Square815,156 — — 815,156 1067,853 96.8 96.8 One Kendall Square – Buildings 100, 200, 300, 400, 500, 600/700, 1400, 1800, 2000, and 399 Binney Street480 and 500 Arsenal Street234,260 — — 234,260 29,769 86.6 86.6 640 Memorial Drive 225,504 — — 225,504 113,860 100.0 100.0 780 and 790 Memorial Drive 99,658 — — 99,658 28,292 100.0 100.0 167 Sidney Street and 99 Erie Street54,549 — — 54,549 24,025 100.0 100.0 79/96 13th Street (Charlestown Navy Yard) 25,309 — — 25,309 1620 100.0 100.0 Cambridge/Inner Suburbs5,541,357 — 296,489 5,837,846 46397,070 98.4 93.4 Seaport Innovation District380 and 420 E Street195,506 — — 195,506 23,522 100.0 100.0 5 Necco Street87,163 — — 87,163 14,672 86.6 86.6 Seaport Innovation District282,669 — — 282,669 38,194 95.9 95.9 Route 128Reservoir Woods515,273 — — 515,273 322,004 100.0 100.0 40, 50, and 60 Sylvan Road275 Grove Street509,702 — — 509,702 122,577 87.4 87.4 One Upland Road and 100 Tech Drive443,513 — — 443,513 218,008 100.0 100.0 Alexandria Park at 128343,882 — — 343,882 812,544 100.0 100.0 3 and 6/8 Preston Court, 29, 35, and 44 Hartwell Avenue, 35 and 45/47 Wiggins Avenue, and 60 Westview Street225, 266, and 275 Second Avenue317,617 — — 317,617 314,073 100.0 100.0 19 Presidential Way144,892 — — 144,892 15,174 99.8 99.8 100 Beaver Street82,330 — — 82,330 14,254 100.0 100.0 285 Bear Hill Road26,270 — — 26,270 11,167 100.0 100.0 Route 1282,383,479 — — 2,383,479 2099,801 97.3 97.3 Route 495111 and 130 Forbes Boulevard155,846 — — 155,846 21,745 100.0 100.0 20 Walkup Drive91,045 — — 91,045 1649 100.0 100.0 Route 495246,891 — — 246,891 32,394 100.0 100.0 Greater Boston8,454,396 — 296,489 8,750,885 72$507,459 98.1 %94.8 %(1) We own a partial interest in this property through a real estate joint venture. Refer to the “Joint venture financial information” section under Item 7 in this annual report in Form 10-K for additional details.54Property listing (continued)Occupancy PercentageRSFNumber of PropertiesAnnual Rental RevenueOperatingOperating and RedevelopmentMarket / Submarket / AddressOperatingDevelopmentRedevelopmentTotalSan FranciscoMission BayAlexandria Center® for Science and Technology – Mission Bay1,990,262 — — 1,990,262 9$90,364 99.9 %99.9 %1455, 1515, 1655(1), and 1725(1) Third Street, 409 and 499 Illinois Street(1), 1500(1) and 1700 Owens Street, and 455 Mission Bay Boulevard SouthMission Bay1,990,262 — — 1,990,262 990,364 99.9 99.9 South San FranciscoAlexandria Technology Center® – Gateway1,412,480 — — 1,412,480 1154,517 81.5 81.5 600, 601(1), 611(1), 630, 650, 651(1), 681(1), 685(1), 701(1), 901, and 951 Gateway Boulevard213, 249, 259, 269, and 279 East Grand Avenue919,704 — — 919,704 548,744 100.0 100.0 201 Haskins Way— 315,000 — 315,000 1— N/AN/A400 and 450 East Jamie Court163,035 — — 163,035 29,549 100.0 100.0 500 Forbes Boulevard(1)155,685 — — 155,685 16,619 100.0 100.0 7000 Shoreline Court136,395 — — 136,395 18,547 99.4 99.4 341 and 343 Oyster Point Boulevard107,960 — — 107,960 25,767 100.0 100.0 849/863 Mitten Road/866 Malcolm Road103,857 — — 103,857 15,086 100.0 100.0 South San Francisco2,999,116 315,000 — 3,314,116 24138,829 91.3 91.3 Greater StanfordMenlo Gateway(1)772,983 — — 772,983 329,790 100.0 100.0 100 Independence Drive and 125 and 135 Constitution DriveAlexandria Center® for Life Science – San Carlos233,201 429,715 — 662,916 510,853 100.0 100.0 825, 835, and 960 Industrial Road and 987 and 1075 Commercial Street3825 and 3875 Fabian Way478,000 — — 478,000 221,577 100.0 100.0 Alexandria Stanford Life Science District289,685 — 92,147 381,832 423,888 100.0 75.9 3160, 3165, 3170, and 3181 Porter DriveAlexandria PARC197,498 — — 197,498 410,164 85.9 85.9 2100, 2200, 2300, and 2400 Geng Road3330, 3412, 3450, and 3460 Hillview Avenue183,267 — — 183,267 415,180 100.0 100.0 2425 Garcia Avenue/2400/2450 Bayshore Parkway 99,208 — — 99,208 14,257 100.0 100.0 Shoreway Science Center82,462 — — 82,462 25,340 100.0 100.0 75 and 125 Shoreway Road1450 Page Mill Road77,634 — — 77,634 18,009 100.0 100.0 3350 West Bayshore Road60,000 — — 60,000 12,191 62.3 62.3 2625/2627/2631 Hanover Street32,074 — — 32,074 11,820 100.0 100.0 Greater Stanford2,506,012 429,715 92,147 3,027,874 28133,069 98.0 94.5 San Francisco7,495,390 744,715 92,147 8,332,252 61$362,262 95.8 %94.7 %(1) We own a partial interest in this property through a real estate joint venture. Refer to the “Joint venture financial information” section under Item 7 in this annual report in Form 10-K for additional information.55Property listing (continued)Occupancy PercentageRSFNumber of PropertiesAnnual Rental RevenueOperatingOperating and RedevelopmentMarket / Submarket / AddressOperatingDevelopmentRedevelopmentTotalNew York CityNew York CityAlexandria Center® for Life Science – New York City740,972 — — 740,972 3$64,994 95.9 %95.9 %430 and 450 East 29th Street219 East 42nd Street349,947 — — 349,947 114,006 100.0 100.0 Alexandria Center® – Long Island City54,377 — 122,382 176,759 12,185 100.0 30.8 30-02 48th AvenueNew York City1,145,296 — 122,382 1,267,678 581,185 97.3 87.8 San DiegoTorrey PinesARE Spectrum336,461 146,456 — 482,917 418,072 100.0 100.0 3115 and 3215 Merryfield Row and 3013 and 3033 Science Park RoadARE Torrey Ridge294,326 — — 294,326 310,297 72.1 72.1 10578, 10618, and 10628 Science Center DriveARE Sunrise236,635 — — 236,635 38,238 100.0 100.0 10931/10933 and 10975 North Torrey Pines Road, 3010 Science Park Road, and 10996 Torreyana RoadARE Nautilus220,651 — — 220,651 410,924 100.0 100.0 3530 and 3550 John Hopkins Court and 3535 and 3565 General Atomics Court11119, 11255, and 11355 North Torrey Pines Road211,641 — — 211,641 38,738 100.0 100.0 3545 Cray Court118,225 — — 118,225 1— — — Torrey Pines1,417,939 146,456 — 1,564,395 1856,269 85.9 85.9 University Town CenterAlexandria Point(1)1,435,916 — — 1,435,916 861,391 99.1 99.1 9880(2), 10210, 10260, 10290, and 10300 Campus Point Drive and 4161, 4224, and 4242 Campus Point Court5200 Illumina Way(1)792,687 — — 792,687 629,977 100.0 100.0 University District535,459 — — 535,459 819,979 100.0 100.0 9363, 9393, and 9625(1) Towne Centre Drive, 4755, 4757, and 4767 Nexus Center Drive, and 4555 and 4796 Executive DriveUniversity Town Center2,764,062 — — 2,764,062 22$111,347 99.5 %99.5 %(1) We own a partial interest in this property through a real estate joint venture. Refer to the “Joint venture financial information” section under Item 7 in this annual report in Form 10-K for additional information.(2) We own 100% of this property.56Property listing (continued)Occupancy PercentageRSFNumber of PropertiesAnnual Rental RevenueOperatingOperating and RedevelopmentMarket / Submarket / AddressOperatingDevelopmentRedevelopmentTotalSan Diego (continued)Sorrento MesaSD Tech by Alexandria(1)779,989 — 79,945 859,934 13$24,130 87.3 %79.2 %9605, 9645, 9675, 9685, 9725, 9735, 9808, 9855, and 9868 Scranton Road, 5505 Morehouse Drive(2), and 10065, 10121(2), and 10151(2) Barnes Canyon Road6420 and 6450 Sequence Drive318,200 — — 318,200 28,069 89.5 89.5 Summers Ridge Science Park316,531 — — 316,531 411,077 100.0 100.0 9965, 9975, 9985, and 9995 Summers Ridge RoadARE Portola101,857 — — 101,857 33,603 100.0 100.0 6175, 6225, and 6275 Nancy Ridge Drive5810/5820 Nancy Ridge Drive82,272 — — 82,272 1855 41.4 41.4 7330 Carroll Road66,244 — — 66,244 12,431 100.0 100.0 9877 Waples Street63,774 — — 63,774 12,364 100.0 100.0 5871 Oberlin Drive33,817 — — 33,817 1892 50.2 50.2 Sorrento Mesa1,762,684 — 79,945 1,842,629 2653,421 88.8 84.9 Sorrento Valley3911, 3931, 3985, 4025, 4031, 4045, and 4075 Sorrento Valley Boulevard191,406 — — 191,406 75,691 100.0 100.0 11025, 11035, 11045, 11055, 11065, and 11075 Roselle Street121,655 — — 121,655 63,428 100.0 100.0 Sorrento Valley313,061 — — 313,061 139,119 100.0 100.0 I-15 Corridor13112 Evening Creek Drive109,780 — — 109,780 12,972 100.0 100.0 San Diego6,367,526 146,456 79,945 6,593,927 80233,128 93.5 92.4 SeattleLake UnionThe Eastlake Life Science Campus by Alexandria837,204 100,086 — 937,290 846,609 97.6 97.6 1165, 1201(1), 1208(1), 1616 and 1551 Eastlake Avenue East, 188 and 199(1) East Blaine Street, and 1600 Fairview Avenue East400 Dexter Avenue North290,111 — — 290,111 114,820 100.0 100.0 2301 5th Avenue197,135 — — 197,135 19,308 99.0 99.0 219 Terry Avenue North30,705 — — 30,705 11,852 100.0 100.0 601 Dexter Avenue North18,680 — — 18,680 1425 100.0 100.0 Lake Union1,373,835 100,086 — 1,473,921 12$73,014 98.4 %98.4 %(1) We own a partial interest in this property through a real estate joint venture. Refer to the “Joint venture financial information” section under Item 7 in this annual report in Form 10-K for additional information.(2) We own 100% of this property.57Property listing (continued)Occupancy PercentageRSFNumber of PropertiesAnnual Rental RevenueOperatingOperating and RedevelopmentMarket / Submarket / AddressOperatingDevelopmentRedevelopmentTotalSeattle (continued)SoDo830 4th Avenue South42,380 — — 42,380 1$1,479 70.5 %70.5 %Elliott Bay3000/3018 Western Avenue47,746 — — 47,746 11,839 100.0 100.0 410 West Harrison Street and 410 Elliott Avenue West36,724 — — 36,724 2415 36.4 36.4 Elliott Bay84,470 — — 84,470 32,254 72.4 72.4 Other246,647 — 213,976 460,623 64,730 94.9 50.8 Seattle1,747,332 100,086 213,976 2,061,394 2281,477 96.0 85.5 MarylandRockville9800, 9804, 9900, 9920, and 9950 Medical Center Drive383,956 261,096 — 645,052 814,944 93.1 93.1 9704, 9708, 9712, and 9714 Medical Center Drive215,619 — — 215,619 47,926 100.0 100.0 1330 Piccard Drive131,511 — — 131,511 13,810 100.0 100.0 9605 Medical Center Drive115,691 — — 115,691 13,100 83.1 83.1 1500 and 1550 East Gude Drive90,489 — — 90,489 21,411 77.3 77.3 14920 and 15010 Broschart Road86,703 — — 86,703 22,283 100.0 100.0 1405 Research Boulevard72,170 — — 72,170 12,476 100.0 100.0 5 Research Place63,852 — — 63,852 12,743 100.0 100.0 5 Research Court51,520 — — 51,520 11,788 100.0 100.0 9920 Belward Campus Drive51,181 — — 51,181 11,687 100.0 100.0 12301 Parklawn Drive49,185 — — 49,185 11,329 100.0 100.0 Rockville1,311,877 261,096 — 1,572,973 2343,497 94.9 94.9 GaithersburgAlexandria Technology Center® – Gaithersburg I613,438 — — 613,438 916,177 96.3 96.3 9, 25, 35, 45, 50, and 55 West Watkins Mill Road and 910, 930, and 940 Clopper RoadAlexandria Technology Center® – Gaithersburg II315,085 — 169,420 484,505 77,966 94.3 61.3 700, 704(1), and 708 Quince Orchard Road and 19, 20, 21, and 22 Firstfield Road401 Professional Drive63,154 — — 63,154 11,833 100.0 100.0 950 Wind River Lane50,000 — — 50,000 11,004 100.0 100.0 620 Professional Drive27,950 — — 27,950 11,207 100.0 100.0 Gaithersburg1,069,627 — 169,420 1,239,047 1928,187 96.2 83.0 Beltsville8000/9000/10000 Virginia Manor Road 191,884 — — 191,884 12,618 98.4 98.4 Northern Virginia14225 Newbrook Drive248,186 — — 248,186 16,127 100.0 100.0 Maryland2,821,574 261,096 169,420 3,252,090 44$80,429 96.1 %90.6 %(1) We own a partial interest in this property through a real estate joint venture. Refer to the “Joint venture financial information” section under Item 7 in this annual report in Form 10-K for additional information.58Property listing (continued)Occupancy PercentageRSFNumber of PropertiesAnnual Rental RevenueOperatingOperating and RedevelopmentMarket / Submarket / AddressOperatingDevelopmentRedevelopmentTotalResearch TriangleResearch TriangleAlexandria Center® for Life Science – Durham1,585,766 — 652,381 2,238,147 16$26,261 84.1 %59.6 %6, 8, 10, 12, 14, 40, 41, 42, and 65 Moore Drive, 21, 25, 27, 29, and 31 Parmer Way, 2400 Ellis Road, and 14 TW Alexander DriveAlexandria Center® for Advanced Technologies100,000 250,000 — 350,000 32,296 99.0 99.0 6, 8, and 10 Davis DriveAlexandria Center® for AgTech180,400 160,000 — 340,400 26,488 95.2 95.2 5 and 9 Laboratory DriveAlexandria Technology Center® – Alston186,870 — — 186,870 33,951 94.7 94.7 100, 800, and 801 Capitola Drive108/110/112/114 TW Alexander Drive 158,417 — — 158,417 14,624 85.8 85.8 Alexandria Innovation Center® – Research Triangle136,455 — — 136,455 34,108 100.0 100.0 7010, 7020, and 7030 Kit Creek Road7 Triangle Drive96,626 — — 96,626 13,156 100.0 100.0 2525 East NC Highway 5482,996 — — 82,996 13,651 100.0 100.0 407 Davis Drive81,956 — — 81,956 11,644 100.0 100.0 601 Keystone Park Drive77,395 — — 77,395 11,375 100.0 100.0 6040 George Watts Hill Drive61,547 — — 61,547 12,148 100.0 100.0 5 Triangle Drive32,120 — — 32,120 11,112 100.0 100.0 6101 Quadrangle Drive30,122 — — 30,122 1540 100.0 100.0 Research Triangle2,810,670 410,000 652,381 3,873,051 3561,354 89.6 72.7 Canada256,967 — — 256,967 34,870 81.8 81.8 Non-cluster/other markets549,479 — — 549,479 1210,608 52.7 52.7 North America, excluding properties held for sale31,648,630 1,662,353 1,626,740 34,937,723 3341,422,772 94.6 %90.0 %Properties held for sale225,849 — — 225,849 46,257 51.1 %51.1 %Total – North America31,874,479 1,662,353 1,626,740 35,163,572 338$1,429,029 59Leasing activity •Executed a total of 244 leases, with a weighted-average lease term of 7.3 years, for 4.4 million RSF, including 1.0 million RSF related to our development and redevelopment projects, during the year ended December 31, 2020; leasing activity of 2.6 million RSF of renewed and re-leased space represents the highest annual leasing activity in the past 10 years; and •Strong rental rate increases of 37.6% and 18.3% (cash basis) on renewed and re-leased space, representing our highest annual increase during the past 10 years. Approximately 59% of the 244 leases executed during the year ended December 31, 2020, did not include concessions for free rent. During the year ended December 31, 2020, we granted tenant concessions/free rent averaging 2.1 months with respect to the 4.4 million RSF leased.The following chart presents renewed/re-leased space and development/redevelopment/previously vacant space leased for the years ended December 31, 2020, 2019, and 2018:Lease structureOur Same Properties total revenue growth of 2.1% for the year ended December 31, 2020, and our Same Properties net operating income and Same Properties net operating income (cash basis) increases for the year ended December 31, 2020, of 2.6% and 5.1%, respectively, benefited significantly from strong market fundamentals. The limited supply of Class A space in AAA locations and strong demand from innovative tenants drove rental rate increases of 37.6% and 18.3% (cash basis) on 2.6 million renewed/re-leased RSF, while a favorable triple net lease structure with contractual annual rent escalations resulted in both a consistent Same Properties operating margin of 73.0% and occupancy of 96.6% across our 209 Same Properties aggregating 20.7 million RSF. As of December 31, 2020, approximately 94% of our leases (on an RSF basis) were triple net leases, which require tenants to pay substantially all real estate taxes, insurance, utilities, repairs and maintenance, common area expenses, and other operating expenses (including increases thereto) in addition to base rent. Additionally, approximately 94% of our leases (on an RSF basis) contained contractual annual rent escalations that were either fixed or based on a consumer price index or another index, and approximately 93% of our leases (on an RSF basis) provided for the recapture of certain capital expenditures. 60Leasing activity (continued)The following table summarizes our leasing activity at our properties for the years ended December 31, 2020 and 2019:Year Ended December 31,20202019Including Straight-Line RentCash BasisIncluding Straight-Line RentCash Basis(Dollars per RSF)Leasing activity:Renewed/re-leased space(1) Rental rate changes37.6%(2)18.3%(2)32.2%17.6%New rates$49.51 $46.53 $58.65 $56.19 Expiring rates$35.99 $39.32 $44.35 $47.79 RSF2,556,833 (2)2,427,108 Tenant improvements/leasing commissions$35.08 $20.28 Weighted-average lease term6.0 years5.7 yearsDeveloped/redeveloped/previously vacant space leasedNew rates$56.67 $53.61 $55.95 $52.19 RSF1,802,013 2,635,614 Tenant improvements/leasing commissions$28.17 $13.74 Weighted-average lease term9.0 years9.8 yearsLeasing activity summary (totals):New rates$52.47 $49.46 $57.25 $54.11 RSF4,358,846 (3)5,062,722 Tenant improvements/leasing commissions$32.22 $16.88 Weighted-average lease term7.3 years7.8 yearsLease expirations(1)Expiring rates$36.03 $39.01 $43.43 $46.59 RSF3,560,188 2,822,434 Leasing activity includes 100% of results for properties in which we have an investment in North America. (1)Excludes month-to-month leases aggregating 96,383 RSF and 41,809 RSF as of December 31, 2020 and 2019, respectively.(2)Represents our highest annual rental rate increases and RSF leasing activity for renewed and re-leased space in the past 10 years. (3)During the year ended December 31, 2020, we granted tenant concessions/free rent averaging 2.1 months with respect to the 4,358,846 RSF leased. Approximately 59% of the leases executed during the year ended December 31, 2020, did not include concessions for free rent.61Summary of contractual lease expirationsThe following table summarizes information with respect to the contractual lease expirations at our properties as of December 31, 2020:YearRSFPercentage ofOccupied RSFAnnual Rental Revenue(Per RSF)(1)Percentage of TotalAnnual Rental Revenue2021(2)1,880,366 6.3 %$40.75 5.3 %20222,512,016 8.4 %$45.95 7.9 %20233,387,053 11.3 %$41.50 9.6 %20242,273,200 7.6 %$45.03 7.0 %20252,366,093 7.9 %$46.79 7.6 %20261,725,242 5.8 %$47.71 5.6 %20272,071,365 6.9 %$52.36 7.4 %20282,449,460 8.2 %$49.28 8.3 %20291,829,233 6.1 %$55.68 7.0 %20302,074,876 6.9 %$52.67 7.5 %Thereafter7,386,330 24.6 %$52.73 26.8 %(1)Represents amounts in effect as of December 31, 2020.(2)Excludes month-to-month leases aggregating 96,383 RSF as of December 31, 2020.The following tables present information by market with respect to our 2021 and 2022 contractual lease expirations in North America as of December 31, 2020:2021 Contractual Lease Expirations (in RSF)Annual Rental Revenue(Per RSF)(4)MarketLeasedNegotiating/AnticipatingTargeted for Development/Redevelopment(1)RemainingExpiring Leases(2)Total(3)Greater Boston60,186 80,265 266,484 228,358 635,293 $44.31 San Francisco37,839 233,606 26,738 212,785 510,968 45.76 New York City— 7,924 — 2,007 9,931 N/ASan Diego101,437 89,576 41,475 213,047 445,535 31.73 Seattle— 15,184 — 20,974 36,158 49.69 Maryland33,000 — — 29,865 62,865 23.38 Research Triangle16,942 — — 90,364 107,306 31.37 Canada— — — 13,672 13,672 23.71 Non-cluster/other markets— — — 58,638 58,638 44.70 Total249,404 426,555 334,697 869,710 1,880,366 $40.75 Percentage of expiring leases13 %23 %18 %46 %100 %2022 Contractual Lease Expirations (in RSF)Annual Rental Revenue(Per RSF)(4)MarketLeasedNegotiating/AnticipatingTargeted for Development/Redevelopment(1)RemainingExpiring Leases(5)TotalGreater Boston— 7,072 — 568,831 (6)575,903 $58.15 San Francisco— 10,011 490,127 277,836 777,974 49.56 New York City18,120 27,179 — 2,979 48,278 N/ASan Diego83,104 — 231,585 243,454 558,143 38.55 Seattle— — 51,255 125,462 176,717 36.36 Maryland— — — 74,817 74,817 29.40 Research Triangle— — — 221,937 221,937 21.77 Canada— — — 28,664 28,664 20.97 Non-cluster/other markets— — — 49,583 49,583 55.84 Total101,224 44,262 772,967 1,593,563 2,512,016 $45.95 Percentage of expiring leases4 %2 %31 %63 %100 % (1)Represents RSF targeted for development or redevelopment upon expiration of existing in-place leases, primarily related to recently acquired properties. Refer to “Investments in real estate – value-creation square footage currently in rental properties” in the “Non-GAAP measures and definitions” section under Item 7 in this annual report on Form 10-K for additional details on value-creation square feet currently included in rental properties.(2)The largest remaining contractual lease expirations are three leases ranging from 35,000 RSF to 45,000 RSF.(3)Excludes month-to-month leases aggregating 96,383 RSF as of December 31, 2020.(4)Represents amounts in effect as of December 31, 2020.(5)The largest remaining contractual lease expiration includes Class A office/laboratory buildings aggregating 113,555 RSF in our Cambridge/Inner Suburbs submarket and four other leases ranging from 50,000 RSF to 60,000 RSF.(6)68% of the remaining expiring leases in Greater Boston are located in our Cambridge/Inner Suburbs submarket.62Investments in real estateA key component of our business model is our disciplined allocation of capital to the development and redevelopment of new Class A properties located in collaborative life science, technology, and agtech campuses in AAA urban innovation clusters. These projects are focused on providing high-quality, generic, and reusable spaces that meet the real estate requirements of, and are reusable by, a wide range of tenants. Upon completion, each value-creation project is expected to generate a significant increase in rental income, net operating income, and cash flows. Our development and redevelopment projects are generally in locations that are highly desirable to high-quality entities, which we believe results in higher occupancy levels, longer lease terms, higher rental income, higher returns, and greater long-term asset value. Our pre-construction activities are undertaken in order to get the property ready for its intended use and include entitlements, permitting, design, site work, and other activities preceding commencement of construction of aboveground building improvements. As of the date of this report, construction activities were in process at all of our active construction projects. Construction workers continue to observe social distancing and follow rules that restrict gatherings of large groups of people in close proximity, aswell as adhere to other appropriate measures, which may slow the pace of construction.Our investments in real estate consisted of the following as of December 31, 2020 (dollars in thousands):Development and RedevelopmentOperatingUnder ConstructionNearTermIntermediateTermFutureSubtotalTotalInvestments in real estateBook value as of December 31, 2020(1)$17,423,908 $1,667,842 $955,207 $452,404 $738,994 $3,814,447 $21,238,355 Square footageOperating31,874,479 — — — — — 31,874,479 New Class A development and redevelopment properties— 3,289,093 4,931,216 3,521,115 9,208,795 20,950,219 20,950,219 Value-creation square feet currently included in rental properties(2)— — (617,749)(684,030)(1,810,218)(3,111,997)(3,111,997)Total square footage31,874,479 3,289,093 4,313,467 2,837,085 7,398,577 17,838,222 49,712,701 (1)Balances exclude our share of the cost basis associated with our properties held by our unconsolidated real estate joint ventures, which is classified as investments in unconsolidated real estate joint ventures in our consolidated balance sheets.(2)Refer to “Investments in real estate – value-creation square footage currently in rental properties” in the “Non-GAAP measures and definitions” section under Item 7 in this annual report on Form 10-K for additional details on value-creation square feet currently included in rental properties.63AcquisitionsOur real estate asset acquisitions for the year ended December 31, 2020, consisted of the following (dollars in thousands):PropertySubmarket/MarketDate of PurchaseNumber of PropertiesOperatingOccupancySquare FootageUnlevered YieldsPurchase PriceFuture DevelopmentActive RedevelopmentOperating With Future Development/ RedevelopmentOperatingInitial StabilizedInitial Stabilized (Cash)Year ended December 31, 2020:Alexandria Center® for Life Science – DurhamResearch Triangle/ Research Triangle8/21/201684 %— 652,381 100,145 1,485,621 (1)(1)$590,412 Reservoir WoodsRoute 128/ Greater Boston8/25/203100 440,000 — 515,273 — (2)(2)325,307 275 Grove StreetRoute 128/Greater Boston1/10/20199 — — — 509,702 8.0 %6.7 %226,512 601, 611, and 651 Gateway Boulevard (51% interest in consolidated JV)South San Francisco/San Francisco1/28/20373 (3)260,000 — 300,010 475,993 (2)(2)(4)6420 and 6450 Sequence DriveSorrento Mesa/San Diego11/13/20289 (5)709,000 — 202,915 115,285 7.2 %(5)6.2 %(5)169,698 380 and 420 E StreetSeaport Innovation District/Greater Boston10/29/202100 1,000,000 (6)— 195,506 — (2)(2)168,500 3181 Porter DriveGreater Stanford/ San Francisco8/6/201100 — — — 104,011 7.2 %5.0 %115,200 987 and 1075 Commercial StreetGreater Stanford/ San Francisco4/14/202N/A700,000 (6)— 26,738 — (2)(2)113,250 One Upland RoadRoute 128/Greater Boston8/19/201100 450,000 — — 243,082 6.3 %(7)5.6 %(7)110,257 3330 and 3412 Hillview AvenueGreater Stanford/ San Francisco2/5/202100 — — — 106,316 7.6 %4.2 %105,000 9808 and 9868 Scranton Road(8)Sorrento Mesa/San Diego1/10/20288 — — — 219,628 7.3 %6.8 %102,250 11255 and 11355 North Torrey Pines RoadTorrey Pines/San Diego7/22/202100 240,000 (6)— 139,135 — (2)(2)97,500 3450 and 3460 Hillview AvenueGreater Stanford/ San Francisco10/6/202100 — — 76,951 — (2)(2)65,748 4555 Executive DriveUniversity Town Center/San Diego6/2/201100 200,000 (6)— 41,475 — (2)(2)43,000 700 Quince Orchard RoadGaithersburg/Maryland10/23/201N/A— 169,420 — — 8.6 %7.3 %43,000 OtherVariousVarious1455 1,082,713 277,750 164,656 570,952 N/AN/A287,768 5585 %5,081,713 1,099,551 1,762,804 3,830,590 $2,563,402 (1)The campus includes 16 properties, of which three properties aggregating 652,381 RSF are currently undergoing active redevelopment. We expect to achieve unlevered initial stabilized yields of 6.2% and 5.8% (cash basis) for the 13 operating properties. These operating properties generate 99% of annual rental revenue from investment-grade tenants. Refer to “New Class A development and redevelopment properties: current projects” within this Item 2 in this annual report on Form 10-K for additional details on the three properties undergoing active redevelopment.(2)We expect to provide total estimated costs and related yields for development and redevelopment projects in the future, subsequent to the commencement of construction.(3)Includes 199,895 RSF of vacancy as of December 31, 2020. Refer to the “Summary of occupancy percentages in North America” section earlier within this Item 2 in this annual report on Form 10-K for additional details.(4)Refer to Note 4 – “Consolidated and unconsolidated real estate joint ventures” to our consolidated financial statements under Item 15 in this annual report on Form 10-K for additional details.(5)The two operating properties are currently 89% occupied, and upon completion of renovations, a lease for 60,432 RSF will commence in the second half of 2021, which will increase occupancy to 100%. We expect to achieve unlevered initial stabilized yields of 7.2% and 6.2% (cash basis) for these operating properties.(6)Represents total square footage upon completion of development or redevelopment of a new Class A property. Square footage presented includes RSF of buildings currently in operation at properties with inherent future development or redevelopment opportunities. We intend to demolish or redevelop the existing property upon expiration of the existing in-place leases and commencement of future construction. Refer to the definition of “Investments in real estate – value-creation square footage currently in rental properties” in the “Non-GAAP measures and definitions” section under Item 7 in this annual report on Form 10-K for additional information.(7)Represents unlevered initial stabilized yields for the operating property, excluding excess land.(8)In April 2020, we completed the sale of properties at 9808 and 9868 Scranton Road to the existing SD Tech by Alexandria consolidated real estate joint venture, of which we own 50%. We received gross proceeds of $51.1 million for the 50% interest in the properties that our joint venture partner acquired through the joint venture. We continue to control and consolidate this joint venture; therefore, we accounted for the sale as an equity transaction with no gain or loss recognized in earnings. Refer to the next page for additional information.64DispositionsOur completed dispositions of real estate assets during the year ended December 31, 2020, consisted of the following (dollars in thousands, except for sales price per RSF):PropertySubmarket/MarketDate of SaleInterest SoldRSFSales PriceSales Price per RSFGain510 Townsend Street and 505 Brannan StreetSoMa/San Francisco11/20/20100%443,479 $560,162 (1)$1,263 $151,871 945 Market StreetSoMa/San Francisco9/4/2099.5%255,765 198,000 $774 — 9808 and 9868 Scranton RoadSorrento Mesa/San Diego4/13/2050%219,628 51,104 $465 (2)1201 and 1208 Eastlake Avenue East and 199 East Blaine StreetLake Union/Seattle11/24/2070%321,218 314,466 (3)$1,399 (4)OtherVariousVarious100%105,614 13,600 $129 2,218 1,345,704 $1,137,332 $154,089 (1)We completed the dispositions of these two tech office properties at capitalization rates of 5.3% and 5.0% (cash basis) based on annualized net operating income and net operating income (cash basis), respectively, for the three months ended September 30, 2020.(2)We completed the sale of properties at 9808 and 9868 Scranton Road in our Sorrento Mesa submarket to the existing SD Tech by Alexandria consolidated real estate joint venture, in which we have a 50% ownership interest. We retained control over this real estate joint venture, and therefore, we continue to consolidate these properties. For consolidated joint ventures, we account for the difference between the consideration received and the book value of the interest sold as an equity transaction, with no gain or loss recognized in earnings.(3)This transaction represents capitalization rate of 4.2%, based on annualized net operating income and net operating income (cash basis) for the three months ended December 31, 2020.(4)This sale of a partial interest represents consideration in excess of book value aggregating $211.3 million. We retained control over this real estate joint venture, and therefore, we continue to consolidate these properties. For consolidated joint ventures, we account for the consideration in excess of net book value of the interest sold as an equity transaction, with no gain or loss recognized in earnings. 65Sustainability(1)Source: Centers for Disease Control and Prevention, “Overdose Deaths Accelerating During COVID-19,” December 17, 2020.66(1)13 projects have been certified and another 38 projects are in process targeting WELL or Fitwel certification.(2)Alexandria LaunchLabs® – New York City achieved the WELL Health-Safety Rating in October 2020.(3)Relative to a 2015 baseline for buildings in operation that Alexandria directly manages.(4)For buildings in operation that Alexandria indirectly and directly manages.(5)Reflects sum of annual like-for-like progress from 2015 to 2019.(6)Reflects progress for all buildings in operation in 2019 that Alexandria indirectly and directly manages.67New Class A development and redevelopment properties: recent deliveriesAlexandria Center® for Life Science – San CarlosAlexandria Center® – Long Island City9877 Waples StreetSan Francisco/Greater Stanford New York City/New York CitySan Diego/Sorrento Mesa96,463 RSF17,716 RSF63,744 RSF The following table presents value-creation development and redevelopment of new Class A properties placed into service during the three months ended December 31, 2020 (dollars in thousands):Property/Market/SubmarketDelivery DateOur Ownership InterestDev/RedevRSF Placed in Service in 4Q20Occupancy Percentage(1)Total ProjectUnlevered YieldsInitial StabilizedInitial Stabilized (Cash Basis)RSFInvestmentAlexandria Center® for Life Science – San Carlos/San Francisco/Greater StanfordDecember 2020100%Dev96,463 100%526,178 $630,000 6.4 %6.1 %Alexandria Center® – Long Island City/New York City/New York CityDecember 2020100%Redev17,716 100%176,759 $184,300 5.5 %5.6 %9877 Waples Street/San Diego/Sorrento MesaDecember 2020100%Redev63,774 100%63,744 $31,000 8.8 %8.1 %Total177,953 (1) Relates to total operating RSF placed in service as of the most recent delivery.68New Class A development and redevelopment properties: current projectsThe Arsenal on the Charles201 Haskins WayAlexandria Center® for Life Science – San CarlosGreater Boston/Cambridge/Inner SuburbsSan Francisco/South San FranciscoSan Francisco/Greater Stanford 296,489 RSF315,000 RSF429,715 RSF3160 Porter DriveAlexandria Center® – Long Island City3115 Merryfield Row5505 Morehouse DriveSan Francisco/Greater StanfordNew York City/New York CitySan Diego/Torrey PinesSan Diego/Sorrento Mesa92,147 RSF122,382 RSF146,456 RSF79,945 RSF69New Class A development and redevelopment properties: current projects (continued)1165 Eastlake Avenue East9804 Medical Center Drive9950 Medical Center DriveSeattle/Lake UnionMaryland/RockvilleMaryland/Rockville100,086 RSF176,832 RSF84,264 RSF700 Quince Orchard RoadAlexandria Center® for Life Science – Durham(1)Alexandria Center® for AgTechAlexandria Center® for Advanced TechnologiesMaryland/GaithersburgResearch Triangle/Research TriangleResearch Triangle/Research TriangleResearch Triangle/Research Triangle169,420 RSF652,381 RSF160,000 RSF250,000 RSF(1) Represents 2400 Ellis Road in our Alexandria Center® for Life Science – Durham campus.70New Class A development and redevelopment properties: current projects (continued)The following tables set forth a summary of our new Class A development and redevelopment properties under construction and pre-leased near-term projects as of December 31, 2020 (dollars in thousands):Property/Market/SubmarketSquare FootagePercentageDev/RedevIn ServiceCIPTotalLeasedLeased/NegotiatingInitialOccupancy(1)Under constructionThe Arsenal on the Charles/Greater Boston/Cambridge/Inner SuburbsRedev539,799 296,489 836,288 86 %92 %2021201 Haskins Way/San Francisco/South San FranciscoDev— 315,000 315,000 100 100 2Q21Alexandria Center® for Life Science – San Carlos/San Francisco/ Greater StanfordDev96,463 429,715 526,178 89 100 4Q203160 Porter Drive/San Francisco/Greater StanfordRedev— 92,147 92,147 20 20 1H21Alexandria Center® – Long Island City/New York City/New York CityRedev54,377 122,382 176,759 31 31 4Q203115 Merryfield Row/San Diego/Torrey PinesDev— 146,456 146,456 80 87 20225505 Morehouse Drive/San Diego/Sorrento MesaRedev— 79,945 79,945 35 35 20211165 Eastlake Avenue East/Seattle/Lake UnionDev— 100,086 100,086 100 100 2Q21Other/SeattleRedev246,647 213,976 460,623 51 51 20229804 Medical Center Drive/Maryland/RockvilleDev— 176,832 176,832 100 100 1Q219950 Medical Center Drive/Maryland/RockvilleDev— 84,264 84,264 100 100 2021700 Quince Orchard Road/Maryland/GaithersburgRedev— 169,420 169,420 100 100 2021Alexandria Center® for Life Science – Durham/Research Triangle/ Research Triangle(2)Redev— 652,381 652,381 77 77 1H21/2022Alexandria Center® for AgTech/Research Triangle/Research Triangle(3)Redev/Dev180,400 160,000 340,400 55 55 2021Alexandria Center® for Advanced Technologies/Research Triangle/ Research TriangleDev— 250,000 250,000 (4)40 (4)55 (4)2H21/20221,117,686 3,289,093 4,406,779 74 78 Pre-leased near-term projectsAlexandria Point/San Diego/University Town Center(5)Dev— 171,102 171,102 100 100 SD Tech by Alexandria/San Diego/Sorrento Mesa(6)Dev— 176,428 176,428 59 59 — 347,530 347,530 79 79 1,117,686 3,636,623 4,754,309 75 %78 %Key additions in January 2021201 Brookline Avenue/Greater Boston/FenwayDev— 510,116 510,116 17 %25 %840 Winter Street/Greater Boston/Route 128Redev30,009 130,000 160,009 19 %19 %30,009 640,116 670,125 1,147,695 4,276,739 5,424,434 (1)Initial occupancy dates are subject to leasing and/or market conditions. Construction disruptions resulting from COVID-19 and observance of social distancing measures may further impact construction and occupancy forecasts and will continue to be monitored closely. Multi-tenant projects may have occupancy by tenants over a period of time. Stabilized occupancy may vary depending on single tenancy versus multi-tenancy.(2)The recently acquired Alexandria Center® for Life Science – Durham redevelopment project includes three properties at 40 Moore Drive, 2400 Ellis Road, and 14 TW Alexander Drive. 2400 Ellis Road is 100% leased, with initial occupancy anticipated in the first half of 2021 and stabilized occupancy expected for the remaining buildings in 2022.(3)The new strategic collaborative agtech campus consists of Phase I at 5 Laboratory Drive, including campus amenities, and Phase II at 9 Laboratory Drive. (4)Represents 150,000 RSF with 26% negotiating at 8 Davis Drive and 100,000 RSF that is 100% leased at 10 Davis Drive. Vertical construction at 8 Davis Drive has commenced, and 10 Davis Drive is expected to commence in the second quarter of 2021.(5)Represents our 4150 Campus Point Court property and is expected to commence vertical construction in the second quarter of 2021.(6)Represents our 10055 Barnes Canyon Road property and is expected to commence vertical construction in the second quarter of 2021.71New Class A development and redevelopment properties: current projects (continued)Our Ownership InterestUnlevered YieldsProperty/Market/SubmarketIn ServiceCIPCost to CompleteTotal atCompletionInitial StabilizedInitial Stabilized (Cash Basis)Under constructionThe Arsenal on the Charles/Greater Boston/Cambridge/Inner Suburbs100 %$391,180 $184,995 $195,825 $772,000 6.2 %5.5 %201 Haskins Way/San Francisco/South San Francisco100 %— 255,992 $114,008 $370,000 6.4 %6.2 %Alexandria Center® for Life Science – San Carlos/San Francisco/Greater Stanford100 %85,898 389,460 $154,642 $630,000 6.4 %6.1 %3160 Porter Drive/San Francisco/Greater Stanford100 %— 60,895 TBDAlexandria Center® – Long Island City/New York City/New York City100 %33,683 125,929 $24,688 $184,300 5.5 %5.6 %3115 Merryfield Row/San Diego/Torrey Pines100 %— 66,609 $85,391 $152,000 6.2 %6.2 %5505 Morehouse Drive/San Diego/Sorrento Mesa100 %— 16,996 TBD1165 Eastlake Avenue East/Seattle/Lake Union100 %— 106,061 $31,939 $138,000 6.5 %(1)6.3 %(1)Other/Seattle100 %53,941 64,323 TBD9804 Medical Center Drive/Maryland/Rockville100 %— 85,725 $9,675 $95,400 7.7 %7.2 %9950 Medical Center Drive/Maryland/Rockville100 %— 40,520 $13,780 $54,300 7.3 %6.8 %700 Quince Orchard Road/Maryland/Gaithersburg100 %— 45,887 $33,613 $79,500 8.6 %7.3 %Alexandria Center® for Life Science – Durham/Research Triangle/Research Triangle100 %— 134,451 $110,549 $245,000 7.5 %6.7 %Alexandria Center® for AgTech/Research Triangle/Research Triangle100 %90,001 57,394 TBDAlexandria Center® for Advanced Technologies/Research Triangle/Research Triangle100 %— 32,605 654,703 1,667,842 Pre-leased near-term projectsAlexandria Point/San Diego/University Town Center55.0 %— 26,922 SD Tech by Alexandria/San Diego/Sorrento Mesa50.0 %— 15,310 — 42,232 Total$654,703 $1,710,074 (1)Unlevered yields represent anticipated aggregate returns for 1165 Eastlake Avenue East, an amenity-rich research headquarters for Adaptive Biotechnologies Corporation, and 1208 Eastlake Avenue East, an adjacent multi-tenant office/laboratory building.72New Class A development and redevelopment properties: summary of pipelineThe following table summarizes the key information for all our development and redevelopment projects in North America as of December 31, 2020 (dollars in thousands):Property/SubmarketOur Ownership InterestBook ValueSquare FootageDevelopment and RedevelopmentTotalUnder ConstructionNear TermIntermediate TermFutureGreater BostonThe Arsenal on the Charles/Cambridge/Inner Suburbs100 %$202,801 296,489 264,056 (1)(2)— — 560,545 325 Binney Street/Cambridge100 %128,666 — 450,000 (1)— — 450,000 57 Coolidge Avenue/Cambridge/Inner Suburbs75.0 %47,461 — 275,000 (1)— — 275,000 15 Necco Street/Seaport Innovation District97.1 %185,049 — 350,000 (1)— — 350,000 Reservoir Woods/Route 128100 %42,246 — 202,428 (1)(2)— 752,845 (2)955,273 10 Necco Street/Seaport Innovation District100 %91,032 — — 175,000 — 175,000 215 Presidential Way/Route 128100 %6,803 — — 112,000 — 112,000 Alexandria Technology Square®/Cambridge100 %7,881 — — — 100,000 100,000 380 and 420 E Street/Seaport Innovation District100 %115,818 — — — 1,000,000 (2)1,000,000 99 A Street/Seaport Innovation District95.5 %44,700 — — — 235,000 235,000 One Upland Road and 100 Tech Drive/Route 128100 %8,498 — — — 750,000 750,000 231 Second Avenue/Route 128100 %1,093 — — — 32,000 32,000 Other value-creation projects100 %9,774 — — — 16,955 16,955 891,822 296,489 1,541,484 287,000 2,886,800 5,011,773 San Francisco201 Haskins Way/South San Francisco100 %255,992 315,000 — — — 315,000 Alexandria Center® for Life Science – San Carlos/Greater Stanford100 %641,372 429,715 — 700,000 (2)587,000 (2)1,716,715 3160 Porter Drive/Greater Stanford100 %60,895 92,147 — — — 92,147 88 Bluxome Street/SoMa100 %300,025 — 1,070,925 — — 1,070,925 Alexandria Technology Center® – Gateway/South San Francisco45.1 %45,814 — 517,010 (1)(2)— 291,000 808,010 3825 and 3875 Fabian Way/Greater Stanford100 %— — — 250,000 (2)228,000 (2)478,000 3450 and 3460 Hillview Avenue/Greater Stanford100 %— — — 76,951 (2)— 76,951 East Grand Avenue/South San Francisco100 %6,112 — — — 90,000 90,000 Other value-creation projects100 %55,379 — — 191,000 25,000 216,000 $1,365,589 836,862 1,587,935 1,217,951 1,221,000 4,863,748 (1)We expect to commence vertical construction or redevelopment of all or a portion of this project in 2021.(2)Represents total square footage upon completion of development or redevelopment of a new Class A property. Square footage presented includes RSF of buildings currently in operation at properties that also have inherent future development or redevelopment opportunities, for which we have the intent to demolish or redevelop the existing property upon expiration of the existing in-place leases and commencement of future construction. Refer to the definition of “Investments in real estate – value-creation square footage currently in rental properties” in the “Non-GAAP measures and definitions” section under Item 7 in this annual report on Form 10-K for additional information.73New Class A development and redevelopment properties: summary of pipeline (continued)Property/SubmarketOur Ownership InterestBook ValueSquare FootageDevelopment and RedevelopmentTotalUnder ConstructionNear TermIntermediate TermFutureNew York CityAlexandria Center® – Long Island City/New York City100 %$125,929 122,382 — — — 122,382 47-50 30th Street/New York City100 %29,351 — 135,938 — — 135,938 Alexandria Center® for Life Science – New York City/New York City100 %58,381 — — 550,000 (1)— 550,000 219 East 42nd Street/New York City100 %— — — — 579,947 (2)579,947 213,661 122,382 135,938 550,000 579,947 1,388,267 San Diego3115 Merryfield Row/Torrey Pines100 %66,609 146,456 — — — 146,456 5505 Morehouse Drive/Sorrento Mesa100 %16,996 79,945 — — — 79,945 Alexandria Point/University Town Center55.0 %104,646 — 351,102 (3)249,164 (4)320,281 (4)920,547 SD Tech by Alexandria/Sorrento Mesa50.0 %99,681 — 366,502 (3)160,000 333,845 860,347 Townsgate by Alexandria/Del Mar Heights100 %22,424 — 185,000 — — 185,000 10931 and 10933 Torrey Pines Road/Torrey Pines100 %— — — 242,000 (4)— 242,000 University District/University Town Center100 %54,020 — — 600,000 (4)(5)— 600,000 11255 and 11355 North Torrey Pines Road/Torrey Pines100 %106,889 — — — 240,000 (4)240,000 5200 Illumina Way/University Town Center51.0 %12,302 — — — 451,832 451,832 6450 Sequence Drive and Excess Land/Sorrento Mesa100 %35,834 — — — 911,915 (4)911,915 4045 and 4075 Sorrento Valley Boulevard/Sorrento Valley100 %7,671 — — — 149,000 (4)149,000 Other value-creation projects100 %— — — — 50,000 50,000 $527,072 226,401 902,604 1,251,164 2,456,873 4,837,042 (1)We are currently negotiating a long-term ground lease with the City of New York for the future site of a new building approximating 550,000 RSF.(2)Includes 349,947 RSF in operation with an opportunity either to convert the existing office space into office/laboratory space through future redevelopment or to expand the building by an additional 230,000 RSF through ground-up development. The building is currently occupied by Pfizer Inc. with a remaining lease term of approximately five years.(3)We expect to commence vertical construction or redevelopment of all or a portion of this project during 2021.(4)Represents total square footage upon completion of development or redevelopment of a new Class A property. Square footage presented includes RSF of buildings currently in operation at properties that also have inherent future development or redevelopment opportunities, for which we have the intent to demolish or redevelop the existing property upon expiration of the existing in-place leases and commencement of future construction. Refer to the definition of “Investments in real estate – value-creation square footage currently in rental properties” in the “Non-GAAP measures and definitions” section under Item 7 in this annual report on Form 10-K for additional information.(5)Includes our recently acquired project at 4555 Executive Drive and 9363, 9373, and 9393 Towne Centre Drive in our University Town Center submarket, which is currently under evaluation for development, subject to future market conditions.74New Class A development and redevelopment properties: summary of pipeline (continued)Property/SubmarketOur Ownership InterestBook ValueSquare FootageDevelopment and RedevelopmentTotalUnder ConstructionNear TermIntermediate TermFutureSeattle1165 Eastlake Avenue East/Lake Union100 %$106,061 100,086 — — — 100,086 1150 Eastlake Avenue East/Lake Union100 %49,196 — 260,000 (1)— — 260,000 701 Dexter Avenue North/Lake Union100 %53,612 — 217,000 — — 217,000 601 Dexter Avenue North/Lake Union100 %35,356 — — — 188,400 (2)188,400 1010 4th Avenue South/SoDo100 %49,278 — — — 544,825 544,825 830 4th Avenue South/SoDo100 %— — — — 52,488 (2)52,488 Other value-creation projects100 %70,304 213,976 51,255 (2)— 35,000 300,231 363,807 314,062 528,255 — 820,713 1,663,030 Maryland9804 and 9800 Medical Center Drive/Rockville100 %87,765 176,832 90,000 (1)— — 266,832 9950 Medical Center Drive/Rockville100 %40,520 84,264 — — — 84,264 700 Quince Orchard Road/Gaithersburg100 %45,887 169,420 — — — 169,420 14200 Shady Grove Road/Rockville100 %28,668 — 145,000 145,000 145,000 435,000 202,840 430,516 235,000 145,000 145,000 955,516 Research TriangleAlexandria Center® for Life Science – Durham/Research Triangle100 %134,451 652,381 — — — 652,381 Alexandria Center® for Advanced Technologies/Research Triangle100 %48,769 250,000 — 70,000 700,000 1,020,000 Alexandria Center® for AgTech, Phase II/Research Triangle100 %57,394 160,000 — — — 160,000 Other value-creation projects100 %4,185 — — — 76,262 76,262 244,799 1,062,381 — 70,000 776,262 1,908,643 Other value-creation projects100 %4,857 — — — 322,200 322,200 Total pipeline as of December 31, 2020$3,814,447 3,289,093 4,931,216 3,521,115 9,208,795 20,950,219 (3)Key subsequent and pending acquisitionsAlexandria Center® for Life Science – Fenway/Fenway510,116 — 305,000 — 815,116 840 Winter Street/Route 128130,000 — — — 130,000 Mercer Mega Block/Lake Union— 800,000 — — 800,000 3,929,209 5,731,216 3,826,115 9,208,795 22,695,335 (1)We expect to commence vertical construction or redevelopment of all or a portion of this project during 2021.(2)Represents total square footage upon completion of development or redevelopment of a new Class A property. Square footage presented includes RSF of buildings currently in operation at properties that also have inherent future development or redevelopment opportunities, for which we have the intent to demolish or redevelop the existing property upon expiration of the existing in-place leases and commencement of future construction. Refer to the definition of “Investments in real estate – value-creation square footage currently in rental properties” in the “Non-GAAP measures and definitions” section under Item 7 in this annual report on Form 10-K for additional information.(3)Total square footage includes 3,111,997 RSF of buildings currently in operation that will be redeveloped or replaced with new development RSF upon commencement of future construction. Refer to the definition of “Investments in real estate – value-creation square footage currently in rental properties” in the “Non-GAAP measures and definitions” section under Item 7 in this annual report on Form 10-K for additional information.75Summary of capital expendituresOur construction spending for the year ended December 31, 2020, consisted of the following (in thousands):Year EndedConstruction SpendingDecember 31, 2020Additions to real estate – consolidated projects$1,445,171 Investments in unconsolidated real estate joint ventures3,444 Contributions from noncontrolling interests(22,045)Construction spending (cash basis)1,426,570 Change in accrued construction29,819 Construction spending$1,456,389 The following table summarizes the total projected construction spending for the year ending December 31, 2021, which includes interest, property taxes, insurance, payroll, and other indirect project costs (in thousands):Year EndingProjected Construction SpendingDecember 31, 2021Development, redevelopment, and pre-construction projects$1,625,000 Contributions from noncontrolling interests (consolidated real estate joint ventures)(100,000)Revenue-enhancing and repositioning capital expenditures150,000 Non-revenue-enhancing capital expenditures65,000 Guidance midpoint$1,740,000 76ITEM 3. LEGAL PROCEEDINGSTo our knowledge, no legal proceedings are pending against us, other than routine actions and administrative proceedings, and other actions not deemed material, substantially all of which are expected to be covered by liability insurance and which, in the aggregate, are not expected to have a material adverse effect on our financial condition, results of operations, or cash flows.ITEM 4. MINE SAFETY DISCLOSURESNot applicable.PART IIITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS, AND ISSUER PURCHASES OF EQUITY SECURITIESOur common stock is traded on the NYSE under the symbol “ARE.” On January 15, 2021, the last reported sales price per share of our common stock was $168.37, and there were 597 holders of record of our common stock (excluding beneficial owners whose shares are held in the name of Cede & Co.). To maintain our qualification as a REIT, we must make annual distributions to stockholders of at least 90% of our taxable income for the current taxable year, determined without regard to deductions for dividends paid and excluding any net capital gains. Under certain circumstances, we may be required to make distributions in excess of cash flows available for distributions to meet these distribution requirements. In such a case, we may borrow funds or may raise funds through the issuance of additional debt or equity capital. No dividends can be paid on our common stock unless we have paid full cumulative dividends on our preferred stock. From the date of issuance of our preferred stock through December 31, 2020, we have paid full cumulative dividends on our preferred stock. As of December 31, 2020, we had no outstanding shares of preferred stock. Future distributions on our common stock will be determined by, and made at the discretion of, our Board of Directors and will depend on a number of factors, including actual cash available for distribution to our stockholders, our financial condition and capital requirements, the annual distribution requirements under the REIT provisions of the Internal Revenue Code, restrictions under Maryland law, and such other factors as our Board of Directors deems relevant. We cannot assure our stockholders that we will make any future distributions.Refer to “Item 12. Security ownership of certain beneficial owners and management and related stockholder matters” in this annual report on Form 10-K for information on securities authorized for issuance under equity compensation plans.77ITEM 6. SELECTED FINANCIAL DATAThe following table should be read in conjunction with our consolidated financial statements and notes thereto appearing elsewhere in this annual report on Form 10-K. Refer to “Item 15. Exhibits and financial statement schedules.”Year Ended December 31,(In thousands, except per share amounts)20202019201820172016Operating Data:Revenues:Income from rentals$1,878,208 $1,516,864 $1,314,781 $1,122,325 $897,475 Other income7,429 14,432 12,678 5,772 24,231 Total revenues1,885,637 1,531,296 1,327,459 1,128,097 921,706 Expenses:Rental operations530,224 445,492 381,120 325,609 278,408 General and administrative133,341 108,823 90,405 75,009 63,884 Interest171,609 173,675 157,495 128,645 106,953 Depreciation and amortization698,104 544,612 477,661 416,783 313,390 Impairment of real estate48,078 12,334 6,311 203 209,261 Loss on early extinguishment of debt60,668 47,570 1,122 3,451 3,230 Total expenses1,642,024 1,332,506 1,114,114 949,700 975,126 Equity in earnings (losses) of unconsolidated real estate JVs8,148 10,136 43,981 15,426 (184)Investment income421,321 194,647 136,763 — — Gain on sales of real estate – rental properties154,089 474 8,704 270 3,715 Gain on sales of real estate – land parcels— — — 111 90 Net income (loss)827,171 404,047 402,793 194,204 (49,799)Net income attributable to noncontrolling interests(56,212)(40,882)(23,481)(25,111)(16,102)Net income (loss) attributable to Alexandria Real Estate Equities, Inc.’s stockholders770,959 363,165 379,312 169,093 (65,901)Dividends on preferred stock— (3,204)(5,060)(7,666)(20,223)Preferred stock redemption charge— (2,580)(4,240)(11,279)(61,267)Net income attributable to unvested restricted stock awards(10,168)(6,386)(6,029)(4,753)(3,750)Net income (loss) attributable to Alexandria Real Estate Equities, Inc.’s common stockholders$760,791 $350,995 $363,983 $145,395 $(151,141)Net income (loss) per share attributable to Alexandria Real Estate Equities, Inc.'s common stockholders:Basic$6.03 $3.13 $3.53 $1.59 $(1.99)Diluted$6.01 $3.12 $3.52 $1.58 $(1.99)Weighted-average shares of common stock outstanding – basic126,106 112,204 103,010 91,546 76,103 Weighted-average shares of common stock outstanding – diluted126,490 112,524 103,321 92,063 76,103 Dividends declared per share of common stock$4.24 $4.00 $3.73 $3.45 $3.23 Balance Sheet Data (at year end):Investments in real estate$18,092,372 $14,844,038 $11,913,693 $10,298,019 $9,077,972 Total assets$22,827,878 $18,390,503 $14,464,956 $12,103,953 $10,354,888 Total debt$7,563,286 $6,777,479 $5,478,255 $4,764,807 $4,164,025 Total liabilities$9,384,100 $8,224,025 $6,570,242 $5,620,784 $4,972,610 Redeemable noncontrolling interests$11,342 $12,300 $10,786 $11,509 $11,307 Total equity$13,432,436 $10,154,178 $7,883,928 $6,471,660 $5,370,971 78ITEM 6. SELECTED FINANCIAL DATA (CONTINUED)Year Ended December 31,(Dollars in thousands, except per occupied RSF amounts)20202019201820172016Other Data:Net cash provided by operating activities$882,510 $683,857 $570,339 $450,882 $393,487 Net cash used in investing activities$3,278,161 $3,641,320 $2,161,760 $1,737,126 $1,498,406 Net cash provided by financing activities$2,750,356 $2,927,482 $1,588,433 $1,420,341 $1,093,775 Number of properties – North America338 291 237 213 199 RSF – North America (including development and redevelopment projects under construction)35,163,57229,098,43324,587,43821,981,13319,869,729Occupancy of operating properties – North America94.6%96.8%97.3%96.8%96.6%Occupancy of operating and redevelopment properties – North America90.0%94.4%95.1%94.7%95.7%Annual rental revenue per occupied RSF – North America$49.08 $51.04 $48.42 $48.01 $45.15 Reconciliation of net income (loss) attributable to Alexandria's common stockholders to funds from operations attributable to Alexandria's common stockholders – diluted:Net income (loss) attributable to Alexandria Real Estate Equities, Inc.’s common stockholders$760,791 $350,995 $363,983 $145,395 $(151,141)Depreciation and amortization of real estate assets 684,682 541,855 477,661 416,783 313,390 Noncontrolling share of depreciation and amortization from consolidated real estate JVs(61,933)(30,960)(16,077)(14,762)(9,349)Our share of depreciation and amortization from unconsolidated real estate JVs(1)11,413 6,366 3,181 1,551 2,707 Gain on sales of real estate – rental properties(154,089)(474)(8,704)(270)(3,715)Our share of gain on sales of real estate from unconsolidated real estate JVs(1)— — (35,678)(14,106)— Gain on sales of real estate – land parcels— — — (111)(90)Impairment of real estate – rental properties40,501 (3)12,334 — 203 98,194 Assumed conversion of 7.00% Series D cumulative convertible preferred stock(2)— 3,204 5,060 — — Allocation to unvested restricted stock awards (7,018)(5,904)(5,961)(2,920)— Funds from operations attributable to Alexandria’s common stockholders – diluted(4)1,274,347 877,416 783,465 531,763 249,996 Unrealized gains on non-real estate investments(374,033)(161,489)(99,634)— — Realized gains on non-real estate investments— — (14,680)— (4,361)Impairment of real estate15,221 — 6,311 — 110,474 Impairment of non-real estate investments24,482 17,124 5,483 8,296 3,065 Loss on early extinguishment of debt60,668 47,570 1,122 3,451 3,230 Loss on early termination of interest rate hedge agreements— 1,702 — — — Termination fee(86,179)— — — — Acceleration of stock compensation expense due to executive officer resignation 4,499 — — — — Our share of gain on early extinguishment of debt from unconsolidated real estate JVs(1)— — (761)— — Preferred stock redemption charge— 2,580 4,240 11,279 61,267 Removal of assumed conversion of 7.00% Series D cumulative convertible preferred stock(2)— (3,204)(5,060)— — Allocation to unvested restricted stock awards4,790 1,307 1,517 (321)(2,356)Funds from operations attributable to Alexandria’s common stockholders – diluted, as adjusted(4)$923,795 $783,006 $682,003 $554,468 $421,315 (1)Classified in equity in earnings from unconsolidated real estate joint ventures in our consolidated statements of operations under Item 15 in this annual report on Form 10-K.(2)Refer to “Weighted-average shares of common stock outstanding – diluted” in the “Non-GAAP measures and definitions” section under Item 7 in this annual report on Form 10-K for additional information.(3)Includes a $7.6 million impairment of our investment in a recently developed retail property held by our unconsolidated real estate joint venture recognized during the three months ended March 31, 2020. This impairment is classified in equity in earnings of unconsolidated real estate joint ventures within our consolidated statements of operations.(4)Refer to “Funds from operations and funds from operations, as adjusted, attributable to Alexandria Real Estate Equities, Inc.’s common stockholders” in the “Non-GAAP measures and definitions” section under Item 7 in this annual report on Form 10-K.79ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSThe following discussion should be read in conjunction with our consolidated financial statements and notes thereto under “Item 15. Exhibits and financial statement schedules” in this annual report on Form 10-K. Forward-looking statements involve inherent risks and uncertainties regarding events, conditions, and financial trends that may affect our future plans of operations, business strategy, results of operations, and financial position. A number of important factors could cause actual results to differ materially from those included within or contemplated by such forward-looking statements, including, but not limited to, those described under “Item 7. Management’s discussion and analysis of financial condition and results of operations” in this annual report on Form 10-K. We do not undertake any responsibility to update any of these factors or to announce publicly any revisions to any of the forward-looking statements contained in this or any other document, whether as a result of new information, future events, or otherwise.As used in this annual report on Form 10-K, references to the “Company,” “Alexandria,” “we,” “us,” and “our” refer to Alexandria Real Estate Equities, Inc. and its consolidated subsidiaries.The COVID-19 pandemic In December 2019, a novel coronavirus, which causes respiratory illness and spreads from person to person (COVID-19), was first identified during an investigation into an outbreak in Wuhan, China. The first case of COVID-19 in the U.S. was reported on January 20, 2020. On March 11, 2020, the World Health Organization declared COVID-19 a pandemic, and on March 13, 2020, the U.S. declared a national emergency with respect to COVID-19. As of January 29, 2021, according to the World Health Organization, over 101.0 million novel coronavirus cases have been reported worldwide. The U.S. has reported more than 25.3 million cases of COVID-19 and over 425,670 deaths as of January 29, 2021.COVID-19 disease, treatment, and measures to combat the pandemicMost patients with COVID-19 have had mild to severe respiratory illness with symptoms of fever, chills, cough, shortness of breath, fatigue, and loss of taste. Many individuals with COVID-19 are asymptomatic and show limited to no symptoms, highlighting the ongoing challenge of containing the continued spread of COVID-19. Some patients develop pneumonia in both lungs and/or multi-organ failure, which in some cases leads to death. Since scientists shared the virus’s genetic makeup in January 2020, intense research has been underway around the world to develop treatments and vaccines for COVID-19. This has led to the FDA issuing Emergency Use Authorizations (“EUA”s) for therapeutics to treat patients with COVID-19 and, most recently, approving two vaccines for use in the prevention of coronavirus disease caused by COVID-19.The two approved vaccines were created by Pfizer Inc. (in partnership with BioNTech) and Moderna, Inc. (in partnership with the National Institutes of Health), each a tenant of ours. The U.S. began a large-scale COVID-19 vaccination campaign in December 2020. As of January 29, 2021, according to the U.S. Centers for Disease Control and Prevention, over 4.7 million individuals in the U.S. have been fully vaccinated for COVID-19, and the U.S. will continue to roll out vaccines across the nation, prioritizing frontline and essential workers, the elderly, and individuals considered high risk.Although the U.S. FDA has approved two vaccines and certain therapies for use as of the date of this report, the initial rollout of vaccine distribution has encountered significant delays, and uncertainties remain as to the amount of vaccine available for distribution, the logistics of implementing a national vaccine program, and the overall efficacy of the vaccines once widely administered, especially as new strains of COVID-19 have been discovered, and the level of resistance these new strains have to the existing vaccines, if any, remains unknown.In response to the supply and distribution issues surrounding the vaccine, in January 2021, President Biden outlined a plan to create additional vaccination sites, increase the supply and distribution of vaccines, and increase the number of vaccinations administered to Americans. The Biden administration plans to utilize the Defense Production Act to maximize the manufacturing and distribution of vaccines in order to administer 100 million vaccination shots within the first 100 days of holding office.In addition to the currently approved vaccines, as of January 29, 2021, there are over 60 other potential vaccines in clinical development that may contribute to increasing the supply of vaccines in 2021. The current vaccines in development use a myriad of different scientific approaches to attempt to provoke an immune response, including:•Genetic vaccines that use part of the coronavirus’s genetic code;•Viral vector vaccines that use a virus to deliver coronavirus genes into cells; •Protein-based vaccines that use a coronavirus protein or protein fragment to stimulate the immune system; and•Whole-virus vaccines that use a weakened or inactivated version of the coronavirus.Over 60 potential vaccines are currently in human clinical trials, with nearly a third of these in later stages of clinical development. Phase I trials typically include a small number of participants to test safety and dosage as well as to confirm that the vaccine stimulates the immune system. Phase II trials involve hundreds of participants split into groups, such as children and the elderly, to determine whether the vaccine acts differently in each subpopulation. Phase III trials involve delivering the vaccine to tens of thousands of people, observing how many subsequently become infected, and determining the severity of symptoms when compared with volunteer subjects who received a placebo. Regulators in each country will review the trial results to make a determination as to 80whether the drug or vaccine should be approved. As of January 29, 2021, there were 20 potential vaccines in Phase III trials, including a number that require only a single dose, rather than two doses for the currently approved vaccines and that are potentially easier to distribute.Shelter-in-place and stay-at-home ordersOn March 19, 2020, California became the first state to set mandatory stay-at-home restrictions to help combat the spread of the coronavirus. The order included the shutdown of all nonessential services, such as dine-in restaurants, bars, gyms, conference or convention centers, and other businesses not deemed to support critical infrastructure. Exceptions for essential services, such as grocery stores, pharmacies, gas stations, food banks, convenience stores, and delivery restaurants, have allowed these services to remain open. Subsequently, almost all states issued similar orders, including New York, Massachusetts, Washington, Maryland, and North Carolina, where our remaining properties outside California are located. Countries around the world also implemented measures to slow the spread of the coronavirus, from national quarantines to school closures or similar types of stay-at-home orders or movement limitations. Most state orders expired or were rescinded between May and early June 2020, and authorities began reopening businesses, including retail stores, restaurants, bars, salons, houses of worship, entertainment venues such as movie theaters and museums, and manufacturing facilities and offices. Daily new COVID-19 cases in the U.S., which had declined to approximately 18,000 new daily cases by June 9, 2020, from the low- to mid-30,000 daily range in April 2020, began to surge, leading to additional restrictions in many parts of the country. Additionally, in recent months, new COVID-19 variants were discovered in the U.K, among other countries, which have spread globally, including the U.S. While these strains do not appear to cause more severe symptoms in individuals, they have shown to be more infectious than the original strain discovered in China. As a result, more stringent lockdown restrictions have been implemented globally and within the U.S. On January 29, 2021, according to the World Health Organization, 155,203 new cases and 4,100 deaths were reported in the U.S. Impact to the global and U.S. economyAs a result of the unprecedented measures taken in the U.S. and around the world, the disruption and impact to the U.S. and global economies and financial markets by the COVID-19 pandemic have been significant. In January 2021, the IMF estimated that the global and U.S. economies contracted by 3.5% and 3.4%, respectively, during 2020, in contrast to the expansion of 3.3% and 2.0%, respectively, that IMF projected for the year 2020 in January 2020. However, multiple vaccine approvals have raised hopes for an eventual end to the pandemic, and the rollout of vaccines has contributed to the positive global and U.S. growth projections for 2021, as estimated by IMF in January 2021, of 5.5% and 5.1%, respectively. These projections may be negatively impacted by potential new strains of the virus, renewed lockdowns, or logistical problems with vaccine distribution. Based on the data provided by the U.S. Bureau of Labor Statistics on January 8, 2021, the unemployment rate in the U.S. is up by 3.2% since February 2020 to 6.7%. The December 2020 data reported 140 thousand jobs lost in December 2020. Stock markets around the globe have rebounded substantially since March 2020; however, since the pandemic was declared, access to capital has become much more challenging for most companies or non-existent for some. The unprecedented disruption and impact to the U.S. and global economies and financial markets from the COVID-19 pandemic resulted in the U.S. President Trump’s signing into law on March 27, 2020, the Coronavirus Aid, Relief, and Economic Security Act (“CARES Act”), a $2 trillion economic stimulus package. The CARES Act allocated over $140 billion to the U.S. health system to support COVID-19-related manufacturing, production, diagnostics, and treatments, and to accelerate the market entrance of necessary vaccines and cures. The CARES Act also designated $945.4 million specifically to the NIH, a tenant of ours in our Maryland market, to combat COVID-19, which includes, but is not limited to, providing support for research, construction, and acquisition of equipment for vaccine and infectious disease research facilities, including the acquisition of real property. In addition, on April 24, 2020, the President Trump signed the Paycheck Protection Program and Health Care Enhancement Act into law, which provided an additional $484 billion of relief primarily to assist distressed small businesses and prevent them from shutting their operations and laying off employees. This package designated $75 billion to hospitals and $25 billion for a new COVID-19 testing program. It is too early to determine if the CARES Act and the $484 billion relief package were effective or sufficient to offset some of the most severe economic effects of the pandemic.On August 8, 2020, President Trump signed four executive actions to provide additional COVID-19 relief along with unemployment benefits of $400 weekly payment to those receiving more than $100 a week in state-funded unemployment benefits through December 6, 2020. On December 27, 2020, a second stimulus package was passed to provide relief aid to Americans during financial hardship, aggregating $900 billion in provisions, which included an additional $600 payment to eligible American adults and $600 for qualifying child dependents, a reinstatement of unemployment benefits of $300 per week through March 14, 2021, an additional $285 billion towards loan programs for small businesses, $82 billion towards education, and additional aid for hard-hit industries, including the airline industry.81On January 14, 2020, then President-elect Biden unveiled a $1.9 trillion “American Rescue Plan” proposal to combat the pandemic and stimulate the economy. The proposal provides additional provisions for increased unemployment benefits, rental assistance, small businesses, state and local governments, educational institutions, and substantial funding towards accelerated distribution of vaccinations and for COVID-19 testing, as well as direct payments of $1,400 to all eligible Americans. The American Rescue Plan is the first of two major spending initiatives expected to be proposed by President Biden in the coming weeks.Potential ineffectiveness or delay of such relief measures could lead to further deterioration of economic conditions, higher unemployment rates, and prolonged recession, which in turn could materially affect our (or our tenants’ or venture investment portfolio companies’) performance, financial condition, results of operations, and cash flows. See “Item 1A. Risk factors” within “Part I” in this annual report on Form 10-K for additional discussion of the risks posed by the COVID-19 pandemic, and uncertainties we, our tenants, and the national and global economies face as a result.Executive summaryOperating resultsYear Ended December 31,20202019Net income attributable to Alexandria’s common stockholders – diluted:In millions$760.8 $351.0 Per share$6.01 $3.12 Funds from operations attributable to Alexandria’s common stockholders – diluted, as adjusted:In millions$923.8 $783.0 Per share$7.30 $6.96 The operating results shown above include certain items related to corporate-level investing and financing decisions. For additional information, refer to “Funds from operations and funds from operations, as adjusted, attributable to Alexandria Real Estate Equities, Inc.’s common stockholders” in the “Non-GAAP measures and definitions” section and to the tabular presentation of these items in the “Results of operations” section within this Item 7 in this annual report on Form 10-K. Alexandria and our tenants at the vanguard and heart of the life science ecosystemBringing together our unique and pioneering strategic vertical platforms of essential Labspace® real estate, strategic venture investments, impactful thought leadership, and purposeful corporate responsibility, Alexandria is at the vanguard and heart of the vital life science ecosystem that is advancing solutions for COVID-19 and other key challenges to human health. Owing to the efforts of numerous Alexandria tenants, including Pfizer and Moderna, in developing and delivering safe and effective vaccines and therapies to people around the world, the inherent value and critical need for the life science industry has been globally recognized. The essential R&D engine of the biopharma industry continued with productivity and resilience throughout this past year. By maintaining continuous operations across our campuses and facilities, Alexandria has enabled our tenants to continue to pursue their essential, mission-critical research, development, manufacturing, and commercialization efforts to solve the most pressing current and future healthcare challenges.Strong and flexible balance sheet with significant liquidity•Investment-grade credit ratings ranked in the top 10% among all publicly traded REITs as of December 31, 2020.•Net debt and preferred stock to Adjusted EBITDA of 5.3x and fixed-charge coverage ratio of 4.6x represent the lowest and highest, respectively, in the past 10 years.•$4.1 billion of liquidity as of December 31, 2020.•No debt maturing prior to 2024.•10.6 years weighted-average remaining term of debt as of December 31, 2020.Continued dividend strategy to share growth in cash flows with stockholdersCommon stock dividend declared for the three months ended December 31, 2020 of $1.09 per common share, aggregating $4.24 per common share for the year ended December 31, 2020, up 24 cents, or 6%, over the year ended December 31, 2019. Our FFO payout ratio of 60% for the three months ended December 31, 2020, allows us to share growth in cash flows from operating activities with our stockholders while also retaining a significant portion for reinvestment.82A REIT industry-leading, high-quality tenant roster•55% of annual rental revenue from investment-grade or publicly traded large cap tenants.•Weighted-average remaining lease term of 7.6 years.Key strategic transactions that generated capital for investment into our highly leased value-creation pipeline and strategic acquisitions•During the three months ended December 31, 2020, we completed two strategic transactions that generated capital aggregating $874.6 million for investment into our highly leased development and redevelopment projects and strategic acquisitions:•Sale of 70% ownership interest in our properties at 1201 and 1208 Eastlake Avenue East and 199 East Blaine Street in our Lake Union submarket for an aggregate sales price of $314.5 million, representing a capitalization rate of 4.2% (cash basis), and setting a new record in Seattle of $1,399 per RSF; and•Disposition of two tech office buildings at 510 Townsend Street and 505 Brannan Street in our SoMa submarket for an aggregate sales price of $560.2 million, or $1,263 per RSF, representing capitalization rates of 5.3% and 5.0% (cash basis), and a gain on sale of $151.9 million.Continued solid net operating income and internal growth•Total revenues of $1.9 billion, up 23.1%, for the year ended December 31, 2020, compared to $1.5 billion for the year ended December 31, 2019.•Net operating income (cash basis) of $1.2 billion for the year ended December 31, 2020, increased by $249.7 million, or 26.2%, compared to the year ended December 31, 2019.•94% of our leases contain contractual annual rent escalations approximating 3%.•Same property net operating income growth of 2.6% and 5.1% (cash basis) for the year ended December 31, 2020, compared to the year ended December 31, 2019.•Continued solid leasing activity and rental rate growth during 2020 over expiring rates on renewed and re-leased space, representing our highest annual rental rate increases during the past 10 years:2020Total leasing activity – RSF4,358,846 Leasing of development and redevelopment space – RSF1,012,364 Lease renewals and re-leasing of space:RSF (included in total leasing activity above)2,556,833 Rental rate increases37.6%Rental rate increases (cash basis)18.3%•Guidance ranges for expected 2021 rental rate increases on lease renewals and re-leasing of space are 29.0% to 32.0%, and 16.0% to 19.0% (cash basis).High-quality revenues and cash flows, strong margins, and operational excellenceAs of December 31, 2020Percentage of annual rental revenue in effect from investment-grade or publicly traded large cap tenants55 %Occupancy of operating properties in North America94.6 %(1)Operating margin71 %(2)Adjusted EBITDA margin69 %(2)Weighted-average remaining lease term:All tenants7.6yearsTop 20 tenants11.0years(1)Includes 970,199 RSF, or 3.1%, of vacancy in our North America markets, representing lease-up opportunities that will contribute to growth in cash flows at recently acquired properties. Excluding these acquired vacancies, occupancy of operating properties in North America was 97.7% as of December 31, 2020. Refer to the “Summary of occupancy percentages in North America” section under Item 2 in this annual report on Form 10-K for additional information regarding vacancy from recently acquired properties.(2)For the three months ended December 31, 2020.83Sustained strength in tenant collections during the ongoing COVID-19 pandemic•We have collected rents and tenant recoveries as follows:•99.8% for April 1, 2020 through December 31, 2020; and•99.2% for January 2021 as of January 29, 2021.•As of December 31, 2020, our tenant receivables balance was $7.3 million.Strategic acquisitions with significant value-creation opportunities in key submarkets•During the three months ended December 31, 2020, we completed acquisitions of 16 properties in key submarkets aggregating 3.3 million SF, with significant value-creation opportunities including, 1.9 million RSF of future developments, 383,396 RSF of active redevelopments, and 1.0 million of operating RSF, currently 80% occupied, for an aggregate purchase price of $580.7 million.•In January 2021, we completed the acquisition of 401 Park Drive, 201 Brookline Avenue, and one future development opportunity, as described in further detail below.Acquisition of 401 Park Drive and 201 Brookline Avenue•In January 2021, we acquired 401 Park Drive, 201 Brookline Avenue, and one future development opportunity, located in the heart of our Greater Boston life science cluster market, for a purchase price of $1.48 billion. The future collaborative life science campus, aggregating 1.8 million SF, consists of the following:•401 Park Drive (operating property with future redevelopment opportunity):•Highly amenitized Class A office/R&D building aggregating 973,145 RSF, currently 93% occupied with a weighted-average remaining lease term of 8.8 years;•50% of annual rental revenue generated from investment-grade tenants;•In-place rents are 38% below market; 30% of the RSF has a weighted-average remaining lease term of 3.3 years with in-place rents approximately 41% below market;•Initial stabilized yields of 5.7% and 4.5% (cash basis); and•Future opportunity to redevelop up to 221,000 RSF, or 23% of the building, to office/laboratory space.•201 Brookline Avenue (active development):•Office/laboratory building undergoing ground-up development, aggregating 510,116 RSF, targeting initial occupancy in 2022; and •17% pre-leased to high-quality tenants.•Future development opportunity for one office/laboratory building for which we are pursuing net new entitlement rights totaling approximately 400,000 SF of office/laboratory along with retail and common spaces.Highly leased value-creation pipeline, including COVID-19-focused R&D spaces•Current and pre-leased near-term projects aggregating 4.8 million RSF, including COVID-19-focused R&D spaces, are highly leased/negotiating at 78% and will generate significant revenues and cash flows.•We commenced development and redevelopment of four projects aggregating 609,797 RSF during the three months ended December 31, 2020, and two projects aggregating 640,116 RSF during January 2021. •Key development and redevelopment projects placed into service during the three months ended December 31, 2020:•63,774 RSF at our redevelopment project at 9877 Waples Street in our Sorrento Mesa submarket, 100% leased to Cue Health Inc.; and•96,463 RSF at our development project at the Alexandria Center® for Life Science – San Carlos in our Greater Stanford submarket, leased to ChemoCentryx, Inc.•Annual net operating income (cash basis), including our share of unconsolidated real estate joint ventures, is expected to increase by $28 million upon the burn-off of initial free rent on recently delivered projects.Balance sheet managementRefer to the “Execution of capital strategy” section below within this Item 7 in this annual report on Form 10-K.84Operating summarySame Property Net Operating Income GrowthFavorable Lease Structure(1)Strategic Lease Structure by Owner and Operator of Collaborative Life Science, Technology, and Agtech CampusesIncreasing cash flowsPercentage of leases containing annual rent escalations94%Stable cash flowsPercentage of triple net leases94%Lower capex burdenPercentage of leases providing for the recapture of capital expenditures 93%Rental Rate Growth: Renewed/Re-Leased SpaceMargins(2)OperatingAdjusted EBITDA71%69%(1)Percentages calculated based on RSF as of December 31, 2020.(2)Represents percentages for the three months ended December 31, 2020.85Execution of capital strategyDuring 2020, we continued to execute on many of the long-term components of our capital strategy. Some of our key accomplishments include the following:2020 capital strategyKey metrics as of December 31, 2020•$31.9 billion(1) of total market capitalization.•$24.4 billion of total equity capitalization.•$4.1 billion of liquidity as of December 31, 2020.(1) Refer to the “Non-GAAP measures and definitions” section under this Item 7 in this annual report on Form 10-K for the definition of “Total market capitalization.”As of December 31, 2020Goal for Fourth Quarter of 2021, AnnualizedQuarter AnnualizedTrailing 12 MonthsNet debt and preferred stock to Adjusted EBITDA5.3x5.5xLess than or equal to 5.2xFixed-charge coverage ratio4.6x4.4xGreater than or equal to 4.5xValue-creation pipeline of new Class A development and redevelopment projects as a percentage of gross investments in real estateAs of December 31, 2020Current and pre-leased near-term projects 78% leased/negotiating8%Income-producing/potential cash flows/covered land play(1)7%Land3%(1)Includes projects that have existing buildings that are generating or can generate operating cash flows. Also includes development rights associated with existing operating campuses.Key capital events in 2020Unsecured senior line of credit•On October 6, 2020, we amended our unsecured senior line of credit. Key changes include the following:New AgreementChangeCommitments available for borrowing$3.0 billionUp $800 millionInterest rateLIBOR+0.825%Added a 0% LIBOR floorMaturity dateJanuary 6, 2026Extended 2 years•In April 2020, we closed an additional unsecured senior line of credit with $750.0 million of available commitments, which had a maturity date of April 14, 2022, and bore interest at LIBOR plus 1.05%. In addition to the cost of borrowing, this line of credit was subject to an annual facility fee of 0.20% based on the aggregate commitment outstanding. The terms of the $750.0 million unsecured senior line of credit agreement required that the outstanding commitments be reduced by 100% of net cash proceeds from certain new debt transactions and 50% of net cash proceeds from new equity offerings as defined in the agreement. In August 2020, we received cash proceeds from the issuance of our $1.0 billion 1.875% Unsecured Senior Notes, and, pursuant to the terms of the $750.0 million unsecured senior line of credit agreement, all outstanding commitments from the line of credit were reduced to zero, and we terminated this facility.Commercial paper program•During 2020, we increased the aggregate amount we may issue under our commercial paper program from $750.0 million to $1.5 billion as of December 31, 2020. Borrowings under our commercial paper program are backed by our $3.0 billion unsecured senior line of credit.Unsecured senior notes payable•In March 2020, we completed an offering of $700.0 million of unsecured senior notes payable due on December 15, 2030, at an interest rate of 4.90% for net proceeds of $691.6 million. 86•In August 2020, we opportunistically issued $1.0 billion of unsecured senior notes payable due in 2033 at an interest rate of 1.875% (“1.875% Unsecured Senior Notes”). •We used a portion of the proceeds from our 1.875% Unsecured Senior Notes to refinance $500.0 million of our 3.90% unsecured senior notes payable due in 2023, pursuant to a partial cash tender offer completed on August 5, 2020, and a subsequent call for redemption for the remaining outstanding amounts, which settled on September 4, 2020. As a result of our debt refinancing, we recognized a loss on early extinguishment of debt of $50.8 million, including the write-off of unamortized loan feesExtinguishment of unsecured senior notes payable, unsecured senior line of credit, and secured notes payable•In August 2020, we refinanced our 3.90% unsecured senior notes payable due in 2023 aggregating $500.0 million and recognized a loss on early extinguishment of debt aggregating $50.8 million, including the write-off of unamortized loan fees. Additionally, we recognized a loss on early extinguishment of debt aggregating $1.9 million due to the termination of our $750.0 million unsecured senior line of credit.•In December 2020, we extinguished two secured notes payable aggregating $108.2 million, due in 2023 with a weighted-average interest rate of 3.67%, and recognized losses on early extinguishment of debt aggregating $7.3 million. As a result of these extinguishments, we have no debt maturing until 2024.Forward equity sales agreements•In January 2020 and July 2020, we entered into forward equity sales agreements aggregating $1.0 billion and $1.1 billion, respectively, to sell an aggregate of 6.9 million shares for each offering (13.8 million in aggregate) of our common stock, including the exercise of underwriters’ options, at public offering prices of $155.00 per share and $160.50 per share, respectively, before underwriting discounts. During 2020, we issued all 13.8 million shares under these forward equity sales agreements and received net proceeds of $2.1 billion. •In January 2021, we entered into forward equity sales agreements aggregating $1.1 billion to sell an aggregate of 6.9 million shares of our common stock (including the exercise of underwriters’ option) at a public offering price of $164.00 per share, before underwriting discounts and commissions. We expect to settle these forward equity sales agreements in March 2021.ATM common stock offering program•In February 2020, we entered into a new ATM common stock offering program, which allows us to sell up to an aggregate of $850.0 million of our common stock. •We issued 1.5 million shares of common stock under our ATM program at a price of $159.09 per share (before underwriting discounts), and received net proceeds of $235.0 million in 2020.•We have 362 thousand shares under our ATM program subject to forward equity sales agreements that remain outstanding at a price of $159.09 per share (before underwriting discounts) as of December 31, 2020. We expect to settle these forward equity sales agreements in 2021 and receive net proceeds of approximately $56.3 million. •The remaining availability of $547.3 million under this ATM program expired in December 2020 concurrently with the expiration of the associated shelf registration. In January 2021, we filed a new shelf registration and we expect to establish a new ATM program soon in 2021.Unconsolidated real estate joint venture loan•In March 2020, our unconsolidated joint venture at 1655 and 1725 Third Street, in which we own a 10% interest, located in Mission Bay/SoMa, refinanced an existing variable-rate secured construction loan with a fixed-rate loan with terms as follows:100% at Joint Venture LevelAmended AgreementChangeAggregate commitments$600.0 millionIncrease of $225.0 millionMaturity dateMarch 2025Extended by 45 monthsInterest rateFixed at 4.50%Previously LIBOR + 3.70%Investments•Our investments in publicly traded companies and privately held entities aggregated a carrying amount of $1.6 billion, including an adjusted cost basis of $835.4 million and unrealized gains of $775.7 million, as of December 31, 2020.•Investment income of $421.3 million during the year ended December 31, 2020, consisted of $47.3 million of realized gains, which included $24.5 million of impairments related to investments in privately held entities that do not report NAV, and $374.0 million of unrealized gains.872021 Capital strategyDuring 2021, we intend to continue to execute our capital strategy to achieve further improvements to our credit profile, which will allow us to further improve our cost of capital and continue our disciplined approach to capital allocation. For further information, refer to the “Projected results” section below under this Item 7 in this annual report on Form 10-K. Consistent with 2020, our capital strategy for 2021 includes the following elements:•Allocate capital to Class A properties located in collaborative life science, technology, and agtech campuses in AAA urban innovation clusters;•Continue to improve our credit profile;•Maintain prudent access to diverse sources of capital, which include cash flows from operating activities after dividends, incremental debt supported by our growth in EBITDA, real estate asset sales, non-real estate investment sales, joint venture capital, and other capital such as sales of equity;•Maintain commitment to long-term capital to fund growth;•Prudently ladder debt maturities;•Reduce short-term variable-rate debt;•Prudently manage equity investments to support corporate-level investment strategies;•Maintain significant balance sheet liquidity; and•Maintain a stable and flexible balance sheet.Given the anticipated delivery of significant incremental EBITDA from our development and redevelopment of new Class A properties, we expect to be able to debt fund a significant portion of construction on a leverage-neutral basis. We expect to continue to maintain access to a diverse source of debt, including unsecured senior notes payable, as well as secured construction loans for our development and redevelopment projects from time to time. We expect to continue to maintain a significant proportion of our net operating income on an unencumbered basis to allow for future flexibility for accessing both unsecured and secured debt markets, although we expect traditional secured mortgage notes payable will remain a small component of our capital structure. In addition to debt funding on a leverage-neutral basis, we intend to supplement our remaining capital needs with net cash flows from operating activities, after dividends and proceeds from real estate asset sales, non-real estate investment sales, partial interest sales, and other debt and equity capital.Improved cost of capitalAs part of our capital strategy to continue strengthening our credit profile, we expect to complete and place into service development and redevelopment projects currently under construction, which we expect will deliver significant incremental EBITDA. The expected growth in our EBITDA in 2021 and beyond should allow us to obtain debt funding on a leverage-neutral basis and provide significant capital to fund our development and redevelopment projects. Additionally, the resulting expected improvement in our balance sheet leverage ratio should allow us to access diverse sources of capital, strengthen our credit profile, and reduce our cost of capital. In addition, we expect to continue to maintain a significant proportion of unencumbered net operating income. For the year ended December 31, 2020, our unencumbered net operating income as a percentage of total net operating income was 96%. 88InvestmentsWe present our equity investments at fair value whenever fair value or NAV is readily available. Adjustments for our limited partnership investments represent changes in reported NAV as a practical expedient to estimate fair value. For investments without readily available fair values, we adjust the carrying amount whenever such investments have an observable price change, and further adjustments are not made until another price change, if any, is observed. Refer to Note 7 – “Investments” to our consolidated financial statements under Item 15 in this annual report on Form 10-K for additional information. December 31, 2020(In thousands)Three Months EndedYear EndedYear Ended December 31, 2019Realized gains$21,599 $47,288 (1)$33,158 (2)Unrealized gains233,538 374,033 161,489 Investment income$255,137 $421,321 $194,647 Investments(In thousands)CostAdjustmentsCarrying AmountFair value:Publicly traded companies$208,754 $351,076 (3)$559,830 Entities that report NAV334,341 327,741 662,082 Entities that do not report NAV:Entities with observable price changes47,545 96,859 144,404 Entities without observable price changes244,798 — 244,798 December 31, 2020$835,438 (4)$775,676 $1,611,114 September 30, 2020$788,807 $542,138 $1,330,945 (1)Includes impairments related to investments in privately held entities that do not report NAV of $24.5 million for the year ended December 31, 2020.(2)Includes impairments related to investments in privately held entities that do not report NAV of $17.1 million for the year ended December 31, 2019.(3)Includes gross unrealized gains and losses of $366.9 million and $15.8 million, respectively, as of December 31, 2020.(4)Represents 3.2% of total gross assets as of December 31, 2020.Public/PrivateMix (Cost)Tenant/Non-TenantMix (Cost)89Represents an illustrative subset of approximately 100 tenants focused on COVID-19-related efforts, with some of these companies working on multiple efforts that span testing, treatment, and/or vaccine development.(1)Source: National Institutes of Health, “NIH launches clinical trials network to test COVID-19-related vaccines and other preventive tools,” July 8, 2020.90(1)As of January 29, 2021. Source: U.S. Department of Health & Human Services. Federal funding presented includes the total commitment value.(2)Source: U.S. Food and Drug Administration, “FDA Takes Additional Action in Fight Against COVID-19 By Issuing Emergency Use Authorization for Second COVID-19 Vaccine,” December 18, 2020.91Alexandria and our innovative tenants are at the vanguard and heart of the life science ecosystem advancing solutions for COVID-19Safe and effective vaccines and therapies, in addition to widespread testing, continue to be critically needed to combat the global COVID-19 pandemic. By maintaining essential continuous operations across our campuses, Alexandria has enabled several of our life science tenants to pursue mission-critical COVID-19-related research and development. The heroic work being done by so many of our tenants and campus community members to help test for, treat, and prevent COVID-19, as well as provide medical supplies and protective equipment to neighboring hospitals, is profound and inspiring. We are currently tracking approximately 100 tenants across our cluster markets that have contributed meaningful time and resources to advancing solutions for COVID-19.Developing preventative vaccines•A prophylactic vaccine is critically needed to resolve the global COVID-19 pandemic. As such, researchers around the world are working tirelessly to develop a safe and effective vaccine in record time. Furthermore to help expedite the development, manufacturing, and distribution of COVID-19 vaccines, the U.S. government initiated an unprecedented public-private collaboration, allocating several billions of dollars to these efforts.•This support along with the internal vaccine development expertise and innovative technology platforms of our tenants Pfizer Inc. (in partnership with BioNTech) and Moderna, Inc. (in partnership with the National institutes of Health), culminated in the FDA providing Emergency Use Authorization (“EUA”) in December 2020 for their respective mRNA based COVID-19 vaccines. The U.S. has begun a large-scale COVID-19 vaccination campaign and will continue to roll out vaccines across the nation, prioritizing frontline and essential workers, the elderly, and individuals considered high-risk.•Additional tenants, including AstraZeneca plc, Emergent BioSolutions Inc., FUJIFILM Diosynth Biotechnologies, GlaxoSmithKline, Johnson & Johnson, Novavax, Inc., and Sanofi, have similarly received strong government support for their efforts in the development, manufacturing, and/or distribution of COVID-19 vaccines. Many of these companies will report critical trial data over the coming months, which, if positive, could help bolster the widespread delivery of a safe and effective COVID-19 vaccine around the world.Advancing new and repurposed therapies•Safe and effective therapies are important for mitigating the impact of COVID-19, decreasing hospitalizations, and improving patient outcomes overall. On October 22, 2020, the FDA approved Veklury® (remdesivir), developed by our tenant Gilead Sciences, Inc., as the first antiviral treatment approved for COVID-19 patients requiring hospitalization. Subsequently, in November 2020, the FDA granted EUAs to tenant Eli Lilly and Company’s bamlanivimab for the treatment of newly infected high-risk patients with mild or moderate disease, as well as to Regeneron Pharmaceutical’s antibody cocktail for a similar indication. •In addition, over 300 experimental therapies to treat COVID-19 are being studied in over 900 clinical trials around the world, as well as over more than 150 therapeutic candidates in preclinical development. A substantial number of these programs are sponsored by our tenants, including the following:•Vir Biotechnology, Inc. and GlaxoSmithKline announced on October 6, 2020, that their most advanced antibody therapy for the early treatment of patients with COVID-19 has entered Phase III and that they expect complete results in the first quarter of 2021. •AbbVie Inc., Amgen, AstraZeneca plc, Atreca Inc., Enanta Pharmaceuticals, Inc., Novartis AG, and Pfizer Inc. are similarly endeavoring to develop novel therapies and repurpose existing and investigational drugs to provide near-term treatments for moderate and severe COVID-19 patients and those at highest risk.Improving testing quality and capacity•Abbott Laboratories, Adaptive Biotechnologies Corporation, Color, Cue Health Inc., Laboratory Corporation of America Holdings, Quest Diagnostics, Quidel Corporation, Roche, Thermo Fisher Scientific Inc., Verily Life Sciences, and others are working to improve testing quality, capacity, and turnaround time to more effectively determine who has an active COVID-19 infection, who has been exposed to the virus, and who has developed immunity against it. The increased availability of widespread COVID-19 testing is critical for curtailing the pandemic and facilitating a safer reopening of workplaces, communities, and society overall.92Industry and corporate leadership: catalyzing and leading the way for positive change to benefit human health and societyIndustry leadership•In January 2020, we announced our first national $100,000 AgTech Innovation Prize competition to recognize startup and early-stage agtech and foodtech companies that demonstrate innovative approaches to addressing challenges related to agriculture, food, and nutrition. •In June 2020, we announced that Alexandria LaunchLabs® – AgTech awarded its inaugural $100,000 AgTech Innovation Prize to TerMir Inc., an early-stage agtech company aiming to address key, unresolved agricultural, environmental, and human health challenges.•In January 2020, Alexandria Venture Investments, our strategic venture capital arm, was recognized for a third consecutive year as the most active biopharma investor by new deal volume by Silicon Valley Bank in its “2020 Healthcare Investments and Exits Report.” Alexandria’s venture activity provides us with, among other things, mission-critical data and knowledge of innovations and trends. •In July 2020, Alexandria Venture Investments was recognized as the most active biopharma investor by new deal volume from 2019 to the six months ended June 30, 2020, by Silicon Valley Bank in its “Mid-Year 2020 Healthcare Investments and Exits Report.”•In January 2021, Alexandria Venture Investments, our strategic venture capital platform, was recognized for a fourth consecutive year as the most active biopharma corporate investor by new deal volume from 2019 to 2020 by Silicon Valley Bank in its “Healthcare Investments and Exits: Annual Report 2021.”•In February 2020, Alexandria LaunchLabs® at the Alexandria Center® at One Kendall Square earned the Fitwel Impact Award for the highest Fitwel certification of all time, as well as the highest score in 2019 for a commercial interior space, in the Fitwel 2020 Best in Building Health awards program. This marks the second consecutive year Alexandria LaunchLabs® – Cambridge has held the record for Fitwel’s top certification score. The award recognizes our commitment to supporting high levels of health, wellness, and productivity through the design, construction, and operation of our best-in-class buildings and spaces.•In March 2020, the Navy SEAL Foundation honored Joel S. Marcus, our executive chairman and founder, and the company with the 2020 Navy SEAL Foundation Patriot Award, which highlights our contributions and unwavering support for the Naval Special Warfare community. We have proudly supported the Navy SEAL Foundation in its mission to provide immediate and ongoing support and assistance to the Naval Special Warfare community and their families since 2010.•In June 2020, our executive chairman and founder, Joel S. Marcus, had the honor of serving as the keynote speaker for a special fireside chat at the virtual BIO Health Caucus hosted by the Association of University Research Parks, an organization dedicated to guiding leaders to cultivate communities of innovation at global anchor institutions. The virtual fireside, titled “Three Decades of Building Bio Health Facilities and Companies,” covered a broad array of topics that provided a comprehensive view of our essential business, our dynamic cluster locations, and our critical role at the vanguard of the life science ecosystem fighting COVID-19.•In June 2020, we released our 2019 Corporate Responsibility Report, which reinforces Alexandria’s longstanding environmental, social, and governance commitment, strong progress toward our 2025 environmental impact goals, and critical role at the vanguard and heart of the life science ecosystem advancing solutions for COVID-19.•In September 2020, Alexandria won the Commercial Brokers Association (“CBA”) Boston Landlord of the Year award. The CBA was established as a freestanding division of the Greater Boston Real Estate Board in 2001 and represents over 400 members in the commercial brokerage community throughout Massachusetts.•In November 2020, Alexandria was ranked as the #1 public REIT for construction-in-progress in 2019 from Engineering News-Record’s (ENR) Top 50 List. ENR recognize leaders in the construction industry, and its top ranking of our construction activity highlights our commitment to creating and delivering life-changing and essential facilities to our tenant community.•In December 2020, we achieved the following in the 2020 Global Real Estate Sustainability Benchmark (“GRESB”) Real Estate Assessment: (i) #1 global ranking in the Science & Technology sector, (ii) #1 global ranking and 5 Star Rating (out of 5 stars) in our Diversified Listed Peer Group for highly sustainable development initiatives, and (iii) our third consecutive “A” disclosure score.Pioneering social responsibility initiatives to continue to drive unique, disruptive, and highly impactful solutions to tackle some of society’s most complex and pressing challenges Alexandria is profoundly committed to driving forward significant collaborative and innovative solutions to address some of today’s most urgent and widespread societal challenges, including the COVID-19 pandemic, the opioid epidemic, and the educational achievement gap.93At the vanguard and heart of the life science ecosystem’s fight against COVID-19•As a testament to our comprehensive and industry-leading COVID‑19 prevention guidelines and practices, in October 2020, we became the first-ever company to achieve a Fitwel Viral Response Certification with Distinction, the highest designation within the new Viral Response Module developed by the world’s leading healthy building certification system. Additionally, in November 2020, we achieved the world’s first WELL Health-Safety Rating for Laboratory Space at Alexandria LaunchLabs® – New York City. This latest evidence-based, third-party-verified rating further affirms our longstanding and robust practices to help keep our tenants, employees, visitors, service providers, and key industry stakeholders healthy and safe.•Throughout the COVID-19 pandemic, Alexandria has been a critical partner to several impactful organizations supporting communities adversely affected by the COVID-19 pandemic. In total, Alexandria has donated more than $1 million to non-profit organizations on the front lines of combating the devastating impact of the COVID-19 pandemic, including Robin Hood, New York City’s largest poverty-fighting organization. As a member of the Robin Hood Board of Directors, Joel S. Marcus has played a key leadership role in the distribution of over $60 million to 575 organizations across all five New York City boroughs, providing critical emergency support for New Yorkers in need through food, housing, financial assistance, job security, and more.•In lieu of tenant holiday gifts, in December 2020, Alexandria made donations to several regional COVID-19-related non-profit programs, including Seattle Foundation’s COVID-19 Relief Fund, Robin Hood COVID-19 Relief Fund, SF New Deal COVID-19 Relief for San Francisco, Nourish Now in Maryland, and the Greg Hill Foundation’s Restaurant Strong Fund in Boston.Pioneering a groundbreaking, data-driven, and evidence-based model to help solve the opioid epidemic•Determined to reverse the trajectory of the U.S. opioid epidemic, which is one of the most pervasive public health challenges in our nation’s history, Alexandria partnered with Verily Life Sciences to establish an innovative, non-profit healthcare ecosystem dedicated to the full and sustained recovery of people living with addiction. Together, we pioneered a fully integrated campus in Dayton, Ohio, to house an evidence-based comprehensive treatment model encompassing a full continuum of care with dedicated facilities and services for treatment, residential housing, group therapy, family reunification, workforce development programs, job placement, and community transition.•Over the last year, we completed construction of the OneFifteen Outpatient Clinic; the Crisis Stabilization Unit; and most recently, OneFifteen Living, the residential housing component that opened in late 2020.•Overdose deaths continue to rise dramatically during the COVID-19 pandemic, demonstrating the tremendous need for the OneFifteen ecosystem. Since opening in the fall of 2019, OneFifteen has made a positive and comprehensive impact on the local community and the way addiction is treated, seeing approximately 2,200 patients in 2020, including over 1,150 people during the three months ended December 31, 2020. It is our hope that OneFifteen’s unique approach to treatment will serve as a model of recovery for the rest of the country to replicate.Building educational foundations for students to pave paths for long-term success and close the achievement gap•Alexandria is deeply committed to driving educational opportunities and providing the support and resources needed to build the foundations for underserved, low-income students to succeed and become engaged and leading members of society. Understanding that education is one of the most fundamental foundations for a safe, healthy, and good life and essential for opportunity and economic mobility, we have forged deep partnerships in our communities with highly impactful organizations that provide holistic educational resources to underserved populations.•In December 2020, Alexandria celebrated the culmination of the Emily Krzyzewski Center’s $15 million Game Changer Campaign, in which Alexandria played a critical leadership role. The Emily K Center paves a path to success in higher education for academically focused, low-income K–12 students in Durham, North Carolina. Students receive holistic support that encompasses academic skills development, personal management and leadership training, college planning, and career exploration. Of those who complete Emily K’s Scholars to College program, nearly 100% are accepted to college each year.•The campaign funds will support ongoing programs to prepare students for life-changing college access while bolstering their achievement and developing their character and leadership; an endowment to ensure support for students in years to come; and a new 7,500 square foot facility designed for the specific needs of college-access programs to provide much needed classroom space as well as rooms for quiet study and one-on-one advising and financial aid discussions.94Results of operationsWe present a tabular comparison of items, whether gain or loss, that may facilitate a high-level understanding of our results and provide context for the disclosures included in this annual report on Form 10-K. We believe such tabular presentation promotes a better understanding for investors of the corporate-level decisions made and activities performed that significantly affect comparison of our operating results from period to period. We also believe this tabular presentation will supplement for investors an understanding of our disclosures and real estate operating results. Gains or losses on sales of real estate and impairments of held for sale assets are related to corporate-level decisions to dispose of real estate. Gains or losses on early extinguishment of debt, gains or losses on early termination of interest rate hedge agreements, and preferred stock redemption charges are related to corporate-level financing decisions focused on our capital structure strategy. Significant realized and unrealized gains or losses on non-real estate investments, impairments of real estate and non-real estate investments, and significant termination fees are not related to the operating performance of our real estate assets as they result from strategic corporate-level decisions and external market conditions. Impairments of non-real estate investments are not related to the operating performance of our real estate as they represent the write-down of non-real estate investments when their fair values decline below their respective carrying values due to changes in general market or other conditions outside of our control. Significant items included in the tabular disclosure for current periods are described in further detail under this Item 7 in this annual report on Form 10-K. Items included in net income attributable to Alexandria’s common stockholders were as follows:Year Ended December 31,(In millions, except per share amounts)2020201920202019AmountPer Share – DilutedUnrealized gains on non-real estate investments$374.0 $161.5 $2.96 $1.44 Gain on sales of real estate154.1 0.5 1.22 — Impairment of real estate(55.7)(1)(12.3)(0.44)(0.11)Impairment of non-real estate investments(24.5)(17.1)(0.19)(0.15)Loss on early extinguishment of debt(60.7)(47.6)(0.48)(0.42)Loss on early termination of interest rate hedge agreements— (1.7)— (0.02)Termination fee(2)86.2 — 0.68 — Acceleration of stock compensation expense due to executive officer resignation(4.5)— (0.04)— Preferred stock redemption charge— (2.6)— (0.02)Total$468.9 $80.7 $3.71 $0.72 (1)Amount includes $7.6 million impairment of our investment in a recently developed retail property held by our unconsolidated real estate joint venture. This impairment was recognized during the three months ended March 31, 2020, and was classified in equity in earnings from unconsolidated real estate joint ventures within our consolidated statements of operations.(2)Refer to “Income from rentals” in Note 5 – “Leases” to our consolidated financial statements under Item 15 in this annual report on Form 10-K for more information.95Same propertiesWe supplement an evaluation of our results of operations with an evaluation of operating performance of certain of our properties, referred to as “Same Properties.” For additional information on the determination of our Same Properties portfolio, refer to the definition of “Same property comparisons” in the “Non-GAAP measures and definitions” section under this Item 7 in this annual report on Form 10-K. The following table presents information regarding our Same Properties as of December 31, 2020 and 2019:December 31,20202019Percentage change in net operating income over comparable period from prior year2.6%3.1 %Percentage change in net operating income (cash basis) over comparable period from prior year5.1%7.1 %Operating margin73%71%Number of Same Properties209 192RSF20,707,81818,519,783Occupancy – current-period average96.6%96.6 %Occupancy – same-period prior-year average96.7%96.3 %The following table reconciles the number of Same Properties to total properties for the year ended December 31, 2020:Development – under constructionProperties9804 Medical Center Drive1 9950 Medical Center Drive1 Alexandria Center® for Life Science – San Carlos2 3115 Merryfield Row1 201 Haskins Way1 1165 Eastlake Avenue East1 9 Laboratory Drive1 Alexandria Center® for Advanced Technologies2 10 Development – placed into service after January 1, 2019Properties399 Binney Street1 279 East Grand Avenue1 188 East Blaine Street1 3 Redevelopment – under constructionProperties5505 Morehouse Drive1 Alexandria Center® – Long Island City1 3160 Porter Drive1 The Arsenal on the Charles5 700 Quince Orchard Road1 Alexandria Center® for Life Science – Durham3 12 Redevelopment – placed into service after January 1, 2019PropertiesAlexandria PARC4 9877 Waples Street1 681 and 685 Gateway Boulevard2 266 and 275 Second Avenue2 5 Laboratory Drive1 10 Acquisitions after January 1, 2019Properties25, 35, and 45 West Watkins Mill Road3 3170 and 3181 Porter Drive2 Shoreway Science Center2 3911, 3931, and 4075 Sorrento Valley Boulevard3 5 Necco Street1 601 Dexter Avenue North1 4224/4242 Campus Point Court and 10210 Campus Point Drive3 3825 and 3875 Fabian Way2 SD Tech by Alexandria10 The Arsenal on the Charles6 275 Grove Street1 601, 611, and 651 Gateway Boulevard3 3330, 3412, 3450, and 3460 Hillview Avenue4 9605 Medical Center Drive1 987 and 1075 Commercial Street2 4555 Executive Drive1 Alexandria Center® for Life Science – Durham13 Reservoir Woods3 One Upland Road1 830 4th Avenue South1 11255 and 11355 North Torrey Pines Road2 6420 and 6450 Sequence Drive2 380 and 420 E Street2 Other15 84 Unconsolidated real estate JV6 Properties held for sale4 Total properties excluded from Same Properties129 Same Properties209 (1)Total properties in North America as of December 31, 2020338 (1)Includes 9880 Campus Point Drive and 3545 Cray Court. The 9880 Campus Point Drive building was occupied through January 2018 and was placed into service during the three months ended September 30, 2020, and 3545 Cray Court is currently undergoing renovations.96Comparison of results for the year ended December 31, 2020, to the year ended December 31, 2019The following table presents a comparison of the components of net operating income for our Same Properties and Non-Same Properties for the year ended December 31, 2020, compared to the year ended December 31, 2019. Refer to the “Non-GAAP measures and definitions” section under this Item 7 in this annual report on Form 10-K for definitions of “Tenant recoveries” and “Net operating income” and their reconciliations from the most directly comparable financial measures presented in accordance with GAAP, income from rentals and net income, respectively. We provide a comparison of the results for the year ended December 31, 2019, to the year ended December 31, 2018, including a comparison of the components of net operating income for our Same Properties and Non-Same Properties for the year ended December 31, 2019, compared to the year ended December 31, 2018, within the “Results of operations” section in Item 7 of our annual report on Form 10-K for the year ended December 31, 2019.For additional discussion related to the COVID-19 pandemic and its impact to us, refer to “The COVID-19 pandemic” section under Item 7 in this annual report on Form 10-K. In addition, refer to “Item 1A. Risk factors” in this annual report on Form 10-K for a discussion about risks that COVID-19 directly or indirectly may pose to our business.Year Ended December 31,(Dollars in thousands)20202019$ Change% ChangeIncome from rentals:Same Properties$1,031,126 $1,017,749 $13,377 1.3 %Non-Same Properties(1)440,714 148,039 292,675 197.7 Rental revenues1,471,840 1,165,788 306,052 26.3 Same Properties327,815 313,705 14,110 4.5 Non-Same Properties78,553 37,371 41,182 110.2 Tenant recoveries406,368 351,076 55,292 15.7 Income from rentals1,878,208 1,516,864 361,344 23.8 Same Properties368 444 (76)(17.1)Non-Same Properties7,061 13,988 (6,927)(49.5)Other income7,429 14,432 (7,003)(48.5)Same Properties1,359,309 1,331,898 27,411 2.1 Non-Same Properties526,328 199,398 326,930 164.0 Total revenues1,885,637 1,531,296 354,341 23.1 Same Properties373,416 370,926 2,490 0.7 Non-Same Properties156,808 74,566 82,242 110.3 Rental operations530,224 445,492 84,732 19.0 Same Properties985,893 960,972 24,921 2.6 Non-Same Properties369,520 124,832 244,688 196.0 Net operating income$1,355,413 $1,085,804 $269,609 24.8 %Net operating income – Same Properties$985,893 $960,972 $24,921 2.6 %Straight-line rent revenue (67,243)(84,167)16,924 (20.1)Amortization of acquired below-market leases(10,791)(13,372)2,581 (19.3)Net operating income – Same Properties (cash basis)$907,859 $863,433 $44,426 5.1 %(1)Includes a termination fee recognized during the three months ended September 30, 2020. Refer to “Income from rentals” in Note 5 – “Leases” to our consolidated financial statements under Item 15 in this annual report on Form 10-K for detail.97Income from rentalsTotal income from rentals for the year ended December 31, 2020, increased by $361.3 million, or 23.8%, to $1.9 billion, compared to $1.5 billion for the year ended December 31, 2019, as a result of increases in rental revenues and tenant recoveries, as discussed below.Rental revenuesTotal rental revenues for the year ended December 31, 2020, increased by $306.1 million, or 26.3%, to $1.5 billion, compared to $1.2 billion for the year ended December 31, 2019. The increase was primarily due to an increase in rental revenues from our Non-Same Properties aggregating $292.7 million primarily related to 1,008,382 RSF of development and redevelopment projects placed into service subsequent to January 1, 2019, and 84 operating properties aggregating 7.8 million RSF acquired subsequent to January 1, 2019, as well as a termination fee of $89.5 million recognized in connection with the termination of our contract for a future lease at our development project at 88 Bluxome Street in our SoMa submarket during the three months ended September 30, 2020. Our annual rental revenue per RSF was $49.08 as of December 31, 2020 compared to $51.04 as of December 31, 2019. The decrease in our rental revenue per RSF was due to our recent acquisitions of Alexandria Center® for Life Science – Durham in our Research Triangle submarket, and acquisitions made during the three months ended December 31, 2020, including 6420 and 6450 Sequence Drive in our Sorrento Mesa submarket of San Diego, and 380 and 420 E Street in our Seaport Innovation District submarket of Greater Boston. Annual rental rates per RSF in our Research Triangle and Seattle markets, in which most of the operating RSF of the aforementioned acquisitions is concentrated, is generally lower than annual rental rates per RSF in our Greater Boston and San Francisco markets where the majority of our operating RSF is located. Excluding these acquisitions, our annual rental revenue per RSF as of December 31, 2020, would have been $51.26. For the definition of “Annual rental revenue” refer to the “Non-GAAP measures and definitions” section under Item 7 in this annual report on Form 10-K. Rental revenues from our Same Properties for the year ended December 31, 2020, increased by $13.4 million, or 1.3%, to $1.03 billion, compared to $1.02 billion for the year ended December 31, 2019. The increase was primarily due to rental rate increases on lease renewals and re-leasing of space since January 1, 2019. Refer to the “Leasing activity” section of “Item 2. Properties” within “Part I” in this annual report on Form 10-K for additional details. The increase was partially offset by the effect of reduced revenues generated from our transient parking, retail tenants, and amenities, which had limited operations due to COVID-19 restrictions.The increase in total rental revenues was also partially offset by a $5.4 million reduction to rental revenues recognized during the year ended December 31, 2020, due to specific write-offs and a general allowance related to deferred rent balances of tenants that are or may potentially be impacted by uncertainties surrounding COVID-19.Tenant recoveriesTenant recoveries for the year ended December 31, 2020, increased by $55.3 million, or 15.7%, to $406.4 million, compared to $351.1 million for the year ended December 31, 2019. This increase is consistent with the increase in our rental operating expenses of $84.7 million, or 19.0%, as discussed under “Rental operations” below. Same Properties’ tenant recoveries for the year ended December 31, 2020, increased by $14.1 million, or 4.5%, to $327.8 million, compared to $313.7 million for the year ended December 31, 2019, primarily due to the increase in property tax expenses resulting from higher assessed values of our properties, higher property insurance, and higher repairs and maintenance expenses during the year ended December 31, 2020, as discussed under “Rental operations” below. As of December 31, 2020, 94% of our leases (on an RSF basis) were triple net leases, which require tenants to pay substantially all real estate taxes, insurance, utilities, repairs and maintenance, common area expenses, and other operating expenses (including increases thereto) in addition to base rent.Other incomeOther income for the years ended December 31, 2020 and 2019, was $7.4 million and $14.4 million, respectively, primarily consisting of construction management fees and interest income earned during each respective period. The decrease was primarily a result of lower construction management fees recognized due to the completion of certain projects.Rental operationsTotal rental operating expenses for the year ended December 31, 2020, increased by $84.7 million, or 19.0%, to $530.2 million, compared to $445.5 million for the year ended December 31, 2019. The increase was primarily due to incremental expenses from our Non-Same Properties, primarily related to 1,008,382 RSF of development and redevelopment projects placed into service subsequent to January 1, 2019, and 84 operating properties aggregating 7.8 million RSF acquired subsequent to January 1, 2019.98Same Properties’ rental operating expenses increased by $2.5 million, or 0.7%, to $373.4 million, compared to $370.9 million for the year ended December 31, 2019. The increase was primarily due to an increase in property tax expenses resulting from higher assessed values of our properties, higher property insurance, and higher repairs and maintenance expenses, which were partially offset by reduced operating expenses related to retail tenants and amenities, which had no or limited operations due to COVID-19 restrictions during the year ended December 31, 2020.General and administrative expensesGeneral and administrative expenses for the year ended December 31, 2020, increased by $24.5 million, or 22.5%, to $133.3 million, compared to $108.8 million for the year ended December 31, 2019. Approximately $4.5 million of the increase was the result of the acceleration of stock compensation expense recognized in connection with the resignation of an executive officer during the three months ended September 2020. This former executive officer remains a consultant to the Company. A portion of unvested stock outstanding will continue to vest pursuant to the original terms of the awards. This was deemed a modification for accounting purposes due to a significant reduction in future services to the Company, which resulted in an accelerated vesting and recognition of the fair value of the modified award. The remaining increase was primarily due to continued growth in the depth and breadth of our operations in multiple markets, including development and redevelopment projects placed into service and properties acquired subsequent to January 1, 2019, as discussed under “Income from rentals” above. As a percentage of net operating income, our general and administrative expenses for the years ended December 31, 2020 and 2019, were 9.8% and 10.0%, respectively.Interest expenseInterest expense for the years ended December 31, 2020 and 2019, consisted of the following (dollars in thousands):Year Ended December 31,Component20202019ChangeInterest incurred$297,227 $262,238 $34,989 Capitalized interest(125,618)(88,563)(37,055)Interest expense$171,609 $173,675 $(2,066)Average debt balance outstanding(1)$7,762,498 $6,416,773 $1,345,725 Weighted-average annual interest rate(2)3.8 %4.1 %(0.3)%(1)Represents the average debt balance outstanding during the respective periods.(2)Represents total interest incurred divided by the average debt balance outstanding in the respective periods.99The net change in interest expense during the year ended December 31, 2020, compared to the year ended December 31, 2019, resulted from the following (dollars in thousands):ComponentInterest Rate(1)Effective DateChangeIncreases in interest incurred due to:Issuances of debt:$650 million unsecured senior notes payable – green bond4.03 %June 2018/March 2019$1,776 $350 million unsecured senior notes payable – green bond3.96 %March 20192,969 $300 million unsecured senior notes payable4.93 %March 20193,236 $750 million unsecured senior notes payable3.48 %July 201913,685 $700 million unsecured senior notes payable3.91 %July/September 201916,572 $400 million unsecured senior notes payable2.87 %September 20197,712 $700 million unsecured senior notes payable5.05 %March 202026,232 $1.0 billion unsecured senior notes payable1.97 %August 20207,661 Fluctuations in interest rate and average balance:$1.5 billion commercial paper program1,778 Other increase in interest1,570 Total increases83,191 Decreases in interest incurred due to:Repayments of debt:$550 million unsecured senior notes payable4.75 %July/August 2019(14,424)$400 million unsecured senior notes payable2.96 %July/August 2019(6,257)$500 million unsecured senior notes payable4.04 %August/September 2020(7,166)Secured construction loan3.29 %March 2019(1,778)Unsecured senior bank term loanVariousVarious(7,335)Fluctuations in interest rate and average balance:Unsecured senior line of credit(11,242)Total decreases(48,202)Change in interest incurred34,989 Increase in capitalized interest(37,055)Total change in interest expense$(2,066)(1)Represents the weighted-average interest rate as of the end of the applicable period, including amortization of loan fees, amortization of debt premiums (discounts), and other bank fees.In anticipation of LIBOR cessation at the end of 2021, we have been actively reducing LIBOR-based borrowings outstanding on our loans. As of December 31, 2020, the outstanding balance on our unsecured senior line of credit, our only LIBOR-based debt (excluding debt held by our unconsolidated joint ventures), was zero.Depreciation and amortizationDepreciation and amortization expense for the year ended December 31, 2020, increased by $153.5 million, or 28.2%, to $698.1 million, compared to $544.6 million for the year ended December 31, 2019. The increase was primarily due to additional depreciation from 1,008,382 RSF of development and redevelopment projects placed into service subsequent to January 1, 2019, and 84 operating properties aggregating 7.8 million RSF acquired subsequent to January 1, 2019.100Gain on sales of real estateDuring the year ended December 31, 2020, we recognized a gain on sales of real estate aggregating $154.1 million, which primarily consisted of the following:•Gain on sale of $151.9 million recognized in connection with the sale of two tech office properties aggregating 443,479 RSF at 510 Townsend Street and 505 Brannan Street in our SoMa submarket. We completed the sale in November 2020 for an aggregate sales price of $560.2 million.•Gain on sale of $1.6 million recognized in connection with the sale of 30 Bearfoot Road in our Route 495 submarket. We completed the sale of the real estate asset in August 2020 for a sales price of $3.4 million.During the year ended December 31, 2019, we recognized a gain on sale of real estate of $474 thousand in connection with the sale of our property at 6138/6150 Nancy Ridge Drive aggregating 56,698 RSF, located in our Sorrento Mesa submarket, which was classified as held for sale during the three months ended June 30, 2019. The gain on sale was recognized in December 2019, upon completion of the sale of the property for a sales price of $6.6 million, or $117 per RSF.Impairment chargesDuring the year ended December 31, 2020, we recognized impairment charges aggregating $48.1 million, primarily including: •Impairment charges aggregating $15.2 million, which mainly consisted of a $10 million write-off of the pre-acquisition deposit for a previously pending acquisition of an operating tech office property for which our revised economic projections declined from our initial underwriting. We recognized this impairment charge in April 2020 concurrently with the submission of our notice to terminate the transaction. •Impairment charge of $13.5 million recognized during the three months ended December 31, 2020, upon classification of our real estate assets located at 260 Townsend Street in our SoMa submarket as held for sale. We expect to sell this real estate asset during 2021.•Impairment charge of $11.7 million recognized during the three months ended December 31, 2020, upon classification of our real estate asset located at 220 and 240 2nd Avenue South in our SoDo submarket as held for sale. We expect to sell this real estate asset during 2021.•Impairment charge of $6.8 million recognized during the three months ended September 30, 2020, upon classification of our real estate asset located at 945 Market Street in our SoMa submarket as held for sale. In September 2020, we completed the sale of the real estate asset for a sales price of $198.0 million with no gain or loss.During the three months ended December 31, 2019, we decided to sell two of our real estate assets aggregating 123,862 RSF in non-cluster markets to allow for reinvestment of this capital into our highly leased value-creation pipeline. Upon classification as held for sale, we recognized impairment charges aggregating $12.3 million to lower the carrying amounts of these real estate assets to their respective estimated fair value less cost to sell.For additional information, refer to Note 18 – “Assets classified as held for sale” to our consolidated financial statements under Item 15 in this annual report on Form 10-K.Investment incomeDuring the year ended December 31, 2020, we recognized investment income aggregating $421.3 million, which consisted of $47.3 million of realized gains and $374.0 million of unrealized gains. Realized gains primarily consisted of $72.5 million of gains on non-real estate investments, partially offset by realized losses on investments in privately held entities that do not report NAV. Unrealized gains of $374.0 million during the year ended December 31, 2020, primarily consisted of increases in fair values of our investments in publicly traded companies and in privately held entities that report NAV. For more information about our investments, refer to Note 7 – “Investments” to our consolidated financial statements under Item 15 in this annual report on Form 10-K. For our impairments accounting policy, refer to the “Investments” section in Note 2 – “Summary of significant accounting policies” to our consolidated financial statements under Item 15 in this annual report on Form 10-K.During the year ended December 31, 2019, we recognized investment income aggregating $194.6 million, which consisted of $33.2 million of realized gains and $161.5 million of unrealized gains.101Loss on early extinguishment of debtDuring the year ended December 31, 2020, we recognized losses on early extinguishment of debt aggregating $60.7 million, consisting of the following:•$50.8 million, including the write-off of unamortized loan fees, related to the refinancing of our 3.90% unsecured senior notes payable due in 2023 aggregating $500.0 million.•$7.3 million related to the extinguishment of two secured notes payable in December 2020 aggregating $108.2 million, which were originally due in 2023 and had a weighted-average interest rate of 3.67%. This amount includes a $2.8 million loss on early extinguishment of debt recognized in connection with a legal defeasance that extinguished our secured note payable related to 3545 Cray Court. •$1.9 million due to the termination of our $750.0 million unsecured senior line of credit.•$651 thousand related to the write-off of unamortized loan fees upon the amendment of our unsecured senior line of credit in October 6, 2020.For more information about our extinguishment of debt, refer to the “Extinguishment of unsecured senior notes payable, unsecured senior line of credit, and secured notes payable” section in Note 10 – “Secured and unsecured senior debt” to our consolidated financial statements under Item 15 in this annual report on Form 10-K.During the year ended December 31, 2019, we recognized losses on early extinguishment of debt aggregating $47.6 million, consisting of the following:•$40.2 million related to the repayment of the outstanding balance of our unsecured senior bank term loan of $350.0 million and the refinancing of unsecured senior notes payable comprising $400.0 million of 2.75% unsecured senior notes payable due 2020 and $550.0 million of 4.60% unsecured senior notes payable due in 2022. •$7.1 million, including the write-off of unamortized loan fees, related to early repayment of one secured note payable aggregating $106.7 million, which was originally due in 2020 and bore interest at 7.75%. •$269 thousand related to the early repayment of the remaining $193.1 million balance of our secured construction loan related to 50/60 Binney Street. Equity in earnings of unconsolidated real estate joint venturesDuring the year ended December 31, 2020, we recognized equity in earnings of unconsolidated real estate joint ventures of $8.1 million. This balance consisted of earnings from our unconsolidated real estate joint ventures of approximately $15.8 million, partially offset by the impairment charge discussed below. In March 2020, the impact of COVID-19 pandemic and the resulting State of Maryland’s shelter-in-place order led to the closure of a retail center owned by one of our unconsolidated joint ventures. We evaluated the recoverability of our investment in this joint venture and recognized a $7.6 million impairment charge to lower the carrying amount of our investment balance, which primarily consisted of real estate, to its estimated fair value less costs to sell. This impairment charge was classified in equity in earnings of unconsolidated real estate joint ventures within our consolidated statements of operations for the year ended December 31, 2020. Refer to Note 4 – “Consolidated and unconsolidated real estate joint ventures” to our consolidated financial statements under Item 15 in this annual report on Form 10-K for additional information.During the year ended December 31, 2019, we recognized equity in earnings of unconsolidated real estate joint ventures of $10.1 million, which consisted primarily of earnings recognized due to the delivery of our development project at Menlo Gateway in our Greater Stanford submarket during the three months ended September 30, 2019.Preferred stock redemption chargeDuring the year ended December 31, 2019, we repurchased, in privately negotiated transactions, 275,000 outstanding shares of our 7.00% Series D cumulative convertible preferred stock and recognized a preferred stock redemption charge of $2.6 million. As of December 31, 2019 and 2020, we had no outstanding shares of preferred stock.Other comprehensive incomeTotal other comprehensive income for the year ended December 31, 2020, increased by $2.4 million to aggregate net unrealized gains of $3.1 million, compared to net unrealized gains of $686 thousand for the year ended December 31, 2019, primarily due to the unrealized gains (losses) on foreign currency translation related to our operations in Canada and China.102Projected resultsBased on our current view of existing market conditions and certain current assumptions, we present guidance for EPS attributable to Alexandria’s common stockholders – diluted and funds from operations per share attributable to Alexandria’s common stockholders – diluted for the year ending December 31, 2021, as set forth in the table below. The tables below also provide a reconciliation of EPS attributable to Alexandria’s common stockholders – diluted, the most directly comparable financial measure presented in accordance with GAAP, to funds from operations per share, a non-GAAP measure, and other key assumptions included in our updated guidance for the year ending December 31, 2021. There can be no assurance that actual amounts will be materially higher or lower than these expectations. Refer to our discussion of “Forward-looking statements” in this annual report on Form 10-K.Projected 2021 Earnings per Share and Funds From Operations per Share Attributable to Alexandria’s Common Stockholders – DilutedEarnings per share(1)$2.14 to $2.34Depreciation and amortization of real estate assets5.50Allocation of unvested restricted stock awards(0.04)Funds from operations per share(2)$7.60 to $7.80Midpoint$7.70(1)Excludes unrealized gains or losses after December 31, 2020, that are required to be recognized in earnings and are excluded from funds from operations per share, as adjusted.(2)Calculated in accordance with standards established by the Advisory Board of Governors of Nareit (the “Nareit Board of Governors”). Refer to the definition of “Funds from operations and funds from operations, as adjusted, attributable to Alexandria Real Estate Equities, Inc.’s common stockholders” in the “Non-GAAP measures and definitions” section under this Item 7 in this annual report on Form 10-K for additional information. Key Assumptions(1)(Dollars in millions)2021 GuidanceLowHighOccupancy percentage for operating properties in North America as of December 31, 202195.6%96.2%Lease renewals and re-leasing of space:Rental rate increases29.0%32.0%Rental rate increases (cash basis)16.0%19.0%Same property performance:Net operating income increase1.0%3.0%Net operating income increase (cash basis)4.0%6.0%Straight-line rent revenue$114 $124 General and administrative expenses$146 $151 Capitalization of interest$167 $177 Interest expense$133 $143 (1)Our assumptions presented in the table above are subject to a number of variables and uncertainties, including those discussed as “Forward-looking statements” under “Part I”; “Item 1A. Risk factors”; and “Item 7. Management’s discussion and analysis of financial condition and results of operations” in this annual report on Form 10-K. To the extent our full-year earnings guidance is updated during the year, we will provide additional disclosure supporting reasons for any significant changes to such guidance.Key Credit Metrics 2021 GuidanceNet debt and preferred stock to Adjusted EBITDA – fourth quarter of 2021, annualizedLess than or equal to 5.2xFixed-charge coverage ratio – fourth quarter of 2021, annualizedGreater than or equal to 4.5x103Consolidated and unconsolidated real estate joint venturesWe present components of balance sheet and operating results information for the noncontrolling interest share of our consolidated real estate joint ventures and for our share of investments in unconsolidated real estate joint ventures to help investors estimate balance sheet and operating results information related to our partially owned entities. These amounts are estimated by computing, for each joint venture that we consolidate in our financial statements, the noncontrolling interest percentage of each financial item to arrive at the cumulative noncontrolling interest share of each component presented. In addition, for our real estate joint ventures that we do not control and do not consolidate, we apply our economic ownership percentage to the unconsolidated real estate joint ventures to arrive at our proportionate share of each component presented. Refer to Note 4 – “Consolidated and unconsolidated real estate joint ventures” to our consolidated financial statements under Item 15 in this annual report on Form 10-K for further discussion.Consolidated Real Estate Joint VenturesProperty/Market/SubmarketNoncontrolling(1)Interest ShareOperating RSF at 100%225 Binney Street/Greater Boston/Cambridge/Inner Suburbs70.0 %305,21275/125 Binney Street/Greater Boston/Cambridge/Inner Suburbs60.0 %388,27057 Coolidge Avenue/Greater Boston/Cambridge/Inner Suburbs25.0 %— (2)409 and 499 Illinois Street/San Francisco/Mission Bay40.0 %455,0691500 Owens Street/San Francisco/Mission Bay49.9 %158,267Alexandria Technology Center® – Gateway/San Francisco/South San Francisco(3)54.9 %1,089,265500 Forbes Boulevard/San Francisco/South San Francisco90.0 %155,685Alexandria Point/San Diego/University Town Center(4)45.0 %1,337,9165200 Illumina Way/San Diego/University Town Center49.0 %792,6879625 Towne Centre Drive/San Diego/University Town Center49.9 %163,648SD Tech by Alexandria/San Diego/Sorrento Mesa(5)50.0 %677,597The Eastlake Life Science Campus by Alexandria/Seattle/Lake Union(6)70.0 %321,218Unconsolidated Real Estate Joint VenturesProperty/Market/SubmarketOur Ownership Share(7)Operating RSF at 100%1655 and 1725 Third Street/San Francisco/Mission Bay10.0 %586,208Menlo Gateway/San Francisco/Greater Stanford49.0 %772,983704 Quince Orchard Road/Maryland/Gaithersburg56.8 %(8)80,032(1)In addition to the consolidated real estate joint ventures listed, various partners hold insignificant noncontrolling interests in five other joint ventures in North America.(2)We expect to commence vertical construction of 275,000 RSF during 2021.(3)Excludes 600, 630, 650, 901, and 951 Gateway Boulevard in our South San Francisco submarket. Noncontrolling interest share is anticipated to be 49% as we make further contributions over time.(4)Excludes 9880 Campus Point Drive in our University Town Center submarket.(5)Excludes 5505 Morehouse Drive and 10121 and 10151 Barnes Canyon Road in our Sorrento Mesa submarket.(6)Excludes 1165, 1616, and 1551 Eastlake Avenue East, 188 East Blaine Street, and 1600 Fairview Avenue East in our Lake Union submarket.(7)In addition to the unconsolidated real estate joint ventures listed, we hold an interest in two other insignificant unconsolidated real estate joint ventures in North America.(8)Represents our ownership interest; our voting interest is limited to 50%.Our unconsolidated real estate joint ventures have the following secured loans that include the following key terms as of December 31, 2020 (dollars in thousands):Unconsolidated Joint VentureOur ShareMaturity DateStated RateInterest Rate(1)Debt Balance at 100%(2)704 Quince Orchard Road56.8%3/16/23L+1.95%3.22%(3)$12,660 1655 and 1725 Third Street10.0%3/10/254.50%4.57%598,232 Menlo Gateway, Phase II49.0%5/1/354.53%4.59%155,942 Menlo Gateway, Phase I49.0%8/10/354.15%4.18%139,558 $906,392 (1)Includes interest expense and amortization of loan fees.(2)Represents outstanding principal, net of unamortized deferred financing costs, as of December 31, 2020.(3)Includes a 1.00% LIBOR floor on the interest rate. 104The following tables present information related to the operating results and financial positions of our consolidated and unconsolidated real estate joint ventures (in thousands):Noncontrolling Interest Share of Consolidated Real Estate Joint VenturesOur Share of Unconsolidated Real Estate Joint VenturesDecember 31, 2020December 31, 2020Three Months EndedYear EndedThree Months EndedYear EndedTotal revenues$42,203 $160,676 $10,474 $41,638 Rental operations(11,622)(42,930)(1,679)(5,932)30,581 117,746 8,795 35,706 General and administrative(120)(504)(29)(217)Interest— — (2,197)(8,284)Depreciation and amortization(15,032)(61,933)(2,976)(11,413)Impairment of real estate— — — (7,644)Fixed returns allocated to redeemable noncontrolling interests(1)220 903 — — $15,649 $56,212 $3,593 $8,148 Straight-line rent and below-market lease revenue $1,055 $5,341 $3,946 $21,210 Funds from operations(2)$30,681 $118,145 $6,569 $27,205 (1)Represents an allocation of joint venture earnings to redeemable noncontrolling interests primarily in one property in our South San Francisco submarket. These redeemable noncontrolling interests earn a fixed return on their investment rather than participate in the operating results of the property.(2)Refer to the definition of “Funds from operations and funds from operations, as adjusted, attributable to Alexandria Real Estate Equities, Inc.’s common stockholders” in the “Non-GAAP measures and definitions” section under this Item 7 in this annual report on Form 10-K for the definition and the reconciliation from the most directly comparable financial measure presented in accordance with GAAP.December 31, 2020Noncontrolling Interest Share of Consolidated Real Estate Joint VenturesOur Share of Unconsolidated Real Estate Joint VenturesInvestments in real estate$1,568,665 $457,672 Cash, cash equivalents, and restricted cash49,633 32,981 Other assets179,699 59,342 Secured notes payable — (210,201)Other liabilities(79,931)(7,445)Redeemable noncontrolling interests(11,342)— $1,706,724 $332,349 During the years ended December 31, 2020 and 2019, our consolidated real estate joint ventures distributed an aggregate of $87.3 million and $48.2 million, respectively, to our joint venture partners. Refer to our consolidated statements of cash flows and Note 4 – “Consolidated and unconsolidated real estate joint ventures” to our consolidated financial statements under Item 15 in this annual report on Form 10-K for additional information.105LiquidityLiquidityMinimal Outstanding Borrowings and Significant Availability on Unsecured Senior Line of Credit(in millions)$4.1B(In millions)Availability under our unsecured senior line of credit, net of amounts outstanding under our commercial paper program$2,900 Outstanding forward equity sales agreements(1)56 Cash, cash equivalents, and restricted cash598 Investments in publicly traded companies560 Liquidity as of December 31, 2020$4,114 Net Debt and Preferred Stock to Adjusted EBITDA(2)Fixed-Charge Coverage Ratio(2)(1)Represents expected net proceeds from the future settlement of the remaining 362 thousand shares outstanding under our forward equity sales agreements as of December 31, 2020. Excludes forward equity sales agreements aggregating $1.1 billion entered into in January 2021.(2)Quarter annualized. We expect to meet certain long-term liquidity requirements, such as requirements for development, redevelopment, other construction projects, capital improvements, tenant improvements, property acquisitions, leasing costs, non-revenue-enhancing capital expenditures, scheduled debt maturities, distributions to noncontrolling interests, and payment of dividends through net cash provided by operating activities, periodic asset sales, strategic real estate joint venture capital, and long-term secured and unsecured indebtedness, including borrowings under our unsecured senior line of credit, issuances under our commercial paper program, and issuances of additional debt and/or equity securities.We expect to continue meeting our short-term liquidity and capital requirements, as further detailed in this section, generally through our working capital and net cash provided by operating activities. We believe that the net cash provided by operating activities will continue to be sufficient to enable us to make the distributions necessary to continue qualifying as a REIT.106Over the next several years, our balance sheet, capital structure, and liquidity objectives are as follows:•Retain positive cash flows from operating activities after payment of dividends and distributions to noncontrolling interests for investment in development and redevelopment projects and/or acquisitions;•Improve credit profile and relative long-term cost of capital;•Maintain diverse sources of capital, including sources from net cash provided by operating activities, unsecured debt, secured debt, selective real estate asset sales, partial interest sales, non-real estate investment sales, preferred stock, and common stock;•Maintain commitment to long-term capital to fund growth;•Maintain prudent laddering of debt maturities;•Maintain solid credit metrics;•Maintain significant balance sheet liquidity;•Mitigate variable-rate debt exposure through the reduction of short-term and medium-term variable-rate bank debt;•Maintain a large unencumbered asset pool to provide financial flexibility;•Fund common stock dividends and distributions to noncontrolling interests from net cash provided by operating activities;•Manage a disciplined level of value-creation projects as a percentage of our gross investments in real estate; and•Maintain high levels of pre-leasing and percentage leased in value-creation projects.In addition, refer to “Item 1A. Risk factors” in this annual report on Form 10-K for a discussion about risks that COVID-19 directly or indirectly may pose to our business.The following table presents the availability under our unsecured senior line of credit less amounts outstanding under our commercial paper program; outstanding forward equity sales agreements; cash, cash equivalents, and restricted cash; and investments in publicly traded companies as of December 31, 2020 (dollars in thousands):DescriptionStated RateAggregateCommitmentsOutstandingBalance under our Commercial Paper ProgramRemaining Commitments/LiquidityAvailability under our unsecured senior line of creditL+0.825%$3,000,000 $99,991 $2,900,000 Outstanding forward equity sales agreements56,291 Cash, cash equivalents, and restricted cash597,705 Investments in publicly traded companies559,830 Total liquidity$4,113,826 Cash, cash equivalents, and restricted cashAs of December 31, 2020 and 2019, we had $597.7 million and $242.7 million, respectively, of cash, cash equivalents, and restricted cash. We expect existing cash, cash equivalents, and restricted cash, net cash from operating activities, proceeds from real estate asset sales and partial interest sales, non-real estate investment sales, borrowings under our unsecured senior line of credit, issuances under our commercial paper program, issuances of unsecured notes payable, and issuances of common stock to continue to be sufficient to fund our operating activities and cash commitments for investing and financing activities, such as regular quarterly dividends, distributions to noncontrolling interests, scheduled debt repayments, acquisitions, and certain capital expenditures, including expenditures related to construction activities.107Cash flowsWe report and analyze our cash flows based on operating activities, investing activities, and financing activities. The following table summarizes changes in our cash flows for the years ended December 31, 2020 and 2019 (in thousands):Year Ended December 31,20202019ChangeNet cash provided by operating activities$882,510 $683,857 $198,653 Net cash used in investing activities$(3,278,161)$(3,641,320)$363,159 Net cash provided by financing activities$2,750,356 $2,927,482 $(177,126)Operating activitiesCash flows provided by operating activities are primarily dependent upon the occupancy level of our asset base, the rental rates of our leases, the collectibility of rent and recovery of operating expenses from our tenants, the timing of completion of development and redevelopment projects, and the timing of acquisitions and dispositions of operating properties. Net cash provided by operating activities for the year ended December 31, 2020, increased to $882.5 million, compared to $683.9 million for the year ended December 31, 2019. This increase was primarily attributable to (i) cash flows generated from our highly leased development and redevelopment projects recently placed into service, (ii) income-producing acquisitions since January 1, 2019, and (iii) increases in rental rates on lease renewals and re-leasing of space since January 1, 2019.Investing activitiesCash used in investing activities for the years ended December 31, 2020 and 2019, consisted of the following (in thousands): Year Ended December 31, 20202019Increase (Decrease)Sources of cash from investing activities: Sales of non-real estate investments$141,149 $147,332 $(6,183)Proceeds from sales of real estate747,020 6,619 740,401 Return of capital from unconsolidated real estate joint ventures20,225 14 20,211 Change in escrow deposits7,408 — 7,408 915,802 153,965 761,837 Uses of cash for investing activities:Purchases of real estate2,570,693 2,259,778 310,915 Additions to real estate1,445,171 1,224,541 220,630 Investments in unconsolidated real estate joint ventures3,444 102,081 (98,637)Change in escrow deposits— 18,107 (18,107)Additions to non-real estate investments174,655 190,778 (16,123)4,193,963 3,795,285 398,678 Net cash used in investing activities$3,278,161 $3,641,320 $(363,159)The decrease in net cash used in investing activities for the year ended December 31, 2020, was primarily due to an increased source of cash from proceeds from sales of real estate, partially offset by cash used in purchases of real estate and additions to real estate. Refer to Note 3 – “Investments in real estate” to our consolidated financial statements under Item 15 in this annual report on Form 10-K for further information.108Financing activitiesCash flows provided by financing activities for the years ended December 31, 2020 and 2019, consisted of the following (in thousands):Year Ended December 31,20202019ChangeRepayments of borrowings from secured notes payable$(84,104)$(306,199)$222,095 Payment for the defeasance of secured note payable(32,865)— (32,865)Proceeds from issuance of unsecured senior notes payable 1,697,651 2,721,169 (1,023,518)Repayments of unsecured senior notes payable(500,000)(950,000)450,000 Borrowings from unsecured senior line of credit2,700,000 5,056,000 (2,356,000)Repayments of borrowings from unsecured senior line of credit(3,084,000)(4,880,000)1,796,000 Repayments of borrowings from unsecured senior bank term loan— (350,000)350,000 Premium paid for early extinguishment of debt(54,385)(41,351)(13,034)Proceeds from issuance under commercial paper program23,539,400 2,233,000 21,306,400 Repayments of borrowings from commercial paper program(23,439,400)(2,233,000)(21,206,400)Payments of loan fees(32,309)(27,182)(5,127)Changes related to debt709,988 1,222,437 (512,449)Contributions from and sales of noncontrolling interests367,613 1,022,712 (655,099)Distributions to and purchases of noncontrolling interests(88,805)(48,225)(40,580)Proceeds from the issuance of common stock2,315,862 1,216,445 1,099,417 Dividend payments(532,980)(451,170)(81,810)Taxes paid related to net settlement of equity awards(21,322)(25,477)4,155 Repurchase of 7.00% Series D cumulative convertible preferred stock— (9,240)9,240 Net cash provided by financing activities$2,750,356 $2,927,482 $(177,126)InflationAs of December 31, 2020, approximately 94% of our leases (on an RSF basis) were triple net leases, which require tenants to pay substantially all real estate taxes, insurance, utilities, repairs and maintenance, common area expenses, and other operating expenses (including increases thereto) in addition to base rent. Approximately 94% of our leases (on an RSF basis) contained effective annual rent escalations that were either fixed (generally ranging from 3.0% to 3.5%) or indexed based on a consumer price index or other indices. Accordingly, we do not believe that our cash flows or earnings from real estate operations are subject to significant risks from inflation. A period of inflation, however, could cause an increase in the cost of our variable-rate borrowings, including borrowings related to our unsecured senior line of credit and secured construction loans held by our unconsolidated joint ventures.109Capital resourcesWe expect that our principal liquidity needs for the year ending December 31, 2021, will be satisfied by the following multiple sources of capital, as shown in the table below. There can be no assurance that our sources and uses of capital will not be materially higher or lower than these expectations. Key Sources and Uses of Capital(In millions)2021 GuidanceCertain Completed ItemsRangeMidpointSources of capital:Net cash provided by operating activities after dividends$210 $250 $230 Incremental debt730 740 735 2020 debt capital proceeds held in cash150 250 200 Real estate dispositions and partial interest sales(1)1,250 1,500 1,375 Common equity1,700 2,100 1,900 $1,141 (2)Total sources of capital$4,040 $4,840 $4,440 Uses of capital:Construction$1,590 $1,890 $1,740 Acquisitions2,450 2,950 2,700 $1,602 Total uses of capital$4,040 $4,840 $4,440 Incremental debt (included above):Issuance of unsecured senior notes payable(3)$700 $1,100 $900 Unsecured senior line of credit, commercial paper program, and other30 (360)(165)Incremental debt$730 $740 $735 (1)In December 2020, three office buildings aggregating 146,842 RSF met the criteria to be classified as held for sale. We expect to complete the sale of these properties in 2021 for a total estimated sales price of $78.1 million, including the buyer’s assumption of a $28.2 million secured note payable related to one of the buildings. Upon the buildings being classified as held for sale, we recognized impairment charges aggregating $25.2 million.(2)Represents forward equity sales agreements that we expect to settle in 2021 and receive net proceeds of approximately $1.1 billion.(3)In addition to our guidance range, we may seek opportunities to refinance our $650 million unsecured senior notes payable green bond due in 2024 prior to its maturity, subject to market conditions. The key assumptions behind the sources and uses of capital in the table above include a favorable capital market environment, performance of our core operating properties, lease-up and delivery of current and future development and redevelopment projects, and leasing activity. Our expected sources and uses of capital are subject to a number of variables and uncertainties, including those discussed as “Forward-looking statements” under “Part 1”; “Item 1A. Risk factors” and “Item 7. Management’s discussion and analysis of financial condition and results of operations” in this annual report on Form 10-K. We expect to update our forecast of sources and uses of capital on a quarterly basis.110Sources of capitalNet cash provided by operating activities after dividendsWe expect to retain $210.0 million to $250.0 million of net cash flows from operating activities after payment of common stock dividends, and distributions to noncontrolling interests for the year ending December 31, 2021. For purposes of this calculation, changes in operating assets and liabilities are excluded as they represent timing differences. We also excluded significant contract termination fees that represent an ancillary source of cash that is not associated with any ongoing activity at any of our operating properties. For the year ending December 31, 2021, we expect our recently delivered projects, our highly pre-leased value-creation projects expected to be completed and along with contributions from Same Properties and recently acquired properties, to contribute significant increases in income from rentals, net operating income, and cash flows. We anticipate significant contractual near-term growth in annual cash rents of $28 million related to the commencement of contractual rents on the projects recently placed into service that are near the end of their initial free rent period. Refer to the “Cash flows” section within this Item 7 in this annual report on Form 10-K for a discussion of cash flows provided by operating activities for the year ended December 31, 2020.DebtAs of December 31, 2020, we have no outstanding balance on our unsecured senior line of credit. Our unsecured senior line of credit bears an interest rate of LIBOR plus 0.825%. In addition to the cost of borrowing, the unsecured senior line of credit is subject to an annual facility fee of 0.15% based on the aggregate commitments outstanding. On October 6, 2020, we amended our unsecured senior line of credit to increase commitments available for borrowing by $800 million to an aggregate of $3.0 billion and to extend the maturity date to January 6, 2026. Among other things, the amended credit agreement includes a 0% LIBOR floor on the interest rate and is subject to certain annual sustainability measures entitling us to a temporary reduction in the interest rate margin of one basis point, but not below zero percent per year.We use our unsecured senior line of credit to fund working capital, construction activities, and, from time to time, acquisition of properties. Borrowings under the unsecured senior line of credit bear interest at a “Eurocurrency Rate,” a “LIBOR Floating Rate,” or a “Base Rate” specified in the unsecured senior line of credit agreement plus, in any case, the Applicable Margin. The Eurocurrency Rate specified in the unsecured senior line of credit agreement is, as applicable, the rate per annum equal to either (i) the LIBOR or a successor rate thereto as agreed to by the administrative agent and the Company for loans denominated in a LIBOR quoted currency (i.e., U.S. dollars, euro, sterling, or yen), (ii) the average annual yield rates applicable to Canadian dollar bankers’ acceptances for loans denominated in Canadian dollars, (iii) the Bank Bill Swap Reference Bid rate for loans denominated in Australian dollars, or (iv) the rate designated with respect to the applicable alternative currency for loans denominated in a non-LIBOR quoted currency (other than Canadian or Australian dollars). The LIBOR Floating Rate means, for any day, one-month LIBOR, or a successor rate thereto as agreed to by the administrative agent and the Company for loans denominated in U.S. dollars. The Base Rate means, for any day, a fluctuating rate per annum equal to the highest of (i) the federal funds rate plus 1/2 of 1.00%, (ii) the rate of interest in effect for such day as publicly announced from time to time by the Administrative Agent as its “prime rate,” and (iii) the Eurocurrency Rate plus 1.00%. Our unsecured senior line of credit contains a feature that allows lenders to competitively bid on the interest rate for borrowings under the facility. This may result in an interest rate that is below the stated rate.We expect to fund a portion of our capital needs in 2021 from the settlement of our outstanding forward equity sales agreements, from sales of our common stock under our ATM program, from issuances under our commercial paper program discussed below, from borrowings under our unsecured senior line of credit, and from real estate dispositions and partial interest sales.We established a commercial paper program that provides us with the ability to issue up to $1.5 billion of commercial paper notes generally with a maturity of 30 days or less and with a maximum maturity of 397 days from the date of issuance. Our commercial paper program is backed by our unsecured senior line of credit, and at all times we expect to retain a minimum undrawn amount of borrowing capacity under our unsecured senior line of credit equal to any outstanding balance on our commercial paper program. We use borrowings under the program to fund short-term capital needs. The notes issued under our commercial paper program are sold under customary terms in the commercial paper market. They are typically issued at a discount to par, representing a yield to maturity dictated by market conditions at the time of issuance. In the event we are unable to issue commercial paper notes or refinance outstanding commercial paper notes under terms equal to or more favorable than those under the unsecured senior line of credit, we expect to borrow under the unsecured senior line of credit at LIBOR plus 0.825%. The commercial paper notes sold during the year ended December 31, 2020, were issued at a weighted-average yield to maturity of 0.26%. As of December 31, 2020, we had $100.0 million of outstanding notes under our commercial paper program.In March 2020, we completed an offering of $700.0 million of unsecured senior notes payable due on December 15, 2030, at an interest rate of 4.90% for net proceeds of $691.6 million. The net proceeds were used to reduce the outstanding indebtedness under our unsecured senior line of credit and commercial paper program. 111In August 2020, we completed an offering of $1.0 billion of unsecured senior notes payable due on February 1, 2033, at an interest rate of 1.875% for net proceeds of $989.1 million. A portion of the proceeds was used to refinance our 3.90% unsecured senior notes payable due in 2023, aggregating $500.0 million, pursuant to a partial cash tender offer and a subsequent call for redemption. On August 5, 2020, we tendered $247.0 million, or 49.4%, of our outstanding 3.90% unsecured senior notes payable and settled the call for redemption of the remaining outstanding balance on September 4, 2020. As a result of our debt refinancing, we recognized a loss on early extinguishment of debt of $50.8 million, including the write-off of unamortized loan fees.In December 2020, we extinguished two secured notes payable aggregating $108.2 million due in 2023 with a weighted-average interest rate of 3.67% and recognized losses on early extinguishment of debt aggregating $7.3 million. As a result of these extinguishments, we have no debt maturing until 2024.Since January 1, 2019, we have completed the issuances of $4.4 billion in unsecured senior notes, with a weighted-average interest rate of 3.48% and a weighted-average maturity of 14.1 years, as of December 31, 2020.Refer to Note 10 – “Secured and unsecured senior debt” to our consolidated financial statements under Item 15 in this annual report on Form 10-K for additional information.Proactive management of transition away from LIBORLIBOR has been used extensively in the U.S. and globally as a reference rate for various commercial and financial contracts, including variable-rate debt and interest rate swap contracts. However, it is expected that LIBOR will no longer be used after June 30, 2023. To address the increased risk of LIBOR discontinuation, in the U.S. the Alternative Reference Rates Committee (“ARRC”) was established to help ensure the successful transition from LIBOR. In June 2017, the ARRC selected SOFR, a new index calculated by reference to short-term repurchase agreements backed by U.S. Treasury securities, as its preferred replacement for U.S. dollar LIBOR. We have been closely monitoring developments related to the transition away from LIBOR and have implemented numerous proactive measures to minimize the potential impact of the transition to the Company, specifically:•We have proactively eliminated outstanding LIBOR-based borrowings under our unsecured senior bank term loans and secured construction loans through repayments. From January 2017 through December 2020, we retired approximately $1.5 billion of such debt.•During 2020, we increased the aggregate amount of our commercial paper program to $1.5 billion from $750.0 million. This program provides us with ability to issue commercial paper notes bearing interest at short-term fixed rates, generally with a maturity of 30 days or less and with a maximum maturity of 397 days from the date of issuance. Our commercial paper program is not subject to LIBOR and is used for funding short-term working capital needs. As of December 31, 2020, we had $100.0 million of outstanding notes under our commercial paper program.•We continue to prudently manage outstanding borrowings under our unsecured senior line of credit, our only LIBOR-based debt (excluding $12.7 million LIBOR-based debt held by one of our unconsolidated joint ventures as of December 31, 2020). As of December 31, 2020, we had no borrowings outstanding under our unsecured senior line of credit.•Our unsecured senior line of credit contains fallback language generally consistent with the ARRC’s Amendment Approach, which provides a streamlined amendment approach for negotiating a benchmark replacement and introduces clarity with respect to the fallback trigger events and an adjustment to be applied to the successor rate.•We continue to monitor developments by the ARRC and other governing bodies involved in LIBOR transition.Refer to Note 10 – “Secured and unsecured senior debt” to our consolidated financial statements under Item 15 and “Item 1A. Risk factors” in this annual report on Form 10-K for additional information about our management of risks related to the transition away from LIBOR.Real estate dispositions and partial interest salesWe expect to continue the disciplined execution of select sales of operating assets. Future sales will provide an important source of capital to fund a portion of pending and recently completed opportunistic acquisitions and our highly leased value-creation development and redevelopment projects, and also provide significant capital for growth over the next two to three quarters. We may also consider additional sales of partial interests in core Class A properties and/or development projects. For 2021, we expect real estate dispositions and partial interest sales ranging from $1.3 billion to $1.5 billion. The amount of asset sales necessary to meet our forecasted sources of capital will vary depending upon the amount of EBITDA associated with the assets sold.During the year ended December 31, 2020, we received proceeds of $1.1 billion, primarily related to our sale of properties at 510 Townsend Street, 505 Brannan Street, and 945 Market Street in our SoMa submarket, our sale of properties at 9808 and 9868 Scranton Road in our Sorrento Mesa submarket, and our partial interest sale of properties at 1201 and 1208 Eastlake Avenue East and 199 East Blaine Street in our Lake Union submarket. The proceeds received were used primarily to fund development and redevelopment projects in our highly leased value-creation pipeline and to fund acquisitions completed in 2020.112As a REIT, generally we are subject to a 100% tax on the net income from real estate asset sales that the IRS characterizes as “prohibited transactions.” We do not expect our sales will be categorized as prohibited transactions. However, unless we meet certain “safe harbor” requirements, whether a real estate asset sale is a prohibited transaction will be based on the facts and circumstances of the sale. Our real estate asset sales may not always meet such safe harbor requirements. Refer to “Item 1A. Risk factors” in this annual report on Form 10-K for additional information about the “prohibited transaction” tax. Common equity transactionsDuring the year ended December 31, 2020, we completed issuances and executed forward equity sales agreements for an aggregate of 15.7 million shares of common stock, including the exercise of an underwriters’ option, for aggregate net proceeds of approximately $2.4 billion, as follows: •In January 2020 and July 2020, we entered into forward equity sales agreements aggregating $1.0 billion and $1.1 billion, respectively, to sell an aggregate of 6.9 million shares for each offering (13.8 million in aggregate) of our common stock, including the exercise of underwriters’ options, at public offering prices of $155.00 per share and $160.50 per share, respectively, before underwriting discounts. During 2020, we issued all 13.8 million shares under these forward equity sales agreements and received net proceeds of $2.1 billion. •In February 2020, we entered into an ATM common stock offering program, which allowed us to sell up to an aggregate of $850.0 million of our common stock. •We issued 1.5 million shares of common stock under our ATM program at a price of $159.09 per share (before underwriting discounts), and received net proceeds of $235.0 million during 2020.•We have 362 thousand shares under our ATM program subject to forward equity sales agreements that remain outstanding at a price of $159.09 per share (before underwriting discounts) As of December 31, 2020. We expect to settle these forward equity sales agreements in 2021 and receive net proceeds of approximately $56.3 million. •The remaining availability of $547.3 million under this ATM program expired in December 2020 concurrently with the expiration of the associated shelf registration. In January 2021, we filed a new shelf registration statement and expect to establish a new ATM program soon in 2021. Other sourcesUnder our current shelf registration statement filed with the SEC, we may offer common stock, preferred stock, debt, and other securities. These securities may be issued, from time to time, at our discretion based on our needs and market conditions, including, as necessary, to balance our use of incremental debt capital.Additionally, we hold interests, together with joint venture partners, in real estate joint ventures that we consolidate in our financial statements. These joint venture partners may contribute equity into these entities primarily related to their share of funds for construction and financing-related activities. During the year ended December 31, 2020, we received $367.6 million of contributions from and sales of noncontrolling interests.Uses of capitalSummary of capital expenditures One of our primary uses of capital relates to the development, redevelopment, pre-construction, and construction of properties. We currently have projects in our growth pipeline aggregating 3.3 million RSF of Class A office/laboratory and tech office space undergoing construction, 7.1 million RSF of near-term and intermediate-term development and redevelopment projects, and 7.4 million SF of future development projects in North America. We incur capitalized construction costs related to development, redevelopment, pre-construction, and other construction activities. We also incur additional capitalized project costs, including interest, property taxes, insurance, and other costs directly related and essential to the development, redevelopment, pre-construction, or construction of a project, during periods when activities necessary to prepare an asset for its intended use are in progress. Refer to the “New Class A development and redevelopment properties: current projects” and “Summary of capital expenditures” subsections of the “Investments in real estate” section under Item 2 in this annual report on Form 10-K for more information on our capital expenditures.113We capitalize interest cost as a cost of the project only during the period for which activities necessary to prepare an asset for its intended use are ongoing, provided that expenditures for the asset have been made and interest cost has been incurred. Capitalized interest for the years ended December 31, 2020 and 2019, of $125.6 million and $88.6 million, respectively, was classified in investments in real estate. Indirect project costs, including construction administration, legal fees, and office costs that clearly relate to projects under development or construction, are capitalized as incurred during the period an asset is undergoing activities to prepare it for its intended use. We capitalized payroll and other indirect project costs related to development, redevelopment, pre-construction, and construction projects, which aggregated $61.0 million and $43.2 million for the years ended December 31, 2020 and 2019, respectively. The increase in capitalized payroll and other indirect project costs for the year ended December 31, 2020, compared to the same period in 2019 was primarily due to an increase in our value-creation pipeline projects undergoing construction and pre-construction activities aggregating 11 projects with 7.2 million RSF in 2020 over 2019. Pre-construction activities include entitlements, permitting, design, site work, and other activities preceding commencement of construction of aboveground building improvements. The advancement of pre-construction efforts is focused on reducing the time required to deliver projects to prospective tenants. These critical activities add significant value for future ground-up development and are required for the vertical construction of buildings. Should we cease activities necessary to prepare an asset for its intended use, the interest, taxes, insurance, and certain other direct project costs related to this asset would be expensed as incurred. Expenditures for repairs and maintenance are expensed as incurred.Fluctuations in our development, redevelopment, and construction activities could result in significant changes to total expenses and net income. For example, had we experienced a 10% reduction in development, redevelopment, and construction activities without a corresponding decrease in indirect project costs, including interest and payroll, total expenses would have increased by approximately $18.7 million for the year ended December 31, 2020.We use third-party brokers to assist in our leasing activity, who are paid on a contingent basis upon successful leasing. We are required to capitalize initial direct costs related to successful leasing transactions that result directly from and are essential to the lease transaction and would not have been incurred had that lease transaction not been successfully executed. During the year ended December 31, 2020, we capitalized total initial direct leasing costs of $61.2 million. Costs that we incur to negotiate or arrange a lease regardless of its outcome, such as fixed employee compensation, tax, or legal advice to negotiate lease terms, and other costs, are expensed as incurred.AcquisitionsRefer to the “Acquisitions” section in Note 3 – “Investments in real estate” and to Note 4 – “Consolidated and unconsolidated real estate joint ventures” to our consolidated financial statements under Item 15 in this annual report on Form 10-K for detailed information on our acquisitions.DividendsDuring the years ended December 31, 2020 and 2019, we paid the following dividends (in thousands):Year Ended December 31,20202019ChangeCommon Stock$532,980 $447,029 $85,951 Series D Convertible Preferred Stock— 4,141 (4,141) $532,980 $451,170 $81,810 The increase in dividends paid on our common stock during the year ended December 31, 2020, compared to the year ended December 31, 2019, was primarily due to an increase in number of common shares outstanding subsequent to January 1, 2019, as a result of issuances of common stock under our ATM program and settlement of forward equity sales agreements, and partially due to the increase in the related dividends to $4.18 per common share paid during the year ended December 31, 2020, from $3.94 per common share paid during the year ended December 31, 2019. The decrease in dividends paid on our Series D Convertible Preferred Stock during the year ended December 31, 2020, compared to the year ended December 31, 2019, was due to the repurchase of 275,000 outstanding shares of our Series D Convertible Preferred Stock and the conversion of the remaining 2.3 million outstanding shares of our Series D Convertible Preferred Stock into shares of our common stock during 2019. As a result, we had no outstanding shares of Series D Convertible Preferred Stock as of December 31, 2020.114Contractual obligations and commitmentsContractual obligations as of December 31, 2020, consisted of the following (in thousands):Payments by PeriodTotal20212022–20232024–2025ThereafterSecured and unsecured debt(1)(2)$7,598,130 $3,420 $7,364 $1,433,593 $6,153,753 Estimated interest payments on fixed-rate debt(3)3,077,819 279,393 558,689 492,553 1,747,184 Ground lease obligations – operating leases798,589 17,127 34,750 35,115 711,597 Ground lease obligations – finance lease35,868 415 836 844 33,773 Other obligations27,215 1,776 5,253 5,583 14,603 Total$11,537,621 $302,131 $606,892 $1,967,688 $8,660,910 (1)Amounts represent principal amounts due and exclude unamortized premiums (discounts) and deferred financing costs reflected in the consolidated balance sheets under Item 15 in this annual report on Form 10-K.(2)Payment dates reflect any extension options that we control. (3)Amounts are based upon contractual interest rates, including interest payment dates and scheduled maturity dates.Secured notes payableSecured notes payable as of December 31, 2020, consisted of four notes secured by nine properties. Our secured notes payable typically require monthly payments of principal and interest and had a weighted-average interest rate of approximately 3.53%. As of December 31, 2020, the total book value of our investments in real estate securing debt was approximately $880.1 million. Additionally, as of December 31, 2020, our entire secured notes payable balance of $230.9 million, including unamortized discounts and deferred financing costs, was fixed-rate debt. Refer to Note 10 – “Secured and unsecured senior debt” to our consolidated financial statements under Item 15 in this annual report on Form 10-K for information on our repayments of secured notes payable during the year ended December 31, 2020. Unsecured senior notes payable and unsecured senior line of creditThe requirements of, and our actual performance with respect to, the key financial covenants under our unsecured senior notes payable as of December 31, 2020, were as follows:Covenant Ratios(1)RequirementDecember 31, 2020Total Debt to Total AssetsLess than or equal to 60%31%Secured Debt to Total AssetsLess than or equal to 40%1%Consolidated EBITDA(2) to Interest ExpenseGreater than or equal to 1.5x8.6xUnencumbered Total Asset Value to Unsecured DebtGreater than or equal to 150%305%(1)All covenant ratio titles utilize terms as defined in the respective debt agreements. (2)The calculation of consolidated EBITDA is based on the definitions contained in our loan agreements and is not directly comparable to the computation of EBITDA as described in Exchange Act Release No. 47226.In addition, the terms of the indentures, among other things, limit the ability of the Company, Alexandria Real Estate Equities, L.P., and the Company’s subsidiaries to (i) consummate a merger, or consolidate or sell all or substantially all of the Company’s assets, and (ii) incur certain secured or unsecured indebtedness.The requirements of, and our actual performance with respect to, the key financial covenants under our unsecured senior line of credit as of December 31, 2020, were as follows:Covenant Ratios (1)RequirementDecember 31, 2020Leverage RatioLess than or equal to 60.0%27.5%Secured Debt RatioLess than or equal to 45.0%0.8%Fixed-Charge Coverage RatioGreater than or equal to 1.50x3.91xUnsecured Interest Coverage RatioGreater than or equal to 1.75x6.64x(1)All covenant ratio titles utilize terms as defined in each respective credit agreement. 115Estimated interest paymentsEstimated interest payments on our fixed-rate debt were calculated based upon contractual interest rates, including interest payment dates and scheduled maturity dates. As of December 31, 2020, 99% of our debt was fixed-rate debt. For additional information regarding our debt, refer to Note 10 – “Secured and unsecured senior debt” to our consolidated financial statements under Item 15 in this annual report on Form 10-K. Ground lease obligationsOperating lease agreementsGround lease obligations as of December 31, 2020, included leases for 36 of our properties, which accounted for approximately 11% of our total number of properties. Excluding one ground lease that expires in 2036 related to one operating property with a net book value of $7.1 million as of December 31, 2020, our ground lease obligations have remaining lease terms ranging from approximately 33 to 94 years, including available extension options that we are reasonably certain to exercise.As of December 31, 2020, the remaining contractual payments under ground and office lease agreements in which we are the lessee aggregated $798.6 million and $27.2 million, respectively. We are required to recognize a right-of-use asset and a related liability to account for our future obligations under operating lease arrangements in which we are the lessee. The operating lease liability is measured based on the present value of the remaining lease payments, including payments during the term under our extension options that we are reasonably certain to exercise. The right-of-use asset is equal to the corresponding operating lease liability, adjusted for the initial direct leasing cost and any other consideration exchanged with the landlord prior to the commencement of the lease, as well as adjustments to reflect favorable or unfavorable terms of an acquired lease when compared with market terms at the time of acquisition. As of December 31, 2020, the present value of the remaining contractual payments, aggregating $825.8 million, under our operating lease agreements, including our extension options that we are reasonably certain to exercise, was $345.8 million, which was classified in accounts payable, accrued expenses, and other liabilities in our consolidated balance sheets. As of December 31, 2020, the weighted-average remaining lease term of operating leases in which we are the lessee was approximately 43 years, and the weighted-average discount rate was 4.88%. Our corresponding operating lease right-of-use assets, adjusted for initial direct leasing costs and other consideration exchanged with the landlord prior to the commencement of the lease, aggregated $335.9 million. We classify the right-of-use asset in other assets in our consolidated balance sheets. Refer to the “Lease accounting” section in Note 2 – “Summary of significant accounting policies” to our consolidated financial statements under Item 15 in this annual report on Form 10-K. CommitmentsAs of December 31, 2020, remaining aggregate costs under contract for the construction of properties undergoing development, redevelopment, and improvements under the terms of leases approximated $1.2 billion. We expect payments for these obligations to occur over one to three years, subject to capital planning adjustments from time to time. We may have the ability to cease the construction of certain properties, which would result in the reduction of our commitments. In addition, we have letters of credit and performance obligations aggregating $11.1 million primarily related to construction projects.We are committed to funding approximately $210.6 million for non-real estate investments primarily related to our investments in privately held entities that report NAV. Our funding commitments expire at various dates over the next 11 years, with a weighted-average expiration of 8.3 years as of December 31, 2020.Exposure to environmental liabilitiesIn connection with the acquisition of all of our properties, we have obtained Phase I environmental assessments to ascertain the existence of any environmental liabilities or other issues. The Phase I environmental assessments of our properties have not revealed any environmental liabilities that we believe would have a material adverse effect on our financial condition or results of operations taken as a whole, nor are we aware of any material environmental liabilities that have occurred since the Phase I environmental assessments were completed. In addition, we carry a policy of pollution legal liability insurance covering exposure to certain environmental losses at substantially all of our properties.116Accumulated other comprehensive lossThe following table presents the change in accumulated other comprehensive loss attributable to Alexandria Real Estate Equities, Inc.’s stockholders during the year ended December 31, 2020, due to the changes in the foreign exchange rates for our real estate investments in Canada and Asia. We reclassify unrealized foreign currency translation gains and losses into net income as we dispose of these holdings. TotalBalance as of December 31, 2019$(9,749)Other comprehensive income before reclassifications3,124 Net other comprehensive income3,124 Balance as of December 31, 2020$(6,625)117Issuer and guarantor subsidiary summarized financial informationAlexandria Real Estate Equities, Inc. (the “Issuer”) has sold certain debt securities registered under the Securities Act of 1933, as amended, that are fully and unconditionally guaranteed by Alexandria Real Estate Equities, L.P. (the “LP” or the “Guarantor Subsidiary”), an indirectly 100% owned subsidiary of the Issuer. The Issuer’s other subsidiaries, including, but not limited to, the subsidiaries that own substantially all of its real estate (collectively, the “Combined Non-Guarantor Subsidiaries”), will not provide a guarantee of such securities, including the subsidiaries that are partially or 100% owned by the LP. The following summarized financial information presents on a combined basis for the Issuer and the Guarantor Subsidiary balance sheet financial information as of December 31, 2020 and 2019, and results of operations and comprehensive income for the years ended December 31, 2020 and 2019. The information presented below excludes eliminations necessary to arrive at the information on a consolidated basis. In presenting the summarized financial statements, the equity method of accounting has been applied to (i) the Issuer’s interests in the Guarantor Subsidiary, (ii) the Guarantor Subsidiary’s interests in the Combined Non-Guarantor Subsidiaries, and (iii) the Combined Non-Guarantor Subsidiaries’ interests in the Guarantor Subsidiary, where applicable, even though all such subsidiaries meet the requirements to be consolidated under GAAP. All assets and liabilities have been allocated to the Issuer and the Guarantor Subsidiary generally based on legal entity ownership.The following tables present combined summarized financial information as of December 31, 2020 and 2019, and for the years ended December 31, 2020 and 2019, for the Issuer and Guarantor Subsidiary. Amounts provided do not represent our total consolidated amounts (in thousands):December 31,20202019Assets:Cash, cash equivalents, and restricted cash$404,802 $4,432 Other assets100,689 71,036 Total assets$505,491 $75,468 Liabilities:Unsecured senior notes payable$7,232,370 $6,044,127 Unsecured senior line of credit and commercial paper99,991 384,000 Other liabilities341,621 278,858 Total liabilities$7,673,982 $6,706,985 Year Ended December 31,20202019Total revenues$22,946 $22,731 Total expenses(355,370)(317,896)Net loss(332,424)(295,165)Net income attributable to unvested restricted stock awards and preferred stock(10,168)(12,170)Net loss attributable to Alexandria Real Estate Equities, Inc.’s common stockholders$(342,592)$(307,335)118Critical accounting policiesOur consolidated financial statements have been prepared in accordance with GAAP. The preparation of these financial statements in conformity with GAAP requires us to make estimates, judgments, and assumptions that affect the reported amounts of assets, liabilities, revenues, and expenses. We base these estimates, judgments, and assumptions on historical experience and on various other factors that we believe to be reasonable under the circumstances. We continually evaluate the policies and estimates we use to prepare our consolidated financial statements. Changes in estimates or policies applied could affect our financial position and specific items in our results of operations that are used by our stockholders, potential investors, industry analysts, and lenders in their evaluation of our performance. Our significant accounting policies are described in Note 2 – “Summary of significant accounting policies” to our consolidated financial statements under Item 15 in this annual report on Form 10-K. REIT complianceWe have elected to be taxed as a REIT under the Internal Revenue Code. Qualification as a REIT involves the application of highly technical and complex provisions of the Internal Revenue Code to our operations and financial results, and the determination of various factual matters and circumstances not entirely within our control. We believe that our current organization and method of operation comply with the rules and regulations promulgated under the Internal Revenue Code to enable us to qualify, and continue to qualify, as a REIT. However, it is possible that we have been organized or have operated in a manner that would not allow us to qualify as a REIT, or that our future operations could cause us to fail to qualify.If we fail to qualify as a REIT in any taxable year, then we will be required to pay federal and state income taxes on our taxable income at regular corporate rates. If we lose our REIT status, then our net earnings available for investment or distribution to our stockholders will be significantly reduced for each of the years involved and we will no longer be required to make distributions to our stockholders.Investments in real estateRecognition of real estate acquiredWe evaluate each acquisition of real estate or in-substance real estate (including equity interests in entities that predominantly hold real estate assets) to determine whether the integrated set of assets and activities acquired meets the definition of a business and needs to be accounted for as a business combination. An acquisition of an integrated set of assets and activities that does not meet the definition of a business is accounted for as an asset acquisition.For acquisitions of real estate or in-substance real estate that are accounted for as business combinations, we allocate the acquisition consideration (excluding acquisition costs) to the assets acquired, liabilities assumed, noncontrolling interests, and previously existing ownership interests at fair value as of the acquisition date. Assets include intangible assets such as tenant relationships, acquired in-place leases, and favorable intangibles associated with in-place leases in which we are the lessor. Liabilities include unfavorable intangibles associated with in-place leases in which we are the lessor. In addition, for acquired in-place finance or operating leases in which we are the lessee, acquisition consideration is allocated to lease liabilities and related right-of-use assets, adjusted to reflect favorable or unfavorable terms of the lease when compared with market terms. Any excess (deficit) of the consideration transferred relative to the fair value of the net assets acquired is accounted for as goodwill (bargain purchase gain). Acquisition costs related to business combinations are expensed as incurred.Generally, we expect that acquisitions of real estate or in-substance real estate will not meet the definition of a business because substantially all of the fair value is concentrated in a single identifiable asset or group of similar identifiable assets (i.e., land, buildings, and related intangible assets). The accounting model for asset acquisitions is similar to the accounting model for business combinations except that the acquisition consideration (including acquisition costs) is allocated to the individual assets acquired and liabilities assumed on a relative fair value basis. Any excess (deficit) of the consideration transferred relative to the sum of the fair value of the assets acquired and liabilities assumed is allocated to the individual assets and liabilities based on their relative fair values. As a result, asset acquisitions do not result in the recognition of goodwill or a bargain purchase gain. Incremental and external direct acquisition costs (such as legal and other third-party services) are capitalized.We exercise judgment to determine the key assumptions used to allocate the purchase price of real estate acquired among its components. The allocation of the consideration to the various components of properties acquired during the year can have an effect on our net income due to the useful depreciable and amortizable lives applicable to each component and the recognition of the related depreciation and amortization expense in our consolidated statements of operations. We apply judgment in utilizing available comparable market information to assess relative fair value. We assess the relative fair values of tangible and intangible assets and liabilities based on available comparable market information, including estimated replacement costs, rental rates, and recent market transactions. In addition, we may use estimated cash flow projections that utilize appropriate discount and capitalization rates. 119Estimates of future cash flows are based on a number of factors, including the historical operating results, known and anticipated trends, and market/economic conditions that may affect the property.The value of tangible assets acquired is based upon our estimation of fair value on an “as if vacant” basis. The value of acquired in-place leases includes the estimated costs during the hypothetical lease-up period and other costs that would have been incurred in the execution of similar leases under the market conditions at the acquisition date of the acquired in-place lease. The value of above-market lease assets and below-market lease liabilities reflects the difference between (i) the contractual rents to be paid over the remaining term for each in-place lease and (ii) the estimated current market lease rates using available comparable market information and tenant credit quality. If there is a bargain fixed-rate renewal option for the period beyond the noncancelable lease term of an in-place lease, we evaluate intangible factors such as the business conditions in the industry in which the lessee operates, the economic conditions in the area in which the property is located, and the ability of the lessee to sublease the property during the renewal term, in order to determine the likelihood that the lessee will renew. When we determine there is reasonable assurance that such bargain purchase option will be exercised, we consider the option in determining the intangible value of such lease and its related amortization period. We also recognize the relative fair values of assets acquired, the liabilities assumed, and any noncontrolling interest in acquisitions of less than a 100% interest when the acquisition constitutes a change in control of the acquired entity.We completed acquisitions of 55 properties for a total purchase price of $2.6 billion during the year ended December 31, 2020. These transactions were accounted for as asset acquisitions, and the purchase price of each was allocated based on the relative fair value of the asset acquired and liabilities assumed.Depreciation and amortizationThe values allocated to buildings and building improvements, land improvements, tenant improvements, and equipment are depreciated on a straight-line basis using the shorter of the respective ground lease term, estimated useful life, or up to 40 years, for buildings and building improvements; estimated life, or up to 20 years, for land improvements; the respective lease term or estimated useful life for tenant improvements; and the shorter of the lease term or estimated useful life for equipment. The values of acquired in-place leases and associated favorable intangibles (i.e., acquired above-market leases) are classified in other assets in our consolidated balance sheets and are amortized over the remaining terms of the related leases as a reduction of income from rentals in our consolidated statements of operations. The values of unfavorable intangibles (i.e., acquired below-market leases) associated with acquired in-place leases are classified in accounts payable, accrued expenses, and other liabilities in our consolidated balance sheets and are amortized over the remaining terms of the related leases, as an increase in income from rentals in our consolidated statements of operations.Capitalized project costsWe capitalize project costs, including pre-construction costs, interest, property taxes, insurance, and other costs directly related and essential to the development, redevelopment, pre-construction, or construction of a project. Capitalization of development, redevelopment, pre-construction, and construction costs is required while activities are ongoing to prepare an asset for its intended use. Fluctuations in our development, redevelopment, pre-construction, and construction activities could result in significant changes to total expenses and net income. Costs incurred after a project is substantially complete and ready for its intended use are expensed as incurred. Should development, redevelopment, pre-construction, or construction activity cease, interest, property taxes, insurance, and certain other costs would no longer be eligible for capitalization and would be expensed as incurred. Expenditures for repairs and maintenance are expensed as incurred.Properties classified as held for saleA property is classified as held for sale when all of the following criteria for a plan of sale have been met: (i) management, having the authority to approve the action, commits to a plan to sell the property; (ii) the property is available for immediate sale in its present condition, subject only to terms that are usual and customary; (iii) an active program to locate a buyer and other actions required to complete the plan to sell have been initiated; (iv) the sale of the property is probable and is expected to be completed within one year; (v) the property is being actively marketed for sale at a price that is reasonable in relation to its current fair value; and (vi) actions necessary to complete the plan of sale indicate that it is unlikely that significant changes to the plan will be made or that the plan will be withdrawn. Depreciation of assets ceases upon designation of a property as held for sale.If the disposal of a property represents a strategic shift that has (or will have) a major effect on our operations or financial results, such as (i) a major line of business, (ii) a major geographic area, (iii) a major equity method investment, or (iv) other major parts of an entity, then the operations of the property, including any interest expense directly attributable to it, are classified as discontinued operations in our consolidated statements of operations, and amounts for all prior periods presented are reclassified from continuing operations to discontinued operations. The disposal of an individual property generally will not represent a strategic shift and therefore will typically not meet the criteria for classification as a discontinued operation.120Impairment of long-lived assetsPrior to and subsequent to the end of each quarter, we review current activities and changes in the business conditions of all of our long-lived assets to determine the existence of any triggering events or impairment indicators requiring an impairment analysis. If triggering events or impairment indicators are identified, we review an estimate of the future undiscounted cash flows, including, if necessary, a probability-weighted approach if multiple outcomes are under consideration.Long-lived assets to be held and used, including our rental properties, CIP, land held for development, right-of-use assets related to operating leases in which we are the lessee, and intangibles, are individually evaluated for impairment when conditions exist that may indicate that the carrying amount of a long-lived asset may not be recoverable. The carrying amount of a long-lived asset to be held and used is not recoverable if it exceeds the sum of the undiscounted cash flows expected to result from the use and eventual disposition of the asset. Triggering events or impairment indicators for long-lived assets to be held and used, including our rental properties, CIP, land held for development, and intangibles, are assessed by project and include significant fluctuations in estimated net operating income, occupancy changes, significant near-term lease expirations, current and historical operating and/or cash flow losses, construction costs, estimated completion dates, rental rates, and other market factors. We assess the expected undiscounted cash flows based upon numerous factors, including, but not limited to, construction costs, available market information, current and historical operating results, known trends, current market/economic conditions that may affect the property, and our assumptions about the use of the asset, including, if necessary, a probability-weighted approach if multiple outcomes are under consideration. Upon determination that an impairment has occurred, a write-down is recognized to reduce the carrying amount to its estimated fair value. If an impairment loss is not required to be recognized, the recognition of depreciation or amortization is adjusted prospectively, as necessary, to reduce the carrying amount of the real estate to its estimated disposition value over the remaining period that the asset is expected to be held and used. We may adjust depreciation of properties that are expected to be disposed of or redeveloped prior to the end of their useful lives.We use the held for sale impairment model for our properties classified as held for sale. The held for sale impairment model is different from the held and used impairment model. Under the held for sale impairment model, an impairment loss is recognized if the carrying amount of the long-lived asset classified as held for sale exceeds its fair value less cost to sell. Because of these two different models, it is possible for a long-lived asset previously classified as held and used to require the recognition of an impairment charge upon classification as held for sale.Equity investmentsWe hold investments in publicly traded companies and privately held entities primarily involved in the life science, technology, and agtech industries. As a REIT, we generally limit our ownership percentage in the voting stock of each individual entity to less than 10%.Our investments in publicly traded companies are classified as investments with readily determinable fair values and are carried at fair value, with changes in fair value recognized in net income. The fair values for our investments in publicly traded companies are determined based on sales prices/quotes available on securities exchanges and therefore generally require no judgment to determine fair value. Investments in privately held entities that report NAV per share, such as our privately held investments in limited partnerships, are carried at fair value using NAV as a practical expedient, with changes in fair value recognized in net income. As a result, fair value estimation for these investments generally requires limited judgment. Investments in privately held entities that do not report NAV are measured at cost, adjusted for observable price changes and impairments, with changes recognized in net income. Observable price changes result from, among other things, equity transactions for the same issuer executed during the reporting period, including subsequent equity offerings or other reported equity transactions related to the same issuer. For these equity transactions to be considered observable price changes of the same issuer, we evaluate whether these transactions have similar rights and obligations, including voting rights, distribution preferences, conversion rights, and other factors, to the investments we hold. We monitor investments in privately held entities that do not report NAV per share throughout the year for new developments, including operating results, prospects and results of clinical trials, new product initiatives, new collaborative agreements, capital-raising events, and merger and acquisition activities. These investments are evaluated on the basis of a qualitative assessment for indicators of impairment by monitoring the presence of the following triggering events or impairment indicators: (i) a significant deterioration in the earnings performance, asset quality, or business prospects of the investee; (ii) a significant adverse change in the regulatory, economic, or technological environment of the investee, (iii) a significant adverse change in the general market condition, including the research and development of technology and products that the investee is bringing or attempting to bring to the market, or (iv) significant concerns about the investee’s ability to continue as a going concern. If such indicators are present, we are required to estimate the investment’s fair value and immediately recognize an impairment loss in an amount equal to the investment’s carrying value in excess of its estimated fair value.121Liability and right-of-use assets related to operating leases in which we are the lesseeWe have operating lease agreements in which we are the lessee consisting of ground and office leases. At the lease commencement date (or at the acquisition date if the lease is acquired as part of a real estate acquisition), we are required to recognize a liability to account for our future obligations under these operating leases, and a corresponding right-of-use asset. The lease liability is measured based on the present value of the future lease payments, including payments during the term under our extension options that we are reasonably certain to exercise. The present value of the future lease payments is calculated for each operating lease using each respective remaining lease term and a corresponding estimated incremental borrowing rate, which is the interest rate that we estimate we would have to pay to borrow on a collateralized basis over a similar term for an amount equal to the lease payments. Subsequently, the lease liability is accreted by applying a discount rate established at the lease commencement date to the lease liability balance as of the beginning of the period and is reduced by the payments made during the period. We classify the operating lease liability in accounts payable, accrued expenses, and other liabilities in our consolidated balance sheets.The right-of-use asset is measured based on the corresponding lease liability, adjusted for initial direct leasing costs and any other consideration exchanged with the landlord prior to the commencement of the lease, as well as adjustments to reflect favorable or unfavorable terms of an acquired lease when compared with market terms at the time of acquisition. Subsequently, the right-of-use asset is amortized on a straight-line basis during the lease term. We classify the right-of-use asset in other assets in our consolidated balance sheets. Refer to the “Lessee Accounting” subsection of “Lease Accounting” section within Note 2 – “Summary of significant accounting policies” to our consolidated financial statements under Item 15 in this annual report on Form 10-K.Monitoring of tenant credit qualityDuring the term of each lease, we monitor the credit quality and any related material changes of our tenants by (i) monitoring the credit rating of tenants that are rated by a nationally recognized credit rating agency, (ii) reviewing financial statements of the tenants that are publicly available or that are required to be delivered to us pursuant to the applicable lease, (iii) monitoring news reports regarding our tenants and their respective businesses, and (iv) monitoring the timeliness of lease payments.Allowance for credit lossesOn January 1, 2020, we adopted an accounting standard that requires companies to estimate and recognize lifetime expected losses, rather than incurred losses, which results in the earlier recognition of credit losses even if the expected risk of credit loss is remote. The accounting standard applies to most financial assets including trade receivables and direct financing leases. The standard does not apply to the receivables arising from operating leases. Upon adoption of the new standard on January 1, 2020, we recognized a credit loss adjustment related to adoption of this accounting standard as a cumulative adjustment to retained earnings. For details, refer to the “Allowance for credit losses” section in Note 2 – “Summary of significant accounting policies” We have one lease classified as a direct financing lease subject to this standard. In this direct financing lease, the payment obligation of the lessee is collateralized by real estate property. At each reporting date, we estimate the current credit loss related to this asset by assessing the probability of default on this lease based on the lessee’s financial condition, credit rating, business prospects, remaining lease term, and expected value of the underlying collateral upon its repossession, and, if necessary, we recognize a credit loss adjustment. We recognized subsequent credit loss adjustments related to our direct financing lease in our consolidated statements of operations during the year ended December 31, 2020. For further details, refer to Note 5 – “Leases” to our consolidated financial statements.122Non-GAAP measures and definitionsThis section contains additional information of certain non-GAAP financial measures and the reasons why we use these supplemental measures of performance and believe they provide useful information to investors, as well as the definitions of other terms used in this annual report on Form 10-K.Funds from operations and funds from operations, as adjusted, attributable to Alexandria Real Estate Equities, Inc.’s common stockholdersGAAP-basis accounting for real estate assets utilizes historical cost accounting and assumes that real estate values diminish over time. In an effort to overcome the difference between real estate values and historical cost accounting for real estate assets, the Nareit Board of Governors established funds from operations as an improved measurement tool. Since its introduction, funds from operations has become a widely used non-GAAP financial measure among equity REITs. We believe that funds from operations is helpful to investors as an additional measure of the performance of an equity REIT. Moreover, we believe that funds from operations, as adjusted, allows investors to compare our performance to the performance of other real estate companies on a consistent basis, without having to account for differences recognized because of real estate acquisition and disposition decisions, financing decisions, capital structure, capital market transactions, variances resulting from the volatility of market conditions outside of our control, or other corporate activities that may not be representative of the operating performance of our properties. On January 1, 2019, we adopted standards established by the Nareit Board of Governors in its November 2018 White Paper (the “Nareit White Paper”) on a prospective basis. The Nareit White Paper defines funds from operations as net income (computed in accordance with GAAP), excluding gains or losses on sales of real estate, and impairments of real estate, plus depreciation and amortization of operating real estate assets, and after adjustments for our share of consolidated and unconsolidated partnerships and real estate joint ventures. Impairments represent the write-down of assets when fair value over the recoverability period is less than the carrying value due to changes in general market conditions and do not necessarily reflect the operating performance of the properties during the corresponding period.We compute funds from operations, as adjusted, as funds from operations calculated in accordance with the Nareit White Paper, excluding significant gains, losses, and impairments realized on non-real estate investments, unrealized gains or losses on non-real estate investments, gains or losses on early extinguishment of debt, gains or losses on early termination of interest rate hedge agreements, significant termination fees, acceleration of stock compensation expense due to the resignation of an executive officer, preferred stock redemption charges, deal costs, the income tax effect related to such items, and the amount of such items that is allocable to our unvested restricted stock awards. Neither funds from operations nor funds from operations, as adjusted, should be considered as alternatives to net income (determined in accordance with GAAP) as indications of financial performance, or to cash flows from operating activities (determined in accordance with GAAP) as measures of liquidity, nor are they indicative of the availability of funds for our cash needs, including our ability to make distributions. The following table reconciles net income to funds from operations for the share of consolidated real estate joint ventures attributable to noncontrolling interests and our share of unconsolidated real estate joint ventures for the year ended December 31, 2020:Noncontrolling Interest Share of Consolidated Real Estate Joint VenturesOur Share of Unconsolidated Real Estate Joint VenturesDecember 31, 2020December 31, 2020(in thousands)Three Months EndedYear EndedThree Months EndedYear EndedNet income$15,649 $56,212 $3,593 $8,148 Depreciation and amortization15,032 61,933 2,976 11,413 Impairment of real estate— — — 7,644 Funds from operations$30,681 $118,145 $6,569 $27,205 123The following tables present a reconciliation of net income attributable to Alexandria Real Estate Equities, Inc.’s common stockholders, the most directly comparable financial measure presented in accordance with GAAP, including our share of amounts from consolidated and unconsolidated real estate joint ventures, to funds from operations attributable to Alexandria Real Estate Equities, Inc.’s common stockholders – diluted, and funds from operations attributable to Alexandria Real Estate Equities, Inc.’s common stockholders – diluted, as adjusted, and the related per share amounts for the years ended December 31, 2020, 2019, and 2018. Per share amounts may not add due to rounding.Year Ended December 31,(In thousands)202020192018Net income attributable to Alexandria Real Estate Equities, Inc.’s common stockholders – basic and diluted$760,791 $350,995 $363,983 Depreciation and amortization of real estate assets684,682 541,855 477,661 Noncontrolling share of depreciation and amortization from consolidated real estate JVs(61,933)(30,960)(16,077)Our share of depreciation and amortization from unconsolidated real estate JVs11,413 6,366 3,181 Gain on sales of real estate(154,089)(474)(8,704)Our share of gain on sales of real estate from unconsolidated real estate JVs— — (35,678)Impairment of real estate – rental properties40,501 (1)12,334 — Assumed conversion of 7.00% Series D cumulative convertible preferred stock— 3,204 5,060 Allocation to unvested restricted stock awards (7,018)(5,904)(5,961)Funds from operations attributable to Alexandria Real Estate Equities, Inc.’s common stockholders – diluted(2)1,274,347 877,416 783,465 Unrealized gains on non-real estate investments(374,033)(161,489)(99,634)Realized gains on non-real estate investments— — (14,680)Impairment of real estate15,221 — — Impairment of real estate – land parcels— — 6,311 Impairment of non-real estate investments24,482 17,124 5,483 Loss on early extinguishment of debt60,668 47,570 1,122 Loss on early termination of interest rate hedge agreements— 1,702 — Termination fee(86,179)— — Acceleration of stock compensation expense due to executive officer resignation4,499 — — Our share of gain on early extinguishment of debt from unconsolidated real estate JVs— — (761)Preferred stock redemption charge— 2,580 4,240 Removal of assumed conversion of 7.00% Series D cumulative convertible preferred stock— (3,204)(5,060)Allocation to unvested restricted stock awards4,790 1,307 1,517 Funds from operations attributable to Alexandria Real Estate Equities, Inc.’s common stockholders – diluted, as adjusted$923,795 $783,006 $682,003 (1)Includes a $7.6 million impairment of our investment in a recently developed retail property held by our unconsolidated real estate joint venture recognized during the three months ended March 31, 2020. This impairment is classified in equity in earnings of unconsolidated real estate joint ventures within our consolidated statements of operations.(2)Calculated in accordance with standards established by the Nareit Board of Governors.124Year Ended December 31,(Per share)202020192018Net income per share attributable to Alexandria Real Estate Equities, Inc.’s common stockholders – diluted$6.01 $3.12 $3.52 Depreciation and amortization of real estate assets5.01 4.60 4.50 Gain on sales of real estate(1.22)— (0.08)Our share of gain on sales of real estate from unconsolidated real estate JVs— — (0.35)Impairment of real estate – rental properties0.32 0.11 — Allocation to unvested restricted stock awards(0.05)(0.06)(0.06)Funds from operations per share attributable to Alexandria Real Estate Equities, Inc.’s common stockholders – diluted10.07 7.77 7.53 Unrealized gains on non-real estate investments(2.96)(1.44)(0.96)Realized losses (gains) on non-real estate investments— — (0.14)Impairment of real estate0.12 — — Impairment of real estate – land parcels— — 0.06 Impairment of non-real estate investments0.19 0.15 0.05 Loss on early extinguishment of debt0.48 0.42 0.01 Loss on early termination of interest rate hedge agreements— 0.02 — Termination fee(0.68)— — Acceleration of stock compensation expense due to executive officer resignation0.04 — — Our share of gain on early extinguishment of debt from unconsolidated real estate JVs— — (0.01)Preferred stock redemption charge— 0.02 0.04 Allocation to unvested restricted stock awards0.04 0.02 0.02 Funds from operations per share attributable to Alexandria Real Estate Equities, Inc.’s common stockholders – diluted, as adjusted$7.30 $6.96 $6.60 Weighted-average shares of common stock outstanding(1) for calculations of:EPS – diluted126,490 112,524 103,321 Funds from operations – diluted, per share126,490 112,966 104,048 Funds from operations – diluted, as adjusted, per share126,490 112,524 103,321 (1)Refer to the definition of “Weighted-average shares of common stock outstanding – diluted” within this section of this Item 7 in this annual report on Form 10-K for additional information.Adjusted EBITDA and Adjusted EBITDA marginWe use Adjusted EBITDA as a supplemental performance measure of our operations, for financial and operational decision-making, and as a supplemental means of evaluating period-to-period comparisons on a consistent basis. Adjusted EBITDA is calculated as earnings before interest, taxes, depreciation, and amortization (“EBITDA”), excluding stock compensation expense, gains or losses on early extinguishment of debt, gains or losses on sales of real estate, impairments of real estate, and significant termination fees. Adjusted EBITDA also excludes unrealized gains or losses and significant realized gains and impairments that result from our non-real estate investments. These non-real estate investment amounts are classified in our consolidated statements of operations outside of revenues.125We believe Adjusted EBITDA provides investors with relevant and useful information as it allows investors to evaluate the operating performance of our business activities without having to account for differences recognized because of investing and financing decisions related to our real estate and non-real estate investments, our capital structure, capital market transactions, and variances resulting from the volatility of market conditions outside of our control. For example, we exclude gains or losses on the early extinguishment of debt to allow investors to measure our performance independent of our indebtedness and capital structure. We believe that adjusting for the effects of impairments and gains or losses on sales of real estate, significant impairments and gains on the sale of non-real estate investments, and significant termination fees allows investors to evaluate performance from period to period on a consistent basis without having to account for differences recognized because of investing and financing decisions related to our real estate and non-real estate investments or other corporate activities that may not be representative of the operating performance of our properties. In addition, we believe that excluding charges related to stock compensation and unrealized gains or losses facilitates for investors a comparison of our business activities across periods without the volatility resulting from market forces outside of our control. Adjusted EBITDA has limitations as a measure of our performance. Adjusted EBITDA does not reflect our historical expenditures or future requirements for capital expenditures or contractual commitments. While Adjusted EBITDA is a relevant measure of performance, it does not represent net income (loss) or cash flows from operations calculated and presented in accordance with GAAP, and it should not be considered as an alternative to those indicators in evaluating performance or liquidity.In order to calculate Adjusted EBITDA margin, we also make comparable adjustments to our revenues. We adjust our total revenues by realized gains, losses, and impairments related to our non-real estate investments and significant termination fees to arrive at revenues, as adjusted. Our calculation of Adjusted EBITDA margin divides Adjusted EBITDA by our revenues, as adjusted. We believe that consistent application of these comparable adjustments to both components of Adjusted EBITDA margin provides a more useful calculation for the comparison across periods.The following table reconciles net income (loss) and revenues, the most directly comparable financial measures calculated and presented in accordance with GAAP, to Adjusted EBITDA and revenues, as adjusted, respectively, for the three months and years ended December 31, 2020 and 2019 (dollars in thousands):Three Months Ended December 31,Year Ended December 31,2020201920202019Net income$457,133 $216,053 $827,171 $404,047 Interest expense37,538 45,493 171,609 173,675 Income taxes2,053 1,269 7,230 4,343 Depreciation and amortization177,750 140,518 698,104 544,612 Stock compensation expense11,394 10,239 43,502 43,640 Loss on early extinguishment of debt7,898 — 60,668 47,570 Gain on sales of real estate(152,503)(474)(154,089)(474)Unrealized gains on non-real estate investments(233,538)(148,268)(374,033)(161,489)Impairment of real estate25,177 12,334 55,722 12,334 Impairment of non-real estate investments— 9,991 24,482 17,124 Termination fee— — (86,179)— Adjusted EBITDA$332,902 $287,155 $1,274,187 $1,085,382 Revenues$463,720 $408,114 $1,885,637 $1,531,296 Non-real estate investments – realized gains21,599 4,399 47,288 33,158 Impairment of non-real estate investments— 9,991 24,482 17,124 Termination fee— — (86,179)— Revenues, as adjusted$485,319 $422,504 $1,871,228 $1,581,578 Adjusted EBITDA margin69%68%68%69%126Annual rental revenueAnnual rental revenue represents the annualized fixed base rental obligations, calculated in accordance with GAAP, for leases in effect as of the end of the period, related to our operating RSF. Annual rental revenue is presented using 100% of the annual rental revenue of our consolidated properties and our share of annual rental revenue for our unconsolidated real estate joint ventures. Annual rental revenue per RSF is computed by dividing annual rental revenue by the sum of 100% of the RSF of our consolidated properties and our share of the RSF of properties held in unconsolidated real estate joint ventures. As of December 31, 2020, approximately 94% of our leases (on an RSF basis) were triple net leases, which require tenants to pay substantially all real estate taxes, insurance, utilities, repairs and maintenance, common area expenses, and other operating expenses (including increases thereto) in addition to base rent. Annual rental revenue excludes these operating expenses recovered from our tenants. Amounts recovered from our tenants related to these operating expenses, along with base rent, are classified in income from rentals in our consolidated statements of operations.Cash interestCash interest is equal to interest expense calculated in accordance with GAAP plus capitalized interest, less amortization of loan fees and debt premiums (discounts). Refer to the definition of “Fixed-charge coverage ratio” in this section under this Item 7 in this annual report on 10-K for a reconciliation of interest expense, the most directly comparable financial measure calculated and presented in accordance with GAAP, to cash interest.Class A properties and AAA locationsClass A properties are properties clustered in AAA locations that provide innovative tenants with highly dynamic and collaborative environments that enhance their ability to successfully recruit and retain world-class talent and inspire productivity, efficiency, creativity, and success. Class A properties generally command higher annual rental rates than other classes of similar properties.AAA locations are in close proximity to concentrations of specialized skills, knowledge, institutions, and related businesses. Such locations are generally characterized by high barriers to entry for new landlords, high barriers to exit for tenants, and a limited supply of available space.Development, redevelopment, and pre-constructionA key component of our business model is our disciplined allocation of capital to the development and redevelopment of new Class A properties, and property enhancements identified during the underwriting of certain acquired properties, located in collaborative life science, technology, and agtech campuses in AAA urban innovation clusters. These projects are generally focused on providing high-quality, generic, and reusable spaces that meet the real estate requirements of, and are reusable by, a wide range of tenants. Upon completion, each value-creation project is expected to generate a significant increase in rental income, net operating income, and cash flows. Our development and redevelopment projects are generally in locations that are highly desirable to high-quality entities, which we believe results in higher occupancy levels, longer lease terms, higher rental income, higher returns, and greater long-term asset value.Development projects generally consist of the ground-up development of generic and reusable facilities. Redevelopment projects consist of the permanent change in use of office, warehouse, and shell space into office/laboratory, tech office, or agtech space. We generally will not commence new development projects for aboveground construction of new Class A office/laboratory, tech office, and agtech space without first securing significant pre-leasing for such space, except when there is solid market demand for high-quality Class A properties. Pre-construction activities include entitlements, permitting, design, site work, and other activities preceding commencement of construction of aboveground building improvements. The advancement of pre-construction efforts is focused on reducing the time required to deliver projects to prospective tenants. These critical activities add significant value for future ground-up development and are required for the vertical construction of buildings. Ultimately, these projects will provide high-quality facilities and are expected to generate significant revenue and cash flows.Development, redevelopment, and pre-construction spending also includes the following costs: (i) certain tenant improvements and renovations that will be reimbursed, (ii) amounts to bring certain acquired properties up to market standard and/or other costs identified during the acquisition process (generally within two years of acquisition), and (iii) permanent conversion of space for highly flexible, move-in-ready office/laboratory space to foster the growth of promising early- and growth-stage life science companies.Revenue-enhancing and repositioning capital expenditures represent spending to reposition or significantly change the use of a property, including through improvement in the asset quality from Class B to Class A.127Non-revenue-enhancing capital expenditures represent costs required to maintain the current revenues of a stabilized property, including the associated costs for renewed and re-leased space.Fixed-charge coverage ratioFixed-charge coverage ratio is a non-GAAP financial measure representing the ratio of Adjusted EBITDA to fixed charges. We believe this ratio is useful to investors as a supplemental measure of our ability to satisfy fixed financing obligations and preferred stock dividends. Cash interest is equal to interest expense calculated in accordance with GAAP plus capitalized interest, less amortization of loan fees and debt premiums (discounts). The following table reconciles interest expense, the most directly comparable financial measure calculated and presented in accordance with GAAP, to cash interest and fixed charges for the three months ended December 31, 2020 and 2019 (dollars in thousands):Three Months Ended December 31,20202019Adjusted EBITDA$332,902 $287,155 Interest expense$37,538 $45,493 Capitalized interest37,589 23,822 Amortization of loan fees(2,905)(2,241)Amortization of debt premiums869 907 Cash interest and fixed charges$73,091 $67,981 Fixed-charge coverage ratio:– period annualized4.6x4.2x– trailing 12 months4.4x4.2xInitial stabilized yield (unlevered)Initial stabilized yield is calculated as the estimated amounts of net operating income at stabilization divided by our investment in the property. Our initial stabilized yield excludes the benefit of leverage. Our cash rents related to our value-creation projects are generally expected to increase over time due to contractual annual rent escalations. Our estimates for initial stabilized yields, initial stabilized yields (cash basis), and total costs at completion represent our initial estimates at the commencement of the project. We expect to update this information upon completion of the project, or sooner if there are significant changes to the expected project yields or costs.•Initial stabilized yield reflects rental income, including contractual rent escalations and any rent concessions over the term(s) of the lease(s), calculated on a straight-line basis.•Initial stabilized yield (cash basis) reflects cash rents at the stabilization date after initial rental concessions, if any, have elapsed and our total cash investment in the property.Investment-grade or publicly traded large cap tenantsInvestment-grade or publicly traded large cap tenants represent tenants that are investment-grade rated or publicly traded companies with an average daily market capitalization greater than $10 billion for the twelve months ended December 31, 2020, as reported by Bloomberg Professional Services. In addition, we monitor the credit quality and related material changes of our tenants. Material changes that cause a tenant’s market capitalization to decline below $10 billion, which are not immediately reflected in the twelve-month average, may result in their exclusion from this measure.128Investments in real estate – value-creation square footage currently in rental propertiesThe square footage presented in the table below includes RSF of buildings in operation as of December 31, 2020, primarily representing lease expirations at recently acquired properties that also have inherent future development or redevelopment opportunities, for which we have the intent to demolish or redevelop the existing property upon expiration of the existing in-place leases and commencement of future construction:Dev/RedevRSF lease expirations going into development and redevelopmentProperty/Submarket20212022ThereafterTotalNear-term projects:The Arsenal on the Charles/Cambridge/Inner SuburbsRedev64,056 — — 64,056 50 and 60 Sylvan Road/Route 128Redev202,428 — — 202,428 651 Gateway Boulevard/South San FranciscoRedev— 197,787 102,223 (1)300,010 Other/SeattleRedev— 51,255 — 51,255 266,484 249,042 102,223 617,749 Intermediate-term projects:3825 Fabian Way/Greater StanfordRedev— 250,000 — 250,000 3450 and 3460 Hillview Avenue/Greater StanfordRedev— 42,340 34,611 76,951 987 and 1075 Commercial Street/Greater StanfordDev26,738 — — 26,738 10931 and 10933 North Torrey Pines Road/Torrey PinesDev— 92,450 — 92,450 10260 Campus Point Drive/University Town CenterDev— — 109,164 109,164 9363 and 9393 Towne Centre Drive/ University Town CenterDev— — 87,252 87,252 4555 Executive Drive/University Town CenterDev41,475 — — 41,475 68,213 384,790 231,027 684,030 Future projects:380 and 420 E Street/Seaport Innovation DistrictDev— — 195,506 195,506 40 Sylvan Road/Route 128Redev— — 312,845 312,845 3875 Fabian Way/Greater StanfordRedev— — 228,000 228,000 960 Industrial Road/Greater StanfordDev— — 110,000 110,000 219 East 42nd Street/New York CityDev— — 349,947 349,947 11255 and 11355 North Torrey Pines Road/Torrey PinesDev— 139,135 — 139,135 4161 Campus Point Court/University Town CenterDev— — 159,884 159,884 6450 Sequence Drive/Sorrento MesaRedev— — 202,915 202,915 4045 and 4075 Sorrento Valley Boulevard/Sorrento ValleyDev— — 50,926 50,926 601 Dexter Avenue North/Lake UnionDev— — 18,680 18,680 830 4th Avenue South/SoDoDev— — 42,380 42,380 — 139,135 1,671,083 1,810,218 334,697 772,967 2,004,333 3,111,997 (1) Represents vacant square footage as of December 31, 2020. 129Joint venture financial informationWe present components of balance sheet and operating results information related to our real estate joint ventures, which are not presented, or intended to be presented, in accordance with GAAP. We present the proportionate share of certain financial line items as follows: (i) for each real estate joint venture that we consolidate in our financial statements, which are controlled by us through contractual rights or majority voting rights, but of which we own less than 100%, we apply the noncontrolling interest economic ownership percentage to each financial item to arrive at the amount of such cumulative noncontrolling interest share of each component presented; and (ii) for each real estate joint venture that we do not control and do not consolidate, and are instead controlled jointly or by our joint venture partners through contractual rights or majority voting rights, we apply our economic ownership percentage to each financial item to arrive at our proportionate share of each component presented.The components of balance sheet and operating results information related to our real estate joint ventures do not represent our legal claim to those items. For each entity that we do not wholly own, the joint venture agreement generally determines what equity holders can receive upon capital events, such as sales or refinancing, or in the event of a liquidation. Equity holders are normally entitled to their respective legal ownership of any residual cash from a joint venture only after all liabilities, priority distributions, and claims have been repaid or satisfied. We believe this information can help investors estimate the balance sheet and operating results information related to our partially owned entities. Presenting this information provides a perspective not immediately available from consolidated financial statements and one that can supplement an understanding of the joint venture assets, liabilities, revenues, and expenses included in our consolidated results.The components of balance sheet and operating results information related to our real estate joint ventures are limited as an analytical tool as the overall economic ownership interest does not represent our legal claim to each of our joint ventures’ assets, liabilities, or results of operations. In addition, joint venture financial information may include financial information related to the unconsolidated real estate joint ventures that we do not control. We believe that in order to facilitate for investors a clear understanding of our operating results and our total assets and liabilities, joint venture financial information should be examined in conjunction with our consolidated statements of operations and balance sheets. Joint venture financial information should not be considered an alternative to our consolidated financial statements, which are prepared in accordance with GAAP.Net cash provided by operating activities after dividendsNet cash provided by operating activities after dividends includes the deduction for distributions to noncontrolling interests. For purposes of this calculation, changes in operating assets and liabilities are excluded as they represent timing differences.Net debt and preferred stock to Adjusted EBITDANet debt and preferred stock to Adjusted EBITDA is a non-GAAP financial measure that we believe is useful to investors as a supplemental measure in evaluating our balance sheet leverage. Net debt and preferred stock is equal to the sum of total consolidated debt less cash, cash equivalents, and restricted cash, plus preferred stock outstanding as of the end of the period. Refer to the definition of “Adjusted EBITDA and Adjusted EBITDA margin” under Item 7 in this annual report on Form 10-K for further information on the calculation of Adjusted EBITDA. The following table reconciles debt to net debt and preferred stock and computes the ratio to Adjusted EBITDA as of December 31, 2020 and 2019 (dollars in thousands):130December 31,20202019Secured notes payable$230,925 $349,352 Unsecured senior notes payable7,232,370 6,044,127 Unsecured senior line of credit and commercial paper99,991 384,000 Unamortized deferred financing costs56,312 47,299 Cash and cash equivalents(568,532)(189,681)Restricted cash(29,173)(53,008)Preferred stock— — Net debt and preferred stock$7,021,893 $6,582,089 Adjusted EBITDA:– quarter annualized$1,331,608 $1,148,620 – trailing 12 months$1,274,187 $1,085,382 Net debt and preferred stock to Adjusted EBITDA:– quarter annualized5.3 x5.7 x– trailing 12 months5.5 x6.1 xNet operating income, net operating income (cash basis), and operating marginThe following table reconciles net income to net operating income, and to net operating income (cash basis) for the years ended December 31, 2020, 2019, and 2018 (dollars in thousands):Year Ended December 31,202020192018Net income$827,171 $404,047 $402,793 Equity in earnings of unconsolidated real estate joint ventures(8,148)(10,136)(43,981)General and administrative expenses133,341 108,823 90,405 Interest expense171,609 173,675 157,495 Depreciation and amortization698,104 544,612 477,661 Impairment of real estate48,078 12,334 6,311 Loss on early extinguishment of debt60,668 47,570 1,122 Gain on sales of real estate(154,089)(474)(8,704)Investment income(421,321)(194,647)(136,763)Net operating income1,355,413 1,085,804 946,339 Straight-line rent revenue(96,676)(104,235)(93,883)Amortization of acquired above- and below-market leases(57,244)(29,813)(21,938)Net operating income (cash basis)$1,201,493 $951,756 $830,518 Net operating income (from above)$1,355,413 $1,085,804 $946,339 Total revenues$1,885,637 $1,531,296 $1,327,459 Operating margin72%71%71%Net operating income is a non-GAAP financial measure calculated as net income, the most directly comparable financial measure calculated and presented in accordance with GAAP, excluding equity in the earnings of our unconsolidated real estate joint ventures, general and administrative expenses, interest expense, depreciation and amortization, impairments of real estate, gains or losses on early extinguishment of debt, gains or losses on sales of real estate, and investment income or loss. We believe net operating income provides useful information to investors regarding our financial condition and results of operations because it primarily reflects 131those income and expense items that are incurred at the property level. Therefore, we believe net operating income is a useful measure for investors to evaluate the operating performance of our consolidated real estate assets. Net operating income on a cash basis is net operating income adjusted to exclude the effect of straight-line rent and amortization of acquired above- and below-market lease revenue adjustments required by GAAP. We believe that net operating income on a cash basis is helpful to investors as an additional measure of operating performance because it eliminates straight-line rent revenue and the amortization of acquired above- and below-market leases.Furthermore, we believe net operating income is useful to investors as a performance measure for our consolidated properties because, when compared across periods, net operating income reflects trends in occupancy rates, rental rates, and operating costs, which provide a perspective not immediately apparent from net income or loss. Net operating income can be used to measure the initial stabilized yields of our properties by calculating net operating income generated by a property divided by our investment in the property. Net operating income excludes certain components from net income in order to provide results that are more closely related to the results of operations of our properties. For example, interest expense is not necessarily linked to the operating performance of a real estate asset and is often incurred at the corporate level rather than at the property level. In addition, depreciation and amortization, because of historical cost accounting and useful life estimates, may distort comparability of operating performance at the property level. Impairments of real estate have been excluded in deriving net operating income because we do not consider impairments of real estate to be property-level operating expenses. Impairments of real estate relate to changes in the values of our assets and do not reflect the current operating performance with respect to related revenues or expenses. Our impairments of real estate represent the write-down in the value of the assets to the estimated fair value less cost to sell. These impairments result from investing decisions or a deterioration in market conditions. We also exclude realized and unrealized investment income or loss, which results from investment decisions that occur at the corporate level related to non-real estate investments in publicly traded companies and certain privately held entities. Therefore, we do not consider these activities to be an indication of operating performance of our real estate assets at the property level. Our calculation of net operating income also excludes charges incurred from changes in certain financing decisions, such as losses on early extinguishment of debt, as these charges often relate to corporate strategy. Property operating expenses included in determining net operating income primarily consist of costs that are related to our operating properties, such as utilities, repairs, and maintenance; rental expense related to ground leases; contracted services, such as janitorial, engineering, and landscaping; property taxes and insurance; and property-level salaries. General and administrative expenses consist primarily of accounting and corporate compensation, corporate insurance, professional fees, office rent, and office supplies that are incurred as part of corporate office management. We calculate operating margin as net operating income divided by total revenues.We believe that in order to facilitate for investors a clear understanding of our operating results, net operating income should be examined in conjunction with net income or loss as presented in our consolidated statements of operations. Net operating income should not be considered as an alternative to net income or loss as an indication of our performance, nor as an alternative to cash flows as a measure of our liquidity or our ability to make distributions. Operating statisticsWe present certain operating statistics related to our properties, including number of properties, RSF, occupancy percentage, leasing activity, and contractual lease expirations as of the end of the period. We believe these measures are useful to investors because they facilitate an understanding of certain trends for our properties. We compute the number of properties, RSF, occupancy percentage, leasing activity, and contractual lease expirations at 100% for all properties in which we have an investment, including properties owned by our consolidated and unconsolidated real estate joint ventures. For operating metrics based on annual rental revenue, refer to the definition of “Annual rental revenue” in this “Non-GAAP measures and definitions” section. Same property comparisonsAs a result of changes within our total property portfolio during the comparative periods presented, including changes from assets acquired or sold, properties placed into development or redevelopment, and development or redevelopment properties recently placed into service, the consolidated total income from rentals, as well as rental operating expenses in our operating results, can show significant changes from period to period. In order to supplement an evaluation of our results of operations over a given quarterly or annual period, we analyze the operating performance for all consolidated properties that were fully operating for the entirety of the comparative periods presented, referred to as same properties. We separately present quarterly and year-to-date same property results to align with the interim financial information required by the SEC in our management’s discussion and analysis of our financial condition and results of operations. These same properties are analyzed separately from properties acquired subsequent to the first day in the earliest comparable quarterly or year-to-date period presented, properties that underwent development or redevelopment at any time during the comparative periods, unconsolidated real estate joint ventures, properties classified as held for sale, and corporate entities (legal entities performing general and administrative functions), which are excluded from same property results. Additionally, termination fees, if any, are excluded from the results of same properties. Refer to the “Same properties” subsection in the “Results of operations” section within this Item 7 in this annual report on Form 10-K for additional information. 132Stabilized occupancy dateThe stabilized occupancy date represents the estimated date on which the project is expected to reach occupancy of 95% or greater.Tenant recoveriesTenant recoveries represent revenues comprising reimbursement of real estate taxes, insurance, utilities, repairs and maintenance, common area expenses, and other operating expenses and earned in the period during which the applicable expenses are incurred and the tenant’s obligation to reimburse us arises.We classify rental revenues and tenant recoveries generated through the leasing of real estate assets within revenue in income from rentals in our consolidated statements of operations. We provide investors with a separate presentation of rental revenues and tenant recoveries in the “Comparison of results for the year ended December 31, 2020, to the year ended December 31, 2019” subsection of the “Results of operations” section within this Item 7 because we believe it promotes investors’ understanding of our operating results. We believe that the presentation of tenant recoveries is useful to investors as a supplemental measure of our ability to recover operating expenses under our triple net leases, including recoveries of utilities, repairs and maintenance, insurance, property taxes, common area expenses, and other operating expenses, and of our ability to mitigate the effect to net income for any significant variability to components of our operating expenses. The following table reconciles income from rentals to tenant recoveries for the years ended December 31, 2020, 2019, and 2018 (in thousands):Year Ended December 31,202020192018Income from rentals$1,878,208 $1,516,864 $1,314,781 Rental revenues(1,471,840)(1,165,788)(1,010,718)Tenant recoveries$406,368 $351,076 $304,063 Total market capitalizationTotal market capitalization is equal to the outstanding shares of common stock at the end of the period multiplied by the closing price on the last trading day of the period (i.e., total equity capitalization), plus total debt outstanding at period-end. Unencumbered net operating income as a percentage of total net operating incomeUnencumbered net operating income as a percentage of total net operating income is a non-GAAP financial measure that we believe is useful to investors as a performance measure of the results of operations of our unencumbered real estate assets as it reflects those income and expense items that are incurred at the unencumbered property level. Unencumbered net operating income is derived from assets classified in continuing operations, which are not subject to any mortgage, deed of trust, lien, or other security interest, as of the period for which income is presented.The following table summarizes unencumbered net operating income as a percentage of total net operating income for the years ended December 31, 2020 and 2019 (dollars in thousands):Year Ended December 31,20202019Unencumbered net operating income$1,295,520 $1,024,619 Encumbered net operating income59,893 61,185 Total net operating income$1,355,413 $1,085,804 Unencumbered net operating income as a percentage of total net operating income96%94%Weighted-average shares of common stock outstanding – dilutedFrom time to time, we enter into capital market transactions, including forward equity sales agreements (“Forward Agreements”), to fund acquisitions, to fund construction of our highly leased development and redevelopment projects, and for general working capital purposes. We are required to consider the potential dilutive effect of our forward equity sales agreements under the treasury stock method while the forward equity sales agreements are outstanding. As of December 31, 2020, we had Forward Agreements outstanding to sell an aggregate of 362 thousand shares of common stock.133Prior to the conversion of our remaining outstanding shares in October 2019, we considered the effect of assumed conversion of our outstanding 7.00% Series D Convertible Preferred Stock when determining potentially dilutive incremental shares to our common stock. When calculating the assumed conversion, we add back to net income or loss the dividends paid on our Series D Convertible Preferred Stock to the numerator and then include additional common shares assumed to have been issued (as displayed in the table below) to the denominator of the per share calculation. The effect of the assumed conversion is considered separately for our per share calculations of net income or loss; funds from operations, computed in accordance with the definition in the Nareit White Paper; and funds from operations, as adjusted. Prior to the conversion of our remaining outstanding shares in October 2019, our Series D Convertible Preferred Stock was dilutive and assumed to be converted when quarterly and annual basic EPS, funds from operations, or funds from operations, as adjusted, exceeded approximately $1.75 and $7.00 per share, respectively, subject to conversion ratio adjustments and the impact of repurchases of our Series D Convertible Preferred Stock. The effect of the assumed conversion was included when it was dilutive on a per share basis. The dilutive effect to both numerator and denominator may result in a per share effect of less than a half cent, which would appear as zero in our per share calculation, even when the dilutive effect to the numerator alone appears in our reconciliation. Refer to Note 12 – “Earnings per share” and Note 15 – “Stockholders’ equity” to our consolidated financial statements under Item 15 in this annual report on Form 10-K for more information related to our forward equity sales agreements.The weighted-average shares of common stock outstanding used in calculating EPS – diluted, funds from operations per share – diluted, and funds from operations per share – diluted, as adjusted, for the years ended December 31, 2020, 2019 and 2018, are calculated as follows (in thousands):Year Ended December 31,202020192018Weighted-average shares of common stock outstanding:Basic shares for EPS126,106 112,204 103,010 Outstanding forward equity sales agreements384 320 311 Series D Convertible Preferred Stock— — — Diluted shares for EPS126,490 112,524 103,321 Basic shares for EPS126,106 112,204 103,010 Outstanding forward equity sales agreements384 320 311 Series D Convertible Preferred Stock— 442 727 Diluted shares for FFO126,490 112,966 104,048 Basic shares for EPS126,106 112,204 103,010 Outstanding forward equity sales agreements384 320 311 Series D Convertible Preferred Stock— — — Diluted shares for FFO, as adjusted126,490 112,524 103,321 134ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKInterest rate riskThe primary market risk to which we believe we may be exposed is interest rate risk, which may result from many factors, including government monetary and tax policies, domestic and international economic and political considerations, and other factors that are beyond our control.In order to modify and manage the interest rate characteristics of our outstanding debt and to limit the effects of interest rate risks on our operations, we may utilize a variety of financial instruments, including interest rate hedge agreements, caps, floors, and other interest rate exchange contracts. The use of these types of instruments to hedge a portion of our exposure to changes in interest rates may carry additional risks, such as counterparty credit risk and the legal enforceability of hedge agreements. As of December 31, 2020, we did not have any outstanding interest rate hedge agreements.Our future earnings and fair values relating to our outstanding debt are primarily dependent upon prevalent market rates of interest. The following table illustrates the effect of a 1% change in interest rates, assuming an interest rate floor of 0%, on our fixed- and variable-rate debt as of December 31, 2020 and 2019 (in thousands):December 31,20202019Annualized effect on future earnings due to variable-rate debt:Rate increase of 1%$(407)$(3,600)Rate decrease of 1%$89 $3,600 Effect on fair value of total consolidated debt:Rate increase of 1%$(700,861)$(527,768)Rate decrease of 1%$795,966 $605,862 These amounts are determined by considering the effect of the hypothetical interest rates on our borrowings as of December 31, 2020 and 2019, respectively. These analyses do not consider the effects of the reduced level of overall economic activity that could exist in such an environment. Furthermore, in the event of a change of such magnitude, we would consider taking actions to further mitigate our exposure to the change. Because of the uncertainty of the specific actions that would be taken and their possible effects, the sensitivity analyses assume no changes in our capital structure.Equity price riskWe have exposure to equity price market risk because of our equity investments in publicly traded companies and privately held entities. All of our investments in actively traded public companies are reflected in the consolidated balance sheets at fair value. Our investments in privately held entities that report NAV per share are measured at fair value using NAV as a practical expedient to fair value. Our equity investments in privately held entities that do not report NAV per share are measured at cost less impairments, adjusted for observable price changes during the period. Changes in fair value of public investments, changes in NAV per share reported by privately held entities, and observable price changes of privately held entities that do not report NAV per share are classified as investment income in our consolidated statements of operations. There is no assurance that future declines in value will not have a material adverse effect on our future results of operations. The following table illustrates the effect that a 10% change in the value of our equity investments would have on earnings as of December 31, 2020 and 2019 (in thousands):December 31,20202019Equity price risk:Fair value increase of 10%$161,111 $114,059 Fair value decrease of 10%$(161,111)$(114,059)135Foreign currency exchange rate riskWe have exposure to foreign currency exchange rate risk related to our subsidiaries operating in Canada and Asia. The functional currencies of our foreign subsidiaries are the local currencies in each respective country. Gains or losses resulting from the translation of our foreign subsidiaries’ balance sheets and statements of operations are classified in accumulated other comprehensive income (loss) as a separate component of total equity and are excluded from net income (loss). Gains or losses will be reflected in our consolidated statements of operations when there is a sale or partial sale of our investment in these operations or upon a complete or substantially complete liquidation of the investment. The following table illustrates the effect that a 10% change in foreign currency rates relative to the U.S. dollar would have on our potential future earnings and on the fair value of our net investment in foreign subsidiaries based on our current operating assets outside the U.S. as of December 31, 2020 and 2019 (in thousands):December 31,20202019Effect on potential future earnings due to foreign currency exchange rate:Rate increase of 10%$118 $107 Rate decrease of 10%$(118)$(107)Effect on the fair value of net investment in foreign subsidiaries due to foreign currency exchange rate:Rate increase of 10%$9,740 $10,120 Rate decrease of 10%$(9,740)$(10,120)This sensitivity analysis assumes a parallel shift of all foreign currency exchange rates with respect to the U.S. dollar; however, foreign currency exchange rates do not typically move in such a manner, and actual results may differ materially.Our exposure to market risk elements for the year ended December 31, 2020, was consistent with the risk elements presented above, including the effects of changes in interest rates, equity prices, and foreign currency exchange rates.136
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+ITEM 7.MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion and analysis of our financial condition and results of operations should be read together with our consolidated financial statements and related notes included elsewhere in this Annual Report on Form 10-K.A discussion regarding our financial condition and results of operations for fiscal 2020 compared to fiscal 2019 is presented under Results of Operations of this Form 10-K. Discussions regarding our financial condition and results of operations for fiscal 2019 compared to 2018 have been omitted from this Annual Report on Form 10-K, but can be found in "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations" in our Annual Report on Form 10-K for the fiscal year ended December 31, 2019, filed with the SEC on February 28, 2020, which is available without charge on the SEC's website at www.sec.gov and on our investor relations website at investor.aligntech.com.OverviewOur purpose is to transform smiles and change lives, and we are accomplishing this goal by establishing clear aligners as the principal solution for the treatment of malocclusions and our Invisalign clear aligners as the treatment solution of choice by orthodontists, general dental practitioners and patients globally. To date, over 9.6 million people worldwide have been treated with our Invisalign System.To encourage consumers to treat malocclusions with clear aligners under the direction and supervision of licensed dental professionals, we have developed a business strategy designed to bring to market solutions that we believe strengthen our digital dental platform for doctors, labs and partners, including establishing the iTero intraoral scanner and related services as the preferred 3D digital scanning solution and integrating computer-aided design and computer-aided manufacturing (“CAD/CAM”) solutions and workflows into the markets for clear aligner orthodontics and dental restorative treatments. Our business strategic priorities are currently based on four principal pillars of growth: (i) International expansion; (ii) GP adoption; (iii) Patient demand & conversion; and (iv) Orthodontic utilization. For a further description of our strategic growth drivers, please see the Business - Business Strategy section of this Annual Report on Form 10-K.We strive to deliver on each of our strategic growth drivers through a variety of interrelated enterprise-wide efforts including:•New Technology, Products, and Feature Enhancements. We believe technological innovations allowing dental professionals to more quickly and accurately diagnose, plan and treat a wide range of cases from simple to complex combined with new and improved products drives greater treatment predictability, clinical applicability, ease of use and confidence for the dental professionals we serve; thereby supporting adoption of Invisalign treatment in their practices. Furthermore, we believe the digital revolution in dentistry is an important aspect of the experience for our customers and their patients, encouraging the utilization of our Invisalign solution and therefore comprising an important component of our digital approach.▪Invisalign clear aligners: Our product portfolio includes Invisalign treatment with Mandibular Advancement, Invisalign Go, Invisalign First and Invisalign Moderate. We also continue to increase the clinical efficacy and applicability of our products as exemplified most recently in the announcement of Invisalign G8 with SmartForce Aligner Activation, and our ClinCheck Pro 6.0 3D treatment planning software. Each of these advancements broadens and strengthens our reach into key markets and demographics central to our strategic plans.34▪iTero Scanner: We continue to expand our intraoral digital scanning solutions; periodically launching or announcing new offerings including most recently the iTero Element® Plus Series of scanner solutions and previously the iTero Element 2, iTero Element Flex and the iTero Element 5D Imaging System, for which we announced in March 2020 that we had obtained U.S. FDA 501(K) clearance and which we continue to release in additional countries. The clearance of the iTero Element 5D Imaging system in the U.S. markets and its release in other countries allows us to sell this first integrated dental imaging system that simultaneously records 3D, intra-oral color and near-infrared (“NIRI”) images into a single, integrated scan that enables comparison over time using the iTero TimeLapse technology; thereby improving doctor experiences and improving engagement opportunities and communications with their patients. The iTero Element 5D aids in the detection and monitoring of interproximal caries lesions above the gingiva without using harmful radiation.•exocad: On April 1, 2020, we completed the acquisition of privately-held exocad Global Holdings GmbH (“exocad”), a German dental CAD/CAM software company that offers fully integrated workflows to dental labs and practices. We believe the acquisition strengthens our digital platform by adding exocad’s expertise in restorative dentistry, implantology, guided surgery, and smile design to extend our digital dental solutions and broadens the Align digital platform towards fully interdisciplinary end-to-end workflows dentistry in lab and at chairside. exocad also broadens our reach in digital dentistry with over 200 partners and more than 40,000 licenses installed worldwide. To further the transformation of dental and orthodontic practices from outdated manual and analog practices to end-to-end digital workflows, in 2020 we introduced virtual solutions such as Invisalign® Virtual Appointment and Invisalign® Virtual Care; solutions that facilitate the safe, effective and successful continuity of treatment of patients by conveniently connecting doctors and their patients throughout their treatment plans.•Invisalign Adoption. Our goal is to establish Invisalign clear aligners as the treatment of choice for treating malocclusion, ultimately driving increased product adoption and frequency of use by dental professionals, which we refer to as “utilization rates.”•For the fourth quarter of 2020, total Invisalign cases submitted with a digital scanner in the Americas increased to 84.0%, up from 79.5% in the fourth quarter of 2019 and international scans increased to 73.7%, up from 64.7% in the fourth quarter of 2019. For the fourth quarter of 2020, 94.8% of Invisalign cases submitted by North American orthodontists were submitted digitally. Our annual utilization rates for the last three fiscal years are as follows:* Invisalign utilization rates are calculated by dividing the number of cases shipped by the number of doctors to whom cases were shipped. Our International region includes Europe, Middle East and Africa (“EMEA”) and Asia Pacific (“APAC”). Latin America (“LATAM”) is excluded from the above chart based on its immateriality. 35•Total utilization rate in 2020 increased to 16.1 cases per doctor compared to 15.9 cases per doctor in 2019 and 15.7 cases per doctor in 2018. •North America: Utilization rate among our North American orthodontist customers increased to 67.3 cases per doctor in 2020 compared to 65.0 cases per doctor in 2019 and 56.7 cases per doctor in 2018 and the utilization rate among our North American GP customers increased to 9.6 cases per doctor in 2020 compared to 9.5 cases per doctor in 2019 and 9.1 cases per doctor in 2018. •International: International doctor utilization rate was 14.5 cases per doctor in 2020 compared to 13.8 cases in 2019 and 13.9 cases per doctor in 2018. We expect global utilization rates to steadily improve as doctors’ clinical confidence in the use of Invisalign clear aligners increases with advancements in products and technology and as patient and doctor demands for treatments that emphasize convenience and safety through fewer in office visits and less invasive and quicker treatments rise. In addition, the teenage and younger market makes up 75% of the approximately 15 million total orthodontic case starts each year, and as we continue to drive adoption by teenage and younger patients through sales and marketing programs, we expect utilization rates to improve. However, our utilization rates will fluctuate from period to period due to a variety of factors, which may include seasonal trends in our business, COVID-19-related preventative measures and adoption rates for new products and features.•Invisalign Doctor Training. We believe our training and education efforts are an important aspect of each of our strategic growth drivers and, accordingly, we continue to expand our Invisalign customer base through the training of new doctors. During 2020, we trained 21,100 new Invisalign doctors of which 9,075 were trained in the Americas region and 12,025 in the International region. In 2019, we trained a total of 22,275 new Invisalign doctors, of which 9,765 were trained in the Americas region and 12,510 in the International region. •International Invisalign Growth. Our future growth is dependent upon the continued penetration and expansion of Invisalign product usage in international markets. Accordingly, we continue to focus our efforts towards increasing Invisalign clear aligner adoption by dental professionals internationally. In 2020, the COVID-19 pandemic caused unprecedented disruptions in our business as we, our customers, and suppliers experienced varying degrees of business and facilities closures and restrictions at various times that differed by geography and conditions and significant uncertainties remain. For a further discussion of COVID-19 and its impact on our business, see the section entitled "COVID-19 Update" below. Moreover, even under ideal circumstances the difficulties and intricacies of international sales and operations can be difficult to manage and we expect to periodically experience fluctuations in growth rates in emerging markets for reasons ranging from regional and macroeconomic conditions, geopolitical tensions and competition among others. For a description of the risks related our international growth efforts, please see the Risk Factors section of this Annual Report on Form 10-K. For instance, prior to the impact of COVID-19, we experienced slower growth rates than prior periods in China which we believe were primarily due to the U.S.-China trade war and resulting economic uncertainty which caused headwind for consumer demand especially for consumption of luxury goods and considered purchases. We also believe there has been increased competitive activity in China from clear aligner suppliers. Notwithstanding these uncertainties, we continue to see growth opportunities with international orthodontists and GP customers, particularly with adopters of digital dentistry platforms and as we continue to segment our sales and marketing resources and programs specifically around each customer channel. Furthermore, we continue to expand in our existing markets through targeted investments in sales coverage and professional marketing and education programs, along with consumer marketing in select country markets. For instance, we increased our sales presence in APAC in the first half of 2020 and will continue to strategically invest in regions as we deem appropriate for long-term success. We also intend to continue expanding our manufacturing and treatment planning operations to meet local and regional demand. Overall, we expect International revenues to grow at a faster rate than Americas' revenues for the foreseeable future due to our continued investment in international market expansion, the size of the market opportunities and our relatively low market penetration of these regions.•Increasing Competition. Our primary competition for the sale of our clear aligners remains traditional wires and brackets although the number of clear aligner competitors, primarily targeting the young adult demographic, continues to increase. We also have competitors in the markets for other products and services, including intraoral scanners and CAD/CAM software. We believe our continued investments in product improvements and operational efficiencies make our products more compelling for our customers and their patients and we intend to maintain these efforts. Additionally, we believe that well-designed, targeted sales and marketing promotions help us build on our strong brand awareness and differentiate us from traditional and emerging competitors. Accordingly, we continue to increase investments intended to grow consumer demand. During 2020, our marketing and consumer engagement included 36social media campaigns targeting teens and mothers through social media influencers, becoming the Official Clear Aligner Sponsor of the National Football League and introducing Invisalign Stickables which patients can apply to their aligners as a fun and simple way to distinguish themselves and our products from the competition. We expect to make further investments to create additional demand for Invisalign System treatment; driving more consumers to dental professionals for those treatments.We also believe that investing in our sales teams is important to our success. The addition of sales representatives in APAC in 2020 follows increases in the U.S. in 2019. We believe the realignment of our sales teams to focus on the channels they serve, allows us to partner with doctors in more meaningful ways; assessing their specific needs and helping to tailor their practices for success while encouraging increased adoption and engagement of a variety of our products and services.COVID-19 UpdateThe COVID-19 pandemic disrupted our business and the businesses and lives of our customers, their patients and our suppliers in unprecedented ways; requiring us to reevaluate priorities, adapt to new ways of doing business and developing new strategies and plans quickly and revising them frequently as conditions evolved. By the end of the fourth quarter of 2020, many dental practices had resumed operations although often at capacities less than pre-pandemic levels. Additionally, in virtually all practices the effects of COVID-19 persist, typically in the form of additional preventative safety measures such as added sterilization requirements, increased costs for personal protective equipment and staggered patient visits intended to reduce the risks of cross contamination, each of which contribute to fewer patient visits per day.To help doctors through the pandemic and to stimulate demand for our products and services during the recovery, we modified existing programs and implemented new promotions in 2020, some of which remain in effect. For instance, we did not implement annual price increases on our various clear aligner products in 2020, offered promotions to encourage doctors with patients in wires and brackets to switch to our Invisalign clear aligners, allowed doctors to maintain their promotional status levels notwithstanding declining sales, increased advertising and launched new media campaigns, implemented new promotions and modified others, all in an effort to help our customers and accelerate our mutual return to normal operations. As a result of these efforts, during the year ended December 31, 2020, we recorded net revenues of $2.5 billion, an increase of 2.7% compared to the same period in 2019. During the year ended December 31, 2020, clear aligner case volume was 1.6 million, an increase of 7.0% compared to the same period in 2019 and Systems and Services net revenues decreased by 2.8% compared to the same period in 2019.In the short term, our business remains susceptible to the COVID-19 pandemic. Concerns about additional outbreaks of the virus, the spread of new variants of the virus and the efficacy of vaccines against those variants, and efforts to slow or prevent a recurrence of its spread are likely to continue causing disruption and uncertainties in the markets, adversely impacting our customers and their patients for an indeterminate period of time. This in turn could impact our operations as purchasing decisions are delayed or lost, create logistics complexities related to uneven or rapid changes in demand, and sales and marketing efforts are postponed or prove ineffective. Conversely, we believe the pandemic emphasizes the benefits of digital dentistry and virtual appointments over traditional practice methods that require frequent in office patient visits to manually adjust wires and brackets. We further believe that this will in turn motivate doctors to use more digital solutions, including our iTero scanner, exocad CAD/CAM software and the Invisalign System.As we assess the possible future short- and long-term impacts to our revenues, operations and financial condition from the COVID-19 pandemic, we are continually evaluating macroeconomic as well as industry-specific factors. For instance, among the many factors we continue to monitor are governmental and societal reactions to the virus, global and regional economic activity, unemployment and its potential impact on discretionary spending and health insurance coverage, patient reluctance or fear of exposure as a result of orthodontic or dental office visits, travel restrictions on employees, suppliers, customers and their patients and other external factors beyond our control. Furthermore, if the threat of further spread of COVID-19 occurs or the pace of recovery by dental practices is haphazard or inconsistent, there may be a substantial impact on our employees or suppliers, our operations, including our ability to timely obtain the materials needed to manufacture our products and manufacture and deliver those products to customers; any of which may harm our results of operations, financial condition and overall financial performance. Moreover, many of the measures we implemented to protect our employees from the spread of the virus remain in effect. For instance, many of our offices across the globe remain underutilized as employees continue to work from home. We are also screening our employees, providing them with personal protective equipment, and altering work environments to facilitate social distancing, which has in the past and may in the future harm productivity. Furthermore, if our employees or their families are sickened by COVID-19, our ability to respond or mitigate the impact of COVID-19 may be adversely impacted.37Ultimately, we believe the markets we serve will continue to recover from the COVID-19 preventative measures at differing rates and times corresponding with regional outbreaks and recoveries. Should any one or more events or circumstances previously mentioned or others occur or materially adversely increase or other unknown circumstances arise, they could materially impact our business and results of operations in 2021 and beyond.Further discussion of the impact of the COVID-19 pandemic on our business may be found in Item 1A of this Annual Report on Form 10-K under the heading “Risk Factors.”2021 ExpensesOverall, we expect expenses in 2021 to increase over 2020 levels; however, as a result of the financial impacts of COVID-19, we expect to continue controlling our discretionary spending, such as travel and meeting related expenses, and focus investments in the following key areas:▪Manufacturing capacity and facilities to enhance our regional capabilities;▪Sales and marketing, including additional direct sales force personnel and consumer marketing; and▪Product and technology innovation to enhance product efficiency and operational productivity.We believe these investments position us to take advantage of a recovering market and thereafter once markets return to greater normalcy, increasing our revenues and growing our market share over the long term, but they could negatively impact our results of operations, particularly in the near term.Relocating HeadquartersEffective January 1, 2021, we moved our corporate headquarters from San Jose, California to Tempe, Arizona which offers a favorable corporate operating environment along with long-term operating efficiencies. The San Jose office will remain our hub for global innovation, product, and market organization and home to our new Digital Innovation Center. There were no layoffs associated with this move. Results of OperationsNet Revenues by Reportable Segment We group our operations into two reportable segments: Clear Aligner segment and Imaging Systems and CAD/CAM Services (“Systems and Services”) segment.•Our Clear Aligner segment consists of Comprehensive Products, Non-Comprehensive Products and Non-Case revenues as defined below:•Comprehensive Products include, but are not limited to, Invisalign Comprehensive and Invisalign First. •Non-Comprehensive Products include, but are not limited to, Invisalign Moderate, Lite and Express packages and Invisalign Go. •Non-Case includes, but is not limited to, Vivera retainers along with our training and ancillary products for treating malocclusion. •Our Systems and Services segment consists of our iTero intraoral scanning systems, which includes a single hardware platform and restorative or orthodontic software options, OrthoCAD services and ancillary products, as well as exocad’s CAD/CAM software solution that integrates workflows to dental labs and dental practices.38Net revenues for our Clear Aligner and Systems and Services segments by region for the year ended December 31, 2020, 2019 and 2018 are as follows (in millions): Year Ended December 31,Year Ended December 31,Net Revenues20202019Change20192018ChangeClear Aligner revenues: Americas$1,010.2 $1,022.1 $(11.9)(1.2)%$1,022.1 $903.3 $118.8 13.2 % International965.4 881.4 84.1 9.5 %881.4 684.2 197.2 28.8 % Non-case 125.8 122.3 3.5 2.9 %122.3 104.0 18.3 17.6 %Total Clear Aligner net revenues $2,101.5 $2,025.8 $75.7 3.7 %$2,025.8 $1,691.5 $334.3 19.8 %Systems and Services net revenues370.5 381.0 (10.6)(2.8)%381.0 275.0 106.0 38.5 %Total net revenues$2,471.9 $2,406.8 $65.1 2.7 %$2,406.8 $1,966.5 $440.3 22.4 %Changes and percentages are based on actual values. Certain tables may not sum or recalculate due to rounding.Clear Aligner Case Volume by RegionCase volume data which represents Clear Aligner case shipments by region for the year ended December 31, 2020, 2019 and 2018 is as follows (in thousands): Year Ended December 31,Year Ended December 31,Region 20202019Change20192018Change Americas 886.5 867.3 19.2 2.2 %867.3 780.7 86.6 11.1 % International 758.9 669.8 89.0 13.3 %669.8 499.9 169.9 34.0 %Total case volume1,645.3 1,537.1 108.3 7.0 %1,537.1 1,280.6 256.5 20.0 % Changes and percentages are based on actual values. Certain tables may not sum or recalculate due to rounding.Total net revenues increased by $65.1 million in 2020 as compared to 2019 primarily as a result of higher Clear Aligner volumes in the International region partially offset by lower average selling prices (“ASP”) in the Americas region and lower Systems and Services net revenues in most regions. Clear Aligner - AmericasAmericas net revenues decreased by $11.9 million in 2020 as compared to 2019 primarily due to lower Clear Aligner ASP that decreased net revenues by $34.6 million. The lower ASP was as a result of higher promotional discounts which reduced net revenues by $44.6 million and unfavorable foreign exchange rates reduced net revenues by $15.2 million; however, these were partially offset by July 2019 price increases which contributed $23.3 million to net revenues. The reduction in net revenues due to lower ASP was partially offset by higher Clear Aligner volume which increased net revenues by $16.1 million.Clear Aligner - InternationalInternational net revenues increased by $84.1 million in 2020 as compared to 2019 primarily due to higher Clear Aligner volume which increased net revenues by $117.2 million partially offset by lower ASP which reduced net revenues by $33.1 million. Lower ASP was the result of higher promotional discounts that reduced net revenues by $44.3 million, higher net deferrals that reduced net revenues by $19.3 million and a product mix shift towards lower priced products. These reductions were partially offset by July 2019 price increases across most products along with a benefit from going direct in several additional countries and therefore we now recognize direct sales at full ASP rather than the discounted distributor ASP which combined, increased net revenues by $20.9 million and favorable foreign exchange rates increased net revenues by $14.5 million.Clear Aligner - Non-CaseNon-case net revenues increased by $3.5 million in 2020 compared to 2019 due to increased Vivera volume across all regions. 39Systems and ServicesSystems and services net revenues decreased by $10.6 million in 2020 as compared to 2019 due to a lower number of scanners recognized which decreased net revenues by $31.7 million and a lower scanner ASP which decreased net revenues by $21.2 million. The ASP decrease was mostly due to higher promotional discounts partially offset by product mix shift to higher priced scanners. These decreases were partially offset by higher iTero service revenues mostly due to a larger scanner install base and the addition of exocad’s CAD/CAM revenues from our acquisition which combined increased net revenues by $42.3 million.Cost of net revenues and gross profit (in millions): Year Ended December 31,Year Ended December 31, 20202019Change20192018ChangeClear AlignerCost of net revenues$569.3 $526.0 $43.3 $526.0 $411.0 $115.0 % of net segment revenues27.1 %26.0 %26.0 %24.3 %Gross profit$1,532.1 $1,499.7 $32.4 $1,499.7 $1,280.5 $219.2 Gross margin %72.9 %74.0 %74.0 %75.7 %Systems and ServicesCost of net revenues$139.4 $136.9 $2.5 $136.9 $107.7 $29.2 % of net segment revenues37.6 %35.9 %35.9 %39.1 %Gross profit$231.1 $244.2 $(13.1)$244.2 $167.4 $76.8 Gross margin %62.4 %64.1 %64.1 %60.9 %Total cost of net revenues$708.7 $662.9 $45.8 $662.9 $518.6 $144.3 % of net revenues28.7 %27.5 %27.5 %26.4 %Gross profit$1,763.2 $1,743.9 $19.3 $1,743.9 $1,447.9 $296.0 Gross margin %71.3 %72.5 %72.5 %73.6 %Changes and percentages are based on actual values. Certain tables may not sum or recalculate due to rounding.Cost of net revenues includes personnel-related costs including payroll and stock-based compensation for staff involved in the production process, the cost of materials, packaging, shipping costs, depreciation on capital equipment and facilities used in the production process, amortization of acquired intangible assets and training costs.Clear AlignerThe gross margin percentage decreased in 2020 compared to 2019 primarily due to lower ASP, higher manufacturing spend partially driven by operational expansion activities and an increase in aligners per case driven by additional aligners which was offset in part by manufacturing efficiencies.Systems and ServicesThe gross margin percentage decreased in 2020 compared to 2019 primarily driven by lower ASP and manufacturing inefficiencies due to lower volumes which was offset in part by higher service revenues. Selling, general and administrative (in millions): Year Ended December 31,Year Ended December 31, 20202019Change20192018ChangeSelling, general and administrative$1,200.8 $1,072.1 $128.7 $1,072.1 $852.4 $219.7 % of net revenues48.6 %44.5 %44.5 %43.3 %Changes and percentages are based on actual values. Certain tables may not sum or recalculate due to rounding.Selling, general and administrative expense includes personnel-related costs including payroll, stock-based compensation and commissions for our sales force, marketing and advertising expenses including media, clinical education, trade shows and 40industry events, legal and outside service costs, equipment and maintenance costs, depreciation and amortization expense and allocations of corporate overhead expenses including facilities and Information Technology (“IT”).Selling, general and administrative expense increased in 2020 compared to 2019 primarily due to higher compensation related costs of $86.5 million mainly from an approximate 21% increase in headcount resulting in higher salaries expense, fringe benefits, commissions and stock-based compensation partially offset by lower incentive bonuses. Additionally, we also incurred higher expenses on equipment, software and maintenance costs of $30.3 million, advertising and marketing costs of $24.2 million and legal and outside service costs of $19.1 million which included transaction costs related to our acquisition of exocad. These increases were partially offset by a decrease in travel related costs of $26.7 million due to the impact of COVID-19.Research and development (in millions): Year Ended December 31,Year Ended December 31, 20202019Change20192018ChangeResearch and development$175.3 $157.4 $17.9 $157.4 $128.9 $28.5 % of net revenues7.1 %6.5 %6.5 %6.6 %Changes and percentages are based on actual values. Certain tables may not sum or recalculate due to rounding.Research and development expense includes the personnel-related costs including payroll and stock-based compensation, equipment, material and maintenance costs, outside consulting expenses associated with the research and development of new products and enhancements to existing products, depreciation and amortization expense and allocations of corporate overhead expenses including facilities and IT.Research and development expense increased in 2020 compared to 2019 primarily due to higher compensation, equipment and material costs. Higher compensation costs, including fringe benefits and stock-based compensation, was mainly from an approximate 27% increase in headcount which was partially offset by lower incentive bonuses as well as a decrease in travel related costs due to the impact of COVID-19.Impairments and other charges (gains), net (in millions): Year Ended December 31,Year Ended December 31, 20202019Change20192018ChangeImpairments and other charges (gains), net$— $23.0 $(23.0)$23.0 $— $23.0 % of net revenues— %1.0 %1.0 %— %Changes and percentages are based on actual values. Certain tables may not sum or recalculate due to rounding.In 2019, we recorded impairments and other charges (gains), net of $23.0 million which are comprised of operating lease right-of-use assets impairments of $14.2 million, store leasehold improvement and other fixed asset impairments of $14.3 million, and employee severance and other expenses of $1.3 million, partially offset by the Invisalign store lease termination gains of $6.8 million (Refer to Note 9“Impairments and Other Charges (Gains), net” for more information).Litigation settlement gain (in millions): Year Ended December 31,Year Ended December 31, 20202019Change20192018ChangeLitigation settlement gain$— $(51.0)$51.0 $(51.0)$— $(51.0)% of net revenues— %(2.1)%(2.1)%— %Changes and percentages are based on actual values. Certain tables may not sum or recalculate due to rounding.In 2019, we recorded a gain of $51.0 million due to the litigation settlement with Straumann Group.41Income from operations (in millions): Year Ended December 31,Year Ended December 31, 20202019Change20192018ChangeClear AlignerIncome from operations$768.0 $836.0 $(67.9)$836.0 $712.4 $123.6 Operating margin %36.5 %41.3 %41.3 %42.1 %Systems and ServicesIncome from operations$96.1 $137.7 $(41.7)$137.7 $99.0 $38.7 Operating margin %25.9 %36.1 %36.1 %36.0 %Total income from operations 1$387.2 $542.5 $(155.3)$542.5 $466.6 $75.9 Operating margin %15.7 %22.5 %22.5 %23.7 %Changes and percentages are based on actual values. Certain tables may not sum or recalculate due to rounding.1 Refer to Note 18 “Segments and Geographical Information” of the Notes to Consolidated Financial Statements for details on unallocated corporate expenses and the reconciliation to Consolidated Income from OperationsClear AlignerOperating margin percentage decreased in 2020 compared to 2019 primarily due to a $51.0 million gain recognized from the litigation settlement with Straumann during 2019 as well as a lower gross margin. These decreases were offset in part by a net impairment charge of $23.0 million recognized in 2019 related to the Invisalign store closures.Systems and ServicesOperating margin percentage decreased in 2020 compared to 2019 primarily due to higher operating expenses, primarily from compensation, material, equipment, software and maintenance costs, in addition to a lower gross margin. Interest income (in millions): Year Ended December 31,Year Ended December 31, 20202019Change20192018ChangeInterest income$3.1 $12.5 $(9.4)$12.5 $8.6 $3.9 % of net revenues0.1 %0.5 %0.5 %0.4 %Changes and percentages are based on actual values. Certain tables may not sum or recalculate due to rounding.Interest income includes interest earned on cash, cash equivalents, investment balances and our unsecured promissory note.Interest income decreased in 2020 compared to 2019 mainly due to the divestiture of our marketable securities portfolio during the first quarter of 2020 and lower interest rates earned on our cash and cash equivalents.Other income (expense), net (in millions): Year Ended December 31,Year Ended December 31, 20202019Change20192018ChangeOther income (expense), net$(11.3)$7.7 $(19.0)$7.7 $(8.5)$16.2 % of net revenues(0.5)%0.3 %0.3 %(0.4)%Changes and percentages are based on actual values. Certain tables may not sum or recalculate due to rounding.Other income (expense), net, includes foreign exchange gains and losses, gains and losses on foreign currency forward contracts, interest expense, gains and losses on equity investments and other miscellaneous charges.Other income (expense), net, decreased in 2020 compared to 2019 primarily due to a $15.8 million gain from the sale of our investment in SDC recorded in 2019 and a $10.2 million loss on a foreign currency forward contract related to the exocad 42acquisition recorded in 2020. These decreases were partially offset by net foreign exchange gains in 2020 as compared to net foreign exchange losses in 2019.Equity in losses of investee, net of tax (in millions): Year Ended December 31,Year Ended December 31, 20202019Change20192018ChangeEquity in losses of investee, net of tax$— $7.5 $(7.5)$7.5 $8.7 $(1.2)% of net revenues— %0.3 %0.3 %0.4 %Changes and percentages are based on actual values. Certain tables may not sum or recalculate due to rounding.For 2020, there were no equity in losses of investee, net of tax. After the second quarter of 2019, we no longer incurred equity in losses of investee, net of tax related to SDC as we tendered our SDC equity interest on April 3, 2019 (Refer to Note 7 “Equity Method Investments” of the Notes to Consolidated Financial Statements for details on equity method investments).Provision for (benefit from) income taxes (in millions): Year Ended December 31,Year Ended December 31, 20202019Change20192018ChangeProvision for (benefit from) income taxes$(1,396.9)$112.3 $(1,509.3)$112.3 $57.7 $54.6 Effective tax rates(368.6)%20.0 %20.0 %12.4 %Changes and percentages are based on actual values. Certain tables may not sum or recalculate due to rounding.During 2020, we completed an intra-entity transfer of certain intellectual property rights and fixed assets to our Swiss subsidiary, where our EMEA regional headquarters is located beginning January 1, 2020. The transfer of intellectual property rights did not result in a taxable gain; however, it did result in a step-up of the Swiss tax deductible basis in the transferred assets, and accordingly, created a temporary difference between the book basis and the tax basis of such intellectual property rights. Consequently, this transaction resulted in the recognition of a deferred tax asset and related one-time tax benefit of approximately $1,493.5 million during the year ended December 31, 2020, which is the net impact of the deferred tax asset recognized as a result of the additional Swiss tax deductible basis in the transferred assets and certain costs related to the transfer of fixed assets and inventory. The amortization of this deferred tax asset depends on the profitability of our Swiss headquarters and the recognition of this tax benefit is allowed for a maximum recovery period of 15 years. The decrease in our effective tax rate for the year ended December 31, 2020 compared to the same period in 2019 is primarily attributable to the recognition of a deferred tax asset related to the intra-entity transfer of certain intellectual property rights during the year ended December 31, 2020.Liquidity and Capital ResourcesWe fund our operations from product sales. As of December 31, 2020 and 2019, we had the following cash and cash equivalents and short-term marketable securities (in thousands): December 31, 20202019Cash and cash equivalents$960,843 $550,425 Marketable securities, short-term — 318,202 Total$960,843 $868,627 Cash equivalents and marketable securities are comprised of money market funds and highly liquid debt instruments which primarily include corporate bonds, U.S. government treasury bonds, U.S. government agency bonds, commercial paper and certificates of deposit.As of December 31, 2020 and 2019, approximately $412.5 million and $278.5 million, respectively, of cash and cash equivalents was held by our foreign subsidiaries. Our intent is to permanently reinvest our earnings from our international operations going forward, and our current plans do not require us to repatriate them to fund our U.S. operations as we generate sufficient domestic operating cash flow and have access to external funding under our revolving line of credit. We believe that 43our current cash balances and the borrowing capacity under our credit facility, if necessary, will be sufficient to fund our business for at least the next 12 months. Our business was materially adversely affected in 2020 by the COVID-19 pandemic and the global and regional efforts by governments to mitigate its spread. While these impacts lessened in the third and fourth quarters of 2020, we could experience further adverse impacts to our business. In addition, as a result of the COVID-19 pandemic, we could experience reduced cash flow from operations as a result of decreased revenues and slower collections on our accounts receivable. Additional information regarding the impact of COVID-19 on our liquidity and capital resources may be found in Item 1A of this Annual Report on Form 10-K under the heading “Risk Factors”. Cash flows (in thousands): Year Ended December 31, 202020192018Net cash provided by (used in):Operating activities$662,174 $747,270 $554,681 Investing activities(231,506)(350,444)6,927 Financing activities(30,808)(485,540)(369,434)Effects of foreign exchange rate changes on cash, cash equivalents, and restricted cash 10,480 2,282 (4,733)Net increase (decrease) in cash, cash equivalents, and restricted cash$410,340 $(86,432)$187,441 Operating ActivitiesFor the year ended December 31, 2020, cash flows from operations of $662.2 million was primarily comprised of our net income of approximately $1.8 billion as well as the following:Significant non-cash activities•Deferred taxes of $1.5 billion related to the one-time tax benefit associated with the intra-entity sale of certain intellectual property rights;•Stock-based compensation of $98.4 million related to equity awards granted to employees and directors;•Depreciation and amortization of $93.5 million related to our investments in property, plant and equipment and intangible assets;•Non-cash operating lease costs of $22.5 million; •Allowance for doubtful accounts provisions of $12.1 million related to slower collections and other impacts as a result of COVID-19; and •Impairment charges of $5.9 million related to our equity investments in privately held companies.Significant changes in working capital •Increase of $228.1 million in deferred revenues primarily related to increased case volumes and timing of revenue recognition;•Increase of $139.8 million in accounts receivable which is primarily a result of the increase and timing in our sales; and •Increase of $52.2 million in accounts payable due to timing of certain invoice payments.For the year ended December 31, 2019, cash flows from operations of $747.3 million was primarily comprised of our net income of approximately $442.8 million as well as the following:Significant non-cash activities•Stock-based compensation of $88.2 million related to equity awards granted to employees and directors;•Depreciation and amortization of $79.0 million related to our investments in property, plant and equipment and intangible assets; •Impairment charges of $28.5 million related to decreases in the fair value of certain assets related to the closure of our Invisalign stores;44•Non-cash operating lease costs of $18.5 million; and•Gain from the sale of equity method investment of $15.8 million.Significant changes in working capital•Increase of $189.1 million in deferred revenues corresponding to the increase in case volume;•Increase of $121.0 million in accounts receivable which is primarily a result of the increase in our sales; and•Increase of $60.2 million in accrued and other long-term liabilities due to timing of payment and activities.Investing ActivitiesNet cash used in investing activities was $231.5 million for the year ended December 31, 2020, which primarily consisted of cash paid for the acquisition of exocad of $420.8 million, net of cash acquired and purchases of property, plant and equipment of $154.9 million. These outflows were partially offset by maturities and sales of marketable securities of $321.5 million and $26.9 million received from payments on an unsecured promissory note issued by SDC in exchange for tendering our shares to them.For 2021, we expect to invest approximately $400.0 million in capital expenditures related to building construction and improvements as well as additional manufacturing capacity to support our international expansion.Net cash used in investing activities was $350.4 million for the year ended December 31, 2019, which primarily consisted of purchases of marketable securities of $693.3 million, purchases of property, plant and equipment of $149.7 million and other investing activities of $14.7 million. These outflows were partially offset by maturities and sales of marketable securities of $485.4 million and payments of $21.8 million received on an unsecured promissory note issued by SDC in exchange for tendering our shares to them.Financing ActivitiesNet cash used in financing activities was $30.8 million for the year ended December 31, 2020 consisted of payroll taxes paid for equity awards through share withholdings of $51.1 million which was partially offset by $20.3 million of proceeds from the issuance of common stock. Net cash used in financing activities was $485.5 million for the year ended December 31, 2019 primarily consisted of common stock repurchases of $400.0 million, payroll taxes paid for equity awards through share withholdings of $57.7 million and the purchase of a building that we previously leased under a finance lease of $45.8 million. These outflows were offset in part by $17.9 million proceeds from the issuance of common stock.Common Stock RepurchasesRefer to Note 13 “Common Stock Repurchase Programs” of the Notes to Consolidated Financial Statements for details on our stock repurchase programs.Credit FacilityOn July 21, 2020, we entered into a new credit facility for a $300.0 million unsecured revolving line of credit, with a $50.0 million letter of credit sublimit, and a maturity date of July 21, 2023 (“2020 Credit Facility”), replacing our previous credit facility which provided for a $200.0 million revolving line of credit with a $50.0 million letter of credit. As of December 31, 2020, we had no outstanding borrowings under this credit facility (Refer to Note 8 "Credit Facility" of the Notes to Consolidated Financial Statements for details of the credit facility). 45Contractual Obligations / Off Balance Sheet Arrangements The impact that our contractual obligations as of December 31, 2020 are expected to have on our liquidity and cash flows in future periods is as follows (in thousands): Payments Due by Period TotalLess than1 Year1-3Years4-5YearsMore than5 YearsOperating leases obligations$100,520 $25,358 $34,388 $11,494 $29,280 Unconditional purchase obligations704,961 474,204 203,977 26,780 — Total contractual cash obligations$805,481 $499,562 $238,365 $38,274 $29,280 Our contractual obligations table above excludes approximately $47.5 million of non-current uncertain tax benefits which are included in other long-term obligations and deferred tax assets on our balance sheet as of December 31, 2020. We have not included this amount because we cannot make a reasonably reliable estimate regarding the timing of settlements with taxing authorities, if any. As of December 31, 2020, we had additional operating leases that have not yet commenced with future lease payments of $18.1 million. These operating leases will commence during 2021 with non-cancelable lease terms of one to seven years. We had no material off-balance sheet arrangements as defined in Regulation S-K Item 303(a)(4) as of December 31, 2020 other than certain items disclosed in Note 11 "Commitments and Contingencies" of the Notes to Consolidated Financial Statements.Indemnification ProvisionsIn the normal course of business to facilitate transactions in our services and products, we indemnify certain parties: customers, vendors, lessors, and other parties with respect to certain matters, including, but not limited to, services to be provided by us and intellectual property infringement claims made by third parties. In addition, we have entered into indemnification agreements with our directors and our executive officers that will require us, among other things, to indemnify them against certain liabilities that may arise by reason of their status or service as directors or officers. Several of these agreements limit the time within which an indemnification claim can be made and the amount of the claim.It is not possible to make a reasonable estimate of the maximum potential amount under these indemnification agreements due to the unique facts and circumstances involved in each particular agreement. Additionally, we have a limited history of prior indemnification claims and the payments we have made under such agreements have not had a material adverse effect on our results of operations, cash flows or financial position. However, to the extent that valid indemnification claims arise in the future, future payments by us could be significant and could have a material adverse effect on our results of operations or cash flows in a particular period. As of December 31, 2020, we did not have any material indemnification claims that were probable or reasonably possible.Critical Accounting Policies and Estimates Management’s discussion and analysis of our financial condition and results of operations is based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of financial statements requires management to make estimates and judgments that affect the reported amounts of assets and liabilities, revenues and expenses and disclosures at the date of the financial statements. We evaluate our estimates on an on-going basis, including those related to revenue recognition, goodwill and finite-lived assets and related impairment, business combinations and income taxes. We use authoritative pronouncements, historical experience and other assumptions as the basis for making estimates. Actual results could differ from those estimates.We believe the following critical accounting policies and estimates affect our more significant judgments used in the preparation of our consolidated financial statements. For further information on all of our significant accounting policies, see Note 1 “Summary of Significant Accounting Policies” of the Notes to Consolidated Financial Statements under
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+Item 7.Management’s Discussion and Analysis of Financial Condition and Results of OperationsForward-Looking StatementsThis Annual Report on Form 10-K includes forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. All statements other than statements of historical fact, including statements regarding guidance, industry prospects, or future results of operations or financial position, made in this Annual Report on Form 10-K are forward-looking. We use words such as anticipates, believes, expects, future, intends, and similar expressions to identify forward-looking statements. Forward-looking statements reflect management’s current expectations and are inherently uncertain. Actual results could differ materially for a variety of reasons, including, among others, fluctuations in foreign exchange rates, changes in global economic conditions and customer spending, world events, the rate of growth of the Internet, online commerce, and cloud services, the amount that Amazon.com invests in new business opportunities and the timing of those investments, the mix of products and services sold to customers, the mix of net sales derived from products as compared with services, the extent to which we owe income or other taxes, competition, management of growth, potential fluctuations in operating results, international growth and expansion, the outcomes of claims, litigation, government investigations, and other proceedings, fulfillment, sortation, delivery, and data center optimization, risks of inventory management, variability in demand, the degree to which we enter into, maintain, and develop commercial agreements, proposed and completed acquisitions and strategic transactions, payments risks, and risks of fulfillment throughput and productivity. In addition, the global economic climate and additional or unforeseen effects from the COVID-19 pandemic amplify many of these risks. These risks and uncertainties, as well as other risks and uncertainties that could cause our actual results to differ significantly from management’s expectations, are described in greater detail in Item 1A of Part I, “Risk Factors.”OverviewOur primary source of revenue is the sale of a wide range of products and services to customers. The products offered through our stores include merchandise and content we have purchased for resale and products offered by third-party sellers, and we also manufacture and sell electronic devices and produce media content. Generally, we recognize gross revenue from items we sell from our inventory as product sales and recognize our net share of revenue of items sold by third-party sellers as service sales. We seek to increase unit sales across our stores, through increased product selection, across numerous product categories. We also offer other services such as compute, storage, and database offerings, fulfillment, advertising, publishing, and digital content subscriptions.Our financial focus is on long-term, sustainable growth in free cash flows. Free cash flows are driven primarily by increasing operating income and efficiently managing accounts receivable, inventory, accounts payable, and cash capital expenditures, including our decision to purchase or lease property and equipment. Increases in operating income primarily result from increases in sales of products and services and efficiently managing our operating costs, partially offset by investments we make in longer-term strategic initiatives, including capital expenditures focused on improving the customer experience. To increase sales of products and services, we focus on improving all aspects of the customer experience, including lowering prices, improving availability, offering faster delivery and performance times, increasing selection, producing original content, increasing product categories and service offerings, expanding product information, improving ease of use, improving reliability, and earning customer trust. See “Results of Operations — Non-GAAP Financial Measures” below for additional information on our non-GAAP free cash flows financial measures.We seek to reduce our variable costs per unit and work to leverage our fixed costs. Our variable costs include product and content costs, payment processing and related transaction costs, picking, packaging, and preparing orders for shipment, transportation, customer service support, costs necessary to run AWS, and a portion of our marketing costs. Our fixed costs include the costs necessary to build and run our technology infrastructure; to build, enhance, and add features to our online stores, web services, electronic devices, and digital offerings; and to build and optimize our fulfillment networks and related facilities. Variable costs generally change directly with sales volume, while fixed costs generally are dependent on the timing of capacity needs, geographic expansion, category expansion, and other factors. To decrease our variable costs on a per unit basis and enable us to lower prices for customers, we seek to increase our direct sourcing, increase discounts from suppliers, and reduce defects in our processes. To minimize unnecessary growth in fixed costs, we seek to improve process efficiencies and maintain a lean culture.Because of our model we are able to turn our inventory quickly and have a cash-generating operating cycle1. On average, our high inventory velocity means we generally collect from consumers before our payments to suppliers come due. We expect variability in inventory turnover over time since it is affected by numerous factors, including our product mix, the mix of sales 1 The operating cycle is the number of days of sales in inventory plus the number of days of sales in accounts receivable minus accounts payable days.19Table of Contentsby us and by third-party sellers, our continuing focus on in-stock inventory availability and selection of product offerings, our investment in new geographies and product lines, and the extent to which we choose to utilize third-party fulfillment providers. We also expect some variability in accounts payable days over time since they are affected by several factors, including the mix of product sales, the mix of sales by third-party sellers, the mix of suppliers, seasonality, and changes in payment terms over time, including the effect of balancing pricing and timing of payment terms with suppliers.We expect spending in technology and content will increase over time as we add computer scientists, designers, software and hardware engineers, and merchandising employees. Our technology and content investment and capital spending projects often support a variety of product and service offerings due to geographic expansion and the cross-functionality of our systems and operations. We seek to invest efficiently in several areas of technology and content, including AWS, and expansion of new and existing product categories and service offerings, as well as in technology infrastructure to enhance the customer experience and improve our process efficiencies. We believe that advances in technology, specifically the speed and reduced cost of processing power, data storage and analytics, improved wireless connectivity, and the practical applications of artificial intelligence and machine learning, will continue to improve users’ experience on the Internet and increase its ubiquity in people’s lives. To best take advantage of these continued advances in technology, we are investing in AWS, which offers a broad set of on-demand technology services, including compute, storage, database, analytics, and machine learning, and other services, to developers and enterprises of all sizes. We are also investing in initiatives to build and deploy innovative and efficient software and electronic devices. We seek to efficiently manage shareholder dilution while maintaining the flexibility to issue shares for strategic purposes, such as financings, acquisitions, and aligning employee compensation with shareholders’ interests. We utilize restricted stock units as our primary vehicle for equity compensation because we believe this compensation model aligns the long-term interests of our shareholders and employees. In measuring shareholder dilution, we include all vested and unvested stock awards outstanding, without regard to estimated forfeitures. Total shares outstanding plus outstanding stock awards were 512 million and 518 million as of December 31, 2019 and 2020.Our financial reporting currency is the U.S. Dollar and changes in foreign exchange rates significantly affect our reported results and consolidated trends. For example, if the U.S. Dollar weakens year-over-year relative to currencies in our international locations, our consolidated net sales and operating expenses will be higher than if currencies had remained constant. Likewise, if the U.S. Dollar strengthens year-over-year relative to currencies in our international locations, our consolidated net sales and operating expenses will be lower than if currencies had remained constant. We believe that our increasing diversification beyond the U.S. economy through our growing international businesses benefits our shareholders over the long-term. We also believe it is useful to evaluate our operating results and growth rates before and after the effect of currency changes.In addition, the remeasurement of our intercompany balances can result in significant gains and losses associated with the effect of movements in foreign currency exchange rates. Currency volatilities may continue, which may significantly impact (either positively or negatively) our reported results and consolidated trends and comparisons.For additional information about each line item addressed above, refer to Item 8 of Part II, “Financial Statements and Supplementary Data — Note 1 — Description of Business, Accounting Policies, and Supplemental Disclosures.”Our Annual Report on Form 10-K for the year ended December 31, 2019 includes a discussion and analysis of our financial condition and results of operations for the year ended December 31, 2018 in Item 7 of Part II, “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”Effects of COVID-19The COVID-19 pandemic and resulting global disruptions have affected our businesses, as well as those of our customers, suppliers, and third-party sellers. To serve our customers while also providing for the safety of our employees and service providers, we have modified numerous aspects of our logistics, transportation, supply chain, purchasing, and third-party seller processes. Beginning in Q1 2020, we made numerous process updates across our operations worldwide, and adapted our fulfillment network, to implement employee and customer safety measures, such as enhanced cleaning and physical distancing, personal protective gear, disinfectant spraying, and temperature checks. Since February 2020, we have hired over 400,000 full-time and part-time employees to increase our fulfillment network capacity. We incurred approximately $4.0 billion in COVID-19 related costs in Q4 2020, for a total of more than $11.5 billion during 2020. We will continue to prioritize employee and customer safety and comply with evolving federal, state, and local standards as well as to implement standards or processes that we determine to be in the best interests of our employees, customers, and communities.20Table of ContentsCritical Accounting JudgmentsThe preparation of financial statements in conformity with generally accepted accounting principles of the United States (“GAAP”) requires estimates and assumptions that affect the reported amounts of assets and liabilities, revenues and expenses, and related disclosures of contingent liabilities in the consolidated financial statements and accompanying notes. The SEC has defined a company’s critical accounting policies as the ones that are most important to the portrayal of the company’s financial condition and results of operations, and which require the company to make its most difficult and subjective judgments, often as a result of the need to make estimates of matters that are inherently uncertain. Based on this definition, we have identified the critical accounting policies and judgments addressed below. We also have other key accounting policies, which involve the use of estimates, judgments, and assumptions that are significant to understanding our results. For additional information, see Item 8 of Part II, “Financial Statements and Supplementary Data — Note 1 — Description of Business, Accounting Policies, and Supplemental Disclosures.” Although we believe that our estimates, assumptions, and judgments are reasonable, they are based upon information presently available. Actual results may differ significantly from these estimates under different assumptions, judgments, or conditions.InventoriesInventories, consisting of products available for sale, are primarily accounted for using the first-in first-out method, and are valued at the lower of cost and net realizable value. This valuation requires us to make judgments, based on currently available information, about the likely method of disposition, such as through sales to individual customers, returns to product vendors, or liquidations, and expected recoverable values of each disposition category. These assumptions about future disposition of inventory are inherently uncertain and changes in our estimates and assumptions may cause us to realize material write-downs in the future. As a measure of sensitivity, for every 1% of additional inventory valuation allowance as of December 31, 2020, we would have recorded an additional cost of sales of approximately $270 million.In addition, we enter into supplier commitments for certain electronic device components and certain products. These commitments are based on forecasted customer demand. If we reduce these commitments, we may incur additional costs.Income TaxesWe are subject to income taxes in the U.S. (federal and state) and numerous foreign jurisdictions. Tax laws, regulations, administrative practices, principles, and interpretations in various jurisdictions may be subject to significant change, with or without notice, due to economic, political, and other conditions, and significant judgment is required in evaluating and estimating our provision and accruals for these taxes. There are many transactions that occur during the ordinary course of business for which the ultimate tax determination is uncertain. In addition, our actual and forecasted earnings are subject to change due to economic, political, and other conditions, such as the COVID-19 pandemic, and significant judgment is required in determining our ability to use our deferred tax assets. Our effective tax rates could be affected by numerous factors, such as changes in our business operations, acquisitions, investments, entry into new businesses and geographies, intercompany transactions, the relative amount of our foreign earnings, including earnings being lower than anticipated in jurisdictions where we have lower statutory rates and higher than anticipated in jurisdictions where we have higher statutory rates, losses incurred in jurisdictions for which we are not able to realize related tax benefits, the applicability of special tax regimes, changes in foreign currency exchange rates, changes in our stock price, changes to our forecasts of income and loss and the mix of jurisdictions to which they relate, changes in our deferred tax assets and liabilities and their valuation, changes in the laws, regulations, administrative practices, principles, and interpretations related to tax, including changes to the global tax framework, competition, and other laws and accounting rules in various jurisdictions. In addition, a number of countries have enacted or are actively pursuing changes to their tax laws applicable to corporate multinationals. We are also currently subject to tax controversies in various jurisdictions, and these jurisdictions may assess additional income tax liabilities against us. Developments in an audit, investigation, or other tax controversy could have a material effect on our operating results or cash flows in the period or periods for which that development occurs, as well as for prior and subsequent periods. We regularly assess the likelihood of an adverse outcome resulting from these proceedings to determine the adequacy of our tax accruals. Although we believe our tax estimates are reasonable, the final outcome of audits, investigations, and any other tax controversies could be materially different from our historical income tax provisions and accruals.21Table of ContentsLiquidity and Capital ResourcesCash flow information is as follows (in millions): Year Ended December 31, 20192020Cash provided by (used in):Operating activities$38,514 $66,064 Investing activities(24,281)(59,611)Financing activities(10,066)(1,104)Our principal sources of liquidity are cash flows generated from operations and our cash, cash equivalents, and marketable securities balances, which, at fair value, were $55.0 billion and $84.4 billion as of December 31, 2019 and 2020. Amounts held in foreign currencies were $15.3 billion and $23.5 billion as of December 31, 2019 and 2020, and were primarily Euros, British Pounds, and Japanese Yen.Cash provided by (used in) operating activities was $38.5 billion and $66.1 billion in 2019 and 2020. Our operating cash flows result primarily from cash received from our consumer, seller, developer, enterprise, and content creator customers, and advertisers, offset by cash payments we make for products and services, employee compensation, payment processing and related transaction costs, operating leases, and interest payments on our long-term obligations. Cash received from our customers and other activities generally corresponds to our net sales. Because consumers primarily use credit cards to buy from us, our receivables from consumers settle quickly. The increase in operating cash flow in 2020, compared to the prior year, was primarily due to the increase in net income, excluding non-cash expenses, and changes in working capital. Working capital at any specific point in time is subject to many variables, including variability in demand, inventory management and category expansion, the timing of cash receipts and payments, vendor payment terms, and fluctuations in foreign exchange rates.Cash provided by (used in) investing activities corresponds with cash capital expenditures, including leasehold improvements, incentives received from property and equipment vendors, proceeds from asset sales, cash outlays for acquisitions, investments in other companies and intellectual property rights, and purchases, sales, and maturities of marketable securities. Cash provided by (used in) investing activities was $(24.3) billion and $(59.6) billion in 2019 and 2020, with the variability caused primarily by our decision to purchase or lease property and equipment, and purchases, maturities, and sales of marketable securities. Cash capital expenditures were $12.7 billion, and $35.0 billion in 2019 and 2020, which primarily reflect investments in additional capacity to support our fulfillment operations and in support of continued business growth in technology infrastructure (the majority of which is to support AWS), which investments we expect to continue over time. We made cash payments, net of acquired cash, related to acquisition and other investment activity of $2.5 billion and $2.3 billion in 2019 and 2020.Cash provided by (used in) financing activities was $(10.1) billion and $(1.1) billion in 2019 and 2020. Cash inflows from financing activities resulted from proceeds of short-term debt, and other and long-term-debt of $2.3 billion and $17.3 billion in 2019 and 2020. Cash outflows from financing activities resulted from payments of short-term debt, and other, long-term debt, finance leases, and financing obligations of $12.3 billion and $18.4 billion in 2019 and 2020. Property and equipment acquired under finance leases was $13.7 billion and $11.6 billion in 2019 and 2020, reflecting investments in support of continued business growth primarily due to investments in technology infrastructure for AWS.We had no borrowings outstanding under the unsecured revolving credit facility (the “Credit Agreement”), $725 million of borrowings outstanding under the commercial paper program (the “Commercial Paper Program”), and $338 million of borrowings outstanding under our secured revolving credit facility (the “Credit Facility”) as of December 31, 2020. See Item 8 of Part II, “Financial Statements and Supplementary Data — Note 6 — Debt” for additional information. As of December 31, 2020, cash, cash equivalents, and marketable securities held by foreign subsidiaries were $17.2 billion. We intend to invest substantially all of our foreign subsidiary earnings, as well as our capital in our foreign subsidiaries, indefinitely outside of the U.S. in those jurisdictions in which we would incur significant, additional costs upon repatriation of such amounts. Tax benefits relating to excess stock-based compensation deductions and accelerated depreciation deductions are reducing our U.S. taxable income, and all remaining federal tax credits, which were primarily related to the U.S. federal research and development credit, reduced our federal tax liability in 2020. U.S. tax rules provide for enhanced accelerated depreciation deductions by allowing the election of full expensing of qualified property, primarily equipment, through 2022. Our federal tax provision included the election of full expensing of qualified property for 2018 and 2019 and a partial election for 2020. Cash taxes paid (net of refunds) were $881 million and $1.7 billion for 2019 and 2020. We endeavor to manage our global taxes on a cash basis, rather than on a financial reporting basis. In connection with the European Commission’s October 2017 decision against us on state aid, Luxembourg tax authorities computed an initial recovery amount, consistent with the 22Table of ContentsEuropean Commission’s decision, of approximately €250 million, that we deposited into escrow in March 2018, subject to adjustment pending conclusion of all appeals. As of December 31, 2019 and 2020, restricted cash, cash equivalents, and marketable securities were $321 million and $257 million. See Item 8 of Part II, “Financial Statements and Supplementary Data — Note 7 — Commitments and Contingencies” for additional discussion of our principal contractual commitments, as well as our pledged assets. Additionally, purchase obligations and open purchase orders, consisting of inventory and significant non-inventory commitments, were $26.6 billion as of December 31, 2020. These purchase obligations and open purchase orders are generally cancellable in full or in part through the contractual provisions.We believe that cash flows generated from operations and our cash, cash equivalents, and marketable securities balances, as well as our borrowing arrangements, will be sufficient to meet our anticipated operating cash needs for at least the next twelve months. However, any projections of future cash needs and cash flows are subject to substantial uncertainty. See Item 1A of Part I, “Risk Factors.” We continually evaluate opportunities to sell additional equity or debt securities, obtain credit facilities, obtain finance and operating lease arrangements, enter into financing obligations, repurchase common stock, pay dividends, or repurchase, refinance, or otherwise restructure our debt for strategic reasons or to further strengthen our financial position.The COVID-19 pandemic and resulting global disruptions have caused significant market volatility. These disruptions can contribute to defaults in our accounts receivable, affect asset valuations resulting in impairment charges, and affect the availability of lease and financing credit as well as other segments of the credit markets. We have utilized a range of financing methods to fund our operations and capital expenditures and expect to continue to maintain financing flexibility in the current market conditions. However, due to the rapidly evolving global situation, it is not possible to predict whether unanticipated consequences of the pandemic are reasonably likely to materially affect our liquidity and capital resources in the future.The sale of additional equity or convertible debt securities would be dilutive to our shareholders. In addition, we will, from time to time, consider the acquisition of, or investment in, complementary businesses, products, services, capital infrastructure, and technologies, which might affect our liquidity requirements or cause us to secure additional financing, or issue additional equity or debt securities. There can be no assurance that additional credit lines or financing instruments will be available in amounts or on terms acceptable to us, if at all.23Table of ContentsResults of OperationsWe have organized our operations into three segments: North America, International, and AWS. These segments reflect the way the Company evaluates its business performance and manages its operations. See Item 8 of Part II, “Financial Statements and Supplementary Data — Note 10 — Segment Information.” Effects of COVID-19As reflected in the discussion below, the impact of the COVID-19 pandemic and actions taken in response to it had varying effects on our 2020 results of operations. Higher net sales in the North America and International segments reflect increased demand, particularly as people are staying at home, including for household staples and other essential and home products, partially offset by fulfillment network capacity and supply chain constraints. Other effects in the North America and International segments include increased fulfillment costs and cost of sales as a percentage of net sales, primarily due to the impact of lower productivity, increased employee hiring and benefits, and costs to maintain safe workplaces.We expect the effects of fulfillment network capacity and supply chain constraints, elevated collection risk in our accounts receivable, and increased fulfillment costs and cost of sales as a percentage of net sales to continue into all or portions of Q1 2021. However, it is not possible to determine the duration and scope of the pandemic, including any recurrence, the actions taken in response to the pandemic, the scale and rate of economic recovery from the pandemic, any ongoing effects on consumer demand and spending patterns, or other impacts of the pandemic, and whether these or other currently unanticipated consequences of the pandemic are reasonably likely to materially affect our results of operations.24Table of ContentsNet SalesNet sales include product and service sales. Product sales represent revenue from the sale of products and related shipping fees and digital media content where we record revenue gross. Service sales primarily represent third-party seller fees, which includes commissions and any related fulfillment and shipping fees, AWS sales, advertising services, Amazon Prime membership fees, and certain digital content subscriptions. Net sales information is as follows (in millions): Year Ended December 31, 20192020Net Sales:North America$170,773 $236,282 International74,723 104,412 AWS35,026 45,370 Consolidated$280,522 $386,064 Year-over-year Percentage Growth:North America21 %38 %International13 40 AWS37 30 Consolidated20 38 Year-over-year Percentage Growth, excluding the effect of foreign exchange rates:North America21 %38 %International17 38 AWS37 30 Consolidated22 37 Net sales mix:North America61 %61 %International27 27 AWS12 12 Consolidated100 %100 %Sales increased 38% in 2020, compared to the prior year. Changes in foreign currency exchange rates impacted net sales by $(2.6) billion and $1.4 billion for 2019 and 2020. For a discussion of the effect of foreign exchange rates on sales growth, see “Effect of Foreign Exchange Rates” below.North America sales increased 38% in 2020, compared to the prior year. The sales growth primarily reflects increased unit sales, including sales by third-party sellers. Increased unit sales were driven largely by our continued efforts to reduce prices for our customers, including from our shipping offers, and increased demand, including for household staples and other essential and home products, partially offset by fulfillment network capacity and supply chain constraints.International sales increased 40% in 2020, compared to the prior year. The sales growth primarily reflects increased unit sales, including sales by third-party sellers. Increased unit sales were driven largely by our continued efforts to reduce prices for our customers, including from our shipping offers, and increased demand, including for household staples and other essential and home products, partially offset by fulfillment network capacity and supply chain constraints. Changes in foreign currency exchange rates impacted International net sales by $(2.4) billion and $1.7 billion in 2019 and 2020.AWS sales increased 30% in 2020, compared to the prior year. The sales growth primarily reflects increased customer usage, partially offset by pricing changes. Pricing changes were driven largely by our continued efforts to reduce prices for our customers. 25Table of ContentsOperating Income (Loss) Operating income (loss) by segment is as follows (in millions):Year Ended December 31,20192020Operating Income (Loss):North America$7,033 $8,651 International(1,693)717 AWS9,201 13,531 Consolidated$14,541 $22,899 Operating income was $14.5 billion and $22.9 billion for 2019 and 2020. We believe that operating income (loss) is a more meaningful measure than gross profit and gross margin due to the diversity of our product categories and services.The increase in North America operating income in absolute dollars in 2020, compared to the prior year, is primarily due to increased unit sales, including sales by third-party sellers, and advertising sales and slower growth in certain operating expenses, partially offset by increased shipping and fulfillment costs due in part to COVID-19. We expect North America operating income to continue to be negatively impacted through at least Q1 2021 by COVID-19 related costs. Changes in foreign exchange rates impacted operating income by $23 million and $8 million for 2019 and 2020.The International operating income in 2020, as compared to the operating loss in the prior year, is primarily due to increased unit sales, including sales by third-party sellers, and advertising sales, and slower growth in certain operating expenses, partially offset by increased shipping and fulfillment costs due in part to COVID-19. We expect International operating income to continue to be negatively impacted through at least Q1 2021 by COVID-19 related costs. Changes in foreign exchange rates impacted operating income (loss) by $(116) million and $411 million for 2019 and 2020. The increase in AWS operating income in absolute dollars in 2020, compared to the prior year, is primarily due to increased customer usage and cost structure productivity, including a reduction in depreciation and amortization expense from our change in the estimated useful life of our servers, partially offset by increased payroll and related expenses and spending on technology infrastructure, both of which were primarily driven by additional investments to support the business growth, and reduced prices for our customers. Changes in foreign exchange rates impacted operating income by $273 million and $30 million for 2019 and 2020.26Table of ContentsOperating ExpensesInformation about operating expenses is as follows (in millions): Year Ended December 31, 20192020Operating expenses:Cost of sales$165,536 $233,307 Fulfillment40,232 58,517 Technology and content35,931 42,740 Marketing18,878 22,008 General and administrative5,203 6,668 Other operating expense (income), net201 (75)Total operating expenses$265,981 $363,165 Year-over-year Percentage Growth:Cost of sales19 %41 %Fulfillment18 45 Technology and content25 19 Marketing37 17 General and administrative20 28 Other operating expense (income), net(32)(137)Percent of Net Sales:Cost of sales59.0 %60.4 %Fulfillment14.3 15.2 Technology and content12.8 11.1 Marketing6.7 5.7 General and administrative1.9 1.7 Other operating expense (income), net0.1 — Cost of SalesCost of sales primarily consists of the purchase price of consumer products, inbound and outbound shipping costs, including costs related to sortation and delivery centers and where we are the transportation service provider, and digital media content costs where we record revenue gross, including video and music.The increase in cost of sales in absolute dollars in 2020, compared to the prior year, is primarily due to increased product and shipping costs resulting from increased sales. We expect cost of sales as a percentage of net sales to continue to be negatively impacted through at least Q1 2021 by COVID-19 related costs.Shipping costs to receive products from our suppliers are included in our inventory and recognized as cost of sales upon sale of products to our customers. Shipping costs, which include sortation and delivery centers and transportation costs, were $37.9 billion and $61.1 billion in 2019 and 2020. We expect our cost of shipping to continue to increase to the extent our customers accept and use our shipping offers at an increasing rate, we use more expensive shipping methods, including faster delivery, and we offer additional services. We seek to mitigate costs of shipping over time in part through achieving higher sales volumes, optimizing our fulfillment network, negotiating better terms with our suppliers, and achieving better operating efficiencies. We believe that offering low prices to our customers is fundamental to our future success, and one way we offer lower prices is through shipping offers.Costs to operate our AWS segment are primarily classified as “Technology and content” as we leverage a shared infrastructure that supports both our internal technology requirements and external sales to AWS customers.27Table of ContentsFulfillmentFulfillment costs primarily consist of those costs incurred in operating and staffing our North America and International fulfillment centers, physical stores, and customer service centers and payment processing costs. While AWS payment processing and related transaction costs are included in “Fulfillment,” AWS costs are primarily classified as “Technology and content.” Fulfillment costs as a percentage of net sales may vary due to several factors, such as payment processing and related transaction costs, our level of productivity and accuracy, changes in volume, size, and weight of units received and fulfilled, the extent to which third party sellers utilize Fulfillment by Amazon services, timing of fulfillment network and physical store expansion, the extent we utilize fulfillment services provided by third parties, mix of products and services sold, and our ability to affect customer service contacts per unit by implementing improvements in our operations and enhancements to our customer self-service features. Additionally, sales by our sellers have higher payment processing and related transaction costs as a percentage of net sales compared to our retail sales because payment processing costs are based on the gross purchase price of underlying transactions.The increase in fulfillment costs in absolute dollars in 2020, compared to the prior year, is primarily due to variable costs corresponding with increased product and service sales volume and inventory levels, costs from expanding our fulfillment network, and the COVID-19 related impact of lower productivity, increased employee hiring and benefits, and costs to maintain safe workplaces. We expect fulfillment costs as a percentage of net sales to continue to be negatively impacted through at least Q1 2021 by COVID-19 related costs.We seek to expand our fulfillment network to accommodate a greater selection and in-stock inventory levels and to meet anticipated shipment volumes from sales of our own products as well as sales by third parties for which we provide the fulfillment services. We regularly evaluate our facility requirements.Technology and ContentTechnology and content costs include payroll and related expenses for employees involved in the research and development of new and existing products and services, development, design, and maintenance of our stores, curation and display of products and services made available in our online stores, and infrastructure costs. Infrastructure costs include servers, networking equipment, and data center related depreciation and amortization, rent, utilities, and other expenses necessary to support AWS and other Amazon businesses. Collectively, these costs reflect the investments we make in order to offer a wide variety of products and services to our customers.We seek to invest efficiently in numerous areas of technology and content so we may continue to enhance the customer experience and improve our process efficiency through rapid technology developments, while operating at an ever increasing scale. Our technology and content investment and capital spending projects often support a variety of product and service offerings due to geographic expansion and the cross-functionality of our systems and operations. We expect spending in technology and content to increase over time as we continue to add employees and technology infrastructure. These costs are allocated to segments based on usage. The increase in technology and content costs in absolute dollars in 2020, compared to the prior year, is primarily due to increased payroll and related costs associated with technical teams responsible for expanding our existing products and services and initiatives to introduce new products and service offerings and an increase in spending on technology infrastructure, offset by a reduction in depreciation and amortization expense from our change in the estimated useful life of our servers. See Item 8 of Part II, “Financial Statements and Supplementary Data — Note 1 — Description of Business, Accounting Policies, and Supplemental Disclosures — Use of Estimates” for additional information on our change in estimated useful life of our servers.MarketingMarketing costs include advertising and payroll and related expenses for personnel engaged in marketing and selling activities, including sales commissions related to AWS. We direct customers to our stores primarily through a number of marketing channels, such as our sponsored search, third party customer referrals, social and online advertising, television advertising, and other initiatives. Our marketing costs are largely variable, based on growth in sales and changes in rates. To the extent there is increased or decreased competition for these traffic sources, or to the extent our mix of these channels shifts, we would expect to see a corresponding change in our marketing costs.The increase in marketing costs in absolute dollars in 2020, compared to the prior year, is primarily due to increased payroll and related expenses for personnel engaged in marketing and selling activities, partially offset by lower spending on marketing channels as a result of COVID-19.While costs associated with Amazon Prime membership benefits and other shipping offers are not included in marketing expense, we view these offers as effective worldwide marketing tools, and intend to continue offering them indefinitely.28Table of ContentsGeneral and AdministrativeThe increase in general and administrative costs in absolute dollars in 2020, compared to the prior year, is primarily due to increases in payroll and related expenses and professional service fees.Other Operating Expense (Income), NetOther operating expense (income), net was $201 million and $(75) million during 2019 and 2020, and was primarily related to a benefit from accelerated vesting of warrants to acquire equity of a vendor in Q4 2020, offset by a lease impairment in Q2 2020 and the amortization of intangible assets.Interest Income and ExpenseOur interest income was $832 million and $555 million during 2019 and 2020. We generally invest our excess cash in AAA-rated money market funds and investment grade short- to intermediate-term fixed income securities. Our interest income corresponds with the average balance of invested funds based on the prevailing rates, which vary depending on the geographies and currencies in which they are invested.Interest expense was $1.6 billion in 2019 and 2020 and was primarily related to debt and finance leases.Our long-term lease liabilities were $39.8 billion and $52.6 billion as of December 31, 2019 and 2020. Our long-term debt was $23.4 billion and $31.8 billion as of December 31, 2019 and 2020. See Item 8 of Part II, “Financial Statements and Supplementary Data — Note 4 — Leases and Note 6 — Debt” for additional information.Other Income (Expense), NetOther income (expense), net was $203 million and $2.4 billion during 2019 and 2020. The primary components of other income (expense), net are related to equity warrant valuations, equity securities valuations and adjustments, and foreign currency.Income TaxesOur effective tax rate is subject to significant variation due to several factors, including variability in our pre-tax and taxable income and loss and the mix of jurisdictions to which they relate, intercompany transactions, the applicability of special tax regimes, changes in how we do business, acquisitions, investments, audit-related developments, changes in our stock price, changes in our deferred tax assets and liabilities and their valuation, foreign currency gains (losses), changes in statutes, regulations, case law, and administrative practices, principles, and interpretations related to tax, including changes to the global tax framework, competition, and other laws and accounting rules in various jurisdictions, and relative changes of expenses or losses for which tax benefits are not recognized. Our effective tax rate can be more or less volatile based on the amount of pre-tax income or loss. For example, the impact of discrete items and non-deductible expenses on our effective tax rate is greater when our pre-tax income is lower. In addition, we record valuation allowances against deferred tax assets when there is uncertainty about our ability to generate future income in relevant jurisdictions, and the effects of the COVID-19 pandemic on our business make estimates of future income more challenging. We recorded a provision for income taxes of $2.4 billion and $2.9 billion in 2019 and 2020. See Item 8 of Part II, “Financial Statements and Supplementary Data — Note 9 — Income Taxes” for additional information.Non-GAAP Financial MeasuresRegulation G, Conditions for Use of Non-GAAP Financial Measures, and other SEC regulations define and prescribe the conditions for use of certain non-GAAP financial information. Our measures of free cash flows and the effect of foreign exchange rates on our consolidated statements of operations meet the definition of non-GAAP financial measures. We provide multiple measures of free cash flows because we believe these measures provide additional perspective on the impact of acquiring property and equipment with cash and through finance leases and financing obligations.29Table of ContentsFree Cash FlowFree cash flow is cash flow from operations reduced by “Purchases of property and equipment, net of proceeds from sales and incentives.” The following is a reconciliation of free cash flow to the most comparable GAAP cash flow measure, “Net cash provided by (used in) operating activities,” for 2019 and 2020 (in millions): Year Ended December 31, 20192020Net cash provided by (used in) operating activities$38,514 $66,064 Purchases of property and equipment, net of proceeds from sales and incentives(12,689)(35,044)Free cash flow$25,825 $31,020 Net cash provided by (used in) investing activities$(24,281)$(59,611)Net cash provided by (used in) financing activities$(10,066)$(1,104)Free Cash Flow Less Principal Repayments of Finance Leases and Financing ObligationsFree cash flow less principal repayments of finance leases and financing obligations is free cash flow reduced by “Principal repayments of finance leases” and “Principal repayments of financing obligations.” Principal repayments of finance leases and financing obligations approximates the actual payments of cash for our finance leases and financing obligations. The following is a reconciliation of free cash flow less principal repayments of finance leases and financing obligations to the most comparable GAAP cash flow measure, “Net cash provided by (used in) operating activities,” for 2019 and 2020 (in millions): Year Ended December 31, 20192020Net cash provided by (used in) operating activities$38,514 $66,064 Purchases of property and equipment, net of proceeds from sales and incentives(12,689)(35,044)Free cash flow25,825 31,020 Principal repayments of finance leases(9,628)(10,642)Principal repayments of financing obligations(27)(53)Free cash flow less principal repayments of finance leases and financing obligations$16,170 $20,325 Net cash provided by (used in) investing activities$(24,281)$(59,611)Net cash provided by (used in) financing activities$(10,066)$(1,104)30Table of ContentsFree Cash Flow Less Equipment Finance Leases and Principal Repayments of All Other Finance Leases and Financing Obligations Free cash flow less equipment finance leases and principal repayments of all other finance leases and financing obligations is free cash flow reduced by equipment acquired under finance leases, which is included in “Property and equipment acquired under finance leases,” principal repayments of all other finance lease liabilities, which is included in “Principal repayments of finance leases,” and “Principal repayments of financing obligations.” All other finance lease liabilities and financing obligations consists of property. In this measure, equipment acquired under finance leases is reflected as if these assets had been purchased with cash, which is not the case as these assets have been leased. The following is a reconciliation of free cash flow less equipment finance leases and principal repayments of all other finance leases and financing obligations to the most comparable GAAP cash flow measure, “Net cash provided by (used in) operating activities,” for 2019 and 2020 (in millions): Year Ended December 31, 20192020Net cash provided by (used in) operating activities$38,514 $66,064 Purchases of property and equipment, net of proceeds from sales and incentives(12,689)(35,044)Free cash flow25,825 31,020 Equipment acquired under finance leases (1)(12,916)(9,104)Principal repayments of all other finance leases (2)(392)(427)Principal repayments of financing obligations(27)(53)Free cash flow less equipment finance leases and principal repayments of all other finance leases and financing obligations$12,490 $21,436 Net cash provided by (used in) investing activities$(24,281)$(59,611)Net cash provided by (used in) financing activities$(10,066)$(1,104)___________________(1)For the year ended December 31, 2019 and 2020, this amount relates to equipment included in “Property and equipment acquired under finance leases” of $13,723 million and $11,588 million. (2)For the year ended December 31, 2019 and 2020, this amount relates to property included in “Principal repayments of finance leases” of $9,628 million and $10,642 million. All of these free cash flows measures have limitations as they omit certain components of the overall cash flow statement and do not represent the residual cash flow available for discretionary expenditures. For example, these measures of free cash flows do not incorporate the portion of payments representing principal reductions of debt or cash payments for business acquisitions. Additionally, our mix of property and equipment acquisitions with cash or other financing options may change over time. Therefore, we believe it is important to view free cash flows measures only as a complement to our entire consolidated statements of cash flows.31Table of ContentsEffect of Foreign Exchange RatesInformation regarding the effect of foreign exchange rates, versus the U.S. Dollar, on our net sales, operating expenses, and operating income is provided to show reported period operating results had the foreign exchange rates remained the same as those in effect in the comparable prior year periods. The effect on our net sales, operating expenses, and operating income from changes in our foreign exchange rates versus the U.S. Dollar is as follows (in millions): Year Ended December 31, 2019Year Ended December 31, 2020 AsReportedExchangeRateEffect (1)At PriorYearRates (2)AsReportedExchangeRateEffect (1)At PriorYearRates (2)Net sales$280,522 $2,560 $283,082 $386,064 $(1,438)$384,626 Operating expenses265,981 2,740 268,721 363,165 (989)362,176 Operating income14,541 (180)14,361 22,899 (449)22,450 ___________________(1)Represents the change in reported amounts resulting from changes in foreign exchange rates from those in effect in the comparable prior year period for operating results.(2)Represents the outcome that would have resulted had foreign exchange rates in the reported period been the same as those in effect in the comparable prior year period for operating results.GuidanceWe provided guidance on February 2, 2021, in our earnings release furnished on Form 8-K as set forth below. These forward-looking statements reflect Amazon.com’s expectations as of February 2, 2021, and are subject to substantial uncertainty. Our results are inherently unpredictable and may be materially affected by many factors, such as fluctuations in foreign exchange rates, changes in global economic conditions and customer spending, world events, the rate of growth of the Internet, online commerce, and cloud services, as well as those outlined in Item 1A of Part I, “Risk Factors.” This guidance reflects our estimates as of February 2, 2021 regarding the impact of the COVID-19 pandemic on our operations, including those discussed above, and is highly dependent on numerous factors that we may not be able to predict or control, including: the duration and scope of the pandemic, including any recurrence; actions taken by governments, businesses, and individuals in response to the pandemic; the impact of the pandemic on global and regional economies and economic activity, workforce staffing and productivity, and our significant and continuing spending on employee safety measures; our ability to continue operations in affected areas; and consumer demand and spending patterns, as well as the effects on suppliers, creditors, and third-party sellers, all of which are uncertain. This guidance also assumes the impacts on consumer demand and spending patterns, including impacts due to concerns over the current economic outlook, will be in line with those experienced during the first quarter of 2021 to date, and the additional assumptions set forth below. However, it is not possible to determine the ultimate impact on our operations for the first quarter of 2021, or whether other currently unanticipated direct or indirect consequences of the pandemic are reasonably likely to materially affect our operations.First Quarter 2021 Guidance•Net sales are expected to be between $100.0 billion and $106.0 billion, or to grow between 33% and 40% compared with first quarter 2020. This guidance anticipates a favorable impact of approximately 300 basis points from foreign exchange rates. •Operating income is expected to be between $3.0 billion and $6.5 billion, compared with $4.0 billion in first quarter 2020. This guidance assumes approximately $2.0 billion of costs related to COVID-19. •This guidance assumes, among other things, that no additional business acquisitions, investments, restructurings, or legal settlements are concluded.32Table of Contents Item 7A.Quantitative and Qualitative Disclosures About Market RiskWe are exposed to market risk for the effect of interest rate changes, foreign currency fluctuations, and changes in the market values of our investments. Information relating to quantitative and qualitative disclosures about market risk is set forth below and in Item 7 of Part II, “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Liquidity and Capital Resources.”Interest Rate RiskOur exposure to market risk for changes in interest rates relates primarily to our investment portfolio and our long-term debt. Our long-term debt is carried at amortized cost and fluctuations in interest rates do not impact our consolidated financial statements. However, the fair value of our debt, which pays interest at a fixed rate, will generally fluctuate with movements of interest rates, increasing in periods of declining rates of interest and declining in periods of increasing rates of interest. We generally invest our excess cash in AAA-rated money market funds and investment grade short- to intermediate-term fixed income securities. Fixed income securities may have their fair market value adversely affected due to a rise in interest rates, and we may suffer losses in principal if forced to sell securities that have declined in market value due to changes in interest rates. The following table provides information about our cash equivalents and marketable fixed income securities, including principal cash flows by expected maturity and the related weighted-average interest rates as of December 31, 2020 (in millions, except percentages): 20212022202320242025ThereafterTotalEstimated Fair Value as of December 31, 2020Money market funds$27,430 $— $— $— $— $— $27,430 $27,430 Weighted average interest rate(0.16)%— %— %— %— %— %(0.16)%Corporate debt securities16,505 4,459 5,531 1,990 886 — 29,371 29,988 Weighted average interest rate0.42 %1.65 %1.32 %1.86 %1.84 % 0.92 %U.S. government and agency securities5,439 587 899 298 67 71 7,361 7,439 Weighted average interest rate0.30 %1.38 %1.12 %1.74 %1.13 %2.97 %0.58 %Asset-backed securities870 773 472 763 243 46 3,167 3,235 Weighted average interest rate2.08 %2.00 %1.53 %2.13 %1.57 %1.25 %1.94 %Foreign government and agency securities4,932 147 45 3 — — 5,127 5,131 Weighted average interest rate0.25 %0.74 %1.28 %1.76 %— %— %0.28 %Other fixed income securities109 156 230 160 43 — 698 710 Weighted average interest rate2.10 %1.85 %1.10 %0.84 %1.31 %— %1.38 %$55,285 $6,122 $7,177 $3,214 $1,239 $117 $73,154 Cash equivalents and marketable fixed income securities$73,933 As of December 31, 2020, we had long-term debt with a face value of $33.2 billion, including the current portion, primarily consisting of fixed rate unsecured senior notes. See Item 8 of Part II, “Financial Statements and Supplementary Data — Note 6 — Debt” for additional information.Foreign Exchange RiskDuring 2020, net sales from our International segment accounted for 27% of our consolidated revenues. Net sales and related expenses generated from our internationally-focused stores, including within Canada and Mexico (which are included in our North America segment), are primarily denominated in the functional currencies of the corresponding stores and primarily include Euros, British Pounds, and Japanese Yen. The results of operations of, and certain of our intercompany balances associated with, our internationally-focused stores and AWS are exposed to foreign exchange rate fluctuations. Upon consolidation, as foreign exchange rates vary, net sales and other operating results may differ materially from expectations, and we may record significant gains or losses on the remeasurement of intercompany balances. For example, as a result of fluctuations in foreign exchange rates throughout the year compared to rates in effect the prior year, International segment net sales increased by $1.7 billion in comparison with the prior year.33Table of ContentsWe have foreign exchange risk related to foreign-denominated cash, cash equivalents, and marketable securities (“foreign funds”). Based on the balance of foreign funds as of December 31, 2020, of $23.5 billion, an assumed 5%, 10%, and 20% adverse change to foreign exchange would result in fair value declines of $1.2 billion, $2.4 billion, and $4.7 billion. Fluctuations in fair value are recorded in “Accumulated other comprehensive income (loss),” a separate component of stockholders’ equity. Equity securities with readily determinable fair values are included in “Marketable securities” on our consolidated balance sheets and are measured at fair value with changes recognized in net income.We have foreign exchange risk related to our intercompany balances denominated in various foreign currencies. Based on the intercompany balances as of December 31, 2020, an assumed 5%, 10%, and 20% adverse change to foreign exchange rates would result in losses of $245 million, $485 million, and $970 million, recorded to “Other income (expense), net.”See Item 7 of Part II, “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Results of Operations — Effect of Foreign Exchange Rates” for additional information on the effect on reported results of changes in foreign exchange rates.Equity Investment RiskAs of December 31, 2020, our recorded value in equity and equity warrant investments in public and private companies was $6.9 billion. Our equity and equity warrant investments in publicly traded companies represent $3.2 billion of our investments as of December 31, 2020, and are recorded at fair value, which is subject to market price volatility. We assess our equity investments in private companies for impairment. Valuations of private companies are inherently more complex due to the lack of readily available market data. The current global economic climate provides additional uncertainty. As such, we believe that market sensitivities are not practicable.34Table of Contents
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+ITEM 7.MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSAmeren, headquartered in St. Louis, Missouri, is a public utility holding company whose primary assets are its equity interests in its subsidiaries. Ameren’s subsidiaries are separate, independent legal entities with separate businesses, assets, and liabilities. Dividends on Ameren’s common stock and the payment of expenses by Ameren depend on distributions made to it by its subsidiaries.Below is a summary description of Ameren’s principal subsidiaries – Ameren Missouri, Ameren Illinois, and ATXI. Ameren also has other subsidiaries that conduct other activities, such as providing shared services. A more detailed description can be found in Note 1 – Summary of Significant Accounting Policies under Part II, Item 8, of this report.•Ameren Missouri operates a rate-regulated electric generation, transmission, and distribution business and a rate-regulated natural gas distribution business in Missouri.•Ameren Illinois operates rate-regulated electric transmission, electric distribution, and natural gas distribution businesses in Illinois.•ATXI operates a FERC rate-regulated electric transmission business in the MISO.Ameren has four segments: Ameren Missouri, Ameren Illinois Electric Distribution, Ameren Illinois Natural Gas, and Ameren Transmission. The Ameren Missouri segment includes all of the operations of Ameren Missouri. Ameren Illinois Electric Distribution consists of the electric distribution business of Ameren Illinois. Ameren Illinois Natural Gas consists of the natural gas business of Ameren Illinois. Ameren Transmission primarily consists of the aggregated electric transmission businesses of Ameren Illinois and ATXI. See Note 16 – Segment Information under Part II, Item 8, of this report for further discussion of Ameren’s and Ameren Illinois’ segments.Ameren’s financial statements are prepared on a consolidated basis and therefore include the accounts of its majority-owned subsidiaries. All intercompany transactions have been eliminated, except as disclosed in Note 13 – Related-party Transactions under Part II, Item 8, of this report. Ameren Missouri and Ameren Illinois have no subsidiaries. All tabular and graphical dollar amounts are in millions, unless otherwise indicated.The following discussion should be read in conjunction with the financial statements contained in this Form 10-K. We intend for this discussion to provide the reader with information that will assist in understanding our financial statements, the changes in certain key items in those financial statements, and the primary factors that accounted for those changes, as well as how certain accounting principles affect our financial statements. The discussion also provides information about the financial results of our business segments to provide a better understanding of how those segments and their results affect the financial condition and results of operations of Ameren as a whole. Discussion regarding our financial condition and results of operations for the year ended December 31, 2018, including comparisons with the year ended December 31, 2019, is included in Item 7 of our Form 10-K for the year ended December 31, 2019, filed with the SEC on February 28, 2020.In addition to presenting results of operations and earnings amounts in total, we present certain information in cents per share. These amounts reflect factors that directly affect Ameren’s earnings. We believe this per share information helps readers to understand the impact of these factors on Ameren’s earnings per share.34Table of ContentsOVERVIEWOur core strategy is driven by the following three pillars:Investing in and operating our utilities in a manner consistent with existing regulatory frameworksEnhancing regulatory frameworks and advocating for responsible energy and economic policiesCreating and capitalizing on opportunities for investment for the benefit of our customers and shareholdersWe seek to earn competitive returns on investments in our businesses. Accordingly, we remain focused on disciplined cost management and strategic capital allocation. We align our overall spending, both operating and capital, with economic conditions and with the frameworks established by our regulators, to create and capitalize on investment opportunities for the benefit of our customers and shareholders. We focus on minimizing the gap between allowed and earned ROEs and allocating capital resources to business opportunities that we expect will provide the most benefit to our customers and offer the most attractive risk-adjusted return potential.We seek to partner with our stakeholders, including our customers, regulators, federal and state legislators, and RTOs, to enhance our regulatory frameworks and advocate for responsible energy and economic policies for the benefit of our customers and shareholders. We believe constructive regulatory frameworks for investment exist at all of our business segments. Accordingly, we expect to earn competitive returns on investments in our businesses and realize timely recovery of our costs in the coming years with the benefits accruing to both customers and shareholders.We seek to make prudent investments that benefit our customers. The goal of these investments is to maintain and enhance the reliability of our services, develop cleaner sources of energy, create economic development opportunities in our region, and provide customers with more options and greater control over their energy usage, among other things. By prudently investing in our businesses, we believe that we deliver superior value to both customers and shareholders.Customer Rates, (¢/KWH)(e)Rate Base ($ in billions)(a)Constructive Regulatory Frameworks(c)TSR 2015-2020(f)SegmentRegulatory FrameworkAmerenTransmissionFormula ratemakingAllowed ROE is 10.52%Ameren IllinoisNatural GasFuture test year ratemaking and QIP, PGA, VBAAllowed ROE is 9.67%Ameren IllinoisElectric DistributionFormula ratemakingAllowed ROE is 30-year U.S. Treasury + 5.8%AmerenMissouriHistorical test year ratemaking andPISA, RESRAM, FAC, MEEIAAllowed ROE is 9.4% - 9.8%(d)(a) Reflects year-end rate base except for Ameren Transmission, which is average rate base.(b) Compound annual growth rate.(c) As of January 2021.(d) Allowed ROE applicable to electric service.(e) Average residential electric prices. Source: Edison Electric Institute, “Typical Bills and Average Rates Report” for the 12 months ended June 30, 2020.(f) Ameren management cautions that the stock price performance shown above should not be considered indicative of future stock price performance.Key announcements, updates, and regulatory outcomesThe COVID-19 pandemic continues to be a constantly evolving situation. In 2020, we experienced a net decrease in our sales volumes, an increase in our accounts receivable balances that were past due or that were a part of a deferred payment arrangement, and a decline in our cash collections from customers. The continued effect of the COVID-19 pandemic on our results of operations, financial position, and liquidity in subsequent periods will depend on its severity and longevity, future regulatory or legislative actions with respect thereto, and the resulting impact on business, economic, and capital market conditions. Shelter-in-place orders began taking effect in our service territories in mid-March 2020. These orders generally required individuals to remain at home and precluded or limited the operation of businesses that were deemed nonessential. In early 2020, Ameren began implementing its business continuity plans, and continues to take measures to mitigate the risk of COVID-19 transmission. Actions included restricting travel for employees, implementing work-from-home policies, securing and supplying personal protective equipment, and implementing work practices to protect the safety of our employees and customers. While our business operations were deemed essential and were not directly impacted by the shelter-in-place orders, approximately 65% of our workforce transitioned to remote working arrangements in mid-March 2020. In order to work more effectively in certain areas, a portion of our workforce returned to our work locations in early June 2020 under a phased approach, and, as of the date of this filing, approximately 50% of our workforce continues to work remotely. In mid-May 2020, shelter-in-place orders effective in our service territories began to be relaxed, with fewer restrictions on social activities and nonessential businesses beginning to reopen. However, certain 35Table of Contentsrestrictions remain in place that limit individual activities and the operation of nonessential businesses. Additional restrictions may be imposed in the future. We continue to assess the impacts the pandemic is having on our businesses, including impacts on electric and natural gas sales volumes, liquidity, and bad debt expense, among other things. For further discussion of these and other matters, see Note 1 – Summary of Significant Accounting Policies and Note 2 – Rate and Regulatory Matters under Part II, Item 8, of this report, and Results of Operations, Liquidity and Capital Resources, and Outlook sections below. In addition, for information regarding Ameren Missouri’s and Ameren Illinois’ suspensions and reinstatement of customer disconnection activities and late fee charges for nonpayment, see Note 2 – Rate and Regulatory Matters under Part II, Item 8, of this report.In February 2020, the MoPSC issued an order approving a stipulation and agreement allowing Ameren Missouri to defer and amortize maintenance expenses related to scheduled refueling and maintenance outages at its Callaway Energy Center. Maintenance expenses associated with the fall 2020 refueling and maintenance outage were deferred as a regulatory asset. Amortization of those expenses began in January 2021, and will be amortized until the completion of the next refueling and maintenance outage. During its return to full power after the completion of the last refueling and maintenance outage in late December 2020, the Callaway Energy Center experienced a non-nuclear operating issue related to its generator. A thorough investigation of this matter was conducted. Work has begun to replace certain key components of the generator in order to return the energy center to service. Ameren Missouri expects generator repairs of $65 million, which are expected to be largely capital expenditures. Due to the long lead time for the manufacture, repair, and installation of the components, the energy center is expected to return to service in late June or early July 2021. See Note 9 – Callaway Energy Center under Part II, Item 8, of this report for additional information.In March 2020, the MoPSC issued an order in Ameren Missouri’s July 2019 electric service regulatory rate review, approving nonunanimous stipulation and agreements. The order resulted in a decrease of $32 million to Ameren Missouri’s annual revenue requirement for electric retail service, which reflected infrastructure investments as of December 31, 2019. The order also provided for the continued use of the FAC and trackers for pension and postretirement benefits, uncertain income tax positions, and certain excess deferred income taxes that the MoPSC previously authorized in earlier electric rate orders. In addition, the order required Ameren Missouri to donate $8 million to low-income assistance programs, which was reflected in results of operations in the first quarter of 2020. The new rates became effective on April 1, 2020.In August 2020, the MoPSC issued an order approving a unanimous stipulation and agreement with respect to the 2022 program year of Ameren Missouri’s six-year MEEIA 2019 program and related performance incentives. The order also approved Ameren Missouri’s energy savings results for the first year of the MEEIA 2019 program. As a result of this order and in accordance with revenue recognition guidance, Ameren Missouri recognized revenues of $6 million in the third quarter of 2020.In September 2020, Ameren Missouri filed its 2020 IRP with the MoPSC. In connection with the 2020 IRP filing, Ameren established a goal of achieving net-zero carbon emissions by 2050. Ameren is also targeting a 50% CO2 emission reduction by 2030 and an 85% reduction by 2040 from the 2005 level. The plan, which is subject to review by the MoPSC for compliance with Missouri law, targets cleaner and more diverse sources of energy generation, including solar, wind, hydro, and nuclear power, and supports increased investment in new energy technologies. It also includes expanding renewable sources by adding 3,100 MWs of renewable generation by the end of 2030 and a total of 5,400 MWs of renewable generation by 2040. These amounts include the 700 MWs of wind generation projects discussed below, which will support Ameren Missouri’s compliance with the state of Missouri’s requirement of achieving 15% of native load sales from renewable energy sources beginning in 2021. The plan also includes advancing the retirement dates of the Sioux and Rush Island coal-fired energy centers to 2028 and 2039, respectively, which are subject to the approval of a change in the assets’ depreciable lives by the MoPSC in a future regulatory rate review, the continued implementation of customer energy-efficiency programs, and the expectation that Ameren Missouri will seek NRC approval for an extension of the operating license for the Callaway Energy Center beyond its current 2044 expiration date. Additionally, the plan includes retiring the Meramec and Labadie coal-fired energy centers at the end of their useful lives (by 2022 and 2042, respectively).In October 2020, Ameren Missouri filed requests with the MoPSC for accounting authority orders related to its electric and natural gas services. If issued as requested, the orders would allow Ameren Missouri to accumulate certain costs incurred related to the COVID-19 pandemic, including bad debt write-offs, net of cost savings, as well as forgone customer late fee and reconnection fee revenues, for a specified time period, for potential recovery in future electric and natural gas service regulatory rate reviews. Costs incurred, net of savings, and forgone customer late fee and reconnection fee revenues related to the COVID-19 pandemic from March 2020 through December 2020 were immaterial. The MoPSC is under no deadline to issue orders, and Ameren Missouri cannot predict the ultimate outcome of these regulatory proceedings.In December 2020, Ameren Missouri acquired a 400-MW wind generation project located in northeastern Missouri for approximately $615 million, and placed the assets in service as the High Prairie Renewable Energy Center. In January 2021, Ameren Missouri acquired an up-to 300-MW wind generation project located in northwestern Missouri. At the date of this filing, Ameren Missouri placed 120 MWs in service as the Atchison Renewable Energy Center, with a purchase price of approximately $200 million. There have been changes to the schedule 36Table of Contentsfor this project, particularly as a result of component delivery delays. Ameren Missouri expects approximately 150 MWs of the up-to 300-MW project to be in service by the end of the first quarter of 2021, and the remaining portion to be in service later in 2021.In February 2021, Ameren Missouri filed an update to its Smart Energy Plan with the MoPSC, which includes a five-year capital investment overview with a detailed one-year plan for 2021. The plan is designed to upgrade Ameren Missouri’s electric infrastructure and includes investments that will upgrade the grid and accommodate more renewable energy. Investments under the plan are expected to total approximately $8.4 billion over the five-year period from 2021 through 2025, with expenditures largely recoverable under the PISA and the RESRAM. The planned investments in 2024 and 2025 are based on the assumption that Ameren Missouri requests and receives MoPSC approval of an extension of the PISA through December 2028.In December 2020, the ICC issued an order in Ameren Illinois’ annual update filing that approved a $49 million decrease in Ameren Illinois’ electric distribution service rates beginning in January 2021. This order reflected a decrease to the annual formula rate based on 2019 actual costs, a decrease to include the 2019 revenue requirement reconciliation adjustment, and a decrease for the conclusion of the 2018 revenue requirement reconciliation adjustment, which was fully collected from customers in 2020, consistent with the ICC’s December 2019 annual update filing order. It also reflected an increase based on expected net plant additions for 2020.In January 2021, the ICC issued an order in Ameren Illinois’ February 2020 natural gas delivery service regulatory rate review, which resulted in an increase to its annual revenues for natural gas delivery service of $76 million, based on a 9.67% allowed ROE, a capital structure composed of 52% common equity, and a rate base of $2.1 billion. The new rates became effective in January 2021. As a result of this order, the rate base under the QIP was reset to zero. Ameren Illinois used a 2021 future test year in this proceeding.In October 2020, Ameren’s board of directors increased the quarterly common stock dividend to 51.5 cents per share. In February 2021, the board increased the quarterly common stock dividend to 55 cents per share, resulting in an annualized equivalent dividend rate of $2.20 per share.EarningsNet income attributable to Ameren common shareholders was $871 million, or $3.50 per diluted share, for 2020, and $828 million, or $3.35 per diluted share, for 2019. Net income was favorably affected in 2020, compared with 2019, by the results of Ameren Missouri’s March 2020 electric rate order; infrastructure investments that drove higher earnings at Ameren Transmission, Ameren Illinois Electric Distribution, and Ameren Illinois Natural Gas; and increased Ameren Transmission earnings resulting from the May 2020 FERC order addressing the allowed base ROE. Earnings in 2020, compared with 2019, were also favorably affected by lower other operations and maintenance expenses not subject to riders or trackers, primarily due to the absence in 2020 of expenses related to the Callaway Energy Center’s 2019 scheduled refueling and maintenance outage; and by lower electric system infrastructure maintenance expenses as a result of decreased system load, disciplined cost management, and the deferral of projects to future periods. Net income was unfavorably affected in 2020, compared with 2019, by decreased electric retail sales at Ameren Missouri largely due to the COVID-19 pandemic, and due to milder summer and warmer winter temperatures in 2020; higher net financing costs at Ameren Missouri and Ameren (parent); lower revenues due to reduced MEEIA performance incentives at Ameren Missouri; and a lower recognized ROE at Ameren Illinois Electric Distribution.LiquidityAt December 31, 2020, Ameren, on a consolidated basis, had available liquidity in the form of cash on hand and amounts available under the Credit Agreements of $1.9 billion.37Table of ContentsAmeren remains focused on strategic capital allocation. The following chart presents 2020 capital expenditures by segment and the midpoint of projected cumulative capital expenditures for 2021 through 2025 by segment:2020 Capital Expenditures by Segment (Total Ameren – $3.2 billion)(in billions)Midpoint of 2021 – 2025 Projected Capital Expenditures by Segment (Total Ameren – $17.1 billion)(in billions)Ameren Missouri(a)Ameren Illinois Natural GasAmeren Illinois Electric DistributionAmeren Transmission(a)Ameren Missouri capital expenditures include $564 million for the acquisition of the High Prairie Renewable Energy Center for the year ended December 31, 2020.For 2021 through 2025, Ameren’s cumulative capital expenditures are projected to range from $16.4 billion to $17.8 billion. The following table presents the range of projected spending by segment:Range (in billions)Ameren Missouri(a)$8.7 –$9.3 Ameren Illinois Electric Distribution2.6 –2.8 Ameren Illinois Natural Gas1.7 –1.8 Ameren Transmission3.5 –3.8 Ameren(a)$16.4 –$17.8 (a)Amounts include 300 MWs of wind generation at the Atchison Renewable Energy Center, but exclude incremental renewable generation investment opportunities of 1,200 MWs by 2025, which are included in Ameren Missouri’s 2020 IRP.RESULTS OF OPERATIONSOur results of operations and financial position are affected by many factors. Economic conditions, including those resulting from the COVID-19 pandemic discussed below, energy-efficiency investments by our customers and by us, technological advances, distributed generation, and the actions of key customers can significantly affect the demand for our services. Ameren and Ameren Missouri results are also affected by seasonal fluctuations in winter heating and summer cooling demands, as well as by energy center maintenance outages. Additionally, fluctuations in interest rates and conditions in the capital and credit markets affect our cost of borrowing, and our pension and postretirement benefits costs. Almost all of Ameren’s revenues are subject to state or federal regulation. This regulation has a material impact on the rates we charge customers for our services. Our results of operations, financial position, and liquidity are affected by our ability to align our overall spending, both operating and capital, with the frameworks established by our regulators. See Note 2 – Rate and Regulatory Matters under Part II, Item 8, of this report for additional information regarding Ameren Missouri’s, Ameren Illinois’, and ATXI’s regulatory frameworks.We continue to assess the impacts of the COVID-19 pandemic on our businesses, including impacts on electric and natural gas sales volumes, supply chain operations, and bad debt expense. Ameren Missouri and Ameren Illinois suspended customer disconnections and late 38Table of Contentsfee charges for nonpayment in mid-March 2020 and began resuming these activities, with certain exceptions, in the third quarter of 2020. For additional information on Ameren Missouri’s and Ameren Illinois’ reinstatement of customer disconnection and late fee charges for non-payment, see Note 2 – Rate and Regulatory Matters under Part II, Item 8, of this report. With respect to uncollectible accounts receivable, Ameren Illinois’ electric distribution and natural gas distribution businesses have bad debt riders, which provide for recovery of bad debt write-offs, net of any subsequent recoveries. Pursuant to a June 2020 ICC order, Ameren Illinois’ electric bad debt rider provided for the recovery of bad debt expense in 2020, which reverted to the recovery of bad debt write-offs, net of any subsequent recoveries, in 2021. Ameren Missouri does not have a bad debt rider or tracker, and thus its earnings are exposed to increases in bad debt expense, absent regulatory relief. However, Ameren Missouri does not expect a material impact to earnings from increases in bad debt expense. In October 2020, Ameren Missouri filed requests with the MoPSC for accounting authority orders related to certain impacts resulting from the COVID-19 pandemic. If issued as requested, the orders would allow Ameren Missouri to accumulate certain costs incurred related to the COVID-19 pandemic, including bad debt write-offs, net of cost savings, as well as forgone customer late fee and reconnection fee revenues, for a specified time period, for potential recovery in future electric and natural gas service regulatory rate reviews. As of December 31, 2020, accounts receivable balances that were 30 days or greater past due or that were a part of a deferred payment arrangement represented 29%, 22%, and 35%, or $133 million, $40 million, and $93 million, of Ameren’s, Ameren Missouri’s, and Ameren Illinois’ customer trade receivables before allowance for doubtful accounts, respectively. As of December 31, 2019, these percentages were 18%, 18%, and 20%, or $75 million, $30 million, and $45 million, for Ameren, Ameren Missouri, and Ameren Illinois, respectively. Ameren Missouri’s electric sales volumes have been, and continue to be, affected by the COVID-19 pandemic. In 2020, compared to 2019, Ameren Missouri experienced a reduction in commercial and industrial electric sales volumes, partially offset by increased electric sales volumes to higher margin residential customers, excluding the estimated effects of weather and customer energy-efficiency programs. For 2021, Ameren Missouri expects gradual improvement in economic activities to result in increased electric sales volumes, excluding the estimated effects of weather and customer energy-efficiency programs. The table below provides the increases and (decreases) in Ameren Missouri electric sales volumes by customer class for 2020, compared to 2019, and the estimated increases and (decreases) for 2021, compared to 2020, excluding the estimated effects of weather and customer energy-efficiency programs:2020 versus 2019Estimated 2021 versus 2020Ameren Missouri Customer ClassResidential3.0 %1 %Commercial(7.0)%2 %Industrial(2.1)%3 %Total(2.2)%2 %Assuming a ratable change in Ameren Missouri’s electric sales volumes by month, a 1% change for the calendar year 2021 to residential, commercial, and industrial customers would affect earnings per diluted share by approximately 3 cents, 2 cents, and a half-cent, respectively. The actual change in earnings per diluted share will be affected by the timing of sales volume changes due to seasonal customer rates.Ameren Missouri principally uses coal and enriched uranium for fuel in its electric operations and purchases natural gas for its customers. Ameren Illinois purchases power and natural gas for its customers. The prices for these commodities can fluctuate significantly because of the global economic and political environment, weather, supply, demand, and many other factors. We have natural gas cost recovery mechanisms for our Illinois and Missouri natural gas distribution businesses, a purchased power cost recovery mechanism for Ameren Illinois’ electric distribution business, and a FAC for Ameren Missouri’s electric business.We employ various risk management strategies to reduce our exposure to commodity risk and other risks inherent in our business. The reliability of Ameren Missouri’s energy centers and our transmission and distribution systems and the level and timing of operations and maintenance costs and capital investment are key factors that we seek to manage in order to optimize our results of operations, financial position, and liquidity.Earnings SummaryThe following table presents a summary of Ameren’s earnings for the years ended December 31, 2020 and 2019:20202019Net income attributable to Ameren common shareholders$871 $828 Earnings per common share – diluted3.50 3.35 Net income attributable to Ameren common shareholders in 2020 increased $43 million, or $0.15 per diluted share, from 2019. The increase was due to net income increases of $31 million, $15 million, and $10 million, at Ameren Transmission, Ameren Illinois Natural Gas, and Ameren Missouri, respectively. The increases in net income were partially offset by an increase in the net loss for activity not reported as part of a segment, primarily at Ameren (parent) of $10 million and a decrease in net income at Ameren Illinois Electric Distribution of $3 million.39Table of ContentsEarnings per share in 2020, compared with 2019, were favorably affected by:•lower base level of expenses, partially offset by lower base rates, net of recovery for amounts associated with the reduction in sales volumes resulting from MEEIA programs and recoverable depreciation under the PISA, at Ameren Missouri pursuant to the March 2020 MoPSC electric rate order as discussed in Note 2 – Rate and Regulatory Matters under Part II, Item 8, of this report (23 cents per share);•increased rate base investments, which increased earnings at Ameren Transmission and Ameren Illinois Electric Distribution, including energy-efficiency investments at Ameren Illinois (14 cents per share);•decreased Callaway Energy Center scheduled refueling and maintenance expenses, due to the treatment of the 2019 scheduled refueling and maintenance outage costs at the Callaway Energy Center, which were expensed as incurred, as compared with the deferral of expenses for the fall 2020 scheduled refueling and maintenance outage pursuant to the February 2020 MoPSC order, which decreased other operations and maintenance expenses (10 cents per share);•decreased system load, disciplined cost management, the deferral of projects to future periods, and decreased other costs not recoverable under riders or trackers, excluding decreased costs associated with the Callaway Energy Center’s scheduled refueling and maintenance outage, which decreased other operations and maintenance expenses (10 cents per share);•the result of the May 2020 FERC order addressing the allowed base ROE for FERC regulated transmission rate base under the MISO tariff, which increased Ameren Transmission earnings (4 cents per share); and•increased investments in qualifying infrastructure recovered under the QIP, which increased earnings at Ameren Illinois Natural Gas (4 cents per share).Earnings per share in 2020, compared with 2019, were unfavorably affected by:•lower MEEIA performance incentives recognized at Ameren Missouri (9 cents per share);•increased net financing costs at Ameren (parent) and Ameren Missouri, primarily due to higher long-term debt balances (9 cents per share);•decreased electric retail sales, excluding the estimated effects of weather, at Ameren Missouri, largely due to the COVID-19 pandemic, which decreased sales volumes and demand charge revenue from commercial and industrial customers, partially offset by increased sales volumes to higher margin residential customers (8 cents per share);•the impact of weather on electric retail sales at Ameren Missouri, primarily resulting from milder summer and warmer winter temperatures experienced in 2020 (estimated at 7 cents per share);•a lower recognized ROE at Ameren Illinois Electric Distribution under performance-based formula ratemaking driven by lower annual average monthly yields on 30-year United States Treasury bonds (7 cents per share);•increased charitable donations, primarily at Ameren Missouri, which included an increase of 2 cents per share pursuant to its March 2020 electric rate order (4 cents per share);•decreased electric margins from transmission services, and customer late fees and reconnection fees at Ameren Missouri, largely due to the COVID-19 pandemic (3 cents per share);•decreased income tax benefits at Ameren (parent) related to stock-based compensation (3 cents per share);•increased depreciation and amortization expenses not recoverable under riders or trackers at Ameren Missouri, primarily due to additional property, plant, and equipment investments (2 cents per share); and•increased weighted-average basic common shares outstanding (2 cents per share).The cents per share information presented is based on the weighted-average basic shares outstanding in 2019 and does not reflect any change in earnings per share resulting from dilution, unless otherwise noted. Amounts other than variances related to income taxes have been presented net of income taxes using Ameren’s 2020 statutory tax rate of 26%. For additional details regarding the Ameren Companies’ results of operations, including explanations of Electric and Natural Gas Margins, Other Operations and Maintenance Expenses, Depreciation and Amortization, Taxes Other Than Income Taxes, Other Income, Net, Interest Charges, and Income Taxes, see the major headings below.40Table of ContentsBelow is Ameren’s table of income statement components by segment for the years ended December 31, 2020 and 2019:2020Ameren MissouriAmerenIllinoisElectricDistributionAmerenIllinoisNatural GasAmeren TransmissionOther /IntersegmentEliminationsAmerenElectric margins$2,323 $1,091 $— $523 $(29)$3,908 Natural gas margins82 — 531 — (2)611 Other operations and maintenance expenses(886)(506)(221)(57)9 (1,661)Depreciation and amortization(604)(288)(81)(98)(4)(1,075)Taxes other than income taxes(328)(72)(65)(8)(10)(483)Other income, net76 33 13 13 16 151 Interest charges(190)(72)(41)(78)(38)(419)Income (taxes) benefit(34)(42)(36)(78)35 (155)Net income (loss)439 144 100 217 (23)877 Noncontrolling interests – preferred stock dividends(3)(1)(1)(1)— (6)Net income (loss) attributable to Ameren common shareholders$436 $143 $99 $216 $(23)$871 2019Electric margins$2,381 $1,074 $— $464 $(29)$3,890 Natural gas margins81 — 519 — (2)598 Other operations and maintenance expenses(960)(498)(233)(60)6 (1,745)Depreciation and amortization(556)(273)(78)(84)(4)(995)Taxes other than income taxes(329)(73)(67)(4)(8)(481)Other income, net58 33 12 8 19 130 Interest charges(178)(71)(38)(74)(20)(381)Income (taxes) benefit(68)(45)(30)(64)25 (182)Net income (loss)429 147 85 186 (13)834 Noncontrolling interests – preferred stock dividends(3)(1)(1)(1)— (6)Net income (loss) attributable to Ameren common shareholders$426 $146 $84 $185 $(13)$828 41Table of ContentsBelow is Ameren Illinois’ table of income statement components by segment for the years ended December 31, 2020 and 2019:2020Ameren Illinois Electric DistributionAmeren Illinois Natural GasAmeren Illinois TransmissionAmeren IllinoisElectric margins$1,091 $— $329 $1,420 Natural gas margins— 531 — 531 Other operations and maintenance expenses(506)(221)(48)(775)Depreciation and amortization(288)(81)(65)(434)Taxes other than income taxes(72)(65)(3)(140)Other income, net33 13 13 59 Interest charges(72)(41)(42)(155)Income taxes(42)(36)(46)(124)Net income144 100 138 382 Preferred stock dividends(1)(1)(1)(3)Net income attributable to common shareholder$143 $99 $137 $379 2019Electric margins$1,074 $— $288 $1,362 Natural gas margins— 519 — 519 Other operations and maintenance expenses(498)(233)(51)(782)Depreciation and amortization(273)(78)(55)(406)Taxes other than income taxes(73)(67)(3)(143)Other income, net33 12 8 53 Interest charges(71)(38)(38)(147)Income taxes(45)(30)(35)(110)Net income147 85 114 346 Preferred stock dividends(1)(1)(1)(3)Net income attributable to common shareholder$146 $84 $113 $343 MarginsElectric margins are defined as electric revenues less fuel and purchased power costs. Natural gas margins are defined as natural gas revenues less natural gas purchased for resale. We consider electric and natural gas margins useful measures to analyze the change in profitability of our electric and natural gas operations between periods. We have included the analysis below as a complement to the financial information we provide in accordance with GAAP. However, these margins may not be a presentation defined under GAAP, and they may not be comparable to other companies’ presentations or more useful than the GAAP information we provide elsewhere in this report.42Table of ContentsElectric MarginsTotal by Segment(a)Increase (Decrease) by Segment(Overall Ameren Increase of $18 Million)(a)Includes other/intersegment eliminations of $(29) million and $(29) million in 2020 and 2019, respectively.Ameren MissouriAmeren Illinois Electric DistributionAmeren TransmissionOther/Intersegment EliminationsNatural Gas MarginsTotal by Segment(a)Increase (Decrease) by Segment(Overall Ameren Increase of $13 Million)(a)Includes other/intersegment eliminations of $(2) million and $(2) million in 2020 and 2019, respectively.Ameren MissouriAmeren Illinois Natural Gas43Table of ContentsThe following table presents the favorable (unfavorable) variations by segment for electric and natural gas margins in 2020, compared with 2019: Electric and Natural Gas Margins2020 versus 2019AmerenMissouriAmeren IllinoisElectric DistributionAmeren IllinoisNatural GasAmerenTransmission(a)Other /IntersegmentEliminationsAmerenElectric revenue change:Effect of weather (estimate)(b)$(30)$— $— $— $— $(30)Base rates (estimate)(c)(58)(3)— 59 — (2)Sales volumes and changes in customer usage patterns (excluding the estimated effects of weather and MEEIA)(36)— — — — (36)Customer demand charges(7)— — — — (7)MEEIA performance incentives(31)— — — — (31)Off-system sales47 — — — — 47 Customer late fees and reconnection fees(4)— — — — (4)Energy-efficiency program investments— 12 — — — 12 Transmission service revenues(3)— — — — (3)Other(1)5 — — 2 6 Cost recovery mechanisms – offset in fuel and purchased power(d)(4)(23)— — — (27)Other cost recovery mechanisms(e)2 3 — — — 5 Total electric revenue change$(125)$(6)$— $59 $2 $(70)Fuel and purchased power change:Energy costs (excluding the estimated effect of weather)$(34)$— $— $— $— $(34)Effect of weather (estimate)(b)8 — — — — 8 Effect of lower net energy costs included in base rates92 — — — — 92 Transmission service charges(3)— — — — (3)Other— — — — (2)(2)Cost recovery mechanisms – offset in electric revenue(d)4 23 — — — 27 Total fuel and purchased power change$67 $23 $— $— $(2)$88 Net change in electric margins$(58)$17 $— $59 $— $18 Natural gas revenue change:Effect of weather (estimate)(b)$(5)$— $— $— $— $(5)QIP— — 23 — — 23 Software licensing agreement— — (5)— — (5)Other3 — (1)— — 2 Cost recovery mechanisms – offset in natural gas purchased for resale(d)(6)— (49)— — (55)Other cost recovery mechanisms(e)(1)— (5)— — (6)Total natural gas revenue change$(9)$— $(37)$— $— $(46)Natural gas purchased for resale change:Effect of weather (estimate)(b)$4 $— $— $— $— $4 Cost recovery mechanisms – offset in natural gas revenue(d)6 — 49 — — 55 Total natural gas purchased for resale change$10 $— $49 $— $— $59 Net change in natural gas margins$1 $— $12 $— $— $13 (a)Includes an increase in transmission electric margins of $41 million in 2020, compared with 2019, at Ameren Illinois.(b)Represents the estimated variation resulting primarily from changes in cooling and heating degree days on electric and natural gas demand compared with the prior year; this variation is based on temperature readings from the National Oceanic and Atmospheric Administration weather stations at local airports in our service territories.(c)For Ameren Illinois Electric Distribution and Ameren Transmission, base rates include increases or decreases to operating revenues related to the revenue requirement reconciliation adjustment under formula rates. For Ameren Missouri, base rates exclude an increase of $43 million for the recovery of lost electric margins in 2020, compared with 2019, resulting from the MEEIA 2016 and 2019 customer energy-efficiency programs. This amount is included in the “sales volumes and changes in customer usage patterns (excluding the estimated effects of weather and MEEIA)” line item.(d)Electric and natural gas revenue changes are offset by corresponding changes in “Fuel,” “Purchased power,” and “Natural gas purchased for resale” on the statement of income, resulting in no change to electric and natural gas margins.(e)Offsetting expense increases or decreases are reflected in “Other operations and maintenance,” “Depreciation and amortization,” or in “Taxes other than income taxes,” within the “Operating Expenses” section of the statement of income. These items have no overall impact on earnings.AmerenAmeren’s electric margins increased $18 million, or less than 1%, in 2020, compared with 2019, primarily because of increased margins at Ameren Transmission and Ameren Illinois Electric Distribution, partially offset by decreased margins at Ameren Missouri, as discussed 44Table of Contentsbelow. Ameren’s natural gas margins increased $13 million, or 2%, between years primarily because of increased margins at Ameren Illinois Natural Gas, as discussed below.Ameren TransmissionAmeren Transmission’s electric margins increased $59 million, or 13%, in 2020, compared with 2019. Margins were favorably affected by increased capital investment, as evidenced by a 13% increase in the 13-month average rate base used to calculate the revenue requirement between years, and an increase in the allowed ROE resulting from the May 2020 FERC order. See Note 2 – Rate and Regulatory Matters under Part II, Item 8, of this report for additional information regarding the May 2020 FERC order.Ameren MissouriAmeren Missouri’s electric margins decreased $58 million, or 2%, in 2020, compared with 2019. Ameren Missouri’s natural gas margins were comparable between years.The following items had an unfavorable effect on Ameren Missouri’s electric margins in 2020, compared with 2019:•The aggregate effect of changes in customer usage, excluding the estimated effects of weather and the MEEIA customer energy-efficiency programs, decreased electric revenues an estimated $43 million. The decrease was primarily due to a reduction in sales volumes (-$44 million) and decreased revenues from customer demand charges (-$7 million), both of which were unfavorably affected by the COVID-19 pandemic. An increase in the average retail price per kilowatthour due to changes in customer usage patterns partially offset the decreases by a favorable $8 million. While the MEEIA customer energy-efficiency programs reduced retail sales volumes, the recovery of lost electric margins under the MEEIA ensured that electric margins were not affected.•The absence of revenues associated with MEEIA 2013 and 2016 performance incentives in 2020, partially offset by revenues from the MEEIA 2019 performance incentive, decreased revenues $31 million. See Note 2 – Rate and Regulatory Matters under Part II, Item 8, of this report for information regarding the MEEIA performance incentives.•Summer temperatures were milder as cooling degree days decreased 7%, and winter temperatures were warmer as heating degree days decreased 9%. The aggregate effect of weather decreased margins by an estimated $22 million. The change in margins due to weather is the sum of the “Effect of weather (estimate)” on electric revenues (-$30 million) and the “Effect of weather (estimate)” on fuel and purchased power (+$8 million) in the table above.•Additional investments made by other transmission entities contributed to increased transmission service charges of $3 million and lower system load contributed to decreased transmission service revenues of $3 million.•In response to the COVID-19 pandemic, suspensions of customer late fees and reconnection fees resulted in a $4 million decrease in revenue. See Note 2 – Rate and Regulatory Matters under Part II, Item 8, of this report for information on the suspension of customer late fees and disconnections.The following items had a favorable effect on Ameren Missouri’s electric margins in 2020, compared with 2019:•The March 2020 MoPSC electric rate order, with new rates effective April 1, 2020, increased margins $34 million. The change in electric base rates is the sum of the “Change in base rates (estimate)” (-$58 million) and the “Effect of lower net energy costs included in base rates” (+$92 million) in the table above.•Decreased sales volumes, which were affected by the COVID-19 pandemic, resulted in lower net energy costs and increased margins $13 million. The change in net energy costs is the sum of the effect of the revenue change in “Off-system sales” (+$47 million) and the “Effect of the change in energy costs” (-$34 million) in the table above.Ameren IllinoisAmeren Illinois’ electric margins increased $58 million, or 4%, in 2020, compared with 2019, driven by increased margins at Ameren Illinois Transmission (+$41 million) and Ameren Illinois Electric Distribution (+$17 million). Ameren Illinois Natural Gas’ margins increased $12 million, or 2%, between years.Ameren Illinois Electric DistributionAmeren Illinois Electric Distribution’s margins increased $17 million, or 2%, in 2020, compared with 2019. Revenues increased $12 million due to increased energy-efficiency program investments under performance-based formula ratemaking. Margins decreased due to a lower recognized ROE (-$17 million), as evidenced by a decrease of 102 basis points in the annual average of the monthly yields of the 30-year United States Treasury bonds, partially offset by increased capital investment (+$8 million), as evidenced by a 6% increase in year-end rate base, and higher recoverable non-purchased power expenses (+$6 million). The sum of these base rate changes collectively decreased margins $3 million in 2020, compared with 2019.45Table of ContentsAmeren Illinois Natural GasAmeren Illinois Natural Gas’ margins increased $12 million, or 2%, in 2020, compared with 2019. Revenues from increased QIP recoveries due to additional investment in qualified natural gas infrastructure increased margins $23 million. The absence of revenues from a software licensing agreement with Ameren Missouri decreased margins $5 million. See the Software Licensing Agreement section within Note 13 – Related-party Transactions under Part II, Item 8, of this report for information regarding this transaction.Ameren Illinois TransmissionAmeren Illinois Transmission’s electric margins increased $41 million, or 14%, in 2020, compared with 2019. Margins were favorably affected by increased capital investment, as evidenced by a 19% increase in the 13-month average rate base between years, and an increase in the allowed ROE resulting from the May 2020 FERC order. See Note 2 – Rate and Regulatory Matters under Part II, Item 8, of this report for additional information regarding the May 2020 FERC order.Other Operations and Maintenance ExpensesTotal by Segment(a)Increase (Decrease) by Segment(Overall Ameren Decrease of $84 Million)(a)Includes $57 million and $60 million at Ameren Transmission in 2020 and 2019, respectively, and other/intersegment eliminations of $(9) million and $(6) million in 2020 and 2019, respectively.Ameren MissouriAmeren Illinois Natural GasOther/Intersegment EliminationsAmeren Illinois Electric DistributionAmeren TransmissionAmerenOther operations and maintenance expenses were $84 million lower in 2020, compared with 2019. In addition to changes by segments discussed below, other operations and maintenance expenses decreased $3 million in 2020 for activity not reported as part of a segment, as reflected in “Other/Intersegment Eliminations” above, primarily because of decreased costs for support services.Ameren TransmissionOther operations and maintenance expenses were $3 million lower in 2020, compared with 2019, primarily due to a decrease in transmission expenditures at Ameren Illinois Transmission resulting from disciplined cost management. 46Table of ContentsAmeren MissouriThe $74 million decrease in other operations and maintenance expenses in 2020, compared with 2019, was primarily due to the following items:•Callaway Energy Center refueling operations and maintenance costs decreased $34 million, due to the treatment of the 2019 scheduled refueling and maintenance outage costs at the Callaway Energy Center, which were expensed as incurred, as compared with the deferral of expenses for the fall 2020 scheduled refueling and maintenance outage pursuant to the February 2020 MoPSC order. •Energy center maintenance costs, other than those associated with the Callaway refueling and maintenance outage, decreased $29 million, primarily because of lower electric system infrastructure maintenance expenses as a result of decreased system load, disciplined cost management, and the deferral of projects to future periods.•Transmission and distribution expenditures decreased $15 million, primarily resulting from less maintenance due to recent capital improvements and disciplined cost management. •Amortization of solar rebate costs incurred prior to the RESRAM decreased $13 million as a result of the March 2020 MoPSC electric rate order.The following items partially offset the above decreases in other operations and maintenance expenses between years:•Solar rebate costs recoverable under the RESRAM increased $9 million, primarily because of the amortization of previously-deferred rebates included in customer rates in 2020.•Bad debt costs increased $7 million, primarily because of an increase in accounts receivable balances that were past due or that were a part of a deferred payment arrangement, which increased primarily due to the COVID-19 pandemic. •Technology-related expenditures increased $5 million, primarily because of costs associated with the implementation of cloud computing technology. Ameren IllinoisOther operations and maintenance expenses were $7 million lower at Ameren Illinois in 2020, compared with 2019, as discussed below.Ameren Illinois Electric DistributionThe $8 million increase in other operations and maintenance expenses in 2020, compared with 2019, was primarily due to the following items:•Amortization of energy-efficiency program investments under performance-based formula ratemaking increased $8 million.•Labor and benefit costs increased $8 million, primarily because of higher pension costs.The following items partially offset the above increases in other operations and maintenance expenses between years: •Meter reading costs decreased $4 million, as deployment of automated smart meters was substantially completed in 2019.•Distribution expenditures decreased $3 million, primarily because of lower storm costs. Ameren Illinois Natural GasThe $12 million decrease in other operations and maintenance expenses in 2020, compared with 2019, was primarily due to a $4 million reduction in costs recovered through riders and a $4 million reduction in meter reading costs, as deployment of automated smart meters was substantially completed in 2019. Other operations and maintenance expenses also decreased because of a $4 million reduction in distribution expenditures due to disciplined cost management. Ameren Illinois TransmissionThe $3 million decrease in other operations and maintenance expenses in 2020, compared with 2019, was primarily due to a decrease in transmission expenditures resulting from disciplined cost management. 47Table of ContentsDepreciation and AmortizationTotal by Segment(a)Increase (Decrease) by Segment(Overall Ameren Increase of $80 Million)(a)Includes other/intersegment eliminations of $4 million and $4 million in 2020 and 2019, respectively.Ameren MissouriAmeren Illinois Natural GasOther/Intersegment EliminationsAmeren Illinois Electric DistributionAmeren TransmissionThe $80 million, $48 million, and $28 million increase in depreciation and amortization expenses in 2020, compared with 2019, at Ameren, Ameren Missouri, and Ameren Illinois, respectively, was primarily due to additional property, plant, and equipment across their respective segments. Ameren’s and Ameren Missouri’s depreciation and amortization expenses reflected a deferral to a regulatory asset of depreciation and amortization expenses pursuant to the PISA. The PISA deferral of depreciation and amortization expenses was $27 million and $24 million in 2020 and 2019, respectively.48Table of ContentsTaxes Other Than Income TaxesTotal by Segment(a)Increase (Decrease) by Segment(Overall Ameren Increase of $2 Million)(a)Includes $8 million and $4 million at Ameren Transmission in 2020 and 2019, respectively, and other/intersegment eliminations of $10 million and $8 million in 2020 and 2019, respectively.Ameren MissouriAmeren Illinois Natural GasOther/Intersegment EliminationsAmeren Illinois Electric DistributionAmeren TransmissionTaxes other than income taxes were comparable at Ameren between 2020 and 2019. Excise taxes decreased $8 million and $4 million at Ameren Missouri and Ameren Illinois Natural Gas, respectively, because of reduced sales. These decreases were mostly offset by increases of $7 million and $4 million in property taxes at Ameren Missouri and Ameren Transmission, respectively, primarily due to higher assessed property values. See Excise Taxes in Note 15 – Supplemental Information under Part II, Item 8, of this report for additional information.49Table of ContentsOther Income, NetTotal by SegmentIncrease (Decrease) by Segment(Overall Ameren Increase of $21 Million)Ameren MissouriAmeren Illinois Natural GasOther/Intersegment EliminationsAmeren Illinois Electric DistributionAmeren TransmissionOther income, net, increased $21 million at Ameren in 2020, compared with 2019. An increase of $28 million in the non-service cost components of net periodic benefit income at Ameren Missouri was partially offset by a $9 million increase in donations, primarily due to charitable donations made pursuant to the March 2020 MoPSC electric rate order. Additionally, other income, net, increased because of a $4 million increase in the equity portion of allowance for funds used during construction at Ameren Transmission. See Note 6 – Other Income, Net under Part II, Item 8, of this report for additional information. See Note 2 – Rate and Regulatory Matters under Part II, Item 8, of this report for additional information regarding Ameren Missouri’s March 2020 electric rate order. See Note 10 – Retirement Benefits under Part II, Item 8, of this report for more information on the non-service cost components of net periodic benefit income. 50Table of ContentsInterest ChargesTotal by SegmentIncrease (Decrease) by Segment(Overall Ameren Increase of $38 Million)Ameren MissouriAmeren Illinois Natural GasOther/Intersegment EliminationsAmeren Illinois Electric DistributionAmeren TransmissionInterest charges increased $38 million in 2020, compared with 2019, primarily because of a long-term debt issuance at Ameren (parent) in April 2020, which increased interest charges by $21 million, which was partially offset by a decrease associated with the reduction in average short-term debt outstanding, as proceeds from the long-term debt issuance were used to repay outstanding short-term debt. Interest charges also increased due to long-term debt issuances at Ameren Missouri in March 2020 and October 2020, partially offset by lower average interest rates applicable to long-term debt, which increased interest charges by $14 million. Interest charges at Ameren Missouri reflected a deferral to a regulatory asset of interest charges pursuant to PISA. The PISA deferral of interest charges was $12 million and $15 million in 2020 and 2019, respectively. Income TaxesThe following table presents effective income tax rates for the years ended December 31, 2020 and 2019:20202019Ameren15%18%Ameren Missouri7%14%Ameren Illinois24%24%Ameren Illinois Electric Distribution22%23%Ameren Illinois Natural Gas26%26%Ameren Illinois Transmission25%24%Ameren Transmission26%25%See Note 12 – Income Taxes under Part II, Item 8, of this report for information regarding reconciliations of effective income tax rates for Ameren, Ameren Missouri, and Ameren Illinois. See Note 2 – Rate and Regulatory Matters under Part II, Item 8, of this report for information regarding reductions in revenues related to the lower federal statutory corporate income tax rate enacted under the TCJA and the return of excess deferred income taxes to customers.51Table of ContentsLIQUIDITY AND CAPITAL RESOURCESCollections from our tariff-based revenues are our principal source of cash provided by operating activities. A diversified retail customer mix, primarily consisting of rate-regulated residential, commercial, and industrial customers, provides us with a reasonably predictable source of cash. In addition to using cash provided by operating activities, we use available cash, drawings under committed credit agreements, commercial paper issuances, and/or, in the case of Ameren Missouri and Ameren Illinois, short-term affiliate borrowings to support normal operations and temporary capital requirements. We may reduce our short-term borrowings with cash provided by operations or, at our discretion, with long-term borrowings, or, in the case of Ameren Missouri and Ameren Illinois, with capital contributions from Ameren (parent). We expect to make significant capital expenditures over the next five years as we invest in our electric and natural gas utility infrastructure to support overall system reliability, grid modernization, renewable energy targets requirements, environmental compliance, and other improvements. As part of its plan to fund these cash flow requirements, Ameren is using newly issued shares of common stock, rather than market-purchased shares, to satisfy requirements under the DRPlus and employee benefit plans and expects to continue to do so through at least 2025. Ameren expects these issuances to provide equity of about $100 million annually. In addition to the issuance of common shares in connection with the 2021 settlement of the remaining portion of the forward sale agreement, Ameren plans to issue incremental equity of about $150 million in 2021 and about $300 million each year from 2022 to 2025. Ameren expects its equity to total capitalization to be about 45% through December 31, 2025, with the long-term intent to support solid investment-grade credit ratings.The use of cash provided by operating activities and short-term borrowings to fund capital expenditures and other long-term investments at the Ameren Companies frequently results in a working capital deficit, defined as current liabilities exceeding current assets, as was the case at December 31, 2020, for Ameren and Ameren Illinois. With the credit capacity available under the Credit Agreements, and cash and cash equivalents, Ameren (parent), Ameren Missouri, and Ameren Illinois, collectively had net available liquidity of $1.9 billion at December 31, 2020. As a result of capital market volatility, due, in part, to the COVID-19 pandemic, and to increase net available liquidity, Ameren (parent) accelerated a debt issuance to April 2020, which had been planned for later in 2020, and used a portion of the proceeds to repay $350 million of senior unsecured notes held by Ameren (parent) in October 2020. Also, in August 2019, Ameren entered into a forward sale agreement with a counterparty relating to 7.5 million shares of common stock. In December 2020, Ameren partially settled the forward sale agreement by physically delivering 5.9 million shares of common stock for cash proceeds of $425 million. In February 2021, Ameren settled the remainder of the forward sale agreement by physically delivering 1.6 million shares of common stock for cash proceeds of $113 million. The proceeds were used to fund a portion of Ameren Missouri’s wind generation investments. See Credit Facility Borrowings and Liquidity and Long-term Debt and Equity below for additional information.The following table presents net cash provided by (used in) operating, investing, and financing activities for the years ended December 31, 2020 and 2019:Net Cash Provided byOperating ActivitiesNet Cash Used inInvesting ActivitiesNet Cash Provided by Financing Activities20202019Variance20202019Variance20202019VarianceAmeren$1,727 $2,170 $(443)$(3,329)$(2,435)$(894)$1,727 $334 $1,393 Ameren Missouri911 1,067 (156)(1,904)(1,095)(809)1,099 59 1,040 Ameren Illinois679 962 (283)(1,444)(1,205)(239)787 288 499 Cash Flows from Operating ActivitiesOur cash provided by operating activities is affected by fluctuations of trade accounts receivable, inventories, and accounts and wages payable, among other things, as well as the unique regulatory environment for each of our businesses. Substantially all expenditures related to fuel, purchased power, and natural gas purchased for resale are recovered from customers through riders, which may be adjusted without a traditional regulatory rate review, subject to prudence reviews. Similar regulatory mechanisms exist for certain operating expenses that can also affect the timing of cash provided by operating activities. The timing of cash payments for costs recoverable under our regulatory mechanisms differs from the recovery period of those costs. Additionally, the seasonality of our electric and natural gas businesses, primarily caused by seasonal customer rates and changes in customer demand due to weather, significantly affect the amount and timing of our cash provided by operating activities. See Note 2 – Rate and Regulatory Matters under Part II, Item 8, of this report for more information about our regulatory frameworks. Our customers’ payment for our services has been adversely affected by the COVID-19 pandemic, resulting in a decrease to our cash flow from operations. For information regarding Ameren Missouri’s and Ameren Illinois’ suspensions and reinstatement of customer disconnection activities and late fee charges for nonpayment, see Note 2 – Rate and Regulatory Matters under Part II, Item 8, of this report. In addition, see Results of Operations above for more information on Ameren’s, Ameren Missouri’s, and Ameren Illinois’ accounts receivable balances that were 30 days or greater past due or that were a part of a deferred payment arrangement.52Table of ContentsAmerenAmeren’s cash provided by operating activities decreased $443 million in 2020, compared with 2019. The following items contributed to the decrease:•A $381 million decrease resulting from reduced customer collections, primarily resulting from a decrease in sales volumes and an increase in accounts receivable balances, which were primarily due to the COVID-19 pandemic, and a net decrease attributable to regulatory recovery mechanisms, partially offset by decreased fuel and purchased power costs at Ameren Missouri and decreased purchased power costs and volumes, and natural gas costs, at Ameren Illinois.•A $38 million increase in payments to settle ARO liabilities, primarily related to Ameren Missouri’s CCR storage facilities.•A $28 million increase in pension and postretirement benefit plan contributions.•A $27 million decrease in net collateral activity with counterparties, primarily resulting from changes in the market prices of power and natural gas, changes in contracted commodity volumes, and decreases resulting from Ameren Illinois’ renewable energy contracts entered into pursuant to the FEJA.•A $25 million decrease, primarily resulting from increases to materials and supplies to support operations as levels were increased in 2020 to mitigate against any potential supply disruptions associated with the COVID-19 pandemic.•A $16 million increase in interest payments, primarily due to an increase in the average outstanding debt at Ameren (parent) and Ameren Illinois.•A $13 million increase in property tax payments at Ameren Missouri due to higher assessed property tax values. •Refunds paid in 2020 of $13 million associated with the November 2013 FERC complaint case, as discussed in Note 2 – Rate and Regulatory Matters under Part II, Item 8, of this report.The following items partially offset the decrease in Ameren’s cash from operating activities between periods:•A $37 million decrease in payroll tax payments primarily due to the employer portion of Social Security taxes as a result of a payment deferral allowed under the Coronavirus Aid, Relief, and Economic Security Act. Half of this deferral will be paid at the end of 2021 and the remaining half will be paid at the end of 2022.•A $35 million decrease in energy center maintenance costs, other than those associated with the Callaway refueling and maintenance outage, at Ameren Missouri, primarily due to lower electric system infrastructure maintenance expenses as a result of decreased system load, disciplined cost management, and the deferral of projects to future periods.•An $11 million decrease in coal inventory at Ameren Missouri primarily as a result of decreased market prices and inventory reductions at the coal-fired energy centers.Ameren MissouriAmeren Missouri’s cash provided by operating activities decreased $156 million in 2020, compared with 2019. The following items contributed to the decrease:•A $190 million decrease resulting from reduced customer collections, primarily resulting from a decrease in sales volumes and an increase in accounts receivable balances, which were primarily due to the COVID-19 pandemic, and a net decrease attributable to regulatory recovery mechanisms, partially offset by decreased fuel and purchased power costs.•A $38 million increase in payments to settle ARO liabilities, primarily related to CCR storage facilities.•A $17 million decrease in net collateral activity with counterparties, primarily resulting from changes in the market prices of power and natural gas and changes in contracted commodity volumes.•A $14 million increase in pension and postretirement benefit plan contributions.•A $13 million increase in property tax payments due to higher assessed property tax values.•A $12 million decrease, primarily resulting from increases to materials and supplies to support operations as levels were increased in 2020 to mitigate against any potential supply disruptions associated with the COVID-19 pandemic.The following items partially offset the decrease in Ameren Missouri’s cash from operating activities between periods:•A $76 million decrease in income tax payments to Ameren (parent) pursuant to the tax allocation agreement, primarily due to the timing of payments and lower taxable income in 2020.•A $35 million decrease in energy center maintenance costs, other than those associated with the Callaway refueling and maintenance outage, primarily due to lower electric system infrastructure maintenance expenses as a result of decreased system load, disciplined cost management, and the deferral of projects to future periods.•A $17 million decrease in payroll tax payments primarily due to the employer portion of Social Security taxes as a result of a payment deferral allowed under the Coronavirus Aid, Relief, and Economic Security Act. Half of this deferral will be paid at the end of 2021 and the remaining half will be paid at the end of 2022.•An $11 million decrease in coal inventory primarily as a result of decreased market prices and inventory reductions at the coal-fired 53Table of Contentsenergy centers.Ameren IllinoisAmeren Illinois’ cash provided by operating activities decreased $283 million in 2020, compared with 2019. The following items contributed to the decrease:•A $195 million decrease resulting from reduced customer collections, primarily resulting from a decrease in sales volumes and an increase in accounts receivable balances, which were primarily due to the COVID-19 pandemic, and a net decrease attributable to regulatory recovery mechanisms, partially offset by decreased purchased power costs and volumes, and natural gas costs.•A $37 million increase in income tax payments to Ameren (parent) pursuant to the tax allocation agreement, primarily due to the timing of payments in 2020.•A $13 million decrease, primarily resulting from increases to materials and supplies to support operations as levels were increased in 2020 to mitigate against any potential supply disruptions associated with the COVID-19 pandemic.•A $10 million increase in interest payments, primarily due to an increase in the average outstanding debt.•A $10 million decrease in net collateral activity with counterparties, primarily resulting from changes in the market prices of power and natural gas, changes in contracted commodity volumes, and decreases resulting from renewable energy contracts entered into pursuant to the FEJA.•Refunds paid in 2020 of $9 million associated with the November 2013 FERC complaint case, as discussed in Note 2 – Rate and Regulatory Matters under Part II, Item 8, of this report.•A $8 million increase in pension and postretirement benefit plan contributions.The decrease in Ameren Illinois’ cash from operating activities between periods was partially offset by a $14 million decrease in payroll tax payments primarily due to the employer portion of Social Security taxes as a result of a payment deferral allowed under the Coronavirus Aid, Relief, and Economic Security Act. Half of this deferral will be paid at the end of 2021 and the remaining half will be paid at the end of 2022.Pension PlansAmeren’s pension plans are funded in compliance with income tax regulations, federal funding requirements, and other regulatory requirements. As a result, Ameren expects to fund its pension plans at a level equal to the greater of the pension cost or the legally required minimum contribution. Based on Ameren’s assumptions at December 31, 2020, its investment performance in 2020, and its pension funding policy, Ameren expects to make aggregate contributions of $60 million over the next five years. We estimate that Ameren Missouri’s and Ameren Illinois’ portions of the future funding requirements will be approximately 30% and 60%, respectively. These estimates may change based on actual investment performance, changes in interest rates, changes in our assumptions, changes in government regulations, and any voluntary contributions. In 2020, Ameren contributed $52 million to its pension plans. See Note 10 – Retirement Benefits under Part II, Item 8, of this report for additional information. Cash Flows from Investing ActivitiesAmeren’s cash used in investing activities increased $894 million during 2020, compared with 2019, primarily as a result of a $564 million increase from the acquisition of the High Prairie Renewable Energy Center and a $258 million increase in capital expenditures. Cash used in investing activities also increased due to a $45 million increase in net investment activity in the nuclear decommissioning trust fund at Ameren Missouri and a $35 million increase due to the timing of nuclear fuel expenditures. In addition to the capital expenditure changes at Ameren Missouri and Ameren Illinois discussed below, Ameren’s capital expenditures were partially offset by a $43 million decrease in capital expenditures at ATXI and other electric transmission subsidiaries, primarily as a result of decreased Mark Twain transmission line expenditures, as it was placed in service in 2019. In 2020, ATXI placed the ninth and final line segment of the Illinois Rivers transmission line in service.Ameren Missouri’s cash used in investing activities increased $809 million during 2020, compared with 2019, primarily as a result of $564 million in cash paid for the acquisition of the High Prairie Renewable Energy Center and a $139 million increase in net money pool advances. Cash used in investing activities also increased due to a $45 million increase in net investment activity in the nuclear decommissioning trust fund, a $35 million increase due to the timing of nuclear fuel expenditures, and a $26 million increase in capital expenditures, primarily related to electric delivery infrastructure upgrades and electric transmission system reliability projects.Ameren Illinois’ cash used in investing activities increased $239 million during 2020, compared with 2019, due to an increase in capital expenditures, primarily related to electric transmission system reliability projects.54Table of ContentsCapital ExpendituresThe following charts present our capital expenditures for the years ended December 31, 2020 and 2019:2020 – Total Ameren $3,233(a)2019 – Total Ameren $2,411(a)Ameren Missouri(b)Ameren Illinois Natural GasATXI and other electric transmission subsidiariesAmeren Illinois Electric DistributionAmeren Illinois Transmission(a)Includes Other capital expenditures of $7 million and $(29) million for the years ended December 31, 2020 and 2019, respectively, which includes amounts for the elimination of intercompany transfers.(b)Ameren Missouri capital expenditures include $564 million for the acquisition of the High Prairie Renewable Energy Center for the year ended December 31, 2020.Ameren’s 2020 capital expenditures consisted of expenditures made by its subsidiaries, including ATXI and other electric transmission subsidiaries, which spent $113 million primarily on the Illinois Rivers transmission line. Of the $301 million in capital expenditures spent by Ameren Illinois Natural Gas during 2020, $189 million related to natural gas projects eligible for QIP recovery. In addition, Ameren Missouri expenditures included approximately $564 million for the acquisition of the High Prairie Renewable Energy Center. In both years, other capital expenditures were made principally to maintain, upgrade, and improve the reliability of the transmission and distribution systems of Ameren Missouri and Ameren Illinois by investing in substation upgrades, energy center projects, and smart-grid technology. Additionally, the Ameren Companies invested in various software projects.Ameren’s 2019 capital expenditures consisted of expenditures made by its subsidiaries, including ATXI, which spent $156 million primarily on the Mark Twain and Illinois Rivers transmission lines. Of the $318 million in capital expenditures spent by Ameren Illinois Natural Gas during 2019, $203 million related to natural gas projects eligible for QIP recovery. Ameren Illinois exceeded the minimum capital spending levels required pursuant to IEIMA in 2019.55Table of ContentsThe following table presents Ameren’s estimate of capital expenditures that will be incurred from 2021 through 2025, including construction expenditures, allowance for funds used during construction, and expenditures for compliance with existing environmental regulations:20212022-2025TotalAmeren Missouri$2,205 $6,450 –$7,130 $8,655 –$9,335 Ameren Illinois Electric Distribution515 2,060 –2,280 2,575 –2,795 Ameren Illinois Natural Gas335 1,315 –1,450 1,650 –1,785 Ameren Illinois Transmission615 2,715 –3,000 3,330 –3,615 ATXI and Other Electric Transmission Subsidiaries55 130 –140 185 –195 Other5 20 –25 25 –30 Ameren$3,730 $12,690 –$14,025 $16,420 –$17,755 Ameren Missouri’s estimated capital expenditures include transmission, distribution, grid modernization, and generation-related investments, as well as expenditures for compliance with environmental regulations. In addition, Ameren Missouri’s estimated capital expenditures include approximately $500 million related to 300 MWs of wind generation at the Atchison Renewable Energy Center, but exclude incremental renewable generation investment opportunities of 1,200 MWs by 2025, which are included in Ameren Missouri’s 2020 IRP. As of the date of this filing, no contractual agreements have been entered into, and no regulatory approvals have been requested, related to these opportunities. Ameren Illinois’ estimated capital expenditures are primarily for electric and natural gas transmission and distribution-related investments, including capital expenditures to modernize its electric and gas distribution systems. These planned investments are based on the assumption of continued constructive regulatory frameworks, including an assumption that Ameren Missouri requests and receives MoPSC approval of an extension of the PISA through December 2028.Ameren Missouri continually reviews its generation portfolio and expected power needs. As a result, Ameren Missouri could modify its plan for generation capacity, the type of generation asset technology that will be employed, and whether capacity or power may be purchased, among other changes. Additionally, we continually review the reliability of our transmission and distribution systems, expected capacity needs, and opportunities for transmission investments within and outside our service territories. The timing and amount of investments could vary because of changes in expected capacity, the condition of transmission and distribution systems, and our ability and willingness to pursue transmission investments, among other factors. Any changes in future generation, transmission, or distribution needs could result in significant changes in capital expenditures or losses, which could be material. Compliance with environmental regulations could also have significant impacts on the level of capital expenditures.Environmental Capital ExpendituresAmeren Missouri will continue to incur costs to comply with federal and state regulations, including those requiring the reduction of SO2, NOx, and mercury emissions from its coal-fired energy centers. See Note 14 – Commitments and Contingencies under Part II, Item 8, of this report for a discussion of existing and proposed environmental laws that affect, or may affect, our facilities and capital expenditures to comply with such laws.Cash Flows from Financing ActivitiesCash provided by, or used in, financing activities is a result of our financing needs, which depend on the level of cash provided by operating activities, the level of cash used in investing activities, the level of dividends, and our long-term debt maturities, among other things. As a result of capital market volatility, due, in part, to the COVID-19 pandemic, and to increase net available liquidity, Ameren (parent) accelerated a debt issuance to April 2020, which had been planned for later in 2020.Ameren’s cash provided by financing activities increased $1,393 million during 2020, compared with 2019. During 2020, Ameren utilized net proceeds of $2,183 million from the issuance of long-term debt for general corporate purposes, including to repay then-outstanding short-term debt, including short-term debt incurred in connection with the repayment at maturity of long-term debt, to partially finance the acquisition of two wind generation facilities, and to repay other long-term debt. In addition, Ameren received cash proceeds of $425 million from the partial settlement of a forward sale agreement of common stock that were used to fund a portion of Ameren Missouri’s wind generation investments. Collectively, in 2020, Ameren repaid long-term debt of $442 million, received $50 million from net commercial paper issuances, and used cash provided by financing activities to fund, in part, investing activities. In comparison, in 2019, Ameren utilized net proceeds of $1,527 million from the issuance of long-term debt to repay then-outstanding short-term debt, including short-term debt incurred in connection with the repayment at maturity of long-term debt, and to repay at maturity other long-term debt. Collectively, in 2019, Ameren repaid long-term debt of $580 million, repaid net short-term debt of $157 million, and used cash provided by financing activities to fund, in part, investing activities. During 2020, Ameren paid common stock dividends of $494 million, compared with $472 million, in dividend payments in 2019.56Table of ContentsAmeren Missouri’s cash provided by financing activities increased $1,040 million during 2020, compared with 2019. During 2020, Ameren Missouri utilized net proceeds of $1,012 million from the issuance of long-term debt to repay then-outstanding short-term debt, including short-term debt incurred in connection with the repayment at maturity of long-term debt, and to partially finance the acquisition of two wind generation facilities. Collectively, in 2020, Ameren Missouri repaid long-term debt of $92 million, repaid net short-term debt of $234 million, and used cash provided by financing activities to fund, in part, investing activities. In comparison, in 2019, Ameren Missouri utilized net proceeds of $778 million from the issuance of long-term debt to repay then-outstanding short-term debt, including short-term debt incurred in connection with the repayment at maturity of long-term debt, and to repay at maturity other long-term debt. Collectively, in 2019, Ameren Missouri repaid long-term debt of $580 million, received $179 million from net commercial paper issuances, and used cash provided by financing activities to fund, in part, investing activities. During 2020, Ameren Missouri received $491 million in capital contributions from Ameren (parent), of which, $67 million was associated with the tax allocation agreement, compared with $124 million in capital contributions received in 2019. During 2020, Ameren Missouri paid common stock dividends of $66 million, compared with $430 million in dividend payments in 2019, due to an increase in investing cash needs, including the acquisition of wind generation facilities.Ameren Illinois’ cash provided by financing activities increased $499 million during 2020, compared with 2019. During 2020, Ameren Illinois received $464 million in capital contributions from Ameren (parent), of which, $9 million was associated with the tax allocation agreement, compared with $15 million in capital contributions received in 2019. In addition, Ameren Illinois utilized net proceeds of $373 million from the issuance of long-term debt to repay then-outstanding short-term debt. Collectively, in 2020, Ameren Illinois repaid net short-term debt of $53 million, and used cash provided by financing activities to fund, in part, investing activities. In comparison, in 2019, Ameren Illinois utilized net proceeds of $299 million from the issuance of long-term debt to repay then-outstanding short-term debt. Collectively, in 2019 Ameren Illinois repaid net short-term debt of $19 million, and used cash provided by financing activities to fund, in part, investing activities. In addition, during 2020, Ameren Illinois borrowed $19 million from the money pool and paid common stock dividends of $9 million.Credit Facility Borrowings and LiquidityThe liquidity needs of the Ameren Companies are typically supported through the use of available cash, drawings under committed credit agreements, commercial paper issuances, and/or, in the case of Ameren Missouri and Ameren Illinois, short-term affiliate borrowings. See Note 4 – Short-term Debt and Liquidity under Part II, Item 8, of this report for additional information on credit agreements, commercial paper issuances, Ameren’s money pool arrangements and related borrowings, and relevant interest rates.The following table presents Ameren’s consolidated net available liquidity as of December 31, 2020:Available at December 31, 2020Ameren (parent) and Ameren Missouri(a):Missouri Credit Agreement – borrowing capacity$1,200 Less: Ameren (parent) commercial paper outstanding315 Less: Letters of credit3 Missouri Credit Agreement – subtotal882 Ameren (parent) and Ameren Illinois(b):Illinois Credit Agreement – borrowing capacity1,100 Less: Ameren (parent) commercial paper outstanding175 Less: Letters of credit1 Illinois Credit Agreement – subtotal924 Subtotal$1,806 Cash and cash equivalents139 Net Available Liquidity$1,945 (a) The maximum aggregate amount available to Ameren (parent) and Ameren Missouri under the Missouri Credit Agreement is $900 million and $850 million, respectively. See Note 4 – Short-term Debt and Liquidity under Part II, Item 8, of this report for further discussion of the Credit Agreements.(b) The maximum aggregate amount available to Ameren (parent) and Ameren Illinois under the Illinois Credit Agreement is $500 million and $800 million, respectively. See Note 4 – Short-term Debt and Liquidity under Part II, Item 8, of this report for further discussion of the Credit Agreements.The Credit Agreements, among other things, provide $2.3 billion of credit until maturity in December 2024. See Note 4 – Short-term Debt and Liquidity under Part II, Item 8, of this report for additional information on the Credit Agreements. During the year ended December 31, 2020, Ameren (parent), Ameren Missouri, and Ameren Illinois each borrowed under the Credit Agreements and issued commercial paper. Borrowings under the Credit Agreements and commercial paper issuances are based upon available interest rates at that time of the borrowing or issuance. As a result of volatility in the capital markets, the Ameren Companies borrowed under the Credit Agreements in certain instances in the first quarter of 2020 rather than issuing commercial paper.57Table of ContentsAmeren has a money pool agreement with and among its utility subsidiaries to coordinate and to provide for certain short-term cash and working capital requirements. As short-term capital needs arise, and based on availability of funding sources, Ameren Missouri and Ameren Illinois will access funds from the utility money pool, the Credit Agreements, or the commercial paper programs depending on which option has the lowest interest rates.The issuance of short-term debt securities by Ameren’s utility subsidiaries is subject to FERC approval under the Federal Power Act. In 2020, the FERC issued orders authorizing Ameren Missouri and Ameren Illinois to each issue up to $1 billion of short-term debt securities through March 2022 and September 2022, respectively. In July 2019, the FERC issued an order authorizing ATXI to issue up to $300 million of short-term debt securities through July 2021.The Ameren Companies continually evaluate the adequacy and appropriateness of their liquidity arrangements for changing business conditions. When business conditions warrant, changes may be made to existing credit agreements or to other short-term borrowing arrangements, or other arrangements may be made.Long-term Debt and EquityThe following table presents Ameren’s issuances (net of any issuance premiums or discounts) of long-term debt and equity, as well as redemptions and maturities of long-term debt for the years ended December 31, 2020 and 2019. For additional information related to the terms and uses of these issuances and effective registration statements, and Ameren’s forward sale agreement relating to common stock, see Note 5 – Long-term Debt and Equity Financings under Part II, Item 8, of this report. For information on capital contributions received by Ameren Missouri and Ameren Illinois from Ameren (parent), see Note 13 – Related-party Transactions under Part II, Item 8, of this report. Additionally, Ameren Illinois will redeem all outstanding shares of its 6.625% and 7.75% series preferred stock in March 2021. Month Issued, Redeemed, Repurchased, or Matured20202019Issuances of Long-term DebtAmeren:3.50% Senior unsecured notes due 2031April$798 $— 2.50% Senior unsecured notes due 2024September— 450 Ameren Missouri:2.95% First mortgage bonds due 2030March465 — 2.625% First mortgage bonds due 2051 (green bonds)October547 — 3.50% First mortgage bonds due 2029March— 450 3.25% First mortgage bonds due 2049October— 328 Ameren Illinois:1.55% First mortgage bonds due 2030November373 — 3.25% First mortgage bonds due 2050November— 299 Total long-term debt issuances $2,183 $1,527 Issuances of Common StockAmeren:DRPlus and 401(k)(a)(b)Various$51 $68 Forward sale agreement(c)December425 — Total common stock issuances$476 $68 Total Ameren long-term debt and common stock issuances$2,659 $1,595 Redemptions, Repurchases, and Maturities of Long-term DebtAmeren:2.70% Senior unsecured notes due 2020October$350 $— Ameren Missouri:5.00% Senior secured notes due 2020February85 — 6.70% Senior secured notes due 2019February— 329 5.10% Senior unsecured notes due 2019October— 244 5.45% First mortgage bonds due 2028October— (d)City of Bowling Green financing obligation (Peno Creek CT)December7 7 Ameren Illinois:5.70% First mortgage bonds due 2024September— (d)5.90% First mortgage bonds due 2023October— (d)Total long-term debt redemptions, repurchases, and maturities $442 $580 (a) Ameren issued a total of 0.7 million and 0.9 million shares of common stock under its DRPlus and 401(k) plan in 2020 and 2019, respectively.58Table of Contents(b) Excludes 0.5 million and 0.8 million shares of common stock valued at $38 million and $54 million issued for no cash consideration in connection with stock-based compensation in 2020 and 2019, respectively.(c) Ameren issued 5.9 million shares of common stock pursuant to a partial settlement of a forward sale agreement in December 2020.(d) Amount less than $1 million.The Ameren Companies may sell securities registered under their effective registration statements if market conditions and capital requirements warrant such sales. Any offer and sale will be made only by means of a prospectus that meets the requirements of the Securities Act of 1933 and the rules and regulations thereunder.Indebtedness Provisions and Other CovenantsAt December 31, 2020, the Ameren Companies were in compliance with the provisions and covenants contained within their credit agreements, indentures, and articles of incorporation, as applicable, and ATXI was in compliance with the provisions and covenants contained in its note purchase agreement. See Note 4 – Short-term Debt and Liquidity and Note 5 – Long-term Debt and Equity Financings under Part II, Item 8, of this report for a discussion of covenants and provisions (and applicable cross-default provisions) contained in our credit agreements, certain of the Ameren Companies’ indentures and articles of incorporation, and ATXI’s note purchase agreement.We consider access to short-term and long-term capital markets to be a significant source of funding for capital requirements not satisfied by cash provided by our operating activities. Inability to raise capital on reasonable terms, particularly during times of uncertainty in the capital markets, could negatively affect our ability to maintain and expand our businesses. After assessing its current operating performance, liquidity, and credit ratings (see Credit Ratings below), Ameren, Ameren Missouri, and Ameren Illinois each believes that it will continue to have access to the capital markets on reasonable terms. However, events beyond Ameren’s, Ameren Missouri’s, and Ameren Illinois’ control may create uncertainty in the capital markets or make access to the capital markets uncertain or limited. Such events could increase our cost of capital and adversely affect our ability to access the capital markets.DividendsAmeren paid to its shareholders common stock dividends totaling $494 million, or $2.00 per share, in 2020 and $472 million, or $1.92 per share, in 2019. The amount and timing of dividends payable on Ameren’s common stock are within the sole discretion of Ameren’s board of directors. Ameren’s board of directors has not set specific targets or payout parameters when declaring common stock dividends, but it considers various factors, including Ameren’s overall payout ratio, payout ratios of our peers, projected cash flow and potential future cash flow requirements, historical earnings and cash flow, projected earnings, impacts of regulatory orders or legislation, and other key business considerations. Ameren expects its dividend payout ratio to be between 55% and 70% of earnings over the next few years. On February 12, 2021, the board of directors of Ameren declared a quarterly dividend on Ameren’s common stock of 55 cents per share, payable on March 31, 2021, to shareholders of record on March 10, 2021.Certain of our financial agreements and corporate organizational documents contain covenants and conditions that, among other things, restrict the Ameren Companies’ payment of dividends in certain circumstances.Ameren Illinois’ articles of incorporation require its dividend payments on common stock to be based on ratios of common stock to total capitalization and other provisions with respect to certain operating expenses and accumulations of earned surplus. Additionally, Ameren has committed to the FERC to maintain a minimum of 30% equity in the capital structure at Ameren Illinois.Ameren Missouri and Ameren Illinois, as well as certain other nonregistrant Ameren subsidiaries, are subject to Section 305(a) of the Federal Power Act, which makes it unlawful for any officer or director of a public utility, as defined in the Federal Power Act, to participate in the making or paying of any dividend from any funds “properly included in capital account.” The FERC has consistently interpreted the provision to allow dividends to be paid as long as (1) the source of the dividends is clearly disclosed, (2) the dividends are not excessive, and (3) there is no self-dealing on the part of corporate officials. At a minimum, Ameren believes that dividends can be paid by its subsidiaries that are public utilities from net income and from retained earnings. In addition, under Illinois law, Ameren Illinois and ATXI may not pay any dividend on their respective stock unless, among other things, their respective earnings and earned surplus are sufficient to declare and pay a dividend after provisions are made for reasonable and proper reserves, or unless Ameren Illinois or ATXI has specific authorization from the ICC.At December 31, 2020, the amount of restricted net assets of Ameren’s subsidiaries that may not be distributed to Ameren in the form of a loan or dividend was $3.3 billion.59Table of ContentsThe following table presents common stock dividends declared and paid by Ameren Corporation to its common shareholders and by Ameren subsidiaries to their parent, Ameren:20202019Ameren$494 $472 Ameren Missouri66 430 Ameren Illinois9 — ATXI30 15 Ameren Missouri and Ameren Illinois each have issued preferred stock, which provides for cumulative preferred stock dividends. Each company’s board of directors considers the declaration of preferred stock dividends to shareholders of record on a certain date, stating the date on which the dividend is payable and the amount to be paid. See Note 5 – Long-term Debt and Equity Financings under Part II, Item 8, of this report for further detail concerning the preferred stock issuances.Contractual ObligationsThe following table presents our contractual obligations as of December 31, 2020. See Note 10 – Retirement Benefits under Part II, Item 8, of this report for information regarding expected minimum funding levels for our pension plans, which are not included in the table below. In addition, routine short-term purchase order commitments are not included.20212022 – 20232024 – 20252026 and ThereafterTotalAmeren:Long-term debt and financing obligations(a)$8 $745 $1,150 $9,287 $11,190 Interest payments431 843 741 4,876 6,891 Operating leases9 16 11 5 41 Other obligations(b)788 697 289 195 1,969 Total cash contractual obligations$1,236 $2,301 $2,191 $14,363 $20,091 Ameren Missouri:Long-term debt and financing obligations(a)$8 $295 $350 $4,499 $5,152 Interest payments216 427 358 2,412 3,413 Operating leases8 14 10 5 37 Other obligations(b)503 503 258 126 1,390 Total cash contractual obligations$735 $1,239 $976 $7,042 $9,992 Ameren Illinois:Long-term debt(a)$— $400 $300 $3,288 $3,988 Interest payments148 283 268 2,166 2,865 Other obligations(b)290 200 33 47 570 Total cash contractual obligations$438 $883 $601 $5,501 $7,423 (a)Excludes unamortized discount and premium and debt issuance costs of $12 million, $48 million, and $42 million at Ameren, Ameren Missouri, and Ameren Illinois, respectively. See Note 5 – Long-term Debt and Equity Financings under Part II, Item 8 of this report, for discussion of items included herein.(b)See Other Obligations in Note 14 – Commitments and Contingencies under Part II, Item 8 of this report, for discussion of items included herein.Off-balance-sheet ArrangementsAt December 31, 2020, none of the Ameren Companies had any significant off-balance-sheet financing arrangements, other than the forward sale agreement relating to common stock, which was fully settled by mid-February 2021, and variable interest entities. See Note 1 – Summary of Significant Accounting Policies under Part II, Item 8, of this report for further detail concerning variable interest entities. See Note 5 – Long-term Debt and Equity Financings under Part II, Item 8, of this report for further detail concerning the forward sale agreement relating to common stock.Credit RatingsOur credit ratings affect our liquidity, our access to the capital markets and credit markets, our cost of borrowing under our credit facilities and our commercial paper programs, and our collateral posting requirements under commodity contracts.60Table of ContentsThe following table presents the principal credit ratings of the Ameren Companies by Moody’s and S&P effective on the date of this report:Moody’sS&PAmeren:Issuer/corporate credit ratingBaa1BBB+Senior unsecured debtBaa1BBBCommercial paperP-2A-2Ameren Missouri:Issuer/corporate credit ratingBaa1BBB+Secured debtA2ASenior unsecured debtBaa1Not RatedCommercial paperP-2A-2Ameren Illinois:Issuer/corporate credit ratingA3BBB+Secured debtA1ASenior unsecured debtA3BBB+Commercial paperP-2A-2ATXI:Issuer credit ratingA2Not RatedSenior unsecured debtA2Not RatedA credit rating is not a recommendation to buy, sell, or hold securities. It should be evaluated independently of any other rating. Ratings are subject to revision or withdrawal at any time by the rating organization.Collateral PostingsAny weakening of our credit ratings may reduce access to capital and trigger additional collateral postings and prepayments. Such changes may also increase the cost of borrowing, resulting in an adverse effect on earnings. Cash collateral postings and prepayments made with external parties, including postings related to exchange-traded contracts, and cash collateral posted by external parties were immaterial at December 31, 2020. A sub-investment-grade issuer or senior unsecured debt rating (below “Baa3” from Moody’s or below “BBB-” from S&P) at December 31, 2020, could have resulted in Ameren, Ameren Missouri, or Ameren Illinois being required to post additional collateral or other assurances for certain trade obligations amounting to $119 million, $105 million, and $14 million, respectively.Changes in commodity prices could trigger additional collateral postings and prepayments. Based on credit ratings at December 31, 2020, if market prices were 15% higher or lower than December 31, 2020 levels in the next 12 months and 20% higher or lower thereafter through the end of the term of the commodity contracts, then Ameren, Ameren Missouri, or Ameren Illinois could be required to post an immaterial amount, compared to each company’s liquidity, of collateral or provide other assurances for certain trade obligations.OUTLOOKBelow are some key trends, events, and uncertainties that may reasonably affect our results of operations, financial condition, or liquidity, as well as our ability to achieve strategic and financial objectives, for 2021 and beyond. The continued effect of the COVID-19 pandemic on our results of operations, financial position, and liquidity in subsequent periods will depend on its severity and longevity, future regulatory or legislative actions with respect thereto, and the resulting impact on business, economic, and capital market conditions. We continue to assess the impacts the pandemic is having on our businesses, including but not limited to impacts on our liquidity; demand for residential, commercial, and industrial electric and natural gas services; changes in deferred payment arrangements for customers; the timing and extent to which recovery of incremental costs incurred, net of savings, and forgone customer late fee revenues at Ameren Missouri is allowed by the MoPSC; changes in our ability to disconnect customers for nonpayment; bad debt expense; supply chain operations; the availability of our employees and contractors; counterparty credit; capital construction; infrastructure operations and maintenance; energy-efficiency programs; and pension valuations. For additional information regarding recent rate orders, lawsuits, and pending requests filed with state and federal regulatory commissions, including those discussed below, see Note 2 – Rate and Regulatory Matters under Part II, Item 8, of this report.Operations•In 2020, we experienced a net decrease in our sales volumes, which have been, and continue to be, affected by the COVID-19 pandemic, among other things, but we expect gradual improvement in economic activities in 2021. Further, our customers’ payment for services has been adversely affected by the COVID-19 pandemic, which led to an increase in our accounts receivable balances that are past due or that are a part of a deferred payment arrangement. Because of their regulatory frameworks, Ameren Illinois’ and ATXI’s 61Table of Contentsrevenues are largely decoupled from changes in sales volumes. Additionally, Ameren Illinois’ electric distribution and natural gas distribution businesses have bad debt riders, which provide for recovery of bad debt write-offs, net of any subsequent recoveries. Pursuant to a June 2020 ICC order, Ameren Illinois’ electric bad debt rider provided for the recovery of bad debt expense in 2020, which reverted to the recovery of bad debt write-offs, net of any subsequent recoveries, in 2021. Ameren Missouri does not have a bad debt rider or tracker, and thus its earnings are exposed to increases in bad debt expense, absent regulatory relief. However, Ameren Missouri does not expect a material impact to earnings from increases in bad debt expense. See the Results of Operations section above for additional information on our accounts receivable balances and changes in Ameren Missouri’s sales volumes in 2020, compared to 2019, and sales volumes expected in 2021, compared to 2020. Additionally, see Note 2 – Rate and Regulatory Matters under Part II, Item 8, of this report for information on Ameren Missouri’s and Ameren Illinois’ reinstatement of customer disconnection and late fee charges for non-payment, requests filed with the MoPSC for accounting authority orders related to Ameren Missouri’s electric and natural gas services to allow Ameren Missouri to accumulate certain costs incurred, net of savings, and forgone customer late fee revenues related to the COVID-19 pandemic for consideration of recovery in future regulatory rate reviews, and a June 2020 ICC order in a service disconnection moratorium proceeding, which required Ameren Illinois to implement more flexible credit and collection practices and allowed for recovery of costs incurred related to the COVID-19 pandemic and forgone late fees.•In mid-February 2021, extremely cold weather in the central and southern United States, including in our service territories, caused a significant increase in customer demand for electricity and natural gas. These weather conditions resulted in industry natural gas supply disruptions and limitations, and operational issues at generation and transmission facilities throughout the regions. However, we did not experience significant generation or reliability issues. These events resulted in significant increases in power and natural gas prices in the energy markets. As a result of market purchases to serve incremental demand, Ameren Illinois and Ameren Missouri incurred additional natural gas costs of approximately $200 million and $50 million, respectively, for purchases made for resale between February 13, 2021, and February 17, 2021. These amounts are preliminary estimates and are subject to final settlement. The increase in our purchased power costs over the same time period was immaterial. Ameren Missouri and Ameren Illinois have riders to recover natural gas and purchased power costs. We do not expect this event will have a significant impact on our financial results or liquidity. •The PISA permits Ameren Missouri to defer and recover 85% of the depreciation expense and earn a return at the applicable WACC on investments in certain property, plant, and equipment placed in service, and not included in base rates. The regulatory asset for accumulated PISA deferrals also earns a return at the applicable WACC, with all approved PISA deferrals added to rate base prospectively and recovered over a period of 20 years following a regulatory rate review. Additionally, under the RESRAM, Ameren Missouri is permitted to recover the 15% of depreciation expense not recovered under the PISA, and earn a return at the applicable WACC for investments in renewable generation plant placed in service. Accumulated RESRAM deferrals earn carrying costs at short-term interest rates. The PISA and the RESRAM mitigate the effects of regulatory lag between regulatory rate reviews. Those investments not eligible for recovery under the PISA and the remaining 15% of certain property, plant, and equipment placed in service, unless eligible for recovery under the RESRAM, remain subject to regulatory lag. Ameren Missouri recognizes the cost of debt on PISA deferrals in revenue, instead of using the applicable WACC, with the difference recognized in revenues when recovery of such deferrals is reflected in customer rates. As a result of the PISA election, additional provisions of the law apply to Ameren Missouri, including limitations on electric customer rate increases. Ameren Missouri does not expect to exceed these rate increase limitations in 2021. Both the rate increase limitation and the PISA are effective through December 2023, unless Ameren Missouri requests and the MoPSC approves an extension through December 2028.•In 2018, the MoPSC issued an order approving Ameren Missouri’s MEEIA 2019 plan. The plan includes a portfolio of customer energy-efficiency programs through December 2022 and low-income customer energy-efficiency programs through December 2024, along with a rider. Ameren Missouri intends to invest $290 million over the life of the plan, including $65 million in 2021 and $70 million in 2022. The plan includes the continued use of the MEEIA rider, which allows Ameren Missouri to collect from, or refund to, customers any difference in actual MEEIA program costs and related lost electric margins and the amounts collected from customers. In addition, the plan includes a performance incentive that provides Ameren Missouri an opportunity to earn additional revenues by achieving certain customer energy-efficiency goals. If the target goals are achieved for 2020, 2021, and 2022, additional revenues of $10 million, $13 million, and $11 million would be recognized in 2021, 2022, and 2022, respectively. Incremental additional revenues of $3 million, $3 million, and $1 million may be earned for 2020, 2021, and 2022, respectively, and would be recognized in the respective following year if Ameren Missouri exceeds its targeted goals. Ameren Missouri’s ability to achieve and/or exceed targeted goals could be affected by the COVID-19 pandemic. Ameren Missouri recognized $6 million, $37 million, $11 million, and $28 million in revenues related to MEEIA performance incentives in 2020, 2019, 2018, and 2016, respectively.•In March 2020, the MoPSC issued an order in Ameren Missouri’s July 2019 electric service regulatory rate review, resulting in a decrease of $32 million to Ameren Missouri’s annual revenue requirement for electric retail service. The order reduced the annualized base level of net energy costs pursuant to the FAC by approximately $115 million from the base level established in the MoPSC’s March 2017 electric rate order. The order also changed the annualized regulatory asset and liability amortization amounts and the base level of expenses for trackers. On an annualized basis, these changes reflect approximately $20 million of increased revenues and approximate decreases in purchased power expenses of $15 million, other operating and maintenance expenses of $60 million, and income tax 62Table of Contentsexpenses of $20 million. Additionally, the annual revenue requirement incorporated increases of approximately $50 million for the reduction in sales volumes resulting from MEEIA programs and approximately $50 million of depreciation and amortization expense for amounts previously deferred under PISA. The increase in the annual revenue requirement related to the MEEIA programs is seasonally weighted to the summer. One of the stipulation and agreements approved by the MoPSC’s March 2020 order states that the net impact of the revenue and expense changes noted above reflects a 9.4% to 9.8% ROE on an unspecified percent of common equity applicable to rate base. The new rates, base level of expenses, and amortizations became effective on April 1, 2020.•Ameren Missouri expects to file for electric and natural gas service regulatory rate reviews by the end of March 2021. Ameren Missouri expects key drivers of the electric service regulatory rate review to include increased infrastructure investments and other costs of service.•Ameren Illinois and ATXI use a forward-looking rate calculation with an annual revenue requirement reconciliation for each company’s electric transmission business. Based on expected rate base growth and the currently allowed 10.52% ROE, the revenue requirements included in 2021 rates for Ameren Illinois’ and ATXI’s electric transmission businesses are $380 million and $200 million, respectively. These revenue requirements represent an increase in Ameren Illinois’ and ATXI’s revenue requirements of $67 million and $8 million, respectively, from the revenue requirements reflected in 2020 rates, primarily due to the expected rate base growth. These rates will affect Ameren Illinois’ and ATXI’s cash receipts during 2021, but will not determine their respective electric transmission service operating revenues, which will instead be based on 2021 actual recoverable costs, rate base, and a return on rate base at the applicable WACC as calculated under the FERC formula ratemaking framework.•The allowed base ROE for FERC-regulated transmission rates previously charged under the MISO tariff is the subject of an appeal filed with the United States Court of Appeals for the District of Columbia Circuit. Depending on the outcome of the appeal, the transmission rates charged during previous periods and the currently effective rates may be subject to change. A proposed rulemaking also has been issued by the FERC regarding the transmission incentives policy, including the basis points added for transmission owner participation in an RTO, and a separate notice of inquiry regarding the base ROE generally applicable to the industry. Ameren is unable to predict the ultimate impact of any changes to the FERC’s incentives policy, action on the notice of inquiry on ROE, or any further order on base ROE. A 50 basis point change in the FERC-allowed base ROE would affect Ameren’s and Ameren Illinois’ annual net income by an estimated $11 million and $7 million, respectively, based on each company’s 2021 projected rate base.•Ameren Illinois’ electric distribution service performance-based formula ratemaking framework allows Ameren Illinois to reconcile electric distribution service rates to its actual revenue requirement on an annual basis. If a given year’s revenue requirement varies from the amount collected from customers, an adjustment is made to electric operating revenues with an offset to a regulatory asset or liability to reflect that year’s actual revenue requirement, independent of actual sales volumes. The regulatory balance is then collected from, or refunded to, customers within two years from the end of the year. Unless extended, the performance-based formula ratemaking framework expires at the end of 2022. If not extended, Ameren Illinois would be required to establish future rates through a traditional regulatory rate review, which would allow the use of a future test year, with the ICC. The decoupling provisions extend beyond the end of the formula ratemaking by law, which ensures that Ameren Illinois’ electric distribution revenues authorized in a regulatory rate review are not affected by changes in sales volumes. Ameren Illinois is actively pursuing constructive ratemaking, and filed a request with the ICC in April 2020, which, if approved, would allow Ameren Illinois to continue to reconcile electric distribution service rates to the last annual revenue requirement approved by the ICC under the performance-based formula ratemaking framework, for a period of up to two years after the framework expires or is no longer elected. Ameren Illinois expects a decision by the ICC in March 2021.•In December 2020, the ICC issued an order in Ameren Illinois’ annual update filing that approved a $49 million decrease in Ameren Illinois’ electric distribution service rates beginning in January 2021. Illinois law provides for an annual reconciliation of the electric distribution revenue requirement as is necessary to reflect the actual costs incurred and a return at the applicable WACC on year-end rate base in a given year with the revenue requirement that was reflected in customer rates for that year. Consequently, Ameren Illinois’ 2021 electric distribution service revenues will be based on its 2021 actual recoverable costs, 2021 year-end rate base, and a return at the applicable WACC, with the ROE based on the annual average of the monthly yields of the 30-year United States Treasury bonds plus 580 basis points. As of December 31, 2020, Ameren Illinois expects its 2021 year-end rate base to be $3.7 billion. With or without extension of the formula ratemaking framework, the 2021 revenue requirement reconciliation will be collected from, or refunded to, customers in 2023. A 50 basis point change in the annual average of the monthly yields of the 30-year United States Treasury bonds would result in an estimated $10 million change in Ameren’s and Ameren Illinois’ annual net income, based on Ameren Illinois’ 2021 projected year-end rate base. Ameren Illinois’ allowed ROE for 2020 was based on an annual average of the monthly yields of the 30-year United States Treasury bonds of 1.56%.•Ameren Illinois earns a return at the applicable WACC on its electric energy-efficiency program investments. Ameren Illinois’ electric energy-efficiency investments are deferred as a regulatory asset and earn a return at the applicable WACC, with the ROE based on the annual average of the monthly yields of the 30-year United States Treasury bonds plus 580 basis points. The allowed ROE on electric energy-efficiency investments can be increased or decreased by up to 200 basis points, depending on the achievement of annual 63Table of Contentsenergy savings goals. Ameren Illinois plans to invest up to approximately $100 million per year in electric energy-efficiency programs through 2025, and will earn a return on those investments. While the ICC has approved a plan consistent with this spending level through 2021, the ICC has the ability to reduce the amount of electric energy-efficiency savings goals in future plan program years if there are insufficient cost-effective programs available, which could reduce the investments in electric energy-efficiency programs. The electric energy-efficiency program investments and the return on those investments are collected from customers through a rider and are not included in the electric distribution service performance-based formula ratemaking framework.•In January 2021, the ICC issued an order in Ameren Illinois’ February 2020 natural gas delivery service regulatory rate review, which resulted in an increase to its annual revenues for natural gas delivery service of $76 million. The new rates became effective in January 2021. As a result of this order, the rate base under the QIP was reset to zero. Ameren Illinois used a 2021 future test year in this proceeding.•In February 2020, the MoPSC issued an order approving a stipulation and agreement allowing Ameren Missouri to defer and amortize maintenance expenses related to scheduled refueling and maintenance outages at its Callaway Energy Center. Maintenance expenses are amortized over the period between refueling and maintenance outages, which is approximately 18 months. During its return to full power after the completion of the last refueling and maintenance outage in late December 2020, the Callaway Energy Center experienced a non-nuclear operating issue related to its generator. A thorough investigation of this matter was conducted. Work has begun to replace certain key components of the generator in order to return the energy center to service. Ameren Missouri expects generator repairs of $65 million, which are expected to be largely capital expenditures. Due to the long lead time for the manufacture, repair, and installation of the components, the energy center is expected to return to service in late June or early July 2021. As of December 31, 2020, Ameren Missouri deferred, as a regulatory asset, $39 million in maintenance expenses related to its scheduled fall 2020 outage, which it began to amortize in January 2021. The regulatory asset will be amortized until the completion of the next refueling and maintenance outage. For the duration of the unplanned outage, Ameren Missouri expects an increase to its purchased power expense and a decrease to its off-system sales, with changes to both items recovered under the FAC. Ameren Missouri does not expect a significant increase to other operations and maintenance expense as a result of the unplanned outage. Prior to 2020, maintenance expenses for refueling and maintenance outages were expensed as incurred.•Ameren Missouri and Ameren Illinois continue to make infrastructure investments and expect to seek increases to electric and natural gas rates to recover the cost of investments and earn an adequate return. Ameren Missouri and Ameren Illinois will also seek new, or to maintain existing, legislative solutions to address regulatory lag and to support investment in their utility infrastructure for the benefit of their customers. Ameren Missouri and Ameren Illinois continue to face cost recovery pressures, including limited economic growth in their service territories, economic impacts of COVID-19, customer conservation efforts, the impacts of additional customer energy-efficiency programs, and increased customer use of increasingly cost-effective technological advances, including private generation and energy storage. However, over the long-term, we expect the decreased demand to be partially offset by increased demand resulting from increased electrification of the economy for efficiencies and as a means to address economy-wide CO2 emission concerns. We expect that increased investments, including expected future investments for environmental compliance, system reliability improvements, and potential new generation sources, will result in rate base and revenue growth but also higher depreciation and financing costs.Liquidity and Capital Resources•Our customers’ payment for our services has been adversely affected by the COVID-19 pandemic, resulting in a decrease to our cash flow from operations. See the Results of Operations section above for additional information on our accounts receivable balances. Further, our liquidity and our capital expenditure plans could be adversely affected by other impacts resulting from the COVID-19 pandemic, including but not limited to potential impacts on our ability to access the capital markets on reasonable terms and when needed, Ameren Missouri’s expected wind generation additions remaining in 2021, and the timing of tax payments and the utilization of tax credits. We expect to make significant capital expenditures to improve our electric and natural gas utility infrastructure, however, disruptions to the capital markets and the ability of our suppliers and contractors to perform as required under their contracts could impact the execution of our capital investment strategy. For further discussion on the impacts to our ability to access the capital markets and Ameren Missouri’s expected wind generation additions remaining in 2021, see below. •In February 2021, Ameren Missouri filed an update to its Smart Energy Plan with the MoPSC, which includes a five-year capital investment overview with a detailed one-year plan for 2021. The plan is designed to upgrade Ameren Missouri’s electric infrastructure and includes investments that will upgrade the grid and accommodate more renewable energy. Investments under the plan are expected to total approximately $8.4 billion over the five-year period from 2021 through 2025, with expenditures largely recoverable under the PISA and the RESRAM. The planned investments in 2024 and 2025 are based on the assumption that Ameren Missouri requests and receives MoPSC approval of an extension of the PISA through December 2028.64Table of Contents•In September 2020, Ameren Missouri filed its 2020 IRP with the MoPSC. In connection with the 2020 IRP filing, Ameren established a goal of achieving net-zero carbon emissions by 2050. Ameren is also targeting a 50% CO2 emission reduction by 2030 and an 85% reduction by 2040 from the 2005 level. The plan, which is subject to review by the MoPSC for compliance with Missouri law, targets cleaner and more diverse sources of energy generation, including solar, wind, hydro, and nuclear power, and supports increased investment in new energy technologies. It also includes expanding renewable sources by adding 3,100 MWs of renewable generation by the end of 2030 and a total of 5,400 MWs of renewable generation by 2040. These amounts include the 700 MWs of wind generation projects discussed below, which will support Ameren Missouri’s compliance with the state of Missouri’s requirement of achieving 15% of native load sales from renewable energy sources beginning in 2021. The plan also includes advancing the retirement dates of the Sioux and Rush Island coal-fired energy centers to 2028 and 2039, respectively, which are subject to the approval of a change in the assets’ depreciable lives by the MoPSC in a future regulatory rate review, the continued implementation of customer energy-efficiency programs, and the expectation that Ameren Missouri will seek NRC approval for an extension of the operating license for the Callaway Energy Center beyond its current 2044 expiration date. Additionally, the plan includes retiring the Meramec and Labadie coal-fired energy centers at the end of their useful lives (by 2022 and 2042, respectively). Ameren Missouri’s plan could be affected by, among other factors: Ameren Missouri’s ability to obtain a certificate of convenience and necessity from the MoPSC, and any other required approvals for the addition of renewable resources, retirement of energy centers, and new or continued customer energy-efficiency programs; the ability of developers to meet contractual commitments and timely complete projects, which is dependent upon the availability of necessary materials and equipment, including those that are affected by the disruptions in the global supply chain caused by the COVID-19 pandemic, among other things; the availability of federal production and investment tax credits related to renewable energy and Ameren Missouri’s ability to use such credits; the cost of wind, solar, and other renewable generation and storage technologies; changes in environmental laws or requirements, including those related to carbon emissions; energy prices and demand; and Ameren Missouri’s ability to obtain timely interconnection agreements with the MISO or other RTOs at an acceptable cost. The next integrated resource plan is expected to be filed in September 2023.•In December 2020, Ameren Missouri acquired a 400-MW wind generation project located in northeastern Missouri for approximately $615 million, and placed the assets in service as the High Prairie Renewable Energy Center. In January 2021, Ameren Missouri acquired an up-to 300-MW wind generation project located in northwestern Missouri. At the date of this filing, Ameren Missouri placed 120 MWs in service as the Atchison Renewable Energy Center, with a purchase price of approximately $200 million. There have been changes to the schedule for this project, particularly as a result of component delivery delays. Ameren Missouri expects approximately 150 MWs of the up-to 300-MW project to be in service by the end of the first quarter of 2021, and the remaining portion to be in service later in 2021. See discussion below related to production tax credits.•Through 2025, we expect to make significant capital expenditures to improve our electric and natural gas utility infrastructure, with a major portion directed to our transmission and distribution systems. We estimate that we will invest up to $17.8 billion (Ameren Missouri – up to $9.3 billion; Ameren Illinois – up to $8.2 billion; ATXI – up to $0.2 billion) of capital expenditures during the period from 2021 through 2025. Ameren’s and Ameren Missouri’s estimates include 300 MWs of wind generation at the Atchison Renewable Energy Center, but exclude incremental renewable generation investment opportunities of 1,200 MWs by 2025, which are included in Ameren Missouri’s 2020 IRP. As of the date of this filing, no contractual agreements have been entered into, and no regulatory approvals have been requested, related to these opportunities. These planned investments are based on the assumption of continued constructive regulatory frameworks, including an assumption that Ameren Missouri requests and receives MoPSC approval of an extension of the PISA through December 2028.•Environmental regulations, including those related to CO2 emissions, or other actions taken by the EPA, or requirements that may result from the NSR and Clean Air Act Litigation discussed in Note 14 – Commitments and Contingencies under Part II, Item 8, of this report, could result in significant increases in capital expenditures and operating costs. Regulations enacted by a prior federal administration and under legal challenge can be reviewed or recommended for repeal by the EPA, and new replacement or alternative regulations can be proposed, or adopted by the current federal administration, the EPA and state regulators. The ultimate implementation of any of these regulations, as well as the timing of any such implementation, is uncertain. However, the individual or combined effects of existing and new environmental regulations could result in significant capital expenditures, increased operating costs, or the closure or alteration of some of Ameren Missouri’s coal-fired energy centers. Ameren Missouri’s capital expenditures are subject to MoPSC prudence reviews, which could result in cost disallowances as well as regulatory lag. The cost of Ameren Illinois’ purchased power and natural gas purchased for resale could increase. However, Ameren Illinois expects that these costs would be recovered from customers with no material adverse effect on its results of operations, financial position, or liquidity. Ameren’s and Ameren Missouri’s earnings could benefit from increased investment to comply with environmental regulations if those investments are reflected and recovered on a timely basis in customer rates.•The Ameren Companies have multiyear credit agreements that cumulatively provide $2.3 billion of credit through December 2024, subject to a 364-day repayment term for Ameren Missouri and Ameren Illinois, with the option to seek incremental commitments to increase the cumulative credit provided to $2.7 billion. See Note 4 – Short-term Debt and Liquidity under Part II, Item 8, of this report for additional information regarding the Credit Agreements. The Ameren Companies have no material maturities of long-term debt until 65Table of Contents2022. With the recently completed Ameren Missouri and Ameren Illinois debt issuances and availability under the Credit Agreements, as well as the proceeds from the recent settlement of the forward sale agreement, Ameren, Ameren Missouri, and Ameren Illinois believe that their liquidity is adequate given their expected operating cash flows, capital expenditures, including expected wind generation additions remaining in 2021, and financing plans. The Ameren Companies continue to monitor the effect of the COVID-19 pandemic on their liquidity, including as a result of decreased sales and increased customer nonpayment. To date, the Ameren Companies have been able to access the capital markets on reasonable terms when needed. However, there can be no assurance that significant changes in economic conditions, disruptions in the capital and credit markets, or other unforeseen events will not materially affect their ability to execute their expected operating, capital, or financing plans.•Ameren expects its cash used for currently planned capital expenditures and dividends to exceed cash provided by operating activities over the next several years. As part of its plan to fund these cash flow requirements, Ameren is using newly issued shares of common stock, rather than market-purchased shares, to satisfy requirements under the DRPlus and employee benefit plans and expects to continue to do so through at least 2025. Ameren expects these issuances to provide equity of about $100 million annually. In addition to the issuance of common shares in connection with the 2021 settlement of the remaining portion of the forward sale agreement, Ameren plans to issue incremental equity of about $150 million in 2021 and about $300 million each year from 2022 to 2025. Ameren expects its equity to total capitalization to be about 45% through December 31, 2025, with the long-term intent to support solid investment-grade credit ratings. Ameren Missouri and Ameren Illinois expect to fund cash flow needs through debt issuances, adjustments of dividends to Ameren (parent), and/or capital contributions from Ameren (parent).•As of December 31, 2020, Ameren had $90 million in tax benefits related to federal and state income tax credit carryforwards and $7 million in tax benefits from state net operating loss carryforwards, which will be utilized in future periods. Ameren expects federal income tax payments at the required minimum levels from 2021 to 2025 resulting from the anticipated use of production tax credits that will be generated by Ameren Missouri’s High Prairie and Atchison renewable energy centers and existing tax credit carryforwards.The above items could have a material impact on our results of operations, financial position, and liquidity. Additionally, in the ordinary course of business, we evaluate strategies to enhance our results of operations, financial position, and liquidity. These strategies may include acquisitions, divestitures, opportunities to reduce costs or increase revenues, and other strategic initiatives to increase Ameren’s shareholder value. We are unable to predict which, if any, of these initiatives will be executed. The execution of these initiatives may have a material impact on our future results of operations, financial position, or liquidity.REGULATORY MATTERSSee Note 2 – Rate and Regulatory Matters under Part II, Item 8, of this report.ACCOUNTING MATTERSCritical Accounting EstimatesPreparation of the financial statements and related disclosures in compliance with GAAP requires the application of appropriate technical accounting rules and guidance, as well as the use of estimates. These estimates involve judgments regarding many factors that in and of themselves could materially affect the financial statements and disclosures. We have outlined below the critical accounting estimates that we believe are the most difficult, subjective, or complex. Any change in the assumptions or judgments applied in determining the following matters, among others, could have a material impact on future financial results.66Table of ContentsAccounting EstimateUncertainties Affecting ApplicationRegulatory Mechanisms and Cost RecoveryWe defer costs and recognize revenues that we intend to collect in future rates.•Regulatory environment and external regulatory decisions and requirements•Anticipated future regulatory decisions and our assessment of their impact•The impact of prudence reviews, complaint cases, limitations on electric rate increases in Missouri, and opposition during the ratemaking process that may limit our ability to timely recover costs and earn a fair return on our investments•Ameren Illinois’ assessment of and ability to estimate the current year’s electric distribution service costs to be reflected in revenues and recovered from customers in a subsequent year under performance-based formula ratemaking framework•Ameren Illinois’ and ATXI’s assessment of and ability to estimate the current year’s electric transmission service costs to be reflected in revenues and recovered from customers in a subsequent year under the FERC ratemaking frameworks•Ameren Missouri’s estimate of revenue recovery under the MEEIA plansBasis for JudgmentThe application of accounting guidance for rate-regulated businesses results in recording regulatory assets and liabilities. Regulatory assets represent the deferral of incurred costs that are probable of future recovery in customer rates. Regulatory assets are amortized as the incurred costs are recovered through customer rates. In some cases, we record regulatory assets before approval for recovery has been received from the applicable regulatory commission. We must use judgment to conclude that costs deferred as regulatory assets are probable of future recovery. We base our conclusion on certain factors including, but not limited to, orders issued by our regulatory commissions, legislation, or historical experience, as well as discussions with legal counsel. If facts and circumstances lead us to conclude that a recorded regulatory asset is no longer probable of recovery or that plant assets are probable of disallowance, we record a charge to earnings, which could be material. Regulatory liabilities represent revenues received from customers to fund expected costs that have not yet been incurred or that are probable of future refunds to customers. We also recognize revenues for alternative revenue programs authorized by our regulators that allow for an automatic rate adjustment, are probable of recovery, and are collected within 24 months following the end of the annual period in which they are recognized. Under performance-based formula ratemaking, which expires at the end of 2022 unless extended, Ameren Illinois estimates its annual electric distribution revenue requirement for interim periods by using internal forecasted rate base and published forecasted data regarding the annual average of the monthly yields of the 30-year United States Treasury bonds. Ameren Illinois estimates its annual revenue requirement as of December 31 of each year using that year’s actual operating results and assesses the probability of recovery from or refund to customers that the ICC will order at the end of the following year. Variations in investments made or orders by the ICC or courts can result in a subsequent change in Ameren Illinois’ estimate. Ameren Illinois and ATXI follow a similar process for their FERC rate-regulated electric transmission businesses. Ameren Missouri estimates lost electric margins resulting from its MEEIA customer energy-efficiency programs, which are subsequently recovered through the MEEIA rider. See Note 2 – Rate and Regulatory Matters under Part II, Item 8, of this report for a description of our regulatory mechanisms and quantification of these assets or liabilities for each of the Ameren Companies.67Table of ContentsAccounting EstimateUncertainties Affecting ApplicationBenefit Plan AccountingBased on actuarial calculations, we accrue costs of providing future employee benefits for the benefit plans we offer our employees. See Note 10 – Retirement Benefits under Part II, Item 8, of this report.•Valuation inputs and assumptions used in the fair value measurements of plan assets, excluding those inputs that are readily observable•Discount rate•Cash balance plan interest crediting rate on certain plans•Future compensation increase assumption•Health care cost trend rates•Assumptions on the timing of employee retirements, terminations, benefit payments, and mortality•Ability to recover certain benefit plan costs from our customers•Changing market conditions that may affect investment and interest rate environments•Future rate of return on pension and other plan assetsBasis for JudgmentAmeren has defined benefit pension plans covering substantially all of its employees and has postretirement benefit plans covering non-union employees hired before October 2015 and union employees hired before January 2020. Our ultimate selection of the discount rate, health care trend rate, and expected rate of return on pension and other postretirement benefit plan assets is based on our consistent application of assumption-setting methodologies and our review of available historical, current, and projected rates, as applicable. We also make mortality assumptions to estimate our pension and other postretirement benefit obligations. See Note 10 – Retirement Benefits under Part II, Item 8, of this report for these assumptions and the sensitivity of Ameren’s benefit plans to potential changes in these assumptions.Accounting EstimateUncertainties Affecting ApplicationAccounting for ContingenciesWe make judgments and estimates in the recording and the disclosing of liabilities for claims, litigation, environmental remediation, the actions of various regulatory agencies, or other matters that occur in the normal course of business. We record a loss contingency when it is probable that a liability has been incurred and that the amount of the loss can be reasonably estimated.•Estimating financial impact of events•Estimating likelihood of various potential outcomes•Regulatory and political environments and requirements•Outcome of legal proceedings, settlements, or other factors•Changes in regulation, expected scope of work, technology, or timing of environmental remediationBasis for JudgmentThe determination of a loss contingency requires significant judgment as to the expected outcome of the contingency in future periods. In making the determination as to the amount of potential loss and the probability of loss, we consider the nature of the litigation, the claim or assessment, opinions or views of legal counsel, and the expected outcome of potential litigation, among other things. If no estimate is better than another within our range of estimates, we record as our best estimate of a loss the minimum value of our estimated range of outcomes. As additional information becomes available, we reassess the potential liability related to the contingency and revise our estimates. The amount recorded for any contingency may differ from actual costs incurred when the contingency is resolved. Contingencies are normally resolved over long periods of time. In our evaluation of legal matters, management consults with legal counsel and relies on analysis of relevant case law and legal precedents. See Note 2 – Rate and Regulatory Matters, Note 9 – Callaway Energy Center, and Note 14 – Commitments and Contingencies under Part II, Item 8, of this report for information on the Ameren Companies’ contingencies.68Table of ContentsAccounting EstimateUncertainties Affecting ApplicationAccounting for Income TaxesWe record a provision for income taxes, deferred tax assets and liabilities, and a valuation allowance against net deferred tax assets, if any. See Note 12 – Income Taxes under Part II, Item 8, of this report.•Changes in business, industry, laws, technology, or economic and market conditions affecting forecasted financial condition and/or results of operations•Estimates of the amount and character of future taxable income and forecasted use of our tax credit carryforwards•Enacted tax rates applicable to taxable income in years in which temporary differences are recovered or settled•Effectiveness of implementing tax planning strategies•Changes in income tax laws, including amounts subject to income tax, and the regulatory treatment of any tax reform changes•Results of audits and examinations by taxing authoritiesBasis for JudgmentThe reporting of tax-related assets and liabilities requires the use of estimates and significant management judgment. Deferred tax assets and liabilities are recorded to represent future effects on income taxes for temporary differences between the basis of assets for financial reporting and tax purposes. Although management believes that current estimates for deferred tax assets and liabilities are reasonable, actual results could differ from these estimates for a variety of reasons, including: a change in forecasted financial condition and/or results of operations; changes in income tax laws, enacted tax rates or amounts subject to income tax; the form, structure, and timing of asset or stock sales or dispositions; changes in the regulatory treatment of any tax reform benefits; and changes resulting from audits and examinations by taxing authorities. Valuation allowances against deferred tax assets are recorded when management concludes it is more likely than not such asset will not be realized in future periods. Accounting for income taxes also requires that only tax benefits for positions taken or expected to be taken on tax returns that meet the more-likely-than-not recognition threshold can be recognized or continue to be recognized. Management evaluates each position solely on the technical merits and facts and circumstances of the position, assuming that the position will be examined by a taxing authority that has full knowledge of all relevant information. Significant judgment is required to determine recognition thresholds and the related amount of tax benefits to be recognized. At each period end, and as new developments occur, management reevaluates its tax positions. See Note 12 – Income Taxes under Part II, Item 8, of this report for the amount of deferred income taxes recorded at December 31, 2020.Accounting EstimateUncertainties Affecting ApplicationAccounting for Asset Retirement ObligationsWe record the estimated fair value of legal obligations associated with the retirement of tangible long-lived assets. See Note 1 – Summary of Significant Accounting Policies under Part II, Item 8, of this report.•Discount rates•Cost escalation rates•Changes in regulation, expected scope of work, technology, or timing of environmental remediation•Estimates as to the probability, timing, or amount of cash expenditures associated with AROsBasis for JudgmentWe record the estimated fair value of legal obligations associated with the retirement of tangible long-lived assets in the period in which the liabilities are incurred and capitalize a corresponding amount as part of the book value of the related long-lived asset. In subsequent periods, we adjust AROs for accretion and changes in the estimated fair values of the obligations, with a corresponding increase or decrease in the asset book value for the fair value changes. We estimate the fair value of our AROs using present value techniques, in which we make various assumptions about discount rates and cost escalation rates. In addition, these estimates include assumptions of the probability, timing, and amount of cash expenditures to settle the ARO, and are based on currently available technology. Ameren and Ameren Missouri have recorded AROs for retirement costs associated with the decommissioning of Ameren Missouri’s Callaway and High Prairie Renewable energy centers, CCR facilities, and river structures. Also, Ameren, Ameren Missouri, and Ameren Illinois have recorded AROs for retirement costs associated with asbestos removal and the disposal of certain transformers. An increase of 0.25% in the assumed escalation rates would increase Ameren’s AROs at December 31, 2020, by $78 million. See Note 15 – Supplemental Information under Part II, Item 8, of this report for the amount of AROs recorded at December 31, 2020.Impact of New Accounting PronouncementsSee Note 1 – Summary of Significant Accounting Policies under Part II, Item 8, of this report.69Table of ContentsEFFECTS OF INFLATION AND CHANGING PRICESAmeren’s rates for retail electric and natural gas utility service are regulated by the MoPSC and the ICC. Nonretail electric rates are regulated by the FERC. Rate regulation is generally based on the recovery of historical or projected costs. As a result, revenue increases could lag changing prices. The current replacement cost of our utility plant substantially exceeds our recorded historical cost. Under existing regulatory practice, the historical cost of plant is recoverable from customers. As a result, customer rates designed to provide recovery of historical costs through depreciation might not be adequate to replace plant in future years.Ameren Illinois participates in performance-based formula ratemaking for its electric distribution business and its electric energy-efficiency investments. Within those ratemaking frameworks, the annual average of the monthly yields of the 30-year United States Treasury bonds are the basis for Ameren Illinois’ allowed ROE. Therefore, there is a direct correlation between the yield of United States Treasury bonds, which are affected by inflation, and the allowed ROE applicable to Ameren Illinois’ electric distribution business and electric energy-efficiency investments. Ameren Illinois’ and ATXI’s electric transmission rates are determined pursuant to formula ratemaking. Additionally, Ameren Illinois and ATXI use a company-specific, forward-looking formula ratemaking framework in setting their transmission rates. These forward-looking rates are updated each January with forecasted information. A reconciliation during the year, which adjusts for the actual revenue requirement and for actual sales volumes, is used to adjust billing rates in a subsequent year.Ameren Missouri recovers the cost of fuel for electric generation and the cost of purchased power by adjusting rates as allowed through the FAC. However, the FAC excludes substantially all transmission revenues and charges. Ameren Missouri is therefore exposed to transmission charges to the extent that they exceed transmission revenues. Ameren Illinois is required to purchase all of its expected power supply through procurement processes administered by the IPA. The cost of procured power can be affected by inflation. Ameren Illinois recovers power supply costs from electric customers by adjusting rates through a rider mechanism to accommodate changes in power prices.In our Missouri and Illinois retail natural gas utility jurisdictions, changes in natural gas costs are generally reflected in billings to natural gas customers through PGA clauses.See Part I, Item 1, and Note 2 – Rate and Regulatory Matters under Part II, Item 8, of this report for additional information on our recovery mechanisms.ITEM 7A.QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKMarket risk is the risk of changes in value of a physical asset or a financial instrument, derivative or nonderivative, caused by fluctuations in market variables such as interest rates, commodity prices, and equity security prices. A derivative is a contract whose value is dependent on, or derived from, the value of some underlying asset or index. The following discussion of our risk management activities includes forward-looking statements that involve risks and uncertainties. Actual results could differ materially from those projected in the forward-looking statements. We handle market risks in accordance with established policies, which may include entering into various derivative transactions. In the normal course of business, we also face risks that are either nonfinancial or nonquantifiable. Such risks, principally business, legal, and operational risks, are not part of the following discussion.Our risk management objectives are to optimize our physical generating assets and to pursue market opportunities within prudent risk parameters. Our risk management policies are set by a risk management steering committee, which is composed of senior-level Ameren officers, with Ameren board of directors’ oversight.Interest Rate RiskWe are exposed to market risk through changes in interest rates associated with:•short-term variable-rate debt;•fixed-rate debt;•United States Treasury bonds; and•the discount rate applicable to asset retirement obligations, goodwill, and defined pension and postretirement benefit plans.We manage our interest rate exposure by controlling the amount of debt instruments within our total capitalization portfolio and by monitoring the effects of market changes on interest rates. For defined pension and postretirement benefit plans, we control the duration and the portfolio mix of our plan assets. See Note 1 – Summary of Significant Accounting Policies and Note 10 – Retirement Benefits under Part II, Item 8, of this report for additional information related to asset retirement obligations, goodwill, and the defined pension and postretirement benefit plans.The estimated increase in our annual interest expense and decrease in net income if interest rates were to increase by 100 basis points on variable-rate debt outstanding at December 31, 2020 is immaterial.70Table of ContentsThe allowed ROE under Ameren Illinois’ electric distribution service and its electric energy-efficiency investments formula ratemaking recovery mechanisms is based on the annual average of the monthly yields of the 30-year United States Treasury bonds plus 580 basis points. Therefore, Ameren Illinois’ annual ROE for its electric distribution business is directly correlated to the yields on such bonds, which are outside of Ameren Illinois’ control. A 50 basis point change in the annual average of the monthly yields of the 30-year United States Treasury bonds would result in an estimated $10 million change in Ameren’s and Ameren Illinois’ annual net income, based on its 2021 projected rate base. Interest rate levels also influence the ROE allowed by our regulators in our other ratemaking jurisdictions as well as the carrying costs associated with certain regulatory assets and liabilities.Credit RiskCredit risk represents the loss that would be recognized if counterparties should fail to perform as contracted. Exchange-traded contracts are supported by the financial and credit quality of the clearing members of the respective exchanges and carry only a nominal credit risk. In all other transactions, we are exposed to credit risk in the event of nonperformance by the counterparties to the transaction. See Note 7 – Derivative Financial Instruments under Part II, Item 8, of this report for information on the potential loss on counterparty exposure as of December 31, 2020.Our revenues are primarily derived from sales or delivery of electricity and natural gas to customers in Missouri and Illinois. Our physical and financial instruments are subject to credit risk consisting of trade accounts receivables and executory contracts with market risk exposures. The risk associated with trade receivables is mitigated by the large number of customers in a broad range of industry groups who make up our customer base. At December 31, 2020, no nonaffiliated customer represented more than 10% of our accounts receivable. Additionally, Ameren Illinois faces risks associated with the purchase of receivables. The Illinois Public Utilities Act requires Ameren Illinois to establish electric utility consolidated billing and purchase of receivables services. At the option of an alternative retail electric supplier, Ameren Illinois may be required to purchase the supplier’s receivables relating to Ameren Illinois’ distribution customers who elected to receive power supply from the alternative retail electric supplier. When that option is selected, Ameren Illinois produces consolidated bills for the applicable retail customers to reflect charges for electric distribution and purchased receivables. As of December 31, 2020, Ameren Illinois’ balance of purchased accounts receivable associated with the utility consolidated billing and purchase of receivables services was $28 million. The risk associated with Ameren Illinois’ electric and natural gas trade receivables is also mitigated by a rider that allows Ameren Illinois to recover the difference between its actual net bad debt write-offs under GAAP and the amount of net bad debt write-offs included in its base rates. Ameren Missouri and Ameren Illinois continue to monitor the impact of increasing rates on customer collections, as applicable, and increasing customer account balances largely associated with the COVID-19 pandemic. Ameren Missouri and Ameren Illinois make adjustments to their respective allowance for doubtful accounts as deemed necessary to ensure that such allowances are adequate to cover estimated uncollectible customer account balances. See Note 1 – Summary of Significant Accounting Policies under Part II, Item 8, of this report for more information on Ameren’s, Ameren Missouri’s, and Ameren Illinois’ accounts receivable balances that were 30 days or greater past due or that were a part of a deferred payment arrangement as of December 31, 2020. In addition, for information regarding Ameren Missouri’s and Ameren Illinois’ suspensions and reinstatement of customer disconnection activities and late fee charges for nonpayment, see Note 2 – Rate and Regulatory Matters under Part II, Item 8, of this report.Investment Price RiskPlan assets of the pension and postretirement trusts, the nuclear decommissioning trust fund, and company-owned life insurance contracts include equity and debt securities. The equity securities are exposed to price fluctuations in equity markets. The debt securities are exposed to changes in interest rates.Our costs for providing defined benefit retirement and postretirement benefit plans are dependent upon a number of factors, including the rate of return on plan assets. Ameren manages plan assets in accordance with the “prudent investor” guidelines contained in ERISA. Ameren’s goal is to ensure that sufficient funds are available to provide benefits at the time they are payable, while also maximizing total return on plan assets and minimizing expense volatility consistent with its tolerance for risk. Ameren delegates investment management to specialists. Where appropriate, Ameren provides the investment manager with guidelines that specify allowable and prohibited investment types. Ameren regularly monitors manager performance and compliance with investment guidelines.The expected return on plan assets assumption is based on historical and projected rates of return for current and planned asset classes in the investment portfolio. Projected rates of return for each asset class are estimated after an analysis of historical experience, future expectations, and the volatility of the various asset classes. After considering the target asset allocation for each asset class, we adjust the overall expected rate of return for the portfolio for historical and expected experience of active portfolio management results compared with benchmark returns, and for the effect of expenses paid from plan assets. Contributions to the plans and future costs could increase materially if we do not achieve pension and postretirement asset portfolio investment returns equal to or in excess of our 2021 assumed return on plan assets of 6.50%.Ameren Missouri also maintains a trust fund, as required by the NRC and Missouri law, to fund certain costs of nuclear plant decommissioning. As of December 31, 2020, this fund was invested in domestic equity securities (69%) and debt securities (30%). By 71Table of Contentsmaintaining a portfolio that includes long-term equity investments, Ameren Missouri seeks to maximize the returns to be used to fund nuclear decommissioning costs within acceptable parameters of risk. Ameren Missouri actively monitors the portfolio by benchmarking the performance of its investments against certain indices and by maintaining and periodically reviewing established target allocation percentages of the trust assets to various investment options. Ameren Missouri’s exposure to equity price market risk is in large part mitigated because Ameren Missouri is currently allowed to recover its decommissioning costs, which would include unfavorable investment results, through electric rates.Additionally, Ameren and Ameren Illinois have company-owned life insurance contracts with net asset values of $165 million and $8 million, respectively, as of December 31, 2020. Changes in the market values of these contracts are reflected in earnings.Commodity Price RiskAmeren Missouri’s and Ameren Illinois’ electric and natural gas distribution businesses’ exposure to changing market prices for commodities is in large part mitigated by the fact that there are cost recovery mechanisms in place. These cost recovery mechanisms allow Ameren Missouri and Ameren Illinois to pass on to retail customers prudently incurred costs for fuel, purchased power, and natural gas supply.Ameren Missouri’s and Ameren Illinois’ strategy is designed to reduce the effect of market fluctuations for their customers. The effects of price volatility cannot be eliminated. However, procurement and sales strategies involve risk management techniques and instruments, as well as the management of physical assets.Ameren Missouri has a FAC that allows it to recover or refund, through customer rates, 95% of the variance in net energy costs from the amount set in base rates without a traditional regulatory rate review, subject to MoPSC prudence reviews. Ameren Missouri remains exposed to the remaining 5% of such changes.Ameren Illinois has cost recovery mechanisms for power purchased, capacity, zero emission credit, and renewable energy credit costs and expects full recovery of such costs. Ameren Illinois is required to serve as the provider of last resort for electric customers in its service territory who have not chosen an alternative retail electric supplier. In 2020, Ameren Illinois procured power on behalf of its customers for 23% of its total kilowatthour sales. Ameren Illinois purchases energy and capacity through the MISO and through bilateral contracts resulting from IPA procurement events. The IPA has proposed and the ICC has approved multiple procurement events covering portions of years through 2023 for capacity and energy. Ameren Illinois has also entered into ICC-approved contracts for zero emission credits through 2026 and for renewable energy credits with various terms, including contracts with a 20-year term ending 2032, and contracts entered into beginning 2018 with 15-year terms commencing on the date of first renewable energy credit delivery. Ameren Illinois does not generate earnings based on the resale of power or purchase of zero emission credits or renewable energy credits but rather on the delivery of the energy.Ameren Missouri and Ameren Illinois have PGA clauses that permit costs incurred for natural gas to be recovered directly from utility customers without a traditional regulatory rate review, subject to prudence reviews.72Table of ContentsThe following table presents, as of December 31, 2020, the percentages of the projected required supply of coal and coal transportation for Ameren Missouri’s coal-fired energy centers, nuclear fuel for Ameren Missouri’s Callaway Energy Center, natural gas for Ameren Missouri’s retail distribution, and purchased power for Ameren Illinois that are price-hedged over the period 2021 through 2025. The projected required supply of these commodities could be significantly affected by changes in our assumptions about customer demand for our electric generation and our electric and natural gas distribution services, generation output, and inventory levels, among other matters.202120222023 – 2025Ameren:Coal100 %87 %39 %Coal transportation100 99 98 Nuclear fuel(a)— 82 53 Natural gas for distribution(b)73 31 10 Purchased power for Ameren Illinois(c)69 35 11 Ameren Missouri:Coal100 %87 %39 %Coal transportation100 99 98 Nuclear fuel(a)— 82 53 Natural gas for distribution(b)68 36 21 Ameren Illinois:Natural gas for distribution(b)73 %30 %8 %Purchased power(c)69 35 11 (a)The Callaway Energy Center has historically required refueling at 18-month intervals. During its return to full power after the completion of the last refueling and maintenance outage in late December 2020, the Callaway Energy Center experienced a non-nuclear operating issue related to its generator. A thorough investigation of this matter was conducted. Work has begun to replace certain key components of the generator in order to return the energy center to service. As of the date of this filing, due to the long lead time for the manufacture, repair, and installation of these components, the energy center is expected to return to service in late June or early July 2021. As there are no refuelings scheduled to occur during 2021 or 2024, there are also no nuclear fuel deliveries anticipated to occur in these years.(b)Represents the percentage of natural gas price-hedged for peak winter season of November through March. The year 2021 represents January 2021 through March 2021. The year 2022 represents November 2021 through March 2022. This continues each successive year through March 2025.(c)Represents the percentage of purchased power price-hedged for fixed-price residential and nonresidential customers with less than 150 kilowatts of demand.Our exposure to commodity price risk for construction and maintenance activities is related to changes in market prices for metal commodities and to labor availability.Also see Note 14 – Commitments and Contingencies under Part II, Item 8, of this report for additional information.Commodity Supplier RiskThe use of low-sulfur coal is part of Ameren Missouri’s environmental compliance strategy. Ameren Missouri has agreements with multiple suppliers to purchase low-sulfur coal through 2025 to comply with environmental regulations. Disruptions to the deliveries of low-sulfur coal from a supplier could compromise Ameren Missouri’s ability to operate in compliance with emission standards. The suppliers of low-sulfur coal are limited, and the construction of pollution control equipment requires significant lead time. In addition, low-sulfur coal suppliers have experienced financial hardships in recent years and could continue to experience financial hardships that could impact their ability to deliver shipments of low-sulfur coal in accordance with existing supply contracts. If Ameren Missouri were to experience a temporary disruption of low-sulfur coal deliveries that caused it to exhaust its existing inventory, and if other sources of low-sulfur coal were not available, Ameren Missouri would have to use its existing emission allowances, purchase emission allowances to achieve compliance with environmental regulations, or purchase power necessary to meet demand.Currently, the Callaway Energy Center has a single NRC-licensed supplier able to provide fuel assemblies to the Callaway Energy Center. Ameren Missouri is pursuing a program to qualify an alternate NRC-licensed supplier, and expects to obtain NRC approval in 2023.73Table of Contents
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+ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSAEPThe information required by this item is incorporated herein by reference to the material under Management’s Discussion and Analysis of Financial Condition and Results of Operations in the 2020 Annual Report. Year-to-year comparisons between 2019 and 2018 have been omitted from this Form 10-K but may be found in "Management's Discussion and Analysis of Financial Condition" in Part II, Item 7 of our Form 10-K for the fiscal year ended December 31, 2019, which specific discussion is incorporated herein by reference.AEP Texas, AEPTCo, APCo, I&M, OPCo, PSO and SWEPCoOmitted pursuant to Instruction I(2)(a). Management’s narrative analysis of the results of operations and other information required by Instruction I(2)(a) is incorporated herein by reference to the material under Management’s Discussion and Analysis of Financial Condition and Results of Operations in the 2020 Annual Report.ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKAEP, AEP Texas, AEPTCo, APCo, I&M, OPCo, PSO and SWEPCoThe information required by this item is incorporated herein by reference to the material under the “Quantitative and Qualitative Disclosures About Market Risk” section of Management’s Discussion and Analysis of Financial Condition and Results of Operations in the 2020 Annual Report.ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA542020 Annual ReportsAmerican Electric Power Company, Inc. and Subsidiary CompaniesAEP Texas Inc. and SubsidiariesAEP Transmission Company, LLC and SubsidiariesAppalachian Power Company and SubsidiariesIndiana Michigan Power Company and SubsidiariesOhio Power Company and SubsidiariesPublic Service Company of OklahomaSouthwestern Electric Power Company ConsolidatedAudited Financial Statements andManagement’s Discussion and Analysis of Financial Condition and Results of Operations55AMERICAN ELECTRIC POWER COMPANY, INC. AND SUBSIDIARY COMPANIESINDEX OF ANNUAL REPORTSPageNumberAmerican Electric Power Company, Inc. and Subsidiary Companies:Management’s Discussion and Analysis of Financial Condition and Results of Operations57Report of Independent Registered Public Accounting Firm121Management’s Report on Internal Control Over Financial Reporting124Consolidated Financial Statements125AEP Texas Inc. and Subsidiaries:Management’s Narrative Discussion and Analysis of Results of Operations132Report of Independent Registered Public Accounting Firm137Management’s Report on Internal Control Over Financial Reporting139Consolidated Financial Statements140AEP Transmission Company, LLC and Subsidiaries:Management’s Narrative Discussion and Analysis of Results of Operations147Report of Independent Registered Public Accounting Firm150Management’s Report on Internal Control Over Financial Reporting152Consolidated Financial Statements153Appalachian Power Company and Subsidiaries:Management’s Narrative Discussion and Analysis of Results of Operations159Report of Independent Registered Public Accounting Firm163Management’s Report on Internal Control Over Financial Reporting165Consolidated Financial Statements166Indiana Michigan Power Company and Subsidiaries:Management’s Narrative Discussion and Analysis of Results of Operations173Report of Independent Registered Public Accounting Firm177Management’s Report on Internal Control Over Financial Reporting179Consolidated Financial Statements180Ohio Power Company and Subsidiaries:Management’s Narrative Discussion and Analysis of Results of Operations187Report of Independent Registered Public Accounting Firm191Management’s Report on Internal Control Over Financial Reporting194Consolidated Financial Statements195Public Service Company of Oklahoma:Management’s Narrative Discussion and Analysis of Results of Operations202Report of Independent Registered Public Accounting Firm206Management’s Report on Internal Control Over Financial Reporting208Financial Statements209Southwestern Electric Power Company Consolidated:Management’s Narrative Discussion and Analysis of Results of Operations216Report of Independent Registered Public Accounting Firm220Management’s Report on Internal Control Over Financial Reporting222Consolidated Financial Statements223Index of Notes to Financial Statements of Registrants22956AMERICAN ELECTRIC POWER COMPANY, INC. AND SUBSIDIARY COMPANIES MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS EXECUTIVE OVERVIEWCompany OverviewAEP is one of the largest investor-owned electric public utility holding companies in the United States. AEP’s electric utility operating companies provide generation, transmission and distribution services to more than five million retail customers in Arkansas, Indiana, Kentucky, Louisiana, Michigan, Ohio, Oklahoma, Tennessee, Texas, Virginia and West Virginia.AEP’s subsidiaries operate an extensive portfolio of assets including:•Approximately 223,000 circuit miles of distribution lines that deliver electricity to 5.5 million customers.•Approximately 40,000 circuit miles of transmission lines, including approximately 2,200 circuit miles of 765 kV lines, the backbone of the electric interconnection grid in the eastern United States.•Approximately 22,000 MWs of regulated owned generating capacity and approximately 4,700 MWs of regulated PPA capacity in 2 RTOs as of December 31, 2020, one of the largest complements of generation in the United States.COVID-19In March 2020, COVID-19 was declared a pandemic by the World Health Organization and the Centers for Disease Control and Prevention. Its rapid spread around the world and throughout the United States prompted many countries, including the United States, to institute restrictions on travel, public gatherings and certain business operations. These restrictions significantly disrupted economic activity in AEP’s service territory and reduced demand for energy, particularly from commercial and industrial customers in 2020. Although AEP cannot predict the severity or duration of the impact of the COVID-19 pandemic, AEP currently anticipates a 0.2% increase in weather-normalized retail sales volume in 2021 as compared to 2020. For the year ended December 31, 2020, AEP experienced a reduction in weather-normalized retail sales volume of 2.2% as compared to the same period in 2019 primarily driven by a 5.7% decrease in the industrial customer class and a 4.2% decrease in the commercial customer class offset by an increase in demand of 3.2% from the residential customer class. The reduction in weather-normalized retail sales volume of 2.2% did not result in a significant decrease in the corresponding retail margins for the year ended December 31, 2020 as the increase in higher margin residential sales volumes partially offset the decreases in the industrial and commercial sales volumes. Furthermore, the rate design for certain industrial customers includes demand provisions designed to cover the fixed portion of utility costs minimizing the impact of the fluctuations in usage on revenues. AEP’s load forecast is highly dependent on many factors including, but not limited to, the speed and strength of economic recovery and the extent and duration of the next wave of COVID-19 infection. If the severity of the economic disruption increases, AEP’s future results of operations, financial condition, and cash flows could be further adversely impacted. See Customer Demand for additional information.During the first quarter of 2020, AEP’s electric operating companies informed both retail customers and state regulators that disconnections for non-payment were temporarily suspended. Shortly thereafter, AEP’s state regulators also imposed temporary moratoria on customary disconnection practices. During the third and the fourth quarters of 2020, most state regulators began to lift restrictions on disconnects. As of December 31, 2020, AEP had resumed disconnections in its regulated jurisdictions with the exception of Virginia, Kentucky and Arkansas. Disconnections resumed in Kentucky during January 2021. AEP continues to work with regulators and stakeholders in Virginia and Arkansas and management currently anticipates resuming customary disconnection practices in the first half of 2021. However, this timing could change if there is new legislation or other regulatory directives issued in the future. Continuing adverse economic conditions may result in the inability of customers to pay for electric service, which could affect revenue recognition and the collectability of accounts receivable. 57Throughout 2020, the Registrants reviewed current collections experience with historical trends, specifically reviewing metrics such as cash collections, days sales outstanding, daily customer deposits and aging summaries. In addition, the Registrants reviewed historical loss information generally comprised of a rolling 12-month average, in conjunction with a qualitative assessment of elements that impact the collectability of receivables, such as changes in economic factors, regulatory matters, industry trends, customer credit factors, payment plan options and other programs available to customers. Based on this review, the Registrants’ accounts receivable aging was negatively impacted primarily due to the suspension of customer disconnects, but has continued to improve throughout the fourth quarter of 2020 as disconnect moratoriums have ended in most jurisdictions. Accounts receivable aging is also improving due to AEP proactively engaging with customers to collect payments or establish payment arrangements for outstanding balances. AEP has received, from the states of Virginia and West Virginia, $10 million and $20 million, respectively, to apply to residential customer balances that are past-due. In addition, customers in other states have access to various programs that assist customers who have accumulated larger than normal past-due balances. As of December 31, 2020, AEP currently does not expect accounts receivable aging to have a material adverse impact on the Registrants’ allowance for uncollectible accounts based on considerations of the COVID-19 impacts and past trends during times of economic instability. Management continues to monitor developments affecting suspensions of disconnections and its impact on customer collections. Further deterioration in AEP’s ability to collect from its customers could significantly impact AEP’s future results of operations, financial conditions and cash flows.In May 2020, AEP Credit amended its receivables securitization agreement to increase the eligibility criteria related to aged receivable requirements for the participating affiliated utility subsidiaries in response to the COVID-19 pandemic. As of December 31, 2020, the affiliated utility subsidiaries are in compliance with all requirements under the agreement. To the extent that an affiliated utility subsidiary is deemed ineligible under the agreement, the affiliated utility subsidiary would no longer participate in the receivables securitization agreement and the Registrants would need to rely on additional sources of funding for operation and working capital, which may adversely impact liquidity. The receivables that are ineligible under the receivables securitization agreement are financed with short-term debt at AEP Credit.The Registrants have worked with their state commissions to achieve deferral authority for incremental expenses incurred due to COVID-19. All of AEP’s regulated jurisdictions have issued COVID-19 orders, granting deferral authority for incremental COVID-19 expenses, with the exception of Kentucky and Tennessee. If any costs related to COVID-19 are not recoverable, it could reduce future net income and cash flows and impact financial condition.The effects of the continued COVID-19 pandemic and related government responses could also include extended disruptions to supply chains, reduced labor availability, reduced dispatch for certain generation assets and a prolonged reduction in economic activity. These effects could have a variety of adverse impacts to the Registrants, including their ability to operate their facilities. As of December 31, 2020, there were no material adverse impacts to the Registrants’ operations and supplier contracts due to COVID-19. AEP will continue to monitor developments affecting facility operations and will take additional actions necessary in order to mitigate adverse impacts to the Registrants’ future results of operations, financial condition and cash flows.In addition, the economic disruptions caused by COVID-19 could also adversely impact the impairment risks for certain long-lived assets, equity method investments and goodwill. AEP evaluated these impairment considerations and determined that no such impairments existed as of December 31, 2020.Market volatility and reduction in collections coupled with longer collection periods due to the expansion of customer payment arrangements could reduce cash from operations and cause an adverse impact to liquidity. During 2020, AEP increased its liquidity position to mitigate the market risk and the collections risk due to COVID-19. During the first quarter of 2020, AEP entered into a $1 billion 364–day term loan to reduce reliance on commercial paper and help mitigate potential future liquidity risks. The $1 billion 364-day term loan was repaid in the fourth quarter of 2020. In addition, during 2020, AEP issued approximately $5.6 billion in long-term debt. As of December 31, 2020, AEP’s available liquidity was $2.5 billion. Management believes the Registrants have adequate liquidity under existing credit facilities. In the first quarter of 2020, AEP shifted capital expenditures of 58$500 million out of 2020 into future periods to further mitigate adverse liquidity impacts. In the second quarter of 2020, AEP reinstated $100 million of capital expenditures back into 2020 that had previously been deferred. To the extent that future access to the capital markets or the cost of funding is adversely affected by COVID-19, future results of operations, financial condition, and cash flows may be adversely impacted.In March 2020, the CARES Act was signed into law. The CARES Act includes tax relief provisions such as: (a) an AMT Credit Refund, (b) a 5-year NOL carryback from years 2018-2020 and (c) delayed payment of employer payroll taxes. Pursuant to the CARES Act, AEP, APCo and OPCo requested and in July received refunds of AMT credit of $20 million, $7 million and $9 million, respectively. In the third quarter of 2020, AEP also requested a $95 million refund of taxes paid in 2014 under the 5-year NOL carryback provision of the CARES Act. AEP carried back a NOL generated on the 2019 Federal income tax return at a 21% federal corporate income tax rate to the 2014 Federal income tax return at a 35% corporate income tax rate. As a result of the change in the corporate income tax rates between the two periods, AEP realized a tax benefit of $48 million primarily at the Generation & Marketing segment. Management will continue to monitor potential legislation and any impacts to the AMT Credit and NOL refunds that were filed in 2020 pursuant to the CARES Act. The Registrants deferred payments of the employer share of payroll taxes for the period March 27, 2020 through December 31, 2020 and will pay 50% of the obligation by December 31, 2021 and the remaining 50% by December 31, 2022. As of December 31, 2020, the Registrants have deferred $55 million of the employer share of payroll taxes.In December 2020, the CAA of 2021 was signed into law. The CAA of 2021 includes: (a) COVID-19 tax relief and tax extender provisions including extensions of time to begin construction on and placed in-service assets generating PTCs and ITCs, (b) 100% deductibility of business meals in 2021 and 2022 and (c) an extension of the work opportunity tax credit. The ITC percentage has been increased for projects starting construction through 2023 and placed in-service by the end of 2025. The PTC has been extended for an additional year, to include projects started in 2021 and completed in 2025. These provisions provide time and flexibility on the construction start and in-service dates.The Registrants have taken steps to mitigate the potential risks to customers, suppliers and employees posed by the spread of COVID-19. The Registrants have updated and implemented a company-wide pandemic plan to address specific aspects of COVID-19. This plan guides emergency response, business continuity and the precautionary measures AEP is taking on behalf of its employees and the public. The Registrants have taken extra precautions for employees who work in the field and for employees who work in their facilities, and have work from home policies where appropriate. The Registrants will continue to monitor developments affecting both their workforce and customers, and will take additional precautions that management determines are necessary in order to mitigate the impacts. AEP continues to focus on providing safe, uninterrupted service to its customers, which includes the implementation of strong physical and cyber-security measures to ensure that its systems remain functional with a partially remote workforce. As of December 31, 2020, there has been no material adverse impact to the Registrants’ business operations and customer service due to remote work. Management will continue to review and modify plans as conditions change. Despite efforts to manage these impacts to the Registrants, the ultimate impact of COVID-19 also depends on factors beyond management’s knowledge or control, including the duration and severity of this outbreak as well as third-party actions taken to contain its spread and mitigate its public health effects. Therefore, management cannot estimate the potential future impact to financial position, results of operations and cash flows, but the impacts could be material.Customer DemandAEP’s weather-normalized retail sales volumes for the year ended December 31, 2020 decreased by 2.2% from the year ended December 31, 2019. Weather-normalized residential sales increased 3.2% for the year ended December 31, 2020 compared to the year ended December 31, 2019. AEP’s 2020 industrial sales volumes decreased 5.7% compared to 2019. The decline in industrial sales was spread across many industries. Weather-normalized commercial sales decreased by 4.2% in 2020 compared to 2019.59In 2021, AEP anticipates weather-normalized retail sales volumes will increase by 0.2%. The industrial class is expected to increase by 1.9% in 2021, while weather-normalized residential sales volumes are projected to decrease by 1.1%. Finally, AEP projects weather-normalized commercial sales volumes to decrease by 0.5%.(a)Percentage change for the year ended December 31, 2020 as compared to the year ended December 31, 2019. (b)Forecasted percentage change for the year ended December 31, 2021 compared to the year ended December 31, 2020. Regulatory MattersAEP’s public utility subsidiaries are involved in rate and regulatory proceedings at the FERC and their state commissions. Depending on the outcomes, these rate and regulatory proceedings can have a material impact on results of operations, cash flows and possibly financial condition. AEP is currently involved in the following key proceedings. See Note 4 - Rate Matters for additional information.•2017-2019 Virginia Triennial Review - In March 2020, APCo submitted its 2017-2019 Virginia triennial earnings review filing and base rate case with the Virginia SCC as required by state law. APCo requested a $65 million annual increase in base rates based upon a proposed 9.9% ROE. Triennial reviews are subject to an earnings test, which provides that 70% of any earnings in excess of 70 basis points above APCo’s Virginia SCC authorized ROE would be refunded to customers. In such case, the Virginia SCC could also lower APCo’s Virginia retail base rates on a prospective basis. Virginia law provides that costs associated with asset impairments of retired coal generation assets, or automated meters, or both, which a utility records as an expense, shall be attributed to the test periods under review in a triennial review proceeding, and be deemed recovered. In 2015, APCo retired the Sporn Plant, the Kanawha River Plant, the Glen Lyn Plant, Clinch River Unit 3 and the coal portions of Clinch River Units 1 and 2 (collectively, the retired coal-fired generation assets). The net book value of the Virginia jurisdictional share of these plants was $93 million before cost of removal, including materials and supplies inventory and ARO balances. Based on management’s interpretation of Virginia law and more certainty regarding APCo’s triennial revenues, expenses and resulting earnings upon reaching the end of the three-year review period, APCo recorded a pretax expense of $93 million related to its previously retired coal-fired generation assets in December 2019. As a result, management deemed these costs to be substantially recovered by APCo during the triennial review period. Inclusive of the Virginia jurisdictional share of the $93 million expense associated with APCo’s retired coal-fired generation assets, APCo calculated its 2017-2019 Virginia earnings for the triennial period to be below the authorized ROE range. 60In November 2020, the Virginia SCC issued an order concluding that APCo earned above its authorized ROE but within its ROE band for the 2017-2019 period, resulting in no refund to customers and no change to APCo base rates on a prospective basis. The Virginia SCC also disagreed with APCo’s treatment of the retired coal-fired generation assets for regulatory purposes, and instead adopted the Virginia SCC Staff’s recommendation to treat the remaining unrecovered costs of the retired coal-fired generation assets as a regulatory asset to be amortized over 10 years as of the June 2015 retirement date. The Virginia SCC’s adoption of the Staff’s recommended regulatory treatment of the coal-fired generation assets resulted in a net $40 million increase to APCo’s 2020 pretax income. In addition, the Virginia SCC’s order also included: (a) implementation of the Staff-modified APCo 2017 depreciation study effective January 1, 2018 and (b) implementation of the Staff-modified APCo 2019 depreciation study effective January 1, 2020. The adoption of these depreciation studies resulted in an approximate $47 million reduction to APCo’s 2020 pretax income comprised of a $44 million reduction to revenues for amounts recognized in advance of the recording of depreciation expense for the periods January 2018 through October 2020 and a $3 million increase in depreciation expense for the periods November and December 2020. A corresponding regulatory liability was recorded for the $44 million reduction to revenues. Also in November 2020, APCo filed a notice of appeal of the Virginia SCC’s order with the Virginia Supreme Court. In December 2020, an intervenor filed a petition at the Virginia SCC requesting reconsideration of: (a) the failure of the Virginia SCC to apply a threshold earnings test to the approved regulatory asset for APCo’s closed coal-fired generation assets, (b) the Virginia SCC’s use of a 2011 benchmark study to measure the replacement value of capacity for purposes of APCo’s 2017 – 2019 earnings test and (c) the reasonableness and prudency of APCo’s investments in AMI meters. Also in December 2020, APCo filed a petition at the Virginia SCC requesting reconsideration of: (a) certain issues related to APCo’s going-forward rates and (b) the Virginia SCC’s decision to deny APCo tariff changes that align rates with underlying costs. For APCo’s going-forward rates, APCo requested that the Virginia SCC clarify its final order and whether APCo’s current rates will allow it to earn a fair return. If the Virginia SCC’s order did conclude on APCo’s ability to earn a fair return through existing base rates, APCo further requested that the Virginia SCC clarify whether it has the authority to also permit an increase in base rates. If the Virginia SCC did not conclude on APCo’s ability to earn a fair return, APCo requested the Virginia SCC provide such a conclusion. In January 2021, as requested by the Virginia SCC, APCo filed briefs related to the petition for reconsideration. •2020 Ohio Base Rate Case - In June 2020, OPCo filed a request with the PUCO for a $42 million annual increase in base rates based upon a proposed 10.15% ROE net of existing riders. In November 2020, PUCO staff filed testimony supporting an annual revenue decrease ranging from $102 million to $123 million based upon an ROE of 8.76% to 9.78%. The staff’s proposal included a disallowance of plant in-service which could result in a write-off of up to $27 million. In addition, the staff recommended that capitalized incentives be excluded from base rates prospectively and also recommended annual revenue caps for the DIR of $57 million in 2021, $78 million in 2022, $96 million in 2023 and $46 million for the first five months of 2024. In December 2020, OPCo and intervenors filed objections. A procedural schedule for the case is pending due to ongoing settlement discussions.•Hurricane Laura - In August 2020, Hurricane Laura hit the coasts of Louisiana and Texas, causing power outages to more than 130,000 customers across SWEPCo’s service territories. Prior to Hurricane Laura, SWEPCo did not have a catastrophe reserve or automatic deferral authority within any of its jurisdictions. In October 2020, the LPSC issued an order allowing Louisiana utilities, including SWEPCo, to establish a regulatory asset to track and defer expenses associated with Hurricane Laura. In October 2020, as part of the 2020 Texas Base Rate Case, SWEPCo requested deferral authority of incremental other operation and maintenance expenses. As of December 31, 2020, management estimates that SWEPCo has incurred incremental other operation and maintenance expenses of $84 million ($82 million of which has been deferred as a regulatory asset related to the Louisiana jurisdiction) and incremental capital expenditures of $23 million, all of which is related to the Louisiana jurisdiction.61•2012 Texas Base Rate Case - In 2012, SWEPCo filed a request with the PUCT to increase annual base rates primarily due to the completion of the Turk Plant. In 2013, the PUCT issued an order affirming the prudence of the Turk Plant. In July 2018, the Texas Third Court of Appeals reversed the PUCT’s judgment affirming the prudence of the Turk Plant and remanded the issue back to the PUCT. In January 2019, SWEPCo and the PUCT filed petitions for review with the Texas Supreme Court. In the fourth quarter of 2019 and first quarter of 2020, SWEPCo and various intervenors filed briefs with the Texas Supreme Court. In August 2020, the Texas Supreme Court granted SWEPCo’s petition for review and oral arguments were held in December 2020. SWEPCo expects a decision from the Texas Supreme Court in 2021. As of December 31, 2020, the net book value of Turk Plant was $1.4 billion, before cost of removal, including materials and supplies inventory and CWIP. SWEPCo’s Texas jurisdictional share of the Turk Plant investment is approximately 33%. •In July 2019, clean energy legislation (HB 6) which offers incentives for power-generating facilities with zero or reduced carbon emissions was signed into law by the Ohio Governor. HB 6 phased out current energy efficiency programs as of December 31, 2020, including shared savings revenues of $26 million annually and renewable mandates after 2026. HB 6 also provided for the recovery of existing renewable energy contracts on a bypassable basis through 2032 and included a provision for recovery of OVEC costs through 2030 which will be allocated to all electric distribution utilities on a non-bypassable basis. OPCo’s Inter-Company Power Agreement for OVEC terminates in June 2040. In July 2020, an investigation led by the U.S. Attorney’s Office resulted in a federal grand jury indictment of the Speaker of the Ohio House of Representatives, Larry Householder, four other individuals, and Generation Now, an entity registered as a 501(c)(4) social welfare organization, in connection with a racketeering conspiracy involving the adoption of HB 6. In light of the allegations in the indictment, proposed legislation has been introduced that would repeal HB 6. The outcome of the U.S. Attorney’s Office investigation and its impact on HB 6 is not known. If the provisions of HB 6 were to be eliminated, it is unclear whether and in what form the Ohio General Assembly would pass new legislation addressing similar issues. In August 2020, an AEP shareholder filed a putative class action lawsuit against AEP and certain of its officers for alleged violations of securities laws. In January and February 2021, two AEP shareholders filed two derivative actions purporting to assert claims on behalf of AEP against certain AEP officers and directors based on allegations similar to those in the putative securities class action. See Litigation Related to Ohio House Bill 6 section of Litigation below for additional information. To the extent that OPCo is unable to recover the costs of renewable energy contracts on a bypassable basis by the end of 2032, recover costs of OVEC after 2030, fully recover energy efficiency costs incurred through 2020 or incurs significant costs defending against the securities class action or the derivative actions, it could reduce future net income and cash flows and impact financial condition. •In April 2020, the Virginia Clean Economy Act was signed into law by the Virginia Governor and became effective in July 2020. The law includes the following requirements: (a) Virginia electric utilities to retire no later than 2045 all electric generating units located in Virginia that emit carbon as a by-product, (b) APCo to produce 100% of the company’s power to serve Virginia customers from renewable sources by 2050 with increasing percentages of mandatory renewable energy sources each year and (c) Virginia electric utilities to achieve increasing annual energy efficiency savings from 2022-2025 using 2019 as the base year. This law also provides that if the Virginia SCC finds in any triennial review that revenue reductions related to energy efficiency programs approved and deployed since the utility's previous triennial review have caused the utility to earn more than 70 basis points below its authorized rate of return, the Virginia SCC shall order increases to the utility's rates necessary to recover such revenue reductions. If any of these costs are not recoverable, it could reduce future net income and cash flows and impact financial condition.•In December 2020, APCo and WPCo filed a proposal with the WVPSC to implement an investment tracker surcharge mechanism for recovering costs associated with capital investment made between base rate cases. The initial filing requests a total annual increase of $50 million ($41 million related to APCo), which represents recovery of costs associated with infrastructure investments made over an approximate three-year period since the companies’ last base rate case filing in 2018. The filing also proposes that APCo and 62WPCo could submit annual filings with requested increases capped to a percentage of total retail revenues (3.5% in the first year and 3% in subsequent filings with an overall cap of 9.5%). If a future base rate case is filed, the surcharge would reset to zero on implementation of the new rates. In January 2021, WVPSC staff filed a motion recommending that the WVPSC reject the proposal. If APCo and WPCo do not receive approval to recover these incremental investments through the proposed tracker surcharge mechanism between base rate cases, it could cause a temporary reduction in future net income and cash flows and impact financial condition until APCo and WPCo can seek approval in their next base rate case.Utility Rates and Rate ProceedingsThe Registrants file rate cases with their regulatory commissions in order to establish fair and appropriate electric service rates to recover their costs and earn a fair return on their investments. The outcomes of these regulatory proceedings impact the Registrants’ current and future results of operations, cash flows and financial position.The following tables show the Registrants’ completed and pending base rate case proceedings in 2020. See Note 4 - Rate Matters for additional information.Completed Base Rate Case ProceedingsApproved RevenueApprovedNew RatesCompanyJurisdictionRequirement Increase (Decrease)ROEEffective(in millions)I&MMichigan$36.4 (a)9.86%February 2020I&MIndiana60.0 (b)9.7%March 2020AEP TexasTexas(40.0)9.4%June 2020APCoVirginia— (c)9.2%February 2021KPCoKentucky52.7 9.3%January 2021(a)See “2019 Michigan Base Rate Case” section of Note 4 Rate Matters in the 2019 Annual Report for additional information.(b)Phased-in through an increase in base rates which included: (a) an annual increase in base rates of $44 million effective March 2020 and (b) an annual increase in base rates of $60 million effective January 2021 based on the IURC-approved forecast of December 31, 2020 Indiana jurisdictional electric plant in-service. The order rejected I&M’s proposed re-allocation of capacity costs related to the loss of a significant FERC wholesale contract, which negatively impacted I&M’s annual pretax earnings by approximately $20 million starting June 2020.(c)APCo filed a notice of appeal with the Virginia Supreme Court and a petition requesting reconsideration with the Virginia SCC. In addition, an intervenor has also filed a petition requesting reconsideration with the Virginia SCC.Pending Base Rate Case ProceedingsCommission Staff/FilingRequested RevenueRequestedIntervenor Range ofCompanyJurisdictionDateRequirement IncreaseROERecommended ROE(in millions)OPCoOhioJune 2020$42.3 10.15%8.76% - 9.78%SWEPCoTexasOctober 2020105.0 (a)10.35%(b)SWEPCoLouisianaDecember 2020134.0 10.35%(c)(a)The request would move transmission and distribution interim revenues recovered through riders into base rates. Eliminating these riders would result in a net annual requested base rate increase of $90 million primarily due to increased investments. (b)Intervenor and staff testimony is scheduled to be filed in March and April 2021, respectively.(c)Awaiting procedural schedule.63Dolet Hills Power Station and Related Fuel OperationsDuring the second quarter of 2019, the Dolet Hills Power Station initiated a seasonal operating schedule. In January 2020, in accordance with the terms of SWEPCo’s settlement of its base rate review filed with the APSC, management announced that SWEPCo will seek regulatory approval to retire the Dolet Hills Power Station by the end of 2026. DHLC provides 100% of the fuel supply to Dolet Hills Power Station. After careful consideration of current economic conditions, and particularly for the benefit of their customers, management of SWEPCo and CLECO determined DHLC would not proceed developing additional Oxbow Lignite Company (Oxbow) mining areas for future lignite extraction and ceased extraction of lignite at the mine in May 2020. Based on these actions, management revised the estimated useful life of DHLC’s and Oxbow’s assets to coincide with the date at which extraction was discontinued in the second quarter of 2020 and the date at which delivery of lignite is expected to cease in September 2021. Management also revised the useful life of the Dolet Hills Power Station to 2021 based on the remaining estimated fuel supply available for continued seasonal operation. In March 2020, primarily due to the revision in the useful life of DHLC, SWEPCo recorded a revision to increase estimated ARO liabilities by $21 million. In April 2020, SWEPCo and CLECO jointly filed a notification letter to the LPSC providing notice of the cessation of lignite mining. The Dolet Hills Power Station costs are recoverable by SWEPCo through base rates. SWEPCo’s share of the net investment in the Dolet Hills Power Station is $151 million, including CWIP and materials and supplies, before cost of removal. Fuel costs incurred by the Dolet Hills Power Station are recoverable by SWEPCo through active fuel clauses. Under the fuel agreements, SWEPCo’s fuel inventory and unbilled fuel costs from mining related activities were $131 million as of December 31, 2020. Also, as of December 31, 2020, SWEPCo had a net over-recovered fuel balance of $35 million, which includes fuel burned at the Dolet Hills Power Station. Additional operational and land-related costs are expected to be incurred by DHLC and Oxbow and billed to SWEPCo prior to the closure of the Dolet Hills Power Station and recovered through fuel clauses.In October 2020, SWEPCo filed a request with the LPSC for recovery of the Louisiana share of these additional fuel costs. SWEPCo’s filing proposes to defer $36 million of fuel costs in 2021 and recover the deferral plus carrying costs over five years beginning in 2022. If any of these costs are not recoverable, it could reduce future net income and cash flows and impact financial condition.Pirkey Power Plant and Related Fuel OperationsIn November 2020, management announced plans to retire the Pirkey Power Plant in 2023. The Pirkey Power Plant costs are recoverable by SWEPCo through base rates. SWEPCo’s share of the net investment in the Pirkey Power Plant is $212 million, including CWIP, before cost of removal. Sabine is a mining operator providing mining services to the Pirkey Power Plant. Under the provisions of the mining agreement, SWEPCo is required to pay, as part of the cost of lignite delivered, an amount equal to mining costs plus a management fee. SWEPCo expects fuel deliveries, including billings of all fixed and operating costs, from Sabine to cease during the first quarter of 2023. Under the fuel agreements, SWEPCo’s fuel inventory and unbilled fuel costs from mining related activities were $193 million as of December 31, 2020. Also, as of December 31, 2020, SWEPCo had a net over-recovered fuel balance of $35 million, which includes fuel burned at the Pirkey Power Plant. Additional operational costs are expected to be incurred by Sabine and billed to SWEPCo, as well as land-related costs incurred by SWEPCo, prior to the closure of the Pirkey Power Plant and recovered through fuel clauses. If any of these costs are not recoverable, it could reduce future net income and cash flows and impact financial condition.64Renewable GenerationThe growth of AEP’s renewable generation portfolio reflects the company’s strategy to diversify generation resources to provide clean energy options to customers that meet both their energy and capacity needs.Contracted Renewable Generation FacilitiesAEP continues to develop its renewable portfolio within the Generation & Marketing segment. Activities include working directly with wholesale and large retail customers to provide tailored solutions based upon market knowledge, technology innovations and deal structuring which may include distributed solar, wind, combined heat and power, energy storage, waste heat recovery, energy efficiency, peaking generation and other forms of cost reducing energy technologies. The Generation & Marketing segment also develops and/or acquires large scale renewable generation projects that are backed with long-term contracts with creditworthy counterparties.In November 2020, AEP acquired an additional 10% interest, or approximately 30 MWs, in Santa Rita East. The project is located in west Texas and was placed in-service in July 2019. Long-term virtual power purchase agreements are in place with nonaffiliates for the project’s generation. See Note 17 - Variable Interest Entities and Equity Method Investments for additional information.In November 2020, AEP signed a Purchase and Sale Agreement with a nonaffiliate to acquire a 75% interest in the 100 MW Dry Lake Solar Project located in southern Nevada. Management expects the transaction to close in the first quarter of 2021 and the solar project is expected to be in-service in the second quarter of 2021.As of December 31, 2020, subsidiaries within AEP’s Generation & Marketing segment had approximately 1,549 MWs of contracted renewable generation projects in-service. In addition, as of December 31, 2020, these subsidiaries had approximately 137 MWs of renewable generation projects under construction with total estimated capital costs of $208 million related to these projects.Regulated Renewable Generation FacilitiesIn 2020, PSO received approval from the OCC and SWEPCo received approval from the APSC and LPSC to acquire the North Central Wind Energy Facilities, comprised of three Oklahoma wind facilities totaling 1,485 MWs, on a fixed cost turn-key basis at completion. Both the APSC and LPSC approved the flex-up option, agreeing to acquire the Texas portion, which the PUCT denied. PSO will own 45.5% and SWEPCo will own 54.5% of the project, which will cost approximately $2 billion.In May 2020, the IRS issued a notice extending the “Continuity Safe Harbor” deadlines for qualifying renewable energy projects that began construction in 2016 and 2017 by one year as many projects are facing supply chain and other project development delays caused by COVID-19. Under the May 2020 IRS notice, qualifying renewable energy projects that began construction in 2016 and 2017 and which are placed in-service by the end of 2021 and 2022, respectively, will satisfy the Continuity Safe Harbor. Provided that each facility does satisfy the Continuity Safe Harbor, under the current IRS guidance, the 199 MW wind facility will qualify for 100% of the federal PTC, and the remaining two wind facilities, totaling 1,286 MWs, will qualify for 80% of the federal PTC.Having regulatory approval, and the expectation that all three wind facilities will be eligible for the IRS extension of the “Continuity Safe Harbor,” PSO and SWEPCo are proceeding with the full 1,485 MW development of these three projects. The 199 MW wind facility is targeted to be acquired and placed in-service in March 2021. The 287 MW wind facility is targeted to be acquired and placed in-service in December 2021 and the 999 MW wind facility is targeted to be acquired and placed in-service between December 2021 and April 2022.65Hydroelectric GenerationEvaluating Sale of Hydroelectric GenerationIn March 2020, management placed 10 hydroelectric generation plants under study for a potential sale. In April 2020, the Virginia Clean Economy Act was signed into law by the Virginia Governor. The new law will provide renewable credits to APCo for its existing hydroelectric generation plants. As a result of the new law, management removed the three APCo hydroelectric generation plants (London, Marmet and Winfield) from the list of plants identified for potential sale. In December 2020, management decided they would only proceed with the potential sale of Racine. The two Racine units have a net maximum capacity of 48 MWs and the net book value is $45 million as of December 31, 2020. In February 2021, AEP signed an agreement to sell Racine to a nonaffiliated party. The sale of Racine requires FERC approval. The sale is expected to close in the second quarter of 2021 and result in an immaterial gain. Racine was not presented as Held for Sale on AEP’s Consolidated Balance Sheets due to immateriality. Federal Tax ReformBased on current regulatory orders received, management anticipates amortization of $233 million of Excess ADIT in 2021 ($64 million of Excess ADIT subject to normalization requirements and $169 million of Excess ADIT that is not subject to normalization requirements). Customer usage or new regulatory orders could result in changes to these estimates. Management anticipates amortizing the following ranges of Excess ADIT that is not subject to normalization requirements during the years 2022 through 2026:Annual Amortization of Excess ADITNot Subject to Normalization RequirementsYearRange(in millions)2022$75.0 -$105.0 202368.0 -98.0 202435.0 -65.0 20255.0 -26.0 20265.0 -25.0 Merchant Portion of Turk PlantSWEPCo constructed the Turk Plant, a base load 600 MW (650 MW net maximum capacity) pulverized coal ultra-supercritical generating unit in Arkansas, which was placed in-service in December 2012 and is included in the Vertically Integrated Utilities segment. SWEPCo owns 73% (440 MWs/477 MWs) of the Turk Plant and operates the facility.The APSC granted approval for SWEPCo to build the Turk Plant by issuing a Certificate of Environmental Compatibility and Public Need (CECPN) for the SWEPCo Arkansas jurisdictional share of the Turk Plant (approximately 20%). Following an appeal by certain intervenors, the Arkansas Supreme Court issued a decision that reversed the APSC’s grant of the CECPN. In June 2010, in response to an Arkansas Supreme Court decision, the APSC issued an order which reversed and set aside the previously granted CECPN. This share of the Turk Plant output is currently not subject to cost-based rate recovery and is being sold into the wholesale market. Approximately 80% of the Turk Plant investment is recovered under cost-based rate recovery in Texas, Louisiana and through SWEPCo’s wholesale customers under FERC-based rates. As of December 31, 2020, the net book value of Turk Plant was $1.4 billion, before cost of removal, including materials and supplies inventory and CWIP. If SWEPCo cannot ultimately recover its investment and expenses related to the Turk Plant, it could reduce future net income and cash flows and impact financial condition.66FERC Transmission ROE MethodologyManagement continues to monitor FERC’s 2019 Notice of Inquiry regarding base ROE policy, FERC’s 2020 Notice of Proposed Rulemaking regarding transmission incentives policy, and various other matters pending before FERC with the potential to affect FERC transmission ROE methodology.In the second quarter of 2019, FERC approved settlement agreements establishing base ROEs of 9.85% (10.35% inclusive of RTO incentive adder of 0.5%) and 10% (10.5% inclusive of RTO incentive adder of 0.5%) for AEP’s PJM and SPP transmission-owning subsidiaries, respectively. In the second quarter of 2020, FERC Order 569A determined the base ROE for MISO’s transmission owning members, including AEP’s MISO transmission-owning subsidiaries, should be 10.02% (10.52% inclusive of the RTO incentive adder of 0.5%).If FERC makes any changes to its ROE and incentive policies, they would be applied, as applicable, to AEP’s PJM, SPP and MISO transmission owning subsidiaries on a prospective basis, and could affect future net income and cash flows and impact financial condition.Impacts of Severe Winter Weather in February 2021In February 2021, many of AEP’s service territories and customers were impacted by severe winter weather and extreme cold temperatures resulting in power outages, extensive damage to transmission and distribution infrastructure and disruption to the energy markets. Storm CostsBased on the information currently available, APCo, KPCo and SWEPCo currently estimate significant February 2021 storm restoration expenditures as shown in the table below. Management currently anticipates the storm restoration expenditures will be more heavily weighted towards other operation and maintenance expenses as compared to capital expenditures. Management will continue to refine these storm cost estimates as restoration efforts are completed and final costs become available. Total Estimated February 2021Storm Restoration Expenditures(in millions)APCo$65.0-$75.0KPCo$75.0-$95.0SWEPCo$30.0-$40.0Management plans to seek regulatory recovery of these costs. If any of the storm costs are not recoverable, it could reduce future net income and cash flows and impact financial condition. 67February 2021 Severe Winter Weather Impacts in SPPThe February 2021 severe winter weather also had a significant impact in SPP resulting in the declaration of Energy Emergency Alert Levels 2 and 3 for the first time in SPP’s history. The winter storm increased the demand for natural gas and restricted the available natural gas supply resulting in significantly increased market prices for natural gas power plants to meet reliability needs for the SPP electric system. From February 9, 2021, to February 20, 2021, based on the information currently available, PSO’s and SWEPCo’s preliminary estimates of natural gas expenses and purchases of electricity are as follows:PSOSWEPCo(in millions)Estimated Natural Gas Expenses$175.0 $375.0 Estimated Electricity Purchases650.0 — $825.0 $375.0 The amounts in the table above represent preliminary estimates as of February 25, 2021, and are subject to final settlement as additional information becomes available. In addition, SPP notified PSO and SWEPCo of additional collateral requirements of approximately $868 million on a cumulative basis for the companies due March 2, 2021. Subsequently, SPP filed a waiver request with the FERC that would grant a limited waiver for Load Serving Entities to post this additional collateral requirement between February 24, 2021 and March 11, 2021. FERC approved the waiver request on February 24, 2021. PSO and SWEPCo have active fuel clauses that allow for the recovery of prudently incurred fuel and purchased power expenses. Given the significance of these costs, PSO and SWEPCo expect regulators to perform a heightened review of the costs. Management believes these costs are probable of future recovery. However, the recovery of these costs from customers may be extended over longer than usual time periods to mitigate the impact on customer bills. Nevertheless, PSO and SWEPCo’s payments to suppliers are due in March 2021.PSO and SWEPCo are evaluating financing alternatives including funding contributions from Parent and long-term debt issuances to address the timing difference between the payment to suppliers and recovery from customers. If either PSO or SWEPCo is unable to recover these fuel and purchased power expenses or recover these expenses in a timely manner, it could reduce future net income and cash flows and impact financial condition.ERCOTIn response to the extreme winter weather event, the Governor of Texas issued a Declaration of a State of Disaster for all counties in Texas. While recovery from the emergency conditions is continuing, some market conditions and activities have yet to return to normal. To assist with a return to normalcy, the PUCT issued an order that placed a temporary moratorium on customer disconnections due to non-payment for transmission and distribution utilities. This moratorium will be in effect until otherwise ordered by the PUCT.68LITIGATIONIn the ordinary course of business, AEP is involved in employment, commercial, environmental and regulatory litigation. Since it is difficult to predict the outcome of these proceedings, management cannot predict the eventual resolution, timing or amount of any loss, fine or penalty. Management assesses the probability of loss for each contingency and accrues a liability for cases that have a probable likelihood of loss if the loss can be estimated. Adverse results in these proceedings have the potential to reduce future net income and cash flows and impact financial condition. See Note 4 – Rate Matters and Note 6 – Commitments, Guarantees and Contingencies for additional information.Rockport Plant LitigationIn 2013, the Wilmington Trust Company filed a complaint in the U.S. District Court for the Southern District of New York against AEGCo and I&M alleging that it would be unlawfully burdened by the terms of the modified NSR consent decree after the Rockport Plant, Unit 2 lease expiration in December 2022. The terms of the consent decree allow the installation of environmental emission control equipment, repowering, refueling or retirement of the unit. The plaintiffs seek a judgment declaring that the defendants breached the lease, must satisfy obligations related to installation of emission control equipment and indemnify the plaintiffs. The New York court granted a motion to transfer this case to the U.S. District Court for the Southern District of Ohio.AEGCo and I&M sought and were granted dismissal by the U.S. District Court for the Southern District of Ohio of certain of the plaintiffs’ claims, including claims for compensatory damages, breach of contract, breach of the implied covenant of good faith and fair dealing and indemnification of costs. Plaintiffs voluntarily dismissed the surviving claims that AEGCo and I&M failed to exercise prudent utility practices with prejudice, and the court issued a final judgment. The plaintiffs subsequently filed an appeal in the U.S. Court of Appeals for the Sixth Circuit.In 2017, the U.S. Court of Appeals for the Sixth Circuit issued an opinion and judgment affirming the district court’s dismissal of the owners’ breach of good faith and fair dealing claim as duplicative of the breach of contract claims, reversing the district court’s dismissal of the breach of contract claims and remanding the case for further proceedings.Thereafter, AEP filed a motion with the U.S. District Court for the Southern District of Ohio in the original NSR litigation, seeking to modify the consent decree. The district court granted the owners’ unopposed motion to stay the lease litigation to afford time for resolution of AEP’s motion to modify the consent decree. The consent decree was modified based on an agreement among the parties in July 2019. The district court’s stay of the lease litigation expired in August 2020. Upon expiration of the stay, plaintiffs filed a motion for partial summary judgment, arguing that the consent decree violates the facility lease and the participation agreement and requesting that the district court enter a judgment for the plaintiffs on their breach of contract claim. AEP’s memorandum in opposition to plaintiffs’ motion for partial summary judgement was filed in October 2020. At the parties’ request, the district court stayed the case until February 16, 2021 to provide the parties an opportunity to resolve the case, and the court has since extended the stay until April 26, 2021. See “Modification of the New Source Review Litigation Consent Decree” section below for additional information.Management will continue to defend against the claims and believes its financial statements appropriately reflect the potential outcome of the pending litigation. The ultimate outcome of the pending litigation could reduce future net income and cash flows and impact financial condition.69Patent Infringement ComplaintIn July 2019, Midwest Energy Emissions Corporation and MES Inc. (collectively, the plaintiffs) filed a patent infringement complaint against various parties, including AEP Texas, AGR, Cardinal Operating Company and SWEPCo (collectively, the AEP Defendants). The complaint alleges that the AEP Defendants infringed two patents owned by the plaintiffs by using specific processes for mercury control at certain coal-fired generating stations. The complaint was resolved in December 2020 and did not have a material impact on net income, cash flows or financial condition.Claims Challenging Transition of American Electric Power System Retirement Plan to Cash Balance FormulaThe American Electric Power System Retirement Plan (the Plan) has received a letter written on behalf of four participants (the Claimants) making a claim for additional plan benefits and purporting to advance such claims on behalf of a class. When the Plan’s benefit formula was changed in the year 2000, AEP provided a special provision for employees hired before January 1, 2001, allowing them to continue benefit accruals under the then benefit formula for a full 10 years alongside of the new cash balance benefit formula then being implemented. Employees who were hired on or after January 1, 2001 accrued benefits only under the new cash balance benefit formula. The Claimants have asserted claims that: (a) the Plan violates the requirements under the Employee Retirement Income Security Act (ERISA) intended to preclude back-loading the accrual of benefits to the end of a participant’s career, (b) the Plan violates the age discrimination prohibitions of ERISA and the Age Discrimination in Employment Act and (c) the company failed to provide required notice regarding the changes to the Plan. AEP has responded to the Claimants providing a reasoned explanation for why each of their claims have been denied. The denial of those claims was appealed to the AEP System Retirement Plan Appeal Committee and the Committee upheld the denial of claims. Management will continue to defend against the claims. Management is unable to determine a range of potential losses that is reasonably possible of occurring.Litigation Related to Ohio House Bill 6In August 2020, an AEP shareholder filed a putative class action lawsuit in the United States District Court for the Southern District of Ohio against AEP and certain of its officers for alleged violations of securities laws. The complaint alleges misrepresentations or omissions by AEP regarding: (a) its alleged participation in public corruption with respect to the passage of Ohio House Bill 6, (b) its regulatory, legislative and lobbying activities in Ohio and (c) its clean energy strategy. The complaint seeks monetary damages among other forms of relief. The company will continue to defend against the claims. Management is unable to determine a range of potential losses that is reasonably possible of occurring.In January 2021, an AEP shareholder filed a derivative action in the United States District Court for the Southern District of Ohio purporting to assert claims on behalf of AEP against certain AEP officers and directors. In February 2021, a second AEP shareholder filed a similar derivative action in the Court of Common Pleas of Franklin County, Ohio. The derivative complaints allege the officers and directors made misrepresentations and omissions similar to those alleged in the putative securities class action lawsuit filed against AEP. The complaints assert claims for: (a) breach of fiduciary duty, (b) waste of corporate assets and (c) unjust enrichment and seek monetary damages and changes to AEP’s corporate governance and internal policies among other forms of relief. The company will continue to defend against the claims. Management is unable to determine a range of potential losses that is reasonably possible of occurring.ENVIRONMENTAL ISSUESAEP has a substantial capital investment program and incurs additional operational costs to comply with environmental control requirements. Additional investments and operational changes will be made in response to existing and anticipated requirements to reduce emissions from fossil generation and in response to rules governing the beneficial use and disposal of coal combustion by-products, clean water and renewal permits for certain water discharges.AEP is engaged in litigation about environmental issues, was notified of potential responsibility for the clean-up of contaminated sites and incurred costs for disposal of SNF and future decommissioning of the nuclear units. AEP, 70along with other parties, challenged some of the Federal EPA requirements. Management is engaged in the development of possible future requirements including the items discussed below. Management believes that further analysis and better coordination of these environmental requirements would facilitate planning and lower overall compliance costs while achieving the same environmental goals.AEP will seek recovery of expenditures for pollution control technologies and associated costs from customers through rates in regulated jurisdictions. Environmental rules could result in accelerated depreciation, impairment of assets or regulatory disallowances. If AEP cannot recover the costs of environmental compliance, it would reduce future net income and cash flows and impact financial condition.Environmental Controls Impact on the Generating FleetThe rules and proposed environmental controls discussed below will have a material impact on AEP System generating units. Management continues to evaluate the impact of these rules, project scope and technology available to achieve compliance. As of December 31, 2020, the AEP System owned generating capacity of approximately 24,400 MWs, of which approximately 12,100 MWs were coal-fired. Management continues to refine the cost estimates of complying with these rules and other impacts of the environmental proposals on fossil generation. Based upon management estimates, AEP’s future investment to meet these existing and proposed requirements ranges from approximately $350 million to $700 million through 2027.The cost estimates will change depending on the timing of implementation and whether the Federal EPA provides flexibility in finalizing proposed rules or revising certain existing requirements. The cost estimates will also change based on: (a) potential state rules that impose more stringent standards, (b) additional rulemaking activities in response to court decisions, (c) actual performance of the pollution control technologies installed, (d) changes in costs for new pollution controls, (e) new generating technology developments, (f) total MWs of capacity retired and replaced, including the type and amount of such replacement capacity and (g) other factors. In addition, management continues to evaluate the economic feasibility of environmental investments on regulated and competitive plants.Modification of the New Source Review Litigation Consent DecreeIn 2007, the U.S. District Court for the Southern District of Ohio approved a consent decree between AEP subsidiaries in the eastern area of the AEP System and the Department of Justice, the Federal EPA, eight northeastern states and other interested parties to settle claims that the AEP subsidiaries violated the NSR provisions of the CAA when they undertook various equipment repair and replacement projects over a period of nearly 20 years. The consent decree’s terms include installation of environmental control equipment on certain generating units, a declining cap on SO2 and NOX emissions from the AEP System and various mitigation projects.In 2017, AEP filed a motion with the district court seeking to modify the consent decree to eliminate an obligation to install future controls at Rockport Plant, Unit 2 if AEP does not acquire ownership of that unit, and to modify the consent decree in other respects to preserve the environmental benefits of the consent decree. The other parties to the consent decree opposed AEP’s motion. The district court granted AEP’s request to delay the deadline to install Selective Catalytic Reduction (SCR) technology at Rockport Plant, Unit 2 until June 2020. Construction of the SCR technology was completed by June 1, 2020, testing was conducted, and the unit was released for dispatch on June 5, 2020.In May 2019, the parties filed a proposed order to modify the consent decree. The proposed order requires AEP to enhance the dry sorbent injection (DSI) system on both units at the Rockport Plant by the end of 2020, and meet 30-day rolling average emission rates for SO2 and NOX at the combined stack for the Rockport Plant beginning in 2021. Total SO2 emissions from the Rockport Plant are limited to 10,000 tons per year beginning in 2021 and reduce to 5,000 tons per year when Rockport Plant, Unit 1 retires in 2028. The proposed modification was approved by the district court and became effective in July 2019. As part of the modification to the consent decree, I&M agreed to provide an additional $7.5 million to citizens’ groups and the states for environmental mitigation projects. As joint-owners in the Rockport Plant, the $7.5 million payment was shared between AEGCo and I&M based on the joint-ownership agreement.71Clean Air Act RequirementsThe CAA establishes a comprehensive program to protect and improve the nation’s air quality and control sources of air emissions. The states implement and administer many of these programs and could impose additional or more stringent requirements. The primary regulatory programs that continue to drive investments in AEP’s existing generating units include: (a) periodic revisions to NAAQS and the development of SIPs to achieve any more stringent standards, (b) implementation of the regional haze program by the states and the Federal EPA, (c) regulation of hazardous air pollutant emissions under MATS, (d) implementation and review of CSAPR and (e) the Federal EPA’s regulation of greenhouse gas emissions from fossil generation under Section 111 of the CAA. Notable developments in significant CAA regulatory requirements affecting AEP’s operations are discussed in the following sections.National Ambient Air Quality StandardsThe Federal EPA reviewed the existing standards for NO2 and SO2 in 2018 and 2019, respectively, and decided to retain the standards without change. Implementation of these standards is underway. The Federal EPA recently reviewed the existing standards for PM and ozone and in December 2020 announced both standards would be retained without change.The Federal EPA finalized non-attainment designations for the 2015 ozone standard in 2018. The Federal EPA confirmed that for states included in the CSAPR program, there are no additional interstate transport obligations, as all areas of the country are expected to attain the 2008 ozone standard before 2023. Challenges to the 2015 ozone standard and the Federal EPA’s determination that CSAPR satisfies certain states’ interstate transport obligations were filed in the U.S. Court of Appeals for the District of Columbia Circuit. In August 2019, the court upheld the 2015 primary ozone standard, but remanded the secondary welfare-based standard for further review. The court vacated the Federal EPA’s determination that CSAPR fulfilled the states’ interstate transport obligations, because the Federal EPA’s modeling analysis did not demonstrate that all significant contributions would be eliminated by the attainment deadlines for downwind states. Any further changes will require additional rulemaking. Management cannot currently predict the nature, stringency or timing of additional requirements for AEP’s facilities based on the outcome of these activities.Regional HazeThe Federal EPA issued a Clean Air Visibility Rule (CAVR), detailing how the CAA’s requirement that certain facilities install best available retrofit technology (BART) would address regional haze in federal parks and other protected areas. BART requirements apply to certain power plants. CAVR will be implemented through SIPs or FIPs. In 2017, the Federal EPA revised the rules governing submission of SIPs to implement the visibility programs, including a provision that postpones the due date for the next comprehensive SIP revisions until 2021. Petitions for review of the final rule revisions have been filed in the U.S. Court of Appeals for the District of Columbia Circuit.The Federal EPA initially disapproved portions of the Arkansas regional haze SIP, but has approved a revised SIP and all of SWEPCo's affected units are in compliance with the relevant requirements.The Federal EPA also disapproved portions of the Texas regional haze SIP. In 2017, the Federal EPA finalized a FIP that allows participation in the CSAPR ozone season program to satisfy the NOX regional haze obligations for electric generating units in Texas. Additionally, the Federal EPA finalized an intrastate SO2 emissions trading program based on CSAPR allowance allocations. A challenge to the FIP was filed in the U.S. Court of Appeals for the Fifth Circuit and the case is pending the Federal EPA’s reconsideration of the final rule. In August 2018, the Federal EPA proposed to affirm its 2017 FIP approval. In November 2019, in response to comment, the Federal EPA proposed revisions to the intrastate trading program. The Federal EPA finalized the intrastate trading program in July 2020, and that rule has been challenged in the U.S. Court of Appeals for the Fifth Circuit as well as in the U.S. Court of Appeals for the District of Columbia Circuit. Management cannot predict the outcome of that litigation, although management supports the intrastate trading program as a compliance alternative to source-specific controls and has intervened in the litigation in support of the Federal EPA.72Cross-State Air Pollution RuleIn 2011, the Federal EPA issued CSAPR as a replacement for the Clean Air Interstate Rule, a regional trading program designed to address interstate transport of emissions that contributed significantly to downwind non-attainment with the 1997 ozone and PM NAAQS. CSAPR relies on SO2 and NOX allowances and individual state budgets to compel further emission reductions from electric utility generating units. Interstate trading of allowances is allowed on a restricted sub-regional basis.Petitions to review the CSAPR were filed in the U.S. Court of Appeals for the District of Columbia Circuit. In 2015, the court found that the Federal EPA over-controlled the SO2 and/or NOX budgets of 14 states. The court remanded the rule to the Federal EPA for revision consistent with the court’s opinion while CSAPR remained in place.In 2016, the Federal EPA issued a final rule, the CSAPR Update, to address the remand and to incorporate additional changes necessary to address the 2008 ozone standard. The CSAPR Update significantly reduced ozone season budgets in many states and discounted the value of banked CSAPR ozone season allowances beginning with the 2017 ozone season. In 2019, the appeals court remanded the CSAPR Update to the Federal EPA because it determined the Federal EPA had not properly considered the attainment dates for downwind areas in establishing its partial remedy, and should have considered whether there were available measures to control emissions from sources other than generating units. Any further changes to the CSAPR rule will require additional rulemaking.In October 2020, the Federal EPA proposed a revised CSAPR Update rule, which would substantially reduce the ozone season NOX budgets in 2021-2024. The Federal EPA recently released the underlying modeling and budget allocations and management is evaluating the potential impacts of this proposed rule.Mercury and Other Hazardous Air Pollutants (HAPs) RegulationIn 2012, the Federal EPA issued a rule addressing a broad range of HAPs from coal and oil-fired power plants. The rule established unit-specific emission rates for units burning coal on a 30-day rolling average basis for mercury, PM (as a surrogate for particles of non-mercury metals) and hydrogen chloride (as a surrogate for acid gases). In addition, the rule proposed work practice standards for controlling emissions of organic HAPs and dioxin/furans, with compliance required within three years. Management obtained administrative extensions for up to one year at several units to facilitate the installation of controls or to avoid a serious reliability problem.In 2014, the U.S. Court of Appeals for the District of Columbia Circuit denied all of the petitions for review of the 2012 final rule. Various intervenors filed petitions for further review in the U.S. Supreme Court.In 2015, the U.S. Supreme Court reversed the decision of the U.S. Court of Appeals for the District of Columbia Circuit. The court remanded the MATS rule to the Federal EPA to consider costs in determining whether to regulate emissions of HAPs from power plants. In 2016, the Federal EPA issued a supplemental finding concluding that, after considering the costs of compliance, it was appropriate and necessary to regulate HAP emissions from coal and oil-fired units. Petitions for review of the Federal EPA’s determination were filed in the U.S. Court of Appeals for the District of Columbia Circuit. In 2018, the Federal EPA released a revised finding that the costs of reducing HAP emissions to the level in the current rule exceed the benefits of those HAP emission reductions. The Federal EPA also determined that there are no significant changes in control technologies and the remaining risks associated with HAP emissions do not justify any more stringent standards. Therefore, the Federal EPA proposed to retain the current MATS standards without change. In April 2020, the Federal EPA released a final rule adopting the conclusions set forth in the proposal and retaining the existing MATS standards. The rule has been challenged in the U.S. Court of Appeals for the District of Columbia Circuit.Climate Change, CO2 Regulation and Energy PolicyIn 2015, the Federal EPA published the final CO2 emissions standards for new, modified and reconstructed fossil generating units, and final guidelines for the development of state plans to regulate CO2 emissions from existing sources, known as the Clean Power Plan (CPP). Implementation of the CPP was stayed by the U.S. Supreme Court pending the outcome of legal challenges, and the CPP was ultimately repealed by the Federal EPA in 2019 and 73replaced with the Affordable Clean Energy (ACE) rule. ACE established a framework for states to adopt standards of performance for utility boilers based on heat rate improvements for such boilers. States were to submit their plans for implementing the ACE rule in 2022, and the Federal EPA would have had up to two years to review and approve a plan or disapprove it and adopt a federal plan. However, in January 2021, the U.S. Court of Appeals for the D.C. Circuit vacated the ACE rule and remanded it to the Federal EPA. It is too soon to predict how the Federal EPA will respond to the court’s remand.In 2018, the Federal EPA filed a proposed rule revising the standards for new sources and determined that partial carbon capture and storage is not the best system of emission reduction because it is not available throughout the U.S. and is not cost-effective. That rule has not been finalized. Management continues to actively monitor these rulemaking activities.While no federal regulatory requirements to reduce CO2 emissions are in place, AEP has taken action to reduce and offset CO2 emissions from its generating fleet. AEP expects CO2 emissions from its operations to continue to decline due to the retirement of some of its coal-fired generation units, and actions taken to diversify the generation fleet and increase energy efficiency where there is regulatory support for such activities. The majority of the states where AEP has generating facilities passed legislation establishing renewable energy, alternative energy and/or energy efficiency requirements that can assist in reducing carbon emissions. In April 2020, Virginia enacted clean energy legislation to allow the state to participate in the Regional Greenhouse Gas Initiative, require the retirement of all fossil-fueled generation by 2045 and require 100% renewable energy to be provided to Virginia customers by 2050. Management is taking steps to comply with these requirements, including increasing wind and solar installations, purchasing renewable power and broadening AEP System’s portfolio of energy efficiency programs.In February 2021, AEP announced new intermediate and long-term CO2 emission reduction goals, based on the output of the company’s integrated resource plans, which take into account economics, customer demand, grid reliability and resiliency, regulations and the company’s current business strategy. The intermediate goal is an 80% reduction from 2000 CO2 emission levels from AEP generating facilities by 2030; the long-term goal is net-zero CO2 emissions from AEP generating facilities by 2050. AEP’s total estimated CO2 emissions in 2020 were approximately 44 million metric tons, a 73% reduction from AEP’s 2000 CO2 emissions. AEP has made significant progress in reducing CO2 emissions from its power generation fleet and expects its emissions to continue to decline. Technological advances, including energy storage, will determine how quickly AEP can achieve zero emissions while continuing to provide reliable, affordable power for customers.Excessive costs to comply with future legislation or regulations has led to the announcement of early plant closures and could force AEP to close additional coal-fired generation facilities earlier than their estimate useful life. If AEP is unable to recover the costs of its investments, it would reduce future net income and cash flows and impact financial condition.Coal Combustion Residual (CCR) RuleIn 2015, the Federal EPA published a final rule to regulate the disposal and beneficial re-use of CCR, including fly ash and bottom ash created from coal-fired generating units and FGD gypsum generated at some coal-fired plants. The rule applies to active CCR landfills and surface impoundments at operating electric utility or independent generation facilities. The rule imposes construction and operating obligations, including location restrictions, liner criteria, structural integrity requirements for impoundments, operating criteria and additional groundwater monitoring requirements to be implemented on a schedule spanning an approximate four-year implementation period. In 2018, some of AEP’s facilities were required to begin monitoring programs to determine if unacceptable groundwater impacts will trigger future corrective measures. Based on additional groundwater data, further studies to design and assess appropriate corrective measures have been undertaken at two facilities.In a challenge to the final 2015 rule, the parties initially agreed to settle some of the issues. In 2018, the U.S. Court of Appeals for the District of Columbia Circuit addressed or dismissed the remaining issues in its decision vacating and remanding certain provisions of the 2015 rule. The provisions addressed by the court’s decision, including changes to the provisions for unlined impoundments and legacy sites, are the subject of further rulemaking that has not been finalized.74Prior to the court’s decision, the Federal EPA issued the July 2018 rule that modifies certain compliance deadlines and other requirements in the 2015 rule. In December 2018, challengers filed a motion for partial stay or vacatur of the July 2018 rule. On the same day, the Federal EPA filed a motion for partial remand of the July 2018 rule. The court granted the Federal EPA’s motion. In November 2019, the Federal EPA proposed revisions to implement the court’s decision regarding the timing for closure of unlined surface impoundments along with impoundments not meeting the required distance from an aquifer. The final rule was published in August 2020. In December 2019, the Federal EPA proposed a federal permit program, implementing the Water Infrastructure Improvements for the Nation Act that would apply in states that do not have an approved CCR program.Other utilities and industrial sources have been engaged in litigation with environmental advocacy groups who claim that releases of contaminants from wells, CCR units, pipelines and other facilities to groundwaters that have a hydrologic connection to a surface water body represent an “unpermitted discharge” under the CWA. Two cases were accepted by the U.S. Supreme Court for further review of the scope of CWA jurisdiction. In April 2020, the Supreme Court issued an opinion remanding one of these cases to the Ninth Circuit based on its determination that discharges from an injection well that make their way to the Pacific Ocean through ground water may require a permit if the distance traveled through ground water, length of time to reach the surface water and other factors make it “functionally equivalent” to a direct discharge from a point source. The second case was also remanded to the lower court. Prior to the Supreme Court’s decision, the Federal EPA opened a rulemaking docket to solicit information to determine whether it should provide additional clarification of the scope of CWA permitting requirements for discharges to groundwater, and issued an interpretive statement finding that discharges to groundwater are not subject to NPDES permitting requirements under the CWA. In December 2020, the Federal EPA issued draft guidance for public comment on applying the outcome of the Supreme Court’s decision and consideration of functionally equivalent factors. Management is unable to predict the impact of these developments on AEP’s facilities.In August 2020, the Federal EPA revised the CCR rule to include a requirement that unlined CCR storage ponds cease operations and initiate closure by April 11, 2021. The revised rule provides two options that allow facilities to extend the date by which they must cease receipt of coal ash and close the ponds. The first option provides an extension to cease receipt of CCR no later than October 15, 2023 for most units, and October 15, 2024 for a narrow subset of units; however, the Federal EPA’s grant of such an extension will be based upon a satisfactory demonstration of the need for additional time to develop alternative ash disposal capacity and will be limited to the soonest timeframe technically feasible to cease receipt of CCR. Additionally, each request must undergo formal review, including public comments, and be approved by the Federal EPA. AEP filed applications for additional time to develop alternative disposal capacity at the following plants:CompanyPlant Name and UnitGeneratingCapacityNet Book Value (a)Projected Retirement Date(in MWs)(in millions)APCoAmos2,930$2,171.8 2040APCoMountaineer1,320980.2 2040SWEPCoFlint Creek Plant258279.2 2038KPCoMitchell Plant780605.1 2040WPCoMitchell Plant780603.7 2040AEGCoRockport Plant, Unit 1655248.9 2028I&MRockport Plant, Unit 1655573.8 (b)2028(a)Net book value before cost of removal including CWIP and inventory.(b)Amount includes a $191 million regulatory asset related to the retired Tanners Creek Plant. The IURC and MPSC authorized recovery of the Tanners Creek Plant regulatory asset over the useful life of Rockport Plant, Unit 1 in 2015 and 2014, respectively.75In December 2020, APCo filed requests with the Virginia SCC and WVPSC to obtain the regulatory approvals necessary to implement the compliance plans and seek recovery of the estimated $240 million investment for the Amos and Mountaineer plants. In December 2020 and February 2021, WPCo and KPCo filed requests with the WVPSC and KPSC, respectively, to obtain the regulatory approvals necessary to implement the compliance plans and seek recovery of the estimated $132 million investment for the Mitchell Plant. Within those requests, WPCo and KPCo also filed a $25 million alternative with the WVPSC and KPSC, respectively, which would allow the Mitchell Plant to continue operating only through 2028.The second option is a retirement option, which provides a generating facility an extended operating time without developing alternative CCR disposal. Under the retirement option, a generating facility would have until October 17, 2023 to cease operation and to close CCR storage ponds 40 acres or less in size, or through October 17, 2028 for facilities with CCR storage ponds greater than 40 acres in size. Pursuant to this option, AEP informed the Federal EPA of its intent to retire the Pirkey Power Plant and cease using coal at the Welsh Plant:CompanyPlant Name and UnitGeneratingCapacityNet Investment (a)Accelerated Depreciation Regulatory AssetProjected Retirement Date(in MWs)(in millions)SWEPCoPirkey Power Plant580$199.5 $12.2 2023 (b)SWEPCoWelsh Plants, Units 1 & 31,053549.8 3.6 2028 (c)(d)(a)Net book value including CWIP excluding cost of removal and materials and supplies.(b)Pirkey Power Plant is currently being recovered through 2025 in the Louisiana jurisdiction and through 2045 in the Arkansas and Texas jurisdictions.(c)In November 2020, management announced it will cease using coal at the Welsh Plant in 2028.(d)Unit 1 is currently being recovered through 2027 in the Louisiana jurisdiction and through 2037 in the Arkansas and Texas jurisdictions. Unit 3 is currently being recovered through 2032 in the Louisiana jurisdiction and through 2042 in the Arkansas and Texas jurisdictions.AEP may incur significant costs to upgrade or close and replace surface impoundments and landfills used to manage CCR and to conduct any required remedial actions. Under the retirement option above, AEP may need to recover remaining depreciation and estimated closure costs associated with retiring plants over a shorter period. If AEP cannot ultimately recover the costs of environmental compliance and/or the remaining depreciation and estimated closure costs associated with retiring plants in a timely manner, it would reduce future net income and cash flows and impact financial condition.Closure and post-closure costs have been included in ARO in accordance with the requirements in the final rule. Additional ARO revisions will occur on a site-by-site basis if groundwater monitoring activities conclude that corrective actions are required to mitigate groundwater impacts, which could include costs to remove ash from some unlined units.In March 2020, Virginia’s Governor signed House Bill 443 (HB 443), effective July 2020, requiring APCo to close certain ash disposal units at the retired Glen Lyn Station by removal of all coal combustion material. As a result, in June 2020, APCo recorded a $199 million revision to increase estimated Glen Lyn Station ash disposal ARO liabilities. The closure is required to be completed within 15 years from the start of the excavation process. HB 443 provides for the recovery of all costs associated with closure by removal through the Virginia environmental rate adjustment clause (E-RAC). APCo is permitted to record carrying costs on the unrecovered balance of closure costs at a weighted-average cost of capital approved by the Virginia SCC. HB 443 also allows any closure costs allocated to non-Virginia jurisdictional customers, but not collected from such non-Virginia jurisdictional customers, to be recovered from Virginia jurisdictional customers through the E-RAC. APCo will submit filings with the Virginia SCC and the WVPSC requesting recovery of the respective Virginia and West Virginia jurisdictional shares of these Glen Lyn Station ARO costs. As of December 31, 2020, APCo has not yet incurred any incremental costs associated with the removal of coal combustion material at the Glen Lyn Station.If removal of ash is required without providing similar assurances of cost recovery in regulated jurisdictions, it would impose significant additional operating costs on AEP, which could lead to increased financing costs and liquidity needs. Other units in Virginia, Ohio, West Virginia and Kentucky have already been closed in place in 76accordance with state law programs. Management will continue to participate in rulemaking activities and make adjustments based on new federal and state requirements affecting its ash disposal units.Clean Water Act RegulationsIn 2014, the Federal EPA issued a final rule setting forth standards for existing power plants that is intended to reduce mortality of aquatic organisms impinged or entrained in the cooling water. The rule was upheld on review by the U.S. Court of Appeals for the Second Circuit. Compliance timeframes are established by the permit agency through each facility’s NPDES permit as those permits are renewed and have been incorporated into permits at several AEP facilities. AEP facilities that have had their wastewater discharge permits renewed have been asked to monitor intake flows or to enhance monitoring practices to assure the current technology is being properly managed to ensure compliance with this rule.In 2015, the Federal EPA issued a final rule revising effluent limitation guidelines for generating facilities. The rule established limits on FGD wastewater, fly ash and bottom ash transport water and flue gas mercury control wastewater to be imposed as soon as possible after November 2018 and no later than December 2023. These requirements would be implemented through each facility’s wastewater discharge permit. The rule was challenged in the U.S. Court of Appeals for the Fifth Circuit. In 2017, the Federal EPA announced its intent to reconsider and potentially revise the standards for FGD wastewater and bottom ash transport water. The Federal EPA postponed the compliance deadlines for those wastewater categories to be no earlier than 2020, to allow for reconsideration. In April 2019, the Fifth Circuit vacated the standards for landfill leachate and legacy wastewater, and remanded them to the Federal EPA for reconsideration. In November 2019, the Federal EPA proposed revisions to the guidelines for existing generation facilities. A final rule was signed by the Federal EPA in August 2020 and was published in October 2020. The final rule establishes additional options for reusing and discharging small volumes of bottom ash transport water, provides an exception for retiring units, and extends the compliance deadline to a date as soon as possible beginning one year after the rule was published but no later than December 2025. Management has assessed technology additions and retrofits to comply with the rule and the impacts of the Federal EPA’s recent actions on facilities’ wastewater discharge permitting for FGD wastewater and bottom ash transport water. Permit modifications for affected facilities were filed in January 2021 that reflect the outcome of that assessment.In 2015, the Federal EPA and the U.S. Army Corps of Engineers jointly issued a final rule to clarify the scope of the regulatory definition of “waters of the United States” in light of recent U.S. Supreme Court cases. Various parties challenged the 2015 rule in different U.S. District Courts, which resulted in a patchwork of applicability of the 2015 rule and its predecessor. In December 2018, the Federal EPA and the U.S. Army Corps of Engineers proposed a replacement rule. In September 2019, the Federal EPA repealed the 2015 rule. The final replacement rule was published in the Federal Register in April 2020 and became effective in June 2020. The final rule limits the scope of CWA jurisdiction to four categories of waters, and clarifies exclusions for ground water, ephemeral streams, artificial ponds and waste treatment systems. Challenges to the final rule and requests for a preliminary injunction have been brought by states and other groups in multiple U.S. District Courts. At this time, none of the jurisdictions in which AEP operates are impacted by a stay. Management is monitoring these various proceedings but is unable to predict the actions of the various courts.In April 2020, the U.S. District Court for the District of Montana issued a decision vacating the U.S. Army Corps of Engineers’ (Corps) General Nationwide Permit (NWP) 12, which provides standard conditions governing linear utility projects in streams, wetlands and other waters of the United States having minimal adverse environmental impacts. The Court found that in reissuing NWP 12 in 2017, the Corps failed to comply with Section 7 of the Endangered Species Act (ESA), which requires the Corps to consult with the U.S. Fish and Wildlife Service regarding potential impacts on endangered species. The Court remanded the permit back to the Corps to complete its ESA consultation, and also enjoined the Corps from authorizing any dredge or fill activities under NWP 12 pending completion of the consultation process. The Department of Justice filed a motion to stay the injunction and tailor the remedy imposed by the Court. In May 2020, the Court revised its order lifting the injunction for non-oil and gas pipeline construction activities and routine maintenance, inspection and repair activities on existing NWP 12 projects. The Department of Justice appealed the Court’s decision to the Court of Appeals for the Ninth Circuit 77and moved for stay pending appeal, which was denied. In June 2020, the Department of Justice submitted an application to the U.S. Supreme Court requesting a stay of the District Court’s Order, and the Court granted the request with respect to all oil and gas pipelines except the Keystone Pipeline. Management is monitoring the litigation, but is currently unable to predict the impact of future proceedings on current and planned projects.In September 2020, the Corps issued for public comment the proposed renewal of all General Nationwide Permits. As part of that proposal the Corps narrowed the focus of NWP 12 to only oil and natural gas pipeline activities. The Corps proposed two new Nationwide Permits governing electric utility line and telecommunications activities, and other utility lines (e.g., conveyance of potable water, sewage, other substances), respectively. In January 2021, the Corps issued 16 final Nationwide Permits, including NWP 12 and the two new utility line permits, NWP 57 and NWP 58. The Corps chose not to reissue or modify the remaining Nationwide Permits at this time. The 2017 versions of those permits remain in effect. Management is currently assessing impacts of the rulemaking on current and planned projects.Impact of Environmental Regulation on Coal-Fired Generation Compliance with extensive environmental regulations requires significant capital investment in environmental monitoring, installation of pollution control equipment, emission fees, disposal costs and permits. Management continuously evaluates cost estimates of complying with these regulations which may result in a decision to retire coal-fired generating facilities earlier than their currently estimated useful lives.In addition to the November 2020 announcement related to the Federal EPA’s CCR rules, management also decided not to renew the Rockport Plant, Unit 2 lease when it expires in 2022. Previously, management retired or announced early closure plans for Welsh Unit 2, Oklaunion Power Station, Dolet Hills Power Station and Northeastern Plant Unit 3.The table below summarizes the net book value, as of December 31, 2020, of generating facilities retired or planned for early retirement:CompanyPlantNetInvestment (a)Accelerated Depreciation Regulatory AssetActual/ProjectedRetirementDateCurrent Authorized RecoveryPeriodAnnual Depreciation (b)(in millions)(in millions)SWEPCoDolet Hills Power Station$74.4 $71.2 2021(c)$60.8 PSONortheastern Plant, Unit 3198.4 110.4 2026(d)14.9 PSOOklaunion Power Station— 34.4 2020(e)— SWEPCoPirkey Power Plant199.5 12.2 2023(f)13.8 SWEPCoWelsh Plant, Units 1 and 3549.8 3.6 2028 (g)(h)33.3 SWEPCoWelsh Plant, Unit 2— 35.2 2016(i)— (a)Net book value including CWIP excluding cost of removal and materials and supplies.(b)These amounts represent the amount of annual depreciation that has been collected from customers over the prior 12-month period.(c)Dolet Hills Power Station is current being recovered through 2026 in the Louisiana jurisdiction and through 2046 in the Arkansas and Texas jurisdictions.(d)Northeastern Plant, Unit 3 is currently being recovered through 2040.(e)Oklaunion Power Station is currently being recovered through 2046.(f)Pirkey Power Plant is currently being recovered through 2025 in the Louisiana jurisdiction and through 2045 in the Arkansas and Texas jurisdictions.(g)In November 2020, management announced it will cease using coal at the Welsh Plant in 2028.(h)Welsh Plant, Unit 1 is being recovered through 2027 in the Louisiana jurisdiction and through 2037 in the Arkansas and Texas jurisdictions. Welsh Plant, Unit 3 is being recovered through 2032 in the Louisiana jurisdiction and through 2042 in the Arkansas and Texas jurisdictions.(i)Welsh Plant, Unit 2 is being recovered over the blended useful life of Welsh Plant, Units 1 and 3.Management is seeking or will seek regulatory recovery, as necessary, for any net book value remaining when the plants are retired. To the extent the net book value of these generation assets are not deemed recoverable, it could materially reduce future net income, cash flows and impact financial condition.78RESULTS OF OPERATIONSSEGMENTSAEP’s primary business is the generation, transmission and distribution of electricity. Within its Vertically Integrated Utilities segment, AEP centrally dispatches generation assets and manages its overall utility operations on an integrated basis because of the substantial impact of cost-based rates and regulatory oversight. Intersegment sales and transfers are generally based on underlying contractual arrangements and agreements.AEP’s reportable segments and their related business activities are outlined below:Vertically Integrated Utilities•Generation, transmission and distribution of electricity for sale to retail and wholesale customers through assets owned and operated by AEGCo, APCo, I&M, KGPCo, KPCo, PSO, SWEPCo and WPCo.Transmission and Distribution Utilities•Transmission and distribution of electricity for sale to retail and wholesale customers through assets owned and operated by AEP Texas and OPCo.•OPCo purchases energy and capacity at auction to serve standard service offer customers and provides transmission and distribution services for all connected load.AEP Transmission Holdco•Development, construction and operation of transmission facilities through investments in AEPTCo. These investments have FERC-approved returns on equity.•Development, construction and operation of transmission facilities through investments in AEP’s transmission-only joint ventures. These investments have PUCT-approved or FERC-approved returns on equity.Generation & Marketing•Contracted renewable energy investments and management services.•Marketing, risk management and retail activities in ERCOT, MISO, PJM and SPP.•Competitive generation in PJM.The remainder of AEP’s activities are presented as Corporate and Other. While not considered a reportable segment, Corporate and Other primarily includes the purchasing of receivables from certain AEP utility subsidiaries, Parent’s guarantee revenue received from affiliates, investment income, interest income and interest expense and other nonallocated costs. The following discussion of AEP’s 2020 results of operations by operating segment includes an analysis of Gross Margin, which is a non-GAAP financial measure. Gross Margin includes Total Revenues less the costs of Fuel and Other Consumables Used for Electric Generation as well as Purchased Electricity for Resale and Amortization of Generation Deferrals as presented in the Registrants’ statements of income as applicable. Under the various state utility rate-making processes, these expenses are generally reimbursable directly from and billed to customers. As a result, they do not typically impact Operating Income or Earnings Attributable to AEP Common Shareholders. Management believes that Gross Margin provides a useful measure for investors and other financial statement users to analyze AEP’s financial performance in that it excludes the effect on Total Revenues caused by volatility in these expenses. Operating Income, which is presented in accordance with GAAP in AEP’s statements of income, is the most directly comparable GAAP financial measure to the presentation of Gross Margin. AEP’s definition of Gross Margin may not be directly comparable to similarly titled financial measures used by other companies.79A detailed discussion of AEP’s 2019 results of operations by operating segment can be found in Management’s Discussion and Analysis of Financial Condition and Results of Operation section included in the 2019 Annual Report on Form 10-K filed with the SEC on February 20, 2020.The following table presents Earnings (Loss) Attributable to AEP Common Shareholders by segment:Years Ended December 31,202020192018(in millions)Vertically Integrated Utilities$1,061.6 $982.0 $990.5 Transmission and Distribution Utilities496.4 451.0 527.4 AEP Transmission Holdco504.8 516.3 369.9 Generation & Marketing226.9 112.8 135.3 Corporate and Other(89.6)(141.0)(99.3)Earnings Attributable to AEP Common Shareholders$2,200.1 $1,921.1 $1,923.8 Note: 2020 Earnings Attributable to AEP Common Shareholders by Segment excludes Corporate and Other which is not considered a reportable segment.AEP CONSOLIDATED2020 Compared to 2019 Earnings Attributable to AEP Common Shareholders increased from $1.9 billion in 2019 to $2.2 billion in 2020 primarily due to:•Favorable rate proceedings in AEP’s various jurisdictions.•A planned decrease in Other Operation and Maintenance expenses.•Continued transmission investment, which resulted in higher revenues and income.These increases were partially offset by:•A decrease in weather-related usage.•A one-time reversal of a regulatory provision in 2019.AEP’s results of operations by reportable segment are discussed below.80VERTICALLY INTEGRATED UTILITIES (a)Other AEP Segments excludes Corporate and Other which is not considered a reportable segment.Years Ended December 31,Vertically Integrated Utilities202020192018(in millions)Revenues$8,879.4 $9,367.1 $9,645.5 Fuel and Purchased Electricity2,544.9 3,103.1 3,488.9 Gross Margin6,334.5 6,264.0 6,156.6 Other Operation and Maintenance2,754.3 2,934.4 2,959.8 Asset Impairments and Other Related Charges— 92.9 3.4 Depreciation and Amortization1,600.5 1,447.0 1,316.2 Taxes Other Than Income Taxes472.6 460.9 433.2 Operating Income1,507.1 1,328.8 1,444.0 Other Income2.4 6.1 17.0 Allowance for Equity Funds Used During Construction42.2 50.7 35.4 Non-Service Cost Components of Net Periodic Benefit Cost67.9 67.6 69.9 Interest Expense(565.0)(568.3)(567.8)Income Before Income Tax Expense (Benefit) and Equity Earnings1,054.6 884.9 998.5 Income Tax Expense (Benefit)(7.0)(97.7)5.7 Equity Earnings of Unconsolidated Subsidiary2.9 3.0 2.7 Net Income1,064.5 985.6 995.5 Net Income Attributable to Noncontrolling Interests2.9 3.6 5.0 Earnings Attributable to AEP Common Shareholders$1,061.6 $982.0 $990.5 81Summary of KWh Energy Sales for Vertically Integrated UtilitiesYears Ended December 31,202020192018(in millions of KWhs)Retail:Residential31,526 32,359 33,908 Commercial22,225 23,839 24,452 Industrial32,860 35,252 35,730 Miscellaneous2,185 2,302 2,330 Total Retail88,796 93,752 96,420 Wholesale (a)16,987 20,090 22,682 Total KWhs105,783 113,842 119,102 (a)Includes Off-system Sales, municipalities and cooperatives, unit power and other wholesale customers.82Heating degree days and cooling degree days are metrics commonly used in the utility industry as a measure of the impact of weather on revenues. In general, degree day changes in the eastern region have a larger effect on revenues than changes in the western region due to the relative size of the two regions and the number of customers within each region.Summary of Heating and Cooling Degree Days for Vertically Integrated UtilitiesYears Ended December 31,202020192018(in degree days)Eastern RegionActual – Heating (a)2,295 2,617 2,886 Normal – Heating (b)2,727 2,732 2,738 Actual – Cooling (c)1,222 1,369 1,443 Normal – Cooling (b)1,104 1,092 1,083 Western RegionActual – Heating (a)1,160 1,512 1,599 Normal – Heating (b)1,464 1,473 1,475 Actual – Cooling (c)2,117 2,328 2,502 Normal – Cooling (b)2,253 2,240 2,230 (a)Heating degree days are calculated on a 55 degree temperature base.(b)Normal Heating/Cooling represents the thirty-year average of degree days.(c)Cooling degree days are calculated on a 65 degree temperature base.832020 Compared to 2019 Reconciliation of Year Ended December 31, 2019 to Year Ended December 31, 2020 Earnings Attributable to AEP Common Shareholders from Vertically Integrated Utilities(in millions)Year Ended December 31, 2019$982.0 Changes in Gross Margin:Retail Margins30.7 Margins from Off-system Sales(12.5)Transmission Revenues60.3 Other Revenues(8.0)Total Change in Gross Margin70.5 Changes in Expenses and Other:Other Operation and Maintenance180.1 Asset Impairments and Other Related Charges92.9 Depreciation and Amortization(153.5)Taxes Other Than Income Taxes(11.7)Other Income(3.7)Allowance for Equity Funds Used During Construction(8.5)Non-Service Cost Components of Net Periodic Pension Cost0.3 Interest Expense3.3 Total Change in Expenses and Other99.2 Income Tax Expense(90.7)Equity Earnings of Unconsolidated Subsidiary(0.1)Net Income Attributable to Noncontrolling Interests0.7 Year Ended December 31, 2020$1,061.6 The major components of the increase in Gross Margin, defined as revenues less the related direct cost of fuel, including consumption of chemicals and emissions allowances, and purchased electricity were as follows:•Retail Margins increased $31 million primarily due to the following:•A $35 million increase in deferred fuel at APCo and WPCo primarily due to the timing of recoverable PJM expenses.•A $20 million increase at APCo and WPCo due to the WVPSC approval of the Mitchell Plant surcharge effective January 1, 2020. Pursuant to the WVPSC approval of the surcharge, this increase was partially offset by the amortization of Excess ADIT not subject to normalization requirements in Income Tax Expense below.•A $17 million increase due to a decrease in customer refunds related to Tax Reform. This increase was partially offset in Income Tax Expense below.•A $14 million increase due to the impact of the 2019 WVPSC order which required APCo and WPCo to offset Excess ADIT not subject to normalization requirements against the deferred fuel under-recovery balance in 2019.•A $10 million increase at APCo and WPCo due to revenue from rate riders primarily in West Virginia. This increase was partially offset in other expense items below.•A $9 million increase due to an environmental expense deferral at APCo.•An $8 million increase in weather-normalized retail margins driven by a $111 million increase in the residential customer class partially offset by a $97 million decrease in the commercial and industrial classes.84•The effect of rate proceedings in AEP’s service territories which included:•A $109 million increase at I&M primarily due to the Indiana and Michigan base rate cases and increases in rider revenues. This increase was partially offset in other expense items below.•A $45 million increase at SWEPCo primarily due to rider increases in all jurisdictions and a base rate revenue increase in Arkansas. This increase was partially offset in other expense items below.•A $10 million increase at PSO due to new base rates implemented in April 2019.•An $8 million increase at APCo and WPCo due to new base rates implemented in 2019 in West Virginia. This increase was partially offset in Depreciation and Amortization expenses below.These increases were partially offset by:•A $128 million decrease in weather-related usage primarily in the eastern region and primarily in the residential class.•A $66 million decrease in weather-normalized margins for wholesale contracts, including the loss of a significant wholesale contract at I&M.•A $44 million decrease due to the cumulative impact of the implementation of APCo’s 2017 and 2019 generation and distribution depreciation studies as ordered in the Virginia triennial base rate case. •A $13 million decrease in revenue from rate riders at PSO. This decrease was partially offset in other expense items below.•Margins from Off-system Sales decreased $13 million due to weaker market prices for energy in the RTOs which caused a decrease in sales margins and volume. In addition, the historical merchant portion of WPCo’s Mitchell Plant moved to retail rates beginning in January 2020.•Transmission Revenues increased $60 million primarily due to the following:•A $31 million increase as a result of the annual transmission formula rate true-up primarily at SWEPCo. This increase was partially offset by an increase in transmission expenses in SPP.•A $22 million increase due to continued investment in transmission projects primarily at SWEPCo.•A $12 million increase at APCo resulting from the 2017-2019 Virginia triennial base rate case. This increase was offset in Depreciation Expense below.•Other Revenues decreased $8 million primarily due to the following:•A $10 million decrease at I&M primarily due to a decrease in barging revenues by River Transportation Division. This decrease was partially offset in Other Operation and Maintenance expenses below.•An $8 million decrease primarily due to suspension of late fees and disconnections in 2020 as a result of the COVID-19 pandemic.These decreases were partially offset by:•A $9 million increase at PSO primarily due to business development revenue. This increase was partially offset in other expense items below.Expenses and Other and Income Tax Expense changed between years as follows:•Other Operation and Maintenance expenses decreased $180 million primarily due to the following:•A $49 million decrease due to the re-establishment of a regulatory asset in 2020 as result of APCo’s 2017-2019 Virginia triennial review which authorized the recovery of previously retired coal-fired generation assets.•A $47 million decrease in plant outage and maintenance expenses primarily at APCo, I&M, WPCo, KPCo and PSO.•A $34 million decrease in charitable contributions primarily driven by the contribution to the AEP Foundation in 2019.•A $32 million decrease in distribution expenses primarily related to vegetation management and other distribution expenses.•A $28 million decrease in transmission expenses primarily related to accelerated vegetation management and maintenance in 2019.•A $15 million decrease due to the capitalization of previously expensed North Central Wind Energy Facilities costs at SWEPCo and PSO.•A $14 million decrease related to a 2020 insurance settlement primarily at SWEPCo and PSO.•An $8 million decrease due to the modification of the NSR consent decree impacting I&M and AEGCo in 2019.85•A $7 million decrease at I&M due to an increased Nuclear Electric Insurance Limited distribution in 2020.These decreases were partially offset by:•A $39 million increase due to SPP transmission services including the annual formula rate true-up.•A $37 million increase in employee-related expenses.•Asset Impairments and Other Related Charges decreased $93 million primarily due to a pretax expense recorded in 2019 related to previously retired coal-fired assets.•Depreciation and Amortization expenses increased $154 million primarily due to a higher depreciable base and increased depreciation rates approved at I&M, APCo and SWEPCo. This increase was partially offset in Retail Margins above.•Taxes Other Than Income Taxes increased $12 million primarily due to increased property taxes primarily at APCo, I&M, PSO and SWEPCo.•Other Income decreased $4 million primarily due to a decrease in affiliated interest income due to a decrease in interest rates in 2020.•Allowance for Equity Funds Used During Construction decreased $9 million primarily due to a decrease in the AFUDC base at I&M and the favorable impact of a FERC settlement agreement recorded in 2019.•Interest Expense decreased $3 million primarily due to the following:•A $10 million decrease primarily due to lower interest rates on long-term debt primarily at PSO and AEGCo.•A $6 million decrease primarily due to lower interest rates on variable rate loans and carrying charges recorded on various riders at I&M. This decrease was partially offset by a decrease in AFUDC base.These decreases were partially offset by:•A $13 million increase primarily due to higher long-term debt balances at APCo.•Income Tax Expense increased $91 million primarily due to a decrease in amortization of Excess ADIT and an increase in pretax book income. The decrease in amortization of Excess ADIT not subject to normalization requirements is partially offset above in Gross Margin and Other Operation and Maintenance expenses.86TRANSMISSION AND DISTRIBUTION UTILITIES (a)Other AEP Segments excludes Corporate and Other which is not considered a reportable segment.Years Ended December 31,Transmission and Distribution Utilities202020192018(in millions)Revenues$4,345.9 $4,482.5 $4,653.1 Purchased Electricity682.7 794.3 858.3 Amortization of Generation Deferrals— 65.3 223.9 Gross Margin3,663.2 3,622.9 3,570.9 Other Operation and Maintenance1,575.4 1,628.1 1,541.7 Asset Impairments and Other Related Charges— 32.5 — Depreciation and Amortization751.1 789.5 734.1 Taxes Other Than Income Taxes586.7 575.0 545.3 Operating Income750.0 597.8 749.8 Interest and Investment Income2.4 6.6 4.2 Carrying Costs Income1.6 1.0 1.7 Allowance for Equity Funds Used During Construction31.9 33.4 29.9 Non-Service Cost Components of Net Periodic Benefit Cost29.4 30.3 32.3 Interest Expense(289.2)(243.3)(248.1)Income Before Income Tax Expense (Benefit)526.1 425.8 569.8 Income Tax Expense (Benefit)29.7 (25.2)42.4 Net Income496.4 451.0 527.4 Net Income Attributable to Noncontrolling Interests— — — Earnings Attributable to AEP Common Shareholders$496.4 $451.0 $527.4 87Summary of KWh Energy Sales for Transmission and Distribution UtilitiesYears Ended December 31,202020192018(in millions of KWhs)Retail:Residential26,518 26,407 27,042 Commercial23,998 25,018 24,877 Industrial22,432 23,289 23,908 Miscellaneous749 779 760 Total Retail (a)73,697 75,493 76,587 Wholesale (b)1,859 2,335 2,441 Total KWhs75,556 77,828 79,028 (a)Represents energy delivered to distribution customers.(b)Primarily Ohio’s contractually obligated purchases of OVEC power sold into PJM.88Heating degree days and cooling degree days are metrics commonly used in the utility industry as a measure of the impact of weather on revenues. In general, degree day changes in the eastern region have a larger effect on revenues than changes in the western region due to the relative size of the two regions and the number of customers within each region.Summary of Heating and Cooling Degree Days for Transmission and Distribution UtilitiesYears Ended December 31,202020192018(in degree days)Eastern RegionActual – Heating (a)2,743 3,071 3,357 Normal – Heating (b)3,202 3,208 3,215 Actual – Cooling (c)1,140 1,224 1,402 Normal – Cooling (b)1,006 992 980 Western RegionActual – Heating (a)189 301 354 Normal – Heating (b)313 322 325 Actual – Cooling (d)2,846 2,989 2,861 Normal – Cooling (b)2,711 2,699 2,688 (a)Heating degree days are calculated on a 55 degree temperature base.(b)Normal Heating/Cooling represents the thirty-year average of degree days.(c)Eastern Region cooling degree days are calculated on a 65 degree temperature base.(d)Western Region cooling degree days are calculated on a 70 degree temperature base.892020 Compared to 2019 Reconciliation of Year Ended December 31, 2019 to Year Ended December 31, 2020 Earnings Attributable to AEP Common Shareholders from Transmission and Distribution Utilities(in millions)Year Ended December 31, 2019$451.0 Changes in Gross Margin:Retail Margins90.4 Margins from Off-system Sales(39.3)Transmission Revenues44.2 Other Revenues(55.0)Total Change in Gross Margin40.3 Changes in Expenses and Other:Other Operation and Maintenance52.7 Asset Impairments and Other Related Charges32.5 Depreciation and Amortization38.4 Taxes Other Than Income Taxes(11.7)Interest and Investment Income(4.2)Carrying Costs Income0.6 Allowance for Equity Funds Used During Construction(1.5)Non-Service Cost Components of Net Periodic Benefit Cost(0.9)Interest Expense(45.9)Total Change in Expenses and Other60.0 Income Tax Expense(54.9)Year Ended December 31, 2020$496.4 The major components of the increase in Gross Margin, defined as revenues less the related direct cost of purchased electricity and amortization of generation deferrals were as follows:•Retail Margins increased $90 million primarily due to the following:•A $69 million net increase related to other various rider revenues in Ohio. This increase was partially offset in other expense items below.•A $61 million increase in rider revenues in Ohio associated with the DIR. This increase was partially offset in other expense items below.•A $30 million increase due to a provision for refund recorded in December 2019 as part of the 2019 Texas base rate case.•A $16 million increase from interim rate increases driven by increased distribution investment in Texas.•A $13 million increase due to new base rates implemented in June 2020 in Texas.•A $12 million increase from interim rate increases driven by increased transmission investment in Texas.•A $9 million increase in weather-normalized margins primarily in the residential class and partially offset in the industrial and commercial classes.•A $6 million increase in revenues associated with Ohio smart grid riders. This increase was partially offset in other expense items below.•A $5 million increase due to the change in the recording of merger savings as authorized by the PUCT in the most recent base rate case.These increases were partially offset by:•A $58 million decrease due to a reversal of a regulatory provision in Ohio in the first quarter of 2019.•A $38 million decrease due to refunds in Texas of Excess ADIT and excess federal income taxes collected as a result of Tax Reform. This decrease was offset in Income Tax Expense below.90•A $17 million net decrease in margin in Ohio for the Rate Stability Rider including associated amortizations which ended in the third quarter of 2019.•A $17 million decrease in weather-related usage in Texas primarily due to a 5% decrease in cooling degree days.•A $6 million decrease due to refunds to customers associated with the most recent base rate case in Texas. This decrease was offset in Other Revenues below.•Margins from Off-system Sales decreased $39 million primarily due to the following:•A $52 million decrease in Texas due to lower Oklaunion Power Station PPA revenues. This decrease was offset in Other Operation and Maintenance expenses below.•A $17 million decrease in sales in Ohio due to lower market prices and decreased sales volumes in 2020. This decrease was offset in Retail Margins above.These decreases were partially offset by:•A $26 million increase in Ohio due to higher OVEC PPA deferrals. This increase was offset in Retail Margins above.•Transmission Revenues increased $44 million primarily due to the following:•A $48 million increase from interim rate increases driven by increased transmission investment in Texas.•A $16 million increase in Ohio due to the annual transmission formula rate true-up.•A $6 million increase due to additional investment in transmission assets in Ohio.These increases were partially offset by:•A $14 million decrease in Texas due to a one-time credit to transmission customers as a result of Tax Reform and the most recent base rate case. This decrease was offset in Income Tax Expense below.•A $12 million decrease due to refunds to customers associated with the most recent base rate case in Texas. This decrease is offset in Other Revenues below.•Other Revenues decreased $55 million primarily due to the following:•A $96 million decrease in securitization revenue due to the AEP Texas Central Transition Funding II LLC bonds that matured in July 2020. This decrease was offset in Depreciation and Amortization expenses and Interest Expense below.This decrease was partially offset by:•A $19 million increase in Ohio primarily due to third-party Legacy Generation Resource Rider revenue related to the recovery of OVEC costs. This increase was offset in Retail Margins above.•An $18 million increase in revenues due to the amortization of a provision for refund recorded in December 2019 as part of the most recent base rate case in Texas. This increase was offset in Retail Margins and Transmission Revenues above.Expenses and Other and Income Tax Expense changed between years as follows:•Other Operation and Maintenance expenses decreased $53 million primarily due to the following:•A $67 million decrease due to prior year partial amortization of the AEP Texas Storm Restoration Securitization regulatory asset as a result of the AEP Texas Storm Cost Securitization financing order issued by the PUCT in June 2019. This decrease was offset in Income Tax Expense below.•An $18 million decrease in distribution expenses primarily due to vegetation management. This decrease was partially offset in Retail Margins above.•A $17 million decrease due to the revision of the Oklaunion Power Station ARO. This decrease was offset in Margins from Off-System Sales above.•A $16 million decrease in affiliated PPA expenses in Texas. This decrease was offset in Margins from Off-system Sales above.•A $12 million decrease due to a charitable contribution to the AEP Foundation in 2019.•A $7 million decrease in customer-related expenses.•A $5 million decrease due to a PUCO order to refund unused 2018 major storm reserve collections to customers. This decrease was offset in Retail Margins above.These decreases were partially offset by:•A $62 million net increase in PJM transmission expenses, primarily due to a $94 million increase in recoverable expenses, partially offset by a $28 million decrease related to the annual transmission formula rate true-up. This increase was offset in Gross Margin above.91•A $19 million increase in remitted USF surcharge payments to the Ohio Department of Development to fund an energy assistance program for qualified Ohio customers. This increase was offset in Retail Margins above.•A $17 million increase in ERCOT transmission expenses. This increase was partially offset in Gross Margin above.•Asset Impairments and Other Related Charges decreased $33 million due to prior year regulatory disallowances in the 2019 Texas Base Rate Case.•Depreciation and Amortization expenses decreased $38 million primarily due to the following:•An $87 million decrease in securitization amortizations due to the AEP Texas Central Transition Funding II LLC bonds that matured in July 2020. This decrease was offset in Other Revenues above and Interest Expense below.•A $24 million decrease in amortizations associated with the Deferred Asset Phase-In-Recovery Rider in Ohio which ended in the second quarter of 2019. This decrease was offset in Retail Margins above.These decreases were partially offset by:•A $31 million increase in depreciation expense due to an increase in the depreciable base of transmission and distribution assets.•A $22 million increase in Ohio recoverable DIR depreciation expense. This increase was partially offset in Retail Margins above.•An $11 million increase due to lower deferred equity amortizations associated with the Deferred Asset Phase-In-Recovery Rider in Ohio which ended in the second quarter of 2019.•A $6 million increase due to prior year under-recovery of revenues in Ohio associated with the Deferred Asset Phase-In-Recovery securitization which ended in the 2nd quarter of 2019. This decrease was offset in Retail Margins above.•Taxes Other Than Income Taxes increased $12 million primarily due to the following:•A $19 million increase in property taxes driven by additional investments in transmission and distribution assets and higher tax rates.This increase was partially offset by:•A $6 million decrease in excise taxes due to lower demand in 2020 in Ohio. This decrease was offset in Retail Margins above.•Interest Expense increased $46 million primarily due to the following:•A $32 million increase due to higher long-term debt balances.•A $22 million increase due to the prior year deferral of previously recorded interest expense approved for recovery as a result of the Texas Storm Cost Securitization financing order issued by the PUCT in June 2019.•An $8 million increase due to due to a decrease in the debt component of AFUDC.These increases were partially offset by:•An $8 million decrease in expense related to securitization assets. This decrease was offset above in Other Revenues and Depreciation and Amortization expenses.•A $6 million decrease due to lower short-term debt balances.•Income Tax Expense increased $55 million primarily due to an increase in pretax book income and a decrease in Excess ADIT not subject to normalization requirements as approved in the Texas Storm Cost Securitization financing order issued by the PUCT in 2019. The decrease in Excess ADIT not subject to normalization requirements was partially offset in Gross Margins and Other Operation and Maintenance Expenses above.92AEP TRANSMISSION HOLDCO (a)Other AEP Segments excludes Corporate and Other which is not considered a reportable segment.Years Ended December 31,AEP Transmission Holdco202020192018(in millions)Transmission Revenues$1,198.8 $1,073.2 $804.1 Other Operation and Maintenance119.0 119.0 105.6 Depreciation and Amortization257.6 183.4 137.8 Taxes Other Than Income Taxes211.0 174.4 142.3 Operating Income611.2 596.4 418.4 Interest and Investment Income2.9 3.4 2.1 Allowance for Equity Funds Used During Construction74.0 84.3 67.2 Non-Service Cost Components of Net Periodic Benefit Cost2.0 2.7 2.6 Interest Expense(133.2)(103.3)(90.7)Income Before Income Tax Expense and Equity Earnings556.9 583.5 399.6 Income Tax Expense130.8 136.2 95.3 Equity Earnings of Unconsolidated Subsidiary82.4 72.8 68.7 Net Income508.5 520.1 373.0 Net Income Attributable to Noncontrolling Interests3.7 3.8 3.1 Earnings Attributable to AEP Common Shareholders$504.8 $516.3 $369.9 93Summary of Investment in Transmission Assets for AEP Transmission HoldcoDecember 31,202020192018(in millions)Plant in Service$10,327.5 $8,812.2 $7,008.4 Construction Work in Progress1,499.7 1,521.8 1,651.1 Accumulated Depreciation and Amortization595.7 418.9 282.8 Total Transmission Property, Net$11,231.5 $9,915.1 $8,376.7 942020 Compared to 2019 Reconciliation of Year Ended December 31, 2019 to Year Ended December 31, 2020 Earnings Attributable to AEP Common Shareholders from AEP Transmission Holdco(in millions)Year Ended December 31, 2019$516.3 Changes in Transmission Revenues:Transmission Revenues125.6 Total Change in Transmission Revenues125.6 Changes in Expenses and Other:Depreciation and Amortization(74.2)Taxes Other Than Income Taxes(36.6)Other Income(0.5)Allowance for Equity Funds Used During Construction(10.3)Non-Service Cost Components of Net Periodic Pension Cost(0.7)Interest Expense(29.9)Total Change in Expenses and Other(152.2)Income Tax Expense5.4 Equity Earnings of Unconsolidated Subsidiary9.6 Net Income Attributable to Noncontrolling Interests0.1 Year Ended December 31, 2020$504.8 The major components of the increase in transmission revenues, which consists of wholesale sales to affiliates and nonaffiliates were as follows:•Transmission Revenues increased $126 million primarily due to the following:•A $208 million increase due to continued investment in transmission assets.This increase was partially offset by the following:•A $65 million decrease as a result of the affiliated annual transmission formula rate true-up which is offset in Other Operation and Maintenance expense across affiliated load-serving entities.•A $17 million decrease as a result of the nonaffiliated annual transmission formula rate true-up.Expenses and Other, Income Tax Expense and Equity Earnings of Unconsolidated Subsidiary changed between years as follows:•Depreciation and Amortization expenses increased $74 million primarily due to a higher depreciable base and an increase in depreciation rates as a result of regulatory orders in 2020 in Indiana, Virginia and Michigan.•Taxes Other Than Income Taxes increased $37 million primarily due to higher property taxes as a result of increased transmission investment.•Allowance for Equity Funds Used During Construction decreased $10 million primarily due to the following:•A $13 million decrease due to lower CWIP.•A $12 million decrease driven by the favorable impact of a FERC settlement agreement recorded in 2019.These decreases were partially offset by:•A $13 million increase driven by FERC audit findings recorded in 2019.•Interest Expense increased $30 million primarily due to higher long-term debt balances.•Income Tax Expense decreased $5 million primarily due to lower pretax book income and an increase in amortization of Excess ADIT. •Equity Earnings of Unconsolidated Subsidiary increased $10 million primarily due to higher pretax equity earnings at PATH-WV and ETT.95GENERATION & MARKETING (a)Other AEP Segments excludes Corporate and Other which is not considered a reportable segment.Years Ended December 31,Generation & Marketing202020192018(in millions)Revenues$1,725.6 $1,857.6 $1,940.3 Fuel, Purchased Electricity and Other1,403.6 1,456.2 1,537.3 Gross Margin322.0 401.4 403.0 Other Operation and Maintenance124.9 223.8 229.3 Asset Impairments and Other Related Charges— 31.0 47.7 Depreciation and Amortization72.8 69.5 41.0 Taxes Other Than Income Taxes13.2 15.6 13.4 Operating Income111.1 61.5 71.6 Interest and Investment Income3.2 7.7 13.1 Non-Service Cost Components of Net Periodic Benefit Cost15.4 14.9 15.2 Interest Expense(24.0)(30.0)(14.9)Income Before Income Tax Benefit and Equity Earnings (Loss)105.7 54.1 85.0 Income Tax Benefit(108.0)(53.8)(49.2)Equity Earnings (Loss) of Unconsolidated Subsidiaries3.2 (3.8)0.5 Net Income 216.9 104.1 134.7 Net Loss Attributable to Noncontrolling Interests(10.0)(8.7)(0.6)Earnings Attributable to AEP Common Shareholders$226.9 $112.8 $135.3 96Summary of MWhs Generated for Generation & MarketingYears Ended December 31,202020192018(in millions of MWhs)Fuel Type:Coal4 6 8 Renewables3 2 1 Total MWhs7 8 9 972020 Compared to 2019 Reconciliation of Year Ended December 31, 2019 to Year Ended December 31, 2020 Earnings Attributable to AEP Common Shareholders from Generation & Marketing(in millions)Year Ended December 31, 2019$112.8 Changes in Gross Margin:Merchant Generation(78.2)Renewable Generation9.7 Retail, Trading and Marketing(10.9)Total Change in Gross Margin(79.4)Changes in Expenses and Other:Other Operation and Maintenance98.9 Asset Impairments and Other Related Charges31.0 Depreciation and Amortization(3.3)Taxes Other Than Income Taxes2.4 Interest and Investment Income(4.5)Non-Service Cost Components of Net Periodic Benefit Cost0.5 Interest Expense6.0 Total Change in Expenses and Other131.0 Income Tax Benefit54.2 Equity Earnings of Unconsolidated Subsidiaries7.0 Net Loss Attributable to Noncontrolling Interests1.3 Year Ended December 31, 2020$226.9 The major components of the decrease in Gross Margin, defined as revenues less the related direct cost of fuel, including consumption of chemicals and emissions allowances, purchased electricity and certain cost-of-service for retail operations were as follows:•Merchant Generation decreased $78 million primarily due to the reduction of capacity revenues and energy margins in 2020 and the retirement of the Conesville Plant, Units 5 and 6 in 2019, Unit 4 in 2020 and the Oklaunion Power Station in 2020. •Renewable Generation increased $10 million primarily due to the Sempra Renewables LLC acquisition and other renewable projects placed in-service.•Retail, Trading and Marketing decreased $11 million primarily due to lower retail margins.Expenses and Other, Income Tax Benefit and Equity Earnings of Unconsolidated Subsidiaries changed between years as follows:•Other Operation and Maintenance expenses decreased $99 million primarily due to following:•A $36 million decrease due to the retirements of Conesville Plant Units 5 and 6 in 2019 and Unit 4 in 2020. •A $34 million decrease due to a gain recorded on the sale of land.•An $18 million decrease related to the Oklaunion PPA with AEP Texas primarily due to an ARO revision.•An $11 million decrease primarily in employee expenses due to the sale of the Stuart Plant in 2019.•Asset Impairments and Other Related Charges decreased $31 million primarily due to impairment charges related to the Conesville Plant in 2019.•Depreciation and Amortization expenses increased $3 million primarily due to a higher depreciable base from increased investments in renewable energy sources.98•Interest and Investment Income decreased $5 million due to lower returns on investments.•Interest Expense decreased $6 million primarily due lower borrowing costs in 2020.•Income Tax Benefit increased $54 million primarily due to the realization of tax benefit related to the 5-year NOL carryback provision of the CARES Act and an increase in PTCs. This decrease was partially offset by an increase in pretax book income.•Equity Earnings of Unconsolidated Subsidiaries increased $7 million primarily due to the Sempra Renewables LLC acquisition.99CORPORATE AND OTHER2020 Compared to 2019 Earnings attributable to AEP Common Shareholders from Corporate and Other increased from a loss of $141 million in 2019 to a loss of $90 million in 2020 primarily due to:•A $32 million decrease in tax expense primarily due to the following:•A $21 million decrease in state income tax expense related to unitary state filing requirements.•A $5 million decrease in permanent tax expense.•A $3 million decrease due to a favorable true-up related to the 2019 federal income tax return.•A $2 million decrease due to the realization of tax benefit related to the 5-year NOL carryback provision of the CARES Act.•A $32 million gain on the valuation of common share warrants for an interest in a privately held investee.•A $5 million write-off of an equity investment and related assets in 2019.These items were partially offset by:•A $12 million decrease in interest income from affiliates.•A $7 million increase in general corporate expenses.AEP SYSTEM INCOME TAXES2020 Compared to 2019 Income Tax Expense increased $53 million primarily due to a decrease in amortization of Excess ADIT and an increase in pretax book income. This increase is partially offset by the recognition of tax benefit related to the 5-year NOL carryback provision as a result of the CARES Act, an increase in PTCs and a decrease in state tax expense.100FINANCIAL CONDITIONAEP measures financial condition by the strength of its balance sheet and the liquidity provided by its cash flows.LIQUIDITY AND CAPITAL RESOURCESDebt and Equity CapitalizationDecember 31,20202019(dollars in millions)Long-term Debt, including amounts due within one year$31,072.5 57.2 %$26,725.5 54.1 %Short-term Debt2,479.3 4.6 2,838.3 5.7 Total Debt33,551.8 61.8 29,563.8 59.8 AEP Common Equity20,550.9 37.8 19,632.2 39.6 Noncontrolling Interests223.6 0.4 281.0 0.6 Total Debt and Equity Capitalization$54,326.3 100.0 %$49,477.0 100.0 %AEP’s ratio of debt-to-total capital increased from 59.8% to 61.8% as of December 31, 2019 and 2020, respectively, primarily due to an increase in debt to support distribution, transmission and renewable investment growth.LiquidityLiquidity, or access to cash, is an important factor in determining AEP’s financial stability. Management believes AEP has adequate liquidity under its existing credit facilities. As of December 31, 2020, AEP had a $4 billion revolving credit facility to support its commercial paper program. Additional liquidity is available from cash from operations and a receivables securitization agreement. Management is committed to maintaining adequate liquidity. AEP generally uses short-term borrowings to fund working capital needs, property acquisitions and construction until long-term funding is arranged. Sources of long-term funding include issuance of long-term debt, leasing agreements, hybrid securities or common stock. There was increased volatility in the capital markets during the first quarter of 2020 resulting in higher commercial paper cost and limited access. To address these issues and the uncertainty around COVID-19, in March 2020, AEP entered into a $1 billion 364-day Term Loan and borrowed the full amount. In November 2020, AEP repaid the 364-day Term Loan.Net Available LiquidityAEP manages liquidity by maintaining adequate external financing commitments. As of December 31, 2020, available liquidity was approximately $2.5 billion as illustrated in the table below:AmountMaturity(in millions)Commercial Paper Backup:Revolving Credit Facility$4,000.0 June 2022Cash and Cash Equivalents392.7 Total Liquidity Sources4,392.7 Less: AEP Commercial Paper Outstanding1,852.3 Net Available Liquidity$2,540.4 AEP uses its commercial paper program to meet the short-term borrowing needs of its subsidiaries. The program funds a Utility Money Pool, which funds AEP’s utility subsidiaries; a Nonutility Money Pool, which funds certain AEP nonutility subsidiaries; and the short-term debt requirements of subsidiaries that are not participating in either money pool for regulatory or operational reasons, as direct borrowers. The maximum amount of commercial paper outstanding during 2020 was $3 billion. The weighted-average interest rate for AEP’s commercial paper during 2020 was 1.28%.101Other Credit FacilitiesAn uncommitted facility gives the issuer of the facility the right to accept or decline each request made under the facility. AEP issues letters of credit on behalf of subsidiaries under six uncommitted facilities totaling $405 million. The Registrants’ maximum future payments for letters of credit issued under the uncommitted facilities as of December 31, 2020, was $180 million with maturities ranging from January 2021 to December 2021.Financing PlanAs of December 31, 2020, AEP had $2.1 billion of long-term debt due within one year. This included $235 million of Pollution Control Bonds with mandatory tender dates and credit support for variable interest rates that requires the debt be classified as current and $190 million of securitization bonds and DCC Fuel notes. Management plans to refinance the majority of the maturities due within one year on a long-term basis.Securitized Accounts ReceivablesAEP receivables securitization agreement provides a commitment of $750 million from bank conduits to purchase receivables and expires in September 2022.In May 2020, AEP Credit amended its receivables securitization agreement to increase the eligibility criteria related to aged receivable requirements for the participating affiliated utility subsidiaries in response to the COVID-19 pandemic. As of December 31, 2020, the affiliated utility subsidiaries are in compliance with all requirements under the agreement. To the extent that an affiliated utility subsidiary is deemed ineligible under the agreement, the affiliated utility subsidiary would no longer participate in the receivables securitization agreement and the Registrants would need to rely on additional sources of funding for operation and working capital, which may adversely impact liquidity. The receivables that are ineligible under the receivables securitization agreement are financed with short-term debt at AEP Credit.Debt Covenants and Borrowing LimitationsAEP’s credit agreements contain certain covenants and require it to maintain a percentage of debt-to-total capitalization at a level that does not exceed 67.5%. The method for calculating outstanding debt and capitalization is contractually-defined in AEP’s credit agreements. Debt as defined in the revolving credit agreement excludes securitization bonds and debt of AEP Credit. As of December 31, 2020, this contractually-defined percentage was 58.6%. Non-performance under these covenants could result in an event of default under these credit agreements. In addition, the acceleration of AEP’s payment obligations, or the obligations of certain of AEP’s major subsidiaries, prior to maturity under any other agreement or instrument relating to debt outstanding in excess of $50 million, would cause an event of default under these credit agreements. This condition also applies in a majority of AEP’s non-exchange-traded commodity contracts and would similarly allow lenders and counterparties to declare the outstanding amounts payable. However, a default under AEP’s non-exchange-traded commodity contracts would not cause an event of default under its credit agreements.The revolving credit facility does not permit the lenders to refuse a draw on any facility if a material adverse change occurs.Utility Money Pool borrowings and external borrowings may not exceed amounts authorized by regulatory orders and AEP manages its borrowings to stay within those authorized limits.Equity UnitsIn August 2020, AEP issued 17 million Equity Units initially in the form of corporate units, at a stated amount of $50 per unit, for a total stated amount of $850 million. Net proceeds from the issuance were approximately $833 million. Each corporate unit represents a 1/20 undivided beneficial ownership interest in $1,000 principal amount of AEP’s 1.30% Junior Subordinated Notes due in 2025 and a forward equity purchase contract which settles after three years in 2023. The proceeds were used to support AEP’s overall capital expenditure plans.102In March 2019, AEP issued 16.1 million Equity Units initially in the form of corporate units, at a stated amount of $50 per unit, for a total stated amount of $805 million. Net proceeds from the issuance were approximately $785 million. Each corporate unit represents a 1/20 undivided beneficial ownership interest in $1,000 principal amount of AEP’s 3.40% Junior Subordinated Notes due in 2024 and a forward equity purchase contract which settles after three years in 2022. The proceeds from this issuance were used to support AEP’s overall capital expenditure plans including the recent acquisition of Sempra Renewables LLC. See Note 14 - Financing Activities for additional information.Dividend Policy and RestrictionsThe Board of Directors declared a quarterly dividend of $0.74 per-share in January 2021. Future dividends may vary depending upon AEP’s profit levels, operating cash flow levels and capital requirements, as well as financial and other business conditions existing at the time. Parent’s income primarily derives from common stock equity in the earnings of its utility subsidiaries. Various financing arrangements and regulatory requirements may impose certain restrictions on the ability of the subsidiaries to transfer funds to Parent in the form of dividends. Management does not believe these restrictions will have any significant impact on its ability to access cash to meet the payment of dividends on its common stock. See “Dividend Restrictions” section of Note 14 for additional information.Credit RatingsAEP and its utility subsidiaries do not have any credit arrangements that would require material changes in payment schedules or terminations as a result of a credit downgrade, but its access to the commercial paper market may depend on its credit ratings. In addition, downgrades in AEP’s credit ratings by one of the rating agencies could increase its borrowing costs. Counterparty concerns about the credit quality of AEP or its utility subsidiaries could subject AEP to additional collateral demands under adequate assurance clauses under its derivative and non-derivative energy contracts.CASH FLOWAEP relies primarily on cash flows from operations, debt issuances and its existing cash and cash equivalents to fund its liquidity and investing activities. AEP’s investing and capital requirements are primarily capital expenditures, repaying of long-term debt and paying dividends to shareholders. AEP uses short-term debt, including commercial paper, as a bridge to long-term debt financing. The levels of borrowing may vary significantly due to the timing of long-term debt financings and the impact of fluctuations in cash flows.Years Ended December 31,202020192018(in millions)Cash, Cash Equivalents and Restricted Cash at Beginning of Period$432.6 $444.1 $412.6 Net Cash Flows from Operating Activities3,832.9 4,270.1 5,223.2 Net Cash Flows Used for Investing Activities(6,233.9)(7,144.5)(6,353.6)Net Cash Flows from Financing Activities2,406.7 2,862.9 1,161.9 Net Increase (Decrease) in Cash, Cash Equivalents and Restricted Cash5.7 (11.5)31.5 Cash, Cash Equivalents and Restricted Cash at End of Period$438.3 $432.6 $444.1 103Operating ActivitiesYears Ended December 31,202020192018(in millions)Net Income$2,196.7 $1,919.8 $1,931.3 Non-Cash Adjustments to Net Income (a)2,946.3 2,685.7 2,400.0 Mark-to-Market of Risk Management Contracts66.5 (29.2)(66.4)Pension Contributions to Qualified Plan Trust(110.3)— — Property Taxes(43.3)(73.8)(59.1)Deferred Fuel Over/Under Recovery, Net(31.8)85.2 189.7 Change in Regulatory Assets(337.9)49.5 354.1 Change in Other Noncurrent Assets(142.5)(112.8)(172.1)Change in Other Noncurrent Liabilities(54.5)(116.1)129.0 Change in Certain Components of Working Capital(656.3)(138.2)516.7 Net Cash Flows from Operating Activities$3,832.9 $4,270.1 $5,223.2 (a)Non-Cash Adjustments to Net Income includes Depreciation and Amortization, Rockport Plant Unit 2 Operating Lease Amortization, Deferred Income Taxes, Asset Impairments and Other Related Charges, Allowance for Equity Funds Used During Construction, Amortization of Nuclear Fuel and Pension and Postemployment Benefit Reserves. 2020 Compared to 2019Net Cash Flows from Operating Activities decreased by $437 million primarily due to the following:•A $518 million decrease in cash from Changes in Certain Components of Working Capital. This decrease is primarily due to an increase in accounts receivable driven by increased sales in December 2020 and increased days sales outstanding. •A $387 million decrease in cash from Changes in Regulatory Assets primarily due to deferred storm costs related to Hurricanes Laura and Delta, the establishment of regulatory assets as a result of the Virginia SCC order issued in the 2017-2019 Virginia Triennial Review and the settlement of deferred restoration costs from the Texas Storm Cost Securitization financing order received in 2019. See Note 4 - Rate Matters and Note 5 - Effects of Regulation for additional information.•A $117 million decrease in cash from Deferred Fuel Over/Under Recovery, Net primarily due to an increase in the under recovered fuel balances at PSO.•A $110 million decrease in cash due to a discretionary contribution to the qualified pension plan. See Note 8 - Benefit Plans for additional information.These decreases in cash were partially offset by:•A $538 million increase in cash from Net Income, after non-cash adjustments. See Results of Operations for further detail.•A $96 million increase in the fair value of risk management contracts due to pricing movement in the commodities markets.104Investing ActivitiesYears Ended December 31,202020192018(in millions)Construction Expenditures$(6,246.3)$(6,051.4)$(6,310.9)Acquisitions of Nuclear Fuel(69.7)(92.3)(46.1)Acquisition of Sempra Renewables LLC and Santa Rita East, net of cash and restricted cash acquired— (918.4)— Other82.1 (82.4)3.4 Net Cash Flows Used for Investing Activities$(6,233.9)$(7,144.5)$(6,353.6)2020 Compared to 2019Net Cash Flows Used for Investing Activities decreased by $911 million primarily due to the following:•A $918 million decrease due to the acquisition of Sempra Renewables LLC and Santa Rita East. The $918 million represents a cash payment of $936 million, net of cash and restricted cash acquired of $18 million. See Note 7 - Acquisitions, Dispositions and Impairments for additional information.This decrease in the use of cash was partially offset by:•A $195 million increase in construction expenditures primarily due to increases in Transmission Operations of $190 million and Generation & Marketing of $110 million, partially offset by a decrease in Vertically Integrated of $146 million.Financing ActivitiesYears Ended December 31,202020192018(in millions)Issuance of Common Stock$155.0 $65.3 $73.6 Issuance/Retirement of Debt, Net3,927.3 4,244.1 2,435.1 Dividends Paid on Common Stock(1,424.9)(1,350.0)(1,255.5)Redemption of Noncontrolling Interests(100.2)— — Other(150.5)(96.5)(91.3)Net Cash Flows from Financing Activities$2,406.7 $2,862.9 $1,161.9 2020 Compared to 2019Net Cash Flows from Financing Activities decreased by $456 million primarily due to the following:•A $1.3 billion decrease in short-term debt primarily due to increased repayments of commercial paper. See Note 14 - Financing Activities for additional information. •A $119 million decrease due to increased retirements of long-term debt. See Note 14 - Financing Activities for additional information.•A $100 million decrease due to the redemption of noncontrolling interests in Desert Sky Wind Farm LLC and Trent Wind Farm LLC as well as the acquisition of an additional 10% interest in Santa Rita East. See Note 7 - Acquisitions, Dispositions and Impairments for additional information. These decreases in cash were partially offset by:•A $1.1 billion increase in issuances of long-term debt. See Note 14 - Financing Activities for additional information.105The following financing activities occurred during 2020:AEP Common Stock:•During 2020, AEP issued 2.4 million shares of common stock under the incentive compensation, employee saving and dividend reinvestment plans and received net proceeds of $155 million.Debt:•During 2020, AEP issued approximately $5.6 billion of long-term debt, including $4.4 billion of senior unsecured notes at interest rates ranging from 0.75% to 3.7%, $850 million of junior subordinated debenture notes at an interest rate of 1.3%, $175 million of pollution control bonds at interest rates ranging from 0.625% to 1.00%, and $238 million of other debt at various interest rates. The proceeds from these issuances were used to fund long-term debt maturities and construction programs.•During 2020, AEP entered into interest rate derivatives with notional amounts totaling $1.8 billion that were designated as either fair value or cash flow hedges. During 2020, settlements of AEP’s interest rate derivatives resulted in net cash received of $59 million for derivatives designated as fair value hedges and net cash paid of $38 million for derivatives designated as cash flow hedges. As of December 31, 2020, AEP had a total notional amount of $950 million of outstanding interest rate derivatives designated as fair value hedges and $200 million designated as cash flow hedges.See “Long-term Debt Subsequent Events” section of Note 14 for Long-term debt and other securities issued, retired and principal payments made after December 31, 2020 through February 25, 2021, the date that the 10-K was issued.BUDGETED CAPITAL EXPENDITURES Management forecasts approximately $7.5 billion of capital expenditures in 2021. For the four year period, 2022 through 2025, management forecasts capital expenditures of $29.8 billion. The expenditures are generally for transmission, generation, distribution, regulated and contracted renewables, and required environmental investment to comply with the Federal EPA rules. Estimated capital expenditures are subject to periodic review and modification and may vary based on the ongoing effects of regulatory constraints, environmental regulations, business opportunities, market volatility, economic trends, weather, legal reviews and the ability to access capital. Management expects to fund these capital expenditures through cash flows from operations and financing activities. Generally, the Registrant Subsidiaries use cash or short-term borrowings under the money pool to fund these expenditures until long-term funding is arranged. The 2021 estimated capital expenditures include generation, transmission and distribution related investments, as well as expenditures for compliance with environmental regulations as follows:2021 Budgeted Capital ExpendituresSegmentEnvironmentalGenerationRenewablesTransmissionDistributionOther (a)Total(in millions)Vertically Integrated Utilities$124.7 $264.7 $711.3 $787.1 $1,040.5 $364.3 $3,292.6 Transmission and Distribution Utilities— — — 833.9 977.3 233.1 2,044.3 AEP Transmission Holdco— — — 1,564.5 — 32.8 1,597.3 Generation & Marketing9.1 39.9 434.1 — — 17.7 500.8 Corporate and Other— — — — — 31.8 31.8 Total$133.8 $304.6 $1,145.4 $3,185.5 $2,017.8 $679.7 $7,466.8 (a)Amount primarily consists of facilities, software and telecommunications.106The 2021 estimated capital expenditures by Registrant Subsidiary include distribution, transmission and generation-related investments, as well as expenditures for compliance with environmental regulations as follows:2021 Budgeted Capital ExpendituresCompanyEnvironmentalGenerationRenewablesTransmissionDistributionOther (a)Total(in millions)AEP Texas$— $— $— $606.8 $513.7 $104.8 $1,225.3 AEPTCo— — — 1,451.7 — 33.4 1,485.1 APCo60.6 64.1 1.0 309.6 341.8 100.7 877.8 I&M16.8 75.9 1.3 98.3 268.1 114.4 574.8 OPCo— — — 227.1 463.6 128.3 819.0 PSO— 42.5 322.3 102.3 210.7 48.5 726.3 SWEPCo8.8 43.9 386.7 205.4 135.8 67.1 847.7 (a) Amount primarily consists of facilities, software and telecommunications.107CYBER SECURITYThe electric utility industry is an identified critical infrastructure function with mandatory cyber security requirements under the authority of FERC. The NERC, which FERC certified as the nation’s Electric Reliability Organization, developed mandatory critical infrastructure protection cyber security reliability standards. AEP’s service territory covers multiple NERC regions, and is audited at least annually by one or more of the regions. AEP began participating in the NERC grid security and emergency response exercises, GridEx, in 2013 and continues to participate in the bi-yearly exercises. These efforts, led by NERC, test and further develop the coordination, threat sharing and interaction between utilities and various government agencies relative to potential cyber and physical threats against the nation’s electric grid. The operations of AEP’s electric utility subsidiaries are subject to extensive and rigorous mandatory cyber and physical security requirements that are developed and enforced by NERC to protect grid security and reliability. AEP’s Enterprise Security program uses the National Institute of Standards and Technology Cybersecurity Framework as a guideline. AEP’s Chief Security Officer (CSO) is also its NERC Critical Infrastructure Protection Senior Manager, ensuring alignment of compliance with the enterprise security program.Critical cyber assets, such as data centers, power plants, transmission operations centers and business networks are protected using multiple layers of cyber security controls and authentication. Cyber hackers have been successful in breaching a number of very secure facilities, including federal agencies, banks and retailers. As understanding of these events develop, AEP has adopted a defense in depth approach to cyber security and continually assesses its cyber security tools and processes to determine where to strengthen its defenses. These strategies include monitoring, alerting and emergency response, forensic analysis, disaster recovery, threat sharing and criminal activity reporting. This approach has allowed AEP to deal with threats in real-time and to limit the impact of cyber and related events to levels that would be expected in the ordinary course of business in the absence of such activity.AEP has undertaken a variety of actions to monitor and address cyber-related risks. Cyber security and the effectiveness of AEP’s cyber security processes are reviewed annually with the Board of Directors and at several meetings with the Audit Committee throughout the year. AEP’s Chief Executive Officer and Executive team participate in interactive threat briefings from AEP’s CSO and cyber security team on a monthly basis. AEP’s strategy for managing cyber-related risks is integrated within its enterprise risk management processes. AEP enterprise security continually adjusts staff and resources in response to the evolving threat landscape. In addition, AEP maintains cyber liability insurance to cover certain damages caused by cyber incidents.AEP’s CSO leads the cyber security and physical security teams and is responsible for the design, implementation and execution of AEP’s security risk management strategy, which includes cyber security. AEP’s cyber security team operates a 24/7 Cyber Security Intelligence and Response Center responsible for monitoring the AEP System for cyber risks and threats. Under the direction of the CSO, the cyber security team actively monitors best practices, performs penetration testing, leads response exercises and internal campaigns and provides training and communication across the organization.The cyber security team constantly scans the AEP System for risks and threats. AEP also continually reviews its business continuity plan to develop an effective recovery strategy that seeks to decrease response times, limit financial impacts and maintain customer confidence during any business interruption. AEP has implemented a third-party risk governance program to identify potential risks introduced through third-party relationships, such as vendors, software and hardware manufacturers or professional service providers. As warranted, AEP obtains certain contractual security guarantees and assurances with these third-party relationships to help ensure the security and safety of its information. The cyber security team works closely with a broad range of departments, including legal, regulatory, corporate communications and audit services and information technology.The cyber security team collaborates with partners from both industry and government, and routinely participates in industry-wide programs that exchange knowledge of threats with utility peers, industry and federal agencies. AEP is an active member of a number of industry specific threat and information sharing communities including the Department of Homeland Security and the Electricity Information Sharing and Analysis Center. AEP continues to work with nonaffiliated entities to do penetration testing and to design and implement appropriate remediation strategies. There can be no assurance, however, that these efforts will be effective to prevent interruption of services or other damages to AEP's business or operations in connection with any cyber-related incident.108CRITICAL ACCOUNTING POLICIES AND ESTIMATES AND ACCOUNTING STANDARDSCRITICAL ACCOUNTING POLICIES AND ESTIMATESThe preparation of financial statements in accordance with GAAP requires management to make estimates and assumptions that affect reported amounts and related disclosures, including amounts related to legal matters and contingencies. Management considers an accounting estimate to be critical if: •It requires assumptions to be made that were uncertain at the time the estimate was made; and•Changes in the estimate or different estimates that could have been selected could have a material effect on net income or financial condition.Management discusses the development and selection of critical accounting estimates as presented below with the Audit Committee of AEP’s Board of Directors and the Audit Committee reviews the disclosures relating to them.Management believes that the current assumptions and other considerations used to estimate amounts reflected in the financial statements are appropriate. However, actual results can differ significantly from those estimates.The sections that follow present information about critical accounting estimates, as well as the effects of hypothetical changes in the material assumptions used to develop each estimate.Regulatory AccountingNature of Estimates RequiredThe Registrants’ financial statements reflect the actions of regulators that can result in the recognition of revenues and expenses in different time periods than enterprises that are not rate-regulated.The Registrants recognize regulatory assets (deferred expenses to be recovered in the future) and regulatory liabilities (deferred future revenue reductions or refunds) for the economic effects of regulation. Specifically, the timing of expense and income recognition is matched with regulated revenues. Liabilities are also recorded for refunds, or probable refunds, to customers that have not been made.Assumptions and Approach UsedWhen incurred costs are probable of recovery through regulated rates, regulatory assets are recorded on the balance sheets. Management reviews the probability of recovery at each balance sheet date and whenever new events occur. Similarly, regulatory liabilities are recorded when a determination is made that a refund is probable or when ordered by a commission. Examples of new events that affect probability include changes in the regulatory environment, issuance of a regulatory commission order or passage of new legislation. The assumptions and judgments used by regulatory authorities continue to have an impact on the recovery of costs as well as the return of revenues, rate of return earned on invested capital and timing and amount of assets to be recovered through regulated rates. If recovery of a regulatory asset is no longer probable, that regulatory asset is written-off as a charge against earnings. A write-off of regulatory assets or establishment of a regulatory liability may also reduce future cash flows since there will be no recovery through regulated rates.Effect if Different Assumptions UsedA change in the above assumptions may result in a material impact on net income. See Note 5 - Effects of Regulation for additional information related to regulatory assets and regulatory liabilities.109Revenue Recognition – Unbilled RevenuesNature of Estimates RequiredAEP recognizes revenues from customers as the performance obligations of delivering energy to customers are satisfied. The determination of sales to individual customers is based on the reading of their meters, which is performed on a systematic basis throughout the month. At the end of each month, amounts of energy delivered to customers since the date of the last meter reading are estimated and the corresponding unbilled revenue accrual is recorded. This estimate is reversed in the following month and actual revenue is recorded based on meter readings. PSO and SWEPCo do not include the fuel portion in unbilled revenue in accordance with the applicable state commission regulatory treatment in Arkansas, Louisiana, Oklahoma and Texas.Accrued unbilled revenues for the Vertically Integrated Utilities segment were $288 million and $248 million as of December 31, 2020 and 2019, respectively. The changes in unbilled electric utility revenues for AEP’s Vertically Integrated Utilities segment were $40 million, $(7) million and $(23) million for the years ended December 31, 2020, 2019 and 2018, respectively. The changes in unbilled electric revenues are primarily due to changes in weather and rates. Accrued unbilled revenues for the Transmission and Distribution Utilities segment were $171 million and $166 million as of December 31, 2020 and 2019, respectively. The changes in unbilled electric utility revenues for AEP’s Transmission and Distribution Utilities segment were $5 million, $(12) million and $(24) million for the years ended December 31, 2020, 2019 and 2018, respectively. The changes in unbilled electric revenues are primarily due to changes in weather and rates. Accrued unbilled revenues for the Generation & Marketing segment were $86 million and $75 million as of December 31, 2020 and 2019, respectively. The changes in unbilled electric utility revenues for AEP’s Generation & Marketing segment were $11 million, $16 million and $5 million for the years ended December 31, 2020, 2019 and 2018, respectively. Assumptions and Approach UsedFor each Registrant except AEPTCo, the monthly estimate for unbilled revenues is based upon a primary computation of net generation (generation plus purchases less sales) less the current month’s billed KWh and estimated line losses, plus the prior month’s unbilled KWh. However, due to the potential for meter reading issues, meter drift and other anomalies, a secondary computation is made, based upon an allocation of billed KWh to the current month and previous month, on a billing cycle-by-cycle basis, and by dividing the current month aggregated result by the billed KWh. The two methodologies are evaluated to confirm that they are not statistically different. For AEP’s Generation & Marketing segment, management calculates unbilled based on a primary computation of load as provided by PJM less the current month’s billed KWh and estimated line losses, plus the prior month’s unbilled KWh. However, due to the potential for meter reading issues, meter drift and other anomalies, a secondary computation is made, based upon using the most recent historic daily activity on a per contract basis. The two methodologies are evaluated to confirm that they are not statistically different.Effect if Different Assumptions UsedIf the two methodologies used to estimate unbilled revenue are statistically different, a limiter adjustment is made to bring the primary computation within one standard deviation of the secondary computation. Additionally, significant fluctuations in energy demand for the unbilled period, weather, line losses or changes in the composition of customer classes could impact the estimate of unbilled revenue. 110Accounting for Derivative InstrumentsNature of Estimates RequiredManagement considers fair value techniques, valuation adjustments related to credit and liquidity and judgments related to the probability of forecasted transactions occurring within the specified time period to be critical accounting estimates. These estimates are considered significant because they are highly susceptible to change from period to period and are dependent on many subjective factors.Assumptions and Approach UsedThe Registrants measure the fair values of derivative instruments and hedge instruments accounted for using MTM accounting based primarily on exchange prices and broker quotes. If a quoted market price is not available, the fair value is estimated based on the best market information available including valuation models that estimate future energy prices based on existing market and broker quotes and other assumptions. Fair value estimates, based upon the best market information available, involve uncertainties and matters of significant judgment. These uncertainties include projections of future commodity prices, including future price volatility.The Registrants reduce fair values by estimated valuation adjustments for items such as discounting, liquidity and credit quality. Liquidity adjustments are calculated by utilizing bid/ask spreads to estimate the potential fair value impact of liquidating open positions over a reasonable period of time. Credit adjustments on risk management contracts are calculated using estimated default probabilities and recovery rates relative to the counterparties or counterparties with similar credit profiles and contractual netting agreements.With respect to hedge accounting, management assesses hedge effectiveness and evaluates a forecasted transaction’s probability of occurrence within the specified time period as provided in the original hedge documentation.Effect if Different Assumptions UsedThere is inherent risk in valuation modeling given the complexity and volatility of energy markets. Therefore, it is possible that results in future periods may be materially different as contracts settle.The probability that hedged forecasted transactions will not occur by the end of the specified time period could change operating results by requiring amounts currently classified in Accumulated Other Comprehensive Income (Loss) to be classified into operating income.For additional information see Note 10 - Derivatives and Hedging and Note 11 - Fair Value Measurements. See “Fair Value Measurements of Assets and Liabilities” section of Note 1 for AEP’s fair value calculation policy.111Long-Lived AssetsNature of Estimates RequiredIn accordance with the requirements of “Property, Plant and Equipment” accounting guidance and “Regulated Operations” accounting guidance, the Registrants evaluate long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying amount of any such assets may not be recoverable. Such events or changes in circumstance include planned abandonments, probable disallowances for rate-making purposes of assets determined to be recently completed plant, and assets that meet the held-for-sale criteria. The Registrants utilize a group composite method of depreciation to estimate the useful lives of long-lived assets. An impairment evaluation of a long-lived, held and used asset may result from an abandonment, significant decreases in the market price of an asset, a significant adverse change in the extent or manner in which an asset is being used or in its physical condition, a significant adverse change in legal factors or in the business climate that could affect the value of an asset, as well as other economic or operations analyses. If the carrying amount of the asset is not recoverable, the Registrants record an impairment to the extent that the fair value of the asset is less than its book value. Performing an impairment evaluation involves a significant degree of estimation and judgment in areas such as identifying circumstances that indicate an impairment may exist, identifying and grouping affected assets and developing the non-discounted and discounted future cash flows (used to estimate fair value in the absence of market-based value, in some instances) associated with the asset. Assets held for sale must be measured at the lower of the book value or fair value less cost to sell. An impairment is recognized if an asset’s fair value less costs to sell is less than its book value. Any impairment charge is recorded as a reduction to earnings.Assumptions and Approach UsedThe fair value of an asset is the amount at which that asset could be bought or sold in a current transaction between willing parties other than in a forced or liquidation sale. Quoted market prices in active markets are the best evidence of fair value and are used as the basis for the measurement, if available. In the absence of quoted prices for identical or similar assets in active markets, the Registrants estimate fair value using various internal and external valuation methods including cash flow projections or other market indicators of fair value such as bids received, comparable sales or independent appraisals. Cash flow estimates are based on relevant information available at the time the estimates are made. Estimates of future cash flows are, by nature, highly uncertain and may vary significantly from actual results. Also, when measuring fair value, management evaluates the characteristics of the asset or liability to determine if market participants would take those characteristics into account when pricing the asset or liability at the measurement date. Such characteristics include, for example, the condition and location of the asset or restrictions on the use of the asset. The Registrants perform depreciation studies that include a review of any external factors that may affect the useful life to determine composite depreciation rates and related lives which are subject to periodic review by state regulatory commissions for regulated assets. The fair value of the asset could be different using different estimates and assumptions in these valuation techniques.Effect if Different Assumptions UsedIn connection with the evaluation of long-lived assets in accordance with the requirements of “Property, Plant and Equipment” accounting guidance, the fair value of the asset can vary if different estimates and assumptions are used in the applied valuation techniques. Estimates for depreciation rates contemplate the history of interim capital replacements and the amount of salvage expected. In cases of impairment, the best estimate of fair value was made using valuation methods based on the most current information at that time. Fluctuations in realized sales proceeds versus the estimated fair value of the asset are generally due to a variety of factors including, but not limited to, differences in subsequent market conditions, the level of bidder interest, the timing and terms of the transactions and management’s analysis of the benefits of the transaction.112Pension and OPEBAEP maintains a qualified, defined benefit pension plan (Qualified Plan), which covers substantially all nonunion and certain union employees, and unfunded, non-qualified supplemental plans (Nonqualified Plans) to provide benefits in excess of amounts permitted under the provisions of the tax law for participants in the Qualified Plan (collectively the Pension Plans). AEP also sponsors OPEB plans to provide health and life insurance benefits for retired employees. The Pension Plans and OPEB plans are collectively referred to as the Plans.For a discussion of investment strategy, investment limitations, target asset allocations and the classification of investments within the fair value hierarchy, see “Investments Held in Trust for Future Liabilities” and “Fair Value Measurements of Assets and Liabilities” sections of Note 1. See Note 8 - Benefit Plans for information regarding costs and assumptions for the Plans.The following table shows the net periodic cost (credit) of the Plans:Years Ended December 31,Net Periodic Cost (Credit)202020192018(in millions)Pension Plans$108.6 $61.5 $82.9 OPEB(109.7)(80.7)(101.8)The net periodic benefit cost is calculated based upon a number of actuarial assumptions, including expected long-term rates of return on the Plans’ assets. In developing the expected long-term rate of return assumption for 2021, management evaluated input from actuaries and investment consultants, including their reviews of asset class return expectations as well as long-term inflation assumptions. Management also considered historical returns of the investment markets and tax rates which affect a portion of the OPEB plans’ assets. Management anticipates that the investment managers employed for the Plans will invest the assets to generate future returns averaging 4.75% for the Qualified Plan and 4.75% for the OPEB plans.The expected long-term rate of return on the Plans’ assets is based on management’s targeted asset allocation and expected investment returns for each investment category. Assumptions for the Plans are summarized in the following table:Pension PlansOPEBAssumed/Assumed/2021Expected2021ExpectedTargetLong-TermTargetLong-TermAssetRate ofAssetRate ofAllocationReturnAllocationReturnEquity25 %6.79 %49 %6.45 %Fixed Income59 3.30 49 3.18 Other Investments15 7.88 — — Cash and Cash Equivalents1 1.21 2 1.21 Total100 %100 %Management regularly reviews the actual asset allocation and periodically rebalances the investments to the targeted allocation. Management believes that 4.75% for the Qualified Plan and 4.75% for the OPEB plans are reasonable estimates of the long-term rate of return on the Plans’ assets. The Pension Plans’ assets had an actual gain of 16.91% and 15.81% for the year ended December 31, 2020 and 2019, respectively. The OPEB plans’ assets had an actual gain of 16.33% and 20.93% for the year ended December 31, 2020 and 2019, respectively. Management will continue to evaluate the actuarial assumptions, including the expected rate of return, at least annually, and will adjust the assumptions as necessary.113AEP bases the determination of pension expense or income on a market-related valuation of assets, which reduces year-to-year volatility. This market-related valuation recognizes investment gains or losses over a five-year period from the year in which they occur. Investment gains or losses for this purpose are the difference between the expected return calculated using the market-related value of assets and the actual return based on the market-related value of assets. Since the market-related value of assets recognizes gains or losses over a five-year period, the future value of assets will be impacted as previously deferred gains or losses are recorded. As of December 31, 2020, AEP had cumulative gains of approximately $575 million for the Qualified Plan that remain to be recognized in the calculation of the market-related value of assets. These unrecognized market-related net actuarial gains may result in decreases in the future pension costs depending on several factors, including whether such gains at each measurement date exceed the corridor in accordance with “Compensation – Retirement Benefits” accounting guidance.The method used to determine the discount rate that AEP utilizes for determining future obligations is a duration-based method in which a hypothetical portfolio of high quality corporate bonds is constructed with cash flows matching the benefit plan liability. The composite yield on the hypothetical bond portfolio is used as the discount rate for the plan. The discount rate as of December 31, 2020 under this method was 2.5% for the Qualified Plan, 2.25% for the Nonqualified Plans and 2.55% for the OPEB plans. Due to the effect of the unrecognized net actuarial losses and based on an expected rate of return on the Pension Plans’ assets of 4.75%, discount rates of 2.5% and 2.25% and various other assumptions, management estimates that the pension costs for the Pension Plans will approximate $137 million, $137 million and $137 million in 2021, 2022 and 2023, respectively. Based on an expected rate of return on the OPEB plans’ assets of 4.75%, a discount rate of 2.55% and various other assumptions, management estimates OPEB plan credits will approximate $121 million, $120 million and $112 million in 2021, 2022 and 2023, respectively. Future actual costs will depend on future investment performance, changes in future discount rates and various other factors related to the populations participating in the Plans. The actuarial assumptions used may differ materially from actual results. The effects of a 50 basis point change to selective actuarial assumptions are included in the “Effect if Different Assumptions Used” section below.The value of AEP’s Pension Plans’ assets increased to $5.6 billion as of December 31, 2020 from $5.0 billion as of December 31, 2019 primarily due to higher investment returns. During 2020, the Qualified Plan paid $402 million and the Nonqualified Plans paid $5 million in benefits to plan participants. The value of AEP’s OPEB plans’ assets increased to $1.9 billion as of December 31, 2020 from $1.8 billion as of December 31, 2019 primarily due to higher investment returns. The OPEB plans paid $131 million in benefits to plan participants during 2020.Nature of Estimates RequiredAEP sponsors pension and OPEB plans in various forms covering all employees who meet eligibility requirements. These benefits are accounted for under “Compensation” and “Plan Accounting” accounting guidance. The measurement of pension and OPEB obligations, costs and liabilities is dependent on a variety of assumptions.Assumptions and Approach UsedThe critical assumptions used in developing the required estimates include the following key factors:•Discount rate•Compensation increase rate•Cash balance crediting rate•Health care cost trend rate•Expected return on plan assetsOther assumptions, such as retirement, mortality and turnover, are evaluated periodically and updated to reflect actual experience.114Effect if Different Assumptions UsedThe actuarial assumptions used may differ materially from actual results due to changing market and economic conditions, higher or lower withdrawal rates, longer or shorter life spans of participants or higher or lower lump sum versus annuity payout elections by plan participants. These differences may result in a significant impact to the amount of pension and OPEB expense recorded. If a 50 basis point change were to occur for the following assumptions, the approximate effect on the financial statements would be as follows:Pension PlansOPEB+0.5%-0.5%+0.5%-0.5%(in millions)Effect on December 31, 2020 Benefit ObligationsDiscount Rate$(286.9)$316.2 $(66.6)$73.7 Compensation Increase Rate32.9 (30.3)NANACash Balance Crediting Rate81.2 (75.4)NANAHealth Care Cost Trend RateNANA12.7 (11.7)Effect on 2020 Periodic CostDiscount Rate$(12.5)$13.6 $(3.2)$3.4 Compensation Increase Rate6.5 (5.9)NANACash Balance Crediting Rate14.1 (13.2)NANAHealth Care Cost Trend RateNANA0.9 (0.8)Expected Return on Plan Assets(23.0)23.0 (8.7)8.7 NA Not applicable.115CONTRACTUAL OBLIGATION INFORMATIONAEP’s contractual cash obligations include amounts reported on the balance sheets and other obligations disclosed in the footnotes. The following table summarizes AEP’s contractual cash obligations as of December 31, 2020:Payments Due by PeriodContractual Cash ObligationsLess Than 1 Year2-3 Years4-5 YearsAfter 5 YearsTotal(in millions)Short-term Debt (a)$2,479.3 $— $— $— $2,479.3 Interest on Fixed Rate Portion of Long-term Debt (b)1,310.7 2,373.0 2,209.0 14,918.9 20,811.6 Fixed Rate Portion of Long-term Debt (c)1,533.1 4,481.8 2,443.1 20,599.2 29,057.2 Variable Rate Portion of Long-term Debt (d)553.0 1,715.9 6.6 — 2,275.5 Finance Lease Obligations (e)72.2 120.2 96.2 48.9 337.5 Operating Lease Obligations (e)270.8 357.5 149.6 193.0 970.9 Fuel Purchase Contracts (f)763.9 715.1 212.9 381.5 2,073.4 Energy and Capacity Purchase Contracts211.6 291.8 277.0 928.5 1,708.9 Construction Contracts for Capital Assets (g)1,624.2 3,211.8 2,347.4 4,379.1 11,562.5 Total$8,818.8 $13,267.1 $7,741.8 $41,449.1 $71,276.8 (a)Represents principal only, excluding interest.(b)Interest payments are estimated based on final maturity dates of debt securities outstanding as of December 31, 2020 and do not reflect anticipated future refinancing, early redemptions or debt issuances.(c)See “Long-term Debt” section of Note 14 for additional information. Represents principal only, excluding interest.(d)See “Long-term Debt” section of Note 14 for additional information. Represents principal only, excluding interest. Variable rate debt had interest rates that ranged between 0.18% and 2.25% as of December 31, 2020.(e)See Note 13 - Leases for additional information.(f)Represents contractual obligations to purchase coal, natural gas, uranium and other consumables as fuel for electric generation along with related transportation of the fuel.(g)Represents only capital assets for which there are signed contracts. Actual payments are dependent upon and may vary significantly based upon the decision to build, regulatory approval schedules, timing and escalation of project costs. AEP’s pension funding requirements are not included in the above table. As of December 31, 2020, AEP expects to make contributions to the pension plans totaling $133 million in 2021. Estimated contributions of $135 million in 2022 and $136 million in 2023 may vary significantly based on market returns, changes in actuarial assumptions and other factors. Based upon the projected benefit obligation and fair value of assets available to pay pension benefits, the pension plans were 100.2% funded as of December 31, 2020. See “Estimated Future Benefit Payments and Contributions” section of Note 8 for additional information. In addition to the amounts disclosed in the contractual cash obligations table above, standby letters of credit are entered into with third-parties. These letters of credit are issued in the ordinary course of business and cover items such as natural gas and electricity risk management contracts, construction contracts, insurance programs, security deposits and debt service reserves. There is no collateral held in relation to any guarantees in excess of the ownership percentages. In the event any letters of credit are drawn, there is no recourse to third-parties. See “Letters of Credit” section of Note 6 for additional information.SIGNIFICANT TAX LEGISLATIONIn March 2020, the CARES Act was signed into law and includes tax relief provisions such as: (a) an AMT Credit Refund, (b) a 5-year NOL carryback from years 2018-2020 and (c) delayed payment of employer payroll taxes. See “Federal Tax Legislation” section of Note 12 for additional information.In December 2020, the CAA of 2021 was signed into law and includes: (a) COVID-19 tax relief and tax extender provisions including, extensions of time to begin construction on and placed in-service assets generating PTCs and ITCs, (b) 100% deductibility of business meals in 2021 and 2022 and (c) an extension of the work opportunity tax credit. See “Federal Tax Legislation” section of Note 12 for additional information.116ACCOUNTING STANDARDSSee Note 2 - New Accounting Standards for information related to accounting standards adopted in 2020 and standards effective in the future.QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKMarket RisksThe Vertically Integrated Utilities segment is exposed to certain market risks as a major power producer and through transactions in power, coal, natural gas and marketing contracts. These risks include commodity price risks which may be subject to capacity risk, credit risk as well as interest rate risk. These risks represent the risk of loss that may impact this segment due to changes in the underlying market prices or rates.The Transmission and Distribution Utilities segment is exposed to energy procurement risk and interest rate risk.The Generation & Marketing segment conducts marketing, risk management and retail activities in ERCOT, PJM, SPP and MISO. This segment is exposed to certain market risks as a marketer of wholesale and retail electricity. These risks include commodity price risks which may be subject to capacity risk, credit risk as well as interest rate risk. These risks represent the risk of loss that may impact this segment due to changes in the underlying market prices or rates. In addition, the Generation & Marketing segment is also exposed to certain market risks as a power producer and through transactions in wholesale electricity, natural gas and marketing contracts.Management employs risk management contracts including physical forward and financial forward purchase-and-sale contracts. Management engages in risk management of power, capacity, coal, natural gas and, to a lesser extent, heating oil, gasoline and other commodity contracts to manage the risk associated with the energy business. As a result, AEP is subject to price risk. The amount of risk taken is determined by the Commercial Operations, Energy Supply and Finance groups in accordance with established risk management policies as approved by the Finance Committee of the Board of Directors. AEPSC’s market risk oversight staff independently monitors risk policies, procedures and risk levels and provides members of the Commercial Operations Risk Committee (Regulated Risk Committee) and the Energy Supply Risk Committee (Competitive Risk Committee) various reports regarding compliance with policies, limits and procedures. The Regulated Risk Committee consists of AEPSC’s Chief Financial Officer, Executive Vice President of Generation, Executive Vice President of Utilities, Senior Vice President of Commercial Operations, Senior Vice President of Treasury and Risk and Chief Risk Officer. The Competitive Risk Committee consists of AEPSC’s Chief Financial Officer, Senior Vice President of Treasury and Risk and Chief Risk Officer in addition to Energy Supply’s President and Vice President. When commercial activities exceed predetermined limits, positions are modified to reduce the risk to be within the limits unless specifically approved by the respective committee.The effects of COVID-19 may adversely impact AEP’s risk management contracts on a forward basis. Markets could experience reduced market liquidity as they face potential uncertainties. Credit risk may increase as counterparties encounter business and supply chain disruptions and overall solvency. Also, interest rates could continue to see increased volatility as capital markets confront uncertainty.117The following table summarizes the reasons for changes in total MTM value as compared to December 31, 2019:MTM Risk Management Contract Net Assets (Liabilities)Year Ended December 31, 2020VerticallyIntegratedUtilitiesTransmissionandDistributionUtilitiesGeneration&MarketingTotal(in millions)Total MTM Risk Management Contract Net Assets (Liabilities) as of December 31, 2019$75.9 $(103.6)$163.4 $135.7 Gain from Contracts Realized/Settled During the Period and Entered in a Prior Period(44.3)(7.2)(17.9)(69.4)Fair Value of New Contracts at Inception When Entered During the Period (a)— — 15.2 15.2 Changes in Fair Value Due to Market Fluctuations During the Period (b)— — 7.4 7.4 Changes in Fair Value Allocated to Regulated Jurisdictions (c)9.6 1.3 — 10.9 Total MTM Risk Management Contract Net Assets (Liabilities) as of December 31, 2020$41.2 $(109.5)$168.1 99.8 Commodity Cash Flow Hedge Contracts(75.4)Interest Rate Cash Flow Hedge Contracts(1.0)Fair Value Hedge Contracts(1.5)Collateral Deposits3.4 Total MTM Derivative Contract Net Assets as of December 31, 2020$25.3 (a)Reflects fair value on primarily long-term structured contracts which are typically with customers that seek fixed pricing to limit their risk against fluctuating energy prices. The contract prices are valued against market curves associated with the delivery location and delivery term. A significant portion of the total volumetric position has been economically hedged.(b)Market fluctuations are attributable to various factors such as supply/demand, weather, etc.(c)Relates to the net gains (losses) of those contracts that are not reflected on the statements of income. These net gains (losses) are recorded as regulatory liabilities/assets or accounts payable.See Note 10 – Derivatives and Hedging and Note 11 – Fair Value Measurements for additional information related to risk management contracts. The following tables and discussion provide information on credit risk and market volatility risk.118Credit RiskCredit risk is mitigated in wholesale marketing and trading activities by assessing the creditworthiness of potential counterparties before entering into transactions with them and continuing to evaluate their creditworthiness on an ongoing basis. Management uses credit agency ratings and current market-based qualitative and quantitative data as well as financial statements to assess the financial health of counterparties on an ongoing basis.AEP has risk management contracts (includes non-derivative contracts) with numerous counterparties. Since open risk management contracts are valued based on changes in market prices of the related commodities, exposures change daily. As of December 31, 2020, credit exposure net of collateral to sub investment grade counterparties was approximately 6.6%, expressed in terms of net MTM assets, net receivables and the net open positions for contracts not subject to MTM (representing economic risk even though there may not be risk of accounting loss). As of December 31, 2020, the following table approximates AEP’s counterparty credit quality and exposure based on netting across commodities, instruments and legal entities where applicable:Counterparty Credit QualityExposureBeforeCreditCollateralCreditCollateralNetExposureNumber ofCounterparties>10% of Net ExposureNet ExposureofCounterparties>10%(in millions, except number of counterparties)Investment Grade$412.2 $— $412.2 2 $198.2 Split Rating1.1 — 1.1 1 1.1 No External Ratings:Internal Investment Grade133.8 — 133.8 3 91.8 Internal Noninvestment Grade49.4 10.5 38.9 2 25.6 Total as of December 31, 2020$596.5 $10.5 $586.0 All exposure in the table above relates to AEPSC and AEPEP as AEPSC is agent for and transacts on behalf of AEP subsidiaries, including the Registrant Subsidiaries and AEPEP is agent for and transacts on behalf of other AEP subsidiaries.In addition, AEP is exposed to credit risk related to participation in RTOs. For each of the RTOs in which AEP participates, this risk is generally determined based on the proportionate share of member gross activity over a specified period of time.Value at Risk (VaR) Associated with Risk Management ContractsManagement uses a risk measurement model, which calculates VaR, to measure AEP’s commodity price risk in the risk management portfolio. The VaR is based on the variance-covariance method using historical prices to estimate volatilities and correlations and assumes a 95% confidence level and a one-day holding period. Based on this VaR analysis, as of December 31, 2020, a near term typical change in commodity prices is not expected to materially impact net income, cash flows or financial condition.Management calculates the VaR for both a trading and non-trading portfolio. The trading portfolio consists primarily of contracts related to energy trading and marketing activities. The non-trading portfolio consists primarily of economic hedges of generation and retail supply activities. 119The following tables show the end, high, average and low market risk as measured by VaR for the periods indicated:VaR ModelTrading PortfolioTwelve Months EndedTwelve Months EndedDecember 31, 2020December 31, 2019EndHighAverageLowEndHighAverageLow(in millions)(in millions)$0.1 $0.3 $0.1 $— $0.1 $1.2 $0.2 $0.1 VaR ModelNon-Trading PortfolioTwelve Months EndedTwelve Months EndedDecember 31, 2020December 31, 2019EndHighAverageLowEndHighAverageLow(in millions)(in millions)$2.2 $2.9 $1.0 $0.1 $0.2 $8.5 $1.1 $0.2 Management back-tests VaR results against performance due to actual price movements. Based on the assumed 95% confidence interval, the performance due to actual price movements would be expected to exceed the VaR at least once every 20 trading days.As the VaR calculation captures recent price movements, management also performs regular stress testing of the trading portfolio to understand AEP’s exposure to extreme price movements. A historical-based method is employed whereby the current trading portfolio is subjected to actual, observed price movements from the last several years in order to ascertain which historical price movements translated into the largest potential MTM loss. Management then researches the underlying positions, price movements and market events that created the most significant exposure and reports the findings to the Risk Executive Committee, Regulated Risk Committee or Competitive Risk Committee as appropriate.Interest Rate RiskAEP is exposed to interest rate market fluctuations in the normal course of business operations. AEP has outstanding short and long-term debt which is subject to a variable rate. AEP manages interest rate risk by limiting variable-rate exposures to a percentage of total debt, by entering into interest rate derivative instruments and by monitoring the effects of market changes in interest rates. For the 12 months ended December 31, 2020, 2019 and 2018, a 100 basis point change in the benchmark rate on AEP’s variable rate debt would impact pretax interest expense annually by $32 million, $24 million and $25 million, respectively.120REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRMTo the Board of Directors and Shareholders of American Electric Power Company, Inc. Opinions on the Financial Statements and Internal Control over Financial Reporting We have audited the accompanying consolidated balance sheets of American Electric Power Company, Inc. and its subsidiaries (the “Company”) as of December 31, 2020 and 2019, and the related consolidated statements of income, of comprehensive income (loss), of changes in equity and of cash flows for each of the three years in the period ended December 31, 2020, including the related notes (collectively referred to as the “consolidated financial statements”). We also have audited the Company's internal control over financial reporting as of December 31, 2020, based on criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of the Company as of December 31, 2020 and 2019, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2020 in conformity with accounting principles generally accepted in the United States of America. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2020, based on criteria established in Internal Control - Integrated Framework (2013) issued by the COSO. Change in Accounting Principle As discussed in Note 13 to the consolidated financial statements, the Company changed the manner in which it accounts for leases in 2019. Basis for Opinions The Company's management is responsible for these consolidated financial statements, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Report on Internal Control over Financial Reporting. Our responsibility is to express opinions on the Company’s consolidated financial statements and on the Company's internal control over financial reporting based on our audits. We are a public accounting firm registered with the Public Company Accounting Oversight Board (United States) (PCAOB) and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB. We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement, whether due to error or fraud, and whether effective internal control over financial reporting was maintained in all material respects. Our audits of the consolidated financial statements included performing procedures to assess the risks of material misstatement of the consolidated financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the consolidated financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the consolidated financial statements. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions. 121Definition and Limitations of Internal Control over Financial Reporting A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. Critical Audit Matters The critical audit matters communicated below are matters arising from the current period audit of the consolidated financial statements that were communicated or required to be communicated to the audit committee and that (i) relate to accounts or disclosures that are material to the consolidated financial statements and (ii) involved our especially challenging, subjective, or complex judgments. The communication of critical audit matters does not alter in any way our opinion on the consolidated financial statements, taken as a whole, and we are not, by communicating the critical audit matters below, providing separate opinions on the critical audit matters or on the accounts or disclosures to which they relate. Accounting for the Effects of Cost-Based Regulation As described in Notes 1 and 5 to the consolidated financial statements, the Company’s consolidated financial statements reflect the actions of regulators that result in the recognition of certain revenues and expenses in different time periods than enterprises that are not rate-regulated. Regulatory assets (deferred expenses) and regulatory liabilities (deferred future revenue reductions or refunds) are recorded to reflect the economic effects of regulation in the same accounting period by matching expenses with their recovery through regulated revenues and matching income with its passage to customers in cost-based regulated rates. Management reviews the probability of recovery of regulatory assets and refund of regulatory liabilities at each balance sheet date and whenever new events occur, whether influenced by issuance of regulatory commission orders, passage of new legislation, or changes in the regulatory environment. As of December 31, 2020, there were $3.6 billion of deferred costs included in regulatory assets, $0.4 billion of which were pending final regulatory approval, and $8.4 billion of regulatory liabilities awaiting potential refund or future rate reduction, $0.5 billion of which were pending final regulatory determination. The principal considerations for our determination that performing procedures relating to the accounting for the effects of cost-based regulation is a critical audit matter are the significant judgment by management in the ongoing evaluation of the recovery of regulatory assets and refund of regulatory liabilities, and applying guidance contained in rate orders and other relevant evidence; which in turn led to significant audit effort and a high degree of auditor subjectivity in performing procedures and in evaluating audit evidence relating to management’s judgments about the probability of recovery of regulatory assets and refund of regulatory liabilities. 122Addressing the matter involved performing procedures and evaluating audit evidence in connection with forming our overall opinion on the consolidated financial statements. These procedures included testing the effectiveness of controls relating to management’s assessment of regulatory proceedings, including the probability of recovery of regulatory assets and refund of regulatory liabilities. These procedures also included, among others, evaluating the reasonableness of management’s assessment of probability of future recovery for regulatory assets and refund of regulatory liabilities. Testing of regulatory assets and liabilities, including those subject to pending rate cases, also involved evaluating the provisions and formulas outlined in rate orders, other regulatory correspondence, and application of regulatory precedents. Valuation of Level 3 Risk Management Commodity Contracts As described in Notes 1, 10 and 11 to the consolidated financial statements, the Company employs risk management commodity contracts including physical and financial forward purchase-and-sale contracts and, to a lesser extent, over-the-counter swaps and options to accomplish its risk management strategies. Certain over-the-counter and bilaterally executed derivative instruments are executed in less active markets with a lower availability of pricing information. The fair value of these risk management commodity contracts is estimated based on available market information including valuation models that estimate future energy prices based on existing market and broker quotes, and other assumptions. Fair value estimates involve significant uncertainties and matters of significant judgement including future commodity prices and future price volatility. The main driver of contracts being classified as Level 3 is the inability to substantiate energy price curves in the market. Management utilized such unobservable pricing data to value its Level 3 risk management commodity contract assets and liabilities, which totaled $256.3 million and $174.8 million, as of December 31, 2020, respectively. The principal considerations for our determination that performing procedures relating to the valuation of Level 3 risk management commodity contracts is a critical audit matter are the significant judgment and estimation by management when developing the fair value of the commodity contracts; which in turn led to significant audit effort and a high degree of auditor subjectivity in performing procedures and in evaluating audit evidence relating to the unobservable assumptions for projections of future commodity prices and future price volatilities used within management’s discounted cash flow models. In addition, the audit effort involved the use of professionals with specialized skill and knowledge to assist in performing these procedures and evaluating the audit evidence obtained. Addressing the matter involved performing procedures and evaluating audit evidence in connection with forming our overall opinion on the consolidated financial statements. These procedures included testing the effectiveness of controls relating to management’s valuation of the risk management commodity contracts, including controls over the assumptions used to value the Level 3 risk management commodity contracts. These procedures also included, among others, testing the data used in and management’s process for developing the fair value of the Level 3 risk management commodity contracts. Professionals with specialized skill and knowledge were used to assist in evaluating the appropriateness of the discounted cash flow models and reasonableness of the future commodity prices and future price volatilities assumptions. /s/ PricewaterhouseCoopers LLP Columbus, Ohio February 25, 2021 We have served as the Company’s auditor since 2017. 123MANAGEMENT’S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTINGThe management of American Electric Power Company, Inc. and Subsidiary Companies (AEP) is responsible for establishing and maintaining adequate internal control over financial reporting as such term is defined in Rule 13a-15(f) and 15d-15(f) under the Securities Exchange Act of 1934, as amended. AEP’s internal control is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles.Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.Management assessed the effectiveness of AEP’s internal control over financial reporting as of December 31, 2020. In making this assessment, management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control – Integrated Framework (2013). Based on management’s assessment, management concluded AEP’s internal control over financial reporting was effective as of December 31, 2020.PricewaterhouseCoopers LLP, AEP’s independent registered public accounting firm has issued an audit report on the effectiveness of AEP’s internal control over financial reporting as of December 31, 2020. The Report of Independent Registered Public Accounting Firm appears on the previous page.124AMERICAN ELECTRIC POWER COMPANY, INC. AND SUBSIDIARY COMPANIESCONSOLIDATED STATEMENTS OF INCOMEFor the Years Ended December 31, 2020, 2019 and 2018 (in millions, except per-share and share amounts)Years Ended December 31,202020192018REVENUESVertically Integrated Utilities$8,753.2 $9,245.7 $9,556.7 Transmission and Distribution Utilities4,238.7 4,319.0 4,552.3 Generation & Marketing1,621.0 1,721.8 1,818.1 Other Revenues305.6 274.9 268.6 TOTAL REVENUES14,918.5 15,561.4 16,195.7 EXPENSESFuel and Other Consumables Used for Electric Generation1,439.3 1,940.9 2,359.4 Purchased Electricity for Resale2,930.4 3,165.2 3,427.1 Other Operation2,572.4 2,743.7 2,979.2 Maintenance1,010.4 1,213.9 1,247.4 Asset Impairments and Other Related Charges— 156.4 70.6 Depreciation and Amortization2,682.8 2,514.5 2,286.6 Taxes Other Than Income Taxes1,295.5 1,234.5 1,142.7 TOTAL EXPENSES11,930.8 12,969.1 13,513.0 OPERATING INCOME2,987.7 2,592.3 2,682.7 Other Income (Expense):Other Income57.0 26.6 18.2 Allowance for Equity Funds Used During Construction148.1 168.4 132.5 Non-Service Cost Components of Net Periodic Benefit Cost119.0 120.0 124.5 Interest Expense(1,165.7)(1,072.5)(984.4)INCOME BEFORE INCOME TAX EXPENSE (BENEFIT) AND EQUITY EARNINGS2,146.1 1,834.8 1,973.5 Income Tax Expense (Benefit)40.5 (12.9)115.3 Equity Earnings of Unconsolidated Subsidiaries91.1 72.1 73.1 NET INCOME2,196.7 1,919.8 1,931.3 Net Income (Loss) Attributable to Noncontrolling Interests(3.4)(1.3)7.5 EARNINGS ATTRIBUTABLE TO AEP COMMON SHAREHOLDERS$2,200.1 $1,921.1 $1,923.8 WEIGHTED AVERAGE NUMBER OF BASIC AEP COMMON SHARES OUTSTANDING495,718,223 493,694,345 492,774,600 TOTAL BASIC EARNINGS PER SHARE ATTRIBUTABLE TO AEP COMMON SHAREHOLDERS$4.44 $3.89 $3.90 WEIGHTED AVERAGE NUMBER OF DILUTED AEP COMMON SHARES OUTSTANDING497,226,867 495,306,238 493,758,277 TOTAL DILUTED EARNINGS PER SHARE ATTRIBUTABLE TO AEP COMMON SHAREHOLDERS$4.42 $3.88 $3.90 See Notes to Financial Statements of Registrants beginning on page 229.125AMERICAN ELECTRIC POWER COMPANY, INC. AND SUBSIDIARY COMPANIESCONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)For the Years Ended December 31, 2020, 2019 and 2018 (in millions)Years Ended December 31,202020192018Net Income$2,196.7 $1,919.8 $1,931.3 OTHER COMPREHENSIVE INCOME (LOSS), NET OF TAXESCash Flow Hedges, Net of Tax of $1.8, $(21.1) and $3.9 in 2020, 2019 and 2018, Respectively6.9 (79.4)14.6 Amortization of Pension and OPEB Deferred Costs, Net of Tax of $(1.9), $(1.5) and $(1.4) in 2020, 2019 and 2018, Respectively(7.0)(5.6)(5.3)Pension and OPEB Funded Status, Net of Tax of $16.7, $15.3 and $(8.8) in 2020, 2019 and 2018, Respectively62.7 57.7 (33.0)TOTAL OTHER COMPREHENSIVE INCOME (LOSS)62.6 (27.3)(23.7)TOTAL COMPREHENSIVE INCOME2,259.3 1,892.5 1,907.6 Total Comprehensive Income (Loss) Attributable To Noncontrolling Interests(3.4)(1.3)7.5 TOTAL COMPREHENSIVE INCOME ATTRIBUTABLE TO AEP COMMON SHAREHOLDERS$2,262.7 $1,893.8 $1,900.1 See Notes to Financial Statements of Registrants beginning on page 229.126AMERICAN ELECTRIC POWER COMPANY, INC. AND SUBSIDIARY COMPANIESCONSOLIDATED STATEMENTS OF CHANGES IN EQUITYFor the Years Ended December 31, 2020, 2019 and 2018 (in millions)AEP Common ShareholdersCommon StockAccumulatedOtherComprehensiveIncome (Loss)SharesAmountPaid-inCapitalRetainedEarningsNoncontrollingInterestsTotalTOTAL EQUITY – DECEMBER 31, 2017512.2 $3,329.4 $6,398.7 $8,626.7 $(67.8)$26.6 $18,313.6 Issuance of Common Stock1.3 8.0 65.6 73.6 Common Stock Dividends(1,251.1)(a)(4.4)(1,255.5)Other Changes in Equity21.8 1.3 23.1 ASU 2018-02 Adoption14.0 (17.0)(3.0)ASU 2016-01 Adoption11.9 (11.9)— Net Income1,923.8 7.5 1,931.3 Other Comprehensive Loss (23.7)(23.7)TOTAL EQUITY – DECEMBER 31, 2018513.5 3,337.4 6,486.1 9,325.3 (120.4)31.0 19,059.4 Issuance of Common Stock0.9 6.0 59.3 65.3 Common Stock Dividends(1,345.5)(a)(4.5)(1,350.0)Other Changes in Equity(9.8)(b)2.2 (7.6)Acquisition of Sempra Renewables LLC134.8 134.8 Acquisition of Santa Rita East118.8 118.8 Net Income (Loss)1,921.1 (1.3)1,919.8 Other Comprehensive Loss (27.3)(27.3)TOTAL EQUITY – DECEMBER 31, 2019514.4 3,343.4 6,535.6 9,900.9 (147.7)281.0 19,913.2 Issuance of Common Stock2.4 15.9 139.1 155.0 Common Stock Dividends(1,415.0)(a)(9.9)(1,424.9)Other Changes in Equity(85.8)(c)(0.4)(86.2)ASU 2016-13 Adoption1.8 1.8 Acquisition of Incremental Interest in Santa Rita East(43.7)(43.7)Net Income (Loss)2,200.1 (3.4)2,196.7 Other Comprehensive Income62.6 62.6 TOTAL EQUITY – DECEMBER 31, 2020516.8 $3,359.3 $6,588.9 $10,687.8 $(85.1)$223.6 $20,774.5 (a) Cash dividends declared per AEP common share were $2.84, $2.71 and $2.53 for the years ended December 31, 2020, 2019 and 2018, respectively.(b) Includes $(62) million related to a forward equity purchase contract associated with the issuance of Equity Units. See “Equity Units” section of Note 14 for additional information.(c) Includes $(121) million related to a forward equity purchase contract associated with the issuance of Equity Units. See “Equity Units” section of Note 14 for additional information.See Notes to Financial Statements of Registrants beginning on page 229.127AMERICAN ELECTRIC POWER COMPANY, INC. AND SUBSIDIARY COMPANIESCONSOLIDATED BALANCE SHEETSASSETSDecember 31, 2020 and 2019 (in millions)December 31,20202019CURRENT ASSETSCash and Cash Equivalents$392.7 $246.8 Restricted Cash(December 31, 2020 and 2019 Amounts Include $45.6 and $185.8, Respectively, Related to Transition Funding, Restoration Funding, Appalachian Consumer Rate Relief Funding and Santa Rita East)45.6 185.8 Other Temporary Investments(December 31, 2020 and 2019 Amounts Include $194.6 and $187.8, Respectively, Related to EIS and Transource Energy)200.8 202.7 Accounts Receivable:Customers613.6 625.3 Accrued Unbilled Revenues248.7 222.4 Pledged Accounts Receivable – AEP Credit1,018.4 873.9 Miscellaneous33.1 27.2 Allowance for Uncollectible Accounts(71.1)(43.7)Total Accounts Receivable1,842.7 1,705.1 Fuel629.4 528.5 Materials and Supplies680.6 640.7 Risk Management Assets94.7 172.8 Accrued Tax Benefits185.3 85.8 Regulatory Asset for Under-Recovered Fuel Costs90.7 92.9 Margin Deposits62.0 60.4 Prepayments and Other Current Assets127.0 156.3 TOTAL CURRENT ASSETS4,351.5 4,077.8 PROPERTY, PLANT AND EQUIPMENTElectric:Generation23,133.9 22,762.4 Transmission27,886.7 24,808.6 Distribution23,972.1 22,443.4 Other Property, Plant and Equipment (Including Coal Mining and Nuclear Fuel)5,294.6 4,811.5 Construction Work in Progress4,025.7 4,319.8 Total Property, Plant and Equipment84,313.0 79,145.7 Accumulated Depreciation and Amortization20,411.4 19,007.6 TOTAL PROPERTY, PLANT AND EQUIPMENT – NET63,901.6 60,138.1 OTHER NONCURRENT ASSETSRegulatory Assets3,527.0 3,158.8 Securitized Assets657.0 858.1 Spent Nuclear Fuel and Decommissioning Trusts3,306.7 2,975.7 Goodwill52.5 52.5 Long-term Risk Management Assets242.2 266.6 Operating Lease Assets866.4 957.4 Deferred Charges and Other Noncurrent Assets3,852.3 3,407.3 TOTAL OTHER NONCURRENT ASSETS12,504.1 11,676.4 TOTAL ASSETS$80,757.2 $75,892.3 See Notes to Financial Statements of Registrants beginning on page 229.128AMERICAN ELECTRIC POWER COMPANY, INC. AND SUBSIDIARY COMPANIESCONSOLIDATED BALANCE SHEETSLIABILITIES AND EQUITYDecember 31, 2020 and 2019 (dollars in millions)December 31,20202019CURRENT LIABILITIESAccounts Payable$1,709.7 $2,085.8 Short-term Debt:Securitized Debt for Receivables – AEP Credit592.0 710.0 Other Short-term Debt1,887.3 2,128.3 Total Short-term Debt2,479.3 2,838.3 Long-term Debt Due Within One Year(December 31, 2020 and 2019 Amounts Include $198.3 and $565.1, Respectively, Related to Sabine, DCC Fuel, Transition Funding, Restoration Funding, Appalachian Consumer Rate Relief Funding and Transource Energy)2,086.1 1,598.7 Risk Management Liabilities78.8 114.3 Customer Deposits335.6 366.1 Accrued Taxes1,476.4 1,357.8 Accrued Interest267.6 243.6 Obligations Under Operating Leases241.3 234.1 Regulatory Liability for Over-Recovered Fuel Costs52.6 86.6 Other Current Liabilities1,199.3 1,373.8 TOTAL CURRENT LIABILITIES9,926.7 10,299.1 NONCURRENT LIABILITIESLong-term Debt(December 31, 2020 and 2019 Amounts Include $950.1 and $907, Respectively, Related to Sabine, DCC Fuel, Transition Funding, Restoration Funding, Appalachian Consumer Rate Relief Funding and Transource Energy)28,986.4 25,126.8 Long-term Risk Management Liabilities232.8 261.8 Deferred Income Taxes8,240.9 7,588.2 Regulatory Liabilities and Deferred Investment Tax Credits8,378.7 8,457.6 Asset Retirement Obligations2,469.2 2,216.6 Employee Benefits and Pension Obligations336.4 466.0 Obligations Under Operating Leases638.4 734.6 Deferred Credits and Other Noncurrent Liabilities728.0 719.8 TOTAL NONCURRENT LIABILITIES50,010.8 45,571.4 TOTAL LIABILITIES59,937.5 55,870.5 Rate Matters (Note 4)Commitments and Contingencies (Note 6)MEZZANINE EQUITYRedeemable Noncontrolling Interest— 65.7 Contingently Redeemable Performance Share Awards45.2 42.9 TOTAL MEZZANINE EQUITY45.2 108.6 EQUITYCommon Stock – Par Value – $6.50 Per Share:20202019Shares Authorized600,000,000600,000,000Shares Issued516,808,354514,373,631(20,204,160 Shares were Held in Treasury as of December 31, 2020 and 2019, Respectively)3,359.3 3,343.4 Paid-in Capital6,588.9 6,535.6 Retained Earnings10,687.8 9,900.9 Accumulated Other Comprehensive Income (Loss)(85.1)(147.7)TOTAL AEP COMMON SHAREHOLDERS’ EQUITY20,550.9 19,632.2 Noncontrolling Interests223.6 281.0 TOTAL EQUITY20,774.5 19,913.2 TOTAL LIABILITIES, MEZZANINE EQUITY AND EQUITY$80,757.2 $75,892.3 See Notes to Financial Statements of Registrants beginning on page 229.129AMERICAN ELECTRIC POWER COMPANY, INC. AND SUBSIDIARY COMPANIESCONSOLIDATED STATEMENTS OF CASH FLOWSFor the Years Ended December 31, 2020, 2019 and 2018 (in millions)Years Ended December 31,202020192018OPERATING ACTIVITIESNet Income$2,196.7 $1,919.8 $1,931.3 Adjustments to Reconcile Net Income to Net Cash Flows from Operating Activities:Depreciation and Amortization2,682.8 2,514.5 2,286.6 Rockport Plant, Unit 2 Operating Lease Amortization136.5 136.5 — Deferred Income Taxes196.1 (17.8)104.3 Asset Impairments and Other Related Charges— 156.4 70.6 Allowance for Equity Funds Used During Construction(148.1)(168.4)(132.5)Mark-to-Market of Risk Management Contracts66.5 (29.2)(66.4)Amortization of Nuclear Fuel87.5 89.1 113.8 Pension and Postemployment Benefit Reserves(8.5)(24.6)(42.8)Pension Contributions to Qualified Plan Trust(110.3)— — Property Taxes(43.3)(73.8)(59.1)Deferred Fuel Over/Under-Recovery, Net(31.8)85.2 189.7 Change in Regulatory Assets(337.9)49.5 354.1 Change in Other Noncurrent Assets(142.5)(112.8)(172.1)Change in Other Noncurrent Liabilities(54.5)(116.1)129.0 Changes in Certain Components of Working Capital:Accounts Receivable, Net(129.3)247.8 145.9 Fuel, Materials and Supplies(142.9)(248.2)20.7 Accounts Payable(35.3)5.8 36.6 Accrued Taxes, Net20.1 138.9 153.2 Rockport Plant, Unit 2 Operating Lease Payments(147.7)(147.7)— Other Current Assets34.3 70.7 10.5 Other Current Liabilities(255.5)(205.5)149.8 Net Cash Flows from Operating Activities3,832.9 4,270.1 5,223.2 INVESTING ACTIVITIESConstruction Expenditures(6,246.3)(6,051.4)(6,310.9)Purchases of Investment Securities(1,678.8)(1,576.0)(2,067.8)Sales of Investment Securities1,644.3 1,494.2 2,010.0 Acquisitions of Nuclear Fuel(69.7)(92.3)(46.1)Acquisition of Sempra Renewables LLC and Santa Rita East, Net of Cash and Restricted Cash Acquired— (918.4)— Other Investing Activities116.6 (0.6)61.2 Net Cash Flows Used for Investing Activities(6,233.9)(7,144.5)(6,353.6)FINANCING ACTIVITIESIssuance of Common Stock155.0 65.3 73.6 Issuance of Long-term Debt5,626.1 4,536.6 4,945.7 Issuance of Short-term Debt with Original Maturities Greater Than 90 Days1,396.5 — 205.6 Change in Short-term Debt with Original Maturities Less Than 90 Day, Net(448.4)928.3 271.4 Retirement of Long-term Debt(1,339.8)(1,220.8)(2,782.0)Redemption of Short-term Debt with Original Maturities Greater Than 90 Days(1,307.1)— (205.6)Principal Payments for Finance Lease Obligations(61.7)(70.7)(65.1)Dividends Paid on Common Stock(1,424.9)(1,350.0)(1,255.5)Redemption of Noncontrolling Interests(100.2)— — Other Financing Activities(88.8)(25.8)(26.2)Net Cash Flows from Financing Activities2,406.7 2,862.9 1,161.9 Net Increase (Decrease) in Cash, Cash Equivalents and Restricted Cash5.7 (11.5)31.5 Cash, Cash Equivalents and Restricted Cash at Beginning of Period432.6 444.1 412.6 Cash, Cash Equivalents and Restricted Cash at End of Period$438.3 $432.6 $444.1 See Notes to Financial Statements of Registrants beginning on page 229.130AEP TEXAS INC.AND SUBSIDIARIES131AEP TEXAS INC. AND SUBSIDIARIESMANAGEMENT’S NARRATIVE DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONSCOMPANY OVERVIEWAEP Texas was formed by the merger of TCC and TNC into AEP Utilities on December 31, 2016. The merging parties consolidated the majority of their rate structures following the completion of their 2019 base rate case. See Note 4 - Rate Matters for additional information related to the 2019 base rate case. Following the merger, AEP Utilities changed its name to AEP Texas.AEP Texas is engaged in the transmission and distribution of electric power to approximately 1,068,000 retail customers through REPs in west, central and southern Texas. Among the principal industries served by AEP Texas are petroleum and coal products manufacturing, chemical manufacturing, oil and gas extraction, pipeline transportation and support activities for mining. The territory served by AEP Texas also includes several military installations and correctional facilities. AEP Texas is a member of ERCOT. Under Texas Restructuring Legislation, AEP Texas’ utility predecessors, TCC and TNC, exited the generation business and ceased serving retail load. However, AEP Texas continued as part owner in the Oklaunion Power Station operated by PSO until the Oklaunion Power Station was retired in September 2020 and subsequently sold to a nonaffiliated third-party in October 2020. See “Oklaunion Power Station” section of Note 7 for additional information about the sale.AEP Texas consolidates AEP Texas North Generation Company, LLC, AEP Texas Central Transition Funding II LLC, AEP Texas Central Transition Funding III LLC and AEP Texas Restoration Funding LLC, its wholly-owned subsidiaries. The AEP Texas Central Transition Funding II LLC securitization bonds matured in July 2020.132RESULTS OF OPERATIONSKWh Sales/Degree DaysSummary of KWh Energy SalesYears Ended December 31,202020192018(in millions of KWhs)Retail:Residential12,163 11,996 12,101 Commercial10,065 10,419 10,220 Industrial9,085 8,882 9,053 Miscellaneous636 665 646 Total Retail31,949 31,962 32,020 Heating degree days and cooling degree days are metrics commonly used in the utility industry as a measure of the impact of weather on revenues.Summary of Heating and Cooling Degree DaysYears Ended December 31,202020192018(in degree days)Actual – Heating (a)189 301 354 Normal – Heating (b)313 322 325 Actual – Cooling (c)2,846 2,989 2,861 Normal – Cooling (b)2,711 2,699 2,688 (a)Heating degree days are calculated on a 55 degree temperature base.(b)Normal Heating/Cooling represents the thirty-year average of degree days.(c)Cooling degree days are calculated on a 70 degree temperature base.1332020 Compared to 2019 Reconciliation of Year Ended December 31, 2019 to Year Ended December 31, 2020 Net Income(in millions)Year Ended December 31, 2019$178.3 Changes in Gross Margin:Retail Margins34.2 Margins from Off-system Sales(52.2)Transmission Revenues21.6 Other Revenues(76.6)Total Change in Gross Margin(73.0)Changes in Expenses and Other:Other Operation and Maintenance81.4 Asset Impairments and Other Related Charges32.5 Depreciation and Amortization92.5 Taxes Other Than Income Taxes4.2 Interest Income(2.0)Allowance for Equity Funds Used During Construction4.2 Non-Service Cost Components of Net Periodic Benefit Cost(0.1)Interest Expense(34.6)Total Change in Expenses and Other178.1 Income Tax Expense(42.4)Year Ended December 31, 2020$241.0 The major components of the decrease in Gross Margin, defined as revenues less the related direct cost of fuel, including consumption of chemicals were as follows:•Retail Margins increased $34 million primarily due to the following:•A $30 million increase due to a provision for refund recorded in December 2019 as part of the most recent base rate case.•A $19 million increase in weather-normalized margins primarily driven by the residential class and partially offset by a decrease in the industrial and commercial classes.•A $16 million increase from interim rate increases driven by increased distribution investment.•A $13 million increase due to new base rates implemented in June 2020.•A $12 million increase from interim rate increases driven by increased transmission investment.•A $5 million increase due to the change in the recording of merger savings as authorized by the PUCT in the most recent base rate case.These increases were partially offset by:•A $38 million decrease due to refunds of Excess ADIT and excess federal income taxes collected as a result of Tax Reform. This decrease was partially offset in Income Tax Expense below.•A $17 million decrease in weather-related usage primarily due to a 5% decrease in cooling degree days and a 37% decrease in heating degree days.•A $6 million decrease due to refunds to customers associated with the most recent base rate case. This decrease was offset in Other Revenues below.•Margins from Off-system Sales decreased $52 million due to lower Oklaunion Power Station PPA revenues. This decrease was partially offset in Other Operation and Maintenance expenses below.134•Transmission Revenues increased $22 million primarily due to the following:•A $48 million increase from interim rate increases driven by increased transmission investment.This increase was partially offset by:•A $14 million decrease due to a one-time credit to transmission customers as a result of Tax Reform and the most recent base rate case. This decrease was offset in Income Tax Expense below.•An $11 million decrease due to refunds to customers associated with the most recent base rate case. This decrease was offset in Other Revenues below.•Other Revenues decreased $77 million primarily due to the following:•A $96 million decrease related to securitization revenues primarily due to the AEP Texas Central Transition Funding II LLC bonds that matured in July 2020. This decrease was offset below in Depreciation and Amortization expenses and in Interest Expense.This decrease was partially offset by:•An $18 million increase in revenues due to the amortization of a provision for refund recorded in December 2019 as part of the most recent base rate case. This increase was offset in Retail Margins and Transmission Revenues above.Expenses and Other and Income Tax Expense changed between years as follows:•Other Operation and Maintenance expenses decreased $81 million primarily due to the following:•A $67 million decrease due to prior year partial amortization of the AEP Texas Storm Restoration Securitization regulatory asset as a result of the AEP Texas Storm Cost Securitization financing order issued by the PUCT in June 2019. This decrease was offset in Income Tax Expense below.•A $17 million decrease due to the revision of the Oklaunion Power Station ARO. This decrease was offset in Margins from Off-system Sales above.•A $6 million decrease due to a charitable contribution to the AEP Foundation in 2019.These decreases were partially offset by:•A $17 million increase in transmission expenses. This increase was partially offset in Gross Margin above.•Asset Impairments and Other Related Charges decreased $33 million due to prior year regulatory disallowances in the 2019 Texas Base Rate Case.•Depreciation and Amortization expenses decreased $93 million primarily due to the following:•An $87 million decrease in securitization amortizations primarily due to the AEP Texas Central Transition Funding II LLC bonds that matured in July 2020. This decrease was offset in Other Revenues above and in Interest Expense below.•A $16 million decrease in depreciation expense due to the retirement of the Oklaunion Power Station in September 2020. This decrease was partially offset above in Margins from Off-system Sales and Other Operation and Maintenance expenses.These decreases were partially offset by:•A $16 million increase in depreciation expense due to an increase in the depreciable base of transmission and distribution assets. •Taxes Other Than Income Taxes decreased $4 million primarily due to lower property taxes.•Allowance for Equity Funds Used During Construction increased $4 million primarily due to an increase in the equity component of AFUDC as a result of lower short-term balances and increased transmission projects.•Interest Expense increased $35 million primarily due to the following: •A $22 million increase due to the prior year deferral of previously recorded interest expense approved for recovery as a result of the Texas Storm Cost Securitization financing order issued by the PUCT in June 2019.•A $19 million increase due to higher long-term debt balances.•An $8 million increase due to a decrease in the debt component of AFUDC.These increases were partially offset by:•An $8 million decrease in expense related to securitization assets. This decrease was offset in Other Revenues and Depreciation and Amortization expenses above.•A $5 million decrease due to lower short-term debt balances.135•Income Tax Expense increased $42 million primarily due to an increase in pretax book income and the prior year amortization of Excess ADIT not subject to normalization requirements as approved in the Texas Storm Cost Securitization financing order issued by the PUCT in 2019. This increase is partially offset by a decrease in state tax expense. The amortization of Excess ADIT was partially offset in Gross Margins and Other Operation and Maintenance expenses above.136REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRMTo the Board of Directors and Shareholder of AEP Texas Inc. Opinion on the Financial Statements We have audited the accompanying consolidated balance sheets of AEP Texas Inc. and its subsidiaries (the “Company”) as of December 31, 2020 and 2019, and the related consolidated statements of income, of comprehensive income (loss), of changes in common shareholder's equity and of cash flows for each of the three years in the period ended December 31, 2020, including the related notes (collectively referred to as the “consolidated financial statements”). In our opinion, the consolidated financial statements present fairly, in all material respects, the financial position of the Company as of December 31, 2020 and 2019, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2020 in conformity with accounting principles generally accepted in the United States of America. Change in Accounting Principle As discussed in Note 13 to the consolidated financial statements, the Company changed the manner in which it accounts for leases in 2019. Basis for Opinion These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on the Company’s consolidated financial statements based on our audits. We are a public accounting firm registered with the Public Company Accounting Oversight Board (United States) (PCAOB) and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB. We conducted our audits of these consolidated financial statements in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement, whether due to error or fraud. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. As part of our audits we are required to obtain an understanding of internal control over financial reporting but not for the purpose of expressing an opinion on the effectiveness of the Company's internal control over financial reporting. Accordingly, we express no such opinion. Our audits included performing procedures to assess the risks of material misstatement of the consolidated financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the consolidated financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the consolidated financial statements. We believe that our audits provide a reasonable basis for our opinion. Critical Audit Matters The critical audit matter communicated below is a matter arising from the current period audit of the consolidated financial statements that was communicated or required to be communicated to the audit committee and that (i) relates to accounts or disclosures that are material to the consolidated financial statements and (ii) involved our especially challenging, subjective, or complex judgments. The communication of critical audit matters does not alter in any way our opinion on the consolidated financial statements, taken as a whole, and we are not, by communicating the critical audit matter below, providing a separate opinion on the critical audit matter or on the accounts or disclosures to which it relates. 137Accounting for the Effects of Cost-Based Regulation As described in Notes 1 and 5 to the consolidated financial statements, the Company’s consolidated financial statements reflect the actions of regulators that result in the recognition of certain revenues and expenses in different time periods than enterprises that are not rate-regulated. Regulatory assets (deferred expenses) and regulatory liabilities (deferred future revenue reductions or refunds) are recorded to reflect the economic effects of regulation in the same accounting period by matching expenses with their recovery through regulated revenues and matching income with its passage to customers in cost-based regulated rates. Management reviews the probability of recovery of regulatory assets and refund of regulatory liabilities at each balance sheet date and whenever new events occur, whether influenced by issuance of regulatory commission orders, passage of new legislation, or changes in the regulatory environment. As of December 31, 2020, there were $266.8 million of deferred costs included in regulatory assets, $32.9 million of which were pending final regulatory approval, and $1,270.8 million of regulatoryliabilities awaiting potential refund or future rate reduction, ($5.7) million of which were pending final regulatory determination. The principal considerations for our determination that performing procedures relating to the accounting for the effects of cost-based regulation is a critical audit matter are the significant judgment by management in the ongoing evaluation of the recovery of regulatory assets and refund of regulatory liabilities, and applying guidance contained in rate orders and other relevant evidence; which in turn led to significant audit effort and a high degree of auditor subjectivity in performing procedures and in evaluating audit evidence relating to management’s judgments about the probability of recovery of regulatory assets and refund of regulatory liabilities. Addressing the matter involved performing procedures and evaluating audit evidence in connection with forming our overall opinion on the consolidated financial statements. These procedures included testing the effectiveness of controls relating to management’s assessment of regulatory proceedings, including the probability of recovery of regulatory assets and refund of regulatory liabilities. These procedures also included, among others, evaluating the reasonableness of management’s assessment of probability of future recovery for regulatory assets and refund of regulatory liabilities. Testing of regulatory assets and liabilities, including those subject to pending rate cases, also involved evaluating the provisions and formulas outlined in rate orders, other regulatory correspondence, and application of regulatory precedents. /s/ PricewaterhouseCoopers LLP Columbus, Ohio February 25, 2021 We have served as the Company's auditor since 2017. 138MANAGEMENT’S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTINGThe management of AEP Texas Inc. and Subsidiaries (AEP Texas) is responsible for establishing and maintaining adequate internal control over financial reporting as such term is defined in Rule 13a-15(f) and 15d-15(f) under the Securities Exchange Act of 1934, as amended. AEP Texas’ internal control is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles.Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.Management assessed the effectiveness of AEP Texas’ internal control over financial reporting as of December 31, 2020. In making this assessment, management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control – Integrated Framework (2013). Based on management’s assessment, management concluded AEP Texas’ internal control over financial reporting was effective as of December 31, 2020.This annual report does not include an audit report from PricewaterhouseCoopers LLP, AEP Texas’ registered public accounting firm regarding internal control over financial reporting pursuant to the Securities and Exchange Commission rules that permit AEP Texas to provide only management’s report in this annual report.139AEP TEXAS INC. AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF INCOME For the Years Ended December 31, 2020, 2019 and 2018 (in millions)Years Ended December 31, 202020192018REVENUES Electric Transmission and Distribution$1,524.9 $1,545.9 $1,486.3 Sales to AEP Affiliates90.8 160.5 105.2 Other Revenues3.2 2.9 3.8 TOTAL REVENUES1,618.9 1,709.3 1,595.3 EXPENSES Fuel and Other Consumables Used for Electric Generation13.7 31.1 38.5 Other Operation488.9 492.0 488.9 Maintenance80.5 158.8 89.4 Asset Impairments and Other Related Charges— 32.5 — Depreciation and Amortization529.8 622.3 499.6 Taxes Other Than Income Taxes136.4 140.6 132.6 TOTAL EXPENSES1,249.3 1,477.3 1,249.0 OPERATING INCOME369.6 232.0 346.3 Other Income (Expense): Interest Income1.4 3.4 0.8 Allowance for Equity Funds Used During Construction19.4 15.2 20.0 Non-Service Cost Components of Net Periodic Benefit Cost11.2 11.3 12.3 Interest Expense(171.8)(137.2)(147.3) INCOME BEFORE INCOME TAX EXPENSE (BENEFIT)229.8 124.7 232.1 Income Tax Expense (Benefit)(11.2)(53.6)20.8 NET INCOME$241.0 $178.3 $211.3 The common stock of AEP Texas is wholly-owned by Parent.See Notes to Financial Statements of Registrants beginning on page 229.140 AEP TEXAS INC. AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)For the Years Ended December 31, 2020, 2019 and 2018 (in millions) Years Ended December 31,202020192018Net Income$241.0 $178.3 $211.3 OTHER COMPREHENSIVE INCOME (LOSS), NET OF TAXES Cash Flow Hedges, Net of Tax of $0.3, $0.3 and $0.3 in 2020, 2019 and 2018, Respectively1.1 1.0 1.0 Amortization of Pension and OPEB Deferred Costs, Net of Tax of $0, $0 and $0.1 in 2020, 2019 and 2018, Respectively0.2 0.2 0.2 Pension and OPEB Funded Status, Net of Tax of $0.7, $0.3 and $(0.3) in 2020, 2019 and 2018, Respectively2.6 1.1 (1.0)TOTAL OTHER COMPREHENSIVE INCOME3.9 2.3 0.2 TOTAL COMPREHENSIVE INCOME$244.9 $180.6 $211.5 See Notes to Financial Statements of Registrants beginning on page 229.141AEP TEXAS INC. AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF CHANGES IN COMMON SHAREHOLDER’S EQUITYFor the Years Ended December 31, 2020, 2019 and 2018 (in millions)Paid-inCapitalRetainedEarningsAccumulatedOtherComprehensiveIncome (Loss)TotalTOTAL COMMON SHAREHOLDER’S EQUITY – DECEMBER 31, 2017$1,057.9 $1,124.6 $(12.6)$2,169.9 Capital Contribution from Parent200.0 200.0 ASU 2018-02 Adoption1.8 (2.7)(0.9)Net Income211.3 211.3 Other Comprehensive Income0.2 0.2 TOTAL COMMON SHAREHOLDER’S EQUITY – DECEMBER 31, 20181,257.9 1,337.7 (15.1)2,580.5 Capital Contribution from Parent200.0 200.0 Net Income178.3 178.3 Other Comprehensive Income2.3 2.3 TOTAL COMMON SHAREHOLDER’S EQUITY – DECEMBER 31, 20191,457.9 1,516.0 (12.8)2,961.1 Net Income241.0 241.0 Other Comprehensive Income3.9 3.9 TOTAL COMMON SHAREHOLDER’S EQUITY – DECEMBER 31, 2020$1,457.9 $1,757.0 $(8.9)$3,206.0 See Notes to Financial Statements of Registrants beginning on page 229.142AEP TEXAS INC. AND SUBSIDIARIESCONSOLIDATED BALANCE SHEETSASSETSDecember 31, 2020 and 2019 (in millions)December 31, 20202019CURRENT ASSETS Cash and Cash Equivalents$0.1 $3.1 Restricted Cash(December 31, 2020 and 2019 Amounts Include $28.7 and $154.7, Respectively, Related to Transition Funding and Restoration Funding)28.7 154.7 Advances to Affiliates7.1 207.2 Accounts Receivable: Customers112.8 116.0 Affiliated Companies5.1 10.1 Accrued Unbilled Revenues65.8 68.8 Miscellaneous— 0.3 Allowance for Uncollectible Accounts(0.1)(1.8)Total Accounts Receivable183.6 193.4 Fuel— 5.9 Materials and Supplies70.0 56.7 Accrued Tax Benefits16.8 66.1 Prepayments and Other Current Assets4.6 5.8 TOTAL CURRENT ASSETS310.9 692.9 PROPERTY, PLANT AND EQUIPMENT Electric: Generation— 351.7 Transmission5,279.6 4,466.5 Distribution4,580.8 4,215.2 Other Property, Plant and Equipment868.4 805.9 Construction Work in Progress614.1 763.9 Total Property, Plant and Equipment11,342.9 10,603.2 Accumulated Depreciation and Amortization1,529.3 1,758.1 TOTAL PROPERTY, PLANT AND EQUIPMENT – NET9,813.6 8,845.1 OTHER NONCURRENT ASSETS Regulatory Assets266.8 280.6 Securitized Assets(December 31, 2020 and 2019 Amounts Include $446.8 and $621.2, Respectively, Related to Transition Funding and Restoration Funding)446.8 623.4 Deferred Charges and Other Noncurrent Assets192.1 147.1 TOTAL OTHER NONCURRENT ASSETS905.7 1,051.1 TOTAL ASSETS$11,030.2 $10,589.1 See Notes to Financial Statements of Registrants beginning on page 229.143AEP TEXAS INC. AND SUBSIDIARIESCONSOLIDATED BALANCE SHEETSLIABILITIES AND COMMON SHAREHOLDER’S EQUITYDecember 31, 2020 and 2019 (in millions)December 31, 2020 2019CURRENT LIABILITIES Advances from Affiliates$67.1 $— Accounts Payable:General231.7 256.8 Affiliated Companies44.0 35.6 Long-term Debt Due Within One Year – Nonaffiliated (December 31, 2020 and 2019 Amounts Include $88.7 and $281.4, Respectively, Related to Transition Funding and Restoration Funding)88.7 392.1 Accrued Taxes78.3 84.9 Accrued Interest(December 31, 2020 and 2019 Amounts Include $2.5 and $7.5, Respectively, Related to Transition Funding and Restoration Funding)43.9 35.7 Oklaunion Purchase Power Agreement— 22.1 Obligations Under Operating Leases14.5 12.0 Provision for Refund20.1 64.7 Other Current Liabilities88.5 123.3 TOTAL CURRENT LIABILITIES676.8 1,027.2 NONCURRENT LIABILITIES Long-term Debt – Nonaffiliated(December 31, 2020 and 2019 Amounts Include $403.9 and $495.4, Respectively, Related to Transition Funding and Restoration Funding)4,731.7 4,166.3 Deferred Income Taxes1,016.7 965.4 Regulatory Liabilities and Deferred Investment Tax Credits1,270.8 1,316.9 Obligations Under Operating Leases71.0 71.1 Deferred Credits and Other Noncurrent Liabilities57.2 81.1 TOTAL NONCURRENT LIABILITIES7,147.4 6,600.8 TOTAL LIABILITIES7,824.2 7,628.0 Rate Matters (Note 4)Commitments and Contingencies (Note 6) COMMON SHAREHOLDER’S EQUITY Paid-in Capital 1,457.9 1,457.9 Retained Earnings 1,757.0 1,516.0 Accumulated Other Comprehensive Income (Loss)(8.9)(12.8)TOTAL COMMON SHAREHOLDER’S EQUITY 3,206.0 2,961.1 TOTAL LIABILITIES AND COMMON SHAREHOLDER'S EQUITY $11,030.2 $10,589.1 See Notes to Financial Statements of Registrants beginning on page 229.144AEP TEXAS INC. AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF CASH FLOWSFor the Years Ended December 31, 2020, 2019 and 2018 (in millions) Years Ended December 31, 202020192018OPERATING ACTIVITIES Net Income $241.0 $178.3 $211.3 Adjustments to Reconcile Net Income to Net Cash Flows from Operating Activities: Depreciation and Amortization 529.8 622.3 499.6 Deferred Income Taxes (15.2)(23.5)(16.5)Asset Impairments and Other Related Charges— 32.5 — Allowance for Equity Funds Used During Construction(19.4)(15.2)(20.0)Mark-to-Market of Risk Management Contracts — (0.2)0.7 Pension Contributions to Qualified Plan Trust(11.3)— — Change in Other Noncurrent Assets (74.0)9.3 (60.3)Change in Other Noncurrent Liabilities (24.7)11.3 44.9 Changes in Certain Components of Working Capital: Accounts Receivable, Net 9.8 3.5 (2.9)Fuel, Materials and Supplies (7.4)(1.0)(6.0)Accounts Payable 30.2 7.5 (20.3)Accrued Taxes, Net42.7 (11.8)(5.6)Other Current Assets 0.8 (0.4)0.8 Other Current Liabilities (88.1)10.8 26.2 Net Cash Flows from Operating Activities 614.2 823.4 651.9 INVESTING ACTIVITIES Construction Expenditures(1,295.0)(1,275.1)(1,428.8)Change in Advances to Affiliates, Net 200.1 (199.2)103.9 Other Investing Activities29.5 2.1 35.2 Net Cash Flows Used for Investing Activities (1,065.4)(1,472.2)(1,289.7) FINANCING ACTIVITIES Capital Contribution from Parent— 200.0 200.0 Issuance of Long-term Debt – Nonaffiliated652.7 1,070.4 494.0 Change in Advances from Affiliates, Net 67.1 (216.0)216.0 Retirement of Long-term Debt – Nonaffiliated (392.1)(401.8)(266.1)Principal Payments for Finance Lease Obligations (6.3)(5.1)(4.7)Other Financing Activities0.8 (0.7)1.2 Net Cash Flows from Financing Activities 322.2 646.8 640.4 Net Increase (Decrease) in Cash, Cash Equivalents and Restricted Cash(129.0)(2.0)2.6 Cash, Cash Equivalents and Restricted Cash at Beginning of Period157.8 159.8 157.2 Cash, Cash Equivalents and Restricted Cash at End of Period$28.8 $157.8 $159.8 SUPPLEMENTARY INFORMATION Cash Paid for Interest, Net of Capitalized Amounts $153.2 $148.6 $145.9 Net Cash Paid (Received) for Income Taxes (42.9)(11.0)7.9 Noncash Acquisitions Under Finance Leases 5.6 11.4 10.6 Construction Expenditures Included in Current Liabilities as of December 31, 177.8 225.5 243.1 See Notes to Financial Statements of Registrants beginning on page 229.145AEP TRANSMISSION COMPANY, LLC AND SUBSIDIARIES146AEP TRANSMISSION COMPANY, LLC AND SUBSIDIARIESMANAGEMENT’S NARRATIVE DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONSCOMPANY OVERVIEWAEPTCo is a holding company for seven FERC regulated transmission-only electric utilities. AEPTCo is an indirect wholly-owned subsidiary of American Electric Power Company, Inc. (AEP).AEPTCo’s seven wholly-owned public utility companies are (collectively referred to herein as the State Transcos):•AEP Appalachian Transmission Company, Inc. (APTCo)•AEP Indiana Michigan Transmission Company, Inc. (IMTCo)•AEP Kentucky Transmission Company, Inc. (KTCo)•AEP Ohio Transmission Company, Inc. (OHTCo)•AEP West Virginia Transmission Company, Inc. (WVTCo)•AEP Oklahoma Transmission Company, Inc. (OKTCo)•AEP Southwestern Transmission Company, Inc. (SWTCo)AEPTCo’s business activities are the development, construction and operation of transmission facilities through investments in seven wholly-owned FERC-regulated transmission only electric subsidiaries.147RESULTS OF OPERATIONSSummary of Investment in Transmission Assets for AEPTCoAs of December 31,202020192018(in millions)Plant In Service$9,923.0 $8,407.5 $6,689.8 CWIP1,422.6 1,485.7 1,578.3 Accumulated Depreciation572.8 402.3 271.9 Total Transmission Property, Net$10,772.8 $9,490.9 $7,996.2 2020 Compared to 2019 Reconciliation of Year Ended December 31, 2019 to Year Ended December 31, 2020 Net Income(in millions)Year Ended December 31, 2019$439.7 Changes in Transmission Revenues:Transmission Revenues124.3 Total Change in Transmission Revenues124.3 Changes in Expenses and Other:Other Operation and Maintenance(0.7)Depreciation and Amortization(73.0)Taxes Other Than Income Taxes(36.3)Interest Income - Affiliated(0.6)Allowance for Equity Funds Used During Construction(10.3)Interest Expense(30.4)Total Change in Expenses and Other(151.3)Income Tax Expense10.7 Year Ended December 31, 2020$423.4 The major components of the increase in transmission revenues, which consists of wholesale sales to affiliates and nonaffiliates were as follows:•Transmission Revenues increased $124 million primarily due to the following:•A $205 million increase due to continued investment in transmission assets.This increase was partially offset by the following:•A $65 million decrease as a result of the affiliated annual transmission formula rate true-up which is offset in Other Operation and Maintenance expense across affiliated load-serving entities.•A $17 million decrease as a result of the nonaffiliated annual transmission formula rate true-up. Expenses and Other and Income Tax Expense changed between years as follows:•Depreciation and Amortization expenses increased $73 million primarily due to a higher depreciable base and an increase in depreciation rates as a result of regulatory orders in 2020 in Indiana, Virginia and Michigan.•Taxes Other Than Income Taxes increased $36 million primarily due to higher property taxes as a result of increased transmission investment.148•Allowance for Equity Funds Used During Construction decreased $10 million primarily due to the following:•A $13 million decrease due to lower CWIP.•A $12 million decrease driven by the favorable impact of a FERC settlement agreement recorded in 2019.These decreases were partially offset by:•A $13 million increase driven by FERC audit findings recorded in 2019. •Interest Expense increased $30 million primarily due to higher long-term debt balances.•Income Tax Expense decreased $11 million primarily due to lower pretax book income, a decrease in state tax expense and an increase in Excess ADIT amortization. 149REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM To the Board of Directors and Member of AEP Transmission Company, LLCOpinion on the Financial Statements We have audited the accompanying consolidated balance sheets of AEP Transmission Company, LLC and its subsidiaries (the “Company”) as of December 31, 2020 and 2019, and the related consolidated statements of income, of changes in member's equity and of cash flows for each of the three years in the period ended December 31, 2020, including the related notes (collectively referred to as the “consolidated financial statements”). In our opinion, the consolidated financial statements present fairly, in all material respects, the financial position of the Company as of December 31, 2020 and 2019, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2020 in conformity with accounting principles generally accepted in the United States of America. Basis for Opinion These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on the Company’s consolidated financial statements based on our audits. We are a public accounting firm registered with the Public Company Accounting Oversight Board (United States) (PCAOB) and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB. We conducted our audits of these consolidated financial statements in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement, whether due to error or fraud. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. As part of our audits we are required to obtain an understanding of internal control over financial reporting but not for the purpose of expressing an opinion on the effectiveness of the Company's internal control over financial reporting. Accordingly, we express no such opinion. Our audits included performing procedures to assess the risks of material misstatement of the consolidated financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the consolidated financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the consolidated financial statements. We believe that our audits provide a reasonable basis for our opinion. Critical Audit Matters The critical audit matter communicated below is a matter arising from the current period audit of the consolidated financial statements that was communicated or required to be communicated to the audit committee and that (i) relates to accounts or disclosures that are material to the consolidated financial statements and (ii) involved our especially challenging, subjective, or complex judgments. The communication of critical audit matters does not alter in any way our opinion on the consolidated financial statements, taken as a whole, and we are not, by communicating the critical audit matter below, providing a separate opinion on the critical audit matter or on the accounts or disclosures to which it relates. 150Accounting for the Effects of Cost-Based Regulation As described in Notes 1 and 5 to the consolidated financial statements, the Company’s consolidated financial statements reflect the actions of regulators that result in the recognition of certain revenues and expenses in different time periods than enterprises that are not rate-regulated. Regulatory assets (deferred expenses) and regulatory liabilities (deferred future revenue reductions or refunds) are recorded to reflect the economic effects of regulation in the same accounting period by matching expenses with their recovery through regulated revenues and matching income with its passage to customers in cost-based regulated rates. Management reviews the probability of recovery of regulatory assets and refund of regulatory liabilities at each balance sheet date and whenever new events occur, whether influenced by issuance of regulatory commission orders, passage of new legislation, or changes in the regulatory environment. As of December 31, 2020, there were $15.1 million of deferred costs included in regulatory assets and $581.8 million of regulatory liabilities awaiting potential refund or future rate reduction. The principal considerations for our determination that performing procedures relating to the accounting for the effects of cost-based regulation is a critical audit matter are the significant judgment by management in the ongoing evaluation of the recovery of regulatory assets and refund of regulatory liabilities, and applying guidance contained in rate orders and other relevant evidence; which in turn led to significant audit effort and a high degree of auditor subjectivity in performing procedures and in evaluating audit evidence relating to management’s judgments about the probability of recovery of regulatory assets and refund of regulatory liabilities. Addressing the matter involved performing procedures and evaluating audit evidence in connection with forming our overall opinion on the consolidated financial statements. These procedures included testing the effectiveness of controls relating to management’s assessment of regulatory proceedings, including the probability of recovery of regulatory assets and refund of regulatory liabilities. These procedures also included, among others, evaluating the reasonableness of management’s assessment of probability of future recovery for regulatory assets and refund of regulatory liabilities. Testing of regulatory assets and liabilities, including those subject to pending rate cases, also involved evaluating the provisions and formulas outlined in rate orders, other regulatory correspondence, and application of regulatory precedents. /s/ PricewaterhouseCoopers LLPColumbus, Ohio February 25, 2021 We have served as the Company's auditor since 2017. 151MANAGEMENT’S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTINGThe management of AEP Transmission Company, LLC and Subsidiaries (AEPTCo) is responsible for establishing and maintaining adequate internal control over financial reporting as such term is defined in Rule 13a-15(f) and 15d-15(f) under the Securities Exchange Act of 1934, as amended. AEPTCo’s internal control is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles.Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.Management assessed the effectiveness of AEPTCo’s internal control over financial reporting as of December 31, 2020. In making this assessment, management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control – Integrated Framework (2013). Based on management’s assessment, management concluded AEPTCo’s internal control over financial reporting was effective as of December 31, 2020.This annual report does not include an audit report from PricewaterhouseCoopers LLP, AEPTCo’s registered public accounting firm regarding internal control over financial reporting pursuant to the Securities and Exchange Commission rules that permit AEPTCo to provide only management’s report in this annual report.152AEP TRANSMISSION COMPANY, LLC AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF INCOME For the Years Ended December 31, 2020, 2019 and 2018 (in millions)Years Ended December 31,202020192018REVENUESTransmission Revenues$248.8 $214.6 $177.0 Sales to AEP Affiliates896.3 806.7 598.9 Other Revenues0.6 0.1 0.2 TOTAL REVENUES1,145.7 1,021.4 776.1 EXPENSESOther Operation99.8 93.9 83.8 Maintenance10.2 15.4 10.5 Depreciation and Amortization249.0 176.0 133.9 Taxes Other Than Income Taxes205.2 168.9 137.8 TOTAL EXPENSES564.2 454.2 366.0 OPERATING INCOME581.5 567.2 410.1 Other Income (Expense):Interest Income - Affiliated2.4 3.0 2.5 Allowance for Equity Funds Used During Construction74.0 84.3 70.6 Interest Expense(127.8)(97.4)(83.2)INCOME BEFORE INCOME TAX EXPENSE530.1 557.1 400.0 Income Tax Expense106.7 117.4 84.1 NET INCOME$423.4 $439.7 $315.9 See Notes to Financial Statements of Registrants beginning on page 229.153AEP TRANSMISSION COMPANY, LLC AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF CHANGES IN MEMBER’S EQUITYFor the Years Ended December 31, 2020, 2019 and 2018 (in millions)Paid-inCapitalRetainedEarningsTotal Member’s EquityTOTAL MEMBER'S EQUITY - DECEMBER 31, 2017$1,816.6 $773.3 $2,589.9 Capital Contribution from Member664.0 664.0 Net Income315.9 315.9 TOTAL MEMBER'S EQUITY - DECEMBER 31, 20182,480.6 1,089.2 3,569.8 Net Income439.7 439.7 TOTAL MEMBER'S EQUITY - DECEMBER 31, 20192,480.6 1,528.9 4,009.5 Capital Contribution from Member335.0 335.0 Capital Distribution of Radial Assets to Member(50.0)(50.0)Dividends Paid to Member(5.0)(5.0)Net Income423.4 423.4 TOTAL MEMBER'S EQUITY - DECEMBER 31, 2020$2,765.6 $1,947.3 $4,712.9 See Notes to Financial Statements of Registrants beginning on page 229.154AEP TRANSMISSION COMPANY, LLC AND SUBSIDIARIESCONSOLIDATED BALANCE SHEETSASSETSDecember 31, 2020 and 2019 (in millions)December 31,20202019CURRENT ASSETSAdvances to Affiliates$109.1 $85.4 Accounts Receivable:Customers22.9 19.0 Affiliated Companies81.2 66.1 Total Accounts Receivable104.1 85.1 Materials and Supplies8.5 13.8 Accrued Tax Benefits9.9 9.3 Prepayments and Other Current Assets4.2 3.8 TOTAL CURRENT ASSETS235.8 197.4 TRANSMISSION PROPERTYTransmission Property9,593.5 8,137.9 Other Property, Plant and Equipment329.5 269.6 Construction Work in Progress1,422.6 1,485.7 Total Transmission Property11,345.6 9,893.2 Accumulated Depreciation and Amortization572.8 402.3 TOTAL TRANSMISSION PROPERTY – NET10,772.8 9,490.9 OTHER NONCURRENT ASSETSRegulatory Assets15.1 4.2 Deferred Property Taxes220.1 193.5 Deferred Charges and Other Noncurrent Assets2.2 4.8 TOTAL OTHER NONCURRENT ASSETS237.4 202.5 TOTAL ASSETS$11,246.0 $9,890.8 See Notes to Financial Statements of Registrants beginning on page 229.155AEP TRANSMISSION COMPANY, LLC AND SUBSIDIARIESCONSOLIDATED BALANCE SHEETSLIABILITIES AND MEMBER’S EQUITYDecember 31, 2020 and 2019 December 31,20202019(in millions)CURRENT LIABILITIESAdvances from Affiliates$156.7 $137.0 Accounts Payable:General380.4 493.4 Affiliated Companies97.3 71.2 Long-term Debt Due Within One Year – Nonaffiliated50.0 — Accrued Taxes418.1 355.6 Accrued Interest23.9 19.2 Obligations Under Operating Leases1.2 2.1 Other Current Liabilities9.9 14.6 TOTAL CURRENT LIABILITIES1,137.5 1,093.1 NONCURRENT LIABILITIESLong-term Debt – Nonaffiliated3,898.5 3,427.3 Deferred Income Taxes906.9 817.8 Regulatory Liabilities581.8 540.9 Obligations Under Operating Leases0.4 1.9 Deferred Credits and Other Noncurrent Liabilities8.0 0.3 TOTAL NONCURRENT LIABILITIES5,395.6 4,788.2 TOTAL LIABILITIES6,533.1 5,881.3 Rate Matters (Note 4)Commitments and Contingencies (Note 6)MEMBER’S EQUITYPaid-in Capital2,765.6 2,480.6 Retained Earnings1,947.3 1,528.9 TOTAL MEMBER’S EQUITY4,712.9 4,009.5 TOTAL LIABILITIES AND MEMBER’S EQUITY$11,246.0 $9,890.8 See Notes to Financial Statements of Registrants beginning on page 229.156AEP TRANSMISSION COMPANY, LLC AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF CASH FLOWSFor the Years Ended December 31, 2020, 2019 and 2018 (in millions)Years Ended December 31,202020192018OPERATING ACTIVITIESNet Income$423.4 $439.7 $315.9 Adjustments to Reconcile Net Income to Net Cash Flows from Operating Activities:Depreciation and Amortization249.0 176.0 133.9 Deferred Income Taxes81.6 91.3 98.9 Allowance for Equity Funds Used During Construction(74.0)(84.3)(70.6)Property Taxes(26.6)(35.6)(32.9)Change in Other Noncurrent Assets(8.2)9.6 14.6 Change in Other Noncurrent Liabilities8.3 (8.1)17.4 Changes in Certain Components of Working Capital:Accounts Receivable, Net(19.0)(5.4)36.7 Materials and Supplies5.3 5.2 (5.4)Accounts Payable77.8 37.6 (7.5)Accrued Taxes, Net62.7 90.8 73.4 Accrued Interest4.7 3.3 0.9 Other Current Assets0.7 (0.3)(0.3)Other Current Liabilities(14.5)(11.2)(26.4)Net Cash Flows from Operating Activities771.2 708.6 548.6 INVESTING ACTIVITIESConstruction Expenditures(1,615.9)(1,410.1)(1,526.4)Change in Advances to Affiliates, Net(23.7)11.5 49.4 Acquisitions of Assets(6.0)(9.4)(37.4)Other Investing Activities5.2 4.8 1.1 Net Cash Flows Used for Investing Activities(1,640.4)(1,403.2)(1,513.3)FINANCING ACTIVITIESCapital Contributions from Member335.0 — 664.0 Issuance of Long-term Debt – Nonaffiliated519.5 688.0 321.0 Change in Advances from Affiliates, Net19.7 91.6 29.7 Retirement of Long-term Debt – Nonaffiliated— (85.0)(50.0)Dividends Paid to Member(5.0)— — Net Cash Flows from Financing Activities869.2 694.6 964.7 Net Change in Cash and Cash Equivalents— — — Cash and Cash Equivalents at Beginning of Period— — — Cash and Cash Equivalents at End of Period$— $— $— SUPPLEMENTARY INFORMATIONCash Paid for Interest, Net of Capitalized Amounts$119.7 $90.6 $80.2 Net Cash Paid (Received) for Income Taxes22.9 1.5 (30.7)Construction Expenditures Included in Current Liabilities as of December 31,311.9 472.7 345.0 Noncash Distribution of Radial Assets to Member(50.0)— — See Notes to Financial Statements of Registrants beginning on page 229.157APPALACHIAN POWER COMPANYAND SUBSIDIARIES158APPALACHIAN POWER COMPANY AND SUBSIDIARIESMANAGEMENT’S NARRATIVE DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONSCOMPANY OVERVIEWAs a public utility, APCo engages in the generation and purchase of electric power, and the subsequent sale, transmission and distribution of that power to approximately 964,000 retail customers in its service territory in southwestern Virginia and southern West Virginia. APCo consolidates Cedar Coal Company, Central Appalachian Coal Company, Southern Appalachian Coal Company and Appalachian Consumer Rate Relief Funding LLC, its wholly-owned subsidiaries. APCo sells power at wholesale to municipalities.To minimize the credit requirements and operating constraints when operating within PJM, participating AEP companies, including APCo, agreed to a netting of certain payment obligations incurred by the participating AEP companies against certain balances due to such AEP companies and to hold PJM harmless from actions that any one or more AEP companies may take with respect to PJM.159RESULTS OF OPERATIONSKWh Sales/Degree DaysSummary of KWh Energy SalesYears Ended December 31,202020192018(in millions of KWhs)Retail:Residential10,916 11,253 11,871 Commercial5,887 6,365 6,581 Industrial8,873 9,546 9,576 Miscellaneous794 857 866 Total Retail26,470 28,021 28,894 Wholesale3,281 3,085 2,693 Total KWhs29,751 31,106 31,587 Heating degree days and cooling degree days are metrics commonly used in the utility industry as a measure of the impact of weather on revenues.Summary of Heating and Cooling Degree DaysYears Ended December 31,202020192018(in degree days)Actual – Heating (a)1,764 2,057 2,400 Normal – Heating (b)2,216 2,224 2,230 Actual – Cooling (c)1,379 1,597 1,587 Normal – Cooling (b)1,236 1,221 1,208 (a)Heating degree days are calculated on a 55 degree temperature base.(b)Normal Heating/Cooling represents the thirty-year average of degree days.(c)Cooling degree days are calculated on a 65 degree temperature base.1602020 Compared to 2019 Reconciliation of Year Ended December 31, 2019 to Year Ended December 31, 2020 Net Income(in millions)Year Ended December 31, 2019$306.3 Changes in Gross Margin:Retail Margins(0.8)Margins from Off-system Sales(3.7)Transmission Revenues3.0 Other Revenues(2.1)Total Change in Gross Margin(3.6)Changes in Expenses and Other:Other Operation and Maintenance65.7 Asset Impairment and Other Related Charges - Coal Fired Generation92.9 Re-Establishment of Regulatory Asset - Coal Fired Generation49.0 Depreciation and Amortization(40.7)Taxes Other Than Income Taxes(4.0)Interest Income(0.8)Allowance for Equity Funds Used During Construction(2.0)Non-Service Cost Components of Net Periodic Benefit Cost1.8 Interest Expense (12.6)Total Change in Expenses and Other149.3 Income Tax Expense(82.3)Year Ended December 31, 2020$369.7 The major components of the decrease in Gross Margin, defined as revenues less the related direct cost of fuel, including consumption of chemicals and emissions allowances, and purchased electricity were as follows:•Retail Margins decreased $1 million primarily due to the following:•A $58 million decrease in weather-related usage primarily driven by a 14% decrease in heating degree days and a 14% decrease in cooling degree days.•A $44 million decrease due to the cumulative impact of the implementation of APCo’s 2017 and 2019 generation and distribution depreciation studies as ordered in the Virginia triennial base rate case. •A $19 million decrease in weather-normalized margins primarily in the commercial and industrial classes, partially offset in the residential class.These decreases were partially offset by:•A $33 million increase due to a decrease in customer refunds related to Tax Reform. This increase was partially offset in Income Tax Expense below.•A $26 million increase in deferred fuel primarily due to the timing of recoverable PJM expenses.•A $16 million increase due to the WVPSC approval of the Mitchell Plant surcharge effective January 2020. Pursuant to the WVPSC approval of the surcharge, this increase was partially offset by the amortization of Excess ADIT not subject to normalization requirements in Income Tax Expense below.•A $13 million increase due to rider revenues primarily in West Virginia. This increase was partially offset in other expense items below. •A $12 million increase due to the impact of the 2019 WVPSC order which required APCo to offset Excess ADIT not subject to normalization requirements against the deferred fuel under-recovery balance in 2019.•A $10 million increase due to a West Virginia base rate increase implemented in March 2019. This increase was partially offset in Depreciation and Amortization expenses below.•A $9 million increase due to an environmental expense deferral. 161•Margins from Off-system Sales decreased $4 million due to weaker market prices for energy in RTOs which caused a decrease in sales volume and margins.•Transmission Revenues increased $3 million primarily due to the following:•A $12 million increase due to the implementation of updated depreciation rates as ordered in the 2017-2019 Virginia triennial base rate case. The impact of the revised depreciation rates will be reflected in the annual transmission formula rate true-up. This increase was offset in Depreciation Expense below.•A $4 million increase from investment in transmission assets.These increases were partially offset by:•A $13 million decrease from the annual transmission formula rate true-up.Expenses and Other and Income Tax Expense changed between years as follows: •Other Operation and Maintenance expenses decreased $66 million primarily due to the following:•A $24 million decrease in transmission expenses primarily due to the annual transmission formula rate true-up.•A $24 million decrease as a result of prior year contributions to benefit low income West Virginia residential customers as a result of the West Virginia Tax Reform settlement. This decrease was offset in Income Tax Expense below.•A $13 million decrease in storm-related expenses.•A $9 million decrease in maintenance expense at various generation plants.These decreases were partially offset by:•A $9 million increase in expense due to the current year amortization of regulatory assets related to the 2017-2019 Virginia triennial review which authorized regulatory recovery of previously retired coal-fired generation assets.•An $8 million increase in vegetation management services. This increase was offset in Retail Margin above. •Asset Impairments and Other Related Charges - Coal Fired Generation decreased $93 million due to a pretax expense recorded in 2019 related to previously retired coal-fired generation assets.•Re-Establishment of Regulatory Asset - Coal Fired Generation increased $49 million due to the 2017-2019 Virginia triennial review which authorized regulatory recovery of previously retired coal-fired generation assets.•Depreciation and Amortization expenses increased $41 million primarily due to:•A $35 million increase due to a higher depreciable base.•A $17 million increase in West Virginia depreciation rates beginning in March 2019.These increases were partially offset by:•A $12 million decrease due to the cumulative impact of the implementation of APCo’s 2017 and 2019 depreciation studies as ordered in the Virginia triennial base rate case. •Taxes Other Than Income Taxes increased $4 million primarily due to an increase in West Virginia business and occupational taxes.•Interest Expense increased $13 million primarily due to higher long-term debt balances. •Income Tax Expense increased $82 million primarily due to an increase in pretax book income as well as a decrease in amortization of Excess ADIT not subject to normalization requirements. The decrease in Excess ADIT was partially offset in Gross Margin and Other Operation and Maintenance expenses above.162REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRMTo the Board of Directors and Shareholder of Appalachian Power Company Opinion on the Financial Statements We have audited the accompanying consolidated balance sheets of Appalachian Power Company and its subsidiaries (the “Company”) as of December 31, 2020 and 2019, and the related consolidated statements of income, of comprehensive income (loss), of changes in common shareholder's equity and of cash flows for each of the three years in the period ended December 31, 2020, including the related notes (collectively referred to as the “consolidated financial statements”). In our opinion, the consolidated financial statements present fairly, in all material respects, the financial position of the Company as of December 31, 2020 and 2019, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2020 in conformity with accounting principles generally accepted in the United States of America. Change in Accounting Principle As discussed in Note 13 to the consolidated financial statements, the Company changed the manner in which it accounts for leases in 2019. Basis for Opinion These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on the Company’s consolidated financial statements based on our audits. We are a public accounting firm registered with the Public Company Accounting Oversight Board (United States) (PCAOB) and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB. We conducted our audits of these consolidated financial statements in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement, whether due to error or fraud. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. As part of our audits we are required to obtain an understanding of internal control over financial reporting but not for the purpose of expressing an opinion on the effectiveness of the Company's internal control over financial reporting. Accordingly, we express no such opinion. Our audits included performing procedures to assess the risks of material misstatement of the consolidated financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the consolidated financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the consolidated financial statements. We believe that our audits provide a reasonable basis for our opinion. Critical Audit Matters The critical audit matter communicated below is a matter arising from the current period audit of the consolidated financial statements that was communicated or required to be communicated to the audit committee and that (i) relates to accounts or disclosures that are material to the consolidated financial statements and (ii) involved our especially challenging, subjective, or complex judgments. The communication of critical audit matters does not alter in any way our opinion on the consolidated financial statements, taken as a whole, and we are not, by communicating the critical audit matter below, providing a separate opinion on the critical audit matter or on the accounts or disclosures to which it relates. 163Accounting for the Effects of Cost-Based Regulation As described in Notes 1, 4, and 5 to the consolidated financial statements, the Company’s consolidated financial statements reflect the actions of regulators that result in the recognition of certain revenues and expenses in different time periods than enterprises that are not rate-regulated. Regulatory assets (deferred expenses) and regulatory liabilities (deferred future revenue reductions or refunds) are recorded to reflect the economic effects of regulation in the same accounting period by matching expenses with their recovery through regulated revenues and matching income with its passage to customers in cost-based regulated rates. Management reviews the probability of recovery of regulatory assets and refund of regulatory liabilities at each balance sheet date and whenever new events occur, whether influenced by issuance of regulatory commission orders, passage of new legislation, or changes in the regulatory environment, which included a $49.0 million gain recorded for the year ended December 31, 2020 for the re-establishment of a regulatory asset related to previously retired coal fired generation assets as the result of the 2017-2019 Virginia triennial review. As of December 31, 2020, there were $691.6 million of deferred costs included in regulatory assets, $43.8 million of which were pending final regulatory approval, and $1,224.7 million of regulatory liabilities awaiting potential refund or future rate reduction. The principal considerations for our determination that performing procedures relating to the accounting for the effects of cost-based regulation is a critical audit matter are the significant judgment by management in the ongoing evaluation of the recovery of regulatory assets and refund of regulatory liabilities, and applying guidance contained in rate orders and other relevant evidence; which in turn led to significant audit effort and a high degree of auditor subjectivity in performing procedures and in evaluating audit evidence relating to management’s judgments about the probability of recovery of regulatory assets and refund of regulatory liabilities. Addressing the matter involved performing procedures and evaluating audit evidence in connection with forming our overall opinion on the consolidated financial statements. These procedures included testing the effectiveness of controls relating to management’s assessment of regulatory proceedings, including the probability of recovery of regulatory assets and refund of regulatory liabilities. These procedures also included, among others, evaluating the reasonableness of management’s assessment of probability of future recovery for regulatory assets and refund of regulatory liabilities. Testing of regulatory assets and liabilities, including those subject to pending rate cases, also involved evaluating the provisions and formulas outlined in rate orders, other regulatory correspondence, and application of regulatory precedents. /s/ PricewaterhouseCoopers LLP Columbus, Ohio February 25, 2021 We have served as the Company's auditor since 2017. 164MANAGEMENT’S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTINGThe management of Appalachian Power Company and Subsidiaries (APCo) is responsible for establishing and maintaining adequate internal control over financial reporting as such term is defined in Rule 13a-15(f) and 15d-15(f) under the Securities Exchange Act of 1934, as amended. APCo’s internal control is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles.Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.Management assessed the effectiveness of APCo’s internal control over financial reporting as of December 31, 2020. In making this assessment, management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control – Integrated Framework (2013). Based on management’s assessment, management concluded APCo’s internal control over financial reporting was effective as of December 31, 2020.This annual report does not include an audit report from PricewaterhouseCoopers LLP, APCo’s registered public accounting firm regarding internal control over financial reporting pursuant to the Securities and Exchange Commission rules that permit APCo to provide only management’s report in this annual report.165APPALACHIAN POWER COMPANY AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF INCOME For the Years Ended December 31, 2020, 2019 and 2018 (in millions)Years Ended December 31,202020192018REVENUESElectric Generation, Transmission and Distribution$2,610.9 $2,708.2 $2,777.1 Sales to AEP Affiliates174.7 205.3 181.4 Other Revenues10.6 11.2 9.0 TOTAL REVENUES2,796.2 2,924.7 2,967.5 EXPENSESFuel and Other Consumables Used for Electric Generation513.3 607.5 588.9 Purchased Electricity for Resale360.3 391.0 503.5 Other Operation530.5 567.6 511.6 Maintenance226.8 255.4 316.9 Asset Impairments and Other Related Charges - Coal Fired Generation— 92.9 — Re-Establishment of Regulatory Asset - Coal Fired Generation(49.0)— — Depreciation and Amortization507.5 466.8 428.4 Taxes Other Than Income Taxes150.2 146.2 134.7 TOTAL EXPENSES2,239.6 2,527.4 2,484.0 OPERATING INCOME556.6 397.3 483.5 Other Income (Expense):Interest Income1.6 2.4 1.8 Carrying Costs Income— — 1.3 Allowance for Equity Funds Used During Construction14.6 16.6 13.2 Non-Service Cost Components of Net Periodic Benefit Cost18.8 17.0 17.9 Interest Expense(217.6)(205.0)(194.8)INCOME BEFORE INCOME TAX EXPENSE (BENEFIT)374.0 228.3 322.9 Income Tax Expense (Benefit)4.3 (78.0)(44.9)NET INCOME$369.7 $306.3 $367.8 The common stock of APCo is wholly-owned by Parent.See Notes to Financial Statements of Registrants beginning on page 229.166APPALACHIAN POWER COMPANY AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)For the Years Ended December 31, 2020, 2019 and 2018 (in millions)Years Ended December 31,202020192018Net Income$369.7 $306.3 $367.8 OTHER COMPREHENSIVE INCOME (LOSS), NET OF TAXESCash Flow Hedges, Net of Tax of $(0.5), $(0.2) and $(0.2) in 2020, 2019 and 2018, Respectively(1.7)(0.9)(0.9)Amortization of Pension and OPEB Deferred Costs, Net of Tax of $(1.0), $(0.7) and $(0.8) in 2020, 2019 and 2018, Respectively(3.8)(2.5)(3.1)Pension and OPEB Funded Status, Net of Tax of $2.0, $3.6 and $(0.7) in 2020, 2019 and 2018, Respectively7.713.4(2.6)TOTAL OTHER COMPREHENSIVE INCOME (LOSS)2.2 10.0 (6.6)TOTAL COMPREHENSIVE INCOME$371.9 $316.3 $361.2 See Notes to Financial Statements of Registrants beginning on page 229.167APPALACHIAN POWER COMPANY AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF CHANGES IN COMMON SHAREHOLDER’S EQUITYFor the Years Ended December 31, 2020, 2019 and 2018 (in millions)CommonStockPaid-inCapitalRetainedEarningsAccumulatedOtherComprehensiveIncome (Loss)TotalTOTAL COMMON SHAREHOLDER’S EQUITY – DECEMBER 31, 2017$260.4 $1,828.7 $1,714.1 $1.3 $3,804.5 Common Stock Dividends(160.0)(160.0)ASU 2018-02 Adoption0.1 0.3 0.4 Net Income367.8 367.8 Other Comprehensive Loss(6.6)(6.6)TOTAL COMMON SHAREHOLDER’S EQUITY – DECEMBER 31, 2018260.4 1,828.7 1,922.0 (5.0)4,006.1 Common Stock Dividends(150.0)(150.0)Net Income306.3 306.3 Other Comprehensive Income10.0 10.0 TOTAL COMMON SHAREHOLDER’S EQUITY – DECEMBER 31, 2019260.4 1,828.7 2,078.3 5.0 4,172.4 Common Stock Dividends(200.0)(200.0)Net Income369.7 369.7 Other Comprehensive Income2.2 2.2 TOTAL COMMON SHAREHOLDER’S EQUITY – DECEMBER 31, 2020$260.4 $1,828.7 $2,248.0 $7.2 $4,344.3 See Notes to Financial Statements of Registrants beginning on page 229.168APPALACHIAN POWER COMPANY AND SUBSIDIARIESCONSOLIDATED BALANCE SHEETSASSETSDecember 31, 2020 and 2019 (in millions)December 31,20202019CURRENT ASSETSCash and Cash Equivalents$5.8 $3.3 Restricted Cash for Securitized Funding16.9 23.5 Advances to Affiliates21.4 22.1 Accounts Receivable:Customers142.8 129.0 Affiliated Companies64.3 64.3 Accrued Unbilled Revenues80.1 59.7 Miscellaneous0.3 0.5 Allowance for Uncollectible Accounts(3.1)(2.6)Total Accounts Receivable284.4 250.9 Fuel193.6 149.7 Materials and Supplies99.6 105.2 Risk Management Assets 22.4 39.4 Regulatory Asset for Under-Recovered Fuel Costs5.3 42.5 Prepayments and Other Current Assets24.7 64.0 TOTAL CURRENT ASSETS674.1 700.6 PROPERTY, PLANT AND EQUIPMENTElectric:Generation6,633.7 6,563.7 Transmission3,900.5 3,584.1 Distribution4,464.3 4,201.7 Other Property, Plant and Equipment627.2 571.3 Construction Work in Progress484.6 593.4 Total Property, Plant and Equipment16,110.3 15,514.2 Accumulated Depreciation and Amortization4,716.2 4,432.3 TOTAL PROPERTY, PLANT AND EQUIPMENT – NET11,394.1 11,081.9 OTHER NONCURRENT ASSETSRegulatory Assets686.3 457.2 Securitized Assets210.1 234.7 Employee Benefits and Pension Assets150.1 92.0 Operating Lease Assets78.8 78.5 Deferred Charges and Other Noncurrent Assets121.7 123.4 TOTAL OTHER NONCURRENT ASSETS1,247.0 985.8 TOTAL ASSETS$13,315.2 $12,768.3 See Notes to Financial Statements of Registrants beginning on page 229.169APPALACHIAN POWER COMPANY AND SUBSIDIARIESCONSOLIDATED BALANCE SHEETSLIABILITIES AND COMMON SHAREHOLDER’S EQUITYDecember 31, 2020 and 2019 December 31,20202019(in millions)CURRENT LIABILITIESAdvances from Affiliates$18.6 $236.7 Accounts Payable:General212.0 307.8 Affiliated Companies97.1 92.5 Long-term Debt Due Within One Year - Nonaffiliated518.3 215.6 Risk Management Liabilities4.6 1.9 Customer Deposits77.8 85.8 Accrued Taxes109.9 99.6 Obligations Under Operating Leases14.9 15.2 Other Current Liabilities164.5 170.9 TOTAL CURRENT LIABILITIES1,217.7 1,226.0 NONCURRENT LIABILITIESLong-term Debt – Nonaffiliated4,315.8 4,148.2 Deferred Income Taxes1,749.9 1,680.8 Regulatory Liabilities and Deferred Investment Tax Credits1,224.7 1,268.7 Asset Retirement Obligations304.8 102.1 Employee Benefits and Pension Obligations44.0 50.9 Obligations Under Operating Leases64.4 64.0 Deferred Credits and Other Noncurrent Liabilities49.6 55.2 TOTAL NONCURRENT LIABILITIES7,753.2 7,369.9 TOTAL LIABILITIES8,970.9 8,595.9 Rate Matters (Note 4)Commitments and Contingencies (Note 6)COMMON SHAREHOLDER’S EQUITYCommon Stock – No Par Value:Authorized –30,000,000 SharesOutstanding – 13,499,500 Shares260.4 260.4 Paid-in Capital1,828.7 1,828.7 Retained Earnings2,248.0 2,078.3 Accumulated Other Comprehensive Income (Loss)7.2 5.0 TOTAL COMMON SHAREHOLDER’S EQUITY4,344.3 4,172.4 TOTAL LIABILITIES AND COMMON SHAREHOLDER’S EQUITY$13,315.2 $12,768.3 See Notes to Financial Statements of Registrants beginning on page 229.170APPALACHIAN POWER COMPANY AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF CASH FLOWSFor the Years Ended December 31, 2020, 2019 and 2018 (in millions)Years Ended December 31,202020192018OPERATING ACTIVITIESNet Income$369.7 $306.3 $367.8 Adjustments to Reconcile Net Income to Net Cash Flows from Operating Activities:Depreciation and Amortization507.5 466.8 428.4 Deferred Income Taxes(26.2)(126.2)(16.8)Asset Impairments and Other Related Charges - Coal Fired Generation— 92.9 — Allowance for Equity Funds Used During Construction(14.6)(16.6)(13.2)Mark-to-Market of Risk Management Contracts18.8 19.9 (33.0)Pension Contributions to Qualified Plan Trust(7.0)— — Deferred Fuel Over/Under-Recovery, Net37.2 57.1 (10.8)Re-Establishment of Regulatory Asset - Coal Fired Generation(49.0)— — Change in Other Noncurrent Assets(40.4)(38.2)58.1 Change in Other Noncurrent Liabilities11.2 (40.3)(4.8)Changes in Certain Components of Working Capital:Accounts Receivable, Net(30.2)35.7 33.6 Fuel, Materials and Supplies(38.2)(93.4)27.8 Accounts Payable(48.1)37.7 (13.3)Accrued Taxes, Net31.3 (10.2)(13.2)Other Current Assets18.3 15.4 (6.1)Other Current Liabilities(28.3)(45.5)42.1 Net Cash Flows from Operating Activities712.0 661.4 846.6 INVESTING ACTIVITIESConstruction Expenditures(767.4)(862.6)(780.7)Change in Advances to Affiliates, Net0.7 0.9 0.5 Other Investing Activities8.8 24.3 10.8 Net Cash Flows Used for Investing Activities(757.9)(837.4)(769.4)FINANCING ACTIVITIESIssuance of Long-term Debt – Nonaffiliated606.9 478.2 203.2 Change in Advances from Affiliates, Net(218.1)31.1 19.6 Retirement of Long-term Debt – Nonaffiliated(140.3)(180.5)(124.0)Principal Payments for Finance Lease Obligations(7.4)(6.7)(6.9)Dividends Paid on Common Stock(200.0)(150.0)(160.0)Other Financing Activities0.7 0.9 1.5 Net Cash Flows from (Used for) Financing Activities41.8 173.0 (66.6)Net Increase (Decrease) in Cash, Cash Equivalents and Restricted Cash for Securitized Funding(4.1)(3.0)10.6 Cash, Cash Equivalents and Restricted Cash for Securitized Funding at Beginning of Period26.8 29.8 19.2 Cash, Cash Equivalents and Restricted Cash for Securitized Funding at End of Period$22.7 $26.8 $29.8 SUPPLEMENTARY INFORMATIONCash Paid for Interest, Net of Capitalized Amounts$207.1 $190.7 $182.0 Net Cash Paid (Received) for Income Taxes— 63.0 (13.0)Noncash Acquisitions Under Finance Leases7.2 8.8 5.5 Construction Expenditures Included in Current Liabilities as of December 31,105.6 149.7 134.4 See Notes to Financial Statements of Registrants beginning on page 229.171INDIANA MICHIGAN POWER COMPANYAND SUBSIDIARIES172INDIANA MICHIGAN POWER COMPANY AND SUBSIDIARIESMANAGEMENT’S NARRATIVE DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONSCOMPANY OVERVIEWAs a public utility, I&M engages in the generation and purchase of electric power, and the subsequent sale, transmission and distribution of that power to approximately 602,000 retail customers in its service territory in northern and eastern Indiana and southwestern Michigan. I&M consolidates Blackhawk Coal Company and Price River Coal Company, its wholly-owned subsidiaries. I&M also consolidates DCC Fuel. I&M sells power at wholesale to municipalities and electric cooperatives. I&M’s River Transportation Division provides barging services to affiliates and nonaffiliated companies. The revenues from barging represent the majority of other revenues.AEGCo holds a 50% interest in each of the Rockport Plant units and is entitled to 50% of the capacity and associated energy from each unit. Under unit power agreements approved by the FERC, I&M and KPCo purchase approximately 920 MWs and 390 MWs, respectively, of the output from AEGCo’s 50% share of the Rockport Plant.To minimize the credit requirements and operating constraints when operating within PJM, participating AEP companies, including I&M, agreed to a netting of certain payment obligations incurred by the participating AEP companies against certain balances due to such AEP companies and to hold PJM harmless from actions that any one or more AEP companies may take with respect to PJM.173RESULTS OF OPERATIONSKWh Sales/Degree DaysSummary of KWh Energy SalesYears Ended December 31,202020192018(in millions of KWhs)Retail:Residential5,464 5,409 5,731 Commercial4,475 4,685 4,851 Industrial7,225 7,589 7,836 Miscellaneous67 69 71 Total Retail17,231 17,752 18,489 Wholesale7,135 8,268 10,873 Total KWhs24,366 26,020 29,362 Heating degree days and cooling degree days are metrics commonly used in the utility industry as a measure of the impact of weather on revenues.Summary of Heating and Cooling Degree DaysYears Ended December 31,202020192018(in degree days)Actual – Heating (a)3,352 3,782 3,886 Normal – Heating (b)3,742 3,740 3,747 Actual – Cooling (c)928 940 1,132 Normal – Cooling (b)854 849 849 (a)Heating degree days are calculated on a 55 degree temperature base.(b)Normal Heating/Cooling represents the thirty-year average of degree days.(c)Cooling degree days are calculated on a 65 degree temperature base.1742020 Compared to 2019 Reconciliation of Year Ended December 31, 2019 to Year Ended December 31, 2020 Net Income(in millions)Year Ended December 31, 2019$269.4 Changes in Gross Margin:Retail Margins55.1 Margins from Off-system Sales0.1 Transmission Revenues11.0 Other Revenues(10.3)Total Change in Gross Margin55.9 Changes in Expenses and Other:Other Operation and Maintenance29.2 Depreciation and Amortization(61.0)Taxes Other Than Income Taxes(2.0)Other Income(8.2)Non-Service Cost Components of Net Periodic Benefit Cost(1.0)Interest Expense5.6 Total Change in Expenses and Other(37.4)Income Tax Expense(3.1)Year Ended December 31, 2020$284.8 The major components of the increase in Gross Margin, defined as revenues less the related direct cost of fuel, including consumption of chemicals and emissions allowances, and purchased electricity were as follows:•Retail Margins increased $55 million primarily due to the following:•A $109 million increase primarily due to the Indiana and Michigan base rate cases and increases in rider revenues. This increase was partially offset in other expense items below.•A $5 million increase in weather-normalized retail margins primarily in the residential class, partially offset in the commercial and industrial classes.These increases were partially offset by:•A $53 million decrease in weather-normalized wholesale margins, including the loss of a significant wholesale contract.•A $16 million decrease in weather-related usage primarily due to an 11% decrease in heating degree days.•Transmission Revenues increased $11 million primarily due to the following:•A $6 million increase from the annual transmission formula rate true-up.•A $5 million increase from investment in transmission assets.•Other Revenues decreased $10 million primarily due to a decrease in barging revenues by River Transportation Division (RTD). This decrease was partially offset in Other Operation and Maintenance expenses below.175Expenses and Other and Income Tax Expense changed between years as follows:•Other Operation and Maintenance expenses decreased $29 million primarily due to the following:•A $15 million decrease in Cook Plant refueling outage expenses and various maintenance activities.•An $11 million decrease in nonutility operation expenses primarily due to a decrease in RTD expenses. This decrease was partially offset in Other Revenues above.•A $10 million decrease in distribution expenses primarily due to a decrease in vegetation management expenses.•A $9 million decrease due to a charitable contribution to the AEP Foundation in 2019.•A $7 million decrease due to an increased Nuclear Electric Insurance Limited distribution in 2020.•A $5 million decrease in steam generation expense primarily due to 2019 NSR Consent Decree modifications.These decreases were partially offset by:•A $15 million increase in employee-related expenses.•A $12 million increase in transmission expenses primarily due to a $24 million increase in recoverable PJM expenses, partially offset by an $11 million decrease from the annual transmission formula rate true-up. This increase was partially offset in Retail Margins above.•Depreciation and Amortization expenses increased $61 million primarily due to a higher depreciable base and an increase in depreciation rates. This increase was partially offset in Retail Margins above.•Other Income decreased $8 million primarily due to a decrease in the AFUDC base and the favorable impact of a FERC settlement agreement recorded in 2019.•Interest Expense decreased $6 million primarily due to lower interest rates on variable rate loans and carrying charges recorded on various riders. This decrease was partially offset by a decrease in AFUDC base.•Income Tax Expense increased $3 million due to an increase in pretax book income, state tax expense and AFUDC equity partially offset by an increase in amortization of Excess ADIT not subject to normalization requirements. The increase in amortization of Excess ADIT was partially offset in Gross Margin above.176REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRMTo the Board of Directors and Shareholder of Indiana Michigan Power Company Opinion on the Financial Statements We have audited the accompanying consolidated balance sheets of Indiana Michigan Power Company and its subsidiaries (the “Company”) as of December 31, 2020 and 2019, and the related consolidated statements of income, of comprehensive income (loss), of changes in common shareholder's equity and of cash flows for each of the three years in the period ended December 31, 2020, including the related notes (collectively referred to as the “consolidated financial statements”). In our opinion, the consolidated financial statements present fairly, in all material respects, the financial position of the Company as of December 31, 2020 and 2019, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2020 in conformity with accounting principles generally accepted in the United States of America. Change in Accounting Principle As discussed in Note 13 to the consolidated financial statements, the Company changed the manner in which it accounts for leases in 2019. Basis for Opinion These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on the Company’s consolidated financial statements based on our audits. We are a public accounting firm registered with the Public Company Accounting Oversight Board (United States) (PCAOB) and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB. We conducted our audits of these consolidated financial statements in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement, whether due to error or fraud. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. As part of our audits we are required to obtain an understanding of internal control over financial reporting but not for the purpose of expressing an opinion on the effectiveness of the Company's internal control over financial reporting. Accordingly, we express no such opinion. Our audits included performing procedures to assess the risks of material misstatement of the consolidated financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the consolidated financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the consolidated financial statements. We believe that our audits provide a reasonable basis for our opinion. Critical Audit Matters The critical audit matter communicated below is a matter arising from the current period audit of the consolidated financial statements that was communicated or required to be communicated to the audit committee and that (i) relates to accounts or disclosures that are material to the consolidated financial statements and (ii) involved our especially challenging, subjective, or complex judgments. The communication of critical audit matters does not alter in any way our opinion on the consolidated financial statements, taken as a whole, and we are not, by communicating the critical audit matter below, providing a separate opinion on the critical audit matter or on the accounts or disclosures to which it relates. 177Accounting for the Effects of Cost-Based Regulation As described in Notes 1 and 5 to the consolidated financial statements, the Company’s consolidated financial statements reflect the actions of regulators that result in the recognition of certain revenues and expenses in different time periods than enterprises that are not rate-regulated. Regulatory assets (deferred expenses) and regulatory liabilities (deferred future revenue reductions or refunds) are recorded to reflect the economic effects of regulation in the same accounting period by matching expenses with their recovery through regulated revenues and matching income with its passage to customers in cost-based regulated rates. Management reviews the probability of recovery of regulatory assets and refund of regulatory liabilities at each balance sheet date and whenever new events occur, whether influenced by issuance of regulatory commission orders, passage of new legislation, or changes in the regulatory environment. As of December 31, 2020, there were $410.2 million of deferred costs included in regulatory assets, $4.3 million of which were pending final regulatory approval, and $2,062.7 million of regulatory liabilities awaiting potential refund or future rate reduction. The principal considerations for our determination that performing procedures relating to the accounting for the effects of cost-based regulation is a critical audit matter are the significant judgment by management in the ongoing evaluation of the recovery of regulatory assets and refund of regulatory liabilities, and applying guidance contained in rate orders and other relevant evidence; which in turn led to significant audit effort and a high degree of auditor subjectivity in performing procedures and in evaluating audit evidence relating to management’s judgments about the probability of recovery of regulatory assets and refund of regulatory liabilities. Addressing the matter involved performing procedures and evaluating audit evidence in connection with forming our overall opinion on the consolidated financial statements. These procedures included testing the effectiveness of controls relating to management’s assessment of regulatory proceedings, including the probability of recovery of regulatory assets and refund of regulatory liabilities. These procedures also included, among others, evaluating the reasonableness of management’s assessment of probability of future recovery for regulatory assets and refund of regulatory liabilities. Testing of regulatory assets and liabilities, including those subject to pending rate cases, also involved evaluating the provisions and formulas outlined in rate orders, other regulatory correspondence, and application of regulatory precedents. /s/ PricewaterhouseCoopers Columbus, Ohio February 25, 2021 We have served as the Company's auditor since 2017. 178MANAGEMENT’S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTINGThe management of Indiana Michigan Power Company and Subsidiaries (I&M) is responsible for establishing and maintaining adequate internal control over financial reporting as such term is defined in Rule 13a-15(f) and 15d-15(f) under the Securities Exchange Act of 1934, as amended. I&M’s internal control is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles.Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.Management assessed the effectiveness of I&M’s internal control over financial reporting as of December 31, 2020. In making this assessment, management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control – Integrated Framework (2013). Based on management’s assessment, management concluded I&M’s internal control over financial reporting was effective as of December 31, 2020.This annual report does not include an audit report from PricewaterhouseCoopers LLP, I&M’s registered public accounting firm regarding internal control over financial reporting pursuant to the Securities and Exchange Commission rules that permit I&M to provide only management’s report in this annual report.179INDIANA MICHIGAN POWER COMPANY AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF INCOMEFor the Years Ended December 31, 2020, 2019 and 2018 (in millions)Years Ended December 31,202020192018REVENUESElectric Generation, Transmission and Distribution$2,165.3 $2,222.1 $2,272.6 Sales to AEP Affiliates10.5 10.5 22.1 Other Revenues - Affiliated60.8 63.4 63.4 Other Revenues - Nonaffiliated5.2 10.7 12.6 TOTAL REVENUES2,241.8 2,306.7 2,370.7 EXPENSESFuel and Other Consumables Used for Electric Generation162.0 190.6 318.3 Purchased Electricity for Resale182.2 232.3 221.8 Purchased Electricity from AEP Affiliates172.8 214.9 237.9 Other Operation650.0 641.2 585.4 Maintenance193.2 231.2 238.1 Depreciation and Amortization411.6 350.6 293.1 Taxes Other Than Income Taxes107.1 105.1 98.9 TOTAL EXPENSES1,878.9 1,965.9 1,993.5 OPERATING INCOME362.9 340.8 377.2 Other Income (Expense):Other Income10.0 18.2 19.2 Non-Service Cost Components of Net Periodic Benefit Cost16.7 17.7 18.1 Interest Expense(112.3)(117.9)(124.1)INCOME BEFORE INCOME TAX EXPENSE (BENEFIT)277.3 258.8 290.4 Income Tax Expense (Benefit)(7.5)(10.6)29.1 NET INCOME$284.8 $269.4 $261.3 The common stock of I&M is wholly-owned by Parent.See Notes to Financial Statements of Registrants beginning on page 229.180INDIANA MICHIGAN POWER COMPANY AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)For the Years Ended December 31, 2020, 2019 and 2018 (in millions)Years Ended December 31,202020192018Net Income$284.8 $269.4 $261.3 OTHER COMPREHENSIVE INCOME (LOSS), NET OF TAXESCash Flow Hedges, Net of Tax of $0.4, $0.4 and $0.4 in 2020, 2019 and 2018, Respectively1.6 1.6 1.6 Amortization of Pension and OPEB Deferred Costs, Net of Tax of $0, $0 and $0 in 2020, 2019 and 2018, Respectively(0.1)(0.2)— Pension and OPEB Funded Status, Net of Tax of $0.8, $0.2 and $(0.2) in 2020, 2019 and 2018, Respectively3.1 0.8 (0.6)TOTAL OTHER COMPREHENSIVE INCOME4.6 2.2 1.0 TOTAL COMPREHENSIVE INCOME$289.4 $271.6 $262.3 See Notes to Financial Statements of Registrants beginning on page 229.181INDIANA MICHIGAN POWER COMPANY AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF CHANGES IN COMMON SHAREHOLDER’S EQUITYFor the Years Ended December 31, 2020, 2019 and 2018 (in millions)CommonStockPaid-inCapitalRetained EarningsAccumulatedOtherComprehensiveIncome (Loss)TotalTOTAL COMMON SHAREHOLDER’S EQUITY – DECEMBER 31, 2017$56.6 $980.9 $1,192.2 $(12.1)$2,217.6 Common Stock Dividends(124.7)(124.7)ASU 2018-02 Adoption0.3 (2.7)(2.4)Net Income261.3 261.3 Other Comprehensive Income1.0 1.0 TOTAL COMMON SHAREHOLDER’S EQUITY – DECEMBER 31, 201856.6 980.9 1,329.1 (13.8)2,352.8 Common Stock Dividends(80.0)(80.0)Net Income269.4 269.4 Other Comprehensive Income2.2 2.2 TOTAL COMMON SHAREHOLDER’S EQUITY – DECEMBER 31, 201956.6 980.9 1,518.5 (11.6)2,544.4 Common Stock Dividends(85.0)(85.0)ASU 2016-13 Adoption0.4 0.4 Net Income284.8 284.8 Other Comprehensive Income4.6 4.6 TOTAL COMMON SHAREHOLDER’S EQUITY – DECEMBER 31, 2020$56.6 $980.9 $1,718.7 $(7.0)$2,749.2 See Notes to Financial Statements of Registrants beginning on page 229.182INDIANA MICHIGAN POWER COMPANY AND SUBSIDIARIESCONSOLIDATED BALANCE SHEETSASSETSDecember 31, 2020 and 2019 (in millions)December 31,20202019CURRENT ASSETSCash and Cash Equivalents$3.3 $2.0 Advances to Affiliates13.3 13.2 Accounts Receivable:Customers44.0 53.6 Affiliated Companies51.3 53.7 Accrued Unbilled Revenues— 2.5 Miscellaneous2.0 0.3 Allowance for Uncollectible Accounts(0.3)(0.6)Total Accounts Receivable97.0 109.5 Fuel86.0 56.2 Materials and Supplies175.8 171.3 Risk Management Assets3.6 9.8 Accrued Tax Benefits10.3 — Regulatory Asset for Under-Recovered Fuel Costs5.4 3.0 Accrued Reimbursement of Spent Nuclear Fuel Costs14.2 24.0 Prepayments and Other Current Assets9.9 14.0 TOTAL CURRENT ASSETS418.8 403.0 PROPERTY, PLANT AND EQUIPMENTElectric:Generation5,264.7 5,099.7 Transmission1,696.4 1,641.8 Distribution2,594.6 2,437.6 Other Property, Plant and Equipment (Including Coal Mining and Nuclear Fuel)686.7 632.6 Construction Work in Progress362.4 382.3 Total Property, Plant and Equipment10,604.8 10,194.0 Accumulated Depreciation, Depletion and Amortization3,552.5 3,294.3 TOTAL PROPERTY, PLANT AND EQUIPMENT – NET7,052.3 6,899.7 OTHER NONCURRENT ASSETSRegulatory Assets404.8 482.1 Spent Nuclear Fuel and Decommissioning Trusts3,306.7 2,975.7 Operating Lease Assets218.1 294.9 Deferred Charges and Other Noncurrent Assets237.6 182.0 TOTAL OTHER NONCURRENT ASSETS4,167.2 3,934.7 TOTAL ASSETS$11,638.3 $11,237.4 See Notes to Financial Statements of Registrants beginning on page 229.183INDIANA MICHIGAN POWER COMPANY AND SUBSIDIARIESCONSOLIDATED BALANCE SHEETSLIABILITIES AND COMMON SHAREHOLDER’S EQUITYDecember 31, 2020 and 2019 (dollars in millions)December 31,20202019CURRENT LIABILITIESAdvances from Affiliates$103.0 $114.4 Accounts Payable:General153.2 169.4 Affiliated Companies80.5 68.4 Long-term Debt Due Within One Year – Nonaffiliated(December 31, 2020 and 2019 Amounts Include $75.7 and $86.1 Respectively, Related to DCC Fuel)369.6 139.7 Customer Deposits41.7 39.4 Accrued Taxes102.5 112.4 Accrued Interest35.6 36.2 Obligations Under Operating Leases85.6 87.3 Regulatory Liability for Over-Recovered Fuel Costs20.8 6.1 Other Current Liabilities112.0 110.1 TOTAL CURRENT LIABILITIES1,104.5 883.4 NONCURRENT LIABILITIESLong-term Debt – Nonaffiliated2,660.3 2,910.5 Deferred Income Taxes1,064.4 979.7 Regulatory Liabilities and Deferred Investment Tax Credits2,041.9 1,891.4 Asset Retirement Obligations1,812.9 1,748.6 Obligations Under Operating Leases135.9 211.6 Deferred Credits and Other Noncurrent Liabilities69.2 67.8 TOTAL NONCURRENT LIABILITIES7,784.6 7,809.6 TOTAL LIABILITIES8,889.1 8,693.0 Rate Matters (Note 4)Commitments and Contingencies (Note 6)COMMON SHAREHOLDER’S EQUITYCommon Stock – No Par Value:Authorized – 2,500,000 SharesOutstanding – 1,400,000 Shares56.6 56.6 Paid-in Capital980.9 980.9 Retained Earnings1,718.7 1,518.5 Accumulated Other Comprehensive Income (Loss)(7.0)(11.6)TOTAL COMMON SHAREHOLDER’S EQUITY2,749.2 2,544.4 TOTAL LIABILITIES AND COMMON SHAREHOLDER'S EQUITY$11,638.3 $11,237.4 See Notes to Financial Statements of Registrants beginning on page 229.184INDIANA MICHIGAN POWER COMPANY AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF CASH FLOWSFor the Years Ended December 31, 2020, 2019 and 2018 (in millions)Years Ended December 31,202020192018OPERATING ACTIVITIESNet Income$284.8 $269.4 $261.3 Adjustments to Reconcile Net Income to Net Cash Flows from Operating Activities:Depreciation and Amortization411.6 350.6 293.1 Rockport Plant, Unit 2 Operating Lease Amortization69.2 69.2 — Deferred Income Taxes(16.2)(52.7)(42.9)Amortization (Deferral) of Incremental Nuclear Refueling Outage Expenses, Net24.4 (26.4)29.2 Allowance for Equity Funds Used During Construction(11.5)(19.4)(11.9)Mark-to-Market of Risk Management Contracts5.9 (0.6)(4.1)Amortization of Nuclear Fuel87.5 89.1 113.8 Pension Contributions to Qualified Plan Trust(6.4)— — Deferred Fuel Over/Under-Recovery, Net12.4 (24.3)39.7 Change in Other Noncurrent Assets6.1 8.3 (36.5)Change in Other Noncurrent Liabilities45.0 33.7 72.1 Changes in Certain Components of Working Capital:Accounts Receivable, Net14.5 35.4 4.8 Fuel, Materials and Supplies(34.7)(22.4)(11.2)Accounts Payable(10.8)3.6 (14.1)Accrued Taxes, Net(20.2)48.3 41.2 Rockport Plant, Unit 2 Operating Lease Payments(73.9)(73.9)— Other Current Assets14.3 11.2 1.5 Other Current Liabilities(25.7)(13.9)(10.3)Net Cash Flows from Operating Activities776.3 685.2 725.7 INVESTING ACTIVITIESConstruction Expenditures(544.7)(585.9)(568.5)Change in Advances to Affiliates, Net(0.1)(0.5)(0.3)Purchases of Investment Securities(1,637.2)(1,531.0)(2,064.7)Sales of Investment Securities1,593.4 1,473.0 2,010.0 Acquisitions of Nuclear Fuel(69.7)(92.3)(46.1)Other Investing Activities9.4 16.6 14.8 Net Cash Flows Used for Investing Activities(648.9)(720.1)(654.8)FINANCING ACTIVITIESIssuance of Long-term Debt - Nonaffiliated69.5 123.3 1,168.1 Change in Advances from Affiliates, Net(11.4)113.3 (210.5)Retirement of Long-term Debt - Nonaffiliated(93.2)(117.1)(884.9)Principal Payments for Finance Lease Obligations(6.5)(5.7)(8.8)Dividends Paid on Common Stock(85.0)(80.0)(124.7)Other Financing Activities0.5 0.7 (9.0)Net Cash Flows from (Used for) Financing Activities(126.1)34.5 (69.8)Net Increase (Decrease) in Cash and Cash Equivalents1.3 (0.4)1.1 Cash and Cash Equivalents at Beginning of Period2.0 2.4 1.3 Cash and Cash Equivalents at End of Period$3.3 $2.0 $2.4 SUPPLEMENTARY INFORMATIONCash Paid for Interest, Net of Capitalized Amounts$107.6 $111.9 $116.9 Net Cash Paid for Income Taxes42.1 3.4 32.6 Noncash Acquisitions Under Finance Leases3.0 11.9 5.8 Construction Expenditures Included in Current Liabilities as of December 31,62.8 86.0 93.0 Acquisition of Nuclear Fuel Included in Current Liabilities as of December 31,33.4 0.1 4.0 Expected Reimbursement for Capital Cost of Spent Nuclear Fuel Dry Cask Storage2.6 0.3 2.2 See Notes to Financial Statements of Registrants beginning on page 229.185OHIO POWER COMPANY AND SUBSIDIARIES186OHIO POWER COMPANY AND SUBSIDIARIESMANAGEMENT’S NARRATIVE DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONSCOMPANY OVERVIEWAs a public utility, OPCo engages in the transmission and distribution of power to approximately 1,507,000 retail customers in the northwestern, central, eastern and southern sections of Ohio. Effective January 2014, OPCo purchases power from both affiliated and nonaffiliated entities, subject to auction requirements and PUCO approval, to meet the energy and capacity needs of its remaining SSO customers. OPCo consolidates Ohio Phase-in-Recovery Funding LLC, its wholly-owned subsidiary. The Ohio Phase-in-Recovery Funding LLC securitization bonds matured in July 2019.To minimize the credit requirements and operating constraints when operating within PJM, participating AEP companies, including OPCo, agreed to a netting of certain payment obligations incurred by the participating AEP companies against certain balances due to such AEP companies and to hold PJM harmless from actions that any one or more AEP companies may take with respect to PJM.187RESULTS OF OPERATIONSKWh Sales/Degree DaysSummary of KWh Energy SalesYears Ended December 31,202020192018(in millions of KWhs)Retail:Residential14,355 14,411 14,940 Commercial13,933 14,599 14,655 Industrial13,347 14,407 14,857 Miscellaneous113 114 115 Total Retail (a)41,748 43,531 44,567 Wholesale (b)1,859 2,335 2,441 Total KWhs43,607 45,866 47,008 (a)Represents energy delivered to distribution customers.(b)Primarily Ohio’s contractually obligated purchases of OVEC power sold into PJM.Heating degree days and cooling degree days are metrics commonly used in the utility industry as a measure of the impact of weather on revenues.Summary of Heating and Cooling Degree DaysYears Ended December 31,202020192018(in degree days)Actual – Heating (a)2,743 3,071 3,357 Normal – Heating (b)3,202 3,208 3,215 Actual – Cooling (c)1,140 1,224 1,402 Normal – Cooling (b)1,006 992 980 (a)Heating degree days are calculated on a 55 degree temperature base.(b)Normal Heating/Cooling represents the thirty-year average of degree days.(c)Cooling degree days are calculated on a 65 degree temperature base.1882020 Compared to 2019 Reconciliation of Year Ended December 31, 2019 to Year Ended December 31, 2020 Net Income(in millions)Year Ended December 31, 2019$297.1 Changes in Gross Margin:Retail Margins58.8 Margins from Off-system Sales10.7 Transmission Revenues22.6 Other Revenues19.1 Total Change in Gross Margin111.2 Changes in Expenses and Other:Other Operation and Maintenance(57.0)Depreciation and Amortization(35.7)Taxes Other Than Income Taxes(16.0)Interest Income(2.2)Carrying Costs Income0.6 Allowance for Equity Funds Used During Construction(5.7)Non-Service Cost Components of Net Periodic Benefit Cost0.4 Interest Expense(11.0)Total Change in Expenses and Other(126.6)Income Tax Expense(10.3)Year Ended December 31, 2020$271.4 The major components of the increase in Gross Margin, defined as revenues less the related direct cost of purchased electricity and amortization of generation deferrals were as follows:•Retail Margins increased $59 million primarily due to the following:•A $69 million net increase related to other various rider revenues. This increase was partially offset in other expense items below.•A $61 million increase in rider revenues associated with the DIR. This increase was partially offset in other expense items below.•A $6 million increase in revenues associated with smart grid riders. This increase was partially offset in other expense items below.These increases were partially offset by:•A $58 million decrease due to a reversal of a regulatory provision in the first quarter of 2019.•A $17 million net decrease in margin for the Rate Stability Rider including associated amortizations which ended in the third quarter of 2019.•A $10 million decrease in usage primarily in the commercial class, partially offset by an increase in the retail class.•Margins from Off-system Sales increased $11 million primarily due to the following:•A $26 million increase due to higher OVEC PPA deferrals. This increase was offset in Retail Margins above.This increase was partially offset by:•A $17 million decrease in sales due to lower market prices and decreased sales volumes in 2020. This decrease was offset in Retail Margins above.•Transmission Revenues increased $23 million primarily due to the following:•A $16 million increase from the annual transmission formula rate true-up.•A $6 million increase due to additional investment in transmission assets.189•Other Revenues increased $19 million primarily due to third-party Legacy Generation Resource Rider revenue related to the recovery of OVEC costs. This increase was offset in Retail Margins above.Expenses and Other and Income Tax Expense changed between years as follows:•Other Operation and Maintenance expenses increased $57 million primarily due to the following: •A $62 million net increase in transmission expenses, primarily due to a $94 million increase in recoverable PJM expenses, partially offset by a $28 million decrease related to the annual transmission formula rate true-up. This increase was offset in Gross Margins above.•A $19 million increase in remitted Universal Service Fund surcharge payments to the Ohio Department of Development to fund an energy assistance program for qualified Ohio customers. This increase was offset in Retail Margins above.These increases were partially offset by:•A $12 million decrease in recoverable distribution expenses primarily related to vegetation management. This decrease was offset in Retail Margins above.•A $5 million decrease due to a charitable contribution to the AEP Foundation in 2019.•A $5 million decrease due to a PUCO order to refund unused 2018 major storm reserve collections to customers. This decrease was offset in Retail Margins above.•Depreciation and Amortization expenses increased $36 million primarily due to the following:•A $22 million increase in recoverable DIR depreciation expense. This increase was partially offset in Retail Margins above.•A $19 million increase in depreciation expense due to an increase in the depreciable base of transmission and distribution assets.•An $11 million increase due to lower deferred equity amortizations associated with the Deferred Asset Phase-In-Recovery Rider which ended in the second quarter of 2019.•A $6 million increase due to prior year under-recovery of revenues associated with the Deferred Asset Phase-In-Recovery securitization which ended in the 2nd quarter of 2019. This decrease was offset in Retail Margins above.These increases were partially offset by:•A $24 million decrease in amortizations associated with the Deferred Asset Phase-In-Recovery Rider which ended in the second quarter of 2019. This decrease was offset in Retail Margins above.•Taxes Other Than Income Taxes increased $16 million primarily due to the following:•A $22 million increase in property taxes driven by additional investments in transmission and distribution assets and higher tax rates.This increase was partially offset by:•A $6 million decrease in excise taxes due to lower demand in 2020. This decrease was offset in Retail Margins above.•Allowance for Equity Funds Used During Construction decreased $6 million primarily due to adjustments that resulted from 2019 FERC audit findings and a decrease in AFUDC base.•Interest Expense increased $11 million primarily due to higher long-term debt balances.•Income Tax Expense increased $10 million primarily due to an increase in tax expense for benefits previously flowed through to customers.190REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRMTo the Board of Directors and Shareholder of Ohio Power Company Opinion on the Financial Statements We have audited the accompanying consolidated balance sheets of Ohio Power Company and its subsidiaries (the “Company”) as of December 31, 2020 and 2019, and the related consolidated statements of income, of comprehensive income (loss), of changes in common shareholder's equity and of cash flows for each of the three years in the period ended December 31, 2020, including the related notes (collectively referred to as the “consolidated financial statements”). In our opinion, the consolidated financial statements present fairly, in all material respects, the financial position of the Company as of December 31, 2020 and 2019, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2020 in conformity with accounting principles generally accepted in the United States of America. Change in Accounting Principle As discussed in Note 13 to the consolidated financial statements, the Company changed the manner in which it accounts for leases in 2019. Basis for Opinion These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on the Company’s consolidated financial statements based on our audits. We are a public accounting firm registered with the Public Company Accounting Oversight Board (United States) (PCAOB) and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB. We conducted our audits of these consolidated financial statements in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement, whether due to error or fraud. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. As part of our audits we are required to obtain an understanding of internal control over financial reporting but not for the purpose of expressing an opinion on the effectiveness of the Company's internal control over financial reporting. Accordingly, we express no such opinion. Our audits included performing procedures to assess the risks of material misstatement of the consolidated financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the consolidated financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the consolidated financial statements. We believe that our audits provide a reasonable basis for our opinion. Critical Audit Matters The critical audit matters communicated below are matters arising from the current period audit of the consolidated financial statements that were communicated or required to be communicated to the audit committee and that (i) relate to accounts or disclosures that are material to the consolidated financial statements and (ii) involved our especially challenging, subjective, or complex judgments. The communication of critical audit matters does not alter in any way our opinion on the consolidated financial statements, taken as a whole, and we are not, by communicating the critical audit matters below, providing separate opinions on the critical audit matters or on the accounts or disclosures to which they relate. 191Accounting for the Effects of Cost-Based Regulation As described in Notes 1 and 5 to the consolidated financial statements, the Company’s consolidated financial statements reflect the actions of regulators that result in the recognition of certain revenues and expenses in different time periods than enterprises that are not rate-regulated. Regulatory assets (deferred expenses) and regulatory liabilities (deferred future revenue reductions or refunds) are recorded to reflect the economic effects of regulation in the same accounting period by matching expenses with their recovery through regulated revenues and matching income with its passage to customers in cost-based regulated rates. Management reviews the probability of recovery of regulatory assets and refund of regulatory liabilities at each balance sheet date and whenever new events occur, whether influenced by issuance of regulatory commission orders, passage of new legislation, or changes in the regulatory environment. As of December 31, 2020, there were $385.8 million of deferred costs included in regulatory assets, $8.4 million of which were pending final regulatory approval, and $1,009.1 million of regulatory liabilities awaiting potential refund or future rate reduction, $0.2 million of which were pending final regulatory determination. The principal considerations for our determination that performing procedures relating to the accounting for the effects of cost-based regulation is a critical audit matter are the significant judgment by management in the ongoing evaluation of the recovery of regulatory assets and refund of regulatory liabilities, and applying guidance contained in rate orders and other relevant evidence; which in turn led to significant audit effort and a high degree of auditor subjectivity in performing procedures and in evaluating audit evidence relating to management’s judgments about the probability of recovery of regulatory assets and refund of regulatory liabilities. Addressing the matter involved performing procedures and evaluating audit evidence in connection with forming our overall opinion on the consolidated financial statements. These procedures included testing the effectiveness of controls relating to management’s assessment of regulatory proceedings, including the probability of recovery of regulatory assets and refund of regulatory liabilities. These procedures also included, among others, evaluating the reasonableness of management’s assessment of probability of future recovery for regulatory assets and refund of regulatory liabilities. Testing of regulatory assets and liabilities, including those subject to pending rate cases, also involved evaluating the provisions and formulas outlined in rate orders, other regulatory correspondence, and application of regulatory precedents. Valuation of Level 3 Risk Management Commodity Contracts As described in Notes 1, 10 and 11 to the consolidated financial statements, the Company employs risk management commodity contracts including physical and financial forward purchase-and-sale contracts and, to a lesser extent, over-the-counter swaps and options to accomplish its risk management strategies. Certain over-the-counter and bilaterally executed derivative instruments are executed in less active markets with a lower availability of pricing information. The fair value of these risk management commodity contracts is estimated based on available market information including valuation models that estimate future energy prices based on existing market and broker quotes, and other assumptions. Fair value estimates involve significant uncertainties and matters of significant judgement including future commodity prices and future price volatility. The main driver of contracts being classified as Level 3 is the inability to substantiate energy price curves in the market. Management utilized such unobservable pricing data to value its Level 3 risk management commodity contract liabilities, which totaled $110.3million, as of December 31, 2020. The principal considerations for our determination that performing procedures relating to the valuation of Level 3 risk management commodity contracts is a critical audit matter are the significant judgment and estimation by management when developing the fair value of the commodity contracts; which in turn led to significant audit effort and a high degree of auditor subjectivity in performing procedures and in evaluating audit evidence relating to the unobservable assumptions for projections of future commodity prices and future price volatilities used within management’s discounted cash flow models. In addition, the audit effort involved the use of professionals with specialized skill and knowledge to assist in performing these procedures and evaluating the audit evidence obtained. 192Addressing the matter involved performing procedures and evaluating audit evidence in connection with forming our overall opinion on the consolidated financial statements. These procedures included testing the effectiveness of controls relating to management’s valuation of the risk management commodity contracts, including controls over the assumptions used to value the Level 3 risk management commodity contracts. These procedures also included, among others, testing the data used in and management’s process for developing the fair value of the Level 3 risk management commodity contracts. Professionals with specialized skill and knowledge were used to assist in evaluating the appropriateness of the discounted cash flow models and reasonableness of the future commodity prices and future price volatilities assumptions. /s/ PricewaterhouseCoopers LLPColumbus, Ohio February 25, 2021 We have served as the Company's auditor since 2017. 193MANAGEMENT’S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTINGThe management of Ohio Power Company and Subsidiaries (OPCo) is responsible for establishing and maintaining adequate internal control over financial reporting as such term is defined in Rule 13a-15(f) and 15d-15(f) under the Securities Exchange Act of 1934, as amended. OPCo’s internal control is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles.Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.Management assessed the effectiveness of OPCo’s internal control over financial reporting as of December 31, 2020. In making this assessment, management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control – Integrated Framework (2013). Based on management’s assessment, management concluded OPCo’s internal control over financial reporting was effective as of December 31, 2020.This annual report does not include an audit report from PricewaterhouseCoopers LLP, OPCo’s registered public accounting firm regarding internal control over financial reporting pursuant to the Securities and Exchange Commission rules that permit OPCo to provide only management’s report in this annual report.194OHIO POWER COMPANY AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF INCOME For the Years Ended December 31, 2020, 2019 and 2018 (in millions)Years Ended December 31,202020192018REVENUESElectricity, Transmission and Distribution$2,698.6 $2,759.5 $3,033.8 Sales to AEP Affiliates41.5 27.3 21.0 Other Revenues9.0 10.8 8.6 TOTAL REVENUES2,749.1 2,797.6 3,063.4 EXPENSESPurchased Electricity for Resale549.2 607.3 684.6 Purchased Electricity from AEP Affiliates119.7 156.0 135.3 Amortization of Generation Deferrals— 65.3 223.9 Other Operation822.6 742.6 771.3 Maintenance127.1 150.1 156.0 Depreciation and Amortization276.6 240.9 259.7 Taxes Other Than Income Taxes450.2 434.2 412.8 TOTAL EXPENSES2,345.4 2,396.4 2,643.6 OPERATING INCOME403.7 401.2 419.8 Other Income (Expense):Interest Income1.0 3.2 3.4 Carrying Costs Income1.6 1.0 1.7 Allowance for Equity Funds Used During Construction12.5 18.2 9.8 Non-Service Cost Components of Net Periodic Benefit Cost15.0 14.6 15.5 Interest Expense(117.2)(106.2)(100.7)INCOME BEFORE INCOME TAX EXPENSE316.6 332.0 349.5 Income Tax Expense45.2 34.9 24.0 NET INCOME$271.4 $297.1 $325.5 The common stock of OPCo is wholly-owned by Parent.See Notes to Financial Statements of Registrants beginning on page 229.195OHIO POWER COMPANY AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)For the Years Ended December 31, 2020, 2019 and 2018 (in millions)Years Ended December 31,202020192018Net Income$271.4 $297.1 $325.5 OTHER COMPREHENSIVE LOSS, NET OF TAXESCash Flow Hedges, Net of Tax of $0, $(0.3) and $(0.4) in 2020, 2019 and 2018, Respectively— (1.0)(1.3)TOTAL COMPREHENSIVE INCOME$271.4 $296.1 $324.2 See Notes to Financial Statements of Registrants beginning on page 229.196OHIO POWER COMPANY AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF CHANGES IN COMMON SHAREHOLDER’S EQUITYFor the Years Ended December 31, 2020, 2019 and 2018 (in millions)CommonStockPaid-inCapitalRetained EarningsAccumulatedOtherComprehensiveIncome (Loss)TotalTOTAL COMMON SHAREHOLDER’S EQUITY – DECEMBER 31, 2017$321.2 $838.8 $1,148.4 $1.9 $2,310.3 Common Stock Dividends(337.5)(337.5)ASU 2018-02 Adoption0.4 0.4 Net Income325.5 325.5 Other Comprehensive Loss(1.3)(1.3)TOTAL COMMON SHAREHOLDER’S EQUITY – DECEMBER 31, 2018321.2 838.8 1,136.4 1.0 2,297.4 Common Stock Dividends(85.0)(85.0)Net Income297.1 297.1 Other Comprehensive Loss(1.0)(1.0)TOTAL COMMON SHAREHOLDER’S EQUITY – DECEMBER 31, 2019321.2 838.8 1,348.5 — 2,508.5 Common Stock Dividends(87.5)(87.5)ASU 2016-13 Adoption0.3 0.3 Net Income271.4 271.4 TOTAL COMMON SHAREHOLDER’S EQUITY – DECEMBER 31, 2020$321.2 $838.8 $1,532.7 $— $2,692.7 See Notes to Financial Statements of Registrants beginning on page 229.197OHIO POWER COMPANY AND SUBSIDIARIESCONSOLIDATED BALANCE SHEETSASSETSDecember 31, 2020 and 2019 (in millions)December 31,20202019CURRENT ASSETSCash and Cash Equivalents$7.4 $3.7 Accounts Receivable:Customers50.0 53.0 Affiliated Companies65.1 59.3 Accrued Unbilled Revenues14.8 20.3 Miscellaneous3.9 0.5 Allowance for Uncollectible Accounts(0.6)(0.7)Total Accounts Receivable133.2 132.4 Materials and Supplies66.9 52.3 Renewable Energy Credits29.5 30.9 Prepayments and Other Current Assets19.3 19.2 TOTAL CURRENT ASSETS256.3 238.5 PROPERTY, PLANT AND EQUIPMENTElectric:Transmission2,831.9 2,686.3 Distribution5,708.3 5,323.5 Other Property, Plant and Equipment899.6 765.8 Construction Work in Progress362.3 394.4 Total Property, Plant and Equipment9,802.1 9,170.0 Accumulated Depreciation and Amortization2,350.0 2,263.0 TOTAL PROPERTY, PLANT AND EQUIPMENT – NET7,452.1 6,907.0 OTHER NONCURRENT ASSETSRegulatory Assets385.8 351.8 Deferred Charges and Other Noncurrent Assets616.2 546.3 TOTAL OTHER NONCURRENT ASSETS1,002.0 898.1 TOTAL ASSETS$8,710.4 $8,043.6 See Notes to Financial Statements of Registrants beginning on page 229.198OHIO POWER COMPANY AND SUBSIDIARIESCONSOLIDATED BALANCE SHEETSLIABILITIES AND COMMON SHAREHOLDER’S EQUITYDecember 31, 2020 and 2019 (dollars in millions)December 31,20202019CURRENT LIABILITIESAdvances from Affiliates$259.2 $131.0 Accounts Payable:General181.0 233.7 Affiliated Companies118.4 103.6 Long-term Debt Due Within One Year – Nonaffiliated500.1 0.1 Risk Management Liabilities8.7 7.3 Customer Deposits55.1 70.6 Accrued Taxes631.0 587.9 Obligations Under Operating Leases13.1 12.5 Other Current Liabilities139.6 151.2 TOTAL CURRENT LIABILITIES1,906.2 1,297.9 NONCURRENT LIABILITIESLong-term Debt – Nonaffiliated1,930.1 2,081.9 Long-term Risk Management Liabilities101.6 96.3 Deferred Income Taxes955.1 849.4 Regulatory Liabilities and Deferred Investment Tax Credits1,005.2 1,090.9 Obligations Under Operating Leases79.5 76.0 Deferred Credits and Other Noncurrent Liabilities40.0 42.7 TOTAL NONCURRENT LIABILITIES4,111.5 4,237.2 TOTAL LIABILITIES6,017.7 5,535.1 Rate Matters (Note 4)Commitments and Contingencies (Note 6)COMMON SHAREHOLDER'S EQUITYCommon Stock – No Par Value:Authorized – 40,000,000 SharesOutstanding – 27,952,473 Shares321.2 321.2 Paid-in Capital838.8 838.8 Retained Earnings1,532.7 1,348.5 TOTAL COMMON SHAREHOLDER’S EQUITY2,692.7 2,508.5 TOTAL LIABILITIES AND COMMON SHAREHOLDER'S EQUITY$8,710.4 $8,043.6 See Notes to Financial Statements of Registrants beginning on page 229.199OHIO POWER COMPANY AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF CASH FLOWSFor the Years Ended December 31, 2020, 2019 and 2018 (in millions)Years Ended December 31,202020192018OPERATING ACTIVITIESNet Income$271.4 $297.1 $325.5 Adjustments to Reconcile Net Income to Net Cash Flows from Operating Activities:Depreciation and Amortization276.6 240.9 259.7 Amortization of Generation Deferrals— 65.3 223.9 Deferred Income Taxes77.2 43.8 (36.2)Allowance for Equity Funds Used During Construction(12.5)(18.2)(9.8)Mark-to-Market of Risk Management Contracts6.7 4.0 (32.2)Property Taxes(16.6)(33.7)(12.5)Refund of Global Settlement— (16.5)(5.5)Reversal of Regulatory Provision— (56.2)— Change in Regulatory Assets(69.4)(20.1)171.5 Change in Other Noncurrent Assets(49.4)(35.3)(11.5)Change in Other Noncurrent Liabilities(66.4)(93.2)53.8 Changes in Certain Components of Working Capital:Accounts Receivable, Net4.2 75.0 43.1 Materials and Supplies(23.9)(16.4)(11.3)Accounts Payable10.3 0.4 (13.8)Accrued Taxes, Net43.3 38.7 26.8 Other Current Assets1.9 0.8 8.1 Other Current Liabilities(42.5)(55.2)49.1 Net Cash Flows from Operating Activities410.9 421.2 1,028.7 INVESTING ACTIVITIESConstruction Expenditures(813.2)(799.2)(725.9)Other Investing Activities22.2 55.1 18.4 Net Cash Flows Used for Investing Activities(791.0)(744.1)(707.5)FINANCING ACTIVITIESIssuance of Long-term Debt – Nonaffiliated347.0 444.3 392.8 Change in Advances from Affiliates, Net128.2 16.9 26.3 Retirement of Long-term Debt – Nonaffiliated(0.1)(80.3)(397.1)Principal Payments for Finance Lease Obligations(4.7)(3.5)(3.8)Dividends Paid on Common Stock(87.5)(85.0)(337.5)Other Financing Activities0.9 1.7 0.9 Net Cash Flows from (Used for) Financing Activities383.8 294.1 (318.4)Net Increase (Decrease) in Cash, Cash Equivalents and Restricted Cash for Securitized Funding3.7 (28.8)2.8 Cash, Cash Equivalents and Restricted Cash for Securitized Funding at Beginning of Period3.7 32.5 29.7 Cash, Cash Equivalents and Restricted Cash for Securitized Funding at End of Period$7.4 $3.7 $32.5 SUPPLEMENTARY INFORMATIONCash Paid for Interest, Net of Capitalized Amounts$111.2 $100.6 $97.1 Net Cash Paid (Received) for Income Taxes(26.9)7.3 51.3 Noncash Acquisitions Under Finance Leases6.1 11.3 4.4 Construction Expenditures Included in Current Liabilities as of December 31,76.7 125.9 98.2 See Notes to Financial Statements of Registrants beginning on page 229.200PUBLIC SERVICE COMPANY OF OKLAHOMA201PUBLIC SERVICE COMPANY OF OKLAHOMAMANAGEMENT’S NARRATIVE DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONSCOMPANY OVERVIEWAs a public utility, PSO engages in the generation and purchase of electric power, and the subsequent sale, transmission and distribution of that power to approximately 565,000 retail customers in its service territory in eastern and southwestern Oklahoma. PSO sells electric power at wholesale to other utilities, municipalities and electric cooperatives.202RESULTS OF OPERATIONSKWh Sales/Degree DaysSummary of KWh Energy SalesYears Ended December 31,202020192018(in millions of KWhs)Retail:Residential6,117 6,273 6,452 Commercial4,673 4,958 5,005 Industrial5,713 6,156 6,120 Miscellaneous1,199 1,246 1,263 Total Retail17,702 18,633 18,840 Wholesale345 714 758 Total KWhs18,047 19,347 19,598 Heating degree days and cooling degree days are metrics commonly used in the utility industry as a measure of the impact of weather on revenues.Summary of Heating and Cooling Degree DaysYears Ended December 31,202020192018(in degree days)Actual – Heating (a)1,454 1,846 1,886 Normal – Heating (b)1,744 1,751 1,752 Actual – Cooling (c)2,069 2,265 2,445 Normal – Cooling (b)2,174 2,160 2,149 (a)Heating degree days are calculated on a 55 degree temperature base.(b)Normal Heating/Cooling represents the thirty-year average of degree days.(c)Cooling degree days are calculated on a 65 degree temperature base.2032020 Compared to 2019 Reconciliation of Year Ended December 31, 2019 to Year Ended December 31, 2020 Net Income(in millions)Year Ended December 31, 2019$137.6 Changes in Gross Margin:Retail Margins (a)(14.0)Margins from Off-system Sales(1.6)Transmission Revenues1.9 Other Revenues8.5 Total Change in Gross Margin(5.2)Changes in Expenses and Other:Other Operation and Maintenance(10.0)Depreciation and Amortization(4.0)Taxes Other Than Income Taxes(4.2)Interest Income(1.1)Allowance for Funds Used During Construction1.3 Non-Service Cost Components of Net Periodic Benefit Cost0.1 Interest Expense6.2 Total Change in Expenses and Other(11.7)Income Tax Expense2.3 Year Ended December 31, 2020$123.0 (a)Includes firm wholesale sales to municipals and cooperatives.The major components of the decrease in Gross Margin, defined as revenues less the related direct cost of fuel, including consumption of chemicals and emissions allowances, and purchased electricity were as follows:•Retail Margins decreased $14 million primarily due to the following:•A $15 million decrease in weather-related usage due to a 21% decrease in heating degree days and a 9% decrease in cooling degree days.•A $13 million decrease in revenue from rate riders. This decrease was partially offset in other expense items below. •An $8 million decrease due to customer refunds related to Tax Reform. This decrease is partially offset in Income Tax Expense. These decreases were partially offset by:•An $11 million increase in weather-normalized margins primarily in the residential class.•A $10 million increase due to new base rates implemented in April 2019.•Other Revenues increased $9 million primarily due to business development revenue. This increase was offset in other expense items below. Expenses and Other changed between years as follows:•Other Operation and Maintenance expenses increased $10 million primarily due to the following:•A $20 million increase in transmission expenses primarily due to the annual transmission formula rate true-up. This increase was partially offset in Retail Margins above.•A $9 million increase in business development expenses. This increase was offset in Other Revenues above.•A $6 million increase in customer-related expenses primarily related to energy efficiency programs. This increase was partially offset in Retail Margins above. 204 These increases were partially offset by:•A $7 million decrease in administrative and general expenses primarily due to the receipt of an insurance settlement.•A $6 million decrease due to the capitalization of previously expensed North Central Wind Energy Facilities costs.•A $4 million decrease in expenses at various generation plants.•A $3 million decrease due to a charitable contribution to the AEP Foundation in 2019.•A $3 million decrease in fees for factoring accounts receivable.•Depreciation and Amortization expenses increased $4 million primarily due to higher a depreciable base.•Taxes Other Than Income Taxes increased $4 million primarily due to increased property taxes.•Interest Expense decreased $6 million primarily due to lower interest rates on long-term debt.205REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRMTo the Board of Directors and Shareholder of Public Service Company of Oklahoma Opinion on the Financial Statements We have audited the accompanying balance sheets of Public Service Company of Oklahoma (the “Company”) as of December 31, 2020 and 2019, and the related statements of income, of comprehensive income (loss), of changes in common shareholder's equity and of cash flows for each of the three years in the period ended December 31, 2020, including the related notes (collectively referred to as the “financial statements”). In our opinion, the financial statements present fairly, in all material respects, the financial position of the Company as of December 31, 2020 and 2019, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2020 in conformity with accounting principles generally accepted in the United States of America. Change in Accounting Principle As discussed in Note 13 to the financial statements, the Company changed the manner in which it accounts for leases in 2019. Basis for Opinion These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on the Company’s financial statements based on our audits. We are a public accounting firm registered with the Public Company Accounting Oversight Board (United States) (PCAOB) and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB. We conducted our audits of these financial statements in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether due to error or fraud. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. As part of our audits we are required to obtain an understanding of internal control over financial reporting but not for the purpose of expressing an opinion on the effectiveness of the Company's internal control over financial reporting. Accordingly, we express no such opinion. Our audits included performing procedures to assess the risks of material misstatement of the financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements. We believe that our audits provide a reasonable basis for our opinion. Critical Audit Matters The critical audit matter communicated below is a matter arising from the current period audit of the financial statements that was communicated or required to be communicated to the audit committee and that (i) relates to accounts or disclosures that are material to the financial statements and (ii) involved our especially challenging, subjective, or complex judgments. The communication of critical audit matters does not alter in any way our opinion on the financial statements, taken as a whole, and we are not, by communicating the critical audit matter below, providing a separate opinion on the critical audit matter or on the accounts or disclosures to which it relates. 206Accounting for the Effects of Cost-Based Regulation As described in Notes 1 and 5 to the financial statements, the Company’s financial statements reflect the actions of regulators that result in the recognition of certain revenues and expenses in different time periods than enterprises that are not rate-regulated. Regulatory assets (deferred expenses) and regulatory liabilities (deferred future revenue reductions or refunds) are recorded to reflect the economic effects of regulation in the same accounting period by matching expenses with their recovery through regulated revenues and matching income with its passage to customers in cost-based regulated rates. Management reviews the probability of recovery of regulatory assets and refund of regulatory liabilities at each balance sheet date and whenever new events occur, whether influenced by issuance of regulatory commission orders, passage of new legislation, or changes in the regulatory environment. As of December 31, 2020, there were $405.1 million of deferred costs included in regulatory assets, $50.5 million of which were pending final regulatory approval, and $802.2 million of regulatory liabilities awaiting potential refund or future rate reduction. The principal considerations for our determination that performing procedures relating to the accounting for the effects of cost-based regulation is a critical audit matter are the significant judgment by management in the ongoing evaluation of the recovery of regulatory assets and refund of regulatory liabilities, and applying guidance contained in rate orders and other relevant evidence; which in turn led to significant audit effort and a high degree of auditor subjectivity in performing procedures and in evaluating audit evidence relating to management’s judgments about the probability of recovery of regulatory assets and refund of regulatory liabilities. Addressing the matter involved performing procedures and evaluating audit evidence in connection with forming our overall opinion on the financial statements. These procedures included testing the effectiveness of controls relating to management’s assessment of regulatory proceedings, including the probability of recovery of regulatory assets and refund of regulatory liabilities. These procedures also included, among others, evaluating the reasonableness of management’s assessment of probability of future recovery for regulatory assets and refund of regulatory liabilities. Testing of regulatory assets and liabilities, including those subject to pending rate cases, also involved evaluating the provisions and formulas outlined in rate orders, other regulatory correspondence, and application of regulatory precedents. /s/ PricewaterhouseCoopers LLPColumbus, Ohio February 25, 2021 We have served as the Company's auditor since 2017. 207MANAGEMENT’S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTINGThe management of Public Service Company of Oklahoma (PSO) is responsible for establishing and maintaining adequate internal control over financial reporting as such term is defined in Rule 13a-15(f) and 15d-15(f) under the Securities Exchange Act of 1934, as amended. PSO’s internal control is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles.Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.Management assessed the effectiveness of PSO’s internal control over financial reporting as of December 31, 2020. In making this assessment, management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control – Integrated Framework (2013). Based on management’s assessment, management concluded PSO’s internal control over financial reporting was effective as of December 31, 2020.This annual report does not include an audit report from PricewaterhouseCoopers LLP, PSO’s registered public accounting firm regarding internal control over financial reporting pursuant to the Securities and Exchange Commission rules that permit PSO to provide only management’s report in this annual report.208PUBLIC SERVICE COMPANY OF OKLAHOMASTATEMENTS OF INCOME For the Years Ended December 31, 2020, 2019 and 2018 (in millions)Years Ended December 31,202020192018REVENUESElectric Generation, Transmission and Distribution$1,246.1 $1,469.6 $1,537.6 Sales to AEP Affiliates5.2 6.1 5.4 Other Revenues14.8 6.1 4.3 TOTAL REVENUES1,266.1 1,481.8 1,547.3 EXPENSESFuel and Other Consumables Used for Electric Generation15.6 195.1 240.5 Purchased Electricity for Resale427.9 458.9 479.9 Other Operation327.3 315.0 372.8 Maintenance98.4 100.7 104.8 Depreciation and Amortization173.5 169.5 164.0 Taxes Other Than Income Taxes47.5 43.3 42.8 TOTAL EXPENSES1,090.2 1,282.5 1,404.8 OPERATING INCOME175.9 199.3 142.5 Other Income (Expense):Interest Income0.1 1.2 0.1 Allowance for Equity Funds Used During Construction4.0 2.7 0.4 Non-Service Cost Components of Net Periodic Benefit Cost8.5 8.4 8.7 Interest Expense(60.3)(66.5)(63.5)INCOME BEFORE INCOME TAX EXPENSE128.2 145.1 88.2 Income Tax Expense5.2 7.5 5.0 NET INCOME$123.0 $137.6 $83.2 The common stock of PSO is wholly-owned by Parent.See Notes to Financial Statements of Registrants beginning on page 229.209PUBLIC SERVICE COMPANY OF OKLAHOMASTATEMENTS OF COMPREHENSIVE INCOME (LOSS)For the Years Ended December 31, 2020, 2019 and 2018 (in millions)Years Ended December 31,202020192018Net Income$123.0 $137.6 $83.2 OTHER COMPREHENSIVE LOSS, NET OF TAXESCash Flow Hedges, Net of Tax of $(0.3), $(0.3) and $(0.3) in 2020, 2019 and 2018, Respectively(1.0)(1.0)(1.0)TOTAL COMPREHENSIVE INCOME$122.0 $136.6 $82.2 See Notes to Financial Statements of Registrants beginning on page 229.210PUBLIC SERVICE COMPANY OF OKLAHOMASTATEMENTS OF CHANGES IN COMMON SHAREHOLDER’S EQUITYFor the Years Ended December 31, 2020, 2019 and 2018 (in millions)CommonStockPaid-inCapitalRetained EarningsAccumulatedOtherComprehensiveIncome (Loss)TotalTOTAL COMMON SHAREHOLDER’S EQUITY – DECEMBER 31, 2017$157.2 $364.0 $691.5 $2.6 $1,215.3 Common Stock Dividends(50.0)(50.0)ASU 2018-02 Adoption0.5 0.5 Net Income83.2 83.2 Other Comprehensive Loss(1.0)(1.0)TOTAL COMMON SHAREHOLDER’S EQUITY – DECEMBER 31, 2018157.2 364.0 724.7 2.1 1,248.0 Common Stock Dividends(11.3)(11.3)Net Income137.6 137.6 Other Comprehensive Loss(1.0)(1.0)TOTAL COMMON SHAREHOLDER’S EQUITY – DECEMBER 31, 2019157.2 364.0 851.0 1.1 1,373.3 Capital Contribution of Radial Assets from Parent50.0 50.0 ASU 2016-13 Adoption0.3 0.3 Net Income123.0 123.0 Other Comprehensive Loss(1.0)(1.0)TOTAL COMMON SHAREHOLDER’S EQUITY – DECEMBER 31, 2020$157.2 $414.0 $974.3 $0.1 $1,545.6 See Notes to Financial Statements of Registrants beginning on page 229.211PUBLIC SERVICE COMPANY OF OKLAHOMABALANCE SHEETSASSETSDecember 31, 2020 and 2019 (in millions)December 31,20202019CURRENT ASSETSCash and Cash Equivalents$2.6 $1.5 Advances to Affiliates— 38.8 Accounts Receivable:Customers30.8 28.9 Affiliated Companies15.6 20.6 Miscellaneous2.0 0.6 Allowance for Uncollectible Accounts— (0.3)Total Accounts Receivable48.4 49.8 Fuel17.9 12.2 Materials and Supplies54.0 46.8 Risk Management Assets10.3 15.8 Accrued Tax Benefits10.9 11.3 Regulatory Asset for Under-Recovered Fuel Costs30.1 — Prepayments and Other Current Assets7.1 12.0 TOTAL CURRENT ASSETS181.3 188.2 PROPERTY, PLANT AND EQUIPMENTElectric:Generation1,480.7 1,574.6 Transmission1,069.9 948.5 Distribution2,853.0 2,684.8 Other Property, Plant and Equipment393.3 342.1 Construction Work in Progress128.7 133.4 Total Property, Plant and Equipment5,925.6 5,683.4 Accumulated Depreciation and Amortization1,605.6 1,580.1 TOTAL PROPERTY, PLANT AND EQUIPMENT – NET4,320.0 4,103.3 OTHER NONCURRENT ASSETSRegulatory Assets375.0 375.2 Employee Benefits and Pension Assets65.8 43.9 Operating Lease Assets42.6 36.8 Deferred Charges and Other Noncurrent Assets6.0 4.1 TOTAL OTHER NONCURRENT ASSETS489.4 460.0 TOTAL ASSETS$4,990.7 $4,751.5 See Notes to Financial Statements of Registrants beginning on page 229.212PUBLIC SERVICE COMPANY OF OKLAHOMABALANCE SHEETSLIABILITIES AND COMMON SHAREHOLDER’S EQUITYDecember 31, 2020 and 2019 December 31,20202019(in millions)CURRENT LIABILITIESAdvances from Affiliates$155.4 $— Accounts Payable:General107.0 134.3 Affiliated Companies43.4 59.3 Long-term Debt Due Within One Year – Nonaffiliated0.5 13.2 Customer Deposits54.8 58.9 Accrued Taxes26.8 22.9 Obligations Under Operating Leases6.5 5.8 Regulatory Liability for Over-Recovered Fuel Costs— 63.9 Other Current Liabilities84.2 87.5 TOTAL CURRENT LIABILITIES478.6 445.8 NONCURRENT LIABILITIESLong-term Debt – Nonaffiliated1,373.3 1,373.0 Deferred Income Taxes688.5 628.3 Regulatory Liabilities and Deferred Investment Tax Credits802.2 837.2 Asset Retirement Obligations45.7 44.5 Obligations Under Operating Leases36.2 31.0 Deferred Credits and Other Noncurrent Liabilities20.6 18.4 TOTAL NONCURRENT LIABILITIES2,966.5 2,932.4 TOTAL LIABILITIES3,445.1 3,378.2 Rate Matters (Note 4)Commitments and Contingencies (Note 6)COMMON SHAREHOLDER’S EQUITYCommon Stock – Par Value – $15 Per Share:Authorized – 11,000,000 SharesIssued – 10,482,000 SharesOutstanding – 9,013,000 Shares157.2 157.2 Paid-in Capital414.0 364.0 Retained Earnings974.3 851.0 Accumulated Other Comprehensive Income (Loss)0.1 1.1 TOTAL COMMON SHAREHOLDER’S EQUITY1,545.6 1,373.3 TOTAL LIABILITIES AND COMMON SHAREHOLDER’S EQUITY$4,990.7 $4,751.5 See Notes to Financial Statements of Registrants beginning on page 229.213PUBLIC SERVICE COMPANY OF OKLAHOMASTATEMENTS OF CASH FLOWSFor the Years Ended December 31, 2020, 2019 and 2018 (in millions)Years Ended December 31,202020192018OPERATING ACTIVITIESNet Income$123.0 $137.6 $83.2 Adjustments to Reconcile Net Income to Net Cash Flows from Operating Activities:Depreciation and Amortization173.5 169.5 164.0 Deferred Income Taxes17.0 (18.2)(31.1)Allowance for Equity Funds Used During Construction(4.0)(2.7)(0.4)Mark-to-Market of Risk Management Contracts5.5 (6.4)(3.0)Deferred Fuel Over/Under-Recovery, Net(94.0)43.8 57.4 Change in Other Noncurrent Assets(17.9)5.7 — Change in Other Noncurrent Liabilities1.6 (7.3)21.4 Changes in Certain Components of Working Capital:Accounts Receivable, Net1.4 15.4 5.1 Fuel, Materials and Supplies(14.1)(1.9)(2.6)Accounts Payable(29.5)7.0 17.7 Accrued Taxes, Net3.6 3.9 13.2 Other Current Assets4.6 (0.7)(0.8)Other Current Liabilities(13.7)4.6 6.4 Net Cash Flows from Operating Activities157.0 350.3 330.5 INVESTING ACTIVITIESConstruction Expenditures(337.9)(291.9)(240.2)Change in Advances to Affiliates, Net38.8 (38.8)— Other Investing Activities4.0 2.6 7.2 Net Cash Flows Used for Investing Activities(295.1)(328.1)(233.0)FINANCING ACTIVITIESIssuance of Long-term Debt – Nonaffiliated— 349.5 — Change in Advances from Affiliates, Net155.4 (105.5)(44.1)Retirement of Long-term Debt – Nonaffiliated(13.2)(250.5)(0.5)Principal Payments for Finance Lease Obligations(3.5)(3.1)(3.3)Dividends Paid on Common Stock— (11.3)(50.0)Other Financing Activities0.5 (1.8)0.8 Net Cash Flows from (Used for) Financing Activities139.2 (22.7)(97.1)Net Increase (Decrease) in Cash and Cash Equivalents1.1 (0.5)0.4 Cash and Cash Equivalents at Beginning of Period1.5 2.0 1.6 Cash and Cash Equivalents at End of Period$2.6 $1.5 $2.0 SUPPLEMENTARY INFORMATIONCash Paid for Interest, Net of Capitalized Amounts$59.1 $61.1 $62.0 Net Cash Paid (Received) for Income Taxes(11.8)22.4 17.9 Noncash Acquisitions Under Finance Leases3.2 5.3 4.3 Construction Expenditures Included in Current Liabilities as of December 31,35.5 46.0 33.2 Noncash Contribution of Radial Assets from Parent50.0 — — See Notes to Financial Statements of Registrants beginning on page 229.214SOUTHWESTERN ELECTRIC POWER COMPANY CONSOLIDATED215SOUTHWESTERN ELECTRIC POWER COMPANY CONSOLIDATEDMANAGEMENT’S NARRATIVE DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONSCOMPANY OVERVIEWAs a public utility, SWEPCo engages in the generation and purchase of electric power, and the subsequent sale, transmission and distribution of that power to approximately 545,000 retail customers in its service territory in northeastern and the panhandle of Texas, northwestern Louisiana and western Arkansas. SWEPCo consolidates its wholly-owned subsidiary, Southwest Arkansas Utilities Corporation. SWEPCo also consolidates Sabine Mining Company, a VIE. SWEPCo sells electric power at wholesale to other utilities, municipalities and electric cooperatives.216RESULTS OF OPERATIONSKWh Sales/Degree DaysSummary of KWh Energy SalesYears Ended December 31,202020192018(in millions of KWhs)Retail:Residential5,988 6,303 6,564 Commercial5,296 5,776 5,911 Industrial4,891 5,337 5,391 Miscellaneous79 80 79 Total Retail16,254 17,496 17,945 Wholesale5,838 6,791 7,071 Total KWhs22,092 24,287 25,016 Heating degree days and cooling degree days are metrics commonly used in the utility industry as a measure of the impact of weather on revenues.Summary of Heating and Cooling Degree DaysYears Ended December 31,202020192018(in degree days)Actual – Heating (a)862 1,174 1,308 Normal – Heating (b)1,181 1,191 1,195 Actual – Cooling (c)2,165 2,392 2,560 Normal – Cooling (b)2,333 2,321 2,311 (a)Heating degree days are calculated on a 55 degree temperature base.(b)Normal Heating/Cooling represents the thirty-year average of degree days.(c)Cooling degree days are calculated on a 65 degree temperature base.2172020 Compared to 2019 Reconciliation of Year Ended December 31, 2019 to Year Ended December 31, 2020 Earnings Attributable to SWEPCo Common Shareholder(in millions)Year Ended December 31, 2019$158.6 Changes in Gross Margin:Retail Margins (a)(14.9)Margins from Off-system Sales(0.1)Transmission Revenues52.8 Other Revenues(2.4)Total Change in Gross Margin35.4 Changes in Expenses and Other:Other Operation and Maintenance25.6 Depreciation and Amortization(23.6)Taxes Other Than Income Taxes(2.6)Interest Income(0.5)Allowance for Equity Funds Used During Construction0.9 Non-Service Cost Components of Net Periodic Benefit Cost(0.1)Interest Expense0.6 Total Change in Expenses and Other0.3 Income Tax Expense(14.1)Equity Earnings of Unconsolidated Subsidiary(0.1)Net Income Attributable to Noncontrolling Interest0.7 Year Ended December 31, 2020$180.8 (a)Includes firm wholesale sales to municipals and cooperatives.The major components of the increase in Gross Margin, defined as revenues less the related direct cost of fuel, including consumption of chemicals and emissions allowances, and purchased electricity were as follows:•Retail Margins decreased $15 million primarily due to the following:•A $30 million decrease in weather-related usage primarily due to a 9% decrease in cooling degree days and a 27% decrease in heating degree days.•An $11 million decrease in weather-normalized margins primarily in the commercial and industrial classes, partially offset in the residential class.•An $11 million decrease in weather-normalized wholesale margins, including the loss of a wholesale contract.•A $10 million decrease due to a 2020 regulatory provision.These decreases were partially offset by:•A $45 million increase primarily due to rider increases in all jurisdictions and a base rate revenue increase in Arkansas. This increase was partially offset in other expense items below.•Transmission Revenues increased $53 million primarily due to the following:•A $31 million increase as a result of the annual transmission formula rate true-up. This increase was partially offset by an increase in transmission expenses in SPP. •A $22 million increase due to continued investment in transmission projects.218Expenses and Other and Income Tax Expense changed between years as follows:•Other Operation and Maintenance expenses decreased $26 million primarily due to the following:•A $10 million decrease in expenses at various generation plants.•A $10 million decrease in administrative and general expenses primarily due to an insurance settlement.•A $9 million decrease due to the capitalization of previously expensed North Central Wind Energy Facilities costs.•A $6 million decrease in customer-related expenses primarily in energy efficiency programs. This decrease was offset in Retail Margins above.•A $6 million decrease due to a charitable contribution to the AEP Foundation in 2019.These decreases were partially offset by:•A $19 million increase in SPP transmission expenses primarily due to the annual formula rate true-up. This increase was offset in Transmission Revenues above.•Depreciation and Amortization expenses increased $24 million primarily due to a higher depreciable base and an increase in Arkansas depreciation rates beginning in January 2020. This increase was partially offset in Retail Margins above.•Income Tax Expense increased $14 million primarily due to an increase in pretax book income and a decrease in Excess ADIT amortization. This decrease of Excess ADIT not subject to normalization requirements amortization was partially offset in Retail Margins above.219REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRMTo the Board of Directors and Shareholder of Southwestern Electric Power Company Opinion on the Financial Statements We have audited the accompanying consolidated balance sheets of Southwestern Electric Power Company and its subsidiaries (the “Company”) as of December 31, 2020 and 2019, and the related consolidated statements of income, of comprehensive income (loss), of changes in equity and of cash flows for each of the three years in the period ended December 31, 2020, including the related notes (collectively referred to as the “consolidated financial statements”). In our opinion, the consolidated financial statements present fairly, in all material respects, the financial position of the Company as of December 31, 2020 and 2019, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2020 in conformity with accounting principles generally accepted in the United States of America. Change in Accounting Principle As discussed in Note 13 to the consolidated financial statements, the Company changed the manner in which it accounts for leases in 2019. Basis for Opinion These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on the Company’s consolidated financial statements based on our audits. We are a public accounting firm registered with the Public Company Accounting Oversight Board (United States) (PCAOB) and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB. We conducted our audits of these consolidated financial statements in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement, whether due to error or fraud. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. As part of our audits we are required to obtain an understanding of internal control over financial reporting but not for the purpose of expressing an opinion on the effectiveness of the Company's internal control over financial reporting. Accordingly, we express no such opinion. Our audits included performing procedures to assess the risks of material misstatement of the consolidated financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the consolidated financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the consolidated financial statements. We believe that our audits provide a reasonable basis for our opinion. Critical Audit Matters The critical audit matter communicated below is a matter arising from the current period audit of the consolidated financial statements that was communicated or required to be communicated to the audit committee and that (i) relates to accounts or disclosures that are material to the consolidated financial statements and (ii) involved our especially challenging, subjective, or complex judgments. The communication of critical audit matters does not alter in any way our opinion on the consolidated financial statements, taken as a whole, and we are not, by communicating the critical audit matter below, providing a separate opinion on the critical audit matter or on the accounts or disclosures to which it relates. 220Accounting for the Effects of Cost-Based Regulation As described in Notes 1 and 5 to the consolidated financial statements, the Company’s consolidated financial statements reflect the actions of regulators that result in the recognition of certain revenues and expenses in different time periods than enterprises that are not rate-regulated. Regulatory assets (deferred expenses) and regulatory liabilities (deferred future revenue reductions or refunds) are recorded to reflect the economic effects of regulation in the same accounting period by matching expenses with their recovery through regulated revenues and matching income with its passage to customers in cost-based regulated rates. Management reviews the probability of recovery of regulatory assets and refund of regulatory liabilities at each balance sheet date and whenever new events occur, whether influenced by issuance of regulatory commission orders, passage of new legislation, or changes in the regulatory environment. As of December 31, 2020, there were $405.7 million of deferred costs included in regulatory assets, $247.3 million of which were pending final regulatory approval, and $901.0 million of regulatory liabilities awaiting potential refund or future rate reduction, $313.4 million of which were pending final regulatory determination. The principal considerations for our determination that performing procedures relating to the accounting for the effects of cost-based regulation is a critical audit matter are the significant judgment by management in the ongoing evaluation of the recovery of regulatory assets and refund of regulatory liabilities, and applying guidance contained in rate orders and other relevant evidence; which in turn led to significant audit effort and a high degree of auditor subjectivity in performing procedures and in evaluating audit evidence relating to management’s judgments about the probability of recovery of regulatory assets and refund of regulatory liabilities. Addressing the matter involved performing procedures and evaluating audit evidence in connection with forming our overall opinion on the consolidated financial statements. These procedures included testing the effectiveness of controls relating to management’s assessment of regulatory proceedings, including the probability of recovery of regulatory assets and refund of regulatory liabilities. These procedures also included, among others, evaluating the reasonableness of management’s assessment of probability of future recovery for regulatory assets and refund of regulatory liabilities. Testing of regulatory assets and liabilities, including those subject to pending rate cases, also involved evaluating the provisions and formulas outlined in rate orders, other regulatory correspondence, and application of regulatory precedents. /s/ PricewaterhouseCoopers LLPColumbus, Ohio February 25, 2021 We have served as the Company's auditor since 2017. 221MANAGEMENT’S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTINGThe management of Southwestern Electric Power Company Consolidated (SWEPCo) is responsible for establishing and maintaining adequate internal control over financial reporting as such term is defined in Rule 13a-15(f) and 15d-15(f) under the Securities Exchange Act of 1934, as amended. SWEPCo’s internal control is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles.Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.Management assessed the effectiveness of SWEPCo’s internal control over financial reporting as of December 31, 2020. In making this assessment, management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control – Integrated Framework (2013). Based on management’s assessment, management concluded SWEPCo’s internal control over financial reporting was effective as of December 31, 2020.This annual report does not include an audit report from PricewaterhouseCoopers LLP, SWEPCo’s registered public accounting firm regarding internal control over financial reporting pursuant to the Securities and Exchange Commission rules that permit SWEPCo to provide only management’s report in this annual report.222SOUTHWESTERN ELECTRIC POWER COMPANY CONSOLIDATEDCONSOLIDATED STATEMENTS OF INCOMEFor the Years Ended December 31, 2020, 2019 and 2018 (in millions)Years Ended December 31,202020192018REVENUESElectric Generation, Transmission and Distribution$1,696.6 $1,744.6 $1,791.9 Sales to AEP Affiliates41.0 36.9 35.1 Provision for Refund - Affiliated(2.0)(32.0)(6.7)Other Revenues2.9 1.4 1.6 TOTAL REVENUES1,738.5 1,750.9 1,821.9 EXPENSESFuel and Other Consumables Used for Electric Generation443.5 472.8 502.3 Purchased Electricity for Resale161.0 179.5 177.1 Other Operation338.3 348.0 384.2 Maintenance129.7 145.6 141.5 Depreciation and Amortization272.7 249.1 239.5 Taxes Other Than Income Taxes102.8 100.2 99.6 TOTAL EXPENSES1,448.0 1,495.2 1,544.2 OPERATING INCOME290.5 255.7 277.7 Other Income (Expense):Interest Income2.1 2.6 5.4 Allowance for Equity Funds Used During Construction7.7 6.8 6.0 Non-Service Cost Components of Net Periodic Benefit Cost8.4 8.5 8.7 Interest Expense(118.5)(119.1)(127.9)INCOME BEFORE INCOME TAX EXPENSE (BENEFIT) AND EQUITY EARNINGS190.2 154.5 169.9 Income Tax Expense (Benefit)9.4 (4.7)20.4 Equity Earnings of Unconsolidated Subsidiary2.9 3.0 2.7 NET INCOME183.7 162.2 152.2 Net Income Attributable to Noncontrolling Interest2.9 3.6 5.0 EARNINGS ATTRIBUTABLE TO SWEPCo COMMON SHAREHOLDER$180.8 $158.6 $147.2 The common stock of SWEPCo is wholly-owned by Parent.See Notes to Financial Statements of Registrants beginning on page 229.223SOUTHWESTERN ELECTRIC POWER COMPANY CONSOLIDATEDCONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)For the Years Ended December 31, 2020, 2019 and 2018 (in millions)Years Ended December 31,202020192018Net Income$183.7 $162.2 $152.2 OTHER COMPREHENSIVE INCOME (LOSS), NET OF TAXESCash Flow Hedges, Net of Tax of $0.4, $0.4 and $1.1 in 2020, 2019 and 2018, Respectively1.5 1.5 4.0 Amortization of Pension and OPEB Deferred Costs, Net of Tax of $(0.4), $(0.3) and $(0.4) in 2020, 2019 and 2018, Respectively(1.5)(1.1)(1.4)Pension and OPEB Funded Status, Net of Tax of $0.9, $1.0 and $(0.8) in 2020, 2019 and 2018, Respectively3.2 3.7 (3.1)TOTAL OTHER COMPREHENSIVE INCOME (LOSS)3.2 4.1 (0.5)TOTAL COMPREHENSIVE INCOME186.9 166.3 151.7 Total Comprehensive Income Attributable to Noncontrolling Interest2.9 3.6 5.0 TOTAL COMPREHENSIVE INCOME ATTRIBUTABLE TO SWEPCo COMMON SHAREHOLDER$184.0 $162.7 $146.7 See Notes to Financial Statements of Registrants beginning on page 229.224SOUTHWESTERN ELECTRIC POWER COMPANY CONSOLIDATEDCONSOLIDATED STATEMENTS OF CHANGES IN EQUITYFor the Years Ended December 31, 2020, 2019 and 2018 (in millions)SWEPCo Common ShareholderCommon StockPaid-inCapitalRetainedEarningsAccumulatedOtherComprehensiveIncome (Loss)NoncontrollingInterestTotalTOTAL EQUITY – DECEMBER 31, 2017$135.7 $676.6 $1,426.6 $(4.0)$(0.4)$2,234.5 Common Stock Dividends(65.0)(65.0)Common Stock Dividends – Nonaffiliated(4.3)(4.3)ASU 2018-02 Adoption(0.4)(0.9)(1.3)Net Income147.2 5.0 152.2 Other Comprehensive Loss(0.5)(0.5)TOTAL EQUITY – DECEMBER 31, 2018135.7 676.6 1,508.4 (5.4)0.3 2,315.6 Common Stock Dividends(37.5)(37.5)Common Stock Dividends – Nonaffiliated(3.3)(3.3)Net Income158.6 3.6 162.2 Other Comprehensive Income4.1 4.1 TOTAL EQUITY – DECEMBER 31, 2019135.7 676.6 1,629.5 (1.3)0.6 2,441.1 Reverse Common Stock Split (a)(135.6)135.6 — Common Stock Dividends – Nonaffiliated(1.9)(1.9)ASU 2016-03 Adoption1.6 1.6 Net Income180.8 2.9 183.7 Other Comprehensive Income3.2 3.2 TOTAL EQUITY – DECEMBER 31, 2020$0.1 $812.2 $1,811.9 $1.9 $1.6 $2,627.7 (a) See Note 14 - Financing Activities for additional information.See Notes to Financial Statements of Registrants beginning on page 229.225SOUTHWESTERN ELECTRIC POWER COMPANY CONSOLIDATEDCONSOLIDATED BALANCE SHEETSASSETSDecember 31, 2020 and 2019 (in millions)December 31,20202019CURRENT ASSETSCash and Cash Equivalents(December 31, 2020 and 2019 Amounts Include $10.1 and $0, Respectively, Related to Sabine)$13.2 $1.6 Advances to Affiliates2.1 2.1 Accounts Receivable:Customers27.1 29.0 Affiliated Companies25.1 34.5 Miscellaneous12.7 13.5 Allowance for Uncollectible Accounts— (1.7)Total Accounts Receivable64.9 75.3 Fuel(December 31, 2020 and 2019 Amounts Include $35.2 and $47, Respectively, Related to Sabine)191.1 140.1 Materials and Supplies(December 31, 2020 and 2019 Amounts Include $23.3 and $23.1, Respectively, Related to Sabine)95.8 94.0 Risk Management Assets3.2 6.4 Accrued Tax Benefits29.9 7.6 Regulatory Asset for Under-Recovered Fuel Costs2.6 4.9 Prepayments and Other Current Assets25.2 22.1 TOTAL CURRENT ASSETS428.0 354.1 PROPERTY, PLANT AND EQUIPMENTElectric:Generation4,681.4 4,691.4 Transmission2,165.7 2,056.5 Distribution2,382.5 2,270.7 Other Property, Plant and Equipment (December 31, 2020 and 2019 Amounts Include $223.7 and $212.3, Respectively, Related to Sabine)788.8 733.4 Construction Work in Progress228.3 216.9 Total Property, Plant and Equipment10,246.7 9,968.9 Accumulated Depreciation and Amortization (December 31, 2020 and 2019 Amounts Include $126.5 and $107.5, Respectively, Related to Sabine)3,158.5 2,873.7 TOTAL PROPERTY, PLANT AND EQUIPMENT – NET7,088.2 7,095.2 OTHER NONCURRENT ASSETSRegulatory Assets403.1 222.4 Deferred Charges and Other Noncurrent Assets234.8 160.5 TOTAL OTHER NONCURRENT ASSETS637.9 382.9 TOTAL ASSETS$8,154.1 $7,832.2 See Notes to Financial Statements of Registrants beginning on page 229.226SOUTHWESTERN ELECTRIC POWER COMPANY CONSOLIDATEDCONSOLIDATED BALANCE SHEETSLIABILITIES AND EQUITYDecember 31, 2020 and 2019 December 31,20202019(in millions)CURRENT LIABILITIESAdvances from Affiliates$124.6 $59.9 Accounts Payable:General135.9 138.0 Affiliated Companies43.0 53.6 Short-term Debt – Nonaffiliated35.0 18.3 Long-term Debt Due Within One Year – Nonaffiliated106.2 121.2 Risk Management Liabilities0.7 1.9 Customer Deposits61.3 65.0 Accrued Taxes41.0 41.8 Accrued Interest34.6 34.6 Obligations Under Operating Leases7.9 6.5 Other Current Liabilities173.4 133.9 TOTAL CURRENT LIABILITIES763.6 674.7 NONCURRENT LIABILITIESLong-term Debt – Nonaffiliated2,530.2 2,534.4 Long-term Risk Management Liabilities1.0 3.1 Deferred Income Taxes1,017.6 940.9 Regulatory Liabilities and Deferred Investment Tax Credits863.4 892.3 Asset Retirement Obligations193.7 196.7 Employee Benefits and Pension Obligations18.6 28.1 Obligations Under Operating Leases44.1 34.7 Deferred Credits and Other Noncurrent Liabilities94.2 86.2 TOTAL NONCURRENT LIABILITIES4,762.8 4,716.4 TOTAL LIABILITIES5,526.4 5,391.1 Rate Matters (Notes 4)Commitments and Contingencies (Note 6)EQUITYCommon Stock – Par Value – $18 Per Share:Authorized – 3,680 SharesOutstanding – 3,680 Shares0.1 135.7 Paid-in Capital812.2 676.6 Retained Earnings1,811.9 1,629.5 Accumulated Other Comprehensive Income (Loss)1.9 (1.3)TOTAL COMMON SHAREHOLDER’S EQUITY2,626.1 2,440.5 Noncontrolling Interest1.6 0.6 TOTAL EQUITY2,627.7 2,441.1 TOTAL LIABILITIES AND EQUITY$8,154.1 $7,832.2 See Notes to Financial Statements of Registrants beginning on page 229.227SOUTHWESTERN ELECTRIC POWER COMPANY CONSOLIDATEDCONSOLIDATED STATEMENTS OF CASH FLOWSFor the Years Ended December 31, 2020, 2019 and 2018 (in millions)Years Ended December 31,202020192018OPERATING ACTIVITIESNet Income$183.7 $162.2 $152.2 Adjustments to Reconcile Net Income to Net Cash Flows from Operating Activities:Depreciation and Amortization272.7 249.1 239.5 Deferred Income Taxes32.4 (11.0)1.2 Allowance for Equity Funds Used During Construction(7.7)(6.8)(6.0)Mark-to-Market of Risk Management Contracts(0.1)0.8 4.0 Pension Contributions to Qualified Plan Trust(8.9)— — Deferred Fuel Over/Under-Recovery, Net26.3 16.5 (2.4)Change in Regulatory Assets(108.4)3.5 (0.7)Change in Other Noncurrent Assets16.1 2.7 (18.1)Change in Other Noncurrent Liabilities25.2 2.7 42.8 Changes in Certain Components of Working Capital:Accounts Receivable, Net7.3 — 53.5 Fuel, Materials and Supplies(46.4)(46.1)3.5 Accounts Payable11.1 (28.4)0.9 Accrued Taxes, Net(23.1)(3.2)2.3 Other Current Assets(2.8)(8.9)15.6 Other Current Liabilities(21.1)6.7 16.5 Net Cash Flows from Operating Activities356.3 339.8 504.8 INVESTING ACTIVITIESConstruction Expenditures(402.7)(412.7)(451.0)Change in Advances to Affiliates, Net— 81.3 (81.4)Proceeds from Sales of Assets4.4 0.2 1.4 Other Investing Activities5.7 1.0 2.1 Net Cash Flows Used for Investing Activities(392.6)(330.2)(528.9)FINANCING ACTIVITIESIssuance of Long-term Debt – Nonaffiliated— — 1,065.7 Change in Short-term Debt – Nonaffiliated 16.7 18.3 (22.0)Change in Advances from Affiliates, Net64.7 59.9 (118.7)Retirement of Long-term Debt – Nonaffiliated(21.2)(59.7)(794.5)Principal Payments for Finance Lease Obligations(10.9)(11.0)(11.5)Dividends Paid on Common Stock— (37.5)(65.0)Dividends Paid on Common Stock – Nonaffiliated(1.9)(3.3)(4.3)Other Financing Activities0.5 0.8 (2.7)Net Cash Flows from (Used for) Financing Activities47.9 (32.5)47.0 Net Increase (Decrease) in Cash and Cash Equivalents11.6 (22.9)22.9 Cash and Cash Equivalents at Beginning of Period1.6 24.5 1.6 Cash and Cash Equivalents at End of Period$13.2 $1.6 $24.5 SUPPLEMENTARY INFORMATIONCash Paid for Interest, Net of Capitalized Amounts$110.7 $111.1 $125.7 Net Cash Paid for Income Taxes4.3 8.6 18.8 Noncash Acquisitions Under Finance Leases8.9 7.4 3.6 Construction Expenditures Included in Current Liabilities as of December 31,46.0 69.1 42.0 See Notes to Financial Statements of Registrants beginning on page 229.228INDEX OF NOTES TO FINANCIAL STATEMENTS OF REGISTRANTSThe notes to financial statements are a combined presentation for the Registrants. The following list indicates Registrants to which the notes apply. Specific disclosures within each note apply to all Registrants unless indicated otherwise. NoteRegistrantPageNumberOrganization and Summary of Significant Accounting PoliciesAEP, AEP Texas, AEPTCo, APCo, I&M, OPCo, PSO, SWEPCo230New Accounting StandardsAEP, AEP Texas, AEPTCo, APCo, I&M, OPCo, PSO, SWEPCo247Comprehensive IncomeAEP, AEP Texas, APCo, I&M, OPCo, PSO, SWEPCo248Rate MattersAEP, AEP Texas, AEPTCo, APCo, I&M, OPCo, PSO, SWEPCo256Effects of RegulationAEP, AEP Texas, AEPTCo, APCo, I&M, OPCo, PSO, SWEPCo264Commitments, Guarantees and ContingenciesAEP, AEP Texas, AEPTCo, APCo, I&M, OPCo, PSO, SWEPCo282Acquisitions, Dispositions and ImpairmentsAEP, AEP Texas, APCo, I&M, SWEPCo289Benefit PlansAEP, AEP Texas, APCo, I&M, OPCo, PSO, SWEPCo293Business SegmentsAEP, AEP Texas, AEPTCo, APCo, I&M, OPCo, PSO, SWEPCo316Derivatives and HedgingAEP, AEP Texas, APCo, I&M, OPCo, PSO, SWEPCo322Fair Value MeasurementsAEP, AEP Texas, AEPTCo, APCo, I&M, OPCo, PSO, SWEPCo335Income TaxesAEP, AEP Texas, AEPTCo, APCo, I&M, OPCo, PSO, SWEPCo349LeasesAEP, AEP Texas, AEPTCo, APCo, I&M, OPCo, PSO, SWEPCo360Financing ActivitiesAEP, AEP Texas, AEPTCo, APCo, I&M, OPCo, PSO, SWEPCo366Stock-based CompensationAEP377Related Party TransactionsAEP, AEP Texas, AEPTCo, APCo, I&M, OPCo, PSO, SWEPCo382Variable Interest Entities and Equity Method InvestmentsAEP, AEP Texas, AEPTCo, APCo, I&M, OPCo, PSO, SWEPCo390Property, Plant and EquipmentAEP, AEP Texas, AEPTCo, APCo, I&M, OPCo, PSO, SWEPCo401Revenue from Contracts with CustomersAEP, AEP Texas, AEPTCo, APCo, I&M, OPCo, PSO, SWEPCo408GoodwillAEP417Subsequent EventsAEP, AEP Texas, APCo, PSO, SWEPCo4182291. ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIESThe disclosures in this note apply to all Registrants unless indicated otherwise.ORGANIZATIONThe Registrants engage in the generation, transmission and distribution of electric power. The Registrant Subsidiaries that conduct most of these activities are regulated by the FERC under the Federal Power Act and the Energy Policy Act of 2005 and maintain accounts in accordance with the FERC and other regulatory guidelines. Most of these companies are subject to further regulation with regard to rates and other matters by state regulatory commissions.AEP provides competitive electric and gas supply for residential, commercial and industrial customers in deregulated electricity markets and also provides energy management solutions throughout the United States, including energy efficiency services through its independent retail electric supplier.The Registrants also engage in wholesale electricity, natural gas and other commodity marketing and risk management activities in the United States and provide various energy-related services. In addition, AEP operates competitive wind and solar farms. I&M provides barging services to both affiliated and nonaffiliated companies. SWEPCo, through consolidated and non-consolidated affiliates, conducts lignite mining operations to fuel certain of its generation facilities. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIESRates and Service RegulationAEP’s public utility subsidiaries’ rates are regulated by the FERC and state regulatory commissions in the eleven state operating territories in which they operate. The FERC also regulates the Registrants’ affiliated transactions, including AEPSC intercompany service billings which are generally at cost, under the 2005 Public Utility Holding Company Act and the Federal Power Act. The FERC also has jurisdiction over the issuances and acquisitions of securities of the public utility subsidiaries, the acquisition or sale of certain utility assets and mergers with another electric utility or holding company. The state regulatory commissions also regulate certain intercompany transactions under various orders and affiliate statutes. Both the FERC and state regulatory commissions are permitted to review and audit the relevant books and records of companies within a public utility holding company system.The FERC regulates wholesale power markets and wholesale power transactions. The Registrants’ wholesale power transactions are generally market-based. Wholesale power transactions are cost-based regulated when a cost-based contract is negotiated and filed with the FERC or the FERC determines that the Registrants have “market power” in the region where the transaction occurs. Wholesale power supply contracts have been entered into with various municipalities and cooperatives that are FERC-regulated, cost-based contracts. These contracts are generally formula rate mechanisms, which are trued-up to actual costs annually. The state regulatory commissions regulate all of the retail distribution operations and rates of the Registrants’ retail public utility subsidiaries on a cost basis. The state regulatory commissions also regulate the retail generation/power supply operations and rates except in Ohio and the ERCOT region of Texas. For generation in Ohio, customers who have not switched to a CRES provider for generation pay market-based auction rates. In addition, all OPCo distribution customers paid for certain legacy generation deferral balances that were fully recovered as of December 31, 2019 and continue to pay for certain legacy deferred generation-related costs through PUCO approved riders. In the ERCOT region of Texas, the generation/supply business is under customer choice and market pricing is conducted by REPs. AEP has one active REP in ERCOT. AEP’s nonregulated subsidiaries enter into short and long-term wholesale transactions to buy or sell capacity, energy and ancillary services in the ERCOT market. In addition, these nonregulated subsidiaries control certain wind assets, the power from which is marketed and sold in ERCOT. Power from the Oklaunion Power Station was also marketed and sold by these nonregulated subsidiaries in ERCOT prior to its retirement in September 2020.230The FERC also regulates the Registrants’ wholesale transmission operations and rates. Retail transmission rates are based upon the FERC OATT rate when retail rates are unbundled in connection with restructuring. Retail transmission rates are based on formula rates included in the PJM OATT that are cost-based and are unbundled in Ohio for OPCo, in Virginia for APCo and in Michigan for I&M. AEP Texas’ retail transmission rates in Texas are unbundled but the retail transmission rates are regulated, on a cost basis, by the PUCT. Bundled retail transmission rates are regulated, on a cost basis, by the state commissions. Transmission rates for AEPTCo’s seven wholly-owned transmission subsidiaries within the AEP Transmission Holdco segment are based on formula rates included in the applicable RTO’s OATT that are cost-based.In West Virginia, APCo and WPCo provide retail electric service at bundled rates approved by the WVPSC, with rates set on a combined cost-of-service basis. In addition, the FERC regulates the SIA, Operating Agreement, TA and TCA, all of which allocate shared system costs and revenues among the utility subsidiaries that are parties to each agreement. The FERC also regulates the PCA. See Note 16 - Related Party Transactions for additional information. Principles of ConsolidationAEP’s consolidated financial statements include its wholly-owned and majority-owned subsidiaries and VIEs of which AEP is the primary beneficiary. The consolidated financial statements for AEP Texas include the Registrant Subsidiary, its wholly-owned subsidiaries, Transition Funding (consolidated VIEs) and Restoration Funding (a consolidated VIE). The consolidated financial statements for APCo include the Registrant Subsidiary, its wholly-owned subsidiaries and Appalachian Consumer Rate Relief Funding (a consolidated VIE). The consolidated financial statements for I&M include the Registrant Subsidiary, its wholly-owned subsidiaries and DCC Fuel (consolidated VIEs). The consolidated statements of cash flows for OPCo include the Registrant Subsidiary and Ohio Phase-in Recovery Funding (a consolidated VIE) for the years ended December 31, 2019 and 2018. In July 2019, the Ohio Phase-in Recovery funding securitization bonds matured. The consolidated financial statements for SWEPCo include the Registrant Subsidiary, its wholly-owned subsidiary and Sabine (a consolidated VIE). Intercompany items are eliminated in consolidation. The equity method of accounting is used for equity investments where the Registrants exercise significant influence but do not hold a controlling financial interest. Such investments are initially recorded at cost in Deferred Charges and Other Noncurrent Assets on the balance sheets. The proportionate share of the investee’s equity earnings or losses is included in Equity Earnings of Unconsolidated Subsidiaries on the statements of income. AEP, I&M and SWEPCo have ownership interests in generating units that are jointly-owned. The proportionate share of the operating costs associated with such facilities is included on the income statements and the assets and liabilities are reflected on the balance sheets. See Note 17 - Variable Interest Entities and Equity Method Investments and Note 18 - Property, Plant and Equipment for additional information. In October 2020, AEP Texas, PSO and a nonaffiliated joint-owner executed an Environmental Liability and Property Transfer and Asset Purchase Agreement with a nonaffiliated third-party related to the Oklaunion Power Station site. See Note 7 – Acquisitions, Dispositions and Impairments for additional information. Accounting for the Effects of Cost-Based RegulationThe Registrants’ financial statements reflect the actions of regulators that result in the recognition of certain revenues and expenses in different time periods than enterprises that are not rate-regulated. In accordance with accounting guidance for “Regulated Operations,” regulatory assets (deferred expenses) and regulatory liabilities (deferred revenue reductions or refunds) are recorded to reflect the economic effects of regulation in the same accounting period by matching expenses with their recovery through regulated revenues and by matching income with its passage to customers in cost-based regulated rates.231Use of EstimatesThe preparation of these financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. These estimates include, but are not limited to, inventory valuation, allowance for doubtful accounts, goodwill, intangible and long-lived asset impairment, unbilled electricity revenue, valuation of long-term energy contracts, the effects of regulation, long-lived asset recovery, storm costs, the effects of contingencies and certain assumptions made in accounting for pension and postretirement benefits. The estimates and assumptions used are based upon management’s evaluation of the relevant facts and circumstances as of the date of the financial statements. Actual results could ultimately differ from those estimates.Cash and Cash EquivalentsCash and Cash Equivalents include temporary cash investments with original maturities of three months or less.Restricted Cash (Applies to AEP, AEP Texas and APCo)Restricted Cash primarily includes funds held by trustees for the payment of securitization bonds.Reconciliation of Cash, Cash Equivalents and Restricted CashThe following tables provide a reconciliation of Cash, Cash Equivalents and Restricted Cash reported within the balance sheets that sum to the total of the same amounts shown on the statement of cash flows:December 31, 2020AEPAEP TexasAPCo(in millions)Cash and Cash Equivalents$392.7 $0.1 $5.8 Restricted Cash45.6 28.7 16.9 Total Cash, Cash Equivalents and Restricted Cash$438.3 $28.8 $22.7 December 31, 2019AEPAEP TexasAPCo(in millions)Cash and Cash Equivalents$246.8 $3.1 $3.3 Restricted Cash185.8 154.7 23.5 Total Cash, Cash Equivalents and Restricted Cash$432.6 $157.8 $26.8 Other Temporary Investments (Applies to AEP)Other Temporary Investments primarily include marketable securities and investments by its protected cell of EIS. These securities have readily determinable fair values and are carried at fair value with changes in fair value recognized in net income. The cost of securities sold is based on the specific identification or weighted-average cost method. See “Fair Value Measurements of Other Temporary Investments” section of Note 11 for additional information.InventoryFossil fuel inventories are carried at average cost with the exception of AGR, which is carried at the lower of average cost or net realizable value. Materials and supplies inventories are carried at average cost. 232Accounts ReceivableCustomer accounts receivable primarily include receivables from wholesale and retail energy customers, receivables from energy contract counterparties related to risk management activities and customer receivables primarily related to other revenue-generating activities.Revenue is recognized over time as the performance obligations of delivering energy to customers are satisfied. To the extent that deliveries have occurred but a bill has not been issued, the Registrants accrue and recognize, as Accrued Unbilled Revenues on the balance sheets, an estimate of the revenues for energy delivered since the last billing.AEP Credit factors accounts receivable on a daily basis, excluding receivables from risk management activities, through purchase agreements with I&M, KGPCo, KPCo, OPCo, PSO, SWEPCo and a portion of APCo. Since APCo does not have regulatory authority to sell accounts receivable in its West Virginia regulatory jurisdiction, only a portion of APCo’s accounts receivable are sold to AEP Credit. AEP Credit has a receivables securitization agreement with bank conduits. Under the securitization agreement, AEP Credit receives financing from bank conduits for the interest in the billed and unbilled receivables they acquire from affiliated utility subsidiaries. See “Securitized Accounts Receivable – AEP Credit” section of Note 14 for additional information.Allowance for Uncollectible AccountsGenerally, AEP Credit records bad debt expense based upon a 12-month rolling average of bad debt write-offs in proportion to gross accounts receivable purchased from participating AEP subsidiaries. The assessment is performed separately by each participating AEP subsidiary, which inherently contemplates any differences in geographical risk characteristics for the allowance. For receivables related to APCo’s West Virginia operations, the bad debt reserve is calculated based on a rolling two-year average write-off in proportion to gross accounts receivable. For customer accounts receivables relating to risk management activities, accounts receivables are reviewed for bad debt reserves at a specific counterparty level basis. For AEP Texas, bad debt reserves are calculated using the specific identification of receivable balances greater than 120 days delinquent, and for those balances less than 120 days where the collection is doubtful. For miscellaneous accounts receivable, bad debt expense is recorded based upon a 12-month rolling average of bad debt write-offs in proportion to gross accounts receivable, unless specifically identified. In addition to these processes, management contemplates available current information, as well as any reasonable and supportable forecast information, to determine if allowances for uncollectible accounts should be further adjusted in accordance with the accounting guidance for “Credit Losses.” Management’s assessments contemplate expected losses over the life of the accounts receivable.Concentrations of Credit Risk and Significant Customers (Applies to Registrant Subsidiaries)APCo, I&M, OPCo, PSO and SWEPCo do not have any significant customers that comprise 10% or more of their operating revenues. AEP Texas had significant transactions with REPs which on a combined basis account for the following percentages of Total Revenues for the years ended December 31 and Accounts Receivable – Customers as of December 31:Significant Customers of AEP Texas: Reliant Energy, Direct Energy and TXU Energy (a) 2020 2019 2018Percentage of Total Revenues 46 % 48 % 45 %Percentage of Accounts Receivable – Customers 40 % 43 % 35 %(a)In January 2021, NRG Energy, parent company of Reliant Energy, completed a deal to purchase Direct Energy from Centrica.233AEPTCo had significant transactions with AEP Subsidiaries which on a combined basis account for the following percentages of Total Revenues for the years ended December 31 and Total Accounts Receivable as of December 31:Significant Customers of AEPTCo:AEP Subsidiaries2020 20192018Percentage of Total Revenues78 %79 %77 %Percentage of Total Accounts Receivable78 %78 %84 %The Registrant Subsidiaries monitor credit levels and the financial condition of their customers on a continuous basis to minimize credit risk. The regulatory commissions allow recovery in rates for a reasonable level of bad debt costs. Management believes adequate provisions for credit loss have been made in the accompanying Registrant Subsidiary financial statements.Renewable Energy Credits (Applies to all Registrants except AEP Texas and AEPTCo)In regulated jurisdictions, the Registrants record renewable energy credits (RECs) at cost. For AEP’s competitive generation business, management records RECs at the lower of cost or market. The Registrants follow the inventory model for these RECs. RECs expected to be consumed within one year are reported in Materials and Supplies on the balance sheets. RECs with expected consumption beyond one year are included in Deferred Charges and Other Noncurrent Assets on the balance sheets. The purchases and sales of RECs are reported in the Operating Activities section of the statements of cash flows. RECs are consumed to meet applicable state renewable portfolio standards and are recorded in Fuel and Other Consumables Used for Electric Generation at an average cost on the statements of income. The net margin on sales of RECs affects the determination of deferred fuel and REC costs and the amortization of regulatory assets for certain jurisdictions.Property, Plant and EquipmentRegulatedElectric utility property, plant and equipment for rate-regulated operations are stated at original cost. Additions, major replacements and betterments are added to the plant accounts. Under the group composite method of depreciation, continuous interim routine replacements of items such as boiler tubes, pumps, motors, etc. result in original cost retirements, less salvage, being charged to accumulated depreciation. The group composite method of depreciation assumes that on average, asset components are retired at the end of their useful lives and thus there is no gain or loss. The equipment in each primary electric plant account is identified as a separate group. The depreciation rates that are established take into account the past history of interim capital replacements and the amount of removal cost incurred and salvage received. These rates and the related lives are subject to periodic review. Removal costs accrued are typically recorded as regulatory liabilities when the revenue received for removal costs accrued exceeds actual removal costs incurred. The asset removal costs liability is relieved as removal costs are incurred. A regulatory asset balance will occur if actual removal costs incurred exceed accumulated removal costs accrued.The costs of labor, materials and overhead incurred to operate and maintain plant and equipment are included in operating expenses.Nuclear fuel, including nuclear fuel in the fabrication phase, is included in Other Property, Plant and Equipment on the balance sheets.Long-lived assets are required to be tested for impairment when it is determined that the carrying value of the assets may no longer be recoverable or when the assets meet the held-for-sale criteria under the accounting guidance for “Impairment or Disposal of Long-Lived Assets.” When it becomes probable that an asset in-service or an asset under construction will be abandoned and regulatory cost recovery has been disallowed or is not probable, the cost 234of that asset shall be removed from plant-in-service or CWIP and charged to expense. The fair value of an asset is the amount at which that asset could be bought or sold in a current transaction between willing parties, as opposed to a forced or liquidation sale. Quoted market prices in active markets are the best evidence of fair value and are used as the basis for the measurement, if available. In the absence of quoted prices for identical or similar assets in active markets, fair value is estimated using various internal and external valuation methods including cash flow analysis and appraisals.NonregulatedNonregulated operations generally follow the policies of rate-regulated operations listed above but with the following exceptions. Property, plant and equipment of nonregulated operations are stated at original cost (or as adjusted for any applicable impairments) plus the original cost of property acquired or constructed since the acquisition, less disposals. Normal and routine retirements from the plant accounts, net of salvage, are charged to accumulated depreciation for most nonregulated operations under the group composite method of depreciation. A gain or loss would be recorded if the retirement is not considered an interim routine replacement. Removal costs are charged to expense.Allowance for Funds Used During Construction and Interest CapitalizationFor regulated operations, AFUDC represents the estimated cost of borrowed and equity funds used to finance construction projects that is capitalized and recovered through depreciation over the service life of regulated electric utility plant. The Registrants record the equity component of AFUDC in Allowance for Equity Funds Used During Construction and the debt component of AFUDC as a reduction to Interest Expense on the statements of income. For nonregulated operations, including certain generating assets, interest is capitalized during construction in accordance with the accounting guidance for “Capitalization of Interest.”Valuation of Nonderivative Financial InstrumentsThe book values of Cash and Cash Equivalents, Advances to/from Affiliates, Accounts Receivable, Accounts Payable and Short-term Debt approximate fair value because of the short-term maturity of these instruments.Fair Value Measurements of Assets and Liabilities (Applies to all Registrants except AEPTCo)The accounting guidance for “Fair Value Measurements and Disclosures” establishes a fair value hierarchy that prioritizes the inputs used to measure fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1 measurement) and the lowest priority to unobservable inputs (Level 3 measurement). Where observable inputs are available for substantially the full term of the asset or liability, the instrument is categorized in Level 2. When quoted market prices are not available, pricing may be completed using comparable securities, dealer values, operating data and general market conditions to determine fair value. Valuation models utilize various inputs such as commodity, interest rate and, to a lesser degree, volatility and credit that include quoted prices for similar assets or liabilities in active markets, quoted prices for identical or similar assets or liabilities in inactive markets, market corroborated inputs (i.e. inputs derived principally from, or correlated to, observable market data) and other observable inputs for the asset or liability.For commercial activities, exchange-traded derivatives, namely futures contracts, are generally fair valued based on unadjusted quoted prices in active markets and are classified as Level 1. Level 2 inputs primarily consist of OTC broker quotes in moderately active or less active markets, as well as exchange-traded derivatives where there is insufficient market liquidity to warrant inclusion in Level 1. Management verifies price curves using these broker quotes and classifies these fair values within Level 2 when substantially all of the fair value can be corroborated. Management typically obtains multiple broker quotes, which are nonbinding in nature but are based on recent trades in the marketplace. When multiple broker quotes are obtained, the quoted bid and ask prices are averaged. In certain circumstances, a broker quote may be discarded if it is a clear outlier. Management uses a historical correlation analysis between the broker quoted location and the illiquid locations. If the points are highly 235correlated, these locations are included within Level 2 as well. Certain OTC and bilaterally executed derivative instruments are executed in less active markets with a lower availability of pricing information. Illiquid transactions, complex structured transactions, FTRs and counterparty credit risk may require nonmarket-based inputs. Some of these inputs may be internally developed or extrapolated and utilized to estimate fair value. When such inputs have a significant impact on the measurement of fair value, the instrument is categorized as Level 3. The main driver of contracts being classified as Level 3 is the inability to substantiate energy price curves in the market. A portion of the Level 3 instruments have been economically hedged which limits potential earnings volatility.AEP utilizes its trustee’s external pricing service to estimate the fair value of the underlying investments held in the benefit plan and nuclear trusts. AEP’s investment managers review and validate the prices utilized by the trustee to determine fair value. AEP’s management performs its own valuation testing to verify the fair values of the securities. AEP receives audit reports of the trustee’s operating controls and valuation processes. Assets in the benefits and nuclear trusts, cash and cash equivalents, other temporary investments and restricted cash for securitized funding are classified using the following methods. Equities are classified as Level 1 holdings if they are actively traded on exchanges. Items classified as Level 1 are investments in money market funds, fixed income and equity mutual funds and equity securities. They are valued based on observable inputs, primarily unadjusted quoted prices in active markets for identical assets. Items classified as Level 2 are primarily investments in individual fixed income securities. Fixed income securities generally do not trade on exchanges and do not have an official closing price but their valuation inputs are based on observable market data. Pricing vendors calculate bond valuations using financial models and matrices. The models use observable inputs including yields on benchmark securities, quotes by securities brokers, rating agency actions, discounts or premiums on securities compared to par prices, changes in yields for U.S. Treasury securities, corporate actions by bond issuers, prepayment schedules and histories, economic events and, for certain securities, adjustments to yields to reflect changes in the rate of inflation. Other securities with model-derived valuation inputs that are observable are also classified as Level 2 investments. Investments with unobservable valuation inputs are classified as Level 3 investments. Investments classified as Other are valued using Net Asset Value as a practical expedient. Items classified as Other are primarily cash equivalent funds, common collective trusts, commingled funds, structured products, private equity, real estate, infrastructure and alternative credit investments. These investments do not have a readily determinable fair value or they contain redemption restrictions which may include the right to suspend redemptions under certain circumstances. Redemption restrictions may also prevent certain investments from being redeemed at the reporting date for the underlying value.Deferred Fuel Costs (Applies to all Registrants except AEP Texas and AEPTCo)The cost of fuel and related emission allowances and emission control chemicals/consumables is charged to Fuel and Other Consumables Used for Electric Generation expense when the fuel is burned or the allowance or consumable is utilized. The cost of fuel also includes the cost of nuclear fuel burned which is computed primarily using the units-of-production method. In regulated jurisdictions with an active FAC, fuel cost over-recoveries (the excess of fuel-related revenues over applicable fuel costs incurred) are generally deferred as current regulatory liabilities and under-recoveries (the excess of applicable fuel costs incurred over fuel-related revenues) are generally deferred as current regulatory assets. Fuel cost over-recovery and under-recovery balances are classified as noncurrent when there is a commission-approved plan to delay refunds or recoveries beyond a one year period. These deferrals are amortized when refunded or when billed to customers in later months with the state regulatory commissions’ review and approval. The amount of an over-recovery or under-recovery can also be affected by actions of the state regulatory commissions. On a routine basis, state regulatory commissions review and/or audit the Registrants’ fuel procurement policies and practices, the fuel cost calculations and FAC deferrals. FAC deferrals are adjusted when costs are no longer probable of recovery or when refunds of fuel reserves are probable. The Registrants share the majority of their Off-system Sales margins to customers either through an active FAC or other rate mechanisms. Where the FAC or Off-system Sales sharing mechanism is capped, frozen or non-existent, changes in fuel costs or sharing of off-system sales impact earnings.236Revenue RecognitionRegulatory AccountingThe Registrants’ financial statements reflect the actions of regulators that can result in the recognition of revenues and expenses in different time periods than enterprises that are not rate-regulated. Regulatory assets (deferred expenses or alternative revenues recognized in accordance with the guidance for “Regulated Operations”) and regulatory liabilities (deferred revenue reductions or refunds) are recorded to reflect the economic effects of regulation in the same accounting period by matching expenses with their recovery through regulated revenues and by matching revenue with its passage to customers in cost-based regulated rates.When regulatory assets are probable of recovery through regulated rates, assets are recorded on the balance sheets. Regulatory assets are tested for probability of recovery at each balance sheet date or whenever new events occur. Examples of new events include the issuance of a regulatory commission order or passage of new legislation. If it is determined that recovery of a regulatory asset is no longer probable, the regulatory asset is derecognized as a charge against income.Retail and Wholesale Supply and Delivery of ElectricityThe Registrants recognize revenues from customers for retail and wholesale electricity sales and electricity transmission and distribution delivery services. The Registrants recognize such revenues on the statements of income as the performance obligations of delivering energy to customers are satisfied. Recognized revenues include both billed and unbilled amounts. In accordance with the applicable state commission’s regulatory treatment, PSO and SWEPCo do not include the fuel portion in unbilled revenue, but rather recognize such revenues when billed to customers.Wholesale transmission revenue is based on FERC-approved formula rate filings made for each calendar year using estimated costs. Revenues initially recognized per the annual rate filing are compared to actual costs, resulting in the subsequent recognition of an over or under-recovered amount, with interest, that is refunded or recovered, respectively, in a future year’s rates. These annual true-ups meet the definition of alternative revenues in accordance with the accounting guidance for “Regulated Operations”, and are recognized by the Registrants in the second quarter of each calendar year following the filing of annual FERC reports. Any portion of the true-ups applicable to an affiliated company is recorded as Accounts Receivable - Affiliated Companies or Accounts Payable - Affiliated Companies on the balance sheets. Any portion of the true-ups applicable to third-parties is recorded as Regulatory Assets or Regulatory Liabilities on the balance sheets. See Note 19 - Revenue from Contracts with Customers for additional information.Gross versus Net Presentation of Certain Electricity Supply and Delivery ActivitiesMost of the power produced at the generation plants is sold to PJM or SPP. The Registrants also purchase power from PJM and SPP to supply power to customers. Generally, these power sales and purchases are reported on a net basis as revenues on the statements of income. However, purchases of power in excess of sales to PJM or SPP, on an hourly net basis, used to serve retail load are recorded gross as Purchased Electricity for Resale on the statements of income. With the exception of certain dedicated load bilateral power supply contracts, the transactions of AEP’s nonregulated subsidiaries are reported as gross purchases or sales.Physical energy purchases arising from non-derivative contracts are accounted for on a gross basis in Purchased Electricity for Resale on the statements of income. Energy purchases arising from non-trading derivative contracts are recorded based on the transaction’s facts and circumstances. Purchases under non-trading derivatives used to serve accrual based obligations are recorded in Purchased Electricity for Resale on the statements of income. All other non-trading derivative purchases are recorded net in revenues.237In general, the Registrants record expenses when purchased electricity is received and when expenses are incurred, with the exception of certain power purchase contracts that are derivatives and accounted for using MTM accounting where generation/supply rates are not cost-based regulated. In jurisdictions where the generation/supply business is subject to cost-based regulation, the unrealized MTM amounts are deferred as regulatory assets (for losses) and regulatory liabilities (for gains).Energy Marketing and Risk Management Activities (Applies to all Registrants except AEPTCo)The Registrants engage in power, capacity and, to a lesser extent, natural gas marketing as major power producers and participants in electricity and natural gas markets. The Registrants also engage in power, capacity, coal, natural gas and, to a lesser extent, heating oil, gasoline and other commodity risk management activities focused on markets where the AEP System owns assets and on adjacent markets. These activities include the purchase-and-sale of energy under forward contracts at fixed and variable prices. These contracts include physical transactions, exchange-traded futures, and to a lesser extent, OTC swaps and options. Certain energy marketing and risk management transactions are with RTOs.The Registrants recognize revenues from marketing and risk management transactions that are not derivatives as the performance obligation of delivering the commodity is satisfied. Expenses from marketing and risk management transactions that are not derivatives are also recognized upon delivery of the commodity.The Registrants use MTM accounting for marketing and risk management transactions that are derivatives unless the derivative is designated in a qualifying cash flow hedge relationship or elected normal under the normal purchase normal sale election. The Registrants include realized gains and losses on marketing and risk management transactions in revenues or expense based on the transaction’s facts and circumstances. In certain jurisdictions subject to cost-based regulation, unrealized MTM amounts and some realized gains and losses are deferred as regulatory assets (for losses) and regulatory liabilities (for gains). Unrealized MTM gains and losses are included on the balance sheets as Risk Management Assets or Liabilities as appropriate.Certain qualifying marketing and risk management derivatives transactions are designated as hedges of variability in future cash flows as a result of forecasted transactions (cash flow hedge). In the event the Registrants designate a cash flow hedge, the cash flow hedge’s gain or loss is initially recorded as a component of AOCI. When the forecasted transaction is realized and affects net income, the Registrants subsequently reclassify the gain or loss on the hedge from AOCI into revenues or expenses within the same financial statement line item as the forecasted transaction on their statements of income. See “Accounting for Cash Flow Hedging Strategies” section of Note 10 for additional information. Levelization of Nuclear Refueling Outage Costs (Applies to AEP and I&M)In accordance with regulatory orders, I&M defers incremental operation and maintenance costs associated with periodic refueling outages at its Cook Plant and amortizes the costs over approximately 18 months, beginning with the month following the start of each unit’s refueling outage and lasting until the end of the month in which the same unit’s next scheduled refueling outage begins.MaintenanceThe Registrants expense maintenance costs as incurred. If it becomes probable that the Registrants will recover specifically-incurred costs through future rates, a regulatory asset is established to match the expensing of those maintenance costs with their recovery in cost-based regulated revenues. In certain regulated jurisdictions, the Registrants defer costs above the level included in base rates and amortize those deferrals commensurate with recovery through rate riders.238Income Taxes and Investment and Production Tax CreditsThe Registrants use the liability method of accounting for income taxes. Under the liability method, deferred income taxes are provided for all temporary differences between the book and tax basis of assets and liabilities which will result in a future tax consequence. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which the temporary differences are expected to be recovered or settled. When the flow-through method of accounting for temporary differences is required by a regulator to be reflected in regulated revenues (that is, when deferred taxes are not included in the cost-of-service for determining regulated rates for electricity), deferred income taxes are recorded and related regulatory assets and liabilities are established to match the regulated revenues and tax expense.AEP and subsidiaries apply the deferral methodology for the recognition of ITCs. Deferred ITCs are amortized to income tax expense over the life of the asset that generated the credit. Amortization of deferred ITCs begins when the asset is placed in-service, except where regulatory commissions reflect ITCs in the rate-making process, then amortization begins when the cash tax benefit is recognized. Alternatively, PTCs reduce income tax expense as they are earned. PTCs are earned when electricity is produced. The Registrants account for uncertain tax positions in accordance with the accounting guidance for “Income Taxes.” The Registrants classify interest expense or income related to uncertain tax positions as interest expense or income as appropriate and classify penalties as Other Operation expense on the statements of income.Excise Taxes (Applies to all Registrants except AEPTCo)As agents for some state and local governments, the Registrants collect from customers certain excise taxes levied by those state or local governments on customers. The Registrants do not record these taxes as revenue or expense.DebtGains and losses from the reacquisition of debt used to finance regulated electric utility plants are deferred and amortized over the remaining term of the reacquired debt in accordance with their rate-making treatment unless the debt is refinanced. If the reacquired debt associated with the regulated business is refinanced, the reacquisition costs attributable to the portions of the business that are subject to cost-based regulatory accounting are generally deferred and amortized over the term of the replacement debt consistent with its recovery in rates. Operations not subject to cost-based rate regulation report gains and losses on the reacquisition of debt in Interest Expense on the statements of income upon reacquisition.Debt discount or premium and debt issuance expenses are deferred and amortized generally utilizing the straight-line method over the term of the related debt. The straight-line method approximates the effective interest method and is consistent with the treatment in rates for regulated operations. The net amortization expense is included in Interest Expense on the statements of income.Goodwill (Applies to AEP)When AEP acquires a business, as defined by the accounting guidance for “Business Combinations,” management recognizes all acquired assets and liabilities at their fair value. To the extent that consideration exceeds the net fair value of the identified assets and liabilities, goodwill is recognized on the balance sheets. Goodwill is not amortized. Management tests acquired goodwill at the reporting unit level for impairment at least annually at its estimated fair value. Fair value is the amount at which an asset or liability could be bought or sold in a current transaction between willing parties other than in a forced or liquidation sale. Quoted market prices in active markets are the best evidence of fair value and are used as the basis for the measurement, if available. In the absence of quoted prices for identical or similar assets in active markets, management estimates fair value using various internal and external valuation methods. 239Pension and OPEB Plans (Applies to all Registrants except AEPTCo)AEP sponsors a qualified pension plan and two unfunded non-qualified pension plans. Substantially all AEP employees are covered by the qualified plan or both the qualified and a non-qualified pension plan. AEP also sponsors OPEB plans to provide health and life insurance benefits for retired employees. The Registrant Subsidiaries account for their participation in the AEP sponsored pension and OPEB plans using multiple-employer accounting. See Note 8 - Benefit Plans for additional information including significant accounting policies associated with the plans.Investments Held in Trust for Future Liabilities (Applies to all Registrants except AEPTCo)AEP has several trust funds with significant investments intended to provide for future payments of pension and OPEB benefits, nuclear decommissioning and SNF disposal. All of the trust funds’ investments are diversified and managed in compliance with all laws and regulations. The investment strategy for the trust funds is to use a diversified portfolio of investments to achieve an acceptable rate of return while managing the investment risk of the assets relative to the associated liabilities. To minimize investment risk, the trust funds are broadly diversified among classes of assets, investment strategies and investment managers. Management regularly reviews the actual asset allocations and periodically rebalances the investments to targeted allocations when appropriate. Investment policies and guidelines allow investment managers in approved strategies to use financial derivatives to obtain or manage market exposures and to hedge assets and liabilities. The investments are reported at fair value under the “Fair Value Measurements and Disclosures” accounting guidance.Benefit PlansAll benefit plan assets are invested in accordance with each plan’s investment policy. The investment policy outlines the investment objectives, strategies and target asset allocations by plan.The investment philosophies for AEP’s benefit plans support the allocation of assets to minimize risks and optimize net returns. Strategies used include:•Maintaining a long-term investment horizon.•Diversifying assets to help control volatility of returns at acceptable levels.•Managing fees, transaction costs and tax liabilities to maximize investment earnings.•Using active management of investments where appropriate risk/return opportunities exist.•Keeping portfolio structure style-neutral to limit volatility compared to applicable benchmarks.•Using alternative asset classes such as real estate and private equity to maximize return and provide additional portfolio diversification.The objective of the investment policy for the pension fund is to maintain the funded status of the plan while providing for growth in the plan assets to offset the growth in the plan liabilities. The current target asset allocations are as follows:Pension Plan AssetsTargetEquity25 %Fixed Income59 %Other Investments15 %Cash and Cash Equivalents1 %OPEB Plans AssetsTargetEquity49 %Fixed Income49 %Cash and Cash Equivalents2 %240The investment policy for each benefit plan contains various investment limitations. The investment policies establish concentration limits for securities and prohibit the purchase of securities issued by AEP (with the exception of proportionate and immaterial holdings of AEP securities in passive index strategies or certain commingled funds). However, the investment policies do not preclude the benefit trust funds from receiving contributions in the form of AEP securities, provided that the AEP securities acquired by each plan may not exceed the limitations imposed by law.For equity investments, the concentration limits are generally as follows:•No security in excess of 5% of all equities. •Cash equivalents must be less than 10% of an investment manager’s equity portfolio. •No individual stock may be more than 10% and 7% for pension and OPEB investments, respectively, of each manager’s equity portfolio. •No securities may be bought or sold on margin or other use of leverage. For fixed income investments, each investment manager’s portfolio is compared to investment grade, diversified long and intermediate benchmark indices.A portion of the pension assets is invested in real estate funds to provide diversification, add return and hedge against inflation. Real estate properties are illiquid, difficult to value and not actively traded. The pension plan uses external real estate investment managers to invest in commingled funds that hold real estate properties. To mitigate investment risk in the real estate portfolio, commingled real estate funds are used to ensure that holdings are diversified by region, property type and risk classification. Real estate holdings include core, value-added and opportunistic classifications.A portion of the pension assets is invested in private equity. Private equity investments add return and provide diversification and typically require a long-term time horizon to evaluate investment performance. Private equity is classified as an alternative investment because it is illiquid, difficult to value and not actively traded. The pension plan uses limited partnerships to invest across the private equity investment spectrum. The private equity holdings are with multiple general partners who help monitor the investments and provide investment selection expertise. The holdings are currently comprised of venture capital, buyout and hybrid debt and equity investments. AEP participates in a securities lending program with BNY Mellon to provide incremental income on idle assets and to provide income to offset custody fees and other administrative expenses. AEP lends securities to borrowers approved by BNY Mellon in exchange for collateral. All loans are collateralized by at least 102% of the loaned asset’s market value and the collateral is invested. The difference between the rebate owed to the borrower and the collateral rate of return determines the earnings on the loaned security. The securities lending program’s objective is to provide modest incremental income with a limited increase in risk. As of December 31, 2020 and 2019, the fair value of securities on loan as part of the program was $177 million and $246 million, respectively. Cash and securities obtained as collateral exceeded the fair value of the securities loaned as of December 31, 2020 and 2019.Trust owned life insurance (TOLI) underwritten by The Prudential Insurance Company is held in the OPEB plan trusts. The strategy for holding life insurance contracts in the taxable Voluntary Employees’ Beneficiary Association trust is to minimize taxes paid on the asset growth in the trust. Earnings on plan assets are tax-deferred within the TOLI contract and can be tax-free if held until claims are paid. Life insurance proceeds remain in the trust and are used to fund future retiree medical benefit liabilities. With consideration to other investments held in the trust, the cash value of the TOLI contracts is invested in two diversified funds. A portion is invested in a commingled fund with underlying investments in stocks that are actively traded on major international equity exchanges. The other portion of the TOLI cash value is invested in a diversified, commingled fixed income fund with underlying investments in government bonds, corporate bonds and asset-backed securities.241Cash and cash equivalents are held in each trust to provide liquidity and meet short-term cash needs. Cash equivalent funds are used to provide diversification and preserve principal. The underlying holdings in the cash funds are investment grade money market instruments including commercial paper, certificates of deposit, treasury bills and other types of investment grade short-term debt securities. The cash funds are valued each business day and provide daily liquidity.Nuclear Trust Funds (Applies to AEP and I&M)Nuclear decommissioning and SNF trust funds represent funds that regulatory commissions allow I&M to collect through rates to fund future decommissioning and SNF disposal liabilities. By rules or orders, the IURC, the MPSC and the FERC established investment limitations and general risk management guidelines. In general, limitations include:•Acceptable investments (rated investment grade or above when purchased).•Maximum percentage invested in a specific type of investment.•Prohibition of investment in obligations of AEP, I&M or their affiliates.•Withdrawals permitted only for payment of decommissioning costs and trust expenses.I&M maintains trust funds for each regulatory jurisdiction. Regulatory approval is required to withdraw decommissioning funds. These funds are managed by an external investment manager that must comply with the guidelines and rules of the applicable regulatory authorities. The trust assets are invested to optimize the net of tax earnings of the trust giving consideration to liquidity, risk, diversification and other prudent investment objectives.I&M records securities held in these trust funds in Spent Nuclear Fuel and Decommissioning Trusts on its balance sheets. I&M records these securities at fair value. I&M classifies debt securities in the trust funds as available-for-sale due to their long-term purpose. Other-than-temporary impairments for investments in debt securities are considered realized losses as a result of securities being managed by an external investment management firm. The external investment management firm makes specific investment decisions regarding the debt and equity investments held in these trusts and generally intends to sell debt securities in an unrealized loss position as part of a tax optimization strategy. Impairments reduce the cost basis of the securities which will affect any future unrealized gain or realized gain or loss due to the adjusted cost of investment. I&M records unrealized gains, unrealized losses and other-than-temporary impairments from securities in these trust funds as adjustments to the regulatory liability account for the nuclear decommissioning trust funds and to regulatory assets or liabilities for the SNF disposal trust funds in accordance with their treatment in rates. Consequently, changes in fair value of trust assets do not affect earnings or AOCI. See the “Nuclear Contingencies” section of Note 6 for additional discussion of nuclear matters. See “Fair Value Measurements of Trust Assets for Decommissioning and SNF Disposal” section of Note 11 for disclosure of the fair value of assets within the trusts.Comprehensive Income (Loss) (Applies to all Registrants except AEPTCo)Comprehensive income (loss) is defined as the change in equity (net assets) of a business enterprise during a period from transactions and other events and circumstances from non-owner sources. It includes all changes in equity during a period except those resulting from investments by owners and distributions to owners. Comprehensive income (loss) has two components: net income (loss) and other comprehensive income (loss).Stock-Based Compensation Plans As of December 31, 2020, AEP had performance shares and restricted stock units outstanding under the American Electric Power System 2015 Long-Term Incentive Plan (2015 LTIP). Upon vesting, all outstanding performance shares and restricted stock units settle in AEP common stock. Performance units awarded prior to 2017 and restricted stock units granted after January 1, 2013 and prior to January 1, 2017 that vested to executive officers 242were settled in cash. During 2019, all of the remaining performance units and restricted stock units that settle in cash were settled. The impact of AEP’s stock-based compensation plans are insignificant to the financial statements of the Registrant Subsidiaries. AEP maintains a variety of tax qualified and non-qualified deferred compensation plans for employees and non-employee directors that include, among other options, an investment in or an investment return equivalent to that of AEP common stock. This includes AEP career shares maintained under the American Electric Power System Stock Ownership Requirement Plan (SORP), which facilitates executives in meeting minimum stock ownership requirements assigned to them by the Human Resources Committee of the Board of Directors. AEP career shares are derived from vested performance shares granted to employees under the 2015 LTIP. AEP career shares accrue additional dividend shares in an amount equal to dividends paid on AEP common shares at the closing market price on the dividend payments date. All AEP career shares are settled in shares of AEP common stock after the executive’s service with AEP ends.Performance shares awarded after January 1, 2017 are classified as temporary equity in the Mezzanine Equity section of the balance sheets until the awards vest. Upon vesting, the performance shares are classified as permanent equity. These awards may be settled in cash upon an employee’s qualifying termination due to a change in control. Because such event is not solely within the control of the company, these awards are classified outside of permanent equity until the awards vest.AEP compensates their non-employee directors, in part, with stock units under the American Electric Power Company, Inc. Stock Unit Accumulation Plan for Non-Employee Directors. These stock units become payable in cash to directors after their service ends.Management measures and recognizes compensation expense for all share-based payment awards to employees and directors based on estimated fair values. For share-based payment awards with service only vesting conditions, management recognizes compensation expense on a straight-line basis. Stock-based compensation expense recognized on the statements of income for the years ended December 31, 2020, 2019 and 2018 is based on the number of outstanding awards at the end of each period without a reduction for estimated forfeitures. AEP accounts for forfeitures in the period in which they occur.For the years ended December 31, 2020, 2019 and 2018, compensation cost is included in Net Income for the performance shares, career shares, restricted stock units and the non-employee director’s stock units. Compensation cost may also be capitalized. See Note 15 - Stock-based Compensation for additional information.Equity Investment in Unconsolidated Entities (Applies to AEP and SWEPCo)The equity method of accounting is used for equity investments where either AEP or SWEPCo exercise significant influence but do not hold a controlling financial interest. Such investments are initially recorded at cost in Deferred Charges and Other Noncurrent Assets on the balance sheets. The proportionate share of the investee’s equity earnings or losses is included in Equity Earnings (Loss) of Unconsolidated Subsidiaries on the statements of income. AEP and SWEPCo regularly monitor and evaluate equity method investments to determine whether they are impaired. An impairment is recorded when the investment has experienced a decline in value that is other-than-temporary in nature.AEP has various significant equity method investments, which include ETT, DHLC and five wind farms acquired in the purchase of Sempra Renewables LLC. See Note 17 - Variable Interest Entities and Equity Method Investments for additional information. 243COVID-19In March 2020, COVID-19 was declared a pandemic by the World Health Organization and the Centers for Disease Control and Prevention. Its rapid spread around the world and throughout the United States prompted many countries, including the United States, to institute restrictions on travel, public gatherings and certain business operations. These restrictions significantly disrupted economic activity in AEP’s service territory and reduced demand for energy, particularly from commercial and industrial customers in 2020. The Registrants have taken steps to mitigate the potential risks to customers, suppliers and employees posed by the spread of COVID-19. As of December 31, 2020 and through the date of this report, the Registrants assessed certain accounting matters that require consideration of forecasted financial information, including, but not limited to, the allowance for credit losses and the carrying value of long-lived assets. While there were not any impairments or significant increases in credit allowances resulting from these assessments for the year ended December 31, 2020, the ultimate impact of COVID-19 also depends on factors beyond management’s knowledge or control, including the duration and severity of this outbreak as well as third-party actions taken to contain its spread and mitigate its public health effects. Therefore, management cannot estimate the potential future impact to financial position, results of operations and cash flows, but the impacts could be material.Voluntary Retirement Incentive ProgramIn June 2020, AEP announced a voluntary retirement incentive program. Eligible employees volunteered for retirement from the date of the announcement through July 6, 2020, with most having an effective retirement date of August 1, 2020. Participating employees were eligible to receive up to six months base pay and a medical premium subsidy. Certain participating employees were also eligible to receive a long-term incentive plan grant, with immediate vesting, of AEP common shares. A total of 200 employees participated in the voluntary retirement program. In August 2020, AEP recorded a charge to expense of $13 million primarily related to lump sum salary payments and cash subsidies. AEP also recorded a charge to expense of $5 million related to the incremental Long-Term Incentive Plan grants issued related to this initiative. Approximately 92% of the expense was initially recorded within the AEPSC and then allocated among affiliated entities including the Registrant Subsidiaries. The impact of this program was immaterial on the Registrants’ financial statements as of December 31, 2020.Earnings Per Share (EPS) (Applies to AEP)Basic EPS is calculated by dividing net earnings available to common shareholders by the weighted-average number of common shares outstanding during the period. Diluted EPS is calculated by adjusting the weighted-average outstanding common shares, assuming conversion of all potentially dilutive stock options and awards.The following table presents AEP’s basic and diluted EPS calculations included on the statements of income:Years Ended December 31,202020192018(in millions, except per-share data)$/share$/share$/shareEarnings Attributable to AEP Common Shareholders$2,200.1 $1,921.1 $1,923.8 Weighted-Average Number of Basic AEP Common Shares Outstanding495.7 $4.44 493.7 $3.89 492.8 $3.90 Weighted-Average Dilutive Effect of Stock-Based Awards1.5 (0.02)1.6 (0.01)1.0 — Weighted-Average Number of Diluted AEP Common Shares Outstanding497.2 $4.42 495.3 $3.88 493.8 $3.90 244Equity Units are potentially dilutive securities but were excluded from the calculation of diluted EPS for the years ended December 31, 2020 and 2019, as the dilutive stock price thresholds were not met. See Note 14 - Financing Activities for additional information related to Equity Units.There were 128 thousand antidilutive shares outstanding as of December 31, 2020. There were no antidilutive shares outstanding as of December 31, 2019 and 2018.ReclassificationsCertain reclassifications have been made in the 2019 financial statements and notes to conform to the 2020 presentation.Supplementary Income Statement InformationThe following tables provide the components of Depreciation and Amortization for the years ended December 31, 2020, 2019 and 2018:2020Depreciation and AmortizationAEPAEP TexasAEPTCoAPCoI&MOPCoPSOSWEPCo(in millions)Depreciation and Amortization of Property, Plant and Equipment$2,487.5 $364.2 $249.0 $507.8 $393.3 $275.0 $171.9 $271.2 Amortization of Certain Securitized Assets171.3 171.3 — — — — — — Amortization of Regulatory Assets and Liabilities24.0 (5.7)— (0.3)18.3 1.6 1.6 1.5 Total Depreciation and Amortization$2,682.8 $529.8 $249.0 $507.5 $411.6 $276.6 $173.5 $272.7 2019Depreciation and AmortizationAEPAEP TexasAEPTCoAPCoI&MOPCoPSOSWEPCo(in millions)Depreciation and Amortization of Property, Plant and Equipment$2,203.7 $365.9 $176.0 $466.5 $330.6 $229.4 $162.5 $247.9 Amortization of Certain Securitized Assets280.7 258.7 — — — 22.0 — — Amortization of Regulatory Assets and Liabilities30.1 (2.3)— 0.3 20.0 (10.5)7.0 1.2 Total Depreciation and Amortization$2,514.5 $622.3 $176.0 $466.8 $350.6 $240.9 $169.5 $249.1 2018Depreciation and AmortizationAEPAEP TexasAEPTCoAPCoI&MOPCoPSOSWEPCo(in millions)Depreciation and Amortization of Property, Plant and Equipment$1,965.0 $262.2 $133.9 $428.1 $278.9 $232.6 $155.5 $237.0 Amortization of Certain Securitized Assets287.9 240.0 — — — 47.9 — — Amortization of Regulatory Assets and Liabilities33.7 (2.6)— 0.3 14.2 (20.8)8.5 2.5 Total Depreciation and Amortization$2,286.6 $499.6 $133.9 $428.4 $293.1 $259.7 $164.0 $239.5 245Supplementary Cash Flow Information (Applies to AEP)Years Ended December 31,Cash Flow Information202020192018(in millions)Cash Paid (Received) for:Interest, Net of Capitalized Amounts$1,029.1 $1,022.5 $939.3 Income Taxes(49.1)6.1 (24.7)Noncash Investing and Financing Activities:Acquisitions Under Finance Leases44.2 87.5 55.6 Construction Expenditures Included in Current Liabilities as of December 31,975.4 1,341.1 1,120.4 Construction Expenditures Included in Noncurrent Liabilities as of December 31,5.5 — — Acquisition of Nuclear Fuel Included in Current Liabilities as of December 31,33.4 0.1 4.0 Noncash Contribution of Assets by Noncontrolling Interest— — 84.0 Expected Reimbursement for Spent Nuclear Fuel Dry Cask Storage2.6 0.3 2.2 Noncontrolling Interest Assumed with Sempra Renewables LLC and Santa Rita East Acquisition— 253.4 — Liabilities Assumed with Sempra Renewable LLC and Santa Rita East Acquisition— 32.4 — Forward Equity Purchase Contracts Included in Current and Noncurrent Liabilities as of December 31,110.6 47.3 — 2462. NEW ACCOUNTING STANDARDSThe disclosures in this note apply to all Registrants unless indicated otherwise.During the FASB’s standard-setting process and upon issuance of final standards, management reviews the new accounting literature to determine its relevance, if any, to the Registrants’ business. The following standards will impact the financial statements.ASU 2016-13 “Measurement of Credit Losses on Financial Instruments” (ASU 2016-13)In June 2016, the FASB issued ASU 2016-13 requiring the recognition of an allowance for expected credit losses for financial instruments within its scope. Examples of financial instruments that are in scope include trade receivables, certain financial guarantees and held-to-maturity debt securities. The allowance for expected credit losses should be based on historical information, current conditions and reasonable and supportable forecasts. Entities are required to evaluate, and if necessary, recognize expected credit losses at the inception or initial acquisition of a financial instrument (or pool of financial instruments that share similar risk characteristics) subject to ASU 2016-13, and subsequently as of each reporting date. The new standard also revises the other-than-temporary impairment model for available-for-sale debt securities. New standard implementation activities included: (a) the identification and evaluation of the population of financial instruments within the AEP system that are subject to the new standard, (b) the development of supporting valuation models to also contemplate appropriate metrics for current and supportable forecasted information and (c) the development of disclosures to comply with the requirements of ASU 2016-13. As required by ASU 2016-13, the financial instruments subject to the new standard were evaluated on a pool-basis to the extent such financial instruments shared similar risk characteristics. Management adopted ASU 2016-13 and its related implementation guidance effective January 1, 2020, by means of an immaterial cumulative-effect adjustment to Retained Earnings on the balance sheets. The adoption of the new standard did not have a material impact to financial position and had no impact on the results of operations or cash flows. Additionally, the adoption of the new standard did not result in any changes to current accounting systems.ASU 2020-04 “Reference Rate Reform: Facilitation of the Effects of Reference Rate Reform on Financial Reporting” (ASU 2020-04)In March 2020, the FASB issued ASU 2020-04 providing guidance to ease the potential burden in accounting for Reference Rate Reform on financial reporting. The new standard is elective and applies to all entities, subject to meeting certain criteria, that have contracts, hedging relationships, and other transactions that reference the London Interbank Offered Rate (LIBOR) or another reference rate expected to be discontinued because of Reference Rate Reform. The new standard establishes a general contract modification principle that entities can apply in other areas that may be affected by Reference Rate Reform and certain elective hedge accounting expedients. Under the new standard, an entity may make a one-time election to sell or to transfer to the available-for-sale or trading classifications (or both sell and transfer), debt securities that both reference an affected rate, and were classified as held-to-maturity before January 1, 2020. Management adopted ASU 2020-04 and its related implementation guidance effective January 1, 2021. There was no impact to results of operations, financial position or cash flows upon initial adoption. Management is applying the accounting guidance as relevant contract and hedge accounting relationship modifications are made during the course of the reference rate reform transition period, which ends on December 31, 2022. The guidance generally allows for contract modifications solely related to the replacement of the reference rate to be accounted for as a continuation of the existing contract instead of as an extinguishment of the contract, and would therefore, not trigger certain accounting impacts that would otherwise be required. It also allows entities to change certain critical terms of existing hedge accounting relationships that are affected by reference rate reform. These changes would not require de-designating the hedge accounting relationship. 2473. COMPREHENSIVE INCOMEThe disclosures in this note apply to all Registrants except for AEPTCo. AEPTCo does not have any components of other comprehensive income for any period presented in the financial statements.Presentation of Comprehensive IncomeThe following tables provide the components of changes in AOCI and details of reclassifications from AOCI for the years ended December 31, 2020, 2019 and 2018. The amortization of pension and OPEB AOCI components are included in the computation of net periodic pension and OPEB costs. See Note 8 - Benefit Plans for additional information. AEPCash Flow HedgesPension and OPEB For the Year Ended December 31, 2020CommodityInterest RateAmortization of Deferred CostsChanges in Funded StatusTotal (in millions)Balance in AOCI as of December 31, 2019$(103.5)$(11.5)$130.7 $(163.4)$(147.7)Change in Fair Value Recognized in AOCI(89.2)(39.9)(a)— 62.7 (66.4)Amount of (Gain) Loss Reclassified from AOCI Generation & Marketing Revenues (b)(0.4)— — — (0.4)Purchased Electricity for Resale (b)167.6 — — — 167.6 Interest Expense (b)— 4.9 — — 4.9 Amortization of Prior Service Cost (Credit)— — (19.2)— (19.2)Amortization of Actuarial (Gains) Losses— — 10.3 — 10.3 Reclassifications from AOCI, before Income Tax (Expense) Benefit167.2 4.9 (8.9)— 163.2 Income Tax (Expense) Benefit35.1 1.0 (1.9)— 34.2 Reclassifications from AOCI, Net of Income Tax (Expense) Benefit132.1 3.9 (7.0)— 129.0 Net Current Period Other Comprehensive Income (Loss)42.9 (36.0)(7.0)62.7 62.6 Balance in AOCI as of December 31, 2020$(60.6)$(47.5)$123.7 $(100.7)$(85.1)248AEP Cash Flow HedgesPension and OPEB For the Year Ended December 31, 2019CommodityInterest Rate Amortization of Deferred CostsChanges in Funded StatusTotal (in millions)Balance in AOCI as of December 31, 2018$(23.0)$(12.6)$136.3 $(221.1)$(120.4)Change in Fair Value Recognized in AOCI(127.2)(0.2)(a)— 57.7 (69.7)Amount of (Gain) Loss Reclassified from AOCI Generation & Marketing Revenues (b)(0.2)— — — (0.2)Purchased Electricity for Resale (b)59.5 — — — 59.5 Interest Expense (b)— 1.5 — — 1.5 Amortization of Prior Service Cost (Credit)— — (19.2)— (19.2)Amortization of Actuarial (Gains) Losses— — 12.1 — 12.1 Reclassifications from AOCI, before Income Tax (Expense) Benefit59.3 1.5 (7.1)— 53.7 Income Tax (Expense) Benefit12.6 0.2 (1.5)— 11.3 Reclassifications from AOCI, Net of Income Tax (Expense) Benefit46.7 1.3 (5.6)— 42.4 Net Current Period Other Comprehensive Income (Loss)(80.5)1.1 (5.6)57.7 (27.3)Balance in AOCI as of December 31, 2019$(103.5)$(11.5)$130.7 $(163.4)$(147.7) Cash Flow Hedges Pension and OPEB For the Year Ended December 31, 2018CommodityInterest Rate Securities Available for SaleAmortization of Deferred CostsChanges in Funded StatusTotal (in millions)Balance in AOCI as of December 31, 2017$(28.4)$(13.0)$11.9 $141.6 $(179.9)$(67.8)Change in Fair Value Recognized in AOCI37.3 2.3 — — (33.0)6.6 Amount of (Gain) Loss Reclassified from AOCI Generation & Marketing Revenues (b)(0.1)— — — — (0.1)Purchased Electricity for Resale (b)(32.6)— — — — (32.6)Interest Expense (b)— 1.1 — — — 1.1 Amortization of Prior Service Cost (Credit)— — — (19.5)— (19.5)Amortization of Actuarial (Gains) Losses— — — 12.8 — 12.8 Reclassifications from AOCI, before Income Tax (Expense) Benefit(32.7)1.1 — (6.7)— (38.3)Income Tax (Expense) Benefit(6.9)0.3 — (1.4)— (8.0)Reclassifications from AOCI, Net of Income Tax (Expense) Benefit(25.8)0.8 — (5.3)— (30.3)Net Current Period Other Comprehensive Income (Loss)11.5 3.1 — (5.3)(33.0)(23.7)ASU 2018-02 Adoption(6.1)(2.7)— — (8.2)(17.0)ASU 2016-01 Adoption— — (11.9)— — (11.9)Balance in AOCI as of December 31, 2018$(23.0)$(12.6)$— $136.3 $(221.1)$(120.4)249AEP TexasPension and OPEBAmortizationChanges inCash Flow Hedge – of DeferredFundedFor the Year Ended December 31, 2020Interest RateCostsStatusTotal(in millions)Balance in AOCI as of December 31, 2019$(3.4)$4.9 $(14.3)$(12.8)Change in Fair Value Recognized in AOCI0.1 — 2.6 2.7 Amount of (Gain) Loss Reclassified from AOCI Interest Expense (b)1.3 — — 1.3 Amortization of Prior Service Cost (Credit)— (0.1)— (0.1)Amortization of Actuarial (Gains) Losses— 0.3 — 0.3 Reclassifications from AOCI, before Income Tax (Expense) Benefit1.3 0.2 — 1.5 Income Tax (Expense) Benefit0.3 — — 0.3 Reclassifications from AOCI, Net of Income Tax (Expense) Benefit1.0 0.2 — 1.2 Net Current Period Other Comprehensive Income (Loss)1.1 0.2 2.6 3.9 Balance in AOCI as of December 31, 2020$(2.3)$5.1 $(11.7)$(8.9)Pension and OPEBAmortizationChanges inCash Flow Hedge – of DeferredFundedFor the Year Ended December 31, 2019Interest RateCostsStatusTotal(in millions)Balance in AOCI as of December 31, 2018$(4.4)$4.7 $(15.4)$(15.1)Change in Fair Value Recognized in AOCI— — 1.1 1.1 Amount of (Gain) Loss Reclassified from AOCI Interest Expense (b)1.3 — — 1.3 Amortization of Prior Service Cost (Credit)— (0.1)— (0.1)Amortization of Actuarial (Gains) Losses— 0.3 — 0.3 Reclassifications from AOCI, before Income Tax (Expense) Benefit1.3 0.2 — 1.5 Income Tax (Expense) Benefit0.3 — — 0.3 Reclassifications from AOCI, Net of Income Tax (Expense) Benefit1.0 0.2 — 1.2 Net Current Period Other Comprehensive Income (Loss)1.0 0.2 1.1 2.3 ASU 2018-02 Adoption— — — — Balance in AOCI as of December 31, 2019$(3.4)$4.9 $(14.3)$(12.8)Pension and OPEBAmortizationChanges inCash Flow Hedge – of DeferredFundedFor the Year Ended December 31, 2018Interest RateCostsStatusTotal(in millions)Balance in AOCI as of December 31, 2017$(4.5)$4.5 $(12.6)$(12.6)Change in Fair Value Recognized in AOCI— — (1.0)(1.0)Amount of (Gain) Loss Reclassified from AOCI Interest Expense (b)1.3 — — 1.3 Amortization of Prior Service Cost (Credit)— (0.1)— (0.1)Amortization of Actuarial (Gains) Losses— 0.4 — 0.4 Reclassifications from AOCI, before Income Tax (Expense) Benefit1.3 0.3 — 1.6 Income Tax (Expense) Benefit0.3 0.1 — 0.4 Reclassifications from AOCI, Net of Income Tax (Expense) Benefit1.0 0.2 — 1.2 Net Current Period Other Comprehensive Income (Loss)1.0 0.2 (1.0)0.2 ASU 2018-02 Adoption(0.9)— (1.8)(2.7)Balance in AOCI as of December 31, 2018$(4.4)$4.7 $(15.4)$(15.1)250APCoPension and OPEB AmortizationChanges inCash Flow Hedge – of DeferredFundedFor the Year Ended December 31, 2020Interest RateCostsStatusTotal(in millions)Balance in AOCI as of December 31, 2019$0.9 $9.2 $(5.1)$5.0 Change in Fair Value Recognized in AOCI(0.7)— 7.7 7.0 Amount of (Gain) Loss Reclassified from AOCI Interest Expense (b)(1.3)— — (1.3)Amortization of Prior Service Cost (Credit)— (5.3)— (5.3)Amortization of Actuarial (Gains) Losses— 0.5 — 0.5 Reclassifications from AOCI, before Income Tax (Expense) Benefit(1.3)(4.8)— (6.1)Income Tax (Expense) Benefit(0.3)(1.0)— (1.3)Reclassifications from AOCI, Net of Income Tax (Expense) Benefit(1.0)(3.8)— (4.8)Net Current Period Other Comprehensive Income (Loss)(1.7)(3.8)7.7 2.2 Balance in AOCI as of December 31, 2020$(0.8)$5.4 $2.6 $7.2 Pension and OPEBAmortizationChanges inCash Flow Hedges -of DeferredFundedFor the Year Ended December 31, 2019Interest RateCostsStatusTotal(in millions)Balance in AOCI as of December 31, 2018$1.8 $11.7 $(18.5)$(5.0)Change in Fair Value Recognized in AOCI— — 13.4 13.4 Amount of (Gain) Loss Reclassified from AOCI Interest Expense (b)(1.1)— — (1.1)Amortization of Prior Service Cost (Credit)— (5.3)— (5.3)Amortization of Actuarial (Gains) Losses— 2.1 — 2.1 Reclassifications from AOCI, before Income Tax (Expense) Benefit(1.1)(3.2)— (4.3)Income Tax (Expense) Benefit(0.2)(0.7)— (0.9)Reclassifications from AOCI, Net of Income Tax (Expense) Benefit(0.9)(2.5)— (3.4)Net Current Period Other Comprehensive Income (Loss)(0.9)(2.5)13.4 10.0 Balance in AOCI as of December 31, 2019$0.9 $9.2 $(5.1)$5.0 Pension and OPEBAmortizationChanges inCash Flow Hedgesof DeferredFundedFor the Year Ended December 31, 2018CommodityInterest RateCostsStatusTotal(in millions)Balance in AOCI as of December 31, 2017$— $2.2 $14.8 $(15.7)$1.3 Change in Fair Value Recognized in AOCI(0.7)— — (2.6)(3.3)Amount of (Gain) Loss Reclassified from AOCI Purchased Electricity for Resale (b)0.9 — — — 0.9 Interest Expense (b)— (1.1)— — (1.1)Amortization of Prior Service Cost (Credit)— — (5.2)— (5.2)Amortization of Actuarial (Gains) Losses— — 1.3 — 1.3 Reclassifications from AOCI, before Income Tax (Expense) Benefit0.9 (1.1)(3.9)— (4.1)Income Tax (Expense) Benefit0.2 (0.2)(0.8)— (0.8)Reclassifications from AOCI, Net of Income Tax (Expense) Benefit0.7 (0.9)(3.1)— (3.3)Net Current Period Other Comprehensive Income (Loss)— (0.9)(3.1)(2.6)(6.6)ASU 2018-02 Adoption— 0.5 — (0.2)0.3 Balance in AOCI as of December 31, 2018$— $1.8 $11.7 $(18.5)$(5.0)251I&MPension and OPEBAmortizationChanges inCash Flow Hedge – of DeferredFundedFor the Year Ended December 31, 2020Interest RateCostsStatusTotal(in millions)Balance in AOCI as of December 31, 2019$(9.9)$4.9 $(6.6)$(11.6)Change in Fair Value Recognized in AOCI— — 3.1 3.1 Amount of (Gain) Loss Reclassified from AOCI Interest Expense (b)2.0 — — 2.0 Amortization of Prior Service Cost (Credit)— (0.8)— (0.8)Amortization of Actuarial (Gains) Losses— 0.7 — 0.7 Reclassifications from AOCI, before Income Tax (Expense) Benefit2.0 (0.1)— 1.9 Income Tax (Expense) Benefit0.4 — — 0.4 Reclassifications from AOCI, Net of Income Tax (Expense) Benefit1.6 (0.1)— 1.5 Net Current Period Other Comprehensive Income (Loss)1.6 (0.1)3.1 4.6 Balance in AOCI as of December 31, 2020$(8.3)$4.8 $(3.5)$(7.0)Pension and OPEBAmortizationChanges inCash Flow Hedge – of DeferredFundedFor the Year Ended December 31, 2019Interest RateCostsStatusTotal(in millions)Balance in AOCI as of December 31, 2018$(11.5)$5.1 $(7.4)$(13.8)Change in Fair Value Recognized in AOCI— — 0.8 0.8 Amount of (Gain) Loss Reclassified from AOCI Interest Expense (b)2.0 — — 2.0 Amortization of Prior Service Cost (Credit)— (0.8)— (0.8)Amortization of Actuarial (Gains) Losses— 0.6 — 0.6 Reclassifications from AOCI, before Income Tax (Expense) Benefit2.0 (0.2)— 1.8 Income Tax (Expense) Benefit0.4 — — 0.4 Reclassifications from AOCI, Net of Income Tax (Expense) Benefit1.6 (0.2)— 1.4 Net Current Period Other Comprehensive Income (Loss)1.6 (0.2)0.8 2.2 Balance in AOCI as of December 31, 2019$(9.9)$4.9 $(6.6)$(11.6)Pension and OPEBAmortizationChanges inCash Flow Hedge – of DeferredFundedFor the Year Ended December 31, 2018Interest RateCostsStatusTotal(in millions)Balance in AOCI as of December 31, 2017$(10.7)$5.1 $(6.5)$(12.1)Change in Fair Value Recognized in AOCI— — (0.6)(0.6)Amount of (Gain) Loss Reclassified from AOCI Interest Expense (b)2.0 — — 2.0 Amortization of Prior Service Cost (Credit)— (0.8)— (0.8)Amortization of Actuarial (Gains) Losses— 0.8 — 0.8 Reclassifications from AOCI, before Income Tax (Expense) Benefit2.0 — — 2.0 Income Tax (Expense) Benefit0.4 — — 0.4 Reclassifications from AOCI, Net of Income Tax (Expense) Benefit1.6 — — 1.6 Net Current Period Other Comprehensive Income (Loss)1.6 — (0.6)1.0 ASU 2018-02 Adoption(2.4)— (0.3)(2.7)Balance in AOCI as of December 31, 2018$(11.5)$5.1 $(7.4)$(13.8)252OPCoCash Flow Hedge – For the Year Ended December 31, 2020Interest Rate(in millions)Balance in AOCI as of December 31, 2019$— Change in Fair Value Recognized in AOCI— Amount of (Gain) Loss Reclassified from AOCI Interest Expense (b)— Reclassifications from AOCI, before Income Tax (Expense) Benefit— Income Tax (Expense) Benefit— Reclassifications from AOCI, Net of Income Tax (Expense) Benefit— Net Current Period Other Comprehensive Income (Loss)— Balance in AOCI as of December 31, 2020$— Cash Flow Hedge – For the Year Ended December 31, 2019Interest Rate(in millions)Balance in AOCI as of December 31, 2018$1.0 Change in Fair Value Recognized in AOCI— Amount of (Gain) Loss Reclassified from AOCI Interest Expense (b)(1.3)Reclassifications from AOCI, before Income Tax (Expense) Benefit(1.3)Income Tax (Expense) Benefit(0.3)Reclassifications from AOCI, Net of Income Tax (Expense) Benefit(1.0)Net Current Period Other Comprehensive Income (Loss)(1.0)Balance in AOCI as of December 31, 2019$— Cash Flow Hedge – For the Year Ended December 31, 2018Interest Rate(in millions)Balance in AOCI as of December 31, 2017$1.9 Change in Fair Value Recognized in AOCI— Amount of (Gain) Loss Reclassified from AOCI Interest Expense (b)(1.7)Reclassifications from AOCI, before Income Tax (Expense) Benefit(1.7)Income Tax (Expense) Benefit(0.4)Reclassifications from AOCI, Net of Income Tax (Expense) Benefit(1.3)Net Current Period Other Comprehensive Income (Loss)(1.3)ASU 2018-02 Adoption0.4 Balance in AOCI as of December 31, 2018$1.0 253PSOCash Flow Hedge – For the Year Ended December 31, 2020Interest Rate(in millions)Balance in AOCI as of December 31, 2019$1.1 Change in Fair Value Recognized in AOCI— Amount of (Gain) Loss Reclassified from AOCI Interest Expense (b)(1.3)Reclassifications from AOCI, before Income Tax (Expense) Benefit(1.3)Income Tax (Expense) Benefit(0.3)Reclassifications from AOCI, Net of Income Tax (Expense) Benefit(1.0)Net Current Period Other Comprehensive Income (Loss)(1.0)Balance in AOCI as of December 31, 2020$0.1 Cash Flow Hedge – For the Year Ended December 31, 2019Interest Rate(in millions)Balance in AOCI as of December 31, 2018$2.1 Change in Fair Value Recognized in AOCI— Amount of (Gain) Loss Reclassified from AOCI Interest Expense (b)(1.3)Reclassifications from AOCI, before Income Tax (Expense) Benefit(1.3)Income Tax (Expense) Benefit(0.3)Reclassifications from AOCI, Net of Income Tax (Expense) Benefit(1.0)Net Current Period Other Comprehensive Income (Loss)(1.0)Balance in AOCI as of December 31, 2019$1.1 Cash Flow Hedge – For the Year Ended December 31, 2018Interest Rate(in millions)Balance in AOCI as of December 31, 2017$2.6 Change in Fair Value Recognized in AOCI— Amount of (Gain) Loss Reclassified from AOCI Interest Expense (b)(1.3)Reclassifications from AOCI, before Income Tax (Expense) Benefit(1.3)Income Tax (Expense) Benefit(0.3)Reclassifications from AOCI, Net of Income Tax (Expense) Benefit(1.0)Net Current Period Other Comprehensive Income (Loss)(1.0)ASU 2018-02 Adoption0.5 Balance in AOCI as of December 31, 2018$2.1 254SWEPCoPension and OPEBAmortizationChanges inCash Flow Hedge – of DeferredFundedFor the Year Ended December 31, 2020Interest RateCostsStatusTotal(in millions)Balance in AOCI as of December 31, 2019$(1.8)$(1.3)$1.8 $(1.3)Change in Fair Value Recognized in AOCI— — 3.2 3.2 Amount of (Gain) Loss Reclassified from AOCI Interest Expense (b)1.9 — — 1.9 Amortization of Prior Service Cost (Credit)— (2.0)— (2.0)Amortization of Actuarial (Gains) Losses— 0.1 — 0.1 Reclassifications from AOCI, before Income Tax (Expense) Benefit1.9 (1.9)— — Income Tax (Expense) Benefit0.4 (0.4)— — Reclassifications from AOCI, Net of Income Tax (Expense) Benefit1.5 (1.5)— — Net Current Period Other Comprehensive Income (Loss)1.5 (1.5)3.2 3.2 Balance in AOCI as of December 31, 2020$(0.3)$(2.8)$5.0 $1.9 Pension and OPEBAmortizationChanges inCash Flow Hedge – of DeferredFundedFor the Year Ended December 31, 2019Interest RateCostsStatusTotal(in millions)Balance in AOCI as of December 31, 2018$(3.3)$(0.2)$(1.9)$(5.4)Change in Fair Value Recognized in AOCI— — 3.7 3.7 Amount of (Gain) Loss Reclassified from AOCI Interest Expense (b)1.9 — — 1.9 Amortization of Prior Service Cost (Credit)— (2.0)— (2.0)Amortization of Actuarial (Gains) Losses— 0.6 — 0.6 Reclassifications from AOCI, before Income Tax (Expense) Benefit1.9 (1.4)— 0.5 Income Tax (Expense) Benefit0.4 (0.3)— 0.1 Reclassifications from AOCI, Net of Income Tax (Expense) Benefit1.5 (1.1)— 0.4 Net Current Period Other Comprehensive Income (Loss)1.5 (1.1)3.7 4.1 Balance in AOCI as of December 31, 2019$(1.8)$(1.3)$1.8 $(1.3)Pension and OPEBAmortizationChanges inCash Flow Hedge – of DeferredFundedFor the Year Ended December 31, 2018Interest RateCostsStatusTotal(in millions)Balance in AOCI as of December 31, 2017$(6.0)$1.2 $0.8 $(4.0)Change in Fair Value Recognized in AOCI2.3 — (3.1)(0.8)Amount of (Gain) Loss Reclassified from AOCI Interest Expense (b)2.1 — — 2.1 Amortization of Prior Service Cost (Credit)— (2.0)— (2.0)Amortization of Actuarial (Gains) Losses— 0.2 — 0.2 Reclassifications from AOCI, before Income Tax (Expense) Benefit2.1 (1.8)— 0.3 Income Tax (Expense) Benefit0.4 (0.4)— — Reclassifications from AOCI, Net of Income Tax (Expense) Benefit1.7 (1.4)— 0.3 Net Current Period Other Comprehensive Income (Loss)4.0 (1.4)(3.1)(0.5)ASU 2018-02 Adoption(1.3)— 0.4 (0.9)Balance in AOCI as of December 31, 2018$(3.3)$(0.2)$(1.9)$(5.4)(a)The change in fair value includes $6 million and $4 million related to AEP's investment in joint venture wind farms acquired as part of the purchase of Sempra Renewables LLC for the years ended December 31, 2020 and December 31, 2019. See “Sempra Renewables LLC” section of Note 17 for additional information. (b)Amounts reclassified to the referenced line item on the statements of income.2554. RATE MATTERSThe disclosures in this note apply to all Registrants unless indicated otherwise.The Registrants are involved in rate and regulatory proceedings at the FERC and their state commissions. Rate matters can have a material impact on net income, cash flows and possibly financial condition. The Registrants’ recent significant rate orders and pending rate filings are addressed in this note.COVID-19 PandemicDuring the first quarter of 2020, AEP’s electric operating companies informed both retail customers and state regulators that disconnections for non-payment were temporarily suspended. Shortly thereafter, AEP’s state regulators also imposed temporary moratoria on customary disconnection practices. During the third and the fourth quarters of 2020, most state regulators began to lift restrictions on disconnects. As of December 31, 2020, AEP had resumed disconnections in its regulated jurisdictions with the exception of Virginia, Kentucky and Arkansas. Disconnections resumed in Kentucky during January 2021. AEP continues to work with regulators and stakeholders in Virginia and Arkansas and management currently anticipates resuming customary disconnection practices in the first half of 2021. However, this timing could change if there is new legislation or other regulatory directives issued in the future. Continuing adverse economic conditions may result in the inability of customers to pay for electric service, which could affect revenue recognition and the collectability of accounts receivable. The Registrants have worked with their state commissions to achieve deferral authority for incremental expenses incurred due to COVID-19. All of AEP’s regulated jurisdictions have issued COVID-19 orders, granting deferral authority for incremental COVID-19 expenses, with the exception of Kentucky and Tennessee. If any costs related to COVID-19 are not recoverable, it could reduce future net income and cash flows and impact financial condition.AEP Texas Rate Matters (Applies to AEP and AEP Texas)2019 Texas Base Rate CaseIn May 2019, AEP Texas filed a request with the PUCT for a $56 million annual increase in rates based upon a proposed 10.5% ROE. The filing included a proposed Income Tax Refund Rider that will refund $21 million annually of Excess ADIT that is primarily not subject to normalization requirements. The rate case also sought a prudence determination on all transmission and distribution capital additions through 2018 included in interim rates from 2008 to December 2019. In April 2020, the PUCT issued an order approving a stipulation and settlement agreement. The order includes an annual base rate reduction of $40 million based upon a 9.4% ROE with a capital structure of 57.5% debt and 42.5% common equity effective with the first billing cycle in June 2020. The order provides recovery of $26 million in capitalized vegetation management expenses that were incurred through 2018. The order includes disallowances of $23 million related to capital investments recorded through 2018 and $4 million related to rate case expenses. In addition, AEP Texas will refund: (a) $77 million of Excess ADIT and excess federal income taxes collected as a result of Tax Reform to distribution customers over a one year period, (b) $31 million of Excess ADIT and excess federal income taxes collected as a result of Tax Reform to transmission customers as a one-time credit and (c) $30 million of previously collected rates that were subject to reconciliation in this proceeding over a one year period with no carrying costs. The order requires AEP Texas to file its next base rate case within four years of the date that the final order was issued. The order also states future financially based capital incentives will not be included in interim transmission and distribution rates and contains various ring-fencing provisions. As a result of the final order, AEP Texas will refund $275 million of Excess ADIT associated with certain depreciable property using ARAM to transmission customers. AEP Texas will determine how to refund the remaining Excess ADIT that is not subject to normalization requirements in future proceedings. 256In December 2019, as a result of the initial stipulation and settlement agreement, AEP Texas (a) recorded an impairment of $33 million related to capital investments, which included $10 million of 2019 investments, in Asset Impairments and Other Related Charges on the statements of income, (b) recorded a $30 million provision for refund on the statements of income for revenues previously collected through rates and (c) wrote-off $4 million of rate case expenses to Other Operation on the statements of income. AEP Texas Interim Transmission and Distribution RatesThrough December 31, 2020, AEP Texas’ cumulative revenues from interim base rate increases that are subject to review is estimated to be $79 million. A base rate review could result in a refund to customers if AEP Texas incurs a disallowance of the transmission or distribution investment on which an interim increase was based. Management is unable to determine a range of potential losses, if any, that are reasonably possible of occurring. A revenue decrease, including a refund of interim transmission and distribution rates, could reduce future net income and cash flows and impact financial condition. AEP Texas is required to file for a comprehensive rate review no later than April 3, 2024.APCo and WPCo Rate Matters (Applies to AEP and APCo)2017-2019 Virginia Triennial ReviewAmendments to Virginia law impacting investor-owned utilities were enacted, effective July 1, 2018, that required APCo to file a generation and distribution base rate case by March 31, 2020 using 2017, 2018 and 2019 earnings test years (triennial review). Triennial reviews are subject to an earnings test, which provides that 70% of any earnings in excess of 70 basis points above APCo’s Virginia SCC authorized ROE would be refunded to customers. In such case, the Virginia SCC could also lower APCo’s Virginia retail base rates on a prospective basis. In November 2018, the Virginia SCC authorized a ROE of 9.42% applicable to APCo base rate earnings for the 2017-2019 triennial period.Virginia law provides that costs associated with asset impairments of retired coal generation assets, or automated meters, or both, which a utility records as an expense, shall be attributed to the test periods under review in a triennial review proceeding, and be deemed recovered. In 2015, APCo retired the Sporn Plant, the Kanawha River Plant, the Glen Lyn Plant, Clinch River Unit 3 and the coal portions of Clinch River Units 1 and 2 (collectively, the retired coal-fired generation assets). The net book value of the Virginia jurisdictional share of these plants was $93 million before cost of removal, including materials and supplies inventory and ARO balances. Based on management’s interpretation of Virginia law and more certainty regarding APCo’s triennial revenues, expenses and resulting earnings upon reaching the end of the three-year review period, APCo recorded a pretax expense of $93 million related to its previously retired coal-fired generation assets in December 2019. As a result, management deemed these costs to be substantially recovered by APCo during the triennial review period.In March 2020, APCo submitted its 2017-2019 Virginia triennial earnings review filing and base rate case with the Virginia SCC as required by state law. APCo requested a $65 million annual increase in base rates based upon a proposed 9.9% ROE. The requested annual increase included $19 million related to depreciation for updated test year end depreciable balances and a proposed increase in APCo’s Virginia depreciation rates and $8 million related to APCo’s calculated shortfall in 2017-2019 Virginia earnings. Inclusive of the Virginia jurisdictional share of the $93 million expense associated with APCo’s retired coal-fired generation assets, APCo calculated its 2017-2019 Virginia earnings for the triennial period to be below the authorized ROE range.APCo is currently in the process of retiring and replacing its Virginia jurisdictional Automated Meter Reading (AMR) meters with AMI meters. As of December 31, 2020 and 2019, APCo had approximately $35 million and $51 million of Virginia jurisdictional AMR meters as well as $73 million and $75 million of Virginia jurisdictional AMI meters recorded on its balance sheets. APCo pursued full recovery of these assets through its Virginia depreciation rates as discussed above.257In November 2020, the Virginia SCC issued an order concluding that APCo earned above its authorized ROE but within its ROE band for the 2017-2019 period, resulting in no refund to customers and no change to APCo base rates on a prospective basis. The Virginia SCC approved a prospective 9.2% ROE for APCo's 2020-2022 triennial review period with the continuation of a 140 basis point band (8.5% bottom, 9.2% midpoint, 9.9% top). This 9.2% authorized ROE will also be applied to certain APCo rate adjustment clauses. APCo’s earnings for the 2020-2022 triennial review will continue to be subject to an earnings test, which provides that 70% of any earnings in excess of 70 basis points above APCo’s Virginia SCC authorized ROE would be refunded to customers. Conversely, as defined by Virginia law, APCo is also eligible to defer for future recovery certain environmental and major storm operation and maintenance expenses up to the bottom of APCo’s authorized Virginia 2020-2022 earnings ROE band. The Virginia SCC also disagreed with APCo’s treatment of the retired coal-fired generation assets for regulatory purposes, and instead adopted the Virginia SCC Staff’s recommendation to treat the remaining unrecovered costs of the retired coal-fired generation assets as a regulatory asset to be amortized over 10 years as of the June 2015 retirement date. The Virginia SCC’s adoption of the Staff’s recommended regulatory treatment of the coal-fired generation assets resulted in a net $40 million increase to APCo’s 2020 pretax income. In addition, the Virginia SCC’s order also included: (a) implementation of the Staff-modified APCo 2017 depreciation study effective January 1, 2018 and (b) implementation of the Staff-modified APCo 2019 depreciation study effective January 1, 2020. The adoption of these depreciation studies resulted in an approximate $47 million reduction to APCo’s 2020 pretax income comprised of a $44 million reduction to revenues for amounts recognized in advance of the recording of depreciation expense for the periods January 2018 through October 2020 and a $3 million increase in depreciation expense for the periods November and December 2020. A corresponding regulatory liability was recorded for the $44 million reduction to revenues. The Virginia SCC’s approval of APCo’s 2019 depreciation study included the ongoing depreciation and recovery of APCo’s Virginia AMI/AMR meter balances. In November 2020, APCo filed a notice of appeal with the Virginia Supreme Court. In December 2020, an intervenor filed a petition at the Virginia SCC requesting reconsideration of: (a) the failure of the Virginia SCC to apply a threshold earnings test to the approved regulatory asset for APCo’s closed coal-fired generation assets, (b) the Virginia SCC’s use of a 2011 benchmark study to measure the replacement value of capacity for purposes of APCo’s 2017 – 2019 earnings test and (c) the reasonableness and prudency of APCo’s investments in AMI meters. In December 2020, APCo filed a petition at the Virginia SCC requesting reconsideration of: (a) certain issues related to APCo’s going-forward rates and (b) the Virginia SCC’s decision to deny APCo tariff changes that align rates with underlying costs. For APCo’s going-forward rates, APCo requested that the Virginia SCC clarify its final order and whether APCo’s current rates will allow it to earn a fair return. If the Virginia SCC’s order did conclude on APCo’s ability to earn a fair return through existing base rates, APCo further requested that the Virginia SCC clarify whether it has the authority to also permit an increase in base rates. If the Virginia SCC did not conclude on APCo’s ability to earn a fair return, APCo requested the Virginia SCC provide such a conclusion. In January 2021, as requested by the Virginia SCC, APCo filed briefs related to the petition for reconsideration.If the Virginia SCC issues an unfavorable ruling related to the intervenor petition, it could reduce future net income and cash flows and impact financial condition.West Virginia ENEC and Vegetation Management RidersIn June 2020, the WVPSC issued an order directing APCo and WPCo to increase rider rates relating to ENEC and vegetation management by a combined $101 million ($81 million related to APCo) over twelve months beginning September 2020. This increase will be partially offset by a refund of $38 million ($31 million related to APCo) of Excess ADIT that is not subject to normalization requirements over ten months beginning September 2020. These transactions will result in no overall impact to net income.258ETT Rate Matters (Applies to AEP)ETT Interim Transmission RatesAEP has a 50% equity ownership interest in ETT. Predominantly all of ETT’s revenues are based on interim rate changes that can be filed twice annually and are subject to review and possible true-up in the next base rate proceeding. Through December 31, 2020, AEP’s share of ETT’s cumulative revenues that are subject to review is estimated to be $1.2 billion. A base rate review could produce a refund if ETT incurs a disallowance of the transmission investment on which an interim increase was based. A revenue decrease, including a refund of interim transmission rates, could reduce future net income and cash flows and impact financial condition. Management is unable to determine a range of potential losses, if any, that are reasonably possible of occurring.In 2018, the PUCT adopted a rule requiring investor-owned utilities operating solely inside ERCOT to make periodic filings for base rate proceedings. The rule required ETT to file for a comprehensive base rate review no later than February 1, 2021. In December 2020, ETT and various intervenors filed a stipulation and settlement agreement with the PUCT. The agreement maintained ETT’s previously allowed ROE and capital structure and includes: (a) an $8 million decrease to the current annual revenue requirement effective February 1, 2021, (b) ETT must make an interim transmission cost of service filing by April 1, 2021, (c) a $2 million line item decrease to the revenue requirement determined in each interim transmission cost of service filing until the filing of the next comprehensive base rate review and (d) no determination of prudence on any transmission investment added since ETT’s last comprehensive base rate review, which would leave the $1.2 billion of cumulative revenues above subject to review in the next comprehensive base rate review. In January 2021, the PUCT approved the stipulation and settlement agreement. As part of the approved agreement, new rates were implemented in February 2021 and ETT is required to file for a comprehensive base rate review no later than February 1, 2023.I&M Rate Matters (Applies to AEP and I&M)2019 Indiana Base Rate CaseIn May 2019, I&M filed a request with the IURC for a $172 million annual increase. The requested increase in Indiana rates would be phased-in through January 2021 and was based upon a proposed 10.5% ROE. The proposed annual increase included $78 million related to a proposed annual increase in depreciation expense. The requested annual increase in depreciation expense included $52 million related to proposed investments and $26 million related to increased depreciation rates. The request included the continuation of all existing riders and a new AMI rider for proposed meter projects. In March 2020, the IURC issued an order approving a phased-in increase in base rates of up to $77 million based upon an ROE of 9.7%. This approved phase-in increase includes: (a) an annual increase in base rates of $44 million effective March 2020 and (b) an annual increase in base rates of up to $77 million, effective January 2021, based on the IURC-approved forecast of December 31, 2020 Indiana jurisdictional electric plant in service. In January 2021, I&M updated its Indiana retail rates with the IURC based on actual December 31, 2020 I&M Indiana jurisdictional electric plant in service, resulting in a $60 million net annual base rate increase when compared to I&M Indiana base rate levels prior to March 2020. The order also approved the majority of I&M’s proposed changes in depreciation as well as the test year level of AMI deployment, but did not approve a cost recovery rider for AMI investments made in subsequent years. The order rejected I&M’s proposed re-allocation of capacity costs related to the loss of a significant FERC wholesale contract, which negatively impacts I&M’s annual pretax earnings by approximately $20 million starting June 2020. 259KPCo Rate Matters (Applies to AEP)2020 Kentucky Base Rate CaseIn June 2020, KPCo filed a request with the KPSC for a $65 million net annual increase in base rates based upon a proposed 10% ROE with the increase to be implemented no earlier than January 2021. The filing proposes that KPCo would offset the first year of rate increases by refunding Excess ADIT that is not subject to normalization requirements to customers. Additionally, KPCo requested recovery of the previously authorized deferral of $50 million of Rockport Plant UPA expenses and related carrying charges over a 5-year period beginning in December 2022, through an existing purchased power rider. In January 2021, the KPSC issued an order approving an annual increase in base rates of $52 million based upon an ROE of 9.3% effective with billing cycles mid-January 2021. The order shortened the previously authorized refund period for Excess ADIT that is not subject to normalization requirements being refunded through a rider from 18 years to 3 years. In addition, the order approved recovery of certain annual PJM OATT expenses above/below the corresponding level recovered in base rates through a rider until KPCo’s next base case; however, recovery of these transmission costs will be re-examined by the KPSC in KPCo’s next base case. The KPSC deferred KPCo’s request to authorize a specific recovery period and mechanism for the previously authorized deferral of $50 million of Rockport Plant UPA expenses and related carrying charges to a future proceeding. The order requires KPCo to submit its next base case in June 2023 for rates effective in January 2024. In February 2021, KPCo filed for rehearing with the KPSC challenging various adjustments that were made in the order and requesting certain clarifications. Also in February 2021, the KPSC issued an order on rehearing that modified the approved annual increase in base rates from $52 million to $53 million and clarified several items, including the timing of the future proceeding to address a specific recovery period and mechanism for the previously authorized deferral of $50 million of Rockport Plant Unit Power Agreement expenses and related carrying charges. The KPSC will initiate a future proceeding to address a specific recovery period and mechanism for the deferral after KPCo makes a written filing identifying the capacity replacement for the Rockport Unit Power Agreement, including the name of the capacity resource and related reasonably anticipated costs. OPCo Rate Matters (Applies to AEP and OPCo)2020 Ohio Base Rate CaseIn June 2020, OPCo filed a request with the PUCO for a $42 million annual increase in base rates based upon a proposed 10.15% ROE net of existing riders. Additionally, OPCo filed a request with the PUCO for a 60-day temporary delay of the normal rate case proceeding due to the COVID-19 pandemic with rates expected to be effective approximately mid-2021. In November 2020, PUCO staff filed testimony supporting an annual revenue decrease ranging from $102 million to $123 million based upon an ROE of 8.76% to 9.78%. The difference between OPCo’s request and the staff testimony are primarily due to reductions in: (a) demand-side management programs of $40 million, (b) ROE ranging from $9 million to $30 million, (c) employee-related expenses of $23 million, (d) rate base of $19 million, (e) property taxes of $17 million, (f) other various expenses of $15 million, (g) depreciation expense of $11 million and (h) vegetation management programs of $10 million which is subject to over/under-recovery through a rider. The staff’s proposed disallowance of plant in service could also result in a write-off of up to $27 million. In addition, the staff recommended that capitalized incentives be excluded from base rates prospectively and also recommended annual revenue caps for the DIR of $57 million in 2021, $78 million in 2022, $96 million in 2023 and $46 million for the first five months of 2024. In December 2020, OPCo and intervenors filed objections. A procedural schedule for the case is pending due to ongoing settlement discussions. If any of the requested costs are not recoverable, it could reduce future net income and cash flows and impact financial condition.2602019 Ohio DIR AuditOPCo conducts business under an ESP as approved by the PUCO which subjects the DIR to annual audits. In August 2020, a third-party consulting company filed an audit report with the PUCO indicating that OPCo exceeded its 2019 authorized revenue limit by $17 million. Management disagrees with the audit results and believes that OPCo was below its authorized revenue limit in 2019. The PUCO has not yet issued a procedural schedule to address the audit results. If the results of the audit are upheld by the PUCO and any refunds to customers or revenue reductions are ordered, it could reduce future net income and cash flows and impact financial condition.SWEPCo Rate Matters (Applies to AEP and SWEPCo)2012 Texas Base Rate CaseIn 2012, SWEPCo filed a request with the PUCT to increase annual base rates primarily due to the completion of the Turk Plant. In 2013, the PUCT issued an order affirming the prudence of the Turk Plant but determined that the Turk Plant’s Texas jurisdictional capital cost cap established in a previous Certificate of Convenience and Necessity case also limited SWEPCo’s recovery of AFUDC in addition to limits on its recovery of cash construction costs.Upon rehearing in 2014, the PUCT reversed its initial ruling and determined that AFUDC was excluded from the Turk Plant’s Texas jurisdictional capital cost cap. As a result, SWEPCo reversed $114 million of a previously recorded regulatory disallowance in 2013. The resulting annual base rate increase was approximately $52 million. In 2017, the Texas District Court upheld the PUCT’s 2014 order and intervenors filed appeals with the Texas Third Court of Appeals.In July 2018, the Texas Third Court of Appeals reversed the PUCT’s judgment affirming the prudence of the Turk Plant and remanded the issue back to the PUCT. In January 2019, SWEPCo and the PUCT filed petitions for review with the Texas Supreme Court. In the fourth quarter of 2019 and first quarter of 2020, SWEPCo and various intervenors filed briefs with the Texas Supreme Court. In August 2020, the Texas Supreme Court granted SWEPCo’s petition for review and oral arguments were held in December 2020. SWEPCo expects a decision from the Texas Supreme Court in 2021.As of December 31, 2020, the net book value of Turk Plant was $1.4 billion, before cost of removal, including materials and supplies inventory and CWIP. If certain parts of the PUCT order are overturned and if SWEPCo cannot ultimately fully recover its approximate 33% Texas jurisdictional share of the Turk Plant investment, including AFUDC, it could reduce future net income and cash flows and impact financial condition.2016 Texas Base Rate CaseIn 2016, SWEPCo filed a request with the PUCT for a net increase in Texas annual revenues of $69 million based upon a 10% ROE. In January 2018, the PUCT issued a final order approving a net increase in Texas annual revenues of $50 million based upon a ROE of 9.6%, effective May 2017. The final order also included: (a) approval to recover the Texas jurisdictional share of environmental investments placed in- service, as of June 30, 2016, at various plants, including Welsh Plant, Units 1 and 3, (b) approval of recovery of, but no return on, the Texas jurisdictional share of the net book value of Welsh Plant, Unit 2, (c) approval of $2 million in additional vegetation management expenses and (d) the rejection of SWEPCo’s proposed transmission cost recovery mechanism. As a result of the final order, in 2017 SWEPCo: (a) recorded an impairment charge of $19 million, which included $7 million associated with the lack of return on Welsh Plant, Unit 2 and $12 million related to other disallowed plant investments, (b) recognized $32 million of additional revenues, for the period of May 2017 through December 2017, that was surcharged to customers in 2018 and (c) recognized an additional $7 million of expenses consisting primarily of depreciation expense and vegetation management expense, offset by the deferral of rate case expense. SWEPCo implemented new rates in February 2018 billings. The $32 million of additional 2017 revenues was collected during 2018. In March 2018, the PUCT clarified and corrected portions of the final order, without 261changing the overall decision or amounts of the rate change. The order has been appealed by various intervenors. If certain parts of the PUCT order are overturned, it could reduce future net income and cash flows and impact financial condition.2018 Louisiana Formula Rate FilingIn April 2018, SWEPCo filed its formula rate plan for test year 2017 with the LPSC. The filing included a net $28 million annual increase, which was effective August 2018 and included SWEPCo’s Louisiana jurisdictional share of Welsh Plant and Flint Creek Plant environmental controls. The filing also included a reduction in the federal income tax rate due to Tax Reform but did not address the return of Excess ADIT benefits to customers.In July 2018, SWEPCo made a supplemental filing to its formula rate plan with the LPSC to reduce the requested annual increase to $18 million. The difference between SWEPCo’s requested $28 million annual increase and the $18 million annual increase in the supplemental filing is primarily the result of the return of Excess ADIT benefits to customers.In October 2018, the LPSC staff issued a recommendation that SWEPCo refund $11 million of excess federal income taxes collected, as a result of Tax Reform, from January 1, 2018 through July 31, 2018. In June 2019, the LPSC staff issued its report which reaffirmed its $11 million refund recommendation. The report also contends that SWEPCo’s requested annual rate increase of $18 million, which was implemented in August 2018, is overstated by $4 million and proposes an annual rate increase of $14 million. Additionally, the report recommends SWEPCo refund the excess over-collections associated with the $4 million difference for the period of August 2018 through the implementation of new rates. In July 2019, the LPSC approved the $11 million refund. In July 2020, the LPSC issued an order approving an unopposed stipulation and settlement agreement for a one-time refund of $6 million over three months beginning in August 2020. Hurricane Laura In August 2020, Hurricane Laura hit the coasts of Louisiana and Texas, causing power outages to more than 130,000 customers across SWEPCo’s service territories. Prior to Hurricane Laura, SWEPCo did not have a catastrophe reserve or automatic deferral authority within any of its jurisdictions. In October 2020, the LPSC issued an order allowing Louisiana utilities, including SWEPCo, to establish a regulatory asset to track and defer expenses associated with Hurricane Laura. In October 2020, as part of the 2020 Texas Base Rate Case, SWEPCo requested deferral authority of incremental other operation and maintenance expenses. As of December 31, 2020, management estimates that SWEPCo has incurred incremental other operation and maintenance expenses of $84 million ($82 million of which has been deferred as a regulatory asset related to the Louisiana jurisdiction) and incremental capital expenditures of $23 million, all of which is related to the Louisiana jurisdiction. If any costs related to Hurricane Laura are not recoverable, it could reduce future net income and cash flows and impact financial condition.Hurricane DeltaIn October 2020, Hurricane Delta hit the coast of Louisiana, causing power outages to more than 23,000 customers in SWEPCo’s Louisiana jurisdiction. In November 2020, the LPSC issued an order allowing Louisiana utilities, including SWEPCo, to establish a regulatory asset to track and defer expenses associated with Hurricane Delta. As of December 31, 2020, management estimates that SWEPCo has incurred incremental other operation and maintenance expenses of $17 million, which has been deferred as a regulatory asset. Also, management estimates that SWEPCo has incurred incremental capital expenditures of $2 million. If any costs related to Hurricane Delta are not recoverable, it could reduce future net income and cash flows and impact financial condition.2622020 Texas Base Rate CaseIn October 2020, SWEPCo filed a request with the PUCT for a $105 million annual increase in Texas base rates based upon a proposed 10.35% ROE. The request would move transmission and distribution interim revenues recovered through riders into base rates. Eliminating these riders would result in a net annual requested base rate increase of $90 million primarily due to increased investments. The proposed net annual increase: (a) includes $5 million related to vegetation management to maintain and improve the reliability of its Texas jurisdictional distribution system, (b) requests a $10 million annual depreciation increase and (c) seeks $2 million annually to establish a storm catastrophe reserve. In addition, SWEPCo also requested recovery of the Texas jurisdictional share of the Dolet Hills Power Station of $45 million which is expected to be retired by the end of 2021. Intervenor and staff testimony is scheduled to be filed in March and April 2021, respectively. If any of these costs are not recoverable, it could reduce future net income and cash flows and impact financial condition.2020 Louisiana Base Rate CaseIn December 2020, SWEPCo filed a request with the LPSC for a $134 million annual increase in Louisiana base rates based upon a proposed 10.35% ROE. The request would extend the formula rate plan for five years and includes modifications to the formula rate plan to allow for forward-looking transmission costs, reflects the impact of net operating losses associated with the acceleration of certain tax benefits and incorporates future federal corporate income tax changes. The proposed net annual increase: (a) requests a $32 million annual depreciation increase to recover Louisiana’s share of the Dolet Hills Power Station, Pirkey Power Plant and Welsh Plant, all of which are expected to be retired early, and (b) includes $10 million annually to recover deferred other operation and maintenance expenses related to Hurricanes Laura and Delta. If any of these costs are not recoverable, it could reduce future net income and cash flows and impact financial condition.FERC Rate MattersAFUDC Waiver (Applies to all Registrants except AEP Texas)In June 2020, FERC granted a temporary waiver providing utilities the option to elect to modify the existing AFUDC rate calculations in response to the COVID-19 pandemic. As a result of the waiver, the AFUDC formula for the 12-month period starting with March 2020 may be calculated using the simple average of the actual historical short-term debt balances for 2019, instead of current period short-term balances. All other aspects of the AFUDC formula remained unchanged. AEP subsidiaries including certain Registrant Subsidiaries elected to apply the waiver in July 2020. The impact upon election was immaterial on the Registrants’ financial statements. In February 2021, FERC issued an order extending the waiver through September 2021.OKTCo Radial Asset Transfer (Applies to AEP, AEPTCo and PSO)In August 2020, AEPSC filed a request with FERC, on behalf of PSO and OKTCo, to transfer OKTCo’s interests in its radial assets to PSO. OKTCo had previously constructed radial assets in the PSO service territory and after the radial assets were placed into service, management determined the radial assets were not eligible to be included as part of OKTCo’s SPP OATT formula rates. In October 2020, FERC approved the request and in December 2020, OKTCo completed the transfer of its interest in the radial assets to PSO, through Parent, at net book value. At the transfer date, the net book value of the radial assets were $60 million, before associated tax liabilities. PSO will seek recovery of the radial assets in its next base rate case, which must be filed by October 2021. If PSO does not receive approval to recover the radial assets, it could reduce future net income and cash flows and impact financial condition.2635. EFFECTS OF REGULATIONThe disclosures in this note apply to all Registrants unless indicated otherwise.Coal-Fired Generation Plants (Applies to AEP, PSO and SWEPCo)Compliance with extensive environmental regulations requires significant capital investment in environmental monitoring, installation of pollution control equipment, emission fees, disposal costs and permits. Management continuously evaluates cost estimates of complying with these regulations which has resulted in, and in the future may result in, a decision to retire coal-fired generating facilities earlier than their currently estimated useful lives. Management is seeking or will seek regulatory recovery, as necessary, for any net book value remaining when the plants are retired. To the extent the net book value of these generation assets are not deemed recoverable, it could materially reduce future net income and cash flows and impact financial condition. Regulated Generating Units that have been RetiredPSOIn September 2020, the Oklaunion Power Station was retired. As of December 31, 2020, PSO has a regulatory asset for accelerated depreciation pending approval recorded on its balance sheet for $34 million. PSO will seek recovery of the Oklaunion Power Station in its next base rate case. In October 2020, the Oklaunion Power Station site was sold to a nonaffiliated third-party. See “Oklaunion Power Station” section of Note 7 for additional information.SWEPCoIn April 2016, Welsh Plant, Unit 2 was retired. As part of the 2016 Texas Base Rate Case, SWEPCo received approval from the PUCT to recover the Texas jurisdictional share of Welsh Plant, Unit 2. See “2016 Texas Base Rate Case” section of Note 4 for additional information. As part of the 2019 Arkansas Base Rate Case, SWEPCo received approval from the APSC to recover the Arkansas jurisdictional share of Welsh Plant, Unit 2. In December 2020, SWEPCo filed a request with the LPSC to recover the Louisiana jurisdictional share of Welsh Plant, Unit 2. As of December 31, 2020, SWEPCo has a regulatory asset for plant retirement costs pending approval recorded on its balance sheet for $35 million related to the Louisiana jurisdictional share of Welsh Plant, Unit 2. See “2020 Louisiana Base Rate Case” section of Note 4 for additional information. Regulated Generating Units to be RetiredPSOIn 2014, PSO received final approval from the EPA to close Northeastern Plant, Unit 3, in 2026. The plant was originally scheduled to close in 2040. As a result of the early retirement date, PSO revised the useful life of Northeastern Plant, Unit 3, to the projected retirement date of 2026 and the incremental depreciation is being deferred as a regulatory asset. In 2016, as part of the 2015 Oklahoma Base Rate Case, the OCC issued an order approving the continued depreciation of Northeastern Plant, Unit 3 through 2040. The order did not approve accelerating the recovery of the incremental depreciation based on the revised retirement date of 2026.SWEPCoIn January 2020, as part of the 2019 Arkansas Base Rate Case, management announced that the Dolet Hills Power Station was probable of abandonment and was to be retired by December 2026. As a result of the announcement, SWEPCo began recording a regulatory asset for accelerated depreciation. In March 2020, management announced plans to retire the plant in 2021.In November 2020, management announced plans to retire Pirkey Power Plant in 2023 and that it will cease using coal at the Welsh Plant in 2028. As a result of the announcement, SWEPCo began recording a regulatory asset for accelerated depreciation.264The table below summarizes the net book value including CWIP, before cost of removal and materials and supplies, as of December 31, 2020, of generating facilities planned for early retirement:PlantNetInvestmentAccelerated Depreciation Regulatory AssetCost of RemovalRegulatory LiabilityProjectedRetirement DateCurrent AuthorizedRecovery PeriodAnnual Depreciation (a)(dollars in millions)Northeastern Plant, Unit 3$198.4 $110.4 $19.8 (b)2026(c)$14.9 Dolet Hills Power Station74.4 71.2 24.0 2021(d)60.8 Pirkey Power Plant199.5 12.2 38.7 2023(e)13.8 Welsh Plant, Units 1 and 3549.8 3.6 57.6 (f)2028(g)33.3 (a)Represents the amount of annual depreciation that has been collected from customers over the prior 12-month period.(b)Includes Northeastern Plant, Unit 4, which was retired in 2016. Removal of Northeastern Plant, Unit 4, will be performed with Northeastern Plant, Unit 3, after retirement.(c)Northeastern Plant, Unit 3 is currently being recovered through 2040.(d)Dolet Hills Power Station is current being recovered through 2026 in the Louisiana jurisdiction and through 2046 in the Arkansas and Texas jurisdictions.(e)Pirkey Power Plant is currently being recovered through 2025 in the Louisiana jurisdiction and through 2045 in the Arkansas and Texas jurisdictions.(f)Includes Welsh Plant, Unit 2, which was retired in 2016. Removal of Welsh Plant, Unit 2, will be performed with Welsh Plant, Units 1 and 3, after retirement.(g)Unit 1 is being recovered through 2027 in the Louisiana jurisdiction and through 2037 in the Arkansas and Texas jurisdictions. Unit 3 is being recovered through 2032 in the Louisiana jurisdiction and through 2042 in the Arkansas and Texas jurisdictions. Dolet Hills Power Station and Related Fuel Operations (Applies to AEP and SWEPCo)During the second quarter of 2019, the Dolet Hills Power Station initiated a seasonal operating schedule. In January 2020, in accordance with the terms of SWEPCo’s settlement of its base rate review filed with the APSC, management announced that SWEPCo will seek regulatory approval to retire the Dolet Hills Power Station by the end of 2026. DHLC provides 100% of the fuel supply to Dolet Hills Power Station. After careful consideration of current economic conditions, and particularly for the benefit of their customers, management of SWEPCo and CLECO determined DHLC would not proceed developing additional Oxbow Lignite Company (Oxbow) mining areas for future lignite extraction and ceased extraction of lignite at the mine in May 2020. Based on these actions, management revised the estimated useful life of DHLC’s and Oxbow’s assets to coincide with the date at which extraction was discontinued in the second quarter of 2020 and the date at which delivery of lignite is expected to cease in September 2021. Management also revised the useful life of the Dolet Hills Power Station to 2021 based on the remaining estimated fuel supply available for continued seasonal operation. In March 2020, primarily due to the revision in the useful life of DHLC, SWEPCo recorded a revision to increase estimated ARO liabilities by $21 million. In April 2020, SWEPCo and CLECO jointly filed a notification letter to the LPSC providing notice of the cessation of lignite mining. The Dolet Hills Power Station costs are recoverable by SWEPCo through base rates. SWEPCo’s share of the net investment in the Dolet Hills Power Station is $151 million, including CWIP and materials and supplies, before cost of removal. Fuel costs incurred by the Dolet Hills Power Station are recoverable by SWEPCo through active fuel clauses. Under the fuel agreements, SWEPCo’s fuel inventory and unbilled fuel costs from mining related activities were $131 million as of December 31, 2020. Also, as of December 31, 2020, SWEPCo had a net over-recovered fuel balance of $35 million, which includes fuel burned at the Dolet Hills Power Station. Additional operational and land-related costs are expected to be incurred by DHLC and Oxbow and billed to SWEPCo prior to the closure of the Dolet Hills Power Station and recovered through fuel clauses.In October 2020, SWEPCo filed a request with the LPSC for recovery of the Louisiana share of these additional fuel costs. SWEPCo’s filing proposes to defer $36 million of fuel costs in 2021 and recover the deferral plus carrying costs over five years beginning in 2022.If any of these costs are not recoverable, it could reduce future net income and cash flows and impact financial condition.265Pirkey Power Plant and Related Fuel Operations (Applies to AEP and SWEPCo)In November 2020, management announced plans to retire the Pirkey Power Plant in 2023. The Pirkey Power Plant costs are recoverable by SWEPCo through base rates. SWEPCo’s share of the net investment in the Pirkey Power Plant is $212 million, including CWIP, before cost of removal. Sabine is a mining operator providing mining services to the Pirkey Power Plant. Under the provisions of the mining agreement, SWEPCo is required to pay, as part of the cost of lignite delivered, an amount equal to mining costs plus a management fee. SWEPCo expects fuel deliveries, including billings of all fixed and operating costs, from Sabine to cease during the first quarter of 2023. Under the fuel agreements, SWEPCo’s fuel inventory and unbilled fuel costs from mining related activities were $193 million as of December 31, 2020. Also, as of December 31, 2020, SWEPCo had a net over-recovered fuel balance of $35 million, which includes fuel burned at the Pirkey Power Plant. Additional operational costs are expected to be incurred by Sabine and billed to SWEPCo, as well as land-related costs incurred by SWEPCo, prior to the closure of the Pirkey Power Plant and recovered through fuel clauses. If any of these costs are not recoverable, it could reduce future net income and cash flows and impact financial condition.2020 Texas Fuel Reconciliation (Applies to AEP and SWEPCo)In June 2020, SWEPCo filed a fuel reconciliation with the PUCT for its retail operations in Texas for the reconciliation period of March 1, 2017 to December 31, 2019. The fuel reconciliation included total fuel costs of $1.7 billion ($616 million of which is related to the Texas jurisdiction). In January 2021, various parties filed testimony recommending fuel cost disallowances totaling $125 million relating to the Texas jurisdiction. Also in January 2021, SWEPCo filed rebuttal testimony disputing the recommended disallowances. In February 2021, SWEPCo and various parties reached a settlement in principle which resulted in an immaterial impact to SWEPCo’s 2020 financial statements. If additional costs are not recoverable, it could reduce future net income and cash flows and impact financial condition.266Regulatory Assets and LiabilitiesRegulatory assets and liabilities are comprised of the following items:AEPDecember 31,Remaining Recovery Period20202019Current Regulatory Assets(in millions)Under-recovered Fuel Costs - earns a return$41.4 $44.7 1 yearUnder-recovered Fuel Costs - does not earn a return49.3 48.2 1 yearTotal Current Regulatory Assets$90.7 $92.9 Noncurrent Regulatory AssetsRegulatory assets pending final regulatory approval:Regulatory Assets Currently Earning a ReturnDolet Hills Power Station Accelerated Depreciation$71.2 $— Kentucky Deferred Purchased Power Expenses41.3 30.2 Plant Retirement Costs - Unrecovered Plant, Louisiana35.2 35.2 Oklaunion Power Station Accelerated Depreciation34.4 27.4 Other Regulatory Assets Pending Final Regulatory Approval38.6 0.7 Total Regulatory Assets Currently Earning a Return220.7 93.5 Regulatory Assets Currently Not Earning a ReturnStorm-Related Costs134.2 7.2 Plant Retirement Costs - Asset Retirement Obligation Costs25.9 30.1 COVID-1924.9 — Vegetation Management Program - AEP Texas3.8 29.4 Other Regulatory Assets Pending Final Regulatory Approval32.7 21.5 Total Regulatory Assets Currently Not Earning a Return221.5 88.2 Total Regulatory Assets Pending Final Regulatory Approval442.2 181.7 Regulatory assets approved for recovery:Regulatory Assets Currently Earning a ReturnPlant Retirement Costs - Unrecovered Plant (a)713.1 690.5 23 yearsPlant Retirement Costs - Asset Retirement Obligation Costs107.1 87.4 20 yearsMeter Replacement Costs55.5 65.4 7 yearsOhio Distribution Decoupling46.6 31.4 2 yearsEnvironmental Control Projects38.6 41.0 20 yearsRockport Plant Dry Sorbent Injection System and Selective Catalytic Reduction34.4 13.5 8 yearsCook Plant Uprate Project30.2 32.6 13 yearsStorm-Related Costs11.5 21.3 2 yearsAdvanced Metering System— 26.5 Other Regulatory Assets Approved for Recovery94.4 79.6 variousTotal Regulatory Assets Currently Earning a Return1,131.4 1,089.2 Regulatory Assets Currently Not Earning a ReturnPension and OPEB Funded Status1,088.6 1,309.8 12 yearsPlant Retirement Costs - Asset Retirement Obligation Costs212.7 28.8 22 yearsUnamortized Loss on Reacquired Debt120.0 129.0 28 yearsUnrealized Loss on Forward Commitments111.3 106.8 12 yearsVegetation Management67.8 43.6 5 yearsCook Plant Nuclear Refueling Outage Levelization39.5 63.8 2 yearsPJM/SPP Annual Formula Rate True-up33.0 7.3 2 yearsPostemployment Benefits29.1 34.2 3 yearsOVEC Purchased Power27.4 1.5 2 yearsFuel and Purchased Power Adjustment Rider24.0 7.1 2 yearsMedicare Subsidy18.6 23.2 4 yearsOther Regulatory Assets Approved for Recovery181.4 132.8 variousTotal Regulatory Assets Currently Not Earning a Return1,953.4 1,887.9 Total Regulatory Assets Approved for Recovery3,084.8 2,977.1 Total Noncurrent Regulatory Assets$3,527.0 $3,158.8 (a)Northeastern Plant, Unit 3 is approved for recovery through 2040, but expected to retire in 2026. PSO records a regulatory asset for accelerated depreciation. See “Regulated Generating Units to be Retired” section above for additional information.267AEPDecember 31,Remaining20202019Refund PeriodCurrent Regulatory Liabilities(in millions)Over-recovered Fuel Costs - pays a return$27.6 $77.5 1 yearOver-recovered Fuel Costs - does not pay a return25.0 9.1 1 yearTotal Current Regulatory Liabilities$52.6 $86.6 Noncurrent Regulatory Liabilities andDeferred Investment Tax CreditsRegulatory liabilities pending final regulatory determination:Regulatory Liabilities Currently Paying a ReturnOther Regulatory Liabilities Pending Final Regulatory Determination$2.5 $— Total Regulatory Liabilities Currently Paying a Return2.5 — Regulatory Liabilities Currently Not Paying a ReturnOther Regulatory Liabilities Pending Final Regulatory Determination1.5 0.2 Total Regulatory Liabilities Currently Not Paying a Return1.5 0.2 Income Tax Related Regulatory Liabilities (a)Excess ADIT Associated with Certain Depreciable Property291.6 571.8 Excess ADIT that is Not Subject to Rate Normalization Requirements193.3 291.0 (b)Total Income Tax Related Regulatory Liabilities484.9 862.8 Total Regulatory Liabilities Pending Final Regulatory Determination488.9 863.0 Regulatory liabilities approved for payment:Regulatory Liabilities Currently Paying a ReturnAsset Removal Costs3,061.9 2,876.7 (c)Deferred Investment Tax Credits4.1 6.2 33 yearsOhio Basic Transmission Cost Rider— 37.2 Other Regulatory Liabilities Approved for Payment25.2 14.4 variousTotal Regulatory Liabilities Currently Paying a Return3,091.2 2,934.5 Regulatory Liabilities Currently Not Paying a ReturnExcess Nuclear Decommissioning Funding1,476.6 1,236.0 (d)Deferred Investment Tax Credits216.7 215.3 34 yearsPJM Transmission Enhancement Refund56.2 67.3 5 yearsTransition and Restoration Charges - Texas48.2 50.5 9 years2017-2019 Virginia Triennial Revenue Provision44.2 — 28 yearsSpent Nuclear Fuel43.1 43.6 (d)Peak Demand Reduction/Energy Efficiency26.3 23.0 2 yearsDeferred Gain on Sale of Rockport Unit 217.9 27.2 2 yearsOhio Enhanced Service Reliability Plan5.7 29.7 2 yearsVirginia Transmission Rate Adjustment Clause— 28.1 Other Regulatory Liabilities Approved for Payment71.0 87.7 variousTotal Regulatory Liabilities Currently Not Paying a Return2,005.9 1,808.4 Income Tax Related Regulatory Liabilities (a)Excess ADIT Associated with Certain Depreciable Property3,485.7 3,303.0 (e)Excess ADIT that is Not Subject to Rate Normalization Requirements714.9 890.5 10 yearsIncome Taxes Subject to Flow Through(1,407.9)(1,341.8)54 yearsTotal Income Tax Related Regulatory Liabilities2,792.7 2,851.7 Total Regulatory Liabilities Approved for Payment7,889.8 7,594.6 Total Noncurrent Regulatory Liabilities and Deferred Investment Tax Credits$8,378.7 $8,457.6 (a)This balance primarily represents regulatory liabilities for Excess ADIT as a result of the reduction in the corporate federal income tax rate from 35% to 21% related to the enactment of Tax Reform. The regulatory liability balance predominately pays a return due to the inclusion of Excess ADIT in rate base.(b)2020 and 2019 amounts include approximately $173 million and $172 million, respectively, related to AEP Transmission Holdco’s investment in ETT and Transource Energy. AEP Transmission Holdco expects to amortize the balance commensurate with the return of Excess ADIT to ETT and Transource Energy’s customers.(c)Relieved as removal costs are incurred.(d)Relieved when plant is decommissioned.(e)Refunded using ARAM.268AEP TexasDecember 31,RemainingRecoveryPeriodRegulatory Assets:20202019(in millions)Noncurrent Regulatory AssetsRegulatory assets pending final regulatory approval:Regulatory Assets Currently Earning a ReturnAdvanced Metering System$16.3 $— Total Regulatory Assets Currently Earning a Return16.3 — Regulatory Assets Currently Not Earning a ReturnCOVID-1910.5 — Vegetation Management Program3.8 29.4 Other Regulatory Assets Pending Final Regulatory Approval2.3 1.4 Total Regulatory Assets Currently Not Earning a Return16.6 30.8 Total Regulatory Assets Pending Final Regulatory Approval32.9 30.8 Regulatory assets approved for recovery:Regulatory Assets Currently Earning a ReturnMeter Replacement Costs29.3 35.2 6 yearsAdvanced Metering System— 26.5 Total Regulatory Assets Currently Earning a Return29.3 61.7 Regulatory Assets Currently Not Earning a ReturnPension and OPEB Funded Status145.0 172.0 12 yearsVegetation Management Program22.4 — 5 yearsStorm-Related Costs17.1 — 4 yearsPeak Demand Reduction/Energy Efficiency7.7 3.5 2 yearsOther Regulatory Assets Approved for Recovery12.4 12.6 variousTotal Regulatory Assets Currently Not Earning a Return204.6 188.1 Total Regulatory Assets Approved for Recovery233.9 249.8 Total Noncurrent Regulatory Assets$266.8 $280.6 269AEP TexasDecember 31,RemainingRefundPeriodRegulatory Liabilities:20202019(in millions)Noncurrent Regulatory Liabilities andDeferred Investment Tax CreditsRegulatory liabilities pending final regulatory determination:Regulatory Liabilities Currently Paying a ReturnOther Regulatory Liabilities Pending Final Regulatory Determination$2.5 $— Total Regulatory Liabilities Currently Paying a Return2.5 — Income Tax Related Regulatory Liabilities (a)Excess ADIT Associated with Certain Depreciable Property— 274.9 Excess ADIT that is Not Subject to Rate Normalization Requirements(8.2)87.1 Total Income Tax Related Regulatory Liabilities(8.2)362.0 Total Regulatory Liabilities Pending Final Regulatory Determination(5.7)362.0 Regulatory liabilities approved for payment:Regulatory Liabilities Currently Paying a ReturnAsset Removal Costs718.3 689.6 (b)Other Regulatory Liabilities Approved for Payment5.3 10.1 variousTotal Regulatory Liabilities Currently Paying a Return723.6 699.7 Regulatory Liabilities Currently Not Paying a ReturnTransition and Restoration Charges48.2 50.5 9 yearsDeferred Investment Tax Credits8.5 9.6 20 yearsOther Regulatory Liabilities Approved for Payment1.2 4.8 variousTotal Regulatory Liabilities Currently Not Paying a Return57.9 64.9 Income Tax Related Regulatory Liabilities (a)Excess ADIT Associated with Certain Depreciable Property506.0 236.5 (c)Excess ADIT that is Not Subject to Rate Normalization Requirements41.7 — 1 yearsIncome Taxes Subject to Flow Through(52.7)(46.2)28 yearsTotal Income Tax Related Regulatory Liabilities495.0 190.3 Total Regulatory Liabilities Approved for Payment1,276.5 954.9 Total Noncurrent Regulatory Liabilities and Deferred Investment Tax Credits$1,270.8 $1,316.9 (a)This balance primarily represents regulatory liabilities for Excess ADIT as a result of the reduction in the corporate federal income tax rate from 35% to 21% related to the enactment of Tax Reform. The regulatory liability balance predominately pays a return due to the inclusion of Excess ADIT in rate base.(b)Relieved as removal costs are incurred.(c)Refunded using ARAM.270AEPTCoDecember 31,RemainingRecoveryPeriodRegulatory Assets:20202019(in millions)Noncurrent Regulatory AssetsRegulatory assets approved for recovery:Regulatory Assets Currently Not Earning a ReturnPJM/SPP Annual Formula Rate True-up$15.1 $4.2 2 yearsTotal Regulatory Assets Approved for Recovery15.1 4.2 Total Noncurrent Regulatory Assets$15.1 $4.2 AEPTCoDecember 31,RemainingRefundPeriodRegulatory Liabilities:20202019(in millions)Noncurrent Regulatory LiabilitiesRegulatory Liabilities Currently Paying a ReturnAsset Removal Costs$198.6 $141.0 (b)Total Regulatory Liabilities Currently Paying a Return198.6 141.0 Income Tax Related Regulatory Liabilities (a)Excess ADIT Associated with Certain Depreciable Property531.5 535.7 (c)Excess ADIT that is Not Subject to Rate Normalization Requirements(30.6)(35.4)8 yearsIncome Taxes Subject to Flow Through(117.7)(100.4)38 yearsTotal Income Tax Related Regulatory Liabilities383.2 399.9 Total Regulatory Liabilities Approved for Payment581.8 540.9 Total Noncurrent Regulatory Liabilities$581.8 $540.9 (a)This balance primarily represents regulatory liabilities for Excess ADIT as a result of the reduction in the corporate federal income tax rate from 35% to 21% related to the enactment of Tax Reform. The regulatory liability balance predominately pays a return due to the inclusion of Excess ADIT in rate base. (b)Relieved as removal costs are incurred.(c)Refunded using ARAM.271APCoDecember 31,RemainingRecoveryPeriodRegulatory Assets:20202019(in millions)Current Regulatory AssetsUnder-recovered Fuel Costs, Virginia - earns a return$3.3 $36.8 1 yearUnder-recovered Fuel Costs - does not earn a return2.0 5.7 1 yearTotal Current Regulatory Assets$5.3 $42.5 Noncurrent Regulatory AssetsRegulatory assets pending final regulatory approval:Regulatory Assets Currently Earning a ReturnCOVID-19 - Virginia$3.7 $— Plant Retirement Costs - Materials and Supplies— 0.5 Total Regulatory Assets Currently Earning a Return3.7 0.5 Regulatory Assets Currently Not Earning a ReturnPlant Retirement Costs - Asset Retirement Obligation Costs25.9 30.1 Environmental Expense Deferral - Virginia9.3 — COVID-19 - West Virginia1.5 — Other Regulatory Assets Pending Final Regulatory Approval3.4 — Total Regulatory Assets Currently Not Earning a Return40.1 30.1 Total Regulatory Assets Pending Final Regulatory Approval43.8 30.6 Regulatory assets approved for recovery:Regulatory Assets Currently Earning a ReturnPlant Retirement Costs - Unrecovered Plant (a)122.4 86.4 23 yearsOther Regulatory Assets Approved for Recovery1.0 0.5 variousTotal Regulatory Assets Currently Earning a Return123.4 86.9 Regulatory Assets Currently Not Earning a ReturnPlant Retirement Costs - Asset Retirement Obligation Costs202.7 — 15 yearsPension and OPEB Funded Status114.4 160.8 12 yearsUnamortized Loss on Reacquired Debt82.1 85.5 25 yearsVegetation Management Program - West Virginia45.4 43.6 2 yearsVirginia Transmission Rate Adjustment Clause18.8 — 2 yearsPeak Demand Reduction/Energy Efficiency16.8 19.5 6 yearsPostemployment Benefits13.5 15.9 3 yearsPJM Annual Formula Rate True-up12.7 — 2 yearsOther Regulatory Assets Approved for Recovery12.7 14.4 variousTotal Regulatory Assets Currently Not Earning a Return519.1 339.7 Total Regulatory Assets Approved for Recovery642.5 426.6 Total Noncurrent Regulatory Assets$686.3 $457.2 (a)December 31, 2020 amount includes Virginia and West Virginia jurisdictions. December 31, 2019 amount includes West Virginia jurisdiction.272APCoDecember 31,RemainingRefundPeriodRegulatory Liabilities:20202019(in millions)Noncurrent Regulatory Liabilities andDeferred Investment Tax CreditsRegulatory liabilities approved for payment:Regulatory Liabilities Currently Paying a ReturnAsset Removal Costs$678.9 $635.3 (b)Deferred Investment Tax Credits0.3 0.5 33 yearsTotal Regulatory Liabilities Currently Paying a Return679.2 635.8 Regulatory Liabilities Currently Not Paying a Return2017-2019 Virginia Triennial Revenue Provision44.2 — 28 yearsPJM Transmission Enhancement Refund16.3 19.5 5 yearsVirginia Transmission Rate Adjustment Clause— 28.1 Other Regulatory Liabilities Approved for Payment12.3 18.0 variousTotal Regulatory Liabilities Currently Not Paying a Return72.8 65.6 Income Tax Related Regulatory Liabilities (a)Excess ADIT Associated with Certain Depreciable Property690.0 718.9 (c)Excess ADIT that is Not Subject to Rate Normalization Requirements139.1 210.7 8 yearsIncome Taxes Subject to Flow Through(356.4)(362.3)24 yearsTotal Income Tax Related Regulatory Liabilities472.7 567.3 Total Regulatory Liabilities Approved for Payment1,224.7 1,268.7 Total Noncurrent Regulatory Liabilities and Deferred Investment Tax Credits$1,224.7 $1,268.7 (a)This balance primarily represents regulatory liabilities for Excess ADIT as a result of the reduction in the corporate federal income tax rate from 35% to 21% related to the enactment of Tax Reform. The regulatory liability balance predominately pays a return due to the inclusion of Excess ADIT in rate base.(b)Relieved as removal costs are incurred.(c)Refunded using ARAM.273I&MDecember 31,RemainingRecoveryPeriodRegulatory Assets:20202019(in millions)Current Regulatory AssetsUnder-recovered Fuel Costs - earns a return$5.4 $3.0 1 yearTotal Current Regulatory Assets$5.4 $3.0 Noncurrent Regulatory AssetsRegulatory assets pending final regulatory approval:Regulatory Assets Currently Earning a ReturnOther Regulatory Assets Pending Final Regulatory Approval$0.5 $— Total Regulatory Assets Currently Earning a Return0.5 — Regulatory Assets Currently Not Earning a ReturnCOVID-193.8 — Cook Plant Study Costs— 7.6 Other Regulatory Assets Pending Final Regulatory Approval— 0.1 Total Regulatory Assets Currently Not Earning a Return3.8 7.7 Total Regulatory Assets Pending Final Regulatory Approval4.3 7.7 Regulatory assets approved for recovery:Regulatory Assets Currently Earning a ReturnPlant Retirement Costs - Unrecovered Plant191.5 214.9 8 yearsRockport Plant Dry Sorbent Injection System and Selective Catalytic Reduction34.4 13.5 8 yearsCook Plant Uprate Project30.2 32.6 13 yearsDeferred Cook Plant Life Cycle Management Project Costs14.1 15.1 14 yearsCook Plant Turbine11.1 13.4 18 yearsCook Plant Study Costs - Indiana10.1 — 15 yearsOther Regulatory Assets Approved for Recovery7.0 6.9 variousTotal Regulatory Assets Currently Earning a Return298.4 296.4 Regulatory Assets Currently Not Earning a ReturnCook Plant Nuclear Refueling Outage Levelization39.5 63.8 2 yearsPension and OPEB Funded Status25.7 67.5 12 yearsUnamortized Loss on Reacquired Debt15.7 17.2 28 yearsPostemployment Benefits4.9 7.2 3 yearsOther Regulatory Assets Approved for Recovery16.3 22.3 variousTotal Regulatory Assets Currently Not Earning a Return102.1 178.0 Total Regulatory Assets Approved for Recovery400.5 474.4 Total Noncurrent Regulatory Assets$404.8 $482.1 274I&MDecember 31,RemainingRefundPeriodRegulatory Liabilities:20202019(in millions)Current Regulatory LiabilitiesOver-recovered Fuel Costs, Indiana - does not pay a return$20.8 $6.1 1 yearTotal Current Regulatory Liabilities$20.8 $6.1 Noncurrent Regulatory Liabilities andDeferred Investment Tax CreditsRegulatory liabilities approved for payment:Regulatory Liabilities Currently Paying a ReturnAsset Removal Costs$168.2 $166.7 (b)Other Regulatory Liabilities Approved for Payment17.4 0.3 variousTotal Regulatory Liabilities Currently Paying a Return185.6 167.0 Regulatory Liabilities Currently Not Paying a ReturnExcess Nuclear Decommissioning Funding1,476.6 1,236.0 (c)Spent Nuclear Fuel43.1 43.6 (c)Deferred Investment Tax Credits21.3 25.8 19 yearsPJM Costs and Off-system Sales Margin Sharing - Indiana13.3 17.0 2 yearsPJM Transmission Enhancement Refund9.9 11.8 5 yearsDeferred Gain on Sale of Rockport Unit 27.2 10.9 2 yearsOther Regulatory Liabilities Approved for Payment30.1 24.9 variousTotal Regulatory Liabilities Currently Not Paying a Return1,601.5 1,370.0 Income Tax Related Regulatory Liabilities (a)Excess ADIT Associated with Certain Depreciable Property450.6 470.9 (d)Excess ADIT that is Not Subject to Rate Normalization Requirements136.2 184.5 4 yearsIncome Taxes Subject to Flow Through(332.0)(301.0)20 yearsTotal Income Tax Related Regulatory Liabilities254.8 354.4 Total Regulatory Liabilities Approved for Payment2,041.9 1,891.4 Total Noncurrent Regulatory Liabilities and Deferred Investment Tax Credits$2,041.9 $1,891.4 (a)This balance primarily represents regulatory liabilities for Excess ADIT as a result of the reduction in the corporate federal income tax rate from 35% to 21% related to the enactment of Tax Reform. The regulatory liability balance predominately pays a return due to the inclusion of Excess ADIT in rate base.(b)Relieved as removal costs are incurred.(c)Relieved when plant is decommissioned.(d)Refunded using ARAM.275OPCoDecember 31,RemainingRecoveryPeriodRegulatory Assets:20202019(in millions)Noncurrent Regulatory AssetsRegulatory assets pending final regulatory approval:Regulatory Assets Currently Not Earning a ReturnCOVID-19$4.4 $— Storm-Related Costs4.0 — Other Regulatory Assets Pending Final Regulatory Approval— 0.1 Total Regulatory Assets Pending Final Regulatory Approval8.4 0.1 Regulatory assets approved for recovery:Regulatory Assets Currently Earning a ReturnOhio Distribution Decoupling46.6 31.4 2 yearsOhio Basic Transmission Cost Rider12.3 — 2 yearsOther Regulatory Assets Approved for Recovery1.3 — variousTotal Regulatory Assets Currently Earning a Return60.2 31.4 Regulatory Assets Currently Not Earning a ReturnPension and OPEB Funded Status130.7 167.3 12 yearsUnrealized Loss on Forward Commitments110.0 103.6 12 yearsOVEC Purchased Power27.4 1.5 2 yearsSmart Grid Costs19.2 13.7 2 yearsDistribution Investment Rider7.4 10.9 2 yearsPostemployment Benefits6.7 7.6 3 yearsOther Regulatory Assets Approved for Recovery15.8 15.7 variousTotal Regulatory Assets Currently Not Earning a Return317.2 320.3 Total Regulatory Assets Approved for Recovery377.4 351.7 Total Noncurrent Regulatory Assets$385.8 $351.8 276OPCoDecember 31,RemainingRefundPeriod20202019Regulatory Liabilities:(in millions)Current Regulatory LiabilitiesOver-recovered Fuel Costs - does not pay a return$3.9 $2.8 1 yearTotal Current Regulatory Liabilities$3.9 $2.8 Noncurrent Regulatory Liabilities and Deferred Investment Tax CreditsRegulatory liabilities pending final regulatory determination:Regulatory Liabilities Currently Not Paying a ReturnOther Regulatory Liabilities Pending Final Regulatory Determination$0.2 $0.2 Total Regulatory Liabilities Pending Final Regulatory Determination0.2 0.2 Regulatory liabilities approved for payment:Regulatory Liabilities Currently Paying a ReturnAsset Removal Costs458.4 446.3 (b)Ohio Basic Transmission Cost Rider— 37.2 Other Regulatory Liabilities Approved for Payment— 1.3 Total Regulatory Liabilities Currently Paying a Return458.4 484.8 Regulatory Liabilities Currently Not Paying a ReturnPJM Transmission Enhancement Refund24.5 29.4 5 yearsPeak Demand Reduction/Energy Efficiency19.9 19.7 2 yearsOhio Enhanced Service Reliability Plan5.7 29.7 2 yearsOther Regulatory Liabilities Approved for Payment0.7 2.9 variousTotal Regulatory Liabilities Currently Not Paying a Return50.8 81.7 Income Tax Related Regulatory Liabilities (a)Excess ADIT Associated with Certain Depreciable Property334.6 341.6 (c)Excess ADIT that is Not Subject to Rate Normalization Requirements223.9 252.3 8 yearsIncome Taxes Subject to Flow Through(62.7)(69.7)29 yearsTotal Income Tax Related Regulatory Liabilities495.8 524.2 Total Regulatory Liabilities Approved for Payment1,005.0 1,090.7 Total Noncurrent Regulatory Liabilities and Deferred Investment Tax Credits$1,005.2 $1,090.9 (a)This balance primarily represents regulatory liabilities for Excess ADIT as a result of the reduction in the corporate federal income tax rate from 35% to 21% related to the enactment of Tax Reform. The regulatory liability balance predominately pays a return due to the inclusion of Excess ADIT in rate base.(b)Relieved as removal costs are incurred.(c)Refunded using ARAM. 277PSODecember 31,RemainingRecoveryPeriod20202019Regulatory Assets:(in millions)Current Regulatory AssetsUnder-recovered Fuel Costs - earns a return$30.1 $— 1 yearTotal Current Regulatory Assets$30.1 $— Noncurrent Regulatory AssetsRegulatory assets pending final regulatory approval:Regulatory Assets Currently Earning a ReturnOklaunion Power Station Accelerated Depreciation$34.4 $27.4 Total Regulatory Assets Currently Earning a Return34.4 27.4 Regulatory Assets Currently Not Earning a ReturnStorm-Related Costs15.8 7.2 COVID-190.3 — Total Regulatory Assets Currently Not Earning a Return16.1 7.2 Total Regulatory Assets Pending Final Regulatory Approval50.5 34.6 Regulatory assets approved for recovery:Regulatory Assets Currently Earning a ReturnPlant Retirement Costs - Unrecovered Plant (a)180.8 167.0 20 yearsEnvironmental Control Projects26.5 27.8 20 yearsMeter Replacement Costs26.2 30.2 7 yearsStorm-Related Costs11.5 21.3 2 yearsRed Rock Generating Facility8.2 8.4 36 yearsOther Regulatory Assets Approved for Recovery0.5 0.6 variousTotal Regulatory Assets Currently Earning a Return253.7 255.3 Regulatory Assets Currently Not Earning a ReturnPension and OPEB Funded Status52.3 73.4 12 yearsUnamortized Loss on Reacquired Debt6.1 6.5 18 yearsOther Regulatory Assets Approved for Recovery12.4 5.4 variousTotal Regulatory Assets Currently Not Earning a Return70.8 85.3 Total Regulatory Assets Approved for Recovery324.5 340.6 Total Noncurrent Regulatory Assets$375.0 $375.2 (a)Northeastern Plant, Unit 3 is approved for recovery through 2040, but expected to retire in 2026. PSO records a regulatory asset for accelerated depreciation. See “Regulated Generating Units to be Retired” section above for additional information.278PSODecember 31,RemainingRefundPeriod20202019Regulatory Liabilities:(in millions)Current Regulatory LiabilitiesOver-recovered Fuel Costs - pays a return$— $63.9 Total Current Regulatory Liabilities$— $63.9 Noncurrent Regulatory Liabilities andDeferred Investment Tax CreditsRegulatory liabilities approved for payment:Regulatory Liabilities Currently Paying a ReturnAsset Removal Costs$289.9 $286.8 (b)Total Regulatory Liabilities Currently Paying a Return289.9 286.8 Regulatory Liabilities Currently Not Paying a ReturnDeferred Investment Tax Credits51.0 51.5 24 yearsOther Regulatory Liabilities Approved for Payment1.3 4.7 variousTotal Regulatory Liabilities Currently Not Paying a Return52.3 56.2 Income Tax Related Regulatory Liabilities (a)Excess ADIT Associated with Certain Depreciable Property397.0 405.8 (c)Excess ADIT that is Not Subject to Rate Normalization Requirements71.3 96.3 4 yearsIncome Taxes Subject to Flow Through(8.3)(7.9)27 yearsTotal Income Tax Related Regulatory Liabilities460.0 494.2 Total Regulatory Liabilities Approved for Payment802.2 837.2 Total Noncurrent Regulatory Liabilities and Deferred Investment Tax Credits$802.2 $837.2 (a)This balance primarily represents regulatory liabilities for Excess ADIT as a result of the reduction in the corporate federal income tax rate from 35% to 21% related to the enactment of Tax Reform. The regulatory liability balance predominately pays a return due to the inclusion of Excess ADIT in rate base.(b)Relieved as removal costs are incurred.(c)Refunded using ARAM.279SWEPCoDecember 31,RemainingRecoveryPeriod20202019Regulatory Assets:(in millions)Current Regulatory AssetsUnder-recovered Fuel Costs - earns a return (a)$2.6 $4.9 1 yearTotal Current Regulatory Assets$2.6 $4.9 Noncurrent Regulatory AssetsRegulatory assets pending final regulatory approval:Regulatory Assets Currently Earning a ReturnDolet Hills Power Station Accelerated Depreciation$71.2 $— Plant Retirement Costs - Unrecovered Plant, Louisiana35.2 35.2 Pirkey Power Plant Accelerated Depreciation12.2 — Welsh Plant, Units 1 and 3 Accelerated Depreciation3.6 — Other Regulatory Assets Pending Final Regulatory Approval2.2 0.2 Total Regulatory Assets Currently Earning a Return124.4 35.4 Regulatory Assets Currently Not Earning a ReturnStorm-Related Costs99.3 — Asset Retirement Obligation - Louisiana9.1 7.2 Other Regulatory Assets Pending Final Regulatory Approval14.5 3.7 Total Regulatory Assets Currently Not Earning a Return122.9 10.9 Total Regulatory Assets Pending Final Regulatory Approval247.3 46.3 Regulatory assets approved for recovery:Regulatory Assets Currently Earning a ReturnPlant Retirement Costs - Unrecovered Plant, Arkansas14.4 15.1 22 yearsEnvironmental Controls Projects12.1 13.2 12 yearsOther Regulatory Assets Approved for Recovery7.1 8.9 variousTotal Regulatory Assets Currently Earning a Return33.6 37.2 Regulatory Assets Currently Not Earning a ReturnPension and OPEB Funded Status89.1 102.6 12 yearsPlant Retirement Costs - Unrecovered Plant, Texas16.1 16.6 21 yearsOther Regulatory Assets Approved for Recovery17.0 19.7 variousTotal Regulatory Assets Currently Not Earning a Return122.2 138.9 Total Regulatory Assets Approved for Recovery155.8 176.1 Total Noncurrent Regulatory Assets$403.1 $222.4 (a)December 31, 2020 amount includes Louisiana jurisdiction. December 31, 2019 amount includes Arkansas jurisdiction. 280SWEPCoDecember 31,RemainingRefundPeriod20202019Regulatory Liabilities:(in millions)Current Regulatory LiabilitiesOver-recovered Fuel Costs - pays a return (a)$37.6 $13.6 1 yearTotal Current Regulatory Liabilities$37.6 $13.6 Noncurrent Regulatory Liabilities andDeferred Investment Tax CreditsRegulatory liabilities pending final regulatory determination:Income Tax Related Regulatory Liabilities (b)Excess ADIT Associated with Certain Depreciable Property$291.6 $297.0 Excess ADIT that is Not Subject to Rate Normalization Requirements21.8 22.7 Total Regulatory Liabilities Pending Final Regulatory Determination313.4 319.7 Regulatory liabilities approved for payment:Regulatory Liabilities Currently Paying a ReturnAsset Removal Costs470.9 453.4 (c)Other Regulatory Liabilities Approved for Payment2.4 2.8 variousTotal Regulatory Liabilities Currently Paying a Return473.3 456.2 Regulatory Liabilities Currently Not Paying a ReturnPeak Demand Reduction/Energy Efficiency5.2 6.0 2 yearsDeferred Investment Tax Credits1.8 3.1 10 yearsOther Regulatory Liabilities Approved for Payment1.2 1.7 variousTotal Regulatory Liabilities Currently Not Paying a Return8.2 10.8 Income Tax Related Regulatory Liabilities (b)Excess ADIT Associated with Certain Depreciable Property332.5 339.4 (d)Excess ADIT that is Not Subject to Rate Normalization Requirements11.5 27.8 (e)Income Taxes Subject to Flow Through(275.5)(261.6)28 yearsTotal Income Tax Related Regulatory Liabilities68.5 105.6 Total Regulatory Liabilities Approved for Payment550.0 572.6 Total Noncurrent Regulatory Liabilities and Deferred Investment Tax Credits$863.4 $892.3 (a)December 31, 2020 amount includes Arkansas and Texas jurisdictions. December 31, 2019 amount includes Texas and Louisiana jurisdictions. (b)This balance primarily represents regulatory liabilities for Excess ADIT as a result of the reduction in the corporate federal income tax rate from 35% to 21% related to the enactment of Tax Reform. The regulatory liability balance predominately pays a return due to the inclusion of Excess ADIT in rate base.(c)Relieved as removal costs are incurred.(d)Refunded using ARAM.(e)Current balance represents revisions to balances for jurisdictions having previously issued orders on treatment for refund, refund period to be addressed in future proceedings.2816. COMMITMENTS, GUARANTEES AND CONTINGENCIESThe disclosures in this note apply to all Registrants unless indicated otherwise.The Registrants are subject to certain claims and legal actions arising in the ordinary course of business. In addition, the Registrants business activities are subject to extensive governmental regulation related to public health and the environment. The ultimate outcome of such pending or potential litigation against the Registrants cannot be predicted. Management accrues contingent liabilities only when management concludes that it is both probable that a liability has been incurred at the date of the financial statements and the amount of loss can be reasonably estimated. When management determines that it is not probable, but rather reasonably possible that a liability has been incurred at the date of the financial statements, management discloses such contingencies and the possible loss or range of loss if such estimate can be made. Any estimated range is based on currently available information and involves elements of judgment and significant uncertainties. Any estimated range of possible loss may not represent the maximum possible loss exposure. Circumstances change over time and actual results may vary significantly from estimates.For current proceedings not specifically discussed below, management does not anticipate that the liabilities, if any, arising from such proceedings would have a material effect on the financial statements.COMMITMENTS (Applies to all Registrants except AEP Texas and AEPTCo)The AEP System has substantial commitments for fuel, energy and capacity contracts as part of the normal course of business. Certain contracts contain penalty provisions for early termination.In accordance with the accounting guidance for “Commitments”, the following tables summarize the Registrants’ actual contractual commitments as of December 31, 2020:Contractual Commitments - AEPLess Than 1 Year2-3 Years4-5 YearsAfter5 YearsTotal(in millions)Fuel Purchase Contracts (a)$763.9 $715.1 $212.9 $381.5 $2,073.4 Energy and Capacity Purchase Contracts211.6 291.8 277.0 928.5 1,708.9 Total$975.5 $1,006.9 $489.9 $1,310.0 $3,782.3 Contractual Commitments - APCoLess Than1 Year2-3 Years4-5 YearsAfter5 YearsTotal(in millions)Fuel Purchase Contracts (a)$362.8 $217.6 $11.6 $16.3 $608.3 Energy and Capacity Purchase Contracts35.5 72.5 73.9 230.2 412.1 Total$398.3 $290.1 $85.5 $246.5 $1,020.4 Contractual Commitments - I&MLess Than1 Year2-3 Years4-5 YearsAfter 5 YearsTotal(in millions)Fuel Purchase Contracts (a)$157.7 $278.9 $189.3 $332.7 $958.6 Energy and Capacity Purchase Contracts165.2 196.7 60.9 254.6 677.4 Total$322.9 $475.6 $250.2 $587.3 $1,636.0 Contractual Commitments - OPCoLess Than1 Year2-3 Years4-5 YearsAfter 5 YearsTotal(in millions)Energy and Capacity Purchase Contracts$28.8 $58.2 $58.1 $263.3 $408.4 282Contractual Commitments - PSOLess Than1 Year2-3 Years4-5 YearsAfter 5 YearsTotal(in millions)Fuel Purchase Contracts (a)$25.3 $36.2 $— $— $61.5 Energy and Capacity Purchase Contracts89.6 77.4 66.8 160.0 393.8 Total$114.9 $113.6 $66.8 $160.0 $455.3 Contractual Commitments - SWEPCoLess Than1 Year2-3 Years4-5 YearsAfter 5 YearsTotal(in millions)Fuel Purchase Contracts (a)$68.5 $39.2 $— $— $107.7 Energy and Capacity Purchase Contracts8.3 8.4 8.4 4.2 29.3 Total$76.8 $47.6 $8.4 $4.2 $137.0 (a)Represents contractual commitments to purchase coal, natural gas, uranium and other consumables as fuel for electric generation along with related transportation of the fuel.GUARANTEESLiabilities for guarantees are recorded in accordance with the accounting guidance for “Guarantees.” There is no collateral held in relation to any guarantees. In the event any guarantee is drawn, there is no recourse to third-parties unless specified below.Letters of Credit (Applies to AEP and AEP Texas)Standby letters of credit are entered into with third-parties. These letters of credit are issued in the ordinary course of business and cover items such as natural gas and electricity risk management contracts, construction contracts, insurance programs, security deposits and debt service reserves.AEP has a $4 billion revolving credit facility due in June 2022, under which up to $1.2 billion may be issued as letters of credit on behalf of subsidiaries. As of December 31, 2020, no letters of credit were issued under the revolving credit facility.An uncommitted facility gives the issuer of the facility the right to accept or decline each request made under the facility. AEP issues letters of credit on behalf of subsidiaries under six uncommitted facilities totaling $405 million. The Registrants’ maximum future payments for letters of credit issued under the uncommitted facilities as of December 31, 2020 were as follows:CompanyAmountMaturity(in millions)AEP$179.8 January 2021 to December 2021AEP Texas2.2 July 2021Guarantees of Equity Method Investees (Applies to AEP)In April 2019, AEP acquired Sempra Renewables LLC. The transaction resulted in the acquisition of a 50% ownership interest in five non-consolidated joint ventures and the acquisition of two tax equity partnerships. Parent has issued guarantees over the performance of the joint ventures. If a joint venture were to default on payments or performance, Parent would be required to make payments on behalf of the joint venture. As of December 31, 2020, the maximum potential amount of future payments associated with these guarantees was $157 million, with the last guarantee expiring in December 2037. The non-contingent liability recorded associated with these guarantees was $31 million, with an additional $1 million expected credit loss liability for the contingent portion of the guarantees. Management considered historical losses, economic conditions, and reasonable and supportable forecasts in the calculation of the expected credit loss. As the joint ventures generate cash flows through PPAs, the measurement of the contingent portion of the guarantee liability is based upon assessments of the credit quality and default probabilities of the respective PPA counterparties. See “Acquisitions” section of Note 7 for additional information.283Indemnifications and Other GuaranteesContractsThe Registrants enter into certain types of contracts which require indemnifications. Typically these contracts include, but are not limited to, sale agreements, lease agreements, purchase agreements and financing agreements. Generally, these agreements may include, but are not limited to, indemnifications around certain tax, contractual and environmental matters. With respect to sale agreements, exposure generally does not exceed the sale price. As of December 31, 2020, there were no material liabilities recorded for any indemnifications.AEPSC conducts power purchase-and-sale activity on behalf of APCo, I&M, KPCo and WPCo, who are jointly and severally liable for activity conducted on their behalf. AEPSC also conducts power purchase-and-sale activity on behalf of PSO and SWEPCo, who are jointly and severally liable for activity conducted on their behalf.Lease ObligationsCertain Registrants lease equipment under master lease agreements. See “Master Lease Agreements” and “AEPRO Boat and Barge Leases” sections of Note 13 for additional information.ENVIRONMENTAL CONTINGENCIES (Applies to All Registrants except AEPTCo)The Comprehensive Environmental Response Compensation and Liability Act (Superfund) and State Remediation By-products from the generation of electricity include materials such as ash, slag, sludge, low-level radioactive waste and SNF. Coal combustion by-products, which constitute the overwhelming percentage of these materials, are typically treated and deposited in captive disposal facilities or are beneficially utilized. In addition, the generation plants and transmission and distribution facilities have used asbestos, polychlorinated biphenyls and other hazardous and non-hazardous materials. The Registrants currently incur costs to dispose of these substances safely.Superfund addresses clean-up of hazardous substances that are released to the environment. The Federal EPA administers the clean-up programs. Several states enacted similar laws. As of December 31, 2020, APCo, OPCo and SWEPCo are named as a Potentially Responsible Party (PRP) for one, three and one sites, respectively, by the Federal EPA for which alleged liability is unresolved. There are 11 additional sites for which APCo, I&M, KPCo, OPCo and SWEPCo received information requests which could lead to PRP designation. I&M has also been named potentially liable at three sites under state law. In those instances where a PRP or defendant has been named, disposal or recycling activities were in accordance with the then-applicable laws and regulations. Superfund does not recognize compliance as a defense, but imposes strict liability on parties who fall within its broad statutory categories. Liability has been resolved for a number of sites with no significant effect on net income.Management evaluates the potential liability for each Superfund site separately, but several general statements can be made about potential future liability. Allegations that materials were disposed at a particular site are often unsubstantiated and the quantity of materials deposited at a site can be small and often non-hazardous. Although Superfund liability has been interpreted by the courts as joint and several, typically many parties are named as PRPs for each site and several of the parties are financially sound enterprises. As of December 31, 2020, management’s estimates do not anticipate material clean-up costs for identified Superfund sites.284Virginia House Bill 443 (Applies to AEP and APCo)In March 2020, Virginia’s Governor signed House Bill 443 (HB 443), effective July 2020, requiring APCo to close certain ash disposal units at the retired Glen Lyn Station by removal of all coal combustion material. As a result, in June 2020, APCo recorded a $199 million revision to increase estimated Glen Lyn Station ash disposal ARO liabilities. The closure is required to be completed within 15 years from the start of the excavation process. HB 443 provides for the recovery of all costs associated with closure by removal through the Virginia environmental rate adjustment clause (E-RAC). APCo is permitted to record carrying costs on the unrecovered balance of closure costs at a weighted-average cost of capital approved by the Virginia SCC. HB 443 also allows any closure costs allocated to non-Virginia jurisdictional customers, but not collected from such non-Virginia jurisdictional customers, to be recovered from Virginia jurisdictional customers through the E-RAC. APCo will submit filings with the Virginia SCC and the WVPSC requesting recovery of the respective Virginia and West Virginia jurisdictional shares of these Glen Lyn Station ARO costs. As of December 31, 2020, APCo has not yet incurred any incremental costs associated with the removal of coal combustion material at the Glen Lyn Station.NUCLEAR CONTINGENCIES (APPLIES TO AEP AND I&M)I&M owns and operates the two-unit 2,288 MW Cook Plant under licenses granted by the NRC. I&M has a significant future financial commitment to dispose of SNF and to safely decommission and decontaminate the plant. The licenses to operate the two nuclear units at the Cook Plant expire in 2034 and 2037. The operation of a nuclear facility also involves special risks, potential liabilities and specific regulatory and safety requirements. By agreement, I&M is partially liable, together with all other electric utility companies that own nuclear generation units, for a nuclear power plant incident at any nuclear plant in the U.S. Should a nuclear incident occur at any nuclear power plant in the U.S., the resultant liability could be substantial.Decommissioning and Low-Level Waste Accumulation DisposalThe costs to decommission a nuclear plant are affected by NRC regulations and the SNF disposal program. Decommissioning costs are accrued over the service life of Cook Plant. The most recent decommissioning cost study was performed in 2018. According to that study, the estimated cost of decommissioning and disposal of low-level radioactive waste was $2 billion in 2018 non-discounted dollars, with additional ongoing costs of $6 million per year for post decommissioning storage of SNF and an eventual cost of $37 million for the subsequent decommissioning of the SNF storage facility, also in 2018 non-discounted dollars. I&M recovers estimated decommissioning costs for the Cook Plant in its rates. The amounts recovered in rates were $4 million, $7 million and $8 million for the years ended December 31, 2020, 2019 and 2018, respectively. Decommissioning costs recovered from customers are deposited in external trusts.As of December 31, 2020 and 2019, the total decommissioning trust fund balances were $3 billion and $2.7 billion, respectively. Trust fund earnings increase the fund assets and decrease the amount remaining to be recovered from customers. The decommissioning costs (including unrealized gains and losses, interest and trust funds expenses) increase or decrease the recorded liability.I&M continues to work with regulators and customers to recover the remaining estimated costs of decommissioning the Cook Plant. However, future net income and cash flows would be reduced and financial condition could be impacted if the cost of SNF disposal and decommissioning continues to increase and cannot be recovered.285Spent Nuclear Fuel DisposalThe federal government is responsible for permanent SNF disposal and assesses fees to nuclear plant owners for SNF disposal. A fee of one-mill per KWh for fuel consumed after April 6, 1983 at the Cook Plant was collected from customers and remitted to the DOE through May 14, 2014. In May 2014, pursuant to court order from the U.S Court of Appeals for the District of Columbia Circuit, the DOE adjusted the fee to $0. As of December 31, 2020 and 2019, fees and related interest of $281 million and $280 million, respectively, for fuel consumed prior to April 7, 1983 were recorded as Long-term Debt and funds collected from customers along with related earnings totaling $324 million and $323 million, respectively, to pay the fee were recorded as part of Spent Nuclear Fuel and Decommissioning Trusts on the balance sheets. I&M has not paid the government the pre-April 1983 fees due to continued delays and uncertainties related to the federal disposal program.In 2011, I&M signed a settlement agreement with the federal government which permits I&M to make annual filings to recover certain SNF storage costs incurred as a result of the government’s delay in accepting SNF for permanent storage. Under the settlement agreement, I&M received $24 million, $8 million and $11 million in 2020, 2019 and 2018, respectively, to recover costs and will be eligible to receive additional payment of annual claims for allowed costs that are incurred through December 31, 2022. The proceeds reduced costs for dry cask storage. As of December 31, 2020 and 2019, I&M deferred $14 million and $24 million, respectively, in Prepayments and Other Current Assets and $1 million and $1 million, respectively, in Deferred Charges and Other Noncurrent Assets on the balance sheets for dry cask storage and related operation and maintenance costs for recovery under this agreement. See “Fair Value Measurements of Trust Assets for Decommissioning and SNF Disposal” section of Note 11 for additional information.Nuclear InsuranceI&M carries nuclear property insurance of $2.7 billion to cover an incident at Cook Plant including coverage for decontamination and stabilization, as well as premature decommissioning caused by an extraordinary incident. Insurance coverage for a nonnuclear property incident at Cook Plant is $500 million. Additional insurance provides coverage for a weekly indemnity payment resulting from an insured accidental outage. I&M utilizes industry mutual insurers for the placement of this insurance coverage. Coverage from these industry mutual insurance programs require a contingent financial obligation of up to $42 million for I&M, which is assessable if the insurer’s financial resources would be inadequate to pay for industry losses.The Price-Anderson Act, extended through December 31, 2025, establishes insurance protection for public nuclear liability arising from a nuclear incident of $13.8 billion and applies to any incident at a licensed reactor in the U.S. Commercially available insurance, which must be carried for each licensed reactor, provides $450 million of coverage. In the event of a nuclear incident at any nuclear plant in the U.S., the remainder of the liability would be provided by a deferred premium assessment of $275 million per nuclear incident on Cook Plant’s reactors payable in annual installments of $41 million. The number of incidents for which payments could be required is not limited.In the event of an incident of a catastrophic nature, I&M is covered for public nuclear liability for the first $450 million through commercially available insurance. The next level of liability coverage of up to $13.3 billion would be covered by claim premium assessments made under the Price-Anderson Act. In the event nuclear losses or liabilities are underinsured or exceed accumulated funds, I&M would seek recovery of those amounts from customers through a rate increase. If recovery from customers is not possible, it could reduce future net income and cash flows and impact financial condition.286OPERATIONAL CONTINGENCIESInsurance and Potential LossesThe Registrants maintain insurance coverage normal and customary for electric utilities, subject to various deductibles. The Registrants also maintain property and casualty insurance that may cover certain physical damage or third-party injuries caused by cyber security incidents. Insurance coverage includes all risks of physical loss or damage to nonnuclear assets, subject to insurance policy conditions and exclusions. Covered property generally includes power plants, substations, facilities and inventories. Excluded property generally includes transmission and distribution lines, poles and towers. The insurance programs also generally provide coverage against loss arising from certain claims made by third-parties and are in excess of retentions absorbed by the Registrants. Coverage is generally provided by a combination of the protected cell of EIS and/or various industry mutual and/or commercial insurance carriers. See “Nuclear Contingencies” section above for additional information.Some potential losses or liabilities may not be insurable or the amount of insurance carried may not be sufficient to meet potential losses and liabilities, including, but not limited to, liabilities relating to a cyber security incident or damage to the Cook Plant and costs of replacement power in the event of an incident at the Cook Plant. Future losses or liabilities, if they occur, which are not completely insured, unless recovered from customers, could reduce future net income and cash flows and impact financial condition.Rockport Plant Litigation (Applies to AEP and I&M)In 2013, the Wilmington Trust Company filed a complaint in the U.S. District Court for the Southern District of New York against AEGCo and I&M alleging that it would be unlawfully burdened by the terms of the modified NSR consent decree after the Rockport Plant, Unit 2 lease expiration in December 2022. The terms of the consent decree allow the installation of environmental emission control equipment, repowering, refueling or retirement of the unit. The plaintiffs seek a judgment declaring that the defendants breached the lease, must satisfy obligations related to installation of emission control equipment and indemnify the plaintiffs. The New York court granted a motion to transfer this case to the U.S. District Court for the Southern District of Ohio.AEGCo and I&M sought and were granted dismissal by the U.S. District Court for the Southern District of Ohio of certain of the plaintiffs’ claims, including claims for compensatory damages, breach of contract, breach of the implied covenant of good faith and fair dealing and indemnification of costs. Plaintiffs voluntarily dismissed the surviving claims that AEGCo and I&M failed to exercise prudent utility practices with prejudice, and the court issued a final judgment. The plaintiffs subsequently filed an appeal in the U.S. Court of Appeals for the Sixth Circuit.In 2017, the U.S. Court of Appeals for the Sixth Circuit issued an opinion and judgment affirming the district court’s dismissal of the owners’ breach of good faith and fair dealing claim as duplicative of the breach of contract claims, reversing the district court’s dismissal of the breach of contract claims and remanding the case for further proceedings.Thereafter, AEP filed a motion with the U.S. District Court for the Southern District of Ohio in the original NSR litigation, seeking to modify the consent decree. The district court granted the owners’ unopposed motion to stay the lease litigation to afford time for resolution of AEP’s motion to modify the consent decree. The consent decree was modified based on an agreement among the parties in July 2019. The district court’s stay of the lease litigation expired in August 2020. Upon expiration of the stay, plaintiffs filed a motion for partial summary judgment, arguing that the consent decree violates the facility lease and the participation agreement and requesting that the district court enter a judgment for the plaintiffs on their breach of contract claim. AEP’s memorandum in opposition to plaintiffs’ motion for partial summary judgement was filed in October 2020. At the parties’ request, the district court stayed the case until February 16, 2021 to provide the parties an opportunity to resolve the case, and the court has since extended the stay until April 26, 2021.287Management will continue to defend against the claims and believes its financial statements appropriately reflect the potential outcome of the pending litigation. The ultimate outcome of the pending litigation could reduce future net income and cash flows and impact financial condition.Patent Infringement ComplaintIn July 2019, Midwest Energy Emissions Corporation and MES Inc. (collectively, the plaintiffs) filed a patent infringement complaint against various parties, including AEP Texas, AGR, Cardinal Operating Company and SWEPCo (collectively, the AEP Defendants). The complaint alleges that the AEP Defendants infringed two patents owned by the plaintiffs by using specific processes for mercury control at certain coal-fired generating stations. The complaint was resolved in December 2020 and did not have a material impact on net income, cash flows or financial condition.Claims Challenging Transition of American Electric Power System Retirement Plan to Cash Balance Formula The American Electric Power System Retirement Plan (the Plan) has received a letter written on behalf of four participants (the Claimants) making a claim for additional plan benefits and purporting to advance such claims on behalf of a class. When the Plan’s benefit formula was changed in the year 2000, AEP provided a special provision for employees hired before January 1, 2001, allowing them to continue benefit accruals under the then benefit formula for a full 10 years alongside of the new cash balance benefit formula then being implemented. Employees who were hired on or after January 1, 2001 accrued benefits only under the new cash balance benefit formula. The Claimants have asserted claims that: (a) the Plan violates the requirements under the Employee Retirement Income Security Act (ERISA) intended to preclude back-loading the accrual of benefits to the end of a participant’s career, (b) the Plan violates the age discrimination prohibitions of ERISA and the Age Discrimination in Employment Act and (c) the company failed to provide required notice regarding the changes to the Plan. AEP has responded to the Claimants providing a reasoned explanation for why each of their claims have been denied. The denial of those claims was appealed to the AEP System Retirement Plan Appeal Committee and the Committee upheld the denial of claims. Management will continue to defend against the claims. Management is unable to determine a range of potential losses that is reasonably possible of occurring.Litigation Related to Ohio House Bill 6 (Applies to AEP and OPCo)In August 2020, an AEP shareholder filed a putative class action lawsuit in the United States District Court for the Southern District of Ohio against AEP and certain of its officers for alleged violations of securities laws. The complaint alleges misrepresentations or omissions by AEP regarding: (a) its alleged participation in public corruption with respect to the passage of Ohio House Bill 6, (b) its regulatory, legislative and lobbying activities in Ohio and (c) its clean energy strategy. The complaint seeks monetary damages among other forms of relief. The company will continue to defend against the claims. Management is unable to determine a range of potential losses that is reasonably possible of occurring.In January 2021, an AEP shareholder filed a derivative action in the United States District Court for the Southern District of Ohio purporting to assert claims on behalf of AEP against certain AEP officers and directors. In February 2021, a second AEP shareholder filed a similar derivative action in the Court of Common Pleas of Franklin County, Ohio. The derivative complaints allege the officers and directors made misrepresentations and omissions similar to those alleged in the putative securities class action lawsuit filed against AEP. The complaints assert claims for: (a) breach of fiduciary duty, (b) waste of corporate assets and (c) unjust enrichment and seek monetary damages and changes to AEP’s corporate governance and internal policies among other forms of relief. The company will continue to defend against the claims. Management is unable to determine a range of potential losses that is reasonably possible of occurring.2887. ACQUISITIONS, DISPOSITIONS AND IMPAIRMENTSThe disclosures in this note apply to AEP unless indicated otherwise.ACQUISITIONS2020Santa Rita East (Generation & Marketing Segment)In November 2020, AEP acquired an additional 10% interest in Santa Rita East for approximately $44 million resulting in AEP having a total interest of 85%. The acquisition of the incremental ownership interest was accounted for as an equity transaction in accordance with the accounting guidance for "Consolidation" and reduced Noncontrolling Interests on the balance sheets by approximately $44 million. See Note 17 - Variable Interest Entities and Equity Method Investments for additional information.Desert Sky Wind Farm and Trent Wind Farm (Generation & Marketing Segment)In August 2020, AEP exercised its call right which required the nonaffiliated member of Desert Sky Wind Farm LLC and Trent Wind Farm LLC (collectively the LLCs) to sell its noncontrolling interest to AEP. The exercise price for the call right was determined using a discounted cash flow model with agreed input assumptions as well as updates to certain assumptions reasonably expected based on the actual results of the LLCs. As a result, the LLCs are wholly-owned by AEP and management has concluded that the LLCs are no longer VIEs. AEP paid $57 million in cash, derecognized $63 million of Redeemable Noncontrolling Interest within Mezzanine Equity and recorded an increase of $6 million of Paid-In Capital on the balance sheets. See Note 17 - Variable Interest Entities and Equity Method Investments for additional information. 2019Sempra Renewables LLC (Generation & Marketing Segment)In April 2019, AEP acquired Sempra Renewables LLC and its ownership interests in 724 MWs of wind generation and battery assets valued at approximately $1.1 billion. This acquisition is part of AEP’s strategy to grow its renewable generation portfolio and to diversify generation resources. AEP paid $580 million in cash and acquired a 50% ownership interest in five non-consolidated joint ventures with net assets valued at $404 million as of the acquisition date (which includes $364 million of existing debt obligations). Additionally, the transaction included the acquisition of two tax equity partnerships and the associated recognition of noncontrolling tax equity interest of $135 million. Purchase Price Allocation of Sempra Renewables LLC at Acquisition Date - April 22nd, 2019Assets:Liabilities and Equity:Net Purchase Price(in millions)Current Assets$8.8 Current Liabilities$12.9 Property, Plant and Equipment238.1 Asset Retirement Obligations5.7 Investment in Joint Ventures404.0 Total Liabilities18.6 Other Noncurrent Assets82.9 Noncontrolling Interest134.8 Total Assets$733.8 Liabilities and Noncontrolling Interest$153.4 $580.4 Management allocated the purchase price based upon the relative fair value of the assets acquired and noncontrolling interests assumed. The fair value of the primary assets acquired and the noncontrolling interests assumed was determined using a discounted cash flow method under the income approach. The key input assumptions utilized in the determination of the fair value of these assets were the pricing and terms of the existing PPAs, forecasted market power prices, expected wind farm net capacity and discount rates reflecting risk inherent in the future cash flows and future power prices. Estimating forecasted market power prices involved determining the 289cost of constructing and operating a new wind plant over an assumed life in the same geographic region as of the acquisition date using third-party market participant assumptions. The expected wind farm net capacity was developed by evaluating each wind farm’s historical and expected generation against historical generation of comparable wind farms in the same locations. Discount rates were evaluated by considering the cost of capital of comparable businesses. Additional key input assumptions for the fair value of the noncontrolling interests include the terms of the limited liability company agreements that dictate the sharing of the tax attributes and cash flows associated with the tax equity partnerships.Upon closing of the purchase, Sempra Renewables LLC was legally renamed AEP Wind Holdings LLC. AEP Wind Holdings LLC develops, owns and operates, or holds interests in, wind generation facilities in the United States. The operating wind generation portfolio includes seven wind farms. Five wind farms are jointly-owned with BP Wind Energy, and two wind farms are consolidated by AEP and are tax equity partnerships with nonaffiliated noncontrolling interests. All seven wind farms have long-term PPAs for 100% of their energy production. The PPAs with I&M, OPCo and SWEPCo were executed prior to the acquisition of the wind farms and will be accounted for in accordance with the accounting guidance for “Related Parties.” See “Sempra Renewables LLC PPAs” section of Note 16 for additional information.The acquired business contributed revenues and net income to AEP that were not material for the period April 22, 2019 to December 31, 2019. The pro-forma revenue and net income related to the acquisition of Sempra Renewables LLC were not material for the year ended December 31, 2019. See Note 17 - Variable Interest Entities and Equity Method Investments for additional information related to the purchased wind farms. Santa Rita East (Generation & Marketing Segment)In July 2019, AEP acquired a 75% interest, or 227 MWs, in Santa Rita East for approximately $356 million. In accordance with the accounting guidance for “Business Combinations,” management determined that the acquisition of Santa Rita East represents an asset acquisition. Additionally, and in accordance with the accounting guidance for “Consolidation,” management concluded that Santa Rita East is a VIE. As a result, to account for the initial consolidation of Santa Rita East, management applied the acquisition method by allocating the purchase price based on the relative fair value of the assets acquired and noncontrolling interest assumed. The fair value of the primary assets acquired and the noncontrolling interest assumed was determined using the market approach. The key input assumptions were the transaction price paid for AEP’s interest in Santa Rita East and recent third-party market transactions for similar wind farms. See “Santa Rita East” section of Note 17 for additional information.290DISPOSITIONS2020Conesville Plant (Generation & Marketing Segment)In June 2020, AEP and a nonaffiliated joint-owner executed an Environmental Liability and Property Transfer and Asset Purchase Agreement with a nonaffiliated third-party related to the merchant Conesville Plant site. The purchaser took ownership of the assets and assumed responsibility for environmental liabilities, including ash pond closure, asbestos abatement and decommissioning and demolition of the Conesville Plant site. In consideration of the transfer of the acquired assets to the purchaser and the purchaser’s assumption of liabilities, AEP will pay a total of approximately $98 million over three years, derecognized $106 million in ARO and recorded an immaterial gain on the transaction which is recorded in Other Operation on the statements of income. AEP paid approximately $26 million at closing in June 2020 and made an additional payment of $10 million in the fourth quarter of 2020. AEP will make additional payments as detailed in the table below:20212022(in millions)First Quarter$9.6 $9.6 Second Quarter9.6 9.6 Third Quarter9.6 5.2 Fourth Quarter9.6 — Total$38.4 $24.4 Oklaunion Power Station (Transmission and Distribution Segment and Vertically Integrated Utilities Segment) (Applies to AEP, AEP Texas and PSO)In October 2020, AEP Texas, PSO and a nonaffiliated joint-owner executed an Environmental Liability and Property Transfer and Asset Purchase Agreement with a nonaffiliated third-party related to the Oklaunion Power Station site. The purchaser took ownership of the assets and assumed responsibility for environmental liabilities, including ash pond closure, asbestos abatement and decommissioning and demolition of the Oklaunion Power Station site. The sale had an immaterial impact on the financial statements in the fourth quarter of 2020. IMPAIRMENTS20192019 Texas Base Rate Case (Transmission and Distribution Segment) (Applies to AEP and AEP Texas)In December 2019, AEP Texas recorded a pretax impairment of $33 million in Asset Impairments and Other Related Charges on the statements of income due to regulatory disallowances in the 2019 Texas Base Rate Case. See “2019 Texas Base Rate Case” section of Note 4 for additional information.Virginia Jurisdictional Book Value of Retired Coal-Fired Plants (Vertically Integrated Utilities Segment) (Applies to AEP and APCo)In December 2019, based on management’s interpretation of Virginia law and more certainty regarding APCo’s triennial revenues, expenses and resulting earnings upon reaching the end of the three-year review period, APCo recorded a pretax expense of $93 million in Asset Impairments and Other Related Charges on the statements of income related to its previously retired coal-fired generation. As a result, management deemed these costs to be substantially recovered by APCo during the triennial review period. See “2017-2019 Virginia Triennial Review” section of Note 4 for additional information.291Merchant Generating Assets (Generation & Marketing Segment)Due to a significant increase in the asset retirement costs recorded in December 2019 for the Ash Pond Complex at Conesville Plant, AEP performed an impairment analysis on Conesville Plant in accordance with accounting guidance for impairments of long-lived assets. AEP performed step one and step two of the impairment analysis using a cash flow model for the estimated useful life of Conesville Plant based upon energy and capacity price curves, which were developed internally with both observable Level 2 third-party quotations and unobservable Level 3 inputs, as well as management’s forecasts of operating expenses. The step two analysis resulted in a fair value determination for Conesville Plant of $0 and AEP recorded a $31 million pretax impairment, equal to the net book value of the plant, in Asset Impairments and Other Related Charges on AEP’s statements of income in the fourth quarter of 2019.2018Other Assets (Corporate and Other) (Vertically Integrated Utilities Segment) (Applies to AEP and APCo)In the first quarter of 2018, AEP was notified by an equity investee that it had ceased operations. AEP recorded a pretax impairment of $21 million in Asset Impairments and Other Related Charges on the statements of income related to the equity investment and related assets. The impairment also had an immaterial impact to APCo.Merchant Generating Assets (Generation & Marketing Segment)A project to reconstruct a defective dam structure at Racine began in the first quarter of 2017 and reconstruction activities continued throughout 2018. AEP initially impaired Racine in 2017 as discussed in the “2017 Merchant Generating Assets” section of the Acquisitions, Dispositions and Impairments Note within the 2019 Annual Report.Through the third quarter of 2018, the Racine reconstruction project had accumulated new capital expenditures of $35 million. Due to a significant increase in estimated costs to complete the reconstruction project, an impairment analysis was performed. AEP performed step one of the impairment analysis using undiscounted cash flows for the estimated useful life of Racine based upon energy and capacity price curves, which were developed internally with observable Level 2 third-party quotations and unobservable Level 3 inputs, as well as management’s forecasts of operating expenses and capital expenditures. AEP performed step two of the impairment analysis on Racine using a ten-year discounted cash flow model based upon similar forecasted information used in the step one test. The step two analysis resulted in a determination that the fair value of Racine in its condition as of September 30, 2018 was $0. As a result, AEP recorded a pretax impairment of $35 million in Other Operation on the statements of income in the third quarter of 2018. In October 2018, AEP received authorization from the FERC to restart generation at Racine and generation resumed in November 2018. Reconstruction activities at Racine were completed in 2020.2928. BENEFIT PLANSThe disclosures in this note apply to all Registrants except AEPTCo unless indicated otherwise.For a discussion of investment strategy, investment limitations, target asset allocations and the classification of investments within the fair value hierarchy, see “Fair Value Measurements of Assets and Liabilities” and “Investments Held in Trust for Future Liabilities” sections of Note 1.AEP sponsors a qualified pension plan and two unfunded non-qualified pension plans. Substantially all AEP employees are covered by the qualified plan or both the qualified and a non-qualified pension plan. AEP also sponsors OPEB plans to provide health and life insurance benefits for retired employees.Due to the Registrant Subsidiaries’ participation in AEP’s benefit plans, the assumptions used by the actuary, with the exception of the rate of compensation increase, and the accounting for the plans by each subsidiary are the same. This section details the assumptions that apply to all Registrants and the rate of compensation increase for each Registrant.The Registrants recognize the funded status associated with defined benefit pension and OPEB plans on the balance sheets. Disclosures about the plans are required by the “Compensation – Retirement Benefits” accounting guidance. The Registrants recognize an asset for a plan’s overfunded status or a liability for a plan’s underfunded status, and recognize, as a component of other comprehensive income, the changes in the funded status of the plan that arise during the year that are not recognized as a component of net periodic benefit cost. The Registrants record a regulatory asset instead of other comprehensive income for qualifying benefit costs of regulated operations that for rate-making purposes are deferred for future recovery. The cumulative funded status adjustment is equal to the remaining unrecognized deferrals for unamortized actuarial losses or gains, prior service costs and transition obligations, such that remaining deferred costs result in an AOCI equity reduction or regulatory asset and deferred gains result in an AOCI equity addition or regulatory liability.Actuarial Assumptions for Benefit ObligationsThe weighted-average assumptions used in the measurement of the Registrants’ benefit obligations are shown in the following tables:Pension PlansOPEBDecember 31,Assumption2020201920202019Discount Rate2.50 %3.25 %2.55 %3.30 %Interest Crediting Rate4.00 %4.00 %NANANA Not applicable.Pension PlansDecember 31,Assumption – Rate of Compensation Increase (a)20202019AEP5.00 %4.95 %AEP Texas5.05 %5.00 %APCo4.85 %4.80 %I&M5.00 %4.95 %OPCo5.25 %5.15 %PSO5.05 %5.05 %SWEPCo4.90 %4.90 %(a)Rates are for base pay only. In addition, an amount is added to reflect target incentive compensation for exempt employees and overtime and incentive pay for nonexempt employees.293A duration-based method is used to determine the discount rate for the plans. A hypothetical portfolio of high quality corporate bonds is constructed with cash flows matching the benefit plan liability. The composite yield on the hypothetical bond portfolio is used as the discount rate for the plan. The discount rate is the same for each Registrant.For 2020, the rate of compensation increase assumed varies with the age of the employee, ranging from 3% per year to 11.5% per year, with the average increase shown in the table above. The compensation increase rates reflect variations in each Registrants’ population participating in the pension plan.Actuarial Assumptions for Net Periodic Benefit CostsThe weighted-average assumptions used in the measurement of each Registrants’ benefit costs are shown in the following tables:Pension PlansOPEBYear Ended December 31,Assumption202020192018202020192018Discount Rate3.25 %4.30 %3.65 %3.30 %4.30 %3.60 %Interest Crediting Rate4.00 %4.00 %4.00 %NANANAExpected Return on Plan Assets5.75 %6.25 %6.00 %5.50 %6.25 %6.00 %NA Not applicable.Pension PlansYear Ended December 31,Assumption – Rate of Compensation Increase (a)202020192018AEP5.00 %4.95 %4.85 %AEP Texas5.05 %5.00 %4.95 %APCo4.85 %4.75 %4.75 %I&M5.00 %4.95 %4.90 %OPCo5.25 %5.20 %5.00 %PSO5.05 %5.05 %4.90 %SWEPCo4.90 %4.90 %4.85 %(a)Rates are for base pay only. In addition, an amount is added to reflect target incentive compensation for exempt employees and overtime and incentive pay for nonexempt employees.The expected return on plan assets was determined by evaluating historical returns, the current investment climate (yield on fixed income securities and other recent investment market indicators), rate of inflation, third-party forecasts and current prospects for economic growth. The expected return on plan assets is the same for each Registrant.The health care trend rate assumptions used for OPEB plans measurement purposes are shown below:December 31,Health Care Trend Rates20202019Initial6.50 % 6.00 %Ultimate4.50 % 4.50 %Year Ultimate Reached2029 2026294Significant Concentrations of Risk within Plan AssetsIn addition to establishing the target asset allocation of plan assets, the investment policy also places restrictions on securities to limit significant concentrations within plan assets. The investment policy establishes guidelines that govern maximum market exposure, security restrictions, prohibited asset classes, prohibited types of transactions, minimum credit quality, average portfolio credit quality, portfolio duration and concentration limits. The guidelines were established to mitigate the risk of loss due to significant concentrations in any investment. Management monitors the plans to control security diversification and ensure compliance with the investment policy. As of December 31, 2020, the assets were invested in compliance with all investment limits. See “Investments Held in Trust for Future Liabilities” section of Note 1 for limit details.Benefit Plan Obligations, Plan Assets, Funded Status and Amounts Recognized on the Balance SheetsFor the year ended December 31, 2020, the pension plans had an actuarial loss primarily due to a decrease in the discount rate, partially offset by a decrease in the assumed rate used to convert account balances to annuities. For the year ended December 31, 2020, the OPEB plans had an actuarial loss primarily due to a decrease in the discount rate and an update to the health care trend assumption, partially offset by updated projected per capita claims costs due to rate negotiations for Medicare advantage premium rates. For the year ended December 31, 2019, the pension plans had an actuarial loss due to a decrease in the discount rate, partially offset by updates to the mortality table. For the year ended December 31, 2019, the OPEB plans had an actuarial loss due to a decrease in the discount rate and an update to the persistency assumption, partially offset by an update to the projected per capita cost assumption as well as savings resulting from legislation signed in December 2019 which eliminated two Affordable Care Act taxes. The following tables provide a reconciliation of the changes in the plans’ benefit obligations, fair value of plan assets, funded status and the presentation on the balance sheets. The benefit obligation for the defined benefit pension and OPEB plans are the projected benefit obligation and the accumulated benefit obligation, respectively. AEPPension PlansOPEB2020201920202019Change in Benefit Obligation(in millions)Benefit Obligation as of January 1,$5,236.8 $4,810.3 $1,225.4 $1,194.5 Service Cost111.9 95.5 10.0 9.5 Interest Cost167.9 204.4 39.8 50.5 Actuarial Loss434.7 493.6 39.3 58.8 Plan Amendments— 0.2 (11.4)(11.0)Benefit Payments(406.8)(367.2)(131.0)(113.0)Participant Contributions— — 38.2 35.5 Medicare Subsidy— — 0.6 0.6 Benefit Obligation as of December 31,$5,544.5 $5,236.8 $1,210.9 $1,225.4 Change in Fair Value of Plan AssetsFair Value of Plan Assets as of January 1,$5,015.4 $4,695.9 $1,781.8 $1,534.2 Actual Gain on Plan Assets832.4 681.1 253.0 321.0 Company Contributions (a)115.6 5.6 4.7 4.1 Participant Contributions— — 38.2 35.5 Benefit Payments(406.8)(367.2)(131.0)(113.0)Fair Value of Plan Assets as of December 31,$5,556.6 $5,015.4 $1,946.7 $1,781.8 Funded (Underfunded) Status as of December 31,$12.1 $(221.4)$735.8 $556.4 (a)Contributions to the qualified pension plan were $110 million and $0 for the years ended December 31, 2020 and 2019, respectively. Contributions to the non-qualified pension plans were $6 million and $6 million for the years ended December 31, 2020 and 2019, respectively.295Pension PlansOPEBDecember 31,AEP2020201920202019(in millions)Deferred Charges and Other Noncurrent Assets – Prepaid Benefit Costs$93.5 $— $771.9 $590.8 Other Current Liabilities – Accrued Short-term Benefit Liability(6.7)(6.1)(2.4)(2.6)Employee Benefits and Pension Obligations – Accrued Long-term Benefit Liability(74.7)(215.3)(33.7)(31.8)Funded (Underfunded) Status$12.1 $(221.4)$735.8 $556.4 AEP TexasPension PlansOPEB2020201920202019Change in Benefit Obligation(in millions)Benefit Obligation as of January 1,$441.2 $409.3 $97.8 $95.9 Service Cost10.0 8.6 0.8 0.8 Interest Cost13.9 17.5 3.2 4.0 Actuarial Loss28.1 40.1 2.4 3.9 Plan Amendments— — (1.0)(0.9)Benefit Payments(40.0)(34.3)(10.0)(8.8)Participant Contributions— — 3.1 2.9 Benefit Obligation as of December 31,$453.2 $441.2 $96.3 $97.8 Change in Fair Value of Plan AssetsFair Value of Plan Assets as of January 1,$435.1 $410.7 $148.1 $129.9 Actual Gain on Plan Assets67.2 58.3 21.1 24.0 Company Contributions11.7 0.4 — 0.1 Participant Contributions— — 3.1 2.9 Benefit Payments(40.0)(34.3)(10.0)(8.8)Fair Value of Plan Assets as of December 31,$474.0 $435.1 $162.3 $148.1 Funded (Underfunded) Status as of December 31,$20.8 $(6.1)$66.0 $50.3 Pension PlansOPEBDecember 31,AEP Texas2020201920202019(in millions)Deferred Charges and Other Noncurrent Assets – Prepaid Benefit Costs$24.7 $— $66.0 $50.3 Other Current Liabilities – Accrued Short-term Benefit Liability(0.4)(0.4)— — Deferred Credits and Other Noncurrent Liabilities – Accrued Long-term Benefit Liability(3.5)(5.7)— — Funded (Underfunded) Status$20.8 $(6.1)$66.0 $50.3 296APCoPension PlansOPEB2020201920202019Change in Benefit Obligation(in millions)Benefit Obligation as of January 1,$647.2 $603.1 $203.5 $205.5 Service Cost10.5 9.4 1.0 1.0 Interest Cost20.3 25.2 6.6 8.7 Actuarial Loss40.0 52.9 5.6 4.7 Plan Amendments— — (1.8)(1.7)Benefit Payments(47.2)(43.4)(23.2)(20.8)Participant Contributions— — 6.3 5.9 Medicare Subsidy— — 0.2 0.2 Benefit Obligation as of December 31,$670.8 $647.2 $198.2 $203.5 Change in Fair Value of Plan AssetsFair Value of Plan Assets as of January 1,$637.0 $593.3 $271.0 $238.4 Actual Gain on Plan Assets104.5 87.1 36.8 45.3 Company Contributions7.0 — 2.1 2.2 Participant Contributions— — 6.3 5.9 Benefit Payments(47.2)(43.4)(23.2)(20.8)Fair Value of Plan Assets as of December 31,$701.3 $637.0 $293.0 $271.0 Funded (Underfunded) Status as of December 31,$30.5 $(10.2)$94.8 $67.5 Pension PlansOPEBDecember 31,APCo2020201920202019(in millions)Employee Benefits and Pension Assets – Prepaid Benefit Costs$31.0 $— $119.1 $92.0 Other Current Liabilities – Accrued Short-term Benefit Liability— — (1.8)(2.0)Employee Benefits and Pension Obligations – Accrued Long-term Benefit Liability(0.5)(10.2)(22.5)(22.5)Funded (Underfunded) Status$30.5 $(10.2)$94.8 $67.5 297I&MPension PlansOPEB2020201920202019Change in Benefit Obligation(in millions)Benefit Obligation as of January 1,$616.1 $567.0 $142.9 $138.3 Service Cost15.4 13.4 1.4 1.4 Interest Cost19.7 23.8 4.7 5.8 Actuarial Loss44.3 49.8 5.1 8.1 Plan Amendments— — (1.6)(1.5)Benefit Payments(42.2)(37.9)(15.9)(13.6)Participant Contributions— — 4.8 4.4 Benefit Obligation as of December 31,$653.3 $616.1 $141.4 $142.9 Change in Fair Value of Plan AssetsFair Value of Plan Assets as of January 1,$630.5 $583.8 $216.3 $187.3 Actual Gain on Plan Assets103.3 84.6 33.0 38.2 Company Contributions6.5 — — — Participant Contributions— — 4.8 4.4 Benefit Payments(42.2)(37.9)(15.9)(13.6)Fair Value of Plan Assets as of December 31,$698.1 $630.5 $238.2 $216.3 Funded Status as of December 31,$44.8 $14.4 $96.8 $73.4 Pension PlansOPEBDecember 31,I&M2020201920202019(in millions)Deferred Charges and Other Noncurrent Assets – Prepaid Benefit Costs$46.5 $15.8 $96.8 $73.4 Deferred Credits and Other Noncurrent Liabilities – Accrued Long-term Benefit Liability(1.7)(1.4)— — Funded Status$44.8 $14.4 $96.8 $73.4 298OPCoPension PlansOPEB2020201920202019Change in Benefit Obligation(in millions)Benefit Obligation as of January 1,$487.8 $453.9 $130.2 $129.5 Service Cost9.7 7.9 0.9 0.8 Interest Cost15.4 19.1 4.2 5.5 Actuarial Loss33.4 40.5 3.1 4.9 Plan Amendments— — (1.3)(1.2)Benefit Payments(36.0)(33.6)(15.0)(13.5)Participant Contributions— — 4.3 4.1 Medicare Subsidy— — — 0.1 Benefit Obligation as of December 31,$510.3 $487.8 $126.4 $130.2 Change in Fair Value of Plan AssetsFair Value of Plan Assets as of January 1,$499.1 $466.1 $197.1 $175.4 Actual Gain on Plan Assets79.9 66.6 26.6 31.1 Company Contributions0.1 — — — Participant Contributions— — 4.3 4.1 Benefit Payments(36.0)(33.6)(15.0)(13.5)Fair Value of Plan Assets as of December 31,$543.1 $499.1 $213.0 $197.1 Funded Status as of December 31,$32.8 $11.3 $86.6 $66.9 Pension PlansOPEBDecember 31,OPCo2020201920202019(in millions)Deferred Charges and Other Noncurrent Assets – Prepaid Benefit Costs$33.3 $11.7 $86.6 $66.9 Deferred Credits and Other Noncurrent Liabilities – Accrued Long-term Benefit Liability(0.5)(0.4)— — Funded Status$32.8 $11.3 $86.6 $66.9 299PSOPension PlansOPEB2020201920202019Change in Benefit Obligation(in millions)Benefit Obligation as of January 1,$267.5 $253.8 $64.7 $62.3 Service Cost7.3 6.5 0.7 0.6 Interest Cost8.5 10.6 2.1 2.6 Actuarial Loss17.7 16.8 1.9 3.8 Plan Amendments— — (0.7)(0.7)Benefit Payments(21.1)(20.2)(6.8)(5.9)Participant Contributions— — 2.1 2.0 Benefit Obligation as of December 31,$279.9 $267.5 $64.0 $64.7 Change in Fair Value of Plan AssetsFair Value of Plan Assets as of January 1,$276.2 $261.2 $98.0 $84.3 Actual Gain on Plan Assets44.6 34.7 14.5 17.6 Company Contributions0.1 0.5 — — Participant Contributions— — 2.1 2.0 Benefit Payments(21.1)(20.2)(6.8)(5.9)Fair Value of Plan Assets as of December 31,$299.8 $276.2 $107.8 $98.0 Funded Status as of December 31,$19.9 $8.7 $43.8 $33.3 Pension PlansOPEBDecember 31,PSO2020201920202019(in millions)Employee Benefits and Pension Assets – Prepaid Benefit Costs$21.9 $10.6 $43.8 $33.3 Other Current Liabilities – Accrued Short-term Benefit Liability(0.1)(0.1)— — Deferred Credits and Other Noncurrent Liabilities – Accrued Long-term Benefit Liability(1.9)(1.8)— — Funded Status$19.9 $8.7 $43.8 $33.3 300SWEPCoPension PlansOPEB2020201920202019Change in Benefit Obligation(in millions)Benefit Obligation as of January 1,$314.2 $291.4 $77.4 $72.7 Service Cost9.9 8.6 0.8 0.8 Interest Cost10.2 12.4 2.5 3.1 Actuarial Loss27.4 25.5 2.5 6.0 Plan Amendments— — (0.8)(0.8)Benefit Payments(27.2)(23.7)(7.7)(6.6)Participant Contributions— — 2.4 2.2 Benefit Obligation as of December 31,$334.5 $314.2 $77.1 $77.4 Change in Fair Value of Plan AssetsFair Value of Plan Assets as of January 1,$296.9 $281.0 $117.2 $98.5 Actual Gain on Plan Assets48.2 39.5 18.0 23.1 Company Contributions9.0 0.1 — — Participant Contributions— — 2.4 2.2 Benefit Payments(27.2)(23.7)(7.7)(6.6)Fair Value of Plan Assets as of December 31,$326.9 $296.9 $129.9 $117.2 Funded (Underfunded) Status as of December 31,$(7.6)$(17.3)$52.8 $39.8 Pension PlansOPEBDecember 31,SWEPCo2020201920202019(in millions)Deferred Charges and Other Noncurrent Assets – Prepaid Benefit Costs$— $— $52.8 $39.8 Other Current Liabilities – Accrued Short-term Benefit Liability(0.1)(0.1)— — Employee Benefits and Pension Obligations – Accrued Long-term Benefit Liability(7.5)(17.2)— — Funded (Underfunded) Status$(7.6)$(17.3)$52.8 $39.8 301Amounts Included in Regulatory Assets, Deferred Income Taxes and AOCIThe following tables show the components of the plans included in Regulatory Assets, Deferred Income Taxes and AOCI and the items attributable to the change in these components:AEPPension PlansOPEBDecember 31,2020201920202019Components(in millions)Net Actuarial Loss$1,179.6 $1,406.2 $101.9 $225.8 Prior Service Cost (Credit)0.2 0.2 (227.3)(285.7)Recorded asRegulatory Assets$1,182.4 $1,351.8 $(99.0)$(46.8)Deferred Income Taxes(0.5)11.5 (5.5)(2.7)Net of Tax AOCI(2.1)43.1 (20.9)(10.4)AEPPension PlansOPEB2020201920202019Components(in millions)Actuarial (Gain) Loss During the Year$(132.9)$108.6 $(118.0)$(171.9)Amortization of Actuarial Loss(93.7)(57.6)(5.9)(22.1)Prior Service (Credit) Cost— 0.2 (11.4)(7.6)Amortization of Prior Service Credit— — 69.8 69.1 Change for the Year Ended December 31,$(226.6)$51.2 $(65.5)$(132.5)AEP TexasPension PlansOPEBDecember 31,2020201920202019Components(in millions)Net Actuarial Loss$160.5 $184.7 $12.3 $23.5 Prior Service Credit— — (19.3)(24.2)Recorded asRegulatory Assets$151.3 $172.2 $(6.3)$(0.2)Deferred Income Taxes2.0 2.7 (0.1)(0.1)Net of Tax AOCI7.2 9.8 (0.6)(0.4)AEP TexasPension PlansOPEB2020201920202019Components(in millions)Actuarial (Gain) Loss During the Year$(16.4)$7.6 $(10.7)$(12.7)Amortization of Actuarial Loss(7.8)(4.9)(0.5)(1.8)Prior Service Credit— — (1.0)(0.6)Amortization of Prior Service Credit— — 5.9 5.9 Change for the Year Ended December 31,$(24.2)$2.7 $(6.3)$(9.2)302APCoPension PlansOPEBDecember 31,2020201920202019Components(in millions)Net Actuarial Loss$126.3 $168.3 $11.1 $28.8 Prior Service Credit— — (33.2)(41.6)Recorded asRegulatory Assets$124.7 $166.3 $(10.3)$(5.5)Deferred Income Taxes0.3 0.3 (2.5)(1.5)Net of Tax AOCI1.3 1.7 (9.3)(5.8)APCoPension PlansOPEB2020201920202019Components(in millions)Actuarial (Gain) Loss During the Year$(30.8)$3.1 $(16.8)$(26.4)Amortization of Actuarial Loss(11.2)(7.0)(0.9)(3.7)Prior Service Credit— — (1.8)(1.3)Amortization of Prior Service Credit— — 10.2 10.1 Change for the Year Ended December 31,$(42.0)$(3.9)$(9.3)$(21.3)I&MPension PlansOPEBDecember 31,2020201920202019Components(in millions)Net Actuarial Loss$39.5 $76.0 $15.6 $32.7 Prior Service Credit— — (31.0)(39.0)Recorded asRegulatory Assets$40.3 $73.7 $(14.6)$(6.2)Deferred Income Taxes(0.1)0.5 (0.2)— Net of Tax AOCI(0.7)1.8 (0.6)(0.1)I&MPension PlansOPEB2020201920202019Components(in millions)Actuarial (Gain) Loss During the Year$(25.7)$2.0 $(16.4)$(19.3)Amortization of Actuarial Loss(10.8)(6.6)(0.7)(2.7)Prior Service Credit— — (1.5)(1.0)Amortization of Prior Service Credit— — 9.5 9.4 Change for the Year Ended December 31,$(36.5)$(4.6)$(9.1)$(13.6)303OPCoPension PlansOPEBDecember 31,2020201920202019Components(in millions)Net Actuarial Loss$150.0 $178.7 $3.6 $17.2 Prior Service Credit— — (22.9)(28.6)Recorded asRegulatory Assets$150.0 $178.7 $(19.3)$(11.4)OPCoPension PlansOPEB2020201920202019Components(in millions)Actuarial (Gain) Loss During the Year$(20.2)$3.3 $(12.9)$(15.8)Amortization of Actuarial Loss(8.5)(5.3)(0.7)(2.5)Prior Service Credit— — (1.3)(0.8)Amortization of Prior Service Credit— — 7.0 6.9 Change for the Year Ended December 31,$(28.7)$(2.0)$(7.9)$(12.2)PSOPension PlansOPEBDecember 31,2020201920202019Components(in millions)Net Actuarial Loss$55.9 $73.0 $10.5 $18.2 Prior Service Credit— — (14.1)(17.8)Recorded asRegulatory Assets$55.9 $73.0 $(3.6)$0.4 PSOPension PlansOPEB2020201920202019Components(in millions)Actuarial Gain During the Year$(12.4)$(1.7)$(7.4)$(8.9)Amortization of Actuarial Loss(4.7)(2.9)(0.3)(1.2)Prior Service Credit— — (0.7)(0.5)Amortization of Prior Service Credit— — 4.4 4.3 Change for the Year Ended December 31,$(17.1)$(4.6)$(4.0)$(6.3)304SWEPCoPension PlansOPEBDecember 31,2020201920202019Components(in millions)Net Actuarial Loss$86.9 $97.8 $11.5 $21.1 Prior Service Credit— — (17.2)(21.6)Recorded asRegulatory Assets$86.9 $97.8 $(3.0)$— Deferred Income Taxes— — (0.5)— Net of Tax AOCI— — (2.2)(0.5)SWEPCoPension PlansOPEB2020201920202019Components(in millions)Actuarial (Gain) Loss During the Year$(5.2)$3.8 $(9.2)$(11.4)Amortization of Actuarial Loss(5.7)(3.4)(0.4)(1.4)Prior Service Credit— — (0.8)(0.6)Amortization of Prior Service Credit— — 5.2 5.2 Change for the Year Ended December 31,$(10.9)$0.4 $(5.2)$(8.2)Determination of Pension ExpenseThe determination of pension expense or income is based on a market-related valuation of assets which reduces year-to-year volatility. This market-related valuation recognizes investment gains or losses over a five-year period from the year in which they occur. Investment gains or losses for this purpose are the difference between the expected return calculated using the market-related value of assets and the actual return.Pension and OPEB AssetsThe fair value tables within Pension and OPEB Assets present the classification of assets for AEP within the fair value hierarchy. All Level 1, 2, 3 and Other amounts can be allocated to the Registrant Subsidiaries using the percentages in the table below:Pension PlanOPEBDecember 31,Company2020201920202019AEP Texas8.5 %8.7 %8.3 %8.3 %APCo12.6 %12.7 %15.1 %15.2 %I&M12.6 %12.6 %12.2 %12.1 %OPCo9.8 %10.0 %10.9 %11.1 %PSO5.4 %5.5 %5.5 %5.5 %SWEPCo5.9 %5.9 %6.7 %6.6 %305The following table presents the classification of pension plan assets for AEP within the fair value hierarchy as of December 31, 2020:Asset ClassLevel 1Level 2Level 3OtherTotalYear EndAllocation(in millions)Equities (a):Domestic$542.3 $— $— $— $542.3 9.7 %International676.3 — — — 676.3 12.2 %Common Collective Trusts (c)— — — 650.0 650.0 11.7 %Subtotal – Equities1,218.6 — — 650.0 1,868.6 33.6 %Fixed Income (a):United States Government and Agency Securities(1.4)1,134.1 — — 1,132.7 20.4 %Corporate Debt— 1,425.0 — — 1,425.0 25.6 %Foreign Debt— 214.0 — — 214.0 3.9 %State and Local Government— 56.0 — — 56.0 1.0 %Other – Asset Backed— 0.8 — — 0.8 — %Subtotal – Fixed Income(1.4)2,829.9 — — 2,828.5 50.9 %Infrastructure (c)— — — 91.1 91.1 1.6 %Real Estate (c)— — — 231.6 231.6 4.2 %Alternative Investments (c)— — — 431.8 431.8 7.8 %Cash and Cash Equivalents (c)— 49.3 — 58.2 107.5 1.9 %Other – Pending Transactions and Accrued Income (b)— — — (2.5)(2.5)— %Total$1,217.2 $2,879.2 $— $1,460.2 $5,556.6 100.0 %(a)Includes investment securities loaned to borrowers under the securities lending program. See the “Investments Held in Trust for Future Liabilities” section of Note 1 for additional information.(b)Amounts in “Other” column primarily represent accrued interest, dividend receivables and transactions pending settlement.(c)Amounts in “Other” column represent investments for which fair value is measured using net asset value per-share.306The following table presents the classification of OPEB plan assets for AEP within the fair value hierarchy as of December 31, 2020:Asset ClassLevel 1Level 2Level 3OtherTotalYear EndAllocation(in millions)Equities:Domestic$399.9 $— $— $— $399.9 20.6 %International290.7 — — — 290.7 14.9 %Common Collective Trusts (b)— — — 264.7 264.7 13.6 %Subtotal – Equities690.6 — — 264.7 955.3 49.1 %Fixed Income:Common Collective Trust – Debt (b)— — — 186.4 186.4 9.6 %United States Government and Agency Securities(0.2)199.7 — — 199.5 10.2 %Corporate Debt— 248.7 — — 248.7 12.8 %Foreign Debt— 34.9 — — 34.9 1.8 %State and Local Government73.9 13.1 — — 87.0 4.5 %Subtotal – Fixed Income73.7 496.4 — 186.4 756.5 38.9 %Trust Owned Life Insurance:International Equities— 64.8 — — 64.8 3.3 %United States Bonds— 135.9 — — 135.9 7.0 %Subtotal – Trust Owned Life Insurance— 200.7 — — 200.7 10.3 %Cash and Cash Equivalents (b)26.3 — — 5.7 32.0 1.6 %Other – Pending Transactions and Accrued Income (a)— — — 2.2 2.2 0.1 %Total$790.6 $697.1 $— $459.0 $1,946.7 100.0 % (a)Amounts in “Other” column primarily represent accrued interest, dividend receivables and transactions pending settlement.(b)Amounts in “Other” column represent investments for which fair value is measured using net asset value per-share.307The following table presents the classification of pension plan assets for AEP within the fair value hierarchy as of December 31, 2019:Asset ClassLevel 1Level 2Level 3OtherTotalYear EndAllocation(in millions)Equities (a):Domestic$387.8 $— $— $— $387.8 7.8 %International609.1 — — — 609.1 12.1 %Common Collective Trusts (c)— — — 547.3 547.3 10.9 %Subtotal – Equities996.9 — — 547.3 1,544.2 30.8 %Fixed Income (a):United States Government and Agency Securities(5.8)1,248.6 — — 1,242.8 24.8 %Corporate Debt— 1,143.7 — — 1,143.7 22.8 %Foreign Debt— 211.6 — — 211.6 4.2 %State and Local Government— 55.1 — — 55.1 1.1 %Other – Asset Backed— 3.6 — — 3.6 0.1 %Subtotal – Fixed Income(5.8)2,662.6 — — 2,656.8 53.0 %Infrastructure (c)— — — 85.8 85.8 1.7 %Real Estate (c)— — — 239.4 239.4 4.8 %Alternative Investments (c)— — — 448.3 448.3 8.9 %Cash and Cash Equivalents (c)— 24.4 — 37.2 61.6 1.2 %Other – Pending Transactions and Accrued Income (b)— — — (20.7)(20.7)(0.4)%Total$991.1 $2,687.0 $— $1,337.3 $5,015.4 100.0 %(a)Includes investment securities loaned to borrowers under the securities lending program. See the “Investments Held in Trust for Future Liabilities” section of Note 1 for additional information.(b)Amounts in “Other” column primarily represent accrued interest, dividend receivables and transactions pending settlement.(c)Amounts in “Other” column represent investments for which fair value is measured using net asset value per-share.308The following table presents the classification of OPEB plan assets for AEP within the fair value hierarchy as of December 31, 2019:Asset ClassLevel 1Level 2Level 3OtherTotalYear EndAllocation(in millions)Equities:Domestic$312.2 $— $— $— $312.2 17.5 %International251.5 — — — 251.5 14.1 %Common Collective Trusts (b)— — — 260.8 260.8 14.7 %Subtotal – Equities563.7 — — 260.8 824.5 46.3 %Fixed Income:Common Collective Trust – Debt (b)— — — 177.6 177.6 10.0 %United States Government and Agency Securities(0.1)214.4 — — 214.3 12.0 %Corporate Debt— 206.7 — — 206.7 11.6 %Foreign Debt— 35.5 — — 35.5 2.0 %State and Local Government58.8 14.8 — — 73.6 4.1 %Other – Asset Backed— 0.2 — — 0.2 — %Subtotal – Fixed Income58.7 471.6 — 177.6 707.9 39.7 %Trust Owned Life Insurance:International Equities— 60.2 — — 60.2 3.4 %United States Bonds— 151.6 — — 151.6 8.5 %Subtotal – Trust Owned Life Insurance— 211.8 — — 211.8 11.9 %Cash and Cash Equivalents (b)26.7 — — 6.7 33.4 1.9 %Other – Pending Transactions and Accrued Income (a)— — — 4.2 4.2 0.2 %Total$649.1 $683.4 $— $449.3 $1,781.8 100.0 %(a)Amounts in “Other” column primarily represent accrued interest, dividend receivables and transactions pending settlement.(b)Amounts in “Other” column represent investments for which fair value is measured using net asset value per-share.Accumulated Benefit ObligationThe accumulated benefit obligation for the pension plans is as follows:Accumulated Benefit ObligationAEPAEP TexasAPCoI&MOPCoPSOSWEPCo(in millions)Qualified Pension Plan$5,171.3 $424.5 $645.8 $615.8 $479.2 $258.3 $307.1 Nonqualified Pension Plans72.9 3.6 0.2 0.8 0.2 1.6 1.4 Total as of December 31, 2020$5,244.2 $428.1 $646.0 $616.6 $479.4 $259.9 $308.5 Accumulated Benefit ObligationAEPAEP TexasAPCoI&MOPCoPSOSWEPCo(in millions)Qualified Pension Plan$4,929.0 $417.5 $627.3 $586.3 $464.2 $248.9 $291.9 Nonqualified Pension Plans69.7 3.6 0.2 0.6 0.1 1.6 1.3 Total as of December 31, 2019$4,998.7 $421.1 $627.5 $586.9 $464.3 $250.5 $293.2 309Obligations in Excess of Fair ValuesThe tables below show the underfunded pension plans that had obligations in excess of plan assets.Projected Benefit ObligationAEPAEP TexasAPCoI&MOPCoPSOSWEPCo(in millions)Projected Benefit Obligation$81.4 $3.9 $0.5 $1.7 $0.6 $2.0 $334.5 Fair Value of Plan Assets— — — — — — 326.9 Underfunded Projected Benefit Obligation as of December 31, 2020$(81.4)$(3.9)$(0.5)$(1.7)$(0.6)$(2.0)$(7.6)AEPAEP TexasAPCoI&MOPCoPSOSWEPCo(in millions)Projected Benefit Obligation$5,236.8 $441.2 $647.2 $1.5 $0.4 $1.9 $314.2 Fair Value of Plan Assets5,015.4 435.1 637.0 — — — 296.9 Underfunded Projected Benefit Obligation as of December 31, 2019$(221.4)$(6.1)$(10.2)$(1.5)$(0.4)$(1.9)$(17.3)Accumulated Benefit ObligationAEPAEP TexasAPCoI&MOPCoPSOSWEPCo(in millions)Accumulated Benefit Obligation$72.9 $3.6 $0.2 $0.8 $0.2 $1.6 $1.4 Fair Value of Plan Assets— — — — — — — Underfunded Accumulated Benefit Obligation as of December 31, 2020$(72.9)$(3.6)$(0.2)$(0.8)$(0.2)$(1.6)$(1.4)AEPAEP TexasAPCoI&MOPCoPSOSWEPCo(in millions)Accumulated Benefit Obligation$69.7 $3.6 $0.2 $0.6 $0.1 $1.6 $1.3 Fair Value of Plan Assets— — — — — — — Underfunded Accumulated Benefit Obligation as of December 31, 2019$(69.7)$(3.6)$(0.2)$(0.6)$(0.1)$(1.6)$(1.3)Estimated Future Benefit Payments and ContributionsThe estimated pension benefit payments and contributions to the trust are at least the minimum amount required by the Employee Retirement Income Security Act plus payment of unfunded non-qualified benefits. For the qualified pension plan, additional discretionary contributions may also be made to maintain the funded status of the plan. For OPEB plans, expected payments include the payment of unfunded benefits. The following table provides the estimated contributions and payments by Registrant for 2021:CompanyPension PlansOPEB(in millions)AEP$132.8 $3.1 AEP Texas5.1 0.1 APCo1.8 1.8 I&M1.3 — PSO0.1 — SWEPCo7.1 — 310The tables below reflect the total benefits expected to be paid from the plan or from the Registrants’ assets. The payments include the participants’ contributions to the plan for their share of the cost. Future benefit payments are dependent on the number of employees retiring, whether the retiring employees elect to receive pension benefits as annuities or as lump sum distributions, future integration of the benefit plans with changes to Medicare and other legislation, future levels of interest rates and variances in actuarial results. The estimated payments for the pension benefits and OPEB are as follows:Pension PlansAEPAEP TexasAPCoI&MOPCoPSOSWEPCo(in millions)2021$385.3 $36.3 $44.7 $40.2 $35.4 $21.8 $25.2 2022382.8 35.9 45.1 42.4 36.0 21.2 25.4 2023384.3 36.1 45.1 41.5 34.2 22.3 25.7 2024384.0 35.9 45.7 42.7 34.0 21.9 25.7 2025377.1 35.2 44.0 42.7 33.3 21.1 25.3 Years 2026 to 2030, in Total1,763.1 154.1 209.7 205.2 155.0 94.8 115.7 OPEB Benefit PaymentsAEPAEP TexasAPCoI&MOPCoPSOSWEPCo(in millions)2021$121.6 $9.5 $21.1 $15.1 $13.7 $6.4 $7.5 2022122.5 9.9 20.8 15.3 13.9 6.7 7.8 2023117.4 9.7 19.8 14.7 13.2 6.6 7.6 2024121.9 10.3 20.5 15.3 13.7 6.9 8.2 2025120.9 10.4 20.0 15.1 13.4 6.9 8.2 Years 2026 to 2030, in Total573.9 48.6 93.3 70.9 61.7 32.1 39.1 OPEB Medicare Subsidy ReceiptsAEPAEP TexasAPCoI&MOPCoPSOSWEPCo(in millions)2021$0.2 $— $0.1 $— $— $— $— 20220.2 — 0.1 — — — — 20230.3 — 0.1 — — — — 20240.3 — 0.1 — — — — 20250.3 — 0.1 — — — — Years 2026 to 2030, in Total1.5 — 0.6 — — — — Components of Net Periodic Benefit CostThe following tables provide the components of net periodic benefit cost (credit) by Registrant for the plans:AEPPension PlansOPEBYears Ended December 31,202020192018202020192018(in millions)Service Cost$111.9 $95.5 $97.6 $10.0 $9.5 $11.6 Interest Cost167.9 204.4 187.8 39.8 50.5 47.4 Expected Return on Plan Assets(264.9)(296.0)(290.3)(95.6)(93.7)(102.2)Amortization of Prior Service Credit— — — (69.8)(69.1)(69.1)Amortization of Net Actuarial Loss93.7 57.6 85.2 5.9 22.1 10.5 Settlements— — 2.6 — — — Net Periodic Benefit Cost (Credit)108.6 61.5 82.9 (109.7)(80.7)(101.8)Capitalized Portion(47.0)(38.6)(41.1)(4.2)(3.8)(4.9)Net Periodic Benefit Cost (Credit) Recognized in Expense$61.6 $22.9 $41.8 $(113.9)$(84.5)$(106.7)311AEP TexasPension PlansOPEBYears Ended December 31,202020192018202020192018(in millions)Service Cost$10.0 $8.6 $9.2 $0.8 $0.8 $0.9 Interest Cost13.9 17.5 16.0 3.2 4.0 3.8 Expected Return on Plan Assets(22.7)(25.8)(25.6)(8.0)(7.8)(8.6)Amortization of Prior Service Credit— — — (5.9)(5.9)(5.9)Amortization of Net Actuarial Loss7.8 4.9 7.2 0.5 1.8 0.8 Net Periodic Benefit Cost (Credit)9.0 5.2 6.8 (9.4)(7.1)(9.0)Capitalized Portion(5.5)(4.5)(4.8)(0.4)(0.4)(0.5)Net Periodic Benefit Cost (Credit) Recognized in Expense$3.5 $0.7 $2.0 $(9.8)$(7.5)$(9.5)APCoPension PlansOPEBYears Ended December 31,202020192018202020192018(in millions)Service Cost$10.5 $9.4 $9.3 $1.0 $1.0 $1.1 Interest Cost20.3 25.2 23.5 6.6 8.7 8.2 Expected Return on Plan Assets(33.6)(37.4)(36.6)(14.4)(14.6)(16.0)Amortization of Prior Service Credit— — — (10.2)(10.1)(10.0)Amortization of Net Actuarial Loss11.2 7.0 10.6 0.9 3.7 1.9 Net Periodic Benefit Cost (Credit)8.4 4.2 6.8 (16.1)(11.3)(14.8)Capitalized Portion(4.5)(4.0)(3.8)(0.4)(0.4)(0.5)Net Periodic Benefit Cost (Credit) Recognized in Expense$3.9 $0.2 $3.0 $(16.5)$(11.7)$(15.3)I&MPension PlansOPEBYears Ended December 31,202020192018202020192018(in millions)Service Cost$15.4 $13.4 $13.6 $1.4 $1.4 $1.6 Interest Cost19.7 23.8 22.1 4.7 5.8 5.4 Expected Return on Plan Assets(33.3)(36.8)(35.7)(11.7)(11.4)(12.3)Amortization of Prior Service Credit— — — (9.5)(9.4)(9.5)Amortization of Net Actuarial Loss10.8 6.6 9.8 0.7 2.7 1.2 Net Periodic Benefit Cost (Credit)12.6 7.0 9.8 (14.4)(10.9)(13.6)Capitalized Portion(4.3)(3.4)(5.6)(0.4)(0.4)(0.7)Net Periodic Benefit Cost (Credit) Recognized in Expense$8.3 $3.6 $4.2 $(14.8)$(11.3)$(14.3)312OPCoPension PlansOPEBYears Ended December 31,202020192018202020192018(in millions)Service Cost$9.7 $7.9 $7.7 $0.9 $0.8 $0.9 Interest Cost15.4 19.1 17.7 4.2 5.5 5.1 Expected Return on Plan Assets(26.3)(29.3)(28.8)(10.5)(10.8)(11.7)Amortization of Prior Service Credit— — — (7.0)(6.9)(6.9)Amortization of Net Actuarial Loss8.5 5.3 8.0 0.7 2.5 1.1 Net Periodic Benefit Cost (Credit)7.3 3.0 4.6 (11.7)(8.9)(11.5)Capitalized Portion(5.0)(3.7)(3.6)(0.5)(0.4)(0.4)Net Periodic Benefit Cost (Credit) Recognized in Expense$2.3 $(0.7)$1.0 $(12.2)$(9.3)$(11.9)PSOPension PlansOPEBYears Ended December 31,202020192018202020192018(in millions)Service Cost$7.3 $6.5 $7.0 $0.7 $0.6 $0.7 Interest Cost8.5 10.6 9.9 2.1 2.6 2.5 Expected Return on Plan Assets(14.5)(16.3)(16.1)(5.2)(5.1)(5.6)Amortization of Prior Service Credit— — — (4.4)(4.3)(4.3)Amortization of Net Actuarial Loss4.7 2.9 4.4 0.3 1.2 0.5 Net Periodic Benefit Cost (Credit)6.0 3.7 5.2 (6.5)(5.0)(6.2)Capitalized Portion(2.8)(2.4)(2.6)(0.3)(0.2)(0.3)Net Periodic Benefit Cost (Credit) Recognized in Expense$3.2 $1.3 $2.6 $(6.8)$(5.2)$(6.5)SWEPCoPension PlansOPEBYears Ended December 31,202020192018202020192018(in millions)Service Cost$9.9 $8.6 $9.3 $0.8 $0.8 $0.9 Interest Cost10.2 12.4 11.3 2.5 3.1 2.8 Expected Return on Plan Assets(15.7)(17.7)(17.3)(6.3)(5.9)(6.4)Amortization of Prior Service Credit— — — (5.2)(5.2)(5.2)Amortization of Net Actuarial Loss5.7 3.4 5.1 0.4 1.4 0.6 Settlements— — 0.4 — — — Net Periodic Benefit Cost (Credit)10.1 6.7 8.8 (7.8)(5.8)(7.3)Capitalized Portion(3.4)(2.9)(3.1)(0.3)(0.3)(0.3)Net Periodic Benefit Cost (Credit) Recognized in Expense$6.7 $3.8 $5.7 $(8.1)$(6.1)$(7.6)American Electric Power System Retirement Savings PlanAEP sponsors the American Electric Power System Retirement Savings Plan, a defined contribution retirement savings plan for substantially all employees who are not covered by a retirement savings plan of the UMWA. This qualified plan offers participants an opportunity to contribute a portion of their pay, includes features under Section 401(k) of the Internal Revenue Code and provides for company matching contributions. The matching contributions to the plan are 100% of the first 1% of eligible employee contributions and 70% of the next 5% of contributions.313The following table provides the cost for matching contributions to the retirement savings plans by Registrant:Year Ended December 31,Company202020192018(in millions)AEP$81.8 $76.4 $71.8 AEP Texas6.4 5.9 5.7 APCo7.7 7.5 7.5 I&M11.3 11.0 10.5 OPCo7.3 6.6 6.3 PSO4.9 4.6 4.5 SWEPCo6.7 6.2 5.9 UMWA BenefitsHealth and Welfare Benefits (Applies to AEP and APCo)AEP provides health and welfare benefits negotiated with the UMWA for certain unionized employees, retirees and their survivors who meet eligibility requirements. APCo also provides the same UMWA health and welfare benefits for certain unionized mining retirees and their survivors who meet eligibility requirements. AEP and APCo administer the health and welfare benefits and pay them from their general assets.Multiemployer Pension Benefits (Applies to AEP)UMWA pension benefits are provided through the United Mine Workers of America 1974 Pension Plan (Employer Identification Number: 52-1050282, Plan Number 002), a multiemployer plan. The UMWA pension benefits are administered by a board of trustees appointed in equal numbers by the UMWA and the Bituminous Coal Operators’ Association (BCOA), an industry bargaining association. AEP makes contributions to the United Mine Workers of America 1974 Pension Plan based on provisions in its labor agreement and the plan documents. The UMWA pension plan is different from single-employer plans as an employer’s contributions may be used to provide benefits to employees of other participating employers. A withdrawing employer may be subject to a withdrawal liability, which is calculated based upon that employer’s share of the plan’s unfunded benefit obligations. If an employer fails to make required contributions or if its payments in connection with its withdrawal liability fall short of satisfying its share of the plan’s unfunded benefit obligations, the remaining employers may be allocated a greater share of the remaining unfunded plan obligations. Under the Pension Protection Act of 2006 (PPA), the UMWA pension plan was in Critical and Declining Status for the plan years ending June 30, 2020 and 2019, without utilization of extended amortization provisions. As required under the PPA, the Plan adopted a Rehabilitation Plan in 2015. The Rehabilitation Plan has been updated annually, most recently in April 2020.The amounts contributed by AEP affiliates in 2020, 2019 and 2018 were immaterial and represent less than 5% of the total contributions in the plan’s latest annual report based on the plan year ended June 30, 2019. The contributions in 2020, 2019 and 2018 did not include surcharges.Under the terms of the UMWA pension plan, contributions will be required to continue beyond the December 31, 2020 expiration of the current collective bargaining agreement between the Cook Coal Terminal (CCT) facility and the UMWA, whether or not the term of that agreement is extended or a subsequent agreement is entered, so long as both the UMWA pension plan remains in effect and an AEP affiliate continues to operate the facility covered by the current collective bargaining agreement. The contribution rate applicable would be determined in accordance with the terms of the UMWA pension plan by reference to the National Bituminous Coal Wage Agreement, subject to periodic revisions, between the UMWA and the BCOA. If the UMWA pension plan would terminate or an AEP affiliate would cease operation of the facility without arranging for a successor operator to assume its liability, the withdrawal liability obligation would be triggered.314Based upon the planned closure of CCT in 2022, AEP records a UMWA pension withdrawal liability on the balance sheet. The UMWA pension withdrawal liability is re-measured annually and is the estimated value of the company’s anticipated contributions toward its proportionate share of the plan’s unfunded vested liabilities. As of December 31, 2020 and 2019, the liability balance was $25 million and $20 million, respectively. AEP recovers the estimated value of its UMWA pension withdrawal liability through fuel clauses in certain regulated jurisdictions. AEP records a regulatory asset on the balance sheets when the UMWA pension withdrawal liability exceeds the cumulative billings collected and a regulatory liability on the balance sheets when the cumulative billings collected exceed the withdrawal liability. As of December 31, 2020 and 2019, AEP recorded a regulatory asset on the balance sheets for $6 million and $2 million, respectively. If any portion of the UMWA pension withdrawal liability is not recoverable, it could reduce future net income and cash flows and impact financial condition.3159. BUSINESS SEGMENTS The disclosures in this note apply to all Registrants unless indicated otherwise.AEP’s Reportable SegmentsAEP’s primary business is the generation, transmission and distribution of electricity. Within its Vertically Integrated Utilities segment, AEP centrally dispatches generation assets and manages its overall utility operations on an integrated basis because of the substantial impact of cost-based rates and regulatory oversight. Intersegment sales and transfers are generally based on underlying contractual arrangements and agreements.AEP’s reportable segments and their related business activities are outlined below:Vertically Integrated Utilities•Generation, transmission and distribution of electricity for sale to retail and wholesale customers through assets owned and operated by AEGCo, APCo, I&M, KGPCo, KPCo, PSO, SWEPCo and WPCo.Transmission and Distribution Utilities•Transmission and distribution of electricity for sale to retail and wholesale customers through assets owned and operated by AEP Texas and OPCo. •OPCo purchases energy and capacity to serve standard service offer customers and provides transmission and distribution services for all connected load.AEP Transmission Holdco•Development, construction and operation of transmission facilities through investments in AEPTCo. These investments have FERC-approved returns on equity. •Development, construction and operation of transmission facilities through investments in AEP’s transmission-only joint ventures. These investments have PUCT-approved or FERC-approved returns on equity.Generation & Marketing•Contracted renewable energy investments and management services.•Marketing, risk management and retail activities in ERCOT, MISO, PJM and SPP.•Competitive generation in PJM.The remainder of AEP’s activities are presented as Corporate and Other. While not considered a reportable segment, Corporate and Other primarily includes the purchasing of receivables from certain AEP utility subsidiaries, Parent’s guarantee revenue received from affiliates, investment income, interest income and interest expense, income tax expense and other nonallocated costs. 316The tables below present AEP’s reportable segment income statement information for the years ended December 31, 2020, 2019 and 2018 and reportable segment balance sheet information as of December 31, 2020 and 2019. Vertically Integrated UtilitiesTransmission and Distribution UtilitiesAEP Transmission HoldcoGeneration & MarketingCorporate and Other (a)Reconciling AdjustmentsConsolidated(in millions)2020Revenues from:External Customers$8,753.2 $4,238.7 $297.4 $1,621.0 $8.2 $— $14,918.5 Other Operating Segments126.2 107.2 901.4 104.6 88.6 (1,328.0)— Total Revenues$8,879.4 $4,345.9 $1,198.8 $1,725.6 $96.8 $(1,328.0)$14,918.5 Depreciation and Amortization$1,600.5 $751.1 $257.6 $72.8 $0.8 $— $2,682.8 Interest Expense565.0 289.2 133.2 24.0 196.4 (42.1)1,165.7 Income Tax Expense (Benefit)(7.0)29.7 130.8 (108.0)(5.0)— 40.5 Equity Earnings of Unconsolidated Subsidiaries2.9 — 82.4 3.2 2.6 — 91.1 Net Income (Loss)$1,064.5 $496.4 $508.5 $216.9 $(89.6)$— $2,196.7 Gross Property Additions$2,291.2 $2,108.1 $1,649.3 $197.0 $16.0 $(15.3)$6,246.3 Total Property, Plant and Equipment$49,023.3 $21,145.0 $11,827.2 $1,910.2 $407.3 $— $84,313.0 Accumulated Depreciation and Amortization15,586.2 3,879.3 595.7 166.1 184.1 — 20,411.4 Total Property, Plant and Equipment – Net$33,437.1 $17,265.7 $11,231.5 $1,744.1 $223.2 $— $63,901.6 Total Assets$42,752.7 $19,765.9 $12,627.3 $3,585.9 $5,987.1 (b)$(3,961.7)(c)$80,757.2 Investments in Equity Method Investees$37.1 $2.1 $831.3 $467.0 $68.8 $— $1,406.3 Long-term Debt Due Within One Year:Nonaffiliated$1,034.6 $588.8 $52.3 $— $410.4 (d)$— $2,086.1 Long-term Debt:Affiliated65.0 — — — — (65.0)— Nonaffiliated12,375.6 6,661.9 4,075.7 — 5,873.2 (d)— 28,986.4 Total Long-term Debt$13,475.2 $7,250.7 $4,128.0 $— $6,283.6 $(65.0)$31,072.5 317Vertically Integrated UtilitiesTransmission and Distribution UtilitiesAEP Transmission HoldcoGeneration & MarketingCorporate and Other (a)Reconciling AdjustmentsConsolidated(in millions)2019Revenues from:External Customers$9,245.7 $4,319.0 $260.2 $1,721.8 $14.7 $— $15,561.4 Other Operating Segments121.4 163.5 813.0 135.8 81.1 (1,314.8)— Total Revenues$9,367.1 $4,482.5 $1,073.2 $1,857.6 $95.8 $(1,314.8)$15,561.4 Asset Impairments and Other Related Charges$92.9 $32.5 $— $31.0 $— $— $156.4 Depreciation and Amortization1,447.0 789.5 183.4 69.5 0.6 24.5 (e)2,514.5 Interest Expense568.3 243.3 103.3 30.0 193.7 (66.1)(e)1,072.5 Income Tax Expense (Benefit)(97.7)(25.2)136.2 (53.8)27.6 — (12.9)Equity Earnings (Loss) of Unconsolidated Subsidiaries3.0 — 72.8 (3.8)0.1 — 72.1 Net Income (Loss)$985.6 $451.0 $520.1 $104.1 $(141.0)$— $1,919.8 Gross Property Additions$2,437.4 $2,074.3 $1,458.9 $1,005.1 $14.5 $(20.4)$6,969.8 Total Property, Plant and Equipment$47,323.7 $19,773.3 $10,334.0 $1,650.8 $418.4 $(354.5)(e)$79,145.7 Accumulated Depreciation and Amortization14,580.4 3,911.2 418.9 99.0 184.5 (186.4)(e)19,007.6 Total Property, Plant and Equipment – Net$32,743.3 $15,862.1 $9,915.1 $1,551.8 $233.9 $(168.1)(e)$60,138.1 Total Assets$41,228.8 $18,757.5 $11,143.5 $3,123.8 $5,440.0 (b)$(3,801.3)(c)(e)$75,892.3 Investments in Equity Method Investees$41.7 $2.5 $787.5 $459.5 $65.4 $— $1,356.6 Long-term Debt Due Within One Year:Affiliated$20.0 $— $— $— $— $(20.0)— Nonaffiliated704.7 392.2 — — 501.8 (d)— 1,598.7 Long-term Debt:Affiliated39.0 — — — — (39.0)— Nonaffiliated12,162.0 6,248.1 3,593.8 — 3,122.9 — 25,126.8 Total Long-term Debt$12,925.7 $6,640.3 $3,593.8 $— $3,624.7 (d)$(59.0)$26,725.5 318Vertically Integrated UtilitiesTransmission and Distribution UtilitiesAEP Transmission HoldcoGeneration & MarketingCorporate and Other(a)Reconciling AdjustmentsConsolidated(in millions)2018Revenues from:External Customers$9,556.7 $4,552.3 $248.6 $1,818.1 $20.0 $— $16,195.7 Other Operating Segments88.8 100.8 555.5 122.2 75.1 (942.4)— Total Revenues$9,645.5 $4,653.1 $804.1 $1,940.3 $95.1 $(942.4)$16,195.7 Asset Impairments and Other Related Charges$3.4 $— $— $47.7 $19.5 $— $70.6 Depreciation and Amortization1,316.2 734.1 137.8 41.0 0.4 57.1 (e)2,286.6 Interest Expense567.8 248.1 90.7 14.9 122.6 (59.7)(e)984.4 Income Tax Expense5.7 42.4 95.3 (49.2)21.1 — 115.3 Equity Earnings of Unconsolidated Subsidiaries2.7 — 68.7 0.5 1.2 — 73.1 Net Income (Loss)$995.5 $527.4 $373.0 $134.7 $(99.3)$— $1,931.3 Gross Property Additions$2,282.2 $2,162.4 $1,614.1 $289.7 $16.3 $(39.2)$6,325.5 Total Assets$38,874.3 $17,083.4 $9,543.7 $1,979.7 $4,036.5 (b)$(2,714.8)(c)(e)$68,802.8 (a)Corporate and Other primarily includes the purchasing of receivables from certain AEP utility subsidiaries. This segment also includes Parent’s guarantee revenue received from affiliates, investment income, interest income, interest expense and other nonallocated costs.(b)Includes elimination of AEP Parent’s investments in wholly-owned subsidiary companies. (c)Reconciling Adjustments for Total Assets primarily include elimination of intercompany advances to affiliates and intercompany accounts receivable.(d)Amounts reflect the impact of fair value hedge accounting. See “Accounting for Fair Value Hedging Strategies” section of Note 10 for additional information.(e)Includes eliminations due to an intercompany finance lease.Registrant Subsidiaries’ Reportable Segments (Applies to all Registrant Subsidiaries except AEPTCo)The Registrant Subsidiaries each have one reportable segment, an integrated electricity generation, transmission and distribution business for APCo, I&M, PSO and SWEPCo, and an integrated electricity transmission and distribution business for AEP Texas and OPCo. Other activities are insignificant. The Registrant Subsidiaries’ operations are managed on an integrated basis because of the substantial impact of cost-based rates and regulatory oversight on the business process, cost structures and operating results.319AEPTCo’s Reportable SegmentsAEPTCo Parent is the holding company of seven FERC-regulated transmission-only electric utilities. The seven State Transcos have been identified as operating segments of AEPTCo under the accounting guidance for “Segment Reporting.” The State Transcos business consists of developing, constructing and operating transmission facilities at the request of the RTOs in which they operate and in replacing and upgrading facilities, assets and components of the existing AEP transmission system as needed to maintain reliability standards and provide service to AEP’s wholesale and retail customers. The State Transcos are regulated for rate-making purposes exclusively by the FERC and earn revenues through tariff rates charged for the use of their electric transmission systems.AEPTCo’s Chief Operating Decision Maker makes operating decisions, allocates resources to and assesses performance-based on these operating segments. The seven State Transcos operating segments all have similar economic characteristics and meet all of the criteria under the accounting guidance for “Segment Reporting” to be aggregated into one operating segment. As a result, AEPTCo has one reportable segment. The remainder of AEPTCo’s activity is presented in AEPTCo Parent. While not considered a reportable segment, AEPTCo Parent represents the activity of the holding company which primarily relates to debt financing activity and general corporate activities.The tables below present AEPTCo’s reportable segment income statement information for the years ended December 31, 2020, 2019 and 2018 and reportable segment balance sheet information as of December 31, 2020 and 2019. State TranscosAEPTCo ParentReconciling AdjustmentsAEPTCoConsolidated2020(in millions)Revenues from:External Customers$248.8 $— $— $248.8 Sales to AEP Affiliates896.3 — — 896.3 Other Revenues0.6 — — 0.6 Total Revenues$1,145.7 $— $— $1,145.7 Depreciation and Amortization $249.0 $— $— $249.0 Interest Income0.9 149.6 (148.1)(a)2.4 Allowance for Equity Funds Used During Construction 74.0 — — 74.0 Interest Expense 127.8 148.1 (148.1)(a)127.8 Income Tax Expense 106.5 0.2 — 106.7 Net Income $422.3 $1.1 (b)$— $423.4 Gross Property Additions$1,621.9 $— $— $1,621.9 Total Transmission Property$11,345.6 $— $— $11,345.6 Accumulated Depreciation and Amortization 572.8 — — 572.8 Total Transmission Property - Net$10,772.8 $— $— $10,772.8 Notes Receivable - Affiliated$— $3,948.5 $(3,948.5)(c)$— Total Assets$11,185.1 $4,084.0 (d)$(4,023.1)(e)$11,246.0 Total Long-Term Debt$3,990.0 $3,948.5 $(3,990.0)(c)$3,948.5 320State Transcos AEPTCo ParentReconciling AdjustmentsAEPTCoConsolidated2019(in millions)Revenues from:External Customers$214.6 $— $— $214.6 Sales to AEP Affiliates806.7 — — 806.7 Other Revenues0.1 — — 0.1 Total Revenues$1,021.4 $— $— $1,021.4 Depreciation and Amortization $176.0 $— $— $176.0 Interest Income1.3 123.8 (122.1)(a)3.0 Allowance for Equity Funds Used During Construction 84.3 — — 84.3 Interest Expense 97.4 122.1 (122.1)(a)97.4 Income Tax Expense 117.1 0.3 — 117.4 Net Income $438.6 $1.1 (b)$— $439.7 Gross Property Additions$1,419.5 $— $— $1,419.5 Total Transmission Property$9,893.2 $— $— $9,893.2 Accumulated Depreciation and Amortization 402.3 — — 402.3 Total Transmission Property - Net$9,490.9 $— $— $9,490.9 Notes Receivable - Affiliated$— $3,427.3 $(3,427.3)(c)$— Total Assets$9,865.0 $3,519.1 (d)$(3,493.3)(e)$9,890.8 Total Long-Term Debt$3,465.0 $3,427.3 $(3,465.0)(c)$3,427.3 State TranscosAEPTCo ParentReconciling AdjustmentsAEPTCoConsolidated2018(in millions)Revenues from:External Customers$177.0 $— $— $177.0 Sales to AEP Affiliates598.9 — — 598.9 Other0.2 — — 0.2 Total Revenues$776.1 $— $— $776.1 Depreciation and Amortization $133.9 $— $— $133.9 Interest Income1.3 104.6 (103.4)(a)2.5 Allowance for Equity Funds Used During Construction 70.6 — — 70.6 Interest Expense83.2 103.4 (103.4)(a)83.2 Income Tax Expense 83.9 0.2 — 84.1 Net Income$314.9 $1.0 (b)$— $315.9 Gross Property Additions$1,570.8 $— $— $1,570.8 Total Assets$8,406.8 $2,857.1 (d)$(2,869.8)(e)$8,394.1 (a) Elimination of intercompany interest income/interest expense on affiliated debt arrangement.(b) Includes elimination of AEPTCo Parent’s equity earnings in the State Transcos. (c) Elimination of intercompany debt.(d) Includes elimination of AEPTCo Parent’s investments in the State Transcos. (e) Primarily relates to elimination of Notes Receivable from the State Transcos.32110. DERIVATIVES AND HEDGINGThe disclosures in this note apply to all Registrants unless indicated otherwise. For the periods presented, AEPTCo did not have any derivative and hedging activity.OBJECTIVES FOR UTILIZATION OF DERIVATIVE INSTRUMENTSAEPSC is agent for and transacts on behalf of AEP subsidiaries, including the Registrant Subsidiaries. AEPEP is agent for and transacts on behalf of other AEP subsidiaries.The Registrants are exposed to certain market risks as major power producers and participants in the electricity, capacity, natural gas, coal and emission allowance markets. These risks include commodity price risks which may be subject to capacity risk, interest rate risk and credit risk. These risks represent the risk of loss that may impact the Registrants due to changes in the underlying market prices or rates. Management utilizes derivative instruments to manage these risks.STRATEGIES FOR UTILIZATION OF DERIVATIVE INSTRUMENTS TO ACHIEVE OBJECTIVESRisk Management StrategiesThe strategy surrounding the use of derivative instruments primarily focuses on managing risk exposures, future cash flows and creating value utilizing both economic and formal hedging strategies. The risk management strategies also include the use of derivative instruments for trading purposes which focus on seizing market opportunities to create value driven by expected changes in the market prices of the commodities. To accomplish these objectives, the Registrants primarily employ risk management contracts including physical and financial forward purchase-and-sale contracts and, to a lesser extent, OTC swaps and options. Not all risk management contracts meet the definition of a derivative under the accounting guidance for “Derivatives and Hedging.” Derivative risk management contracts elected normal under the normal purchases and normal sales scope exception are not subject to the requirements of this accounting guidance.The Registrants utilize power, capacity, coal, natural gas, interest rate and, to a lesser extent, heating oil, gasoline and other commodity contracts to manage the risk associated with the energy business. The Registrants utilize interest rate derivative contracts in order to manage the interest rate exposure associated with the commodity portfolio. For disclosure purposes, such risks are grouped as “Commodity,” as these risks are related to energy risk management activities. The Registrants also utilize derivative contracts to manage interest rate risk associated with debt financing. For disclosure purposes, these risks are grouped as “Interest Rate.” The amount of risk taken is determined by the Commercial Operations, Energy Supply and Finance groups in accordance with established risk management policies as approved by the Finance Committee of the Board of Directors.322The following tables represent the gross notional volume of the Registrants’ outstanding derivative contracts:December 31, 2020Primary RiskExposureUnit ofMeasureAEPAEP TexasAPCoI&MOPCoPSOSWEPCo(in millions)Commodity:PowerMWhs331.3 — 46.9 19.7 3.0 11.9 4.0 Natural GasMMBtus26.9 — — — — — 7.9 Heating Oil and GasolineGallons6.9 1.8 1.1 0.6 1.4 0.7 0.9 Interest RateUSD$129.8 $— $— $— $— $— $— Interest Rate on Long-term DebtUSD$1,150.0 $— $200.0 $— $— $— $— December 31, 2019Primary RiskExposureUnit ofMeasureAEPAEP TexasAPCoI&MOPCoPSOSWEPCo(in millions)Commodity:PowerMWhs365.9 — 61.0 26.8 7.1 14.9 4.4 Natural GasMMBtus40.7 — — — — — 11.6 Heating Oil and GasolineGallons6.9 1.8 1.1 0.6 1.4 0.7 0.9 Interest RateUSD$140.1 $— $— $— $— $— $— Interest Rate on Long-term DebtUSD$625.0 $— $— $— $— $— $— Fair Value Hedging Strategies (Applies to AEP)Parent enters into interest rate derivative transactions as part of an overall strategy to manage the mix of fixed-rate and floating-rate debt. Certain interest rate derivative transactions effectively modify exposure to interest rate risk by converting a portion of fixed-rate debt to a floating-rate. Provided specific criteria are met, these interest rate derivatives may be designated as fair value hedges.Cash Flow Hedging StrategiesThe Registrants utilize cash flow hedges on certain derivative transactions for the purchase-and-sale of power (“Commodity”) in order to manage the variable price risk related to forecasted purchases and sales. Management monitors the potential impacts of commodity price changes and, where appropriate, enters into derivative transactions to protect profit margins for a portion of future electricity sales and purchases. The Registrants do not hedge all commodity price risk.The Registrants utilize a variety of interest rate derivative transactions in order to manage interest rate risk exposure. The Registrants also utilize interest rate derivative contracts to manage interest rate exposure related to future borrowings of fixed-rate debt. The Registrants do not hedge all interest rate exposure.323ACCOUNTING FOR DERIVATIVE INSTRUMENTS AND THE IMPACT ON THE FINANCIAL STATEMENTSThe accounting guidance for “Derivatives and Hedging” requires recognition of all qualifying derivative instruments as either assets or liabilities on the balance sheets at fair value. The fair values of derivative instruments accounted for using MTM accounting or hedge accounting are based on exchange prices and broker quotes. If a quoted market price is not available, the estimate of fair value is based on the best information available including valuation models that estimate future energy prices based on existing market and broker quotes and other assumptions. In order to determine the relevant fair values of the derivative instruments, the Registrants apply valuation adjustments for discounting, liquidity and credit quality.Credit risk is the risk that a counterparty will fail to perform on the contract or fail to pay amounts due. Liquidity risk represents the risk that imperfections in the market will cause the price to vary from estimated fair value based upon prevailing market supply and demand conditions. Since energy markets are imperfect and volatile, there are inherent risks related to the underlying assumptions in models used to fair value risk management contracts. Unforeseen events may cause reasonable price curves to differ from actual price curves throughout a contract’s term and at the time a contract settles. Consequently, there could be significant adverse or favorable effects on future net income and cash flows if market prices are not consistent with management’s estimates of current market consensus for forward prices in the current period. This is particularly true for longer term contracts. Cash flows may vary based on market conditions, margin requirements and the timing of settlement of risk management contracts.According to the accounting guidance for “Derivatives and Hedging,” the Registrants reflect the fair values of derivative instruments subject to netting agreements with the same counterparty net of related cash collateral. For certain risk management contracts, the Registrants are required to post or receive cash collateral based on third-party contractual agreements and risk profiles. AEP netted cash collateral received from third-parties against short-term and long-term risk management assets in the amounts of $3 million and $5 million as of December 31, 2020 and 2019, respectively. AEP netted cash collateral paid to third-parties against short-term and long-term risk management liabilities in the amounts of $7 million and $39 million as of December 31, 2020 and 2019, respectively. The netted cash collateral from third-parties against short-term and long-term risk management assets and netted cash collateral paid to third-parties against short-term and long-term risk management liabilities were immaterial for the Registrant Subsidiaries as of December 31, 2020 and 2019.324The following tables represent the gross fair value of the Registrants’ derivative activity on the balance sheets:AEPDecember 31, 2020RiskManagementContractsHedging ContractsGross Amountsof RiskManagementAssets/LiabilitiesRecognizedGrossAmountsOffset in theStatement ofFinancialPosition (b)Net Amounts ofAssets/LiabilitiesPresented in theStatement ofFinancialPosition (c)Balance Sheet LocationCommodity (a)Commodity (a)Interest Rate (a)(in millions)Current Risk Management Assets$239.1 $21.1 $5.0 $265.2 $(170.5)$94.7 Long-term Risk Management Assets275.9 18.0 — 293.9 (51.7)242.2 Total Assets515.0 39.1 5.0 559.1 (222.2)336.9 Current Risk Management Liabilities193.0 54.4 3.4 250.8 (172.0)78.8 Long-term Risk Management Liabilities222.2 60.1 4.1 286.4 (53.6)232.8 Total Liabilities415.2 114.5 7.5 537.2 (225.6)311.6 Total MTM Derivative Contract Net Assets (Liabilities)$99.8 $(75.4)$(2.5)$21.9 $3.4 $25.3 December 31, 2019RiskManagementContractsHedging ContractsGross Amountsof RiskManagementAssets/LiabilitiesRecognizedGrossAmountsOffset in theStatement ofFinancialPosition (b)Net Amounts ofAssets/LiabilitiesPresented in theStatement ofFinancialPosition (c)Balance Sheet LocationCommodity (a)Commodity (a)Interest Rate (a)(in millions)Current Risk Management Assets$513.9 $11.5 $6.5 $531.9 $(359.1)$172.8 Long-term Risk Management Assets290.8 11.0 12.6 314.4 (47.8)266.6 Total Assets804.7 22.5 19.1 846.3 (406.9)439.4 Current Risk Management Liabilities424.5 72.3 — 496.8 (382.5)114.3 Long-term Risk Management Liabilities244.5 75.7 — 320.2 (58.4)261.8 Total Liabilities669.0 148.0 — 817.0 (440.9)376.1 Total MTM Derivative Contract Net Assets (Liabilities)$135.7 $(125.5)$19.1 $29.3 $34.0 $63.3 325AEP TexasDecember 31, 2020Risk ManagementGross Amounts OffsetNet Amounts of Assets/LiabilitiesContracts -in the Statement ofPresented in the StatementBalance Sheet LocationCommodity (a)Financial Position (b)of Financial Position (c)(in millions)Current Risk Management Assets$0.4 $(0.4)$— Long-term Risk Management Assets— — — Total Assets0.4 (0.4)— Current Risk Management Liabilities— — — Long-term Risk Management Liabilities— — — Total Liabilities— — — Total MTM Derivative Net Assets (Liabilities)$0.4 $(0.4)$— December 31, 2019Risk ManagementGross Amounts OffsetNet Amounts of Assets/LiabilitiesContracts -in the Statement ofPresented in the StatementBalance Sheet LocationCommodity (a)Financial Position (b)of Financial Position (c)(in millions)Current Risk Management Assets$— $— $— Long-term Risk Management Assets— — — Total Assets— — — Current Risk Management Liabilities— — — Long-term Risk Management Liabilities— — — Total Liabilities— — — Total MTM Derivative Contract Net Assets$— $— $— 326APCoDecember 31, 2020Risk Gross Amounts of RiskGross AmountsNet Amounts of Assets/ManagementHedgingManagementOffset in theLiabilities Presented inContracts -Contracts -Assets/LiabilitiesStatement ofthe Statement ofBalance Sheet LocationCommodity (a)Interest Rate (a) RecognizedFinancial Position (b)Financial Position (c)(in millions)Current Risk Management Assets$38.8 $2.4 $41.2 $(18.8)$22.4 Deferred Charges and Other Noncurrent Assets - Long-term Risk Management Assets0.7 — 0.7 (0.6)0.1 Total Assets39.5 2.4 41.9 (19.4)22.5 Current Risk Management Liabilities19.7 3.4 23.1 (18.5)4.6 Deferred Credits and Other Noncurrent Liabilities - Long-term Risk Management Liabilities0.6 — 0.6 (0.5)0.1 Total Liabilities20.3 3.4 23.7 (19.0)4.7 Total MTM Derivative Contract Net Assets (Liabilities)$19.2 $(1.0)$18.2 $(0.4)$17.8 December 31, 2019Risk ManagementGross Amounts OffsetNet Amounts of Assets/LiabilitiesContracts -in the Statement ofPresented in the StatementBalance Sheet LocationCommodity (a)Financial Position (b)of Financial Position (c)(in millions)Current Risk Management Assets$124.4 $(85.0)$39.4 Deferred Charges and Other Noncurrent Assets - Long-term Risk Management Assets0.9 (0.8)0.1 Total Assets125.3 (85.8)39.5 Current Risk Management Liabilities86.2 (84.3)1.9 Deferred Credits and Other Noncurrent Liabilities - Long-term Risk Management Liabilities0.7 (0.7)— Total Liabilities86.9 (85.0)1.9 Total MTM Derivative Contract Net Assets (Liabilities)$38.4 $(0.8)$37.6 327I&MDecember 31, 2020Risk ManagementGross Amounts OffsetNet Amounts of Assets/LiabilitiesContracts -in the Statement ofPresented in the StatementBalance Sheet LocationCommodity (a)Financial Position (b)of Financial Position (c)(in millions)Current Risk Management Assets$17.2 $(13.6)$3.6 Deferred Charges and Other Noncurrent Assets - Long-term Risk Management Assets0.5 (0.4)0.1 Total Assets17.7 (14.0)3.7 Other Current Liabilities - Current Risk Management Liabilities12.1 (12.0)0.1 Deferred Credits and Other Noncurrent Liabilities - Long-term Risk Management Liabilities0.4 (0.3)0.1 Total Liabilities12.5 (12.3)0.2 Total MTM Derivative Contract Net Assets (Liabilities)$5.2 $(1.7)$3.5 December 31, 2019Risk ManagementGross Amounts OffsetNet Amounts of Assets/LiabilitiesContracts -in the Statement ofPresented in the StatementBalance Sheet LocationCommodity (a)Financial Position (b)of Financial Position (c)(in millions)Current Risk Management Assets$66.9 $(57.1)$9.8 Deferred Charges and Other Noncurrent Assets - Long-term Risk Management Assets0.5 (0.4)0.1 Total Assets67.4 (57.5)9.9 Other Current Liabilities - Current Risk Management Liabilities55.2 (54.7)0.5 Deferred Credits and Other Noncurrent Liabilities - Long-term Risk Management Liabilities0.4 (0.4)— Total Liabilities55.6 (55.1)0.5 Total MTM Derivative Contract Net Assets (Liabilities)$11.8 $(2.4)$9.4 OPCoDecember 31, 2020Risk ManagementGross Amounts OffsetNet Amounts of Assets/LiabilitiesContracts -in the Statement ofPresented in the StatementBalance Sheet LocationCommodity (a)Financial Position (b)of Financial Position (c)(in millions)Current Risk Management Assets$0.3 $(0.3)$— Long-term Risk Management Assets— — — Total Assets0.3 (0.3)— Current Risk Management Liabilities8.7 — 8.7 Long-term Risk Management Liabilities101.6 — 101.6 Total Liabilities110.3 — 110.3 Total MTM Derivative Contract Net Liabilities$(110.0)$(0.3)$(110.3)December 31, 2019Risk ManagementGross Amounts OffsetNet Amounts of Assets/LiabilitiesContracts -in the Statement ofPresented in the StatementBalance Sheet LocationCommodity (a)Financial Position (b)of Financial Position (c)(in millions)Current Risk Management Assets$— $— $— Long-term Risk Management Assets— — — Total Assets— — — Current Risk Management Liabilities7.3 — 7.3 Long-term Risk Management Liabilities96.3 — 96.3 Total Liabilities103.6 — 103.6 Total MTM Derivative Contract Net Liabilities$(103.6)$— $(103.6)328PSODecember 31, 2020Risk ManagementGross Amounts OffsetNet Amounts of Assets/LiabilitiesContracts -in the Statement ofPresented in the StatementBalance Sheet LocationCommodity (a)Financial Position (b)of Financial Position (c)(in millions)Current Risk Management Assets$10.5 $(0.2)$10.3 Long-term Risk Management Assets— — — Total Assets10.5 (0.2)10.3 Current Risk Management Liabilities— — — Long-term Risk Management Liabilities— — — Total Liabilities— — — Total MTM Derivative Net Assets (Liabilities)$10.5 $(0.2)$10.3 December 31, 2019Risk ManagementGross Amounts OffsetNet Amounts of Assets/LiabilitiesContracts -in the Statement ofPresented in the StatementBalance Sheet LocationCommodity (a)Financial Position (b)of Financial Position (c)(in millions)Current Risk Management Assets$16.3 $(0.5)$15.8 Long-term Risk Management Assets— — — Total Assets16.3 (0.5)15.8 Current Risk Management Liabilities0.5 (0.5)— Long-term Risk Management Liabilities— — — Total Liabilities0.5 (0.5)— Total MTM Derivative Contract Net Assets$15.8 $— $15.8 SWEPCoDecember 31, 2020Risk ManagementGross Amounts OffsetNet Amounts of Assets/LiabilitiesContracts -in the Statement ofPresented in the StatementBalance Sheet LocationCommodity (a)Financial Position (b)of Financial Position (c)(in millions)Current Risk Management Assets$3.4 $(0.2)$3.2 Long-term Risk Management Assets— — — Total Assets3.4 (0.2)3.2 Current Risk Management Liabilities0.7 — 0.7 Long-term Risk Management Liabilities1.0 — 1.0 Total Liabilities1.7 — 1.7 Total MTM Derivative Net Assets (Liabilities)$1.7 $(0.2)$1.5 December 31, 2019Risk ManagementGross Amounts OffsetNet Amounts of Assets/LiabilitiesContracts -in the Statement ofPresented in the StatementBalance Sheet LocationCommodity (a)Financial Position (b)of Financial Position (c)(in millions)Current Risk Management Assets$6.5 $(0.1)$6.4 Long-term Risk Management Assets— — — Total Assets6.5 (0.1)6.4 Current Risk Management Liabilities2.0 (0.1)1.9 Long-term Risk Management Liabilities3.1 — 3.1 Total Liabilities5.1 (0.1)5.0 Total MTM Derivative Contract Net Assets$1.4 $— $1.4 (a)Derivative instruments within these categories are reported gross. These instruments are subject to master netting agreements and are presented on the balance sheets on a net basis in accordance with the accounting guidance for “Derivatives and Hedging.”(b)Amounts include counterparty netting of risk management and hedging contracts and associated cash collateral in accordance with the accounting guidance for “Derivatives and Hedging.”(c)All derivative contracts subject to a master netting arrangement or similar agreement are offset in the statement of financial position.329The tables below present the Registrants’ amount of gain (loss) recognized on risk management contracts:Year Ended December 31, 2020Location of Gain (Loss)AEPAEP TexasAPCoI&MOPCoPSOSWEPCo(in millions)Vertically Integrated Utilities Revenues$0.8 $— $— $— $— $— $— Generation & Marketing Revenues9.5 — — — — — — Electric Generation, Transmission and Distribution Revenues— — 0.4 0.1 — — 0.1 Purchased Electricity for Resale1.4 — 1.2 0.1 — — — Other Operation(2.0)(0.6)(0.2)(0.2)(0.3)(0.2)(0.3)Maintenance(2.9)(0.8)(0.4)(0.3)(0.5)(0.3)(0.4)Regulatory Assets (a)(4.8)— — (0.1)(6.6)— 1.4 Regulatory Liabilities (a)114.9 0.4 20.3 12.4 12.4 39.1 20.2 Total Gain (Loss) on Risk Management Contracts$116.9 $(1.0)$21.3 $12.0 $5.0 $38.6 $21.0 Year Ended December 31, 2019Location of Gain (Loss)AEPAEP TexasAPCoI&MOPCoPSOSWEPCo(in millions)Vertically Integrated Utilities Revenues$0.7 $— $— $— $— $— $— Generation & Marketing Revenues25.1 — — — — — — Electric Generation, Transmission and Distribution Revenues— — 0.1 0.5 — — 0.1 Purchased Electricity for Resale1.9 — 1.6 0.1 — — — Other Operation(0.8)(0.2)(0.1)(0.1)(0.2)(0.1)(0.1)Maintenance(0.8)(0.2)(0.2)(0.1)(0.2)(0.1)(0.1)Regulatory Assets (a)(3.7)0.7 0.3 0.3 (3.7)1.2 (1.5)Regulatory Liabilities (a)102.6 — 2.4 24.5 10.1 34.6 26.6 Total Gain on Risk Management Contracts$125.0 $0.3 $4.1 $25.2 $6.0 $35.6 $25.0 Year Ended December 31, 2018Location of Gain (Loss)AEPAEP TexasAPCoI&MOPCoPSOSWEPCo(in millions)Vertically Integrated Utilities Revenues$(10.4)$— $— $— $— $— $— Generation & Marketing Revenues38.9 — — — — — — Electric Generation, Transmission and Distribution Revenues— — (1.9)(8.2)— — 0.1 Purchased Electricity for Resale8.6 — 7.6 0.8 — — — Other Operation1.7 0.4 0.2 0.2 0.3 0.2 0.2 Maintenance1.9 0.4 0.4 0.2 0.4 0.2 0.2 Regulatory Assets (a)27.9 (0.7)(0.7)7.1 24.9 (1.1)(1.2)Regulatory Liabilities (a)222.7 (0.5)135.5 11.6 — 37.3 11.9 Total Gain (Loss) on Risk Management Contracts$291.3 $(0.4)$141.1 $11.7 $25.6 $36.6 $11.2 (a)Represents realized and unrealized gains and losses subject to regulatory accounting treatment recorded as either current or noncurrent on the balance sheets.330Certain qualifying derivative instruments have been designated as normal purchase or normal sale contracts, as provided in the accounting guidance for “Derivatives and Hedging.” Derivative contracts that have been designated as normal purchases or normal sales under that accounting guidance are not subject to MTM accounting treatment and are recognized on the statements of income on an accrual basis.The accounting for the changes in the fair value of a derivative instrument depends on whether it qualifies for and has been designated as part of a hedging relationship and further, on the type of hedging relationship. Depending on the exposure, management designates a hedging instrument as a fair value hedge or a cash flow hedge.For contracts that have not been designated as part of a hedging relationship, the accounting for changes in fair value depends on whether the derivative instrument is held for trading purposes. Unrealized and realized gains and losses on derivative instruments held for trading purposes are included in revenues on a net basis on the statements of income. Unrealized and realized gains and losses on derivative instruments not held for trading purposes are included in revenues or expenses on the statements of income depending on the relevant facts and circumstances. Certain derivatives that economically hedge future commodity risk are recorded in the same expense line item on the statements of income as that of the associated risk. However, unrealized and some realized gains and losses in regulated jurisdictions for both trading and non-trading derivative instruments are recorded as regulatory assets (for losses) or regulatory liabilities (for gains) in accordance with the accounting guidance for “Regulated Operations.”Accounting for Fair Value Hedging Strategies (Applies to AEP)For fair value hedges (i.e. hedging the exposure to changes in the fair value of an asset, liability or an identified portion thereof attributable to a particular risk), the gain or loss on the derivative instrument as well as the offsetting gain or loss on the hedged item associated with the hedged risk impacts net income during the period of change.AEP records realized and unrealized gains or losses on interest rate swaps that are designated and qualify for fair value hedge accounting treatment and any offsetting changes in the fair value of the debt being hedged in Interest Expense on the statements of income.The following table shows the impacts recognized on the balance sheets related to the hedged items in fair value hedging relationships:Carrying Amount of the Hedged Assets/(Liabilities)Cumulative Amount of Fair Value Hedging Adjustment Included in the Carrying Amount of the Hedged Assets/(Liabilities)December 31, 2020December 31, 2019December 31, 2020December 31, 2019(in millions)Long-term Debt (a) (b)$(995.9)$(510.8)$(51.7)$(14.5)(a)Amounts included on the balance sheets within Long-term Debt Due within One Year and Long-term Debt, respectively. (b)Amounts include $(53) million and $0 as of December 31, 2020 and 2019, respectively, for the fair value hedge adjustment of hedged debt obligations for which hedge accounting has been discontinued.The pretax effects of fair value hedge accounting on income were as follows:Years Ended December 31,202020192018(in millions)Gain (Loss) on Interest Rate Contracts:Fair Value Hedging Instruments (a)$41.1 $31.9 $(11.3)Fair Value Portion of Long-term Debt (a)(41.1)(31.9)11.3 (a)Gain (Loss) is included in Interest Expense on the statements of income.331In June 2020, AEP terminated a $500 million notional amount interest rate swap resulting in the discontinuance of the hedging relationship. A gain of $57 million on the fair value of the hedging instrument was settled in cash and recorded within operating activities on the statement of cash flows. Subsequent to the discontinuation of hedge accounting, the remaining adjustment to the carrying amount of the hedged item of $57 million will be amortized on a straight-line basis through November 2027 in Interest Expense on the statements of income.Accounting for Cash Flow Hedging StrategiesFor cash flow hedges (i.e. hedging the exposure to variability in expected future cash flows that is attributable to a particular risk), the Registrants initially report the gain or loss on the derivative instrument as a component of Accumulated Other Comprehensive Income (Loss) on the balance sheets until the period the hedged item affects net income. Realized gains and losses on derivative contracts for the purchase and sale of power designated as cash flow hedges are included in Total Revenues or Purchased Electricity for Resale on the statements of income or in Regulatory Assets or Regulatory Liabilities on the balance sheets, depending on the specific nature of the risk being hedged. During the years ended 2020, 2019 and 2018, AEP applied cash flow hedging to outstanding power derivatives. During the years ended 2020, 2019 and 2018, the Registrant Subsidiaries did not apply cash flow hedging to outstanding power derivatives.The Registrants reclassify gains and losses on interest rate derivative hedges related to debt financings from Accumulated Other Comprehensive Income (Loss) on the balance sheets into Interest Expense on the statements of income in those periods in which hedged interest payments occur. During the years ended 2020, 2019 and 2018, AEP applied cash flow hedging to outstanding interest rate derivatives. During the year ended 2020, APCo applied cash flow hedging to outstanding interest rate derivatives and the other Registrant Subsidiaries did not. During the year ended 2019, the Registrant Subsidiaries did not apply cash flow hedging to outstanding interest rate derivatives. During the year ended 2018, SWEPCo applied cash flow hedging to outstanding interest rate derivatives and the other Registrant Subsidiaries did not. For details on effective cash flow hedges included in Accumulated Other Comprehensive Income (Loss) on the balance sheets and the reasons for changes in cash flow hedges, see Note 3 - Comprehensive Income.Cash flow hedges included in Accumulated Other Comprehensive Income (Loss) on the balance sheets were:Impact of Cash Flow Hedges on AEP’s Balance SheetsDecember 31, 2020December 31, 2019CommodityInterest RateCommodityInterest Rate(in millions)AOCI Gain (Loss) Net of Tax$(60.6)$(47.5)$(103.5)$(11.5)Portion Expected to be Reclassed to Net Income During the Next Twelve Months(27.1)(5.7)(51.7)(2.1)As of December 31, 2020 the maximum length of time that AEP is hedging its exposure to variability in future cash flows related to forecasted transactions is 123 months and 120 months for commodity and interest rate hedges, respectively.332Impact of Cash Flow Hedges on the Registrant Subsidiaries’ Balance SheetsDecember 31, 2020December 31, 2019Interest RateExpected to beExpected to beReclassified toReclassified toNet Income DuringNet Income DuringAOCI Gain (Loss)the NextAOCI Gain (Loss)the NextCompanyNet of TaxTwelve MonthsNet of TaxTwelve Months(in millions)AEP Texas$(2.3)$(1.1)$(3.4)$(1.1)APCo(0.8)0.4 0.9 0.9 I&M(8.3)(1.6)(9.9)(1.6)PSO0.1 0.1 1.1 1.0 SWEPCo(0.3)(1.5)(1.8)(1.5)The actual amounts reclassified from Accumulated Other Comprehensive Income (Loss) to Net Income can differ from the estimate above due to market price changes.Credit RiskManagement mitigates credit risk in wholesale marketing and trading activities by assessing the creditworthiness of potential counterparties before entering into transactions with them and continuing to evaluate their creditworthiness on an ongoing basis. Management uses credit agency ratings and current market-based qualitative and quantitative data as well as financial statements to assess the financial health of counterparties on an ongoing basis.Master agreements are typically used to facilitate the netting of cash flows associated with a single counterparty and may include collateral requirements. Collateral requirements in the form of cash, letters of credit, surety bonds and parental/affiliate guarantees may be obtained as security from counterparties in order to mitigate credit risk. Some master agreements include margining, which requires a counterparty to post cash or letters of credit in the event exposure exceeds the established threshold. The threshold represents an unsecured credit limit which may be supported by a parental/affiliate guaranty, as determined in accordance with AEP’s credit policy. In addition, master agreements allow for termination and liquidation of all positions in the event of a default including a failure or inability to post collateral when required.Collateral Triggering EventsCredit Downgrade Triggers (Applies to AEP, APCo, I&M, PSO and SWEPCo)A limited number of derivative contracts include collateral triggering events, which include a requirement to maintain certain credit ratings. On an ongoing basis, AEP’s risk management organization assesses the appropriateness of these collateral triggering events in contracts. The Registrants have not experienced a downgrade below a specified credit rating threshold that would require the posting of additional collateral. The Registrants had no derivative contracts with collateral triggering events in a net liability position as of December 31, 2020 and 2019.333Cross-Default Triggers (Applies to AEP, APCo, I&M and SWEPCo)In addition, a majority of non-exchange-traded commodity contracts contain cross-default provisions that, if triggered, would permit the counterparty to declare a default and require settlement of the outstanding payable. These cross-default provisions could be triggered if there was a non-performance event by Parent or the obligor under outstanding debt or a third-party obligation that is $50 million or greater. On an ongoing basis, AEP’s risk management organization assesses the appropriateness of these cross-default provisions in the contracts. The following tables represent: (a) the fair value of these derivative liabilities subject to cross-default provisions prior to consideration of contractual netting arrangements, (b) the amount that the exposure has been reduced by cash collateral posted and (c) if a cross-default provision would have been triggered, the settlement amount that would be required after considering contractual netting arrangements:December 31, 2020Liabilities forAdditionalContracts with CrossSettlementDefault ProvisionsLiability if CrossPrior to ContractualAmount of CashDefault ProvisionCompanyNetting ArrangementsCollateral Postedis Triggered(in millions)AEP$188.4 $— $169.2 APCo4.3 — 3.5 I&M0.5 — 0.1 SWEPCo1.8 — 1.8 December 31, 2019Liabilities forAdditionalContracts with CrossSettlementDefault ProvisionsLiability if CrossPrior to ContractualAmount of CashDefault ProvisionCompanyNetting ArrangementsCollateral Postedis Triggered(in millions)AEP$267.3 $3.7 $246.7 APCo2.3 — 0.4 I&M1.3 — 0.2 SWEPCo5.1 — 5.1 Warrants Held in Investee (Applies to AEP)As of December 31, 2020, AEP held an $8 million investment in a privately held investee that is anticipated to complete an initial public offering (IPO) in the first quarter of 2021. The IPO is expected to be completed via a reverse merger with a public special purpose acquisition company. AEP’s interests in the investee as of December 31, 2020 consisted of a noncontrolling equity interest of preferred shares, which were accounted for at historical cost until completion of the IPO, and common share warrants, which management has determined are derivative instruments based on the accounting guidance for “Derivatives and Hedging”.As of December 31, 2020, the warrants were valued at $32 million and were recorded in Deferred Charges and Other Noncurrent Assets on AEP’s balance sheet. AEP recognized an unrealized gain of $32 million associated with the warrants for the year ended December 31, 2020, presented in Other Income on AEP’s statement of income.Management utilized a Black-Scholes options pricing model to value the warrants as of December 31, 2020. As the reverse merger and IPO did not close prior to the end of 2020, the valuation contemplated a liquidity adjustment that resulted in the overall fair value of the warrants being categorized as Level 3 in the fair value hierarchy. See “Fair Value Measurements of Financial Assets and Liabilities” section of Note 11 for additional information.33411. FAIR VALUE MEASUREMENTSThe disclosures in this note apply to all Registrants except AEPTCo unless indicated otherwise.Fair Value Measurements of Long-term Debt (Applies to all Registrants)The fair values of Long-term Debt are based on quoted market prices, without credit enhancements, for the same or similar issues and the current interest rates offered for instruments with similar maturities classified as Level 2 measurement inputs. These instruments are not marked-to-market. The estimates presented are not necessarily indicative of the amounts that could be realized in a current market exchange. The fair value of AEP’s Equity Units (Level 1) are valued based on publicly-traded securities issued by AEP.The book values and fair values of Long-term Debt are summarized in the following table:December 31,20202019CompanyBook ValueFair ValueBook ValueFair Value(in millions)AEP (a)$31,072.5 $37,457.0 $26,725.5 $30,172.0 AEP Texas4,820.4 5,682.6 4,558.4 4,981.5 AEPTCo3,948.5 4,984.3 3,427.3 3,868.0 APCo4,834.1 6,391.8 4,363.8 5,253.1 I&M3,029.9 3,775.3 3,050.2 3,453.8 OPCo2,430.2 3,154.9 2,082.0 2,554.3 PSO1,373.8 1,732.1 1,386.2 1,603.3 SWEPCo2,636.4 3,210.1 2,655.6 2,927.9 (a)The fair value amounts include debt related to AEP’s Equity Units and had a fair value of $1.7 billion and $871 million as of December 31, 2020 and 2019, respectively. See “Equity Units” section of Note 14 for additional information.Fair Value Measurements of Other Temporary Investments (Applies to AEP)Other Temporary Investments include marketable securities that management intends to hold for less than one year and investments by AEP’s protected cell of EIS. See “Other Temporary Investments” section of Note 1 for additional information.The following is a summary of Other Temporary Investments:December 31, 2020GrossGrossUnrealizedUnrealizedFairOther Temporary InvestmentsCostGainsLossesValue(in millions)Restricted Cash and Other Cash Deposits (a)$68.3 $— $— $68.3 Fixed Income Securities – Mutual Funds (b)120.7 2.8 — 123.5 Equity Securities – Mutual Funds25.9 28.7 — 54.6 Total Other Temporary Investments$214.9 $31.5 $— $246.4 335December 31, 2019GrossGrossUnrealizedUnrealizedFairOther Temporary InvestmentsCostGainsLossesValue(in millions)Restricted Cash and Other Cash Deposits (a)$214.7 $— $— $214.7 Fixed Income Securities – Mutual Funds (b)123.2 0.1 — 123.3 Equity Securities – Mutual Funds29.2 21.3 — 50.5 Total Other Temporary Investments$367.1 $21.4 $— $388.5 (a)Primarily represents amounts held for the repayment of debt.(b)Primarily short and intermediate maturities which may be sold and do not contain maturity dates.The following table provides the activity for fixed income and equity securities within Other Temporary Investments:Years Ended December 31,202020192018(in millions)Proceeds from Investment Sales$50.9 $21.2 $— Purchases of Investments41.6 45.0 3.1 Gross Realized Gains on Investment Sales3.8 — — Gross Realized Losses on Investment Sales0.2 0.4 — Fair Value Measurements of Trust Assets for Decommissioning and SNF Disposal (Applies to AEP and I&M)Securities held in trust funds for decommissioning nuclear facilities and for the disposal of SNF are recorded at fair value. See “Nuclear Trust Funds” section of Note 1 for additional information.The following is a summary of nuclear trust fund investments:December 31,20202019GrossOther-Than-GrossOther-Than-FairUnrealizedTemporaryFairUnrealizedTemporaryValueGainsImpairmentsValueGainsImpairments(in millions)Cash and Cash Equivalents$25.8 $— $— $15.3 $— $— Fixed Income Securities:United States Government1,025.6 98.5 (7.1)1,112.5 55.5 (6.1)Corporate Debt86.3 9.6 (1.7)72.4 5.3 (1.6)State and Local Government114.3 0.9 (0.4)7.6 0.7 (0.2)Subtotal Fixed Income Securities1,226.2 109.0 (9.2)1,192.5 61.5 (7.9)Equity Securities - Domestic (a)2,054.7 1,400.8 — 1,767.9 1,144.4 — Spent Nuclear Fuel and Decommissioning Trusts$3,306.7 $1,509.8 $(9.2)$2,975.7 $1,205.9 $(7.9)(a)Amount reported as Gross Unrealized Gains includes unrealized gains of $1.4 billion and $1.1 billion and unrealized losses of $9 million and $5 million as of December 31, 2020 and 2019, respectively.336The following table provides the securities activity within the decommissioning and SNF trusts:Years Ended December 31,202020192018(in millions)Proceeds from Investment Sales$1,593.4 $1,473.0 $2,010.0 Purchases of Investments1,637.2 1,531.0 2,064.7 Gross Realized Gains on Investment Sales26.4 76.5 47.5 Gross Realized Losses on Investment Sales26.1 24.3 32.8 The base cost of fixed income securities was $1.1 billion and $1.1 billion as of December 31, 2020 and 2019, respectively. The base cost of equity securities was $654 million and $623 million as of December 31, 2020 and 2019, respectively.The fair value of fixed income securities held in the nuclear trust funds, summarized by contractual maturities, as of December 31, 2020 was as follows:Fair Value of FixedIncome Securities(in millions)Within 1 year$294.8 After 1 year through 5 years371.3 After 5 years through 10 years214.4 After 10 years345.7 Total$1,226.2 337Fair Value Measurements of Financial Assets and LiabilitiesFor a discussion of fair value accounting and the classification of assets and liabilities within the fair value hierarchy, see the “Fair Value Measurements of Assets and Liabilities” section of Note 1.The following tables set forth, by level within the fair value hierarchy, the Registrants’ financial assets and liabilities that were accounted for at fair value on a recurring basis. As required by the accounting guidance for “Fair Value Measurements and Disclosures,” financial assets and liabilities are classified in their entirety based on the lowest level of input that is significant to the fair value measurement. Management’s assessment of the significance of a particular input to the fair value measurement requires judgment and may affect the valuation of fair value assets and liabilities and their placement within the fair value hierarchy levels. There have not been any significant changes in management’s valuation techniques.AEPDecember 31, 2020Level 1Level 2Level 3OtherTotalAssets:(in millions)Other Temporary InvestmentsRestricted Cash and Other Cash Deposits (a)$57.8 $— $— $10.5 $68.3 Fixed Income Securities – Mutual Funds123.5 — — — 123.5 Equity Securities – Mutual Funds (b)54.6 — — — 54.6 Total Other Temporary Investments235.9 — — 10.5 246.4 Risk Management AssetsRisk Management Commodity Contracts (c) (d)0.9 258.8 252.4 (190.0)322.1 Cash Flow Hedges:Commodity Hedges (c)— 34.4 3.9 (28.5)9.8 Interest Rate Hedges— 2.4 — — 2.4 Fair Value Hedges— 2.6 — — 2.6 Total Risk Management Assets0.9 298.2 256.3 (218.5)336.9 Spent Nuclear Fuel and Decommissioning TrustsCash and Cash Equivalents (e)16.8 — — 9.0 25.8 Fixed Income Securities:United States Government— 1,025.6 — — 1,025.6 Corporate Debt— 86.3 — — 86.3 State and Local Government— 114.3 — — 114.3 Subtotal Fixed Income Securities— 1,226.2 — — 1,226.2 Equity Securities – Domestic (b)2,054.7 — — — 2,054.7 Total Spent Nuclear Fuel and Decommissioning Trusts2,071.5 1,226.2 — 9.0 3,306.7 Other Investments (h)— — 31.8 — 31.8 Total Assets$2,308.3 $1,524.4 $288.1 $(199.0)$3,921.8 Liabilities:Risk Management LiabilitiesRisk Management Commodity Contracts (c) (d)$0.9 $244.2 $167.2 $(193.4)$218.9 Cash Flow Hedges:Commodity Hedges (c)— 106.1 7.6 (28.5)85.2 Interest Rate Hedges— 3.4 — — 3.4 Fair Value Hedges— 4.1 — — 4.1 Total Risk Management Liabilities$0.9 $357.8 $174.8 $(221.9)$311.6 338AEPDecember 31, 2019Level 1Level 2Level 3OtherTotalAssets:(in millions)Other Temporary InvestmentsRestricted Cash and Other Cash Deposits (a)$197.6 $— $— $17.1 $214.7 Fixed Income Securities – Mutual Funds123.3 — — — 123.3 Equity Securities – Mutual Funds (b)50.5 — — — 50.5 Total Other Temporary Investments371.4 — — 17.1 388.5 Risk Management AssetsRisk Management Commodity Contracts (c) (f)4.0 440.1 369.2 (404.5)408.8 Cash Flow Hedges:Commodity Hedges (c)— 15.0 3.2 (6.7)11.5 Interest Rate Hedges— 4.6 — — 4.6 Fair Value Hedges— 14.5 — — 14.5 Total Risk Management Assets4.0 474.2 372.4 (411.2)439.4 Spent Nuclear Fuel and Decommissioning TrustsCash and Cash Equivalents (e)6.7 — — 8.6 15.3 Fixed Income Securities:United States Government— 1,112.5 — — 1,112.5 Corporate Debt— 72.4 — — 72.4 State and Local Government— 7.6 — — 7.6 Subtotal Fixed Income Securities— 1,192.5 — — 1,192.5 Equity Securities – Domestic (b)1,767.9 — — — 1,767.9 Total Spent Nuclear Fuel and Decommissioning Trusts1,774.6 1,192.5 — 8.6 2,975.7 Total Assets$2,150.0 $1,666.7 $372.4 $(385.5)$3,803.6 Liabilities:Risk Management LiabilitiesRisk Management Commodity Contracts (c) (f)$3.8 $450.0 $224.0 $(438.8)$239.0 Cash Flow Hedges:Commodity Hedges (c)— 105.3 38.5 (6.7)137.1 Total Risk Management Liabilities$3.8 $555.3 $262.5 $(445.5)$376.1 339AEP TexasDecember 31, 2020Level 1Level 2Level 3OtherTotalAssets:(in millions)Restricted Cash for Securitized Funding$28.7 $— $— $— $28.7 Risk Management AssetsRisk Management Commodity Contracts (c)— 0.4 — (0.4)— Total Assets$28.7 $0.4 $— $(0.4)$28.7 December 31, 2019Level 1Level 2Level 3OtherTotalAssets:(in millions)Restricted Cash for Securitized Funding$154.7 $— $— $— $154.7 APCoDecember 31, 2020Level 1Level 2Level 3OtherTotalAssets:(in millions)Restricted Cash for Securitized Funding$16.9 $— $— $— $16.9 Risk Management AssetsRisk Management Commodity Contracts (c) (g)— 19.4 19.9 (19.2)20.1 Cash Flow Hedges:Interest Rate Hedges— 2.4 — — 2.4 Total Risk Management Assets— 21.8 19.9 (19.2)22.5 Total Assets$16.9 $21.8 $19.9 $(19.2)$39.4 Liabilities:Risk Management LiabilitiesRisk Management Commodity Contracts (c) (g)$— $19.5 $0.6 $(18.8)$1.3 Cash Flow Hedges:Interest Rate Hedges— 3.4 — — 3.4 Total Risk Management Liabilities$— $22.9 $0.6 $(18.8)$4.7 December 31, 2019Level 1Level 2Level 3OtherTotalAssets:(in millions)Restricted Cash for Securitized Funding$23.5 $— $— $— $23.5 Risk Management AssetsRisk Management Commodity Contracts (c) (g)— 84.6 40.5 (85.6)39.5 Total Assets$23.5 $84.6 $40.5 $(85.6)$63.0 Liabilities:Risk Management LiabilitiesRisk Management Commodity Contracts (c) (g)$— $84.0 $2.8 $(84.9)$1.9 340I&MDecember 31, 2020Level 1Level 2Level 3OtherTotalAssets:(in millions)Risk Management AssetsRisk Management Commodity Contracts (c) (g)$— $15.1 $2.5 $(13.9)$3.7 Spent Nuclear Fuel and Decommissioning TrustsCash and Cash Equivalents (e)16.8 — — 9.0 25.8 Fixed Income Securities:United States Government— 1,025.6 — — 1,025.6 Corporate Debt— 86.3 — — 86.3 State and Local Government— 114.3 — — 114.3 Subtotal Fixed Income Securities— 1,226.2 — — 1,226.2 Equity Securities - Domestic (b)2,054.7 — — — 2,054.7 Total Spent Nuclear Fuel and Decommissioning Trusts2,071.5 1,226.2 — 9.0 3,306.7 Total Assets$2,071.5 $1,241.3 $2.5 $(4.9)$3,310.4 Liabilities:Risk Management LiabilitiesRisk Management Commodity Contracts (c) (g)$— $12.0 $0.4 $(12.2)$0.2 December 31, 2019Level 1Level 2Level 3OtherTotalAssets:(in millions)Risk Management AssetsRisk Management Commodity Contracts (c) (g)$— $59.5 $8.0 $(57.6)$9.9 Spent Nuclear Fuel and Decommissioning TrustsCash and Cash Equivalents (e)6.7 — — 8.6 15.3 Fixed Income Securities:United States Government— 1,112.5 — — 1,112.5 Corporate Debt— 72.4 — — 72.4 State and Local Government— 7.6 — — 7.6 Subtotal Fixed Income Securities— 1,192.5 — — 1,192.5 Equity Securities - Domestic (b)1,767.9 — — — 1,767.9 Total Spent Nuclear Fuel and Decommissioning Trusts1,774.6 1,192.5 — 8.6 2,975.7 Total Assets$1,774.6 $1,252.0 $8.0 $(49.0)$2,985.6 Liabilities:Risk Management LiabilitiesRisk Management Commodity Contracts (c) (g)$— $53.4 $2.2 $(55.1)$0.5 341OPCoDecember 31, 2020Level 1Level 2Level 3OtherTotalAssets:(in millions)Risk Management AssetsRisk Management Commodity Contracts (c) (g)$— $0.3 $— $(0.3)$— Liabilities:Risk Management LiabilitiesRisk Management Commodity Contracts (c) (g)$— $— $110.3 $— $110.3 December 31, 2019Level 1Level 2Level 3OtherTotalLiabilities:(in millions)Risk Management LiabilitiesRisk Management Commodity Contracts (c) (g)$— $— $103.6 $— $103.6 PSODecember 31, 2020Level 1Level 2Level 3OtherTotalAssets:(in millions)Risk Management AssetsRisk Management Commodity Contracts (c) (g)$— $0.2 $10.3 $(0.2)$10.3 December 31, 2019Level 1Level 2Level 3OtherTotalAssets:(in millions)Risk Management AssetsRisk Management Commodity Contracts (c) (g)$— $— $16.3 $(0.5)$15.8 Liabilities:Risk Management LiabilitiesRisk Management Commodity Contracts (c) (g)$— $— $0.5 $(0.5)$— 342SWEPCoDecember 31, 2020Level 1Level 2Level 3OtherTotalAssets:(in millions)Risk Management AssetsRisk Management Commodity Contracts (c) (g)$— $0.1 $3.3 $(0.2)$3.2 Liabilities:Risk Management LiabilitiesRisk Management Commodity Contracts (c) (g)$— $— $1.7 $— $1.7 December 31, 2019Level 1Level 2Level 3OtherTotalAssets:(in millions)Risk Management AssetsRisk Management Commodity Contracts (c) (g)$— $— $6.5 $(0.1)$6.4 Liabilities:Risk Management LiabilitiesRisk Management Commodity Contracts (c) (g)$— $— $5.1 $(0.1)$5.0 (a)Amounts in “Other” column primarily represent cash deposits in bank accounts with financial institutions or third-parties. Level 1 and Level 2 amounts primarily represent investments in money market funds.(b)Amounts represent publicly-traded equity securities and equity-based mutual funds.(c)Amounts in “Other” column primarily represent counterparty netting of risk management and hedging contracts and associated cash collateral under the accounting guidance for “Derivatives and Hedging.”(d)The December 31, 2020 maturities of the net fair value of risk management contracts prior to cash collateral, assets/(liabilities), were as follows: Level 2 matures $3 million in periods 2022-2024, $11 million in periods 2025-2026 and $1 million in periods 2027-2033; Level 3 matures $47 million in 2021, $37 million in periods 2022-2024, $14 million in periods 2025-2026 and $(13) million in periods 2027-2033. Risk management commodity contracts are substantially comprised of power contracts.(e)Amounts in “Other” column primarily represent accrued interest receivables from financial institutions. Level 1 amounts primarily represent investments in money market funds.(f)The December 31, 2019 maturities of the net fair value of risk management contracts prior to cash collateral, assets/(liabilities), were as follows: Level 2 matures $(7) million in 2020 and $(3) million in periods 2021-2023; Level 3 matures $96 million in 2020, $36 million in periods 2021-2023, $25 million in periods 2024-2025 and $(12) million in periods 2026-2032. Risk management commodity contracts are substantially comprised of power contracts.(g)Substantially comprised of power contracts for the Registrant Subsidiaries.(h)See “Warrants Held in Investee” section of Note 10 for additional information.343The following tables set forth a reconciliation of changes in the fair value of net trading derivatives classified as Level 3 in the fair value hierarchy:Year Ended December 31, 2020AEPAPCoI&MOPCoPSOSWEPCo(in millions)Balance as of December 31, 2019$109.9 $37.7 $5.8 $(103.6)$15.8 $1.4 Realized Gain (Loss) Included in Net Income (or Changes in Net Assets) (a) (b)39.5 13.2 2.5 (1.6)11.9 2.8 Unrealized Gain (Loss) Included in Net Income (or Changes in Net Assets) Relating to Assets Still Held at the Reporting Date (a)35.3 — — — — — Realized and Unrealized Gains (Losses) Included in Other Comprehensive Income (c)13.8 — — — — — Settlements(113.1)(51.6)(8.6)8.9 (27.6)(6.6)Transfers into Level 3 (d) (e)(3.8)— — — — — Transfers out of Level 3 (e)5.6 0.7 0.4 — — — Changes in Fair Value Allocated to Regulated Jurisdictions (f)26.1 19.3 2.0 (14.0)10.2 4.0 Balance as of December 31, 2020$113.3 $19.3 $2.1 $(110.3)$10.3 $1.6 Year Ended December 31, 2019AEPAPCoI&MOPCoPSOSWEPCo(in millions)Balance as of December 31, 2018$131.2 $57.8 $8.9 $(99.4)$9.5 $2.3 Realized Gain (Loss) Included in Net Income (or Changes in Net Assets) (a) (b)15.8 (13.9)4.7 (0.9)13.5 6.0 Unrealized Gain (Loss) Included in Net Income (or Changes in Net Assets) Relating to Assets Still Held at the Reporting Date (a)(0.1)— — — — — Realized and Unrealized Gains (Losses) Included in Other Comprehensive Income (c)(15.1)— — — — — Settlements(117.6)(42.5)(13.0)6.6 (23.0)(9.6)Transfers into Level 3 (d) (e)(0.6)(0.5)(0.3)— — — Transfers out of Level 3 (e)35.6 (0.7)(0.4)— — — Changes in Fair Value Allocated to Regulated Jurisdictions (f)60.7 37.5 5.9 (9.9)15.8 2.7 Balance as of December 31, 2019$109.9 $37.7 $5.8 $(103.6)$15.8 $1.4 Year Ended December 31, 2018AEPAPCoI&MOPCoPSOSWEPCo(in millions)Balance as of December 31, 2017$40.3 $24.7 $7.6 $(132.4)$6.2 $5.9 Realized Gain (Loss) Included in Net Income (or Changes in Net Assets) (a) (b)148.9 104.1 14.2 1.8 18.1 (4.8)Unrealized Gain (Loss) Included in Net Income (or Changes in Net Assets) Relating to Assets Still Held at the Reporting Date (a)9.8 — — — — — Realized and Unrealized Gains (Losses) Included in Other Comprehensive Income (c)15.7 — — — — — Settlements(214.0)(127.9)(21.3)4.6 (24.3)(2.1)Transfers into Level 3 (d) (e)15.8 — — — — — Transfers out of Level 3 (e)(1.6)— (0.3)— — — Changes in Fair Value Allocated to Regulated Jurisdictions (f)116.3 56.9 8.7 26.6 9.5 3.3 Balance as of December 31, 2018$131.2 $57.8 $8.9 $(99.4)$9.5 $2.3 (a)Included in revenues on the statements of income.(b)Represents the change in fair value between the beginning of the reporting period and the settlement of the risk management commodity contract.(c)Included in cash flow hedges on the statements of comprehensive income.(d)Represents existing assets or liabilities that were previously categorized as Level 2.(e)Transfers are recognized based on their value at the beginning of the reporting period that the transfer occurred.(f)Relates to the net gains (losses) of those contracts that are not reflected on the statements of income. These net gains (losses) are recorded as regulatory assets/liabilities or accounts payable.344The following tables quantify the significant unobservable inputs used in developing the fair value of Level 3 positions:AEPDecember 31, 2020SignificantInput/RangeFair ValueValuationUnobservableWeightedAssetsLiabilitiesTechniqueInputLowHighAverage(in millions)Energy Contracts$213.5 $169.7 Discounted Cash FlowForward Market Price (a) (c)$5.33$100.47 $32.73Natural Gas Contracts— 1.7 Discounted Cash FlowForward Market Price (b) (c)2.182.772.40FTRs42.8 3.4 Discounted Cash FlowForward Market Price (a) (c)(15.08)9.660.19Other Investments31.8 — Black-Scholes ModelLiquidity Adjustment (d)10 %20 %15 %Total$288.1 $174.8 December 31, 2019SignificantInput/RangeFair ValueValuationUnobservableWeightedAssetsLiabilitiesTechniqueInputLowHighAverage (c)(in millions)Energy Contracts$296.7 $249.3 Discounted Cash FlowForward Market Price (a)$(0.05)$177.30 $31.31 Natural Gas Contracts— 4.9 Discounted Cash FlowForward Market Price (b)1.89 2.51 2.19 FTRs75.7 8.3 Discounted Cash FlowForward Market Price (a)(8.52)9.34 0.42 Total$372.4 $262.5 345APCoDecember 31, 2020SignificantInput/RangeFair ValueValuationUnobservableWeightedAssetsLiabilitiesTechniqueInput (a)LowHighAverage (c)(in millions)Energy Contracts$1.0 $0.6 Discounted Cash FlowForward Market Price$10.84 $41.09 $25.08 FTRs18.9 — Discounted Cash FlowForward Market Price0.04 5.61 1.13 Total$19.9 $0.6 December 31, 2019SignificantInput/RangeFair ValueValuationUnobservableWeightedAssetsLiabilitiesTechniqueInput (a)LowHighAverage (c)(in millions)Energy Contracts$5.7 $2.6 Discounted Cash FlowForward Market Price$12.70 $41.20 $25.92 FTRs34.8 0.2 Discounted Cash FlowForward Market Price(0.14)7.08 1.70 Total$40.5 $2.8 I&MDecember 31, 2020SignificantInput/RangeFair ValueValuationUnobservableWeightedAssetsLiabilitiesTechniqueInput (a)LowHighAverage (c)(in millions)Energy Contracts$0.6 $0.3 Discounted Cash FlowForward Market Price$10.84 $41.09 $25.08 FTRs1.9 0.1 Discounted Cash FlowForward Market Price(1.96)3.69 0.33 Total$2.5 $0.4 December 31, 2019SignificantInput/RangeFair ValueValuationUnobservableWeightedAssetsLiabilitiesTechniqueInput (a)LowHighAverage (c)(in millions)Energy Contracts$3.4 $1.5 Discounted Cash FlowForward Market Price$12.70 $41.20 $25.92 FTRs4.6 0.7 Discounted Cash FlowForward Market Price(0.75)4.07 0.74 Total$8.0 $2.2 346OPCoDecember 31, 2020SignificantInput/RangeFair ValueValuationUnobservableWeightedAssetsLiabilitiesTechniqueInput (a)LowHighAverage (c)(in millions)Energy Contracts$— $110.3 Discounted Cash FlowForward Market Price$16.19 $46.98 $28.30 December 31, 2019SignificantInput/RangeFair ValueValuationUnobservableWeightedAssetsLiabilitiesTechniqueInput (a)LowHighAverage (c)(in millions)Energy Contracts$— $103.6 Discounted Cash FlowForward Market Price$29.23 $61.43 $42.46 PSODecember 31, 2020SignificantInput/RangeFair ValueValuationUnobservableWeightedAssetsLiabilitiesTechniqueInput (a)LowHighAverage (c)(in millions)FTRs$10.3 $— Discounted Cash FlowForward Market Price$(6.93)$0.48 $(1.93)December 31, 2019SignificantInput/RangeFair ValueValuationUnobservableWeightedAssetsLiabilitiesTechniqueInput (a)LowHighAverage (c)(in millions)FTRs$16.3 $0.5 Discounted Cash FlowForward Market Price$(8.52)$0.85 $(2.31)347SWEPCoDecember 31, 2020SignificantInput/RangeFair ValueValuationUnobservableWeightedAssetsLiabilitiesTechniqueInputLowHighAverage (c)(in millions)Natural Gas Contracts$— $1.7 Discounted Cash FlowForward Market Price (b)$2.18 $2.77 $2.41 FTRs3.3 — Discounted Cash FlowForward Market Price (a)(6.93)0.48 (1.93)Total$3.3 $1.7 December 31, 2019SignificantInput/RangeFair ValueValuationUnobservableWeightedAssetsLiabilitiesTechniqueInputLowHighAverage (c)(in millions)Natural Gas Contracts$— $4.9 Discounted Cash FlowForward Market Price (b)$1.89 $2.51 $2.18 FTRs6.5 0.2 Discounted Cash FlowForward Market Price (a)(8.52)0.85 (2.31)Total$6.5 $5.1 (a)Represents market prices in dollars per MWh.(b)Represents market prices in dollars per MMBtu.(c)The weighted-average is the product of the forward market price of the underlying commodity and volume weighted by term.(d)Represents percentage discount applied to the publically available share price.The following table provides the measurement uncertainty of fair value measurements to increases (decreases) in significant unobservable inputs related to Energy Contracts, Natural Gas Contracts, FTRs and Other Investments for the Registrants as of December 31, 2020 and 2019:Uncertainty of Fair Value MeasurementsSignificant Unobservable InputPositionChange in InputImpact on Fair ValueMeasurementForward Market PriceBuyIncrease (Decrease)Higher (Lower)Forward Market PriceSellIncrease (Decrease)Lower (Higher)Liquidity AdjustmentBuyIncrease (Decrease)Lower (Higher)34812. INCOME TAXESThe disclosures in this note apply to all Registrants unless indicated otherwise.Income Tax Expense (Benefit)The details of the Registrants’ Income Tax Expense (Benefit) as reported are as follows:Year Ended December 31, 2020AEPAEP TexasAEPTCoAPCoI&MOPCoPSOSWEPCo(in millions)Federal:Current$(138.2)$5.2 $22.2 $21.4 $11.3 $(26.6)$(11.4)$(13.6)Deferred146.9 (15.4)65.4 (27.1)(20.6)74.0 8.3 19.6 Total Federal8.7 (10.2)87.6 (5.7)(9.3)47.4 (3.1)6.0 State and Local:Current(16.7)(0.1)2.8 9.3 1.9 (5.4)0.1 (8.2)Deferred48.5 (0.9)16.3 0.7 (0.1)3.2 8.2 11.6 Total State and Local31.8 (1.0)19.1 10.0 1.8 (2.2)8.3 3.4 Income Tax Expense (Benefit)$40.5 $(11.2)$106.7 $4.3 $(7.5)$45.2 $5.2 $9.4 Year Ended December 31, 2019AEPAEP TexasAEPTCoAPCoI&MOPCoPSOSWEPCo(in millions)Federal:Current$(7.4)$(31.8)$23.7 $36.7 $48.1 $(10.0)$25.5 $6.9 Deferred(71.6)(24.7)71.7 (126.1)(57.1)40.6 (26.0)(10.0)Total Federal(79.0)(56.5)95.4 (89.4)(9.0)30.6 (0.5)(3.1)State and Local:Current4.4 2.9 2.4 12.0 (2.4)1.1 0.2 0.8 Deferred61.7 — 19.6 (0.6)0.8 3.2 7.8 (2.4)Total State and Local66.1 2.9 22.0 11.4 (1.6)4.3 8.0 (1.6)Income Tax Expense (Benefit)$(12.9)$(53.6)$117.4 $(78.0)$(10.6)$34.9 $7.5 $(4.7)Year Ended December 31, 2018AEPAEP TexasAEPTCoAPCoI&MOPCoPSOSWEPCo(in millions)Federal:Current$(31.7)$37.0 $(14.2)$(31.9)$60.9 $55.6 $35.6 $18.3 Deferred122.0 (17.9)82.3 (24.5)(48.8)(36.9)(36.7)(1.9)Total Federal90.3 19.1 68.1 (56.4)12.1 18.7 (1.1)16.4 State and Local:Current30.8 1.8 (0.6)3.7 15.8 4.6 (0.2)2.3 Deferred(5.8)(0.1)16.6 7.8 1.2 0.7 6.3 1.7 Total State and Local25.0 1.7 16.0 11.5 17.0 5.3 6.1 4.0 Income Tax Expense (Benefit)$115.3 $20.8 $84.1 $(44.9)$29.1 $24.0 $5.0 $20.4 349The following are reconciliations for the Registrants between the federal income taxes computed by multiplying pretax income by the federal statutory tax rate and the income taxes reported:AEPYears Ended December 31,202020192018(in millions)Net Income$2,196.7 $1,919.8 $1,931.3 Less: Equity Earnings – Dolet Hills(2.9)(3.0)(2.7)Income Tax Expense (Benefit)40.5 (12.9)115.3 Pretax Income$2,234.3 $1,903.9 $2,043.9 Income Taxes on Pretax Income at Statutory Rate (21%)$469.2 $399.8 $429.2 Increase (Decrease) in Income Taxes Resulting from the Following Items:Depreciation26.5 20.4 24.6 Investment Tax Credit Amortization(18.8)(13.0)(20.4)Production Tax Credits(83.1)(59.6)(10.3)State and Local Income Taxes, Net25.1 52.2 19.7 Removal Costs(18.6)(22.2)(18.6)AFUDC(32.5)(37.1)(29.4)Tax Reform Adjustments— — (10.9)Tax Reform Excess ADIT Reversal(268.2)(353.2)(257.2)CARES Act(48.0)— — Other(11.1)(0.2)(11.4)Income Tax Expense (Benefit) $40.5 $(12.9)$115.3 Effective Income Tax Rate1.8 %(0.7)%5.6 %AEP TexasYears Ended December 31,202020192018(in millions)Net Income$241.0 $178.3 $211.3 Income Tax Expense (Benefit)(11.2)(53.6)20.8 Pretax Income$229.8 $124.7 $232.1 Income Taxes on Pretax Income at Statutory Rate (21%)$48.3 $26.2 $48.7 Increase (Decrease) in Income Taxes Resulting from the Following Items:Depreciation1.0 1.0 0.7 Investment Tax Credit Amortization(1.1)(1.2)(2.3)State and Local Income Taxes, Net(0.8)2.3 1.3 AFUDC(4.1)(3.2)(4.2)Parent Company Loss Benefit(4.5)(3.8)(3.0)Tax Reform Adjustments— — (11.0)Tax Reform Excess ADIT Reversal(47.9)(73.4)(11.8)Other(2.1)(1.5)2.4 Income Tax Expense (Benefit) $(11.2)$(53.6)$20.8 Effective Income Tax Rate(4.9)%(43.0)%9.0 %350AEPTCoYears Ended December 31,202020192018(in millions)Net Income$423.4 $439.7 $315.9 Income Tax Expense106.7 117.4 84.1 Pretax Income$530.1 $557.1 $400.0 Income Taxes on Pretax Income at Statutory Rate (21%)$111.3 $117.0 $84.0 Increase (Decrease) in Income Taxes Resulting from the Following Items:State and Local Income Taxes, Net15.1 17.4 12.6 AFUDC(15.5)(17.7)(14.1)Parent Company Loss Benefit(7.0)(4.2)(0.6)Other2.8 4.9 2.2 Income Tax Expense$106.7 $117.4 $84.1 Effective Income Tax Rate20.1 %21.1 %21.0 % APCoYears Ended December 31,202020192018(in millions)Net Income$369.7 $306.3 $367.8 Income Tax Expense (Benefit)4.3 (78.0)(44.9)Pretax Income$374.0 $228.3 $322.9 Income Taxes on Pretax Income at Statutory Rate (21%)$78.5 $47.9 $67.8 Increase (Decrease) in Income Taxes Resulting from the Following Items:Depreciation12.7 10.8 9.4 State and Local Income Taxes, Net7.9 9.0 9.1 Removal Costs(5.7)(6.4)(7.9)AFUDC(4.5)(5.2)(4.3)Parent Company Loss Benefit(6.2)(4.1)(3.6)Tax Reform Excess ADIT Reversal(72.3)(130.4)(108.5)Federal Return to Provision(7.2)(1.0)(6.6)Other1.1 1.4 (0.3)Income Tax Expense (Benefit)$4.3 $(78.0)$(44.9)Effective Income Tax Rate1.1 %(34.2)%(13.9)%351I&MYears Ended December 31,202020192018(in millions)Net Income$284.8 $269.4 $261.3 Income Tax Expense (Benefit)(7.5)(10.6)29.1 Pretax Income$277.3 $258.8 $290.4 Income Taxes on Pretax Income at Statutory Rate (21%)$58.2 $54.3 $61.0 Increase (Decrease) in Income Taxes Resulting from the Following Items:Depreciation1.6 4.0 1.5 Investment Tax Credit Amortization(4.5)(3.6)(4.7)State and Local Income Taxes, Net1.5 (1.2)13.4 Removal Costs(10.5)(12.8)(8.0)AFUDC(2.4)(4.1)(2.5)Parent Company Loss Benefit(6.4)(3.3)(2.3)Tax Reform Excess ADIT Reversal(46.8)(42.5)(25.8)Federal Return to Provision1.9 (0.3)(4.6)Other(0.1)(1.1)1.1 Income Tax Expense (Benefit)$(7.5)$(10.6)$29.1 Effective Income Tax Rate(2.7)%(4.1)%10.0 %OPCoYears Ended December 31,202020192018(in millions)Net Income$271.4 $297.1 $325.5 Income Tax Expense45.2 34.9 24.0 Pretax Income$316.6 $332.0 $349.5 Income Taxes on Pretax Income at Statutory Rate (21%)$66.5 $69.7 $73.4 Increase (Decrease) in Income Taxes Resulting from the Following Items:Depreciation3.7 (1.4)2.4 State and Local Income Taxes, Net(1.7)3.4 4.2 AFUDC(2.6)(3.8)(2.1)Parent Company Loss Benefit— (1.8)(6.0)Tax Reform Excess ADIT Reversal(27.2)(27.3)(51.0)Federal Return to Provision6.5 (3.7)0.2 Other— (0.2)2.9 Income Tax Expense$45.2 $34.9 $24.0 Effective Income Tax Rate14.3 %10.5 %6.9 %352PSOYears Ended December 31,202020192018(in millions)Net Income$123.0 $137.6 $83.2 Income Tax Expense5.2 7.5 5.0 Pretax Income$128.2 $145.1 $88.2 Income Taxes on Pretax Income at Statutory Rate (21%)$26.9 $30.5 $18.5 Increase (Decrease) in Income Taxes Resulting from the Following Items:Depreciation1.1 0.6 0.7 Investment Tax Credit Amortization(2.1)(0.5)(1.7)State and Local Income Taxes, Net6.5 6.3 4.8 Parent Company Loss Benefit(0.2)(2.1)(1.4)Tax Reform Excess ADIT Reversal(25.5)(24.5)(15.5)Other(1.5)(2.8)(0.4)Income Tax Expense$5.2 $7.5 $5.0 Effective Income Tax Rate4.1 %5.2 %5.7 %SWEPCoYears Ended December 31,202020192018(in millions)Net Income$183.7 $162.2 $152.2 Less: Equity Earnings – Dolet Hills(2.9)(3.0)(2.7)Income Tax Expense (Benefit)9.4 (4.7)20.4 Pretax Income$190.2 $154.5 $169.9 Income Taxes on Pretax Income at Statutory Rate (21%)$39.9 $32.4 $35.7 Increase (Decrease) in Income Taxes Resulting from the Following Items:Depreciation1.9 1.9 1.9 Depletion(3.4)(3.4)(3.4)State and Local Income Taxes, Net2.7 (1.3)3.2 AFUDC(1.5)(1.4)(1.3)Parent Company Loss Benefit(5.6)(1.6)(0.6)Tax Reform Excess ADIT Reversal(21.9)(29.9)(16.0)Other(2.7)(1.4)0.9 Income Tax Expense (Benefit)$9.4 $(4.7)$20.4 Effective Income Tax Rate4.9 %(3.0)%12.0 %353Net Deferred Tax LiabilityThe following tables show elements of the net deferred tax liability and significant temporary differences for each Registrant:AEPDecember 31,20202019(in millions)Deferred Tax Assets$3,259.7 $3,246.1 Deferred Tax Liabilities(11,500.6)(10,834.3)Net Deferred Tax Liabilities$(8,240.9)$(7,588.2)Property Related Temporary Differences$(7,340.5)$(6,602.9)Amounts Due to Customers for Future Income Taxes1,075.8 1,173.5 Deferred State Income Taxes(1,317.6)(1,198.0)Securitized Assets(140.0)(178.7)Regulatory Assets(391.6)(371.1)Accrued Nuclear Decommissioning(626.4)(557.4)Net Operating Loss Carryforward112.9 77.6 Tax Credit Carryforward323.6 247.2 Operating Lease Liability183.7 182.6 Investment in Partnership(362.0)(446.6)All Other, Net241.2 85.6 Net Deferred Tax Liabilities$(8,240.9)$(7,588.2) AEP TexasDecember 31,20202019(in millions)Deferred Tax Assets$183.6 $220.0 Deferred Tax Liabilities(1,200.3)(1,185.4)Net Deferred Tax Liabilities$(1,016.7)$(965.4)Property Related Temporary Differences$(1,039.6)$(973.5)Amounts Due to Customers for Future Income Taxes114.4 126.7 Deferred State Income Taxes(29.1)(27.5)Securitized Transition Assets(90.2)(124.3)Regulatory Assets(47.4)(51.2)Operating Lease Liability18.0 17.2 All Other, Net57.2 67.2 Net Deferred Tax Liabilities$(1,016.7)$(965.4)AEPTCoDecember 31,20202019(in millions)Deferred Tax Assets$166.5 $162.9 Deferred Tax Liabilities(1,073.4)(980.7)Net Deferred Tax Liabilities$(906.9)$(817.8)Property Related Temporary Differences$(937.8)$(847.1)Amounts Due to Customers for Future Income Taxes118.9 119.9 Deferred State Income Taxes(98.3)(86.1)Net Operating Loss Carryforward13.2 12.3 All Other, Net(2.9)(16.8)Net Deferred Tax Liabilities$(906.9)$(817.8)354APCoDecember 31,20202019(in millions)Deferred Tax Assets$500.6 $486.2 Deferred Tax Liabilities(2,250.5)(2,167.0)Net Deferred Tax Liabilities$(1,749.9)$(1,680.8)Property Related Temporary Differences$(1,412.0)$(1,420.0)Amounts Due to Customers for Future Income Taxes198.3 222.8 Deferred State Income Taxes(336.5)(337.2)Securitized Assets(44.7)(49.3)Regulatory Assets(114.8)(71.0)Operating Lease Liability16.7 16.5 All Other, Net(56.9)(42.6)Net Deferred Tax Liabilities$(1,749.9)$(1,680.8)I&MDecember 31,20202019(in millions)Deferred Tax Assets$989.5 $970.5 Deferred Tax Liabilities(2,053.9)(1,950.2)Net Deferred Tax Liabilities$(1,064.4)$(979.7)Property Related Temporary Differences$(409.2)$(430.7)Amounts Due to Customers for Future Income Taxes147.9 169.6 Deferred State Income Taxes(211.1)(194.4)Regulatory Assets(16.5)(26.9)Accrued Nuclear Decommissioning(626.4)(557.4)Operating Lease Liability46.6 61.9 All Other, Net4.3 (1.8)Net Deferred Tax Liabilities$(1,064.4)$(979.7)OPCoDecember 31,20202019(in millions)Deferred Tax Assets$210.8 $202.3 Deferred Tax Liabilities(1,165.9)(1,051.6)Net Deferred Tax Liabilities$(955.1)$(849.3)Property Related Temporary Differences$(1,016.0)$(890.8)Amounts Due to Customers for Future Income Taxes121.1 130.2 Deferred State Income Taxes(40.7)(35.5)Regulatory Assets(53.7)(48.0)Operating Lease Liability19.4 18.3 All Other, Net14.8 (23.5)Net Deferred Tax Liabilities$(955.1)$(849.3)355PSODecember 31,20202019(in millions)Deferred Tax Assets$239.8 $257.4 Deferred Tax Liabilities(928.3)(885.7)Net Deferred Tax Liabilities$(688.5)$(628.3)Property Related Temporary Differences$(661.8)$(627.6)Amounts Due to Customers for Future Income Taxes118.5 127.2 Deferred State Income Taxes(107.7)(100.4)Regulatory Assets(39.1)(44.6)Net Operating Loss Carryforward12.9 10.2 All Other, Net(11.3)6.9 Net Deferred Tax Liabilities$(688.5)$(628.3)SWEPCoDecember 31,20202019(in millions)Deferred Tax Assets$338.1 $359.6 Deferred Tax Liabilities(1,355.7)(1,300.5)Net Deferred Tax Liabilities$(1,017.6)$(940.9)Property Related Temporary Differences$(985.1)$(947.6)Amounts Due to Customers for Future Income Taxes162.7 169.8 Deferred State Income Taxes(214.7)(200.3)Regulatory Assets(26.2)(30.2)Net Operating Loss Carryforward33.4 38.2 All Other, Net12.3 29.2 Net Deferred Tax Liabilities$(1,017.6)$(940.9)AEP System Tax Allocation AgreementAEP and subsidiaries join in the filing of a consolidated federal income tax return. The allocation of the AEP System’s current consolidated federal income tax to the AEP System companies allocates the benefit of current tax loss of the parent company (Parent Company Loss Benefit) to the AEP System subsidiaries with taxable income reducing their current tax expense proportionately. The consolidated NOL of the AEP System is allocated to each company in the consolidated group with taxable losses. With the exception of the allocation of the consolidated AEP System NOL, the loss of the Parent and tax credits, the method of allocation reflects a separate return result for each company in the consolidated group.Federal Income Tax Audit StatusThe statute of limitations for the IRS to examine AEP and subsidiaries originally filed federal return has expired for tax years 2016 and earlier. In the third quarter of 2019, AEP and subsidiaries elected to amend the 2014 and 2015 federal returns. In the first quarter of 2020, the IRS notified AEP that it was beginning an examination of these amended returns, including the NOL carryback to 2015 that originated in the 2017 return. As of December 31, 2020, the IRS has not challenged any items on these returns and the IRS is limited in their proposed adjustments to the amount AEP claimed on the amended returns.356Net Income Tax Operating Loss CarryforwardAs of December 31, 2020, AEP has no federal net income tax operating loss carryforward. AEP, AEPTCo, I&M, PSO and SWEPCo have state net income tax operating loss carryforwards as indicated in the table below:State Net Income Tax Operating LossYears ofCompanyState/MunicipalityCarryforwardExpiration(in millions)AEPArkansas$87.2 2021-2028AEPKentucky163.7 2030-2037AEPLouisiana466.8 2025-2040AEPOklahoma569.4 2034-2037AEPTennessee31.1 2028-2035AEPVirginia29.4 2025-2037AEPWest Virginia21.9 2029-2037AEPOhio Municipal649.8 2021-2025AEPIndiana145.7 2039AEPColorado95.7 NAAEPPennsylvania56.5 2030-2040AEPNew Jersey60.2 2036-2040AEPIllinois15.6 2031AEP Michigan14.9 2029AEPTCoOklahoma195.4 2034-2037AEPTCoOhio Municipal18.4 2023I&MWest Virginia2.5 2032-2037PSOOklahoma354.5 2034-2037SWEPCoArkansas86.4 2021-2024SWEPCoLouisiana454.3 2032-2037As of December 31, 2020, AEP recorded a valuation allowance of $9 million, against certain state and municipal net income tax operating loss carryforwards since future taxable income is not expected to be sufficient to realize the remaining state net income tax operating loss tax benefits before the carryforward expires. Management anticipates future taxable income will be sufficient to realize the remaining state net income tax operating loss tax benefits before the carryforward expires for each state.Tax Credit CarryforwardFederal and state net income tax operating losses sustained in 2016, 2017 and 2019 resulted in unused federal and state income tax credits. As of December 31, 2020, the Registrants have federal tax credit carryforwards and AEP and PSO have state tax credit carryforwards as indicated in the table below. If these credits are not utilized, federal general business tax credits will expire in the years 2036 through 2040 and state tax credits will remain available indefinitely.Total FederalTotal StateTax CreditTax CreditCompanyCarryforwardCarryforward(in millions)AEP$323.6 $38.4 AEP Texas1.2 — AEPTCo0.1 — APCo1.6 — I&M9.7 — OPCo0.5 — PSO0.5 38.4 SWEPCo1.3 — The Registrants anticipate future federal taxable income will be sufficient to realize the tax benefits of the federal tax credits before they expire unused.357Valuation AllowanceAEP assesses the available positive and negative evidence to estimate whether sufficient future taxable income of the appropriate tax character will be generated to realize the benefits of existing deferred tax assets. When the evaluation of the evidence indicates that AEP will not be able to realize the benefits of existing deferred tax assets, a valuation allowance is recorded to reduce existing deferred tax assets to the net realizable amount. Objective evidence evaluated includes whether AEP has a history of recognizing income, future reversals of existing temporary differences and tax planning strategies. Valuation allowance activity for the years ended December 31, 2020, 2019 and 2018 was immaterial.Uncertain Tax PositionsThe reconciliations of the beginning and ending amounts of unrecognized tax benefits for AEP are presented below. The amount and activity of unrecognized tax benefits for Registrants Subsidiaries was immaterial for periods presented:AEP202020192018(in millions)Balance as of January 1, $24.1 $14.6 $86.6 Increase – Tax Positions Taken During a Prior Period0.6 8.8 0.1 Decrease – Tax Positions Taken During a Prior Period(14.5)(2.1)— Increase – Tax Positions Taken During the Current Year3.0 2.8 — Decrease – Tax Positions Taken During the Current Year— — — Decrease – Settlements with Taxing Authorities— — (71.0)Decrease – Lapse of the Applicable Statute of Limitations— — (1.1)Balance as of December 31, $13.2 $24.1 $14.6 Management believes that there will be no significant net increase or decrease in unrecognized benefits within 12 months of the reporting date. The total amount of unrecognized tax benefits that, if recognized, would affect the effective tax rate for AEP as of December 31, 2020, 2019 and 2018 were $12 million, $20 million and $12 million, respectively.Federal Tax LegislationIn March 2020, the CARES Act was signed into law. The CARES Act includes tax relief provisions such as: (a) an AMT Credit Refund, (b) a 5-year NOL carryback from years 2018-2020 and (c) delayed payment of employer payroll taxes. Pursuant to the CARES Act, AEP, APCo and OPCo requested and in July received refunds of AMT credit of $20 million, $7 million and $9 million, respectively. In the third quarter of 2020, AEP also requested a $95 million refund of taxes paid in 2014 under the 5-year NOL carryback provision of the CARES Act. AEP carried back a NOL generated on the 2019 Federal income tax return at a 21% federal corporate income tax rate to the 2014 Federal income tax return at a 35% corporate income tax rate. As a result of the change in the corporate income tax rates between the two periods, AEP realized a tax benefit of $48 million primarily at the Generation & Marketing segment. Management will continue to monitor potential legislation and any impacts to the AMT Credit and NOL refunds that were filed in 2020 pursuant to the CARES Act.In December 2020, the CAA of 2021 was signed into law. The CAA of 2021 includes: (a) COVID-19 tax relief and tax extender provisions including extensions of time to begin construction on and placed in-service assets generating PTCs and ITCs, (b) 100% deductibility of business meals in 2021 and 2022 and (c) an extension of the work opportunity tax credit. The ITC percentage has been increased for projects starting construction through 2023 and placed in-service by the end of 2025. The PTC has been extended for an additional year, to include projects started in 2021 and completed in 2025. These provisions provide time and flexibility on the construction start and in-service dates.358In September and November 2020, the IRS issued final regulations that provide guidance regarding the additional first-year depreciation deduction under Section 168(k). The final regulations reflect changes as a result of Tax Reform, which affects taxpayers with qualified depreciable property acquired and placed in-service after September 27, 2017. Generally, AEP’s regulated utilities will not be eligible for any bonus depreciation for property acquired and placed in-service after December 31, 2017. AEP’s competitive businesses will be eligible for 100% expensing.The IRS issued final regulations in 2020 that provide guidance concerning potential limitations on the deduction of business interest expense. These regulations require an allocation of net interest expense between regulated and competitive businesses within the consolidated tax return. This allocation is based upon net tax basis, and the proposed regulations provide de minimis tests under which all interest is deductible if less than 10% is allocable to the competitive businesses. AEP will deduct materially all business interest expense under this de minimis provision.On December 30, 2020, the IRS issued regulations that provide guidance on the non-deductibility of certain executives compensation above $1 million under Internal Revenue Code Section 162(m). The regulations clarify the application of rules passed under Tax Reform that expanded the application of Section 162(m) to SEC registered companies that issue either public equity or debt. These rules also expanded the type of compensation and the number of executives subject to this deduction disallowance. AEP limits certain executives’ compensation to the $1 million limitation on its federal income tax return.35913. LEASES The disclosures in this note apply to all Registrants unless indicated otherwise. Management adopted ASU 2016-02 effective January 1, 2019 by means of a cumulative-effect adjustment to the balance sheets.The Registrants lease property, plant and equipment including, but not limited to, fleet, information technology and real estate leases. These leases require payments of non-lease components, including related property taxes, operating and maintenance costs. AEP does not separate non-lease components from associated lease components. Many of these leases have purchase or renewal options. Leases not renewed are often replaced by other leases. Options to renew or purchase a lease are included in the measurement of lease assets and liabilities if it is reasonably certain the Registrant will exercise the option. Lease obligations are measured using the discount rate implicit in the lease when that rate is readily determinable. AEP has visibility into the rate implicit in the lease when assets are leased from selected financial institutions under master leasing agreements. When the implicit rate is not readily determinable, the Registrants measure their lease obligation using their estimated secured incremental borrowing rate. Incremental borrowing rates are comprised of an underlying risk-free rate and a secured credit spread relative to the lessee on a matched maturity basis.Operating lease rentals and finance lease amortization costs are generally charged to Other Operation and Maintenance expense in accordance with rate-making treatment for regulated operations. Effective in 2019, interest on finance lease liabilities is generally charged to Interest Expense. Finance lease interest for periods prior to 2019 were charged to Other Operation and Maintenance expense. Lease costs associated with capital projects are included in Property, Plant and Equipment on the balance sheets. For regulated operations with finance leases, a finance lease asset and offsetting liability are recorded at the present value of the remaining lease payments for each reporting period. Finance leases for nonregulated property are accounted for as if the assets were owned and financed. The components of rental costs were as follows: Year Ended December 31, 2020AEPAEP TexasAEPTCoAPCoI&MOPCoPSOSWEPCo(in millions)Operating Lease Cost $279.6 $17.4 $2.6 $19.1 $101.5 $17.1 $7.8 $9.4 Finance Lease Cost:Amortization of Right-of-Use Assets61.9 6.3 — 7.4 6.5 4.7 3.5 10.9 Interest on Lease Liabilities 15.4 1.5 — 2.7 3.1 0.9 0.7 2.2 Total Lease Rental Costs (a)$356.9 $25.2 $2.6 $29.2 $111.1 $22.7 $12.0 $22.5 Year Ended December 31, 2019AEPAEP TexasAEPTCoAPCoI&MOPCoPSOSWEPCo(in millions)Operating Lease Cost $286.0 $16.5 $2.5 $19.5 $93.1 $18.0 $6.8 $8.0 Finance Lease Cost:Amortization of Right-of-Use Assets 70.8 5.1 0.1 6.7 5.7 3.5 3.1 11.0 Interest on Lease Liabilities 16.4 1.4 — 2.9 2.9 0.7 0.6 2.9 Total Lease Rental Costs (a)$373.2 $23.0 $2.6 $29.1 $101.7 $22.2 $10.5 $21.9 Year Ended December 31, 2018AEPAEP TexasAEPTCoAPCoI&MOPCoPSOSWEPCo(in millions)Operating Lease Cost $245.0 $13.6 $2.7 $18.2 $89.2 $10.7 $5.7 $6.5 Finance Lease Cost:Amortization of Right-of-Use Assets 62.4 4.8 0.1 7.0 6.6 3.9 3.2 11.2 Interest on Lease Liabilities 16.4 1.2 — 3.0 3.3 0.5 0.4 3.2 Total Lease Rental Costs$323.8 $19.6 $2.8 $28.2 $99.1 $15.1 $9.3 $20.9 (a)Excludes variable and short-term lease costs, which were immaterial for the twelve months ended December 31, 2020 and December 31, 2019.360Supplemental information related to leases are shown in the tables below:December 31, 2020AEPAEP Texas AEPTCoAPCoI&MOPCoPSOSWEPCoWeighted-Average Remaining Lease Term (years):Operating Leases5.306.512.016.273.507.447.037.54Finance Leases5.436.070.005.755.795.906.164.95Weighted-Average Discount Rate:Operating Leases3.44 %3.60 %1.51 %3.48 %3.42 %3.60 %3.39 %3.45 %Finance Leases5.68 %4.39 %— %7.33 %8.29 %4.25 %4.35 %4.77 %December 31, 2019AEPAEP Texas AEPTCoAPCoI&MOPCoPSOSWEPCoWeighted-Average Remaining Lease Term (years):Operating Leases5.236.932.256.283.917.947.076.64Finance Leases5.856.690.256.126.556.496.235.16Weighted-Average Discount Rate:Operating Leases3.60 %3.77 %3.14 %3.64 %3.45 %3.76 %3.64 %3.76 %Finance Leases5.98 %4.62 %9.33 %8.08 %8.47 %4.54 %4.62 %5.01 %Year Ended December 31, 2020AEPAEP Texas AEPTCoAPCoI&MOPCoPSOSWEPCo(in millions)Cash paid for amounts included in the measurement of lease liabilities: Operating Cash Flows Used for Operating Leases$280.3 $17.1 $2.6 $19.2 $102.2 $16.9 $7.7 $9.4 Operating Cash Flows Used for Finance Leases15.4 1.5 — 2.7 3.1 0.9 0.7 2.2 Financing Cash Flows Used for Finance Leases61.7 6.3 — 7.4 6.5 4.7 3.5 10.9 Non-cash Acquisitions Under Operating Leases$161.7 $15.8 $1.8 $16.2 $18.1 $18.1 $12.3 $18.4 Year Ended December 31, 2019AEPAEP Texas AEPTCoAPCoI&MOPCoPSOSWEPCo(in millions)Cash paid for amounts included in the measurement of lease liabilities: Operating Cash Flows Used for Operating Leases$284.7 $15.3 $2.4 $19.0 $94.3 $18.0 $6.7 $7.9 Operating Cash Flows Used for Finance Leases16.4 1.4 — 2.9 3.1 0.7 0.6 3.0 Financing Cash Flows Used for Finance Leases70.7 5.1 — 6.7 5.7 3.5 3.1 11.0 Non-cash Acquisitions Under Operating Leases$125.0 $13.8 $0.6 $10.2 $18.7 $35.4 $8.2 $11.4 361The following tables show property, plant and equipment under finance leases and noncurrent assets under operating leases and related obligations recorded on the balance sheets. Unless shown as a separate line on the balance sheets due to materiality, net operating lease assets are included in Deferred Charges and Other Noncurrent Assets, current finance lease obligations are included in Other Current Liabilities and long-term finance lease obligations are included in Deferred Credits and Other Noncurrent Liabilities on the balance sheets. Lease obligations are not recognized on the balance sheets for lease agreements with a lease term of less than twelve months.December 31, 2020AEPAEP TexasAEPTCoAPCoI&MOPCoPSOSWEPCo(in millions)Property, Plant and Equipment Under Finance Leases:Generation$138.2 $— $— $42.8 $28.8 $— $0.7 $37.7 Other Property, Plant and Equipment322.8 49.7 — 20.3 40.2 31.4 23.0 52.4 Total Property, Plant and Equipment461.0 49.7 — 63.1 69.0 31.4 23.7 90.1 Accumulated Amortization176.8 16.6 — 21.4 27.3 9.8 8.7 36.5 Net Property, Plant and Equipment Under Finance Leases$284.2 $33.1 $— $41.7 $41.7 $21.6 $15.0 $53.6 Obligations Under Finance Leases:Noncurrent Liability$231.0 $26.8 $— $34.4 $35.3 $16.9 $11.9 $44.6 Liability Due Within One Year58.1 6.3 — 7.3 6.4 4.7 3.1 10.7 Total Obligations Under Finance Leases$289.1 $33.1 $— $41.7 $41.7 $21.6 $15.0 $55.3 December 31, 2019AEPAEP TexasAEPTCoAPCoI&MOPCoPSOSWEPCo(in millions)Property, Plant and Equipment Under Finance Leases:Generation$131.6 $— $— $39.9 $28.8 $— $0.6 $34.1 Other Property, Plant and Equipment323.0 45.9 0.2 18.9 39.3 27.3 21.6 51.6 Total Property, Plant and Equipment454.6 45.9 0.2 58.8 68.1 27.3 22.2 85.7 Accumulated Amortization151.5 11.8 0.2 17.0 23.0 7.2 7.1 28.4 Net Property, Plant and Equipment Under Finance Leases$303.1 $34.1 $— $41.8 $45.1 $20.1 $15.1 $57.3 Obligations Under Finance Leases:Noncurrent Liability$249.2 $28.2 $— $35.0 $38.8 $16.2 $11.9 $47.1 Liability Due Within One Year57.6 5.9 — 6.8 6.3 3.9 3.2 10.5 Total Obligations Under Finance Leases$306.8 $34.1 $— $41.8 $45.1 $20.1 $15.1 $57.6 362December 31, 2020AEPAEP TexasAEPTCoAPCoI&MOPCoPSOSWEPCo(in millions)Operating Lease Assets$866.4 $84.1 $1.6 $78.8 $218.1 $92.0 $42.6 $48.5 Obligations Under Operating Leases:Noncurrent Liability$638.4 $71.0 $0.4 $64.4 $135.9 $79.5 $36.2 $44.1 Liability Due Within One Year241.3 14.5 1.2 14.9 85.6 13.1 6.5 7.9 Total Obligations Under Operating Leases$879.7 $85.5 $1.6 $79.3 $221.5 $92.6 $42.7 $52.0 December 31, 2019AEPAEP TexasAEPTCoAPCoI&MOPCoPSOSWEPCo(in millions)Operating Lease Assets$957.4 $81.8 $3.8 $78.5 $294.9 $88.0 $36.8 $40.5 Obligations Under Operating Leases:Noncurrent Liability$734.6 $71.1 $1.9 $64.0 $211.6 $76.0 $31.0 $34.7 Liability Due Within One Year234.1 12.0 2.1 15.2 87.3 12.5 5.8 6.5 Total Obligations Under Operating Leases$968.7 $83.1 $4.0 $79.2 $298.9 $88.5 $36.8 $41.2 Future minimum lease payments consisted of the following as of December 31, 2020:Finance LeasesAEPAEP Texas AEPTCoAPCoI&MOPCoPSOSWEPCo(in millions)2021$72.2 $7.6 $— $9.9 $9.3 $5.5 $3.6 $13.1 202264.0 6.9 — 9.4 8.6 4.6 3.1 11.8 202356.2 6.2 — 8.7 7.9 3.9 2.7 10.9 202463.5 5.4 — 8.1 11.1 3.3 2.3 15.3 202532.7 4.0 — 7.0 5.5 2.2 1.6 5.7 Later Years48.9 7.8 — 6.4 12.2 4.9 3.8 5.8 Total Future Minimum Lease Payments337.5 37.9 — 49.5 54.6 24.4 17.1 62.6 Less: Imputed Interest48.4 4.8 — 7.8 12.9 2.8 2.1 7.3 Estimated Present Value of Future Minimum Lease Payments$289.1 $33.1 $— $41.7 $41.7 $21.6 $15.0 $55.3 Operating LeasesAEPAEP Texas AEPTCoAPCoI&MOPCoPSOSWEPCo(in millions)2021$270.8 $17.5 $1.2 $17.7 $92.5 $16.6 $7.9 $10.1 2022263.3 16.4 0.2 17.0 92.5 16.0 7.6 9.6 202394.2 14.8 0.1 14.2 11.4 14.9 7.3 8.4 202481.6 13.3 0.1 11.3 10.0 13.2 6.5 6.9 202568.0 10.9 — 8.5 8.9 11.5 5.4 5.8 Later Years193.0 23.9 — 20.0 21.8 34.0 13.3 17.4 Total Future Minimum Lease Payments970.9 96.8 1.6 88.7 237.1 106.2 48.0 58.2 Less: Imputed Interest91.2 11.3 — 9.4 15.6 13.6 5.3 6.2 Estimated Present Value of Future Minimum Lease Payments$879.7 $85.5 $1.6 $79.3 $221.5 $92.6 $42.7 $52.0 363Future minimum lease payments consisted of the following as of December 31, 2019:Finance LeasesAEPAEP Texas AEPTCoAPCoI&MOPCoPSOSWEPCo(in millions)2020$72.7 $7.3 $— $9.6 $9.4 $4.7 $3.8 $12.9 202164.9 6.7 — 8.9 8.7 4.3 3.2 11.9 202256.4 6.0 — 8.2 8.0 3.4 2.6 10.6 202349.6 5.4 — 7.7 7.5 2.8 2.3 9.8 202457.4 4.6 — 7.1 10.8 2.4 1.8 14.2 Later Years64.4 9.8 — 9.8 16.4 5.7 3.8 6.8 Total Future Minimum Lease Payments365.4 39.8 — 51.3 60.8 23.3 17.5 66.2 Less: Imputed Interest58.6 5.7 — 9.5 15.7 3.2 2.4 8.6 Estimated Present Value of Future Minimum Lease Payments$306.8 $34.1 $— $41.8 $45.1 $20.1 $15.1 $57.6 Operating LeasesAEPAEP Texas AEPTCoAPCoI&MOPCoPSOSWEPCo(in millions)2020$269.9 $16.0 $2.2 $18.3 $97.0 $16.2 $7.3 $8.6 2021253.6 15.3 1.2 15.7 92.9 14.2 6.4 8.2 2022245.6 14.2 0.6 14.7 92.8 13.5 6.0 7.6 202374.8 13.0 0.1 11.9 10.1 12.3 5.6 6.4 202462.0 11.4 — 9.0 8.6 10.7 4.8 5.0 Later Years169.7 26.0 — 20.0 21.0 36.5 12.0 11.8 Total Future Minimum Lease Payments1,075.6 95.9 4.1 89.6 322.4 103.4 42.1 47.6 Less: Imputed Interest106.9 12.8 0.1 10.4 23.5 14.9 5.3 6.4 Estimated Present Value of Future Minimum Lease Payments$968.7 $83.1 $4.0 $79.2 $298.9 $88.5 $36.8 $41.2 Master Lease Agreements (Applies to all Registrants except AEPTCo)The Registrants lease certain equipment under master lease agreements. Under the lease agreements, the lessor is guaranteed a residual value up to a stated percentage of the equipment cost at the end of the lease term. If the actual fair value of the leased equipment is below the guaranteed residual value at the end of the lease term, the Registrants are committed to pay the difference between the actual fair value and the residual value guarantee. Historically, at the end of the lease term the fair value has been in excess of the amount guaranteed. As of December 31, 2020, the maximum potential loss by the Registrants for these lease agreements assuming the fair value of the equipment is zero at the end of the lease term was as follows:CompanyMaximumPotential Loss(in millions)AEP$50.3 AEP Texas11.7 APCo6.6 I&M4.4 OPCo8.1 PSO4.8 SWEPCo5.4 364Rockport Lease (Applies to AEP and I&M)AEGCo and I&M entered into a sale-and-leaseback transaction in 1989 with Wilmington Trust Company (Owner Trustee), an unrelated, unconsolidated trustee for Rockport Plant, Unit 2 (the Plant). The Owner Trustee was capitalized with equity from six owner participants with no relationship to AEP or any of its subsidiaries and debt from a syndicate of banks and securities in a private placement to certain institutional investors. In the first quarter of 2019, in accordance with ASU 2016-02, the $37 million unamortized gain ($15 million related to I&M) associated with the sale-and-leaseback of the Plant was recognized as an adjustment to equity. The adjustment to equity was then reclassified to regulatory liabilities in accordance with accounting guidance for “Regulated Operations” as AEGCo and I&M will continue to provide the benefit of the unamortized gain to customers in future periods. The Owner Trustee owns the Plant and leases equal portions to AEGCo and I&M. The lease is accounted for as an operating lease with the payment obligations included in the future minimum lease payments schedule earlier in this note. The lease term is for 33 years and at the end of the lease term, AEGCo and I&M have the option to renew the lease at a rate that approximates fair value. In November 2020, management announced that AEP will not renew the lease when it expires in 2022. AEP, AEGCo and I&M have no ownership interest in the Owner Trustee and do not guarantee its debt. The future minimum lease payments for this sale-and-leaseback transaction as of December 31, 2020 were as follows:Future Minimum Lease PaymentsAEP (a)I&M(in millions)2021$147.8 $73.9 2022147.6 73.8 Total Future Minimum Lease Payments$295.4 $147.7 (a) AEP’s future minimum lease payments include equal shares from AEGCo and I&M.AEPRO Boat and Barge Leases (Applies to AEP)In 2015, AEP sold its commercial barge transportation subsidiary, AEPRO, to a nonaffiliated party. Certain boat and barge leases acquired by the nonaffiliated party are subject to an AEP guarantee in favor of the respective lessors, ensuring future payments under such leases with maturities up to 2027. As of December 31, 2020, the maximum potential amount of future payments required under the guaranteed leases was $48 million. Under the terms of certain of the arrangements, upon the lessors exercising their rights after an event of default by the nonaffiliated party, AEP is entitled to enter into new lease arrangements as a lessee that would have substantially the same terms as the existing leases. Alternatively, for the arrangements with one of the lessors, upon an event of default by the nonaffiliated party and the lessor exercising its rights, payment to the lessor would allow AEP to step into the lessor’s rights as well as obtaining title to the assets. Under either situation, AEP would have the ability to utilize the assets in the normal course of barging operations. AEP would also have the right to sell the acquired assets for which it obtained title. As of December 31, 2020, AEP’s boat and barge lease guarantee liability was $3 million, of which $1 million was recorded in Other Current Liabilities and $2 million was recorded in Deferred Credits and Other Noncurrent Liabilities on AEP’s balance sheet.In February 2020, the nonaffiliated party filed Chapter 11 bankruptcy. The party entered into a restructuring support agreement and has announced it expects to continue their operations as normal. In March 2020, the bankruptcy court approved the party’s recapitalization plan. In April 2020, the nonaffiliated party emerged from bankruptcy. Management has determined that it is reasonably possible that enforcement of AEP’s liability for future payments under these leases will be exercised within the next twelve months. In such an event, if AEP is unable to sell or incorporate any of the acquired assets into its fleet operations, it could reduce future net income and cash flows and impact financial condition.Lessor ActivityThe Registrants’ lessor activity was immaterial as of and for the twelve months ended December 31, 2020 and December 31, 2019, respectively.36514. FINANCING ACTIVITIESThe disclosures in this note apply to all Registrants, unless indicated otherwise.Common Stock (Applies to AEP)The following table is a reconciliation of common stock share activity:Shares of AEP Common StockIssuedHeld in TreasuryBalance, December 31, 2017512,210,644 20,205,046 Issued1,239,392 — Treasury Stock Reissued— (886)(a)Balance, December 31, 2018513,450,036 20,204,160 Issued923,595 — Balance, December 31, 2019514,373,631 20,204,160 Issued2,434,723 — Balance, December 31, 2020516,808,354 20,204,160 (a) Reissued Treasury Stock used to fulfill share commitments related to AEP’s Share-based Compensation. See “Shared-based Compensation Plans” section of Note 15 for additional information.At-the-Market (ATM) ProgramIn November 2020, AEP filed a prospectus supplement and executed an Equity Distribution Agreement (EDA), pursuant to which AEP may sell, from time to time, up to an aggregate of $1 billion of its common stock through an ATM offering program, including an equity forward sales component. The compensation paid to the selling agents by AEP may be up to 2% of the gross offering proceeds of the shares. There were no issuances under the ATM program for the year ended December 31, 2020.Reverse Stock Split (Applies to SWEPCo)In August 2020, SWEPCo executed a reverse stock split with each 2,048 shares of common stock issued and outstanding being combined into one share of common stock. The common stock of SWEPCo is wholly-owned by Parent.366Long-term DebtThe following table details long-term debt outstanding:Weighted-AverageInterest Rate Ranges as ofOutstanding as ofInterest Rate as ofDecember 31,December 31,CompanyMaturityDecember 31, 20202020201920202019AEP(in millions)Senior Unsecured Notes2020-20503.97%0.70%-8.13%2.15%-8.13%$25,116.1 $21,180.7 Pollution Control Bonds (a)2020-2036 (b)2.39%0.18%-4.63%1.35%-5.38%1,936.7 1,998.8 Notes Payable – Nonaffiliated (c)2020-20322.34%0.84%-6.37%2.42%-6.37%239.1 234.3 Securitization Bonds2020-2029 (d)2.78%2.01%-3.77%1.98%-5.31%716.4 1,025.1 Spent Nuclear Fuel Obligation (e)281.2 279.8 Junior Subordinated Notes (f)2022-20232.32%1.30%-3.40%3.40%1,624.1 787.8 Other Long-term Debt2020-20591.59%0.81%-13.72%1.15%-13.718%1,158.9 1,219.0 Total Long-term Debt Outstanding$31,072.5 $26,725.5 AEP TexasSenior Unsecured Notes2022-20503.70%2.10%-6.76%2.40%-6.76%$3,687.6 $3,090.9 Pollution Control Bonds2020-2030 (b)3.42%0.90%-4.55%1.75%-4.55%439.7 490.3 Securitization Bonds2020-2029 (d)2.55%2.06%-2.84%1.98%-5.31%492.6 776.8 Other Long-term Debt2022-20591.41%1.40%-4.50%3.05%-4.50%200.5 200.4 Total Long-term Debt Outstanding$4,820.4 $4,558.4 AEPTCoSenior Unsecured Notes2021-20503.83%3.10%-5.52%3.10%-5.52%$3,948.5 $3,427.3 Total Long-term Debt Outstanding$3,948.5 $3,427.3 APCoSenior Unsecured Notes2021-20504.94%3.30%-7.00%3.30%-7.00%$3,937.2 $3,442.7 Pollution Control Bonds (a)2020-2036 (b)1.77%0.19%-4.63%1.67%-5.38%546.3 546.1 Securitization Bonds2023-2028 (d)3.29%2.01%-3.77%2.008%-3.772%223.8 248.3 Other Long-term Debt2022-20261.51%1.32%-13.72%2.97%-13.718%126.8 126.7 Total Long-term Debt Outstanding$4,834.1 $4,363.8 I&MSenior Unsecured Notes2023-20484.38%3.20%-6.05%3.20%-6.05%$2,152.2 $2,150.7 Pollution Control Bonds (a)2021-2025 (b)2.21%0.18%-3.05%1.79%-3.05%240.5 240.0 Notes Payable – Nonaffiliated (c)2020-20251.06%0.84%-1.29%2.42%-2.80%146.7 168.7 Spent Nuclear Fuel Obligation (e)281.2 279.8 Other Long-term Debt2021-20251.49%1.28%-6.00%2.93%-6.00%209.3 211.0 Total Long-term Debt Outstanding$3,029.9 $3,050.2 OPCoSenior Unsecured Notes2021-20494.82%2.60%-6.60%4.00%-6.60%$2,429.4 $2,081.0 Other Long-term Debt20281.15%1.15%1.15%0.8 1.0 Total Long-term Debt Outstanding$2,430.2 $2,082.0 PSOSenior Unsecured Notes2021-20494.55%3.05%-6.63%3.05%-6.625%$1,246.3 $1,245.6 Pollution Control Bonds20204.45%— 12.7 Other Long-term Debt2022-20271.47%1.42%-3.00%3.00%-3.20%127.5 127.9 Total Long-term Debt Outstanding$1,373.8 $1,386.2 SWEPCoSenior Unsecured Notes2022-20484.04%2.75%-6.20%2.75%-6.20%$2,430.8 $2,428.9 Notes Payable – Nonaffiliated (c)2024-20325.30%4.58%-6.37%4.58%-6.37%62.4 65.6 Other Long-term Debt2021-20352.99%2.25%-4.68%3.08%-4.68%143.2 161.1 Total Long-term Debt Outstanding$2,636.4 $2,655.6 (a)For certain series of Pollution Control Bonds, interest rates are subject to periodic adjustment. Certain series may be purchased on demand at periodic interest adjustment dates. Letters of credit from banks and insurance policies support certain series. Consequently, these bonds have been classified for maturity purposes as Long-term Debt Due Within One Year - Nonaffiliated on the balance sheets.(b)Certain Pollution Control Bonds are subject to redemption earlier than the maturity date.(c)Notes payable represent outstanding promissory notes issued under term loan agreements and credit agreements with a number of banks and other financial institutions. At expiration, all notes then issued and outstanding are due and payable. Interest rates are both fixed and variable. Variable rates generally relate to specified short-term interest rates.(d)Dates represent the scheduled final payment dates for the securitization bonds. The legal maturity date is one to two years later. These bonds have been classified for maturity and repayment purposes based on the scheduled final payment date.(e)Spent Nuclear Fuel Obligation consists of a liability along with accrued interest for disposal of SNF. See “Spent Nuclear Fuel Disposal” section of Note 6 for additional information.(f)See “Equity Units” section below for additional information.367As of December 31, 2020, outstanding long-term debt was payable as follows:AEPAEP TexasAEPTCoAPCoI&MOPCoPSOSWEPCo(in millions)2021$2,086.1 $88.7 $50.0 $518.3 $369.6 $500.1 $0.5 $106.2 20223,538.4 (a)716.0 104.0 355.4 45.1 0.1 375.5 281.2 20232,659.3 (b)278.5 60.0 26.6 273.9 0.1 0.5 6.2 2024723.4 96.0 95.0 113.5 8.1 0.1 0.6 31.2 20251,726.3 324.5 90.0 443.9 151.5 0.1 125.6 6.2 After 202520,599.2 3,357.0 3,591.0 3,418.3 2,206.2 1,950.3 875.8 2,225.5 Principal Amount31,332.7 4,860.7 3,990.0 4,876.0 3,054.4 2,450.8 1,378.5 2,656.5 Unamortized Discount, Net and Debt Issuance Costs(260.2)(40.3)(41.5)(41.9)(24.5)(20.6)(4.7)(20.1)Total Long-term Debt Outstanding$31,072.5 $4,820.4 $3,948.5 $4,834.1 $3,029.9 $2,430.2 $1,373.8 $2,636.4 (a) Amount includes $805 million of Junior Subordinated Notes. See “Equity Units” section below for additional information.(b) Amount includes $850 million of Junior Subordinated Notes. See “Equity Units” section below for additional information.Long-term Debt Subsequent EventsIn January and February 2021, I&M retired $8 million and $7 million, respectively, of Notes Payable related to DCC Fuel.In January 2021, OPCo issued $450 million of Senior Unsecured Notes.In January 2021, PSO issued $400 million of variable rate Other Long-term Debt due in 2022, which it used to retire $250 million of Senior Unsecured Notes in February 2021.In January and February 2021, Transource Energy issued $5 million and $9 million, respectively, of variable rate Other Long-term Debt due in 2023.In February 2021, AEP Texas retired $11 million of Securitization Bonds.In February 2021, APCo retired $12 million of Securitization Bonds.Equity Units (Applies to AEP)2020 Equity UnitsIn August 2020, AEP issued 17 million Equity Units initially in the form of corporate units, at a stated amount of $50 per unit, for a total stated amount of $850 million. Net proceeds from the issuance were approximately $833 million. The proceeds were used to support AEP’s overall capital expenditure plans.Each corporate unit represents a 1/20 undivided beneficial ownership interest in $1,000 principal amount of AEP’s 1.30% Junior Subordinated Notes (notes) due in 2025 and a forward equity purchase contract which settles after three years in 2023. The notes are expected to be remarketed in 2023, at which time the interest rate will reset at the then-current market rate. Investors may choose to remarket their notes to receive the remarketing proceeds and use those funds to settle the forward equity purchase contract, or accept the remarketed debt and use other funds for the equity purchase. If the remarketing is unsuccessful, investors have the right to put their notes to AEP at a price equal to the principal. The Equity Units carry an annual distribution rate of 6.125%, which is comprised of a quarterly coupon rate of interest of 1.30% and a quarterly forward equity purchase contract payment of 4.825%.368Each forward equity purchase contract obligates the holder to purchase, and AEP to sell, for $50 a number of shares in common stock in accordance with the conversion ratios set forth below (subject to an anti-dilution adjustment):•If the AEP common stock market price is equal to or greater than $99.95: 0.5003 shares per contract.•If the AEP common stock market price is less than $99.95 but greater than $83.29: a number of shares per contract equal to $50 divided by the applicable market price. The holder receives a variable number of shares at $50.•If the AEP common stock market price is less than or equal to $83.29: 0.6003 shares per contract.A holder’s ownership interest in the notes is pledged to AEP to secure the holder’s obligation under the related forward equity purchase contract. If a holder of the forward equity purchase contract chooses at any time to no longer be a holder of the notes, such holder’s obligation under the forward equity purchase contract must be secured by a U.S. Treasury security which must be equal to the aggregate principal amount of the notes.At the time of issuance, the $850 million of notes were recorded within Long-term Debt on the balance sheets. The present value of the purchase contract payments of $121 million were recorded in Deferred Credits and Other Noncurrent Liabilities with a current portion in Other Current Liabilities at the time of issuance, representing the obligation to make forward equity contract payments, with an offsetting reduction to Paid-in Capital. The difference between the face value and present value of the purchase contract payments will be accreted to Interest Expense on the statements of income over the three year period ending in 2023. The liability recorded for the contract payments is considered non-cash and excluded from the statements of cash flows. Until settlement of the forward equity purchase contract, earnings per-share dilution resulting from the equity unit issuance will be determined under the treasury stock method. The maximum amount of shares AEP will be required to issue to settle the purchase contract is 10,205,100 shares (subject to an anti-dilution adjustment).2019 Equity UnitsIn March 2019, AEP issued 16.1 million Equity Units initially in the form of corporate units, at a stated amount of $50 per unit, for a total stated amount of $805 million. Net proceeds from the issuance were approximately $785 million. The proceeds were used to support AEP’s overall capital expenditure plans including the acquisition of Sempra Renewables LLC.Each corporate unit represents a 1/20 undivided beneficial ownership interest in $1,000 principal amount of AEP’s 3.40% Junior Subordinated Notes (notes) due in 2024 and a forward equity purchase contract which settles after three years in 2022. The notes are expected to be remarketed in 2022, at which time the interest rate will reset at the then-current market rate. Investors may choose to remarket their notes to receive the remarketing proceeds and use those funds to settle the forward equity purchase contract, or accept the remarketed debt and use other funds for the equity purchase. If the remarketing is unsuccessful, investors have the right to put their notes to AEP at a price equal to the principal. The Equity Units carry an annual distribution rate of 6.125%, which is comprised of a quarterly coupon rate of interest of 3.40% and a quarterly forward equity purchase contract payment of 2.725%.Each forward equity purchase contract obligates the holder to purchase, and AEP to sell, for $50 a number of shares in common stock in accordance with the conversion ratios set forth below (subject to an anti-dilution adjustment):•If the AEP common stock market price is equal to or greater than $99.58: 0.5021 shares per contract.•If the AEP common stock market price is less than $99.58 but greater than $82.98: a number of shares per contract equal to $50 divided by the applicable market price. The holder receives a variable number of shares at $50.•If the AEP common stock market price is less than or equal to $82.98: 0.6026 shares per contract.A holder’s ownership interest in the notes is pledged to AEP to secure the holder’s obligation under the related forward equity purchase contract. If a holder of the forward equity purchase contract chooses at any time to no longer be a holder of the notes, such holder’s obligation under the forward equity purchase contract must be secured by a U.S. Treasury security which must be equal to the aggregate principal amount of the notes.369At the time of issuance, the $805 million of notes were recorded within Long-term Debt on the balance sheets. The present value of the purchase contract payments of $62 million were recorded in Deferred Credits and Other Noncurrent Liabilities with a current portion in Other Current Liabilities at the time of issuance, representing the obligation to make forward equity contract payments, with an offsetting reduction to Paid-in Capital. The difference between the face value and present value of the purchase contract payments will be accreted to Interest Expense on the statements of income over the three year period ending in 2022. The liability recorded for the contract payments is considered non-cash and excluded from the statements of cash flows. Until settlement of the forward equity purchase contract, earnings per-share dilution resulting from the equity unit issuance will be determined under the treasury stock method. The maximum amount of shares AEP will be required to issue to settle the purchase contract is 9,701,860 shares (subject to an anti-dilution adjustment).Debt Covenants (Applies to AEP and AEPTCo)Covenants in AEPTCo’s note purchase agreements and indenture limit the amount of contractually-defined priority debt (which includes a further sub-limit of $50 million of secured debt) to 10% of consolidated tangible net assets. AEPTCo’s contractually-defined priority debt was 1.6% of consolidated tangible net assets as of December 31, 2020. The method for calculating the consolidated tangible net assets is contractually-defined in the note purchase agreement.Dividend RestrictionsUtility Subsidiaries’ RestrictionsParent depends on its utility subsidiaries to pay dividends to shareholders. AEP utility subsidiaries pay dividends to Parent provided funds are legally available. Various financing arrangements and regulatory requirements may impose certain restrictions on the ability of the subsidiaries to transfer funds to Parent in the form of dividends.All of the dividends declared by AEP’s utility subsidiaries that provide transmission or local distribution services are subject to a Federal Power Act restriction that prohibits the payment of dividends out of capital accounts without regulatory approval; payment of dividends is allowed out of retained earnings only. The Federal Power Act also creates a reserve on retained earnings attributable to hydroelectric generation plants. Because of their ownership of such plants, this reserve applies to AGR, APCo and I&M.Certain AEP subsidiaries have credit agreements that contain covenants that limit their debt to capitalization ratio to 67.5%. The method for calculating outstanding debt and capitalization is contractually-defined in the credit agreements.The most restrictive dividend limitation for certain AEP subsidiaries is through the Federal Power Act restriction, while for other AEP subsidiaries the most restrictive dividend limitation is through the credit agreements. As of December 31, 2020, the maximum amount of restricted net assets of AEP’s subsidiaries that may not be distributed to the Parent in the form of a loan, advance or dividend was $14 billion.The Federal Power Act restriction limits the ability of the AEP subsidiaries owning hydroelectric generation to pay dividends out of retained earnings. Additionally, the credit agreement covenant restrictions can limit the ability of the AEP subsidiaries to pay dividends out of retained earnings. As of December 31, 2020, the amount of any such restrictions were as follows:AEPAEP TexasAEPTCoAPCoI&MOPCoPSOSWEPCo(in millions)Restricted Retained Earnings$2,369.5 (a)$694.0 $— $175.1 $519.7 $— $182.3 $571.9 (a) Includes the restrictions of consolidated and non-consolidated subsidiaries.370Parent Restrictions (Applies to AEP)The holders of AEP’s common stock are entitled to receive the dividends declared by the Board of Directors provided funds are legally available for such dividends. Parent’s income primarily derives from common stock equity in the earnings of its utility subsidiaries.Pursuant to the leverage restrictions in credit agreements, AEP must maintain a percentage of debt-to-total capitalization at a level that does not exceed 67.5%. The method for calculating outstanding debt and capitalization is contractually-defined in the credit agreements. As of December 31, 2020, AEP had $7.1 billion of available retained earnings to pay dividends to common shareholders. AEP paid $1.4 billion, $1.3 billion and $1.3 billion of dividends to common shareholders for the years ended December 31, 2020, 2019 and 2018, respectively.Lines of Credit and Short-term Debt (Applies to AEP and SWEPCo)AEP uses its commercial paper program to meet the short-term borrowing needs of its subsidiaries. The program funds a Utility Money Pool, which funds AEP’s utility subsidiaries; a Nonutility Money Pool, which funds certain AEP nonutility subsidiaries; and the short-term debt requirements of subsidiaries that are not participating in either money pool for regulatory or operational reasons, as direct borrowers. As of December 31, 2020, AEP had a $4 billion revolving credit facility to support its commercial paper program. The commercial paper program for the year ended 2020, had a weighted-average interest rate of 1.28% and a maximum amount outstanding of $3 billion. AEP’s outstanding short-term debt was as follows:December 31,20202019CompanyType of DebtOutstandingAmountInterestRate (a)OutstandingAmountInterestRate (a)(in millions)(in millions)AEPSecuritized Debt for Receivables (b)$592.0 0.85 %$710.0 2.42 %AEPCommercial Paper1,852.3 0.29 %2,110.0 2.10 %SWEPCoNotes Payable35.0 2.55 %18.3 3.29 %Total Short-term Debt$2,479.3 $2,838.3 (a) Weighted-average rate.(b) Amount of securitized debt for receivables as accounted for under the “Transfers and Servicing” accounting guidance.371Corporate Borrowing Program – AEP System (Applies to Registrant Subsidiaries)The AEP System uses a corporate borrowing program to meet the short-term borrowing needs of AEP’s subsidiaries. The corporate borrowing program includes a Utility Money Pool, which funds AEP’s utility subsidiaries; a Nonutility Money Pool, which funds certain AEP nonutility subsidiaries; and direct borrowing from AEP. The AEP System Utility Money Pool operates in accordance with the terms and conditions of its agreement filed with the FERC. The amounts of outstanding loans to (borrowings from) the Utility Money Pool as of December 31, 2020 and 2019 are included in Advances to Affiliates and Advances from Affiliates, respectively, on the Registrant Subsidiaries’ balance sheets. The Utility Money Pool participants’ money pool activity and corresponding authorized borrowing limits are described in the following tables:Year Ended December 31, 2020:MaximumAverageNet Loans toBorrowingsMaximumBorrowingsAverage(Borrowings from)Authorizedfrom the Loans to the from the Loans to the the Utility MoneyShort-termUtilityUtilityUtilityUtilityPool as ofBorrowingCompanyMoney PoolMoney PoolMoney PoolMoney PoolDecember 31, 2020Limit(in millions)AEP Texas$320.4 $313.4 $132.0 $139.0 $(67.1)$500.0 AEPTCo358.4 259.7 116.3 55.0 (155.4)820.0 (a)APCo434.3 189.0 242.8 76.3 2.8 500.0 I&M218.6 13.4 114.5 13.3 (89.7)500.0 OPCo353.9 32.8 182.4 25.2 (259.2)500.0 PSO155.4 57.1 72.3 28.4 (155.4)300.0 SWEPCo178.9 — 113.0 — (124.6)350.0 Year Ended December 31, 2019:MaximumAverageNet Loans toBorrowingsMaximumBorrowingsAverage(Borrowings from)Authorizedfrom theLoans to thefrom the Loans to the the Utility MoneyShort-termUtilityUtilityUtilityUtilityPool as ofBorrowingCompanyMoney PoolMoney PoolMoney PoolMoney PoolDecember 31, 2019Limit(in millions)AEP Texas$390.7 $213.1 $239.3 $194.4 $199.7 $500.0 AEPTCo374.9 244.4 152.0 52.8 (119.0)795.0 (a)APCo270.0 232.2 115.9 51.9 (214.6)500.0 I&M158.8 66.0 71.5 16.2 (101.2)500.0 OPCo291.2 178.6 129.2 50.1 (131.0)500.0 PSO140.5 215.6 63.9 98.3 38.8 300.0 SWEPCo105.1 81.4 53.3 13.6 (59.9)350.0 (a) Amount represents the combined authorized short-term borrowing limit the State Transcos have from FERC or state regulatory commissions.372The activity in the above tables does not include short-term lending activity of certain AEP nonutility subsidiaries. AEP Texas’ wholly-owned subsidiary, AEP Texas North Generation Company, LLC and SWEPCo’s wholly-owned subsidiary, Mutual Energy SWEPCo, LLC participate in the Nonutility Money Pool. The amounts of outstanding loans to the Nonutility Money Pool as of December 31, 2020 and 2019 are included in Advances to Affiliates on each subsidiaries’ balance sheets. The Nonutility Money Pool participants’ money pool activity is described in the following tables:Year Ended December 31, 2020:Maximum LoansAverage LoansLoans to the Nonutilityto the Nonutilityto the NonutilityMoney Pool as ofCompanyMoney PoolMoney PoolDecember 31, 2020(in millions)AEP Texas$7.5 $7.1 $7.1 SWEPCo2.1 2.1 2.1 Year Ended December 31, 2019:Maximum LoansAverage LoansLoans to the Nonutilityto the Nonutilityto the NonutilityMoney Pool as ofCompanyMoney PoolMoney PoolDecember 31, 2019(in millions)AEP Texas$8.0 $7.7 $7.5 SWEPCo2.1 2.0 2.1 AEP has a direct financing relationship with AEPTCo to meet its short-term borrowing needs. The amounts of outstanding loans to and borrowings from AEP as of December 31, 2020 and 2019 are included in Advances to Affiliates and Advances from Affiliates, respectively, on AEPTCo’s balance sheets. AEPTCo’s direct financing activities with AEP and corresponding authorized borrowing limits are described in the following tables:Year Ended December 31, 2020:MaximumMaximumAverageAverageBorrowings fromLoans toAuthorizedBorrowingsLoansBorrowingsLoansAEP as ofAEP as ofShort-termfrom AEPto AEPfrom AEPto AEPDecember 31, 2020December 31, 2020Borrowing Limit(in millions)$1.4 $215.3 $1.3 $132.6 $1.2 $109.0 $50.0 (a)Year Ended December 31, 2019:MaximumMaximumAverageAverageBorrowings fromLoans toAuthorizedBorrowingsLoansBorrowingsLoansAEP as ofAEP as ofShort-termfrom AEPto AEPfrom AEPto AEPDecember 31, 2019December 31, 2019Borrowing Limit(in millions)$1.3 $153.5 $1.3 $68.0 $1.3 $68.7 $75.0 (a)(a) Amount represents the combined authorized short-term borrowing limit the State Transcos have from FERC or state regulatory commissions.The maximum and minimum interest rates for funds either borrowed from or loaned to the Utility Money Pool are summarized in the following table:Years Ended December 31,202020192018Maximum Interest Rate2.70 %3.43 %2.97 %Minimum Interest Rate0.27 %1.77 %1.81 %373The average interest rates for funds borrowed from and loaned to the Utility Money Pool are summarized in the following table:Average Interest Rate for Funds Borrowedfrom the Utility Money Pool for theYears Ended December 31,Average Interest Rate for Funds Loanedto the Utility Money Pool for theYears Ended December 31,Company202020192018202020192018AEP Texas1.51 %2.63 %2.26 %0.81 %2.03 %2.29 %AEPTCo1.29 %2.64 %2.27 %1.99 %2.41 %2.10 %APCo2.12 %2.45 %2.26 %0.85 %2.66 %2.21 %I&M1.07 %2.34 %2.16 %1.18 %2.60 %2.08 %OPCo0.99 %2.67 %2.18 %2.06 %2.68 %2.47 %PSO0.92 %2.85 %2.27 %1.95 %2.27 %1.98 %SWEPCo1.27 %2.72 %2.31 %— %2.22 %2.00 %Maximum, minimum and average interest rates for funds loaned to the Nonutility Money Pool are summarized in the following table: Maximum Interest Rate Minimum Interest Rate Average Interest RateYear Ended for Funds Loaned to for Funds Loaned to for Funds Loaned toDecember 31,Company the Nonutility Money Pool the Nonutility Money Pool the Nonutility Money Pool2020AEP Texas 2.70 %0.27 %1.18 %2020SWEPCo 2.70 %0.27 %1.18 %2019AEP Texas3.02 %1.91 %2.56 %2019SWEPCo3.02 %1.91 %2.55 %2018AEP Texas2.97 %1.83 %2.36 %2018SWEPCo2.97 %1.83 %2.36 %AEPTCo’s maximum, minimum and average interest rates for funds either borrowed from or loaned to AEP are summarized in the following table: Maximum Minimum Maximum Minimum Average Average Interest Rate Interest Rate Interest Rate Interest Rate Interest Rate Interest Rate for Funds for Funds for Funds for Funds for Funds for FundsYear Ended Borrowed from Borrowed from Loaned to Loaned to Borrowed from Loaned toDecember 31, AEP AEPAEP AEP AEP AEP2020 2.70 %0.27 %2.70 %0.27 %1.20 %1.13 %2019 3.02 %1.91 %3.02 %1.91 %2.55 %2.51 %20182.97 %1.76 %2.97 %1.76 %2.36 %2.36 %Interest expense and interest income related to the Utility Money Pool, Nonutility Money Pool and direct borrowing financing relationship are included in Interest Expense and Interest Income, respectively, on each of the Registrant Subsidiaries’ statements of income. The interest expense and interest income related to the corporate borrowing programs were immaterial for the years ended December 31, 2020, 2019 and 2018.Credit FacilitiesSee “Letters of Credit” section of Note 6 for additional information.374Securitized Accounts Receivables – AEP Credit (Applies to AEP)AEP Credit has a receivables securitization agreement that provides a commitment of $750 million from bank conduits to purchase receivables and expires in September 2022. Under the securitization agreement, AEP Credit receives financing from the bank conduits for the interest in the receivables AEP Credit acquires from affiliated utility subsidiaries. These securitized transactions allow AEP Credit to repay its outstanding debt obligations, continue to purchase the operating companies’ receivables and accelerate AEP Credit’s cash collections.In May 2020, AEP Credit amended its receivables securitization agreement to increase the eligibility criteria related to aged receivable requirements for the participating affiliated utility subsidiaries in response to the COVID-19 pandemic. As of December 31, 2020, the affiliated utility subsidiaries are in compliance with all requirements under the agreement. To the extent that an affiliated utility subsidiary is deemed ineligible under the agreement, the affiliated utility subsidiary would no longer participate in the receivables securitization agreement and the Registrants would need to rely on additional sources of funding for operation and working capital, which may adversely impact liquidity. The receivables that are ineligible under the receivables securitization agreement are financed with short-term debt at AEP Credit.Accounts receivable information for AEP Credit was as follows:Years Ended December 31,202020192018(dollars in millions)Effective Interest Rates on Securitization of Accounts Receivable0.85 %2.42 %2.16 %Net Uncollectible Accounts Receivable Written Off$15.3 $26.6 $27.6 December 31,20202019(in millions)Accounts Receivable Retained Interest and Pledged as Collateral Less Uncollectible Accounts$958.4 $841.8 Short-term – Securitized Debt of Receivables592.0 710.0 Delinquent Securitized Accounts Receivable62.3 39.6 Bad Debt Reserves Related to Securitization60.0 32.1 Unbilled Receivables Related to Securitization296.8 266.8 AEP Credit’s delinquent customer accounts receivable represent accounts greater than 30 days past due.Securitized Accounts Receivables – AEP Credit (Applies to Registrant Subsidiaries, except AEP Texas and AEPTCo)Under this sale of receivables arrangement, the Registrant Subsidiaries sell, without recourse, certain of their customer accounts receivable and accrued unbilled revenue balances to AEP Credit and are charged a fee based on AEP Credit’s financing costs, administrative costs and uncollectible accounts experience for each Registrant Subsidiary’s receivables. APCo does not have regulatory authority to sell its West Virginia accounts receivable. The costs of customer accounts receivable sold are reported in Other Operation expense on the Registrant Subsidiaries’ statements of income. The Registrant Subsidiaries manage and service their customer accounts receivable, which are sold to AEP Credit. AEP Credit securitizes the eligible receivables for the operating companies and retains the remainder.375The amount of accounts receivable and accrued unbilled revenues under the sale of receivables agreement were:December 31,Company20202019(in millions)APCo$136.0 $120.9 I&M170.5 141.8 OPCo398.8 330.3 PSO85.0 101.1 SWEPCo158.6 125.2 The fees paid to AEP Credit for customer accounts receivable sold were:Years Ended December 31,Company202020192018(in millions)APCo$5.2 $7.4 $7.0 I&M7.9 11.1 9.2 OPCo24.1 27.1 26.3 PSO4.8 7.8 7.9 SWEPCo6.7 10.2 8.9 The proceeds on the sale of receivables to AEP Credit were:Years Ended December 31,Company202020192018(in millions)APCo$1,272.9 $1,310.3 $1,421.0 I&M1,891.8 1,824.2 1,843.0 OPCo2,366.2 2,293.6 2,674.5 PSO1,221.0 1,442.5 1,484.6 SWEPCo1,593.8 1,618.5 1,736.1 37615. STOCK-BASED COMPENSATIONThe disclosures in this note apply to AEP only. The impact of AEP’s share-based compensation plans is insignificant to the financial statements of the Registrant Subsidiaries. Awards under AEP’s long-term incentive plan may be granted to employees and directors. The Amended and Restated American Electric Power System Long-Term Incentive Plan (Prior Plan), was replaced prospectively for new grants by the American Electric Power System 2015 Long-Term Incentive Plan (2015 LTIP) effective in April 2015. The 2015 LTIP was subsequently amended in September 2016. The 2015 LTIP provides for a maximum of 10 million AEP common shares to be available for grant to eligible employees and directors. As of December 31, 2020, 6,712,148 shares remained available for issuance under the 2015 LTIP. No new awards may be granted under the Prior Plan. The 2015 LTIP awards may be stock options, stock appreciation rights, restricted stock, restricted stock units, performance shares, performance units, cash-based awards and other stock-based awards. Shares issued pursuant to a stock option or a stock appreciation right reduce the shares remaining available for grants under the 2015 LTIP by 0.286 of a share. Each share issued for any other award that settles in AEP stock reduces the shares remaining available for grants under the 2015 LTIP by one share. Cash settled awards do not reduce the number of shares remaining available under the 2015 LTIP. The following sections provide further information regarding each type of stock-based compensation award granted under these plans.Performance SharesPerformance units granted prior to 2017 were settled in cash rather than AEP common stock and did not reduce the number of shares remaining available under the 2015 LTIP. Those performance units had a fair value upon vesting equal to the average closing market price of AEP common stock for the last 20 trading days of the performance period. Performance shares granted in and after 2017 are settled in AEP common stock and reduce the aggregate share authorization. In all cases the number of performance shares held at the end of the three-year performance period is multiplied by the performance score for such period to determine the actual number of performance shares that participants realize. The performance score can range from 0% to 200% and is determined at the end of the performance period based on performance measures, which include both performance and market conditions, established for each grant at the beginning of the performance period by the Human Resources Committee of AEP’s Board of Directors (HR Committee).Certain employees must satisfy a minimum stock ownership requirement. If those employees have not met their stock ownership requirement, a portion or all of their performance shares are mandatorily deferred as AEP career shares to the extent needed to meet their stock ownership requirement. AEP career shares are a form of non-qualified deferred compensation that has a value equivalent to a share of AEP common stock. AEP career shares are settled in AEP common stock after the participant’s termination of employment. AEP career shares are recorded in Paid-in Capital on the balance sheets. Amounts equivalent to cash dividends on both performance shares and AEP career shares accrue as additional shares. Management records compensation cost for performance shares over an approximately three-year vesting period. Performance shares are recorded as mezzanine equity on the balance sheets until the vesting date and compensation cost is calculated at fair value based on metrics for each grant. Performance shares granted in 2020 had three performance metrics: (a) three-year cumulative operating earnings per-share with a 50% weight, (b) total shareholder return with a 40% weight and (c) non-emitting generation capacity as a percentage of total owned and purchased capacity with a 10% weight. Performance shares granted prior to 2020 had two equally-weighted performance metrics: (a) three-year cumulative operating earnings per-share and (b) total shareholder return. The three-year cumulative operating earnings per-share metric and non-emitting generating capacity metric are adjusted quarterly for changes in performance relative to a target approved by the HR Committee. The total shareholder return metric is measured relative to a peer group of similar companies and is based on a third-party Monte Carlo valuation. The value related to this metric does not change over the three-year vesting period. 377The HR Committee awarded performance shares and reinvested dividends on outstanding performance shares and AEP career shares as follows:Years Ended December 31,Performance Shares202020192018Awarded Shares (in thousands)424.8 535.0 581.4 Weighted-Average Share Fair Value at Grant Date$116.56 $83.21 $67.21 Vesting Period (in years)333Performance Shares and AEP Career Shares(Reinvested Dividends Portion)Years Ended December 31,202020192018Awarded Shares (in thousands) (a)73.4 66.4 80.2 Weighted-Average Fair Value at Grant Date$84.87 $88.73 $70.58 Vesting Period (in years)(b)(b)(b)(a)All awarded dividends in both 2020 and 2019 were equity awards and awarded dividends in 2018 were a mix of equity awards and liability awards.(b)The vesting period for the reinvested dividends on performance shares is equal to the remaining life of the related performance shares. Dividends on AEP career shares vest immediately when the dividend is awarded but are not settled in AEP common stock until after the participant’s AEP employment ends. Performance scores and final awards are determined and approved by the HR Committee in accordance with the pre-established performance measures within approximately two months after the end of the performance period.The certified performance scores and shares earned for the three-year periods were as follows:Years Ended December 31,Performance Shares202020192018Certified Performance Score128.2 %132.7 %136.7 %Performance Shares Earned757,858 792,897 820,780 Performance Shares Mandatorily Deferred as AEP Career Shares13,614 10,063 11,248 Performance Shares Voluntarily Deferred into the Incentive Compensation Deferral Program26,936 49,392 56,826 Performance Shares to be Settled (a)717,308 733,442 752,706 (a)Performance shares settled for the three-year periods ended December 31, 2020 and 2019 settled in AEP common stock. Performance units settled for the three-year period ended December 31, 2018 settled in cash. In all cases, the settlement of common stock or cash occurs in the quarter following the end of the year shown.The settlements were as follows:Years Ended December 31,Performance Shares and AEP Career Shares202020192018(in millions)Cash Settlements for Performance Units$— $58.3 $66.9 AEP Common Stock Settlements for Performance Shares75.4 — — AEP Common Stock Settlements for Career Share Distributions1.9 6.6 5.1 378A summary of the status of AEP’s nonvested Performance Shares as of December 31, 2020 and changes during the year ended December 31, 2020 were as follows:Nonvested Performance SharesSharesWeightedAverageGrant DateFair Value(in thousands)Nonvested as of January 1, 20201,113.4 $73.64 Awarded424.8 116.56 Dividends53.8 84.91 Vested (a)(597.0)66.45 Forfeited(56.4)87.58 Nonvested as of December 31, 2020938.6 98.05 (a)The vested Performance Shares will be converted to 717 thousand shares based on the closing share price on the day before settlement.Monte Carlo ValuationAEP engages a third-party for a Monte Carlo valuation to calculate the fair value of the total shareholder return metric for the performance shares awarded during and after 2017. The valuations use a lattice model and the expected volatility assumptions used were the historical volatilities for AEP and the members of their peer group. The assumptions used in the Monte Carlo valuations were as follows:Years Ended December 31,Assumptions202020192018Valuation Period (in years) (a)2.872.872.87Expected Volatility Minimum13.67 %14.83 %14.77 %Expected Volatility Maximum28.15 %25.57 %26.72 %Expected Volatility Average16.39 %17.39 %17.90 %Dividend Rate (b)— %— %— %Risk Free Rate1.40 %2.49 %2.34 %(a)Period from award date to vesting date.(b)Equivalent to reinvesting dividends.Restricted Stock UnitsThe HR Committee grants restricted stock units (RSUs), which generally vest, subject to the participant’s continued employment, over at least three years in approximately equal annual increments. The RSUs accrue dividends as additional RSUs. The additional RSUs granted as dividends vest on the same date as the underlying RSUs. RSUs are converted into shares of AEP common stock upon vesting, except the RSUs granted prior to 2017 to AEP’s executive officers which settled in cash. Executive officers are those officers who are subject to the disclosure requirements set forth in Section 16 of the Securities Exchange Act of 1934. For RSUs that settle in shares, compensation cost is measured at fair value on the grant date and recorded over the vesting period. Fair value is determined by multiplying the number of RSUs granted by the grant date market closing price. For RSUs that settled in cash, compensation cost was recorded over the vesting period and adjusted for changes in fair value until vested. The fair value at vesting was determined by multiplying the number of RSUs vested by the 20-day average closing price of AEP common stock. The maximum contractual term of outstanding RSUs is approximately 40 months from the grant date.379The HR Committee awarded RSUs, including additional units awarded as dividends, as follows:Years Ended December 31,Restricted Stock Units202020192018Awarded Units (in thousands)268.7 304.8 260.0 Weighted-Average Grant Date Fair Value$94.38 $81.57 $67.96 The total fair value and total intrinsic value of restricted stock units vested were as follows:Years Ended December 31,Restricted Stock Units202020192018(in millions)Fair Value of Restricted Stock Units Vested$22.9 $16.3 $16.6 Intrinsic Value of Restricted Stock Units Vested (a)25.2 21.6 19.2 (a)Intrinsic value is calculated as market price at the vesting date.A summary of the status of AEP’s nonvested RSUs as of December 31, 2020 and changes during the year ended December 31, 2020 were as follows:Nonvested Restricted Stock UnitsShares/UnitsWeightedAverageGrant DateFair Value(in thousands)Nonvested as of January 1, 2020516.9 $75.55 Awarded268.7 94.38 Vested(307.6)74.58 Forfeited(30.0)84.27 Nonvested as of December 31, 2020448.0 86.56 The total aggregate intrinsic value of nonvested RSUs as of December 31, 2020 was $37 million and the weighted-average remaining contractual life was 1.6 years. Retirement Incentive and Severance AwardsIn 2020 64,186 shares with a weighted-average grant date fair value of $83.74 were granted in connection with the voluntary retirement incentive program and other executive severance. The shares were fully vested on the grant date with a fair value of $5 million. See “Voluntary Retirement Incentive Program” section of Note 1 for additional information.Other Stock-Based PlansAEP also has a Stock Unit Accumulation Plan for Non-Employee Directors providing each non-employee director with AEP stock units as a substantial portion of the compensation for their services as a director. The number of stock units provided is based on the closing price of AEP common stock on the last trading day of the quarter for which the stock units were earned. Amounts equivalent to cash dividends on the stock units accrue as additional AEP stock units. The stock units granted to non-employee directors are fully vested on their grant date. Stock units are settled in cash upon termination of board service or up to 10 years later if the participant so elects. Cash settlements for stock units are calculated based on the average closing price of AEP common stock for the last 20 trading days prior to the distribution date. After five years of service on the Board of Directors, non-employee directors receive subsequent AEP stock units as contributions to an AEP stock fund awarded under the Stock Unit Accumulation Plan. Such amounts may be exchanged into other market-based investments that are similar to the investment options available to employees that participate in AEP’s Incentive Compensation Deferral Plan. These balances are also paid in cash upon termination of board service or up to 10 years later if the participant so elects. 380Management records compensation cost for stock units when the units are awarded and adjusts the liability for changes in value based on the current 20-day average closing price of AEP common stock on the valuation date.For the years ended December 31, 2020, 2019 and 2018, cash settlements for stock unit distributions were immaterial.The Board of Directors awarded stock units, including units awarded for dividends, as follows:Years Ended December 31,Stock Unit Accumulation Plan for Non-Employee Directors202020192018Awarded Units (in thousands)12.1 10.0 11.4 Weighted-Average Grant Date Fair Value$83.80 $89.13 $70.41 Share-based Compensation PlansFor share-based payment arrangements the compensation cost, the actual tax benefit from the tax deductions for compensation cost recognized in income and the total compensation cost capitalized were as follows:Years Ended December 31,Share-based Compensation Plans202020192018(in millions)Compensation Cost for Share-based Payment Arrangements (a)$53.8 $57.9 $53.2 Actual Tax Benefit7.2 8.4 7.7 Total Compensation Cost Capitalized20.4 20.0 19.7 (a)Compensation cost for share-based payment arrangements is included in Other Operation and Maintenance expenses on the statements of income.As of December 31, 2020, there was $78 million of total unrecognized compensation cost related to unvested share-based compensation arrangements granted under the 2015 LTIP. Unrecognized compensation cost related to unvested share-based arrangements will change as the fair value of performance shares is adjusted each period and as forfeitures for all award types are realized. AEP’s unrecognized compensation cost will be recognized over a weighted-average period of 1.39 years.Under the 2015 LTIP, AEP is permitted to use authorized but unissued shares, treasury shares, shares acquired in the open market specifically for distribution under these plans, or any combination thereof to fulfill share commitments. AEP’s current practice is to use authorized but unissued shares to fulfill share commitments. The number of shares used to fulfill share commitments is generally reduced to offset tax withholding obligations.38116. RELATED PARTY TRANSACTIONSThe disclosures in this note apply to all Registrant Subsidiaries unless indicated otherwise.For other related party transactions, also see “AEP System Tax Allocation Agreement” section of Note 12 in addition to “Corporate Borrowing Program – AEP System” and “Securitized Accounts Receivables – AEP Credit” sections of Note 14.Power Coordination Agreement (Applies to all Registrant Subsidiaries except AEP Texas and AEPTCo)Effective January 1, 2014, the FERC approved the PCA. Under the PCA, APCo, I&M, KPCo and WPCo are individually responsible for planning their respective capacity obligations. The PCA allows, but does not obligate, APCo, I&M, KPCo and WPCo to participate collectively under a common fixed resource requirement capacity plan in PJM and to participate in specified collective Off-system Sales and purchase activities.AEPSC conducts power, capacity, coal, natural gas, interest rate and, to a lesser extent, heating oil, gasoline and other risk management activities on behalf of APCo, I&M, KPCo, PSO, SWEPCo and WPCo. Certain power and natural gas risk management activities for APCo, I&M, KPCo and WPCo are allocated based on the four member companies’ respective equity positions, while power and natural gas risk management activities for PSO and SWEPCo are allocated based on the Operating Agreement. With the transfer of OPCo’s generation assets to AGR in 2014, AEPSC conducts only gasoline, diesel fuel, energy procurement and risk management activities on OPCo’s behalf.System Integration Agreement (Applies to APCo, I&M, PSO and SWEPCo)Under the SIA, AEPSC allocates physical and financial revenues and expenses from transactions with neighboring utilities, power marketers and other power and natural gas risk management activities based upon the location of such activity. Margins resulting from trading and marketing activities originating in PJM generally accrue to the benefit of APCo, I&M, KPCo and WPCo, while trading and marketing activities originating in SPP generally accrue to the benefit of PSO and SWEPCo. Margins resulting from other transactions are allocated among APCo, I&M, KPCo, PSO, SWEPCo and WPCo based upon the equity positions of these companies.382Affiliated Revenues and PurchasesThe tables below represent revenues from affiliates, net of respective provisions for refund, by type of revenue for the Registrant Subsidiaries:Related Party RevenuesAEP TexasAEPTCoAPCoI&MOPCoPSOSWEPCo(in millions)Year Ended December 31, 2020Direct Sales to East Affiliates$— $— $112.5 $— $— $— $— Auction Sales to OPCo (a)— — 5.3 3.1 — — — Direct Sales to AEPEP87.5 — — — — — — Transmission Revenues— 885.0 49.1 2.9 16.6 — 37.4 Other Revenues3.3 11.3 7.8 4.5 24.9 5.2 1.6 Total Affiliated Revenues$90.8 $896.3 $174.7 $10.5 $41.5 $5.2 $39.0 Related Party RevenuesAEP TexasAEPTCoAPCoI&MOPCoPSOSWEPCo(in millions)Year Ended December 31, 2019Direct Sales to East Affiliates$— $— $128.6 $— $— $— $— Auction Sales to OPCo (a)— — 11.4 6.7 — — — Direct Sales to AEPEP157.2 — — — — — (0.1)Transmission Revenues— 795.5 58.5 0.7 7.7 1.3 3.6 Other Revenues3.3 11.2 6.8 3.1 19.6 4.8 1.4 Total Affiliated Revenues$160.5 $806.7 $205.3 $10.5 $27.3 $6.1 $4.9 Related Party RevenuesAEP TexasAEPTCoAPCoI&MOPCoPSOSWEPCo(in millions)Year Ended December 31, 2018Direct Sales to East Affiliates$— $— $133.2 $0.1 $— $— $— Auction Sales to OPCo (a)— — 5.8 7.1 — — — Direct Sales to AEPEP103.6 — — — — — — Transmission Revenues— 591.4 36.4 11.7 3.9 0.9 26.9 Other Revenues1.6 7.5 6.0 3.2 17.1 4.5 1.5 Total Affiliated Revenues$105.2 $598.9 $181.4 $22.1 $21.0 $5.4 $28.4 (a)Refer to the Ohio Auctions section below for further information regarding these amounts.383The tables below represent the purchased power expenses incurred for purchases from affiliates. AEP Texas, AEPTCo, APCo, PSO and SWEPCo did not purchase any power from affiliates for the years ended December 31, 2020, 2019 and 2018.Related Party PurchasesI&MOPCo(in millions)Year Ended December 31, 2020Auction Purchases from AEPEP (a)$— $51.0 Auction Purchases from AEP Energy (a)— 58.7 Auction Purchases from AEPSC (a)— 10.0 Direct Purchases from AEGCo172.8 — Total Affiliated Purchases$172.8 $119.7 Related Party PurchasesI&MOPCo(in millions)Year Ended December 31, 2019Auction Purchases from AEPEP (a)$— $64.6 Auction Purchases from AEP Energy (a)— 69.9 Auction Purchases from AEPSC (a)— 21.5 Direct Purchases from AEGCo214.9 — Total Affiliated Purchases$214.9 $156.0 Related Party PurchasesI&MOPCo(in millions)Year Ended December 31, 2018Auction Purchases from AEPEP (a)$— $79.7 Auction Purchases from AEP Energy (a)— 41.0 Auction Purchases from AEPSC (a)— 14.6 Direct Purchases from AEGCo237.9 — Total Affiliated Purchases$237.9 $135.3 (a) Refer to the Ohio Auctions section below for further information regarding this amount.The above summarized related party revenues and expenses are reported in Sales to AEP Affiliates and Purchased Electricity from AEP Affiliates, respectively, on the Registrant Subsidiaries’ statements of income. Since the Registrant Subsidiaries are included in AEP’s consolidated results, the above summarized related party transactions are eliminated in total in AEP’s consolidated revenues and expenses.PJM and SPP Transmission Service Charges (Applies to all Registrant Subsidiaries except AEP Texas)The AEP East Companies are parties to the TA, which defines how transmission costs through the PJM OATT are allocated among the AEP East Companies on a 12-month average coincident peak basis. Additional costs for transmission services provided by AEPTCo and other transmission affiliates are billed to AEP East Companies through the PJM OATT.The following table shows the net transmission service charges recorded by APCo, I&M and OPCo:Years Ended December 31,Company202020192018(in millions)APCo$243.2 $222.3 $128.3 I&M145.9 143.5 91.4 OPCo417.4 373.4 210.1 The charges shown above are recorded in Other Operation expenses on the statements of income.384PSO, SWEPCo and AEPSC are parties to the TCA in connection with the operation of the transmission assets of PSO and SWEPCo. The TCA has been approved by the FERC and establishes a coordinating committee, which is charged with overseeing the coordinated planning of the transmission facilities of the parties to the agreement. This includes the performance of transmission planning studies, the interaction of such companies with independent system operators and other regional bodies interested in transmission planning and compliance with the terms of the OATT filed with the FERC and the rules of the FERC relating to such a tariff.Under the TCA, the parties to the agreement delegated to AEPSC the responsibility of monitoring the reliability of their transmission systems and administering the OATT on their behalf. The allocations have been governed by the FERC-approved OATT for the SPP. Additional costs for transmission services provided by AEPTCo and other transmission affiliates are billed to PSO and SWEPCo through the SPP OATT.The following table shows the net transmission service charges recorded by PSO and SWEPCo:Years Ended December 31,Company202020192018(in millions)PSO$69.7 $46.9 $65.9 SWEPCo31.3 20.1 10.5 The charges shown above are recorded in Other Operation expenses on the statements of income.AEPTCo provides transmission services to affiliates in accordance with the OATT, TA and TCA. AEPTCo recorded affiliated transmission revenues in Sales to AEP Affiliates on the statements of income. Refer to the Affiliated Revenues and Purchases section above for amounts related to these transactions.ERCOT Transmission Service Charges (Applies to AEP and AEP Texas)Pursuant to an order from the PUCT, ETT bills AEP Texas for its ERCOT wholesale transmission services. ETT billed AEP Texas $28 million, $27 million and $27 million for transmission services in 2020, 2019 and 2018, respectively. The billings are recorded in Other Operation expenses on AEP Texas’ statements of income.Oklaunion PPA between AEP Texas and AEPEP (Applies to AEP Texas)In 2007, AEP Texas entered into a PPA with an affiliate, AEPEP, whereby AEP Texas agreed to sell AEPEP 100% of AEP Texas’ capacity and associated energy from its undivided interest (54.69%) in the Oklaunion Power Station. The PPA was approved by the FERC. In September 2018, the co-owners of Oklaunion Power Station voted to close the plant in 2020. Effective October 2018, AEP Texas increased depreciation expense to ensure the plant balances are fully depreciated as of September 2020 and recovered through the PPA billings to AEPEP. Under the early termination provisions of the PPA, AEPEP paid AEP Texas the full Property, Plant and Equipment balance through depreciation payments until termination of the PPA due to the plant closing in September 2020. See “Dispositions” section of Note 7 for additional information.AEP Texas recorded revenue of $88 million, $157 million and $104 million from AEPEP for the years ended December 31, 2020, 2019 and 2018, respectively. These amounts are included in Sales to AEP Affiliates on AEP Texas’ statements of income.385Joint License Agreement (Applies to AEPTCo, APCo, I&M, OPCo and PSO)AEPTCo entered into a 50-year joint license agreement with APCo, I&M, KPCo, OPCo and PSO, respectively, allowing either party to occupy the granting party’s facilities or real property. In addition, AEPTCo entered into a 5-year joint license agreement with APCo and WPCo. After the expiration of these agreements, the term shall automatically renew for successive one-year terms unless either party provides notice. The joint license billing provides compensation to the granting party for the cost of carrying assets, including depreciation expense, property taxes, interest expense, return on equity and income taxes. AEPTCo recorded the following costs in Other Operation expense related to these agreements:Years Ended December 31,Billing Company202020192018(in millions)APCo$0.9 $0.2 $— I&M3.0 1.5 2.2 KPCo0.4 0.3 0.2 OPCo4.5 2.2 2.9 PSO0.4 0.3 0.3 WPCo0.2 0.1 — APCo, I&M, KPCo, OPCo, PSO and WPCo recorded income related to these agreements in Sales to AEP Affiliates on the statements of income.Ohio Auctions (Applies to APCo, I&M and OPCo)In connection with OPCo’s June 2012 - May 2015 ESP, the PUCO ordered OPCo to conduct energy and capacity auctions for its entire SSO load for delivery beginning in June 2015. AEP Energy, AEPEP, APCo, KPCo, I&M and WPCo participate in the auction process and have been awarded tranches of OPCo’s SSO load. Refer to the Affiliated Revenues and Purchases section above for amounts related to these transactions.Unit Power Agreements (Applies to I&M)UPA between AEGCo and I&MA UPA between AEGCo and I&M (the I&M Power Agreement) provides for the sale by AEGCo to I&M of all the power (and the energy associated therewith) available to AEGCo at the Rockport Plant unless it is sold to another utility. Subsequently, I&M assigns 30% of the power to KPCo. See the “UPA between AEGCo and KPCo” section below. I&M is obligated, whether or not power is available from AEGCo, to pay as a demand charge for the right to receive such power (and as an energy charge for any associated energy taken by I&M) net of amounts received by AEGCo from any other sources, sufficient to enable AEGCo to pay all its operating and other expenses, including a rate of return on the common equity of AEGCo as approved by the FERC. In November 2020, management announced that AEP will not renew the Rockport Plant, Unit 2 lease when it expires in December 2022. The I&M Power Agreement will continue in effect until the debt obligations of AEGCo secured by the Rockport Plant have been satisfied and discharged (currently expected to be December 2028).UPA between AEGCo and KPCoPursuant to an assignment between I&M and KPCo and a UPA between AEGCo and KPCo, AEGCo sells KPCo 30% of the power (and the energy associated therewith) available to AEGCo from both units of the Rockport Plant. KPCo pays to AEGCo in consideration for the right to receive such power the same amounts which I&M would have paid AEGCo under the terms of the I&M Power Agreement for such entitlement. In November 2020, management announced that AEP will not renew the Rockport Plant, Unit 2 lease when it expires in December 2022. The KPCo UPA ends in December 2022.386Cook Coal Terminal (Applies to I&M, PSO and SWEPCo)Cook Coal Terminal, which is owned by AEGCo, performs coal transloading and storage services at cost for I&M. The coal transloading costs were $12 million, $13 million and $12 million in 2020, 2019 and 2018, respectively. I&M recorded the cost of transloading services in Fuel on the balance sheets.Cook Coal Terminal also performs railcar maintenance services at cost for I&M, PSO and SWEPCo. The railcar maintenance costs were as follows:Years Ended December 31,Company202020192018(in millions)I&M$0.9 $1.3 $1.5 PSO0.7 0.8 0.7 SWEPCo3.0 4.0 3.4 I&M, PSO and SWEPCo recorded the cost of the railcar maintenance services in Fuel on the balance sheets.I&M Barging, Urea Transloading and Other Services (Applies to APCo and I&M)I&M provides barging, urea transloading and other transportation services to affiliates. Urea is a chemical used to control NOx emissions at certain generation plants in the AEP System. I&M recorded revenues from barging, transloading and other services in Other Revenues – Affiliated on the statements of income. The affiliated companies recorded these costs paid to I&M as fuel expenses or other operation expenses. The amounts of affiliated expenses were:Years Ended December 31,Company202020192018(in millions)AEGCo$10.6 $14.9 $19.9 APCo43.7 38.9 35.1 KPCo3.2 4.8 4.2 WPCo3.3 4.8 4.2 Central Machine Shop (Applies to APCo, I&M, PSO and SWEPCo)APCo operates a facility which repairs and rebuilds specialized components for the generation plants across the AEP System. APCo defers the cost of performing these services on the balance sheet and then transfers the cost to the affiliate for reimbursement. The AEP subsidiaries recorded these billings as capital or maintenance expenses depending on the nature of the services received. These billings are recoverable from customers. The following table provides the amounts billed by APCo to the following affiliates:Years Ended December 31,Company202020192018(in millions)AGR$2.9 $0.8 $1.6 I&M3.2 2.3 2.4 KPCo0.9 1.4 1.7 PSO0.9 1.1 0.5 SWEPCo0.5 1.1 0.7 387Sales and Purchases of PropertyCertain AEP subsidiaries had affiliated sales and purchases of electric property individually amounting to $100 thousand or more, sales and purchases of meters and transformers, and sales and purchases of transmission property. There were no gains or losses recorded on the transactions. The following tables show the sales and purchases, recorded at net book value:SalesYears Ended December 31,Company202020192018(in millions)AEP Texas$0.9 $0.9 $0.3 AEPTCo0.2 — — APCo5.7 5.5 5.4 I&M1.5 7.5 8.2 OPCo7.0 7.0 10.7 PSO1.1 0.8 1.0 SWEPCo0.8 0.2 0.8 PurchasesYears Ended December 31,Company202020192018(in millions)AEP Texas$1.5 $0.3 $0.1 AEPTCo6.0 10.2 18.5 APCo1.3 6.0 0.6 I&M3.4 0.9 2.0 OPCo1.2 3.0 2.8 PSO0.4 0.5 1.3 SWEPCo2.8 0.7 0.8 The amounts above are recorded in Property, Plant and Equipment on the balance sheets.Sempra Renewables LLC PPAs (Applies to I&M, OPCo and SWEPCo)In April 2019, AEP acquired Sempra Renewables LLC and its ownership interests in 724 MWs of wind generation. The operating wind generation portfolio includes seven wind farms. Prior to the acquisition, two wind farms had existing PPAs with I&M, OPCo and SWEPCo. One of the joint venture wind farms has PPAs with I&M and OPCo for a portion of its energy production. The I&M portion totaled $11 million and $9 million and the OPCo portion totaled $23 million and $17 million, respectively, for the years ended December 31, 2020 and 2019. Another joint venture wind farm has a PPA with SWEPCo for a portion of its energy production which totaled $14 million and $10 million, respectively, of purchased electricity for the years ended December 31, 2020 and 2019. See “Acquisitions” section of Note 7 for additional information.Intercompany BillingsThe Registrant Subsidiaries and other AEP subsidiaries perform certain utility services for each other when necessary or practical. The costs of these services are billed on a direct-charge basis, whenever possible, or on reasonable basis of proration for services that benefit multiple companies. The billings for services are made at cost and include no compensation for the use of equity capital.388Charitable Contributions to AEP FoundationThe American Electric Power Foundation is funded by American Electric Power and its utility operating units. The Foundation provides a permanent, ongoing resource for charitable initiatives and multi-year commitments in the communities served by AEP and initiatives outside of AEP’s 11-state service area. Charitable contributions to the AEP Foundation were recorded in Other Operation on the statements of income. In 2020, there were no charitable contributions made to the AEP Foundation. The charitable contributions to the AEP Foundation recorded in 2019 were as follows:Year EndedCompanyDecember 31, 2019(in millions)AEP$50.0 AEP Texas6.2 AEPTCo6.5 APCo8.9 I&M9.0 OPCo5.4 PSO3.4 SWEPCo5.5 OKTCo Radial Assets Transfer (Applies to AEP, AEPTCo and PSO)In August 2020, AEPSC filed a request with FERC, on behalf of PSO and OKTCo, to transfer OKTCo's interests in its radial assets to PSO. See “FERC Rate Matters” section of Note 4 for additional information.38917. VARIABLE INTEREST ENTITIES AND EQUITY METHOD INVESTMENTSThe disclosures in this note apply to all Registrants unless indicated otherwise. The accounting guidance for “Variable Interest Entities” is a consolidation model that considers if a company has a variable interest in a VIE. A VIE is a legal entity that possesses any of the following conditions: the entity’s equity at risk is not sufficient to permit the legal entity to finance its activities without additional subordinated financial support, equity owners are unable to direct the activities that most significantly impact the legal entity’s economic performance (or they possess disproportionate voting rights in relation to the economic interest in the legal entity), or the equity owners lack the obligation to absorb the legal entity’s expected losses or the right to receive the legal entity’s expected residual returns. Entities are required to consolidate a VIE when it is determined that they have a controlling financial interest in a VIE and therefore, are the primary beneficiary of that VIE, as defined by the accounting guidance for “Variable Interest Entities.” In determining whether AEP is the primary beneficiary of a VIE, management considers whether AEP has the power to direct the most significant activities of the VIE and is obligated to absorb losses or receive the expected residual returns that are significant to the VIE. Management believes that significant assumptions and judgments were applied consistently. AEP holds ownership interests in businesses with varying ownership structures. Partnership interests and other variable interests are evaluated to determine if each entity is a VIE, and if so, whether or not the VIE should be consolidated into AEP’s financial statements. AEP has not provided material financial or other support that was not previously contractually required to any of its consolidated VIEs. If an entity is determined not to be a VIE, or if the entity is determined to be a VIE and AEP is not deemed to be the primary beneficiary, the entity is accounted for under the equity method of accounting.Consolidated Variable Interests Entities (Applies to all Registrants except AEPTCo, OPCo and PSO)SabineSabine is a mining operator providing mining services to SWEPCo. SWEPCo has no equity investment in Sabine but is Sabine’s only customer. SWEPCo guarantees the debt obligations and lease obligations of Sabine. Under the terms of the note agreements, substantially all assets are pledged and all rights under the lignite mining agreement are assigned to SWEPCo. The creditors of Sabine have no recourse to any AEP entity other than SWEPCo. Under the provisions of the mining agreement, SWEPCo is required to pay, as a part of the cost of lignite delivered, an amount equal to mining costs plus a management fee. In addition, SWEPCo determines how much coal will be mined each year. Based on these facts, management concluded that SWEPCo is the primary beneficiary and is required to consolidate Sabine. SWEPCo’s total billings from Sabine for the years ended December 31, 2020, 2019 and 2018 were $131 million, $110 million and $152 million, respectively. See the tables below for the classification of Sabine’s assets and liabilities on SWEPCo’s balance sheets.As part of the process to receive a renewal of a Texas Railroad Commission permit for lignite mining, SWEPCo provides guarantees of mine reclamation of $155 million. Since SWEPCo uses self-bonding, the guarantee commits SWEPCo to complete the reclamation, in the event, Sabine does not complete the work. This guarantee ends upon completion of reclamation. The mine end-of-life has been adjusted to March 2023, in order to align with the announced closure of the Pirkey Power Plant. Reclamation is expected to be complete by 2037 at an estimated cost of $104 million. Actual reclamation costs could vary due to inflation and scope changes to the mine reclamation. SWEPCo recovers these costs through its fuel clauses. As of December 31, 2020, SWEPCo has recorded $89 million of mine reclamation costs in Asset Retirement Obligations and has collected $81 million through a rider for reclamation costs. The remaining $8 million is recorded in Deferred Charges and Other Noncurrent Assets on SWEPCo’s balance sheets.390DCC Fuel I&M has nuclear fuel lease agreements with DCC Fuel, which was formed for the purpose of acquiring, owning and leasing nuclear fuel to I&M. DCC Fuel purchased the nuclear fuel from I&M with funds received from the issuance of notes to financial institutions. Each DCC Fuel entity is a single-lessee leasing arrangement with only one asset and is capitalized with all debt. Each is a separate legal entity from I&M, the assets of which are not available to satisfy the debts of I&M. Payments on the leases for the years ended December 31, 2020, 2019 and 2018 were $94 million, $95 million and $113 million, respectively. The leases were recorded as finance leases on I&M’s balance sheets as title to the nuclear fuel transfers to I&M at the end of the respective lease terms, which do not exceed 54 months. Based on I&M’s control of DCC Fuel, management concluded that I&M is the primary beneficiary and is required to consolidate DCC Fuel. The finance leases are eliminated upon consolidation. See the tables below for the classification of DCC Fuel’s assets and liabilities on I&M’s balance sheets.Transition FundingTransition Funding was formed for the sole purpose of issuing and servicing securitization bonds related to Texas Restructuring Legislation. Management has concluded that AEP Texas is the primary beneficiary of Transition Funding because AEP Texas has the power to direct the most significant activities of the VIE and AEP Texas’ equity interest could potentially be significant. Therefore, AEP Texas is required to consolidate Transition Funding. As of December 31, 2020 and 2019, $66 million and $267 million of the securitized bonds were included in Long-term Debt Due Within One Year - Nonaffiliated, respectively, and $209 million and $274 million were included in Long-term Debt - Nonaffiliated, respectively, on the balance sheets. Transition Funding has securitized transition assets of $242 million and $389 million as of December 31, 2020 and 2019, respectively, which are presented separately on the face of the balance sheets. The securitized transition assets represent the right to impose and collect Texas true-up costs from customers receiving electric transmission or distribution service from AEP Texas under-recovery mechanisms approved by the PUCT. The securitization bonds are payable only from and secured by the securitized transition assets. The bondholders have no recourse to AEP Texas or any other AEP entity. AEP Texas acts as the servicer for Transition Funding’s securitized transition assets and remits all related amounts collected from customers to Transition Funding for interest and principal payments on the securitization bonds and related costs. See the tables below for the classification of Transition Funding’s assets and liabilities on the balance sheets. Restoration FundingRestoration Funding was formed for the sole purpose of issuing and servicing securitization bonds related to storm restoration of AEP Texas’ distribution system primarily due to damage caused by Hurricane Harvey. Management has concluded that AEP Texas is the primary beneficiary of Restoration Funding because AEP Texas has the power to direct the most significant activities of the VIE and AEP Texas’ equity interest could potentially be significant. Therefore, AEP Texas is required to consolidate Restoration Funding. As of December 2020 and 2019, $23 million and $14 million of the securitized bonds were included in Long-term Debt Due Within One Year - Nonaffiliated, respectively, and $195 million and $221 million were included in Long-term Debt - Nonaffiliated, respectively, on the balance sheets. Restoration Funding has securitized assets of $205 million and $232 million as of December 31, 2020 and 2019, respectively, which are presented separately on the face of the balance sheets. The securitized restoration assets represent the right to impose and collect Texas storm restoration costs from customers receiving electric transmission or distribution service from AEP Texas under-recovery mechanisms approved by the PUCT. The securitization bonds are payable only from and secured by the securitized assets. The bondholders have no recourse to AEP Texas or any other AEP entity. AEP Texas acts as the servicer for Restoration Funding’s securitized assets and remits all related amounts collected from customers to Restoration Funding for interest and principal payments on the securitization bonds and related costs. See the table below for the classification of Restoration Funding’s assets and liabilities on the balance sheets.391Appalachian Consumer Rate Relief FundingAppalachian Consumer Rate Relief Funding was formed for the sole purpose of issuing and servicing securitization bonds related to APCo’s under-recovered ENEC deferral balance. Management has concluded that APCo is the primary beneficiary of Appalachian Consumer Rate Relief Funding because APCo has the power to direct the most significant activities of the VIE and APCo’s equity interest could potentially be significant. Therefore, APCo is required to consolidate Appalachian Consumer Rate Relief Funding. As of December 31, 2020 and 2019, $25 million and $25 million of the securitized bonds were included in Long-term Debt Due Within One Year - Nonaffiliated, respectively, and $199 million and $223 million were included in Long-term Debt - Nonaffiliated, respectively, on the balance sheets. Appalachian Consumer Rate Relief Funding has securitized assets of $210 million and $235 million as of December 31, 2020 and 2019, respectively, which are presented separately on the face of the balance sheets. The phase-in recovery property represents the right to impose and collect West Virginia deferred generation charges from customers receiving electric transmission, distribution and generation service from APCo under a recovery mechanism approved by the WVPSC. In November 2013, securitization bonds were issued. The securitization bonds are payable only from and secured by the securitized assets. The bondholders have no recourse to APCo or any other AEP entity. APCo acts as the servicer for Appalachian Consumer Rate Relief Funding’s securitized assets and remits all related amounts collected from customers to Appalachian Consumer Rate Relief Funding for interest and principal payments on the securitization bonds and related costs. See the tables below for the classification of Appalachian Consumer Rate Relief Funding’s assets and liabilities on APCo’s balance sheets. AEP CreditAEP Credit is a wholly-owned subsidiary of Parent. AEP Credit purchases, without recourse, accounts receivable from certain utility subsidiaries of AEP to reduce working capital requirements. AEP provides a minimum of 5% equity and up to 25% of AEP Credit’s short-term borrowing needs in excess of third-party financings. Any third-party financing of AEP Credit only has recourse to the receivables securitized for such financing. Based on AEP’s control of AEP Credit, management concluded that AEP is the primary beneficiary and is required to consolidate AEP Credit. See the tables below for the classification of AEP Credit’s assets and liabilities on the balance sheets. See “Securitized Accounts Receivables - AEP Credit” section of Note 14.EIS AEP’s subsidiaries participate in one protected cell of EIS for six lines of insurance. EIS has multiple protected cells. Neither AEP nor its subsidiaries have an equity investment in EIS. The AEP System is essentially this EIS cell’s only participant, but allows certain third-parties access to this insurance. AEP’s subsidiaries and any allowed third-parties share in the insurance coverage, premiums and risk of loss from claims. Based on AEP’s control and the structure of the protected cell of EIS, management concluded that AEP is the primary beneficiary of the protected cell and is required to consolidate the protected cell of EIS. The insurance premium expense to the protected cell for the years ended December 31, 2020, 2019 and 2018 was $31 million, $34 million and $34 million, respectively. See the tables below for the classification of the protected cell’s assets and liabilities on the balance sheets. The amount reported as equity is the protected cell’s policy holders’ surplus.392Transource EnergyTransource Energy was formed for the purpose of investing in utilities which develop, acquire, construct, own and operate transmission facilities in accordance with FERC-approved rates. AEP has equity and voting ownership of 86.5% with the other owner having 13.5% interest. Management has concluded that Transource Energy is a VIE and that AEP is the primary beneficiary because AEP has the power to direct the most significant activities of the entity and AEP’s equity interest could potentially be significant. Therefore, AEP is required to consolidate Transource Energy. Transource Energy’s activities consist of the development, construction and operation of FERC-regulated transmission assets in Missouri, West Virginia, Pennsylvania, Maryland and Oklahoma. Transource Energy has a credit facility agreement where borrowings are loaned through intercompany lending agreements to its subsidiaries. The creditor to the agreement has no recourse to the general credit of AEP. Transource Energy’s credit facility agreement contains certain covenants and require it to maintain a percentage of debt-to-total capitalization at a level that does not exceed 67.5%. See the tables below for the classification of Transource Energy’s assets and liabilities on the balance sheets.Desert Sky Wind Farm LLC and Trent Wind Farm LLCDesert Sky Wind Farm LLC and Trent Wind Farm LLC (collectively the LLCs) were established for the purpose of repowering, owning and operating wind-powered electric energy generation facilities in Texas. In January 2018, AEP admitted a nonaffiliate as a member of the LLCs to own and repower Desert Sky and Trent. The nonaffiliate contributed full turbine sets to each project in exchange for a 20.1% interest in the LLCs. The nonaffiliates’ contribution of $84 million was recorded as Net Property, Plant and Equipment on the balance sheets, which was the fair value as of the contribution date determined based on key input assumptions of the original cost of the full turbine sets and the discounted cash flow benefit associated with the production tax credits available from repowering Desert Sky and Trent based on their expected net capacity, capacity factor and the operational availability. From January 2018 through July 2020, AEP owned 79.9% of the LLCs. As a result, management concluded that the LLCs were VIEs and that AEP was the primary beneficiary based on its power to direct the activities that most significantly impact their economic performance. Also in January 2018, the LLCs entered into a forward PPA for the sale of power to AEPEP related to deliveries of electricity beginning January 1, 2021 for a 12 year period. Prior to the effective date of the PPA, the LLCs sold power at market rates into ERCOT. AEP and the nonaffiliate shared tax attributes including PTC and cash distributions from the operation of the LLCs generally consistent with the ownership percentages. See the tables below for the classification of the LLCs’ assets and liabilities on the balance sheets.In August 2020, AEP exercised its call right which required the nonaffiliate to sell its noncontrolling interest in the LLCs to AEP. The nonaffiliates’ interest in the LLCs was presented as Redeemable Noncontrolling Interest on the balance sheets. The exercise price for the call right was determined using a discounted cash flow model with agreed input assumptions as well as updates to certain assumptions reasonably expected based on the actual results of the LLCs. As a result, the LLCs are wholly-owned by AEP and management has concluded that the LLCs are no longer VIEs. As of December 31, 2020 and 2019, AEP recorded $0 and $66 million, respectively, of Redeemable Noncontrolling Interest in Mezzanine Equity on the balance sheets.393Apple Blossom Wind Holdings LLC and Black Oak Getty Wind Holdings LLCIn April 2019, AEP acquired an equity interest in Apple Blossom Wind Holdings LLC (Apple Blossom) and Black Oak Getty Wind Holdings LLC (Black Oak) (collectively the Project Entities) as part of the purchase of Sempra Renewables LLC. Both of the Project Entities have long-term PPAs for 100% of their energy production. The Project Entities are tax equity partnerships with nonaffiliated noncontrolling interests to which a percentage of earnings, tax attributes and cash flows are allocated in accordance with the respective limited liability company agreements. Management has concluded that the Project Entities are VIEs and that AEP is the primary beneficiary based on its power as managing member to direct the activities that most significantly impact the Project Entities’ economic performance. In addition, AEP has not provided material financial or other support to the Project Entities that was not previously contractually required. As the primary beneficiary of the Project Entities, AEP consolidates the Project Entities into its financial statements. See the table below for the classification of Project Entities’ assets and liabilities on the balance sheets.The nonaffiliated interests in the Project Entities is presented in Noncontrolling Interests on the balance sheets. As of December 31, 2020 and 2019, AEP recorded $119 million and $128 million, respectively, of Noncontrolling Interests related to the Project Entities in Equity on the balance sheets.The Project Entities’ tax equity partnerships represent substantive profit-sharing arrangements. The method for attributing income and loss to the noncontrolling interests is a balance sheet approach referred to as the hypothetical liquidation at book value (HLBV) method. Under the HLBV method, the income and loss attributable to the noncontrolling interests reflect changes in the amounts the members would hypothetically receive at each balance sheet date under the liquidation provisions of the respective limited liability company agreements, assuming the net assets of these entities were liquidated at recorded amounts, after taking into account any capital transactions, such as contributions or distributions, between the entities and the members. For the years ended December 31, 2020 and 2019, the HLBV method resulted in a loss of $6 million and $6 million, respectively, allocated to Noncontrolling Interests.Santa Rita EastIn July 2019, AEP acquired a 75% interest in Santa Rita East Wind Energy Holdings, LLC and its wholly-owned subsidiary, Santa Rita East Wind Energy, LLC (collectively, Santa Rita East). In November 2020, AEP acquired an additional 10% interest in Santa Rita East resulting in AEP having a total interest of 85%. Santa Rita East is a partnership whose sole purpose is to own and operate a 302 MW wind generation facility in west Texas. Santa Rita East delivers energy and provides renewable energy credits through three long-term PPAs totaling 260 MWs. The remaining 42 MWs of energy are sold at wholesale into ERCOT. Management has concluded that Santa Rita East is a VIE and that AEP is the primary beneficiary based on its power as managing member of the partnership to direct the activities that most significantly impact Santa Rita East’s economic performance. As the primary beneficiary of Santa Rita East, AEP consolidates Santa Rita East into its financial statements. See the table below for the classification of Santa Rita East’s assets and liabilities on the balance sheets.AEP recognized $23 million and $10 million of PTC attributable to Santa Rita East for the years ended December 31, 2020 and 2019, respectively, which was recorded in Income Tax Expense (Benefit) on the statements of income. The nonaffiliated interest in Santa Rita East is presented in Noncontrolling Interests on the balance sheets. As of December 31, 2020 and 2019, AEP recorded $61 million and $118 million, respectively, of Noncontrolling Interests related to Santa Rita East in Equity on the balance sheets.394The balances below represent the assets and liabilities of the VIEs that are consolidated. These balances include intercompany transactions that are eliminated upon consolidation.American Electric Power Company, Inc. and Subsidiary CompaniesVariable Interest EntitiesDecember 31, 2020Registrant SubsidiariesSWEPCoSabineI&MDCC FuelAEP Texas Transition FundingAEP Texas Restoration FundingAPCoAppalachianConsumerRateRelief Funding(in millions)ASSETSCurrent Assets$88.0 $76.1 $61.2 $23.3 $16.8 Net Property, Plant and Equipment97.3 138.9 — — — Other Noncurrent Assets99.3 70.9 273.9 (a)214.9 (b)212.7 (c)Total Assets$284.6 $285.9 $335.1 $238.2 $229.5 LIABILITIES AND EQUITYCurrent Liabilities$57.7 $76.0 $69.8 $33.9 $28.7 Noncurrent Liabilities225.3 209.9 246.5 203.1 198.9 Equity1.6 — 18.8 1.2 1.9 Total Liabilities and Equity$284.6 $285.9 $335.1 $238.2 $229.5 (a)Includes an intercompany item eliminated in consolidation of $32 million. (b)Includes an intercompany item eliminated in consolidation of $9 million.(c)Includes an intercompany item eliminated in consolidation of $3 million.American Electric Power Company, Inc. and Subsidiary CompaniesVariable Interest EntitiesDecember 31, 2020Other Consolidated VIEsAEP CreditProtectedCellof EISTransource EnergyApple Blossom and Black OakSanta Rita East(in millions)ASSETSCurrent Assets$960.4 $198.1 $22.2 $9.6 $6.0 Net Property, Plant and Equipment— — 458.7 223.1 453.1 Other Noncurrent Assets12.9 — 3.7 12.1 — Total Assets$973.3 $198.1 $484.6 $244.8 $459.1 LIABILITIES AND EQUITYCurrent Liabilities$827.2 $43.1 $32.6 $5.3 $3.5 Noncurrent Liabilities0.8 62.5 185.0 4.9 6.7 Equity145.3 92.5 267.0 234.6 448.9 Total Liabilities and Equity$973.3 $198.1 $484.6 $244.8 $459.1 395American Electric Power Company, Inc. and Subsidiary CompaniesVariable Interest EntitiesDecember 31, 2019Registrant SubsidiariesSWEPCoSabineI&MDCC FuelAEP Texas Transition FundingAEP Texas Restoration FundingAPCoAppalachianConsumerRateRelief Funding(in millions)ASSETSCurrent Assets$80.0 $86.5 $187.0 $9.4 $21.5 Net Property, Plant and Equipment111.6 156.8 — — — Other Noncurrent Assets93.2 82.5 428.1 (a)234.4 (b)237.5 (c)Total Assets$284.8 $325.8 $615.1 $243.8 $259.0 LIABILITIES AND EQUITYCurrent Liabilities$50.6 $86.4 $280.2 $16.3 $28.3 Noncurrent Liabilities233.6 239.4 316.3 226.3 228.8 Equity0.6 — 18.6 1.2 1.9 Total Liabilities and Equity$284.8 $325.8 $615.1 $243.8 $259.0 (a)Includes an intercompany item eliminated in consolidation of $39 million.(b)Includes an intercompany item eliminated in consolidation of $1 million.(c)Includes an intercompany item eliminated in consolidation of $3 million.American Electric Power Company, Inc. and Subsidiary CompaniesVariable Interest EntitiesDecember 31, 2019Other Consolidated VIEsAEP CreditProtectedCellof EISTransource EnergyDesert Sky and TrentApple Blossom and Black OakSanta Rita East(in millions)ASSETSCurrent Assets$842.8 $194.6 $25.8 $7.8 $10.1 $17.7 Net Property, Plant and Equipment— — 424.1 330.6 231.4 465.2 Other Noncurrent Assets7.1 — 3.2 10.1 13.1 0.3 Total Assets$849.9 $194.6 $453.1 $348.5 $254.6 $483.2 LIABILITIES AND EQUITYCurrent Liabilities$805.2 $40.7 $192.4 $5.5 $5.4 $3.9 Noncurrent Liabilities0.9 78.0 4.8 15.8 4.7 7.5 Equity43.8 75.9 255.9 327.2 244.5 471.8 Total Liabilities and Equity$849.9 $194.6 $453.1 $348.5 $254.6 $483.2 396Non-Consolidated Significant Variable InterestsDHLCDHLC is a mining operator which sells 50% of the lignite produced to SWEPCo and 50% to CLECO. The operations of DHLC are governed by the lignite mining agreement among SWEPCo, CLECO and DHLC. SWEPCo and CLECO share the executive board seats and voting rights equally. In accordance with the lignite mining agreement, each entity is responsible for 50% of DHLC’s obligations, including debt. SWEPCo and CLECO equally approve DHLC’s annual budget. The creditors of DHLC have no recourse to any AEP entity other than SWEPCo. As SWEPCo is the sole equity owner of DHLC, it receives 100% of the management fee. SWEPCo’s total billings from DHLC for the years ended December 31, 2020, 2019 and 2018 were $142 million, $55 million and $58 million, respectively. SWEPCo is not required to consolidate DHLC as it is not the primary beneficiary, although SWEPCo holds a significant variable interest in DHLC. SWEPCo’s equity investment in DHLC is included in Deferred Charges and Other Noncurrent Assets on SWEPCo’s balance sheets.SWEPCo’s investment in DHLC was:December 31,20202019As Reported onthe Balance SheetMaximumExposureAs Reported onthe Balance SheetMaximumExposure(in millions)Capital Contribution from SWEPCo$7.6 $7.6 $7.6 $7.6 Retained Earnings20.4 20.4 17.5 17.5 SWEPCo’s Share of Obligations— 98.5 — 130.0 Total Investment in DHLC$28.0 $126.5 $25.1 $155.1 OVECAEP and several nonaffiliated utility companies jointly own OVEC. As of December 31, 2020, AEP’s ownership in OVEC was 43.47%. Parent owns 39.17% and OPCo owns 4.3%. APCo, I&M and OPCo are members to an intercompany power agreement. The Registrants’ power participation ratios are 15.69% for APCo, 7.85% for I&M and 19.93% for OPCo. Participants of this agreement are entitled to receive and are obligated to pay for all OVEC generating capacity, approximately 2,400 MWs, in proportion to their respective power participation ratios. The proceeds from the sale of power by OVEC are designed to be sufficient for OVEC to meet its operating expenses and fixed costs, including outstanding indebtedness, and provide a return on capital. The intercompany power agreement ends in June 2040. AEP and other nonaffiliated owners authorized environmental investments related to their ownership interests. OVEC financed capital expenditures in connection with the engineering and construction of FGD projects and the associated waste disposal landfills at its two generation plants. These environmental projects were funded through debt issuances. As of December 31, 2020 and 2019, OVEC’s outstanding indebtedness was approximately $1.3 billion and $1.4 billion, respectively. Although they are not an obligor or guarantor, the Registrants’ are responsible for their respective ratio of OVEC’s outstanding debt through the intercompany power agreement. Principal and interest payments related to OVEC’s outstanding indebtedness are disclosed in accordance with the accounting guidance for “Commitments.” See the “Commitments” section of Note 6 for additional information.AEP is not required to consolidate OVEC as it is not the primary beneficiary, although AEP and its subsidiary holds a significant variable interest in OVEC. Power to control decision making that significantly impacts the economic performance of OVEC is shared amongst the owners through their representation on the Board of Directors of OVEC and the representation of the sponsoring companies on the Operating Committee under the intercompany power agreement. 397AEP’s investment in OVEC was:December 31,20202019As Reported onthe Balance SheetMaximumExposureAs Reported onthe Balance SheetMaximum Exposure(in millions)Capital Contribution from AEP$4.4 $4.4 $4.4 $4.4 AEP’s Ratio of OVEC Debt (a)— 555.0 — 588.9 Total Investment in OVEC$4.4 $559.4 $4.4 $593.3 (a)Based on the Registrants’ power participation ratios APCo, I&M and OPCo’s share of OVEC debt was $200 million, $100 million and $255 million as of December 31, 2020 and $213 million, $106 million and $270 million as of December 31, 2019, respectively. Power purchased by the Registrant Subsidiaries from OVEC is included in Purchased Electricity for Resale on the statements of income and is shown in the table below:Years Ended December 31,Company202020192018(in millions)APCo$94.4 $104.5 $100.4 I&M 47.2 52.3 50.2 OPCo120.8 132.7 127.5 AEPSCAEPSC provides certain managerial and professional services to AEP’s subsidiaries. Parent is the sole equity owner of AEPSC. AEP management controls the activities of AEPSC. The costs of the services are based on a direct-charge or on a prorated basis and billed to the AEP subsidiary companies at AEPSC’s cost. AEP subsidiaries have not provided financial or other support outside of the reimbursement of costs for services rendered. AEPSC finances its operations through cost reimbursement from other AEP subsidiaries. There are no other terms or arrangements between AEPSC and any of the AEP subsidiaries that could require additional financial support from an AEP subsidiary or expose them to losses outside of the normal course of business. AEPSC and its billings are subject to regulation by the FERC. AEP subsidiaries are exposed to losses to the extent they cannot recover the costs of AEPSC through their normal business operations. AEP subsidiaries are considered to have a significant interest in AEPSC due to their activity in AEPSC’s cost reimbursement structure. However, AEP subsidiaries do not have control over AEPSC. AEPSC is consolidated by AEP. In the event AEPSC would require financing or other support outside the cost reimbursement billings, this financing would be provided by AEP.398Total AEPSC billings to the Registrant Subsidiaries were as follows:Years Ended December 31,Company202020192018(in millions)AEP Texas$199.4 $206.6 $184.3 AEPTCo270.3 242.3 220.4 APCo294.9 308.3 295.6 I&M210.2 184.8 173.5 OPCo232.8 230.4 214.9 PSO113.2 125.7 121.5 SWEPCo161.8 169.5 164.4 The carrying amount and classification of variable interest in AEPSC’s accounts payable were as follows:December 31,20202019CompanyAs Reported onthe Balance SheetMaximumExposureAs Reported onthe Balance SheetMaximumExposure(in millions)AEP Texas$30.5 $30.5 $32.4 $32.4 AEPTCo45.9 45.9 33.4 33.4 APCo42.8 42.8 44.1 44.1 I&M27.1 27.1 28.6 28.6 OPCo33.9 33.9 33.2 33.2 PSO15.7 15.7 18.1 18.1 SWEPCo22.0 22.0 23.4 23.4 AEGCoAEGCo, a wholly-owned subsidiary of Parent, is consolidated by AEP. AEGCo owns a 50% ownership interest in Rockport Plant, Unit 1 and leases a 50% interest in Rockport Plant, Unit 2. AEGCo sells all the output from the Rockport Plant to I&M and KPCo. AEP has agreed to provide AEGCo with the funds necessary to satisfy all of the debt obligations of AEGCo. I&M is considered to have a significant interest in AEGCo due to these transactions. I&M is exposed to losses to the extent it cannot recover the costs of AEGCo through its normal business operations. In the event AEGCo would require financing or other support outside the billings to I&M and KPCo, this financing would be provided by AEP. Total billings to I&M from AEGCo for the years ended December 31, 2020, 2019 and 2018 were $173 million, $215 million and $238 million, respectively. The carrying amounts of I&M’s liabilities associated with AEGCo as of December 31, 2020 and 2019 were $9 million and $10 million, respectively. Management estimates the maximum exposure of loss to be equal to the amount of such liability. See “Rockport Lease” section of Note 13 for additional information. 399Significant Equity Method Investments in Unconsolidated EntitiesFor a discussion of the equity method of accounting, see the “Equity Investment in Unconsolidated Entities” section of Note 1.Sempra Renewables LLCIn April 2019, AEP acquired a 50% interest in five wind farms in multiple states as part of the purchase of Sempra Renewables LLC. The wind farms are joint ventures with BP Wind Energy who holds the other 50% interest. All five wind farms have long-term PPAs for 100% of their energy production. One of the jointly-owned wind farms has PPAs with I&M and OPCo for a portion of its energy production. Another jointly-owned wind farm has a PPA with SWEPCo for a portion of its energy production. The joint venture wind farms are not considered VIEs and AEP is not required to consolidate them as AEP does not have a controlling financial interest. However, AEP is able to exercise significant influence over the wind farms and therefore applies the equity method of accounting. As of December 31, 2020 and 2019, AEP’s investment in the five joint venture wind farms was $376 million and $394 million, respectively. The investment includes amounts recognized in AOCI related to interest rate cash flow hedges. The investment is comprised of a historical investment of $399 million plus a basis difference of $(12) million. AEP’s equity earnings associated with the five joint venture wind farms was $2 million and a loss of $4 million for the years ended December 31, 2020 and 2019, respectively. AEP recognized $36 million and $27 million of PTC attributable to the joint venture wind farms for the years ended December 31, 2020 and 2019, respectively, which was recorded in Income Tax Expense (Benefit) on the statements of income.ETTETT designs, acquires, constructs, owns and operates certain transmission facilities in ERCOT. Berkshire Hathaway Energy, a nonaffiliated entity, holds a 50% membership interest in ETT and AEP Transmission Holdco holds a 50% membership interest in ETT. As a result, AEP, through its wholly-owned subsidiary, holds a 50% membership interest in ETT. As of December 31, 2020 and 2019, AEP’s investment in ETT was $732 million and $695 million, respectively. AEP’s equity earnings associated with ETT were $68 million, $66 million and $62 million for the years ended December 31, 2020, 2019 and 2018 respectively. 40018. PROPERTY, PLANT AND EQUIPMENTThe disclosures in this note apply to all Registrants unless indicated otherwise.Property, Plant and Equipment is shown functionally on the face of the balance sheets. The following tables include the total plant balances as of December 31, 2020 and 2019: December 31, 2020AEPAEP TexasAEPTCoAPCoI&MOPCoPSOSWEPCo(in millions)Regulated Property, Plant and EquipmentGeneration$21,587.8 (a)$— $— $6,633.7 $5,264.7 $— $1,480.7 $4,681.4 (a)Transmission27,841.5 5,279.6 9,593.5 3,900.5 1,696.4 2,831.9 1,069.9 2,165.7 Distribution23,972.1 4,580.8 — 4,464.3 2,594.6 5,708.3 2,853.0 2,382.5 Other4,852.4 866.0 328.8 598.0 644.6 888.5 388.1 564.5 CWIP3,815.0 (a)614.1 1,422.6 484.6 362.4 362.3 128.7 228.3 (a)Less: Accumulated Depreciation20,094.2 1,528.1 572.8 4,711.0 3,538.6 2,348.8 1,607.3 3,032.0 Total Regulated Property, Plant and Equipment - Net61,974.6 9,812.4 10,772.1 11,370.1 7,024.1 7,442.2 4,313.1 6,990.4 Nonregulated Property, Plant and Equipment - Net1,927.0 1.2 0.7 24.0 28.2 9.9 6.9 97.8 Total Property, Plant and Equipment - Net$63,901.6 $9,813.6 $10,772.8 $11,394.1 $7,052.3 $7,452.1 $4,320.0 $7,088.2 December 31, 2019AEPAEP TexasAEPTCoAPCoI&MOPCoPSOSWEPCo(in millions)Regulated Property, Plant and EquipmentGeneration$21,323.5 (a)$— $— $6,563.7 $5,099.7 $— $1,574.6 $4,691.4 (a)Transmission24,763.4 4,466.5 8,137.9 3,584.1 1,641.8 2,686.3 948.5 2,056.5 Distribution22,440.8 4,215.2 — 4,201.7 2,437.6 5,323.5 2,684.8 2,270.7 Other4,369.6 803.4 268.2 542.0 590.9 754.7 337.2 520.6 CWIP4,261.2 (a)763.9 1,485.7 593.4 382.3 394.4 133.4 210.1 (a)Less: Accumulated Depreciation18,778.1 1,465.0 402.3 4,425.6 3,281.4 2,261.7 1,579.9 2,766.2 Total Regulated Property, Plant and Equipment - Net58,380.4 8,784.0 9,489.5 11,059.3 6,870.9 6,897.2 4,098.6 6,983.1 Nonregulated Property, Plant and Equipment - Net1,757.7 61.1 1.4 22.6 28.8 9.8 4.7 112.1 Total Property, Plant and Equipment - Net$60,138.1 $8,845.1 $9,490.9 $11,081.9 $6,899.7 $6,907.0 $4,103.3 $7,095.2 (a)AEP and SWEPCo’s regulated generation and regulated CWIP include amounts related to SWEPCo’s Arkansas jurisdictional share of the Turk Plant.401Depreciation, Depletion and AmortizationThe Registrants provide for depreciation of Property, Plant and Equipment, excluding coal-mining properties, on a straight-line basis over the estimated useful lives of property, generally using composite rates by functional class. The following tables provide total regulated annual composite depreciation rates and depreciable lives for the Registrants:AEP202020192018Functional Class of PropertyAnnual CompositeDepreciation Rate RangesDepreciableLife RangesAnnual CompositeDepreciation Rate RangesDepreciableLife RangesAnnual CompositeDepreciation Rate RangesDepreciableLife Ranges(in years)(in years)(in years)Generation2.7%-6.3%20-1322.5%-5.5%20-1322.4%-4.0%20-132Transmission2.0%-2.6%15-751.8%-2.6%15-811.6%-2.7%15-81Distribution2.7%-3.7%7-782.7%-3.7%7-782.7%-3.6%7-78Other2.8%-11.3%5-752.6%-9.5%5-752.3%-9.8%5-75AEP Texas202020192018Functional Class of PropertyAnnual CompositeDepreciation RateDepreciableLife RangesAnnual CompositeDepreciation RateDepreciableLife RangesAnnual CompositeDepreciation RateDepreciableLife Ranges(in years)(in years)(in years)Transmission2.0%50-751.8%45-811.7%45-81Distribution3.1%7-703.5%7-703.6%7-70Other6.1%5-506.3%5-506.0%5-50AEPTCo202020192018Functional Class of PropertyAnnual CompositeDepreciation RateDepreciableLife RangesAnnual CompositeDepreciation RateDepreciableLife RangesAnnual CompositeDepreciation RateDepreciableLife Ranges(in years)(in years)(in years)Transmission2.4%24-752.0%24-751.9%20-75Other6.3%5-645.8%5-645.6%5-64APCo202020192018Functional Class of PropertyAnnual CompositeDepreciation RateDepreciableLife RangesAnnual CompositeDepreciation RateDepreciableLife RangesAnnual CompositeDepreciation RateDepreciableLife Ranges(in years)(in years)(in years)Generation3.3%35-1183.2%35-1183.1%35-112Transmission2.2%15-751.8%15-711.6%15-68Distribution3.7%12-573.7%12-573.6%10-57Other7.8%5-557.2%5-557.4%5-55I&M202020192018Functional Class of PropertyAnnual CompositeDepreciation RateDepreciableLife RangesAnnual CompositeDepreciation RateDepreciableLife RangesAnnual CompositeDepreciation RateDepreciableLife Ranges(in years)(in years)(in years)Generation4.6%20-1324.0%20-1323.4%20-132Transmission2.3%45-701.9%50-731.8%50-73Distribution3.4%14-713.4%9-753.1%9-75Other10.2%5-519.4%5-508.9%5-50OPCo202020192018Functional Class of PropertyAnnual CompositeDepreciation RateDepreciableLife RangesAnnual CompositeDepreciation RateDepreciableLife RangesAnnual CompositeDepreciation RateDepreciableLife Ranges(in years)(in years)(in years)Transmission2.3%39-602.3%39-602.3%39-60Distribution3.1%14-653.1%14-653.0%14-65Other5.0%5-504.9%5-506.3%5-50402PSO202020192018Functional Class of PropertyAnnual CompositeDepreciation RateDepreciableLife RangesAnnual CompositeDepreciation RateDepreciableLife RangesAnnual CompositeDepreciation RateDepreciableLife Ranges(in years)(in years)(in years)Generation3.1%35-752.9%35-752.9%35-75Transmission2.2%45-752.4%45-752.3%45-75Distribution2.9%15-782.9%15-782.9%15-78Other5.7%5-645.6%5-646.3%5-64SWEPCo202020192018Functional Class of PropertyAnnual CompositeDepreciation RateDepreciableLife RangesAnnual CompositeDepreciation RateDepreciableLife RangesAnnual CompositeDepreciation RateDepreciableLife Ranges(in years)(in years)(in years)Generation2.7%35-652.5%40-702.4%40-70Transmission2.3%47-732.4%50-732.2%50-73Distribution2.7%15-672.7%25-702.7%25-70Other8.5%5-527.6%5-558.0%5-55The following table includes the nonregulated annual composite depreciation rate ranges and nonregulated depreciable life ranges for AEP. Depreciation rate ranges and depreciable life ranges are not meaningful for nonregulated property of AEPTCo, APCo, I&M, OPCo, PSO and SWEPCo for 2020, 2019 and 2018.202020192018Functional Class of PropertyAnnual CompositeDepreciation Rate RangesDepreciableLife RangesAnnual CompositeDepreciation Rate RangesDepreciableLife RangesAnnual CompositeDepreciation Rate RangesDepreciableLife Ranges(in years)(in years)(in years)Generation3.6%-4.0%15-593.2%-21.2%15-593.4%-22.3%15-59Transmission2.5%30-402.5%30-402.4%40DistributionNANA2.3%402.3%40Other16.1%5-50(a)17.6%5-50(a)16.3%5-50(a)(a)SWEPCo’s nonregulated property, plant and equipment is depreciated using the straight-line method over a range of 3 to 20 years.NA Not applicable.SWEPCo provides for depreciation, depletion and amortization of coal-mining assets over each asset’s estimated useful life or the estimated life of each mine, whichever is shorter, using the straight-line method for mining structures and equipment. SWEPCo uses either the straight-line method or the units-of-production method to amortize mine development costs and deplete coal rights based on estimated recoverable tonnages. SWEPCo includes these costs in fuel expense.For regulated operations, the composite depreciation rate generally includes a component for non-ARO removal costs, which is credited to Accumulated Depreciation and Amortization on the balance sheets. Actual removal costs incurred are charged to Accumulated Depreciation and Amortization. Any excess of accrued non-ARO removal costs over actual removal costs incurred is reclassified from Accumulated Depreciation and Amortization and reflected as a regulatory liability. For nonregulated operations, non-ARO removal costs are expensed as incurred. Asset Retirement Obligations (Applies to all Registrants except AEPTCo)The Registrants record ARO in accordance with the accounting guidance for “Asset Retirement and Environmental Obligations” for legal obligations for asbestos removal and for the retirement of certain ash disposal facilities, wind farms, solar farms and certain coal-mining facilities. I&M records ARO for the decommissioning of the Cook Plant. The Registrants have identified, but not recognized, ARO liabilities related to electric transmission and distribution assets as a result of certain easements on property on which assets are owned. Generally, such easements are perpetual and require only the retirement and removal of assets upon the cessation of the property’s use. The retirement obligation is not estimable for such easements since the Registrants plan to use their facilities indefinitely. The retirement obligation would only be recognized if and when the Registrants abandon or cease the use of specific easements, which is not expected. 403The Registrants recorded the following revisions to ARO estimates as of December 31, 2020:•In March 2020, SWEPCo recorded a revision to increase estimated ARO liabilities by $21 million primarily due to the revision in the useful life of DHLC. See Note 5 - Effects of Regulation for additional information. In September 2020, SWEPCo recorded an $18 million revision due to a reduction in estimated ash pond closure costs.•In June 2020, AEP Texas and PSO recorded a revision to decrease estimated ARO liabilities by $17 million and $5 million, respectively, due to the retirement of the Oklaunion Power Station in September 2020. See Note 5 - Effects of Regulation for additional information. •In June 2020, AGR derecognized $106 million of Conesville Plant related ARO liabilities as a result of the Environmental Liability and Property Transfer and Asset Purchase Agreement executed with a non-affiliated third-party. See Note 7 - Acquisitions and Dispositions for additional information. •In June 2020, APCo recorded a revision to increase estimated Glen Lyn Station ash disposal ARO liabilities by $199 million due to the enactment of House Bill 443. This bill requires APCo to close the ash disposal units at the retired Glen Lyn Station by removal of all coal combustion material. The legislation provides for regulatory recovery of these costs. See Note 6 - Commitments, Guarantees and Contingencies for additional information. As of December 31, 2020 and 2019, I&M’s ARO liability for nuclear decommissioning of the Cook Plant was $1.80 billion and $1.73 billion, respectively. These liabilities are reflected in Asset Retirement Obligations on I&M’s balance sheets. As of December 31, 2020 and 2019, the fair value of I&M’s assets that are legally restricted for purposes of settling decommissioning liabilities totaled $2.98 billion and $2.65 billion, respectively. These assets are included in Spent Nuclear Fuel and Decommissioning Trusts on I&M’s balance sheets.The following is a reconciliation of the 2020 and 2019 aggregate carrying amounts of ARO by Registrant: CompanyARO as of December 31, 2019AccretionExpenseLiabilitiesIncurredLiabilitiesSettledRevisions inCash FlowEstimates (a)ARO as of December 31, 2020(in millions)AEP (b)(c)(d)(e)$2,418.9 $102.4 $0.3 $(188.0)$183.1 $2,516.7 AEP Texas (b)(e)29.1 0.8 — (8.5)(16.8)4.6 APCo (b)(e)111.1 8.9 — (7.8)200.9 313.1 I&M (b)(c)(e)1,748.6 70.2 0.1 (0.2)(4.9)1,813.8 OPCo (e)1.8 0.1 — — — 1.9 PSO (b)(e)52.2 3.1 — (3.1)(4.8)47.4 SWEPCo (b)(d)(e)212.2 10.7 — (10.9)10.1 222.1 CompanyARO as of December 31, 2018AccretionExpenseLiabilitiesIncurredLiabilitiesSettledRevisions inCash FlowEstimates (a)ARO as of December 31, 2019(in millions)AEP (b)(c)(d)(e)$2,355.5 $102.5 $12.0 $(118.1)$67.0 $2,418.9 AEP Texas (b)(e)27.9 1.3 — (0.2)0.1 29.1 APCo (b)(e)116.1 5.9 — (17.6)6.7 111.1 I&M (b)(c)(e)1,681.3 67.4 — (0.2)0.1 1,748.6 OPCo (e)1.8 0.1 — (0.3)0.2 1.8 PSO (b)(e)46.9 3.1 — (0.4)2.6 52.2 SWEPCo (b)(d)(e)206.8 10.3 — (11.8)6.9 212.2 (a)Unless discussed above, primarily related to ash ponds, landfills and mine reclamation, generally due to changes in estimated closure area, volumes and/or unit costs.(b)Includes ARO related to ash disposal facilities.(c)Includes ARO related to nuclear decommissioning costs for the Cook Plant of $1.80 billion and $1.73 billion as of December 31, 2020 and 2019, respectively.(d)Includes ARO related to Sabine and DHLC.404(e)Includes ARO related to asbestos removal.Allowance for Funds Used During Construction and Interest CapitalizationThe Registrants’ amounts of Allowance for Equity Funds Used During Construction are summarized in the following table:Years Ended December 31,Company202020192018(in millions)AEP$148.1 $168.4 $132.5 AEP Texas19.4 15.2 20.0 AEPTCo74.0 84.3 70.6 APCo14.6 16.6 13.2 I&M11.5 19.4 11.9 OPCo12.5 18.2 9.8 PSO4.0 2.7 0.4 SWEPCo7.7 6.8 6.0 The Registrants’ amounts of allowance for borrowed funds used during construction, including capitalized interest, are summarized in the following table:Years Ended December 31,Company202020192018(in millions)AEP$66.0 $88.7 $73.6 AEP Texas12.5 20.0 18.4 AEPTCo25.5 32.2 26.1 APCo7.9 9.3 8.4 I&M5.7 8.9 7.4 OPCo6.2 6.7 5.8 PSO2.0 1.9 0.9 SWEPCo3.9 4.0 4.8 405Jointly-owned Electric Facilities (Applies to AEP, AEP Texas, I&M, PSO and SWEPCo)The Registrants have electric facilities that are jointly-owned with affiliated and nonaffiliated companies. Using its own financing, each participating company is obligated to pay its share of the costs of these jointly-owned facilities in the same proportion as its ownership interest. Each Registrant’s proportionate share of the operating costs associated with these facilities is included in its statements of income and the investments and accumulated depreciation are reflected in its balance sheets under Property, Plant and Equipment as follows:Registrant’s Share as of December 31, 2020FuelTypePercent ofOwnershipUtility Plantin ServiceConstructionWork inProgressAccumulatedDepreciation(in millions)AEPDolet Hills Power Station, Unit 1 (a)Lignite40.2 %$342.4 $4.6 $295.4 Flint Creek Generating Station, Unit 1 (b)Coal50.0 %377.2 3.0 116.0 Pirkey Power Plant, Unit 1 (b)Lignite85.9 %602.8 3.7 441.0 Oklaunion Power Station (f)(g)Coal70.3 %— — — Turk Generating Plant (b)Coal73.3 %1,594.3 2.8 257.3 Total$2,916.7 $14.1 $1,109.7 AEP TexasOklaunion Power Station (f)(g)Coal54.7 %$— $— $— I&MRockport Generating Plant (c)(d)(e)Coal50.0 %$1,228.5 $19.6 $677.3 PSOOklaunion Power Station (f)(g)Coal15.6 %$— $— $— SWEPCoDolet Hills Power Station, Unit 1 (a)Lignite40.2 %$342.4 $4.6 $295.4 Flint Creek Generating Station, Unit 1 (b)Coal50.0 %377.2 3.0 116.0 Pirkey Power Plant, Unit 1 (b)Lignite85.9 %602.8 3.7 441.0 Turk Generating Plant (b)Coal73.3 %1,594.3 2.8 257.3 Total$2,916.7 $14.1 $1,109.7 406Registrant’s Share as of December 31, 2019FuelTypePercent ofOwnershipUtility Plantin ServiceConstructionWork inProgressAccumulatedDepreciation(in millions)AEPDolet Hills Power Station, Unit 1 (a)Lignite40.2 %$337.3 $6.2 $216.5 Flint Creek Generating Station, Unit 1 (b)Coal50.0 %374.3 3.4 101.1 Pirkey Power Plant, Unit 1 (b)Lignite85.9 %607.8 7.7 416.8 Oklaunion Power Station (f)(g)Coal70.3 %106.6 0.1 91.7 Turk Generating Plant (b)Coal73.3 %1,593.3 1.7 225.8 Total$3,019.3 $19.1 $1,051.9 AEP TexasOklaunion Power Station (f)(g)Coal54.7 %$351.7 $— $291.9 I&MRockport Generating Plant (c)(d)(e)Coal50.0 %$1,114.2 $105.5 $586.2 PSOOklaunion Power Station (f)(g)Coal15.6 %$106.6 $0.1 $91.7 SWEPCoDolet Hills Power Station, Unit 1 (a)Lignite40.2 %$337.3 $6.2 $216.5 Flint Creek Generating Station, Unit 1 (b)Coal50.0 %374.3 3.4 101.1 Pirkey Power Plant, Unit 1 (b)Lignite85.9 %607.8 7.7 416.8 Turk Generating Plant (b)Coal73.3 %1,593.3 1.7 225.8 Total$2,912.7 $19.0 $960.2 (a)Operated by CLECO, a nonaffiliated company.(b)Operated by SWEPCo.(c)Operated by I&M.(d)Amounts include I&M’s 50% ownership of both Unit 1 and capital additions for Unit 2. Unit 2 is subject to an operating lease with a nonaffiliated company. See the “Rockport Lease” section of Note 13 for additional information.(e)AEGCo owns 50% of Unit 1 with I&M and 50% of capital additions for Unit 2.(f)Operated by PSO, which owned 15.6%. Also was jointly-owned (54.7%) by AEP Texas and various nonaffiliated companies.(g)Oklaunion Power Station was retired in September 2020 and sold to a nonaffiliated third-party in October 2020. See the “Dispositions” section of Note 7 for additional information.40719. REVENUE FROM CONTRACTS WITH CUSTOMERSThe disclosures in this note apply to all Registrants, unless indicated otherwise.Disaggregated Revenues from Contracts with CustomersThe table below represents AEP’s reportable segment revenues from contracts with customers, net of respective provisions for refund, by type of revenue:Year Ended December 31, 2020Vertically Integrated UtilitiesTransmission and Distribution UtilitiesAEP Transmission HoldcoGeneration & MarketingCorporate and OtherReconciling AdjustmentsAEP Consolidated(in millions)Retail Revenues:Residential Revenues$3,606.8 $2,086.9 $— $— $— $— $5,693.7 Commercial Revenues2,016.2 1,048.6 — — — — 3,064.8 Industrial Revenues2,018.0 390.1 — — — (0.7)2,407.4 Other Retail Revenues155.6 42.5 — — — — 198.1 Total Retail Revenues7,796.6 3,568.1 — — — (0.7)11,364.0 Wholesale and Competitive Retail Revenues:Generation Revenues 588.3 — — 131.9 — — 720.2 Transmission Revenues (a)334.5 467.0 1,257.0 — — (1,006.7)1,051.8 Renewable Generation Revenues (b)— — — 60.9 — (1.6)59.3 Retail, Trading and Marketing Revenues (c)— — — 1,486.9 (5.5)(103.0)1,378.4 Total Wholesale and Competitive Retail Revenues922.8 467.0 1,257.0 1,679.7 (5.5)(1,111.3)3,209.7 Other Revenues from Contracts with Customers (b)163.2 157.8 22.4 2.3 92.5 (148.6)289.6 Total Revenues from Contracts with Customers8,882.6 4,192.9 1,279.4 1,682.0 87.0 (1,260.6)14,863.3 Other Revenues:Alternative Revenues (b)(3.2)70.0 (80.6)— — 7.5 (6.3)Other Revenues (b)— 83.0 — 43.6 9.8 (74.9)61.5 Total Other Revenues(3.2)153.0 (80.6)43.6 9.8 (67.4)55.2 Total Revenues$8,879.4 $4,345.9 $1,198.8 $1,725.6 $96.8 $(1,328.0)$14,918.5 (a)Amounts include affiliated and nonaffiliated revenues. The affiliated revenue for AEP Transmission Holdco was $965 million. The remaining affiliated amounts were immaterial.(b)Amounts include affiliated and nonaffiliated revenues.(c)Amounts include affiliated and nonaffiliated revenues. The affiliated revenue for Generation & Marketing was $103 million. The remaining affiliated amounts were immaterial.408Year Ended December 31, 2019Vertically Integrated UtilitiesTransmission and Distribution UtilitiesAEP Transmission HoldcoGeneration & MarketingCorporate and OtherReconciling AdjustmentsAEP Consolidated(in millions)Retail Revenues:Residential Revenues$3,643.7 $2,069.9 $— $— $— $— $5,713.6 Commercial Revenues2,155.3 1,152.9 — — — — 3,308.2 Industrial Revenues2,179.0 429.1 — — — (0.9)2,607.2 Other Retail Revenues179.1 43.8 — — — — 222.9 Total Retail Revenues8,157.1 3,695.7 — — — (0.9)11,851.9 Wholesale and Competitive Retail Revenues:Generation Revenues 807.6 — — 254.8 — — 1,062.4 Transmission Revenues (a)292.1 435.1 1,077.2 — — (825.0)979.4 Renewable Generation Revenues (b)— — — 57.3 — — 57.3 Retail, Trading and Marketing Revenues (c)— — — 1,480.7 — (135.6)1,345.1 Total Wholesale and Competitive Retail Revenues1,099.7 435.1 1,077.2 1,792.8 — (960.6)3,444.2 Other Revenues from Contracts with Customers (b)168.2 169.4 16.6 4.9 104.7 (147.1)316.7 Total Revenues from Contracts with Customers9,425.0 4,300.2 1,093.8 1,797.7 104.7 (1,108.6)15,612.8 Other Revenues:Alternative Revenues (b)(57.9)32.3 (20.6)— — (66.9)(113.1)Other Revenues (b)— 150.0 — 59.9 (8.9)(139.3)61.7 Total Other Revenues(57.9)182.3 (20.6)59.9 (8.9)(206.2)(51.4)Total Revenues$9,367.1 $4,482.5 $1,073.2 $1,857.6 $95.8 $(1,314.8)$15,561.4 (a)Amounts include affiliated and nonaffiliated revenues. The affiliated revenue for AEP Transmission Holdco was $794 million. The remaining affiliated amounts were immaterial.(b)Amounts include affiliated and nonaffiliated revenues.(c)Amounts include affiliated and nonaffiliated revenues. The affiliated revenue for Generation & Marketing was $136 million. The remaining affiliated amounts were immaterial. 409Year Ended December 31, 2018Vertically Integrated UtilitiesTransmission and Distribution UtilitiesAEP Transmission HoldcoGeneration & MarketingCorporate and OtherReconciling AdjustmentsAEP Consolidated(in millions)Retail Revenues:Residential Revenues$3,751.8 $2,189.4 $— $— $— $— $5,941.2 Commercial Revenues2,183.4 1,251.7 — — — — 3,435.1 Industrial Revenues2,212.8 512.5 — — — — 2,725.3 Other Retail Revenues183.5 42.7 — — — — 226.2 Total Retail Revenues (a)8,331.5 3,996.3 — — — — 12,327.8 Wholesale and Competitive Retail Revenues:Generation Revenues899.8 — — 423.7 — (7.3)(e)1,316.2 Transmission Revenues (b)282.2 372.1 849.3 — — (737.1)766.5 Renewable Generation Revenues (c)— — — 50.8 — — 50.8 Retail, Trading and Marketing Revenues (d)— — — 1,422.9 — (120.7)1,302.2 Total Wholesale and Competitive Retail Revenues1,182.0 372.1 849.3 1,897.4 — (865.1)3,435.7 Other Revenues from Contracts with Customers (c)158.4 204.6 15.2 20.6 86.2 (32.0)453.0 Total Revenues from Contracts with Customers9,671.9 4,573.0 864.5 1,918.0 86.2 (897.1)16,216.5 Other Revenues:Alternative Revenues (c)(15.9)(22.2)(60.4)— — 52.7 (45.8)Other Revenues (c)(10.5)102.3 — 22.3 8.9 (98.0)(e)25.0 Total Other Revenues(26.4)80.1 (60.4)22.3 8.9 (45.3)(20.8)Total Revenues$9,645.5 $4,653.1 $804.1 $1,940.3 $95.1 $(942.4)$16,195.7 (a)2018 amounts have been revised to reflect the reclassification of certain customer accounts between Retail classes. This reclassification did not impact previously reported Total Retail Revenues. Management concluded that these prior period disclosure only errors were immaterial individually and in the aggregate.(b)Amounts include affiliated and nonaffiliated revenues. The affiliated revenue for AEP Transmission Holdco was $643 million. The remaining affiliated amounts were immaterial.(c)Amounts include affiliated and nonaffiliated revenues.(d)Amounts include affiliated and nonaffiliated revenues. The affiliated revenue for Generation & Marketing was $121 million. The remaining affiliated amounts were immaterial.(e)2018 amounts have been revised to reflect the reclassification of $98 million of affiliated revenues between Generation Revenues and Other Revenues. This reclassification did not impact previously reported Total Revenues. Management concluded that these prior period disclosure only errors were immaterial individually and in the aggregate.410The table below represents revenues from contracts with customers, net of respective provisions for refund, by type of revenue for the Registrant Subsidiaries:Year Ended December 31, 2020AEP TexasAEPTCoAPCoI&MOPCoPSOSWEPCo(in millions)Retail Revenues:Residential Revenues$563.6 $— $1,250.6 $794.1 $1,523.4 $579.4 $630.8 Commercial Revenues366.7 — 517.0 499.3 682.0 320.1 466.7 Industrial Revenues120.1 — 553.5 547.4 270.0 221.1 328.8 Other Retail Revenues29.5 — 67.6 6.6 13.1 66.0 9.1 Total Retail Revenues1,079.9 — 2,388.7 1,847.4 2,488.5 1,186.6 1,435.4 Wholesale Revenues:Generation Revenues (a)— — 230.2 274.6 — 15.1 162.0 Transmission Revenues (b)399.9 1,210.3 130.8 29.0 67.0 27.5 111.2 Total Wholesale Revenues399.9 1,210.3 361.0 303.6 67.0 42.6 273.2 Other Revenues from Contracts with Customers (c)48.2 22.4 59.5 85.0 109.5 34.7 26.7 Total Revenues from Contracts with Customers1,528.0 1,232.7 2,809.2 2,236.0 2,665.0 1,263.9 1,735.3 Other Revenues:Alternative Revenues (d)3.4 (87.0)(13.0)5.8 66.6 2.2 3.2 Other Revenues (d)87.5 — — — 17.5 — — Total Other Revenues90.9 (87.0)(13.0)5.8 84.1 2.2 3.2 Total Revenues$1,618.9 $1,145.7 $2,796.2 $2,241.8 $2,749.1 $1,266.1 $1,738.5 (a)Amounts include affiliated and nonaffiliated revenues. The affiliated revenue for APCo was $112 million primarily relating to the PPA with KGPCo. The remaining affiliated amounts were immaterial.(b)Amounts include affiliated and nonaffiliated revenues. The affiliated revenue for AEPTCo was $952 million. The remaining affiliated amounts were immaterial.(c)Amounts include affiliated and nonaffiliated revenues. The affiliated revenue for I&M was $69 million primarily relating to barging, urea transloading and other transportation services. The remaining affiliated amounts were immaterial.(d)Amounts include affiliated and nonaffiliated revenues.411Year Ended December 31, 2019AEP TexasAEPTCoAPCoI&MOPCoPSOSWEPCo(in millions)Retail Revenues:Residential Revenues$571.5 $— $1,266.9 $730.0 $1,502.0 $650.2 $638.6 Commercial Revenues411.5 — 559.9 494.2 738.5 388.5 485.4 Industrial Revenues129.4 — 592.2 550.7 299.9 303.5 338.7 Other Retail Revenues29.9 — 75.2 7.3 13.1 81.6 9.0 Total Retail Revenues1,142.3 — 2,494.2 1,782.2 2,553.5 1,423.8 1,471.7 Wholesale Revenues:Generation Revenues (a)— — 251.5 402.4 — 39.5 194.7 Transmission Revenues (b)379.2 1,025.5 103.6 25.1 56.0 27.5 106.7 Total Wholesale Revenues379.2 1,025.5 355.1 427.5 56.0 67.0 301.4 Other Revenues from Contracts with Customers (c)30.1 16.6 61.8 98.4 139.3 22.0 26.1 Total Revenues from Contracts with Customers1,551.6 1,042.1 2,911.1 2,308.1 2,748.8 1,512.8 1,799.2 Other Revenues:Alternative Revenues (d)0.6 (20.7)13.6 (1.4)31.7 (31.0)(48.3)Other Revenues (d)157.1 — — — 17.1 — — Total Other Revenues157.7 (20.7)13.6 (1.4)48.8 (31.0)(48.3)Total Revenues$1,709.3 $1,021.4 $2,924.7 $2,306.7 $2,797.6 $1,481.8 $1,750.9 (a)Amounts include affiliated and nonaffiliated revenues. The affiliated revenue for APCo was $129 million primarily relating to the PPA with KGPCo. The remaining affiliated amounts were immaterial.(b)Amounts include affiliated and nonaffiliated revenues. The affiliated revenue for AEPTCo was $782 million. The remaining affiliated amounts were immaterial.(c)Amounts include affiliated and nonaffiliated revenues. The affiliated revenue for I&M was $73 million primarily relating to barging, urea transloading and other transportation services. The remaining affiliated amounts were immaterial.(d)Amounts include affiliated and nonaffiliated revenues.412Year Ended December 31, 2018AEP TexasAEPTCoAPCoI&MOPCoPSOSWEPCo(in millions)Retail Revenues:Residential Revenues$578.9 $— $1,342.7 $730.0 $1,611.6 $659.0 $641.6 Commercial Revenues414.7 — 580.4 485.0 835.6 394.2 483.9 Industrial Revenues128.0 — 604.3 565.6 385.2 304.0 333.7 Other Retail Revenues29.4 — 77.4 7.2 12.9 83.6 8.6 Total Retail Revenues (a)1,151.0 — 2,604.8 1,787.8 2,845.3 1,440.8 1,467.8 Wholesale Revenues:Generation Revenues (b)— — 250.4 470.5 — 36.3 216.8 Transmission Revenues (c)313.4 816.9 82.7 23.1 58.5 40.2 108.4 Total Wholesale Revenues313.4 816.9 333.1 493.6 58.5 76.5 325.2 Other Revenues from Contracts with Customers (d)28.6 15.1 55.3 99.6 176.1 19.1 24.0 Total Revenues from Contracts with Customers1,493.0 832.0 2,993.2 2,381.0 3,079.9 1,536.4 1,817.0 Other Revenues:Alternative Revenues (e)(1.3)(55.9)(23.8)(2.1)(20.8)10.9 4.9 Other Revenues (e)103.6 — (1.9)(8.2)4.3 — — Total Other Revenues102.3 (55.9)(25.7)(10.3)(16.5)10.9 4.9 Total Revenues$1,595.3 $776.1 $2,967.5 $2,370.7 $3,063.4 $1,547.3 $1,821.9 (a)2018 amounts have been revised to reflect the reclassification of certain customer accounts between Retail classes. This reclassification did not impact previously reported Total Retail Revenues. Management concluded that these prior period disclosure only errors were immaterial individually and in the aggregate.(b)Amounts include affiliated and nonaffiliated revenues. The affiliated revenue for APCo was $134 million primarily relating to the PPA with KGPCo. The remaining affiliated amounts were immaterial.(c)Amounts include affiliated and nonaffiliated revenues. The affiliated revenue for AEPTCo was $646 million. The remaining affiliated amounts were immaterial.(d)Amounts include affiliated and nonaffiliated revenues. The affiliated revenue for I&M was $70 million primarily relating to barging, urea transloading and other transportation services. The remaining affiliated amounts were immaterial.(e)Amounts include affiliated and nonaffiliated revenues.Performance ObligationsAEP has performance obligations as part of its normal course of business. A performance obligation is a promise to transfer a distinct good or service, or a series of distinct goods or services that are substantially the same and have the same pattern of transfer to a customer. The invoice practical expedient within the accounting guidance for “Revenue from Contracts with Customers” allows for the recognition of revenue from performance obligations in the amount of consideration to which there is a right to invoice the customer and when the amount for which there is a right to invoice corresponds directly to the value transferred to the customer. The purpose of the invoice practical expedient is to depict an entity’s measure of progress toward completion of the performance obligation within a contract and can only be applied to performance obligations that are satisfied over time and when the invoice is representative of services provided to date. AEP subsidiaries elected to apply the invoice practical expedient to recognize revenue for performance obligations satisfied over time as the invoices from the respective revenue streams are representative of services or goods provided to date to the customer. Performance obligations for AEP’s subsidiaries are summarized as follows:413Retail Revenues AEP’s subsidiaries within the Vertically Integrated Utilities and Transmission and Distribution Utilities segments have performance obligations to generate, transmit and distribute electricity for sale to rate-regulated retail customers. The performance obligation to deliver electricity is satisfied over time as the customer simultaneously receives and consumes the benefits provided. Revenues are variable as they are subject to the customer’s usage requirements.Rate-regulated retail customers typically have the right to discontinue receiving service at will, therefore these contracts between AEP’s subsidiaries and their customers for rate-regulated services are generally limited to the services requested and received to date for such arrangements. Retail customers are generally billed on a monthly basis, and payment is typically due within 15 to 20 days after the issuance of the invoice. Payments from REPs are due to AEP Texas within 35 days.Wholesale Revenues - GenerationAEP’s subsidiaries within the Vertically Integrated Utilities and Generation & Marketing segments have performance obligations to sell electricity to wholesale customers from generation assets in PJM, SPP and ERCOT. The performance obligation to deliver electricity from generation assets is satisfied over time as the customer simultaneously receives and consumes the benefits provided. Wholesale generation revenues are variable as they are subject to the customer’s usage requirements.AEP’s subsidiaries within the Vertically Integrated Utilities and Generation & Marketing segments also have performance obligations to stand ready in order to promote grid reliability. Stand ready services are sold into PJM’s RPM capacity market. RPM entails a base auction and at least three incremental auctions for a specific PJM delivery year, with the incremental auctions spanning three years. The performance obligation to stand ready is satisfied over time and the consideration for which is variable until the occurrence of the final incremental auction, at which point the performance obligation becomes fixed.Payments from the RTO for stand ready services are typically received within one week from the issuance of the invoice, which is typically issued weekly. Gross margin resulting from generation sales within the Vertically Integrated Utilities segment are primarily subject to margin sharing agreements with customers and vary by state, where the revenues are reflected gross in the disaggregated revenues tables above.APCo has a performance obligation to supply wholesale electricity to KGPCo through a PPA. The FERC regulates the cost-based wholesale power transactions between APCo and KGPCo. The purchased power agreement includes a component for the recovery of transmission costs under the FERC OATT. The transmission cost component of purchased power is cost-based and regulated by the Tennessee Regulatory Authority. APCo’s performance obligation under the purchased power agreement is satisfied over time as KGPCo simultaneously receives and consumes the wholesale electricity. APCo’s revenues from the purchased power agreement are presented within the Generation Revenues line in the disaggregated revenues tables above.Wholesale Revenues - Transmission AEP’s subsidiaries within the Vertically Integrated Utilities, Transmission and Distribution Utilities and AEP Transmission Holdco segments have performance obligations to transmit electricity to wholesale customers through assets owned and operated by AEP subsidiaries. The performance obligation to provide transmission services in PJM, SPP and ERCOT encompass a time frame greater than a year, where the performance obligation within each RTO is partially fixed for a period of one year or less. Payments from the RTO for transmission services are typically received within one week from the issuance of the invoice, which is issued monthly for SPP and ERCOT and weekly for PJM. 414AEP subsidiaries within the PJM and SPP regions collect revenues through transmission formula rates. The FERC-approved rates establish the annual transmission revenue requirement (ATRR) and transmission service rates for transmission owners. The formula rates establish rates for a one year period and also include a true-up calculation for the prior year’s billings, allowing for over/under-recovery of the transmission owner’s ATRR. The annual true-ups meet the definition of alternative revenues in accordance with the accounting guidance for “Regulated Operations,” and are therefore presented as such in the disaggregated revenues tables above. AEP subsidiaries within the ERCOT region collect revenues through a combination of base rates and interim Transmission Costs of Services filings that are approved by the PUCT.The AEP East Companies are parties to the TA, which defines how transmission costs are allocated among the AEP East Companies on a 12-month average coincident peak basis. PSO, SWEPCo and AEPSC are parties to the TCA by and among PSO, SWEPCo and AEPSC, in connection with the operation of the transmission assets of the two AEP utility subsidiaries. AEPTCo is a transmission owner within the PJM and SPP regions providing transmission services to affiliates in accordance with the OATT, TA and TCA. Affiliate revenues as a result of the respective TA and the TCA are reflected as Transmission Revenues in the disaggregated revenues tables above.Marketing, Competitive Retail and Renewable RevenuesAEP’s subsidiaries within the Generation & Marketing segment have performance obligations to deliver electricity to competitive retail and wholesale customers. Performance obligations for marketing, competitive retail and renewable offtake sales are satisfied over time as the customer simultaneously receives and consumes the benefits provided. Revenues are primarily variable as they are subject to customer’s usage requirements; however, certain contracts mandate a delivery of a set quantity of electricity at a predetermined price, resulting in a fixed performance obligation. Payment terms under marketing arrangements typically follow standard Edison Electric Institute and International Swaps and Derivatives Association terms, which call for payment in 20 days. Payments for competitive retail and offtake arrangements for renewable assets range from 15 to 60 days and are dependent on the product sold, location and the creditworthiness of customer. Invoices for marketing arrangements, competitive retail and offtake arrangements for renewable assets are issued monthly.Fixed Performance ObligationsThe following table represents the Registrants’ remaining fixed performance obligations satisfied over time as of December 31, 2020. Fixed performance obligations primarily include wholesale transmission services, electricity sales for fixed amounts of energy and stand ready services into PJM’s RPM market. The Registrant Subsidiaries amounts shown in the table below include affiliated and nonaffiliated revenues.Company20212022-20232024-2025After 2025Total(in millions)AEP$1,122.9 $164.1 $162.2 $161.5 $1,610.7 AEP Texas465.4 — — — 465.4 AEPTCo1,319.5 — — — 1,319.5 APCo173.4 32.3 23.2 11.6 240.5 I&M35.1 8.8 8.8 4.5 57.2 OPCo68.1 — — 0.1 68.2 PSO14.8 — — — 14.8 SWEPCo41.6 — — — 41.6 415Contract Assets and LiabilitiesContract assets are recognized when the Registrants have a right to consideration that is conditional upon the occurrence of an event other than the passage of time, such as future performance under a contract. The Registrants did not have any material contract assets as of December 31, 2020 and 2019.When the Registrants receive consideration, or such consideration is unconditionally due from a customer prior to transferring goods or services to the customer under the terms of a sales contract, they recognize a contract liability on the balance sheet in the amount of that consideration. Revenue for such consideration is subsequently recognized in the period or periods in which the remaining performance obligations in the contract are satisfied. The Registrants’ contract liabilities typically arise from services provided under joint use agreements for utility poles. The Registrants did not have any material contract liabilities as of December 31, 2020 and 2019.Accounts Receivable from Contracts with CustomersAccounts receivable from contracts with customers are presented on the Registrants’ balance sheets within the Accounts Receivable - Customers line item. The Registrants’ balances for receivables from contracts that are not recognized in accordance with the accounting guidance for “Revenue from Contracts with Customers” included in Accounts Receivable - Customers were not material as of December 31, 2020 and 2019. See “Securitized Accounts Receivable - AEP Credit” section of Note 14 for additional information. The following table represents the amount of affiliated accounts receivable from contracts with customers included in Accounts Receivable - Affiliated Companies on the Registrant Subsidiaries’ balance sheets:Years Ended December 31,Company20202019(in millions)AEPTCo$81.0 $65.9 APCo52.7 47.3 I&M34.8 37.1 OPCo45.9 33.9 PSO7.8 9.7 SWEPCo11.2 17.6 Contract CostsContract costs to obtain or fulfill a contract for AEP subsidiaries within the Generation & Marketing segment are accounted for under the guidance for “Other Assets and Deferred Costs” and presented as a single asset and are neither bifurcated nor reclassified between current and noncurrent assets on the Registrants’ balance sheets. Contract costs to acquire a contract are amortized in a manner consistent with the transfer of goods or services to the customer in Other Operation on the Registrants’ income statements. The Registrants did not have material contract costs as of December 31, 2020 and 2019.41620. GOODWILLThe disclosure in this note applies to AEP only.The changes in AEP’s carrying amount of goodwill for the years ended December 31, 2020 and 2019 by operating segment are as follows:Corporate and OtherGeneration&MarketingAEP Consolidated(in millions)Balance as of December 31, 2018$37.1 $15.4 $52.5 Impairment Losses— — — Balance as of December 31, 201937.1 15.4 52.5 Impairment Losses— — — Balance as of December 31, 2020$37.1 $15.4 $52.5 In the fourth quarters of 2020 and 2019, annual impairment tests were performed. The fair values of the reporting units with goodwill were estimated using cash flow projections and other market value indicators. There were no goodwill impairment losses. AEP does not have any accumulated impairment on existing goodwill.41721. SUBSEQUENT EVENTSImpacts of Severe Winter Weather in February 2021In February 2021, many of AEP’s service territories and customers were impacted by severe winter weather and extreme cold temperatures resulting in power outages, extensive damage to transmission and distribution infrastructure and disruption to the energy markets. Storm Costs (Applies to AEP, APCo and SWEPCo)Based on the information currently available, APCo, KPCo and SWEPCo currently estimate significant February 2021 storm restoration expenditures as shown in the table below. Management currently anticipates the storm restoration expenditures will be more heavily weighted towards other operation and maintenance expenses as compared to capital expenditures. Management will continue to refine these storm cost estimates as restoration efforts are completed and final costs become available. Total Estimated February 2021Storm Restoration Expenditures(in millions)APCo$65.0-$75.0KPCo$75.0-$95.0SWEPCo$30.0-$40.0Management plans to seek regulatory recovery of these costs. If any of the storm costs are not recoverable, it could reduce future net income and cash flows and impact financial condition. February 2021 Severe Winter Weather Impacts in SPP (Applies to AEP, PSO and SWEPCo)The February 2021 severe winter weather also had a significant impact in SPP resulting in the declaration of Energy Emergency Alert Levels 2 and 3 for the first time in SPP’s history. The winter storm increased the demand for natural gas and restricted the available natural gas supply resulting in significantly increased market prices for natural gas power plants to meet reliability needs for the SPP electric system. From February 9, 2021, to February 20, 2021, based on the information currently available, PSO’s and SWEPCo’s preliminary estimates of natural gas expenses and purchases of electricity are as follows:PSOSWEPCo(in millions)Estimated Natural Gas Expenses$175.0 $375.0 Estimated Electricity Purchases650.0 — $825.0 $375.0 The amounts in the table above represent preliminary estimates as of February 25, 2021, and are subject to final settlement as additional information becomes available. In addition, SPP notified PSO and SWEPCo of additional collateral requirements of approximately $868 million on a cumulative basis for the companies due March 2, 2021. Subsequently, SPP filed a waiver request with the FERC that would grant a limited waiver for Load Serving Entities to post this additional collateral requirement between February 24, 2021 and March 11, 2021. FERC approved the waiver request on February 24, 2021. PSO and SWEPCo have active fuel clauses that allow for the recovery of prudently incurred fuel and purchased power expenses. Given the significance of these costs, PSO and SWEPCo expect regulators to perform a heightened review of the costs. Management believes these costs are probable of future recovery. However, the recovery of these costs from customers may be extended over longer than usual time periods to mitigate the impact on customer bills. Nevertheless, PSO and SWEPCo’s payments to suppliers are due in March 2021.418PSO and SWEPCo are evaluating financing alternatives including funding contributions from Parent and long-term debt issuances to address the timing difference between the payment to suppliers and recovery from customers. If either PSO or SWEPCo is unable to recover these fuel and purchased power expenses or recover these expenses in a timely manner, it could reduce future net income and cash flows and impact financial condition.ERCOT (Applies to AEP and AEP Texas)In response to the extreme winter weather event, the Governor of Texas issued a Declaration of a State of Disaster for all counties in Texas. While recovery from the emergency conditions is continuing, some market conditions and activities have yet to return to normal. To assist with a return to normalcy, the PUCT issued an order that placed a temporary moratorium on customer disconnections due to non-payment for transmission and distribution utilities. This moratorium will be in effect until otherwise ordered by the PUCT.419ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSUREAEP, AEP Texas, AEPTCo, APCo, I&M, OPCo, PSO and SWEPCoInformation required by this item is set forth under the caption Proposal to Ratify the Appointment of the Independent Registered Public Accounting Firm in the 2021 Proxy Statement, which is incorporated by reference into this item.ITEM 9A. CONTROLS AND PROCEDURESDisclosure Controls and ProceduresDuring 2020, management, including the principal executive officer and principal financial officer of each of the Registrants evaluated each respective Registrant’s disclosure controls and procedures. Disclosure controls and procedures are defined as controls and other procedures of the Registrant that are designed to ensure that information required to be disclosed by the Registrants in the reports that they file or submit under the Exchange Act are recorded, processed, summarized and reported within the time periods specified in the Commission’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by the Registrants in the reports that they file or submit under the Exchange Act is accumulated and communicated to each Registrant’s management, including the principal executive and principal financial officers, or persons performing similar functions, as appropriate to allow timely decisions regarding required disclosure.As of December 31, 2020, the principal executive officer and financial officer of each of the Registrants concluded that the disclosure controls and procedures in place were effective at the reasonable assurance level. The Registrants continually strive to improve their disclosure controls and procedures to enhance the quality of their financial reporting and to maintain dynamic systems that change as events warrant.Changes in Internal Control over Financial ReportingThere have been no changes in the Registrants’ internal control over financial reporting (as such term is defined in Rule 13a-15(f) and 15d-15(f) under the Exchange Act) during the fourth quarter 2020 that materially affected, or are reasonably likely to materially affect, the Registrants’ internal control over financial reporting.Internal Control over Financial ReportingSee Management’s Report on Internal Control over Financial Reporting for each Registrant under
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+ITEM 7.MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSThe discussion and analysis of our financial condition and results of operations that follow are based upon our consolidated financial statements, which have been prepared in accordance with GAAP. The preparation of our financial statements requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities, revenues and expenses and the related disclosure of contingent assets and liabilities at the date of our financial statements. Actual results may differ from these estimates and such differences could be material to the financial statements. This discussion should be read in conjunction with our consolidated financial statements included in this Annual Report and the accompanying notes, and the information set forth under the caption “Critical Accounting Policies and Estimates” below. During the fourth quarter of 2020, as a result of the InSite Acquisition, we updated our reportable segments to rename U.S. property and Asia property to U.S. & Canada property and Asia-Pacific property, respectively. We continue to report our results in six segments – U.S. & Canada property, Asia-Pacific property, Africa property, Europe property, Latin America property and 21Table of Contents services. This change was made to better align the names of our reportable segments with the geographical areas of our business operations following the InSite Acquisition. The change of our reportable segments names is solely reflective of the inclusion of Canada and Australia in our business operations, as a result of the InSite Acquisition, and had no impact on our consolidated financial statements for any prior periods. Historical financial information included in Management’s Discussion and Analysis of Financial Condition and Results of Operations has not been adjusted.In evaluating financial performance in each business segment, management uses, among other factors, segment gross margin and segment operating profit (see note 21 to our consolidated financial statements included in this Annual Report). Executive OverviewWe are one of the largest global REITs and a leading independent owner, operator and developer of multitenant communications real estate. Our primary business is the leasing of space on communications sites to wireless service providers, radio and television broadcast companies, wireless data providers, government agencies and municipalities and tenants in a number of other industries. In addition to the communications sites in our portfolio, we manage rooftop and tower sites for property owners under various contractual arrangements. We also hold other telecommunications infrastructure, fiber and property interests that we lease primarily to communications service providers and third-party tower operators. We refer to the business encompassing the above as our property operations, which accounted for 99% of our total revenues for the year ended December 31, 2020 and includes our U.S. & Canada property, Asia-Pacific property, Africa property, Europe property and Latin America property segments. We also offer tower-related services in the United States, including site application, zoning and permitting and structural analysis, which primarily support our site leasing business, including the addition of new tenants and equipment on our sites. 22Table of Contents The following table details the number of communications sites, excluding managed sites, that we owned or operated as of December 31, 2020: Number ofOwned TowersNumber ofOperated Towers (1)Number ofOwned DAS SitesU.S. & Canada:Canada (2)208 — — United States27,058 15,432 448 U.S. & Canada total27,266 15,432 448 Asia-Pacific: (2)India74,732 — 1,040 Asia-Pacific total74,732 — 1,040 Africa:Burkina Faso707 — — Ghana3,298 663 28 Kenya2,397 — 9 Niger720 — — Nigeria5,823 — — South Africa2,831 — — Uganda3,375 — 12 Africa total19,151 663 49 Europe:France2,769 309 9 Germany2,217 — — Poland 27 — — Europe total5,013 309 9 Latin America:Argentina119 — 10 Brazil16,792 2,249 104 Chile3,005 — 23 Colombia4,992 — 4 Costa Rica661 — 2 Mexico9,500 186 92 Paraguay1,426 — — Peru1,935 429 — Latin America total38,430 2,864 235 _______________(1)Approximately 95% of the operated towers are held pursuant to long-term finance leases, including those subject to purchase options. (2)In December 2020, we launched operations in Canada and Australia through the InSite Acquisition. In Australia, we do not own or operate communications sites but control land under carrier or other third-party communications sites, which provides recurring cash flow through tenant leasing arrangements. In Canada, we also control land under carrier or other third-party communications sites.On January 13, 2021, we signed agreements for the Pending Telxius Acquisition, pursuant to which we expect to acquire approximately 31,000 communications sites in Argentina, Brazil, Chile, Germany, Peru and Spain, for approximately 7.7 billion EUR (approximately $9.4 billion at the time of signing) at closing, subject to certain conditions and limited adjustments. The Pending Telxius Acquisition is expected to close in multiple tranches, beginning in the second quarter of 2021, subject to customary closing conditions, including government and regulatory approval. The impact of the Pending Telxius Acquisition on our 2021 results of operations will be dependent on a number of factors, including the timing of any closings.In most of our markets, our tenant leases with wireless carriers generally have initial non-cancellable terms of five to ten years with multiple renewal terms. Accordingly, the vast majority of the revenue generated by our property operations during the year ended December 31, 2020 was recurring revenue that we should continue to receive in future periods. Based upon existing tenant leases and foreign currency exchange rates as of December 31, 2020, we expect to generate nearly $59 billion of non-cancellable tenant lease revenue over future periods, before the impact of straight-line lease accounting. Most of our tenant leases have provisions that periodically increase the rent due under the lease, typically based on an annual fixed escalation (averaging approximately 3% in the United States) or an inflationary index in most of our international markets, or a combination of both. In addition, certain of our tenant leases provide for additional revenue primarily to cover costs, such as ground rent or power and fuel costs. 23Table of Contents The revenues generated by our property operations may be affected by cancellations of existing tenant leases. As discussed above, most of our tenant leases with wireless carriers and broadcasters are multiyear contracts, which typically are non-cancellable; however, in some instances, a lease may be cancelled upon the payment of a termination fee.Revenue lost from either tenant lease cancellations or the non-renewal of leases or rent renegotiations, which we refer to as churn, has historically not had a material adverse effect on the revenues generated by our consolidated property operations. During the year ended December 31, 2020, churn was approximately 3% of our tenant billings. Beginning in late 2017, we experienced an increase in revenue lost from cancellations or non-renewals primarily due to carrier consolidation-driven churn in India, which compressed our gross margin and operating profit, particularly in our Asia-Pacific property segment, although this impact was partially offset by lower expenses due to reduced tenancy on existing sites and the decommissioning of certain sites. For the year ended December 31, 2020, aggregate carrier consolidation in India did not have a material impact on our consolidated property revenue, gross margin or operating profit, although overall churn rates in India remained elevated relative to historical levels.We anticipate that our churn rate in India will moderate over time and result in reduced impacts on our property revenue, gross margin and operating profit. In the immediate term, we believe that our churn rate may remain elevated as our tenants in India evaluate the recent court rulings by the Indian Supreme Court and determine their payment plans for the AGR fees and charges prescribed by such court, as set forth in Item 1A of this Annual Report under the caption “Risk Factors—Our business, and that of our tenants, is subject to laws, regulations and administrative and judicial decisions, and changes thereto, that could restrict our ability to operate our business as we currently do or impact our competitive landscape.” We expect to periodically evaluate the carrying value of our Indian assets, which may result in the realization of additional impairment expense or other similar charges. For more information, please see the information under the caption “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Critical Accounting Policies and Estimates.”Additionally, we expect that our churn rate in our U.S. & Canada property segment will be elevated for a period of several years due to contractual lease cancellations and non-renewals by T-Mobile, including legacy Sprint Corporation leases, pursuant to the terms of the T-Mobile MLA signed in September 2020.As further set forth in Item 1A of this Annual Report under the captions “Risk Factors,” the ongoing COVID-19 pandemic, as well as the response to mitigate its spread and effects, may adversely impact us and our tenants and the demand for our communications sites in the United States and globally. We have taken a variety of actions to ensure the continued availability of our communications sites, while ensuring the safety and security of our employees, tenants, vendors and surrounding communities. These measures include providing support for our tenants remotely, requiring work-from-home arrangements and restricting travel for our employees where practicable and other modifications to our business practices. We will continue to actively monitor the situation and may take further actions as may be required by governmental authorities or that we determine are in the best interests of our employees, tenants and business partners.As a result of the impact of COVID-19 on global financial markets, foreign currency exchange rates have been volatile in many of the markets in which we operate. We estimate that the adverse impact from changes in foreign currency exchange rates on our consolidated revenue and operating profit in the current period, as compared to the year ended December 31, 2019, was approximately $315 million and $172 million, respectively. If exchange rates become significantly more unfavorable, the impact to our revenue and other future operating results could be material. Additionally, the impact of COVID-19 on our operational results in subsequent periods will largely depend on future developments, which are highly uncertain and cannot be accurately predicted at this time. These developments may include, but are not limited to, new information concerning the severity and duration of the COVID-19 pandemic, the degree of success of actions taken to contain or treat COVID-19, including the availability and effectiveness of vaccines and treatments, and the reactions by consumers, companies, governmental entities and capital markets to such actions.Property Operations Revenue Growth. Due to our diversified communications site portfolio, our tenant lease rates vary considerably depending upon numerous factors, including, but not limited to, amount, type and position of tenant equipment on the tower, remaining tower capacity and tower location. We measure the remaining tower capacity by assessing several factors, including tower height, tower type, environmental conditions, existing equipment on the tower and zoning and permitting regulations in effect in the jurisdiction where the tower is located. In many instances, tower capacity can be increased with relatively modest tower augmentation capital expenditures, which are often reimbursed to us.The primary factors affecting the revenue growth of our property segments are:•Growth in tenant billings, including:•New revenue attributable to leasing additional space on our sites (“colocations”) and lease amendments; •Contractual rent escalations on existing tenant leases, net of churn; and24Table of Contents •New revenue attributable to leases in place on day one on sites acquired or constructed since the beginning of the prior-year period.•Revenue growth from other items, including additional tenant payments primarily to cover costs, such as ground rent or power and fuel costs included in certain tenant leases (“pass-through”), straight-line revenue and decommissioning.We continue to believe that our site leasing revenue is likely to increase due to the growing use of wireless services globally and our ability to meet the corresponding incremental demand for our communications real estate. By adding new tenants and new equipment for existing tenants on our sites, we are able to increase these sites’ utilization and profitability. We believe the majority of our site leasing activity will continue to come from wireless service providers, with tenants in a number of other industries contributing incremental leasing demand. Our site portfolio and our established tenant base provide us with new business opportunities, which have historically resulted in consistent and predictable organic revenue growth as wireless carriers seek to increase the coverage and capacity of their existing networks, while also deploying next generation wireless technologies. In addition, we intend to continue to supplement our organic growth by selectively developing or acquiring new sites in our existing and new markets where we can achieve our risk-adjusted return on investment objectives. Property Operations Organic Revenue Growth. Consistent with our strategy to increase the utilization and return on investment from our sites, our objective is to add new tenants and new equipment for existing tenants through colocation and lease amendments. Our ability to lease additional space on our sites is primarily a function of the rate at which wireless carriers and other tenants deploy capital to improve and expand their wireless networks. This rate, in turn, is influenced by the growth of wireless services, the penetration of advanced wireless devices, the level of emphasis on network quality and capacity in carrier competition, the financial performance of our tenants and their access to capital and general economic conditions. According to industry data, recent aggregate annual wireless capital spending in the United States has averaged at least $30 billion, resulting in consistent demand for our sites. Based on industry research and projections, we expect that a number of key industry trends will result in incremental revenue opportunities for us:•In less advanced wireless markets where network deployments are in earlier stages, we expect these deployments to drive demand for our tower space as carriers seek to expand their footprints and increase the scope and density of their networks. We have established operations in many of these markets at the early stages of wireless development, which we believe will enable us to meaningfully participate in these deployments over the long term.•Subscribers’ use of mobile data continues to grow rapidly given increasing smartphone and other advanced device penetration, the proliferation of bandwidth-intensive applications on these devices and the continuing evolution of the mobile ecosystem. We believe carriers will be compelled to deploy additional equipment on existing networks while also rolling out more advanced wireless networks to address coverage and capacity needs resulting from this increasing mobile data usage.•The deployment of advanced mobile technology, such as 4G and 5G, will provide higher speed data services and further enable fixed broadband substitution. As a result, we expect that our tenants will continue deploying additional equipment across their existing networks.•Wireless service providers compete based on the quality of their networks, which is driven by capacity and coverage. To maintain or improve their network performance as overall network usage increases, our tenants continue to deploy additional equipment across their existing sites while also adding new cell sites. We anticipate increasing network densification over the next several years, as existing network density is anticipated to be insufficient to account for rapidly increasing levels of wireless data usage. •Wireless service providers continue to acquire additional spectrum, and as a result are expected to add additional sites and equipment to their networks as they seek to optimize their network configuration and utilize additional spectrum. We expect this to be particularly relevant in the context of higher-band spectrum such as 2.5 gigahertz (GHz) and C-Band being deployed for 5G, as these spectrum assets tend to have more limited propagation characteristics compared to the lower-band spectrum that has historically been deployed on our towers.•Next generation technologies requiring wireless connectivity have the potential to provide incremental revenue opportunities for us. These technologies may include edge computing functionality, autonomous vehicle networks and a number of other internet-of-things, or IoT, applications, as well as other potential use cases for wireless services. These technologies may create new and complementary use cases for our communications real estate over time, although these use cases are currently in nascent stages.As part of our international expansion initiatives, we have targeted markets in various stages of network development to diversify our international exposure and position us to benefit from a number of different wireless technology deployments over the long term. For example, as part of our Pending Telxius Acquisition, we expect to increase our exposure to more developed markets in Europe. In addition, we have focused on building relationships with large multinational carriers to increase the opportunities for growth or mutually beneficial transactional opportunities across common markets. We believe that consistent 25Table of Contents carrier network investments across our international markets will, over the long term, position us to generate meaningful organic revenue growth going forward.In emerging markets, such as Burkina Faso, Ghana, India, Kenya, Niger, Nigeria and Uganda, wireless networks tend to be significantly less advanced than those in the United States, and initial voice networks continue to be deployed in certain underdeveloped areas. A majority of consumers in these markets still utilize basic wireless services and advanced device penetration remains low. In more developed urban locations within these markets, mobile data usage tends to be higher and advanced network deployments are further along. Carriers are focused on completing voice network build-outs while increasing investments in data networks as mobile data usage and smartphone penetration within their customer bases begin to accelerate. In India, the ongoing transition from 2G technology to 4G technology has included a period of carrier consolidation, whereby the number of carriers operating in the marketplace has been reduced through mergers, acquisitions and select carrier exits from the marketplace, which we believe is now substantially complete. We believe that this consolidation process has resulted in an industry structure for both the wireless carriers and communications infrastructure providers that will be more conducive to sustained growth and profitability over time. In markets with rapidly evolving network technology, such as South Africa, Poland and most of the countries in Latin America where we do business, initial voice networks, for the most part, have already been built out, and carriers are increasingly focused on 4G network deployments. Consumers in these regions are increasingly adopting smartphones and other advanced devices, in particular as lower cost smartphones become increasingly available. As a result, the usage of bandwidth-intensive mobile applications is growing materially. Recent spectrum auctions in these rapidly evolving markets have allowed incumbent carriers to accelerate their data network deployments and have also enabled new entrants to begin initial investments in data networks. Smartphone penetration and wireless data usage in these markets are advancing rapidly, which typically requires that carriers continue to invest in their networks to maintain and augment their quality of service.Finally, in markets with more mature network technology, such as Australia, Canada, Germany, France and, following the expected closing of our Pending Telxius Acquisition, Spain, carriers are focused on deploying 4G data networks to account for rapidly increasing wireless data usage among their customer base. With higher smartphone and advanced device penetration and significantly higher per capita data usage, carrier investment in networks is focused on 4G coverage and capacity, as well as the early stages of 5G deployment.We believe that the network technology migration we have seen in the United States, which has led to significantly denser networks and meaningful new business commencements for us over a number of years, will be replicated in our international markets over time. As a result, we expect to be able to leverage our extensive international portfolio of approximately 143,000 communications sites and the relationships we have built with our carrier tenants to drive sustainable, long-term growth.We have master lease agreements with many of our tenants that provide for consistent, long-term revenue and reduce the likelihood of non-contractual churn. Certain of those master lease agreements are comprehensive in nature and further build and augment strong strategic partnerships with our tenants while significantly reducing colocation cycle times, thereby providing our tenants with the ability to rapidly and efficiently deploy equipment on our sites.Demand for our communications sites could be negatively impacted by a number of factors, including an increase in network sharing or consolidation among our tenants, as set forth in Item 1A of this Annual Report under the captions “Risk Factors—If our tenants consolidate their operations, exit the telecommunications business or share site infrastructure to a significant degree, our growth, revenue and ability to generate positive cash flows could be materially and adversely affected” and “Risk Factors—A substantial portion of our revenue is derived from a small number of tenants, and we are sensitive to adverse changes in the creditworthiness and financial strength of our tenants.” In addition, the emergence and growth of new technologies could reduce demand for our sites, as set forth under the caption “Risk Factors—New technologies or changes in our or a tenant’s business model could make our tower leasing business less desirable and result in decreasing revenues and operating results.” Further, our tenants may be subject to new regulatory policies from time to time that materially and adversely affect the demand for our communications sites.Property Operations New Site Revenue Growth. During the year ended December 31, 2020, we grew our portfolio of communications real estate through the acquisition and construction of approximately 9,365 sites globally. In a majority of our Asia-Pacific, Africa, Europe and Latin America markets, the revenue generated from newly acquired or constructed sites resulted in increases in both tenant and pass-through revenues (such as ground rent or power and fuel costs) and expenses. We continue to evaluate opportunities to acquire communications real estate portfolios, both domestically and internationally, to determine whether they meet our risk-adjusted hurdle rates and whether we believe we can effectively integrate them into our existing portfolio.26Table of Contents New Sites (Acquired or Constructed)202020192018U.S. & Canada2,255 430 285 Asia-Pacific3,960 3,330 21,470 Africa1,540 6,455 1,040 Europe610 15 15 Latin America1,000 3,475 1,655 Property Operations Expenses. Direct operating expenses incurred by our property segments include direct site level expenses and consist primarily of ground rent and power and fuel costs, some or all of which may be passed through to our tenants, as well as property taxes and repairs and maintenance expenses. These segment direct operating expenses exclude all segment and corporate selling, general, administrative and development expenses, which are aggregated into one line item entitled Selling, general, administrative and development expense in our consolidated statements of operations. In general, our property segments’ selling, general, administrative and development expenses do not significantly increase as a result of adding incremental tenants to our sites and typically increase only modestly year-over-year. As a result, leasing additional space to new tenants on our sites provides significant incremental gross margin and cash flow. We may, however, incur additional segment selling, general, administrative and development expenses as we increase our presence in our existing markets or expand into new markets. Our profit margin growth is therefore positively impacted by the addition of new tenants to our sites but can be temporarily diluted by our development activities.Services Segment Revenue Growth. As we continue to focus on growing our property operations, we anticipate that our services revenue will continue to represent a small percentage of our total revenues. Non-GAAP Financial MeasuresIncluded in our analysis of our results of operations are discussions regarding earnings before interest, taxes, depreciation, amortization and accretion, as adjusted (“Adjusted EBITDA”), Funds From Operations, as defined by the National Association of Real Estate Investment Trusts (“Nareit FFO”) attributable to American Tower Corporation common stockholders, Consolidated Adjusted Funds From Operations (“Consolidated AFFO”) and AFFO attributable to American Tower Corporation common stockholders.We define Adjusted EBITDA as Net income before Income (loss) from equity method investments; Income tax benefit (provision); Other income (expense); Gain (loss) on retirement of long-term obligations; Interest expense; Interest income; Other operating income (expense); Depreciation, amortization and accretion; and stock-based compensation expense. Nareit FFO attributable to American Tower Corporation common stockholders is defined as net income before gains or losses from the sale or disposal of real estate, real estate related impairment charges, real estate related depreciation, amortization and accretion and dividends on preferred stock, and including adjustments for (i) unconsolidated affiliates and (ii) noncontrolling interests. In this section, we refer to Nareit FFO attributable to American Tower Corporation common stockholders as “Nareit FFO (common stockholders).” We define Consolidated AFFO as Nareit FFO (common stockholders) before (i) straight-line revenue and expense; (ii) stock-based compensation expense; (iii) the deferred portion of income tax; (iv) non-real estate related depreciation, amortization and accretion; (v) amortization of deferred financing costs, capitalized interest, debt discounts and premiums and long-term deferred interest charges; (vi) other income (expense); (vii) gain (loss) on retirement of long-term obligations; (viii) other operating income (expense); and adjustments for (ix) unconsolidated affiliates and (x) noncontrolling interests, less cash payments related to capital improvements and cash payments related to corporate capital expenditures. We define AFFO attributable to American Tower Corporation common stockholders as Consolidated AFFO, excluding the impact of noncontrolling interests on both Nareit FFO (common stockholders) and the other adjustments included in the calculation of Consolidated AFFO. In this section, we refer to AFFO attributable to American Tower Corporation common stockholders as “AFFO (common stockholders).” Adjusted EBITDA, Nareit FFO (common stockholders), Consolidated AFFO and AFFO (common stockholders) are not intended to replace net income or any other performance measures determined in accordance with GAAP. None of Adjusted EBITDA, Nareit FFO (common stockholders), Consolidated AFFO or AFFO (common stockholders) represents cash flows from operating activities in accordance with GAAP and, therefore, these measures should not be considered indicative of cash flows from operating activities, as a measure of liquidity or a measure of funds available to fund our cash needs, including our ability to make cash distributions. Rather, Adjusted EBITDA, Nareit FFO (common stockholders), Consolidated AFFO and AFFO (common stockholders) are presented as we believe each is a useful indicator of our current operating performance. We believe that these metrics are useful to an investor in evaluating our operating performance because (1) each is a key measure 27Table of Contents used by our management team for decision making purposes and for evaluating our operating segments’ performance; (2) Adjusted EBITDA is a component underlying our credit ratings; (3) Adjusted EBITDA is widely used in the telecommunications real estate sector to measure operating performance as depreciation, amortization and accretion may vary significantly among companies depending upon accounting methods and useful lives, particularly where acquisitions and non-operating factors are involved; (4) Consolidated AFFO is widely used in the telecommunications real estate sector to adjust Nareit FFO (common stockholders) for items that may otherwise cause material fluctuations in Nareit FFO (common stockholders) growth from period to period that would not be representative of the underlying performance of property assets in those periods; (5) each provides investors with a meaningful measure for evaluating our period-to-period operating performance by eliminating items that are not operational in nature; and (6) each provides investors with a measure for comparing our results of operations to those of other companies, particularly those in our industry.Our measurement of Adjusted EBITDA, Nareit FFO (common stockholders), Consolidated AFFO and AFFO (common stockholders) may not, however, be fully comparable to similarly titled measures used by other companies. Reconciliations of Adjusted EBITDA, Nareit FFO (common stockholders), Consolidated AFFO and AFFO (common stockholders) to net income, the most directly comparable GAAP measure, have been included below.28Table of Contents Results of OperationsYear Ended December 31, 2019 Compared to Year Ended December 31, 2018For a discussion of our 2019 Results of Operations, including a discussion of our financial results for the fiscal year ended December 31, 2019 compared to the fiscal year ended December 31, 2018, refer to Part I, Item 7 of our annual report on Form 10-K filed with the SEC on February 25, 2020 (the “2019 Form 10-K”). During the fourth quarter of 2020, as a result of the InSite Acquisition, we updated our reportable segments to rename U.S. property and Asia property to U.S. & Canada property and Asia-Pacific property, respectively. The change of our reportable segments names is solely reflective of the inclusion of Canada and Australia in our business operations, as a result of the InSite Acquisition, and had no impact on our consolidated financial statements for any prior periods. Historical financial information included in Part I, Item 7 of the 2019 Form 10-K has not been adjusted.Years Ended December 31, 2020 and 2019 (in millions, except percentages) Revenue Year Ended December 31,Percent Change 2020 vs 2019 20202019PropertyU.S. & Canada$4,517.0 $4,188.7 8 %Asia-Pacific1,139.4 1,217.0 (6)Africa890.2 583.9 52 Europe149.6 134.6 11 Latin America1,257.4 1,340.7 (6)Total property7,953.6 7,464.9 7 Services87.9 115.4 (24)Total revenues$8,041.5 $7,580.3 6 %Year ended December 31, 2020 U.S. & Canada property segment revenue growth of $328.3 million was attributable to: • Tenant billings growth of $196.1 million, which was driven by:◦$134.3 million due to colocations and amendments; ◦$57.4 million from contractual escalations, net of churn (as discussed above, we expect that our churn rate will be elevated for a period of several years pursuant to the terms of the T-Mobile MLA); and◦$16.1 million generated from newly acquired or constructed sites; ◦Partially offset by a decrease of $11.7 million from other tenant billings; and• An increase of $132.2 million in other revenue, which includes a $135.1 million increase due to straight-line accounting as a result of the T-Mobile MLA and the full year to date impact of the our master lease agreement entered into with AT&T in August 2019.Segment revenue growth was not meaningfully impacted by foreign currency translation related to fluctuations in the Canadian Dollar. The InSite Acquisition did not meaningfully impact revenue growth during the current period due to the timing of the closing in December 2020. We expect the assets acquired from InSite to generate approximately $150 million in property revenue in 2021.Asia-Pacific property segment revenue decrease of $77.6 million was attributable to:• A decrease of $30.3 million in other revenue, primarily due to a decrease in tenant settlement payments received attributable to prior tenant cancellations; and• A decrease of $8.1 million in pass-through revenue; • Partially offset by an increase of $18.3 million in tenant billings, which was driven by:◦$69.0 million due to colocations and amendments; and◦$19.6 million generated from newly acquired or constructed sites;◦Partially offset by:▪A decrease of $69.4 million resulting from churn in excess of contractual escalations; and▪A decrease of $0.9 million from other tenant billings. 29Table of Contents Segment revenue decline included a decrease of $57.5 million attributable to the negative impact of foreign currency translation related to fluctuations in Indian Rupee (“INR”).Africa property segment revenue growth of $306.3 million was attributable to:• Tenant billings growth of $245.0 million, which was driven by: ◦$206.2 million generated from newly acquired or constructed sites, primarily due to the Eaton Towers Acquisition; ◦$24.9 million due to colocations and amendments; ◦$13.1 million from contractual escalations, net of churn; and◦$0.8 million from other tenant billings;• An increase of $71.0 million in pass-through revenue, including amounts related to the Eaton Towers Acquisition; and• An increase of $30.7 million in other revenue. Segment revenue growth was partially offset by a decrease of $40.4 million attributable to the negative impact of foreign currency translation, which included, among others, $16.7 million related to fluctuations in South African Rand and $11.6 million related to fluctuations in Ghanaian Cedi.Europe property segment revenue growth of $15.0 million was attributable to:• Tenant billings growth of $6.7 million, which was driven by: ◦$4.1 million due to colocations and amendments; ◦$4.0 million generated from newly acquired or constructed sites, primarily attributable to the Orange Acquisition; and◦$0.2 million from other tenant billings;◦Partially offset by a decrease of $1.6 million resulting from churn in excess of contractual escalations;• An increase of $5.2 million in other revenue; and• An increase of $0.1 million in pass-through revenue.Segment revenue growth included an increase of $3.0 million attributable to the positive impact of foreign currency translation related to fluctuations in EUR.Latin America property segment revenue decrease of $83.3 million was attributable to: • A decrease of $15.7 million in other revenue, primarily due to the nonrecurrence of an $11.6 million tenant settlement payment in Mexico in the prior-year period; • Partially offset by an increase of $46.7 million in pass-through revenue and an increase of $108.1 million in tenant billings, which was driven by:◦$43.5 million generated from newly acquired or constructed sites, primarily due to the Entel Acquisition;◦$35.4 million due to colocations and amendments; ◦$25.6 million from contractual escalations, net of churn; and◦$3.6 million from other tenant billings.Segment revenue decline included a decrease of $222.4 million attributable to the negative impact of foreign currency translation, which included, among others, $149.2 million related to fluctuations in Brazilian Real, $49.6 million related to fluctuations in Mexican Peso and $11.9 million related to fluctuations in Colombian Peso.The decrease in services segment revenue of $27.5 million was primarily attributable to a decrease in site application, zoning and permitting services.Gross Margin Year Ended December 31,Percent Change 2020 vs 2019 20202019PropertyU.S. & Canada$3,709.0 $3,380.8 10 %Asia-Pacific478.0 501.1 (5)Africa592.5 374.9 58 Europe121.5 106.8 14 Latin America864.9 929.4 (7)Total property5,765.9 5,293.0 9 Services51.4 73.3 (30)%30Table of Contents Year ended December 31, 2020 •The increase in U.S. & Canada property segment gross margin was primarily attributable to the increase in revenue described above. The InSite Acquisition did not meaningfully impact U.S. & Canada property segment gross margin during the current period due to the timing of the closing in December 2020. We expect the assets acquired from InSite to generate approximately $115 million in gross margin in 2021.•The decrease in Asia-Pacific property segment gross margin was primarily attributable to the decrease in revenue described above, partially offset by a decrease in direct expenses of $21.1 million, primarily due to a combination of (i) lower land rent costs, partially due to site decommissioning, and (ii) lower security and monitoring costs. Direct expenses also benefited by $33.4 million from the impact of foreign currency translation.•The increase in Africa property segment gross margin was primarily attributable to the increase in revenue described above, partially offset by an increase in direct expenses of $104.3 million, primarily due to the Eaton Towers Acquisition. Direct expenses also benefited by $15.6 million from the impact of foreign currency translation.•The increase in Europe property segment gross margin was primarily attributable to the increase in revenue described above and a decrease in direct expenses of $0.2 million. Direct expenses were negatively impacted by $0.5 million attributable to the impact of foreign currency translation. •The decrease in Latin America property segment gross margin was primarily attributable to the decrease in revenue described above and an increase in direct expenses of $52.5 million, primarily due to the Entel Acquisition. Direct expenses also benefited by $71.3 million from the impact of foreign currency translation.•The decrease in services segment gross margin was primarily due to the decrease in revenue described above, partially offset by a decrease in direct expenses of $5.6 million. Selling, General, Administrative and Development Expense (“SG&A”) Year Ended December 31,Percent Change 2020 vs 2019 20202019PropertyU.S. & Canada$162.2 $175.5 (8)%Asia-Pacific97.4 99.9 (3)Africa94.4 53.7 76 Europe23.0 23.2 (1)Latin America93.1 101.0 (8)Total property470.1 453.3 4 Services14.8 12.0 23 Other 293.8 265.1 11 Total selling, general, administrative and development expense$778.7 $730.4 7 %Year Ended December 31, 2020 •The decrease in our U.S. & Canada property segment SG&A was primarily driven by a decrease in legal costs as compared to the prior-year period and lower travel and discretionary spending as a result of the COVID-19 pandemic and stay-at-home orders.•The decrease in our Asia-Pacific property segment SG&A was primarily driven by the benefit of foreign currency translation on SG&A and lower travel spending, partially offset by increased personnel costs and an increase in bad debt expense of $3.1 million.•The increase in our Africa property segment SG&A was primarily driven by increased personnel costs to support our business, including due to the Eaton Towers Acquisition, and an increase in bad debt expense of $23.5 million as a result of receivable reserves with certain tenants.•Our Europe property segment SG&A remained relatively consistent as compared to the prior-year period.•The decrease in our Latin America property segment SG&A was primarily driven by the benefit of foreign currency translation on SG&A, partially offset by increased personnel costs, including costs to support our fiber business. 31Table of Contents •The increase in our services segment SG&A was primarily driven by an increase in personnel costs, partially offset by lower travel and discretionary spending as a result of the COVID-19 pandemic and stay-at-home orders.•The increase in other SG&A was primarily attributable to an increase in stock-based compensation expense of $9.2 million and an increase in corporate SG&A, including an increase in personnel costs and charitable contributions.Operating Profit Year Ended December 31,Percent Change 2020 vs 2019 20202019PropertyU.S. & Canada$3,546.8 $3,205.3 11 %Asia-Pacific380.6 401.2 (5)Africa498.1 321.2 55 Europe98.5 83.6 18 Latin America771.8 828.4 (7)Total property5,295.8 4,839.7 9 Services36.6 61.3 (40)%Year Ended December 31, 2020 •The increase in operating profit for our U.S. & Canada property segment was primarily attributable to an increase in our segment gross margin and a decrease in our segment SG&A.•The decreases in operating profit for our Asia-Pacific and Latin America property segments were primarily attributable to decreases in our segment gross margin, partially offset by decreases in our segment SG&A.•The increase in operating profit for our Africa property segment was primarily attributable to an increase in our segment gross margin, partially offset by an increase in our segment SG&A.•The increase in operating profit for our Europe property segment was primarily attributable to an increase in our segment gross margin.•The decrease in operating profit for our services segment was primarily attributable to a decrease in our segment gross margin and an increase in our segment SG&A.Depreciation, Amortization and Accretion Year Ended December 31,Percent Change 2020 vs 2019 20202019Depreciation, amortization and accretion$1,882.3 $1,778.4 6 %The increase in depreciation, amortization and accretion expense for the year ended December 31, 2020 was primarily attributable to the acquisition, lease or construction of new sites since the beginning of the prior-year period, including due to the Eaton Towers Acquisition and the Entel Acquisition, which resulted in increases in property and equipment and intangible assets subject to amortization, partially offset by foreign currency exchange rate fluctuations.Other Operating Expenses Year Ended December 31,Percent Change 2020 vs 2019 20202019Other operating expenses$265.8 $166.3 60 %The increase in other operating expenses for the year ended December 31, 2020 was primarily attributable to increases in impairment charges of $128.6 million, including an increase of $66.2 million in impairment charges related to Right-of-use assets. These items were partially offset by a decrease in losses on sales or disposals of assets of $27.8 million and a one-time benefit in Brazil in the current period.32Table of Contents Total Other Expense Year Ended December 31,Percent Change 2020 vs 2019 20202019Total Other expense$1,066.4 $772.0 38 %Total other expense consists primarily of interest expense and realized and unrealized foreign currency gains and losses. We record unrealized foreign currency gains or losses as a result of foreign currency exchange rate fluctuations primarily associated with our intercompany notes and similar unaffiliated balances denominated in a currency other than the subsidiaries’ functional currencies.The increase in total other expense during the year ended December 31, 2020 was due to foreign currency losses of $216.4 million in the current period, as compared to foreign currency gains of $6.1 million in the prior-year period, and a loss on retirement of long-term obligations of $71.8 million in the current period, attributable to the repayment of our 5.900% senior unsecured notes due 2021 (the “5.900% Notes”), our 3.300% senior unsecured notes due 2021 (the “3.300% Notes”) and our 3.450% senior unsecured notes due 2021 (the “3.450% Notes”), as compared to a loss on retirement of long-term obligations of $22.2 million during the prior-year period, primarily attributable to the repayment of our 5.050% senior unsecured notes due 2020 (the “5.050% Notes”).Income Tax Provision (Benefit) Year Ended December 31,Percent Change 2020 vs 2019 20202019Income tax provision (benefit)$129.6 $(0.2)(64,900)%Effective tax rate7.1 %(0.0)%As a REIT, we may deduct earnings distributed to stockholders against the income generated by our REIT operations. In addition, we are able to offset certain income by utilizing our NOLs, subject to specified limitations. Consequently, the effective tax rate on income from continuing operations for each of the years ended December 31, 2020 and 2019 differs from the federal statutory rate.The change in the income tax provision (benefit) for the year ended December 31, 2020 was primarily attributable to a $113.0 million one-time tax benefit included in the prior-year period arising from revaluing our net deferred tax liability due to tax law changes in India, partially offset by changes in the valuation allowance in the current year.Net Income / Adjusted EBITDA and Net Income / Nareit FFO attributable to American Tower Corporation common stockholders / Consolidated AFFO / AFFO attributable to American Tower Corporation common stockholders Year Ended December 31,Percent Change 2020 vs 2019 20202019Net income$1,691.5 $1,916.6 (12)%Income tax provision (benefit) 129.6 (0.2)(64,900)Other expense (income)240.8 (17.6)(1,468)Loss on retirement of long-term obligations71.8 22.2 223 Interest expense793.5 814.2 (3)Interest income(39.7)(46.8)(15)Other operating expenses265.8 166.3 60 Depreciation, amortization and accretion1,882.3 1,778.4 6 Stock-based compensation expense120.8 111.4 8 Adjusted EBITDA$5,156.4 $4,744.5 9 %33Table of Contents Year Ended December 31,Percent Change 2020 vs 2019 20202019Net income$1,691.5 $1,916.6 (12)%Real estate related depreciation, amortization and accretion1,674.1 1,578.8 6 Losses from sale or disposal of real estate and real estate related impairment charges (1)241.8 139.5 73 Dividend to noncontrolling interest(7.9)(13.2)(40)Adjustments for unconsolidated affiliates and noncontrolling interests (88.7)(130.0)(32)Nareit FFO attributable to American Tower Corporation common stockholders$3,510.8 $3,491.7 1 Straight-line revenue(322.0)(183.5)75 Straight-line expense51.6 44.4 16 Stock-based compensation expense120.8 111.4 8 Deferred portion of income tax (2)(16.7)(147.7)(89)Non-real estate related depreciation, amortization and accretion208.2 199.6 4 Amortization of deferred financing costs, capitalized interest, debt discounts and premiums and long-term deferred interest charges33.3 28.4 17 Payment of shareholder loan interest (3)(63.3)(14.2)346 Other expense (income) (4)240.8 (17.6)(1,468)Loss on retirement of long-term obligations71.8 22.2 223 Other operating expenses (5)24.0 26.8 (10)Capital improvement capital expenditures(150.3)(160.0)(6)Corporate capital expenditures(9.3)(10.6)(12)Adjustments for unconsolidated affiliates and noncontrolling interests 88.7 130.0 (32)Consolidated AFFO $3,788.4 $3,520.9 8 %Adjustments for unconsolidated affiliates and noncontrolling interests (6)(24.9)(79.2)(69)%AFFO attributable to American Tower Corporation common stockholders$3,763.5 $3,441.7 9 %_______________(1) Included in these amounts are impairment charges of $222.8 million and $94.2 million for the years ended December 31, 2020 and 2019, respectively.(2) For the year ended December 31, 2019, amount includes a tax benefit of $113.0 million as a result of revaluing our net deferred tax liability due to tax law changes in India.(3) For the year ended December 31, 2020, relates to the payment of capitalized interest associated with the acquisition of MTN’s redeemable noncontrolling interests in each of our joint ventures in Ghana and Uganda (see note 15 to our consolidated financial statements included in this Annual Report). For the year ended December 31, 2019, relates to the payment of capitalized interest associated with the shareholder loan previously owed to our joint venture partner in Ghana. These long-term deferred interest payments were previously expensed but excluded from Consolidated AFFO.(4) Includes losses (gains) on foreign currency exchange rate fluctuations of $216.4 million and ($6.1 million), respectively.(5) Primarily includes acquisition-related costs and integration costs. (6) Includes adjustments for the impact on both Nareit FFO attributable to American Tower Corporation common stockholders as well as the other line items included in the calculation of Consolidated AFFO. Year Ended December 31, 2020 The decrease in net income was primarily due to (i) an increase in other expense, attributable to an increase in net foreign currency losses, and a loss on retirement of long-term obligations of $71.8 million, attributable to the repayment of the 5.900% Notes, the 3.300% Notes and the 3.450% Notes, as compared to a loss on retirement of long-term obligations of $22.2 million during the year ended December 31, 2019, primarily attributable to the repayment of the 5.050% Notes, (ii) a change in the income tax provision (benefit), (iii) an increase in depreciation, amortization and accretion expense and (iv) an increase in other operating expenses, primarily attributable to an increase in impairment charges, partially offset by an increase in our operating profit.The increase in Adjusted EBITDA was primarily attributable to the increase in our gross margin and was partially offset by an increase in SG&A, excluding the impact of stock-based compensation expense, of $39.1 million.The increase in Consolidated AFFO and AFFO attributable to American Tower Corporation common stockholders was primarily attributable to the increase in our operating profit, excluding the impact of straight-line accounting and decreases in capital improvement and corporate capital expenditures, which were partially offset by an increase in cash paid for interest, including previously deferred interest associated with the shareholder loans. The growth in AFFO attributable to American 34Table of Contents Tower Corporation common stockholders was also impacted by lower adjustments for unconsolidated affiliates and noncontrolling interests in Africa, which is now fully consolidated.35Table of Contents Liquidity and Capital Resources Overview During the year ended December 31, 2020, we increased our financial flexibility and our ability to grow our business while maintaining our long-term financial policies. Our significant 2020 financing transactions included:•Entry into (i) a $750.0 million unsecured term loan due February 12, 2021 (the “2020 Term Loan”) and (ii) the April 2020 Term Loan (as defined below), which was repaid in full during the year ended December 31, 2020.•Registered public offerings in an aggregate amount of $8.0 billion, including an aggregate amount of 1.4 billion EUR, of senior unsecured notes with maturities ranging from 2024 to 2051. •Redemption of the 5.900% Notes, our 2.800% senior unsecured notes due 2020 (the “2.800% Notes”), the 3.300% Notes and the 3.450% Notes for an aggregate amount of $2.7 billion. •Repayment of $350.0 million aggregate principal amount outstanding under the American Tower Secured Revenue Notes, Series 2015-1, Class A (the “Series 2015-1 Notes”). •Establishment of an “at the market” stock offering program through which we may issue and sell shares of our common stock having an aggregate gross sales price of up to $1.0 billion (the “2020 ATM Program”).The following table summarizes our liquidity as of December 31, 2020 (in millions): Available under the 2019 Multicurrency Credit Facility$3,100.0 Available under the 2019 Credit Facility55.0 Letters of credit(4.6)Total available under credit facilities, net3,150.4 Cash and cash equivalents1,746.3 Total liquidity$4,896.7 Subsequent to December 31, 2020, we made additional borrowings of (i) $50.0 million under our $2.9 billion senior unsecured revolving credit facility, as amended and restated in December 2019 and as further amended as described below (the “2019 Credit Facility”), and (ii) $1.8 billion under our $4.1 billion senior unsecured multicurrency revolving credit facility, as amended and restated in December 2019 and as further amended as described below (the “2019 Multicurrency Credit Facility”). The borrowings were used to repay existing indebtedness, including repayment of the InSite Debt and the 2020 Term Loan, and for general corporate purposes. Summary cash flow information is set forth below for the years ended December 31, (in millions): 202020192018Net cash provided by (used for):Operating activities$3,881.4 $3,752.6 $3,748.3 Investing activities(4,784.6)(3,987.5)(2,749.5)Financing activities1,215.3 521.7 (607.7)Net effect of changes in foreign currency exchange rates on cash and cash equivalents, and restricted cash(28.7)(13.7)(41.1)Net increase in cash and cash equivalents, and restricted cash$283.4 $273.1 $350.0 We use our cash flows to fund our operations and investments in our business, including tower maintenance and improvements, communications site construction, managed network installations and tower and land acquisitions. Additionally, we use our cash flows to make distributions, including distributions of our REIT taxable income to maintain our qualification for taxation as a REIT under the Code. We may also repay or repurchase our existing indebtedness or equity from time to time. We typically fund our international expansion efforts primarily through a combination of cash on hand, intercompany debt and equity contributions. During the year ended December 31, 2020, we completed the acquisition of MTN’s noncontrolling interests in each of our joint ventures in Ghana and Uganda for total consideration of approximately $524.4 million (see note 15 to our consolidated financial statements included in this Annual Report), which resulted in an increase in our controlling interests in such joint ventures from 51% to 100%. During the year ended December 31, 2020, we redeemed Tata Teleservices Limited and Tata Sons’ remaining combined holdings of ATC TIPL (see note 15 to our consolidated financial statements included in this Annual Report), for total consideration of INR 24.8 billion ($337.3 million at the date of redemption). As a result of the redemption, our controlling interest in ATC TIPL increased from 79% to 92% and the noncontrolling interest decreased from 21% to 8%.36Table of Contents In February 2021, we entered into an agreement with Macquarie SBI Infrastructure Investments Pte Limited and SBI Macquarie Infrastructure Trust, our remaining minority holders in ATC TIPL, to redeem 100% of their combined holdings in ATC TIPL (see note 15 to our consolidated financial statements included in this Annual Report) at a price of INR 175 per share, subject to certain adjustments. Accordingly, we expect to pay an amount equivalent to INR 12.9 billion (approximately $176.6 million) to redeem the shares in 2021, subject to regulatory approval. After the completion of the redemption, we will hold a 100% ownership interest in ATC TIPL.As of December 31, 2020, we had total outstanding indebtedness of $29.5 billion, with a current portion of $0.8 billion. During the year ended December 31, 2020, we generated sufficient cash flow from operations, together with borrowings under our credit facilities and cash on hand, to fund our capital expenditures and debt service obligations, as well as our required distributions. We believe the cash generated by operating activities during the year ending December 31, 2021, together with our increased borrowing capacity under our credit facilities, recently executed delayed draw term loans and bridge loan commitment, will be sufficient to fund our required distributions, capital expenditures, debt service obligations (interest and principal repayments) and signed acquisitions. Our material current and long term cash requirements are further described below. As of December 31, 2020, we had $1.5 billion of cash and cash equivalents held by our foreign subsidiaries, of which $570.5 million was held by our joint ventures. While certain subsidiaries may pay us interest or principal on intercompany debt, it has not been our practice to repatriate earnings from our foreign subsidiaries primarily due to our ongoing expansion efforts and related capital needs. However, in the event that we do repatriate any funds, we may be required to accrue and pay certain taxes. Cash Flows from Operating ActivitiesFor the year ended December 31, 2020, cash provided by operating activities increased $128.8 million as compared to the year ended December 31, 2019. The primary factors that impacted cash provided by operating activities as compared to the year ended December 31, 2019, include:•An increase in our operating profit of $431.4 million; •An increase in non-cash operating activities, including an increase of approximately $138.5 million in straight-line revenue, partially offset by an increase of approximately $7.2 million in straight-line expense;•An increase in cash required for working capital, primarily as a result of an increase in accounts receivable; and•An increase of approximately $12.1 million in cash paid for interest. For the year ended December 31, 2019, cash provided by operating activities increased $4.3 million as compared to the year ended December 31, 2018. The primary factors that impacted cash provided by operating activities as compared to the year ended December 31, 2018, include:•An increase in non-cash operating activities, including an increase of approximately $95.9 million in straight-line revenue and a decrease of approximately $13.5 million in straight-line expense;•An increase in our operating profit of $78.4 million; and•A decrease of approximately $39.5 million in cash paid for interest. Cash Flows from Investing ActivitiesOur significant investing activities during the year ended December 31, 2020 are highlighted below: •We spent approximately $3.8 billion for acquisitions, primarily related to the InSite Acquisition and asset acquisitions in the United States, Chile, France, Mexico, Peru, Poland and South Africa. •We spent $1.1 billion for capital expenditures, as follows (in millions):Discretionary capital projects (1)$402.4 Ground lease purchases (2)194.6 Capital improvements and corporate expenditures (3)159.6 Redevelopment179.4 Start-up capital projects135.2 Total capital expenditures (4)$1,071.2 _______________(1)Includes the construction of 5,886 communications sites globally.(2)Includes $36.9 million of perpetual land easement payments reported in Deferred financing costs and other financing activities in the cash flows from financing activities in our consolidated statements of cash flows.(3)Includes $9.2 million of finance lease payments included in Repayments of notes payable, credit facilities, term loan, senior notes, secured debt, finance leases and capital leases in the cash flow from financing activities in our consolidated statements of cash flows.37Table of Contents (4)Net of purchase credits of $6.6 million on certain assets, which are reported in operating activities in our consolidated statements of cash flows. Our significant investing transactions in 2019 included the following: •We spent approximately $3.0 billion for acquisitions, primarily related to the Eaton Towers Acquisition, the Entel Acquisition and asset acquisitions in the United States, Colombia, Mexico, Paraguay and Peru. •We spent $1,029.7 million for capital expenditures, as follows (in millions):Discretionary capital projects (1)$366.6 Ground lease purchases (2)153.9 Capital improvements and corporate expenditures (3)170.6 Redevelopment258.5 Start-up capital projects80.1 Total capital expenditures (4)$1,029.7 _______________(1)Includes the construction of 4,511 communications sites globally.(2)Includes $29.6 million of perpetual land easement payments reported in Deferred financing costs and other financing activities in the cash flows from financing activities in our consolidated statements of cash flows.(3)Includes $18.0 million of finance lease payments included in Repayments of notes payable, credit facilities, term loan, senior notes, secured debt, finance leases and capital leases in the cash flow from financing activities in our consolidated statements of cash flows.(4)Net of purchase credits of $9.2 million on certain assets, which are reported in operating activities in our consolidated statements of cash flows.We plan to continue to allocate our available capital, after satisfying our distribution requirements, among investment alternatives that meet our return on investment criteria, while maintaining our commitment to our long-term financial policies. Accordingly, we expect to continue to deploy capital through our annual capital expenditure program, including land purchases and new site construction, and through acquisitions. We also regularly review our tower portfolios as to capital expenditures required to upgrade our towers to our structural standards or address capacity, structural or permitting issues. We expect that our 2021 total capital expenditures will be as follows (in millions): Discretionary capital projects (1)$475 to$505 Ground lease purchases230 to250 Capital improvements and corporate expenditures165 to175 Redevelopment290 to310 Start-up capital projects190 to210 Total capital expenditures$1,350 to$1,450 _______________ (1) Includes the construction of approximately 6,000 to 7,000 communications sites globally.Cash Flows from Financing Activities Our significant financing activities were as follows (in millions): Year Ended December 31,202020192018Proceeds from issuance of senior notes, net$7,925.1 $4,876.7 $584.9 (Repayments of) proceeds from credit facilities, net(5.1)425.0 (695.9)Distributions paid on common and preferred stock(1,928.2)(1,603.0)(1,342.4)Purchases of common stock(56.0)(19.6)(232.8)Repayments of securitized debt(350.0)— (500.0)Distributions to noncontrolling interest holders, net (12.3)(11.8)(14.4)Repayments of senior notes(2,650.0)(1,700.0)— (Repayments of) proceeds from term loans, net(250.0)(500.0)1,500.0 Purchases of redeemable noncontrolling interests (1)(861.7)(425.7)— Proceeds from issuance of securities in securitization transaction— — 500.0 _______________ (1)Includes the redemption of minority interests in ATC TIPL. For the year ended December 31, 2020, also includes the redemption of MTN’s noncontrolling interests in each of our joint ventures in Ghana and Uganda. 38Table of Contents Senior NotesRepayments of Senior Notes Repayment of 5.900% Senior Notes—On January 15, 2020, we redeemed all of the $500.0 million aggregate principal amount of the 5.900% Notes at a price equal to 106.7090% of the principal amount, plus accrued and unpaid interest up to, but excluding January 15, 2020, for an aggregate redemption price of approximately $539.6 million, including $6.1 million in accrued and unpaid interest. We recorded a loss on retirement of long-term obligations of $34.6 million, which includes prepayment consideration of $33.5 million and the associated unamortized discount and deferred financing costs. The redemption was funded with borrowings under the 2019 Credit Facility and cash on hand. Upon completion of the redemption, none of the 5.900% Notes remained outstanding.Repayment of 2.800% Senior Notes—On May 11, 2020, we redeemed all of the $750.0 million aggregate principal amount of the 2.800% Notes at a price equal to the principal amount, together with accrued interest up to, but excluding May 11, 2020, for an aggregate redemption price of approximately $759.3 million, including $9.3 million in accrued interest. The redemption was funded with borrowings under the 2019 Credit Facility and cash on hand. Upon completion of the redemption, none of the 2.800% Notes remained outstanding.Repayment of 3.450% Senior Notes and 3.300% Senior Notes—On July 6, 2020, we redeemed all of the $650.0 million aggregate principal amount of the 3.450% Notes at a price equal to 103.5980% of the principal amount of the 3.450% Notes, plus accrued and unpaid interest up to, but excluding, July 6, 2020, for an aggregate redemption price of $680.3 million, including $6.9 million in accrued and unpaid interest. Also on July 6, 2020, we redeemed all of the $750.0 million aggregate principal amount of the 3.300% Notes at a price equal to 101.5090% of the principal amount of the 3.300% Notes, plus accrued and unpaid interest up to, but excluding, July 6, 2020, for an aggregate redemption price of $771.0 million, including $9.7 million in accrued and unpaid interest. We recorded a loss on retirement of long-term obligations of approximately $37.2 million, which includes prepayment consideration of $34.7 million and the associated unamortized discount and deferred financing costs. The redemptions were funded with borrowings under the 2019 Credit Facility and cash on hand. Upon completion of these redemptions, none of the 3.450% Notes or the 3.300% Notes remained outstanding.Offerings of Senior Notes2.400% Senior Notes and 2.900% Senior Notes Offering—On January 10, 2020, we completed a registered public offering of $750.0 million aggregate principal amount of 2.400% senior unsecured notes due 2025 (the “2.400% Notes”) and $750.0 million aggregate principal amount of 2.900% senior unsecured notes due 2030 (the “2.900% Notes”). The net proceeds from this offering were approximately $1,483.4 million, after deducting commissions and estimated expenses. We used the net proceeds to repay existing indebtedness under the 2019 Credit Facility. 1.300% Senior Notes, 2.100% Senior Notes and 3.100% Senior Notes Offering—On June 3, 2020, we completed a registered public offering of $500.0 million aggregate principal amount of 1.300% senior unsecured notes due 2025 (the “1.300% Notes”), $750.0 million aggregate principal amount of 2.100% senior unsecured notes due 2030 (the “2.100% Notes”) and $750.0 million aggregate principal amount of 3.100% senior unsecured notes due 2050 (the “Initial 3.100% Notes”). The net proceeds from this offering were approximately $1,968.2 million, after deducting commissions and estimated expenses. We used the net proceeds to repay existing indebtedness under the 2019 Credit Facility and for general corporate purposes. 0.500% Senior Notes and 1.000% Senior Notes Offering—On September 10, 2020, we completed a registered public offering of 750.0 million EUR ($886.1 million at the date of issuance) aggregate principal amount of 0.500% senior unsecured notes due 2028 (the “0.500% Notes”) and 650.0 million EUR ($768.0 million at the date of issuance) aggregate principal amount of 1.000% senior unsecured notes due 2032 (the “1.000% Notes”). The net proceeds from this offering were approximately 1,385.2 million EUR ($1,636.6 million at the date of issuance), after deducting commissions and estimated expenses. We used the net proceeds to repay existing indebtedness under the 2019 Multicurrency Credit Facility and the April 2020 Term Loan (as defined below) and for general corporate purposes. 1.875% Senior Notes and 3.100% Senior Notes Offering—On September 28, 2020, we completed a registered public offering of $300.0 million aggregate principal amount through a reopening of the Initial 3.100% Notes (the “Reopened 3.100% Notes” and, collectively with the Initial 3.100% Notes, the “3.100% Notes”) and $800.0 million aggregate principal amount of 1.875% senior unsecured notes due 2030 (the “1.875% Notes”). The net proceeds from this offering were approximately $1,092.1 million, after deducting commissions and estimated expenses. We used the net proceeds to repay existing indebtedness under the 2019 Credit Facility and the April 2020 Term Loan (as defined below).0.600% Senior Notes, 1.500% Senior Notes and 2.950% Senior Notes Offering—On November 20, 2020, we completed a registered public offering of $500.0 million aggregate principal amount of 0.600% senior unsecured notes due 2024 (the “0.600% Notes”), $650.0 million aggregate principal amount of 1.500% senior unsecured notes due 2028 (the “1.500% Notes”) 39Table of Contents and $550.0 million aggregate principal amount of 2.950% senior unsecured notes due 2051 (the “2.950% Notes” and, collectively with the 2.400% Notes, the 2.900% Notes, the 1.300% Notes, the 2.100% Notes, the 3.100% Notes, the 0.500% Notes, the 1.000% Notes, the 1.875% Notes, the 0.600% Notes and the 1.500% Notes, the “Notes”). The net proceeds from this offering were approximately $1,678.9 million, after deducting commissions and estimated expenses. We used the net proceeds to repay existing indebtedness under the 2019 Credit Facility and for general corporate purposes, including the funding of the InSite Acquisition. The key terms of the Notes are as follows:Senior NotesAggregate Principal Amount (in millions)Issue Date and Interest Accrual DateMaturity DateContractual Interest RateFirst Interest PaymentInterest Payments Due (1)Par Call Date (2)2.400% Notes$750.0 January 10, 2020March 15, 20252.400 %September 15, 2020March 15 and September 15February 15, 20252.900% Notes$750.0 January 10, 2020January 15, 20302.900 %July 15, 2020January 15 and July 15October 15, 20291.300% Notes$500.0 June 3, 2020September 15, 20251.300 %March 15, 2021March 15 and September 15August 15, 20252.100% Notes$750.0 June 3, 2020June 15, 20302.100 %December 15, 2020June 15 and December 15March 15, 20303.100% Notes (3)$1,050.0 June 3, 2020June 15, 20503.100 %December 15, 2020June 15 and December 15December 15, 20490.500% Notes (4)$886.1 September 10, 2020January 15, 20280.500 %January 15, 2021January 15October 15, 20271.000% Notes (4)$768.0 September 10, 2020January 15, 20321.000 %January 15, 2021January 15 October 15, 20311.875% Notes$800.0 September 28, 2020October 15, 20301.875 %April 15, 2021April 15 and October 15July 15, 20300.600% Notes$500.0 November 20, 2020January 15, 20240.600 %July 15, 2021January 15 and July 15N/A1.500% Notes$650.0 November 20, 2020January 31, 20281.500 %July 31, 2021January 31 and July 31November 30, 20272.950% Notes$550.0 November 20, 2020January 15, 20512.950 %July 15, 2021January 15 and July 15July 15, 2050_______________ (1)Accrued and unpaid interest on USD denominated notes is payable in USD semi-annually in arrears and will be computed from the issue date on the basis of a 360-day year comprised of twelve 30-day months. Interest on EUR denominated notes is payable in EUR annually in arrears and will be computed on the basis of the actual number of days in the period for which interest is being calculated and the actual number of days from and including the last date on which interest was paid on the notes, beginning on the issue date.(2)We may redeem the Notes at any time, in whole or in part, at a redemption price equal to 100% of the principal amount of the Notes plus a make-whole premium, together with accrued interest to the redemption date. If we redeem the Notes on or after the par call date, we will not be required to pay a make-whole premium.(3)The Initial 3.100% Notes were issued on June 3, 2020. The Reopened 3.100% Notes were issued on September 28, 2020. (4)The 0.500% Notes and the 1.000% Notes are denominated in EUR. Represents the dollar equivalent of the aggregate principal amount as of the issue date.If we undergo a change of control and corresponding ratings decline, each as defined in the applicable supplemental indenture, we may be required to repurchase all of the Notes at a purchase price equal to 101% of the principal amount of such Notes, plus accrued and unpaid interest (including additional interest, if any), up to but not including the repurchase date. The Notes rank equally with all of our other senior unsecured debt and are structurally subordinated to all existing and future indebtedness and other obligations of our subsidiaries.The supplemental indentures contain certain covenants that restrict our ability to merge, consolidate or sell assets and our (together with our subsidiaries’) ability to incur liens. These covenants are subject to a number of exceptions, including that we and our subsidiaries may incur certain liens on assets, mortgages or other liens securing indebtedness if the aggregate amount of indebtedness secured by such liens does not exceed 3.5x Adjusted EBITDA, as defined in the applicable supplemental indenture.SecuritizationsRepayment of Series 2015-1 Notes—On the June 2020 payment date, we repaid the entire $350.0 million aggregate principal amount outstanding under the Series 2015-1 Notes pursuant to the terms of the agreements governing such securities. The repayment was funded with cash on hand. As of December 31, 2020, none of the Series 2015-1 Notes remained outstanding. 40Table of Contents Repayment of InSite Debt—The InSite Debt includes securitizations entered into by certain InSite subsidiaries. The InSite Debt was recorded at fair value upon acquisition. On January 15, 2021, we repaid the entire amount outstanding under the InSite Debt, plus accrued and unpaid interest up to, but excluding, January 15, 2021, for an aggregate redemption price of $826.4 million, including $2.3 million in accrued and unpaid interest. We recorded a loss on retirement of long-term obligations of approximately $24.5 million, which consists of prepayment consideration offset by the unamortized fair value adjustment recorded upon acquisition. The repayment of the InSite Debt was funded with borrowings from the 2019 Multicurrency Credit Facility and the 2019 Credit Facility, and cash on hand.Bank FacilitiesDuring the year ended December 31, 2020, we increased the commitments under the 2019 Multicurrency Credit Facility and the 2019 Credit Facility by $100.0 million each to $3.1 billion and $2.35 billion, respectively.2019 Multicurrency Credit Facility—As of December 31, 2020, we had the ability to borrow up to $3.1 billion under the 2019 Multicurrency Credit Facility, which includes a $1.0 billion sublimit for multicurrency borrowings, a $200.0 million sublimit for letters of credit and a $50.0 million sublimit for swingline loans. During the year ended December 31, 2020, we borrowed an aggregate of $1.0 billion and repaid an aggregate of $1.8 billion of revolving indebtedness under the 2019 Multicurrency Credit Facility. We used the borrowings to repay existing indebtedness and for general corporate purposes.2019 Credit Facility—As of December 31, 2020, we had the ability to borrow up to $2.35 billion under the 2019 Credit Facility, which includes a $200.0 million sublimit for letters of credit and a $50.0 million sublimit for swingline loans. During the year ended December 31, 2020, we borrowed an aggregate of $7.2 billion and repaid an aggregate of $6.5 billion of revolving indebtedness under the 2019 Credit Facility. We used the borrowings to fund acquisitions, including the InSite Acquisition, to repay existing indebtedness and for general corporate purposes.2020 Term Loan—On February 13, 2020, we entered into the 2020 Term Loan, the net proceeds of which were used, together with borrowings under the 2019 Credit Facility and cash on hand, to repay all outstanding indebtedness under our $1.3 billion unsecured term loan entered into on February 14, 2019. The 2020 Term Loan matured on February 12, 2021 and had an interest rate that was 0.650% above the London Interbank Offered Rate (“LIBOR”) for LIBOR-based borrowings or 0.000% above the defined base rate for base rate borrowings. On February 5, 2021, we repaid all amounts outstanding under the 2020 Term Loan with borrowings from the 2019 Multicurrency Credit Facility and cash on hand.April 2020 Term Loan—On April 3, 2020, we entered into a $1.14 billion unsecured term loan due April 2, 2021, which was subsequently increased to $1.19 billion effective April 21, 2020 (the “April 2020 Term Loan”), the net proceeds of which were used to repay outstanding indebtedness under the 2019 Credit Facility. During the year ended December 31, 2020, we repaid all amounts outstanding under the April 2020 Term Loan with proceeds from the issuances of the 0.500% Notes, the 1.000% Notes, the 1.875% Notes and the Reopened 3.100% Notes. As of December 31, 2020, the key terms under the 2019 Multicurrency Credit Facility, the 2019 Credit Facility, our $1.0 billion unsecured term loan, as amended and restated in December 2019 (the “2019 Term Loan”), and the 2020 Term Loan were as follows: Bank Facility (1)Outstanding Principal BalanceMaturity DateLIBOR borrowing interest rate range (2)Base rate borrowing interest rate range (2)Current margin over LIBOR and the base rate, respectively2019 Multicurrency Credit Facility— June 28, 2023(3)0.875% - 1.750%0.000% - 0.750%1.125% and 0.125%2019 Credit Facility$2,295.0 January 31, 2025(3)0.875% - 1.750%0.000% - 0.750%1.125% and 0.125%2019 Term Loan$1,000.0 January 31, 20250.875% - 1.750%0.000% - 0.750%1.125% and 0.125%2020 Term Loan$750.0 February 12, 20210.650%0.000 %0.650% and 0.000%_______________(1) Currently borrowed at LIBOR.(2) Represents interest rate above LIBOR for LIBOR-based borrowings and the interest rate above the defined base rate for base rate borrowings, in each case based on our debt ratings.(3) Subject to two optional renewal periods. We must pay a quarterly commitment fee on the undrawn portion of each of the 2019 Multicurrency Credit Facility and the 2019 Credit Facility. The commitment fee for the 2019 Multicurrency Credit Facility and the 2019 Credit Facility ranges from 0.080% to 0.300% per annum, based upon our debt ratings, and is currently 0.110%. The 2019 Multicurrency Credit Facility, the 2019 Credit Facility and the 2019 Term Loan do not require amortization of principal and may be paid prior to maturity in whole or in part at our option without penalty or premium. We have the option of choosing either a defined base rate or LIBOR as the applicable base rate for borrowings under these bank facilities. 41Table of Contents The loan agreements for each of the 2019 Multicurrency Credit Facility, the 2019 Credit Facility and the 2019 Term Loan contain certain reporting, information, financial and operating covenants and other restrictions (including limitations on additional debt, guaranties, sales of assets and liens) with which we must comply. Failure to comply with the financial and operating covenants of the loan agreements could not only prevent us from being able to borrow additional funds under the revolving credit facilities, but may constitute a default, which could result in, among other things, the amounts outstanding, including all accrued interest and unpaid fees, becoming immediately due and payable.Amendments to Bank Facilities—On February 10, 2021, we amended and restated the 2019 Multicurrency Credit Facility and the 2019 Credit Facility and entered into an amendment agreement with respect to the 2019 Term Loan. These amendments, among other things, i.extend the maturity dates by one year to June 28, 2024 and January 31, 2026 for the 2019 Multicurrency Credit Facility and the 2019 Credit Facility, respectively, ii.increase the commitments under the 2019 Multicurrency Credit Facility and the 2019 Credit Facility to $4.1 billion and $2.9 billion, respectively, of which 1.3 billion EUR borrowed under the 2019 Multicurrency Credit Facility is to be reserved to finance the Pending Telxius Acquisition, iii.increase the maximum Revolving Loan Commitments, after giving effect to any Incremental Commitments (each as defined in the loan agreements for each of the 2019 Multicurrency Credit Facility and the 2019 Credit Facility) to $6.1 billion and $4.4 billion under the 2019 Multicurrency Credit Facility and the 2019 Credit Facility, respectively, iv.expand the sublimit for multicurrency borrowings under the 2019 Multicurrency Credit Facility from $1.0 billion to $3.0 billion and add a EUR borrowing option for the 2019 Credit Facility with a $1.5 billion sublimit, v.amend the limitation of our permitted ratio of Total Debt to Adjusted EBITDA (each as defined in each of the loan agreements for each of the facilities) to be no greater than 7.50 to 1.00 for the four fiscal quarters following the consummation of the Pending Telxius Acquisition, stepping down to 6.00 to 1.00 thereafter (with a further step up to 7.00 to 1.00 if we consummate a Qualified Acquisition (as defined in each of the loan agreements for the facilities)), vi.amend the limitation on indebtedness of, and guaranteed by, our subsidiaries to the greater of (a) $3.0 billion and (b) 50% of Adjusted EBITDA (as defined in each of the loan agreements for the facilities) of us and our subsidiaries on a consolidated basis andvii.increase the threshold for certain defaults with respect to judgments, attachments or acceleration of indebtedness from $400.0 million to $500.0 million.2021 Delayed Draw Term Loans—On February 10, 2021, we entered into (i) a 1.1 billion EUR (approximately $1.3 billion at the date of signing) unsecured term loan, the proceeds of which are to be used to fund the Pending Telxius Acquisition, with a maturity date that is 364 days from the date of the first draw thereunder and bears interest at a rate based on our senior unsecured debt rating, which, based on our current debt ratings, is 1.000% above the Euro Interbank Offered Rate (“EURIBOR”) (the “2021 364-Day Delayed Draw Term Loan”) and (ii) an 825.0 million EUR (approximately $1.0 billion at the date of signing) unsecured term loan, the proceeds of which are to be used to fund the Pending Telxius Acquisition, with a maturity date that is three years from the date of the first draw thereunder and bears interest at a rate based on our senior unsecured debt rating, which, based on our current debt ratings, is 1.125% above EURIBOR (the “2021 Three Year Delayed Draw Term Loan,” and, together with the 2021 364-Day Delayed Draw Term Loan, the “2021 Delayed Draw Term Loans”).The loan agreements for the 2021 Delayed Draw Term Loans contain certain reporting, information, financial and operating covenants and other restrictions (including limitations on additional debt, guaranties, sales of assets and liens) with which we must comply. Failure to comply with the financial and operating covenants of the loan agreements could not only prevent us from being able to borrow additional funds under the revolving credit facilities, but may constitute a default, which could result in, among other things, the amounts outstanding, including all accrued interest and unpaid fees, becoming immediately due and payable.Bridge Facility—In connection with entering into the Pending Telxius Acquisition, we entered into a commitment letter (the “Commitment Letter”), dated January 13, 2021, with Bank of America, N.A. and BofA Securities, Inc. (together, “BoA”) pursuant to which BoA has committed to provide up to 7.5 billion EUR (approximately $9.1 billion at date of signing) in bridge loans (the “Bridge Loan Commitment”) to ensure financing for the Pending Telxius Acquisition. Effective February 10, 2021, the Bridge Loan Commitment was reduced to 4.275 billion EUR (approximately $5.2 billion at the date of signing) as a result of an aggregate of 3.225 billion EUR (approximately $3.9 billion at the date of signing) of additional committed amounts under the 2019 Multicurrency Credit Facility, the 2019 Credit Facility and the 2021 Delayed Draw Term Loans, as described above.42Table of Contents The Commitment Letter contains, and the credit agreement in respect of the Bridge Loan Commitment, if any, will contain, certain customary conditions to funding, including, without limitation, (i) the execution and delivery of definitive financing agreements for the Bridge Loan Commitment and (ii) other customary closing conditions set forth in the Commitment Letter. The Company will pay certain customary commitment fees and, in the event it makes any borrowings in connection with the Bridge Loan Commitment, funding and other fees.India Indebtedness—We maintain several working capital facilities in India, most of which are subject to annual renewal. The working capital facilities bear interest at rates that consist of the applicable bank’s Marginal Cost of Funds based Lending Rate (as defined in the applicable agreement), plus a spread.Generally, the working capital facilities are payable on demand prior to maturity. Amounts outstanding and key terms of theIndia indebtedness consisted of the following as of December 31, 2020 (in millions, except percentages):Amount Outstanding (INR)Amount Outstanding (USD)Interest Rate (Range)Maturity Date (Range)Working capital facilities (1)— $— 7.45% -8.75%March 18, 2021 - October 23, 2021______________(1) 5.6 billion INR ($76.9 million) of borrowing capacity as of December 31, 2020. Subsequent to December 31, 2020, we entered into two additional working capital facilities in India, under which we currently have no amounts outstanding.Stock Repurchase Programs—In March 2011, our Board of Directors approved a stock repurchase program, pursuant to which we are authorized to repurchase up to $1.5 billion of our common stock (the “2011 Buyback”). In addition to the 2011 Buyback, in December 2017, our Board of Directors approved an additional stock repurchase program, pursuant to which we are authorized to repurchase up to $2.0 billion of our common stock (the “2017 Buyback,” and, together with the 2011 Buyback, the “Buyback Programs”).During the year ended December 31, 2020, we repurchased 264,086 shares of our common stock under the 2011 Buyback for an aggregate of $56.0 million, including commissions and fees. We had no repurchases under the 2017 Buyback.Under each program, we are authorized to purchase shares from time to time through open market purchases or in privately negotiated transactions not to exceed market prices and subject to market conditions and other factors. With respect to open market purchases, we may use plans adopted in accordance with Rule 10b5-1 under the Exchange Act in accordance with securities laws and other legal requirements, which allows us to repurchase shares during periods when we may otherwise be prevented from doing so under insider trading laws or because of self-imposed trading blackout periods. These programs may be discontinued at any time.We have repurchased a total of 14.4 million shares of our common stock under the 2011 Buyback for an aggregate of $1.5 billion, including commissions and fees. We expect to continue managing the pacing of the remaining approximately $2.0 billion under the Buyback Programs in response to general market conditions and other relevant factors. We expect to fund any further repurchases of our common stock through a combination of cash on hand, cash generated by operations and borrowings under our credit facilities. Repurchases under the Buyback Programs are subject to, among other things, us having available cash to fund the repurchases. Sales of Equity Securities—We receive proceeds from sales of our equity securities pursuant to our employee stock purchase plan (the “ESPP”) and upon exercise of stock options granted under our equity incentive plan. For the year ended December 31, 2020, we received an aggregate of $98.1 million in proceeds upon exercises of stock options and sales pursuant to the ESPP.2020 “At the Market” Stock Offering Program—In August 2020, we established the 2020 ATM Program. Sales under the 2020 ATM Program may be made by means of ordinary brokers’ transactions on the New York Stock Exchange or otherwise at market prices prevailing at the time of sale, at prices related to prevailing market prices or, subject to our specific instructions, at negotiated prices. We intend to use the net proceeds of the 2020 ATM Program for general corporate purposes, which may include, among other things, the funding of acquisitions, additions to working capital and repayment or refinancing of existing indebtedness. As of December 31, 2020, we have not sold any shares of common stock under the 2020 ATM Program.Distributions—As a REIT, we must annually distribute to our stockholders an amount equal to at least 90% of our REIT taxable income (determined before the deduction for distributed earnings and excluding any net capital gain). Generally, we have distributed, and expect to continue to distribute, all or substantially all of our REIT taxable income after taking into consideration our utilization of NOLs. We have distributed an aggregate of approximately $9.4 billion to our common 43Table of Contents stockholders, including the dividend paid in February 2021, primarily classified as ordinary income that may be treated as qualified REIT dividends under Section 199A of the Code for taxable years ending before 2026. The amount, timing and frequency of future distributions will be at the sole discretion of our Board of Directors and will depend on various factors, a number of which may be beyond our control, including our financial condition and operating cash flows, the amount required to maintain our qualification for taxation as a REIT and reduce any income and excise taxes that we otherwise would be required to pay, limitations on distributions in our existing and future debt and preferred equity instruments, our ability to utilize NOLs to offset our distribution requirements, limitations on our ability to fund distributions using cash generated through our TRSs and other factors that our Board of Directors may deem relevant.During the year ended December 31, 2020, we paid $4.33 per share, or $1.9 billion, to common stockholders of record. In addition, we declared a distribution of $1.21 per share, or $537.6 million, paid on February 2, 2021 to our common stockholders of record at the close of business on December 28, 2020.We accrue distributions on unvested restricted stock units, which are payable upon vesting. The amount accrued for distributions payable related to unvested restricted stock units was $12.6 million and $14.3 million as of December 31, 2020 and 2019, respectively. During the year ended December 31, 2020, we paid $7.8 million of distributions upon the vesting of restricted stock units. For more details on the cash distributions paid to our common stockholders during the year ended December 31, 2020, see note 16 to our consolidated financial statements included in this Annual Report.Material Cash Requirements—The following table summarizes material cash requirements from known contractual and other obligations as of December 31, 2020 (in millions):20212022202320242025ThereafterTotalDebt obligations (1)$789.8 $1,304.6 $3,318.9 $2,151.9 $7,566.0 $14,331.5 $29,462.7 Operating lease obligations (2)901.1 869.0 836.4 798.0 751.8 6,423.4 10,579.7 44Table of Contents ______________(1) Includes aggregate principal maturities of long-term debt, including finance lease obligations (see note 9 to our consolidated financial statements included in this Annual Report).(2) Includes payments under non-cancellable initial terms, as well as payments for certain renewal periods at our option, which we expect to renew because failure to do so could result in a loss of the applicable communications sites and related revenues from tenant leases (see note 4 to our consolidated financial statements included in this Annual Report).Distributions—We expect that our 2021 total distributions paid to our common stockholders will be $2.3 billion. The amount, timing and frequency of future distributions will be at the sole discretion of our Board of Directors. Signed Acquisitions—On November 28, 2019, we entered into definitive agreements with Orange for the acquisition of up to approximately 2,000 communications sites in France over a period of up to five years for total consideration in the range of approximately 500.0 million EUR to 600.0 million EUR (approximately $550.5 million to $660.5 million at the date of signing) to be paid over the five-year term. During the year ended December 31, 2020, we completed the acquisition of 564 communications sites. The remaining communications sites are expected to close in tranches, subject to customary closing conditions.On December 19, 2019, we entered into a definitive agreement to acquire approximately 3,200 communications sites in Chile and Peru from Entel PCS Telecomunicaciones S.A. and Entel Peru S.A. for total consideration of approximately $0.8 billion (as of the date of signing). We completed the acquisition of approximately 2,400 communications sites in December 2019. During the year ended December 31, 2020, we completed the acquisition of an additional 530 communications sites pursuant to this agreement for an aggregate total purchase price of $137.7 million (as of the dates of acquisition), including value added tax. The remaining communications sites are expected to continue to close in tranches, subject to certain closing conditions.On January 13, 2021, we entered into the Pending Telxius Acquisition for approximately 7.7 billion EUR (approximately $9.4 billion at the date of signing), subject to limited adjustments. The Pending Telxius Acquisition is expected to close in tranches beginning in the second quarter of 2021, subject to customary closing conditions, including government and regulatory approval.Asset Retirement Obligations—We are required to remove our tower assets and remediate the leased land upon which certain of our tower assets are located. As of December 31, 2020, the estimated undiscounted future cash outlay for asset retirement obligations was $3.7 billion. Purchase of Redeemable Noncontrolling Interests— As described above, we expect to pay an amount equivalent to INR 12.9 billion (approximately $176.6 million) to redeem the shares of our remaining minority holders in ATC TIPL in 2021, subject to regulatory approval. Factors Affecting Sources of LiquidityOur liquidity depends on our ability to generate cash flow from operating activities, borrow funds under our credit facilities and maintain compliance with the contractual agreements governing our indebtedness. We believe that the debt agreements discussed below represent our material debt agreements that contain covenants, our compliance with which would be material to an investor’s understanding of our financial results and the impact of those results on our liquidity.Internally Generated Funds—Because the majority of our tenant leases are multiyear contracts, a significant majority of the revenues generated by our property operations as of the end of 2020 is recurring revenue that we should continue to receive in future periods. Accordingly, a key factor affecting our ability to generate cash flow from operating activities is to maintain this recurring revenue and to convert it into operating profit by minimizing operating costs and fully achieving our operating efficiencies. In addition, our ability to increase cash flow from operating activities depends upon the demand for our communications sites and our related services and our ability to increase the utilization of our existing communications sites.Restrictions Under Loan Agreements Relating to Our Credit Facilities—The loan agreements for the 2019 Multicurrency Credit Facility, the 2019 Credit Facility, the 2019 Term Loan and the 2021 Delayed Draw Term Loans contain certain financial and operating covenants and other restrictions applicable to us and our subsidiaries that are not designated as unrestricted subsidiaries on a consolidated basis. These restrictions include limitations on additional debt, distributions and dividends, guaranties, sales of assets and liens. The loan agreements also contain covenants that establish financial tests with which we and our restricted subsidiaries must comply related to total leverage and senior secured leverage, as set forth in the table below. As 45Table of Contents of December 31, 2020, we were in compliance with each of these covenants. Compliance Tests For The 12 Months Ended December 31, 2020($ in billions)Ratio (1)Additional Debt Capacity Under Covenants (2)Capacity for Adjusted EBITDA Decrease Under Covenants (3)Consolidated Total Leverage RatioTotal Debt to Adjusted EBITDA ≤ 6.00:1.00~$2.5~$0.4Consolidated Senior Secured Leverage RatioSenior Secured Debt to Adjusted EBITDA ≤ 3.00:1.00~$12.6 (4)~$4.2_______________(1) Each component of the ratio as defined in the applicable loan agreement.(2) Assumes no change to Adjusted EBITDA.(3) Assumes no change to our debt levels. (4) Effectively, however, additional Senior Secured Debt under this ratio would be limited to the capacity under the Consolidated Total Leverage Ratio.Under the terms of the agreements for the 2019 Multicurrency Credit Facility, the 2019 Credit Facility, the 2019 Term Loan and the 2021 Delayed Draw Term Loans, the Pending Telxius Acquisition is designated as a Qualified Acquisition, whereby our Total Debt to Adjusted EBITDA ratio is adjusted to not exceed 7:50 to 1:00 for four fiscal quarters following consummation of the Pending Telxius Acquisition. The loan agreements for our credit facilities also contain reporting and information covenants that require us to provide financial and operating information to the lenders within certain time periods. If we are unable to provide the required information on a timely basis, we would be in breach of these covenants.Failure to comply with the financial maintenance tests and certain other covenants of the loan agreements for our credit facilities could not only prevent us from being able to borrow additional funds under these credit facilities, but may also constitute a default under these credit facilities, which could result in, among other things, the amounts outstanding, including all accrued interest and unpaid fees, becoming immediately due and payable. If this were to occur, we may not have sufficient cash on hand to repay such indebtedness. The key factors affecting our ability to comply with the debt covenants described above are our financial performance relative to the financial maintenance tests defined in the loan agreements for these credit facilities and our ability to fund our debt service obligations. Based upon our current expectations, we believe our operating results during the next 12 months will be sufficient to comply with these covenants.Restrictions Under Agreements Relating to the 2015 Securitization and the Trust Securitizations—The indenture and related supplemental indenture governing the American Tower Secured Revenue Notes, Series 2015-2, Class A (the “Series 2015-2 Notes”) issued by GTP Acquisition Partners I, LLC (“GTP Acquisition Partners”) in a private securitization transaction in May 2015 (the “2015 Securitization”) and the loan agreement related to the securitization transactions completed in March 2013 (the “2013 Securitization”) and March 2018 (the “2018 Securitization” and, together with the 2013 Securitization, the “Trust Securitizations”) include certain financial ratios and operating covenants and other restrictions customary for transactions subject to rated securitizations. Among other things, GTP Acquisition Partners and American Tower Asset Sub, LLC and American Tower Asset Sub II, LLC (together, the “AMT Asset Subs”) are prohibited from incurring other indebtedness for borrowed money or further encumbering their assets, subject to customary carve-outs for ordinary course trade payables and permitted encumbrances (as defined in the applicable agreements).Under the agreements, amounts due will be paid from the cash flows generated by the assets securing the Series 2015-2 Notes or the assets securing the nonrecourse loan that secures the Secured Tower Revenue Securities, Series 2013-2A (the “Series 2013-2A Securities”), Secured Tower Revenue Securities, Series 2018-1, Subclass A (the “Series 2018-1A Securities”), and the Secured Tower Revenue Securities, Series 2018-1, Subclass R (the “Series 2018-1R Securities” and, together with the Series 2018-1A Securities, the “2018 Securities”) issued in the Trust Securitizations (the “Loan”), as applicable, which must be deposited into certain reserve accounts, and thereafter distributed, solely pursuant to the terms of the applicable agreement. On a monthly basis, after payment of all required amounts under the applicable agreement, subject to the conditions described in the table below, the excess cash flows generated from the operation of such assets are released to GTP Acquisition Partners or the AMT Asset Subs, as applicable, which can then be distributed to, and used by, us. As of December 31, 2020, $81.0 million held in such reserve accounts was classified as restricted cash. Certain information with respect to the 2015 Securitization and the Trust Securitizations is set forth below. The debt service coverage ratio (“DSCR”) is generally calculated as the ratio of the net cash flow (as defined in the applicable agreement) to the amount of interest, servicing fees and trustee fees required to be paid over the succeeding 12 months on the principal amount of the Series 2015-2 Notes or the Loan, as applicable, that will be outstanding on the payment date following such date of determination. 46Table of Contents Issuer or BorrowerNotes/Securities IssuedConditions Limiting Distributions of Excess CashExcess Cash Distributed During Year Ended December 31, 2020DSCR as of December 31, 2020Capacity for Decrease in Net Cash Flow Before Triggering Cash Trap DSCR (1)Capacity for Decrease in Net Cash Flow Before Triggering Minimum DSCR (1)Cash Trap DSCRAmortization Period(in millions)(in millions)(in millions)2015 Securitization (2)GTP Acquisition PartnersAmerican Tower Secured Revenue Notes, Series 2015-1 and Series 2015-21.30x, Tested Quarterly (3)(4)(5)$269.316.00x$270.5$273.3Trust SecuritizationsAMT Asset SubsSecured Tower Revenue Securities, Series 2013-2A, Secured Tower Revenue Securities, Series 2018-1, Subclass A and Secured Tower Revenue Securities, Series 2018-1, Subclass R1.30x, Tested Quarterly (3)(4)(6)$448.811.31x$597.9$606.9_______________(1) Based on the net cash flow of the applicable issuer or borrower as of December 31, 2020 and the expenses payable over the next 12 months on the Series 2015-2 Notes or the Loan, as applicable. (2) On the June 2020 payment date, the Series 2015-1 Notes were repaid in full. As of December 31, 2020, none of the Series 2015-1 Notes remained outstanding. (3) Once triggered, a Cash Trap DSCR condition continues to exist until the DSCR exceeds the Cash Trap DSCR for two consecutive calendar quarters. During a Cash Trap DSCR condition, all cash flow in excess of amounts required to make debt service payments, fund required reserves, pay management fees and budgeted operating expenses and make other payments required under the applicable transaction documents, referred to as excess cash flow, will be deposited into a reserve account (the “Cash Trap Reserve Account”) instead of being released to the applicable issuer or borrower. (4) An amortization period commences if the DSCR is equal to or below 1.15x (the “Minimum DSCR”) at the end of any calendar quarter and continues to exist until the DSCR exceeds the Minimum DSCR for two consecutive calendar quarters.(5) No amortization period is triggered if the outstanding principal amount of a series has not been repaid in full on the applicable anticipated repayment date. However, in such event, additional interest will accrue on the unpaid principal balance of the applicable series, and such series will begin to amortize on a monthly basis from excess cash flow.(6) An amortization period exists if the outstanding principal amount has not been paid in full on the applicable anticipated repayment date and continues to exist until such principal has been repaid in full. A failure to meet the noted DSCR tests could prevent GTP Acquisition Partners or the AMT Asset Subs from distributing excess cash flow to us, which could affect our ability to fund our capital expenditures, including tower construction and acquisitions and to meet REIT distribution requirements. During an “amortization period,” all excess cash flow and any amounts then in the applicable Cash Trap Reserve Account would be applied to pay principal of the Series 2015-2 Notes or the Loan, as applicable, on each monthly payment date, and so would not be available for distribution to us. Further, additional interest will begin to accrue with respect to the Series 2015-2 Notes or subclass of the Loan from and after the anticipated repayment date at a per annum rate determined in accordance with the applicable agreement. With respect to the Series 2015-2 Notes, upon the occurrence of, and during, an event of default, the applicable trustee may, in its discretion or at the direction of holders of more than 50% of the aggregate outstanding principal of the Series 2015-2 Notes, declare the Series 2015-2 Notes immediately due and payable, in which case any excess cash flow would need to be used to pay holders of such notes. Furthermore, if GTP Acquisition Partners or the AMT Asset Subs were to default on the Series 2015-2 Notes or the Loan, the applicable trustee may seek to foreclose upon or otherwise convert the ownership of all or any portion of the 3,538 communications sites that secure the Series 2015-2 Notes or the 5,114 broadcast and wireless communications towers and related assets that secure the Loan, respectively, in which case we could lose such sites and the revenue associated with those assets.As discussed above, we use our available liquidity and seek new sources of liquidity to fund capital expenditures, future growth and expansion initiatives, satisfy our distribution requirements and repay or repurchase our debt. If we determine that it is desirable or necessary to raise additional capital, we may be unable to do so, or such additional financing may be prohibitively expensive or restricted by the terms of our outstanding indebtedness. Additionally, as further discussed under Item 1A of this Annual Report under the caption “Risk Factors,” extreme market volatility and disruption caused by the COVID-19 pandemic 47Table of Contents may impact our ability to raise additional capital through debt financing activities or our ability to repay or refinance maturing liabilities, or impact the terms of any new obligations. If we are unable to raise capital when our needs arise, we may not be able to fund capital expenditures, future growth and expansion initiatives, satisfy our REIT distribution requirements and debt service obligations or refinance our existing indebtedness. In addition, our liquidity depends on our ability to generate cash flow from operating activities. As set forth under Item 1A of this Annual Report under the caption “Risk Factors,” we derive a substantial portion of our revenues from a small number of tenants and, consequently, a failure by a significant tenant to perform its contractual obligations to us could adversely affect our cash flow and liquidity.Critical Accounting Policies and EstimatesManagement’s discussion and analysis of financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with GAAP. The preparation of these financial statements requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses, as well as related disclosures of contingent assets and liabilities. We evaluate our policies and estimates on an ongoing basis. Management bases its estimates on historical experience and various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying amounts of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.We have reviewed our policies and estimates to determine our critical accounting policies for the year ended December 31, 2020. We have identified the following policies as critical to an understanding of our results of operations and financial condition. This is not a comprehensive list of our accounting policies. See note 1 to our consolidated financial statements included in this Annual Report for a summary of our significant accounting policies. In many cases, the accounting treatment of a particular transaction is specifically dictated by GAAP, with no need for management’s judgment in its application. There are also areas in which management’s judgment in selecting any available alternative would not produce a materially different result.•Impairment of Assets—Assets Subject to Depreciation and Amortization: We review long-lived assets for impairment at least annually or whenever events, changes in circumstances or other indicators or evidence indicate that the carrying amount of our assets may not be recoverable. We review our tower portfolio, network location intangible and right-of-use assets for indicators of impairment at the lowest level of identifiable cash flows, typically at an individual tower basis. Possible indicators include a tower not having current tenant leases or having expenses in excess of revenues. A cash flow modeling approach is utilized to assess recoverability and incorporates, among other items, the tower location, the tower location demographics, the timing of additions of new tenants, lease rates and estimated length of tenancy and ongoing cash requirements.We review our tenant-related intangible assets on a tenant by tenant basis for indicators of impairment, such as high levels of turnover or attrition, non-renewal of a significant number of contracts or the cancellation or termination of a relationship. We assess recoverability by determining whether the carrying amount of the tenant-related intangible assets will be recovered primarily through projected undiscounted future cash flows. If the sum of the estimated undiscounted future cash flows of our long-lived assets is less than the carrying amount of the assets, an impairment loss may be recognized. Key assumptions included in the undiscounted cash flows are future revenue projections, estimates of ongoing tenancies and operating margins. An impairment loss would be based on the fair value of the asset, which is based on an estimate of discounted future cash flows to be provided from the asset. We record any related impairment charge in the period in which we identify such impairment.In October 2019, the Supreme Court of India issued a ruling regarding the definition of AGR and associated fees and charges, which was reaffirmed in March 2020, that may have a material financial impact on certain of our tenants which could affect their ability to perform their obligations under agreements with us. In September 2020, the Supreme Court of India defined the expected timeline of ten years for payments owed under the ruling. We will continue to monitor the status of these developments, as it is possible that the estimated future cash flows may differ from current estimates and changes in estimated cash flows from tenants in India could have an impact on previously recorded tangible and intangible assets, including amounts originally recorded as tenant-related intangibles. The carrying value of tenant-related intangibles in India was $1.0 billion as of December 31, 2020, which represents 10% of our consolidated balance of $10.1 billion. Additionally, a significant reduction in tenant related cash flows in India could also impact our tower portfolio and network location intangibles. The carrying values of our tower portfolio and network location intangibles in India were $1.0 billion and $410.9 million, respectively, as of December 31, 2020, which represent 13% and 11% of our consolidated balances of $8.0 billion and $3.7 billion, respectively. 48Table of Contents •Impairment of Assets—Goodwill: We review goodwill for impairment at least annually (as of December 31) or whenever events or circumstances indicate the carrying amount of an asset may not be recoverable. Goodwill is recorded in the applicable segment and assessed for impairment at the reporting unit level. We employ a discounted cash flow analysis when testing goodwill. The key assumptions utilized in the discounted cash flow analysis include current operating performance, terminal sales growth rate, management’s expectations of future operating results and cash requirements, the current weighted average cost of capital and an expected tax rate. We compare the fair value of the reporting unit, as calculated under an income approach using future discounted cash flows, to the carrying amount of the applicable reporting unit. If the carrying amount exceeds the fair value, an impairment loss would be recognized for the amount of the excess. The loss recognized is limited to the total amount of goodwill allocated to that reporting unit. During the year ended December 31, 2020, no potential goodwill impairment was identified as the fair value of each of our reporting units was in excess of its carrying amount. •Asset Retirement Obligations: When required, we recognize the fair value of obligations to remove our tower assets and remediate the leased land upon which certain of our tower assets are located. Generally, the associated retirement costs are capitalized as part of the carrying amount of the related tower assets and depreciated over their estimated useful lives and the liability is accreted through the obligation’s estimated settlement date. We updated our assumptions used in estimating our aggregate asset retirement obligation, which resulted in a net increase in the estimated obligation of $65.0 million during the year ended December 31, 2020. The change in 2020 primarily resulted from changes in timing of certain settlement date and cost assumptions. Fair value estimates of liabilities for asset retirement obligations generally involve discounting of estimated future cash flows. Periodic accretion of such liabilities due to the passage of time is included in Depreciation, amortization and accretion expense in the consolidated statements of operations. The significant assumptions used in estimating our aggregate asset retirement obligation are: timing of tower removals; cost of tower removals; timing and number of land lease renewals; expected inflation rates; and credit-adjusted risk-free interest rates that approximate our incremental borrowing rate. While we feel the assumptions are appropriate, there can be no assurances that actual costs and the probability of incurring obligations will not differ from these estimates. We will continue to review these assumptions periodically and we may need to adjust them as necessary.•Acquisitions: We evaluate each of our acquisitions under the accounting guidance framework to determine whether to treat an acquisition as an asset acquisition or a business combination. For those transactions treated as asset acquisitions, the purchase price is allocated to the assets acquired, with no recognition of goodwill. For those acquisitions that meet the definition of a business combination, we apply the acquisition method of accounting where assets acquired and liabilities assumed are recorded at fair value at the date of each acquisition, and the results of operations are included with our results from the dates of the respective acquisitions. Any excess of the purchase price paid over the amounts recognized for assets acquired and liabilities assumed is recorded as goodwill. We continue to evaluate acquisitions accounted for as business combinations for a period not to exceed one year after the applicable acquisition date of each transaction to determine whether any additional adjustments are needed to the allocation of the purchase price paid for the assets acquired and liabilities assumed. The fair value of the assets acquired and liabilities assumed is typically determined by using either estimates of replacement costs or discounted cash flow valuation methods. When determining the fair value of tangible assets acquired, we must estimate the cost to replace the asset with a new asset taking into consideration such factors as age, condition and the economic useful life of the asset. When determining the fair value of intangible assets acquired, we must estimate the applicable discount rate and the timing and amount of future tenant cash flows, including rate and terms of renewal and attrition. •Revenue Recognition: Our revenue is derived from leasing the right to use our communications sites and the land on which the sites are located (the “lease component”) and from the reimbursement of costs incurred in operating the communications sites and supporting the tenants’ equipment as well as other services and contractual rights (the “non-lease component”). Most of our revenue is derived from leasing arrangements and is accounted for as lease revenue unless the timing and pattern of revenue recognition of the non-lease component differs from the lease component. If the timing and pattern of the non-lease component revenue recognition differs from that of the lease component, we separately determine the stand-alone selling prices and pattern of revenue recognition for each performance obligation.Our revenue from leasing arrangements, including fixed escalation clauses present in non-cancellable lease arrangements, is reported on a straight-line basis over the term of the respective leases when collectibility is probable. Escalation clauses tied to a consumer price index or other inflation-based indices, and other incentives present in lease agreements with our tenants, are excluded from the straight-line calculation. Total property straight-line revenues for the years ended December 31, 2020, 2019 and 2018 were $322.0 million, $183.5 million and $87.6 million, 49Table of Contents respectively. Amounts billed upfront in connection with the execution of lease agreements are initially deferred and reflected in Unearned revenue in the accompanying consolidated balance sheets and recognized as revenue over the terms of the applicable lease arrangements. Amounts billed or received for services prior to being earned are deferred and reflected in Unearned revenue in the accompanying consolidated balance sheets until the criteria for recognition have been met.We derive the largest portion of our revenues, corresponding trade receivables and the related deferred rent asset from a small number of tenants in the telecommunications industry, with 55% of our revenues derived from three tenants. In addition, we have concentrations of credit risk in certain geographic areas. We mitigate the concentrations of credit risk with respect to notes and trade receivables by actively monitoring the creditworthiness of our borrowers and tenants. In recognizing tenant revenue we assess the collectibility of both the amounts billed and the portion recognized on a straight-line basis. This assessment takes tenant credit risk and business and industry conditions into consideration to ultimately determine the collectibility of the amounts billed. To the extent the amounts, based on management’s estimates, may not be collectible, recognition is deferred until such point as the uncertainty is resolved. Any amounts that were previously recognized as revenue and subsequently determined to be uncollectible are charged to bad debt expense. Accounts receivable are reported net of allowances for doubtful accounts related to estimated losses resulting from a tenant’s inability to make required payments and allowances for amounts invoiced whose collectibility is not reasonably assured.•Rent Expense and Lease Accounting: Many of the leases underlying our tower sites have fixed rent escalations, which provide for periodic increases in the amount of ground rent payable over time. In addition, certain of our tenant leases require us to exercise available renewal options pursuant to the underlying ground lease if the tenant exercises its renewal option. Our calculation of the lease liability includes straight-line ground rent expense for these leases based on the term of the underlying ground lease plus all periods, if any, for which failure to renew the lease imposes an economic penalty to us such that renewal appears to be reasonably assured. Effective January 1, 2019, we adopted the new lease standard using the modified retrospective method applied to lease arrangements that were in place on the transition date. The new lease accounting guidance required us to recognize a right-of-use lease asset and lease liability for operating and finance leases. The right-of-use asset is measured as the sum of the lease liability, prepaid or accrued lease payments, any initial direct costs incurred and any other applicable amounts.The calculation of the lease liability requires us to make certain assumptions for each lease, including lease term and discount rate implicit in each lease, which could significantly impact the gross lease obligation, the duration and the present value of the lease liability. When calculating the lease term, we consider the renewal, cancellation and termination rights available to us and the lessor. We determine the discount rate by calculating the incremental borrowing rate on a collateralized basis at the commencement of a lease or upon a change in the lease term.•Income Taxes: Accounting for income taxes requires us to estimate the timing and impact of amounts recorded in our financial statements that may be recognized differently for tax purposes. To the extent that the timing of amounts recognized for financial reporting purposes differs from the timing of recognition for tax reporting purposes, deferred tax assets or liabilities are required to be recorded. We measure deferred tax assets and liabilities using enacted tax rates expected to apply to taxable income in the years in which those temporary differences and carryforwards are expected to be recovered or settled. The effect on deferred tax assets and liabilities as a result of a change in tax rates is recognized in income in the period that includes the enactment date. We do not expect to pay federal income taxes on our REIT taxable income.We periodically review our deferred tax assets, and we record a valuation allowance if, based on the available evidence, it is more likely than not that some or all of the deferred tax assets will not be realized. Management assesses the available positive and negative evidence to estimate if sufficient future taxable income will be generated to use the existing deferred tax assets. Valuation allowances would be reversed as a reduction to the provision for income taxes, if related deferred tax assets are deemed realizable based on changes in facts and circumstances relevant to the assets’ recoverability.We recognize the benefit of uncertain tax positions when, in management’s judgment, it is more likely than not that positions we have taken in our tax returns will be sustained upon examination, which are measured at the largest amount that is greater than 50% likely of being realized upon settlement. We adjust our tax liabilities when our judgment changes as a result of the evaluation of new information or information not previously available. Due to the complexity of some of these uncertainties, the ultimate resolution may result in a payment that is materially different from our current estimate of the tax liabilities. These differences will be reflected as increases or decreases to income tax expense in the period in which additional information is available or the position is ultimately settled under audit.50Table of Contents Accounting Standards UpdateFor a discussion of recent accounting standards updates, see note 1 to our consolidated financial statements included in this Annual Report.ITEM 7A.QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKThe following table provides information as of December 31, 2020 about our market risk exposure associated with changing interest rates. For long-term debt obligations, the table presents principal cash flows by maturity date and average interest rates related to outstanding obligations. For interest rate swaps, the table presents notional principal amounts and weighted-average interest rates (in millions, except percentages). For more information, see Item 7 of this Annual Report under the caption “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Liquidity and Capital Resources” and note 9 to our consolidated financial statements included in this Annual Report. Long-Term Debt20212022202320242025ThereafterTotalFair ValueFixed Rate Debt (a)$28.1 $1,304.6 $3,318.9 $2,151.9 $4,271.0 $14,331.5 $25,406.0 $27,308.6 Weighted-Average Interest Rate (a)7.09 %3.69 %2.89 %3.49 %2.35 %2.82 %Variable Rate Debt (b)$761.7 $— $— $— $3,295.0 $— $4,056.7 $4,054.5 Weighted-Average Interest Rate (b)(c)0.92 %— %— %— %1.25 %— %Interest Rate SwapsHedged Variable-Rate Notional Amount$8.7 $— $— $— $— $— $8.7 $(0.1)(d)Fixed Rate Debt Rate (e)9.37 %Hedged Fixed-Rate Notional Amount$— $600.0 $500.0 $— $— $— $1,100.0 $29.2 (f)Variable Rate Debt Rate (g)1.24 %_______________(a) Fixed rate debt consisted of: Securities issued in the Trust Securitizations; Securities issued in the 2015-2 Securitization; the InSite Debt, which was subsequently repaid in full on January 15, 2021; our senior unsecured notes (see note 9 to our consolidated financial statements included in this Annual Report for a detailed description of all such senior unsecured notes); the Kenya Debt; the U.S. Subsidiary Debt; and other debt including finance leases. (b) Variable rate debt consisted of: the 2020 Term Loan, which was subsequently repaid in full on February 5, 2021; the 2019 Multicurrency Credit Facility, which matures on June 28, 2024; the 2019 Credit Facility, which matures on January 31, 2026; the 2019 Term Loan, which matures on January 31, 2025; and the Colombian credit facility, which amortizes through April 24, 2021.(c) Based on rates effective as of December 31, 2020.(d) As of December 31, 2020, the interest rate swap agreement in Colombia was included in Other non-current liabilities on the consolidated balance sheet. (e) Represents the fixed rate of interest based on contractual notional amount as a percentage of the total notional amount. The interest rate consists of fixed interest of 5.37%, per the interest rate agreement, and a fixed margin of 4.00%, per the loan agreement for the Colombian credit facility.(f) As of December 31, 2020, the interest rate swap agreements in the U.S. were included in Other non-current assets on the consolidated balance sheet. (g) Represents the weighted average variable rate of interest based on contractual notional amount as a percentage of total notional amounts.Interest Rate RiskAs of December 31, 2020, we have one interest rate swap agreement related to debt in Colombia. This swap has been designated as a cash flow hedge, has a notional amount of $8.7 million, has an interest rate of 5.37% and expires in April 2021. We also have three interest rate swap agreements related to the 2.250% Notes. These swaps have been designated as fair value hedges, have an aggregate notional amount of $600.0 million, an interest rate of one-month LIBOR plus applicable spreads and expire in January 2022. In addition, we have three interest rate swap agreements related to a portion of the 3.000% Notes. These swaps have been designated as fair value hedges, have an aggregate notional amount of $500.0 million, an interest rate of one-month LIBOR plus applicable spreads and expire in June 2023.Changes in interest rates can cause interest charges to fluctuate on our variable rate debt. Variable rate debt as of December 31, 2020 consisted of $2.3 billion under the 2019 Credit Facility, $1.0 billion under the 2019 Term Loan, $750.0 million under the 2020 Term Loan, $600.0 million under the interest rate swap agreements related to the 2.250% Notes, $500.0 million under the interest rate swap agreements related to the 3.000% Notes and $2.9 million under the Colombian credit facility after giving effect to our interest rate swap agreements. A 10% increase in current interest rates would result in an additional $6.1 million of interest expense for the year ended December 31, 2020. Foreign Currency Risk51Table of Contents We are exposed to market risk from changes in foreign currency exchange rates primarily in connection with our foreign subsidiaries and joint ventures internationally. Any transaction denominated in a currency other than the U.S. Dollar is reported in U.S. Dollars at the applicable exchange rate. All assets and liabilities are translated into U.S. Dollars at exchange rates in effect at the end of the applicable fiscal reporting period and all revenues and expenses are translated at average rates for the period. The cumulative translation effect is included in equity as a component of Accumulated other comprehensive loss. We may enter into additional foreign currency financial instruments in anticipation of future transactions to minimize the impact of foreign currency fluctuations. For the year ended December 31, 2020, 42% of our revenues and 52% of our total operating expenses were denominated in foreign currencies.As of December 31, 2020, we have incurred intercompany debt that is not considered to be permanently reinvested, and similar unaffiliated balances that were denominated in a currency other than the functional currency of the subsidiary in which it is recorded. As this debt had not been designated as being a long-term investment in nature, any changes in the foreign currency exchange rates will result in unrealized gains or losses, which will be included in our determination of net income. An adverse change of 10% in the underlying exchange rates of our unsettled intercompany debt and similar unaffiliated balances would result in $129.2 million of unrealized losses that would be included in Other expense in our consolidated statements of operations for the year ended December 31, 2020.
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+Item 7. Management’s Discussion and Analysis of Financial Condition and Results of OperationsThis report includes forward-looking statements based on the Company’s current assumptions, expectations and projections about future events. When used in this report, the words “believes,” “anticipates,” “may,” “expect,” “intend,” “estimate,” “project” and similar expressions are intended to identify forward-looking statements, although not all forward-looking statements contain such words. In this report, the Company discloses important factors that could cause actual results to differ materially from management’s expectations. For more information on these and other factors, see “Forward-Looking Information” herein. The following Management’s Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with “Item 1A. Risk Factors,” “Item 6. Selected Financial Data”, and the consolidated financial statements and related notes included elsewhere in this Annual Report on Form 10-K. Business Overview AMETEK’s operations are affected by global, regional and industry economic factors. However, the Company’s strategic geographic and industry diversification, and its mix of products and services, have helped to mitigate the potential adverse impact of any unfavorable developments in any one industry or the economy of any single country on its consolidated operating results. In 2020, the Company was impacted by a weak global economy as a result of the COVID-19 pandemic, discussed below. In response to the weak global economy, the Company recorded 2020 realignment costs totaling $43.9 million (the “2020 realignment costs”). The 2020 realignment costs were composed of $35.5 million in severance costs for a reduction in workforce and $8.4 million of asset write-downs, primarily inventory. Contributions from the acquisitions of IntelliPower in January 2020, Pacific Design Technologies, Inc. (“PDT”) in September 2019, Gatan in October 2019, and a continued focus on and implementation of Operational Excellence initiatives, including the 2020 realignment actions, had a positive impact on the Company’s 2020 results.Highlights of 2020 were:•In January 2020, the Company spent $116.5 million, net of cash acquired, to acquire IntelliPower, a leading provider of high-reliability, ruggedized uninterruptible power systems serving a wide range of defense and industrial applications. •In March 2020, the Company completed the sale of its Reading Alloys business (“Reading”) to Kymera International for net proceeds of $245.3 million in cash. The sale resulted in a pre-tax gain of $141.0 million recorded in other income, net and income tax expense of $31.4 million.•Cash flow provided by operating activities for 2020 was a record $1,281.0 million, an increase of $166.6 million or 14.9%, compared with $1,114.4 million in 2019. •Free cash flow (cash flow provided by operating activities less capital expenditures) increased to a record $1,206.8 million in 2020, compared with $1,012.1 million in 2019.•EBITDA (earnings before interest, income taxes, depreciation, and amortization) was a record $1,421.6 million in 2020, compared with $1,388.3 million in 2019.•The Company continued its emphasis on investment in research, development and engineering, spending $246.2 million in 2020. Sales from products introduced in the past three years were $1,074.0 million or 23.7% of net sales. 22Table of ContentsImpact of COVID-19 Pandemic on our Business Our business, operations and end markets were negatively impacted in 2020 by the global outbreak and rapid spread of COVID-19. As the situation rapidly evolved, we remained focused on safely serving our customers and protecting the health and safety of our employees. All of our manufacturing locations remain operational with enhanced safety measures to help keep our employees, contractors, customers, and communities safe. In compliance with government protocols, certain of the Company's employees were instructed to work from home until government mandated restrictions allow for a safe return to the workplace. Those working at our sites are required to follow appropriate procedures, including completion of multiple training sessions and performance of self- and on-site screenings, as well as adhere to our personal protective equipment, social distancing, and personal hygiene protocols. We are committed to safely maintaining plant operations and focusing on business continuity, while reliably supplying critical products to our customers.During 2020, the COVID-19 pandemic resulted in a rapid decline in demand which impacted most of our end markets and geographies. We continue to experience end market volatility, however, orders have begun to return and stabilize in many of our end markets. Our financial position remains strong, however, we continue to closely monitor our fixed costs, capital expenditure plans, inventory, and capital resources to respond to changing conditions and to ensure we have the resources to meet our future needs. We believe that we will emerge from these events well positioned for long-term growth, though we cannot reasonably estimate the duration and severity of this global pandemic or its ultimate impact on the global economy and our business and results. Please refer to "Risk Factors", Part I, Item 1A of this Form 10-K for more information.Results of Operations The following table sets forth net sales and income by reportable segment and on a consolidated basis: Year Ended December 31,202020192018(In thousands)Net sales:Electronic Instruments$2,989,928 $3,322,881 $3,028,959 Electromechanical1,550,101 1,835,676 1,816,913 Consolidated net sales$4,540,029 $5,158,557 $4,845,872 Operating income and income before income taxes:Segment operating income:Electronic Instruments$770,620 $865,307 $782,144 Electromechanical324,962 387,931 363,765 Total segment operating income1,095,582 1,253,238 1,145,909 Corporate administrative expenses(67,698)(75,858)(70,369)Consolidated operating income1,027,884 1,177,380 1,075,540 Interest expense(86,062)(88,481)(82,180)Other income (expense), net140,487 (19,151)(5,615)Consolidated income before income taxes$1,082,309 $1,069,748 $987,745 ______________________The following “Results of Operations of the year ended December 31, 2020 compared with the year ended December 31, 2019” section presents an analysis of the Company’s consolidated operating results displayed in the Consolidated Statement of Income. A discussion regarding our financial condition and results of operations for the year ended December 31, 2019 compared to the year ended December 31, 2018 can be found under Item 7 in our 23Table of ContentsAnnual Report on Form 10-K for the fiscal year ended December 31, 2019, filed with the Securities and Exchange Commission on February 20, 2020.Results of Operations for the year ended December 31, 2020 compared with the year ended December 31, 2019 Net sales for 2020 were $4,540.0 million, a decrease of $618.6 million or 12.0%, compared with net sales of $5,158.6 million in 2019. The decrease in net sales for 2019 was due to a 13% organic sales decline driven by a weak economy as a result of the COVID-19 pandemic, an unfavorable 3% from the Reading divestiture, partially offset by a 4% increase from acquisitions. EIG net sales were $2,989.9 million in 2020, a decrease of 10.0%, compared with $3,322.9 million in 2019. EMG net sales were $1,550.1 million in 2020, a decrease of 15.6%, compared with $1,835.7 million in 2019. Total international sales for 2020 were $2,209.9 million or 48.7% of net sales, a decrease of $265.0 million or 10.7%, compared with international sales of $2,474.9 million or 48.0% of net sales in 2019. The decrease in international sales was primarily driven by lower sales in Europe as a result of the COVID-19 pandemic. Export shipments from the United States, which are included in total international sales, were $1,196.4 million in 2020, a decrease of $109.8 million or 8.4%, compared with $1,306.2 million in 2019. Orders for 2020 were $4,624.4 million, a decrease of $649.9 million or 12.3% compared with $5,274.3 million in 2019. The decrease in orders was due to an 11% organic order decline driven by a weak economy as a result of the COVID-19 pandemic, an unfavorable 3% from the Reading divestiture, partially offset by a favorable 1% from acquisitions, and a favorable 1% effect of foreign currency translation. The Company’s backlog of unfilled orders at December 31, 2020 was a record $1,802.2 million, an increase of $84.3 million or 4.9%, compared with $1,717.9 million at December 31, 2019. The Company recorded 2020 realignment costs totaling $43.9 million in the first quarter of 2020 (the “2020 realignment costs”). The 2020 realignment costs were composed of $35.5 million in severance costs for a reduction in workforce and $8.4 million of asset write-downs, primarily inventory, in response to the impact of a weak global economy as a result of the COVID-19 pandemic. See Note 18 to the Consolidated Financial Statements included in Part II, Item 8 of this Annual Report on Form 10-K for further details.The 2020 realignment costs (in millions) reported in the consolidated statement of income as well as the impact on segment operating margins (in basis points) in 2020 are as follows:2020RealignmentCostsOperatingMarginsEIG$22.8 (70)EMG20.9 (130)Total reported in segment operating income43.7 (100)Selling, general and administrative expenses0.2 Total reported in the consolidated statement of income$43.9 (100)Segment operating income for 2020 was $1,095.6 million, a decrease of $157.6 million or 12.6%, compared with segment operating income of $1,253.2 million in 2019. The decrease in segment operating income was primarily due to the lower sales discussed above and the $43.7 million of 2020 realignment costs, partially offset by the benefits of the Company's Operational Excellence initiatives. Segment operating income, as a percentage of net sales, decreased to 24.1% in 2020, compared with 24.3% in 2019. The segment operating margins were negatively impacted by 100 basis points due to the 2020 realignment costs discussed above, partially offset by the benefits of the Company’s Operational Excellence initiatives. Cost of sales for 2020 was $2,996.5 million or 66.0% of net sales, a decrease of $374.4 million or 11.1%, compared with $3,370.9 million or 65.3% of net sales for 2019. The cost of sales decrease was primarily due to the net sales decrease discussed above, partially offset by the increase from the 2020 realignment costs discussed above.24Table of ContentsSelling, general and administrative expenses for 2020 were $515.6 million or 11.4% of net sales, a decrease of $94.7 million or 15.5%, compared with $610.3 million or 11.8% of net sales in 2019. Selling, general and administrative expenses decreased primarily due to the decrease in net sales discussed above as well as lower discretionary spending as a result of the COVID-19 pandemic.Consolidated operating income was $1,027.9 million or 22.6% of net sales for 2020, a decrease of $149.5 million or 12.7%, compared with $1,177.4 million or 22.8% of net sales in 2019. The consolidated operating income margins were negatively impacted by 100 basis points due to the 2020 realignment costs discussed above, partially offset by the benefits of the Company's Operational Excellence initiatives.Other income, net was $140.5 million for 2020, an increase of $159.7 million, compared with $19.2 million of other expense in 2019. The increase in other income was primarily due to the gain on the sale of Reading of $141.0 million, higher defined benefit pension income of $7.5 million, and lower acquisition-related expenses. The effective tax rate for 2020 was 19.4%, compared with 19.5% in 2019. See Note 9 to the Consolidated Financial Statements included in Part II, Item 8 of this Annual Report on Form 10-K for further details.Net income for 2020 was a record $872.4 million, an increase of $11.1 million or 1.3%, compared with $861.3 million in 2019. The net of tax gain of $109.6 million on the sale of Reading and net of tax expense of $33.6 million on the 2020 realignment costs are included in net income in 2020.Diluted earnings per share for 2020 were a record $3.77, an increase of $0.02 or 0.5%, compared with $3.75 per diluted share in 2019. The net of tax gain of $0.47 per diluted share on the sale of Reading and net of tax expense of $0.15 per diluted share on the 2020 realignment costs are included in diluted earnings per share in 2020.Segment Results EIG’s net sales totaled $2,989.9 million for 2020, a decrease of $333.0 million or 10.0%, compared with $3,322.9 million in 2019. The net sales decrease was due to a 15% organic sales decline driven by a weak global economy as a result of the COVID-19 pandemic, partially offset by the acquisitions of Gatan and IntelliPower.EIG’s operating income was $770.6 million for 2020, a decrease of $94.7 million or 10.9%, compared with $865.3 million in 2019. EIG’s operating margins were 25.8% of net sales for 2020, compared with 26.0% of net sales in 2019. EIG’s decrease in operating income was primarily due to the decrease in sales discussed above as well as the $22.8 million of 2020 realignment costs, partially offset by the benefits of the Company's Operational Excellence initiatives. EIG’s 2020 operating margins were negatively impacted by 70 basis points due to the 2020 realignment costs discussed above.EMG’s net sales totaled $1,550.1 million for 2020, a decrease of $285.6 million or 15.6%, compared with $1,835.7 million in 2019. The net sales decrease was due to a 10% organic sales decline driven by a weak global economy as a result of the COVID-19 pandemic, a favorable 2% impact from the PDT acquisition as well as an unfavorable 8% impact from the Reading divestiture.EMG’s operating income was $325.0 million for 2020, a decrease of $62.9 million or 16.2%, compared with $387.9 million in 2019. EMG’s operating margins were 21.0% of net sales for 2020, compared with 21.1% of net sales in 2019. EMG’s decrease in operating income was primarily due to the decrease in sales discussed above as well as the $20.9 million of 2020 realignment costs, partially offset by benefits from the Group’s Operating Excellence initiatives. EMG’s 2020 operating margins were negatively impacted by 130 basis points due to the 2020 realignment costs discussed above.25Table of ContentsLiquidity and Capital Resources Cash provided by operating activities totaled a record $1,281.0 million in 2020, an increase of $166.6 million or 14.9%, compared with $1,114.4 million in 2019. The increase in cash provided by operating activities for 2020 was primarily due to strong working capital management. Free cash flow (cash flow provided by operating activities less capital expenditures) was a record $1,206.8 million in 2020, compared with $1,012.1 million in 2019. EBITDA (earnings before interest, income taxes, depreciation and amortization) was $1,421.6 million in 2020, compared with $1,388.3 million in 2019. Free cash flow and EBITDA are presented because the Company is aware that they are measures used by third parties in evaluating the Company. (See the “Notes to Selected Financial Data” included in Item 6 in this Annual Report on Form 10-K for a reconciliation of U.S. GAAP measures to comparable non-GAAP measures).Cash provided by investing activities totaled $61.6 million in 2020, compared with cash used by investing activities of $1,150.9 million in 2019. In 2020, the Company paid $116.5 million, net of cash acquired, to purchase IntelliPower in January 2020 and received proceeds of $245.3 million from the sale of its Reading business. Additions to property, plant and equipment totaled $74.2 million in 2020, compared with $102.3 million in 2019.Cash used by financing activities totaled $539.4 million in 2020, compared with $72.9 million of cash provided by financing activities in 2019. At December 31, 2020, total debt, net was $2,413.7 million, compared with $2,768.7 million at December 31, 2018. In 2020, short-term borrowings decreased $328.0 million, compared with an increase of $130.7 million in 2019. Long-term borrowings decreased $102.9 million in 2020, compared to no change in long-term borrowings in 2019. In October 2018, the Company along with certain of its foreign subsidiaries amended and restated its Credit Agreement. The Credit Agreement amends and restates the Company’s existing $850 million revolving credit facility, which was due to expire in March 2021. The amended Credit Agreement consists of a five-year revolving credit facility in an aggregate principal amount of $1.5 billion with a final maturity date in October 2023. The revolving credit facility total borrowing capacity excludes an accordion feature that permits the Company to request up to an additional $500 million in revolving credit commitments at any time during the life of the Credit Agreement under certain conditions. The revolving credit facility provides the Company with additional financial flexibility to support its growth plans, including its acquisition strategy. At December 31, 2020, the Company had available borrowing capacity of $1,897.7 million under its revolving credit facility, including the $500 million accordion feature. In the third quarter of 2020, an 80 million British pound ($102.9 million) 4.68% senior note matured and was paid. In the fourth quarter of 2019, $100 million of 6.30% senior notes matured and were paid. The debt-to-capital ratio was 28.9% at December 31, 2020, compared with 35.1% at December 31, 2019. The net debt-to-capital ratio (total debt, net less cash and cash equivalents divided by the sum of net debt and stockholders’ equity) was 16.8% at December 31, 2020, compared with 31.7% at December 31, 2019. The net debt-to-capital ratio is presented because the Company is aware that this measure is used by third parties in evaluating the Company. (See the “Notes to Selected Financial Data” included in Item 6 in this Annual Report on Form 10-K for a reconciliation of U.S. GAAP measures to comparable non-GAAP measures).In 2020, the Company repurchased approximately 55,000 shares of its common stock for $4.7 million, compared with $11.9 million used for repurchases of approximately 133,000 shares in 2019. At December 31, 2020, $484.4 million was available under the Company’s Board of Directors authorization for future share repurchases. On February 12, 2019, the Company’s Board of Directors approved an increase of $500 million in the authorization for the repurchase of the Company’s common stock. Additional financing activities for 2020 included cash dividends paid of $165.0 million, compared with $127.5 million in 2019. On February 12, 2020, the Company’s Board of Directors approved a 29% increase in the quarterly cash dividend on the Company’s common stock to $0.18 per common share from $0.14 per common share. 26Table of ContentsProceeds from the exercise of employee stock options were $64.9 million in 2020, compared with $90.4 million in 2019. As a result of all of the Company’s cash flow activities in 2020, cash and cash equivalents at December 31, 2019 totaled $1,212.8 million, compared with $393.0 million at December 31, 2019. At December 31, 2020, the Company had $344.0 million in cash outside the United States, compared with $357.9 million at December 31, 2019. The Company utilizes this cash to fund its international operations, as well as to acquire international businesses. The Company is in compliance with all covenants, including financial covenants, for all of its debt agreements. The Company believes it has sufficient cash-generating capabilities from domestic and unrestricted foreign sources, available credit facilities and access to long-term capital funds to enable it to meet its operating needs and contractual obligations in the foreseeable future. Subsequent EventEffective February 11, 2021, the Company's Board of Directors approved an 11% increase in the quarterly cash dividend on the Company's common stock to $0.20 per common share from $0.18 per common share.The following table summarizes AMETEK’s contractual cash obligations and the effect such obligations are expected to have on the Company’s liquidity and cash flows in future years at December 31, 2020. Payments DueContractual Obligations (1)TotalLess ThanOne YearMore Than One Year(In millions)Long-term debt borrowings(2)$2,347.6 $62.2 $2,285.4 Revolving credit loans(3)72.1 72.1 — Total debt(4)2,419.7 134.3 2,285.4 Interest on long-term fixed-rate debt454.4 71.4 383.0 Non-cancellable operating leases(5)190.1 50.3 139.8 Purchase obligations(6)526.1 462.1 32.0 Total$3,590.3 $718.1 $2,840.2 ______________________(1)The liability for uncertain tax positions was not included in the table of contractual obligations as of December 31, 2020 because the timing of the settlements of these uncertain tax positions cannot be reasonably estimated at this time. See Note 9 to the Consolidated Financial Statements included in Part II, Item 8 of this Annual Report on Form 10-K for further details.(2)See Note 10 to the Consolidated Financial Statements included in Part II, Item 8 of this Annual Report on Form 10-K for further details.(3)Although not contractually obligated, the Company expects to have the capability to repay the revolving credit loan within one year as permitted in the Credit Agreement. Accordingly, $72.1 million was classified as short-term debt at December 31, 2020.(4)Excludes debt issuance costs of $6.0 million, of which $2.0 million is classified as current and $4.0 million is classified as long-term. See Note 10 to the Consolidated Financial Statements included in Part II, Item 8 of this Annual Report on Form 10-K for further details.(5)The leases expire over a range of years from 2021 to 2035, except for a single land lease with 63 years remaining. Most of the leases contain renewal or purchase options, subject to various terms and conditions.(6)Purchase obligations primarily consist of contractual commitments to purchase certain inventories at fixed prices.27Table of ContentsOther CommitmentsThe Company has standby letters of credit and surety bonds of $46.8 million related to performance and payment guarantees at December 31, 2020. Based on experience with these arrangements, the Company believes that any obligations that may arise will not be material to its financial position. Internal Reinvestment Capital Expenditures Capital expenditures were $74.2 million or 1.6% of net sales in 2020, compared with $102.3 million or 2.0% of net sales in 2019. In 2020, approximately 73% of capital expenditures were for improvements to existing equipment or additional equipment to increase productivity and expand capacity. Capital expenditures in 2021 are expected to be approximately 2% of net sales, with a continued emphasis on spending to improve productivity. Research, Development and Engineering The Company is committed to, and has consistently invested in, research, development and engineering activities to design and develop new and improved products and solutions. Research, development and engineering costs before customer reimbursement were $246.2 million in 2020, $260.3 million in 2019 and $230.2 million in 2018. These amounts included research and development expenses of $158.9 million, $161.9 million and $141.0 million in 2020, 2019, and 2018, respectively. All such expenditures were directed toward the development of new products and solutions and the improvement of existing products and solutions.Environmental MattersInformation with respect to environmental matters is set forth in Note 13 to the Consolidated Financial Statements included in Part II, Item 8 of this Annual Report on Form 10-K.Critical Accounting Policies and EstimatesCritical accounting policies are those policies that can have a significant impact on the presentation of the Company’s financial condition and results of operations and that require the use of complex and subjective estimates based on the Company’s historical experience and management’s judgment. Because of the uncertainty inherent in such estimates, actual results may differ materially from the estimates used. Below are the policies used in preparing the Company's financial statements that management believes are the most dependent upon the application of estimates and assumptions. A complete list of the Company’s significant accounting policies is in Note 1 to the Consolidated Financial Statements included in Part II, Item 8 of this Annual Report on Form 10-K. •Business Combinations. The Company allocates the purchase price of an acquired company, including when applicable, the acquisition date fair value of contingent consideration between tangible and intangible assets acquired and liabilities assumed from the acquired business based on their estimated fair values, with the residual of the purchase price recorded as goodwill. Third party appraisal firms and other consultants are engaged to assist management in determining the fair values of certain assets acquired and liabilities assumed. Estimating fair values requires significant judgments, estimates and assumptions, including but not limited to: discount rates, future cash flows and the economic lives of trade names, technology, and customer relationships. These estimates are based on historical experience and information obtained from the management of the acquired companies and are inherently uncertain.•Goodwill and Other Intangible Assets. Goodwill and other intangible assets with indefinite lives, primarily trademarks and trade names, are not amortized; rather, they are tested for impairment at least annually. The Company can elect to perform a qualitative analysis to determine if it is more likely than not that the fair values of its reporting units are less than the respective carrying values of those reporting units. The 28Table of ContentsCompany elected to bypass performing the qualitative screen and performed the first step quantitative analysis of the goodwill impairment test in the current year. The Company may elect to perform the qualitative analysis in future periods.The Company principally relies on a discounted cash flow analysis to determine the fair value of each reporting unit, which considers forecasted cash flows discounted at an appropriate discount rate. The Company believes that market participants would use a discounted cash flow analysis to determine the fair value of its reporting units in a sale transaction. The annual goodwill impairment test requires the Company to make a number of assumptions and estimates concerning future levels of revenue growth, operating margins, depreciation, amortization and working capital requirements, which are based on the Company’s long-range plan and are considered level 3 inputs. The Company’s long-range plan is updated as part of its annual planning process and is reviewed and approved by management. The discount rate is an estimate of the overall after-tax rate of return required by a market participant whose weighted average cost of capital includes both equity and debt, including a risk premium. While the Company uses the best available information to prepare its cash flow and discount rate assumptions, actual future cash flows or market conditions could differ significantly resulting in future impairment charges related to recorded goodwill balances. While there are always changes in assumptions to reflect changing business and market conditions, the Company’s overall methodology and the population of assumptions used have remained unchanged. In order to evaluate the sensitivity of the goodwill impairment test to changes in the fair value calculations, the Company applied a hypothetical 10% decrease in fair values of each reporting unit. The 2020 results (expressed as a percentage of carrying value for the respective reporting unit) showed that, despite the hypothetical 10% decrease in fair value, the fair values of the Company’s reporting units still exceeded their respective carrying values by 40% to 779%.The impairment test for indefinite-lived intangibles other than goodwill (primarily trademarks and trade names) consists of a comparison of the fair value of the indefinite-lived intangible asset to the carrying value of the asset as of the impairment testing date. The Company can elect to perform a qualitative analysis to determine if it is more likely than not that the fair values of its indefinite-lived intangible assets are less than the respective carrying values of those assets. The Company elected to bypass performing the qualitative screen. The Company may elect to perform the qualitative analysis in future periods. The Company estimates the fair value of its indefinite-lived intangibles using the relief from royalty method using level 3 inputs, which is a widely used valuation technique for such assets. The fair value derived from the relief from royalty method is determined by applying a royalty rate to a projection of net revenues discounted using an appropriate discount rate. Each royalty rate is determined based on the profitability of the trade name to which it relates and observed market royalty rates. Certain impairment models have discount rates calculated based on a debt/equity cost of capital. While the Company uses the best available information to prepare its cash flow and discount rate assumptions, actual future cash flows or market conditions could differ significantly resulting in future impairment charges related to recorded intangible balances. While there are always changes in assumptions to reflect changing business and market conditions, the Company’s overall methodology and the population of assumptions used have remained unchanged.The Company’s acquisitions have generally included a significant goodwill component and the Company expects to continue to make acquisitions. At December 31, 2020, goodwill and other indefinite-lived intangible assets totaled $4,977.9 million or 48.1% of the Company’s total assets. The Company completed its required annual impairment tests in the fourth quarter of 2020 and determined that the carrying values of the Company’s goodwill and indefinite-lived intangibles were not impaired. There can be no assurance that goodwill or indefinite-lived intangibles impairment will not occur in the future.•Pensions. The Company has U.S. and foreign defined benefit and defined contribution pension plans. The most significant elements in determining the Company’s pension income or expense are the assumed pension liability discount rate and the expected return on plan assets. The pension discount rate reflects the current interest rate at which the pension liabilities could be settled at the valuation date. At the end of each year, the Company determines the assumed discount rate to be used to discount plan liabilities. In 29Table of Contentsestimating this rate for 2020, the Company considered rates of return on high-quality, fixed-income investments that have maturities consistent with the anticipated funding requirements of the plan. In estimating the U.S. and foreign discount rates, the Company’s actuaries developed a customized discount rate appropriate to the plans’ projected benefit cash flow based on yields derived from a database of long-term bonds at consistent maturity dates. The Company determines the expected long-term rate of return based primarily on its expectation of future returns for the pension plans’ investments. Additionally, the Company considers historical returns on comparable fixed-income and equity investments and adjusts its estimate as deemed appropriate.•Income Taxes. The process of providing for income taxes and determining the related balance sheet accounts requires management to assess uncertainties, make judgments regarding outcomes and utilize estimates. The Company conducts a broad range of operations around the world and is therefore subject to complex tax regulations in numerous international taxing jurisdictions, resulting at times in tax audits, disputes and potential litigation, the outcome of which is uncertain. Management must make judgments currently about such uncertainties and determine estimates of the Company’s tax assets and liabilities. To the extent the final outcome differs, future adjustments to the Company’s tax assets and liabilities may be necessary.The Company assesses the realizability of its deferred tax assets, taking into consideration the Company’s forecast of future taxable income, available net operating loss carryforwards and available tax planning strategies that could be implemented to realize the deferred tax assets. Based on this assessment, management must evaluate the need for, and the amount of, valuation allowances against the Company’s deferred tax assets. To the extent facts and circumstances change in the future, adjustments to the valuation allowances may be required.The Company assesses the uncertainty in its tax positions, by applying a minimum recognition threshold which a tax position is required to meet before a tax benefit is recognized in the financial statements. Once the minimum threshold is met, using a more likely than not standard, a series of probability estimates is made for each item to properly measure and record a tax benefit. The tax benefit recorded is generally equal to the highest probable outcome that is more than 50% likely to be realized after full disclosure and resolution of a tax examination. The underlying probabilities are determined based on the best available objective evidence such as recent tax audit outcomes, published guidance, external expert opinion, or by analogy to the outcome of similar issues in the past. There can be no assurance that these estimates will ultimately be realized given continuous changes in tax policy, legislation and audit practice. The Company recognizes interest and penalties accrued related to uncertain tax positions in income tax expense.Recent Accounting Pronouncements See Note 2, Recent Accounting Pronouncements, to the Company’s Consolidated Financial Statements included in Part II, Item 8 of this Annual Report on Form 10-K for information regarding recently issued accounting pronouncements.Forward-Looking Information Certain matters discussed in this Form 10-K are “forward-looking statements” as defined in the Private Securities Litigation Reform Act of 1995 (“PSLRA”), which involve risk and uncertainties that exist in the Company’s operations and business environment and can be affected by inaccurate assumptions, or by known or unknown risks and uncertainties. Many such factors will be important in determining the Company’s actual future results. The Company wishes to take advantage of the “safe harbor” provisions of the PSLRA by cautioning readers that numerous important factors in some cases have caused, and in the future could cause, the Company’s actual results to differ materially from those expressed in any forward-looking statements made by, or on behalf of, the Company. Some, but not all, of the factors or uncertainties that could cause actual results to differ from present expectations are set forth above and under Item 1A. Risk Factors. The Company undertakes no obligation to 30Table of Contentspublicly update any forward-looking statements, whether as a result of new information, subsequent events or otherwise, unless required by the securities laws to do so.Item 7A. Quantitative and Qualitative Disclosures About Market RiskThe Company’s primary exposures to market risk are fluctuations in interest rates, foreign currency exchange rates and commodity prices, which could impact its financial condition and results of operations. The Company addresses its exposure to these risks through its normal operating and financing activities. The Company’s differentiated and global business activities help to reduce the impact that any particular market risk may have on its operating income as a whole. The Company’s short-term debt carries variable interest rates and generally its long-term debt carries fixed rates. These financial instruments are more fully described in the Notes to the Consolidated Financial Statements included in Part II, Item 8 of this Annual Report on Form 10-K. The foreign currencies to which the Company has the most significant exchange rate exposure are the Euro, the British pound, the Japanese yen, the Chinese renminbi, the Canadian dollar, and the Mexican peso. Exposure to foreign currency rate fluctuation is modest, monitored, and when possible, mitigated through the use of local borrowings and occasional derivative financial instruments in the foreign currency affected. The effect of translating foreign subsidiaries’ balance sheets into U.S. dollars is included in other comprehensive income within stockholders’ equity. Foreign currency transactions have not had a significant effect on the operating results reported by the Company because revenues and costs associated with the revenues are generally transacted in the same foreign currencies.The primary commodities to which the Company has market exposure are raw material purchases of nickel, aluminum, copper, steel, titanium, and gold. Exposure to price changes in these commodities are generally mitigated through adjustments in selling prices of the ultimate product and purchase order pricing arrangements, although forward contracts are sometimes used to manage some of those exposures. Based on a hypothetical ten percent adverse movement in interest rates, commodity prices or foreign currency exchange rates, the Company’s best estimate is that the potential losses in future earnings, fair value of risk-sensitive financial instruments and cash flows are not material, although the actual effects may differ materially from the hypothetical analysis.31Table of Contents
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+Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.​Our Strategy​The Company’s overall strategy is to provide its customers with comprehensive design capabilities, a broad selection of products and a high level of service on a worldwide basis while maintaining continuing programs of productivity improvement and cost control. Specifically, our business strategy is as follows:​●Pursue broad diversification - The Company constantly drives to increase the diversity of its markets, customers, applications and products. Due to the tremendous variety of opportunities in the electronics industry, management believes that it is important to ensure participation wherever significant growth opportunities are available. This diversification positions us to proliferate our technologies across the broadest array of opportunities and reduces our exposure to any particular market, thereby reducing the variability of our financial performance. An overview of the Company’s market and product participation is described under “Markets”.​●Develop high technology performance-enhancing interconnect solutions - The Company seeks to expand the scope and number of its preferred supplier relationships. The Company works closely with its customers at the design stage to create and manufacture innovative solutions. These products generally have higher value-added content than other interconnect products and have been developed across the Company’s markets. The Company is focused on technology leadership in the interconnect areas of radio frequency, power, harsh environment, high-speed and fiber optics, as well as sensors, as it views these technology areas to be of particular importance to our global customer base.​●Expand global presence - The Company intends to further expand its global manufacturing, engineering, sales and service operations to better serve its existing customer base, penetrate developing markets and establish new customer relationships. As the Company’s global customers expand their international operations to access developing world markets and lower manufacturing costs in certain regions, the Company is continuing to expand its international footprint in order to provide real-time capabilities to these customers. The majority of the Company’s international operations have broad capabilities including new product development. The Company is also able to take advantage of the lower manufacturing costs in some regions, and has established low-cost manufacturing and assembly facilities in the Americas, Europe/Africa and Asia.​●Control costs - The Company recognizes the importance in today’s global marketplace of maintaining a competitive cost structure. Innovation, product quality and performance and comprehensive customer service are not mutually exclusive with controlling costs. Controlling costs is part of a mindset. It is having the discipline to invest in programs that have a good return, maintaining a cost structure as flexible as possible to respond to changes in the marketplace, dealing with suppliers and vendors in a fair but prudent way to ensure a 4 Table of Contentsreasonable cost for materials and services and creating a mindset where managers manage the Company’s assets as if they were their own.​●Pursue strategic acquisitions and investments - The Company believes that the industry in which it operates is highly fragmented and continues to provide significant opportunities for strategic acquisitions. Accordingly, we continue to pursue acquisitions of high potential companies with strong management teams that complement our existing business while further expanding our product lines, technological capabilities and geographic presence. Furthermore, we seek to enhance the performance of acquired companies by leveraging Amphenol’s position with customers across our diverse end markets, our leading technologies and our access to low-cost manufacturing around the world. In 2020, the Company invested approximately $50 million to fund two acquisitions and announced a definitive agreement to acquire MTS for $1.7 billion, while in 2019, the Company invested approximately $937 million to fund nine acquisitions. Our acquisitions in 2020 and 2019 have strengthened our customer base and product offerings in many of our end markets. ​●Foster collaborative, entrepreneurial management - Amphenol’s management system is designed to provide clear income statement and balance sheet responsibility in a flat organizational structure. Each general manager is incented to grow and develop his or her business and to think entrepreneurially in providing innovative, timely and cost-effective solutions to customer needs. In addition, Amphenol’s general managers have access to the resources of the larger organization and are encouraged to work collaboratively with their peers throughout the Company to meet the needs of the expanding marketplace and to achieve common goals.​Markets​The Company sells products to customers in a diversified set of end markets. For a discussion of certain risks related to the Company’s markets, refer to the subsection titled “Risks related to our end markets” included in Part I, Item 1A. Risk Factors herein.​Automotive - Amphenol is a leading supplier of advanced interconnect systems, sensors and antennas for a growing array of automotive applications. In addition, Amphenol has developed advanced technology solutions for hybrid and electric vehicles and is working with leading global customers to proliferate these advanced interconnect products into next-generation automobiles. Sales into the automotive market represented approximately 17% of the Company’s net sales in 2020 with sales into the following primary end applications:​●antennas●electric vehicles●engine management and control●exhaust monitoring and cleaning●hybrid vehicles●infotainment and communications●lighting●power management●safety and security systems●sensing systems●telematics systems●transmission systems​Broadband Communications - Amphenol is a world leader in broadband communication products for cable, satellite and telco video and data networks, with industry-leading engineering, design and manufacturing expertise. The Company offers a wide range of products to service the broadband market, from customer premises cable and interconnect devices to distribution cable and fiber optic components, as well as interconnect products integrated into headend equipment. Sales into the broadband communications market represented approximately 4% of the Company’s net sales in 2020 with sales into the following primary end applications:​●cable, satellite and telco networks●customer premises equipment●high-speed internet hardware●network switching equipment●satellite interface devices●set top boxes​5 Table of ContentsCommercial Aerospace - Amphenol is a leading provider of high-performance interconnect systems and components to the commercial aerospace market. In addition to connector and interconnect assembly products, the Company also provides rigid and flexible printed circuits as well as high-technology cable management products. Our products are specifically designed to operate in the harsh environments of commercial aerospace while also providing substantial weight reduction, simplified installation and minimal maintenance. Sales into the commercial aerospace market represented approximately 3% of the Company’s net sales in 2020 with sales into the following primary end applications:​●aircraft and airframe power distribution●avionics●controls and instrumentation●engines●in-flight entertainment●in-flight internet connectivity●lighting and control systems●wire bundling and cable management​Industrial - Amphenol is a technology leader in the design, manufacture and supply of high-performance interconnect systems, sensors and antennas for a broad range of industrial applications. Amphenol’s core competencies include application-specific industrial interconnect solutions utilizing integrated assemblies, including with both cable and flexible printed circuits, as well as high-power interconnects requiring advanced engineering and system integration. In particular, our innovative solutions facilitate the increasing demands of embedded computing and power distribution. Sales into the industrial market represented approximately 22% of the Company’s net sales in 2020 with sales into the following primary end applications:​●agriculture equipment●alternative and traditional energy generation●batteries and hybrid drive systems●entertainment●factory and machine tool automation●heavy equipment●instrumentation●internet of things●LED lighting●marine●medical equipment●oil and gas●power distribution●public safety●rail mass transit●smart manufacturing●transportation​Information Technology and Data Communications - Amphenol is a global provider of interconnect solutions to designers, manufacturers and operators of internet-enabling systems. With our industry-leading high-speed, power and fiber optic technologies, together with superior simulation and testing capability and cost effectiveness, Amphenol is a market leader in interconnect development for the information technology (“IT”) and datacom market. Whether industry standard or application-specific designs are required, Amphenol provides customers with products that enable performance at the leading edge of next-generation, high-speed, power and fiber optic technologies. Sales into the IT and datacom market represented approximately 21% of the Company’s net sales in 2020 with sales into the following primary end applications:​●cloud computing and data centers●gaming systems●internet appliances●networking equipment●servers 6 Table of Contents●storage systems●transmission●web service providers​Military - Amphenol is a world leader in the design, manufacture and supply of high-performance interconnect systems for harsh environment military applications. Such products require superior performance and reliability under conditions of stress and in hostile environments such as vibration, pressure, humidity, nuclear radiation and rapid and severe temperature changes. Amphenol provides an unparalleled product breadth, from military specification connectors to customized high-speed board level interconnects; from flexible to rigid printed circuit boards; and from backplane systems to completely integrated assemblies. Amphenol is a technology leader, participating in major programs from the earliest inception across each phase of the production cycle. Sales into the military market represented approximately 12% of the Company’s net sales in 2020 with sales into the following primary end applications:​●avionics●communications●engines●ground vehicles and tanks●homeland security●naval●ordnance and missile systems●radar systems●rotorcraft●satellite and space programs●unmanned aerial vehicles​Mobile Devices - Amphenol designs and manufactures an extensive range of interconnect products, antennas and electromechanical components found in a wide array of mobile computing devices. Amphenol’s capability for high-volume production of these technically demanding, miniaturized products, combined with our speed of new product introduction, are critical drivers of the Company’s long-term success in this market. Sales into the mobile devices market represented approximately 15% of the Company’s net sales in 2020 with sales into the following primary end applications:​●consumer electronics●mobile and smart phones, including accessories ●mobile computing devices, including laptops, tablets, ultrabooks and e-readers●production-related products●wearable and hearable devices​Mobile Networks - Amphenol is a leading global interconnect solutions provider to the mobile networks market and offers a wide product portfolio, including antennas, connectors and interconnect systems. The Company’s products are used in current and next generation wireless communications standards, including in 5G networks. In addition, the Company works with service providers around the world to offer an array of antennas and installation-related site solution interconnect products. Sales into the mobile networks market represented approximately 6% of the Company’s net sales in 2020 with sales into the following primary end applications:​●antenna systems●base stations●combiners, filters and amplifiers●core network controllers●distributed antenna systems (DAS)●mobile switches●radio links●small cells●wireless routers​7 Table of ContentsCustomers and Geographies​The Company manufactures and sells a broad portfolio of products on a global basis to customers in various industries. Our customers include many of the leaders in their respective industries, and our relationships with them typically date back many years. We believe that our diversified customer base provides us an opportunity to leverage our skills and experience across markets and reduces our exposure to particular end markets. Additionally, we believe that the diversity of our customer base is an important strength of the Company.​There has been a trend on the part of customers to consolidate their lists of qualified suppliers to companies that have the ability to meet certain technical, quality, delivery and other standards while maintaining competitive prices. The Company has positioned its global resources to compete effectively in this environment. As an industry leader, the Company has established close working relationships with many of its customers on a global basis. These relationships allow the Company to better anticipate and respond to these customer needs when designing new products and new technical solutions. By working with customers in developing new products and technologies, the Company is able to identify and act on trends and leverage knowledge about next-generation technology across our portfolio of products. In addition, the Company has concentrated its efforts on service, procurement and manufacturing improvements designed to increase product quality and performance and lower product lead-time and cost. For a discussion of certain risks related to the Company’s sales, refer to the subsection titled “Risks related to our end markets” included in Part I, Item 1A. Risk Factors herein.​The Company’s products are sold to thousands of original equipment manufacturers (“OEMs”) in numerous countries throughout the world. The Company’s products are also sold to electronic manufacturing services (“EMS”) companies, to original design manufacturers (“ODMs”) and to service providers, including telecommunications network service providers and web service providers. During the year ended December 31, 2020, aggregate sales to Apple Inc., including sales of products to EMS companies that the Company believes are manufacturing products on Apple’s behalf, accounted for approximately 11% of our net sales. No single customer accounted for 10% or more of the Company’s net sales for the year ended December 31, 2019. ​The Company sells its products through its own global sales force, independent representatives and a global network of electronics distributors. The Company’s sales to distributors represented approximately 16% and 15% of the Company’s net sales in 2020 and 2019, respectively. In addition to product design teams and collaborative initiatives with customers, the Company uses key account managers to manage customer relationships on a global basis such that it can bring to bear its total resources to meet the worldwide needs of its multinational customers.​Manufacturing​The Company is a global manufacturer employing advanced manufacturing processes including molding, stamping, plating, turning, computer numerical control (“CNC”) machining, extruding, die casting and assembly operations and proprietary process technology for specialty and coaxial cable production, antenna and sensor fabrication. Outsourcing of certain manufacturing processes is used when cost-effective. Substantially all of the Company’s manufacturing facilities are certified under the requirements of the International Organization for Standardization (the “ISO”), specifically to the ISO 9000 series of quality standards, and many of the Company’s manufacturing facilities are certified to other quality standards, including QS 9000, ISO 14000 and TS 16949.​The Company’s manufacturing facilities are generally vertically-integrated operations from the initial design stage through final design and manufacturing. The Company has an established manufacturing presence in approximately 40 countries. Our global coverage positions us near many of our customers’ locations and allows us to assist them in consolidating their supply base and lowering their production and logistics costs. In addition, the Company generally relies on local general management in every region, which we believe creates a strong degree of organizational stability and deeper understanding of local markets. We believe our balanced geographic distribution lowers our exposure to particular geographies. The Company designs, manufactures and assembles its products at facilities in the Americas, Europe, Asia, Australia and Africa. The Company believes that its global presence is an important competitive advantage, as it allows the Company to provide quality products on a timely and worldwide basis to its multinational customers.​The Company employs a global manufacturing strategy to ensure proximity and outstanding service to customers, while also lowering production and logistics costs. The Company’s strategy is to maintain strong cost controls in its manufacturing and assembly operations. The Company is continually evaluating and adjusting its expense levels and workforce to reflect current business conditions and maximize the return on capital investments. The Company sources 8 Table of Contentsits products on a worldwide basis. To better serve certain high-volume customers, the Company has established certain facilities near these major customers. The Company seeks to position its manufacturing and assembly facilities in order to serve local markets while coordinating, as appropriate, product design and manufacturing responsibility with the Company’s other operations around the world. For a discussion of certain risks related to the Company’s foreign operations, refer to the subsection titled “Risks related to our global operations” included in Part I, Item 1A. Risk Factors herein.​Research and Development​The Company generally implements its product development strategy through product design teams and collaborative initiatives with customers, which often results in the Company obtaining approved vendor status for its customers’ new products and programs. The Company focuses its research and development efforts primarily on those product areas that it believes have the potential for broad market applications and significant sales within a one- to three-year period. The Company seeks to have its products become widely accepted within the industry for similar applications and products manufactured by other potential customers, which the Company believes will provide additional sources of future revenue. By developing application specific products, the Company is able to decrease its exposure to standard products, which are more likely to experience greater pricing pressure. At the end of 2020, our research, development, and engineering efforts, which relate to the creation of new and improved products and processes, were supported by approximately 3,300 employees and were performed primarily by individual operating units focused on specific markets and product technologies. ​Intellectual Property​Patents and other proprietary rights are important to our business. We own a large portfolio of patents that principally relate to mechanical, electrical, optical and electronic features of connector, antenna and sensor products. We also own a portfolio of trademarks and are a licensee of various patents and trademarks. Patents for individual products extend for varying periods according to the date of patent filing or grant and the legal term of patents in the various countries where patent protection is obtained. Trademark rights may potentially extend for longer periods of time and are dependent upon the laws of various jurisdictions and the use of the trademarks.​We also rely upon trade secrets, manufacturing know-how, continuing technological innovations and licensing opportunities to maintain and improve our competitive position. We review third-party proprietary rights, including patents and patent applications, as available, in an effort to develop an effective intellectual property strategy, avoid infringement of third-party proprietary rights, identify licensing opportunities and monitor the intellectual property claims of others.​From time to time, the Company is involved in disputes with third parties regarding the Company’s or such third party’s intellectual property assets, particularly patents. While we consider our patents and trademarks to be valuable assets, we do not believe that our competitive position or our operations are dependent upon or would be materially impacted by the loss of any single patent or group of related patents, or by a third party’s successful enforcement of its patents against us or any of our products. For a discussion of certain risks related to the Company’s intellectual property, refer to the risk factor titled “The Company relies on patent and trade secret laws, copyright, trademark, confidentiality procedures, controls and contractual commitments to protect our intellectual property rights” in Part I, Item 1A. Risk Factors herein.​Raw Materials​The Company purchases a wide variety of raw materials for the manufacture of its products, including (i) precious metals such as gold, silver and palladium, (ii) aluminum, steel, copper, titanium and metal alloy products and (iii) plastic materials. The Company also purchases a wide variety of mechanical and electronic components for the manufacturing of its products. Such raw materials and components are generally available throughout the world and are purchased locally from a variety of suppliers. The Company is generally not dependent upon any one source for raw materials or components or, if one source is used, the Company attempts to protect itself through long-term supply agreements. The Company does not anticipate any difficulties in obtaining raw materials or components necessary for production. Information regarding our obligations related to commitments to purchase certain goods and services is disclosed in Note 14 of the Notes to Consolidated Financial Statements. For a discussion of certain risks related to raw materials and components, refer to the risk factor titled “The Company has at times experienced difficulties in obtaining a consistent supply of materials at stable pricing levels” in Part I, Item 1A. Risk Factors herein.​9 Table of ContentsCompetition​The Company encounters competition in substantially all areas of its business. The Company competes primarily on the basis of technology innovation, product quality and performance, price, customer service and delivery time. Primary competitors within the Interconnect Products and Assemblies segment include Aptiv, Carlisle, Commscope, Eaton, Foxconn, Hirose, Huber & Suhner, ICT Luxshare, JAE, Jonhon, JST, Molex, Radiall, Rosenberger, Sensata, TE Connectivity, Yazaki and 3M, among others. Primary competitors within the Cable Products and Solutions segment include Belden and Commscope, among others. In addition, the Company competes with a large number of smaller companies who compete in specific geographies, markets or products. For a discussion of certain risks related to competition, refer to the risk factor titled “The Company encounters competition in substantially all areas of its business” in Part I, Item 1A. Risk Factors herein.​Backlog and Seasonality​The Company estimates that its backlog of unfilled firm orders as of December 31, 2020 was approximately $2.380 billion compared with backlog of approximately $1.978 billion as of December 31, 2019. Orders typically fluctuate from quarter to quarter based on customer demand and general business conditions. Unfilled orders may generally be cancelled prior to shipment of goods. It is expected that all or a substantial portion of the backlog will be filled within the next 12 months. Significant elements of the Company’s business, such as sales to the communications-related markets (including wireless communications, information technology and data communications and broadband communications) and sales to distributors, generally have short lead times. Therefore, backlog may not be indicative of future demand.​Generally, the Company does not experience significant seasonality in its business, although historically, the strongest quarters have typically been the last two quarters of our fiscal year. The ongoing COVID-19 pandemic could result in temporary changes to the seasonality of our business. For a discussion of certain risks related to the COVID-19 pandemic, refer to the risk factor titled “We face significant risks related to adverse public health developments, including epidemics and pandemics such as the COVID-19 pandemic” in Part I, Item 1A. Risk Factors herein.​Human Capital Management and Our Culture​The Company’s success is based on the capability, adaptability and accountability of our people around the world. One of the key components of our business strategy is the fostering of a collaborative and entrepreneurial management culture. Each of our general managers operates in a flat organizational structure and is incented to grow and develop their business, with the support of the resources of the larger organization. We believe this structure, with approximately 120 general managers running unique businesses, creates an environment and culture where each of our employees has a more direct link to the success of their individual businesses and a more personal connection to the employees they oversee and the communities in which they operate.​As of December 31, 2020, the Company had approximately 80,000 employees worldwide, with the majority of our people based in the Asia-Pacific region. The Company believes that it has a good relationship with both its unionized and non-unionized employees. ​Governance and Culture - Our Board of Directors (the “Board”) is actively involved in overseeing the Company’s employee-related strategies and practices as well as the Company’s culture. This oversight is conducted both directly and through certain of the Board’s committees. At each of its regularly scheduled quarterly meetings, the Board reviews changes in key personnel and, at least annually, meets with management to discuss various human resources related topics, including talent development, succession planning, compensation and culture. We believe the Company’s culture has been a critical component of the Company’s success and reinforcing that culture is a key responsibility of our executive management.​Diversity and Inclusion - Our business spans the globe and the employees in our facilities reflect the diversity of our geographic footprint. The Company generally relies on local general management in every region, which we believe creates a strong degree of organizational stability and a deep commitment to our people and the local community. At Amphenol, we aim to create an inclusive working environment where all employees are respected and treated equally. This message is emphasized from the top of our organization down to each of our employees. A key hallmark of our structure is our entrepreneurial culture that creates clear accountability for each of our general managers, who are our key business leaders. Our core management team is comprised of these general managers, as well as their controllers and our 10 Table of Contentsexecutive team. Women represented 29% of this core management group at the end of 2020. Of our total employees worldwide, we are proud that approximately half are women.​Health, Safety and Well-being - The safety and well-being of our employees is critical to our successful operation. Our health and safety activities are overseen by our corporate environmental, health, safety and sustainability leadership team but are managed by our local teams, who coordinate on-site safety programs, resources, reporting and training in our facilities. We believe that this model of coaching and tracking at the corporate level, but administering at the facility level, has allowed us to provide training and supervision that better fits the local needs of each of our workforces. During the COVID-19 pandemic, we have taken additional actions to protect the physical and mental health and well-being of our employees throughout the world, including in particular those employees who work in our factories. We have also encouraged employees to work from home when possible and appropriate and have taken an integrated approach to helping our employees optimally manage their work and personal responsibilities.​Community and Social Impact - Amphenol recognizes that we have a responsibility to be a positive influence in the communities in which we operate around the world. Most of our community outreach is organized by our local management teams, which helps ensure that our efforts are working in support of the local communities in which our employees live and work. Our local teams are actively supporting their communities in a variety of ways including: school supply drives, local blood drives, mentoring of at-risk students, community clean-up events, local tree planting, holiday-giving events and food delivery services to immobile individuals. To support our communities during the COVID-19 pandemic, we leveraged our global supply chain to procure face masks, sanitizer, thermometers and other critical supplies, which our teams donated to local hospitals, clinics, at risk individuals, our employees and their families.​Environmental Matters​Certain operations of the Company are subject to environmental laws and regulations which govern the discharge of pollutants into the air and water, as well as the handling and disposal of solid and hazardous wastes. The Company believes that its operations are currently in substantial compliance with applicable environmental laws and regulations and that the costs of continuing compliance will not have a material adverse effect on the Company’s financial condition, results of operations or cash flows. For more information on certain environmental matters, refer to Note 14 of the Notes to Consolidated Financial Statements. For a discussion of certain risks related to environmental matters, refer to the risk factor titled “The Company is subject to environmental laws and regulations that could adversely affect its business” in Part I, Item 1A. Risk Factors herein.​Available Information​The U.S. Securities and Exchange Commission (“SEC”) maintains a website that contains reports, proxy and information statements and other information regarding issuers, including Amphenol, that file with the SEC. Any such documents that the Company files with the SEC can be obtained by the public on the SEC’s website at http://www.sec.gov. The Company’s annual report on Form 10-K and all of the Company’s other filings with the SEC, such as quarterly reports on Form 10-Q, current reports on Form 8-K, proxy statements, and any amendments to such reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934 (the “Exchange Act”), are also available to view, free of charge, on the Company’s website, www.amphenol.com, as soon as reasonably practicable after they are electronically filed with, or furnished to, the SEC. Copies are also available without charge, from Amphenol Corporation, Investor Relations, 358 Hall Avenue, Wallingford, CT 06492. The information on our website is not incorporated by reference in this Annual Report on Form 10-K.​11 Table of ContentsItem 1A. Risk Factors​Investors should carefully consider the risks described below and all other information in this annual report on Form 10-K. The risks and uncertainties described below are not the only ones facing the Company. Additional risks and uncertainties not presently known to the Company or that we currently consider immaterial may also impair the Company’s business, operations, liquidity and financial condition. In addition to the risk factor included below related to adverse public health developments and, in particular, the ongoing COVID-19 pandemic and its effects on public health and the global economy, the Company also notes that the effects of the pandemic have and may continue to impact many of the other risk factors described below. ​If actions taken by management to limit, monitor or control enterprise risk exposures are not successful, the Company’s business and consolidated financial statements could be materially adversely affected. In such case, the trading price of the Company’s common stock and debt securities could decline and investors may lose all or part of their investment.​Risks related to our global operations​Non-U.S. markets form a substantial portion of the Company’s business and as a result, the Company is more exposed to political, economic, military and other risks in countries outside the United States.​During 2020, non-U.S. markets constituted approximately 71% of the Company’s net sales, with China constituting approximately 30% of the Company’s net sales. The Company employs approximately 90% of its workforce outside the United States. The Company’s customers are located throughout the world and the Company has many manufacturing, administrative and sales facilities outside the United States. As a result, our financial results and our operations, including our ability to manufacture, assemble and test, design, develop or sell products, and the demand for our products, may be adversely affected by a number of global and regional factors outside of our control. Because the Company has extensive non-U.S. operations as well as significant cash and cash investments held at institutions located outside of the United States, it is exposed to additional risks that could have a material adverse effect on the Company’s business, financial condition, results of operations or cash flows, including:​●instability in political or economic conditions, including but not limited to inflation, recession or slowing growth, changes in tariff and trade barriers and import and export licensing requirements, our ability to hire and maintain qualified staff in these regions, foreign currency exchange restrictions and devaluations, restrictive governmental controls on the movement and repatriation of earnings and capital, and actual or anticipated military or political conflicts, particularly in emerging markets;​●intergovernmental conflicts or actions, including but not limited to armed conflict, trade wars, cyber attacks and acts of terrorism or war; and​●interruptions to the Company’s business with its largest customers, distributors and suppliers resulting from but not limited to, strikes, financial instabilities, computer malfunctions or cybersecurity incidents, inventory excesses, natural disasters such as fires, floods, earthquakes, hurricanes or tornadoes or adverse public health developments, including the ongoing COVID-19 pandemic discussed further below.​International trade or other disputes may result in increased tariffs, trade barriers, retaliatory governmental regulations or actions and other protectionist measures that could increase our manufacturing costs, make our products less competitive, reduce consumer demand or impede or slow the movement of our goods across borders. Increasing protectionism and economic nationalism may lead to further changes in trade policy, domestic sourcing initiatives, or other formal and informal measures that could make it more difficult to sell our products in some markets.​Changes in general economic conditions, geopolitical conditions, U.S. trade policies and other factors beyond the Company’s control may adversely impact our business and operating results.​The Company’s operations and performance depend significantly on global, regional and U.S. economic and geopolitical conditions. In recent years, there have been significant changes to U.S. trade policies, legislation, treaties and tariffs, in particular trade policies and tariffs affecting China. Some of these trade policies, including the U.S.’s trading relationship with China, have been renegotiated during this timeframe and are subject to further changes in the future. Changes to current policies by the U.S. or other governments could affect our business, including potentially through increased import tariffs and other influences on U.S. trade relations with China and other countries. The imposition of additional tariffs or other trade barriers could increase our costs in certain markets, and may cause our 12 Table of Contentscustomers to find alternative sourcing. In addition, other countries have changed and may continue to change their own policies on trade as well as business and foreign investment in their respective countries. Additionally, it is possible that U.S. policy changes and uncertainty about such changes could increase market volatility and currency exchange rate fluctuations. Market volatility and currency exchange rate fluctuations could have a material adverse effect on our business, financial condition, results of operations or cash flows. As a result of these dynamics, we cannot predict the impact to our business of any future changes to the U.S.’s trading relationships or of new laws or regulations by the U.S. or other countries.​In addition to changes in U.S. trade policy, a number of other economic and geopolitical factors both in the United States and abroad could have a material adverse effect on the Company’s business, financial condition, results of operations or cash flows, such as:​●a global or regional economic slowdown in any of the Company’s market segments;●postponement of spending, in response to tighter credit, financial market volatility and other factors;●effects of significant changes in economic, monetary and/or fiscal policies in the United States and abroad including significant income tax changes, currency fluctuations and inflationary pressures;●employment regulations and local labor conditions, including increases in employment costs, particularly in low-cost regions in which the Company currently operates;●industrial policies in various countries that favor domestic industries over multinationals or that restrict foreign companies altogether;●difficulties protecting intellectual property;●longer payment cycles;●credit risks and other challenges in collecting accounts receivable;●changes in assumptions, such as discount rates, along with lower than expected investment returns and performance related to the Company’s benefit plans; ●the impact of each of the foregoing on outsourcing and procurement arrangements; ●social unrest due to escalating racial tensions in the United States and certain other countries where we operate; and●continuing uncertainty regarding the United Kingdom’s recent withdrawal from the European Union, otherwise known as “Brexit”.​We face significant risks related to adverse public health developments, including epidemics and pandemics such as the COVID-19 pandemic.​Any outbreaks of contagious diseases and other adverse public health developments in countries where we operate could have a material and adverse effect on our business, financial condition, liquidity and results of operations. For example, the COVID-19 pandemic has affected our manufacturing facilities throughout the world, as well as the facilities of our suppliers, customers and our customers’ contract manufacturers. The COVID-19 pandemic has caused widespread disruptions to our Company throughout most of 2020, particularly during the first half of the year. During the first quarter of 2020, these disruptions were primarily limited to our operations in China, which were closed for three weeks during January and February due to government mandates. As the virus spread to the rest of the world beginning in March and continuing throughout the remainder of 2020, most of our other operations outside of China were also impacted. As of December 31, 2020, we continue to experience some disruptions, and at a minimum, we expect those disruptions to continue through the first half of 2021 and they could, potentially, extend for the full year and beyond. These disruptions have included and may continue to include, depending on the specific location, government regulations that limit our ability to operate certain of our facilities at full capacity and to adjust certain costs, travel restrictions, “work-from-home” orders, supplier constraints, supply-chain interruptions, logistics challenges and limitations, and reduced demand from certain customers. The extent to which the COVID-19 pandemic will continue to impact our business and financial results going forward will be dependent on future developments such as the length and severity of the crisis, future government regulations and actions in response to the crisis, the timing, availability and effectiveness of vaccines, some of which have recently been approved and distributed for use, and the overall impact of the COVID-19 pandemic on the global economy and capital markets, among many other factors, all of which remain highly uncertain and unpredictable. In addition, the COVID-19 pandemic could impact the health of our management team and other employees. It is impossible to predict the overall future impact of the COVID-19 pandemic on our business, financial condition, liquidity and financial results, and there can be no assurance that the COVID-19 pandemic will not have a material and adverse effect on our financial results in the future during any quarter or period in which we are affected.​13 Table of ContentsIn addition, the COVID-19 pandemic increases the likelihood and potential severity of other risks (including some discussed separately within this Item 1A. Risk Factors), including but not limited to, the following:​●A protracted economic slowdown could negatively affect the financial condition of our customers, which may result in an increase in bankruptcies or insolvencies, a delay in payments and decreased sales.​●A scarcity of resources or other hardships caused by the COVID-19 pandemic may result in increased nationalism, protectionism and political tensions which may cause governments and/or other entities to take actions that may have a significant negative impact on the ability of the Company, its suppliers and its customers to conduct business.​●We have transitioned a significant subset of our employee population to a remote work environment in an effort to mitigate the spread of COVID-19. This change may exacerbate certain risks to our business, including an increased demand for information technology resources, an increased risk of phishing and other cybersecurity attacks, and an increased risk of unauthorized dissemination of sensitive personal information or proprietary or confidential information.​●If the vaccines that have recently been approved and distributed for use prove ineffective, we could experience another disruption in the global capital markets, which could increase the cost of, and adversely impact access to, capital (including the commercial paper markets) and increase economic uncertainty.​●If the financial performance of our businesses were to decline significantly as a result of the COVID-19 pandemic, we could incur a material non-cash charge to our income statement for the impairment of goodwill and other intangible assets.​●If there is a general market downturn and continued high degree of volatility in the financial markets, we may experience a material re-valuation of, for example, our pension assets and obligations.​Our international operations require us to comply with anti-corruption laws and regulations of the U.S. government and various foreign jurisdictions and our business reputation and financial results may be impaired by improper conduct by any of our employees, customers, suppliers, distributors or any other business partners.​Doing business on a worldwide basis requires us and our subsidiaries to comply with the laws and regulations of the U.S. government and various foreign jurisdictions, and our failure to comply with these rules and regulations may expose us to significant liabilities. These laws and regulations may apply to companies, individual directors, officers, employees, subcontractors and agents, and may restrict our operations, trade practices, investment decisions and partnering activities. In particular, our international operations are subject to U.S. and foreign anti-corruption laws and regulations, such as the Foreign Corrupt Practices Act of 1977, as amended (“FCPA”). The FCPA prohibits U.S. companies and their officers, directors, employees and agents acting on their behalf from corruptly offering, promising, authorizing or providing anything of value to foreign officials for the purposes of influencing official decisions or obtaining or retaining business or otherwise obtaining favorable treatment. The FCPA also requires companies to make and keep books, records and accounts that accurately and fairly reflect transactions and dispositions of assets and to maintain a system of adequate internal accounting controls. As part of our business, we deal with state-owned business enterprises, the employees and representatives of which may be considered foreign officials for purposes of the FCPA. In addition, some of the foreign locations in which we operate lack a developed legal system and have elevated levels of corruption. As a result of the above activities, we are exposed to the risk of violating anti-corruption laws. ​We have established policies and procedures designed to assist us and our personnel in complying with applicable U.S. and international laws and regulations. However, there can be no assurance that these policies will be effective in preventing our directors, officers, employees, subcontractors and agents from taking actions that violate these legal requirements. Violations of these legal requirements could subject us to criminal fines and imprisonment, civil penalties, disgorgement of profits, injunctions, debarment from government contracts and other remedial measures. In addition, any actual or alleged violations could disrupt our operations, cause reputational harm, involve significant management distraction and result in a material adverse effect on our competitive position, results of operations, cash flows or financial condition.​The Company’s results have at times been negatively affected by foreign currency exchange rates.​The Company conducts business in many foreign currencies through its worldwide operations, and as a result is subject to foreign exchange exposure due to changes in exchange rates of the various currencies including possible currency devaluations. Changes in exchange rates can positively or negatively affect the Company’s sales, operating 14 Table of Contentsmargins and equity. The Company manages currency exposure risk in a number of ways, including producing its products in the same country or region in which the products are sold (thereby generating revenues and incurring expenses in the same currency), cost reduction and pricing actions, working capital management and hedging contracts. However, there can be no assurance that these actions will be fully effective in managing currency risk, including in the event of a significant and sudden decline in the value of any of the foreign currencies of the Company’s worldwide operations, which could have an adverse effect on the Company’s business, financial condition and results of operations.​The Company has at times experienced difficulties in obtaining a consistent supply of materials at stable pricing levels.​The Company uses basic materials like aluminum, steel, copper, titanium, metal alloys, gold, silver, palladium and plastic resins in its manufacturing processes as well as a variety of components and relies on third party suppliers to secure these materials. Volatility in the prices of such materials and availability of supply may have a substantial impact on the price the Company pays for such materials. In addition, the Company may not be able to pass along increased raw material or component prices to its customers. Consequently, our results of operations and financial condition may be adversely affected. ​In limited instances we depend on a single source of supply or participate in commodity markets that may be served by a limited number of suppliers. Delays in obtaining supplies may result from a number of factors affecting our suppliers, and any delay could impair our ability to deliver products to our customers. For example, the COVID-19 pandemic initially disrupted the supply of raw materials, primarily in the first half of 2020; reoccurrences of such unforeseen events may result in the Company experiencing difficulties in obtaining a consistent supply of materials at stable pricing levels. Accordingly, such delays and associated risks could have an adverse effect on our business, results of operations and financial condition.​Risks related to our end markets​The Company is dependent on the communications industry, including information technology and data communications, wireless communications and broadband communications.​Approximately 46% of the Company’s 2020 net sales came from sales to the communications industry, including information technology and data communication, wireless communications and broadband communications, with 15% of the Company’s 2020 net sales coming from sales to the mobile devices market. Demand for these products is subject to rapid technological change. These markets are dominated by several large manufacturers and operators who regularly exert significant pressure on their suppliers, including the Company. Furthermore, there has been a trend on the part of customers to consolidate their lists of qualified suppliers to companies that have the ability to meet certain technical, quality, delivery and other standards while maintaining competitive prices. There can be no assurance that the Company will be able to meet these standards or maintain competitive pricing and therefore continue to compete successfully in the communications industry. The Company’s failure to do so could have a material adverse effect on the Company’s business, financial condition and results of operations.​Approximately 4% and 6% of the Company’s 2020 net sales came from sales to the broadband communications and mobile networks markets, respectively. Demand for the Company’s products in these markets depends primarily on capital spending by operators for constructing, rebuilding or upgrading their systems. The amount of this capital spending and, therefore, the Company’s sales and profitability will be affected by a variety of factors, including general economic conditions, consolidation within the communications industry, the financial condition of operators and their access to financing, competition, technological developments, new legislation and regulation of operators. There can be no assurance that existing levels of capital spending will continue or that spending will not decrease.​Changes in defense expenditures may reduce the Company’s sales.​Approximately 12% of the Company’s 2020 net sales came from sales to the military market. The Company participates in a broad spectrum of defense programs. The Company’s military sales are generally to contractors and subcontractors of the U.S. or foreign governments or to distributors that in turn sell to the contractors and subcontractors. Accordingly, the Company’s sales are affected by changes in the defense budgets of the U.S. and foreign governments. A significant decline in U.S. or foreign government defense expenditures could have an adverse effect on the Company’s business, financial condition and results of operations. U.S. and foreign government expenditures are also subject to 15 Table of Contentspolitical and budgetary fluctuations and constraints, which may result in significant unexpected changes in levels of demand for our products.​The Company is dependent on the acceptance of new product introductions for continued revenue growth.​The Company estimates that products introduced in the last two years accounted for approximately 25% of 2020 net sales. The Company’s long-term results of operations depend substantially upon its ability to continue to conceive, design, manufacture and market new products and upon continuing market acceptance of its existing and future product lines. In the ordinary course of business, the Company continually develops or creates new product line concepts. If the Company fails, or is significantly delayed, in introducing new product line concepts or if the Company’s new products are not met with market acceptance, its business, financial condition and results of operations may be adversely affected.​The Company encounters competition in substantially all areas of its business.​The Company competes primarily on the basis of technology innovation, product quality and performance, price, customer service and delivery time. Competitors include large, diversified companies, some of which have greater assets and financial resources than the Company, as well as medium- to small-sized companies. In addition, rapid technological changes occurring in the communications industry could also lead to the entry of new competitors of all sizes against whom we may not be able to successfully compete. There can be no assurance that the Company will be able to compete successfully against existing or new competition, and the inability to do so may result in price reductions, reduced margins, or loss of market share, any of which could have an adverse effect on the Company’s business, financial condition and results of operations.​Risks related to acquisitions​The Company has at times experienced difficulties and unanticipated expenses in connection with purchasing and integrating newly acquired businesses.​The Company has completed a number of acquisitions in recent years, including nine in 2019 and two in 2020. The Company anticipates that it will continue to pursue acquisition opportunities as part of its growth strategy. From time to time, the Company experiences difficulty and unanticipated expenses associated with purchasing and integrating acquisitions, and acquisitions do not always perform as expected. The Company has also experienced challenges at times following the acquisition of a new company or business, including but not limited to: managing the operations, manufacturing facilities and technology; maintaining and increasing the customer base; or retaining key employees, suppliers and distributors. In some cases, the Company may pursue indemnification claims against the seller or sellers of an acquired business for pre-acquisition liabilities, breaches of representations, warranties or covenants or for other reasons provided for in the relevant acquisition agreement. To the extent we pursue indemnification claims against the seller or sellers of any acquired business, such seller or sellers may successfully contest such claims, such seller or sellers may not have the financial capacity to compensate us for such claims or such claims may otherwise be difficult or impractical to enforce. Although we expect to realize strategic, operational and financial benefits as a result of past or future acquisitions and investments, we cannot predict or guarantee whether and to what extent anticipated cost savings, benefits and growth prospects will be achieved.​On December 9, 2020, the Company announced that we had entered into a definitive agreement to acquire MTS Systems Corporation (“MTS”) for $58.50 per share in cash, or approximately $1.7 billion, net of cash acquired and including the assumption of outstanding debt and liabilities. On January 19, 2021, the Company announced that we had entered into an agreement to sell the MTS Test & Simulation (“T&S”) business to Illinois Tool Works Inc. (“ITW”). The agreement to acquire MTS is expected to close by the middle of 2021, but is subject to certain regulatory approvals, approval from MTS’s shareholders and other customary closing conditions. The sale of the MTS T&S business to ITW is expected to close following the anticipated closing of our acquisition of MTS, but is also subject to certain regulatory approvals and other customary closing conditions. The acquisition of MTS and the sale of the MTS T&S business to ITW are subject to a number of risks that include, but are not limited to: (i) the risk that the proposed merger between Amphenol and MTS, and/or the proposed subsequent sale of the MTS T&S business to ITW, may not be completed in a timely manner or at all, (ii) unanticipated difficulties or expenditures relating to the proposed transactions, the response of business partners and competitors to the announcement of the proposed transactions, potential disruptions to current plans and operations and/or potential difficulties in employee retention as a result of the announcement and pendency of the proposed transactions and (iii) the failure of the transactions, if completed, to deliver the financial benefits to Amphenol currently anticipated by the Amphenol management team.​16 Table of ContentsThe Company may in the future incur goodwill and other intangible asset impairment charges.​At December 31, 2020, the total assets of the Company were $12.3 billion, which included $5.0 billion of goodwill (the excess of fair value of consideration paid over the fair value of net identifiable assets of businesses acquired) and $397.5 million of other intangible assets, net. The Company performs annual evaluations (or more frequently, if necessary) for the potential impairment of the carrying value of goodwill and other intangible assets. Such evaluations to date have not resulted in the need to recognize an impairment. However, if the financial performance of the Company’s businesses were to decline significantly, the Company could incur a material non-cash charge to its income statement for the impairment of goodwill and other intangible assets. Furthermore, we cannot provide assurance that impairment charges in the future will not be required if the expected cash flow estimates as projected by management do not occur, especially if an economic recession occurs and continues for a lengthy period or becomes severe, or if acquisitions and investments made by the Company fail to achieve expected returns.​Risks related to our liquidity and capital resources​The Company’s credit agreements contain certain covenants, which if breached, could have a material adverse effect on the Company.​The Credit Agreement, as amended and restated effective January 15, 2019, among the Company, certain subsidiaries of the Company and a syndicate of financial institutions (the “Revolving Credit Facility”), which also backstops the Company’s U.S. commercial paper program (“U.S. Commercial Paper Program”) and Euro commercial paper program, contains financial and other covenants, such as a limit on the ratio of debt to earnings before interest, taxes, depreciation and amortization, a limit on priority indebtedness and limits on incurrence of liens. Although the Company believes none of these covenants is presently restrictive to the Company’s operations, the ability to meet the financial covenants can be affected by events beyond the Company’s control, and the Company cannot provide assurance that it will meet those tests. A breach of any of these covenants could result in a default under the Revolving Credit Facility. Upon the occurrence of an event of default under any of the Company’s credit facilities, the lenders could terminate all commitments to extend further credit and elect to declare amounts outstanding thereunder to be immediately due and payable which could result in the acceleration of certain of the Company’s other indebtedness and the Company not having sufficient assets to repay the Revolving Credit Facility and such other indebtedness. As of December 31, 2020, the Company had no outstanding borrowings under the Revolving Credit Facility, U.S. Commercial Paper Program and Euro commercial paper program.​The Company relies on the capital markets, and its inability to access those markets on favorable terms could adversely affect the Company’s results.​The Company has used the capital markets to invest in its business and make strategic acquisitions. If general economic and capital market conditions deteriorate significantly, it could impact the Company’s ability to access the capital markets. While the Company has not recently encountered any financing difficulties, the capital and credit markets have experienced significant volatility in the past. Market conditions could make it more difficult to access capital to finance capital investments, acquisitions and other initiatives including dividends and share repurchases. As such, this could have a material adverse effect on the Company’s business, financial condition, results of operations or cash flows. In addition, while the Company has not encountered any such issues to date, if the credit rating agencies that rate the Company’s debt were to downgrade the Company’s credit rating in conjunction with a deterioration of the Company’s performance, it would likely increase the Company’s cost of capital and make it more difficult for the Company to obtain new financing and access capital markets, which could also have a material adverse effect on the Company’s business, financial condition, results of operations or cash flows.​The Company’s results may be negatively affected by changing interest rates.​The Company is subject to interest rate volatility with regard to existing and future issuances of debt. The Company monitors its mix of fixed-rate and variable-rate debt, as well as its mix of short-term and long-term debt. As of December 31, 2020, less than 1% of the Company’s outstanding borrowings were subject to floating interest rates and were primarily comprised of foreign borrowings. A 10% change in the London Interbank Offered Rate (“LIBOR”) or floating interest rates at December 31, 2020 would not have a material effect on the Company’s interest expense. The Company does not expect changes in interest rates to have a material effect on income or cash flows in 2021, although there can be no assurance that interest rates will not change significantly.​17 Table of ContentsIn 2017, the United Kingdom's Financial Conduct Authority, which regulates LIBOR, announced its intent to phase out the use of LIBOR by the end of 2021. On December 4, 2020, the ICE Benchmark Administration published a consultation on its intention to extend the publication of certain U.S. dollar LIBOR (“USD LIBOR”) rates until June 30, 2023. The U.S. Federal Reserve, in conjunction with the Alternative Reference Rates Committee, a steering committee comprised of large U.S. financial institutions, identified the Secured Overnight Financing Rate (the “SOFR”) as its preferred benchmark alternative to USD LIBOR. The SOFR represents a measure of the cost of borrowing cash overnight, collateralized by U.S. Treasury securities, and is calculated based on directly observable U.S. Treasury-backed repurchase transactions. If LIBOR ceases to exist or if the methods of calculating LIBOR change from their current form, interest rates on, and the market price for, our current or future indebtedness may be adversely affected. Refer to Part II, Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations and Note 1 of the Notes to Consolidated Financial Statements for further discussion and details on this development.​As of December 31, 2020, nearly all of the Company’s outstanding borrowings were based on fixed rates and primarily related to the following unsecured Senior Notes:​​​​​​​Principal ​Fixed​​Amount ​Interest​​(in millions) ​Rate​Maturity$ 227.7 ​3.125% September 2021​ 295.0 ​4.00% February 2022​ 350.0 ​3.20% April 2024​ 400.0​2.050% March 2025​ 500.0 ​4.350% June 2029​ 900.0 ​2.80% February 2030​​​​​​€ 500.0 ​0.750% May 2026 (Euro Notes)​ 500.0 ​2.00% October 2028 (Euro Notes)​Legal and regulatory risks​Our business and financial results may be adversely affected by government contracting risks. ​We are subject to various laws and regulations applicable to parties doing business with the U.S. government, including laws and regulations governing performance of U.S. government contracts, the use and treatment of U.S. government furnished property and the nature of materials used in our products. We may be unilaterally suspended or barred from conducting business with the U.S. government or its suppliers (both directly and indirectly), or become subject to fines or other sanctions if we are found to have violated such laws or regulations. As a result of the need to comply with these laws and regulations, we are subject to increased risks of governmental investigations, civil fraud actions, criminal prosecutions, whistleblower lawsuits and other enforcement actions. For example, in August 2018, we received a subpoena from the U.S. Department of Defense, Office of the Inspector General, requesting documents pertaining to certain products manufactured by the Company’s Military and Aerospace Group that are purchased or used by the U.S. government, as noted herein in Item 3. Legal Proceedings and Note 14 of the Notes to Consolidated Financial Statements. The laws and regulations to which we are subject include, but are not limited to, Export Administration Regulations, the Federal Acquisition Regulation, the False Claims Act, International Traffic in Arms Regulations and regulations from the Bureau of Alcohol, Tobacco and Firearms and the FCPA. Failure to comply with applicable requirements also could harm our reputation and our ability to compete for future government contracts or sell commercial equivalent products. Any of these outcomes could have a material adverse effect on our business, results of operations and financial condition.​In addition, U.S. government contracts are subject to modification, curtailment or termination by the U.S. government without prior written notice, either for convenience or for default as a result of our failure to perform under the applicable contract. If terminated by the U.S. government as a result of our default, we could be liable for additional costs the U.S. government incurs in acquiring undelivered goods or services from another source and any other damages it suffers. We are also prohibited from assigning prime U.S. government contracts without the prior consent of the U.S. government contracting officer. Furthermore, the U.S. government periodically audits our governmental contract costs, which could result in fines, penalties or adjustment of costs and prices under the contracts. Any such fines, penalties or payment adjustments resulting from such audits could adversely affect our reputation, business, financial condition, results of operations or cash flows.​18 Table of ContentsThe Company is subject to governmental export and import controls.​Certain of our products, including purchased components of such products, are subject to export controls and may be exported only with the required export license or through an export license exception. In addition, we are required to comply with certain U.S. and foreign sanctions and embargoes. These laws and regulations are complex, may change frequently and with limited notice, have generally become more stringent over time and have intensified under recent U.S. administrations, especially in light of recent trade tensions with China. For example, in 2019, the U.S. government added certain of the Company’s customers based in China to its “Entity List”, which imposes additional restrictions on sales to such customers. Although such restrictions did not have a material adverse effect on the Company’s business, financial condition and results of operations, the U.S. government has the power to place even greater restrictions on these and other customers, and such restrictions could prohibit the Company from selling products to such customers. If we were to fail to comply with these restrictions or applicable export licensing, customs regulations, economic sanctions and other laws, we could be subject to substantial civil and criminal penalties, including fines for us, the incarceration of responsible employees and managers, and the possible loss of export or import privileges. In addition, if our distributors fail to obtain appropriate import, export or re-export licenses or permits, we may also be adversely affected through reputational harm and penalties. Obtaining the necessary export license for a particular sale may be time-consuming and may result in the delay or loss of sales opportunities.​Cybersecurity incidents on our information technology systems could disrupt business operations or cause the release of highly sensitive confidential information, resulting in adverse impacts to our reputation and operating results and potentially leading to litigation and/or governmental investigations.​Cybersecurity threats continue to expand and evolve globally, making it difficult to detect and prevent such threats from impacting the Company. While the Company has been a target of various cybersecurity attacks, including but not limited to ransomware attacks, the impact of such attacks has not been material. Cybersecurity threats to the Company could lead to unauthorized access to the Company’s information technology systems, products, customers, suppliers and third party service providers. Cybersecurity incidents could potentially result in the disruption of our business operations and/or the misappropriation, destruction or corruption of critical data and confidential or proprietary information. Cybersecurity events could also result in the Company being unable to access critical data in a timely manner, or at all. Cybersecurity incidents could also result from unauthorized parties gaining access to our systems or information through fraudulent or other means of deceiving our employees, suppliers or third party service providers. In addition, the ongoing COVID-19 pandemic may increase our susceptibility to cybersecurity incidents and risks, especially as certain of our employees have transitioned and continue to work from home. Despite the Company’s implementation of preventative security measures to prevent, detect, address and mitigate these threats, our infrastructure may still be susceptible to disruptions from cybersecurity incidents, ransomware attacks, security breaches, computer viruses, outages, systems failures, natural disasters, adverse public health developments, or other catastrophic events, any of which could include reputational damage, loss of our intellectual property, release of highly sensitive confidential information, the inability to access critical data, litigation with third parties and/or governmental investigations, among other things, which could have a material adverse effect on our business, financial condition and results of operations. ​We and our business partners maintain significant amounts of data electronically in locations around the world. This data relates to all aspects of our business, including financial information and current and future products under development, and also contains certain customer, supplier, partner and employee data. We maintain systems and processes designed to protect this data, but notwithstanding such protective measures, there is a risk of intrusion, cyber attacks or tampering that could compromise the integrity and privacy of this data or make the data inaccessible to us. In addition, in certain cases, in order to conduct business, we outsource to third-party business partners. We obtain assurances from those parties that they have systems and processes in place to protect our data, and where applicable, that they will take steps to assure the protection of our data; nonetheless, those partners may also be subject to data intrusion or a cyber attack. Any compromise of the data could substantially disrupt our operations, harm our customers, employees and other business partners, damage our reputation, violate applicable laws and regulations, and subject us to potentially significant costs and liabilities.​The regulatory environment surrounding information security and privacy is increasingly demanding, with frequent imposition of new and changing requirements. For example, the European Union's General Data Protection Regulation (“GDPR”), which became effective in May 2018, and the state of California’s California Consumer Privacy Act (“CCPA”), which became effective January 1, 2020, impose significant new requirements and additional obligations for companies on how they collect, process and transfer personal data by enhancing consumer privacy rights and imposing significant fines for non-compliance. The potential for fines and other related costs in the event of a breach of or non-19 Table of Contentscompliance with the GDPR, CCPA or other existing or proposed information security or privacy laws and requirements may have an adverse effect on our financial results. ​Changes in fiscal and tax policies, audits and examinations by taxing authorities could impact the Company’s results.​The Company is subject to tax in the U.S. and numerous foreign jurisdictions. The Company is currently under tax examination in several jurisdictions, and in addition, new examinations could be initiated by additional tax authorities. As the Company has operations in jurisdictions throughout the world, the risk of tax examinations will continue to occur. The Company’s financial condition, results of operations or cash flows may be materially impacted by the results of these tax examinations. ​Any future changes in tax laws, regulations, accounting standards for income taxes and/or other tax guidance, including related interpretations, could materially impact the Company’s current and non-current tax liabilities, along with deferred tax assets and liabilities, and consequently, our financial condition, results of operations or cash flows. ​The Company relies on patent and trade secret laws, copyright, trademark, confidentiality procedures, controls and contractual commitments to protect our intellectual property rights.​We rely on patent and trade secret laws, copyright, trademark, confidentiality procedures, controls and contractual commitments to protect our intellectual property rights. Despite our efforts, these protections may be limited and we may encounter difficulties in protecting our intellectual property rights, particularly in certain countries outside the U.S. We cannot provide assurance that the patents that we hold or may obtain will provide meaningful protection against our competitors. Changes in national or international laws concerning intellectual property may affect our ability to prevent or address the misappropriation of, or the unauthorized use of, our intellectual property, potentially resulting in loss of market share. Litigation may be necessary to enforce our intellectual property rights. Litigation is inherently uncertain and outcomes are often unpredictable. If we cannot protect our intellectual property rights against unauthorized copying or use, or other misappropriation, we may not remain competitive.​The Company is subject to customer claims, litigation and other regulatory or legal proceedings.​The Company is currently engaged in, or subject to, various customer claims, litigation and other regulatory and legal matters and may be subject to additional claims, litigation and other regulatory or legal proceedings in the future. Such matters expose the Company to risks that could be material, including but not limited to, risks related to employment disputes, tax controversies, government investigations, intellectual property infringement, compliance with environmental laws, unfair sales practices, product safety and liability, and product warranty, indemnity and other contract-related claims. These matters may subject the Company to lawsuits, product recalls, government investigations and criminal liability, including claims for compensatory, punitive or consequential damages, and could result in disruptions to our business and significant legal expenses. These matters could also damage our reputation, harm our relationships with customers or negatively affect product demand. While the Company does maintain certain insurance coverages that may mitigate losses associated with some of these types of claims and proceedings, the policies may not respond in all cases and, where insurance exists, the amount of insurance coverage may not be adequate to cover the total claims and liabilities. Any current or future substantial liabilities or regulatory actions could have a material adverse effect on our business, financial condition, cash flows and reputation. ​The Company is subject to environmental laws and regulations that could adversely affect its business.​The Company operates in both the United States and various foreign jurisdictions, and we must comply with locally enacted laws and regulations addressing health, safety and environmental matters in such jurisdictions in which we manufacture and/or sell our products. Certain operations of the Company are subject to locally enacted environmental laws and regulations which govern the discharge of pollutants into the air and water, as well as the handling and disposal of solid and hazardous wastes. While the Company believes that its operations are currently in substantial compliance with applicable environmental laws and regulations, the Company and its operations may be subject to liabilities, regardless of fault, for investigative and/or remediation efforts on such matters that may arise at any of the Company’s former or current properties, either owned or leased. For example, as disclosed in Note 14 of the Notes to Consolidated Financial Statements, the Company has been named as one of several defendants in four separate lawsuits filed in the State of Indiana relating to a manufacturing site in Franklin, Indiana where the Company has been conducting an environmental clean-up effort under the direction of the United States Environmental Protection Agency. All costs incurred by the Company relating to these lawsuits as well as all costs associated with the clean-up effort at the manufacturing site are reimbursed by the former owner pursuant to an indemnification agreement entered into in 20 Table of Contentsconnection with the acquisition of the manufacturing site as part of a larger acquisition that led to the establishment of the Company’s business in 1987. Environmental liabilities can result from the use of hazardous materials in production, the disposal of products, damages associated with the use of any of our products or other related matters. We cannot be certain as to the potential impact of any changes to environmental conditions or environmental policies that may arise at any of our jurisdictions. Our failure to comply with these local environmental laws and regulations could result in fines or other punitive damages and/or modifications to our production processes as well as subject us to reputational harm, any of which could adversely impact our financial position, results of operations, or cash flows.​Item 1B. Unresolved Staff Comments​None.​Item 2. Properties​The Company’s fixed assets include plants and warehouses and a substantial quantity of machinery and equipment, most of which is general purpose machinery and equipment using tools and fixtures and in many instances having automatic control features and special adaptations. The Company’s plants, warehouses and machinery and equipment are generally in good operating condition, are reasonably maintained and substantially all of its facilities are in regular use. The Company considers the present level of fixed assets along with planned capital expenditures as suitable and adequate for operations in the current business environment. At December 31, 2020, the Company operated a total of approximately 480 plants, warehouses and offices of which (a) the locations in the U.S. had approximately 3.9 million square feet, of which approximately 2.0 million square feet were leased; (b) the locations outside the U.S. had approximately 17.6 million square feet, of which approximately 13.6 million square feet were leased; and (c) the square footage by segment was approximately 20.2 million square feet and approximately 1.3 million square feet for the Interconnect Products and Assemblies segment and the Cable Products and Solutions segment, respectively. Of the total plants, warehouses and offices operated by the Company, approximately 200 are manufacturing facilities with over 10,000 square feet, of which approximately half are ISO 14001 certified. ​The Company believes that its facilities are suitable and adequate for the business conducted therein and are being appropriately utilized for their intended purposes. Utilization of the facilities varies based on demand for the products. The Company continuously reviews its anticipated requirements for facilities and, based on that review, may from time to time acquire or lease additional facilities and/or dispose of existing facilities. ​Item 3. Legal Proceedings​Information with respect to legal proceedings and this item is included in Note 14 of the Notes to Consolidated Financial Statements contained in Part II, Item 8 of this report, which is incorporated herein by reference.​Item 4. Mine Safety Disclosures​Not applicable.​​21 Table of ContentsPART II​Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities​Market Information​The Company effected the initial public offering of its Class A Common Stock (“Common Stock”) in November 1991. The Company’s Common Stock has been listed on the New York Stock Exchange since that time under the ticker symbol “APH”. As of January 31, 2021, there were 32 holders of record of the Company’s Common Stock. A significant number of outstanding shares of Common Stock are registered in the name of only one holder, which is a nominee of The Depository Trust Company, a securities depository for banks and brokerage firms. The Company believes that there are a significant number of beneficial owners of its Common Stock. ​Stock Split​On January 27, 2021, the Company announced that its Board of Directors approved a two-for-one split of the Company’s common stock. The stock split will be effected in the form of a stock dividend paid to shareholders of record as of the close of business on February 16, 2021. The Company expects the additional shares will be distributed on March 4, 2021. Refer to Note 8 of the Notes to Consolidated Financial Statements for the pro forma effect of this stock split as if it had been effective for all years presented.​Stock Performance Graph​The following graph compares the cumulative total shareholder return of Amphenol over a period of five years ending December 31, 2020 with the performance of the Standard & Poor’s 500 (“S&P 500”) Stock Index and the Dow Jones U.S. Electrical Components & Equipment Index. This graph assumes that $100 was invested in the Common Stock of Amphenol and each index on December 31, 2015, reflects reinvested dividends and is weighted on a market capitalization basis as of the beginning of each year. Each reported data point below represents the last trading day of each calendar year. The comparisons in the graph below are based upon historical data and are not indicative of, nor intended to forecast, future performance. ​Dividends​Contingent upon declaration by the Board of Directors, the Company generally pays a quarterly dividend on shares of its Common Stock. ​​22 Table of ContentsThe following table sets forth the dividends declared per common share for each quarter of 2020 and 2019:​​​​​​​​​ 2020 2019First Quarter​$ 0.25​$ 0.23Second Quarter​ 0.25​ 0.23Third Quarter​ 0.25​ 0.25Fourth Quarter​ 0.29​ 0.25Total​$ 1.04​$ 0.96​Dividends declared and paid for the years ended December 31, 2020 and 2019 (in millions) were as follows:​​​​​​​​​​ ​​​2020​2019Dividends declared​$ 310.0​$ 285.3Dividends paid (including those declared in the prior year)​ 297.6​ 279.5​The Company’s Revolving Credit Facility contains financial covenants and restrictions, some of which may limit the Company’s ability to pay dividends, and any future indebtedness that the Company may incur could limit its ability to pay dividends.​Equity Compensation Plan Information​The following table summarizes the Company’s equity compensation plan information as of December 31, 2020:​​​​​​​​​​​​Equity Compensation Plan Information​​ Number of securities to Weighted average Number of​​ be issued upon exercise​exercise price of​securities​​ of outstanding options,​outstanding options,​remaining available​Plan category warrants and rights​warrants and rights​for future issuance​Equity compensation plans approved by security holders 34,005,999​$ 75.17 17,863,121​Equity compensation plans not approved by security holders —​ — —​Total 34,005,999​$ 75.17 17,863,121​​Repurchase of Equity Securities​In April 2018, the Company’s Board of Directors authorized a stock repurchase program under which the Company may purchase up to $2.0 billion of the Company’s Common Stock during the three-year period ending April 24, 2021 (the “2018 Stock Repurchase Program”) in accordance with the requirements of Rule 10b-18 of the Securities Exchange Act of 1934, as amended. During the year ended December 31, 2020, the Company repurchased 6.0 million shares of its Common Stock for $641.3 million under the 2018 Stock Repurchase Program. Of the total repurchases in 2020, 1.4 million shares, or $153.9 million, have been retained in Treasury stock at time of repurchase; the remaining 4.6 million shares, or $487.4 million, have been retired by the Company. From January 1, 2021 through January 31, 2021, the Company repurchased $4.0 million of its Common Stock, and has remaining authorization to purchase up to $199.8 million of its Common Stock under the 2018 Stock Repurchase Program. The price and timing of any future purchases under the 2018 Stock Repurchase Program will depend on a number of factors such as levels of cash generation from operations, the level of uncertainty relating to the COVID-19 pandemic, the volume of stock option exercises by employees, cash requirements for acquisitions, dividends, economic and market conditions and stock price.​The table below reflects the Company’s stock repurchases for the year ended December 31, 2020:​​​​​​​​​​​​​​ ​​​​​Total Number of​Maximum Dollar​(dollars in millions, except price per share)​​​​​​Shares Purchased as​Value of Shares​​​Total Number​Average​Part of Publicly​that May Yet be​​​of Shares​Price Paid​Announced Plans or​Purchased Under the​Period​Purchased per Share Programs Plans or Programs​First Quarter - 2020​ 2,692,461​$ 95.54​ 2,692,461​$ 587.9​Second Quarter - 2020​ —​​ —​ —​​ 587.9​Third Quarter - 2020​ 1,869,448​​ 108.01​ 1,869,448​​ 385.9​​​​​​​​​​​​​Fourth Quarter - 2020:​​​​​​​​​​​October 1 to October 31, 2020 193,338​ 113.77 193,338 ​ 363.9​November 1 to November 30, 2020 778,155​ 123.31 778,155 ​ 268.0​December 1 to December 31, 2020 486,227​ 132.07 486,227 ​ 203.8​​​ 1,457,720​​ 124.97​ 1,457,720​​ 203.8​​​​​​​​​​​​​Total - 2020 6,019,629​$ 106.54 6,019,629 $ 203.8​​​23 Table of Contents​​Item 6. Selected Financial Data​The following table presents selected consolidated financial data that is derived from the Company’s audited Consolidated Financial Statements and that should be read in conjunction with our “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and Consolidated Financial Statements and accompanying notes included herein. The Company’s acquisitions during the five-year period below may affect the comparability of results. Our consolidated financial information may not be indicative of our future performance. ​​​​​​​​​​​​​​​​​​​(dollars and shares ​​ ​​ ​​ ​​ ​​ ​in millions, except per share data)​2020​2019​2018​2017​2016 ​​​​​​​​​​​​​​​​​​​Operations​​​​​​​​​​​​​​​​​Net sales​$ 8,598.9​$ 8,225.4​$ 8,202.0​$ 7,011.3​$ 6,286.4​​Net income attributable to Amphenol Corporation​ 1,203.4(1) 1,155.0(2) 1,205.0(3) 650.5(4) 822.9(5)​Net income per common share—Diluted​ 3.91(1) 3.75(2) 3.85(3) 2.06(4) 2.61(5)​​​​​​​​​​​​​​​​​​​Financial Condition​​​​​​​​​​​​​​​​​Cash, cash equivalents and short-term investments​$ 1,738.1​$ 908.6​$ 1,291.7​$ 1,753.7​$ 1,173.2​​Working capital​ 3,186.5​ 2,078.5​ 2,120.3​ 3,076.6​ 1,956.0​​Total assets​ 12,327.3​ 10,815.5​ 10,044.9​ 10,003.9​ 8,498.7​​Long-term debt, including current portion​ 3,866.5​ 3,606.7​ 3,570.7​ 3,542.6​ 3,010.7​​Shareholders’ equity attributable to Amphenol Corporation​ 5,384.9​ 4,530.3​ 4,017.0​ 3,989.8​ 3,674.9​​Weighted average shares outstanding—Diluted​ 307.5​ 307.9​ 312.6​ 316.5​ 315.2​​Cash dividends declared per share​$ 1.04​$ 0.96​$ 0.88​$ 0.70​$ 0.58​​(1)Includes (a) excess tax benefits related to stock-based compensation of $42.8 resulting from stock option exercises and (b) a discrete tax benefit of $19.9 related to the settlements of refund claims in certain non-U.S. jurisdictions and the resulting adjustments to deferred taxes, partially offset by (c) acquisition-related expenses of $11.5 ($10.7 after-tax) primarily comprised of external transaction costs related to acquisitions that were announced or closed. These items had the aggregate effect of increasing Net income attributable to Amphenol Corporation and Net income per common share-Diluted by $52.0 and $0.17 per share, respectively. Excluding the effect of these items, Adjusted Net Income attributable to Amphenol Corporation and Adjusted Diluted EPS, both non-GAAP financial measures defined in Part II, Item 7 herein, were $1,151.4 and $3.74 per share, respectively, for the year ended December 31, 2020.​(2)Includes (a) excess tax benefits related to stock-based compensation of $38.1 resulting from stock option exercises, partially offset by (b) acquisition-related expenses of $25.4 ($21.0 after-tax) comprised of the amortization related to the value associated with acquired backlog from two acquisitions, along with external transaction costs and (c) refinancing-related costs of $14.3 ($12.5 after-tax) associated with the early extinguishment of debt. These items had the aggregate effect of increasing Net income attributable to Amphenol Corporation and Net income per common share-Diluted by $4.6 and $0.01 per share, respectively. Excluding the effect of these items, Adjusted Net Income attributable to Amphenol Corporation and Adjusted Diluted EPS, both non-GAAP financial measures defined in Part II, Item 7 herein, were $1,150.4 and $3.74 per share, respectively, for the year ended December 31, 2019.​(3)Includes (a) an income tax benefit of $14.5 recorded in 2018 related to the completion of the accounting associated with the provisional income tax charge recorded in 2017 related to the enactment of the Tax Cuts and Jobs Act and (b) excess tax benefits related to stock-based compensation of $19.8 resulting from stock option exercises, partially offset by (c) acquisition-related expenses of $8.5 ($7.2 after-tax) primarily relating to external transaction costs. These items had the aggregate effect of increasing Net income attributable to Amphenol Corporation and Net income per common share-Diluted by $27.1 and $0.08 per share, respectively. Excluding the effect of these items, Adjusted Net Income attributable to Amphenol Corporation and Adjusted Diluted EPS were $1,177.9 and $3.77 per share, respectively, for the year ended December 31, 2018.​(4)Includes (a) an income tax charge of $398.5 related to the enactment of the Tax Cuts and Jobs Act, which represented our estimate of taxes arising from the implementation of a modified territorial tax regime and the deemed and intended repatriation of prior unremitted earnings of foreign subsidiaries, partially offset by the tax benefit associated with the remeasurement of the Company’s U.S. net deferred tax liabilities due to the U.S. federal corporate tax rate reduction and (b) acquisition-related expenses of $4.0 ($3.7 after-tax) primarily relating to external transaction costs associated with 2017 acquisitions, partially offset by (c) excess tax benefits related to stock-based compensation of $66.6 resulting from stock option exercises. These items had the aggregate effect of decreasing Net income attributable to Amphenol Corporation and Net income per common share-Diluted by $335.6 and $1.06 per share, respectively. Excluding the effect of these items, Adjusted Net Income attributable to Amphenol Corporation and Adjusted Diluted EPS were $986.1 and $3.12 per share, respectively, for the year ended December 31, 2017. ​(5)Includes acquisition-related expenses of $36.6 ($33.1 after-tax) primarily relating to the FCI Asia Pte. Ltd. (“FCI”) and other 2016 acquisitions, including external transaction costs, amortization related to the value associated with acquired backlog and restructuring charges. These items had the aggregate effect of decreasing Net income attributable to Amphenol Corporation and Net income per common share-Diluted by $33.1 and $0.11 per share, respectively. Excluding the effect of these items, Adjusted Net Income attributable to Amphenol Corporation and Adjusted Diluted EPS were $856.0 and $2.72 per share, respectively, for the year ended December 31, 2016.​​24 Table of ContentsItem 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations​(amounts in millions, except share and per share data, unless otherwise noted)​The following discussion and analysis of the results of operations and financial condition for the three years ended December 31, 2020, 2019 and 2018 has been derived from and should be read in conjunction with the Consolidated Financial Statements and accompanying Notes to Consolidated Financial Statements included in Part II, Item 8, herein. The Consolidated Financial Statements have been prepared in U.S. dollars, in accordance with accounting principles generally accepted in the United States (“U.S. GAAP”). The following discussion and analysis also includes references to certain non-GAAP financial measures, which are defined in the “Non-GAAP Financial Measures” section below, including “Constant Currency Net Sales Growth” and “Organic Net Sales Growth”. For purposes of the following discussion, the terms “constant currencies” and “organically” have the same meanings, respectively, as these aforementioned non-GAAP financial measures. Refer to “Non-GAAP Financial Measures” within this Item 7 for more information, including our reasons for including non-GAAP financial measures and material limitations with respect to the usefulness of the measures.​In addition to historical information, the following discussion and analysis also contains certain forward-looking statements that are subject to risks and uncertainties, including but not limited to the risk factors described in Part I, Item 1A herein, as well as the risks and uncertainties that exist with the use of forward-looking statements as described in the “Cautionary Note Regarding Forward-Looking Statements” section included herein at the beginning of this Annual Report on Form 10-K. ​Overview​General​Amphenol Corporation (together with its subsidiaries, “Amphenol”, the “Company”, “we”, “our”, or “us”) is one of the world’s largest designers, manufacturers and marketers of electrical, electronic and fiber optic connectors and interconnect systems, antennas, sensors and sensor-based products and coaxial and high-speed specialty cable. The Company operates through two reporting segments: (i) Interconnect Products and Assemblies and (ii) Cable Products and Solutions. In 2020, approximately 71% of the Company’s sales were outside the United States. The primary end markets for our products are:​●information technology and communication devices and systems for the converging technologies of voice, video and data communications;●a broad range of industrial applications and traditional, hybrid and electric automotive applications; and●military and commercial aerospace applications.​The Company’s products are used in a wide variety of applications by numerous customers around the world. The Company competes primarily on the basis of technology innovation, product quality and performance, price, customer service and delivery time. There has been a trend on the part of customers to consolidate their lists of qualified suppliers to companies that have the ability to meet certain technical, quality, delivery and other standards while maintaining competitive prices. The Company has focused its global resources to position itself to compete effectively in this environment. The Company believes that its global presence is an important competitive advantage as it allows the Company to provide quality products on a timely and worldwide basis to its multinational customers.​Strategy​The Company’s strategy is to provide its customers with comprehensive design capabilities, a broad selection of products and a high level of service on a worldwide basis while maintaining continuing programs of productivity improvement and cost control. The Company focuses its research and development efforts through close collaboration with its customers to develop highly-engineered products that meet customer needs and have the potential for broad market applications and significant sales within a one- to three-year period. The Company is also focused on controlling costs. The Company does this by investing in modern manufacturing technologies, controlling purchasing processes and expanding into lower cost areas.​​25 Table of ContentsThe Company’s strategic objective is to further enhance its position in its served markets by pursuing the following success factors:​●Pursue broad diversification;●Develop high technology performance-enhancing interconnect solutions;●Expand global presence;●Control costs;●Pursue strategic acquisitions and investments; and●Foster collaborative, entrepreneurial management.​In 2020, the Company reported net sales, operating income and net income attributable to Amphenol Corporation of $8,598.9, $1,638.4 and $1,203.4, respectively, representing an increase of 5%, 1% and 4%, respectively, from 2019. In 2020, the Company’s net income attributable to Amphenol Corporation was impacted by (a) excess tax benefits related to stock-based compensation of $42.8 resulting from stock option exercises and (b) a discrete tax benefit of $19.9 related to the settlements of refund claims in certain non-U.S. jurisdictions and the resulting adjustments to deferred taxes, partially offset by (c) acquisition-related expenses of $11.5 ($10.7 after-tax) primarily comprised of external transaction costs related to acquisitions that were announced or closed. In 2019, the Company’s net income attributable to Amphenol Corporation was impacted by (a) excess tax benefits related to stock-based compensation of $38.1 resulting from stock option exercises, partially offset by (b) acquisition-related expenses of $25.4 ($21.0 after-tax) primarily from the amortization related to the value associated with acquired backlog as well as external transaction costs and (c) refinancing-related costs associated with the early extinguishment of debt of $14.3 ($12.5 after-tax), comprised primarily of the premiums and other fees incurred from the early extinguishment of redeemed amounts of our 3.125% Senior Notes and 4.00% Senior Notes resulting from the tender offers in September 2019 described herein under “Liquidity and Capital Resources – Financing Activities”. Excluding the effects of these items, Adjusted Operating Income and Adjusted Net Income attributable to Amphenol Corporation, as defined in the “Non-GAAP Financial Measures” section below and reconciled in Part II, Item 7 herein, was unchanged in 2020 compared to 2019. Sales and profitability trends are discussed in detail in “Results of Operations” below. In addition, a strength of the Company has been its ability to consistently generate cash from operations (“Operating Cash Flow”). The Company uses Operating Cash Flow to fund capital expenditures and acquisitions, repurchase shares of its common stock, pay dividends and reduce indebtedness. In 2020, the Company generated Operating Cash Flow of $1,592.0 and Free Cash Flow of $1,327.9. Free Cash Flow, a non-GAAP financial measure, is defined in the “Non-GAAP Financial Measures” section below and reconciled within this Part II, Item 7 herein.​Impact of Coronavirus (“COVID-19”) on our Operations, Financial Condition, Liquidity and Results of Operations​The COVID-19 pandemic has caused widespread disruptions to our Company during 2020, particularly during the first half of the year. During the first quarter, these disruptions were primarily limited to our operations in China, which were closed for three weeks during January and February due to government mandates. As the virus spread to the rest of the world beginning in March and continuing throughout the remainder of 2020, most of our other operations outside of China were also impacted. As of December 31, 2020, we continue to experience some disruptions, and at a minimum, we expect those disruptions to continue through the first half of 2021 and they could, potentially, extend for the full year and beyond. These disruptions have included and may continue to include, depending on the specific location, government regulations that limit our ability to operate certain of our facilities at full capacity and to adjust certain costs, travel restrictions, “work-from-home” orders, supplier constraints, supply-chain interruptions, logistics challenges and limitations, and reduced demand from certain customers. During the fourth quarter of 2020 and into 2021, in several regions around the world, including the United States and Europe, there has been a resurgence in COVID-19 cases. The extent to which the COVID-19 pandemic will continue to impact our business and financial results going forward will be dependent on future developments such as the length and severity of the crisis, future government regulations and actions in response to the crisis, the timing, availability and effectiveness of vaccines, some of which have recently been approved and distributed for use, and the overall impact of the COVID-19 pandemic on the global economy and capital markets, among many other factors, all of which remain highly uncertain and unpredictable. In addition, the COVID-19 pandemic could impact the health of our management team and other employees. The Company continues taking actions to mitigate, as best we can, the impact of the COVID-19 pandemic on the health and well-being of our employees, the communities in which we operate and our partners, as well as the impact on our operations and business as a whole. However, there can be no assurance that the COVID-19 pandemic will not have a material and adverse impact on our operations, financial condition, liquidity and results of operations. For further discussion on the risks and uncertainties associated with the COVID-19 pandemic, refer to Part I, Item 1A. Risk Factors.​26 Table of ContentsResults of Operations​The following table sets forth the components of net income attributable to Amphenol Corporation as a percentage of net sales for the years indicated.​​​​​​​​​​​​​​Year Ended December 31, ​​ 2020 ​2019 ​2018 ​Net sales 100.0% ​ 100.0% ​ 100.0% ​Cost of sales 69.0​​ 68.2​​ 67.6​​Acquisition-related expenses 0.1​​ 0.3​​ 0.1​​Selling, general and administrative expenses 11.8​​ 11.8​​ 11.7​​Operating income 19.1​​ 19.7​​ 20.6​​Interest expense (1.3)​​ (1.4)​​ (1.2)​​Loss on early extinguishment of debt​ —​​ (0.2)​​ —​​Other income, net —​​ 0.1​​ —​​Income before income taxes 17.8​​ 18.2​​ 19.4​​Provision for income taxes (3.7)​​ (4.1)​​ (4.5)​​Net income 14.1​​ 14.1​​ 14.9​​Net income attributable to noncontrolling interests (0.1)​​ (0.1)​​ (0.2)​​Net income attributable to Amphenol Corporation 14.0% ​ 14.0% ​ 14.7% ​​2020 Compared to 2019​Net sales were $8,598.9 for the year ended December 31, 2020 compared to $8,225.4 for the year ended December 31, 2019, which was an increase of 5% in U.S. dollars, 4% in constant currencies, and 2% organically (excluding both currency and acquisition impacts), over the prior year. The increase in net sales in 2020 was driven by strong growth in several markets, which was partially offset by the sudden and severe slowdown in certain of our markets resulting from the global outbreak of the COVID-19 pandemic, which also caused production disruptions in many parts of the world during much of the first half of 2020. ​Net sales in the Interconnect Products and Assemblies segment (approximately 96% of net sales) increased 5% in U.S. dollars, 4% in constant currencies, and 2% organically, in 2020 compared to 2019. The sales growth was driven by strong growth in the industrial, information technology and data communications, and mobile devices markets, along with moderate growth in the military market, and contributions from the Company’s acquisition program. This sales growth was partially offset by declines in the commercial aerospace, mobile networks and automotive markets, all of which were negatively impacted by the COVID-19 pandemic. Net sales to the industrial market increased (approximately $246.4), primarily driven by strength in battery and electric vehicle, industrial instrumentation, heavy equipment, alternative energy and medical applications, along with contributions from acquisitions. Net sales to the information technology and data communications market increased (approximately $234.0), driven primarily by strong sales growth to data center customers and market demand for storage and networking related products as customers worked to support higher demand for increased bandwidth to support work, school and entertainment activities during the pandemic, along with contributions from acquisitions. Net sales to the mobile devices market increased (approximately $179.9), driven by strength in products incorporated into laptops, tablets, wearable devices, and accessories along with production-related products, which was partially offset by a slight moderation of sales into smartphones. Net sales to the military market increased (approximately $32.2), driven by strength across multiple segments of the military market, offset in part by the impact of pandemic-related production disruptions experienced during the first half of the year. Net sales to the commercial aerospace market decreased significantly (approximately $135.3) primarily due to the significant impact of the COVID-19 pandemic on travel and aircraft production. Net sales to the mobile networks market decreased (approximately $98.5), which reflected the impact of the 2019 U.S. Government restrictions on certain Chinese customers as well as reduced demand from both mobile networks equipment manufacturers and mobile operators, partially as a result of the negative impact of the COVID-19 pandemic, offset in part by contributions from acquisitions. Net sales to the automotive market decreased (approximately $86.0), due to a significant reduction in demand resulting from customer factory shutdowns together with production disruptions in the first half of 2020 resulting from the COVID-19 pandemic, which was partially offset by a strong recovery of demand during the second half of the year. ​Net sales in the Cable Products and Solutions segment (approximately 4% of net sales), which primarily serves the broadband communications market, decreased 4% in U.S. dollars, 1% in constant currencies and 1% organically in 2020, compared to 2019. The decrease in net sales in the Cable Products and Solutions segment was largely driven by the 27 Table of Contentsnegative impact of the COVID-19 pandemic primarily during the first half of 2020, as well as an overall weakness in market demand.​The table below reconciles Constant Currency Net Sales Growth and Organic Net Sales Growth to the most directly comparable U.S. GAAP financial measures, by segment and consolidated, for the year ended December 31, 2020 compared to the year ended December 31, 2019:​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​Percentage Growth (relative to prior year)​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​Net sales​Foreign​Constant​​​Organic​​​​​growth in​currency​Currency Net​Acquisition​Net Sales​​​​​​​​​U.S. Dollars (1)​impact (2)​ Sales Growth (3)​impact (4)​Growth (3)​​ 2020 2019​(GAAP)​(non-GAAP)​(non-GAAP)​(non-GAAP)​(non-GAAP)​Net sales: ​​​​​​​​​​​​​​​​​​​​​Interconnect Products and Assemblies​$ 8,229.9 $ 7,840.3​ 5% ​ 1% ​ 4% ​ 2% ​ 2% ​Cable Products and Solutions​ 369.0​ 385.1​ (4)% ​ (3)% ​ (1)% ​ —% ​ (1)% ​Consolidated​$ 8,598.9​$ 8,225.4​ 5% ​ 1% ​ 4% ​ 2% ​ 2% ​​​​​​​​​​​​​​​​​​​​​​​​​(1)Net sales growth in U.S. dollars is calculated based on Net sales as reported in the Consolidated Statements of Income and Note 13 of the accompanying financial statements. While the term “net sales growth in U.S. dollars” is not considered a U.S. GAAP financial measure, for purposes of this table, we derive the reported (GAAP) measure based on GAAP results, which serves as the basis for the reconciliation to its comparable non-GAAP financial measures.(2)Foreign currency translation impact, a non-GAAP measure, represents the impact on net sales resulting from foreign currency exchange rate changes in the current year compared to the prior year. Such amount is calculated by subtracting current year net sales translated at average foreign currency exchange rates for the respective prior year from current year reported net sales, taken as a percentage of the respective prior year’s net sales.(3)Constant Currency Net Sales Growth and Organic Net Sales Growth are non-GAAP financial measures as defined in the “Non-GAAP Financial Measures” section.(4)Acquisition impact, a non-GAAP measure, represents the impact on net sales resulting from acquisitions closed since the beginning of the prior calendar year, which were not included in the Company’s results as of the comparable prior year and which do not reflect the underlying growth of the Company on a comparative basis. ​Geographically, net sales in the United States in 2020 decreased approximately 1% in U.S. dollars ($2,494.0 in 2020 versus $2,524.7 in 2019) and 5% organically, compared to 2019. Foreign sales in 2020 increased approximately 7% in U.S. dollars ($6,104.9 in 2020 versus $5,700.7 in 2019), 7% in constant currencies and 5% organically, compared to 2019, driven by strong growth in Asia. The comparatively weaker U.S. dollar in 2020 had an insignificant effect on net sales compared to 2019.​Selling, general and administrative expenses were $1,014.2 or 11.8% of net sales for 2020, compared to $971.4 or 11.8% of net sales for 2019. Administrative expenses increased approximately $27.5 in 2020, and represented approximately 4.8% of net sales in 2020 and 4.7% of net sales in 2019. Research and development expenses increased approximately $26.5 in 2020 primarily related to increases in expenses for new product development, and represented approximately 3.0% of net sales in 2020 and 2.8% of net sales in 2019. Selling and marketing expenses decreased approximately $11.2 in 2020 compared to 2019, and represented approximately 4.0% of net sales in 2020 and 4.3% of net sales in 2019.​Operating income was $1,638.4 or 19.1% of net sales in 2020, compared to $1,619.2 or 19.7% of net sales in 2019. Operating income for 2020 included acquisition-related expenses of $11.5, primarily comprised of external transaction costs related to acquisitions that were announced or closed. Operating income for 2019 included acquisition-related expenses of $25.4, comprised of the amortization of $15.7 related to the value associated with the acquired backlog resulting from two of our 2019 acquisitions, with the remainder representing external transaction costs. These acquisition-related expenses in 2020 and 2019 had the effect of decreasing net income by $10.7 or $0.03 per share, and $21.0 or $0.07 per share, respectively. Acquisition-related expenses are separately presented in the Consolidated Statements of Income. Excluding the effect of these acquisition-related expenses, Adjusted Operating Income and Adjusted Operating Margin, as defined in the “Non-GAAP Financial Measures” section below, was $1,649.9 or 19.2% of net sales, respectively, in 2020 and $1,644.6 or 20.0% of net sales, respectively, in 2019. ​Operating income for the Interconnect Products and Assemblies segment in 2020 was $1,741.2 or 21.2% of net sales, compared to $1,722.7 or 22.0% of net sales in 2019. The decrease in operating margin for the Interconnect Products and Assemblies segment for 2020 compared to 2019 was primarily driven by the significant incremental costs incurred, primarily during the first half of 2020, related to the COVID-19 pandemic. This decrease in the operating margin during the first half of 2020 was partly offset by strong operating leverage on higher sales volumes during the second half of 2020.​28 Table of ContentsOperating income for the Cable Products and Solutions segment in 2020 was $35.4 or 9.6% of net sales, compared to $39.5 or 10.2% of net sales in 2019. The decrease in operating margin for the Cable Products and Solutions segment in 2020 compared to 2019 was primarily driven by lower volumes as well as the negative impact of the COVID-19 pandemic, primarily during the first half of 2020.​Interest expense was $115.4 in 2020 compared to $117.6 in 2019. Refer to Note 4 of the Consolidated Financial Statements for further information related to the Company’s debt.​Loss on early extinguishment of debt was $14.3 in 2019, which related to refinancing-related costs, specifically premiums and fees incurred associated with the early extinguishment of certain redeemed principal amounts of the 3.125% Senior Notes and 4.00% Senior Notes (collectively, the “Tendered Notes”) as a result of the tender offers in September 2019. Refer to Note 4 of the accompanying Consolidated Financial Statements and the “Liquidity and Capital Resources” section within this Item 7 for further information related to the Tendered Notes.​Provision for income taxes was at an effective rate of 20.5% in 2020 and 22.2% in 2019. Provision for income taxes in 2020 included (i) excess tax benefits of $42.8 from stock option exercises and (ii) a discrete tax benefit of $19.9 related to the settlements of refund claims in certain non-U.S. jurisdictions and the resulting adjustments to deferred taxes, which was partially offset by the tax effect related to acquisition-related expenses during the year, each of which had an impact on the effective tax rate and earnings per share by the amounts noted in the table below. Provision for income taxes in 2019 included excess tax benefits of $38.1 from stock option exercises, which was partially offset by the tax effects related to (i) acquisition-related expenses during the year and (ii) refinancing-related costs associated with the early extinguishment of debt, each of which had an impact on the effective tax rate and earnings per share by the amounts noted in the table below. Excluding the effect of these items, the Adjusted Effective Tax Rate, a non-GAAP financial measure as defined in the “Non-GAAP Financial Measures” section below within this Item 7, was 24.5% for both 2020 and 2019, as reconciled in the table below to the comparable effective tax rate based on GAAP results. For additional details related to the reconciliation between the U.S. statutory federal tax rate and the Company’s effective tax rate for these years, refer to Note 6 of the Notes to Consolidated Financial Statements. ​Net income attributable to Amphenol Corporation and Net income per common share-Diluted (“Diluted EPS”) were $1,203.4 and $3.91, respectively, for 2020, compared to $1,155.0 and $3.75, respectively, for 2019. Excluding the effect of the aforementioned items discussed above, Adjusted Net Income attributable to Amphenol Corporation and Adjusted Diluted EPS, non-GAAP financial measures as defined in the “Non-GAAP Financial Measures” section below within this Item 7, were $1,151.4 and $3.74, respectively, for 2020, compared to $1,150.4 and $3.74, respectively, for 2019.​The following table reconciles Adjusted Operating Income, Adjusted Operating Margin, Adjusted Net Income attributable to Amphenol Corporation, Adjusted Effective Tax Rate and Adjusted Diluted EPS (all defined in the “Non-GAAP Financial Measures” section below) to the most directly comparable U.S. GAAP financial measures for the years ended December 31, 2020 and 2019:​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​2020​2019​​​​​​​Net Income​​​​​​​​​​​Net Income​​​​​​​​​​​​attributable​Effective​​​​​​​​​attributable​Effective​​​​​Operating​Operating​to Amphenol​Tax ​Diluted​Operating​Operating​to Amphenol​Tax ​Diluted​​Income Margin (1) Corporation​Rate (1) ​EPS​Income Margin (1) Corporation​Rate (1) ​EPSReported (GAAP)​$ 1,638.4 19.1% $ 1,203.4​ 20.5% $ 3.91​$ 1,619.2 19.7% $ 1,155.0​ 22.2% $ 3.75Acquisition-related expenses ​​ 11.5​ 0.1​​ 10.7​ (0.1)​​ 0.03​​ 25.4​ 0.3​​ 21.0​ (0.1)​​ 0.07Loss on early extinguishment of debt​​ -​ -​​ -​ -​​ -​​ -​ -​​ 12.5​ (0.1)​​ 0.04Excess tax benefits related to stock-based compensation​​ -​ -​​ (42.8)​ 2.8​​ (0.14)​​ -​ -​​ (38.1)​ 2.5​​ (0.12)Discrete tax item​​ -​ -​​ (19.9)​ 1.3​​ (0.06)​​ -​ -​​ -​ -​​ -Adjusted (non-GAAP)​$ 1,649.9​ 19.2% $ 1,151.4​ 24.5% $ 3.74​$ 1,644.6​ 20.0% $ 1,150.4​ 24.5% $ 3.74​(1)While the terms “operating margin” and “effective tax rate” are not considered U.S. GAAP financial measures, for purposes of this table, we derive the reported (GAAP) measures based on GAAP results, which serve as the basis for the reconciliation to their comparable non-GAAP financial measure.​​29 Table of Contents2019 Compared to 2018​Net sales were $8,225.4 for the year ended December 31, 2019 compared to $8,202.0 for the year ended December 31, 2018, which was flat in U.S. dollars, an increase of 2% in constant currencies and a decrease of 3% organically (excluding both currency and acquisition impacts), over the prior year. ​Net sales in the Interconnect Products and Assemblies segment (approximately 95% of net sales) increased 1% in U.S. dollars and 2% in constant currencies, while decreasing 3% organically, in 2019 compared to 2018. The sales growth was driven by strong growth in the military and commercial aerospace markets as well as contributions from the Company’s acquisition program. This sales growth was largely offset by reductions in the communications-related markets, in particular the mobile devices market, along with the negative effect of currency translation. Net sales to the military market increased (approximately $181.0), driven by broad-based strength across essentially all segments including military vehicle, rotorcraft, and military airframe applications. Net sales to the commercial aerospace market increased (approximately $48.7) primarily due to strength in large passenger planes. Net sales to the industrial market increased (approximately $66.1), primarily driven by contributions from acquisitions, as well as strength in medical and factory automation applications, which were partially offset by moderations in industrial instrumentation, heavy equipment and transportation, as well as other applications. Net sales to the automotive market increased (approximately $38.0), driven primarily by contributions from acquisitions, which were partially offset by moderations in demand due to the slowing of the worldwide automotive market. Net sales to the information technology and data communications market slightly increased (approximately $5.6), driven primarily by contributions from acquisitions and organic growth of sales to data center customers, offset by moderations in market demand for storage and networking related products. Net sales to the mobile devices market decreased (approximately $277.5), driven by moderations in sales of products incorporated into smartphones. Net sales to the mobile networks market decreased (approximately $10.2), due to reduced demand from both mobile networks equipment manufacturers and mobile operators, offset in part by contributions from acquisitions. ​Net sales in the Cable Products and Solutions segment (approximately 5% of net sales), which primarily serves the broadband communications market, decreased 8% in U.S. dollars, 6% in constant currencies and 7% organically in 2019, compared to 2018. The decrease in net sales in the Cable Products and Solutions segment was primarily due to a reduction in demand from broadband service providers.​The table below reconciles Constant Currency Net Sales Growth and Organic Net Sales Growth to the most directly comparable U.S. GAAP financial measures, by segment and consolidated, for the year ended December 31, 2019 compared to the year ended December 31, 2018:​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​Percentage Growth (relative to prior year)​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​Net sales​Foreign​Constant​​​Organic​​​​​growth in​currency​Currency Net​Acquisition​Net Sales​​​​​​​​​U.S. Dollars (1)​impact (2)​ Sales Growth (3)​impact (4)​Growth (3)​​ 2019 2018​(GAAP)​(non-GAAP)​(non-GAAP)​(non-GAAP)​(non-GAAP)​Net sales: ​​​​​​​​​​​​​​​​​​​​​Interconnect Products and Assemblies​$ 7,840.3 $ 7,781.9​ 1% ​ (1)% ​ 2% ​ 5% ​ (3)% ​Cable Products and Solutions​ 385.1​ 420.1​ (8)% ​ (2)% ​ (6)% ​ 1% ​ (7)% ​Consolidated​$ 8,225.4​$ 8,202.0​ —% ​ (2)% ​ 2% ​ 5% ​ (3)% ​​​​​​​​​​​​​​​​​​​​​​​​​(1)Net sales growth in U.S. dollars is calculated based on Net sales as reported in the Consolidated Statements of Income and Note 13 of the accompanying financial statements. While the term “net sales growth in U.S. dollars” is not considered a U.S. GAAP financial measure, for purposes of this table, we derive the reported (GAAP) measure based on GAAP results, which serves as the basis for the reconciliation to its comparable non-GAAP financial measures.(2)Foreign currency translation impact, a non-GAAP measure, represents the impact on net sales resulting from foreign currency exchange rate changes in the current year compared to the prior year. Such amount is calculated by subtracting current year net sales translated at average foreign currency exchange rates for the respective prior year from current year reported net sales, taken as a percentage of the respective prior year’s net sales.(3)Constant Currency Net Sales Growth and Organic Net Sales Growth are non-GAAP financial measures as defined in the “Non-GAAP Financial Measures” section.(4)Acquisition impact, a non-GAAP measure, represents the impact on net sales resulting from acquisitions closed since the beginning of the prior calendar year, which were not included in the Company’s results as of the comparable prior year and which do not reflect the underlying growth of the Company on a comparative basis. ​Geographically, net sales in the United States in 2019 increased approximately 13% in U.S. dollars ($2,524.7 in 2019 versus $2,241.4 in 2018) and 4% organically, compared to 2018. Foreign sales in 2019 decreased approximately 4% in U.S. dollars ($5,700.7 in 2019 versus $5,960.6 in 2018), 2% in constant currencies and 6% organically, compared to 2018, driven by moderations in Asia. The comparatively stronger U.S. dollar in 2019 had the effect of decreasing net sales by approximately $125.8, compared to foreign currency translation rates in 2018.30 Table of Contents​Selling, general and administrative expenses were $971.4 or 11.8% of net sales for 2019, compared to $959.5 or 11.7% of net sales for 2018. Administrative expenses were flat in 2019 compared to 2018, and represented approximately 4.7% of net sales in both years. Research and development expenses increased approximately $13.3 in 2019 primarily related to increases in expenses for new product development, and represented approximately 2.8% of net sales in 2019 and 2.7% of net sales in 2018. Selling and marketing expenses were flat in 2019 compared to 2018, and represented approximately 4.3% of net sales in both years.​Operating income was $1,619.2 or 19.7% of net sales in 2019, compared to $1,686.9 or 20.6% of net sales in 2018. Operating income for 2019 included acquisition-related expenses of $25.4, comprised of the amortization of $15.7 related to the value associated with the acquired backlog resulting from two of our 2019 acquisitions, with the remainder representing external transaction costs. Operating income for 2018 included acquisition-related expenses of $8.5, related to external transaction costs. These acquisition-related expenses are separately presented in the Consolidated Statements of Income. Excluding the effect of these acquisition-related expenses, Adjusted Operating Income and Adjusted Operating Margin, as defined in the “Non-GAAP Financial Measures” section below, were $1,644.6 or 20.0% of net sales, respectively, in 2019 and $1,695.4 or 20.7% of net sales, respectively, in 2018. ​Operating income for the Interconnect Products and Assemblies segment in 2019 was $1,722.7 or 22.0% of net sales, compared to $1,752.5 or 22.5% of net sales in 2018. The slight decrease in operating margin for the Interconnect Products and Assemblies segment for 2019 compared to 2018 was primarily driven by normal downside conversion related to the organic decline in sales as well as the impact of recent acquisitions which currently have, on average, a lower operating margin than the average of the Interconnect Products and Assemblies segment. ​Operating income for the Cable Products and Solutions segment in 2019 was $39.5 or 10.2% of net sales, compared to $52.6 or 12.5% of net sales in 2018. The decrease in operating margin for the Cable Products and Solutions segment in 2019 compared to 2018 was primarily driven by lower volumes and product mix.​Interest expense was $117.6 in 2019 compared to $101.7 in 2018. The increase is primarily due to higher average debt levels and the higher average interest rate associated with the 4.350% U.S. Senior Notes issuance in January 2019 (the net proceeds of which, along with commercial paper borrowings, were used to repay the Company’s 2.55% U.S. Senior Notes also in January 2019). ​Loss on early extinguishment of debt was $14.3 in 2019, which related to refinancing-related costs, specifically premiums and fees incurred associated with the early extinguishment of the Tendered Notes as a result of the tender offers in September 2019. Refer to Note 4 of the accompanying Consolidated Financial Statements and the Liquidity and Capital Resources section within this Item 7 for further information related to the Tendered Notes. ​Provision for income taxes was at an effective rate of 22.2% in 2019 and 23.4% in 2018. Provision for income taxes in 2019 included excess tax benefits of $38.1 from stock option exercises, which was partially offset by the tax effects related to (i) acquisition-related expenses during the year and (ii) refinancing-related costs associated with the early extinguishment of debt, each of which had an impact on the effective tax rate and earnings per share by the amounts noted in the table below. Provision for income taxes in 2018 included (i) excess tax benefits of $19.8 from stock option exercises and (ii) an income tax benefit of $14.5 related to the completion of the accounting of the income tax charge (“Tax Act Charge”) associated with the Tax Cuts and Jobs Act (“Tax Act”), which were partially offset by the tax effect related to acquisition-related expenses during the year, each of which had an impact on the effective tax rate and earnings per share by the amounts noted in the table below. These items had the aggregate effect of lowering the effective tax rate and increasing earnings per share by the amounts noted in the tables below. Excluding the effect of these items, the Adjusted Effective Tax Rate, a non-GAAP financial measure as defined in the “Non-GAAP Financial Measures” section below within this Item 7, was 24.5% and 25.5% for 2019 and 2018, respectively, as reconciled in the table below to the comparable effective tax rate based on GAAP results. For additional details related to the reconciliation between the U.S. statutory federal tax rate and the Company’s effective tax rate for these years, refer to Note 6 of the Notes to Consolidated Financial Statements. ​Net income attributable to Amphenol Corporation and Net income per common share-Diluted (“Diluted EPS”) were $1,155.0 and $3.75, respectively, for 2019, compared to $1,205.0 and $3.85, respectively, for 2018. Excluding the effect of the aforementioned items discussed above, Adjusted Net Income attributable to Amphenol Corporation and Adjusted Diluted EPS, as defined in the “Non-GAAP Financial Measures” section below within this Item 7, were $1,150.4 and $3.74, respectively, for 2019, compared to $1,177.9 and $3.77, respectively, for 2018.​31 Table of ContentsThe following table reconciles Adjusted Operating Income, Adjusted Operating Margin, Adjusted Net Income attributable to Amphenol Corporation, Adjusted Effective Tax Rate and Adjusted Diluted EPS (all defined in the “Non-GAAP Financial Measures” section below) to the most directly comparable U.S. GAAP financial measures for the years ended December 31, 2019 and 2018:​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​2019​2018​​​​​​​Net Income​​​​​​​​​​​Net Income​​​​​​​​​​​​attributable​Effective​​​​​​​​​attributable​Effective​​​​​Operating​Operating​to Amphenol​Tax ​Diluted​Operating​Operating​to Amphenol​Tax ​Diluted​​Income Margin (1) Corporation​Rate (1) ​EPS Income Margin (1) Corporation​Rate (1) ​EPSReported (GAAP)​$ 1,619.2 19.7% $ 1,155.0​ 22.2% $ 3.75​$ 1,686.9 20.6% $ 1,205.0​ 23.4% $ 3.85Acquisition-related expenses ​​ 25.4​ 0.3​​ 21.0​ (0.1)​​ 0.07​​ 8.5​ 0.1​​ 7.2​ -​​ 0.02Loss on early extinguishment of debt​​ -​ -​​ 12.5​ (0.1)​​ 0.04​​ -​ -​​ -​ -​​ -Excess tax benefits related to stock-based compensation​​ -​ -​​ (38.1)​ 2.5​​ (0.12)​​ -​ -​​ (19.8)​ 1.2​​ (0.06)Tax Act Charge (benefit)​​ -​ -​​ -​ -​​ -​​ -​ -​​ (14.5)​ 0.9​​ (0.04)Adjusted (non-GAAP)​$ 1,644.6​ 20.0% $ 1,150.4​ 24.5% $ 3.74​$ 1,695.4​ 20.7% $ 1,177.9​ 25.5% $ 3.77​(1)While the terms “operating margin” and “effective tax rate” are not considered U.S. GAAP financial measures, for purposes of this table, we derive the reported (GAAP) measures based on GAAP results, which serve as the basis for the reconciliation to their comparable non-GAAP financial measure.​Liquidity and Capital Resources​Liquidity and Cash Requirements​At December 31, 2020 and 2019, the Company had cash, cash equivalents and short-term investments of $1,738.1 and $908.6, respectively. The majority of the Company’s cash, cash equivalents and short-term investments on hand as of December 31, 2020 and 2019 was located outside of the United States. The Company used approximately $145, net of cash acquired, of its cash and cash equivalents as of December 31, 2020 to fund two acquisitions in January 2021. The Company also expects to fund the anticipated acquisition of MTS (as defined below) by the middle of 2021, through a combination of cash and cash equivalents on hand, along with borrowings under our existing revolving credit or commercial paper facilities, as discussed in more detail later within this Item 7. As of December 31, 2020, there were no outstanding borrowings under the Company’s Commercial Paper Programs and the Revolving Credit Facility (each defined below). ​Prior to the Tax Act, the Company asserted its intention to indefinitely reinvest outside of the United States all of its foreign earnings not otherwise distributed currently. For earnings occurring on or after January 1, 2018, the Tax Act’s change to a modified territorial tax system in the United States has significantly reduced the U.S. tax expense associated with the remittance of foreign earnings, among other changes. The Tax Act also imposed a one-time transition tax (“Transition Tax”) on all of the Company’s pre-2018 accumulated unremitted foreign earnings. As a result, on December 31, 2017, the Company recorded a provisional U.S. tax expense for the Transition Tax, which was adjusted and finalized in 2018. This Transition Tax on the deemed repatriation of the accumulated unremitted earnings and profits of foreign subsidiaries will be paid, net of applicable tax credits and deductions, in annual installments until 2025, as permitted under the Tax Act. ​As a result of the Tax Act, on December 31, 2017, the Company indicated an intention to repatriate most of its pre-2018 accumulated earnings and recorded the foreign and U.S. state and local tax costs related to the repatriation. The associated tax payments are due as the repatriations are made. On December 31, 2019 and 2018, the Company indicated its intention to distribute certain 2019 and 2018 foreign earnings, respectively, and accrued foreign and U.S. state and local taxes, if applicable, on those earnings as appropriate and indefinitely reinvest all remaining 2019 and 2018 foreign earnings, respectively. The Company intends to distribute certain 2020 foreign earnings and has accrued foreign and U.S. state and local taxes, if applicable, on those earnings as appropriate as of December 31, 2020, and intends to indefinitely reinvest all remaining 2020 foreign earnings. The Company intends to evaluate certain post-2020 earnings for distribution, and accrue for those distributions where appropriate, and to indefinitely reinvest all other foreign earnings. As of December 31, 2020, the Company has not provided for deferred income taxes on undistributed foreign 32 Table of Contentsearnings of approximately $900 related to certain geographies, as it is the Company’s intention to permanently reinvest such earnings outside the United States. It is impracticable to calculate the amount of taxes that would be payable if these undistributed foreign earnings were to be repatriated. ​The Company’s primary sources of liquidity are internally generated cash flow, our cash, cash equivalents and short-term investments on hand, the U.S. Commercial Paper Program, the Euro Commercial Paper Program, and the Revolving Credit Facility (each as defined below in this Item 7). The Company believes that its cash, cash equivalents and short-term investment position on hand, ability to generate future cash flow from operations, availability under its credit facilities, and access to capital markets (including the issuances of the 2025 Senior Notes in February 2020 and the 2026 Euro Notes in May 2020, each as defined and discussed further within this Item 7), provide adequate liquidity to meet its obligations for at least the next twelve months.​The Company’s primary ongoing cash requirements will be for operating and capital expenditures, the MTS acquisition, product development activities, repurchases of its Common Stock, dividends, debt service, payments associated with the Transition Tax (which is payable in annual installments until 2025), taxes due upon the repatriation of foreign earnings (which will be payable upon the repatriation of such earnings), and funding of pension obligations. The Company’s debt service requirements consist primarily of principal and interest on the Company’s Senior Notes (including the 3.125% Senior Notes due in September 2021), and to the extent of any amounts outstanding, the Revolving Credit Facility and the Commercial Paper Programs (all as defined below). The Company may also use cash to fund all or part of the cost of future acquisitions. The Company expects that capital expenditures in 2021 will be in a range of 3% to 4% of net sales.​Cash Flow Summary​The following table summarizes the Company’s cash flows from operating, investing and financing activities for the years ended December 31, 2020, 2019 and 2018, as reflected in the Consolidated Statements of Cash Flow:​​​​​​​​​​​​​Year Ended December 31, ​ 2020 2019 2018Net cash provided by operating activities ​$ 1,592.0​$ 1,502.3​$ 1,112.7Net cash used in investing activities ​ (333.5)​ (1,228.8)​ (441.8)Net cash used in financing activities ​ (516.6)​ (648.4)​ (1,070.1)Effect of exchange rate changes on cash and cash equivalents ​ 68.9​ (13.2)​ (40.6)Net change in cash and cash equivalents ​$ 810.8​$ (388.1)​$ (439.8)​Operating Activities​The ability to generate cash from operating activities is one of the Company’s fundamental financial strengths. Net cash provided by operating activities (“Operating Cash Flow”) was $1,592.0 for 2020, compared to $1,502.3 for 2019 and $1,112.7 for 2018. The increase in Operating Cash Flow for 2020 compared to 2019 is primarily due to the increase in net income, along with a lower usage of cash related to the change in working capital as discussed below. The increase in Operating Cash Flow for 2019 compared to 2018 was primarily related to a lower usage of cash related to the change in working capital. Operating Cash Flow in 2018 also reflected the Company’s voluntary cash contribution of approximately $81.0 in the first quarter of 2018 to fund our U.S. defined benefit pension plans (“U.S. Plans”, and together with its foreign plans, the “Plans”), while no such voluntary cash contribution to the U.S. Plans was made in 2019. ​In 2020, the components of working capital as presented on the accompanying Consolidated Statements of Cash Flow increased $38.9, excluding the impact of acquisitions and foreign currency translation, due to increases in accounts receivable, inventories, and prepaid expenses and other current assets of $146.3, $102.0 and $88.6, respectively, partially offset by increases in accounts payable of $204.3 and accrued liabilities, including income taxes, of $93.7. In 2019, the components of working capital as presented on the accompanying Consolidated Statements of Cash Flow increased $81.6, excluding the impact of acquisitions and foreign currency translation, primarily due to decreases in accrued liabilities, including income taxes, of $129.3 and accounts payable of $60.2, partially offset by a decrease in accounts receivable of $117.3. In 2018, the components of working capital as presented on the accompanying Consolidated Statements of Cash Flow increased $362.4, excluding the impact of acquisitions and foreign currency translation, primarily due to increases in accounts receivable, inventories, and prepaid expenses and other current assets of $237.9, 33 Table of Contents$173.3 and $47.7, respectively, partially offset by increases in accounts payable and accrued liabilities, including income taxes, of $48.8 and $47.7, respectively. ​The following describes the significant changes in the amounts as presented on the accompanying Consolidated Balance Sheets at December 31, 2020 compared to December 31, 2019. Accounts receivable increased $215.2 to $1,951.6 primarily due to higher sales in the fourth quarter of 2020 relative to the fourth quarter of 2019, along with the effect of translation from exchange rate changes at December 31, 2020 compared to December 31, 2019 (“Translation”). Days sales outstanding at December 31, 2020 and 2019 were 72 days and 73 days, respectively. Inventories increased $152.1 to $1,462.2, primarily to support higher sales levels, along with the effect of Translation. Inventory days at December 31, 2020 and 2019 were 79 days and 80 days, respectively. Prepaid expenses and other current assets increased $82.8 to $338.9, primarily due to increases in certain prepaid expenses and other current receivables. Property, plant and equipment, net, increased $55.6 to $1,054.6, primarily due to capital expenditures of $276.8 and Translation, partially offset by depreciation of $252.7 and disposals. Goodwill increased $165.0 to $5,032.1, primarily as a result of Translation, as well as goodwill recognized related to two acquisitions that closed in 2020. Other intangible assets, net, decreased $44.5 to $397.5 primarily due to the amortization of $49.6 related to the Company’s intangible assets. Other long-term assets increased $56.1 to $352.3, primarily due to an increase in operating lease right-of-use assets, along with an increase in deferred tax assets. Accounts payable increased $253.9 to $1,120.7, primarily as a result of increased purchasing activity related to higher sales levels, along with Translation. Payable days at December 31, 2020 and 2019 were 61 days and 53 days, respectively. Total accrued expenses, including accrued income taxes, increased $90.7 to $953.3, primarily as a result of an increase in accrued salaries and wages and other accrued expenses, partly offset by the contingent consideration payment (related to the SSI acquisition) of $75.0 in June 2020, a deferred purchase price payment in the third quarter of $16.2, and a decrease in accrued income taxes, primarily resulting from U.S. federal tax payments. Accrued pension and postretirement benefit obligations increased $29.8 to $228.6, primarily due to a decrease in the discount rate used to calculate the pension liabilities, partially offset by benefit payments. Other long-term liabilities, including deferred tax liabilities, increased $21.9 to $706.3, primarily as a result of an increase in deferred tax liabilities.​In 2020, 2019 and 2018, the Company made aggregate cash contributions to its defined benefit pension plans of approximately $6.5, $6.6 and $88.3, respectively. In 2018, approximately $81.0 of the contributions in that year related to the January 2018 voluntary cash contribution to fund our U.S. Plans. There is no current requirement for cash contributions to any of the Company’s U.S. Plans, and the Company plans to evaluate annually, based on actuarial calculations and the investment performance of the Plans’ assets, the timing and amount of cash contributions in the future, as discussed in more detail in Note 9 of the Notes to Consolidated Financial Statements. ​In addition to Operating Cash Flow, the Company also considers Free Cash Flow, a non-GAAP financial measure defined in the “Non-GAAP Financial Measures” section below, as a key metric in measuring the Company’s ability to generate cash. The following table reconciles Free Cash Flow to its most directly comparable U.S. GAAP financial measure for the years ended December 31, 2020, 2019 and 2018. The increase in Free Cash Flow in 2020 compared to 2019 was driven by the increase in Operating Cash Flow, as described above, and to a lesser extent, a decrease in capital expenditures. The increase in Free Cash Flow in 2019 compared to 2018 was driven by the increase in Operating Cash Flow, as described above.​​​​​​​​​​​​ 2020 2019 2018Operating Cash Flow (GAAP) $ 1,592.0 $ 1,502.3 $ 1,112.7Capital expenditures (GAAP)​ (276.8)​ (295.0)​ (310.6)Proceeds from disposals of property, plant and equipment (GAAP)​ 12.7​ 7.4​ 5.0Free Cash Flow (non-GAAP)​$ 1,327.9​$ 1,214.7​$ 807.1​Investing Activities​Cash flows from investing activities consist primarily of cash flows associated with capital expenditures, proceeds from disposals of property, plant and equipment, sales and maturities (purchases) of short-term investments, net, and acquisitions. ​Net cash used in investing activities was $333.5 in 2020, compared to $1,228.8 in 2019 and $441.8 in 2018. In 2020, net cash used in investing activities was driven primarily by capital expenditures (net of disposals) of $264.1, the use of $50.4 to fund acquisitions, and net purchases of short-term investments of $18.4. In 2019, net cash used in 34 Table of Contentsinvesting activities was driven primarily by the use of $937.4 to fund acquisitions, capital expenditures (net of disposals) of $287.6, and net purchases of short-term investments of $3.8. In 2018, net cash used in investing activities was driven primarily by capital expenditures (net of disposals) of $305.6 and the use of $158.9 to fund acquisitions, partially offset by net sales and maturities of short-term investments of $22.7.​Financing Activities​Cash flows from financing activities consist primarily of cash flows associated with borrowings and repayments of the Company’s credit facilities and other long-term debt, repurchases of common stock, proceeds from stock option exercises, dividend payments, and distributions to and purchases of noncontrolling interests. ​Net cash used in financing activities was $516.6 in 2020, compared to $648.4 in 2019 and $1,070.1 in 2018. In 2020, net cash used in financing activities was driven primarily by (i) repurchases of the Company’s common stock of $641.3, (ii) the repayments of $404.4 associated with the Company’s 2.20% U.S. Senior Notes due April 2020 and other debt, (iii) net repayments of $385.8 related to the Company’s commercial paper programs, (iv) dividend payments of $297.6, (v) payment of $75.0 related to acquisition-related contingent consideration, (vi) payment of $16.2 associated with the deferred purchase price related to an acquisition, (vii) distributions to and purchases of noncontrolling interests of $14.9, (vii) payments of costs of $8.7 related to debt financing primarily associated with the 2025 Senior Notes and 2026 Euro Notes (each as defined below), and (viii) net repayments under the Company’s credit facilities of $0.7, partially offset by (i) net cash proceeds from both the February 2020 issuance of the 2025 Senior Notes and the May 2020 issuance of the 2026 Euro Notes of $942.3 and (ii) cash proceeds of $385.7 from the exercise of stock options. In 2019, net cash used in financing activities was driven primarily by (i) the aggregate repayments of $1,111.5 associated with certain of the Company’s senior notes (the 2.55% U.S. Senior Notes due January 2019 and the early extinguishment of the Tendered Notes in September 2019) and other long-term debt, (ii) repurchases of the Company’s common stock of $601.7, (iii) dividend payments of $279.5, (iv) net repayments of $229.0 associated with the Company’s commercial paper programs, (v) distributions to and purchases of noncontrolling interests of $43.3, (vi) payments of costs of $14.9 related to debt financing primarily associated with the 2029 Senior Notes, the Revolving Credit Facility, and the 2030 Senior Notes (each as defined below), and (vii) premiums and fees paid of $13.4 related to the early extinguishment of the Tendered Notes, partially offset by (i) aggregate net cash proceeds from the issuances of the 2029 Senior Notes and the 2030 Senior Notes of $1,398.8 and (ii) cash proceeds of $246.1 from the exercise of stock options. In 2018, net cash used in financing activities was driven primarily by (i) repurchases of the Company’s common stock of $935.2, (ii) net repayments of $559.8 associated with commercial paper and other debt, (iii) dividend payments of $253.7, (iv) distributions to and purchases of noncontrolling interests of $18.2 and (v) payments of costs of $5.6 related to debt financing associated with the issuances of the 2028 Euro Notes and Euro Commercial Paper Program (each defined below), partially offset by (i) net cash proceeds of $571.7 from the October 2018 issuance of the 2028 Euro Notes and (ii) cash proceeds of $130.7 from the exercise of stock options.​The Company has significant flexibility to meet its financial commitments. The Company uses debt financing to lower the overall cost of capital and increase return on stockholders’ equity. The Company’s debt financing includes the use of the commercial paper programs, the Revolving Credit Facility and senior notes as part of its overall cash management strategy. ​On January 15, 2019, the Company amended its existing $2,000.0 unsecured credit facility with a $2,500.0 unsecured credit facility (the “Revolving Credit Facility”). The Revolving Credit Facility, which matures January 2024, gives the Company the ability to borrow, in various currencies, at a spread over LIBOR. The Company may utilize the Revolving Credit Facility for general corporate purposes. At December 31, 2020, there were no outstanding borrowings under the Revolving Credit Facility. The Revolving Credit Facility requires payment of certain annual agency and commitment fees and requires that the Company satisfy certain financial covenants. At December 31, 2020, the Company was in compliance with the financial covenants under the Revolving Credit Facility. ​The Company has a commercial paper program pursuant to which the Company may issue short-term unsecured commercial paper notes (the “USCP Notes”) in one or more private placements in the United States (the “U.S. Commercial Paper Program”). As of December 31, 2020, there were no USCP Notes outstanding.​In July 2018, the Company and one of its wholly owned European subsidiaries (collectively, the “Euro Issuer”) entered into a euro-commercial paper program (the “Euro Commercial Paper Program” and, together with the U.S. Commercial Paper Program, the “Commercial Paper Programs”) pursuant to which the Euro Issuer may issue short-term unsecured commercial paper notes (the “ECP Notes” and, together with the USCP Notes, the “Commercial Paper”), 35 Table of Contentswhich are guaranteed by the Company and are to be issued outside of the United States. The ECP Notes may be issued in Euros, Sterling, U.S. dollars or other currencies. In addition, effective April 14, 2020, a subsidiary of the Company is able to issue ECP Notes through the Bank of England’s COVID Corporate Financing Facility (the “BOE Facility”). The BOE Facility will be available until March 22, 2021, although the Company has no current intentions to borrow under the BOE Facility. As of December 31, 2020, there were no ECP Notes outstanding, including under the BOE Facility.​Amounts available under the Commercial Paper Programs may be borrowed, repaid and re-borrowed from time to time. As of December 31, 2020, the authorization from the Company’s Board of Directors limits the maximum aggregate principal amount outstanding of USCP Notes, ECP Notes, and any other commercial paper, euro-commercial paper or similar programs at any time to $2,500.0, consistent with the Revolving Credit Facility. In addition, the maximum aggregate principal amount outstanding of USCP Notes at any time is $2,500.0, while the maximum aggregate principal amount outstanding of ECP Notes at any time is $2,000.0. The Commercial Paper Programs are rated A-2 by Standard & Poor’s and P-2 by Moody’s and are currently backstopped by the Revolving Credit Facility, as amounts undrawn under the Company’s Revolving Credit Facility are available to repay Commercial Paper, if necessary. Net proceeds of the issuances of Commercial Paper are expected to be used for general corporate purposes. The Company reviews its optimal mix of short-term and long-term debt regularly and may replace certain amounts of Commercial Paper, short-term debt and current maturities of long-term debt with new issuances of long-term debt in the future.​On March 20, 2020, the Company, through one of its wholly owned foreign subsidiaries, borrowed $100.0 (the maximum borrowing capacity) on an uncommitted line of credit, at a variable LIBOR-based interest rate, initially set at 1.92%. This line of credit, which was guaranteed by the Company and carried an interest rate of LIBOR plus 80 basis points, expired on December 19, 2020. Borrowings under this line of credit arrangement were used for general corporate purposes. Prior to maturity, on May 5, 2020, the Company repaid, in full, the outstanding borrowing on this uncommitted line of credit, using cash and cash equivalents on hand. ​As of December 31, 2020, the Company has outstanding senior notes (the “Senior Notes”) as follows:​​​​​​​Principal Interest ​Amount Rate​Maturity$ 227.7 3.125% September 2021​ 295.0 4.00% February 2022​ 350.0 3.20% April 2024​ 400.0 2.050% March 2025​ 500.0 4.350% June 2029​ 900.0 2.80% February 2030​​​​​​€ 500.0​0.750% May 2026 (Euro Notes)​ 500.0 2.00% October 2028 (Euro Notes)​On February 20, 2020, the Company issued $400.0 principal amount of unsecured 2.050% Senior Notes due March 1, 2025 at 99.829% of face value (the “2025 Senior Notes”). On April 1, 2020, the Company used the net proceeds from the 2025 Senior Notes to repay the $400.0 principal amount of unsecured 2.20% Senior Notes due April 1, 2020 upon maturity.​On January 9, 2019, the Company issued $500.0 principal amount of unsecured 4.350% Senior Notes due June 1, 2029 at 99.904% of face value (the “2029 Senior Notes”), the net proceeds of which were used, along with proceeds from borrowings under the U.S. Commercial Paper Program, to repay the $750.0 principal amount of unsecured 2.55% Senior Notes due in January 2019.​On September 4, 2019, the Company commenced tender offers (the “Tender Offers”) to purchase for cash any and all of the Company’s outstanding (i) $375.0 principal amount of 3.125% Senior Notes due September 2021 (the “2021 Senior Notes”) and (ii) $500.0 principal amount of 4.00% Senior Notes due February 2022 (the “2022 Senior Notes”). On September 11, 2019, as a result of the Tender Offers, the Company accepted for payment $147.3 aggregate principal amount of the 2021 Senior Notes and $205.0 aggregate principal amount of the 2022 Senior Notes for 101.9% and 104.5% of par value, respectively (collectively, the “Tendered Notes”), plus accrued and unpaid interest to, but not including, the settlement date of the Tender Offers. The total consideration for the Tendered Notes was $368.8, which in addition to the Tendered Notes, included $13.4 of premiums and fees paid related to the early extinguishment of debt 36 Table of Contentsand $3.1 of accrued interest. The remaining principal amounts associated with the 2021 Senior Notes and 2022 Senior Notes, which were not redeemed as a result of the Tender Offers, remain outstanding as of December 31, 2020. ​On September 10, 2019, the Company issued $900.0 principal amount of unsecured 2.800% Senior Notes due February 15, 2030 at 99.920% of face value (the “2030 Senior Notes”). In September 2019, the Company used the net proceeds from the 2030 Senior Notes to fund the cash consideration payable in the Tender Offers, with the remaining net proceeds being used for general corporate purposes, including to partially reduce outstanding borrowings related to the U.S. Commercial Paper Program. ​All of the Company’s outstanding senior notes in the United States (the “U.S. Senior Notes”) are unsecured and rank equally in right of payment with the Company’s other unsecured senior indebtedness. Interest on each series of U.S. Senior Notes is payable semiannually. The Company may, at its option, redeem some or all of any series of U.S. Senior Notes, subject to certain terms and conditions. The 2021 Senior Notes are due in September 2021 and are therefore recorded, net of the related unamortized discount and debt issuance costs, within Current portion of long-term debt in the accompanying Consolidated Balance Sheets as of December 31, 2020.​On May 4, 2020, the Euro Issuer issued €500.0 (approximately $545.4 at date of issuance) principal amount of unsecured 0.750% Senior Notes due May 4, 2026 at 99.563% of face value (the “2026 Euro Notes” or “0.750% Euro Senior Notes”). The Company used the net proceeds from the 2026 Euro Notes to repay amounts outstanding under its Revolving Credit Facility.​On October 8, 2018, the Euro Issuer issued €500.0 (approximately $574.6 at date of issuance) principal amount of unsecured 2.000% Senior Notes due October 8, 2028 at 99.498% of face value (the “2028 Euro Notes”, collectively with the 2026 Euro Notes, “Euro Notes”, and collectively with the 2026 Euro Notes and the U.S. Senior Notes, the “Senior Notes”). The Company used a portion of the net proceeds from the 2028 Euro Notes to repay a portion of the outstanding amounts under its Commercial Paper Programs, with the remainder of the net proceeds being used for general corporate purposes. ​The Euro Notes are unsecured and rank equally in right of payment with the Euro Issuer’s other unsecured senior indebtedness, and are fully and unconditionally guaranteed on a senior unsecured basis by the Company. Interest on each series of Euro Notes is payable annually. The Company may, at its option, redeem some or all of any series of Euro Notes, subject to certain terms and conditions.​The Company’s Senior Notes contain certain financial and non-financial covenants. At December 31, 2020, the Company was in compliance with the financial covenants under its Senior Notes. Refer to Note 4 of the Notes to Consolidated Financial Statements for further information related to the Company’s debt.​In April 2018, the Company’s Board of Directors authorized a stock repurchase program under which the Company may purchase up to $2,000.0 of the Company’s Common Stock during the three-year period ending April 24, 2021 (the “2018 Stock Repurchase Program”) in accordance with the requirements of Rule 10b-18 of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). During the years ended December 31, 2020, 2019 and 2018, the Company repurchased 6.0 million, 6.5 million and 6.4 million shares of its Common Stock for $641.3, $601.7 and $553.2, respectively, under the 2018 Stock Repurchase Program. Of the total repurchases in 2020, 1.4 million shares, or $153.9, have been retained in Treasury stock at time of repurchase; the remaining 4.6 million shares, or $487.4, have been retired by the Company. Of the total repurchases in 2019, 1.0 million shares, or $87.6, were retained in Treasury stock at time of repurchase; the remaining 5.5 million shares, or $514.1, were retired by the Company. Of the total repurchases in 2018, 0.7 million shares, or $55.0, were retained in Treasury stock at time of repurchase; the remaining 5.7 million shares, or $498.2, were retired by the Company. From January 1, 2021 through January 31, 2021, the Company repurchased $4.0 of its Common Stock, and has remaining authorization to purchase up to $199.8 of its Common Stock under the 2018 Stock Repurchase Program. The price and timing of any future purchases under the 2018 Stock Repurchase Program will depend on a number of factors such as levels of cash generation from operations, the level of uncertainty relating to the COVID-19 pandemic, the volume of stock option exercises by employees, cash requirements for acquisitions, dividends, economic and market conditions and stock price. ​37 Table of ContentsIn January 2017, the Company’s Board of Directors authorized a stock repurchase program under which the Company could purchase up to $1,000.0 of the Company’s Common Stock during the two-year period ending January 24, 2019 (the “2017 Stock Repurchase Program”) in accordance with the requirements of Rule 10b-18 of the Exchange Act. During the three months ended March 31, 2018, the Company repurchased 4.2 million shares of its Common Stock for $382.0, all of which were retired by the Company; these repurchases completed the $1,000.0 2017 Stock Repurchase Program. The repurchases in the first quarter of 2018, coupled with the Company’s repurchase of 6.4 million shares of its Common Stock for $553.2 under the 2018 Stock Repurchase Program during the nine months ended December 31, 2018, resulted in total repurchases of 10.6 million shares for $935.2 during the year ended December 31, 2018.​Contingent upon declaration by the Board of Directors, the Company generally pays a quarterly dividend on shares of its Common Stock. On October 20, 2020, the Company’s Board of Directors approved an increase to its quarterly dividend rate from $0.25 per share to $0.29 per share effective with dividends declared in the fourth quarter of 2020. The following table summarizes the declared quarterly dividends per share for each of the three years ended December 31, 2020, 2019 and 2018:​​​​​​​​​​​​ 2020​2019​2018First Quarter​$ 0.25​$ 0.23​$ 0.19Second Quarter​​ 0.25​​ 0.23​​ 0.23Third Quarter​​ 0.25​​ 0.25​​ 0.23Fourth Quarter​​ 0.29​​ 0.25​​ 0.23Total​$ 1.04​$ 0.96​$ 0.88​The following table summarizes the dividends declared and paid for the years ended December 31, 2020, 2019 and 2018:​​​​​​​​​​​​ 2020​2019​2018Dividends declared​$ 310.0​$ 285.3​$ 264.3Dividends paid (including those declared in the prior year)​ 297.6​ 279.5​ 253.7​LIBOR Transition​In July 2017, the United Kingdom's Financial Conduct Authority, which regulates the London Interbank Offered Rate (“LIBOR”), announced its intent to phase out the use of LIBOR by the end of 2021. On December 4, 2020, the ICE Benchmark Administration published a consultation on its intention to extend the publication of certain U.S. dollar LIBOR (“USD LIBOR”) rates until June 30, 2023. The U.S. Federal Reserve, in conjunction with the Alternative Reference Rates Committee, a steering committee comprised of large U.S. financial institutions, identified the Secured Overnight Financing Rate (the “SOFR”) as its preferred benchmark alternative to USD LIBOR. The SOFR represents a measure of the cost of borrowing cash overnight, collateralized by U.S. Treasury securities, and is calculated based on directly observable U.S. Treasury-backed repurchase transactions. In March 2020, in response to this transition, the Financial Accounting Standards Board (“FASB”) issued accounting guidance providing certain optional expedients and exceptions for applying U.S. GAAP to contracts, hedging relationships and other transactions that reference LIBOR or another reference rate expected to be discontinued by reference rate reform, and addresses operational issues likely to arise in modifying contracts to replace discontinued reference rates with new rates. In January 2021, the FASB issued further clarifying guidance surrounding derivatives, as it relates to this transition. The Company is evaluating the potential impact of the replacement of LIBOR from both a risk management and financial reporting perspective. Our current portfolio of debt and financial instruments currently tied to LIBOR consists primarily of our Revolving Credit Facility, which had no outstanding borrowings as of December 31, 2020. Due to our current limited reliance on borrowings tied to LIBOR, the Company does not currently believe that this transition will have a material impact on our financial condition, results of operations or cash flows. ​Pensions​The Company and certain of its subsidiaries in the United States have defined benefit pension plans (“U.S. Plans”), which cover certain U.S. employees and which represent the majority of the plan assets and benefit obligations of the aggregate defined benefit plans of the Company. The U.S. Plans’ benefits are generally based on years of service and compensation and are generally noncontributory. The majority of U.S. employees are not covered by the U.S. Plans and are covered by defined contribution plans. Certain foreign subsidiaries also have defined benefit plans covering their employees (the “Foreign Plans” and, together with the U.S. Plans, the “Plans”). The total liability for accrued pension and postretirement benefit obligations associated with the Company’s underfunded pension and postretirement benefit plans increased in 2020 to $211.0 from $184.8 in 2019 primarily due to the impact of lower discount rates on our projected benefit obligation, which was partially offset by actual returns on plan assets. In 2018, the Company also 38 Table of Contentsmade a voluntary cash contribution of $81.0 to fund the U.S. Plans. There is no current requirement for cash contributions to any of the U.S. Plans, and the Company plans to evaluate annually, based on actuarial calculations and the investment performance of the Plans’ assets, the timing and amount of cash contributions in the future. ​Refer to Note 9 of the Notes to Consolidated Financial Statements for further discussion of the Company’s benefit plans and other postretirement benefit plans.​Acquisitions​During 2020, the Company completed two acquisitions for $50.4, net of cash acquired. The 2020 acquisitions were included in the Interconnect Products and Assemblies segment and were not material, either individually or in the aggregate, to the Company. During 2019, the Company completed nine acquisitions (including the January 2019 acquisition of SSI Controls Technologies) for $937.4, net of cash acquired. All but one of the acquisitions in 2019 were included in the Interconnect Products and Assemblies segment. These 2019 acquisitions were not material, either individually or in the aggregate, to the Company.​On December 9, 2020, Amphenol announced that the Company entered into a definitive agreement under which Amphenol will acquire MTS Systems Corporation (Nasdaq: MTSC) (“MTS”) for $58.50 per share in cash, or approximately $1,700, net of cash acquired and including the assumption of outstanding debt and liabilities. MTS, which is headquartered in the state of Minnesota in the United States, is a leading global supplier of precision sensors, advanced test systems and motion simulators. MTS is organized into two business segments: Sensors and Test & Simulation. The Sensors segment represents a highly complementary offering of high-technology, harsh environment sensors sold into diverse end markets and applications. The Company expects the MTS acquisition to further expand our range of sensor and sensor-based products across a wide array of industries. The definitive agreement to acquire MTS has been unanimously approved by the boards of both companies and is expected to close by the middle of 2021, subject to certain regulatory approvals, approval from MTS’s shareholders and other customary closing conditions. Amphenol expects to fund the MTS acquisition through a combination of cash and cash equivalents on hand, along with borrowings under our existing revolving credit or commercial paper facilities. ​On January 19, 2021, the Company announced that it has entered into an agreement to sell the MTS Test & Simulation business to Illinois Tool Works Inc. (NYSE: ITW). The sale of this business is expected to close following the anticipated closing of our acquisition of MTS, subject to certain regulatory approvals and other customary closing conditions.​In January 2021, the Company also completed two acquisitions, each in the Interconnect Products and Assemblies segment, for approximately $145, net of cash acquired. These acquisitions, which were funded using cash and cash equivalents on hand, are not material, either individually or in the aggregate, to the Company’s financial results. ​For further discussion of the Company’s acquisitions, refer to Note 11 of the Notes to Consolidated Financial Statements.​Stock Split​On January 27, 2021, the Company announced that its Board of Directors approved a two-for-one split of the Company’s common stock. The stock split will be effected in the form of a stock dividend paid to shareholders of record as of the close of business on February 16, 2021. The Company expects the additional shares will be distributed on March 4, 2021. Refer to Note 8 of the Notes to Consolidated Financial Statements for the pro forma effect of this stock split as if it had been effective for all years presented.​Environmental Matters​Certain operations of the Company are subject to environmental laws and regulations which govern the discharge of pollutants into the air and water, as well as the handling and disposal of solid and hazardous wastes. The Company believes that its operations are currently in substantial compliance with applicable environmental laws and regulations and that the costs of continuing compliance will not have a material adverse effect on the Company’s financial condition, results of operations or cash flows. For more information on certain environmental matters, refer to Note 14 of the Notes to Consolidated Financial Statements.​39 Table of ContentsInflation and Costs​The cost of the Company’s products is influenced by the cost of a wide variety of raw materials. The Company strives to offset the impact of increases in the cost of raw materials, labor and services through price increases, productivity improvements and cost saving programs. However, in certain markets, particularly in communications related markets, implementing price increases can be difficult and there is no guarantee that the Company will be successful. For a discussion of certain risks related to inflation and costs, refer to the risk factor titled “The Company has at times experienced difficulties in obtaining a consistent supply of materials at stable pricing levels” in Part I, Item 1A herein.​Foreign Exchange​The Company conducts business in many foreign currencies through its worldwide operations, and as a result is subject to foreign exchange exposure due to changes in exchange rates of the various currencies including possible currency devaluations. Changes in exchange rates can positively or negatively affect the Company’s sales, operating margins and equity. The Company attempts to minimize currency exposure risk in a number of ways including producing its products in the same country or region in which the products are sold, thereby generating revenues and incurring expenses in the same currency, cost reduction and pricing actions, working capital management and hedging contracts. However, there can be no assurance that these actions will be fully effective in managing currency risk, including in the event of a significant and sudden decline in the value of any of the foreign currencies of the Company’s worldwide operations. For further discussion of foreign exchange exposures, risks and uncertainties, refer to the risk factor titled “The Company’s results have at times been negatively affected by foreign currency exchange rates” in Part I, Item 1A herein.​Non-GAAP Financial Measures​In addition to assessing the Company’s financial condition, results of operations, liquidity and cash flows in accordance with U.S. GAAP, management utilizes certain non-GAAP financial measures defined below as part of its internal reviews for purposes of monitoring, evaluating and forecasting the Company’s financial performance, communicating operating results to the Company’s Board of Directors and assessing related employee compensation measures. Management believes that these non-GAAP financial measures may be helpful to investors in assessing the Company’s overall financial performance, trends and year-over-year comparative results, in addition to the reasons noted below. Non-GAAP financial measures related to operating income, operating margin, net income attributable to Amphenol Corporation, effective tax rate and diluted EPS exclude income and expenses that are not directly related to the Company’s operating performance during the years presented. Items excluded in the presentation of such non-GAAP financial measures in any period may consist of, without limitation, acquisition-related expenses, refinancing-related costs, and certain discrete tax items including but not limited to (i) the excess tax benefits related to stock-based compensation and (ii) the impact of significant changes in tax law. Non-GAAP financial measures related to net sales exclude the impact related to foreign currency exchange and acquisitions. The non-GAAP financial information contained herein is included for supplemental purposes only and should not be considered in isolation, as a substitute for or superior to the related U.S. GAAP financial measures. In addition, these non-GAAP financial measures are not necessarily the same or comparable to similar measures presented by other companies, as such measures may be calculated differently or may exclude different items. ​The non-GAAP financial measures defined below should be read in conjunction with the Company’s financial statements presented in accordance with U.S. GAAP. The reconciliations of these non-GAAP financial measures to the most directly comparable U.S. GAAP financial measures for the years ended December 31, 2020, 2019 and 2018 are included in “Results of Operations” and “Liquidity and Capital Resources” within this Item 7: ​●Adjusted Diluted EPS is defined as diluted earnings per share (as reported in accordance with U.S. GAAP), excluding income and expenses and their specific tax effects that are not directly related to the Company’s operating performance during the years presented. Adjusted Diluted EPS is calculated as Adjusted Net Income attributable to Amphenol Corporation, as defined below, divided by the weighted average outstanding diluted shares as reported in the Consolidated Statements of Income.​●Adjusted Effective Tax Rate is defined as Provision for income taxes, as reported in the Consolidated Statements of Income, expressed as a percentage of Income before income taxes, as reported in the Consolidated Statements of Income, each excluding the income and expenses and their specific tax effects that are not directly related to the Company’s operating performance during the years presented.40 Table of Contents​●Adjusted Net Income attributable to Amphenol Corporation is defined as Net income attributable to Amphenol Corporation, as reported in the Consolidated Statements of Income, excluding income and expenses and their specific tax effects that are not directly related to the Company's operating performance during the years presented.​●Adjusted Operating Income is defined as Operating income, as reported in the Consolidated Statements of Income, excluding income and expenses that are not directly related to the Company's operating performance during the years presented.​●Adjusted Operating Margin is defined as Adjusted Operating Income (as defined above) expressed as a percentage of Net sales (as reported in the Consolidated Statements of Income).​●Constant Currency Net Sales Growth is defined as the year-over-year percentage change in net sales growth, excluding the impact of changes in foreign currency exchange rates. Amphenol’s results are subject to volatility related to foreign currency translation fluctuations. As such, management evaluates the Company’s sales performance based on actual sales growth in U.S. dollars, as well as Organic Net Sales Growth (defined below) and Constant Currency Net Sales Growth, and believes that such information is useful to investors to assess the underlying sales trends.​●Free Cash Flow is defined as (i) Net cash provided by operating activities (“Operating Cash Flow” - as reported in accordance with U.S. GAAP) less (ii) capital expenditures (as reported in accordance with U.S. GAAP), net of proceeds from disposals of property, plant and equipment (as reported in accordance with U.S. GAAP), all of which are derived from the Consolidated Statements of Cash Flow. Free Cash Flow is an important liquidity measure for the Company, as we believe it is useful for management and investors to assess our ability to generate cash, as well as to assess how much cash can be used to reinvest in the growth of the Company or to return to shareholders through either stock repurchases or dividends.​●Organic Net Sales Growth is defined as the year-over-year percentage change in net sales growth resulting from operating volume and pricing changes, and excludes the impact of (i) changes in foreign currency exchange rates, which directly impact the Company’s operating results and are outside the control of the Company and (ii) acquisitions closed since the beginning of the prior calendar year, which were not included in the Company’s results as of the comparable prior year periods and which do not reflect the underlying growth of the Company on a comparative basis. Management evaluates the Company’s sales performance based on actual sales growth in U.S. dollars, as well as Constant Currency Net Sales Growth (defined above) and Organic Net Sales Growth, and believes that such information is useful to investors to assess the underlying sales trends. ​Recent Accounting Pronouncements​Refer to Note 1 of the Notes to Consolidated Financial Statements for a discussion of recently issued accounting pronouncements, including those adopted by the Company.​​Critical Accounting Policies and Estimates​The preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. Management bases its estimates on historical experience along with other assumptions that we believe are reasonable in formulating our bases for making judgements regarding the carrying amounts of assets and liabilities that are not readily apparent elsewhere. Estimates are adjusted as new information becomes available. Actual results could differ from those estimates. The Company believes that the most significant areas involving critical accounting policies are set forth below. The significant accounting policies are more fully described in Note 1 of the Notes to Consolidated Financial Statements.​Revenue Recognition ​Topic 606​The Company’s net sales in the Consolidated Statements of Income for the years ended December 31, 2020, 2019 and 2018 are presented under Accounting Standards Update (“ASU”) No. 2014-09, Revenue from Contracts with 41 Table of ContentsCustomers (Topic 606) (collectively with its related subsequent amendments, “Topic 606”), resulting from the modified retrospective adoption of Topic 606 applied to those contracts which were not completed as of January 1, 2018. ​The Company’s primary source of revenues consist of product sales to either end customers and their appointed contract manufacturers (including original equipment manufacturers) or to distributors. Our revenues are derived from contracts with customers, which in most cases are customer purchase orders that may be governed by master sales agreements. For each contract, the promise to transfer the control of the products, each of which is individually distinct, is considered to be the identified performance obligation. As part of the consideration promised in each contract, the Company evaluates the customer’s credit risk. Our contracts do not have any significant financing components, as payment terms are generally due net 30 to 120 days after delivery. Although products are almost always sold at fixed prices, in determining the transaction price, we evaluate whether the price is subject to refund (due to returns) or adjustment (due to volume discounts, rebates, or price concessions) to determine the net consideration we expect to be entitled to. We allocate the transaction price to each distinct product based on its relative standalone selling price. Taxes assessed by governmental authorities and collected from the customer, including but not limited to sales and use taxes and value-added taxes, are not included in the transaction price. ​The vast majority of our sales are recognized at a point-in-time under the core principle of recognizing revenue when control transfers to the customer, which generally occurs when we ship or deliver the product from our manufacturing facility to our customers, when our customer accepts and has legal title of the goods, and where the Company has a present right to payment for such goods. Based on the respective contract terms, most of our contracts’ revenues are recognized either (i) upon shipment based on free on board (“FOB”) shipping point, (ii) when the product arrives at its destination or (iii) when the products are pulled from consignment inventory. For the years ended December 31, 2020, 2019 and 2018, less than 5% of our net sales were recognized over time, where the associated contracts relate to the sale of goods with no alternative use as they are only sold to a single customer and whose underlying contract terms provide the Company with an enforceable right to payment, including a reasonable profit margin, for performance completed to date, in the event of customer termination. For the contracts recognized over time, we typically record revenue using the input method, based on the materials and labor costs incurred to date relative to the contract’s total estimated costs. This method reasonably depicts when and as control of the goods transfers to the customer, since it measures our progress in producing the goods which is generally commensurate with this transfer of control. Since we typically invoice our customers at the same time that we satisfy our performance obligations, contract assets and contract liabilities related to our contracts with customers recorded in the Consolidated Balance Sheets were not material as of December 31, 2020 and 2019. ​Income Taxes​Deferred income taxes are provided for revenue and expenses which are recognized in different periods for income tax and financial statement reporting purposes. The Company recognizes the effects of changes in tax laws and rates on deferred income taxes in the period in which legislation is enacted. Deferred income taxes are provided on undistributed earnings of foreign subsidiaries in the period in which the Company determines it no longer intends to permanently reinvest such earnings outside the United States. As of December 31, 2020, the Company has not provided for deferred income taxes on undistributed foreign earnings of approximately $900 related to certain geographies, as it is the Company’s intention to permanently reinvest such earnings outside the United States. It is impracticable to calculate the amount of taxes that would be payable if these undistributed foreign earnings were to be repatriated. In addition, the Company remains indefinitely reinvested with respect to its financial statement basis in excess of tax basis of its investments in foreign subsidiaries. It is not practicable to determine the deferred tax liability with respect to such basis differences. Deferred tax assets are regularly assessed for recoverability based on both historical and anticipated earnings levels and a valuation allowance is recorded when it is more likely than not that these amounts will not be recovered. The tax effects of an uncertain tax position taken or expected to be taken in income tax returns are recognized only if it is “more likely than not” to be sustained on examination by the taxing authorities, based on its technical merits as of the reporting date. The tax benefits recognized in the financial statements from such a position are measured based on the largest benefit that has a greater than fifty percent likelihood of being realized upon ultimate settlement. The Company includes estimated interest and penalties related to unrecognized tax benefits in the provision for income taxes. ​As a result of the Tax Act, in 2017, the Company recorded (i) a provisional income tax charge related to the deemed repatriation of the accumulated unremitted earnings and profits of foreign subsidiaries, (ii) a provisional income tax charge related to changes in the Company’s permanent reinvestment assertion with regards to prior accumulated unremitted earnings from certain foreign subsidiaries, partially offset by (iii) a provisional income tax benefit associated 42 Table of Contentswith the remeasurement of its net deferred tax liabilities due to the U.S. federal corporate tax rate reduction, and included these amounts in its consolidated financial statements for the year ended December 31, 2017. The accounting associated with each of the provisional amounts was completed in 2018. Beginning in 2018, the global intangible low-taxed income (“GILTI”) provision imposed a tax on certain earnings of foreign subsidiaries. The Company elected an accounting policy to account for GILTI as a period cost. The U.S. Treasury Department has issued final interpretive guidance relating to certain provisions of the Tax Act and proposed additional guidance related to the same provisions. The Company will account for the impact of additional guidance in the period in which any new guidance is released, if appropriate.​Disclosures about contractual obligations and commitments​The following table summarizes the Company’s known obligations to make future payments pursuant to certain contracts as of December 31, 2020, as well as an estimate of the timing in which such obligations are expected to be satisfied.​​​​​​​​​​​​​​​​​​​​Payment Due By Period Contractual Obligations ​​ Less than 1-3 3-5 More than (dollars in millions)​Total​1 year​years​years​5 years Debt (1)​$ 3,894.3​$ 230.5​$ 296.3​$ 750.5​$ 2,617.0​Interest related to senior notes (1)​ 650.4​ 102.1​ 172.2​ 145.4​ 230.7​Operating leases (2)​ 246.8​ 72.7​ 85.8​ 45.2​ 43.1​Purchase obligations (3)​ 462.6​ 424.1​ 34.6​ 2.1​ 1.8​Accrued pension and postretirement benefit obligations (4)​ 60.4​ 7.2​ 11.3​ 12.5​ 29.4​Transition tax (5)​ 97.6​ 15.8​ 45.4​ 36.4​ —​Total (6)​$ 5,412.1​$ 852.4​$ 645.6​$ 992.1​$ 2,922.0​​(1)The Company has excluded expected interest payments on the Revolving Credit Facility, U.S. Commercial Paper Program and Euro Commercial Paper Program from the above table, as this calculation is largely dependent on average debt levels the Company expects to have during each of the years presented. The actual interest payments made related to the Company’s Revolving Credit Facility and both Commercial Paper Programs combined, in 2020, were approximately $4.6. Expected debt levels, and therefore expected interest payments, are difficult to predict, as they are significantly impacted by such items as future acquisitions, repurchases of common stock, dividend payments as well as payments or additional borrowings made to reduce or increase the underlying revolver balance.​(2)The Company’s operating lease payments included in this table reflect the future minimum undiscounted fixed lease payments, which serve as the basis for calculating the Company’s operating lease liabilities as of December 31, 2020. The table above excludes any variable lease payments not included in the measurement of the Company’s right-of-use assets and operating lease liabilities in accordance with ASC Topic 842, due to their uncertainty. Finance leases are not material to the Company individually or in the aggregate and as such, have been excluded from the table above. ​(3)Purchase obligations relate primarily to open purchase orders for goods and services, including but not limited to, raw materials and components to be used in production.​(4)Included in this table are estimated benefit payments expected to be made under the Company’s unfunded pension and postretirement benefit plans, as well as the anticipated minimum required contributions under the Company’s funded pension plans, the most significant funded plan of which covers certain of its U.S. employees. Over the past several years, there has been no minimum requirement for Company contributions to the U.S. Plans due to prior contributions made in excess of minimum requirements and as a result, there was no anticipated minimum required contribution included in the table above related to the U.S. Plans for 2021. However, the Company did make a voluntary contribution of approximately $81.0 in 2018 to fund the U.S. Plans, while no such voluntary contribution was made in 2020 and 2019. It is not possible to reasonably estimate expected required contributions in the above table after 2021 since several assumptions are required to calculate minimum required contributions, such as the discount rate and expected returns on pension assets.​(5)As a result of the enactment of the Tax Act in December 2017, the Company recorded a provisional tax charge on the deemed repatriation of the accumulated unremitted earnings and profits of foreign subsidiaries (“Transition Tax”) for the year ended December 31, 2017, based on certain assumptions made upon the Company’s then current interpretation of the Tax Act. The Company analyzed guidance and technical interpretations issued in 2018 related to the provisions of the Tax Act, and refined, analyzed and updated the underlying data, computations and assumptions used to prepare the provisional amount, and consequently completed its accounting and recorded an adjustment related to the Transition Tax. The amounts noted in the table above reflect the final Transition Tax, which is net of applicable tax credits and deductions, and in accordance with the Tax Act, is to be paid over the eight year period starting in 2018. The third installment of the Transition Tax was paid in the third quarter of 2020. ​(6)As of December 31, 2020, the Company has recorded net liabilities of approximately $168.2 related to unrecognized tax benefits. These liabilities have been excluded from the above table due to the high degree of uncertainty regarding the timing of potential future cash flows; it is difficult to make a reasonably reliable estimate of the amount and period in which all of these liabilities might be paid.​43 Table of ContentsItem 7A. Quantitative and Qualitative Disclosures About Market Risk​(amounts in millions)​The Company, in the normal course of doing business, is exposed to a variety of risks, including market risks associated with foreign currency exchange rates and changes in interest rates. The Company does not have any significant concentration with any one counterparty.​Foreign Currency Exchange Rate Risk​The Company conducts business in many foreign currencies through its worldwide operations, and as a result is subject to foreign exchange exposure due to changes in exchange rates of the various currencies. Changes in exchange rates can positively or negatively affect the Company’s sales, operating margins and equity. The Company attempts to manage currency exposure risk in a number of ways including producing its products in the same country or region in which the products are sold (thereby generating revenues and incurring expenses in the same currency), cost reduction and pricing actions, working capital management and hedging contracts. However, there can be no assurance that these actions will be fully effective in managing currency risk, including in the event of a significant and sudden decline in the value of any of the foreign currencies of the Company’s worldwide operations.​In May 2020, the Company and one of its wholly owned European subsidiaries (collectively, the “Euro Issuer”) issued €500.0 (approximately $545.4) principal amount of unsecured 0.750% senior notes (“2026 Euro Notes”) due May 4, 2026. In October 2018, the Euro Issuer issued €500.0 (approximately $574.6) principal amount of unsecured 2.000% senior notes (“2028 Euro Notes” and collectively with the 2026 Euro Notes, the “Euro Notes”) due October 8, 2028. In July 2018, the Euro Issuer entered into a euro-commercial paper program (the “Euro Commercial Paper Program” and collectively with the U.S. Commercial Paper Program, “Commercial Paper Programs”). While the Euro Notes are denominated in Euros, any borrowings under the Company’s Euro Commercial Paper Program and Revolving Credit Facility may be denominated in various foreign currencies, including the Euro. When borrowing in foreign currencies, there can be no assurance that the Company can successfully manage these changes in exchange rates, including in the event of a significant and sudden decline in the value of any of the foreign currencies for which such borrowings are made. Refer to Note 4 of the Notes to Consolidated Financial Statements for a discussion of debt.​The Company utilizes foreign exchange forward contracts to hedge foreign currency exchange rate fluctuations for exposures associated with (i) certain transactions denominated in foreign currencies and (ii) the net investments in certain foreign subsidiaries from which we expect to repatriate earnings to the United States. As of December 31, 2020, the fair value of such contracts was not material. A 10% change in foreign currency exchange rates would not have a material effect on the value of the hedges as of December 31, 2020 and 2019. The Company does not engage in purchasing forward contracts for trading or speculative purposes, and our derivative financial instruments are with large financial institutions with strong credit ratings. As of December 31, 2020, the Company does not have any significant concentration of exposure with any one counterparty. Refer to Note 1 and Note 5 of the Notes to Consolidated Financial Statements for a discussion of derivative financial instruments.​Interest Rate Risk​The Company is subject to market risk from exposure to changes in interest rates based on the Company’s financing activities. The Company manages its exposure to interest rate risk through a mix of fixed and variable rate debt. The Company currently has various fixed rate series of senior notes outstanding over various maturity dates, two of which were issued in 2020. In February 2020, the Company issued $400.0 principal amount of unsecured 2.050% Senior Notes due March 1, 2025, the net proceeds of which were used to repay the $400.0 principal amount of 2.20% Senior Notes due April 1, 2020 upon maturity. In May 2020, the Euro Issuer issued the unsecured 0.750% 2026 Euro Notes, the net proceeds of which were used to repay amounts outstanding under our Revolving Credit Facility.​While there were no such outstanding borrowings as of December 31, 2020, any borrowings under the Revolving Credit Facility either bear interest at or trade at rates that fluctuate with a spread over LIBOR, and any borrowings under the Commercial Paper Programs are subject to floating interest rates. Therefore, when the Company borrows under these debt instruments, the Company is exposed to market risk related to changes in interest rates. As of December 31, 2020, there were no outstanding borrowings under the Revolving Credit Facility and Commercial Paper Programs, and therefore, the amount of outstanding borrowings subject to floating interest rates was not material. As of December 31, 2019, approximately $400, or 11% of the Company’s outstanding borrowings, which related primarily to the Company’s Commercial Paper Programs, were subject to floating interest rates; the Company’s average floating rate on borrowings under the U.S. Commercial Paper Program and Euro Commercial Paper Program as of December 31, 2019 was 1.85% and (0.13)%, respectively. A 10% change in the interest rate at December 31, 2020 and 2019 under our Revolving Credit Facility or Commercial Paper Programs would not have a material effect on interest expense. The Company does not expect changes in interest rates to have a material effect on income or cash flows in 2021, although there can be no assurances that interest rates will not change significantly.44 Table of Contents
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+Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations ("MD&A")Management’s Discussion and Analysis of Financial Condition and Results of Operations ("MD&A") is designed to provide a reader of our consolidated financial statements with a narrative from the perspective of our management on our financial condition, results of operations, liquidity and certain other factors that may affect our future results. Our MD&A should be read in conjunction with the other sections of this Annual Report on Form 10-K, including Part I, Item 1A: “Risk Factors” and Part II, Item 8: “Financial Statements and Supplementary Data.” The various sections of this MD&A contain a number of forward-looking statements, all of which are based on our current expectations and could be affected by the uncertainties and risk factors described throughout this filing. The tables in the MD&A sections below are derived from exact numbers and may have immaterial rounding differences.This section discusses our results of operations for the year ended December 31, 2020 as compared to the year ended December 31, 2019. For a discussion and analysis of the year ended December 31, 2019, compared to the same period in 2018 please refer to Management’s Discussion and Analysis of Financial Condition and Results of Operations included in Part II, Item 7 of our Annual Report on Form 10-K for the year ended December 31, 2019, filed with the SEC on February 27, 2020.OverviewAxon is a global network of devices, apps and people that helps public safety personnel become smarter and safer. With a mission of protecting life, our technologies give law enforcement the confidence, focus and time they need to protect their communities. Our products impact every aspect of a public safety officer’s day-to-day experience with the goal of helping everyone get home safe. Our revenues for the year ended December 31, 2020 were $681.0 million, an increase of $150.1 million, or 28.2%, from the prior year. We had a loss from operations of $14.2 million compared to $6.4 million in the prior year. The higher loss from operations was primarily the result of increased stock compensation expense for our CEO Performance Award and XSPP awards and an increase in legal expenses. Remaining cost increases were primarily attributable to the increase in unit sales and an increase in headcount. These cost increases were largely offset by higher revenue and improved gross margin. For the year ended December 31, 2020, we recorded net loss of $1.7 million compared to net income of $0.9 million for the prior year.2021 OutlookFor the year ending December 31, 2021, we expect revenue of $740 million to $780 million. We anticipate that revenue for the three months ending March 31, 2021 will reflect approximately 12% growth as compared to the three months ended March 31, 2020. We anticipate capital expenditures of approximately $65 million to $70 million in 2021, including approximately $25 million in support of capacity expansion and automation of TASER device and cartridge manufacturing, approximately $20 million for development of our planned new manufacturing and office facility in Scottsdale, Arizona, and the remainder on investments to support our continued growth.COVID-19In late 2019, COVID-19 was first detected in Wuhan, China. In March 2020 the World Health Organization declared COVID-19 a global pandemic. This contagious disease outbreak, which has continued to spread throughout the United States and world, has adversely affected workforces, economies, and financial markets globally, leading to an economic downturn. As an essential provider of products and services for law enforcement and other first responders, we remain focused on protecting the health and wellbeing of our employees while assuring the continuity of our business operations.In response to the pandemic, Axon has taken a number of actions:Customer support:●Free access to Axon Citizen cloud software to all public law enforcement agencies in 2020 to enable social distancing;28 Table of Contents●A partnership with the National Police Foundation to provide personal protective equipment (“PPE”) for first responders;●An online support center for our customers, www.axon.com/covid-19-support-center; and●Our annual Axon Accelerate user conference was held virtually in late August 2020.​Employee safety and manufacturing:●Curbed all non-essential travel at the beginning of March;●We continue to allow for a remote work model for the majority of our office staff, with medical screening for any employees who do work in our offices; and●Mitigating contamination risk in our facilities through staggered shifts, the use of PPE, increased distancing, cleaning standards that exceed CDC guidance, and paying or subsidizing certain high-risk employees while they stay at home.​Supply chain:●We previously took steps to diversify our supply chain and global manufacturing footprint, which have positioned us well to manage through the pandemic. Thus far, we have been able to produce and ship our critical core products with little to no interruption.●We have proactively built up a safety stock of raw and finished goods inventory aligned to our strategic model to help meet strong product demand while also preparing us to stagger factory work schedules. We continue to adjust strategic inventory levels based on areas of risk to mitigate potential supply disruptions.●In light of our broad geographic supplier base both domestic and international, we are continuously monitoring our supply chain to manage through potential impacts, finding alternate sources as well as shipping / logistic options as available or working with foreign regulators to ensure that our suppliers can provide parts.​Shareholder engagement:●We have pivoted our shareholder engagement to a virtual format.oOur annual meeting was held virtually on May 29, 2020, and we anticipate holding our 2021 annual meeting virtually;oWe completed a follow-on equity offering in June 2020 for which all related marketing was conducted virtually; andoWe will continue to participate in several upcoming investor conferences utilizing video conferencing. All investor materials and events are available at investor.axon.com.​We are in a strong liquidity position, with substantial cash and investments on hand, which are discussed in more detail under Liquidity and Capital Resources. We believe that our existing liquidity and other sources of funding will be sufficient to satisfy our currently anticipated cash requirements including capital expenditures, working capital requirements, potential acquisitions or strategic investments and other liquidity requirements through at least the next 12 months. Our expenses for the year ended December 31, 2020 increased by approximately $4.1 million for costs related to the pandemic. We expect ongoing increased costs related to the mitigation of contamination risk at our facilities. We expect these incremental costs will continue to be partially offset by savings on travel and events and other cost-savings measures. ​We have elected to participate in the social security deferral program offered under the Coronavirus Aid, Relief, and Economic Security Act, whereby we deferred payment of the employer portion of all social security taxes that would otherwise have been payable from March 27, 2020 through December 31, 2020. Payment of the deferred amount is due 50% on December 31, 2021 and 50% on December 31, 2022.29 Table of Contents​Results of OperationsThe following table presents data from our consolidated statements of operations as well as the percentage relationship to total net sales of items included in our statements of operations (dollars in thousands):​​​​​​​​​​​​​​​​Year Ended December 31, ​​2020 ​2019 Net sales from products $ 500,250 73.5% ​$ 399,474 75.3%Net sales from services​ 180,753 26.5​​ 131,386 24.7​Net sales​ 681,003 100.0​​ 530,860 100.0​Cost of product sales​ 224,131 32.9​​ 190,683 35.9​Cost of service sales​ 40,541 6.0​​ 32,891 6.2​Cost of sales​ 264,672 38.9​​ 223,574 42.1​Gross margin​ 416,331 61.1​​ 307,286 57.9​Operating expenses:​​​​​​​​​​​​Sales, general and administrative​ 307,286 45.1​​ 212,959 40.1​Research and development​ 123,195 18.1​​ 100,721 19.0​Total operating expenses​ 430,481 63.2​​ 313,680 59.1​Income (loss) from operations​ (14,150) (2.1)​​ (6,394) (1.2)​Interest and other income, net​ 7,859 1.1​​ 8,464 1.6​Income (loss) before provision for income taxes​ (6,291) (1.0)​​ 2,070 0.4​Provision for (benefit from) income taxes​ (4,567) (0.7)​​ 1,188 0.2​Net income (loss) $ (1,724) (0.3)% ​$ 882 0.2%​Net sales to the U.S. and other countries are summarized as follows (dollars in thousands):​​​​​​​​​​​​​​​​Year Ended December 31, ​​2020​​2019 United States $ 535,079 79% ​$ 446,100 84%Other Countries​ 145,924 21​​ 84,760 16​Total​$ 681,003 100% ​$ 530,860 100%​International revenue in 2020 increased substantially compared to 2019, driven by strength in all of our international regions and most notably within EMEA.Our operations are comprised of two reportable segments: the manufacture and sale of CEDs, batteries, accessories and extended warranties and other products and services (collectively, the “TASER” segment); and software and sensors, which includes the sale of devices, wearables, applications, cloud and mobile products, and services (collectively, the "Software and Sensors" segment). In both segments, we report sales of products and services. Service revenue in both segments includes sales related to Axon Evidence. In the TASER segment, service revenue also includes digital subscription training content. In the Software and Sensors segment, service revenue also includes other recurring cloud-hosted software revenue and related professional services. Collectively, this revenue is sometimes referred to as "Axon Cloud revenue." Revenue from our “products” in the Software and Sensors segment are generally from sales of sensors, including on-officer body cameras, Axon Fleet cameras, other hardware sensors, warranties on sensors, and other products, and is sometimes referred to as "Sensors and Other revenue." Within the Software and Sensors segment, we include only revenues and costs attributable to that segment which costs include: costs of sales for both products and services, direct labor, and product management and R&D for products included, or to be included, within the Software and Sensors segment. All other costs are included in the TASER segment.30 Table of ContentsFor the Years Ended December 31, 2020 and 2019Net SalesNet sales by product line were as follows for the years ended December 31, 2020 and 2019 (dollars in thousands):​​​​​​​​​​​​​​​​​​​​Year Ended December 31, Dollar Percent ​​2020​2019​Change​Change TASER segment: ​ ​ ​ ​TASER 7​$ 107,506 15.8% $ 56,652 10.7% $ 50,854 89.8%TASER X26P​ 41,724 6.1​ 52,524 9.9​ (10,800) (20.6)​TASER X2​ 60,107 8.8​ 55,920 10.5​ 4,187 7.5​TASER Pulse​ 9,407 1.4​ 4,089 0.8​ 5,318 130.1​Cartridges​ 115,193 16.9​ 85,987 16.2​ 29,206 34.0​Axon Evidence and cloud services​ 2,935 0.4​ 704 0.1​ 2,231 316.9​Extended warranties​ 20,754 3.0​ 18,074 3.4​ 2,680 14.8​Other​ 8,926 1.3​ 7,711 1.5​ 1,215 15.8​TASER segment​ 366,552 53.7​ 281,661 53.1​ 84,891 30.1​Software and Sensors segment:​ ​ ​​ ​ ​​ ​Axon Body​ 57,150 8.4​ 44,039 8.3​ 13,111 29.8​Axon Flex​ 4,082 0.6​ 5,928 1.1​ (1,846) (31.1)​Axon Fleet​ 20,108 3.0​ 16,182 3.0​ 3,926 24.3​Axon Dock​ 19,723 2.9​ 20,449 3.9​ (726) (3.6)​Axon Evidence and cloud services​ 176,797 26.0​ 130,265 24.5​ 46,532 35.7​Extended warranties​ 24,408 3.6​ 19,188 3.6​ 5,220 27.2​Other​ 12,183 1.8​ 13,148 2.5​ (965) (7.3)​Software and Sensors segment​ 314,451 46.3​ 249,199 46.9​ 65,252 26.2​Total net sales​$ 681,003 100.0% $ 530,860 100.0% $ 150,143 28.3%​Net unit sales were as follows:​​​​​​​​​​​​​Year Ended December 31, ​Unit​Percent​ 2020 2019 Change ChangeTASER 7 77,451 49,221 28,230 57.4%TASER X26P 37,391 48,798 (11,407) (23.4)%TASER X2 43,407 40,973 2,434 5.9%TASER Pulse 33,158 11,785 21,373 181.4%Cartridges 3,714,291 2,751,603 962,688 35.0%Axon Body 182,538 151,499 31,039 20.5%Axon Flex 8,962 15,586 (6,624) (42.5)%Axon Fleet 11,304 10,467 837 8.0%Axon Dock 25,422 22,275 3,147 14.1%​Net sales for the TASER segment increased $84.9 million, or 30.1%, primarily as a result of a net increase of $49.6 million in TASER device sales and a $29.2 million increase in cartridge revenue. Cartridge revenue increased due to increased unit sales, partially offset by a slight decrease in average selling price. We continue to see a shift to purchases of our latest generation device, TASER 7, from legacy devices, especially X26P devices. Sales of our TASER 7 device also drove the increase in revenue from Axon Evidence and cloud services. Revenue was also impacted by higher average selling prices for TASER 7, X2, and X26P. Revenue from consumer TASER Pulse devices increased due to a substantial increase in volume, partially offset by lower average selling prices. Net sales for the Software and Sensors segment increased $65.3 million, or 26.2%. Revenue from Axon Evidence and cloud services increased $46.5 million as we continued to add users and associated devices to our network during 31 Table of Contentsthe year ended December 31, 2020. The increase in the aggregate number of users and devices also resulted in increased extended warranty revenues of $5.2 million. Revenue from Axon Body cameras increased $13.1 million following the introduction of our Axon Body 3 camera during the third quarter of 2019. Backlog - As of December 31, 2020 compared to December 31, 2019Our backlog for products and services includes all orders that have been received and are believed to be firm.In the TASER segment, we define backlog as equal to deferred revenue. Deferred revenue represents amounts invoiced to customers for goods and services to be delivered in subsequent periods. We process orders within the TASER segment quickly, and our best estimate of firm orders outstanding as of period end represents those that have been invoiced but remain undelivered. The TASER segment backlog balance was $61.8 million as of December 31, 2020. We expect to realize $28.9 million of this deferred revenue balance as revenue during the next 12 months. This represents cash received and accounts receivable from customers on or prior to December 31, 2020 for products and services expected to be delivered in the next 12 months.In the Software and Sensors segment, we define backlog as cumulative bookings, net of cancellations, less product and service revenue recognized to date. Bookings are generally realized as revenue over multiple years. The Software and Sensors backlog balance was $1.4 billion as of December 31, 2020. This backlog balance includes $213.4 million of deferred revenue, and $1.2 billion that has been recorded as bookings but not yet invoiced, all as of December 31, 2020. We expect to realize approximately $370.0 million of the December 31, 2020 backlog balance as revenue during the next 12 months.​​​​​​​​​​​​ TASER Software and Sensors Total​​(in thousands)Balance, beginning of period​$ 55,189​$ 1,026,192​$ 1,081,381Add: additions to backlog, net of cancellations​​ 373,119​​ 716,145​​ 1,089,264Less: revenue recognized during period​​ (366,552)​​ (314,451)​​ (681,003)Balance end of period​$ 61,756 $ 1,427,886 $ 1,489,642​Our backlog of $1.5 billion as of December 31, 2020 has increased significantly from $1.1 billion as of December 31, 2019. The increase in TASER segment backlog is not expected to have a material impact on revenue or operating margins. Our significant increase in backlog, primarily in the Software and Sensors segment is indicative of expected revenue growth in this segment.Cost of Product and Service SalesCost of product and services sales in dollars and as a percent of related segment sales (dollars in thousands):​​​​​​​​​​​​​​​​​​​​Year Ended December 31, ​Dollar​Percent ​​2020​2019​Change​Change TASER segment: ​​ ​ ​​ ​ ​​ ​ Cost of product sales​$ 136,925​ 37.4% $ 107,188​ 38.1% $ 29,737​ 27.7%Software and Sensors segment:​​​​​​​​​​​​​​​ Cost of product sales​​ 87,206 27.7% 83,495 33.5% 3,711 4.4%Cost of service sales​​ 40,541 12.9% 32,891 13.2% 7,650 23.3%Total cost of sales​​ 127,747 40.6% 116,386 46.7% 11,361 9.8%Total cost of product and service sales​$ 264,672 38.9% $ 223,574 42.1% $ 41,098 18.4%​Within the TASER segment, cost of product and service sales was $136.9 million, an increase of $29.7 million, or 27.7%, from 2019. Cost as a percentage of sales decreased to 37.4% from 38.1%. The increase in cost of sales was primarily a result of increased sales, with improvement to the cost as a percentage of sales primarily a result of 32 Table of Contentsincreased leverage on manufacturing overhead expenses and higher expense in the prior year for TASER 7 ramp-up and optimization costs related to scrap, obsolete inventory, and higher labor costs.Within the Software and Sensors segment, cost of product and service sales was $127.7 million, an increase of $11.4 million, or 9.8%, from 2019. As a percentage of net sales, cost of product and service sales decreased to 40.6% in 2020 from 46.7% in 2019. Cost of product sales increased $3.7 million primarily driven by the impact of increased units, but decreased as a percentage of total segment net sales, reflecting higher average selling prices on Axon cameras and docks, overall product mix, and relatively stable unit costs. Cost of service sales increased $7.7 million driven primarily by a $3.9 million increase in third party cloud data cost, and an increase in professional services expense due to increased deployments in 2020. Gross MarginGross Margin (dollars in thousands):​​​​​​​​​​​​​​​​​​​​​​​​​​​​​Year Ended December 31, ​Dollar​Percent​​ 2020 2019 Change Change​TASER segment​$ 229,627​$ 174,473​$ 55,154​ 31.6%Software and Sensors segment​​ 186,704​​ 132,813​​ 53,891​ 40.6%Total gross margin​$ 416,331​$ 307,286​$ 109,045 35.5%Gross margin as % of net sales​​ 61.1% 57.9% ​​​​​​Gross margin increased $109.0 million to $416.3 million for the year ended December 31, 2020 compared to $307.3 million for 2019. As a percentage of net sales, gross margin increased to 61.1% for 2020 from 57.9% for 2019.As a percentage of net sales, gross margin for the TASER segment increased to 62.6% for the year ended December 31, 2020 from 61.9% for the year ended December 31, 2019.Within the Software and Sensors segment, gross margin as a percentage of total segment net sales was 59.4% and 53.3% for the years ended 2020 and 2019, respectively. Within the Software and Sensors segment, product gross margin was 36.6% for the year ended December 31, 2020 and 29.8% for the same period in 2019, while the service margins were 77.1% and 74.8% during those same periods, respectively.Sales, General and Administrative ExpensesSales, General and Administrative ("SG&A") Expenses (dollars in thousands):​​​​​​​​​​​​​​​​Year Ended December 31, ​Dollar​Percent​ 2020 2019 Change ChangeSalaries, benefits and bonus​$ 83,287​$ 67,582​$ 15,705​ 23.2% Stock-based compensation​​ 103,860​​ 59,341​​ 44,519​ 75.0​Professional, consulting and lobbying​​ 45,541​​ 21,590​​ 23,951​ 110.9​Sales and marketing​​ 32,464​​ 28,961​​ 3,503​ 12.1​Office and building​​ 9,076​​ 6,650​​ 2,426​ 36.5​Travel and meals​​ 5,630​​ 11,407​​ (5,777)​ (50.6)​Depreciation and amortization​​ 6,079​​ 5,739​​ 340​ 5.9​Other​​ 21,349​​ 11,689​​ 9,660​ 82.6​Total sales, general and administrative expenses​$ 307,286​$ 212,959​$ 94,327 44.3%SG&A expenses as a percentage of net sales​​ 45.1% ​ 40.1% ​​​​​​SG&A expenses increased $94.3 million, or 44.3%. Stock-based compensation expense increased $44.5 million in comparison to the prior year comparable period, which was primarily attributable to an increase of $41.5 33 Table of Contentsmillion in expense related to the CEO Performance Award and XSPP. As of December 31, 2020, eleven operational goals for the CEO Performance Award and XSPP are considered probable of attainment or have been attained; during the prior year comparable period, nine operational goals were considered probable. Refer to Note 13 of the notes to our consolidated financial statements within this Annual Report on Form 10-K for additional discussion of the CEO Performance Award and XSPP. Stock-based compensation expense also increased over the prior year comparable period due to an increase in headcount.Professional, consulting and lobbying expenses increased $24.0 million, driven primarily by an increase of $19.1 million in expenses related to the FTC litigation. As discussed in Note 10 of the notes to our consolidated financial statements within this Annual Report on Form 10-K, on January 3, 2020, we sued the FTC in the District of Arizona, and the FTC filed an enforcement action regarding our May 2018 acquisition of Vievu LLC. Also contributing to the increase were higher expenses related to our enterprise resource planning system conversion.Salaries, benefits and bonus expense increased $15.7 million, primarily due to an increase in headcount. Salaries, benefits and bonus expense decreased as a percentage of sales from 12.7% for 2019 to 12.2% for 2020. Sales and marketing expenses increased $3.5 million, driven by a $4.8 million increase in commissions tied to higher revenues. The increase was partially offset by savings driven by the cancellation of in-person events, including our annual Axon Accelerate user conference.Other SG&A expenses increased by $9.7 million, primarily driven by the following:●Supplies expense increased $3.0 million, including a $2.4 million increase in computer licenses and maintenance supporting increased headcount, and a $0.7 million increase for PPE and other COVID-19 related expenses.●Charitable contributions increased $1.8 million, primarily reflecting our donations of PPE under our Got You Covered campaign. ●Insurance expense increased $1.4 million primarily as a result of increases in the cost of comparable policies. ●Recruiting expense increased $0.9 million as a result of increased hiring needs in 2020. ​Partially offsetting the noted increases was a $5.8 million decrease in travel expenses following the suspension of all non-essential travel in mid-March 2020 in response to the COVID-19 pandemic.Research and Development ExpensesResearch and Development ("R&D") Expenses (dollars in thousands):​​​​​​​​​​​​​​​​Year Ended December 31, ​Dollar​Percent​ 2020 2019 Change ChangeSalaries, benefits and bonus​$ 71,488​$ 63,763​$ 7,725​ 12.1% Stock-based compensation​​ 26,248​​ 17,588​​ 8,660​ 49.2​Professional and consulting​​ 10,503​​ 4,525​​ 5,978​ 132.1​Travel and meals​​ 594​​ 2,247​​ (1,653)​ (73.6)​Other​​ 14,362​​ 12,598​​ 1,764​ 14.0​Total research and development expenses​$ 123,195​$ 100,721​$ 22,474 22.3%R&D expenses as a percentage of net sales​​ 18.1%​ 19.0%​​​​​​The increase in R&D expense was primarily attributable to our Software and Sensors segment. Within the TASER segment, R&D expenses increased $0.9 million or 6.3%, reflecting increased consulting expense and supplies in the current year related to the development of next generation products. The increase was partially offset by lower compensation and benefits resulting from decreased headcount.34 Table of ContentsR&D expense for the Software and Sensors segment increased $21.6 million or 25.0% but remained relatively consistent at 34.3% of sales as compared to 34.6% in the prior year. Of the increase, $9.1 million related to salaries, benefits, and bonus attributable to increased headcount.Stock-based compensation expense increased $8.7 million. Contributing to the increase was expense of $3.8 million related to our XSPP. As of December 31, 2020, eleven operational goals for the XSPP are considered probable of attainment or have been attained; during the prior year comparable period, nine operational goals were considered probable. Stock-based compensation expense also increased over the prior year comparable period due to an increase in headcount.Professional and consulting expenses increased $6.0 million related to development of next generation products. The increases were partially offset by a decrease of $1.7 million in travel and meals expense following the suspension of all non-essential travel in mid-March 2020 due to the COVID-19 pandemicWe expect R&D expense to continue to increase in absolute dollars as we focus on growing the Software and Sensors segment as we add headcount and additional resources to develop new products and services to further advance our scalable cloud-connected device platform. We believe that these investments will result in an increase in our subscription revenue base, which over time will result in revenue increasing faster than the increase in SG&A expenses as we reach economies of scale.Interest and Other Income, NetInterest and other income, net was $7.9 million and $8.5 million for the years ended December 31, 2020 and 2019, respectively.For the year ended December 31, 2020, we earned interest income of $5.1 million, other income, net of $0.6 million, had losses from foreign currency transaction adjustments of $0.2 million, and interest expense of $0.1 million. Additionally, we recorded a net gain of $2.1 million related to an observable price change for our investment in Flock Group, Inc. and related warrants. The decrease in interest income was a result of decreased interest rates during the current period, partially offset by higher balances of cash, cash equivalents, and investments. For the year ended December 31, 2019, we earned interest income of $8.7 million and had losses from foreign currency transaction adjustments of $0.3 million, other income, net of $0.1 million, and interest expense of less than $0.1 million.Provision for Income TaxesThe provision for income taxes was a benefit of $4.6 million for the year ended December 31, 2020. The effective income tax rate for 2020 was 72.6%. The benefits related to excess stock-based compensation of $9.0 million, research and development credits of $10.2 million, and a deduction for foreign derived intangible income (“FDII”) of $0.9 million were partially offset by the tax effects of permanently non-deductible expenses for executive compensation of $15.5 million, an increase in uncertain tax benefits of $1.0 million, other permanently non-deductible expenses of $0.8 million and state tax expense of $0.9 million. Additionally, we recorded a $0.2 million increase to our valuation allowance as of December 31, 2020 related to research and development tax credits that may not be utilized prior to expiration, partially offset by changes in certain foreign jurisdictions.The provision for income taxes was $1.2 million for the year ended December 31, 2019. The effective income tax rate for 2019 was 57.4%. The benefits related to excess stock-based compensation of $5.0 million and research and development credits of $4.9 million were partially offset by the tax effects of permanently non-deductible expenses for executive compensation of $7.6 million, an increase in uncertain tax benefits of $1.2 million and other permanently non-deductible expenses of $1.1 million and state tax expense of $0.5 million. Additionally, we recorded 35 Table of Contentsa $0.4 million increase to our valuation allowance as of December 31, 2019 related to research and development tax credits that may not be utilized prior to expiration, partially offset by changes in certain foreign jurisdictions.Net IncomeWe recorded net loss of $1.7 million for the year ended December 31, 2020 compared to net income of $0.9 million in 2019. Net loss per basic and diluted share was $0.03 for 2020, compared to net income per basic and diluted share of $0.01 for 2019.Three Months Ended December 31, 2020 Compared to September 30, 2020Net sales by product line were as follows (dollars in thousands):​​​​​​​​​​​​​​​​​​​ Three Months Ended Three Months Ended Dollar Percent​​December 31, 2020​September 30, 2020​Change​ChangeTASER segment:​​​​​​​​​​​​​​​​TASER 7​$ 58,890 26.0% $ 21,702 13.0% $ 37,188 171.4%TASER X26P​ 11,386 5.0​ 9,766 5.9​ 1,620 16.6​TASER X2​ 14,706 6.5​ 14,494 8.7​ 212 1.5​TASER Pulse​ 3,033 1.4​ 2,981 1.8​ 52 1.7​Cartridges​​ 38,461​ 17.0​​ 26,335​ 15.8​​ 12,126​ 46.0​Axon Evidence and cloud services​ 1,159 0.5​ 692 0.4​ 467 67.5​Extended warranties​ 5,414 2.4​ 5,265 3.2​ 149 2.8​Other​ 2,712 1.2​ 3,171 1.9​ (459) (14.5)​TASER segment​ 135,761 60.0​ 84,406 50.7​ 51,355 60.8​Software and Sensors segment:​ ​ ​ ​Axon Body​ 16,505 7.3​ 15,978 9.6​ 527 3.3​Axon Flex​ 630 0.3​ 1,589 1.0​ (959) (60.4)​Axon Fleet​ 7,020 3.1​ 4,215 2.5​ 2,805 66.5​Axon Dock​ 5,009 2.2​ 5,708 3.4​ (699) (12.2)​Axon Evidence and cloud services​ 50,302 22.2​ 45,450 27.3​ 4,852 10.7​Extended warranties​ 6,701 3.0​ 6,514 3.9​ 187 2.9​Other​ 4,212 1.9​ 2,582 1.6​ 1,630 63.1​Software and Sensors segment​ 90,379 40.0​ 82,036 49.3​ 8,343 10.2​Total net sales​$ 226,140 100.0% $ 166,442 100.0% $ 59,698 35.9%​Net unit sales were as follows:​​​​​​​​​​​​ Three Months Ended ​ ​ ​​​​​​Unit​Percent​​December 31, 2020​September 30, 2020​Change​ChangeTASER 7 41,099 15,908 25,191 158.4% TASER X26P 10,611 8,119 2,492 30.7% TASER X2 9,751 10,078 (327) (3.2)% TASER Pulse 11,657 12,811 (1,154) (9.0)% Cartridges 1,272,679 852,980 419,699 49.2% Axon Body 44,735 62,873 (18,138) (28.8)% Axon Flex 749 3,175 (2,426) (76.4)% Axon Fleet 3,905 2,396 1,509 63.0% Axon Dock 6,326 9,165 (2,839) (31.0)% ​Net sales for the TASER segment increased $51.4 million, or 60.8%, on a sequential basis primarily due to a $37.2 million increase in revenue from TASER 7 devices and a $12.1 million increase in cartridge revenue. The 36 Table of Contentsincrease in TASER 7 revenues was a result of both increased unit sales and a higher average selling price, driven by greater adoption of TASER 7, especially internationally.Net sales for the Software and Sensors segment increased $8.3 million, or 10.2%, on a sequential basis primarily due to a $4.9 million increase in Axon Evidence and cloud services revenue and a $2.8 million increase in Axon Fleet revenue. The increase in Axon Evidence and cloud services revenue was a result of the increase in the aggregate number of users on our network. Axon Fleet revenue was driven primarily by increased unit sales, as well as an increase in the average selling price. International sales were $59.5 million in for the three months ended December 31, 2020 as compared to $23.1 million for the three months ended September 30, 2020, an increase of $36.4 million, primarily driven by increased sales in Europe.Non-GAAP Financial MeasuresTo supplement our financial results presented in accordance with accounting principles generally accepted in the U.S. ("GAAP"), we present the non-GAAP financial measures of EBITDA and Adjusted EBITDA (CEO Performance Award). Our management uses these non-GAAP financial measures in evaluating our performance in comparison to prior periods. We believe that both management and investors benefit from referring to these non-GAAP financial measures in assessing our performance, and when planning and forecasting our future periods. A reconciliation of GAAP to the non-GAAP financial measures is presented below.●EBITDA (Most comparable GAAP Measure: Net income) - Earnings before interest expense, investment interest income, taxes, depreciation and amortization.●Adjusted EBITDA (CEO Performance Award) (Most comparable GAAP Measure: Net income) - Earnings before interest expense, investment interest income, taxes, depreciation, amortization and non-cash stock-based compensation expense.Although these non-GAAP financial measures are not consistent with GAAP, management believes investors will benefit by referring to these non-GAAP financial measures when assessing our operating results, as well as when forecasting and analyzing future periods. However, management recognizes that:●these non-GAAP financial measures are limited in their usefulness and should be considered only as a supplement to our GAAP financial measures;●these non-GAAP financial measures should not be considered in isolation from, or as a substitute for, our GAAP financial measures;●these non-GAAP financial measures should not be considered to be superior to our GAAP financial measures; and●these non-GAAP financial measures were not prepared in accordance with GAAP and investors should not assume that the non-GAAP financial measures presented in this Annual Report on Form 10-K were prepared under a comprehensive set of rules or principles.37 Table of ContentsEBITDA and Adjusted EBITDA (CEO Performance Award) reconcile to net income as follows (dollars in thousands):​​​​​​​​​​For the Years Ended December 31, ​ December 31, December 31, ​​2020​2019Net income (loss)​$ (1,724)​$ 882Depreciation and amortization​ 12,475​ 11,361Interest expense​ 55​ 46Investment interest income​ (4,086)​ (7,040)Provision for (benefit from) income taxes​ (4,567)​ 1,188EBITDA​$ 2,153​$ 6,437​​​​​​​Adjustments:​ ​ Stock-based compensation expense​ 133,572​ 78,495Adjusted EBITDA (CEO Performance Award)​$ 135,725​$ 84,932​Liquidity and Capital ResourcesSummaryAs of December 31, 2020, we had $155.4 million of cash and cash equivalents, a decrease of $16.8 million from December 31, 2019. Cash and cash equivalents and investments totaled $652.6 million, an increase of $256.4 million from December 31, 2019.Cash FlowsThe following table summarizes our cash flows from operating, investing and financing activities (in thousands):​​​​​​​​​​Year Ended December 31, ​ 2020 2019Operating activities​$ 38,481​$ 65,673Investing activities​​ (356,526)​​ (240,737)Financing activities​​ 299,265​​ (3,937)Effect of exchange rate changes on cash and cash equivalents​ 1,976​ 329Net decrease in cash and cash equivalents and restricted cash​$ (16,804)​$ (178,672)​Operating activitiesNet cash provided by operating activities in 2020 of $38.5 million consisted of $1.7 million in net loss, the net add-back of non-cash income statement items totaling $141.0 million and a $100.8 million net change in operating assets and liabilities. Included in the non-cash items were $12.5 million in depreciation and amortization expense, $133.6 million in stock-based compensation expense, and a $16.5 million increase in deferred income tax assets. The most significant increase to the portion of cash provided by operating activities related to the changes in operating assets and liabilities was a $107.8 million increase in accounts and notes receivable and contract assets. The increase in accounts and notes receivable and contract assets was attributable to increased sales in 2020, primarily sales made under subscription plans. Operating cash flows were also negatively impacted by increased inventory of $52.2 million, as we proactively built up a safety stock of inventory to help meet strong product demand while also preparing us to stagger factory work schedules, and increased prepaid expenses and other assets of $14.9 million resulting primarily from an increase in deferred commissions expense. Operating cash flows were positively impacted by an increase in deferred revenue of $65.1 million. The increase in deferred revenue was primarily attributable to increased prepayments for Software and Sensors hardware and services, and a smaller increase in hardware deferred revenue from TASER subscription sales. 38 Table of ContentsInvesting activitiesWe used $356.5 million for investing activities in 2020. Purchases of investments, net of calls and maturities, were $276.7 million. We also invested $72.6 million in the purchase of property and equipment and intangibles, including $54.1 million for land on which we intend to construct our new manufacturing and office facility, and $7.1 million for equity investments in unconsolidated affiliates. Financing activitiesNet cash used provided by financing activities was $299.3 million for the year ended December 31, 2020. During 2020, we completed an equity offering that generated net proceeds of $306.8 million. Certain RSUs that vested in the year ended December 31, 2020 were net-share settled, such that we withheld shares to cover the employees’ tax obligation for the applicable income and other employment taxes, and remitted the cash, which totaled $7.8 million, to the appropriate taxing authorities.Liquidity and Capital ResourcesOur most significant source of liquidity continues to be funds generated by operating activities and available cash and cash equivalents. In addition, our $50.0 million revolving credit facility is available for additional working capital needs or investment opportunities. Under the terms of the line of credit, available borrowings are reduced by outstanding letters of credit. Advances under the line of credit bear interest at LIBOR plus 1.0 to 1.5% per year determined in accordance with a pricing grid based on our funded debt to earnings before interest, taxes, depreciation and amortization ("EBITDA") ratio.As of December 31, 2020, we had letters of credit outstanding of $6.1 million, leaving the net amount available for borrowing of $43.9 million. The facility matures on December 31, 2021 and has an accordion feature which allows for an increase in the total line of credit up to $100.0 million, subject to certain conditions, including the availability of additional bank commitments. There can be no assurance that we will continue to generate cash flows at or above current levels or that we will be able to maintain our ability to borrow under our revolving credit facility. At December 31, 2020 and 2019, there were no borrowings under the line.Our agreement with the bank requires us to comply with a maximum funded debt to EBITDA ratio, as defined, of no greater than 2.50 to 1.00 based upon a trailing four fiscal quarter period. At December 31, 2020, the Company’s funded debt to EBITDA ratio was 0.0000 to 1.00.On January 29, 2021, we entered into an amendment to the credit agreement which extends the maturity date to December 31, 2023 and increases the amount of the unsecured revolving line of credit which is available for letters of credit from $10 million to $20 million.TASER subscription and installment purchase arrangements typically involve amounts invoiced in five equal installments at the beginning of each year of the five-year term. This is in contrast to a traditional CED sale in which the entire amount being charged for the hardware is invoiced upon shipment. This impacts liquidity in a commensurate fashion, with the cash for the subscription or installment purchase received in five annual installments rather than up front. It is our strategic intent to shift an increasing amount of our business to a subscription model, to better match the municipal budgeting process of our customers as well as to allow for multiple product offerings to be bundled into existing subscriptions. We carefully considered the cash flow impacts of this strategic shift and regularly revisit our cash flow forecast with the goal of maintaining a comfortable level of liquidity as we introduce commercial offerings in which we incur upfront cash costs to produce and fulfill hardware sales ahead of the cash inflows from our customers. Based on our strong balance sheet and the fact that we had no long-term debt or financing lease obligations at December 31, 2020, we believe financing will be available, both through our existing credit line and possible 39 Table of Contentsadditional financing. However, there is no assurance that such funding will be available on terms acceptable to us, or at all.We believe that our sources of funding will be sufficient to satisfy our currently anticipated cash requirements including capital expenditures, working capital requirements, potential acquisitions or strategic investments and other liquidity requirements through at least the next 12 months. We and our Board of Directors may consider repurchases of our common stock. Further repurchases of our common stock would take place on the open market, would be financed with available cash and are subject to authorization as well as market and business conditions.Contractual ObligationsThe following table outlines our future contractual financial obligations by period in which payment is expected, as of December 31, 2020 (dollars in thousands):​​​​​​​​​​​​​​​​​​​​​​Less than​​​​​​​More than​ Total 1 Year 1 - 3 Years 3 - 5 Years 5 YearsOperating lease obligations​$ 26,409​$ 6,277​$ 12,069​$ 7,860​$ 203Purchase obligations​​ 209,258​​ 192,826​​ 4,169​​ 5,003​​ 7,260Total contractual obligations $ 235,667 $ 199,103 $ 16,238 $ 12,863 $ 7,463​Purchase obligations in the table above represent $169.3 million of open purchase orders and $40.0 million of other purchase obligations. The open purchase orders represent both cancelable and non-cancelable purchase orders with key vendors, which are included in this table due to our strategic relationships with these vendors.We are subject to U.S. federal income tax as well as income taxes imposed by state and foreign jurisdictions. As of December 31, 2020, we had $7.7 million of gross unrecognized tax benefits related to uncertain tax positions. The settlement period for these long-term income tax liabilities cannot be determined; however, the liabilities are expected to increase by approximately $0.1 million within the next 12 months.Off-Balance Sheet ArrangementsThe discussion of off-balance sheet arrangements in Note 10 to the consolidated financial statements included in Part II, Item 8 of this Annual Report on Form 10-K is incorporated by reference herein.Critical Accounting EstimatesWe have identified the following accounting estimates as critical to our business operations and the understanding of our results of operations. The preparation of this Annual Report on Form 10-K requires us to make estimates and assumptions that affect the reported amount of assets and liabilities, disclosure of contingent assets and liabilities at the date of our consolidated financial statements, and the reported amounts of revenue and expenses during the reporting period. While we do not believe that a change in these estimates is reasonably likely, there can be no assurance that our actual results will not differ from these estimates. The effect of these estimates on our business operations is discussed below.Product WarrantiesWe warranty our CEDs, Axon cameras and certain related accessories from manufacturing defects on a limited basis for a period of one year after purchase and, thereafter, will replace any defective unit for a fee. Estimated costs for the standard warranty are charged to cost of products sold when revenue is recorded for the related product. Future warranty costs are estimated based on historical data related to warranty claims on a quarterly basis and this rate is applied to current product sales. Historically, reserve amounts have been increased if management becomes aware of a component failure or other issue that could result in larger than anticipated warranty claims from customers. The warranty reserve is reviewed quarterly to verify that it sufficiently reflects the remaining warranty obligations based 40 Table of Contentson the anticipated expenditures over the balance of the warranty obligation period, and adjustments are made when actual warranty claim experience differs from estimates. As of December 31, 2020 and 2019, our warranty reserve was approximately $0.8 million and $1.5 million, respectively. Warranty expense for the years ended December 31, 2020, 2019 and 2018 was $0.0 million, $1.6 million and $0.7 million, respectively. Warranty expense for the year ended December 31, 2020, was impacted by lower than expected warranty claims for the Axon Body 3 on-officer body camera. Warranty expense for the year ended December 31, 2019 was impacted by higher than initially expected warranty claims for the Axon Flex 2 on-officer body camera. Warranty expense for the year ended December 31, 2018, was impacted by lower than expected warranty claims for the Axon Body 2 on-officer body camera.Revenue related to separately-priced extended warranties is initially recorded as deferred revenue at its allocated amount and subsequently recognized as net sales on a straight-line basis over the warranty service period. Costs related to extended warranties are charged to cost of product and service sales when incurred.InventoryInventories are stated at the lower of cost and net realizable value. Cost is determined using the weighted average cost of raw materials, which approximates the first-in, first-out (“FIFO”) method and includes allocations of manufacturing labor and overhead. Provisions are made to reduce potentially excess, obsolete or slow-moving inventories, as well as trial and evaluation inventories to their net realizable value. These provisions are based on management’s best estimate after considering historical demand, projected future demand, inventory purchase commitments, industry and market trends and conditions among other factors. We evaluate inventory costs for abnormal costs due to excess production capacity and treat such costs as period costs.During the year ended December 31, 2020, we recorded provisions to reduce inventories to their lower of cost and net realizable value of approximately $3.8 million compared to $1.3 million during the year ended December 31, 2019. The largest driver of the increase in the provision in 2020 compared to 2019 was a $2.2 million reduction in the carrying amount of our trial and evaluation inventory to zero which is our estimate of its net realizable value. The provision in 2020 and in 2019 was driven by analyses of projected sales data for existing products resulting in adjustments to state inventories at their lower of cost and net realizable value.Revenue Recognition, Deferred Revenue and Accounts and Notes ReceivableWe derive revenue from two primary sources: (1) the sale of physical products, including CEDs, Axon cameras, Axon Signal enabled devices, corresponding hardware extended warranties, and related accessories such as Axon docks, cartridges and batteries, among others, and (2) subscriptions to our Axon Evidence digital evidence management SaaS (including data storage fees and other ancillary services), which includes varying levels of support. To a lesser extent, we also recognize training, professional services and revenue related to other software and SaaS services. We apply the five-step model outlined in Accounting Standards Codification ("ASC") Topic 606, Revenue from Contracts with Customers ("Topic 606").A performance obligation is a promise in a contract to transfer a distinct good or service to the customer, and is the unit of account in Topic 606. For contracts with multiple performance obligations, we allocate the contract transaction price to each performance obligation using our estimate of the standalone selling price ("SSP") of each distinct good or service in the contract.Revenues are recognized upon transfer of control of promised products or services to customers in an amount that reflects the consideration we expect to receive in exchange for those products or services. We enter into contracts that can include various combinations of products and services, each of which is generally distinct and accounted for as a separate performance obligation. Revenue is recognized net of allowances for returns.Performance obligations to deliver products, including CEDs, cameras and related accessories such as cartridges, batteries and docks, are generally satisfied at the point in time we ship the product, as this is when the customer obtains control of the asset under our standard terms and conditions. In certain contracts with non-standard terms and 41 Table of Contentsconditions, these performance obligations may not be satisfied until formal customer acceptance occurs. Performance obligations to fulfill service-type extended warranties and provide our SaaS offerings, including Axon Evidence and other cloud services, are generally satisfied over time as the customer receives and consumes the benefits of these services over the stated service period.Many of our products and services are sold on a standalone basis. We also bundle our hardware products and services together and sell them to our customers in single transactions, where the customer can make payments over a multi-year period. For the years ended December 31, 2020, 2019 and 2018, the composition of revenue recognized from contracts containing multiple performance obligations and those not containing multiple performance obligations was as follows (dollars in thousands):​​​​​​​​​​​​​​​​​​​​For the Year Ended December 31, 2020​​​TASER Software and Sensors Total Contracts with Multiple Performance Obligations $ 186,427 50.9% $ 311,187 99.0% $ 497,614 73.1%Contracts without Multiple Performance Obligations​​ 180,125​ 49.1​​ 3,264​ 1.0​​ 183,389​ 26.9 Total​$ 366,552​ 100.0% $ 314,451​ 100.0% $ 681,003​ 100.0%​​​​​​​​​​​​​​​​​​​​For the Year Ended December 31, 2019​​ TASER Software and Sensors Total Contracts with Multiple Performance Obligations $ 130,761 46.4% $ 245,416 98.5% $ 376,177 70.9%Contracts without Multiple Performance Obligations​​ 150,900​ 53.6​​ 3,783​ 1.5​​ 154,683​ 29.1 Total​$ 281,661​ 100.0% $249,199​ 100.0% $ 530,860​ 100.0%​​​​​​​​​​​​​​​​​​​​For the Year Ended December 31, 2018​​ TASER Software and Sensors Total Contracts with Multiple Performance Obligations $ 72,355 28.6% $ 159,318 95.4% $ 231,673 55.2%Contracts without Multiple Performance Obligations​​ 180,760​ 71.4​​ 7,635​ 4.6​​ 188,395​ 44.8 Total​$ 253,115​ 100.0% $ 166,953​ 100.0% $ 420,068​ 100.0%​Additionally, we offer customers the ability to purchase CED cartridges and certain services on an unlimited basis over the contractual term. Due to the unlimited nature of these arrangements whereby we are obligated to deliver unlimited products at the customer’s request, we account for these arrangements as stand-ready obligations, and recognize revenue ratably over the contract period. Cost of product sales is recognized as the products are shipped to the customer.We have elected to recognize shipping costs as an expense in cost of product sales when the control of hardware products or accessories have transferred to the customer.Sales tax collected on sales is netted against government remittances and thus, recorded on a net basis.Deferred revenue consists of payments received in advance related to products and services for which the criteria for revenue recognition have not yet been met. Deferred revenue that will be recognized during the subsequent twelve month period from the balance sheet date is recorded as current deferred revenue and the remaining portion is recorded as long-term. Generally, customers are billed in annual installments.Sales are typically made on credit, and we generally do not require collateral. 42 Table of ContentsValuation of Goodwill, Intangible and Long-lived AssetsWe do not amortize goodwill and intangible assets with indefinite useful lives; rather, such assets are required to be tested for impairment at least annually, or sooner whenever events or changes in circumstances indicate that the assets may be impaired. We perform our annual impairment assessment in the fourth quarter of each year. Finite-lived intangible assets and other long-lived assets are amortized over their estimated useful lives. Management evaluates whether events and circumstances have occurred that indicate the remaining estimated useful life of long-lived assets and intangible assets may warrant revision or that the remaining balance of these assets, including intangible assets with indefinite lives, may not be recoverable.Circumstances that might indicate long-lived assets might not be recoverable could include, but are not limited to, a change in the product mix, a change in the way products and services are created, produced or delivered, or a significant change in the way our products are branded and marketed. When performing a review for recoverability, management estimates the future undiscounted cash flows expected to result from the use of the assets and their eventual disposition. The amount of the impairment loss, if impairment exists, is calculated based on the excess of the carrying amounts of the assets over their estimated fair value computed using discounted cash flows. During the year ended December 31, 2020, we abandoned certain planning and site development activities related to our planned new headquarters, resulting in an impairment charge of $0.7 million. Additionally, we recognized impairment charges totaling $0.5 million related to improvements and remodeling of certain of our offices. Both charges were included in sales, general and administrative expense in the accompanying consolidated statements of operations. During the year ended December 31, 2019, we abandoned certain capitalized software related to implementation work on an enterprise resource planning system conversion, resulting in an impairment charge of $1.3 million, and certain planning and site development activities related to our planned new headquarters, resulting in an impairment charge of $0.7 million, both of which were included in sales, general and administrative expense in the accompanying consolidated statements of operations and comprehensive income (loss). During the year ended December 31, 2018, we abandoned certain developed technology acquired in a business combination resulting in an impairment charge of $2.0 million.Income TaxesWe recognize federal, state and foreign current tax liabilities or assets based on our estimate of taxes payable or refundable in the current fiscal year by tax jurisdiction. We also recognize federal, state and foreign deferred tax assets or liabilities, as appropriate, for our estimate of future tax effects attributable to temporary differences and carry forwards.We recognize the tax benefit from an uncertain tax position only if it is more likely than not that the tax position will be sustained based on the technical merits of the position. The tax benefits recognized in the consolidated financial statements from such positions are measured based on the largest benefit that has a greater than fifty percent likelihood of being realized upon ultimate resolution. We must also assess whether uncertain tax positions as filed could result in the recognition of a liability for possible interest and penalties if any. We have completed research and development tax credit studies for each year a tax credit was claimed for federal, Arizona, and California income tax purposes. We determined that it was more likely than not that the full benefit of the research and development tax credit would not be sustained on examination and accordingly, have established a liability for unrecognized tax benefits of $7.7 million as of December 31, 2020. We expect the amount of the unrecognized tax benefit to increase by approximately $0.1 million within the next 12 months. Should the unrecognized tax benefit of $7.7 million be recognized, our effective tax rate would be favorably impacted. Our estimates are based on information available to us at the time we prepare the income tax provision. Our income tax returns are subject to audit by federal, state, and local governments, generally years after the returns are filed. These returns could be subject to material adjustments or differing interpretations of the tax laws. During 2020, we completed an audit of our 2016 U.S. federal income tax return by the Internal Revenue Service and began an audit of our 2016 and 2017 California income tax returns for which we are currently in the closing phase with the Franchise Tax Board. Additionally, we have been notified that an audit will commence for Axon Public Safety Southeast Asia LLC, our entity in Vietnam. The tax period has not yet been defined.43 Table of ContentsOur calculation of current and deferred tax assets and liabilities is based on certain estimates and judgments and involves dealing with uncertainties in the application of complex tax laws. Our estimates of current and deferred tax assets and liabilities may change based, in part, on added certainty or finality to an anticipated outcome, changes in accounting or tax laws in the U.S. and internationally, or changes in other facts or circumstances. In addition, we recognize liabilities for potential tax contingencies based on our estimate of whether, and the extent to which, additional taxes may be due. If we determine that payment of these amounts is unnecessary, or if the recorded tax liability is greater than our current assessment, we may be required to recognize an income tax benefit, or additional income tax expense, respectively, in our consolidated financial statements.In preparing our consolidated financial statements, we assess the likelihood that our deferred tax assets will be realized from future taxable income. In evaluating our ability to recover our deferred income tax assets, we consider all available positive and negative evidence, including operating results, ongoing tax planning and forecasts of future taxable income on a jurisdiction by jurisdiction basis. A valuation allowance is established if we determine that it is more likely than not that some portion or all of the net deferred tax assets will not be realized. Although we believe that our tax estimates are reasonable, the ultimate tax determination involves significant judgments that could become subject to audit by tax authorities in the ordinary course of business.We anticipate sufficient future pre-tax book income to realize a large portion of our deferred tax assets. However, based on expected income for years in which Arizona R&D tax credits are set to expire, and certain identified intangibles with an indefinite life, a reserve of $7.3 million has been recorded as a valuation allowance against deferred tax assets as of December 31, 2020.Stock-Based CompensationWe have historically granted stock-based compensation to key employees and non-employee directors as a means of attracting and retaining highly qualified personnel. Stock-based compensation awards primarily consist of service-based RSUs, performance-based RSUs, and performance-based stock options. Our stock-based compensation awards are classified as equity and measured at the fair market value of the underlying stock at the grant date. For service-based awards, we recognize RSU expense using the straight-line attribution method over the requisite service period. Vesting of performance-based RSUs is contingent upon the achievement of certain performance criteria related to our operating performance, as well as successful and timely development and market acceptance of future product introductions. For performance-based RSUs containing only performance conditions, compensation cost is recognized using the graded attribution model over the explicit or implicit service period. For awards containing multiple service, performance or market conditions, where all conditions must be satisfied prior to vesting, compensation expense is recognized over the requisite service period, which is defined as the longest explicit, implicit or derived service period, based on management’s estimate of the probability and timing of the performance criteria being satisfied, adjusted at each balance sheet date. For both service-based and performance-based RSUs, we account for forfeitures as they occur as a reduction to stock-based compensation expense and additional paid-in-capital.For performance-based options, stock-based compensation expense is recognized over the expected performance achievement period of individual performance goals when the achievement of each individual performance goal becomes probable. For performance-based awards with a vesting schedule based entirely on the attainment of both performance and market conditions, stock-based compensation expense is recognized over the longer of the expected achievement period of the performance and market conditions, beginning at the point in time that the relevant performance condition is considered probable of achievement. The fair value of such awards is estimated on the grant date using Monte Carlo simulations. Refer to Note 13 of the notes to our consolidated financial statements within this Annual Report on Form 10-K.We have granted a total of approximately 15.0 million performance-based awards (options and restricted stock units) of which approximately 12.0 million are outstanding as of December 31, 2020, the vesting of which is contingent upon the achievement of certain performance criteria including the successful development and market acceptance of future product introductions as well as our future sales targets and operating performance and market capitalization. Compensation expense for performance awards will be recognized based on management’s best 44 Table of Contentsestimate of the probability of the performance criteria being satisfied using the most currently available projections of future product adoption and operating performance, adjusted at each balance sheet date. Changes in the subjective and probability-based assumptions can materially affect the estimates of the fair value of the awards and timing of recognition of stock-based compensation and consequently, the related amount recognized in our statements of operations and comprehensive income.Contingencies and Accrued Litigation ExpenseWe are subject to the possibility of various loss contingencies arising in the ordinary course of business, including product-related and other litigation. We consider the likelihood of loss or impairment of an asset or the incurrence of a liability, as well as our ability to reasonably estimate the amount of loss in determining loss contingencies. An estimated loss contingency is accrued when it is probable that an asset has been impaired or a liability has been incurred and the amount of loss can be reasonably estimated. We regularly evaluate current information available to us to determine whether such accruals should be adjusted and whether new accruals are required. Refer to Note 10 of our consolidated financial statements within this Annual Report on Form 10-K.Reserve for Expected Credit LossesWe are exposed to the risk of credit losses primarily through sales of products and services. Our expected credit loss allowance for accounts receivable, notes receivable, and contract assets represents management’s best estimate and application of judgment considering a number of factors, including historical collection experience, published or estimated credit default rates for entities that represent our customer base, current and future economic and market conditions and a review of the current status of customers' trade accounts receivables. Additionally, specific reserve amounts are established to record the appropriate provision for customers that have a higher probability of default. Our monitoring activities include account reconciliation, dispute resolution, payment confirmation, consideration of customers' financial condition and macroeconomic conditions. Balances are written off when determined to be uncollectible.​We review receivables for U.S. and international customers separately to better reflect different published credit default rates and economic and market conditions.A majority of our customers are governmental agencies. Due to municipal government funding rules, certain of our contracts are subject to appropriation, termination for convenience, or similar cancellation clauses, which could allow our customers to cancel or not exercise options to renew contracts in the future. Economic slowdowns that negatively affect municipal tax collections and put pressure on law enforcement may increase this risk and negatively impact the realizability of our accounts and notes receivable and contract assets. We considered the current and expected future economic and market conditions surrounding the COVID-19 pandemic and increased our reserve for expected credit losses by approximately $0.9 million during the year ended December 31, 2020.Based on the balances of our financial instruments as of December 31, 2020, a hypothetical 25 percent increase in expected credit loss rates across all pools would result in a $0.7 million increase in the allowance for expected credit losses.​Item 7A. Quantitative and Qualitative Disclosures About Market RiskInterest Rate RiskWe typically invest in a limited number of financial instruments, consisting principally of investments in money market accounts, certificates of deposit, corporate and municipal bonds with a typical long-term debt rating of “A” or better by any nationally recognized statistical rating organization, denominated in U.S. dollars. All of our cash equivalents and investments are treated as “held-to-maturity.” Investments in fixed-rate interest-earning instruments carry a degree of interest rate risk as their market value may be adversely impacted due to a rise in interest rates. As a result, we may suffer losses in principal if we sell securities that have declined in market value due to changes in 45 Table of Contentsinterest rates. However, because we classify our debt securities as “held-to-maturity” based on our intent and ability to hold these instruments to maturity, no gains or losses are recognized due to changes in interest rates. These securities are reported at amortized cost. Based on investment positions as of December 31, 2020, a hypothetical 100 basis point increase in interest rates across all maturities would result in a $1.7 million decline in the fair market value of the portfolio. Such losses would only be realized if we sold the investments prior to maturity.Additionally, we have access to a $50.0 million line of credit borrowing facility which bears interest at LIBOR plus 1.0 to 1.5% per year determined in accordance with a pricing grid based on our funded debt to EBITDA ratio. Under the terms of the line of credit, available borrowings are reduced by outstanding letters of credit, which totaled $6.1 million at December 31, 2020. At December 31, 2020, there was no amount outstanding under the line of credit, and the available borrowing under the line of credit was $43.9 million. We have not borrowed any funds under the line of credit since its inception; however; should we need to do so in the future, such borrowings could be subject to adverse or favorable changes in the underlying interest rate.Exchange Rate RiskOur results of operations and cash flows are subject to fluctuations due to changes in foreign currency exchange rates, in each case compared to the U.S. dollar, related to transactions by our foreign subsidiaries. The majority of our sales to international customers are transacted in foreign currencies and therefore are subject to exchange rate fluctuations on these transactions. The cost of our products to our customers increases when the U.S. dollar strengthens against their local currency, and we may have more sales and expenses denominated in foreign currencies in future years which could increase our foreign exchange rate risk. Additionally, intercompany sales to our non-U.S. dollar functional currency international subsidiaries are transacted in U.S. dollars which could increase our foreign exchange rate risk caused by foreign currency transaction gains and losses.To date, we have not engaged in any currency hedging activities. However, we may enter into foreign currency forward and option contracts with financial institutions to protect against foreign exchange risks associated with certain existing assets and liabilities, certain firmly committed transactions, forecasted future cash flows and net investments in foreign subsidiaries. However, we may choose not to hedge certain foreign exchange exposures for a variety of reasons, including but not limited to the prohibitive economic cost of hedging particular exposures. As such, fluctuations in currency exchange rates could harm our business in the future.​46 Table of Contents
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+ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSThe following is a discussion and analysis of the financial condition of AbbVie Inc. (AbbVie or the company). This commentary should be read in conjunction with the consolidated financial statements and accompanying notes appearing in Item 8, "Financial Statements and Supplementary Data." This section of this Form 10-K generally discusses 2020 and 2019 items and year-to-year comparisons between 2020 and 2019. Discussions of 2018 items and year-to-year comparisons between 2019 and 2018 that are not included in this Form 10-K can be found in “Management's Discussion and Analysis of Financial Condition and Results of Operations” in Part II, Item 7 of the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2019.EXECUTIVE OVERVIEWCompany OverviewAbbVie is a global, research-based biopharmaceutical company formed in 2013 following separation from Abbott Laboratories (Abbott). AbbVie uses its expertise, dedicated people and unique approach to innovation to develop and market advanced therapies that address some of the world's most complex and serious diseases. On May 8, 2020, AbbVie completed the acquisition of Allergan plc (Allergan). The acquisition of Allergan creates a diversified biopharmaceutical company positioned for success with a comprehensive product portfolio that has leadership positions in key therapeutic areas of immunology, hematologic oncology, aesthetics, neuroscience, eye care and women's health. AbbVie's existing product portfolio and pipeline is enhanced with numerous Allergan assets and Allergan's product portfolio benefits from AbbVie's commercial strength, expertise and international infrastructure. See Note 5 to the Consolidated Financial Statements for additional information on the acquisition. Subsequent to the acquisition date, AbbVie's consolidated financial statements include the assets, liabilities, operating results and cash flows of Allergan.AbbVie's products are generally sold worldwide directly to wholesalers, distributors, government agencies, health care facilities, specialty pharmacies and independent retailers from AbbVie-owned distribution centers and public warehouses. Certain products (including aesthetic products and devices) are also sold directly to physicians and other licensed healthcare providers. In the United States, AbbVie distributes pharmaceutical products principally through independent wholesale distributors, with some sales directly to retailers, pharmacies and patients. Outside the United States, AbbVie sells products primarily to customers or through distributors, depending on the market served. Certain products are co-marketed or co-promoted with other companies. AbbVie has approximately 47,000 employees. AbbVie operates as a single global business segment. 2020 Financial ResultsAbbVie's strategy has focused on delivering strong financial results, maximizing the benefits of the Allergan acquisition, advancing and investing in its pipeline and returning value to shareholders while ensuring a strong, sustainable growth business over the long term. The company's financial performance in 2020 included delivering worldwide net revenues of $45.8 billion, operating earnings of $11.4 billion, diluted earnings per share of $2.72 and cash flows from operations of $17.6 billion. Worldwide net revenues increased by 38% on a reported basis and on a constant currency basis, which included $10.3 billion of contributed revenues from the Allergan acquisition, growth in the immunology portfolio from Skyrizi, Rinvoq and the continued strength of Humira in the U.S. as well as revenue growth from Imbruvica and Venclexta.Diluted earnings per share in 2020 was $2.72 and included the following after-tax costs: (i) $5.7 billion for the change in fair value of contingent consideration liabilities; (ii) $4.8 billion related to the amortization of intangible assets; (iii) $3.0 billion of Allergan acquisition and integration expenses; (iv) $1.2 billion for acquired in-process research and development (IPR&D); and $241 million for milestones and other research and development (R&D) expenses. These costs were partially offset by $1.7 billion of certain tax benefits. Additionally, financial results reflected continued funding to support all stages of AbbVie’s pipeline assets and continued investment in AbbVie’s on-market brands.In October 2020, AbbVie's board of directors declared a quarterly cash dividend of $1.30 per share of common stock payable in February 2021. This reflects an increase of approximately 10.2% over the previous quarterly dividend of $1.18 per share of common stock.Following the closing of the Allergan acquisition, AbbVie implemented an integration plan designed to reduce costs, integrate and optimize the combined organization. The integration plan is expected to realize more than $2 billion of expected annual cost synergies over a three-year period, with approximately 50% realized in R&D, 40% in selling, general and administrative (SG&A) and 10% in cost of products sold.2020 Form 10-K | 32To achieve these integration objectives, AbbVie expects to incur approximately $2 billion of charges through 2022. These costs will consist of severance and employee benefit costs (cash severance, non-cash severance, including accelerated equity award compensation expense, retention and other termination benefits) and other integration expenses.Impact of the Coronavirus Disease 2019 (COVID-19)In March 2020, the World Health Organization declared the outbreak of a novel coronavirus (COVID-19) as a pandemic, which continues to spread throughout the United States and around the world. In response to the growing public health crisis, AbbVie has partnered with global authorities to support the experimental use of multiple AbbVie assets to determine their efficacy in the treatment of COVID-19. In June 2020, AbbVie announced that it entered into a collaboration with Harbour BioMed, Utrecht University and Erasmus Medical Center to develop a novel antibody therapeutic to prevent and treat COVID-19. Additionally, AbbVie donated $35 million to increase healthcare capacity, supply critical equipment and deliver food and essential supplies during the crisis. AbbVie continues to closely manage manufacturing and supply chain resources around the world to help ensure that patients continue to receive an uninterrupted supply of their medicines. Clinical trial sites are being monitored locally to protect the safety of study participants, staff and employees. While the impact of COVID-19 on AbbVie's operations to date has not been material, AbbVie has experienced lower new patient starts across the therapeutic portfolio. AbbVie expects this matter could continue to negatively impact its results of operations throughout the duration of the outbreak. The extent to which COVID-19 may impact AbbVie's financial condition and results of operations remains uncertain.2021 Strategic ObjectivesAbbVie's mission is to discover and develop innovative medicines and products that solve serious health issues today and address the medical challenges of tomorrow while achieving top-tier financial performance through outstanding execution. AbbVie intends to continue to advance its mission in a number of ways, including: (i) maximizing the benefits of the Allergan acquisition to create a more diversified revenue base with multiple long-term growth drivers; (ii) growing revenues by leveraging AbbVie's commercial strength and international infrastructure across Allergan's therapeutic areas and ensuring strong commercial execution of new product launches; (iii) continuing to invest in and expand its pipeline in support of opportunities in immunology, oncology, aesthetics, neuroscience, eye care and women's health as well as continued investment in key on-market products; (iv) expanding operating margins; and (v) returning cash to shareholders via a strong and growing dividend while also reducing debt. In addition, AbbVie anticipates several regulatory submissions and key data readouts from key clinical trials in the next 12 months.AbbVie expects to achieve its strategic objectives through:•Immunology revenue growth driven by increasing market share and expanding patient access of Skyrizi and Rinvoq, as well as Humira U.S. sales growth. •Hematologic oncology revenue growth from both Imbruvica and Venclexta.•Expansion of the company’s revenue base from additional Allergan products contributing to key aesthetics and neuroscience portfolios.•Effective management of Humira international biosimilar erosion.•Optimization of combined AbbVie and Allergan research and development, commercial, and manufacturing operations while maintaining key growth portfolios.•The favorable impact of pipeline products and indications recently approved or currently under regulatory review where approval is expected in 2021. These products are described in greater detail in the section labeled "Research and Development" included as part of this Item 7.AbbVie remains committed to driving continued expansion of operating margins and expects to achieve this objective through continued leverage from revenue growth, realization of expense synergies from the Allergan acquisition, productivity initiatives in supply chain and ongoing efficiency programs to optimize manufacturing, commercial infrastructure, administrative costs and general corporate expenses.The combination of AbbVie and Allergan creates a diverse entity with leadership positions across immunology, hematologic oncology, aesthetics, neuroscience, women's health, eye care and virology. AbbVie's existing product portfolio and pipeline is enhanced with numerous Allergan assets and Allergan's product portfolio benefits from AbbVie's commercial strength, expertise and international infrastructure.33 | 2020 Form 10-KResearch and DevelopmentResearch and innovation are the cornerstones of AbbVie's business as a global biopharmaceutical company. AbbVie's long-term success depends to a great extent on its ability to continue to discover and develop innovative products and acquire or collaborate on compounds currently in development by other biotechnology or pharmaceutical companies.AbbVie's pipeline currently includes more than 90 compounds, devices or indications in development individually or under collaboration or license agreements and is focused on such important specialties as immunology, oncology, aesthetics, neuroscience, eye care and women's health along with targeted investments in cystic fibrosis. Of these programs, more than 50 are in mid- and late-stage development.The following sections summarize transitions of significant programs from mid-stage development to late-stage development as well as developments in significant late-stage and registration programs. AbbVie expects multiple mid-stage programs to transition into late-stage programs in the next 12 months.Significant Programs and DevelopmentsImmunologySkyrizi•In January 2021, AbbVie announced top-line results from its Phase 3 KEEPsAKE-1 and KEEPsAKE-2 clinical trials of Skyrizi in adults with active psoriatic arthritis (PsA) met the primary and ranked secondary endpoints.•In January 2021, AbbVie announced top-line results from its Phase 3 ADVANCE and MOTIVATE induction studies of Skyrizi in patients with Crohn’s Disease met the primary and key secondary endpoints.Rinvoq•In February 2020, AbbVie announced top-line results from its second Phase 3 clinical trial of Rinvoq in adult patients with active PsA. Results from the SELECT-PsA 1 study, which evaluated Rinvoq versus placebo in patients who did not adequately respond to treatment with one or more non-biologic disease-modifying anti-rheumatic drugs (DMARDs), showed that both doses of Rinvoq met the primary and key secondary endpoints. The safety profile was consistent with that of previous studies across indications, with no new safety risks detected.•In May 2020, AbbVie submitted a supplemental New Drug Application (sNDA) to the U.S. Food and Drug Administration (FDA) and, in June 2020, submitted a marketing authorization application (MAA) to the European Medicines Agency (EMA) for Rinvoq for the treatment of adult patients with active PsA.•In June 2020, AbbVie announced top-line results from its Phase 3 Measure Up 1 study and, in July 2020, announced top-line results from its Phase 3 Measure Up 2 and AD Up studies of Rinvoq for the treatment of moderate to severe atopic dermatitis (AD) met all primary and secondary endpoints versus placebo.•In August 2020, AbbVie submitted an sNDA to the FDA and, earlier this year, submitted an MAA to the EMA for Rinvoq for the treatment of adult patients with active ankylosing spondylitis (AS).•In October 2020, AbbVie submitted an sNDA to the FDA and an MAA to the EMA for Rinvoq for the treatment of adult and adolescent patients with moderate to severe AD.•In December 2020, AbbVie announced its Phase 3 U-ACHIEVE induction study of Rinvoq for the treatment of adult patients with moderate to severe ulcerative colitis met the primary and all ranked secondary endpoints.•In January 2021, AbbVie announced that the European Commission (EC) approved Rinvoq for the treatment of adults with active PsA and active AS.2020 Form 10-K | 34OncologyImbruvica•In April 2020, AbbVie received FDA approval for the use of Imbruvica in combination with rituximab for the treatment of previously untreated patients with chronic lymphocytic leukemia (CLL) or small lymphocytic lymphoma (SLL). •In August 2020, the EC granted marketing authorization for Imbruvica in combination with rituximab for the treatment of adult patients with previously untreated CLL.Venclexta•In February 2020, AbbVie announced that the Phase 3 VIALE-C trial of Venclexta in combination with low-dose cytarabine in newly-diagnosed patients with acute myeloid leukemia (AML) did not meet its primary endpoint. •In March 2020, AbbVie announced that top-line results from its Phase 3 VIALE-A trial of Venclexta in combination with azacitidine in patients with AML met its primary endpoints. •In March 2020, AbbVie received EC approval of Venclyxto in combination with obinutuzumab for patients with previously untreated CLL. •In June 2020, AbbVie submitted an MAA to the EMA for Venclyxto for the treatment of patients with AML.•In October 2020, AbbVie received FDA full approval of Venclexta for the treatment of patients with AML. The approval is supported by data from a series of trials including the Phase 3 VIALE-A and VIALE-C studies.AestheticsJuvederm Collection•In June 2020, AbbVie received FDA approval of Juvederm Voluma XC for the augmentation of the chin region to improve the chin profile in adults over the age of 21.NeuroscienceBotox Therapeutic•In June 2020, the FDA accepted the company's supplemental Biologics License Application (sBLA) to expand the Botox prescribing information for the treatment of detrusor (bladder muscle) overactivity associated with an underlying neurologic condition in certain pediatric patients. In February 2021, AbbVie received FDA approval of Botox for the treatment of detrusor overactivity associated with a neurological condition in certain pediatric patients 5 years of age and older.•In July 2020, AbbVie received FDA approval of Botox for the treatment of lower limb spasticity caused by cerebral palsy in pediatric patients over the age of 2.Atogepant•In July 2020, AbbVie announced that the Phase 3 ADVANCE trial evaluating atogepant, an orally administered calcitonin gene-related peptide receptor antagonist, for migraine prevention met its primary endpoint for all doses (10mg, 30mg, and 60mg) compared to placebo, all secondary endpoints with 30mg and 60mg doses, and four out of six secondary endpoints with the 10mg dose. •In January 2021, AbbVie submitted a New Drug Application to the FDA for atogepant for the prevention of episodic migraine.Elezanumab•In September 2020, AbbVie announced that the FDA granted Orphan Drug and Fast Track designations for elezanumab, an investigational treatment for patients following spinal cord injury.35 | 2020 Form 10-KVirology/Liver DiseaseMavyret•In March 2020, AbbVie announced that the EC granted marketing authorization for Maviret to shorten once-daily treatment duration from 12 to 8 weeks in treatment-naïve, compensated cirrhotic, chronic hepatitis C virus (HCV) patients with genotype 3 infection.Eye CareAGN-190584•In October 2020, AbbVie announced that top-line results from its Phase 3 GEMINI 1 and 2 studies of AGN-190584, an investigational ophthalmic solution, for the treatment of presbyopia met their primary endpoint and majority of the secondary endpoints.Abicipar pegol•In June 2020, AbbVie announced that the FDA issued a Complete Response Letter (CRL) to the Biologics License Application (BLA) for abicipar pegol, a novel, investigational DARPin therapy for patients with neovascular (wet) age-related macular degeneration (nAMD). The CRL indicated that the rate of intraocular inflammation observed following administration of abicipar pegol results in an unfavorable benefit-risk ratio in the treatment of nAMD. In July 2020, AbbVie withdrew the regulatory application with the EMA for abicipar pegol for the treatment of nAMD.Women's HealthOriahnn•In May 2020, the FDA approved Oriahnn (elagolix, estradiol, and norethindrone acetate capsules; elagolix capsules) for the management of heavy menstrual bleeding due to uterine fibroids in pre-menopausal women.RESULTS OF OPERATIONSNet RevenuesThe comparisons presented at constant currency rates reflect comparative local currency net revenues at the prior year's foreign exchange rates. This measure provides information on the change in net revenues assuming that foreign currency exchange rates had not changed between the prior and current periods. AbbVie believes that the non-GAAP measure of change in net revenues at constant currency rates, when used in conjunction with the GAAP measure of change in net revenues at actual currency rates, may provide a more complete understanding of the company's operations and can facilitate analysis of the company's results of operations, particularly in evaluating performance from one period to another.Percent changeAt actual currency ratesAt constant currency ratesyears ended (dollars in millions)2020201920182020201920202019United States$34,879 $23,907 $21,524 45.9 %11.1 %45.9 %11.1 %International10,925 9,359 11,229 16.7 %(16.7)%17.8 %(13.6)%Net revenues$45,804 $33,266 $32,753 37.7 %1.6 %38.0 %2.6 %2020 Form 10-K | 36The following table details AbbVie's worldwide net revenues:Percent changeAt actual currency ratesAt constant currency ratesyears ended December 31 (dollars in millions)2020201920182020201920202019ImmunologyHumiraUnited States$16,112 $14,864 $13,685 8.4 %8.6 %8.4 %8.6 %International3,720 4,305 6,251 (13.6)%(31.1)%(12.5)%(27.8)%Total$19,832 $19,169 $19,936 3.5 %(3.9)%3.7 %(2.9)%SkyriziUnited States$1,385 $311 $— >100.0%n/m>100.0%n/mInternational205 44 — >100.0%n/m>100.0%n/mTotal$1,590 $355 $— >100.0%n/m>100.0%n/mRinvoqUnited States$653 $47 $— >100.0%n/m>100.0%n/mInternational78 — — >100.0%n/m>100.0%n/mTotal$731 $47 $— >100.0%n/m>100.0%n/mHematologic OncologyImbruvicaUnited States$4,305 $3,830 $2,968 12.4 %29.1 %12.4 %29.1 %Collaboration revenues1,009 844 622 19.5 %35.8 %19.5 %35.8 %Total$5,314 $4,674 $3,590 13.7 %30.2 %13.7 %30.2 %VenclextaUnited States$804 $521 $247 54.4 %>100.0%54.4 %>100.0%International533 271 97 97.0 %>100.0%97.8 %>100.0%Total$1,337 $792 $344 69.0 %>100.0%69.3 %>100.0%AestheticsBotox Cosmetic (a)United States$687 $— $— n/mn/mn/mn/mInternational425 — — n/mn/mn/mn/mTotal$1,112 $— $— n/mn/mn/mn/mJuvederm Collection (a)United States$318 $— $— n/mn/mn/mn/mInternational400 — — n/mn/mn/mn/mTotal$718 $— $— n/mn/mn/mn/mOther Aesthetics (a)United States$666 $— $— n/mn/mn/mn/mInternational94 — — n/mn/mn/mn/mTotal$760 $— $— n/mn/mn/mn/mNeuroscienceBotox Therapeutic (a)United States$1,155 $— $— n/mn/mn/mn/mInternational232 — — n/mn/mn/mn/mTotal$1,387 $— $— n/mn/mn/mn/mVraylar (a)United States$951 $— $— n/mn/mn/mn/mDuodopaUnited States$103 $97 $80 5.9 %20.4 %5.9 %20.4 %International391 364 350 7.4 %4.2 %6.3 %9.8 %Total$494 $461 $430 7.1 %7.2 %6.2 %11.7 %Ubrelvy (a)United States$125 $— $— n/mn/mn/mn/mOther Neuroscience (a)United States$528 $— $— n/mn/mn/mn/mInternational11 — — n/mn/mn/mn/mTotal$539 $— $— n/mn/mn/mn/m37 | 2020 Form 10-KPercent changeAt actual currency ratesAt constant currency ratesyears ended December 31 (dollars in millions)2020201920182020201920202019Eye CareLumigan/Ganfort (a)United States$165 $— $— n/mn/mn/mn/mInternational213 — — n/mn/mn/mn/mTotal$378 $— $— n/mn/mn/mn/mAlphagan/Combigan (a)United States$223 $— $— n/mn/mn/mn/mInternational103 — — n/mn/mn/mn/mTotal$326 $— $— n/mn/mn/mn/mRestasis (a)United States$755 $— $— n/mn/mn/mn/mInternational32 — — n/mn/mn/mn/mTotal$787 $— $— n/mn/mn/mn/mOther Eye Care (a)United States$305 $— $— n/mn/mn/mn/mInternational388 — — n/mn/mn/mn/mTotal$693 $— $— n/mn/mn/mn/mWomen's HealthLo Loestrin (a)United States$346 $— $— n/mn/mn/mn/mInternational10 — — n/mn/mn/mn/mTotal$356 $— $— n/mn/mn/mn/mOrilissa/OriahnnUnited States$121 $91 $11 33.3 %>100.0%33.3 %>100.0%International4 2 — 96.1 %n/m97.7 %n/mTotal$125 $93 $11 34.6 %>100.0%34.6 %>100.0%Other Women's Health (a)United States$181 $— $— n/mn/mn/mn/mInternational11 — — n/mn/mn/mn/mTotal$192 $— $— n/mn/mn/mn/mOther Key ProductsMavyretUnited States$785 $1,473 $1,614 (46.7)%(8.8)%(46.7)%(8.8)%International1,045 1,420 1,824 (26.4)%(22.1)%(26.8)%(19.6)%Total$1,830 $2,893 $3,438 (36.7)%(15.9)%(36.9)%(14.6)%CreonUnited States$1,114 $1,041 $928 6.9 %12.2 %6.9 %12.2 %LupronUnited States$600 $720 $726 (16.6)%(0.8)%(16.6)%(0.8)%International152 167 166 (9.1)%0.8 %(5.4)%6.0 %Total$752 $887 $892 (15.2)%(0.5)%(14.5)%0.5 %Linzess/Constella (a)United States$649 $— $— n/mn/mn/mn/mInternational18 — — n/mn/mn/mn/mTotal$667 $— $— n/mn/mn/mn/mSynthroidUnited States$771 $786 $776 (1.9)%1.3 %(1.9)%1.3 %All other$2,923 $2,068 $2,408 41.3 %(14.1)%42.4 %(11.5)%Total net revenues$45,804 $33,266 $32,753 37.7 %1.6 %38.0 %2.6 %n/m – Not meaningful(a)Net revenues include Allergan product revenues from the date of the acquisition, May 8, 2020, through December 31, 2020.The following discussion and analysis of AbbVie's net revenues by product is presented on a constant currency basis.Global Humira sales increased 4% in 2020 primarily driven by market growth across therapeutic categories, offset by direct biosimilar competition in certain international markets. In the United States, Humira sales increased 8% in 2020 driven by market growth across all indications and favorable pricing, partially offset by lower new patient starts due to the COVID-19 pandemic. Internationally, Humira revenues decreased 12% in 2020 primarily driven by direct biosimilar competition in certain international markets. Biosimilar competition for Humira is not expected in the United States until 2023. AbbVie continues to pursue strategies intended to maintain market leadership among its installed patient base and add to the sustainability of Humira.Net revenues for Skyrizi increased more than 100% in 2020 primarily driven by market growth and market share gains over the prior year following the April 2019 regulatory approvals for the treatment of moderate to severe plaque psoriasis.Net revenues for Rinvoq increased more than 100% in 2020 primarily driven by the August 2019 FDA approval and December 2019 EC approval for the treatment of moderate to severe rheumatoid arthritis.2020 Form 10-K | 38Net revenues for Imbruvica represent product revenues in the United States and collaboration revenues outside of the United States related to AbbVie's 50% share of Imbruvica profit. AbbVie's global Imbruvica revenues increased 14% in 2020 as a result of continued penetration of Imbruvica for patients with CLL, partially offset by lower new patient starts due to the COVID-19 pandemic in 2020.Net revenues for Venclexta increased 69% in 2020 primarily due to continued expansion of Venclexta for the treatment of patients with first-line CLL, relapsed/refractory CLL and first-line AML.Net revenues for Botox Cosmetic used in facial aesthetics were $1.1 billion in 2020 for the period subsequent to the completion of the Allergan acquisition.Net revenues for Juvederm Collection (including Juvederm Ultra XC, Juvederm Voluma XC and other Juvederm products) used in facial aesthetics were $718 million in 2020 for the period subsequent to the completion of the Allergan acquisition.Net revenues for Botox Therapeutic used primarily in neuroscience and urology therapeutic areas were $1.4 billion in 2020 for the period subsequent to the completion of the Allergan acquisition.Net revenues for Vraylar for the treatment of schizophrenia, bipolar I disorder and bipolar depression were $951 million in 2020 for the period subsequent to the completion of the Allergan acquisition.Global Mavyret sales decreased 37% in 2020 primarily driven by lower global new patient starts due to the COVID-19 pandemic as well as competitive dynamics in the U.S.Net revenues for Creon increased 7% in 2020 primarily driven by continued market growth, partially offset by lower new patient starts due to the COVID-19 pandemic. Creon maintains market leadership in the pancreatic enzyme market with approximately 80% total market share.Net revenues for Lupron decreased 14% in 2020 primarily due to a near-term supply issue which has impacted product availability of certain formulations.Gross MarginPercent changeyears ended December 31 (dollars in millions)20202019201820202019Gross margin$30,417 $25,827 $25,035 18 %3 %as a percent of net revenues66 %78 %76 %Gross margin as a percentage of net revenues in 2020 decreased from 2019 primarily due to the unfavorable impacts of higher amortization of intangible assets and inventory fair value step-up adjustments associated with the Allergan acquisition as well as collaboration profit sharing arrangements for Imbruvica and Venclexta.Selling, General and AdministrativePercent changeyears ended December 31 (dollars in millions)20202019201820202019Selling, general and administrative$11,299 $6,942 $7,399 63 %(6)%as a percent of net revenues25 %21 %23 %Selling, general and administrative (SG&A) expenses as a percentage of net revenues in 2020 increased from 2019 primarily due to the unfavorable impacts of incremental SG&A expenses of Allergan, including transaction and integration costs resulting from the acquisition.Research and Development and Acquired In-Process Research and DevelopmentPercent changeyears ended December 31 (dollars in millions)20202019201820202019Research and development$6,557 $6,407 $10,329 2 %(38)%as a percent of net revenues14 %19 %32 %Acquired in-process research and development$1,198 $385 $424 >100%(9)%Research and Development (R&D) expenses as a percentage of net revenues decreased in 2020 primarily due to the $1.0 billion intangible asset impairment charge in 2019, which represented the remaining value of the IPR&D acquired as part 39 | 2020 Form 10-Kof the 2016 Stemcentrx acquisition following the decision to terminate the Rova-T R&D program. See Note 7 to the Consolidated Financial Statements for additional information regarding the impairment charge. R&D expenses as a percentage of net revenues in 2020 were also favorably impacted by increased scale of the combined company for the period subsequent to the completion of the Allergan acquisition.Acquired IPR&D expenses reflect upfront payments related to various collaborations. Acquired IPR&D expense in 2020 included a charge of $750 million as a result of entering a collaboration agreement with Genmab A/S (Genmab) to research, develop and commercialize investigational bispecific antibody therapeutics for the treatment of cancer. Acquired IPR&D expense in 2020 also included a charge of $200 million as a result of a collaboration agreement with I-Mab Biopharma (I-Mab) for the development and commercialization of lemzoparlimab for the treatment of multiple cancers. See Note 5 to the Consolidated Financial Statements for additional information regarding the Genmab and I-Mab agreements. There were no individually significant transactions or cash flows during 2019.Other Operating Expenses and IncomeOther operating income in 2019 included $550 million of income from a legal settlement related to an intellectual property dispute with a third party and $330 million of income related to an amended and restated license agreement between AbbVie and Reata. See Note 5 to the Consolidated Financial Statements for additional information on the Reata agreement. Other Non-Operating Expensesyears ended December 31 (in millions)202020192018Interest expense$2,454 $1,784 $1,348 Interest income(174)(275)(204)Interest expense, net$2,280 $1,509 $1,144 Net foreign exchange loss$71 $42 $24 Other expense, net5,614 3,006 18 Interest expense in 2020 increased compared to 2019 primarily due to a higher average debt balance associated with the financing of the Allergan acquisition as well as the incremental Allergan debt acquired, partially offset by the favorable impact of lower interest rates on the company’s debt obligations.Interest income in 2020 decreased compared to 2019 primarily due to a lower average cash and cash equivalents balance as a result of the cash paid for the Allergan acquisition and the unfavorable impact of lower interest rates.Other expense, net included charges related to the change in fair value of the contingent consideration liabilities of $5.8 billion in 2020 and $3.1 billion in 2019. The fair value of contingent consideration liabilities is impacted by the passage of time and multiple other inputs, including the probability of success of achieving regulatory/commercial milestones, discount rates, the estimated amount of future sales of the acquired products and other market-based factors. In 2020, the change in fair value primarily included the increase in the Skyrizi contingent consideration liability due to higher estimated future sales driven by stronger market share uptake and favorable clinical trial results as well as lower interest rates. In 2019, the Skyrizi contingent consideration liability increased due to higher probabilities of success, higher estimated future sales, declining interest rates and passage of time. The higher probabilities of success primarily resulted from the April 2019 regulatory approvals of Skyrizi for the treatment of moderate to severe plaque psoriasis. These changes were partially offset by a $91 million decrease in the Stemcentrx contingent consideration liability due to the termination of the Rova-T R&D program.Income Tax ExpenseThe effective income tax rate was negative 36% in 2020, 6% in 2019 and negative 9% in 2018. The effective tax rate in each period differed from the statutory tax rate principally due to the impact of foreign operations which reflects the impact of lower income tax rates in locations outside the United States, tax incentives in Puerto Rico and other foreign tax jurisdictions, business development activities, changes in enacted tax rates and laws and related restructuring, the cost of repatriation decisions, tax audit settlements and Boehringer Ingelheim accretion on contingent consideration. The decrease in the effective tax rate for 2020 over the prior year was principally due to the recognition of a net tax benefit of $1.7 billion related to changes in tax laws and related restructuring, including certain intra-group transfers of intellectual property and deferred tax remeasurement.2020 Form 10-K | 40FINANCIAL POSITION, LIQUIDITY AND CAPITAL RESOURCESyears ended December 31 (in millions)202020192018Cash flows from:Operating activities$17,588 $13,324 $13,427 Investing activities(37,557)596 (1,006)Financing activities(11,501)18,708 (14,396)Operating cash flows in 2020 increased from 2019 and included the results of Allergan subsequent to the May 8 acquisition date. Operating cash flows in 2020 were favorably impacted by higher net revenues of the combined company and the timing of working capital cash flows, partially offset by acquisition-related cash expenses. Operating cash flows also reflected AbbVie’s contributions to its defined benefit plans of $367 million in 2020 and $727 million in 2019.Investing cash flows in 2020 primarily included $39.7 billion cash consideration paid to acquire Allergan offset by cash acquired of $1.5 billion. Investing cash flows also included net sales and maturities of investments totaling $1.5 billion, payments made for other acquisitions and investments of $1.4 billion and capital expenditures of $798 million. Investing cash flows in 2019 included net sales and maturities of investment securities totaling $2.1 billion resulting from the sale of substantially all of the company's investments in debt securities, payments made for other acquisitions and investments of $1.1 billion and capital expenditures of $552 million.Financing cash flows in 2020 included the issuance of term loans totaling $3.0 billion under the existing $6.0 billion term loan credit agreement which were used to finance the acquisition of Allergan. Subsequent to these borrowings, AbbVie terminated the unused commitments of the lenders under the term loan. Additionally, financing cash flows included the May 2020 repayment of $3.8 billion aggregate principal amount of the company's 2.50% senior notes at maturity, the September 2020 repayment of $650 million aggregate principal amount of 3.375% Allergan exchange notes at maturity, and the November 2020 repayments of €700 million aggregate principal amount of floating rate Allergan exchange notes at maturity and $450 million aggregate principal amount of 4.875% Allergan exchange notes due February 2021. Financing cash flows in 2019 included the issuance of $30.0 billion aggregate principal amount of floating rate and fixed rate unsecured senior notes which were used to finance the acquisition of Allergan. Additionally, financing cash flows in 2019 included the issuance of €1.4 billion aggregate principal amount of unsecured senior Euro notes which the company used to redeem €1.4 billion aggregate principal amount of 0.38% senior Euro notes that were due to mature in November 2019, as well as the repayment of a $3.0 billion 364-day term loan credit agreement that was scheduled to mature in June 2019. Cash dividend payments totaled $7.7 billion in 2020 and $6.4 billion in 2019. The increase in cash dividend payments was primarily driven by higher outstanding shares following the 286 million shares of AbbVie common stock issued to Allergan shareholders in May 2020 as well as an increase in the dividend rate. On October 30, 2020, AbbVie announced that its board of directors declared an increase in the quarterly cash dividend from $1.18 per share to $1.30 per share beginning with the dividend payable on February 16, 2021 to stockholders of record as of January 15, 2021. This reflects an increase of approximately 10.2% over the previous quarterly rate. The timing, declaration, amount of and payment of any dividends by AbbVie in the future is within the discretion of its board of directors and will depend upon many factors, including AbbVie's financial condition, earnings, capital requirements of its operating subsidiaries, covenants associated with certain of AbbVie's debt service obligations, legal requirements, regulatory constraints, industry practice, ability to access capital markets and other factors deemed relevant by its board of directors.The company's stock repurchase authorization permits purchases of AbbVie shares from time to time in open-market or private transactions at management’s discretion. The program has no time limit and can be discontinued at any time. Under this authorization, AbbVie repurchased 8 million shares for $757 million in 2020 and 4 million shares for $300 million in 2019. AbbVie cash-settled $201 million of its December 2018 open market purchases in January 2019. AbbVie's remaining stock repurchase authorization was $3.2 billion as of December 31, 2020.In 2020 and 2019, the company issued and redeemed commercial paper. There were no commercial paper borrowings outstanding as of December 31, 2020 or December 31, 2019. AbbVie may issue additional commercial paper or retire commercial paper to meet liquidity requirements as needed.Credit RiskAbbVie monitors economic conditions, the creditworthiness of customers and government regulations and funding, both domestically and abroad. AbbVie regularly communicates with its customers regarding the status of receivable balances, including their payment plans and obtains positive confirmation of the validity of the receivables. AbbVie establishes an 41 | 2020 Form 10-Kallowance for credit losses equal to the estimate of future losses over the contractual life of outstanding accounts receivable. AbbVie may also utilize factoring arrangements to mitigate credit risk, although the receivables included in such arrangements have historically not been a significant amount of total outstanding receivables.Credit Facility, Access to Capital and Credit RatingsCredit FacilityAbbVie currently has a $4.0 billion five-year revolving credit facility that matures in August 2024. This amended facility enables the company to borrow funds on an unsecured basis at variable interest rates and contains various covenants. At December 31, 2020, the company was in compliance with all covenants, and commitment fees under the credit facility were insignificant. No amounts were outstanding under the company's credit facility as of December 31, 2020 and 2019.Access to CapitalThe company intends to fund short-term and long-term financial obligations as they mature through cash on hand, future cash flows from operations or has the ability to issue additional debt. The company's ability to generate cash flows from operations, issue debt or enter into financing arrangements on acceptable terms could be adversely affected if there is a material decline in the demand for the company's products or in the solvency of its customers or suppliers, deterioration in the company's key financial ratios or credit ratings, or other material unfavorable changes in business conditions. At the current time, the company believes it has sufficient financial flexibility to issue debt, enter into other financing arrangements and attract long-term capital on acceptable terms to support the company's growth objectives.Credit RatingsFollowing the acquisition of Allergan, S&P Global Ratings revised its ratings outlook to stable from negative and lowered the issuer credit rating by one notch to BBB+ from A- and the short-term rating to A-2 from A-1. There were no changes in Moody's Investor Service of its Baa2 senior unsecured long-term rating and Prime-2 short-term rating with a stable outlook.Unfavorable changes to the ratings may have an adverse impact on future financing arrangements; however, they would not affect the company’s ability to draw on its credit facility and would not result in an acceleration of scheduled maturities of any of the company’s outstanding debt.Contractual ObligationsThe following table summarizes AbbVie's estimated contractual obligations as of December 31, 2020:(in millions)TotalLess than one yearOne to three yearsThree to five yearsMore than five yearsShort-term borrowings$34 $34 $— $— $— Long-term debt, including current portion84,948 8,422 16,643 16,197 43,686 Interest on long-term debt(a)33,664 2,752 4,652 3,898 22,362 Non-cancelable operating and finance lease payments1,154 229 323 208 394 Purchase obligations and other(b)5,432 5,040 249 112 31 Other long-term liabilities (c) (d) (e)18,478 1,029 3,036 4,144 10,269 Total$143,710 $17,506 $24,903 $24,559 $76,742 (a)Includes estimated future interest payments on long-term debt. Interest payments on debt are calculated for future periods using forecasted interest rates in effect at the end of 2020. Projected interest payments include the related effects of interest rate swap agreements. Certain of these projected interest payments may differ in the future based on changes in floating interest rates or other factors or events. The projected interest payments only pertain to obligations and agreements outstanding at December 31, 2020. See Note 10 to the Consolidated Financial Statements for additional information regarding the company's debt instruments and Note 11 for additional information on the interest rate swap agreements outstanding at December 31, 2020.(b)Includes the company's significant unconditional purchase obligations. These commitments do not exceed the company's projected requirements and are made in the normal course of business.(c)Excludes liabilities associated with the company's unrecognized tax benefits as it is not possible to reliably estimate the timing of the future cash outflows related to these liabilities. See Note 14 to the Consolidated Financial Statements for additional information on these unrecognized tax benefits.2020 Form 10-K | 42(d)Includes $13.0 billion of contingent consideration liabilities which are recorded at fair value on the consolidated balance sheet. Potential contingent consideration payments that exceed the fair value recorded on the consolidated balance sheet are not included in the table of contractual obligations. See Note 11 to the Consolidated Financial Statements for additional information regarding these liabilities.(e)Includes a one-time transition tax liability on a mandatory deemed repatriation of previously untaxed earnings of foreign subsidiaries resulting from U.S. tax reform enacted in 2017. The one-time transition tax is generally payable in eight annual installments. AbbVie enters into R&D collaboration arrangements with third parties that may require future milestone payments to third parties contingent upon the achievement of certain development, regulatory, or commercial milestones. Individually, these arrangements are insignificant in any one annual reporting period. However, if milestones for multiple products covered by these arrangements would happen to be reached in the same reporting period, the aggregate charge to expense could be material to the results of operations in that period. From a business perspective, the payments are viewed as positive because they signify that the product is successfully moving through development and is now generating or is more likely to generate future cash flows from product sales. It is not possible to predict with reasonable certainty whether these milestones will be achieved or the timing for achievement. As a result, these potential payments are not included in the table of contractual obligations. See Note 5 to the Consolidated Financial Statements for additional information on these collaboration arrangements.CRITICAL ACCOUNTING POLICIES AND ESTIMATESThe preparation of financial statements in accordance with generally accepted accounting principles in the United States requires the use of estimates and assumptions that affect the reported amounts of assets and liabilities and the reported amounts of revenue and expenses. A summary of the company's significant accounting policies is included in Note 2 to the Consolidated Financial Statements. Certain of these policies are considered critical as these most significantly impact the company's financial condition and results of operations and require the most difficult, subjective, or complex judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain. Actual results may vary from these estimates.Revenue RecognitionAbbVie recognizes revenue when control of promised goods or services is transferred to the company’s customers, in an amount that reflects the consideration AbbVie expects to be entitled to in exchange for those goods or services. Sales, value add and other taxes collected concurrent with revenue-producing activities are excluded from revenue. AbbVie generates revenue primarily from product sales. For the majority of sales, the company transfers control, invoices the customer and recognizes revenue upon shipment to the customer. Rebates AbbVie provides rebates to pharmacy benefit managers, state government Medicaid programs, insurance companies that administer Medicare drug plans, wholesalers, group purchasing organizations and other government agencies and private entities.Rebate and chargeback accruals are accounted for as variable consideration and are recorded as a reduction to revenue in the period the related product is sold. Provisions for rebates and chargebacks totaled $27.0 billion in 2020, $18.8 billion in 2019 and $16.4 billion in 2018. Rebate amounts are typically based upon the volume of purchases using contractual or statutory prices, which may vary by product and by payer. For each type of rebate, the factors used in the calculations of the accrual for that rebate include the identification of the products subject to the rebate, the applicable price terms and the estimated lag time between sale and payment of the rebate, which can be significant.In order to establish its rebate and chargeback accruals, the company uses both internal and external data to estimate the level of inventory in the distribution channel and the rebate claims processing lag time for each type of rebate. To estimate the rebate percentage or net price, the company tracks sales by product and by customer or payer. The company evaluates inventory data reported by wholesalers, available prescription volume information, product pricing, historical experience and other factors in order to determine the adequacy of its reserves. AbbVie regularly monitors its reserves and records adjustments when rebate trends, rebate programs and contract terms, legislative changes, or other significant events indicate that a change in the reserve is appropriate. Historically, adjustments to rebate accruals have not been material to net earnings.43 | 2020 Form 10-KThe following table is an analysis of the three largest rebate accruals and chargeback allowances, which comprise approximately 89% of the total consolidated rebate and chargebacks recorded as reductions to revenues in 2020. Remaining rebate provisions charged against gross revenues are not significant in the determination of operating earnings.(in millions)Medicaid and Medicare RebatesManaged Care RebatesWholesalerChargebacksBalance at December 31, 2017$1,340 $1,195 $522 Provisions3,493 4,729 6,659 Payments(3,188)(4,485)(6,525)Balance at December 31, 20181,645 1,439 656 Provisions4,035 5,772 7,947 Payments(3,915)(5,275)(7,917)Balance at December 31, 20191,765 1,936 686 Additions(a)1,266 649 71 Provisions6,715 8,656 8,677 Payments(6,801)(8,334)(8,693)Balance at December 31, 2020$2,945 $2,907 $741 (a)Represents rebate accruals and chargeback allowances assumed in the Allergan acquisition.Cash Discounts and Product ReturnsCash discounts and product returns, which totaled $2.4 billion in 2020, $1.6 billion in 2019 and $1.6 billion in 2018, are accounted for as variable consideration and are recorded as a reduction to revenue in the same period the related product is sold. The reserve for cash discounts is readily determinable because the company's experience of payment history is fairly consistent. Product returns can be reliably estimated based on the company's historical return experience.Pension and Other Post-Employment BenefitsAbbVie engages outside actuaries to assist in the determination of the obligations and costs under the pension and other post-employment benefit plans that are direct obligations of AbbVie. The valuation of the funded status and the net periodic benefit cost for these plans are calculated using actuarial assumptions. The significant assumptions, which are reviewed annually, include the discount rate, the expected long-term rate of return on plan assets and the health care cost trend rates, and are disclosed in Note 12 to the Consolidated Financial Statements.The discount rate is selected based on current market rates on high-quality, fixed-income investments at December 31 each year. AbbVie employs a yield-curve approach for countries where a robust bond market exists. The yield curve is developed using high-quality bonds. The yield-curve approach reflects the plans' specific cash flows (i.e. duration) in calculating the benefit obligations by applying the corresponding individual spot rates along the yield curve. AbbVie reflects the plans' specific cash flows and applies them to the corresponding individual spot rates along the yield curve in calculating the service cost and interest cost portions of expense. For other countries, AbbVie reviews various indices such as corporate bond and government bond benchmarks to estimate the discount rate. AbbVie's assumed discount rates have a significant effect on the amounts reported for defined benefit pension and other post-employment plans as of December 31, 2020. A 50 basis point change in the assumed discount rate would have had the following effects on AbbVie's calculation of net periodic benefit costs in 2021 and projected benefit obligations as of December 31, 2020:50 basis point(in millions) (brackets denote a reduction)IncreaseDecreaseDefined benefit plansService and interest cost$(89)$101 Projected benefit obligation(1,000)1,140 Other post-employment plansService and interest cost$(6)$7 Projected benefit obligation(56)63 2020 Form 10-K | 44The expected long-term rate of return is based on the asset allocation, historical performance and the current view of expected future returns. AbbVie considers these inputs with a long-term focus to avoid short-term market influences. The current long-term rate of return on plan assets for each plan is supported by the historical performance of the trust's actual and target asset allocation. AbbVie's assumed expected long-term rate of return has a significant effect on the amounts reported for defined benefit pension plans as of December 31, 2020 and will be used in the calculation of net periodic benefit cost in 2021. A one percentage point change in assumed expected long-term rate of return on plan assets would increase or decrease the net period benefit cost of these plans in 2021 by $94 million.The health care cost trend rate is selected by reviewing historical trends and current views on projected future health care cost increases. The current health care cost trend rate is supported by the historical trend experience of each plan. Assumed health care cost trend rates have a significant effect on the amounts reported for health care plans as of December 31, 2020 and will be used in the calculation of net periodic benefit cost in 2021. Income TaxesAbbVie accounts for income taxes under the asset and liability method. Provisions for federal, state and foreign income taxes are calculated on reported pretax earnings based on current tax laws. Deferred taxes are provided using enacted tax rates on the future tax consequences of temporary differences, which are the differences between the financial statement carrying amount of assets and liabilities and their respective tax bases and the tax benefits of carryforwards. A valuation allowance is established or maintained when, based on currently available information, it is more likely than not that all or a portion of a deferred tax asset will not be realized.LitigationThe company is subject to contingencies, such as various claims, legal proceedings and investigations regarding product liability, intellectual property, commercial, securities and other matters that arise in the normal course of business. See Note 15 to the Consolidated Financial Statements for additional information. Loss contingency provisions are recorded for probable losses at management's best estimate of a loss, or when a best estimate cannot be made, a minimum loss contingency amount within a probable range is recorded. Accordingly, AbbVie is often initially unable to develop a best estimate of loss and therefore, the minimum amount, which could be zero, is recorded. As information becomes known, either the minimum loss amount is increased, resulting in additional loss provisions, or a best estimate can be made, also resulting in additional loss provisions. Occasionally, a best estimate amount is changed to a lower amount when events result in an expectation of a more favorable outcome than previously expected.Valuation of Goodwill and Intangible AssetsAbbVie has acquired and may continue to acquire significant intangible assets in connection with business combinations that AbbVie records at fair value. Transactions involving the purchase or sale of intangible assets occur with some frequency between companies in the pharmaceuticals industry and valuations are usually based on a discounted cash flow analysis incorporating the stage of completion. The discounted cash flow model requires assumptions about the timing and amount of future net cash flows, risk, cost of capital, terminal values and market participants. Each of these factors can significantly affect the value of the intangible asset. IPR&D acquired in a business combination is capitalized as an indefinite-lived intangible asset until regulatory approval is obtained, at which time it is accounted for as a definite-lived asset and amortized over its estimated useful life, or discontinuation, at which point the intangible asset will be written off. IPR&D acquired in transactions that are not business combinations is expensed immediately, unless deemed to have an alternative future use. Payments made to third parties subsequent to regulatory approval are capitalized and amortized over the remaining useful life.AbbVie reviews the recoverability of definite-lived intangible assets whenever events or changes in circumstances indicate the carrying value of an asset may not be recoverable. Goodwill and indefinite-lived intangible assets are reviewed for impairment annually or when an event occurs that could result in an impairment. See Note 2 to the Consolidated Financial Statements for further information.Annually, the company tests its goodwill for impairment by first assessing qualitative factors to determine whether it is more likely than not that the fair value is less than its carrying amount. Some of the factors considered in the assessment include general macro-economic conditions, conditions specific to the industry and market, cost factors, the overall financial performance and whether there have been sustained declines in the company's share price. If the company concludes it is more likely than not that the fair value of the reporting unit is less than its carrying amount, a quantitative impairment test is performed. AbbVie tests indefinite-lived intangible assets for impairment by first assessing qualitative factors to determine whether it is more likely than not that the fair value is less than its carrying amount. If the company concludes it is more likely than not that the fair value is less than its carrying amount, a quantitative impairment test is performed. 45 | 2020 Form 10-KFor its quantitative impairment tests, the company uses an estimated future cash flow approach that requires significant judgment with respect to future volume, revenue and expense growth rates, changes in working capital use, the selection of an appropriate discount rate, asset groupings and other assumptions and estimates. The estimates and assumptions used are consistent with the company's business plans and a market participant's views. The use of alternative estimates and assumptions could increase or decrease the estimated fair value of the assets and could potentially impact the company's results of operations. Actual results may differ from the company's estimates.Contingent ConsiderationThe fair value measurements of contingent consideration liabilities are determined as of the acquisition date based on significant unobservable inputs, including the discount rate, estimated probabilities and timing of achieving specified development, regulatory and commercial milestones and the estimated amount of future sales of the acquired products. Contingent consideration liabilities are revalued to fair value at each subsequent reporting date until the related contingency is resolved. The potential contingent consideration payments are estimated by applying a probability-weighted expected payment model for contingent milestone payments and a Monte Carlo simulation model for contingent royalty payments, which are then discounted to present value. Changes to the fair value of the contingent consideration liabilities can result from changes to one or a number of inputs, including discount rates, the probabilities of achieving the milestones, the time required to achieve the milestones and estimated future sales. Significant judgment is employed in determining the appropriateness of certain of these inputs. Changes to the inputs described above could have a material impact on the company's financial position and results of operations in any given period. The fair value of the company's contingent consideration liabilities as of December 31, 2020 was calculated using the following significant unobservable inputs:RangeWeighted Average(a)Discount rate0.1% - 2.2%1.1%Probability of payment for unachieved milestones56% - 92%64%Probability of payment for royalties by indication(b)56% - 100%91%Projected year of payments2021 - 20342027(a)Unobservable inputs were weighted by the relative fair value of the contingent consideration liabilities.(b)Excludes early stage indications with 0% estimated probability of payment and includes approved indications with 100% probability of payment. Excluding approved indications, the estimated probability of payment ranged from 56% to 89% at December 31, 2020. Recent Accounting PronouncementsSee Note 2 to the Consolidated Financial Statements for additional information on recent accounting pronouncements.2020 Form 10-K | 46ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKThe company is exposed to risk that its earnings, cash flows and equity could be adversely impacted by changes in foreign exchange rates and interest rates. Certain derivative instruments are used when available on a cost-effective basis to hedge the company's underlying economic exposures. See Note 11 to the Consolidated Financial Statements for additional information regarding the company's financial instruments and hedging strategies.Foreign Currency RiskAbbVie's primary net foreign currency exposures are the Euro, Japanese yen, Canadian dollar and British pound. The following table reflects the total foreign currency forward exchange contracts outstanding at December 31, 2020 and 2019:20202019as of December 31 (in millions)Contract amountWeighted average exchange rateFair and carrying value receivable/(payable)Contract amountWeighted average exchange rateFair and carrying value receivable/(payable)Receive primarily U.S. dollars in exchange for the following currencies:Euro$7,818 1.213 $(39)$6,217 1.116 $(12)Japanese yen837 103.9 (7)820 108.7 — Canadian dollar591 1.328 (23)504 1.324 (6)British pound275 1.341 3 427 1.305 (6)All other currencies1,706 n/a(15)1,508 n/a(10)Total$11,227 $(81)$9,476 $(34)The company estimates that a 10% appreciation in the underlying currencies being hedged from their levels against the U.S. dollar, with all other variables held constant, would decrease the fair value of foreign exchange forward contracts by $1.14 billion at December 31, 2020. If realized, this appreciation would negatively affect earnings over the remaining life of the contracts. However, gains and losses on the hedging instruments offset losses and gains on the hedged transactions and reduce the earnings and stockholders' equity volatility relating to foreign exchange. A 10% appreciation is believed to be a reasonably possible near-term change in foreign currencies.As of December 31, 2020, the company has €6.6 billion aggregate principal amount of unsecured senior Euro notes outstanding, which are exposed to foreign currency risk. The company designated these foreign currency denominated notes as hedges of its net investments in certain foreign subsidiaries and affiliates. As a result, any foreign currency translation gains or losses related to the Euro notes will be included in accumulated other comprehensive loss. See Note 10 to the Consolidated Financial Statements for additional information regarding to the senior Euro notes and Note 11 to the Consolidated Financial Statements for additional information regarding to the net investment hedging program. Interest Rate RiskThe company estimates that an increase in interest rates of 100 basis points would adversely impact the fair value of AbbVie's interest rate swap contracts by approximately $111 million at December 31, 2020. If realized, the fair value reduction would affect earnings over the remaining life of the contracts. The company estimates that an increase of 100 basis points in long-term interest rates would decrease the fair value of long-term debt by $5.7 billion at December 31, 2020. A 100 basis point change is believed to be a reasonably possible near-term change in interest rates. 47 | 2020 Form 10-K
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+Item 7. Management’s Discussion and Analysis of Financial Condition and Results of OperationsYou should read the following discussion and analysis of our financial condition and results of operations together with our consolidated financial statements and related notes included elsewhere in this Annual Report on Form 10-K. This discussion contains forward-looking statements based upon current expectations that involve risks and uncertainties. Our actual results may differ materially from those anticipated in these forward-looking statements as a result of various factors, including those set forth under the section titled “Risk Factors” or in other parts of this Annual Report on Form 10-K. Our historical results are not necessarily indicative of the results that may be expected for any period in the future. Except as otherwise noted, all references to 2020 refer to the year ended December 31, 2020, references to 2019 refer to the year ended December 31, 2019, and references to 2018 refer to the year ended December 31, 2018.Overview Airbnb is a community based on connection and belonging—a community that was born in 2007 when two hosts welcomed three guests to their San Francisco home, and has since grown to 4 million hosts who have welcomed over 800 million guest arrivals to approximately 100,000 cities in almost every country and region across the globe. Hosts on Airbnb are everyday people who share their worlds to provide guests with the feeling of connection and being at home. Airbnb has five stakeholders and is designed with all of them in mind. Along with employees and shareholders, we serve hosts, guests, and the communities in which they live. We intend to make long-term decisions considering all of our stakeholders because their collective success is key for our business to thrive. Our Business Model We operate a global marketplace, where hosts offer guests stays and experiences on our platform. Our business model relies on the success of hosts and guests who join our community and generate consistent bookings over time. As hosts become more successful on our platform and as guests return over time, we benefit from the recurring activity of our community.We experienced rapid growth since our founding through 2019. In 2019, we generated GBV of $38.0 billion, representing growth of 29% from $29.4 billion in 2018, and revenue of $4.8 billion, representing growth of 32% from $3.7 billion in 2018. During the year ended December 31, 2020, our business was materially impacted by the COVID-19 pandemic, with GBV of $23.9 billion, down 37% year over year, and revenue of $3.4 billion, down 30% year over year. We expect continued volatility in these trends and fluctuations from month to month as the continued impact from COVID-19 is not linear across geographies and as COVID-19 is continuing to materially adversely affect our business and financial results.Initial Public Offering Our IPO was completed on December 14, 2020. Our consolidated financial statements as of December 31, 2020 and for the year then-ended reflect the sale by us of an aggregate of 55,000,000 shares in our IPO, including the exercise of the underwriters’ option to purchase 56Table of Contentsadditional shares, at the public offering price of $68.00 per share, for net proceeds to us of approximately $3.7 billion, after underwriting discounts and commissions and offering expenses, and the conversion of all outstanding shares of our redeemable convertible preferred stock into an aggregate of 240,910,588 shares of Class B common stock, including 1,286,694 shares of Class B common stock issuable pursuant to the anti-dilution adjustment provisions relating to our Series C redeemable convertible preferred stock.Our consolidated financial statements as of December 31, 2020 and for the year then-ended include stock-based compensation expense of $2.8 billion associated with the vesting of RSUs in connection with our IPO for which the requisite service-based vesting condition was met as of December 31, 2020. The liquidity-based vesting condition for RSUs was satisfied upon the effectiveness of our IPO Registration Statement on December 9, 2020.Key Business Metrics and Non-GAAP Financial Measures We track the following key business metrics and financial measures that are not calculated and presented in accordance with GAAP (“non-GAAP financial measures”) to evaluate our performance, identify trends, formulate financial projections, and make strategic decisions. Accordingly, we believe that these key business metrics and non-GAAP financial measures provide useful information to investors and others in understanding and evaluating our results of operations in the same manner as our management team. These key business metrics and non-GAAP financial measures are presented for supplemental informational purposes only, should not be considered a substitute for financial information presented in accordance with GAAP, and may be different from similarly titled metrics or measures presented by other companies. A reconciliation of each non-GAAP financial measure to the most directly comparable financial measure stated in accordance with GAAP is provided under the subsection titled “— Adjusted EBITDA” and “— Free Cash Flow” below. Key Business MetricsWe review the following key business metrics to measure our performance, identify trends, formulate financial projections, and make strategic decisions. We are not aware of any uniform standards for calculating these key metrics, which may hinder comparability with other companies that may calculate similarly titled metrics in a different way.Year Ended December 31,20162017201820192020(in millions)Nights and Experiences Booked125.7 185.8 250.3 326.9 193.2 Gross Booking Value$13,924.8 $20,975.3 $29,440.7 $37,962.6 $23,896.9 Nights and Experiences Booked Nights and Experiences Booked is a key measure of the scale of our platform, which in turn drives our financial performance. Nights and Experiences Booked on our platform in a period represents the sum of the total number of nights booked for stays and the total number of seats booked for experiences, net of cancellations and alterations that occurred in that period. For example, a booking made on February 15 would be reflected in Nights and Experiences Booked for our quarter ended March 31. If, in the example, the booking were canceled on May 15, Nights and Experiences Booked would be reduced by the cancellation for our quarter ended June 30. A night can include one or more guests and can be for a listing with one or more bedrooms. A seat is booked for each participant in an experience. Substantially all of the bookings on our platform to date have come from nights. We believe Nights and Experiences Booked is a key business metric to help investors and others understand and evaluate our results of operations in the same manner as our management team, as it represents a single unit of transaction on our platform. In 2020, we had 193.2 million Nights and Experiences Booked, a 41% decrease from 326.9 million Nights and Experiences Booked in 2019, which in turn was a 31% increase from 250.3 million Nights and Experiences Booked in 2018. Nights and Experiences Booked grows as we attract new hosts and guests to our platform and as repeat guests increase their activity on our platform. Our Nights and Experiences Booked declined from prior levels as a result of the COVID-19 pandemic. The decline in 2020 was most severe in the second quarter, with Nights and Experiences Booked declining 67% from the prior year period, and our business improved from those levels in the third and fourth quarters with declines of 28% and 39%, respectively, from the prior year period. This improvement was driven by stronger results in North America and Europe, in particular with resilience in domestic and short-distance travel, with more people gravitating toward Airbnb stays within driving distance of their homes. Gross Booking Value GBV represents the dollar value of bookings on our platform in a period and is inclusive of host earnings, service fees, cleaning fees, and taxes, net of cancellations and alterations that occurred during that period. The timing of recording GBV and any related cancellations is similar to that described in the subsection titled “— Key Business Metrics and Non-GAAP Financial Measures — Nights and Experiences Booked” above. Revenue from the booking is recognized upon check-in; accordingly, GBV is a leading indicator of revenue. The entire amount of a booking is reflected in GBV during the quarter in which booking occurs, whether the guest pays the entire amount of the booking upfront or elects to use our Pay Less Upfront program.Growth in GBV reflects our ability to attract and retain hosts and guests and reflects growth in Nights and Experiences Booked. In 2020, our GBV was $23.9 billion, a 37% decrease from $38.0 billion in 2019, which in turn was a 29% increase from $29.4 billion in 2018. The decrease in our GBV in 2020 was due to the reduction in Nights and Experiences Booked due to the COVID-19 pandemic, as described above. On a constant currency basis, the reduction in GBV was 37%. The decline was most severe in the second quarter, with GBV declining 67% from the prior year. We experienced an increase in GBV in the third and fourth quarters of 2020 as domestic travel rebounded on our platform from 57Table of Contentsthe second quarter levels, but below third and fourth quarter 2019 levels by 17% and 31%, respectively. In the third and fourth quarters of 2020, GBV declined less than Nights and Experiences Booked as a result of increased GBV per Night and Experience Booked driven by a shift towards North America compared to other regions and entire home bookings.Non-GAAP Financial MeasuresIn addition to our results determined in accordance with GAAP, we believe the following non-GAAP measures are useful in evaluating our operating performance. We use the following non-GAAP financial information, collectively, to evaluate our ongoing operations and for internal planning and forecasting purposes.We believe that non-GAAP financial information, when taken collectively, may be helpful to investors because it provides consistency and comparability with past financial performance, and assists in comparisons with other companies, some of which use similar non-GAAP financial information to supplement their GAAP results. The non-GAAP financial information is presented for supplemental informational purposes only, should not be considered a substitute for financial information presented in accordance with GAAP, and may be different from similarly titled non-GAAP measures used by other companies. A reconciliation of each non-GAAP financial measure to the most directly comparable financial measure stated in accordance with GAAP is provided below. Investors are encouraged to review the related GAAP financial measures and the reconciliation of these non-GAAP financial measures to their most directly comparable GAAP financial measures. The following table summarizes our non-GAAP financial measures, along with the most directly comparable GAAP measure, for each period presented below.Year Ended December 31, 201820192020(in thousands)Net loss$(16,860)$(674,339)$(4,584,716)Adjusted EBITDA$170,625 $(253,260)$(250,673)Net cash provided by (used in) operating activities$595,557 $222,727 $(629,732)Free Cash Flow$504,933 $97,275 $(667,103)Adjusted EBITDA We define Adjusted EBITDA as net income or loss adjusted for (i) provision for (benefit from) income taxes; (ii) interest income, interest expense, and other income (expense), net; (iii) depreciation and amortization; (iv) stock-based compensation expense and stock-settlement obligations related to the IPO; (v) acquisition-related impacts consisting of gains (losses) recognized on changes in the fair value of contingent consideration arrangements; (vi) net changes to the reserves for lodging taxes for which management believes it is probable that we may be held jointly liable with hosts for collecting and remitting such taxes; and (vii) restructuring charges. The above items are excluded from our Adjusted EBITDA measure because these items are non-cash in nature, or because the amount and timing of these items is unpredictable, not driven by core results of operations and renders comparisons with prior periods and competitors less meaningful. We believe Adjusted EBITDA provides useful information to investors and others in understanding and evaluating our results of operations, as well as provides a useful measure for period-to-period comparisons of our business performance. Moreover, we have included Adjusted EBITDA in this Annual Report on Form 10-K because it is a key measurement used by our management internally to make operating decisions, including those related to operating expenses, evaluating performance, and performing strategic planning and annual budgeting. Adjusted EBITDA also excludes certain items related to transactional tax matters, for which management believes it is probable that we may be held jointly liable with hosts in certain jurisdictions, and we urge investors to review the detailed disclosure regarding these matters included in the subsection titled “—Critical Accounting Policies and Estimates—Lodging Tax Obligations,” as well as the notes to our consolidated financial statements included elsewhere in this Annual Report on Form 10-K.Adjusted EBITDA has limitations as a financial measure, should be considered as supplemental in nature, and is not meant as a substitute for the related financial information prepared in accordance with GAAP. These limitations include the following: •Adjusted EBITDA does not reflect interest income (expense) and other income (expense), net, which include unrealized and realized gains and losses on foreign currency exchange, investments, and financial instruments, including the warrants issued in connection with a term loan agreement entered into in April 2020; •Adjusted EBITDA excludes certain recurring, non-cash charges, such as depreciation of property and equipment and amortization of intangible assets, and although these are non-cash charges, the assets being depreciated and amortized may have to be replaced in the future, and Adjusted EBITDA does not reflect all cash requirements for such replacements or for new capital expenditure requirements; •Adjusted EBITDA excludes stock-based compensation expense, which has been, and will continue to be for the foreseeable future, a significant recurring expense in our business and an important part of our compensation strategy as well as stock-settlement obligations, which represent employer and related taxes related to the IPO; •Adjusted EBITDA excludes acquisition-related impacts consisting of gains (losses) recognized on changes in the fair value of contingent consideration arrangements. The contingent consideration, which was in the form of equity, was valued as of the 58Table of Contentsacquisition date and is mark-to-market at each reporting period based on factors including our stock price. The changes in fair value of contingent consideration was insignificant prior to the fourth quarter of 2020;•Adjusted EBITDA does not reflect net changes to reserves for lodging taxes for which management believes it is probable that we may be held jointly liable with hosts for collecting and remitting such taxes; and •Adjusted EBITDA does not reflect restructuring charges, which include severance and other employee costs, lease impairments, and contract amendments and terminations. Because of these limitations, you should consider Adjusted EBITDA alongside other financial performance measures, including net loss and our other GAAP results.In 2020, Adjusted EBITDA was $(250.7) million, compared to Adjusted EBITDA in 2019 of $(253.3) million, primarily due to the reduction in Nights and Experiences Booked and GBV due to the COVID-19 pandemic, as described above, partially offset by a reduction in overall spend. In 2019, Adjusted EBITDA was $(253.3) million, compared to Adjusted EBITDA in 2018 of $170.6 million, primarily due to significant investments in growth initiatives and investments in our technical infrastructure in 2019. Adjusted EBITDA ReconciliationThe following is a reconciliation of Adjusted EBITDA to the most comparable GAAP measure, net loss: Year Ended December 31, 201820192020(in thousands, except percentages)Revenue$3,651,985 $4,805,239 $3,378,199 Net loss$(16,860)$(674,339)$(4,584,716)Adjusted to exclude the following:Provision for (benefit from) income taxes63,893 262,636 (97,222)Other (income) expense, net12,361 (13,906)947,220 Interest expense26,143 9,968 171,688 Interest income(66,793)(85,902)(27,117)Depreciation and amortization82,401 114,162 125,876 Stock-based compensation expense(1)53,893 97,547 3,002,148 Stock-settlement obligations related to IPO— — 103,411 Acquisition-related impacts— — 37,215 Net changes in lodging tax reserves15,587 36,574 (80,531)Restructuring charges— — 151,355 Adjusted EBITDA$170,625 $(253,260)$(250,673)Adjusted EBITDA as a percentage of Revenue5 %(5)%(7)%(1)Excludes stock-based compensation related to restructuring, which is included in restructuring charges in the table above. Free Cash Flow We define Free Cash Flow as net cash provided by (used in) operating activities less purchases of property and equipment. We believe that Free Cash Flow is a meaningful indicator of liquidity that provides information to our management and investors about the amount of cash generated from operations, after purchases of property and equipment, that can be used for investment in our business and for acquisitions as well as to strengthen our balance sheet. Our Free Cash Flow is impacted by the timing of GBV because we collect our service fees at the time of booking, which is generally before a stay or experience occurs. Funds held on behalf of our hosts and guests and amounts payable to our hosts and guests do not impact Free Cash Flow, except interest earned on these funds. Free Cash Flow has limitations as an analytical tool and should not be considered in isolation or as a substitute for analysis of other GAAP financial measures, such as net cash provided by (used in) operating activities. Free Cash Flow does not reflect our ability to meet future contractual commitments and may be calculated differently by other companies in our industry, limiting its usefulness as a comparative measure.In 2020, Free Cash Flow was $(667.1) million compared to $97.3 million in 2019, representing 2% of revenue, and $504.9 million in 2018, representing 14% of revenue in 2018. Free Cash Flow decreased in 2020 due to the reduction in Nights and Experiences Booked and GBV due to the COVID-19 pandemic, as described above, partially offset by cost reductions. Free Cash Flow decreased in 2019 largely due to higher operating expenses, while it increased in 2018 compared to the prior year primarily due to higher operating income and to a lesser extent, lower capital expenditures.59Table of ContentsFree Cash Flow Reconciliation The following is a reconciliation of Free Cash Flow to the most comparable GAAP cash flow measure, net cash provided by (used in) operating activities: Year Ended December 31, 201820192020 (in thousands, except percentages)Revenue$3,651,985 $4,805,239 $3,378,199 Net cash provided by (used in) operating activities$595,557 $222,727 $(629,732)Purchases of property and equipment(90,624)(125,452)(37,371)Free Cash Flow$504,933 $97,275 $(667,103)Free Cash Flow as a percentage of Revenue14 %2 %(20)%Other cash flow components: Net cash provided by (used in) investing activities$(668,171)$(347,155)$79,590 Net cash provided by financing activities$140,516 $854,579 $2,940,814 Impact of COVID-19 on our BusinessCOVID-19 Has Had a Disproportionately Negative Effect on the Travel Industry In December 2019, a novel strain of coronavirus disease was first reported. Only three months later, in March 2020, the World Health Organization characterized COVID-19 as a global pandemic. The COVID-19 pandemic has forced international, federal, state, and local governments to enforce prohibitions of non-essential activities. The outbreak will have a continued adverse impact on economic and market conditions and has already triggered a period of global economic slowdown, the depth and breadth of which are yet to be determined. The COVID-19 pandemic has resulted in global travel restrictions and a corresponding significant reduction in travel. While many industries have been adversely impacted, travel has been disproportionately affected, as governments have implemented travel restrictions and as people have become reluctant to travel irrespective of such restrictions. Prior to the outbreak, we had seen strong year-over-year growth in Nights and Experiences Booked in the first three weeks of 2020. We first saw the impact of COVID-19 in China in the last week of January, which when contained to China, had a minor impact on the entire business. The outbreak spread throughout Asia, and then through Europe, North America, and the rest of the world by the end of the first quarter of 2020. In order to protect our business from these near-term market disruptions and the prospect of a prolonged business impact, we raised $2.0 billion in the form of term loans in April 2020 and took action to dramatically reduce our operating expenses as described below. We believe these incremental funds and our rapid management of expenses, in addition to our existing cash position, has helped and will continue to help us to prudently manage our business through the effects of the COVID-19 pandemic. As of the date of this Annual Report on Form 10-K, the full impact of the COVID-19 pandemic on the global economy and the extent to which the COVID-19 pandemic will continue to adversely impact our financial condition, results of operations, and cash flows remains uncertain. Our financial results for 2020 were materially adversely affected, and we expect that COVID-19 will continue to materially impact our bookings, revenue, and business operations in future periods. While we experienced an increase in GBV and revenue in the third quarter of 2020 compared to the second quarter of 2020 as domestic travel rebounded, both were down compared to the same periods in 2019. During the fourth quarter of 2020, another wave of COVID-19 infections emerged. As a result, countries imposed strict lockdowns. Similar to the impact of the initial COVID-19 wave in March 2020, we saw a decrease in bookings in the most affected regions. As a result, while the fourth quarter GBV and revenue were greater than the second quarter, there were greater year-over-year declines in Nights and Experiences Booked and GBV in the fourth quarter of 2020 than in the third quarter of 2020. The extent and duration of the impact of the COVID-19 pandemic over the longer term remain uncertain and dependent on future developments that cannot be accurately predicted at this time, such as the severity and transmission rate of COVID-19, the extent and effectiveness of containment actions taken, including mobility restrictions, the timing, availability, and effectiveness of vaccines, and the impact of these and other factors on travel behavior in general, and on our business in particular. Multiple Resilient Categories Were Less Impacted and Showed Strong Recovery We believe that the recovery in GBV that we experienced in the second half of 2020 was attributable to the renewed ability and willingness for guests to travel, the resilience of our hosts, and relative strength of our business model. From December 31, 2019 through December 31, 2020, active listings remained stable at approximately 5.6 million despite the decline in booking activity on our platform due to COVID-19. Against an otherwise highly negative travel backdrop, there are several areas of our business that have shown resilience, notably, domestic travel, short-distance travel, travel outside of our top 20 cities, and long-term stays. While we believe that travel will change as a result of 60Table of ContentsCOVID-19, the adaptability of our business suggests that we are well-positioned to serve this dynamic market as it continues to evolve and recover. COVID-19 Cost Reductions Helped Position Our Business for Improved Financial Performance In response to the spread of COVID-19 and the resulting material decrease in GBV, we undertook an internal review of our cost structure, ultimately making changes to improve the strength of our business in the long term. Specifically, we significantly reduced our fixed and variable costs in 2020, which we believe will result in improved operating leverage as we emerge from COVID-19. In 2020, we rapidly made changes to manage our expenses in a period of material business interruption, which included suspending substantially all discretionary marketing program spend, reducing full-time employee headcount by approximately 25%, and suspending all facilities build-outs and significantly reducing capital expenditures.These headcount reductions and other restructuring actions resulted in charges of $151.4 million for 2020. In conjunction with these actions, we have realigned our organizational priorities to further increase our focus on individual hosts and brand marketing, while pausing our investments in newer areas such as transportation and content and reducing performance marketing. We have done this to sharpen our focus on investments that directly strengthen our community and to increase the efficiency of our operations as the travel industry begins to recover from the COVID-19 pandemic. We believe these changes should allow us to more effectively manage our business and improve our financial operating results. Geographic Mix Our operations are global, and certain trends in our business, such as Nights and Experiences Booked, GBV, revenue, GBV per Night and Experience Booked, and Nights per Booking vary by geography. We measure Nights and Experiences Booked by region based on the location of the listing. As a result of COVID-19, the geographic mix of Nights and Experiences Booked, GBV, and revenue during 2020 reflected a shift toward North America, which saw the strongest recovery in the second half of the year. For 2020, Nights and Experiences Booked were 75.5 million, or 39% of the total, in North America compared to 67.7 million, or 35%, in EMEA, 27.6 million, or 14%, in Asia Pacific, and 22.4 million, or 12%, in Latin America. For 2020, GBV was $13.2 billion, or 55% of the total, in North America compared to $6.6 billion, or 28%, in EMEA, $2.4 billion, or 10%, in Asia Pacific, and $1.7 billion, or 7%, in Latin America. Similarly, for 2020, revenue was $1.8 billion, or 53% of the total, in North America compared to $1.0 billion, or 30%, in EMEA, $0.3 billion, or 10%, in Asia Pacific, and $0.3 billion, or 7%, in Latin America. We saw an increase in GBV per Night and Experience Booked in 2020 compared to 2019, in part because our geographic mix shifted to these higher GBV per Night and Experience Booked regions. North America saw an increase in GBV per Night and Experience Booked as larger entire homes have been in greater demand. The average nights per booking also increased globally 2020, reflecting demand for longer stays. Specifically, GBV per Night and Experience Booked in 2020 was $174.43 for North America compared to $98.41 for EMEA, $85.83 for Asia Pacific, and $75.74 for Latin America, with a total global GBV per Night and Experience Booked of $123.69. Average nights per booking, excluding experiences, for 2020 were 4.4 nights for each of North America, EMEA, and Latin America and 2.8 nights for Asia Pacific, with a total average of 4.1 nights. We expect that our blended global average nights per booking will fluctuate based on our geographic mix and changes in traveler behaviors. SeasonalityOur business is seasonal, reflecting typical travel behavior patterns over the course of the calendar year. In a typical year, the first, second, and third quarters have higher Nights and Experiences Booked than the fourth quarter, as guests plan for travel during the peak travel season, which is in the third quarter for North America and EMEA. Our business metrics, including GBV and Adjusted EBITDA, can also be impacted by the timing of holidays and other events. We experience seasonality in our GBV that is generally consistent with the seasonality of Nights and Experiences Booked. Revenue and Adjusted EBITDA have historically been, and are expected to continue to be, highest in the third quarter when we have the most check-ins, which is the point at which we recognize revenue. Seasonal trends in our GBV impact Free Cash Flow for any given quarter. Our costs are relatively fixed across quarters or vary in line with the volume of transactions, and we historically achieve our highest GBV in the first and second quarters of the year with comparatively lower check-ins. As a result, increases in unearned fees make our Free Cash Flow and Free Cash Flow as a percentage of revenue the highest in the first two quarters of the year. We typically see a slight decline in GBV and a peak in check-ins in the third quarter, which results in a decrease in unearned fees and lower sequential level of Free Cash Flow, and a greater decline in GBV in the fourth quarter, where Free Cash Flow is typically negative. As our business matures, other seasonal trends may develop, or these existing seasonal trends may become more extreme.In 2020, we saw COVID-19 overwhelm the historical patterns of seasonality in our GBV, revenue, Adjusted EBITDA, and Free Cash Flow as a result of travel restrictions and changing travel preferences relating to the COVID-19 pandemic. We expect this impact on seasonality to continue as long as COVID-19 is impacting travel patterns globally.Regulations Permitting or Limiting Our Offerings Regulations that permit or limit our hosts’ ability to provide their listings impact our growth and penetration in certain geographies. In particular, among other regulations governing our short-term rentals, many large cities have placed night caps on short-term rentals of certain types of properties, limited short-term rentals to primary residences, or limited the length of a stay. No single city represented more than 1.1% of our revenue before adjustments for incentives and refunds during the year ended December 31, 2020 or 1.2% of our active listings as of December 31, 2020. An increase in short-term rental regulations could harm our business and negatively impact our financial performance. See the section titled “Risk Factors — Laws, regulations, and rules that affect the short-term rental and home sharing business may limit the ability or willingness of hosts to share their spaces over our platform and expose our hosts or us to significant penalties, which could have a material adverse effect on our business, results of operations, and financial condition.”61Table of ContentsComponents of Results of Operations RevenueOur revenue consists of service fees, net of incentives and refunds, charged to our customers. We consider both hosts and guests to be our customers. For stays, service fees, which are charged to customers as a percentage of the value of the booking, excluding taxes, vary based on factors specific to the booking, such as booking value, the duration of the booking, geography, and host type. For experiences, we only earn a host fee. Substantially all of our revenue comes from stays booked on our platform. Incentives include our referral programs and marketing promotions to encourage the use of our platform and attract new customers, while our refunds to customers are part of our customer support activities. We experience a difference in timing between when a booking is made and when we recognize revenue, which occurs upon check-in. We record the service fees that we collect from customers prior to check-in on our balance sheet as unearned fees. Revenue is net of incentives and refunds provided to customers totaling $221.5 million, $274.5 million, and $384.2 million in 2018, 2019, and 2020, respectively, representing 6%, 6%, and 11% of revenue, respectively. The elevated level of incentives and refunds provided to customers during the year ended December 31, 2020 was related to payments made to support hosts impacted by increased guest cancellations and COVID-19 related guest cancellation coupons. Cost of Revenue Cost of revenue includes payment processing costs, including merchant fees and chargebacks, costs associated with third-party data centers used to host our platform, and amortization of internally developed software and acquired technology. Because we act as the merchant of record, we incur all payment processing costs associated with our bookings, and we have chargebacks, which arise from account takeovers and other fraudulent activities. We expect our cost of revenue will continue to increase on an absolute dollar basis for the foreseeable future to the extent that we continue to see growth on our platform. Cost of revenue may vary as a percentage of revenue from year to year based on activity on our platform and may also vary from quarter to quarter as a percentage of revenue based on the seasonality of our business and the difference in the timing of when bookings are made and when we recognize revenue. Operations and Support Operations and support expense primarily consists of personnel-related expenses and third-party service provider fees associated with community support provided via phone, email, and chat to hosts and guests; customer relations costs, which include refunds and credits related to customer satisfaction and expenses associated with our host protection programs; and allocated costs for facilities and information technology. We expect that operations and support expense will continue to increase on an absolute dollar basis for the foreseeable future to the extent that we continue to see growth on our platform. We also expect operations and support to increase in the near-term as a percentage of revenue, as we continue to invest in trust and safety programs. We are also investing in the near-term in initiatives to reduce customer contact rates and improve the operational efficiency of our operations and support organization, which we expect will decrease operations and support expense as a percentage of revenue over the longer term. We incurred additional operations and support expense during 2020, the year in which we completed our IPO, as a result of the stock-based compensation expense associated with our RSUs as described in the subsection titled “— Critical Accounting Policies and Estimates—Stock-Based Compensation—Restricted Stock Units,” and anticipate additional stock-based compensation expense going forward.Product Development Product development expense primarily consists of personnel-related expenses and third-party service provider fees incurred in connection with the development of our platform, and allocated costs for facilities and information technology. We expect that our product development expense will increase on an absolute dollar basis and will vary from period to period as a percentage of revenue for the foreseeable future as we continue to invest in product development activities relating to ongoing improvements to and maintenance of our technology platform and other programs, including the hiring of personnel to support these efforts. We incurred additional product development expense during 2020, the year in which we completed our IPO, as a result of the stock-based compensation expense associated with our RSUs as described in the subsection titled “— Critical Accounting Policies and Estimates—Stock-Based Compensation—Restricted Stock Units,” and anticipate additional stock-based compensation expense going forward.Sales and Marketing Sales and marketing expense primarily consists of brand and performance marketing, personnel-related expenses, including those related to our field operations, policy and communications, portions of referral incentives and coupons, and allocated costs for facilities and information technology. We expect our sales and marketing expense will vary from period to period as a percentage of revenue for the foreseeable future, and over the long term, we expect it will decline as a percentage of revenue relative to 2019. We expect that sales and marketing expenses as a percentage of revenue in the first half of 2021 will be higher than that of the second half. This is partially due to the marketing campaign that we are running in the first half of 2021 in advance of the summer travel season. We incurred additional sales and marketing expense during 2020, the year in which we completed our IPO, as a result of the stock-based compensation expense associated with our RSUs as described in the subsection titled “— Critical Accounting Policies and Estimates—Stock-Based Compensation—Restricted Stock Units,” and anticipate additional stock-based compensation expense going forward.General and Administrative General and administrative expense primarily consists of personnel-related expenses for management and administrative functions, including finance and accounting, legal, and human resources. General and administrative expense also includes certain professional 62Table of Contentsservices fees, general corporate and director and officer insurance, allocated costs for facilities and information technology, indirect taxes, including lodging tax reserves for which we may be held jointly liable with hosts for collecting and remitting such taxes, and bad debt expense. We expect to incur additional general and administrative expense as a result of operating as a public company, including expenses to comply with the rules and regulations of the SEC and Listing Rules of Nasdaq, as well as higher expenses for corporate insurance, director and officer insurance, investor relations, and professional services. Overall, we expect our general and administrative expense will vary from period to period as a percentage of revenue for the foreseeable future. We incurred additional general and administrative expense during 2020, the year in which we completed our IPO, as a result of the stock-based compensation expense associated with our RSUs as described in the subsection titled “— Critical Accounting Policies and Estimates—Stock-Based Compensation—Restricted Stock Units,” and anticipate additional stock-based compensation expense going forward.Restructuring Charges Restructuring charges primarily consist of costs associated with a global workforce reduction in May 2020, lease impairments, and costs associated with amendments and terminations of contracts, including commercial agreements with service providers. Interest Income Interest income consists primarily of interest earned on our cash, cash equivalents, marketable securities, and amounts held on behalf of customers. Interest Expense Interest expense consists primarily of expense related to financing lease obligations in 2018 before the adoption of Accounting Standards Codification 842, Leases (“ASC 842”), interest associated with various indirect tax reserves, amortization of debt issuance costs associated with our $1.0 billion five-year unsecured revolving Credit and Guarantee Agreement (the “2016 Credit Facility”), as well as interest expense and amortization of debt issuance costs associated with our term loan agreements entered into in April 2020. Other Income (Expense), Net Other income (expense), net consists primarily of realized and unrealized gains and losses on foreign currency transactions and balances, the change in fair value of investments and financial instruments, including the warrants issued in connection with a term loan agreement entered into in April 2020, and our share of income or loss from our equity method investments. Our platform generally enables guests to make payments in the currency of their choice to the extent that the currency is supported by Airbnb, which may not match the currency in which the host elects to be paid. As a result, in those cases, we bear the currency risk of both the guest payment as well as the host payment due to timing differences in such payments. In 2019, we began entering into derivative contracts to offset a portion of our exposure to the impact of movements in currency exchange rates on our transactional balances denominated in currencies other than the U.S. dollar. The effects of these derivative contracts are reflected in other income (expense), net. Provision for (Benefit from) Income Taxes We are subject to income taxes in the United States and foreign jurisdictions in which we do business. Foreign jurisdictions have different statutory tax rates than those in the United States. Additionally, certain of our foreign earnings may also be taxable in the United States. Accordingly, our effective tax rate is subject to significant variation due to several factors, including variability in our pre-tax and taxable income and loss and the mix of jurisdictions to which they relate, intercompany transactions, changes in how we do business, acquisitions, investments, tax audit developments, changes in our deferred tax assets and liabilities and their valuation, foreign currency gains and losses, changes in statutes, regulations, case law, and administrative practices, principles, and interpretations related to tax, including changes to the global tax framework, competition, and other laws and accounting rules in various jurisdictions, and relative changes of expenses or losses for which tax benefits are not recognized. Additionally, our effective tax rate can vary based on the amount of pre-tax income or loss. For example, the impact of discrete items and non-deductible expenses on our effective tax rate is greater when our pre-tax income is lower. We have a valuation allowance for our net deferred tax assets, including federal and state net operating loss carryforwards, tax credits, and intangible assets. We expect to maintain these valuation allowances until it becomes more likely than not that the benefit of our deferred tax assets will be realized by way of expected future taxable income in the United States and Ireland. We recognize accrued interest and penalties related to unrecognized tax benefits in the provision for (benefit from) income taxes. As of December 31, 2019 and 2020, we had net operating loss carryforwards for federal income tax purposes of $116.7 million and $5.1 billion, respectively. The federal net operating loss carryforwards will expire, if not utilized, beginning in 2034. As of December 31, 2019 and 2020, we had net operating loss carryforwards for state income tax purposes of $167.6 million and $2.5 billion, respectively. The state net operating loss carryforwards will expire, if not utilized, beginning in 2033. In the event that we experience an ownership change within the meaning of Section 382 of the Internal Revenue Code, our ability to utilize net operating losses, tax credits, and other tax attributes may be limited. The most recent analysis of our historical ownership changes was completed through December 31, 2020. Based on the analysis, we do not anticipate a permanent limitation on the existing tax attributes under Section 382, although subsequent changes in our ownership structure may create such a limitation. We are currently under examination for income taxes by the Internal Revenue Service (“IRS”) for the years 2013, 2016, 2017, and 2018. In December 2020, we received a Notice of Proposed Adjustment from the IRS for the 2013 tax year relating to the valuation of our international intellectual property which was sold to a subsidiary in 2013. The notice proposes an increase to our U.S. taxable income that 63Table of Contentscould result in additional income tax expense and cash tax liability of $1.35 billion, plus penalties and interest, which exceeds our current reserve recorded in our consolidated financial statements by more than $1.0 billion. We intend to vigorously contest the IRS’s proposed adjustment, including through all administrative and, if necessary, judicial remedies which may include: entering into administrative settlement discussions with the IRS Independent Office of Appeals (“IRS Appeals”) in 2021, and if necessary petitioning the U.S. Tax Court (“Tax Court”) for redetermination if an acceptable outcome cannot be reached with IRS Appeals, and finally, and if necessary, appealing the Tax Court’s decision to the appropriate appellate court. If the IRS prevails in the assessment of additional tax due based on its position and such tax and related interest and penalties, if any, exceeds our current reserves, such outcome could have a material adverse impact on our financial position and results of operations, and any assessment of additional tax could require a significant cash payment and have a material adverse impact on our cash flow. Results of Operations The following table sets forth our results of operations for the periods presented: Year Ended December 31,201820192020(in thousands)Revenue$3,651,985 $4,805,239 $3,378,199 Costs and expenses:Cost of revenue864,032 1,196,313 876,042 Operations and support(1)609,202 815,074 877,901 Product development(1)579,193 976,695 2,752,872 Sales and marketing(1)1,101,327 1,621,519 1,175,325 General and administrative(1)479,487 697,181 1,134,851 Restructuring charges(1)— — 151,355 Total costs and expenses3,633,241 5,306,782 6,968,346 Income (loss) from operations18,744 (501,543)(3,590,147)Interest income66,793 85,902 27,117 Interest expense(26,143)(9,968)(171,688)Other income (expense), net(12,361)13,906 (947,220)Income (loss) before income taxes47,033 (411,703)(4,681,938)Provision for (benefit from) income taxes63,893 262,636 (97,222)Net loss$(16,860)$(674,339)$(4,584,716)(1)Includes stock-based compensation expense as follows: Year Ended December 31,201820192020(in thousands)Operations and support$1,968 $817 $143,997 Product development33,895 56,632 1,878,793 Sales and marketing12,465 23,919 435,272 General and administrative5,565 16,179 544,086 Restructuring charges— — (200)Stock-based compensation expense$53,893 $97,547 $3,001,948 64Table of ContentsThe following table sets forth the components of our consolidated statements of operations for each of the periods presented as a percentage of revenue: Year Ended December 31,201820192020Revenue100 %100 %100 %Costs and expenses:Cost of revenue24 25 26 Operations and support17 17 26 Product development16 20 81 Sales and marketing30 34 35 General and administrative12 14 34 Restructuring charges— — 4 Total costs and expenses99 110 206 Income (loss) from operations1 (10)(106)Interest income2 2 1 Interest expense(1)(1)(5)Other income (expense), net0 0 (28)Income (loss) before income taxes2 (9)(138)Provision for (benefit from) income taxes2 5 (2)Net loss0 %(14)%(136)%Comparison of the Years Ended December 31, 2018, 2019, and 2020 Revenue Year Ended December 31,2018201920202018 to 2019 %Change2019 to 2020 %Change(in thousands, except percentages)Revenue$3,651,985 $4,805,239 $3,378,199 32 %(30)%2020 Compared to 2019. Revenue decreased $1.4 billion, or 30%, in 2020 compared to 2019, almost entirely due to a 41% decrease in the number of Nights and Experiences Booked on our platform due to the COVID-19 pandemic, partially offset by a 6% increase in GBV per Night and Experience Booked. Service fees as a percentage of booking value, exclusive of taxes, remained relatively flat compared to the same prior year period. Also, contributing to the change was a $109.7 million increase in the reductions to revenue recorded for payments to hosts and coupons issued to guests resulting from elevated cancellations related to COVID-19. On a constant currency basis, revenue decreased 30% compared to 2019. 2019 Compared to 2018. Revenue increased $1.2 billion, or 32%, in 2019 compared to 2018, almost entirely due to a 33% increase in the number of check-ins related to Nights and Experiences Booked on our platform. GBV per Night and Experience Booked and service fees as a percentage of booking value, exclusive of taxes, remained relatively flat compared to the prior year. On a constant currency basis, revenue increased 35% compared to 2018. Cost of Revenue Year Ended December 31,2018201920202018 to 2019 %Change2019 to 2020 %Change(in thousands, except percentages)Cost of revenue$864,032 $1,196,313 $876,042 38 %(27)%Percentage of revenue24 %25 %26 %2020 Compared to 2019. Cost of revenue decreased $320.3 million, or 27%, in 2020 compared to 2019. The change was primarily due to a $236.8 million decrease in payment processing costs, consisting of merchant fees and chargebacks and a $87.9 million decrease in the cost of data hosting services. In 2020 and 2019, payment processing costs totaled $600.2 million and $837.0 million, respectively, which represented 3% and 2% of GBV, respectively. The decrease in payment processing costs resulted from the decreased dollar value of 65Table of Contentspayments processed through our platform attributable to COVID-19 and lower payment processing fees. The decrease in data hosting resulted from lower usage and demand charges. 2019 Compared to 2018. Cost of revenue increased $332.3 million, or 38%, in 2019 compared to 2018. The change was primarily due to a $193.0 million increase in payment processing costs, consisting of merchant fees and chargebacks, a $90.2 million increase in the cost of data hosting services, and a $29.4 million increase in spend with other third-party service providers and technologies to support our platform. In 2019 and 2018, payment processing costs totaled $837.0 million and $644.0 million, respectively, which represented 2% of GBV for both periods. The increase in payment processing costs resulted from the increased dollar value of payments processed through our platform associated with the growth in GBV, while increases in data hosting and third-party service providers resulted from the associated growth in traffic on our platform. A portion of our increase in data hosting services was related to costs associated with our migration to a service-oriented architecture. Operations and Support Year Ended December 31, 2018201920202018 to 2019 %Change2019 to 2020 %Change(in thousands, except percentages) Operations and support$609,202 $815,074 $877,901 34 %8 %Percentage of revenue17 %17 %26 %2020 Compared to 2019. Operations and support expense increased $62.8 million, or 8%, in 2020 compared to 2019. The change was primarily due to a $139.9 million increase in personnel-related expenses, predominantly comprised of stock-based compensation related to RSUs, for which the liquidity-based vesting condition was satisfied in connection with our IPO, and a $34.0 million increase in insurance costs, partially offset by a $53.7 million decrease in spending on third-party community support personnel and a $57.4 million decrease in customer relations costs. The decrease in spending on third-party community support personnel and customer relations costs was largely the result of decline in GBV and associated check-ins in the period due to COVID-19.2019 Compared to 2018. Operations and support expense increased $205.9 million, or 34%, in 2019 compared to 2018. The change was primarily due to a $125.8 million increase in spending on third-party community support personnel, a $33.0 million increase in customer relations costs, a $21.7 million increase in personnel-related expenses, and a $15.9 million increase in allocated costs for facilities and information technology, which are allocated based on headcount. The increase in spending on third-party community support personnel and customer relations costs was largely the result of growth in GBV and associated check-ins in the period. Product Development Year Ended December 31,2018201920202018 to 2019 %Change2019 to 2020 %Change(in thousands, except percentages)Product development$579,193 $976,695 $2,752,872 69 %182 %Percentage of revenue16 %20 %81 %2020 Compared to 2019. Product development expense increased $1.8 billion, or 182%, in 2020 compared to 2019. The change was primarily due to a $1.8 billion increase in personnel-related expenses, predominantly comprised of stock-based compensation related to RSUs, for which the liquidity-based vesting condition was satisfied in connection with our IPO. 2019 Compared to 2018. Product development expense increased $397.5 million, or 69%, in 2019 compared to 2018. The change was primarily due to a $271.7 million increase in personnel-related expenses driven by an increase in product development headcount as we invested in existing offerings, new initiatives, including our China offering, Airbnb Experiences, Airbnb Plus, hotels, and Airbnb Luxe, and platform enhancements, a $58.1 million increase in allocated costs for facilities and information technology, a $26.1 million increase in spend for consultants and service providers, and a $23.0 million increase in spend for software, maintenance, and equipment. The growth in employee headcount supported our efforts to enhance the underlying architecture and scalability of our platform by upgrading our systems and moving to a new service-oriented architecture. 66Table of ContentsSales and Marketing Year Ended December 31,2018201920202018 to 2019 %Change2019 to 2020 %Change(in thousands, except percentages)Brand and performance marketing$666,455 $1,140,366 $478,608 71 %(58)%Field operations and policy434,872 481,153 696,717 11 %45 %Total sales and marketing$1,101,327 $1,621,519 $1,175,325 47 %(28)%Percentage of revenue30 %34 %35 %2020 Compared to 2019. Sales and marketing expense decreased $446.2 million, or 28%, in 2020 compared to 2019. The change was primarily due to a $691.7 million decrease in marketing activities and a $52.4 million decrease in expenses for third-party service providers, partially offset by a $391.3 million increase in personnel-related expenses, predominantly comprised of stock-based compensation related to RSUs, for which the liquidity-based vesting condition was satisfied in connection with our IPO. Total brand and performance marketing decreased $661.8 million, of which $540.5 million was related to performance marketing and $121.2 million was related to brand marketing. In March 2020, driven by COVID-19, we paused our sales and marketing investments in new initiatives and our performance marketing spend. We implemented a marketing strategy that shifted our marketing mix more towards brand marketing spend and away from spending on performance marketing. Total field operations and policy expense increased $215.6 million from 2019, which included $30.9 million of changes in the fair value of contingent consideration arrangements related to an acquisition completed in 2019. 2019 Compared to 2018. Sales and marketing expense increased $520.2 million, or 47%, in 2019 compared to 2018. The change was primarily due to a $358.8 million increase in marketing activities, a $77.8 million increase in personnel-related expenses, a $49.2 million increase in expenses for third-party service providers, and a $15.4 million increase in allocated costs for facilities and information technology. Total brand and performance marketing increased $473.9 million, of which $314.2 million was related to performance marketing, and $159.7 million was related to brand marketing. These increases were primarily due to our efforts to optimize our performance marketing bidding and to support the expansion of our China offering, Airbnb Experiences, Airbnb Plus, hotels, and Airbnb Luxe. General and Administrative Year Ended December 31,2018201920202018 to 2019 %Change2019 to 2020 %Change(in thousands, except percentages)General and administrative$479,487 $697,181 $1,134,851 45 %63 %Percentage of revenue12 %14 %34 %2020 Compared to 2019. General and administrative expense increased $437.7 million, or 63%, in 2020 compared to 2019. The change was primarily due to a $601.9 million increase in payroll-related expenses, predominantly comprised of stock-based compensation related to RSUs, for which the liquidity-based vesting condition was satisfied in connection with our IPO and a $30.9 million increase in bad debt expense. These increases were partially offset by a net $117.8 million decrease in lodging and business tax expense and a $63.0 million decrease in spend for consultants and service providers. The decrease in lodging and business tax expense resulted largely from a $81.7 million reduction in our reserve for lodging taxes in jurisdictions in which management no longer believed a liability was probable following a favorable outcome in a related legal proceeding.2019 Compared to 2018. General and administrative expense increased $217.7 million, or 45%, in 2019 compared to 2018. The change was primarily due to a $116.4 million increase in payroll-related expenses resulting from an increase in headcount as we prepared to become a public company, a $29.9 million increase in lease expense related to our build-to-suit leases due to the adoption of ASC 842 in 2019 whereby lease expense is reported as a component of costs and expenses rather than interest expense, a $28.0 million increase in bad debt expense, and a net $17.5 million increase in lodging and business tax expense. Restructuring ChargesYear Ended December 31,2018201920202018 to 2019 %Change2019 to 2020 %Change(in thousands, except percentages)Restructuring charges$— $— $151,355 **Percentage of revenue— %— %4 %67Table of Contents* Not meaningful2020 Compared to 2019. Restructuring charges totaled $151.4 million for 2020. In May 2020, we announced a reduction in force of approximately 25% of employees, and the resulting restructuring charges primarily included severance and other employee-related costs, lease impairments, and contract amendments and terminations.Interest Income and Expense Year Ended December 31,2018201920202018 to 2019 %Change2019 to 2020 %Change(in thousands, except percentages)Interest income$66,793 $85,902 $27,117 29 %(68)%Percentage of revenue2 %2 %1 %Interest expense$(26,143)$(9,968)$(171,688)(62)%1,622 %Percentage of revenue(1)%(1)%(5)%2020 Compared to 2019. Interest income decreased $58.8 million, or 68%, in 2020 compared to 2019. The decrease was primarily due to a decline in average interest rates and our investment portfolio mix, which was largely invested in short-term, high quality bonds. Interest expense increased $161.7 million in 2020 compared to 2019 primarily due to the interest owed on the term loans issued in April 2020. 2019 Compared to 2018. Interest income increased $19.1 million, or 29%, in 2019 compared to 2018. The increase was primarily due to higher invested balances and average interest rates. Interest expense decreased $16.2 million, or 62%, in 2019 compared to 2018. The decrease was primarily due to the adoption of ASC 842 in 2019 whereby a component of lease expense for build-to-suit leases was no longer recorded in interest expense, but rather, as a component of general and administrative expense. In 2018, we recorded $13.5 million of lease expense related to certain build-to-suit leases within interest expense. Other Income (Expense), Net Year Ended December 31,2018201920202018 to 2019 %Change2019 to 2020 %Change(in thousands, except percentages)Other income (expense), net$(12,361)$13,906 $(947,220)**Percentage of revenue0 %0 %(28)%*Not meaningful 2020 Compared to 2019. Other expense, net was $947.2 million in 2020 compared to other income, net of $13.9 million in 2019. The unfavorable change was primarily driven by $868.5 million of fair value remeasurement on our warrants issued in 2020 in connection with our second lien loan. The warrants were issued with an initial exercise price of $28.355 per share and are remeasured to fair value at each reporting date as long as the warrants remain outstanding. The year-over-year change was also attributable to a $54.3 million increase of impairment charges related to non-marketable equity investments in privately-held companies and a $36.7 million increase in net realized and unrealized losses on our investments. Impairment charges recorded during 2020 totaled $82.1 million. Furthermore, a $24.6 million gain related to an equity method investment that was acquired by a third party was recorded during 2019. Partially offsetting these items was a $36.3 million increase in net realized and unrealized foreign exchange gains.2019 Compared to 2018. Other income, net was $13.9 million in 2019 compared to other expense, net of $12.4 million in 2018. The change was primarily driven by $28.3 million of net realized and unrealized gains on our investments and other income and expense, including our share of income or loss from our equity method investments, as well as a $24.6 million gain related to an equity method investment that was acquired by a third party in 2019. Partially offsetting these amounts were impairment charges of $27.8 million recorded during 2019. Provision for (Benefit from) Income Taxes Year Ended December 31,2018201920202018 to 2019 %Change2019 to 2020 %Change(in thousands, except percentages)Provision for (benefit from) income taxes$63,893 $262,636 $(97,222)311 %(137)%Effective tax rate136 %(64)%2 %68Table of Contents2020 Compared to 2019. The benefit from income taxes totaled $97.2 million in 2020 compared to a provision for income taxes of $262.6 million in 2019. The benefit from income taxes was primarily due to the five-year net operating loss carryback provision of the CARES Act accrued for in 2020. See Note 14 to our consolidated financial statements included elsewhere in this Annual Report on Form 10-K for further details.2019 Compared to 2018. The provision for income taxes increased $198.7 million, or 311%, in 2019 compared to 2018. The increase was primarily due to a remeasurement of uncertain tax positions relating to the valuation of our international intellectual property that was previously sold to a subsidiary. See Note 14 to our consolidated financial statements included elsewhere in this Annual Report on Form 10-K for further details. Selected Quarterly Financial DataThe following table sets forth our unaudited quarterly consolidated results of operations for each of the quarterly periods for the years ended December 31, 2019 and 2020. These unaudited quarterly results of operations have been prepared on the same basis as our audited consolidated financial statements included elsewhere in this Annual Report on Form 10-K. In the opinion of management, the financial information set forth in the table below reflects all normal recurring adjustments necessary for the fair statement of results of operations for these periods. Our historical results are not necessarily indicative of the results that may be expected in the future, and the results of a particular quarter or other interim period are not necessarily indicative of the results for a full year. You should read the following unaudited quarterly consolidated results of operations in conjunction with our consolidated financial statements and related notes included elsewhere in this Annual Report on Form 10-K. 69Table of ContentsQuarterly Unaudited Consolidated Statements of Operations Three Months EndedMar 31,2019Jun 30,2019Sept 30,2019Dec 31,2019Mar 31,2020Jun 30,2020Sept 30,2020Dec 31,2020(in thousands, except per share amounts)Revenue$839,004 $1,213,678 $1,645,761 $1,106,796 $841,830 $334,774 $1,342,331 $859,264 Costs and expenses:Cost of revenue280,568 313,460 308,667 293,618 277,772 161,198 227,325 209,747 Operations and support(1)166,755 210,569 223,464 214,286 221,787 160,476 166,106 329,532 Product development(1)185,101 232,327 276,368 282,899 258,819 217,938 213,920 2,062,195 Sales and marketing(1)366,546 388,246 429,714 437,013 317,179 114,837 113,494 629,815 General and administrative(1)146,013 169,231 175,018 206,919 91,762 149,299 180,021 713,769 Restructuring charges— — — — — 114,241 22,728 14,386 Total costs and expenses1,144,983 1,313,833 1,413,231 1,434,735 1,167,319 917,989 923,594 3,959,444 Income (loss) from operations(305,979)(100,155)232,530 (327,939)(325,489)(583,215)418,737 (3,100,180)Interest income22,304 24,367 21,990 17,241 13,649 5,856 4,325 3,287 Interest expense(1,818)(2,450)(2,533)(3,167)1,510 (49,191)(59,867)(64,140)Other income (expense), net(2) 6,531 6,284 29,315 (28,224)(46,760)(12,848)(56,143)(831,469)Income (loss) before income taxes(278,962)(71,954)281,302 (342,089)(357,090)(639,398)307,052 (3,992,502)Provision for (benefit from) income taxes13,065 225,470 14,652 9,449 (16,485)(63,810)87,724 (104,651)Net income (loss)$(292,027)$(297,424)$266,650 $(351,538)$(340,605)$(575,588)$219,328 $(3,887,851)Net income (loss) per share attributable to Class A and Class B common stockholders, basic $(1.13)$(1.14)$0.01 $(1.34)$(1.30)$(2.18)$— $(11.24)Net income (loss) per share attributable to Class A and Class B common stockholders, diluted$(1.13)$(1.14)$0.01 $(1.34)$(1.30)$(2.18)$— $(11.24) (1)Includes stock-based compensation expense as follows:Three Months EndedMar 31,2019Jun 30,2019Sept 30,2019Dec 31,2019Mar 31,2020Jun 30,2020Sept 30,2020Dec 31,2020(in thousands)Operations and support$31 $124 $128 $534 $949 $855 $1,065 $141,128 Product development6,711 7,995 30,285 11,641 22,436 20,716 20,936 1,814,705 Sales and marketing4,793 6,197 6,084 6,845 6,048 4,387 1,544 423,293 General and administrative2,528 3,733 3,701 6,217 12,193 13,608 5,888 512,397 Restructuring charges— — — — — (1,776)(73)1,649 Stock-based compensation expense$14,063 $18,049 $40,198 $25,237 $41,626 $37,790 $29,360 $2,893,172 (2)For the year ended December 31, 2020, we recorded $868.5 million of fair value remeasurement on our warrants issued in connection with our second lien loan, the majority of which was recorded in the fourth quarter of 2020. Refer to Note 11 to our consolidated financial statements included elsewhere in this Annual Report on Form 10-K for additional information.70Table of ContentsQuarterly Unaudited Consolidated Statements of Operations, as a Percentage of Revenue Three Months EndedMar 31,2019Jun 30,2019Sept 30,2019Dec 31,2019Mar 31,2020Jun 30,2020Sept 30,2020Dec 31,2020Revenue100 %100 %100 %100 %100 %100 %100 %100 %Costs and expenses:Cost of revenue33 26 19 27 33 48 17 24 Operations and support20 17 14 19 26 48 12 38 Product development22 19 17 26 31 65 16 241 Sales and marketing44 32 26 39 38 34 9 73 General and administrative17 14 10 19 11 45 13 83 Restructuring charges— — — — — 34 2 2 Total costs and expenses136 108 86 130 139 274 69 461 Income (loss) from operations(36)(8)14 (30)(39)(174)31 (361)Interest income3 2 1 2 2 2 — — Interest expense0 0 0 0 0 (15)(4)(7)Other income (expense), net0 0 2 (3)(5)(4)(4)(96)Income (loss) before income taxes(33)(6)17 (31)(42)(191)23 (464)Provision for (benefit from) income taxes2 19 1 1 (2)(19)7 (12)Net income (loss)(35)%(25)%16 %(32)%(40)%(172)%16 %(452)%Liquidity and Capital Resources In December 2020, upon the completion of our IPO, we received net proceeds of $3.7 billion after deducting underwriting discounts and commissions of $79.3 million and offering expenses of $9.8 million. We used a portion of these net proceeds to satisfy the tax withholding and remittance obligations of approximately $1.6 billion related to the settlement of our outstanding RSUs in connection with our IPO. As of December 31, 2020, our principal sources of liquidity were cash and cash equivalents of $5.5 billion and marketable securities of $0.9 billion, which included $1.2 billion and $0.2 billion, respectively, held by foreign subsidiaries. Cash and cash equivalents consist of checking and interest-bearing accounts and highly-liquid securities with an original maturity of 90 days or less. Marketable securities consist of corporate debt securities, mutual funds, highly-liquid debt instruments of the U.S. government and its agencies, and certificates of deposit. These amounts do not include funds of $2.2 billion as of December 31, 2020 that we held for bookings in advance of guests completing check-ins that we record separately on our balance sheet in funds receivable and amounts held on behalf of customers with a corresponding liability in funds payable and amounts payable to customers. Cash, cash equivalents, and marketable securities held outside the United States may be repatriated, subject to certain limitations, and would be available to be used to fund our domestic operations. However, repatriation of such funds may result in additional tax liabilities. We believe that our existing cash, cash equivalents, and marketable securities balances in the United States are sufficient to fund our working capital needs in the United States. Loan Agreements In April 2020, we entered into a $1.0 billion First Lien Credit and Guaranty Agreement (the “First Lien Credit Agreement,” and the loans thereunder, the “First Lien Loan”), resulting in proceeds of $961.4 million, net of debt discount and issuance costs. The loan is due and payable in April 2025. The underlying loan can be repaid in whole or in part prior to April 2025 at our option, subject to applicable prepayment premiums and make-whole premiums. Beginning in September 2020, we are required to repay the First Lien Loan in quarterly installments equal to 0.25% of the $1.0 billion aggregate principal amount of the First Lien Loan, with the remaining principal amount payable on the maturity date. Interest on the First Lien Loan is payable monthly or quarterly in arrears at our option depending on the chosen per annum interest rate equal to (i) in the case of LIBOR borrowings, 7.5% plus the London interbank offered rate (customarily defined, with LIBOR replacement provisions consistent with the April 2019 Alternative Reference Rates Commission recommended fallback language for syndicated loans, “LIBOR”), subject to a floor of 1%, or (ii) in the case of base rate borrowings, 6.5% plus the greatest of (a) the prime rate, (b) the federal funds effective rate plus 0.5%, and (c) LIBOR for a one-month period plus 1%, in each case subject to a floor of 2%. In April 2020, we entered into a $1.0 billion Second Lien Credit and Guaranty Agreement (the “Second Lien Credit Agreement,” and the loans thereunder, the “Second Lien Loan”), resulting in proceeds of $967.5 million, net of debt discount and issuance costs. The loan is due and payable in July 2025. The underlying loan can be repaid in whole or in part prior to July 2025 at our option, subject to applicable prepayment premiums and make-whole premiums and the priority of lenders under the First Lien Credit Agreement over any proceeds we receive from the sale of collateral. Interest on the Second Lien Loan is payable monthly or quarterly in arrears at our option depending on the chosen per annum interest rate equal to (i) in the case of LIBOR borrowings, 10% plus LIBOR, in each case subject to a floor of 1%, or (ii) in the case of base rate borrowings, 9% plus the greatest of (a) the prime rate, (b) the federal funds effective rate plus 0.5%, and (c) LIBOR for a one-month period plus 1%, subject to a floor of 3%. In addition, at our election, payment-in-kind interest up to 5.5% per annum may be paid by increasing the principal amount of the Second Lien Loan by such amount. 71Table of ContentsIn connection with the Second Lien Loan, we issued warrants to purchase 7,934,794 shares of Class A common stock with an initial exercise price of $28.355 per share, subject to adjustments upon the occurrence of certain specified events, to the Second Lien Loan lenders. The warrants expire on April 17, 2030 and the exercise price can be settled in cash or in net shares at the holder’s option. The fair value of the warrants of $116.6 million at issuance was recorded as a liability on the consolidated balance sheet, and the warrant liability is remeasured to fair value at each reporting date as long as the warrants remain outstanding and unexercised with changes in fair value recorded in other income (expense), net in the consolidated statements of operations. As of December 31, 2020, the fair value of the warrant totaled $985.2 million, or an increase in liability of $868.5 million since their issuance in April 2020.The First Lien Credit Agreement and Second Lien Credit Agreement include customary conditions to borrowing, events of default, and covenants, including those that restrict our and our subsidiaries’ ability to, among other things, incur additional indebtedness, create or incur liens, merge or consolidate with other companies, liquidate or dissolve, sell or transfer assets, pay dividends or make distributions, make acquisitions, investments, loans or advances, or payments and prepayments of junior or unsecured indebtedness, subject to certain exceptions. As of December 31, 2020, we were in compliance with all covenants of the First Lien Credit Agreement and Second Lien Credit Agreement. 2020 Credit FacilityIn November 2020, we entered into a $500.0 million five-year senior secured revolving Credit and Guarantee Agreement (the “Revolving Credit Agreement”), which provides for an initial borrowing commitment by a group of lenders led by Morgan Stanley Senior Funding, Inc. of $500.0 million (the “2020 Credit Facility”). The 2020 Credit Facility provides a $200.0 million sub-limit for the issuance of letters of credit. The 2020 Credit Facility has a commitment fee of 0.15% per annum on any undrawn amounts, payable quarterly in arrears. Interest on borrowings is equal to (i) in the case of LIBOR borrowings, 1.5% plus LIBOR, subject to a floor of 0%, or (ii) in the case of base rate borrowings, 0.5% plus the greatest of (a) the federal funds effective rate plus 0.5%, (b) the prime rate, and (c) LIBOR for a one-month period plus 1%, in each case subject to a floor of 1%. The Revolving Credit Agreement includes customary conditions to borrowing, events of default, and covenants, including a minimum liquidity covenant requiring us to have liquidity of at least $200.0 million as of the last day of each fiscal quarter and those that restrict our and our subsidiaries’ ability to, among other things, incur additional indebtedness, create or incur liens, merge or consolidate with other companies, liquidate or dissolve, sell or transfer assets, pay dividends or make distributions, subject to certain exceptions. As of December 31, 2020, the principal amount of the borrowings outstanding under the First Lien Loan and Second Lien Loan totaled $1,995.0 million. As of December 31, 2020, there were no borrowings outstanding on the 2020 Credit Facility and outstanding letters of credit totaled approximately $21.4 million. 2016 Credit Facility In April 2020, we terminated our 2016 Credit Facility, which provided an initial borrowing commitment by a group of lenders led by Bank of America, N.A. of $1.0 billion. The 2016 Credit Facility also provided a $100.0 million sub-limit for the issuance of letters of credit. The 2016 Credit Facility had a commitment fee of 0.125% per annum on any undrawn amounts. Outstanding borrowings bore interest at a fluctuating rate per annum equal to the highest of (i) the federal funds effective rate plus one-half of 1.00%, (ii) the rate of interest in effect for such day by Bank of America as its “prime rate,” or (iii) the eurocurrency rate for one month plus 1.00%. As of December 31, 2019, there were no borrowings outstanding on the 2016 Credit Facility and outstanding letters of credit totaled $53.0 million. The 2016 Credit Facility contained customary affirmative and negative covenants, including restrictions on our and certain of our subsidiaries’ ability to incur debt and liens, undergo fundamental changes, and pay dividends or other distributions, as well as certain financial covenants. We were in compliance with all covenants as of December 31, 2019. On April 17, 2020, we terminated the 2016 Credit Facility. Certain letters of credit under the 2016 Credit Facility were transferred to new issuers upon the termination of the 2016 Credit Facility. As of December 31, 2020, letters of credit formerly under the 2016 Credit Facility totaled $32.9 million and were collateralized by $33.8 million of restricted cash on the consolidated balance sheet. We believe that our current available cash, cash equivalents, and marketable securities will be sufficient to meet our operational cash needs for the foreseeable future. Our future capital requirements, however, will depend on many factors, including, but not limited to our growth, headcount, ability to attract and retain hosts and guests on our platform, capital expenditures, acquisitions, introduction of new products and offerings, timing and extent of spending to support our efforts to develop our platform, and expansion of sales and marketing activities. Additionally, we may in the future raise additional capital or incur additional indebtedness to continue to fund our strategic initiatives. In the event that additional financing is required from outside sources, we may seek to raise additional funds at any time through equity, equity-linked arrangements, and/or debt, which may not be available on favorable terms, or at all. If we are unable to raise additional capital when desired and at reasonable rates, our business, results of operations, and financial condition could be materially adversely affected. We expect our capital expenditures in 2021 will be higher than that of 2020, but significantly lower than 2019. The majority of our expected investments are related to office improvements in North America, many of which were delayed in 2020. 72Table of ContentsCash Flows The following table summarizes our cash flows for the periods indicated: Year Ended December 31, 201820192020 (in thousands)Net cash provided by (used in) operating activities$595,557 $222,727 $(629,732)Net cash provided by (used in) investing activities(668,171)(347,155)79,590 Net cash provided by financing activities140,516 854,579 2,940,814 Effect of exchange rate changes on cash, cash equivalents and restricted cash(158,919)(25,284)134,137 Net increase (decrease) in cash, cash equivalents and restricted cash$(91,017)$704,867 $2,524,809 Cash Provided by (Used in) Operating Activities Net cash used in operating activities for 2020 was $629.7 million. Our net loss for 2020 was $4.6 billion, adjusted for non-cash charges, primarily consisting of $3.0 billion of stock-based compensation expense, $868.5 million of fair value remeasurement on warrants issued in connection with a term loan agreement entered into in April 2020, $125.9 million of depreciation and amortization, $107.7 million of bad debt expense, and $82.1 million of impairment charges of investments. Additional uses of cash resulted from changes in working capital, including a $267.0 million decrease in unearned fees resulting from fewer bookings on our platform due to COVID-19. Net cash provided by operating activities in 2019 was $222.7 million. Our net loss for 2019 was $674.3 million, adjusted for non-cash charges, primarily consisting of $114.2 million of depreciation and amortization, $97.5 million of stock-based compensation expense, and $77.1 million of bad debt expense. Additional sources of cash flows resulted from changes in working capital, including a $547.7 million increase in accrued expenses and other liabilities resulting from increased spending and headcount growth, as well as a $176.3 million increase in unearned fees resulting from increased bookings on our platform. The primary use of operating cash was a $186.4 million increase in prepaids and other assets associated with the growth in our operations. Net cash provided by operating activities in 2018 was $595.6 million. Our net loss for 2018 was $16.9 million, adjusted for non-cash charges, primarily consisting of $82.4 million of depreciation and amortization, $53.9 million of stock-based compensation expense, and $49.0 million of bad debt expense. Additional sources of cash flows resulted from changes in working capital, including a $348.1 million increase in accrued expenses and other liabilities resulting from increased spending and headcount growth, as well as a $145.9 million increase in unearned fees resulting from increased bookings on our platform. The primary use of operating cash was a $102.8 million increase in prepaids and other assets associated with the growth in our operations. Cash Provided by (Used in) Investing Activities Net cash provided by investing activities in 2020 was $79.6 million, which was primarily provided by proceeds resulting from sales and maturities of marketable securities of $1.3 billion and $1.8 billion, respectively, partially offset by cash used to purchase marketable securities of $3.0 billion and property and equipment of $37.4 million. Net cash used in investing activities in 2019 was $347.2 million, which was primarily used to purchase marketable securities of $1.0 billion and property and equipment of $125.5 million, to fund acquisitions of $192.1 million, and to make equity investments in privately-held companies of $208.2 million. These uses were partially offset by proceeds resulting from sales and maturities of marketable securities of $609.4 million and $551.6 million, respectively. Net cash used in investing activities in 2018 was $668.2 million, which was primarily used to purchase marketable securities of $1.3 billion and property and equipment of $90.6 million, to fund acquisitions of $31.3 million, and to make equity investments in privately-held companies of $28.9 million. These uses were partially offset by proceeds resulting from sales and maturities of marketable securities of $555.2 million and $201.3 million, respectively. Cash Provided by Financing Activities Net cash provided by financing activities in 2020 was $2.9 billion, primarily reflecting proceeds of $3.7 billion from the issuance of Class A common stock upon IPO, net of underwriting discounts and offering costs, $1.9 billion from the issuance of long-term debt and warrants, net of issuance costs, partially offset by a decrease of $1.7 billion for taxes paid related to net share settlement of equity awards and $1.0 billion in funds payable and amounts payable to customers. Net cash provided by financing activities in 2019 was $854.6 million, reflecting the change in funds payable and amounts payable to customers of $848.7 million and proceeds from the exercise of stock options of $5.9 million. Net cash provided by financing activities in 2018 was $140.5 million, primarily reflecting the change in funds payable and amounts payable to customers of $117.6 million, proceeds from the exercise of stock options of $16.0 million, and reimbursements for improvements we made at leased office facilities of $6.9 million. 73Table of ContentsEffect of Exchange Rates The effect of exchange rate changes on cash, cash equivalents, and restricted cash on our consolidated statements of cash flows relates to certain of our assets, principally cash balances held on behalf of hosts and guests, that are denominated in currencies other than the functional currency of certain of our subsidiaries. During 2020, we recorded a $134.1 million increase in cash, cash equivalents, and restricted cash primarily due to the weakening of the U.S. dollar. During 2019 and 2018, we recorded a $25.3 million and a $158.9 million reduction in cash, cash equivalents, and restricted cash, respectively, primarily due to the strengthening of the U.S. dollar. The impact of exchange rate changes on cash balances can serve as a natural hedge for the effect of exchange rates on our liabilities to our guests and hosts.Off-Balance Sheet Arrangements As of December 31, 2020, we did not have any off-balance sheet arrangements, as defined in Regulation S-K, that have or are reasonably likely to have a current or future effect on our financial condition, results of operations, or cash flows. Indemnification Agreements In the ordinary course of business, we include limited indemnification provisions under certain agreements with parties with whom we have commercial relations of varying scope and terms. Under these contracts, we may indemnify, hold harmless and agree to reimburse the indemnified party for losses suffered or incurred by the indemnified party in connection with breach of the agreements, or intellectual property infringement claims made by a third party, including claims by a third party with respect to our domain names, trademarks, logos and other branding elements to the extent that such marks are applicable to its performance under the subject agreement. It is not possible to determine the maximum potential loss under these indemnification provisions due to the limited history of prior indemnification claims and the unique facts and circumstances involved in each particular provision. To date, no significant costs have been incurred, either individually or collectively, in connection with our indemnification provisions. In addition, we have entered into indemnification agreements with our directors, executive officers and certain other employees that require us, among other things, to indemnify them against certain liabilities that may arise by reason of their status or service as directors, executive officers, or employees. Contractual Obligations and Commitments The following table summarizes our contractual obligations and commitments as of December 31, 2020: Payments Due by Period(1)TotalLess than 1 Year1-3 Years3-5 YearsMore than 5 Years(in thousands)Operating lease commitments(2)$686,635 $79,696 $143,548 $167,357 $296,034 Noncancelable purchase commitments(3)1,176,667 110,000 225,000 454,167 387,500 Long-term debt(4)2,862,788 206,952 411,319 2,244,517 — Other commitments311,500 43,500 73,000 76,000 119,000 Total contractual obligations$5,037,590 $440,148 $852,867 $2,942,041 $802,534 (1)Excludes income tax matters as we are not able to reasonably estimate the timing of future cash flows related to uncertain tax positions. For further discussion of income taxes, refer to Note 14 to our consolidated financial statements included elsewhere in this Annual Report on Form 10-K for additional information. (2)Consists of future non-cancelable minimum rental payments under operating lease obligations, excluding short-term leases. Refer to Note 9 to our consolidated financial statements included elsewhere in this Annual Report on Form 10-K for additional information. (3)Noncancelable purchase commitments include amounts related to our commercial agreement with a data hosting services provider, pursuant to which we committed to spend an aggregate of at least $1.2 billion for vendor services through 2027. (4)Consists of two separate loan agreements entered into in April 2020, including principal and interest. Refer to Note 11 to our consolidated financial statements included elsewhere in this Annual Report on Form 10-K for additional information. Amounts represent the future principal and interest payments based on contractual interest rates.74Table of ContentsCritical Accounting Policies and Estimates Our consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States. The preparation of these consolidated financial statements requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue, costs, and expenses, and related disclosures. On an ongoing basis, we evaluate our estimates and assumptions. Our actual results may differ from these estimates under different assumptions or conditions. We believe that of our significant accounting policies, which are described in Note 2 to our consolidated financial statements included elsewhere in this Annual Report on Form 10-K, the following accounting policies involve a greater degree of judgment and complexity. Accordingly, these are the policies we believe are the most critical to aid in fully understanding and evaluating our consolidated financial condition, results of operations, and cash flows.Revenue Recognition We recognize revenue in accordance with ASC Topic 606, which we adopted as of January 1, 2018 on a full retrospective basis. We generate substantially all of our revenue from facilitating guest stays at accommodations offered by hosts on the Airbnb platform. We consider both hosts and guests to be our customers. Our revenue is comprised of service fees from our customers. Our single performance obligation is identified as the facilitation of a stay, which occurs upon the completion of a check-in event. Revenue is recognized at a point in time when the performance obligation is satisfied upon check-in.We evaluate the presentation of revenue on a gross versus net basis based on whether or not we are the principal in the transaction (gross) or whether we arrange for other parties to provide the service to guests and are the agent (net) in the transaction. We determined that we do not control the right to use the accommodations provided by us either before or after completion of our service. Accordingly, we concluded that we are acting in an agent capacity and revenue is presented net reflecting the service fees received from our customers to facilitate a stay.Revenue is presented net of certain payments we make to customers as part of our referral programs and marketing promotions, collectively referred to as our incentive programs, and refund activities. The payments are generally in the form of coupon credits to be applied toward future bookings or as cash refunds. We encourage the use of our platform and attract new customers through our incentive programs. Under the referral program, the referring party (“referrer”) earns a coupon when the new host or guest (“referee”) completes their first stay on our platform. We record the incentive as a liability at the time the incentive is earned by the referrer with the corresponding charge recorded to sales and marketing expense. Any amounts paid in excess of the fair value of the referral service received are recorded as a reduction of revenue. Through marketing promotions, we issue customer coupon credits to encourage the use of our platform. After a customer redeems such incentives, we record a reduction to revenue at the date we record the corresponding revenue transaction. From time to time, we issue refunds to customers in the form of cash or credits to be applied toward a future booking. We reduce the transaction price by the estimated amount of the payments by applying the most likely outcome method based on known facts and circumstances and historical experience. These refunds are recorded as a reduction to revenue. We evaluate whether the cumulative amount of payments made to customers that are not in exchange for a distinct good or service received from a customer exceeds the cumulative revenue earned since inception of the customer relationship. Any cumulative payments in excess of cumulative revenue are presented as operating expenses in our consolidated statements of operations. Stock-Based Compensation We have granted stock-based awards consisting primarily of stock options, restricted common stock, and restricted stock units (“RSUs”) to employees, members of our board of directors, and non-employees. We estimate the fair value of stock options granted using the Black-Scholes option-pricing model. The Black-Scholes option-pricing model requires certain subjective inputs and assumptions, including the fair value of our common stock, the expected term, risk-free interest rates, expected stock price volatility, and expected dividend yield of our common stock. The fair value of stock options is recognized as stock-based compensation expense on a straight-line basis over the requisite service period. We account for forfeitures as they occur. These assumptions used in the Black-Scholes option-pricing model, other than the fair value of our common stock (see the subsection titled “— Common Stock Valuations” below), are estimated as follows: •Expected term. We estimate the expected term based on the simplified method. •Risk-free interest rate. The risk-free interest rate is based on the U.S. Treasury yield curve in effect at the time of grant. •Expected volatility. We estimate the volatility of our common stock on the date of grant based on the average historical stock price volatility of comparable publicly-traded companies. •Expected dividend yield. Expected dividend yield is zero, as we have not paid and do not anticipate paying dividends on our common stock. We continue to use judgment in evaluating the expected volatility and expected term utilized in our stock-based compensation expense calculation on a prospective basis. As we continue to accumulate additional data related to our common stock, we may refine our estimates of expected volatility and expected term, which could materially impact our future stock-based compensation expense. Restricted Stock Units The fair value of RSUs is estimated based on the fair value of our common stock on the date of grant. Substantially all of our RSUs vest upon the satisfaction of both a service-based vesting condition and a liquidity-based vesting condition. In November 2019, we also began granting RSUs with a service-based vesting condition only. The service-based vesting condition for the majority of these awards is 75Table of Contentssatisfied over four years, generally on or around each of February 25, May 25, August 25, and November 25. The liquidity-based vesting condition for RSUs was satisfied upon the effectiveness of our IPO Registration Statement on December 9, 2020.We measure and recognize compensation expense for all stock-based awards based on the estimated fair value of the award. Prior to our IPO in December 2020, no stock-based compensation expense had been recognized for RSUs with both service-based and liquidity-based vesting conditions because the liquidity-based vesting condition had not been probable of being satisfied. Upon our IPO in December 2020, we recorded a cumulative one-time stock-based compensation expense of $2.8 billion, determined using the grant-date fair values. As of December 31, 2020, the total unrecognized compensation cost related to RSUs was $1.0 billion, which we expect to recognize over the remaining weighted-average period of approximately 1.9 years.Common Stock Valuations Subsequent to our IPO in December 2020, the fair value of common stock is determined on the grant date using the closing price of our Class A common stock.Prior to our IPO, given the absence of a public trading market for our common stock, and in accordance with the American Institute of Certified Public Accountants Accounting and Valuation Guide, Valuation of Privately-Held Company Equity Securities Issued as Compensation, our board of directors exercised its reasonable judgment and considered numerous objective and subjective factors to determine the best estimate of fair value of our common stock underlying the stock options and RSUs, including: •independent third-party valuations of our common stock; •the prices at which others have purchased our redeemable convertible preferred stock in arm’s-length transactions; •the rights, preferences and privileges of our redeemable convertible preferred stock relative to those of our common stock; •our financial condition, results of operations, and capital resources; •the likelihood and timing of achieving a liquidity event, such as an initial public offering or sale of the company, given prevailing market conditions; •the lack of marketability of our common stock; •our estimates of future financial performance; •valuations of comparable companies; •the hiring or loss of key personnel; •the status of our development, product introduction, and sales efforts; •industry information, such as market growth and volume and macro-economic events; and •additional objective and subjective factors relating to our business. To determine the fair value of our common stock, we first determined our enterprise value and then allocated that enterprise value to our common stock and common stock equivalents. Our enterprise value was estimated using two generally accepted approaches: the income approach and the market approach. The income approach estimates enterprise value based on the estimated present value of future cash flows the business is expected to generate over its remaining life. The estimated present value is calculated using a discount rate reflective of the risks associated with an investment in a similar company in a similar industry or having a similar history of revenue growth. The market approach measures the value of a business through an analysis of recent sales or offerings of comparable investments or assets, and in our case, focused on comparing us to a group of our peer companies. In applying this method, valuation multiples are derived from historical operating data of the peer company group. We then apply multiples to our operating data to arrive at a range of indicated values of the company. For each valuation, we prepared a financial forecast to be used in the computation of the value of invested capital for both the income approach and market approach. The financial forecast considered our past results and expected future financial performance. The risk associated with achieving this forecast was assessed in selecting the appropriate discount rate. There is inherent uncertainty in these estimates as the assumptions used are highly subjective and subject to changes as a result of new operating data and economic and other conditions that impact our business. As an additional indicator of fair value, we provided weighting to arm’s-length transactions involving issuances of our securities near the respective valuation dates in connection with acquisitions. Lodging Tax Obligations Some states, cities, and localities in the United States and elsewhere in the world impose transient occupancy or lodging accommodations taxes (“lodging taxes”) on the use or occupancy of lodging accommodations or other traveler services. We collect and remit lodging taxes in more than 29,800 jurisdictions on behalf of our hosts, and lodging taxes are primarily collected in the United States. Such lodging taxes are generally remitted to tax jurisdictions within a 30 to 90-day period following the end of each month. In jurisdictions where we do not collect and remit lodging taxes, the responsibility for collecting and remitting these taxes, if applicable, generally rests with hosts. We estimate liabilities for a certain number of jurisdictions with respect to state, city, and local taxes related to lodging where we believe it is probable that Airbnb could be held jointly liable with hosts for collecting and remitting such taxes and the related amounts can be reasonably estimated. Our accrued obligations related to lodging taxes, including estimated penalties and taxes, totaled $138.4 million and $52.9 million as of December 31, 2019 and December 31, 2020, respectively, and changes to this reserve are recorded in general and administrative expense in our consolidated statements of operations.76Table of ContentsWe are currently involved in a number of lawsuits brought by certain states and localities involving the payment of lodging taxes. These jurisdictions are asserting that we are liable or jointly liable with hosts to collect and remit lodging taxes. These lawsuits are in various stages and we continue to vigorously defend these claims. We believe that the statutes at issue impose a lodging tax obligation on the person exercising the taxable privilege of providing accommodations, our hosts. The ultimate resolution of these lawsuits cannot be determined at this time. Evaluating potential outcomes for lodging taxes is inherently uncertain and requires us to utilize various judgments, assumptions and estimates in determining our reserves. A variety of factors could affect our potential obligation for collecting and remitting such taxes which include, but are not limited to, whether we determine, or any tax authority asserts, that we have a responsibility to collect lodging and related taxes on either historic or future transactions; the introduction of new ordinances and taxes which subject our operations to such taxes; or the ultimate resolution of any historic claims that may be settled through negotiation. Accordingly, the ultimate resolution of lodging taxes may be greater or less than reserve amounts we have established. Income Taxes We are subject to income taxes in the United States and foreign jurisdictions. We account for income taxes using the asset and liability method. We account for uncertainty in tax positions by recognizing a tax benefit from uncertain tax positions when it is more likely than not that the position will be sustained upon examination. Evaluating our uncertain tax positions, determining our provision for (benefit from) income taxes, and evaluating the impact of the Tax Cuts and Jobs Act, are inherently uncertain and require making judgments, assumptions, and estimates. While we believe that we have adequately reserved for our uncertain tax positions, no assurance can be given that the final tax outcome of these matters will not be different. We adjust these reserves in light of changing facts and circumstances, such as the closing of a tax audit. To the extent that the final tax outcome of these matters is different than the amounts recorded, such differences will impact the provision for (benefit from) income taxes and the effective tax rate in the period in which such determination is made. The provision for (benefit from) income taxes includes the impact of reserve provisions and changes to reserves as well as the related net interest and penalties. In addition, we are subject to the continuous examination of our income tax returns by the United States Internal Revenue Service and other tax authorities that may assert assessments against us. We regularly assess the likelihood of adverse outcomes resulting from these examinations and assessments to determine the adequacy of our provision for (benefit from) income taxes. Goodwill and Impairment of Long-Lived Assets Goodwill represents the excess of the purchase price over the fair value of net assets acquired in a business combination. We have one reporting unit. We test goodwill for impairment at least annually, in the fourth quarter, and whenever events or changes in circumstances indicate that goodwill might be impaired. As a result of the goodwill impairment assessment, management concluded goodwill was not impaired as of December 31, 2020 and does not believe that its reporting unit is at risk of failing the impairment test since the fair value of the reporting unit substantially exceeded the carrying value. Long-lived assets that are held and used by us are reviewed for impairment when events or changes in circumstances indicate that the carrying amount of the asset may not be recoverable. Determination of recoverability of long-lived assets is based on an estimate of the undiscounted cash flows resulting from the use of the asset group and its eventual disposition. If the carrying value of the long-lived asset group is not recoverable on an undiscounted cash flow basis, we recognize impairment to the extent that the carrying value exceeds its fair value. We determine fair value through various valuation techniques including discounted cash flow models, quoted market values, and third-party independent appraisals. Any impairments to right-of-use (“ROU”) assets, leasehold improvements, or other assets as a result of a sublease, abandonment, or other similar factor are initially recognized when a decision to do so is made and recorded as an operating expense. Similar to other long-lived assets, management tests ROU assets for impairment whenever events or changes in circumstances occur that could impact the recoverability of these assets. For lease assets, such circumstances would include subleases that do not fully recover the costs of the associated leases or a decision to abandon the use of all or part of an asset. For the year ended December 31, 2020, we recorded $35.8 million of ROU asset impairment charges within restructuring charges in the consolidated statement of operations. Significant judgment and estimates are required in assessing impairment of goodwill and long-lived assets, including identifying whether events or changes in circumstances require an impairment assessment, estimating future cash flows, and determining appropriate discount rates. Our estimates of fair value are based on assumptions believed to be reasonable, but which are inherently uncertain and unpredictable and, as a result, actual results may differ from estimates. 77Table of ContentsRecent Accounting Pronouncements See Note 2 to our consolidated financial statements for a description of recently adopted accounting pronouncements and recently issued accounting pronouncements not yet adopted. Item 7A. Quantitative and Qualitative Disclosures About Market RiskOur substantial operations around the world expose us to various market risks. These risks primarily include foreign currency risk and investment risk. Foreign Currency Exchange Risk We offer the ability to transact on our platform in over 40 currencies, of which the most significant foreign currencies to our operations in 2020 were the Euro, British Pound, Australian Dollar, Canadian Dollar, Brazilian Real, and Chinese Yuan. Our international revenue, as well as costs and expenses denominated in foreign currencies, expose us to the risk of fluctuations in foreign currency exchange rates against the U.S. dollar. Accordingly, we are subject to foreign currency risk, which may adversely impact our financial results. We have foreign currency exchange risks related primarily to: •revenue and cost of revenue associated with bookings on our platform denominated in currencies other than the U.S. dollar; •balances held as funds receivable and amounts held on behalf of customers and funds payable and amounts payable to customers; •unbilled amounts for confirmed bookings under the terms of our Pay Less Upfront program; and •intercompany balances primarily related to our payment entities that process customer payments. For revenue and cost of revenue associated with bookings on our platform outside of the United States, we generally receive net foreign currency amounts and therefore benefit from a weakening of the U.S. dollar and are adversely affected by a strengthening of the U.S. dollar. Movements in foreign exchange rates are recorded in other income (expense), net in our consolidated statements of operations. Furthermore, our platform generally enables guests to make payments in the currency of their choice to the extent that the currency is supported by Airbnb, which may not match the currency in which the host elects to be paid. As a result, in those cases, we bear the currency risk of both the guest payment as well as the host payment due to timing differences in such payments.In 2019, we began entering into foreign currency derivative contracts to protect against foreign exchange risks. Presently, these hedges are primarily designed to manage foreign exchange risk associated with balances held as funds payable and amounts payable to customers. These contracts reduce, but do not entirely eliminate, the impact of currency exchange rate movements on our assets and liabilities. We may choose not to hedge the risk associated with our foreign currency exposures, primarily if such exposure acts as a natural hedge for offsetting amounts denominated in the same currency or if the currency is too difficult or too expensive to hedge. We have experienced and will continue to experience fluctuations in foreign exchange gains and losses related to changes in exchange rates. If our foreign-currency denominated assets, liabilities, revenues, or expenses increase, our results of operations may be more significantly impacted by fluctuations in the exchange rates of the currencies in which we do business. If an adverse 10% foreign currency exchange rate change was applied to total net monetary assets and liabilities denominated in currencies other than the local currencies as of December 31, 2020, it would not have had a material impact on our consolidated financial statements. Investment and Interest Rate Risk We are exposed to interest rate risk related primarily to our investment portfolio and outstanding debt. Changes in interest rates affect the interest earned on our total cash, cash equivalents, and marketable securities and the fair value of those securities, as well as interest paid on our debt. We had cash and cash equivalents of $5.5 billion and marketable securities of $0.9 billion as of December 31, 2020, which consisted of corporate debt securities, mutual funds, highly-liquid debt instruments of the U.S. government and its agencies, and certificates of deposit. As of December 31, 2020, we had an additional $2.2 billion that we held for bookings in advance of guests completing check-ins, which we record separately on our consolidated balance sheets as funds receivable and amounts held on behalf of customers. The primary objective of our investment activities is to preserve capital and meet liquidity requirements without significantly increasing risk. We invest primarily in highly-liquid, investment grade debt securities, and we limit the amount of credit exposure to any one issuer. We do not enter into investments for trading or speculative purposes and have not used any derivative financial instruments to manage our interest rate risk exposure. Because our cash equivalents and marketable securities generally have short maturities, the fair value of our portfolio is relatively insensitive to interest rate fluctuations. Due to the short-term nature of our investments, we have not been exposed to, nor do we anticipate being exposed to, material risks due to changes in interest rates. A hypothetical 100 basis points increase or decrease in interest rates would not have had a material impact on our consolidated financial statements as of December 31, 2020. As of December 31, 2020, we had floating-rate loans of $1,995.0 million, subject to LIBOR floors. As a result, we are exposed to the risk related to fluctuations in interest rates to the extent LIBOR exceeds the floors. As of December 31, 2020, a hypothetical 100 basis points increase in interest rates would not have had a material impact on our consolidated financial statements. 78Table of Contents
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+Item 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSThe following Management’s Discussion and Analysis of Financial Condition and Results of Operations contains forward-looking statements that involve risks and uncertainties. Our actual results may differ materially from the results discussed in the forward-looking statements. Factors that might cause a difference include, but are not limited to, those discussed under Item 1A. Risk Factors in this Annual Report on Form 10-K. The following section is qualified in its entirety by the more detailed information, including our consolidated financial statements and the notes thereto, which appears elsewhere in this Annual Report.OverviewOrganizationWe are a leading global provider of security products and solutions operating in three geographic regions: Americas, EMEA and Asia Pacific. We sell a wide range of security products and solutions for end-users in commercial, institutional and residential markets worldwide, including the education, healthcare, government, hospitality, commercial office and single and multi-family residential markets. Our leading brands include CISA, Interflex, LCN, Schlage, SimonsVoss and Von Duprin. Recent DevelopmentsCOVID-19 PandemicIn March 2020, a global pandemic was declared by the WHO related to COVID-19. The impacts of the COVID-19 pandemic negatively affected the global economy, disrupted supply chains and created significant volatility and disruption in financial markets. The outbreak and spread of COVID-19 also resulted in a substantial curtailment of business activities worldwide, including the major geographic markets we serve. As part of the efforts to contain the spread of COVID-19, federal, state and local governments have imposed various restrictions on the conduct of business and travel, such as stay-at-home orders, travel restrictions and quarantines. These measures, as well as changes in employee health and safety concerns and consumer spending patterns, trends and preferences, have led to widespread business closures and lower demand for our products, with the most pronounced negative impacts of these measures on our results of operations occurring during the second quarter of 2020. Further, changes in commercial real estate occupancy, constraints on government and institutional budgets and the uncertain business climate have led to declines and delays in new construction activity and discretionary projects, including in many of the commercial and institutional construction markets we serve. As the pandemic and resulting economic challenges have adversely impacted, and will likely continue to adversely impact us, we continue to closely monitor their effects on all aspects of our business and the markets in which we operate. Throughout the pandemic, our primary focus has been, and continues to be, the health and safety of employees, our business continuity plan, meeting the evolving needs of our customers and the well-being of the many communities around the world in which we operate. During the early months of the pandemic, we experienced temporary production shut-downs due either to government mandate or to help ensure employee safety, most notably in Italy and the Baja region of Mexico. However, the vast majority of our manufacturing facilities have remained open and operational throughout 2020, in part due to the numerous health and safety measures we adopted to promote the health and safety of our workforce and because many of our global operations have been deemed essential businesses. All of our global production and assembly facilities were operational as of December 31, 2020, and while we currently expect they will remain operational for the foreseeable future, such expectation is dependent upon future governmental actions, demand for our products, the stability of our global supply chain and our ability to continue to operate in a safe manner. We remain focused on business continuity and ensuring our facilities remain operational where safe and appropriate to do so. We will also continue to serve our customers when needed through our channel partners or inventory on hand. To the extent any additional temporary closures or adjustments to production are necessary, such measures will be implemented in a way that allows us to resume operations in an efficient and safe manner, while also minimizing disruption to customers and our overall business, including prudent measures to mitigate, to the extent possible, any financial impacts, although any additional local orders or decrees resulting in new temporary shut-downs will drive further unfavorable impacts to our operations, ability to serve our customers and potentially, our financial position and liquidity. The pandemic will likely continue to impact us in numerous and evolving ways that we may not be able to accurately predict; however, we will continue to closely monitor its impact on our business, employees, customers, suppliers, distribution channels and other business partners, and we believe that our actions taken to date, our financial flexibility and potential measures within our control will allow us to maintain a sound financial position and provide for adequate resources to fund our ongoing operating and financing needs.32Table of ContentsAdditionally, as a response to the COVID-19 pandemic, on March 27, 2020, the Coronavirus Aid, Relief and Economic Security Act (the "CARES Act") was enacted and signed into law, which included measures to assist companies in response to the COVID-19 pandemic. One measure allowed companies to defer the remittance of the employer portion of the social security tax through December 31, 2020, with half the amount deferred required to be paid by December 31, 2021, and the other half by December 31, 2022. Through December 31, 2020, we have elected to defer approximately $13 million under this provision, which is classified in Accrued expenses and other current liabilities and Other noncurrent liabilities within our Consolidated Balance Sheet. A second measure of the CARES Act raised the limit on business interest deductions from 30% to 50% of adjusted taxable income for tax years 2019 and 2020. This increased interest limitation resulted in approximately $20 million of reduced cash tax payments in 2020. Each of these two measures has resulted in a benefit to our cash flows from operations for the year ended December 31, 2020; however, neither measure is expected to materially impact our effective tax rate, and no income tax effects have been recorded during the year ended December 31, 2020.The challenges and uncertainties related to the COVID-19 pandemic and its potential impact on our business, results of operations, financial condition and cash flows, as well as a number of other challenges and uncertainties that could affect our businesses are described further under Part I, Item 1A. "Risk Factors."2020 and 2019 Significant Events AcquisitionsIn December 2020, we acquired Yonomi, Inc. ("Yonomi), a U.S. based smart home integration platform provider and innovation leader in IoT Cloud platforms. Yonomi has been integrated into our Americas segment. Impairment of Goodwill and Intangible AssetsAs a result of the global economic disruption and uncertainty due to the COVID-19 pandemic, we performed interim impairment tests on the goodwill balances of our EMEA and Asia Pacific reporting units, as well as on certain indefinite-lived trade name assets in these two regions, during the first quarter of 2020. As discussed in Notes 5 and 6 to the Consolidated Financial Statements, the results of these interim impairment tests indicated that the estimated fair value of our Asia Pacific reporting unit and three indefinite-lived trade names were impaired. Consequently, goodwill and intangible asset impairment charges totaling $96.3 million were recorded. Further impairment charges were recorded in our Asia Pacific segment during the year ended December 31, 2020, including $2.6 million related to supply chain disruptions that reduced a brand's expected future cash flows and $2.8 million related to declines in volumes and pricing pressure for a separate subsidiary in the region. Loss on Assets Held for SaleThe assets and liabilities of our QMI business met the criteria to be classified as held for sale as of December 31, 2020. Accordingly, QMI's net assets, which primarily included working capital and long-lived assets, were written down to fair value, estimated based on expected sales proceeds, less cost to sell, resulting in a Loss on assets held for sale of $37.9 million. Turkey and Colombia DivestituresIn 2019, we closed our production facility in Turkey to help streamline our footprint in EMEA and subsequently sold certain of the production assets, which represented a business, for total proceeds of approximately $4.1 million. We recorded a loss on divestiture of $24.2 million ($25.5 million, net of tax), primarily driven by the reclassification of $25.0 million of accumulated foreign currency translation adjustments to earnings upon sale. We also sold our interests in our Colombia operations in 2019 for a nominal amount, recording a net loss on divestiture of $5.9 million, of which $1.2 million related to the reclassification of accumulated foreign currency translation adjustments to earnings upon sale.2020 Dividends and Share RepurchasesWe paid quarterly dividends of $0.32 per ordinary share to shareholders on record as of March 17, 2020, June 16, 2020, September 16, 2020, and December 16, 2020. We paid a total of $117.3 million in cash for dividends to ordinary shareholders and repurchased approximately 1.9 million shares for approximately $208.8 million during the year ended December 31, 2020.33Table of ContentsOther Financing ActivitiesIn 2019, we issued $400.0 million of 3.500% Senior Notes due 2029 (the "3.500% Senior Notes"). Net proceeds from the issuance of the 3.500% Senior Notes, along with cash on hand, were utilized to make a $400.0 million principal payment to partially pay down the Company's outstanding term loan facility (the "Term Facility") balance. As a result of this payment, we have satisfied our obligation to make quarterly installments on the Term Facility up to its maturity date, with the remaining outstanding balance of $238.8 million due on September 12, 2022.Subsequent EventEffective January 1, 2021, we have combined our EMEA and Asia Pacific operations into a new segment named Allegion International, in addition to renaming our Americas segment "Allegion Americas". The new Allegion International segment has been created to drive speed and efficiency, simplify our operating segments and optimize our non-U.S. operations.34Table of ContentsResults of Operations - For the years ended December 31Dollar amounts in millions, except per share amounts2020% of Netrevenues2019% of NetrevenuesNet revenues$2,719.9 $2,854.0 Cost of goods sold1,541.1 56.7 %1,601.7 56.1 %Selling and administrative expenses635.7 23.4 %681.3 23.9 %Impairment of goodwill and intangible assets101.7 3.7 %5.9 0.2 %Loss on assets held for sale37.9 1.4 %— — %Operating income403.5 14.8 %565.1 19.8 %Interest expense51.1 56.0 Loss on divestitures— 30.1 Other (income) expense, net(13.0) 3.8 Earnings before income taxes365.4 475.2 Provision for income taxes50.9 73.1 Net earnings314.5 402.1 Less: Net earnings attributable to noncontrolling interests0.2 0.3 Net earnings attributable to Allegion plc$314.3 $401.8 Diluted net earnings per ordinary share attributable to Allegion plc ordinary shareholders:$3.39 $4.26 The discussions that follow describe the significant factors contributing to the changes in our results of operations for the years presented and form the basis used by management to evaluate the financial performance of the business. For a discussion of our results of operations for the year ended December 31, 2019, compared to the year ended December 31, 2018, see “Part II, Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations” of our 2019 Annual Report on Form 10-K filed with the SEC on February 18, 2020.Net RevenuesNet revenues for the year ended December 31, 2020, decreased by 4.7%, or $134.1 million, compared to the same period in 2019, due to the following:Pricing1.0 %Volume(5.8)%Divestitures(0.3)%Currency exchange rates0.4 %Total(4.7)%The decrease in Net revenues was principally driven by lower volumes across all regions, primarily due to the economic challenges stemming from the ongoing COVID-19 pandemic, particularly during the second quarter of 2020. The decrease was, to a lesser degree, due to the impact of the divestitures of our Colombia and Turkey businesses in 2019, as discussed above. These decreases were slightly offset by improved pricing and the impact of foreign currency exchange rate movements.Pricing includes increases or decreases of price, including discounts, surcharges and/or other sales deductions, on our existing products and services. Volume includes increases or decreases of revenue due to changes in unit volume of existing products and services, as well as new products and services.Cost of Goods SoldFor the year ended December 31, 2020, Cost of goods sold as a percentage of Net revenues increased to 56.7% from 56.1%, due to the following:35Table of ContentsInflation in excess of pricing and productivity0.2 %Volume / product mix0.8 %Divestitures(0.1)%Currency exchange rates(0.2)%Restructuring expenses(0.1)%Total0.6 %Costs of goods sold as a percentage of Net revenues for the year ended December 31, 2020, increased primarily due to the impact of reduced volumes and product mix and, to a lesser extent, inflation in excess of pricing and productivity. Inflation in excess of pricing and productivity was driven by productivity challenges stemming from the temporary closures during the second quarter discussed above; labor inefficiencies, such as increased absenteeism; and, increased costs related to ensuring a safe and healthy work environment in light of the COVID-19 pandemic. These increases were partially offset by certain non-U.S. government incentives, which were included within inflation in excess of pricing and productivity, as well as the impacts of the divestitures discussed above, foreign currency exchange rate movements and a year-over-year decrease in restructuring expenses. The year-over-year decrease in restructuring expenses impacting Costs of goods sold is due to the prior year restructuring costs related to the closure of our production facility in Turkey in 2019. Inflation in excess of pricing and productivity includes the impact to Cost of goods sold from pricing, as defined above, in addition to productivity and inflation. Productivity represents improvements in unit costs of materials and cost reductions related to improvements to our manufacturing design and processes. Inflation includes unit costs for the current period compared to the average actual cost for the prior period, multiplied by current year volumes. Volume/product mix represents the impact due to increases or decreases of revenue due to changes in unit volume, including new products and services, including the effect of changes in the mix of products and services sold on Cost of goods sold.Selling and Administrative ExpensesFor the year ended December 31, 2020, Selling and administrative expenses as a percentage of Net revenues decreased to 23.4% from 23.9%, due to the following:Productivity in excess of inflation(2.3)%Volume leverage1.4 %Investment spending0.1 %Currency exchange rates(0.1)%Restructuring / acquisition expenses0.4 %Total(0.5)%Selling and administrative expenses as a percentage of Net revenues for the year ended December 31, 2020, decreased primarily due to productivity benefits in excess of inflation and foreign currency exchange rate movements. These decreases were partially offset by unfavorable leverage due to lower volumes, increased investment spending and a year-over-year increase in restructuring and acquisition expenses.Productivity in excess of inflation includes the impact from reductions in selling and administrative expenses due to productivity projects and current period costs of ongoing selling and administrative functions compared to the same ongoing expenses in the prior period. Productivity in excess of inflation also reflects the benefits of certain non-U.S. government incentives, reductions in variable compensation and reductions or delays of other business spending in the current year, in response to the COVID-19 pandemic.Volume leverage represents the contribution margin related to changes in sales volume, excluding the impact of price, productivity, mix and inflation. Expenses related to increased head count for strategic initiatives, new facilities or significant improvements for strategic initiatives and new product development, are captured in Investment spending in the table above. Operating Income/MarginOperating income for the year ended December 31, 2020, decreased $161.6 million from the same period in 2019, and Operating margin decreased to 14.8% from 19.8%, due to the following: 36Table of ContentsIn millionsOperating IncomeOperating MarginDecember 31, 2019$565.1 19.8 %Pricing and productivity in excess of inflation66.7 2.1 %Volume / product mix(94.9)(2.3)%Currency exchange rates8.6 0.2 %Investment spending(2.1)(0.1)%Divestitures0.6 0.1 %Restructuring / acquisition expenses(6.8)(0.3)%Impairment of goodwill and intangible assets(95.8)(3.4)%Loss on assets held for sale(37.9)(1.3)%December 31, 2020$403.5 14.8 %The decreases in Operating income and Operating margin were largely driven by our current year goodwill and intangible asset impairment charges and loss on assets held for sale related to our QMI business. As a result of the global economic disruption and uncertainty due to the COVID-19 pandemic, we determined a triggering event had occurred as of March 31, 2020, and performed interim impairment testing on the goodwill balances of our EMEA and Asia Pacific reporting units, as well as on certain indefinite-lived trade name assets in these two regions, which resulted in impairment charges totaling $96.3 million. Additional intangible asset impairments of $2.6 million and $2.8 million were recorded in our Asia Pacific segment in the third and fourth quarters of 2020, respectively. Further, as we concluded that the net assets of our QMI business met the criteria to be classified as held for sale as of December 31, 2020, they were written down to fair value, estimated based on expected sales proceeds, less cost to sell, which resulted in a loss of $37.9 million. The decreases in Operating income and Operating margin were also attributable to unfavorable volume/product mix, a year-over-year increase in restructuring and acquisition expenses and increased investment spending. These decreases were partially offset by pricing improvements and productivity in excess of inflation, foreign currency exchange rate movements and the impact of the divestitures discussed above. Interest ExpenseInterest expense for the year ended December 31, 2020, decreased $4.9 million compared to 2019, which is due to a lower weighted-average interest rate during the current year on our outstanding indebtedness and a $2.7 million prior year charge for the write-off of previously deferred financing costs related to the Term Facility, which did not recur in the current period.Loss on DivestituresIn 2019, we closed our production facility in Turkey and subsequently sold certain of the production assets thereof, which represented a business, for total proceeds of approximately $4.1 million. We recorded a loss on divestiture of $24.2 million ($25.5 million, net of tax), primarily driven by the reclassification of $25.0 million of accumulated foreign currency translation adjustments to earnings upon sale. We also sold our interests in our Colombia operations in 2019 for a nominal amount, recording a net loss on divestiture of $5.9 million, of which $1.2 million related to the reclassification of accumulated foreign currency translation adjustments to earnings upon sale. Other (Income) Expense, netThe components of Other (income) expense, net, for the years ended December 31 were as follows:In millions20202019Interest income$(0.9)$(1.8)Foreign currency exchange loss0.7 1.8 (Earnings) loss from equity method investments(0.3)0.1 Net periodic pension and postretirement benefit (income) cost, less service cost(2.2)6.8 Other(10.3)(3.1)Other (income) expense, net$(13.0)$3.8 37Table of ContentsFor the year ended December 31, 2020, Other (income) expense, net was favorable $16.8 million compared to 2019, primarily due to gains of $12.8 million related to the reclassification to earnings of accumulated foreign currency translation adjustments upon the liquidation of two legal entities in our EMEA region, which are included within Other in the table above, as well as favorable net periodic pension and postretirement benefit (income) cost, less service cost in 2020 compared to 2019. Provision for Income TaxesFor the year ended December 31, 2020, our effective tax rate was 13.9%, compared to 15.4% for the year ended December 31, 2019. The decrease in the effective tax rate was primarily due to the favorable mix of income earned in lower tax rate jurisdictions, partially offset by the unfavorable tax impact related to goodwill and intangible asset impairment charges and the unfavorable year-over-year change in the amounts recognized for valuation allowances. Review of Business SegmentsWe operate in and report financial results for three segments: Americas, EMEA and Asia Pacific. Beginning in the second quarter of 2020, results for the Company's India operations have been included within the Asia Pacific segment results, due to an operational change. This change did not result in a material impact to Segment results of operations for either the EMEA or Asia Pacific segment. These segments represent the level at which our chief operating decision maker reviews company financial performance and makes operating decisions.Segment operating income (loss) is the measure of profit and loss that our chief operating decision maker uses to evaluate the financial performance of the business and as the basis for resource allocation, performance reviews and compensation. For these reasons, we believe that Segment operating income (loss) represents the most relevant measure of Segment profit and loss. Our chief operating decision maker may exclude certain charges or gains, such as corporate charges and other special charges, to arrive at a Segment operating income (loss) that is a more meaningful measure of profit and loss upon which to base our operating decisions. We define Segment operating margin as Segment operating income (loss) as a percentage of the segment's Net revenues.The segment discussions that follow describe the significant factors contributing to the changes in results for each segment included in Net earnings. Segment Results of Operations - For the years ended December 31In millions20202019% ChangeNet revenuesAmericas$2,016.7 $2,114.5 (4.6)%EMEA554.6 572.5 (3.1)%Asia Pacific148.6 167.0 (11.0)%Total$2,719.9 $2,854.0 Segment operating income (loss)Americas$580.2 $611.6 (5.1)%EMEA(5.4)34.3 (115.7)%Asia Pacific(96.7)0.5 N/MTotal$478.1 $646.4 Segment operating marginAmericas28.8 %28.9 %EMEA(1.0)%6.0 %Asia Pacific(65.1)%0.3 %"N/M" = not meaningful38Table of ContentsAmericasOur Americas segment is a leading provider of security products and solutions in approximately 30 countries throughout North America, Central America, the Caribbean and South America. The segment sells a broad range of products and solutions including, locks, locksets, portable locks, key systems, door closers, exit devices, doors and door systems, electronic products and access control systems to end-users in commercial, institutional and residential facilities, including the education, healthcare, government, hospitality, commercial office and single and multi-family residential markets. This segment’s primary brands are LCN, Schlage, Steelcraft, Technical Glass Products ("TGP") and Von Duprin.Net revenuesNet revenues for the year ended December 31, 2020, decreased by 4.6%, or $97.8 million, compared to the same period in 2019, due to the following: Pricing1.1 %Volume(5.3)%Divestitures(0.4)%Total(4.6)%The decrease in Net revenues was principally driven by lower volumes due to the economic challenges stemming from the ongoing COVID-19 pandemic, as well as the impact of the divestiture of our Colombia business in 2019. These decreases were partially offset by improved pricing. Net revenues from residential products for the year ended December 31, 2020, increased mid-single digits compared to the same period in the prior year, primarily driven by higher volumes. Net revenues from non-residential products for the year ended December 31, 2020, decreased high single digits compared to the prior year, primarily driven by lower volumes. As a result of the COVID-19 pandemic, there have been changes in commercial real estate occupancy, constraints on government and institutional budgets and an overall uncertain business climate, which have led to declines and delays in new construction activity and discretionary projects in the non-residential construction markets we serve. These challenges are expected to continue in 2021, but the long-term impacts of the pandemic and related market disruption are not yet known. Additionally, as end-users have continued to adopt newer technologies in their facilities and homes, accelerated by the increasing adoption of the Internet of Things ("IoT"), growth in electronic security products and solutions has become an increased metric monitored by management and of focus to our investors. For the year ended December 31, 2020, Net revenues from the sale of electronic products in the Americas segment decreased mid-single digits compared to the same period in the prior year, primarily driven by lower volumes due to delays in discretionary projects. Electronic products include all electrified product categories including, but not limited to, electronic locks, access controls and electrified exit devices.Operating income/marginSegment operating income for the year ended December 31, 2020, decreased $31.4 million, and Segment operating margin decreased to 28.8% from 28.9% compared to the same period in 2019, due to the following: In millionsOperating IncomeOperating MarginDecember 31, 2019$611.6 28.9 %Pricing and productivity in excess of inflation31.0 1.1 %Volume / product mix(64.8)(1.5)%Currency exchange rates5.9 0.3 %Investment spending(2.0)(0.1)%Divestitures0.7 0.2 %Restructuring / acquisition expenses(2.2)(0.1)%December 31, 2020$580.2 28.8 %The decreases in Segment operating income and Segment operating margin were primarily due to unfavorable volume/product mix, as well as increased investment spending and year-over-year increases in restructuring and acquisition expenses. These decreases were partially offset by pricing improvements and productivity in excess of inflation, foreign currency exchange rate movements and the impact of the divestiture of our Colombia business in 2019. As a result of the ongoing COVID-19 pandemic, certain of our facilities in the Americas experienced productivity challenges due to temporary closures and lower volume and demand, particularly during the second quarter; however, these productivity decreases were more than offset by reductions in variable compensation and reductions or delays of other business spending.39Table of ContentsEMEAOur EMEA segment provides security products, services and solutions in approximately 80 countries throughout Europe, the Middle East and Africa. The segment offers end-users a broad range of products, services and solutions including, locks, locksets, portable locks, key systems, door closers, exit devices, doors and door systems, electronic products and access control systems, as well as time and attendance and workforce productivity solutions. This segment’s primary brands are AXA, Bricard, Briton, CISA, Interflex and SimonsVoss. This segment also resells LCN, Schlage and Von Duprin products, primarily in the Middle East. Net revenuesNet revenues for the year ended December 31, 2020, decreased by 3.1%, or $17.9 million, compared to the same period in 2019, due to the following:Pricing0.9 %Volume(6.0)%Divestitures(0.2)%Currency exchange rates2.2 %Total(3.1)%The decrease in Net revenues was principally driven by lower volumes due to the economic challenges stemming from the ongoing COVID-19 pandemic, particularly during the second quarter, as well as the divestiture of our Turkey business in 2019. These decreases were partially offset by improved pricing and favorable foreign currency exchange rate movements.Operating income (loss)/marginSegment operating income (loss) for the year ended December 31, 2020, was unfavorable $39.7 million, and Segment operating margin decreased to (1.0)% from 6.0% compared to the same period in 2019, due to the following:In millionsOperating Income (Loss)Operating MarginDecember 31, 2019$34.3 6.0 %Pricing and productivity in excess of inflation15.0 2.6 %Volume / product mix(22.4)(3.8)%Currency exchange rates2.8 0.4 %Investment spending(0.3)(0.1)%Divestitures(0.1)— %Restructuring / acquisition expenses3.1 0.5 %Impairment of intangible assets0.1 — %Loss on assets held for sale(37.9)(6.6)%December 31, 2020$(5.4)(1.0)%Segment operating income (loss) was unfavorable primarily due to the loss on assets held for sale related to our QMI business, unfavorable volume/product mix and, to a lesser extent, increased investment spending and the impact of the divestiture of our Turkey business in 2019. These decreases were partially offset by pricing improvements and productivity in excess of inflation, foreign currency exchange rate movements, year-over-year decreases in restructuring and acquisition expenses and intangible asset impairment charges. Certain of our facilities in EMEA did experience productivity challenges as a result of the COVID-19 pandemic due to temporary closures and lower volume and demand, particularly during the second quarter in Italy; however, this was more than offset by the benefits of certain government incentives and reductions in variable compensation and other business spending. Pricing and productivity in excess of inflation also includes the impact of a $5.1 million environmental remediation charge incurred during the fourth quarter of 2020. Segment operating margin decreased primarily due to the loss on assets held for sale, unfavorable volume/product mix and increased investment spending. These decreases were partially offset by pricing improvements and productivity in excess of inflation, foreign currency exchange rate movements and year-over-year decreases in restructuring and acquisition expenses.40Table of ContentsAsia PacificOur Asia Pacific segment provides security products, services and solutions in approximately 15 countries throughout the Asia Pacific region. The segment offers end-users a broad range of products, services and solutions including, locks, locksets, portable locks, key systems, door closers, exit devices, electronic products and access control systems. This segment’s primary brands are Brio, Briton, FSH, Gainsborough, Legge, Milre and Schlage.Net revenuesNet revenues for the year ended December 31, 2020, decreased by 11.0%, or $18.4 million, compared to the same period in 2019, due to the following: Pricing(0.7)%Volume(9.9)%Currency exchange rates(0.4)%Total(11.0)%The decrease in Net revenues was principally driven by lower volumes in our Korea business, declines attributable to the economic challenges stemming from the ongoing COVID-19 pandemic and weakness in end markets throughout the region. Unfavorable foreign currency exchange rate movements and lower pricing also contributed to the decrease in Net revenues during the current year.Operating income (loss)/marginSegment operating income (loss) for the year ended December 31, 2020, was unfavorable $97.2 million, and Segment operating margin decreased to (65.1)% from 0.3% compared to the same period in 2019, due to the following: In millionsOperating Income (Loss)Operating MarginDecember 31, 2019$0.5 0.3 %Pricing and productivity in excess of inflation8.2 4.9 %Volume / product mix(7.7)(4.9)%Currency exchange rates(0.1)(0.1)%Investment spending0.8 0.5 %Restructuring / acquisition expenses(2.5)(1.5)%Impairment of goodwill and intangible assets(95.9)(64.3)%December 31, 2020$(96.7)(65.1)%The decreases to Segment operating income (loss) and Segment operating margin were both primarily due to an $88.1 million goodwill impairment charge in the first quarter of 2020 and increased year-over-year intangible asset impairment charges, as well as unfavorable volume/product mix, year-over-year increases in restructuring and acquisition expenses and foreign currency exchange rate movements. These decreases were partially offset by productivity improvements in excess of lower pricing and inflation and decreased investment spending. Pricing and productivity in excess of inflation includes the impact of a $4.0 million gain on the sale of a building within the region during the fourth quarter of 2020.Liquidity and Capital ResourcesSources and uses of liquidityOur primary source of liquidity is cash provided by operating activities. Cash provided by operating activities is used to invest in new product development and fund capital expenditures and working capital requirements and is expected to be adequate to service any future debt, pay any declared dividends and potentially fund acquisitions and share repurchases. Our ability to fund these capital needs depends on our ongoing ability to generate cash from our operating activities and to access our borrowing facilities (including unused availability under our Revolving Facility) and capital markets. Throughout 2020, we have closely monitored the developments related to the COVID-19 pandemic, including the resulting uncertainties around customer demand, supply chain disruption, the availability and cost of materials, customer and supplier financial condition, levels of liquidity and our ongoing compliance with debt covenants. While our business and results of 41Table of Contentsoperations have been negatively impacted by the pandemic and the resulting global economic slowdown, we have no required principal payments on our long-term debt until September 2022, maintain cash and cash equivalents of $480.4 million and have unused availability of $485.0 million under our Revolving Facility as of December 31, 2020. Further, our business operates with low capital intensity, providing financial flexibility during this time of continued uncertainty. We believe that our actions taken to date, future cash provided by operating activities, availability under our Revolving Facility, access to funds on hand and capital markets, as well as other potential measures within our control to maintain a sound financial position and liquidity, will provide adequate resources to fund our operating and financing needs.The following table reflects the major categories of cash flows for the years ended December 31. For additional details, please see the Consolidated Statements of Cash Flows in the Consolidated Financial Statements.In millions20202019Net cash provided by operating activities$490.3 $488.2 Net cash used in investing activities(56.7)(77.6)Net cash used in financing activities$(321.9)$(342.2)Operating activitiesNet cash provided by operating activities for the year ended December 31, 2020, increased $2.1 million compared to 2019. As discussed above, Net cash provided by operating activities for the year ended December 31, 2020, included benefits totaling approximately $30 million due to measures included in the CARES Act.Investing activitiesNet cash used in investing activities for the year ended December 31, 2020, decreased $20.9 million compared to 2019, primarily due to a decrease in capital expenditures.Financing activitiesNet cash used in financing activities for the year ended December 31, 2020, decreased $20.3 million compared to 2019. The year over-year reductions in debt repayments and cash used to repurchase shares of $17.7 million and $17.2 million, respectively, were partially offset by a year-over-year increase in dividend payments to ordinary shareholders of $16.7 million. CapitalizationAt December 31, long-term debt and other borrowings consisted of the following:In millions20202019Term Facility$238.8 $238.8 Revolving Facility— — 3.200% Senior Notes due 2024400.0 400.0 3.550% Senior Notes due 2027400.0 400.0 3.500% Senior Notes due 2029400.0 400.0 Other debt0.6 0.7 Total borrowings outstanding1,439.4 1,439.5 Less discounts and debt issuance costs, net(9.8)(11.8)Total debt1,429.6 1,427.7 Less current portion of long-term debt0.2 0.1 Total long-term debt$1,429.4 $1,427.6 As of December 31, 2020, we have an unsecured Credit Agreement in place, consisting of a $700.0 million term loan facility (the “Term Facility”), of which $238.8 million is outstanding, and a $500.0 million revolving credit facility (the “Revolving Facility” and, together with the Term Facility, the “Credit Facilities”). The Credit Facilities mature on September 12, 2022. At inception, the Term Facility was scheduled to amortize in quarterly installments at the following rates: 1.25% per quarter starting December 31, 2017 through December 31, 2020, 2.5% per quarter from March 31, 2021 through June 30, 2022, with the balance due on September 12, 2022. Principal amounts repaid on the Term Facility may not be reborrowed. During the third 42Table of Contentsquarter of 2019, we made a $400.0 million principal payment to partially pay down the outstanding Term Facility balance. As a result of this payment, we have satisfied our obligation to make quarterly installments on the Term Facility up to the maturity date, with the remaining outstanding balance due on September 12, 2022.The Revolving Facility provides aggregate commitments of up to $500.0 million, which includes up to $100.0 million for the issuance of letters of credit. At December 31, 2020, there were no borrowings outstanding on the Revolving Facility, and we had $15.0 million of letters of credit outstanding. Commitments under the Revolving Facility may be reduced at any time without premium or penalty, and amounts repaid may be reborrowed.Outstanding borrowings under the Credit Facilities accrue interest at our option of (i) a LIBOR rate plus the applicable margin or (ii) a base rate plus the applicable margin. The applicable margin ranges from 1.125% to 1.500% depending on our credit ratings. At December 31, 2020, outstanding borrowings under the Credit Facilities accrue interest at LIBOR plus a margin of 1.250%, resulting in an interest rate of 1.51%. As of December 31, 2020, we also have $400.0 million outstanding of 3.200% Senior Notes due 2024 (the "3.200% Senior Notes"), $400.0 million outstanding of 3.550% Senior Notes due 2027 (the "3.550% Senior Notes") and $400.0 million outstanding of 3.500% Senior Notes due 2029 (the "3.500% Senior Notes", and all three senior notes collectively, the "Senior Notes"). The Senior Notes require semi-annual interest payments on April 1 and October 1 of each year, and will mature on October 1, 2024, October 1, 2027, and October 1, 2029, respectively. Historically, the majority of our earnings were considered to be permanently reinvested in jurisdictions where we have made, and intend to continue to make, substantial investments to support the ongoing development and growth of our global operations. At December 31, 2020, we have analyzed our working capital requirements and the potential tax liabilities that would be incurred if certain subsidiaries made distributions and concluded that no material changes to our historic permanent reinvestment assertions are required.Defined Benefit PlansOur investment objective in managing defined benefit plan assets is to ensure that all present and future benefit obligations are met as they come due. We seek to achieve this goal while trying to mitigate volatility in plan funded status, contributions and expense by better matching the characteristics of the plan assets to that of the plan liabilities. Global asset allocation decisions are based on a dynamic approach whereby a plan's allocation to fixed income assets increases as the funded status increases. We monitor plan funded status, asset allocation and the impact of market conditions on our defined benefit plans regularly in addition to investment manager performance. None of our defined benefit pension plans have experienced a significant impact on their liquidity due to volatility in the markets. For further details on pension plan activity, see Note 12 to the Consolidated Financial Statements.Contractual ObligationsThe following table summarizes our contractual cash obligations by required payment periods:In millions20212022-20232024-2025ThereafterTotalLong-term debt (including current maturities)$0.2 $239.1 $400.1 $800.0 $1,439.4 Interest payments on long-term debt45.6 85.4 66.0 77.3 274.3 Purchase obligations462.5 ———462.5 Operating leases30.4 38.2 16.8 19.5 104.9 Total contractual cash obligations$538.7 $362.7 $482.9 $896.8 $2,281.1 Future interest payments on variable rate long-term debt are estimated based on the rate in effect as of December 31, 2020. As the timing and amounts of our future expected obligations under our defined benefit plans, income taxes, environmental and product liability matters are uncertain, they have not been included in the contractual cash obligations table above, but rather, are discussed below:Defined Benefit Pension and Postretirement ("OPEB") PlansAt December 31, 2020, we had net pension liabilities of $20.2 million, which consist of plan assets of $796.9 million and benefit obligations of $817.1 million. It is our objective to contribute to our pension plans in order to ensure adequate funds are available in the plans to make benefit payments to plan participants and beneficiaries when required. At December 31, 2020, the funded status of our qualified pension plan for U.S. employees increased to 98.7% from 93.5% at December 31, 2019. The 43Table of Contentsfunded status for our non-U.S. pension plans increased to 101.8% at December 31, 2020 from 101.1% at December 31, 2019. The funded status for all of our pension plans at December 31, 2020 increased to 97.5% from 95.3% at December 31, 2019. We currently project that approximately $11.4 million will be contributed to our plans worldwide in 2021. At December 31, 2020, we also had OPEB obligations of $5.2 million. We fund OPEB costs principally on a pay-as-you-go basis as medical costs are incurred by covered retiree populations. Benefit payments, which are net of expected plan participant contributions and Medicare Part D subsidies, are not expected to be material in 2021. See Note 12 to the Consolidated Financial Statements for additional information related to our pension and OPEB obligations.Income TaxesAt December 31, 2020, we have total unrecognized tax benefits for uncertain tax positions of $41.2 million and $7.6 million of related accrued interest and penalties, net of tax. These liabilities have been excluded from the preceding table as we are unable to reasonably estimate the amount and period in which these liabilities might be paid. See Note 18 to the Consolidated Financial Statements for additional information regarding matters relating to income taxes, including unrecognized tax benefits and tax authority disputes. Contingent LiabilitiesWe are involved in various litigation, claims and administrative proceedings, including those related to environmental, asbestos-related and product liability matters. We believe that these liabilities are subject to the uncertainties inherent in estimating future costs for contingent liabilities and will likely be resolved over an extended period of time. See Note 21 to the Consolidated Financial Statements for additional information.Guarantor Financial InformationIn March 2020, the SEC adopted amendments to the financial disclosure requirements applicable to registered debt offerings that include credit enhancements, such as subsidiary guarantees, in Rule 3-10 of Regulation S-X. The amended rules focus on providing material, relevant and decision-useful information regarding guarantees and other credit enhancements, while eliminating certain prescriptive requirements. We adopted these amendments on March 31, 2020. Accordingly, summarized financial information has been presented only for the issuers and guarantors of our registered securities for the most recent fiscal year, and the location of the required disclosures has been moved outside the Notes to the Consolidated Financial Statements and is provided below.Allegion US Holding Company Inc. ("Allegion US Hold Co") is the issuer of the 3.200% Senior Notes and 3.550% Senior Notes and is the guarantor of the 3.500% Senior Notes. Allegion plc (the “Parent”) is the issuer of the 3.500% Senior Notes and is the guarantor of the 3.200% Senior Notes and 3.550% Senior Notes. Allegion US Hold Co is 100% owned by the Parent and each of the guarantees of Allegion US Hold Co and the Parent is full and unconditional and joint and several.The 3.200% Senior Notes and the 3.550% Senior Notes are senior unsecured obligations of Allegion US Hold Co and rank equally with all of Allegion US Hold Co’s existing and future senior unsecured and unsubordinated indebtedness. The guarantee of the 3.200% Senior Notes and the 3.550% Senior Notes is the senior unsecured obligation of the Parent and ranks equally with all of Allegion plc’s existing and future senior unsecured and unsubordinated indebtedness. The 3.500% Senior Notes are senior unsecured obligations of the Parent, are guaranteed by Allegion US Hold Co and rank equally with all of Allegion plc’s existing and future senior unsecured indebtedness. Each guarantee is effectively subordinated to any secured indebtedness of the Guarantor to the extent of the value of the assets securing such indebtedness. The Senior Notes are structurally subordinated to indebtedness and other liabilities of the subsidiaries of the Guarantor, none of which guarantee the notes. The obligations of the Guarantor under its Guarantee are limited as necessary to prevent such Guarantee from constituting a fraudulent conveyance under applicable law and, therefore, are limited to the amount that the Guarantor could guarantee without such Guarantee constituting a fraudulent conveyance; this limitation, however, may not be effective to prevent such Guarantee from constituting a fraudulent conveyance. If the Guarantee was rendered voidable, it could be subordinated by a court to all other indebtedness (including guarantees and other contingent liabilities) of the Guarantor, and, depending on the amount of such indebtedness, the Guarantor’s liability on its Guarantee could be reduced to zero. In such an event, the notes would be structurally subordinated to the indebtedness and other liabilities of the Guarantor. For further details, terms and conditions of the Senior Notes refer to the Company’s Form 8-K filed October 2, 2017 and Form 8-K filed September 27, 2019.44Table of ContentsThe following tables present the summarized financial information specified in Rule 1-02(bb)(1) of Regulation S-X for each issuer and guarantor. The summarized financial information has been prepared in accordance with Rule 13-01 of Regulation S-X.Selected Condensed Statement of Comprehensive Income InformationYear ended December 31, 2020In millionsAllegion plcAllegion US Hold CoNet revenues$— $— Gross profit— — Operating loss(7.5)(0.2)Equity earnings in affiliates, net of tax358.8 216.5 Transactions with related parties and subsidiaries(a)(15.3)(39.3)Net earnings314.3 164.7 Net earnings attributable to the entity314.3 164.7 (a) Transactions with related parties and subsidiaries include intercompany interest and fees.Selected Condensed Balance Sheet InformationDecember 31, 2020In millionsAllegion plcAllegion US Hold CoCurrent assets:Amounts due from related parties and subsidiaries$— $20.0 Total current assets19.0 38.7 Noncurrent assets:Amounts due from related parties and subsidiaries— 1,644.2 Total noncurrent assets1,793.3 1,671.8 Current liabilities:Amounts due to related parties and subsidiaries$197.5 $183.9 Total current liabilities204.4 190.7 Noncurrent liabilities:Amounts due to related parties and subsidiaries507.3 2,463.9 Total noncurrent liabilities1,143.2 3,267.3 Critical Accounting PoliciesManagement’s Discussion and Analysis of Financial Condition and Results of Operations are based upon our Consolidated Financial Statements, which have been prepared in accordance with GAAP. The preparation of financial statements in conformity with those accounting principles requires management to use judgment in making estimates and assumptions based on the relevant information available at the end of each period. These estimates and assumptions have a significant effect on reported amounts of assets and liabilities, revenues and expenses as well as the disclosure of contingent assets and liabilities because they result primarily from the need to make estimates and assumptions on matters that are inherently uncertain. Actual results may differ from estimates. If updated information or actual amounts are different from previous estimates, the revisions are included in our results for the period in which they become known.The following is a summary of certain accounting estimates and assumptions made by management that we consider critical:•Goodwill – Goodwill is tested annually during the fourth quarter for impairment or when there is a significant change in events or circumstances that indicate the fair value of a reporting unit is more likely than not less than its carrying amount. Recoverability of goodwill is measured at the reporting unit level and starts with a comparison of the carrying amount of a reporting unit to its estimated fair value. If the estimated fair value of a reporting unit exceeds its carrying amount, goodwill of the reporting unit is not impaired. To the extent that the carrying value of a reporting unit exceeds its estimated fair value, a goodwill impairment charge will be recognized for the amount by which the carrying value of the reporting unit exceeds its fair value, not to exceed the carrying amount of the reporting unit's goodwill. 45Table of ContentsAs quoted market prices are not available for our reporting units, the calculation of their estimated fair values is based on two valuation techniques, a discounted cash flow model (income approach) and a market multiple of earnings (market approach), with each method being weighted in the calculation. The income approach relies on the Company’s estimates of revenue growth rates, terminal growth rates, margin assumptions and discount rates to estimate future cash flows and explicitly addresses factors such as timing, with due consideration given to forecasting risk. The market approach requires determining an appropriate peer group, which is utilized to derive estimated fair values of our reporting units based on selected market multiples. The market approach reflects the market’s expectations for future growth and risk, with adjustments to account for differences between the selected peer group companies and the subject reporting units. As a result of the global economic disruption and uncertainty due to the COVID-19 pandemic, we concluded a triggering event had occurred as of March 31, 2020, and accordingly, performed interim impairment testing on the goodwill balances of our EMEA and Asia Pacific reporting units. Given the high degree of market volatility and lack of reliable market data that existed as of March 31, 2020, we determined a discounted cash flow model (income approach) provided the best approximation of fair value of the EMEA and Asia Pacific reporting units for the purpose of performing these interim tests. This was a change in estimate, as historically our determination of reporting unit fair values has been estimated based on both an income and a market approach, as discussed above, with each method being weighted in the calculation. The results of the interim impairment testing indicated the estimated fair value of the Asia Pacific reporting unit was less than its carrying value, and consequently, a goodwill impairment charge of $88.1 million was recorded. As markets stabilized throughout the year, we reverted to utilizing both an income and market approach while performing our annual impairment test in the fourth quarter. The estimated fair values for each of our reporting units exceeded their carrying values by more than 20% for the annual 2020 goodwill impairment test, completed in the fourth quarter. Assessing the fair value of our reporting units includes, among other things, making key assumptions for estimating future cash flows and appropriate market multiples. These assumptions are subject to a high degree of judgment and complexity. We make every effort to estimate future cash flows as accurately as possible with the information available at the time the forecast is developed. However, changes in assumptions and estimates may affect the estimated fair value of the reporting unit and could result in impairment charges in future periods. Factors that have the potential to create variances in the estimated fair value of the reporting unit include, but are not limited to, the following:•Decreases in estimated market sizes or market growth rates due to greater-than-expected declines in volumes, pricing pressures or disruptive technology;•Declines in our market share and penetration assumptions due to increased competition or an inability to develop or launch new products;•The impacts of market volatility, including greater-than-expected declines in pricing, reductions in volumes or fluctuations in foreign exchange rates;•The level of success of on-going and future research and development efforts, including those related to acquisitions, and increases in the research and development costs necessary to obtain regulatory approvals and launch new products;•Increases in the price or decreases in the availability of key commodities and the impact of higher energy prices; and•Increases in our market-participant risk-adjusted weighted-average cost of capital.•Indefinite-lived intangible assets – Similar to goodwill, indefinite-lived intangible assets are tested annually during the fourth quarter for impairment or when there is a significant change in events or circumstances that indicate the fair value of the asset is more likely than not less than its carrying amount. Recoverability of indefinite-lived intangible assets is determined on a relief from royalty methodology, which is based on the implied royalty paid, at an appropriate discount rate, to license the use of an asset rather than owning the asset. The present value of the after-tax cost savings (i.e. royalty relief) indicates the estimated fair value of the asset. Any excess of the carrying value over the estimated fair value is recognized as an impairment loss equal to that excess. During the first quarter of 2020, we concluded the global economic disruption and uncertainty due to the COVID-19 pandemic to be a triggering event. Accordingly, interim impairment tests on certain indefinite-lived trade names were performed as of March 31, 2020. Based on these tests, it was determined that three of our indefinite-lived trade names in the EMEA and Asia Pacific segments were impaired, and impairment charges totaling $8.2 million were recorded.A significant increase in the discount rate, decrease in the terminal growth rate, decrease in the royalty rate or substantial reductions in future revenue projections could have a negative impact on the estimated fair values of any of our indefinite-lived intangible assets. 46Table of Contents•Income taxes – We account for income taxes in accordance with ASC Topic 740. Deferred tax assets and liabilities are determined based on temporary differences between financial reporting and tax bases of assets and liabilities, applying enacted tax rates expected to be in effect for the year in which the differences are expected to reverse. We recognize future tax benefits, such as net operating losses and non-U.S. tax credits, to the extent that realizing these benefits is considered in our judgment to be more likely than not. We regularly review the recoverability of our deferred tax assets considering our historic profitability, projected future taxable income, timing of the reversals of existing temporary differences and the feasibility of our tax planning strategies. Where appropriate, we record a valuation allowance with respect to future tax benefits. The provision for income taxes involves a significant amount of management judgment regarding interpretation of relevant facts and laws in the jurisdictions in which we operate. Future changes in applicable laws, projected levels of taxable income and tax planning could change the effective tax rate and tax balances recorded by us. In addition, tax authorities periodically review income tax returns filed by us and can raise issues regarding our filing positions, timing and amount of income or deductions and the allocation of income among the jurisdictions in which we operate. A significant period of time may elapse between the filing of an income tax return and the ultimate resolution of an issue raised by a revenue authority with respect to that return. We believe that we have adequately provided for any reasonably foreseeable resolution of these matters. We will adjust our estimates if significant events so dictate. To the extent that the ultimate results differ from our original or adjusted estimates, the effect will be recorded in the provision for income taxes in the period that the matter is finally resolved.•Defined benefit plans – We provide several U.S. and non-U.S. defined benefit pension plan benefits to eligible employees and retirees. Our noncontributory defined benefit pension plans covering non-collectively bargained U.S. employees provide benefits on an average pay formula while most plans for collectively bargained U.S. employees provide benefits on a flat dollar benefit formula. The non-U.S. pension plans generally provide benefits based on earnings and years of service. Determining the costs associated with such plans is dependent on various actuarial assumptions including discount rates, expected return on plan assets, employee mortality and turnover rates. Actuarial valuations are performed to determine expense in accordance with GAAP. Actual results may differ from the actuarial assumptions and are generally recorded to Accumulated other comprehensive loss and amortized into earnings over future periods. We review our actuarial assumptions at each measurement date and make modifications to the assumptions as appropriate. The discount rate and expected return on plan assets are determined as of each measurement date. Discount rates for all plans are established using hypothetical yield curves based on the yields of corporate bonds rated AA quality. Spot rates are developed from the yield curve and used to discount future benefit payments. The expected return on plan assets reflects the average rate of returns expected on the funds invested or to be invested to provide for the benefits included in the projected benefit obligation. The expected return on plan assets is based on what is achievable given the plan’s investment policy, the types of assets held and the target asset allocation. We believe the assumptions utilized in recording our defined benefit obligations are reasonable based on input from our actuaries, outside investment advisors and information as to assumptions used by plan sponsors.Changes in any of the assumptions can have an impact on the net periodic pension benefit cost. An estimated 0.25% rate decline in the discount rate would increase net periodic pension benefit cost by approximately $1.1 million in 2021, while a 0.25% rate decline in the estimated return on assets would increase net periodic pension benefit cost by approximately $1.9 million. •Business combinations – The fair value of consideration paid in a business combination is allocated to the tangible and identifiable intangible assets acquired, liabilities assumed and goodwill. Acquired intangible assets primarily include indefinite-lived trade names, customer relationships and completed technologies. The accounting for business combinations involves a considerable amount of judgment and estimation, including the fair value of acquired intangible assets involving projections of future revenues and cash flows that are either discounted at an estimated discount rate or measured at an estimated royalty rate; fair value of other acquired assets and assumed liabilities, including potential contingencies; and the useful lives of the acquired assets. The assumptions used to determine the fair value of acquired intangible assets include projections developed using internal forecasts, available industry and market data, estimates of long-term growth rates, profitability, customer attrition and royalty rates, which are determined at the time of acquisition. An income approach or market approach (or both) is utilized in accordance with accepted valuation models for each acquired intangible asset to determine fair value. The impact of prior or future business combinations on our financial condition or results of operations may be materially impacted by the change in or initial selection of assumptions and estimates.47Table of ContentsRecent Accounting PronouncementsSee Note 2 to our Consolidated Financial Statements included in Item 8 herein for a discussion of recently issued and adopted accounting pronouncements.Item 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKWe are exposed to fluctuations in currency exchange rates, interest rates and commodity prices which could impact our results of operations and financial condition. Foreign Currency ExposuresWe have operations throughout the world that manufacture and sell products in various international markets. As a result, we are exposed to movements in exchange rates of various currencies against the U.S. dollar as well as against other currencies throughout the world. We actively manage material currency exposures that are associated with purchases and sales and other assets and liabilities at the legal entity level; however, we do not hedge currency translation risk. We attempt to hedge exposures that cannot be naturally offset to an insignificant amount with foreign currency derivatives. Derivative instruments utilized by us in our hedging activities are viewed as risk management tools, involve little complexity and are not used for trading or speculative purposes. To minimize the risk of counter party non-performance, derivative instrument agreements are made only through major financial institutions with significant experience in such derivative instruments.We evaluate our exposure to changes in currency exchange rates on our foreign currency derivatives using a sensitivity analysis. The sensitivity analysis is a measurement of the potential loss in fair value based on a percentage change in exchange rates. Based on the firmly committed currency derivative instruments in place at December 31, 2020, a hypothetical change in fair value of those derivative instruments assuming a 10% adverse change in exchange rates would result in an additional unrealized loss of approximately $16.9 million. This amount, when realized, would be partially offset by changes in the fair value of the underlying transactions.Commodity Price ExposuresWe are exposed to volatility in the prices of commodities used in some of our products and we use fixed price contracts to manage this exposure. We do not have committed commodity derivative instruments in place at December 31, 2020.Interest Rate ExposureOutstanding borrowings under our Credit Facilities accrue interest at our option of (i) a LIBOR rate plus the applicable margin or (ii) a base rate plus the applicable margin. The applicable margin ranges from 1.125% to 1.500% depending on our credit ratings. At December 31, 2020, the outstanding borrowings of $238.8 million under the Term Facility accrue interest at LIBOR plus a margin of 1.250%. We are also exposed to the risk of rising interest rates to the extent that we fund our operations with short-term or variable-rate borrowings, as we currently have unused availability of $485.0 million under our Revolving Facility as of December 31, 2020. If LIBOR or other applicable base rates of our Credit Facilities increase in the future, our Interest expense could increase.48Table of Contents
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+ITEM 7.MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSPlease read the following discussion and analysis of our financial condition and results of operations together with our consolidated financial statements and related notes included under Part II, Item 8 of this Annual Report on Form 10-K. We have omitted discussion of 2018 results where it would be redundant to the discussion previously included in Part II, Item 7 of our 2019 Annual Report on Form 10-K.Trends in Our BusinessThe following long-term trends have contributed to the results of our consolidated operations, and we anticipate that they will continue to affect our future results:•Users' behaviors and advertising continue to shift online as the digital economy evolves.The continuing shift from an offline to online world has contributed to the growth of our business since inception, contributing to revenue growth, and we expect that this online shift will continue to benefit our business.•Users are increasingly using diverse devices and modalities to access our products and services, and our advertising revenues are increasingly coming from new formats.Our users are accessing the Internet via diverse devices and modalities, such as smartphones, wearables and smart home devices, and want to feel connected no matter where they are or what they are doing. We seek to expand our products and services to stay in front of these trends in order to maintain and grow our business.We generate our advertising revenues increasingly from different channels, including mobile, and newer advertising formats, and the margins from the advertising revenues from these channels and newer products have generally been lower than those from traditional desktop search. Additionally, as the market for a particular device type or modality matures, our revenues may be affected. For example, growth in the global smartphone market has slowed due to various factors, including increased market saturation in developed countries, which can affect our mobile advertising revenue growth rates. We expect TAC paid to our distribution partners and Google Network Members to increase as our revenues grow and to be affected by changes in device mix; geographic mix; partner mix; partner agreement terms; the percentage of queries channeled through paid access points; product mix; the relative revenue growth rates of advertising revenues from different channels; and revenue share terms. We expect these trends to continue to affect our revenue growth rates and put pressure on our overall margins.•As online advertising evolves, we continue to expand our product offerings which may affect our monetization.As interactions between users and advertisers change and as online user behavior evolves, we continue to expand and evolve our product offerings to serve their changing needs. Over time, we expect our monetization trends to fluctuate. For example, we have seen an increase in YouTube ads and Google Play ads, which monetize at a lower rate than our traditional search ads.•As users in developing economies increasingly come online, our revenues from international markets continue to increase and movements in foreign exchange rates affect such revenues.The shift to online, as well as the advent of the multi-device world, has brought opportunities outside of the U.S., including in emerging markets, such as India, where we continue to invest heavily and develop localized versions of our products and relevant advertising programs useful to our users in these markets. This has led to a trend of increased revenues from international markets over time, as regions with emerging markets, such as APAC, have demonstrated higher revenue growth rates. We expect that our results will continue to be affected by our performance in these markets, particularly as low-cost mobile devices become more available. This trend could impact our margins as developing markets initially monetize at a lower rate than more mature markets.Our international revenues represent a significant portion of our revenues and are subject to fluctuations in foreign currency exchange rates relative to the U.S. dollar. While we have a foreign exchange risk management program designed to reduce our exposure to these fluctuations, this program does not fully offset their effect on our revenues and earnings.30Table of ContentsAlphabet Inc.•The portion of our revenues that we derive from non-advertising revenues is increasing and may affect margins.Non-advertising revenues have grown over time. We expect this trend to continue as we focus on expanding our offerings to our users through products and services like Google Cloud, Google Play, hardware products, and YouTube subscriptions. Across these initiatives, we currently derive non-advertising revenues primarily from sales of apps, in-app purchases, digital content products, and hardware; and licensing and service fees, including fees received for Google Cloud services and subscription and other services. The margins on these revenues vary significantly and may be lower than the margins on our advertising revenues. A number of our Other Bets initiatives are in their initial development stages, and as such, the sources of revenues from these businesses could change over time and the revenues could be volatile.•As we continue to serve our users and expand our businesses, we will invest heavily in operating and capital expenditures.We continue to make significant R&D investments in areas of strategic focus such as advertising, cloud, machine learning, and search, as well as in new products and services. In addition, we expect to continue to invest in land and buildings for data centers and offices, and information technology assets, which includes servers and network equipment, to support the long-term growth of our business.In addition, acquisitions and strategic investments are an important part of our strategy and use of capital, contributing to the breadth and depth of our offerings, expanding our expertise in engineering and other functional areas, and building strong partnerships around strategic initiatives. For example, in 2020 we announced our Google for India Digitization Fund to invest approximately $10 billion into India over the next 5-7 years through a mix of equity investments, partnerships, and operational, infrastructure and ecosystem investments.•We face continuing changes in regulatory conditions, laws and public policies, which could impact our business practices and financial results.Changes in social, political, economic, tax, and regulatory conditions or in laws and policies governing a wide range of topics and related legal matters have resulted in fines and caused us to change our business practices. As these global trends continue, for example the recent antitrust complaints filed by the U.S. Department of Justice and a number of state Attorneys General as well as the News Media Bargaining Code drafted by the Australian Competition and Consumer Commission, our cost of doing business may increase and our ability to pursue certain business models or offer certain products or services may be limited.•Our employees are critical to our success and we expect to continue investing in them.Our employees are among our best assets and are critical for our continued success. We expect to continue hiring talented employees around the globe and to provide competitive compensation programs to our employees.The Impact of COVID-19 on our Results and OperationsIn late 2019, an outbreak of COVID-19 emerged and by March 11, 2020 was declared a global pandemic by the World Health Organization. Across the United States and the world, governments and municipalities instituted measures in an effort to control the spread of COVID-19, including quarantines, shelter-in-place orders, school closings, travel restrictions and the closure of non-essential businesses. The macroeconomic impacts of COVID-19 are significant and continue to evolve, as exhibited by, among other things, a rise in unemployment, changes in consumer behavior, and market volatility. We began to observe the impact of COVID-19 and the related reductions in global economic activity on our financial results in March 2020 when, despite an increase in users' search activity, our advertising revenues declined compared to the prior year due to a shift of user search activity to less commercial topics and reduced spending by our advertisers. During the course of the quarter ended June 30, 2020, we observed a gradual return in user search activity to more commercial topics, followed by increased spending by our advertisers that continued throughout the second half of 2020.We continue to assess the realized and potential credit deterioration of our customers due to changes in the macroeconomic environment, which has been reflected in our allowance for credit losses for accounts receivable. Additionally, over the course of the year we experienced variability in our margins as many of our expenses are less variable in nature and/or may not correlate to changes in revenues, including costs associated with our data centers and facilities as well as employee compensation. Also, market volatility has contributed to fluctuations in the valuation of our equity investments.31Table of ContentsAlphabet Inc.While we continued to make investments in land and buildings for data centers, offices and information technology, in 2020 we slowed the pace of our investments, primarily as it relates to office facilities, as a result of COVID-19.The ongoing impact of COVID-19 on our business continues to evolve and be unpredictable. For example, to the extent the pandemic disrupts economic activity globally we, like other businesses, are not immune to continued adverse impacts to our business, operations and financial results from volatility in advertising spending, changes in user behavior and preferences, credit deterioration and liquidity of our customers, depressed economic activity, or volatility in capital markets. The ongoing impact will depend on a number of factors, including the duration and severity of the pandemic; the uneven impact to certain industries; advances in testing, treatment and prevention including vaccines; and the macroeconomic impact of government measures to contain the spread of the virus and related government stimulus measures. To address the potential impact to our business, over the near-term, we continue to evaluate the pace of our investment plans, including, but not limited to, our hiring, investments in data centers, servers, network equipment, real estate and facilities, marketing and travel spending, as well as taking certain measures to support our customers, our overall workforce, and communities we operate in. As we look to return our workforce in more locations back to the office in 2021, we may experience increased costs as we prepare our facilities for a safe return to work environment and experiment with hybrid work models. At the same time, we believe the current environment is accelerating digital transformation and we remain focused on innovating and investing in the services we offer to consumers and businesses. For example, as it relates to Google Cloud, we continue to invest aggressively around the globe in our go-to-market capabilities, product development and technical infrastructure to support long term growth. The ongoing impact of COVID-19 and the extent of these measures we have taken and the additional measures that we may implement could have a material impact on our financial results. Our past results may not be indicative of our future performance, and historical trends in our financial results may differ materially.Executive OverviewThe following table summarizes our consolidated financial results for the years ended December 31, 2019 and 2020 (in millions, except for per share information and percentages).Year Ended December 31,20192020Revenues$161,857 $182,527 Increase in revenues year over year18 %13 %Increase in constant currency revenues year over year20 %14 %Operating income(1)$34,231 $41,224 Operating margin(1)21 %23 %Other income (expense), net$5,394 $6,858 Net Income(1)$34,343 $40,269 Diluted EPS(1)$49.16 $58.61 (1) Results for 2019 include the effect of the $1.7 billion EC fine. See Note 10 of the Notes to Consolidated Financial Statements included in Part II, Item 8 of this Annual Report on Form 10-K for further information.•Total revenues were $182.5 billion, an increase of 13% year over year, primarily driven by an increase in Google Services segment revenues of $16.8 billion or 11% and an increase in Google Cloud segment revenues of $4.1 billion or 46%. Revenues from the United States, EMEA, APAC, and Other Americas were $85.0 billion, $55.4 billion, $32.6 billion, and $9.4 billion, respectively.•Total cost of revenues was $84.7 billion, an increase of 18% year over year. TAC was $32.8 billion, an increase of 9% year over year, primarily driven by an increase in revenues subject to TAC. Other cost of revenues were $51.9 billion, an increase of 24% year over year, primarily driven by an increase in data centers and other operations costs and content acquisition costs.32Table of ContentsAlphabet Inc.•Operating expenses were $56.6 billion, an increase of 5% year over year primarily driven by headcount growth and partially offset by declines in advertising and promotional expenses and travel and entertainment expenses.Other information:•Operating cash flow was $65.1 billion.•Capital expenditures, which primarily included investments in technical infrastructure, were $22.3 billion.•Number of employees was 135,301 as of December 31, 2020. The majority of new hires during the year were engineers and product managers.Our SegmentsBeginning in the fourth quarter of 2020, we report our segment results as Google Services, Google Cloud, and Other Bets: •Google Services includes products and services such as ads, Android, Chrome, hardware, Google Maps, Google Play, Search, and YouTube. Google Services generates revenues primarily from advertising; sales of apps, in-app purchases, digital content products, and hardware; and fees received for subscription-based products such as YouTube Premium and YouTube TV.•Google Cloud includes Google’s infrastructure and data analytics platforms, collaboration tools, and other services for enterprise customers. Google Cloud generates revenues primarily from fees received for Google Cloud Platform ("GCP") services and Google Workspace (formerly known as G Suite) collaboration tools.•Other Bets is a combination of multiple operating segments that are not individually material. Revenues from the Other Bets are derived primarily through the sale of internet services as well as licensing and R&D services.Unallocated corporate costs primarily include corporate initiatives, corporate shared costs, such as finance and legal, including fines and settlements, as well as costs associated with certain shared research and development activities. Additionally, hedging gains (losses) related to revenue are included in corporate costs.Financial ResultsRevenuesThe following table presents our revenues by type (in millions).Year Ended December 31,20192020Google Search & other$98,115 $104,062 YouTube ads15,149 19,772 Google Network Members' properties21,547 23,090 Google advertising134,811 146,924 Google other17,014 21,711 Google Services total151,825 168,635 Google Cloud8,918 13,059 Other Bets659 657 Hedging gains (losses)455 176 Total revenues$161,857 $182,527 Google ServicesGoogle advertising revenuesOur advertising revenue growth, as well as the change in paid clicks and cost-per-click on Google Search & other properties and the change in impressions and cost-per-impression on Google Network Members' properties and the correlation between these items, have been affected and may continue to be affected by various factors, including:•advertiser competition for keywords;•changes in advertising quality, formats, delivery or policy;33Table of ContentsAlphabet Inc.•changes in device mix;•changes in foreign currency exchange rates;•fees advertisers are willing to pay based on how they manage their advertising costs;•general economic conditions including the impact of COVID-19;•seasonality; and•traffic growth in emerging markets compared to more mature markets and across various advertising verticals and channels.Our advertising revenue growth rate has been affected over time as a result of a number of factors, including challenges in maintaining our growth rate as revenues increase to higher levels; changes in our product mix; changes in advertising quality or formats and delivery; the evolution of the online advertising market; increasing competition; our investments in new business strategies; query growth rates; and shifts in the geographic mix of our revenues. We also expect that our revenue growth rate will continue to be affected by evolving user preferences, the acceptance by users of our products and services as they are delivered on diverse devices and modalities, our ability to create a seamless experience for both users and advertisers, and movements in foreign currency exchange rates.Google advertising revenues consist primarily of the following:•Google Search & other consists of revenues generated on Google search properties (including revenues from traffic generated by search distribution partners who use Google.com as their default search in browsers, toolbars, etc.) and other Google owned and operated properties like Gmail, Google Maps, and Google Play;•YouTube ads consists of revenues generated on YouTube properties; and•Google Network Members' properties consist of revenues generated on Google Network Members' properties participating in AdMob, AdSense, and Google Ad Manager.Google Search & otherGoogle Search & other revenues increased $5,947 million from 2019 to 2020. The overall growth was primarily driven by interrelated factors including increases in search queries resulting from ongoing growth in user adoption and usage, primarily on mobile devices, growth in advertiser spending primarily in the second half of the year, and improvements we have made in ad formats and delivery. This increase was partially offset by a decline in advertiser spending primarily in the first half of the year driven by the impact of COVID-19.YouTube adsYouTube ads revenues increased $4,623 million from 2019 to 2020. Growth was primarily driven by our direct response advertising products, which benefited from improvements to ad formats and delivery and increased advertiser spending. Brand advertising products also contributed to growth despite revenues being adversely impacted by a decline in advertiser spending primarily in the first half of the year driven by the impact of COVID-19.Google Network Members' propertiesGoogle Network Members' properties revenues increased $1,543 million from 2019 to 2020. The growth was primarily driven by strength in AdMob and Google Ad Manager. Use of Monetization MetricsPaid clicks for our Google Search & other properties represent engagement by users and include clicks on advertisements by end-users on Google search properties and other owned and operated properties including Gmail, Google Maps, and Google Play. Historically, we included certain viewed YouTube engagement ads and the related revenues in our paid clicks and cost-per-click monetization metrics. Over time, advertising on YouTube has expanded to multiple advertising formats and the type of viewed engagement ads historically included in paid clicks and cost-per-click metrics have increasingly covered a smaller portion of YouTube advertising revenues. As a result, we removed these ads and the related revenues from the paid clicks and cost-per-click metrics for the current and historical periods presented. The revised metrics provide a better understanding of monetization trends on the properties included within Google Search & other, as they now more closely correlate with the related changes in revenues.Impressions for our Google Network Members' properties include impressions displayed to users served on Google Network Members' properties participating primarily in AdMob, AdSense and Google Ad Manager.Cost-per-click is defined as click-driven revenues divided by our total number of paid clicks and represents the average amount we charge advertisers for each engagement by users.34Table of ContentsAlphabet Inc.Cost-per-impression is defined as impression-based and click-based revenues divided by our total number of impressions and represents the average amount we charge advertisers for each impression displayed to users.As our business evolves, we periodically review, refine and update our methodologies for monitoring, gathering, and counting the number of paid clicks on our Google Search & other properties and the number of impressions on Google Network Members’ properties and for identifying the revenues generated by click activity on our Google Search & other properties and the revenues generated by impression activity on Google Network Members’ properties. Paid clicks and cost-per-clickThe following table presents changes in our paid clicks and cost-per-click (expressed as a percentage): Year Ended December 31, 20192020Paid clicks change23 %19 %Cost-per-click change(6)%(10)%Paid clicks increased from 2019 to 2020 primarily due to an increase in clicks due to interrelated factors, resulting from ongoing growth in user adoption and usage, primarily on mobile devices; continued growth in advertiser activity; and improvements we have made in ad formats and delivery. Growth was also driven by an increase in clicks relating to ads on Google Play. The positive effect on our revenues from an increase in paid clicks was partially offset by a decrease in the cost-per-click paid by our advertisers. The decrease in cost-per-click was primarily driven by reduced advertiser spending in response to COVID-19 primarily during the first half of the year. The decrease in cost-per-click was also affected by changes in device mix, geographic mix, ongoing product changes, product mix, property mix, and fluctuations of the U.S. dollar compared to certain foreign currencies.Paid clicks increased from 2018 to 2019 primarily due to an increase in clicks due to interrelated factors, including an increase in search queries resulting from ongoing growth in user adoption and usage, primarily on mobile devices; continued growth in advertiser activity; and improvements we have made in ad formats and delivery. Growth was also driven by an increase in clicks relating to ads on Google Play. The positive effect on our revenues from an increase in paid clicks was partially offset by a decrease in the cost-per-click paid by our advertisers. The decrease in cost-per-click was driven by changes in device mix, geographic mix, ongoing product changes, product mix, property mix, and fluctuations of the U.S. dollar compared to certain foreign currencies.Impressions and cost-per-impressionThe following table presents changes in our impressions and cost-per-impression (expressed as a percentage): Year Ended December 31, 2020Impressions change15 %Cost-per-impression change(8)%Impressions increased from 2019 to 2020 primarily due to growth in Google Ad Manager. The positive effect on our revenues from an increase in impressions was partially offset by a decrease in the cost-per-impression paid by our advertisers which was driven by a reduction in advertiser spending in response to COVID-19, primarily during the first half of the year, as well as the effect of a combination of factors including ongoing product and policy changes and improvements we have made in ad formats and delivery, changes in device mix, geographic mix, product mix, property mix, and fluctuations of the U.S. dollar compared to certain foreign currencies.Google other revenuesGoogle other revenues consist primarily of revenues from: •Google Play, which includes revenues from sales of apps and in-app purchases (which we recognize net of payout to developers) and digital content sold in the Google Play store; •hardware, including Google Nest home products, Pixelbooks, Pixel phones and other devices; •YouTube non-advertising, including YouTube Premium and YouTube TV subscriptions and other services; and•other products and services.35Table of ContentsAlphabet Inc.Google other revenues increased $4,697 million from 2019 to 2020. The growth was primarily driven by Google Play and YouTube non-advertising. Growth for Google Play was primarily driven by sales of apps and in-app purchases, which benefited from elevated user engagement partially due to the impact of COVID-19. Growth for YouTube non-advertising was primarily driven by an increase in paid subscribers. Over time, our growth rate for Google other revenues may be affected by the seasonality associated with new product and service launches as well as market dynamics.Google CloudOur Google Cloud revenues increased $4,141 million from 2019 to 2020. The growth was primarily driven by GCP followed by our Google Workspace offerings. Our infrastructure and our data and analytics platform products were the largest drivers of growth in GCP.Over time, our growth rate for Google Cloud revenues may be affected by customer usage, market dynamics, as well as new product and service launches.Revenues by GeographyThe following table presents our revenues by geography as a percentage of revenues, determined based on the addresses of our customers: Year Ended December 31, 20192020United States46 %47 %EMEA31 %30 %APAC17 %18 %Other Americas6 %5 %For further details on revenues by geography, see Note 2 of the Notes to Consolidated Financial Statements included in Part II, Item 8 of this Annual Report on Form 10-K.Use of Constant Currency Revenues and Constant Currency Revenue Percentage ChangeThe effect of currency exchange rates on our business is an important factor in understanding period to period comparisons. Our international revenues are favorably affected as the U.S. dollar weakens relative to other foreign currencies, and unfavorably affected as the U.S. dollar strengthens relative to other foreign currencies. Our revenues are also favorably affected by net hedging gains and unfavorably affected by net hedging losses.We use non-GAAP constant currency revenues and non-GAAP percentage change in constant currency revenues for financial and operational decision-making and as a means to evaluate period-to-period comparisons. We believe the presentation of results on a constant currency basis in addition to U.S. Generally Accepted Accounting Principles ("GAAP") results helps improve the ability to understand our performance because they exclude the effects of foreign currency volatility that are not indicative of our core operating results.Constant currency information compares results between periods as if exchange rates had remained constant period over period. We define constant currency revenues as total revenues excluding the effect of foreign exchange rate movements and hedging activities, and use it to determine the constant currency revenue percentage change on a year-on-year basis. Constant currency revenues are calculated by translating current period revenues using prior period exchange rates, as well as excluding any hedging effects realized in the current period.Constant currency revenue percentage change is calculated by determining the change in period revenues over prior period revenues where current period foreign currency revenues are translated using prior period exchange rates and hedging effects are excluded from revenues of both periods.These results should be considered in addition to, not as a substitute for, results reported in accordance with GAAP. Results on a constant currency basis, as we present them, may not be comparable to similarly titled measures used by other companies and are not a measure of performance presented in accordance with GAAP.36Table of ContentsAlphabet Inc.The following table presents the foreign exchange effect on our international revenues and total revenues (in millions, except percentages): Year Ended December 31,20192020EMEA revenues$50,645 $55,370 Exclude foreign exchange effect on current period revenues using prior year rates2,397 (111)EMEA constant currency revenues$53,042 $55,259 Prior period EMEA revenues$44,739 $50,645 EMEA revenue percentage change13 %9 %EMEA constant currency revenue percentage change19 %9 %APAC revenues$26,928 $32,550 Exclude foreign exchange effect on current period revenues using prior year rates388 11 APAC constant currency revenues$27,316 $32,561 Prior period APAC revenues$21,341 $26,928 APAC revenue percentage change26 %21 %APAC constant currency revenue percentage change28 %21 %Other Americas revenues$8,986 $9,417 Exclude foreign exchange effect on current period revenues using prior year rates541 964 Other Americas constant currency revenues$9,527 $10,381 Prior period Other Americas revenues$7,608 $8,986 Other Americas revenue percentage change18 %5 %Other Americas constant currency revenue percentage change25 %16 %United States revenues$74,843 $85,014 United States revenue percentage change18 %14 %Hedging gains (losses)455 176 Total revenues$161,857 $182,527 Total constant currency revenues$164,728 $183,215 Prior period revenues, excluding hedging effect(1)$136,957 $161,402 Total revenue percentage change18 %13 %Total constant currency revenue percentage change20 %14 %(1) Total revenues and hedging gains (losses) for the year ended December 31, 2018 were $136,819 million and $(138) million, respectively.EMEA revenue percentage change from 2019 to 2020 was not significantly affected by foreign currency exchange rates, primarily due to the U.S. dollar weakening relative to the Euro offset by the U.S. dollar strengthening relative to the Turkish lira and Russian ruble.APAC revenue percentage change from 2019 to 2020 was not significantly affected by foreign currency exchange rates, primarily due to the U.S. dollar strengthening relative to the Indian rupee, partially offset by the U.S. dollar weakening relative to the Japanese yen.Other Americas revenue percentage change from 2019 to 2020 was unfavorably affected by changes in foreign currency exchange rates, primarily due to the U.S. dollar strengthening relative to the Brazilian real and Argentine peso. 37Table of ContentsAlphabet Inc.Costs and Operating ExpensesCost of RevenuesCost of revenues includes TAC which are paid to our distribution partners who make available our search access points and services, and amounts paid to Google Network Members primarily for ads displayed on their properties. Our distribution partners include browser providers, mobile carriers, original equipment manufacturers, and software developers.The cost of revenues as a percentage of revenues generated from ads placed on Google Network Members' properties are significantly higher than the cost of revenues as a percentage of revenues generated from ads placed on Google properties (which includes Google Search & other and YouTube ads), because most of the advertiser revenues from ads served on Google Network Members’ properties are paid as TAC to our Google Network Members.Additionally, other cost of revenues (which is the cost of revenues excluding TAC) includes the following:•Content acquisition costs primarily related to payments to content providers from whom we license video and other content for distribution on YouTube advertising and subscription services and Google Play (we pay fees to these content providers based on revenues generated or a flat fee);•Expenses associated with our data centers (including bandwidth, compensation expenses including stock-based compensation ("SBC"), depreciation, energy, and other equipment costs) as well as other operations costs (such as content review and customer support costs). These costs are generally less variable in nature and may not correlate with related changes in revenues; and•Inventory related costs for hardware we sell. The following tables present our cost of revenues, including TAC (in millions, except percentages): Year Ended December 31, 20192020TAC$30,089 $32,778 Other cost of revenues41,807 51,954 Total cost of revenues$71,896 $84,732 Total cost of revenues as a percentage of revenues44.4 %46.4 %Cost of revenues increased $12,836 million from 2019 to 2020. The increase was due to increases in other cost of revenues and TAC of $10,147 million and $2,689 million, respectively. The increase in other cost of revenues from 2019 to 2020 was due to an increase in data center and other operations costs and an increase in content acquisition costs primarily for YouTube. This increase was partially offset by a decline in hardware costs.The increase in TAC from 2019 to 2020 was due to increases in TAC paid to distribution partners and to Google Network Members, driven by growth in revenues subject to TAC. The TAC rate was 22.3% in both 2019 and 2020. The TAC rate on Google properties revenues and the TAC rate on Google Network revenues were both substantially consistent from 2019 to 2020.Over time, cost of revenues as a percentage of total revenues may be affected by a number of factors, including the following:•The amount of TAC paid to distribution partners, which is affected by changes in device mix, geographic mix, partner mix, partner agreement terms such as revenue share arrangements, and the percentage of queries channeled through paid access points;•The amount of TAC paid to Google Network Members, which is affected by a combination of factors such as geographic mix, product mix, and revenue share terms;•Relative revenue growth rates of Google properties and Google Network Members' properties;•Certain costs that are less variable in nature and may not correlate with the related revenues;•Costs associated with our data centers and other operations to support ads, Google Cloud, Search, YouTube and other products;•Content acquisition costs, which are primarily affected by the relative growth rates in our YouTube advertising and subscription revenues; •Costs related to hardware sales; and•Increased proportion of non-advertising revenues, which generally have higher costs of revenues, relative to our advertising revenues.38Table of ContentsAlphabet Inc.Research and DevelopmentThe following table presents our R&D expenses (in millions, except percentages): Year Ended December 31, 20192020Research and development expenses$26,018 $27,573 Research and development expenses as a percentage of revenues16.1 %15.1 %R&D expenses consist primarily of:•Compensation expenses (including SBC) for engineering and technical employees responsible for R&D of our existing and new products and services; •Depreciation expenses; •Equipment-related expenses; and•Professional services fees primarily related to consulting and outsourcing services.R&D expenses increased $1,555 million from 2019 to 2020. The increase was primarily due to an increase in compensation expenses of $1,619 million, largely resulting from a 11% increase in headcount and partially offset by higher compensation charges in certain Other Bets in 2019. Additionally, the increase in R&D expenses was partially offset by a decrease in travel and entertainment expenses of $383 million. Over time, R&D expenses as a percentage of revenues may fluctuate due to certain expenses that are generally less variable in nature and may not correlate to the changes in revenues. In addition, R&D expenses may be affected by a number of factors including continued investment in ads, Android, Chrome, Google Cloud, Google Play, hardware, machine learning, Other Bets, Search and YouTube.Sales and MarketingThe following table presents our sales and marketing expenses (in millions, except percentages): Year Ended December 31, 20192020Sales and marketing expenses$18,464 $17,946 Sales and marketing expenses as a percentage of revenues11.4 %9.8 %Sales and marketing expenses consist primarily of:•Advertising and promotional expenditures related to our products and services; and•Compensation expenses (including SBC) for employees engaged in sales and marketing, sales support, and certain customer service functions.Sales and marketing expenses decreased $518 million from 2019 to 2020. The decrease was primarily due to a decrease in advertising and promotional expenses of $1,395 million, as we reduced spending and paused or rescheduled campaigns and changed some events to digital-only formats as a result of COVID-19, and a decrease in travel and entertainment expenses of $371 million. The decrease was partially offset by an increase in compensation expenses of $1,347 million, largely resulting from an 8% increase in headcount.Over time, sales and marketing expenses as a percentage of revenues may fluctuate due to certain expenses that are generally less variable in nature and may not correlate to the changes in revenues. In addition, sales and marketing expenses may be affected by a number of factors including the seasonality associated with new product and service launches and strategic decisions regarding the timing and extent of our spending.General and AdministrativeThe following table presents our general and administrative expenses (in millions, except percentages): Year Ended December 31, 20192020General and administrative expenses$9,551 $11,052 General and administrative expenses as a percentage of revenues5.9 %6.1 %General and administrative expenses consist primarily of:•Compensation expenses (including SBC) for employees in our finance, human resources, information technology, and legal organizations; •Depreciation;39Table of ContentsAlphabet Inc.•Equipment-related expenses; •Legal-related expenses; and•Professional services fees primarily related to audit, information technology consulting, outside legal, and outsourcing services.General and administrative expenses increased $1,501 million from 2019 to 2020. The increase was primarily due to an increase in compensation expenses of $887 million, largely resulting from a 16% increase in headcount. In addition, there was an increase of $440 million related to allowance for credit losses for accounts receivable. The increase was partially offset by a $554 million charge recognized in 2019 relating to a legal settlement.Over time, general and administrative expenses as a percentage of revenues may fluctuate due to certain expenses that are generally less variable in nature and may not correlate to the changes in revenues, the effect of discrete items such as legal settlements, or allowances for credit losses for accounts receivable.European Commission FinesIn March 2019, the EC announced its decision that certain contractual provisions in agreements that Google had with AdSense for Search partners infringed European competition law. The EC decision imposed a €1.5 billion ($1.7 billion as of March 20, 2019) fine, which was accrued in the first quarter of 2019.Please refer to Note 10 of the Notes to Consolidated Financial Statements included in Part II, Item 8 of this Annual Report on Form 10-K for further information.Segment ProfitabilityThe following table presents our segment operating income (loss) (in millions). For comparative purposes, amounts in prior periods have been recast.Year Ended December 31,201820192020Operating income (loss):Google Services$43,137 $48,999 $54,606 Google Cloud(4,348)(4,645)(5,607)Other Bets(3,358)(4,824)(4,476)Corporate costs, unallocated(1)(7,907)(5,299)(3,299)Total income from operations$27,524 $34,231 $41,224 (1) Corporate costs, unallocated includes a fine of $5.1 billion for the year ended December 31, 2018 and a fine and legal settlement totaling $2.3 billion for the year ended December 31, 2019.Google ServicesGoogle services operating income increased $5,607 million from 2019 to 2020. The increase was primarily driven by an increase in revenues partially offset by increases in content acquisition costs primarily for YouTube, data center and other operations costs, and TAC. Additionally, there was an increase in operating expenses primarily driven by an increase in compensation expenses (including SBC) largely due to increases in headcount. Operating income benefited from a decline in hardware costs.Google services operating income increased $5,862 million from 2018 to 2019. The increase was primarily driven by an increase in revenues partially offset by increases in TAC, data center and other operations costs, and content acquisition costs primarily for YouTube. Additionally, there was an increase in operating expenses primarily driven by an increase in compensation expenses (including SBC) largely due to an increase in headcount.Google CloudGoogle Cloud operating loss increased $962 million from 2019 to 2020 and increased $297 million from 2018 to 2019. The increase in operating loss in both periods was driven by an increase in total expenses of $5,103 million from 2019 to 2020 and $3,377 million from 2018 to 2019. Operating expenses increased primarily due to compensation expenses (including SBC), largely driven by an increase in headcount. Additionally, data center and other operating costs increased in both periods.Other BetsOther Bets operating loss decreased $348 million from 2019 to 2020 and increased $1,466 million from 2018 to 2019. The fluctuations were primarily driven by compensation expenses (including SBC).40Table of ContentsAlphabet Inc.Other Income (Expense), NetThe following table presents other income (expense), net, (in millions): Year Ended December 31, 20192020Other income (expense), net$5,394 $6,858 Other income (expense), net, increased $1,464 million from 2019 to 2020. The change was primarily driven by an increase in net gains on equity and debt securities of $3,519 million, partially offset by a $902 million loss resulting from our equity derivatives, which hedged the changes in fair value of certain marketable equity securities, and a decrease in interest income of $562 million.Over time, other income (expense), net, may be affected by market dynamics and other factors. Equity values generally change daily for marketable equity securities and upon the occurrence of observable price changes or upon impairment of non-marketable equity securities. In addition, volatility in the global economic climate and financial markets, including the effects of COVID-19, could result in a significant change in the value of our investments. Fluctuations in the value of these investments has, and we expect will continue to, contribute to volatility of OI&E in future periods. For additional information about our investments, see Note 1 and Note 3 of the Notes to Consolidated Financial Statements included in Part II, Item 8 of this Annual Report on Form 10-K.Provision for Income TaxesThe following table presents our provision for income taxes (in millions, except for effective tax rate): Year Ended December 31, 20192020Provision for income taxes$5,282 $7,813 Effective tax rate13.3 %16.2 %Our provision for income taxes and our effective tax rate increased from 2019 to 2020. The increase in the provision for income taxes and our effective tax rate is primarily due to benefits related to the resolution of multi-year audits in 2019 that did not recur in 2020, higher earnings in countries that have higher statutory rates resulting from the change in our corporate legal entity structure implemented as of December 31, 2019, and an increase in valuation allowance for net deferred tax assets that are not likely to be realized relating to certain of our Other Bets, partially offset by an increase in the U.S. federal Foreign-Derived Intangible Income tax deduction benefits. See Note 14 of the Notes to Consolidated Financial Statements included in Part II, Item 8 of this Annual Report on Form 10-K for further information.We expect our future effective tax rate to be affected by the geographic mix of earnings in countries with different statutory rates. Additionally, our future effective tax rate may be affected by changes in the valuation of our deferred tax assets or liabilities, or changes in tax laws, regulations, or accounting principles, as well as certain discrete items.41Table of ContentsAlphabet Inc.Quarterly Results of OperationsThe following tables presenting our quarterly results of operations should be read in conjunction with the consolidated financial statements and related notes included in Part II, Item 8 of this Annual Report on Form 10-K. We have prepared the unaudited information on the same basis as our audited consolidated financial statements. Our operating results for any quarter are not necessarily indicative of results for any future quarters or for a full year. The following table presents our unaudited quarterly results of operations for the eight quarters ended December 31, 2020. This table includes all adjustments, consisting only of normal recurring adjustments, that we consider necessary for a fair presentation of our consolidated financial position and operating results for the quarters presented. Seasonal fluctuations in internet usage and advertiser expenditures, underlying business trends such as traditional retail seasonality and macroeconomic conditions have affected, and are likely to continue to affect, our business (including developments and volatility arising from COVID-19). Commercial queries typically increase significantly in the fourth quarter of each year. These seasonal trends have caused, and will likely continue to cause, fluctuations in our quarterly results, including fluctuations in sequential revenue growth rates. Quarter Ended Mar 31,2019Jun 30,2019Sept 30,2019Dec 31,2019Mar 31,2020Jun 30,2020Sept 30,2020Dec 31,2020(In millions, except per share amounts) (unaudited)Consolidated Statements of Income Data:Revenues$36,339 $38,944 $40,499 $46,075 $41,159 $38,297 $46,173 56,898 Costs and expenses:Cost of revenues16,012 17,296 17,568 21,020 18,982 18,553 21,117 26,080 Research and development6,029 6,213 6,554 7,222 6,820 6,875 6,856 7,022 Sales and marketing3,905 4,212 4,609 5,738 4,500 3,901 4,231 5,314 General and administrative2,088 2,043 2,591 2,829 2,880 2,585 2,756 2,831 European Commission fines1,697 0 0 0 0 0 0 0 Total costs and expenses29,731 29,764 31,322 36,809 33,182 31,914 34,960 41,247 Income from operations6,608 9,180 9,177 9,266 7,977 6,383 11,213 15,651 Other income (expense), net1,538 2,967 (549)1,438 (220)1,894 2,146 3,038 Income before income taxes8,146 12,147 8,628 10,704 7,757 8,277 13,359 18,689 Provision for income taxes1,489 2,200 1,560 33 921 1,318 2,112 3,462 Net income$6,657 $9,947 $7,068 $10,671 $6,836 $6,959 $11,247 15,227 Basic net income per share of Class A and B common stock and Class C capital stock$9.58 $14.33 $10.20 $15.49 $9.96 $10.21 $16.55 $22.54 Diluted net income per share of Class A and B common stock and Class C capital stock$9.50 $14.21 $10.12 $15.35 $9.87 $10.13 $16.40 $22.30 Financial ConditionCash, Cash Equivalents, and Marketable SecuritiesAs of December 31, 2020, we had $136.7 billion in cash, cash equivalents, and short-term marketable securities. Cash equivalents and marketable securities are comprised of time deposits, money market funds, highly liquid government bonds, corporate debt securities, mortgage-backed and asset-backed securities and marketable equity securities.Sources, Uses of Cash and Related TrendsOur principal sources of liquidity are our cash, cash equivalents, and marketable securities, as well as the cash flow that we generate from our operations. The primary use of capital continues to be to invest for the long term growth of the business. We regularly evaluate our cash and capital structure, including the size, pace and form of capital return to stockholders.42Table of ContentsAlphabet Inc.The following table presents our cash flows (in millions): Year Ended December 31, 20192020Net cash provided by operating activities$54,520 $65,124 Net cash used in investing activities$(29,491)$(32,773)Net cash used in financing activities$(23,209)$(24,408)Cash Provided by Operating ActivitiesOur largest source of cash provided by our operations are advertising revenues generated by Google Search & other properties, Google Network Members' properties and YouTube ads. Additionally, we generate cash through sales of apps, in-app purchases, digital content products, and hardware; and licensing and service fees including fees received for Google Cloud offerings and subscription-based products.Our primary uses of cash from our operating activities include compensation and related costs, payments to our distribution partners and Google Network Members, and payments for content acquisition costs. In addition, uses of cash from operating activities include hardware inventory costs, income taxes, and other general corporate expenditures.Net cash provided by operating activities increased from 2019 to 2020 primarily due to the net effect of increases in cash received from revenues and cash paid for cost of revenues and operating expenses, and changes in operating assets and liabilities.Cash Used in Investing ActivitiesCash provided by investing activities consists primarily of maturities and sales of our investments in marketable and non-marketable securities. Cash used in investing activities consists primarily of purchases of marketable and non-marketable securities, purchases of property and equipment, and payments for acquisitions.Net cash used in investing activities increased from 2019 to 2020 primarily due to a net increase in purchases of securities, partially offset by decreases in payments for acquisitions and purchases of property and equipment. The net decrease in purchases of property and equipment was driven by decreases in purchases of land and buildings for offices as well as data center construction, partially offset by increases in purchases of servers.Cash Used in Financing ActivitiesCash provided by financing activities consists primarily of proceeds from issuance of debt and proceeds from the sale of interest in consolidated entities. Cash used in financing activities consists primarily of repurchases of capital stock, net payments related to stock-based award activities, and repayments of debt.Net cash used in financing activities increased from 2019 to 2020 primarily due to an increase in cash payments for repurchases of capital stock, partially offset by increases in net proceeds from issuance of debt and proceeds from the sale of interest in consolidated entities.Liquidity and Material Cash RequirementsWe expect existing cash, cash equivalents, short-term marketable securities, cash flows from operations and financing activities to continue to be sufficient to fund our operating activities and cash commitments for investing and financing activities for at least the next 12 months and thereafter for the foreseeable future.As of December 31, 2020, we had long-term taxes payable of $6.5 billion related to a one-time transition tax payable incurred as a result of the U.S. Tax Cuts and Jobs Act ("Tax Act"). As permitted by the Tax Act, we will pay the transition tax in annual interest-free installments through 2025.In 2017, 2018 and 2019, the EC announced decisions that certain actions taken by Google infringed European competition law and imposed fines of €2.4 billion ($2.7 billion as of June 27, 2017), €4.3 billion ($5.1 billion as of June 30, 2018), and €1.5 billion ($1.7 billion as of March 20, 2019), respectively. While each EC decision is under appeal, we included the fines in accrued expenses and other current liabilities on our Consolidated Balance Sheets as we provided bank guarantees (in lieu of a cash payment) for the fines. In January 2021, we closed the acquisition of Fitbit, a leading wearables brand, for $2.1 billion.We have a short-term debt financing program of up to $5.0 billion through the issuance of commercial paper. Net proceeds from this program are used for general corporate purposes. As of December 31, 2020, we had no commercial paper outstanding. As of December 31, 2020, we have $4.0 billion of revolving credit facilities expiring 43Table of ContentsAlphabet Inc.in July 2023 with no amounts outstanding. The interest rate for the credit facilities is determined based on a formula using certain market rates. In August 2020, we issued $10.0 billion of fixed-rate senior unsecured notes in six tranches: $1.0 billion due in 2025, $1.0 billion due in 2027, $2.25 billion due in 2030, $1.25 billion due in 2040, $2.5 billion due in 2050 and $2.0 billion due in 2060. The 2020 Notes had a weighted average duration of 21.5 years and weighted average coupon rate of 1.57%. Of the total issuance, $5.75 billion was designated as Sustainability Bonds, the net proceeds of which are used to fund environmentally and socially responsible projects in the following eight areas: energy efficiency, clean energy, green buildings, clean transportation, circular economy and design, affordable housing, commitment to racial equity, and support for small businesses and COVID-19 crisis response. The remaining net proceeds are used for general corporate purposes. As of December 31, 2020, we have senior unsecured notes outstanding with a total carrying value of $13.8 billion. Refer to Note 6 of the Notes to Consolidated Financial Statements included in Part II, Item 8 of this Annual Report on Form 10-K for further information on the debts.In accordance with the authorizations of the Board of Directors of Alphabet, in 2020 we repurchased and subsequently retired 21.5 million shares of Alphabet Class C capital stock for an aggregate amount of $31.1 billion. As of December 31, 2020, $17.6 billion remains authorized and available for repurchase. The repurchases are being executed from time to time, subject to general business and market conditions and other investment opportunities, through open market purchases or privately negotiated transactions, including through Rule 10b5-1 plans. The repurchase program does not have an expiration date. Refer to Note 11 of the Notes to Consolidated Financial Statements included in Part II, Item 8 of this Annual Report on Form 10-K.Capital Expenditures and LeasesWe make investments in land and buildings for data centers and offices and information technology assets through purchases of property and equipment and lease arrangements to provide capacity for the growth of our services and products. Our capital investments in property and equipment consist primarily of the following major categories:•Technical infrastructure, which consists of our investments in servers and network equipment for compute, storage and networking requirements for ongoing business activities, including machine learning, (collectively referred to as our information technology assets) and data center land and building construction; and•Office facilities, ground up development projects and related building improvements.Due to the integrated nature of Alphabet, our technical infrastructure and office facilities are managed centrally at a consolidated level. The associated costs, including depreciation and impairment, are allocated to operating segments as a service cost generally based on usage or headcount. Our technical infrastructure investments are designed to support all of Alphabet, including primarily ads, Google Cloud, Search, and YouTube.Construction in progress consists primarily of technical infrastructure and office facilities which have not yet been placed in service for our intended use. The time frame from date of purchase to placement in service of these assets may extend to multiple periods. For example, our data center construction projects are generally multi-year projects with multiple phases, where we acquire qualified land and buildings, construct buildings, and secure and install information technology assets. During the years ended December 31, 2019 and 2020, we spent $23.5 billion and $22.3 billion on capital expenditures and recognized total operating lease assets of $4.4 billion and $2.8 billion, respectively. As of December 31, 2020, the amount of total future lease payments under operating leases, which had a weighted average remaining lease term of 9 years, was $15.1 billion. As of December 31, 2020, we have entered into leases that have not yet commenced with future lease payments of $8.0 billion, excluding purchase options, that are not yet recorded on our Consolidated Balance Sheets. These leases will commence between 2021 and 2026 with non-cancelable lease terms of 1 to 25 years.Depreciation of our property and equipment commences when the deployment of such assets are completed and are ready for our intended use. Land is not depreciated. For the years ended December 31, 2019 and 2020, our depreciation and impairment expenses on property and equipment were $10.9 billion and $12.9 billion, respectively.For the years ended December 31, 2019 and 2020, our operating lease expenses (including variable lease costs), were $2.4 billion and $2.9 billion, respectively. Finance leases were not material for the years ended December 31, 2019 and 2020. Please refer to Note 4 of the Notes to Consolidated Financial Statements included in Part II, Item 8 of this Annual Report on Form 10-K for further information on the leases.44Table of ContentsAlphabet Inc.Contractual Obligations as of December 31, 2020The following summarizes our contractual obligations as of December 31, 2020 (in millions): Payments Due By Period TotalLess than1 year1-3years3-5yearsMore than5 yearsOperating lease obligations(1)$15,091 $2,198 $4,165 $3,127 $5,601 Obligations for leases that have not yet commenced(1)8,049 370 1,198 1,469 5,012 Purchase obligations(2)10,656 7,368 1,968 354 966 Long-term debt obligations(3)19,840 1,357 634 2,587 15,262 Tax payable(4)7,359 834 1,916 4,609 0 Other long-term liabilities reflected on our balance sheet(5)1,421 532 616 185 88 Total contractual obligations$62,416 $12,659 $10,497 $12,331 $26,929 (1) For further information, refer to Note 4 of the Notes to Consolidated Financial Statements included in Part II, Item 8 of this Annual Report on Form 10-K.(2) Represents non-cancelable contractual obligations primarily related to data center operations and build-outs; information technology assets; purchases of inventory; and digital media content licensing arrangements. The amounts included above represent the non-cancelable portion of agreements or the minimum cancellation fee. For those agreements with variable terms, we do not estimate the non-cancelable obligation beyond any minimum quantities and/or pricing as of December 31, 2020. Excluded from the table above are open orders for purchases that support normal operations, which are generally cancelable.(3) Represents our principal and interest payments. For further information on long-term debt, refer to Note 6 of the Notes to Consolidated Financial Statements included in Part II, Item 8 of this Annual Report on Form 10-K.(4) Represents one-time transition tax payable incurred as a result of the Tax Act. For further information, refer to Note 14 of the Notes to Consolidated Financial Statements included in Part II, Item 8 of this Annual Report on Form 10-K. Excluded from the table above are long-term taxes payable of $2.3 billion as of December 31, 2020 primarily related to uncertain tax positions, for which we are unable to make a reasonably reliable estimate of the timing of payments in individual years beyond 12 months due to uncertainties in the timing and outcomes of tax audits.(5) Represents cash obligations recorded on our Consolidated Balance Sheets, including the short-term portion of these long-term liabilities, primarily for certain commercial agreements. These amounts do not include the EC fines which are classified as current liabilities on our Consolidated Balance Sheets. For further information regarding the EC fines, refer to Note 10 of the Notes to Consolidated Financial Statements included in Part II, Item 8 of this Annual Report on Form 10-K.Off-Balance Sheet ArrangementsAs of December 31, 2020, we did not have any off-balance sheet arrangements, as defined in Item 303(a)(4)(ii) of Regulation S-K, that have or are reasonably likely to have a current or future effect on our financial condition, changes in our financial condition, revenues, or expenses, results of operations, liquidity, capital expenditures, or capital resources that is material to investors. See Note 10 included in Part II, Item 8 of this annual report on Form 10-K for more information on our commitments and contingencies.Critical Accounting Policies and EstimatesWe prepare our consolidated financial statements in accordance with GAAP. In doing so, we have to make estimates and assumptions that affect our reported amounts of assets, liabilities, revenues, expenses, gains and losses, as well as related disclosure of contingent assets and liabilities. In some cases, we could reasonably have used different accounting policies and estimates. In some cases, changes in the accounting estimates are reasonably likely to occur from period to period. Accordingly, actual results could differ materially from our estimates. To the extent that there are material differences between these estimates and actual results, our financial condition or results of operations will be affected. We base our estimates on past experience and other assumptions that we believe are reasonable under the circumstances, and we evaluate these estimates on an ongoing basis. We refer to accounting estimates of this type as critical accounting policies and estimates, which we discuss further below. We have reviewed our critical accounting policies and estimates with the audit and compliance committee of our Board of Directors.Please see Notes to Consolidated Financial Statements included in Part II, Item 8 of this Annual Report on Form 10-K for a summary of significant accounting policies and the effect on our financial statements.45Table of ContentsAlphabet Inc.RevenuesFor the sale of third-party goods and services, we evaluate whether we are the principal, and report revenues on a gross basis, or an agent, and report revenues on a net basis. In this assessment, we consider if we obtain control of the specified goods or services before they are transferred to the customer, as well as other indicators such as the party primarily responsible for fulfillment, inventory risk, and discretion in establishing price.Income TaxesWe are subject to income taxes in the U.S. and foreign jurisdictions. Significant judgment is required in evaluating our uncertain tax positions and determining our provision for income taxes.Although we believe we have adequately reserved for our uncertain tax positions, no assurance can be given that the final tax outcome of these matters will not be different. We adjust these reserves in light of changing facts and circumstances, such as the closing of a tax audit or the refinement of an estimate. To the extent that the final tax outcome of these matters is different than the amounts recorded, such differences will affect the provision for income taxes and the effective tax rate in the period in which such determination is made.The provision for income taxes includes the effect of reserve provisions and changes to reserves that are considered appropriate as well as the related net interest and penalties. In addition, we are subject to the continuous examination of our income tax returns by the Internal Revenue Services ("IRS") and other tax authorities which may assert assessments against us. We regularly assess the likelihood of adverse outcomes resulting from these examinations and assessments to determine the adequacy of our provision for income taxes.Loss ContingenciesWe are regularly subject to claims, suits, government investigations, and other proceedings involving competition, intellectual property, privacy, tax and related compliance, labor and employment, commercial disputes, content generated by our users, goods and services offered by advertisers or publishers using our platforms, personal injury consumer protection, and other matters. Certain of these matters include speculative claims for substantial or indeterminate amounts of damages. We record a liability when we believe that it is probable that a loss has been incurred and the amount can be reasonably estimated. If we determine that a loss is reasonably possible and the loss or range of loss can be estimated, we disclose the possible loss in the Notes to the Consolidated Financial Statements.We evaluate, on a regular basis, developments in our legal matters that could affect the amount of liability that has been previously accrued, and the matters and related reasonably possible losses disclosed, and make adjustments and changes to our disclosures as appropriate. Significant judgment is required to determine both the likelihood of there being, and the estimated amount of, a loss related to such matters. Until the final resolution of such matters, there may be an exposure to loss in excess of the amount recorded, and such amounts could be material. Should any of our estimates and assumptions change or prove to have been incorrect, it could have a material effect on our business, consolidated financial position, results of operations, or cash flows.Long-lived AssetsLong-lived assets, including property and equipment, long-term prepayments, and intangible assets, excluding goodwill, are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. The evaluation is performed at the lowest level of identifiable cash flows independent of other assets. An impairment loss would be recognized when estimated undiscounted future cash flows generated from the assets are less than their carrying amount. Measurement of an impairment loss would be based on the excess of the carrying amount of the asset group over its fair value.Fair Value MeasurementsWe measure certain of our non-marketable equity and debt investments, certain other instruments including stock-based compensation awards settled in the stock of certain Other Bets, and certain assets and liabilities acquired in a business combination, at fair value on a nonrecurring basis. The determination of fair value involves the use of appropriate valuation methods and relevant inputs into valuation models. The fair value hierarchy prioritizes the inputs used to measure fair value whereby it gives the highest priority to quoted prices (unadjusted) in active markets for identical assets or liabilities and the lowest priority to unobservable inputs. We maximize the use of relevant observable inputs and minimize the use of unobservable inputs. Our use of unobservable inputs reflects the assumptions that market participants would use and may include our own data adjusted based on reasonably available information. We apply judgment in assessing the relevance of observable market data to determine the priority of inputs under the fair value hierarchy, particularly in situations where there is very little or no market activity.46Table of ContentsAlphabet Inc.In determining the fair values of our non-marketable equity and debt investments, as well as assets acquired (especially with respect to intangible assets) and liabilities assumed in business combinations, we make significant estimates and assumptions, some of which include the use of unobservable inputs.Certain stock-based compensation awards may be settled in the stock of certain of our Other Bets or in cash. These awards are based on the equity values of the respective Other Bet, which requires use of unobservable inputs.We also have compensation arrangements with payouts based on realized investment returns, i.e. performance fees. We recognize compensation expense based on the estimated payouts, which may result in expense recognized before investment returns are realized, and may require the use of unobservable inputs.Non-marketable Equity SecuritiesOur non-marketable equity securities not accounted for under the equity method are carried either at fair value or under the measurement alternative. Under the measurement alternative, the carrying value is measured at cost, less any impairment, plus or minus changes resulting from observable price changes in orderly transactions for the identical or a similar investment of the same issuer. Determining whether an observed transaction is similar to a security within our portfolio requires judgment based on the rights and obligations of the securities. Recording upward and downward adjustments to the carrying value of our equity securities as a result of observable price changes requires quantitative assessments of the fair value of our securities using various valuation methodologies and involves the use of estimates.Non-marketable equity securities are also subject to periodic impairment reviews. Our quarterly impairment analysis considers both qualitative and quantitative factors that may have a significant effect on the investment's fair value. Qualitative factors considered include the companies' financial and liquidity position, access to capital resources and the time since the last adjustment to fair value, among others. When indicators of impairment exist, we prepare quantitative assessments of the fair value of our equity investments using both the market and income approaches which require judgment and the use of estimates, including discount rates, investee revenues and costs, and comparable market data of private and public companies, among others. When our assessment indicates that an impairment exists, we write down the investment to its fair value.Change in Accounting EstimateIn January 2021, we completed an assessment of the useful lives of our servers and network equipment and determined we should adjust the estimated useful life of our servers from three years to four years and the estimated useful life of certain network equipment from three years to five years. This change in accounting estimate will be effective beginning fiscal year 2021. For assets that are in-service as of December 31, 2020, we expect operating results to be favorably impacted by approximately $2.1 billion for the full fiscal year 2021. The effect of the change may be different due to our capital investments during the fiscal year 2021.ITEM 7A.QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKWe are exposed to financial market risks, including changes in foreign currency exchange rates, interest rates, and equity investment risks. Foreign Currency Exchange RiskWe transact business globally in multiple currencies. Our international revenues, as well as costs and expenses denominated in foreign currencies, expose us to the risk of fluctuations in foreign currency exchange rates against the U.S. dollar. Principal currencies hedged included the Australian dollar, British pound, Canadian dollar, Euro and Japanese yen. For the purpose of analyzing foreign currency exchange risk, we considered the historical trends in foreign currency exchange rates and determined that it was reasonably possible that adverse changes in exchange rates of 10% could be experienced in the near term.We use foreign exchange forward contracts to offset the foreign exchange risk on our assets and liabilities denominated in currencies other than the functional currency of the subsidiary. These forward contracts reduce, but do not entirely eliminate, the effect of foreign currency exchange rate movements on our assets and liabilities. The foreign currency gains and losses on the assets and liabilities are recorded in other income (expense), net, which are offset by the gains and losses on the forward contracts.If an adverse 10% foreign currency exchange rate change was applied to total monetary assets, liabilities, and commitments denominated in currencies other than the functional currencies at the balance sheet date, it would have resulted in an adverse effect on income before income taxes of approximately $8 million and $497 million as of 47Table of ContentsAlphabet Inc.December 31, 2019 and 2020, respectively, after consideration of the effect of foreign exchange contracts in place for the years ended December 31, 2019 and 2020.We use foreign currency forwards and option contracts, including collars (an option strategy comprised of a combination of purchased and written options) to protect our forecasted U.S. dollar-equivalent earnings from changes in foreign currency exchange rates. When the U.S. dollar strengthens, gains from foreign currency options and forwards reduce the foreign currency losses related to our earnings. When the U.S. dollar weakens, losses from foreign currency collars and forwards offset the foreign currency gains related to our earnings. These hedging contracts reduce, but do not entirely eliminate, the effect of foreign currency exchange rate movements. We designate these contracts as cash flow hedges for accounting purposes. We reflect the gains or losses of foreign currency spot rate changes as a component of AOCI and subsequently reclassify them into revenues to offset the hedged exposures as they occur. If the U.S. dollar weakened by 10% as of December 31, 2019 and 2020, the amount recorded in AOCI related to our foreign exchange contracts before tax effect would have been approximately $1.1 billion and $912 million lower as of December 31, 2019 and 2020, respectively. The change in the value recorded in AOCI would be expected to offset a corresponding foreign currency change in forecasted hedged revenues when recognized.We use foreign exchange forward contracts designated as net investment hedges to hedge the foreign currency risks related to our investment in foreign subsidiaries. These forward contracts serve to offset the foreign currency translation risk from our foreign operations.If the U.S. dollar weakened by 10%, the amount recorded in cumulative translation adjustment ("CTA") within AOCI related to our net investment hedge would have been approximately $936 million and $1 billion lower as of December 31, 2019 and 2020, respectively. The change in value recorded in CTA would be expected to offset a corresponding foreign currency translation gain or loss from our investment in foreign subsidiaries.Interest Rate RiskOur Corporate Treasury investment strategy is to achieve a return that will allow us to preserve capital and maintain liquidity. We invest primarily in debt securities including those of the U.S. government and its agencies, corporate debt securities, mortgage-backed securities, money market and other funds, municipal securities, time deposits, asset backed securities, and debt instruments issued by foreign governments. By policy, we limit the amount of credit exposure to any one issuer. Our investments in both fixed rate and floating rate interest earning securities carry a degree of interest rate risk. Fixed rate securities may have their fair market value adversely affected due to a rise in interest rates, while floating rate securities may produce less income than predicted if interest rates fall. Unrealized gains or losses on our marketable debt securities are primarily due to interest rate fluctuations as compared to interest rates at the time of purchase. For certain fixed and variable rate debt securities, we have elected the fair value option for which changes in fair value are recorded in other income (expense), net. We measure securities for which we have not elected the fair value option at fair value with gains and losses recorded in AOCI until the securities are sold, less any expected credit losses. We use value-at-risk ("VaR") analysis to determine the potential effect of fluctuations in interest rates on the value of our marketable debt security portfolio. The VaR is the expected loss in fair value, for a given confidence interval, for our investment portfolio due to adverse movements in interest rates. We use a variance/covariance VaR model with 95% confidence interval. The estimated one-day loss in fair value of our marketable debt securities as of December 31, 2019 and 2020 are shown below (in millions): As of December 31,12-Month Average As of December 31, 2019202020192020Risk Category - Interest Rate$104 $144 $90 $145 Actual future gains and losses associated with our marketable debt security portfolio may differ materially from the sensitivity analyses performed as of December 31, 2019 and 2020 due to the inherent limitations associated with predicting the timing and amount of changes in interest rates and our actual exposures and positions. VaR analysis is not intended to represent actual losses but is used as a risk estimation.Equity Investment RiskOur marketable and non-marketable equity securities are subject to a wide variety of market-related risks that could substantially reduce or increase the fair value of our holdings.Our marketable equity securities are publicly traded stocks or funds and our non-marketable equity securities are investments in privately held companies, some of which are in the startup or development stages.48Table of ContentsAlphabet Inc.We record our marketable equity securities not accounted for under the equity method at fair value based on readily determinable market values, of which publicly traded stocks and mutual funds are subject to market price volatility, and represent $3.3 billion and $5.9 billion of our investments as of December 31, 2019 and 2020, respectively. A hypothetical adverse price change of 30% on our December 31, 2020 balance, which could be experienced in the near term, would decrease the fair value of our marketable equity securities by $1.8 billion. From time to time, we may enter into derivatives to hedge the market price risk on certain of our marketable equity securities.Our non-marketable equity securities not accounted for under the equity method are adjusted to fair value for observable transactions for identical or similar investments of the same issuer or impairment (referred to as the measurement alternative). The fair value measured at the time of the observable transaction is not necessarily an indication of the current fair value as of the balance sheet date. These investments, especially those that are in the early stages, are inherently risky because the technologies or products these companies have under development are typically in the early phases and may never materialize and they may experience a decline in financial condition, which could result in a loss of a substantial part of our investment in these companies. The success of our investment in any private company is also typically dependent on the likelihood of our ability to realize appreciation in the value of our investments through liquidity events such as public offerings, acquisitions, private sales or other market events. As of December 31, 2019 and 2020, the carrying value of our non-marketable equity securities, which were accounted for under the measurement alternative, was $11.4 billion and $18.9 billion, respectively. Valuations of our equity investments in private companies are inherently more complex due to the lack of readily available market data. Volatility in the global economic climate and financial markets could result in a significant impairment charge relating to our non-marketable equity securities. Changes in valuation of non-marketable equity securities may not directly correlate with changes in valuation of marketable equity securities. Additionally, observable transactions at lower valuations could result in significant losses on our non-marketable equity securities. The effect of COVID-19 on our impairment assessment requires significant judgment due to the uncertainty around the duration and severity of the impact.The carrying values of our equity method investments, which totaled approximately $1.3 billion and $1.4 billion as of December 31, 2019 and 2020, respectively, generally do not fluctuate based on market price changes, however these investments could be impaired if the carrying value exceeds the fair value and is not expected to recover.For further information about our equity investments, please refer to Note 1 and Note 3 of the Notes to Consolidated Financial Statements included in Part II of this Annual Report on Form 10-K.49Table of ContentsAlphabet Inc.
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+Item 7.MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued)•the announcement in November 2020 of the Company’s investment in the Health for Life Capital Fund II, a leading venture capital fund dedicated to health, nutrition, microbiota, and digital health;•the announcement in November 2020 of plans to collaborate with InnovaFeed, the world leader in producing premium insect ingredients for animal feed, on the construction and operation of the world’s largest insect protein production site in Decatur, Illinois; and•the announcement in December 2020 of the end of dry lysine production in early 2021.The Company executes its strategic vision through three pillars: Optimize the Core, Drive Efficiencies, and Expand Strategically, all supported by its Readiness effort. The Company launched Readiness to drive new efficiencies and improve the customer experience in the Company’s existing businesses through a combination of data and analytics, process simplification and standardization, and behavioral and cultural change, building upon its earlier 1ADM and operational excellence programs. Operating Performance IndicatorsThe Company’s Ag Services and Oilseeds operations are principally agricultural commodity-based businesses where changes in selling prices move in relationship to changes in prices of the commodity-based agricultural raw materials. As a result, changes in agricultural commodity prices have relatively equal impacts on both revenues and cost of products sold. Therefore, changes in revenues of these businesses do not necessarily correspond to the changes in margins or gross profit. Thus, gross margins per volume or metric ton are more meaningful than gross margins as percentage of revenues.The Company’s Carbohydrate Solutions operations and Nutrition businesses also utilize agricultural commodities (or products derived from agricultural commodities) as raw materials. However, in these operations, agricultural commodity market price changes do not necessarily correlate to changes in cost of products sold. Therefore, changes in revenues of these businesses may correspond to changes in margins or gross profit. Thus, gross margin rates are more meaningful as a performance indicator in these businesses.The Company has consolidated subsidiaries in more than 70 countries. For the majority of the Company’s subsidiaries located outside the United States, the local currency is the functional currency except certain significant subsidiaries in Switzerland where Euro is the functional currency, and Brazil and Argentina where U.S. dollar is the functional currency. Revenues and expenses denominated in foreign currencies are translated into U.S. dollars at the weighted average exchange rates for the applicable periods. For the majority of the Company’s business activities in Brazil and Argentina, the functional currency is the U.S. dollar; however, certain transactions, including taxes, occur in local currency and require remeasurement to the functional currency. Changes in revenues are expected to be correlated to changes in expenses reported by the Company caused by fluctuations in the exchange rates of foreign currencies, primarily the Euro, British pound, Canadian dollar, and Brazilian real, as compared to the U.S. dollar.The Company measures its performance using key financial metrics including net earnings, gross margins, segment operating profit, return on invested capital, EBITDA, economic value added, manufacturing expenses, and selling, general, and administrative expenses. The Company’s financial results can vary significantly due to changes in factors such as fluctuations in energy prices, weather conditions, crop plantings, government programs and policies, trade policies, changes in global demand, general global economic conditions, changes in standards of living, and global production of similar and competitive crops. Due to these unpredictable factors, the Company undertakes no responsibility for updating any forward-looking information contained within “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”33Item 7.MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued)Market Factors Influencing Operations or Results in the Twelve Months Ended December 31, 2020 The Company is subject to a variety of market factors which affect the Company’s operating results. North American crushing margins were volatile due to slow farmer selling and COVID-19 impacts on demand for meal and oil earlier in 2020, but strengthened in the third quarter due to the increasingly tight soybean stocks in South America. South America saw record origination volumes in the first half of 2020 as it benefited from strong farmer selling in Brazil driven by the devaluation of the Brazilian Real. Record U.S. industry exports in the fourth quarter were driven by strong demand from China and the rest of the world. Demand and margins for biodiesel remained solid in North and South America. Margins for starches and sweeteners and wheat flour remained solid while demand was soft due to the impacts of COVID-19 in the food service sector. Ethanol margins were mixed as U.S. industry ethanol production exceeded demand and inventories remained high early in the year, but improved and stabilized the rest of the year as ADM and many ethanol producers idled some capacity due to the low demand. Nutrition benefited from growing demand for flavors, pet food, feed for livestock, plant-based proteins, edible beans, and probiotics. Lower out-of-home consumption caused by COVID-19 lockdown measures negatively impacted flavors and textured plant-based protein volumes, especially in the food service channel, as well as demand for aqua feed and amino acids. Global demand for amino acids was also negatively impacted by lower livestock counts following an African swine fever outbreak.Year Ended December 31, 2020 Compared to Year Ended December 31, 2019 Net earnings attributable to controlling interests increased 28% or $0.4 billion, to $1.8 billion. Segment operating profit increased 17% or $0.5 billion, to $3.5 billion, and included net income of $7 million consisting of gains on the sale of a portion of the Company’s shares in Wilmar and certain other assets, partially offset by asset impairment, restructuring, and settlement charges. Included in segment operating profit in the prior year was a net charge of $134 million consisting of asset impairment, restructuring, and settlement charges, gains on the sale of certain assets, and a step-up gain on an equity investment. Adjusted segment operating profit increased $0.4 billion to $3.4 billion due primarily to higher results in Ag Services, Vantage Corn Processors, Human and Animal Nutrition, and higher equity earnings from the Wilmar investment, partially offset by lower results in Crushing, Refined Products and Other, and Other Business. Refined Products and Other in the prior year included the $128 million 2018 portion of the two-year retroactive biodiesel tax credits. Corporate results in the current year were a net charge of $1.6 billion included early debt retirement charges of $409 million, a mark-to-market loss of $17 million on the conversion option of the exchangeable bonds issued in August 2020, impairment and restructuring charges of $16 million, acquisition-related expenses of $4 million, gains on the sale of certain assets of $7 million, and a credit of $91 million from the elimination of the last-in, first-out (LIFO) reserve in connection with the accounting change effective January 1, 2020. Corporate results in the prior year were a net charge of $1.4 billion and included restructuring and pension settlement and remeasurement charges of $159 million primarily related to early retirement and reorganization initiatives, a loss on sale of the Company's equity investment in CIP of $101 million, and a charge of $37 million from the effect of changes in agricultural commodity prices on LIFO inventory valuation reserves.Income taxes of $101 million decreased $108 million. The Company’s effective tax rate for 2020 was 5.4% compared to 13.2% for 2019. The change in rate was due primarily to changes in the geographic mix of earnings, foreign currency remeasurement, and adjustments to previously filed returns. The rates for 2020 and 2019 were also impacted by U.S. tax credits, mainly the railroad maintenance tax credit, which had an offsetting expense in cost of products sold.Analysis of Statements of EarningsProcessed volumes by product for the years ended December 31, 2020 and 2019 are as follows (in metric tons):(In thousands)20202019ChangeOilseeds36,565 36,271 294 Corn17,885 22,079 (4,194) Total54,450 58,350 (3,900)34Item 7.MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued)The Company generally operates its production facilities, on an overall basis, at or near capacity, adjusting facilities individually, as needed, to react to local supply and demand conditions. The overall increase in oilseeds is due to increased plant capacity utilization combined with downtime in the prior year due to weather-related issues. The overall decrease in corn processed is primarily related to the temporary idling of two dry mill facilities in the second quarter due to the low ethanol demand. The Company currently expects that the idled facilities will be restarted as demand for ethanol improves within the next 12 months.Revenues by segment for the years ended December 31, 2020 and 2019 are as follows:(In millions)20202019ChangeAg Services and Oilseeds Ag Services$32,726 $31,705 $1,021 Crushing9,593 9,479 114 Refined Products and Other7,397 7,557 (160)Total Ag Services and Oilseeds49,716 48,741 975 Carbohydrate Solutions Starches and Sweeteners6,387 6,854 (467)Vantage Corn Processors2,085 3,032 (947)Total Carbohydrate Solutions8,472 9,886 (1,414)NutritionHuman Nutrition2,812 2,745 67 Animal Nutrition2,988 2,932 56 Total Nutrition5,800 5,677 123 Other Business367 352 15 Total Other Business367 352 15 Total$64,355 $64,656 $(301)Revenues and cost of products sold in agricultural merchandising and processing businesses are significantly correlated to the underlying commodity prices and volumes. In periods of significant changes in market prices, the underlying performance of the Company is better evaluated by looking at margins since both revenues and cost of products sold, particularly in Ag Services and Oilseeds, generally have a relatively equal impact from market price changes which generally result in an insignificant impact to gross profit. Revenues decreased $0.3 billion to $64.4 billion due to lower sales volumes ($2.3 billion), partially offset by higher sales prices ($2.0 billion). Lower sales volumes of rice, ethanol, oils, and corn by-products and lower sales prices of biodiesel were partially offset by higher sales volumes of biodiesel and higher sales prices of soybeans, oils, and meal. Ag Services and Oilseeds revenues increased 2% to $49.7 billion due to higher sales prices ($1.9 billion), partially offset by lower sales volumes ($0.9 billion). Carbohydrate Solutions revenues decreased 14% to $8.5 billion due to lower sales volumes ($1.4 billion) primarily due to temporarily idled dry mill facilities. Nutrition revenues increased 2% to $5.8 billion due to higher sales prices ($0.1 billion). 35Item 7.MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued)Cost of products sold decreased $0.6 billion to $59.9 billion due principally to lower sales volumes, partially offset by higher commodity prices. Included in cost of products sold in the current year was a credit of $91 million from the effect of the elimination of the LIFO reserve in connection with the accounting change in the current year compared to a charge of $37 million from the effect of changes in agricultural commodity prices on LIFO inventory valuation reserves in the prior year. Manufacturing expenses decreased $0.1 billion to $5.6 billion due principally to lower energy costs and decreased operating supplies, partially offset by increased railroad maintenance expenses. Foreign currency translation impacts decreased both revenues and cost of products sold by $0.3 billion.Gross profit increased $0.3 billion or 7%, to $4.5 billion. Higher results in Human and Animal Nutrition ($0.2 billion) and Ag Services ($0.3 billion) were partially offset by lower results in Refined Products and Other ($0.1 billion) and Crushing ($0.1 billion). These factors are explained in the segment operating profit discussion on page 38. In Corporate, the positive period-over-period impact from LIFO of $0.1 billion due to the elimination of the LIFO reserve in connection with the accounting change effective January 1, 2020 and the changes in agricultural commodity prices on LIFO inventory valuation reserves in the prior period, were offset by the increase in railroad maintenance expenses of $0.1 billion. Selling, general, and administrative expenses increased 8% to $2.7 billion due principally to higher variable performance related compensation expenses and increased IT and project-related expenses. Asset impairment, exit, and restructuring costs decreased $223 million to $80 million. Charges in the current year consisted primarily of $47 million of impairments related to certain intangible and other long-lived assets and $17 million of individually insignificant restructuring charges presented as specified items within segment operating profit, $7 million of individually insignificant impairments and $9 million of individually insignificant restructuring charges in Corporate. Prior year charges consisted of impairments of $131 million related to certain facilities, vessels, and other long lived assets and $11 million related to goodwill and other intangible assets presented as specified items within segment operating profit, $159 million of restructuring and pension settlement and remeasurement charges in Corporate primarily related to early retirement and reorganization initiatives, and several individually insignificant restructuring charges presented as specified items within segment operating profit.Interest expense decreased $63 million to $339 million due to lower interest rates and net interest savings from cross currency swaps, partially offset by the mark-to-market loss adjustment related to the conversion option of the exchangeable bonds issuedin August 2020.Equity in earnings of unconsolidated affiliates increased $125 million to $579 million due principally to higher earnings from the Company’s investment in Wilmar. Loss on debt extinguishment of $409 million in the current year related to multiple early debt redemptions including the $0.7 billion debt tender in September 2020.Interest income decreased $104 million to $88 million. Interest income on segregated funds in the Company’s futures commission and brokerage business declined due to lower interest rates.Other income - net of $278 million increased $285 million. Current year income included gains related to the sale of a portion of the Company’s shares in Wilmar and certain other assets, an investment revaluation gain, the non-service components of net pension benefit income, foreign exchange gains, and other income. Prior year expense included a loss on sale of the Company’s equity investment in CIP and foreign exchange losses, partially offset by gains on the sale of certain assets, step-up gains on equity investments, gains on disposals of individually insignificant assets in the ordinary course of business, and other income.36Item 7.MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued)Segment operating profit, adjusted segment operating profit (a non-GAAP measure), and earnings before income taxes for the years ended December 31, 2020 and 2019 are as follows:Segment Operating Profit20202019Change(In millions)Ag Services and Oilseeds Ag Services$828 $502 $326 Crushing466 580 (114)Refined Products and Other439 586 (147)Wilmar372 267 105 Total Ag Services and Oilseeds2,105 1,935 170 Carbohydrate Solutions Starches and Sweeteners762 753 9 Vantage Corn Processors(45)(109)64 Total Carbohydrate Solutions717 644 73 NutritionHuman Nutrition 462 376 86 Animal Nutrition112 42 70 Total Nutrition574 418 156 Other Business52 85 (33)Total Other52 85 (33)Specified Items:Gain on sales of assets83 12 71 Impairment, restructuring, and settlement charges(76)(146)70 Total Specified Items7 (134)141 Total Segment Operating Profit$3,455 $2,948 $507 Adjusted Segment Operating Profit(1)$3,448 $3,082 $366 Segment Operating Profit$3,455 $2,948 $507 Corporate(1,572)(1,360)(212)Earnings Before Income Taxes$1,883 $1,588 $295 (1) Adjusted segment operating profit is segment operating profit excluding the listed specified items.37Item 7.MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued)Ag Services and Oilseeds operating profit increased 9%. Ag Services results were higher than the prior year, which was negatively impacted by challenging weather conditions and the U.S.-China trade tensions. Strong performance in global trade was driven by strong results in destination marketing and increased trading volumes. Robust farmer selling in Brazil and strong margins in North America drove higher origination results. Current year results also included a $54 million settlement related to U.S. high water insurance claims in 2019. Crushing results were lower than the prior year. Although volumes were strong and execution margins were solid, negative timing impacts drove lower results in the current year compared to the favorable timing effects in the prior year. Refined Products and Other results were lower due to decreased biodiesel margins in North America and the $128 million 2018 portion of retroactive biodiesel tax credits that were recorded in the prior year. Equity earnings from Wilmar were higher year-over-year.Carbohydrate Solutions operating profit increased 11%. Starches and Sweeteners results were higher due to strong margins in corn wet milling and wheat milling in North America and improved conditions in EMEAI, partially offset by negative mark-to-market timing effects on corn oil and COVID-related impacts on volumes across the business. Vantage Corn Processors results improved from the prior year due to effective risk management and strong demand for industrial alcohol.Nutrition operating profit increased 37%. Human Nutrition delivered strong performance and growth across its broad portfolio. Strong execution to meet rising customer demand for plant-based proteins and edible beans drove higher results in Specialty Ingredients. Additional income from fermentation and strong sales for probiotics and fiber drove higher performance in Health & Wellness. Flavors continued to deliver strong results. Animal Nutrition results improved year-over-year driven by strong performance from Neovia, good margins in commercial and livestock premix, and improved margins in amino acids.Other Business operating profit decreased 39%. Lower results, including loss provisions related to the Company’s futures commission and brokerage business, were partially offset by improvements in underwriting performance at the captive insurance operations.Corporate results are as follows:(In millions)20202019ChangeLIFO credit (charge)$91 $(37)$128 Interest expense - net(313)(348)35 Unallocated corporate costs(857)(647)(210)Gain (loss) on sale of assets7 (101)108 Expenses related to acquisitions(4)(17)13 Loss on debt extinguishment(409)— (409)Loss on debt conversion option(17)— (17)Impairment, restructuring, and settlement charges(16)(159)143 Other charges(54)(51)(3)Total Corporate$(1,572)$(1,360)$(212)38Item 7.MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued)Corporate results were a net charge of $1.6 billion in the current year compared to $1.4 billion in the prior year. The elimination of the LIFO reserve in connection with the accounting change effective January 1, 2020 resulted in a credit of $91 million in the current year compared to a charge of $37 million from the effect of changes in agricultural commodity prices on LIFO inventory valuation reserves in the prior year. Interest expense - net decreased $35 million due principally to lower interest rates and net interest savings from cross currency swaps. Unallocated corporate costs increased $210 million due principally to higher variable performance-related compensation expenses and increased IT and project-related expenses related to the business transformation program which includes the implementation of an Enterprise Resource Planning system. Loss on sale of assets in the prior year related to the sale of the Company’s equity investment in CIP. Expenses related to acquisitions in the prior year consisted of expenses primarily related to the Neovia acquisition. Loss on debt extinguishment was related to multiple early debt redemptions and the $0.7 billion debt tender in September 2020. Loss on debt conversion option was related to the mark-to-market adjustment of the conversion option of the exchangeable bonds issued in August 2020. Impairment and restructuring charges in the current year related to impairment of certain assets and individually insignificant restructuring charges. Impairment, restructuring, and settlement charges in the prior year included restructuring and pension settlement and remeasurement charges related to early retirement and reorganization initiatives. Other charges in the current year included railroad maintenance expenses of $138 million, partially offset by foreign exchange gains, an investment revaluation gain, and the non-service components of net pension benefit income. Other charges in the prior year included railroad maintenance expenses of $51 million. Non-GAAP Financial MeasuresThe Company uses adjusted earnings per share (EPS), adjusted earnings before taxes, interest, and depreciation and amortization (EBITDA), and adjusted segment operating profit, non-GAAP financial measures as defined by the SEC, to evaluate the Company’s financial performance. These performance measures are not defined by accounting principles generally accepted in the United States and should be considered in addition to, and not in lieu of, GAAP financial measures. Adjusted EPS is defined as diluted EPS adjusted for the effects on reported diluted EPS of specified items. Adjusted EBITDA is defined as earnings before taxes, interest, and depreciation and amortization, adjusted for specified items. The Company calculates adjusted EBITDA by removing the impact of specified items and adding back the amounts of interest expense and depreciation and amortization to earnings before income taxes. Adjusted segment operating profit is segment operating profit adjusted, where applicable, for specified items. Management believes that adjusted EPS, adjusted EBITDA, and adjusted segment operating profit are useful measures of the Company’s performance because they provide investors additional information about the Company’s operations allowing better evaluation of underlying business performance and better period-to-period comparability. Adjusted EPS, adjusted EBITDA, and adjusted segment operating profit are not intended to replace or be an alternative to diluted EPS, earnings before income taxes, and segment operating profit, respectively, the most directly comparable amounts reported under GAAP. 39Item 7.MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued)The table below provides a reconciliation of diluted EPS to adjusted EPS for the years ended December 31, 2020 and 2019.20202019In millionsPer shareIn millionsPer shareAverage number of shares outstanding - diluted563 565 Net earnings and reported EPS (fully diluted)$1,772 $3.15 $1,379 $2.44 Adjustments:LIFO charge (credit) (net of tax of $22 million in 2020 and $9 million in 2019) (1)(69)(0.12)28 0.05 (Gain) loss on sales of assets (net of tax of $10 million in 2020 and $35 million in 2019) (2)(80)(0.14)124 0.22 Asset impairment, restructuring, and settlement charges (net of tax of $23 million in 2020 and $56 million in 2019) (2)69 0.12 249 0.44 Expenses related to acquisitions (net of tax of $1 million in 2020 and $6 million in 2019) (2)3 0.01 11 0.02 Loss on debt extinguishment (net of tax of $99 million) (2)310 0.55 — — Loss on debt conversion option (net of tax of $0) (2)17 0.03 — — Tax adjustments(3)(0.01)39 0.07 Adjusted net earnings and adjusted EPS$2,019 $3.59 $1,830 $3.24 (1) Tax effected using the Company’s U.S. tax rate. LIFO accounting was discontinued effective January 1, 2020.(2) Tax effected using the applicable tax rates.The tables below provide a reconciliation of earnings before income taxes to adjusted EBITDA and adjusted EBITDA by segment for the years ended December 31, 2020 and 2019.(In millions)20202019ChangeEarnings before income taxes$1,883 $1,588 $295 Interest expense339 402 (63)Depreciation and amortization976 993 (17)LIFO charge (credit)(91)37 (128)(Gain) loss on sales of assets(90)89 (179)Asset impairment, restructuring, and settlement charges92 305 (213)Railroad maintenance expense138 51 87 Expenses related to acquisitions4 17 (13)Loss on debt extinguishment409 — 409 Adjusted EBITDA$3,660 $3,482 $178 (In millions)20202019ChangeAg Services and Oilseeds$2,469 $2,311 158 Carbohydrate Solutions1,029 974 55 Nutrition802 642 160 Other Business61 117 (56)Corporate(701)(562)(139)Adjusted EBITDA$3,660 $3,482 $178 40Item 7.MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued) Market Factors Influencing Operations or Results in the Twelve Months Ended December 31, 2019 The Company is subject to a variety of market factors which affect the Company’s operating results. Sales volumes and margins in Ag Services and Oilseeds were negatively impacted by challenging North American weather conditions, in particular high water in the Mississippi river system in the first half of 2019, and the continuing global trade tensions with China. Handling volumes in North America were impacted by the late harvest as planting was delayed due to spring flooding. Continued good global meal demand resulted in strong global crushing volumes and solid margins. South American origination volumes benefited from the U.S.-China trade dispute but were also impacted by softer Chinese demand due to the African swine fever impact on local feed demand and intermittent farmer selling. Global demand and margins for refined oil and biodiesel remained solid. Demand and prices for sweeteners and starches remained solid in North America while co-product prices were stable. Although ethanol demand remained steady in North America, margins were severely pressured as U.S. industry ethanol production and stocks remained at high levels and U.S. exports to China ceased during the trade dispute. The severe weather conditions in North America also adversely impacted operations in the Carbohydrate Solutions business unit. Nutrition benefited from growing demand for flavors, flavors systems, human and pet health and wellness products, and plant-based proteins but was negatively impacted by the African swine fever in Asia Pacific, which also resulted in pricing pressures in the global lysine market. Year Ended December 31, 2019 Compared to Year Ended December 31, 2018Net earnings attributable to controlling interests decreased 24% or $0.4 billion, to $1.4 billion. Segment operating profit decreased 10% or $0.3 billion, to $2.9 billion, and included a net charge of $134 million consisting of asset impairment, restructuring, and settlement charges, gains on sale of certain assets, and a step-up gain on an equity investment. Included in segment operating profit in 2018 was a net charge of $89 million consisting of asset impairment, restructuring, and settlement charges and a net gain on sales of assets and businesses. Adjusted segment operating profit decreased $0.3 billion to $3.1 billion due to lower results in Ag Services, Crushing, and Carbohydrate Solutions, and lower equity earnings from Wilmar, partially offset by higher results in Refined Products and Other and Nutrition. Refined Products and Other in 2019 included $270 million related to the biodiesel tax credit for 2018 and 2019 compared to $120 million for 2017 recorded in the prior year. Corporate results were a net charge of $1.4 billion in 2019, and included restructuring and pension settlement and remeasurement charges of $159 million primarily related to early retirement and reorganization initiatives, a loss on sale of the Company’s equity investment in CIP of $101 million, and a charge of $37 million from the effect of changes in agricultural commodity prices on LIFO inventory valuation reserves, compared to a credit of $18 million in 2018. Corporate results in 2018 of $1.2 billion included a pension settlement charge of $117 million, a $49 million charge related to a discontinued software project, and restructuring charges of $24 million primarily related to the reorganization of IT services.Income taxes of $209 million decreased $36 million. The Company’s effective tax rate for 2019 was 13.2% compared to 11.9% for 2018. The low 2019 tax rate was primarily due to the impact of U.S. tax credits, including the 2018 and 2019 biodiesel tax credit and the railroad maintenance tax credit, signed into law in December 2019. The effective tax rate for 2018 included the 2017 biodiesel tax credit recorded in the first quarter of 2018 and the additional true-up adjustments related to the 2017 U.S. tax reform, along with certain favorable discrete tax items netting to a favorable $74 million.Analysis of Statements of EarningsProcessed volumes by product for the years ended December 31, 2019 and 2018 are as follows (in metric tons):(In thousands)20192018ChangeOilseeds36,271 36,308 (37)Corn22,079 22,343 (264) Total58,350 58,651 (301)41Item 7.MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued)The Company generally operates its production facilities, on an overall basis, at or near capacity, adjusting facilities individually, as needed, to react to local supply and demand conditions. Processed volumes of Corn decreased slightly from the prior year levels primarily related to the production disruptions in the Columbus, Nebraska corn processing plant due to flooding and production issues in the Decatur, Illinois corn complex.Revenues by segment for the years ended December 31, 2019 and 2018 are as follows:(In millions)20192018ChangeAg Services and Oilseeds Ag Services$31,705 $31,766 $(61)Crushing9,479 10,319 (840)Refined Products and Other7,557 7,806 (249)Total Ag Services and Oilseeds48,741 49,891 (1,150)Carbohydrate Solutions Starches and Sweeteners6,854 6,922 (68)Vantage Corn Processors3,032 3,357 (325)Total Carbohydrate Solutions9,886 10,279 (393)NutritionHuman Nutrition2,745 2,571 174 Animal Nutrition2,932 1,219 1,713 Total Nutrition5,677 3,790 1,887 Other Business352 381 (29)Total Other Business352 381 (29)Total$64,656 $64,341 $315 Revenues and cost of products sold in agricultural merchandising and processing businesses are significantly correlated to the underlying commodity prices and volumes. In periods of significant changes in market prices, the underlying performance of the Company is better evaluated by looking at margins since both revenues and cost of products sold, particularly in Ag Services and Oilseeds, generally have a relatively equal impact from market price changes which generally result in an insignificant impact to gross profit. Revenues increased $315 million to $64.7 billion due to overall higher sales volumes ($3.2 billion), partially offset by lower sales prices ($2.9 billion). The increase in sales volumes was due principally to soybeans, wheat, cotton, and higher sales volumes of feed ingredients related to acquisitions. The decrease in sales prices was due principally to soybeans, meal, and wheat. Ag Services and Oilseeds revenues decreased 2% to $48.7 billion due to lower sales prices ($3.0 billion), partially offset by higher sales volumes ($1.8 billion). Carbohydrate Solutions revenues decreased 4% to $9.9 billion due to lower sales volumes ($0.4 billion). Nutrition revenues increased 50% to $5.7 billion due to higher sales volumes ($1.8 billion), primarily related to acquisitions and higher sales prices ($0.1 billion). Cost of products sold increased $0.3 billion to $60.5 billion due to overall higher sales volumes, partially offset by lower prices of commodities. Included in cost of products sold in 2019 was a charge of $37 million from the effect of changes in agricultural commodity prices on LIFO inventory valuation reserves compared to a credit of $18 million in 2018. Manufacturing expenses increased $0.3 billion to $5.7 billion due principally to new acquisitions. Foreign currency translation impacts decreased both revenues and cost of products sold by $0.8 billion.42Item 7.MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued)Gross profit decreased $34 million or 1%, to $4.1 billion. Lower results in Ag Services and Oilseeds ($40 million), Carbohydrate Solutions ($301 million), and Other ($6 million) were offset by higher results in Nutrition ($400 million). These factors are explained in the discussions of segment operating profit on page 45. The effect of changes in agricultural commodity prices on LIFO inventory valuation reserves had a negative impact on gross profit of $37 million in 2019 compared to a positive impact of $18 million in 2018.Selling, general, and administrative expenses increased 15% to $2.5 billion due principally to new acquisitions, primarily in the Nutrition segment, and higher spending on IT, business transformation, growth-related investments, and Readiness-related projects, partially offset by lower variable performance-related and stock compensation expenses. Asset impairment, exit, and restructuring costs increased $132 million to $303 million. Charges in 2019 consisted of asset impairments of $131 million related to certain facilities, vessels, and other long-lived assets and $11 million related to goodwill and other intangible assets presented as specified items within segment operating profit, and $159 million of restructuring and pension settlement and remeasurement charges in Corporate primarily related to early retirement and reorganization initiatives and several individually insignificant restructuring charges presented as specified items within segment operating profit. Charges in 2018 totaling $171 million consisted of $56 million of impairment of certain long-lived assets, a $12 million impairment of an equity investment, a $21 million impairment related to a long-term financing receivable, and $9 million of other individually insignificant impairment and restructuring charges presented as specified items within segment operating profit, and a $49 million charge related to a discontinued software project, $18 million of restructuring charges related to the reorganization of IT services and $6 million individually insignificant restructuring charges in Corporate. Interest expense increased $38 million to $402 million due to higher borrowings to fund recent acquisitions, partially offset by lower interest rates.Equity in earnings of unconsolidated affiliates decreased $64 million to $454 million due to lower earnings from the Company’s investments in Wilmar and CIP, partially offset by higher earnings from the Company’s investments in Olenex and other equity investees.Other expense - net of $7 million decreased $94 million. Expense in 2019 included a loss on sale of the Company’s equity investment in CIP and foreign exchange loss, partially offset by gains on the sale of certain assets, step-up gains on equity investments, gains on disposals of individually insignificant assets in the ordinary course of business, and other income. Expense in 2018 included foreign exchange losses and a non-cash pension settlement charge of $117 million related to the purchase of a group annuity contract that irrevocably transferred the future benefit obligations and annuity administration for certain U.S. salaried retirees under the Company’s ADM Retirement Plan. These expenses were partially offset by gains on disposals of businesses, an equity investment, and individually insignificant assets in the ordinary course of business, and other income. 43Item 7.MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued)Operating profit by segment and earnings before income taxes for the years ended December 31, 2019 and 2018 are as follows:Segment Operating Profit20192018Change(In millions)Ag Services and Oilseeds Ag Services$502 $657 $(155)Crushing580 650 (70)Refined Products and Other586 370 216 Wilmar267 343 (76)Total Ag Services and Oilseeds1,935 2,020 (85)Carbohydrate Solutions Sweeteners and Starches753 905 (152)Vantage Corn Processors(109)40 (149)Total Carbohydrate Solutions644 945 (301)NutritionHuman Nutrition376 318 58 Animal Nutrition42 21 21 Total Nutrition418 339 79 Other Business85 58 27 Total Other Business85 58 27 Specified Items:Gain on sales of assets and businesses12 13 (1)Impairment, restructuring, and exit charges(146)(102)(44)Total Specified Items(134)(89)(45)Total Segment Operating Profit2,948 3,273 (325)Adjusted Segment Operating Profit(1)3,082 3,362 (280)Segment Operating Profit2,948 3,273 (325)Corporate(1,360)(1,213)(147)Earnings Before Income Taxes$1,588 $2,060 $(472)(1) Adjusted segment operating profit is segment operating profit excluding the above specified items.44Item 7.MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued)Ag Services and Oilseeds operating profit decreased 4%. Ag Services results were lower due to weaker North American grain margins and lower volumes, in part due to challenging weather conditions and the U.S.-China trade tensions. Results in 2019 were negatively impacted by high water conditions in the first half of the year, which limited grain movement and sales in North America. Slow farmer selling and lower Chinese demand for South American origination, in part due to African swine fever, also impacted results. Crushing results were strong but down compared to 2018. Lower executed crush margins around the globe drove lower results, partially offset by favorable timing effects of approximately $102 million from hedges entered in 2018. Refined Products and Other results were up compared to 2018 primarily due to the retroactive biodiesel tax credit of $270 million for 2018 and 2019 recorded in 2019 compared to $120 million for 2017 recorded in 2018, strong demand, and higher results from equity investments. Wilmar results were lower year over year.Carbohydrate Solutions operating profit decreased 32%. Starches and Sweeteners results were down primarily due to lower results in EMEA where margins were pressured due to low sugar prices and the Turkish quota on starch-based sweeteners. Higher manufacturing costs at the Decatur, IL complex and weaker margins in flour milling also contributed to the decrease. Vantage Corn Processors results were down due to significantly lower ethanol margins amid a continued unfavorable ethanol industry environment, exacerbated by the lack of Chinese demand for ethanol due to the U.S.-China trade dispute.Nutrition operating profit increased 23%. Human Nutrition results were higher year over year on strong sales and margin growth in North America and Europe, Middle East, Africa, and India (EMEAI) and contributions from acquisitions. Animal Nutrition results were up driven largely by contributions from the acquisition of Neovia, partially offset by additional expenses related to inventory valuation of newly-acquired Neovia and weaker lysine results.Other Business operating profit increased 47% primarily due to improved results from the Company’s futures commission brokerage business and captive insurance underwriting performance.Corporate results are as follows:(In millions)20192018ChangeLIFO credit (charge)$(37)$18 $(55)Interest expense - net(348)(321)(27)Unallocated corporate costs(647)(660)13 Loss on sale of asset(101)— (101)Expenses related to acquisitions(17)(8)(9)Impairment, restructuring, and settlement charges(159)(190)31 Other charges(51)(52)1 Total Corporate$(1,360)$(1,213)$(147)Corporate results were a net charge of $1.4 billion in 2019 compared to $1.2 billion in 2018. The effect of changes in agricultural commodity prices on LIFO inventory valuation reserves resulted in a charge of $37 million in 2019 compared to a credit of $18 million in 2018. Interest expense - net increased $27 million due to higher borrowings to fund recent acquisitions, partially offset by interest savings from cross-currency swaps. Unallocated corporate costs decreased $13 million due principally to decreased performance-related compensation accruals partially offset by higher spending on IT, business transformation, growth-related investments, and Readiness-related projects. Loss on sale of asset related to the sale of the Company’s equity investment in CIP. Expenses related to acquisitions in 2019 consisted of expenses primarily related to the Neovia acquisition. Expenses related to acquisitions in 2018 consisted of expenses and losses on foreign currency derivative contracts entered into to economically hedge certain acquisitions. Impairment, restructuring, and settlement charges in 2019 included restructuring and pension settlement and remeasurement charges related to early retirement and reorganization initiatives. Impairment, restructuring, and settlement charges in 2018 included pension settlement charge of $117 million related to the purchase of a group annuity contract that irrevocably transferred the future benefit obligations and annuity administration for certain U.S. salaried retirees under the Company’s ADM Retirement Plan, a $49 million charge related to a discontinued software project, and restructuring charges of $24 million primarily related to the reorganization of IT services. Other charges in 2019 included railroad maintenance expenses of $51 million. Other charges in 2018 included foreign exchange losses which were partially offset by earnings from the Company’s equity investment in CIP.45Item 7.MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued)Non-GAAP Financial MeasuresThe Company uses adjusted earnings per share (EPS), adjusted earnings before taxes, interest, and depreciation and amortization (EBITDA), and adjusted segment operating profit, non-GAAP financial measures as defined by the SEC, to evaluate the Company’s financial performance. These performance measures are not defined by accounting principles generally accepted in the United States and should be considered in addition to, and not in lieu of, GAAP financial measures. Adjusted EPS is defined as diluted EPS adjusted for the effects on reported diluted EPS of specified items. Adjusted EBITDA is defined as earnings before taxes, interest, and depreciation and amortization, adjusted for specified items. The Company calculates adjusted EBITDA by removing the impact of specified items and adding back the amounts of interest expense and depreciation and amortization to earnings before income taxes. Adjusted segment operating profit is segment operating profit adjusted, where applicable, for specified items. Management believes that adjusted EPS, adjusted EBITDA, and adjusted segment operating profit are useful measures of the Company’s performance because they provide investors additional information about the Company’s operations allowing better evaluation of underlying business performance and better period-to-period comparability. Adjusted EPS, adjusted EBITDA, and adjusted segment operating profit are not intended to replace or be an alternative to diluted EPS, earnings before income taxes, and segment operating profit, respectively, the most directly comparable amounts reported under GAAP. The table below provides a reconciliation of diluted EPS to adjusted EPS for the years ended December 31, 2019 and 2018.20192018In millionsPer shareIn millionsPer shareAverage number of shares outstanding - diluted565 567 Net earnings and reported EPS (fully diluted)$1,379 $2.44 $1,810 $3.19 Adjustments:LIFO charge (credit) (net of tax of $9 million in 2019 and $4 million in 2018) (1)28 0.05 (14)(0.02)(Gain) loss on sales of assets and businesses (net of tax of $35 million in 2019 and $0 million in 2018) (2)124 0.22 (13)(0.02)Asset impairment, restructuring, and settlement charges (net of tax of $56 million in 2019 and $66 million in 2018) (2)249 0.44 226 0.40 Expenses related to acquisitions (net of tax of $6 million in 2019 and $2 million in 2018) (2)11 0.02 6 0.01 Tax adjustments (3)39 0.07 (33)(0.06)Adjusted net earnings and adjusted EPS$1,830 $3.24 $1,982 $3.50 (1) Tax effected using the Company’s U.S. tax rate.(2) Tax effected using the applicable tax rates.(3) Includes tax adjustments related to the U.S. Tax Cuts and Jobs Act and other discrete items.46Item 7.MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued)The tables below provide a reconciliation of earnings before income taxes to adjusted EBITDA and adjusted EBITDA by segment for the years ended December 31, 2019 and 2018.(In millions)20192018ChangeEarnings before income taxes$1,588 $2,060 $(472)Interest expense402 364 38 Depreciation and amortization993 941 52 LIFO charge (credit)37 (18)55 Gain (loss) on sales of assets and businesses89 (13)102 Asset impairment, restructuring, and settlement charges305 292 13 Railroad maintenance expense51 — 51 Expenses related to acquisitions17 8 9 Adjusted EBITDA$3,482 $3,634 $(152)(In millions)20192018ChangeAg Services and Oilseeds$2,311 $2,410 (99)Carbohydrate Solutions974 1,282 (308)Nutrition642 486 156 Other Business117 92 25 Corporate(562)(636)74 Adjusted EBITDA$3,482 $3,634 $(152)47Item 7.MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued)Liquidity and Capital ResourcesA Company objective is to have sufficient liquidity, balance sheet strength, and financial flexibility to fund the operating and capital requirements of a capital intensive agricultural commodity-based business. The Company depends on access to credit markets, which can be impacted by its credit rating and factors outside of ADM’s control, to fund its working capital needs and capital expenditures. The primary source of funds to finance ADM’s operations, capital expenditures, and advancement of its growth strategy is cash generated by operations and lines of credit, including a commercial paper borrowing facility and accounts receivable securitization programs. In addition, the Company believes it has access to funds from public and private equity and debt capital markets in both U.S. and international markets.Cash used in operating activities was $2.4 billion in 2020 compared to $5.5 billion in 2019. Working capital changes as described below, including the impact of deferred consideration, decreased cash by $5.5 billion in the current year compared to $7.7 billion in the prior year.Trade receivables increased $0.1 billion primarily due to lower receivables sold. Inventories increased $2.4 billion primarily due to higher inventory prices. Other current assets and accrued expenses and other payables increased $2.1 billion and $1.3 billion, respectively, primarily due to increases in contracts and futures gains and losses. Trade payables increased $0.7 billion principally reflecting seasonal cash payments for North American harvest-related grain purchases. Payables to brokerage customers increased $1.4 billion due to increased customer trading activity in the Company’s futures commission and brokerage business.Deferred consideration in securitized receivables of $4.6 billion and $7.7 billion in 2020 and 2019, respectively, was offset by the same amounts of net consideration received for beneficial interest obtained for selling trade receivables. Cash provided by investing activities was $4.5 billion this year compared to $5.3 billion last year. Capital expenditures of $0.8 billion in the current year were comparable to last year. Net assets of businesses acquired were $15 million this year compared to $1.9 billion last year due to the acquisition of Neovia in 2019. Proceeds from sales of business and assets of $0.7 billion in the current year related to the sale of a portion of the Company shares in Wilmar and certain other assets compared to $0.3 billion in the prior year. Net consideration received for beneficial interest obtained for selling trade receivables was $4.6 billion and $7.7 billion in 2020 and 2019, respectively.Cash used in financing activities was $0.4 billion this year compared to $0.7 billion last year. Long-term debt borrowings in the current year of $1.8 billion consisted of the $0.5 billion and $1.0 billion aggregate principal amounts of 2.75% Notes due in 2025 and 3.25% Notes due in 2030, respectively, issued on March 27, 2020 and the $0.3 billion aggregate principal amount of zero coupon exchangeable bonds due in 2023 issued on August 26, 2020. Proceeds from the borrowings in the current year were used for general corporate purposes, including the reduction of short-term debt. Commercial paper net borrowings were $0.8 billion in the current year compared to $0.9 billion in the prior year. Long-term debt payments in the current year of $2.1 billion related primarily to the early redemption of the $0.5 billion and $0.4 billion aggregate principal amounts of 4.479% debentures due in 2021 and 3.375% debentures due in 2022, respectively, the repurchase of $0.7 billion aggregate principal amount of certain outstanding notes and debentures, and the redemption of $0.2 billion aggregate principal amount of private placement notes due in 2021 and 2024. Long-term debt payments of $0.6 billion in the prior year related to the €500 million Floating Rate Notes that matured in June 2019. Share repurchases in the current year were $0.1 billion compared to $0.2 billion in the prior year. Dividends paid in the current year of $0.8 billion were comparable to the prior year. At December 31, 2020, ADM had $0.7 billion of cash, cash equivalents, and short-term marketable securities and a current ratio, defined as current assets divided by current liabilities, of 1.5 to 1. Included in working capital is $7.9 billion of readily marketable commodity inventories. At December 31, 2020, the Company’s capital resources included shareholders’ equity of $20.0 billion and lines of credit, including the accounts receivable securitization programs described below, totaling $10.2 billion, of which $6.6 billion was unused. ADM’s ratio of long-term debt to total capital (the sum of long-term debt and shareholders’ equity) was 28% and 29% at December 31, 2020 and 2019, respectively. The Company uses this ratio as a measure of ADM’s long-term indebtedness and an indicator of financial flexibility. The Company’s ratio of net debt (the sum of short-term debt, current maturities of long-term debt, and long-term debt less the sum of cash and cash equivalents and short-term marketable securities) to capital (the sum of net debt and shareholders’ equity) was 32% and 29% at December 31, 2020 and 2019, respectively. Of the Company’s total lines of credit, $5.0 billion supported the commercial paper borrowing programs, against which there was $1.7 billion of commercial paper outstanding at December 31, 2020.48Item 7.MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued)COVID-19 has not significantly impacted ADM’s capital and financial resources, and pricing on its revolving credit facility remains unchanged. However, in line with the overall markets, COVID-19 created dislocations in the credit markets during certain periods in the first half of 2020 with corporate spreads increasing, partially offset by a decline in benchmark yields. The Company has utilized its diversified sources of liquidity, including its inventory financing and bilateral bank facilities, to ensure it has ample cash and is prepared for possible unexpected credit market disruptions. Additionally, ADM has been accepted into the Federal Reserve’s Commercial Paper Financing Facility and the Bank of England’s COVID Corporate Financing Facility ensuring uninterrupted access to both the U.S. and European commercial paper markets. The Federal Reserve’s Commercial Paper Financing Facility and the Bank of England’s COVID Corporate Financing Facility expire in March and June 2021, respectively, unless renewed. To date, the Company has not utilized these facilities.During the second half of 2020, the global credit market stabilized with corporate credit spreads below pre-pandemic levels. Continued actions by central banks provided additional support in both the short-term and long-term funding markets further stabilizing corporate credit markets. Low benchmark yields and favorable credit spreads coupled with continued strong cash flow generation during the second half of the year presented opportunities for ADM to re-balance the company’s liability portfolio to pre-pandemic levels. Starting in June 2020, ADM began a series of liability management transactions including multiple early debt redemptions and the $0.7 billion debt tender in September 2020 to capitalize on all-time low interest rates. As of December 31, 2020, the Company had $0.7 billion of cash and cash equivalents, $0.3 billion of which is cash held by foreign subsidiaries whose undistributed earnings are considered indefinitely reinvested. Based on the Company’s historical ability to generate sufficient cash flows from its U.S. operations and unused and available U.S. credit capacity of $4.0 billion, the Company has asserted that these funds are indefinitely reinvested outside the U.S. The Company has accounts receivable securitization programs (the “Programs”) with certain commercial paper conduit purchasers and committed purchasers. The Programs provide the Company with up to $1.8 billion in funding against accounts receivable transferred into the Programs and expand the Company’s access to liquidity through efficient use of its balance sheet assets (see Note 19 in Item 8 for more information and disclosures on the Programs). As of December 31, 2020, the Company utilized $1.6 billion of its facility under the Programs. On November 5, 2014, the Company’s Board of Directors approved a stock repurchase program authorizing the Company to repurchase up to 100,000,000 shares of the Company’s common stock during the period commencing January 1, 2015 and ending December 31, 2019. On August 7, 2019, the Company’s Board of Directors approved the extension of the stock repurchase program through December 31, 2024 and the repurchase of up to an additional 100,000,000 shares under the extended program. The Company has acquired approximately 95.5 million shares under this program as of December 31, 2020.In 2021, the Company expects capital expenditures of $0.9 billion to $1.0 billion, and additional cash outlays of approximately $0.8 billion in dividends and up to $0.5 billion in share repurchases, subject to other strategic uses of capital.The Company’s credit facilities and certain debentures require the Company to comply with specified financial and non-financial covenants including maintenance of minimum tangible net worth as well as limitations related to incurring liens, secured debt, and certain other financing arrangements. The Company was in compliance with these covenants as of December 31, 2020.The three major credit rating agencies have maintained the Company’s credit ratings at solid investment grade levels with stable outlooks. 49Item 7.MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued)Contractual ObligationsIn the normal course of business, the Company enters into contracts and commitments which obligate the Company to make payments in the future. The following table sets forth the Company’s significant future obligations by time period. Purchases include commodity-based contracts entered into in the normal course of business, which are further described in Item 7A, “Quantitative and Qualitative Disclosures About Market Risk,” energy-related purchase contracts entered into in the normal course of business, and other purchase obligations related to the Company’s normal business activities. The following table does not include unrecognized income tax benefits of $151 million as of December 31, 2020 as the Company is unable to reasonably estimate the timing of settlement. Where applicable, information included in the Company’s consolidated financial statements and notes is cross-referenced in this table. Payments Due by Period Item 8 Contractual Obligations and Note Less than1 - 33 - 5 More thanOther CommitmentsReferenceTotal1 YearYearsYears5 Years (In millions)Purchases Inventories $18,220 $17,915 $301 $4 $— Energy 537 184 166 187 — Other 940 553 158 41 188 Total purchases 19,697 18,652 625 232 188 Short-term debt 2,042 2,042 — — — Long-term debtNote 107,887 2 1,061 1 6,823 Estimated interest payments 5,370 319 632 598 3,821 One-time transition taxNote 13164 25 56 83 — Operating leasesNote 141,299 302 486 251 260 Estimated pension and other postretirement plan contributions (1)Note 15151 45 29 27 50 Total $36,610 $21,387 $2,889 $1,192 $11,142 (1) Includes pension contributions of $29 million for fiscal 2021. The Company is unable to estimate the amount of pension contributions beyond fiscal year 2021. For more information concerning the Company’s pension and other postretirement plans, see Note 15 in Item 8.At December 31, 2020, the Company estimates it will spend approximately $1.7 billion through fiscal year 2025 to complete currently approved capital projects which are not included in the table above. The Company also has outstanding letters of credit and surety bonds of $1.2 billion at December 31, 2020 which are not included in the table above.The Company has entered into agreements, primarily debt guarantee agreements related to equity-method investees, which could obligate the Company to make future payments. The Company’s liability under these agreements is immaterial and arises only if the primary entity fails to perform its contractual obligation. The Company has collateral for a portion of these contingent obligations. 50Item 7.MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued)Off Balance Sheet ArrangementsAccounts Receivable Securitization ProgramsOn April 1, 2020 and October 1, 2020, the Company restructured its accounts receivable securitization programs (Programs) from a deferred purchase price to a pledge structure. Under the new structure, ADM Ireland Receivables and ADM Receivables transfer a portion of the purchased accounts receivable together with an equally proportional interest in all of its right, title and interest in the remaining purchased accounts receivable to each of the commercial paper conduit purchasers and committed purchasers. In exchange, ADM Ireland Receivables and ADM Receivables receive a cash payment for the accounts receivables transferred. See Note 19 of “Notes to Consolidated Financial Statements” included in Item 8 herein, “Financial Statements and Supplementary Data” for more information and disclosures on the ProgramsThere were no other material changes in the Company’s off balance sheet arrangements during the year. Critical Accounting PoliciesThe process of preparing financial statements requires management to make estimates and judgments that affect the carrying values of the Company’s assets and liabilities as well as the recognition of revenues and expenses. These estimates and judgments are based on the Company’s historical experience and management’s knowledge and understanding of current facts and circumstances. Certain of the Company’s accounting policies are considered critical, as these policies are important to the depiction of the Company’s financial statements and require significant or complex judgment by management. Management has discussed with the Company’s Audit Committee the development, selection, disclosure, and application of these critical accounting policies. Following are the accounting policies management considers critical to the Company’s financial statements.Fair Value Measurements - Inventories and Commodity DerivativesCertain of the Company’s inventory and commodity derivative assets and liabilities as of December 31, 2020 are valued at estimated fair values, including $7.9 billion of merchandisable agricultural commodity inventories, $2.8 billion of commodity derivative assets, $2.0 billion of commodity derivative liabilities, and $0.5 billion of inventory-related payables. Commodity derivative assets and liabilities include forward fixed-price purchase and sale contracts for agricultural commodities. Merchandisable agricultural commodities are freely traded, have quoted market prices, and may be sold without significant additional processing. Management estimates fair value for its commodity-related assets and liabilities based on exchange-quoted prices, adjusted for differences in local markets. The Company’s inventory and derivative commodity fair value measurements are mainly based on observable market quotations without significant adjustments and are therefore reported as Level 2 within the fair value hierarchy. Level 3 fair value measurements of approximately $3.0 billion of assets and $0.9 billion of liabilities represent fair value estimates where unobservable price components represent 10% or more of the total fair value price. For more information concerning amounts reported as Level 3, see Note 4 in
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+Item 7. Management’s Discussion and Analysis of Financial Condition and Results of OperationsYou should read the following discussion and analysis of our financial condition and results of operations together with the consolidated financial statements and related notes that are included elsewhere in this Annual Report on Form 10-K. This discussion contains forward-looking statements based upon current plans, expectations and beliefs that involve risks and uncertainties. Our actual results may differ materially from those anticipated in these forward-looking statements as a result of various factors, including those set forth under “Risk Factors” and elsewhere in this Annual Report on Form 10-K.Overview Arista Networks pioneered software-driven, cognitive cloud networking for large-scale data center and campus workspace environments. Our industry-leading cloud networking platform is highly scalable and programmable, and purpose built to address the functional and performance requirements for cloud networks, including workflow automation, network visibility and analytics, and has further allowed us to integrate rapidly with a wide range of third-party applications for virtualization, management, automation, orchestration and network services. We generate revenue primarily from sales of our switching and routing platforms, which incorporate our EOS software, and related network applications. We also generate revenue from post contract support, or PCS, which end customers typically purchase in conjunction with our products, and renewals of PCS. We sell our products through both our direct sales force and our channel partners. Our end customers span a range of industries and include large internet companies, service providers, financial services organizations, government agencies, media and entertainment companies and others. Historically, large purchases by a relatively limited number of end customers have accounted for a significant portion of our revenue. We have experienced unpredictability in the timing of orders from these large end customers primarily due to changes in demand patterns specific to these customers, the time it takes these end customers to evaluate, test, qualify and accept our products, and the overall complexity of these large orders. We expect continued variability in our customer concentration and timing of sales on a quarterly and annual basis. For example, sales to our end customers Microsoft and Facebook in fiscal 2019 collectively represented 40% of our total revenue, whereas sales to our end customer Microsoft in fiscal 2020 amounted to 21.5% of our revenues, with our end customer Facebook representing less than 10% of our revenues in the period. These changes contributed to a year-over-year decline in our revenue for fiscal 2020. However, this decline in revenue from these large end customers was in part offset by stronger sales to our enterprise and other cloud and service provider customers. In addition, we typically provide pricing discounts to large end customers, which may result in lower margins for the period in which such sales occur. We believe that cloud networking will continue to replace legacy network technologies across data center and campus environments. Our cloud networking platforms are well positioned to address the growing cloud networking market, and to address increasing performance requirements driven by the growing number of connected devices, as well as the need for constant connectivity and access to data and applications.52Table of ContentsThe markets for cloud networking solutions are highly competitive and characterized by rapidly changing technology, changing end-customer needs, evolving industry standards, frequent introductions of new products and services and industry consolidation. We expect competition to intensify in the future as the market for cloud networking expands and existing competitors and new market entrants introduce new products or enhance existing products. Our future success is dependent upon our ability to continue to evolve and adapt to our rapidly changing environment. We must also continue to develop market leading products and features that address the needs of our existing and new customers, and increase sales in the enterprise data center switching, and campus workspace markets. We intend to continue expanding our sales force and marketing activities in key geographies, as well as our relationships with channel, technology and system-level partners in order to reach new end customers more effectively, increase sales to existing customers, and provide services and support. In addition, we intend to continue to invest in our research and development organization to enhance the functionality of our existing cloud networking platform, introduce new products and features, and build upon our technology leadership. We believe one of our greatest strengths lies in our ability to rapidly develop new features and applications.Our development model is focused on the development of new products based on our EOS software and enhancements to EOS. We engineer our products to be agnostic with respect to the underlying merchant silicon architecture. Today, we combine our EOS software with merchant silicon into a family of switching and routing products. This enables us to focus our research and development resources on our software core competencies and to leverage the investments made by merchant silicon vendors to achieve cost-effective solutions. We work closely with third party contract manufacturers to manufacture our products. Our contract manufacturers deliver our products to our third party direct fulfillment facilities. We and our fulfillment partners then perform labeling, final configuration, quality assurance testing and shipment to our customers.Recent Developments The global coronavirus (“COVID-19”) pandemic and related shelter in place, travel and social distancing restrictions imposed by governments around the world in an effort to contain or slow its spread have negatively impacted the global economy, disrupted business, sales activities, supply chains and workforce participation, including our own, and created significant volatility and disruption of financial markets, and we expect that the global health crisis caused by COVID-19 will continue to negatively impact business activity for the foreseeable future.We have taken numerous steps, and will continue to take further actions, in our approach to address COVID-19. We have prioritized the protection of our employees during this pandemic and, as a result, have closed our offices across the globe (including our corporate headquarters), limiting access to only those employees providing essential activities, instructed employees to work from home, and implemented travel restrictions. We continue to work closely with our contract manufacturers and supply chain partners who have experienced delays in component sourcing, workforce disruptions and governmental restrictions on the production and export of their products. Although we have worked diligently to drive improvements in these areas, including funding additional working capital and incremental purchase commitments, these delays have negatively impacted our ability to supply products to our customers on a timely basis. We expect to continue to invest in working capital as supply availability improves in order to address the risk of future COVID-19 related supply chain disruptions, but we cannot be certain that such disruptions will not occur. When the COVID-19 pandemic began, we initially experienced some volatility in customer demand, but sales activity subsequently stabilized and we experienced incremental improvements in overall demand as the year progressed. However, the supply chain disruptions outlined above and the earlier volatility in customer demand contributed in part to a year-over-year decline in total revenue for the year ended December 31, 2020. The extent of the impact of COVID-19 on our operational and financial performance, including our ability to execute our business strategies and initiatives in the expected time frame, will depend on future developments, including the duration and spread of the pandemic, the breadth and duration of governmental containment measures such as shelter in place, travel and social distancing restrictions as well as the reauthorization of or increase in such measures in the event of spikes in COVID-19 infection rates, the success of the COVID-19 vaccination deployment, and the impact on our customers, partners, contract manufacturers 53Table of Contentsand supply chain, all of which are uncertain and cannot be predicted. However, any continued or renewed disruption in manufacturing and supply resulting from the COVID-19 pandemic or related containment measures could negatively impact our business. We also believe that any extended or renewed COVID-19 related economic disruption could have a negative impact on demand from our customers in future periods. Accordingly, current results and financial condition discussed herein may not be indicative of future operating results and trends.In response to potential future COVID-19 related disruptions to our business, we have continued to carefully review our investment and spending plans, cautiously increasing incremental spending in the second half of fiscal 2020 as overall customer demand stabilized. Although management is actively monitoring the impact of COVID-19 on the Company’s financial condition, liquidity, operations, suppliers, industry, and workforce, the full impact of the pandemic continues to evolve as of the date of this report. As such, the Company is unable to estimate the effects of COVID-19 on its future results of operations, financial condition, or liquidity.AcquisitionsOn February 5, 2020, we acquired Big Switch Networks, Inc. (“Big Switch”), a network monitoring and software-defined networking pioneer headquartered in Santa Clara, California. With the acquisition of Big Switch, we expanded our data center networking solutions and further strengthen our network monitoring and observability suite delivered through Arista’s software platform CloudVision and DANZ (DataANalyZer) capabilities. In addition, on October 7, 2020, we completed the acquisition of Awake Security Inc. (“Awake Security”), a network detection and response (“NDR”) platform provider headquartered in Santa Clara, California. With the acquisition of Awake Security, we added an NDR platform to our product portfolio that combines artificial intelligence (AI) with human expertise to autonomously hunt for and respond to insider and external threats.Results of OperationsYear Ended December 31, 2020 Compared to Year Ended December 31, 2019 Revenue, Cost of Revenue and Gross Profit (in thousands, except percentages) Year Ended December 31,20202019Change in$% ofRevenue$% ofRevenue$%RevenueProduct$1,830,842 79.0 %$2,021,150 83.8 %$(190,308)(9.4)%Service 486,670 21.0 389,556 16.2 97,114 24.9 Total revenue2,317,512 100.0 2,410,706 100.0 (93,194)(3.9)Cost of revenueProduct749,962 32.4 792,382 32.9 (42,420)(5.4)Service 85,664 3.7 73,986 3.0 11,678 15.8 Total cost of revenue835,626 36.1 866,368 35.9 (30,742)(3.5)Gross profit$1,481,886 63.9 %$1,544,338 64.1 %$(62,452)(4.0)%Gross margin63.9 %64.1 %54Table of ContentsRevenue by Geography (in thousands, except percentages)Year Ended December 31,2020% of Total2019% of TotalAmericas$1,771,992 76.5 %$1,833,163 76.1 %Europe, Middle East and Africa 326,729 14.1 381,651 15.8 Asia-Pacific 218,791 9.4 195,892 8.1 Total revenue $2,317,512 100.0 %$2,410,706 100.0 %Revenue Product revenue primarily consists of sales of our switching and routing products, and software licenses. Service revenue is primarily derived from sales of post-contract support, or PCS, which is typically purchased in conjunction with our products, and subsequent renewals of those contracts. We expect our revenue may vary from period to period based on, among other things, the timing, size, and complexity of orders, especially with respect to our large end customers. Product revenue decreased $190.3 million, or 9.4%, in the year ended December 31, 2020 compared to 2019. The decrease was primarily due to the recognition of $125.1 million of deferred product revenue in the year ended December 31, 2019 related to customer acceptance of products shipped in prior periods. In addition, we experienced reduced sales to our larger customers during fiscal 2020, combined with the impact of some COVID-19 related supply constraints. Service revenue increased $97.1 million, or 24.9% in the year ended December 31, 2020 compared to 2019 as a result of continued growth in initial and renewal support contracts as our customer installed base continued to expand. International revenues remained relatively constant at 23.5% of total revenues in the year ended December 31, 2020, compared to 23.9% in 2019, with a slight decrease in growth in our EMEA region, mostly offset by an increase in growth in our Asia-Pacific region. International revenue generally fluctuates based on the timing of deployments by certain of our large end customers. Cost of Revenue and Gross Margin Cost of product revenue primarily consists of amounts paid for inventory to our third-party contract manufacturers and merchant silicon vendors, overhead costs of our manufacturing operations, and other costs associated with manufacturing our products and managing our inventory. Cost of service revenue primarily consists of personnel and other costs associated with our global customer support and services organizations.Cost of revenue decreased $30.7 million or 3.5% for the year ended December 31, 2020 compared to 2019. The decrease in cost of revenue was primarily due to a corresponding decrease in product revenues, and was partially offset by incremental COVID-19 related supply chain costs and increased product transition costs. Gross margin, or gross profit as a percentage of revenue, has been and will continue to be affected by a variety of factors, including pricing pressure on our products and services due to competition, the mix of sales to large end customers who generally receive lower pricing, manufacturing-related costs, including costs associated with supply chain sourcing activities, merchant silicon costs, the mix of products sold, and excess/obsolete inventory write-downs, including charges for excess/obsolete component inventory held by our contract manufacturers. We expect our gross margins to fluctuate over time, depending on the factors described above. Gross margin slightly decreased from 64.1% for the year ended December 31, 2019 to 63.9% in 2020. Gross margin was negatively impacted by incremental COVID-19 related supply chain costs and some increased product transition costs, combined with the impact of fixed overhead costs on a lower revenue base. These negative impacts were partially offset by a reduction in sales to our larger end customers who generally receive larger discounts, and improved service margins as we scale our services organization.55Table of ContentsOperating Expenses (in thousands, except percentages) Our operating expenses consist of research and development, sales and marketing, and general and administrative expenses. The largest component of our operating expenses is personnel costs. Personnel costs consist of wages, benefits, bonuses and, with respect to sales and marketing expenses, sales commissions. Personnel costs also include stock-based compensation and travel expenses. Year Ended December 31, 20202019Change in $% ofRevenue$% ofRevenue$%Operating expenses:Research and development$486,594 20.9 %$462,759 19.2 %$23,835 5.2 %Sales and marketing229,366 9.9 213,907 8.9 15,459 7.2 General and administrative66,242 2.9 61,898 2.6 4,344 7.0 Total operating expenses$782,202 33.7 %$738,564 30.7 %$43,638 5.9 %Research and development. Research and development expenses consist primarily of personnel costs, prototype expenses, third-party engineering costs, and an allocated portion of facility and IT costs. Our research and development efforts are focused on new product development and maintaining and developing additional functionality for our existing products, including new releases and upgrades to our EOS software and applications. We expect our research and development expenses to increase in absolute dollars as we continue to invest in software development in order to expand the capabilities of our cloud networking platform, introduce new products and features, and build upon our technology leadership.Research and development expenses increased $23.8 million, or 5.2%, for the year ended December 31, 2020 compared to 2019. The increase was primarily due to a $26.8 million increase in stock-based compensation from new and refresh grants during the current fiscal year, and a $7.8 million increase in acquisition-related expenses and amortization of acquired intangible assets from our acquisition of Big Switch and Awake Security, partially offset by an $11.4 million decrease in new product introduction costs, including third-party engineering and other product development costs.Sales and marketing. Sales and marketing expenses consist primarily of personnel costs, marketing, trade shows, and other promotional activities, and an allocated portion of facility and IT costs. We expect our sales and marketing expenses to increase in absolute dollars as we continue to expand our sales and marketing efforts worldwide.Sales and marketing expenses increased $15.5 million, or 7.2%, for the year ended December 31, 2020 compared to 2019. The increase was driven by increased headcount, resulting in increased compensation costs, including salaries and stock-based compensation, partially offset by a decrease in travel and other sales and marketing activities due to COVID-19. General and administrative. General and administrative expenses consist primarily of personnel costs and professional services costs. General and administrative personnel costs include those for our executive, finance, human resources and legal functions. Our professional services costs are primarily related to external legal, accounting, and tax services. General and administrative expenses increased $4.3 million, or 7.0%, for the year ended December 31, 2020 compared to 2019. The increase was primarily driven by acquisition-related costs from our acquisitions of Big Switch and Awake Security in the current fiscal year. 56Table of ContentsOther Income, Net (in thousands, except percentages)Other income, net consists primarily of interest income from our cash, cash equivalents and marketable securities, gains and losses on our investments in privately-held companies, and foreign currency transaction gains and losses. We expect other income, net may fluctuate in the future as a result of the re-measurement of our private company equity investments upon the occurrence of observable price changes and/or impairments, changes in interest rates or returns on our cash and cash equivalents and marketable securities, and foreign currency exchange rate fluctuations. Year Ended December 31, 20202019Change in $% ofRevenue$% ofRevenue$%Other income, net:Interest income$27,139 1.2 %$51,144 2.2 %$(24,005)(46.9)%Gain on sale of marketable securities9,432 0.4 — — 9,432 100.0 Gain on investments in privately-held companies4,164 0.2 5,427 0.2 (1,263)(23.3)Other income (expense)(1,556)(0.1)(75)— (1,481)1,974.7 Total other income, net$39,179 1.7 %$56,496 2.4 %$(17,317)(30.7)%The unfavorable change in other income, net, during the year ended December 31, 2020 as compared to 2019 was driven by a $24.0 million decrease in interest income largely due to lower interest rates. This was partially offset by a realized gain of $9.4 million on the sale of marketable securities in the third quarter of the year ended December 31, 2020. Provision for Income Taxes (in thousands, except percentages) We operate in a number of tax jurisdictions and are subject to taxes in each country or jurisdiction in which we conduct business. Earnings from our non-U.S. activities are subject to local country income tax and may also be subject to U.S. income tax. Generally, our U.S. tax obligations are reduced by a credit for foreign income taxes paid on these foreign earnings, which avoids double taxation. Our tax expense to date consists of federal, state and foreign current and deferred income taxes. Year Ended December 31, 20202019Change in $% ofRevenue$% ofRevenue$%Provision for income taxes$104,306 4.5 %$2,403 0.1 %$101,903 4,240.7 Effective tax rate14.1 %0.3 %For the years ended December 31, 2020 and 2019, we recorded an expense of $104.3 million and $2.4 million for income taxes, respectively, and our effective tax rate increased from 0.3% in 2019 to 14.1% in 2020. The change in our income taxes was largely attributable to a net tax benefit of $86 million in 2019 resulting from an intra-entity transaction to sell our non-Americas economic and beneficial intellectual property rights. Further, while we experienced a decrease in worldwide profit before tax in 2020 compared to 2019, the tax benefits attributable to stock-based compensation also decreased, along with an increase in foreign earnings taxed in non-zero rate jurisdictions, resulting in overall higher tax expense. For further information regarding income taxes and the impact on our results of operations and financial position, refer to Note 10. Income Taxes of the Notes to Consolidated Financial Statements included in Part II, Item 8, of this Annual Report on Form 10-K. Year Ended December 31, 2019 Compared to Year Ended December 31, 2018 Revenue, Cost of Revenue and Gross Profit (in thousands, except percentages) 57Table of Contents Year Ended December 31, 20192018Change in $% ofRevenue$% ofRevenue$%RevenueProduct$2,021,150 83.8 %$1,841,100 85.6 %$180,050 9.8 %Service 389,556 16.2 310,269 14.4 79,287 25.6 Total revenue2,410,706 100.0 2,151,369 100.0 259,337 12.1 Cost of revenueProduct792,382 32.9 720,584 33.5 71,798 10.0 Service 73,986 3.0 57,408 2.7 16,578 28.9 Total cost of revenue866,368 35.9 777,992 36.2 88,376 11.4 Gross profit$1,544,338 64.1 %$1,373,377 63.8 %$170,961 12.4 %Gross margin64.1 %63.8 %Revenue by Geography (in thousands, except percentages)Year Ended December 31,2019% of Total2018% of TotalAmericas$1,833,163 76.1 %$1,550,453 72.1 %Europe, Middle East and Africa 381,651 15.8 414,069 19.2 Asia-Pacific 195,892 8.1 186,847 8.7 Total revenue $2,410,706 100.0 %$2,151,369 100.0 %Revenue Product revenue increased $180.1 million, or 9.8%, in the year ended December 31, 2019 compared to 2018. The increase was primarily driven by increased demand from both new and existing customers, and the recognition of product deferred revenue related to sales in the prior year for which revenue was recognized in 2019. Service revenue increased $79.3 million, or 25.6% in the year ended December 31, 2019 compared to 2018 as a result of continued growth in initial and renewal support contracts as our customer installed base has continued to expand. International revenues represented 23.9% of total revenues in the year ended December 31, 2019, compared to 27.9% in 2018, which was primarily due to a move toward U.S. deployments by certain of our large end customers during 2019. We continue to experience pricing pressure on our products and services due to competition, but demand for our products and growth in our installed base has more than offset this pricing pressure during the year. However, we have experienced reduced and volatile demand from certain of our large end customers during 2019.Cost of Revenue and Gross Margin Cost of revenue increased $88.4 million or 11.4% for the year ended December 31, 2019 compared to 2018. The increase in cost of revenue was primarily due to the corresponding increases in product and service revenues. Gross margin increased to 64.1% for the year ended December 31, 2019 compared to 63.8% in 2018. The increase in gross margin was primarily driven by an increase in product margins due to favorable customer mix, with lower discounts on smaller volume transactions, partially offset by increased product transition costs, including excess and obsolete inventory-related charges.Operating Expenses (in thousands, except percentages)58Table of Contents Year Ended December 31, 20192018Change in $% ofRevenue$% ofRevenue$%Operating expenses:Research and development $462,759 19.2 %$442,468 20.6 %$20,291 4.6 %Sales and marketing 213,907 8.9 187,142 8.7 26,765 14.3 General and administrative61,898 2.6 65,420 3.0 (3,522)(5.4)Legal settlement— — 405,000 18.8 (405,000)(100.0)Total operating expenses$738,564 30.7 %$1,100,030 51.1 %$(361,466)(32.9)%Research and development Research and development expenses increased $20.3 million, or 4.6%, for the year ended December 31, 2019 compared to 2018. The increase was primarily due to a $17.2 million increase in personnel costs driven primarily by headcount growth, and a $7.8 million increase in development-related facilities costs due to facilities expansion and headcount growth, partially offset by a $5.9 million decrease in new product introduction costs, including third-party engineering and other product development costs.Sales and marketing Sales and marketing expenses increased $26.8 million, or 14.3%, for the year ended December 31, 2019 compared to 2018. The increase primarily included a $23.4 million increase in personnel costs, which was driven by increased headcount as well as higher sales volumes, resulting in increased compensation costs, including commissions and stock-based compensation.General and administrativeGeneral and administrative expenses decreased $3.5 million, or 5.4%, for the year ended December 31, 2019 compared to 2018. The decrease was primarily related to a reduced level of litigation activity as a result of the settlement of our litigation with Cisco in August 2018.Legal settlementDuring the three months ended June 30, 2018, we recorded $405.0 million in legal settlement expenses in connection with the Term Sheet that was entered into on August 6, 2018 between the Company and Cisco, which included a $400.0 million payment and $5.0 million of legal fees associated with the settlement. Pursuant to the Term Sheet, the Company and Cisco obtained dismissals of all then ongoing district court and USITC litigation between us. On December 3, 2018, the parties entered into a mutual release and settlement agreement, which superseded the Term Sheet but did not substantially alter the terms. Other Income, Net (in thousands, except percentages) Year Ended December 31, 20192018Change in $% ofRevenue$% ofRevenue$%Other income, net:Interest income$51,144 2.2 %$31,666 1.4 %$19,478 61.5 %Interest expense— — (2,701)(0.1)2,701 (100.0)Gain (loss) on investments in privately-held companies5,427 0.2 (13,800)(0.6)19,227 (139.3)Other income (expense)(75)— 289 — (364)(126.0)Total other income, net$56,496 2.4 %$15,454 0.7 %$41,042 265.6 %59Table of ContentsThe favorable change in other income, net, during the year ended December 31, 2019 as compared to 2018 was driven by a $19.5 million increase in interest income, as we continued to generate cash and expand our marketable securities portfolios, and a $19.2 million favorable change on our investments in privately-held companies resulting from the gain on certain investments of $5.4 million in 2019, compared to a net loss of $13.8 million on these investments during 2018. Upon adoption of Accounting Standard Codification Topic 842 - Leases (“ASC 842”) on January 1, 2019, we derecognized the finance lease obligation associated with our build-to-suit lease, and therefore ceased to incur further interest expense as it relates to this obligation. Provision for (Benefit from) Income Taxes (in thousands, except percentages) Year Ended December 31, 20192018Change in $% ofRevenue$% ofRevenue$%Provision for (benefit from) income taxes$2,403 0.1 %$(39,314)(1.9)%$41,717 (106.1)%Effective tax rate0.3 %(13.6)%For the years ended December 31, 2019 and 2018, we recorded an expense of $2.4 million and a benefit of $39.3 million for income taxes, respectively. The change in our income taxes was largely attributable to a $96.9 million tax benefit from the Cisco settlement in 2018 and an overall increase in worldwide earnings in 2019, partially offset by a net tax benefit of $86 million in 2019 resulting from an intra-entity transaction to sell our non-Americas economic and beneficial intellectual property rights. Liquidity and Capital Resources Our principal sources of liquidity are cash, cash equivalents, marketable securities, and cash generated from operations. As of December 31, 2020, our total balance of cash, cash equivalents and marketable securities was $2.9 billion, of which approximately $421.0 million was held outside the U.S. in our foreign subsidiaries. Our cash, cash equivalents and marketable securities are held for general business purposes including the funding of working capital. Our marketable securities investment portfolio is primarily invested in highly-rated securities, with the primary objective of minimizing the potential risk of principal loss. We plan to continue to invest for long-term growth. We believe that our existing balances of cash, cash equivalents and marketable securities, together with cash generated from operations will be sufficient to meet our working capital requirements and our growth strategies for at least the next 12 months. Our future capital requirements will depend on many factors, including our growth rate, the timing and extent of our spending to support research and development activities, the timing and cost of establishing additional sales and marketing capabilities, the introduction of new and enhanced product and service offerings, our costs associated with supply chain activities, including access to outsourced manufacturing, our costs related to investing in or acquiring complementary or strategic businesses and technologies, the continued market acceptance of our products, and stock repurchases. If we require or elect to seek additional capital through debt or equity financing in the future, we may not be able to raise capital on terms acceptable to us or at all. If we are required and unable to raise additional capital when desired, our business, operating results and financial condition may be adversely affected.60Table of ContentsCash FlowsYear Ended December 31,202020192018(in thousands)Cash provided by operating activities$735,114 $963,034 $503,119 Cash (used in) investing activities (608,802)(284,072)(755,113)Cash (used in) provided by financing activities(346,339)(217,964)42,851 Effect of exchange rate changes1,966 353 (1,390)Net increase (decrease) in cash, cash equivalents and restricted cash$(218,061)$461,351 $(210,533)Cash Flows from Operating ActivitiesOur operating activities consist of net income, adjusted for certain non-cash items, and changes in assets and liabilities.During the year ended December 31, 2020, cash provided by operating activities was $735.1 million, primarily from net income of $634.6 million and net non-cash adjustments to net income of $186.2 million, partially offset by a net increase of $85.7 million in working capital requirements. The net non-cash adjustments primarily consist of $137.0 million of stock-based compensation expenses and $44.6 million of depreciation and amortization expenses. The increase in working capital primarily consisted of a $235.3 million increase in inventory to help mitigate the impact of COVID-19 related supply chain disruptions, partially offset by a $50.4 million increase in deferred revenue, a $41.1 million increase in accounts payable related to the timing of production receipts, and a $17.1 million increase in other liabilities primarily due to an increase in customer contract liabilities. During the year ended December 31, 2019, cash provided by operating activities was $963.0 million, primarily from net income of $859.9 million and net non-cash adjustments to net income of $62.4 million, partially offset by a net decrease of $40.8 million in cash from changes in our operating assets and liabilities. Cash outflows from operating activities consisted of an $11.9 million decrease in deferred revenue primarily due to the recognition of product deferred revenue related to contract acceptance terms, largely offset by increased service deferred revenue related to growth in customer service and support contracts, a $60.2 million increase in accounts receivable due to timing of shipments, and an $8.1 million increase in other assets resulting from increased spares inventory to support our customer base. These cash outflows were partially offset by cash inflows of $54.3 million in prepaid expenses and other current assets from a decrease in deferred cost of inventory due to the recognition of product deferred revenue, $23.5 million from an increase in income taxes payable, $20.9 million decrease in inventories due to timing of product shipments and receipts, and $16.4 million from increased accrued liabilities primarily due to an increase in supplier liability reserves for excess and obsolete component inventory.Cash Flows from Investing ActivitiesOur investing activities consist of our marketable securities investments, business combinations, investments in privately-held companies, and capital expenditures. During the year ended December 31, 2020, cash used in investing activities was $608.8 million, primarily consisting of purchases of available-for-sale securities of $2.7 billion, $227.4 million for the acquisition of Big Switch and Awake Security, and purchases of property, equipment and intangible assets of 15.4 million, partially offset by proceeds of $1.5 billion from maturities of marketable securities, proceeds from the sale of marketable securities of $773.0 million and proceeds from the sale of one of our investments in privately-held companies of $3.4 million.During the year ended December 31, 2019, cash used in investing activities was $284.1 million, primarily consisting of purchases of available-for-sale securities of $1.5 billion, and purchases of property and 61Table of Contentsequipment of 15.8 million, partially offset by proceeds of $1.2 billion from maturities of marketable securities and proceeds from the sale of one of our investments in privately-held companies of $28.2 million.Cash Flows from Financing ActivitiesOur financing activities consist of proceeds from the issuance of our common stock under employee equity incentive plans, offset by repurchases of our common stock.During the year ended December 31, 2020, cash used in financing activities was $346.3 million, consisting primarily of payments for repurchases of our common stock of $395.2 million and taxes paid of $8.7 million upon vesting of restricted stock units, offset partially by proceeds from the issuance of common stock under employee equity incentive plans of $57.6 million.During the year ended December 31, 2019, cash used in financing activities was $218.0 million, consisting primarily of payments for repurchases of our common stock of $266.1 million and taxes paid of $9.2 million upon vesting of restricted stock units, partially offset by proceeds from the issuance of common stock under employee equity incentive plans of $57.4 million.Stock Repurchase ProgramWe have periodically repurchased our common stock pursuant to our Repurchase Program authorized by our board of directors in April 2019. The Repurchase Program allows for stock repurchases of up to $1.0 billion over three years and these repurchases are to be funded from operating cash flows. The Repurchase Program, which expires in April 2022, does not obligate us to acquire any of our common stock, and may be suspended or discontinued by us at any time without prior notice. As of December 31, 2020, the remaining authorized amount for repurchases under the Repurchase Program was $338.7 million. Refer to Note 8. Stockholders' Equity and Stock-Based Compensation of the Notes to Consolidated Financial Statements included in Part II, Item 8, of this Annual Report on Form 10-K for further discussion. Off-Balance Sheet ArrangementsAs of December 31, 2020, we did not have any relationships with any unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities that would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes.Contractual Obligations and CommitmentsOur contractual commitments will have an impact on our future liquidity. Our contractual obligations represent material expected or contractually committed future payment obligations. We believe that we will be able to fund these obligations through cash generated from operations and from our existing balances of cash, cash equivalent and marketable securities. The following summarizes our contractual obligations and commitments as of December 31, 2020 (in thousands): Payments Due by PeriodTotalLess than1 Year1 to 3 Years3 to 5 YearsMore than5 YearsOperating lease obligations104,258 21,770 41,423 21,139 19,926 Purchase commitments with contract manufacturers and suppliers421,857 421,857 — — — Other non-cancellable purchase obligations32,103 32,103 — — Transition tax payable6,343 — — 6,343 — Total$564,561 $475,730 $41,423 $27,482 $19,926 62Table of ContentsThe contractual obligation table above excludes tax liabilities of $46.7 million related to uncertain tax positions because we are unable to make a reasonably reliable estimate of the timing of settlement, if any, of these future payments. In connection with the Tax Cuts and Jobs Act of 2017, we recorded a federal income tax payable for transition tax on the mandatory deemed repatriation of foreign earnings that will be payable over an eight-year period. The amounts included in the table above represent the remaining federal income tax payable after applying the first year's installment payment and early payments of future installments.Critical Accounting Policies and Estimates We have prepared our consolidated financial statements in accordance with accounting principles generally accepted in the United States ("GAAP" or "U.S. GAAP") and include our accounts and the accounts of our wholly owned subsidiaries. The preparation of these consolidated financial statements requires our management to make estimates, assumptions and judgments that affect the reported amounts of assets and liabilities at the date of the financial statements, disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the applicable periods. We base our estimates, assumptions and judgments on historical experience and on various other factors that we believe to be reasonable under the circumstances. Different assumptions and judgments would change the estimates used in the preparation of our consolidated financial statements, which, in turn, could change the results from those reported. We evaluate our estimates, assumptions and judgments on an ongoing basis. Actual results may differ from these estimates. To the extent that there are material differences between these estimates and our actual results, our future financial statements will be affected. The critical accounting estimates, assumptions and judgments that we believe have the most significant impact on our consolidated financial statements are the following:Revenue RecognitionWe generate revenue from sales of our products, which incorporate our EOS software and accessories such as cables and optics, to direct customers and channel partners together with PCS. We typically sell products and PCS in a single contract. We recognize revenue upon transfer of control of promised products or services to customers in an amount that reflects the consideration we expect to be entitled to receive in exchange for those products or services. We apply the following five-step revenue recognition model:•Identification of the contract, or contracts, with a customer•Identification of the performance obligations in the contract•Determination of the transaction price•Allocation of the transaction price to the performance obligations in the contract•Recognition of revenue when (or as) we satisfy the performance obligationPost-Contract Customer SupportPCS, which includes technical support, hardware repair and replacement parts beyond standard warranty, bug fixes, patches and unspecified upgrades on a when-and-if-available basis, is offered under renewable, fee-based contracts. We initially defer PCS revenue and recognize it ratably over the life of the PCS contract as there is no discernible pattern of delivery related to these promises. We do not provide unspecified upgrades on a set schedule and address customer requests for technical support if and when they arise, with the related expenses recognized as incurred. PCS contracts generally have a term of one to three years. We include billed but unearned PCS revenue in deferred revenue. Contracts with Multiple Performance ObligationsMost of our contracts with customers, other than renewals of PCS, contain multiple performance obligations with a combination of products and PCS. Products and PCS generally qualify as distinct performance obligations. Our hardware includes EOS software, which together deliver the essential functionality of our products. For contracts which contain multiple performance obligations, we allocate revenue to each distinct performance obligation based on the standalone selling price (“SSP”). Judgment is 63Table of Contentsrequired to determine the SSP for each distinct performance obligation. We use a range of amounts to estimate SSP for products and PCS sold together in a contract to determine whether there is a discount to be allocated based on the relative SSP of the various products and PCS.If we do not have an observable SSP, such as when we do not sell a product or service separately, then SSP is estimated using judgment and considering all reasonably available information such as market conditions and information about the size and/or purchase volume of the customer. We generally use a range of amounts to estimate SSP for individual products and services based on multiple factors including, but not limited to, the sales channel (reseller, distributor or end customer), the geographies in which our products and services are sold, and the size of the end customer.We limit the amount of revenue recognition for contracts containing forms of variable consideration, such as future performance obligations, customer-specific returns, and acceptance or refund obligations. We include some or all of an estimate of the related at risk consideration in the transaction price only to the extent that it is probable that a significant reversal in the amount of cumulative revenue recorded under each contract will not occur when the uncertainties surrounding the variable consideration are resolved. Most of our contracts with customers have payment terms of 30 days, with some large high volume customers having terms of up to 60 days. We have determined that our contracts generally do not include a significant financing component because the Company and the customer have specific business reasons other than financing for entering into such contracts. Specifically, both we and our customers seek to ensure the customer has a simplified way of purchasing our products and services.We account for multiple contracts with a single partner as one arrangement if the contractual terms and/or substance of those agreements indicate that they may be so closely related that they are, in effect, parts of a single contract.We may occasionally accept returns to address customer satisfaction issues even though there is generally no contractual provision for such returns. We estimate returns for sales to customers based on historical return rates applied against current-period shipments. Specific customer returns and allowances are considered when determining our sales return reserve estimate.Our policy applies to the accounting for individual contracts. However, we have elected a practical expedient to apply the guidance to a portfolio of contracts or performance obligations with similar characteristics so long as such application would not differ materially from applying the guidance to the individual contracts (or performance obligations) within that portfolio. Consequently, we have chosen to apply the portfolio approach when possible, which we do not believe will happen frequently. Additionally, we will evaluate a portfolio of data, when possible, in various situations, including accounting for commissions, rights of return and transactions with variable consideration.We report revenue net of sales taxes. We include shipping charges billed to customers in revenue and the related shipping costs are included in cost of product revenue.Inventory Valuation and Contract Manufacturer/Supplier LiabilitiesInventories primarily consist of finished goods and strategic components, primarily integrated circuits. Inventories are stated at the lower of cost (computed using the first-in, first-out method) and net realizable value. Manufacturing overhead costs and inbound shipping costs are included in the cost of inventory. We record a provision when inventory is determined to be in excess of anticipated demand, or obsolete, to adjust inventory to its estimated realizable value.Our contract manufacturers procure components and assemble products on our behalf based on our forecasts. We record a liability and a corresponding charge for non-cancellable, non-returnable purchase commitments with our contract manufacturers or suppliers for quantities in excess of our demand forecasts or that are considered obsolete due to manufacturing and engineering change orders resulting from design changes. 64Table of ContentsWe use significant judgment in establishing our forecasts of future demand and obsolete material exposures. These estimates depend on our assessment of current and expected orders from our customers, product development plans and current sales levels. If actual market conditions are less favorable than those projected by management, which may be caused by factors within and/or outside of our control, we may be required to increase our inventory write-downs and liabilities to our contract manufacturers and suppliers, which could have an adverse impact on our gross margins and profitability. We regularly evaluate our exposure for inventory write-downs and adequacy of our contract manufacturer/supplier liabilities.Income Taxes Income tax expense is an estimate of current income taxes payable in the current fiscal year based on reported income before income taxes. Deferred income taxes reflect the effect of temporary differences and carryforwards that we recognize for financial reporting and income tax purposes.We account for income taxes under the liability approach for deferred income taxes, which requires recognition of deferred income tax assets and liabilities for the expected future tax consequences of events that have been recognized in our consolidated financial statements, but have not been reflected in our taxable income. Estimates and judgments occur in the calculation of certain tax liabilities and in the determination of the recoverability of certain deferred income tax assets, which arise from temporary differences and carryforwards. Deferred income tax assets and liabilities are measured using the currently enacted tax rates that apply to taxable income in effect for the years in which those tax assets are expected to be realized or settled. We regularly assess the likelihood that our deferred income tax assets will be realized based on the positive and negative evidence available. We record a valuation allowance to reduce the deferred tax assets to the amount that we are more likely than not to realize. We believe that we have adequately reserved for our uncertain tax positions, although we can provide no assurance that the final tax outcome of these matters will not be materially different. To the extent that the final tax outcome of these matters is different than the amounts recorded, such differences will affect the provision for income taxes in the period in which such determination is made and could have a material impact on our financial condition and results of operations. The provision for income taxes includes the effects of any reserves that we believe are appropriate, as well as the related net interest and penalties.We regularly review our tax positions and benefits to be realized. We recognize tax liabilities based upon our estimate of whether, and to the extent to which, additional taxes will be due when such estimates are more likely than not to be sustained. An uncertain income tax position will not be recognized if it has less than a 50% likelihood of being sustained. We recognize interest and penalties related to income tax matters as income tax expense.The U.S. tax rules require U.S. tax on foreign earnings, known as global intangible low taxed income (“GILTI”). Under U.S. GAAP, we are allowed to make an accounting policy choice of either (1) treating taxes due on future U.S. inclusions in taxable income related to GILTI as a current-period expense when incurred (the “period cost method”) or (2) factoring such amounts into a company’s measurement of its deferred taxes (the “deferred method”). We selected the deferred method of accounting and recorded the associated basis differences anticipated to influence prospective GILTI calculations.Loss ContingenciesIn the ordinary course of business, we are a party to claims and legal proceedings including matters relating to commercial, employee relations, business practices and intellectual property. In assessing loss contingencies, we use significant judgment and assumptions to estimate the likelihood of loss, impairment of an asset or the incurrence of a liability, as well as our ability to reasonably estimate the amount of loss. We record a provision for contingent losses when it is both probable that an asset has been impaired or a liability has been incurred and the amount of the loss can be reasonably estimated. We will record a charge equal to the minimum estimated liability for litigation costs or a loss contingency only when both of the following conditions are met: (i) information available prior to issuance of our consolidated financial statements indicates that it is probable that a liability had been incurred at the date of the financial statements and (ii) the range of loss can be 65Table of Contentsreasonably estimated. We regularly evaluate current information available to us to determine whether such accruals should be adjusted and whether new accruals are required.Recent Accounting PronouncementsRefer to “Recent Accounting Pronouncements” in Note 1. Organization and Summary of Significant Accounting Policies of the Notes to Consolidated Financial Statements included in Part II, Item 8, of this Annual Report on Form 10-K.Item 7A. Quantitative and Qualitative Disclosures About Market RiskWe are exposed to market risk in the ordinary course of our business. Market risk represents the risk of loss that may impact our financial position due to adverse changes in financial market prices and rates. Our market risk exposure is primarily a result of fluctuations in foreign currency exchange rates, interest rates and investments in privately-held companies. The ongoing COVID-19 pandemic has increased the volatility of global financial markets, which may increase our foreign currency exchange risk and interest rate risk. For further discussion of the potential impacts of the COVID-19 pandemic on our business, operating results, and financial condition, see Risk Factors included in Part I, Item 1A of this Form 10-K. Foreign Currency Exchange Risk Our results of operations and cash flows are subject to fluctuations due to changes in foreign currency exchange rates. Substantially all of our revenue is denominated in U.S. dollars, and therefore, our revenue is not directly subject to foreign currency risk. However, we are indirectly exposed to foreign currency risk. A stronger U.S. dollar could make our products and services more expensive in foreign countries and therefore reduce demand. A weaker U.S. dollar could have the opposite effect. Such economic exposure to currency fluctuations is difficult to measure or predict because our sales are also influenced by many other factors.Our expenses are generally denominated in the currencies in which our operations are located, which is primarily in the U.S. and to a lesser extent in Europe and Asia. Our results of operations and cash flows are, therefore, subject to fluctuations due to changes in foreign currency exchange rates and may be adversely affected in the future due to changes in foreign exchange rates. A hypothetical 10% change in foreign currency exchange rates on our monetary assets and liabilities would not be material to our financial condition or results of operations. To date, foreign currency transaction gains and losses and exchange rate fluctuations have not been material to our financial statements. While we have not engaged in the hedging of our foreign currency transactions to date and do not enter into any hedging contracts for trading or speculative purposes, we may in the future hedge selected significant transactions denominated in currencies other than the U.S. dollar.Interest Rate SensitivityAs of December 31, 2020 and 2019, we had cash, cash equivalents and available-for-sale marketable securities totaling $2.9 billion and $2.7 billion, respectively. Cash equivalents and marketable securities were invested primarily in money market funds, corporate bonds, U.S. agency mortgage-backed securities, U.S. treasury securities and commercial paper. Our primary investment objectives are to preserve capital and maintain liquidity requirements. In addition, our policy limits the amount of credit exposure to any single issuer. We do not enter into investments for trading or speculative purposes and have not used any derivative financial instruments to manage our interest rate risk exposure. Our primary exposure to market risk is interest income sensitivity, which is affected by changes in the general level of the interest rates in the U.S. A decline in interest rates would reduce our interest income on our cash, cash equivalents and marketable securities. For the years ended December 31, 2020, 2019 and 2018, the effect of a hypothetical 100 basis point increase or decrease in overall interest rates would not have had a material impact on our interest income. On the other hand, the fair market value of our investments in fixed income securities may be adversely impacted. We would incur unrealized losses on fixed income securities if there is an increase in interest rates compared to interest rates at the time of purchase. Under certain circumstances, if we are forced to sell our marketable securities prior to maturity, we may incur realized losses in such investments. However, 66Table of Contentsbecause of the conservative and short-term nature of the investments in our portfolio, a change in interest rates is not expected to have a material impact on our consolidated financial statements.Investments in Privately-Held CompaniesOur non-marketable equity investments in privately-held companies are recorded in “Investments” in our consolidated balance sheets. As of December 31, 2020 and 2019, the total carrying amount of our investments in privately-held companies was $8.3 million and $4.2 million. During fiscal 2020, we recorded a net gain of $4.1 million on certain investments, compared to a net gain of $5.4 million during fiscal 2019. See Note 5. Investments of the Notes to Consolidated Financial Statements included in Part II, Item 8, of this Annual Report on Form 10-K for details. The privately-held companies in which we invested are in the startup or development stages. These investments are inherently risky because the markets for the technologies or products these companies are developing are typically in the early stages and may never materialize. We could lose our entire investment in these companies. Our evaluation of investments in privately-held companies is based on the fundamentals of the businesses invested in, including among other factors, the nature of their technologies and potential for financial return.67Table of Contents
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+Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations (MD&A) and Note 23 – Business Segment Information to the Consolidated Financial Statements.CompetitionWe operate in a highly competitive environment. Our competitors include banks, thrifts, credit unions, investment banking firms, investment advisory firms, brokerage firms, investment companies, insurance companies, mortgage banking companies, credit card issuers, mutual fund companies, hedge funds, private equity firms, and e-commerce and other internet-based companies. We compete with some of these competitors globally and with others on a regional or product specific basis.Competition is based on a number of factors including, among others, customer service, quality and range of products and services offered, price, reputation, interest rates on loans and deposits, lending limits and customer convenience. Our ability to continue to compete effectively also depends in large part on our ability to attract new employees and retain and Bank of America 2motivate our existing employees, while managing compensation and other costs.Human Capital ResourcesWe strive to make Bank of America a great place to work for our employees. We value our employees and seek to establish and maintain human resource policies that are consistent with our core values and that help realize the power of our people. Our Board and its committees, including the Compensation and Human Capital, Audit, Enterprise Risk, and Corporate Governance, ESG and Sustainability Committees, provide oversight of our human capital management strategies, programs and practices. The Corporation’s senior management provides regular briefings on human capital matters to the Board and its Committees to facilitate the Board’s oversight. At December 31, 2020 and 2019, the Corporation employed approximately 213,000 and 208,000 employees, of which 82 percent were located in the U.S. at both dates. None of our U.S. employees are subject to a collective bargaining agreement. Additionally, in 2020 and 2019, the Corporation’s compensation and benefits expense was $32.7 billion and $32.0 billion, or 59 percent and 58 percent, of total noninterest expense. Diversity and Inclusion The Corporation’s commitment to diversity and inclusion starts at the top of the Corporation with oversight from our Board and CEO. The Corporation’s senior management sets the diversity and inclusion goals of the Corporation, and the Chief Human Resources Officer and Chief Diversity & Inclusion Officer partner with our CEO and senior management to drive our diversity and inclusion strategy, programs, initiatives and policies. The Global Diversity and Inclusion Council, which consists of senior executives from every line of business and is chaired by our CEO, has been in place for over 20 years. The Council sponsors and supports business, operating unit and regional diversity and inclusion councils to ensure alignment to enterprise diversity strategies and goals. Our practices and policies have resulted in strong representation across the Corporation where our broad employee population mirrors the clients and communities we serve. We have a Board and senior management team that are 47 percent and 50 percent racially, ethnically and gender diverse. As of December 31, 2020, over 50 percent of employees were women, and, among U.S.-based employees, nearly 48 percent were people of color, 14 percent were Black/African American and 19 percent were Hispanic/Latino. As of December 31, 2020, the Corporation’s top three management levels in relation to the CEO were composed of more than 42 percent women and nearly 20 percent people of color. These workforce diversity metrics are reported regularly to the senior management team and to the Board and are publicly disclosed on our website. We invest in our leadership by offering a range of development programs and resources that allow employees to develop and progress in their careers. We reinforce our commitment to diversity and inclusion by investing internally in our employee networks and by facilitating conversations with employees about racial, social and economic issues. Further, we partner with various external organizations, which focus on advancing diverse talent. We also have practices in place for attracting and retaining diverse talent, including campus recruitment. For example, in 2020, approximately 45 percent of our campus hires were women, and, in the U.S., approximately 54 percent were people of color.Employee Engagement and Talent RetentionAs part of our ongoing efforts to make the Corporation a great place to work, we have conducted a confidential annual Employee Engagement Survey (Survey) for nearly two decades. The Survey results are reviewed by the Board and senior management and used to assist in reviewing the Corporation’s human capital strategies, programs and practices. In 2020, more than 90 percent of the Corporation’s employees participated in the Survey, and our Employee Engagement Index, an overall measure of employee satisfaction with the Corporation, was 91 percent. In 2020, we also had historically low turnover among our employees of seven percent.Fair and Equitable Compensation The Corporation is committed to racial and gender pay equity by striving to fairly and equitably compensate all of our employees. We maintain robust policies and practices that reinforce our commitment, including reviews with oversight from our Board and senior management. In 2020, our review covered our regional hubs (U.S., U.K., France, Ireland, Hong Kong, and Singapore) and India and showed that compensation received by women, on average, was greater than 99 percent of that received by men in comparable positions and, in the U.S., compensation received by people of color was, on average, greater than 99 percent of that received by teammates who are not people of color in comparable positions.We also strive to pay our employees fairly based on market rates for their roles, experience and how they perform, and we regularly benchmark against other companies both within and outside our industry to help ensure our pay is competitive. In the first quarter of 2020, we raised our minimum hourly wage for U.S. employees to $20 per hour, which is above all governmental minimum wage levels in all jurisdictions in which we operate in the U.S.Health and Wellness – 2020 FocusThe Corporation also is committed to supporting employees’ physical, emotional and financial wellness by offering flexible and competitive benefits, including comprehensive health and insurance benefits and wellness resources. In 2020, we took steps to support our employees during the ongoing health crisis resulting from the pandemic, including monitoring guidance from the U.S. Centers for Disease Control and Prevention, medical boards and health authorities and sharing such guidance with our employees. In addition, as a result of the pandemic we transitioned to a work-from-home posture for the substantial majority of our employees and provided various benefits and resources related to the pandemic, including the implementation of child and adult care solutions, offering no-cost COVID-19 testing and mental health resources and additional support for teammates who work in the office, such as transportation and meal subsidies. We continue to engage with state and national governments to understand their vaccination plans for essential workers, including the extent to which that may include some of our employees, and with our employees to educate them about vaccines and the importance of being vaccinated. For more information on our response to the pandemic, including with respect to human capital measures, see Executive Summary – Recent Developments – COVID-19 Pandemic on page 25.Government Supervision and RegulationThe following discussion describes, among other things, elements of an extensive regulatory framework applicable to BHCs, financial holding companies, banks and broker-dealers, including specific information about Bank of America.3 Bank of AmericaWe are subject to an extensive regulatory framework applicable to BHCs, financial holding companies and banks and other financial services entities. U.S. federal regulation of banks, BHCs and financial holding companies is intended primarily for the protection of depositors and the Deposit Insurance Fund (DIF) rather than for the protection of shareholders and creditors.As a registered financial holding company and BHC, the Corporation is subject to the supervision of, and regular inspection by, the Board of Governors of the Federal Reserve System (Federal Reserve). Our U.S. bank subsidiaries (the Banks), organized as national banking associations, are subject to regulation, supervision and examination by the Office of the Comptroller of the Currency (OCC), the Federal Deposit Insurance Corporation (FDIC) and the Federal Reserve. In addition, the Federal Reserve and the OCC have adopted guidelines that establish minimum standards for the design, implementation and board oversight of BHCs’ and national banks’ risk governance frameworks. U.S. financial holding companies, and the companies under their control, are permitted to engage in activities considered “financial in nature” as defined by the Gramm-Leach-Bliley Act and related Federal Reserve interpretations. The Corporation's status as a financial holding company is conditioned upon maintaining certain eligibility requirements for both the Corporation and its U.S. depository institution subsidiaries, including minimum capital ratios, supervisory ratings and, in the case of the depository institutions, at least satisfactory Community Reinvestment Act ratings. Failure to be an eligible financial holding company could result in the Federal Reserve limiting Bank of America's activities, including potential acquisitions.The scope of the laws and regulations and the intensity of the supervision to which we are subject have increased over the past several years, beginning with the response to the financial crisis, as well as other factors such as technological and market changes. In addition, the banking and financial services sector is subject to substantial regulatory enforcement and fines. Many of these changes have occurred as a result of the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act (the Financial Reform Act). We cannot assess whether there will be any additional major changes in the regulatory environment and expect that our business will remain subject to continuing and extensive regulation and supervision.We are also subject to various other laws and regulations, as well as supervision and examination by other regulatory agencies, all of which directly or indirectly affect our entities and management and our ability to make distributions to shareholders. For instance, our broker-dealer subsidiaries are subject to both U.S. and international regulation, including supervision by the SEC, Financial Industry Regulatory Authority and New York Stock Exchange, among others; our futures commission merchant subsidiaries supporting commodities and derivatives businesses in the U.S. are subject to regulation by and supervision of the U.S. Commodity Futures Trading Commission (CFTC), National Futures Association, the Chicago Mercantile Exchange and in the case of the Banks, certain banking regulators; our insurance activities are subject to licensing and regulation by state insurance regulatory agencies; and our consumer financial products and services are regulated by the Consumer Financial Protection Bureau (CFPB).Our non-U.S. businesses are also subject to extensive regulation by various non-U.S. regulators, including governments, securities exchanges, prudential regulators, central banks and other regulatory bodies, in the jurisdictions in which those businesses operate. For example, our financial services entities in the United Kingdom (U.K.), Ireland and France are subject to regulation by the Prudential Regulatory Authority and Financial Conduct Authority, the European Central Bank and Central Bank of Ireland, and the Autorité de Contrôle Prudentiel et de Résolution and Autorité des Marchés Financiers, respectively. Source of StrengthUnder the Financial Reform Act and Federal Reserve policy, BHCs are expected to act as a source of financial strength to each subsidiary bank and to commit resources to support each such subsidiary. Similarly, under the cross-guarantee provisions of the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA), in the event of a loss suffered or anticipated by the FDIC, either as a result of default of a bank subsidiary or related to FDIC assistance provided to such a subsidiary in danger of default, the affiliate banks of such a subsidiary may be assessed for the FDIC’s loss, subject to certain exceptions.Transactions with AffiliatesPursuant to Section 23A and 23B of the Federal Reserve Act, as implemented by the Federal Reserve’s Regulation W, the Banks are subject to restrictions that limit certain types of transactions between the Banks and their nonbank affiliates. In general, U.S. banks are subject to quantitative and qualitative limits on extensions of credit, purchases of assets and certain other transactions involving their nonbank affiliates. Additionally, transactions between U.S. banks and their nonbank affiliates are required to be on arm’s length terms and must be consistent with standards of safety and soundness.Deposit InsuranceDeposits placed at U.S. domiciled banks are insured by the FDIC, subject to limits and conditions of applicable law and the FDIC’s regulations. Pursuant to the Financial Reform Act, FDIC insurance coverage limits are $250,000 per customer. All insured depository institutions are required to pay assessments to the FDIC in order to fund the DIF.The FDIC is required to maintain at least a designated minimum ratio of the DIF to insured deposits in the U.S. The FDIC adopted regulations that establish a long-term target DIF ratio of greater than two percent. As of the date of this report, the DIF ratio is below this required target, and the FDIC has adopted a restoration plan that may result in increased deposit insurance assessments. Deposit insurance assessment rates are subject to change by the FDIC and will be impacted by the overall economy and the stability of the banking industry as a whole. For more information regarding deposit insurance, see Item 1A. Risk Factors – Regulatory, Compliance and Legal on page 16.Capital, Liquidity and Operational RequirementsAs a financial holding company, we and our bank subsidiaries are subject to the regulatory capital and liquidity rules issued by the Federal Reserve and other U.S. banking regulators, including the OCC and the FDIC. These rules are complex and are evolving as U.S. and international regulatory authorities propose and enact amendments to these rules. The Corporation seeks to manage its capital position to maintain sufficient capital to satisfy these regulatory rules and to support our business activities. These continually evolving rules are likely to influence our planning processes and may require additional regulatory capital and liquidity, as well as impose additional operational and compliance costs on the Corporation. For more information on regulatory capital rules, capital composition and pending or proposed regulatory capital Bank of America 4changes, see Capital Management on page 50, and Note 16 – Regulatory Requirements and Restrictions to the Consolidated Financial Statements, which are incorporated by reference in this Item 1.DistributionsWe are subject to various regulatory policies and requirements relating to capital actions, including payment of dividends and common stock repurchases. For instance, Federal Reserve regulations require major U.S. BHCs to submit a capital plan as part of an annual Comprehensive Capital Analysis and Review (CCAR). Our ability to pay dividends and make common stock repurchases depends in part on our ability to maintain regulatory capital levels above minimum requirements plus buffers and non-capital standards established under the FDICIA. To the extent that the Federal Reserve increases our stress capital buffer (SCB), global systemically important bank (G-SIB) surcharge or countercyclical capital buffer, our returns of capital to shareholders could decrease. As part of its CCAR, the Federal Reserve conducts stress testing on parts of our business using hypothetical economic scenarios prepared by the Federal Reserve. Those scenarios may affect our CCAR stress test results, which may impact the level of our SCB. Additionally, the Federal Reserve may impose limitations or prohibitions on taking capital actions such as paying or increasing common stock dividends or repurchasing common stock. For example, as a result of the economic uncertainty resulting from the pandemic, the Federal Reserve required that during the second half of 2020, all large banks, including the Corporation, suspend share repurchase programs, except for repurchases to offset shares awarded under equity-based compensation plans, and limit common stock dividends to existing rates that did not exceed the average of the last four quarters' net income. In the first quarter of 2021, the Federal Reserve lifted the suspension of share repurchase programs and permitted large banks to pay common stock dividends and to repurchase shares in an amount that, when combined with dividends paid, does not exceed the average of net income over the last four quarters. If the Federal Reserve finds that any of our Banks are not “well-capitalized” or “well-managed,” we would be required to enter into an agreement with the Federal Reserve to comply with all applicable capital and management requirements, which may contain additional limitations or conditions relating to our activities. Additionally, the applicable federal regulatory authority is authorized to determine, under certain circumstances relating to the financial condition of a bank or BHC, that the payment of dividends would be an unsafe or unsound practice and to prohibit payment thereof.For more information regarding the requirements relating to the payment of dividends, including the minimum capital requirements, see Note 13 – Shareholders’ Equity and Note 16 – Regulatory Requirements and Restrictions to the Consolidated Financial Statements.Many of our subsidiaries, including our bank and broker-dealer subsidiaries, are subject to laws that restrict dividend payments, or authorize regulatory bodies to block or reduce the flow of funds from those subsidiaries to the parent company or other subsidiaries. The rights of the Corporation, our shareholders and our creditors to participate in any distribution of the assets or earnings of our subsidiaries is further subject to the prior claims of creditors of the respective subsidiaries.Resolution PlanningAs a BHC with greater than $250 billion of assets, the Corporation is required by the Federal Reserve and the FDIC to periodically submit a plan for a rapid and orderly resolution in the event of material financial distress or failure.Such resolution plan is intended to be a detailed roadmap for the orderly resolution of the BHC, including the continued operations or solvent wind down of its material entities, pursuant to the U.S. Bankruptcy Code under one or more hypothetical scenarios assuming no extraordinary government assistance.If both the Federal Reserve and the FDIC determine that the BHC’s plan is not credible, the Federal Reserve and the FDIC may jointly impose more stringent capital, leverage or liquidity requirements or restrictions on growth, activities or operations. A summary of our plan is available on the Federal Reserve and FDIC websites.The FDIC also requires the submission of a resolution plan for Bank of America, National Association (BANA), which must describe how the insured depository institution would be resolved under the bank resolution provisions of the Federal Deposit Insurance Act. A description of this plan is available on the FDIC’s website. We continue to make substantial progress to enhance our resolvability, including simplifying our legal entity structure and business operations, and increasing our preparedness to implement our resolution plan, both from a financial and operational standpoint.Across international jurisdictions, resolution planning is the responsibility of national resolution authorities (RA). Among those, the jurisdictions of most impact to the Corporation are the requirements associated with subsidiaries in the U.K., Ireland and France, where rules have been issued requiring the submission of significant information about locally-incorporated subsidiaries (including information on intra-group dependencies, legal entity separation and barriers to resolution) as well as the Corporation’s banking branches located in those jurisdictions that are deemed to be material for resolution planning purposes. As a result of the RA's review of the submitted information, we could be required to take certain actions over the next several years that could increase operating costs and potentially result in the restructuring of certain businesses and subsidiaries.For more information regarding our resolution plan, see Item 1A. Risk Factors – Liquidity on page 9. Insolvency and the Orderly Liquidation AuthorityUnder the Federal Deposit Insurance Act, the FDIC may be appointed receiver of an insured depository institution if it is insolvent or in certain other circumstances. In addition, under the Financial Reform Act, when a systemically important financial institution (SIFI) such as the Corporation is in default or danger of default, the FDIC may be appointed receiver in order to conduct an orderly liquidation of such institution. In the event of such appointment, the FDIC could, among other things, invoke the orderly liquidation authority, instead of the U.S. Bankruptcy Code, if the Secretary of the Treasury makes certain financial distress and systemic risk determinations. The orderly liquidation authority is modeled in part on the Federal Deposit Insurance Act, but also adopts certain concepts from the U.S. Bankruptcy Code.The orderly liquidation authority contains certain differences from the U.S. Bankruptcy Code. For example, in certain circumstances, the FDIC could permit payment of obligations it determines to be systemically significant (e.g., short-term 5 Bank of Americacreditors or operating creditors) in lieu of paying other obligations (e.g., long-term creditors) without the need to obtain creditors’ consent or prior court review. The insolvency and resolution process could also lead to a large reduction or total elimination of the value of a BHC’s outstanding equity, as well as impairment or elimination of certain debt.Under the FDIC’s “single point of entry” strategy for resolving SIFIs, the FDIC could replace a distressed BHC with a bridge holding company, which could continue operations and result in an orderly resolution of the underlying bank, but whose equity is held solely for the benefit of creditors of the original BHC.Furthermore, the Federal Reserve requires that BHCs maintain minimum levels of long-term debt required to provide adequate loss absorbing capacity in the event of a resolution.For more information regarding our resolution, see Item 1A. Risk Factors – Liquidity on page 9.Limitations on AcquisitionsThe Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 permits a BHC to acquire banks located in states other than its home state without regard to state law, subject to certain conditions, including the condition that the BHC, after and as a result of the acquisition, controls no more than 10 percent of the total amount of deposits of insured depository institutions in the U.S. and no more than 30 percent or such lesser or greater amount set by state law of such deposits in that state. At June 30, 2020, we held greater than 10 percent of the total amount of deposits of insured depository institutions in the U.S.In addition, the Financial Reform Act restricts acquisitions by a financial institution if, as a result of the acquisition, the total liabilities of the financial institution would exceed 10 percent of the total liabilities of all financial institutions in the U.S. At June 30, 2020, our liabilities did not exceed 10 percent of the total liabilities of all financial institutions in the U.S.The Volcker RuleThe Volcker Rule prohibits insured depository institutions and companies affiliated with insured depository institutions (collectively, banking entities) from engaging in short-term proprietary trading of certain securities, derivatives, commodity futures and options for their own account. The Volcker Rule also imposes limits on banking entities’ investments in, and other relationships with, hedge funds and private equity funds. The Volcker Rule provides exemptions for certain activities, including market making, underwriting, hedging, trading in government obligations, insurance company activities and organizing and offering hedge funds and private equity funds. The Volcker Rule also clarifies that certain activities are not prohibited, including acting as agent, broker or custodian. A banking entity with significant trading operations, such as the Corporation, is required to maintain a detailed compliance program to comply with the restrictions of the Volcker Rule. DerivativesOur derivatives operations are subject to extensive regulation globally. These operations are subject to regulation under the Financial Reform Act, the European Union (EU) Markets in Financial Instruments Directive and Regulation, the European Market Infrastructure Regulation, analogous U.K. regulatory regimes and similar regulatory regimes in other jurisdictions, that regulate or will regulate the derivatives markets in which we operate by, among other things: requiring clearing and exchange trading of certain derivatives; imposing new capital, margin, reporting, registration and business conduct requirements for certain market participants; imposing position limits on certain over-the-counter (OTC) derivatives; and imposing derivatives trading transparency requirements. Regulations of derivatives are already in effect in many markets in which we operate. In addition, many G-20 jurisdictions, including the U.S., U.K., Germany and Japan, have adopted resolution stay regulations to address concerns that the close-out of derivatives and other financial contracts in resolution could impede orderly resolution of G-SIBs, and additional jurisdictions are expected to follow suit. Generally, these resolution stay regulations require amendment of certain financial contracts to provide for contractual recognition of stays of termination rights under various statutory resolution regimes and a stay on the exercise of cross-default rights based on an affiliate’s entry into insolvency proceedings. As resolution stay regulations of a particular jurisdiction applicable to us go into effect, we amend impacted financial contracts in compliance with such regulations either as a regulated entity or as a counterparty facing a regulated entity in such jurisdiction. Consumer RegulationsOur consumer businesses are subject to extensive regulation and oversight by federal and state regulators. Certain federal consumer finance laws to which we are subject, including the Equal Credit Opportunity Act, Home Mortgage Disclosure Act, Electronic Fund Transfer Act, Fair Credit Reporting Act, Real Estate Settlement Procedures Act, Truth in Lending Act and Truth in Savings Act, are enforced by the CFPB. Other federal consumer finance laws, such as the Servicemembers Civil Relief Act, are enforced by the OCC. Privacy and Information SecurityWe are subject to many U.S. federal, state and international laws and regulations governing requirements for maintaining policies and procedures regarding the disclosure, use and protection of the non-public confidential information of our customers and employees. The Gramm-Leach-Bliley Act requires us to periodically disclose Bank of America’s privacy policies and practices relating to sharing such information and enables retail customers to opt out of our ability to share information with unaffiliated third parties, under certain circumstances. The Gramm-Leach-Bliley Act and other laws also require us to implement a comprehensive information security program that includes administrative, technical and physical safeguards to provide the security and confidentiality of customer records and information. Security and privacy policies and procedures for the protection of personal and confidential information are in effect across all businesses and geographic locations. Other laws and regulations, at the international, federal and state level, impact our ability to share certain information with affiliates and non-affiliates for marketing and/or non-marketing purposes, or contact customers with marketing offers and establish certain rights of consumers in connection with their personal information. For example, California’s Consumer Privacy Act (CCPA), which went into effect in January 2020, as modified by the California Privacy Rights Act (CPRA), provides consumers with the right to know what personal data is being collected, know whether their personal data is sold or disclosed and to whom and opt out of the sale of their personal data, among other rights. In addition, in the EU, the General Data Protection Regulation (GDPR) replaced the Data Protection Directive and related implementing national laws in its member states. The CCPA's, CPRA's and GDPR’s impact on the Corporation was assessed and addressed through comprehensive compliance implementation programs. These existing and evolving legal requirements in the U.S. and abroad, Bank of America 6as well as court proceedings and changing guidance from regulatory bodies with respect to the validity of cross-border data transfer mechanisms from the EU, continue to lend uncertainty to privacy compliance globally.Item 1A. Risk FactorsThe discussion below addresses the material factors of which we are currently aware that could affect our businesses, results of operations and financial condition. However, other factors not currently known to us or that we currently deem immaterial could also adversely affect our businesses, results of operations and financial condition. Therefore, the risk factors below should not be considered all of the potential risks that we may face. For more information on how we manage risks, see Managing Risk in the MD&A on page 47. For more information about the risks contained in the Risk Factors section, see Item 1. Business on page 2, MD&A on page 24 and Notes to Consolidated Financial Statements on page 101.Coronavirus DiseaseThe effects of the pandemic have adversely affected, and are expected to continue to adversely affect, our businesses and results of operations, and its duration and future impacts on the economy and our businesses, results of operations and financial condition remain uncertain.The negative economic conditions arising from the pandemic negatively impacted our financial results during 2020 in various respects, including contributing to increases in our allowance and provision for credit losses and noninterest expense. These negative economic conditions may have a continued adverse effect on our businesses and results of operations, which could include: decreased demand for and use of our products and services; protracted periods of historically low interest rates; lower fees, including asset management fees; lower sales and trading revenue due to decreased market liquidity resulting from heightened volatility; higher levels of uncollectible reversed charges in our merchant services business; increased noninterest expense, including operational losses; and increased credit losses due to our customers' and clients' inability to fulfill contractual obligations and deterioration in the financial condition of our consumer and commercial borrowers, which may vary by region, sector or industry, that may increase our provision for credit losses and net charge-offs. Our provision for credit losses and net charge-offs may also continue to be impacted by volatility in the energy and commodity markets. Additionally, our liquidity and/or regulatory capital could be adversely impacted by customers’ withdrawal of deposits, volatility and disruptions in the capital and credit markets, volatility in foreign exchange rates and customer draws on lines of credit. Continued adverse macroeconomic conditions could also result in potential downgrades to our credit ratings, negative impacts to regulatory capital and liquidity and further restrictions on dividends and/or common stock repurchases. If we become unable to operate our businesses from remote locations including, for example, because of an internal or external failure of our information technology infrastructure, we experience increased rates of employee illness or unavailability, or governmental restrictions are placed on our employees or operations, this could adversely affect our business continuity status and result in disruption to our businesses. Additionally, we rely on third parties who could experience adverse effects on their business continuity and business interruptions, which could increase our risks and adversely impact our businesses. There can be no assurance that current or future governmental fiscal and monetary relief programs will stimulate the global economy or avert negative economic or market conditions. Our participation in such programs could result in reputational harm and government actions and proceedings, and has resulted in, and may continue to result in, litigation, including class actions. Such actions may result in judgments, settlements, penalties, and fines. Our participation in such programs has also resulted and may continue to result in operational losses, including from the Paycheck Protection Program (PPP) and processing unemployment insurance.We continue to closely monitor the pandemic and related risks as they evolve globally and in the U.S. The magnitude and duration of the pandemic and its future direct and indirect effects on the global economy and our businesses, results of operations and financial condition are highly uncertain and depend on future developments that cannot be predicted, including the likelihood of further surges of COVID-19 cases and the spread of more easily communicable variants of COVID-19, the timing and availability of effective medical treatments and vaccines, future actions taken by governmental authorities, including additional stimulus legislation, and/or other third parties in response to the pandemic. The pandemic may cause prolonged global or national negative economic conditions or longer lasting effects on economic conditions than currently exist, which could have a material adverse effect on our businesses, results of operations and financial condition.Market Our business and results of operations may be adversely affected by the financial markets, fiscal, monetary, and regulatory policies, and economic conditions generally.General economic, political, social and health conditions in the U.S. and in one or more countries abroad affect markets in the U.S. and abroad and our business. In particular, markets in the U.S. or abroad may be affected by the level and volatility of interest rates, availability and market conditions of financing, unexpected changes in gross domestic product (GDP), economic growth or its sustainability, inflation, consumer spending, employment levels, wage stagnation, federal government shutdowns, developments related to the federal debt ceiling, energy prices, home prices, bankruptcies, a default by a significant market participant, fluctuations or other significant changes in both debt and equity capital markets and currencies, liquidity of the global financial markets, the growth of global trade and commerce, trade policies, the availability and cost of capital and credit, disruption of communication, transportation or energy infrastructure and investor sentiment and confidence. Additionally, global markets, including energy and commodity markets, may be adversely affected by the current or anticipated impact of climate change, extreme weather events or natural disasters, the emergence of widespread health emergencies or pandemics, cyber attacks or campaigns, military conflict, terrorism or other geopolitical events. Market fluctuations may impact our margin requirements and affect our business liquidity. Also, any sudden or prolonged market downturn in the U.S. or abroad, as a result of the above factors or otherwise, could result in a decline in net interest income and noninterest income and adversely affect our results of operations and financial condition, including capital and liquidity levels. For example, the global markets, including the energy and commodity markets, experienced significant volatility and disruption as a result of the uncertainty and economic impact of the pandemic. Further uncertainty and ongoing developments in connection with the pandemic, including its further spread, changing consumer and business behaviors, government restrictions in an effort to control the virus and timing and availability of effective medical treatments and vaccines, could 7 Bank of Americaresult in further market volatility and disruptions globally and continue to adversely impact macroeconomic conditions.Actions taken by the Federal Reserve, including changes in its target funds rate, balance sheet management, and lending facilities, and other central banks are beyond our control and difficult to predict. These actions can affect interest rates and the value of financial instruments and other assets and liabilities, and impact our borrowers. The continued protracted period of lower interest rates has resulted in lower revenue through lower net interest income, which has adversely affected our results of operations. Additional periods of lower interest rates or a move to negative interest rates in the U.S., could have a further adverse impact on our net interest income and results of operations. Uncertainty or ongoing developments in connection with the U.K.’s exit from the EU, and the resulting impact on the financial markets and regulations in relevant jurisdictions, could negatively impact our revenues and ongoing operations in Europe and other jurisdictions.Changes to existing U.S. laws and regulatory policies, including those related to financial regulation, taxation, international trade, fiscal policy and healthcare, may adversely impact U.S. or global economic activity and our customers', our counterparties' and our earnings and operations. For example, additional fiscal stimulus and rising debt levels, in the U.S. and abroad, in response to the ongoing pandemic could affect macroeconomic conditions, market liquidity conditions, and interest rates. Significant fiscal policy changes and/or initiatives, including as a result of the change in the U.S. presidential administration and Congress, may also increase uncertainty surrounding the formulation and direction of U.S. monetary policy and volatility of interest rates. Higher U.S. interest rates relative to other major economies could increase the likelihood of a more volatile and appreciating U.S. dollar. Changes, or proposed changes, to certain U.S. trade and international investment policies, particularly with important trading partners (including China and the EU) have negatively impacted and may continue to negatively impact financial markets, disrupt world trade and commerce and lead to trade retaliation, including through the use of tariffs, foreign exchange measures or the large-scale sale of U.S. Treasury Bonds. Further, the use of tariffs among countries not directly involving the U.S. could spread and could damage our customers directly and indirectly.Any of these developments could adversely affect our consumer and commercial businesses, our customers, our securities and derivatives portfolios, including the risk of lower re-investment rates within those portfolios, our level of charge-offs and provision for credit losses, the carrying value of our deferred tax assets, our capital levels, our liquidity and our results of operations. Additionally, the uncertainty related to the transition from Interbank Offered Rates (IBORs) and other benchmark rates to alternative reference rates (ARRs) could negatively impact markets globally and our business, and/or magnify any negative impact of the above referenced factors on our business, customers and results of operations.Increased market volatility and adverse changes in financial or capital market conditions may increase our market risk.Our liquidity, competitive position, business, results of operations and financial condition are affected by market risks such as changes in interest and currency exchange rates, fluctuations in equity and futures prices, lower trading volumes and prices of securitized products, the implied volatility of interest rates and credit spreads and other economic and business factors. These market risks may adversely affect, among other things, the value of our on- and off-balance sheet securities, trading assets and other financial instruments, the cost of debt capital and our access to credit markets, the value of assets under management (AUM), fee income relating to AUM, customer allocation of capital among investment alternatives, the volume of client activity in our trading operations, investment banking fees, the general profitability and risk level of the transactions in which we engage and our competitiveness with respect to deposit pricing. For example, the value of certain of our assets is sensitive to changes in market interest rates. If the Federal Reserve or a non-U.S. central bank changes or signals a change in monetary policy, market interest rates could be affected, which could adversely impact the value of such assets. Changes to fiscal policy, including rapid expansion of U.S. federal deficit spending and resultant debt issuance, could also affect market interest rates. In addition, the low interest rate environment and a flat or inverted yield curve has had and could continue to have a negative impact on our results of operations, including on future revenue and earnings growth.We use various models and strategies to assess and control our market risk exposures, but those are subject to inherent limitations. In times of market stress or other unforeseen circumstances, previously uncorrelated indicators may become correlated and vice versa. These types of market movements may limit the effectiveness of our hedging strategies and cause us to incur significant losses. These changes in correlation can be exacerbated where other market participants are using risk or trading models with assumptions or algorithms similar to ours. In these and other cases, it may be difficult to reduce our risk positions due to activity of other market participants or widespread market dislocations, including circumstances where asset values are declining significantly or no market exists for certain assets. To the extent that we own securities that do not have an established liquid trading market or are otherwise subject to restrictions on sale or hedging, we may not be able to reduce our positions and therefore reduce our risk associated with such positions. We may incur losses if the value of assets decline, including due to changes in interest rates and prepayment speeds.We have a large portfolio of financial instruments, including loans and loan commitments, securities financing agreements, asset-backed secured financings, derivative assets and liabilities, debt securities, marketable equity securities and certain other assets and liabilities that we measure at fair value that are subject to valuation and impairment assessments. We determine these values based on applicable accounting guidance, which for financial instruments measured at fair value, requires an entity to base fair value on exit price and to maximize the use of observable inputs and minimize the use of unobservable inputs in fair value measurements. The fair values of these financial instruments include adjustments for market liquidity, credit quality, funding impact on certain derivatives and other transaction-specific factors, where appropriate.Gains or losses on these instruments can have a direct impact on our results of operations, unless we have effectively hedged our exposures. Increases in interest rates may result in a decrease in residential mortgage loan originations. In addition, increases in interest rates may adversely impact the fair value of debt securities and, accordingly, for debt securities classified as available for sale, may adversely affect accumulated other comprehensive income and, thus, capital levels. Decreases in interest rates may increase prepayment speeds of certain assets, and therefore may adversely affect net interest income.Fair values may be impacted by declining values of the underlying assets or the prices at which observable market Bank of America 8transactions occur and the continued availability of these transactions or indices. The financial strength of counterparties, with whom we have economically hedged some of our exposure to these assets, also will affect the fair value of these assets. Sudden declines and volatility in the prices of assets may curtail or eliminate trading activities in these assets, which may make it difficult to sell, hedge or value these assets. The inability to sell or effectively hedge assets reduces our ability to limit losses in such positions and the difficulty in valuing assets may increase our risk-weighted assets (RWA), which requires us to maintain additional capital and increases our funding costs. Values of AUM also impact revenues in our wealth management and related advisory businesses for asset-based management and performance fees. Declines in values of AUM can result in lower fees earned for managing such assets.LiquidityIf we are unable to access the capital markets or continue to maintain deposits, or our borrowing costs increase, our liquidity and competitive position will be negatively affected.Liquidity is essential to our businesses. We fund our assets primarily with globally sourced deposits in our bank entities, as well as secured and unsecured liabilities transacted in the capital markets. We rely on certain secured funding sources, such as repo markets, which are typically short-term and credit-sensitive in nature. We also engage in asset securitization transactions, including with the government-sponsored enterprises (GSEs), to fund consumer lending activities. Our liquidity could be adversely affected by any inability to access the capital markets, illiquidity or volatility in the capital markets, the decrease in value of eligible collateral or increased collateral requirements (including as a result of credit concerns for short-term borrowing), changes to our relationships with our funding providers based on real or perceived changes in our risk profile, prolonged federal government shutdowns, or changes in regulations, guidance or GSE status that impact our funding avenues or ability to access certain funding sources. Additionally, our liquidity may be negatively impacted by the unwillingness or inability of the Federal Reserve to act as lender of last resort, unexpected simultaneous draws on lines of credit, slower customer payment rates, restricted access to the assets of prime brokerage clients, the withdrawal of or failure to attract customer deposits or invested funds (which could result from customer attrition for higher yields, the desire for more conservative alternatives or our customers’ increased need for cash), increased regulatory liquidity, capital and margin requirements for our U.S. or international banks and their nonbank subsidiaries, changes in patterns of intraday liquidity usage resulting from a counterparty or technology failure or other idiosyncratic event or failure or default by a significant market participant or third party (including clearing agents, custodians or central counterparties (CCPs)). These factors also have the potential to increase our borrowing costs. Several of these factors may arise due to circumstances beyond our control, such as general market volatility, disruption, shock or stress, the emergence of widespread health emergencies or pandemics, Federal Reserve policy decisions (including fluctuations in interest rates or Federal Reserve balance sheet composition), negative views about the Corporation (including short- and long-term business prospects) or the financial services industry generally or due to a specific news event, changes in the regulatory environment or governmental fiscal or monetary policies (including as a result of the change in the U.S. presidential administration and Congress), actions by credit rating agencies or an operational problem that affects third parties or us. The impact of these events, whether within our control or not, could include an inability to sell assets or redeem investments, unforeseen outflows of cash, the need to draw on liquidity facilities, the reduction of financing balances and the loss of equity secured funding, debt repurchases to support the secondary market or meet client requests, the need for additional funding for commitments and contingencies and unexpected collateral calls, among other things, the result of which could be increased costs, a liquidity shortfall and/or impact on our liquidity coverage ratio.Our liquidity and cost of obtaining funding is directly related to prevailing market conditions, including changes in interest and currency exchange rates, fluctuations in equity and futures prices, lower trading volumes and prices of securitized products and our credit spreads. Credit spreads are the amount in excess of the interest rate of U.S. Treasury securities, or other benchmark securities, of a similar maturity that we need to pay to our funding providers. Increases in interest rates and our credit spreads can increase the cost of our funding and result in mark-to-market or credit valuation adjustment exposures. Changes in our credit spreads are market-driven and may be influenced by market perceptions of our creditworthiness. Changes to interest rates and our credit spreads occur continuously and may be unpredictable and highly volatile. We may also experience spread compression as a result of offering higher than expected deposit rates in order to attract and maintain deposits due to increased marketplace rate competition. Additionally, concentrations within our funding profile, such as maturities, currencies or counterparties, can reduce our funding efficiency.Reduction in our credit ratings could significantly limit our access to funding or the capital markets, increase borrowing costs or trigger additional collateral or funding requirements.Our borrowing costs and ability to raise funds are directly impacted by our credit ratings. In addition, credit ratings may be important to customers or counterparties when we compete in certain markets and seek to engage in certain transactions, including OTC derivatives. Credit ratings and outlooks are opinions expressed by rating agencies on our creditworthiness and that of our obligations or securities, including long-term debt, short-term borrowings, preferred stock and asset securitizations. Our credit ratings are subject to ongoing review by rating agencies, which consider a number of factors, including our financial strength, performance, prospects and operations and factors not under our control, such as the macroeconomic and geopolitical environment, including the macroeconomic stress caused by the pandemic. Rating agencies could make adjustments to our credit ratings at any time, and there can be no assurance as to when and whether downgrades will occur. A reduction in certain of our credit ratings could result in a wider credit spread and negatively affect our liquidity, access to credit markets, the related cost of funds, our businesses and certain trading revenues, particularly in those businesses where counterparty creditworthiness is critical. If the short-term credit ratings of our parent company, or bank or broker-dealer subsidiaries, were downgraded by one or more levels, we may suffer the potential loss of access to short-term funding sources such as repo financing, and/or incur increased cost of funds and increased collateral requirements. Under the terms of certain OTC derivative contracts and other trading agreements, if our or our subsidiaries’ credit ratings are downgraded, the counterparties may require additional collateral or terminate these contracts or agreements.9 Bank of AmericaWhile certain potential impacts are contractual and quantifiable, the full consequences of a credit rating downgrade to a financial institution are inherently uncertain, as they depend upon numerous dynamic, complex and inter-related factors and assumptions, including whether any downgrade of a firm’s long-term credit ratings precipitates downgrades to its short-term credit ratings, and assumptions about the potential behaviors of various customers, investors and counterparties.Bank of America Corporation is a holding company, is dependent on its subsidiaries for liquidity and may be restricted from transferring funds from subsidiaries. Bank of America Corporation, as the parent company, is a separate and distinct legal entity from our bank and nonbank subsidiaries. We evaluate and manage liquidity on a legal entity basis. Legal entity liquidity is an important consideration as there are legal, regulatory, contractual and other limitations on our ability to utilize liquidity from one legal entity to satisfy the liquidity requirements of another, including the parent company, which could result in adverse liquidity events. The parent company depends on dividends, distributions, loans and other payments from our bank and nonbank subsidiaries to fund dividend payments on our common stock and preferred stock and to fund all payments on our other obligations, including debt obligations. Any inability of our subsidiaries to pay dividends or make payments to us may adversely affect our cash flow and financial condition.Many of our subsidiaries, including our bank and broker-dealer subsidiaries, are subject to laws that restrict dividend payments, or authorize regulatory bodies to block or reduce the flow of funds from those subsidiaries to the parent company or other subsidiaries. Our bank and broker-dealer subsidiaries are subject to restrictions on their ability to lend or transact with affiliates and to minimum regulatory capital and liquidity requirements, as well as restrictions on their ability to use funds deposited with them in bank or brokerage accounts to fund their businesses. Intercompany arrangements we entered into in connection with our resolution planning submissions could restrict the amount of funding available to the parent company from our subsidiaries under certain adverse conditions.Additional restrictions on related party transactions, increased capital and liquidity requirements and additional limitations on the use of funds on deposit in bank or brokerage accounts, as well as lower earnings, can reduce the amount of funds available to meet the obligations of the parent company and even require the parent company to provide additional funding to such subsidiaries. Also, regulatory action that requires additional liquidity at each of our subsidiaries could impede access to funds we need to pay our obligations or pay dividends. In addition, our right to participate in a distribution of assets upon a subsidiary’s liquidation or reorganization is subject to prior claims of the subsidiary’s creditors. Our liquidity and financial condition, and the ability to pay dividends to shareholders and to pay obligations could be materially adversely affected in the event of a resolution.Bank of America Corporation, our parent holding company, is required to periodically submit a plan to the FDIC and Federal Reserve describing its resolution strategy under the U.S. Bankruptcy Code in the event of material financial distress or failure. In the current plan, Bank of America Corporation’s preferred resolution strategy is a “single point of entry” strategy. This strategy provides that only the parent holding company files for resolution under the U.S. Bankruptcy Code and contemplates providing certain key operating subsidiaries with sufficient capital and liquidity to operate through severe stress and to enable such subsidiaries to continue operating or be wound down in a solvent manner following a bankruptcy of the parent holding company. Bank of America Corporation has entered into intercompany arrangements resulting in the contribution of most of its capital and liquidity to key subsidiaries. Pursuant to these arrangements, if Bank of America Corporation’s liquidity resources deteriorate so severely that resolution becomes imminent, Bank of America Corporation will no longer be able to draw liquidity from its key subsidiaries, and will be required to contribute its remaining financial assets to a wholly-owned holding company subsidiary, which could materially and adversely affect our liquidity and financial condition and the ability to return capital to shareholders, including through the payment of dividends and repurchase of the Corporation’s common stock, and meet our payment obligations.If the FDIC and Federal Reserve jointly determine that Bank of America Corporation’s resolution plan is not credible, they could impose more stringent capital, leverage or liquidity requirements or restrictions on our growth, activities or operations. We could also be required to take certain actions that could impose operating costs and could potentially result in the divestiture or restructuring of businesses and subsidiaries.Additionally, under the Financial Reform Act, when a G-SIB such as Bank of America Corporation is in default or danger of default, the FDIC may be appointed receiver in order to conduct an orderly liquidation of such institution. In the event of such appointment, the FDIC could, among other things, invoke the orderly liquidation authority, instead of the U.S. Bankruptcy Code, if the Secretary of the Treasury makes certain financial distress and systemic risk determinations. In 2013, the FDIC issued a notice describing its preferred “single point of entry” strategy for resolving a G-SIB. Under this approach, the FDIC could replace Bank of America Corporation with a bridge holding company, which could continue operations and result in an orderly resolution of the underlying bank, but whose equity would be held solely for the benefit of our creditors. The FDIC’s “single point of entry” strategy may result in our security holders suffering greater losses than would have been the case under a bankruptcy proceeding or a different resolution strategy.Credit Economic or market disruptions and insufficient credit loss reserves may result in a higher provision for credit losses.A number of our products expose us to credit risk, including loans, letters of credit, derivatives, debt securities, trading account assets and assets held-for-sale. Deterioration in the financial condition of our consumer and commercial borrowers, counterparties or underlying collateral could adversely affect our financial condition and results of operations.Our credit portfolios may be impacted by global and U.S. macroeconomic and market conditions, events and disruptions, including sustained weakness in GDP, consumer-spending declines, property value declines or asset-price corrections, increasing consumer and corporate leverage, increases in corporate bond spreads, rising or elevated unemployment levels, fluctuations in foreign exchange or interest rates, widespread health emergencies or pandemics, extreme weather events and the impacts of climate change and domestic and global efforts to transition to a low-carbon economy. Significant economic or market stresses and disruptions typically have a negative impact on the business environment and financial markets. Property value declines or asset-price corrections could increase the risk of borrowers or counterparties defaulting or becoming delinquent in their obligations to us, which could increase credit losses. Simultaneous drawdowns on lines of credit and/or an increase in a borrower’s leverage in a Bank of America 10weakening economic environment could result in deterioration in our credit portfolio, should borrowers be unable to fulfill competing financial obligations. Credit portfolio deterioration could also be magnified by lending to leveraged borrowers, elevated asset prices or declining property or collateral values unrelated to macroeconomic stress. Increased delinquency and default rates could adversely affect our consumer credit card, home equity and residential mortgage portfolios through increased charge-offs and provision for credit losses. Beginning in the first quarter of 2020, the pandemic resulted in changes to consumer and business behaviors and restrictions on economic activity, which have negatively impacted the global economy and could continue to negatively impact our consumer and commercial credit portfolios. Accordingly, we increased our allowance for credit losses as a result of the expected macroeconomic impact of COVID-19, which has adversely affected our results of operations. Although the economy, including GDP, and unemployment have improved since the first half of 2020, certain sectors remain significantly impacted (e.g., hospitality, entertainment and travel). As COVID-19 cases have surged in the fourth quarter of 2020 and early 2021, compared to earlier levels, and restrictions on economic activity have been reintroduced in certain geographies, there remains significant uncertainty on what the ultimate impact the pandemic will have on the economy and our allowance for credit losses.We establish an allowance for credit losses, which includes the allowance for loan and lease losses and the reserve for unfunded lending commitments, based on management's best estimate of lifetime expected credit losses inherent in the Corporation's relevant financial assets. The process to determine the allowance requires us to make difficult and complex judgments, including forecasting how borrowers will perform in changing and unprecedented economic conditions and predicting developments in public health and fiscal policy related to the pandemic. The ability of our borrowers or counterparties to repay their obligations will likely be impacted by changes in future economic conditions, which in turn could impact the accuracy of our loss forecasts and allowance estimates. There is also the possibility that we have failed or will fail to accurately identify the appropriate economic indicators or accurately estimate their impacts to our borrowers, which similarly could impact the accuracy of our loss forecasts and allowance estimates.We may suffer unexpected losses if the models and assumptions we use to establish reserves or the judgments we make in extending credit to our borrowers or counterparties, which are more sensitive due to the uncertainty regarding the magnitude and duration of the pandemic and related macroeconomic impact, prove inaccurate in predicting future events. In addition, changes to external factors can negatively impact our recognition of credit losses in our portfolios and allowance for credit losses. As of January 1, 2020, we implemented a new accounting standard to estimate our allowance for credit losses. Although we believe that the allowance for credit losses is in compliance with the new accounting standard, there is no guarantee that it will be sufficient to address credit losses, particularly if the economic outlook deteriorates significantly. In such an event, we may increase our allowance which would reduce our earnings. Additionally, to the extent that economic conditions worsen as a result of COVID-19 or otherwise, impacting our consumer and commercial borrowers, counterparties or underlying collateral, and credit losses are worse than expected, we may further increase our provision for credit losses, which could have a further adverse effect on our results of operations and could negatively impact our financial condition. Our concentrations of credit risk could adversely affect our credit losses, results of operations and financial condition. In the ordinary course of our business, we may be subject to concentrations of credit risk because of a common characteristic or common sensitivity to economic, financial, public health or business developments. For example, concentrations in credit risk may result in a particular industry, geography, product, asset class, counterparty, individual exposure or within any pool of exposures with a common risk characteristic. A deterioration in the financial condition or prospects of a particular industry, geographic location, product or asset class, or a failure or downgrade of, or default by, any particular entity or group of entities could negatively affect our businesses, and it is possible our limits and credit monitoring exposure controls will not function as anticipated.While our activities expose us to many different industries and counterparties, we routinely execute a high volume of transactions with counterparties in the financial services industry, including broker-dealers, commercial banks, investment banks, insurers, mutual funds and hedge funds, central counterparties and other institutional clients, resulting in significant credit concentration with respect to this industry. Financial services institutions and other counterparties are inter-related because of trading, funding, clearing or other relationships. As a result, defaults by one or more counterparties, or market uncertainty about the financial stability of one or more financial services institutions, or the financial services industry generally, could lead to market-wide liquidity disruptions, losses and defaults.Many of these transactions expose us to credit risk and, in some cases, disputes and litigation in the event of default of a counterparty. In addition, our credit risk may be heightened by market risk when the collateral held by us cannot be liquidated or is liquidated at prices not sufficient to recover the full amount of the loan or derivatives exposure due to us, which may occur as a result of fraud or other events that impact the value of the collateral. Further, disputes with obligors as to the valuation of collateral could increase in times of significant market stress, volatility or illiquidity, and we could suffer losses during such periods if we are unable to realize the fair value of the collateral or manage declines in the value of collateral.Our commercial portfolios include exposures to certain industries, including asset managers and funds, real estate, capital goods and finance companies. Economic weaknesses, adverse business conditions, market disruptions, rising interest or capitalization rates, the collapse of speculative bubbles, greater volatility in areas where we have concentrated credit risk or deterioration in real estate values or household incomes may cause us to experience a decrease in cash flow and higher credit losses in either our consumer or commercial portfolios or cause us to write down the value of certain assets. Additionally, we could experience continued and long-term negative impact to our commercial credit exposure and an increase in credit losses within those industries that continue to be disproportionately impacted by COVID-19 or are permanently impacted by a change in consumer preferences resulting from COVID-19 (including hospitality, entertainment and travel). Furthermore, we have concentrations of credit risk with respect to our consumer real estate, auto, consumer credit card and commercial real estate portfolios, which represent a significant percentage of our overall credit portfolio. Decreases in home price valuations or commercial real estate valuations in certain markets where we have large concentrations, as well as 11 Bank of Americamore broadly within the U.S. or globally, could result in increased defaults, delinquencies or credit loss. In particular, the impact of climate change, such as rising average global temperatures and rising sea levels, and the increasing frequency and severity of extreme weather events and natural disasters such as droughts, floods, wildfires and hurricanes could negatively impact collateral, the valuations of home prices or commercial real estate or our customers’ ability and/or willingness to pay outstanding loans. This could also cause insurability risk and/or increased insurance costs to customers. We also enter into transactions with sovereign nations, U.S. states and municipalities. Unfavorable economic or political conditions, disruptions to capital markets, currency fluctuations, changes in oil prices, social instability and changes in government or monetary policies could adversely impact the operating budgets or credit ratings of these government entities and expose us to credit risk.Liquidity disruptions in the financial markets may result in our inability to sell, syndicate or realize the value of our positions, leading to increased concentrations, which could increase the credit and market risk associated with our positions, as well as increase our RWA.We may be adversely affected if the U.S. housing market weakens or home prices decline. U.S. home prices continued to generally remain stable or increase in 2020, supported by single-family housing demand and low interest rates. However, changes in business and household behaviors and restrictions on activity in response to the pandemic have had a negative impact on some property markets, particularly in high-density urban areas. We remain conscious of geographic markets where housing price growth has slowed or decreased, or is vulnerable to lasting shifts in demand due to the pandemic, as further declines in future periods may negatively impact the demand for many of our products. Additionally, our mortgage loan production volume is generally influenced by the rate of growth in residential mortgage debt outstanding and the size of the residential mortgage market, both of which may be adversely affected by rising interest rates. Conditions in the U.S. housing market during the 2008 financial crisis resulted in both significant write-downs of asset values in several asset classes, notably mortgage-backed securities, and exposure to monolines. If the U.S. housing market were to weaken, the value of real estate could decline, which could result in increased credit losses and delinquent servicing expenses and negatively affect our representations and warranties exposures, and adversely affect our financial condition and results of operations.Our derivatives businesses may expose us to unexpected risks and potential losses.We are party to a large number of derivatives transactions that may expose us to unexpected market, credit and operational risks that could cause us to suffer unexpected losses. Severe declines in asset values, unanticipated credit events or unforeseen circumstances that may cause previously uncorrelated factors to become correlated and vice versa, may create losses resulting from risks not appropriately taken into account or anticipated in the development, structuring or pricing of a derivative instrument. Certain OTC derivative contracts and other trading agreements provide that upon the occurrence of certain specified events, such as a change in the credit rating of the Corporation or one or more of its affiliates, we may be required to provide additional collateral or take other remedial actions and could experience increased difficulty obtaining funding or hedging risks. In some cases our counterparties may have the right to terminate or otherwise diminish our rights under these contracts or agreements.We are also a member of various central counterparties (CCPs), in part due to regulatory requirements for mandatory clearing of derivative transactions, which potentially increases our credit risk exposures to CCPs. In the event that one or more members of the CCP defaults on its obligations, we may be required to pay a portion of any losses incurred by the CCP as a result of that default. A CCP may modify, in its discretion, the margin we are required to post, which could mean unexpected and increased exposure to the CCP. As a clearing member, we are exposed to the risk of non-performance by our clients for which we clear transactions, which may not be covered by available collateral. Additionally, default by a significant market participant may result in further risk and potential losses.GeopoliticalWe are subject to numerous political, economic, market, reputational, operational, legal, regulatory and other risks in the jurisdictions in which we operate.We do business throughout the world, including in emerging markets. Economic or geopolitical stress in one or more countries could have a negative impact regionally or globally, resulting in, among other things, market volatility, reduced market value and economic output. Our businesses and revenues derived from non-U.S. jurisdictions are subject to risk of loss from currency fluctuations, financial, social or judicial instability, changes in government leadership, including as a result of electoral outcomes or otherwise, changes in governmental policies or policies of central banks, expropriation, nationalization and/or confiscation of assets, price controls, high inflation, natural disasters, the emergence of widespread health emergencies or pandemics, capital controls, currency redenomination risk, exchange controls, unfavorable political and diplomatic developments, oil price fluctuations and changes in legislation. These risks are especially elevated in emerging markets. Additionally, protectionist trade policies and continued trade tensions between the U.S. and important trading partners, particularly China and the EU, including the risk that tariffs continue to rise and other restrictive actions on cross-border trade, investment, and transfer of information technology are taken that weigh heavily on regional trade volumes and domestic demand through falling business sentiment and lower consumer confidence, could adversely affect our businesses and revenues, as well as our customers and counterparties. Elevated tensions between the U.S. and China also raise the risk that current or future U.S. sanctions against individuals or export controls targeting Chinese firms could prompt retaliatory responses, potentially impacting our operations and revenue.Additionally, the realization of any significant geopolitical events, negative market conditions and/or change in market dynamics as a result of the U.K.’s exit from the EU could adversely impact our businesses. The short- and long-term impact of the U.K.’s exit from the EU on European and global macroeconomic conditions, our business operations and results of operations remain unknown.A number of non-U.S. jurisdictions in which we do business have been or may be negatively impacted by slowing growth or recessionary conditions, market volatility and/or political or civil unrest. The ongoing pandemic has had a severe negative impact on global GDP, and the global economic environment remains challenging even as output has begun to improve. Economic weakness may prove persistent in many countries and regions, including Europe, Japan, and numerous emerging markets. Potential risks of default on or devaluation of sovereign debt in some non-U.S. jurisdictions could expose us to substantial losses. As a result of the pandemic and fiscal policy responses Bank of America 12to it, government debt levels have increased significantly, raising the risk of volatility, significant valuation changes, or default in markets for sovereign debt. Risks in one nation can limit our opportunities for portfolio growth and negatively affect our operations in other nations, including our U.S. operations. Market and economic disruptions of all types may affect consumer confidence levels and spending, corporate investment and job creation, bankruptcy rates, levels of incurrence and default on consumer and corporate debt, economic growth rates and asset values, among other factors. Any such unfavorable conditions or developments could adversely impact us.We also invest or trade in the securities of corporations and governments located in non-U.S. jurisdictions, including emerging markets. Revenues from the trading of non-U.S. securities may be subject to negative fluctuations as a result of the above factors. Furthermore, the impact of these fluctuations could be magnified because non-U.S. trading markets, particularly in emerging markets, are generally smaller, less liquid and more volatile than U.S. trading markets.Our non-U.S. businesses are also subject to extensive regulation by governments, securities exchanges and regulators, central banks and other regulatory bodies. In many countries, the laws and regulations applicable to the financial services and securities industries are uncertain and evolving, and it may be difficult for us to determine the exact requirements of local laws in every market or manage our relationships with multiple regulators in various jurisdictions. Our potential inability to remain in compliance with local laws in a particular market and manage our relationships with regulators could result in increased expenses and changes to our organizational structure and adversely affect our businesses and results of operations in that market, as well as our reputation in general.In connection with the U.K.’s exit from the EU, we are now subject to different laws, regulations and regulatory authorities and increased organizational and operational complexity. We may incur additional costs and/or experience negative tax consequences as a result of operating our principal EU banking and broker-dealer operations outside of the U.K., which could adversely impact our EU business, results of operations and operational model. Further, changes to the legal and regulatory framework under which our subsidiaries provide products and services in the U.K. and in the EU may result in additional compliance costs and have negative tax consequences or an adverse impact on our results of operations.In addition to non-U.S. legislation, our international operations are also subject to U.S. legal requirements, which subjects us to operational and compliance costs and risks. For example, our operations are subject to U.S. and non-U.S. laws and regulations relating to bribery and corruption, anti-money laundering, and economic sanctions, which can vary by jurisdiction. The increasing speed and novel ways in which funds circulate could make it more challenging to track the movement of funds and heightens financial crimes risk. Our ability to comply with these legal requirements depends on our ability to continually improve surveillance, detection and reporting and analytic capabilities.In the U.S., debt ceiling and budget deficit concerns, which have increased the possibility of U.S. government defaults on its debt and/or downgrades to its credit ratings, and prolonged government shutdowns could negatively impact the global economy and banking system and adversely affect our financial condition, including our liquidity. Additionally, changes in fiscal, monetary or regulatory policy, including as a result of the change in the U.S. presidential administration and Congress, could increase our compliance costs and adversely affect our business operations, organizational structure and results of operations. We are also subject to geopolitical risks, including economic sanctions, acts or threats of international or domestic terrorism, actions taken by the U.S. or other governments in response thereto, state-sponsored cyber attacks or campaigns, civil unrest and/or military conflicts, which could adversely affect business and economic conditions abroad and in the U.S.Business OperationsA failure in or breach of our operational or security systems or infrastructure or business continuity plans, or those of third parties or the financial services industry, could disrupt our critical business operations and customer services, result in regulatory, market, privacy, liquidity and operational risk exposures, and adversely impact our results of operations and financial condition, and cause legal or reputational harm.The potential for operational risk exposure exists throughout our organization and as a result of our interactions with, and reliance on, third parties (including their downstream service providers) and the financial services industry infrastructure. Our operational and security systems infrastructure, including our computer systems, emerging technologies, data management and internal processes, as well as those of third parties, are integral to our performance. We also rely on our employees and third parties (including downstream service providers) in our day-to-day and ongoing operations, who may, as a result of human error, misconduct (including fraudulent activity), malfeasance or a failure or breach of systems or infrastructure cause disruptions to our organization and expose us to operational and regulatory risk. Additionally, our financial, accounting, data processing and transmission, storage, backup or other operating or security systems and infrastructure, or those of third parties with whom we interact or upon whom we rely may fail to operate properly or become disabled or damaged as a result of a number of factors including events that are wholly or partially beyond our or such third party’s control, which could adversely affect our ability to process transactions or provide services. We could also experience prolonged computer and network outages resulting in disruptions to our critical business operations and customer services, including abuse or failure of our electronic trading and algorithmic platforms. We may experience sudden increases in customer transaction volume or electrical, telecommunications or other major physical infrastructure outages, newly identified vulnerabilities in key hardware or software, failure of aging infrastructure and technology project implementation challenges, which could result in prolonged operational outages. Climate change is increasing the frequency and severity of natural disasters, such as earthquakes, wildfires, tornadoes, hurricanes and floods, which could result in increased exposure to operational risks, including outages. Additionally, events arising from local or larger scale political or social matters, including civil unrest and terrorist acts, could result in operational disruptions and prolonged operational outages. Additionally, the Corporation and the third parties on which it relies have been and will likely continue to be subject to additional operational risks while operating in a work-from-home posture (which places greater reliance on remote access tools and technology and employees’ personal systems), while executing business continuity plans due to COVID-19. We are increasingly dependent upon our information technology infrastructure to operate our businesses remotely due to our work-from-home posture and evolving customer preferences, including increased reliance on digital banking and other digital 13 Bank of Americaservices provided by our businesses. Effective management of our work-from-home posture depends on the security, reliability and adequacy of such systems. We are also at greater risk of business disruptions due to illness and unavailability. Regardless of the measures we have taken to implement training, procedures, backup systems and other safeguards to support our operations and bolster our operational resilience, our ability to conduct business may be adversely affected by any significant disruptions to us or to third parties (including their downstream service providers) with whom we interact or upon whom we rely, including systemic cyber events that result in system outages and unavailability of part or all of the financial services industry infrastructure. Our ability to implement backup systems and other safeguards with respect to third-party systems and the financial services industry infrastructure is more limited than with respect to our own systems.Furthermore, to the extent that backup systems are available and utilized, they may not process data as quickly as our primary systems and some data might not have been backed up. We regularly update the systems on which we rely to support our operations and growth and to remain compliant with all applicable laws, rules and regulations globally. This updating entails significant costs and creates risks associated with implementing new systems and integrating them with existing ones, including business interruptions. A failure or breach of our operational or security systems or infrastructure or business continuity plans resulting in disruption to our critical business operations and customer services could expose us to regulatory, market, privacy and liquidity risk, and adversely impact our results of operations and financial condition, as well as cause legal or reputational harm.A cyber attack, information or security breach, or a technology failure of ours or of a third party could adversely affect our ability to conduct our business, manage our exposure to risk or expand our businesses, result in the disclosure or misuse of confidential or proprietary information, and/or fraudulent activity, and increase our costs to maintain and update our operational and security systems and infrastructure.Our business is highly dependent on the security, controls and efficacy of our infrastructure, computer and data management systems, as well as those of our customers, suppliers, counterparties and other third parties (including their downstream service providers) the financial services industry and financial data aggregators, with whom we interact, on whom we rely or who have access to our customers' personal or account information. Our business relies on effective access management and the secure collection, processing, transmission, storage and retrieval of confidential, proprietary, personal and other information in our computer and data management systems and networks, and in the computer and data management systems and networks of third parties. In addition, to access our network, products and services, our employees, customers, suppliers, counterparties and other third parties increasingly use personal mobile devices or computing devices that are outside of our network and control environments and are subject to their own cybersecurity risks.We, our employees and customers, regulators and other third parties (including contractors and vendors) are regularly the target of cyber attacks and are likely to continue to be the target of cyber attacks. These cyber attacks are pervasive, sophisticated, evolving, difficult to prevent and include computer viruses, malicious or destructive code (such as ransomware), social engineering (including phishing, vishing and smithing), denial of service or information or other security breach tactics that could result in the unauthorized release, gathering, monitoring, misuse, loss or destruction or theft of confidential, proprietary and other information, including intellectual property, of ours, our employees, our customers or of third parties. These cyber attacks could also result in damages to systems, financial risk or otherwise material disruption to our or our customers’ or other third parties’ network access or business operations, both domestically and internationally. Our cybersecurity risk and exposure remains heightened because of, among other things, the evolving nature and pervasiveness of cyber threats, our prominent size and scale, our geographic footprint and international presence and our role in the financial services industry and the broader economy. Additionally, our risk and exposure to cyber attacks and security breaches is magnified due to our work-from-home posture which places greater reliance on remote access tools and technology, resulting in a larger number of access points to our networks that must be secured. This increased risk of unauthorized access to our networks results in greater amounts of information being available for access from employees’ personal devices over which we do not have the same controls as we do in a non-work-from-home posture. Additionally, our customers’ increasing reliance on digital banking and other digital services provided by our businesses in response to COVID-19, has resulted in more demand on our information technology infrastructure and security tools and processes. The financial services industry is particularly at risk because of the proliferation of new and emerging technologies, including third-party financial data aggregators, and the use of the internet and telecommunications technologies to conduct financial transactions. Additionally, our use of automation, artificial intelligence (AI) and robotics, increased use of internet and mobile banking products, including mobile payment and other web- and cloud-based products and applications and plans to use or develop additional remote connectivity solutions increase our cybersecurity risks and exposure.Additionally, we have exposure to cyber threats as a result of our continuous transmission of sensitive information to, and storage of such information by, third parties, including our vendors and regulators, the outsourcing of some of our business operations, and system and customer account updates and conversions. Cybersecurity risks have also significantly increased in recent years in part due to the increasingly sophisticated activities of organized crime groups, hackers, terrorist organizations, extremist parties, hostile foreign governments and state-sponsored actors, in some instances acting to promote political ends. We could also be the target of disgruntled employees or vendors, activists and other parties, including those involved in corporate espionage. Cyber threats and the techniques used in cyber attacks change rapidly and frequently. Despite substantial efforts to protect the integrity and resilience of our systems and implement controls, processes, policies and other protective measures, we may not be able to anticipate cyber attacks or information or security breaches and implement effective preventive or defensive measures to address or mitigate such attacks or breaches. Even the most advanced internal control environment is vulnerable to compromise. Internal access management failures could result in the compromise or unauthorized exposure of confidential data.Cyber attacks or security breaches could persist for an extended period of time before being detected. It could take considerable additional time for us to determine the scope, extent, amount, and type of information compromised, at which time the impact on the Corporation and measures to recover and restore to a business-as-usual state may be difficult to Bank of America 14assess. As cyber threats continue to evolve, we may be required to expend significant additional resources to modify or enhance our protective measures, investigate and remediate any information security vulnerabilities or incidents and develop our capabilities to respond and recover. As a result, increasing resources to develop and enhance our controls, processes and practices designed to protect our systems, workstations, intellectual property and proprietary information, software, data and networks from attack, damage or unauthorized access, remains a critical priority.We also face indirect technology, cybersecurity and operational risks relating to the customers, clients and other third parties (including their downstream service providers) and the financial services industry, with whom we do business, upon whom we rely to facilitate or enable our business activities or upon whom our customers rely. Such third parties also include financial counterparties, financial data aggregators, financial intermediaries, such as clearing agents, exchanges and clearing houses, vendors, regulators, providers of critical infrastructure, such as internet access and electrical power, and retailers for whom we process transactions. As a result of increasing consolidation, interdependence and complexity of financial entities and technology systems, a technology failure, cyber attack or other information or security breach that significantly degrades, deletes or compromises the systems or data of one or more financial entities or third parties (or their downstream service providers) could have a material impact on counterparties or other market participants, including us. Similarly, any failure, cyber attack or other information or security breach that significantly degrades, deletes or compromises our systems or data could adversely impact third parties, counterparties and the financial services industry infrastructure, which in turn could harm our reputation and damage our business. This consolidation, interconnectivity and complexity increases the risk of operational failure, on both individual and industry-wide bases, as disparate systems need to be integrated, often on an accelerated basis. Any technology failure, cyber attack or other information or security breach, termination or constraint of any third party (including their downstream service providers) the financial services industry infrastructure or financial data aggregators, could, among other things, adversely affect our ability to conduct day-to-day business activities, effect transactions, service our clients, manage our exposure to risk or expand our businesses, result in the misappropriation or destruction of the personal, proprietary or confidential information of our employees, customers, suppliers, counterparties and other third parties or result in fraudulent or unauthorized transactions. Further, any such event may not be disclosed to us in a timely manner.Although to date we have not experienced any material losses or other material consequences relating to technology failure, cyber attacks or other information or security breaches, whether directed at us or third parties, there can be no assurance that our controls and procedures in place to monitor and mitigate the risks of cyber threats will be sufficient and that we will not suffer material losses or consequences in the future. Cyber attacks or other information or security breaches, whether directed at us or third parties, may result in significant lost revenue, give rise to losses and claims brought by third parties, government penalties and other negative consequences. Furthermore, the public perception that a cyber attack on our systems has been successful, whether or not this perception is correct, may damage our reputation with customers and third parties with whom we do business. Although we maintain cyber insurance, there can be no assurance that liabilities or losses we may incur will be covered under such policies or that the amount of insurance will be adequate.Also, successful penetration or circumvention of system security could result in negative consequences, including loss of customers and business opportunities, the withdrawal of customer deposits, prolonged computer and network outages resulting in disruptions to our critical business operations and customer services, misappropriation or destruction of our intellectual property, proprietary information or confidential information and/or the confidential, proprietary or personal information of certain parties, such as our employees, customers, suppliers, counterparties and other third parties, or damage to their computers or systems. This could result in a violation of applicable privacy and other laws in the U.S. and abroad, litigation exposure, regulatory fines, penalties or intervention, loss of confidence in our security measures, reputational damage, reimbursement or other compensatory costs, additional compliance costs, and our internal controls or disclosure controls being rendered ineffective. The occurrence of any of these events could adversely impact our results of operations, liquidity and financial condition.Failure to satisfy our obligations as servicer for residential mortgage securitizations, loans owned by other entities and other losses we could incur as servicer, could adversely impact our reputation, servicing costs or results of operations.We and our legacy companies service mortgage loans on behalf of third-party securitization vehicles and other investors. If we commit a material breach of our obligations as servicer or master servicer, we may be subject to termination if the breach is not cured within a specified period of time following notice, which could cause us to lose servicing income. In addition, we may have liability for any failure by us, as a servicer or master servicer, for any act or omission on our part that involves willful misfeasance, bad faith, gross negligence or reckless disregard of our duties. If any such breach was found to have occurred, it may harm our reputation, increase our servicing costs, result in litigation or regulatory action or adversely impact our results of operations. Additionally, with respect to foreclosures, we may incur costs or losses due to irregularities in the underlying documentation, or if the validity of a foreclosure action is challenged by a borrower or overturned by a court because of errors or deficiencies in the foreclosure process. We may also incur costs or losses relating to delays or alleged deficiencies in processing documents necessary to comply with state law governing foreclosure.Changes in the structure of and relationship among the GSEs could adversely impact our business.During 2020, we sold approximately $3.6 billion of loans to GSEs, primarily Freddie Mac (FHLMC). FHLMC and Fannie Mae (FNMA) are currently in conservatorship with their primary regulator, the Federal Housing Finance Agency (FHFA) acting as conservator. In September 2019, the Treasury Department published a proposal to recapitalize FHLMC and FNMA and remove them from conservatorship as well as reduce their role in the marketplace. Consistent with this proposal, in January 2021, the Treasury Department further amended the agreement that governs the conservatorship of FHLMC and FNMA to allow them to retain their earnings until they reach certain previously determined capital requirements, among other policy actions, potentially putting them on a long-term path to emergence from conservatorship. However, we cannot predict the future prospects of the GSEs, timing of the recapitalization or release from conservatorship, or content of legislative or rulemaking proposals regarding the future status of the GSEs in the housing market. Additionally, if the GSEs were to take a reduced role in 15 Bank of Americathe marketplace, including by limiting the mortgage products they offer, we could be required to seek alternative funding sources, retain additional loans on our balance sheet, secure funding through the Federal Home Loan Bank system, or securitize the loans through Private Label Securitization. Accordingly, uncertainty regarding their future and the mortgage-backed securities they guarantee continues to exist for the foreseeable future.Any of these developments could adversely affect the value of our securities portfolios, capital levels, liquidity and results of operations.Our risk management framework may not be effective in mitigating risk and reducing the potential for losses.Our risk management framework is designed to minimize risk and loss to us. We seek to effectively and consistently identify, measure, monitor, report and control the types of risk to which we are subject, including strategic, credit, market, liquidity, compliance, operational and reputational risks. While we employ a broad and diversified set of controls and risk mitigation techniques, including modeling and forecasting, hedging strategies and techniques that seek to balance our ability to profit from trading positions with our exposure to potential losses, our ability to control and mitigate risks that result in losses is inherently limited by our ability to identify all risks, including emerging and unknown risks, anticipate the timing of risks, apply effective hedging strategies, make correct assumptions, manage and aggregate data correctly and efficiently, and develop risk management models to assess and control risk.Our ability to manage risk is dependent on our ability to consistently execute all elements of our risk management program and develop and maintain a culture of managing risk well throughout the Corporation and manage risks associated with third parties (including their downstream service providers) and vendors, to enable effective risk management and ensure that risks are appropriately considered, evaluated and responded to in a timely manner. Uncertain economic conditions, heightened legislative and regulatory scrutiny of and change within the financial services industry, the pace of technological changes, accounting and market developments, the failure of employees to comply with policies, values and our risk framework and the overall complexity of our operations, among other developments, may result in a heightened level of risk for us. We have experienced increased operational, reputational and compliance risk as a result of the need to rapidly implement multiple and varying pandemic relief programs, including consumer and commercial assistance programs and the PPP, coupled with the concurrent transition of the Corporation’s workforce to a work-from-home posture. Accordingly, we could suffer losses as a result of our failure to manage evolving risks or properly anticipate, manage, control or mitigate risks.Regulatory, Compliance and LegalWe are subject to comprehensive government legislation and regulations and certain settlements, orders and agreements with government authorities from time to time.We are subject to comprehensive regulation under federal and state laws in the U.S. and the laws of the various jurisdictions in which we operate, including increasing and complex economic sanctions regimes. These laws and regulations significantly affect and have the potential to restrict the scope of our existing businesses, limit our ability to pursue certain business opportunities, including the products and services we offer, reduce certain fees and rates or make our products and services more expensive for our clients.We continue to make adjustments to our business and operations, legal entity structure and capital and liquidity management policies, procedures and controls to comply with currently effective laws and regulations, as well as final rulemaking, guidance and interpretation by regulatory authorities, including the Department of Treasury, Federal Reserve, OCC, CFPB, Financial Stability Oversight Council, FDIC, Department of Labor, SEC and CFTC in the U.S. and foreign regulators and other government authorities. Further, we could become subject to future legislation and regulatory requirements beyond those currently proposed, adopted or contemplated in the U.S. or abroad, including policies and rulemaking related to the Financial Reform Act, the pandemic and climate change. The cumulative effect of all of the legislation and regulations on our business, operations and profitability remains uncertain. This uncertainty necessitates that in our business planning we make certain assumptions with respect to the scope and requirements of prospective and proposed rules. If these assumptions prove incorrect, we could be subject to increased regulatory and compliance risks and costs as well as potential reputational harm. In addition, U.S. and international regulatory initiatives may overlap, and non-U.S. regulations and initiatives may be inconsistent or may conflict with current or proposed U.S. regulations, which could lead to compliance risks and increased costs. Our regulators’ prudential and supervisory authority gives them broad power and discretion to direct our actions, and they have assumed an active oversight, inspection and investigatory role across the financial services industry. However, regulatory focus is not limited to laws and regulations applicable to the financial services industry, but extends to other significant laws and regulations that apply across industries and jurisdictions, including those related to data management and privacy, anti-money laundering, anti-corruption and economic sanctions. We are also subject to laws, rules and regulations in the U.S. and abroad, including GDPR, CCPA and CPRA, regarding compliance with our privacy policies and the disclosure, collection, use, sharing and safeguarding of personal identifiable information of certain parties, such as our employees, customers, suppliers, counterparties and other third parties, the violation of which could result in litigation, regulatory fines and enforcement actions. Additionally, we will likely be subject to new and evolving data privacy laws in the U.S. and abroad, which could result in additional costs of compliance, litigation, regulatory fines and enforcement actions. In particular, there is increased complexity and uncertainty, including potential suspension or prohibition, regarding the standards used by the Corporation for cross-border flows and transfers of personal data from the European Economic Area (EEA) to the U.S. and other jurisdictions outside of the EEA resulting from a decision of the Court of Justice of the EU and guidance from the European Data Protection Board. Additionally, the European Commission has proposed new standards of personal data transfer. If our personal data transfers are suspended or prohibited or we are required to implement new standards, this could result in operational disruptions to our businesses, additional costs, increased enforcement activity, new contract negotiations with third parties, and/or modification of our cross-border data management.As part of their enforcement authority, our regulators and other government authorities have the authority to, among other things, assess significant civil or criminal monetary penalties or restitution and issue cease and desist or removal orders and Bank of America 16initiate injunctive actions. The amounts paid by us and other financial institutions to settle proceedings or investigations have, in some instances, been substantial and may increase. In some cases, governmental authorities have required criminal pleas or other extraordinary terms as part of such resolutions, which could have significant consequences, including reputational harm, loss of customers, restrictions on the ability to access capital markets, and the inability to operate certain businesses or offer certain products for a period of time.The Corporation and the conduct of its employees and representatives are subject to regulatory scrutiny across jurisdictions. The complexity of the federal and state regulatory and enforcement regimes in the U.S., coupled with the global scope of our operations and the regulatory environment worldwide also means that a single event or practice or a series of related events or practices may give rise to a significant number of overlapping investigations and regulatory proceedings, either by multiple federal and state agencies in the U.S. or by multiple regulators and other governmental entities in different jurisdictions. Additionally, actions by other members of the financial services industry related to business activities in which we participate may result in investigations by regulators or other government authorities. Responding to inquiries, investigations, lawsuits and proceedings is time-consuming and expensive and can divert senior management attention from our business. The outcome of such proceedings, which may last a number of years, may be difficult to predict or estimate.We are and may become subject to the terms of settlements, orders and agreements that we have entered into with government entities and regulatory authorities, which impose, or could impose, significant operational and compliance costs on us as they typically require us to enhance our procedures and controls, expand our risk and control functions within our lines of business, invest in technology and hire significant numbers of additional risk, control and compliance personnel. Moreover, if we fail to meet the requirements of the regulatory settlements, orders or agreements to which we are subject, or, more generally, fail to maintain risk and control procedures and processes that meet the heightened standards established by our regulators and other government authorities, we could be required to enter into further settlements, orders or agreements and pay additional fines, penalties or judgments, or accept material regulatory restrictions on our businesses.While we believe that we have adopted appropriate risk management and compliance programs to identify, assess, monitor and report on applicable laws, policies and procedures, compliance risks will continue to exist, particularly as we adapt to new and evolving laws, rules and regulations. Additionally, changing U.S. fiscal, monetary and regulatory policies arising from changes to the U.S. presidential administration and Congress result in ongoing regulatory uncertainties. There is no guarantee that our risk management and compliance programs will be consistently executed to successfully manage compliance risk. We also rely upon third parties who may expose us to compliance and legal risk. Future legislative or regulatory actions, and any required changes to our business or operations, or those of third parties (including their downstream providers) upon whom we rely, resulting from such developments and actions could result in a significant loss of revenue, impose additional compliance and other costs or otherwise reduce our profitability, limit the products and services that we offer or our ability to pursue certain business opportunities, require us to dispose of or curtail certain businesses, affect the value of assets that we hold, require us to increase our prices and therefore reduce demand for our products, or otherwise adversely affect our businesses. In addition, legal and regulatory proceedings and other contingencies will arise from time to time that may result in fines, regulatory sanctions, penalties, equitable relief and changes to our business practices. As a result, we are and will continue to be subject to heightened compliance and operating costs that could adversely affect our results of operations.We are subject to significant financial and reputational risks from potential liability arising from lawsuits and regulatory and government action.We continue to face significant legal risks in our business, with a high volume of claims against us and other financial institutions. The damages, penalties and fines that litigants and regulators seek from us and other financial institutions continue to be high. This includes disputes with consumers, customers and other counterparties.Financial institutions, including us, continue to be the subject of claims alleging anti-competitive conduct with respect to various products and markets, including U.S. antitrust class actions claiming joint and several liability for treble damages. As disclosed in Note 12 — Commitments and Contingencies to the Consolidated Financial Statements, we also face contractual indemnification and loan-repurchase claims arising from alleged breaches of representations and warranties in the sale of residential mortgages by legacy companies, which may result in a requirement that we repurchase the mortgage loans, or otherwise make whole or provide other remedies to counterparties. In addition, regulatory authorities have had a supervisory focus on enforcement, including in connection with alleged violations of law and customer harm. For example, U.S. regulators and government agencies have pursued claims against financial institutions under the Financial Institutions Reform, Recovery, and Enforcement Act, False Claims Act, Equal Credit Opportunity Act, Fair Housing Act and antitrust laws. Such claims may carry significant and, in certain cases, treble damages. There is also an increased focus on compliance with global laws, rules and regulations related to the collection, use, sharing and safeguarding of personally identifiable information and corporate data. Additionally, misconduct by employees, including unethical, fraudulent, improper or illegal conduct, or other unfair, deceptive, abusive or discriminatory business practices, can result in litigation and/or government investigations and enforcement actions, and cause significant reputational harm. The global environment of extensive regulation, regulatory compliance burdens, litigation and regulatory enforcement, combined with uncertainty related to the continually evolving regulatory environment, may affect operational and compliance costs and risks, which may limit or cease our ability to continue providing certain products and services. This is magnified by the Corporation's implementation of government relief measures related to the pandemic. Lawsuits and regulatory actions may result in judgments, settlements, penalties and fines adverse to the Corporation. Litigation and investigation costs, substantial legal liability or significant regulatory or government action against us could have adverse effects on our business, financial condition, including liquidity, and results of operations, and/or cause significant reputational harm to us. U.S. federal banking agencies may require us to increase our regulatory capital, total loss-absorbing capacity (TLAC), long-term debt or liquidity requirements.We are subject to U.S. regulatory capital and liquidity rules. These rules, among other things, establish minimum requirements to qualify as a well-capitalized institution. If any of 17 Bank of Americaour subsidiary insured depository institutions fails to maintain its status as well capitalized under the applicable regulatory capital rules, the Federal Reserve will require us to agree to bring the insured depository institution back to well-capitalized status. For the duration of such an agreement, the Federal Reserve may impose restrictions on our activities. If we were to fail to enter into or comply with such an agreement, or fail to comply with the terms of such agreement, the Federal Reserve may impose more severe restrictions on our activities, including requiring us to cease and desist activities permitted under the Bank Holding Company Act of 1956.Capital and liquidity requirements are frequently introduced and amended. It is possible that regulators may increase regulatory capital requirements including TLAC and long-term debt requirements, change how regulatory capital is calculated or increase liquidity requirements. Our ability to return capital to our shareholders depends in part on our ability to maintain regulatory capital levels above minimum requirements plus buffers. To the extent that increases occur in our SCB, G-SIB surcharge or countercyclical capital buffer, our returns of capital to shareholders could decrease. As part of its CCAR, the Federal Reserve conducts stress testing on parts of our business using hypothetical economic scenarios prepared by the Federal Reserve. Those scenarios may affect our CCAR stress test results, which may impact the level of our SCB. Additionally, the Federal Reserve may impose limitations or prohibitions on taking capital actions, such as paying or increasing dividends or repurchasing common stock. For example, as a result of the economic uncertainty resulting from the pandemic, the Federal Reserve applied certain restrictions on our common stock dividends and repurchase program during the second half of 2020, and the first quarter of 2021, as disclosed in Item 1. Business – Distributions on page 5 and MD&A – Executive Summary – Recent Developments – Capital Management on page 25. A significant component of regulatory capital ratios is calculating our RWA and our leverage exposure, which may increase. The Basel Committee on Banking Supervision has also revised several key methodologies for measuring RWA that have not yet been implemented in the U.S., including a standardized approach for operational risk, revised market risk requirements and constraints on the use of internal models, as well as a capital floor based on the revised standardized approaches. U.S. banking regulators may update the U.S. Basel 3 rules to incorporate the Basel Committee revisions.Changes to and compliance with the regulatory capital and liquidity requirements may impact our operations by requiring us to liquidate assets, increase borrowings, issue additional equity or other securities, cease or alter certain operations or hold highly liquid assets, which may adversely affect our results of operations. Changes in accounting standards or assumptions in applying accounting policies could adversely affect us.Our accounting policies and methods are fundamental to how we record and report our financial condition and results of operations. Some of these policies require use of estimates and assumptions that may affect the reported value of our assets or liabilities and results of operations and are critical because they require management to make difficult, subjective and complex judgments about matters that are inherently uncertain. If those assumptions, estimates or judgments were incorrectly made, we could be required to correct and restate prior-period financial statements. Accounting standard-setters and those who interpret the accounting standards, the SEC, banking regulators and our independent registered public accounting firm may also amend or even reverse their previous interpretations or positions on how various standards should be applied. These changes may be difficult to predict and could impact how we prepare and report our financial statements. In some cases, we could be required to apply a new or revised standard retrospectively, resulting in us revising prior-period financial statements. We may be adversely affected by changes in U.S. and non-U.S. tax laws and regulations.In December 2017, the Tax Cuts and Jobs Act (the Tax Act) was enacted, which made significant changes to federal income tax law including, among other things, reducing the statutory corporate income tax rate to 21 percent from 35 percent and changing the taxation of our non-U.S. business activities.In addition, we have U.K. net deferred tax assets (DTA) which consist primarily of net operating losses that are expected to be realized by certain subsidiaries over an extended number of years. Adverse developments with respect to tax laws or to other material factors, such as prolonged worsening of Europe’s capital markets or changes in the ability of our U.K. subsidiaries to conduct business in the EU, could lead our management to reassess and/or change its current conclusion that no valuation allowance is necessary with respect to our U.K. net DTA. It is possible that governmental authorities in the U.S. and/or other countries could further amend or repeal tax laws in a way that would adversely affect us, including the possibility that aspects of the Tax Act could be amended in the future. Any future change in tax laws and regulations or interpretations of current or future tax laws and regulations could adversely affect our results of operations. ReputationDamage to our reputation could harm our businesses, including our competitive position and business prospects.Our ability to attract and retain customers, clients, investors and employees is impacted by our reputation. Harm to our reputation can arise from various sources, including officer, director or employee fraud, misconduct and unethical behavior, security breaches, litigation or regulatory outcomes, compensation practices, lending practices, the suitability or reasonableness of recommending particular trading or investment strategies, including the reliability of our research and models, prohibiting clients from engaging in certain transactions and employee sales practices. Additionally, our reputation may be harmed by failing to deliver products, subpar standards of service and quality expected by our customers, clients and the community, compliance failures, the inability to manage technology change or maintain effective data management, cyber incidents, internal and external fraud, inadequacy of responsiveness to internal controls, unintended disclosure of personal, proprietary or confidential information, conflicts of interest and breach of fiduciary obligations, the handling of health emergencies or pandemics, and the activities of our clients, customers, counterparties and third parties, including vendors. For example, our reputation may be harmed in connection with our implementation of government programs to provide relief to address the economic impact of the pandemic. Our reputation may also be negatively impacted by our ESG practices and disclosures, our businesses and our customers, including practices and disclosures related to climate change. Actions by the financial services industry generally or by certain members or individuals in the industry also can adversely affect our reputation. In addition, adverse publicity or negative information posted on social media by employees, the media or otherwise, whether or not factually Bank of America 18correct, may adversely impact our business prospects or financial results.We are subject to complex and evolving laws and regulations regarding privacy, know-your-customer requirements, data protection, including the GDPR, CCPA and CPRA, cross-border data movement and other matters. Principles concerning the appropriate scope of consumer and commercial privacy vary considerably in different jurisdictions, and regulatory and public expectations regarding the definition and scope of consumer and commercial privacy may remain fluid. It is possible that these laws may be interpreted and applied by various jurisdictions in a manner inconsistent with our current or future practices, or that is inconsistent with one another. If personal, confidential or proprietary information of customers or clients in our possession, or in the possession of third parties (including their downstream service providers) or financial data aggregators, is mishandled, misused or mismanaged, or if we do not timely or adequately address such information, we may face regulatory, reputational and operational risks which could adversely affect our financial condition and results of operations.We could suffer reputational harm if we fail to properly identify and manage potential conflicts of interest. Management of potential conflicts of interest has become increasingly complex as we expand our business activities through more numerous transactions, obligations and interests with and among our clients. The failure to adequately address, or the perceived failure to adequately address, conflicts of interest could affect the willingness of clients to use our products and services, or give rise to litigation or enforcement actions, which could adversely affect our business.Our actual or perceived failure to address these and other issues, such as operational risks, gives rise to reputational risk that could harm us and our business prospects. Failure to appropriately address any of these issues could also give rise to additional regulatory restrictions, legal risks and reputational harm, which could, among other consequences, increase the size and number of litigation claims and damages asserted or subject us to enforcement actions, fines and penalties, and cause us to incur related costs and expenses. OtherReforms to and replacement of IBORs and certain other rates or indices may adversely affect our reputation, business, financial condition and results of operations.There is a major transition in progress in global financial markets with respect to the replacement of IBORs, including the London Interbank Offered Rate (LIBOR), and certain other rates or indices that serve as “benchmarks.” Such benchmarks are used extensively across global financial markets and in our business. In particular, LIBOR is used in many of our products and contracts, including derivatives, consumer and commercial loans, mortgages, floating-rate notes and other adjustable-rate products and financial instruments. The aggregate notional amount of these products and contracts is material to our business, and there are significant risks and challenges associated with the transition that may result in significant uncertainty, or have other consequences that cannot be fully anticipated, which expose us to various financial, operational, supervisory, conduct and legal risks. Although certain ARRs have been proposed to replace LIBOR and other IBORs, market and client adoption of ARRs may vary across or within categories of contracts, products and services, resulting in market fragmentation, decreased trading volumes and liquidity, increased complexity and modeling and operational risks. ARRs have compositions and characteristics that differ significantly from the benchmarks they may replace, in some cases have limited history, and may demonstrate less predictable performance over time than the benchmarks they replace. Additionally, most ARRs are calculated on a compounded or weighted-average basis, involve complex billing and reconciliation and, unlike IBORs, do not reflect bank credit risk and therefore may require a spread adjustment. The market transition from IBORs to ARRs is complex and there are important differences between the fallbacks, triggers and calculation methodologies being implemented in cash and derivatives markets (including within cash markets). Any mismatch between the adoption of ARRs in loans, securities and derivatives markets may impact hedging or other financial arrangements we have implemented, and as a result we may experience unanticipated market exposures. There can be no assurance that ARRs will be comparable or adequate alternatives to IBORs or perform in the same way, that existing assets and liabilities based on or linked to IBORs will transition successfully to ARRs, of the timing of adoption and degree of integration and acceptance of ARRs in the financial markets, or of the future availability or representativeness of such ARRs. The discontinuation of IBORs, including LIBOR, requires us to transition a significant number of IBOR-based products and contracts, including related hedging arrangements (IBOR Products). Although, a significant majority of the aggregate notional amount of our LIBOR-based products and contracts maturing after 2021 include or have been updated to include fallbacks to ARRs, the transitioning of certain contracts, products and clients will be more complex. While some of these outstanding IBOR Products include fallback provisions to ARRs, some of these products and contracts do not include fallback provisions or adequate fallback mechanisms and require remediation to modify their terms. Additionally, some outstanding IBOR Products are particularly challenging to modify due to the requirement that all impacted parties consent to such modification. Legislation has been adopted in the EU and proposed in the U.S. and the U.K. to address such challenges in IBOR Products, including the use of a statutory replacement or “synthetic” rate to replace the existing benchmark rate in certain of our IBOR Products. Litigation, disputes or other action may occur as a result of the interpretation or application of legislation, in particular, if there is an overlap between legislation introduced in different jurisdictions. There is no guarantee that the legislative proposals will become law and no assurance that we and other market participants will be able to successfully modify all outstanding IBOR Products or be adequately prepared for a discontinuation of an IBOR at the time such IBOR may cease to be published or otherwise discontinued. Also, there can be no assurance that existing or new provisions for successor rates in our IBOR Products will include adequate methodologies for adjustments or that the characteristics of the successor rates will be similar to or produce the economic equivalent of the benchmarks they seek to replace. These changes may adversely affect the yield on loans or securities held by us, amounts paid on securities we have issued, amounts received and paid on derivatives we have entered into, the value of such loans, securities or derivative instruments, the trading market for such products and contracts, and our ability to effectively use hedging instruments to manage risk. Certain impacted clients, counterparties and other market participants may refuse, delay, or lack operational readiness to transition to ARRs, resulting in the risk that some contracts and products may not transition to an ARR before discontinuation of the relevant IBOR, exposing us to financial, operational, supervisory, conduct and legal risks.19 Bank of AmericaOur products and contracts that reference IBORs, in particular LIBOR, may contain language that determines when a successor rate including the ARR and/or the applicable spread adjustment to the designated rate (including IBORs) would be selected or determined. If a trigger is satisfied, our products and contracts may give the calculation agent (which may be us) discretion over the successor rate to be selected. We may face a risk of litigation, disputes or other actions from clients, counterparties, customers, investors or others regarding the interpretation or enforcement of IBOR-based contract provisions or if we fail to appropriately communicate the effect that the transition to ARRs will have on existing and future products.The Corporation has launched, and expects to continue to develop, launch and support, ARR-based products and services. The transition to ARR-based products is complex and involves client and financial contract changes, internal and external communication, technology and operations modifications, industry and regulatory engagement, migration of existing clients, execution of business strategy and governance. New financial products linked to ARRs may be less liquid, result in mispricing and additional legal, financial, tax, operational, market, compliance, reputational, competitive or other risks to us, our clients and other market participants. There is no guarantee that liquidity in ARR-based products will develop, and it is possible that ARR-based products will perform differently to IBOR Products during times of economic stress, adverse or volatile market conditions and across the credit and economic cycle, which may impact the value, return on and profitability of our ARR-based assets.Failure to meet industry-wide IBOR transition milestones and to cease issuance of IBOR Products by relevant cessation dates may, subject to certain regulatory exceptions, result in supervisory enforcement by applicable regulators, increase our cost of, and access to, capital and other consequences. In addition, IBOR Products held by us may become less liquid as the transition process develops, and other unforeseen consequences may arise if such products are held beyond relevant cessation dates.Changes or uncertainty resulting from the market transition from IBORs to ARRs could adversely affect the return on and pricing, liquidity and value of outstanding IBOR Products, cause significant market dislocations and disruptions, potentially increase the cost of and access to capital, increase the risk of litigation or other disputes, including in connection with the interpretation and enforceability of, or our historical marketing practices or disclosures with respect to outstanding IBOR products with counterparties, and/or increase expenses related to the transition to ARRs, among other adverse consequences. The market transition may also alter our risk profile and risk management strategies, including derivatives and hedging strategies, modeling and analytics, valuation tools, product design and systems, controls, procedures and operational infrastructure. This may prove challenging given the limited history of many of the proposed ARRs and may increase the costs and risks related to potential regulatory compliance, requirements or inquiries. Among other risks, various products and contracts may transition to ARRs at different times or in different manners, with the result that we may face significant unexpected interest rate, pricing or other exposures across business or product lines. Reforms to and uncertainty regarding market transition and other factors may adversely affect our business, including the ability to serve customers and maintain market share, financial condition or results of operations and could result in reputational harm to the Corporation.We face significant and increasing competition in the financial services industry.We operate in a highly competitive environment and experience intense competition from local and global financial institutions as well as new entrants, in both domestic and foreign markets, in which we compete on the basis of a number of factors, including customer service, quality and range of products and services offered, technology, price, fees, reputation, interest rates on loans and deposits, lending limits and customer convenience. Additionally, the changing regulatory environment may create competitive disadvantages for us given geography-driven capital and liquidity requirements. Additionally, we may face competitors with more experience and established relationships in the relevant market, which could adversely affect our ability to compete.In addition, emerging technologies and advances and the growth of e-commerce have lowered geographic and monetary barriers of other financial institutions, made it easier for non-depository institutions to offer products and services that traditionally were banking products and allowed non-traditional financial service providers and technology companies to compete with traditional financial service companies in providing electronic and internet-based financial solutions and services, including electronic securities trading with low or no fees and commissions, marketplace lending, financial data aggregation and payment processing, including real-time payment platforms. Further, clients may choose to conduct business with other market participants who engage in business or offer products in areas we deem speculative or risky, such as cryptocurrencies. Increased competition may negatively affect our earnings by creating pressure to lower prices, fees, commissions or credit standards on our products and services requiring additional investment to improve the quality and delivery of our technology and/or reducing our market share, or affecting the willingness of our clients to do business with us.Our inability to adapt our products and services could harm our business.Our business model is based on a diversified mix of businesses that provide a broad range of financial products and services, delivered through multiple distribution channels. Our success depends on our, and our third-party vendors', ability to adapt and develop products, services and technology to rapidly evolving industry standards and consumer preferences. In particular, the emergence of the pandemic has resulted in increased reliance on digital banking and other digital services provided by the Corporation’s businesses. There is increasing pressure by competitors to provide products and services on more attractive terms, including higher interest rates on deposits, and offer lower cost investment strategies, which may impact our ability to grow revenue and/or effectively compete. Additionally, legislative and regulatory developments may affect the competitive landscape. Further, the competitive landscape may be impacted by the growth of non-depository institutions that offer traditional banking products at higher rates or with low or no fees, or otherwise offer alternative products. This can reduce our net interest margin and revenues from our fee-based products and services, either from a decrease in the volume of transactions or through a compression of spreads.In addition, the widespread adoption and rapid evolution of new technologies, including analytic capabilities, self-service digital trading platforms, internet services, distributed ledgers, such as the blockchain system, cryptocurrencies and payment systems, could require substantial expenditures to modify or adapt our existing products and services as we grow and develop our online and mobile banking channel strategies in Bank of America 20addition to remote connectivity solutions. We may not be as timely or successful in developing or introducing new products and services, integrating new products or services into our existing offerings, responding or adapting to changes in consumer behavior, preferences, spending, investing and/or saving habits, achieving market acceptance of our products and services, reducing costs in response to pressures to deliver products and services at lower prices or sufficiently developing and maintaining loyal customers. The Corporation’s or its third-party vendors' inability to adapt products and services to evolving industry standards and consumer preferences could result in service disruptions and harm our business and adversely affect our results of operations and reputation.We could suffer operational, reputational and financial harm if our models and strategies fail to properly anticipate and manage risk.We use proprietary models and strategies extensively to forecast losses, project revenue, measure and assess capital requirements for credit, country, market, operational and strategic risks and assess and control our operations and financial condition. Model risk management is a dedicated and independent risk function that defines model risk governance, policy and guidelines for the Corporation based on laws, rules and regulations, as well as internal requirements. Under the Corporation's Enterprise Model Risk Policy, model risk management is required to perform model oversight, including independent validation before initial use, ongoing monitoring through outcomes analysis and benchmarking, and periodic revalidation. Models are subject to inherent limitations due to the use of historical trends and simplifying assumptions, uncertainty regarding economic and financial outcomes, and emerging risks from the use of applications that rely on AI.Our models and strategies may not be sufficiently predictive of future results due to limited historical patterns, extreme or unanticipated market movements or customer behavior and liquidity, especially during severe market downturns or stress events, which could limit their effectiveness. The models that we use to assess and control our market risk exposures also reflect assumptions about the degree of correlation among prices of various asset classes or other market indicators, which may not be representative of the next downturn and would magnify the limitations inherent in using historical data to manage risk. Our models may not be effective if we fail to properly oversee them and detect their flaws during our review and monitoring processes, they contain erroneous data, assumptions, valuations, formulas or algorithms or our applications running the models do not perform as expected. Regardless of the steps we take to ensure effective controls, governance, monitoring and testing, and implement new technology and automated processes, we could suffer operational, reputational and financial harm if models and strategies fail to properly anticipate and manage current and evolving risks. Failure to properly manage and aggregate data may result in our inability to manage risk and business needs, errors in our day-to-day operations, critical reporting and strategic decision-making and inaccurate reporting.We rely on our ability to manage, surveil, aggregate, interpret and use data in an accurate, timely and complete manner for effective risk reporting and management. Our policies, programs, processes and practices govern how data is surveilled, managed, aggregated, interpreted and used. While we continuously update our policies, programs, processes and practices and implement emerging technologies, such as automation, AI and robotics, our data management and aggregation processes are subject to failure, including human error, system failure or failed controls. Failure to surveil, maintain and manage data and information effectively and to aggregate data and information in an accurate, timely and complete manner may impact its quality and reliability and limit our ability to manage current and emerging risk, to produce accurate financial, regulatory and operational reporting, as well as to manage changing business needs, strategic decision-making and day-to-day operations. The failure to establish and maintain effective, efficient and controlled data management could adversely impact our ability to develop our products and relationships with our customers and damage our reputation.Our operations, businesses and customers could be materially adversely affected by the impacts related to climate change.There is an increasing concern over the risks of climate change and related environmental sustainability matters. The physical risks of climate change include rising average global temperatures, rising sea levels and an increase in the frequency and severity of extreme weather events and natural disasters, including floods, wildfires, hurricanes and tornados. Such disasters could disrupt our operations or the operations of customers or third parties on which we rely. Such disasters could result in market volatility or negatively impact our customers’ ability to pay outstanding loans, damage collateral or result in the deterioration of the value of collateral or insurance shortfalls. Additionally, climate change concerns could result in transition risk. Changes in consumer preferences and additional legislation and regulatory requirements, including those associated with the transition to a low-carbon economy, could increase expenses or otherwise adversely impact the Corporation, its businesses or its customers. We could also experience increased expenses resulting from strategic planning, litigation and technology and market changes, and reputational harm as a result of negative public sentiment, regulatory scrutiny and reduced investor and stakeholder confidence due to our response to climate change and our climate change strategy. Our ability to attract and retain qualified employees is critical to our success, business prospects and competitive position.Our performance is heavily dependent on the talents and efforts of highly skilled individuals. Competition for qualified personnel within the financial services industry and from businesses outside the financial services industry is intense. Our competitors include non-U.S. based institutions and institutions subject to different compensation and hiring regulations than those imposed on U.S. institutions and financial institutions.In order to attract and retain qualified personnel, we must provide market-level compensation. As a large financial and banking institution, we are and may become subject to additional limitations on compensation practices, which may or may not affect our competitors, by the Federal Reserve, the OCC, the FDIC and other regulators around the world. EU and U.K. rules limit and subject to clawback certain forms of variable compensation for senior employees. Furthermore, a substantial portion of our annual incentive compensation paid to our senior employees consists of long-term equity-based awards, the value of which is based on the price of our common stock when the awards vest. Our business prospects and competitive position could be adversely affected if we cannot attract and retain qualified individuals. 21 Bank of AmericaItem 1B. Unresolved Staff CommentsNoneItem 2. PropertiesAs of December 31, 2020, certain principal offices and other materially important properties consisted of the following:Facility NameLocationGeneral Character of the Physical PropertyPrimary Business SegmentProperty StatusProperty Square Feet (1)Bank of America Corporate CenterCharlotte, NC60 Story BuildingPrincipal Executive OfficesOwned1,212,177Bank of America Tower at One Bryant ParkNew York, NY55 Story BuildingGWIM, Global Banking and Global MarketsLeased (2)1,836,575 Bank of America Financial CentreLondon, UK4 Building CampusGlobal Banking and Global MarketsLeased565,362Cheung Kong CenterHong Kong62 Story BuildingGlobal Banking and Global MarketsLeased149,790(1)For leased properties, property square feet represents the square footage occupied by the Corporation.(2)The Corporation has a 49.9 percent joint venture interest in this property.We own or lease approximately 74.6 million square feet in over 20,000 facilities and ATM locations globally, including approximately 69.2 million square feet in the U.S. (all 50 states and the District of Columbia, the U.S. Virgin Islands, Puerto Rico and Guam) and approximately 5.4 million square feet in approximately 35 countries.We believe our owned and leased properties are adequate for our business needs and are well maintained. We continue to evaluate our owned and leased real estate and may determine from time to time that certain of our premises and facilities, or ownership structures, are no longer necessary for ouroperations. In connection therewith, we regularly evaluate the sale or sale/leaseback of certain properties and we may incur costs in connection with any such transactions.Item 3. Legal ProceedingsSee Litigation and Regulatory Matters in Note 12 – Commitments and Contingencies to the Consolidated Financial Statements, which is incorporated herein by reference.Item 4. Mine Safety DisclosuresNonePart IIBank of America Corporation and SubsidiariesItem 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity SecuritiesThe principal market on which our common stock is traded is the New York Stock Exchange under the symbol “BAC.” As of February 23, 2021, there were 156,206 registered shareholders of common stock. The table below presents share repurchase activity for the three months ended December 31, 2020. The primary source of funds for cash distributions by the Corporation to its shareholders is dividends received from its bank subsidiaries. Each of the bank subsidiaries is subject to various regulatory policies and requirements relating to the payment of dividends, including requirements to maintain capital above regulatory minimums. All of the Corporation’s preferred stock outstanding has preference over the Corporation’s common stock with respect to payment of dividends.(Dollars in millions, except per share information; shares in thousands)Total Common Shares Purchased (1,2)Weighted-Average Per Share PriceTotal SharesPurchased asPart of PubliclyAnnounced ProgramsRemaining BuybackAuthority Amounts (3)October 1 - 31, 202010,762 $24.44 — $— November 1 - 30, 20201 24.81 — — December 1 - 31, 20201 27.39 — — Three months ended December 31, 202010,764 24.44 — — (1)Includes two thousand shares of the Corporation’s common stock acquired by the Corporation in connection with satisfaction of tax withholding obligations on vested restricted stock or restricted stock units and certain forfeitures and terminations of employment-related awards and for potential re-issuance to certain employees under equity incentive plans.(2)During the three months ended December 31, 2020, pursuant to the Corporation's Board's authorization, the Corporation repurchased approximately 11 million shares, or $263 million, of its common stock solely to offset shares awarded under equity-based compensation plans.(3)On January 19, 2021, the Board authorized the repurchase of $2.9 billion in common stock through March 31, 2021, plus approximately $300 million to offset shares awarded under equity-based compensation plans during the same period. For more information, see Capital Management - CCAR and Capital Planning in the MD&A on page 50 and Note 13 – Shareholders’ Equity to the Consolidated Financial Statements.The Corporation did not have any unregistered sales of equity securities during the three months ended December 31, 2020. Item 6. Selected Financial DataSee Tables 6 and 7 in the MD&A beginning on page 32, which are incorporated herein by reference.Bank of America 22Item 7. Bank of America Corporation and SubsidiariesManagement's Discussion and Analysis of Financial Condition and Results of OperationsTable of ContentsPageExecutive Summary24Recent Developments25Financial Highlights27Balance Sheet Overview29Supplemental Financial Data31Business Segment Operations36Consumer Banking37Global Wealth & Investment Management40Global Banking42Global Markets44All Other45Off-Balance Sheet Arrangements and Contractual Obligations46Managing Risk47Strategic Risk Management50Capital Management50Liquidity Risk57Credit Risk Management61Consumer Portfolio Credit Risk Management62Commercial Portfolio Credit Risk Management68Non-U.S. Portfolio74Allowance for Credit Losses76Market Risk Management78Trading Risk Management79Interest Rate Risk Management for the Banking Book82Mortgage Banking Risk Management84Compliance and Operational Risk Management84Reputational Risk Management85Climate Risk Management85Complex Accounting Estimates85Non-GAAP Reconciliations88Statistical Tables8923 Bank of AmericaManagement’s Discussion and Analysis of Financial Condition and Results of OperationsBank of America Corporation (the “Corporation”) and its management may make certain statements that constitute “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. These statements can be identified by the fact that they do not relate strictly to historical or current facts. Forward-looking statements often use words such as “anticipates,” “targets,” “expects,” “hopes,” “estimates,” “intends,” “plans,” “goals,” “believes,” “continue” and other similar expressions or future or conditional verbs such as “will,” “may,” “might,” “should,” “would” and “could.” Forward-looking statements represent the Corporation’s current expectations, plans or forecasts of its future results, revenues, provision for credit losses, expenses, efficiency ratio, capital measures, strategy and future business and economic conditions more generally, and other future matters. These statements are not guarantees of future results or performance and involve certain known and unknown risks, uncertainties and assumptions that are difficult to predict and are often beyond the Corporation’s control. Actual outcomes and results may differ materially from those expressed in, or implied by, any of these forward-looking statements. You should not place undue reliance on any forward-looking statement and should consider the following uncertainties and risks, as well as the risks and uncertainties more fully discussed under Item 1A. Risk Factors of this Annual Report on Form 10-K: the Corporation’s potential judgments, damages, penalties, fines and reputational damage resulting from pending or future litigation, regulatory proceedings and enforcement actions; the possibility that the Corporation's future liabilities may be in excess of its recorded liability and estimated range of possible loss for litigation, and regulatory and government actions, including as a result of our participation in and execution of government programs related to the Coronavirus Disease 2019 (COVID-19) pandemic; the possibility that the Corporation could face increased claims from one or more parties involved in mortgage securitizations; the Corporation’s ability to resolve representations and warranties repurchase and related claims; the risks related to the discontinuation of the London Interbank Offered Rate and other reference rates, including increased expenses and litigation and the effectiveness of hedging strategies; uncertainties about the financial stability and growth rates of non-U.S. jurisdictions, the risk that those jurisdictions may face difficulties servicing their sovereign debt, and related stresses on financial markets, currencies and trade, and the Corporation’s exposures to such risks, including direct, indirect and operational; the impact of U.S. and global interest rates, inflation, currency exchange rates, economic conditions, trade policies and tensions, including tariffs, and potential geopolitical instability; the impact of the interest rate environment on the Corporation’s business, financial condition and results of operations; the possibility that future credit losses may be higher than currently expected due to changes in economic assumptions, customer behavior, adverse developments with respect to U.S. or global economic conditions and other uncertainties; the Corporation's concentration of credit risk; the Corporation’s ability to achieve its expense targets and expectations regarding revenue, net interest income, provision for credit losses, net charge-offs, effective tax rate, loan growth or other projections; adverse changes to the Corporation’s credit ratings from the major credit rating agencies; an inability to access capital markets or maintain deposits or borrowing costs; estimates of the fair value and other accounting values, subject to impairment assessments, of certain of the Corporation’s assets and liabilities; the estimated or actual impact of changes in accounting standards or assumptions in applying those standards; uncertainty regarding the content, timing and impact of regulatory capital and liquidity requirements; the impact of adverse changes to total loss-absorbing capacity requirements, stress capital buffer requirements and/or global systemically important bank surcharges; the potential impact of actions of the Board of Governors of the Federal Reserve System on the Corporation’s capital plans; the effect of regulations, other guidance or additional information on the impact from the Tax Cuts and Jobs Act; the impact of implementation and compliance with U.S. and international laws, regulations and regulatory interpretations, including, but not limited to, recovery and resolution planning requirements, Federal Deposit Insurance Corporation assessments, the Volcker Rule, fiduciary standards, derivatives regulations and the Coronavirus Aid, Relief, and Economic Security Act and any similar or related rules and regulations; a failure or disruption in or breach of the Corporation’s operational or security systems or infrastructure, or those of third parties, including as a result of cyber attacks or campaigns; the impact on the Corporation’s business, financial condition and results of operations from the United Kingdom's exit from the European Union; the impact of climate change; the impact of any future federal government shutdown and uncertainty regarding the federal government’s debt limit or changes to the U.S. presidential administration and Congress; the emergence of widespread health emergencies or pandemics, including the magnitude and duration of the COVID-19 pandemic and its impact on the U.S. and/or global, financial market conditions and our business, results of operations, financial condition and prospects; the impact of natural disasters, extreme weather events, military conflict, terrorism or other geopolitical events; and other matters.Forward-looking statements speak only as of the date they are made, and the Corporation undertakes no obligation to update any forward-looking statement to reflect the impact of circumstances or events that arise after the date the forward-looking statement was made.Notes to the Consolidated Financial Statements referred to in the Management’s Discussion and Analysis of Financial Condition and Results of Operations (MD&A) are incorporated by reference into the MD&A. Certain prior-year amounts have been reclassified to conform to current-year presentation. Throughout the MD&A, the Corporation uses certain acronyms and abbreviations which are defined in the Glossary.Executive SummaryBusiness OverviewThe Corporation is a Delaware corporation, a bank holding company (BHC) and a financial holding company. When used in this report, “the Corporation,” “we,” “us” and “our” may refer to Bank of America Corporation individually, Bank of America Corporation and its subsidiaries, or certain of Bank of America Corporation’s subsidiaries or affiliates. Our principal executive offices are located in Charlotte, North Carolina. Through our various bank and nonbank subsidiaries throughout the U.S. and in international markets, we provide a diversified range of banking and nonbank financial services and products through four business segments: Consumer Banking, Global Wealth & Investment Management (GWIM), Global Banking and Global Markets, with the remaining operations recorded in All Other. We operate our banking activities primarily under the Bank of Bank of America 24America, National Association (Bank of America, N.A. or BANA) charter. At December 31, 2020, the Corporation had $2.8 trillion in assets and a headcount of approximately 213,000 employees.As of December 31, 2020, we served clients through operations across the U.S., its territories and approximately 35 countries. Our retail banking footprint covers all major markets in the U.S., and we serve approximately 66 million consumer and small business clients with approximately 4,300 retail financial centers, approximately 17,000 ATMs, and leading digital banking platforms (www.bankofamerica.com) with more than 39 million active users, including approximately 31 million active mobile users. We offer industry-leading support to approximately three million small business households. Our GWIM businesses, with client balances of $3.3 trillion, provide tailored solutions to meet client needs through a full set of investment management, brokerage, banking, trust and retirement products. We are a global leader in corporate and investment banking and trading across a broad range of asset classes serving corporations, governments, institutions and individuals around the world.Recent DevelopmentsCapital ManagementIn June 2020, the Board of Governors of the Federal Reserve System (Federal Reserve) notified BHCs of their 2020 Comprehensive Capital Analysis and Review (CCAR) supervisory stress test results. Due to economic uncertainty resulting from the Coronavirus Disease 2019 (COVID-19) pandemic (the pandemic), the Federal Reserve required all large banks to update and resubmit their capital plans in November 2020 based on the Federal Reserve’s updated supervisory stress test scenarios. The results of the additional supervisory stress tests were published in December 2020.The Federal Reserve also required large banks to suspend share repurchase programs during the second half of 2020, except for repurchases to offset shares awarded under equity-based compensation plans, and to limit common stock dividends to existing rates that did not exceed the average of the last four quarters’ net income. In December 2020, the Federal Reserve announced that beginning in the first quarter of 2021, large banks would be permitted to pay common stock dividends at existing rates and to repurchase shares in an amount that, when combined with dividends paid, does not exceed the average of net income over the last four quarters. On January 19, 2021, we announced that the Board of Directors (the Board) declared a quarterly common stock dividend of $0.18 per share, payable on March 26, 2021 to shareholders of record as of March 5, 2021. We also announced that the Board authorized the repurchase of $2.9 billion in common stock through March 31, 2021, plus repurchases to offset shares awarded under equity-based compensation plans during the same period, estimated to be approximately $300 million. This authorization equals the maximum amount allowed by the Federal Reserve for the period. For more information, see Capital Management on page 50.COVID-19 PandemicIn the first quarter of 2020, the World Health Organization declared the outbreak of COVID-19 a pandemic. In an attempt to contain the spread and impact of the pandemic, travel bans and restrictions, quarantines, shelter-in-place orders and other limitations on business activity were implemented. Additionally, there has been a decline in global economic activity, reduced U.S. and global economic output and a deterioration in macroeconomic conditions in the U.S. and globally. This has resulted in, among other things, higher rates of unemployment and underemployment and caused volatility and disruptions in the global financial markets, including the energy and commodity markets. Although vaccines have been approved for immunization against COVID-19 in certain countries and restrictive measures have been eased in certain areas, COVID-19 cases have significantly increased in recent months in the U.S. and many regions of the world compared to earlier levels. Businesses, market participants, our counterparties and clients, and the U.S. and global economies have been negatively impacted and are likely to be so for an extended period of time, as there remains significant uncertainty about the timing and strength of an economic recovery.To address the economic impact in the U.S., in March and April 2020, four economic stimulus packages were enacted to provide relief to businesses and individuals, including the Coronavirus Aid, Relief, and Economic Security Act (CARES Act). Among other measures, the CARES Act established the Small Business Administration (SBA) Paycheck Protection Program (PPP), which provides loans to small businesses to keep their employees on payroll and make other eligible payments. The original funding for the PPP under the CARES Act was fully allocated by mid-April 2020, with additional funding made available on April 24, 2020 under the Paycheck Protection Program and Health Care Enhancement Act. In December 2020, an additional economic stimulus package was included as part of the Consolidated Appropriations Act of 2021 (the Consolidated Appropriations Act), which provides relief to individuals and businesses. This relief included additional funding for the PPP under the Economic Aid to Hard-Hit Small Businesses, Nonprofits, and Venues Act (the Economic Aid Act).In response to the pandemic, the Corporation has implemented protocols and processes to execute its business continuity plans and help protect its employees and support its clients. The Corporation is managing its response to the pandemic according to its Enterprise Response Framework, which invokes centralized management of the crisis event and the integration of its response. The CEO and key members of the Corporation’s management team meet regularly with co-leaders of the Executive Response Team, which is composed of senior executives across the Corporation, to help drive decisions, communications and consistency of response across all businesses and functions. We are also coordinating with global, regional and local authorities and health experts, including the U.S. Centers for Disease Control and Prevention (CDC) and the World Health Organization.Additionally, we have implemented a number of measures to assist our employees, clients and the communities we serve as discussed below.EmployeesWe are providing support to our teammates to help promote the health and safety of our employees and help to ensure our protocols remain aligned to current guidance by monitoring guidance from the CDC, medical boards and health authorities and sharing such guidance with our employees. We are also operating our businesses from remote locations and leveraging our business continuity plans and capabilities. The Corporation has globally implemented a work-from-home posture, which has resulted in the substantial majority of our employees working from home, and pre-planned contingency strategies for site-based operations for our remaining employees. We continue to evaluate our continuity plans and work-from-home strategy in an effort to best protect the health and safety of our employees.25 Bank of AmericaClientsWe continue to leverage our business continuity plans and capabilities to service our clients and meet our clients’ financial needs by offering assistance to clients affected by the pandemic, including providing access to credit and the important financial services on which our clients rely. We are also participating in the programs created by the CARES Act and Federal Reserve lending programs for businesses, including originating PPP loans. We have also participated in the Main Street Lending Program, which ended on January 8, 2021. While most of our deferral programs expired in the third quarter of 2020, we continue to offer assistance on a case-by-case basis when requested by clients affected by the pandemic. As of December 31, 2020, we had approximately 332,000 PPP loans outstanding with a carrying value of $22.7 billion, which were recorded in the Consumer, GWIM and Global Banking segments. Since the PPP's inception through February 17, 2021, borrowers have submitted applications for forgiveness to us for approximately 113,000 PPP loans with balances totaling $10.9 billion. We have submitted approximately 72,000 PPP loans with balances totaling $8.5 billion to the SBA for repayment, of which we have received to date $5.4 billion in repayment from the SBA. Additionally, as of February 17, 2021, we have originated $4.1 billion in PPP loans under the Economic Aid Act. For more information on PPP loans, see Credit Risk Management on page 61, and for more information on accounting for PPP loans and loan modifications under the CARES Act, see Note 1 – Summary of Significant Accounting Principles to the Consolidated Financial Statements.Community PartnersWe continue to support the communities where we live and work by engaging in various initiatives to help those affected by COVID-19. These initiatives include committing resources to provide medical supplies, food and other necessities for those in need. We are also supporting racial equality, economic opportunity and environmental sustainability through direct equity investments in minority-owned depository institutions, equity investments in minority entrepreneurs, businesses and funds, as well as other initiatives.Risk ManagementWe continue to manage the increased operational risk related to the execution of our business continuity plans in accordance with our Enterprise Response Framework, Risk Framework and Operational Risk Management Program. For more information, see Managing Risk on page 47.Loan ModificationsThe Corporation has implemented various consumer and commercial loan modification programs to provide its borrowers relief from the economic impacts of COVID-19. Based on guidance in the CARES Act that the Corporation adopted, COVID-19 related modifications to consumer and commercial loans that were current as of December 31, 2019 are exempt from troubled debt restructuring (TDR) classification under accounting principles generally accepted in the United States of America (GAAP). In addition, the bank regulatory agencies issued interagency guidance stating that COVID-19 related short-term modifications (i.e., six months or less) granted to consumer or commercial loans that were current as of the loan modification program implementation date are not TDRs. In December 2020, the Consolidated Appropriations Act amended the CARES Act by extending the exemption from TDR classification for COVID-19 related modifications from December 31, 2020 to the earlier of January 1, 2022 or 60 days after the national emergency has ended. For more information, see Note 1 – Summary of Significant Accounting Principles and Note 5 – Outstanding Loans and Leases and Allowance for Credit Losses to the Consolidated Financial Statements.We have provided borrowers with relief from the economic impacts of COVID-19 through payment deferral and forbearance programs. A significant portion of deferrals expired during the second half of 2020, reflecting a decline in customer requests for assistance. As of February 17, 2021, deferred consumer and small business loans recorded on the Consolidated Balance Sheet totaled $6.8 billion, predominantly consisting of $6.4 billion of residential mortgage and home equity loans, including loans serviced by others, that are well-collateralized.Other Related MattersAlthough the macroeconomic outlook improved modestly during the second half of 2020, the future direct and indirect impact of COVID-19 on our businesses, results of operations and financial condition of the Corporation remains highly uncertain. Should current economic conditions persist or deteriorate, this macroeconomic environment will have a continued adverse effect on our businesses and results of operations and could have an adverse effect on our financial condition. For more information on how the risks related to the pandemic may adversely affect our businesses, results of operations and financial condition, see Part I. Item 1A. Risk Factors on page 7.LIBOR and Other Benchmark RatesFollowing the 2017 announcement by the U.K.’s Financial Conduct Authority (FCA) that it would no longer compel participating banks to submit rates for the London Interbank Offered Rate (LIBOR) after 2021, regulators, trade associations and financial industry working groups have identified recommended replacement rates for LIBOR, as well as other Interbank Offered Rates (IBORs), and have published recommended conventions to allow new and existing products to incorporate fallbacks or that reference these Alternative Reference Rates (ARRs). The continuation of all British Pound Sterling, Euro, Swiss Franc and Japanese Yen LIBOR settings and one-week and two-month U.S. dollar LIBOR settings on the current basis are expected to terminate at the end of December 2021, and the remaining U.S. dollar LIBOR settings (i.e., overnight, one month, three month, six month and 12 month) are expected to terminate at the end of June 2023.As a result of this and other announcements, financial benchmark reforms, regulatory guidance and changes in short-term interbank lending markets more generally, a major transition is in progress in global financial markets with respect to the replacement of IBORs and certain benchmarks. The transition of IBORs to ARRs is a complex process impacting a variety of global financial markets and our business and operations.IBORs are used in many of the Corporation’s products and contracts, including derivatives, consumer and commercial loans, mortgages, floating-rate notes and other adjustable-rate products and financial instruments. The discontinuation of IBORs requires us to transition a significant number of IBOR-based products and contracts, including related hedging arrangements. In response, the Corporation established an enterprise-wide IBOR transition program led by senior management in early 2018. This program, which is led by the Corporation's Chief Operating Officer, includes active involvement of senior management and regular reports to the Enterprise Risk Committee (ERC). The program is intended to address the Corporation's industry and regulatory engagement, client and financial contract changes, internal and external communications, technology and operations modifications, Bank of America 26introduction of new products, migration of existing clients, and program strategy and governance. In addition, the program is designed to monitor a variety of scenarios, including operational risks associated with insufficient preparation by individual market participants or the overall market ecosystem, volatility along the Secured Overnight Financing Rate (SOFR) curve, development and adoption of credit-sensitive and other rates, regulatory and legal uncertainty with respect to various matters including contract continuity, access by market participants to liquidity in certain products, and IBOR continuity beyond December 2021.As of February 1, 2021, a significant majority of the aggregate notional amount of our LIBOR-based products and contracts maturing after 2021 include or have been updated to include fallbacks to ARRs based on market driven protocols, regulatory guidance and industry-recommended fallback provisions and related mechanisms. For certain of the remaining products and contracts, the transition will be more complex, particularly where there is no industry-wide protocol or similar mechanism. The Corporation is executing transition plans that are intended to be in line with applicable major industry-wide IBOR product cessation and launch milestones recommended by the Alternative Reference Rates Committee, a group of private market participants and official sector entities convened by the Federal Reserve and the Federal Reserve Bank of New York, and the Bank of England Sterling Risk Free Rate Working Group, other than the cessation of LIBOR-based adjustable-rate consumer mortgages. The Corporation plans to no longer offer these mortgages and launch SOFR-based adjustable-rate consumer mortgages by the end of the first quarter of 2021.The Corporation is executing product and client roadmaps that it believes align with industry-recommended and regulatory milestones, and the Corporation has developed employee training programs as well as other internal and external sources of information on the various challenges and opportunities that the replacement of IBORs presents. As the transition to ARRs evolves, the Corporation continues to monitor and participate in the development and usage of certain ARRs, including SOFR, the Euro Short Term Rate and the Sterling Overnight Index Average (SONIA). The Corporation’s key transition efforts to date include issuances of debt and deposits linked to SOFR and SONIA by the Corporation, facilitating debt issuances linked to ARRs by clients and secondary market liquidity for products linked to ARRs, originating and arranging loans linked to ARRs, including hedging arrangements, executing, trading, market making and clearing ARR-based derivatives, and launching capabilities and services to support the issuance and trading in products indexed to certain ARRs. The Corporation updated its operational models, systems, procedures and internal infrastructure in connection with the transition to ARRs by the central clearing counterparties. In October 2020, the Corporation and certain of its subsidiaries adhered to the International Swaps and Derivatives Association, Inc. 2020 IBOR Fallbacks Protocol, effective January 25, 2021, which provides a mechanism to enable market participants to incorporate fallbacks for certain legacy non-cleared derivatives linked to certain IBORs.Additionally, the Corporation is continuing to evaluate potential regulatory, tax and accounting impacts of the transition, including guidance published and/or proposed by the Internal Revenue Service and Financial Accounting Standards Board, engage impacted clients in connection with the transition to ARRs and work actively with global regulators, industry working groups and trade associations to develop strategies for an effective transition to ARRs. For more information on the expected replacement of LIBOR and other benchmark rates, see Item 1A. Risk Factors – Other on page 19.U.K. Exit from the EUOn January 31, 2020, the U.K. formally exited the European Union (EU), and a transition period began during which time the U.K. and the EU negotiated a trade agreement and other terms associated with their future relationship. The transition period ended on December 31, 2020.We conduct business in Europe, the Middle East and Africa primarily through our subsidiaries in the U.K., Ireland and France and implemented changes to enable us to continue to operate in the region, including establishing a bank and broker-dealer in the EU, as well as minimize the potential for any operational disruption. As the global economic impact of the U.K.’s withdrawal from the EU remains uncertain and could result in regional and global financial market disruptions, we continue to assess potential operational, regulatory and legal risks. For more information, see Item 1A. Risk Factors – Geopolitical on page 12.Financial HighlightsEffective January 1, 2020, we adopted the new accounting standard on current expected credit losses (CECL), under which the allowance is measured based on management’s best estimate of lifetime expected credit losses (ECL). Prior-year periods presented reflect measurement of the allowance based on management’s estimate of probable incurred credit losses. For more information, see Note 1 – Summary of Significant Accounting Principles to the Consolidated Financial Statements.Table 1Summary Income Statement and Selected Financial Data(Dollars in millions, except per share information)20202019Income statementNet interest income$43,360 $48,891 Noninterest income42,168 42,353 Total revenue, net of interest expense85,528 91,244 Provision for credit losses11,320 3,590 Noninterest expense55,213 54,900 Income before income taxes18,995 32,754 Income tax expense1,101 5,324 Net income17,894 27,430 Preferred stock dividends1,421 1,432 Net income applicable to common shareholders$16,473 $25,998 Per common share information Earnings$1.88 $2.77 Diluted earnings1.87 2.75 Dividends paid0.72 0.66 Performance ratiosReturn on average assets (1)0.67 %1.14 %Return on average common shareholders’ equity (1)6.76 10.62 Return on average tangible common shareholders’ equity (2)9.48 14.86 Efficiency ratio (1)64.55 60.17 Balance sheet at year end Total loans and leases$927,861 $983,426 Total assets2,819,627 2,434,079 Total deposits1,795,480 1,434,803 Total liabilities2,546,703 2,169,269 Total common shareholders’ equity248,414 241,409 Total shareholders’ equity272,924 264,810 (1)For definitions, see Key Metrics on page 173. (2)Return on average tangible common shareholders’ equity is a non-GAAP financial measure. For more information and a corresponding reconciliation to the most closely related financial measures defined by accounting principles generally accepted in the United States of America, see Non-GAAP Reconciliations on page 88. 27 Bank of AmericaNet income was $17.9 billion or $1.87 per diluted share in 2020 compared to $27.4 billion or $2.75 per diluted share in 2019. The decline in net income was primarily due to higher provision for credit losses driven by the weaker economic outlook related to COVID-19 and lower net interest income.For discussion and analysis of our consolidated and business segment results of operations for 2019 compared to 2018, see the Financial Highlights and Business Segment Operations sections in the MD&A of the Corporation's 2019 Annual Report on Form 10-K. Net Interest IncomeNet interest income decreased $5.5 billion to $43.4 billion in 2020 compared to 2019. Net interest yield on a fully taxable-equivalent (FTE) basis decreased 53 basis points (bps) to 1.90 percent for 2020. The decrease in net interest income was primarily driven by lower interest rates, partially offset by reduced deposit and funding costs, the deployment of excess deposits into securities and an additional day of interest accrual. Assuming continued economic improvement and based on the forward interest rate curve as of January 19, 2021, when we announced quarterly and annual results for the periods ended December 31, 2020, we expect net interest income to be higher in the second half of 2021 as compared to both the second half of 2020 and the first half of 2021. For more information on net interest yield and the FTE basis, see Supplemental Financial Data on page 31, and for more information on interest rate risk management, see Interest Rate Risk Management for the Banking Book on page 82.Noninterest IncomeTable 2Noninterest Income(Dollars in millions)20202019Fees and commissions:Card income$5,656 $5,797 Service charges7,141 7,674 Investment and brokerage services14,574 13,902 Investment banking fees7,180 5,642 Total fees and commissions34,551 33,015 Market making and similar activities8,355 9,034 Other income(738)304 Total noninterest income$42,168 $42,353 Noninterest income decreased $185 million to $42.2 billion in 2020 compared to 2019. The following highlights the significant changes.● Card income decreased $141 million primarily due to lower levels of consumer spending driven by the impact of COVID-19, partially offset by higher income related to the processing of unemployment insurance.● Service charges decreased $533 million primarily due to higher deposit balances and lower client activity due to the impact of COVID-19.● Investment and brokerage services income increased $672 million primarily due to higher client transactional activity, higher market valuations and assets under management (AUM) flows, partially offset by declines in AUM pricing.● Investment banking fees increased $1.5 billion primarily driven by higher equity issuance fees.● Market making and similar activities decreased $679 million primarily due to the impact of lower U.S. interest rates on certain risk management derivatives, partially offset by increased client activity and strong trading performance in fixed income, currencies and commodities (FICC).● Other income decreased $1.0 billion primarily due to lower equity investment income, higher partnership losses on tax credit investments, primarily affordable housing and renewable energy, partially offset by higher gains on loan sales and sales of debt securities. Provision for Credit LossesThe provision for credit losses increased $7.7 billion to $11.3 billion in 2020 compared to 2019 primarily driven by higher ECL due to a weaker economic outlook related to COVID-19. For more information on the provision for credit losses, see Allowance for Credit Losses on page 76.Noninterest ExpenseTable 3Noninterest Expense(Dollars in millions)20202019Compensation and benefits$32,725 $31,977 Occupancy and equipment7,141 6,588 Information processing and communications5,222 4,646 Product delivery and transaction related3,433 2,762 Marketing1,701 1,934 Professional fees1,694 1,597 Other general operating3,297 5,396 Total noninterest expense$55,213 $54,900 Noninterest expense increased $313 million to $55.2 billion in 2020 compared to 2019. The increase was primarily due to higher operating costs related to COVID-19, merchant services expenses, which were previously recorded in other income as part of joint venture net earnings, and higher activity-based expenses due to increased client activity, partially offset by a $2.1 billion pretax impairment charge related to the notice of termination of the merchant services joint venture in 2019. Income Tax ExpenseTable 4Income Tax Expense(Dollars in millions)20202019Income before income taxes$18,995 $32,754 Income tax expense1,101 5,324 Effective tax rate5.8 %16.3 %Income tax expense was $1.1 billion for 2020 compared to $5.3 billion in 2019, resulting in an effective tax rate of 5.8 percent compared to 16.3 percent.Bank of America 28The change in the effective tax rate for 2020 was driven by the impact of our recurring tax preference benefits on lower levels of pretax income. These benefits primarily consist of tax credits from environmental, social and governance (ESG) investments in affordable housing and renewable energy, aligning with our responsible growth strategy to address global sustainability challenges. Excluding tax credits related to our ESG investment activity, the effective tax rate for 2020 would have been 21 percent. The 2020 rate also included the impact of the U.K. tax law change, whereby on July 22, 2020, the U.K. enacted a repeal of the final two percent of scheduled decreases in the U.K. corporation tax rate, which had been previously enacted. This change will unfavorably affect income tax expense on future U.K. earnings, and requires a reversal of the adjustment to the U.K. net deferred tax assets recognized at the time the tax rate decreases were originally enacted. Accordingly, during the third quarter of 2020, the Corporation recorded an income tax benefit of approximately $700 million along with a corresponding increase to the U.K. net deferred tax assets. The effective tax rate for 2019 included net tax benefits primarily related to the resolution of various tax controversy matters. Absent unusual items, we expect the effective tax rate for 2021 to be in the range of 10 – 12 percent, reflecting tax credits related to our ESG investment activity.Balance Sheet OverviewTable 5Selected Balance Sheet Data December 31(Dollars in millions)20202019% ChangeAssets Cash and cash equivalents$380,463 $161,560 135 %Federal funds sold and securities borrowed or purchased under agreements to resell304,058 274,597 11 Trading account assets198,854 229,826 (13)Debt securities684,850 472,197 45 Loans and leases927,861 983,426 (6)Allowance for loan and lease losses(18,802)(9,416)100 All other assets342,343 321,889 6 Total assets$2,819,627 $2,434,079 16 LiabilitiesDeposits$1,795,480 $1,434,803 25 Federal funds purchased and securities loaned or sold under agreements to repurchase170,323 165,109 3 Trading account liabilities71,320 83,270 (14)Short-term borrowings19,321 24,204 (20)Long-term debt262,934 240,856 9 All other liabilities227,325 221,027 3 Total liabilities2,546,703 2,169,269 17 Shareholders’ equity272,924 264,810 3 Total liabilities and shareholders’ equity$2,819,627 $2,434,079 16 AssetsAt December 31, 2020, total assets were approximately $2.8 trillion, up $385.5 billion from December 31, 2019. The increase in assets was primarily due to higher cash held at central banks that was primarily funded by deposit growth and debt securities, partially offset by a decline in loans and leases.Cash and Cash EquivalentsCash and cash equivalents increased $218.9 billion driven by deposit growth.Federal Funds Sold and Securities Borrowed or Purchased Under Agreements to ResellFederal funds transactions involve lending reserve balances on a short-term basis. Securities borrowed or purchased under agreements to resell are collateralized lending transactions utilized to accommodate customer transactions, earn interest rate spreads, and obtain securities for settlement and for collateral. Federal funds sold and securities borrowed or purchased under agreements to resell increased $29.5 billion primarily due to deployment of deposit inflows.Trading Account AssetsTrading account assets consist primarily of long positions in equity and fixed-income securities including U.S. government and agency securities, corporate securities and non-U.S. sovereign debt. Trading account assets decreased $31.0 billion due to a decline in inventory within Global Markets.Debt SecuritiesDebt securities primarily include U.S. Treasury and agency securities, mortgage-backed securities (MBS), principally agency MBS, non-U.S. bonds, corporate bonds and municipal debt. We use the debt securities portfolio primarily to manage interest rate and liquidity risk and to take advantage of market conditions that create economically attractive returns on these investments. Debt securities increased $212.7 billion primarily driven by the deployment of deposit inflows. For more information on debt securities, see Note 4 – Securities to the Consolidated Financial Statements.29 Bank of AmericaLoans and LeasesLoans and leases decreased $55.6 billion primarily driven by commercial loan paydowns, lower credit card spending and lower residential mortgages due to higher paydowns and a decline in originations. For more information on the loan portfolio, see Credit Risk Management on page 61.Allowance for Loan and Lease LossesThe allowance for loan and lease losses increased $9.4 billion primarily due to the weaker economic outlook related to COVID-19 and the impact of the adoption of the new credit loss accounting standard. For more information, see Allowance for Credit Losses on page 76.LiabilitiesAt December 31, 2020, total liabilities were approximately $2.5 trillion, up $377.4 billion from December 31, 2019, primarily due to deposit growth.DepositsDeposits increased $360.7 billion primarily due to an increase in retail and wholesale deposits.Federal Funds Purchased and Securities Loaned or Sold Under Agreements to RepurchaseFederal funds transactions involve borrowing reserve balances on a short-term basis. Securities loaned or sold under agreements to repurchase are collateralized borrowing transactions utilized to accommodate customer transactions, earn interest rate spreads and finance assets on the balance sheet. Federal funds purchased and securities loaned or sold under agreements to repurchase increased $5.2 billion primarily driven by client activity within Global Markets.Trading Account LiabilitiesTrading account liabilities consist primarily of short positions in equity and fixed-income securities including U.S. Treasury and agency securities, corporate securities and non-U.S. sovereign debt. Trading account liabilities decreased $12.0 billion primarily due to lower levels of short positions within Global Markets.Short-term BorrowingsShort-term borrowings provide an additional funding source and primarily consist of Federal Home Loan Bank (FHLB) short-term borrowings, notes payable and various other borrowings that generally have maturities of one year or less. Short-term borrowings decreased $4.9 billion due to higher deposit levels. For more information on short-term borrowings, see Note 10 – Federal Funds Sold or Purchased, Securities Financing Agreements, Short-term Borrowings and Restricted Cash to the Consolidated Financial Statements.Long-term DebtLong-term debt increased $22.1 billion primarily due to debt issuances and valuation adjustments, partially offset by maturities and redemptions. For more information on long-term debt, see Note 11 – Long-term Debt to the Consolidated Financial Statements.Shareholders’ EquityShareholders’ equity increased $8.1 billion driven by net income, market value increases on debt securities and issuances of preferred and common stock, partially offset by the return of capital to shareholders totaling $14.7 billion through share repurchases and common and preferred stock dividends, as well as the impact of the adoption of the new credit loss accounting standard and the redemption of preferred stock.Cash Flows OverviewThe Corporation’s operating assets and liabilities support our global markets and lending activities. We believe that cash flows from operations, available cash balances and our ability to generate cash through short- and long-term debt are sufficient to fund our operating liquidity needs. Our investing activities primarily include the debt securities portfolio and loans and leases. Our financing activities reflect cash flows primarily related to customer deposits, securities financing agreements and long-term debt. For more information on liquidity, see Liquidity Risk on page 57.Bank of America 30Supplemental Financial DataNon-GAAP Financial MeasuresIn this Form 10-K, we present certain non-GAAP financial measures. Non-GAAP financial measures exclude certain items or otherwise include components that differ from the most directly comparable measures calculated in accordance with GAAP. Non-GAAP financial measures are provided as additional useful information to assess our financial condition, results of operations (including period-to-period operating performance) or compliance with prospective regulatory requirements. These non-GAAP financial measures are not intended as a substitute for GAAP financial measures and may not be defined or calculated the same way as non-GAAP financial measures used by other companies.We view net interest income and related ratios and analyses on an FTE basis, which when presented on a consolidated basis are non-GAAP financial measures. To derive the FTE basis, net interest income is adjusted to reflect tax-exempt income on an equivalent before-tax basis with a corresponding increase in income tax expense. For purposes of this calculation, we use the federal statutory tax rate of 21 percent and a representative state tax rate. Net interest yield, which measures the basis points we earn over the cost of funds, utilizes net interest income on an FTE basis. We believe that presentation of these items on an FTE basis allows for comparison of amounts from both taxable and tax-exempt sources and is consistent with industry practices.We may present certain key performance indicators and ratios excluding certain items (e.g., debit valuation adjustment (DVA) gains (losses)) which result in non-GAAP financial measures. We believe that the presentation of measures that exclude these items is useful because such measures provide additional information to assess the underlying operational performance and trends of our businesses and to allow better comparison of period-to-period operating performance.We also evaluate our business based on certain ratios that utilize tangible equity, a non-GAAP financial measure. Tangible equity represents shareholders’ equity or common shareholders’ equity reduced by goodwill and intangible assets (excluding mortgage servicing rights (MSRs)), net of related deferred tax liabilities ("adjusted" shareholders' equity or common shareholders' equity). These measures are used to evaluate our use of equity. In addition, profitability, relationship and investment models use both return on average tangible common shareholders’ equity and return on average tangible shareholders’ equity as key measures to support our overall growth objectives. These ratios are as follows:● Return on average tangible common shareholders’ equity measures our net income applicable to common shareholders as a percentage of adjusted average common shareholders’ equity. The tangible common equity ratio represents adjusted ending common shareholders’ equity divided by total tangible assets.● Return on average tangible shareholders' equity measures our net income as a percentage of adjusted average total shareholders’ equity. The tangible equity ratio represents adjusted ending shareholders’ equity divided by total tangible assets.● Tangible book value per common share represents adjusted ending common shareholders’ equity divided by ending common shares outstanding.We believe ratios utilizing tangible equity provide additional useful information because they present measures of those assets that can generate income. Tangible book value per common share provides additional useful information about the level of tangible assets in relation to outstanding shares of common stock.The aforementioned supplemental data and performance measures are presented in Tables 6 and 7.For more information on the reconciliation of these non-GAAP financial measures to the corresponding GAAP financial measures, see Non-GAAP Reconciliations on page 88.Key Performance IndicatorsWe present certain key financial and nonfinancial performance indicators (key performance indicators) that management uses when assessing our consolidated and/or segment results. We believe they are useful to investors because they provide additional information about our underlying operational performance and trends. These key performance indicators (KPIs) may not be defined or calculated in the same way as similar KPIs used by other companies. For information on how these metrics are defined, see Key Metrics on page 173. Our consolidated key performance indicators, which include various equity and credit metrics, are presented in Table 1 on page 27 and/or Tables 6 and 7 on pages 32 and 33.For information on key segment performance metrics, see Business Segment Operations on page 36. 31 Bank of AmericaTable 6Five-year Summary of Selected Financial Data(In millions, except per share information)20202019201820172016Income statement Net interest income$43,360 $48,891 $48,162 $45,239 $41,486 Noninterest income42,168 42,353 42,858 41,887 42,012 Total revenue, net of interest expense85,528 91,244 91,020 87,126 83,498 Provision for credit losses11,320 3,590 3,282 3,396 3,597 Noninterest expense55,213 54,900 53,154 54,517 54,880 Income before income taxes18,995 32,754 34,584 29,213 25,021 Income tax expense1,101 5,324 6,437 10,981 7,199 Net income17,894 27,430 28,147 18,232 17,822 Net income applicable to common shareholders16,473 25,998 26,696 16,618 16,140 Average common shares issued and outstanding8,753.2 9,390.5 10,096.5 10,195.6 10,248.1 Average diluted common shares issued and outstanding8,796.9 9,442.9 10,236.9 10,778.4 11,046.8 Performance ratios Return on average assets (1)0.67 %1.14 %1.21 %0.80 %0.81 %Return on average common shareholders’ equity (1)6.76 10.62 11.04 6.72 6.69 Return on average tangible common shareholders’ equity (2)9.48 14.86 15.55 9.41 9.51 Return on average shareholders’ equity (1)6.69 10.24 10.63 6.72 6.70 Return on average tangible shareholders’ equity (2)9.07 13.85 14.46 9.08 9.17 Total ending equity to total ending assets9.68 10.88 11.27 11.71 12.17 Total average equity to total average assets9.96 11.14 11.39 11.96 12.14 Dividend payout38.18 23.65 20.31 24.24 15.94 Per common share data Earnings$1.88 $2.77 $2.64 $1.63 $1.57 Diluted earnings1.87 2.75 2.61 1.56 1.49 Dividends paid0.72 0.66 0.54 0.39 0.25 Book value (1)28.72 27.32 25.13 23.80 23.97 Tangible book value (2)20.60 19.41 17.91 16.96 16.89 Market capitalization$262,206 $311,209 $238,251 $303,681 $222,163 Average balance sheet Total loans and leases$982,467 $958,416 $933,049 $918,731 $900,433 Total assets2,683,122 2,405,830 2,325,246 2,268,633 2,190,218 Total deposits1,632,998 1,380,326 1,314,941 1,269,796 1,222,561 Long-term debt220,440 201,623 200,399 194,882 204,826 Common shareholders’ equity243,685 244,853 241,799 247,101 241,187 Total shareholders’ equity267,309 267,889 264,748 271,289 265,843 Asset quality (3) Allowance for credit losses (4)$20,680 $10,229 $10,398 $11,170 $11,999 Nonperforming loans, leases and foreclosed properties (5)5,116 3,837 5,244 6,758 8,084 Allowance for loan and lease losses as a percentage of total loans and leases outstanding (5)2.04 %0.97 %1.02 %1.12 %1.26 %Allowance for loan and lease losses as a percentage of total nonperforming loans and leases (5)380 265 194 161 149 Net charge-offs $4,121 $3,648 $3,763 $3,979 $3,821 Net charge-offs as a percentage of average loans and leases outstanding (5)0.42 %0.38 %0.41 %0.44 %0.43 %Capital ratios at year end (6) Common equity tier 1 capital11.9 %11.2 %11.6 %11.5 %10.8 %Tier 1 capital13.5 12.6 13.2 13.0 12.4 Total capital16.1 14.7 15.1 14.8 14.2 Tier 1 leverage7.4 7.9 8.4 8.6 8.8 Supplementary leverage ratio7.2 6.4 6.8 n/a n/aTangible equity (2)7.4 8.2 8.6 8.9 9.2 Tangible common equity (2)6.5 7.3 7.6 7.9 8.0 (1)For definitions, see Key Metrics on page 173(2)Tangible equity ratios and tangible book value per share of common stock are non-GAAP financial measures. For more information on these ratios and corresponding reconciliations to GAAP financial measures, see Supplemental Financial Data on page 31 and Non-GAAP Reconciliations on page 88.(3)Asset quality metrics include $75 million of non-U.S. consumer credit card net charge-offs in 2017 and $243 million of non-U.S. consumer credit card allowance for loan and lease losses, $9.2 billion of non-U.S. consumer credit card loans and $175 million of non-U.S. consumer credit card net charge-offs in 2016. The Corporation sold its non-U.S. consumer credit card business in 2017.(4)Includes the allowance for loan and leases losses and the reserve for unfunded lending commitments. (5)Balances and ratios do not include loans accounted for under the fair value option. For additional exclusions from nonperforming loans, leases and foreclosed properties, see Consumer Portfolio Credit Risk Management – Nonperforming Consumer Loans, Leases and Foreclosed Properties Activity on page 67 and corresponding Table 28 and Commercial Portfolio Credit Risk Management – Nonperforming Commercial Loans, Leases and Foreclosed Properties Activity on page 71 and corresponding Table 35.(6)Basel 3 transition provisions for regulatory capital adjustments and deductions were fully phased-in as of January 1, 2018. Prior periods are presented on a fully phased-in basis. For additional information, including which approach is used to assess capital adequacy, see Capital Management on page 50.n/a = not applicableBank of America 32Table 7Selected Quarterly Financial Data2020 Quarters2019 Quarters(In millions, except per share information)FourthThirdSecondFirstFourthThirdSecondFirstIncome statement Net interest income$10,253 $10,129 $10,848 $12,130 $12,140 $12,187 $12,189 $12,375 Noninterest income 9,846 10,207 11,478 10,637 10,209 10,620 10,895 10,629 Total revenue, net of interest expense20,099 20,336 22,326 22,767 22,349 22,807 23,084 23,004 Provision for credit losses53 1,389 5,117 4,761 941 779 857 1,013 Noninterest expense13,927 14,401 13,410 13,475 13,239 15,169 13,268 13,224 Income before income taxes6,119 4,546 3,799 4,531 8,169 6,859 8,959 8,767 Income tax expense 649 (335)266 521 1,175 1,082 1,611 1,456 Net income 5,470 4,881 3,533 4,010 6,994 5,777 7,348 7,311 Net income applicable to common shareholders5,208 4,440 3,284 3,541 6,748 5,272 7,109 6,869 Average common shares issued and outstanding8,724.9 8,732.9 8,739.9 8,815.6 9,017.1 9,303.6 9,523.2 9,725.9 Average diluted common shares issued and outstanding8,785.0 8,777.5 8,768.1 8,862.7 9,079.5 9,353.0 9,559.6 9,787.3 Performance ratios Return on average assets (1)0.78 %0.71 %0.53 %0.65 %1.13 %0.95 %1.23 %1.26 %Four-quarter trailing return on average assets (2)0.67 0.75 0.81 0.99 1.14 1.17 1.24 1.22 Return on average common shareholders’ equity (1)8.39 7.24 5.44 5.91 11.00 8.48 11.62 11.42 Return on average tangible common shareholders’ equity (3)11.73 10.16 7.63 8.32 15.43 11.84 16.24 16.01 Return on average shareholders’ equity (1)8.03 7.26 5.34 6.10 10.40 8.48 11.00 11.14 Return on average tangible shareholders’ equity (3)10.84 9.84 7.23 8.29 14.09 11.43 14.88 15.10 Total ending equity to total ending assets9.68 9.82 9.69 10.11 10.88 11.06 11.33 11.23 Total average equity to total average assets9.71 9.76 9.85 10.60 10.89 11.21 11.17 11.28 Dividend payout30.11 35.36 47.87 44.57 23.90 31.48 19.95 21.20 Per common share data Earnings $0.60 $0.51 $0.38 $0.40 $0.75 $0.57 $0.75 $0.71 Diluted earnings 0.59 0.51 0.37 0.40 0.74 0.56 0.74 0.70 Dividends paid0.18 0.18 0.18 0.18 0.18 0.18 0.15 0.15 Book value (1)28.72 28.33 27.96 27.84 27.32 26.96 26.41 25.57 Tangible book value (3)20.60 20.23 19.90 19.79 19.41 19.26 18.92 18.26 Market capitalization$262,206 $208,656 $205,772 $184,181 $311,209 $264,842 $270,935 $263,992 Average balance sheet Total loans and leases$934,798 $974,018 $1,031,387 $990,283 $973,986 $964,733 $950,525 $944,020 Total assets2,791,874 2,739,684 2,704,186 2,494,928 2,450,005 2,412,223 2,399,051 2,360,992 Total deposits1,737,139 1,695,488 1,658,197 1,439,336 1,410,439 1,375,052 1,375,450 1,359,864 Long-term debt225,423 224,254 221,167 210,816 206,026 202,620 201,007 196,726 Common shareholders’ equity246,840 243,896 242,889 241,078 243,439 246,630 245,438 243,891 Total shareholders’ equity271,020 267,323 266,316 264,534 266,900 270,430 267,975 266,217 Asset quality Allowance for credit losses (4)$20,680 $21,506 $21,091 $17,126 $10,229 $10,242 $10,333 $10,379 Nonperforming loans, leases and foreclosed properties (5)5,116 4,730 4,611 4,331 3,837 3,723 4,452 5,145 Allowance for loan and lease losses as a percentage of total loans and leases outstanding (5)2.04 %2.07 %1.96 %1.51 %0.97 %0.98 %1.00 %1.02 %Allowance for loan and lease losses as a percentage of total nonperforming loans and leases (5)380 431 441 389 265 271 228 197 Net charge-offs $881 $972 $1,146 $1,122 $959 $811 $887 $991 Annualized net charge-offs as a percentage of average loans and leases outstanding (5)0.38 %0.40 %0.45 %0.46 %0.39 %0.34 %0.38 %0.43 %Capital ratios at period end (6) Common equity tier 1 capital11.9 %11.9 %11.4 %10.8 %11.2 %11.4 %11.7 %11.6 %Tier 1 capital13.5 13.5 12.9 12.3 12.6 12.9 13.3 13.1 Total capital16.1 16.1 14.8 14.6 14.7 15.1 15.4 15.2 Tier 1 leverage7.4 7.4 7.4 7.9 7.9 8.2 8.4 8.4 Supplementary leverage ratio7.2 6.9 7.1 6.4 6.4 6.6 6.8 6.8 Tangible equity (3)7.4 7.4 7.3 7.7 8.2 8.4 8.7 8.5 Tangible common equity (3)6.5 6.6 6.5 6.7 7.3 7.4 7.6 7.6 Total loss-absorbing capacity and long-term debt metrics Total loss-absorbing capacity to risk-weighted assets27.4 %26.9 %26.0 %24.6 %24.6 %24.8 %25.5 %24.8 %Total loss-absorbing capacity to supplementary leverage exposure14.5 13.7 14.2 12.8 12.5 12.7 13.0 12.8 Eligible long-term debt to risk-weighted assets13.3 12.9 12.4 11.6 11.5 11.4 11.8 11.4 Eligible long-term debt to supplementary leverage exposure7.1 6.6 6.7 6.1 5.8 5.8 6.0 5.9 (1)For definitions, see Key Metrics on page 173. (2)Calculated as total net income for four consecutive quarters divided by annualized average assets for four consecutive quarters.(3)Tangible equity ratios and tangible book value per share of common stock are non-GAAP financial measures. For more information on these ratios and corresponding reconciliations to GAAP financial measures, see Supplemental Financial Data on page 31 and Non-GAAP Reconciliations on page 88.(4)Includes the allowance for loan and lease losses and the reserve for unfunded lending commitments.(5)Balances and ratios do not include loans accounted for under the fair value option. For additional exclusions from nonperforming loans, leases and foreclosed properties, see Consumer Portfolio Credit Risk Management – Nonperforming Consumer Loans, Leases and Foreclosed Properties Activity on page 68 and corresponding Table 28 and Commercial Portfolio Credit Risk Management – Nonperforming Commercial Loans, Leases and Foreclosed Properties Activity on page 72 and corresponding Table 35.(6)For more information, including which approach is used to assess capital adequacy, see Capital Management on page 50. 33 Bank of America Table 8Average Balances and Interest Rates - FTE BasisAverageBalanceInterestIncome/Expense (1)Yield/RateAverageBalanceInterestIncome/Expense (1)Yield/RateAverageBalanceInterestIncome/Expense (1)Yield/Rate(Dollars in millions)202020192018Earning assets Interest-bearing deposits with the Federal Reserve, non- U.S. central banks and other banks$253,227 $359 0.14 %$125,555 $1,823 1.45 %$139,848 $1,926 1.38 %Time deposits placed and other short-term investments8,840 29 0.33 9,427 207 2.19 9,446 216 2.29 Federal funds sold and securities borrowed or purchased under agreements to resell309,945 903 0.29 279,610 4,843 1.73 251,328 3,176 1.26 Trading account assets148,076 4,185 2.83 148,076 5,269 3.56 132,724 4,901 3.69 Debt securities532,266 9,868 1.87 450,090 11,917 2.65 437,312 11,837 2.66 Loans and leases (2) Residential mortgage236,719 7,338 3.10 220,552 7,651 3.47 207,523 7,294 3.51 Home equity38,251 1,290 3.37 44,600 2,194 4.92 53,886 2,573 4.77 Credit card85,017 8,759 10.30 94,488 10,166 10.76 94,612 9,579 10.12 Direct/Indirect and other consumer (3)89,974 2,545 2.83 90,656 3,261 3.60 93,036 3,104 3.34 Total consumer449,961 19,932 4.43 450,296 23,272 5.17 449,057 22,550 5.02 U.S. commercial (4)344,095 9,712 2.82 321,467 13,161 4.09 304,387 11,937 3.92 Non-U.S. commercial (4)106,487 2,208 2.07 103,918 3,402 3.27 97,664 3,220 3.30 Commercial real estate (5)63,428 1,790 2.82 62,044 2,741 4.42 60,384 2,618 4.34 Commercial lease financing18,496 559 3.02 20,691 718 3.47 21,557 698 3.24 Total commercial532,506 14,269 2.68 508,120 20,022 3.94 483,992 18,473 3.82 Total loans and leases982,467 34,201 3.48 958,416 43,294 4.52 933,049 41,023 4.40 Other earning assets83,078 2,539 3.06 69,089 4,478 6.48 76,524 4,300 5.62 Total earning assets2,317,899 52,084 2.25 2,040,263 71,831 3.52 1,980,231 67,379 3.40 Cash and due from banks31,885 26,193 25,830 Other assets, less allowance for loan and lease losses333,338 339,374 319,185 Total assets$2,683,122 $2,405,830 $2,325,246 Interest-bearing liabilities U.S. interest-bearing deposits Savings$58,113 $6 0.01 %$52,020 $5 0.01 %$54,226 $6 0.01 %Demand and money market deposit accounts829,719 977 0.12 741,126 4,471 0.60 676,382 2,636 0.39 Consumer CDs and IRAs47,780 405 0.85 47,577 471 0.99 39,823 157 0.39 Negotiable CDs, public funds and other deposits64,857 323 0.50 66,866 1,407 2.11 50,593 991 1.96 Total U.S. interest-bearing deposits1,000,469 1,711 0.17 907,589 6,354 0.70 821,024 3,790 0.46 Non-U.S. interest-bearing deposits Banks located in non-U.S. countries1,476 4 0.27 1,936 20 1.04 2,312 39 1.69 Governments and official institutions184 — 0.01 181 — 0.05 810 — 0.01 Time, savings and other75,386 228 0.30 69,351 814 1.17 65,097 666 1.02 Total non-U.S. interest-bearing deposits77,046 232 0.30 71,468 834 1.17 68,219 705 1.03 Total interest-bearing deposits1,077,515 1,943 0.18 979,057 7,188 0.73 889,243 4,495 0.51 Federal funds purchased, securities loaned or sold under agreements to repurchase, short-term borrowings and other interest-bearing liabilities293,466 987 0.34 276,432 7,208 2.61 269,748 5,839 2.17 Trading account liabilities41,386 974 2.35 45,449 1,249 2.75 50,928 1,358 2.67 Long-term debt220,440 4,321 1.96 201,623 6,700 3.32 200,399 6,915 3.45 Total interest-bearing liabilities1,632,807 8,225 0.50 1,502,561 22,345 1.49 1,410,318 18,607 1.32 Noninterest-bearing sources Noninterest-bearing deposits555,483 401,269 425,698 Other liabilities (6)227,523 234,111 224,482 Shareholders’ equity267,309 267,889 264,748 Total liabilities and shareholders’ equity$2,683,122 $2,405,830 $2,325,246 Net interest spread 1.75 % 2.03 % 2.08 %Impact of noninterest-bearing sources 0.15 0.40 0.37 Net interest income/yield on earning assets (7) $43,859 1.90 % $49,486 2.43 % $48,772 2.45 %(1)Includes the impact of interest rate risk management contracts. For more information, see Interest Rate Risk Management for the Banking Book on page 82.(2)Nonperforming loans are included in the respective average loan balances. Income on these nonperforming loans is generally recognized on a cost recovery basis.(3)Includes non-U.S. consumer loans of $2.9 billion, $2.9 billion and $2.8 billion for 2020, 2019 and 2018, respectively.(4)Certain prior-period amounts for 2019 have been reclassified to conform to current-period presentation.(5)Includes U.S. commercial real estate loans of $59.8 billion, $57.3 billion and $56.4 billion, and non-U.S. commercial real estate loans of $3.6 billion, $4.7 billion and $4.0 billion for 2020, 2019 and 2018, respectively. (6)Includes $34.3 billion, $35.5 billion and $30.4 billion of structured notes and liabilities for 2020, 2019 and 2018, respectively.(7)Net interest income includes FTE adjustments of $499 million, $595 million and $610 million for 2020, 2019 and 2018, respectively.Bank of America 34Table 9Analysis of Changes in Net Interest Income - FTE Basis Due to Change in (1)Net ChangeDue to Change in (1)Net ChangeVolumeRateVolumeRate(Dollars in millions)From 2019 to 2020From 2018 to 2019Increase (decrease) in interest income Interest-bearing deposits with the Federal Reserve, non-U.S. central banks and other banks$1,849 $(3,313)$(1,464)$(193)$90 $(103)Time deposits placed and other short-term investments(13)(165)(178)— (9)(9)Federal funds sold and securities borrowed or purchased under agreements to resell519 (4,459)(3,940)347 1,320 1,667 Trading account assets3 (1,087)(1,084)563 (195)368 Debt securities2,188 (4,237)(2,049)135 (55)80 Loans and leases Residential mortgage563 (876)(313)447 (90)357 Home equity(312)(592)(904)(446)67 (379)Credit card(1,018)(389)(1,407)(17)604 587 Direct/Indirect and other consumer(22)(694)(716)(76)233 157 Total consumer (3,340) 722 U.S. commercial (2)912 (4,361)(3,449)665 559 1,224 Non-U.S. commercial (2)80 (1,274)(1,194)209 (27)182 Commercial real estate63 (1,014)(951)75 48 123 Commercial lease financing(76)(83)(159)(28)48 20 Total commercial (5,753) 1,549 Total loans and leases (9,093) 2,271 Other earning assets905 (2,844)(1,939)(417)595 178 Net increase (decrease) in interest income $(19,747) $4,452 Increase (decrease) in interest expense U.S. interest-bearing deposits Savings$1 $— $1 $(1)$— $(1)Demand and money market deposit accounts507 (4,001)(3,494)254 1,581 1,835 Consumer CDs and IRAs2 (68)(66)29 285 314 Negotiable CDs, public funds and other deposits(39)(1,045)(1,084)320 96 416 Total U.S. interest-bearing deposits (4,643) 2,564 Non-U.S. interest-bearing deposits Banks located in non-U.S. countries(5)(11)(16)(6)(13)(19)Time, savings and other68 (654)(586)41 107 148 Total non-U.S. interest-bearing deposits (602) 129 Total interest-bearing deposits (5,245) 2,693 Federal funds purchased, securities loaned or sold under agreements to repurchase, short-term borrowings and other interest-bearing liabilities451 (6,672)(6,221)160 1,209 1,369 Trading account liabilities(111)(164)(275)(145)36 (109)Long-term debt619 (2,998)(2,379)41 (256)(215)Net increase (decrease) in interest expense (14,120) 3,738 Net increase (decrease) in net interest income (3) $(5,627) $714 (1)The changes for each category of interest income and expense are divided between the portion of change attributable to the variance in volume and the portion of change attributable to the variance in rate for that category. The unallocated change in rate or volume variance is allocated between the rate and volume variances.(2)Certain prior-period amounts have been reclassified to conform to current-period presentation.(3)Includes changes in FTE basis adjustments of a $96 million decrease from 2019 to 2020 and a $15 million decrease from 2018 to 2019.35 Bank of AmericaBusiness Segment OperationsSegment Description and Basis of PresentationWe report our results of operations through four business segments: Consumer Banking, GWIM, Global Banking and Global Markets, with the remaining operations recorded in All Other. We manage our segments and report their results on an FTE basis. The primary activities, products and businesses of the business segments and All Other are shown below. We periodically review capital allocated to our businesses and allocate capital annually during the strategic and capital planning processes. We utilize a methodology that considers the effect of regulatory capital requirements in addition to internal risk-based capital models. Our internal risk-based capital models use a risk-adjusted methodology incorporating each segment’s credit, market, interest rate, business and operational risk components. For more information on the nature of these risks, see Managing Risk on page 47. The capital allocated to the business segments is referred to as allocated capital. Allocated equity in the reporting units is comprised of allocated capital plus capital for the portion of goodwill and intangibles specifically assigned to the reporting unit. For more information, including the definition of a reporting unit, see Note 7 – Goodwill and Intangible Assets to the Consolidated Financial Statements.For more information on our presentation of financial information on an FTE basis, see Supplemental Financial Data on page 31, and for reconciliations to consolidated total revenue, net income and period-end total assets, see Note 23 – Business Segment Information to the Consolidated Financial Statements.Key Performance IndicatorsWe present certain key financial and nonfinancial performance indicators that management uses when evaluating segment results. We believe they are useful to investors because they provide additional information about our segments’ operational performance, customer trends and business growth.Bank of America 36Consumer BankingDepositsConsumer LendingTotal Consumer Banking(Dollars in millions)202020192020201920202019% ChangeNet interest income$13,739 $16,904 $10,959 $11,254 $24,698 $28,158 (12)%Noninterest income:Card income(20)(33)4,693 5,117 4,673 5,084 (8)Service charges3,416 4,216 1 2 3,417 4,218 (19)All other income310 833 164 294 474 1,127 (58)Total noninterest income3,706 5,016 4,858 5,413 8,564 10,429 (18)Total revenue, net of interest expense17,445 21,920 15,817 16,667 33,262 38,587 (14)Provision for credit losses379 269 5,386 3,503 5,765 3,772 53 Noninterest expense11,508 10,718 7,370 6,928 18,878 17,646 7 Income before income taxes5,558 10,933 3,061 6,236 8,619 17,169 (50)Income tax expense1,362 2,679 750 1,528 2,112 4,207 (50)Net income$4,196 $8,254 $2,311 $4,708 $6,507 $12,962 (50)Effective tax rate (1)24.5 %24.5 %Net interest yield1.69 %2.40 %3.53 %3.80 %2.88 3.81 Return on average allocated capital35 69 9 19 17 35 Efficiency ratio65.97 48.90 46.60 41.56 56.76 45.73 Balance SheetAverageTotal loans and leases$5,144 $5,371 $310,436 $295,562 $315,580 $300,933 5 %Total earning assets (2)813,779 703,481 310,862 296,051 858,724 738,807 16 Total assets (2)849,924 735,298 314,599 306,169 898,606 780,742 15 Total deposits816,968 702,972 6,698 5,368 823,666 708,340 16 Allocated capital12,000 12,000 26,500 25,000 38,500 37,000 4 Year endTotal loans and leases$4,673 $5,467 $295,261 $311,942 $299,934 $317,409 (6)%Total earning assets (2)899,951 724,573 295,627 312,684 945,343 760,174 24 Total assets (2)939,629 758,459 299,186 322,717 988,580 804,093 23 Total deposits906,092 725,665 6,560 5,080 912,652 730,745 25 (1)Estimated at the segment level only.(2)In segments and businesses where the total of liabilities and equity exceeds assets, we allocate assets from All Other to match the segments’ and businesses’ liabilities and allocated shareholders’ equity. As a result, total earning assets and total assets of the businesses may not equal total Consumer Banking.Consumer Banking, which is comprised of Deposits and Consumer Lending, offers a diversified range of credit, banking and investment products and services to consumers and small businesses. Deposits and Consumer Lending include the net impact of migrating customers and their related deposit, brokerage asset and loan balances between Deposits, Consumer Lending and GWIM, as well as other client-managed businesses. Our customers and clients have access to a coast to coast network including financial centers in 38 states and the District of Columbia. Our network includes approximately 4,300 financial centers, approximately 17,000 ATMS, nationwide call centers and leading digital banking platforms with more than 39 million active users, including approximately 31 million active mobile users.Consumer Banking Results.Net income for Consumer Banking decreased $6.5 billion to $6.5 billion in 2020 compared to 2019 primarily due to lower revenue, higher provision for credit losses and higher expenses. Net interest income decreased $3.5 billion to $24.7 billion primarily due to lower rates, partially offset by the benefit of higher deposit and loan balances. Noninterest income decreased $1.9 billion to $8.6 billion driven by a decline in service charges primarily due to higher deposit balances and lower card income due to decreased client activity, as well as lower other income due to the allocation of asset and liability management (ALM) results.The provision for credit losses increased $2.0 billion to $5.8 billion primarily due to the weaker economic outlook related to COVID-19. Noninterest expense increased $1.2 billion to $18.9 billion primarily driven by incremental expense to support customers and employees during the pandemic, as well as the cost of increased client activity and continued investments for business growth, including the merchant services platform.The return on average allocated capital was 17 percent, down from 35 percent, driven by lower net income and, to a lesser extent, an increase in allocated capital. For information on capital allocated to the business segments, see Business Segment Operations on page 36.37 Bank of AmericaDepositsDeposits includes the results of consumer deposit activities which consist of a comprehensive range of products provided to consumers and small businesses. Our deposit products include traditional savings accounts, money market savings accounts, CDs and IRAs, and noninterest- and interest-bearing checking accounts, as well as investment accounts and products. Net interest income is allocated to the deposit products using our funds transfer pricing process that matches assets and liabilities with similar interest rate sensitivity and maturity characteristics. Deposits generates fees such as account service fees, non-sufficient funds fees, overdraft charges and ATM fees, as well as investment and brokerage fees from Merrill Edge accounts. Merrill Edge is an integrated investing and banking service targeted at customers with less than $250,000 in investable assets. Merrill Edge provides investment advice and guidance, client brokerage asset services, a self-directed online investing platform and key banking capabilities including access to the Corporation’s network of financial centers and ATMs.Net income for Deposits decreased $4.1 billion to $4.2 billion primarily driven by lower revenue. Net interest income declined $3.2 billion to $13.7 billion primarily due to lower interest rates, partially offset by the benefit of growth in deposits. Noninterest income decreased $1.3 billion to $3.7 billion primarily driven by lower service charges due to higher deposit balances and lower client activity related to the impact of COVID-19, as well as lower other income due to the allocation of ALM results.The provision for credit losses increased $110 million to $379 million in 2020 due to the weaker economic outlook related to COVID-19. Noninterest expense increased $790 million to $11.5 billion driven by continued investments in the business and incremental expense to support customers and employees during the pandemic.Average deposits increased $114.0 billion to $817.0 billion in 2020 driven by strong organic growth of $79.3 billion in checking and time deposits and $34.4 billion in traditional savings and money market savings.The following table provides key performance indicators for Deposits. Management uses these metrics, and we believe they are useful to investors because they provide additional information to evaluate our deposit profitability and digital/mobile trends.Key Statistics – Deposits20202019Total deposit spreads (excludes noninterest costs) (1)1.94%2.34%Year EndConsumer investment assets (in millions) (2)$306,104$240,132Active digital banking users (units in thousands) (3)39,31538,266Active mobile banking users (units in thousands) (4)30,78329,174Financial centers4,3124,300ATMs16,90416,788(1)Includes deposits held in Consumer Lending.(2)Includes client brokerage assets, deposit sweep balances and AUM in Consumer Banking.(3)Active digital banking users represents mobile and/or online users at period end. (4)Active mobile banking users represents mobile users at period end.Consumer investment assets increased $66.0 billion in 2020 driven by market performance and client flows. Active mobile banking users increased approximately two million reflecting continuing changes in our customers’ banking preferences. We had a net increase of 12 financial centers as we continued to optimize our consumer banking network.Consumer LendingConsumer Lending offers products to consumers and small businesses across the U.S. The products offered include credit and debit cards, residential mortgages and home equity loans, and direct and indirect loans such as automotive, recreational vehicle and consumer personal loans. In addition to earning net interest spread revenue on its lending activities, Consumer Lending generates interchange revenue from credit and debit card transactions, late fees, cash advance fees, annual credit card fees, mortgage banking fee income and other miscellaneous fees. Consumer Lending products are available to our customers through our retail network, direct telephone, and online and mobile channels. Consumer Lending results also include the impact of servicing residential mortgages and home equity loans in the core portfolio, including loans held on the balance sheet of Consumer Lending and loans serviced for others.Bank of America 38Net income for Consumer Lending was $2.3 billion, a decrease of $2.4 billion, primarily due to higher provision for credit losses. Net interest income declined $295 million to $11.0 billion primarily due to lower interest rates, partially offset by loan growth. Noninterest income decreased $555 million to $4.9 billion primarily driven by lower card income due to lower client activity, as well as lower other income due to the allocation of ALM results.The provision for credit losses increased $1.9 billion to $5.4 billion primarily due to the weaker economic outlook related to COVID-19. Noninterest expense increased $442 million to $7.4 billion primarily driven by investments in the business and incremental expense to support customers and employees during the pandemic.Average loans increased $14.9 billion to $310.4 billion primarily driven by an increase in residential mortgages and PPP loans, partially offset by a decline in credit cards.The following table provides key performance indicators for Consumer Lending. Management uses these metrics, and we believe they are useful to investors because they provide additional information about loan growth and profitability.Key Statistics – Consumer Lending(Dollars in millions)20202019Total credit card (1)Gross interest yield (2)10.27 %10.76 %Risk-adjusted margin (3)9.16 8.28 New accounts (in thousands)2,505 4,320 Purchase volumes$251,599 $277,852 Debit card purchase volumes$384,503 $360,672 (1)Includes GWIM's credit card portfolio.(2)Calculated as the effective annual percentage rate divided by average loans.(3)Calculated as the difference between total revenue, net of interest expense, and net credit losses divided by average loans.During 2020, the total risk-adjusted margin increased 88 bps compared to 2019 driven by a lower mix of customer balances at promotional rates, the lower interest rate environment and lower net credit losses. Total credit card purchase volumes declined $26.3 billion to $251.6 billion. The decline in credit card purchase volumes was driven by the impact of COVID-19. While overall spending improved during the second half of 2020, spending for travel and entertainment remained lower compared to 2019. During 2020, debit card purchase volumes increased $23.8 billion to $384.5 billion, despite COVID-19 impacts. Debit card purchase volumes improved in the second half of 2020 as businesses reopened and spending improved.Key Statistics – Residential Mortgage Loan Production (1)(Dollars in millions)20202019Consumer Banking:First mortgage$43,197 $49,179 Home equity6,930 9,755 Total (2):First mortgage$69,086 $72,467 Home equity8,160 11,131 (1)The loan production amounts represent the unpaid principal balance of loans and, in the case of home equity, the principal amount of the total line of credit.(2)In addition to loan production in Consumer Banking, there is also first mortgage and home equity loan production in GWIM.First mortgage loan originations in Consumer Banking and for the total Corporation decreased $6.0 billion and $3.4 billion in 2020 primarily driven by a decline in nonconforming applications.Home equity production in Consumer Banking and for the total Corporation decreased $2.8 billion and $3.0 billion in 2020 primarily driven by a decline in applications.39 Bank of AmericaGlobal Wealth & Investment Management(Dollars in millions)20202019% ChangeNet interest income$5,468 $6,504 (16)%Noninterest income:Investment and brokerage services12,270 11,870 3 All other income846 1,164 (27)Total noninterest income13,116 13,034 1 Total revenue, net of interest expense18,584 19,538 (5)Provision for credit losses357 82 n/mNoninterest expense14,154 13,825 2 Income before income taxes4,073 5,631 (28)Income tax expense998 1,380 (28)Net income$3,075 $4,251 (28)Effective tax rate24.5 %24.5 %Net interest yield1.73 2.33 Return on average allocated capital21 29 Efficiency ratio76.16 70.76 Balance SheetAverageTotal loans and leases$183,402 $168,910 9 %Total earning assets316,008 279,681 13 Total assets328,384 292,016 12 Total deposits287,123 256,516 12 Allocated capital15,000 14,500 3 Year endTotal loans and leases$188,562 $176,600 7 %Total earning assets356,873 287,201 24 Total assets369,736 299,770 23 Total deposits322,157 263,113 22 n/m = not meaningfulGWIM consists of two primary businesses: Merrill Lynch Global Wealth Management (MLGWM) and Bank of America Private Bank. MLGWM's advisory business provides a high-touch client experience through a network of financial advisors focused on clients with over $250,000 in total investable assets. MLGWM provides tailored solutions to meet clients' needs through a full set of investment management, brokerage, banking and retirement products.Bank of America Private Bank, together with MLGWM's Private Wealth Management business, provides comprehensive wealth management solutions targeted to high net worth and ultra high net worth clients, as well as customized solutions to meet clients' wealth structuring, investment management, trust and banking needs, including specialty asset management services.Net income for GWIM decreased $1.2 billion to $3.1 billion primarily due to lower net interest income, higher noninterest expense and higher provision for credit losses. Net interest income decreased $1.0 billion to $5.5 billion due to the impact of lower interest rates, partially offset by the benefit of strong deposit and loan growth. Noninterest income, which primarily includes investment and brokerage services income, increased $82 million to $13.1 billion primarily due to higher market valuations and positive AUM flows, largely offset by declines in AUM pricing as well as lower other income due to the allocation of ALM results.The provision for credit losses increased $275 million to $357 million primarily due to the weaker economic outlook related to COVID-19. Noninterest expense increased $329 million to $14.2 billion primarily driven by higher investments in primary sales professionals and revenue-related incentives.The return on average allocated capital was 21 percent, down from 29 percent, due to lower net income and, to a lesser extent, a small increase in allocated capital. Average loans increased $14.5 billion to $183.4 billion primarily driven by residential mortgage and custom lending. Average deposits increased $30.6 billion to $287.1 billion primarily driven by inflows resulting from client responses to market volatility and lower spending.MLGWM revenue of $15.3 billion decreased five percent primarily driven by the impact of lower interest rates, partially offset by the benefits of higher market valuations and positive AUM flows.Bank of America Private Bank revenue of $3.3 billion decreased four percent primarily driven by the impact of lower interest rates.Bank of America 40Key Indicators and Metrics(Dollars in millions, except as noted)20202019Revenue by BusinessMerrill Lynch Global Wealth Management$15,292 $16,112 Bank of America Private Bank3,292 3,426 Total revenue, net of interest expense$18,584 $19,538 Client Balances by Business, at year end Merrill Lynch Global Wealth Management$2,808,340 $2,558,102 Bank of America Private Bank541,464 489,690 Total client balances$3,349,804 $3,047,792 Client Balances by Type, at year end Assets under management$1,408,465 $1,275,555 Brokerage and other assets1,479,614 1,372,733 Deposits322,157 263,103 Loans and leases (1)191,124 179,296 Less: Managed deposits in assets under management(51,556)(42,895)Total client balances$3,349,804 $3,047,792 Assets Under Management RollforwardAssets under management, beginning of year$1,275,555 $1,072,234 Net client flows 19,596 24,865 Market valuation/other 113,314 178,456 Total assets under management, end of year$1,408,465 $1,275,555 Associates, at year endNumber of financial advisors17,331 17,458 Total wealth advisors, including financial advisors19,373 19,440 Total primary sales professionals, including financial advisors and wealth advisors21,213 20,586 Merrill Lynch Global Wealth Management MetricFinancial advisor productivity (2) (in thousands)$1,126 $1,082 Bank of America Private Bank Metric, at year endPrimary sales professionals1,759 1,766 (1)Includes margin receivables which are classified in customer and other receivables on the Consolidated Balance Sheet.(2)For a definition, see Key Metrics on page 173.Client Balances Client balances managed under advisory and/or discretion of GWIM are AUM and are typically held in diversified portfolios. Fees earned on AUM are calculated as a percentage of clients’ AUM balances. The asset management fees charged to clients per year depend on various factors, but are commonly driven by the breadth of the client’s relationship. The net client AUM flows represent the net change in clients’ AUM balances over a specified period of time, excluding market appreciation/depreciation and other adjustments.Client balances increased $302.0 billion, or 10 percent, to $3.3 trillion at December 31, 2020 compared to December 31, 2019. The increase in client balances was primarily due to higher market valuations and positive client flows.41 Bank of AmericaGlobal Banking(Dollars in millions)20202019% ChangeNet interest income$9,013 $10,675 (16)%Noninterest income:Service charges3,238 3,015 7 Investment banking fees4,010 3,137 28 All other income2,726 3,656 (25)Total noninterest income9,974 9,808 2 Total revenue, net of interest expense 18,987 20,483 (7)Provision for credit losses4,897 414 n/mNoninterest expense9,337 9,011 4 Income before income taxes4,753 11,058 (57)Income tax expense 1,283 2,985 (57)Net income$3,470 $8,073 (57)Effective tax rate 27.0 %27.0 %Net interest yield1.86 2.75 Return on average allocated capital8 20 Efficiency ratio49.17 43.99 Balance SheetAverageTotal loans and leases $382,264 $374,304 2 %Total earning assets485,688 388,152 25 Total assets542,302 443,083 22 Total deposits456,562 362,731 26 Allocated capital42,500 41,000 4 Year endTotal loans and leases$339,649 $379,268 (10)%Total earning assets522,650 407,180 28 Total assets580,561 464,032 25 Total deposits493,748 383,180 29 n/m = not meaningfulGlobal Banking, which includes Global Corporate Banking, Global Commercial Banking, Business Banking and Global Investment Banking, provides a wide range of lending-related products and services, integrated working capital management and treasury solutions, and underwriting and advisory services through our network of offices and client relationship teams. Our lending products and services include commercial loans, leases, commitment facilities, trade finance, commercial real estate lending and asset-based lending. Our treasury solutions business includes treasury management, foreign exchange, short-term investing options and merchant services. We also provide investment banking products to our clients such as debt and equity underwriting and distribution, and merger-related and other advisory services. Underwriting debt and equity issuances, fixed-income and equity research, and certain market-based activities are executed through our global broker-dealer affiliates, which are our primary dealers in several countries. Within Global Banking, Global Corporate Banking clients generally include large global corporations, financial institutions and leasing clients. Global Commercial Banking clients generally include middle-market companies, commercial real estate firms and not-for-profit companies. Business Banking clients include mid-sized U.S.-based businesses requiring customized and integrated financial advice and solutions.Net income for Global Banking decreased $4.6 billion to $3.5 billion primarily driven by higher provision for credit losses as well as lower revenue.Revenue decreased $1.5 billion to $19.0 billion driven by lower net interest income. Net interest income decreased $1.7 billion to $9.0 billion primarily driven by lower interest rates, partially offset by higher loan and deposit balances.Noninterest income of $10.0 billion increased $166 million driven by higher investment banking fees, partially offset by lower valuation driven adjustments on the fair value loan portfolio, debt securities and leveraged loans, as well as the allocation of ALM results.The provision for credit losses increased $4.5 billion to $4.9 billion primarily due to the weaker economic outlook related to COVID-19. Noninterest expense increased $326 million primarily due to continued investments in the business, partially offset by lower revenue-related incentives.The return on average allocated capital was eight percent in 2020 compared to 20 percent in 2019 due to lower net income and, to a lesser extent, an increase in allocated capital. For information on capital allocated to the business segments, see Business Segment Operations on page 36.Global Corporate, Global Commercial and Business Banking Global Corporate, Global Commercial and Business Banking each include Business Lending and Global Transaction Services activities. Business Lending includes various lending-related products and services, and related hedging activities, including commercial loans, leases, commitment facilities, trade finance, real estate lending and asset-based lending. Global Transaction Services includes deposits, treasury management, credit card, foreign exchange and short-term investment products.Bank of America 42The table below and following discussion present a summary of the results, which exclude certain investment banking, merchant services and PPP activities in Global Banking.Global Corporate, Global Commercial and Business BankingGlobal Corporate BankingGlobal Commercial BankingBusiness BankingTotal(Dollars in millions)20202019202020192020201920202019RevenueBusiness Lending$3,552 $3,994 $3,743 $4,132 $261 $363 $7,556 $8,489 Global Transaction Services2,986 3,994 3,169 3,499 893 1,064 7,048 8,557 Total revenue, net of interest expense$6,538 $7,988 $6,912 $7,631 $1,154 $1,427 $14,604 $17,046 Balance SheetAverageTotal loans and leases $179,393 $177,713 $182,212 $181,485 $14,410 $15,058 $376,015 $374,256 Total deposits216,371 177,924 191,813 144,620 48,214 40,196 456,398 362,740 Year endTotal loans and leases $153,126 $181,409 $164,641 $182,727 $13,242 $15,152 $331,009 $379,288 Total deposits233,484 185,352 207,597 157,322 52,150 40,504 493,231 383,178 Business Lending revenue decreased $933 million in 2020 compared to 2019. The decrease was primarily driven by lower interest rates. Global Transaction Services revenue decreased $1.5 billion in 2020 compared to 2019 driven by the allocation of ALM results, partially offset by the impact of higher deposit balances.Average loans and leases were relatively flat in 2020 compared to 2019. Average deposits increased 26 percent primarily due to client responses to market volatility, government stimulus and placement of credit draws.Global Investment BankingClient teams and product specialists underwrite and distribute debt, equity and loan products, and provide advisory services and tailored risk management solutions. The economics of certain investment banking and underwriting activities are shared primarily between Global Banking and Global Markets under an internal revenue-sharing arrangement. Global Banking originates certain deal-related transactions with our corporate and commercial clients that are executed and distributed by Global Markets. To provide a complete discussion of our consolidated investment banking fees, the following table presents total Corporation investment banking fees and the portion attributable to Global Banking.Investment Banking FeesGlobal BankingTotal Corporation(Dollars in millions)2020201920202019ProductsAdvisory$1,458 $1,336 $1,621 $1,460 Debt issuance1,555 1,348 3,443 3,107 Equity issuance997 453 2,328 1,259 Gross investment banking fees4,010 3,137 7,392 5,826 Self-led deals(93)(62)(212)(184)Total investment banking fees$3,917 $3,075 $7,180 $5,642 Total Corporation investment banking fees, excluding self-led deals, of $7.2 billion, which are primarily included within Global Banking and Global Markets, increased 27 percent primarily driven by higher equity issuance fees.43 Bank of AmericaGlobal Markets(Dollars in millions)20202019% ChangeNet interest income$4,646 $3,915 19 %Noninterest income:Investment and brokerage services1,973 1,738 14 Investment banking fees2,991 2,288 31 Market making and similar activities8,471 7,065 20 All other income685 608 13 Total noninterest income14,120 11,699 21 Total revenue, net of interest expense18,766 15,614 20 Provision for credit losses251 (9)n/mNoninterest expense11,422 10,728 6 Income before income taxes7,093 4,895 45 Income tax expense1,844 1,395 32 Net income$5,249 $3,500 50 Effective tax rate26.0 %28.5 %Return on average allocated capital15 10 Efficiency ratio60.86 68.71 Balance SheetAverageTrading-related assets:Trading account securities$243,519 $246,336 (1)%Reverse repurchases104,697 116,883 (10)Securities borrowed87,125 83,216 5 Derivative assets47,655 43,273 10 Total trading-related assets482,996 489,708 (1)Total loans and leases73,062 71,334 2 Total earning assets482,171 476,225 1 Total assets685,047 679,300 1 Total deposits47,400 31,380 51 Allocated capital36,000 35,000 3 Year endTotal trading-related assets$421,698 $452,499 (7)%Total loans and leases78,415 72,993 7 Total earning assets447,350 471,701 (5)Total assets616,609 641,809 (4)Total deposits53,925 34,676 56 n/m = not meaningfulGlobal Markets offers sales and trading services and research services to institutional clients across fixed-income, credit, currency, commodity and equity businesses. Global Markets product coverage includes securities and derivative products in both the primary and secondary markets. Global Markets provides market-making, financing, securities clearing, settlement and custody services globally to our institutional investor clients in support of their investing and trading activities. We also work with our commercial and corporate clients to provide risk management products using interest rate, equity, credit, currency and commodity derivatives, foreign exchange, fixed-income and mortgage-related products. As a result of our market-making activities in these products, we may be required to manage risk in a broad range of financial products including government securities, equity and equity-linked securities, high-grade and high-yield corporate debt securities, syndicated loans, MBS, commodities and asset-backed securities. The economics of certain investment banking and underwriting activities are shared primarily between Global Markets and Global Banking under an internal revenue-sharing arrangement. Global Banking originates certain deal-related transactions with our corporate and commercial clients that are executed and distributed by Global Markets. For information on investment banking fees on a consolidated basis, see page 43.The following explanations for year-over-year changes for Global Markets, including those disclosed under Sales and Trading Revenue, are the same for amounts including and excluding net DVA. Amounts excluding net DVA are a non-GAAP financial measure. For more information on net DVA, see Supplemental Financial Data on page 31.Net income for Global Markets increased $1.7 billion to $5.2 billion. Net DVA losses were $133 million compared to losses of $222 million in 2019. Excluding net DVA, net income increased $1.7 billion to $5.4 billion. These increases were primarily driven by higher revenue, partially offset by higher noninterest expense and provision for credit losses.Revenue increased $3.2 billion to $18.8 billion primarily driven by higher sales and trading revenue and investment banking fees. Sales and trading revenue increased $2.3 billion, and excluding net DVA, increased $2.2 billion. These increases were driven by higher revenue across FICC and Equities.The provision for credit losses increased $260 million primarily due to the weaker economic outlook related to COVID-19. Noninterest expense increased $694 million to Bank of America 44$11.4 billion driven by higher activity-based expenses for both card and trading.Average total assets increased $5.7 billion to $685.0 billion driven by higher client balances in Global Equities. Year-end total assets decreased $25.2 billion to $616.6 billion driven by lower levels of inventory in FICC and increased hedging of client activity in Equities with derivative transactions relative to stock positions.The return on average allocated capital was 15 percent, up from 10 percent, reflecting higher net income, partially offset by an increase in allocated capital.Sales and Trading RevenueSales and trading revenue includes unrealized and realized gains and losses on trading and other assets which are included in market making and similar activities, net interest income, and fees primarily from commissions on equity securities. Sales and trading revenue is segregated into fixed-income (government debt obligations, investment and non-investment grade corporate debt obligations, commercial MBS, residential mortgage-backed securities, collateralized loan obligations, interest rate and credit derivative contracts), currencies (interest rate and foreign exchange contracts), commodities (primarily futures, forwards, swaps and options) and equities (equity-linked derivatives and cash equity activity). The following table and related discussion present sales and trading revenue, substantially all of which is in Global Markets, with the remainder in Global Banking. In addition, the following table and related discussion present sales and trading revenue, excluding net DVA, which is a non-GAAP financial measure. For more information on net DVA, see Supplemental Financial Data on page 31.Sales and Trading Revenue (1, 2, 3)(Dollars in millions)20202019Sales and trading revenueFixed income, currencies and commodities$9,595 $8,189 Equities5,422 4,493 Total sales and trading revenue$15,017 $12,682 Sales and trading revenue, excluding net DVA (4)Fixed income, currencies and commodities$9,725 $8,397 Equities5,425 4,507 Total sales and trading revenue, excluding net DVA$15,150 $12,904 (1)For more information on sales and trading revenue, see Note 3 – Derivatives to the Consolidated Financial Statements.(2)Includes FTE adjustments of $196 million and $187 million for 2020 and 2019.(3) Includes Global Banking sales and trading revenue of $478 million and $538 million for 2020 and 2019.(4) FICC and Equities sales and trading revenue, excluding net DVA, is a non-GAAP financial measure. FICC net DVA losses were $130 million and $208 million for 2020 and 2019. Equities net DVA losses were $3 million and $14 million for 2020 and 2019.FICC revenue increased $1.3 billion driven by increased client activity and improved market-making conditions across macro products. Equities revenue increased $918 million driven by increased client activity and a strong trading performance in a more volatile market environment.All Other(Dollars in millions)20202019% ChangeNet interest income$34 $234 (85)%Noninterest income (loss)(3,606)(2,617)38 Total revenue, net of interest expense(3,572)(2,383)50 Provision for credit losses50 (669)(107)Noninterest expense1,422 3,690 (61)Loss before income taxes(5,044)(5,404)(7)Income tax benefit(4,637)(4,048)15 Net loss$(407)$(1,356)(70)Balance SheetAverageTotal loans and leases$28,159 $42,935 (34)%Total assets (1)228,783 210,689 9 Total deposits18,247 21,359 (15)Year endTotal loans and leases$21,301 $37,156 (43)%Total assets (1)264,141 224,375 18 Total deposits12,998 23,089 (44)(1)In segments where the total of liabilities and equity exceeds assets, which are generally deposit-taking segments, we allocate assets from All Other to those segments to match liabilities (i.e., deposits) and allocated shareholders’ equity. Average allocated assets were $763.1 billion and $544.3 billion for 2020 and 2019, and year-end allocated assets were $977.7 billion and $565.4 billion at December 31, 2020 and 2019.All Other consists of ALM activities, equity investments, non-core mortgage loans and servicing activities, liquidating businesses and certain expenses not otherwise allocated to a business segment. ALM activities encompass certain residential mortgages, debt securities, and interest rate and foreign currency risk management activities. Substantially all of the results of ALM activities are allocated to our business segments. For more information on our ALM activities, see Note 23 – Business Segment Information to the Consolidated Financial Statements. Residential mortgage loans that are held for ALM purposes, including interest rate or liquidity risk management, are classified as core and are presented on the balance sheet of All Other. During 2020, residential mortgage loans held for ALM activities decreased $12.7 billion to $9.0 billion due primarily to loan sales. Non-core residential mortgage and home equity loans, which are principally runoff portfolios, are also held in All 45 Bank of AmericaOther. During 2020, total non-core loans decreased $3.0 billion to $12.6 billion due primarily to payoffs and paydowns, as well as Federal Housing Administration (FHA) loan conveyances and sales, partially offset by repurchases. For more information on the composition of the core and non-core portfolios, see Consumer Portfolio Credit Risk Management on page 62.The net loss for All Other decreased $949 million to a net loss of $407 million, primarily due to a $2.1 billion pretax impairment charge related to the notice of termination of the merchant services joint venture in 2019, partially offset by lower revenue and higher provision for credit losses.Revenue decreased $1.2 billion primarily due to extinguishment losses on certain structured liabilities, higher client-driven ESG investment activity, resulting in higher partnership losses on these tax-advantaged investments, and lower net interest income, partially offset by a gain on sales of mortgage loans.The provision for credit losses increased $719 million to $50 million from a provision benefit of $669 million in 2019, primarily due to recoveries from sales of previously charged-off non-core consumer real estate loans in 2019, as well as the weaker economic outlook related to COVID-19.Noninterest expense decreased $2.3 billion to $1.4 billion primarily due to the $2.1 billion pretax impairment charge in 2019, partially offset by higher litigation expense.The income tax benefit increased $589 million primarily driven by the impact of the U.K. tax law change and a higher level of income tax credits related to our ESG investment activity, partially offset by the positive impact from the resolution of various tax controversy matters in 2019. Both years included income tax benefit adjustments to eliminate the FTE treatment of certain tax credits recorded in Global Banking.Off-Balance Sheet Arrangements and Contractual ObligationsWe have contractual obligations to make future payments on debt and lease agreements. Additionally, in the normal course of business, we enter into contractual arrangements whereby we commit to future purchases of products or services from unaffiliated parties. Purchase obligations are defined as obligations that are legally binding agreements whereby we agree to purchase products or services with a specific minimum quantity at a fixed, minimum or variable price over a specified period of time. Included in purchase obligations are vendor contracts, the most significant of which include communication services, processing services and software contracts. Debt, lease and other obligations are more fully discussed in Note 11 – Long-term Debt and Note 12 – Commitments and Contingencies to the Consolidated Financial Statements.Other long-term liabilities include our contractual funding obligations related to the Non-U.S. Pension Plans and Nonqualified and Other Pension Plans (together, the Plans). Obligations to the Plans are based on the current and projected obligations of the Plans, performance of the Plans’ assets, and any participant contributions, if applicable. During 2020 and 2019, we contributed $115 million and $135 million to the Plans, and we expect to make $136 million of contributions during 2021. The Plans are more fully discussed in Note 17 – Employee Benefit Plans to the Consolidated Financial Statements.We enter into commitments to extend credit such as loan commitments, standby letters of credit (SBLCs) and commercial letters of credit to meet the financing needs of our customers. For a summary of the total unfunded, or off-balance sheet, credit extension commitment amounts by expiration date, see Credit Extension Commitments in Note 12 – Commitments and Contingencies to the Consolidated Financial Statements.We also utilize variable interest entities (VIEs) in the ordinary course of business to support our financing and investing needs as well as those of our customers. For more information on our involvement with unconsolidated VIEs, see Note 6 – Securitizations and Other Variable Interest Entities to the Consolidated Financial Statements.Table 10 includes certain contractual obligations at December 31, 2020 and 2019.Table 10Contractual ObligationsDecember 31, 2020December 312019(Dollars in millions)Due in One Year or LessDue AfterOne Year ThroughThree YearsDue AfterThree Years ThroughFive YearsDue AfterFive YearsTotalTotalLong-term debt$20,352 $50,824 $48,568 $143,190 $262,934 $240,856 Operating lease obligations1,927 3,169 2,395 4,609 12,100 11,794 Purchase obligations551 700 80 103 1,434 3,530 Time deposits50,661 3,206 426 1,563 55,856 74,673 Other long-term liabilities1,656 1,092 953 781 4,482 4,099 Estimated interest expense on long-term debt and time deposits (1)4,542 8,123 6,958 30,924 50,547 44,385 Total contractual obligations$79,689 $67,114 $59,380 $181,170 $387,353 $379,337 (1)Represents forecasted net interest expense on long-term debt and time deposits based on interest rates at December 31, 2020 and 2019. Forecasts are based on the contractual maturity dates of each liability, and are net of derivative hedges, where applicable.Representations and Warranties ObligationsFor information on representations and warranties obligations in connection with the sale of mortgage loans, see Note 12 – Commitments and Contingencies to the Consolidated Financial Statements. Bank of America 46Managing RiskRisk is inherent in all our business activities. Sound risk management enables us to serve our customers and deliver for our shareholders. If not managed well, risks can result in financial loss, regulatory sanctions and penalties, and damage to our reputation, each of which may adversely impact our ability to execute our business strategies. We take a comprehensive approach to risk management with a defined Risk Framework and an articulated Risk Appetite Statement, which are approved annually by the ERC and the Board.The seven key types of risk faced by the Corporation are strategic, credit, market, liquidity, compliance, operational and reputational.● Strategic risk is the risk to current or projected financial condition arising from incorrect assumptions about external or internal factors, inappropriate business plans, ineffective business strategy execution, or failure to respond in a timely manner to changes in the regulatory, macroeconomic or competitive environments in the geographic locations in which we operate.● Credit risk is the risk of loss arising from the inability or failure of a borrower or counterparty to meet its obligations.● Market risk is the risk that changes in market conditions may adversely impact the value of assets or liabilities, or otherwise negatively impact earnings. Market risk is composed of price risk and interest rate risk.● Liquidity risk is the inability to meet expected or unexpected cash flow and collateral needs while continuing to support our businesses and customers under a range of economic conditions.● Compliance risk is the risk of legal or regulatory sanctions, material financial loss or damage to the reputation of the Corporation arising from the failure of the Corporation to comply with the requirements of applicable laws, rules and regulations and our internal policies and procedures.● Operational risk is the risk of loss resulting from inadequate or failed processes, people and systems, or from external events.● Reputational risk is the risk that negative perceptions of the Corporation’s conduct or business practices may adversely impact its profitability or operations.The following sections address in more detail the specific procedures, measures and analyses of the major categories of risk. This discussion of managing risk focuses on the current Risk Framework that, as part of its annual review process, was approved by the ERC and the Board. As set forth in our Risk Framework, a culture of managing risk well is fundamental to fulfilling our purpose and our values and delivering responsible growth. It requires us to focus on risk in all activities and encourages the necessary mindset and behavior to enable effective risk management, and promotes sound risk-taking within our risk appetite. Sustaining a culture of managing risk well throughout the organization is critical to our success and is a clear expectation of our executive management team and the Board.Our Risk Framework serves as the foundation for the consistent and effective management of risks facing the Corporation. The Risk Framework sets forth clear roles, responsibilities and accountability for the management of risk and provides a blueprint for how the Board, through delegation of authority to committees and executive officers, establishes risk appetite and associated limits for our activities. Executive management assesses, with Board oversight, the risk-adjusted returns of each business. Management reviews and approves the strategic and financial operating plans, as well as the capital plan and Risk Appetite Statement, and recommends them annually to the Board for approval. Our strategic plan takes into consideration return objectives and financial resources, which must align with risk capacity and risk appetite. Management sets financial objectives for each business by allocating capital and setting a target for return on capital for each business. Capital allocations and operating limits are regularly evaluated as part of our overall governance processes as the businesses and the economic environment in which we operate continue to evolve. For more information regarding capital allocations, see Business Segment Operations on page 36.The Corporation’s risk appetite indicates the amount of capital, earnings or liquidity we are willing to put at risk to achieve our strategic objectives and business plans, consistent with applicable regulatory requirements. Our risk appetite provides a common and comparable set of measures for senior management and the Board to clearly indicate our aggregate level of risk and to monitor whether the Corporation’s risk profile remains in alignment with our strategic and capital plans. Our risk appetite is formally articulated in the Risk Appetite Statement, which includes both qualitative components and quantitative limits.Our overall capacity to take risk is limited; therefore, we prioritize the risks we take in order to maintain a strong and flexible financial position so we can withstand challenging economic conditions and take advantage of organic growth opportunities. Therefore, we set objectives and targets for capital and liquidity that are intended to permit us to continue to operate in a safe and sound manner, including during periods of stress. Our lines of business operate with risk limits (which may include credit, market and/or operational limits, as applicable) that align with the Corporation’s risk appetite. Executive management is responsible for tracking and reporting performance measurements as well as any exceptions to guidelines or limits. The Board, and its committees when appropriate, oversee financial performance, execution of the strategic and financial operating plans, adherence to risk appetite limits and the adequacy of internal controls. For a more detailed discussion of our risk management activities, see the discussion below and pages 50 through 85.For more information about the Corporation's risks related to the pandemic, see Part I. Item 1A. Risk Factors on page 7. These COVID-19 related risks are being managed within our Risk Framework and supporting risk management programs.Risk Management GovernanceThe Risk Framework describes delegations of authority whereby the Board and its committees may delegate authority to management-level committees or executive officers. Such delegations may authorize certain decision-making and approval functions, which may be evidenced in, for example, committee charters, job descriptions, meeting minutes and resolutions.The chart below illustrates the inter-relationship among the Board, Board committees and management committees that have the majority of risk oversight responsibilities for the Corporation.47 Bank of AmericaThe chart below illustrates the inter-relationship among the Board, Board committees and management committees that have the majority of risk oversight responsibilities for the Corporation.Board of Directors and Board CommitteesThe Board is composed of 17 directors, all but one of whom are independent. The Board authorizes management to maintain an effective Risk Framework, and oversees compliance with safe and sound banking practices. In addition, the Board or its committees conduct inquiries of, and receive reports from management on risk-related matters to assess scope or resource limitations that could impede the ability of Independent Risk Management (IRM) and/or Corporate Audit to execute its responsibilities. The Board committees discussed below have the principal responsibility for enterprise-wide oversight of our risk management activities. Through these activities, the Board and applicable committees are provided with information on our risk profile and oversee executive management addressing key risks we face. Other Board committees, as described below, provide additional oversight of specific risks. Each of the committees shown on the above chart regularly reports to the Board on risk-related matters within the committee’s responsibilities, which is intended to collectively provide the Board with integrated insight about our management of enterprise-wide risks.Audit CommitteeThe Audit Committee oversees the qualifications, performance and independence of the Independent Registered Public Accounting Firm, the performance of our corporate audit function, the integrity of our consolidated financial statements, our compliance with legal and regulatory requirements, and makes inquiries of management or the Chief Audit Executive (CAE) to determine whether there are scope or resource limitations that impede the ability of Corporate Audit to execute its responsibilities. The Audit Committee is also responsible for overseeing compliance risk pursuant to the New York Stock Exchange listing standards.Enterprise Risk CommitteeThe ERC has primary responsibility for oversight of the Risk Framework and key risks we face and of the Corporation’s overall risk appetite. It approves the Risk Framework and the Risk Appetite Statement and further recommends these documents to the Board for approval. The ERC oversees senior management’s responsibilities for the identification, measurement, monitoring and control of key risks we face. The ERC may consult with other Board committees on risk-related matters.Other Board CommitteesOur Corporate Governance, ESG, and Sustainability Committee oversees our Board’s governance processes, identifies and reviews the qualifications of potential Board members, recommends nominees for election to our Board, recommends committee appointments for Board approval and reviews our Environmental, Social and Governance and stockholder engagement activities. Our Compensation and Human Capital Committee oversees establishing, maintaining and administering our compensation programs and employee benefit plans, including approving and recommending our Chief Executive Officer’s (CEO) compensation to our Board for further approval by all independent directors; reviewing and approving all of our executive officers’ compensation, as well as compensation for non-management directors; and reviewing certain other human capital management topics.Management CommitteesManagement committees may receive their authority from the Board, a Board committee, another management committee or from one or more executive officers. Our primary management level risk committee is the Management Risk Committee (MRC). Subject to Board oversight, the MRC is responsible for management oversight of key risks facing the Corporation. This includes providing management oversight of our compliance and operational risk programs, balance sheet and capital management, funding activities and other liquidity activities, stress testing, trading activities, recovery and resolution planning, model risk, subsidiary governance and activities between member banks and their nonbank affiliates pursuant to Federal Reserve rules and regulations, among other things.Lines of DefenseWe have clear ownership and accountability across three lines of defense: Front Line Units (FLUs), IRM and Corporate Audit. We also have control functions outside of FLUs and IRM (e.g., Legal and Global Human Resources). The three lines of defense are integrated into our management-level governance structure. Each of these functional roles is further described in this section.Bank of America 48Executive OfficersExecutive officers lead various functions representing the functional roles. Authority for functional roles may be delegated to executive officers from the Board, Board committees or management-level committees. Executive officers, in turn, may further delegate responsibilities, as appropriate, to management level committees, management routines or individuals. Executive officers review our activities for consistency with our Risk Framework, Risk Appetite Statement and applicable strategic, capital and financial operating plans, as well as applicable policies, standards, procedures and processes. Executive officers and other employees make decisions individually on a day-to-day basis, consistent with the authority they have been delegated. Executive officers and other employees may also serve on committees and participate in committee decisions.Front Line UnitsFLUs, which include the lines of business as well as the Global Technology and Operations Group, are responsible for appropriately assessing and effectively managing all of the risksassociated with their activities. Three organizational units that include FLU activities and control function activities, but are not part of IRM are first, the Chief Financial Officer (CFO) Group; second, Environmental, Social and Governance (ESG), Capital Deployment (CD) and Public Policy (PP); and third, the Chief Administrative Officer (CAO) Group.Independent Risk ManagementIRM is part of our control functions and includes Global Risk Management. We have other control functions that are not part of IRM (other control functions may also provide oversight to FLU activities), including Legal, Global Human Resources and certain activities within the CFO Group; ESG, CD and PP; and CAO Group. IRM, led by the Chief Risk Officer (CRO), is responsible for independently assessing and overseeing risks within FLUs and other control functions. IRM establishes written enterprise policies and procedures that include concentration risk limits, where appropriate. Such policies and procedures outline how aggregate risks are identified, measured, monitored and controlled. The CRO has the stature, authority and independence to develop and implement a meaningful risk management framework. The CRO has unrestricted access to the Board and reports directly to both the ERC and to the CEO. Global Risk Management is organized into horizontal risk teams that cover a specific risk area and vertical CRO teams that cover a particular front line unit or control function. These teams work collaboratively in executing their respective duties.Corporate AuditCorporate Audit and the CAE maintain their independence from the FLUs, IRM and other control functions by reporting directly to the Audit Committee or the Board. The CAE administratively reports to the CEO. Corporate Audit provides independent assessment and validation through testing of key processes and controls across the Corporation. Corporate Audit includes Credit Review which periodically tests and examines credit portfolios and processes.Risk Management ProcessesThe Risk Framework requires that strong risk management practices are integrated in key strategic, capital and financial planning processes and in day-to-day business processes across the Corporation, with a goal of ensuring risks are appropriately considered, evaluated and responded to in a timely manner. We employ our risk management process, referred to as Identify, Measure, Monitor and Control, as part of our daily activities.Identify – To be effectively managed, risks must be clearly defined and proactively identified. Proper risk identification focuses on recognizing and understanding key risks inherent in our business activities or key risks that may arise from external factors. Each employee is expected to identify and escalate risks promptly. Risk identification is an ongoing process, incorporating input from FLUs and control functions, designed to be forward looking and capture relevant risk factors across all of our lines of business.Measure – Once a risk is identified, it must be prioritized and accurately measured through a systematic risk quantification process including quantitative and qualitative components. Risk is measured at various levels including, but not limited to, risk type, FLU, legal entity and on an aggregate basis. Thisrisk quantification process helps to capture changes in our risk profile due to changes in strategic direction, concentrations, portfolio quality and the overall economic environment. Senior management considers how risk exposures might evolve under a variety of stress scenarios.Monitor – We monitor risk levels regularly to track adherence to risk appetite, policies, standards, procedures and processes. We also regularly update risk assessments and review risk exposures. Through our monitoring, we can determine our level of risk relative to limits and can take action in a timely manner. We also can determine when risk limits are breached and have processes to appropriately report and escalate exceptions. This includes requests for approval to managers and alerts to executive management, management-level committees or the Board (directly or through an appropriate committee).Control – We establish and communicate risk limits and controls through policies, standards, procedures and processes that define the responsibilities and authority for risk-taking. The limits and controls can be adjusted by the Board or management when conditions or risk tolerances warrant. These limits may be absolute (e.g., loan amount, trading volume) or relative (e.g., percentage of loan book in higher-risk categories). Our lines of business are held accountable to perform within the established limits. The formal processes used to manage risk represent a part of our overall risk management process. We instill a strong and comprehensive culture of managing risk well through communications, training, policies, procedures and organizational roles and responsibilities. Establishing a culture reflective of our purpose to help make our customers’ financial lives better and delivering our responsible growth strategy is also critical to effective risk management. We understand that improper actions, behaviors or practices that are illegal, unethical or contrary to our core values could result in harm to the Corporation, our shareholders or our customers, damage the integrity of the financial markets, or negatively impact our reputation, and have established protocols and structures so that such conduct risk is governed and reported across the Corporation. Specifically, our Code of Conduct provides a framework for all of our employees to conduct themselves with the highest integrity. Additionally, we continue to strengthen the link between the employee performance management process and individual compensation to encourage employees to work toward enterprise-wide risk goals.49 Bank of AmericaCorporation-wide Stress TestingIntegral to our Capital Planning, Financial Planning and Strategic Planning processes, we conduct capital scenario management and stress forecasting on a periodic basis to better understand balance sheet, earnings and capital sensitivities to certain economic and business scenarios, including economic and market conditions that are more severe than anticipated. These stress forecasts provide an understanding of the potential impacts from our risk profile on the balance sheet, earnings and capital, and serve as a key component of our capital and risk management practices. The intent of stress testing is to develop a comprehensive understanding of potential impacts of on- and off-balance sheet risks at the Corporation and how they impact financial resiliency, which provides confidence to management, regulators and our investors.Contingency PlanningWe have developed and maintain contingency plans that are designed to prepare us in advance to respond in the event of potential adverse economic, financial or market stress. These contingency plans include our Capital Contingency Plan and Financial Contingency and Recovery Plan, which provide monitoring, escalation, actions and routines designed to enable us to increase capital, access funding sources and reduce risk through consideration of potential options that include asset sales, business sales, capital or debt issuances, or other de-risking strategies. We also maintain a Resolution Plan to limit adverse systemic impacts that could be associated with a potential resolution of Bank of America.Strategic Risk ManagementStrategic risk is embedded in every business and is one of the major risk categories along with credit, market, liquidity, compliance, operational and reputational risks. This risk results from incorrect assumptions about external or internal factors, inappropriate business plans, ineffective business strategy execution, or failure to respond in a timely manner to changes in the regulatory, macroeconomic or competitive environments in the geographic locations in which we operate, such as competitor actions, changing customer preferences, product obsolescence and technology developments. Our strategic plan is consistent with our risk appetite, capital plan and liquidity requirements and specifically addresses strategic risks.On an annual basis, the Board reviews and approves the strategic plan, capital plan, financial operating plan and Risk Appetite Statement. With oversight by the Board, executive management directs the lines of business to execute our strategic plan consistent with our core operating principles and risk appetite. The executive management team monitors business performance throughout the year and provides the Board with regular progress reports on whether strategic objectives and timelines are being met, including reports on strategic risks and if additional or alternative actions need to be considered or implemented. The regular executive reviews focus on assessing forecasted earnings and returns on capital, the current risk profile, current capital and liquidity requirements, staffing levels and changes required to support the strategic plan, stress testing results, and other qualitative factors such as market growth rates and peer analysis.Significant strategic actions, such as capital actions, material acquisitions or divestitures, and resolution plans are reviewed and approved by the Board. At the business level, processes are in place to discuss the strategic risk implications of new, expanded or modified businesses, products or services and other strategic initiatives, and to provide formal review and approval where required. With oversight by the Board and the ERC, executive management performs similar analyses throughout the year and evaluates changes to the financial forecast or the risk, capital or liquidity positions as deemed appropriate to balance and optimize achieving the targeted risk appetite, shareholder returns and maintaining the targeted financial strength. Proprietary models are used to measure the capital requirements for credit, country, market, operational and strategic risks. The allocated capital assigned to each business is based on its unique risk profile. With oversight by the Board, executive management assesses the risk-adjusted returns of each business in approving strategic and financial operating plans. The businesses use allocated capital to define business strategies and price products and transactions.Capital ManagementThe Corporation manages its capital position so that its capital is more than adequate to support its business activities and aligns with risk, risk appetite and strategic planning. Additionally, we seek to maintain safety and soundness at all times, even under adverse scenarios, take advantage of organic growth opportunities, meet obligations to creditors and counterparties, maintain ready access to financial markets, continue to serve as a credit intermediary, remain a source of strength for our subsidiaries, and satisfy current and future regulatory capital requirements. Capital management is integrated into our risk and governance processes, as capital is a key consideration in the development of our strategic plan, risk appetite and risk limits.We conduct an Internal Capital Adequacy Assessment Process (ICAAP) on a periodic basis. The ICAAP is a forward-looking assessment of our projected capital needs and resources, incorporating earnings, balance sheet and risk forecasts under baseline and adverse economic and market conditions. We utilize periodic stress tests to assess the potential impacts to our balance sheet, earnings, regulatory capital and liquidity under a variety of stress scenarios. We perform qualitative risk assessments to identify and assess material risks not fully captured in our forecasts or stress tests. We assess the potential capital impacts of proposed changes to regulatory capital requirements. Management assesses ICAAP results and provides documented quarterly assessments of the adequacy of our capital guidelines and capital position to the Board or its committees. We periodically review capital allocated to our businesses and allocate capital annually during the strategic and capital planning processes. For more information, see Business Segment Operations on page 36. CCAR and Capital PlanningThe Federal Reserve requires BHCs to submit a capital plan and planned capital actions on an annual basis, consistent with the rules governing the CCAR capital plan. Based on the results of our 2020 CCAR supervisory stress test that was submitted to the Federal Reserve in the second quarter of 2020, we are subject to a 2.5 percent stress capital buffer (SCB) for the period beginning October 1, 2020 and ending on September 30, 2021. Our Common equity tier 1 (CET1) capital ratio under the Standardized approach must remain above 9.5 percent during this period (the sum of our CET1 capital ratio minimum of 4.5 percent, global systemically important bank (G-SIB) surcharge of 2.5 percent and our SCB of 2.5 percent) in order to avoid restrictions on capital distributions and discretionary bonus payments. Bank of America 50Due to economic uncertainty resulting from the pandemic, the Federal Reserve required all large banks to update and resubmit their capital plans in November 2020 based on the Federal Reserve’s updated supervisory stress test scenarios. The results of the additional supervisory stress tests were published in December 2020.The Federal Reserve also required large banks to suspend share repurchase programs during the second half of 2020, except for repurchases to offset shares awarded under equity-based compensation plans, and to limit common stock dividends to existing rates that did not exceed the average of the last four quarters’ net income. The Federal Reserve’s directives regarding share repurchases aligned with our decision to voluntarily suspend our general common stock repurchase program during the first half of 2020. The suspension of our repurchases did not include repurchases to offset shares awarded under our equity-based compensation plans. Pursuant to the Board’s authorization, we repurchased $7.0 billion of common stock during 2020. In December 2020, the Federal Reserve announced that beginning in the first quarter of 2021, large banks would be permitted to pay common stock dividends at existing rates and to repurchase shares in an amount that, when combined with dividends paid, does not exceed the average of net income over the last four quarters.On January 19, 2021, we announced that the Board declared a quarterly common stock dividend of $0.18 per share, payable on March 26, 2021 to shareholders of record as of March 5, 2021. We also announced that the Board authorized the repurchase of $2.9 billion in common stock through March 31, 2021, plus repurchases to offset shares awarded under equity-based compensation plans during the same period, estimated to be approximately $300 million. This authorization equals the maximum amount allowed by the Federal Reserve for the period. Our stock repurchase program is subject to various factors, including the Corporation’s capital position, liquidity, financial performance and alternative uses of capital, stock trading price and general market conditions, and may be suspended at any time. Such repurchases may be effected through open market purchases or privately negotiated transactions, including repurchase plans that satisfy the conditions of Rule 10b5-1 of the Securities Exchange Act of 1934, as amended (Exchange Act). Regulatory CapitalAs a financial services holding company, we are subject to regulatory capital rules, including Basel 3, issued by U.S. banking regulators. Basel 3 established minimum capital ratios and buffer requirements and outlined two methods of calculating risk-weighted assets (RWA), the Standardized approach and the Advanced approaches. The Standardized approach relies primarily on supervisory risk weights based on exposure type, and the Advanced approaches determine risk weights based on internal models. The Corporation's depository institution subsidiaries are also subject to the Prompt Corrective Action (PCA) framework. The Corporation and its primary affiliated banking entity, BANA, are Advanced approaches institutions under Basel 3 and are required to report regulatory risk-based capital ratios and RWA under both the Standardized and Advanced approaches. The approach that yields the lower ratio is used to assess capital adequacy including under the PCA framework. As of December 31, 2020, the CET1, Tier 1 capital and Total capital ratios for the Corporation were lower under the Standardized approach.Minimum Capital RequirementsIn order to avoid restrictions on capital distributions and discretionary bonus payments, the Corporation must meet risk-based capital ratio requirements that include a capital conservation buffer greater than 2.5 percent, plus any applicable countercyclical capital buffer and a G-SIB surcharge. On October 1, 2020, the capital conservation buffer was replaced by the SCB for the Corporation’s Standardized approach ratio requirements. The buffers and surcharge must be comprised solely of CET1 capital.The Corporation is also required to maintain a minimum supplementary leverage ratio (SLR) of 3.0 percent plus a leverage buffer of 2.0 percent in order to avoid certain restrictions on capital distributions and discretionary bonus payments. Our insured depository institution subsidiaries are required to maintain a minimum 6.0 percent SLR to be considered well capitalized under the PCA framework. The numerator of the SLR is quarter-end Basel 3 Tier 1 capital. The denominator is total leverage exposure based on the daily average of the sum of on-balance sheet exposures less permitted deductions and applicable temporary exclusions, as well as the simple average of certain off-balance sheet exposures, as of the end of each month in a quarter. For more information, see Capital Management – Regulatory Developments on page 55.Capital Composition and RatiosTable 11 presents Bank of America Corporation’s capital ratios and related information in accordance with Basel 3 Standardized and Advanced approaches as measured at December 31, 2020 and 2019. For the periods presented herein, the Corporation met the definition of well capitalized under current regulatory requirements.51 Bank of AmericaTable 11Bank of America Corporation Regulatory Capital under Basel 3StandardizedApproach (1, 2)AdvancedApproaches (1)RegulatoryMinimum (3)(Dollars in millions, except as noted)December 31, 2020Risk-based capital metrics:Common equity tier 1 capital$176,660 $176,660 Tier 1 capital200,096 200,096 Total capital (4)237,936 227,685 Risk-weighted assets (in billions) 1,480 1,371 Common equity tier 1 capital ratio11.9 %12.9 %9.5 %Tier 1 capital ratio13.5 14.6 11.0 Total capital ratio16.1 16.6 13.0 Leverage-based metrics:Adjusted quarterly average assets (in billions) (5)$2,719 $2,719 Tier 1 leverage ratio7.4 %7.4 %4.0 Supplementary leverage exposure (in billions) (6)$2,786 Supplementary leverage ratio7.2 %5.0 December 31, 2019Risk-based capital metrics:Common equity tier 1 capital$166,760 $166,760 Tier 1 capital188,492 188,492 Total capital (4)221,230 213,098 Risk-weighted assets (in billions)1,493 1,447 Common equity tier 1 capital ratio11.2 %11.5 %9.5 %Tier 1 capital ratio12.6 13.0 11.0 Total capital ratio14.8 14.7 13.0 Leverage-based metrics:Adjusted quarterly average assets (in billions) (5)$2,374 $2,374 Tier 1 leverage ratio7.9 %7.9 %4.0 Supplementary leverage exposure (in billions)$2,946 Supplementary leverage ratio6.4 %5.0 (1)As of December 31, 2020, capital ratios are calculated using the regulatory capital rule that allows a five-year transition period related to the adoption of CECL.(2)Derivative exposure amounts are calculated using the standardized approach for measuring counterparty credit risk at December 31, 2020 and the current exposure method at December 31, 2019.(3)The capital conservation buffer and G-SIB surcharge were 2.5 percent at both December 31, 2020 and 2019. At December 31, 2020, the Corporation's SCB of 2.5 percent was applied in place of the capital conservation buffer under the Standardized approach. The countercyclical capital buffer for both periods was zero. The SLR minimum includes a leverage buffer of 2.0 percent.(4)Total capital under the Advanced approaches differs from the Standardized approach due to differences in the amount permitted in Tier 2 capital related to the qualifying allowance for credit losses. (5)Reflects total average assets adjusted for certain Tier 1 capital deductions.(6)Supplementary leverage exposure at December 31, 2020 reflects the temporary exclusion of U.S. Treasury securities and deposits at Federal Reserve Banks.At December 31, 2020, CET1 capital was $176.7 billion, an increase of $9.9 billion from December 31, 2019, driven by earnings and net unrealized gains on available-for-sale (AFS) debt securities included in accumulated other comprehensive income (OCI), partially offset by common stock repurchases and dividends. Total capital under the Standardized approach increased $16.7 billion primarily driven by the same factors as CET1 capital, an increase in the adjusted allowance for credit losses included in Tier 2 capital and the issuance of preferred stock. RWA under the Standardized approach, which yielded the lower CET1 capital ratio at December 31, 2020, decreased $13.7 billion during 2020 to $1,480 billion primarily due to lower commercial and consumer lending exposures, partially offset by investments of excess deposits in securities. Table 12 shows the capital composition at December 31, 2020 and 2019.Bank of America 52Table 12Capital Composition under Basel 3 December 31(Dollars in millions)20202019Total common shareholders’ equity$248,414 $241,409 CECL transitional amount (1)4,213 — Goodwill, net of related deferred tax liabilities(68,565)(68,570)Deferred tax assets arising from net operating loss and tax credit carryforwards(5,773)(5,193)Intangibles, other than mortgage servicing rights, net of related deferred tax liabilities(1,617)(1,328)Defined benefit pension plan net assets(1,164)(1,003)Cumulative unrealized net (gain) loss related to changes in fair value of financial liabilities attributable to own creditworthiness, net-of-tax1,753 1,278 Other(601)167 Common equity tier 1 capital176,660 166,760 Qualifying preferred stock, net of issuance cost23,437 22,329 Other(1)(597)Tier 1 capital200,096 188,492 Tier 2 capital instruments22,213 22,538 Qualifying allowance for credit losses (2)15,649 10,229 Other(22)(29)Total capital under the Standardized approach237,936 221,230 Adjustment in qualifying allowance for credit losses under the Advanced approaches (2)(10,251)(8,132)Total capital under the Advanced approaches$227,685 $213,098 (1)The CECL transitional amount includes the impact of the Corporation's adoption of the new CECL accounting standard on January 1, 2020 plus 25 percent of the increase in the adjusted allowance for credit losses from January 1, 2020 through December 31, 2020.(2)The balance at December 31, 2020 includes the impact of transition provisions related to the new CECL accounting standard.Table 13 shows the components of RWA as measured under Basel 3 at December 31, 2020 and 2019.Table 13Risk-weighted Assets under Basel 3Standardized Approach (1)Advanced ApproachesStandardized Approach (1)Advanced ApproachesDecember 31(Dollars in billions)20202019Credit risk$1,420 $896 $1,437 $858 Market risk60 60 56 55 Operational risk (2)n/a372 n/a500 Risks related to credit valuation adjustmentsn/a43 n/a34 Total risk-weighted assets$1,480 $1,371 $1,493 $1,447 (1) Derivative exposure amounts are calculated using the standardized approach for measuring counterparty credit risk at December 31, 2020 and the current exposure method at December 31, 2019.(2) December 31, 2020 includes the effects of an update made to our operational risk RWA model during the third quarter of 2020.n/a = not applicable53 Bank of AmericaBank of America, N.A. Regulatory CapitalTable 14 presents regulatory capital information for BANA in accordance with Basel 3 Standardized and Advanced approaches as measured at December 31, 2020 and 2019. BANA met the definition of well capitalized under the PCA framework for both periods.Table 14Bank of America, N.A. Regulatory Capital under Basel 3StandardizedApproach (1, 2)AdvancedApproaches (1)RegulatoryMinimum (3)(Dollars in millions, except as noted)December 31, 2020Risk-based capital metrics:Common equity tier 1 capital$164,593 $164,593 Tier 1 capital164,593 164,593 Total capital (4)181,370 170,922 Risk-weighted assets (in billions) 1,221 1,014 Common equity tier 1 capital ratio13.5 %16.2 %7.0 %Tier 1 capital ratio13.5 16.2 8.5 Total capital ratio14.9 16.9 10.5 Leverage-based metrics:Adjusted quarterly average assets (in billions) (5)$2,143 $2,143 Tier 1 leverage ratio7.7 %7.7 %5.0 Supplementary leverage exposure (in billions)$2,525 Supplementary leverage ratio6.5 %6.0 December 31, 2019Risk-based capital metrics:Common equity tier 1 capital$154,626 $154,626 Tier 1 capital154,626 154,626 Total capital (4)166,567 158,665 Risk-weighted assets (in billions) 1,241 991 Common equity tier 1 capital ratio12.5 %15.6 %7.0 %Tier 1 capital ratio12.5 15.6 8.5 Total capital ratio13.4 16.0 10.5 Leverage-based metrics:Adjusted quarterly average assets (in billions) (5)$1,780 $1,780 Tier 1 leverage ratio8.7 %8.7 %5.0 Supplementary leverage exposure (in billions)$2,177 Supplementary leverage ratio7.1 %6.0 (1)As of December 31, 2020, capital ratios are calculated using the regulatory capital rule that allows a five-year transition period related to the adoption of CECL.(2)Derivative exposure amounts are calculated using the standardized approach for measuring counterparty credit risk at December 31, 2020 and the current exposure method at December 31, 2019.(3)Risk-based capital regulatory minimums at both December 31, 2020 and 2019 are the minimum ratios under Basel 3 including a capital conservation buffer of 2.5 percent. The regulatory minimums for the leverage ratios as of both period ends are the percent required to be considered well capitalized under the PCA framework.(4)Total capital under the Advanced approaches differs from the Standardized approach due to differences in the amount permitted in Tier 2 capital related to the qualifying allowance for credit losses.(5)Reflects total average assets adjusted for certain Tier 1 capital deductions.Total Loss-Absorbing Capacity RequirementsTotal loss-absorbing capacity (TLAC) consists of the Corporation’s Tier 1 capital and eligible long-term debt issued directly by the Corporation. Eligible long-term debt for TLAC ratios is comprised of unsecured debt that has a remaining maturity of at least one year and satisfies additional requirements as prescribed in the TLAC final rule. As with the risk-based capital ratios and SLR, the Corporation is required to maintain TLAC ratios in excess of minimum requirements plus applicable buffers to avoid restrictions on capital distributions and discretionary bonus payments. Table 15 presents the Corporation's TLAC and long-term debt ratios and related information as of December 31, 2020 and 2019.Bank of America 54Table 15Bank of America Corporation Total Loss-Absorbing Capacity and Long-Term DebtTLAC (1)Regulatory Minimum (2)Long-term DebtRegulatory Minimum (3)(Dollars in millions)December 31, 2020Total eligible balance$405,153 $196,997 Percentage of risk-weighted assets (4)27.4 %22.0 %13.3 %8.5 %Percentage of supplementary leverage exposure (5, 6)14.5 9.5 7.1 4.5 December 31, 2019Total eligible balance$367,449 $171,349 Percentage of risk-weighted assets (4)24.6 %22.0 %11.5 %8.5 %Percentage of supplementary leverage exposure (6)12.5 9.5 5.8 4.5 (1)As of December 31, 2020, TLAC ratios are calculated using the regulatory capital rule that allows a five-year transition period related to the adoption of CECL.(2)The TLAC RWA regulatory minimum consists of 18.0 percent plus a TLAC RWA buffer comprised of 2.5 percent plus the Method 1 G-SIB surcharge of 1.5 percent. The countercyclical buffer is zero for both periods. The TLAC supplementary leverage exposure regulatory minimum consists of 7.5 percent plus a 2.0 percent TLAC leverage buffer. The TLAC RWA and leverage buffers must be comprised solely of CET1 capital and Tier 1 capital, respectively.(3)The long-term debt RWA regulatory minimum is comprised of 6.0 percent plus an additional 2.5 percent requirement based on the Corporation’s Method 2 G-SIB surcharge. The long-term debt leverage exposure regulatory minimum is 4.5 percent.(4)The approach that yields the higher RWA is used to calculate TLAC and long-term debt ratios, which was the Standardized approach as of both December 31, 2020 and 2019.(5)Supplementary leverage exposure at December 31, 2020 reflects the temporary exclusion of U.S. Treasury Securities and deposits at Federal Reserve Banks.(6)Derivative exposure amounts are calculated using the standardized approach for measuring counterparty credit risk at December 31, 2020 and the current exposure method at December 31, 2019.Regulatory DevelopmentsRevisions to Basel 3 to Address Current Expected Credit Loss AccountingOn January 1, 2020, the Corporation adopted the new accounting standard that requires the measurement of the allowance for credit losses to be based on management’s best estimate of lifetime ECL inherent in the Corporation's relevant financial assets. For more information, see Note 1 – Summary of Significant Accounting Principles to the Consolidated Financial Statements. During the first quarter of 2020, in accordance with an interim final rule issued by U.S. banking regulators that was finalized on August 26, 2020, the Corporation delayed for two years the initial adoption impact of CECL on regulatory capital, followed by a three-year transition period to phase out the aggregate amount of the capital benefit provided during 2020 and 2021 (i.e., a five-year transition period). During the two-year delay, the Corporation will add back to CET1 capital 100 percent of the initial adoption impact of CECL plus 25 percent of the cumulative quarterly changes in the allowance for credit losses (i.e., quarterly transitional amounts). After two years, starting on January 1, 2022, the quarterly transitional amounts along with the initial adoption impact of CECL will be phased out of CET1 capital over the three-year period.Stress Capital BufferOn March 4, 2020, the Federal Reserve issued a final rule that integrates the annual quantitative assessment of the CCAR program with the buffer requirements in the U.S. Basel 3 Final Rule. The new approach replaced the static 2.5 percent capital conservation buffer for Basel 3 Standardized approach requirements with a SCB, calculated as the decline in the CET1 capital ratio under the supervisory severely adverse scenario plus four quarters of planned common stock dividends, floored at 2.5 percent. Based on the CCAR 2020 supervisory stress test results, the Corporation is subject to a 2.5 percent SCB for the period beginning October 1, 2020 and ending on September 30, 2021. In conjunction with this new requirement, the Federal Reserve has removed the annual CCAR quantitative objection process beginning with CCAR 2020. While the final rule continues to require that the Corporation describe its planned capital distributions in its CCAR capital plan, the Corporation is no longer required to seek prior approval if it makes capital distributions in excess of those included in its CCAR capital plan. The Corporation is instead subject to automatic distribution limitations if its capital ratios fall below its buffer requirements, which include the SCB.Eligible Retained IncomeOn March 17, 2020, in response to the economic impact of the pandemic, the U.S. banking regulators issued an interim final rule that revises the definition of eligible retained income to be based on average net income over the prior four quarters. This change, which was finalized on August 26, 2020, more gradually phases in automatic distribution restrictions to the extent capital buffers are breached.Supplementary Leverage RatioOn April 1, 2020, in response to the economic impact of the pandemic, the Federal Reserve issued an interim final rule to temporarily exclude the on-balance sheet amounts of U.S. Treasury securities and deposits at Federal Reserve Banks from the calculation of supplementary leverage exposure for bank holding companies. The rule is effective for June 30, 2020 through March 31, 2021 reports. As of December 31, 2020, temporary exclusions improved the SLR by 1.0 percent to 7.2 percent.On May 15, 2020, the U.S. banking regulators issued an interim final rule that provides a similar temporary exclusion to depository institutions, effective from the beginning of the second quarter of 2020 through March 31, 2021; however, institutions must elect the relief. Beginning in the third quarter of 2020, a depository institution electing to apply the exclusion must receive approval from its primary regulator prior to making any capital distributions as long as the exclusion is in effect. As of December 31, 2020, the Corporation’s insured depository institution subsidiaries have not elected the exclusion.Paycheck Protection Program LoansOn April 9, 2020, in response to the economic impact of the pandemic, the U.S. banking regulators issued an interim final rule that, among other things, stipulates PPP loans, which are guaranteed by the SBA, will receive a zero percent risk weight under the Basel 3 Advanced and Standardized approaches. The rule was later finalized by the U.S. banking regulators on October 28, 2020. For more information on the PPP, see Executive Summary – Recent Developments – COVID-19 Pandemic on page 25 and Note 1 – Summary of Significant Accounting Principles to the Consolidated Financial Statements.55 Bank of AmericaStandardized Approach for Measuring Counterparty Credit RiskOn June 30, 2020 the Corporation adopted the new standardized approach for measuring counterparty credit risk (SA-CCR), which replaces the current exposure method for calculating the exposure amount of derivative contracts for risk-weighted assets and supplementary leverage exposure. Adoption of SA-CCR resulted in a decrease of approximately $15 billion in the Corporation’s Standardized RWA, and a $66 billion decrease in supplementary leverage exposure.Swap Dealer Capital RequirementsOn July 22, 2020, the U.S. Commodity Futures Trading Commission (CFTC) issued a final rule to establish capital requirements for swap dealers and major swap participants that are not subject to existing U.S. prudential regulation. Under the rule, applicable subsidiaries of the Corporation would be permitted to elect one of two approaches to compute their regulatory capital. The first approach is a bank-based capital approach, which requires that firms maintain CET1 capital greater than or equal to 6.5 percent of the entity’s RWA as calculated under Basel 3, Total capital greater than or equal to 8.0 percent of the entity’s RWA as calculated under Basel 3 and Total capital greater than or equal to 8.0 percent of the entity’s uncleared swap margin. The second approach is based on net liquid assets and requires that a firm maintain net capital greater than or equal to 2.0 percent of its uncleared swap margin. The final rule also includes reporting requirements. The impact on the Corporation is not expected to be significant.Deduction of Unsecured Debt of G-SIBsOn October 20, 2020, the Federal Reserve, Federal Deposit Insurance Corporation (FDIC) and the Office of the Comptroller of the Currency (U.S. Agencies) finalized a rule requiring Advanced approaches institutions to deduct from regulatory capital certain investments in TLAC-eligible long-term debt and other pari passu or subordinated debt instruments issued by G-SIBs above a specified threshold. The final rule is intended to limit the interconnectedness between G-SIBs and is complementary to existing regulatory capital requirements that generally require banks to deduct investments in the regulatory capital of financial institutions. The final rule is effective April 1, 2021. The impact to the Corporation is not expected to be significant.Volcker RuleEffective January 1, 2020, we became subject to certain changes to the Volcker Rule, including removing the requirement for banking organizations to deduct from Tier 1 capital ownership interests of covered funds acquired or retained under the underwriting or market-making exemptions of the Volcker Rule, which the banking entity did not organize or offer. Single-Counterparty Credit Limits The Federal Reserve established single-counterparty credit limits (SCCL) for BHCs with total consolidated assets of $250 billion or more. The SCCL rule is designed to ensure that the maximum possible loss that a BHC could incur due to the default of a single counterparty or a group of connected counterparties would not endanger the BHC’s survival, thereby reducing the probability of future financial crises. Beginning January 1, 2020, G-SIBs must calculate SCCL on a daily basis by dividing the aggregate net credit exposure to a given counterparty by the G-SIB’s Tier 1 capital, ensuring that exposures to other G-SIBs and nonbank financial institutions regulated by the Federal Reserve do not breach 15 percent of Tier 1 capital and exposures to most other counterparties do not breach 25 percent of Tier 1 capital. Certain exposures, including exposures to the U.S. government, U.S. government-sponsored entities and qualifying central counterparties, are exempt from the credit limits.Regulatory Capital and Securities Regulation The Corporation’s principal U.S. broker-dealer subsidiaries are BofA Securities, Inc. (BofAS), Merrill Lynch Professional Clearing Corp. (MLPCC) and Merrill Lynch, Pierce, Fenner & Smith Incorporated (MLPF&S). The Corporation's principal European broker-dealer subsidiaries are Merrill Lynch International (MLI) and BofA Securities Europe SA (BofASE).The U.S. broker-dealer subsidiaries are subject to the net capital requirements of Rule 15c3-1 under the Exchange Act. BofAS computes its minimum capital requirements as an alternative net capital broker-dealer under Rule 15c3-1e, and MLPCC and MLPF&S compute their minimum capital requirements in accordance with the alternative standard under Rule 15c3-1. BofAS and MLPCC are also registered as futures commission merchants and are subject to CFTC Regulation 1.17. The U.S. broker-dealer subsidiaries are also registered with the Financial Industry Regulatory Authority, Inc. (FINRA). Pursuant to FINRA Rule 4110, FINRA may impose higher net capital requirements than Rule 15c3-1 under the Exchange Act with respect to each of the broker-dealers.BofAS provides institutional services, and in accordance with the alternative net capital requirements, is required to maintain tentative net capital in excess of $1.0 billion and net capital in excess of the greater of $500 million or a certain percentage of its reserve requirement. BofAS must also notify the Securities and Exchange Commission (SEC) in the event its tentative net capital is less than $5.0 billion. BofAS is also required to hold a certain percentage of its customers' and affiliates' risk-based margin in order to meet its CFTC minimum net capital requirement. At December 31, 2020, BofAS had tentative net capital of $16.8 billion. BofAS also had regulatory net capital of $14.1 billion, which exceeded the minimum requirement of $2.9 billion. MLPCC is a fully-guaranteed subsidiary of BofAS and provides clearing and settlement services as well as prime brokerage and arranged financing services for institutional clients. At December 31, 2020, MLPCC’s regulatory net capital of $8.6 billion exceeded the minimum requirement of $1.4 billion. MLPF&S provides retail services. At December 31, 2020, MLPF&S' regulatory net capital was $3.6 billion, which exceeded the minimum requirement of $180 million.Our European broker-dealers are regulated by non-U.S. regulators. MLI, a U.K. investment firm, is regulated by the Prudential Regulation Authority and the FCA and is subject to certain regulatory capital requirements. At December 31, 2020, MLI’s capital resources were $34.1 billion, which exceeded the minimum Pillar 1 requirement of $14.7 billion. BofASE, a French investment firm, is regulated by the Autorité de Contrôle Prudentiel et de Résolution and the Autorité des Marchés Financiers, and is subject to certain regulatory capital requirements. At December 31, 2020, BofASE's capital resources were $6.2 billion, which exceeded the minimum Pillar 1 requirement of $1.9 billion.Bank of America 56Liquidity RiskFunding and Liquidity Risk ManagementOur primary liquidity risk management objective is to meet expected or unexpected cash flow and collateral needs while continuing to support our businesses and customers under a range of economic conditions. To achieve that objective, we analyze and monitor our liquidity risk under expected and stressed conditions, maintain liquidity and access to diverse funding sources, including our stable deposit base, and seek to align liquidity-related incentives and risks. These liquidity risk management practices have allowed us to effectively manage the market stress from the pandemic that began in the first quarter of 2020. For more information on the effects of the pandemic, see Part I. Item 1A. Risk Factors – Coronavirus Disease on page 7 and Executive Summary – Recent Developments – COVID-19 Pandemic on page 25.We define liquidity as readily available assets, limited to cash and high-quality, liquid, unencumbered securities that we can use to meet our contractual and contingent financial obligations as those obligations arise. We manage our liquidity position through line-of-business and ALM activities, as well as through our legal entity funding strategy, on both a forward and current (including intraday) basis under both expected and stressed conditions. We believe that a centralized approach to funding and liquidity management enhances our ability to monitor liquidity requirements, maximizes access to funding sources, minimizes borrowing costs and facilitates timely responses to liquidity events. The Board approves our liquidity risk policy and the Financial Contingency and Recovery Plan. The ERC establishes our liquidity risk tolerance levels. The MRC is responsible for overseeing liquidity risks and directing management to maintain exposures within the established tolerance levels. The MRC reviews and monitors our liquidity position and stress testing results, approves certain liquidity risk limits and reviews the impact of strategic decisions on our liquidity. For more information, see Managing Risk on page 47. Under this governance framework, we have developed certain funding and liquidity risk management practices which include: maintaining liquidity at the parent company and selected subsidiaries, including our bank subsidiaries and other regulated entities; determining what amounts of liquidity are appropriate for these entities based on analysis of debt maturities and other potential cash outflows, including those that we may experience during stressed market conditions; diversifying funding sources, considering our asset profile and legal entity structure; and performing contingency planning.NB Holdings CorporationWe have intercompany arrangements with certain key subsidiaries under which we transferred certain assets of Bank of America Corporation, as the parent company, which is a separate and distinct legal entity from our bank and nonbank subsidiaries, and agreed to transfer certain additional parent company assets not needed to satisfy anticipated near-term expenditures, to NB Holdings Corporation, a wholly-owned holding company subsidiary (NB Holdings). The parent company is expected to continue to have access to the same flow of dividends, interest and other amounts of cash necessary to service its debt, pay dividends and perform other obligations as it would have had if it had not entered into these arrangements and transferred any assets. In consideration for the transfer of assets, NB Holdings issued a subordinated note to the parent company in a principal amount equal to the value of the transferred assets. The aggregate principal amount of the note will increase by the amount of any future asset transfers. NB Holdings also provided the parent company with a committed line of credit that allows the parent company to draw funds necessary to service near-term cash needs. These arrangements support our preferred single point of entry resolution strategy, under which only the parent company would be resolved under the U.S. Bankruptcy Code. These arrangements include provisions to terminate the line of credit, forgive the subordinated note and require the parent company to transfer its remaining financial assets to NB Holdings if our projected liquidity resources deteriorate so severely that resolution of the parent company becomes imminent.Global Liquidity Sources and Other Unencumbered AssetsWe maintain liquidity available to the Corporation, including the parent company and selected subsidiaries, in the form of cash and high-quality, liquid, unencumbered securities. Our liquidity buffer, referred to as Global Liquidity Sources (GLS), is comprised of assets that are readily available to the parent company and selected subsidiaries, including holding company, bank and broker-dealer subsidiaries, even during stressed market conditions. Our cash is primarily on deposit with the Federal Reserve Bank and, to a lesser extent, central banks outside of the U.S. We limit the composition of high-quality, liquid, unencumbered securities to U.S. government securities, U.S. agency securities, U.S. agency MBS and a select group of non-U.S. government securities. We can quickly obtain cash for these securities, even in stressed conditions, through repurchase agreements or outright sales. We hold our GLS in legal entities that allow us to meet the liquidity requirements of our global businesses, and we consider the impact of potential regulatory, tax, legal and other restrictions that could limit the transferability of funds among entities.Table 16 presents average GLS for the three months ended December 31, 2020 and 2019.Table 16Average Global Liquidity SourcesThree Months EndedDecember 31(Dollars in billions)20202019Bank entities$773 $454 Nonbank and other entities (1)170 122 Total Average Global Liquidity Sources$943 $576 (1) Nonbank includes Parent, NB Holdings and other regulated entities.Our bank subsidiaries’ liquidity is primarily driven by deposit and lending activity, as well as securities valuation and net debt activity. Bank subsidiaries can also generate incremental liquidity by pledging a range of unencumbered loans and securities to certain FHLBs and the Federal Reserve Discount Window. The cash we could have obtained by borrowing against this pool of specifically-identified eligible assets was $306 billion and $372 billion at December 31, 2020 and 2019. We have established operational procedures to enable us to borrow against these assets, including regularly monitoring our total pool of eligible loans and securities collateral. Eligibility is defined in guidelines from the FHLBs and the Federal Reserve and is subject to change at their discretion. Due to regulatory restrictions, liquidity generated by the bank subsidiaries can generally be used only to fund obligations within the bank subsidiaries, and transfers to the parent company or nonbank subsidiaries may be subject to prior regulatory approval.57 Bank of AmericaLiquidity is also held in nonbank entities, including the Parent, NB Holdings and other regulated entities. Parent company and NB Holdings liquidity is typically in the form of cash deposited at BANA and is excluded from the liquidity at bank subsidiaries. Liquidity held in other regulated entities, comprised primarily of broker-dealer subsidiaries, is primarily available to meet the obligations of that entity, and transfers to the parent company or to any other subsidiary may be subject to prior regulatory approval due to regulatory restrictions and minimum requirements. Our other regulated entities also hold unencumbered investment-grade securities and equities that we believe could be used to generate additional liquidity.Table 17 presents the composition of average GLS for the three months ended December 31, 2020 and 2019.Table 17Average Global Liquidity Sources CompositionThree Months EndedDecember 31(Dollars in billions)20202019Cash on deposit$322 $103 U.S. Treasury securities141 98 U.S. agency securities, mortgage-backed securities, and other investment-grade securities462 358 Non-U.S. government securities18 17 Total Average Global Liquidity Sources$943 $576 Our GLS are substantially the same in composition to what qualifies as High Quality Liquid Assets (HQLA) under the final U.S. Liquidity Coverage Ratio (LCR) rules. However, HQLA for purposes of calculating LCR is not reported at market value, but at a lower value that incorporates regulatory deductions and the exclusion of excess liquidity held at certain subsidiaries. The LCR is calculated as the amount of a financial institution’s unencumbered HQLA relative to the estimated net cash outflows the institution could encounter over a 30-day period of significant liquidity stress, expressed as a percentage. Our average consolidated HQLA, on a net basis, was $584 billion and $464 billion for the three months ended December 31, 2020 and 2019. For the same periods, the average consolidated LCR was 122 percent and 116 percent. Our LCR fluctuates due to normal business flows from customer activity.Liquidity Stress Analysis We utilize liquidity stress analysis to assist us in determining the appropriate amounts of liquidity to maintain at the parent company and our subsidiaries to meet contractual and contingent cash outflows under a range of scenarios. The scenarios we consider and utilize incorporate market-wide and Corporation-specific events, including potential credit rating downgrades for the parent company and our subsidiaries, and more severe events including potential resolution scenarios. The scenarios are based on our historical experience, experience of distressed and failed financial institutions, regulatory guidance, and both expected and unexpected future events.The types of potential contractual and contingent cash outflows we consider in our scenarios may include, but are not limited to, upcoming contractual maturities of unsecured debt and reductions in new debt issuances; diminished access to secured financing markets; potential deposit withdrawals; increased draws on loan commitments, liquidity facilities and letters of credit; additional collateral that counterparties could call if our credit ratings were downgraded; collateral and margin requirements arising from market value changes; and potential liquidity required to maintain businesses and finance customer activities. Changes in certain market factors, including, but not limited to, credit rating downgrades, could negatively impact potential contractual and contingent outflows and the related financial instruments, and in some cases these impacts could be material to our financial results.We consider all sources of funds that we could access during each stress scenario and focus particularly on matching available sources with corresponding liquidity requirements by legal entity. We also use the stress modeling results to manage our asset and liability profile and establish limits and guidelines on certain funding sources and businesses.Net Stable Funding Ratio Final RuleOn October 20, 2020, the U.S. Agencies finalized the Net Stable Funding Ratio (NSFR), a rule requiring large banks to maintain a minimum level of stable funding over a one-year period. The final rule is intended to support the ability of banks to lend to households and businesses in both normal and adverse economic conditions and is complementary to the LCR rule, which focuses on short-term liquidity risks. The final rule is effective July 1, 2021. The U.S. NSFR would apply to the Corporation on a consolidated basis and to our insured depository institutions. The Corporation expects to be in compliance within the final NSFR rule in the regulatory timeline provided and does not expect any significant impacts to the Corporation.Diversified Funding SourcesWe fund our assets primarily with a mix of deposits, and secured and unsecured liabilities through a centralized, globally coordinated funding approach diversified across products, programs, markets, currencies and investor groups. The primary benefits of our centralized funding approach include greater control, reduced funding costs, wider name recognition by investors and greater flexibility to meet the variable funding requirements of subsidiaries. Where regulations, time zone differences or other business considerations make parent company funding impractical, certain other subsidiaries may issue their own debt.We fund a substantial portion of our lending activities through our deposits, which were $1.80 trillion and $1.43 trillion at December 31, 2020 and 2019. Deposits are primarily generated by our Consumer Banking, GWIM and Global Banking segments. These deposits are diversified by clients, product type and geography, and the majority of our U.S. deposits are insured by the FDIC. We consider a substantial portion of our deposits to be a stable, low-cost and consistent source of funding. We believe this deposit funding is generally less sensitive to interest rate changes, market volatility or changes in our credit ratings than wholesale funding sources. Our lending activities may also be financed through secured borrowings, including credit card securitizations and securitizations with government-sponsored enterprises (GSE), the FHA and private-label investors, as well as FHLB loans.Our trading activities in other regulated entities are primarily funded on a secured basis through securities lending and repurchase agreements, and these amounts will vary based on customer activity and market conditions. We believe funding these activities in the secured financing markets is more cost-efficient and less sensitive to changes in our credit ratings than unsecured financing. Repurchase agreements are generally short-term and often overnight. Disruptions in secured financing markets for financial institutions have occurred in prior market cycles which resulted in adverse changes in terms or significant Bank of America 58reductions in the availability of such financing. We manage the liquidity risks arising from secured funding by sourcing funding globally from a diverse group of counterparties, providing a range of securities collateral and pursuing longer durations, when appropriate. For more information on secured financing agreements, see Note 10 – Federal Funds Sold or Purchased, Securities Financing Agreements, Short-term Borrowings and Restricted Cash to the Consolidated Financial Statements.Total long-term debt increased $22.1 billion to $262.9 billion during 2020, primarily due to debt issuances and valuation adjustments, partially offset by maturities and redemptions. We may, from time to time, purchase outstanding debt instruments in various transactions, depending on market conditions, liquidity and other factors. Our other regulated entities may also make markets in our debt instruments to provide liquidity for investors.During 2020, we issued $56.9 billion of long-term debt consisting of $43.8 billion of notes issued by Bank of America Corporation, substantially all of which was TLAC compliant, $4.8 billion of notes issued by Bank of America, N.A. and $8.3 billion of other debt. During 2019, we issued $52.5 billion of long-term debt consisting of $29.3 billion of notes issued by Bank of America Corporation, substantially all of which was TLAC compliant, $10.9 billion of notes issued by Bank of America, N.A. and $12.3 billion of other debt. During 2020, we had total long-term debt maturities and redemptions in the aggregate of $47.1 billion consisting of $22.6 billion for Bank of America Corporation, $11.5 billion for Bank of America, N.A. and $13.0 billion of other debt. During 2019, we had total long-term debt maturities and redemptions in the aggregate of $50.6 billion consisting of $21.1 billion for Bank of America Corporation, $19.9 billion for Bank of America, N.A. and $9.6 billion of other debt.At December 31, 2020, Bank of America Corporation's senior notes of $191.2 billion included $146.6 billion of outstanding notes that are both TLAC eligible and callable at least one year before their stated maturities. Of these senior notes, $12.0 billion will be callable and become TLAC ineligible during 2021, and $15.3 billion, $14.6 billion, $11.7 billion and $13.2 billion will do so during each of 2022 through 2025, respectively, and $79.8 billion thereafter.We issue long-term unsecured debt in a variety of maturities and currencies to achieve cost-efficient funding and to maintain an appropriate maturity profile. While the cost and availability of unsecured funding may be negatively impacted by general market conditions or by matters specific to the financial services industry or the Corporation, we seek to mitigate refinancing risk by actively managing the amount of our borrowings that we anticipate will mature within any month or quarter. We may issue unsecured debt in the form of structured notes for client purposes, certain of which qualify as TLAC-eligible debt. During 2020, we issued $7.3 billion of structured notes, which are unsecured debt obligations that pay investors returns linked to other debt or equity securities, indices, currencies or commodities. We typically hedge the returns we are obligated to pay on these liabilities with derivatives and/or investments in the underlying instruments, so that from a funding perspective, the cost is similar to our other unsecured long-term debt. We could be required to settle certain structured note obligations for cash or other securities prior to maturity under certain circumstances, which we consider for liquidity planning purposes. We believe, however, that a portion of such borrowings will remain outstanding beyond the earliest put or redemption date.Substantially all of our senior and subordinated debt obligations contain no provisions that could trigger a requirement for an early repayment, require additional collateral support, result in changes to terms, accelerate maturity or create additional financial obligations upon an adverse change in our credit ratings, financial ratios, earnings, cash flows or stock price. For more information on long-term debt funding, including issuances and maturities and redemptions, see Note 11 – Long-term Debt to the Consolidated Financial Statements.We use derivative transactions to manage the duration, interest rate and currency risks of our borrowings, considering the characteristics of the assets they are funding. For more information on our ALM activities, see Interest Rate Risk Management for the Banking Book on page 82.Contingency PlanningWe maintain contingency funding plans that outline our potential responses to liquidity stress events at various levels of severity. These policies and plans are based on stress scenarios and include potential funding strategies and communication and notification procedures that we would implement in the event we experienced stressed liquidity conditions. We periodically review and test the contingency funding plans to validate efficacy and assess readiness.Our U.S. bank subsidiaries can access contingency funding through the Federal Reserve Discount Window. Certain non-U.S. subsidiaries have access to central bank facilities in the jurisdictions in which they operate. While we do not rely on these sources in our liquidity modeling, we maintain the policies, procedures and governance processes that would enable us to access these sources if necessary.Credit RatingsOur borrowing costs and ability to raise funds are impacted by our credit ratings. In addition, credit ratings may be important to customers or counterparties when we compete in certain markets and when we seek to engage in certain transactions, including over-the-counter (OTC) derivatives. Thus, it is our objective to maintain high-quality credit ratings, and management maintains an active dialogue with the major rating agencies.Credit ratings and outlooks are opinions expressed by rating agencies on our creditworthiness and that of our obligations or securities, including long-term debt, short-term borrowings, preferred stock and other securities, including asset securitizations. Our credit ratings are subject to ongoing review by the rating agencies, and they consider a number of factors, including our own financial strength, performance, prospects and operations as well as factors not under our control. The rating agencies could make adjustments to our ratings at any time, and they provide no assurances that they will maintain our ratings at current levels.Other factors that influence our credit ratings include changes to the rating agencies’ methodologies for our industry or certain security types; the rating agencies’ assessment of the general operating environment for financial services companies; our relative positions in the markets in which we compete; our various risk exposures and risk management policies and activities; pending litigation and other contingencies or potential tail risks; our reputation; our liquidity position, diversity of funding sources and funding costs; the current and expected level and volatility of our earnings; our capital position and capital management practices; our corporate governance; the sovereign credit ratings of the U.S. government; current or future regulatory and legislative 59 Bank of Americainitiatives; and the agencies’ views on whether the U.S. government would provide meaningful support to the Corporation or its subsidiaries in a crisis.On April 22, 2020, Fitch Ratings (Fitch) completed its review of large, complex securities trading and universal banks in the U.S., including Bank of America, in response to declining economic activity from the pandemic. The agency affirmed its long-term and short-term senior debt ratings for the Corporation and all of its rated subsidiaries, except for select issuer and instrument-level ratings that had previously been placed under criteria observation on March 4, 2020, following changes in the agency’s bank rating criteria on February 28, 2020. Concurrently, Fitch reached a conclusion on select under-criteria-observation designations for the Corporation and upgraded its long-term and short-term senior debt ratings of MLI and BofASE by one notch to AA-/F1+. The agency also upgraded its preferred stock rating for the Corporation by one notch to BBB and downgraded its subordinated debt rating for the Corporation by one notch to A-. According to Fitch, rating changes under criteria observation are the sole result of bank rating criteria changes and do not reflect a change in the underlying fundamentals of the institution. Fitch’s outlook for all of our long-term ratings is currently Stable.On June 9, 2020, Fitch affirmed its rating for the subordinated debt of BANA at A. This rating had remained under criteria observation following Fitch’s broader rating actions.On November 18, 2020, Moody’s Investors Service (Moody's) affirmed its long-term and short-term debt ratings for the Corporation and all of its rated subsidiaries, which did not change during 2020. Moody’s outlook for all of our long-term ratings is currently Stable.The current ratings and Stable outlooks for the Corporation and its subsidiaries from Standard & Poor’s Global Ratings also did not change during 2020.Table 18 presents the Corporation’s current long-term/short-term senior debt ratings and outlooks expressed by the rating agencies.Table 18Senior Debt RatingsMoody’s Investors ServiceStandard & Poor’s Global RatingsFitch RatingsLong-termShort-termOutlookLong-termShort-termOutlookLong-termShort-termOutlookBank of America Corporation A2 P-1 Stable A- A-2 Stable A+ F1 StableBank of America, N.A. Aa2 P-1 Stable A+ A-1 Stable AA- F1+ StableBank of America Europe Designated Activity Company NR NR NR A+ A-1 Stable AA- F1+ StableMerrill Lynch, Pierce, Fenner & Smith Incorporated NR NR NR A+ A-1 Stable AA- F1+ StableBofA Securities, Inc. NR NR NR A+ A-1 Stable AA- F1+ StableMerrill Lynch International NR NR NR A+ A-1 Stable AA- F1+ StableBofA Securities Europe SA NR NR NR A+ A-1 Stable AA- F1+ StableNR = not ratedA reduction in certain of our credit ratings or the ratings of certain asset-backed securitizations may have a material adverse effect on our liquidity, potential loss of access to credit markets, the related cost of funds, our businesses and on certain revenues, particularly in those businesses where counterparty creditworthiness is critical. In addition, under the terms of certain OTC derivative contracts and other trading agreements, in the event of downgrades of our or our rated subsidiaries’ credit ratings, the counterparties to those agreements may require us to provide additional collateral, or to terminate these contracts or agreements, which could cause us to sustain losses and/or adversely impact our liquidity. If the short-term credit ratings of our parent company, bank or broker-dealer subsidiaries were downgraded by one or more levels, the potential loss of access to short-term funding sources such as repo financing and the effect on our incremental cost of funds could be material.While certain potential impacts are contractual and quantifiable, the full scope of the consequences of a credit rating downgrade to a financial institution is inherently uncertain, as it depends upon numerous dynamic, complex and inter-related factors and assumptions, including whether any downgrade of a company’s long-term credit ratings precipitates downgrades to its short-term credit ratings, and assumptions about the potential behaviors of various customers, investors and counterparties. For more information on potential impacts of credit rating downgrades, see Liquidity Risk – Liquidity Stress Analysis on page 58. For more information on additional collateral and termination payments that could be required in connection with certain over-the-counter derivative contracts and other trading agreements in the event of a credit rating downgrade, see Note 3 – Derivatives to the Consolidated Financial Statements and Part I. Item 1A. Risk Factors.Bank of America 60Common Stock DividendsFor a summary of our declared quarterly cash dividends on common stock during 2020 and through February 24, 2021, see Note 13 – Shareholders’ Equity to the Consolidated Financial Statements.Finance Subsidiary Issuers and Parent GuarantorBofA Finance LLC, a Delaware limited liability company (BofA Finance), is a consolidated finance subsidiary of the Corporation that has issued and sold, and is expected to continue to issue and sell, its senior unsecured debt securities (Guaranteed Notes), that are fully and unconditionally guaranteed by the Corporation. The Corporation guarantees the due and punctual payment, on demand, of amounts payable on the Guaranteed Notes if not paid by BofA Finance. In addition, each of BAC Capital Trust XIII and BAC Capital Trust XIV, Delaware statutory trusts (collectively, the Trusts), is a 100 percent owned finance subsidiary of the Corporation that has issued and sold trust preferred securities (the Trust Preferred Securities and, together with the Guaranteed Notes, the Guaranteed Securities) that remained outstanding at December 31, 2020. The Corporation guarantees the payment of amounts and distributions with respect to the Trust Preferred Securities if not paid by the Trusts, to the extent of funds held by the Trusts, and this guarantee, together with the Corporation’s other obligations with respect to the Trust Preferred Securities, effectively constitutes a full and unconditional guarantee of the Trusts’ payment obligations on the Trust Preferred Securities. No other subsidiary of the Corporation guarantees the Guaranteed Securities. BofA Finance and each of the Trusts are finance subsidiaries, have no independent assets, revenues or operations and are dependent upon the Corporation and/or the Corporation’s other subsidiaries to meet their respective obligations under the Guaranteed Securities in the ordinary course. If holders of the Guaranteed Securities make claims on their Guaranteed Securities in a bankruptcy, resolution or similar proceeding, any recoveries on those claims will be limited to those available under the applicable guarantee by the Corporation, as described above.The Corporation is a holding company and depends upon its subsidiaries for liquidity. Applicable laws and regulations and intercompany arrangements entered into in connection with the Corporation’s resolution plan could restrict the availability of funds from subsidiaries to the Corporation, which could adversely affect the Corporation’s ability to make payments under its guarantees. In addition, the obligations of the Corporation under the guarantees of the Guaranteed Securities will be structurally subordinated to all existing and future liabilities of its subsidiaries, and claimants should look only to assets of the Corporation for payments. If the Corporation, as guarantor of the Guaranteed Notes, transfers all or substantially all of its assets to one or more direct or indirect majority-owned subsidiaries, under the indenture governing the Guaranteed Notes, the subsidiary or subsidiaries will not be required to assume the Corporation’s obligations under its guarantee of the Guaranteed Notes.For more information on factors that may affect payments to holders of the Guaranteed Securities, see Liquidity Risk – NB Holdings Corporation in this section, Item 1. Business – Insolvency and the Orderly Liquidation Authority on page 5 and Part I. Item 1A. Risk Factors – Liquidity on page 9.Credit Risk ManagementCredit risk is the risk of loss arising from the inability or failure of a borrower or counterparty to meet its obligations. Credit risk can also arise from operational failures that result in an erroneous advance, commitment or investment of funds. We define the credit exposure to a borrower or counterparty as the loss potential arising from all product classifications including loans and leases, deposit overdrafts, derivatives, assets held-for-sale and unfunded lending commitments which include loan commitments, letters of credit and financial guarantees. Derivative positions are recorded at fair value and assets held-for-sale are recorded at either fair value or the lower of cost or fair value. Certain loans and unfunded commitments are accounted for under the fair value option. Credit risk for categories of assets carried at fair value is not accounted for as part of the allowance for credit losses but as part of the fair value adjustments recorded in earnings. For derivative positions, our credit risk is measured as the net cost in the event the counterparties with contracts in which we are in a gain position fail to perform under the terms of those contracts. We use the current fair value to represent credit exposure without giving consideration to future mark-to-market changes. The credit risk amounts take into consideration the effects of legally enforceable master netting agreements and cash collateral. Our consumer and commercial credit extension and review procedures encompass funded and unfunded credit exposures. For more information on derivatives and credit extension commitments, see Note 3 – Derivatives and Note 12 – Commitments and Contingencies to the Consolidated Financial Statements.We manage credit risk based on the risk profile of the borrower or counterparty, repayment sources, the nature of underlying collateral, and other support given current events, conditions and expectations. We classify our portfolios as either consumer or commercial and monitor credit risk in each as discussed below.We refine our underwriting and credit risk management practices as well as credit standards to meet the changing economic environment. To mitigate losses and enhance customer support in our consumer businesses, we have in place collection programs and loan modification and customer assistance infrastructures. We utilize a number of actions to mitigate losses in the commercial businesses including increasing the frequency and intensity of portfolio monitoring, hedging activity and our practice of transferring management of deteriorating commercial exposures to independent special asset officers as credits enter criticized categories.For information on our credit risk management activities, see Consumer Portfolio Credit Risk Management below, Commercial Portfolio Credit Risk Management on page 68, Non-U.S. Portfolio on page 74, Allowance for Credit Losses on page 76, and Note 5 – Outstanding Loans and Leases and Allowance for Credit Losses to the Consolidated Financial Statements.During 2020, the pandemic negatively impacted economic activity in the U.S. and around the world. In particular, beginning in the latter portion of the first quarter of 2020, the pandemic resulted in changes to consumer and business behaviors and restrictions on economic activity. These restrictions gave rise to increased unemployment and underemployment, lower business profits, increased business closures and bankruptcies, fluctuations and disruptions to commercial and consumer spending and markets, and lower global GDP, all of which negatively impacted our consumer and commercial credit portfolio.61 Bank of AmericaTo provide relief to individuals and businesses in the U.S., economic stimulus packages were enacted throughout 2020, including the CARES Act, an executive order signed in August 2020 to establish the Lost Wage Assistance Program, and most recently, the Consolidated Appropriations Act enacted in December 2020. In addition, U.S. bank regulatory agencies issued interagency guidance to financial institutions that have worked with and continue to work with borrowers affected by COVID-19. To support our customers, we implemented various loan modification programs and other forms of support beginning in March 2020, including offering loan payment deferrals, refunding certain fees, and pausing foreclosure sales, evictions and repossessions. Since June 2020, we have experienced a decline in the need for customer assistance as the number of customer accounts and balances on deferral decreased significantly. For information on the accounting for loan modifications related to the pandemic, see Note 1 – Summary of Significant Accounting Principles to the Consolidated Financial Statements.Furthermore, as COVID-19 cases eased and initial restrictions lifted, the global economy began to improve. This improvement, coupled with the aforementioned relief, facilitated economic recovery, with unemployment dropping from double-digit highs in the second quarter of 2020 and GDP significantly rebounding in the third quarter of 2020.However, economic recovery remains uneven, with certain sectors of the economy more significantly impacted from the pandemic (e.g., travel and entertainment). As a result, we have experienced increases in commercial reservable criticized utilized exposures driven by industries most heavily impacted by COVID-19. Also, we have seen modest increases in nonperforming loans driven by commercial loans and consumer real estate customer deferral activities, though consumer charge-offs remained low during 2020 due to payment deferrals and government stimulus benefits.The pandemic and its full impact on the global economy continue to be highly uncertain. While COVID-19 cases have begun to ease from their January 2021 peak, the spread of new, more contagious variants could impact the magnitude and duration of this health crisis. However, ongoing virus containment efforts and vaccination progress, as well as the possibility of further government stimulus, could accelerate the macroeconomic recovery. For more information on how the pandemic may affect our operations, see Executive Summary – Recent Developments – COVID-19 Pandemic on page 25 and Part I. Item 1A. Risk Factors – Coronavirus Disease on page 7. Consumer Portfolio Credit Risk ManagementCredit risk management for the consumer portfolio begins with initial underwriting and continues throughout a borrower’s credit cycle. Statistical techniques in conjunction with experiential judgment are used in all aspects of portfolio management including underwriting, product pricing, risk appetite, setting credit limits, and establishing operating processes and metrics to quantify and balance risks and returns. Statistical models are built using detailed behavioral information from external sources such as credit bureaus and/or internal historical experience and are a component of our consumer credit risk management process. These models are used in part to assist in making both new and ongoing credit decisions, as well as portfolio management strategies, including authorizations and line management, collection practices and strategies, and determination of the allowance for loan and lease losses and allocated capital for credit risk.Consumer Credit PortfolioWhile COVID-19 is severely impacting economic activity, and is contributing to increasing nonperforming loans within certain consumer portfolios, it did not have a significant impact on consumer portfolio charge-offs during 2020 due to payment deferrals and government stimulus benefits. However, COVID-19 could lead to adverse impacts to credit quality metrics in future periods if negative economic conditions continue or worsen. During 2020, net charge-offs decreased $334 million to $2.7 billion primarily due to lower credit card losses.The consumer allowance for loan and lease losses increased $5.5 billion in 2020 to $10.1 billion due to the adoption of the new CECL accounting standard and deterioration in the economic outlook resulting from the impact of COVID-19. For more information, see Allowance for Credit Losses on page 76.For more information on our accounting policies regarding delinquencies, nonperforming status, charge-offs, TDRs for the consumer portfolio, as well as interest accrual policies and delinquency status for loan modifications related to the pandemic, see Note 1 – Summary of Significant Accounting Principles and Note 5 – Outstanding Loans and Leases and Allowance for Credit Losses to the Consolidated Financial Statements.Table 19 presents our outstanding consumer loans and leases, consumer nonperforming loans and accruing consumer loans past due 90 days or more. Bank of America 62Table 19Consumer Credit Quality OutstandingsNonperformingAccruing Past Due90 Days or MoreDecember 31(Dollars in millions)202020192020201920202019Residential mortgage (1)$223,555 $236,169 $2,005 $1,470 $762 $1,088 Home equity 34,311 40,208 649 536 — — Credit card78,708 97,608 n/an/a903 1,042 Direct/Indirect consumer (2)91,363 90,998 71 47 33 33 Other consumer124 192 — — — — Consumer loans excluding loans accounted for under the fair value option$428,061 $465,175 $2,725 $2,053 $1,698 $2,163 Loans accounted for under the fair value option (3)735 594 Total consumer loans and leases $428,796 $465,769 Percentage of outstanding consumer loans and leases (4)n/an/a0.64 %0.44 %0.40 %0.47 %Percentage of outstanding consumer loans and leases, excluding fully-insured loan portfolios (4)n/an/a0.65 0.46 0.22 0.24 (1)Residential mortgage loans accruing past due 90 days or more are fully-insured loans. At December 31, 2020 and 2019, residential mortgage includes $537 million and $740 million of loans on which interest had been curtailed by the FHA, and therefore were no longer accruing interest, although principal was still insured, and $225 million and $348 million of loans on which interest was still accruing.(2)Outstandings primarily include auto and specialty lending loans and leases of $46.4 billion and $50.4 billion, U.S. securities-based lending loans of $41.1 billion and $36.7 billion and non-U.S. consumer loans of $3.0 billion and $2.8 billion at December 31, 2020 and 2019.(3)Consumer loans accounted for under the fair value option include residential mortgage loans of $298 million and $257 million and home equity loans of $437 million and $337 million at December 31, 2020 and 2019. For more information on the fair value option, see Note 21 – Fair Value Option to the Consolidated Financial Statements.(4)Excludes consumer loans accounted for under the fair value option. At December 31, 2020 and 2019, $11 million and $6 million of loans accounted for under the fair value option were past due 90 days or more and not accruing interest.n/a = not applicableTable 20 presents net charge-offs and related ratios for consumer loans and leases.Table 20Consumer Net Charge-offs and Related RatiosNet Charge-offsNet Charge-off Ratios (1)(Dollars in millions)2020201920202019Residential mortgage$(30)$(47)(0.01)%(0.02)%Home equity(73)(358)(0.19)(0.81)Credit card2,349 2,948 2.76 3.12 Direct/Indirect consumer122 209 0.14 0.23 Other consumer284 234 n/mn/mTotal$2,652 $2,986 0.59 0.66 (1)Net charge-off ratios are calculated as net charge-offs divided by average outstanding loans and leases excluding loans accounted for under the fair value option.n/m = not meaningfulTable 21 presents outstandings, nonperforming balances, net charge-offs, allowance for credit losses and provision for credit losses for the core and non-core portfolios within the consumer real estate portfolio. We categorize consumer real estate loans as core and non-core based on loan and customer characteristics such as origination date, product type, loan-to value (LTV), Fair Isaac Corporation (FICO) score and delinquency status consistent with our current consumer and mortgage servicing strategy. Generally, loans that were originated after January 1, 2010, qualified under GSE underwriting guidelines, or otherwise met our underwriting guidelines in place in 2015 are characterized as core loans. All other loans are generally characterized as non-core loans and represent runoff portfolios. Core loans as reported in Table 21 include loans held in the Consumer Banking and GWIM segments, as well as loans held for ALM activities in All Other.As shown in Table 21, outstanding core consumer real estate loans decreased $15.4 billion during 2020 driven by a decrease of $10.5 billion in residential mortgage and a $4.9 billion decrease in home equity. 63 Bank of AmericaTable 21Consumer Real Estate Portfolio (1)OutstandingsNonperformingDecember 31Net Charge-offs(Dollars in millions)202020192020201920202019Core portfolio Residential mortgage$215,273 $225,770 $1,390 $883 $(25)$7 Home equity30,328 35,226 462 363 (6)51 Total core portfolio245,601 260,996 1,852 1,246 (31)58 Non-core portfolio Residential mortgage8,282 10,399 615 587 (5)(54)Home equity3,983 4,982 187 173 (67)(409)Total non-core portfolio12,265 15,381 802 760 (72)(463)Consumer real estate portfolio Residential mortgage223,555 236,169 2,005 1,470 (30)(47) Home equity34,311 40,208 649 536 (73)(358)Total consumer real estate portfolio$257,866 $276,377 $2,654 $2,006 $(103)$(405)Allowance for Loanand Lease LossesProvision for Loanand Lease LossesDecember 312020201920202019Core portfolioResidential mortgage$374 $229 $136 $22 Home equity599 120 135 (58)Total core portfolio973 349 271 (36)Non-core portfolio Residential mortgage85 96 75 (134) Home equity (2)(63)101 (21)(510)Total non-core portfolio22 197 54 (644)Consumer real estate portfolio Residential mortgage459 325 211 (112) Home equity (3)536 221 114 (568)Total consumer real estate portfolio$995 $546 $325 $(680)(1)Outstandings and nonperforming loans exclude loans accounted for under the fair value option. Consumer loans accounted for under the fair value option include residential mortgage loans of $298 million and $257 million and home equity loans of $437 million and $337 million at December 31, 2020 and 2019. For more information, see Note 21 – Fair Value Option to the Consolidated Financial Statements.(2)The home equity non-core allowance is in a negative position at December 31, 2020 as it includes expected recoveries of amounts previously charged off.(3)Home equity allowance includes a reserve for unfunded lending commitments of $137 million at December 31, 2020.We believe that the presentation of information adjusted to exclude the impact of the fully-insured loan portfolio and loans accounted for under the fair value option is more representative of the ongoing operations and credit quality of the business. As a result, in the following tables and discussions of the residential mortgage and home equity portfolios, we exclude loans accounted for under the fair value option and provide information that excludes the impact of the fully-insured loan portfolio in certain credit quality statistics.Residential MortgageThe residential mortgage portfolio made up the largest percentage of our consumer loan portfolio at 52 percent of consumer loans and leases at December 31, 2020. Approximately 52 percent of the residential mortgage portfolio was in Consumer Banking and 40 percent was in GWIM. The remaining portion was in All Other and was comprised of loans used in our overall ALM activities, delinquent FHA loans repurchased pursuant to our servicing agreements with the Government National Mortgage Association as well as loans repurchased related to our representations and warranties. Outstanding balances in the residential mortgage portfolio decreased $12.6 billion in 2020 as both loan sales and paydowns were partially offset by originations. At December 31, 2020 and 2019, the residential mortgage portfolio included $11.8 billion and $18.7 billion of outstanding fully-insured loans, of which $2.8 billion and $11.2 billion had FHA insurance, with the remainder protected by Fannie Mae long-term standby agreements. The decline was primarily driven by sales of loans with FHA insurance during 2020.Table 22 presents certain residential mortgage key credit statistics on both a reported basis and excluding the fully-insured loan portfolio. The following discussion presents the residential mortgage portfolio excluding the fully-insured loan portfolio.Bank of America 64Table 22Residential Mortgage – Key Credit StatisticsReported Basis (1)Excluding Fully-insured Loans (1)December 31(Dollars in millions)2020201920202019Outstandings$223,555 $236,169 $211,737 $217,479 Accruing past due 30 days or more2,314 3,108 1,224 1,296 Accruing past due 90 days or more762 1,088 — — Nonperforming loans (2)2,005 1,470 2,005 1,470 Percent of portfolio Refreshed LTV greater than 90 but less than or equal to 1002 %2 %1 %2 %Refreshed LTV greater than 1001 1 1 1 Refreshed FICO below 6202 3 1 2 2006 and 2007 vintages (3)3 4 3 4 (1)Outstandings, accruing past due, nonperforming loans and percentages of portfolio exclude loans accounted for under the fair value option. For information on our interest accrual policies and delinquency status for loan modifications related to the pandemic, see Note 1 – Summary of Significant Accounting Principles to the Consolidated Financial Statements.(2)Includes loans that are contractually current which primarily consist of collateral-dependent TDRs, including those that have been discharged in Chapter 7 bankruptcy and loans that have not yet demonstrated a sustained period of payment performance following a TDR.(3)These vintages of loans accounted for $503 million and $365 million, or 25 percent, of nonperforming residential mortgage loans at both December 31, 2020 and 2019.Nonperforming outstanding balances in the residential mortgage portfolio increased $535 million in 2020 primarily driven by COVID-19 deferral activity, as well as the inclusion of certain loans that, upon adoption of the new credit loss standard, became accounted for on an individual basis, which previously had been accounted for under a pool basis. Of the nonperforming residential mortgage loans at December 31, 2020, $892 million, or 45 percent, were current on contractual payments. Loans accruing past due 30 days or more decreased $72 million. Net charge-offs increased $17 million to a net recovery of $30 million in 2020 compared to a net recovery of $47 million in 2019. This increase is due largely to lower recoveries from the sales of previously charged-off loans.Of the $211.7 billion in total residential mortgage loans outstanding at December 31, 2020, as shown in Table 22, 27 percent were originated as interest-only loans. The outstanding balance of interest-only residential mortgage loans that have entered the amortization period was $5.9 billion, or 10 percent, at December 31, 2020. Residential mortgage loans that have entered the amortization period generally have experienced a higher rate of early stage delinquencies and nonperforming status compared to the residential mortgage portfolio as a whole. At December 31, 2020, $113 million, or two percent of outstanding interest-only residential mortgages that had entered the amortization period were accruing past due 30 days or more compared to $1.2 billion, or less than one percent, for the entire residential mortgage portfolio. In addition, at December 31, 2020, $356 million, or six percent, of outstanding interest-only residential mortgage loans that had entered the amortization period were nonperforming, of which $96 million were contractually current, compared to $2.0 billion, or one percent, for the entire residential mortgage portfolio. Loans that have yet to enter the amortization period in our interest-only residential mortgage portfolio are primarily well-collateralized loans to our wealth management clients and have an interest-only period of three to ten years. Approximately 98 percent of these loans that have yet to enter the amortization period will not be required to make a fully-amortizing payment until 2022 or later.Table 23 presents outstandings, nonperforming loans and net charge-offs by certain state concentrations for the residential mortgage portfolio. The Los Angeles-Long Beach-Santa Ana Metropolitan Statistical Area (MSA) within California represented 16 percent of outstandings at both December 31, 2020 and 2019. In the New York area, the New York-Northern New Jersey-Long Island MSA made up 14 percent and 13 percent of outstandings at December 31, 2020 and 2019. Table 23Residential Mortgage State ConcentrationsOutstandings (1)Nonperforming (1)December 31Net Charge-offs(Dollars in millions)202020192020201920202019California$83,185 $88,998 $570 $274 $(18)$(22)New York23,832 22,385 272 196 3 5 Florida13,017 12,833 175 143 (5)(12)Texas8,868 8,943 78 65 — 1 New Jersey8,806 8,734 98 77 (1)(4)Other74,029 75,586 812 715 (9)(15)Residential mortgage loans$211,737 $217,479 $2,005 $1,470 $(30)$(47)Fully-insured loan portfolio11,818 18,690 Total residential mortgage loan portfolio$223,555 $236,169 (1)Outstandings and nonperforming loans exclude loans accounted for under the fair value option.Home Equity At December 31, 2020, the home equity portfolio made up eight percent of the consumer portfolio and was comprised of home equity lines of credit (HELOCs), home equity loans and reverse mortgages. HELOCs generally have an initial draw period of 10 years, and after the initial draw period ends, the loans generally convert to 15- or 20-year amortizing loans. We no longer originate home equity loans or reverse mortgages.At December 31, 2020, 80 percent of the home equity portfolio was in Consumer Banking, 12 percent was in All Other and the remainder of the portfolio was primarily in GWIM. Outstanding balances in the home equity portfolio decreased 65 Bank of America$5.9 billion in 2020 primarily due to paydowns outpacing new originations and draws on existing lines. Of the total home equity portfolio at December 31, 2020 and 2019, $13.8 billion, or 40 percent, and $15.0 billion, or 37 percent, were in first-lien positions. At December 31, 2020, outstanding balances in the home equity portfolio that were in a second-lien or more junior-lien position and where we also held the first-lien loan totaled $5.9 billion, or 17 percent, of our total home equity portfolio.Unused HELOCs totaled $42.3 billion and $43.6 billion at December 31, 2020 and 2019. The HELOC utilization rate was 43 percent and 46 percent at December 31, 2020 and 2019.Table 24 presents certain home equity portfolio key credit statistics. Table 24Home Equity – Key Credit Statistics (1)December 31(Dollars in millions)20202019Outstandings$34,311 $40,208 Accruing past due 30 days or more (2)186 218 Nonperforming loans (2, 3)649 536 Percent of portfolioRefreshed CLTV greater than 90 but less than or equal to 1001 %1 %Refreshed CLTV greater than 1001 2 Refreshed FICO below 6203 3 2006 and 2007 vintages (4)16 18 (1)Outstandings, accruing past due, nonperforming loans and percentages of the portfolio exclude loans accounted for under the fair value option. For information on our interest accrual policies and delinquency status for loan modifications related to the pandemic, see Note 1 – Summary of Significant Accounting Principles to the Consolidated Financial Statements.(2)Accruing past due 30 days or more include $25 million and $30 million and nonperforming loans include $88 million and $57 million of loans where we serviced the underlying first lien at December 31, 2020 and 2019. (3)Includes loans that are contractually current which primarily consist of collateral-dependent TDRs, including those that have been discharged in Chapter 7 bankruptcy, junior-lien loans where the underlying first lien is 90 days or more past due, as well as loans that have not yet demonstrated a sustained period of payment performance following a TDR. (4)These vintages of loans accounted for 36 percent and 34 percent of nonperforming home equity loans at December 31, 2020 and 2019. Nonperforming outstanding balances in the home equity portfolio increased $113 million during 2020 primarily driven by COVID-19 deferral activity. Of the nonperforming home equity loans at December 31, 2020, $259 million, or 40 percent, were current on contractual payments. In addition, $237 million, or 36 percent, of nonperforming home equity loans were 180 days or more past due and had been written down to the estimated fair value of the collateral, less costs to sell. Accruing loans that were 30 days or more past due decreased $32 million in 2020.Net charge-offs increased $285 million to a net recovery of $73 million in 2020 compared to a net recovery of $358 million in 2019 as the prior-year period included recoveries from non-core home equity loan sales. Of the $34.3 billion in total home equity portfolio outstandings at December 31, 2020, as shown in Table 24, 15 percent require interest-only payments. The outstanding balance of HELOCs that have reached the end of their draw period and have entered the amortization period was $9.2 billion at December 31, 2020. The HELOCs that have entered the amortization period have experienced a higher percentage of early stage delinquencies and nonperforming status when compared to the HELOC portfolio as a whole. At December 31, 2020, $121 million, or one percent of outstanding HELOCs that had entered the amortization period were accruing past due 30 days or more. In addition, at December 31, 2020, $477 million, or five percent, were nonperforming. Loans that have yet to enter the amortization period in our interest-only portfolio are primarily post-2008 vintages and generally have better credit quality than the previous vintages that had entered the amortization period. We communicate to contractually current customers more than a year prior to the end of their draw period to inform them of the potential change to the payment structure before entering the amortization period, and provide payment options to customers prior to the end of the draw period.Although we do not actively track how many of our home equity customers pay only the minimum amount due on their home equity loans and lines, we can infer some of this information through a review of our HELOC portfolio that we service and that is still in its revolving period. During 2020, nine percent of these customers with an outstanding balance did not pay any principal on their HELOCs. Table 25 presents outstandings, nonperforming balances and net charge-offs by certain state concentrations for the home equity portfolio. In the New York area, the New York-Northern New Jersey-Long Island MSA made up 13 percent of the outstanding home equity portfolio at both December 31, 2020 and 2019. The Los Angeles-Long Beach-Santa Ana MSA within California made up 11 percent of the outstanding home equity portfolio at both December 31, 2020 and 2019.Table 25Home Equity State ConcentrationsOutstandings (1)Nonperforming (1)December 31Net Charge-offs(Dollars in millions)202020192020201920202019California$9,488 $11,232 $143 $101 $(26)$(117)Florida3,715 4,327 80 71 (11)(74)New Jersey2,749 3,216 67 56 (3)(8)New York2,495 2,899 103 85 (1)(1)Massachusetts1,719 2,023 32 29 (1)(5)Other14,145 16,511 224 194 (31)(153)Total home equity loan portfolio$34,311 $40,208 $649 $536 $(73)$(358)(1)Outstandings and nonperforming loans exclude loans accounted for under the fair value option.Bank of America 66Credit CardAt December 31, 2020, 97 percent of the credit card portfolio was managed in Consumer Banking with the remainder in GWIM. Outstandings in the credit card portfolio decreased $18.9 billion in 2020 to $78.7 billion due to lower retail spending and higher payments. Net charge-offs decreased $599 million to $2.3 billion during 2020 compared to net charge-offs of $2.9 billion in 2019 due to government stimulus benefits and payment deferrals associated with COVID-19. Credit card loans 30 days or more past due and still accruing interest decreased $346 million, and loans 90 days or more past due and still accruing interest decreased $139 million primarily due to government stimulus benefits and declines in loan balances. Unused lines of credit for credit card increased to $342.4 billion at December 31, 2020 from $336.9 billion in 2019. Table 26 presents certain state concentrations for the credit card portfolio.Table 26Credit Card State ConcentrationsOutstandingsAccruing Past Due90 Days or More (1)December 31Net Charge-offs(Dollars in millions)202020192020201920202019California$12,543 $16,135 $166 $178 $419 $526 Florida7,666 9,075 135 135 306 363 Texas6,499 7,815 87 93 202 241 New York4,654 5,975 76 80 188 243 Washington3,685 4,639 21 26 56 71 Other43,661 53,969 418 530 1,178 1,504 Total credit card portfolio$78,708 $97,608 $903 $1,042 $2,349 $2,948 (1)For information on our interest accrual policies and delinquency status for loan modifications related to the pandemic, see Note 1 – Summary of Significant Accounting Principles to the Consolidated Financial Statements.Direct/Indirect ConsumerAt December 31, 2020, 51 percent of the direct/indirect portfolio was included in Consumer Banking (consumer auto and recreational vehicle lending) and 49 percent was included in GWIM (principally securities-based lending loans). Outstandings in the direct/indirect portfolio increased $365 million in 2020 to $91.4 billion primarily due to increases in securities-based lending offset by lower originations in Auto.Table 27 presents certain state concentrations for the direct/indirect consumer loan portfolio. Table 27Direct/Indirect State ConcentrationsOutstandingsAccruing Past Due 90 Days or More (1)December 31Net Charge-offs(Dollars in millions)202020192020201920202019California$12,248 $11,912 $6 $4 $20 $49 Florida10,891 10,154 4 4 20 27 Texas8,981 9,516 6 5 20 29 New York6,609 6,394 2 1 9 12 New Jersey3,572 3,468 — 1 2 4 Other49,062 49,554 15 18 51 88 Total direct/indirect loan portfolio$91,363 $90,998 $33 $33 $122 $209 (1)For information on our interest accrual policies and delinquency status for loan modifications related to the pandemic, see Note 1 – Summary of Significant Accounting Principles to the Consolidated Financial Statements.Nonperforming Consumer Loans, Leases and Foreclosed Properties ActivityTable 28 presents nonperforming consumer loans, leases and foreclosed properties activity during 2020 and 2019. During 2020, nonperforming consumer loans increased $672 million to $2.7 billion primarily driven by COVID-19 deferral activity, as well as the inclusion of $144 million of certain loans that were previously classified as purchased credit-impaired loans and accounted for under a pool basis. At December 31, 2020, $892 million, or 33 percent of nonperforming loans were 180 days or more past due and had been written down to their estimated property value less costs to sell. In addition, at December 31, 2020, $1.2 billion, or 45 percent of nonperforming consumer loans were modified and are now current after successful trial periods, or are current loans classified as nonperforming loans in accordance with applicable policies.Foreclosed properties decreased $106 million in 2020 to $123 million as the Corporation has paused formal loan foreclosure proceedings and foreclosure sales for occupied properties during 2020. Nonperforming loans also include certain loans that have been modified in TDRs where economic concessions have been granted to borrowers experiencing financial difficulties. Nonperforming TDRs are included in Table 28. For more information on our loan modification programs offered in response to the pandemic, most of which are not TDRs, see Executive Summary – Recent Developments – COVID-19 Pandemic on page 25 and Note 1 – Summary of Significant Accounting Principles to the Consolidated Financial Statements.67 Bank of AmericaTable 28Nonperforming Consumer Loans, Leases and Foreclosed Properties Activity (Dollars in millions)20202019Nonperforming loans and leases, January 1$2,053 $3,842 Additions 2,278 1,407 Reductions:Paydowns and payoffs(440)(701)Sales(38)(1,523)Returns to performing status (1)(1,014)(766)Charge-offs(78)(111)Transfers to foreclosed properties (36)(95)Total net additions/(reductions) to nonperforming loans and leases672 (1,789)Total nonperforming loans and leases, December 312,725 2,053 Foreclosed properties, December 31 (2)123 229 Nonperforming consumer loans, leases and foreclosed properties, December 31$2,848 $2,282 Nonperforming consumer loans and leases as a percentage of outstanding consumer loans and leases (3)0.64 %0.44 %Nonperforming consumer loans, leases and foreclosed properties as a percentage of outstanding consumer loans, leases and foreclosed properties (3)0.66 0.49 (1)Consumer loans may be returned to performing status when all principal and interest is current and full repayment of the remaining contractual principal and interest is expected, or when the loan otherwise becomes well-secured and is in the process of collection.(2)Foreclosed property balances do not include properties insured by certain government-guaranteed loans, principally FHA-insured, of $119 million and $260 million at December 31, 2020 and 2019. (3)Outstanding consumer loans and leases exclude loans accounted for under the fair value option.Table 29 presents TDRs for the consumer real estate portfolio. Performing TDR balances are excluded from nonperforming loans and leases in Table 28. For more information on our loan modification programs offered in response to the pandemic, most of which are not TDRs, see Executive Summary – Recent Developments – COVID-19 Pandemic on page 25 and Note 1 – Summary of Significant Accounting Principles to the Consolidated Financial Statements.Table 29Consumer Real Estate Troubled Debt RestructuringsDecember 31, 2020December 31, 2019(Dollars in millions)NonperformingPerformingTotalNonperformingPerformingTotalResidential mortgage (1, 2)$1,195 $2,899 $4,094 $921 $3,832 $4,753 Home equity (3)248 836 1,084 252 977 1,229 Total consumer real estate troubled debt restructurings$1,443 $3,735 $5,178 $1,173 $4,809 $5,982 (1)At December 31, 2020 and 2019, residential mortgage TDRs deemed collateral dependent totaled $1.4 billion and $1.2 billion, and included $1.0 billion and $748 million of loans classified as nonperforming and $361 million and $468 million of loans classified as performing.(2)At December 31, 2020 and 2019, residential mortgage performing TDRs include $1.5 billion and $2.1 billion of loans that were fully-insured.(3)At December 31, 2020 and 2019, home equity TDRs deemed collateral dependent totaled $407 million and $442 million, and include $216 million and $209 million of loans classified as nonperforming and $191 million and $233 million of loans classified as performing.In addition to modifying consumer real estate loans, we work with customers who are experiencing financial difficulty by modifying credit card and other consumer loans. Credit card and other consumer loan modifications generally involve a reduction in the customer’s interest rate on the account and placing the customer on a fixed payment plan not exceeding 60 months. Modifications of credit card and other consumer loans are made through programs utilizing direct customer contact, but may also utilize external programs. At December 31, 2020 and 2019, our credit card and other consumer TDR portfolio was $701 million and $679 million, of which $614 million and $570 million were current or less than 30 days past due under the modified terms. Commercial Portfolio Credit Risk ManagementCredit risk management for the commercial portfolio begins with an assessment of the credit risk profile of the borrower or counterparty based on an analysis of its financial position. As part of the overall credit risk assessment, our commercial credit exposures are assigned a risk rating and are subject to approval based on defined credit approval standards. Subsequent to loan origination, risk ratings are monitored on an ongoing basis, and if necessary, adjusted to reflect changes in the financial condition, cash flow, risk profile or outlook of a borrower or counterparty. In making credit decisions, we consider risk rating, collateral, country, industry and single-name concentration limits while also balancing these considerations with the total borrower or counterparty relationship. We use a variety of tools to continuously monitor the ability of a borrower or counterparty to perform under its obligations. We use risk rating aggregations to measure and evaluate concentrations within portfolios. In addition, risk ratings are a factor in determining the level of allocated capital and the allowance for credit losses.As part of our ongoing risk mitigation initiatives, we attempt to work with clients experiencing financial difficulty to modify their loans to terms that better align with their current ability to pay. In situations where an economic concession has been granted to a borrower experiencing financial difficulty, we identify these loans as TDRs. For more information on our accounting policies regarding delinquencies, nonperforming status and net charge-offs for the commercial portfolio, see Note 1 – Summary of Significant Accounting Principles to the Consolidated Financial Statements.Management of Commercial Credit Risk ConcentrationsCommercial credit risk is evaluated and managed with the goal that concentrations of credit exposure continue to be aligned with our risk appetite. We review, measure and manage concentrations of credit exposure by industry, product, geography, customer relationship and loan size. We also review, measure and manage commercial real estate loans by geographic location and property type. In addition, within our Bank of America 68non-U.S. portfolio, we evaluate exposures by region and by country. Tables 34, 37 and 40 summarize our concentrations. We also utilize syndications of exposure to third parties, loan sales, hedging and other risk mitigation techniques to manage the size and risk profile of the commercial credit portfolio. For more information on our industry concentrations, see Commercial Portfolio Credit Risk Management – Industry Concentrations on page 72 and Table 37.We account for certain large corporate loans and loan commitments, including issued but unfunded letters of credit which are considered utilized for credit risk management purposes, that exceed our single-name credit risk concentration guidelines under the fair value option. Lending commitments, both funded and unfunded, are actively managed and monitored, and as appropriate, credit risk for these lending relationships may be mitigated through the use of credit derivatives, with our credit view and market perspectives determining the size and timing of the hedging activity. In addition, we purchase credit protection to cover the funded portion as well as the unfunded portion of certain other credit exposures. To lessen the cost of obtaining our desired credit protection levels, credit exposure may be added within an industry, borrower or counterparty group by selling protection. These credit derivatives do not meet the requirements for treatment as accounting hedges. They are carried at fair value with changes in fair value recorded in other income.In addition, we are a member of various securities and derivative exchanges and clearinghouses, both in the U.S. and other countries. As a member, we may be required to pay a pro-rata share of the losses incurred by some of these organizations as a result of another member default and under other loss scenarios. For more information, see Note 12 – Commitments and Contingencies to the Consolidated Financial Statements.Commercial Credit PortfolioDuring 2020, commercial asset quality weakened as a result of the economic impact from COVID-19. However, there were also positive signs during this period. The draws by large corporate and commercial clients contributing to the $67.2 billion loan growth in the first quarter of 2020 have largely been repaid, as emergency or contingent funding was no longer needed or clients were able to access capital markets. Additionally, as part of the CARES Act, we had $22.7 billion of PPP loans outstanding with our small business clients at December 31, 2020, which are included in U.S. small business commercial in the tables in this section. For more information on PPP loans, see Note 1 – Summary of Significant Accounting Principles to the Consolidated Financial Statements.Credit quality of commercial real estate borrowers has begun to stabilize in many sectors as certain economies have reopened. Certain sectors, including hospitality and retail, continue to be negatively impacted as a result of COVID-19. Moreover, many real estate markets, while improving, are still experiencing some disruptions in demand, supply chain challenges and tenant difficulties.The commercial allowance for loan and lease losses increased $3.9 billion during 2020 to $8.7 billion due to the deterioration in the economic outlook resulting from the impact of COVID-19. For more information, see Allowance for Credit Losses on page 76.Total commercial utilized credit exposure decreased $15.0 billion during 2020 to $620.3 billion driven by lower loans and leases. The utilization rate for loans and leases, SBLCs and financial guarantees, and commercial letters of credit, in the aggregate, was 57 percent at December 31, 2020 and 58 percent at December 31, 2019.Table 30 presents commercial credit exposure by type for utilized, unfunded and total binding committed credit exposure. Commercial utilized credit exposure includes SBLCs and financial guarantees and commercial letters of credit that have been issued and for which we are legally bound to advance funds under prescribed conditions during a specified time period, and excludes exposure related to trading account assets. Although funds have not yet been advanced, these exposure types are considered utilized for credit risk management purposes.Table 30Commercial Credit Exposure by Type Commercial Utilized (1)Commercial Unfunded (2, 3, 4)Total Commercial CommittedDecember 31(Dollars in millions)202020192020201920202019Loans and leases$499,065 $517,657 $404,740 $405,834 $903,805 $923,491 Derivative assets (5)47,179 40,485 — — 47,179 40,485 Standby letters of credit and financial guarantees34,616 36,062 538 468 35,154 36,530 Debt securities and other investments22,618 25,546 4,827 5,101 27,445 30,647 Loans held-for-sale8,378 7,047 9,556 15,135 17,934 22,182 Operating leases6,424 6,660 — — 6,424 6,660 Commercial letters of credit855 1,049 280 451 1,135 1,500 Other1,168 800 — — 1,168 800 Total$620,303 $635,306 $419,941 $426,989 $1,040,244 $1,062,295 (1)Commercial utilized exposure includes loans of $5.9 billion and $7.7 billion and issued letters of credit with a notional amount of $89 million and $170 million accounted for under the fair value option at December 31, 2020 and 2019.(2)Commercial unfunded exposure includes commitments accounted for under the fair value option with a notional amount of $3.9 billion and $4.2 billion at December 31, 2020 and 2019.(3)Excludes unused business card lines, which are not legally binding.(4)Includes the notional amount of unfunded legally binding lending commitments net of amounts distributed (i.e., syndicated or participated) to other financial institutions. The distributed amounts were $10.5 billion and $10.6 billion at December 31, 2020 and 2019.(5)Derivative assets are carried at fair value, reflect the effects of legally enforceable master netting agreements and have been reduced by cash collateral of $42.5 billion and $33.9 billion at December 31, 2020 and 2019. Not reflected in utilized and committed exposure is additional non-cash derivative collateral held of $39.3 billion and $35.2 billion at December 31, 2020 and 2019, which consists primarily of other marketable securities.69 Bank of AmericaOutstanding commercial loans and leases decreased $18.6 billion during 2020 primarily driven by repayments due in part to reduced working capital needs and a favorable capital markets environment, partially offset by $22.7 billion of PPP loans outstanding at December 31, 2020. Nonperforming commercial loans increased $728 million across industries, and commercial reservable criticized utilized exposure increased $27.2 billion spread across several industries, including travel and entertainment, as a result of weaker economic conditions arising from COVID-19. Table 31 presents our commercial loans and leases portfolio and related credit quality information at December 31, 2020 and 2019.Table 31Commercial Credit QualityOutstandingsNonperforming Accruing Past Due90 Days or More (3)December 31(Dollars in millions)202020192020201920202019Commercial and industrial:U.S. commercial$288,728 $307,048 $1,243 $1,094 $228 $106 Non-U.S. commercial90,460 104,966 418 43 10 8 Total commercial and industrial379,188 412,014 1,661 1,137 238 114 Commercial real estate60,364 62,689 404 280 6 19 Commercial lease financing17,098 19,880 87 32 25 20 456,650 494,583 2,152 1,449 269 153 U.S. small business commercial (1)36,469 15,333 75 50 115 97 Commercial loans excluding loans accounted for under the fair value option493,119 509,916 2,227 1,499 384 250 Loans accounted for under the fair value option (2)5,946 7,741 Total commercial loans and leases$499,065 $517,657 (1)Includes card-related products.(2)Commercial loans accounted for under the fair value option include U.S. commercial of $2.9 billion and $4.7 billion and non-U.S. commercial of $3.0 billion and $3.1 billion at December 31, 2020 and 2019. For more information on the fair value option, see Note 21 – Fair Value Option to the Consolidated Financial Statements. (3)For information on our interest accrual policies and delinquency status for loan modifications related to the pandemic, see Note 1 – Summary of Significant Accounting Principles to the Consolidated Financial Statements.Table 32 presents net charge-offs and related ratios for our commercial loans and leases for 2020 and 2019. Table 32Commercial Net Charge-offs and Related RatiosNet Charge-offsNet Charge-off Ratios (1)(Dollars in millions)2020201920202019Commercial and industrial:U.S. commercial$718 $256 0.23 %0.08 %Non-U.S. commercial155 84 0.15 0.08 Total commercial and industrial873 340 0.21 0.08 Commercial real estate270 29 0.43 0.05 Commercial lease financing59 21 0.32 0.10 1,202 390 0.24 0.08 U.S. small business commercial267 272 0.86 1.83 Total commercial$1,469 $662 0.28 0.13 (1)Net charge-off ratios are calculated as net charge-offs divided by average outstanding loans and leases excluding loans accounted for under the fair value option.Table 33 presents commercial reservable criticized utilized exposure by loan type. Criticized exposure corresponds to the Special Mention, Substandard and Doubtful asset categories as defined by regulatory authorities. Total commercial reservable criticized utilized exposure increased $27.2 billion during 2020, which was spread across several industries, including travel and entertainment, as a result of weaker economic conditions arising from COVID-19. At December 31, 2020 and 2019, 79 percent and 90 percent of commercial reservable criticized utilized exposure was secured.Table 33Commercial Reservable Criticized Utilized Exposure (1, 2)December 31(Dollars in millions)20202019Commercial and industrial:U.S. commercial$21,388 6.83 %$8,272 2.46 %Non-U.S. commercial5,051 5.03 989 0.89 Total commercial and industrial26,439 6.40 9,261 2.07 Commercial real estate10,213 16.42 1,129 1.75 Commercial lease financing714 4.18 329 1.66 37,366 7.59 10,719 2.01 U.S. small business commercial1,300 3.56 733 4.78 Total commercial reservable criticized utilized exposure (1)$38,666 7.31 $11,452 2.09 (1)Total commercial reservable criticized utilized exposure includes loans and leases of $36.6 billion and $10.7 billion and commercial letters of credit of $2.1 billion and $715 million at December 31, 2020 and 2019.(2)Percentages are calculated as commercial reservable criticized utilized exposure divided by total commercial reservable utilized exposure for each exposure category.Bank of America 70Commercial and IndustrialCommercial and industrial loans include U.S. commercial and non-U.S. commercial portfolios.U.S. CommercialAt December 31, 2020, 65 percent of the U.S. commercial loan portfolio, excluding small business, was managed in Global Banking, 18 percent in Global Markets, 15 percent in GWIM (generally business-purpose loans for high net worth clients) and the remainder primarily in Consumer Banking. U.S. commercial loans decreased $18.3 billion during 2020 driven by Global Banking. Reservable criticized utilized exposure increased $13.1 billion, which was spread across several industries, including travel and entertainment, as a result of weaker economic conditions arising from COVID-19.Non-U.S. CommercialAt December 31, 2020, 79 percent of the non-U.S. commercial loan portfolio was managed in Global Banking and 21 percent in Global Markets. Non-U.S. commercial loans decreased $14.5 billion during 2020, primarily in Global Banking. For information on the non-U.S. commercial portfolio, see Non-U.S. Portfolio on page 74.Commercial Real EstateCommercial real estate primarily includes commercial loans secured by non-owner-occupied real estate and is dependent on the sale or lease of the real estate as the primary source of repayment. Outstanding loans declined by $2.3 billion during 2020 as paydowns exceeded new originations. Reservable criticized utilized exposure increased $9.1 billion to $10.2 billion from $1.1 billion, or 16.42 and 1.75 percent of the commercial real estate portfolio at December 31, 2020 and 2019, due to downgrades driven by the impact of COVID-19 across industries, primarily hotels. Although we have observed property-level improvements in a number of the most impacted sectors, the length of time for recovery has been slower than originally anticipated, which has prompted additional downgrades. The portfolio remains diversified across property types and geographic regions. California represented the largest state concentration at 23 percent and 24 percent of the commercial real estate portfolio at December 31, 2020 and 2019. The commercial real estate portfolio is predominantly managed in Global Banking and consists of loans made primarily to public and private developers, and commercial real estate firms.During 2020, we continued to see low default rates and varying degrees of improvement in the portfolio. We use a number of proactive risk mitigation initiatives to reduce adversely rated exposure in the commercial real estate portfolio, including transfers of deteriorating exposures to management by independent special asset officers and the pursuit of loan restructurings or asset sales to achieve the best results for our customers and the Corporation.Table 34 presents outstanding commercial real estate loans by geographic region, based on the geographic location of the collateral, and by property type. Table 34Outstanding Commercial Real Estate LoansDecember 31(Dollars in millions)20202019By Geographic Region California$14,028 $14,910 Northeast11,628 12,408 Southwest8,551 8,408 Southeast6,588 5,937 Florida4,294 3,984 Midwest3,483 3,203 Illinois2,594 3,349 Midsouth2,370 2,468 Northwest1,634 1,638 Non-U.S. 3,187 3,724 Other (1)2,007 2,660 Total outstanding commercial real estate loans$60,364 $62,689 By Property Type Non-residentialOffice$17,667 $17,902 Industrial / Warehouse8,330 8,677 Shopping centers / Retail7,931 8,183 Hotels / Motels7,226 6,982 Multi-family rental7,051 7,250 Unsecured2,336 3,438 Multi-use1,460 1,788 Other7,146 6,958 Total non-residential59,147 61,178 Residential1,217 1,511 Total outstanding commercial real estate loans$60,364 $62,689 (1)Includes unsecured loans to real estate investment trusts and national home builders whose portfolios of properties span multiple geographic regions and properties in the states of Colorado, Utah, Hawaii, Wyoming and Montana.U.S. Small Business CommercialThe U.S. small business commercial loan portfolio is comprised of small business card loans and small business loans primarily managed in Consumer Banking, and includes $22.7 billion of PPP loans outstanding at December 31, 2020. Excluding PPP, credit card-related products were 50 percent and 52 percent of the U.S. small business commercial portfolio at December 31, 2020 and 2019. Of the U.S. small business commercial net charge-offs, 91 percent and 94 percent were credit card-related products in 2020 and 2019.Nonperforming Commercial Loans, Leases and Foreclosed Properties ActivityTable 35 presents the nonperforming commercial loans, leases and foreclosed properties activity during 2020 and 2019. 71 Bank of AmericaNonperforming loans do not include loans accounted for under the fair value option. During 2020, nonperforming commercial loans and leases increased $728 million to $2.2 billion, primarily driven by the impact of COVID-19. At December 31, 2020, 84 percent of commercial nonperforming loans, leases and foreclosed properties were secured and 66 percent were contractually current. Commercial nonperforming loans were carried at 81 percent of their unpaid principal balance beforeconsideration of the allowance for loan and lease losses, as the carrying value of these loans has been reduced to the estimated collateral value less costs to sell.Table 35Nonperforming Commercial Loans, Leases and Foreclosed Properties Activity (1, 2)(Dollars in millions)20202019Nonperforming loans and leases, January 1$1,499 $1,102 Additions3,518 2,048 Reductions: Paydowns(1,002)(648)Sales(350)(215)Returns to performing status (3)(172)(120)Charge-offs(1,208)(478)Transfers to foreclosed properties(2)(9)Transfers to loans held-for-sale(56)(181)Total net additions to nonperforming loans and leases728 397 Total nonperforming loans and leases, December 312,227 1,499 Foreclosed properties, December 3141 56 Nonperforming commercial loans, leases and foreclosed properties, December 312,268 1,555 Nonperforming commercial loans and leases as a percentage of outstanding commercial loans and leases (4)0.45 %0.29 %Nonperforming commercial loans, leases and foreclosed properties as a percentage of outstanding commercial loans, leases and foreclosed properties (4)0.46 0.30 (1)Balances do not include nonperforming loans held-for-sale of $359 million and $239 million at December 31, 2020 and 2019.(2)Includes U.S. small business commercial activity. Small business card loans are excluded as they are not classified as nonperforming.(3)Commercial loans and leases may be returned to performing status when all principal and interest is current and full repayment of the remaining contractual principal and interest is expected, or when the loan otherwise becomes well-secured and is in the process of collection. TDRs are generally classified as performing after a sustained period of demonstrated payment performance.(4)Outstanding commercial loans exclude loans accounted for under the fair value option.Table 36 presents our commercial TDRs by product type and performing status. U.S. small business commercial TDRs are comprised of renegotiated small business card loans and small business loans. The renegotiated small business card loans are not classified as nonperforming as they are charged off no later than the end of the month in which the loan becomes 180 days past due. For more information on TDRs, see Note 5 – Outstanding Loans and Leases and Allowance for Credit Losses to the Consolidated Financial Statements. For more information on our loan modification programs offered in response to the pandemic, most of which are not TDRs, see Executive Summary – Recent Developments – COVID-19 Pandemic on page 25 and Note 1 – Summary of Significant Accounting Principles to the Consolidated Financial Statements.Table 36Commercial Troubled Debt RestructuringsDecember 31, 2020December 31, 2019(Dollars in millions)NonperformingPerformingTotalNonperformingPerformingTotalCommercial and industrial:U.S. commercial$509 $850 $1,359 $617 $999 $1,616 Non-U.S. commercial49 119 168 41 193 234 Total commercial and industrial558 969 1,527 658 1,192 1,850 Commercial real estate137 — 137 212 14 226 Commercial lease financing42 2 44 18 31 49 737 971 1,708 888 1,237 2,125 U.S. small business commercial— 29 29 — 27 27 Total commercial troubled debt restructurings$737 $1,000 $1,737 $888 $1,264 $2,152 Industry Concentrations Table 37 presents commercial committed and utilized credit exposure by industry and the total net credit default protection purchased to cover the funded and unfunded portions of certain credit exposures. Our commercial credit exposure is diversified across a broad range of industries. Total commercial committed exposure decreased $22.1 billion, or two percent, during 2020 to $1.0 trillion. The decrease in commercial committed exposure was concentrated in the Global commercial banks, Asset managers and funds, Utilities, and Real estate industry sectors. Decreases were partially offset by increased exposure to the Finance companies and Automobiles and components industry sectors.Industry limits are used internally to manage industry concentrations and are based on committed exposure that is determined on an industry-by-industry basis. A risk management framework is in place to set and approve industry limits as well as to provide ongoing monitoring. The MRC oversees industry limit governance. Asset managers and funds, our largest industry concentration with committed exposure of $101.5 billion, decreased $8.5 billion, or eight percent, during 2020.Real estate, our second largest industry concentration with committed exposure of $92.4 billion, decreased $4.0 billion, or four percent, during 2020. For more information on the commercial real estate and related portfolios, see Commercial Portfolio Credit Risk Management – Commercial Real Estate on page 71.Capital goods, our third largest industry concentration with committed exposure of $81.0 billion, remained flat during 2020. Bank of America 72Given the widespread impact of the pandemic on the U.S. and global economy, a number of industries have been and will likely continue to be adversely impacted. We continue to monitor all industries, particularly higher risk industries which are experiencing or could experience a more significant impact to their financial condition. The impact of the pandemic has also placed significant stress on global demand for oil. Our energy-related committed exposure decreased $3.3 billion, or nine percent, during 2020 to $33.0 billion, driven by declines in exploration and production, refining and marketing exposure, energy equipment and services, partially offset by an increase in our integrated client exposure. For more information on COVID-19, see Executive Summary – Recent Developments – COVID-19 Pandemic on page 25.Table 37Commercial Credit Exposure by Industry (1)Commercial UtilizedTotal Commercial Committed (2)December 31(Dollars in millions)2020201920202019Asset managers and funds$68,093 $71,386 $101,540 $110,069 Real estate (3)69,267 70,361 92,414 96,370 Capital goods39,911 41,082 80,959 80,892 Finance companies46,948 40,173 70,004 63,942 Healthcare equipment and services33,759 34,353 57,880 55,918 Government and public education41,669 41,889 56,212 53,566 Materials24,548 26,663 50,792 52,129 Retailing24,749 25,868 49,710 48,317 Consumer services32,000 28,434 48,026 49,071 Food, beverage and tobacco22,871 24,163 44,628 45,956 Commercial services and supplies21,154 23,103 38,149 38,944 Transportation23,426 23,449 33,444 33,028 Energy13,936 16,406 32,983 36,326 Utilities12,387 12,383 29,234 36,060 Individuals and trusts18,784 18,927 25,881 27,817 Technology hardware and equipment10,515 10,646 24,796 24,072 Media13,144 12,445 24,677 23,645 Software and services11,709 10,432 23,647 20,556 Global commercial banks20,751 30,171 22,922 32,345 Automobiles and components10,956 7,345 20,765 14,910 Consumer durables and apparel9,232 10,193 20,223 21,245 Vehicle dealers15,028 18,013 18,696 21,435 Pharmaceuticals and biotechnology5,217 5,964 16,349 20,206 Telecommunication services9,411 9,154 15,605 16,113 Insurance5,921 6,673 13,491 15,218 Food and staples retailing5,209 6,290 11,810 10,392 Financial markets infrastructure (clearinghouses)4,939 5,496 8,648 7,997 Religious and social organizations4,769 3,844 6,759 5,756 Total commercial credit exposure by industry$620,303 $635,306 $1,040,244 $1,062,295 Net credit default protection purchased on total commitments (4) $(4,170)$(3,349)(1)Includes U.S. small business commercial exposure.(2)Includes the notional amount of unfunded legally binding lending commitments net of amounts distributed (i.e., syndicated or participated) to other financial institutions. The distributed amounts were $10.5 billion and $10.6 billion at December 31, 2020 and 2019.(3)Industries are viewed from a variety of perspectives to best isolate the perceived risks. For purposes of this table, the real estate industry is defined based on the primary business activity of the borrowers or counterparties using operating cash flows and primary source of repayment as key factors.(4)Represents net notional credit protection purchased to hedge funded and unfunded exposures for which we elected the fair value option, as well as certain other credit exposures. For more information, see Commercial Portfolio Credit Risk Management – Risk Mitigation.Risk MitigationWe purchase credit protection to cover the funded portion as well as the unfunded portion of certain credit exposures. To lower the cost of obtaining our desired credit protection levels, we may add credit exposure within an industry, borrower or counterparty group by selling protection.At December 31, 2020 and 2019, net notional credit default protection purchased in our credit derivatives portfolio to hedge our funded and unfunded exposures for which we elected the fair value option, as well as certain other credit exposures, was $4.2 billion and $3.3 billion. We recorded net losses of $240 million in 2020 compared to net losses of $145 million in 2019 for these same positions. The gains and losses on these instruments were offset by gains and losses on the related exposures. The Value-at-Risk (VaR) results for these exposures are included in the fair value option portfolio information in Table 44. For more information, see Trading Risk Management on page 79.73 Bank of AmericaTables 38 and 39 present the maturity profiles and the credit exposure debt ratings of the net credit default protection portfolio at December 31, 2020 and 2019.Table 38Net Credit Default Protection by MaturityDecember 3120202019Less than or equal to one year65 %54 %Greater than one year and less than or equal to five years34 45 Greater than five years1 1 Total net credit default protection100 %100 %Table 39Net Credit Default Protection by Credit Exposure Debt RatingNetNotional (1)Percent ofTotalNetNotional (1)Percent ofTotal December 31(Dollars in millions)20202019Ratings (2, 3) A$(250)6.0 %$(697)20.8 %BBB(1,856)44.5 (1,089)32.5 BB(1,363)32.7 (766)22.9 B(465)11.2 (373)11.1 CCC and below(182)4.4 (119)3.6 NR (4)(54)1.2 (305)9.1 Total net credit default protection$(4,170)100.0 %$(3,349)100.0 %(1)Represents net credit default protection purchased.(2)Ratings are refreshed on a quarterly basis.(3)Ratings of BBB- or higher are considered to meet the definition of investment grade.(4)NR is comprised of index positions held and any names that have not been rated.In addition to our net notional credit default protection purchased to cover the funded and unfunded portion of certain credit exposures, credit derivatives are used for market-making activities for clients and establishing positions intended to profit from directional or relative value changes. We execute the majority of our credit derivative trades in the OTC market with large, multinational financial institutions, including broker-dealers and, to a lesser degree, with a variety of other investors. Because these transactions are executed in the OTC market, we are subject to settlement risk. We are also subject to credit risk in the event that these counterparties fail to perform under the terms of these contracts. In order to properly reflect counterparty credit risk, we record counterparty credit risk valuation adjustments on certain derivative assets, including our purchased credit default protection. In most cases, credit derivative transactions are executed on a daily margin basis. Therefore, events such as a credit downgrade, depending on the ultimate rating level, or a breach of credit covenants would typically require an increase in the amount of collateral required by the counterparty, where applicable, and/or allow us to take additional protective measures such as early termination of all trades. For more information on credit derivatives and counterparty credit risk valuation adjustments, see Note 3 – Derivatives to the Consolidated Financial Statements.Non-U.S. PortfolioOur non-U.S. credit and trading portfolios are subject to country risk. We define country risk as the risk of loss from unfavorable economic and political conditions, currency fluctuations, social instability and changes in government policies. A risk management framework is in place to measure, monitor and manage non-U.S. risk and exposures. In addition to the direct risk of doing business in a country, we also are exposed to indirect country risks (e.g., related to the collateral received on secured financing transactions or related to client clearing activities). These indirect exposures are managed in the normal course of business through credit, market and operational risk governance, rather than through country risk governance.Table 40 presents our 20 largest non-U.S. country exposures at December 31, 2020. These exposures accounted for 90 percent and 88 percent of our total non-U.S. exposure at December 31, 2020 and 2019. Net country exposure for these 20 countries increased $21.2 billion in 2020. The majority of the increase was due to higher deposits with central banks in Germany and Japan.Non-U.S. exposure is presented on an internal risk management basis and includes sovereign and non-sovereign credit exposure, securities and other investments issued by or domiciled in countries other than the U.S.Funded loans and loan equivalents include loans, leases, and other extensions of credit and funds, including letters of credit and due from placements. Unfunded commitments are the undrawn portion of legally binding commitments related to loans and loan equivalents. Net counterparty exposure includes the fair value of derivatives, including the counterparty risk associated with credit default swaps (CDS), and secured financing transactions. Securities and other investments are carried at fair value and long securities exposures are netted against short exposures with the same underlying issuer to, but not below, zero. Net country exposure represents country exposure less hedges and credit default protection purchased, net of credit default protection sold.Bank of America 74Table 40Top 20 Non-U.S. Countries Exposure(Dollars in millions)Funded Loans and Loan EquivalentsUnfunded Loan CommitmentsNet Counterparty ExposureSecurities/OtherInvestmentsCountry Exposure at December 312020Hedges and Credit Default ProtectionNet Country Exposure at December 312020Increase (Decrease) from December 312019United Kingdom$31,817 $18,201 $6,601 $4,086 $60,705 $(1,233)$59,472 $3,628 Germany29,169 10,772 2,155 4,492 46,588 (1,685)44,903 14,075 Canada8,657 8,681 1,624 2,628 21,590 (456)21,134 1,012 France8,219 8,353 988 4,329 21,889 (1,098)20,791 4,536 Japan12,679 1,086 1,115 3,325 18,205 (709)17,496 6,964 China10,098 67 1,529 1,952 13,646 (226)13,420 (2,167)Australia6,559 4,242 372 2,235 13,408 (321)13,087 1,985 Brazil5,854 696 708 3,288 10,546 (253)10,293 (1,479)Netherlands4,654 4,109 486 997 10,246 (562)9,684 (643)Singapore4,115 278 359 4,603 9,355 (73)9,282 1,456 South Korea5,161 856 488 2,214 8,719 (168)8,551 (154)India5,428 221 353 1,989 7,991 (180)7,811 (4,206)Switzerland3,811 2,817 412 130 7,170 (275)6,895 (490)Hong Kong4,434 452 584 1,128 6,598 (61)6,537 (519)Mexico3,712 1,379 205 1,112 6,408 (121)6,287 (1,524)Italy2,456 1,784 553 1,568 6,361 (669)5,692 315 Belgium2,471 1,334 505 797 5,107 (140)4,967 (1,540)Spain2,835 1,156 262 914 5,167 (351)4,816 94 Ireland2,785 1,050 100 253 4,188 (23)4,165 798 United Arab Emirates2,218 136 266 77 2,697 (10)2,687 (900)Total top 20 non-U.S. countries exposure$157,132 $67,670 $19,665 $42,117 $286,584 $(8,614)$277,970 $21,241 Our largest non-U.S. country exposure at December 31, 2020 was the U.K. with net exposure of $59.5 billion, which represents a $3.6 billion increase from December 31, 2019. Our second largest non-U.S. country exposure was Germany with net exposure of $44.9 billion at December 31, 2020, a $14.1 billion increase from December 31, 2019. The increase in Germany was primarily driven by an increase in deposits with the central bank. In light of the global pandemic, we are monitoring our non-U.S. exposure closely, particularly in countries where restrictions on certain activities, in an attempt to contain the spread and impact of the virus, have affected and will likely continue to adversely affect economic activity. We are managing the impact to our international business operations as part of our overall response framework and are taking actions to manage exposure carefully in impacted regions while supporting the needs of our clients. The magnitude and duration of the pandemic and its full impact on the global economy continue to be highly uncertain. The impact of COVID-19 could have an adverse impact on the global economy for a prolonged period of time. For more information on how the pandemic may affect our operations, see Executive Summary – Recent Developments – COVID-19 Pandemic on page 25 and Part I. Item 1A. Risk Factors on page 7.Table 41 presents countries that had total cross-border exposure, including the notional amount of cash loaned under secured financing agreements, exceeding one percent of our total assets at December 31, 2020. Local exposure, defined as exposure booked in local offices of a respective country with clients in the same country, is excluded. At December 31, 2020, the U.K. and France were the only countries where their respective total cross-border exposures exceeded one percent of our total assets. No other countries had total cross-border exposure that exceeded 0.75 percent of our total assets at December 31, 2020.Table 41Total Cross-border Exposure Exceeding One Percent of Total Assets(Dollars in millions)December 31Public SectorBanksPrivate SectorCross-borderExposureExposure as aPercent ofTotal AssetsUnited Kingdom2020$4,733 $2,269 $95,180 $102,182 3.62 %20191,859 3,580 93,232 98,671 4.05 20181,505 3,458 46,191 51,154 2.17 France20203,073 1,726 26,399 31,198 1.11 2019736 2,473 23,172 26,381 1.08 2018633 2,385 29,847 32,865 1.40 75 Bank of AmericaAllowance for Credit LossesOn January 1, 2020, the Corporation adopted the new accounting standard that requires the measurement of the allowance for credit losses to be based on management’s best estimate of lifetime ECL inherent in the Corporation’s relevant financial assets. Upon adoption of the new accounting standard, the Corporation recorded a net increase of $3.3 billion in the allowance for credit losses which was comprised of a net increase of $2.9 billion in the allowance for loan and lease losses and an increase of $310 million in the reserve for unfunded lending commitments. The net increase was primarily driven by a $3.1 billion increase related to the credit card portfolio. The allowance for credit losses further increased by $7.2 billion from January 1, 2020 to $20.7 billion at December 31, 2020, which included a $5.0 billion reserve increase related to the commercial portfolio and a $2.2 billion reserve increase related to the consumer portfolio. The increases were driven by deterioration in the economic outlook resulting from the impact of COVID-19.The following table presents an allocation of the allowance for credit losses by product type for December 31, 2020, January 1, 2020 and December 31, 2019 (prior to the adoption of the CECL accounting standard).Table 42Allocation of the Allowance for Credit Losses by Product TypeAmountPercent ofTotalPercent ofLoans andLeasesOutstanding (1)AmountPercent ofTotalPercent ofLoans andLeasesOutstanding (1)AmountPercent ofTotalPercent ofLoans andLeasesOutstanding (1)(Dollars in millions)December 31, 2020January 1, 2020December 31, 2019Allowance for loan and lease losses Residential mortgage$459 2.44 %0.21 %$212 1.72 %0.09 %$325 3.45 %0.14 %Home equity399 2.12 1.16 228 1.84 0.57 221 2.35 0.55 Credit card8,420 44.79 10.70 6,809 55.10 6.98 3,710 39.39 3.80 Direct/Indirect consumer752 4.00 0.82 566 4.58 0.62 234 2.49 0.26 Other consumer41 0.22 n/m55 0.45 n/m52 0.55 n/mTotal consumer10,071 53.57 2.35 7,870 63.69 1.69 4,542 48.23 0.98 U.S. commercial (2)5,043 26.82 1.55 2,723 22.03 0.84 3,015 32.02 0.94 Non-U.S. commercial1,241 6.60 1.37 668 5.41 0.64 658 6.99 0.63 Commercial real estate2,285 12.15 3.79 1,036 8.38 1.65 1,042 11.07 1.66 Commercial lease financing162 0.86 0.95 61 0.49 0.31 159 1.69 0.80 Total commercial8,731 46.43 1.77 4,488 36.31 0.88 4,874 51.77 0.96 Allowance for loan and lease losses18,802 100.00 %2.04 12,358 100.00 %1.27 9,416 100.00 %0.97 Reserve for unfunded lending commitments1,878 1,123 813 Allowance for credit losses$20,680 $13,481 $10,229 (1)Ratios are calculated as allowance for loan and lease losses as a percentage of loans and leases outstanding excluding loans accounted for under the fair value option. Consumer loans accounted for under the fair value option include residential mortgage loans of $298 million at December 31, 2020 and $257 million at January 1, 2020 and December 31, 2019 and home equity loans of $437 million at December 31, 2020 and $337 million at January 1, 2020 and December 31, 2019. Commercial loans accounted for under the fair value option include U.S. commercial loans of $2.9 billion, $5.1 billion and $4.7 billion at December 31, 2020, January 1, 2020 and December 31, 2019, and non-U.S. commercial loans of $3.0 billion, $3.2 billion and $3.1 billion at December 31, 2020, January 1, 2020 and December 31, 2019.(2)Includes allowance for loan and lease losses for U.S. small business commercial loans of $1.5 billion, $831 million and $523 million at December 31, 2020, January 1, 2020 and December 31, 2019.n/m = not meaningfulNet charge-offs for 2020 were $4.1 billion compared to $3.6 billion in 2019 driven by increases in commercial losses. The provision for credit losses increased $7.7 billion to $11.3 billion during 2020 compared to 2019. The allowance for credit losses included a reserve build of $7.2 billion for 2020, excluding the impact of the new accounting standard, primarily due to the deterioration in the economic outlook resulting from the impact of COVID-19 on both the consumer and commercial portfolios. The provision for credit losses for the consumer portfolio, including unfunded lending commitments, increased $2.0 billion to $4.9 billion during 2020 compared to 2019. The provision for credit losses for the commercial portfolio, including unfunded lending commitments, increased $5.7 billion to $6.5 billion during 2020 compared to 2019.The following table presents a rollforward of the allowance for credit losses, including certain loan and allowance ratios for 2020, noting that measurement of the allowance for credit losses for 2019 was based on management’s estimate of probable incurred losses. For more information on the Corporation’s credit loss accounting policies and activity related to the allowance for credit losses, see Note 1 – Summary of Significant Accounting Principles and Note 5 – Outstanding Loans and Leases and Allowance for Credit Losses to the Consolidated Financial Statements.Bank of America 76Table 43Allowance for Credit Losses(Dollars in millions)20202019Allowance for loan and lease losses, January 1$12,358 $9,601 Loans and leases charged offResidential mortgage(40)(93)Home equity(58)(429)Credit card(2,967)(3,535)Direct/Indirect consumer(372)(518)Other consumer(307)(249)Total consumer charge-offs(3,744)(4,824)U.S. commercial (1)(1,163)(650)Non-U.S. commercial(168)(115)Commercial real estate(275)(31)Commercial lease financing(69)(26)Total commercial charge-offs(1,675)(822)Total loans and leases charged off(5,419)(5,646)Recoveries of loans and leases previously charged offResidential mortgage70 140 Home equity131 787 Credit card618 587 Direct/Indirect consumer250 309 Other consumer23 15 Total consumer recoveries1,092 1,838 U.S. commercial (2)178 122 Non-U.S. commercial13 31 Commercial real estate5 2 Commercial lease financing10 5 Total commercial recoveries206 160 Total recoveries of loans and leases previously charged off1,298 1,998 Net charge-offs (4,121)(3,648)Provision for loan and lease losses10,565 3,574 Other— (111)Allowance for loan and lease losses, December 3118,802 9,416 Reserve for unfunded lending commitments, January 11,123 797 Provision for unfunded lending commitments755 16 Reserve for unfunded lending commitments, December 311,878 813 Allowance for credit losses, December 31$20,680 $10,229 Loan and allowance ratios:Loans and leases outstanding at December 31 (3)$921,180 $975,091 Allowance for loan and lease losses as a percentage of total loans and leases outstanding at December 31 (3)2.04 %0.97 %Consumer allowance for loan and lease losses as a percentage of total consumer loans and leases outstanding at December 31 (4)2.35 0.98 Commercial allowance for loan and lease losses as a percentage of total commercial loans and leases outstanding at December 31 (5)1.77 0.96 Average loans and leases outstanding (3)$974,281 $951,583 Annualized net charge-offs as a percentage of average loans and leases outstanding (3)0.42 %0.38 %Allowance for loan and lease losses as a percentage of total nonperforming loans and leases at December 31380 265 Ratio of the allowance for loan and lease losses at December 31 to net charge-offs4.56 2.58 Amounts included in allowance for loan and lease losses for loans and leases that are excluded from nonperforming loans and leases at December 31 (6)$9,854 $4,151 Allowance for loan and lease losses as a percentage of total nonperforming loans and leases, excluding the allowance for loan and lease losses for loans and leases that are excluded from nonperforming loans and leases at December 31 (6)181 %148 %(1)Includes U.S. small business commercial charge-offs of $321 million in 2020 compared to $320 million in 2019.(2)Includes U.S. small business commercial recoveries of $54 million in 2020 compared to $48 million in 2019.(3)Outstanding loan and lease balances and ratios do not include loans accounted for under the fair value option of $6.7 billion and $8.3 billion at December 31, 2020 and 2019. Average loans accounted for under the fair value option were $8.2 billion in 2020 compared to $6.8 billion in 2019.(4)Excludes consumer loans accounted for under the fair value option of $735 million and $594 million at December 31, 2020 and 2019.(5)Excludes commercial loans accounted for under the fair value option of $5.9 billion and $7.7 billion at December 31, 2020 and 2019.(6)Primarily includes amounts related to credit card and unsecured consumer lending portfolios in Consumer Banking.77 Bank of AmericaMarket Risk ManagementMarket risk is the risk that changes in market conditions may adversely impact the value of assets or liabilities, or otherwise negatively impact earnings. This risk is inherent in the financial instruments associated with our operations, primarily within our Global Markets segment. We are also exposed to these risks in other areas of the Corporation (e.g., our ALM activities). In the event of market stress, these risks could have a material impact on our results. For more information, see Interest Rate Risk Management for the Banking Book on page 82.We have been affected, and expect to continue to be affected, by market stress resulting from the pandemic that began in the first quarter of 2020. For more information on the effects of the pandemic, see Executive Summary – Recent Developments – COVID-19 Pandemic on page 25.Our traditional banking loan and deposit products are non-trading positions and are generally reported at amortized cost for assets or the amount owed for liabilities (historical cost). However, these positions are still subject to changes in economic value based on varying market conditions, with one of the primary risks being changes in the levels of interest rates. The risk of adverse changes in the economic value of our non-trading positions arising from changes in interest rates is managed through our ALM activities. We have elected to account for certain assets and liabilities under the fair value option.Our trading positions are reported at fair value with changes reflected in income. Trading positions are subject to various changes in market-based risk factors. The majority of this risk is generated by our activities in the interest rate, foreign exchange, credit, equity and commodities markets. In addition, the values of assets and liabilities could change due to market liquidity, correlations across markets and expectations of market volatility. We seek to manage these risk exposures by using a variety of techniques that encompass a broad range of financial instruments. The key risk management techniques are discussed in more detail in the Trading Risk Management section.Global Risk Management is responsible for providing senior management with a clear and comprehensive understanding of the trading risks to which we are exposed. These responsibilities include ownership of market risk policy, developing and maintaining quantitative risk models, calculating aggregated risk measures, establishing and monitoring position limits consistent with risk appetite, conducting daily reviews and analysis of trading inventory, approving material risk exposures and fulfilling regulatory requirements. Market risks that impact businesses outside of Global Markets are monitored and governed by their respective governance functions.Model risk is the potential for adverse consequences from decisions based on incorrect or misused model outputs and reports. Given that models are used across the Corporation, model risk impacts all risk types including credit, market and operational risks. The Enterprise Model Risk Policy defines model risk standards, consistent with our risk framework and risk appetite, prevailing regulatory guidance and industry best practice. All models, including risk management, valuation and regulatory capital models, must meet certain validation criteria, including effective challenge of the conceptual soundness of the model, independent model testing and ongoing monitoring through outcomes analysis and benchmarking. The Enterprise Model Risk Committee (EMRC), a subcommittee of the MRC, oversees that model standards are consistent with model risk requirements and monitors the effective challenge in the model validation process across the Corporation. Interest Rate RiskInterest rate risk represents exposures to instruments whose values vary with the level or volatility of interest rates. These instruments include, but are not limited to, loans, debt securities, certain trading-related assets and liabilities, deposits, borrowings and derivatives. Hedging instruments used to mitigate these risks include derivatives such as options, futures, forwards and swaps.Foreign Exchange RiskForeign exchange risk represents exposures to changes in the values of current holdings and future cash flows denominated in currencies other than the U.S. dollar. The types of instruments exposed to this risk include investments in non-U.S. subsidiaries, foreign currency-denominated loans and securities, future cash flows in foreign currencies arising from foreign exchange transactions, foreign currency-denominated debt and various foreign exchange derivatives whose values fluctuate with changes in the level or volatility of currency exchange rates or non-U.S. interest rates. Hedging instruments used to mitigate this risk include foreign exchange options, currency swaps, futures, forwards, and foreign currency-denominated debt and deposits.Mortgage RiskMortgage risk represents exposures to changes in the values of mortgage-related instruments. The values of these instruments are sensitive to prepayment rates, mortgage rates, agency debt ratings, default, market liquidity, government participation and interest rate volatility. Our exposure to these instruments takes several forms. For example, we trade and engage in market-making activities in a variety of mortgage securities including whole loans, pass-through certificates, commercial mortgages and collateralized mortgage obligations including collateralized debt obligations using mortgages as underlying collateral. In addition, we originate a variety of MBS, which involves the accumulation of mortgage-related loans in anticipation of eventual securitization, and we may hold positions in mortgage securities and residential mortgage loans as part of the ALM portfolio. We also record MSRs as part of our mortgage origination activities. Hedging instruments used to mitigate this risk include derivatives such as options, swaps, futures and forwards as well as securities including MBS and U.S. Treasury securities. For more information, see Mortgage Banking Risk Management on page 84.Equity Market RiskEquity market risk represents exposures to securities that represent an ownership interest in a corporation in the form of domestic and foreign common stock or other equity-linked instruments. Instruments that would lead to this exposure include, but are not limited to, the following: common stock, exchange-traded funds, American Depositary Receipts, convertible bonds, listed equity options (puts and calls), OTC equity options, equity total return swaps, equity index futures and other equity derivative products. Hedging instruments used to mitigate this risk include options, futures, swaps, convertible bonds and cash positions.Commodity RiskCommodity risk represents exposures to instruments traded in the petroleum, natural gas, power and metals markets. These instruments consist primarily of futures, forwards, swaps and options. Hedging instruments used to mitigate this risk include Bank of America 78options, futures and swaps in the same or similar commodity product, as well as cash positions.Issuer Credit RiskIssuer credit risk represents exposures to changes in the creditworthiness of individual issuers or groups of issuers. Our portfolio is exposed to issuer credit risk where the value of an asset may be adversely impacted by changes in the levels of credit spreads, by credit migration or by defaults. Hedging instruments used to mitigate this risk include bonds, CDS and other credit fixed-income instruments.Market Liquidity RiskMarket liquidity risk represents the risk that the level of expected market activity changes dramatically and, in certain cases, may even cease. This exposes us to the risk that we will not be able to transact business and execute trades in an orderly manner which may impact our results. This impact could be further exacerbated if expected hedging or pricing correlations are compromised by disproportionate demand or lack of demand for certain instruments. We utilize various risk mitigating techniques as discussed in more detail in Trading Risk Management.Trading Risk ManagementTo evaluate risks in our trading activities, we focus on the actual and potential volatility of revenues generated by individual positions as well as portfolios of positions. Various techniques and procedures are utilized to enable the most complete understanding of these risks. Quantitative measures of market risk are evaluated on a daily basis from a single position to the portfolio of the Corporation. These measures include sensitivities of positions to various market risk factors, such as the potential impact on revenue from a one basis point change in interest rates, and statistical measures utilizing both actual and hypothetical market moves, such as VaR and stress testing. Periods of extreme market stress influence the reliability of these techniques to varying degrees. Qualitative evaluations of market risk utilize the suite of quantitative risk measures while understanding each of their respective limitations. Additionally, risk managers independently evaluate the risk of the portfolios under the current market environment and potential future environments.VaR is a common statistic used to measure market risk as it allows the aggregation of market risk factors, including the effects of portfolio diversification. A VaR model simulates the value of a portfolio under a range of scenarios in order to generate a distribution of potential gains and losses. VaR represents the loss a portfolio is not expected to exceed more than a certain number of times per period, based on a specified holding period, confidence level and window of historical data. We use one VaR model consistently across the trading portfolios and it uses a historical simulation approach based on a three-year window of historical data. Our primary VaR statistic is equivalent to a 99 percent confidence level, which means that for a VaR with a one-day holding period, there should not be losses in excess of VaR, on average, 99 out of 100 trading days.Within any VaR model, there are significant and numerous assumptions that will differ from company to company. The accuracy of a VaR model depends on the availability and quality of historical data for each of the risk factors in the portfolio. A VaR model may require additional modeling assumptions for new products that do not have the necessary historical market data or for less liquid positions for which accurate daily prices are not consistently available. For positions with insufficient historical data for the VaR calculation, the process for establishing an appropriate proxy is based on fundamental and statistical analysis of the new product or less liquid position. This analysis identifies reasonable alternatives that replicate both the expected volatility and correlation to other market risk factors that the missing data would be expected to experience.VaR may not be indicative of realized revenue volatility as changes in market conditions or in the composition of the portfolio can have a material impact on the results. In particular, the historical data used for the VaR calculation might indicate higher or lower levels of portfolio diversification than will be experienced. In order for the VaR model to reflect current market conditions, we update the historical data underlying our VaR model on a weekly basis, or more frequently during periods of market stress, and regularly review the assumptions underlying the model. A minor portion of risks related to our trading positions is not included in VaR. These risks are reviewed as part of our ICAAP. For more information regarding ICAAP, see Capital Management on page 50.Global Risk Management continually reviews, evaluates and enhances our VaR model so that it reflects the material risks in our trading portfolio. Changes to the VaR model are reviewed and approved prior to implementation and any material changes are reported to management through the appropriate management committees.Trading limits on quantitative risk measures, including VaR, are independently set by Global Markets Risk Management and reviewed on a regular basis so that trading limits remain relevant and within our overall risk appetite for market risks. Trading limits are reviewed in the context of market liquidity, volatility and strategic business priorities. Trading limits are set at both a granular level to allow for extensive coverage of risks as well as at aggregated portfolios to account for correlations among risk factors. All trading limits are approved at least annually. Approved trading limits are stored and tracked in a centralized limits management system. Trading limit excesses are communicated to management for review. Certain quantitative market risk measures and corresponding limits have been identified as critical in the Corporation’s Risk Appetite Statement. These risk appetite limits are reported on a daily basis and are approved at least annually by the ERC and the Board.In periods of market stress, Global Markets senior leadership communicates daily to discuss losses, key risk positions and any limit excesses. As a result of this process, the businesses may selectively reduce risk.Table 44 presents the total market-based portfolio VaR which is the combination of the total covered positions (and less liquid trading positions) portfolio and the fair value option portfolio. Covered positions are defined by regulatory standards as trading assets and liabilities, both on- and off-balance sheet, that meet a defined set of specifications. These specifications identify the most liquid trading positions which are intended to be held for a short-term horizon and where we are able to hedge the material risk elements in a two-way market. Positions in less liquid markets, or where there are restrictions on the ability to trade the positions, typically do not qualify as covered positions. Foreign exchange and commodity positions are always considered covered positions, except for structural foreign currency positions that are excluded with prior regulatory approval. In addition, Table 44 presents our fair value option portfolio, which includes substantially all of the funded and unfunded exposures for which we elect the fair value option, and their corresponding hedges. Additionally, market risk VaR for 79 Bank of Americatrading activities as presented in Table 44 differs from VaR used for regulatory capital calculations due to the holding period being used. The holding period for VaR used for regulatory capital calculations is 10 days, while for the market risk VaR presented below, it is one day. Both measures utilize the same process and methodology.The total market-based portfolio VaR results in Table 44 include market risk to which we are exposed from all business segments, excluding credit valuation adjustment (CVA), DVA and related hedges. The majority of this portfolio is within the Global Markets segment.Table 44 presents year-end, average, high and low daily trading VaR for 2020 and 2019 using a 99 percent confidence level. The amounts disclosed in Table 44 and Table 45 align to the view of covered positions used in the Basel 3 capital calculations. Foreign exchange and commodity positions are always considered covered positions, regardless of trading or banking treatment for the trade, except for structural foreign currency positions that are excluded with prior regulatory approval.The annual average of total covered positions and less liquid trading positions portfolio VaR increased for 2020 compared to 2019 primarily due to the impact of market volatility related to the pandemic in the VaR look back period. Table 44Market Risk VaR for Trading Activities20202019(Dollars in millions)Year EndAverageHigh (1)Low (1)Year EndAverageHigh (1)Low (1)Foreign exchange$8 $7 $25 $2 $4 $6 $13 $2 Interest rate30 19 39 7 25 24 49 14 Credit79 58 91 25 26 23 32 16 Equity20 24 162 12 29 22 33 14 Commodities4 6 12 3 4 6 31 4 Portfolio diversification(72)(61)— — (47)(49)— — Total covered positions portfolio69 53 171 27 41 32 47 24 Impact from less liquid exposures52 27 — — — 3 — — Total covered positions and less liquid trading positions portfolio121 80 169 30 41 35 53 27 Fair value option loans52 52 84 7 8 10 13 7 Fair value option hedges11 13 17 9 10 10 17 4 Fair value option portfolio diversification(17)(24)— — (9)(10)— — Total fair value option portfolio46 41 86 9 9 10 16 5 Portfolio diversification(4)(15)— — (5)(7)— — Total market-based portfolio$163 $106 171 32 $45 $38 56 28 (1)The high and low for each portfolio may have occurred on different trading days than the high and low for the components. Therefore the impact from less liquid exposures and the amount of portfolio diversification, which is the difference between the total portfolio and the sum of the individual components, is not relevant.The graph below presents the daily covered positions and less liquid trading positions portfolio VaR for 2020, corresponding to the data in Table 44. Peak VaR in mid-March 2020 was driven by increased market realized volatility and higher implied volatilities.Additional VaR statistics produced within our single VaR model are provided in Table 45 at the same level of detail as in Table 44. Evaluating VaR with additional statistics allows for an increased understanding of the risks in the portfolio as the historical market data used in the VaR calculation does not necessarily follow a predefined statistical distribution. Table 45 presents average trading VaR statistics at 99 percent and 95 percent confidence levels for 2020 and 2019. The increase in VaR for the 99 percent confidence level for 2020 was primarily due to COVID-19 related market volatility, which impacted the 99 percent VaR average more severely than the 95 percent VaR average.Bank of America 80Table 45Average Market Risk VaR for Trading Activities – 99 percent and 95 percent VaR Statistics20202019(Dollars in millions)99 percent95 percent99 percent95 percentForeign exchange$7 $4 $6 $3 Interest rate19 9 24 15 Credit58 18 23 15 Equity24 13 22 11 Commodities6 3 6 3 Portfolio diversification(61)(26)(49)(29)Total covered positions portfolio53 21 32 18 Impact from less liquid exposures27 2 3 2 Total covered positions and less liquid trading positions portfolio80 23 35 20 Fair value option loans52 13 10 5 Fair value option hedges13 7 10 6 Fair value option portfolio diversification(24)(8)(10)(5)Total fair value option portfolio41 12 10 6 Portfolio diversification(15)(6)(7)(5)Total market-based portfolio$106 $29 $38 $21 BacktestingThe accuracy of the VaR methodology is evaluated by backtesting, which compares the daily VaR results, utilizing a one-day holding period, against a comparable subset of trading revenue. A backtesting excess occurs when a trading loss exceeds the VaR for the corresponding day. These excesses are evaluated to understand the positions and market moves that produced the trading loss with a goal to ensure that the VaR methodology accurately represents those losses. We expect the frequency of trading losses in excess of VaR to be in line with the confidence level of the VaR statistic being tested. For example, with a 99 percent confidence level, we expect one trading loss in excess of VaR every 100 days or between two to three trading losses in excess of VaR over the course of a year. The number of backtesting excesses observed can differ from the statistically expected number of excesses if the current level of market volatility is materially different than the level of market volatility that existed during the three years of historical data used in the VaR calculation.The trading revenue used for backtesting is defined by regulatory agencies in order to most closely align with the VaR component of the regulatory capital calculation. This revenue differs from total trading-related revenue in that it excludes revenue from trading activities that either do not generate market risk or the market risk cannot be included in VaR. Some examples of the types of revenue excluded for backtesting are fees, commissions, reserves, net interest income and intra-day trading revenues. We conduct daily backtesting on the VaR results used for regulatory capital calculations as well as the VaR results for key legal entities, regions and risk factors. These results are reported to senior market risk management. Senior management regularly reviews and evaluates the results of these tests. During 2020, there were seven days where this subset of trading revenue had losses that exceeded our total covered portfolio VaR, utilizing a one-day holding period. Total Trading-related RevenueTotal trading-related revenue, excluding brokerage fees, and CVA, DVA and funding valuation adjustment gains (losses), represents the total amount earned from trading positions, including market-based net interest income, which are taken in a diverse range of financial instruments and markets. For more information on fair value, see Note 20 – Fair Value Measurements to the Consolidated Financial Statements. Trading-related revenue can be volatile and is largely driven by general market conditions and customer demand. Also, trading-related revenue is dependent on the volume and type of transactions, the level of risk assumed, and the volatility of price and rate movements at any given time within the ever-changing market environment. Significant daily revenue by business is monitored and the primary drivers of these are reviewed.The following histogram is a graphic depiction of trading volatility and illustrates the daily level of trading-related revenue for 2020 and 2019. During 2020, positive trading-related revenue was recorded for 98 percent of the trading days, of which 87 percent were daily trading gains of over $25 million, and the largest loss was $90 million. This compares to 2019 where positive trading-related revenue was recorded for 98 percent of the trading days, of which 80 percent were daily trading gains of over $25 million, and the largest loss was $35 million. Trading Portfolio Stress TestingBecause the very nature of a VaR model suggests results can exceed our estimates and it is dependent on a limited historical window, we also stress test our portfolio using scenario analysis. This analysis estimates the change in the value of our trading portfolio that may result from abnormal market movements. A set of scenarios, categorized as either historical or hypothetical, are computed daily for the overall trading portfolio and individual businesses. These scenarios include shocks to underlying market risk factors that may be well beyond the shocks found in the historical data used to calculate VaR. Historical scenarios simulate the impact of the market moves that occurred during a period of extended historical market stress. Generally, a multi-week period representing the most 81 Bank of Americasevere point during a crisis is selected for each historical scenario. Hypothetical scenarios provide estimated portfolio impacts from potential future market stress events. Scenarios are reviewed and updated in response to changing positions and new economic or political information. In addition, new or ad hoc scenarios are developed to address specific potential market events or particular vulnerabilities in the portfolio. The stress tests are reviewed on a regular basis and the results are presented to senior management.Stress testing for the trading portfolio is integrated with enterprise-wide stress testing and incorporated into the limits framework. The macroeconomic scenarios used for enterprise-wide stress testing purposes differ from the typical trading portfolio scenarios in that they have a longer time horizon and the results are forecasted over multiple periods for use in consolidated capital and liquidity planning. For more information, see Managing Risk on page 47.Interest Rate Risk Management for the Banking Book The following discussion presents net interest income for banking book activities. Interest rate risk represents the most significant market risk exposure to our banking book balance sheet. Interest rate risk is measured as the potential change in net interest income caused by movements in market interest rates. Client-facing activities, primarily lending and deposit-taking, create interest rate sensitive positions on our balance sheet.We prepare forward-looking forecasts of net interest income. The baseline forecast takes into consideration expected future business growth, ALM positioning -and the direction of interest rate movements as implied by the market-based forward curve. We then measure and evaluate the impact that alternative interest rate scenarios have on the baseline forecast in order to assess interest rate sensitivity under varied conditions. The net interest income forecast is frequently updated for changing assumptions and differing outlooks based on economic trends, market conditions and business strategies. Thus, we continually monitor our balance sheet position in order to maintain an acceptable level of exposure to interest rate changes.The interest rate scenarios that we analyze incorporate balance sheet assumptions such as loan and deposit growth and pricing, changes in funding mix, product repricing, maturity characteristics and investment securities premium amortization. Our overall goal is to manage interest rate risk so that movements in interest rates do not significantly adversely affect earnings and capital.Table 46 presents the spot and 12-month forward rates used in our baseline forecasts at December 31, 2020 and 2019.Table 46Forward RatesDecember 31, 2020 FederalFundsThree-monthLIBOR10-YearSwapSpot rates0.25 %0.24 %0.93 %12-month forward rates0.25 0.19 1.06 December 31, 2019Spot rates1.75 %1.91 %1.90 %12-month forward rates1.50 1.62 1.92 Table 47 shows the pretax impact to forecasted net interest income over the next 12 months from December 31, 2020 and 2019 resulting from instantaneous parallel and non-parallel shocks to the market-based forward curve. Periodically we evaluate the scenarios presented so that they are meaningful in the context of the current rate environment. The interest rate scenarios also assume U.S. dollar rates are floored at zero.During 2020, the asset sensitivity of our balance sheet increased in both up-rate and down-rate scenarios primarily due to continued deposit growth invested in long-term securities. We continue to be asset sensitive to a parallel upward move in interest rates with the majority of that impact coming from the short end of the yield curve. Additionally, higher interest rates impact the fair value of debt securities and, accordingly, for debt securities classified as AFS, may adversely affect accumulated OCI and thus capital levels under the Basel 3 capital rules. Under instantaneous upward parallel shifts, the near-term adverse impact to Basel 3 capital is reduced over time by offsetting positive impacts to net interest income. For more information on Basel 3, see Capital Management – Regulatory Capital on page 51.Table 47Estimated Banking Book Net Interest Income Sensitivity to Curve ChangesShort Rate (bps)Long Rate (bps)December 31(Dollars in millions)20202019Parallel Shifts+100 bps instantaneous shift+100+100$10,468 $4,190 -25 bps instantaneous shift-25 -25 (2,766)(1,500)Flatteners Short-end instantaneous change+100— 6,321 2,641 Long-end instantaneous change— -25 (1,686)(653)Steepeners Short-end instantaneous change-25 — (1,084)(844)Long-end instantaneous change— +1004,333 1,561 The sensitivity analysis in Table 47 assumes that we take no action in response to these rate shocks and does not assume any change in other macroeconomic variables normally correlated with changes in interest rates. As part of our ALM activities, we use securities, certain residential mortgages, and interest rate and foreign exchange derivatives in managing interest rate sensitivity.The behavior of our deposits portfolio in the baseline forecast and in alternate interest rate scenarios is a key assumption in our projected estimates of net interest income. The sensitivity analysis in Table 47 assumes no change in deposit portfolio size or mix from the baseline forecast in alternate rate environments. In higher rate scenarios, any customer activity resulting in the replacement of low-cost or non-interest-bearing deposits with higher yielding deposits or market-based funding would reduce our benefit in those scenarios.Interest Rate and Foreign Exchange Derivative ContractsInterest rate and foreign exchange derivative contracts are utilized in our ALM activities and serve as an efficient tool to manage our interest rate and foreign exchange risk. We use derivatives to hedge the variability in cash flows or changes in fair value on our balance sheet due to interest rate and foreign exchange components. For more information on our hedging Bank of America 82activities, see Note 3 – Derivatives to the Consolidated Financial Statements. Our interest rate contracts are generally non-leveraged generic interest rate and foreign exchange basis swaps, options, futures and forwards. In addition, we use foreign exchange contracts, including cross-currency interest rate swaps, foreign currency futures contracts, foreign currency forward contracts and options to mitigate the foreign exchange risk associated with foreign currency-denominated assets and liabilities.Changes to the composition of our derivatives portfolio during 2020 reflect actions taken for interest rate and foreign exchange rate risk management. The decisions to reposition our derivatives portfolio are based on the current assessment of economic and financial conditions including the interest rate and foreign currency environments, balance sheet composition and trends, and the relative mix of our cash and derivative positions. We use interest rate derivative instruments to hedge the variability in the cash flows of our assets and liabilities and other forecasted transactions (collectively referred to as cash flow hedges). The net results on both open and terminated cash flow hedge derivative instruments recorded in accumulated OCI were a gain of $580 million and a loss of $496 million, on a pretax basis, at December 31, 2020 and 2019. These gains and losses are expected to be reclassified into earnings in the same period as the hedged cash flows affect earnings and will decrease income or increase expense on the respective hedged cash flows. Assuming no change in open cash flow derivative hedge positions and no changes in prices or interest rates beyond what is implied in forward yield curves at December 31, 2020, the after-tax net gains are expected to be reclassified into earnings as follows: a gain of $187 million within the next year, a gain of $358 million in years two through five, a loss of $59 million in years six through ten, with the remaining loss of $50 million thereafter. For more information on derivatives designated as cash flow hedges, see Note 3 – Derivatives to the Consolidated Financial Statements. We hedge our net investment in non-U.S. operations determined to have functional currencies other than the U.S. dollar using forward foreign exchange contracts that typically settle in less than 180 days, cross-currency basis swaps and foreign exchange options. We recorded net after-tax losses on derivatives in accumulated OCI associated with net investment hedges which were offset by gains on our net investments in consolidated non-U.S. entities at December 31, 2020.Table 48 presents derivatives utilized in our ALM activities and shows the notional amount, fair value, weighted-average receive-fixed and pay-fixed rates, expected maturity and average estimated durations of our open ALM derivatives at December 31, 2020 and 2019. These amounts do not include derivative hedges on our MSRs. During 2020, the fair value of receive-fixed interest rate swaps increased while pay-fixed interest swaps decreased, primarily driven by lower swap rates on hedges of U.S. dollar long-term debt. Table 48Asset and Liability Management Interest Rate and Foreign Exchange ContractsDecember 31, 2020Expected Maturity(Dollars in millions, average estimated duration in years)FairValueTotal20212022202320242025ThereafterAverageEstimatedDurationReceive-fixed interest rate swaps (1)$14,885 8.08 Notional amount $269,015 $11,050 $20,908 $30,654 $31,317 $32,898 $142,188 Weighted-average fixed-rate1.54 %3.25 %0.91 %1.48 %1.17 %1.07 %1.69 %Pay-fixed interest rate swaps (1)(5,502) 6.52 Notional amount $252,698 $7,562 $21,667 $24,671 $24,406 $32,052 $142,340 Weighted-average fixed-rate0.89 %0.57 %0.10 %1.28 %0.86 %0.68 %1.00 %Same-currency basis swaps (2)(235) Notional amount $223,659 $18,769 $12,245 $9,747 $22,737 $28,222 $131,939 Foreign exchange basis swaps (1, 3, 4)(1,014) Notional amount 112,465 27,424 16,038 8,066 3,819 4,446 52,672 Foreign exchange contracts (1, 4, 5)349 Notional amount (6)(42,490)(69,299)2,841 2,505 4,735 4,369 12,359 Futures and forward rate contracts47 Notional amount14,255 14,255 — — — — — Option products— Notional amount 17 — — 17 — — — Net ALM contracts$8,530 83 Bank of AmericaTable 48Asset and Liability Management Interest Rate and Foreign Exchange Contracts (continued) December 31, 2019 Expected Maturity(Dollars in millions, average estimated duration in years)FairValueTotal20202021202220232024ThereafterAverageEstimatedDurationReceive-fixed interest rate swaps (1)$12,370 6.47 Notional amount $215,123 $16,347 $14,642 $21,616 $36,356 $21,257 $104,905 Weighted-average fixed-rate2.68 %2.68 %3.17 %2.48 %2.36 %2.55 %2.79 %Pay-fixed interest rate swaps (1)(2,669) 6.99 Notional amount $69,586 $4,344 $2,117 $— $13,993 $8,194 $40,938 Weighted-average fixed-rate2.36 %2.16 %2.15 %— %2.52 %2.26 %2.35 %Same-currency basis swaps (2)(290) Notional amount $152,160 $18,857 $18,590 $4,306 $2,017 $14,567 $93,823 Foreign exchange basis swaps (1, 3, 4)(1,258) Notional amount 113,529 23,639 24,215 14,611 7,111 3,521 40,432 Foreign exchange contracts (1, 4, 5)414 Notional amount (6)(53,106)(79,315)4,539 2,674 2,340 4,432 12,224 Option products — Notional amount 15 — — — 15 — — Net ALM contracts$8,567 (1)Does not include basis adjustments on either fixed-rate debt issued by the Corporation or AFS debt securities, which are hedged using derivatives designated as fair value hedging instruments, that substantially offset the fair values of these derivatives.(2)At December 31, 2020 and 2019, the notional amount of same-currency basis swaps included $223.7 billion and $152.2 billion in both foreign currency and U.S. dollar-denominated basis swaps in which both sides of the swap are in the same currency.(3)Foreign exchange basis swaps consisted of cross-currency variable interest rate swaps used separately or in conjunction with receive-fixed interest rate swaps.(4)Does not include foreign currency translation adjustments on certain non-U.S. debt issued by the Corporation that substantially offset the fair values of these derivatives.(5)The notional amount of foreign exchange contracts of $(42.5) billion at December 31, 2020 was comprised of $34.2 billion in foreign currency-denominated and cross-currency receive-fixed swaps, $(74.3) billion in net foreign currency forward rate contracts, $(3.1) billion in foreign currency-denominated interest rate swaps and $711 million in net foreign currency futures contracts. Foreign exchange contracts of $(53.1) billion at December 31, 2019 were comprised of $29.0 billion in foreign currency-denominated and cross-currency receive-fixed swaps, $(82.4) billion in net foreign currency forward rate contracts, $(313) million in foreign currency-denominated interest rate swaps and $644 million in foreign currency futures contracts.(6)Reflects the net of long and short positions. Amounts shown as negative reflect a net short position.Mortgage Banking Risk ManagementWe originate, fund and service mortgage loans, which subject us to credit, liquidity and interest rate risks, among others. We determine whether loans will be held for investment or held for sale at the time of commitment and manage credit and liquidity risks by selling or securitizing a portion of the loans we originate.Interest rate risk and market risk can be substantial in the mortgage business. Changes in interest rates and other market factors impact the volume of mortgage originations. Changes in interest rates also impact the value of interest rate lock commitments (IRLCs) and the related residential first mortgage loans held-for-sale (LHFS) between the date of the IRLC and the date the loans are sold to the secondary market. An increase in mortgage interest rates typically leads to a decrease in the value of these instruments. Conversely, when there is an increase in interest rates, the value of the MSRs will increase driven by lower prepayment expectations. Because the interest rate risks of these hedged items offset, we combine them into one overall hedged item with one combined economic hedge portfolio consisting of derivative contracts and securities.During 2020, 2019 and 2018, we recorded gains of $321 million, $291 million and $244 million related to the change in fair value of the MSRs, IRLCs and LHFS, net of gains and losses on the hedge portfolio. For more information on MSRs, see Note 20 – Fair Value Measurements to the Consolidated Financial Statements.Compliance and Operational Risk ManagementCompliance risk is the risk of legal or regulatory sanctions, material financial loss or damage to the reputation of the Corporation arising from the failure of the Corporation to comply with the requirements of applicable laws, rules, regulations and our internal policies and procedures (collectively, applicable laws, rules and regulations).Operational risk is the risk of loss resulting from inadequate or failed processes, people and systems or from external events. Operational risk may occur anywhere in the Corporation, including third-party business processes, and is not limited to operations functions. Effects may extend beyond financial losses and may result in reputational risk impacts. Operational risk includes legal risk. Additionally, operational risk is a component in the calculation of total RWA used in the Basel 3 capital calculation. For more information on Basel 3 calculations, see Capital Management on page 50. FLUs and control functions are first and foremost responsible for managing all aspects of their businesses, including their compliance and operational risk. FLUs and control functions are required to understand their business processes and related risks and controls, including third-party dependencies, the related regulatory requirements, and monitor and report on the effectiveness of the control environment. In order to actively monitor and assess the performance of their processes and controls, they must conduct comprehensive quality assurance activities and identify issues and risks to remediate control gaps and weaknesses. FLUs and control functions must also adhere to compliance and operational risk appetite limits to meet strategic, capital and financial planning objectives. Finally, FLUs and control functions are responsible for the proactive identification, management and escalation of compliance and operational risks across the Corporation.Global Compliance and Operational Risk teams independently assess compliance and operational risk, monitor business activities and processes and evaluate FLUs and control functions for adherence to applicable laws, rules and regulations, including identifying issues and risks, determining and developing tests to be conducted by the Enterprise Independent Testing unit, and reporting on the state of the control environment. Enterprise Independent Testing, an independent testing function within IRM, works with Global Compliance and Operational Risk, the FLUs and control functions in the identification of testing needs and test design, and is accountable for test execution, reporting and analysis of results.Bank of America 84Corporate Audit provides independent assessment and validation through testing of key compliance and operational risk processes and controls across the Corporation.The Corporation's Global Compliance Enterprise Policy and Operational Risk Management - Enterprise Policy set the requirements for reporting compliance and operational risk information to executive management as well as the Board or appropriate Board-level committees in support of Global Compliance and Operational Risk’s responsibilities for conducting independent oversight of our compliance and operational risk management activities. The Board provides oversight of compliance risk through its Audit Committee and the ERC, and operational risk through the ERC.A key operational risk facing the Corporation is information security, which includes cybersecurity. Cybersecurity risk represents, among other things, exposure to failures or interruptions of service or breaches of security, including as a result of malicious technological attacks, that impact the confidentiality, availability or integrity of our, or third parties' (including their downstream service providers, the financial services industry and financial data aggregators) operations, systems or data, including sensitive corporate and customer information. The Corporation manages information security risk in accordance with internal policies which govern our comprehensive information security program designed to protect the Corporation by enabling preventative, detective and responsive measures to combat information and cybersecurity risks. The Board and the ERC provide cybersecurity and information security risk oversight for the Corporation, and our Global Information Security Team manages the day-to-day implementation of our information security program.Reputational Risk ManagementReputational risk is the risk that negative perceptions of the Corporation’s conduct or business practices may adversely impact its profitability or operations. Reputational risk may result from many of the Corporation’s activities, including those related to the management of our strategic, operational, compliance and credit risks.The Corporation manages reputational risk through established policies and controls in its businesses and risk management processes to mitigate reputational risks in a timely manner and through proactive monitoring and identification of potential reputational risk events. If reputational risk events occur, we focus on remediating the underlying issue and taking action to minimize damage to the Corporation’s reputation. The Corporation has processes and procedures in place to respond to events that give rise to reputational risk, including educating individuals and organizations that influence public opinion, implementing external communication strategies to mitigate the risk, and informing key stakeholders of potential reputational risks. The Corporation’s organization and governance structure provides oversight of reputational risks, and reputational risk reporting is provided regularly and directly to management and the ERC, which provides primary oversight of reputational risk. In addition, each FLU has a committee, which includes representatives from Compliance, Legal and Risk, that is responsible for the oversight of reputational risk. Such committees’ oversight includes providing approval for business activities that present elevated levels of reputational risks.Climate Risk ManagementClimate-related risks are divided into two major categories: (1) risks related to the transition to a low-carbon economy, which may entail extensive policy, legal, technology and market changes, and (2) risks related to the physical impacts of climate change, driven by extreme weather events, such as hurricanes and floods, as well as chronic longer-term shifts, such as temperature increases and sea level rises. These changes and events can have broad impacts on operations, supply chains, distribution networks, customers, and markets and are otherwise referred to, respectively, as transition risk and physical risk. The financial impacts of transition risk can lead to and amplify credit risk. Physical risk can also lead to increased credit risk by diminishing borrowers’ repayment capacity or collateral values. As climate risk is interconnected with all key risk types, we have developed and continue to enhance processes to embed climate risk considerations into our Risk Framework and risk management programs established for strategic, credit, market, liquidity, compliance, operational and reputational risks. A key element of how we manage climate risk is the Risk Identification process through which climate and other risks are identified across all FLUs and control functions, prioritized in our risk inventory and evaluated to determine estimated severity and likelihood of occurrence. Once identified, climate risks are assessed for potential impacts and incorporated into the design of macroeconomic scenarios to generate loss forecasts and assess how climate-related impacts could affect us and our clients.Our governance framework establishes oversight of climate risk practices and strategies by the Board, supported by its Corporate Governance, ESG, and Sustainability Committee, the ERC and the Global Environmental, Social and Governance Committee, a management-level committee comprised of senior leaders across every major FLU and control function. The Climate Risk Steering Council oversees our climate risk management practices, shapes our approach to managing climate-related risks in line with our Risk Framework and meets monthly. In 2020, the climate risk management effort was bolstered through the appointment of a Global Climate Risk Executive who reports to the CRO, and establishment of a new division within our Global Risk organization to drive execution of the climate risk management program with the support of FLUs, Technology & Operations and Risk partners. For additional information about climate risk, see the Bank of America website (the content of which is not incorporated by reference into this Annual Report on Form 10-K).Complex Accounting EstimatesOur significant accounting principles, as described in Note 1 – Summary of Significant Accounting Principles to the Consolidated Financial Statements, are essential in understanding the MD&A. Many of our significant accounting principles require complex judgments to estimate the values of assets and liabilities. We have procedures and processes in place to facilitate making these judgments. The more judgmental estimates are summarized in the following discussion. We have identified and described the development of the variables most important in the estimation processes that involve mathematical models to derive the estimates. In many cases, there are numerous alternative judgments that could be used in the process of determining the inputs to the models. Where alternatives exist, we have used the factors that we believe represent the most reasonable value in developing the inputs. Actual performance that differs from our estimates of the key variables could materially impact our results of operations. Separate from the possible future impact to our results of operations from input and model variables, the value of our lending portfolio and market-sensitive assets and 85 Bank of Americaliabilities may change subsequent to the balance sheet date, often significantly, due to the nature and magnitude of future credit and market conditions. Such credit and market conditions may change quickly and in unforeseen ways and the resulting volatility could have a significant, negative effect on future operating results. These fluctuations would not be indicative of deficiencies in our models or inputs.Allowance for Credit LossesOn January 1, 2020, the Corporation adopted the new accounting standard that requires the measurement of the allowance for credit losses, which includes the allowance for loan and lease losses and the reserve for unfunded lending commitments, to be based on management’s best estimate of lifetime ECL inherent in the Corporation's relevant financial assets.The Corporation's estimate of lifetime ECL includes the use of quantitative models that incorporate forward-looking macroeconomic scenarios that are applied over the contractual life of the loan portfolios, adjusted for expected prepayments and borrower-controlled extension options. These macroeconomic scenarios include variables that have historically been key drivers of increases and decreases in credit losses. These variables include, but are not limited to, unemployment rates, real estate prices, gross domestic product and corporate bond spreads. As any one economic outlook is inherently uncertain, the Corporation leverages multiple scenarios. The scenarios that are chosen each quarter and the amount of weighting given to each scenario depend on a variety of factors including recent economic events, leading economic indicators, views of internal and third-party economists and industry trends.The Corporation also includes qualitative reserves to cover losses that are expected but, in the Corporation's assessment, may not be adequately reflected in the economic assumptions described above. For example, factors the Corporation considers include changes in lending policies and procedures, business conditions, the nature and size of the portfolio, portfolio concentrations, the volume and severity of past due loans and nonaccrual loans, the effect of external factors such as competition and legal and regulatory requirements, among others. Further, the Corporation considers the inherent uncertainty in quantitative models that are built on historical data.The allowance for credit losses can also be impacted by unanticipated changes in asset quality of the portfolio, such as increases in risk rating downgrades in our commercial portfolio, deterioration in borrower delinquencies or credit scores in our credit card portfolio or increases in LTVs in our consumer real estate portfolio. In addition, while we have incorporated our estimated impact of COVID-19 into our allowance for credit losses, the ultimate impact of the pandemic is still unknown, including how long economic activities will be impacted and what effect the unprecedented levels of government fiscal and monetary actions will have on the economy and our credit losses. As described above, the process to determine the allowance for credit losses requires numerous estimates and assumptions, some of which require a high degree of judgment and are often interrelated. Changes in the estimates and assumptions can result in significant changes in the allowance for credit losses. Our process for determining the allowance for credit losses is further discussed in Note 1 – Summary of Significant Accounting Principles and Note 5 – Outstanding Loans and Leases and Allowance for Credit Losses to the Consolidated Financial Statements.Fair Value of Financial InstrumentsUnder applicable accounting standards, we are required to maximize the use of observable inputs and minimize the use of unobservable inputs in measuring fair value. We classify fair value measurements of financial instruments and MSRs based on the three-level fair value hierarchy in the accounting standards. The fair values of assets and liabilities may include adjustments, such as market liquidity and credit quality, where appropriate. Valuations of products using models or other techniques are sensitive to assumptions used for the significant inputs. Where market data is available, the inputs used for valuation reflect that information as of our valuation date. Inputs to valuation models are considered unobservable if they are supported by little or no market activity. In periods of extreme volatility, lessened liquidity or in illiquid markets, there may be more variability in market pricing or a lack of market data to use in the valuation process. In keeping with the prudent application of estimates and management judgment in determining the fair value of assets and liabilities, we have in place various processes and controls that include: a model validation policy that requires review and approval of quantitative models used for deal pricing, financial statement fair value determination and risk quantification; a trading product valuation policy that requires verification of all traded product valuations; and a periodic review and substantiation of daily profit and loss reporting for all traded products. Primarily through validation controls, we utilize both broker and pricing service inputs which can and do include both market-observable and internally-modeled values and/or valuation inputs. Our reliance on this information is affected by our understanding of how the broker and/or pricing service develops its data with a higher degree of reliance applied to those that are more directly observable and lesser reliance applied to those developed through their own internal modeling. For example, broker quotes in less active markets may only be indicative and therefore less reliable. These processes and controls are performed independently of the business. For more information, see Note 20 – Fair Value Measurements and Note 21 – Fair Value Option to the Consolidated Financial Statements. Level 3 Assets and LiabilitiesFinancial assets and liabilities, and MSRs, where values are based on valuation techniques that require inputs that are both unobservable and are significant to the overall fair value measurement are classified as Level 3 under the fair value hierarchy established in applicable accounting standards. The fair value of these Level 3 financial assets and liabilities and MSRs is determined using pricing models, discounted cash flow methodologies or similar techniques for which the determination of fair value requires significant management judgment or estimation. Level 3 financial instruments may be hedged with derivatives classified as Level 1 or 2; therefore, gains or losses associated with Level 3 financial instruments may be offset by gains or losses associated with financial instruments classified in other levels of the fair value hierarchy. The Level 3 gains and losses recorded in earnings did not have a significant impact on our liquidity or capital. We conduct a review of our fair value hierarchy classifications on a quarterly basis. Transfers into or out of Level 3 are made if the significant inputs used in the financial models measuring the fair values of the assets and Bank of America 86liabilities became unobservable or observable, respectively, in the current marketplace. For more information on transfers into and out of Level 3 during 2020, 2019 and 2018, see Note 20 – Fair Value Measurements to the Consolidated Financial Statements.Accrued Income Taxes and Deferred Tax AssetsAccrued income taxes, reported as a component of either other assets or accrued expenses and other liabilities on the Consolidated Balance Sheet, represent the net amount of current income taxes we expect to pay to or receive from various taxing jurisdictions attributable to our operations to date. We currently file income tax returns in more than 100 jurisdictions and consider many factors, including statutory, judicial and regulatory guidance, in estimating the appropriate accrued income taxes for each jurisdiction.Net deferred tax assets, reported as a component of other assets on the Consolidated Balance Sheet, represent the net decrease in taxes expected to be paid in the future because of net operating loss (NOL) and tax credit carryforwards and because of future reversals of temporary differences in the bases of assets and liabilities as measured by tax laws and their bases as reported in the financial statements. NOL and tax credit carryforwards result in reductions to future tax liabilities, and many of these attributes can expire if not utilized within certain periods. We consider the need for valuation allowances to reduce net deferred tax assets to the amounts that we estimate are more likely than not to be realized.Consistent with the applicable accounting guidance, we monitor relevant tax authorities and change our estimates of accrued income taxes and/or net deferred tax assets due to changes in income tax laws and their interpretation by the courts and regulatory authorities. These revisions of our estimates, which also may result from our income tax planning and from the resolution of income tax audit matters, may be material to our operating results for any given period.See Note 19 – Income Taxes to the Consolidated Financial Statements for a table of significant tax attributes and additional information. For more information, see page 16 under Part I. Item 1A. Risk Factors – Regulatory, Compliance and Legal.Goodwill and Intangible AssetsThe nature of and accounting for goodwill and intangible assets are discussed in Note 1 – Summary of Significant Accounting Principles, and Note 7 – Goodwill and Intangible Assets to the Consolidated Financial Statements. We completed our annual goodwill impairment test as of June 30, 2020. In performing that test, we compared the fair value of each reporting unit to its estimated carrying value as measured by allocated equity. We estimated the fair value of each reporting unit based on the income approach (which utilizes the present value of cash flows to estimate fair value) and the market multiplier approach (which utilizes observable market prices and metrics of peer companies to estimate fair value). Our discounted cash flows were generally based on the Corporation’s three-year internal forecasts with a long-term growth rate of 3.68 percent. Our estimated cash flows considered the current challenging global industry and market conditions related to the pandemic, including the low interest rate environment. The cash flows were discounted using rates that ranged from 9 percent to 12 percent, which were derived from a capital asset pricing model that incorporates the risk and uncertainty in the cash flow forecasts, the financial markets and industries similar to each of the reporting units.Under the market multiplier approach, we estimated the fair value of the individual reporting units utilizing various market multiples, primarily various pricing multiples, from comparable publicly-traded companies in industries similar to the reporting unit and then factored in a control premium based upon observed comparable premiums paid for change-in-control transactions for financial institutions.Based on the results of the test, we determined that each reporting unit’s estimated fair value exceeded its respective carrying value and that the goodwill assigned to each reporting unit was not impaired. The fair values of the reporting units as a percentage of their carrying values ranged from 109 percent to 213 percent. It currently remains difficult to estimate the future economic impacts related to the pandemic. If economic and market conditions (both in the U.S. and internationally) deteriorate, our reporting units could be negatively impacted, which could change our key assumptions and related estimates and may result in a future impairment charge.Certain Contingent Liabilities For more information on the complex judgments associated with certain contingent liabilities, see Note 12 – Commitments and Contingencies to the Consolidated Financial Statements.87 Bank of AmericaNon-GAAP ReconciliationsTables 49 and 50 provide reconciliations of certain non-GAAP financial measures to GAAP financial measures.Table 49Five-year Reconciliations to GAAP Financial Measures (1)(Dollars in millions, shares in thousands)20202019201820172016Reconciliation of average shareholders’ equity to average tangible shareholders’ equity and average tangible common shareholders’ equity Shareholders’ equity$267,309 $267,889 $264,748 $271,289 $265,843 Goodwill(68,951)(68,951)(68,951)(69,286)(69,750)Intangible assets (excluding MSRs)(1,862)(1,721)(2,058)(2,652)(3,382)Related deferred tax liabilities821 773 906 1,463 1,644 Tangible shareholders’ equity$197,317 $197,990 $194,645 $200,814 $194,355 Preferred stock(23,624)(23,036)(22,949)(24,188)(24,656)Tangible common shareholders’ equity$173,693 $174,954 $171,696 $176,626 $169,699 Reconciliation of year-end shareholders’ equity to year-end tangible shareholders’ equity and year-end tangible common shareholders’ equity Shareholders’ equity$272,924 $264,810 $265,325 $267,146 $266,195 Goodwill(68,951)(68,951)(68,951)(68,951)(69,744)Intangible assets (excluding MSRs)(2,151)(1,661)(1,774)(2,312)(2,989)Related deferred tax liabilities920 713 858 943 1,545 Tangible shareholders’ equity$202,742 $194,911 $195,458 $196,826 $195,007 Preferred stock(24,510)(23,401)(22,326)(22,323)(25,220)Tangible common shareholders’ equity$178,232 $171,510 $173,132 $174,503 $169,787 Reconciliation of year-end assets to year-end tangible assets Assets$2,819,627 $2,434,079 $2,354,507 $2,281,234 $2,188,067 Goodwill(68,951)(68,951)(68,951)(68,951)(69,744)Intangible assets (excluding MSRs)(2,151)(1,661)(1,774)(2,312)(2,989)Related deferred tax liabilities920 713 858 943 1,545 Tangible assets$2,749,445 $2,364,180 $2,284,640 $2,210,914 $2,116,879 (1)Presents reconciliations of non-GAAP financial measures to GAAP financial measures. For more information on non-GAAP financial measures and ratios we use in assessing the results of the Corporation, see Supplemental Financial Data on page 31.Table 50Quarterly Reconciliations to GAAP Financial Measures (1)2020 Quarters2019 Quarters(Dollars in millions)FourthThirdSecondFirstFourthThirdSecondFirstReconciliation of average shareholders’ equity to average tangible shareholders’ equity and average tangible common shareholders’ equity Shareholders’ equity$271,020 $267,323 $266,316 $264,534 $266,900 $270,430 $267,975 $266,217 Goodwill(68,951)(68,951)(68,951)(68,951)(68,951)(68,951)(68,951)(68,951)Intangible assets (excluding MSRs)(2,173)(1,976)(1,640)(1,655)(1,678)(1,707)(1,736)(1,763)Related deferred tax liabilities910 855 790 728 730 752 770 841 Tangible shareholders’ equity$200,806 $197,251 $196,515 $194,656 $197,001 $200,524 $198,058 $196,344 Preferred stock(24,180)(23,427)(23,427)(23,456)(23,461)(23,800)(22,537)(22,326)Tangible common shareholders’ equity$176,626 $173,824 $173,088 $171,200 $173,540 $176,724 $175,521 $174,018 Reconciliation of period-end shareholders’ equity to period-end tangible shareholders’ equity and period-end tangible common shareholders’ equity Shareholders’ equity$272,924 $268,850 $265,637 $264,918 $264,810 $268,387 $271,408 $267,010 Goodwill(68,951)(68,951)(68,951)(68,951)(68,951)(68,951)(68,951)(68,951)Intangible assets (excluding MSRs)(2,151)(2,185)(1,630)(1,646)(1,661)(1,690)(1,718)(1,747)Related deferred tax liabilities920 910 789 790 713 734 756 773 Tangible shareholders’ equity$202,742 $198,624 $195,845 $195,111 $194,911 $198,480 $201,495 $197,085 Preferred stock(24,510)(23,427)(23,427)(23,427)(23,401)(23,606)(24,689)(22,326)Tangible common shareholders’ equity$178,232 $175,197 $172,418 $171,684 $171,510 $174,874 $176,806 $174,759 Reconciliation of period-end assets to period-end tangible assets Assets$2,819,627 $2,738,452 $2,741,688 $2,619,954 $2,434,079 $2,426,330 $2,395,892 $2,377,164 Goodwill(68,951)(68,951)(68,951)(68,951)(68,951)(68,951)(68,951)(68,951)Intangible assets (excluding MSRs)(2,151)(2,185)(1,630)(1,646)(1,661)(1,690)(1,718)(1,747)Related deferred tax liabilities920 910 789 790 713 734 756 773 Tangible assets$2,749,445 $2,668,226 $2,671,896 $2,550,147 $2,364,180 $2,356,423 $2,325,979 $2,307,239 (1)Presents reconciliations of non-GAAP financial measures to GAAP financial measures. For more information on non-GAAP financial measures and ratios we use in assessing the results of the Corporation, see Supplemental Financial Data on page 31.Bank of America 88Statistical TablesTable of ContentsPageTable I – Outstanding Loans and Leases89Table II – Nonperforming Loans, Leases and Foreclosed Properties90Table III – Accruing Loans and Leases Past Due 90 Days or More90Table IV – Selected Loan Maturity Data91Table V – Allowance for Credit Losses91Table VI – Allocation of the Allowance for Credit Losses by Product Type92Table IOutstanding Loans and Leases December 31(Dollars in millions)20202019201820172016Consumer Residential mortgage$223,555 $236,169 $208,557 $203,811 $191,797 Home equity34,311 40,208 48,286 57,744 66,443 Credit card78,708 97,608 98,338 96,285 92,278 Non-U.S. credit card— — — — 9,214 Direct/Indirect consumer (1)91,363 90,998 91,166 96,342 95,962 Other consumer (2)124 192 202 166 626 Total consumer loans excluding loans accounted for under the fair value option428,061 465,175 446,549 454,348 456,320 Consumer loans accounted for under the fair value option (3)735 594 682 928 1,051 Total consumer428,796 465,769 447,231 455,276 457,371 CommercialU.S. commercial288,728 307,048 299,277 284,836 270,372 Non-U.S. commercial90,460 104,966 98,776 97,792 89,397 Commercial real estate (4)60,364 62,689 60,845 58,298 57,355 Commercial lease financing17,098 19,880 22,534 22,116 22,375 456,650 494,583 481,432 463,042 439,499 U.S. small business commercial (5)36,469 15,333 14,565 13,649 12,993 Total commercial loans excluding loans accounted for under the fair value option493,119 509,916 495,997 476,691 452,492 Commercial loans accounted for under the fair value option (3)5,946 7,741 3,667 4,782 6,034 Total commercial499,065 517,657 499,664 481,473 458,526 Less: Loans of business held for sale (6)— — — — (9,214)Total loans and leases$927,861 $983,426 $946,895 $936,749 $906,683 (1)Includes primarily auto and specialty lending loans and leases of $46.4 billion, $50.4 billion, $50.1 billion, $52.4 billion and $50.7 billion, U.S. securities-based lending loans of $41.1 billion, $36.7 billion, $37.0 billion, $39.8 billion and $40.1 billion and non-U.S. consumer loans of $3.0 billion, $2.8 billion, $2.9 billion, $3.0 billion and $3.0 billion at December 31, 2020, 2019, 2018, 2017 and 2016, respectively.(2)Substantially all of other consumer at December 31, 2020, 2019, 2018 and 2017 is consumer overdrafts. Other consumer at December 31, 2016 also includes consumer finance loans of $465 million.(3)Consumer loans accounted for under the fair value option include residential mortgage loans of $298 million, $257 million, $336 million, $567 million and $710 million, and home equity loans of $437 million, $337 million, $346 million, $361 million and $341 million at December 31, 2020, 2019, 2018, 2017 and 2016, respectively. Commercial loans accounted for under the fair value option include U.S. commercial loans of $2.9 billion, $4.7 billion, $2.5 billion, $2.6 billion and $2.9 billion, and non-U.S. commercial loans of $3.0 billion, $3.1 billion, $1.1 billion, $2.2 billion and $3.1 billion at December 31, 2020, 2019, 2018, 2017 and 2016, respectively. (4)Includes U.S. commercial real estate loans of $57.2 billion, $59.0 billion, $56.6 billion, $54.8 billion and $54.3 billion, and non-U.S. commercial real estate loans of $3.2 billion, $3.7 billion, $4.2 billion, $3.5 billion and $3.1 billion at December 31, 2020, 2019, 2018, 2017 and 2016, respectively.(5)Includes card-related products.(6)Represents non-U.S. credit card loans, which were included in assets of business held for sale on the Consolidated Balance Sheet.89 Bank of AmericaTable IINonperforming Loans, Leases and Foreclosed Properties (1) December 31(Dollars in millions)20202019201820172016Consumer Residential mortgage$2,005 $1,470 $1,893 $2,476 $3,056 Home equity649 536 1,893 2,644 2,918 Direct/Indirect consumer71 47 56 46 28 Other consumer— — — — 2 Total consumer (2)2,725 2,053 3,842 5,166 6,004 Commercial U.S. commercial1,243 1,094 794 814 1,256 Non-U.S. commercial418 43 80 299 279 Commercial real estate404 280 156 112 72 Commercial lease financing87 32 18 24 36 2,152 1,449 1,048 1,249 1,643 U.S. small business commercial75 50 54 55 60 Total commercial (3)2,227 1,499 1,102 1,304 1,703 Total nonperforming loans and leases4,952 3,552 4,944 6,470 7,707 Foreclosed properties164 285 300 288 377 Total nonperforming loans, leases and foreclosed properties$5,116 $3,837 $5,244 $6,758 $8,084 (1)Balances exclude foreclosed properties insured by certain government-guaranteed loans, principally FHA-insured loans, that entered foreclosure of $119 million, $260 million, $488 million, $801 million and $1.2 billion at December 31, 2020, 2019, 2018, 2017 and 2016, respectively.(2)In 2020, $372 million in interest income was estimated to be contractually due on $2.7 billion of consumer loans and leases classified as nonperforming at December 31, 2020, as presented in the table above, plus $4.4 billion of TDRs classified as performing at December 31, 2020. Approximately $254 million of the estimated $372 million in contractual interest was received and included in interest income for 2020. (3)In 2020, $115 million in interest income was estimated to be contractually due on $2.2 billion of commercial loans and leases classified as nonperforming at December 31, 2020, as presented in the table above, plus $1.0 billion of TDRs classified as performing at December 31, 2020. Approximately $71 million of the estimated $115 million in contractual interest was received and included in interest income for 2020.Table III Accruing Loans and Leases Past Due 90 Days or More (1) December 31(Dollars in millions)20202019201820172016Consumer Residential mortgage (2)$762 $1,088 $1,884 $3,230 $4,793 Credit card903 1,042 994 900 782 Non-U.S. credit card— — — — 66 Direct/Indirect consumer33 33 38 40 34 Other consumer— — — — 4 Total consumer1,698 2,163 2,916 4,170 5,679 Commercial U.S. commercial 228 106 197 144 106 Non-U.S. commercial10 8 — 3 5 Commercial real estate6 19 4 4 7 Commercial lease financing25 20 29 19 19 269 153 230 170 137 U.S. small business commercial115 97 84 75 71 Total commercial384 250 314 245 208 Total accruing loans and leases past due 90 days or more$2,082 $2,413 $3,230 $4,415 $5,887 (1)Our policy is to classify consumer real estate-secured loans as nonperforming at 90 days past due, except for the fully-insured loan portfolio and loans accounted for under the fair value option.(2)Balances are fully-insured loans.Bank of America 90Table IVSelected Loan Maturity Data (1, 2) December 31, 2020(Dollars in millions)Due in OneYear or LessDue After One Year Through Five YearsDue AfterFive YearsTotalU.S. commercial$82,577 $198,898 $46,642 $328,117 U.S. commercial real estate14,073 37,552 5,552 57,177 Non-U.S. and other (3)33,196 54,488 8,989 96,673 Total selected loans$129,846 $290,938 $61,183 $481,967 Percent of total27 %60 %13 %100 %Sensitivity of selected loans to changes in interest rates for loans due after one year: Fixed interest rates $46,911 $32,280 Floating or adjustable interest rates 244,027 28,903 Total $290,938 $61,183 (1)Loan maturities are based on the remaining maturities under contractual terms.(2)Includes loans accounted for under the fair value option.(3)Loan maturities include non-U.S. commercial and commercial real estate loans.Table VAllowance for Credit Losses (1)(Dollars in millions)20202019201820172016Allowance for loan and lease losses, January 1$12,358 $9,601 $10,393 $11,237 $12,234 Loans and leases charged off Residential mortgage(40)(93)(207)(188)(403)Home equity(58)(429)(483)(582)(752)Credit card(2,967)(3,535)(3,345)(2,968)(2,691)Non-U.S. credit card (2)— — — (103)(238)Direct/Indirect consumer(372)(518)(495)(491)(392)Other consumer(307)(249)(197)(212)(232)Total consumer charge-offs(3,744)(4,824)(4,727)(4,544)(4,708)U.S. commercial (3)(1,163)(650)(575)(589)(567)Non-U.S. commercial(168)(115)(82)(446)(133)Commercial real estate(275)(31)(10)(24)(10)Commercial lease financing(69)(26)(8)(16)(30)Total commercial charge-offs(1,675)(822)(675)(1,075)(740)Total loans and leases charged off(5,419)(5,646)(5,402)(5,619)(5,448)Recoveries of loans and leases previously charged off Residential mortgage70 140 179 288 272 Home equity131 787 485 369 347 Credit card618 587 508 455 422 Non-U.S. credit card (2)— — — 28 63 Direct/Indirect consumer250 309 300 277 258 Other consumer23 15 15 49 27 Total consumer recoveries1,092 1,838 1,487 1,466 1,389 U.S. commercial (4)178 122 120 142 175 Non-U.S. commercial13 31 14 6 13 Commercial real estate5 2 9 15 41 Commercial lease financing10 5 9 11 9 Total commercial recoveries206 160 152 174 238 Total recoveries of loans and leases previously charged off1,298 1,998 1,639 1,640 1,627 Net charge-offs(4,121)(3,648)(3,763)(3,979)(3,821)Provision for loan and lease losses10,565 3,574 3,262 3,381 3,581 Other (5)— (111)(291)(246)(514)Total allowance for loan and lease losses, December 31 18,802 9,416 9,601 10,393 11,480 Less: Allowance included in assets of business held for sale (6)— — — — (243)Allowance for loan and lease losses, December 3118,802 9,416 9,601 10,393 11,237 Reserve for unfunded lending commitments, January 11,123 797 777 762 646 Provision for unfunded lending commitments755 16 20 15 16 Other (5)— — — — 100 Reserve for unfunded lending commitments, December 311,878 813 797 777 762 Allowance for credit losses, December 31$20,680 $10,229 $10,398 $11,170 $11,999 (1)On January 1, 2020, the Corporation adopted the CECL accounting standard, which increased the allowance for loan and lease losses by $2.9 billion and the reserve for unfunded lending commitments by $310 million. For more information, see Note 1 – Summary of Significant Accounting Principles to the Consolidated Financial Statements.(2)Represents amounts related to the non-U.S. credit card loan portfolio, which was sold in 2017.(3)Includes U.S. small business commercial charge-offs of $321 million, $320 million, $287 million, $258 million and $253 million in 2020, 2019, 2018, 2017 and 2016, respectively.(4)Includes U.S. small business commercial recoveries of $54 million, $48 million, $47 million, $43 million and $45 million in 2020, 2019, 2018, 2017 and 2016, respectively.(5)Primarily represents write-offs of purchased credit-impaired loans for years prior to 2020, the net impact of portfolio sales, consolidations and deconsolidations, foreign currency translation adjustments, transfers to held for sale and certain other reclassifications.(6)Represents allowance related to the non-U.S. credit card loan portfolio, which was sold in 2017.91 Bank of AmericaTable VAllowance for Credit Losses (continued)(Dollars in millions)20202019201820172016Loan and allowance ratios (7):Loans and leases outstanding at December 31 (8)$921,180 $975,091 $942,546 $931,039 $908,812 Allowance for loan and lease losses as a percentage of total loans and leases outstanding at December 31 (8)2.04 %0.97 %1.02 %1.12 %1.26 %Consumer allowance for loan and lease losses as a percentage of total consumer loans and leases outstanding at December 31 (9)2.35 0.98 1.08 1.18 1.36 Commercial allowance for loan and lease losses as a percentage of total commercial loans and leases outstanding at December 31 (10)1.77 0.96 0.97 1.05 1.16 Average loans and leases outstanding (8)$974,281 $951,583 $927,531 $911,988 $892,255 Net charge-offs as a percentage of average loans and leases outstanding (8)0.42 %0.38 %0.41 %0.44 %0.43 %Allowance for loan and lease losses as a percentage of total nonperforming loans and leases at December 31380 265 194 161 149 Ratio of the allowance for loan and lease losses at December 31 to net charge-offs 4.56 2.58 2.55 2.61 3.00 Amounts included in allowance for loan and lease losses for loans and leases that are excluded from nonperforming loans and leases at December 31 (11)$9,854 $4,151 $4,031 $3,971 $3,951 Allowance for loan and lease losses as a percentage of total nonperforming loans and leases, excluding the allowance for loan and lease losses for loans and leases that are excluded from nonperforming loans and leases at December 31 (11)181 %148 %113 %99 %98 %(7)Loan and allowance ratios for 2016 include $243 million of non-U.S. credit card allowance for loan and lease losses and $9.2 billion of ending non-U.S. credit card loans, which were sold in 2017.(8)Outstanding loan and lease balances and ratios do not include loans accounted for under the fair value option of $6.7 billion, $8.3 billion, $4.3 billion, $5.7 billion and $7.1 billion at December 31, 2020, 2019, 2018, 2017 and 2016, respectively. Average loans accounted for under the fair value option were $8.2 billion, $6.8 billion, $5.5 billion, $6.7 billion and $8.2 billion in 2020, 2019, 2018, 2017 and 2016, respectively.(9)Excludes consumer loans accounted for under the fair value option of $735 million, $594 million, $682 million, $928 million and $1.1 billion at December 31, 2020, 2019, 2018, 2017 and 2016, respectively.(10)Excludes commercial loans accounted for under the fair value option of $5.9 billion, $7.7 billion, $3.7 billion, $4.8 billion and $6.0 billion at December 31, 2020, 2019, 2018, 2017 and 2016, respectively. (11)Primarily includes amounts related to credit card and unsecured consumer lending portfolios in Consumer Banking and, in 2017 and 2016, the non-U.S. credit card portfolio in All Other.Table VIAllocation of the Allowance for Credit Losses by Product Type (1) December 3120202019201820172016(Dollars in millions)AmountPercentof TotalAmountPercentof TotalAmountPercentof TotalAmountPercentof TotalAmountPercentof TotalAllowance for loan and lease losses Residential mortgage$459 2.44 %$325 3.45 %$422 4.40 %$701 6.74 %$1,012 8.82 %Home equity399 2.12 221 2.35 506 5.27 1,019 9.80 1,738 15.14 Credit card8,420 44.79 3,710 39.39 3,597 37.47 3,368 32.41 2,934 25.56 Non-U.S. credit card— — — — — — — — 243 2.12 Direct/Indirect consumer752 4.00 234 2.49 248 2.58 264 2.54 244 2.13 Other consumer41 0.22 52 0.55 29 0.30 31 0.30 51 0.44 Total consumer10,071 53.57 4,542 48.23 4,802 50.02 5,383 51.79 6,222 54.21 U.S. commercial (2)5,043 26.82 3,015 32.02 3,010 31.35 3,113 29.95 3,326 28.97 Non-U.S. commercial1,241 6.60 658 6.99 677 7.05 803 7.73 874 7.61 Commercial real estate2,285 12.15 1,042 11.07 958 9.98 935 9.00 920 8.01 Commercial lease financing162 0.86 159 1.69 154 1.60 159 1.53 138 1.20 Total commercial8,731 46.43 4,874 51.77 4,799 49.98 5,010 48.21 5,258 45.79 Total allowance for loan and lease losses18,802 100.00 %9,416 100.00 %9,601 100.00 %10,393 100.00 %11,480 100.00 %Less: Allowance included in assets of business held for sale (3)— — — — (243)Allowance for loan and lease losses18,802 9,416 9,601 10,393 11,237 Reserve for unfunded lending commitments1,878 813 797 777 762 Allowance for credit losses$20,680 $10,229 $10,398 $11,170 $11,999 (1)On January 1, 2020, the Corporation adopted the CECL accounting standard. For more information, see Note 1 – Summary of Significant Accounting Principles to the Consolidated Financial Statements.(2)Includes allowance for loan and lease losses for U.S. small business commercial loans of $1.5 billion, $523 million, $474 million, $439 million and $416 million at December 31, 2020, 2019, 2018, 2017 and 2016, respectively.(3)Represents allowance for loan and lease losses related to the non-U.S. credit card loan portfolio, which was sold in 2017. Bank of America 92Item 7A. Quantitative and Qualitative Disclosures about Market RiskSee Market Risk Management on page 78 in the MD&A and the sections referenced therein for Quantitative and Qualitative Disclosures about Market Risk.
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+Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.The following commentary should be read in conjunction with the consolidated financial statements and accompanying notes.EXECUTIVE OVERVIEWDescription of the Company and Business SegmentsWe manage our business based on three geographic segments: Americas (North and South America), EMEA (Europe, Middle East and Africa) and APAC (Asia-Pacific). Each of our segments provides a broad portfolio of essential healthcare products including acute and chronic dialysis therapies; sterile IV solutions; infusion systems and devices; parenteral nutrition therapies; inhaled anesthetics; generic injectable pharmaceuticals; and surgical hemostat and sealant products. These products are used by hospitals, kidney dialysis centers, nursing homes, rehabilitation centers, doctors’ offices and patients at home under physician supervision. Our global footprint and the critical nature of our products and services play a key role in expanding access to healthcare in emerging and developed countries. For financial information about our segments, see Note 16 in Item 8 of this Annual Report on Form 10-K.Recent Business Combinations and Asset AcquisitionsSeprafilm Adhesion BarrierIn February 2020, we completed the acquisition of the product rights to Seprafilm Adhesion Barrier (Seprafilm) from Sanofi for approximately $342 million in cash. Seprafilm is indicated for use in patients undergoing abdominal or pelvic laparotomy as an adjunct intended to reduce the incidence, extent and severity of postoperative adhesions between the abdominal wall and the underlying viscera such as omentum, small bowel, bladder, and stomach, and between the uterus and surrounding structures such as tubes and ovaries, large bowel, and bladder. Refer to Note 2 in Item 8 of this Annual Report on Form 10-K for additional information regarding the acquisition of Seprafilm.Cheetah MedicalIn October 2019, we acquired 100 percent of Cheetah Medical, Inc. (Cheetah) for total cash consideration of $188 million, net of cash acquired, with the potential for additional cash consideration, up to $40 million, based on clinical and commercial milestones for which the acquisition date fair value was $18 million. Cheetah is a leading provider of hemodynamic monitoring technologies. Refer to Note 2 in Item 8 of this Annual Report on Form 10-K for additional information regarding the acquisition of Cheetah.Recothrom and PreveleakIn March 2018, we acquired two hemostat and sealant products from Mallinckrodt plc: Recothrom Thrombin topical (Recombinant), the first and only stand-alone recombinant thrombin, and Preveleak Surgical Sealant, which is used in vascular reconstruction. The purchase price included an upfront payment of approximately $163 million and potential contingent payments in the future. Refer to Note 2 in Item 8 of this Annual Report on Form 10-K for additional information regarding the acquisition of the Recothrom and Preveleak products.Transderm ScopIn February 2021, we agreed to acquire the rights to Transderm Scop from subsidiaries of GlaxoSmithKline for an upfront purchase price of $55 million plus the cost of acquired inventory and the potential for additional cash consideration of $30 million based upon a successful technology transfer by a specified date. We currently sell this product under a distribution license to the U.S. institutional market. Transderm Scop is indicated for post-operative nausea and vomiting in the U.S. and motion sickness in European markets. We expect the transaction to close late in the first quarter or early in the second quarter of 2021, subject to the satisfaction of closing conditions.Caelyx and DoxilIn December 2020, we agreed to acquire the rights to Caelyx and Doxil, the branded versions of liposomal doxorubicin, from a subsidiary of Johnson & Johnson for specified territories outside of the U.S for $325 million. We previously acquired the U.S. rights to this product in 2019. Liposomal doxorubicin is a chemotherapy medicine used 26to treat various types of cancer. We expect the transaction to close late in the first quarter or early in the second quarter of 2021, subject to the satisfaction of regulatory approvals and other closing conditions.Financial ResultsOur global net sales totaled $11.7 billion in 2020, an increase of 3% over 2019 on both a reported and constant currency basis. International sales totaled $6.8 billion in 2020, an increase of 4% compared to 2019 on a reported basis and 5% on a constant currency basis. Sales in the United States totaled $4.9 billion in 2020, an increase of 1% compared to 2019. Refer to the Net Sales discussion in the Results of Operations section below for more information related to changes in net sales on a constant currency basis. Our income from continuing operations totaled $1.1 billion, or $2.13 per diluted share, in 2020. Income from continuing operations in 2020 included special items which resulted in a net decrease to income from continuing operations of $495 million, or $0.96 per diluted share. Our special items are discussed in the Results of Operations section below.Our financial results included R&D expenses totaling $521 million in 2020, which reflects our focus on balancing investments to support our new product pipeline with efforts to optimize overall R&D spending.Our financial position remains strong, with operating cash flows from continuing operations totaling $1.9 billion in 2020. We have continued to execute on our disciplined capital allocation framework, which is designed to optimize stockholder value creation through reinvestment in our businesses, dividends and share repurchases, as well as acquisitions and other business development initiatives as discussed in the Strategic Objectives section below.Capital expenditures totaled $709 million in 2020 as we continue to invest across our businesses to support future growth, including additional investments in support of new and existing product capacity expansions. Our investments in capital expenditures in 2020 were focused on projects that improve production efficiency and enhance manufacturing capabilities to support our strategy of geographic expansion with select investments in growing markets.We also continued to return value to our stockholders in the form of dividends. During 2020, we paid cash dividends to our stockholders totaling $473 million. Additionally, in 2020 we repurchased 6.3 million shares through cash repurchases pursuant to a Rule 10b5-1 repurchase plan. For information on our share repurchase plans, see Note 8 in Item 8 of this Annual Report on Form 10-K.Strategic ObjectivesWe continue to focus on several key objectives to successfully execute our long-term strategy to achieve sustainable growth and deliver enhanced stockholder value. Our diversified and broad portfolio of medical products that treat life-threatening acute or chronic conditions and our global presence are core components of our strategy to achieve these objectives. We are focused on three strategic factors as part of our pursuit of industry leading performance: optimizing our core portfolio globally; operational excellence focused on streamlining our cost structure and enhancing operational efficiency; and maintaining a disciplined and balanced approach to capital allocation.Optimizing the Core Portfolio GloballyOur global product portfolio optimization strategy identifies products that we believe to have characteristics of core growth, products that we expect to provide us with a core return on capital, products that we intend to maintain or manage differently and products that we consider to be strategic bets. For products with core growth characteristics, we look to invest for long-term, higher margin growth. For products that we expect to generate a core return on capital, we seek to optimize our return on investment and to maintain or enhance our market position. For products that we intend to maintain or manage differently, we look to sustain or reposition our underlying investment. Finally, we are evaluating our market position and investment strategy for products that we consider to be strategic bets.As part of our portfolio management strategy, we seek to optimize our position in product areas where we have a stable, profitable business model, identify and alter investments in products that have reached the end of their life 27cycles or for which market positions have evolved unfavorably. In the course of doing so, we expect to continue to reallocate capital to more promising opportunities or business groupings, as described above.As part of this strategy, we are shifting our investments to drive innovation in product areas where we have compelling opportunities to serve patients and healthcare professionals while advancing our business and we are accelerating the pace in which we bring these advances to market. We are in the midst of launching several new products, geographic expansions and line extensions by 2023 including in such areas as chronic and acute renal care, smart pump technology, hospital pharmaceuticals and nutritionals, surgical sealants, and more. These comprise a mix of entirely new offerings, improvements on existing technologies, and the expansion of current products into new geographies.Operational ExcellenceWe have undertaken a comprehensive review of all aspects of our operations and are actively implementing changes in line with our business goals. As part of our pursuit of improved margin performance, we are working to optimize our cost structure and we are critically assessing optimal support levels in light of our ongoing portfolio optimization efforts. We intend to continue to actively manage our cost structure to help ensure that we are committing resources to the highest value uses. Such high value activities include supporting innovation, building out the portfolio, expanding patient access and accelerating growth for our stockholders.Maintaining Disciplined and Balanced Capital AllocationOur capital allocation strategies include the following:•reinvest in the business by funding opportunities that are positioned to deliver sustainable growth, support our innovation efforts and improve margin performance;•return capital to stockholders through dividends, which we expect to meaningfully increase with earnings growth;•share repurchases; and•identify and pursue accretive merger and acquisition (M&A) opportunities.Responsible Corporate CitizenWe strive for continued growth and profitability, while furthering our focus on acting as a responsible corporate citizen. To us, sustainability means creating lasting social, environmental and economic value by addressing the needs of our wide-ranging stakeholder base. Our comprehensive sustainability program is focused on areas in which we are uniquely positioned to make a positive impact. Priorities include providing employees a safe, healthy and inclusive workplace, fostering a culture that drives integrity, strengthening access to healthcare, enhancing math and science education, and driving environmental performance across the product life cycle, including development, manufacturing and transport. Along with the Baxter International Foundation, we provide financial support and product donations in support of critical needs, from assisting underserved communities to providing emergency relief for countries experiencing natural disasters.Throughout 2020, we continued to implement a range of water conservation strategies and facility-based energy saving initiatives. In the area of product stewardship and life cycle management, we are pursuing efforts such as sustainable design and reduced packaging. We are also responding to the challenges of climate change through innovative greenhouse gas emissions-reduction programs, such as shifting to less carbon-intensive energy sources in manufacturing and transport. Additionally, we monitor our progress against long-term goals to drive continued environmental stewardship while creating healthier, more sustainable communities where our employees work and live.Risk FactorsOur ability to sustain long-term growth and successfully execute the strategies discussed above depends in part on our ability to manage within an increasingly competitive and regulated environment and to address the other risk factors described in Item 1A of this Annual Report on Form 10-K.28RESULTS OF OPERATIONSSpecial ItemsThe following table provides a summary of our special items and the related impact by line item on our results of continuing operations for 2020, 2019 and 2018.years ended December 31 (in millions)202020192018Gross MarginIntangible asset amortization expense$(222)$(183)$(169)Intangible asset impairment1(17)(31)— Business optimization items2(53)(69)(49)Product-related items3(29)— 6 Acquisition and integration expenses4(11)(30)(27)Litigation5— — (8)Hurricane Maria insurance recoveries6— — 32 European medical devices regulation7(33)(25)(6)Investigation and related costs8(3)— — Total Special Items$(368)$(338)$(221)Impact on Gross Margin Ratio(3.1 pts)(3.0 pts)(2.0 pts)Selling, General and Administrative (SG&A) ExpensesBusiness optimization items2$78 $70 $145 Acquisition and integration expenses49 20 23 Litigation5— — 2 Investigation and related costs819 8 — Total Special Items$106 $98 $170 Impact on SG&A Expense Ratio1.0 pts0.9 pts1.5 ptsR&D ExpensesBusiness optimization items2$3 $45 $26 Acquisition and integration expenses422 8 7 European medical devices regulation7— — 3 Investigation and related costs81 — — Total Special Items$26 $53 $36 Impact on R&D Expense Ratio0.3 pts0.4 pts0.3 ptsOther Operating Income, netBusiness optimization items2$(17)$— $— Acquisition and integration expenses4(2)(4)— Hurricane Maria insurance recoveries6— (100)(10)Claris Settlement⁹— — (80)Insurance recoveries from a legacy product-related matter10— (37)— Total Special Items$(19)$(141)$(90)Other (Income) Expense, NetAcquisition and integration activities4$— $— $(24)Pension settlements1143 755 — Loss on debt extinguishment12110 — — Total Special Items$153 $755 $(24)Income Tax ExpenseTax effects of special items and impact of U.S. Tax Reform13$(139)$(387)$(277)Total Special Items$(139)$(387)$(277)Impact on Effective Tax Rate(2.6 pts)(20.9) pts(13.7) pts29Intangible asset amortization expense is identified as a special item to facilitate an evaluation of current and past operating performance and is consistent with how management and our Board of Directors internally assess performance. Additional special items are identified above because they are highly variable, difficult to predict and of a size that may substantially impact our results of operations for a period. Management believes that providing the separate impact of the above items on our results in accordance with U.S. GAAP may provide a more complete understanding of our operations and can facilitate a fuller analysis of our results of operations, particularly in evaluating performance from one period to another. 1In 2020 and 2019, our results included charges of $17 million and $31 million, respectively, for asset impairments related to developed-technology intangible assets. Refer to Note 4 in Item 8 of this Annual Report on Form 10-K for further information regarding these asset impairments.2In 2020, 2019 and 2018, our results were impacted by costs associated with our execution of programs to optimize our organization and cost structure. These actions included streamlining our international operations, rationalizing our manufacturing facilities, reducing our general and administrative infrastructure, re-aligning certain R&D activities and canceling certain R&D programs. Our results in 2020, 2019 and 2018 included business optimization charges of $134 million, $184 million and $220 million, respectively. Additionally, we recognized a gain of $17 million in 2020 for property we sold in conjunction with our business optimization initiatives. Refer to Note 10 in Item 8 of this Annual Report on Form 10-K for further information regarding these charges and related liabilities. 3Our results in 2020 included a charge of $29 million related to Sigma Spectrum infusion pump inspection and remediation activities. Our results in 2018 included a net benefit of $6 million related to an adjustment to our accrual for Sigma Spectrum infusion pump inspection and remediation activities. 4Our results in 2020 included $40 million of acquisition and integration expenses related to the acquisitions of Cheetah and Seprafilm and in-process R&D assets, partially offset by a benefit related to the change in the estimated fair value of contingent consideration liabilities. Our results in 2019 included $54 million of acquisition and integration expenses. This included integration expenses relate to our acquisitions of Claris Injectables Limited (Claris) and the Recothrom and Preveleak products in prior periods, as well as the 2019 acquisitions of Cheetah and in-process R&D assets, partially offset by a benefit related to the change in the estimated fair value of contingent consideration liabilities. Our results in 2018 included $33 million of acquisition and integration costs related to our acquisitions of Claris and the Recothrom and Preveleak products, upfront payments related to R&D collaborations and license agreements, and a gain from remeasuring our previously held investment to fair value upon acquisition of a controlling interest in our joint venture in Saudi Arabia. Refer to Note 2 in Item 8 of this Annual Report on Form 10-K for further information regarding business development activities. 5Our results in 2018 included charges of $10 million related to certain product litigation. 6Our results in 2019 and 2018 included benefits of $100 million and $42 million, respectively, related to insurance recoveries as a result of losses incurred due to Hurricane Maria. Refer to Note 7 in Item 8 of this Annual Report on Form 10-K for further information.7Our results in 2020, 2019 and 2018 included costs of $33 million, $25 million and $9 million, respectively, related to updating our quality systems and product labeling to comply with the new medical device reporting regulation and other requirements of the European Union’s regulations for medical devices that are scheduled to become effective in 2021.8Our results in 2020 and 2019 included charges of $23 million and $8 million, respectively, for investigation and related costs. This included $15 million in 2020 and $8 million in 2019 related to our investigation of foreign exchange gains and losses associated with certain intra-company transactions and related legal matters. Additionally, we recorded incremental stock compensation expense of $8 million in 2020 as we extended the term of certain stock options that were scheduled to expire in the first quarter of 2020. Refer to Notes 7 and 8 in Item 8 of this Annual Report on Form 10-K for further information regarding the investigation and stock compensation expense.309Our results in 2018 included a benefit of $80 million for the settlement of certain claims related to the acquired operations of Claris. Refer to Note 2 in Item 8 of this Annual Report on Form 10-K for further information.10Our results in 2019 included a benefit of $37 million for our allocation of insurance proceeds received pursuant to a settlement and cost-sharing arrangement for a legacy product-related matter. Refer to Note 7 in Item 8 of this Annual Report on Form 10-K for further information.11Our results in 2020 included a charge of $43 million related to lump-sum settlement distributions made to certain former U.S. employees with vested pension benefits. Our results in 2019 included a charge of $755 million related to the annuitization of a portion of our U.S. pension plan. Refer to Note 11 in Item 8 of this Annual Report on Form 10-K for further information regarding the lump-sum settlements and the pension annuitization.12Our results in 2020 included a loss of $110 million on the November 2020 early extinguishment of $750 million of 3.75% senior notes that were issued in March 2020. Refer to Note 5 in Item 8 of this Annual Report on Form 10-K for further information.13Reflected in this item is the income tax impact of the special items identified in this table. The tax effect of each special item is based on the jurisdiction in which the item was incurred and the tax laws in effect for each such jurisdiction. Additionally, our results in 2019 included a net tax benefit of $125 million related to income tax reform in Switzerland and India and an adjustment for U.S. federal tax reform. Our results in 2018 included a net tax benefit of $196 million related to updates to the estimated impact of U.S. federal tax reform previously made in 2017. Net Sales Percent changeAt actualcurrency ratesAt constantcurrency ratesyears ended December 31 (in millions)2020201920182020201920202019United States$4,878 $4,826 $4,723 1 %2 %1 %2 %International6,795 6,536 6,376 4 %3 %5 %7 %Total net sales$11,673 $11,362 $11,099 3 %2 %3 %5 %Net sales for the year ended December 31, 2020 increased 3% at actual and constant currency rates. Net sales for the year ended December 31, 2019 increased 2% at actual rates and 5% at constant currency rates.Foreign currency exchange rates had no net impact on 2020 net sales growth. Foreign currency exchange rates unfavorably impacted 2019 net sales growth by three percentage points principally due to the strengthening of the U.S Dollar relative to the Euro, Australian Dollar, British Pound, Chinese Yuan and Colombian Peso. The comparisons presented at constant currency rates reflect current year local currency sales at the prior year’s foreign exchange rates. This measure provides information on the change in net sales assuming that foreign currency exchange rates had not changed between the prior and the current period. We believe that the non-GAAP measure of change in net sales at constant currency rates, when used in conjunction with the U.S. GAAP measure of change in net sales at actual currency rates, may provide a more complete understanding and facilitate a fuller analysis of our results of operations, particularly in evaluating performance from one period to another.In 2020, the acquisition of Seprafilm contributed $94 million in revenue. In 2020 and 2019, the acquisition of Cheetah had an insignificant impact on reported revenues. The Recothrom and Preveleak products acquired in 2018 contributed $80 million and $52 million of revenues in 2019 and 2018, respectively. Our global operations expose us to risks associated with public health crises and epidemics/pandemics, such as the COVID-19 pandemic. COVID-19 has had, and we expect will continue to have, an adverse impact on our operations, supply chains and distribution systems and has increased and we expect will continue to increase our expenses, including as a result of impacts associated with preventive and precautionary measures that we, other businesses and governments are taking. These measures have led to unprecedented restrictions on, disruptions in, and other related impacts on businesses and personal activities. In addition to travel restrictions put in place in early 312020, governments have closed borders, imposed prolonged quarantines and may continue those measures or implement other restrictions and requirements in light of the continuing spread of the pandemic. We expect that these evolving restrictions and requirements, as well as the corresponding need to adapt to new methods of conducting business remotely, will continue to have an adverse effect on our business. For further discussion, refer to the Global Business Unit Net Sales Reporting section below and Item 1A of this Annual Report on Form 10-K.Global Business Unit Net Sales ReportingOur global business units (GBUs) include the following:•Renal Care includes sales of our peritoneal dialysis (PD), hemodialysis (HD) and additional dialysis therapies and services.•Medication Delivery includes sales of our intravenous (IV) therapies, infusion pumps, administration sets and drug reconstitution devices. •Pharmaceuticals includes sales of our premixed and oncology drug platforms, inhaled anesthesia and critical care products and pharmacy compounding services.•Clinical Nutrition includes sales of our parenteral nutrition (PN) therapies and related products.•Advanced Surgery includes sales of our biological products and medical devices used in surgical procedures for hemostasis, tissue sealing and adhesion prevention. •Acute Therapies includes sales of our continuous renal replacement therapies (CRRT) and other organ support therapies focused in the intensive care unit (ICU).•Other primarily includes sales of contract manufacturing services from our pharmaceutical partnering business.The following is a summary of net sales by GBU.Percent changeAt actualcurrency ratesAt constantcurrency ratesyears ended December 31 (in millions)2020201920182020201920202019Renal Care$3,757 $3,639 $3,651 3 %— %4 %3 %Medication Delivery2,735 2,799 2,664 (2)%5 %(2)%7 %Pharmaceuticals2,123 2,155 2,087 (1)%3 %(1)%6 %Clinical Nutrition922 872 875 6 %— %6 %3 %Advanced Surgery888 877 798 1 %10 %1 %12 %Acute Therapies740 535 515 38 %4 %39 %7 %Other508 485 509 5 %(5)%4 %(2)%Total Baxter$11,673 $11,362 $11,099 3 %2 %3 %5 %Renal Care net sales increased 3% in 2020 and were flat in 2019. The increase in 2020 was driven by global patient growth in PD, partially offset by a 1% negative impact from foreign exchange rate changes, as compared to the prior-year period. Global patient growth in PD in 2019 was offset by lower U.S. in-center HD sales and a 3% negative impact from foreign exchange rate changes, as compared to the prior-year period. Medication Delivery net sales decreased 2% in 2020 and increased 5% in 2019. The decrease in 2020 was primarily driven by lower demand for our infusion systems and related IV administration sets and solutions due to lower hospital admission rates and a reduction in elective surgeries resulting from the COVID-19 pandemic, including the impact from shelter in place initiatives as well as patient safety concerns related to potential COVID-19 infection risk. The increase in 2019 was attributable to increased sales of our Spectrum IQ Infusion System in the U.S. and EVO IQ Infusion System internationally and related IV access administration sets. Changes in foreign exchange rates had a negative impact on Medication Delivery net sales of 2% in 2019, compared to the prior-year period. Pharmaceuticals net sales decreased 1% in 2020 and increased 3% in 2019. The decrease in 2020 was driven by lower demand for inhaled anesthesia products resulting from the COVID-19 pandemic and new competitive entrants for TransDerm Scop. Those impacts were partially offset by increased demand for our international pharmacy compounding services along with certain generic injectables and a nonrecurring purchase from the U.S. 32government. The increase in 2019 was due to growth in international pharmacy compounding sales and increased sales of our generic injectables. Partially offsetting those increases were reduced sales of inhaled anesthetics as well as BREVIBLOC and U.S. cylophosphamide due to increased generic competition. Changes in foreign exchange rates had a negative impact on Pharmaceuticals net sales of 3% in 2019, compared to the prior-year period. Clinical Nutrition net sales increased 6% in 2020 and were flat in 2019. The increase in 2020 was driven by increased demand for our PN therapies and related products, recent product launches and competitor shortages of amino acids. A positive impact on net sales in 2019 from the launch of new products was offset by a 3% negative impact from foreign exchange rate changes, as compared to the prior-year period. Advanced Surgery net sales increased 1% and 10% in 2020 and 2019, respectively. The increase in 2020 was driven by the acquisition of Seprafilm, which contributed $94 million in net sales during 2020, and a benefit from increased demand for our hemostats and sealants early in the year due, in part, to competitive supply disruptions. Partially offsetting the increase was the impact of the COVID-19 pandemic as many elective surgeries were postponed. The increase in 2019 was primarily driven by higher sales as a result of a temporary supply disruption of a competitor, partially offset by a 2% negative impact from foreign exchange rate changes, as compared to the prior-year period. Acute Therapies net sales increased 38% and 4% in 2020 and 2019, respectively. The increase in 2020 was driven by increased global demand for our CRRT systems to treat acute kidney injuries during the COVID-19 pandemic, partially offset by a 1% negative impact from foreign exchange rate changes, as compared to the prior-year period. The increase in 2019 was due to higher global demand for our CRRT systems to treat acute kidney injuries, including the launch of PrisMax in several countries across the Americas, Europe and Asia. Partially offsetting the increase in 2019 was a 3% negative impact from foreign exchange rate changes, as compared to the prior-year period.Other net sales increased 5% in 2020 and decreased 5% in 2019. The increase in 2020 was driven by increased demand for our contract manufacturing services and a 1% positive impact from foreign exchange rate changes, as compared to the prior-year period. The decrease in 2019 was due to strong sales performance in 2018 and a 3% negative impact from foreign exchange rate changes, as compared to the prior-year period. Gross Margin and Expense Ratios20202019years ended December 312020% of net sales2019% of net sales2018% of net sales$ change% change$ change% changeGross margin$4,587 39.3 %$4,761 41.9 %$4,759 42.9 %$(174)(3.7)%$2 — %SG&A$2,469 21.2 %$2,535 22.3 %$2,620 23.6 %$(66)(2.6)%$(85)(3.2)%R&D$521 4.5 %$595 5.2 %$654 5.9 %$(74)(12.4)%$(59)(9.0)%Gross MarginThe gross margin ratio was 39.3%, 41.9% and 42.9% in 2020, 2019 and 2018, respectively. The special items identified above had an unfavorable impact of 3.1, 3.0 and 2.0 percentage points on the gross margin ratio in 2020, 2019 and 2018, respectively. Refer to the Special Items section above for additional detail.Excluding the impact of the special items, the gross margin ratio decreased 2.5 percentage points in 2020 compared to 2019 due to an unfavorable product mix, additional compensation costs, primarily for our manufacturing employees, reduced manufacturing efficiencies and incremental logistics costs, all resulting from the COVID-19 pandemic.Excluding the impact of the special items, the gross margin ratio was unchanged in 2019 compared to 2018. The gross margin ratio was impacted by an unfavorable product mix as well as inventory write-downs and incremental costs relating to improvements at a dialyzer facility in the U.S. that experienced manufacturing issues during the second quarter of 2019, offset by manufacturing efficiencies.33SG&AThe SG&A expenses ratio was 21.2%, 22.3% and 23.6% in 2020, 2019 and 2018, respectively. The special items identified above had an unfavorable impact of 1.0, 0.9 and 1.5 percentage points on the SG&A expenses ratio in 2020, 2019 and 2018, respectively. Refer to the Special Items section above for additional detail.Excluding the impact of the special items, the SG&A expenses ratio decreased 1.2 percentage points in 2020 primarily due to lower bonus accruals under our annual employee incentive compensation plans, actions we took to restructure our cost position and focus on expense management and reduced travel and related expenses due to the COVID-19 pandemic.Excluding the impact of the special items, the SG&A expenses ratio decreased 0.7 percentage points in 2019 primarily due to actions we took to restructure our cost position and focus on expense management.R&DThe R&D expenses ratio was 4.5%, 5.2% and 5.9% in 2020, 2019 and 2018, respectively. The special items identified above had an unfavorable impact of 0.3, 0.4 and 0.3 percentage points on the R&D expenses ratio in 2020, 2019 and 2018, respectively. Refer to the Special Items section above for additional detail.Excluding the impact of the special items, the R&D expenses ratio decreased 0.6 percentage points in 2020 as a result of reduced project-related expenditures compared to the prior year and actions we took to restructure our cost position and focus on expense management.Excluding the impact of the special items, the R&D expenses ratio decreased 0.8 percentage points in 2019 as a result of reduced project-related expenditures compared to the prior year and actions we took to restructure our cost position and focus on expense management.Business Optimization ItemsIn recent years, we have undertaken actions to transform our cost structure and enhance our operational efficiency. These efforts have included restructuring the organization, optimizing our manufacturing footprint, R&D operations and supply chain network, employing disciplined cost management, and centralizing and streamlining certain support functions. From the commencement of our business optimization actions in the second half of 2015 through December 31, 2020, we have incurred cumulative pre-tax costs of $1.1 billion related to these actions. The costs consisted primarily of employee termination costs, implementation costs, contract termination costs, asset impairments, and accelerated depreciation. We currently expect to incur additional pre-tax costs of approximately $14 million through the completion of the initiatives that are currently underway, primarily related to implementation costs. We continue to pursue cost savings initiatives and, to the extent further cost savings opportunities are identified, we may incur additional restructuring charges and costs to implement business optimization programs in future periods. The reductions in our cost base from these actions in the aggregate are expected to provide cumulative annual pretax savings of more than $1.2 billion once the remaining actions are complete. The savings from these actions will impact cost of sales, SG&A expenses, and R&D expenses. Approximately 95 percent of the expected annual pre-tax savings has been realized through December 31, 2020, with the remainder expected to be realized by the end of 2023. Refer to Note 10 in Item 8 of this Annual Report on Form 10-K for additional information regarding our business optimization programs.Other Operating Income, NetOther operating income, net was $19 million, $141 million and $99 million in 2020, 2019 and 2018, respectively. In 2020, we recognized a $17 million gain on the sale of property in conjunction with our business optimization initiatives. In 2020 and 2019, we recognized benefits of $2 million and $4 million, respectively, related to the change in the estimated fair value of contingent consideration liabilities. In 2019 and 2018, we recognized $100 million and $10 million, respectively, of insurance recoveries related to losses incurred due to Hurricane Maria within Other operating income, net. In 2019, we also recognized a benefit of $37 million when our share of the proceeds under a cost-sharing agreement became realizable following the resolution of a dispute with an insurer related to a legacy product-related matter. In 2018, we settled certain claims with the seller related to the acquired operations of Claris, which resulted in a benefit of $80 million. Additionally, included in other operating income in 2018 was $9 million of transition service income earned in connection with our separation of Baxalta in 2015. The agreement for these services terminated as of July 1, 2018.34Interest Expense, NetInterest expense, net was $134 million, $71 million and $45 million in 2020, 2019 and 2018, respectively. The increase in 2020 was primarily driven by higher average debt outstanding as a result of the March 2020 issuance of $750 million of 3.75% senior notes due October 2025 and $500 million of 3.95% senior notes due April 2030, and the May 2019 issuance of €750 million of 0.40% senior notes due May 2024 and €750 million of 1.3% senior notes due May 2029. The 3.75% senior notes due October 2025 were repaid in November 2020 with the proceeds from the issuance of $650 million of 1.73% senior notes due April 2031 and cash on hand. The increase in 2019 was primarily driven by higher average debt outstanding as a result of the issuance of €750 million of 0.40% senior notes due May 2024 and €750 million of 1.3% senior notes due May 2029. Refer to Note 5 in Item 8 of this Annual Report on Form 10-K for a summary of the components of interest expense, net for 2020, 2019 and 2018.Other (Income) Expense, NetOther (income) expense, net was an expense of $190 million in 2020, expense of $731 million in 2019 and income of $78 million in 2018. The net expense in 2020 was primarily driven by a $110 million loss on the early extinguishment of debt related to our November 2020 redemption of $750 million of senior notes that were issued in March 2020, foreign exchange net losses of $49 million and $46 million of pension settlement charges, which included a $43 million charge related to lump-sum settlement distributions made to certain former U.S. employees with vested pension benefits. These expenses in 2020 were partially offset by net unrealized gains of $13 million related to marketable equity securities. The net expense in 2019 was primarily driven by a $755 million pension settlement charge related to the transfer of U.S. pension plan liabilities to an insurance company and $37 million of foreign exchange net losses, partially offset by $53 million of pension and OPEB plan net benefits. The income in 2018 was primarily driven by $49 million of pension and OPEB plan net benefits, a $24 million gain from remeasuring our previously held investment to fair value upon acquisition of a controlling interest in our joint venture in Saudi Arabia and foreign exchange net gains of $14 million.We expect expenses from pension and OPEB plans to increase in 2021 primarily due to lower discount rates and a lower expected return on assets. Refer to Note 11 in Item 8 of this Annual Report on Form 10-K for further information regarding pension and OPEB plan expenses.Income Taxes The effective income tax rate for continuing operations was 14.1% in 2020, (4.2)% in 2019, and 4.0% in 2018. The special items identified above had a favorable impact of 2.6, 20.9 and 13.7 percentage points on the effective income tax rate in 2020, 2019 and 2018, respectively. Refer to the Special Items section above for additional detail. Our effective income tax rate can differ from the 21% U.S. federal statutory rate due to a number of factors, including foreign rate differences, tax incentives, increases or decreases in valuation allowances and liabilities for uncertain tax positions and excess tax benefits on stock compensation awards.For the twelve months ended December 31, 2020, the difference between our effective income tax rate and the U.S. federal statutory rate was primarily attributable to favorable geographic earnings mix and excess tax benefits on stock compensation awards. For the twelve months ended December 31, 2019, the difference between our effective income tax rate and the U.S. federal statutory rate was primarily due to special items, the most significant of which was the impact of recently enacted tax reform in Switzerland and India. We recognized a deferred tax benefit of $90 million to reflect a tax basis step-up, net of a valuation allowance, partially offset by a $5 million deferred tax revaluation to reflect an increase in the statutory tax rate, under the newly enacted Swiss tax laws. We also recognized a net deferred tax benefit of $24 million associated with deferred tax revaluation in India to reflect a decrease in the statutory tax rate. In addition to the Swiss and Indian tax reform impacts, our effective rate in 2019 was different from the U.S. federal statutory rate due to the recognition of tax benefits associated with a favorable tax ruling, a benefit related to a notional interest deduction on the share capital of a foreign subsidiary, and excess tax benefits on stock compensation awards. For the twelve months ended December 31, 2018, the difference between our effective income tax rate and the U.S. federal statutory rate was primarily due to special items, the most significant of which was our finalization of our provisional adjustments resulting from the 2017 Tax Act. SEC Staff Accounting Bulletin 118 (SAB 118) allowed a one-year measurement period from the December 22, 2017 Tax Act enactment date to refine the provisional amounts recognized in the 2017 financial statements. 35 We recorded several SAB 118 measurement period provisional adjustments in 2018. First, after further studying the 2017 Tax Act and related U.S. Treasury Regulations, we refined our provisional estimate of a full valuation allowance against our U.S. foreign tax credit deferred tax assets and released a $194 million valuation allowance due to our ability to utilize a portion of our U.S. foreign tax credit deferred tax assets. Second, the 2017 Tax Act requires us to pay U.S. income taxes on accumulated foreign subsidiary earnings not previously subject to U.S. income tax at a rate of 15.5% to the extent of foreign cash and certain other net current assets and 8% on the remaining earnings. During 2018, we refined our estimated one-time transition tax expense, recognizing a benefit of $5 million. Third, the 2017 Tax Act lowered the U.S. federal rate from 35% to 21% and generally exempts foreign income from U.S. taxation. We finalized our provisional revaluation of U.S. deferred tax assets, recording an additional $8 million benefit. Refer to Note 12 in Item 8 of this Annual Report on Form 10-K for further information related to the 2017 Tax Act and the finalization of associated SAB 118 provisional adjustments. Additionally, our effective rate in 2018 was different from the U.S. federal statutory rate due to excess tax benefits on stock compensation. Our tax provisions for 2020, 2019 and 2018 do not include any tax charges related to either the Base Erosion and Anti-Abuse Tax (BEAT) or Global Intangible Low Taxed Income (GILTI) provisions, except for the inability to fully utilize foreign tax credits against such GILTI. We anticipate that our effective income tax rate from continuing operations, calculated in accordance with U.S. GAAP, will be approximately 18% in 2021. This rate may be further impacted by a number of factors including discrete items, such as tax windfalls or deficiencies attributable to stock compensation awards, additional audit developments, or the tax effects of any future special items.Income from Continuing Operations and Earnings per Diluted ShareIncome from continuing operations was $1.1 billion in 2020, $1.0 billion in 2019 and $1.6 billion in 2018. Diluted earnings per share from continuing operations was $2.13 in 2020, $1.93 in 2019 and $2.84 in 2018. The significant factors and events causing the net changes from 2019 to 2020 and 2018 to 2019 are discussed above. Additionally, earnings per share from continuing operations was positively impacted by the repurchase of 35.8 million shares in 2018 through Rule 10b5-1 purchase plans, an accelerated share repurchase plan and otherwise and the repurchase of 16.5 million shares in 2019 through Rule 10b5-1 purchase plans, an accelerated share repurchase plan and otherwise. Refer to Note 8 in Item 8 of this Annual Report on Form 10-K for further information regarding our stock repurchases.Loss from Discontinued OperationsLoss from discontinued operations, net of tax was $6 million in 2018 and related to Baxalta.Segment resultsWe use operating income on a segment basis to make resource allocation decisions and assess the ongoing performance of our segments. Refer to Note 16 in Item 8 of this Annual Report on Form 10-K for additional details regarding our segments. The following is a summary of significant factors impacting our reportable segments’ financial results.Net salesOperating incomeyears ended December 31 (in millions)202020192018202020192018Americas$6,069 $6,094 $5,951 $2,235 $2,374 $2,411 EMEA3,129 2,968 2,946 677 652 666 APAC2,475 2,300 2,202 591 549 532 Corporate and other— — — (1,887)(1,803)(2,025)Total$11,673 $11,362 $11,099 $1,616 $1,772 $1,584 AmericasSegment operating income was $2.2 billion, $2.4 billion and $2.4 billion in 2020, 2019 and 2018, respectively. The decrease in 2020 was primarily driven by decreased sales and gross margin in multiple GBUs, particularly Medication Delivery, Pharmaceuticals and Advanced Surgery, and lower gross profit as a result of an unfavorable product mix and incremental logistics costs due primarily to the impact of the COVID-19 pandemic. The decreases 36were partially offset by favorable performance in Acute Therapies and Clinical Nutrition as well as the acquisition of Seprafilm. The decrease in 2019 was primarily driven by lower sales and gross margin in Pharmaceuticals and lower U.S. in-center HD sales, partially offset by favorable performance in Medication Delivery and Advanced Surgery, primarily due to a temporary supply disruption of a competitor. Additionally, results in 2019 were adversely impacted by unfavorable foreign exchange rates. EMEASegment operating income was $677 million, $652 million and $666 million in 2020, 2019 and 2018, respectively. The increase in 2020 was primarily driven by increased sales and gross margin in Acute Therapies, Clinical Nutrition, Pharmaceuticals and Renal Care, partially offset by decreased sales in Advanced Surgery. The decrease in 2019 was primarily driven by unfavorable foreign exchange rates, partially offset by increased local currency sales and gross margin in Renal Care and Pharmaceuticals. APACSegment operating income was $591 million, $549 million and $532 million in 2020, 2019 and 2018, respectively. The increase in 2020 was primarily driven by increased sales and gross margin in multiple GBUs, particularly Renal Care, Acute Therapies and Pharmaceuticals. The acquisition of Seprafilm also positively contributed to results in 2020. Results in 2019 were driven by higher sales and gross margin, primarily from China and Australia, in Renal Care and Pharmaceuticals. Corporate and otherCertain items are maintained at Corporate and are not allocated to a segment. They primarily include certain foreign currency hedging activities, corporate headquarters costs, certain R&D costs, certain GBU support costs, stock compensation expense, certain employee benefit plan costs, and certain gains, losses, and other charges (such as business optimization, acquisition and integration costs, intangible asset amortization and asset impairments). The operating loss in 2020 was higher than 2019 due to insurance recoveries received in 2019 from a legacy product-related matter and Hurricane Maria, as well as the Sigma Spectrum infusion pump inspection and remediation charge in 2020 and higher investigation and related costs and intangible asset amortization in 2020. Partially offsetting the increase in 2020 was lower business optimization charges, lower intangible asset impairment charges, lower bonus accruals under our annual employee incentive compensation plans and reduced travel and related expenses. The operating loss in 2019 decreased due to higher Hurricane Maria insurance recoveries in 2019, a benefit for our allocation of insurance proceeds received pursuant to a settlement and cost-sharing arrangement for a legacy product-related matter in 2019, lower SG&A and R&D expenses in 2019 and lower business optimization charges in 2019, partially offset by an impairment of a developed-technology intangible asset in 2019 and the benefit from the Claris settlement in 2018. LIQUIDITY AND CAPITAL RESOURCESCash Flows from Operations — Continuing OperationsIn 2020, 2019 and 2018, cash provided by operating activities was $1.9 billion, $2.1 billion and $2.0 billion, respectively. Operating cash flows decreased in 2020 primarily due to payments of $173 million to settle interest rate derivative contracts in 2020, an increase in inventory levels in 2020 and insurance recoveries received in 2019 from a legacy product-related matter and Hurricane Maria, partially offset by the timing of vendor payments and lower restructuring and employee incentive compensation payments in 2020. Operating cash flows increased in 2019 primarily due to an increase in our operating income, which included the insurance recoveries related to Hurricane Maria and a legacy product-related matter. Cash Flows from Investing ActivitiesIn 2020, cash used for investing activities included payments for acquisitions of $494 million, primarily related to Seprafilm and multiple product acquisitions, and capital expenditures of $709 million. In 2019, cash used for investing activities included payments for acquisitions of $418 million, primarily related to Cheetah and multiple product acquisitions, and capital expenditures of $696 million. In 2018, cash used in investing activities included 37payments for acquisitions of $268 million, primarily related to Recothrom and Preveleak and multiple product acquisitions, and capital expenditures of $659 million.We expect that our capital expenditures will increase in 2021 as we make investments in our manufacturing capacity in response to proposed regulatory changes of the U.S. Department of Health and Human Services in kidney health policy and reimbursement, which may substantially change the U.S. end stage renal disease market and demand for our peritoneal dialysis products.In February 2021, we agreed to acquire the rights to Transderm Scop from subsidiaries of GlaxoSmithKline for an upfront purchase price of $55 million plus the cost of acquired inventory and the potential for additional cash consideration of $30 million based upon a successful technology transfer by a specified date. We expect the transaction to close late in the first quarter or early in the second quarter of 2021, subject to the satisfaction of closing conditions.In December 2020, we agreed to acquire the rights to Caelyx and Doxil, the branded versions of liposomal doxorubicin, from a subsidiary of Johnson & Johnson for specified territories outside of the U.S for $325 million. We expect the transaction to close late in the first quarter or early in the second quarter of 2021, subject to the satisfaction of regulatory approvals and other closing conditions.Refer to Note 2 in Item 8 of this Annual Report on Form 10-K for further information about our significant acquisitions and other arrangements.Cash Flows from Financing ActivitiesIn 2020, cash generated from financing activities included $1.2 billion of net proceeds from the March 2020 issuance of $750 million of senior notes due in 2025 and $500 million of senior notes due in 2030. In November 2020, we issued $650 million of senior notes due in 2031 and used the proceeds, along with cash on hand, to redeem the $750 million senior notes due in 2025 that were issued in March 2020 for $854 million, which included a $104 million make-whole premium. We have used the net proceeds from the senior notes issuances and redemptions for general corporate purposes, including to strengthen our balance sheet as a precautionary measure in light of the COVID-19 pandemic. In 2020, we also repaid $322 million of variable rate notes that matured and the borrowings under our Euro-denominated credit facility of €200 million ($225 million). Financing activities in 2020 also included payments for stock repurchases of $500 million, dividend payments of $473 million and receipts from stock issued under employee benefit plans of $202 million.In 2019, cash generated from financing activities included $1.7 billion in net proceeds from the issuance of €750 million of senior notes due in 2024 and €750 million of senior notes due in 2029, €200 million ($222 million) of borrowings under our Euro-denominated credit facility and stock issued under employee benefit plans of $356 million, partially offset by payments for stock repurchases of $1.3 billion and dividend payments of $423 million. In 2018, cash used for financing activities included payments for stock repurchases of $2.5 billion and dividend payments of $376 million, partially offset by the proceeds from stock issued under employee benefit plans of $258 million.As authorized by the Board of Directors, we repurchase our stock depending upon our cash flows, net debt levels and market conditions. In July 2012, the Board of Directors authorized the repurchase of up to $2.0 billion of our common stock. The Board of Directors increased this authority by an additional $1.5 billion in each of November 2016 and February 2018, by an additional $2.0 billion in November 2018 and by an additional $1.5 billion in October 2020. We paid $500 million in cash to repurchase approximately 6.3 million shares under this authority pursuant to a Rule 10b5-1 plan in 2020 and had $1.9 billion remaining available under this authorization as of December 31, 2020.In December 2018, we entered into a $300 million accelerated share repurchase agreement (ASR Agreement) with an investment bank. We funded the ASR Agreement with available cash. Under the ASR Agreement, we received 3.6 million shares upon execution. Based on the volume-weighted average price of our common stock during the term of the ASR Agreement, we received an additional 0.6 million shares from the investment bank at settlement in May 2019.38Credit Facilities and Access to Capital and Credit RatingsCredit FacilitiesAs of December 31, 2020, our U.S. dollar-denominated revolving credit facility had capacity of $2.0 billion. As of December 31, 2020, our Euro-denominated revolving credit facility had a capacity of approximately €200 million. Each of the facilities matures in 2024. There were no amounts outstanding under our credit facilities as of December 31, 2020. There was no amount outstanding under our U.S. dollar-denominated credit facility as of December 31, 2019 and €200 million ($224 million) was outstanding at a 0.91% interest rate under our Euro-denominated credit facility as of December 31, 2019. As of December 31, 2020, we were in compliance with the financial covenants in these agreements. The non-performance of any financial institution supporting either of the credit facilities would reduce the maximum capacity of these facilities by the institution’s respective commitment. We also maintain other credit arrangements, as described in Note 5 in Item 8 of this Annual Report on Form 10-K.Access to Capital and Credit RatingsWe intend to fund short-term and long-term obligations as they mature through cash on hand and future cash flows from operations or by issuing additional debt. We had $3.7 billion of cash and cash equivalents as of December 31, 2020, with adequate cash available to meet operating requirements in each jurisdiction in which we operate. We invest our excess cash in money market and other funds and diversify the concentration of cash among different financial institutions. As of December 31, 2020, we had approximately $6.2 billion of long-term debt and finance lease obligations, including current maturities. Subject to market conditions, we regularly evaluate opportunities with respect to our capital structure.Our ability to generate cash flows from operations, issue debt, including commercial paper, or enter into other financing arrangements on acceptable terms could be adversely affected if there is a material decline in the demand for our products or in the solvency of our customers or suppliers, deterioration in our key financial ratios or credit ratings or other significantly unfavorable changes in conditions. However, we believe we have sufficient financial flexibility to issue debt, enter into other financing arrangements and attract long-term capital on acceptable terms to support our growth objectives. Our credit ratings at December 31, 2020 were as follows:Standard & Poor’sFitchMoody’sRatingsSenior debtA-A-Baa1Short-term debtA2F2P2OutlookStableStableStableLIBOR ReformIn 2017, the United Kingdom’s Financial Conduct Authority announced that after 2021 it would no longer compel banks to submit the rates required to calculate the London Interbank Offered Rate (LIBOR) and other interbank offered rates, which have been widely used as reference rates for various securities and financial contracts, including loans, debt and derivatives. This announcement indicated that the continuation of LIBOR on the current basis was not guaranteed after 2021. Regulators in the U.S. and other jurisdictions have been working to replace these rates with alternative reference interest rates that are supported by transactions in liquid and observable markets, such as the Secured Overnight Financing Rate (SOFR). In 2020, it was announced that certain U.S. dollar LIBOR tenors would not cease until 2023. Currently, our credit facilities reference LIBOR-based rates. The discontinuation of LIBOR will require these arrangements to be modified in order to replace LIBOR with an alternative reference interest rate, which could impact our cost of funds. Our credit facilities include a provision specifying that we and the lenders will negotiate in good faith for the determination of a successor LIBOR rate.39Contractual ObligationsAs of December 31, 2020, we had contractual obligations, excluding accounts payable and accrued liabilities, payable or maturing in the following periods.(in millions)TotalLess thanone yearOne tothree yearsThree tofive yearsMore thanfive yearsLong-term debt and finance lease obligations, including current maturities6,233 406 212 1,664 3,951 Interest on short- and long-term debt and finance lease obligations 11,627 142 267 251 967 Operating leases673 121 186 126 240 Other non-current liabilities2408 — 84 48 276 Purchase obligations31,209 485 352 198 174 Contractual obligations2$10,150 $1,154 $1,101 $2,287 $5,608 1.Interest payments on debt and finance lease obligations are calculated for future periods using interest rates in effect at the end of 2020. Certain of these projected interest payments may differ in the future based on foreign currency fluctuations or other factors or events. The projected interest payments only pertain to obligations and agreements outstanding at December 31, 2020. Refer to Note 5 and Note 6, respectively, in Item 8 of this Annual Report on Form 10-K for further discussion regarding our debt instruments outstanding and finance lease obligations at December 31, 2020.2.The primary components of other non-current liabilities in our consolidated balance sheet as of December 31, 2020 are pension and other postretirement benefits, deferred tax liabilities, long-term tax liabilities, and litigation and environmental reserves. We projected the timing of the related future cash payments based on contractual maturity dates (where applicable) and estimates of the timing of payments (for liabilities with no contractual maturity dates). The actual timing of payments could differ from our estimates. We contributed $74 million, $69 million, and $51 million to our defined benefit pension plans in 2020, 2019, and 2018, respectively. The timing of funding in future periods is uncertain and is dependent on future movements in interest rates, investment returns, changes in laws and regulations, and other variables. Therefore, the table above excludes cash outflows related to our pension plans. The amount included within other non-current liabilities (and excluded from the table above) related to our pension plan liabilities was $1.0 billion as of December 31, 2020. In 2021, we have no obligation to fund our principal plans in the United States and we expect to make contributions of at least $45 million to our foreign pension plans. Additionally, we have excluded long-term tax liabilities, which include liabilities for unrecognized tax positions, and deferred tax liabilities from the table above because we are unable to estimate the timing of the related cash outflows. The amounts of long-term tax liabilities and deferred tax liabilities included within other non-current liabilities (and excluded from the table above) were $84 million and $143 million, respectively, as of December 31, 2020. 3.Includes our significant contractual unconditional purchase obligations. For cancellable agreements, any penalty due upon cancellation is included. These commitments do not exceed our projected requirements and are in the normal course of business. Examples include firm commitments for raw material purchases, utility agreements and service contracts.Off-Balance Sheet ArrangementsWe periodically enter into off-balance sheet arrangements. Certain contingencies arise in the normal course of business and are not recorded in the consolidated balance sheets in accordance with U.S. GAAP (such as contingent joint development and commercialization arrangement payments). Also, upon resolution of uncertainties, we may incur charges in excess of presently established liabilities for certain matters (such as contractual indemnifications). For a discussion of our significant off-balance sheet arrangements, refer to Note 14 in Item 8 of this Annual Report on Form 10-K for information regarding receivable transactions, and Note 2 and Note 7 in Item 8 of this Annual Report on Form 10-K regarding joint development and commercialization arrangements, indemnifications and legal contingencies.40FINANCIAL INSTRUMENT MARKET RISKWe operate on a global basis and are exposed to the risk that our earnings, cash flows and equity could be adversely impacted by fluctuations in foreign exchange and interest rates. Our hedging policy attempts to manage these risks to an acceptable level based on our judgment of the appropriate trade-off between risk, opportunity and costs. Refer to Note 14 and Note 15 in Item 8 of this Annual Report on Form 10-K for further information regarding our financial instruments and hedging strategies.Currency RiskWe are primarily exposed to foreign exchange risk with respect to revenues generated outside of the United States denominated in the Euro, British Pound, Chinese Yuan, Korean Won, Australian Dollar, Canadian Dollar, Japanese Yen, Colombian Peso, Brazilian Real, Mexican Peso, Indian Rupee and Swedish Krona. We manage our foreign currency exposures on a consolidated basis, which allows us to net exposures and take advantage of any natural offsets. In addition, we use derivative and nonderivative financial instruments to further reduce the net exposure to foreign exchange. Gains and losses on the hedging instruments offset losses and gains on the hedged transactions and reduce the earnings and stockholders’ equity volatility relating to foreign exchange. However, we don't hedge our entire foreign exchange exposure and are still subject to earnings and stockholders' equity volatility relating to foreign exchange risk. Financial market and currency volatility may limit our ability to cost-effectively hedge these exposures.We use options and forwards to hedge the foreign exchange risk to earnings relating to forecasted transactions and recognized assets and liabilities denominated in foreign currencies. The maximum term over which we have cash flow hedge contracts in place related to foreign exchange risk on forecasted transactions as of December 31, 2020 is 12 months. We also enter into derivative instruments to hedge foreign exchange risk on certain intra-company and third-party receivables and payables and debt denominated in foreign currencies.As part of our risk-management program, we perform sensitivity analyses to assess potential changes in the fair value of our foreign exchange instruments relating to hypothetical and reasonably possible near-term movements in foreign exchange rates.A sensitivity analysis of changes in the fair value of foreign exchange contracts outstanding as of December 31, 2020, while not predictive in nature, indicated that if the U.S. Dollar uniformly weakened by 10% against all currencies, the net pre-tax liability balance of $8 million with respect to those contracts would increase by $32 million, resulting in a net asset position. A similar analysis performed with respect to contracts outstanding as of December 31, 2019 indicated that, on a pre-tax basis, the net asset balance of $9 million would decrease by $18 million, resulting in a net liability position.The sensitivity analysis model recalculates the fair value of the foreign exchange contracts outstanding as of December 31, 2020 by replacing the actual exchange rates as of December 31, 2020 with exchange rates that are 10% weaker compared to the actual exchange rates for each applicable currency. All other factors are held constant. These sensitivity analyses disregard the possibility that currency exchange rates can move in opposite directions and that gains from one currency may or may not be offset by losses from another currency. The analyses also disregard the offsetting change in value of the underlying hedged transactions and balances.Our operations in Argentina are reported using highly inflationary accounting effective July 1, 2018. Changes in the value of the Argentine peso applied to our peso-denominated net monetary asset positions are recorded in income at the time of the change. As of December 31, 2020, our net monetary assets denominated in Argentine pesos are not significant.Interest Rate RiskWe are also exposed to the risk that our earnings and cash flows could be adversely impacted by fluctuations in interest rates. Our policy is to manage interest costs using the mix of fixed- and floating-rate debt that we believe is appropriate at that time. To manage this mix in a cost-efficient manner, we periodically enter into interest rate swaps in which we agree to exchange, at specified intervals, the difference between fixed and floating interest amounts calculated by reference to an agreed-upon notional amount. We also periodically use forward-starting interest rate swaps and treasury rate locks to hedge the risk to earnings associated with fluctuations in interest rates relating to anticipated issuances of term debt. As of December 31, 2020, all of our outstanding debt obligations were at fixed interest rates and no interest rate derivative instruments were outstanding.41CHANGES IN ACCOUNTING STANDARDSRefer to Note 1 in Item 8 of this Annual Report on Form 10-K for information on changes in accounting standards.RECENT ACCOUNTING PRONOUNCEMENTSThere are no accounting standards issued but not yet effective that we believe will have a material impact on our condensed consolidated financial statements. CRITICAL ACCOUNTING POLICIESThe preparation of financial statements in accordance with U.S. GAAP requires management to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses. A summary of our significant accounting policies is included in Note 1 in Item 8 of this Annual Report on Form 10-K. Certain of our accounting policies are considered critical, as these policies are the most important to the depiction of our financial statements and require significant, difficult or complex judgments by us, often employing the use of estimates about the effects of matters that are inherently uncertain. Actual results that differ from our estimates could have an unfavorable effect on our results of operations and financial position. The following is a summary of accounting policies that we consider critical to the consolidated financial statements.Revenue Recognition and Related Provisions and AllowancesRevenues from product sales are recorded at the net sales price (transaction price), which includes estimates of variable consideration primarily related to rebates and wholesaler chargebacks. These reserves are based on estimates of the amounts earned or to be claimed on the related sales. Our estimates take into consideration historical experience, current contractual and statutory requirements, specific known market events and trends, industry data, and forecasted customer buying and payment patterns. Overall, these reserves reflect our best estimates of the amount of consideration to which we are entitled based on the terms of the contract. The amount of variable consideration included in the net sales price is limited to the amount that is probable not to result in a significant reversal in the amount of the cumulative revenue recognized in a future period. Additionally, our contracts with customers often include promises to transfer multiple products and services to a customer. Determining whether products and services are considered distinct performance obligations that should be accounted for separately and determining the allocation of the transaction price may require significant judgment.Pension and OPEB PlansWe provide pension and other postretirement benefits to certain of our employees. The service component of employee benefit expenses is reported in the same line items in the consolidated income statements as the applicable employee’s compensation expense. All other components of these employee benefit expenses are reported in other (income) expense, net in our consolidated statements of income. The valuation of the funded status and net periodic benefit cost for the plans is calculated using actuarial assumptions. These assumptions are reviewed annually and revised if appropriate. The significant assumptions include the following:•interest rates used to discount pension and OPEB plan liabilities;•the long-term rate of return on pension plan assets;•rates of increases in employee compensation (used in estimating liabilities);•anticipated future healthcare trend rates (used in estimating the OPEB plan liability); and•other assumptions involving demographic factors such as retirement, mortality and turnover (used in estimating liabilities).Selecting assumptions involves an analysis of both short-term and long-term historical trends and known economic and market conditions at the time of the valuation (also called the measurement date). The use of different assumptions would result in different measures of the funded status and net cost. Actual results in the future could differ from expected results.Our key assumptions are listed in Note 11 in Item 8 of this Annual Report on Form 10-K. The most critical assumptions relate to the plans covering U.S. and Puerto Rico employees, because these plans are the most significant to our consolidated financial statements.42Discount Rate AssumptionEffective for the December 31, 2020 measurement date, we utilized discount rates of 2.73% and 2.33% to measure our benefit obligations for the U.S. and Puerto Rico pension plans and OPEB plan, respectively. We used a broad population of approximately 200 Aa-rated corporate bonds as of December 31, 2020 to determine the discount rate assumption. All bonds were denominated in U.S. dollars, with a minimum amount outstanding of $50 million. This population of bonds was narrowed from a broader universe of approximately 700 Moody’s Aa rated, non-callable (or callable with make-whole provisions) bonds by eliminating the top 10th percentile and bottom 40th percentile to adjust for any pricing anomalies and to represent the bonds we would most likely select if we were to actually annuitize our pension and OPEB plan liabilities. This portfolio of bonds was used to generate a yield curve and associated spot rate curve to discount the projected benefit payments for the U.S. and Puerto Rico plans. The discount rate is the single level rate that produces the same result as the spot rate curve.For plans in Canada, Japan, the United Kingdom and other European countries, we use a method essentially the same as that described for the U.S. and Puerto Rico plans. For our other international plans, the discount rate is generally determined by reviewing country- and region-specific government and corporate bond interest rates.To understand the impact of changes in discount rates on pension and OPEB plan cost, we perform a sensitivity analysis. Holding all other assumptions constant, for each 50 basis point (i.e., one-half of one percent) increase in the discount rate, global pre-tax pension and OPEB plan cost would decrease by approximately $25 million, and for each 50 basis point decrease in the discount rate, global pre-tax pension and OPEB plan cost would increase by approximately $30 million.Return on Plan Assets AssumptionIn measuring the net periodic cost for 2020, we used a long-term expected rate of return of 6.5% for the pension plans covering U.S. and Puerto Rico employees. This assumption will decrease to 5.5% in 2021. This assumption is not applicable to our OPEB plan because it is not funded.We establish the long-term asset return assumption based on a review of historical compound average asset returns, both company-specific and relating to the broad market (based on our asset allocation), as well as an analysis of current market and economic information and future expectations. The current asset return assumption is supported by historical market experience for both our actual and targeted asset allocation. In calculating net pension cost, the expected return on assets is applied to a calculated value of plan assets, which recognizes changes in the fair value of plan assets in a systematic manner over five years. The difference between this expected return and the actual return on plan assets is a component of the total net unrecognized gain or loss and is subject to amortization in the future.To understand the impact of changes in the expected asset return assumption on net cost, we perform a sensitivity analysis. Holding all other assumptions constant, for each 50 basis point increase (decrease) in the asset return assumption, global pre-tax pension plan cost would decrease (increase) by approximately $15 million.Other AssumptionsFor the U.S. and Puerto Rico plans, we used the Pri-2012 combined mortality table with improvements projected using the MP-2019 projection scale adjusted to a long-term improvement of 0.8% as of December 31, 2020. For all other pension plans, we utilized country- and region-specific mortality tables to calculate the plans’ benefit obligations. We periodically analyze and update our assumptions concerning demographic factors such as retirement, mortality and turnover, considering historical experience as well as anticipated future trends.The assumptions relating to employee compensation increases and future healthcare costs are based on historical experience, market trends, and anticipated future company actions. Deferred Tax Asset Valuation Allowances, Reserves for Uncertain Tax Positions and Tax ReformWe maintain valuation allowances unless it is more likely than not that all or a portion of the deferred tax asset will be realized. Changes in valuation allowances are included in our tax provision in the period of change. In determining whether a valuation allowance is warranted, we evaluate factors such as prior earnings history, 43expected future earnings, carryback and carryforward periods, and tax strategies that could potentially enhance the likelihood of realization of a deferred tax asset. The realizability assessments made at a given balance sheet date are subject to change in the future, particularly if earnings of a subsidiary are significantly higher or lower than expected, or if we take operational or tax planning actions that could impact the future taxable earnings of a subsidiary.In the normal course of business, we are audited by federal, state and foreign tax authorities, and are periodically challenged regarding the amount of taxes due. These challenges relate to the timing and amount of deductions and the allocation of income among various tax jurisdictions. We believe our tax positions comply with applicable tax law and we intend to defend our positions. In evaluating the exposure associated with various tax filing positions, we record reserves for uncertain tax positions in accordance with U.S. GAAP based on the technical support for the positions, our past audit experience with similar situations, and potential interest and penalties related to the matters. Our results of operations and effective tax rate in a given period could be impacted if, upon final resolution with taxing authorities, we prevail in positions for which reserves have been established, or we are required to pay amounts in excess of established reserves.On December 22, 2017, the 2017 Tax Act was enacted into law and the new legislation contains several key tax provisions that affected us, including a one-time mandatory transition tax on accumulated foreign earnings and a reduction of the U.S. corporate income tax rate to 21% effective January 1, 2018, among others. We were required to recognize the effect of the tax law changes in the period of enactment, such as determining the transition tax, remeasuring our U.S. deferred tax assets and liabilities and reassessing the realizability of our deferred tax assets. In December 2017, the SEC staff issued SAB 118 which allowed us to record provisional amounts during a measurement period not to extend beyond one year of the enactment date. We updated our accounting for the initial impact of the 2017 Tax Act in 2018 in accordance with the guidance in SAB 118. Refer to Note 12 within Item 8 of this Annual Report on Form 10-K for further information.Valuation of Intangible Assets, Including IPR&D We record acquired intangible assets at fair value in business combinations and at cost in asset acquisitions. Valuations are generally completed for intangible assets acquired in business acquisitions using a discounted cash flow analysis, incorporating the stage of completion and consideration of market participant assumptions. The most significant estimates and assumptions inherent in a discounted cash flow analysis include the amount and timing of projected future cash flows, the discount rate used to measure the risks inherent in the future cash flows, the assessment of the asset’s life cycle, and the competitive and other trends impacting the asset, including consideration of technical, legal, regulatory, economic and other factors. Each of these factors and assumptions can significantly affect the value of the intangible asset.Acquired in-process R&D (IPR&D) is the value assigned to acquired technology or products under development which have not received regulatory approval and have no alternative future use. IPR&D acquired in a business combination is capitalized as an indefinite-lived intangible asset. Development costs incurred after the acquisition are expensed as incurred. Upon receipt of regulatory approval of the related technology or product, the indefinite-lived intangible asset is then accounted for as a finite-lived intangible asset and amortized on a straight-line basis over its estimated useful life. If the R&D project is abandoned, the indefinite-lived intangible asset is charged to expense.IPR&D acquired in transactions that are not business combinations is expensed immediately. For such transactions, payments made to third parties on or after regulatory approval are capitalized as intangible assets and amortized over the remaining useful life of the related asset.Due to the inherent uncertainty associated with R&D projects, there is no assurance that actual results will not differ materially from the underlying assumptions used to prepare discounted cash flow analyses, nor that the R&D project will result in a successful commercial product.Due to a change in the timing and amount of projected cash flows associated with $140 million of acquired in-process R&D intangible assets from a historical acquisition, we updated the estimated fair values of these assets in 2020. While no impairment has been recorded because the estimated fair values of those assets exceeded their carrying values, the estimated excess of fair value over carrying value of these assets declined in 2020 and are at risk of future impairment should the estimated timing or amount of projected cash flows further deteriorate. 44CERTAIN REGULATORY MATTERS The U.S. Food and Drug Administration (FDA) commenced an inspection of Claris’ facilities in Ahmedabad, India in July 2017, immediately prior to the closing of the Claris acquisition. FDA completed the inspection and subsequently issued a Warning Letter based on observations identified in the 2017 inspection (Claris Warning Letter).¹ FDA has not yet re-inspected the facilities and management cannot speculate on when the Claris Warning Letter will be lifted. However, we are continuing to implement corrective and preventive actions to address FDA’s prior observations and other items we identified and management continues to pursue and implement other manufacturing locations, including contract manufacturing organizations, to support the production of new products for distribution in the U.S. As of December 31, 2020, we have secured alternative locations to produce a majority of the planned new products to be manufactured in Ahmedabad for distribution into the U.S.On May 6, 2019, we received a Show Cause Notice under the Drugs & Cosmetics Act, 1940 and Rules thereunder (Show Cause Notice) from the Commissioner of the Food & Drugs Control Administration in the Gujarat State in Gandhinagar, India (Commissioner). The Show Cause Notice was issued regarding an April 9, 2019 inspection of our Claris facilities in Ahmedabad, India by the Commissioner. The Show Cause Notice contained a number of observations of alleged Good Manufacturing Practice related issues across a variety of areas, some of which overlap with the areas covered in the Claris Warning Letter. We responded to the Show Cause Notice and a follow up inspection occurred in July 2019. This matter resulted in a two-day suspension order for certain manufacturing operations, which occurred on March 19 and 20, 2020. This matter is now closed.Refer to Item 1A of this Annual Report on Form 10-K for additional discussion of regulatory matters and how they may impact us.1 Available online at https://www.fda.gov/ICECI/EnforcementActions/WarningLetters/ucm613538.htmFORWARD-LOOKING INFORMATIONThis annual report includes forward-looking statements. Use of the words “may,” “will,” “would,” “could,” “should,” “believes,” “estimates,” “projects,” “potential,” “expects,” “plans,” “seeks,” “intends,” “evaluates,” “pursues,” “anticipates,” “continues,” “designs,” “impacts,” “affects,” “forecasts,” “target,” “outlook,” “initiative,” “objective,” “designed,” “priorities,” “goal,” or the negative of those words or other similar expressions is intended to identify forward-looking statements that represent our current judgment about possible future events. These forward-looking statements may include statements with respect to accounting estimates and assumptions, impacts of the COVID-19 pandemic, litigation-related matters including outcomes, impacts of the internal investigation related to foreign exchange gains and losses, future regulatory filings and our R&D pipeline, strategic objectives, sales from new product offerings, credit exposure to foreign governments, potential developments with respect to credit ratings, investment of foreign earnings, estimates of liabilities including those related to uncertain tax positions, contingent payments, future pension plan contributions, costs, discount rates and rates of return, our exposure to financial market volatility and foreign currency and interest rate risks, potential tax liabilities associated with the separation of our biopharmaceuticals business from our medical products businesses, the impact of competition, future sales growth, business development activities (including the acquisitions of Cheetah and Seprafilm and the proposed acquisitions of Caelyx and Doxil and Transderm Scop), business optimization initiatives, cost saving initiatives, future capital and R&D expenditures, future debt issuances, manufacturing expansion, the sufficiency of our facilities and financial flexibility, the adequacy of credit facilities, tax provisions and reserves, the effective tax rate and all other statements that do not relate to historical facts.These forward-looking statements are based on certain assumptions and analyses made in light of our experience and perception of historical trends, current conditions, and expected future developments as well as other factors that we believe are appropriate in the circumstances. While these statements represent our judgment on what the future may hold, and we believe these judgments are reasonable, these statements are not guarantees of any events or financial results. Whether actual future results and developments will conform to expectations and predictions is subject to a number of risks and uncertainties, including the following factors, many of which are beyond our control:45•demand for, market acceptance risks for and competitive pressures related to new and existing products (including challenges with our ability to accurately predict these pressures and the resulting impact on customer inventory levels and the impact of reduced hospital admission rates and elective surgery volumes), and the impact of those products on quality and patient safety concerns;•product development risks, including satisfactory clinical performance, the ability to manufacture at appropriate scale, and the general unpredictability associated with the product development cycle;•our ability to finance and develop new products or enhancements on commercially acceptable terms or at all;•our ability to identify business development and growth opportunities and to successfully execute on business development strategies;•product quality or patient safety issues, leading to product recalls, withdrawals, launch delays, warning letters, import bans, sanctions, seizures, litigation, or declining sales;•the impact of global economic conditions (including potential trade wars) and pandemics, epidemics or other public health crises, such as COVID-19, on us and our customers and suppliers, including foreign governments in countries in which we operate;•the continuity, availability and pricing of acceptable raw materials and component supply, and the related continuity of our manufacturing and distribution;•inability to create additional production capacity in a timely manner or the occurrence of other manufacturing, sterilization or supply difficulties (including as a result of natural disaster, public health crises and epidemics/pandemics, regulatory actions or otherwise);•breaches or failures of our information technology systems or products, including by cyber-attack, data leakage, unauthorized access or theft (as a result of increased remote working arrangements or otherwise);•future actions of (or failures to act or delays in acting by) FDA, the European Medicines Agency or any other regulatory body or government authority (including the SEC, DOJ or the Attorney General of any State) that could delay, limit or suspend product development, manufacturing or sale or result in seizures, recalls, injunctions, monetary sanctions or criminal or civil liabilities, including the continued delay in lifting the warning letter at our Ahmedabad facility or proceedings related to the misstatements in previously reported non-operating income related to foreign exchange gains and losses;•developments that would require the correction of additional misstatements in our previously issued financial statements;•failures with respect to our quality, compliance or ethics programs;46•future actions of third parties, including third-party payers, the impact of healthcare reform and its implementation, suspension, repeal, replacement, amendment, modification and other similar actions undertaken by the United States or foreign governments, including with respect to pricing, reimbursement, taxation and rebate policies; legislation, regulation and other governmental pressures in the United States or globally, including the cost of compliance and potential penalties for purported noncompliance thereof, all of which may affect pricing, reimbursement, taxation and rebate policies of government agencies and private payers or other elements of our business, including new or amended laws, rules and regulations (such as the California Consumer Privacy Act of 2018, the European Union’s General Data Protection Regulation and proposed regulatory changes of the U.S. Department of Health and Human Services in kidney health policy and reimbursement, which may substantially change the U.S. end stage renal disease market and demand for our peritoneal dialysis products, necessitating significant multi-year capital expenditures, which are difficult to estimate in advance, for example);•the outcome of pending or future litigation or government investigations, including the opioid litigation and litigation related to the internal investigation of foreign exchange gains and losses;•the impact of competitive products and pricing, including generic competition, drug reimportation and disruptive technologies;•global regulatory, trade and tax policies;•the ability to protect or enforce our owned or in-licensed patent or other proprietary rights (including trademarks, copyrights, trade secrets and know-how) or patents of third parties preventing or restricting our manufacture, sale or use of affected products or technology;•the impact of any goodwill or other intangible asset impairments on our operating results;•any failure by Baxalta or Shire to satisfy its obligations under the separation agreements, including the tax matters agreement, or that certain letter agreement entered into with Shire and Baxalta;•fluctuations in foreign exchange and interest rates;•any changes in law concerning the taxation of income (whether with respect to current or future tax reform), including income earned outside the United States and potential taxes associated with the Base Erosion and Anti-Abuse Tax;•actions by tax authorities in connection with ongoing tax audits;•loss of key employees or inability to identify and recruit new employees;•other factors identified elsewhere in this Annual Report on Form 10-K including those factors described in Item 1A and other filings with the SEC, all of which are available on our website.Actual results may differ materially from those projected in the forward-looking statements. We do not undertake to update our forward-looking statements.Item 7A. Quantitative and Qualitative Disclosures About Market Risk.Incorporated by reference to the section entitled “Financial Instrument Market Risk” in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Item 7 of this Annual Report on Form 10-K.47
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+Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations Results of Operations Net earnings attributable to Berkshire Hathaway shareholders for each of the past three years are disaggregated in the table that follows. Amounts are after deducting income taxes and exclude earnings attributable to noncontrolling interests (in millions). 2020 2019 2018 Insurance – underwriting $ 657 $ 325 $ 1,566 Insurance – investment income 5,039 5,530 4,554 Railroad 5,161 5,481 5,219 Utilities and energy 3,091 2,840 2,621 Manufacturing, service and retailing 8,300 9,372 9,364 Investment and derivative gains/losses 31,591 57,445 (17,737 ) Other* (11,318 ) 424 (1,566 ) Net earnings attributable to Berkshire Hathaway shareholders $ 42,521 $ 81,417 $ 4,021 * Includes goodwill and indefinite-lived intangible asset impairment charges of $11.0 billion in 2020, $435 million in 2019 and $3.0 billion in 2018, which includes our share of charges recorded by Kraft Heinz. Through our subsidiaries, we engage in a number of diverse business activities. We manage our operating businesses on an unusually decentralized basis. There are few centralized or integrated business functions. Our senior corporate management team participates in and is ultimately responsible for significant capital allocation decisions, investment activities and the selection of the Chief Executive to head each of the operating businesses. The business segment data (Note 27 to the accompanying Consolidated Financial Statements) should be read in conjunction with this discussion. As the COVID-19 pandemic accelerated beginning in the second half of March, most of our businesses were negatively affected, with the effects to date ranging from relatively minor to severe. Revenues and earnings of most of our manufacturing, service and retailing businesses declined considerably, and in certain instances severely, in the second quarter due to closures of facilities where crowds gather, such as retail stores, restaurants and entertainment venues as well as from public travel restrictions and from closures of certain of our businesses. In each of the third and fourth quarters of 2020, several of these businesses experienced significant increases in revenues and earnings as compared to the second quarter. Our businesses that were deemed essential continued to operate through the pandemic, including our railroad, utilities and energy, insurance and certain of our manufacturing, wholesale distribution and service businesses. In response to the effects of the pandemic, our businesses implemented various business continuity plans to protect our employees and customers. Such plans include a variety of actions, such as temporarily closing certain retail stores, manufacturing facilities and service centers of businesses that were not subject to government mandated closure. Our businesses also implemented practices to protect employees while at work. Such practices included work-from-home, staggered or reduced work schedules, increased cleaning and sanitation of workspaces, providing employee health screenings, eliminating non-essential travel and face-to-face meetings and providing general health reminders intended to lower the risk of spreading COVID-19. We also took actions in response to the economic losses from reductions in consumer demand for products and services we offer and our temporary inability to produce goods and provide services at certain of our businesses. These actions included employee furloughs, wage and salary reductions, capital spending reductions and other actions intended to help mitigate the economic losses and preserve capital and liquidity. Certain of our businesses undertook and may continue to undertake restructuring activities to resize their operations to better fit expected customer demand. We cannot reliably predict future economic effects of the pandemic or when business activities at all of our numerous and diverse operations will normalize. Nor can we predict how these events will alter the future consumption patterns of consumers and businesses we serve. Our insurance businesses generated after-tax earnings from underwriting of $657 million in 2020, $325 million in 2019 and $1.6 billion in 2018. In each year, we generated underwriting earnings from primary insurance and underwriting losses from reinsurance. Insurance underwriting results included after-tax losses from significant catastrophe events of approximately $750 million in 2020, $800 million in 2019 and $1.3 billion in 2018. Underwriting results in 2020 also reflected the effects of the pandemic, arising from premium reductions from the GEICO Giveback program, reduced claims frequencies for private passenger automobile insurance and increased loss estimates for certain commercial insurance and property and casualty reinsurance business. K-33 Management’s Discussion and Analysis (Continued) Results of Operations (Continued) After-tax earnings from insurance investment income in 2020 declined $491 million (8.9%) versus 2019, reflecting lower interest income primarily attributable to declines in interest rates on our substantial holdings of cash and U.S. Treasury Bills. After-tax earnings from insurance investment income in 2019 increased 21.4% over 2018, attributable to increases in interest and dividend income. After-tax earnings of our railroad business decreased 5.8% in 2020 as compared to 2019. Earnings in 2020 reflected lower railroad operating revenues from lower shipping volumes, attributable to the negative effects of the COVID-19 pandemic, partly offset by lower operating costs and the effects of productivity improvements. After-tax earnings of our utilities and energy business increased 8.8% as compared to 2019. The increase reflected increased tax benefits from renewable energy and increased earnings from the real estate brokerage business. Earnings in 2020 from our manufacturing, service and retailing businesses declined 11.4% versus 2019. The effects of the COVID-19 pandemic varied among our manufacturing businesses relative to significance and duration. Other earnings included after-tax goodwill and indefinite-lived intangible asset impairment charges of $11.0 billion in 2020, $435 million in 2019 and $3.0 billion in 2018. Such amounts included our share of impairment charges recorded by Kraft Heinz. Approximately $9.8 billion of the charges in 2020 were attributable to impairments of goodwill and identifiable intangible assets recorded in connection with Berkshire’s acquisition of Precision Castparts in 2016. Other earnings in 2020 also included after-tax foreign exchange rate losses of $764 million related to non-U.S. Dollar denominated debt issued by Berkshire and its U.S.-based finance subsidiary, Berkshire Hathaway Finance Corporation (“BHFC”). After-tax earnings of our railroad business increased 5.0% in 2019 compared to 2018. Earnings in 2019 benefitted from higher rates per car/unit, a curtailment gain related to an amendment to defined benefit retirement plans and ongoing operating cost control initiatives, partly offset by lower freight volumes and incremental costs associated with the persistent flooding conditions and severe winter weather in the first half of 2019. After-tax earnings of our utilities and energy business increased 8.4% in 2019 compared to 2018. Earnings from our manufacturing, service and retailing businesses in 2019 were relatively unchanged from 2018, reflecting mixed operating results with several of these businesses experiencing lower earnings in 2019 from a variety of factors. Revenues and pre-tax earnings in 2019 of certain of these businesses were negatively affected by the unfavorable effects of foreign currency translation attributable to a stronger U.S. Dollar, international trade tensions and U.S. trade tariffs. Investment and derivative gains/losses in each of the three years presented included significant gains and losses on our investments in equity securities, including unrealized gains and losses from market price changes on securities we continue to hold. We believe that investment and derivative gains/losses, whether realized from dispositions or unrealized from changes in market prices of equity securities, are generally meaningless in understanding our reported results or evaluating the economic performance of our businesses. These gains and losses have caused and will continue to cause significant volatility in our periodic earnings. Insurance—Underwriting Our management views our insurance businesses as possessing two distinct activities – underwriting and investing. Underwriting decisions are the responsibility of the unit managers, while investing decisions are the responsibility of Berkshire’s Chairman and CEO, Warren E. Buffett and Berkshire’s corporate investment managers. Accordingly, we evaluate performance of underwriting operations without any allocation of investment income or investment gains/losses. We consider investment income as an integral component of our aggregate insurance operating results. However, we consider investment gains and losses, whether realized or unrealized as non-operating, based on our long-held strategy of acquiring securities and holding those securities for long periods. We believe that such gains and losses are not meaningful in understanding the operating results of our insurance businesses. The timing and amount of catastrophe losses can produce significant volatility in our periodic underwriting results, particularly with respect to our reinsurance businesses. Generally, we consider pre-tax losses in excess of $100 million from a current year catastrophic event to be significant. Changes in estimates for unpaid losses and loss adjustment expenses, including amounts established for occurrences in prior years, can also significantly affect our periodic underwriting results. Unpaid loss estimates, including estimates under retroactive reinsurance contracts, were approximately $120.8 billion as of December 31, 2020. Our periodic underwriting results may also include significant foreign currency transaction gains and losses arising from the changes in the valuation of non-U.S. Dollar denominated liabilities of our U.S. based insurance subsidiaries due to foreign currency exchange rate fluctuations. K-34 Management’s Discussion and Analysis (Continued) Insurance—Underwriting (Continued) Underwriting results in 2020 of certain of our commercial insurance and reinsurance businesses were negatively affected by estimated losses and costs associated with the COVID-19 pandemic, including estimated provisions for claims and uncollectible premiums and incremental operating costs to maintain customer service levels. The effects of the pandemic in the future may be further affected by judicial rulings and regulatory and legislative actions pertaining to insurance coverage and claims and by its effects on general economic activity, which we cannot reasonably estimate at this time. We provide primary insurance and reinsurance products covering property and casualty risks, as well as life and health risks. Our insurance and reinsurance businesses are GEICO, Berkshire Hathaway Primary Group and Berkshire Hathaway Reinsurance Group (“BHRG”). Underwriting results of our insurance businesses are summarized below (dollars in millions). 2020 2019 2018 Pre-tax underwriting earnings (loss): GEICO $ 3,428 $ 1,506 $ 2,449 Berkshire Hathaway Primary Group 110 383 670 Berkshire Hathaway Reinsurance Group (2,700 ) (1,472 ) (1,109 ) Pre-tax underwriting earnings 838 417 2,010 Income taxes and noncontrolling interests 181 92 444 Net underwriting earnings $ 657 $ 325 $ 1,566 Effective income tax rate 21.5 % 24.2 % 21.4 % GEICO GEICO writes private passenger automobile insurance, offering coverages to insureds in all 50 states and the District of Columbia. GEICO markets its policies mainly by direct response methods where most customers apply for coverage directly to the company via the Internet or over the telephone. A summary of GEICO’s underwriting results follows (dollars in millions). 2020 2019 2018 Amount % Amount % Amount % Premiums written $ 34,928 $ 36,016 $ 34,123 Premiums earned $ 35,093 100.0 $ 35,572 100.0 $ 33,363 100.0 Losses and loss adjustment expenses 26,018 74.1 28,937 81.3 26,278 78.8 Underwriting expenses 5,647 16.1 5,129 14.5 4,636 13.9 Total losses and expenses 31,665 90.2 34,066 95.8 30,914 92.7 Pre-tax underwriting earnings $ 3,428 $ 1,506 $ 2,449 2020 versus 2019 GEICO’s pre-tax underwriting earnings for 2020 reflected significant declines in losses and loss adjustment expenses attributable to lower claims frequencies from the effects of less driving by policyholders during the COVID-19 pandemic offset by the effects of the GEICO Giveback program (see following paragraph) on earned premiums. Premiums written decreased 3.0% compared to 2019. The GEICO Giveback program provided for a 15% premium credit to all voluntary auto and motorcycle policies renewing between April 8, 2020 and October 7, 2020, as well as to any new policies written during the same period. The GEICO Giveback program reduced premiums written in 2020 by approximately $2.9 billion. Premiums earned decreased 1.3% in 2020 compared to 2019, which included reductions of approximately $2.5 billion attributable to the GEICO Giveback program. K-35 Management’s Discussion and Analysis (Continued) Insurance—Underwriting (Continued) GEICO (Continued) Voluntary auto policies-in-force at the end of 2020 increased approximately 820,000 (4.6%) compared to the end of 2019. The increase reflected a 7.3% decrease in new business sales and a 2.5% decrease in non-renewals and policy cancellations. Losses and loss adjustment expenses decreased $2.9 billion (10.1%) in 2020 compared to 2019. GEICO’s ratio of losses and loss adjustment expenses to premiums earned (the “loss ratio”) was 74.1%, a decrease of 7.2 percentage points compared to 2019. The decrease in the loss ratio reflected declines in claims frequencies, partly offset by increases in claims severities and the impact of lower premiums earned attributable to the GEICO Giveback program. Claims frequencies in 2020 were lower for property damage, bodily injury and personal injury protection coverages (twenty-eight to thirty percent range) and collision coverage (twenty-three to twenty-four percent range) compared to 2019. Average claims severities in 2020 were higher for property damage and collision coverages (eight to ten percent range) and bodily injury coverage (twelve to thirteen percent range). Losses and loss adjustment expenses included net reductions of $253 million in 2020 for decreases in the ultimate loss estimates for prior years’ loss events compared to net increases of $42 million in 2019. Losses incurred included $81 million in 2020 from Hurricanes Laura and Sally and U.S. wildfires. There were no losses from significant catastrophe events in 2019. Underwriting expenses in 2020 increased $518 million (10.1%) compared to 2019, reflecting higher employee-related, advertising and technology costs partly offset by lower premium taxes. GEICO’s expense ratio in 2020 (underwriting expenses to premiums earned) was 16.1%, an increase of 1.6 percentage points compared to 2019. The expense ratio increase was primarily attributable to the decline in earned premiums from the GEICO Giveback program. 2019 versus 2018 Premiums written and earned in 2019 increased 5.5% and 6.6%, respectively, compared to 2018. These increases were primarily attributable to voluntary auto policies-in-force growth of 6.4%, partially offset by a decrease in average premiums per auto policy. The increase in voluntary auto policies-in-force primarily resulted from an increase in new business sales and a decrease in policies cancelled or not renewed. Voluntary auto policies-in-force increased approximately 1,068,000 during 2019. Losses and loss adjustment expenses in 2019 increased 10.1% compared to 2018. The loss ratio in 2019 was 81.3%, an increase of 2.5 percentage points over 2018, primarily due to increases in average claims severities. Average claims severities in 2019 were higher versus 2018 for property damage and collision coverages (four to six percent range) and bodily injury coverage (seven to nine percent range). Claims frequencies in 2019 declined compared to 2018 for property damage and collision coverages (two to four percent range) and personal injury protection coverage (one to two percent range) and were relatively unchanged for bodily injury coverage. Losses and loss adjustment expenses included net increases of $42 million in 2019 and net of decreases $222 million in 2018 for changes in the ultimate loss estimates for prior years’ loss events. Underwriting expenses in 2019 increased $493 million (10.6%) over 2018. GEICO’s underwriting expense ratio in 2019 was 14.5%, an increase of 0.6 percentage points compared to 2018. The underwriting expense increase was primarily attributable to increases in advertising expenses and employee-related costs, which reflected wage and staffing increases. K-36 Management’s Discussion and Analysis (Continued) Insurance—Underwriting (Continued) Berkshire Hathaway Primary Group The Berkshire Hathaway Primary Group (“BH Primary”) provides a variety of commercial insurance solutions, including healthcare malpractice, workers’ compensation, automobile, general liability, property and various specialty coverages for small, medium and large clients. The largest of these insurers are Berkshire Hathaway Specialty Insurance (“BH Specialty”), Berkshire Hathaway Homestate Companies (“BHHC”), MedPro Group, Berkshire Hathaway GUARD Insurance Companies (“GUARD”) and National Indemnity Company (“NICO Primary”). Other BH Primary insurers include U.S. Liability Insurance Company, Central States Indemnity Company and MLMIC Insurance Company (“MLMIC”), acquired October 1, 2018. A summary of BH Primary underwriting results follows (dollars in millions). 2020 2019 2018 Amount % Amount % Amount % Premiums written $ 10,212 $ 9,843 $ 8,561 Premiums earned $ 9,615 100.0 $ 9,165 100.0 $ 8,111 100.0 Losses and loss adjustment expenses 7,129 74.1 6,336 69.1 5,261 64.9 Underwriting expenses 2,376 24.7 2,446 26.7 2,180 26.9 Total losses and expenses 9,505 98.8 8,782 95.8 7,441 91.8 Pre-tax underwriting earnings $ 110 $ 383 $ 670 Premiums written increased $369 million (3.7%) in 2020 compared to 2019, reflecting increased premiums written from BH Specialty (34%) and MedPro Group (9%), partially offset by a 13% decrease in premiums written by our other primary insurers. The increase at BH Specialty was driven by increased casualty business globally and the increase at MedPro Group reflected increases across several product categories. The decline in volume by our other primary insurers was primarily due to lower workers’ compensation and commercial automobile volumes and the effect of the divestiture of Applied Underwriters in October 2019. The declines in workers’ compensation and commercial auto business written reflected the effects of reduced exposures and premium refunds related to the COVID-19 pandemic and volume reductions attributable to increased price competition in the market. Premiums written increased $1.3 billion (15.0%) in 2019 compared to 2018. The increase was attributable to higher volumes from BH Specialty, MedPro Group and GUARD, as well as from the effects of the MLMIC acquisition. These increases were partly offset by lower volume at BHHC and the effect of the Applied Underwriters divestiture. BH Primary’s combined loss ratios were 74.1% in 2020, 69.1% in 2019 and 64.9% in 2018, which reflected the effects of significant catastrophe events during the year and changes in estimated losses for prior years’ loss events. Losses and loss adjustment expenses attributable to significant catastrophe events were $207 million in 2020 (Hurricanes Laura and Sally and U.S. wildfires) and $190 million in 2018 (Hurricanes Florence and Michael and the wildfires in California). We incurred no losses from significant catastrophe events in 2019. Losses in 2020 also included $167 million attributable to the pandemic. Finally, losses and loss adjustment expenses were reduced $265 million in 2020, $499 million in 2019 and $715 million in 2018 for net reductions in estimated ultimate liabilities for prior years’ loss events. BH Primary insurers write significant levels of commercial and professional liability and workers’ compensation insurance and the related claim costs may be subject to high severity and long claim-tails. Accordingly, we could experience significant increases in claims liabilities in the future attributable to higher-than-expected claim settlements, adverse litigation outcomes or judicial rulings and other factors not currently anticipated. Berkshire Hathaway Reinsurance Group We offer excess-of-loss and quota-share reinsurance coverages on property and casualty risks and life and health reinsurance to insurers and reinsurers worldwide through several subsidiaries, led by National Indemnity Company (“NICO”), Berkshire Hathaway Life Insurance Company of Nebraska (“BHLN”) and General Reinsurance Corporation, General Reinsurance AG and General Re Life Corporation (collectively, “General Re”). We also periodically assume property and casualty risks under retroactive reinsurance contracts written through NICO. In addition, we write periodic payment annuity contracts predominantly through BHLN. K-37 Management’s Discussion and Analysis (Continued) Insurance—Underwriting (Continued) Berkshire Hathaway Reinsurance Group (Continued) Generally, we strive to generate underwriting profits. However, time-value-of-money concepts are important elements in establishing prices for retroactive reinsurance and periodic payment annuity businesses due to the expected long durations of the liabilities. We expect to incur pre-tax underwriting losses from such businesses, primarily through deferred charge amortization and discount accretion charges. We receive premiums at the inception of these contracts, which are then available for investment. A summary of BHRG’s premiums and pre-tax underwriting results follows (dollars in millions). Premiums written Premiums earned Pre-tax underwriting earnings (loss) 2020 2019 2018 2020 2019 2018 2020 2019 2018 Property/casualty $ 13,295 $ 10,428 $ 9,413 $ 12,214 $ 9,911 $ 8,928 $ (799 ) $ 16 $ (207 ) Life/health 5,848 4,963 5,430 5,861 4,869 5,327 (18 ) 159 182 Retroactive reinsurance 38 684 517 38 684 517 (1,248 ) (1,265 ) (778 ) Periodic payment annuity 566 863 1,156 566 863 1,156 (617 ) (549 ) (340 ) Variable annuity 14 14 16 14 14 16 (18 ) 167 34 $ 19,761 $ 16,952 $ 16,532 $ 18,693 $ 16,341 $ 15,944 $ (2,700 ) $ (1,472 ) $ (1,109 ) Property/casualty A summary of property/casualty reinsurance underwriting results follows (dollars in millions). 2020 2019 2018 Amount % Amount % Amount % Premiums written $ 13,295 $ 10,428 $ 9,413 Premiums earned $ 12,214 100.0 $ 9,911 100.0 $ 8,928 100.0 Losses and loss adjustment expenses 9,898 81.0 7,313 73.8 6,929 77.6 Underwriting expenses 3,115 25.5 2,582 26.0 2,206 24.7 Total losses and expenses 13,013 106.5 9,895 99.8 9,135 102.3 Pre-tax underwriting earnings (loss) $ (799 ) $ 16 $ (207 ) Premiums written in 2020 increased $2.9 billion (27.5%) compared to 2019. The increase was primarily attributable to new business, including a small number of contracts with very large premiums, and increased participations on renewals. Premiums written in 2019 increased $1.0 billion (10.8%) compared to 2018. The increase was primarily attributable to new business, net of non-renewals, and increased participations on renewal business, partly offset by the unfavorable foreign currency translation effects of a stronger U.S. Dollar. Underwriting earnings in 2020 were negatively affected by an increase in losses and loss adjustment expenses of $2.6 billion (35.3%). The loss ratio in 2020 was 81.0%, an increase of 7.2 percentage points over 2019. Losses and loss adjustment expenses in 2020 included estimated losses of $964 million attributable to the COVID-19 pandemic and estimated losses from significant catastrophe events of $667 million from Hurricanes Laura and Sally and U.S. wildfires. Losses and loss adjustment expenses also reflected net increases in estimated ultimate liabilities for prior years’ loss events of $162 million in 2020 primarily attributable to legacy environmental, asbestos and other latent injury claims. Such amount as a percentage of the related net unpaid claim liabilities as of the beginning of 2020 was 0.5%. BHRG’s loss ratio was 73.8% in 2019 and 77.6% in 2018. Losses in 2019 included approximately $1.0 billion from Typhoons Faxia and Hagibis and various U.S. and non-U.S. wildfires, while losses in 2018 included approximately $1.3 billion from Hurricanes Florence and Michael, Typhoon Jebi and wildfires in California. Losses and loss adjustment expenses also included net decreases of $295 million in 2019 and $469 million in 2018 for prior years’ loss events. Such amounts as percentages of the related net unpaid claim liabilities as of the beginning of the applicable year were 1.0% in 2019 and 1.7% in 2018. Underwriting expenses are primarily commissions and brokerage costs. Underwriting expenses in 2020 increased $533 million (20.6%) over 2019, and underwriting expenses in 2019 increased $376 million (17.0%) over 2018. The increases reflected the increases in premium volumes and changes in business mix. K-38 Management’s Discussion and Analysis (Continued) Insurance—Underwriting (Continued) Life/health A summary of our life/health reinsurance underwriting results follows (dollars in millions). 2020 2019 2018 Amount % Amount % Amount % Premiums written $ 5,848 $ 4,963 $ 5,430 Premiums earned $ 5,861 100.0 $ 4,869 100.0 $ 5,327 100.0 Life and health insurance benefits 4,883 83.3 3,800 78.0 4,240 79.6 Underwriting expenses 996 17.0 910 18.7 905 17.0 Total benefits and expenses 5,879 100.3 4,710 96.7 5,145 96.6 Pre-tax underwriting earnings (loss) $ (18 ) $ 159 $ 182 Life/health premiums written increased $885 million (17.8%) in 2020 compared to 2019. Approximately $480 million of the increase was attributable to a reinsurance contract covering U.S. health insurance risks that incepted in the fourth quarter of 2019, which was not renewed for 2021. The remainder of the increase was primarily from volume growth in the Asian and European life reinsurance markets. Underwriting earnings in 2020 were negatively affected by increased life benefits from COVID-19-related claims (approximately $275 million) and continuing losses from increased liabilities from changes in underlying assumptions with respect to disability benefit liabilities in Australia, which were mostly offset by lower other life claims and reduced losses from U.S. long-term care business that is in run-off. The ratio of life and health insurance benefits to premiums earned was 83.3% in 2020 and 81.5% in 2019, which is before the effects of the BHLN contract amendment referred to below. Life/health premiums written in 2019 decreased $467 million (8.6%) compared to 2018. In the first quarter of 2019, BHLN amended a yearly-renewable-term life reinsurance contract with a major reinsurer. BHLN recorded a reduction in earned premiums on this contract in 2019 of $49 million, while premiums earned in 2018 related to this contract were $954 million. In 2019, premiums earned also included $228 million from a new health reinsurance contract and reflected volume growth in life markets, partially offset by the unfavorable effects of foreign currency translation attributable to a stronger U.S. Dollar. Underwriting earnings in 2019 included a one-time gain of $163 million attributable to the BHLN yearly-renewable-term life reinsurance contract amendment. Pre-tax underwriting earnings in 2019 also included losses from increased disability benefit liabilities in Australia, attributable to higher claims experience and changes to various underlying assumptions increased U.S. long-term care liabilities due to discount rate reductions and changes in other actuarial assumptions, and an increase in life claims in North America, partially offset by increased earnings from other international life business. Retroactive reinsurance There were no significant retroactive reinsurance contracts written in 2020. Premiums written were $684 million in 2019 and $517 million in 2018, attributable to a limited number of contracts in each year. Pre-tax underwriting losses in each year derived from deferred charge amortization and changes in the estimated timing and amounts of future claim payments. Underwriting results also include foreign currency exchange gains and losses from the effects of changes in foreign currency exchange rates on non-U.S. Dollar denominated liabilities of our U.S. subsidiaries. Underwriting results included pre-tax foreign currency losses of $139 million in 2020 and $76 million in 2019 and pre-tax gains of $169 million in 2018. Pre-tax underwriting losses before foreign currency gains/losses were $1.1 billion in 2020, $1.2 billion in 2019 and $947 million in 2018. Overall, we decreased estimated ultimate liabilities $399 million in 2020 for prior years’ contracts compared to an increase of $378 million in 2019. After adjustments to the related unamortized deferred charges from changes in the estimated timing and amount of the future claim payments, such changes produced pre-tax underwriting earnings of approximately $230 million in 2020 and pre-tax losses of $125 million in 2019. Gross unpaid losses assumed under retroactive reinsurance contracts were $41.0 billion at December 31, 2020 and $42.4 billion at December 31, 2019. Unamortized deferred charge assets related to such reinsurance contracts were $12.4 billion at December 31, 2020 and $13.7 billion at December 31, 2019. Deferred charge assets will be charged to earnings over the expected remaining claims settlement periods through periodic amortization. K-39 Management’s Discussion and Analysis (Continued) Insurance—Underwriting (Continued) Periodic payment annuity Periodic payment annuity premiums earned in 2020 decreased $297 million (34.4%) compared to 2019, which decreased $293 million (25.3%) from 2018. Periodic payment annuity business is price sensitive. The volumes written can change rapidly due to changes in prices, which are affected by prevailing interest rates, the perceived risks and durations associated with the expected annuity payments, as well as the level of competition. Periodic payment annuity contracts normally produce pre-tax underwriting losses deriving from the recurring discount accretion of annuity liabilities. Underwriting results also include gains or losses from the effects of changes in mortality and interest rates and from foreign currency exchange rate changes on non-U.S. Dollar denominated liabilities of our U.S. subsidiaries. Pre-tax underwriting results included foreign currency losses of $67 million in 2020 and $40 million in 2019 compared to pre-tax gains of $93 million in 2018. Excluding foreign currency gains/losses, pre-tax underwriting losses from periodic payment annuity contracts were $550 million in 2020, $509 million in 2019 and $433 million in 2018. These losses primarily derived from the recurring discount accretion of annuity liabilities, as well as from the impact of mortality and interest rate changes. Discounted annuity liabilities were $14.3 billion at December 31, 2020 and $13.5 billion at December 31, 2019. The weighted average discount rate was approximately 4.0%. Variable annuity Variable annuity guarantee reinsurance contracts produced pre-tax losses of $18 million in 2020 compared to pre-tax earnings of $167 million in 2019 and $34 million in 2018. The results of this business reflect changes in remaining liabilities for underlying guaranteed benefits reinsured, which are affected by changes in securities markets and interest rates and from the periodic amortization of expected profit margins. Underwriting results from these contracts can be volatile, reflecting the volatility of securities markets, interest rates and foreign currency exchange rates. Insurance—Investment Income A summary of net investment income attributable to our insurance operations follows (dollars in millions). Percentage change 2020 2019 2018 2020 vs 2019 2019 vs 2018 Interest and other investment income $ 1,059 $ 2,075 $ 1,851 (49.0 )% 12.1 % Dividend income 4,890 4,525 3,652 8.1 23.9 Pre-tax net investment income 5,949 6,600 5,503 (9.9 ) 19.9 Income taxes and noncontrolling interests 910 1,070 949 Net investment income $ 5,039 $ 5,530 $ 4,554 Effective income tax rate 15.3 % 16.1 % 17.2 % Interest and other investment income declined $1.0 billion (49.0%) in 2020 compared to 2019, primarily due to lower income from short-term investments. We continue to hold substantial balances of cash, cash equivalents and short-term U.S. Treasury Bills. Short-term interest rates declined over the second half of 2019 and the decline continued throughout 2020, which resulted in significantly lower interest income. We expect such rates, which are historically low, to remain low, negatively affecting our earnings from such investments in 2021. Nevertheless, we believe that maintaining ample liquidity is paramount and we insist on safety over yield with respect to short-term investments. K-40 Management’s Discussion and Analysis (Continued) Insurance—Investment Income (Continued) Dividend income increased $365 million (8.1%) in 2020 compared to 2019. The increase was primarily attributable to dividends from the investment in $10 billion liquidation value of 8% cumulative preferred stock of Occidental Petroleum Corporation (“Occidental”) on August 8, 2019, partly offset by lower dividends from common stock investments. Interest and other investment income increased $224 million (12.1%) in 2019 compared to 2018, primarily due to higher interest rates on short-term investments and interest from a term loan with Seritage Growth Properties, partially offset by lower income earned from fixed maturity securities and limited partnership investments. Dividend income increased $873 million (23.9%) in 2019 compared to 2018. The increase in dividend income was attributable to an overall increase in investment levels, including the investment in Occidental and increased dividends from common stock investments. Invested assets of our insurance businesses derive from shareholder capital, including reinvested earnings, and from net liabilities under insurance and reinsurance contracts or “float.” The major components of float are unpaid losses and loss adjustment expenses, including liabilities under retroactive reinsurance contracts, life, annuity and health insurance benefit liabilities, unearned premiums and other liabilities due to policyholders, which are reduced by insurance premiums and reinsurance receivables, deferred charges assumed under retroactive reinsurance contracts and deferred policy acquisition costs. Float approximated $138 billion at December 31, 2020, $129 billion at December 31, 2019 and $123 billion at December 31, 2018. Our combined insurance operations generated pre-tax underwriting earnings of approximately $838 million in 2020, $417 million in 2019 and $2.0 billion in 2018, and consequently, the average cost of float for each of those periods was negative. A summary of cash and investments held in our insurance businesses as of December 31, 2020 and 2019 follows (in millions). December 31, 2020 2019 Cash, cash equivalents and U.S. Treasury Bills $ 67,082 $ 64,908 Equity securities 269,498 240,126 Fixed maturity securities 20,317 18,537 Other 6,220 2,481 $ 363,117 $ 326,052 Fixed maturity investments as of December 31, 2020 were as follows (in millions). Amortized cost Unrealized gains/losses Carrying value U.S. Treasury, U.S. government corporations and agencies $ 3,339 $ 55 $ 3,394 Foreign governments 11,232 105 11,337 Corporate bonds 4,678 462 5,140 Other 382 64 446 $ 19,631 $ 686 $ 20,317 U.S. government obligations are rated AA+ or Aaa by the major rating agencies. Approximately 88% of all foreign government obligations were rated AA or higher by at least one of the major rating agencies. Foreign government securities include obligations issued or unconditionally guaranteed by national or provincial government entities. K-41 Management’s Discussion and Analysis (Continued) Railroad (“Burlington Northern Santa Fe”) Burlington Northern Santa Fe, LLC (“BNSF”) operates one of the largest railroad systems in North America, with approximately 32,500 route miles of track in 28 states. BNSF also operates in three Canadian provinces. BNSF classifies its major railroad business groups by type of product shipped which includes consumer products, industrial products, agricultural products and coal. A summary of BNSF’s earnings follows (dollars in millions). Percentage change 2020 2019 2018 2020 vs 2019 2019 vs 2018 Railroad operating revenues $ 20,181 $ 22,745 $ 22,999 (11.3 )% (1.1 )% Railroad operating expenses: Compensation and benefits 4,542 5,270 5,322 (13.8 ) (1.0 ) Fuel 1,789 2,944 3,346 (39.2 ) (12.0 ) Purchased services 1,954 2,049 2,131 (4.6 ) (3.8 ) Depreciation and amortization 2,460 2,389 2,306 3.0 3.6 Equipment rents, materials and other 1,684 2,028 2,110 (17.0 ) (3.9 ) Total 12,429 14,680 15,215 (15.3 ) (3.5 ) Railroad operating earnings 7,752 8,065 7,784 (3.9 ) 3.6 Other revenues (expenses): Other revenues 688 770 856 (10.6 ) (10.0 ) Other expenses, net (611 ) (515 ) (736 ) 18.6 (30.0 ) Interest expense (1,037 ) (1,070 ) (1,041 ) (3.1 ) 2.8 Pre-tax earnings 6,792 7,250 6,863 (6.3 ) 5.6 Income taxes 1,631 1,769 1,644 (7.8 ) 7.6 Net earnings $ 5,161 $ 5,481 $ 5,219 (5.8 ) 5.0 Effective income tax rate 24.0 % 24.4 % 24.0 % The following table summarizes BNSF’s railroad freight volumes by business group (cars/units in thousands). Cars/Units Percentage change 2020 2019 2018 2020 vs 2019 2019 vs 2018 Consumer products 5,266 5,342 5,597 (1.4 )% (4.6 )% Industrial products 1,622 1,931 1,991 (16.0 ) (3.0 ) Agricultural products 1,189 1,146 1,208 3.8 (5.1 ) Coal 1,404 1,802 1,902 (22.1 ) (5.3 ) Total cars/units 9,481 10,221 10,698 (7.2 ) (4.5 ) 2020 versus 2019 Railroad operating revenues declined 11.3% in 2020 versus 2019, reflecting a 7.2% decrease in volume and a 4.5% decrease in average revenue per car/unit. The decrease in revenue per car/unit was attributable to lower fuel surcharge revenue driven by lower fuel prices and business mix changes. The overall volume decrease was primarily due to the COVID-19 pandemic, which severely impacted volumes through the first half of the year. Volumes sequentially improved from earlier periods and recovered overall to pre-pandemic levels by the end of the year. BNSF is an important component of the national and global supply chain and, as an essential business, has continued to operate throughout the duration of the COVID-19 pandemic. However, the pandemic caused significant economic disruptions that adversely affected the demand for transportation services. The pandemic continues to evolve, and the full extent to which it may impact BNSF's business, operating results, financial condition, or liquidity will depend on future developments. We believe BNSF's fundamental business remains strong and it has ample liquidity to continue business operations during this volatile period. K-42 Management’s Discussion and Analysis (Continued) Railroad (“Burlington Northern Santa Fe”) (Continued) Pre-tax earnings were $6.8 billion in 2020, a decrease of 6.3% from 2019, principally due to the negative impacts of the pandemic on volumes. In addition, pre-tax earnings in 2019 included an operating revenue increase related to the favorable outcome of an arbitration hearing and a retirement plan curtailment gain that is included in other expenses, net in the preceding table. These effects were partially offset by significant improvements in 2020 in service, system velocity and cost performance compared to 2019, along with lower costs related to severe winter weather and flooding on parts of the network, which negatively affected expenses and service levels in 2019. Operating revenues from consumer products of $7.3 billion in 2020 declined 7.6% compared to 2019, primarily due to a 6.3% decrease in average revenue per car/unit along with lower volumes. The volume decrease was primarily due to the impact of the pandemic. Lower international and automotive volumes were offset by higher domestic intermodal volumes. Increased retail sales, inventory replenishments by retailers and e-commerce activity produced recovery of intermodal volumes in the second half of 2020. Operating revenues from industrial products were $5.0 billion in 2020, a decrease of 17.0% from 2019. The decrease was primarily attributable to the decline in volume and to a lesser extent lower average revenue per car/unit. Volumes decreased primarily due to lower U.S. industrial production driven by the pandemic, including reduced production and demand in the energy sector, which drove lower sand and petroleum products volume, along with reduced steel demand, which drove lower taconite volume. Operating revenues from agricultural products increased 2.9% to $4.8 billion in 2020 compared to 2019. The increase was due to higher volumes, partially offset by slightly lower average revenue per car/unit. The volume increase was primarily due to higher grain and meal exports, partially offsetting adverse impacts of the pandemic, primarily for ethanol and sweeteners shipments. Operating revenues from coal decreased 28.5% to $2.7 billion in 2020 compared to 2019. This decrease was primarily due to lower volumes, as well as lower revenues per car/unit. Volumes decreased primarily due to lower natural gas prices, lower electricity demand driven by the pandemic, utility coal plant retirements and mild temperatures. Railroad operating expenses declined 15.3% to $12.4 billion in 2020 as compared to 2019. The ratio of railroad operating expenses to railroad operating revenues declined 2.9 percentage points to 61.6% in 2020 versus 2019. Railroad operating expenses in 2020 reflected lower volume-related costs, productivity improvements, the effects of cost control initiatives and improved weather conditions compared to 2019. Compensation and benefits expenses decreased $728 million (13.8%) in 2020 compared to 2019, primarily due to lower employee counts associated with lower volume and due to improved workforce productivity. Fuel expenses decreased $1.2 billion (39.2%) compared to 2019, primarily due to lower average fuel prices, lower volumes and improved fuel efficiency. Purchased services expense declined $95 million (4.6%) compared to 2019. The decrease was primarily due to lower volume, improved productivity and higher insurance recoveries in 2020 related to network flooding in 2019. Equipment rents, materials and other expense decreased $344 million (17.0%) compared to 2019, primarily due to lower volume-related costs, the effects of cost controls and lower personal injury and derailment expenses. 2019 versus 2018 Railroad operating revenues were $22.7 billion in 2019, a decline of 1.1% versus 2018. During 2019, BNSF’s revenues reflected a 3.6% comparative increase in average revenue per car/unit and a 4.5% decrease in volume. The increase in average revenue per car/unit was attributable to increased rates per car/unit and a favorable outcome of an arbitration hearing. Pre-tax earnings were approximately $7.3 billion in 2019, an increase of 5.6% over 2018. BNSF experienced severe winter weather and flooding on parts of the network, which negatively affected revenues, expenses and service levels. In addition to the impact of an increase in average revenue per car/unit, earnings in 2019 benefited from a reduction in total operating expenses. K-43 Management’s Discussion and Analysis (Continued) Railroad (“Burlington Northern Santa Fe”) (Continued) Operating revenues from consumer products were $7.9 billion in 2019, a decrease of 0.5% compared to 2018, reflecting volume decreases and higher average revenue per car/unit. The volume decreases were driven by moderated demand and the availability of truck capacity, as well as lower west coast imports. Operating revenues from industrial products were $6.1 billion in 2019, an increase of 1.7% from 2018. The increase was attributable to higher average revenue per car/unit, partially offset by a decrease in volume. Volumes decreased primarily due to overall softness in the industrial sector, lower sand volumes and reduced car loadings, due to the challenging weather conditions in 2019. Increased demand for petroleum products and liquefied petroleum gas, partially offset the other decreases in volumes. Operating revenues from agricultural products decreased 0.3% in 2019 to $4.7 billion compared to 2018. The decrease was due to lower volumes and higher average revenue per car/unit. The volume decreases were attributable to export competition from non-U.S. sources, the impacts of international trade policies and the challenging weather conditions in 2019. Operating revenues from coal decreased 7.4% in 2019 to $3.7 billion compared to 2018, reflecting lower average revenue per car/unit and lower volumes. Volumes were negatively impacted by adverse weather conditions, as well as from the effects of lower natural gas prices. Railroad operating expenses were $14.7 billion in 2019, a decrease of $535 million compared to 2018. Our ratio of operating expenses to railroad operating revenues in 2019 of 64.5% decreased 1.7 percentage points versus 2018. Operating expenses in 2019 reflected lower volume-related costs, lower fuel prices and the effects of cost control initiatives, partially offset by the costs associated with the adverse weather conditions. Fuel expenses decreased $402 million in 2019 compared to 2018, primarily due to lower average fuel prices, lower volumes and improved fuel efficiency. Purchased services expense decreased $82 million compared to 2018. The decrease was due to lower purchased transportation costs of our logistics services business, lower drayage, lower services expense and higher insurance recoveries. Equipment rents, materials and other expense decreased $82 million compared to 2018, due to lower locomotive and various other costs associated with lower volumes and cost controls. Other expenses, net decreased $221 million compared to 2018. In 2019, other expenses were net of a $120 million curtailment gain from an amendment to the company-sponsored defined benefit retirement plans. Utilities and Energy (“Berkshire Hathaway Energy Company”) We currently own 91.1% of the outstanding common stock of Berkshire Hathaway Energy Company (“BHE”), which operates a global energy business. BHE’s domestic regulated utility interests are comprised of PacifiCorp, MidAmerican Energy Company (“MEC”) and NV Energy. In Great Britain, BHE subsidiaries operate two regulated electricity distribution businesses referred to as Northern Powergrid. BHE’s natural gas pipelines consist of five domestic regulated interstate natural gas pipeline systems and a 25% interest in a liquefied natural gas export, import and storage facility in which BHE operates and consolidates for financial reporting purposes. Three of these systems were acquired on November 1, 2020 from Dominion Energy, Inc. (“BHE GT&S acquisition”). See Note 2 to accompanying Consolidated Financial Statements. Other energy businesses include a regulated electricity transmission-only business in Alberta, Canada (“AltaLink, L.P.”) and a diversified portfolio of mostly renewable independent power projects. BHE also operates the largest residential real estate brokerage firm and one of the largest residential real estate brokerage franchise networks in the United States. K-44 Management’s Discussion and Analysis (Continued) Utilities and Energy (“Berkshire Hathaway Energy Company”) (Continued) The rates our regulated businesses charge customers for energy and services are based in large part on the costs of business operations, including income taxes and a return on capital, and are subject to regulatory approval. To the extent such costs are not allowed in the approved rates, operating results will be adversely affected. A summary of BHE’s net earnings follows (dollars in millions). 2020 2019 2018 Revenues: Energy operating revenue $ 15,556 $ 15,371 $ 15,573 Real estate operating revenue 5,396 4,473 4,214 Other income (loss) 79 270 200 Total revenue 21,031 20,114 19,987 Costs and expense: Energy cost of sales 4,187 4,586 4,769 Energy operating expense 7,539 6,824 6,969 Real estate operating costs and expense 4,885 4,251 4,000 Interest expense 1,941 1,835 1,777 Total costs and expense 18,552 17,496 17,515 Pre-tax earnings 2,479 2,618 2,472 Income tax expense (benefit)* (1,010 ) (526 ) (452 ) Net earnings after income taxes 3,489 3,144 2,924 Noncontrolling interests 71 18 23 Net earnings attributable to BHE 3,418 3,126 2,901 Noncontrolling interests and preferred stock dividends 327 286 280 Net earnings attributable to Berkshire Hathaway shareholders $ 3,091 $ 2,840 $ 2,621 Effective income tax rate (40.7 )% (20.1 )% (18.3 )% *Includes significant production tax credits from wind-powered electricity generation. The discussion of BHE’s operating results that follows is based on after-tax earnings, reflecting how the energy businesses are managed and evaluated. A summary of net earnings attributable to BHE follows (dollars in millions). Percentage change 2020 2019 2018 2020 vs 2019 2019 vs 2018 PacifiCorp $ 741 $ 773 $ 739 (4.1 )% 4.6 % MidAmerican Energy Company 818 781 669 4.7 16.7 NV Energy 410 365 317 12.3 15.1 Northern Powergrid 201 256 239 (21.5 ) 7.1 Natural gas pipelines 528 422 387 25.1 9.0 Other energy businesses 697 608 489 14.6 24.3 Real estate brokerage 375 160 145 134.4 10.3 Corporate interest and other (352 ) (239 ) (84 ) 47.3 184.5 $ 3,418 $ 3,126 $ 2,901 9.3 7.8 K-45 Management’s Discussion and Analysis (Continued) Utilities and Energy (“Berkshire Hathaway Energy Company”) (Continued) 2020 versus 2019 PacifiCorp operates a regulated electric utility in portions of several Western states, including Utah, Oregon and Wyoming. PacifiCorp after-tax earnings decreased $32 million in 2020 compared to 2019. The decrease reflected higher operating expenses and net interest expense, partially offset by increased production tax credit benefits driven by repowered wind projects placed in-service, higher utility margin (operating revenue less cost of sales) and higher other income. The increase in operating expenses was largely due to costs associated with wildfires, a settlement agreement and pension benefits. PacifiCorp utility margin was $3.3 billion in 2020, an increase of $47 million compared to 2019. The increase reflected higher operating revenue from favorable average retail prices and lower generation and purchased power costs, partially offset by lower operating revenue from a 1.4% decline in retail customer volumes. The decline in retail customer volumes was due to the impacts of the pandemic, partly offset by an increase in the average number of customers and the favorable impacts of weather. MEC operates a regulated electric and natural gas utility primarily in Iowa and Illinois. After-tax earnings increased $37 million in 2020 compared to 2019. The increase reflected increased income tax benefits, primarily from production tax credits, driven by repowered and new wind projects placed in-service, and the effects of ratemaking. These effects were partially offset by higher depreciation expense from additional assets placed in-service, higher net interest expense, lower other income and lower electric and natural gas utility margins. MEC electric utility margin decreased $10 million to $1.8 billion in 2020 compared to 2019. The electric utility margin decrease was attributable to lower operating revenue from unfavorable wholesale prices and price impacts from changes in retail sales mix. These effects were mostly offset by lower generation and purchased power costs and higher operating revenue from a 1.2% increase in retail customer volumes. The increase in electric retail customer volumes was primarily due to increased usage by certain industrial customers, partially offset by the impacts of the pandemic. Natural gas utility margin decreased $9 million in 2020 compared to 2019, due to the unfavorable impacts of weather. NV Energy operates regulated electric and natural gas utilities in Nevada. After-tax earnings increased $45 million in 2020 compared to 2019. The increase reflected higher electric utility margin and lower income tax expense from the favorable impacts of ratemaking, partially offset by higher operating expenses. The increase in operating expenses was mainly due to higher earnings sharing accruals for customers at Nevada Power Company and higher depreciation expense from additional assets placed in-service. NV Energy electric utility margin increased $100 million to $1.7 billion in 2020 compared to 2019. The increase was primarily due to higher operating revenue from a 1.5% increase in electric retail customer volumes, including distribution-only service customers and price impacts from changes in retail sales mix. The increase in electric retail customer volumes was primarily due to the favorable impacts of weather, partially offset by the impacts of the pandemic. Northern Powergrid after-tax earnings decreased $55 million in 2020 as compared to 2019. The earnings decrease reflected write-offs of gas exploration costs and higher income tax expense, in large part from a change in the United Kingdom corporate income tax rate, partially offset by lower pension costs and interest expense. Natural gas pipelines after-tax earnings increased $106 million in 2020 compared to 2019. The increase was primarily due to $73 million of earnings from the BHE GT&S acquisition, the favorable impact of a rate case settlement at Northern Natural Gas and higher transportation volume and rates, partially offset by higher depreciation, operating expenses and interest expenses. Other energy business after-tax earnings in 2020 increased $89 million compared to 2019. The increase was primarily due to increased income tax benefits from renewable wind tax equity investments, largely from projects reaching commercial operation, partially offset by lower operating revenue and higher operating expenses from geothermal and natural gas units. K-46 Management’s Discussion and Analysis (Continued) Utilities and Energy (“Berkshire Hathaway Energy Company”) (Continued) Real estate brokerage after-tax earnings increased $215 million in 2020 compared to 2019. The increase reflected higher earnings from mortgage and brokerage services. The increase in earnings from mortgage services was attributable to higher refinance activity from the favorable interest rate environment and the earnings increase from brokerage services was due to an increase of 13.1% in closed transaction dollar volume. Corporate interest and other after-tax earnings decreased $113 million in 2020 compared to 2019. The decline was primarily due to higher interest expense and lower state income tax benefits. 2019 versus 2018 PacifiCorp after-tax earnings were $773 million in 2019, an increase of $34 million compared to 2018, reflecting slightly higher utility margin and higher other income, partly offset by higher depreciation expense from additional assets placed in-service. PacifiCorp utility margin was $3.3 billion in 2019, an increase of $4 million compared to 2018, as a 0.4% increase in retail customer volumes was largely offset by lower wholesale revenue mainly due to lower volumes. MEC after-tax earnings of $781 million in 2019 increased $112 million as compared to 2018, primarily attributable to increases in electric utility margin, income tax benefits from higher production tax credits and the effects of ratemaking and other income. Electric utility margin in 2019 increased 2% to $1.8 billion, primarily due to higher wind generation and higher retail customer volumes of 1.4%, as a 4.0% increase in industrial volumes was largely offset by lower residential volumes from the unfavorable impacts of weather. These earnings increases were partially offset by increased depreciation expense from additional assets placed in-service (net of lower Iowa revenue sharing) and higher net interest expense. NV Energy after-tax earnings were $365 million in 2019, an increase of $48 million compared to 2018, as lower operating expenses were partly offset by lower electric utility margin. Electric utility margin in 2019 was $1.6 billion, representing a decrease of $58 million (3%) versus 2018. The decrease was primarily due to a 1.4% decline in retail customer volumes, largely attributable to the impacts of weather, and rate reductions from the impact of the changes in U.S. income tax laws, partially offset by retail customer growth. Northern Powergrid after-tax earnings increased in 2019 compared to 2018, reflecting higher distribution revenues and lower operating expenses, which were largely from lower pension settlement losses in 2019, partially offset by the unfavorable foreign currency translation effects of a strong average U.S. Dollar. Distribution revenues increased $18 million, attributable to higher tariff rates, partly offset by lower distributed units. Natural gas pipelines after-tax earnings increased $35 million in 2019 compared to 2018, primarily due to higher transportation revenues from generally higher volumes and rates, favorable margins from system balancing activities and a decrease in operating expenses, partly offset by higher depreciation expense from increased spending on capital projects. Other energy businesses after-tax earnings in 2019 increased $119 million compared to 2018. The increase was primarily due to improved earnings from renewable wind energy projects ($49 million from tax equity investments and $25 million from new and existing projects and activities), higher income from geothermal and natural gas units, largely due to higher generation and favorable margins and lower operating expenses, partly offset by lower earnings at a hydroelectric facility in the Philippines due to lower rainfall. The increase in earnings also reflected the effects of favorable regulatory decisions received in 2019 and the unfavorable impacts of a regulatory rate order received in 2018 at AltaLink L.P. Real estate brokerage after-tax earnings increased in 2019 compared to 2018. The increase was primarily due to higher earnings at mortgage businesses due to increased refinance activity and earnings attributable to recent business acquisitions, partially offset by lower earnings at brokerage businesses, primarily from a decrease in closed units and lower margins. Corporate interest and other after-tax earnings decreased $155 million in 2019 compared to 2018. The earnings decline was primarily due to income tax benefits recognized in 2018 related to the reduction of accrued repatriation taxes on undistributed foreign earnings in connection with the changes in U.S. income tax laws, higher interest expense and lower earnings from non-regulated energy services. K-47 Management’s Discussion and Analysis (Continued) Manufacturing, Service and Retailing A summary of revenues and earnings of our manufacturing, service and retailing businesses follows (dollars in millions). Percentage change 2020 2019 2018 2020 vs 2019 2019 vs 2018 Revenues Manufacturing $ 59,079 $ 62,730 $ 61,883 (5.8 )% 1.4 % Service and retailing 75,018 79,945 78,926 (6.2 ) 1.3 $ 134,097 $ 142,675 $ 140,809 (6.0 ) 1.3 Pre-tax earnings * Manufacturing $ 8,010 $ 9,522 $ 9,366 (15.9 )% 1.7 % Service and retailing 2,879 2,843 2,942 1.3 (3.4 ) 10,889 12,365 12,308 (11.9 ) 0.5 Income taxes and noncontrolling interests 2,589 2,993 2,944 $ 8,300 $ 9,372 $ 9,364 Effective income tax rate 23.3 % 23.7 % 23.4 % Pretax earnings as a percentage of revenues 8.1 % 8.7 % 8.7 % * Excludes certain acquisition accounting expenses, which primarily related to the amortization of identified intangible assets recorded in connection with our business acquisitions. The after-tax acquisition accounting expenses excluded from earnings above were $783 million in 2020, $788 million in 2019 and $932 million in 2018. In 2020, such expenses also exclude after-tax goodwill and indefinite-lived intangible asset impairment charges of $10.4 billion. These expenses are included in “Other” in the summary of earnings on page K-33 and in the “Other” earnings section on page K-56. Manufacturing Our manufacturing group includes a variety of industrial, building and consumer products businesses. A summary of revenues and pre-tax earnings of our manufacturing operations follows (dollars in millions). Percentage change 2020 2019 2018 2020 vs 2019 2019 vs 2018 Revenues Industrial products $ 25,667 $ 30,594 $ 30,679 (16.1 )% (0.3 )% Building products 21,244 20,327 18,677 4.5 8.8 Consumer products 12,168 11,809 12,527 3.0 (5.7 ) $ 59,079 $ 62,730 $ 61,883 Pretax earnings Industrial products $ 3,755 $ 5,635 $ 5,822 (33.4 )% (3.2 )% Building products 2,858 2,636 2,336 8.4 12.8 Consumer products 1,397 1,251 1,208 11.7 3.6 $ 8,010 $ 9,522 $ 9,366 Pre-tax earnings as a percentage of revenues Industrial products 14.6 % 18.4 % 19.0 % Building products 13.5 % 13.0 % 12.5 % Consumer products 11.5 % 10.6 % 9.6 % K-48 Management’s Discussion and Analysis (Continued) Manufacturing, Service and Retailing (Continued) Industrial products The industrial products group includes specialty chemicals (The Lubrizol Corporation (“Lubrizol”)), complex metal products for aerospace, power and general industrial markets (Precision Castparts Corp. (“PCC”)), metal cutting tools/systems (IMC International Metalworking Companies (“IMC”)), equipment and systems for the livestock and agricultural industries (CTB International (“CTB”)), and a variety of industrial products for diverse markets (Marmon, Scott Fetzer and LiquidPower Specialty Products (“LSPI”)). Marmon consists of more than 100 autonomous manufacturing and service businesses, including equipment leasing for the rail, intermodal tank container and mobile crane industries. 2020 versus 2019 Revenues of the industrial products group in 2020 declined $4.9 billion (16.1%) from 2019, while pre-tax earnings declined $1.9 billion (33.4%). Pre-tax earnings as a percentage of revenues for the group were 14.6% in 2020 compared to 18.4% in 2019. PCC’s revenues were $7.3 billion in 2020, a decrease of $3.0 billion (28.9%) compared to 2019. Historically, a significant portion of PCC’s earnings have been dependent on sales related to the aerospace industry. The COVID-19 pandemic contributed to material declines in commercial air travel and aircraft production. Airlines responded to the pandemic by delaying delivery of aircraft orders or, in some cases, cancelling aircraft orders, resulting in significant reductions in build rates by aircraft manufacturers and significant inventory reduction initiatives by PCC’s customers. Further, Boeing’s 737 MAX aircraft production issues contributed to the declines in aerospace product sales across the industry in 2020. These factors resulted in significant declines in demand for PCC’s aerospace products in 2020. In 2020, PCC’s sales of products for power markets increased 2.2%, primarily driven by increases in industrial gas turbine products, offset by reductions in oil and gas products. PCC’s pre-tax earnings in 2020 were $650 million, a decrease of 64.5% compared to 2019, which reflected the decline in aerospace product sales as well as increased manufacturing inefficiencies attributable to lower volumes. In response to the effects of the pandemic, PCC has taken aggressive restructuring actions to resize operations in response to reduced expected volumes in aerospace markets. PCC’s worldwide workforce was reduced by about 40% since the end of 2019. PCC recorded charges for restructuring and inventory and fixed asset charges of approximately $295 million in 2020. Although earnings as a percentage of revenues were negatively impacted in 2020 due to inefficiencies associated with aligning operations to reduced aircraft build rates, the restructuring actions taken contributed to improved margins in the fourth quarter compared to earlier in the year and further margin improvements are expected in the future. The level of aircraft production is currently expected to slowly increase beginning in the latter half of 2021. However, this is dependent of the timing and extent that COVID-19 infections are lowered on a sustained basis and the return to historical levels of air travel and subsequent demand for aerospace products. Lubrizol’s revenues were $5.95 billion in 2020, a decrease of 8.0% compared to 2019. The decline was primarily attributable to lower volumes from economic effects of the pandemic and a fire at an Additives manufacturing, blending and storage facility in Rouen, France at the end of the third quarter of 2019, which resulted in the temporary suspension of operations. Revenues in 2020 also reflected lower selling prices, partly offset by favorable changes in sales mix. Lubrizol’s consolidated volume for the year declined 9% in 2020 compared to 2019, due to declines in the Additives and Engineered Materials product lines, partly offset by higher volumes in Life Science products. Overall, the effects of the pandemic on Lubrizol were more pronounced in the first half of the year, as volumes rebounded significantly in the second half. Lubrizol’s pre-tax earnings in 2020 were approximately $1.0 billion, essentially unchanged compared to 2019. The effects of lower sales volumes, including the effects from the Rouen fire and lower average selling prices were offset by lower average raw material costs, lower operating expenses and insurance recoveries in 2020 associated with the Rouen fire. Marmon’s revenues were $7.6 billion in 2020, a decrease of $681 million (8.2%) compared to 2019. Excluding the effects of business acquisitions, revenues decreased in essentially all sectors, primarily attributable to lower demand from the effects of the pandemic. The largest effects were experienced in the Transportation Products and Foodservice Technologies sectors. Additionally, revenues decreased due to lower metal prices in the Metal Services sector and the effect of business divestitures in 2019. Declines in oil prices in 2020 also adversely affected demand and revenues in the Rail & Leasing and Crane Services sectors. Marmon’s pre-tax earnings in 2020 decreased $312 million (24.3%) as compared to 2019. The decrease reflected the declines in revenues, increased restructuring charges and lower interest income. Restructuring initiatives were initiated in response to the lower product demand, particularly in the sectors most impacted by the pandemic. K-49 Management’s Discussion and Analysis (Continued) Manufacturing, Service and Retailing (Continued) Industrial products (Continued) IMC’s revenues declined 13.2% in 2020 compared to 2019, reflecting negative economic effects from the pandemic on demand for cutting tools in most geographic regions, partly offset by the effects of business acquisitions over the past year. IMC’s pre-tax earnings declined 26.6% in 2020 versus 2019, attributable to declines in sales and margins due to lower volumes and to changes in sales mix. 2019 versus 2018 Revenues of the industrial products group were slightly lower in 2019 than in 2018 and pre-tax earnings declined 3.2% compared to 2018. Pre-tax earnings as a percentage of revenues for the group were 18.4% in 2019 compared to 19.0% in 2018. PCC’s revenues were $10.3 billion in 2019, an increase of $74 million (0.7%) compared to 2018. In 2019, PCC generated increased sales in aerospace markets, which was partially offset by lower sales in the power markets. The increase in aerospace sales was tempered due to significant efforts focused on the ramp-up requirements for certain new aerospace programs, such as LEAP, that created manufacturing inefficiencies and slowed production cycles contributing to delays in product deliveries and sales. PCC’s pre-tax earnings increased 5.1% in 2019 compared to 2018, reflecting increased sales of aerospace products and higher earnings from various non-recurring items in 2019, which were partially offset by lower earnings from the power markets due to the decrease in sales. Temporary unplanned shutdowns of certain metals facilities and metal press outages also negatively impacted earnings in 2018. PCC incurred incremental costs in 2019 to meet required deliveries to customers associated with the increased aerospace demand, which negatively affected margins and earnings. The production headwinds experienced were primarily attributable to shortages of qualified skilled labor and the rapid increase in requirements for newer, complex aerospace products. Lubrizol’s revenues were $6.5 billion in 2019, a decrease of 5.2% compared to 2018. The decline reflected lower volumes, including the effects from the Rouen fire, and unfavorable foreign currency translation effects, partly offset by higher average selling prices which were necessitated by raw material cost increases. Lubrizol’s consolidated volume in 2019 declined 4% from 2018, primarily due to volume decline of 6% in the Additives product lines. Lubrizol’s pre-tax earnings in 2019 for the fourth quarter and year decreased 50.5% and 14.6%, respectively, compared to the same periods in 2018. Earnings in 2019 were significantly impacted by costs and lost business associated with the Rouen fire. Lubrizol’s operating results in 2019 were also negatively affected by lower sales volumes, higher manufacturing expenses and unfavorable foreign currency translation effects, partly offset by improved material margins. Marmon’s revenues were $8.3 billion in 2019, an increase of $146 million (1.8%) compared to 2018. The revenue increase reflected the effects of business acquisitions, higher volumes in several business sectors, which were largely offset by lower distribution volumes in the Metals Services sector, unfavorable foreign currency translation and the impact of lower metal prices in the Electrical and Plumbing & Refrigeration sectors. Marmon’s business acquisitions included the acquisition of the Colson Medical companies on October 31, 2019, resulting in a new Medical sector. Marmon’s Rail & Leasing and Crane Services sectors benefitted from higher railcar equipment sales, railcar fleet utilization, railcar repair services, intermodal container leasing revenue and improved crane rental demand in the U.S. and Australia. Marmon’s pre-tax earnings increased $12 million in 2019 (1.0%) as compared to 2018. The earnings increase reflected the effects of business acquisitions, partly offset by lower gains from business divestitures. Earnings in 2019 also reflected increased earnings in sectors that experienced sales volume increases, which were substantially offset by lower earnings in the Metal Services and certain other sectors, the unfavorable impacts of foreign currency translation and increased interest and other expenses. IMC’s revenues declined 1.3% in 2019 as compared to 2018, reflecting unfavorable foreign currency translation effects of a stronger U.S. Dollar and lower sales in several regions, including Asia and Europe, mostly offset by increased revenues from recent business acquisitions. IMC’s pre-tax earnings declined 12.8% in 2019 versus 2018, attributable to unfavorable foreign currency translation effects, changes in business mix to lower margin items and the effects of the U.S./China trade disputes. K-50 Management’s Discussion and Analysis (Continued) Manufacturing, Service and Retailing (Continued) Building products The building products group includes manufactured and site-built home construction and related lending and financial services (Clayton Homes), flooring (Shaw), insulation, roofing and engineered products (Johns Manville), bricks and masonry products (Acme Building Brands), paint and coatings (Benjamin Moore), and residential and commercial construction and engineering products and systems (MiTek). 2020 versus 2019 Revenues of the building products group increased $917 million (4.5%) in 2020 compared to 2019 and pre-tax earnings increased $222 million (8.4%) over 2019. Pre-tax earnings as percentages of revenues were 13.5% in 2020 and 13.0% in 2019. Clayton Homes’ revenues were approximately $8.6 billion in 2020, an increase of $1.3 billion (17.1%) over 2019. The increase was primarily due to increases in home sales of $1.0 billion (18.4%), driven by increases in units sold and revenue per home sold and by changes in sales mix. Unit sales of site-built homes increased 28.6% in 2020 over 2019, while revenue per home increased slightly. Manufactured home unit sales increased 2.8% in 2020. Financial services revenues, which include mortgage services, insurance and interest income from lending activities increased 13.7% in 2020 compared to 2019, attributable to increased loan originations and average outstanding loan balances. Loan balances, net of allowances for credit losses, were approximately $17.1 billion at December 31, 2020 compared to $15.9 billion as of December 31, 2019. Pre-tax earnings of Clayton Homes were approximately $1.25 billion in 2020, an increase of $152 million (13.9%) compared to 2019. The earnings increase reflected higher earnings from home sales, partly offset by higher materials costs, which lowered manufactured housing gross margin rates. Earnings in 2020 also benefitted from increased interest income, lower interest expense and higher earnings from mortgage services, partly offset by increased provisions for credit and insurance losses. Aggregate revenues of our other building products businesses were approximately $12.6 billion in 2020, a decrease of 2.6% versus 2019. The revenue decrease reflected lower flooring volumes, partly attributable to the negative effects of the COVID-19 pandemic, partly offset by increased paint and coatings volumes, including volumes from a new agreement with Ace Hardware Stores, and increased volumes in residential markets. Pre-tax earnings of the other building products businesses were approximately $1.6 billion in 2020, an increase of 4.6% over 2019. The earnings increase reflected the effects of lower average input costs, operating cost containment efforts and lower facilities closure costs. 2019 versus 2018 Revenues of the building products group in 2019 increased $1.65 billion (8.8%) compared to 2018, while pre-tax earnings increased 12.8% over 2018. Pre-tax earnings as percentages of revenues were 13.0% in 2019 and 12.5% in 2018. Clayton Homes’ revenues were approximately $7.3 billion in 2019, an increase of $1.3 billion (21.5%) over 2018. The comparative increase was primarily due to a 26% increase in home sales, reflecting a net increase in units sold and changes in sales mix. Unit sales of site-built homes increased 84% in 2019 over 2018, primarily due to business acquisitions, while average prices declined 5%. Manufactured home unit retail sales increased 5% and wholesale sales were 9% lower in 2019. Interest income from lending activities increased 6.7% in 2019 compared to 2018, attributable to increased originations and average outstanding loan balances. Aggregate loan balances outstanding were approximately $15.9 billion at December 31, 2019 compared to $14.7 billion as of December 31, 2018. Clayton Homes’ pre-tax earnings were $1.1 billion in 2019, an increase of $182 million (20.0%) compared to 2018. The increase was attributable to home building activities, which benefitted from the increases in home sales, and to financial services activities. Pre-tax earnings from lending and finance activities increased 12%, primarily due to an increase in interest income attributable to higher average loan balances, increased earnings from other financial services and lower credit losses, partially offset by higher interest expense, attributable to higher average borrowings and interest rates, and by higher other operating costs. Aggregate revenues of our other building products businesses were $13.0 billion in 2019, an increase of 2.8% versus 2018. Revenues increased for paint and coatings, hard surface flooring and roofing products, attributable to a combination of increased volumes, product mix changes and increased average selling prices, while sales of brick products declined. K-51 Management’s Discussion and Analysis (Continued) Manufacturing, Service and Retailing (Continued) Building products (Continued) Pre-tax earnings of the other building products businesses were $1.5 billion in 2019, an increase of 8.2% over 2018. Earnings in 2019 benefitted from a combination of increases in selling prices in certain product categories, declining raw material costs for certain commodities and operating cost control initiatives, which were partly offset by the effects of increased facilities closure costs. Consumer products The consumer products group includes leisure vehicles (Forest River), several apparel and footwear operations (including Fruit of the Loom, Garan, H.H. Brown Shoe Group and Brooks Sports) and a manufacturer of high-performance alkaline batteries (Duracell). This group also includes custom picture framing products (Larson Juhl) and jewelry products (Richline). 2020 versus 2019 Consumer products revenues increased of $359 million (3.0%) in 2020 versus 2019, while pre-tax earnings increased $146 million (11.7%). Pre-tax earnings as a percentage of revenues in 2020 increased 0.9 percentage points to 11.5%. The comparative increase in revenues reflected revenue increases from Forest River and Duracell, partially offset by lower apparel and footwear revenues. Forest River revenues increased 11.7% in 2020 compared to 2019, primarily attributable to a significant increase in recreational vehicle unit sales over the last half of the year and changes in sales mix. Unit sales in the second half of 2020 increased 31% over the second half of 2019. Revenues from Duracell increased 10.0% in 2020 compared to 2019, reflecting the effects of changes in sales mix and increased volume. Apparel and footwear revenues declined 6.1% in 2020 compared to 2019. Apparel and footwear sales volumes in the first half of 2020, particularly in the second quarter, reflected the negative effects of the pandemic, which included retail store closures, reduced or cancelled orders and pandemic-related disruptions at certain manufacturing facilities. Sales recovered somewhat in the second half of 2020, attributable to higher consumer demand and inventory restocking by retailers. Brooks Sports revenues were higher, partly attributable to the effect of the reduced sales in 2019 that were caused by shipping delays at a new distribution facility. The comparative increase in pre-tax earnings was primarily attributable to Forest River and Duracell, partially offset by lower earnings from apparel and footwear. The increase reflected the effects of sales volumes changes and ongoing expense management efforts. 2019 versus 2018 Consumer products revenues declined $718 million (5.7%) in 2019 versus 2018, driven by a 12.9% revenue decline from Forest River, primarily due to lower unit sales. Revenues of Duracell increased 1.3% and apparel and footwear revenues declined 1.1% compared to 2018. Although revenues from Brooks Sports increased 3.5% in 2019, its operating results were negatively affected by lost sales associated with problems encountered at a distribution center that opened in the second quarter. In addition, our other apparel and other footwear businesses continue to experience lower sales volumes for certain products, reflecting the shift by major retailers towards private label products. Consumer products pre-tax earnings increased $43 million (3.6%) in 2019 compared to 2018. The increase was primarily attributable to continuing cost containment efforts across several of the businesses and the effects of a new Duracell product launch, partially offset by the impact of lower recreational vehicle sales at Forest River. K-52 Management’s Discussion and Analysis (Continued) Manufacturing, Service and Retailing (Continued) Service and retailing A summary of revenues and pre-tax earnings of our service and retailing businesses follows (dollars in millions). Percentage change 2020 2019 2018 2020 vs 2019 2019 vs 2018 Revenues Service $ 12,346 $ 13,496 $ 13,333 (8.5 )% 1.2 % Retailing 15,832 15,991 15,606 (1.0 ) 2.5 McLane Company 46,840 50,458 49,987 (7.2 ) 0.9 $ 75,018 $ 79,945 $ 78,926 Pre-tax earnings Service $ 1,600 $ 1,681 $ 1,836 (4.8 )% (8.4 )% Retailing 1,028 874 860 17.6 1.6 McLane Company 251 288 246 (12.8 ) 17.1 $ 2,879 $ 2,843 $ 2,942 Pre-tax earnings as a percentage of revenues Service 13.0 % 12.5 % 13.8 % Retailing 6.5 % 5.5 % 5.5 % McLane Company 0.5 % 0.6 % 0.5 % Service Our service business group offers shared ownership programs for general aviation aircraft (NetJets) and high technology training products and services to operators of aircraft (FlightSafety). We also distribute electronic components (TTI), franchise and service a network of quick service restaurants (Dairy Queen) and offer third party logistics services that primarily serve the petroleum and chemical industries (Charter Brokerage). Other service businesses include transportation equipment leasing (XTRA) and furniture leasing (CORT), electronic news distribution, multimedia and regulatory filings (Business Wire) and the operation of a television station in Miami, Florida (WPLG). 2020 versus 2019 Service group revenues declined $1.15 billion (8.5%) in 2020 compared to 2019 and pre-tax earnings decreased $81 million (4.8%). Pre-tax earnings of the group as a percentage of revenues were 13.0% in 2020 compared to 12.5% in 2019. The aggregate revenues of NetJets and FlightSafety in 2020 declined $816 million (13.5%) compared to 2019, reflecting lower demand for air travel and aviation services attributable to the COVID-19 pandemic. NetJets experienced a decline in flight hours of 27% and FlightSafety’s commercial and corporate simulator training hours declined 30% from 2019. The comparative service group revenue decline was also attributable to the effects of the disposition of the newspaper operations in March of 2020 and lower revenues from CORT, which was driven by lower demand attributable to the effects of the pandemic. Partially offsetting these declines were revenue increases at TTI and at WPLG. The decline in earnings reflected lower earnings from NetJets, TTI and CORT and from the effects of the divestiture of the newspaper operations, partly offset by higher earnings from XTRA, Business Wire, WPLG and FlightSafety. TTI’s earnings decline reflected lower average gross margin rates, attributable to product mix changes and sales price pressures deriving from ample inventory availability. The decline at NetJets was primarily attributable to increased asset impairment charges and restructuring costs, partly offset by lower general and administrative expenses and a slight net increase in margins. The decline at CORT was driven by lower revenues, partly offset by the effects of cost control initiatives. The increase at FlightSafety was attributable to the effects of contract losses recorded in 2019 with respect to an existing government contract and cost control efforts in 2020, which more than offset significantly lower earnings from commercial and corporate training services. K-53 Management’s Discussion and Analysis (Continued) Manufacturing, Service and Retailing (Continued) Service (Continued) 2019 versus 2018 Service group revenues increased $163 million (1.2%) in 2019 compared to 2018, primarily attributable to increased sales at TTI and higher aviation-related services revenues (NetJets and FlightSafety), partially offset by decreases from the media businesses and Charter Brokerage. TTI’s sales increased 2% in 2019 compared to the exceptionally high sales levels in 2018. TTI’s sales slowed throughout 2019, attributable to softening customer demand, lower average selling prices and the effects of U.S. trade tariffs. The increase in NetJets’ revenues in 2019 reflected increased lease revenue, primarily attributable to an increase in aircraft on lease, and increased flight hours, partly offset by lower revenue from prepaid flight cards. The revenue decline at Charter Brokerage was attributable to the divesture of a high revenue, low margin business in mid-2019. Pre-tax earnings of the service group decreased $155 million (8.4%) compared to 2018. The comparative earnings decline was primarily due to lower earnings from TTI and FlightSafety, partly offset by higher earnings from NetJets. TTI’s earnings decline was primarily attributable to lower gross margins, unfavorable foreign currency translation effects and higher operating expenses. The earnings decline at FlightSafety was attributable to pre-tax losses of approximately $165 million recorded in the fourth quarter of 2019 in connection with an existing government contract, partly offset by lower training equipment impairment charges. Earnings from NetJets increased in 2019, primarily attributable to increased revenues and improved fleet and operating efficiencies, which improved operating margins. Retailing Our largest retailing business is Berkshire Hathaway Automotive (“BHA”), which consists of over 80 auto dealerships that sell new and pre-owned automobiles and offer repair services and related products and represented 62.6% of our combined retailing revenue in 2020. BHA also operates two insurance businesses, two auto auctions and an automotive fluid maintenance products distributor. Our retailing businesses also include four home furnishings retailing businesses (Nebraska Furniture Mart, R.C. Willey, Star Furniture and Jordan’s), which sell furniture, appliances, flooring and electronics and represented 20.6% of the combined retailing revenues in 2020. Other retailing businesses include three jewelry retailing businesses (Borsheims, Helzberg and Ben Bridge), See’s Candies (confectionary products), Pampered Chef (high quality kitchen tools), Oriental Trading Company (party supplies, school supplies and toys and novelties) and Detlev Louis Motorrad (“Louis”), a retailer of motorcycle accessories based in Germany. 2020 versus 2019 Retailing group revenues in 2020 declined $159 million (1.0%) compared to 2019. The spread of COVID-19 throughout the U.S. resulted in the temporary closures or restricted operations at several of our retailing businesses and effected consumer spending patterns during 2020. The severity and duration of the effects from the pandemic varied widely at our retail operations. BHA’s revenues decreased 2.9% in 2020 compared to 2019. BHA’s revenues in 2020 reflected decreases in new and pre-owned vehicle sales of 2.6% as well as lower vehicle service and repair revenues. Home furnishings revenues were essentially unchanged in 2020 compared to 2019. The group experienced lower revenues in the first half of 2020, attributable to restricted store hours, which were substantially offset by increased revenues over the second half of the year. However, supply chain disruptions had a negative effect on obtaining product at certain times, which negatively affected sales levels. The effects of the pandemic contributed to significantly lower sales in 2020 for our jewelry stores, See’s Candy and Oriental Trading Company, which were more than offset by significant revenue increases from Pampered Chef and Louis. Sales volumes generally increased and operating results improved beginning in the latter part of the second quarter as our operations slowly reopened. K-54 Management’s Discussion and Analysis (Continued) Manufacturing, Service and Retailing (Continued) Retailing (Continued) Retail group pre-tax earnings increased $154 million (17.6%) in 2020 from 2019. BHA’s pre-tax earnings increased 37.7%, primarily due to lower selling, general and administrative expenses, lower floorplan interest expense and higher average gross sales margin rates. Aggregate pre-tax earnings for the remainder of our retailing group increased 1.1% in 2020 compared to 2019, reflecting higher earnings from the home furnishings businesses and from Pampered Chef, which were substantially offset by lower earnings from our other retailing operations. Home furnishings group pre-tax earnings increased $79 million (36%) in 2020 versus 2019, reflecting generally higher average gross margin rates, sales mix changes and fewer sales promotions, and from lower advertising and other operating expenses. Certain of our other operations, including Pampered Chef and Louis experienced significant earnings increases in 2020, while others, including See’s Candy and Oriental Trading Company, experienced significant declines driven by the negative effects of the pandemic. 2019 versus 2018 Retailing group revenues increased $385 million (2.5%) in 2019 compared to 2018. BHA’s revenues increased 4.1% in 2019 over 2018, primarily attributable to an 11.5% increase in pre-owned vehicle sales, vehicle pricing increases, improvement in vehicle finance and service contract activities and vehicle repair work as compared to 2018. New vehicle sales in 2019 were relatively unchanged from 2018. Home furnishings group revenues declined 1.3% in 2019 compared to 2018, as sales were relatively unchanged or lower in each of our home furnishings operations. Retail group pre-tax earnings increased $14 million (1.6%) in 2019 over 2018. BHA’s pre-tax earnings increased 22.7%, primarily due to the increases in earnings from finance and service contract activities, partly offset by higher floorplan interest expense. Home furnishings group pre-tax earnings declined 14.7% versus 2018, reflecting the decline in revenues and generally higher operating expenses. McLane Company McLane operates a wholesale distribution business that provides grocery and non-food consumer products to retailers and convenience stores (“grocery”) and to restaurants (“foodservice”). McLane also operates businesses that are wholesale distributors of distilled spirits, wine and beer (“beverage”). The grocery and foodservice businesses generate high sales and very low profit margins. These businesses have several significant customers, including Walmart, 7-Eleven, Yum! Brands and others. Grocery sales comprised about two-thirds of McLane’s consolidated sales in 2020 with food service comprising most of the remainder. A curtailment of purchasing by any of its significant customers could have an adverse impact on periodic revenues and earnings. 2020 versus 2019 Revenues declined $3.6 billion (7.2%) in 2020 compared to 2019. The decline was attributable to COVID-19 related restaurant closures (particularly in the casual dining category) in the foodservice business and lower sales in certain product categories within the grocery business. McLane operates on a 52/53-week fiscal year and 2020 included 52 weeks compared to 53 weeks in 2019. Otherwise, revenues declined 5.2% in the grocery business and 7.7% in the foodservice business in 2020 as compared to 2019. Pre-tax earnings decreased $37 million (12.8%) in 2020 as compared to 2019. The earnings decrease included the effects of increased LIFO inventory reserves of $22 million, credit and inventory losses of $12 million in the foodservice operations and the impact of lower sales. McLane continues to operate in an intensely competitive business environment, which is negatively affecting its current operating results. We expect that these operating conditions will continue. 2019 versus 2018 Revenues increased $471 million (0.9%) in 2019 compared to 2018. McLane’s results in 2019 included 53 weeks compared to 52 weeks in 2018. Otherwise, revenues decreased roughly 3% in the grocery business and increased 3% in the foodservice business in 2019 as compared to 2018. Pre-tax earnings increased $42 million (17.1%) as compared to 2018. The earnings increase in 2019 reflected an increase in average gross margin rates and changes in business mix, partly offset by increased operating expenses, the largest portion of which was employee costs. K-55 Management’s Discussion and Analysis (Continued) Investment and Derivative Gains (Losses) A summary of investment and derivative gains and losses follows (dollars in millions). 2020 2019 2018 Investment gains (losses) $ 40,905 $ 71,123 $ (22,155 ) Derivative gains (losses) (159 ) 1,484 (300 ) Gains (losses) before income taxes and noncontrolling interests 40,746 72,607 (22,455 ) Income taxes and noncontrolling interests 9,155 15,162 (4,718 ) Net gains (losses) $ 31,591 $ 57,445 $ (17,737 ) Effective income tax rate 21.7 % 20.9 % 20.8 % Investment gains (losses) We are required to include the unrealized gains and losses arising from changes in market prices of investments in equity securities in earnings, which significantly increases the volatility of our periodic net earnings due to the magnitude of our equity securities portfolio and the inherent volatility of equity securities prices. Pre-tax investment gains included net unrealized gains of approximately $55.0 billion in 2020 attributable to changes in market prices of equity securities we held at December 31, 2020 and net losses of approximately $14.0 billion from changes in market prices during 2020 on securities sold during 2020. We recorded pre-tax unrealized investment gains of approximately $69.6 billion in 2019 attributable to changes in market prices in 2019 on equity securities we held at December 31, 2019. Pre-tax unrealized investment losses of approximately $22.7 billion were recorded in 2018 attributable to market price changes in 2018 on equity securities we held at December 31, 2018. Taxable investment gains on equity securities sold, which is the difference between sales proceeds and the original cost basis of the securities sold, were $6.2 billion in 2020, $3.2 billion in 2019 and $3.3 billion in 2018. We believe that investment gains/losses, whether realized from sales or unrealized from changes in market prices, are often meaningless in terms of understanding our reported consolidated earnings or evaluating our periodic economic performance. We continue to believe the investment gains/losses recorded in earnings, including the changes in market prices for equity securities, in any given period has little analytical or predictive value. Derivative gains (losses) Derivative contract gains/losses include the changes in fair value of our equity index put option contract liabilities, which relate to contracts that were originated prior to March 2008. Substantially all remaining contracts will expire by February 2023. The periodic changes in the fair values of these liabilities are recorded in earnings and can be significant, primarily due to the volatility of underlying equity markets. As of December 31, 2020, the intrinsic value of our equity index put option contracts was $727 million and our recorded liability at fair value was approximately $1.1 billion. Our ultimate payment obligations, if any, under our contracts will be determined as of the contract expiration dates based on the intrinsic value as defined under the contracts. Equity index put option contracts produced pre-tax losses of $159 million in 2020, pre-tax gains of $1.5 billion in 2019 and pre-tax losses of $300 million in 2018. These gains and losses reflected changes in the equity index values and shorter remaining contract durations. Settlement payments to counterparties were relatively insignificant in each of the three years. Other A summary of after-tax other earnings/losses follows (in millions). 2020 2019 2018 Equity method earnings (losses) $ 665 $ 1,023 $ (1,419 ) Acquisition accounting expenses (783 ) (788 ) (831 ) Goodwill and intangible asset impairments (10,381 ) (96 ) (280 ) Corporate interest expense, before foreign currency effects (334 ) (280 ) (311 ) Foreign currency exchange rate gains (losses) on Berkshire and BHFC non-U.S. Dollar senior notes (764 ) 58 289 Income tax expense adjustments (60 ) (377 ) — Other, principally corporate investment income 339 884 986 $ (11,318 ) $ 424 $ (1,566 ) K-56 Management’s Discussion and Analysis (Continued) Other (Continued) After-tax equity method earnings (losses) include our proportionate share of earnings attributable to our investments in Kraft Heinz, Pilot, Berkadia and Electric Transmission of Texas. Our after-tax earnings from Kraft Heinz were $170 million in 2020 and $488 million in 2019 and our after-tax losses were $1,859 million in 2018. Our earnings from Kraft Heinz included our after-tax share of goodwill and other intangible asset impairment charges recorded by Kraft Heinz in each year. Our after-tax share of such charges was $611 million in 2020, $339 million in 2019 and approximately $2.7 billion in 2018. After-tax acquisition accounting expenses include charges arising from the application of the acquisition method in connection with certain of Berkshire’s past business acquisitions. Such charges arise primarily from the amortization or impairment of intangible assets recorded in connection with those business acquisitions. Goodwill and intangible asset impairments in 2020 included after-tax charges of $9.8 billion attributable to impairments of goodwill and certain identifiable intangible assets that were recorded in connection with our acquisition of PCC in 2016. See Critical Accounting Policies on page K-63 for additional details. Foreign currency exchange rate gains and losses pertain to Berkshire’s outstanding Euro denominated debt (€6.85 billion par) and Japanese Yen denominated debt (¥625.5 billion par), and BHFC’s Great Britain Pound denominated debt (£1.75 billion par). Changes in foreign currency exchange rates produced gains and losses from the periodic revaluation of these liabilities into U.S. Dollars. The gains and losses recorded in any given period can be significant due to the magnitude of the borrowings and the inherent volatility in foreign currency exchange rates. The income tax expense adjustments relate to investments that were made between 2015 and 2018 in certain tax equity investment funds. Our investments in these funds aggregated approximately $340 million. In December 2018, we first learned of allegations by federal authorities of fraudulent conduct by the sponsor of these funds. In January 2020, the principals involved in creating the investment funds plead guilty to criminal charges related to the sale of the investments. In the first quarter of 2019, we concluded that it is more likely than not that the previously recognized income tax benefits were not valid. Financial Condition Our consolidated balance sheet continues to reflect very significant liquidity and a very strong capital base. Consolidated shareholders’ equity at December 31, 2020 was $443.2 billion, an increase of $18.4 billion since December 31, 2019, which was net of common stock repurchases of $24.7 billion. Net earnings attributable to Berkshire shareholders was $42.5 billion and included after-tax gains on our investments of approximately $31.7 billion. During each of the last three years, changes in the market prices of our investments in equity securities produced exceptional volatility in our earnings. Our results in 2020 also included after-tax goodwill and other intangible asset impairments charges of $11.0 billion. At December 31, 2020, our insurance and other businesses held cash, cash equivalents and U.S. Treasury Bills of $135.0 billion, which included $112.8 billion in U.S. Treasury Bills. Investments in equity and fixed maturity securities (excluding our investment in Kraft Heinz) were $301.6 billion. Berkshire parent company debt outstanding at December 31, 2020 was $22.7 billion, an increase of $2.8 billion since December 31, 2019. In 2020, Berkshire repaid maturing senior notes of €1.0 billion and issued €1.0 billion of 0.0% senior notes due in 2025. Berkshire also issued ¥195.5 billion of senior notes (approximately $1.8 billion) with a weighted average interest rate of 1.07% and maturity dates ranging from 2023 to 2060. In the first quarter of 2021, senior notes of $1.7 billion will mature, including $665 million (€550 million) that matured in January. In January 2021, Berkshire issued €600 million of 0.5% senior notes due in 2041. Berkshire’s insurance and other subsidiary outstanding borrowings were approximately $18.9 billion at December 31, 2020, which included senior note borrowings of BHFC, a wholly-owned financing subsidiary, of approximately $13.1 billion. BHFC’s borrowings are used to fund a portion of loans originated and acquired by Clayton Homes and equipment held for lease by our railcar leasing business. In 2020, BHFC repaid $900 million of maturing senior notes and issued $3.0 billion of senior notes with maturity dates ranging from 2030 to 2050 and a weighted average interest rate of 2.3%. Berkshire guarantees the full and timely payment of principal and interest with respect to BHFC’s senior notes. In January 2021, $750 million of BHFC debt matured and BHFC issued $750 million of 2.5% senior notes due in 2051. Our railroad, utilities and energy businesses (conducted by BNSF and BHE) maintain very large investments in capital assets (property, plant and equipment) and will regularly make significant capital expenditures in the normal course of business. Capital expenditures of these two operations were $9.8 billion in 2020 and we forecast a similar amount of capital expenditures in 2021. K-57 Management’s Discussion and Analysis (Continued) Financial Condition (Continued) BNSF’s outstanding debt was $23.2 billion as of December 31, 2020. In 2020, BNSF issued $575 million of 3.05% senior unsecured debentures due in 2051. Outstanding borrowings of BHE and its subsidiaries were $52.2 billion at December 31, 2020, an increase of $9.6 billion since December 31, 2019. In 2020, BHE and its subsidiaries issued new term debt of approximately $7.6 billion with maturity dates ranging from 2025 to 2062 and repaid approximately $3.2 billion of debt. BHE also assumed $5.6 billion in debt in connection with the business acquired from Dominion Energy in November 2020. Berkshire does not guarantee the repayment of debt issued by BNSF, BHE or any of their subsidiaries and is not committed to provide capital to support BNSF, BHE or any of their subsidiaries. Berkshire’s common stock repurchase program as amended permits Berkshire to repurchase its Class A and Class B shares at prices below Berkshire’s intrinsic value, as conservatively determined by Warren Buffett, Berkshire’s Chairman of the Board and Chief Executive Officer, and Charlie Munger, Vice Chairman of the Board. The program allows share repurchases in the open market or through privately negotiated transactions and does not specify a maximum number of shares to be repurchased. The program is expected to continue indefinitely. We will not repurchase our stock if it reduces the total amount of Berkshire’s consolidated cash, cash equivalents and U.S. Treasury Bill holdings below $20 billion. Financial strength and redundant liquidity will always be of paramount importance at Berkshire. In 2020, Berkshire paid $24.7 billion to repurchase shares of its Class A and B common stock. Contractual Obligations We are party to contracts associated with ongoing business and financing activities, which will result in cash payments to counterparties in future periods. Certain obligations are included in our Consolidated Balance Sheets, such as notes payable, which require future payments on contractually specified dates and in fixed and determinable amounts. Other obligations pertaining to the acquisition of goods or services in the future, such as certain purchase obligations, are not currently reflected in the financial statements and will be recognized in future periods as the goods are delivered or services are provided. The timing and amount of the payments under insurance and reinsurance contracts are contingent upon the outcome of future events. Actual payments will likely vary, perhaps materially, from the estimated liabilities currently recorded in our Consolidated Balance Sheet. A summary of our contractual obligations as of December 31, 2020 follows (in millions). Actual payments will likely vary, perhaps significantly, from estimates reflected in the table. Estimated payments due by period Total 2021 2022-2023 2024-2025 After 2025 Notes payable and other borrowings, including interest $ 182,004 $ 13,456 $ 23,393 $ 19,596 $ 125,559 Operating leases 6,318 1,342 2,016 1,269 1,691 Purchase obligations (1) 48,413 14,552 7,947 5,939 19,975 Unpaid losses and loss adjustment expenses (2) 120,820 27,617 28,623 16,144 48,436 Life, annuity and health insurance benefits (3) 36,920 2,623 269 540 33,488 Other 26,524 3,136 7,762 1,684 13,942 Total $ 420,999 $ 62,726 $ 70,010 $ 45,172 $ 243,091 (1) Primarily related to fuel, capacity, transmission and maintenance contracts and capital expenditure commitments of BHE and BNSF and aircraft purchase commitments of NetJets. (2) Includes unpaid losses and loss adjustment expenses under retroactive reinsurance contracts. (3) Amounts represent estimated undiscounted benefits, net of estimated future premiums, as applicable. K-58 Management’s Discussion and Analysis (Continued) Critical Accounting Policies Certain accounting policies require us to make estimates and judgments in determining the amounts reflected in the Consolidated Financial Statements. Such estimates and judgments necessarily involve varying, and possibly significant, degrees of uncertainty. Accordingly, certain amounts currently recorded in the financial statements will likely be adjusted in the future based on new available information and changes in other facts and circumstances. A discussion of our principal accounting policies that required the application of significant judgments as of December 31, 2020 follows. Property and casualty insurance unpaid losses We record liabilities for unpaid losses and loss adjustment expenses (also referred to as “gross unpaid losses” or “claim liabilities”) based upon estimates of the ultimate amounts payable for losses occurring on or before the balance sheet date. The timing and amount of ultimate loss payments are contingent upon, among other things, the timing of claim reporting from insureds and ceding companies and the final determination of the loss amount through the loss adjustment process. We use a variety of techniques in establishing claim liabilities and all techniques require significant judgments and assumptions. As of the balance sheet date, recorded claim liabilities include liabilities for reported claims and for claims not yet reported. The period between the loss occurrence date and loss settlement date is the “claim-tail.” Property claims usually have relatively short claim-tails, absent litigation. Casualty claims usually have longer claim-tails, occasionally extending for decades. Casualty claims may be more susceptible to litigation and the impact of changing contract interpretations. The legal environment and judicial process further contribute to extending claim-tails. Our consolidated claim liabilities as of December 31, 2020 were approximately $120.8 billion (including liabilities from retroactive reinsurance), of which 83% related to GEICO and the Berkshire Hathaway Reinsurance Group. Additional information regarding significant uncertainties inherent in the processes and techniques for estimating unpaid losses of these businesses follows. GEICO GEICO predominantly writes private passenger auto insurance. As of December 31, 2020, GEICO’s gross unpaid losses were $22.9 billion and claim liabilities, net of reinsurance recoverable, were $21.8 billion. GEICO’s claim reserving methodologies produce liability estimates based upon the individual claims. The key assumptions affecting our liability estimates include projections of ultimate claim counts (“frequency”) and average loss per claim (“severity”). We utilize a combination of several actuarial estimation methods, including Bornhuetter-Ferguson and chain-ladder methodologies. Claim liability estimates for automobile liability coverages (such as bodily injury (“BI”), uninsured motorists, and personal injury protection) are more uncertain due to the longer claim-tails, so we establish additional case development estimates. As of December 31, 2020, case development liabilities averaged approximately 33% of the case reserves. We select case development factors through analysis of the overall adequacy of historical case liabilities. Incurred-but-not-reported (“IBNR”) claim liabilities are based on projections of the ultimate number of claims expected (reported and unreported) for each significant coverage. We use historical claim count data to develop age-to-age projections of the ultimate counts by quarterly accident period, from which we deduct reported claims to produce the number of unreported claims. We estimate the average costs per unreported claim and apply such estimates to the unreported claim counts, producing an IBNR liability estimate. We may record additional IBNR estimates when actuarial techniques are difficult to apply. We test the adequacy of the aggregate claim liabilities using one or more actuarial projections based on claim closure models and paid and incurred loss triangles. Each type of projection analyzes loss occurrence data for claims occurring in a given period and projects the ultimate cost. Our claim liability estimates recorded at the end of 2019 were reduced by $253 million during 2020, which produced a corresponding increase to pre-tax earnings. The assumptions used to estimate liabilities at December 31, 2020 reflect the most recent frequency and severity results. Future development of recorded liabilities will depend on whether actual frequency and severity of claims are more or less than anticipated. K-59 Management’s Discussion and Analysis (Continued) Property and casualty losses (Continued) GEICO (Continued) With respect to liabilities for BI claims, we believe it is reasonably possible that average severities will change by at least one percentage point from the severities used in establishing the recorded liabilities at December 31, 2020. We estimate that a one percentage point increase or decrease in BI severities would produce a $300 million increase or decrease in recorded liabilities, with a corresponding decrease or increase in pre-tax earnings. Many of the economic forces that would likely cause BI severity to differ from expectations would likely also cause severities for other injury coverages to differ in the same direction. Berkshire Hathaway Reinsurance Group BHRG’s liabilities for unpaid losses and loss adjustment expenses derive primarily from reinsurance contracts issued through NICO and General Re. A summary of BHRG’s property and casualty unpaid losses and loss adjustment expenses, other than retroactive reinsurance losses and loss adjustment expenses, as of December 31, 2020 follows (in millions). Property Casualty Total Reported case liabilities $ 5,714 $ 9,497 $ 15,211 IBNR liabilities 5,821 14,615 20,436 Gross unpaid losses and loss adjustment expenses 11,535 24,112 35,647 Reinsurance recoverable 181 864 1,045 Net unpaid losses and loss adjustment expenses $ 11,354 $ 23,248 $ 34,602 Gross unpaid losses and loss adjustment expenses consist primarily of traditional property and casualty coverages written primarily under excess-of-loss and quota-share treaties. Under certain contracts, coverage can apply to multiple lines of business written and the ceding company may not report loss data by such lines consistently, if at all. In those instances, we allocate losses to property and casualty coverages based on internal estimates. In connection with reinsurance contracts, the nature, extent, timing and perceived reliability of loss information received from ceding companies varies widely depending on the type of coverage and the contractual reporting terms. Contract terms, conditions and coverages also tend to lack standardization and may evolve more rapidly than primary insurance policies. The nature and extent of loss information provided under many facultative (individual risk) or per occurrence excess contracts may be comparable to the information received under a primary insurance contract. However, loss information is often less detailed with respect to aggregate excess-of-loss and quota-share contracts and is often in a summary format rather than on an individual claim basis. Loss data includes recoverable paid losses, as well as case loss estimates. Ceding companies infrequently provide reliable IBNR estimates to reinsurers. Loss reporting to reinsurers is typically slower in comparison to primary insurers. In the U.S., such reporting is generally required at quarterly intervals ranging from 30 to 90 days after the end of the quarterly period, while outside of the U.S., reinsurance reporting practices may vary further. In certain countries, clients report annually from 90 to 180 days after the end of the annual period. Reinsurers may assume and cede underlying risks from other reinsurers, which may further delay the reporting of claims. The relative impact of reporting delays on the reinsurer may vary depending on the type of coverage, contractual reporting terms, the magnitude of the claim relative to the attachment point of the reinsurance coverage, and for other reasons. As reinsurers, the premium and loss data we receive is at least one level removed from the underlying claimant, so there is a risk that the loss data reported is incomplete, inaccurate or the claim is outside the coverage terms. We maintain certain internal procedures in order to determine that the information is complete and in compliance with the contract terms. Generally, our reinsurance contracts permit us to access the ceding company’s records with respect to the subject business, thus providing the ability to audit the reported information. In the normal course of business, disputes occasionally arise concerning whether claims are covered by our reinsurance policies. We resolve most coverage disputes through negotiation with the client. If disputes cannot be resolved, our contracts generally provide arbitration or alternative dispute resolution processes. There are no coverage disputes at this time for which an adverse resolution would likely have a material impact on our consolidated results of operations or financial condition. K-60 Management’s Discussion and Analysis (Continued) Property and casualty losses (Continued) Berkshire Hathaway Reinsurance Group (Continued) Establishing claim liability estimates for reinsurance requires evaluation of loss information received from our clients. We generally rely on the ceding companies reported case loss estimates. We independently evaluate certain reported case losses and if appropriate, we use our own case liability estimate. For instance, as of December 31, 2020, our case loss estimates exceeded ceding company estimates by approximately $800 million for certain legacy workers’ compensation claims occurring over 10 years ago. We also periodically conduct detailed reviews of individual client claims, which may cause us to adjust our case estimates. Although liabilities for losses are initially determined based on pricing and underwriting analysis, BHRG uses a variety of actuarial methodologies that place reliance on the extrapolation of actual historical data, loss development patterns, industry data and other benchmarks, as appropriate. The estimate of the required IBNR liabilities also requires judgment by actuaries and management to reflect the impact of additional factors like change in business mix, volume, claim reporting and handling practices, inflation, social and legal environment and the terms and conditions of the contracts. The methodologies generally fall into one of the following categories or are hybrids of one or more of the following categories: Paid and incurred loss development methods – these methods consider expected case loss emergence and development patterns, together with expected loss ratios by year. Factors affecting our loss development analysis include, but are not limited to, changes in the following: client claims reporting and settlement practices; the frequency of client company claim reviews; policy terms and coverage (such as loss retention levels and occurrence and aggregate policy limits); loss trends; and legal trends that result in unanticipated losses. Collectively, these factors influence our selections of expected case loss emergence patterns. Incurred and paid loss Bornhuetter-Ferguson methods – these methods consider actual paid and incurred losses and expected patterns of paid and incurred losses, taking the initial expected ultimate losses into account to determine an estimate of the expected unpaid or unreported losses. Frequency and severity methods – these methods commonly focus on a review of the number of anticipated claims and the anticipated claims severity and may also rely on development patterns to derive such estimates. However, our processes and techniques for estimating liabilities in such analyses generally rely more on a per-policy assessment of the ultimate cost associated with the individual loss rather than with an analysis of historical development patterns of past losses. Additional Analysis – in some cases we have established reinsurance claim liabilities on a contract-by-contract basis, determined from case loss estimates reported by the ceding company and IBNR liabilities that are primarily a function of an anticipated loss ratio for the contract and the reported case loss estimate. Liabilities are adjusted upward or downward over time to reflect case losses reported versus expected case losses, which we use to form revised judgement on the adequacy of the expected loss ratio and the level of IBNR liabilities required for unreported claims. Anticipated loss ratios are also revised to include estimates of known major catastrophe events. Our claim liability estimation process for short-tail lines, primarily property exposures, utilizes a combination of the paid and incurred loss development methods and the incurred and paid loss Bornhuetter-Ferguson methods. Certain catastrophe, individual risk and aviation excess-of-loss contracts tend to generate low frequency/high severity losses. Our processes and techniques for estimating liabilities under such contracts generally rely more on a per contract assessment of the ultimate cost associated with the individual loss event rather than with an analysis of the historical development patterns of past losses. For our long-tail lines, primarily casualty exposures, we may rely on different methods depending on the maturity of the business, with estimates for the most recent years being based on priced loss expectations and more mature years reflecting the paid or incurred development pattern indications. In 2020, certain workers’ compensation claims reported losses were less than expected. As a result, we reduced estimated ultimate losses for prior years’ loss events by $160 million. We estimate that increases of ten percent in the tail of the expected loss emergence pattern and in the expected loss ratios would produce a net increase of approximately $1.1 billion in IBNR liabilities, producing a corresponding decrease in pre-tax earnings. We believe it is reasonably possible for these assumptions to increase at these rates. K-61 Management’s Discussion and Analysis (Continued) Property and casualty losses (Continued) Berkshire Hathaway Reinsurance Group (Continued) For other casualty losses, excluding asbestos, environmental, and other latent injury claims, the overall change in estimates for prior years’ events was not significant in 2020. However, the potential for significant changes in future periods remains. For certain significant casualty and general liability portfolios, we estimate that increases of five percent in the claim-tails of the expected loss emergence patterns and in the expected loss ratios would produce a net increase in our nominal IBNR liabilities and a corresponding reduction in pre-tax earnings of approximately $900 million, although outcomes of greater than or less than $900 million are possible given the diversification in worldwide business. Estimated ultimate liabilities for asbestos, environmental and other latent injury claims, excluding amounts assumed under retroactive reinsurance contracts increased $468 million in 2020, which produced a corresponding reduction in pre-tax earnings. Net liabilities for such claims were approximately $2.1 billion at December 31, 2020. Loss estimations for these exposures are difficult to determine due to the changing legal environment and increases may be required in the future if new exposures or claimants are identified, new claims are reported or new theories of liability emerge. Retroactive reinsurance Our retroactive reinsurance contracts cover loss events occurring before the contract inception dates. Claim liabilities relating to our retroactive reinsurance contracts are predominately related to casualty or liability exposures. We expect the claim-tails to be very long. As of December 31, 2020, gross unpaid losses were $41.0 billion and deferred charge assets were $12.4 billion. Our contracts are generally subject to maximum limits of indemnifications and, as such, we currently expect that maximum remaining gross losses payable under our retroactive policies will not exceed $56 billion. Absent significant judicial or legislative changes affecting asbestos, environmental or latent injury exposures, we also currently believe it unlikely that losses will develop upward to the maximum losses payable or downward by more than 15% of our estimated gross liability. We establish liability estimates by individual contract, considering exposure and development trends. In establishing our liability estimates, we often analyze historical aggregate loss payment patterns and project expected ultimate losses under various scenarios. We assign judgmental probability factors to these scenarios and an expected outcome is determined. We then monitor subsequent loss payment activity and review ceding company reports and other available information concerning the underlying losses. We re-estimate the expected ultimate losses when significant events or significant deviations from expected results are revealed. Certain of our retroactive reinsurance contracts include asbestos, environmental and other latent injury claims. Our estimated liabilities for such claims were approximately $12.5 billion at December 31, 2020. We do not consistently receive reliable detailed data regarding asbestos, environmental and latent injury claims from all ceding companies, particularly with respect to multi-line or aggregate excess-of-loss policies. When possible, we conduct a detailed analysis of the underlying loss data to make an estimate of ultimate reinsured losses. When detailed loss information is unavailable, we develop estimates by applying recent industry trends and projections to aggregate client data. Judgments in these areas necessarily consider the stability of the legal and regulatory environment under which we expect claims will be adjudicated. Legal reform and legislation could also have a significant impact on our ultimate liabilities. We reduced estimated ultimate liabilities for prior years’ retroactive reinsurance contracts by $399 million in 2020, which after the changes in related deferred charge assets, resulted in pre-tax earnings of $230 million. In 2020, we paid losses and loss adjustment expenses of $1.1 billion with respect to these contracts. K-62 Management’s Discussion and Analysis (Continued) Property and casualty losses (Continued) Retroactive reinsurance (Continued) In connection with our retroactive reinsurance contracts, we also record deferred charge assets, which at contract inception represents the excess, if any, of the estimated ultimate liability for unpaid losses over premiums received. We amortize deferred charge assets, which produces charges to pre-tax earnings in future periods based on the expected timing and amount of loss payments. We also adjust deferred charge balances due to changes in the expected timing and ultimate amount of claim payments. Significant changes in such estimates may have a significant effect on unamortized deferred charge balances and the amount of periodic amortization. Based on the contracts in effect as of December 31, 2020, we currently estimate that amortization expense in 2021 will approximate $1.1 billion. Other Critical Accounting Policies Our Consolidated Balance Sheet at December 31, 2020 includes goodwill of acquired businesses of $73.7 billion and other indefinite-lived intangible assets of $18.3 billion. We evaluate these assets for impairment annually in the fourth quarter and on an interim basis if the facts and circumstances lead us to believe that more-likely-not there has been an impairment. Goodwill and indefinite-lived intangible asset impairment reviews include determining the estimated fair values of our reporting units and intangible assets. The key assumptions and inputs used in such determinations may include forecasting revenues and expenses, cash flows and capital expenditures, as well as an appropriate discount rate and other inputs. Significant judgment by management is required in estimating the fair value of a reporting unit and in performing impairment reviews. Due to the inherent subjectivity and uncertainty in forecasting future cash flows and earnings over long periods of time, actual results may vary materially from the forecasts. If the carrying value of the indefinite-lived intangible asset exceeds fair value, the excess is charged to earnings as an impairment loss. If the carrying value of a reporting unit exceeds the estimated fair value of the reporting unit, then the excess, limited to the carrying amount of goodwill, will be charged to earnings as an impairment loss. In response to the adverse effects of the COVID-19 pandemic, we considered whether goodwill needed to be reevaluated for impairment during the second quarter of 2020. We determined it was necessary to quantitively reevaluate goodwill for impairment for certain reporting units, and most significantly for PCC. As a result of our reviews, we recorded pre-tax goodwill impairment charges of $10.0 billion and indefinite-lived intangible asset impairment charges of $638 million of which approximately $10 billion related to PCC. Prior to the reevaluation, the carrying value of goodwill related to PCC was approximately $17 billion. Additionally, the carrying value of PCC’s indefinite-lived intangible assets was approximately $14 billion. Substantially all of these amounts were recorded in connection with Berkshire’s acquisition of PCC in 2016. The effects of the COVID-19 pandemic on commercial airlines and aircraft manufacturers is particularly severe. We considered a number of factors in our reevaluation, including but not limited to the announcements by airlines concerning potential future demand, employment levels and aircraft orders, announcements by manufacturers on reduced aircraft production, and the actions we are taking or may take to restructure our operations to fit lower expected demand. In our judgment, the timing and extent of the recovery in the commercial airline and aerospace industries may be dependent on the development and wide-scale distribution of medicines and vaccines that effectively treat the virus. Consequently, we deemed it prudent under the prevailing circumstances to increase discount rates and reduce prior long-term forecasts of future cash flows for purposes of reviewing for impairments. As of December 31, 2020, we concluded it is more likely than not that goodwill recorded in our Consolidated Balance Sheet was not impaired. Making estimates of the fair value of reporting units at this time is and will likely be significantly affected by assumptions on the severity, duration or long-term effects of the pandemic on the reporting unit’s business, which we cannot reliably predict. Consequently, any fair value estimates in such instances can be subject to wide variations. The effects of the COVID-19 pandemic could prove to be worse than we currently estimate and could lead us to record additional goodwill or indefinite-lived intangible asset impairment charges in 2021. We primarily use discounted projected future earnings or cash flow methods in determining fair values. The key assumptions and inputs used in such methods may include forecasting revenues and expenses, cash flows and capital expenditures, as well as an appropriate discount rate and other inputs. A significant amount of judgment is required in estimating the fair value of a reporting unit and in performing goodwill impairment tests. K-63 Management’s Discussion and Analysis (Continued) Market Risk Disclosures Our Consolidated Balance Sheets include substantial amounts of assets and liabilities whose fair values are subject to market risks. Our significant market risks are primarily associated with equity prices, interest rates, foreign currency exchange rates and commodity prices. The fair values of our investment portfolios and equity index put option contracts remain subject to considerable volatility. The following sections address the significant market risks associated with our business activities. Equity Price Risk Equity securities represent a significant portion of our investment portfolio. Strategically, we strive to invest in businesses that possess excellent economics and able and honest management, and we prefer to invest a meaningful amount in each investee. Historically, equity investments have been concentrated in relatively few issuers. At December 31, 2020, approximately 68% of the total fair value of equity securities was concentrated in four issuers. We often hold our equity investments for long periods and short-term price volatility has occurred in the past and will occur in the future. We also strive to maintain significant levels of shareholder capital and ample liquidity to provide a margin of safety against short-term price volatility. We are also subject to equity price risk with respect to our equity index put option contracts. Our ultimate liability with respect to these contracts is determined from the movement of the underlying stock index between the contract inception date and expiration date. The fair values of our liabilities arising from these contracts are also affected by changes in other factors such as interest rates and the remaining duration of the contracts. The following table summarizes our equity securities and derivative contract liabilities with significant equity price risk as of December 31, 2020 and 2019 and the estimated effects of a hypothetical 30% increase and a 30% decrease in market prices as of those dates. The selected 30% hypothetical increase and decrease does not reflect the best or worst case scenario. Indeed, results from declines could be far worse due both to the nature of equity markets and the aforementioned concentrations existing in our equity investment portfolio. Dollar amounts are in millions. Fair Value Hypothetical Price Change Estimated Fair Value after Hypothetical Change in Prices Estimated Increase (Decrease) in Net Earnings (1) December 31, 2020 Investments in equity securities $ 281,170 30% increase $ 362,830 $ 63,321 30% decrease 199,547 (63,293 ) Equity index put option contract liabilities 1,065 30% increase 257 638 30% decrease 2,702 (1,293 ) December 31, 2019 Investments in equity securities $ 248,027 30% increase $ 319,445 $ 56,493 30% decrease 176,749 (56,382 ) Equity index put option contract liabilities 968 30% increase 267 554 30% decrease 2,776 (1,428 ) (1) The estimated increase (decrease) is after income taxes at the statutory rate in effect as of the balance sheet date. K-64 Management’s Discussion and Analysis (Continued) Market Risk Disclosures (Continued) Interest Rate Risk We may also invest in bonds, loans or other interest rate sensitive instruments. Our strategy is to acquire or originate such instruments at prices considered appropriate relative to the perceived credit risk. We also issue debt in the ordinary course of business to fund business operations, business acquisitions and for other general purposes. We attempt to maintain high credit ratings, in order to minimize the cost of our debt. We infrequently utilize derivative products, such as interest rate swaps, to manage interest rate risks. The fair values of our fixed maturity investments, loans and finance receivables, and notes payable and other borrowings will fluctuate in response to changes in market interest rates. In addition, changes in interest rate assumptions used in our equity index put option contract models cause changes in the reported liabilities. Increases and decreases in interest rates generally translate into decreases and increases in fair values of these instruments. Additionally, fair values of interest rate sensitive instruments may be affected by the creditworthiness of the issuer, prepayment options, relative values of alternative investments, the liquidity of the instrument and other general market conditions. The following table summarizes the estimated effects of hypothetical changes in interest rates on our significant assets and liabilities that are subject to significant interest rate risk at December 31, 2020 and 2019. We assumed that the interest rate changes occur immediately and uniformly to each category of instrument and that there were no significant changes to other factors used to determine the value of the instrument. The hypothetical changes in interest rates do not reflect the best or worst case scenarios. Actual results may differ from those reflected in the table. Dollars are in millions. Estimated Fair Value after Hypothetical Change in Interest Rates (bp=basis points) Fair Value 100 bp decrease 100 bp increase 200 bp increase 300 bp increase December 31, 2020 Assets: Investments in fixed maturity securities $ 20,410 $ 20,622 $ 20,139 $ 19,879 $ 19,628 Investments in equity securities* 8,891 9,408 8,413 7,970 7,559 Loans and finance receivables 20,554 21,472 19,916 19,219 18,570 Liabilities: Notes payable and other borrowings: Insurance and other 46,677 50,754 42,785 39,514 36,739 Railroad, utilities and energy 92,593 102,926 83,070 75,484 69,093 Equity index put option contracts 1,065 1,125 1,008 953 900 December 31, 2019 Assets: Investments in fixed maturity securities $ 18,685 $ 19,008 $ 18,375 $ 18,075 $ 17,787 Investments in equity securities* 10,314 11,016 9,671 9,081 8,539 Loans and finance receivables 17,861 18,527 17,240 16,660 16,116 Liabilities: Notes payable and other borrowings: Insurance and other 40,589 44,334 37,454 34,799 32,534 Railroad, utilities and energy 76,237 84,758 69,160 63,218 58,193 Equity index put option contracts 968 1,065 877 792 713 *Occidental Petroleum Cumulative Perpetual Preferred Stock K-65 Management’s Discussion and Analysis (Continued) Foreign Currency Risk Certain of our subsidiaries operate in foreign jurisdictions and we transact business in foreign currencies. In addition, we hold investments in common stocks of major multinational companies, who have significant foreign business and foreign currency risk of their own. We generally do not attempt to match assets and liabilities by currency and do not use derivative contracts to manage foreign currency risks in a meaningful way. Our net assets subject to financial statement translation into U.S. Dollars are primarily in our insurance, utilities and energy and certain manufacturing and service subsidiaries. A portion of our financial statement translation-related impact from changes in foreign currency rates is recorded in other comprehensive income. In addition, we include gains or losses in net earnings related to certain liabilities of Berkshire and U.S. insurance subsidiaries that are denominated in foreign currencies, due to changes in exchange rates. A summary of these gains (losses), after-tax, for each of the years ending December 31, 2020 and 2019 follows (in millions). 2020 2019 Non-U.S. denominated debt included in net earnings $ (764 ) $ 58 Net liabilities under certain reinsurance contracts included in net earnings (163 ) (92 ) Foreign currency translation included in other comprehensive income 1,264 257 Commodity Price Risk Our subsidiaries use commodities in various ways in manufacturing and providing services. As such, we are subject to price risks related to various commodities. In most instances, we attempt to manage these risks through the pricing of our products and services to customers. To the extent that we are unable to sustain price increases in response to commodity price increases, our operating results will likely be adversely affected. We do not utilize derivative contracts to manage commodity price risks to any significant degree. Item 7A. Quantitative and Qualitative Disclosures About Market Risk See “Market Risk Disclosures” contained in Item 7 “Management’s Discussion and Analysis of Financial Condition and Results of Operations.” Management’s Report on Internal Control Over Financial Reporting Management of Berkshire Hathaway Inc. is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in the Securities Exchange Act of 1934 Rule 13a-15(f). Under the supervision and with the participation of our management, including our principal executive officer and principal financial officer, we conducted an evaluation of the effectiveness of the Company’s internal control over financial reporting as of December 31, 2020 as required by the Securities Exchange Act of 1934 Rule 13a-15(c). In making this assessment, we used the criteria set forth in the framework in Internal Control—Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on our evaluation under the framework in Internal Control—Integrated Framework (2013), our management concluded that our internal control over financial reporting was effective as of December 31, 2020. The effectiveness of our internal control over financial reporting as of December 31, 2020 has been audited by Deloitte & Touche LLP, an independent registered public accounting firm, as stated in their report which appears on page K-67. Berkshire Hathaway Inc. February 27, 2021 K-66
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+Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations. Management's Discussion and Analysis of Financial Condition and Results of Operations ("MD&A") is intended to provide a reader of our financial statements with a narrative from the perspective of our management on our financial condition, results of operations, liquidity and certain other factors that may affect our future results. Unless otherwise noted, transactions and other factors significantly impacting our financial condition, results of operations and liquidity are discussed in order of magnitude. Our MD&A should be read in conjunction with the Consolidated Financial Statements and related Notes included in Item 8, Financial Statements and Supplementary Data, of this Annual Report on Form 10-K. Refer to Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations, in our Form 10-K for the fiscal year ended February 1, 2020, for discussion of the results of operations for the year ended February 1, 2020, compared to the year ended February 2, 2019, which is incorporated by reference herein. 23 Overview Our purpose is to enrich lives through technology. We have two reportable segments: Domestic and International. The Domestic segment is comprised of the operations, including our Best Buy Health business, in all states, districts and territories of the U.S. under various brand names including Best Buy, Best Buy Business, Best Buy Express, Best Buy Health, CST, Geek Squad, GreatCall, Lively, Magnolia and Pacific Kitchen and Home and the domain names bestbuy.com and greatcall.com. The International segment is comprised of all operations in Canada and Mexico under the brand names Best Buy, Best Buy Express, Best Buy Mobile and Geek Squad and the domain names bestbuy.ca and bestbuy.com.mx. During the third quarter of fiscal 2021 we made the decision to exit our operations in Mexico. Refer to Note 2, Restructuring, of the Notes to Consolidated Financial Statements, included in Item 8, Financial Statements and Supplementary Data, of this Annual Report on Form 10-K for additional information. Our fiscal year ends on the Saturday nearest the end of January. Fiscal 2021, fiscal 2020 and fiscal 2019 included 52 weeks. Our business, like that of many retailers, is seasonal. A large proportion of our revenue and earnings is generated in the fiscal fourth quarter, which includes the majority of the holiday shopping season in the U.S., Canada and Mexico. Comparable Sales Throughout this MD&A, we refer to comparable sales. Comparable sales is a metric used by management to evaluate the performance of our existing stores, websites and call centers by measuring the change in net sales for a particular period over the comparable prior-period of equivalent length. Comparable sales includes revenue from stores, websites and call centers operating for at least 14 full months. Stores closed more than 14 days, including but not limited to relocated, remodeled, expanded and downsized stores, or stores impacted by natural disasters, are excluded from comparable sales until at least 14 full months after reopening. Acquisitions are included in comparable sales beginning with the first full quarter following the first anniversary of the date of the acquisition. Comparable sales also includes credit card revenue, gift card breakage, commercial sales and sales of merchandise to wholesalers and dealers, as applicable. Comparable sales excludes the impact of revenue from discontinued operations and the effect of fluctuations in foreign currency exchange rates (applicable to our International segment only). Online sales are included in comparable sales. Online sales represent those initiated on a website or app, regardless of whether customers choose to pick up product in store, curbside, at an alternative pick-up location or take delivery direct to their homes. All periods presented apply this methodology consistently. In March 2020, the World Health Organization declared the outbreak of novel coronavirus disease (“COVID-19”) as a pandemic. All stores that were temporarily closed as a result of COVID-19 or operating a curbside-only operating model are included in comparable sales. On November 24, 2020, we announced our decision to exit our operations in Mexico. As a result, all revenue from Mexico operations has been excluded from our comparable sales calculation beginning in December of fiscal 2021. On March 1, 2018, we announced our intent to close all of our 257 remaining Best Buy Mobile stand-alone stores in the U.S. As a result, all revenue related to these stores has been excluded from our comparable sales calculation beginning in March 2018. On October 1, 2018, we acquired all outstanding shares of GreatCall, Inc. (“GreatCall”) and on May 9, 2019, we acquired all outstanding shares of Critical Signal Technologies, Inc. (“CST”). Consistent with our comparable sales policy, the results of GreatCall are included in our comparable sales calculation beginning in the fourth quarter of fiscal 2020, and the results of CST are included in our comparable sales calculation beginning in the third quarter of fiscal 2021. We believe comparable sales is a meaningful supplemental metric for investors to evaluate revenue performance resulting from growth in existing stores, websites and call centers versus the portion resulting from opening new stores or closing existing stores. The method of calculating comparable sales varies across the retail industry. As a result, our method of calculating comparable sales may not be the same as other retailers' methods. Non-GAAP Financial Measures This MD&A includes financial information prepared in accordance with accounting principles generally accepted in the United States ("GAAP"), as well as certain adjusted or non-GAAP financial measures, such as constant currency, non-GAAP operating income, non-GAAP effective tax rate and non-GAAP diluted earnings per share ("EPS"). We believe that non-GAAP financial measures, when reviewed in conjunction with GAAP financial measures, can provide more information to assist investors in evaluating current period performance and in assessing future performance. For these reasons, our internal management reporting also includes non-GAAP financial measures. Generally, our non-GAAP financial measures include adjustments for items such as restructuring charges, goodwill impairments, price-fixing settlements, gains and losses on investments, intangible asset amortization, certain acquisition-related costs and the tax effect of all such items. In addition, certain other items may be excluded from non-GAAP financial measures when we believe doing so provides greater clarity to management and our investors. These non-GAAP financial measures should be considered in addition to, and not superior to or as a substitute for, GAAP financial measures. We strongly encourage investors and shareholders to review our financial statements and publicly-filed reports in their entirety and not to rely on any single financial measure. Non-GAAP financial measures as presented herein may not be comparable to similarly titled measures used by other companies. 24 In our discussions of the operating results of our consolidated business and our International segment, we sometimes refer to the impact of changes in foreign currency exchange rates or the impact of foreign currency exchange rate fluctuations, which are references to the differences between the foreign currency exchange rates we use to convert the International segment’s operating results from local currencies into U.S. dollars for reporting purposes. We also may use the term "constant currency," which represents results adjusted to exclude foreign currency impacts. We calculate those impacts as the difference between the current period results translated using the current period currency exchange rates and using the comparable prior period currency exchange rates. We believe the disclosure of revenue changes in constant currency provides useful supplementary information to investors in light of significant fluctuations in currency rates. Refer to the Non-GAAP Financial Measures section below for detailed reconciliations of items impacting non-GAAP operating income, non-GAAP effective tax rate and non-GAAP diluted EPS in the presented periods. Business Strategy and COVID-19 Update In fiscal 2021 our Enterprise comparable sales grew 9.7% as we leveraged our unique capabilities, including our supply chain expertise, flexible store operating model and ability to shift quickly to digital, to meet what was clearly elevated demand for products that help customers work, learn, cook, entertain and connect in their homes. We provided customers with multiple options for how, when and where they shopped with us to ensure it satisfied their need for safety and convenience. The pandemic environment underscored our purpose to enrich lives through technology, and the capabilities we strengthened in fiscal 2021 will benefit us going forward as we execute our strategy. Our strong financial performance allowed us to share our success with the community, our shareholders, and, importantly, our employees. In the third quarter of fiscal 2021, we made a $40 million donation to the Best Buy Foundation to accelerate the progress towards our goal to reach 100 Teen Tech Centers across the U.S. We believe our Teen Tech Centers help to further our commitments towards economic and social justice in our communities by making a measurable difference in the lives of underserved teens who may not otherwise have access to technology. In addition, we resumed our share repurchase program during the fourth quarter of fiscal 2021 and increased our quarterly dividend by 27% to $0.70 per share. For our employees, we provided hourly appreciation pay for those who were working on the frontlines, paid recognition bonuses to field employees and established multiple hardship funds for anyone impacted physically, emotionally or financially by COVID-19. Starting August 1, 2020, we also raised our starting wage to $15 per hour for all domestic employees and enhanced our employee benefits. Throughout the pandemic and across all the ways customers can shop, we adhered to safety protocols that limited store capacity, followed strict social distancing practices and used proper protective equipment, including requiring our employees and customers to wear masks. This COVID-19 pandemic and the shift in customer buying behavior underscores the importance of our strong multi-channel capabilities. In fiscal 2021 our Domestic online revenue grew 144% compared to last year. We believe it is essential to provide options that let customers choose what works best for them. To best serve our customers during the pandemic, we had to be innovative and flexible. Early in the year, we quickly rolled out enhanced curbside pick-up across our stores to provide our customers convenience when we made the difficult decision to close our stores in March 2020. In May 2020 we developed an in-store appointment model that provided our customers with an option to shop in our stores as we prepared to open stores back up to customer shopping. We developed solutions like virtual consultations with advisors and video chats with our store associates. In addition, we made significant improvements to the functionality and customer experience of our app to support shopping, support and fulfillment. We provided fulfillment options that customers have come to expect from all retailers like fast and free home delivery, in-store pick-up and curbside pick-up. As we look forward, the environment is still evolving, and our operating model and supporting cost structure are evolving as well. The pandemic has accelerated the evolution of retail and compelled us to change our operating model in the best interest of our employees and customers. We have also expedited some planned strategic changes that we believe will allow us to emerge from this time even stronger. During the third quarter of fiscal 2021 we made the difficult decision to exit our operations in Mexico and began taking other actions to more broadly align our organizational structure in support of our strategy. As a result, we recorded $144 million of charges in our International segment in fiscal 2021, including $23 million of inventory markdowns within cost of sales and $121 million within restructuring charges primarily comprised of asset impairments, currency translation adjustments and termination benefits. As of January 30, 2021, the exit was substantially complete and we do not expect to incur material future restructuring charges in fiscal 2022 related to the exit. We also recorded $133 million of restructuring charges in our Domestic segment in fiscal 2021, primarily related to termination benefits associated with field and corporate organizational changes in support of our strategy, as well as impairments of technology assets held in service of our Mexico operations. As we continue to evolve our Building the New Blue Strategy, it is possible that we will incur material future restructuring costs, but we are unable to forecast the timing and magnitude of such costs. Refer to Note 2, Restructuring, of the Notes to Consolidated Financial Statements, included in Item 8, Financial Statements and Supplementary Data, of this Annual Report on Form 10-K for additional information. 25 We believe the following will be permanent and structural implications of the pandemic relevant to Best Buy: • Customer shopping behavior will be permanently changed in a way that is even more digital and puts customers entirely in control to shop how they want. Our strategy is to embrace that reality, and lead, not follow.• Our workforce will need to evolve in a way that meets the needs of customers while also providing more flexible opportunities for our people.• Technology is playing an even more crucial role in people’s lives, and, as a result, our purpose to enrich lives through technology has never been more important. Said differently, people are using technology to address their needs in ways they never contemplated before, and we play a vital role in bringing technology to life for both customers and our vendor partners. These implications are extensive and interdependent, and we are, as quickly as possible, both implementing change today and assessing future changes across our entire business, including how we evolve our stores and labor model, and how we spend our investment dollars.‌ In summary, during fiscal 2021 we managed through the challenging environment in a way that allowed us to accelerate many aspects of our strategy to deliver on our purpose. Our teams showed perseverance and commitment through the year and collectively changed the way we do business at a pace we never imagined. Results of Operations In order to align our fiscal reporting periods and comply with statutory filing requirements, we consolidate the financial results of our Mexico operations on a one-month lag. Consistent with such consolidation, the financial and non-financial information presented in our MD&A relative to these operations is also presented on a lag. Our policy is to accelerate the recording of events occurring in the lag period that significantly affect our consolidated financial statements. Other than the restructuring charges incurred related to our decision to exit our operations in Mexico, no such events were identified for the periods presented. Consolidated Results Selected consolidated financial data was as follows ($ in millions, except per share amounts): Consolidated Performance Summary2021 2020 2019Revenue$ 47,262 $ 43,638 $ 42,879 Revenue % increase 8.3 % 1.8 % 1.7 %Comparable sales growth 9.7 % 2.1 % 4.8 %Gross profit$ 10,573 $ 10,048 $ 9,961 Gross profit as a % of revenue(1) 22.4 % 23.0 % 23.2 %SG&A$ 7,928 $ 7,998 $ 8,015 SG&A as a % of revenue(1) 16.8 % 18.3 % 18.7 %Restructuring charges$ 254 $ 41 $ 46 Operating income$ 2,391 $ 2,009 $ 1,900 Operating income as a % of revenue 5.1 % 4.6 % 4.4 %Net earnings$ 1,798 $ 1,541 $ 1,464 Diluted earnings per share$ 6.84 $ 5.75 $ 5.20 (1)Because retailers vary in how they record costs of operating their supply chain between cost of sales and SG&A, our gross profit rate and SG&A rate may not be comparable to other retailers' corresponding rates. For additional information regarding costs classified in cost of sales and SG&A, refer to Note 1, Summary of Significant Accounting Policies, of the Notes to Consolidated Financial Statements, included in Item 8, Financial Statements and Supplementary Data, of this Annual Report on Form 10-K. In fiscal 2021 we generated $47.3 billion in revenue and our comparable sales increased 9.7%. The impact of the pandemic drove strong customer demand for products to help them work, learn, cook, entertain and connect in their homes. Our strong sales performance resulted in operating income rate expansion of 50 basis points compared to fiscal 2020. Revenue, gross profit rate, SG&A rate and operating income rate changes in fiscal 2021 were primarily driven by our Domestic segment. For further discussion of each segment's rate changes, see Segment Performance Summary, below. 26 Segment Performance Summary Domestic Segment Selected financial data for the Domestic segment was as follows ($ in millions): Domestic Segment Performance Summary2021 2020 2019Revenue$ 43,293 $ 40,114 $ 39,304 Revenue % increase 7.9 % 2.1 % 1.7 %Comparable sales growth(1) 9.2 % 2.3 % 4.8 %Gross profit$ 9,720 $ 9,234 $ 9,144 Gross profit as a % of revenue 22.5 % 23.0 % 23.3 %SG&A$ 7,239 $ 7,286 $ 7,300 SG&A as a % of revenue 16.7 % 18.2 % 18.6 %Restructuring charges$ 133 $ 41 $ 47 Operating income$ 2,348 $ 1,907 $ 1,797 Operating income as a % of revenue 5.4 % 4.8 % 4.6 %Selected Online Revenue Data Total online revenue$ 18,674 $ 7,640 $ 6,528 Online revenue as a % of total segment revenue 43.1 % 19.0 % 16.6 %Comparable online sales growth(1) 144.4 % 17.0 % 10.5 %(1)Comparable online sales are included in the comparable sales calculation. The increase in revenue in fiscal 2021 was primarily driven by the comparable sales growth across most of our product categories, partially offset by the loss of revenue from permanent store closures in the past year. Online revenue of $18.7 billion increased 144.4% on a comparable basis in fiscal 2021, primarily due to higher conversion rates and increased traffic as we saw a channel shift in our customer shopping behavior as a result of COVID-19. Domestic segment stores open at the end of each of the last three fiscal years, excluding stores that were temporarily closed as a result of COVID-19 in fiscal 2021, were as follows: 2019 2020 2021 Total Stores‎at End of‎Fiscal Year Stores‎Opened Stores‎Closed Total Stores‎at End of‎Fiscal Year Stores‎Opened Stores‎Closed Total Stores‎at End of‎Fiscal YearBest Buy 997 - (20) 977 - (21) 956 Outlet Centers 8 5 (2) 11 3 - 14 Pacific Sales 21 - - 21 - - 21 Total Domestic segment stores 1,026 5 (22) 1,009 3 (21) 991 We continuously monitor store performance. As we approach the expiration date of our leases, we evaluate various options for each location, including whether a store should remain open. Domestic segment revenue mix percentages and comparable sales percentage changes by revenue category were as follows: Revenue Mix Summary Comparable Sales Summary 2021 2020 2021 2020Computing and Mobile Phones 46 % 45 % 13.0 % 3.2 %Consumer Electronics 30 % 33 % (0.2)% 1.9 %Appliances 13 % 11 % 23.2 % 13.0 %Entertainment 6 % 6 % 17.9 % (18.5)%Services 5 % 5 % (1.4)% 6.8 %Total 100 % 100 % 9.2 % 2.3 % Continued strong demand in categories that help our customers work, learn, cook, entertain and connect from home contributed to our Domestic comparable sales changes across most of our categories. Notable comparable sales changes by revenue category were as follows: • Computing and Mobile Phones: The 13.0% comparable sales growth was driven primarily by computing, tablets and networking, partially offset by declines in mobile phones.• Consumer Electronics: The 0.2% comparable sales decline was driven primarily by headphones and digital imaging, partially offset by growth in home theater.• Appliances: The 23.2% comparable sales growth was driven by both large and small appliances.• Entertainment: The 17.9% comparable sales growth was driven primarily by gaming and virtual reality, partially offset by declines in movies.• Services: The 1.4% comparable sales decline was primarily driven by our repair, delivery and installation services. 27 Our gross profit rate decreased in fiscal 2021 primarily due to higher supply chain costs as a result of the increased mix of online revenue and lower profit-sharing revenue from our private label and co-branded credit card arrangement, partially offset by a more favorable promotional environment. Our SG&A decreased in fiscal 2021 primarily due to lower store payroll expense and other actions taken at the onset of the pandemic, such as the temporary suspension of the 401(k) employer match, reduced advertising and lower store overhead expenses. These decreases were partially offset by increases in variable costs associated with higher sales volume and a $40 million donation to the Best Buy Foundation. Lower store payroll expense was primarily due to fewer labor hours as a result of reduced store operating hours, lower store-generated revenue and efficiencies in our labor model, which was partially offset by increased wage rates. SG&A also includes $81 million of employee retention credits as a result of the Federal Coronavirus Aid, Relief and Economic Security (CARES) Act. Restructuring charges in fiscal 2021 related to termination benefits associated with actions taken to more broadly align our organizational structure in support of our strategy. Refer to Note 2, Restructuring, of the Notes to Consolidated Financial Statements, included in Item 8, Financial Statements and Supplementary Data, of this Annual Report on Form 10-K for additional information. Our operating income rate increased in fiscal 2021 primarily driven by increased leverage from higher sales volume on our fixed expenses, which resulted in favorable SG&A rates, partially offset by the decrease in gross profit rate and restructuring charges described above. International Segment Selected financial data for the International segment was as follows ($ in millions): International Segment Performance Summary2021 2020 2019Revenue$ 3,969 $ 3,524 $ 3,575 Revenue % change 12.6 % (1.4)% 2.5 %Comparable sales % change 15.0 % (0.5)% 4.6 %Gross profit$ 853 $ 814 $ 817 Gross profit as a % of revenue 21.5 % 23.1 % 22.9 %SG&A$ 689 $ 712 $ 715 SG&A as a % of revenue 17.4 % 20.2 % 20.0 %Restructuring charges$ 121 $ - $ (1) Operating income$ 43 $ 102 $ 103 Operating income as a % of revenue 1.1 % 2.9 % 2.9 % The increase in revenue in fiscal 2021 was primarily driven by comparable sales growth across most of our product categories, partially offset by the negative impact of foreign currency exchange rate fluctuations related to our operations in Mexico and Canada, and lower revenue in Mexico as a result of our decision in the third quarter of fiscal 2021 to exit operations. International segment stores open at the end of each of the last three fiscal years, excluding stores that were temporarily closed as a result of COVID-19 in fiscal 2021, were as follows: 2019 2020 2021 Total Stores‎at End of‎Fiscal Year Stores‎Opened Stores Closed Total Stores‎at End of‎Fiscal Year Stores‎Opened Stores‎Closed Total Stores‎at End of‎Fiscal YearCanada Best Buy 132 - (1) 131 - - 131 Best Buy Mobile 45 - (3) 42 - (9) 33 Mexico Best Buy 29 6 - 35 - (31) 4 Best Buy Express 6 8 - 14 - (14) - Total International segment stores 212 14 (4) 222 - (54) 168 International segment revenue mix percentages and comparable sales percentage changes by revenue category were as follows: Revenue Mix Summary Comparable Sales Summary 2021 2020 2021 2020Computing and Mobile Phones 47 % 45 % 23.8 % 0.6 %Consumer Electronics 30 % 33 % 0.3 % 1.4 %Appliances 10 % 9 % 20.9 % 0.7 %Entertainment 8 % 6 % 52.1 % (20.0)%Services 4 % 6 % (11.0)% 9.3 %Other 1 % 1 % 9.4 % (14.1)%Total 100 % 100 % 15.0 % (0.5)% 28 Similar to the Domestic segment, strong demand in categories that help our customers work, learn, cook, entertain and connect from home contributed to our International comparable sales changes across most of our categories. Notable comparable sales changes by revenue category were as follows: • Computing and Mobile Phones: The 23.8% comparable sales growth was driven primarily by computing, tablets and networking, partially offset by declines in mobile phones.• Consumer Electronics: The 0.3% comparable sales growth was driven primarily by home theater and health and fitness, partially offset by declines in smart home and digital imaging.• Appliances: The 20.9% comparable sales growth was driven by both small and large appliances.• Entertainment: The 52.1% comparable sales growth was driven primarily by gaming and virtual reality.• Services: The 11.0% comparable sales decline was driven primarily by warranty and repair services.• Other: The 9.4% comparable sales growth was driven primarily by baby products. Our gross profit rate declined in fiscal 2021 primarily due to operations in Canada, which was largely driven by higher supply chain costs as a result of the increased mix of online revenue and a lower mix of higher margin services revenue. Gross profit also decreased $23 million as a result of inventory markdowns associated with our decision to exit our operations in Mexico. Our SG&A decreased in fiscal 2021 primarily due to operations in Canada as a result of lower store payroll expense, partially offset by higher incentive compensation. Restructuring charges in fiscal 2021 primarily related to asset impairments, currency translation adjustments and termination benefits associated with our decision to exit our operations in Mexico. Refer to Note 2, Restructuring, of the Notes to Consolidated Financial Statements, included in Item 8, Financial Statements and Supplementary Data, of this Annual Report on Form 10-K for additional information. Our operating income rate decreased in fiscal 2021 primarily driven by restructuring charges and the lower gross profit rate described above, partially offset by a favorable SG&A rate driven by increased leverage from higher sales volume on our fixed expenses. Additional Consolidated Results Other Income (Expense) Our investment income and other decreased in fiscal 2021 primarily due to less favorable interest rates on our investments, partially offset by an increase in the fair value of a minority equity investment. Interest expense decreased in fiscal 2021 primarily due to more favorable interest rates related to our interest rate swap contracts, partially offset by an increase in interest expense as a result of our short-term draw on our $1.25 billion five-year senior unsecured revolving credit facility. Refer to Note 8, Debt, of the Notes to Consolidated Financial Statements, included in Item 8, Financial Statements and Supplementary Data, of this Annual Report on Form 10-K for additional information regarding our revolving credit facility. Income Tax Expense Income tax expense increased in fiscal 2021 primarily due to an increase in pre-tax earnings. Our effective tax rate increased in fiscal 2021 primarily due to an increase in losses for which tax benefits were not recognized, a decrease in the tax benefit from stock-based compensation and the impact of higher pre-tax earnings on discrete tax benefits, partially offset by an increase in the tax benefit from federal tax credits and the resolution of discrete tax matters. 29 Non-GAAP Financial Measures Reconciliations of operating income, effective tax rate and diluted EPS (GAAP financial measures) to non-GAAP operating income, non-GAAP effective tax rate and non-GAAP diluted EPS (non-GAAP financial measures) were as follows ($ in millions, except per share amounts): Fiscal Year2021 2020 2019Operating income$ 2,391 $ 2,009 $ 1,900 % of revenue 5.1 % 4.6 % 4.4 %Restructuring - inventory markdowns(1) 23 - - Price-fixing settlement(2) (21) - - Intangible asset amortization(3) 80 72 22 Restructuring charges(4) 254 41 46 Acquisition-related transaction costs(3) - 3 13 Tax reform-related item - employee bonus(5) - - 7 Non-GAAP operating income$ 2,727 $ 2,125 $ 1,988 % of revenue 5.8 % 4.9 % 4.6 % Effective tax rate 24.3 % 22.7 % 22.4 %Price-fixing settlement(2) 0.2 % -% -%Intangible asset amortization(3) (0.6)% 0.1 % -%Restructuring charges(4) (1.0)% -% (0.1)%Gain on investments, net(6) 0.1 % -% -%Tax reform - repatriation tax(5) -% -% 1.1 %Tax reform - deferred tax rate change(5) -% -% 0.3 %Non-GAAP effective tax rate 23.0 % 22.8 % 23.7 % Diluted EPS$ 6.84 $ 5.75 $ 5.20 Restructuring - inventory markdowns(1) 0.09 - - Price-fixing settlement(2) (0.08) - - Intangible asset amortization(3) 0.30 0.27 0.08 Restructuring charges(4) 0.97 0.15 0.16 Gain on investments, net(6) (0.05) - (0.04) Acquisition-related transaction costs(3) - 0.01 0.05 Tax reform-related item - employee bonus(5) - - 0.02 Tax reform - repatriation tax(5) - - (0.07) Tax reform - deferred tax rate change(5) - - (0.02) Income tax impact of non-GAAP adjustments(7) (0.16) (0.11) (0.06) Non-GAAP diluted EPS$ 7.91 $ 6.07 $ 5.32 For additional information regarding the nature of charges discussed below, refer to Note 2, Restructuring; Note 3, Acquisitions; Note 4, Goodwill and Intangible Assets; Note 6, Derivative Instruments; and Note 11, Income Taxes, of the Notes to Consolidated Financial Statements, included in Item 8, Financial Statements and Supplementary Data, of this Annual Report on Form 10-K.(1)Represents inventory markdowns recorded within cost of sales associated with the decision to exit operations in Mexico.(2)Represents a price-fixing litigation settlement received in relation to products purchased and sold in prior fiscal years.(3)Represents charges associated with acquisitions, including: (1) the non-cash amortization of definite-lived intangible assets, including customer relationships, tradenames and developed technology; and (2) acquisition-related transaction costs primarily comprised of professional fees.(4)Represents charges associated with actions taken to better align the company’s organizational structure with its strategic focus and the decision to exit operations in Mexico in fiscal 2021, charges and subsequent adjustments associated with U.S. retail operating model changes in fiscal 2020, and charges and subsequent adjustments primarily associated with the closure of Best Buy Mobile stand-alone stores in the U.S. in fiscal 2019.(5)Represents adjustments resulting from the Tax Cuts and Jobs Act of 2017 (“tax reform”) enacted into law in the fourth quarter of fiscal 2018, including amounts associated with a deemed repatriation tax and the revaluation of deferred tax assets and liabilities, as well as a one-time bonus for certain employees in response to future tax savings created by tax reform.(6)Represents an increase in the fair value of a minority equity investment in fiscal 2021 and a gain on sale of investments in fiscal 2019.(7)Represents the summation of the calculated income tax charge related to each non-GAAP non-income tax adjustment. The non-GAAP adjustments primarily relate to the U.S. and Mexico. As such, the income tax charge is calculated using the statutory tax rate of 24.5% for all U.S. non-GAAP items for all periods presented. There is no income tax charge for Mexico non-GAAP items, as there was no tax benefit recognized on these expenses in the calculation of GAAP income tax expense. Our non-GAAP operating income rate increased in fiscal 2021 primarily driven by increased leverage from higher sales volume on our fixed expenses, which resulted in a favorable SG&A rate, partially offset by a decrease in gross profit rate. Our non-GAAP effective tax rate increased in fiscal 2021 primarily due to a decrease in the tax benefit from stock-based compensation and the impact of higher pre-tax earnings on discrete tax benefits, partially offset by an increase in the tax benefit from federal tax credits and the resolution of discrete tax matters. Our non-GAAP diluted EPS increased in fiscal 2021 primarily driven by increases in non-GAAP operating income and lower diluted weighted-average common shares outstanding from share repurchases. 30 Liquidity and Capital Resources We closely manage our liquidity and capital resources. Our liquidity requirements depend on key variables, including the level of investment required to support our business strategies, the performance of our business, capital expenditures, credit facilities, short-term borrowing arrangements and working capital management. Capital expenditures and share repurchases are a component of our cash flow and capital management strategy which, to a large extent, we can adjust in response to economic and other changes in our business environment. We have a disciplined approach to capital allocation, which focuses on investing in key priorities that support our strategy. Cash and cash equivalents were as follows ($ in millions): January 30, 2021 February 1, 2020Cash and cash equivalents$ 5,494 $ 2,229 The increase in cash and cash equivalents in fiscal 2021 was primarily driven by the increase in operating cash flows and a reduction in share repurchases, which were temporarily suspended from March to November of fiscal 2021. Cash Flows Cash flows from total operations were as follows ($ in millions): 2021 2020 2019Total cash provided by (used in): Operating activities$ 4,927 $ 2,565 $ 2,408 Investing activities (788) (895) 508 Financing activities (876) (1,498) (2,018) Effect of exchange rate changes on cash 7 (1) (14) Increase in cash, cash equivalents and restricted cash$ 3,270 $ 171 $ 884 Operating Activities The increase in cash provided by operating activities in fiscal 2021 was primarily due to higher inventory turnover and the timing of inventory purchases and payments to meet continued higher demand. The increase was also driven by the timing of payments related to accrued compensation and benefits and higher earnings. Investing Activities The decrease in cash used in investing activities in fiscal 2021 was primarily due to the absence of acquisitions. Financing Activities The decrease in cash used in financing activities in fiscal 2021 was primarily due to lower share repurchases, which were temporarily suspended from March to November of fiscal 2021. Sources of Liquidity Funds generated by operating activities, available cash and cash equivalents, our credit facilities and other debt arrangements are our most significant sources of liquidity. We believe our sources of liquidity will be sufficient to fund operations and anticipated capital expenditures, share repurchases, dividends and strategic initiatives, including business combinations. However, in the event our liquidity is insufficient, we may be required to limit our spending. There can be no assurance that we will continue to generate cash flows at or above current levels or that we will be able to maintain our ability to borrow under our existing credit facilities or obtain additional financing, if necessary, on favorable terms. We have a $1.25 billion five-year senior unsecured revolving credit facility (the "Facility”) with a syndicate of banks. Refer to Note 8, Debt, of the Notes to Consolidated Financial Statements, included in Item 8, Financial Statements and Supplementary Data, of this Annual Report on Form 10-K for additional information on the terms of the Facility. In light of the uncertainty surrounding the impact of COVID-19 and to maximize liquidity, we executed a short-term draw on the full amount of the Facility on March 19, 2020, which remained outstanding until July 27, 2020, when the amounts we had borrowed under the Facility were repaid in full. There were no borrowings outstanding under the Facility as of January 30, 2021, or February 1, 2020. Our ability to continue to access the Facility is subject to our compliance with its terms and conditions, including financial covenants. The financial covenants require us to maintain certain financial ratios. As of January 30, 2021, we were in compliance with all financial covenants. If an event of default were to occur with respect to any of our other debt, it would likely constitute an event of default under the Facility as well. 31 Our credit ratings and outlook as of March 18, 2021, are summarized below. On February 26, 2021, Moody’s upgraded its rating to A3 and confirmed its outlook of Stable. Standard & Poor’s rating and outlook remained unchanged from the prior year. Rating AgencyRating OutlookStandard & Poor'sBBB StableMoody'sA3 Stable Credit rating agencies review their ratings periodically, and, therefore, the credit rating assigned to us by each agency may be subject to revision at any time. Factors that can affect our credit ratings include changes in our operating performance, the economic environment, conditions in the retail and consumer electronics industries, our financial position and changes in our business strategy. If changes in our credit ratings were to occur, they could impact, among other things, interest costs for certain of our credit facilities, our future borrowing costs, access to capital markets, vendor financing terms and future new-store leasing costs. Restricted Cash Our liquidity is also affected by restricted cash balances that are primarily restricted to use for workers' compensation and general liability insurance claims. Restricted cash, which is included in Other current assets on our Consolidated Balance Sheets, was $131 million and $126 million as of January 30, 2021, and February 1, 2020, respectively. Capital Expenditures Our capital expenditures typically include investments in our information technology (including e-commerce), stores and distribution capabilities. Capital expenditures were as follows ($ in millions): 2021 2020 2019E-commerce and information technology$ 539 $ 431 $ 448 Store-related projects(1) 117 238 264 Supply chain 57 74 107 Total capital expenditures(2)$ 713 $ 743 $ 819 (1)Store-related projects are primarily comprised of store remodels and various merchandising projects.(2)Total capital expenditures exclude non-cash capital expenditures of $32 million, $10 million and $53 million in fiscal 2021, fiscal 2020 and fiscal 2019, respectively. Non-cash capital expenditures are comprised of finance leases, as well as additions to property and equipment included in accounts payable. Debt and Capital As of January 30, 2021, we had $500 million of principal amount of notes due October 1, 2028 (“2028 Notes”) and $650 million of principal amount of notes due October 1, 2030 (“2030 Notes”). Upon issuance of our 2030 Notes, we cash settled the associated Treasury Rate Lock ("T-Lock") contracts entered into in fiscal 2021 to hedge the base interest rate variability on a portion of our then-expected refinancing of our maturing $650 million of principal amount of notes due March 15, 2021 (“2021 Notes”). The net proceeds from the 2030 Notes were used to replace our 2021 Notes that we retired in December 2020 by exercising our option to redeem the notes at par. Refer to Note 6, Derivative Instruments, and Note 8, Debt, in the Notes to Consolidated Financial Statements, included in Item 8, Financial Statements and Supplementary Data, of this Annual Report on Form 10-K for further information about our T-Lock contracts and outstanding debt. Share Repurchases and Dividends We repurchase our common stock and pay dividends pursuant to programs approved by our Board. The payment of cash dividends is also subject to customary legal and contractual restrictions. Our long-term capital allocation strategy is to first fund operations and investments in growth and then return excess cash over time to shareholders through dividends and share repurchases while maintaining investment-grade credit metrics. On February 23, 2019, the Board authorized a $3.0 billion share repurchase program. On February 16, 2021, the Board approved a new $5.0 billion share repurchase program, replacing the existing program which had $1.7 billion remaining available for repurchases as of January 30, 2021. There is no expiration date governing the period over which we can repurchase shares under this authorization. We temporarily suspended all share repurchases from March to November of fiscal 2021 to conserve liquidity in light of COVID-19-related uncertainties. Between the end of fiscal 2021 on January 30, 2021, and March 18, 2021, we repurchased an incremental 8.1 million shares of our common stock at a cost of $873 million. On February 25, 2021, we announced our plans to spend at least $2 billion on share repurchases in fiscal 2022. Share repurchase and dividend activity were as follows ($ and shares in millions, except per share amounts): 2021 2020 2019Total cost of shares repurchased$ 318 $ 1,009 $ 1,493 Average price per share$ 102.63 $ 72.34 $ 70.28 Total number of shares repurchased 3.1 14.0 21.2 Regular quarterly cash dividends per share$ 2.20 $ 2.00 $ 1.80 Cash dividends declared and paid$ 568 $ 527 $ 497 32 Dividends declared and paid increased in fiscal 2021 primarily due to an increase in the regular quarterly cash dividend per share. On February 25, 2021, we announced the Board’s approval of a 27% increase in the regular quarterly dividend to $0.70 per share. Other Financial Measures Our current ratio, calculated as current assets divided by current liabilities, remained relatively unchanged at 1.2 as of January 30, 2021, compared to 1.1 as of February 1, 2020. Our debt to earnings ratio, calculated as total debt (including current portion) divided by net earnings, remained unchanged at 0.8 as of January 30, 2021, and February 1, 2020. Off-Balance-Sheet Arrangements and Contractual Obligations We do not have outstanding off-balance-sheet arrangements. Contractual obligations as of January 30, 2021, were as follows ($ in millions): Payments Due by PeriodContractual ObligationsTotal Less Than ‎1 Year 1-3 Years 3-5 Years More Than ‎5 YearsPurchase obligations(1)$ 3,107 $ 2,922 $ 151 $ 29 $ 5 Operating lease obligations(2)(3) 2,917 741 1,147 637 392 Long-term debt obligations(4) 1,150 - - - 1,150 Interest payments(5) 217 22 44 50 101 Short-term debt obligations(4) 110 110 - - - Finance lease obligations(2) 41 14 17 6 4 Total$ 7,542 $ 3,809 $ 1,359 $ 722 $ 1,652 For additional information regarding the nature of contractual obligations discussed below, refer to Note 6, Derivative Instruments; Note 7, Leases; Note 8, Debt; and Note 13, Contingencies and Commitments, of the Notes to Consolidated Financial Statements, included in Item 8, Financial Statements and Supplementary Data, of this Annual Report on Form 10-K.(1)Purchase obligations include agreements to purchase goods or services that are enforceable, are legally binding and specify all significant terms, including fixed or minimum quantities to be purchased; fixed, minimum or variable price provisions; and the approximate timing of the transaction. Purchase obligations do not include agreements that are cancelable without penalty. Additionally, although they do not contain legally binding purchase commitments, we included open purchase orders in the table above. Substantially all open purchase orders are fulfilled within 30 days.(2)Lease obligations exclude $56 million of legally binding fixed costs for leases signed but not yet commenced.(3)Operating lease obligations exclude payments to landlords covering real estate taxes and common area maintenance. These charges, if included, would increase total operating lease obligations by $0.7 billion as of January 30, 2021.(4)Represents principal amounts only and excludes interest rate swap valuation adjustments related to our long-term debt obligations.(5)Interest payments related to our 2028 Notes and 2030 Notes include the variable interest rate payments included in our interest rate swaps. Additionally, we have $1.25 billion in undrawn capacity on our Facility as of January 30, 2021, which if drawn upon, would be included as short-term debt on our Consolidated Balance Sheets. Critical Accounting Estimates The preparation of our financial statements requires us to make assumptions and estimates about future events and apply judgments that affect the reported amounts of assets, liabilities, revenue, expenses and the related disclosures. We base our assumptions, estimates and judgments on historical experience, current trends and other factors believed to be relevant at the time our consolidated financial statements are prepared. Because future events and their effects cannot be determined with certainty, actual results could differ from our assumptions and estimates, and such differences could be material. Our significant accounting policies are discussed in Note 1, Summary of Significant Accounting Policies, of the Notes to Consolidated Financial Statements, included in Item 8, Financial Statements and Supplementary Data, of this Annual Report on Form 10-K. Other than our adoption of Accounting Standards Update (“ASU”) 2016-02, Leases, in the first quarter of fiscal 2020, and our adoption of ASU 2014-09, Revenue from Contracts with Customers, in the first quarter of fiscal 2019, we have not made any material changes to our accounting policies or methodologies during the past three fiscal years. We believe that the following accounting estimates are the most critical to aid in fully understanding and evaluating our reported financial results. These estimates require our most difficult, subjective or complex judgments and generally incorporate significant uncertainty. Vendor Allowances DescriptionWe receive funds from our merchandise vendors through a variety of programs and arrangements for product advertising and product placement, primarily in the form of allowances based on purchases or sales volumes. We recognize allowances based on purchases and sales as a reduction of cost of sales when the associated inventory is sold. Allowances for advertising and placement are recognized as a reduction of cost of sales ratably over the corresponding performance period. Funds that are determined to be a reimbursement of specific, incremental and identifiable costs incurred to sell a vendor's products are recorded as an offset to the related expense when incurred. 33 Judgments and uncertainties involved in the estimateDue to the quantity and diverse nature of our vendor agreements, estimates are made to determine the amount of funding to be recognized in earnings or deferred as an offset to inventory. These estimates require a detailed analysis of complex factors, including (1) proper classification of the type of funding received; and (2) the methodology to estimate the portion of purchases-based funding that should be recognized in cost of sales in each period, which considers factors such as inventory turn by product category and actual sell-through of inventory. Effect if actual results differ from assumptionsA 10% change in our vendor funding deferral as of January 30, 2021, would have affected net earnings by approximately $33 million in fiscal 2021. The overall level of deferral has remained relatively stable over the last three years. Goodwill DescriptionGoodwill is not amortized but is evaluated for impairment annually in the fiscal fourth quarter or whenever events or circumstances indicate the carrying value may not be recoverable. The impairment test involves a comparison of the fair value of each reporting unit with its carrying value. Fair value reflects the price a potential market participant would be willing to pay for the reporting unit in an arms-length transaction. Judgments and uncertainties involved in the estimateDetermining fair value of a reporting unit is complex and typically requires analysis of discounted cash flows and other market information, such as trading multiples and other observable metrics. Cash flow analysis requires judgment regarding many factors, such as revenue growth rates, expenses and capital expenditures. Market information requires judgmental selection of relevant market comparables. We have goodwill in two reporting units – Best Buy Domestic and Best Buy Health – with carrying values of $444 million and $542 million, respectively, as of January 30, 2021. There is greater uncertainty surrounding the key assumptions used to estimate the fair value of the Best Buy Health reporting unit and therefore a greater degree of complexity and judgment involved in our impairment analysis. Our valuation of Best Buy Health incorporates relatively higher levels of revenue growth than our valuation of Best Buy Domestic and, consequently, estimation of factors such as new customer growth, customer retention rates, capital expenditure requirements, advertising and cost to serve expenses and weighted-average cost of capital rates that incorporate significant judgment. Effect if actual results differ from assumptionsA 10% change in the fair value of the Best Buy Health reporting unit as of January 30, 2021, would not have had a material effect on our net earnings in fiscal 2021. Since acquisition, our estimate of the fair value of Best Buy Health has remained relatively stable. Inventory Markdown DescriptionOur merchandise inventories were $5.6 billion as of January 30, 2021. We value our inventory at the lower of cost or net realizable value through the establishment of inventory markdown adjustments. Markdown adjustments reflect the excess of cost over the net recovery we expect to realize from the ultimate sale or other disposal of inventory and establish a new cost basis. No adjustment is recorded for inventory that we are able to return to our vendors for full credit. Judgments and uncertainties involved in the estimateMarkdown adjustments involve uncertainty because the calculations require management to make assumptions and to apply judgment about the expected revenue and incremental costs we will generate for current inventory. Such estimates include the evaluation of historical recovery rates, as well as factors such as product type and condition, forecasted consumer demand, product lifecycles, promotional environment, vendor return rights and the expected sales channel of ultimate disposition. We also apply judgment in the assumptions about other components of net realizable value, such as vendor allowances and selling costs. Effect if actual results differ from assumptionsA 10% change in our markdown adjustment as of January 30, 2021, would have affected net earnings by approximately $13 million in fiscal 2021. The level of markdown adjustments has remained relatively stable over the last three fiscal years. Tax Contingencies DescriptionOur income tax returns are periodically audited by U.S. federal, state and local and foreign taxing authorities. Taxing authorities audit our tax filing positions, including the timing and amount of income and deductions and the allocation of income among various tax jurisdictions. At any one time, multiple tax years are subject to audit by the various taxing authorities. In evaluating the exposures associated with our various tax filing positions, we may record a liability for such exposures. A number of years may elapse before a particular matter, for which we have established a liability, is audited and fully resolved or clarified. We adjust our liability for unrecognized tax benefits and income tax provisions in the period in which an uncertain tax position is effectively settled, the statute of limitations expires for the relevant taxing authority to examine the tax position or when more information becomes available. Our effective income tax rate is also affected by changes in tax law, the tax jurisdiction of new stores or business ventures, the level of earnings and the results of tax audits. 34 Judgments and uncertainties involved in the estimateOur liability for unrecognized tax benefits contains uncertainties because management is required to make assumptions and apply judgment to estimate the exposures associated with our various tax filing positions. Such assumptions can include complex and uncertain external factors, such as changes in tax law, interpretations of tax law and the timing of such changes, and uncertain internal factors such as taxable earnings by jurisdiction, the magnitude and timing of certain transactions and capital spending. Effect if actual results differ from assumptionsAlthough we believe that the judgments and estimates discussed herein are reasonable, actual results could differ, and we may be exposed to losses or gains that could be material. To the extent we prevail in matters for which a liability has been established or are required to pay amounts in excess of our established liability, our effective income tax rate in a given financial statement period could be materially affected. An unfavorable tax settlement generally would require use of our cash and may result in an increase in our effective income tax rate in the period of resolution. A favorable tax settlement may reduce our effective income tax rate in the period of resolution. Service Revenue DescriptionWe sell support plans as part of a bundled service offer which may include items such as technical support, price discounts on future purchases, anti-virus software and one-time service repairs. We allocate the transaction price to all performance obligations identified in the contract based on their relative fair value. For technical support services, we typically recognize revenue over time on a usage basis, an input method of measuring progress over the related contract term. This method involves the estimation of expected usage patterns, primarily derived from historical information. Judgments and uncertainties involved in the estimateThere is judgment in (1) measuring the relative standalone selling price for bundled performance obligations, and (2) assessing the appropriate recognition and methodology for each performance obligation, and for those based on usage, estimating the expected pattern of consumption across a large portfolio of customers. When insufficient reliable and relevant history is available to estimate usage, we generally recognize revenue ratably over the life of the contract until such history has accumulated. Effect if actual results differ from assumptionsA 10% change in the amount of services membership deferred revenue as of January 30, 2021, would have affected net earnings by approximately $13 million in fiscal 2021. The amount of services membership deferred revenue has remained relatively stable over the last three fiscal years. New Accounting Pronouncements For a description of new applicable accounting pronouncements, see Note 1, Summary of Significant Accounting Policies, of the Notes to Consolidated Financial Statements, included in Item 8, Financial Statements and Supplementary Data, of this Annual Report on Form 10-K. Item 7A. Quantitative and Qualitative Disclosures About Market Risk. In addition to the risks inherent in our operations, we are exposed to certain market risks. Interest Rate Risk We are exposed to changes in short-term market interest rates and these changes in rates will impact our net interest expense. Our cash and cash equivalents generate interest income that will vary based on changes in short-term interest rates. In addition, we have swapped a portion of our fixed-rate debt to floating-rate such that the interest expense on this debt will vary with short-term interest rates. Refer to Note 6, Derivative Instruments, and Note 8, Debt, of the Notes to Consolidated Financial Statements, included in Item 8, Financial Statements and Supplementary Data, of this Annual Report on Form 10-K for further information regarding our interest rate swaps. In fiscal 2021 we entered into T-Lock contracts to hedge the base interest rate variability on a portion of our then-expected refinancing of our maturing 2021 Notes. The T-Lock contracts were immaterial and cash settled upon issuance of our 2030 Notes in fiscal 2021. The fair value of the T-Lock contracts upon settlement was released from Accumulated other comprehensive income on our Consolidated Balance Sheets and recorded in Interest expense on our Consolidated Statements of Earnings as interest is accrued over the life of the 2030 Notes. As of January 30, 2021, we had $5.5 billion of cash and cash equivalents and $500 million of debt that has been swapped to floating rate, and therefore the net balance exposed to interest rate changes was $5.0 billion. As of January 30, 2021, a 50-basis point increase in short-term interest rates would have led to an estimated $25 million reduction in net interest expense, and conversely a 50-basis point decrease in short-term interest rates would have led to an estimated $25 million increase in net interest expense. 35 Foreign Currency Exchange Rate Risk We have market risk arising from changes in foreign currency exchange rates related to our International segment operations. On a limited basis, we utilize foreign exchange forward contracts to manage foreign currency exposure to certain forecasted inventory purchases, recognized receivable and payable balances and our investment in our Canadian operations. Our primary objective in holding derivatives is to reduce the volatility of net earnings and cash flows, as well as net asset value associated with changes in foreign currency exchange rates. Our foreign currency risk management strategy includes both hedging instruments and derivatives that are not designated as hedging instruments, which generally have terms of up to 12 months. Refer to Note 6, Derivative Instruments, of the Notes to Consolidated Financial Statements, included in Item 8, Financial Statements and Supplementary Data, of this Annual Report on Form 10-K for further information regarding these instruments. In fiscal 2021 foreign currency exchange rate fluctuations were driven by the strength of the U.S. dollar compared to the Mexican peso and the Canadian dollar compared to the prior-year period, which had a negative overall impact on our revenue as foreign currencies translated into fewer U.S. dollars. The strength of the U.S. dollar compared to the Mexican peso also had a favorable impact on earnings as the operating loss in Mexican pesos translated into fewer U.S. dollars. We estimate that foreign currency exchange rate fluctuations had a net unfavorable impact on our revenue of approximately $45 million and a net favorable impact on earnings of approximately $15 million in fiscal 2021, excluding the reclassification of cumulative translation adjustments into earnings as a result of our exit from Mexico. ‎ 36
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+Item 7. Liquidity and Capital Resources includes separate reconciliations of amounts to each entity’s financial statements, where applicable;•Item 8. Financial Statements and Supplementary Data which includes the following specific disclosures for BXP and BPLP:• Note 2. Summary of Significant Accounting Policies;• Note 3. Real Estate;• Note 12. Stockholders’ Equity / Partners’ Capital; • Note 13. Segment Information; and• Note 14. Earnings Per Share / Common Unit; and• Item 15. Financial Statement Schedule—Schedule 3.This report also includes the following separate items for each of BXP and BPLP: Part II, Item 9A. Controls and Procedures, consents of the independent registered public accounting firm (Exhibits 23.1 and 23.2), and certifications (Exhibits 31.1, 31.2, 31.3, 31.4, 32.1, 32.2, 32.3 and 32.4).Table of ContentsTABLE OF CONTENTS ITEM NO.DESCRIPTIONPAGE NO.PART I21.BUSINESS21A.RISK FACTORS191B.UNRESOLVED STAFF COMMENTS422.PROPERTIES433.LEGAL PROCEEDINGS494.MINE SAFETY DISCLOSURES49PART II505.MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES506.SELECTED FINANCIAL DATA527.MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS577A.QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK1108.FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA1119.CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE1829A.CONTROLS AND PROCEDURES1829B.OTHER INFORMATION182PART III18310.DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE18311.EXECUTIVE COMPENSATION18312.SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS18313.CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE18414.PRINCIPAL ACCOUNTANT FEES AND SERVICES184PART IV18515.EXHIBITS AND FINANCIAL STATEMENT SCHEDULES18516.FORM 10-K SUMMARY199Table of ContentsSummary of Risk FactorsThe risk factors detailed in Item 1A titled “Risk Factors” in this Annual Report on Form 10-K are the risks that we believe are material to our investors and a reader should carefully consider them. Those risks are not all of the risks we face and other factors not presently known to us or that we currently believe are immaterial may also affect our business if they occur. The following is a summary of the risk factors detailed in Item 1A:•The COVID-19 pandemic has caused severe disruptions in the United States and global economies and we expect it will continue to materially and adversely affect our financial condition, results of operations, cash flows, liquidity and performance and that of our tenants. •Our performance depends upon the economic climates of our markets—Boston, Los Angeles, New York, San Francisco and Washington, DC.•Adverse economic and geopolitical conditions, health crises and dislocations in the credit markets could have a material adverse effect on our results of operations, financial condition and ability to pay dividends and/or distributions.•Our success depends on key personnel whose continued service is not guaranteed.•Our performance and value are subject to risks associated with our real estate assets and with the real estate industry, including, without limitation:◦potential difficulties or delays renewing leases or re-leasing space; and◦potential adverse effects from major tenants’ bankruptcies or insolvencies.•Our actual costs to develop properties may exceed our budgeted costs.•Our use of joint ventures may limit our flexibility with respect to the assets they own and other assets we may wish to acquire.•Some potential losses are not covered by insurance.•We face risks associated with the physical effects of climate change.•Potential liability for environmental contamination could result in substantial costs.•An increase in interest rates would increase our interest costs on variable rate debt and could adversely impact our ability to re-finance existing debt or sell assets on favorable terms or at all. •Covenants in our debt agreements could adversely affect our financial condition.•We face risks associated with the use of debt to fund acquisitions and developments, including refinancing risk.•Our degree of leverage could limit our ability to obtain additional financing or affect the market price of our equity and debt securities.•We face risks associated with BXP’s status as a real estate investment trust (REIT), including, without limitation:◦failure to qualify as a REIT would cause BXP to be taxed as a corporation, which would substantially reduce funds available for payment of dividends;◦possible adverse state and local tax audits and changes in state and local tax laws could result in increased tax costs that could adversely affect our financial condition and results of operations and the amount of cash available for the payment of dividends and distributions to our securityholders; and◦in order to maintain BXP’s REIT status, we may be forced to borrow funds during unfavorable market conditions.•Litigation could have a material adverse effect.•We face risks associated with security breaches through cyber attacks, cyber intrusions or otherwise, as well as other significant disruptions of our information technology (IT) networks and related systems.•Changes in accounting pronouncements could adversely affect our operating results, in addition to the reported financial performance of our tenants. This section contains forward-looking statements. You should refer to the explanation of the qualifications and limitations on forward-looking statements beginning on page 57.1Table of ContentsPART IItem 1. BusinessGeneralBXP, a Delaware corporation organized in 1997, is a fully integrated, self-administered and self-managed REIT, and is one of the largest publicly-traded office REITs (based on total market capitalization as of December 31, 2020) in the United States that develops, owns and manages primarily Class A office properties.Our properties are concentrated in five markets—Boston, Los Angeles, New York, San Francisco and Washington, DC. At December 31, 2020, we owned or had joint venture interests in a portfolio of 196 commercial real estate properties, aggregating approximately 51.2 million net rentable square feet of primarily Class A office properties, including six properties under construction/redevelopment totaling approximately 3.7 million net rentable square feet. As of December 31, 2020, our properties consisted of: •177 office properties (including six properties under construction/redevelopment);•12 retail properties;•six residential properties; and•one hotel.We consider Class A office properties to be well-located buildings that are modern structures or have been modernized to compete with newer buildings and professionally managed and maintained. As such, these properties attract high-quality tenants and command upper-tier rental rates. Our definition of Class A office properties may be different than those used by other companies.We are a full-service real estate company, with substantial in-house expertise and resources in acquisitions, development, financing, capital markets, construction management, property management, marketing, leasing, accounting, risk management, tax and legal services. BXP manages BPLP as its sole general partner. Our principal executive office and Boston regional office are located at The Prudential Center, 800 Boylston Street, Suite 1900, Boston, Massachusetts 02199 and our telephone number is (617) 236-3300. In addition, we have regional offices at 3250 Ocean Park Boulevard, Suite 300, Santa Monica, California 90405, 599 Lexington Avenue, New York, New York 10022, Four Embarcadero Center, San Francisco, California 94111 and 2200 Pennsylvania Avenue NW, Washington, DC 20037.Our internet address is http://www.bxp.com. On our website, you can obtain free copies of our Annual Reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended, as soon as reasonably practicable after we electronically file such material with, or furnish it to, the Securities and Exchange Commission, or the SEC. You may also obtain BXP’s and BPLP’s reports by accessing the EDGAR database at the SEC’s website at http://www.sec.gov, or we will furnish an electronic or paper copy of these reports free of charge upon written request to: Investor Relations, Boston Properties, Inc., Prudential Center, 800 Boylston Street, Suite 1900, Boston, Massachusetts 02199. “Boston Properties” is a registered trademark and the “bxp” logo is a trademark, in both cases, owned by BPLP.Boston Properties Limited PartnershipBPLP is a Delaware limited partnership organized in 1997, and the entity through which BXP conducts substantially all of its business and owns, either directly or through subsidiaries, substantially all of its assets. BXP is the sole general partner of BPLP and, as of February 22, 2021, the owner of approximately 89.8% of the economic interests in BPLP. Economic interest was calculated as the number of common partnership units of BPLP owned by BXP as a percentage of the sum of (1) the actual aggregate number of outstanding common partnership units of BPLP and (2) the number of common units issuable upon conversion of all outstanding long term incentive plan units of BPLP, or LTIP Units, for which all performance conditions have been satisfied for such conversion. We exclude from (1) and (2) above other LTIP Units issued in the form of Multi-Year Long-Term Incentive Plan Awards in 2019 or later (“MYLTIP Awards”), which remain subject to performance conditions. An LTIP Unit is generally the economic equivalent of a share of BXP’s restricted common stock, although LTIP Units issued in the form of MYLTIP Awards are only entitled to receive one-tenth (1/10th) of the regular quarterly distributions (and no special distributions) prior to being earned.Preferred units of BPLP have the rights, preferences and other privileges set forth in an amendment to the limited partnership agreement of BPLP. As of December 31, 2020 and February 22, 2021, BPLP had one series of 2Table of ContentsPreferred Units outstanding consisting of 80,000 Series B Preferred Units. The Series B Preferred Units have a liquidation preference of $2,500 per share (or an aggregate of approximately $193.6 million at December 31, 2020 and February 22, 2021, after deducting the underwriting discount and transaction expenses). The Series B Preferred Units were issued by BPLP on March 27, 2013 in connection with BXP’s issuance of 80,000 shares (8,000,000 depositary shares each representing 1/100th of a share) of 5.25% Series B Cumulative Redeemable Preferred Stock (the “Series B Preferred Stock”). BXP contributed the net proceeds from the offering to BPLP in exchange for Series B Preferred Units having rights, performance and privileges generally mirroring those of the Series B Preferred Stock. BXP will pay cumulative cash dividends on the Series B Preferred Stock at a rate of 5.25% per annum of the $2,500 liquidation preference per share. On and after March 27, 2018, BXP, at its option, may redeem the Series B Preferred Stock for a cash redemption price of $2,500 per share, plus all accrued and unpaid dividends. The Series B Preferred Stock is not redeemable by the holders, has no maturity date and is not convertible into any other security of ours or our affiliates. Transactions During 2020 DispositionsFor information explaining why BXP and BPLP may report different gains on sales of real estate, see the Explanatory Note that follows the cover page of this Annual Report on Form 10-K.On January 28, 2020, we entered into a joint venture with a third party to own, operate and develop properties at our Gateway Commons complex located in South San Francisco, California. We contributed our 601, 611 and 651 Gateway properties and development rights with an agreed upon value aggregating approximately $350.0 million for our 50% interest in the joint venture. 601, 611 and 651 Gateway consist of three Class A office properties aggregating approximately 768,000 net rentable square feet. The partner contributed three properties and development rights with an agreed upon value aggregating approximately $280.8 million at closing and will contribute cash totaling approximately $69.2 million in the future for its 50% ownership interest in the joint venture. As a result of the partner’s deferred contribution, we have an initial approximately 55% interest in the joint venture. Future development projects will be owned 49% by us and 51% by our partner. Upon the partner’s contribution, we ceased accounting for the joint venture entity on a consolidated basis and are accounting for the joint venture entity on an unconsolidated basis using the equity method of accounting, as we have reduced our ownership interest in the joint venture entity and no longer have a controlling financial or operating interest in the joint venture entity (See Note 6). We recognized a gain on the retained and sold interest in the real estate contributed to the joint venture totaling approximately $217.7 million for BXP and $222.4 million for BPLP during the year ended December 31, 2020 within Gains on Sales of Real Estate on the respective Consolidated Statements of Operations, as the fair value of the real estate exceeded its carrying value (See “Investments in Unconsolidated Joint Ventures” below). On February 20, 2020, we completed the sale of New Dominion Technology Park located in Herndon, Virginia for a gross sale price of $256.0 million. Net cash proceeds totaled approximately $254.0 million, resulting in a gain on sale of real estate totaling approximately $192.3 million for BXP and approximately $197.1 million for BPLP. New Dominion Technology Park is comprised of two Class A office properties aggregating approximately 493,000 net rentable square feet. On June 25, 2020, we completed the sale of a portion of our Capital Gallery property located in Washington, DC for a gross sale price of approximately $253.7 million. Net cash proceeds totaled approximately $246.6 million, resulting in a gain on sale of real estate totaling approximately $203.5 million for BXP and approximately $207.0 million for BPLP. Capital Gallery is an approximately 631,000 net rentable square foot Class A office property. The portion sold was comprised of approximately 455,000 net rentable square feet of commercial office space. We continue to own the land, underground parking garage and remaining commercial office and retail space containing approximately 176,000 net rentable square feet at the property. On December 16, 2020, we completed the sale of a parcel of land located in Marlborough, Massachusetts for a gross sale price of approximately $14.3 million. Net cash proceeds totaled approximately $14.2 million, resulting in a gain on sale of real estate totaling approximately $5.2 million. Developments/RedevelopmentsAs of December 31, 2020, we had six office properties under construction/redevelopment, which we expect will total approximately 3.7 million net rentable square feet. We estimate our share of the total investment to complete these projects, in the aggregate, is approximately $2.2 billion, of which approximately $848.7 million 3Table of Contentsremains to be invested as of December 31, 2020. Approximately 87% of the commercial space in these development projects was pre-leased as of February 22, 2021. For a detailed list of the properties under construction/redevelopment see “Liquidity and Capital Resources” within “Item 7—Management’s Discussion and Analysis of Financial Condition and Results of Operations.” On March 26, 2020, we completed and fully placed in-service 17Fifty Presidents Street located in Reston, Virginia. 17Fifty Presidents Street is a build-to-suit project with approximately 276,000 net rentable square feet of Class A office space that is 100% leased.On June 1, 2020, we completed and fully placed in-service 20 CityPoint, a Class A office project with approximately 211,000 net rentable square feet located in Waltham, Massachusetts. As of December 31, 2020, the office portion of the property was 100% leased, including a lease with a future commencement.On June 26, 2020, we completed the acquisition of real property at 777 Harrison Street (known as Fourth + Harrison and formerly known as 425 Fourth Street) located in San Francisco, California for a gross purchase price, including entitlements, totaling approximately $140.1 million. On July 31, 2020 and December 16, 2020, we acquired real property at 759 Harrison Street located in San Francisco, California, which is expected to be included in the Fourth + Harrison development project, for an aggregate purchase price totaling approximately $4.5 million. 759 Harrison Street and Fourth + Harrison are expected to support the development of approximately 850,000 square feet of primarily commercial office space.On August 15, 2020, we completed and fully placed in-service The Skylyne, an approximately 331,000 square foot project comprised of 402 residential units and retail space located in Oakland, California.On November 3, 2020, we signed an approximately 138,000 square-foot, 10-year lease with a new tenant at 200 West Street in Waltham, Massachusetts. We are currently redeveloping a portion of 200 West Street into life sciences space with expected completion in 2021. With this lease, the property is 100% leased.Ground LeaseOn July 29, 2020, we entered into a 99-year ground lease with a third-party hotel developer for land at our Reston Next property located in Reston, Virginia, which will support the development of a 270-room, approximately 241,000 square foot hotel property. The lease commenced on October 21, 2020 and, upon commencement, we performed classification testing. The ground lease is subject to termination rights with respect to the hotel developer’s ability to obtain construction financing for the property and, as of the lease commencement date, we were not reasonably certain that those termination rights would not be exercised and as such we have accounted for this as an operating lease that will expire on August 28, 2022.Unsecured DebtOn May 5, 2020, BPLP completed a public offering of $1.25 billion in aggregate principal amount of its 3.250% unsecured senior notes due 2031. The notes were priced at 99.850% of the principal amount to yield an effective rate (including financing fees) of approximately 3.343% per annum to maturity. The notes will mature on January 30, 2031, unless earlier redeemed. The aggregate net proceeds from the offering were approximately $1.24 billion, after deducting underwriting discounts and transaction expenses.Equity TransactionsDuring the year ended December 31, 2020, BXP acquired an aggregate of 856,811 common units of limited partnership interest, including 88,168 common units issued upon the conversion of LTIP Units, 2012 OPP Units, 2013 MYLTIP Units, 2014 MYLTIP Units, 2015 MYLTIP Units, 2016 MYLTIP Units and 2017 MYLTIP Units presented by the holders for redemption, in exchange for an equal number of shares of BXP common stock.Investments in Unconsolidated Joint VenturesOn January 28, 2020, we entered into a joint venture with a third party to own, operate and develop properties at our Gateway Commons complex located in South San Francisco, California. We contributed our 601, 611 and 651 Gateway properties and development rights with an agreed upon value aggregating approximately $350.0 million for our 50% interest in the joint venture (See Note 3). 601, 611 and 651 Gateway consist of three Class A office properties aggregating approximately 768,000 net rentable square feet. The partner contributed three properties and development rights with an agreed upon value aggregating approximately $280.8 million at closing and will contribute cash totaling approximately $69.2 million in the future for its 50% ownership interest in the joint 4Table of Contentsventure. As a result of the partner’s deferred contribution, we had an initial approximately 55% interest in the joint venture. Future development projects will be owned 49% by us and 51% by our partner (See “Dispositions” above).On February 20, 2020, a joint venture in which we have a 55% interest acquired the land underlying the ground lease at its Platform 16 property located in San Jose, California for a purchase price totaling approximately $134.8 million. The joint venture had previously made a deposit totaling $15.0 million, which was credited against the purchase price. Platform 16 consists of a parcel of land totaling approximately 5.6 acres that is expected to support the development of approximately 1.1 million square feet of commercial office space. On June 9, 2020, a joint venture in which we have a 20% interest refinanced with a new lender the mortgage loan collateralized by its Metropolitan Square property located in Washington, DC. The outstanding balance of the loan totaled approximately $155.9 million, bore interest at a fixed rate of 5.75% per annum and was scheduled to mature on August 5, 2020. The new mortgage loan totaling $325.0 million, of which $288.0 million was advanced at closing, bears interest at a variable rate equal to (1) the greater of (x) LIBOR or (y) 0.65%, plus (2) 4.75% per annum, and matures on July 7, 2022, with two, one-year extension options, subject to certain conditions. The joint venture entered into an interest rate cap agreement with a financial institution to limit its exposure to increases in the LIBOR rate at a cap of 3.00% per annum on a notional amount of $325.0 million through July 7, 2022. The joint venture distributed excess loan proceeds from the new mortgage loan totaling approximately $112.7 million, of which our share totaled approximately $22.5 million. Metropolitan Square is a Class A office property with approximately 654,000 net rentable square feet.On June 25, 2020, a joint venture in which we have a 50% interest completed the sale of Annapolis Junction Building Eight and two land parcels located in Annapolis, Maryland for a gross sale price of $47.0 million. Net cash proceeds totaled approximately $45.8 million after the payment of transaction costs. We recognized a gain on sale of real estate totaling approximately $5.8 million, which is included in Income (Loss) from Unconsolidated Joint Ventures in the accompanying Consolidated Statements of Operations. The joint venture distributed approximately $36.8 million of available cash and the net proceeds from the sale after the pay down of the mortgage loan, of which our share totaled approximately $18.4 million. Annapolis Junction Building Eight is an approximately 126,000 net rentable square foot Class A office property, which is vacant. The two land parcels will support the development of approximately 300,000 square feet of commercial office space with one parcel currently containing surface parking for approximately 511 vehicles.On June 25, 2020, in conjunction with the joint venture’s sale of Annapolis Junction Building Eight, the joint venture in which we have a 50% interest modified the mortgage loan collateralized by Annapolis Junction Building Seven and Building Eight with the release of Annapolis Junction Building Eight as collateral under the loan in exchange for a principal pay down of approximately $16.1 million using a portion of the net proceeds from the sale of the property. At the time of the modification, the outstanding balance of the loan totaled approximately $34.5 million, bore interest at a variable rate equal to LIBOR plus 2.35% per annum and was scheduled to mature on June 30, 2020. The modified mortgage loan totaling approximately $18.4 million is collateralized by Annapolis Junction Building Seven, continues to bear interest at a variable rate equal to LIBOR plus 2.35% per annum and matures on March 25, 2021. Annapolis Junction Building Seven is a Class A office property with approximately 127,000 net rentable square feet located in Annapolis, Maryland.On July 23, 2020, we acquired a 50% interest in a joint venture entity that owns Beach Cities Media Campus, a 6.4-acre parcel of land located in El Segundo, California, for a purchase price of approximately $21.2 million. Beach Cities Media Campus is expected to support the development of approximately 275,000 square feet of Class A office space. On July 24, 2020, a joint venture in which we have a 50% interest completed and fully placed in-service Hub50House, an approximately 320,000 square foot project comprised of 440 residential units located in Boston, Massachusetts.On September 1, 2020, we entered into an agreement with our partner in the joint venture that owns 1265 Main Street located in Waltham, Massachusetts to (1) form additional joint ventures to own and develop a mixed-use property containing approximately 1.2 million square feet to be developed in phases on an approximately 41-acre site adjacent to 1265 Main Street and (2) share the costs of certain offsite infrastructure improvements with our joint venture partner and other third-party abutting land owners. We will serve as the development manager and expect to own a 50% interest in each of the joint ventures. 5Table of ContentsOn September 30, 2020, a joint venture in which we have a 50% interest extended the mortgage loan collateralized by its Market Square North property. At the time of the extension, the outstanding balance of the loan totaled approximately $114.2 million, bore interest at a fixed rate of 4.85% per annum and was scheduled to mature on October 1, 2020. The extended loan was scheduled to mature on November 1, 2020. On October 30, 2020, the joint venture refinanced the mortgage loan. The outstanding balance of the loan totaled approximately $114.2 million, bore interest at a fixed rate of 4.85% per annum and was scheduled to mature on November 1, 2020. The new mortgage loan totals $125.0 million, bears interest at a variable rate equal to (1) the greater of (x) LIBOR or (y) 0.50%, plus (2) 2.30% per annum, and matures on November 10, 2025, with one, one-year extension option, subject to certain conditions. Market Square North is a Class A office property with approximately 418,000 net rentable square feet.On October 1, 2020, a joint venture in which we have a 50% interest completed and fully placed in-service Dock 72, a Class A office project with approximately 669,000 net rentable square feet located in Brooklyn, New York that is 33% leased. During December 2020, we recognized a non-cash impairment charge totaling approximately $60.5 million, which represented the other-than temporary decline in the fair value below the carrying value of our investment in the unconsolidated joint venture that owns Dock 72. The non-cash impairment charge was the result of an increase in costs and an extension of the projected period to fully lease the property and lower projected rental rates due to the COVID-19 pandemic, resulting in a current fair value that was less than the carrying value of our investment. We assessed the impairment and concluded that it was other than temporary. We determined that our valuation of the investment was categorized within Level 3 of the fair value hierarchy, as it utilized significant unobservable inputs in its assessment including an exit capitalization rate of 5.25%, a discount rate on our equity investment (the property is encumbered by mortgage debt) of 8.0% and an average lease commencement on currently vacant space of mid-2023. In addition, on December 14, 2020, the joint venture extended the mortgage loan collateralized by the property. At the time of the extension, the outstanding balance of the loan totaled approximately $198.6 million, bore interest at a variable rate equal to LIBOR plus 2.25% per annum and was scheduled to mature on December 18, 2020. The extended mortgage loan has a total commitment amount of $250.0 million, bears interest at an initial variable rate equal to (1) the greater of (x) LIBOR or (y) 0.25%, plus (2) 2.85% per annum and matures on December 18, 2023. On November 13, 2020, a joint venture in which we have a 50% interest extended the mortgage loan collateralized by its Annapolis Junction Building Six property located in Annapolis, Maryland. At the time of the extension, the outstanding balance of the loan totaled approximately $12.0 million, bore interest at a variable rate equal to LIBOR plus 2.00% per annum and was scheduled to mature on November 17, 2020. The extended mortgage loan has a total commitment amount of approximately $13.2 million, bears interest at a variable rate equal to (1) the greater of (x) LIBOR or (y) 0.50%, plus (2) 2.50% per annum and matures on November 16, 2021. Annapolis Junction Building Six is a Class A office property with approximately 119,000 net rentable square feet.Stock Option and Incentive PlanOn February 4, 2020, BXP’s Compensation Committee approved a new equity-based, multi-year, long-term incentive program (the “2020 MYLTIP”) as a performance-based component of our overall compensation program. Under the Financial Accounting Standards Board’s Accounting Standards Codification (“ASC”) 718 “Compensation - Stock Compensation,” the 2020 MYLTIP has an aggregate value of approximately $13.7 million, which amount will generally be amortized into earnings over the four-year plan period under the graded vesting method (See Note 16 to the Consolidated Financial Statements).On February 6, 2020, the measurement period for our 2017 MYLTIP awards ended and, based on BXP’s relative TSR performance, the final awards were determined to be 83.8% of target or an aggregate of approximately $17.6 million (after giving effect to employee separations). As a result, an aggregate of 270,942 2017 MYLTIP Units that had been previously granted were automatically forfeited.Business and Growth StrategiesBusiness Strategies Our primary business objective is to maximize return on investment to provide our investors with the greatest possible total return in all points of the economic cycle. Our strategies to achieve this objective are:•to target a few carefully selected geographic markets—Boston, Los Angeles, New York, San Francisco and Washington, DC—and to be one of the leading, if not the leading, developers, owners and managers in 6Table of Contentseach of those markets with a full-service office in each market providing property management, leasing, development, construction and legal expertise. We select markets and submarkets with a diverse economic base and a deep pool of prospective tenants in various industries and where tenants have demonstrated a preference for high-quality office buildings and other facilities. Additionally, our markets have historically been able to recruit new talent to them and as such created job growth that results in growth in rental rates and occupancy over time. We have explored, and may continue to explore for future investment, select domestic and international markets that exhibit these same traits, including specifically Seattle; •to emphasize markets and submarkets within those markets where the difficulty of receiving the necessary approvals for development and the necessary financing constitute high barriers to the creation of new supply, and where skill, financial strength and diligence are required to successfully develop, finance and manage high-quality office and life sciences space, as well as selected retail and residential space;•to take on complex, technically challenging development projects, leveraging the skills of our management team to successfully develop, acquire or reposition properties that other organizations may not have the capacity or resources to pursue;•to own and develop high-quality real estate designed to meet the demands of today’s tenants who require sophisticated telecommunications and related infrastructure, support services, sustainable features and amenities, and to manage those facilities so as to become the landlord of choice for both existing and prospective clients;•to opportunistically acquire assets that increase our market share in the markets in which we have chosen to concentrate, as well as potential new markets, which exhibit an opportunity to improve returns through repositioning (through a combination of capital improvements and shift in marketing strategy), changes in management focus and leasing;•to explore joint venture opportunities with (1) existing property owners located in desirable locations, who seek to benefit from the depth of development and management expertise we are able to provide and our access to capital and (2) strategic institutional partners, leveraging our skills as developers, owners and managers of Class A office space and mixed-use complexes;•to pursue on a selective basis the sale of properties or interests therein, including core properties, to either (1) take advantage of the demand for our premier properties and realize the value we have created or (2) pare from our portfolio properties that we believe have slower future growth potential;•to seek third-party development contracts to enable us to retain and utilize our existing development and construction management staff, especially when our internal development is less active or when new development is less-warranted due to market conditions; and•to enhance our capital structure through our access to a variety of sources of capital and proactively manage our debt expirations. In the current economic climate with relatively low interest rates we have and will continue to attempt to lower the cost of our debt capital and seek opportunities to lock in such low rates through early debt repayment, refinancings and interest rate hedges.Growth StrategiesExternal Growth StrategiesWe believe that our development experience, our organizational depth and our balance sheet position us to continue to selectively develop a range of property types, including high-rise urban developments, mixed-use developments (including office, residential and retail), low-rise suburban office properties and life sciences space, within budget and on schedule. We believe we are also well-positioned to achieve external growth through acquisitions. Other factors that contribute to our competitive position include:•our control of sites (including sites under contract or option to acquire) in our markets that could support approximately 16.7 million additional square feet of new office, life sciences, retail and residential development;•our reputation gained through 51 years of successful operations and the stability and strength of our existing portfolio of properties;7Table of Contents•our relationships with leading national corporations, universities and public institutions, including government agencies, seeking new facilities and development services;•our relationships with nationally recognized financial institutions that provide capital to the real estate industry;•our track record and reputation for executing acquisitions efficiently provide comfort to domestic and foreign institutions, private investors and corporations who seek to sell commercial real estate in our market areas;•our ability to act quickly on due diligence and financing; •our relationships with institutional buyers and sellers of high-quality real estate assets;•our ability to procure entitlements from multiple municipalities to develop sites and attract land owners to sell or partner with us; and•our relationship with domestic and foreign investors who seek to partner with companies like ours.Opportunities to execute our external growth strategy fall into three categories:•Development in selected submarkets. We believe the selected development of well-positioned office, life sciences and residential buildings and mixed-use complexes may be justified in our markets. We believe in acquiring land after taking into consideration timing factors relating to economic cycles and in response to market conditions that allow for its development at the appropriate time. While we purposely concentrate in markets with high barriers-to-entry, we have demonstrated throughout our 51-year history, an ability to make carefully timed land acquisitions in submarkets where we can become one of the market leaders in establishing rent and other business terms. We believe that there are opportunities at key locations in our existing and other markets for a well-capitalized developer to acquire land with development potential.In the past, we have been particularly successful at acquiring sites or options to purchase sites that need governmental approvals for development. Because of our development expertise, knowledge of the governmental approval process and reputation for quality development with local government regulatory bodies, we generally have been able to secure the permits necessary to allow development and to profit from the resulting increase in land value. We seek complex projects where we can add value through the efforts of our experienced and skilled management team leading to attractive returns on investment.Our strong regional relationships and recognized development expertise have enabled us to capitalize on unique build-to-suit opportunities. We intend to seek and expect to continue to be presented with such opportunities in the near term allowing us to earn relatively significant returns on these development opportunities through multiple business cycles.•Acquisition of assets and portfolios of assets from institutions or individuals. We believe that due to our size, management strength and reputation, we are well positioned to acquire portfolios of assets or individual properties from institutions or individuals if valuations meet our criteria. In addition, we believe that our market knowledge and our liquidity and access to capital may provide us with a competitive advantage when pursuing acquisitions. Opportunities to acquire properties may also come through the purchase of first mortgage or mezzanine debt. We are also able to appeal to sellers wishing to contribute on a tax-deferred basis their ownership of property for equity in a diversified real estate operating company that offers liquidity through access to the public equity markets in addition to a quarterly distribution. Our ability to offer common and preferred units of limited partnership in BPLP to sellers who would otherwise recognize a taxable gain upon a sale of assets for cash or BXP’s common stock may facilitate this type of transaction on a tax-efficient basis. Recent Treasury regulations may limit certain of the tax benefits previously available to sellers in these transactions.•Acquisition of underperforming assets and portfolios of assets. We believe that because of our in-depth market knowledge and development experience in each of our markets, our national reputation with brokers, financial institutions, owners of real estate and others involved in the real estate market and our access to competitively-priced capital, we are well-positioned to identify and acquire existing, underperforming properties for competitive prices and to add significant additional value to such properties 8Table of Contentsthrough our effective marketing strategies, repositioning/redevelopment expertise and a responsive property management program. Internal Growth StrategiesWe believe that opportunities will exist to increase cash flow from our existing properties through an increase in occupancy and rental rates because they are of high quality and in desirable locations. Additionally, our markets have diversified economies that have historically experienced job growth and increased use of office space, resulting in growth in rental rates and occupancy over time. Our strategy for maximizing the benefits from these opportunities is three-fold: (1) to provide high-quality property management services using our employees in order to encourage tenants to renew, expand and relocate in our properties, (2) to achieve speed and transaction cost efficiency in replacing departing tenants through the use of in-house services for marketing, lease negotiation and construction of tenant and capital improvements and (3) to work with new or existing tenants with space expansion or contraction needs, leveraging our expertise and clustering of assets to maximize the cash flow from our assets. We expect to continue our internal growth as a result of our ability to: •Cultivate existing submarkets and long-term relationships with credit tenants. In choosing locations for our properties, we have paid particular attention to transportation and commuting patterns, physical environment, adjacency to established business centers and amenities, proximity to sources of business growth and other local factors.The weighted-average lease term of our in-place leases, including leases signed by our unconsolidated joint ventures, was approximately 7.4 years at December 31, 2020, and we continue to cultivate long-term leasing relationships with a diverse base of high-quality, financially stable tenants. Based on leases in place at December 31, 2020, leases with respect to approximately 8.1% of the total square feet in our portfolio, including unconsolidated joint ventures, will expire in calendar year 2021. •Directly manage our office properties to maximize the potential for tenant retention. We provide property management services ourselves, rather than contracting for this service, to maintain awareness of and responsiveness to tenant needs. We and our properties also benefit from cost efficiencies produced by an experienced work force attentive to preventive maintenance and energy management and from our continuing programs to assure that our property management personnel at all levels remain aware of their important role in tenant relations. In addition, we reinvest in our properties by adding new services and amenities that are desirable to our tenants. •Replace tenants quickly at best available market terms and lowest possible transaction costs. We believe that we are well-positioned to attract new tenants and achieve relatively high rental and occupancy rates as a result of our well-located, well-designed and well-maintained properties, our reputation for high-quality building services and responsiveness to tenants, and our ability to offer expansion and relocation alternatives within our submarkets.•Extend terms of existing leases to existing tenants prior to expiration. We have also successfully structured early tenant renewals, which have reduced the cost associated with lease downtime while securing the tenancy of our highest quality credit-worthy tenants on a long-term basis and enhancing relationships.•Re-development of existing assets. We believe the select re-development of assets within our portfolio, where through the ability to increase the building size and/or to increase cash flow and generate appropriate returns on incremental investment after consideration of the asset’s current and future cash flows, may be desirable. This generally occurs in situations in which we are able to increase the building’s size, improve building systems, including conversion to higher yielding life sciences uses, and sustainability features, and/or add tenant amenities, thereby increasing tenant demand, generating acceptable returns on incremental investment and enhancing the long-term value of the property and the company. In the past, we have been particularly successful at gaining local government approval for increased density at several of our assets, providing the opportunity to enhance value at a particular location. Our strong regional relationships and recognized re-development expertise have enabled us to capitalize on unique build-to-suit opportunities. We intend to seek and expect to continue to be presented with such opportunities in the near term allowing us to earn attractive returns on these development opportunities through multiple business cycles.9Table of ContentsSustainabilityOur Sustainability StrategyWe actively work to promote our growth and operations in a sustainable and responsible manner across our five regions. The BXP sustainability strategy is to conduct our business, the development and operation of new and existing buildings, in a manner that contributes to positive economic, social and environmental outcomes for our customers, shareholders, employees and the communities we serve. Our investment philosophy is shaped by our core strategy of long-term ownership and our commitment to our communities and the centers of commerce and civic life that make them thrive. We are focused on developing and maintaining healthy, high-performance buildings, while simultaneously mitigating operational costs and the potential external impacts of energy, water, waste, greenhouse gas emissions and climate change. To that end, we have publicly adopted long-term energy, emissions, water and waste goals that establish aggressive reduction targets and have been aligned with the United Nations Sustainable Development Goals. BXP is a corporate member of the U.S. Green Building Council® (“USGBC”) and has a long history of owning, developing and operating properties that are certified under USGBC’s Leadership in Energy and Environmental Design™ (LEED®) rating system. In 2018, we announced a partnership with a leading healthy building certification system, Fitwel, to support healthy building design and operational practices across our portfolio, becoming a Fitwel Champion. We completed our Fitwel Champion commitments in 2019, adding 12.4 million square feet of Fitwel certified buildings.In addition, we have been an active participant in the green bond market since 2018, which provides access to sustainability-focused investors interested in the positive environmental externalities of our business activities. BXP and its employees also make a social impact through charitable giving, volunteerism, public realm investments and diversity and inclusion. Through these efforts, we demonstrate that operating and developing commercial real estate can be conducted with a conscious regard for the environment and wider society while mutually benefiting our stakeholders.Industry Leadership in SustainabilityWe continue to be recognized as an industry leader in sustainability. In 2020, BXP ranked among the top real estate companies in the Global Real Estate Sustainability Benchmark (“GRESB”) assessment, earning a fifth consecutive 5 Star rating, the highest rating and recognition for being an industry leader. It was the ninth consecutive year that BXP earned the GRESB “Green Star” designation, achieving the highest scores in several categories, including: Data Monitoring & Review, Targets, Policies, Reporting and Leadership. BXP was also named one of America’s Most Responsible Companies by Newsweek magazine in 2020. BXP ranked 56th overall out of 400 companies included. It was the second highest ranking of all property companies and the highest ranking of any office REIT. In 2014, 2015, 2017, 2018 and 2019, BXP was selected by the National Association of Real Estate Investment Trusts (“Nareit”) as a Leader in the Light Award winner. Nareit's annual Leader in the Light Awards honor Nareit member companies that have demonstrated superior and sustained sustainability practices. BXP has adopted sustainable development and operational practices across its portfolio. BXP became a proud signatory of the We Are Still In pledge after the U.S. withdrawal from the Paris Agreement, and has aligned emissions reduction targets with climate science. The SBTi Target Validation Team has classified BXP’s emissions reduction target ambition and has determined that it is in line with a 1.5°C trajectory, currently the most ambitious designation available. As of the end of 2020, BXP is one of six North American Real Estate companies with this distinction and the only North American office company in that group. We have LEED certified 28.8 million square feet of our portfolio, of which 96% is certified at the highest Gold and Platinum levels. BXP’s master lease form includes green lease clauses that support a more sustainable tenant-landlord relationship. In 2020, BXP was named a Green Lease Leader at the highest Gold level by the Institute for Market Transformation and the U.S. Department of Energy for exhibiting a strong commitment to high performance and sustainability in buildings and best practices in leasing. Through active asset management and tenant engagement, BXP has been a leader in energy efficiency and healthy building practices. In 2020 BXP was recognized by the Environmental Performance Agency (“EPA”) as an ENERGY STAR Partner of the Year for Sustained Excellence. This award is reserved for ENERGY STAR partners demonstrating outstanding leadership, year over year. Partners must perform at a superior level of energy management, demonstrate best practices across the organization and prove organization-wide energy savings. BXP was named a 2020 Best in Building Health award winner. We completed the first Fitwel Design Certified project in the world in 2019 and executed more Fitwel certifications by count and building area than any other company in 2019. BXP has 11 Fitwel Ambassadors among our Sustainability, Development and Property Management teams.10Table of ContentsSustainability Accounting Standards Board (“SASB”)The Real Estate Sustainability Accounting Standard issued by SASB in 2018 proposes sustainability accounting metrics designed for disclosure in mandatory filings, such as the Annual Report on Form 10-K, and serves as the framework against which we have aligned our disclosures for sustainability information. The recommended energy and water management activity metrics for the real estate industry include energy consumption data coverage as a percentage of floor area (“Energy Intensity”); percentage of eligible portfolio that is certified ENERGY STAR® (“ENERGY STAR certified”); total energy consumed by portfolio area (“Total Energy Consumption”); water withdrawal as a percentage of total floor area (“Water Intensity”); and total water withdrawn by portfolio area (“Total Water Consumption”). Energy and water data is collected from utility bills and submeters and is assured by a third-party, including all SASB 2019 energy and water metrics, which have been assured. During the 2019 calendar year, 45 buildings representing 42% of our eligible portfolio were ENERGY STAR certified. A licensed professional has verified all ENERGY STAR applications.The charts below detail our Energy Intensity, Total Energy Consumption, Water Intensity and Total Water Consumption for 2015 through 2019 for which data on occupied and actively-managed properties was available.1,2,3,4,5_______________(1)Full 2020 calendar year energy and water data will not be available to be assured by a third party until March 31, 2021. 2019 is the most recent year for which complete energy and water data is available and assured by a third party.(2)The charts reflect the performance of our occupied and actively-managed office building portfolio in Boston, Los Angeles, New York, San Francisco and Washington, DC. Occupied office buildings are buildings with no more than 50% vacancy. Actively-managed buildings are buildings where we have operational control of building system performance and investment decisions. At the end of the 2019 calendar year, this included 102 buildings totaling 40.9 million gross square feet.(3)Floor area is considered to have complete energy consumption data coverage when energy consumption data (i.e., energy types and amounts consumed) is obtained by us for all types of energy consumed in the relevant floor area during the calendar year, regardless of when such data was obtained.(4)The scope of energy includes energy purchased from sources external to us and our tenants or produced by us or our tenants and energy from all sources, including fuel, gas, electricity and steam. Energy use intensity (kBtu/SF) has been weather normalized.(5)Water sources include surface water (including water from wetlands, rivers, lakes and oceans), groundwater, rainwater collected directly and stored by the registrant, wastewater obtained from other entities, municipal water supplies or supply from other water utilities.Climate ResilienceAs a long-term owner and active manager of real estate assets in operation and under development, we take a long-term view of potential risks, including climate change. We are in the process of evaluating physical and transition risks associated with climate change. We view this as an opportunity to protect asset value by proactively assessing climate risk, implementing measures, planning and decision-making processes to protect our investments by improving resilience. We are preparing for long-term climate risk by considering climate change scenarios and will continue to assess climate change vulnerabilities resulting from potential future climate scenarios and sea level rise. In 2020, we began using Four Twenty Seven climate risk scoring to evaluate the forward-looking physical 11Table of Contentsclimate risk exposure of our entire portfolio. Event-driven (acute) and longer-term (chronic) physical risks that may result from climate change could have a material adverse effect on our properties, operations and business. Management’s role in assessing and managing these climate-related risks and initiatives is spread across multiple teams across our organization, including our executive leadership and our Sustainability, Risk Management, Development, Construction and Property Management departments. Climate resilience measures include training and implementation of emergency response plans and the engagement of our executives and BXP’s Board of Directors on climate change and other environmental, social and governance (“ESG”) aspects. ReportingA notable part of our commitment to sustainable development and operations is our commitment to transparent reporting of ESG performance indicators, as we recognize the importance of this information to investors, lenders and others in understanding how BXP assesses sustainability information and evaluates risks and opportunities. We publish an annual sustainability report that is aligned with the Global Reporting Initiative reporting framework, United Nations Sustainable Development Goals and the SASB framework and includes our strategy, key performance indicators, annual like-for-like comparisons, achievements and historical sustainability reports, which is available on our website at http://www.bxp.com under the heading “Sustainability.” In addition, we continue to work to further align our reporting with the recommendations of the Financial Stability Board’s Task Force on Climate-related Financial Disclosures (“TCFD”) to disclose climate-related financial risks and opportunities.In 2018 and 2019, BPLP issued an aggregate of $1.85 billion of green bonds. The terms of the green bonds have use of proceeds restrictions limiting its allocation to “eligible green projects.” We published our first Green Bond Allocation Report in June 2019, disclosing the full allocation of approximately $988 million in net proceeds from BPLP’s inaugural green bond offering to the eligible green project at our Salesforce Tower property in San Francisco, California. We recently published our September 30, 2020 Green Bond Allocation Report disclosing the full allocation of approximately $841 million in net proceeds from BPLP’s green bond offering in June 2019. The Green Bond Allocation Reports are available on our website at http://www.bxp.com under the heading “Sustainability.”Except for the documents specifically incorporated by reference into this Annual Report on Form 10-K, information contained on our website or that can be accessed through our website is not incorporated by reference into this Annual Report on Form 10-K.Human Capital ManagementOur company culture supports and nurtures our employees and provides a unique competitive advantage. We believe our employees are a significant distinguishing factor that sets BXP apart. As of December 31, 2020, we had approximately 750 employees. Our operational and financial performance depends on their talents, energy, experience and well-being. Our ability to attract and retain talented people depends on a number of factors, including work environment, career development and professional training, compensation and benefits, and the health, safety and wellness of our employees. We have an established reputation for excellence and integrity and these core values are inherent in our culture and play a critical role in achieving our goals and overall success. Diversity & Inclusion We strive to create a diverse and inclusive workplace. It has been, and will continue to be, our policy to recruit, hire, assign, promote and train in all job titles without regard to race, national origin, religion, age, color, sex, sexual orientation, gender identity, disability, or protected veteran status, or any other characteristic protected by local, state, or federal laws, rules, or regulations. By implementing this policy, we aim to ensure that all employees have the opportunity to make their maximum contribution to us and to their own career goals.In 2020, we took concrete steps to formalize and elevate our focus on diversity and equity within our company and in the communities we serve. We launched the Diversity & Inclusion Committee in early 2020 with the mission of promoting diversity, inclusion, equality and transparency as part of our culture, business activities and decision-making practices, while also providing an additional mechanism through which we can make a positive impact in the communities in which we operate. Areas of priority include recruiting, retention and professional development, review and assessment of our policies with a focus on business partner diversity and other relationships, and community outreach. In addition, our Chief Executive Officer is a signatory to the CEO Action for Diversity campaign, which is the largest CEO-driven business commitment to advance diversity and inclusion in the workplace.12Table of ContentsDiversity & Inclusion at BXP(1)TOTAL WORKFORCE(2)MANAGER & ABOVE(2)BOARD OF DIRECTORS _______________(1) As of December 31, 2020. We determine race and gender based on our employees' self-identification. Ethnic minorities are defined as those included in the EEO Ethnicity and Race Categories: Asian, Black/African American, Hispanic/Latino, Native American or Pacific Islander, or multiracial background.(2) Represents percentages for all of our employees excluding union employees for which the unions control all aspects of the hiring process.Culture & Employee EngagementWe believe that the success of our business is tied to the quality of our workforce, and we strive to maintain a corporate environment without losing the entrepreneurial spirit with which we were founded more than 50 years ago. By providing a quality workplace and comprehensive benefit programs, we recognize the commitment of our employees to bring their talent, energy and experience to us. Our continued success is attributable to our employees’ expertise and dedication. We conduct employee engagement surveys to monitor our employees’ satisfaction in all aspects of their employment, including leadership, communication, development and benefits offerings. Employee responsiveness to the engagements surveys have been consistently high and the results help inform us on matters that our employees view as key contributors to a positive work experience. Based on the employee engagement survey conducted in 2020, with 93% responsiveness, the overall company-wide favorability result was a “very favorable” rating with ratings exceeding 80% favorability in all categories.The success of our efforts in the workplace is demonstrated by the satisfaction and long tenure of our employees, 32% of whom have worked at BXP for ten or more years. The average tenure of our employees is approximately 9.8 years and that of our executive leadership is 18.2 years. In 2020, our total workforce turnover rate was 10.2%, which is below the total turnover rate of 18.0% reported in the Nareit 2020 Compensation & Benefits Survey (based on 2019 data).Career Development & Training We invest significant resources in our employees’ personal and professional growth and development and provide a wide range of tools and development opportunities that build and strengthen employees’ leadership and professional skills. These development opportunities include in-person and virtual training sessions, in-house learning opportunities, various management trainings, departmental conferences, executive townhalls and external programs. 13Table of ContentsOne particularly relevant training that was offered to all employees in 2020 was Unconscious/Implicit Bias training. We offered this training as part of our commitment to recognize that we all have a role to play to mitigate unconscious bias in the work environment and support an inclusive workforce. We strive for a truly inclusive environment where all employees feel valued and provided the opportunity to succeed. This training, coupled with other trainings and initiatives, aims to enhance awareness, knowledge, collaboration and teamwork and overall enrich our culture. Compensation & BenefitsOur employee benefit programs are designed to meet the needs of our diverse workforce, support our employees and their families by offering comprehensive programs that provide flexibility and choice in coverage, make available valuable resources to protect and enhance financial security and help balance work and personal life. Some of the benefits that we offer our employees include:•health, telehealth, dental and vision insurance, •a 401(k) plan with a generous matching contribution, •an employee stock purchase plan, •health care and dependent care reimbursement accounts, •income protection through our sick pay, salary continuation and long-term disability policies, •a scholarship program for the children of non-officer employees, •a commuter subsidy to support the use of public transportation, •tuition reimbursement, and •paid vacation, holiday, personal and volunteer days to balance work and personal life.Health, Safety & WellnessAs one of the largest publicly-traded office REITs (based on total market capitalization as of December 31, 2020) in the United States, we are keenly aware of the influence of buildings on human health and its importance to our tenants and employees. In light of the COVID-19 pandemic, our focus on healthy buildings has become even more important. The health, safety and security of our employees, tenants, contractors and others is our highest priority. In early 2020, we convened a Health Security Task Force of subject matter experts from both inside and outside BXP to develop the BXP Health Security Plan, which we published in May of 2020. The BXP Health Security Plan is a comprehensive set of building operational measures, including cleaning and disinfection, air and water quality, physical distancing, screening and personal protective equipment and health security communication. We conduct health and security quality audits to ensure implementation and effectiveness of the plan at our properties.We believe the success of our employees is dependent upon their overall well-being, including their physical health, mental health, work-life balance and financial well-being. In addition to the benefits outlined above, we also offer our employees an Employee Wellness Program and an Employee Assistance Program. The Employee Wellness Program was established in 2016 to encourage employees to improve their health and well-being by offering activities facilitated through an engaging and personalized approach. Program participants receive a reduction in their health insurance deduction cost. The Employee Assistance Program includes services for childcare, eldercare, personal relationship information, financial planning assistance, stress management, mental illness and general wellness and self-help.Policies with Respect to Certain ActivitiesThe discussion below sets forth certain additional information regarding our investment, financing and other policies. These policies have been determined by BXP’s Board of Directors and, in general, may be amended or revised from time to time by the Board of Directors.Investment PoliciesInvestments in Real Estate or Interests in Real EstateOur investment objectives are to provide quarterly cash dividends/distributions to our securityholders and to achieve long-term capital appreciation through increases in our value. We have not established a specific policy regarding the relative priority of these investment objectives.14Table of ContentsWe expect to continue to pursue our investment objectives primarily through the ownership of our current properties, development projects and other acquired properties. We currently intend to continue to invest primarily in developments of properties and acquisitions of existing improved properties or properties in need of redevelopment, and acquisitions of land that we believe have development potential, primarily in our existing markets of Boston, Los Angeles, New York, San Francisco and Washington, DC and the target market of Seattle. We have explored and may continue to explore for future investment select domestic and international markets that exhibit these same traits. Future investment or development activities will not be limited to a specified percentage of our assets. We intend to engage in such future investment or development activities in a manner that is consistent with the maintenance of BXP’s status as a REIT for federal income tax purposes. In addition, we may purchase or lease income-producing commercial and other types of properties for long-term investment, expand and improve the real estate presently owned or other properties purchased, or sell such real estate properties, in whole or in part, when circumstances warrant. We do not have a policy that restricts the amount or percentage of assets that will be invested in any specific property, however, our investments may be restricted by our debt covenants.We may also continue to participate with third parties in property ownership, through joint ventures or other types of co-ownership. These investments may permit us to own interests in larger assets without unduly restricting diversification and, therefore, add flexibility in structuring our portfolio.Equity investments may be subject to existing mortgage financing and other indebtedness or such financing or indebtedness as may be incurred in connection with acquiring or refinancing these investments. Debt service on such financing or indebtedness will have a priority over any distributions with respect to BXP’s common stock. Investments are also subject to our policy not to be treated as an investment company under the Investment Company Act of 1940, as amended (the “1940 Act”). Investments in Real Estate MortgagesWhile our current portfolio consists primarily of, and our business objectives emphasize, equity investments in commercial real estate, we may, at the discretion of the Board of Directors of BXP, invest in mortgages and other types of real estate interests consistent with BXP’s qualification as a REIT. Investments in real estate mortgages run the risk that one or more borrowers may default under such mortgages and that the collateral securing such mortgages may not be sufficient to enable us to recoup our full investment. We may invest in participating, convertible or traditional mortgages if we conclude that we may benefit from the cash flow, or any appreciation in value of the property or as an entrance to the fee ownership. As of December 31, 2020, we had three note receivables outstanding, which aggregated approximately $96.3 million. Securities of or Interests in Entities Primarily Engaged in Real Estate ActivitiesSubject to the percentage of ownership limitations and gross income and asset tests necessary for BXP’s REIT qualification, we also may invest in securities of other REITs, other entities engaged in real estate activities or securities of other issuers, including for the purpose of exercising control over such entities.DispositionsWe decide to dispose or partially dispose of properties based upon the periodic review of our portfolio and the determination by the Board of Directors of BXP that doing so is in our best interests. Any decision to dispose of a property will be authorized by the Board of Directors of BXP or a committee thereof. Some holders of limited partnership interests in BPLP could incur adverse tax consequences upon the sale of certain of our properties that differ from the tax consequences to BXP. Consequently, holders of limited partnership interests in BPLP may have different objectives regarding the appropriate pricing and timing of any such sale. Such different tax treatment derives in most cases from the fact that we acquired these properties in exchange for partnership interests in contribution transactions structured to allow the prior owners to defer taxable gain. Generally, this deferral continues so long as we do not dispose of the properties in a taxable transaction. Unless a sale by us of these properties is structured as a like-kind exchange under Section 1031 of the Internal Revenue Code of 1986, as amended (the “Code”), or in a manner that otherwise allows deferral to continue, recognition of the deferred tax gain allocable to these prior owners is generally triggered by a sale. As of December 31, 2020, we had no properties that were subject to a tax protection agreement.15Table of ContentsFinancing Policies The agreement of limited partnership of BPLP and BXP’s certificate of incorporation and bylaws do not limit the amount or percentage of indebtedness that we may incur. Further, we do not have a policy limiting the amount of indebtedness that we may incur, nor have we established any limit on the number or amount of mortgages that may be placed on any single property or on our portfolio as a whole. However, our mortgages, credit facilities, joint venture agreements and unsecured debt securities contain customary restrictions, requirements and other limitations on our ability to incur indebtedness. In addition, we evaluate the impact of incremental leverage on our debt metrics and the credit ratings of BPLP’s publicly traded debt. A reduction in BPLP’s credit ratings could result in us borrowing money at higher interest rates.The Board of Directors of BXP will consider a number of factors when evaluating our level of indebtedness and when making decisions regarding the incurrence of indebtedness, including the purchase price of properties to be acquired with debt financing, the estimated market value of our properties upon refinancing, the entering into agreements such as interest rate swaps, caps, floors and other interest rate hedging contracts and the ability of particular properties and us as a whole to generate cash flow to cover expected debt service. Policies with Respect to Other ActivitiesAs the sole general partner of BPLP, BXP has the authority to issue additional common and preferred units of limited partnership interest of BPLP. BXP has issued, and may in the future issue, common or preferred units of limited partnership interest to persons who contribute their direct or indirect interests in properties to us in exchange for such common or preferred units. We have not engaged in trading, underwriting or agency distribution or sale of securities of issuers other than BXP and BPLP does not intend to do so. At all times, we intend to make investments in such a manner as to enable BXP to maintain its qualification as a REIT, unless, due to changes in circumstances or to the Code, the Board of Directors of BXP determines that it is no longer in the best interest of BXP to qualify as a REIT. We may make loans to third parties, including, without limitation, to joint ventures in which we participate or in connection with the disposition of a property. We intend to make investments in such a way that we will not be treated as an investment company under the 1940 Act. Our policies with respect to these and other activities may be reviewed and modified or amended from time to time by the Board of Directors of BXP. Governmental RegulationsGeneralCompliance with various governmental regulations has an impact on our business, including our capital expenditures, earnings and competitive position, which can be material. We incur costs to monitor and take actions to comply with governmental regulations that are applicable to our business, which include, among others, (1) federal securities laws and regulations, (2) applicable stock exchange requirements, and (3) federal, state and local laws and regulations related to (a) our status as a REIT and other tax laws and regulations, and (b) real property, the improvements thereon and the operation thereof, such as laws and regulations relating to the environment, health and safety, zoning, usage, building, fire and life safety codes, (4) the requirements of the Office of Foreign Assets Control of the United States Department of the Treasury and (5) the Americans with Disabilities Act of 1990. In addition to the discussion below, see “Item 1A – Risk Factors” for a discussion of these governmental regulations and other material risks to us, including, to the extent material, to our competitive position, and see “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations” together with our consolidated financial statements, including the related notes included therein, for a discussion of material information relevant to an assessment of our financial condition and results of operations, including, to the extent material, the effects that compliance with governmental regulations may have upon our capital expenditures and earnings.Environmental MattersIt is our policy to retain independent environmental consultants to conduct or update Phase I environmental assessments (which generally do not involve invasive techniques such as soil or ground water sampling) and asbestos surveys in connection with our acquisition of properties. These pre-purchase environmental assessments have not revealed environmental conditions that we believe will have a material adverse effect on our business, assets, financial condition, results of operations or liquidity, and we are not otherwise aware of environmental conditions with respect to our properties that we believe would have such a material adverse effect. However, from time to time environmental conditions at our properties have required and may in the future require environmental testing and/or regulatory filings, as well as remedial action. 16Table of ContentsFor example, in February 1999, we (through a joint venture) acquired from Exxon Corporation a property in Massachusetts that was formerly used as a petroleum bulk storage and distribution facility and was known by the state regulatory authority to contain soil and groundwater contamination. We developed an office park on the property. We engaged a specially licensed environmental consultant to oversee the management of contaminated soil and groundwater that was disturbed in the course of construction. Under the property acquisition agreement, Exxon agreed to (1) bear the liability arising from releases or discharges of oil and hazardous substances which occurred at the site prior to our ownership, (2) continue monitoring and/or remediating such releases and discharges as necessary and appropriate to comply with applicable requirements, and (3) indemnify us for certain losses arising from preexisting site conditions. Any indemnity claim may be subject to various defenses and contractual limitations, including time limits, and there can be no assurance that the amounts paid under the indemnity, if any, would be sufficient to cover the liabilities arising from any such releases and discharges. Environmental investigations at some of our properties and certain properties owned by our affiliates have identified groundwater contamination migrating from off-site source properties. In each case we engaged a licensed environmental consultant to perform the necessary investigations and assessments, and to prepare any required submittals to the regulatory authorities. In each case the environmental consultant concluded that the properties qualify under the regulatory program or the regulatory practice for a status which eliminates certain deadlines for conducting response actions at a site. We also believe that these properties qualify for liability relief under certain statutory provisions or regulatory practices regarding upgradient releases. Although we believe that the current or former owners of the upgradient source properties may bear responsibility for some or all of the costs of addressing the identified groundwater contamination, we will take such further response actions (if any) that we deem necessary or advisable. Other than periodic testing at some of these properties, no such additional response actions are anticipated at this time. Some of our properties and certain properties owned by our affiliates are located in urban, industrial and other previously developed areas where fill or current or historical use of the areas have caused site contamination. Accordingly, it is sometimes necessary to institute special soil and/or groundwater handling procedures and/or include particular building design features in connection with development, construction and other property operations in order to achieve regulatory closure and/or ensure that contaminated materials are addressed in an appropriate manner. In these situations, it is our practice to investigate the nature and extent of detected contamination, including potential issues associated with vapor intrusion concerns and/or potential contaminant migration to or from the subject property in ground water, assess potential liability risks and estimate the costs of required response actions and special handling procedures. We then use this information as part of our decision-making process with respect to the acquisition, deal structure and/or development of the property. For example, we own a parcel in Massachusetts which was formerly used as a quarry/asphalt batching facility. Pre-purchase testing indicated that the site contained relatively low levels of certain contaminants. We have developed an office park on this property. Prior to and during redevelopment activities, we engaged a specially licensed environmental consultant to monitor environmental conditions at the site and prepare necessary regulatory submittals based on the results of an environmental risk characterization. A submittal has been made to the regulatory authorities in order to achieve regulatory closure at this site. The submittal included an environmental deed restriction that mandates compliance with certain protective measures in a portion of the site where low levels of residual soil contamination have been left in place in accordance with applicable laws. We expect that resolution of the environmental matters described above will not have a material impact on our business, assets, financial condition, results of operations or liquidity. However, we cannot assure you that we have identified all environmental liabilities at our properties, that all necessary remediation actions have been or will be undertaken at our properties, that we will be indemnified, in full or at all, or that we will have insurance coverage in the event that such environmental liabilities arise. Corporate GovernanceBXP is currently governed by an eleven-member Board of Directors. The current members of the Board of Directors of BXP are Kelly A. Ayotte, Bruce W. Duncan, Karen E. Dykstra, Carol B. Einiger, Diane J. Hoskins, Joel I. Klein, Douglas T. Linde, Matthew J. Lustig, Owen D. Thomas, David A. Twardock and William H. Walton III. All directors of BXP stand for election for one-year terms expiring at the next succeeding annual meeting of stockholders. 17Table of ContentsJoel I. Klein currently serves as the Chairman of BXP’s Board of Directors. The Board of Directors of BXP also has Audit, Compensation and Nominating and Corporate Governance Committees. The membership of each of these committees is described below.Independent Director Audit Compensation Nominating andCorporate GovernanceKelly A. AyotteX(1)XBruce W. DuncanXXKaren E. DykstraXCarol B. Einiger X Diane J. HoskinsXJoel I. Klein (2) Matthew J. LustigX(1)David A. Twardock X(1) X William H. Walton IIIX X=Committee member, (1)=Committee Chair, (2)=Chairman of BXP’s Board of DirectorsBXP has the following corporate governance documents and procedures in place:•The Board of Directors has adopted charters for each of its Audit, Compensation and Nominating and Corporate Governance Committees. A copy of each of these charters is available on our website at http://www.bxp.com under the heading “Corporate Governance” and subheading “Committee Charters.”•The Board of Directors has adopted Corporate Governance Guidelines, a copy of which is available on our website at http://www.bxp.com under the heading “Corporate Governance” and subheading “Governance Documents” with the name “Governance Guidelines.”•The Board of Directors has adopted a Code of Business Conduct and Ethics, which governs business decisions made and actions taken by BXP’s directors, officers and employees. A copy of this code is available on our website at http://www.bxp.com under the heading “Corporate Governance” and subheading “Governance Documents” with the name “Code of Business Conduct and Ethics.” BXP intends to disclose on this website any amendment to, or waiver of, any provisions of this Code applicable to the directors and executive officers of BXP that would otherwise be required to be disclosed under the rules of the SEC or the New York Stock Exchange. •The Board of Directors has established an ethics reporting system that employees may use to anonymously report possible violations of the Code of Business Conduct and Ethics, including concerns regarding questionable accounting, internal accounting controls or auditing matters, by telephone or over the internet.•The Board of Directors has adopted a Policy on our Political Spending, a copy of which is available on our website at http://www.bxp.com under the heading “Corporate Governance” and subheading “Governance Documents” with the name “Policy on Political Spending.”CompetitionWe compete in the leasing of office, life sciences, retail and residential space with a considerable number of other real estate companies, some of which may have greater marketing and financial resources than are available to us. In addition, our hotel property competes for guests with other hotels, some of which may have greater marketing and financial resources than are available to us and to the manager of our one hotel, Marriott International, Inc. Principal factors of competition in our primary business of owning, acquiring and developing office properties are the quality of properties, leasing terms (including rent and other charges and allowances for tenant improvements), attractiveness and convenience of location, the quality and breadth of tenant services and amenities provided, and reputation as an owner and operator of quality office properties in the relevant market. Additionally, our ability to compete depends upon, among other factors, trends in the national and local economies, investment alternatives, financial condition and operating results of current and prospective tenants, availability and 18Table of Contentscost of capital, construction and renovation costs, taxes, utilities, governmental regulations, legislation and population trends. In addition, we currently have six residential properties and may in the future decide to acquire or develop additional residential properties. As an owner, we will also face competition for prospective residents from other operators/owners whose properties may be perceived to offer a better location or better amenities or whose rent may be perceived as a better value given the quality, location and amenities that the resident seeks. We will also compete against condominiums and single-family homes that are for sale or rent. Because the scale of our residential portfolio is relatively small, we expect to continue to retain third parties to manage our residential properties.Our Hotel PropertyWe operate our hotel property through a taxable REIT subsidiary. The taxable REIT subsidiary, a wholly-owned subsidiary of BPLP, is the lessee pursuant to a lease for the hotel property. As lessor, BPLP is entitled to a percentage of gross receipts from the hotel property. The hotel lease is intended to provide the economic benefits of ownership of the underlying real estate to flow to us as rental income, while our taxable REIT subsidiary earns the profit from operating the property as a hotel. Marriott International, Inc. continues to manage the hotel property under the Marriott name and under terms of the existing management agreements. Marriott has been engaged under a separate long-term incentive management agreement to operate and manage the hotel on behalf of the taxable REIT subsidiary. Item 1A. Risk Factors.Set forth below are the risks that we believe are material to our investors and they should be carefully considered. Throughout this section, we refer to the equity and debt securities of both BXP and BPLP as our “securities,” and the investors who own securities of BXP, BPLP or both, as our “securityholders.” These risks are not all of the risks we face and other factors not presently known to us or that we currently believe are immaterial may also affect our business if they occur. This section contains forward-looking statements. You should refer to the explanation of the qualifications and limitations on forward-looking statements beginning on page 57.Risks Related to Our Business and OperationsThe COVID-19 pandemic has caused severe disruptions in the United States and global economies and we expect it will continue to materially and adversely affect our financial condition, results of operations, cash flows, liquidity and performance and that of our tenants.The global impact of the COVID-19 pandemic continues to evolve and public health officials and governmental authorities, including those in all of the markets in which we operate, continue to implement measures restricting travel, issuing “stay-at-home” orders, restricting the types of businesses that may continue to operate (including the types of construction projects that may proceed) and the capacity at which businesses may operate. Most of these restrictions began in earnest in March 2020 and they quickly had a material adverse impact on economic and market conditions around the world, including the United States and the markets in which our properties are located, and on us. It is likely that the restrictions and measures of public health officials and governmental authorities will continue through the end of 2021 and possibly longer. There remains uncertainty regarding the duration and breadth of the COVID-19 pandemic. The degree to which the COVID-19 pandemic will continue to adversely impact our business, financial condition, results of operation, cash flows, liquidity and performance, and that of our tenants, will be driven primarily by the speed, effectiveness and distribution of vaccines, the duration of indirect economic impacts such as recession, dislocation in capital markets, and job loss, potential longer term changes in consumer and tenant behavior, as well as possible future governmental responses, which makes it impossible for us to predict with certainty the overall impact that COVID-19 will have on us and our tenants at this time. Factors related to COVID-19 that have had, or could have, a material adverse effect on our results of operations and financial condition, include:•a complete or partial closure of, or other operational issues at, one or more of our properties resulting from government or tenant action, including delays in re-opening or subsequent closures of previously re-opened properties, which could adversely affect our operations and those of our tenants;19Table of Contents•reduced economic activity impacting the businesses, financial condition and liquidity of our tenants has caused, and is expected to continue to cause, one or more of our tenants to be unable to meet their obligations to us, including their ability to make rental payments, in full or at all, or to otherwise seek modifications of such obligations, including rent concessions, deferrals or abatements, or to declare bankruptcy;•the failure of our tenants to properly implement or deploy their business continuity plans, or if those plans are ineffective, could have a material adverse effect on our tenants’ businesses and their ability to pay rent;•the impact of new or continued complete or partial shutdowns of the operations of one or more of our tenants’ businesses, including office, life sciences, hotel and retail tenants, and parking operators, temporary or long-term disruptions in our tenants’ supply chains from local, national and international suppliers or delays in the delivery of products, services or other materials necessary for our tenants’ operations, could force our tenants to reduce, delay or eliminate offerings of their products and services, which could result in less revenue, income and cash flow, and possibly their bankruptcy or insolvency, which in turn could:•reduce our cash flows, •adversely impact our ability to finance, refinance or sell a property, •adversely impact our ability to continue paying dividends to our stockholders at current levels, or at all, and •result in additional legal and other costs to enforce our rights, collect rent and/or re-lease the space occupied by the distressed tenant;•the duration and scope of the mandatory business closures and “stay-at-home” orders have had, and are expected to continue to have, a severe negative impact on our retail, fitness and entertainment tenants that depend on in-person interactions with their customers to generate revenues and have resulted, and are expected to continue to result, in most retail, fitness and entertainment tenants being unable to make timely rental payments in full or at all;•the extent to which COVID-19 decreases customers’ willingness to frequent, or prevents customers from frequenting, our tenants’ businesses in the future, may result in our retail tenants’ continued inability to make timely rental payments to us under their leases;•many of our retail and select office tenants have approached us seeking either rent concessions, deferrals or abatements, and the extent to which we grant these requests or instead seek to enforce our legal remedies could have a material adverse effect on our results of operations, liquidity and cash flows;•the degree to which our tenants’ businesses have been, and continue to be, negatively impacted has required, and may continue to require, us to write-off a tenant’s accrued rent balance and this could have a material adverse effect on our results of operations and liquidity;•if new or existing actions or measures implemented to prevent the spread of COVID-19 continue to result in increasing unemployment, it may negatively affect the leasing of residential units as well as the ability of our existing residential tenants to generate sufficient income to pay, or make them unwilling to pay rent, in full or at all, in a timely manner;•the impact of prolonged restrictions on freedom of movement and business operations, such as travel bans, business closures and “stay-at-home” orders have had, and are expected to continue to have, a material adverse effect on the operators of our parking garages and our hotel property, which negatively impacts our revenues and may also result in a decrease in demand for hotel stays even after the travel bans and other restrictions are lifted;•our failure, or the failure of any of our joint venture partners, to meet our or their, as applicable, responsibilities or obligations to the other or to third parties, such as lenders, including a failure to contribute additional capital needed by the ventures or a default by a party under a joint venture agreement or other agreement relating to a joint venture, each of which, in our case, could result in dilution of our interest or a loss of our management and other rights relating to our joint ventures, and in the case of a joint venture partner, could result in our payment of the partner’s share of the additional capital;20Table of Contents•the impact of COVID-19 could result in an event or change in circumstances that results in an impairment in the value of our properties or our investments in unconsolidated joint ventures, and any such impairment could have a material adverse effect on our results of operations in the periods in which the charge is taken;•we may be unable to restructure or amend leases with certain of our tenants on terms favorable to us or at all;•the impact and validity of interpretations of lease provisions and applicable laws related to claims by tenants regarding their obligations to pay rent as a result of COVID-19, and any adverse court rulings or decisions interpreting these provisions and laws, could have a material adverse effect on our results of operations and liquidity;•restrictions intended to prevent the spread of COVID-19 have limited, and are expected to continue to limit, our leasing activities, such as property tours, and may have a material adverse effect on our ability to renew leases, lease vacant space, including vacant space from tenant bankruptcies and defaults, or re-lease available space as leases expire in our properties on favorable terms, or at all; •COVID-19 has caused a material decline in general business activity and demand for real estate transactions, and if this persists, it would adversely affect our ability or desire to make strategic acquisitions or dispositions;•the impact of recent and future efforts by state, local, federal and industry groups to enact laws and regulations have restricted, and may further restrict, the ability of landlords, such as us, to collect rent, enforce remedies for the failure to pay rent, or otherwise enforce the terms of the lease agreements, such as a rent freeze for tenants or a suspension of a landlord’s ability to enforce evictions; •the extent of construction delays on our development/redevelopment projects due to work-stoppage orders, disruptions in the supply of materials, delays in permitting or inspections, or other factors could result in our failure to meet the development milestones set forth in any applicable lease agreement, which could provide the tenant the right to terminate its lease or entitle the tenant to monetary damages, delay the commencement or completion of construction and our anticipated lease-up plans for a development/redevelopment project or our overall development pipeline, including recognizing revenue for new leases, that may cause returns on investment to be less than projected, and/or increase the costs of construction of new or existing projects, any of which could adversely affect our investment returns, profitability and/or our future growth;•we may be unable to access debt and equity capital on attractive terms, or at all, and a further disruption and instability in the global financial markets or deteriorations in credit and financing conditions may affect our tenants’ and our access to capital and other sources of funding necessary to fund our respective operations or address maturing liabilities on a timely basis; •the financial effects of the COVID-19 pandemic on our future financial results, cash flows and financial condition could adversely impact our compliance with the financial covenants of our credit facility and other debt agreements and could result in an event of default and the acceleration of indebtedness, which could negatively impact our financial condition, results of operations and our ability to make additional borrowings and pay dividends;•adaptions made by companies in response to “stay-at-home” orders and future limitations on in-person work environments could lead to a sustained shift away from collective in-person work environments or relocations away from the cities in which we operate, either of which could adversely affect the overall demand for office space across our portfolio over the long term; •the effectiveness or lack of effectiveness of governmental relief in providing assistance to large and small businesses, including some of our tenants, that have suffered significant declines in revenues as a result of mandatory business shut-downs, “stay-at-home” orders and social distancing practices, and the potential for a prolonged, severe recession, could have a material adverse impact on our financial condition and results of operations; •increased vulnerability to cyber-security threats and potential breaches, including phishing attacks, malware and impersonation tactics, resulting from the increase in numbers of individuals working from home;21Table of Contents•the potential that business interruption, loss of rental income and/or other associated expenses related to our operations will not be covered in whole or in part by our insurance policies, which may increase unreimbursed liabilities;•if the health of our employees, particularly our key personnel and property management teams, are negatively impacted, we may be unable to ensure business continuity and be exposed to lawsuits from tenants; •we may, in managing our liquidity depending on business conditions, choose to pay dividends in our stock instead of cash, which may cause our stockholders to pay income taxes on the dividends without receiving a corresponding amount of cash;•uncertainty as to the conditions that must be satisfied as government authorities continue to lift “stay-at-home” orders and public health officials continue the process of gradually returning Americans to work and whether government authorities will impose (or suggest) requirements on landlords, such as us, to protect the health and safety of tenants and visitors to our buildings could result in increased operating costs and demands on our property management teams to ensure compliance with any such requirements, as well as increased costs associated with protecting against potential liability arising from these measures, such as claims by tenants that the measures violate their leases and claims by visitors that the measures caused them damages; and•limited access to our facilities, management, tenants, support staff and professional advisors could decrease the effectiveness of our disclosure controls and procedures, internal controls over financial reporting and other risk mitigation strategies, increase our susceptibility to security breaches, hamper our ability to comply with regulatory obligations and prevent us from conducting our business as efficiently and effectively as we otherwise would have.The full extent to which the COVID-19 pandemic impacts our operations and those of our tenants will depend on future developments, which remain highly uncertain and cannot be predicted with confidence at this time. The fluidity of the situation presents material uncertainty and risk with respect to our financial condition, results of operations, cash flows, liquidity and overall performance. Moreover, many risk factors detailed in this Item 1A titled “Risk Factors” are heightened risks as a result of the impact of the COVID-19 pandemic.Our performance depends upon the economic climates of our markets—Boston, Los Angeles, New York, San Francisco and Washington, DC.Substantially all of our revenue is derived from properties located in five markets: Boston, Los Angeles, New York, San Francisco and Washington, DC. A downturn in the economies of these markets, or the impact that a downturn in the overall national economy may have upon these economies, could result in reduced demand for office space and/or a reduction in rents. Because our portfolio consists primarily of office buildings (as compared to a more diversified real estate portfolio), a decrease in demand for office space in turn could adversely affect our results of operations. Additionally, there are submarkets within our markets that are dependent upon a limited number of industries. For example, in our Washington, DC market, we focus on leasing office properties to governmental agencies and contractors, as well as legal firms. A reduction in spending by the Federal Government could result in reduced demand for office space and adversely affect our results of operations. In addition, in our New York market, we have historically leased properties to financial, legal and other professional firms. A significant downturn in one or more of these sectors could adversely affect our results of operations. In addition, a significant economic downturn over a period of time could result in an event or change in circumstances that results in an impairment in the value of our properties or our investments in unconsolidated joint ventures. An impairment loss is recognized if the carrying amount of the asset (1) is not recoverable over its expected holding period and (2) exceeds its fair value. There can be no assurance that we will not take charges in the future related to the impairment of our assets or investments. Any future impairment could have a material adverse effect on our results of operations in the period in which the charge is taken.Adverse economic and geopolitical conditions, health crises and dislocations in the credit markets could have a material adverse effect on our results of operations, financial condition and ability to pay dividends and/or distributions. Our business may be affected by market and economic challenges experienced by the U.S. and global economies or real estate industry as a whole, by the local economic conditions in the markets in which our 22Table of Contentsproperties are located, including the impact of high unemployment, volatility in the public equity and debt markets, and international economic and other conditions, including pandemics. These current conditions, or similar conditions existing in the future, may adversely affect our results of operations, financial condition and ability to pay dividends and/or distributions as a result of the following, among other potential consequences: •the financial condition of our tenants may be adversely affected, which may result in tenant defaults under leases due to bankruptcy, lack of liquidity, lack of funding, operational failures or for other reasons;•significant job losses may occur, which may decrease demand for our office space, causing market rental rates and property values to be negatively impacted;•our ability to borrow on terms and conditions that we find acceptable, or at all, may be limited, which could reduce our ability to pursue acquisition and development opportunities and refinance existing debt, reduce our returns from our acquisition and development activities and increase our future interest expense;•reduced values of our properties may limit our ability to dispose of assets at attractive prices or to obtain debt financing secured by our properties and may reduce the availability of unsecured loans;•the value and liquidity of our short-term investments and cash deposits could be reduced as a result of a deterioration of the financial condition of the institutions that hold our cash deposits or the institutions or assets in which we have made short-term investments, a dislocation of the markets for our short-term investments, increased volatility in market rates for such investments or other factors;•one or more lenders under our line of credit could refuse to fund their financing commitment to us or could fail and we may not be able to replace the financing commitment of any such lenders on favorable terms, or at all; and•to the extent we enter into derivative financial instruments, one or more counterparties to our derivative financial instruments could default on their obligations to us, or could fail, increasing the risk that we may not realize the benefits of these instruments.Our success depends on key personnel whose continued service is not guaranteed. We depend on the efforts of key personnel, particularly Owen D. Thomas, Chief Executive Officer, Douglas T. Linde, President, and Raymond A. Ritchey, Senior Executive Vice President. Among the reasons that Messrs. Thomas, Linde and Ritchey are important to our success is that each has a national reputation, which attracts business and investment opportunities and assists us in negotiations with lenders, joint venture partners and other investors. If we lost their services, our relationships with lenders, potential tenants and industry personnel could diminish. Our Chief Financial Officer and Regional Managers also have strong reputations. Their reputations aid us in identifying opportunities, having opportunities brought to us, and negotiating with tenants and build-to-suit prospects. While we believe that we could find replacements for these key personnel, the loss of their services could materially and adversely affect our operations because of diminished relationships with lenders, prospective tenants and industry personnel. Risks Related to Real EstateOur performance and value are subject to risks associated with our real estate assets and with the real estate industry.Our economic performance and the value of our real estate assets, and consequently the value of our securities, are subject to the risk that if our properties do not generate revenues sufficient to meet our operating expenses, including debt service and capital expenditures, our cash flow and ability to pay distributions to our securityholders will be adversely affected. The following factors, among others, may adversely affect the income generated by our properties:•downturns in the national, regional and local economic conditions (particularly increases in unemployment);•competition from other office, life sciences, hotel, retail and residential buildings;23Table of Contents•local real estate market conditions, such as oversupply or reduction in demand for office, life sciences, hotel, retail or residential space;•changes in interest rates and availability of financing;•vacancies, changes in market rental rates and the need to periodically repair, renovate and re-let space;•changes in space utilization by our tenants due to technology, economic conditions and business culture;•increased operating costs, including insurance expense, utilities, real estate taxes, state and local taxes and heightened security costs;•civil disturbances, earthquakes and other natural disasters or terrorist acts or acts of war which may result in uninsured or underinsured losses or decrease the desirability to our tenants in impacted locations;•significant expenditures associated with each investment, such as debt service payments, real estate taxes (including reassessments and changes in tax laws), insurance and maintenance costs which are generally not reduced when circumstances cause a reduction in revenues from a property;•declines in the financial condition of our tenants and our ability to collect rents from our tenants; and•decreases in the underlying value of our real estate.Our properties face significant competition.We face significant competition from developers, owners and managers of office, life sciences and residential properties and other commercial real estate, including sublease space available from our tenants. Substantially all of our properties face competition from similar properties in the same market. This competition may affect our ability to attract and retain tenants and may reduce the rents we are able to charge. These competing properties may have vacancy rates higher than our properties, which may result in their owners being willing to lease available space at lower rates than the space in our properties.We face potential difficulties or delays renewing leases or re-leasing space.We derive most of our income from rent received from our tenants. If a tenant experiences a downturn in its business or other types of financial distress, including as a result of the COVID-19 pandemic or due to the costs of additional federal, state or local tax burdens, it may be unable to make timely rental payments. Also, when our tenants decide not to renew their leases or terminate early, we may not be able to re-let the space or there could be a substantial delay in re-letting the space. Even if tenants decide to renew or lease new space, the terms of renewals or new leases, including the cost of required renovations or concessions to tenants, may be less favorable to us than current lease terms. As a result, our cash flow could decrease and our ability to make distributions to our securityholders could be adversely affected.Changes in rent control or rent stabilization and eviction laws and regulations in our markets could have a material adverse effect on our residential portfolio’s results of operations and residential property values.Various state and local governments have enacted, and may continue to enact, rent control or rent stabilization laws and regulations or take other actions that could limit our ability to raise rents or charge certain fees, such as pet fees or application fees. We have seen a recent increase in governments considering, or being urged by advocacy groups to consider, rent control or rent stabilization laws and regulations, including as a result of the COVID-19 pandemic. Depending on the extent and terms of future enactments of rent control or rent stabilization laws and regulations, as well as any lawsuits against us arising from such issues, such future enactments could have a material adverse effect on our residential portfolio’s results of operations and the value of our residential properties.State and local governments may also make changes to eviction and other tenants’ rights laws and regulations that could have a material adverse effect on our residential portfolio’s results of operations and the value of our residential properties. If we are restricted from re-leasing apartment units due to the inability to evict delinquent residents, our results of operations and property values for our residential properties may be adversely effected.24Table of ContentsWe face potential adverse effects from major tenants’ bankruptcies or insolvencies.The bankruptcy or insolvency of a major tenant may adversely affect the income produced by our properties. Our tenants could file for bankruptcy protection or become insolvent in the future. We cannot evict a tenant solely because of its bankruptcy. On the other hand, a bankrupt tenant may reject and terminate its lease with us. In such case, our claim against the bankrupt tenant for unpaid and future rent would be subject to a statutory cap that might be substantially less than the remaining rent actually owed under the lease, and, even so, our claim for unpaid rent would likely not be paid in full. This shortfall could adversely affect our cash flow and results of operations.Our actual costs to develop properties may exceed our budgeted costs.We intend to continue to develop and substantially renovate office, life sciences, retail and residential properties. Our current and future development and construction activities may be exposed to the following risks: •we may be unable to proceed with the development of properties because we cannot obtain financing on favorable terms or at all;•we may incur construction costs for a development project that exceed our original estimates due to increases in interest rates and increased materials, labor, leasing or other costs, which could make completion of the project less profitable because market rents may not increase sufficiently to compensate for the increase in construction costs;•we may be unable to obtain, or face delays in obtaining, required zoning, land-use, building, occupancy, and other governmental permits and authorizations, which could result in increased costs and could require us to abandon our activities entirely with respect to a project;•we may abandon development opportunities after we begin to explore them and as a result we may lose deposits or fail to recover expenses already incurred;•we may expend funds on and devote management’s time to projects that we do not complete;•we may be unable to complete construction and/or leasing of a property on schedule or at all; and•we may suspend development projects after construction has begun due to changes in economic conditions or other factors, and this may result in the write-off of costs, payment of additional costs or increases in overall costs when the development project is restarted.Investment returns from our developed properties may be less than anticipated. Our developed properties may be exposed to the following risks:•we may lease developed properties at rental rates that are less than projected, or at a slower pace then projected, at the time we decide to undertake the development; •operating expenses and construction costs may be greater than projected at the time of development, resulting in our investment being less profitable than we expected; and•occupancy rates and rents at newly developed properties may fluctuate depending on a number of factors, including market and economic conditions, and may result in our investments being less profitable than we expected or not profitable at all.We face risks associated with the development of mixed-use commercial properties.We operate, are currently developing, and may in the future develop, properties either alone or through joint ventures with other persons that are known as “mixed-use” developments. This means that in addition to the development of office space, the project may also include space for residential, retail, hotel or other commercial purposes. We have less experience in developing and managing non-office and non-retail real estate than we do with office real estate. As a result, if a development project includes a non-office or non-retail use, we may seek to develop that component ourselves, sell the rights to that component to a third-party developer with experience in that use or we may seek to partner with such a developer. If we do not sell the rights or partner with such a developer, or if we choose to develop the other component ourselves, we would be exposed not only to those risks typically associated with the development of commercial real estate generally, but also to specific risks associated with the development and ownership of non-office and non-retail real estate. In addition, even if we sell the rights to develop the other component or elect to participate in the development through a joint venture, we may be exposed 25Table of Contentsto the risks associated with the failure of the other party to complete the development as expected. These include the risk that the other party would default on its obligations necessitating that we complete the other component ourselves (including providing any necessary financing). In the case of residential properties, these risks include competition for prospective residents from other operators whose properties may be perceived to offer a better location or better amenities or whose rent may be perceived as a better value given the quality, location and amenities that the resident seeks. We will also compete against condominiums and single-family homes that are for sale or rent. Because we have less experience with residential properties than with office and retail properties, we expect to retain third parties to manage our residential properties. If we decide to not sell or participate in a joint venture and instead hire a third party manager, we would be dependent on them and their key personnel who provide services to us and we may not find a suitable replacement if the management agreement is terminated, or if key personnel leave or otherwise become unavailable to us. Failure to comply with Federal Government contractor requirements could result in substantial costs and loss of substantial revenue. As of December 31, 2020, the U.S. Government was one of our largest tenants by square feet. We are subject to compliance with a wide variety of complex legal requirements because we are a Federal Government contractor. These laws regulate how we conduct business, require us to administer various compliance programs and require us to impose compliance responsibilities on some of our contractors. Our failure to comply with these laws could subject us to fines, penalties and damages, cause us to be in default of our leases and other contracts with the Federal Government and bar us from entering into future leases and other contracts with the Federal Government. There can be no assurance that these costs and loss of revenue will not have a material adverse effect on our properties, operations or business.Our use of joint ventures limits our flexibility with respect to the assets they own and other assets we may wish to acquire.In appropriate circumstances, we intend to develop, acquire and recapitalize properties in joint ventures with other persons or entities. We currently have joint ventures that are and are not consolidated within our financial statements. Our participation in joint ventures subjects us to risks, including but not limited to, the following risks that: •we could become engaged in a dispute with any of our joint venture partners that might affect our ability to develop, finance or operate a property and could lead to the sale of either parties’ ownership interest or the property;•some of our joint ventures are subject to debt and in the current credit markets the refinancing of such debt may require equity capital calls;•our joint venture partners may default on their obligations necessitating that we fulfill their obligation ourselves;•our joint venture partners may have different objectives than we have regarding the appropriate timing and terms of any sale or refinancing of properties or the commencement of development activities;•our joint venture partners may be structured differently than us for tax purposes and this could create conflicts of interest;•our joint venture partners may have competing interests in our markets that could create conflicts of interest; •our joint ventures may be unable to repay any amounts that we may loan to them; and•our joint venture agreements may contain provisions limiting the liquidity of our interest for sale or sale of the entire asset.We face the risk that third parties will not be able to service or repay loans we make to them. From time to time, we have loaned and in the future may loan funds to (1) a third-party buyer to facilitate the sale of an asset by us to such third party, or (2) a third party in connection with the formation of a joint venture to acquire and/or develop a property. Making these loans subjects us to the following risks, each of which could have a material adverse effect on our cash flow, results of operations and/or financial condition:26Table of Contents•the third party may be unable to make full and timely payments of interest and principal on the loan when due;•if the third-party buyer to whom we provide seller financing and utilizes the assets as collateral does not manage the property well, or the property otherwise fails to meet financial projections, performs poorly or declines in value, then the buyer may not have the funds or ability to raise new debt with which to make required payments of interest and principal to us; •if we loan funds to a joint venture, and the joint venture is unable to make required payments of interest or principal, or both, or there are disagreements with respect to the repayment of the loan or other matters, then we could have a resulting dispute with our partner(s), and such a dispute could harm our relationship(s) with our partner(s) and cause delays in developing or selling the property or the failure to properly manage the property; and•if we loan funds to a joint venture and the joint venture is unable to make required payments of interest and principal, or both, then we may exercise remedies available to us in the joint venture agreement that could allow us to increase our ownership interest or our control over major decisions, or both, which could result in an unconsolidated joint venture becoming consolidated with our financial statement; doing so could require us to reallocate the purchase price among the various asset and liability components and this could result in material changes to our reported results of operations and financial condition.We face risks associated with property acquisitions. We have acquired in the past and intend to continue to pursue the acquisition of properties and portfolios of properties, including large portfolios that could increase our size and result in alterations to our capital structure. Our acquisition activities and their success are subject to the following risks: •even if we enter into an acquisition agreement for a property, we may be unable to complete that acquisition after making a non-refundable deposit and incurring certain other acquisition-related costs;•we may be unable to obtain or assume financing for acquisitions on favorable terms or at all;•acquired properties may fail to perform as expected;•the actual costs of repositioning, redeveloping or maintaining acquired properties may be greater than our estimates;•the acquisition agreement will likely contain conditions to closing, including completion of due diligence investigations to our satisfaction or other conditions that are not within our control, which may not be satisfied;•acquired properties may be located in new markets, either within or outside the United States, where we may face risks associated with a lack of market knowledge or understanding of the local economy, lack of business relationships in the area, costs associated with opening a new regional office and unfamiliarity with local governmental and permitting procedures;•we may acquire real estate through the acquisition of the ownership entity subjecting us to the risks of that entity; and•we may be unable to quickly and efficiently integrate new acquisitions, particularly acquisitions of portfolios of properties, into our existing operations, and this could have an adverse effect on our results of operations and financial condition.We have acquired in the past and in the future may acquire properties through the acquisition of first mortgage or mezzanine debt. Investments in these loans must be carefully structured to ensure that BXP continues to satisfy the various asset and income requirements applicable to REITs. If we fail to structure any such acquisition properly, BXP could fail to qualify as a REIT. In addition, acquisitions of first mortgage or mezzanine loans subject us to the risks associated with the borrower’s default, including potential bankruptcy, and there may be significant delays and costs associated with the process of foreclosure on collateral securing or supporting these investments. There can be no assurance that we would recover any or all of our investment in the event of such a default or bankruptcy. 27Table of ContentsWe have acquired in the past and in the future may acquire properties or portfolios of properties through tax deferred contribution transactions in exchange for partnership interests in BPLP. This acquisition structure has the effect, among others, of reducing the amount of tax depreciation we can deduct over the tax life of the acquired properties, and typically requires that we agree to protect the contributors’ ability to defer recognition of taxable gain through restrictions on our ability to dispose of the acquired properties and/or the allocation of partnership debt to the contributors to maintain their tax bases. These restrictions could limit our ability to sell an asset at a time, or on terms, that would be favorable absent such restrictions. Acquired properties may expose us to unknown liability. We may acquire properties or invest in joint ventures that own properties subject to liabilities and without any recourse, or with only limited recourse, against the prior owners or other third parties with respect to unknown liabilities. As a result, if a liability were asserted against us based upon ownership of those properties, we might have to pay substantial sums to settle or contest it, which could adversely affect our results of operations and cash flow. Unknown liabilities with respect to acquired properties might include: •liabilities for clean-up of undisclosed environmental contamination;•claims by tenants, vendors or other persons against the former owners of the properties;•liabilities incurred in the ordinary course of business; and•claims for indemnification by general partners, directors, officers and others indemnified by the former owners of the properties.Competition for acquisitions may result in increased prices for properties. We plan to continue to acquire properties as we are presented with attractive opportunities. We may face competition for acquisition opportunities with other investors, and this competition may adversely affect us by subjecting us to the following risks: •we may be unable to acquire a desired property because of competition from other well-capitalized real estate investors, including publicly traded and private REITs, institutional investment funds and other real estate investors; and•even if we are able to acquire a desired property, competition from other real estate investors may significantly increase the purchase price.We may have difficulty selling our properties, which may limit our flexibility. Properties like the ones that we own could be difficult to sell. This may limit our ability to change our portfolio promptly in response to changes in economic or other conditions. In addition, federal tax laws limit our ability to sell properties and this may affect our ability to sell properties without adversely affecting returns to our securityholders. These restrictions reduce our ability to respond to changes in the performance of our investments and could adversely affect our financial condition and results of operations. Our ability to dispose of some of our properties is constrained by their tax attributes. Properties which we developed and have owned for a significant period of time or which we acquired through tax deferred contribution transactions in exchange for partnership interests in BPLP often have low tax bases. Furthermore, as a REIT, BXP may be subject to a 100% “prohibited transactions” tax on the gain from dispositions of property if BXP is deemed to hold the property primarily for sale to customers in the ordinary course of business, unless the disposition qualifies under a safe harbor exception for properties that have been held for at least two years and with respect to which certain other requirements are met. The potential application of the prohibited transactions tax could cause us to forego potential dispositions of property or other opportunities that might otherwise be attractive to us, or to undertake such dispositions or other opportunities through a taxable REIT subsidiary, which would generally result in income taxes being incurred. If we dispose of these properties outright in taxable transactions, we may be required to distribute a significant amount of the taxable gain to our securityholders under the requirements of the Code applicable to REITs, which in turn would impact our future cash flow and may increase our leverage. In some cases, without incurring additional costs we may be restricted from disposing of properties contributed in exchange for our partnership interests under tax protection agreements with contributors. To dispose of low basis or tax-protected properties efficiently we from time to time use like-kind exchanges, which are intended to qualify for non-28Table of Contentsrecognition of taxable gain, but can be difficult to consummate and result in the property for which the disposed assets are exchanged inheriting their low tax bases and other tax attributes (including tax protection covenants). Because we own a hotel property, we face the risks associated with the hospitality industry. The following factors, among others, are common to the hotel industry, and may reduce the receipts generated by our hotel property: •our hotel property competes for guests with other hotels, a number of which may have greater marketing and financial resources than our hotel-operating business partners;•if there is an increase in operating costs resulting from inflation and other factors, our hotel-operating business partners may not be able to offset such increase by increasing room rates;•our hotel property is subject to the fluctuating and seasonal demands of business travelers and tourism; and•our hotel property is subject to general and local economic and social conditions that may affect demand for travel in general, including war and terrorism.In addition, because our hotel property is located in Cambridge, Massachusetts, it is subject to the Cambridge market’s fluctuations in demand, increases in operating costs and increased competition from additions in supply. Due to the COVID-19 pandemic, our hotel closed in March 2020 and did not re-open until October 2020. As a result of the pandemic, the hotel has been operating at a diminished occupancy and generating minimal revenue. The closing of the hotel for more than two fiscal quarters, weak demand and low occupancy since its re-opening, have had, and are expected to continue to have, a material adverse effect on the hotel’s operations. We expect hotel occupancy to remain low until a sufficient number of people have been vaccinated and the demand for travel and leisure returns to historical levels. We did not obtain new owner’s title insurance policies in connection with properties acquired during BXP’s initial public offering. We acquired many of our properties from our predecessors at the completion of BXP’s initial public offering in June 1997. Before we acquired these properties, each of them was insured by a title insurance policy. We did not obtain new owner’s title insurance policies in connection with the acquisition of these properties. To the extent we have financed properties after acquiring them in connection with the initial public offering, we have obtained new title insurance policies, however, the amount of these policies may be less than the current or future value of the applicable properties. Nevertheless, because in many instances we acquired these properties indirectly by acquiring ownership of the entity that owned the property and those owners remain in existence as our subsidiaries, some of these title insurance policies may continue to benefit us. Many of these title insurance policies may be for amounts less than the current or future values of the applicable properties. If there was a title defect related to any of these properties, or to any of the properties acquired at the time of the initial public offering of BXP, that is no longer covered by a title insurance policy, we could lose both our capital invested in and our anticipated profits from such property. We have obtained title insurance policies for all properties that we have acquired after the initial public offering of BXP, however, these policies may be for amounts less than the current or future values of the applicable properties. Some potential losses are not covered by insurance. Our property insurance program per occurrence limits are $1.0 billion for its portfolio insurance program, including coverage for acts of terrorism other than nuclear, biological, chemical or radiological terrorism (“Terrorism Coverage”). We also carry $250 million of Terrorism Coverage for 601 Lexington Avenue, New York, New York (“601 Lexington Avenue”) in excess of the $1.0 billion of coverage in our property insurance program. Certain properties, including the General Motors Building located at 767 Fifth Avenue in New York, New York (“767 Fifth Avenue”), are currently insured in separate insurance programs. The property insurance program per occurrence limits for 767 Fifth Avenue are $1.625 billion, including Terrorism Coverage. We also currently carry nuclear, biological, chemical and radiological terrorism insurance coverage for acts of terrorism certified under the Federal Terrorism Risk Insurance Act (as amended, “TRIA”) (“NBCR Coverage”), which is provided by IXP as a direct insurer, for the properties in our portfolio, including 767 Fifth Avenue, but excluding certain other properties owned in joint ventures with third parties or which we manage. The per occurrence limit for NBCR Coverage is $1.0 billion. Under TRIA, after the payment of the required deductible and coinsurance, the NBCR Coverage provided by IXP is 29Table of Contentsbackstopped by the Federal Government if the aggregate industry insured losses resulting from a certified act of terrorism exceed a “program trigger.” The program trigger is $200 million, the coinsurance is 20% and the deductible is 20% of the premiums earned by the insurer for the year prior to a claim. If the Federal Government pays out for a loss under TRIA, it is mandatory that the Federal Government recoup the full amount of the loss from insurers offering TRIA coverage after the payment of the loss pursuant to a formula in TRIA. We may elect to terminate the NBCR Coverage if the Federal Government seeks recoupment for losses paid under TRIA, if TRIA is not extended after its expiration on December 31, 2027, if there is a change in our portfolio or for any other reason. We intend to continue to monitor the scope, nature and cost of available terrorism insurance.We also currently carry earthquake insurance on our properties located in areas known to be subject to earthquakes. In addition, this insurance is subject to a deductible in the amount of 3% of the value of the affected property. Specifically, we currently carry earthquake insurance which covers our San Francisco and Los Angeles regions with a $240 million per occurrence limit and a $240 million annual aggregate limit, $20 million of which is provided by IXP, as a direct insurer. The amount of our earthquake insurance coverage may not be sufficient to cover losses from earthquakes. In addition, the amount of earthquake coverage could impact our ability to finance properties subject to earthquake risk. We may discontinue earthquake insurance or change the structure of our earthquake insurance program on some or all of our properties in the future if the premiums exceed our estimation of the value of the coverage.IXP, a captive insurance company which is a wholly-owned subsidiary, acts as a direct insurer with respect to a portion of our earthquake insurance coverage for our Greater San Francisco and Los Angeles properties and our NBCR Coverage. Insofar as we own IXP, we are responsible for its liquidity and capital resources, and the accounts of IXP are part of our consolidated financial statements. In particular, if a loss occurs which is covered by our NBCR Coverage but is less than the applicable program trigger under TRIA, IXP would be responsible for the full amount of the loss without any backstop by the Federal Government. IXP would also be responsible for any recoupment charges by the Federal Government in the event losses are paid out and its insurance policy is maintained after the payout by the Federal Government. If we experience a loss and IXP is required to pay under its insurance policy, we would ultimately record the loss to the extent of the required payment. Therefore, insurance coverage provided by IXP should not be considered as the equivalent of third-party insurance, but rather as a modified form of self-insurance. In addition, BPLP has issued a guarantee to cover liabilities of IXP in the amount of $20.0 million.Due to the current COVID-19 pandemic, we anticipate the possibility of business interruption, loss of lease revenue and/or other associated expenses related to our operations across our portfolio. Because this is an ongoing situation it is not yet possible to quantify our losses and expenses, which continue to develop. Because of the complexity of our insurance policies and limited precedent for claims being made related to pandemics, it is not yet possible to determine if such losses and expenses will be covered by our insurance policies. Therefore, at this time, we are providing notice to the applicable insurers of the potential for claims in order to protect our rights under our policies.We continue to monitor the state of the insurance market in general, and the scope and costs of coverage for acts of terrorism, California earthquake risk and pandemics, in particular, but we cannot anticipate what coverage will be available on commercially reasonable terms in future policy years. There are other types of losses, such as from wars, for which we cannot obtain insurance at all or at a reasonable cost. With respect to such losses and losses from acts of terrorism, earthquakes or other catastrophic events, if we experience a loss that is uninsured or that exceeds policy limits, we could lose the capital invested in the damaged properties, as well as the anticipated future revenues from those properties. Depending on the specific circumstances of each affected property, it is possible that we could be liable for mortgage indebtedness or other obligations related to the property. Any such loss could materially and adversely affect our business and financial condition and results of operations.Actual or threatened terrorist attacks may adversely affect our ability to generate revenues and the value of our properties. We have significant investments in large metropolitan markets that have been or may be in the future the targets of actual or threatened terrorism attacks, including Boston, Los Angeles, New York, San Francisco and Washington, DC. As a result, some tenants in these markets may choose to relocate their businesses to other markets or to lower-profile office buildings within these markets that may be perceived to be less likely targets of future terrorist activity. This could result in an overall decrease in the demand for office space in these markets generally or in our properties in particular, which could increase vacancies in our properties or necessitate that we lease our properties on less favorable terms or both. In addition, future terrorist attacks in these markets could 30Table of Contentsdirectly or indirectly damage our properties, both physically and financially, or cause losses that materially exceed our insurance coverage. As a result of the foregoing, our ability to generate revenues and the value of our properties could decline materially. See also “—Some potential losses are not covered by insurance.” We face risks associated with our tenants and contractual counterparties being designated “Prohibited Persons” by the Office of Foreign Assets Control. Pursuant to Executive Order 13224 and other laws, the Office of Foreign Assets Control of the United States Department of the Treasury (“OFAC”) maintains a list of persons designated as terrorists or who are otherwise blocked or banned (“Prohibited Persons”). OFAC regulations and other laws prohibit conducting business or engaging in transactions with Prohibited Persons (the “OFAC Requirements”). Certain of our loan and other agreements require us to comply with OFAC Requirements. We have established a compliance program whereby tenants and others with whom we conduct business are checked against the OFAC list of Prohibited Persons prior to entering into any agreement and on a periodic basis thereafter. Our leases and other agreements, in general, require the other party to comply with OFAC Requirements. If a tenant or other party with whom we contract is placed on the OFAC list we may be required by the OFAC Requirements to terminate the lease or other agreement. Any such termination could result in a loss of revenue or a damage claim by the other party that the termination was wrongful. We face risks associated with the physical effects of climate change. The physical effects of climate change could have a material adverse effect on our properties, operations and business. For example, many of our properties are located along the East and West coasts, particularly those in the central business districts of Boston, Los Angeles, New York, San Francisco and Washington, DC. To the extent climate change causes changes in weather patterns, our markets could experience increases in storm intensity, extreme temperatures, rising sea-levels and/or drought. Over time, these conditions could result in declining demand for office space in our buildings or costs associated with infrastructure-related remediation projects. Climate change may also have indirect effects on our business by making property insurance unavailable or by increasing the cost of (i) property insurance on terms we find acceptable, (ii) real estate taxes or other assessments, (iii) energy and (iv) property maintenance. There can be no assurance that climate change will not have a material adverse effect on our properties, operations or business. For additional discussion regarding our approach to climate resiliency and our continued commitment to transparent reporting of ESG performance indicators, see “Item 1. Business—Business and Growth Strategies—Policies with Respect to Certain Activities—Sustainability” and our annual sustainability report available on our website at http://www.bxp.com under the heading “Sustainability.”Potential liability for environmental contamination could result in substantial costs.Under federal, state and local environmental laws, ordinances and regulations, we may be required to investigate and clean up the effects of releases of hazardous or toxic substances or petroleum products at or migrating from our properties simply because of our current or past ownership or operation of the real estate. If unidentified environmental problems arise, we may have to make substantial payments, which could adversely affect our cash flow and our ability to make distributions to our securityholders, because: as owner or operator we may have to pay for property damage and for investigation and clean-up costs incurred in connection with the contamination; the law typically imposes clean-up responsibility and liability regardless of whether the owner or operator knew of or caused the contamination; even if more than one person may be responsible for the contamination, each person who shares legal liability under the environmental laws may be held responsible for all of the clean-up costs; and governmental entities and third parties may sue the owner or operator of a contaminated site for damages and costs.These costs could be substantial and in extreme cases could exceed the amount of our insurance or the value of the contaminated property. We currently carry environmental insurance in an amount and subject to deductibles that we believe are commercially reasonable. Specifically, we carry a pollution legal liability policy with a $20 million limit per incident and a policy aggregate limit of $40 million. The presence or migration of hazardous or toxic substances or petroleum products or the failure to properly remediate contamination may give rise to third-party claims for bodily injury, property damage and/or response costs and may materially and adversely affect our ability to borrow against, sell or rent an affected property. In addition, applicable environmental laws create liens on contaminated sites in favor of the government for damages and costs it incurs in connection with contamination. Changes in laws, regulations and practices and their implementation increasing the potential liability for 31Table of Contentsenvironmental conditions existing at our properties, or increasing the restrictions on the handling, storage or discharge of hazardous or toxic substances or petroleum products or other actions may result in significant unanticipated expenditures.Environmental laws also govern the presence, maintenance and removal of asbestos and other building materials. For example, laws require that owners or operators of buildings containing asbestos: •properly manage and maintain the asbestos;•notify and train those who may come into contact with asbestos; and•undertake special precautions, including removal or other abatement, if asbestos would be disturbed during renovation or demolition of a building.Such laws may impose fines and penalties on building owners or operators who fail to comply with these requirements and may allow third parties to seek recovery from owners or operators for personal injury associated with exposure to asbestos fibers. Some of our properties are located in urban and previously developed areas where fill or current or historic industrial uses of the areas have caused site contamination. It is our policy to retain independent environmental consultants to conduct or update Phase I environmental site assessments and asbestos surveys with respect to our acquisition of properties. These assessments generally include a visual inspection of the properties and the surrounding areas, an examination of current and historical uses of the properties and the surrounding areas and a review of relevant state, federal and historical documents, but do not involve invasive techniques such as soil and ground water sampling. Where appropriate, on a property-by-property basis, our practice is to have these consultants conduct additional testing, including sampling for asbestos, for lead and other contaminants in drinking water and, for soil and/or groundwater contamination where underground storage tanks are or were located or where other past site usage creates a potential environmental problem. Even though these environmental assessments are conducted, there is still the risk that: •the environmental assessments and updates did not identify or properly address all potential environmental liabilities;•a prior owner created a material environmental condition that is not known to us or the independent consultants preparing the assessments;•new environmental liabilities have developed since the environmental assessments were conducted; and•future uses or conditions such as changes in applicable environmental laws and regulations could result in environmental liability for us.Inquiries about indoor air quality may necessitate special investigation and, depending on the results, remediation beyond our regular indoor air quality testing and maintenance programs. Indoor air quality issues can stem from inadequate ventilation, chemical contaminants from indoor or outdoor sources, and biological contaminants such as molds, pollen, viruses and bacteria. Indoor exposure to chemical or biological contaminants can be alleged to be connected to allergic reactions or other adverse health effects. If these conditions were to occur at one of our properties, we may be subject to third-party claims for personal injury, or may need to undertake a targeted remediation program, including without limitation, special cleaning measures and steps to increase indoor ventilation rates and eliminate sources of contaminants. Such remediation programs could be costly, necessitate the temporary relocation of some or all of the property’s tenants or require rehabilitation of the affected property. Compliance or failure to comply with the Americans with Disabilities Act or other safety regulations and requirements could result in substantial costs. The Americans with Disabilities Act generally requires that certain buildings, including office buildings, residential buildings and hotels, be made accessible to disabled persons. Noncompliance could result in the imposition of fines by the federal government or the award of damages to private litigants. If, under the Americans with Disabilities Act, we are required to make substantial alterations and capital expenditures in one or more of our properties, including the removal of access barriers, it could adversely affect our financial condition and results of operations, as well as the amount of cash available for distribution to our securityholders. 32Table of ContentsOur properties are subject to various federal, state and local regulatory requirements, such as state and local fire and life safety requirements. If we fail to comply with these requirements, we could incur fines or private damage awards. We do not know whether existing requirements will change or whether compliance with future requirements will require significant unanticipated expenditures that will affect our cash flow and results of operations. Any future international activities will be subject to special risks and we may not be able to effectively manage our international business. We have underwritten, and in the future may acquire, properties, portfolios of properties or interests in real estate-related entities on a strategic or selective basis in international markets that are new to us. If we acquire properties or platforms located in these markets, we will face risks associated with a lack of market knowledge and understanding of the local economy, forging new business relationships in the area and unfamiliarity with local laws and government and permitting procedures. In addition, our international operations will be subject to the usual risks of doing business abroad such as possible revisions in tax treaties or other laws and regulations, including those governing the taxation of our international income, restrictions on the transfer of funds and uncertainty over terrorist activities. We cannot predict the likelihood that any of these developments may occur. Further, we may in the future enter into agreements with non-U.S. entities that are governed by the laws of, and are subject to dispute resolution in the courts of, another country or region. We cannot accurately predict whether such a forum would provide us with an effective and efficient means of resolving disputes that may arise. Investments in international markets may also subject us to risks associated with funding increasing headcount, integrating new offices, and establishing effective controls and procedures to regulate the operations of new offices and to monitor compliance with U.S. laws and regulations such as the Foreign Corrupt Practices Act and similar foreign laws and regulations, such as the U.K. Bribery Act.We may be subject to risks from potential fluctuations in exchange rates between the U.S. dollar and the currencies of the other countries in which we invest. If we invest in countries where the U.S. dollar is not the national currency, we will be subject to international currency risks from the potential fluctuations in exchange rates between the U.S. dollar and the currencies of those other countries. A significant depreciation in the value of the currency of one or more countries where we have a significant investment may materially affect our results of operations. We may attempt to mitigate any such effects by borrowing in the currency of the country in which we are investing and, under certain circumstances, by hedging exchange rate fluctuations; however, access to capital may be more restricted, or unavailable on favorable terms or at all, in certain locations. For leases denominated in international currencies, we may use derivative financial instruments to manage the international currency exchange risk. We cannot assure you, however, that our efforts will successfully neutralize all international currency risks. Risks Related to Our Indebtedness and FinancingAn increase in interest rates would increase our interest costs on variable rate debt and could adversely impact our ability to refinance existing debt or sell assets on favorable terms or at all. As of February 22, 2021, we had approximately $500 million of outstanding indebtedness, excluding our unconsolidated joint ventures, that bears interest at variable rates, and we may incur more indebtedness in the future. If interest rates increase, then so would the interest costs on our unhedged variable rate debt, which could adversely affect our cash flow and our ability to pay principal and interest on our debt and our ability to make distributions to our securityholders. Further, rising interest rates could limit our ability to refinance existing debt when it matures or significantly increase our future interest expense. From time to time, we enter into interest rate swap agreements and other interest rate hedging contracts, including swaps, caps and floors. While these agreements are intended to lessen the impact of rising interest rates on us, they also expose us to the risk that the other parties to the agreements will not perform, we could incur significant costs associated with the settlement of the agreements, the agreements will be unenforceable and the underlying transactions will fail to qualify as highly-effective cash flow hedges under guidance included in ASC 815 “Derivatives and Hedging.” In addition, an increase in interest rates could decrease the amounts third-parties are willing to pay for our assets, thereby limiting our ability to change our portfolio promptly in response to changes in economic or other conditions. 33Table of ContentsCovenants in our debt agreements could adversely affect our financial condition.The mortgages on our properties contain customary covenants such as those that limit our ability, without the prior consent of the lender, to further mortgage the applicable property or to modify or discontinue insurance coverage. Our unsecured credit facility, unsecured debt securities and certain secured loans contain customary restrictions, requirements and other limitations on our ability to incur indebtedness, including total debt to asset ratios, secured debt to total asset ratios, debt service coverage ratios and minimum ratios of unencumbered assets to unsecured debt, which we must maintain. Our continued ability to borrow under our credit facilities is subject to compliance with our financial and other covenants. In addition, our failure to comply with such covenants could cause a default under the applicable debt agreement, and we may then be required to repay such debt with capital from other sources. Under those circumstances, other sources of capital may not be available to us, or be available only on unattractive terms. Additionally, in the future our ability to satisfy current or prospective lenders’ insurance requirements may be adversely affected if lenders generally insist upon greater insurance coverage against acts of terrorism or losses resulting from earthquakes than is available to us in the marketplace or on commercially reasonable terms. We rely on debt financing, including borrowings under our unsecured credit facility, issuances of unsecured debt securities and debt secured by individual properties, to finance our existing portfolio, our acquisition and development activities and for working capital. If we are unable to obtain debt financing from these or other sources, or to refinance existing indebtedness upon maturity, our financial condition and results of operations would likely be adversely affected. If we breach covenants in our debt agreements, the lenders can declare a default and, if the debt is secured, can take possession of the property securing the defaulted loan. In addition, our unsecured debt agreements contain specific cross-default provisions with respect to specified other indebtedness, giving the unsecured lenders the right to declare a default if we are in default under other loans in some circumstances. Defaults under our debt agreements could materially and adversely affect our financial condition and results of operations. We face risks associated with the use of debt to fund acquisitions and developments, including refinancing risk. We are subject to the risks normally associated with debt financing, including the risk that our cash flow will be insufficient to meet required payments of principal and interest. We anticipate that only a small portion of the principal of our debt will be repaid prior to maturity. Therefore, we are likely to need to refinance at least a portion of our outstanding debt as it matures. There is a risk that we may not be able to refinance existing debt or that the terms of any refinancing will not be as favorable as the terms of our existing debt. If principal payments due at maturity cannot be refinanced, extended or repaid with proceeds from other sources, such as new equity capital, our cash flow may not be sufficient to repay all maturing debt in years when significant “balloon” payments come due. In addition, we may rely on debt to fund a portion of our new investments such as our acquisition and development activity. There is a risk that we may be unable to finance these activities on favorable terms or at all. These conditions, which increase the cost and reduce the availability of debt, may continue or worsen in the future. We have had and may have in the future agreements with a number of limited partners of BPLP who contributed properties in exchange for partnership interests that require BPLP to maintain for specified periods of time secured debt on certain of our assets and/or allocate partnership debt to such limited partners to enable them to continue to defer recognition of their taxable gain with respect to the contributed property. These tax protection and debt allocation agreements may restrict our ability to repay or refinance debt. As of December 31, 2020, we had no tax protection or debt allocation agreement requirements that could restrict our ability to repay or finance debt. Our degree of leverage could limit our ability to obtain additional financing or affect the market price of our equity and debt securities. As of February 22, 2021, our Consolidated Debt was approximately $12.2 billion (excluding unconsolidated joint venture debt). The following table presents Consolidated Market Capitalization as well as the corresponding ratios of Consolidated Debt to Consolidated Market Capitalization (dollars and shares / units in thousands):34Table of ContentsFebruary 22, 2021Shares / Units OutstandingCommon Stock EquivalentEquivalent Value (1)Common Stock155,806 155,806 $15,029,047 Common Operating Partnership Units17,685 17,685 1,705,895 (2)5.25% Series B Cumulative Redeemable Preferred Stock80 — 200,000 Total Equity (A)173,491 $16,934,942 Consolidated Debt (B)$12,197,229 Consolidated Market Capitalization (A + B)$29,132,171 Consolidated Debt/Consolidated Market Capitalization [B / (A + B)]41.87 %_______________ (1)Except for the Series B Cumulative Redeemable Preferred Stock, which is at the liquidation preference of $2,500 per share, values are based on the closing price per share of BXP’s Common Stock on February 22, 2021 of $96.46.(2)Includes LTIP Units (including 2012 OPP Units and 2013 - 2018 MYLTIP Units), but excludes MYLTIP Units granted between 2019 and 2021.Our degree of leverage could affect our ability to obtain additional financing for working capital, capital expenditures, acquisitions, development or other general corporate purposes. Our senior unsecured debt is currently rated investment grade by two major rating agencies. However, there can be no assurance that we will be able to maintain this rating, and in the event our senior debt is downgraded from its current rating, we would likely incur higher borrowing costs and/or difficulty in obtaining additional financing. Our degree of leverage could also make us more vulnerable to a downturn in business or the economy generally. There is a risk that changes in our debt to market capitalization ratio, which is in part a function of BXP’s stock price, or BPLP’s ratio of indebtedness to other measures of asset value used by financial analysts may have an adverse effect on the market price of our equity or debt securities. We may be adversely affected by the potential discontinuation of LIBOR. In July 2017, the Financial Conduct Authority (the “FCA”) announced it intends to stop compelling banks to submit rates for the calculation of LIBOR after 2021. As a result, the Federal Reserve Board and the Federal Reserve Bank of New York organized the Alternative Reference Rates Committee which identified the Secured Overnight Financing Rate (“SOFR”) as its preferred alternative to USD-LIBOR. We are not able to predict when LIBOR will cease to be published or precisely how SOFR will be calculated and published. Any changes adopted by the FCA or other governing bodies in the method used for determining LIBOR may result in a sudden or prolonged increase or decrease in reported LIBOR. If that were to occur, our interest payments could change. In addition, uncertainty about the extent and manner of future changes may result in interest rates and/or payments that are higher or lower than if LIBOR were to remain available in its current form. We have contracts that are indexed to LIBOR and are monitoring and evaluating the related risks, which include interest amounts on our variable rate debt, our unconsolidated joint ventures’ variable rate debt and the swap rate for our unconsolidated joint ventures’ interest rate swaps. In the event that LIBOR is discontinued, the interest rates will be based on an alternative variable rate specified in the applicable documentation governing such debt or swaps or as otherwise agreed upon. Such an event would not affect our ability to borrow or maintain already outstanding borrowings or swaps, but the alternative variable rate could be higher and more volatile than LIBOR prior to its discontinuance. Certain risks arise in connection with transitioning contracts to an alternative variable rate, including any resulting value transfer that may occur. The value of loans, securities, or derivative instruments tied to LIBOR could also be impacted if LIBOR is limited or discontinued. For some instruments, the method of transitioning to an alternative rate may be challenging, as they may require substantial negotiation with each respective counterparty. If a contract is not transitioned to an alternative variable rate and LIBOR is discontinued, the impact is likely to vary by contract. If LIBOR is discontinued or if the method of calculating LIBOR changes from its current form, interest rates on our current or future indebtedness may be adversely affected.35Table of ContentsWhile we expect LIBOR to be available in substantially its current form until the end of 2021, it is possible that LIBOR will become unavailable prior to that point. This could result, for example, if sufficient banks decline to make submissions to the LIBOR administrator. In that case, the risks associated with the transition to an alternative variable rate will be accelerated and magnified.We face risks associated with short-term liquid investments. We may invest cash balances in a variety of short-term investments that are intended to preserve principal value and maintain a high degree of liquidity while providing current income. From time to time, these investments may include (either directly or indirectly): •direct obligations issued by the U.S. Treasury;•obligations issued or guaranteed by the U.S. Government or its agencies;•taxable municipal securities;•obligations (including certificates of deposit) of banks and thrifts;•commercial paper and other instruments consisting of short-term U.S. dollar denominated obligations issued by corporations and banks;•repurchase agreements collateralized by corporate and asset-backed obligations;•both registered and unregistered money market funds; and•other highly rated short-term securities.Investments in these securities and funds are not insured against loss of principal. Under certain circumstances we may be required to redeem all or part of our investment, and our right to redeem some or all of our investment may be delayed or suspended. In addition, there is no guarantee that our investments in these securities or funds will be redeemable at par value. A decline in the value of our investment or a delay or suspension of our right to redeem may have a material adverse effect on our results of operations or financial condition. Risks Related to Our Organization and StructureConflicts of interest exist with holders of interests in BPLP. Sales of properties and repayment of related indebtedness will have different effects on holders of interests in BPLP than on BXP’s stockholders. Some holders of interests in BPLP could incur adverse tax consequences upon the sale of certain of our properties and on the repayment of related debt which differ from the tax consequences to BXP and its stockholders. Consequently, such holders of partnership interests in BPLP may have different objectives regarding the appropriate pricing and timing of any such sale or repayment of debt. While BXP has exclusive authority under the limited partnership agreement of BPLP to determine when to refinance or repay debt or whether, when, and on what terms to sell a property, subject, in the case of certain properties, to the contractual commitments described below, any such decision would require the approval of BXP’s Board of Directors. While the Board of Directors has a policy with respect to these matters directors and executive officers could exercise their influence in a manner inconsistent with the interests of some, or a majority, of BXP’s stockholders, including in a manner which could prevent completion of a sale of a property or the repayment of indebtedness.Agreement not to sell some properties. We have had and may have in the future agreements with the contributors of some properties that we have acquired in exchange for partnership interests in BPLP pursuant to which we have agreed not to sell or otherwise transfer the properties, prior to specified dates, in any transaction that would trigger taxable income to the contributor. In addition, we are responsible for the reimbursement of certain tax-related costs to the prior owners if the subject properties are sold in a taxable sale. In general, our obligations to the prior owners are limited in time and only apply to actual damages suffered. 36Table of ContentsAlso, BPLP has had and may have in the future agreements providing prior owners of properties with the right to guarantee specific amounts of indebtedness and, in the event that the specific indebtedness they guarantee is repaid or reduced, additional and/or substitute indebtedness. These agreements may hinder actions that BPLP may otherwise desire to take to repay or refinance guaranteed indebtedness because BPLP would be required to make payments to the beneficiaries of such agreements if it violates these agreements. Limits on changes in control may discourage takeover attempts beneficial to stockholders. Provisions in BXP’s charter and bylaws, BXP’s shareholder rights agreement and the limited partnership agreement of BPLP, as well as provisions of the Internal Revenue Code and Delaware corporate law, may: •delay or prevent a change of control over BXP or a tender offer, even if such action might be beneficial to BXP’s stockholders; and•limit BXP’s stockholders’ opportunity to receive a potential premium for their shares of common stock over then-prevailing market prices.Stock Ownership Limit To facilitate maintenance of BXP’s qualification as a REIT and to otherwise address concerns relating to concentration of stock ownership, BXP’s charter generally prohibits ownership, directly, indirectly or beneficially, by any single stockholder of more than 6.6% of the number of outstanding shares of any class or series of its common stock. We refer to this limitation as the “ownership limit.” BXP’s Board of Directors may waive, in its sole discretion, or modify the ownership limit with respect to one or more persons if it is satisfied that ownership in excess of this limit will not jeopardize BXP’s status as a REIT for federal income tax purposes. In addition, under BXP’s charter, each of Mortimer B. Zuckerman and the respective families and affiliates of Mortimer B. Zuckerman and Edward H. Linde, as well as, in general, pension plans and mutual funds, may actually and beneficially own up to 15% of the number of outstanding shares of any class or series of BXP’s equity common stock. Shares owned in violation of the ownership limit will be subject to the loss of rights to distributions and voting and other penalties. The ownership limit may have the effect of inhibiting or impeding a change in control. BPLP’s Partnership Agreement BXP has agreed in the limited partnership agreement of BPLP not to engage in specified extraordinary transactions, including, among others, business combinations, unless limited partners of BPLP other than BXP receives, or have the opportunity to receive, either (1) the same consideration for their partnership interests as holders of BXP common stock in the transaction or (2) limited partnership units that, among other things, would entitle the holders, upon redemption of these units, to receive shares of common equity of a publicly traded company or the same consideration as holders of BXP common stock received in the transaction. If these limited partners would not receive such consideration, we cannot engage in the transaction unless limited partners holding at least 75% of the common units of limited partnership interest, other than those held by BXP or its affiliates, consent to the transaction. In addition, BXP has agreed in the limited partnership agreement of BPLP that it will not complete specified extraordinary transactions, including among others, business combinations, in which BXP receive the approval of its common stockholders unless (1) limited partners holding at least 75% of the common units of limited partnership interest, other than those held by BXP or its affiliates, consent to the transaction or (2) the limited partners of BPLP are also allowed to vote and the transaction would have been approved had these limited partners been able to vote as common stockholders on the transaction. Therefore, if BXP’s common stockholders approve a specified extraordinary transaction, the partnership agreement requires the following before it can complete the transaction: •holders of partnership interests in BPLP, including BXP, must vote on the matter;•BXP must vote its partnership interests in the same proportion as its stockholders voted on the transaction; and•the result of the vote of holders of partnership interests in BPLP must be such that had such vote been a vote of stockholders, the business combination would have been approved.37Table of ContentsWith respect to specified extraordinary transactions, BXP has agreed in BPLP’s partnership agreement to use its commercially reasonable efforts to structure such a transaction to avoid causing its limited partners to recognize gain for federal income tax purposes by virtue of the occurrence of or their participation in such a transaction.As a result of these provisions, a potential acquirer may be deterred from making an acquisition proposal, and BXP may be prohibited by contract from engaging in a proposed extraordinary transaction, including a proposed business combination, even though BXP stockholders approve of the transaction. We may change our policies without obtaining the approval of our stockholders. Our operating and financial policies, including our policies with respect to acquisitions of real estate, growth, operations, indebtedness, capitalization and dividends, are exclusively determined by BXP’s Board of Directors. Accordingly, our securityholders do not control these policies.Risks Related to BXP’s Status as a REITFailure to qualify as a REIT would cause BXP to be taxed as a corporation, which would substantially reduce funds available for payment of dividends. If BXP fails to qualify as a REIT for federal income tax purposes, it will be taxed as a corporation unless certain relief provisions apply. We believe that BXP is organized and qualified as a REIT and intends to operate in a manner that will allow BXP to continue to qualify as a REIT. However, we cannot assure you that BXP is qualified as such, or that it will remain qualified as such in the future. This is because qualification as a REIT involves the application of highly technical and complex provisions of the Internal Revenue Code as to which there are only limited judicial and administrative interpretations and involves the determination of facts and circumstances not entirely within our control. Future legislation, new regulations, administrative interpretations or court decisions may significantly change the tax laws or the application of the tax laws with respect to qualification as a REIT for federal income tax purposes or the federal income tax consequences of such qualification. In addition, we currently hold certain of our properties through subsidiaries that have elected to be taxed as REITs and we may in the future determine that it is in our best interests to hold one or more of our other properties through one or more subsidiaries that elect to be taxed as REITs. If any of these subsidiaries fails to qualify as a REIT for federal income tax purposes, then BXP may also fail to qualify as a REIT for federal income tax purposes. If BXP or any of its subsidiaries that are REITs fails to qualify as a REIT then, unless certain relief provisions apply, it will face serious tax consequences that will substantially reduce the funds available for payment of dividends for each of the years involved because: •BXP would not be allowed a deduction for dividends paid to stockholders in computing its taxable income and would be subject to federal income tax at regular corporate rates;•BXP also could be subject to the federal alternative minimum tax for tax years ending before January 1, 2018 and possibly increased state and local taxes; and•unless BXP is entitled to relief under statutory provisions, BXP could not elect to be subject to tax as a REIT for four taxable years following the year during which it was disqualified.In addition, if BXP fails to qualify as a REIT and the relief provisions do not apply, it will no longer be required to pay dividends. As a result of all these factors, BXP’s failure to qualify as a REIT could impair our ability to raise capital and expand our business, and it would adversely affect the value of BXP’s common stock. If BXP or any of its subsidiaries that are REITs fails to qualify as a REIT but is eligible for certain relief provisions, then it may retain its status as a REIT, but may be required to pay a penalty tax, which could be substantial. In order to maintain BXP’s REIT status, we may be forced to borrow funds during unfavorable market conditions. In order to maintain BXP’s REIT status, we may need to borrow funds on a short-term basis to meet the REIT distribution requirements, even if the then-prevailing market conditions are not favorable for these borrowings. To qualify as a REIT, BXP generally must distribute to its stockholders at least 90% of its taxable income each year, excluding capital gains and with certain other adjustments. In addition, BXP will be subject to a 4% nondeductible excise tax on the amount, if any, by which dividends paid in any calendar year are less than the sum of 85% of ordinary income, 95% of capital gain net income and 100% of undistributed income from prior years. We may need 38Table of Contentsshort-term debt or long-term debt or proceeds from asset sales, creation of joint ventures or sales of common stock to fund required distributions as a result of differences in timing between the actual receipt of income and the recognition of income for federal income tax purposes, or the effect of non-deductible capital expenditures, the creation of reserves or required debt or amortization payments. Any inability of our cash flows to cover our distribution requirements could have an adverse impact on our ability to raise short- and long-term debt or sell equity securities in order to fund distributions required to maintain BXP’s REIT status. We may be subject to adverse legislative or regulatory tax changes that could negatively impact our financial condition.At any time, the U.S. federal income tax laws governing REITs or the administrative interpretations of those laws may be amended, including with respect to our hotel ownership structure. We cannot predict if or when any new U.S. federal income tax law, regulation, or administrative interpretation, or any amendment to any existing U.S. federal income tax law, Treasury regulation or administrative interpretation, will be adopted, promulgated or become effective and any such law, regulation, or interpretation may take effect retroactively. BXP, its taxable REIT subsidiaries, and our securityholders could be adversely affected by any such change in, or any new, U.S. federal income tax law, Treasury regulation or administrative interpretation.We face possible adverse state and local tax audits and changes in state and local tax laws.Because BXP is organized and qualifies as a REIT, it is generally not subject to federal income taxes, but we are subject to certain state and local taxes. In the normal course of business, certain entities through which we own real estate either have undergone, or are currently undergoing, tax audits. Although we believe that we have substantial arguments in favor of our positions in the ongoing audits, in some instances there is no controlling precedent or interpretive guidance on the specific point at issue. Collectively, tax deficiency notices received to date from the jurisdictions conducting the ongoing audits have not been material. However, there can be no assurance that future audits will not occur with increased frequency or that the ultimate result of such audits will not have a material adverse effect on our results of operations.From time to time changes in state and local tax laws or regulations are enacted, which may result in an increase in our tax liability. A shortfall in tax revenues for states and municipalities in which we operate may lead to an increase in the frequency and size of such changes. If such changes occur, we may be required to pay additional taxes on our assets or income. These increased tax costs could adversely affect our financial condition and results of operations and the amount of cash available for the payment of dividends and distributions to our securityholders. General Risk FactorsChanges in market conditions could adversely affect the market price of BXP’s common stock. As with other publicly traded equity securities, the value of BXP’s common stock depends on various market conditions that may change from time to time. Among the market conditions that may affect the value of BXP’s common stock are the following: •the extent of investor interest in our securities;•the general reputation of REITs and the attractiveness of our equity securities in comparison to other equity securities, including securities issued by other real estate-based companies;•our underlying asset value;•investor confidence in the stock and bond markets, generally;•national economic conditions;•changes in tax laws;•our financial performance;•changes in our credit ratings; and•general stock and bond market conditions, including changes in interest rates.39Table of ContentsThe market value of BXP’s common stock is based primarily upon the market’s perception of our growth potential and our current and potential future earnings and cash dividends. Consequently, BXP’s common stock may trade at prices that are greater or less than BXP’s net asset value per share of common stock. If our future earnings or cash dividends are less than expected, it is likely that the market price of BXP’s common stock will diminish. Further issuances of equity securities may be dilutive to current securityholders. The interests of our existing securityholders could be diluted if additional equity securities are issued to finance future developments, acquisitions or repay indebtedness. Our ability to execute our business strategy depends on our access to an appropriate blend of debt financing, including unsecured lines of credit and other forms of secured and unsecured debt, and equity financing, including common and preferred equity.The number of shares available for future sale could adversely affect the market price of BXP’s stock. In connection with and subsequent to BXP’s initial public offering, we have completed many private placement transactions in which shares of stock of BXP or partnership interests in BPLP were issued to owners of properties we acquired or to institutional investors. This common stock, or common stock issuable in exchange for such partnership interests in BPLP, may be sold in the public securities markets over time under registration rights we granted to these investors. Additional common stock issuable under our employee benefit and other incentive plans, including as a result of the grant of stock options and restricted equity securities, may also be sold in the market at some time in the future. Future sales of BXP common stock in the market could adversely affect the price of its common stock. We cannot predict the effect the perception in the market that such sales may occur will have on the market price of BXP’s common stock. Litigation could have a material adverse effect.From time to time, we are involved in legal proceedings and other claims. We may also be named as defendants in lawsuits allegedly arising out of our actions or the actions of our vendors, contractors, tenants or other contractual parties in which such parties have agreed to indemnify, defend and hold us harmless from and against various claims, litigation and liabilities arising in connection with their respective businesses and/or added as an additional insured under certain insurance policies. An unfavorable resolution of any legal proceeding or other claim could have a material adverse effect on our financial condition or results from operations. Regardless of its outcome, legal proceedings and other claims may result in substantial costs and expenses and significantly divert the attention of our management. With respect to any legal proceeding or other claim, there can be no assurance that we will be able to prevail, or achieve a favorable settlement or outcome, or that our insurance or the insurance and/or any contractual indemnities of our vendors, contractors, tenants or other contractual parties will be enough to cover all of our defense costs or any resulting liabilities. We face risks associated with security breaches through cyber attacks, cyber intrusions or otherwise, as well as other significant disruptions of our information technology (IT) networks and related systems. We face risks associated with security breaches, whether through cyber attacks or cyber intrusions over the Internet, malware, computer viruses, attachments to e-mails, persons inside our organization or persons with access to systems inside our organization, and other significant disruptions of our IT networks and related systems. The risk of a security breach or disruption, particularly through cyber attack or cyber intrusion, including by computer hackers, foreign governments and cyber terrorists, has generally increased as the number, intensity and sophistication of attempted attacks and intrusions from around the world have increased. Our IT networks and related systems are essential to the operation of our business and our ability to perform day-to-day operations (including managing our building systems) and, in some cases, may be critical to the operations of certain of our tenants. The Audit Committee of BXP’s Board of Directors oversees our risk management processes related to cybersecurity. It meets no less frequently than annually with our IT personnel and senior management to discuss recent trends in cyber risks and our strategy to defend our IT networks, business systems and information against cyber attacks and intrusions. Under the oversight of the Audit Committee, we implemented our cybersecurity standards and overall program by reference to the National Institute of Standards and Technology (“NIST”) Cyber Security Framework. As part of our overall cybersecurity program: 40Table of Contents•we have implemented a continuous improvement methodology including, but not limited to, ongoing enhancements to processes and controls, quarterly control reviews, annual policy reviews, biannual penetration tests and annual investments in our security infrastructure; •we annually assess our cybersecurity program against the NIST framework and periodically engage an outside consulting firm to conduct the assessment; and•we conduct cybersecurity awareness training at least three times per year for our employees and primary on-site providers, and we conduct ongoing phishing simulations to raise awareness of spoofed or manipulated electronic communications and other critical security threats.Although we make efforts to maintain the security and integrity of our IT networks and related systems, and we have implemented various measures to manage the risk of a security breach or disruption, there can be no assurance that our security efforts and measures will be effective or that attempted security breaches or disruptions would not be successful or damaging. Even the most well-protected information, networks, systems and facilities remain potentially vulnerable because the techniques used in such attempted security breaches evolve and generally are not recognized until launched against a target, and in some cases, are designed not be detected and, in fact, may not be detected. Accordingly, we may be unable to anticipate these techniques or to implement adequate security barriers or other preventative measures, and thus it is impossible for us to entirely mitigate this risk. Like other businesses, we have been, and expect to continue to be, subject to attempts at unauthorized access, mishandling or misuse, computer viruses or malware, cyber attacks and intrusions and other events of varying degrees. To date, these events have not adversely affected our operations or business and have not been material, either individually or in the aggregate. However, a security breach or other significant disruption involving our IT networks and related systems could: •disrupt the proper functioning of our networks and systems and therefore our operations and/or those of certain of our tenants; •result in misstated financial reports, violations of loan covenants, missed reporting deadlines and/or missed permitting deadlines; •result in our inability to properly monitor our compliance with the rules and regulations regarding BXP’s qualification as a REIT; •result in the unauthorized access to, and destruction, loss, theft, misappropriation or release of, proprietary, confidential, sensitive or otherwise valuable information of ours or others, which others could use to compete against us or which could expose us to damage claims by third-parties for disruptive, destructive or otherwise harmful purposes and outcomes; •result in our inability to maintain the building systems relied upon by our tenants for the efficient use of their leased space; •require significant management attention and resources to remedy any damages that result; •subject us to claims for breach of contract, damages, credits, penalties or termination of leases or other agreements; and •damage our reputation among our tenants and investors generally. Any one or more of the foregoing could have a material adverse effect on our results of operations, financial condition and cash flows.Changes in accounting pronouncements could adversely affect our operating results, in addition to the reported financial performance of our tenants. Accounting policies and methods are fundamental to how we record and report our financial condition and results of operations. Uncertainties posed by various initiatives of accounting standard-setting by the Financial Accounting Standards Board and the Securities and Exchange Commission, which create and interpret applicable accounting standards for U.S. companies, may change the financial accounting and reporting standards or their interpretation and application of these standards that govern the preparation of our financial statements. Changes 41Table of Contentsinclude, but are not limited to, changes in revenue recognition, lease accounting and the adoption of accounting standards likely to require the increased use of “fair-value” measures. These changes could have a material impact on our reported financial condition and results of operations. In some cases, we could be required to apply a new or revised standard retroactively, resulting in potentially material restatements of prior period financial statements. Similarly, these changes could have a material impact on our tenants’ reported financial condition or results of operations or could affect our tenants’ preferences regarding leasing real estate. Item 1B. Unresolved Staff Comments.None.42Table of ContentsItem 2. Properties. At December 31, 2020, we owned or had joint venture interests in 196 commercial real estate properties, aggregating approximately 51.2 million net rentable square feet of primarily Class A office properties, including six properties under construction/redevelopment totaling approximately 3.7 million net rentable square feet. Our properties consisted of (1) 177 office properties (including six properties under construction/redevelopment), (2) 12 retail properties, (3) six residential properties and (4) one hotel. The table set forth below shows information relating to the properties we owned, or in which we had an ownership interest, at December 31, 2020, and it includes properties held by both consolidated and unconsolidated joint ventures. PropertiesLocation% Leased as of December 31, 2020 (1)NumberofBuildingsNetRentableSquare FeetOffice767 Fifth Avenue (The GM Building) (60% ownership)New York, NY89.3 %1 1,957,768 200 Clarendon StreetBoston, MA98.0 %1 1,768,163 399 Park AvenueNew York, NY90.4 %1 1,576,437 601 Lexington Avenue (55% ownership) (2)New York, NY97.6 %1 1,445,155 Salesforce TowerSan Francisco, CA100.0 %1 1,420,682 Times Square Tower (55% ownership)New York, NY94.7 %1 1,241,443 100 Federal Street (55% ownership)Boston, MA98.2 %1 1,238,461 800 Boylston Street - The Prudential CenterBoston, MA93.0 %1 1,235,538 Colorado Center (50% ownership) (3)Santa Monica, CA93.6 %6 1,128,600 Santa Monica Business Park (55% ownership) (3)Santa Monica, CA93.7 %14 1,102,722 Gateway Commons (50% Ownership) (3) (4)South San Francisco, CA82.0 %6 1,070,388 599 Lexington AvenueNew York, NY99.3 %1 1,062,708 Bay Colony Corporate CenterWaltham, MA81.0 %4 1,001,136 250 West 55th StreetNew York, NY99.4 %1 966,979 Embarcadero Center FourSan Francisco, CA96.2 %1 941,138 111 Huntington Avenue - The Prudential CenterBoston, MA100.0 %1 860,455 Embarcadero Center OneSan Francisco, CA89.4 %1 822,264 Embarcadero Center TwoSan Francisco, CA90.7 %1 799,366 Atlantic Wharf Office (55% ownership)Boston, MA99.8 %1 793,823 Embarcadero Center ThreeSan Francisco, CA91.5 %1 786,078 Dock 72 (50% ownership) (3)Brooklyn, NY33.1 %1 668,625 Metropolitan Square (20% ownership) (3)Washington, DC62.2 %1 654,145 South of MarketReston, VA76.5 %3 623,250 Mountain View Research ParkMountain View, CA76.3 %15 542,264 901 New York Avenue (25% ownership) (3)Washington, DC74.6 %1 541,990 Reservoir PlaceWaltham, MA90.1 %1 526,985 680 Folsom StreetSan Francisco, CA99.1 %2 524,793 101 Huntington Avenue - The Prudential CenterBoston, MA100.0 %1 506,476 Fountain SquareReston, VA80.7 %2 505,458 145 BroadwayCambridge, MA98.5 %1 488,862 43Table of ContentsPropertiesLocation% Leased as of December 31, 2020 (1)NumberofBuildingsNetRentableSquare Feet601 Massachusetts AvenueWashington, DC97.3 %1 478,818 2200 Pennsylvania AvenueWashington, DC97.8 %1 458,831 One Freedom SquareReston, VA64.1 %1 430,640 Two Freedom SquareReston, VA100.0 %1 421,865 Market Square North (50% ownership) (3)Washington, DC78.8 %1 417,979 880 & 890 Winter StreetWaltham, MA78.5 %2 392,576 The Hub on Causeway - Podium (50% ownership) (3)Boston, MA98.3 %1 382,497 140 Kendrick StreetNeedham, MA99.4 %3 380,991 One and Two Discovery SquareReston, VA100.0 %2 366,989 888 Boylston Street - The Prudential CenterBoston, MA100.0 %1 363,320 Weston Corporate CenterWeston, MA100.0 %1 356,995 510 Madison AvenueNew York, NY98.4 %1 355,083 One Reston OverlookReston, VA100.0 %1 319,519 535 Mission StreetSan Francisco, CA95.7 %1 307,235 Waltham Weston Corporate CenterWaltham, MA92.7 %1 301,611 Wisconsin Place OfficeChevy Chase, MD82.3 %1 299,217 230 CityPointWaltham, MA93.9 %1 296,212 17Fifty Presidents Street Reston, VA100.0 %1 275,809 Reston Corporate CenterReston, VA100.0 %2 261,046 355 Main StreetCambridge, MA99.0 %1 259,640 Democracy TowerReston, VA98.4 %1 259,441 1330 Connecticut AvenueWashington, DC89.4 %1 253,941 10 CityPointWaltham, MA98.1 %1 241,203 510 Carnegie CenterPrinceton, NJ— %1 234,160 500 North Capitol Street, N.W. (30% ownership) (3)Washington, DC98.5 %1 230,900 90 BroadwayCambridge, MA100.0 %1 223,771 3625-3635 Peterson Way (5)Santa Clara, CA100.0 %1 218,366 255 Main StreetCambridge, MA92.9 %1 215,394 20 CityPointWaltham, MA62.4 %1 211,476 77 CityPointWaltham, MA95.4 %1 209,712 Sumner SquareWashington, DC97.0 %1 209,556 University PlaceCambridge, MA100.0 %1 195,282 300 Binney StreetCambridge, MA100.0 %1 195,191 North First Business Park (5)San Jose, CA61.9 %5 190,636 150 BroadwayCambridge, MA100.0 %1 177,226 Capital GalleryWashington, DC86.7 %1 176,078 191 Spring StreetLexington, MA100.0 %1 170,997 Lexington Office ParkLexington, MA67.4 %2 166,779 206 Carnegie CenterPrinceton, NJ100.0 %1 161,763 210 Carnegie CenterPrinceton, NJ79.2 %1 159,468 Kingstowne TwoAlexandria, VA70.2 %1 155,995 105 BroadwayCambridge, MA100.0 %1 152,664 212 Carnegie CenterPrinceton, NJ76.6 %1 151,355 44Table of ContentsPropertiesLocation% Leased as of December 31, 2020 (1)NumberofBuildingsNetRentableSquare FeetKingstowne OneAlexandria, VA93.0 %1 150,957 214 Carnegie CenterPrinceton, NJ43.2 %1 146,979 2440 West El Camino RealMountain View, CA87.2 %1 141,392 506 Carnegie CenterPrinceton, NJ80.5 %1 138,616 200 West Street (6)Waltham, MA100.0 %1 134,921 Two Reston OverlookReston, VA— %1 134,615 508 Carnegie CenterPrinceton, NJ100.0 %1 134,433 202 Carnegie CenterPrinceton, NJ91.2 %1 134,068 804 Carnegie CenterPrinceton, NJ100.0 %1 130,000 Annapolis Junction Building Seven (50% ownership) (3)Annapolis, MD100.0 %1 127,229 504 Carnegie CenterPrinceton, NJ100.0 %1 121,990 101 Carnegie CenterPrinceton, NJ100.0 %1 121,620 502 Carnegie CenterPrinceton, NJ100.0 %1 121,460 701 Carnegie CenterPrinceton, NJ100.0 %1 120,000 Annapolis Junction Building Six (50% ownership) (3)Annapolis, MD75.2 %1 119,339 1265 Main Street (50% ownership) (3)Waltham, MA100.0 %1 114,969 7601 Boston BoulevardSpringfield, VA100.0 %1 108,286 201 Spring StreetLexington, MA100.0 %1 106,300 7435 Boston BoulevardSpringfield, VA83.4 %1 103,557 104 Carnegie CenterPrinceton, NJ63.6 %1 102,930 103 Carnegie CenterPrinceton, NJ68.5 %1 96,332 8000 Grainger CourtSpringfield, VA— %1 88,775 33 Hayden AvenueLexington, MA100.0 %1 80,876 7500 Boston BoulevardSpringfield, VA100.0 %1 79,971 7501 Boston BoulevardSpringfield VA100.0 %1 75,756 Reservoir Place NorthWaltham, MA100.0 %1 73,258 105 Carnegie CenterPrinceton, NJ56.3 %1 69,955 32 Hartwell AvenueLexington, MA100.0 %1 69,154 250 Binney StreetCambridge, MA100.0 %1 67,362 302 Carnegie CenterPrinceton, NJ89.3 %1 64,926 195 West StreetWaltham, MA— %1 63,500 7450 Boston BoulevardSpringfield, VA100.0 %1 62,402 7374 Boston BoulevardSpringfield, VA100.0 %1 57,321 100 Hayden AvenueLexington, MA100.0 %1 55,924 181 Spring StreetLexington, MA100.0 %1 55,793 8000 Corporate CourtSpringfield, VA100.0 %1 52,539 211 Carnegie CenterPrinceton, NJ100.0 %1 47,025 7451 Boston BoulevardSpringfield, VA67.4 %1 45,615 7300 Boston BoulevardSpringfield, VA100.0 %1 32,000 92 Hayden AvenueLexington, MA100.0 %1 31,100 17 Hartwell AvenueLexington, MA100.0 %1 30,000 453 Ravendale DriveMountain View, CA60.8 %1 29,620 7375 Boston BoulevardSpringfield, VA100.0 %1 26,865 690 Folsom StreetSan Francisco, CA100.0 %1 26,080 45Table of ContentsPropertiesLocation% Leased as of December 31, 2020 (1)NumberofBuildingsNetRentableSquare Feet201 Carnegie CenterPrinceton, NJ100.0 %— 6,500 Subtotal for Office Properties90.0 %171 44,392,689 RetailPrudential Center (retail shops)Boston, MA97.3 %1 594,771 Fountain Square RetailReston, VA86.0 %1 216,591 Kingstowne RetailAlexandria, VA94.3 %1 88,288 Santa Monica Business Park Retail (55% ownership) (3)Santa Monica, CA90.1 %7 74,404 Star Market at the Prudential CenterBoston, MA100.0 %1 57,236 The PointWaltham, MA84.7 %1 16,300 Subtotal for Retail Properties94.2 %12 1,047,590 ResidentialSignature at Reston (508 units)Reston, VA78.7 %(7)1 517,783 The Avant at Reston Town Center (359 units)Reston, VA90.0 %(7)1 355,374 The Skylyne (402 units) (8)Oakland, CA8.0 %(9)1 330,996 Hub50House (440 units) (50% ownership) (3)Boston, MA51.4 %(10)1 320,444 Proto Kendall Square (280 units)Cambridge, MA90.4 %(7)1 166,717 The Lofts at Atlantic Wharf (86 units)Boston, MA88.4 %(7)1 87,097 Subtotal for Residential Properties63.1 %6 1,778,411 (11)HotelBoston Marriott Cambridge (437 rooms)Cambridge, MA16.4 %(12)1 334,260 (13)Subtotal for Hotel Property16.4 %1 334,260 Subtotal for In-Service Properties90.1 %190 47,552,950 Properties Under Construction/Redevelopment (14)Office325 Main StreetCambridge, MA90.0 %1 420,000 100 Causeway Street (50% ownership) (3)Boston, MA94.0 %1 632,000 7750 Wisconsin Avenue (Marriott International Headquarters) (50% ownership) (3)Bethesda, MD100.0 %1 734,000 Reston Next (formerly Reston Gateway)Reston, VA85.0 %2 1,062,000 2100 Pennsylvania AvenueWashington, DC56.0 %1 480,000 RedevelopmentOne Five Nine East 53rd Street (55% ownership) (15)New York, NY96.0 %— 220,000 200 West Street (16)Waltham, MA100.0 %— 138,000 Subtotal for Properties Under Construction/Redevelopment87.0 %6 3,686,000 Total Portfolio196 51,238,950 _______________(1)Represents signed leases for in-service properties which revenue recognition has commenced in accordance with accounting principles generally accepted in the United States (“GAAP”).(2)Excludes the portion that was removed from the in-service portfolio during the third quarter of 2016 as part of a planned redevelopment.46Table of Contents(3)Property is an unconsolidated joint venture. (4)As a result of the partner’s deferred contribution, we own an approximately 55% interest in the joint venture at December 31, 2020. Future development projects will be owned 49% by us and 51% by our partner.(5)Property is held for redevelopment.(6)Excludes the portion that was removed from the in-service portfolio during the third quarter of 2019 as part of a planned redevelopment.(7)Percentage leased is not included in the calculation of the Total Portfolio occupancy rate for In-Service Properties as of December 31, 2020. (8)This property is subject to a 99-year ground lease (including extension options) with an option to purchase in the future.(9)This property was completed and fully placed in-service on August 15, 2020 and is in its initial lease-up period. Percentage leased is not included in the calculation of the Total Portfolio occupancy rate for In-Service Properties as of December 31, 2020. (10)This property was completed and fully placed in-service on July 24, 2020 and is in its initial lease-up period. Percentage leased is not included in the calculation of the Total Portfolio occupancy rate for In-Service Properties as of December 31, 2020.(11)Includes 87,690 square feet of retail space which is approximately 57.4% leased as of December 31, 2020. Note that this amount is not included in the calculation of the Total Portfolio occupancy rate for In-Service Properties as of December 31, 2020.(12)Represents the weighted-average room occupancy for the year ended December 31, 2020. Note that this amount is not included in the calculation of the Total Portfolio occupancy rate for In-Service Properties as of December 31, 2020. As a result of COVID-19, the Boston Marriott Cambridge was closed in March 2020 and did not re-open until October 2, 2020 with limited occupancy.(13)Includes 4,260 square feet of retail space which is 100% leased as of December 31, 2020. Note that this amount is not included in the calculation of the Total Portfolio occupancy rate for In-Service Properties as of December 31, 2020.(14)Represents percentage leased as of February 22, 2021, including leases with future commencement dates.(15)The low-rise portion of 601 Lexington Avenue.(16)Represents a portion of the property under redevelopment for conversion to life sciences space.Percentage Leased and Average Annualized Revenue per Square Foot for In-Service Properties The following table sets forth our percentage leased and average annualized revenue per square foot on a historical basis for our In-Service Properties. December 31,20202019201820172016Percentage leased (1)90.1 %93.0 %91.4 %90.7 %90.2 %Average annualized revenue per square foot (2)$72.67 $69.72 $66.63 $63.66 $62.54 _______________(1)Represents signed leases, excluding hotel and residential properties, for which revenue recognition has commenced in accordance with GAAP.(2)Represents the monthly contractual base rents and recoveries from tenants under existing leases as of December 31, 2020, 2019, 2018, 2017 and 2016 multiplied by twelve. These annualized amounts are before rent abatements and include expense reimbursements, which may be estimates as of such date. The aggregate amounts of rent abatements per square foot under existing leases as of December 31, 2020, 2019, 2018, 2017 and 2016 for the succeeding twelve-month period were $1.73, $1.70, $0.97, $1.67 and $1.18, respectively.47Table of ContentsTop 20 Tenants by Square Feet Our 20 largest tenants by square feet as of December 31, 2020 were as follows:TenantSquare Feet (1)% of In-Service Portfolio (1)1.salesforce.com905,742 2.30 %2.Arnold & Porter Kaye Scholer813,679 2.07 %3.U.S. Government810,511 2.06 %4.Biogen772,212 1.96 %5.Akamai Technologies658,578 1.67 %6.Ropes & Gray539,467 1.37 %7.Microsoft520,814 1.32 %8.Google501,336 1.27 %9.Shearman & Sterling500,109 1.27 %10.WeWork442,517 1.12 %11.Kirkland & Ellis399,538 1.01 %12.Wellington Management350,102 0.89 %13.Blue Cross Blue Shield347,618 0.88 %14.Bank of America333,885 0.85 %15.Mass Financial Services313,584 0.80 %16.Leidos304,979 0.77 %17.Weil Gotshal & Manges272,593 0.69 %18.Bain Capital268,913 0.68 %19.Bechtel Corporation268,828 0.68 %20.SAIC260,780 0.66 %__________________(1)Amounts are calculated based on our consolidated portfolio square feet, plus our share of the square feet from the unconsolidated joint ventures properties (calculated based on our ownership percentage), minus our partners’ share of square feet from our consolidated joint venture properties (calculated based upon the partners’ percentage ownership interests).Tenant DiversificationOur tenant diversification by square feet as of December 31, 2020 was as follows:Sector% of In-Service PortfolioTechnology, Media and Life Sciences30%Legal Services19%Financial Services - all other13%Other Professional Services9%Financial Services - commercial and investment banking7%Real Estate & Insurance7%Retail6%Manufacturing4%Government / Public Administration3%Other 2%48Table of ContentsLease Expirations (1)(2)Year of Lease ExpirationRentable Square Feet Subject to Expiring LeasesCurrent Annualized Contractual Rent Under Expiring Leases Without Future Step-Ups (3)Current Annualized Contractual Rent Under Expiring Leases Without Future Step-Ups p.s.f. (3)Current Annualized Contractual Rent Under Expiring Leases With Future Step-Ups (4)Current Annualized Contractual Rent Under Expiring Leases With Future Step-Ups p.s.f. (4)Percentage of Total Square Feet2020 (5)467,288 $26,645,483 $57.02 $26,645,483 $57.02 1.03 %20213,231,092 181,992,737 56.33 183,314,717 56.73 7.10 %20222,810,834 180,036,563 64.05 177,956,865 63.31 6.17 %20232,295,877 161,451,754 70.32 173,362,217 75.51 5.04 %20243,769,171 248,606,447 65.96 259,372,010 68.81 8.28 %20252,860,586 184,320,258 64.43 196,043,305 68.53 6.28 %20263,676,130 297,198,209 80.85 324,783,712 88.35 8.07 %20272,220,883 157,823,302 71.06 174,295,528 78.48 4.88 %20282,460,447 176,441,733 71.71 201,169,416 81.76 5.40 %20292,397,528 169,990,187 70.90 197,213,941 82.26 5.27 %Thereafter14,360,818 1,165,966,958 81.19 1,437,602,146 100.11 31.54 % _______________(1)Includes 100% of unconsolidated joint venture properties. Does not include residential units or the hotel. (2)Does not include data for leases expiring in a particular year when leases for the same space have already been signed with replacement tenants with future commencement dates. In those cases, the data is included in the year in which the future lease with the replacement tenant expires.(3)Represents the monthly contractual base rent and recoveries from tenants under existing leases as of December 31, 2020 multiplied by twelve. This amount reflects total rent before any rent abatements and includes expense reimbursements, which may be estimates as of such date.(4)Represents the monthly contractual base rent under expiring leases with future contractual increases upon expiration and recoveries from tenants under existing leases as of December 31, 2020 multiplied by twelve. This amount reflects total rent before any rent abatements and includes expense reimbursements, which may be estimates as of such date.(5)Represents leases that expired on December 31, 2020.Item 3. Legal Proceedings. We are subject to various legal proceedings and claims that arise in the ordinary course of business. Many of these matters are covered by insurance. Management believes that the final outcome of such matters will not have a material adverse effect on our financial position, results of operations or liquidity.Item 4. Mine Safety Disclosures.Not Applicable. 49Table of ContentsPART IIItem 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.The common stock of Boston Properties, Inc. is listed on the New York Stock Exchange under the symbol “BXP.” At February 22, 2021, BXP had approximately 1,106 stockholders of record. There is no established public trading market for BPLP’s common units. On February 22, 2021, there were approximately 311 holders of record and 173,490,466 common units outstanding, 155,805,646 of which were held by BXP. In order to enable BXP to maintain its qualification as a REIT, it must make annual distributions to its stockholders of at least 90% of its taxable income (not including net capital gains and with certain other adjustments). BXP has adopted a policy of paying regular quarterly dividends on its common stock, and, as BPLP’s general partner, BXP has adopted a policy of paying regular quarterly distributions on common units of BPLP. Cash distributions have been paid on the common stock of BXP and BPLP’s common units since BXP’s initial public offering. Distributions are declared at the discretion of the Board of Directors of BXP and depend on actual and anticipated cash from operations, our financial condition, capital requirements, the annual distribution requirements under the REIT provisions of the Internal Revenue Code and other factors the Board of Directors of BXP may consider relevant.Stock Performance Graph The following graph provides a comparison of cumulative total stockholder return for the period from December 31, 2015 through December 31, 2020, among BXP, Standard & Poor’s (“S&P”) 500 Index, FTSE Nareit Equity REIT Total Return Index (the “Equity REIT Index”) and the FTSE Nareit Office REIT Index (the “Office REIT Index”). The Equity REIT Index includes all tax-qualified equity REITs listed on the New York Stock Exchange, the American Stock Exchange and the Nasdaq Stock Market. Equity REITs are defined as those with 75% or more of their gross invested book value of assets invested directly or indirectly in the equity ownership of real estate. The Office REIT Index includes all office REITs included in the Equity REIT Index. Data for BXP, the S&P 500 Index, the Equity REIT Index and the Office REIT Index was provided to us by Nareit. Upon written request, we will provide any stockholder with a list of the REITs included in the Equity REIT Index and the Office REIT Index. The stock performance graph assumes an investment of $100 in each of BXP and the three indices, and the reinvestment of any dividends. The historical information set forth below is not necessarily indicative of future performance. The data shown is based on the share prices or index values, as applicable, at the end of each month shown.50Table of Contents As of the year ended December 31, 201520162017201820192020Boston Properties, Inc.$100.00 $100.71 $106.64 $95.04 $119.82 $85.85 S&P 500 Index$100.00 $111.96 $136.40 $130.42 $171.49 $203.04 Equity REIT Index$100.00 $108.52 $114.19 $108.91 $137.23 $126.25 Office REIT Index$100.00 $113.17 $119.11 $101.84 $133.83 $109.16 Boston Properties, Inc.(a) During the three months ended December 31, 2020, BXP issued an aggregate of 82,953 shares of common stock in exchange for 82,953 common units of limited partnership held by certain limited partners of BPLP. Of these shares, 37,460 shares were issued in reliance on an exemption from registration under Section 4(a)(2) of the Securities Act of 1933, as amended. BXP relied on the exemption under Section 4(a)(2) based upon factual representations received from the limited partners who received the common shares.(b) Not Applicable.(c) Issuer Purchases of Equity Securities.Period(a)Total Number of Shares of Common StockPurchased(b)Average Price Paid per Common Share(c)Total Number of Shares Purchased as Part of Publicly Announced Plans or Programs(d)Maximum Number (or Approximate Dollar Value) of Shares that May Yet be PurchasedOctober 1, 2020 – October 31, 2020428 (1)$0.01 N/AN/ANovember 1, 2020 - November 30, 2020— — N/AN/ADecember 1, 2020 – December 31, 2020— — N/AN/ATotal428 $0.01 N/AN/A____________________(1)Represents shares of restricted common stock of BXP repurchased in connection with the termination of an employee’s employment with BXP. Under the terms of the applicable restricted stock award agreements, the shares were repurchased by BXP at a price of $0.01 per share, which was the amount originally paid by such employee for such shares.Boston Properties Limited Partnership(a) Not Applicable.(b) Not Applicable.(c) Issuer Purchases of Equity Securities.Period(a)Total Number of UnitsPurchased(b)Average Price Paid per Unit(c)Total Number of Units Purchased as Part of Publicly Announced Plans or Programs(d)Maximum Number (or Approximate Dollar Value) of Units that May Yet be PurchasedOctober 1, 2020 – October 31, 20202,713 (1)$0.21 N/AN/ANovember 1, 2020 – November 30, 2020— — N/AN/ADecember 1, 2020 – December 31, 2020— — N/AN/ATotal2,713 $0.21 N/AN/A____________________(1)Includes 428 common units previously held by BXP that were redeemed in connection with the repurchase of shares of restricted common stock of BXP in connection with the termination of an employee’s employment with BXP and 2,285 LTIP units that were repurchased by BPLP in connection with the termination of certain employees’ employment with BXP. Under the terms of the applicable restricted stock award agreements and LTIP unit vesting agreements, such shares were repurchased at a price of $0.01 per share and such LTIP units were repurchased at a price $0.25 per unit, which were the amounts originally paid by such employees for such shares and units. 51Table of ContentsItem 6. Selected Financial Data.The following tables set forth selected financial and operating data on a historical basis for each of BXP and BPLP. The following data should be read in conjunction with BXP’s and BPLP’s financial statements and notes thereto and Management’s Discussion and Analysis of Financial Condition and Results of Operations included elsewhere in this Form 10-K. Our historical operating results may not be comparable to our future operating results.The impact that COVID-19 has had on our business, financial position and results of operations during 2020 is discussed throughout this report. The full extent of the impact of COVID-19 on our business, operations and financial results will depend on numerous evolving factors that we may not be able to accurately predict. The impact of COVID-19 on our revenue, in particular lease, parking and hotel revenue was negatively impacted by COVID-19 for the year ended December 31, 2020, thus negatively impacting our FFO. These decreases are discussed under the heading “Comparison of the year ended December 31, 2020 to the year ended December 31, 2019” within “Item 7—Management’s Discussion and Analysis of Financial Condition and Results of Operations.” Boston Properties, Inc. For the year ended December 31, 20202019201820172016 (in thousands, except per share data)Statement of Operations Information:Total revenue$2,765,686 $2,960,562 $2,717,076 $2,602,076 $2,550,820 Expenses:Rental operating1,017,208 1,050,010 979,151 929,977 889,768 Hotel operating13,136 34,004 33,863 32,059 31,466 General and administrative133,112 140,777 121,722 113,715 105,229 Payroll and related costs from management services contracts11,626 10,386 9,590 — — Transaction costs1,531 1,984 1,604 668 2,387 Depreciation and amortization683,751 677,764 645,649 617,547 694,403 Total expenses1,860,364 1,914,925 1,791,579 1,693,966 1,723,253 Other income (expense):Income (loss) from unconsolidated joint ventures(85,110)46,592 2,222 11,232 8,074 Gain on sale of investment in unconsolidated joint venture— — — — 59,370 Gains on sales of real estate618,982 709 182,356 7,663 80,606 Interest and other income (loss)5,953 18,939 10,823 5,783 7,230 Gains (losses) from investments in securities5,261 6,417 (1,865)3,678 2,273 Gains (losses) from early extinguishments of debt— (29,540)(16,490)496 (371)Impairment losses— (24,038)(11,812)— (1,783)Losses from interest rate contracts— — — — (140)Interest expense(431,717)(412,717)(378,168)(374,481)(412,849)Net income1,018,691 651,999 712,563 562,481 569,977 Net income attributable to noncontrolling interests(145,964)(130,465)(129,716)(100,042)(57,192)Net income attributable to Boston Properties, Inc.872,727 521,534 582,847 462,439 512,785 Preferred dividends(10,500)(10,500)(10,500)(10,500)(10,500)Net income attributable to Boston Properties, Inc. common shareholders$862,227 $511,034 $572,347 $451,939 $502,285 Basic earnings per common share attributable to Boston Properties, Inc.:Net income$5.54 $3.31 $3.71 $2.93 $3.27 Weighted average number of common shares outstanding155,432 154,582 154,427 154,190 153,715 Diluted earnings per common share attributable to Boston Properties, Inc.:Net income$5.54 $3.30 $3.70 $2.93 $3.26 Weighted average number of common and common equivalent shares outstanding155,517 154,883 154,682 154,390 153,977 52Table of Contents December 31, 20202019201820172016 (in thousands)Balance Sheet information:Real estate, gross$23,352,909 $22,889,010 $21,649,896 $21,096,642 $20,147,263 Real estate, net17,818,807 17,622,212 16,752,119 16,507,008 15,925,028 Cash and cash equivalents1,668,742 644,950 543,359 434,767 356,914 Total assets22,858,190 21,284,905 20,256,477 19,372,233 18,851,643 Total indebtedness13,047,758 11,811,806 11,007,757 10,271,611 9,796,133 Redeemable deferred stock units6,897 8,365 — — — Stockholders’ equity attributable to Boston Properties, Inc.5,996,083 5,684,687 5,883,171 5,813,957 5,786,295 Equity noncontrolling interests2,343,529 2,329,549 2,330,797 2,288,499 2,145,629 For the year ended December 31, 20202019201820172016 (in thousands, except per share and percentage data)Other Information:Funds from Operations attributable to Boston Properties, Inc. common shareholders (1)$978,191 $1,085,844 $974,489 $959,412 $927,747 Dividends declared per share3.92 3.83 3.50 3.05 2.70 Cash flows provided by operating activities (2)1,156,840 1,181,165 1,150,245 911,979 1,034,548 Cash flows used in investing activities (2)(613,719)(1,015,091)(1,098,876)(882,044)(1,337,347)Cash flows provided by (used in) financing activities (2)484,322 (113,379)82,453 55,346 (74,621)Total square feet at end of year (including development projects)51,239 51,969 51,586 50,339 47,704 In-service percentage leased at end of year90.1 %93.0 %91.4 %90.7 %90.2 % _______________(1)Pursuant to the revised definition of Funds from Operations adopted by the Board of Governors of Nareit, we calculate Funds from Operations, or “FFO,” for BXP by adjusting net income attributable to Boston Properties, Inc. common shareholders (computed in accordance with GAAP) for gains (or losses) from sales of properties, impairment losses on depreciable real estate consolidated on BXP’s balance sheet, impairment losses on our investments in unconsolidated joint ventures driven by a measurable decrease in the fair value of depreciable real estate held by the unconsolidated joint ventures and our share of real estate-related depreciation and amortization. FFO is a non-GAAP financial measure. We believe the presentation of FFO, combined with the presentation of required GAAP financial measures, improves the understanding of operating results of REITs among the investing public and helps make comparisons of REIT operating results more meaningful. Management generally considers FFO to be a useful measure for understanding and comparing BXP’s operating results because, by excluding gains and losses related to sales of previously depreciated operating real estate assets, impairment losses and real estate asset depreciation and amortization (which can differ across owners of similar assets in similar condition based on historical cost accounting and useful life estimates), FFO can help investors compare the operating performance of a company’s real estate across reporting periods and to the operating performance of other companies. Amount represents BXP’s share, which was 90.03%, 89.77%, 89.83%, 89.82% and 89.70% for the years ended December 31, 2020, 2019, 2018, 2017 and 2016, respectively, after allocation to the noncontrolling interests.Our computation of FFO may not be comparable to FFO reported by other REITs or real estate companies that do not define the term in accordance with the current Nareit definition or that interpret the current Nareit definition differently. We believe that in order to facilitate a clear understanding of our operating results, FFO should be examined in conjunction with net income attributable to Boston Properties, Inc. common shareholders as presented in BXP’s Consolidated Financial Statements. FFO should not be considered as a substitute for net income attributable to Boston Properties, Inc. common shareholders (determined in accordance with GAAP) or any other GAAP financial measures and should only be considered together with and as a supplement to BXP’s financial information prepared in accordance with GAAP. A reconciliation of FFO attributable to Boston Properties, Inc. common shareholders to net income attributable to Boston Properties, Inc. common shareholders computed in accordance with GAAP is provided under the heading “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Funds from Operations.”(2)On January 1, 2018, we adopted Accounting Standards Update (“ASU”) ASU 2016-15 and ASU 2016-18 and retrospectively applied the guidance to our Consolidated Statements of Cash Flows for all periods presented. The adoption of ASU 2016-15 and ASU 2016-18 required us to include Cash Held in Escrows with Cash and Cash Equivalents when reconciling the beginning-of-period and end-of-period total amounts shown on the Consolidated Statements of Cash Flows and required us to classify debt prepayment and extinguishment costs as a component of financing activities instead of as a component of operating activities in our Consolidated Statements of Cash Flows resulting in changes to the reported amounts of cash flows provided by (used in) operating, investing and financing activities.53Table of ContentsBoston Properties Limited Partnership For the year ended December 31, 20202019201820172016 (in thousands, except per unit data)Statement of Operations Information:Total revenue$2,765,686 $2,960,562 $2,717,076 $2,602,076 $2,550,820 Expenses:Rental operating1,017,208 1,050,010 979,151 929,977 889,768 Hotel operating13,136 34,004 33,863 32,059 31,466 General and administrative133,112 140,777 121,722 113,715 105,229 Payroll and related costs from management services contracts11,626 10,386 9,590 — — Transaction costs1,531 1,984 1,604 668 2,387 Depreciation and amortization676,666 669,956 637,891 609,407 682,776 Total expenses1,853,279 1,907,117 1,783,821 1,685,826 1,711,626 Other income (expense):Income (loss) from unconsolidated joint ventures(85,110)46,592 2,222 11,232 8,074 Gain on sale of investment in unconsolidated joint venture— — — — 59,370 Gains on sales of real estate631,945 858 190,716 8,240 82,775 Interest and other income (loss)5,953 18,939 10,823 5,783 7,230 Gains (losses) from investments in securities5,261 6,417 (1,865)3,678 2,273 Gains (losses) from early extinguishments of debt— (29,540)(16,490)496 (371)Impairment losses— (22,272)(10,181)— (1,783)Losses from interest rate contracts— — — — (140)Interest expense(431,717)(412,717)(378,168)(374,481)(412,849)Net income1,038,739 661,722 730,312 571,198 583,773 Net income attributable to noncontrolling interests:Noncontrolling interests in property partnerships(48,260)(71,120)(62,909)(47,832)2,068 Net income attributable to Boston Properties Limited Partnership990,479 590,602 667,403 523,366 585,841 Preferred distributions(10,500)(10,500)(10,500)(10,500)(10,500)Net income attributable to Boston Properties Limited Partnership common unitholders$979,979 $580,102 $656,903 $512,866 $575,341 Basic earnings per common unit attributable to Boston Properties Limited Partnership:Net income$5.67 $3.37 $3.82 $2.99 $3.36 Weighted average number of common units outstanding172,643 172,200 171,912 171,661 171,361 Diluted earnings per common unit attributable to Boston Properties Limited Partnership:Net income$5.67 $3.36 $3.81 $2.98 $3.35 Weighted average number of common and common equivalent units outstanding172,728 172,501 172,167 171,861 171,623 54Table of Contents December 31, 20202019201820172016 (in thousands)Balance Sheet information:Real estate, gross$22,976,100 $22,493,789 $21,251,540 $20,685,164 $19,733,872 Real estate, net17,547,524 17,330,881 16,451,065 16,188,205 15,597,508 Cash and cash equivalents1,668,742 644,950 543,359 434,767 356,914 Total assets22,586,907 20,993,574 19,955,423 19,053,430 18,524,123 Total indebtedness13,047,758 11,811,806 11,007,757 10,271,611 9,796,133 Noncontrolling interests1,643,024 2,468,753 2,000,591 2,292,263 2,262,040 Redeemable deferred stock units6,897 8,365 — — — Boston Properties Limited Partnership partners’ capital4,698,372 3,525,463 4,200,878 3,807,630 3,811,717 Noncontrolling interests in property partnerships1,726,933 1,728,689 1,711,445 1,683,760 1,530,647 For the year ended December 31, 20202019201820172016 (in thousands, except per unit and percentage data)Other Information:Funds from operations attributable to Boston Properties Limited Partnership common unitholders (1)$1,086,501 $1,209,601 $1,084,827 $1,068,119 $1,034,251 Distributions per common unit3.92 3.83 3.50 3.05 2.70 Cash flows provided by operating activities (2)1,156,840 1,181,165 1,150,245 911,979 1,034,548 Cash flows used in investing activities (2)(613,719)(1,015,091)(1,098,876)(882,044)(1,337,347)Cash flows provided by (used in) financing activities (2)484,322 (113,379)82,453 55,346 (74,621)Total square feet at end of year (including development projects)51,239 51,969 51,586 50,339 47,704 In-service percentage leased at end of year90.1 %93.0 %91.4 %90.7 %90.2 % _______________(1)Pursuant to the revised definition of Funds from Operations adopted by the Board of Governors of Nareit, we calculate Funds from Operations, or “FFO,” for BPLP by adjusting net income attributable to Boston Properties Limited Partnership common unitholders (computed in accordance with GAAP) for gains (or losses) from sales of properties, impairment losses on depreciable real estate consolidated on BPLP’s balance sheet, impairment losses on our investments in unconsolidated joint ventures driven by a measurable decrease in the fair value of depreciable real estate held by the unconsolidated joint ventures and our share of real estate-related depreciation and amortization. FFO is a non-GAAP financial measure. We believe the presentation of FFO, combined with the presentation of required GAAP financial measures, improves the understanding of operating results of REITs among the investing public and helps make comparisons of REIT operating results more meaningful. Management generally considers FFO to be useful measures for understanding and comparing BPLP’s operating results because, by excluding gains and losses related to sales of previously depreciated operating real estate assets, impairment losses and real estate asset depreciation and amortization (which can differ across owners of similar assets in similar condition based on historical cost accounting and useful life estimates), FFO can help investors compare the operating performance of a company’s real estate across reporting periods and to the operating performance of other companies. Our computation of FFO may not be comparable to FFO reported by other REITs or real estate companies that do not define the term in accordance with the current Nareit definition or that interpret the current Nareit definition differently. We believe that in order to facilitate a clear understanding of our operating results, FFO should be examined in conjunction with net income attributable to Boston Properties Limited Partnership common unitholders as presented in BPLP’s Consolidated Financial Statements. FFO should not be considered as a substitute for net income attributable to Boston Properties Limited Partnership common unitholders (determined in accordance with GAAP) or any other GAAP financial measures and should only be considered together with and as a supplement to BPLP’s financial information prepared in accordance with GAAP.A reconciliation of FFO attributable to Boston Properties Limited Partnership common unitholders to net income attributable to Boston Properties Limited Partnership common unitholders computed in accordance with GAAP is provided under the heading “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Funds from Operations.”(2)On January 1, 2018, we adopted ASU 2016-15 and ASU 2016-18 and retrospectively applied the guidance to our Consolidated Statements of Cash Flows for all periods presented. The adoption of ASU 2016-15 and ASU 2016-18 required us to include Cash Held in Escrows with Cash and Cash Equivalents when reconciling the beginning-of-period 55Table of Contentsand end-of-period total amounts shown on the Consolidated Statements of Cash Flows and required us to classify debt prepayment and extinguishment costs as a component of financing activities instead of as a component of operating activities in our Consolidated Statements of Cash Flows resulting in changes to the reported amounts of cash flows provided by (used in) operating, investing and financing activities.56Table of ContentsItem 7—Management’s Discussion and Analysis of Financial Condition and Results of OperationsThe following discussion should be read in conjunction with the financial statements and notes thereto appearing elsewhere in this report.Forward-Looking StatementsThis Annual Report on Form 10-K, including the documents incorporated by reference, contain forward-looking statements within the meaning of the federal securities laws, Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. We intend these forward-looking statements to be covered by the safe harbor provisions for forward-looking statements contained in the Private Securities Litigation Reform Act of 1995 and are including this statement for purposes of complying with those safe harbor provisions, in each case, to the extent applicable. Such statements are contained principally, but not only, under the captions “Business—Business and Growth Strategies,” “Risk Factors” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations.” We caution investors that any such forward-looking statements are based on current beliefs or expectations of future events and on assumptions made by, and information currently available to, our management. When used, the words “anticipate,” “believe,” “budget,” “estimate,” “expect,” “intend,” “may,” “might,” “plan,” “project,” “should,” “will” and similar expressions that do not relate solely to historical matters are intended to identify forward-looking statements. Such statements are subject to risks, uncertainties and assumptions and are not guarantees of future performance or occurrences, which may be affected by known and unknown risks, trends, uncertainties and factors that are, in some cases, beyond our control. Should one or more of these known or unknown risks or uncertainties materialize, or should underlying assumptions prove incorrect, actual results may vary materially from those expressed or implied by the forward-looking statements. We caution you that, while forward-looking statements reflect our good-faith beliefs when we make them, they are not guarantees of future performance or occurrences and are impacted by actual events when they occur after we make such statements. Accordingly, investors should use caution in relying on forward-looking statements, which are based on results and trends at the time they are made, to anticipate future results or trends.One of the most significant factors that may cause actual results to differ materially from those expressed or implied by the forward-looking statements is the ongoing impact of the global COVID-19 pandemic on the U.S. and global economies, which has impacted, and is likely to continue to impact, us and, directly or indirectly, many of the other important factors below and the risks set forth in this Form 10-K in Part I, Item 1A.Some of the risks and uncertainties that may cause our actual results, performance or achievements to differ materially from those expressed or implied by forward-looking statements include, among others, the following:•the risks and uncertainties related to the impact of the COVID-19 global pandemic, including the duration, scope and severity of the pandemic domestically and internationally; federal, state and local government actions or restrictive measures implemented in response to COVID-19, the effectiveness of such measures, as well as the effect of any relaxation of current restrictions, and the direct and indirect impact of such measures on our and our tenants' businesses, financial condition, results of operations, cash flows, liquidity and performance, and the U.S. and international economy and economic activity generally; the speed, effectiveness and distribution of vaccines, whether new or existing actions and measures continue to result in increasing unemployment that impacts the ability of our residential tenants to generate sufficient income to pay, or make them unwilling to pay rent in a timely manner, in full or at all; the health, continued service and availability of our personnel, including our key personnel and property management teams; and the effectiveness or lack of effectiveness of governmental relief in providing assistance to individuals and large and small businesses, including our tenants, that have suffered significant adverse effects from COVID-19; •volatile or adverse global economic and political conditions, health crises and dislocations in the credit markets could adversely affect our access to cost-effective capital and have a resulting material adverse effect on our business opportunities, results of operations and financial condition;•general risks affecting the real estate industry (including, without limitation, the inability to enter into or renew leases, tenant space utilization, dependence on tenants’ financial condition, and competition from other developers, owners and operators of real estate);•failure to manage effectively our growth and expansion into new markets and sub-markets or to integrate acquisitions and developments successfully;•the ability of our joint venture partners to satisfy their obligations;57Table of Contents•risks and uncertainties affecting property development and construction (including, without limitation, construction delays, increased construction costs, cost overruns, inability to obtain necessary permits, tenant accounting considerations that may result in negotiated lease provisions that limit a tenant’s liability during construction, and public opposition to such activities);•risks associated with the availability and terms of financing and the use of debt to fund acquisitions and developments or refinance existing indebtedness, including the impact of higher interest rates on the cost and/or availability of financing;•risks associated with forward interest rate contracts and the effectiveness of such arrangements;•risks associated with downturns in the national and local economies, increases in interest rates, and volatility in the securities markets;•risks associated with actual or threatened terrorist attacks;•costs of compliance with the Americans with Disabilities Act and other similar laws;•potential liability for uninsured losses and environmental contamination;•risks associated with the physical effects of climate change;•risks associated with security breaches through cyber attacks, cyber intrusions or otherwise, as well as other significant disruptions of our information technology (IT) networks and related systems, which support our operations and our buildings; •risks associated with BXP’s potential failure to qualify as a REIT under the Internal Revenue Code of 1986, as amended;•possible adverse changes in tax and environmental laws;•the impact of newly adopted accounting principles on our accounting policies and on period-to-period comparisons of financial results;•risks associated with possible state and local tax audits; and•risks associated with our dependence on key personnel whose continued service is not guaranteed.The risks set forth above are not exhaustive. Other sections of this report, including “Part I, Item 1A—Risk Factors,” include additional factors that could adversely affect our business and financial performance. Moreover, we operate in a very competitive and rapidly changing environment, particularly in light of the circumstances relating to COVID-19. New risk factors emerge from time to time and it is not possible for management to predict all risk factors, nor can we assess the impact of all risk factors on our business or the extent to which any factor, or combination of factors, may cause actual results to differ materially from those contained in any forward-looking statements. Given these risks and uncertainties, investors should not place undue reliance on forward-looking statements as a prediction of actual results. Investors should also refer to our Quarterly Reports on Form 10-Q for future periods and Current Reports on Form 8-K as we file them with the SEC, and to other materials we may furnish to the public from time to time through Current Reports on Form 8-K or otherwise, for a discussion of risks and uncertainties that may cause actual results, performance or achievements to differ materially from those expressed or implied by forward-looking statements. We expressly disclaim any responsibility to update any forward-looking statements to reflect changes in underlying assumptions or factors, new information, future events, or otherwise, and you should not rely upon these forward-looking statements after the date of this report.Overview BXP is one of the largest publicly-traded office real estate investment trusts (REITs) (based on total market capitalization as of December 31, 2020) in the United States that develops, owns and manages primarily Class A office properties. Our properties are concentrated in five markets in the United States - Boston, Los Angeles, New York, San Francisco and Washington, DC. BPLP is the entity through which BXP conducts substantially all of its business and owns (either directly or through subsidiaries) substantially all of its assets. We generate revenue and cash primarily by leasing Class A office space to our tenants. When making leasing decisions, we consider, among other things, the creditworthiness of the tenant and the industry in which it conducts business, the length of the lease, the rental rate to be paid at inception and throughout the lease term, the costs of tenant improvements, free rent period and other landlord concessions, anticipated operating expenses and real estate taxes, current and anticipated vacancy in our properties and the market overall (including sublease space), current and expected future demand for the space, the impact of any expansion rights and general economic factors.58Table of ContentsOur core strategy has always been to develop, acquire and manage high-quality properties in supply-constrained markets with high barriers-to-entry and to focus on executing long-term leases with financially strong tenants. Our tenant base is diverse across market sectors and the weighted-average lease term for our in-place leases, excluding residential units, was approximately 7.4 years, as of December 31, 2020, including leases signed by our unconsolidated joint ventures. The weighted-average lease term for our top 20 office tenants was approximately 10.4 years as of December 31, 2020. Historically, these factors have minimized our exposure in weaker economic cycles and enhanced revenues as market conditions improve. To be successful in any leasing environment, we believe we must consider all aspects of the tenant-landlord relationship. In this regard, we believe that our competitive advantage is based on the following attributes:•our understanding of tenants’ short- and long-term space utilization and amenity needs in the local markets;•our reputation as a premier developer, owner and manager of primarily Class A office properties;•our financial strength and our ability to maintain high building standards;•our focus on developing and operating in a sustainable and responsible manner; and •our relationships with local brokers. OutlookStarting in March 2020, the COVID-19 pandemic negatively impacted global macroeconomic conditions. Following a drop in U.S. GDP of 31% in the second quarter of 2020, GDP growth in each of the third and fourth quarters of 2020 showed sequential quarterly improvements after the enactment of federal stimulus programs. While initial estimates indicate that GDP grew 4% in the fourth quarter of 2020, this was a decline from the third quarter as many of the stimulus programs began to expire toward the end of the year. U.S. stocks rose in November of 2020 as news about vaccine efficacy provided optimism. As we begin 2021, the U.S. economic recovery remains slow and operating conditions for several sectors, including commercial real estate, continue to be negatively impacted by the pandemic. The health of the overall economy and employment trends among professional workers have been, and we expect will continue to be, important drivers of office market conditions as vaccine distribution and efficacy drives a return to normal.Late in the first quarter of 2020, public health officials and governmental authorities, including those in all of the markets in which we operate, reacted to the spread of the COVID-19 pandemic by imposing various regulatory measures, including quarantines, travel restrictions, issuing “stay-at-home” orders, restricting the types of businesses that could continue to operate (including the types of construction projects that could proceed), closing schools and otherwise limiting the size of gatherings. Although the state and local authorities in many of our regions eased those regulations in the second half of 2020 to allow for the return to work, the physical occupancy of our properties remained well below capacity for the remainder of 2020 as infection rates increased and most employers continued their COVID-19 response protocols and encouraged employees to work from home when possible. The future impact of the pandemic on the demand for office space is unclear as companies consider the recessionary impact on their business and their demand for labor while, at the same time, evaluate their space requirements in light of their current and projected headcounts and the continued focus on social distancing and employees’ desire for more flexibility to work from home. Real estate is by nature a long-term business and we do not believe these considerations and ultimate decisions by tenants will evidence a clear trend in the short term. In the meantime, we believe our strategically located, high quality office properties will continue to be a component of today’s forward-thinking organizations that desire collaboration, innovation, productivity and culture, and we expect tenants will take advantage of the availability of Class A space and upgrade. In the fourth quarter of 2020, we signed approximately 1.2 million square feet of new leases and renewals with a weighted-average lease term of approximately eight years, indicating that, despite headwinds, many prospective and existing tenants continue to commit to the long-term use of space and view our properties as their preferred choice for a premium Class A office environment. Included in our fourth quarter 2020 leasing activity were (1) an approximately 196,000 square foot, 20-year lease for the U.S. headquarters of a multinational automotive company at our Reston Next development in Reston, Virginia; (2) an approximately 138,000 square-foot, 10-year lease with a biotechnology company at 200 West Street in Waltham, Massachusetts and (3) an approximately 75,000 square-foot, seven-year lease with a leading healthcare technology company at 20 CityPoint, a development in Waltham, Massachusetts that we fully placed-in service in June 2020.59Table of ContentsWhile the volume of leasing in the fourth quarter of 2020 was an improvement of approximately 350,000 square feet of leasing from the third quarter of 2020, new leasing activity in the fourth quarter of 2020 remained lower than it was prior to the COVID-19 pandemic as many existing and prospective tenants deferred decisions on their office space needs as they focused on their employees’ safety and managing their businesses through the recession and economic recovery. The development of primarily pre-leased properties in supply-constrained markets with the strongest economic growth over time continues to be a cornerstone of our long-term growth strategy. As of December 31, 2020, we had approximately 3.7 million square feet of active developments and redevelopments in our pipeline, which are 87% pre-leased, as of February 22, 2021, to predominately credit-strong tenants with long-lease terms. Our development projects are projected to meet required delivery milestones as defined in our leases. The health and safety of our employees, tenants, service providers and visitors continue to be our highest priorities. In the fourth quarter of 2020, we continued to operate in accordance with our health safety protocols in all in-service properties across our portfolio to provide a healthy and safe environment in accordance with the policies and applicable legal requirements in our regions. Rent CollectionsCash rent payments for a particular month are generally due on the first day of that month (although tenants have varying grace periods). Our reported rent collection amounts are based on the total amount of rent billed by us, including all amounts from consolidated operations and all unconsolidated joint ventures, other than Gateway Commons, our residential properties and one hotel for which we do not handle billing. During the fourth quarter of 2020, our rent collections as a percentage of the total amounts billed to all tenants were 99.1%.•Approximately 96.2% of the total amounts billed were made to office tenants. Our fourth quarter rent collections from office tenants continued to be strong at 99.7%. Approximately 91.4% of our lease revenue in the fourth quarter of 2020 was generated by our office portfolio. Our office portfolio has long-term lease contracts and modest rollover exposure over the next few years.•Approximately 3.8% of the total amounts billed related to retail leases. Our fourth quarter rent collections from retail tenants were 84.6%.RevenueAs a result of the impact of the COVID-19 pandemic on the current economic environment and on the commercial real estate sector in particular, our fourth quarter 2020 revenues, when compared to fourth quarter 2019, continued to be adversely affected due to (1) write-offs of accrued rent balances, (2) declines in revenue from our retail tenants, parking and our single hotel, and (3) a decline in occupancy in our in-service office and retail properties due to a slowdown in new leasing activity for vacant and expiring space.When evaluating the collectability of a tenant’s accrued rent and accounts receivable balances, management analyzes the tenant’s creditworthiness, current economic trends, including the impact of COVID-19 on a tenant’s business, and changes in the tenant’s payment patterns on a lease-by-lease basis. In the fourth quarter of 2020, we recorded write-offs totaling approximately $40.1 million, of which approximately $39.8 million were primarily associated with the write-off of accrued rent of all tenants in the co-working sector and approximately $0.3 million were associated with accounts receivable. These amounts represent the write-offs in our consolidated portfolio, plus our share of the write-offs from the unconsolidated joint ventures (calculated based on our ownership percentage), minus our partners’ share of write-offs from our consolidated joint ventures (calculated based upon the partners’ percentage ownership interests). We will recognize lease revenue from tenants in the co-working sector on a cash basis commencing in the first quarter of 2021. Our retail tenants were materially and adversely affected by the COVID-19 pandemic in 2020. Lease revenue from our retail leases was approximately $46.7 million in the fourth quarter of 2020, a $6.3 million, or 12.0%, decrease compared to $53.0 million during the fourth quarter of 2019. 60Table of ContentsIn the fourth quarter of 2020, our parking and other revenue was approximately $15.9 million, representing a small decrease compared to $16.3 million of parking and other revenue in the third quarter of 2020, but a decrease of approximately $10.8 million, or 40%, compared to the fourth quarter of 2019. The year-over-year decline was largely due to the decline in transient parking revenue as employees continue to work from home amid safety concerns during the pandemic. Our hotel property, the Boston Marriott Cambridge, re-opened in October 2020 but operated at diminished occupancy and generated only $0.5 million in revenue in the fourth quarter of 2020. Although this was an improvement from the third quarter of 2020 when the hotel was closed, our hotel revenue in the fourth quarter of 2020 decreased $11.3 million as compared to the fourth quarter of 2019. We expect hotel occupancy to remain low until a sufficient number of people have been vaccinated and the demand for travel and leisure returns to historical levels. The overall occupancy of our in-service office and retail properties was 90.1% at December 31, 2020, a decrease of 290 basis points compared to 93.0% at December 31, 2019. The decrease was primarily due to fully placing in-service Dock 72, an approximately 669,000 square foot office property located in Brooklyn, New York in which we have a 50% ownership interest, which was only 33% leased, as of December 31, 2020, and a slowdown of leasing activity for available space.Despite the concerns of the COVID-19 pandemic and the negative impact on economic conditions in our markets, we continue to be optimistic for our industry generally and our company in particular, given low interest rates, the high quality of our properties, the supply demand characteristics of our markets and the success of our development efforts. In addition, we anticipate our revenue from retail, parking and our hotel to improve as the pandemic subsides. As a leading developer, owner and manager of marquee Class A office properties in the United States, our priorities remain focused on the following:•ensuring tenant health, safety and satisfaction;•leasing available space in our in-service and development properties, as well as proactively focusing on future lease expirations;•completing the construction of our development properties;•continuing and completing the redevelopment and repositioning of several key properties to increase future revenue and asset values over the long-term;•maintaining discipline in our underwriting of investment opportunities;•managing our near-term debt maturities and maintaining our conservative balance sheet; and•actively managing our operations in a sustainable and responsible manner.The following is an overview of portfolio activity and leasing activity in the fourth quarter and full year 2020.During the fourth quarter of 2020, we signed leases across our portfolio totaling approximately 1.2 million square feet and we commenced revenue recognition on approximately 935,000 square feet of leases in second generation space, including lease renewals. Of these second generation leases, approximately 869,000 square feet had been vacant for less than one year and, in the aggregate, they represent an increase in net rental obligations (gross rent less operating expenses) of approximately 11% over the prior leases. Consistent with our long-term investment strategy to invest in high-yielding development opportunities, in 2020, we completed and fully placed in-service approximately 1.8 million square feet of new development, including two office development properties that are each approximately 100% leased, including leases with future commencement dates: 17Fifty Presidents Street, an approximately 276,000 square foot property in Reston, Virginia, and 20 CityPoint, an approximately 211,000 square foot property in Waltham, Massachusetts. We also fully placed in-service Dock 72, an approximately 669,000 square foot office property located in Brooklyn, New York in which we have a 50% ownership interest, which was 33% leased as of December 31, 2020. In addition, during 2020 we fully placed in-service two residential properties: Hub50House, a 440 unit residential property in Boston, Massachusetts in which we have a 50% ownership interest, and The Skylyne, a 402 unit residential property in Oakland, California. 61Table of ContentsAs of December 31, 2020, our construction/redevelopment pipeline consisted of six properties that, when completed, we expect will total approximately 3.7 million net rentable square feet. Three of these development/redevelopment projects are owned by joint ventures. Our share of the estimated total cost for these projects is approximately $2.2 billion, of which approximately $849 million remains to be invested as of December 31, 2020. Approximately 87% of the commercial space in these development projects was pre-leased as of February 22, 2021.As we continue to focus on the development and acquisition of assets to enhance our long-term growth, we also continually review our portfolio to identify properties as potential sales candidates that either no longer fit within our portfolio strategy or could attract premium pricing in the current market environment. For example, during 2020, we completed the sale of several properties and land parcels for aggregate net proceeds of $537.7 million (our share), including New Dominion Technology Park in Herndon, Virginia; approximately 455,000 square feet of Capital Gallery in Washington, DC; Annapolis Junction Building Eight and two parcels of land at Annapolis Junction Business Park in Annapolis, Maryland and a land parcel in Marlborough, Massachusetts. We expect to continue to sell select assets from time to time, subject to market conditions.A brief overview of each of our markets follows.BostonOur Boston central business district (“CBD”) in-service portfolio was approximately 98% leased as of December 31, 2020. This includes approximately 225,000 square feet of retail leases, representing 2.3% of our Boston CBD portfolio, that we terminated due to the nonpayment of rent, but where the tenants have yet to vacate. During the fourth quarter of 2020, we executed approximately 451,000 square feet of leases and had approximately 171,000 square feet of leases commenced in the Boston region. Approximately 163,000 square feet of the leases that commenced had been vacant for less than one year and represent an increase in net rental obligations of approximately 54% over the prior leases. Our approximately 2.0 million square foot in-service office portfolio in Cambridge was approximately 99% leased as of December 31, 2020. During the fourth quarter of 2020, we continued our development of 325 Main Street at Kendall Center in Cambridge, Massachusetts, which is 90% pre-leased to an office tenant for a term of 15 years and we expect to deliver into service in 2022. Waltham and the area surrounding the Route 128-Mass Turnpike interchange continue to comprise a popular submarket of Boston for leading and emerging companies in the life sciences, biotechnology and technology sectors. In our suburban portfolio, we continued the redevelopment of 200 West Street, an approximately 273,000 square feet Class A office property in Waltham, Massachusetts. The redevelopment is a conversion of approximately 138,000 square feet into life sciences space to meet growing demand in the life sciences sector. In the fourth quarter of 2020, we signed a 10-year lease with a new tenant for this life sciences space with occupancy expected by year-end 2021. With this lease, the property, including the office space, is approximately 100% leased. During the fourth quarter of 2020, we also signed a new 75,000 square-foot, seven-year lease with a leading healthcare technology company at 20 CityPoint, a Class A office property that was fully placed in-service in 2020. With this lease, the office portion of the property is 100% leased. Additionally, in the third quarter of 2020, we entered into an agreement with an existing joint venture partner for the future development of a 1.2 million square foot site in Waltham. The agreement allows for the phased development of office and life sciences properties across 41-acres and builds on our current footprint of approximately 4.3 million square feet of office and life sciences properties in this submarket. Los AngelesOur Los Angeles (“LA”) in-service portfolio of approximately 2.3 million square feet is currently focused on West LA and includes Colorado Center, a 1.1 million square foot property of which we own 50%, and Santa Monica Business Park, a 21-building, approximately 1.2 million square foot property of which we own 55%. As of December 31, 2020, our LA in-service properties were approximately 94% leased.We continue to explore opportunities to increase our presence by seeking investments where our financial, operational, redevelopment and development expertise provide the opportunity, either alone or with partners, to achieve accretive returns. In the third quarter of 2020, we acquired a 50% ownership interest in Beach Cities Media Campus, a 6.4-acre land site on the Rosecrans Corridor of the El Segundo submarket of Los Angeles. The site is fully entitled to support the future development of approximately 275,000 square feet of Class A creative office 62Table of Contentsspace and is located in the South Bay of Los Angeles, a creative cluster where several Fortune 500 and emerging office tenants in the technology, entertainment and financial sectors are located. New YorkAs of December 31, 2020, our New York CBD in-service portfolio was approximately 90% leased. In addition, we executed approximately 93,000 square feet of leases and approximately 264,000 square feet of leases commenced in the fourth quarter of 2020. Of these leases, approximately 239,000 square feet had been vacant for less than one year and represent an increase in net rental obligations of approximately 12% over the prior leases. In the fourth quarter of 2020, we fully placed in-service Dock 72, an unconsolidated joint venture development located in Brooklyn, New York in which we own a 50% interest. The property consists of approximately 669,000 square feet of Class A office space and was 33% leased as of December 31, 2020. Excluding Dock 72, the remainder of the New York CBD in-service portfolio is approximately 94% leased. We recognized a $60.5 million non-cash impairment charge related to our investment in Dock 72 due to an increase in construction costs and an extension of the projected period to fully lease the property due to the COVID-19 pandemic, resulting in a lower current fair value.San FranciscoIn the fourth quarter of 2020, governmental authorities in San Francisco extended travel quarantines, stay-at-home orders and restrictions on the types of businesses that could continue to operate, including offices, except for non-essential workers, which impacted the pace of new leasing activity.Our San Francisco CBD in-service properties were approximately 95% leased as of December 31, 2020. During the fourth quarter of 2020, we executed approximately 67,000 square feet of leases and we commenced approximately 50,000 square feet of leases in the San Francisco region. Of these leases, approximately 39,000 square feet had been vacant for less than one year and represent an increase in net rental obligations of approximately 22% over the prior leases. Washington, DCIn the Washington, DC region, we remain focused on (1) expanding our development potential in Reston, Virginia, where demand from technology and cybersecurity tenants remains strong, (2) divesting of certain assets in Washington, DC and select suburban markets and (3) matching development sites with tenants to begin development with significant pre-leasing commitments. During the fourth quarter of 2020, we executed approximately 547,000 square feet of leases and we commenced approximately 229,000 square feet of leases in the Washington, DC region. Of these leases, approximately 207,000 square feet had been vacant for less than one year. Our Washington, DC CBD in-service properties were approximately 84% leased, as of December 31, 2020, with modest near-term exposure, and we have reduced our exposure in the Washington, DC CBD market significantly over the past few years through the dispositions of assets. Our Washington, DC suburban properties, which includes our significant presence in Reston, Virginia, were approximately 85% leased as of December 31, 2020. During the fourth quarter of 2020, we signed an approximately 196,000 square foot, 20-year lease with a tenant at Reston Next, our approximately 1.1 million square foot development, the new phase of Reston Town Center in Reston, Virginia. With this lease, the Reston Next development is 85% pre-leased, as of February 22, 2021, and we expect to place this property in-service in 2022. 63Table of ContentsLeasing StatisticsThe table below details the leasing activity, including 100% of the unconsolidated joint ventures, that commenced during the year ended December 31, 2020:Year ended December 31, 2020Total Square FeetVacant space available at the beginning of the period3,135,170 Property dispositions/properties taken out of service (1)(150,193)Properties placed (and partially placed) in-service (2)824,665 Leases expiring or terminated during the period5,446,846 Total space available for lease9,256,488 1st generation leases 342,007 2nd generation leases with new tenants2,034,259 2nd generation lease renewals2,362,837 Total space leased (3)4,739,103 Vacant space available for lease at the end of the period4,517,385 Leases executed during the period, in square feet (4)3,727,571 Second generation leasing information: (5)Leases commencing during the period, in square feet4,397,096 Weighted Average Lease Term102 MonthsWeighted Average Free Rent Period151 DaysTotal Transaction Costs Per Square Foot (6)$78.68 Increase in Gross Rents (7)15.22 %Increase in Net Rents (8)23.34 % __________________(1)Total square feet of property dispositions/properties taken out of service during the year ended December 31, 2020 consists of 24,508 square feet due to the sale of a portion of Capital Gallery and 125,685 square feet due to the sale of Annapolis Junction Building Eight. (2)Total square feet of properties placed (and partially placed) in-service during the year ended December 31, 2020 consists of 12,825 square feet at The Skylyne, 79,527 square feet at 20 CityPoint, 4,330 square feet at 685 Gateway, 5,156 square feet at 145 Broadway, 275,809 square feet at 17Fifty Presidents Street and 447,018 square feet at Dock 72.(3)Represents leases for which lease revenue recognition has commenced in accordance with GAAP during the year ended December 31, 2020.(4)Represents leases executed during the year ended December 31, 2020 for which we either (1) commenced lease revenue recognition in such period or (2) will commence lease revenue recognition in subsequent periods, in accordance with GAAP, and includes leases at properties currently under development. The total square feet of leases executed and recognized in the year ended December 31, 2020 is 758,340. Amounts for the year ended December 31, 2020 exclude lease modifications related to COVID-19 covering an aggregate of 4,687,343 square feet that were executed in the year ended December 31, 2020, to provide cash rent deferrals and/or abatements. Of these lease modifications, the lease terms associated with 637,713 square feet were extended for a period of 12 or more months during the year ended December 31, 2020.(5)Second generation leases are defined as leases for space that had previously been leased by us. Of the 4,397,096 square feet of second generation leases that commenced during the year ended December 31, 2020, leases for 3,643,912 square feet were signed in prior periods. (6)Total transaction costs include tenant improvements and leasing commissions but exclude free rent concessions and other inducements in accordance with GAAP. (7)Represents the increase in gross rent (base rent plus expense reimbursements) on the new versus expired leases on the 3,670,156 square feet of second generation leases that had been occupied within the prior 12 months for the year ended December 31, 2020; excludes leases that management considers temporary because the tenant is not expected to occupy the space on a long-term basis. (8)Represents the increase in net rent (gross rent less operating expenses) on the new versus expired leases on the 3,670,156 square feet of second generation leases that had been occupied within the prior 12 months for 64Table of Contentsthe year ended December 31, 2020; excludes leases that management considers temporary because the tenant is not expected to occupy the space on a long-term basis. For descriptions of significant transactions that we completed during 2020, see “Item 1. Business—Transactions During 2020.”Critical Accounting PoliciesThe preparation of financial statements in conformity with accounting principles generally accepted in the United States of America, or GAAP, requires management to use judgment in the application of accounting policies, including making estimates and assumptions. We base our estimates on historical experience and on various other assumptions believed to be reasonable under the circumstances. These judgments affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the dates of the financial statements and the reported amounts of revenue and expenses during the reporting periods. If our judgment or interpretation of the facts and circumstances relating to various transactions had been different, it is possible that different accounting policies would have been applied resulting in a different presentation of our financial statements. From time to time, we evaluate our estimates and assumptions. In the event estimates or assumptions prove to be different from actual results, adjustments are made in subsequent periods to reflect more current information. Below is a discussion of accounting policies that we consider critical in that they may require complex judgment in their application or require estimates about matters that are inherently uncertain.Real EstateUpon acquisitions of real estate, we assess whether the transaction should be accounted for as an asset acquisition or as a business combination by applying a screen to determine whether the integrated set of assets and activities acquired meets the definition of a business. Acquisitions of integrated sets of assets and activities that do not meet the definition of a business are accounted for as asset acquisitions. Our acquisitions of real estate or in-substance real estate generally will not meet the definition of a business because substantially all of the fair value is concentrated in a single identifiable asset or group of similar identifiable assets (i.e. land, buildings, and related intangible assets) or because the acquisition does not include a substantive process in the form of an acquired workforce or an acquired contract that cannot be replaced without significant cost, effort or delay. We assess the fair value of acquired tangible and intangible assets (including land, buildings, tenant improvements, “above-” and “below-market” leases, leasing and assumed financing origination costs, acquired in-place leases, other identified intangible assets and assumed liabilities) and allocate the purchase price to the acquired assets and assumed liabilities, including land and buildings as if vacant. We assess fair value based on estimated cash flow projections that utilize discount and/or capitalization rates that we deem appropriate, as well as available market information. Estimates of future cash flows are based on a number of factors including the historical operating results, known and anticipated trends, and market and economic conditions.The fair value of the tangible assets of an acquired property considers the value of the property as if it were vacant. We also consider an allocation of purchase price of other acquired intangibles, including acquired in-place leases that may have a customer relationship intangible value, including (but not limited to) the nature and extent of the existing relationship with the tenants, the tenants’ credit quality and expectations of lease renewals. Based on our acquisitions to date, our allocation to customer relationship intangible assets has been immaterial.We record acquired “above-” and “below-market” leases at their fair values (using a discount rate which reflects the risks associated with the leases acquired) equal to the difference between (1) the contractual amounts to be paid pursuant to each in-place lease and (2) management’s estimate of fair market lease rates for each corresponding in-place lease, measured over a period equal to the remaining term of the lease for above-market leases and the initial term plus the term of any below-market fixed rate renewal options for below-market leases. Acquired “above-” and “below-market” lease values have been reflected within Prepaid Expenses and Other Assets and Other Liabilities, respectively, in our Consolidated Balance Sheets. Other intangible assets acquired include amounts for in-place lease values that are based on our evaluation of the specific characteristics of each tenant’s lease. Factors to be considered include estimates of carrying costs during hypothetical expected lease-up periods considering current market conditions, and costs to execute similar leases. In estimating carrying costs, we include real estate taxes, insurance and other operating expenses and estimates of lost rentals at market rates during the expected lease-up periods, depending on local market conditions. In estimating costs to execute similar leases, we consider leasing commissions, legal and other related expenses.65Table of ContentsManagement reviews its long-lived assets for indicators of impairment following the end of each quarter and when events or changes in circumstances indicate that the carrying amount of the asset may not be recoverable. This evaluation of long-lived assets is dependent on a number of factors, including when there is an event or adverse change in the operating performance of the long-lived asset or a current expectation that, more likely than not, a long-lived asset will be sold or otherwise disposed of significantly before the end of its previously estimated useful life or hold period. An impairment loss is recognized if the carrying amount of an asset is not recoverable and exceeds its fair value. The evaluation of anticipated cash flows is subjective and is based in part on assumptions regarding anticipated hold periods, future occupancy, future rental rates, future capital requirements, discount rates and capitalization rates that could differ materially from actual results in future periods. Because cash flows on properties considered to be “long-lived assets to be held and used” are considered on an undiscounted basis to determine whether an asset may be impaired, our established strategy of holding properties over the long term directly decreases the likelihood of recording an impairment loss. If our hold strategy changes or market conditions otherwise dictate an earlier sale date, an impairment loss may be recognized and such loss could be material. If we determine that an impairment has occurred, the affected assets must be reduced to their fair value.Guidance in Accounting Standards Codification (“ASC”) 360 “Property Plant and Equipment” requires that qualifying assets and liabilities and the results of operations that have been sold, or otherwise qualify as “held for sale,” be presented as discontinued operations in all periods presented if the property operations are expected to be eliminated and we will not have significant continuing involvement following the sale. Discontinued operations presentation applies only to disposals representing a strategic shift that has (or will have) a major effect on an entity’s operations and financial results (e.g., a disposal of a major geographical area, a major line of business, a major equity method investment or other major parts of an entity). The components of the property’s net income that are reflected as discontinued operations include the net gain (or loss) upon the disposition of the property held for sale, operating results, depreciation and interest expense (if the property is subject to a secured loan). We generally consider assets to be “held for sale” when the transaction has been approved by BXP’s Board of Directors, or a committee thereof, and there are no known significant contingencies relating to the sale, such that a sale of the property within one year is considered probable. Following the classification of a property as “held for sale,” no further depreciation is recorded on the assets, and the asset is written down to the lower of carrying value or fair market value, less cost to sell. Real estate is stated at depreciated cost. A variety of costs are incurred in the acquisition, development and leasing of properties. The cost of buildings and improvements includes the purchase price of property, legal fees and other acquisition costs. We capitalize acquisition costs that we incur to effect an asset acquisition and expense acquisition costs that we incur to effect a business combination, including legal, due diligence and other closing related costs. Costs directly related to the development of properties are capitalized. Capitalized development costs include interest, internal wages, property taxes, insurance, and other project costs incurred during the period of development. After the determination is made to capitalize a cost, it is allocated to the specific component of the project that benefited from the investment. Determination of when a development project commences and capitalization begins, and when a development project is substantially complete and held available for occupancy and capitalization must cease, involves a degree of judgment. Our capitalization policy on development properties follows the guidance in ASC 835-20 “Capitalization of Interest” and ASC 970 “Real Estate-General.” The costs of land and buildings under development include specifically identifiable costs.Capitalized costs include pre-construction costs necessary to the development of the property, development costs, construction costs, interest costs, real estate taxes, salaries and related costs and other costs incurred during the period of development. We begin the capitalization of costs during the pre-construction period, which we define as activities that are necessary for the development of the property. We consider a construction project as substantially complete and held available for occupancy upon the completion of tenant improvements, but no later than one year from cessation of major construction activity. We cease capitalization on the portion (1) substantially completed, (2) occupied or held available for occupancy, and capitalize only those costs associated with the portion under construction or (3) if activities necessary for the development of the property have been suspended.Investments in Unconsolidated Joint VenturesWe consolidate variable interest entities (“VIEs”) in which we are considered to be the primary beneficiary. VIEs are entities in which the equity investors do not have sufficient equity at risk to finance their endeavors without additional financial support or that the holders of the equity investment at risk do not have substantive participating rights. The primary beneficiary is defined by the entity having both of the following characteristics: (1) the power to direct the activities that, when taken together, most significantly impact the variable interest entity’s performance, and (2) the obligation to absorb losses and the right to receive the returns from the variable interest entity that could 66Table of Contentspotentially be significant to the VIE. For ventures that are not VIEs, we consolidate entities for which we have significant decision making control over the ventures’ operations. Our judgment with respect to our level of influence or control of an entity involves the consideration of various factors including the form of our ownership interest, our representation in the entity’s governance, the size of our investment (including loans), estimates of future cash flows, our ability to participate in policy making decisions and the rights of the other investors to participate in the decision making process and to replace us as manager and/or liquidate the venture, if applicable. Our assessment of our influence or control over an entity affects the presentation of these investments in our consolidated financial statements. In addition to evaluating control rights, we consolidate entities in which the outside partner has no substantive kick-out rights to remove us as the managing member.Accounts of the consolidated entity are included in our accounts and the noncontrolling interest is reflected on the Consolidated Balance Sheets as a component of equity or in temporary equity between liabilities and equity. Investments in unconsolidated joint ventures are recorded initially at cost, and subsequently adjusted for equity in earnings and cash contributions and distributions. Any difference between the carrying amount of these investments on the balance sheet and the underlying equity in net assets is amortized as an adjustment to equity in earnings of unconsolidated joint ventures over the life of the related asset. Under the equity method of accounting, our net equity investment is reflected within the Consolidated Balance Sheets, and our share of net income or loss from the joint ventures is included within the Consolidated Statements of Operations. The joint venture agreements may designate different percentage allocations among investors for profits and losses; however, our recognition of joint venture income or loss generally follows the joint venture’s distribution priorities, which may change upon the achievement of certain investment return thresholds. We may account for cash distributions in excess of our investment in an unconsolidated joint venture as income when we are not the general partner in a limited partnership and when we have neither the requirement nor the intent to provide financial support to the joint venture. We classify distributions received from equity method investees within our Consolidated Statements of Cash Flows using the nature of the distribution approach, which classifies the distributions received on the basis of the nature of the activity or activities of the investee that generated the distribution as either a return on investment (classified as cash inflows from operating activities) or a return of investment (classified as cash inflows from investing activities). Our investments in unconsolidated joint ventures are reviewed for indicators of impairment on a quarterly basis and we record impairment charges when events or circumstances change indicating that a decline in the fair values below the carrying amounts has occurred and such decline is other-than-temporary. This evaluation of the investments in unconsolidated joint ventures is dependent on a number of factors, including the performance of each investment and market conditions. We will record an impairment charge if we determine that a decline in the fair value below the carrying amount of an investment in an unconsolidated joint venture is other-than-temporary. The fair value is calculated using discounted cash flows which is subjective and considers assumptions regarding future occupancy, future rental rates, future capital requirements, discount rates and capitalization rates that could differ materially from actual results in future periods. To the extent that we contribute assets to a joint venture, our investment in the joint venture is recorded at our cost basis in the assets that were contributed to the joint venture. To the extent that our cost basis is different than the basis reflected at the joint venture level, the basis difference is amortized over the life of the related asset and included in our share of equity in net income of the joint venture. In accordance with the provisions of ASC 610-20 “Gains and Losses from the Derecognition of Nonfinancial Assets” (“ASC 610-20”), we will recognize a full gain on both the retained and sold portions of real estate contributed or sold to a joint venture by recognizing our new equity method investment interest at fair value.The combined summarized financial information of the unconsolidated joint ventures is disclosed in Note 6 to the Consolidated Financial Statements.Revenue RecognitionIn general, we commence lease/rental revenue recognition when the tenant takes possession of the leased space and the leased space is substantially ready for its intended use. Contractual lease/rental revenue is reported on a straight-line basis over the terms of the respective leases. We recognize acquired in-place “above-” and “below-market” leases at their fair values as lease/rental revenue over the original term of the respective leases. Accrued rental income as reported on the Consolidated Balance Sheets represents cumulative lease/rental income earned in excess of rent payments received pursuant to the terms of the individual lease agreements.For the year ended December 31, 2020, the impact of the net adjustments of rents from “above-” and “below-market” leases increased lease revenue by approximately $6.5 million. For the year ended December 31, 2020, the impact of the straight-line rent adjustment increased lease revenue by approximately $104.9 million. Those 67Table of Contentsamounts exclude the adjustment of rents from “above-” and “below-market” leases and straight-line income from unconsolidated joint ventures, which are disclosed in Note 6 to the Consolidated Financial Statements.Our leasing strategy is generally to secure creditworthy tenants that meet our underwriting guidelines. Furthermore, following the initiation of a lease, we continue to actively monitor the tenant’s creditworthiness to ensure that all tenant related assets are recorded at their realizable value. When assessing tenant credit quality, we:•review relevant financial information, including:•financial ratios;•net worth;•revenue;•cash flows;•leverage; and•liquidity;•evaluate the depth and experience of the tenant’s management team; and•assess the strength/growth of the tenant’s industry.As a result of the underwriting process, tenants are then categorized into one of three categories:(1)acceptable-risk tenants;(2)the tenant’s credit is such that we may require collateral, in which case we:•may require a security deposit; and/or•may reduce upfront tenant improvement investments; or(3)the tenant’s credit is below our acceptable parameters.We must make estimates as to the collectability of our accrued rent and accounts receivable related to lease revenue. Management analyzes accrued rent and accounts receivable by considering tenant creditworthiness, current economic trends, including the impact of the novel coronavirus (“COVID-19”) pandemic on tenants’ businesses, and changes in tenants’ payment patterns when evaluating the collectability of the tenant’s receivable balance, including the accrued rent receivable, on a lease-by-lease basis. We write-off the tenant’s receivable balance, including the accrued rent receivable, if we consider the balances no longer probable of collection. In addition, tenants in bankruptcy are analyzed and considerations are made in connection with the expected recovery of pre-petition and post-petition claims If the balances are considered no longer probable of collection and therefore written off, we will cease to recognize lease income, including straight-line rent, unless cash is received. If we subsequently determine that we are probable we will collect substantially all the remaining lessee’s lease payments under the lease term, we will then reinstate the straight-line balance, adjusting for the amount related to the period when the lease payments were considered not probable. If our estimate of collectability differ from the cash received, then the timing and amount of our reported revenue could be impacted. The credit risk is mitigated by the high quality of our existing tenant base, reviews of prospective tenants’ risk profiles prior to lease execution and consistent monitoring of our portfolio to identify potential problem tenants.The weighted-average term of our in-place leases, excluding residential units, was approximately 7.4 years, as of December 31, 2020, including leases signed by our unconsolidated joint ventures. The credit risk is mitigated by the high quality of our existing tenant base, reviews of prospective tenants’ risk profiles prior to lease execution and consistent monitoring of our portfolio to identify potential problem tenants.Recoveries from tenants, consisting of amounts due from tenants for common area maintenance, real estate taxes and other recoverable costs, are recognized as revenue in the period during which the expenses are incurred (See “Leases” ). We recognize these reimbursements on a gross basis, as we obtain control of the goods and services before they are transferred to the tenant. We also receive reimbursements of payroll and payroll related costs from unconsolidated joint venture entities and third party property owners in connection with management services contracts which we reflect on a gross basis instead of on a net basis as we have determined that we are the principal and not the agent under these arrangements in accordance with the guidance in ASC 606 “Revenue from Contracts with Customers” (“ASC 606”). 68Table of ContentsOur parking revenue is derived primarily from monthly and transient daily parking. In addition, we have certain lease arrangements for parking accounted for under the guidance in ASC 842 “Leases” (“ASC 842”). The monthly and transient daily parking revenue falls within the scope of ASC 606 and is accounted for at the point in time when control of the goods or services transfers to the customer and our performance obligation is satisfied.Our hotel revenue is derived from room rentals and other sources such as charges to guests for telephone service, movie and vending commissions, meeting and banquet room revenue and laundry services. Hotel revenue is recognized as the hotel rooms are occupied and the services are rendered to the hotel customers. We earn management and development fees. Development and management services revenue is earned from unconsolidated joint venture entities and third-party property owners. We determined that the performance obligations associated with our development services contracts are satisfied over time and that we would recognize our development services revenue under the output method evenly over time from the development commencement date through the substantial completion date of the development management services project due to the stand-ready nature of the contracts. Significant judgments impacting the amount and timing of revenue recognized from our development services contracts include estimates of total development project costs from which the fees are typically derived and estimates of the period of time until substantial completion of the development project, the period of time over which the development services are required to be performed. We recognize development fees earned from unconsolidated joint venture projects equal to its cost plus profit to the extent of the third party partners’ ownership interest. Property management fees are recorded and earned based on a percentage of collected rents at the properties under management, and not on a straight-line basis, because such fees are contingent upon the collection of rents.Gains on sales of real estate are recognized pursuant to the provisions included in ASC 610-20. Under ASC 610-20, we must first determine whether the transaction is a sale to a customer or non-customer. We typically sell real estate on a selective basis and not within the ordinary course of our business and therefore expects that our sale transactions will not be contracts with customers. We next determine whether we have a controlling financial interest in the property after the sale, consistent with the consolidation model in ASC 810 “Consolidation” (“ASC 810”). If we determine that we do not have a controlling financial interest in the real estate, we evaluate whether a contract exists under ASC 606 and whether the buyer has obtained control of the asset that was sold. We recognize a full gain on sale of real estate when the derecognition criteria under ASC 610-20 have been met.Leases LesseeFor leases in which we are the lessee (generally ground leases), in accordance with ASC 842 we recognize a right-of-use asset and a lease liability. We made the policy election to not apply the revenue recognition requirements of ASC 842 to short-term leases. This policy election is made by class of underlying assets and as described below, we consider real estate to be a class of underlying assets, and will not be further delineating it into specific uses of the real estate asset as the risk profiles are similar in nature. We will recognize the lease payments in net income on a straight-line basis over the lease term. The lease liability is equal to the present value of the minimum lease payments in accordance with ASC 842. We will use our incremental borrowing rate (“IBR”) to determine the net present value of the minimum lease payments. In order to determine the IBR, we utilized a market-based approach to estimate the incremental borrowing rate for each individual lease. The approach required significant judgment. Therefore, we utilized different data sets to estimate base IBRs via an analysis of the following weighted-components: •the interpolated rates from yields on outstanding U.S. Treasury issuances for up to 30 years and for years 31 and beyond, longer-term publicly traded educational institution debt issued by high credit quality educational institutions with maturity dates exceeding 31 years, •observable mortgage rates spread over U.S. Treasury issuances, and •unlevered property yields and discount rates. We then applied adjustments to account for considerations related to term and interpolated the IBR. 69Table of ContentsLessorWe lease primarily Class A office, life sciences, retail and residential space to tenants. These leases may contain extension and termination options that are predominately at the sole discretion of the tenant, provided certain conditions are satisfied. In a few instances, the leases also contain purchase options, which would be exercisable at fair market value. Also, certain of our leases include rental payments that are based on a percentage of the tenant sales in excess of contractual amounts. Per ASC 842, lessors do not need to separate nonlease components from the associated lease component if certain criteria stated above are met for each class of underlying assets. The guidance in ASC 842 defines “underlying asset” as “an asset that is the subject of a lease for which a right to use that asset has been conveyed to a lessee. The underlying asset could be a physically distinct portion of a single asset.” Based on the above guidance, we consider real estate assets as a class of underlying assets and will not be further delineating it into specific uses of the real estate asset as the risk profiles are similar in nature. Lease components are elements of an arrangement that provide the customer with the right to use an identified asset. Nonlease components are distinct elements of a contract that are not related to securing the use of the leased asset and revenue is recognized in accordance with ASC 606. We consider common area maintenance (CAM) and service income associated with tenant work orders to be nonlease components because they represent delivery of a separate service but are not considered a cost of securing the identified asset. In the case of our business, the identified asset would be the leased real estate (office, life sciences, retail or residential). We assessed and concluded that the timing and pattern of transfer for nonlease components and the associated lease component are the same. We determined that the predominant component was the lease component and as such our leases will continue to qualify as operating leases and we have made a policy election to account for and present the lease component and the nonlease component as a single component in the revenue section of the Consolidated Statements of Operations labeled Lease. Prior to the January 1, 2019 adoption of ASC 842, nonlease components had been included within Recoveries from Tenants Revenue, Parking and Other Revenue and Development and Management Services Revenue on our Consolidated Statements of Operations. Recoveries from tenants, consisting of amounts due from tenants for common area maintenance, real estate taxes and other recoverable costs, are recognized as revenue in the period during which the expenses are incurred. In addition, in accordance with ASC 842, lessors will only capitalize incremental direct leasing costs. As a result, upon adoption of ASC 842 on January 1, 2019, we no longer capitalizes non-incremental legal costs and internal leasing wages. These costs are expensed as incurred. The expensing of these items is included within General and Administrative Expense on the Consolidated Statements of Operations. Depreciation and AmortizationWe compute depreciation and amortization on our properties using the straight-line method based on estimated useful asset lives. We allocate the acquisition cost of real estate to its components and depreciate or amortize these assets (or liabilities) over their useful lives. The amortization of acquired “above-” and “below-market” leases and acquired in-place leases is recorded as an adjustment to revenue and depreciation and amortization, respectively, in the Consolidated Statements of Operations.Fair Value of Financial InstrumentsThe carrying values of cash and cash equivalents, marketable securities, escrows, receivables, accounts payable, accrued expenses and other assets and liabilities are reasonable estimates of their fair values because of the short maturities of these instruments.We follow the authoritative guidance for fair value measurements when valuing our financial instruments for disclosure purposes The table below presents the financial instruments that are being valued for disclosure purposes as well as the Level at which they are categorized as defined in ASC 820 “Fair Value Measurements and Disclosures”.70Table of ContentsFinancial InstrumentLevelUnsecured senior notes (1)Level 1Related party note receivableLevel 3Notes receivableLevel 3Mortgage notes payableLevel 3Unsecured term loan / line of creditLevel 3_______________(1) If trading volume for the period is low, the valuation could be categorized as Level 2.Because our valuations of our financial instruments are based on the above Levels and involve the use of estimates, the actual fair values of our financial instruments may differ materially from those estimates.Derivative Instruments and Hedging ActivitiesDerivative instruments and hedging activities require management to make judgments on the nature of its derivatives and their effectiveness as hedges. These judgments determine if the changes in fair value of the derivative instruments are reported in the Consolidated Statements of Operations as a component of net income or as a component of comprehensive income and as a component of equity on the Consolidated Balance Sheets. While management believes its judgments are reasonable, a change in a derivative’s effectiveness as a hedge could materially affect expenses, net income and equity. We account for both the effective and ineffective portions of changes in the fair value of a derivative in other comprehensive income (loss) and subsequently reclassify the fair value of the derivative to earnings over the term that the hedged transaction affects earnings and in the same line item as the hedged transaction within the statements of operations Income Taxes Boston Properties Inc.BXP has elected to be treated as a REIT under Sections 856 through 860 of the Internal Revenue Code of 1986, as amended (the “Code”), commencing with its taxable year ended December 31, 1997. As a result, it generally will not be subject to federal corporate income tax on its taxable income that is distributed to its stockholders. A REIT is subject to a number of organizational and operational requirements, including a requirement that it currently distribute at least 90% of its annual taxable income (with certain adjustments). BXP’s policy is to distribute at least 100% of its taxable income. Accordingly, the only provision for federal income taxes in the accompanying consolidated financial statements relates to BXP’s consolidated taxable REIT subsidiaries. BXP’s taxable REIT subsidiaries did not have significant tax provisions or deferred income tax items. BXP had no uncertain tax positions recognized as of December 31, 2020 and 2019. At December 31, 2020, BXP’s tax returns for the years 2017 forward remain subject to examination by the major tax jurisdictions under the statute of limitations.We own a hotel property that we lease to one of our taxable REIT subsidiaries and that is managed by Marriott International, Inc. The hotel taxable REIT subsidiary, a wholly owned subsidiary of BPLP, is the lessee pursuant to the lease for the hotel property. As lessor, BPLP is entitled to a percentage of gross receipts from the hotel property. Marriott International, Inc. continues to manage the hotel property under the Marriott name and under terms of a management agreement. The hotel taxable REIT subsidiary is subject to tax at the federal and state level and, accordingly, BXP has recorded a tax provision in its Consolidated Statements of Operations for the years ended December 31, 2020, 2019 and 2018. The net difference between the tax basis and the reported amounts of BXP’s assets and liabilities was approximately $2.0 billion and $1.7 billion as of December 31, 2020 and 2019, respectively, which was primarily related to the difference in basis of contributed property and accrued rental income.Certain entities included in BXP’s Consolidated Financial Statements are subject to certain state and local taxes. These taxes are recorded as operating expenses in the accompanying consolidated financial statements. 71Table of ContentsThe following table reconciles GAAP net income attributable to Boston Properties, Inc. to taxable income (unaudited): For the year ended December 31, 202020192018 (in thousands)Net income attributable to Boston Properties, Inc.$872,727 $521,534 $582,847 Straight-line rent and net “above-” and “below-market” rent adjustments(90,144)(65,111)(53,080)Book/Tax differences from depreciation and amortization106,203 125,281 109,756 Book/Tax differences from interest expense— — (18,190)Book/Tax differences on gains/(losses) from capital transactions(345,854)51,555 (26,428)Book/Tax differences from stock-based compensation42,576 49,123 48,817 Tangible Property Regulations (144,981)(148,157)(128,639)Other book/tax differences, net117,166 (15,221)56,870 Taxable income$557,693 $519,004 $571,953 Boston Properties Limited PartnershipThe partners are required to report their respective share of BPLP’s taxable income or loss on their respective tax returns and are liable for any related taxes thereon. Accordingly, the only provision for federal income taxes in the accompanying consolidated financial statements relates to BPLP’s consolidated taxable REIT subsidiaries. BPLP’s taxable REIT subsidiaries did not have significant tax provisions or deferred income tax items. BPLP had no uncertain tax positions recognized as of December 31, 2020 and 2019.We own a hotel property which is managed through a taxable REIT subsidiary. The hotel taxable REIT subsidiary, a wholly owned subsidiary BPLP, is the lessee pursuant to the lease for the hotel property. As lessor, BPLP is entitled to a percentage of gross receipts from the hotel property. Marriott International, Inc. continues to manage the hotel property under the Marriott name and under terms of a management agreement. The hotel taxable REIT subsidiary is subject to tax at the federal and state level and, accordingly, BPLP had recorded a tax provision in its Consolidated Statements of Operations for the years ended December 31, 2020, 2019 and 2018.The net difference between the tax basis and the reported amounts of BPLP’s assets and liabilities was approximately $2.9 billion and $2.7 billion as of December 31, 2020 and 2019, respectively, which was primarily related to the difference in basis of contributed property and accrued rental income.Certain entities included in BPLP’s consolidated financial statements are subject to certain state and local taxes. These taxes are recorded as operating expenses in the accompanying consolidated financial statements.The following table reconciles GAAP net income attributable to Boston Properties Limited Partnership to taxable income (unaudited): For the year ended December 31, 202020192018 (in thousands)Net income attributable to Boston Properties Limited Partnership$990,479 $590,602 $667,403 Straight-line rent and net “above-” and “below-market” rent adjustments(100,375)(72,687)(59,199)Book/Tax differences from depreciation and amortization101,470 124,108 109,673 Book/Tax differences from interest expense— — (20,287)Book/Tax differences on gains/(losses) from capital transactions(359,497)56,955 5,762 Book/Tax differences from stock-based compensation47,408 54,838 54,445 Tangible Property Regulations (161,435)(165,395)(143,468)Other book/tax differences, net121,397 (20,177)70,003 Taxable income$639,447 $568,244 $684,332 72Table of ContentsRecent Accounting PronouncementsFor a discussion concerning new accounting pronouncements that may have an effect on our Consolidated Financial Statements, see Note 2 to the Consolidated Financial Statements. Results of Operations for the Years Ended December 31, 2020 and 2019 This section of this Form 10-K generally discusses 2020 and 2019 items and year-to-year comparisons between 2020 and 2019. Discussions of 2018 items and year-to-year comparisons between 2019 and 2018 that are not included in this Form 10-K can be found in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Part II, Item 7 of our Annual Report on Form 10-K for the year ended December 31, 2019, which was filed with the SEC on March 2, 2020.The impact that COVID-19 has had on our business, financial position and results of operations during the year ended December 31, 2020 is discussed throughout this Annual Report on Form 10-K. The full extent of the impact of COVID-19 on our business, operations and financial results will depend on numerous evolving factors that we may not be able to accurately predict. In addition, we cannot predict the impact that COVID-19 will have on our tenants, employees, contractors, lenders, suppliers, vendors and joint venture partners and any material adverse effect on these parties could also have a material adverse effect on us. The situation surrounding COVID-19 remains fluid, and we are actively managing our response in collaboration with tenants, government officials and joint venture partners and assessing potential impacts to our financial position and operating results, as well as potential adverse developments in our business. See Item 1A: “Risk Factors” for additional details. Net income attributable to Boston Properties, Inc. common shareholders and net income attributable to Boston Properties Limited Partnership common unitholders increased approximately $351.2 million and $399.9 million for the year ended December 31, 2020 compared to 2019, respectively, as set forth in the following tables and for the reasons discussed below under the heading “Comparison of the year ended December 31, 2020 to the year ended December 31, 2019” within “Item 7—Management’s Discussion and Analysis of Financial Condition and Results of Operations.”The following are reconciliations of Net Income Attributable to Boston Properties, Inc. Common Shareholders to Net Operating Income and Net Income Attributable to Boston Properties Limited Partnership Common Unitholders to Net Operating Income for the years ended December 31, 2020 and 2019 (in thousands):73Table of ContentsBoston Properties, Inc.Year ended December 31,20202019Increase/(Decrease)%ChangeNet Income Attributable to Boston Properties, Inc. Common Shareholders$862,227 $511,034 $351,193 68.72 %Preferred dividends10,500 10,500 — — %Net Income Attributable to Boston Properties, Inc.872,727 521,534 351,193 67.34 %Net Income Attributable to Noncontrolling Interests:Noncontrolling interest—common units of the Operating Partnership97,704 59,345 38,359 64.64 %Noncontrolling interests in property partnerships48,260 71,120 (22,860)(32.14)%Net Income1,018,691 651,999 366,692 56.24 %Other Expenses:Add:Interest expense431,717 412,717 19,000 4.60 %Loss from early extinguishment of debt— 29,540 (29,540)(100.00)%Impairment loss— 24,038 (24,038)(100.00)%Other Income:Less:Gains from investments in securities5,261 6,417 (1,156)(18.01)%Interest and other income (loss)5,953 18,939 (12,986)(68.57)%Gains on sales of real estate618,982 709 618,273 87,203.53 %Income (loss) from unconsolidated joint ventures(85,110)46,592 (131,702)(282.67)%Other Expenses:Add:Depreciation and amortization expense683,751 677,764 5,987 0.88 %Transaction costs1,531 1,984 (453)(22.83)%Payroll and related costs from management services contracts11,626 10,386 1,240 11.94 %General and administrative expense133,112 140,777 (7,665)(5.44)%Other Revenue:Less:Direct reimbursements of payroll and related costs from management services contracts11,626 10,386 1,240 11.94 %Development and management services revenue29,641 40,039 (10,398)(25.97)%Net Operating Income$1,694,075 $1,826,123 $(132,048)(7.23)%74Table of ContentsBoston Properties Limited PartnershipYear ended December 31,20202019Increase/(Decrease)%ChangeNet Income Attributable to Boston Properties Limited Partnership Common Unitholders$979,979 $580,102 $399,877 68.93 %Preferred distributions10,500 10,500 — — %Net Income Attributable to Boston Properties Limited Partnership990,479 590,602 399,877 67.71 %Net Income Attributable to Noncontrolling Interests:Noncontrolling interests in property partnerships48,260 71,120 (22,860)(32.14)%Net Income1,038,739 661,722 377,017 56.98 %Other Expenses:Add:Interest expense431,717 412,717 19,000 4.60 %Loss from early extinguishment of debt— 29,540 (29,540)(100.00)%Impairment loss— 22,272 (22,272)(100.00)%Other Income:Less:Gains from investments in securities5,261 6,417 (1,156)(18.01)%Interest and other income (loss)5,953 18,939 (12,986)(68.57)%Gains on sales of real estate631,945 858 631,087 73,553.26 %Income (loss) from unconsolidated joint ventures(85,110)46,592 (131,702)(282.67)%Other Expenses:Add:Depreciation and amortization expense676,666 669,956 6,710 1.00 %Transaction costs1,531 1,984 (453)(22.83)%Payroll and related costs from management services contracts11,626 10,386 1,240 11.94 %General and administrative expense133,112 140,777 (7,665)(5.44)%Other Revenue:Less:Direct reimbursements of payroll and related costs from management services contracts11,626 10,386 1,240 11.94 %Development and management services revenue29,641 40,039 (10,398)(25.97)%Net Operating Income$1,694,075 $1,826,123 $(132,048)(7.23)%At each of December 31, 2020 and 2019, we owned or had joint venture interests in a portfolio of 196 commercial real estate properties (in each case, the “Total Property Portfolio”). As a result of changes within our Total Property Portfolio, the financial data presented below shows significant changes in revenue and expenses from period-to-period. Accordingly, we do not believe that our period-to-period financial data with respect to the Total Property Portfolio is meaningful. Therefore, the comparison of operating results for the years ended December 31, 2020 and 2019 show separately the changes attributable to the properties that were owned by us and in-service throughout each period compared (the “Same Property Portfolio”) and the changes attributable to the properties included in the Acquired, Placed In-Service, Development or Redevelopment or Sold Portfolios.In our analysis of operating results, particularly to make comparisons of net operating income between periods meaningful, it is important to provide information for properties that were in-service and owned by us throughout each period presented. We refer to properties acquired or placed in-service prior to the beginning of the earliest period presented and owned by us and in-service through the end of the latest period presented as our Same Property Portfolio. The Same Property Portfolio therefore excludes properties acquired, placed in-service or in development or redevelopment after the beginning of the earliest period presented or disposed of prior to the end of the latest period presented.75Table of ContentsNet operating income (“NOI”) is a non-GAAP financial measure equal to net income attributable to Boston Properties, Inc. common shareholders and net income attributable to Boston Properties Limited Partnership common unitholders, as applicable, the most directly comparable GAAP financial measures, plus (1) preferred dividends/distributions, net income attributable to noncontrolling interests, interest expense, loss from early extinguishment of debt, impairment loss, depreciation and amortization expense, transaction costs, payroll and related costs from management services contracts and corporate general and administrative expense less (2) gains from investments in securities, interest and other income (loss), gains on sales of real estate, income (loss) from unconsolidated joint ventures, direct reimbursements of payroll and related costs from management services contracts and development and management services revenue. We use NOI internally as a performance measure and believe it provides useful information to investors regarding our results of operations and financial condition because, when compared across periods, it reflects the impact on operations from trends in occupancy rates, rental rates, operating costs and acquisition and development activity on an unleveraged basis, providing perspective not immediately apparent from net income attributable to Boston Properties, Inc. common shareholders and net income attributable to Boston Properties Limited Partnership common unitholders. For example, interest expense is not necessarily linked to the operating performance of a real estate asset and is often incurred at the corporate level as opposed to the property level. Similarly, interest expense may be incurred at the property level even though the financing proceeds may be used at the corporate level (e.g., used for other investment activity). In addition, depreciation and amortization expense, because of historical cost accounting and useful life estimates, may distort operating performance measures at the property level. NOI presented by us may not be comparable to NOI reported by other REITs or real estate companies that define NOI differently. We believe that, in order to facilitate a clear understanding of our operating results, NOI should be examined in conjunction with net income attributable to Boston Properties, Inc. common shareholders and net income attributable to Boston Properties Limited Partnership common unitholders as presented in our Consolidated Financial Statements. NOI should not be considered as a substitute for net income attributable to Boston Properties, Inc. common shareholders or net income attributable to Boston Properties Limited Partnership common unitholders (determined in accordance with GAAP) or any other GAAP financial measures and should only be considered together with and as a supplement to our financial information prepared in accordance with GAAP.The gains on sales of real estate, depreciation expense and impairment losses may differ between BXP and BPLP as a result of previously applied acquisition accounting by BXP for the issuance of common stock in connection with non-sponsor OP Unit redemptions by BPLP. This accounting resulted in a step-up of the real estate assets at BXP that was allocated to certain properties. The difference between the real estate assets of BXP as compared to BPLP for certain properties having an allocation of the real estate step-up will result in a corresponding difference in gains on sales of real estate, depreciation expense and impairment losses, when those properties are sold. For additional information see the Explanatory Note that follows the cover page of this Annual Report on Form 10-K. Comparison of the year ended December 31, 2020 to the year ended December 31, 2019 The table below shows selected operating information for the Same Property Portfolio and the Total Property Portfolio. The Same Property Portfolio consists of 139 properties totaling approximately 38.6 million net rentable square feet, excluding unconsolidated joint ventures. The Same Property Portfolio includes properties acquired or placed in-service on or prior to January 1, 2019 and owned and in service through December 31, 2020. The Total Property Portfolio includes the effects of the other properties either acquired, placed in-service, in development or redevelopment after January 1, 2019 or disposed of on or prior to December 31, 2020. This table includes a reconciliation from the Same Property Portfolio to the Total Property Portfolio by also providing information for the years ended December 31, 2020 and 2019 with respect to the properties that were acquired, placed in-service, in development or redevelopment or sold. 76Table of Contents Same Property PortfolioProperties Acquired PortfolioPropertiesPlaced In-ServicePortfolioProperties in Development or Redevelopment PortfolioProperties Sold PortfolioTotal Property Portfolio20202019Increase/(Decrease)%Change2020201920202019202020192020201920202019Increase/(Decrease)%Change(dollars in thousands)Rental Revenue: (1)Lease Revenue (Excluding Termination Income)$2,492,058 $2,593,591 $(101,533)(3.91)%$13,911 $4,920 $63,397 $10,987 $4,024 $10,368 $26,386 $86,608 $2,599,776 $2,706,474 $(106,698)(3.94)%Termination Income8,914 14,623 (5,709)(39.04)%— — — — — — 59 580 8,973 15,203 (6,230)(40.98)%Lease Revenue2,500,972 2,608,214 (107,242)(4.11)%13,911 4,920 63,397 10,987 4,024 10,368 26,445 87,188 2,608,749 2,721,677 (112,928)(4.15)%Parking and Other66,521 99,625 (33,104)(33.23)%15 — 2,086 — 20 127 1,404 3,205 70,046 102,957 (32,911)(31.97)%Total Rental Revenue (1)2,567,493 2,707,839 (140,346)(5.18)%13,926 4,920 65,483 10,987 4,044 10,495 27,849 90,393 2,678,795 2,824,634 (145,839)(5.16)%Real Estate Operating Expenses964,228 988,400 (24,172)(2.45)%6,445 1,989 12,307 1,795 5,167 8,820 10,322 33,021 998,469 1,034,025 (35,556)(3.44)%Net Operating Income (Loss), Excluding Residential and Hotel 1,603,265 1,719,439 (116,174)(6.76)%7,481 2,931 53,176 9,192 (1,123)1,675 17,527 57,372 1,680,326 1,790,609 (110,283)(6.16)%Residential Net Operating Income (Loss) (2)21,513 20,929 584 2.79 %— — (2,106)— — — — — 19,407 20,929 (1,522)(7.27)%Hotel Net Operating Income (Loss) (2)(5,658)14,585 (20,243)(138.79)%— — — — — — — — (5,658)14,585 (20,243)(138.79)%Net Operating Income (Loss)$1,619,120 $1,754,953 $(135,833)(7.74)%$7,481 $2,931 $51,070 $9,192 $(1,123)$1,675 $17,527 $57,372 $1,694,075 $1,826,123 $(132,048)(7.23)%_______________(1)Rental Revenue is equal to Revenue less Development and Management Services Revenue and Direct Reimbursements of Payroll and Related Costs from Management Services Revenue per the Consolidated Statements of Operations, excluding the residential and hotel revenue that is noted below. We use Rental Revenue internally as a performance measure and in calculating other non-GAAP financial measures (e.g., NOI), which provides investors with information regarding our performance that is not immediately apparent from the comparable non-GAAP measures and allows investors to compare operating performance between periods.(2)For a detailed discussion of NOI, including the reasons management believes NOI is useful to investors, see page 76. Residential Net Operating Income for the year ended December 31, 2020 and 2019 is comprised of Residential Revenue of $38,146 and $36,914 less Residential Expenses of $18,739 and $15,985, respectively. Hotel Net Operating Income for the year ended December 31, 2020 and 2019 is comprised of Hotel Revenue of $7,478 and $48,589 less Hotel Expenses of $13,136 and $34,004, respectively, per the Consolidated Statements of Operations.77Table of ContentsSame Property PortfolioLease Revenue (Excluding Termination Income)Lease revenue from the Same Property Portfolio decreased by approximately $101.5 million for the year ended December 31, 2020 compared to 2019. Approximately $87.3 million of the decrease was related to write-offs, which are discussed below. In addition to the impact of the write-offs, we experienced an approximately $14.2 million decrease due to our average occupancy decreasing from 93.9% to 93.2%. Average revenue per square foot was approximately the same for both years.Under ASC 842, the write-off for bad debt, including accrued rent, is recorded as a reduction to lease revenue. As a result, during the year ended December 31, 2020, for our Same Property Portfolio, we wrote off approximately $65.4 million and $21.9 million of accrued rent and accounts receivable balances, respectively. These write-offs related to tenants, primarily in the retail, entertainment and co-working sectors, that either terminated their leases or for which we determined that substantially all of their amount owed, related to accrued rent and/or accounts receivable balances, were no longer probable of collection. In addition, as a result of COVID-19, for the Same Property Portfolio, during 2020, we executed lease modification agreements for approximately 3.5 million square feet and granted approximately $63.9 million of cash rent abatements and deferrals, of which approximately $50.0 million related to rental charges for 2020. Although some of the lease modifications were deferrals under which we expect the tenant will pay us in full primarily in 2021, the majority of the lease modifications involved extending the lease term (in some cases for a year or more) or providing for a period of time where the tenant will only pay percentage rent. As a result of the lease modification agreements that extended the lease term, we expect to see an increase in the cash rent we will receive in the future.In April 2020, the Financial Accounting Standards Board (“FASB”) staff issued a question and answer document (“Lease Modification Q & A”) related to the application of lease accounting guidance for lease concessions, in accordance with ASC 842, as a result of COVID-19. We did not utilize the guidance provided in the Lease Modification Q & A and instead elected to continue to account for the COVID-19 lease concessions on a lease-by-lease basis in accordance with the existing lease modification accounting framework (See Note 4 to the Consolidated Financial Statements). As such, our accrued rent balances, which are a component of lease revenue, include the accounting impact (adjusted for write-offs) from the rent abatements, deferrals and extensions that were executed during 2020. We expect the volume of lease modifications as a result of COVID-19 to decrease as vaccines are rolled out and the pandemic subsides. However, the degree to which our tenants’ businesses are negatively impacted by COVID-19 may leave some tenants still unable to meet their rental payment obligations and result in a reduction in our cash flows. We may write off additional accrued rent or accounts receivable balances and this could have a material adverse effect on lease revenue. See Item 1A: “Risk Factors” for additional details.Termination Income Termination income decreased by approximately $5.7 million for the year ended December 31, 2020 compared to 2019.Termination income for the year ended December 31, 2020 related to 38 tenants across the Same Property Portfolio and totaled approximately $8.9 million, which was primarily related to tenants that terminated leases early in the New York region. Termination income for the year ended December 31, 2019 related to 39 tenants across the Same Property Portfolio and totaled approximately $14.6 million, of which approximately $8.2 million is from two tenants that terminated leases early at 399 Park Avenue in New York City.Parking and Other RevenueParking and other revenue decreased by approximately $33.1 million for the year ended December 31, 2020 compared to 2019. Parking revenue decreased by approximately $34.7 million while other revenue increased by approximately $1.6 million. The decrease in parking revenue was primarily due to a decrease in transient and monthly parking. 78Table of ContentsDuring the majority of 2020, with stay-at-home orders in effect, business closures and people working remotely in a majority of regions in which our properties are located, we generated minimal hourly/daily parking revenue. As a result, for the year ended December 31, 2020, transient and monthly parking decreased by approximately $24.1 million and $8.0 million, respectively, compared to 2019. However, as these conditions shifted, and stay-at-home orders were partially or fully lifted, businesses began to open, people began to return to working in an office setting, and, as we expected, we have begun to see, an increase in parking revenue. Some of our monthly parking revenues are contractual agreements embedded in our leases, and some are at will individual agreements.Real Estate Operating ExpensesReal estate operating expenses from the Same Property Portfolio decreased by approximately $24.2 million, or 2.4%, for the year ended December 31, 2020 compared to 2019, due primarily to decreases in utility and cleaning expense of approximately $11.9 million, or 13.7%, and $20.8 million, or 19.1%, respectively, partially offset by an increase in other real estate operating expenses of $8.5 million, or 1.1%. The decreases in utility and cleaning expense were experienced across the portfolio and were primarily driven by a decrease in physical tenant occupancy, which led to lower demand for electricity, HVAC, and cleaning. Properties Acquired PortfolioThe table below lists the properties acquired between January 1, 2019 and December 31, 2020. Rental revenue and real estate operating expenses increased by approximately $9.0 million and $4.5 million, respectively, for the year ended December 31, 2020 compared to 2019, as detailed below.Square FeetRental RevenueReal Estate Operating ExpensesNameDate acquired20202019Change20202019Change(dollars in thousands)880 and 890 Winter StreetAugust 27, 2019392,576 $13,527 $4,920 $8,607 $5,575 $1,989 $3,586 777 Harrison Street (1)June 26, 2020N/A399 — 399 870 — 870 392,576 $13,926 $4,920 $9,006 $6,445 $1,989 $4,456 _______________(1)Formerly known as Fourth + Harrison and 425 Fourth Street.Properties Placed In-Service PortfolioThe table below lists the properties that were placed in-service or partially placed in-service between January 1, 2019 and December 31, 2020. Rental revenue and real estate operating expenses from our Properties Placed In-Service Portfolio increased by approximately $54.7 million and $12.8 million, respectively, for the year ended December 31, 2020 compared to 2019, as detailed below. Quarter Initially Placed In-ServiceQuarter Fully Placed In-ServiceRental RevenueReal Estate Operating ExpensesNameSquare Feet20202019Change20202019Change(dollars in thousands)Office20 CityPointSecond Quarter, 2019Second Quarter, 2020211,476 $7,246 $3,320 $3,926 $2,782 $1,048 $1,734 145 Broadway Fourth Quarter, 2019Fourth Quarter, 2019488,862 44,898 7,667 37,231 5,631 747 4,884 17Fifty Presidents StreetFirst Quarter, 2020First Quarter, 2020275,809 13,339 — 13,339 3,894 — 3,894 Total Office976,147 65,483 10,987 54,496 12,307 1,795 10,512 ResidentialThe SkylyneThird Quarter, 2020Third Quarter, 2020330,996 155 — 155 2,261 — 2,261 Total Residential330,996 155 — 155 2,261 — 2,261 1,307,143 $65,638 $10,987 $54,651 $14,568 $1,795 $12,773 79Table of ContentsProperties in Development or Redevelopment PortfolioThe table below lists the properties that were in development or redevelopment between January 1, 2019 and December 31, 2020. Rental revenue and real estate operating expenses from our Properties in Development or Redevelopment Portfolio decreased by approximately $6.5 million and $3.7 million, respectively, for the year ended December 31, 2020 compared to 2019. Rental RevenueReal Estate Operating ExpensesNameDate Commenced Development / RedevelopmentSquare Feet20202019Change20202019Change(dollars in thousands)One Five Nine East 53rd Street (1)August 19, 2016220,000 $(1,041)$3,736 $(4,777)$1,504 $1,999 $(495)325 Main Street (2)May 9, 2019115,000 36 (704)740 276 2,128 (1,852)200 West Street (3)September 30, 2019261,000 5,049 7,463 (2,414)3,387 4,693 (1,306)596,000 $4,044 $10,495 $(6,451)$5,167 $8,820 $(3,653)_______________(1)Rental revenue for the year ended December 31, 2020 includes an approximately $2.9 million write-off of accrued rent and accounts receivable balances for a terminated tenant. (2)Rental revenue for the year ended December 31, 2019 includes the acceleration and write-off of accrued rent associated with the early termination of a lease at the property. Real estate operating expenses for the years ended December 31, 2020 and 2019 includes approximately $0.3 million and $1.5 million of demolition costs, respectively.(3)Rental revenue and real estate operating expenses for the year ended December 31, 2019 are related to the entire building. The redevelopment is a conversion of a 138,000 square foot portion of the property to life sciences space.Properties Sold PortfolioThe table below lists the properties we sold between January 1, 2019 and December 31, 2020. Rental revenue and real estate operating expenses from our Properties Sold Portfolio decreased by approximately $62.5 million and $22.7 million, respectively, for the year ended December 31, 2020 compared to 2019, as detailed below. Rental RevenueReal Estate Operating ExpensesNameDate SoldProperty TypeSquare Feet 20202019Change20202019Change(dollars in thousands)2600 Tower Oaks Boulevard January 24, 2019Office179,000 $— $159 $(159)$— $189 $(189)One Tower CenterJune 3, 2019Office410,000 — 2,605 (2,605)— 2,078 (2,078)164 Lexington RoadJune 28, 2019Office64,000 — — — — 82 (82)Washingtonian NorthDecember 20, 2019LandN/A— 62 (62)— 157 (157)601, 611 and 651 Gateway (1)January 28, 2020Office768,000 1,946 27,964 (26,018)881 10,272 (9,391)New Dominion Technology ParkFebruary 20, 2020Office493,000 2,551 19,437 (16,886)772 6,005 (5,233)Capital Gallery (2)June 25, 2020Office631,000 23,352 40,166 (16,814)8,669 14,238 (5,569)2,545,000 $27,849 $90,393 $(62,544)$10,322 $33,021 $(22,699)_______________(1)Rental revenue for the year ended December 31, 2019 includes approximately $0.8 million of termination income (See Notes 3 and 6 to the Consolidated Financial Statements).(2)We completed the sale of a portion of our Capital Gallery property located in Washington, DC. Capital Gallery is an approximately 631,000 net rentable square foot Class A office property. The portion sold was comprised of approximately 455,000 net rentable square feet of commercial office space. We continue to own the land, underground parking garage and remaining commercial office and retail space. The amounts shown represent the entire property and not just the portion sold (See Note 3 to the Consolidated Financial Statements). For additional information on the sales of the above properties and land parcel refer to “Results of Operations—Other Income and Expense Items—Gains on Sales of Real Estate” within “Item 7—Management’s Discussion and Analysis of Financial Condition and Results of Operations.” 80Table of ContentsResidential Net Operating IncomeNet operating income for our residential same properties increased by approximately $0.6 million for the year ended December 31, 2020 compared to 2019. Some of our residential properties include retail tenants and as a result, net operating income for the year ended December 31, 2020 includes approximately $0.7 million of termination income from a retail tenant. The following reflects our occupancy and rate information for The Lofts at Atlantic Wharf, The Avant at Reston Town Center, Signature at Reston and Proto Kendall Square for the years ended December 31, 2020 and 2019. The Lofts at Atlantic WharfThe Avant at Reston Town CenterSignature at RestonProto Kendall Square20202019Change (%)20202019Change (%)20202019Change (%)20202019Change (%)Average Monthly Rental Rate (1)$4,269 $4,482 (4.8)%$2,336 $2,417 (3.4)%$2,329 $2,347 (0.8)%$2,810 $2,889 (2.7)%Average Rental Rate Per Occupied Square Foot$4.73 $4.95 (4.4)%$2.56 $2.64 (3.0)%$2.45 $2.54 (3.5)%$5.17 $5.36 (3.5)%Average Physical Occupancy (2)88.4 %95.1 %(7.0)%90.3 %92.0 %(1.8)%81.6 %67.4 %21.1 %90.9 %83.9 %8.3 %Average Economic Occupancy (3)87.9 %95.2 %(7.7)%89.1 %91.6 %(2.7)%77.2 %61.4 %25.7 %89.4 %81.9 %9.2 %_______________ (1)Average Monthly Rental Rate is calculated as the average of the quotients obtained by dividing (A) rental revenue as determined in accordance with GAAP, by (B) the number of occupied units for each month within the applicable fiscal period. (2)Average Physical Occupancy is defined as (1) the average number of occupied units divided by (2) the total number of units, expressed as a percentage.(3)Average Economic Occupancy is defined as (1) total possible revenue less vacancy loss divided by (2) total possible revenue, expressed as a percentage. Total possible revenue is determined by valuing average occupied units at contract rates and average vacant units at Market Rents. Vacancy loss is determined by valuing vacant units at current Market Rents. By measuring vacant units at their Market Rents, Average Economic Occupancy takes into account the fact that units of different sizes and locations within a residential property have different economic impacts on a residential property’s total possible gross revenue. Market Rents used by us in calculating Economic Occupancy are based on the current market rates set by the managers of our residential properties based on their experience in renting their residential property’s units and publicly available market data. Actual market rents and trends in such rents for a region as reported by others may vary materially from Market Rents used by us. Market Rents for a period are based on the average Market Rents during that period and do not reflect any impact for cash concessions. Hotel Net Operating IncomeNet operating income for the Boston Marriott Cambridge hotel property decreased by approximately $20.2 million for the year ended December 31, 2020 compared to 2019. The Boston Marriott Cambridge closed in March 2020 due to COVID-19. The hotel re-opened on October 2, 2020 and has been operating at a diminished occupancy due to the continued impacts that COVID-19 has had on business and leisure travel. The closing of the hotel for more than two fiscal quarters, weak demand and low occupancy since its re-opening, have had, and are expected to continue to have, a material adverse effect on the hotel’s operations. We expect hotel occupancy to remain low until a sufficient number of people have been vaccinated and the demand for travel and leisure returns to historical levels. See Item 1A: “Risk Factors” for additional details. The following reflects our occupancy and rate information for the Boston Marriott Cambridge hotel for the year ended December 31, 2020 and 2019.20202019Change (%)Occupancy16.4 %83.8 %(80.4)%Average daily rate$211.36 $281.15 (24.8)%REVPAR$33.52 $235.64 (85.8)%81Table of ContentsOther Operating Revenue and Expense ItemsDevelopment and Management Services RevenueDevelopment and management services revenue decreased by approximately $10.4 million for the year ended December 31, 2020 compared to 2019. Development and management services revenue decreased by approximately $10.0 million and $0.4 million, respectively. The decrease in development services revenue was primarily related to a decrease of approximately $10.7 million in development fees from the completion of development projects in the Boston and Washington, DC regions and fees associated with tenant improvement projects earned in the Boston region, partially offset by an increase of approximately $0.7 million in fees associated with tenant improvement projects earned in the Washington, DC region. The decrease in management services revenue was primarily related to a decrease in leasing commissions earned from our unconsolidated joint ventures in the Boston region, partially offset by property management fees earned from third-party owned buildings in the Washington, DC region and our Gateway Commons unconsolidated joint venture, which was deconsolidated on January 28, 2020.General and Administrative ExpenseGeneral and administrative expense decreased by approximately $7.7 million for the year ended December 31, 2020 compared to 2019 primarily due to a decrease in compensation expense of approximately $7.4 million and an approximately $0.3 million decrease in other general and administrative expenses. The decrease in compensation expense was related to (1) an approximately $2.5 million increase in capitalized wages, which decreases general and administrative expenses, (2) an approximately $1.1 million decrease in the value of our deferred compensation plan, (3) an approximately $0.6 million decrease in health care costs and (3) an approximately $3.2 million decrease in other compensation-related expenses. The increase in capitalized wages is shown as an decrease to general and administrative expense as some of these costs were capitalized and included in real estate assets on our Consolidated Balance Sheets (see below). Wages directly related to the development of rental properties are capitalized and included in real estate assets on our Consolidated Balance Sheets and amortized over the useful lives of the applicable asset or lease term. Capitalized wages for the year ended December 31, 2020 and 2019 were approximately $12.9 million and $10.4 million, respectively. These costs are not included in the general and administrative expenses discussed above.Transaction CostsTransaction costs decreased by approximately $0.5 million for the year ended December 31, 2020 compared to 2019 due primarily to costs incurred in connection with the pursuit and formation of new joint ventures. In general, transaction costs relating to the formation of new and pending joint ventures and the pursuit of other transactions are expensed as incurred. Depreciation and Amortization ExpenseDepreciation expense may differ between BXP and BPLP as a result of previously applied acquisition accounting by BXP for the issuance of common stock in connection with non-sponsor OP Unit redemptions by BPLP. This accounting resulted in a step-up of the real estate assets at BXP that was allocated to certain properties. The difference between the real estate assets of BXP as compared to BPLP for certain properties having an allocation of the real estate step-up will result in a corresponding difference in depreciation expense. For additional information see the Explanatory Note that follows the cover page of this Annual Report on Form 10-K. 82Table of ContentsBoston Properties, Inc.Depreciation and amortization expense increased by approximately $6.0 million for the year ended December 31, 2020 compared to 2019, as detailed below.PortfolioDepreciation and Amortization for the year ended December 31,20202019Change(in thousands)Same Property Portfolio$650,987 $643,655 $7,332 Properties Acquired Portfolio9,285 3,449 5,836 Properties Placed In-Service Portfolio17,664 2,561 15,103 Properties in Development or Redevelopment Portfolio (1)1,819 12,381 (10,562)Properties Sold Portfolio3,996 15,718 (11,722)$683,751 $677,764 $5,987 _______________ (1)On May 9, 2019, we commenced development of 325 Main Street in Cambridge, Massachusetts. As a result, during the year ended December 31, 2019, we recorded approximately $9.9 million of accelerated depreciation expense for the demolition of the building, of which approximately $0.4 million related to the step-up of real estate assets.Boston Properties Limited PartnershipDepreciation and amortization expense increased by approximately $6.7 million for the year ended December 31, 2020 compared to 2019, as detailed below.PortfolioDepreciation and Amortization for the year ended December 31,20202019Change(in thousands)Same Property Portfolio $643,902 $636,226 $7,676 Properties Acquired Portfolio9,285 3,449 5,836 Properties Placed In-Service Portfolio17,664 2,561 15,103 Properties in Development or Redevelopment Portfolio (1)1,819 12,002 (10,183)Properties Sold Portfolio3,996 15,718 (11,722)$676,666 $669,956 $6,710 _______________(1)On May 9, 2019, we commenced development of 325 Main Street in Cambridge, Massachusetts. As a result, during the year ended December 31, 2019, we recorded approximately $9.5 million of accelerated depreciation expense for the demolition of the building.Direct Reimbursements of Payroll and Related Costs From Management Services Contracts and Payroll and Related Costs From Management Service ContractsWe have determined that amounts reimbursed for payroll and related costs received from third parties in connection with management services contracts should be reflected on a gross basis instead of on a net basis as we have determined that we are the principal under these arrangements. We anticipate that these two financial statement line items will generally offset each other.Other Income and Expense ItemsIncome (loss) from Unconsolidated Joint VenturesFor the year ended December 31, 2020 compared to 2019, income (loss) from unconsolidated joint ventures decreased by approximately $131.7 million primarily due to, (1) a $60.5 million non-cash impairment charge at our Dock 72 joint venture during the year ended December 31, 2020, (2) a $47.5 million gain on sale of real estate from the sale of 540 Madison Avenue during the year ended December 31, 2019 and the resulting loss of income thereafter, (3) our share of the write-off of accrued rent and accounts receivable of approximately $16.2 million and $1.5 million, respectively for the year ended December 31, 2020, (4) an approximately $3.3 million net loss from our 83Table of ContentsGateway Commons joint venture, primarily due to depreciation and amortization expense and (5) the fully placing in-service of the Hub50House residential property, which is not expected to be stabilized until the first quarter of 2022, decreased our net income by approximately $3.4 million. These decreases were partially offset by an approximately $5.8 million gain on sale of real estate from the sale of Annapolis Junction Building Eight and two undeveloped land parcels during the year ended December 31, 2020. Under ASC 842, the write-off for bad debt, including accrued rent, is recorded as a reduction to lease revenue. As a result, during the year ended December 31, 2020, for our unconsolidated joint ventures, we wrote off our share of the accrued rent and accounts receivable balances of approximately $16.2 million and $1.5 million, respectively. These write-offs related to tenants that either terminated their leases or for which we determined that their accrued rent and/or accounts receivable balances were no longer probable of collection. In addition, as a result of COVID-19, for properties owned by our unconsolidated joint ventures, during 2020, the joint ventures executed lease modification agreements for approximately 1.1 million square feet. As a result of these lease modification agreements, our share of the total cash rent abatements and deferrals granted was approximately $9.5 million, of which approximately $7.5 million was related to rental charges for 2020. Although some of the lease modifications were deferrals where we expect the tenant will pay the joint venture in full primarily in 2021, the majority of the lease modifications involved extending the lease term (in some cases for longer than a year). As a result of the lease modification agreements that extended the lease term, we expect to see an increase in the cash rent we will receive in the future.In April 2020, the FASB staff issued the Lease Modification Q & A related to the application of lease accounting guidance for lease concessions, in accordance with ASC 842, as a result of COVID-19. We did not utilize the guidance provided in the Lease Modification Q & A and instead elected to continue to account for the COVID-19 lease concessions on a lease-by-lease basis in accordance with the existing lease modification accounting framework (See Note 4 to the Consolidated Financial Statements). As such, the accrued rent balances, which are a component of lease revenue, include the accounting impact (adjusted for write-offs) from the rent abatements, deferrals and extensions that were executed during 2020. The joint ventures expect the volume of lease modifications as a result of COVID-19 to start to decrease. However, the degree to which tenants’ businesses are negatively impacted by COVID-19 could leave some tenants still unable to meet their rental payment obligations and result in a reduction in cash flows. Our unconsolidated joint ventures may write-off additional accrued rent or accounts receivable balances and this could have a material adverse effect on lease revenue. See Item 1A: “Risk Factors” for additional details.Gains on Sales of Real EstateGains on sales of real estate may differ between BXP and BPLP as a result of previously applied acquisition accounting by BXP for the issuance of common stock in connection with non-sponsor OP Unit redemptions by BPLP. This accounting resulted in a step-up of the real estate assets at BXP that was allocated to certain properties. The difference between the real estate assets of BXP as compared to BPLP for certain properties having an allocation of the real estate step-up will result in a corresponding difference in the gains on sales of real estate when those properties are sold. For additional information, see the Explanatory Note that follows the cover page of this Annual Report on Form 10-K. 84Table of ContentsBoston Properties, Inc.Gains on sales of real estate increased by approximately $618.3 million for the year ended December 31, 2020 compared to 2019, as detailed below.NameDate SoldProperty TypeSquare Feet Sale PriceNet Cash ProceedsGain (Loss) on Sale of Real Estate(dollars in millions)2020601, 611 and 651 GatewayJanuary 28, 2020Office768,000 $350.0 $— $217.7 (1)New Dominion Technology ParkFebruary 20, 2020Office493,000 256.0 254.0 192.3 Capital GalleryJune 25, 2020Office455,000 253.7 246.6 203.5 (2)Crane MeadowDecember 16, 2020LandN/A14.3 14.2 5.2 $874.0 $514.8 $618.7 (3)20192600 Tower Oaks BoulevardJanuary 24, 2019Office179,000 $22.7 $21.4 $(0.6)One Tower CenterJune 3, 2019Office410,000 38.0 36.6 (0.8)164 Lexington RoadJune 28, 2019Office64,000 4.0 3.8 2.5 Washingtonian NorthDecember 20, 2019LandN/A7.8 7.3 (0.1)$72.5 $69.1 $1.0 (4)___________ (1)On January 28, 2020, we entered into a joint venture with a third party to own, operate and develop properties at our Gateway Commons complex located in South San Francisco. We contributed our 601, 611 and 651 Gateway properties and development rights with an agreed upon value aggregating approximately $350.0 million for our 50% interest in the joint venture (See Notes 3 and 6 to the Consolidated Financial Statements). (2)We completed the sale of a portion of our Capital Gallery property located in Washington, DC. Capital Gallery is an approximately 631,000 net rentable square foot Class A office property. The portion sold was comprised of approximately 455,000 net rentable square feet of commercial office space. We continue to own the land, underground parking garage and remaining commercial office and retail space (See Note 3 to the Consolidated Financial Statements). (3)Excludes approximately $0.2 million of gains on sales of real estate recognized during the year ended December 31, 2020 related to gain amounts from sales of real estate occurring in the prior year. (4)Excludes approximately $0.3 million of losses on sales of real estate recognized during the year ended December 31, 2019 related to loss amounts from sales of real estate occurring in prior years. 85Table of ContentsBoston Properties Limited PartnershipGains on sales of real estate increased by approximately $631.1 million for the year ended December 31, 2020 compared to 2019, as detailed below.NameDate SoldProperty TypeSquare Feet Sale PriceNet Cash ProceedsGain (Loss) on Sale of Real Estate(dollars in millions)2020601, 611 and 651 GatewayJanuary 28, 2020Office768,000 $350.0 $— $222.4 (1)New Dominion Technology ParkFebruary 20, 2020Office493,000 256.0 254.0 197.1 Capital GalleryJune 25, 2020Office455,000 253.7 246.6 207.0 (2)Crane MeadowDecember 16, 2020LandN/A14.3 14.2 5.2 $874.0 $514.8 $631.7 (3)20192600 Tower Oaks BoulevardJanuary 24, 2019Office179,000 $22.7 $21.4 $(0.6)One Tower CenterJune 3, 2019Office410,000 38.0 36.6 (0.8)164 Lexington RoadJune 28, 2019Office64,000 4.0 3.8 2.6 Washingtonian NorthDecember 20, 2019LandN/A7.8 7.3 (0.1)$72.5 $69.1 $1.1 (4)___________ (1)On January 28, 2020, we entered into a joint venture with a third party to own, operate and develop properties at our Gateway Commons complex located in South San Francisco. We contributed our 601, 611 and 651 Gateway properties and development rights with an agreed upon value aggregating approximately $350.0 million for our 50% interest in the joint venture (See Notes 3 and 6 to the Consolidated Financial Statements). (2)We completed the sale of a portion of our Capital Gallery property located in Washington, DC. Capital Gallery is an approximately 631,000 net rentable square foot Class A office property. The portion sold was comprised of approximately 455,000 net rentable square feet of commercial office space. We continue to own the land, underground parking garage and remaining commercial office and retail space (See Note 3 to the Consolidated Financial Statements). (3)Excludes approximately $0.2 million of gains on sales of real estate recognized during the year ended December 31, 2020 related to gain amounts from sales of real estate occurring in the prior year. (4)Excludes approximately $0.3 million of losses on sales of real estate recognized during the year ended December 31, 2019 related to loss amounts from sales of real estate occurring in prior years.Interest and Other Income (Loss)Interest and other income (loss) decreased by approximately $13.0 million for the year ended December 31, 2020 compared to 2019, due primarily to a decrease of approximately $11.2 million in interest income which was primarily due to a decrease in interest rates. On January 1, 2020, we adopted ASU 2016-13, “Financial Instruments - Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments” (“ASU 2016-13”) and, as a result, we were required to record an allowance for current expected credit losses related to our outstanding (1) related party note receivable, (2) notes receivable and (3) off-balance sheet credit exposures (See Note 2 to the Consolidated Financial Statements). For the year ended December 31, 2020 the allowance for current expected credit losses was $1.8 million. Gains from Investments in SecuritiesGains from investments in securities for the year ended December 31, 2020 and 2019 related to investments that we have made to reduce our market risk relating to deferred compensation plans that we maintain for BXP’s officers and former non-employee directors. Under the deferred compensation plans, each officer or non-employee director who is eligible to participate is permitted to defer a portion of the officer’s current income or the non-employee director’s compensation on a pre-tax basis and receive a tax-deferred return on these deferrals based on the performance of specific investments selected by the officer or non-employee director. In order to reduce our 86Table of Contentsmarket risk relating to these plans, we typically acquire, in a separate account that is not restricted as to its use, similar or identical investments as those selected by each officer or non-employee director. This enables us to generally match our liabilities to BXP’s officers or former non-employee directors under our deferred compensation plans with equivalent assets and thereby limit our market risk. The performance of these investments is recorded as gains from investments in securities. During the year ended December 31, 2020 and 2019, we recognized gains of approximately $5.3 million and $6.4 million, respectively, on these investments. By comparison, our general and administrative expense increased by approximately $5.3 million and $6.4 million during the year ended December 31, 2020 and 2019, respectively, as a result of increases in our liability under our deferred compensation plans that was associated with the performance of the specific investments selected by officers and former non-employee directors of BXP participating in the plans.Impairment LossImpairment loss may differ between BXP and BPLP as a result of previously applied acquisition accounting by BXP for the issuance of common stock in connection with non-sponsor OP Unit redemptions by BPLP. This accounting resulted in a step-up of the real estate assets at BXP that was allocated to certain properties. The difference between the real estate assets of BXP as compared to BPLP for certain properties having an allocation of the real estate step-up will result in a corresponding difference in depreciation expense. For additional information see the Explanatory Note that follows the cover page of this Annual Report on Form 10-K. At March 31, 2019, we evaluated the expected hold period of our One Tower Center property located in East Brunswick, New Jersey and, based on a shorter-than-expected hold period, we reduced the carrying value of the property to its estimated fair value at March 31, 2019 and recognized an impairment loss totaling approximately $24.0 million for BXP and approximately $22.3 million for BPLP. Our estimated fair value was based on a pending offer from a third party to acquire the property and the subsequent execution of a purchase and sale agreement on April 18, 2019 for a gross sale price of approximately $38.0 million. On June 3, 2019, we completed the sale of the property. One Tower Center is an approximately 410,000 net rentable square foot Class A office property. We did not have any impairments during the year ended December 31, 2020.Loss From Early Extinguishment of DebtOn September 18, 2019, BPLP completed the redemption of $700.0 million in aggregate principal amount of its 5.625% senior notes due November 15, 2020. The redemption price was approximately $740.7 million. The redemption price included approximately $13.5 million of accrued and unpaid interest to, but not including, the redemption date. Excluding the accrued and unpaid interest, the redemption price was approximately 103.90% of the principal amount being redeemed. We recognized a loss from early extinguishment of debt totaling approximately $28.0 million, which amount included the payment of the redemption premium totaling approximately $27.3 million.On December 19, 2019, we used available cash to repay the bond financing collateralized by our New Dominion Technology Park, Building One property totaling approximately $26.5 million. The bond financing bore interest at a weighted-average fixed rate of approximately 7.69% per annum and was scheduled to mature on January 15, 2021. We recognized a loss from early extinguishment of debt totaling approximately $1.5 million, which amount included the payment of a prepayment penalty totaling approximately $1.4 million. New Dominion Technology Park, Building One is an approximately 235,000 net rentable square foot Class A office property located in Herndon, Virginia.87Table of ContentsInterest ExpenseInterest expense increased by approximately $19.0 million for the year ended December 31, 2020 compared to 2019, as detailed below.ComponentChange in interest expense for the year ended December 31, 2020 compared to December 31, 2019 (in thousands)Increases to interest expense due to:Issuance of $1.25 billion in aggregate principal of 3.250% senior notes due 2031 on May 5, 2020$26,618 Issuance of $850 million in aggregate principal of 3.400% senior notes due 2029 on June 21, 201913,714 Issuance of $700 million in aggregate principal of 2.900% senior notes due 2030 on September 3, 201913,666 Increase in interest due to finance leases that are related to development properties3,695 Decrease in capitalized interest related to development projects2,665 Increase in interest due to a finance lease for an in-service property535 Other interest expense (excluding senior notes)443 Total increases to interest expense61,336 Decreases to interest expense due to:Redemption of $700 million in aggregate principal of 5.625% senior notes due 2020 on September 18, 2019(28,172)Decrease in interest rates for the 2017 Credit Facility(9,364)Increase in capitalized interest related to development projects that had finance leases(2,665)Repayment of a bond financing collateralized by New Dominion Technology Building One(2,135)Total decreases to interest expense(42,336)Total change in interest expense$19,000 Interest expense directly related to the development of rental properties is capitalized and included in real estate assets on our Consolidated Balance Sheets and amortized over the useful lives of the real estate or lease term. As portions of properties are placed in-service, we cease capitalizing interest on that portion and interest is then expensed. Interest capitalized for the years ended December 31, 2020 and 2019 was approximately $53.9 million and $54.9 million, respectively. These costs are not included in the interest expense referenced above.On May 5, 2020, BPLP completed a public offering of $1.25 billion in aggregate principal amount of its 3.250% unsecured senior notes due 2031 (See Note 8 to the Consolidated Financial Statements). We used a portion of the net proceeds from this offering for the repayment of borrowings outstanding under the Revolving Facility.On February 14, 2021, BPLP completed the redemption of $850.0 million in aggregate principal amount of its 4.125% senior notes due May 15, 2021. The redemption price was approximately $858.7 million, which was equal to par plus approximately $8.7 million of accrued and unpaid interest to, but not including, the redemption date. At December 31, 2020, our variable rate debt consisted of BPLP’s $2.0 billion unsecured revolving credit facility (the “2017 Credit Facility”), which includes the $500.0 million delayed draw term loan facility (the “Delayed Draw Facility”) and the $1.5 billion revolving line of credit (the “Revolving Facility”). The Delayed Draw Facility had $500.0 million outstanding as of December 31, 2020. The Revolving Facility did not have an outstanding balance as of December 31, 2020. For a summary of our consolidated debt as of December 31, 2020 and December 31, 2019 refer to the heading “Liquidity and Capital Resources—Capitalization—Debt Financing” within “Item 7—Management’s Discussion and Analysis of Financial Condition and Results of Operations.”88Table of ContentsNoncontrolling Interests in Property PartnershipsNoncontrolling interests in property partnerships decreased by approximately $22.9 million for the year ended December 31, 2020 compared to 2019, as detailed below. PropertyNoncontrolling Interests in Property Partnerships for the year ended December 31,20202019Change(in thousands)Salesforce Tower (1)$— $116 $(116)767 Fifth Avenue (the General Motors Building) (2)4,954 2,638 2,316 Times Square Tower (3)3,535 27,146 (23,611)601 Lexington Avenue (4)16,575 19,143 (2,568)100 Federal Street (5)14,313 12,614 1,699 Atlantic Wharf Office Building (6)8,883 9,463 (580)$48,260 $71,120 $(22,860)_______________(1)On April 1, 2019, we acquired our partner’s 5% interest and subsequently own 100%. (2)The increase during the year ended December 31, 2020 was related to above-/below-market lease assets that were fully amortized in 2020.(3)During the year ended December 31, 2020, we wrote off approximately $26.8 million of accrued rent and accounts receivable balances for tenants that either terminated their leases or for which we determined their accrued rent and/or accounts receivable balances, primarily retail tenants, were no longer probable of collection. Approximately $14.7 million represents our share of the write-offs. As a result of these terminations, lease revenue decreased for the year ended December 31, 2020.(4)During the year ended December 31, 2020, we wrote off approximately $2.9 million of accrued rent and accounts receivable balances for tenants that either terminated their leases or for which we determined their accrued rent and/or accounts receivable balances, primarily tenants in the retail sector, were no longer probable of collection. Approximately $1.6 million represents our share of the write-offs. As a result of these terminations, lease revenue decreased for the year ended December 31, 2020.(5)The increase was primarily due to an increase in lease revenue from our tenants.(6)During the year ended December 31, 2020, we wrote off approximately $0.5 million of accrued rent and accounts receivable balances for tenants whose balances we determined were no longer probable of collection. Approximately $0.3 million represents our share of the write-offs.Noncontrolling Interest—Common Units of the Operating PartnershipFor BXP, noncontrolling interest—common units of the Operating Partnership increased by approximately $38.4 million for the year ended December 31, 2020 compared to 2019 due primarily to an increase in allocable income, which was the result of recognizing a greater gain on sales of real estate amount during 2020 partially offset by a decrease in the noncontrolling interest’s ownership percentage. Due to our ownership structure, there is no corresponding line item on BPLP’s financial statements. Liquidity and Capital Resources GeneralOur principal liquidity needs for the next twelve months and beyond are to:•fund normal recurring expenses;•meet debt service and principal repayment obligations, including balloon payments on maturing debt;•fund development/redevelopment costs;•fund capital expenditures, including major renovations, tenant improvements and leasing costs;•fund planned and possible acquisitions of properties, either directly or indirectly through the acquisition of equity interests therein; •fund dividend requirements on BXP’s Series B Preferred Stock; and•make the minimum distribution required to enable BXP to maintain its REIT qualification under the Internal Revenue Code of 1986, as amended.89Table of ContentsWe expect to satisfy these needs using one or more of the following:•cash flow from operations;•distribution of cash flows from joint ventures;•cash and cash equivalent balances;•BPLP’s 2017 Credit Facility;•short-term bridge facilities; •construction loans;•long-term secured and unsecured indebtedness (including unsecured exchangeable indebtedness); •sales of real estate; and•issuances of BXP equity securities and/or additional preferred or common units of partnership interest in BPLP.We draw on multiple financing sources to fund our long-term capital needs. Our current development properties are expected to be primarily funded with our available cash balances, construction loans and BPLP’s Revolving Facility. We use BPLP’s Revolving Facility primarily as a bridge facility to fund acquisition opportunities, refinance outstanding indebtedness and meet short-term development and working capital needs. Although we may seek to fund our development projects with construction loans, which may require guarantees by BPLP, the financing for each particular project ultimately depends on several factors, including, among others, the project’s size and duration, the extent of pre-leasing and our available cash and access to cost effective capital at the given time.90Table of ContentsThe following table presents information on properties under construction and redevelopment as of December 31, 2020 (dollars in thousands):FinancingsConstruction PropertiesEstimated Stabilization DateLocation# of BuildingsEstimated Square FeetInvestment to Date (1)(2)(3)Estimated Total Investment (1)(2)Total Available (1)Outstanding at 12/31/2020 (1)Estimated Future Equity Requirement (1)(2)(4)Percentage Leased (5)Office325 Main StreetThird Quarter, 2022Cambridge, MA1 420,000 $181,917 $418,400 $— $— $236,483 90 %100 Causeway Street (50% ownership)Third Quarter, 2022Boston, MA1 632,000 189,528 267,300 200,000 108,287 — 94 %7750 Wisconsin Avenue (Marriott International Headquarters) (50% ownership)Third Quarter, 2022Bethesda, MD1 734,000 148,452 198,900 127,500 81,932 4,880 100 %Reston Next (formerly Reston Gateway)Fourth Quarter, 2023Reston, VA2 1,062,000 372,788 715,300 — — 342,512 85 %2100 Pennsylvania AvenueThird Quarter, 2024Washington, DC1 480,000 134,071 356,100 — — 222,029 56 %Total Office Properties under Construction6 3,328,000 1,026,756 1,956,000 327,500 190,219 805,904 86 %Redevelopment PropertiesOne Five Nine East 53rd Street (55% ownership)First Quarter, 2021New York, NY— 220,000 137,964 150,000 — — 12,036 96 %(6)200 West StreetFourth Quarter, 2021Waltham, MA— 138,000 17,028 47,800 — — 30,772 100 %(7)Total Redevelopment Properties under Construction— 358,000 154,992 197,800 — — 42,808 98 %Total Properties under Construction and Redevelopment6 3,686,000 $1,181,748 $2,153,800 $327,500 $190,219 $848,712 87 %___________ (1)Represents our share. (2)Investment to Date, Estimated Total Investment and Estimated Future Equity Requirement all include our share of acquisition expenses, as applicable, and reflect our share of the estimated net revenue/expenses that we expect to incur prior to stabilization of the project, including any amounts actually received or paid through December 31, 2020. (3)Includes approximately $81.6 million of unpaid but accrued construction costs and leasing commissions.(4)Excludes approximately $81.6 million of unpaid but accrued construction costs and leasing commissions.(5)Represents percentage leased as of February 22, 2021, including leases with future commencement dates.(6)Represents the low-rise portion of 601 Lexington Avenue. (7)Represents a portion of the property under redevelopment for conversion to life sciences space.91Table of ContentsLease revenue (which includes recoveries from tenants), other income from operations, available cash balances, mortgage financings, unsecured indebtedness and draws on BPLP’s Revolving Facility are the principal sources of capital that we use to fund operating expenses, debt service, maintenance and repositioning capital expenditures, tenant improvements and the minimum distribution required to enable BXP to maintain its REIT qualification. We seek to maximize income from our existing properties by maintaining quality standards for our properties that promote high occupancy rates and permit increases in rental rates while reducing tenant turnover and controlling operating expenses. Our sources of revenue also include third-party fees generated by our property management, leasing and development and construction businesses, as well as the sale of assets from time to time. We believe these sources of capital will continue to provide the funds necessary for our short-term liquidity needs, including our properties under development and redevelopment.Material adverse changes in one or more sources of capital, including from the impacts of COVID-19, may adversely affect our net cash flows. During the fourth quarter of 2020, our rent collections remained strong as we collected 99.7% of rents from our office tenants and 99.1% of rents from all tenants, including retail tenants. However, COVID-19 resulted in the write-off of accrued rent balances for all remaining co-working tenants. Decreases in parking and other revenue and the continued disruption in operations for our hotel reduced our revenue for the fourth quarter of 2020. Cash rent abatements and deferrals primarily related to COVID-19 were approximately $19.2 million in the fourth quarter. This amount represents our consolidated cash rent abatements and deferrals plus our share of the cash rent abatements and deferrals from the unconsolidated joint ventures (calculated based on our ownership percentage) minus our partners’ share of cash rent abatements and deferrals from our consolidated joint ventures (calculated based upon the partners’ percentage ownership interests). To date, these impacts have not adversely affected our ability to fund operating expenses, dividends and distributions, debt service payments, maintenance and repositioning capital expenditures and tenant improvements. Any future material adverse change in the cash provided by our operations may affect our ability to comply with the financial covenants under BPLP’s 2017 Credit Facility or its unsecured senior notes.Our primary uses of capital over the next twelve months will be the completion of our current and committed development and redevelopment projects. Following the redemption of the $850 million aggregate principal amount of BPLP’s 4.125% senior unsecured notes on February 14, 2021, we have no further 2021 debt maturities, other than three loans borrowed by our unconsolidated joint ventures of which our share is approximately $102 million. As of December 31, 2020, our share of the remaining development and redevelopment costs that we expect to fund through 2024 was approximately $849 million. In addition, we anticipate development/redevelopment starts in 2021 of over $700 million, the majority of which are new life sciences developments and conversions. To satisfy these capital needs, as of February 22, 2021, we had approximately $517 million of cash and cash equivalents, of which approximately $155 million is attributable to our consolidated joint venture partners. Although the full impact of COVID-19 on our liquidity and capital resources, as well as the duration of such impact, will depend on a wide range of factors, all of which are highly uncertain and cannot be predicted with confidence at this time, we believe that our strong liquidity, including the approximately $1.5 billion available under the Revolving Facility and available cash, as of February 22, 2021, is sufficient to fund our remaining capital requirements on existing development and redevelopment projects, repay our maturing indebtedness when due, satisfy our REIT distribution requirements and still allow us to act opportunistically on attractive investment opportunities.We have not sold any shares under BXP’s $600.0 million “at the market” equity offering program.During 2020 we continued to access various sources of capital, including the sale of more than $920 million of assets generating approximately $538 million of proceeds, the issuance by BPLP in May 2020 of $1.25 billion in aggregate principal amount of its 3.25% senior unsecured notes due 2031 and the completion of $731.6 million of secured debt transactions to refinance maturing debt, of which our share of the aggregate principal is $268.3 million. The refinancing transactions included the following:•A $250.0 million mortgage loan collateralized by Dock 72, a 669,000 square-foot Class A office property in Brooklyn, New York in which we have a 50% interest. The new loan matures on December 18, 2023.92Table of Contents•A $125.0 million mortgage loan collateralized by Market Square North, a 418,000 square foot Class A office property in Washington, DC in which we have a 50% interest. The new loan matures on November 10, 2025.•A $325.0 million mortgage loan collateralized by Metropolitan Square, a 654,000 square foot Class A office property in Washington, DC, in which we have a 20% interest. The new loan matures on July 7, 2022.We may seek to enhance our liquidity to fund our foreseeable potential development activity, pursue additional attractive investment opportunities and refinance or repay indebtedness. Depending on interest rates and overall conditions in the debt and equity markets, we may decide to access either or both of these markets in advance of the need for the funds. Doing so may result in us carrying additional cash and cash equivalents pending our use of the proceeds, which would increase our net interest expense and be dilutive to our earnings. REIT Tax Distribution Considerations Dividend BXP as a REIT is subject to a number of organizational and operational requirements, including a requirement that BXP currently distribute at least 90% of its annual taxable income (excluding capital gains and with certain other adjustments). Our policy is for BXP to distribute at least 100% of its taxable income, including capital gains, to avoid paying federal tax. On December 17, 2019, the Board of Directors of BXP increased our regular quarterly dividend from $0.95 per common share to $0.98 per common share, or 3%, beginning with the fourth quarter of 2019. Common and LTIP unitholders of limited partnership interest in BPLP, received the same total distribution per unit. BXP’s Board of Directors will continue to evaluate BXP’s dividend rate in light of our actual and projected taxable income (including gains on sales), liquidity requirements and other circumstances, including the impact of COVID-19, and there can be no assurance that the future dividends declared by BXP’s Board of Directors will not differ materially from the current quarterly dividend amount. Sales To the extent that we sell assets at a gain and cannot efficiently use the proceeds in a tax deferred manner for either our development activities or attractive acquisitions, BXP would, at the appropriate time, decide whether it is better to declare a special dividend, adopt a stock repurchase program, reduce indebtedness or retain the cash for future investment opportunities. Such a decision will depend on many factors including, among others, the timing, availability and terms of development and acquisition opportunities, our then-current and anticipated leverage, the cost and availability of capital from other sources, the price of BXP’s common stock and REIT distribution requirements. At a minimum, we expect that BXP would distribute at least that amount of proceeds necessary for BXP to avoid paying corporate level tax on the applicable gains realized from any asset sales. From time to time in selected cases, whether due to a change in use, structuring issues to comply with applicable REIT regulations or other reasons, we may sell an asset that is held by a taxable REIT subsidiary (“TRS”). Such a sale by a TRS would be subject to federal and local taxes. Cash Flow SummaryThe following summary discussion of our cash flows is based on the Consolidated Statements of Cash Flows and is not meant to be an all-inclusive discussion of the changes in our cash flows for the periods presented below.Cash and cash equivalents and cash held in escrows aggregated approximately $1.7 billion and $0.7 billion at December 31, 2020 and 2019, respectively, representing an increase of approximately $1.0 billion. The following table sets forth changes in cash flows: Year ended December 31,20202019Increase(Decrease)(in thousands)Net cash provided by operating activities$1,156,840 $1,181,165 $(24,325)Net cash used in investing activities(613,719)(1,015,091)401,372 Net cash provided by (used in) financing activities484,322 (113,379)597,701 93Table of ContentsOur principal source of cash flow is related to the operation of our properties. The weighted-average term of our in-place leases, excluding residential units, was approximately 7.4 years, as of December 31, 2020, including leases signed by our unconsolidated joint ventures, with occupancy rates historically in the range of 90% to 94%. Generally, our properties generate a relatively consistent stream of cash flow that provides us with resources to pay operating expenses, debt service and fund regular quarterly dividend and distribution payment requirements. In addition, over the past several years, we have raised capital through the sale of some of our properties and through secured and unsecured borrowings.The full extent of the impact of COVID-19 on our business, operations and financial results will depend on numerous evolving factors that we may not be able to accurately predict. In addition, we cannot predict the impact that COVID-19 will have on our tenants, employees, contractors, lenders, suppliers, vendors and joint venture partners; any material adverse effect on these parties could also have a material adverse effect on us. See Item 1A: “Risk Factors” for additional details. Cash is used in investing activities to fund acquisitions, development, net investments in unconsolidated joint ventures and maintenance and repositioning capital expenditures. We selectively invest in new projects that enable us to take advantage of our development, leasing, financing and property management skills and invest in existing buildings to enhance or maintain their market position. Cash used in investing activities for the year ended December 31, 2020 consisted primarily of acquisitions of real estate, development projects, building and tenant improvements and capital contributions to unconsolidated joint ventures, partially offset by the proceeds from the sales of real estate and capital distributions from unconsolidated joint ventures. Cash used in investing activities for the year ended December 31, 2019 consisted primarily of the acquisition of real estate, development projects, building and tenant improvements and capital contributions to unconsolidated joint ventures, partially offset by the proceeds from the sale of real estate and capital distributions from unconsolidated joint ventures, as detailed below: Year ended December 31, 20202019 (in thousands)Acquisitions of real estate (1)$(137,976)$(149,031)Construction in progress (2)(482,507)(546,060)Building and other capital improvements(160,126)(180,556)Tenant improvements(234,423)(251,831)Right of use assets - finance leases— (5,152)Proceeds from sales of real estate (3)519,303 90,824 Capital contributions to unconsolidated joint ventures (4)(172,436)(87,392)Capital distributions from unconsolidated joint ventures (5)55,298 136,807 Cash and cash equivalents deconsolidated— (24,112)Issuance of notes receivable, net(9,800)— Proceeds from note receivable6,397 3,544 Investments in securities, net2,551 (2,132)Net cash used in investing activities$(613,719)$(1,015,091)Cash used in investing activities changed primarily due to the following:(1)On June 26, 2020, we completed the acquisition of real property at 777 Harrison Street (known as Fourth + Harrison and formerly known as 425 Fourth Street) located in San Francisco, California for a gross purchase price, including entitlements, totaling approximately $140.1 million. On July 31, 2020 and December 16, 2020, we acquired real property at 759 Harrison Street located in San Francisco, California, which is expected to be included in the Fourth + Harrison development project, for an aggregate purchase price totaling approximately $4.5 million. 759 Harrison Street and Fourth + Harrison are expected to support the development of approximately 850,000 square feet of primarily commercial office space.94Table of ContentsOn January 10, 2019, we acquired land parcels at our Carnegie Center property located in Princeton, New Jersey for a gross purchase price of approximately $51.5 million, which includes an aggregate of approximately $8.6 million of additional amounts that are payable in the future to the seller upon the development or sale of each of the parcels. The land parcels will support approximately 1.7 million square feet of development. On August 27, 2019, we acquired 880 and 890 Winter Street located in Waltham, Massachusetts for a grosspurchase price of approximately $106.0 million in cash, including transaction costs. 880 and 890 WinterStreet consists of two Class A office properties aggregating approximately 392,000 net rentable square feet.(2)Construction in progress for the year ended December 31, 2020 includes ongoing expenditures associated with 20 CityPoint, 17Fifty Presidents Street and The Skylyne, which were completed and fully placed in-service during the year ended December 31, 2020. In addition, we incurred costs associated with our continued development/redevelopment of One Five Nine East 53rd Street, 200 West Street, 325 Main Street, 2100 Pennsylvania Avenue and Reston Next (formerly Reston Gateway). Construction in progress for the year ended December 31, 2019 includes ongoing expenditures associated with Salesforce Tower, which was placed in-service during the year ended December 31, 2018 and 20 CityPoint and 145 Broadway, which were partially or fully placed in-service during the year ended December 31, 2019. In addition, we incurred costs associated with our continued development/redevelopment of 17Fifty Presidents Street, The Skylyne, One Five Nine East 53rd Street, 200 West Street, 325 Main Street, 2100 Pennsylvania Avenue and Reston Next (formerly Reston Gateway).(3)On February 20, 2020, we completed the sale of New Dominion Technology Park located in Herndon, Virginia for a gross sale price of $256.0 million. Net cash proceeds totaled approximately $254.0 million, resulting in a gain on sale of real estate totaling approximately $192.3 million for BXP and approximately $197.1 million for BPLP. New Dominion Technology Park is comprised of two Class A office properties aggregating approximately 493,000 net rentable square feet. On June 25, 2020, we completed the sale of a portion of our Capital Gallery property located in Washington, DC for a gross sale price of approximately $253.7 million. Net cash proceeds totaled approximately $246.6 million, resulting in a gain on sale of real estate totaling approximately $203.5 million for BXP and approximately $207.0 million for BPLP. Capital Gallery is an approximately 631,000 net rentable square foot Class A office property. The portion sold is comprised of approximately 455,000 net rentable square feet of commercial office space. We continue to own the land, underground parking garage and remaining commercial office and retail space containing approximately 176,000 net rentable square feet at the property.On December 16, 2020, we completed the sale of a parcel of land located in Marlborough, Massachusetts for a gross sale price of approximately $14.3 million. Net cash proceeds totaled approximately $14.2 million, resulting in a gain on sale of real estate totaling approximately $5.2 million. On January 24, 2019, we completed the sale of our 2600 Tower Oaks Boulevard property located in Rockville, Maryland for a gross sale price of approximately $22.7 million. Net cash proceeds totaled approximately $21.4 million, resulting in a loss on sale of real estate totaling approximately $0.6 million. 2600 Tower Oaks Boulevard is an approximately 179,000 net rentable square foot Class A office property. On June 3, 2019, we completed the sale of our One Tower Center property located in East Brunswick, New Jersey for a gross sale price of $38.0 million. Net cash proceeds totaled approximately $36.6 million. One Tower Center is an approximately 410,000 net rentable Class A office property.On June 28, 2019, we completed the sale of our 164 Lexington Road property located in Billerica, Massachusetts for a gross sale price of $4.0 million. Net cash proceeds totaled approximately $3.8 million, resulting in a gain on sale of real estate totaling approximately $2.5 million for BXP and approximately $2.6 million for BPLP. 164 Lexington Road is an approximately 64,000 net rentable square foot Class A office property.On September 20, 2019, we sold a 45% interest in our Platform 16 property located in San Jose, California for a gross sale price of approximately $23.1 million. Net cash proceeds totaled approximately $23.1 million. We ceased accounting for the property on a consolidated basis and now account for the property on an unconsolidated basis using the equity method of accounting as we reduced our ownership interest in the 95Table of Contentsproperty and no longer have a controlling financial or operating interest in the property. We did not recognize a gain on the retained or sold interest in the property as the fair value of the property approximated its carrying value. Platform 16 consists of a 65-year ground lease for land totaling approximately 5.6 acres that will support the development of approximately 1.1 million square feet of commercial office space.On December 20, 2019, we completed the sale of the remaining parcel of land at our Washingtonian North property located in Gaithersburg, Maryland for a gross sale price of approximately $7.8 million. Net cash proceeds totaled approximately $7.3 million, resulting in a loss on sale of real estate totaling approximately $0.1 million.(4)Capital contributions to unconsolidated joint ventures for the year ended December 31, 2020 consisted primarily of cash contributions of approximately $79.3 million, $46.3 million, $27.2 million, $7.5 million and $7.4 million to our Platform 16, 3 Hudson Boulevard, Beach Cities Media Campus, Dock 72 and Metropolitan Square joint ventures, respectively. Capital contributions to unconsolidated joint ventures for the year ended December 31, 2019 consisted primarily of cash contributions of approximately $45.0 million, $20.4 million, $12.8 million and $7.2 million to our Hub on Causeway, 3 Hudson Boulevard, Dock 72 and Metropolitan Square joint ventures, respectively.(5)Capital distributions from unconsolidated joint ventures for the year ended December 31, 2020 consisted of (1) a cash distribution totaling approximately $22.5 million from our Metropolitan Square joint venture resulting from the excess proceeds from the refinancing of the mortgage loan on the property, (2) a cash distribution totaling approximately $17.9 million from our Annapolis Junction joint venture resulting from available cash and the net proceeds from the sale of Annapolis Junction Building Eight and two land parcels after the pay down of the mortgage loan and (3) a cash distribution totaling approximately $14.0 million from our Colorado Center joint venture resulting from the excess proceeds from the mortgage financing on the property that occurred during 2017, which proceeds were released from lender reserves.Capital distributions from unconsolidated joint ventures for the year ended December 31, 2019 consisted of (1) cash distributions totaling approximately $104.1 million from our 540 Madison Avenue joint venture resulting from the net proceeds from the sale of the property, (2) a cash distribution totaling approximately $17.6 million from our 100 Causeway Street joint venture resulting from the proceeds from the construction loan financing and (3) a cash distribution totaling approximately $15.1 million from our 7750 Wisconsin Avenue joint venture resulting from the proceeds from the construction loan financing.Cash provided by financing activities for the year ended December 31, 2020 totaled approximately $484.3 million. This consisted primarily of the proceeds from the issuance by BPLP of $1.25 billion in aggregate principal amount of its 3.250% senior unsecured notes due 2031, partially offset by the payment of our regular dividends and distributions to our shareholders and unitholders and distributions to noncontrolling interest holders in property partnerships. Future debt payments are discussed below under the heading “Capitalization—Debt Financing.” CapitalizationThe following table presents Consolidated Market Capitalization and BXP’s Share of Market Capitalization, as well as the corresponding ratios of Consolidated Debt to Consolidated Market Capitalization and BXP’s Share of Debt to BXP’s Share of Market Capitalization (in thousands except for percentages):96Table of ContentsDecember 31, 2020Shares / Units OutstandingCommon Stock EquivalentEquivalent Value (1)Common Stock155,719 155,719 $14,720,117 Common Operating Partnership Units17,373 17,373 1,642,270 (2)5.25% Series B Cumulative Redeemable Preferred Stock80 — 200,000 Total Equity173,092 $16,562,387 Consolidated Debt $13,047,758 Add:BXP’s share of unconsolidated joint venture debt (3)1,153,628 Subtract:Partners’ share of Consolidated Debt (4)(1,194,619)BXP’s Share of Debt$13,006,767 Consolidated Market Capitalization$29,610,145 BXP’s Share of Market Capitalization$29,569,154 Consolidated Debt/Consolidated Market Capitalization44.07 %BXP’s Share of Debt/BXP’s Share of Market Capitalization43.99 %_______________ (1)Except for the Series B Cumulative Redeemable Preferred Stock, which is valued at the liquidation preference of $2,500 per share, values are based on the closing price per share of BXP’s Common Stock on the New York Stock Exchange on December 31, 2020 of $94.53.(2)Includes long-term incentive plan units (including 2012 OPP Units and 2013 - 2017 MYLTIP Units), but excludes MYLTIP Units granted between 2018 and 2020.(3)See page 108 for additional information.(4)See page 100 for additional information.Consolidated Debt to Consolidated Market Capitalization Ratio is a measure of leverage commonly used by analysts in the REIT sector. We present this measure as a percentage and it is calculated by dividing (A) our consolidated debt by (B) our consolidated market capitalization, which is the market value of our outstanding equity securities plus our consolidated debt. Consolidated market capitalization is the sum of:(1) our consolidated debt; plus(2) the product of (x) the closing price per share of BXP common stock on December 31, 2020, as reported by the New York Stock Exchange, multiplied by (y) the sum of:(i) the number of outstanding shares of common stock of BXP, (ii) the number of outstanding OP Units in BPLP (excluding OP Units held by BXP),(iii) the number of OP Units issuable upon conversion of all outstanding LTIP Units, assuming all conditions have been met for the conversion of the LTIP Units, and(iv) the number of OP Units issuable upon conversion of 2012 OPP Units, 2013 - 2017 MYLTIP Units that were issued in the form of LTIP Units; plus(3) the aggregate liquidation preference ($2,500 per share) of the outstanding shares of BXP’s 5.25% Series B Cumulative Redeemable Preferred Stock. The calculation of consolidated market capitalization does not include LTIP Units issued in the form of MYLTIP Awards unless and until certain performance thresholds are achieved and they are earned. Because their three-year performance periods have not yet ended, 2018 - 2020 MYLTIP Units are not included in this calculation as of December 31, 2020. 97Table of ContentsWe also present BXP’s Share of Market Capitalization and BXP’s Share of Debt/BXP’s Share of Market Capitalization, which are calculated in the same manner, except that BXP’s Share of Debt is utilized instead of our consolidated debt in both the numerator and the denominator. BXP’s Share of Debt is defined as our consolidated debt plus our share of debt from our unconsolidated joint ventures (calculated based upon our ownership percentage), minus our partners’ share of debt from our consolidated joint ventures (calculated based upon the partners’ percentage ownership interests adjusted for basis differentials). Management believes that BXP’s Share of Debt provides useful information to investors regarding our financial condition because it includes our share of debt from unconsolidated joint ventures and excludes our partners’ share of debt from consolidated joint ventures, in each case presented on the same basis. We have several significant joint ventures and presenting various measures of financial condition in this manner can help investors better understand our financial condition and/or results of operations after taking into account our economic interest in these joint ventures. We caution investors that the ownership percentages used in calculating BXP’s Share of Debt may not completely and accurately depict all of the legal and economic implications of holding an interest in a consolidated or unconsolidated joint venture. For example, in addition to partners’ interests in profits and capital, venture agreements vary in the allocation of rights regarding decision making (both for routine and major decisions), distributions, transferability of interests, financing and guarantees, liquidations and other matters. Moreover, in some cases we exercise significant influence over, but do not control, the joint venture in which case GAAP requires that we account for the joint venture entity using the equity method of accounting and we do not consolidate it for financial reporting purposes. In other cases, GAAP requires that we consolidate the venture even though our partner(s) own(s) a significant percentage interest. As a result, management believes that the presentation of BXP’s Share of a financial measure should not be considered a substitute for, and should only be considered with and as a supplement to our financial information presented in accordance with GAAP.We present these supplemental ratios because our degree of leverage could affect our ability to obtain additional financing for working capital, capital expenditures, acquisitions, development or other general corporate purposes and because different investors and lenders consider one or both of these ratios. Investors should understand that these ratios are, in part, a function of the market price of the common stock of BXP and as such will fluctuate with changes in such price, and they do not necessarily reflect our capacity to incur additional debt to finance our activities or our ability to manage our existing debt obligations. However, for a company like BXP, whose assets are primarily income-producing real estate, these ratios may provide investors with an alternate indication of leverage, so long as they are evaluated along with the ratio of indebtedness to other measures of asset value used by financial analysts and other financial ratios, as well as the various components of our outstanding indebtedness.For a discussion of our unconsolidated joint venture indebtedness, see “Liquidity and Capital Resources—Capitalization—Off-Balance Sheet Arrangements—Joint Venture Indebtedness” within “Item 7—Management’s Discussion and Analysis of Financial Condition and Results of Operations” and for a discussion of our consolidated joint venture indebtedness see “Liquidity and Capital Resources—Capitalization—Mortgage Notes Payable, Net” within “Item 7—Management’s Discussion and Analysis of Financial Condition and Results of Operations.”Debt FinancingAs of December 31, 2020, we had approximately $13.0 billion of outstanding consolidated indebtedness, representing approximately 44.07% of our Consolidated Market Capitalization as calculated above consisting of approximately (1) $9.6 billion (net of discount and deferred financing fees) in publicly traded unsecured senior notes having a GAAP weighted-average interest rate of 3.71% per annum and maturities in 2021 through 2031 (See Notes 8 and 18 to the Consolidated Financial Statements), (2) $2.9 billion (net of deferred financing fees) of property-specific mortgage debt having a GAAP weighted-average interest rate of 3.89% per annum and a weighted-average term of 5.3 years and (3) $499.4 million (net of deferred financing fees) outstanding under BPLP’s 2017 Credit Facility that matures on April 24, 2022. 98Table of ContentsThe table below summarizes the aggregate carrying value of our mortgage notes payable and BPLP’s unsecured senior notes, line of credit and term loan, as well as Consolidated Debt Financing Statistics at December 31, 2020 and December 31, 2019. December 31,20202019 (dollars in thousands)Debt Summary:BalanceFixed rate mortgage notes payable, net$2,909,081 $2,922,408 Unsecured senior notes, net9,639,287 8,390,459 Unsecured line of credit— — Unsecured term loan, net499,390 498,939 Consolidated Debt13,047,758 11,811,806 Add:BXP’s share of unconsolidated joint venture debt, net (1)1,153,628 980,110 Subtract:Partners’ share of consolidated mortgage notes payable, net (2)(1,194,619)(1,199,854)BXP’s Share of Debt$13,006,767 $11,592,062 December 31,20202019Consolidated Debt Financing Statistics:Percent of total debt:Fixed rate96.17 %95.78 %Variable rate3.83 %4.22 %Total100.00 %100.00 %GAAP Weighted-average interest rate at end of period:Fixed rate3.75 %3.80 %Variable rate1.19 %2.75 %Total3.65 %3.75 %Coupon/Stated Weighted-average interest rate at end of period:Fixed rate3.65 %3.69 %Variable rate1.10 %2.66 %Total3.55 %3.65 %Weighted-average maturity at end of period (in years):Fixed rate5.5 6.0 Variable rate1.3 2.3 Total5.4 5.9 _______________(1)See page 108 for additional information.(2)See page 100 for additional information. Unsecured Credit FacilityOn April 24, 2017, BPLP entered into the 2017 Credit Facility. Among other things, the 2017 Credit Facility (1) increased the total commitment of the Revolving Facility from $1.0 billion to $1.5 billion, (2) extended the maturity date from July 26, 2018 to April 24, 2022, (3) reduced the per annum variable interest rates, and (4) added a $500.0 million Delayed Draw Facility that permitted BPLP to draw until the first anniversary of the closing date. Based on BPLP’s current credit rating, (1) the applicable Eurocurrency margins for the Revolving Facility and Delayed Draw Facility are 87.5 basis points and 95 basis points, respectively, and (2) the facility fee on the Revolving Facility commitment is 0.15% per annum.99Table of ContentsOn April 24, 2018, BPLP exercised its option to draw $500.0 million on its Delayed Draw Facility. The Delayed Draw Facility bears interest at a variable rate equal to LIBOR plus 0.90% per annum based on BPLP’s December 31, 2020 credit rating and matures on April 24, 2022. As of December 31, 2020, BPLP had $500.0 million of borrowings outstanding under its Delayed Draw Facility, no borrowings under its Revolving Facility and letters of credit totaling approximately $2.5 million outstanding with the ability to borrow approximately $1.5 billion under the Revolving Facility. As of February 22, 2021, BPLP had $500.0 million of borrowings outstanding under its Delayed Draw Facility, no borrowings under its Revolving Facility and letters of credit totaling approximately $2.3 million outstanding with the ability to borrow approximately $1.5 billion under the Revolving Facility. Unsecured Senior Notes, NetFor a description of BPLP’s outstanding unsecured senior notes as of December 31, 2020, see Notes 8 and 18 to the Consolidated Financial Statements.On May 5, 2020, BPLP completed a public offering of $1.25 billion in aggregate principal amount of its 3.250% unsecured senior notes due 2031. The notes were priced at 99.850% of the principal amount to yield an effective rate (including financing fees) of approximately 3.343% per annum to maturity. The notes will mature on January 30, 2031, unless earlier redeemed. The aggregate net proceeds from the offering were approximately $1.24 billion after deducting underwriting discounts and transaction expenses.The indenture relating to the unsecured senior notes contains certain financial restrictions and requirements, including (1) a leverage ratio not to exceed 60%, (2) a secured debt leverage ratio not to exceed 50%, (3) an interest coverage ratio of greater than 1.50, and (4) an unencumbered asset value of not less than 150% of unsecured debt. At December 31, 2020, BPLP was in compliance with each of these financial restrictions and requirements.Mortgage Notes Payable, NetThe following represents the outstanding principal balances due under the mortgage notes payable at December 31, 2020: PropertiesStatedInterest RateGAAPInterest Rate (1)StatedPrincipal AmountDeferred Financing Costs, Net Carrying AmountCarrying Amount (Partners’ Share)Maturity Date (dollars in thousands)Wholly-ownedUniversity Place6.94 %6.99 %$1,500 $(9)$1,491 N/AAugust 1, 2021Consolidated Joint Ventures767 Fifth Avenue (the General Motors Building)3.43 %3.64 %2,300,000 (22,478)2,277,522 $911,088 (2)(3)(4)June 9, 2027601 Lexington Avenue4.75 %4.79 %630,486 (418)630,068 283,531 (5)April 10, 20222,930,486 (22,896)2,907,590 1,194,619 Total$2,931,986 $(22,905)$2,909,081 $1,194,619 _______________ (1)GAAP interest rate differs from the stated interest rate due to the inclusion of the amortization of financing charges and the effects of hedging transactions (if any). (2)The mortgage loan requires interest only payments with a balloon payment due at maturity.(3)This property is owned by a consolidated entity in which we have a 60% interest. The partners’ share of the carrying amount has been adjusted for basis differentials.(4)In connection with the refinancing of the loan, we guaranteed the consolidated entity’s obligation to fund various reserves for tenant improvement costs and allowances, leasing commissions and free rent obligations in lieu of cash deposits. As of December 31, 2020, the maximum funding obligation under the guarantee was approximately $30.6 million. We earn a fee from the joint venture for providing the guarantee and have an agreement with our partners to reimburse the joint venture for their share of any payments made under the guarantee (See Note 10 to the Consolidated Financial Statements).(5)This property is owned by a consolidated entity in which we have a 55% interest. 100Table of ContentsContractual aggregate principal payments of mortgage notes payable at December 31, 2020 are as follows:Principal Payments Year(in thousands)2021$17,276 2022614,710 2023— 2024— 2025— Thereafter2,300,000 $2,931,986 Market Risk Market risk is the risk of loss from adverse changes in market prices and interest rates. Our future earnings, cash flows and fair values relevant to financial instruments are dependent upon prevalent market interest rates. Our primary market risk results from our indebtedness, which bears interest at fixed and variable rates. The fair value of our debt obligations are affected by changes in the market interest rates. We manage our market risk by matching long-term leases with long-term, fixed-rate, non-recourse debt of similar duration. We continue to follow a conservative strategy of generally pre-leasing development projects on a long-term basis to creditworthy tenants in order to achieve the most favorable construction and permanent financing terms. Approximately 96.2% of our outstanding debt, excluding our unconsolidated joint ventures, has fixed interest rates, which minimizes the interest rate risk through the maturity of such outstanding debt. We also manage our market risk by entering into hedging arrangements with financial institutions. Our primary objectives when undertaking hedging transactions and derivative positions is to reduce our floating rate exposure and to fix a portion of the interest rate for anticipated financing and refinancing transactions. This in turn, reduces the risks that the variability of cash flows imposes on variable rate debt. Our strategy mitigates against future increases in our interest rates.At December 31, 2020, our weighted-average coupon/stated rate on our fixed rate outstanding Consolidated Debt was 3.65% per annum. At December 31, 2020, we had $500.0 million outstanding of consolidated variable rate debt. At December 31, 2020, the GAAP interest rate on our variable rate debt was approximately 1.19% per annum. If market interest rates on our variable rate debt had been 100 basis points greater, total interest expense would have increased approximately $5.0 million, on an annualized basis, for the year ended December 31, 2020. Funds from OperationsPursuant to the revised definition of Funds from Operations adopted by the Board of Governors of the National Association of Real Estate Investment Trusts (“Nareit”), we calculate Funds from Operations, or “FFO,” for each of BXP and BPLP by adjusting net income (loss) attributable to Boston Properties, Inc. common shareholders and net income (loss) attributable to Boston Properties Limited Partnership common unitholders (computed in accordance with GAAP), respectively, for gains (or losses) from sales of properties, impairment losses on depreciable real estate consolidated on our balance sheet, impairment losses on our investments in unconsolidated joint ventures driven by a measurable decrease in the fair value of depreciable real estate held by the unconsolidated joint ventures and our share of real estate-related depreciation and amortization. FFO is a non-GAAP financial measure. We believe the presentation of FFO, combined with the presentation of required GAAP financial measures, improves the understanding of operating results of REITs among the investing public and helps make comparisons of REIT operating results more meaningful. Management generally considers FFO to be useful measures for understanding and comparing our operating results because, by excluding gains and losses related to sales of previously depreciated operating real estate assets, impairment losses and real estate asset depreciation and amortization (which can differ across owners of similar assets in similar condition based on historical cost accounting and useful life estimates), FFO can help investors compare the operating performance of a company’s real estate across reporting periods and to the operating performance of other companies. Our computation of FFO may not be comparable to FFO reported by other REITs or real estate companies that do not define the term in accordance with the current Nareit definition or that interpret the current Nareit definition differently. We believe that in order to facilitate a clear understanding of our operating results, FFO should be examined in conjunction with net income attributable to Boston Properties, Inc. common shareholders and net 101Table of Contentsincome attributable to Boston Properties Limited Partnership as presented in our Consolidated Financial Statements. FFO should not be considered as a substitute for net income attributable to Boston Properties, Inc. common shareholders or net income attributable to Boston Properties Limited Partnership common unitholders (determined in accordance with GAAP) or any other GAAP financial measures and should only be considered together with and as a supplement to our financial information prepared in accordance with GAAP. The impact that COVID-19 has had on our business, financial position and results of operations during 2020 is discussed throughout this report. The full extent of the impact of COVID-19 on our business, operations and financial results will depend on numerous evolving factors that we may not be able to accurately predict. The impact of COVID-19 on our revenue, in particular lease, parking and hotel revenue was negatively impacted by COVID-19 for the year ended December 31, 2020, thus negatively impacting our FFO. These decreases are discussed under the heading “Comparison of the year ended December 31, 2020 to the year ended December 31, 2019” within “Item 7—Management’s Discussion and Analysis of Financial Condition and Results of Operations.” 102Table of ContentsBoston Properties, Inc.The following table presents a reconciliation of net income attributable to Boston Properties, Inc. common shareholders to FFO attributable to Boston Properties, Inc. common shareholders for the years ended December 31, 2020, 2019, 2018, 2017 and 2016: Year ended December 31, 20202019201820172016 (in thousands)Net income attributable to Boston Properties, Inc. common shareholders$862,227 $511,034 $572,347 $451,939 $502,285 Add:Preferred dividends10,500 10,500 10,500 10,500 10,500 Noncontrolling interest—common units of the Operating Partnership97,704 59,345 66,807 52,210 59,260 Noncontrolling interests in property partnerships48,260 71,120 62,909 47,832 (2,068)Net income1,018,691 651,999 712,563 562,481 569,977 Add:Depreciation and amortization 683,751 677,764 645,649 617,547 694,403 Noncontrolling interests in property partnerships’ share of depreciation and amortization(71,850)(71,389)(73,880)(78,190)(107,087)BXP’s share of depreciation and amortization from unconsolidated joint ventures80,925 58,451 54,352 34,262 26,934 Corporate-related depreciation and amortization(1,840)(1,695)(1,634)(1,986)(1,568)Impairment loss on investment in unconsolidated joint venture (1)60,524 — — — — Impairment loss— 24,038 11,812 — — Less:Gain on sale of investment in unconsolidated joint venture (2)— — — — 59,370 Gain on sale of real estate included within (loss) income from unconsolidated joint ventures (3)5,958 47,238 8,270 — — Gains on sales of real estate618,982 709 182,356 7,663 80,606 Noncontrolling interests in property partnerships48,260 71,120 62,909 47,832 (2,068)Preferred dividends10,500 10,500 10,500 10,500 10,500 Funds from Operations (FFO) attributable to the Operating Partnership common unitholders (including Boston Properties, Inc.)1,086,501 1,209,601 1,084,827 1,068,119 1,034,251 Less:Noncontrolling interest—common units of the Operating Partnership’s share of funds from operations108,310 123,757 110,338 108,707 106,504 Funds from Operations attributable to Boston Properties, Inc. common shareholders$978,191 $1,085,844 $974,489 $959,412 $927,747 Our percentage share of Funds from Operations—basic90.03 %89.77 %89.83 %89.82 %89.70 %Weighted average shares outstanding—basic155,432 154,582 154,427 154,190 153,715 _______________(1)The impairment loss on investment in unconsolidated joint venture consists of an other-than-temporary decline in the fair value below the carrying value of our investment in the Dock 72 unconsolidated joint venture (See Note 6 to the Consolidated Financial Statements).(2)The gain on sale of investment in unconsolidated joint venture consists of the gain on sale of a 31% interest in Metropolitan Square. We continue to own a 20% interest in the joint venture.(3)Consists of the portion of income from unconsolidated joint ventures related to the gain on sale of real estate associated with the sale of Annapolis Junction Building Eight and two land parcels for the year ended December 31, 2020, 540 Madison Avenue for the year ended December 31, 2019 and the gain on the distribution of Annapolis Junction Building One for the year ended December 31, 2018.103Table of ContentsReconciliation to Diluted Funds from Operations: Year ended December 31, 20202019201820172016(in thousands) Income(Numerator)Shares/Units(Denominator)Income(Numerator)Shares/Units(Denominator)Income(Numerator)Shares/Units(Denominator)Income(Numerator)Shares/Units(Denominator)Income(Numerator)Shares/Units(Denominator)Basic Funds from Operations$1,086,501 172,643 $1,209,601 172,200 $1,084,827 171,912 $1,068,119 171,661 $1,034,251 171,361 Effect of Dilutive Securities:Stock based compensation— 85 — 301 — 255 — 200 — 262 Diluted Funds from Operations$1,086,501 172,728 $1,209,601 172,501 $1,084,827 172,167 $1,068,119 171,861 $1,034,251 171,623 Less: Noncontrolling interest—common units of the Operating Partnership’s share of diluted Funds from Operations108,256 17,211 123,541 17,618 110,175 17,485 108,580 17,471 106,341 17,646 Diluted Funds from Operations attributable to Boston Properties, Inc. (1)$978,245 155,517 $1,086,060 154,883 $974,652 154,682 $959,539 154,390 $927,910 153,977 _______________(1)BXP’s share of diluted Funds from Operations was 90.04%, 89.79%, 89.84%, 89.83% and 89.72% for the years ended December 31, 2020, 2019, 2018, 2017 and 2016, respectively.104Table of ContentsBoston Properties Limited PartnershipThe following table presents a reconciliation of net income attributable to Boston Properties Limited Partnership common unitholders to FFO attributable to Boston Properties Limited Partnership common unitholders for the years ended December 31, 2020, 2019, 2018, 2017 and 2016: Year ended December 31, 20202019201820172016 (in thousands)Net income attributable to Boston Properties Limited Partnership common unitholders$979,979 $580,102 $656,903 $512,866 $575,341 Add:Preferred distributions10,500 10,500 10,500 10,500 10,500 Noncontrolling interests in property partnerships48,260 71,120 62,909 47,832 (2,068)Net income1,038,739 661,722 730,312 571,198 583,773 Add:Depreciation and amortization 676,666 669,956 637,891 609,407 682,776 Noncontrolling interests in property partnerships’ share of depreciation and amortization(71,850)(71,389)(73,880)(78,190)(107,087)BXP’s share of depreciation and amortization from unconsolidated joint ventures80,925 58,451 54,352 34,262 26,934 Corporate-related depreciation and amortization(1,840)(1,695)(1,634)(1,986)(1,568)Impairment loss on investment in unconsolidated joint venture (1)60,524 — — — — Impairment loss— 22,272 10,181 — — Less:Gain on sale of investment in unconsolidated joint venture (2)— — — — 59,370 Gain on sale of real estate included within (loss) income from unconsolidated joint ventures (3)5,958 47,238 8,270 — — Gains on sales of real estate631,945 858 190,716 8,240 82,775 Noncontrolling interests in property partnerships48,260 71,120 62,909 47,832 (2,068)Preferred distributions10,500 10,500 10,500 10,500 10,500 Funds from Operations attributable to Boston Properties Limited Partnership common unitholders (4)1,086,501 1,209,601 1,084,827 1,068,119 1,034,251 Weighted average shares outstanding—basic172,643 172,200 171,912 171,661 171,361 _______________(1)The impairment loss on investment in unconsolidated joint venture consists of an other-than-temporary decline in the fair value below the carrying value of our investment in the Dock 72 unconsolidated joint venture (See Note 6 to the Consolidated Financial Statements).(2)The gain on sale of investment in unconsolidated joint venture consists of the gain on sale of a 31% interest in Metropolitan Square. We continue to own a 20% interest in the joint venture.(3)Consists of the portion of income from unconsolidated joint ventures related to the gain on sale of real estate associated with the sale of Annapolis Junction Building Eight and two land parcels for the year ended December 31, 2020, 540 Madison Avenue for the year ended December 31, 2019 and the gain on the distribution of Annapolis Junction Building One for the year ended December 31, 2018.(4)Our calculation includes OP Units and vested LTIP Units (including vested 2012 OPP Units and vested 2013 - 2017 MYLTIP Units).105Table of ContentsReconciliation to Diluted Funds from Operations: Year ended December 31, 20202019201820172016(in thousands) Income(Numerator)Shares/Units(Denominator)Income(Numerator)Shares/Units(Denominator)Income(Numerator)Shares/Units(Denominator)Income(Numerator)Shares/Units(Denominator)Income(Numerator)Shares/Units(Denominator)Basic Funds from Operations$1,086,501 172,643 $1,209,601 172,200 $1,084,827 171,912 $1,068,119 171,661 $1,034,251 171,361 Effect of Dilutive Securities:Stock based compensation— 85 — 301 — 255 — 200 — 262 Diluted Funds from Operations $1,086,501 172,728 $1,209,601 172,501 $1,084,827 172,167 $1,068,119 171,861 $1,034,251 171,623 106Table of ContentsContractual Obligations As of December 31, 2020, we were subject to contractual payment obligations as described in the table below. Payments Due by Period Total20212022202320242025Thereafter (in thousands)Contractual Obligations:Long-term debtMortgage debt (1)$3,479,254 $125,811 $703,301 $78,890 $78,890 $78,890 $2,413,472 Unsecured senior notes (1)11,603,243 1,174,281 306,750 1,773,969 932,675 1,049,943 6,365,625 Unsecured line of credit / term loan (1) (2)507,188 5,500 501,688 — — — — Operating leases 620,605 25,092 18,020 10,262 9,277 9,476 548,478 Tenant obligations (3)587,789 450,885 97,372 34,286 4,264 739 243 Construction contracts on development projects904,978 525,405 323,511 53,357 2,705 — — Finance leases (4)1,457,469 5,896 10,206 9,701 48,518 9,971 1,373,177 Other obligations 11,939 10,756 112 112 112 114 733 Total Contractual Obligations$19,172,465 $2,323,626 $1,960,960 $1,960,577 $1,076,441 $1,149,133 $10,701,728 _______________(1)Amounts include principal and interest payments.(2)Interest payments are calculated using the December 31, 2020 interest rate of 1.10%.(3)Committed tenant-related obligations based on executed leases as of December 31, 2020 (tenant improvements and lease commissions).(4)Finance lease payments in 2024 include approximately $38.7 million related to a purchase option that we are reasonably certain we will exercise. We have various service contracts with vendors related to our property management. In addition, we have certain other contracts we enter into in the ordinary course of business that may extend beyond one year. These contracts include terms that provide for cancellation with insignificant or no cancellation penalties. Contract terms are generally between three and five years. During 2020, we paid approximately $314.2 million to fund tenant-related obligations, including tenant improvements and leasing commissions. In addition, we and our unconsolidated joint venture partners incurred approximately $248 million of new tenant-related obligations associated with approximately 3.7 million square feet of second generation leases, which included approximately 340,000 square feet of lease modifications related to COVID-19, or approximately $66 per square foot. In addition, we signed leases for approximately 276,000 square feet at our development properties. The tenant-related obligations for the development properties are included within the projects’ “Estimated Total Investment” referred to in “Item 7—Management’s Discussion and Analysis of Financial Condition and Results of Operations—Liquidity and Capital Resources.” In the aggregate, during 2020, we signed leases for approximately 4.0 million square feet of space, including approximately 340,000 square feet of lease modifications related to COVID-19, and incurred aggregate tenant-related obligations of approximately $293 million, or approximately $72 per square foot.Off-Balance Sheet Arrangements—Joint Venture IndebtednessWe have investments in unconsolidated joint ventures with our effective ownership interests ranging from 20% to 60%. Fourteen of these ventures have mortgage indebtedness. We exercise significant influence over, but do not control, these entities. As a result, we account for them using the equity method of accounting. See also Note 6 to the Consolidated Financial Statements. At December 31, 2020, the aggregate carrying amount of debt, including both our and our partners’ share, incurred by these ventures was approximately $2.6 billion (of which our proportionate share is approximately $1.2 billion). The table below summarizes the outstanding debt of these joint venture properties at December 31, 2020. In addition to other guarantees specifically noted in the table, we have 107Table of Contentsagreed to customary environmental indemnifications and nonrecourse carve-outs (e.g., guarantees against fraud, misrepresentation and bankruptcy) as well as the completion of development projects on certain of the loans. PropertiesVenture Ownership %Stated Interest RateGAAP Interest Rate (1)Stated Principal AmountDeferred Financing Costs, NetCarrying AmountCarrying Amount (Our share) Maturity Date (dollars in thousands)Santa Monica Business Park55 %4.06 %4.24 %$300,000 $(2,394)$297,606 $163,683 (2)(3)July 19, 2025Market Square North50 %2.80 %2.96 %125,000 (1,003)123,997 61,999 (4)November 10, 2025Annapolis Junction Building Six50 %2.71 %3.12 %11,996 (51)11,945 5,972 (5)November 16, 2021Annapolis Junction Building Seven50 %2.60 %2.95 %18,420 (15)18,405 9,203 (6)March 25, 20211265 Main Street50 %3.77 %3.84 %37,334 (306)37,028 18,514 January 1, 2032Colorado Center50 %3.56 %3.58 %550,000 (679)549,321 274,660 (2)August 9, 2027Dock 7250 %2.63 %2.85 %196,412 (1,630)194,782 97,391 (2)(7)December 18, 2023The Hub on Causeway - Podium50 %2.40 %2.89 %174,329 (687)173,642 86,821 (2)(8)September 6, 2021Hub50House50 %2.15 %2.43 %171,249 (680)170,569 85,284 (2)(9)April 19, 2022100 Causeway Street50 %1.65 %1.86 %216,575 (2,259)214,316 107,158 (2)(10)September 5, 20237750 Wisconsin Avenue (Marriott International Headquarters)50 %1.40 %1.94 %163,863 (3,249)160,614 80,307 (2)(11)April 26, 2023500 North Capitol Street, NW30 %4.15 %4.20 %105,000 (143)104,857 31,457 (2)June 6, 2023901 New York Avenue25 %3.61 %3.69 %221,121 (715)220,406 55,102 January 5, 20253 Hudson Boulevard25 %3.64 %3.72 %80,000 (160)79,840 19,960 (2)(12)July 13, 2023Metropolitan Square20 %5.40 %6.90 %288,000 (7,417)280,583 56,117 (2)(13)July 7, 2022Total$2,659,299 $(21,388)$2,637,911 $1,153,628 _______________(1)GAAP interest rate differs from the stated interest rate due to the inclusion of the amortization of financing charges, which includes mortgage recording fees.(2)The loan requires interest only payments with a balloon payment due at maturity.(3)The loan bears interest at a variable rate equal to LIBOR plus 1.28% per annum and matures on July 19, 2025. A subsidiary of the joint venture entered into interest rate swap contracts with notional amounts aggregating $300.0 million through April 1, 2025, resulting in a fixed rate of approximately 4.063% per annum through the expiration of the interest rate swap contracts.(4)The loan bears interest at a variable rate equal to (1) the greater of (x) LIBOR or (y) 0.50%, plus (2) 2.30% per annum and matures on November 10, 2025, with one, one-year extension option, subject to certain conditions.(5)The loan bears interest at a variable rate equal to (1) the greater of (x) LIBOR or (y) 0.50%, plus (2) 2.50% per annum and matures on November 16, 2021.(6)The loan bears interest at a variable rate equal to LIBOR plus 2.35% per annum and matures on March 25, 2021. (7)The construction financing has a borrowing capacity of $250.0 million. The construction financing bears interest at a variable rate equal to (1) the greater of (x) LIBOR or (y) 0.25%, plus (2) 2.85% per annum and matures on December 18, 2023.(8)The construction financing had a borrowing capacity of $204.6 million. On September 16, 2019, the joint venture paid down the construction loan principal balance in the amount of approximately $28.8 million, reducing the borrowing capacity to $175.8 million. The construction financing bears interest at a variable rate equal to LIBOR plus 2.25% per annum and matures on September 6, 2021, with two, one-year extension options, subject to certain conditions. (9)The construction financing has a borrowing capacity of $180.0 million. The construction financing bears interest at a variable rate equal to LIBOR plus 2.00% per annum and matures on April 19, 2022, with two, one-year extension options, subject to certain conditions.(10)The construction financing has a borrowing capacity of $400.0 million. The construction financing bears interest at a variable rate equal to LIBOR plus 1.50% per annum (LIBOR plus 1.375% per annum upon 108Table of Contentsstabilization, as defined in the loan agreement) and matures on September 5, 2023, with two, one-year extension options, subject to certain conditions. (11)The construction financing has a borrowing capacity of $255.0 million. The construction financing bears interest at a variable rate equal to LIBOR plus 1.25% per annum and matures on April 26, 2023, with two, one-year extension options, subject to certain conditions.(12)We provided $80.0 million of mortgage financing to the joint venture. The loan bears interest at a variable rate equal to LIBOR plus 3.50% per annum and matures on July 13, 2023, with extension options, subject to certain conditions. The loan has been reflected as Related Party Note Receivable, Net on our Consolidated Balance Sheets.(13)The loan bears interest at a variable rate equal to (1) the greater of (x) LIBOR or (y) 0.65%, plus (2) 4.75% per annum and matures on July 7, 2022 with two, one-year extension options, subject to certain conditions. The joint venture entered into an interest rate cap agreement with a financial institution to limit its exposure to increases in the LIBOR rate at a cap of 3.00% per annum on a notional amount of $325.0 million through July 7, 2022.Off-Balance Sheet Arrangements—Joint Venture Contractual ObligationsAs of December 31, 2020, we were subject to contractual payment obligations as described in the table below. The table represents our share of the contractual obligations. Payments Due by Period Total20212022202320242025Thereafter (in thousands)Contractual Obligations:Operating leases (1)$97,051 $587 $838 $849 $861 $896 $93,020 Tenant obligations (2)21,724 11,094 6,098 — — — 4,532 Construction contracts on development projects181,357 100,678 43,164 1,421 36,094 — — Finance leases (3)270,366 9,945 9,945 10,894 10,980 10,980 217,622 Total Contractual Obligations$570,498 $122,304 $60,045 $13,164 $47,935 $11,876 $315,174 _______________(1)Operating leases include approximately $61.7 million related to renewal options that the joint venture is reasonably certain it will exercise.(2)Committed tenant-related obligations based on executed leases as of December 31, 2020 (tenant improvements and lease commissions).(3)Finance leases include approximately $194.7 million related to a purchase option that the joint venture is reasonably certain it will exercise in 2028. New Accounting PronouncementsFor a discussion of the new accounting pronouncements that may have an effect on our Consolidated Financial Statements (See Note 2 to the Consolidated Financial Statements). Inflation Most of our leases provide for separate real estate tax and operating expense escalations over a base amount. In addition, many of our leases provide for fixed base rent increases or indexed increases. We believe that inflationary increases in costs may be at least partially offset by the contractual rent increases and operating expense escalations.109Table of ContentsItem 7A—Quantitative and Qualitative Disclosures about Market Risk.The following table presents the aggregate carrying value of our mortgage notes payable, net, unsecured senior notes, net, unsecured line of credit, unsecured term loan, net and our corresponding estimate of fair value as of December 31, 2020. As of December 31, 2020, approximately $12.5 billion of these borrowings bore interest at fixed rates and therefore the fair value of these instruments is affected by changes in the market interest rates. As of December 31, 2020, the weighted-average interest rate on our variable rate debt was LIBOR plus 0.95% (1.10%) per annum. The following table presents our aggregate fixed rate debt obligations with corresponding weighted-average interest rates sorted by maturity date and our aggregate variable rate debt obligations sorted by maturity date. The table below does not include our unconsolidated joint venture debt. For a discussion concerning our unconsolidated joint venture debt, see Note 6 to the Consolidated Financial Statements and “Item 7—Management’s Discussion and Analysis of Financial Condition and Results of Operations—Capitalization—Off-Balance Sheet Arrangements—Joint Venture Indebtedness.”202120222023202420252026+TotalEstimatedFair Value(dollars in thousands)Mortgage debt, netFixed Rate$13,440 $611,132 $(3,494)$(3,494)$(3,494)$2,294,991 $2,909,081 $3,144,150 GAAP Average Interest Rate4.99 %4.79 %— %— %— %3.64 %3.89 %Variable Rate— — — — — — — — Unsecured debt, netFixed Rate$839,355 $(10,189)$1,490,888 $692,161 $843,439 $5,783,633 $9,639,287 $10,620,527 GAAP Average Interest Rate4.29 %— %3.73 %3.92 %3.35 %3.64 %3.71 %Variable Rate(460)499,850 — — — — 499,390 500,326 Total Debt$852,335 $1,100,793 $1,487,394 $688,667 $839,945 $8,078,624 $13,047,758 $14,265,003 On February 14, 2021, BPLP completed the redemption of $850.0 million in aggregate principal amount of its 4.125% senior notes due May 15, 2021. The redemption price was approximately $858.7 million, which was equal to par plus approximately $8.7 million of accrued and unpaid interest to, but not including, the redemption date. At December 31, 2020, the weighted-average coupon/stated rates on the fixed rate debt stated above was 3.65% per annum. At December 31, 2020, our outstanding variable rate debt based on LIBOR totaled approximately $500.0 million. At December 31, 2020, the coupon/stated rate on our variable rate debt was approximately 1.10% per annum. If market interest rates on our variable rate debt had been 100 basis points greater, total interest expense would have increased approximately $5.0 million for the year ended December 31, 2020. The fair value amounts were determined solely by considering the impact of hypothetical interest rates on our financial instruments. Due to the uncertainty of specific actions we may undertake to minimize possible effects of market interest rate increases, this analysis assumes no changes in our financial structure.Due to the uncertainty of specific actions we may undertake to minimize possible effects of market interest rate increases, this analysis assumes no changes in our financial structure. In the event that LIBOR is discontinued, the interest rate for our variable rate debt and our unconsolidated joint ventures’ variable rate debt and the swap rate for our unconsolidated joint ventures’ interest rate swaps following such event will be based on an alternative variable rate as specified in the applicable documentation governing such debt or swaps or as otherwise agreed upon. Such an event would not affect our ability to borrow or maintain already outstanding borrowings or our unconsolidated joint ventures’ ability to maintain its outstanding swaps, but the alternative variable rate could be higher and more volatile than LIBOR prior to its discontinuance. We understand that LIBOR is expected to remain available through the end of 2021, but may be discontinued or otherwise become unavailable thereafter.Additional disclosure about market risk is incorporated herein by reference from “Item 7—Management’s Discussion and Analysis of Financial Condition and Results of Operations—Liquidity and Capital Resources—Market Risk.”110Table of Contents
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+ITEM 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations. General Impact of COVID-19 The coronavirus pandemic (“COVID-19”) and the resulting economic disruption are impacting and will likely continue to impact business activity across many industries worldwide. COVID-19 remains dynamic, with uncertainty around its duration and broader impact. We are monitoring and assessing the situation and will continue to adapt our business practices over the coming quarters to serve our customers and protect our employees. The pandemic has reduced, and is expected to continue to negatively impact, the volume of business from new customers and insurable exposure units for existing customers. Company Overview The following discussion should be read in conjunction with our Consolidated Financial Statements and the related Notes to those Financial Statements included elsewhere in this Annual Report on Form 10-K. In addition, please see “Information Regarding Non-GAAP Measures” below, regarding important information on non-GAAP financial measures contained in our discussion and analysis. We are a diversified insurance agency, wholesale brokerage, insurance programs and services organization headquartered in Daytona Beach, Florida. As an insurance intermediary, our principal sources of revenue are commissions paid by insurance companies and, to a lesser extent, fees paid directly by customers. Commission revenues generally represent a percentage of the premium paid by an insured and are affected by fluctuations in both premium rate levels charged by insurance companies and the insureds’ underlying “insurable exposure units,” which are units that insurance companies use to measure or express insurance exposed to risk (such as property values, or sales and payroll levels) to determine what premium to charge the insured. Insurance companies establish these premium rates based upon many factors, including loss experience, risk profile and reinsurance rates paid by such insurance companies, none of which we control. We have increased revenues every year from 1993 to 2020, with the exception of 2009, when our revenues declined 1.0%. Our revenues grew from $95.6 million in 1993 to $2.6 billion in 2020, reflecting a compound annual growth rate of 13.0%. In the same 27-year period, we increased net income from $8.1 million to $480.5 million in 2020, a compound annual growth rate of 16.3%. The volume of business from new and existing customers, fluctuations in insurable exposure units, changes in premium rate levels, changes in general economic and competitive conditions, a health pandemic, and the occurrence of catastrophic weather events all affect our revenues. For example, level rates of inflation or a general decline in economic activity could limit increases in the values of insurable exposure units. Conversely, increasing costs of litigation settlements and awards could cause some customers to seek higher levels of insurance coverage. Historically, our revenues have typically grown as a result of our focus on net new business growth and acquisitions. We foster a strong, decentralized sales and service culture with the goal of consistent, sustained growth over the long-term. The term “Organic Revenue,” a non-GAAP measure, is our core commissions and fees less: (i) the core commissions and fees earned for the first 12 months by newly-acquired operations; and (ii) divested business (core commissions and fees generated from offices, books of business or niches sold or terminated during the comparable period). The term “core commissions and fees” excludes profit-sharing contingent commissions and guaranteed supplemental commissions, and therefore represents the revenues earned directly from specific insurance policies sold, and specific fee-based services rendered. “Organic Revenue” is reported in this manner in order to express the current year’s core commissions and fees on a comparable basis with the prior year’s core commissions and fees. The resulting net change reflects the aggregate changes attributable to: (i) net new and lost accounts; (ii) net changes in our customers’ exposure units; (iii) net changes in insurance premium rates or the commission rate paid to us by our carrier partners; and (iv) the net change in fees paid to us by our customers. Organic Revenue is reported in “Results of Operations” and in “Results of Operations – Segment Information” of this Annual Report on Form 10-K. We also earn “profit-sharing contingent commissions,” which are commissions based primarily on underwriting results, but which may also reflect considerations for volume, growth and/or retention. These commissions, which are included in our commissions and fees in the Consolidated Statement of Income, are accrued throughout the year based on actual premiums written and are primarily received in the first and second quarters of each subsequent year, based upon the aforementioned considerations for the prior year(s). Over the last three years, profit-sharing contingent commissions have averaged approximately 3.0% of commissions and fees revenue. Certain insurance companies offer guaranteed fixed-base agreements, referred to as “Guaranteed Supplemental Commissions” (“GSCs”) in lieu of profit-sharing contingent commissions. GSCs are accrued throughout the year based upon actual premiums written. For the year ended December 31, 2020, we had earned $16.2 million of GSCs, of which $11.9 million remained accrued at December 31, 2020 and most of this will be collected over the first and second quarters of 2021. For the years ended December 31, 2020 and 2019, we earned $16.2 million and $23.1 million, respectively, from GSCs. Combined, our profit-sharing contingent commissions and GSCs for the year ended December 31, 2020 increased by $4.9 million over 2019. The net increase of $4.9 million was mainly driven by: (i) cash received for profit-sharing contingent commissions in the first and second quarters of 2020 being somewhat higher than the amount accrued as of December 31, 2019 for the estimate of contingents earned in 2019; (ii) growth associated with acquisitions completed over the last twelve months; and (iii) partially offset by a GSC of approximately $9 million recorded in the second quarter of 2019 for the National Programs Segment that will not recur in the future as the associated multi-year contract has ended. 25 Table of Contents Fee revenues primarily relate to services other than securing coverage for our customers, as well as fees negotiated in lieu of commissions, and are recognized as performance obligations are satisfied. Fee revenues have historically been generated primarily by: (1) our Services Segment, which provides insurance-related services, including third-party claims administration and comprehensive medical utilization management services in both the workers’ compensation and all-lines liability arenas, as well as Medicare Set-aside services, Social Security disability and Medicare benefits advocacy services, and claims adjusting services; (2) our National Programs and Wholesale Brokerage Segments, which earn fees primarily for the issuance of insurance policies on behalf of insurance companies; and to a lesser extent (3) our Retail Segment in our large-account customer base, where we primarily earn fees for securing insurance for our customers, and in our automobile dealer services (“F&I”) businesses where we primarily earn fees for assisting our customers with creating and selling warranty and service risk management programs. Fee revenues as a percentage of our total commissions and fees, represented 26.1% in 2020 and 27.1% in 2019. For the years ended December 31, 2020 and 2019, our commissions and fees growth rate was 9.3% and 18.7%, respectively, and our consolidated Organic Revenue growth rate was 3.8% and 3.6%, respectively. Historically, investment income has consisted primarily of interest earnings on operating cash, and where permitted, on premiums and advance premiums collected and held in a fiduciary capacity before being remitted to insurance companies. Our policy is to invest available funds in high-quality, short-term fixed income investment securities. Investment income also includes gains and losses realized from the sale of investments. Other income primarily reflects legal settlements and other miscellaneous income. Income before income taxes for the year ended December 31, 2020 increased over 2019 by $98.2 million, primarily as a result of net new business, acquisitions we completed since 2019, and management of our expense base. Information Regarding Non-GAAP Measures In the discussion and analysis of our results of operations, in addition to reporting financial results in accordance with generally accepted accounting principles (“GAAP”), we provide references to the following non-GAAP financial measures as defined in Regulation G of SEC rules: Organic Revenue, Organic Revenue growth, EBITDAC and EBITDAC Margin. We view these non-GAAP financial measures as important indicators when assessing and evaluating our performance on a consolidated basis and for each of our segments because they allow us to determine a more comparable, but non-GAAP, measurement of revenue growth and operating performance that is associated with the revenue sources that were a part of our business in both the current and prior year. We believe that Organic Revenue provides a meaningful representation of our operating performance and view Organic Revenue growth as an important indicator when assessing and evaluating the performance of our four segments. Organic Revenue can be expressed as a dollar amount or a percentage rate when describing Organic Revenue growth. We also use Organic Revenue growth and EBITDAC Margin for incentive compensation determinations for executive officers and other key employees. We view EBITDAC and EBITDAC Margin as important indicators of operating performance, because they allow us to determine more comparable, but non-GAAP, measurements of our operating margins in a meaningful and consistent manner by removing the significant non-cash items of depreciation, amortization and the change in estimated acquisition earn-out payables, and also interest expense and taxes, which are reflective of investment and financing activities, not operating performance. These measures are not in accordance with, or an alternative to the GAAP information provided in this Annual Report on Form 10-K. We present such non-GAAP supplemental financial information because we believe such information is of interest to the investment community and because we believe they provide additional meaningful methods of evaluating certain aspects of our operating performance from period to period on a basis that may not be otherwise apparent on a GAAP basis. We believe these non-GAAP financial measures improve the comparability of results between periods by eliminating the impact of certain items that have a high degree of variability. Our industry peers may provide similar supplemental non-GAAP information with respect to one or more of these measures, although they may not use the same or comparable terminology and may not make identical adjustments. This supplemental financial information should be considered in addition to, not in lieu of, our Consolidated Financial Statements. Tabular reconciliations of this supplemental non-GAAP financial information to our most comparable GAAP information are contained in this Annual Report on Form 10-K under “Results of Operation - Segment Information.” Acquisitions Part of our business strategy is to attract high-quality insurance intermediaries and service organizations to join our operations. From 1993 through the fourth quarter of 2020, we acquired 561 insurance intermediary operations. Critical Accounting Policies Our Consolidated Financial Statements are prepared in accordance with U.S. GAAP. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses. We continually evaluate our estimates, which are based upon historical experience and on assumptions that we believe to be reasonable under the circumstances. These estimates form the basis for our judgments about the recognition of revenues, expenses, carrying values of our assets and liabilities, of which values are not readily apparent from other sources. Actual results may differ from these estimates. 26 Table of Contents We believe that of our significant accounting and reporting policies, the more critical policies include our accounting for revenue recognition, business combinations and purchase price allocations, intangible asset impairments, non-cash stock-based compensation and reserves for litigation. In particular, the accounting for these areas requires significant use of judgment to be made by management. Different assumptions in the application of these policies could result in material changes in our consolidated financial position or consolidated results of operations. Revenue Recognition The majority of our revenue is commissions derived from our performance as agents and brokers, acting on behalf of insurance carriers to sell products to customers that are seeking to transfer risk, and conversely, acting on behalf of those customers in negotiating with insurance carriers seeking to acquire risk in exchange for premiums. In the majority of these arrangements, our performance obligation is complete upon the effective date of the bound policy, as such, that is when the associated revenue is recognized. In some arrangements, where we are compensated through commissions, we also perform other services for our customer beyond the binding of coverage. In those arrangements we apportion the commission between the binding of coverage and other services based on their relative fair value and recognize the associated revenue as those performance obligations are satisfied. Where the Company’s performance obligations have been completed, but the final amount of compensation is unknown due to variable factors, we estimate the amount of such compensation. We refine those estimates upon our receipt of additional information or final settlement, whichever occurs first. To a lesser extent, the Company earns revenues in the form of fees. Like commissions, fees paid to us in lieu of commission, are recognized upon the effective date of the bound policy. When we are paid a fee for service, however, the associated revenue is recognized over a period of time that coincides with when the customer simultaneously receives and consumes the benefit of our work, which characterizes most of our claims processing arrangements and various services performed in our property and casualty, and employee benefits practices. Other fees are typically recognized upon the completion of the delivery of the agreed-upon services to the customer. Management determines a policy cancellation reserve based upon historical cancellation experience adjusted in accordance with known circumstances. Please see Note 2 “Revenues” in the “Notes to Consolidated Financial Statements” for additional information regarding the nature and timing of our revenues. Business Combinations and Purchase Price Allocations We have acquired significant intangible assets through acquisitions of businesses. These assets generally consist of purchased customer accounts, non-compete agreements, and the excess of purchase prices over the fair value of identifiable net assets acquired (goodwill). The determination of estimated useful lives and the allocation of purchase price to intangible assets requires significant judgment and affects the amount of future amortization and possible impairment charges. Our business combinations are accounted for using the acquisition method. In connection with these acquisitions, we record the estimated value of the net tangible assets purchased and the value of the identifiable intangible assets purchased, which typically consist of purchased customer accounts and non-compete agreements. Purchased customer accounts include the physical records and files obtained from acquired businesses that contain information about insurance policies, customers and other matters essential to policy renewals of delivery of services. However, they primarily represent the present value of the underlying cash flows expected to be received over the estimated future renewal periods of the insurance policies comprising those purchased customer accounts. The valuation of purchased customer accounts involves significant estimates and assumptions concerning matters such as cancellation frequency, expenses and discount rates. Any change in these assumptions could affect the carrying value of purchased customer accounts. Non-compete agreements are valued based upon their duration and any unique features of the particular agreements. Purchased customer accounts and non-compete agreements are amortized on a straight-line basis over the related estimated lives and contract periods, which range from 3 to 15 years. The excess of the purchase price of an acquisition over the fair value of the identifiable tangible and intangible assets is assigned to goodwill and is not amortized. Acquisition purchase prices are typically based upon a multiple of average EBITDA, annual operating profit and/or core revenue earned over a one to three-year period within a minimum and maximum price range. The recorded purchase prices for all acquisitions include an estimation of the fair value of liabilities associated with any potential earn-out provisions, where an earn-out is part of the negotiated transaction. Subsequent changes in the fair value of earn-out obligations are recorded in the Consolidated Statement of Income when changes to the expected performance of the associated business are realized. 27 Table of Contents The fair value of earn-out obligations is based upon the present value of the expected future payments to be made to the sellers of the acquired businesses in accordance with the provisions contained in the respective purchase agreements. In determining fair value, the acquired business’s future performance is estimated using financial projections developed by management for the acquired business, and this estimate reflects market participant assumptions regarding revenue growth and/or profitability. The expected future payments are estimated based on the earn-out formula and performance targets specified in each purchase agreement compared to the associated financial projections. These estimates are then discounted to a present value using a risk-adjusted rate that takes into consideration the likelihood that the forecasted earn-out payments will be made. Intangible Assets Impairment Goodwill is subject to at least an annual assessment for impairment measured by a fair-value-based test. Amortizable intangible assets are amortized over their useful lives and are subject to an impairment review based upon an estimate of the undiscounted future cash flows resulting from the use of the assets. To determine if there is potential impairment of goodwill, we compare the fair value of each reporting unit with its carrying value. If the fair value of the reporting unit is less than its carrying value, an impairment loss would be recorded to the extent that the fair value of the goodwill within the reporting unit is less than its carrying value. Fair value is estimated based upon multiples of earnings before interest, income taxes, depreciation, amortization and change in estimated acquisition earn-out payables (“EBITDAC”), or on a discounted cash flow basis. Management assesses the recoverability of our goodwill and our amortizable intangibles and other long-lived assets annually and whenever events or changes in circumstances indicate that the carrying value of such assets may not be recoverable. Any of the following factors, if present, may trigger an impairment review: (i) a significant underperformance relative to historical or projected future operating results, (ii) a significant negative industry or economic trend, and (iii) a significant decline in our market capitalization. If the recoverability of these assets is unlikely because of the existence of one or more of the above-referenced factors, an impairment analysis is performed. Management must make assumptions regarding estimated future cash flows and other factors to determine the fair value of these assets. If these estimates or related assumptions change in the future, we may be required to revise the assessment and, if appropriate, record an impairment charge. We completed our most recent evaluation of impairment for goodwill as of November 30, 2020 and determined that the fair value of goodwill exceeded the carrying value of such assets. Additionally, there have been no impairments recorded for amortizable intangible assets for the years ended December 31, 2020 and 2019. Non-Cash Stock-Based Compensation We grant non-vested stock awards to our employees, with the related compensation expense recognized in the financial statements over the associated service period based upon the grant-date fair value of those awards. During the performance measurement period, we review the probable outcome of the performance conditions associated with our performance awards and align the expense accruals with the expected performance outcome. During the first quarter of 2020, the performance conditions for 1,880,512 shares of the Company’s common stock granted under the Company’s 2010 SIP were determined by the Compensation Committee to have been satisfied relative to performance-based grants issued in 2015 and 2017. These grants had a performance measurement period that concluded on December 31, 2019. The vesting condition for these grants requires continuous employment for a period of up to seven years from the 2015 grant date and five years from the 2017 grant date in order for the awarded shares to become fully vested and nonforfeitable. As a result of the awarding of these shares, the grantees will be eligible to receive payments of dividends and exercise voting privileges after the awarding date, and the awarded shares will be included as issued and outstanding common stock shares and included in the calculation of basic and diluted net income per share. During the first quarter of 2021, the performance conditions for approximately 1.2 million shares of the Company’s common stock granted under the Company’s 2010 SIP and approximately 22,000 shares of the Company’s common stock granted under the Company’s 2019 SIP were determined by the Compensation Committee to have been satisfied relative to performance-based grants issued in 2018 and 2020. These grants had a performance measurement period that concluded on December 31, 2020. The vesting condition for these grants requires continuous employment for a period of up to five years from the 2018 grant date and four years from the 2020 grant date in order for the awarded shares to become fully vested and nonforfeitable. As a result of the awarding of these shares, the grantees will be eligible to receive payments of dividends and exercise voting privileges after the awarding date, and the awarded shares will be included as issued and outstanding common stock shares and included in the calculation of basic and diluted net income per share. Litigation and Claims We are subject to numerous litigation claims that arise in the ordinary course of business. If it is probable that a liability has been incurred at the date of the financial statements and the amount of the loss is estimable, an accrual for the costs to resolve these claims is recorded in accrued expenses in the accompanying Consolidated Financial Statements. Professional fees related to these claims are included in other operating expenses in the accompanying Consolidated Statement of Income as incurred. Management, with the assistance of in-house and outside counsel, determines whether it is probable that a liability has been incurred and estimates the amount of loss based upon analysis of individual issues. New developments or changes in settlement strategy in dealing with these matters may significantly affect the required reserves and affect our net income. 28 Table of Contents RESULTS OF OPERATIONS FOR THE YEARS ENDED DECEMBER 31, 2020 AND 2019 The following discussion and analysis regarding results of operations and liquidity and capital resources should be considered in conjunction with the accompanying Consolidated Financial Statements and related Notes. For a comparison of our results of operations and liquidity and capital resources for the years ended December 31, 2019 and 2018, please see Part II, Item 7 of our Annual Report on Form 10-K filed with the SEC on February 24, 2020. Financial information relating to our Consolidated Financial Results is as follows: (in thousands, except percentages) 2020 % Change 2019 REVENUES Core commissions and fees $ 2,518,980 9.4 % $ 2,302,506 Profit-sharing contingent commissions 70,934 19.9 % 59,166 Guaranteed supplemental commissions 16,194 (29.8 )% 23,065 Total commissions and fees 2,606,108 9.3 % 2,384,737 Investment income 2,811 (51.4 )% 5,780 Other income, net 4,456 169.4 % 1,654 Total revenues 2,613,375 9.2 % 2,392,171 EXPENSES Employee compensation and benefits 1,436,377 9.8 % 1,308,165 Other operating expenses 365,973 (2.9 )% 377,089 (Gain)/loss on disposal (2,388 ) (76.2 )% (10,021 ) Amortization 108,523 3.1 % 105,298 Depreciation 26,276 12.2 % 23,417 Interest 58,973 (7.4 )% 63,660 Change in estimated acquisition earn-out payables (4,458 ) NMF (1,366 ) Total expenses 1,989,276 6.6 % 1,866,242 Income before income taxes 624,099 18.7 % 525,929 Income taxes 143,616 12.7 % 127,415 NET INCOME $ 480,483 20.6 % $ 398,514 Income Before Income Taxes Margin (1) 23.9 % 22.0 % EBITDAC (2) $ 813,413 13.5 % $ 716,938 EBITDAC Margin (2) 31.1 % 30.0 % Organic Revenue growth rate (2) 3.8 % 3.6 % Employee compensation and benefits relative to total revenues 55.0 % 54.7 % Other operating expenses relative to total revenues 14.0 % 15.8 % Capital expenditures $ 70,700 (3.3 )% $ 73,108 Total assets at December 31 $ 8,966,492 17.6 % $ 7,622,821 (1) “Income Before Income Taxes Margin” is defined as income before income taxes divided by total revenues (2) A non-GAAP measure NMF = Not a meaningful figure Commissions and Fees Commissions and fees, including profit-sharing contingent commissions and GSCs for 2020, increased $221.4 million to $2,606.1 million, or 9.3% over 2019. Core commissions and fees in 2020 increased $216.5 million, composed of (i) $141.1 million from acquisitions that had no comparable revenues in the same period of 2019; (ii) an offsetting decrease of $12.1 million related to commissions and fees revenue from business divested in the preceding twelve months; and (iii) approximately $87.5 million of net new and renewal business, which reflects an Organic Revenue growth rate of 3.8%. Profit-sharing contingent commissions and GSCs for 2020 increased by $4.9 million, or 6.0%, compared to the same period in 2019. The net increase of $4.9 million was mainly driven by: (i) cash received for profit-sharing contingent commissions in the first and second quarters of 2020 being somewhat higher than the amount accrued as of December 31, 2019 for the estimate of contingents earned in 2019; (ii) growth associated with acquisitions completed over the last twelve months; and (iii) partially offset by a GSC of approximately $9 million recorded in the second quarter of 2019 for the National Programs Segment that will not recur in the future as the associated multi-year contract ended in 2019. 29 Table of Contents Investment Income Investment income decreased to $2.8 million in 2020, compared with $5.8 million in 2019. The decrease was primarily due to lower interest rates as compared to the prior year. Other Income, Net Other income for 2020 was $4.5 million, compared with $1.7 million in 2019. Other income consists primarily of legal settlements and other miscellaneous income. Employee Compensation and Benefits Employee compensation and benefits expense increased 9.8%, or $128.2 million, in 2020 compared to 2019. This increase included $48.0 million of compensation costs related to stand-alone acquisitions that had no comparable costs in the same period of 2019. Therefore, employee compensation and benefits expense attributable to those offices that existed in the same time periods of 2020 and 2019 increased by $80.2 million or 6.2%. This underlying employee compensation and benefits expense increase was primarily related to (i) an increase in staff salaries attributable to salary inflation; (ii) an increase in non-cash stock-based compensation expense; (iii) increased producer compensation due to higher revenue; and (iv) higher accrued performance bonuses. Employee compensation and benefits expense as a percentage of total revenues was 55.0% for 2020 as compared to 54.7% for the year ended December 31, 2019. Other Operating Expenses Other operating expenses represented 14.0% of total revenues for 2020 as compared to 15.8% for the year ended December 31, 2019. Other operating expenses for 2020 decreased $11.1 million, or 2.9%, from the same period of 2019. The net decrease included: (i) lower variable operating expenses, including such items as travel & entertainment, meetings and professional fees, resulting from responses to COVID-19; partially offset by (ii) $22.6 million of other operating expenses related to stand-alone acquisitions that had no comparable costs in the same period of 2019; and (iii) the write-off recorded in 2020 of certain receivables in one of our programs where it was determined the collectability was in doubt. Gain or Loss on Disposal The Company recognized gains on disposal of $2.4 million in 2020 and $10.0 million in 2019. The change in the gain on disposal was due to activity associated with book of business sales. Although we are not in the business of selling customer accounts, we periodically sell an office or a book of business (one or more customer accounts) that we believe does not produce reasonable margins or demonstrate a potential for growth, or because doing so is in the Company’s best interest. Amortization Amortization expense for 2020 increased $3.2 million to $108.5 million, or 3.1% over 2019. The increase reflects the amortization of new intangible assets from recently acquired businesses, partially offset by certain intangible assets becoming fully amortized. Depreciation Depreciation expense for 2020 increased $2.9 million to $26.3 million, or 12.2% over 2019. Changes in depreciation expense reflect the addition of fixed assets resulting from capital projects related to our multi-year technology investment program and other business initiatives, net additions of fixed assets resulting from businesses acquired in the past 12 months, partially offset by fixed assets which became fully depreciated. Interest Expense Interest expense for 2020 decreased $4.7 million to $59.0 million, or 7.4%, from 2019. The decrease is due to the decrease in interest rates associated with our floating rate debt balances, partially offset by higher average debt balances from increased borrowings in 2020. Change in Estimated Acquisition Earn-Out Payables Accounting Standards Codification (“ASC”) Topic 805-Business Combinations is the authoritative guidance requiring an acquirer to recognize 100% of the fair value of acquired assets, including goodwill, and assumed liabilities (with only limited exceptions) upon initially obtaining control of an acquired entity. Additionally, the fair value of contingent consideration arrangements (such as earn-out purchase price arrangements) at the acquisition date must be included in the purchase price consideration. The recorded purchase price for acquisitions includes an estimation of the fair value of liabilities associated with any potential earn-out provisions. Subsequent changes in these earn-out obligations are required to be recorded in the Consolidated Statement of Income when incurred or reasonably estimated. Estimations of potential earn-out obligations are typically based upon future earnings of the acquired operations or entities, usually for periods ranging from one to three years. 30 Table of Contents The net charge or credit to the Consolidated Statement of Income for the period is the combination of the net change in the estimated acquisition earn-out payables balance, and the interest expense imputed on the outstanding balance of the estimated acquisition earn-out payables. As of December 31, 2020, the fair values of the estimated acquisition earn-out payables were re-evaluated and measured at fair value on a recurring basis using unobservable inputs (Level 3) as defined in ASC 820-Fair Value Measurement. The resulting net changes, as well as the interest expense accretion on the estimated acquisition earn-out payables, for the years ended December 31, 2020 and 2019 were as follows: (in thousands) 2020 2019 Change in fair value of estimated acquisition earn-out payables $ (11,814 ) $ (7,298 ) Interest expense accretion 7,356 5,932 Net change in earnings from estimated acquisition earn-out payables $ (4,458 ) $ (1,366 ) For the years ended December 31, 2020 and 2019, the fair value of estimated earn-out payables was re-evaluated and decreased by $11.8 million for 2020 and decreased by $7.3 million for 2019, which resulted in a credit, net of interest expense accretion, to the Consolidated Statement of Income for 2020 and 2019. As of December 31, 2020, the estimated acquisition earn-out payables equaled $258.9 million, of which $79.2 million was recorded as accounts payable and $179.7 million was recorded as other non-current liabilities. As of December 31, 2019, the estimated acquisition earn-out payables equaled $161.5 million, of which $17.9 million was recorded as accounts payable and $143.6 million was recorded as other non-current liabilities. Income Taxes The effective tax rate on income from operations was 23.0% in 2020 and 24.2% in 2019. The reduction in the effective tax rate in 2020 as compared to 2019 was primarily driven the tax benefit associated with additional vesting of stock awards in 2020 as compared to 2019. RESULTS OF OPERATIONS — SEGMENT INFORMATION As discussed in Note 17 “Segment Information” of the Notes to Consolidated Financial Statements, we operate four reportable segments: Retail, National Programs, Wholesale Brokerage and Services. On a segmented basis, changes in amortization, depreciation and interest expenses generally result from activity associated with acquisitions. Likewise, other income in each segment reflects net gains primarily from legal settlements and miscellaneous income. As such, in evaluating the operational efficiency of a segment, management focuses on the Organic Revenue growth rate of core commissions and fees, the ratio of total employee compensation and benefits to total revenues, and the ratio of other operating expenses to total revenues. The reconciliation of total commissions and fees included in the Consolidated Statements of Income to Organic Revenue, a non-GAAP financial measure, including by Segment, and the growth rates for Organic Revenue for the year ended December 31, 2020 are as follows: 2020 Retail(1) National Programs Wholesale Brokerage Services Total (in thousands, except percentages) 2020 2019 2020 2019 2020 2019 2020 2019 2020 2019 Commissions and fees $ 1,470,093 $ 1,364,755 $ 609,842 $ 516,915 $ 352,161 $ 309,426 $ 174,012 $ 193,641 $ 2,606,108 $ 2,384,737 Total change $ 105,338 $ 92,927 $ 42,735 $ (19,629 ) $ 221,371 Total growth % 7.7 % 18.0 % 13.8 % (10.1 )% 9.3 % Profit-sharing contingent commissions (35,785 ) (34,150 ) (27,278 ) (17,517 ) (7,871 ) (7,499 ) — — (70,934 ) (59,166 ) GSCs (15,128 ) (11,056 ) 238 (10,566 ) (1,304 ) (1,443 ) — — (16,194 ) (23,065 ) Core commissions and fees $ 1,419,180 $ 1,319,549 $ 582,802 $ 488,832 $ 342,986 $ 300,484 $ 174,012 $ 193,641 $ 2,518,980 $ 2,302,506 Acquisitions (79,580 ) — (34,173 ) — (25,861 ) — (1,484 ) — (141,098 ) — Dispositions — (11,772 ) — (377 ) — — — — — (12,149 ) Organic Revenue(2) $ 1,339,600 $ 1,307,777 $ 548,629 $ 488,455 $ 317,125 $ 300,484 $ 172,528 $ 193,641 $ 2,377,882 $ 2,290,357 Organic Revenue growth(2) $ 31,823 $ 60,174 $ 16,641 $ (21,113 ) $ 87,525 Organic Revenue growth %(2) 2.4 % 12.3 % 5.5 % (10.9 )% 3.8 % (1) The Retail Segment includes commissions and fees reported in the “Other” column of the Segment Information in Note 17 of the Notes to the Consolidated Financial Statements, which includes corporate and consolidation items. (2) A non-GAAP financial measure. 31 Table of Contents The reconciliation of total commissions and fees included in the Consolidated Statements of Income to Organic Revenue, a non-GAAP financial measure, including by Segment, and the growth rates for Organic Revenue for the year ended December 31, 2019, by Segment, are as follows: 2019 Retail(1) National Programs Wholesale Brokerage Services Total (in thousands, except percentages) 2019 2018 2019 2018 2019 2018 2019 2018 2019 2018 Commissions and fees $ 1,364,755 $ 1,040,574 $ 516,915 $ 493,878 $ 309,426 $ 286,364 $ 193,641 $ 189,041 $ 2,384,737 $ 2,009,857 Total change $ 324,181 $ 23,037 $ 23,062 $ 4,600 $ 374,880 Total growth % 31.2 % 4.7 % 8.1 % 2.4 % 18.7 % Profit-sharing contingent commissions (34,150 ) (24,517 ) (17,517 ) (23,896 ) (7,499 ) (7,462 ) — — (59,166 ) (55,875 ) GSCs (11,056 ) (8,535 ) (10,566 ) (76 ) (1,443 ) (1,350 ) — — (23,065 ) (9,961 ) Core commissions and fees $ 1,319,549 $ 1,007,522 $ 488,832 $ 469,906 $ 300,484 $ 277,552 $ 193,641 $ 189,041 $ 2,302,506 $ 1,944,021 Acquisitions (272,383 ) — (5,721 ) — (3,628 ) — (16,541 ) — (298,273 ) — Dispositions — (7,743 ) — (790 ) — (1,268 ) — — — (9,801 ) Organic Revenue(2) $ 1,047,166 $ 999,779 $ 483,111 $ 469,116 $ 296,856 $ 276,284 $ 177,100 $ 189,041 $ 2,004,233 $ 1,934,220 Organic Revenue growth(2) $ 47,387 $ 13,995 $ 20,572 $ (11,941 ) $ 70,013 Organic Revenue growth %(2) 4.7 % 3.0 % 7.4 % (6.3 )% 3.6 % (1) The Retail Segment includes commissions and fees reported in the “Other” column of the Segment Information in Note 17 of the Notes to the Consolidated Financial Statements, which includes corporate and consolidation items. (2) A non-GAAP financial measure. The reconciliation of income before incomes taxes, included in the Consolidated Statement of Income, to EBITDAC, a non-GAAP measure, and Income Before Income Taxes Margin to EBITDAC Margin, a non-GAAP measure, for the year ended December 31, 2020, is as follows: (in thousands) Retail National Programs Wholesale Brokerage Services Other Total Income before income taxes $ 262,245 $ 182,892 $ 93,593 $ 27,994 $ 57,375 $ 624,099 Income Before Income Taxes Margin 17.8 % 30.0 % 26.5 % 16.1 % NMF 23.9 % Amortization 67,315 27,166 8,481 5,561 — 108,523 Depreciation 9,071 8,658 1,948 1,424 5,175 26,276 Interest 85,968 20,597 10,281 4,142 (62,015 ) 58,973 Change in estimated acquisition earn-out payables 8,689 (10,484 ) 422 (3,085 ) — (4,458 ) EBITDAC $ 433,288 $ 228,829 $ 114,725 $ 36,036 $ 535 $ 813,413 EBITDAC Margin 29.4 % 37.5 % 32.5 % 20.7 % NMF 31.1 % NMF = Not a meaningful figure The reconciliation of income before incomes taxes, included in the Consolidated Statement of Income, to EBITDAC, a non-GAAP measure, and Income Before Income Taxes Margin to EBITDAC Margin, a non-GAAP measure, for the year ended December 31, 2019, is as follows: (in thousands) Retail National Programs Wholesale Brokerage Services Other Total Income before income taxes $ 222,875 $ 143,737 $ 82,739 $ 40,337 $ 36,241 $ 525,929 Income Before Income Taxes Margin 16.3 % 27.7 % 26.7 % 20.8 % NMF 22.0 % Amortization 63,146 25,482 11,191 5,479 — 105,298 Depreciation 7,390 6,791 1,674 1,229 6,333 23,417 Interest 87,295 16,690 4,756 4,404 (49,485 ) 63,660 Change in estimated acquisition earn-out payables 8,004 (751 ) (4 ) (8,615 ) — (1,366 ) EBITDAC $ 388,710 $ 191,949 $ 100,356 $ 42,834 $ (6,911 ) $ 716,938 EBITDAC Margin 28.4 % 37.0 % 32.4 % 22.1 % NMF 30.0 % NMF = Not a meaningful figure 32 Table of Contents Retail Segment The Retail Segment provides a broad range of insurance products and services to commercial, public and quasi-public, professional and individual insured customers, and non-insurance risk-mitigating products through our automobile dealer services (“F&I”) businesses. Approximately 80.8% of the Retail Segment’s commissions and fees revenue is commission based. Financial information relating to our Retail Segment for the twelve months ended December 31, 2020 and 2019 is as follows: (in thousands, except percentages) 2020 % Change 2019 REVENUES Core commissions and fees $ 1,420,439 7.5 % $ 1,320,810 Profit-sharing contingent commissions 35,785 4.8 % 34,150 Guaranteed supplemental commissions 15,128 36.8 % 11,056 Total commissions and fees 1,471,352 7.7 % 1,366,016 Investment income 163 9.4 % 149 Other income, net 1,251 14.1 % 1,096 Total revenues 1,472,766 7.7 % 1,367,261 EXPENSES Employee compensation and benefits 820,368 7.9 % 760,208 Other operating expenses 221,496 (3.0 )% 228,256 (Gain)/loss on disposal (2,386 ) (75.9 )% (9,913 ) Amortization 67,315 6.6 % 63,146 Depreciation 9,071 22.7 % 7,390 Interest 85,968 (1.5 )% 87,295 Change in estimated acquisition earn-out payables 8,689 8.6 % 8,004 Total expenses 1,210,521 5.8 % 1,144,386 Income before income taxes $ 262,245 17.7 % $ 222,875 Income Before Income Taxes Margin (1) 17.8 % 16.3 % EBITDAC (2) 433,288 11.5 % 388,710 EBITDAC Margin (2) 29.4 % 28.4 % Organic Revenue growth rate (2) 2.4 % 4.7 % Employee compensation and benefits relative to total revenues 55.7 % 55.6 % Other operating expenses relative to total revenues 15.0 % 16.7 % Capital expenditures $ 13,175 5.4 % $ 12,497 Total assets at December 31 $ 7,093,627 10.6 % $ 6,413,459 (1) “Income Before Income Taxes Margin” is defined as income before income taxes divided by total revenues (2) A non-GAAP measure NMF = Not a meaningful figure The Retail Segment’s total revenues in 2020 increased 7.7%, or $105.5 million, over the same period in 2019, to $1,472.8 million. The $99.6 million increase in core commissions and fees was driven by the following: (i) approximately $79.6 million related to the core commissions and fees from acquisitions that had no comparable revenues in the same period of 2019; (ii) $31.8 million related to net new and renewal business; offset by (iii) a decrease of $11.8 million related to commissions and fees from businesses or books of business divested in 2019 and 2020. Profit-sharing contingent commissions and GSCs in 2020 increased 12.6%, or $5.7 million, over 2019, to $50.9 million primarily from acquisitions completed in 2019 and 2020. The Retail Segment’s growth rate for total commissions and fees was 7.7% and the Organic Revenue growth rate was 2.4% for 2020. The Organic Revenue growth rate was driven by new business, higher customer retention and increasing premium rates across most lines of business over the preceding 12 months. Income before income taxes for 2020 increased 17.7%, or $39.4 million, over the same period in 2019, to $262.2 million. The primary factors driving this increase were: (i) the net increase in revenue as described above, (ii) other operating expenses which decreased by $6.8 million, or 3.0%, due primarily to COVID-19 related expense savings, partially offset by the impact of our multi-year technology investment program and increased professional services to support our customers and acquisitions over the past 12 months; (iii) offset by a 7.9%, or $60.2 million, increase in employee compensation and benefits, due primarily to the year-on-year impact of acquisitions, salary inflation and additional teammates to support revenue growth and incremental non-cash stock compensation costs, (iv) a decrease in the gain on disposal associated with the sale of certain books of business compared to prior year; and (v) a combined increase in amortization, depreciation and intercompany interest expense of $4.5 million resulting from our acquisition activity in 2020 and 2019. 33 Table of Contents EBITDAC for 2020 increased 11.5%, or $44.6 million, from the same period in 2019, to $433.3 million. EBITDAC Margin for 2020 increased to 29.4% from 28.4% in the same period in 2019. EBITDAC Margin was impacted by (i) the net increase in revenue and COVID-19 related expense savings, as described above, (ii) higher profit-sharing contingent commissions and guaranteed supplemental commissions; partially offset by, (iii) increased non-stock cash compensation costs and intercompany IT charges. National Programs Segment The National Programs Segment manages over 40 programs supported by approximately 100 well-capitalized carrier partners. In most cases, the insurance carriers that support the programs have delegated underwriting and, in many instances, claims-handling authority to our programs operations. These programs are generally distributed through a nationwide network of independent agents and Brown & Brown retail agents, and offer targeted products and services designed for specific industries, trade groups, professions, public entities and market niches. The National Programs Segment operations can be grouped into five broad categories: Professional Programs, Personal Lines Programs, Commercial Programs, Public Entity-Related Programs and the National Flood Program. The National Programs Segment’s revenue is primarily commission based. Financial information relating to our National Programs Segment for the twelve months ended December 31, 2020 and 2019 is as follows: (in thousands, except percentages) 2020 % Change 2019 REVENUES Core commissions and fees $ 582,802 19.2 % $ 488,832 Profit-sharing contingent commissions 27,278 55.7 % 17,517 Guaranteed supplemental commissions (238 ) (102.3 )% 10,566 Total commissions and fees 609,842 18.0 % 516,915 Investment income 756 -45.9 % 1,397 Other income, net 42 (41.7 )% 72 Total revenues 610,640 17.8 % 518,384 EXPENSES Employee compensation and benefits 260,141 17.5 % 221,425 Other operating expenses 121,670 15.7 % 105,118 (Gain)/loss on disposal — (100.0 )% (108 ) Amortization 27,166 6.6 % 25,482 Depreciation 8,658 27.5 % 6,791 Interest 20,597 23.4 % 16,690 Change in estimated acquisition earn-out payables (10,484 ) NMF (751 ) Total expenses 427,748 14.2 % 374,647 Income before income taxes $ 182,892 27.2 % $ 143,737 Income Before Income Taxes Margin (1) 30.0 % 27.7 % EBITDAC (2) 228,829 19.2 % 191,949 EBITDAC Margin (2) 37.5 % 37.0 % Organic Revenue growth rate (2) 12.3 % 3.0 % Employee compensation and benefits relative to total revenues 42.6 % 42.7 % Other operating expenses relative to total revenues 19.9 % 20.3 % Capital expenditures $ 7,208 (30.5 )% $ 10,365 Total assets at December 31 $ 3,510,983 12.9 % $ 3,110,368 (1) “Income Before Income Taxes Margin” is defined as income before income taxes divided by total revenues (2) A non-GAAP measure NMF = Not a meaningful figure The National Programs Segment’s total revenues in 2020 increased 17.8%, or $92.3 million, over 2019, to a total $610.6 million. The $94.0 million increase in core commissions and fees was driven by the following: (i) $60.2 million related to net new and renewal business; (ii) an increase of approximately $34.2 million related to core commissions and fees from acquisitions that had no comparable revenues in 2019; offset by (iii) a decrease of $0.4 million related to commissions and fees recorded in 2019 from businesses since divested. Profit-sharing contingent commissions and GSCs were $27.0 million in 2020, which was a decrease of $1.0 million from 2019, as a result of a non-recurring GSC received from one of our partners in the second quarter of 2019. 34 Table of Contents The National Programs Segment’s growth rate for total commissions and fees was 18.0% and the Organic Revenue growth rate was 12.3% for 2020. The total commissions and fees growth was mainly due to new acquisitions, strong growth in our earthquake programs, lender placement program, personal property program and wind programs. The Organic Revenue growth rate increase was driven by net new business, growth in renewals and higher premium rates in a number of our programs compared to the prior year. Income before income taxes for 2020 increased 27.2%, or $39.2 million, from the same period in 2019, to $182.9 million. The increase was the result of strong total revenue growth and a decrease in estimated acquisition earn-out payables of $9.7 million. EBITDAC for 2020 increased 19.2%, or $36.9 million, from the same period in 2019, to $228.8 million. EBITDAC Margin for 2020 increased to 37.5% due to (i) leveraging revenue growth and scaling of a number of our programs; (ii) new acquisitions in 2020, and (iii) lower variable costs in response to COVID-19. Wholesale Brokerage Segment The Wholesale Brokerage Segment markets and sells excess and surplus commercial and personal lines insurance, primarily through independent agents and brokers, including Brown & Brown retail agents. Like the Retail and National Programs Segments, the Wholesale Brokerage Segment’s revenues are primarily commission based. Financial information relating to our Wholesale Brokerage Segment for the twelve months ended December 31, 2020 and 2019 is as follows: (in thousands, except percentages) 2020 % Change 2019 REVENUES Core commissions and fees $ 342,986 14.1 % $ 300,484 Profit-sharing contingent commissions 7,871 5.0 % 7,499 Guaranteed supplemental commissions 1,304 -9.6 % 1,443 Total commissions and fees 352,161 13.8 % 309,426 Investment income 184 3.4 % 178 Other income, net 452 (6.4 )% 483 Total revenues 352,797 13.8 % 310,087 EXPENSES Employee compensation and benefits 184,429 16.8 % 157,924 Other operating expenses 53,643 3.5 % 51,807 (Gain)/loss on disposal — — — Amortization 8,481 (24.2 )% 11,191 Depreciation 1,948 16.4 % 1,674 Interest 10,281 116.2 % 4,756 Change in estimated acquisition earn-out payables 422 NMF (4 ) Total expenses 259,204 14.0 % 227,348 Income before income taxes $ 93,593 13.1 % $ 82,739 Income Before Income Taxes Margin (1) 26.5 % 26.7 % EBITDAC (2) 114,725 14.3 % 100,356 EBITDAC Margin (2) 32.5 % 32.4 % Organic Revenue growth rate (2) 5.5 % 7.4 % Employee compensation and benefits relative to total revenues 52.3 % 50.9 % Other operating expenses relative to total revenues 15.2 % 16.7 % Capital expenditures $ 3,324 -46.1 % $ 6,171 Total assets at December 31 $ 1,791,717 28.9 % $ 1,390,250 (1) “Income Before Income Taxes Margin” is defined as income before income taxes divided by total revenues (2) A non-GAAP measure NMF = Not a meaningful figure The Wholesale Brokerage Segment’s total revenues for 2020 increased 13.8%, or $42.7 million, over 2019, to $352.8 million. The $42.5 million increase in core commissions and fees was driven by the following: (i) $25.9 million related to the core commissions and fees from acquisitions that had no comparable revenues in 2019 and (ii) $16.6 million related to net new and renewal business. Profit-sharing contingent commissions and GSCs for 2020 increased $0.2 million over 2019, to $9.2 million. The Wholesale Brokerage Segment’s growth rate for total commissions and fees was 13.8%, and the Organic Revenue growth rate was 5.5% for 2020. The Organic Revenue growth rate was driven by net new business, as well as increased rates seen across most lines of business, which was partially offset by shrinking capacity in the catastrophe exposed personal lines market. 35 Table of Contents Income before income taxes for 2020 increased 13.1%, or $10.9 million, over 2019, to $93.6 million, primarily due to the following: (i) the net increase in total revenues as described above, and (ii) a decrease in amortization expense; offset by (iii) an increase in intercompany interest expense, (iv) an increase in employee compensation and benefits of $26.5 million, related to additional teammates from acquisitions completed in the past 12 months and growth to support increased transaction volumes, compensation increases for existing teammates, and additional non-cash stock-based compensation expense, and (v) a net $1.3 million increase in other operating expenses, primarily acquisition related. EBITDAC for 2020 increased 14.3%, or $14.4 million, from the same period in 2019, to $114.7 million. EBITDAC Margin for 2020 increased to 32.5% from 32.4% in the same period in 2019. The increase in EBITDAC Margin was primarily driven by leveraging revenue growth as described above and lower variable costs in response to COVID-19, which were partially offset by increased employee compensation and non-cash stock-based compensation costs. Services Segment The Services Segment provides insurance-related services, including third-party claims administration and comprehensive medical utilization management services in both the workers’ compensation and all-lines liability arenas. The Services Segment also provides Medicare Set-aside account services, Social Security disability and Medicare benefits advocacy services, and claims adjusting services. Unlike the other segments, nearly all of the Services Segment’s revenue is generated from fees, which are not significantly affected by fluctuations in general insurance premiums. Financial information relating to our Services Segment for the twelve months ended December 31, 2020 and 2019 is as follows: (in thousands, except percentages) 2020 % Change 2019 REVENUES Core commissions and fees $ 174,012 (10.1 )% $ 193,641 Profit-sharing contingent commissions — — — Guaranteed supplemental commissions — — — Total commissions and fees 174,012 (10.1 )% 193,641 Investment income — (100.0 )% 139 Other income, net — (100.0 )% 1 Total revenues 174,012 (10.2 )% 193,781 EXPENSES Employee compensation and benefits 88,787 (3.0 )% 91,514 Other operating expenses 49,191 (17.2 )% 59,433 (Gain)/loss on disposal (2 ) — — Amortization 5,561 1.5 % 5,479 Depreciation 1,424 15.9 % 1,229 Interest 4,142 (5.9 )% 4,404 Change in estimated acquisition earn-out payables (3,085 ) (64.2 )% (8,615 ) Total expenses 146,018 (4.8 )% 153,444 Income before income taxes $ 27,994 (30.6 )% $ 40,337 Income Before Income Taxes Margin (1) 16.1 % 20.8 % EBITDAC (2) 36,036 (15.9 )% 42,834 EBITDAC Margin (2) 20.7 % 22.1 % Organic Revenue growth rate (2) (10.9 )% (6.3 )% Employee compensation and benefits relative to total revenues 51.0 % 47.2 % Other operating expenses relative to total revenues 28.3 % 30.7 % Capital expenditures $ 1,424 77.1 % $ 804 Total assets at December 31 $ 480,440 (0.2 )% $ 481,336 (1) “Income Before Income Taxes Margin” is defined as income before income taxes divided by total revenues (2) A non-GAAP measure NMF = Not a meaningful figure 36 Table of Contents The Services Segment’s total revenues for 2020 decreased 10.2%, or $19.8 million, from 2019, to $174.0 million. The $19.6 million decrease in core commissions and fees was driven primarily by a decrease of $21.1 million related to net new and renewal business that was driven by lower claims volume in our Social Security advocacy businesses; (i) the effect a prior year terminated customer contract in one of our claims processing businesses; and (ii) lower weather-driven claims; partially offset by (iii) $1.5 million related to the core commissions and fees from acquisitions that had no comparable revenues in the same period of 2019. Total commissions and fees decreased 10.1%, and Organic Revenue decreased 10.9% in 2020, both as compared to 2019. Income before income taxes for 2020 decreased 30.6%, or $12.3 million, from 2019, to $28.0 million due to a combination of: (i) lower revenue as described above; (ii) a $5.5 million decrease in the change in estimated acquisition earn-out payables; partially offset by (iii) a decline in other operating expenses driven by management of our costs in response to COVID-19. EBITDAC for 2020 decreased 15.9%, or $6.8 million, from the same period in 2019, to $36.0 million. EBITDAC Margin for 2020 decreased to 20.7% from 22.1% in the same period in 2019. The decrease in EBITDAC Margin was due to: (i) lower revenue as described above; offset by (ii) a decline in other operating expenses driven by management of our costs in response to COVID-19. Other As discussed in Note 17 of the Notes to Consolidated Financial Statements, the “Other” column in the Segment Information table includes any income and expenses not allocated to reportable segments, and corporate-related items, including the intercompany interest expense charges to reporting segments. LIQUIDITY AND CAPITAL RESOURCES The Company seeks to maintain a conservative balance sheet and liquidity profile. Our capital requirements to operate as an insurance intermediary are low and we have been able to grow and invest in our business principally through cash that has been generated from operations. We have the ability to utilize our revolving credit facility, which as of December 31, 2020 provided access to up to $800.0 million in available cash. We believe that we have access to additional funds, if needed, through the capital markets or private placements to obtain further debt financing under the current market conditions. The Company believes that its existing cash, cash equivalents, short-term investment portfolio and funds generated from operations, together with the funds available under the revolving credit facility, will be sufficient to satisfy our normal liquidity needs, including principal payments on our long-term debt, for at least the next 12 months. The revolving credit facility contains an expansion for up to an additional $500.0 million of borrowing capacity, subject to the approval of participating lenders. In addition, under the term loan credit agreement, the unsecured term loan in the initial amount of $300.0 million may be increased by up to $150.0 million, subject to the approval of participating lenders. Including the expansion options under all existing credit agreements, the Company has access to up to $1.5 billion of incremental borrowing capacity as of December 31, 2020. Our cash and cash equivalents of $817.4 million at December 31, 2020 reflected an increase of $275.2 million from the $542.2 million balance at December 31, 2019. During 2020, $721.6 million of cash was generated from operating activities, representing an increase of 6.4%. During this period, $694.8 million of cash was used for new acquisitions, $29.5 million was used for acquisition earn-out payments, $70.7 million was used to purchase additional fixed assets, $100.6 million was used for payment of dividends, $55.1 million was used for share repurchases and $55.0 million was used to pay outstanding principal balances owed on long-term debt. We hold approximately $34.3 million in cash outside of the U.S., which we currently have no plans to repatriate in the near future. Our cash and cash equivalents of $542.2 million at December 31, 2019 reflected an increase of $103.2 million from the $439.0 million balance at December 31, 2018. During 2019, $678.2 million of cash was generated from operating activities, representing an increase of 19.5%. During this period, $353.0 million of cash was used for new acquisitions, $9.9 million was used for acquisition earn-out payments, $73.1 million was used to purchase additional fixed assets, $91.3 million was used for payment of dividends, $38.7 million was used for share repurchases and $50.0 million was used to pay outstanding principal balances owed on long-term debt. Our ratio of current assets to current liabilities (the “current ratio”) was 1.26 and 1.22 for December 31, 2020 and December 31, 2019, respectively. 37 Table of Contents Contractual Cash Obligations As of December 31, 2020, our contractual cash obligations were as follows: Payments Due by Period (in thousands) Total Less Than 1 Year(4) 1-3 Years(4) 4-5 Years After 5 Years Long-term debt $ 2,110,000 $ 70,000 $ 490,000 $ 500,000 $ 1,050,000 Other liabilities(1) 110,109 4,456 14,575 7,204 83,874 Operating leases(2) 244,289 50,443 87,255 55,589 51,002 Interest obligations 394,710 62,571 115,394 79,625 137,120 Unrecognized tax benefits 1,267 — 1,267 — — Maximum future acquisition contingency payments(3) 544,723 139,465 405,258 — — Total contractual cash obligations $ 3,405,098 $ 326,935 $ 1,113,749 $ 642,418 $ 1,321,996 (1) Includes the current portion of other long-term liabilities. (2) Includes $5.0 million of future lease commitments expected to commence in 2021. (3) Includes $258.9 million of current and non-current estimated earn-out payables. $25.0 million of this balance is not subject to any further contingency as a result of the Amendment dated as of July 27, 2020 by and among the Company, The Hays Group, Inc., and certain of their affiliates, to the Asset Purchase Agreement, dated as of October 22, 2018. (4) Does not include approximately $31.1 million of deferred employer-only payroll tax payments related to the CARES Act which are expected to be paid in equal installments in each of December 2021 and December 2022. Debt Total debt at December 31, 2020 was $2,095.9 million net of unamortized discount and debt issuance costs, which was an increase of $540.6 million compared to December 31, 2019. The increase includes: (i) incremental borrowings of $700.0 million related to the Company's 2.375% Senior Notes due 2031 issued on September 24, 2020; (ii) net of the amortization of discounted debt related to our various unsecured Senior Notes, and debt issuance cost amortization of $2.3 million; offset by (iii) the repayment of the principal balance of $55.0 million for scheduled principal amortization balances related to our various existing floating rate debt term notes; (iv) the net repayment of $100.0 million under the revolving credit facility; and (v) an additional $6.7 million including debt issuance costs and the portion of discount applied to the proceeds issued under the incremental borrowings related to the Company's 2.375% Senior Notes due 2031 issued on September 24, 2020. On September 24, 2020, the Company completed the issuance of $700.0 million aggregate principal amount of the Company's 2.375% Senior Notes due 2031. The Senior Notes were given investment grade ratings of BBB- stable outlook and Baa3 positive outlook. The notes are subject to certain covenant restrictions, which are customary for credit rated obligations. At the time of funding, the proceeds were offered at a discount of the original note amount, which also excluded an underwriting fee discount. The net proceeds received from the issuance were used to repay a portion of the outstanding balance of $200.0 million on the revolving credit facility, to pay a portion of the purchase price in connection with the acquisitions of LP Insurance Services, LLP and CKP Insurance, LLC and for other general corporate purposes. As of December 31, 2020, there was an outstanding debt balance of $700.0 million exclusive of the associated discount balance. During the twelve months ended December 31, 2020, the Company has repaid $40.0 million of principal related to the amended and restated credit agreement term loan through quarterly scheduled amortized principal payments each equaling $10.0 million on March 31, 2020, June 30, 2020, September 30, 2020 and December 31, 2020. The amended and restated credit agreement term loan had an outstanding balance of $290.0 million as of December 31, 2020. The Company’s next scheduled amortized principal payment is due March 31, 2021 and is equal to $10.0 million. During the twelve months ended December 31, 2020, the Company has repaid $15.0 million of principal related to the term loan credit agreement through quarterly scheduled amortized principal payments each equaling $3.8 million on March 31, 2020, June 30, 2020, September 30, 2020 and December 31, 2020. The term loan credit agreement had an outstanding balance of $270.0 million as of December 31, 2020. The Company’s next scheduled amortized principal payment is due March 31, 2021 and is equal to $7.5 million. On April 30, 2020, the Company borrowed $250.0 million under the revolving credit facility. The proceeds were used in conjunction with the payment of the purchase price for the previously announced acquisition of LP Insurance Services LLC and for additional liquidity to further strengthen the Company’s financial position and balance sheet in the event cash receipts from customers or carrier partners are delayed due to the COVID-19 pandemic. On June 30, 2020, the Company repaid $150.0 million on the revolving credit facility. On September 24, 2020, the Company repaid the total outstanding borrowings under the revolving credit facility of $200.0 million using the proceeds received from the borrowings under the Company's 2.375% Senior Notes due 2031. 38 Table of Contents Total debt at December 31, 2019 was $1,555.3 million net of unamortized discount and debt issuance costs, which was an increase of $48.4 million compared to December 31, 2018. The increase includes (i) a drawdown on the revolving credit facility of $100.0 million on August 9, 2019 in connection with the acquisition of CKP Insurance, LLC and various other acquisitions closed in the third quarter of 2019, (ii) the repayment of principal of $50.0 million for scheduled principal amortization balances related to our various existing floating rate debt term notes, (iii) amortization of discounted debt related to our various unsecured Senior Notes, and debt issuance cost amortization of $2.1 million, offset by (iv) additional discount to par and aggregate debt issuance costs of $3.7 million related to the issuance of the Company's 4.500% Senior Notes due 2029 as of December 31, 2019. On March 11, 2019, the Company completed the issuance of $350.0 million aggregate principal amount of the Company's 4.500% Senior Notes due 2029. The Senior Notes were given investment grade ratings of BBB-/Baa3 with a stable outlook. The notes are subject to certain covenant restrictions which are customary for credit-rated obligations. At the time of funding, the proceeds were offered at a discount to the notional amount which also excluded an underwriting fee discount. The net proceeds received from the issuance were used to repay a portion of the outstanding balance of $350.0 million on the revolving credit facility, utilized in connection with financing related to our acquisition of Hays, and for other general corporate purposes. As of December 31, 2019, there was an outstanding debt balance of $350.0 million exclusive of the associated discount balance. Off-Balance Sheet Arrangements Neither we nor our subsidiaries have ever incurred off-balance sheet obligations through the use of, or investment in, off-balance sheet derivative financial instruments or structured finance or special purpose entities organized as corporations, partnerships or limited liability companies or trusts. For further discussion of our cash management and risk management policies, see “Quantitative and Qualitative Disclosures About Market Risk.” ITEM 7A. Quantitative and Qualitative Disclosures About Market Risk. Market risk is the potential loss arising from adverse changes in market rates and prices, such as interest rates, foreign exchange rates and equity prices. We are exposed to market risk through our investments, revolving credit line, term loan agreements and international operations. Our invested assets are held primarily as cash and cash equivalents, restricted cash, available-for-sale marketable debt securities, non-marketable debt securities, certificates of deposit, U.S. treasury securities, and professionally managed short duration fixed income funds. These investments are subject to interest rate risk. The fair values of our invested assets at December 31, 2020 and December 31, 2019, approximated their respective carrying values due to their short-term duration and therefore, such market risk is not considered to be material. We do not actively invest or trade in equity securities. In addition, we generally dispose of any significant equity securities received in conjunction with an acquisition shortly after the acquisition date. As of December 31, 2020, we had $560.0 million of borrowings outstanding under our various credit agreements, all of which bear interest on a floating basis tied to London Interbank Overnight Rate (“LIBOR”) and is therefore subject to changes in the associated interest expense. The effect of an immediate hypothetical 10% change in interest rates would not have a material effect on our Consolidated Financial Statements. As of July 2017, the UK Financial Conduct Authority (“FCA”) has urged banks and institutions to discontinue their use of the LIBOR benchmark rate for floating rate debt, and other financial instruments tied to the rate after 2021. However, on November 30, 2020, the ICE Benchmark Administration Limited (“IBA”), announced that it would consult in early December 2020 on its intention to cease the publication of the one-week and two-month U.S. dollar LIBOR settings immediately following the LIBOR publication on December 31, 2021, and the remaining U.S. dollar LIBOR settings (overnight and one, three, six and 12 months) immediately following the LIBOR publication on June 30, 2023. The consultation was open for feedback until January 25, 2021 and IBA “intends to share the results of the consultation with the FCA and to publish a feedback statement summarizing responses from the consultation shortly thereafter.” In connection to the released statement from the IBA, on December 4, 2020, the FCA released a similar statement in support of the continuation of the LIBOR rate beyond 2021. The Alternative Reference Rates Committee (“ARRC”) have recommended the Secured Overnight Financing Rate (“SOFR”) as the best alternative rate to LIBOR post discontinuance and has proposed a transition plan and timeline designed to encourage the adoption of SOFR from LIBOR. The Company is currently evaluating the transition from LIBOR as an interest rate benchmark to other potential alternative reference rates, including but not limited to the SOFR interest rate. Management will continue to actively assess the related opportunities and risks associated with the transition and monitor related proposals and guidance published by ARRC and other alternative-rate initiatives, with an expectation that we will be prepared to for a termination of LIBOR benchmarks after 2021. We are subject to exchange rate risk primarily in our U.K.-based wholesale brokerage business that has a cost base principally denominated in British pounds and a revenue base in several other currencies, but principally in U.S. dollars, and in our Canadian MGA business that has substantially all of its revenues and cost base denominated in Canadian Dollars. As of January 14, 2021, the Company announced the completion of the acquisition of O’Leary Insurances, an Ireland based retail brokerage business which has substantially all of its revenue and cost base in Euro Dollars. Based upon our foreign currency rate exposure as of December 31, 2020, an immediate 10% hypothetical changes of foreign currency exchange rates would not have a material effect on our Consolidated Financial Statements. 39 Table of Contents
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+ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSManagement's Discussion and Analysis of Financial Condition and Results of Operations (MD&A) should be read in conjunction with the consolidated financial statements included in
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+ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSThe information required by this Item is set forth in the MD&A and Notes 3, 6, 12, 14, 19, 22 and 23 of the Notes to Consolidated Financial Statements in the Annual Report, which portions are incorporated herein by reference.ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKThe information required by this Item is set forth in the “Critical accounting estimates,” “Trading activities and risk management,” “Asset/liability management” and “Risk Management” sections in the MD&A in the Annual Report and “Derivative financial instruments” under Note 1 and Notes 20 and 23 of the Notes to Consolidated Financial Statements in the Annual Report, which portions are incorporated herein by reference.
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+Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations The following discussion should be read in conjunction with our Consolidated Financial Statements, including the notes to those statements, included elsewhere in this Annual Report on Form 10-K, and the Section entitled "Special Note Regarding Forward-Looking Statements" in this Annual Report on Form 10-K. As discussed in more detail in the Section entitled "Special Note Regarding Forward-Looking Statements," this discussion contains forward-looking statements, which involve risks and uncertainties. Our actual results may differ materially from the results discussed in the forward-looking statements. Factors that might cause those differences include those discussed in "Risk Factors" and elsewhere in this Annual Report on Form 10-K. We evaluate certain operating and financial measures on both an as-reported and constant-currency basis. We calculate constant currency by converting our current-year period operating and financial results for transactions recorded in currencies other than U.S. Dollars using the corresponding prior-year period monthly average exchange rates rather than the current-year period monthly average exchange rates.OverviewOur mission is to make it easier for everyone to experience the world. We seek to empower people to cut through travel barriers, such as money, time, language and overwhelming options, so they can use our services to easily and confidently go where they want to go, stay where they want to stay, dine where they want to dine, pay how they want to pay and experience what they want to experience. We connect consumers wishing to make travel reservations with providers of travel services around the world through our online platforms. Through one or more of our brands, consumers can: book a broad array of accommodations (including hotels, motels, resorts, homes, apartments, bed and breakfasts, hostels and other properties); make a car rental reservation or arrange for an airport taxi; make a dinner reservation; or book a flight, cruise, vacation package, tour or activity. Consumers can also use our meta-search services to easily compare travel reservation information, such as airline ticket, hotel reservation and rental car reservation information, from hundreds of online travel platforms at once. In addition, we offer various other services to consumers and partners, such as certain travel-related insurance products and restaurant management services to restaurants. We offer these services through six primary consumer-facing brands: Booking.com, Priceline, agoda, Rentalcars.com, KAYAK and OpenTable. While historically our brands operated on a largely independent basis and many of them focused on a particular service (e.g., accommodation reservations) or geography, we are increasing the collaboration, cooperation and interdependency among our brands in our efforts to provide consumers with the best and most comprehensive services. We also seek to maximize the benefits of our scale by sharing resources and technological innovations, co-developing new services and coordinating activities in key markets among our brands. For example, Booking.com, the world’s leading brand for booking online accommodation reservations (based on room nights booked), offers rental car and other ground transportation services, flights, tours and activities reservations, restaurant reservations and other services, many of which are supported by our other brands. Similarly, hotel reservations available through Booking.com are also generally available through agoda and Priceline. See Note 2 to the Consolidated Financial Statements - Segment Reporting for information on our operating segments. We refer to our company and all of our subsidiaries and brands collectively as "Booking Holdings," the "Company," "we," "our" or "us." Our business is driven primarily by international results, which consist of the results of Booking.com, agoda and Rentalcars.com in their entirety and the international businesses of KAYAK and OpenTable. This classification is independent of where the consumer resides, where the consumer is physically located while using our services or the location of the travel service provider or restaurant. For example, a reservation made through Booking.com (which is domiciled in the Netherlands) at a hotel in New York by a consumer in the United States is part of our international results. In 2020, our international business (the substantial majority of which is generated by Booking.com) represented approximately 88% of our consolidated revenues. A significant majority of our revenues, including a significant majority of our international revenues, is earned in connection with facilitating accommodation reservations. See Note 18 to the Consolidated Financial Statements for more geographic information. We derive substantially all of our revenues from enabling consumers to make travel service reservations. We also earn revenues from credit card processing rebates and customer processing fees, advertising services, restaurant reservations and restaurant management services, and various other services, such as travel-related insurance revenues.41TrendsIn response to the outbreak of the novel strain of the coronavirus, COVID-19 (the "COVID-19 pandemic"), many governments around the world have implemented, and continue to implement, a variety of measures to reduce the spread of COVID-19, including travel restrictions and bans, instructions to residents to practice social distancing, curfews, quarantine advisories, shelter-in-place orders and required closures of non-essential businesses. These government mandates have forced many of the partners on whom our business relies, including hotels and other accommodation providers, airlines and restaurants, to seek government support in order to continue operating, to curtail drastically their service offerings or to cease operations entirely. Further, these measures have materially adversely affected, and may further adversely affect, consumer sentiment and discretionary spending patterns, economies and financial markets, and our workforce, operations and customers. The COVID-19 pandemic and the resulting economic conditions and government orders have resulted in a material decrease in consumer spending and an unprecedented decline in travel and restaurant activities and consumer demand for related services. Our financial results and prospects are almost entirely dependent on the sale of travel-related services. Our results for the year ended December 31, 2020 have been materially and negatively impacted, with a material decline in gross travel bookings, room nights booked, total revenues, net income and cash flow from operations as compared to the year ended December 31, 2019. Newly-booked room night reservations, excluding the impact of cancellations, declined rapidly as the COVID-19 pandemic spread in the first quarter and the beginning of the second quarter of 2020, but then steadily improved through the end of the second quarter and into the summer travel period in the third quarter of 2020. However, in the fourth quarter of 2020, we saw an increased decline in newly-booked room night reservations, due in part to increased COVID-19 case counts and reimposed or additional government-imposed travel restrictions, particularly in Europe. In September 2020, a variant of COVID-19 that spreads more easily and quickly than other variants was first discovered in the United Kingdom, and has since spread across the country and to other countries, including the United States and in Europe. Another variant of COVID-19 that also appears to spread more easily and quickly than other variants was detected in South Africa in October 2020. In the fourth quarter of 2020, multiple COVID-19 vaccines were approved for widespread distribution throughout various parts of the world, including the United States and in Europe. While this news is encouraging, it is still unknown when these vaccines will be available to broader populations and whether they will be as effective against variants of COVID-19, including the variants mentioned above. We believe that as effective vaccines become widely distributed, people will feel it is safe to travel again and government restrictions will be relaxed, although the timing remains uncertain.Since April 2020, we have seen a substantial year-over-year increase in the share of newly booked room nights booked for domestic travel (travelers booking a stay within their own country) while bookings for international travel have remained very limited throughout the pandemic. Over this same time period, we have seen a year-over-year increase in the share of our newly-booked room nights made on a mobile device. Also, while we saw an increase in the share of newly-booked room nights for alternative accommodation properties in the early months of the pandemic, more recently the share has been consistent with pre-pandemic levels. In addition, we have observed an improvement in cancellation rates since the high in April, though we have seen additional periods of highly elevated cancellation rates typically coinciding with newly imposed travel restrictions. The overall improvement in cancellation rates since April benefits our room nights booked including cancellations but does not impact newly-booked room nights.Our revenue decline in 2020 was impacted to a greater extent than newly-booked room night growth due to the impact of higher cancellations and lower accommodation average daily rates ("ADRs") as compared to 2019. We expect to continue to see severely reduced new travel and restaurant reservation bookings as compared to 2019 levels for the foreseeable future, which will have a materially adverse impact on our business, financial condition, results of operations and cash flows. Further, given the volatility in the global travel industry and the financial difficulties faced by many of our travel service provider and restaurant partners, we have increased our provision for expected credit losses on receivables from and cash advances made to our travel service provider and restaurant partners.Due to the uncertain and rapidly evolving nature of current conditions around the world, we are unable to predict accurately the impact that the COVID-19 pandemic will have on our business going forward. The approval and distribution of COVID-19 vaccines throughout the world is encouraging, however, the COVID-19 pandemic continues to impact global travel and travel restrictions remain in place, particularly in Europe. In the fourth quarter of 2020, we saw room nights decline further, as well as an increase in cancellation rates, in each case as compared to the third quarter of 2020. In January 2021, room nights declined slightly more than the decline in the fourth quarter of 2020, however, we have seen some improvement in these booking trends in recent weeks. If these recent trends were to continue, we currently expect that room nights and gross bookings in the first quarter of 2021 will decline relative to the first quarter of 2019 by a few percentage points less than those metrics declined in the fourth quarter of 2020 relative to the fourth quarter of 2019. We currently expect revenue in the first quarter of 2021 to decline by a similar amount as our expected decline in gross bookings in the first quarter of 2021, both relative to the first quarter of 2019. The comparison of the first quarter of 2021 to the first quarter of 2019 avoids the distortion created from comparing to the initial spread of the COVID-19 pandemic late in the first quarter of 2020. In addition, we 42currently expect that we will experience a greater operating loss in the first quarter of 2021 as compared to the fourth quarter of 2020. With the continued spread of COVID-19 throughout the world, we expect the pandemic and its effects to continue to have a significant adverse impact on our business for the duration of the pandemic, during any resurgences of the pandemic and during the subsequent economic recovery, which could be an extended period of time. For more information, see Part II, Item 1A, Risk Factors - "The COVID-19 pandemic has materially adversely affected, and may further adversely impact, our business and financial performance." In response to the COVID-19 pandemic, we have taken and are taking various actions to address the impact of the pandemic on our business. Among other actions, we have:•Raised $4.1 billion in debt and negotiated amendments to our revolving credit facility to provide additional financial flexibility•Undertaken restructuring activities at all of our brands•Participated in certain government aid programs, including employee wage support programs•Suspended general share repurchases•Eliminated non-essential business travel•Canceled internal company events and offsites•Significantly reduced marketing spend worldwide•Implemented a general temporary company-wide hiring freeze for much of 2020•Sold investments in government debt securities, corporate debt securities and Trip.com Group American DepositaryShares ("ADSs")Further, our Chief Executive Officer and the Chief Executive Officers of our brands voluntarily declined their salaries, certain other senior managers voluntarily reduced their salaries and our non-employee Directors voluntarily waived their cash fees for most of 2020.In response to the reduction in our business volumes as a result of the impact of the COVID-19 pandemic, during the year ended December 31, 2020, we took actions at all of our brands to reduce the size of our workforce to optimize efficiency and reduce costs, which we expect to result in annualized cost savings of approximately $370 million in personnel-related expenses. In addition to the restructuring expenses recorded during the year ended December 31, 2020 and included in “Restructuring and other exit costs” in the Consolidated Statements of Operations, we estimate that we will record approximately $40 million of additional restructuring expenses in early 2021 (see Note 20 to our Consolidated Financial Statements). Our headcount decreased 23% year-over-year as of December 31, 2020, primarily due to the restructuring activities and attrition.We have also been working with travelers and our travel service provider partners to deal with reservation cancellations and other disruptions arising from the impact of the pandemic. For example, when the pandemic started, Booking.com committed to allow cancellations of certain non-refundable bookings that were impacted by government travel restrictions and OpenTable has waived fees payable by restaurants for diners seated through OpenTable's online reservation service and subscription fees for many restaurants. The impacts of the COVID-19 pandemic are wide-ranging and affect all aspects of our business. As a result, the pandemic has negatively affected our financial results and condition as described throughout this Annual Report on Form 10-K. We anticipate that we will continue to make decisions and take actions to address the impacts of the pandemic on our business, including additional efforts to reduce costs while preserving our ability to offer valuable services to consumers and partners when the industry recovers. The full impact of the pandemic on our business is impossible to predict, and therefore we may recognize additional negative impacts to our operating results and financial condition in future periods as a result of the pandemic.Certain governments have passed or are considering modifying legislation to help businesses during the COVID-19 pandemic through loans, wage subsidies, tax relief or other financial aid, and some of these governments have extended or are considering extending these programs. We have participated in several of these programs, including the Netherlands' wage subsidy program and the United Kingdom's job retention scheme. In addition, certain governments have extended support for the travel and tourism industry through special programs whereby discounts are extended to travelers through travel service providers or through travel agents for reservations facilitated by them. We have participated in Japan's Go To Travel program and Thailand's We Travel Together program.43Prior to the COVID-19 pandemic, we experienced many years of significant growth in our accommodation reservation services. We believe this growth was the result of, among other things, the broader shift of travel purchases from offline to online, the widespread adoption of mobile devices and the growth of travel overall. We also believe this growth was the result of the continued innovation and execution by our teams around the world to increase the number and the variety of accommodations we offer consumers, increase and improve content, build distribution and improve the consumer experience on our online platforms, as well as consistently and effectively marketing our brands through performance and brand marketing efforts. Prior to the COVID-19 pandemic, these year-over-year growth rates generally decelerated due to the size of our accommodation reservation business and the generally slowing growth rate of the online travel market. As the travel market recovers from the impact of the COVID-19 pandemic, we expect to see higher than pre-COVID-19 pandemic growth rates until we return to the level of travel market demand that we observed prior to the COVID-19 pandemic, after which we expect prior trends to generally resume. We are a global business, and online travel growth rates vary across the world depending on numerous factors, including local and regional economic conditions, individual disposable income, access to the internet and adoption of e-commerce. Over the last several years, and prior to the COVID-19 pandemic, online travel growth rates had generally slowed in markets such as North America and Europe where online activity was high and consumers had been engaging in e-commerce transactions for many years, while online travel growth rates remained relatively high in markets such as Asia-Pacific where incomes were rising more quickly and the increased availability and use of mobile devices had accelerated the growth of internet usage and travel e-commerce transactions. Over the long term, we expect the broader global economy and online travel market to recover from the COVID-19 pandemic, and following the recovery of the travel industry to the level of pre-COVID-19 pandemic demand, we would expect online travel growth rates will slow as markets continue to mature. However, we believe that the opportunity to grow our business beyond pre-COVID-19 pandemic levels exists for the markets in which we operate, including in both mature and less mature markets. Further, we believe that this opportunity for growth exists because we believe we provide significant value to travel service providers, regardless of size or geography, due to our global reach and marketing expertise. For example, we believe that accommodation providers of all sizes, from large hotel chains to small, independent hotels and alternative accommodations such as homes and apartments, benefit from using our services, which enable them to reach a broader audience of potential customers.Historically, our growth has primarily been generated by the worldwide accommodation reservation business of Booking.com, which is our most significant brand, and has been due, in part, to the availability of a large number of properties through Booking.com. Booking.com included approximately 2,373,000 properties on its website at December 31, 2020, consisting of approximately 434,000 hotels, motels and resorts and approximately 1,939,000 homes, apartments and other unique places to stay, compared to approximately 2,580,000 properties (including approximately 460,000 hotels, motels and resorts and approximately 2,120,000 homes, apartments, and other unique places to stay) at December 31, 2019. Booking.com categorizes properties listed on its website as either (a) hotels, motels and resorts, which groups together more traditional accommodation types (including hostels and inns), or (b) homes, apartments and other unique places to stay, also referred to as alternative accommodations, which encompasses all other types of accommodations, including bed and breakfasts, villas, apart-hotels and beyond. We intend to continue to improve the accommodation choices available for reservation on our platforms, however, the number of accommodations on our platforms may vary in part as a result of removing accommodations from time to time. At December 31, 2020, we saw a year-over-year decrease in the number of properties on Booking.com’s website, as compared to December 31, 2019, driven by an elevated number of accommodations removed from the platform due primarily to the properties not providing availability on our platforms, non-payment of invoices, or property closures. We have continued to see a year-over-year increase in the number of accommodations removed from our platform during the COVID-19 pandemic, and we expect to see further accommodation removals in the future due to increases in property closures or changes in ownership.Many of the newer accommodations we add to our travel reservation services, especially in highly-penetrated markets, may have fewer rooms or higher credit risk and may appeal to a smaller subset of consumers (e.g., hostels and bed and breakfasts). Because alternative accommodations are often either a single unit or a small collection of independent units, these properties generally represent more limited booking opportunities than hotels, motels and resorts, which generally have more units to rent per property. Further, alternative accommodations in general may be subject to increased seasonality due to local tourism seasons or other factors or may not be available at peak times due to use by the property owners. We may also experience lower profit margins with respect to these properties due to certain additional costs, such as increased customer service costs, related to offering these accommodations on our platforms. As our alternative accommodation business has grown, these different characteristics have negatively impacted our profit margins and we expect this trend to continue. Further, to the extent that these properties represent an increasing percentage of the properties on our platforms, the number of reservations per property will likely continue to decrease since alternative accommodation properties typically have fewer 44booking opportunities per property. We believe that continuing to improve the choices of accommodations available through our services, in particular Booking.com, will help us to continue to grow our accommodation reservation business.We are constantly innovating to grow our business by, among other things, providing a best-in-class user experience with intuitive, easy-to-use online platforms (i.e., websites and mobile apps) to ensure that we are meeting the needs of online consumers while aiming to exceed their expectations. As part of these ongoing efforts, we have a long-term strategy to build a more integrated offering of multiple elements of travel, which we refer to as the "Connected Trip", and we expect these efforts to increase room night growth and revenue growth over time. Although we expect our efforts to build the Connected Trip will increase revenue growth over time, we may see a negative impact on our operating margins in the near term as we incur the expenses associated with these investments. Further, to the extent our non-accommodation services grow faster than our accommodation services, whether as part of the Connected Trip or otherwise, our operating margins may be negatively affected if we experience an increasing mix of revenues from lower-margin services. As part of our strategy to provide more payment options to consumers and travel service providers, increase the number and variety of accommodations available on Booking.com and enable the growth of our in-destination activities businesses, Booking.com is increasingly processing transactions on a merchant basis, where it facilitates payments from travelers for the services provided. This allows Booking.com to process transactions for travel service providers and to increase its ability to offer secure and flexible transaction terms to consumers, such as the form and timing of payment. We believe that adding these types of service offerings will benefit consumers and travel service providers, as well as our gross bookings, room night and earnings growth rates. However, this results in additional expenses for personnel, payment processing, customer chargebacks (including those related to fraud) and other expenses related to these transactions, which are recorded in "Personnel" and "Sales and other expenses" in our Consolidated Statements of Operations, as well as associated incremental revenues in the form of credit card rebates, for example, which are recorded in "Merchant revenues." To the extent more of our business is generated on a merchant basis, we will incur a greater level of these merchant-related expenses, which would negatively impact our operating margins despite increases in associated incremental revenues. Components of revenues and expenses related to our merchant business may be recognized in different periods. These timing factors could impact our operating margins as well as the relationship between our gross bookings and revenues in a particular period, especially as our merchant business increases as a percentage of our overall business.We compete globally with both online and traditional providers of travel and restaurant reservation and related services. The markets for the services we offer are intensely competitive, constantly evolving and subject to rapid change, and current and new competitors can launch new services at relatively low cost. Some of our current and potential competitors, such as Google, Apple, Alibaba, Tencent, Amazon and Facebook, have significantly more customers or users, consumer data and financial and other resources than we do, and they may be able to leverage other aspects of their businesses (e.g., search or mobile device businesses) to enable them to compete more effectively with us. For example, Google has entered various aspects of the online travel market and has grown rapidly in this area, including by offering a flight meta-search product (Google Flights), a hotel meta-search product (Google Hotel Ads), a vacation rental meta-search product, its "Book on Google" reservation functionality, Google Travel, a planning tool that aggregates its flight, hotel and packages products in one website and by integrating its hotel meta-search products and restaurant information and reservation products into its Google Maps app. Moreover, as the economy and the travel industry recover from the impact of the COVID-19 pandemic, the structure of the travel industry could change in unexpected ways, which could advantage or disadvantage us and benefit certain of our existing competitors or new entrants. As a result, our historical strengths may not provide the competitive advantages that they did prior to the pandemic. If we are unable to successfully adapt to any changes in how the travel industry operates or to changes in the ways in which consumers purchase travel services, our ability to compete, and therefore our business and results of operations, would be adversely affected.Our markets are also subject to rapidly changing conditions, including technological developments, consumer behavior changes, regulatory changes and travel service provider consolidation. We expect these trends to continue. For example, we have experienced a significant shift of both direct and indirect business to mobile platforms and our advertising partners are also seeing a rapid shift of traffic to mobile platforms. In addition, the revenue earned on a mobile transaction may be less than a typical desktop transaction due to different consumer purchasing patterns. For example, accommodation reservations made on a mobile device typically are for shorter lengths of stay, have lower accommodation ADRs and are not made as far in advance. We observed an increasingly higher share of our newly-booked room nights made on a mobile device throughout 2020, as compared to the corresponding periods in 2019. For more detail regarding the competitive trends and risks we face, see Part I, Item 1, Business - "Competition," Part I, Item 1A, Risk Factors - "Intense competition could reduce our market share and harm our financial performance." and "Consumer adoption and use of mobile devices creates challenges and may enable device companies such as Google and Apple to compete directly with us." and "We may not be able to keep up with rapid technological or other market changes." 45Although we believe that providing an extensive collection of properties, excellent customer service and an intuitive, easy-to-use consumer experience are important factors influencing a consumer's decision to make a reservation, for many consumers, particularly in certain markets, the price of the travel service is the primary factor determining whether a consumer will book a reservation. As a result, it is increasingly important to offer travel services, such as accommodation reservations, at competitive prices, whether through discounts, coupons, closed-user group rates or loyalty programs, or otherwise. These initiatives have resulted and in the future may result in lower ADRs and lower revenue as a percentage of gross bookings. Discounting and couponing coupled with a high degree of consumer shopping behavior is particularly common in Asian markets. In some cases, our competitors are willing to make little or no profit on a transaction, or offer travel services at a loss, in order to gain market share.We have experienced a meaningful decline in constant-currency accommodation ADRs since the outbreak of the COVID-19 pandemic and it is uncertain how long the COVID-19 pandemic will impact our ADRs. These declining ADR trends have resulted in and may continue to result in our gross bookings growing at a lower rate of growth than our accommodation room nights. Prior to the outbreak, we observed a trend of declining constant-currency accommodation ADRs. We believe the trend of declining ADRs, observed prior to the outbreak, was partially driven by the negative impact of the changing geographical mix of our business (e.g., lower ADR regions like Asia-Pacific are generally growing faster than higher ADR regions like Western Europe) as well as pricing pressures within local markets from time to time which resulted from competitive conditions, weakening economic conditions or changes in travel patterns. As the travel market recovers from the impact of the COVID-19 pandemic, we expect travel industry ADRs generally to increase and, as a result, we expect our ADRs similarly to increase during the recovery, however, it is uncertain whether industry ADRs will improve at the same pace as travel demand. In addition, we expect the ADR trends we observed before the COVID-19 pandemic will generally resume after the recovery, which would negatively pressure our ADRs, however, there may also be periods of stable or increasing ADRs.We have established widely used and recognized e-commerce brands through marketing and promotional campaigns. Historically, our marketing expenses increased significantly, however, we experienced more moderate growth rates in recent years, and since the COVID-19 pandemic, our marketing expenses have declined significantly. Our marketing expense is comprised of performance marketing and brand marketing expenses. Our performance marketing expense, which represents a substantial majority of our marketing expense, is primarily related to the use of online search engines (primarily Google), meta-search and travel research services and affiliate marketing to generate traffic to our websites. Our brand marketing expense is primarily related to costs associated with producing and airing television advertising, online video advertising (for example, on YouTube and Facebook), online display advertising and other brand marketing. Total marketing expenses were $2.2 billion and $5.0 billion for the years ended December 31, 2020 and 2019, respectively. We expect that our marketing expenses in 2021 will remain significantly below 2019 levels.Marketing efficiency, expressed as marketing expense as a percentage of total revenues, is impacted by a number of factors that are subject to variability and that are, in some cases, outside of our control, including ADRs, costs per click, cancellation rates, foreign currency exchange rates, our ability to convert paid traffic to booking customers, the timing difference between when revenue is recognized and when marketing expense is recorded, the timing and effectiveness of our brand marketing campaigns and the extent to which consumers come directly to our platforms for bookings. For example, competition for desired rankings in search results and/or a decline in ad clicks by consumers could increase our costs per click and reduce our marketing efficiency. Changes by Google or any of our other search or meta-search partners in how it presents travel search results, including, if applicable, by placing its own offerings at or near the top of search results, or the manner in which it conducts the auction for placement among search results may be competitively disadvantageous to us and may impact our ability to efficiently generate traffic to our websites. We have observed a long-term trend of decreasing performance marketing returns on investment ("ROIs"), however, in recent years, we observed periods of stable or increasing ROIs. During the first several months of the COVID-19 pandemic, we experienced large year-over-year declines in ROIs driven by a significant increase in cancellation rates. While we have observed year-over-year decreases in ROIs for the year ended December 31, 2020, ROIs have improved since the early months of the pandemic, though we expect volatility in our ROIs for the duration of the pandemic. When evaluating our performance marketing spend, we typically consider several factors for each channel, such as the customer experience on the advertising platform, the incrementality of the traffic we receive and the anticipated repeat rate from a particular platform, as well as other factors. However, with the significant decrease in demand due to the COVID-19 pandemic, our performance marketing spend is highly influenced by expected cancellation rates in addition to the other factors listed above. The amount of business we obtain through each performance marketing channel is impacted by numerous factors, including the level of consumer demand for travel, bidding decisions by us and our competitors (including decisions to optimize performance marketing ROIs) and the marketing efforts and success of those channels to attract consumers and generate demand. See Part I, Item 1A, Risk Factors - "We rely on marketing channels to generate a significant amount of traffic to our platforms and grow our business." and "Our 46business could be negatively affected by changes in online search and meta-search algorithms and dynamics or traffic-generating arrangements."In recent years, we experienced significant increases in our cancellation rates, which negatively affected our marketing efficiency and results of operations. However, from the third quarter of 2018 until the fourth quarter of 2019, our cancellation rates generally decreased, which benefited our marketing efficiency and results of operations. Since the COVID-19 pandemic we have experienced unprecedented increases in cancellation rates, which negatively impacted our marketing efficiency and results of operations. For example, increased cancellations, especially early in the pandemic, have resulted in increased customer service costs, as well as higher than normal cash outlays to refund consumers for prepaid reservations. However, in the second and third quarters of 2020, we saw a steady improvement in cancellation rates, which trended towards levels that we observed prior to the COVID-19 pandemic. In the fourth quarter of 2020, we saw a reversal of the improving cancellation rate trend. We expect to continue to see volatility in cancellation rates due to any resurgences of the pandemic leading to reinstituted or additional travel restrictions, shelter-in-place rules and reduced willingness to travel. Further, in the fourth quarter of 2020, a higher share of our newly-booked room night reservations were made with flexible cancellation policies, as compared to the corresponding period in 2019, which could result in higher than normal cancellation rates in future quarters.Perceived or actual adverse economic conditions, including slow, slowing or negative economic growth, high or rising unemployment rates, inflation and weakening currencies, and concerns over government responses such as higher taxes or tariffs and reduced government spending have impaired and could, in the future, impair consumer spending and adversely affect travel demand. We expect the lingering concerns of consumers around the safety of traveling as well as reduced discretionary incomes could negatively impact leisure travel demand for an extended period of time. Further, political uncertainty, conditions or events, such as the variety of measures implemented by many governments around the world to reduce the spread of COVID-19, including travel restrictions and bans, instructions to residents to practice social distancing, quarantine advisories, shelter-in-place orders and required closures of non-essential businesses can also negatively affect consumer spending and adversely affect travel demand. At times, we have experienced volatility in transaction growth rates, increased cancellation rates and weaker trends in ADRs across many regions of the world, particularly in those countries that appear to be most affected by economic and political uncertainties, which we believe are due at least in part to these macro-economic conditions and concerns. For more detail, see Part I, Item 1A, Risk Factors - "The COVID-19 pandemic has materially adversely affected, and may further adversely impact, our business and financial performance" and "Declines or disruptions in the travel industry could adversely affect our business and financial performance."These and other macro-economic uncertainties, such as geopolitical tensions and differing central bank monetary policies, have led to periods of significant volatility in the exchange rates between the U.S. Dollar and the Euro, the British Pound Sterling and other currencies. Significant fluctuations in foreign currency exchange rates, stock markets and oil prices can also impact consumer travel behavior. As noted earlier, our international business represents a substantial majority of our financial results. Therefore, because we report our results in U.S. Dollars, we face exposure to movements in foreign currency exchange rates as the financial results and the financial condition of our international businesses are translated from local currency (principally Euros and British Pounds Sterling) into U.S. Dollars. As a result, both the absolute amounts of and percentage changes in our foreign-currency-denominated net assets, gross bookings, revenues, operating expenses and net income as expressed in U.S. Dollars are affected by foreign currency exchange rate changes. However, for the year ended December 31, 2020, movements in foreign currency exchange rates had little to no impact on our performance metrics and financial results. Since our expenses are generally denominated in foreign currencies on a basis similar to our revenues, our operating margins have not been significantly impacted by currency fluctuations. We designate certain portions of the aggregate principal value of our Euro-denominated debt as a hedge against the impact of foreign currency exchange rate fluctuations on the net assets of one of our Euro functional currency subsidiaries. Foreign currency transaction gains or losses on the Euro-denominated debt that is not designated as a hedging instrument for accounting purposes are recognized in "Other income (expense), net" in the Consolidated Statements of Operations (see Note 12 to our Consolidated Financial Statements). Such foreign currency transaction gains or losses are dependent on the amount of net assets of the Euro functional currency subsidiary, the amount of the Euro-denominated debt that is designated as a hedge and fluctuations in foreign currency exchange rates. For more information, see Part I, Item 1A, Risk Factors - "We are exposed to fluctuations in foreign currency exchange rates."We generally enter into derivative instruments to minimize the impact of foreign currency exchange rate fluctuations on our transactional balances denominated in currencies other than the functional currency. In periods prior to the second quarter of 2020, we also entered into derivative instruments to minimize the impact of short-term foreign currency exchange rate fluctuations on the translation of our consolidated operating results into U.S. Dollars. However, these instruments were short-term in nature and not designed to hedge against currency fluctuations that could impact growth rates for our gross bookings or revenues. Since the first quarter of 2020, we have not entered into such derivative instruments as the impact of the 47COVID-19 pandemic on our operating results are highly uncertain. We will continue to evaluate the use of derivative instruments in the future. See Note 6 to our Consolidated Financial Statements for additional information related to our derivative contracts.Many taxing authorities are increasingly focused on ways to increase tax revenues and have targeted large multinational technology companies in these efforts. As a result, many countries have implemented or are considering the adoption of a digital services tax that imposes a tax on revenue earned from digital advertisements and the use of online platforms, even when there is no physical presence in the jurisdiction. Currently, rates for this tax range from 1.5% to 7.5% of revenue deemed generated in the jurisdiction. The digital services taxes currently in effect, which we record in "General and administrative" expense in Consolidated Statements of Operations, have negatively impacted our results of operations and if many other countries pass similar legislation, the collective impact of all of these measures could have a materially adverse impact on our results of operations and cash flows. For more information, see Part I, Item 1A, Risk Factors - "We may have exposure to additional tax liabilities."Many national governments have conducted or are conducting investigations into competitive practices within the online travel industry, and we may be involved or affected by such investigations and their results. Some countries have adopted or proposed legislation that could also affect business practices within the online travel industry. For example, France, Italy, Belgium and Austria have passed legislation prohibiting parity contract clauses in their entirety. Also, a number of governments are investigating or conducting information-gathering exercises with respect to compliance by online travel companies ("OTCs") with consumer protection laws, including practices related to the display of search results and search ranking algorithms, claims regarding discounts, disclosure of charges and availability, and similar messaging. In December 2020, the European Commission proposed the Digital Markets Act and the Digital Services Act, which are expected to give regulators more instruments to investigate digital businesses and impose new rules on certain digital platforms if they are determined to be "gatekeepers." The proposed legislation is not final and it is not known what the laws will look like in their final forms if adopted. If the regulators were to determine that we are a gatekeeper under the proposed legislation, we could be subject to additional rules and regulations not applicable to all our competitors and our business could be harmed. For more information on these investigations and their potential effects on our business, see Note 16 to our Consolidated Financial Statements and Part I, Item 1A, Risk Factors - "Our business is subject to various competition/anti-trust, consumer protection and online commerce laws, rules and regulations around the world, and as the size of our business grows, scrutiny of our business by legislators and regulators in these areas may intensify." In addition to the price parity and consumer protection investigations, from time to time national competition authorities, other governmental agencies, trade associations and private parties take legal actions, including commencing legal proceedings, that may affect our operations. In general, increased regulatory focus on online businesses, including online travel businesses like ours, could result in increased compliance costs or otherwise adversely affect our business. Seasonality and Other Timing FactorsIn recent years, the majority of our gross bookings have been generated in the first half of the year, as consumers planned and reserved their spring and summer vacations in Europe and North America. However, we would generally recognize revenue from these bookings when the travel begins (at "check-in"), which can be in a quarter other than when the associated reservations are booked. In contrast, we expensed the substantial majority of our marketing activities as the expense is incurred, which, in the case of marketing in particular, is typically in the quarter in which associated reservations were booked. As a result of this timing difference between when we recorded marketing expense and when we recognized associated revenue, we have experienced our highest levels of profitability in the third quarter of the year, which is when we experienced the highest levels of accommodation check-ins for the year for our European and North American markets. The first quarter of the year was typically the quarter in which we recognized the lowest amount of revenue as well as the lowest level of profitability and highest level of volatility in earnings growth rates due to these seasonal timing factors. The COVID-19 pandemic impacted seasonality in 2020; for example, we witnessed a higher share of travel being booked during the second and third quarters as well as a higher share of stays during the third quarter than in prior years. We cannot currently predict travel patterns given the COVID-19 pandemic, and we may not experience typical seasonality effects on our business in 2021.For several years, we experienced an expansion of the booking window (the average time between the booking of a travel reservation and when the travel begins), which impacts the relationship between our gross bookings (recognized at the time of booking) and our revenues (recognized at the time of check-in). However, we saw a contraction of the booking window throughout 2018 and 2019. Due to the impact of the COVID-19 pandemic on our booking trends, we saw an initial expansion in the booking window in the second quarter versus the comparable prior-year period as an increased percentage of newly-booked room nights were made for travel occurring in the third quarter. However, in the third and fourth quarters, we saw a significant contraction of the booking window versus the comparable prior-year period as an increased percentage of newly-48booked room nights were made for travel that was to occur close to the time of booking. We expect that the length of the booking window will be volatile and difficult to predict throughout the duration of the COVID-19 pandemic. Future changes in the length of the booking window will affect the degree to which our gross bookings and revenues occur in the same period and, as a result, whether our gross bookings growth rates and revenue growth rates converge or diverge.In addition, the date on which certain holidays fall can have an impact on our quarterly results. For example, in 2019, Easter fell on April 21 and Easter-related travel began in the second quarter, when the associated revenue was recognized. By comparison, in 2018, Easter was on April 1 and a meaningful amount of Easter-related travel began in the week leading up to the holiday with the associated revenue being recognized in the first quarter of 2018. As a result of the shift in Easter timing relative to 2018, our first quarter 2019 year-over-year growth rates in revenue, operating income and operating margins were negatively impacted and our second quarter 2019 year-over-year growth rates were positively impacted. In 2020, Easter fell on April 12, in the second quarter as it did in 2019, and as a result we did not experience a meaningful impact to our year-over-year growth rates in 2020 from the Easter holiday. Due to the significant reduction in travel demand related to the COVID-19 pandemic, we do not expect the timing of the Easter holiday to have a meaningful impact on our growth rates in 2021. The timing of other holidays such as Ramadan can also impact our quarterly year-over-year growth rates.The impact of seasonality can be exaggerated in the short term by the gross bookings growth rate of the business. For example, in periods where our gross bookings growth rate substantially decelerates, our operating margins typically benefit from relatively less variable marketing expense. In addition, revenue growth is typically less impacted by decelerating gross bookings growth in the near term due to the benefit of revenue related to reservations booked in previous quarters, but any such deceleration would negatively impact revenue growth in subsequent periods. Conversely, in periods where our gross bookings growth rate accelerates, our operating margins are typically negatively impacted by relatively more variable marketing expense. In addition, revenue growth is typically less impacted by accelerating gross bookings growth in the near term, but any such acceleration would positively impact revenue growth in subsequent periods as a portion of the revenue recognized from such gross bookings will occur in future quarters. As the travel market recovers from the impact of the COVID-19 pandemic, we expect to see higher than pre-COVID-19 pandemic growth rates, which will likely result in periods where our operating margins are negatively impacted due to the timing difference of when marketing expense is recorded and when revenue is recognized. Other FactorsWe believe that our future success depends in large part on our ability to continue to profitably grow our brands worldwide, and, over time, to offer other travel and travel-related services. Factors beyond our control, such as oil prices, stock market volatility, terrorist attacks, unusual or extreme weather or natural disasters such as earthquakes, hurricanes, tsunamis, floods, fires, droughts and volcanic eruptions, travel-related health concerns including pandemics and epidemics such as COVID-19 and other coronaviruses, Ebola and Zika, political instability, changes in economic conditions, wars and regional hostilities, imposition of taxes, tariffs or surcharges by regulatory authorities, changes in trade policies or trade disputes, changes in immigration policies or travel-related accidents or increased focus on the environmental impact of travel, can disrupt travel, limit the ability or willingness of travelers to visit certain locations or otherwise result in declines in travel demand. These kinds of events have negatively affected our business and results of operations in the past and may do so again in the future. Because these events or concerns, and the full impact of their effects, are largely unpredictable, they can dramatically and suddenly affect travel behavior by consumers, and therefore demand for our services and our relationships with travel service providers and other partners, any of which can adversely affect our business and results of operations. See Part I, Item 1A, Risk Factors - "The COVID-19 pandemic has materially adversely affected, and may further adversely impact, our business and financial performance" and "Declines or disruptions in the travel industry could adversely affect our business and financial performance."The extent of the effects of the COVID-19 pandemic on our business, results of operations, cash flows and growth prospects is highly uncertain and will ultimately depend on future developments. We expect the pandemic and its effects to continue to have a significant adverse impact on our business for the duration of the pandemic and during the subsequent economic recovery, which could be an extended period of time. Over the long-term, we intend to continue to invest in marketing and promotion, technology and personnel within parameters consistent with attempts to improve long-term operating results, even if those expenditures create pressure on operating margins. In recent years, we have experienced pressure on operating margins as we invested in initiatives to drive future growth. We also intend to broaden the scope of our business, and to that end, we explore strategic alternatives from time to time in the form of, among other things, acquisitions. We believe competitive pressure to innovate will encompass a wider range of services and technologies, including services and technologies that may be outside of our historical core business, and our ability to keep pace may slow. Potential competitors, such as emerging start-ups, may be able to innovate and focus on developing a particularly new product or service faster than we can or may foresee consumer need for new services or technologies before us. Some of our larger competitors or potential 49competitors have more resources or more established or diversified relationships with consumers than we do, and they could use these advantages in ways that could affect our competitive position, including by making acquisitions, entering or investing in travel reservation businesses, investing in research and development, and competing aggressively for highly-skilled employees. For example, because consumers often utilize other online services more frequently than online travel services, a competitor or potential competitor that has established other, more frequent online interactions with consumers may be able to more easily or cost-effectively acquire customers for its online travel services than we can. Our goal is to grow revenue and achieve healthy operating margins in an effort to maintain profitability. The uncertain and highly competitive environment in which we operate makes the prediction of future results of operations difficult, and accordingly, we may not be able to return to the levels of revenue growth and profitability we experienced prior to the COVID-19 pandemic.Critical Accounting Policies and EstimatesManagement's Discussion and Analysis of Financial Condition and Results of Operations is based upon our Consolidated Financial Statements, which have been prepared in accordance with accounting principles generally accepted in the United States ("U.S. GAAP"). Our significant accounting policies and estimates are more fully described in Note 2 to our Consolidated Financial Statements. Certain of our accounting estimates are particularly important to our financial position and results of operations and require us to make difficult and subjective judgments, often as a result of the need to make estimates of matters that are inherently uncertain. Our management uses its judgment to determine the appropriate assumptions to be used in the determination of certain estimates. We evaluate our estimates on an ongoing basis. Estimates are based on, among other things, historical experience, terms of existing contracts, our observance of trends in the travel industry and on various other assumptions that we believe to be reasonable under the circumstances. Our actual results may differ from these estimates under different assumptions or conditions. Our critical accounting policies that involve significant estimates and judgments of management include the following:Valuation of Goodwill and Other Long-lived Assets The application of the acquisition accounting for business combinations requires the use of significant estimates and assumptions to determine the fair value of the assets acquired and liabilities assumed. Our estimates of the fair value are based upon assumptions that we believe are reasonable. When we deem appropriate, we utilize assistance from a third-party valuation firm. The consideration transferred is allocated to the assets acquired and liabilities assumed based on their respective fair values at the acquisition date. The excess of the consideration transferred over the net of the amounts allocated to the identifiable assets acquired and liabilities assumed is recognized as goodwill. Goodwill is assigned to reporting units that are expected to benefit from the synergies of the business combination as of the acquisition date.A substantial portion of our intangible assets and goodwill relates to the acquisitions of OpenTable and KAYAK. We review long-lived assets whenever events or changes in circumstances indicate that the carrying amount of the asset may not be recoverable. The assessment of possible impairment is based upon the ability to recover the carrying value of the assets from the estimated undiscounted future net cash flows, before interest and taxes, of the related asset group. Due to the significant and negative financial impact of the COVID-19 pandemic, we performed the recoverability test of our long-lived assets and concluded there was no impairment at March 31, 2020. For OpenTable and KAYAK, we tested the recoverability of the long-lived assets and concluded there was no impairment at September 30, 2020. We did not identify any additional impairment indicators for our long-lived assets at December 31, 2020. We test goodwill for impairment annually and whenever an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying amount. We test goodwill at a reporting unit level. Our annual goodwill impairment tests are performed as of September 30. Interim Goodwill Impairment TestDue to the significant and negative financial impact of the COVID-19 pandemic, we performed an interim period goodwill impairment test at March 31, 2020. Under the current goodwill impairment standard adopted in the first quarter of 2020, a goodwill impairment loss is measured at the amount by which a reporting unit’s carrying amount exceeds its fair value, not to exceed the carrying amount of goodwill (see Note 2 to our Consolidated Financial Statements). As of March 31, 2020, the estimated fair value of each of our reporting units, except the OpenTable and KAYAK reporting unit, substantially exceeded its respective carrying value. For the OpenTable and KAYAK reporting unit, we recognized a goodwill impairment charge of $489 million for the three months ended March 31, 2020, which is not tax-50deductible, resulting in an adjusted carrying value of goodwill for OpenTable and KAYAK of $1.5 billion at March 31, 2020. The goodwill impairment was primarily driven by a significant reduction in the forecasted near-term cash flows of OpenTable and KAYAK as well as the significant decline in comparable companies' market values as a result of the COVID-19 pandemic.The estimated fair value of OpenTable and KAYAK was determined using a combination of standard valuation techniques, including an income approach (discounted cash flows) and a market approach (applying the recent decline in enterprise values of comparable publicly-traded companies to the recently calculated fair value for OpenTable and KAYAK as well as applying comparable company multiples).The income approach estimates fair value utilizing long-term growth rates and discount rates applied to the cash flow projections. In the cash flow projections, we assumed that OpenTable and KAYAK will experience a significant decline in near-term cash flows with a recovery to 2019 levels of financial performance (including profitability) occurring in 2023. The shape and timing of the recovery was a key assumption in our fair value calculation (both in the income and market approaches).Annual Goodwill Impairment TestAs of September 30, 2020, we performed our annual goodwill impairment test. Other than the OpenTable and KAYAK reporting unit, the fair values of our reporting units substantially exceeded their respective carrying values. For the OpenTable and KAYAK reporting unit, we recognized a goodwill impairment charge of $573 million for the three months ended September 30, 2020, which is not tax-deductible, resulting in an adjusted carrying value of goodwill for OpenTable and KAYAK of $1.0 billion at September 30, 2020. The goodwill impairment was primarily driven by a significant reduction in the forecasted cash flows of OpenTable and KAYAK, reflecting a longer assumed recovery period to 2019 levels of profitability, mainly due to the continued material adverse impact of the COVID-19 pandemic, including its impact on the flight vertical at KAYAK, and the lowered outlook for monetization opportunities in restaurant reservation services. The estimated fair value of OpenTable and KAYAK was determined using a combination of standard valuation techniques, including an income approach (discounted cash flows) and a market approach (applying comparable company multiples). The income approach estimates fair value utilizing long-term growth rates and discount rates applied to the cash flow projections. The income approach, applied as of September 30, 2020, reflected a reduction in the forecasted cash flows of OpenTable and KAYAK and a longer assumed recovery period to 2019 levels of profitability, driven primarily by a lowered outlook for monetization opportunities in restaurant reservation services and slower than previously expected recovery trends for airline travel, which is a key vertical for KAYAK. For the interim goodwill impairment test at March 31, 2020, we expected a recovery to 2019 levels of financial performance occurring in 2023 for OpenTable and KAYAK. Based on our evaluation of all relevant information available as of September 30, 2020 for the annual goodwill impairment test, we expected that OpenTable and KAYAK would not return to the 2019 level of profitability within the next five years, and that it was uncertain whether the shape of the recovery would ultimately match our expectations. An increase or decrease of one percentage point to the profitability growth rates used in the cash flow projections would result in an increase or decrease of approximately $100 million to the estimated fair value of OpenTable and KAYAK at September 30, 2020. The discount rate is determined based on the reporting unit’s estimated weighted-average cost of capital and adjusted to reflect the risks inherent in its cash flows, which requires significant judgments. The discount rate used for the annual goodwill impairment test as of September 30, 2020 is higher than the discount rate used for the interim goodwill impairment test as of March 31, 2020. If the discount rate used in the income approach increases or decreases by 0.5%, the impact to the estimated fair value of OpenTable and KAYAK, at September 30, 2020, ranges from a decrease of approximately $65 million to an increase of approximately $70 million.The estimation of fair value reflects numerous assumptions that are subject to various risks and uncertainties, including key assumptions regarding OpenTable and KAYAK’s expected growth rates and operating margin, expected length and severity of the impact from the COVID-19 pandemic, the shape and timing of the subsequent recovery and the competitive environment, as well as other key assumptions with respect to matters outside of our control, such as discount rates and market comparables. It requires significant judgments and estimates and actual results could be materially different than the judgments and estimates used to estimate fair value. Future events and changing market conditions may lead us to re-evaluate the assumptions reflected in the current forecast disclosed above, particularly the assumptions related to the length and severity of the COVID-19 pandemic and the shape and timing of the subsequent recovery, which may result in a need to recognize an additional goodwill impairment charge that could have a material adverse effect on our results of operations.51No additional impairment indicators were identified as of December 31, 2020. Valuation of Investments in Private CompaniesSee Note 5 to our Consolidated Financial Statements for additional information related to the investments in private companies. The fair value of these investments are measured using unobservable inputs when little or no market data is available ("Level 3 inputs"). See Note 6 to our Consolidated Financial Statements for additional information.Our investments measured using Level 3 inputs primarily consist of preferred stock investments in privately-held companies that are classified as either debt securities or equity securities without readily determinable fair values. Fair values of privately held securities are estimated using a variety of valuation methodologies, including both market and income approaches. We have used valuation techniques appropriate for the type of investment and the information available about the investee as of the valuation date to determine fair value. Recent financing transactions in the investee, such as new investments in preferred stock, are generally considered the best indication of the enterprise value and therefore used as a basis to estimate fair value. However, based on a number of factors, such as the proximity in timing to the valuation date or the volume or other terms of these financing transactions, we may also use other valuation techniques to supplement this data, including the income approach. In addition, an option-pricing model (“OPM”) is utilized to allocate value to the various classes of securities of the investee, including the class owned by us. The model includes assumptions around the investees’ expected time to liquidity and volatility.Our investment in Grab, which is classified as a debt security for accounting purposes, had an aggregate estimated fair value of $200 million at December 31, 2020 and 2019. We measured this investment using "Level 3" inputs and management's estimates that incorporate current market participant expectations of future cash flows considered alongside recent financing transactions of the investee and other relevant information.We performed an impairment analysis on the investment in Didi Chuxing at March 31, 2020 considering the impact of the COVID-19 pandemic, which resulted in an adjusted carrying value of $400 million at March 31, 2020 and December 31, 2020. No additional impairment indicators were identified as of December 31, 2020. As discussed below, we used unobservable inputs in order to determine fair value. We used an income approach in estimating the fair value of Didi Chuxing as of March 31, 2020. The income approach estimates value based on the expectation of future cash flows that a company will generate. These future cash flows are discounted to their present values using a discount rate based on a company’s weighted- average cost of capital, and is adjusted to reflect the risks inherent in its cash flows. The key unobservable inputs and ranges used include the weighted average cost of capital (12%-14%), terminal Earnings before interest, taxes, depreciation and amortization (“EBITDA”) multiple (13x-15x), volatility (60%-70%) and an estimated time to liquidity of 4 years. Significant changes in any of these inputs in isolation would result in significantly different fair value measurements. Generally, a change in the assumption used for terminal EBITDA multiples would result in a directionally similar change in the fair value and a change in the assumption used for weighted average cost of capital or volatility would result in a directionally opposite change in the fair value. The determination of the fair values of investments, where we are a minority shareholder and have access to limited information from the investee, reflects numerous assumptions that are subject to various risks and uncertainties, including key assumptions regarding the investee’s expected growth rates and operating margin, expected length and severity of the impact of the COVID-19 pandemic on the investee and the shape and timing of the subsequent recovery, as well as other key assumptions with respect to matters outside of our control, such as discount rates and market comparables. It requires significant judgments and estimates and actual results could be materially different than those judgments and estimates utilized in the fair value estimate. Future events and changing market conditions may lead us to re-evaluate the assumptions reflected in our valuation, particularly the assumptions related to the length and severity of the COVID-19 pandemic and the shape and timing of the subsequent recovery and the overall impact on the investee’s business, which may result in a need to recognize an additional impairment charge that could have a material adverse effect on our results of operations.Income Taxes We determine our tax expense based on our income and statutory tax rates applicable in the various jurisdictions in which we operate. Due to the complex nature of tax legislation and frequent changes with such associated legislation, significant judgment is required in computing our tax expense and determining our tax positions. The U.S. Tax Cuts and Jobs Act (the "Tax Act") enacted in December 2017 made significant changes to U.S. federal tax law, including a reduction in the U.S. federal statutory tax rate from 35% to 21%, effective January 1, 2018. The Tax Act imposed a one-time deemed repatriation tax on accumulated unremitted international earnings, to be paid over eight years. 52We do not intend to indefinitely reinvest our international earnings that were subject to U.S. taxation pursuant to the mandatory deemed repatriation or subject to U.S. taxation as GILTI. We regularly review our deferred tax assets for recoverability considering historical profitability, projected future taxable income, the expected timing of the reversals of temporary differences and tax planning strategies and record valuation allowances as required. We are subject to ongoing tax examinations and assessments in various jurisdictions. We have been audited in many jurisdictions and, from time to time, face challenges from the tax authorities regarding the amount of taxes due. These challenges include questions regarding the timing and amount of deductions that we have taken on our tax returns. Although we believe that our tax filing positions are reasonable and comply with applicable law, we regularly review our tax filing positions, especially in light of tax law or business practice changes, and we may change our positions or determine that previous positions should be amended, either of which could result in additional tax liabilities. The final determination of tax audits or tax disputes may be different from what is reflected in our historical income tax provisions and accruals. The evaluation of tax positions and recognition of income tax benefits require significant judgment and we consult with external tax and legal counsel, as appropriate. We consider the technical merits of our tax positions along with the applicable tax statutes, related interpretations and precedents and our expectation of the outcome of proceedings (or negotiations) with tax authorities. We recognize liabilities when we believe that uncertain positions may not be fully sustained upon audit by the tax authorities, including any related appeals or litigation processes. Liabilities recognized for uncertain tax positions are based on a two-step approach for recognition and measurement. First, we evaluate the tax position for recognition by determining if the weight of available evidence indicates it is more likely than not that the position will be sustained based on its technical merits. Second, we measure the tax benefit as the largest amount that is more than 50% likely of being realized upon ultimate settlement. Interest and penalties attributable to uncertain tax positions, if any, are recognized as a component of income tax expense. The tax benefits ultimately realized by us may be different than what is recorded in the financial statements due to future events such as our settling the matter with the tax authorities and our success in sustaining our tax positions. See Notes 15 and 16 to our Consolidated Financial Statements for further information.ContingenciesLoss contingencies (other than income tax-related contingencies disclosed above) arise from actual or possible claims and assessments and pending or threatened litigation that may be brought against us by individuals, governments or other entities. Based on our assessment of loss contingencies at each balance sheet date, a loss is recorded in the financial statements if it is probable that an asset has been impaired or a liability has been incurred and the amount of the loss can be reasonably estimated. If the amount of the loss cannot be reasonably estimated, we disclose information about the contingency in the financial statements. We also disclose information in our financial statements about reasonably possible loss contingencies. The determination of whether a loss is probable and whether the amount of the loss can be reasonably estimated requires significant judgment and evaluation of all the underlying facts and circumstances, including judgments about the potential actions of third-party claimants, regulatory authorities and courts. Claims, assessments and litigations involve significant uncertainties such as the complexity of the facts, the legal theories involved, the nature of the claims, the judgment of the courts, the applicable methodology for determining potential damages and, in the case of class actions, whether a class action can be certified, the extent to which members of a class would or would not file a claim and the uncertainty inherent in class actions.On a quarterly basis, we update our analysis and estimates considering all available information, including the impact of negotiations, settlements, rulings and advice of legal counsel. Changes in our assessment of whether a loss is probable, our estimate of the loss, or our determination of whether the amount of loss can be reasonably estimated could have a material impact on our results of operations and financial position. Changes in our assumptions regarding a particular matter or the effectiveness of our strategies related to legal and other proceedings could also have a material impact on our results of operations and financial position. For all loss contingencies, until a matter is finally resolved, there may be an exposure to loss in excess of the liability accrued for the matter and such amounts could be material.See Note 16 to our Consolidated Financial Statements for further information.Recent Accounting Pronouncements - See Note 2 to our Consolidated Financial Statements for details, which is incorporated into this Item 7 by reference thereto.53Results of Operations Year Ended December 31, 2020 compared to Year Ended December 31, 2019We evaluate certain operating and financial measures on both an as-reported and constant-currency basis. We calculate constant currency by converting our current-year period operating and financial results for transactions recorded in currencies other than U.S. Dollars using the corresponding prior-year period monthly average exchange rates rather than the current-year period monthly average exchange rates. Operating and Statistical Metrics Our financial results are driven by certain operating metrics that encompass the booking and other business activity generated by our travel and travel-related services. Specifically, reservations of accommodation room nights, rental car days and airline tickets capture the volume of units booked through our OTC brands by our travel reservation services customers. Gross bookings is an operating and statistical metric that captures the total dollar value, generally inclusive of taxes and fees, of all travel services booked through our OTC brands by our customers, net of cancellations, and is widely used in the travel business. Our non-OTC brands (KAYAK and OpenTable) have different business metrics from those of our OTC brands and therefore search queries through KAYAK and restaurant reservations through OpenTable do not contribute to our gross bookings.Accommodation room nights, rental car days and airline tickets reserved through our services for the years ended December 31, 2020 and 2019 were as follows: Year Ended December 31, (in millions)Increase (Decrease) 20202019Room nights355 845 (58.0)%Rental car days31 77 (59.8)%Airline tickets6 7 (21.6)% Accommodation room nights, rental car days and airline tickets reserved through our services each declined for the year ended December 31, 2020, compared to the year ended December 31, 2019, due to the COVID-19 pandemic, which drove a substantial decline in new travel bookings and increased cancellation rates. Gross bookings resulting from reservations of accommodation room nights, rental car days and airline tickets made through our agency and merchant models for the years ended December 31, 2020 and 2019 were as follows (numbers may not total due to rounding): Year Ended December 31, (in millions)Increase (Decrease) 20202019Agency$24,475 $70,651 (65.4)%Merchant10,920 25,791 (57.7)%Total$35,395 $96,443 (63.3)% Gross bookings decreased by 63.3% for the year ended December 31, 2020, compared to the year ended December 31, 2019 (decreased on a constant-currency basis by approximately 63%), almost entirely due to the 58.0% decline in accommodation room night reservations, as well as a decline in accommodation ADRs of approximately 14% on a constant-currency basis for the year ended December 31, 2020, compared to the year ended December 31, 2019. We believe that unit growth rates and growth in total gross bookings on a constant-currency basis, which excludes the impact of foreign currency exchange rate fluctuations, are important measures to understand the fundamental performance of the business.Agency gross bookings are derived from travel-related transactions where we do not facilitate payments from travelers for the travel services provided. Agency gross bookings decreased by 65.4% for the year ended December 31, 2020, compared to the year ended December 31, 2019, almost entirely due to a decrease in gross bookings from agency accommodation room night reservations at Booking.com.54Merchant gross bookings are derived from services where we facilitate payments from travelers for the travel services provided. Merchant gross bookings decreased by 57.7% for the year ended December 31, 2020, compared to the year ended December 31, 2019, principally due to a decrease in gross bookings from our merchant accommodation reservation services at Booking.com, agoda and Priceline. Merchant gross bookings for the year ended December 31, 2020, compared to the year ended December 31, 2019, declined less than agency gross bookings due to the stronger growth of merchant gross bookings early in the year as Booking.com had been expanding its merchant accommodation reservation services prior to the COVID-19 pandemic, as well as due to relatively better performance from our merchant travel reservation services at Priceline. RevenuesOnline travel reservation servicesSubstantially all of our revenues are generated by providing online travel reservation services, which facilitate online travel purchases between travel service providers and travelers. Revenues from online travel reservation services are classified into two categories: •Agency. Agency revenues are derived from travel-related transactions where we do not facilitate payments from travelers for the services provided. Agency revenues consist almost entirely of travel reservation commissions. Substantially all of our agency revenue is from Booking.com agency accommodation reservations. •Merchant. Merchant revenues are derived from travel-related transactions where we facilitate payments from travelers for the services provided, generally at the time of booking. Merchant revenues include (1) travel reservation commissions and transaction net revenues (i.e., the amount charged to travelers less the amount owed to travel service providers) in connection with our merchant reservation services; (2) credit card processing rebates and customer processing fees; and (3) ancillary fees, including travel-related insurance revenues. Substantially all merchant revenues are derived from transactions where travelers book accommodation reservations or rental car reservations. Advertising and other revenuesAdvertising and other revenues are derived primarily from (1) revenues earned by KAYAK for (a) sending referrals to OTCs and travel service providers and (b) advertising placements on its platforms; and (2) revenues earned by OpenTable for (a) restaurant reservation services (fees paid by restaurants for diners seated through OpenTable's online reservation service) and (b) subscription fees for restaurant management services. Year Ended December 31, (in millions)Increase (Decrease) 20202019Agency revenues$4,314 $10,117 (57.4)%Merchant revenues2,117 3,830 (44.7)%Advertising and other revenues365 1,119 (67.3)%Total revenues$6,796 $15,066 (54.9)%Total revenues for the year ended December 31, 2020, as compared to the year ended December 31, 2019, respectively, decreased by 54.9% (decreased on a constant-currency basis by approximately 55%). A significant majority of the year-over-year decrease was related to revenues from our accommodation reservation services. Total revenues for the year ended December 31, 2020 were negatively impacted by a reduction in revenue of $44 million for refunds paid or estimated to be payable to travelers as a result of the COVID-19 pandemic where we agreed to provide free cancellation for certain non-refundable reservations without a corresponding estimated expected recovery from the travel service providers (see Notes 2 and 3 to the Consolidated Financial Statements). In addition, total revenues for the year ended December 31, 2020 were negatively impacted by additional rebates of approximately $100 million offered to travel service providers meeting certain eligibility requirements under an incentive program that ended in 2020 (see Note 3 to the Consolidated Financial Statements).55Agency revenues decreased by 57.4% for the year ended December 31, 2020, compared to the year ended December 31, 2019, due to the ongoing impacts of the COVID-19 pandemic. Merchant revenues decreased by 44.7% for the year ended December 31, 2020, compared to the year ended December 31, 2019, due primarily to decreases in gross bookings from our merchant accommodation reservation services and merchant rental car reservation services due to the ongoing impacts of the COVID-19 pandemic. Advertising and other revenues decreased by 67.3% for the year ended December 31, 2020, compared to the year ended December 31, 2019, primarily due to the COVID-19 pandemic, which resulted in a decline in consumer demand for the travel and restaurant-related services offered by KAYAK and OpenTable. In addition, advertising and other revenue related to OpenTable has been further impacted by a program that waived fees payable by restaurants for diners seated through OpenTable's online reservation service and subscription fees for many restaurants.Total revenues as a percentage of gross bookings was 19.2% for the year ended December 31, 2020 as compared to 15.6% for the year ended December 31, 2019 due primarily to timing of booking versus travel as revenue benefited from travel early in the year ended December 31, 2020 before the COVID-19 pandemic, while gross bookings were negatively impacted by cancellations of bookings made in 2019. Our international businesses accounted for approximately $6.0 billion of our total revenues for the year ended December 31, 2020, compared to $13.5 billion for the year ended December 31, 2019. Total revenues attributable to our international businesses for the year ended December 31, 2020 decreased by 55.6%, compared to the year ended December 31, 2019 (decreased on a constant-currency basis by approximately 55%). Total revenues attributable to our U.S. businesses decreased 49.0% for the year ended December 31, 2020 compared to the year ended December 31, 2019.Operating Expenses Marketing expenses Year Ended December 31, (in millions)Increase (Decrease) 20202019Marketing expenses$2,179 $4,967 (56.1)%% of Total revenues32.1 %33.0 % We rely on marketing channels to generate a significant amount of traffic to our websites. Marketing expenses consist primarily of the costs of: (1) search engine keyword purchases; (2) referrals from meta-search and travel research websites; (3) affiliate programs; (4) offline and online brand marketing; and (5) other performance-based marketing and incentives. For the year ended December 31, 2020, our marketing expense declined significantly due to reduced travel demand as a result of the COVID-19 pandemic. We adjust our marketing spend based on our growth and profitability objectives, as well as the travel demand and expected ROIs in our marketing channels. Marketing expenses as a percentage of total revenues decreased for the year ended December 31, 2020, compared to the year ended December 31, 2019, primarily due to actions we took to reduce our brand and performance marketing spend in response to the reduced travel demand.Sales and Other Expenses Year Ended December 31, (in millions)Increase (Decrease) 20202019Sales and other expenses$755 $955 (20.8)%% of Total revenues11.1 %6.3 % Sales and other expenses consist primarily of: (1) credit card and other payment processing fees associated with merchant transactions; (2) provisions for expected credit losses, primarily related to accommodation commission receivables and prepayments to certain customers; (3) fees paid to third parties that provide call center, website content translations and other services; (4) customer relations costs; and (5) customer chargeback provisions and fraud prevention expenses associated with merchant transactions. For the year ended December 31, 2020, sales and other expenses, which are substantially variable in nature, decreased compared to the year ended December 31, 2019, due primarily to decreases in expenses related to 56transactions processed on a merchant basis, partially offset by an increase in expected credit loss expenses of $161 million primarily resulting from the impact of the COVID-19 pandemic (see Notes 2 and 7 to the Consolidated Financial Statements).Personnel Year Ended December 31, (in millions)Increase (Decrease) 20202019Personnel$1,944 $2,248 (13.5)%% of Total revenues28.6 %14.9 % Personnel expenses consist of compensation to our personnel, including salaries, stock-based compensation, bonuses, payroll taxes, and employee health and other benefits. Personnel expenses decreased during the year ended December 31, 2020, compared to the year ended December 31, 2019, primarily due to $126 million of government aid benefit and approximately $110 million of savings resulting from restructuring activities at all our brands, as well as a decrease in stock-based compensation expense and lower bonus accruals, both of which were impacted by reduced financial performance and reduced headcount as a result of the COVID-19 pandemic. Stock-based compensation expense was $233 million for the year ended December 31, 2020, compared to $308 million for the year ended December 31, 2019. Headcount decreased 23% year-over-year to approximately 20,300 as of December 31, 2020, compared to approximately 26,400 as of December 31, 2019, primarily due to restructuring actions and attrition, as well as a general temporary company-wide hiring freeze. Given the timing of our restructuring actions, the average quarter-end headcount for 2020 only decreased 6% compared to 2019.General and Administrative Year Ended December 31, (in millions)Increase (Decrease) 20202019General and administrative$581 $797 (27.1)%% of Total revenues8.6 %5.3 % General and administrative expenses consist primarily of: (1) occupancy and office expenses; (2) fees for outside professionals, including litigation expenses; (3) indirect taxes such as travel transaction taxes and digital services taxes; and (4) personnel-related expenses such as travel, relocation, recruiting and training expenses. General and administrative expenses decreased during the year ended December 31, 2020, compared to the year ended December 31, 2019, due to lower personnel-related expenses associated with a general company-wide freeze on non-essential travel and entertainment and employee hiring due to the COVID-19 pandemic, lower office and occupancy expenses due to employees working remotely, and lower professional service fees. Information Technology Year Ended December 31, (in millions)Increase (Decrease) 20202019Information technology$299 $285 4.9 %% of Total revenues4.4 %1.9 % Information technology expenses consist primarily of: (1) software license and system maintenance fees; (2) outsourced data center and cloud computing costs; (3) payments to contractors; and (4) data communications and other expenses associated with operating our services. Information technology expenses increased during the year ended December 31, 2020, compared to the year ended December 31, 2019, due to increased software license fees related to cyber security and data privacy software, as well as increased outsourced data center costs.57Depreciation and Amortization Year Ended December 31, (in millions)Increase (Decrease) 20202019Depreciation and amortization$458 $469 (2.4)%% of Total revenues6.7 %3.1 % Depreciation and amortization expenses consist of: (1) amortization of intangible assets with determinable lives; (2) depreciation of computer equipment; (3) amortization of internally-developed and purchased software; and (4) depreciation of leasehold improvements, furniture and fixtures and office equipment. Depreciation and amortization expenses decreased during the year ended December 31, 2020, compared to the year ended December 31, 2019, as a result of decreased depreciation of computer equipment, amortization of intangible assets and depreciation of leasehold improvements, partially offset by increased internally-developed software amortization expenses.Restructuring and other exit costs Year Ended December 31, (in millions)Increase (Decrease) 20202019Restructuring and other exit costs$149 $— N/A% of Total revenues2.2 %N/A During the year ended December 31, 2020, we took restructuring actions at all our brands in response to the impact of the COVID-19 pandemic on our business, and as a result incurred restructuring charges amounting to $149 million. These restructuring charges are primarily related to employee severance and benefits (see Note 20 to the Consolidated Financial Statements).Impairment of Goodwill Year Ended December 31, (in millions)Increase (Decrease) 20202019Impairment of Goodwill$1,062 $— N/A% of Total revenues15.6 %N/A During the year ended December 31, 2020, we recorded impairment charges to goodwill related to OpenTable and KAYAK, which are not tax-deductible, of $1.1 billion (see Note 11 to our Consolidated Financial Statements and Critical Accounting Policies and Estimates included in this Management's Discussion and Analysis of Financial Condition and Results of Operations).Interest expense Year Ended December 31, (in millions)Increase (Decrease) 20202019Interest expense(356)(266)33.8 % Interest expense increased for the year ended December 31, 2020, compared to the year ended December 31, 2019, primarily due to interest expense attributable to our Senior Notes and Convertible Senior Notes issued in April 2020.58Other income (expense), net Year Ended December 31, (in millions)Increase (Decrease) 20202019Other income (expense), net1,554 879 76.8 %The following table sets forth the breakdown of "Other income (expense), net" for the years ended December 31, 2020 and 2019:Year Ended December 31,(in millions)20202019Interest and dividend income$54 $152 Net gains on marketable equity securities1,811 745 Impairment of investment(100)— Foreign currency transaction losses(207)(31)Other (4)13 Other income (expense), net$1,554 $879 Interest and dividend income decreased for the year ended December 31, 2020, compared to the year ended December 31, 2019, primarily due to lower average invested balances and lower yields as well as increased usage of investments classified as cash equivalents.Net gains on marketable equity securities for the years ended December 31, 2020 and 2019 primarily related to the unrealized gains on our equity investment in Meituan (see Note 5 to our Consolidated Financial Statements for additional information). Impairment of investment for the year ended December 31, 2020 related to our investment in Didi Chuxing (see Notes 5 and 6 to our Consolidated Financial Statements and Critical Accounting Policies and Estimates included in this Management's Discussion and Analysis of Financial Condition and Results of Operations for additional information).Foreign currency transaction losses include losses of $200 million and gains of $7 million related to the portion of our Euro-denominated debt that was not designated as a net investment hedge and foreign currency losses on derivative contracts of $31 million and $19 million for the years ended December 31, 2020 and 2019, respectively.Income Taxes Year Ended December 31, (in millions)Increase (Decrease) 20202019Income tax expense$508 $1,093 (53.5)%% of Earnings before income taxes89.5 %18.3 % Our 2020 effective tax rate differs from the U.S. federal statutory tax rate of 21%, primarily due to the non-deductible goodwill impairment charges related to OpenTable and KAYAK, U.S. federal tax associated with our 2020 international earnings, and an increase in unrecognized tax benefits, partially offset by the benefit of the Netherlands Innovation Box Tax (discussed below). Our 2019 effective tax rate differs from the U.S. federal statutory tax rate of 21%, primarily due to the benefit of the Netherlands Innovation Box Tax, partially offset by the effect of higher international tax rates and U.S. federal and state tax associated with our 2019 international earnings, resulting from the enactment of the Tax Act, as well as certain non-deductible expenses. Our effective tax rate was higher for the year ended December 31, 2020, compared to the year ended December 31, 2019, primarily due to the non-deductible goodwill impairment charges related to OpenTable and KAYAK, an increase in U.S. federal tax associated with our 2020 international earnings, and an increase in unrecognized tax benefits. 59According to Dutch corporate income tax law, income generated from qualifying innovative activities is taxed at a rate of 7% ("Innovation Box Tax") rather than the Dutch statutory rate of 25%. A portion of Booking.com's earnings during the years ended December 31, 2020 and 2019 qualified for Innovation Box Tax treatment, which had a significant beneficial impact on our effective tax rates for those periods. In 2020, the Dutch government approved an increase in the Innovation Box Tax rate from 7% to 9%, effective January 2021. While we expect Booking.com to continue to qualify for Innovation Box Tax treatment with respect to a portion of its earnings for the foreseeable future, the loss of the Innovation Box Tax benefit, whether due to a change in tax law or a determination by the Dutch government that Booking.com's activities are not innovative or for any other reason, could substantially increase our effective tax rate and adversely impact our results of operations and cash flows in future periods. See Part I, Item 1A, Risk Factors - "We may not be able to maintain our 'Innovation Box Tax' benefit."Results of OperationsYear Ended December 31, 2019 compared to Year Ended December 31, 2018 For a comparison of our results of operations for the fiscal years ended December 31, 2019 and 2018, see Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations, of our Annual Report on Form 10-K for the fiscal year ended December 31, 2019, filed with the SEC on February 26, 2020.60Liquidity and Capital Resources The COVID-19 pandemic and the resulting economic conditions and government orders have resulted in a material decrease in consumer spending and an unprecedented decline in travel and restaurant activities and consumer demand for related services. Our financial results and prospects are almost entirely dependent on the sale of travel-related services.The extent of the effects of the COVID-19 pandemic on our business, results of operations, cash flows and growth prospects is highly uncertain and will ultimately depend on future developments. These include, but are not limited to, the severity, extent and duration of the COVID-19 pandemic, including as a result of any new variants of COVID-19 and any resurgences of the pandemic, and its impact on the travel and restaurant industries and consumer spending more broadly. Even if economic and operating conditions for our business improve, we cannot predict the long-term effects of the pandemic on our business or the travel and restaurant industries as a whole. If the travel and restaurant industries are fundamentally changed by the COVID-19 pandemic in ways that are detrimental to our operating model, our business may continue to be adversely affected even as the broader global economy recovers.Our continued access to sources of liquidity depends on multiple factors, including global economic conditions, the condition of global financial markets, the availability of sufficient amounts of financing, our ability to meet debt covenant requirements, our operating performance and our credit ratings. If our credit ratings were to be downgraded, or financing sources were to ascribe higher risk to our rating levels or our industry, our access to capital and the cost of any financing would be negatively impacted. There is no guarantee that additional debt financing will be available in the future to fund our obligations, or that it will be available on commercially reasonable terms, in which case we may need to seek other sources of funding. In addition, the terms of future debt agreements could include more restrictive covenants than those we are currently subject to, which could restrict our business operations. For more information, see Part I, Item 1A, Risk Factors - "Our liquidity, credit ratings and ongoing access to capital could be materially and negatively affected by the impacts of the COVID-19 pandemic."At December 31, 2020, we had $14.8 billion in cash, cash equivalents and short-term and long-term investments, of which approximately $6.0 billion is held by our international subsidiaries. Cash, cash equivalents and long-term investments held by our international subsidiaries are denominated primarily in Hong Kong Dollars, U.S. Dollars and Euros. Cash equivalents and short-term and long-term investments are principally comprised of money market funds, time deposits and certificates of deposit, convertible debt securities of Trip.com Group, Meituan equity securities and our investments in private companies (see Notes 5 and 6 to the Consolidated Financial Statements). In May 2020, our May 2015 investment of $250 million in Trip.com Group's convertible senior notes was repaid upon maturity. We have the option to redeem our December 2015 investment of $500 million in Trip.com Group's convertible senior notes in December 2021, which we expect to exercise (see Note 5 to our Consolidated Financial Statements).During the year ended December 31, 2020, we realized $2.2 billion in cash from sales and maturities of our investments in government and corporate debt securities. In addition, we sold our entire investment in Trip.com Group ADSs, with a cost basis of $655 million for $525 million.At December 31, 2020, we had a remaining transition tax liability of $1.0 billion as a result of the Tax Act, which included $923 million reported as "Long-term U.S. transition tax liability" and $90 million included in "Accrued expenses and other current liabilities" in the Consolidated Balance Sheet. This liability will be paid over the next six years. In accordance with the Tax Act, generally, future repatriation of our international cash will not be subject to a U.S. federal income tax liability as a dividend, but will be subject to U.S. state income taxes and international withholding taxes, which have been accrued by us. In August 2019, we entered into a $2.0 billion five-year unsecured revolving credit facility with a group of lenders. The revolving credit facility provides for the issuance of up to $80 million of letters of credit as well as borrowings of up to $100 million on same-day notice, referred to as swingline loans. The proceeds of loans made under the facility can be used for working capital and general corporate purposes, including acquisitions, share repurchases and debt repayments. At December 31, 2020, there were no borrowings outstanding and $4 million of letters of credit issued under the facility. The revolving credit facility contains a maximum leverage ratio covenant, compliance with which is a condition to our ability to borrow thereunder. In April 2020, we amended the revolving credit facility, pursuant to which the maximum leverage ratio covenant was suspended through and including the three months ending March 31, 2021, and was replaced with a $4.5 billion minimum liquidity covenant based on unrestricted cash, cash equivalents, short-term investments and unused capacity under the revolving credit facility. In October 2020, we further amended the revolving credit facility to extend the suspension of the maximum leverage ratio covenant and the related replacement with the minimum liquidity covenant through and including the three months ending March 31, 2022 and increase the permitted maximum leverage ratio from and including the three months ending June 30, 2022 through and including the three months ending March 31, 2023. We agreed not to declare or make any cash distribution and not to repurchase any of our shares (with certain exceptions including in connection with tax withholding 61related to shares issued to employees) unless (i) prior to the delivery of financial statements for the three months ending June 30, 2022, we have at least $6.0 billion of liquidity on a pro forma basis, based on unrestricted cash, cash equivalents, short-term investments and unused capacity under this revolving credit facility and (ii) after the delivery of financial statements for the three months ending June 30, 2022, we are in compliance on a pro forma basis with the maximum leverage ratio covenant then in effect. Such restriction ends upon delivery of financial statements required for the three months ending June 30, 2023, or we have the ability to terminate this restriction earlier if we demonstrate compliance with the original maximum leverage ratio covenant in the revolving credit facility. Beginning with the quarter ending June 30, 2022, the minimum liquidity covenant will cease to apply and the maximum leverage ratio covenant, as increased, will again be in effect. At December 31, 2020, we were in compliance with the minimum liquidity covenant. There can be no assurance that we will be able to meet either the minimum liquidity covenant or the maximum leverage ratio covenant, as applicable, at any particular time, and our ability to borrow under the revolving credit facility depends on compliance with the applicable covenant. Further, the lenders have the right to require repayment of any amounts borrowed under the facility if we are not in compliance with the applicable covenant (see Note 12 to the Consolidated Financial Statements). In June 2020, in connection with the maturity of our Convertible Senior Notes due June 2020, we paid $1.0 billion to satisfy the aggregate principal amount due and paid an additional $245 million in satisfaction of the conversion value in excess of the principal amount. In addition, the holders of our Convertible Senior Notes due September 2021 will have the right to convert all or any portion of the Notes beginning on June 15, 2021, regardless of our stock price (see Note 12 to our Consolidated Financial Statements). In April 2020, we issued Senior Notes due April 13, 2025 with an interest rate of 4.10% for an aggregate principal amount of $1.0 billion, Senior Notes due April 13, 2027 with an interest rate of 4.50% for an aggregate principal amount of $750 million and Senior Notes due April 13, 2030 with an interest rate of 4.625% for an aggregate principal amount of $1.5 billion. In addition, in April 2020, we issued $863 million aggregate principal amount of Convertible Senior Notes due May 1, 2025 with an interest rate of 0.75%. The proceeds from the issuance of these Senior Notes and Convertible Senior Notes can be used for general corporate purposes, which may include repayment of debt, including the repayment, at maturity or upon conversion prior thereto, of our outstanding Convertible Senior Notes (see Note 12 to the Consolidated Financial Statements).At December 31, 2020 and December 31, 2019, there were $14.0 billion and $9.6 billion, respectively, of payment obligations related to the aggregate principal of our outstanding senior notes outstanding and cumulative interest to maturity. See Note 12 to the Consolidated Financial Statements for information related to the Company's debt including principal, interest rates and maturity dates.During the year ended December 31, 2020, we repurchased 684,827 shares of our common stock for an aggregate cost of $1.3 billion. At December 31, 2020, we had a remaining aggregate amount of $10.4 billion authorized by our Board of Directors to repurchase our common stock. We have not repurchased any shares since March 2020 under this stock repurchase authorization and do not intend to initiate any repurchases under this authorization until we have better visibility into the shape and timing of a recovery from the COVID-19 pandemic. See Note 12 to the Consolidated Financial Statements for a description of the impact of the October 2020 credit facility amendment on our ability to repurchase shares. In September 2016, we signed a turnkey agreement to construct an office building for Booking.com’s future headquarters in the Netherlands for 270 million Euros ($331 million). Upon signing this agreement, we paid 43 million Euros ($48 million) for the acquired land-use rights. In addition, since signing the turnkey agreement we have made several progress payments principally related to the construction of the building. At December 31, 2020, we had a remaining obligation of 56 million Euros ($68 million) related to the turnkey agreement. This remaining obligation will be paid through 2022, when we anticipate construction will be complete. In addition to the turnkey agreement, we have a remaining obligation at December 31, 2020 to pay 70 million Euros ($86 million) over the remaining initial term of the acquired land lease, which expires in 2065. At December 31, 2020, we had 29 million Euros ($35 million) of outstanding commitments to vendors to fit out and furnish the office space. See Note 16 to our Consolidated Financial Statements for additional information related to our commitments and contingencies.We have taken and are taking actions to improve our liquidity including, but not limited to, raising additional capital through the issuance of Senior Notes and Convertible Senior Notes as disclosed above, reducing capital expenditures and operating expenses by significantly reducing marketing spend worldwide and working to eliminate non-essential operating costs, monitoring the financial health of our partners, suppliers and other third-party relationships, implementing a general temporary company-wide hiring freeze for much of 2020 and undertaking certain personnel actions such as furloughs and workforce reductions. We believe that our existing cash balances and liquid resources will be sufficient to fund our operating activities, capital expenditures and other obligations through at least the next twelve months. However, whether as a result of the COVID-19 pandemic or otherwise, if we are not successful in generating sufficient cash flow from operations or in raising additional capital when required in sufficient amounts and on terms acceptable to us, we may be required to reduce our planned capital expenditures and scale back the scope of our business plans, either of which could have a material adverse effect on our business, our ability to compete or our future growth prospects, financial condition and results of operations. If additional funds were raised through the issuance of equity securities, the percentage ownership of our then current stockholders would be diluted. We may not generate sufficient cash flow from operations in the future, revenue growth or sustained profitability may not be realized, and future borrowings or equity sales may not be available in amounts sufficient to make anticipated capital expenditures, finance our strategies or repay our indebtedness. 62Cash Flow AnalysisNet cash provided by operating activities decreased for the year ended December 31, 2020, compared to the year ended December 31, 2019, primarily due to the negative impact of the COVID-19 pandemic to our businesses and financial results, partially offset by the impact of the payment of $403 million in 2019 to French tax authorities to preserve our right to contest certain tax assessments in court (see Note 16 to our Consolidated Financial Statements).Net cash provided by operating activities for the year ended December 31, 2020 was $85 million, resulting from net income of $59 million and a favorable impact from adjustments for non-cash items of $1.0 billion, partially offset by an unfavorable net change in working capital and long-term assets and liabilities of $1.0 billion. Non-cash items were principally associated with net gains on marketable equity securities, impairment of goodwill, depreciation and amortization, provision for expected credit losses and chargebacks, stock-based compensation expense and other stock-based payments, deferred income tax expense and unrealized foreign currency transaction losses on Euro-denominated debt. For the year ended December 31, 2020, prepaid expenses and other current assets decreased by $161 million, primarily due to a refund for overpayment from a vendor and lower prepayment to third-party payment processors due to decreases in business volumes as a result of the COVID-19 pandemic. For the year ended December 31, 2020, accounts receivable decreased by $891 million and deferred merchant bookings and other current liabilities decreased by $2.3 billion primarily due to decreases in business volumes as a result of the COVID-19 pandemic.Net cash provided by operating activities for the year ended December 31, 2019 was $4.9 billion, resulting from net income of $4.9 billion and a favorable impact from adjustments for non-cash items of $541 million, partially offset by an unfavorable net change in working capital and long-term assets and liabilities of $541 million. Non-cash items were principally associated with net gains on marketable equity securities, depreciation and amortization, stock-based compensation expense and other stock-based payments, operating lease amortization and the provision for expected credit losses and chargebacks. The changes in working capital for the year ended December 31, 2019, reflecting the increase in business volumes and growth in Booking.com's merchant transactions, were primarily related to a $480 million increase in deferred merchant bookings and other current liabilities, offset by a $323 million increase in accounts receivable and $263 million increase in prepaid expenses and other current assets. The net change in long-term assets and liabilities of $435 million was primarily due to the increase in other long-term assets related to the payment of $403 million to French tax authorities to preserve our right to contest the assessments in court (see Note 16 to our Consolidated Financial Statements). Net cash provided by investing activities for the year ended December 31, 2020 was $2.6 billion, principally resulting from the proceeds from sales and maturities of investments of $3.0 billion, net of purchases of $74 million. Net cash provided by investing activities for the year ended December 31, 2019 was $7.1 billion, principally resulting from the proceeds from sales and maturities of investments of $8.1 billion, net of purchases of $0.7 billion. Cash invested in the purchase of property and equipment was $286 million and $368 million for the years ended December 31, 2020 and 2019, respectively. Cash invested in the purchase of property and equipment for the years ended December 31, 2020 and 2019 includes payments of $52 million and $51 million, respectively, related to the turnkey agreement for constructing Booking.com's future headquarters. Net cash provided by financing activities for the year ended December 31, 2020 was $1.5 billion, almost entirely resulting from the proceeds from the issuance of long-term debt of $4.1 billion, partially offset by payments for the repurchase of common stock of $1.3 billion and payments for the conversion of convertible notes of $1.2 billion. Net cash used in financing activities for the year ended December 31, 2019 was $8.2 billion, almost entirely resulting from payments for the repurchase of common stock. For a discussion of our liquidity and capital resources as of and our cash flow activities for the fiscal year ended December 31, 2018, see Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations, of our Annual Report on Form 10-K for the fiscal year ended December 31, 2019, filed with the SEC on February 26, 2020.ContingenciesFrench tax authorities conducted audits of Booking.com for the years 2003 through 2012 and years 2013 through 2015 and currently are conducting an audit for the years 2016 through 2018. In December 2015, the French tax authorities issued Booking.com assessments for unpaid income and value added taxes ("VAT") related to tax years 2006 through 2012 for approximately 356 million Euros ($403 million), the majority of which represents penalties and interest. The assessments assert that Booking.com had a permanent establishment in France. In December 2019, the French tax authorities issued an additional assessment of 70 million Euros ($86 million), including interest and penalties, for the 2013 year asserting that Booking.com had taxable income attributable to a permanent establishment in France. The French tax authorities also have issued assessments totaling 39 million Euros ($48 million), including interest and penalties, for certain tax years between 2011 63and 2015 on Booking.com's French subsidiary asserting that the subsidiary did not receive sufficient compensation for the services it rendered to Booking.com in the Netherlands. As a result of a formal demand from the French tax authorities for payment of the amounts assessed against Booking.com for the years 2006 through 2012, in January 2019, we paid the assessments of approximately 356 million Euros ($403 million) in order to preserve our right to contest those assessments in court. The payment, which is included in "Other assets, net" in the Consolidated Balance Sheets at December 31, 2020 and 2019, does not constitute an admission that we owe the taxes and will be refunded (with interest) to us to the extent we prevail. In December 2019 and October 2020, we initiated court proceedings with respect to certain of the assessments. Although we believe that Booking.com has been, and continues to be, in compliance with French tax law, and we are contesting the assessments, during the three months ended September 30, 2020, we contacted the French tax authorities regarding the potential to achieve resolution of the matter through a settlement. After assessing several potential outcomes and potential settlement amounts and terms, an unrecognized tax benefit in the amount of 50 million Euros ($61 million) has been recorded during the year ended December 31, 2020, of which the majority has been included as a partial reduction to the tax payment recorded in "Other Assets, net" in the Consolidated Balance Sheet at December 31, 2020. In December 2020, the French Administrative Court (Conseil d’Etat) delivered a decision in the "ValueClick" case that could have an impact on the outcome in our case. After considering the potential impact of the new decision on the potential outcomes for the Booking.com assessments, we currently estimate that the reasonably possible loss related to VAT is approximately 20 million Euros ($24 million). Additional assessments could result when the French tax authorities complete the outstanding audits. For additional information related to the French tax assessments, see Note 16 to our Consolidated Financial Statements and Part I, Item 1A, Risk Factors - "We may have exposure to additional tax liabilities."Beginning in 2014, Booking.com received several letters from the Netherlands Pension Fund for the Travel Industry (Reiswerk) (“BPF”) claiming that Booking.com is required to participate in the mandatory pension scheme of the BPF with retroactive effect to 1999, which has a higher contribution rate than the pension scheme in which Booking.com is currently participating. BPF instituted legal proceedings against Booking.com and in 2016 the District Court of Amsterdam rejected all of BPF’s claims. BPF appealed the decision to the Court of Appeal, and, in May 2019, the Court of Appeal also rejected all of BPF’s claims, in each case by ruling that Booking.com does not meet the definition of a travel intermediary for purposes of the mandatory pension scheme. BPF has appealed to the Netherlands Supreme Court. In October 2020, the Dutch Advocate General issued an opinion to the Supreme Court stating that the Dutch Advocate General believes the decision of the Court of Appeal to be incorrect based on her interpretation of the pension scheme requirements. We have submitted to the Supreme Court a response to the Advocate General's opinion. While we continue to believe that Booking.com is in compliance with its pension obligations and that the Dutch Supreme Court should uphold the ruling of the Court of Appeal, based on the significant influence the Dutch Advocate General’s opinion typically has on the Supreme Court, we have reevaluated the probability of a loss and believe it is probable that we have incurred a loss related to this matter. We expect the Dutch Supreme Court to rule in the first quarter of 2021. In the event the Supreme Court overturns the decision of the Court of Appeal and remands the case to a lower court, we intend to pursue a number of defenses in any subsequent proceedings and may ultimately prevail in whole or in part. We are not able to reasonably estimate a loss or a range of loss because the litigation is ongoing and there are significant factual and legal questions yet to be determined. As a result, as of December 31, 2020, we have not recorded a liability in connection with a potential adverse outcome to this litigation. However, if Booking.com were to ultimately lose and all of BPF’s claims were to be accepted (including with retroactive effect to 1999), we estimate that as of December 31, 2020, the maximum loss, not including any potential interest or penalties, would be approximately $290 million. Such estimated potential loss increases as Booking.com continues not to contribute to the BPF and depends on Booking.com’s applicable employee compensation after December 31, 2020. For additional information related to the pension matter and our other contingent liabilities, see Note 16 to our Consolidated Financial Statements. 64Contractual Obligations and Commercial CommitmentsThe following table represents our material contractual obligations and commercial commitments at December 31, 2020: By Period (in millions)TotalLess than1 Year1 to 3Years3 to 5 YearsMore than 5 YearsOperating lease obligations(1)$585 $168 $196 $85 $136 Building construction obligation(2)103 87 16 — — Purchase obligations (3)193 77 73 43 — Senior notes(4)13,991 1,323 3,225 4,049 5,394 U.S. transition tax liability1,013 90 212 453 258 Letters of credit and bank guarantees(5)138 110 6 2 20 Revolving credit facility and other(6)11 4 6 1 — Total(7) (8)$16,034 $1,859 $3,734 $4,633 $5,808 (1) Includes the land lease for Booking.com's future headquarters. See Notes 10 and 16 to our Consolidated Financial Statements for further details.(2) Includes commitments to vendors to fit out and furnish the office space. See Note 16 to our Consolidated Financial Statements for further details.(3) Represents significant noncancellable contractual obligations individually greater than $10 million. The obligations are primarily related to sponsorship and cloud hosting arrangements. Purchase obligations included here are those related to agreements to purchase goods and services that are enforceable and legally binding, that specify all significant terms, including the quantities to be purchased, price provisions and the approximate timing of the transaction.(4) Represents the aggregate principal amount of our senior notes outstanding at December 31, 2020 and cumulative interest to maturity of $1.8 billion. Convertible debt does not reflect the market value in excess of the outstanding principal amount because we can settle the conversion premium amount in cash or shares of common stock at our option. See Note 12 to our Consolidated Financial Statements.(5) Standby letters of credit and bank guarantees issued on behalf of the Company at December 31, 2020 are primarily related to payment guarantees to third-party payment processors (see Notes 12 and 16 to our Consolidated Financial Statements). (6) Includes commitment fees on undrawn balances available under the revolving credit facility and fees on outstanding letters of credit at December 31, 2020.(7) We reported "Other long-term liabilities" of $111 million in the Consolidated Balance Sheet at December 31, 2020, the majority of which relates to unrecognized tax benefits of $57 million (see Note 15 to our Consolidated Financial Statements). We have excluded these long-term liabilities from the contractual obligations table above as a variety of factors could affect the timing of payments for the liabilities; therefore, we cannot reasonably estimate the timing of such payments. We believe that these matters will likely not be resolved in the next twelve months and, accordingly, we have classified the estimated liability as non-current in the Consolidated Balance Sheet. (8) In 2018, we entered into an agreement to sign a future lease related to approximately 222,000 square feet of office space in the city of Manchester in the United Kingdom for the future headquarters of Rentalcars.com. Our obligation to execute the lease is conditional upon the lessor completing certain activities, which are expected to be completed in 2021. If these activities are completed, the lease will commence for a term of approximately 13 years and we will have a lease obligation of approximately 65 million British Pounds Sterling ($88 million), excluding lease incentives. We will also make capital expenditures to fit out and furnish the office space. The obligation is not included in the table of contractual obligations presented above. Off-Balance Sheet Arrangements At December 31, 2020, we did not have any off-balance sheet arrangements that have, or are reasonably likely to have, a material current or future effect on our financial condition, results of operations, liquidity, capital expenditures or capital resources.65Item 7A. Quantitative and Qualitative Disclosures About Market Risk We have exposure to several types of market risk: changes in interest rates, foreign currency exchange rates and equity prices.We manage our exposure to interest rate risk and foreign currency risk through internally established policies and procedures and, when deemed appropriate, through the use of derivative financial instruments. We use foreign currency exchange derivative contracts to manage short-term foreign currency risk.The objective of our policies is to mitigate potential income statement, cash flow and fair value exposures resulting from possible future adverse fluctuations in rates. We evaluate our exposure to market risk by assessing the anticipated near-term and long-term fluctuations in interest rates and foreign currency exchange rates. This evaluation includes the review of leading market indicators, discussions with financial analysts and investment bankers regarding current and future economic conditions and the review of market projections as to expected future rates. We utilize this information to determine our own investment strategies as well as to determine if the use of derivative financial instruments is appropriate to mitigate any potential future market exposure that we may face. Our policy does not allow speculation in derivative instruments for profit or execution of derivative instrument contracts for which there are no underlying exposures. We do not use financial instruments for trading purposes and are not a party to any leveraged derivatives. To the extent that changes in interest rates and foreign currency exchange rates affect general economic conditions, we would also be affected by such changes.During the year ended December 31, 2020, we sold our investments in government and corporate debt securities other than our investments in Trip.com Group convertible senior notes (see Note 5 to the Consolidated Financial Statements). Our investments in Trip.com Group convertible senior notes are more sensitive to the equity market price volatility of Trip.com Group's American Depositary Shares ("ADSs") than changes in interest rates. The estimated fair value of our Trip.com Group convertible senior notes will likely increase as the market price of Trip.com Group's ADSs increases and will likely decrease as the market price of Trip.com Group's ADSs falls. At December 31, 2020 and 2019, the outstanding aggregate principal amount of our debt was $12.2 billion and $8.7 billion, respectively. We estimate that the fair value of such debt was approximately $14.0 billion and $9.8 billion at December 31, 2020 and 2019, respectively. The estimated fair value of our debt in excess of the outstanding principal amount at December 31, 2020 primarily relates to Senior Notes and the Convertible Senior Notes issued in April 2020. The estimated fair value of the Company's debt in excess of the outstanding principal amount at December 31, 2019 primarily relates to the conversion premium on the convertible senior notes. Excluding the effect on the fair value of our convertible senior notes, a hypothetical 100 basis point (1.0%) decrease in interest rates would have resulted in an increase in the estimated fair value of our other debt of approximately $544 million and $325 million at December 31, 2020 and 2019, respectively. Our convertible senior notes are more sensitive to the equity market price volatility of our shares than changes in interest rates. The fair value of the convertible senior notes will likely increase as the market price of our shares increases and will likely decrease as the market price of our shares falls. Our international business represents a substantial majority of our financial results. Therefore, because we report our results in U.S. Dollars, we face exposure to movements in foreign currency exchange rates as the financial results and the financial condition of our international businesses are translated from local currencies (principally Euros and British Pounds Sterling) into U.S. Dollars. If the U.S. Dollar weakens against the local currencies, the translation of these foreign-currency-denominated balances will result in increased net assets, gross bookings, revenues, operating expenses and net income. Similarly, our net assets, gross bookings, revenues, operating expenses and net income will decrease if the U.S. Dollar strengthens against the local currencies. However, for the year ended December 31, 2020, movements in foreign currency exchange rates had little to no impact on our performance metrics and financial results. Since our expenses are generally denominated in foreign currencies on a basis similar to our revenues, our operating margins have not been significantly impacted by currency fluctuations. Additionally, foreign currency exchange rate fluctuations on transactions, denominated in currencies other than the functional currency, result in gains and losses that are reflected in our Consolidated Statements of Operations. We have a significant investment that is denominated in Hong Kong Dollars and the related impact from the movements in foreign currency exchange rates is recognized in "Other income (expense), net" in the Consolidated Statements and Operations.We designate certain portions of the aggregate principal value of the Euro-denominated debt as a hedge against the impact of foreign currency exchange rate fluctuations on the net assets of one of our Euro functional currency subsidiaries. Foreign currency transaction gains or losses on the Euro-denominated debt that is not designated as a hedging instrument for accounting purposes are recognized in "Other income (expense), net" in our Consolidated Statements of Operations (see Note 12 to our Consolidated Financial Statements). Such foreign currency transaction gains or losses are dependent on the amount of 66net assets of the Euro functional currency subsidiary, the amount of the Euro-denominated debt that is designated as a hedge and fluctuations in foreign currency exchange rates. We enter into foreign currency forward contracts to hedge our exposure to the impact of movements in foreign currency exchange rates on our transactional balances denominated in currencies other than the functional currency. In periods prior to the second quarter of 2020, we also entered into foreign currency derivative contracts to hedge translation risks from short-term foreign currency exchange rate fluctuations for the Euro, British Pound Sterling and certain other currencies versus the U.S. Dollar. Since the first quarter of 2020, we have not entered into such derivative instruments as the impact of the COVID-19 pandemic on our operating results are highly uncertain. We will continue to evaluate the use of derivative instruments in the future. See Note 6 to our Consolidated Financial Statements for further information. We are exposed to equity price risk as it relates to changes in the fair values of our investments in equity securities of publicly-traded companies and private companies. Due to the impact of the COVID-19 pandemic (see Note 2 to the Consolidated Financial Statements) on the business of the investee and the estimated decline in the value of our investment, we recorded a significant impairment charge related to our investment in a private company during the three months ended March 31, 2020 (see Notes 5 and 6 to the Consolidated Financial Statements). The estimated fair values of our investments in equity securities of publicly-traded companies and private companies, excluding certain investments classified as debt securities for accounting purposes, were $3.1 billion and $455 million, respectively, at December 31, 2020, and $1.8 billion and $501 million, respectively, at December 31, 2019. Our investments in private companies, excluding certain investments classified as debt securities for accounting purposes, are measured at cost less impairment, if any, plus or minus changes resulting from observable price changes in orderly transactions for the identical or a similar investment of the same issuer. A hypothetical 10% decrease in the fair values of these investments at December 31, 2020 and 2019 would have resulted in a loss, before tax, of approximately $355 million and $230 million, respectively, being recognized in net income.
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+ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS OVERVIEWC.H. Robinson Worldwide, Inc. (“C.H. Robinson,” “the company,” “we,” “us,” or “our”) is one of the world's largest logistics platforms. Our mission is to improve the world's supply chains through our people, processes, and technology by delivering exceptional value to our customers and suppliers. We provide freight transportation services and logistics solutions to companies of all sizes in a wide variety of industries. We operate through a network of offices in North America, Europe, Asia, Oceania, and South America. We offer a global suite of services using tailored, market-leading technology built by and for supply chain experts. Our global network of supply chain experts work with our customers to drive better supply chain outcomes by leveraging our experience, data, technology, and scale.Our adjusted gross profit and adjusted gross profit margin are non-GAAP financial measures. Adjusted gross profit is calculated as gross profit excluding amortization of internally developed software utilized to directly serve our customers and contracted carriers. Adjusted gross profit margin is calculated as adjusted gross profit divided by total revenues. We believe adjusted gross profit and adjusted gross profit margin are useful measures of our ability to source, add value, and sell services and products that are provided by third parties, and we consider adjusted gross profit to be a primary performance measurement. Accordingly, the discussion of our results of operations often focuses on the changes in our adjusted gross profit and adjusted gross profit margin. The reconciliation of gross profit to adjusted gross profit and gross profit margin to adjusted gross profit margin is presented below (dollars in thousands):Twelve Months Ended December 31,202020192018Revenues:Transportation$15,147,562 $14,322,295 $15,515,921 Sourcing1,059,544 987,213 1,115,251 Total revenues16,207,106 15,309,508 16,631,172 Costs and expenses:Purchased transportation and related services12,834,608 11,839,433 12,922,177 Purchased products sourced for resale960,241 883,765 1,003,760 Direct internally developed software amortization16,634 11,492 9,664 Total direct costs13,811,483 12,734,690 13,935,601 Gross profit / Gross profit margin2,395,623 14.8 %2,574,818 16.8 %2,695,571 16.2 %Plus: Direct internally developed software amortization16,634 11,492 9,664 Adjusted gross profit / Adjusted gross profit margin$2,412,257 14.9 %$2,586,310 16.9 %$2,705,235 16.3 %Our adjusted operating margin is a non-GAAP financial measure calculated as operating income divided by adjusted gross profit. We believe adjusted operating margin is a useful measure of our profitability in comparison to our adjusted gross profit, which we consider a primary performance metric as discussed above. The reconciliation of operating margin to adjusted operating margin is presented below (dollars in thousands):Twelve Months Ended December 31,202020192018Total revenues$16,207,106 $15,309,508 $16,631,172 Operating income673,268 789,976 912,083 Operating margin4.2 %5.2 %5.5 %Adjusted gross profit$2,412,257 $2,586,310 $2,705,235 Operating income673,268 789,976 912,083 Adjusted operating margin27.9 %30.5 %33.7 %22Table of ContentMARKET TRENDSThe North American surface transportation market experienced significant volatility in freight volumes and costs over the duration of 2020 as a result of the COVID-19 pandemic. The impact on the market varied significantly depending on the severity of the restrictions in place to control the outbreak, industry, and customer size. Certain industries, such as retail, saw periods of elevated demand while other industries, especially smaller customers in those industries, experienced extended periods of demand and production well below historical levels. Industry freight volumes, as measured by the Cass Freight Index, declined approximately eight percent in 2020 compared to 2019, which reflects the volatility resulting from the COVID-19 pandemic. Industry freight volumes compared to 2019 bottomed out in the second quarter of 2020, declining approximately 21 percent before showing growth of approximately four percent in the fourth quarter of 2020 compared to the prior year. The impact of reduced consumer demand and production, in addition to driver shortages, resulted in reduced carrier capacity, most notably in truckload, as many carriers either reduced lanes or exited the market entirely. This reduced carrier capacity caused routing guides to rapidly degrade and more loads moved to the spot market, driving sharp increases in transportation costs, most significantly in the second half of 2020. One of the metrics we use to measure market conditions is the truckload routing guide depth from our Managed Services business. Routing guide depth is calculated as a simple average of all accepted shipments over all tender instances for any shipment facilitated by our Managed Services business. The average routing guide depth was 1.4 in 2020 and increased steadily during the second half of 2020, to 1.8 in the fourth quarter of 2020. This compared to an average depth of tender of 1.2 during 2019, which is among the lowest levels we have experienced this decade. The global forwarding market also experienced significant volatility resulting from the COVID-19 pandemic. The air freight market experienced a significant decline in capacity due to a reduction in commercial flights from COVID-19 restrictions, which resulted in sharp pricing increases. The impact of the COVID-19 pandemic on the ocean freight market varied significantly over the course of 2020 depending on the severity of the outbreak in regions in which we operate. Many industries experienced temporary volume reductions and factory closures due to efforts to contain the spread of the virus, which initially resulted in excess capacity and decreased pricing early in 2020. In the second half of 2020, most industries had resumed production and companies began to replenish low inventory levels amidst continued market uncertainty from the ongoing COVID-19 pandemic. As demand accelerated, it outpaced carrier capacity returning to the market, which resulted in significant pricing increases for the cost of ocean freight. BUSINESS TRENDSOur 2020 surface transportation results were largely consistent with the overall market trends summarized above, although we did experience volume increases in excess of the industry trends as measured by the Cass Freight Index. Despite industry freight volumes declining approximately eight percent in 2020, our combined North American Surface Transportation (“NAST”) truckload and LTL volumes increased approximately 5.5 percent. The COVID-19 pandemic had a significant impact on our small business customers as our customer count decreased nearly 12 percent, driven almost entirely by small and emerging market customers. Similarly, the number of active contracted transportation companies we utilized declined approximately six percent, solely with those carriers having a fleet under 100 trucks. We continued to work with our customers to meet our contractual commitments while adapting our pricing to reflect the volatile cost of transportation pricing seen since the beginning of the COVID-19 pandemic while also serving customers' needs in the spot market. This resulted in an increase in average truckload linehaul rates per mile, excluding fuel costs, charged to customers, although our truckload transportation costs, excluding fuel prices, increased at a faster rate resulting in adjusted gross profit margin compression.Our global forwarding results were largely consistent with the overall market trends summarized above. Throughout 2020, we augmented our air freight capacity with charter flights due to the significant capacity shortages in the market, which resulted in larger than normal shipment sizes. The increase in air freight pricing more than offset an 18.0 percent decline in air freight volumes. Ocean volumes increased a modest 0.5 percent in 2020 as volume reductions in the first half of 2020 due to the COVID-19 pandemic were more than offset by increases in the second half of 2020 as industries resumed production and demand increased. Our ocean business experienced significant increases in the cost of ocean freight beginning in the second quarter as many ocean carriers idled capacity due to the impacts of the COVID-19 pandemic and this capacity was slow to return to the market in comparison to the demand and production increases experienced in the second half of 2020. These factors resulted in a rapidly increasing price and cost environment. On March 2, 2020, we acquired Prime Distribution Services (“Prime Distribution” or "Prime"), a leading provider of retail consolidation services in North America, for $222.7 million in cash. The acquisition was effective as of February 29, 2020, and therefore the results of operations of Prime Distribution have been included as part of the NAST segment in our consolidated financial statements since March 1, 2020. On February 28, 2019, we acquired The Space Cargo Group (“Space Cargo”) for the purpose of expanding our presence and capabilities in Spain and Colombia. Our consolidated results include the results of 23Table of ContentSpace Cargo since March 1, 2019. On May 22, 2019, we acquired Dema Service S.p.A (“Dema Service”) to strengthen our existing footprint in Italy. Our consolidated results include the results of Dema Service since May 23, 2019.SIGNIFICANT DEVELOPMENTSOur 2020 financial results and operations were impacted by the COVID-19 pandemic described above and discussed throughout Item 7, “Management's Discussion and Analysis of Financial Condition and Results of Operations.” In addition, see Part I—“Item 1A, Risk Factors,” included within this Annual Report on Form 10-K for discussion of the impacts and potential impacts of the COVID-19 pandemic. The extent to which the COVID-19 pandemic impacts our financial results and operations in 2021 and going forward will depend on future developments, which are highly uncertain and cannot be predicted, including fluctuations in the severity of the outbreak and the actions being taken to contain and treat it.During 2020, we have taken a variety of measures to ensure the availability, continuity, and security of our critical infrastructure, ensure the health and safety of our employees around the globe, and provide service and supply chain continuity to our customers and contracted carriers in order to deliver critical and essential goods and services. We continue to follow public and private sector policies and initiatives to reduce the transmission of COVID-19, such as requiring social distancing, wearing a mask, and limiting the number of employees to less than 50 percent capacity when in the office, in addition to the elimination of all non-essential travel. We have also adopted work-from-home arrangements, and near the end of 2020 approximately 84 percent of our employees were working remotely, executing their duties and responsibilities. In addition, we took steps in 2020 to reduce costs, including the elimination of all non-essential travel, temporary salary reductions for company executive officers, temporary reductions in cash retainers for board members, temporary suspension of the company match to retirement plans for U.S. and Canadian employees, accelerating the use of paid time off, and furloughing approximately seven percent of our U.S. and Canadian employees in the second quarter of 2020. As we continued to harness the benefits of our technology investment and network transformation, we eliminated certain positions during 2020, and therefore, a portion of employees did not return from furlough. We recognized $4.4 million in severance in 2020 as a result of these reductions.Due to the ongoing uncertainty around the severity and duration of the outbreak, we are not able at this time to estimate the impact the COVID-19 pandemic may have on our financial results and operations in 2021 and going forward. However, the impact could be material in all business segments and could be material during any future period affected either directly or indirectly by this pandemic. Many businesses, in particular small businesses, continue to experience reduced production and output, which could result in a decrease in freight volumes across a number of industries, which may reduce our contractual and spot market opportunities. In addition, a significant number of our contracted carriers may reduce their capacity or charge higher prices in light of the volatile market conditions, which may reduce our adjusted gross profit margins as we honor our contractual freight rates.SELECTED OPERATING PERFORMANCE AND OTHER SIGNIFICANT ITEMSThe following summarizes select 2020 year-over-year operating comparisons to 2019:•Total revenues increased 5.9 percent to $16.2 billion, driven primarily by higher pricing in ocean and air freight services and contributions from the Prime acquisition. •Gross profits decreased 7.0 percent to $2.4 billion. Adjusted gross profits decreased 6.7 percent to $2.4 billion, primarily driven by lower adjusted gross profit margins in truckload services, partially offset by contributions from the Prime acquisition and higher adjusted gross profits in air freight and ocean services. •Personnel expenses decreased 4.3 percent to $1.2 billion, driven primarily by cost savings initiatives, including a 2.8 percent decrease in average headcount and a decline in benefits expenses and incentive compensation.•Selling, general, and administrative (“SG&A”) expenses decreased 0.3 percent to $496.1 million, primarily due to significantly lower travel expenses, partially offset by the ongoing expenses from the Prime acquisition.•Income from operations totaled $673.3 million, down 14.8 percent from last year due to a decline in adjusted gross profits. Adjusted operating margin of 27.9 percent decreased 260 basis points.•Interest and other expenses totaled $44.9 million, which primarily consisted of $49.1 million of interest expense and was partially offset by a $3.3 million favorable impact from foreign currency revaluation and realized foreign currency gains and losses. 24Table of Content•The effective tax rate for 2020 was 19.4 percent compared to 22.3 percent in 2019. The lower effective tax rate was due primarily to the tax benefit related to stock-based compensation, including delivery of a one-time deferred stock award that was granted to the company's prior Chief Executive Officer in 2000, and excess foreign tax credits.•Net income totaled $506.4 million, down 12.2 percent from a year ago. Diluted earnings per share (EPS) decreased 11.2 percent to $3.72. •Cash flow from operations decreased 40.2 percent to $499.2 million. CONSOLIDATED RESULTS OF OPERATIONSThe following table summarizes our results of operations (dollars in thousands, except per share data):Twelve Months Ended December 31,20202019% change2018% changeRevenues:Transportation$15,147,562 $14,322,295 5.8 %$15,515,921 (7.7)%Sourcing1,059,544 987,213 7.3 %1,115,251 (11.5)%Total revenues 16,207,106 15,309,508 5.9 %16,631,172 (7.9)%Costs and expenses:Purchased transportation and related services$12,834,608 11,839,433 8.4 %12,922,177 (8.4)%Purchased products sourced for resale960,241 883,765 8.7 %1,003,760 (12.0)%Personnel expenses1,242,867 1,298,528 (4.3)%1,343,542 (3.4)%Other selling, general, and administrative expenses496,122 497,806 (0.3)%449,610 10.7 %Total costs and expenses 15,533,838 14,519,532 7.0 %15,719,089 (7.6)%Income from operations 673,268 789,976 (14.8)%912,083 (13.4)%Interest and other expense(44,937)(47,719)(5.8)%(31,810)50.0 %Income before provision for income taxes 628,331 742,257 (15.3)%880,273 (15.7)%Provision for income taxes121,910 165,289 (26.2)%215,768 (23.4)%Net income $506,421 $576,968 (12.2)%$664,505 (13.2)%Diluted net income per share $3.72 $4.19 (11.2)%$4.73 (11.4)%Average headcount 15,119 15,551 (2.8)%15,204 2.3 %Adjusted gross profit margin percentage(1)Transportation15.3%17.3%(2.0) pts16.7%0.6 ptsSourcing9.4%10.5%(1.1) pts10.0%0.5 ptsTotal adjusted gross profit margin14.9%16.9%(2.0) pts16.3%0.6 pts________________________________ (1) Adjusted gross profit margin is a non-GAAP financial measure explained above. The following discussion and analysis of our Results of Operations and Liquidity and Capital Resources includes a comparison of the twelve months ended December 31, 2020, to the twelve months ended December 31, 2019. A similar discussion and analysis that compares the twelve months ended December 31, 2019, to the twelve months ended December 31, 2018, can be found in Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations," of our 2019 Annual Report on Form 10-K filed with the SEC on February 19, 2020. A reconciliation of our reportable segments to our consolidated results can be found in Note 9, Segment Reporting, in Part II, Financial Information of this Annual Report on Form 10-K.25Table of ContentConsolidated Results of Operations—Twelve Months Ended December 31, 2020 Compared to Twelve Months Ended December 31, 2019Total revenues and related costs. Total transportation revenues increased driven by significant pricing increases in our ocean and air freight service lines and increased LTL volumes. Ocean pricing increased significantly in the second half of 2020 as improving demand outpaced carrier capacity returning to the market. In addition, a significant decline in capacity due to a reduction in commercial flights from COVID-19 restrictions resulted in sharp increases in air freight pricing. These increases were partially offset by lower pricing in LTL and truckload services. Total purchased transportation and related services increased due to increased cost of transportation in most of our transportation services resulting from the factors discussed above. Our sourcing total revenues and purchased products sourced for resale increased due to higher pricing and costs per case, which was partially offset by lower case volume most notably in the foodservice industry, which has been significantly impacted by the COVID-19 pandemic.Gross profits and adjusted gross profits. Our transportation adjusted gross profit decreased driven by adjusted gross profit margin declines in truckload services due to tight carrier capacity in the marketplace and the significant transportation cost volatility resulting from the impact of the COVID-19 pandemic relative to our contractual customer pricing. We continued to meet our customer commitments despite increases for the cost of capacity, which has resulted in adjusted gross profit margin compression. Partially offsetting these declines was an increase in air freight pricing resulting in adjusted gross profit margin expansion as we were able to leverage our contractual air freight capacity despite significant shortages in the air freight market. Sourcing adjusted gross profits declined driven by the costs of purchased products sourced for resale increasing at a faster rate than our sourcing total revenues in addition to lower case volumes.Operating expenses. Personnel expenses decreased primarily due to cost savings initiatives, including the temporary suspension of the company match to retirement plans for U.S. and Canadian employees, declines in healthcare costs, lower variable compensation and a decrease in average headcount. Other SG&A expenses decreased driven by the elimination of all non-essential travel. Partially offsetting this decrease was an increase in occupancy expenses, including those attributable to acquisitions, and an $11.5 million loss on the sale-leaseback of a company-owned data center. Interest and other expense. Interest and other expense primarily consisted of $49.1 million of interest expense, partially offset by a $3.3 million favorable impact of foreign currency revaluation and realized foreign currency gains and losses in 2020. This compared to a $4.2 million unfavorable impact of foreign currency revaluation and realized foreign currency gains and losses in 2019. Interest expense decreased from 2019 due to lower average borrowings and interest rates.Provision for income taxes. Our effective income tax rate was 19.4 percent in 2020 and 22.3 percent in 2019. The effective income tax rate for the twelve months ended December 31, 2020, was lower than the statutory federal income tax rate primarily due to the tax impact of share-based payment awards, including the tax benefit from the delivery of a one-time deferred stock award that was granted to the company's prior Chief Executive Officer in 2000 and excess foreign tax credits. These impacts were partially offset by state income taxes, net of federal benefits and foreign income taxes. The effective income tax rate for the twelve months ended December 31, 2019, was higher than the statutory federal income tax rate due to state income taxes, net of federal benefit, and foreign income taxes, but was partially offset by the tax impact of excess foreign tax credits and share-based payment awards. 26Table of ContentNAST Segment Results of OperationsTwelve Months Ended December 31,(dollars in thousands)20202019% change2018% changeTotal revenues$11,312,553 $11,283,692 0.3 %$12,346,757 (8.6)%Costs and expenses:Purchased transportation and related services9,795,462 9,486,323 3.3 %10,440,496 (9.1)%Personnel expenses624,358 698,187 (10.6)%749,120 (6.8)%Other selling, general, and administrative expenses384,258 376,419 2.1 %335,297 12.3 %Total costs and expenses10,804,078 10,560,929 2.3 %11,524,913 (8.4)%Income from operations$508,475 $722,763 (29.6)%$821,844 (12.1)%Twelve Months Ended December 31,20202019% change2018% changeAverage headcount 6,811 7,354 (7.4)%7,387 (0.4)%Service line volume statisticsTruckload— %(2.0)%LTL9.5 %3.5 %Adjusted gross profits(1)Truckload$981,420 $1,275,199 (23.0)%$1,375,361 (7.3)%LTL452,033 471,616 (4.2)%466,725 1.0 %Other 83,638 50,554 65.4 %64,175 (21.2)%Total adjusted gross profits$1,517,091 $1,797,369 (15.6)%$1,906,261 (5.7)%________________________________ (1) Adjusted gross profits is a non-GAAP financial measure explained above. Twelve Months Ended December 31, 2020 Compared to Twelve Months Ended December 31, 2019Total revenues and related costs. NAST total revenues increased due to the acquisition of Prime, which added one percentage point to NAST total revenues. This increase was partially offset by declines in truckload total revenues driven by lower pricing in the first half of 2020 and significantly lower fuel prices in 2020. NAST cost of transportation and related services increased driven by increased cost per mile in truckload services and was partially offset by significantly lower fuel prices.Gross profits and adjusted gross profits. NAST adjusted gross profits decreased driven, primarily, by lower adjusted gross profit per shipment in truckload and LTL services. The lower adjusted gross profit per shipment in truckload was driven by the tight carrier capacity in the marketplace and the significant transportation cost volatility resulting from the impact of the COVID-19 pandemic relative to our contractual customer pricing. We continued to meet our customer commitments despite increases for the cost of capacity, which has resulted in adjusted gross profit margin compression. Our average truckload linehaul rate per mile charged to our customers, which excludes fuel surcharges, increased approximately 5.5 percent resulting from the market and business trends discussed above. Our truckload transportation costs, excluding fuel surcharges, increased approximately 11.0 percent. NAST LTL adjusted gross profits decreased primarily due to reduced adjusted gross profit margins driven by the tight carrier capacity in the marketplace, partially offset by increased volume. The acquisition of Prime Distribution contributed five percentage points of LTL adjusted gross profit growth.NAST other adjusted gross profits increased primarily due to incremental warehousing services related to the acquisition of Prime.Operating expenses. NAST personnel expense decreased primarily due to cost savings initiatives, including the temporary suspension of the company match to retirement plans for U.S. and Canadian employees, lower variable compensation, declines in healthcare costs, and a decrease in average headcount. NAST SG&A expenses increased due to the ongoing expenses from the Prime acquisition, which were partially offset by the elimination of all non-essential travel.27Table of ContentGlobal Forwarding Segment Results of OperationsTwelve Months Ended December 31,(dollars in thousands)20202019% change2018% changeTotal revenues$3,100,525 $2,327,913 33.2 %$2,487,744 (6.4)%Costs and expenses:Purchased transportation and related services2,471,537 1,793,937 37.8 %1,943,838 (7.7)%Personnel expenses281,048 276,255 1.7 %284,586 (2.9)%Other selling, general, and administrative expenses172,427 177,194 (2.7)%167,694 5.7 %Total costs and expenses2,925,012 2,247,386 30.2 %2,396,118 (6.2)%Income from operations$175,513 $80,527 118.0 %$91,626 (12.1)%Twelve Months Ended December 31,20202019% change2018% changeAverage headcount 4,7084,766(1.2)%4,7111.2 %Service line volume statisticsOcean0.5 %— %Air(18.0)%(7.0)%Customs(3.5)%0.5 %Adjusted gross profits(1)Ocean$349,868 $308,068 13.6 %$312,327 (1.4)%Air146,056 101,991 43.2 %111,038 (8.1)%Customs87,092 91,833 (5.2)%88,515 3.7 %Other 45,972 32,084 43.3 %32,026 0.2 %Total adjusted gross profits$628,988 $533,976 17.8 %$543,906 (1.8)%________________________________ (1) Adjusted gross profits is a non-GAAP financial measure explained above. Twelve Months Ended December 31, 2020 compared to Twelve Months Ended December 31, 2019Total revenues and related costs. Total revenues and related costs increased driven by higher pricing and costs in the ocean and air freight markets which were significantly impacted by the COVID-19 pandemic as discussed above. Ocean pricing and purchased transportation costs increased significantly in the second half of 2020 as improving demand outpaced carrier capacity returning to the market. The air freight market has been significantly impacted by reduced cargo capacity due to fewer commercial flights, an increase in charter flights, and larger than normal shipment sizes which has created an environment with unusually high pricing and purchased transportation costs.Gross profits and adjusted gross profits. Global Forwarding adjusted gross profits increased driven by the significant increase in air freight and ocean pricing due to the impact of the COVID-19 pandemic. The air freight market has been significantly impacted by reduced cargo capacity due to fewer commercial flights, an increase in charter flights, and larger than normal shipment sizes which has created an environment with unusually high pricing. The price for ocean services has also increased significantly due to tight ocean carrier capacity. These increases were partially offset by volume declines in air freight. Customs adjusted gross profits decreased driven by decreased volumes.Operating expenses. Personnel expenses increased driven by an increase in incentive compensation but was partially offset by a decrease in average headcount. SG&A expenses decreased driven by the elimination of non-essential travel, partially offset by an increase in credit loss expense.28Table of ContentAll Other and Corporate Segment Results of OperationsAll Other and Corporate includes our Robinson Fresh and Managed Services segment, as well as Other Surface Transportation outside of North America and other miscellaneous revenues and unallocated corporate expenses. Twelve Months Ended December 31,(dollars in thousands)20202019% change2018% changeTotal revenues$1,794,028 $1,697,903 5.7 %$1,796,671 (5.5)%Income from operations(10,720)(13,314)N/M(1,387)N/MAdjusted gross profits(1)Robinson Fresh105,700 109,183 (3.2)%116,283 (6.1)%Managed Services94,828 83,365 13.8 %78,789 5.8 %Other Surface Transportation65,650 62,417 5.2 %59,996 4.0 %Total adjusted gross profits$266,178 $254,965 4.4 %$255,068 — %________________________________ (1) Adjusted gross profits is a non-GAAP financial measure explained above. Twelve Months Ended December 31, 2020 compared to Twelve Months Ended December 31, 2019Total revenues and related costs. Total revenues and related costs increased driven by increased pricing in our Robinson Fresh business, which was partially offset by decreased demand from customers in the foodservice industry resulting from the COVID-19 pandemic, and to a lesser extent, an increase in Other Surface Transportation and Managed Services.Gross profits and adjusted gross profits. Robinson Fresh adjusted gross profits decreased driven by reduced case volumes, most notably from customers in the foodservice industry. Managed Services adjusted gross profits increased driven by a combination of new customer wins and selling additional services to existing customers. Other Surface Transportation adjusted gross profits increased primarily driven by the acquisition of Dema Service, which contributed three percentage points of growth in Other Surface Transportation.LIQUIDITY AND CAPITAL RESOURCESWe have historically generated substantial cash from operations, which has enabled us to fund our organic growth while paying cash dividends and repurchasing stock. In addition, we maintain the following debt facilities as described in Note 4, Financing Arrangements (dollars in thousands):DescriptionCarrying Value as of December 31, 2020Borrowing CapacityMaturityRevolving credit facility$— $1,000,000 October 2023Senior Notes, Series A175,000 175,000 August 2023Senior Notes, Series B150,000 150,000 August 2028Senior Notes, Series C175,000 175,000 August 2033Senior Notes (1)593,301 600,000 April 2028Total debt$1,093,301 $2,100,000 ________________________________ (1) Net of unamortized discounts and issuance costs.We expect to use our current debt facilities and potentially other indebtedness incurred in the future to assist us in continuing to fund working capital, capital expenditures, possible acquisitions, dividends, and share repurchases.Cash and cash equivalents totaled $243.8 million as of December 31, 2020, and $447.9 million as of December 31, 2019. Cash and cash equivalents held outside the United States totaled $230.9 million as of December 31, 2020, and $405.1 million as of December 31, 2019. Working capital increased from $1.08 billion at December 31, 2019, to $1.10 billion at December 31, 2020.29Table of ContentWe prioritize our investments to grow the business, as we require some working capital and a relatively small amount of capital expenditures to grow. We are continually looking for acquisitions, but those acquisitions must fit our culture and enhance our growth opportunities.The following table summarizes our major sources and uses of cash and cash equivalents (dollars in thousands):Twelve months ended December 31, 20202019% change2018% changeSources (uses) of cash:Cash provided by operating activities$499,191 $835,419 (40.2)%$792,896 5.4 %Capital expenditures(54,009)(70,465)(63,871)Acquisitions(223,230)(59,200)(5,315)Other investing activities5,525 16,636 (3,622)Cash used for investing activities(271,714)(113,029)140.4 %(72,808)55.2 %Repurchase of common stock(177,514)(309,444)(300,991)Cash dividends(209,956)(277,786)(265,219)Net payments on debt(143,000)(112,000)(118,988)Other financing activities89,803 47,977 30,021 Cash used for financing activities(440,667)(651,253)(32.3)%(655,177)(0.6)%Effect of exchange rates on cash and cash equivalents9,128 (1,894)(20,186)Net change in cash and cash equivalents$(204,062)$69,243 $44,725 Cash flow from operating activities. The decrease in cash flow from operating activities in 2020 from 2019 was primarily due to unfavorable changes in working capital. The unfavorable changes in working capital were primarily related to a sequential increase in accounts receivable associated with increasing pricing in a number of service lines during 2020. Given the COVID-19 pandemic, we are closely monitoring credit and collections activities to minimize risk as well as working with our customers to facilitate the movement of goods across their supply chains while also ensuring timely payment.Cash used for investing activities. Our investing activities consist primarily of capital expenditures and cash paid for acquisitions. Capital expenditures consisted primarily of investments in information technology, which are intended to increase employee productivity, automate interactions with our customers and contracted carriers, and improve our internal workflows to help expand our adjusted operating margins and grow the business. During 2019, we sold a facility we owned in Chicago, Illinois for approximately $17.0 million. In 2020, we used $222.7 million for the acquisition of Prime. In 2019, we used $45.0 million for the acquisition of Space Cargo and $14.2 million for the acquisition of Dema Service. We anticipate capital expenditures in 2021 to be approximately $55 million to $65 million. Cash used for financing activities. We had net repayments on debt of $143.0 million in 2020 and $112.0 million in 2019. The 2020 and 2019 net repayments were primarily to reduce the outstanding balance of the receivables securitization facility (the "Facility"). This Facility expired in December 2020 and was not renewed. There was no outstanding balance on our senior unsecured revolving credit facility (the "Credit Agreement") as of December 31, 2020 and 2019. As of December 31, 2020, we were in compliance with all of the covenants under the Credit Agreement, note purchase agreement, and senior unsecured notes. The decrease in cash dividends paid was the result of our fourth quarter dividend being paid on January 4, 2021. The decrease in share repurchases in 2020 was due to the temporary suspension of our share repurchase activity near the end of the first quarter of 2020 as we assessed the impacts of the COVID-19 pandemic. We resumed our repurchase activity in the fourth quarter of 2020. In May 2018, the Board of Directors increased the number of shares authorized to be repurchased by 15,000,000 shares. As of December 31, 2020, there were 7,789,752 shares remaining for future repurchases. The number of shares we repurchase, if any, during future periods will vary based on our cash position, potential alternative uses of our cash, and market conditions. We may seek to retire or purchase our outstanding Senior Notes through open market cash purchases, privately negotiated transactions, or otherwise.30Table of ContentAlthough there is uncertainty related to the anticipated impact of the COVID-19 pandemic on our future results, we believe that, assuming no change in our current business plan, our available cash, together with expected future cash generated from operations, the amount available under our credit facilities, and credit available in the market, will be sufficient to satisfy our anticipated needs for working capital, capital expenditures, and cash dividends for at least the next 12 months. We also believe we could obtain funds under lines of credit or other forms of indebtedness on short notice, if needed.Recently Issued Accounting Pronouncements. Refer to Note 14, Recently Issued Accounting Pronouncements, of the accompanying consolidated financial statements for a discussion of recently issued accounting pronouncements.CRITICAL ACCOUNTING POLICIES AND ESTIMATESOur consolidated financial statements and accompanying notes are prepared in accordance with accounting principles generally accepted in the United States. The preparation of the consolidated financial statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue, expenses, and the related disclosures. Because future events and their effects cannot be determined with certainty, actual results could differ from our assumptions and estimates, and such differences could be material. Our significant accounting policies are discussed in Note 1, Summary of Significant Accounting Policies, of the Notes to the Consolidated Financial Statements, included in Item 8, Financial Statements and Supplementary Data, of this Annual Report on Form 10-K. We consider the following items in our consolidated financial statements to require significant estimation or judgment. REVENUE RECOGNITION. At contract inception, we assess the goods and services promised in our contracts with customers and identify our performance obligations to provide distinct goods and services to our customers. Our transportation and logistics service arrangements often require management to use judgment and make estimates that impact the amounts and timing of revenue recognition. Transportation and Logistics Services - As a global logistics provider, our primary performance obligation under our customer contracts is to utilize our relationships with a wide variety of transportation companies to efficiently and cost-effectively transport our customers’ freight. Revenue is recognized for these performance obligations as they are satisfied over the contract term, which generally represents the transit period. The transit period can vary based upon the method of transport, generally a number of days for over the road, rail, and air transportation, or several weeks in the case of an ocean shipment. Recognizing revenue for contracts where the transit period is partially complete or completed and not yet invoiced at period end requires management to make judgments that affect the amounts and timing of revenue recognized at period end. At December 31, 2020 we recorded revenue of $197.2 million for services we have provided while a shipment was still in-transit but for which we had not yet completed our performance obligation or had not yet invoiced our customer compared to $132.9 million at December 31, 2019. We utilize our historical knowledge of shipping lanes and estimated transit times to determine the transit period in cases where our customers’ freight has not reached its intended destination. In addition, we analyze contract data for the first few days following the reporting date combined with our historical experience of trends related to partially completed contracts as of the reporting date to determine our right to consideration for the services we have provided where the transit period is partially complete or completed and not yet invoiced at period end. Differences in contract data for the first few days following the reporting date compared with our historical experience or disruptions such as weather events or other delays could cause the actual amount of revenue earned at period end to differ from these estimates. Total revenues represent the total dollar value of revenue recognized from contracts with customers for the goods and services we provide. Substantially all of our revenue is attributable to contracts with our customers. Most transactions in our transportation and sourcing businesses are recorded at the gross amount we charge our customers for the service we provide and goods we sell. In these transactions, we are primarily responsible for fulfilling the promise to provide the specified good or service to our customer and we have discretion in establishing the price for the specified good or service. Additionally, in our sourcing business, in some cases we take inventory risk before the specified good has been transferred to our customer. Customs brokerage, managed services, freight forwarding, and sourcing managed procurement transactions are recorded at the net amount we charge our customers for the service we provide because many of the factors stated above are not present. See also Note 1, Summary of Significant Accounting Policies, for further information regarding our revenue recognition policies. GOODWILL. Goodwill represents the excess of the cost of acquired businesses over the net of the fair value of identifiable tangible assets and identifiable intangible assets purchased and liabilities assumed.Goodwill is tested for impairment annually on November 30, or more frequently if events or changes in circumstances indicate that the asset might be impaired. We first perform a qualitative assessment to determine whether it is more likely than not that the fair value of our reporting units is less than their respective carrying value (“Step Zero Analysis”). If the Step Zero Analysis 31Table of Contentindicates it is more likely than not that the fair value of our reporting units is less than their respective carrying value, an additional impairment assessment is performed (“Step One Analysis”). As part of our Step Zero Analysis, we considered the impacts of the COVID-19 pandemic on financial markets and our business operations and determined that the more likely than not criteria had not been met, and therefore a Step One Analysis was not required. When we perform a Step One Analysis, the fair value of each reporting unit is compared with the carrying amount of the reporting unit, including goodwill. If the carrying amount of a reporting unit exceeds its fair value, an impairment loss is recognized in an amount equal to that excess, limited to the total amount of goodwill allocated to that reporting unit. In the Step One Analysis, the fair value of each reporting unit is determined using a discounted cash flow analysis and market approach. Projecting discounted future cash flows requires us to make significant estimates regarding future revenues and expenses, projected capital expenditures, changes in working capital, and the appropriate discount rate. Use of the market approach consists of comparisons to comparable publicly-traded companies that are similar in size and industry. Actual results may differ from those used in our valuations when a Step One Analysis is performed. DISCLOSURES ABOUT CONTRACTUAL OBLIGATIONS AND COMMERCIAL CONTINGENCIESThe following table aggregates all contractual commitments and commercial obligations, due by period, that affect our financial condition and liquidity position as of December 31, 2020 (dollars in thousands):20212022202320242025ThereafterTotalSenior notes (1)$25,200 $25,200 $25,200 $25,200 $25,200 $657,750 $783,750 Long-term notes payable(1)21,388 21,388 196,388 14,440 14,440 408,570 676,614 Maturity of lease liabilities(2)75,624 69,980 57,597 39,547 29,935 104,455 377,138 Purchase obligations(3)102,799 39,225 35,349 23,649 1,658 210 202,890 Total$225,011 $155,793 $314,534 $102,836 $71,233 $1,170,985 $2,040,392 ________________________________ (1)Amounts payable relate to the semi-annual interest due on the senior and long-term notes and the principal amount at maturity. (2) We maintain operating leases for office space, warehouses, office equipment, and a small number of intermodal containers. See Note 11, Leases, for further information.(3) Purchase obligations include agreements for services that are enforceable and legally binding and that specify all significant terms. As of December 31, 2020, such obligations primarily include ocean and air freight capacity, telecommunications services, maintenance contracts, and information technology related capacity. In some instances our contractual commitments may be usage based or require estimates as to the timing of cash settlement.We have no financing lease obligations. Long-term liabilities consist primarily of noncurrent taxes payable and long-term notes payable. Due to the uncertainty with respect to the amounts or timing of future cash flows associated with our unrecognized tax benefits at December 31, 2020, we are unable to make reasonably reliable estimates of the period of cash settlement with the respective taxing authority. Therefore, $42.3 million of unrecognized tax benefits have been excluded from the contractual obligations table above. See Note 5, Income Taxes, to the consolidated financial statements for a discussion on income taxes. As of December 31, 2020, we do not have significant off-balance sheet arrangements as defined in Item 303(a)(4)(ii) of SEC Regulation S-K.32Table of ContentITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK We had $243.8 million of cash and cash equivalents on December 31, 2020. Substantially all of the cash equivalents are in demand accounts with financial institutions. The primary market risks associated with these investments are liquidity risks. We are a party to a credit agreement with various lenders consisting of a $1 billion revolving loan facility. Interest accrues on the revolving loan at a variable rate determined by a pricing schedule or the base rate (which is the highest of (a) the administrative agent's prime rate, (b) the federal funds rate plus 0.50 percent, or (c) the sum of one-month LIBOR plus a specified margin). At December 31, 2020, there was no outstanding balance on the revolving loan.We are a party to the Note Purchase Agreement, as amended, with various institutional investors with fixed rates consisting of: (i) $175 million of the company’s 3.97 percent Senior Notes, Series A, due August 27, 2023, (ii) $150 million of the company’s 4.26 percent Senior Notes, Series B, due August 27, 2028, and (iii) $175 million of the company’s 4.6 percent Senior Notes, Series C, due August 27, 2033. At December 31, 2020, there was $500 million outstanding on the notes. We issued Senior Notes through a public offering on April 9, 2018. The Senior Notes bear an annual interest rate of 4.2 percent payable semi-annually on April 15 and October 15, until maturity on April 15, 2028. Taking into effect the amortization of the original issue discount and all underwriting and issuance expenses, the Senior Notes have an effective yield to maturity of approximately 4.39 percent per annum. The fair value of the Senior Notes, excluding debt discounts and issuance costs, approximated $710.2 million as of December 31, 2020, based primarily on the market prices quoted from external sources. The carrying value of the Senior Notes was $593.3 million at December 31, 2020.A hypothetical 100-basis-point change in the interest rate would not have a material effect on our earnings. We do not use derivative financial instruments to manage interest rate risk or to speculate on future changes in interest rates. A rise in interest rates could negatively affect the fair value of our debt facilities. Foreign Exchange RiskWe operate through a network of offices in North America, Europe, Asia, Oceania, and South America. As a result, we frequently transact using currencies other than the U.S. Dollar, primarily the Chinese Yuan, Euro, Canadian Dollar, and Mexican Peso. This often results in assets and liabilities, including intercompany balances, denominated in a currency other than the functional currency. In these instances, most commonly, we have balances denominated in U.S. Dollars in regions where the U.S. Dollar is not the functional currency. This results in foreign exchange risk.Foreign exchange risk can be quantified by performing a sensitivity analysis assuming a hypothetical change in the value of the U.S. Dollar compared to other currencies in which we transact. Our primary foreign exchange risk is associated with balances denominated in U.S. Dollars held in China where the functional currency is the Chinese Yuan. All other things being equal, a hypothetical 10 percent weakening of the U.S. Dollar against the Chinese Yuan on December 31, 2020 would have decreased our net income by approximately $11.9 million and a hypothetical 10 percent strengthening of the U.S. Dollar against the Chinese Yuan on December 31, 2020 would have increased our net income by approximately $9.7 million. Our use of derivative financial instruments to manage foreign exchange risk is insignificant.33Table of Content
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+Item 7. Management’s Discussion and Analysis of Financial Condition and Results of OperationsThe following discussion should be read in conjunction with the consolidated financial statements and notes thereto included elsewhere in this Annual Report on Form 10-K and with Part I, Item 1A, “Risk Factors.” Please refer to the cautionary language at the beginning of Part I of this Annual Report on Form 10-K regarding forward-looking statements.Business OverviewWe enable our customers to develop electronic products. Our products and services are designed to give our customers a competitive edge in their development of ICs, SoCs, and increasingly sophisticated electronic devices and systems. Our products and services do this by optimizing performance, minimizing power consumption, shortening the time to bring our customers’ products to market, improving engineering productivity and reducing their design, development and manufacturing costs. We offer software, hardware, services and reusable IC design blocks, which are commonly referred to as IP.Our strategy, which we call Intelligent System Design™, is to provide the technology necessary for our customers to develop electronic products across a variety of vertical markets including consumer, hyperscale computing, 5G communications, automotive, aerospace and defense, industrial and healthcare. Our products and services enable our customers to develop complex and innovative electronic products, so demand for our technology is driven by our customers’ investment in new designs and products. Historically, the industry that provided the tools used by IC engineers was referred to as EDA. Today, our offerings include and extend beyond EDA.We group our products into categories related to major design activities:•Custom IC Design and Simulation;•Digital IC Design and Signoff;•Functional Verification;•IP; and•System Design and Analysis.For additional information about our products, see the discussion in Item 1, “Business,” under the heading “Products and Product Strategy.”During the first quarter of fiscal 2020, we completed our acquisitions of AWR and Integrand. The aggregate cash consideration for these acquisitions of approximately $196 million was allocated to the assets acquired and liabilities assumed based on their respective estimated fair values on the respective acquisition dates. These acquisitions enhance our technology portfolio to address growing radio frequency design activity, driven by expanding use of 5G communications. These acquisitions increased expenses, including amortization of acquired intangible assets, more than revenue during fiscal 2020.During the first quarter of fiscal 2021, we entered into a definitive agreement to acquire all of the outstanding equity of Belgium-based NUMECA, a leader in CFD, mesh generation, multi-physics simulation and optimization. The addition of NUMECA’s technologies and talent supports our Intelligent System Design™ strategy. The acquisition is expected to close in the first quarter of fiscal 2021, subject to customary closing conditions.Management uses certain performance indicators to manage our business, including revenue, certain elements of operating expenses and cash flow from operations, and we describe these items further below under the headings “Results of Operations” and “Liquidity and Capital Resources.”COVID-19 ImpactIn March 2020, the World Health Organization declared the outbreak of COVID-19 a pandemic, which continues to spread throughout the U.S. and the world and has resulted in authorities implementing numerous measures to contain the virus, including travel bans and restrictions, quarantines, shelter-in-place orders, and business limitations and shutdowns. We are unable to accurately predict the full impact that COVID-19 will have on our results of operations, financial condition, liquidity and cash flows due to numerous uncertainties, including the duration and severity of the pandemic and containment measures. Our compliance with these containment measures has impacted our day-to-day operations and could disrupt our business and operations, as well as that of our key customers, suppliers (including contract manufacturers) and other counterparties, for an indefinite period of time. To support the health and well-being of our employees, customers, partners and communities, a vast majority of our employees are still working remotely as of February 22, 2021.The COVID-19 pandemic has caused some volatility in our usual delivery timing for our hardware and IP products to certain customers. Many of our customers' employees are working remotely, and, in some cases, we have experienced delivery lead times that are longer than normal because of delays in getting access to customer sites to complete our deliveries. In other cases, the amount of our hardware and IP products that we have been able to deliver has been greater than we originally anticipated at the beginning of the respective period. We have also received numerous COVID-19 pandemic-related requests from our customers to allow them to delay their payments to us, while we continue to provide services to these customers. Despite the challenges the COVID-19 pandemic has posed to our operations, it did not have material adverse impact on our results of operations, financial condition, liquidity or cash flows during fiscal 2020. We will continue to evaluate the nature and extent of the impact of COVID-19 on our business. See Part I, Item 1A, “Risk Factors” for additional information on the impact of COVID-19.29Table of ContentsResults of OperationsThe discussion of our fiscal 2020 consolidated results of operations include year-over-year comparisons to fiscal 2019 for revenue, cost of revenue, operating expenses, operating margin, other non-operating expenses, income taxes and cash flows. For a discussion of the fiscal 2019 changes compared to fiscal 2018, see the discussion in Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in our Annual Report on Form 10-K for the fiscal year ended December 28, 2019, filed on February 24, 2020.Our fiscal years are 52- or 53-week periods ending on the Saturday closest to December 31. Fiscal 2020 was a 53-week year, compared to 2019 and 2018, which were each 52-week fiscal years. The additional week in fiscal 2020 resulted in additional revenue of approximately $45 million and additional expense, including stock-based compensation and amortization of acquired intangibles, of approximately $35 million.Results of operations for fiscal 2020, as compared to fiscal 2019, reflect the following:•increased product and maintenance revenue, resulting from growth in software, IP and hardware, particularly in China and the United States;•higher selling costs, including additional investment in technical sales support in response to our customers’ increasing technological requirements; •continued investment in research and development activities focused on expanding and enhancing our product portfolio; •decreased operating expenses for travel, meetings and events due to various measures implemented to contain COVID-19; •a 3 percentage point increase in operating margin driven primarily by revenue growth and temporary decreases in certain operating expenses due to the COVID-19 pandemic; and•changes in our provision (benefit) for income taxes due to a non-cash tax benefit resulting from intercompany transfers of certain intangible property rights to our Irish subsidiary during fiscal 2019.RevenueWe primarily generate revenue from licensing our software and IP, selling or leasing our emulation and prototyping hardware technology, providing maintenance for our software, hardware and IP, providing engineering services and earning royalties generated from the use of our IP. The timing of our revenue is significantly affected by the mix of software, hardware and IP products generating revenue in any given period and whether the revenue is recognized over time or at a point in time, upon completion of delivery.In any fiscal year, we expect that between 85% and 90% of our annual revenue will be characterized as recurring revenue. Revenue characterized as recurring includes revenue recognized over time from our software arrangements, services, royalties, maintenance on IP licenses and hardware, and operating leases of hardware and revenue recognized at varying points in time over the term of our IP Access Agreements. The remainder of our revenue is characterized as up-front revenue. Up-front revenue is primarily generated by our sales of emulation and prototyping hardware and individual IP licenses. The percentage of our recurring and up-front revenue may be impacted by delivery of hardware and IP products to our customers in any single fiscal period.Revenue by YearThe following table shows our revenue for fiscal 2020 and 2019 and the change in revenue between years: Change 202020192020 vs. 2019 (In millions, except percentages)Product and maintenance$2,536.6 $2,204.6 $332.0 15 %Services146.3 131.7 14.6 11 %Total revenue$2,682.9 $2,336.3 $346.6 15 %Product and maintenance revenue increased during fiscal 2020, as compared to fiscal 2019, primarily because of increased investments by our customers in new, complex designs for their products that include the design of electronic systems for consumer, hyperscale computing, 5G communications, automotive, aerospace and defense, industrial and healthcare. Services revenue may fluctuate from period to period based on the timing of fulfillment of our services and IP performance obligations.No one customer accounted for 10% or more of total revenue during fiscal 2020 or 2019.30Table of ContentsRevenue by Product CategoryThe following table shows the percentage of product and related maintenance revenue contributed by each of our five product categories and services during fiscal 2020 and 2019: 20202019Custom IC Design and Simulation25 %25 %Digital IC Design and Signoff29 %30 %Functional Verification, including Emulation and Prototyping Hardware22 %23 %IP14 %13 %System Design and Analysis10 %9 %Total100 %100 %Revenue by product category fluctuates from period to period based on demand for our products and services, our available resources and our ability to deliver and support them. Certain of our licensing arrangements allow customers the ability to remix among software products. Additionally, we have arrangements with customers that include a combination of our products, with the actual product selection and number of licensed users to be determined at a later date. For these arrangements, we estimate the allocation of the revenue to product categories based upon the expected usage of our products. The actual usage of our products by these customers may differ and, if that proves to be the case, the revenue allocation in the table above would differ. Revenue by Geography Change 202020192020 vs. 2019 (In millions, except percentages)United States$1,096.3 $982.4 $113.9 12 %Other Americas43.6 43.5 0.1 — %China406.6 241.5 165.1 68 %Other Asia487.4 459.0 28.4 6 %Europe, Middle East and Africa469.8 433.3 36.5 8 %Japan179.2 176.6 2.6 1 %Total revenue$2,682.9 $2,336.3 $346.6 15 %Revenue in the United States increased during fiscal 2020, as compared to fiscal 2019, primarily due to an increase in revenue for software and IP offerings.Revenue in China increased during fiscal 2020, as compared to fiscal 2019,due to increased demand from many of our customers in China. We experienced an increase in demand in the first half of fiscal 2020 that resulted in approximately 13% of our total revenue being generated from customers in China, as compared to approximately 11% during the first half of fiscal 2019. This was followed by an additional increase in demand in the second half of fiscal 2020 that resulted in approximately 17% of our revenue being generated from customers in China, as compared to approximately 10% during the second half of fiscal 2019. During fiscal 2021, we expect revenue from our customers in China to be consistent, as a percentage of total revenue, with the first half of fiscal 2020. Beginning in the second quarter of fiscal 2019, we have not been able to deliver maintenance or support for certain customers in China due to the U.S. Department of Commerce’s designation of these customers to the “Entity List.” We expect these restrictions and new or expanded trade restrictions to continue to impact revenue from certain customers in China.For the primary factors contributing to the change in revenue for other geographies during fiscal 2020, as compared to fiscal 2019, see the general description under “Revenue by Year” and “Revenue by Product Category” above.31Table of ContentsRevenue by Geography as a Percent of Total Revenue 20202019United States41 %42 %Other Americas1 %2 %China15 %10 %Other Asia18 %20 %Europe, Middle East and Africa18 %18 %Japan7 %8 %Total100 %100 %Most of our revenue is transacted in the United States dollar. However, certain revenue transactions are denominated in foreign currencies. For an additional description of how changes in foreign exchange rates affect our consolidated financial statements, see the discussion under Item 7A, “Quantitative and Qualitative Disclosures About Market Risk – Foreign Currency Risk.”Cost of Revenue Change 202020192020 vs. 2019 (In millions, except percentages)Cost of product and maintenance$231.0 $189.1 $41.9 22 %Cost of services74.5 77.2 (2.7)(3)%Total cost of revenue$305.5 $266.3 $39.2 15 %The following table shows cost of revenue as a percentage of related revenue for fiscal 2020 and 2019: 20202019Cost of product and maintenance9 %9 %Cost of services51 %59 %Cost of Product and MaintenanceCost of product and maintenance includes costs associated with the sale and lease of our emulation and prototyping hardware and licensing of our software and IP products, certain employee salary and benefits and other employee-related costs, cost of our customer support services, amortization of technology-related and maintenance-related acquired intangibles, costs of technical documentation and royalties payable to third-party vendors. Cost of product and maintenance depends primarily on our hardware product sales in any given period, but is also affected by employee salary and benefits and other employee-related costs, reserves for inventory, and the timing and extent to which we acquire intangible assets, license third-party technology or IP, and sell our products that include such acquired or licensed technology or IP. A summary of cost of product and maintenance for fiscal 2020 and 2019 is as follows: Change 202020192020 vs. 2019 (In millions, except percentages)Product and maintenance-related costs$184.8 $148.1 $36.7 25 %Amortization of acquired intangibles46.2 41.0 5.2 13 %Total cost of product and maintenance$231.0 $189.1 $41.9 22 %32Table of ContentsProduct and maintenance-related costs increased during fiscal 2020, when compared to fiscal 2019, due to the following: Change 2020 vs. 2019 (In millions)Emulation and prototyping hardware costs34.1 Professional services2.5 Salary, benefits and other employee-related costs1.8 Other items(1.7)Total change in product and maintenance-related costs$36.7 Costs associated with our emulation and prototyping hardware products include components, assembly, testing, applicable reserves and overhead. These costs make our cost of emulation and prototyping hardware products higher, as a percentage of revenue, than our cost of software and IP products. The increase in emulation and prototyping hardware costs during fiscal 2020, as compared to fiscal 2019, was primarily due to increased demand for our emulation and prototyping hardware, increased reserves for inventory, and the mix of products generating revenue. Amortization of acquired intangibles included in cost of product and maintenance increased by $9.4 million during fiscal 2020, as compared to fiscal 2019, due to technology-related intangible assets acquired from AWR and Integrand during fiscal 2020 and in-process technology being placed into service during fiscal 2020 and 2019. This increase was partially offset by certain technology-related intangible assets becoming fully amortized during fiscal 2020 and 2019.Cost of ServicesCost of services primarily includes employee salary, benefits and other employee-related costs to perform work on revenue-generating projects and costs to maintain the infrastructure necessary to manage a services organization. Cost of services may fluctuate from period to period based on our utilization of design services engineers on revenue-generating projects rather than internal development projects. Despite an increase in services revenue, cost of services decreased during fiscal 2020, as compared to fiscal 2019, due to a higher margin on the mix of services arrangements in fiscal 2020, compared to fiscal 2019, and temporary savings due to the COVID pandemic.Operating ExpensesOur operating expenses include marketing and sales, research and development, and general and administrative expenses. Factors that tend to cause our operating expenses to fluctuate include changes in the number of employees due to hiring and acquisitions, stock-based compensation, restructuring activities, foreign exchange rate movements, and the impact of our variable compensation programs that are driven by operating results. During fiscal 2020 we experienced decreased operating expenses for travel, meetings and events due to various measures implemented to contain COVID-19.Many of our operating expenses are transacted in various foreign currencies. We recognize lower expenses in periods when the United States dollar strengthens in value against other currencies and we recognize higher expenses when the United States dollar weakens against other currencies. For an additional description of how changes in foreign exchange rates affect our consolidated financial statements, see the discussion in Item 7A, “Quantitative and Qualitative Disclosures About Market Risk – Foreign Currency Risk.”Our operating expenses for fiscal 2020 and 2019 were as follows: Change 202020192020 vs. 2019 (In millions, except percentages)Marketing and sales$516.5 $481.7 $34.8 7 %Research and development1,033.7 935.9 97.8 10 %General and administrative154.4 139.8 14.6 10 %Total operating expenses$1,704.6 $1,557.4 $147.2 9 %Our operating expenses, as a percentage of total revenue, for fiscal 2020 and 2019 were as follows: 20202019Marketing and sales19 %21 %Research and development39 %40 %General and administrative6 %6 %Total operating expenses64 %67 %33Table of Contents Marketing and SalesThe changes in marketing and sales expense were due to the following: Change 2020 vs. 2019 (In millions)Salary, benefits and other employee-related costs$41.7 Stock-based compensation3.0 Home office-related expenses2.0 Travel and sales meetings(13.0)Other items1.1 Total change in marketing and sales expense$34.8 Salary, benefits and other employee-related costs included in marketing and sales increased during fiscal 2020, as compared to fiscal 2019, salary, benefits and other employee-related costs included in marketing and sales expense increased due primarily to additional headcount from hiring and acquisitions and variable compensation as we continue to invest in technical sales support in response to our customers’ increasing technological requirements. This increase was partially offset by reduced costs for marketing events and travel due to COVID-19.Research and Development The changes in research and development expense were due to the following: Change 2020 vs. 2019 (In millions)Salary, benefits and other employee-related costs95.7 Stock-based compensation10.3 Product development costs3.7 Home office-related expenses5.3 Facilities and other infrastructure costs(2.2)Professional services(2.8)Travel(11.8)Other items(0.4)Total change in research and development expense$97.8 Salary, benefits and other employee-related costs included in research and development expense increased during fiscal 2020, as compared to fiscal 2019, due primarily to additional headcount from hiring and acquisitions and variable compensation as we continue to expand and enhance our product portfolio. This increase was partially offset by reduced costs for travel due to COVID-19. General and AdministrativeThe changes in general and administrative expense were due to the following: Change 2020 vs. 2019 (In millions)Salary, benefits and other employee-related costs$6.5 Facilities and other infrastructure costs2.6 University endowment2.0 Stock-based compensation2.0 Other items1.5 Total change in general and administrative expense$14.6 Salary, benefits and other employee-related costs included in general and administrative expense increased during fiscal 2020, as compared to fiscal 2019, due primarily to an increase in variable compensation and additional headcount from hiring.34Table of ContentsAmortization of Acquired IntangiblesAmortization of acquired intangibles consists primarily of amortization of customer relationships, acquired backlog, trade names, trademarks and patents. Amortization in any given period depends primarily the timing and extent to which we acquire intangible assets. Change 202020192020 vs. 2019 (In millions, except percentages)Amortization of acquired intangibles$18.0 $12.1 $5.9 49 %Amortization of acquired intangibles increased by $7.3 million during fiscal 2020, as compared to fiscal 2019, due to intangibles assets acquired from AWR and Integrand during fiscal 2020. This increase was partially offset by certain intangible assets becoming fully amortized during fiscal 2020 and 2019.Restructuring and Other ChargesWe have initiated restructuring plans in recent years to better align our resources with our business strategy. Because the restructuring charges and related benefits are derived from management’s estimates made during the formulation of the restructuring plans, based on then-currently available information, our restructuring plans may not achieve the benefits anticipated on the timetable or at the level contemplated. Additional actions, including further restructuring of our operations, may be required in the future.The following table presents restructuring and other charges, net for our restructuring plans:20202019(In millions)Severance and benefits$7.5 $8.6 Excess facilities1.7 — Total$9.2 $8.6 For an additional description of our restructuring plans, see Note 13 in the notes to consolidated financial statements.Operating marginOperating margin represents income from operations as a percentage of total revenue. Our operating margin for fiscal 2020 and 2019 was as follows:20202019Operating margin24 %21 %Operating margin increased during fiscal, 2020, as compared to fiscal 2019, because revenue growth exceeded the growth of our costs and expenses. During fiscal 2021, we expect growth in operating margin will be more moderate due to an increase in costs and expenses associated with acquisitions, including increased amortization of intangibles. We also expect an increase in expenses related to travel, meetings and events if measures implemented to contain COVID-19 are lifted.Interest ExpenseInterest expense for fiscal 2020 and 2019 was comprised of the following: 20202019 (In millions)Contractual cash interest expense:2024 Notes$15.5 $15.3 Revolving credit facility4.4 2.4 Amortization of debt discount:2024 Notes0.8 0.7 Other— 0.4 Total interest expense$20.7 $18.8 Interest expense increased during fiscal 2020, as compared to fiscal 2019, due to borrowings of $350 million under our revolving credit facility during the first quarter of fiscal 2020 as a precautionary measure to provide additional liquidity in light of global economic uncertainty. All outstanding borrowings under our revolving credit facility were repaid in the fourth quarter of fiscal 2020. For an additional description of our debt arrangements, including our revolving credit facility, see Note 3 in the notes to consolidated financial statements.35Table of ContentsIncome TaxesThe following table presents the provision (benefit) for income taxes and the effective tax rate for fiscal 2020 and 2019: 20202019 (In millions, except percentages)Provision (benefit) for income taxes$42.1 $(510.0)Effective tax rate6.7 %(106.5)%In June 2020, the State of California enacted legislation that, for a three-year period beginning in fiscal 2020, will limit our utilization of California research and development tax credits to $5 million annually and will suspend the use of California net operating loss deductions. We accounted for the effects of the California tax law change and we recognized a tax benefit of approximately $22.2 million due to a partial release of the valuation allowance on our California research and development tax credit deferred tax assets as a result of certain tax elections made in our 2019 California tax return.Our provision for fiscal 2020 was primarily attributable to federal, state and foreign income taxes on our fiscal 2020 income, partially offset by the tax benefit of $22.2 million related to the partial release of the valuation allowance on our California research and development tax credit deferred tax assets and the tax benefit of $60.1 million related to stock-based compensation that vested or was exercised during fiscal 2020.During fiscal 2019, we completed intercompany transfers of certain intangible property rights to our Irish subsidiary, which resulted in the establishment of a net deferred tax asset and the recognition of an income tax benefit of $575.6 million. We expected to realize the deferred tax asset in future periods and did not provide for a valuation allowance. This income tax benefit was partially offset by the federal, state and foreign income taxes on our fiscal 2019 income. We also recognized $36.8 million of tax benefit related to stock-based compensation that vested or was exercised during the year.Our future effective tax rates may be materially impacted by tax amounts associated with our foreign earnings at rates different from the United States federal statutory rate, research credits, the tax impact of stock-based compensation, accounting for uncertain tax positions, business combinations, closure of statutes of limitations or settlement of tax audits, changes in valuation allowance and changes in tax law. A significant amount of our foreign earnings is generated by our subsidiaries organized in Ireland and Hungary. Our future effective tax rates may be adversely affected if our earnings were to be lower in countries where we have lower statutory tax rates. We currently expect that our fiscal 2021 effective tax rate will be approximately 14%. We expect that our quarterly effective tax rates will vary from our fiscal 2021 effective tax rate as a result of recognizing the income tax effects of stock-based awards in the quarterly periods that the awards vest or are settled and other items that we cannot anticipate. For additional discussion about how our effective tax rate could be affected by various risks, see Part I, Item 1A, “Risk Factors.” For further discussion regarding our income taxes, see Note 6 in the notes to consolidated financial statements.Liquidity and Capital Resources As ofChange January 2,2021December 28,20192020 vs. 2019 (In millions)Cash and cash equivalents$928.4 $705.2 $223.2 Net working capital681.8 497.0 184.8 Cash and Cash EquivalentsAs of January 2, 2021, our principal sources of liquidity consisted of $928.4 million of cash and cash equivalents as compared to $705.2 million as of December 28, 2019.Our primary sources of cash and cash equivalents during fiscal 2020 were cash generated from operations, proceeds from borrowings under our revolving credit facility, proceeds from the exercise of stock options and proceeds from stock purchases under our employee stock purchase plan.Our primary uses of cash and cash equivalents during fiscal 2020 were payments related to salaries and benefits, operating expenses, repurchases of our common stock, payments on our revolving credit facility, payments for business combinations, net of cash acquired, and purchases of property, plant and equipment.36Table of Contents Approximately 61% of our cash and cash equivalents were held by our foreign subsidiaries as of January 2, 2021. Our cash and cash equivalents held by our foreign subsidiaries may vary from period to period due to the timing of collections and repatriation of foreign earnings. We expect that current cash and cash equivalent balances, cash flows that are generated from operations and cash borrowings available under our revolving credit facility will be sufficient to meet our domestic and international working capital needs, and other capital and liquidity requirements, including acquisitions and share repurchases for at least the next 12 months.Net Working CapitalNet working capital is comprised of current assets less current liabilities, as shown on our consolidated balance sheets. The increase in our net working capital as of January 2, 2021, as compared to December 28, 2019, is primarily due to improved results from operations, the timing of cash receipts from customers and disbursements made to vendors.Cash Flows from Operating ActivitiesCash flows from operating activities during fiscal 2020 and 2019 were as follows: Change 202020192020 vs. 2019 (In millions)Cash provided by operating activities$904.9 $729.6 $175.3 Cash flows from operating activities include net income, adjusted for certain non-cash items, as well as changes in the balances of certain assets and liabilities. Our cash flows from operating activities are significantly influenced by business levels and the payment terms set forth in our customer agreements. The increase in cash flows from operating activities during fiscal 2020, as compared to fiscal 2019, was primarily due to the improved results from operations and timing of cash receipts from customers and disbursements made to vendors.Cash Flows from Investing ActivitiesCash flows used for investing activities during fiscal 2020 and 2019 were as follows: Change 202020192020 vs. 2019 (In millions)Cash used for investing activities$(292.2)$(105.7)$(186.5)The increase in cash used for investing activities during fiscal 2020, as compared to fiscal 2019, was primarily due to an increase in cash paid in business combinations, net of cash acquired, and an increase in purchases of property, plant and equipment. These increases were partially offset by a decrease in payments to acquire equity instruments of other entities. We expect to continue our investing activities, including purchasing property, plant and equipment, purchasing intangible assets, business combinations, purchasing software licenses, and making strategic investments.Cash Flows from Financing ActivitiesCash flows used for financing activities during fiscal 2020 and 2019 were as follows: Change 202020192020 vs. 2019 (In millions)Cash used for financing activities$(415.3)$(443.9)$28.6 The decrease in cash used for financing activities during fiscal 2020, as compared to fiscal 2019, was primarily due to a decrease in net cash paid for debt arrangements, partially offset by an increase in payments for repurchases of our common stock.37Table of ContentsOther Factors Affecting Liquidity and Capital ResourcesStock Repurchase ProgramAt the end of fiscal 2019, approximately $369 million remained available under our previously announced authorization to repurchase shares of our common stock. In July 2020, Cadence’s Board of Directors increased the previously announced authorization to repurchase shares of Cadence common stock by an additional $750 million. The actual timing and amount of repurchases are subject to business and market conditions, corporate and regulatory requirements, stock price, acquisition opportunities and other factors. As of January 2, 2021, approximately $739 million remained available to repurchase shares of Cadence common stock. See Part II, Item 5, “Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities” for additional information.Revolving Credit FacilityOur senior unsecured revolving credit facility provides for borrowings up to $350.0 million, with the right to request increased capacity up to an additional $250.0 million upon the receipt of lender commitments, for total maximum borrowings of $600.0 million. The credit facility expires on January 28, 2022 and currently has no subsidiary guarantors. Any outstanding loans drawn under the credit facility are due at maturity on January 28, 2022. Outstanding borrowings may be paid at any time prior to maturity. As of January 2, 2021, there were no borrowings outstanding under our revolving credit facility, and we were in compliance with all financial covenants associated with the revolving credit facility.2024 NotesIn October 2014, we issued $350.0 million aggregate principal amount of 4.375% Senior Notes due October 15, 2024. We received net proceeds of $342.4 million from the issuance of the 2024 Notes, net of a discount of $1.4 million and issuance costs of $6.2 million. Interest is payable in cash semi-annually. The 2024 Notes are unsecured and rank equal in right of payment to all of our existing and future senior indebtedness. As of January 2, 2021, we were in compliance with all covenants associated with the 2024 Notes.For additional information relating to our debt arrangements, see Note 3 in the notes to consolidated financial statements.Contractual ObligationsA summary of our contractual obligations as of January 2, 2021 is as follows:Payments Due by PeriodTotalLessThan 1 Year1-3 Years3-5 YearsMoreThan 5 Years(In millions)Operating lease obligations(1)$173.5 $38.4 $51.9 $35.6 $47.6 Purchase obligations46.8 36.3 8.7 1.3 0.5 Long-term debt350.0 — — 350.0 — Contractual interest payments61.8 15.8 30.7 15.3 — Current income tax payable7.8 7.8 Other long-term contractual obligations (2)40.4 — 19.8 4.0 16.6 Total$680.3 $98.3 $111.1 $406.2 $64.7 _________________(1) This table includes future payments under leases that had commenced as of January 2, 2021 as well as leases that had been signed but not yet commenced as of January 2, 2021.(2) Included in other long-term contractual obligations are long-term income tax liabilities of $17.6 million related to unrecognized tax benefits. Of the $17.6 million, we estimate $16.3 million will be paid or settled within 1 to 3 years, $1.2 million within 3 to 5 years and $0.1 million in more than 5 years. The remaining portion of other long-term contractual obligations is primarily liabilities associated with defined benefit retirement plans and acquisitions.Off-Balance Sheet ArrangementsAs of January 2, 2021, we did not have any significant off-balance sheet arrangements, as defined in Item 303(a)(4)(ii) of SEC Regulation S-K.38Critical Accounting EstimatesIn preparing our consolidated financial statements, we make assumptions, judgments and estimates that can have a significant impact on our revenue, operating income and net income, as well as on the value of certain assets and liabilities on our consolidated balance sheets. We base our assumptions, judgments and estimates on historical experience and various other factors that we believe to be reasonable under the circumstances. Actual results could differ materially from these estimates under different assumptions or conditions. At least quarterly, we evaluate our assumptions, judgments and estimates, and make changes as deemed necessary.We believe that the assumptions, judgments and estimates involved in the accounting for income taxes, revenue recognition and business combinations have the greatest potential impact on our consolidated financial statements; therefore, we consider these to be our critical accounting estimates. For information on our significant accounting policies, see Note 2 in the notes to consolidated financial statements.Revenue Recognition Our contracts with customers often include promises to transfer multiple software and/or IP licenses, hardware and services, including professional services, technical support services, and rights to unspecified updates to a customer. These contracts require us to apply judgement in identifying and evaluating any terms and conditions in contracts which may impact revenue recognition. Determining whether licenses and services are distinct performance obligations that should be accounted for separately, or not distinct and thus accounted for together, requires significant judgment. In some arrangements, such as most of our IP license arrangements, we have concluded that the licenses and associated services are distinct from each other. In other arrangements, like our time-based software arrangements, the licenses and certain services are not distinct from each other. Our time-based software arrangements include multiple software licenses and updates to the licensed software products, as well as technical support, and we have concluded that these promised goods and services are a single, combined performance obligation.Judgment is required to determine the stand-alone selling prices (“SSPs”) for each distinct performance obligation. We rarely license or sell products on a standalone basis, so we are required to estimate the SSP for each performance obligation. In instances where the SSP is not directly observable because we do not sell the license, product or service separately, we determine the SSP using information that may include market conditions and other observable inputs. We typically have more than one SSP for individual performance obligations due to the stratification of those items by classes of customers and circumstances. In these instances, we may use information such as the size of the customer and geographic region of the customer in determining the SSP.Revenue is recognized over time for our combined performance obligations that include software licenses, updates, and technical support as well as for maintenance and professional services that are separate performance obligations. For our professional services, revenue is recognized over time, generally using costs incurred or hours expended to measure progress. Judgment is required in estimating project status and the costs necessary to complete projects. A number of internal and external factors can affect these estimates, including labor rates, utilization and efficiency variances and specification and testing requirement changes. For our other performance obligations recognized over time, revenue is generally recognized using a time-based measure of progress reflecting generally consistent efforts to satisfy those performance obligations throughout the arrangement term.If a group of agreements are so closely related that they are, in effect, part of a single arrangement, such agreements are deemed to be one arrangement for revenue recognition purposes. We exercise significant judgment to evaluate the relevant facts and circumstances in determining whether the separate agreements should be accounted for separately or as, in substance, a single arrangement. Our judgments about whether a group of contracts comprise a single arrangement can affect the allocation of consideration to the distinct performance obligations, which could have an effect on results of operations for the periods involved.We are required to estimate the total consideration expected to be received from contracts with customers. In some circumstances, the consideration expected to be received is variable based on the specific terms of the contract or based on our expectations of the term of the contract. Generally, we have not experienced significant returns or refunds to customers. These estimates require significant judgment and the change in these estimates could have an effect on our results of operations during the periods involved.Accounting for Income TaxesWe are subject to income taxes in the United States and numerous foreign jurisdictions. Significant judgment is required in evaluating and estimating our provision for these taxes. There are many transactions that occur during the ordinary course of business for which the ultimate tax determination is uncertain. Our provision for income taxes could be adversely affected by our earnings being lower than anticipated in countries where we have lower statutory rates and higher than anticipated in countries where we have higher statutory rates, losses incurred in jurisdictions for which we are not able to realize the related tax benefit, changes in foreign currency exchange rates, entry into new businesses and geographies and changes to our existing businesses, acquisitions and investments, changes in our deferred tax assets and liabilities including changes in our assessment of valuation allowances, changes in the relevant tax laws or interpretations of these tax laws, and developments in current and future tax examinations.39We only recognize the tax benefit of an income tax position if we judge that it is more likely than not that the tax position will be sustained, solely on its technical merits, in a tax audit including resolution of any related appeals or litigation processes. To make this judgment, we must interpret complex and sometimes ambiguous tax laws, regulations and administrative practices. If we judge that an income tax position meets this recognition threshold, then we must measure the amount of the tax benefit to be recognized by estimating the largest amount of tax benefit that has a greater than 50% cumulative probability of being realized upon settlement with a taxing authority that has full knowledge of all of the relevant facts. It is inherently difficult and subjective to estimate such amounts, as this requires us to determine the probability of various possible settlement outcomes. We must reevaluate our income tax positions on a quarterly basis to consider factors such as changes in facts or circumstances, changes in tax law, effectively settled issues under audit, the lapse of applicable statute of limitations, and new audit activity. Such a change in recognition or measurement would result in recognition of a tax benefit or an additional charge to the tax provision. For a more detailed description of our unrecognized tax benefits, see Note 6 in the notes to consolidated financial statements.During fiscal 2019, we completed intercompany transfers of certain intangible property rights to our Irish subsidiary, which resulted in the establishment of a deferred tax asset and the recognition of an income tax benefit of $575.6 million. To determine the value of the deferred tax asset, we were required to make significant estimates in determining the fair value of the transferred IP rights. These estimates included, but are not limited to, the income and cash flows that the IP rights are expected to generate in the future, the appropriate discount rate to apply to the income and cash flow projections, and the useful lives of the IP rights. These estimates are inherently uncertain and unpredictable, and if different estimates were used, it would impact the fair value of the IP rights and the related value of the deferred tax asset and the income tax benefit recognized in fiscal 2019 and in future periods when the deferred tax asset is realized. In addition, we reviewed the need to establish a valuation allowance on the deferred tax asset of $575.6 million by evaluating whether there is a greater than 50% likelihood that some portion or all of the deferred tax asset will not be realized. To make this judgment, we must make significant estimates and predictions of the amount and category of future taxable income from various sources and weigh all available positive and negative evidence about these possible sources of taxable income. We give greater weight to evidence that can be objectively verified. Based on our evaluation and weighting of the positive and negative evidence, we concluded that it is greater than 50% likely that the deferred tax asset of $575.6 million will be realized in future periods and that a valuation allowance was not currently required. If, in the future, we evaluate that this deferred tax asset is not likely to be realized, an increase in the related valuation allowance could result in a material income tax expense in the period such a determination is made.Business CombinationsWhen we acquire businesses, we allocate the purchase price to the acquired tangible assets and assumed liabilities, including deferred revenue, liabilities associated with the fair value of contingent consideration and acquired identifiable intangible assets. Any residual purchase price is recorded as goodwill. The allocation of the purchase price requires us to make significant estimates in determining the fair values of these acquired assets and assumed liabilities, especially with respect to intangible assets and goodwill. These estimates are based on information obtained from management of the acquired companies, our assessment of this information, and historical experience. These estimates can include, but are not limited to, the cash flows that an acquired business is expected to generate in the future, the cash flows that specific assets acquired with that business are expected to generate in the future, the appropriate weighted-average cost of capital, and the cost savings expected to be derived from acquiring an asset. These estimates are inherently uncertain and unpredictable, and if different estimates were used, the purchase price for the acquisition could be allocated to the acquired assets and assumed liabilities differently from the allocation that we have made to the acquired assets and assumed liabilities. In addition, unanticipated events and circumstances may occur that may affect the accuracy or validity of such estimates, and if such events occur, we may be required to adjust the value allocated to acquired assets or assumed liabilities.We also make significant judgments and estimates when we assign useful lives to the definite-lived intangible assets identified as part of our acquisitions. These estimates are inherently uncertain and if we used different estimates, the useful life over which we amortize intangible assets would be different. In addition, unanticipated events and circumstances may occur that may impact the useful life assigned to our intangible assets, which would impact our amortization of intangible assets expense and our results of operations.During the first quarter of fiscal 2020, we acquired intangible assets of $101.3 million with our acquisition of AWR and Integrand. The fair value of the definite-lived intangible assets acquired with these acquisitions was determined using variations of the income approach. For existing technology, the fair value was determined by applying the relief-from-royalty method. This method is based on the application of a royalty rate to forecasted revenue to quantify the benefit of owning the intangible asset rather than paying a royalty for use of the asset. To estimate royalty savings over time, we projected revenue from existing technology over the estimated remaining life of the technology, including the effect of technological obsolescence which was estimated at rate between 5% and 7.5% annually, before applying an assumed royalty rate of 20%. The present value of after-tax royalty savings were determined using discount rates ranging from 10% to 11.5%.The fair value for customer contracts and related relationships was determined by using the multi-period excess earnings method. This method reflects the present value of the projected cash flows that are expected to be generated from existing customers, less charges representing the contribution of other assets to those cash flows. Projected income from existing customer relationships considered customer retention rates ranging between 85% and 95%. The present value of operating cash flows from existing customer was determined using discount rates 10% and 11.5%.40We also assumed obligations related to deferred revenue of $6.9 million during the first quarter of fiscal 2020 with our acquisition of AWR. The fair value of these obligations was estimated using the cost build-up approach. The cost build-up approach determines fair value using estimates of the costs required to fulfill the contracted obligations plus an assumed profit margin, which approximates the amount that AWR would be required to pay a third party to assume the obligation.Cadence believes that its estimates and assumptions related to the fair value of its acquired intangible assets and deferred revenue obligations are reasonable, but significant judgment is involved.New Accounting StandardsFor additional information about the adoption of new accounting standards, see Note 2 in the notes to consolidated financial statements.41Item 7A. Quantitative and Qualitative Disclosures About Market RiskForeign Currency RiskA material portion of our revenue, expenses and business activities are transacted in the U.S. dollar. In certain foreign countries where we price our products and services in U.S. dollars, a decrease in value of the local currency relative to the U.S. dollar results in an increase in the prices for our products and services compared to those products of our competitors that are priced in local currency. This could result in our prices being uncompetitive in certain markets.In certain countries where we may invoice customers in the local currency, our revenues benefit from a weaker dollar and are adversely affected by a stronger dollar. The opposite impact occurs in countries where we record expenses in local currencies. In those cases, our costs and expenses benefit from a stronger dollar and are adversely affected by a weaker dollar. The fluctuations in our operating expenses outside the United States resulting from volatility in foreign exchange rates are not generally moderated by corresponding fluctuations in revenues from existing contracts.We enter into foreign currency forward exchange contracts to protect against currency exchange risks associated with existing assets and liabilities. A foreign currency forward exchange contract acts as a hedge by increasing in value when underlying assets decrease in value or underlying liabilities increase in value due to changes in foreign exchange rates. Conversely, a foreign currency forward exchange contract decreases in value when underlying assets increase in value or underlying liabilities decrease in value due to changes in foreign exchange rates. These forward contracts are not designated as accounting hedges, so the unrealized gains and losses are recognized in other income, net, in advance of the actual foreign currency cash flows with the fair value of these forward contracts being recorded as accrued liabilities or other current assets.We do not use forward contracts for trading purposes. Our forward contracts generally have maturities of 90 days or less. We enter into foreign currency forward exchange contracts based on estimated future asset and liability exposures, and the effectiveness of our hedging program depends on our ability to estimate these future asset and liability exposures. Recognized gains and losses with respect to our current hedging activities will ultimately depend on how accurately we are able to match the amount of foreign currency forward exchange contracts with actual underlying asset and liability exposures.The following table provides information about our foreign currency forward exchange contracts as of January 2, 2021. The information is provided in United States dollar equivalent amounts. The table presents the notional amounts, at contract exchange rates, and the weighted average contractual foreign currency exchange rates expressed as units of the foreign currency per United States dollar, which in some cases may not be the market convention for quoting a particular currency. All of these forward contracts matured during February 2021.NotionalPrincipalWeightedAverageContractRate (In millions) Forward Contracts:European Union euro$133.0 0.84 British pound103.2 0.75 Israeli shekel68.4 3.34 Japanese yen31.0 103.96 Swedish krona29.9 8.49 Chinese renminbi24.4 6.59 Indian rupee27.4 74.57 Taiwan dollar14.8 28.02 Canadian dollar7.9 1.3Other 6.6 N/ATotal$446.6 Estimated fair value$8.9 We actively monitor our foreign currency risks, but our foreign currency hedging activities may not substantially offset the impact of fluctuations in currency exchange rates on our results of operations, cash flows and financial position.42Interest Rate RiskOur exposure to market risk for changes in interest rates relates primarily to our portfolio of cash and cash equivalents and balances outstanding on our revolving credit facility, if any. We are exposed to interest rate fluctuations in many of the world’s leading industrialized countries, but our interest income and expense is most sensitive to fluctuations in the general level of United States interest rates. In this regard, changes in United States interest rates affect the interest earned on our cash and cash equivalents and the costs associated with foreign currency hedges.All highly liquid securities with a maturity of three months or less at the date of purchase are considered to be cash equivalents. The carrying value of our interest-bearing instruments approximated fair value as of January 2, 2021.Interest rates under our revolving credit facility are variable, so interest expense could be adversely affected by changes in interest rates, particularly for periods when we maintain a balance outstanding under the revolving credit facility. Interest rates for our revolving credit facility can fluctuate based on changes in market interest rates and in an interest rate margin that varies based on our consolidated leverage ratio. As of January 2, 2021, there were no borrowings outstanding under our revolving credit facility. For an additional description of the revolving credit facility, see Note 3 in the notes to consolidated financial statements. Equity Price RiskEquity InvestmentsWe have a portfolio of equity investments that includes marketable equity securities and non-marketable investments. Our equity investments are made primarily in connection with our strategic investment program. Under our strategic investment program, from time to time, we make cash investments in companies with technologies that are potentially strategically important to us. See Note 8 in the notes to consolidated financial statements for an additional description of these investments.
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+Item 7. "Management's Discussion and Analysis of Financial Condition and Results of Operations."These forward-looking statements reflect our current views with respect to future events and are based on numerous assumptions and assessments made by us in light of our experience and perception of historical trends, current conditions, business strategies, operating environments, future developments and other factors we believe appropriate. By their nature, forward-looking statements involve known and unknown risks and uncertainties and are subject to change because they relate to events and depend on circumstances that will occur in the future, including economic, regulatory, competitive and other factors that may cause our or our industry's actual results, levels of activity, performance or achievements to be materially different from any future results, levels of activity, performance or achievements expressed or implied by these forward-looking statements. These statements are not guarantees of future performance and are subject to risks, uncertainties and assumptions. All forward-looking statements included in this filing are based on information available to us on the date of this filing. Except as may be otherwise required by law, we undertake no obligation to update or revise the forward-looking statements included in this filing, whether as a result of new information, future events or otherwise, after the date of this filing. You should not place undue reliance on any forward-looking statements, as actual results may differ materially from projections, estimates, or other forward-looking statements due to a variety of important factors, variables and events including, but not limited to: •the impact of COVID-19 on global markets, economic conditions, the healthcare industry and our results of operations and the response by governments and other third parties;•the risk that regulatory or other approvals required for the Magellan Acquisition may be delayed or not obtained or are obtained subject to conditions that are not anticipated that could require the exertion of management's time and our resources or otherwise have an adverse effect on us; •the risk that Magellan Health's stockholders do not approve the definitive merger agreement; •the possibility that certain conditions to the consummation of the Magellan Acquisition will not be satisfied or completed on a timely basis and accordingly the Magellan Acquisition may not be consummated on a timely basis or at all;•uncertainty as to the expected financial performance of the combined company following completion of the Magellan Acquisition; •the possibility that the expected synergies and value creation from the Magellan Acquisition or the WellCare Acquisition will not be realized, or will not be realized within the applicable expected time periods;•the exertion of management's time and our resources, and other expenses incurred and business changes required, in connection with complying with the undertakings in connection with any regulatory, governmental or third party consents or approvals for the Magellan Acquisition; •the risk that unexpected costs will be incurred in connection with the completion and/or integration of the Magellan Acquisition or that the integration of Magellan Health will be more difficult or time consuming than expected; •the risk that potential litigation in connection with the Magellan Acquisition may affect the timing or occurrence of the Magellan Acquisition or result in significant costs of defense, indemnification and liability; •a downgrade of the credit rating of our indebtedness, which could give rise to an obligation to redeem existing indebtedness; •the possibility that competing offers will be made to acquire Magellan Health; •the inability to retain key personnel; •disruption from the announcement, pendency and/or completion and/or integration of the Magellan Acquisition or the integration of the WellCare Acquisition, or similar risks from other acquisitions we may announce or complete from Table of Contentstime to time, including potential adverse reactions or changes to business relationships with customers, employees, suppliers or regulators, making it more difficult to maintain business and operational relationships; •our ability to accurately predict and effectively manage health benefits and other operating expenses and reserves, including fluctuations in medical utilization rates due to the impact of COVID-19; •competition; •membership and revenue declines or unexpected trends; •changes in healthcare practices, new technologies, and advances in medicine; •increased healthcare costs; •changes in economic, political or market conditions; •changes in federal or state laws or regulations, including changes with respect to income tax reform or government healthcare programs as well as changes with respect to the Patient Protection and Affordable Care Act (ACA) and the Health Care and Education Affordability Reconciliation Act, collectively referred to as the ACA and any regulations enacted thereunder that may result from changing political conditions, the new administration or judicial actions, including the ultimate outcome in "Texas v. United States of America" regarding the constitutionality of the ACA; •rate cuts or other payment reductions or delays by governmental payors and other risks and uncertainties affecting our government businesses; •our ability to adequately price products; •tax matters; •disasters or major epidemics; •changes in expected contract start dates; •provider, state, federal, foreign and other contract changes and timing of regulatory approval of contracts; •the expiration, suspension, or termination of our contracts with federal or state governments (including, but not limited to, Medicaid, Medicare, TRICARE or other customers); •the difficulty of predicting the timing or outcome of pending or future legal and regulatory proceedings or government investigations; •challenges to our contract awards; •cyber-attacks or other privacy or data security incidents; •the possibility that the expected synergies and value creation from acquired businesses, including businesses we may acquire in the future, will not be realized, or will not be realized within the expected time period; •the exertion of management's time and our resources, and other expenses incurred and business changes required in connection with complying with the undertakings in connection with any regulatory, governmental or third party consents or approvals for acquisitions; •disruption caused by significant completed and pending acquisitions making it more difficult to maintain business and operational relationships; •the risk that unexpected costs will be incurred in connection with the completion and/or integration of acquisition transactions; •changes in expected closing dates, estimated purchase price and accretion for acquisitions; •the risk that acquired businesses will not be integrated successfully; •restrictions and limitations in connection with our indebtedness; •our ability to maintain or achieve improvement in the Centers for Medicare and Medicaid Services (CMS) Star ratings and maintain or achieve improvement in other quality scores in each case that can impact revenue and future growth; •availability of debt and equity financing, on terms that are favorable to us; •inflation; and •foreign currency fluctuations.This list of important factors is not intended to be exhaustive. We discuss certain of these matters more fully, as well as certain other factors that may affect our business operations, financial condition and results of operations, in our filings with the Securities and Exchange Commission (SEC), including quarterly reports on Form 10-Q and current reports on Form 8-K. Item 1A. "Risk Factors" of Part I of this filing contains a further discussion of these and other important factors that could cause actual results to differ from expectations. Due to these important factors and risks, we cannot give assurances with respect to our future performance, including without limitation our ability to maintain adequate premium levels or our ability to control our future medical and selling, general and administrative costs. Table of ContentsSUMMARY OF RISK FACTORSOur business is subject to numerous risks and uncertainties that you should be aware of in evaluating our business, including risks that may prevent us from achieving our business objectives or may adversely affect our business, financial condition, results of operations, cash flows and prospects. The risks include, but are not limited to, the following, all of which are more fully described in Part 1, Item 1A "Risk Factors" section below. This summary should be read in conjunction with the Risk Factors section and should not be relied upon as an exhaustive summary of the material risks facing our business.•Our business could be adversely affected by the effects of widespread public health pandemics, such as the spread of COVID-19;•Our Medicare programs are subject to a variety of unique risks that could adversely impact our financial results;•Failure to accurately estimate and price our medical expenses or effectively manage our medical costs or related administrative costs could negatively affect our results of operations, financial position and cash flows;•Risk-adjustment payment systems make our revenue and results of operations more difficult to estimate and could result in retroactive adjustments that have a material adverse effect on our results of operations, financial condition and cash flows;•Any failure to adequately price products offered or any reduction in products offered in the Health Insurance Marketplaces may have a negative impact on our results of operations, financial position and cash flow;•We derive a portion of our cash flow and gross margin from our prescription drug plan (PDP) operations, for which we submit annual bids for participation. The results of our bids could materially affect our results of operations, financial condition and cash flows;•Our encounter data may be inaccurate or incomplete, which could have a material adverse effect on our results of operations, financial condition, cash flows and ability to bid for, and continue to participate in, certain programs;•If any of our government contracts are terminated or are not renewed on favorable terms or at all, or if we receive an adverse finding or review resulting from an audit or investigation, our business may be adversely affected; •Ineffectiveness of state-operated systems and subcontractors could adversely affect our business; •Execution of our growth strategy may increase costs or liabilities, or create disruptions in our business;•If competing managed care programs are unwilling to purchase specialty services from us, we may not be able to successfully implement our strategy of diversifying our business lines; •If state regulators do not approve payments of dividends and distributions by our subsidiaries to us, we may not have sufficient funds to implement our business strategy;•We derive a significant portion of our premium revenues from operations in a limited number of states, and our results of operations, financial position or cash flows could be materially affected by a decrease in premium revenues or profitability in any one of those states; •Competition may limit our ability to increase penetration of the markets that we serve;•If we are unable to maintain relationships with our provider networks, our profitability may be harmed; •If we are unable to integrate and manage our information systems effectively, our operations could be disrupted; •An impairment charge with respect to our recorded goodwill and intangible assets could have a material impact on our results of operations; •A failure in or breach of our operational or security systems or infrastructure, or those of third parties with which we do business, including as a result of cyber-attacks, could have an adverse effect on our business; •Reductions in funding, changes to eligibility requirements for government sponsored healthcare programs in which we participate and any inability on our part to effectively adapt to changes to these programs could substantially affect our results of operations, financial position and cash flows;•The implementation of the ACA, as well as potential repeal of, changes to, or judicial challenges to the ACA, could materially and adversely affect our results of operations, financial position and cash flows;•Our business activities are highly regulated and new laws or regulations or changes in existing laws or regulations or their enforcement or application could force us to change how we operate and could harm our business; •Our businesses providing pharmacy benefit management and specialty pharmacy services face regulatory and other risks and uncertainties which could materially and adversely affect our results of operations, financial position and cash flows;•From time to time, we may become involved in costly and time-consuming litigation and other regulatory proceedings, which require significant attention from our management; •If we fail to comply with applicable privacy, security, and data laws, regulations and standards, including with respect to third-party service providers that utilize sensitive personal information on our behalf, our business, reputation, results of operations, financial position and cash flows could be materially and adversely affected; •If we fail to comply with the extensive federal and state fraud, waste and abuse laws, our business, reputation, results of operations, financial position and cash flows could be materially and adversely affected;Table of Contents•Our investment portfolio may suffer losses which could materially and adversely affect our results of operations or liquidity; •Adverse credit market conditions may have a material adverse effect on our liquidity or our ability to obtain credit on acceptable terms;•We have substantial indebtedness outstanding and may incur additional indebtedness in the future. Such indebtedness could reduce our agility and may adversely affect our financial condition;•Changes in the method pursuant to which the LIBOR rates are determined and potential phasing out of LIBOR after 2021 may affect the value of the financial obligations to be held or issued by us that are linked to LIBOR or our results of operations or financial condition;•Mergers and acquisitions may not be accretive and may cause dilution to our earning per share, which may cause the market price of our common stock to decline;•We may be unable to successfully integrate our existing business with acquired businesses and realize the anticipated benefits of such acquisitions;•The financing arrangements that we entered into in connection with the WellCare Acquisition may, under certain circumstances, contain restrictions and limitations that could significantly impact our ability to operate our business; •The merger with Magellan Health is subject to conditions, some or all of which may not be satisfied, or completed on a timely basis, if at all. Failure to complete the merger with Magellan Health could have adverse effects on our business;•Centene and Magellan Health may be targets of securities class action and derivative lawsuits that could result in substantial costs and may delay or prevent the Magellan Acquisition from being completed;•Completion of the Magellan Acquisition may trigger change in control or other provisions in certain agreements to which Magellan Health or its subsidiaries are a party, which may have an adverse impact on the combined company’s business and results of operations; and•We may be unable to attract, retain or effectively manage the succession of key personnel; and•Future issuances and sales of additional shares of preferred or common stock could reduce the market price of our shares of common stock.Table of ContentsNon-GAAP Financial Presentation The Company is providing certain non-GAAP financial measures in this report as the Company believes that these figures are helpful in allowing investors to more accurately assess the ongoing nature of the Company's operations and measure the Company's performance more consistently across periods. The Company uses the presented non-GAAP financial measures internally to allow management to focus on period-to-period changes in the Company's core business operations. Therefore, the Company believes that this information is meaningful in addition to the information contained in the GAAP presentation of financial information. The presentation of this additional non-GAAP financial information is not intended to be considered in isolation or as a substitute for the financial information prepared and presented in accordance with GAAP.Specifically, the Company believes the presentation of non-GAAP financial information that excludes amortization of acquired intangible assets, acquisition related expenses, as well as other items, allows investors to develop a more meaningful understanding of the Company's performance over time. The tables below provide reconciliations of non-GAAP items ($ in millions, except per share data). Year Ended December 31,202020192018GAAP net earnings attributable to Centene$1,808 $1,321 $900 Amortization of acquired intangible assets719 258 211 Acquisition related expenses 602 104 425 Other adjustments (1)29 301 30 Income tax effects of adjustments (2)(262)(127)(155)Adjusted net earnings$2,896 $1,857 $1,411 GAAP diluted earnings per share (EPS) attributable to Centene$3.12 $3.14 $2.26 Amortization of acquired intangible assets (3)0.95 0.47 0.41 Acquisition related expenses (4)0.86 0.19 0.81 Other adjustments (1)0.07 0.62 0.06 Adjusted Diluted EPS$5.00 $4.42 $3.54 (1) Other adjustments include the following items:2020 - (a) gain related to the divestiture of certain products of our Illinois health plan of $104 million, or $0.10 per diluted share, net of an income tax expense of $0.08; (b) non-cash impairment of our third-party care management software business of $72 million, or $0.10 per diluted share, net of an income tax benefit of $0.02; and (c) debt extinguishment costs of $61 million, or $0.07 per diluted share, net of an income tax benefit of $0.04.2019 - (a) non-cash goodwill and intangible asset impairment of $271 million or $0.57 per diluted share, net of an income tax benefit of $0.08 and (b) debt extinguishment costs of $30 million or $0.05 per diluted share, net of an income tax benefit of $0.02; and2018 - the impact of retroactive changes to the California minimum medical loss ratio (MLR) of $30 million of expense or $0.06 per diluted share, net of an income tax benefit of $0.02.(2) The income tax effects of adjustments are based on the effective income tax rates applicable to each adjustment.(3) Amortization of acquired intangible assets is net of an income tax benefit of $0.29, $0.14, and $0.12 per diluted share for the years ended December 31, 2020, 2019 and 2018, respectively.(4) Acquisition related expenses are net of an income tax benefit of $0.18, $0.06 and $0.25 per diluted share for the years ended December 31, 2020, 2019 and 2018, respectively.iTable of ContentsYear Ended December 31,202020192018GAAP selling, general and administrative expenses$9,867 $6,533 $6,043 Acquisition related expenses580 85 421 Adjusted selling, general and administrative expenses$9,287 $6,448 $5,622 iiTable of ContentsPART IITEM 1. BusinessOVERVIEW We are a leading multi-national healthcare enterprise that is committed to helping people live healthier lives. We take a local approach - with local brands and local teams - to provide fully integrated, high-quality, and cost-effective services to government-sponsored and commercial healthcare programs, focusing on under-insured and uninsured individuals. We also provide education and outreach programs to inform and assist members in accessing quality, appropriate healthcare services. We believe our local approach, including member and provider services, enables us to provide accessible, quality, culturally-sensitive healthcare coverage to our communities. Our population health management, educational and other initiatives are designed to help members best utilize the healthcare system to ensure they receive appropriate, medically necessary services and effective management of routine, severe and chronic health problems, resulting in better health outcomes. We combine our decentralized local approach for care with a centralized infrastructure of support functions such as finance, information systems and claims processing.Our initial health plan commenced operations in Wisconsin in 1984. We were organized in Wisconsin in 1993 as a holding company for our initial health plan and reincorporated in Delaware in 2001. Our stock is publicly traded on the New York Stock Exchange under the ticker symbol "CNC."We operate in two segments: Managed Care and Specialty Services. Our Managed Care segment provides health plan coverage to individuals through government subsidized and commercial programs. Our Specialty Services segment includes companies offering diversified healthcare services and products to our Managed Care segment and other external customers. For the year ended December 31, 2020, our Managed Care and Specialty Services segments accounted for 96% and 4%, respectively, of our total external revenues. Our membership totaled 25.5 million as of December 31, 2020. For the year ended December 31, 2020, our total revenues and net earnings attributable to Centene were $111.1 billion and $1.8 billion, respectively, and our total cash flow from operations was $5.5 billion.Magellan AcquisitionIn January 2021, we announced that we entered into a definitive merger agreement under which we will acquire Magellan Health for $95.00 per share in cash for a total enterprise value of approximately $2.2 billion. The transaction, which was unanimously approved by the Boards of Directors of both companies, is expected to broaden and deepen our whole health capabilities and establish a leading behavioral health platform. The transaction is subject to clearance under the Hart-Scott Rodino Act, receipt of required state regulatory approvals, the approval of the definitive merger agreement by Magellan Health's stockholders and other customary closing conditions. The transaction is not contingent upon financing. We intend to fund the acquisition primarily through debt financing. The transaction is expected to close in the second half of 2021.WellCare AcquisitionOn January 23, 2020, we acquired all of the issued and outstanding shares of WellCare Health Plans, Inc. (WellCare, and such acquisition, the WellCare Acquisition). The transaction was valued at $19.6 billion, including the assumption of $1.95 billion of outstanding debt. The WellCare Acquisition brought a high-quality Medicare platform and further extended our robust Medicaid offerings. The WellCare Acquisition also enables us to provide access to more comprehensive and differentiated solutions across more markets with a continued focus on affordable, high-quality, culturally-sensitive healthcare services. With the WellCare Acquisition, we further broadened our product offerings by adding a Medicare prescription drug plan to our existing business lines.INDUSTRYWe provide a full spectrum of managed healthcare products and services, primarily through Medicaid, Medicare and commercial products. We currently have operations domestically and internationally.MedicaidEstablished in 1965, Medicaid is the largest publicly funded program in the United States, and provides health insurance to low-income families and individuals with disabilities. Authorized by Title XIX of the Social Security Act, Medicaid is an entitlement program funded jointly by the federal and state governments and administered by the states. The majority of funding is provided by the federal government. Each state establishes its own eligibility standards, benefit packages, payment 1Table of Contentsrates and program administration within federal standards. As a result, there are 56 Medicaid programs - one for each U.S. state, each U.S. territory and the District of Columbia. Eligibility is based on a combination of household income and assets, often determined by an income level relative to the federal poverty level. Historically, children have represented the largest eligibility group. Many states have selected Medicaid managed care as a means of delivering quality healthcare and controlling costs. We refer to these states as mandatory managed care states. Under the Affordable Care Act (ACA), Medicaid coverage was expanded to all individuals under age 65 with incomes up to 138% of the federal poverty level, subject to the states' elections. The federal government paid the entire costs for Medicaid Expansion coverage for newly eligible beneficiaries from 2014 through 2016, 95% of the costs in 2017, 94% of the costs in 2018, 93% of the costs in 2019, and 90% of the costs in 2020. Assuming that the current program remains in effect unchanged, in subsequent years the federal share is scheduled to remain at 90%.Established in 1972 and authorized by Title XVI of the Social Security Act, the Aged, Blind, or Disabled (ABD) program covers low-income persons with chronic physical disabilities or behavioral health impairments. ABD beneficiaries represent a growing portion of all Medicaid recipients. In addition, ABD recipients typically utilize more services as a result of their more complicated health status. The Balanced Budget Act of 1997 created the State Children's Health Insurance Program (CHIP) to help states expand coverage primarily to children whose families earned too much to qualify for Medicaid, yet not enough to afford private health insurance. Costs related to the largest eligibility group, children, are primarily composed of pediatrics and family care. These costs tend to be more predictable than those associated with other healthcare issues which predominantly affect the adult population. Long-Term Services and Supports (LTSS) is a Medicaid product that covers Institutional/Residential Care (Nursing Facilities, Intermediate Care Facilities) and Home and Community Based Services (HCBS) for beneficiaries requiring assistance with their activities of daily living, such as bathing, dressing and transferring. The most common HCBS services include personal care, adult day care, non-emergent transportation, home-delivered meals and personal emergency response systems. LTSS services are provided for individuals requiring nursing home level of care, receiving waiver services, or entitled to state Medicaid LTSS benefits. The largest groups receiving LTSS, by spending, are older individuals and individuals with physical disabilities, followed by individuals with intellectual and developmental disabilities, those with serious mental illness and/or serious emotional disturbance and other populations. States are increasingly turning to managed care as a solution to provide coordinated, holistic care to their LTSS beneficiaries. According to ADvancing States (formerly National Association of States United for Aging and Disabilities), as of November 2020, 25 states utilize some form of managed LTSS, up from eight in 2004.The majority of youth and children in foster care qualify for Medicaid, most commonly through Title IV-E of the Social Security Act, which provides funding to support safe and stable out-of-home care for children who are removed from their homes. The federal government has enacted legislation establishing guidelines and requirements for state child welfare agencies related to the health and well-being of children in foster care, including the provision of grants and technical assistance to enable states to meet these needs and make explicit connections with state Medicaid. In addition, the ACA requires states to make former foster care children eligible for Medicaid until they reach the age of 26, provided that they turned 18 while in foster care, and were enrolled in Medicaid at that time.CMS estimated the total Medicaid market to be approximately $649 billion in 2020, and estimates the market will grow to over $1.0 trillion by 2028. Medicaid spending is estimated to have increased by 4.5% in 2020 and is projected to increase at an average annual rate of 5.7% between 2020 and 2028. Due to the timing of the CMS report and highly uncertain nature of the pandemic, the aforementioned projections do not take into account the impact of COVID-19.A portion of Medicaid beneficiaries are dual-eligible, low-income seniors and people with disabilities who are enrolled in both Medicaid and Medicare. According to CMS, there were approximately 11.0 million dual-eligible enrollees in 2019. These dual-eligible members may receive assistance from Medicaid for benefits, such as nursing home care, HCBS, and/or assistance with Medicare premiums and cost sharing. Dual-eligibles also use more services due to their tendency to have more chronic health issues. We serve dual-eligibles through our ABD, LTSS, Medicare-Medicaid Plans (MMP), Medicare Advantage Dual Special Needs Plan (DSNP) and standard Medicare Advantage lines of business.While Medicaid programs have directed funds to many individuals who cannot afford or otherwise maintain health insurance coverage, they did not initially address the inefficient and costly manner in which the Medicaid population tends to access healthcare. Medicaid recipients in non-managed care programs typically have not sought preventive care or routine treatment for chronic conditions, such as asthma and diabetes. Rather, they have sought healthcare in hospital emergency departments, which is typically more expensive. As a result, many states without managed care programs have found that the costs of providing Medicaid benefits have increased while the medical outcomes for the recipients remained unsatisfactory.2Table of ContentsWe believe managed care has improved the quality of care for Medicaid beneficiaries and lowered costs. The majority of states have mandated that their Medicaid recipients enroll in managed care plans. Other states are considering moving to a mandated managed care approach for additional populations and products. As a result, we believe a significant market opportunity exists for managed care organizations with operations and programs focused on the distinct socio-economic, cultural and healthcare needs of the uninsured population and the Medicaid populations.MedicareWe contract with CMS under the Medicare Advantage program to provide Medicare Advantage products directly to Medicare beneficiaries as well as through employer and union groups. The Medicare program provides health care coverage primarily to individuals age 65 or older, as well as to individuals with certain disabilities.We provide or arrange healthcare benefits for services normally covered by Medicare, plus a broad range of healthcare benefits for services not covered by traditional Medicare, usually in exchange for a fixed monthly premium per member from CMS that varies based upon the county in which the member resides, demographic factors of the member such as age, gender and institutionalized status, and the health status of the member. Any benefits that are not covered by Medicare may result in an additional monthly premium charged to the enrollee or through portions of payments received from CMS that may be allocated to these benefits, according to CMS regulations and guidance. Many of our Medicare Advantage members pay no monthly premium to us for these additional benefits. As our Medicare Advantage members reach their deductibles and out-of-pocket maximums, our medical costs rise, creating seasonality in the business with a higher percentage of earnings in the first half of the year.We provide a wide range of Medicare products, including Medicare Advantage plans with and without prescription drug coverage and Medicare supplement products that supplement traditional fee-for-service Medicare coverage. Our subsidiaries have a number of contracts with CMS under the Medicare Advantage program authorized under Title XVIII of the Social Security Act. CMS developed the Medicare Advantage Star ratings system to help consumers choose among competing plans, awarding between 1.0 and 5.0 stars to Medicare Advantage plans based on performance in certain measures of quality. The Star ratings are used by CMS to award quality bonus payments to Medicare Advantage plans. Beginning with the 2014 Star ratings (calculated in 2013), Medicare Advantage plans are required to achieve a minimum of 4.0 Stars to qualify for a quality bonus payment. The methodology and measures included in the Star ratings system can be modified by CMS annually and Star ratings thresholds are based on performance of Medicare Advantage plans nationally.CMS estimated the total Medicare market was approximately $859 billion in 2020, and estimates the market will grow to approximately $1.6 trillion by 2028. Medicare spending is estimated to have increased 7.2% in fiscal 2020 and is projected to increase at an average annual rate of 7.7% between 2020 and 2028.Medicare Prescription Drug PlanThrough our acquisition of WellCare in January 2020, we now offer stand-alone PDP to Medicare beneficiaries. We have contracted with CMS to serve as a plan sponsor, offering stand-alone Medicare Part D PDP plans to Medicare-eligible beneficiaries. We offer PDPs in 50 states and the District of Columbia. Our PDPs offer national in-network prescription drug coverage, including a preferred pharmacy network, subject to limitations in certain circumstances.Our PDP contracts with CMS are renewable for successive one-year terms unless CMS notifies us of its decision not to renew by May 1 of the current contract year or we notify CMS of our decision not to renew by the first Monday in June of the contract year.The Medicare Part D prescription drug benefit is supported by risk sharing with the federal government through risk corridors designed to limit the losses and gains of the participating drug plans and by reinsurance for catastrophic drug costs. The government subsidy is based on the national weighted average monthly bid for this coverage, adjusted for risk factor payments. Additional subsidies are provided for dually-eligible beneficiaries and specified low-income beneficiaries.CommercialEstablished in 2010 and operational in 2014, the ACA created Health Insurance Marketplaces, which are a key component of the ACA and provide an opportunity for individuals and families to obtain health insurance. States have the option of operating 3Table of Contentstheir own Marketplace or partnering with the federal government. States choosing neither option currently default to a federally-facilitated Marketplace. Premium subsidies are available to make coverage more affordable. Access to Marketplaces is limited to U.S. citizens and legal immigrants. Insurers are required to offer a minimum level of benefits with coverage that varies based on premiums and out-of-pocket costs. Premium subsidies are provided to individuals and families without access to other coverage and with incomes generally between 100-400% of the federal poverty level, with some exceptions, to help them purchase insurance through the Marketplaces. These subsidies are offered on a sliding scale basis.We also offer commercial healthcare products to individuals through large and small employer groups. We offer plans with differing benefit designs and varying levels of co-payments at different premium rates. These plans are offered generally through contracts with participating network physicians, hospitals and other providers. Coverage typically is subject to copays and can be subject to deductibles and coinsurance. As our commercial members reach their deductibles and out-of-pocket maximums, our medical costs rise, creating seasonality in the business with a higher percentage of earnings in the first half of the year.InternationalWe have a growing international presence in Spain, the United Kingdom (UK) and Slovakia. Our presence in Spain is mainly associated with our subsidiaries operating as part of the Ribera Salud Group, which manages health administration concessions and private hospitals in various regions in Spain. Ribera Salud Group also holds a noncontrolling investment in Slovakia, which provides radiology services in the region. In the UK, our subsidiaries, operating as part of Operose Health Group, represent one of the largest provider networks in the country and deliver medical and community based services in the primary care sector of the National Health Service (NHS), which is the publicly funded, national healthcare system for England. We also have a noncontrolling investment in the UK in Circle Health Group, which includes BMI Healthcare and represents the UK’s largest independent hospital operator. OUR COMPETITIVE STRENGTHSOur approach is based on the following key competitive strengths: •Expertise in Government Sponsored Programs. For more than 35 years, we have developed a specialized services expertise that has helped us establish and maintain relationships with members, providers and our government customers. We have implemented programs developed to achieve savings for our government customers and support providers with tools and information to improve health outcomes and quality of care for members. We work to assist the states in which we operate in addressing the operating challenges they face. •Quality and Innovation. Our innovative population health management programs focus on improving quality of care in areas that have the greatest impact on our members. We concentrate on serving the whole person to impact outcomes and costs. We recognize the importance of member-focused delivery of quality managed care services and have developed award winning education and outreach programs including the My Health Pays program, Start Smart for Your Baby, Living Well with Sickle Cell, Fluvention and MemberConnections. It is our objective to provide access to the highest quality of care for our members. As a validation of that objective, we pursue accreditation by independent organizations that have been established to promote healthcare quality. We seek the National Committee for Quality Assurance (NCQA) and the Utilization Review Accreditation Commission (URAC) Health Plan Accreditation in eligible states.•Innovative Technology and Scalable Systems. The ability to access data and translate it into meaningful information is essential to operating across a multi-state service area in a cost-effective manner. Our centralized information systems support our core processing functions under a set of integrated databases and are designed to be both replicable and scalable to accommodate organic growth and growth from acquisitions. We continue to enhance our systems in order to leverage the platforms we have developed for our existing states for configuration into new states or health plan acquisitions. We believe our predictive modeling technology enables our population health management operations to proactively case and disease manage specific high risk members. It can recommend medical care opportunities using a mix of company defined algorithms and evidence based medical guidelines. Interventions are determined by the clinical indicators, the ability to improve health outcomes, and the risk profile of members. We believe our integrated approach helps to assure that consistent sources of claim and member information are provided across all of our health plans. Our membership and claims processing systems are capable of expanding to support additional members in an efficient manner.4Table of Contents•Financial Strength and Scale. We are a large healthcare enterprise with $111.1 billion in revenue and $5.5 billion in operating cash flow in 2020. Our strong historical operating performance, size, and scale allow us to continue to grow, diversify and invest in our businesses through strategic acquisitions and investments in technology and other resources that support our business, allowing us to navigate the changing healthcare landscape. We are a leader in the four largest Medicaid states. We seek to continue to increase our Medicaid, Medicare and Health Insurance Marketplace membership through alliances with key providers, outreach efforts, development and implementation of community-specific products and acquisitions. In 2020, we expanded our Health Insurance Marketplace footprints in several existing markets, and we completed the WellCare Acquisition, further expanding our scale and presence. In addition, in 2019 a nationally recognized statistical rating organization raised our long-term issuer credit rating to an investment grade rating.•Diversified Business Lines. We continue to broaden our service offerings to address areas that we believe have been traditionally under-served by Medicaid and Medicare managed care organizations. In addition to our Medicaid and Medicare services, our service offerings include commercial programs, PDP, correctional healthcare services, government-sponsored care under federal contracts with the Department of Defense (DoD), and other various specialty services. Through the utilization of a multi-business line approach, we are able to improve the quality of care, improve outcomes, diversify our revenues and help control our medical costs. In 2020, we served members in all 50 states through approximately 450 product solutions. We are constantly evaluating new opportunities for expansion both domestically and abroad.•Localized Approach with Centralized Support Infrastructure. We take a localized approach to managing our subsidiaries, including provider and member services. This approach enables us to facilitate access by our members to high quality, culturally sensitive healthcare services. Our systems and procedures have been designed to address these community-specific challenges through outreach, education, transportation and other member support activities. For example, our community outreach programs work with our members and their communities to promote health and self-improvement through education on how best to access care. We complement this localized approach with a centralized infrastructure of support functions such as finance, information systems and claims processing, which allows us to minimize selling, general and administrative (SG&A) expenses and to integrate and realize synergies from acquisitions. We believe this combined approach allows us to efficiently integrate new business opportunities in both Managed Care and Specialty Services, while maintaining our local accountability and improved access. MANAGED CAREBenefits to CustomersWe feel that our ability to establish and maintain a leadership position in the markets we serve results primarily from our demonstrated success in providing quality care while reducing and managing costs, and from our specialized programs with state governments. Among the benefits we are able to provide to the states with which we contract are:•Significant cost savings and budget predictability compared to state paid reimbursement for services. We bring experience relating to quality of care improvement methods, utilization management procedures, an efficient claims payment system, and provider performance reporting, as well as managers and staff experienced in using these key elements to improve the quality of and access to care. We generally receive a contracted premium on a per member basis and are responsible for the medical costs and, as a result, provide budget predictability.•Data-driven approaches to balance cost and verify eligibility. We seek to ensure effective outreach procedures for new members, then educate them and ensure they receive needed services as quickly as possible. Our IT department has created mapping/translation programs for loading membership and linking membership eligibility status to all of Centene's systems. We utilize predictive modeling technology to proactively case and disease manage specific high risk members. In addition, we have developed Centelligence, our enterprise data warehouse system to provide a seamless flow of data across our organization, enabling providers and case managers to access information, apply analytical insight and make informed decisions.•Establishment of realistic and meaningful expectations for quality deliverables. We have collaborated with state agencies in redefining benefits, eligibility requirements and provider fee schedules with the goal of maximizing the number of individuals covered through Medicaid.•Managed care expertise in government subsidized programs. Our expertise in Medicaid has helped us establish and maintain strong relationships with our constituent communities of members, providers and state governments. We 5Table of Contentsprovide access to services through local providers and staff that focus on the cultural norms of their individual communities. To that end, systems and procedures have been designed to address community-specific challenges through outreach, education, transportation and other member support activities.•Improved quality and medical outcomes. We have implemented programs to enhance the ability of providers to improve the quality of healthcare delivered to our members. This is demonstrated through health plan accreditations and program awards.•Timely payment of provider claims. We are committed to ensuring that our information systems and claims payment systems meet or exceed state requirements. We continuously endeavor to update our systems and processes to improve the timeliness of our provider payments.•Provider outreach and programs. Our health plans have adopted a physician-driven approach where network providers are actively engaged in developing and implementing healthcare delivery policies and strategies. We prepare provider comparisons on a severity adjusted basis. This approach is designed to eliminate unnecessary costs, improve services to members and simplify the administrative burdens placed on providers.•Care management for complex populations. Through our experience with Medicaid populations and long-time presence in states with experience in long-term care for children and adolescents in the foster care system, we have developed care management, service coordination and crisis prevention/response programs that increase opportunities for successful outcomes for members. This experience has led to partnerships with specialized networks and community advocates as states transition to managed care programs for vulnerable and complex populations. •Responsible collection and dissemination of utilization data. We gather utilization data from multiple sources, allowing for an integrated view of our members' utilization of services. These sources include medical, vision and behavioral health claims and encounter data, pharmacy data, dental vendor claims and authorization data from the authorization and case management system utilized by us to coordinate care.•Timely and accurate reporting. Our information systems have reporting capabilities which have been instrumental in identifying the need for new and/or improved healthcare and specialty programs. For state agencies, our reporting capability is important in demonstrating an auditable program. •Fraud, waste and abuse prevention. We have several systems in place to help identify, detect and investigate potential fraud, waste, and abuse, including pre- and post-payment review software. We collaborate with state and federal agencies and assist with investigation requests. We use nationally recognized standards to benchmark our processes. Member Programs and ServicesWe recognize the importance of member-focused delivery of quality managed care services. Our locally-based staff assists members in accessing care, coordinating referrals to related health and social services and addressing member concerns and questions. While covered healthcare benefits vary from customer to customer and program to program, our health plans generally provide the following services: •primary and specialty physician care;•inpatient and outpatient hospital care;•emergency and urgent care;•prenatal and postpartum care;•laboratory and x-ray services;•home-based primary care;•transportation assistance;•vision care;•dental care;•telehealth services;•immunizations;•prescriptions and limited over-the-counter drugs;•specialty pharmacy;•provision of durable medical equipment;•behavioral health and substance abuse services;6Table of Contents•24-hour nurse advice line;•therapies;•social work services; and•care coordination.We also provide a comprehensive set of education and outreach programs to inform, assist and incentivize members to access quality, appropriate healthcare services in an efficient manner. Many of these programs have been recognized with awards for their excellence in education, outreach and/or case management techniques. These awards include Case In Point, Hermes Awards, U.S. Environmental Protection Agency and National Health Information Awards.•Start Smart for Your Baby, or Start Smart, is our award winning prenatal and infant health program designed to increase the percentage of pregnant people receiving early prenatal care, reduce the incidence of low-birth-weight and pre-term babies, identify high-risk pregnancies, increase participation in the federal Women, Infant and Children program, prevent hospital admissions in the first year of life and increase well-child visits. The Neonatal Admissions program is an extension of the Start Smart for Your Baby program with a focus on newborns who have a hospital stay longer than standard after delivery, including those with admissions to the Newborn Intensive Care Unit (NICU). The program strives for timely identification of neonatal admissions to coordinate care and provide member education, resources and member-specific care plans to keep both birth parent and baby safe and healthy in the home environment upon discharge from the hospital.•Readmission Reduction aims to reduce preventable readmissions by ensuring optimal transitional care from acute and non-acute settings. The program focuses on post-hospitalization outreach (PHO), calls to members to verify they understand their discharge instructions, follow up with a Primary Care Physician (PCP), receive medication reconciliation, and, for the highest-risk members, are linked with a Community Health Worker.•Chronic Conditions aims to improve the health and quality of life for members with diabetes, asthma, chronic obstructive pulmonary disease (COPD), congestive heart failure (CHF), coronary artery disease (CAD), and/or hypertension. The program focuses on reducing emergent utilization and inpatient admissions by increasing treatment adherence, removing barriers to care, and enhancing self-management skills.•Fall Prevention seeks to decrease the number and severity of older adult falls. The program also aims to support members in maintaining their safety, stability, and independence as long as possible. The program leverages an evidence-based falls prevention toolkit to identify members at risk of falling and provide education and interventions to reduce fall risk.•Compassionate Connections (Palliative Care) works to identify members with at least one serious illness and provide necessary services to both members and those individuals close to them. Potential services may include detailed advanced care planning, a multi-team home visit and home health services, and additional social support. Providing palliative care services works to help alleviate members' suffering, and in turn, provide a better quality of life.•Emergency Department Diversion strives to identify members' reasons for visiting the emergency department and connect them with the right care, at the right time, in the right place in the future. The program also identifies opportunities for members to better manage their chronic conditions with the help of PCPs and Care Managers.•Fluvention works to decrease the spread of the flu by increasing the number of members that receive a timely annual flu vaccination. This multi-layered campaign is designed to promote vaccinations as the key to flu prevention. Centene works to address these issues by utilizing enterprise-wide member and provider marketing and education, as well as increasing access to facilities that provide flu vaccinations.•Connections Plus is a cell phone program developed for high-risk members who have limited or no safe and reliable access to telephone. This program seeks to eliminate lack of safe, reliable access to a telephone as a barrier to coordinating care, thus reducing avoidable adverse events such as inappropriate emergency department utilization, hospital admissions and premature birth.•MemberConnections is a community face-to-face outreach and education program designed to create a link between the member, provider and the care team to help identify potential challenges or risk elements to a member's health, such as nutritional challenges and health education gaps.7Table of Contents•Hepatitis C Care Management Program seeks to empower patients towards Hepatitis C virus treatment success through a series of telephonic interventions. Goals of the program include preventing premature treatment discontinuation due to medication side effects and access to therapy. Through its family of companies, Envolve clinicians and AcariaHealth patient care coordinators collaborate throughout a patient's treatment course to ensure appropriate therapy management and regimen access.•Health Initiatives for Children is aimed at educating child members on a variety of health topics. In order to empower and educate children, we have partnered with a nationally recognized children's author to develop our own children's book series on topics such as obesity prevention and healthy eating, asthma, diabetes, foster care, the ills of smoking, anti-bullying and heart health.•OpiEnd Youth Challenge is a targeted curriculum for adolescents ages 9 through 14 to raise awareness about opioid misuse and prevention. As part of the challenge, teachers and students discuss significant attributes of addiction and opioid misuse, and students then show their understanding by developing and submitting campaign messaging that depicts ways to prevent misuse.•Health Initiatives for Teens is aimed at empowering, educating and reinforcing life skills with our teenage members. We have developed an educational series that addresses health issues, dealing with chronic diseases including diabetes and asthma, as well as teen pregnancy. •Living Well with Sickle Cell is our innovative program that assists with coordination of care for our members with sickle cell disease. Our program ensures that members with sickle cell disease have established a medical home and work on strategies to reduce emergency department visits through disease self-management strategies, medication adherence and proper treatment to control symptoms, pain and chronic complications.•My Route for Health is our adult educational series used with our case management and disease management programs. The topics of this series include how to manage asthma, Chronic Obstructive Pulmonary Disease (COPD), diabetes, heart disease and HIV. •Community Health Record, our patient-centric electronic database, collects patient demographic data, clinician visit records, dispensed medications, vital sign history, lab results, allergy charts, and immunization data. Providers can directly input additional or updated patient data and documentation into the database. All information is accessible anywhere, anytime to all authorized users, including health plan staff, greatly facilitating coordinated care among providers.•My Health Pays offers members financial incentives for performing certain healthy behaviors. The incentives are delivered through a restricted-use prepaid debit card. This incentive-based approach effectively increases the utilization of preventive services while strengthening the relationships between members and their primary care providers. •The Asthma Management Program integrates a hands-on approach with a flexible outreach methodology that can be customized to suit different age groups and populations affected by asthma. We provide proactive identification of members, stratification into appropriate levels of intervention including home visits, culturally sensitive education, and robust outcome reporting. The program also includes aggressive care coordination to ensure patients have basic services such as transportation to the doctor, electricity to power the nebulizer, and a clean, safe home environment.•Preventive Care Programs are designed to educate our members on the benefits of Early and Periodic Screening, Diagnosis and Treatment (EPSDT) services. We have a systematic program of communicating, tracking, outreach, reporting and follow-through that promotes state EPSDT programs. •Outcomes Improvement Central (OIC) is a highly collaborative initiative that empowers partners across the organization to develop evidence-based clinical programs to promote best practice information sharing, and to establish measurable outcomes for clinical studies. The OIC also serves as a repository of enterprise pilots and programs intended to improve the members' health outcomes.•Promotores Health Network (PHN) is a volunteer-driven community health network designed to improve the community's health through health education specific to health conditions impacting their community and providing guidance and linkage to healthcare services and local resources. PHN provides face-to-face education to members where they live, shop, worship and congregate.8Table of Contents•myStrength ("The health club for your mind") is a web and mobile self-help resource to manage depression, anxiety, substance use, and chronic pain. myStrength empowers members to be active participants in their journey to becoming and staying mentally and physically healthy.•OpiEnd is a clinical program designed to identify members at risk for an opioid abuse diagnosis based on a series of critical social and clinical indicators called the Opioid Risk Classification Algorithm (ORCA). Providers will leverage this risk score to flag members for case management and other appropriate interventions. High risk members identified by ORCA will receive educational outreach to provide evidenced-based resources to support pain addiction.•Strong Beginnings addresses the rising US rates of neonatal abstinence syndrome (NAS) and neonatal opioid withdrawal syndrome (NOWS). The program aims to support pregnant people at risk for substance use disorder through case management and care coordination, and to support their providers through incentives and plan of safe care guidance.ProvidersFor each of our service areas, we establish a provider network consisting of primary and specialty care physicians, hospitals and ancillary providers. Our network of primary care physicians is a critical component of care delivery, cost management and the attraction and retention of new members. Primary care physicians include family and general practitioners, pediatricians, internal medicine physicians and obstetricians and gynecologists. Specialty care physicians provide medical care to members generally upon referral by primary care physicians. Specialty care physicians include, but are not limited to, orthopedic surgeons, cardiologists and otolaryngologists. We also provide education and outreach programs to inform and assist members in accessing quality, appropriate healthcare services. Our health plans facilitate access to healthcare services for our members primarily through contracts with our providers. Our contracts with primary and specialty care physicians and hospitals usually are for one to three-year periods and renew automatically for successive one-year terms, but generally are subject to termination by either party upon prior written notice. In the absence of a contract, we typically pay providers at applicable state or federal reimbursement levels, depending on the product (e.g., Medicaid or Medicare). We pay providers under a variety of methods, including fee-for-service, capitation arrangements, and value-based arrangements. •Under our fee-for-service contracts with providers, we pay a negotiated fee for covered services. This model is characterized as having no financial risk for the provider. •Under our capitated contracts, providers can be paid a set amount for their services as outlined in their respective provider agreements. A provider group's financial instability or failure to pay secondary providers for services rendered could lead secondary providers to demand payment from us, even though we have made our regular capitated payments to the provider group. Depending on state law and the regulatory environment, it may be necessary for us to pay such claims.•Under value-based arrangements, providers can be paid under either a capitated or fee-for-service model. The arrangement, however, contains provisions for additional payments to the providers or reimbursement from the providers based upon their performance in cost and quality measures.In addition, we maintain a network of qualified physicians, facilities, and ancillary providers in the prime service areas of our TRICARE contract. Services are provided on a fee-for-service basis. We often start our provider relationships in a pay-for-performance arrangement before we transition to a risk-sharing arrangement, which is based on the total cost of care. As we advance along this continuum, it strengthens our partnerships with our providers, enabling the delivery of high quality care.We work with physicians to help them operate efficiently by providing actionable financial and utilization information, physician and patient educational programs and disease and population health management programs. Our programs are also designed to help physicians coordinate care rendered by other providers. We believe our local and collaborative approach with physicians and other providers gives us a competitive advantage in entering new markets. Our physicians serve on local committees that assist us in implementing preventive care programs, managing costs and improving the overall quality of care delivered to our members, while also simplifying the administrative 9Table of Contentsburdens on our providers. This approach has enabled us to strengthen our provider networks through improved physician recruitment and retention that, in turn, has helped to increase our membership base. The following are among the services we provide to support physicians:•Provider Engagement Performance Tools and Processes lead to measurable improvements in quality and health outcomes, healthcare costs, and member satisfaction. High quality and service levels are important as our key customers are increasingly using performance-based measures to select and pay health plans. We have a suite of network performance tools for use by physicians and other providers which monitor the outcomes and care gaps of their individual patient panels. We meet with the providers to review their performance issues and recommend strategies for improvements in their patient panel outcomes. Our tools also allow the physician and others to see where they stand within their value-based contract.•Integrated Care Model is member-centric and managed by one care manager assigned to a member who looks at the total care for the member in a holistic manner. This single care manager will coordinate all care for that member including behavioral health, medical health, and home-based primary care in accordance with an individualized, integrated care plan. This care manager also coordinates meetings with the member's integrated care team to assess and alter the care plan as needed. This results in better outcomes and improvement in member satisfaction.•Provider Portal provides claims and eligibility research, prior authorizations, member panels, care gaps, patient analytics, and provider analytics meant to drive provider engagement and improved patient outcomes. Data and reporting are delivered via a secure, user-friendly web-based provider portal. This is provided through our suite of proprietary technology developed by Interpreta, Apixio and Casenet.Our contracted physicians also benefit from several of the services offered to our members, including the MemberConnections, EPSDT case management and population health management programs. For example, the MemberConnections staff facilitates doctor/patient relationships by connecting members with physicians, the EPSDT programs encourage routine checkups for children with their physicians and the population health management programs assist physicians in managing their patients with chronic disease.Where appropriate, our health plans contract with our specialty services organizations to provide services and programs such as care management software, dental benefits management, home-based primary care services, life and population health management, managed vision, pharmacy benefits management, specialty pharmacy and telehealth services. When necessary, we also contract with third-party providers on a negotiated fee arrangement for physical therapy, home healthcare, diagnostic laboratory tests, x-ray examinations, transportation, ambulance services and durable medical equipment. Quality ManagementOur population health programs focus on improving quality of care in areas that have the greatest impact on our members. We employ strategies, including complex case management, which are adjusted for implementation in our individual markets by a system of physician committees chaired by local physician leaders. This process promotes physician participation and support, both critical factors in the success of any clinical quality improvement program. We have implemented specialized information systems to support our quality management activities. Information is drawn from our data warehouse, clinical databases and our membership and claims processing system to identify opportunities to improve care and to track the outcomes of the interventions implemented to achieve those improvements. Some examples of these programs include:•use of nationally recognized InterQual or Milliman criteria to help ensure our members receive the right level of care in the most appropriate setting;•pre-authorized high-risk medication and services that are commonly over or inappropriately prescribed;•member education and the provision of appropriate and easily accessed urgent care services to help members avoid unnecessary and costly emergency department visits and improve their healthcare experience; •emphasis on care management and care coordination where clinicians, such as nurses and social workers who are employed to assist high-risk and other selected members with the coordination of healthcare services that meet their specific needs;10Table of Contents•disease management for chronic illnesses, such as asthma and diabetes through a comprehensive, multidisciplinary and collaborative approach;•prenatal case management for those with high-risk pregnancies to help them deliver full-term, healthy infants; and•pharmacy treatment compliance programs driven by evidence-based clinical policies and focused on identifying the appropriate medication in the correct dose, delivered in an efficient format and utilized for the correct duration.We provide reporting on a regular basis using our data warehouse. State and Health Employer Data and Information Set (HEDIS) reporting constitutes the core of the information base that drives our clinical quality performance efforts. This reporting is monitored by health plan quality improvement committees and our corporate population health management and quality improvement teams. In an effort to ensure the quality of our provider networks, we verify the credentials and background of our providers using standards that are supported by NCQA. It is our objective to provide access to the highest quality of care for our members. As a validation of that objective, we pursue accreditation by independent organizations that have been established to promote healthcare quality. NCQA Health Plan Accreditation and URAC Health Plan Accreditation programs provide unbiased, third party reviews to verify and publicly report results on specific quality care metrics. While we have achieved or are pursuing accreditation for all of our plans, accreditation is only one measure of our ability to provide access to quality care for our members. We have achieved accreditation in 30 of 33 eligible states for at least one product (Medicare, Medicaid, or Commercial, including Health Insurance Marketplace).CMS developed the Medicare Advantage Star ratings system to help consumers choose among competing plans, awarding between 1.0 and 5.0 stars to Medicare Advantage plans based on performance in certain measures of quality. •For the 2020 Star rating (calculated in 2019 for the quality bonus payment in 2021), two contracts received a 4.5 out of 5.0 Stars, two contracts received 4.0 Stars, four contracts received 3.5 Stars, and seven contracts received 3.0 Stars. In addition, for the 2020 Star rating, we carry a 3.5 Star parent organization rating. Approximately 46% of our Medicare members are in a 4 star or above plan for the 2021 bonus year.•For the 2021 Star rating (calculated in 2020 for the quality bonus payment in 2022), two contracts received 4.5 out of 5.0 Stars, three contracts received 4.0 Stars, 17 contracts received 3.5 Stars, and 13 contracts received 3.0 Stars. In addition, for the 2021 Star rating, we carry a 3.5 Star parent organization rating. Approximately 30% of our Medicare members are in a 4 star or above plan for the 2022 bonus year.The parent organization Star rating is used for new Medicare contracts, while existing contracts follow their individual Star ratings to determine bonus payments. We remain committed to our quality initiatives and continue to invest in the programs which we expect to translate into value over the next few years. SPECIALTY SERVICES Our specialty services are a key component of our healthcare strategy and complement our core Managed Care business. Our specialty services diversify our revenue stream, enhance the quality of health outcomes for our members and others, and allow Centene to manage costs.EnvolveOur Envolve brand brings together our extensive portfolio of specialty healthcare solutions. Envolve leverages our collective expertise to provide integrated and comprehensive healthcare for members and other organizations.•Pharmacy Solutions. Envolve Pharmacy Solutions utilizes innovative, flexible solutions and customized care management. We offer traditional pharmacy benefits management as well as comprehensive specialized pharmacy benefit services through our specialty pharmacy businesses, AcariaHealth and PANTHERx. Our traditional pharmacy benefits management program offers progressive pharmacy benefits management services that are specifically designed to improve quality of care while containing costs. This is achieved through a low cost strategy that helps optimize clients' pharmacy benefits. Services that we provide include claims processing, pharmacy network management, benefit design consultation, drug utilization review, formulary and rebate management, online drug 11Table of Contentsmanagement tools, mail order pharmacy services, home delivery services, analytics and clinical consulting and patient and physician intervention. AcariaHealth offers specialized care management services for complex diseases and enhances the patient care offering through collaboration with providers and the capture of relevant data to measure patient outcomes. PANTHERx serves patients afflicted with rare and devastating conditions through delivering orphan medications to people living with complicated rare diseases. •Nurse Advice Line & After-Hours Support. Envolve's Nurse Advice Line brings together our nurse advice, telehealth, and health and wellness programs, allowing for a focus on individual health management through education and empowerment. We offer telehealth services where members engage with customer service representatives and nursing staff who provide health education and triage advice and offer continuous access to health plan functions. Our staff can arrange for urgent pharmacy refills, transportation and qualified behavioral health professionals for crisis stabilization assessments. •Vision and Dental Services. Envolve coordinates benefits beyond traditional medical benefits to offer fully integrated vision and dental health services. Our vision benefit program administers routine and medical surgical eye care benefits through a contracted national network of eye care providers. Through the dental benefit, we are dedicated to improving oral health through a contracted network of dental healthcare providers. Health Care Enterprises Our Health Care Enterprises companies aim to improve health outcomes by developing innovative technologies and utilizing efficient care models to reduce healthcare costs.•Clinical Healthcare. Community Medical Group (CMG) provides clinical healthcare, encompassing primary care, access to certain specialty services, and a suite of social and other support services. CMG operates in Florida through an at-risk primary care provider model, focusing on clinical and social care to at-risk beneficiaries. •Data Analytics. Interpreta uses its analytics engine to provide real-time insights to providers, care managers, and payers in the areas of member prioritization, quality management, and risk adjustment. Interpreta's solutions are used by our health plans and available for sale to third parties. Apixio, one of our healthcare analytics companies offers, among other solutions, artificial intelligence (AI) technology which performs retrospective chart reviews for more accurate risk score submission to CMS. Apixio provides services to third party customers as well as our health plans. These businesses continue to digitize the administration of healthcare and accelerate innovation and modernization across the enterprise. •Home-Based Primary Care. U.S. Medical Management (USMM) provides home-based primary care services for high acuity populations and participates as an Accountable Care Organization (ACO) through the CMS Medicare Shared Savings Program. Other Specialty CompaniesOur other specialty companies provide a variety of products and services to complement and expand our business lines.•Correctional Healthcare Services. Centurion provides comprehensive healthcare services to individuals incarcerated in state correctional facilities and detainees in detention facilities in various states. Centurion also provides staffing services to correctional systems and other government agencies.•Federal Services. Health Net Federal Services has a Managed Support Contract in the West Region for the Department of Defense (DoD) TRICARE program. We provide administrative services to Military Health System eligible beneficiaries, which includes eligible active duty service members and their families, retired service members and their families, survivors of retired service members and qualified former spouses.•Third Party Administration. HealthSmart provides customizable and scalable health plan solutions for self-funded employers, universities and colleges, and Native American Tribal Enterprises. Service offerings include plan administration, care management and wellness programs, network, casualty claim, and pharmacy benefit solutions.We currently have NCQA accreditation and/or URAC accreditation for several of our specialty companies.12Table of ContentsCORPORATE COMPLIANCEOur Ethics and Compliance program assists the organization in developing effective internal controls that promote prevention and detection of fraud, waste and abuse and resolution of instances of conduct that do not conform to federal and state law and private payor healthcare program requirements, as well as our own ethics and business policies. Responsibilities also include the ongoing maintenance of our privacy program and oversight of the Health Insurance Portability and Accountability Act (HIPAA) as they pertain to us and our business units from a compliance, business, and technical perspective.Three standards by which corporate compliance programs in the healthcare industry are measured are the Federal Organizational Sentencing Guidelines, the CMS Chapter Guidance and the Compliance Program Guidance series issued by the Department of Health and Human Services' Office of the Inspector General (OIG). Our program contains each of the seven elements suggested by these authorities. These key components are:•written standards of conduct; •designation of compliance officers and compliance committees;•effective training and education;•effective lines for reporting and communication;•enforcement of standards through well-publicized disciplinary guidelines and actions;•internal monitoring and auditing; and•prompt response to detected offenses and development of corrective action plans. The goal of our program is to build a culture of ethics and compliance, which is assessed periodically to measure the values and engagement of the organization. Our Corporate Compliance intranet site, accessible to all employees, contains our Compliance Program description, our Business Ethics and Code of Conduct Policy, and resources for employees to report concerns or ask questions. If needed, employees have access to the contact information for our Board of Directors' Audit Committee Chairman to report concerns. Our Ethics and Compliance Helpline is a toll-free number and web-based reporting tool operated by a third party independent of the Company and allows employees or other persons to report suspected incidents of misconduct, fraud, waste, abuse or other compliance violations anonymously. Furthermore, our Board of Directors has established a Corporate Compliance Committee that, among other things, reviews ethics and compliance reports on a quarterly basis. ENVIRONMENTAL, SOCIAL, HEALTH, GOVERNANCE AND CORPORATE RESPONSIBILITYCentene's steadfast commitment to the environment, the health and social well-being of our communities, and our culture of sound and ethical corporate governance extends far beyond individual programs or initiatives. Through the delivery of high-quality healthcare to at-risk populations, our responsibilities to members, stakeholders, and our planet serve as a living expression of our purpose – transforming the health of communities, one person at a time. Continued focus on environmental, social, and governance (ESG) matters remain foundational to supporting our strategy and long-term value creation. These themes were vital as executive leaders from across the enterprise completed an ESG assessment early in 2020. The results of this work led to the development of Centene's Environmental, Social, Health, and Governance (ESHG) Strategic Framework (the Framework), which incorporates our commitment to healthy individuals and healthy communities. Also in 2020, we formed a board-level Environmental and Social Responsibility Committee to oversee implementation of the Framework and formalized a cross-functional work group comprised of executive representatives to advance ESHG initiatives throughout the organization. In December 2020, we issued a Report to the Community to communicate the value of our ESHG efforts. The formalization of Centene’s ESHG Framework enables us to align our business strategy and long-term planning with our commitments to protect our planet, serve our communities, cultivate healthier lives, and live our values. Interested parties can find our December 2020 Environmental, Social, Health and Governance Report within the Investors section of our website, the URL of which is https://www.centene.com/who-we-are/corporate-facts-reports.html. Nothing on our website, including our Environmental, Social, Health and Governance Report or sections thereof, shall be deemed incorporated by reference into this Annual Report.COMPETITIONWe operate in a highly competitive environment in an industry subject to ongoing significant changes, including business consolidations, new strategic alliances, market pressures, and regulatory and legislative reform both at the federal and state level. This includes, but is not limited to, the federal and state healthcare reform legislation described under the heading "Regulation." In addition, changes to the political environment may drive additional changes to the competitive landscape. 13Table of ContentsIn our business, our principal competitors for customers, members, and providers consist of the following types of organizations: •National and Regional Commercial Managed Care Organizations that focus on providing healthcare services to Medicaid, Medicare and correctional members in addition to members in marketplace and private commercial plans. These organizations consist of national and regional organizations, as well as not-for-profits and organizations that operate in a small geographic location and are owned by providers (primarily hospitals). Some of these organizations offer a range of specialty services including pharmacy benefits management, behavioral health management, population health management, correctional healthcare management, and nurse triage call support centers.•Primary Care Case Management Programs that are established by the states through contracts with primary care providers. Under these programs, physicians provide primary care services to Medicaid recipients, as well as limited population health management oversight. •Accountable Care Organizations that consist of groups of doctors, hospitals, and other healthcare providers, who come together to provide coordinated high quality care to their patients.We compete with other Managed Care Organizations and specialty companies for state, county, federal, and commercial contracts. In addition, the impact of the ACA and potential growth in our segment may attract new competitors including technology companies, new joint ventures, financial services firms, consulting firms and other non-traditional competitors. Before granting a contract, state and federal government agencies consider many competitive factors. These factors include quality of care, financial condition, stability and resources, and established or scalable infrastructure with a demonstrated ability to deliver services and establish comprehensive provider networks. Our specialty companies compete with other providers, such as disease management companies, individual health insurance companies, and pharmacy benefits managers for non-governmental contracts.We also compete to enroll new members and retain existing members. People who wish to enroll in a managed healthcare plan or to change healthcare plans typically choose a plan based on the quality of care and services offered, ease of access to services, a specific provider being part of the network and the availability of supplemental benefits. We believe that the principal competitive features affecting our ability to retain and increase membership include the range and prices of benefit plans offered, size and quality of provider network, quality of service, responsiveness to customer demands, financial stability, comprehensiveness of coverage, diversity of product offerings, market presence and reputation.We also compete with other managed care organizations in establishing provider networks. When contracting with various health plans, we believe that providers consider existing and potential member volume, reimbursement rates, population health management programs, speed of reimbursement and administrative service capabilities. See "Risk Factors - Competition may limit our ability to increase penetration of the markets that we serve." The relative importance of each of the aforementioned competitive factors and the identity of our key competitors varies by market, including by geography and by product. We believe that we compete effectively against other healthcare industry participants.REGULATIONOur operations are comprehensively regulated at the local, state, and federal levels. Government regulation of the provision of healthcare products and services is a changing area of law that varies from jurisdiction to jurisdiction. States have implemented National Association of Insurance Commissioners (NAIC) model regulations, requiring governance practices and risk and solvency assessment reporting. States have adopted these or similar measures to enhance regulations relating to corporate governance and internal controls of health maintenance organizations (HMOs) and insurance companies. We are required to maintain a risk management framework and file reports with state insurance regulators.Regulatory agencies generally have substantial discretion to issue regulations and interpret and enforce laws and rules. Changes in the regulatory environment and applicable laws and rules also may occur periodically, including in connection with changes in political party or administration at the state and federal levels. The ultimate content, timing or effect of any potential future legislation enacted under the new administration remains uncertain.Our regulated subsidiaries are licensed to operate as HMOs, preferred provider organizations (PPOs), third party administrators, utilization review organizations, pharmacies, direct care providers and/or insurance companies in their respective states. In each of the jurisdictions in which we operate, we are regulated by the relevant insurance, health and/or human services departments, 14Table of Contentsdepartments of insurance, boards of pharmacy and other healthcare providers, and departments of health that oversee the activities of managed care organizations and health plans providing or arranging to provide services to enrollees.The process for obtaining authorization to operate as a managed care organization, health insurance plan, prescription drug plan, pharmacy or provider organization is complex and requires us to demonstrate to the regulators the adequacy of the health plan's organizational structure, financial resources, utilization review, quality assurance programs, proper billing, complaint procedures, and an adequate provider network and procedures for covering emergency medical conditions. For example, under both state managed care organization statutes and insurance laws, our health plan subsidiaries, as well as our applicable specialty companies, must comply with minimum statutory capital and other financial solvency requirements, such as deposit and surplus requirements. Insurance regulations may also require prior state approval of acquisitions of other managed care organization businesses and the payment of dividends, as well as notice for loans or the transfer of funds. Our subsidiaries are also subject to periodic state and federal reporting requirements. In addition, each health plan and individual healthcare provider must meet criteria to secure the approval of state regulatory authorities before implementing certain operational changes, including without limitation changes to existing offerings, the development of new product offerings, certain organizational restructurings and, in some states, the expansion of service areas. States have adopted a number of regulations that may affect our business and results of operations. These regulations in certain states include:•premium taxes or similar assessments imposed on us;•stringent prompt payment laws requiring us to pay claims within a specified period of time;•disclosure requirements regarding provider fee schedules and coding procedures; and•programs to monitor and supervise the activities and financial solvency of provider groups.We are regulated as an insurance holding company and are subject to the insurance holding company acts of the states in which our insurance company and HMO subsidiaries are domiciled. These acts contain certain reporting requirements as well as restrictions on transactions between an insurer or HMO and its affiliates. These holding company laws and regulations generally require insurance companies and HMOs within an insurance holding company system to register with the insurance department of each state where they are domiciled and to file with those states' insurance departments reports describing capital structure, ownership, financial condition, intercompany transactions and general business operations. In addition, depending on the size and nature of the transaction, there are various notice and reporting requirements that generally apply to transactions between insurance companies and HMOs and their affiliates within an insurance holding company structure. Some insurance holding company laws and regulations require prior regulatory approval or, in certain circumstances, prior notice of certain material intercompany transfers of assets as well as certain transactions between insurance companies, HMOs, their parent holding companies and affiliates. Among other provisions, state insurance and HMO laws may restrict the ability of our regulated subsidiaries to pay dividends.Additionally, the holding company regulations of the states in which our subsidiaries are domiciled restrict the ability of any person to obtain control of an insurance company or HMO without prior regulatory approval. Under those statutes, without such approval or an exemption, no person may acquire any voting security of an insurance holding company, which controls an insurance company or HMO, or merge with such a holding company, if as a result of such transaction such person would "control" the insurance holding company. "Control" is generally defined as the direct or indirect power to direct or cause the direction of the management and policies of a company and is presumed to exist if a person directly or indirectly owns or controls 10% or more of the voting securities of a company. PPO regulation also varies by state and covers all or most of the subject area referred to above.Our pharmacies must be licensed to do business as pharmacies in the states in which they are located. Our pharmacies must also register with the U.S. Drug Enforcement Administration and individual state controlled substance authorities to dispense controlled substances. In many of the states where our pharmacies deliver pharmaceuticals, there are laws and regulations that require out-of-state mail order pharmacies to register with that state's board of pharmacy or similar regulatory body. These states generally permit the pharmacy to follow the laws of the state in which the mail order pharmacy is located, although some states require that we also comply with certain laws in that state. Our healthcare providers must be licensed to practice medicine and do business as care providers in the state in which they are located. In addition, they must be in good standing with the applicable medical board, board of nursing or other applicable entity. Furthermore, they cannot be excluded from participation at either the state or federal levels. Our facilities are periodically reviewed by state departments of health and other regulatory agencies to ensure the environment is safe to provide care.15Table of ContentsFederal law has also implemented other health programs that are partially funded by the federal government, such as the Medicaid and Medicare programs. Our Medicaid programs are regulated and administered by various state regulatory bodies. Federal funding remains critical to the viability of these programs. Federal law permits the federal government to oversee and, in some cases, to enact, regulations and other requirements that must be followed by states with respect to these programs. Medicaid is administered at the federal level by CMS. Comprehensive legislation, specifically Title XVIII of the Social Security Act, governs our Medicare program. In addition, our Medicare contracts are subject to regulation by CMS. CMS has the right to audit Medicare contractors and the healthcare providers and administrative contractors who provide certain services on their behalf to determine the quality of care being rendered and the degree of compliance with CMS contracts and regulations. The ACA transformed the U.S. healthcare system through a series of complex initiatives. Some of the ACA's most significant provisions include the imposition of significant fees, assessments and taxes, including the non-deductible tax (technically called a "fee") on health insurers based on prior year net premiums written (the "health insurer fee" or "HIF"); the establishment of federally-facilitated and state-based Health Insurance Marketplaces where individuals and small groups may purchase health coverage; the implementation of certain premium stabilization programs designed to apportion risk amongst insurers; and the optional Medicaid Expansion. State and federal regulators have continued to provide additional guidance and specificity to the ACA, and we continue to monitor this new information and evaluate its potential impact on our business. In December 2018, a partial summary judgment ruling in Texas v. United States of America held that the ACA's individual mandate requirement was essential to the ACA, and without it, the remainder of the ACA was invalid (i.e., that it was not "severable" from the ACA). That decision was appealed to the Fifth Circuit, which ruled in December 2019 that the individual mandate was unconstitutional after Congress eliminated the individual mandate penalty, and remanded the case to the district court for additional analysis on the question of severability. The Supreme Court heard oral arguments in November 2020 and a ruling is anticipated in 2021. The ACA remains in effect until judicial review of the decision is concluded. For a further discussion of the ACA, see "Risk Factors - The implementation of the ACA, as well as potential repeal of, changes to, or judicial challenges to the ACA, could materially and adversely affect our results of operations, financial position and cash flows".We must also comply with laws and regulations related to the award, administration and performance of U.S. Government contracts. Government contract laws and regulations affect how we do business with our customers and, in some instances, impose added costs on our business. Money laundering is a method of attempting to conceal the origins of money gained through illegal activity and is itself a crime that can result in substantial criminal and civil sanctions including fines and imprisonment. To ensure compliance with anti-money laundering laws and regulations, it is our policy to conduct business only with legitimate customers and counterparties whose funds are derived from legitimate commercial activity. In addition, as a result of our international operations, we are also subject to the U.S. Foreign Corrupt Practices Act (FCPA) and similar worldwide anti-corruption laws, including the U.K. Bribery Act of 2010, which generally prohibit companies and their intermediaries from making improper payments to non-U.S. officials for the purpose of obtaining or retaining business. A violation of specific laws and regulations by us and/or our agents could result in, among other things, the imposition of fines and penalties on us, changes to our business practices, the termination of our contracts or debarment from bidding on contracts. State and Federal ContractsIn addition to being a licensed insurance company or HMO, in order to be a Medicaid managed care organization in each of the states in which we operate, we generally must operate under a contract with the state's Medicaid agency. States generally either use a formal proposal process, reviewing a number of bidders, or award individual contracts to qualified applicants that apply for entry to the program. Under these state Medicaid program contracts, we receive monthly payments based on specified capitation rates determined on an actuarial basis. These rates differ by membership category and by state depending on the specific benefits and policies adopted by each state. In addition, several of our Medicaid contracts require us to maintain Medicare Advantage special needs plans, which are regulated by CMS, for dual eligible individuals within the state.We provide Medicare Advantage, PDPs, DSNPs, and MMP which are provided under contracts with CMS and subject to federal regulation regarding the award, administration and performance of such contracts. CMS also has the right to audit our performance to determine our compliance with these contracts, as well as other CMS regulations and the quality of care we provide to Medicare beneficiaries under these contracts. We additionally provide behavioral and other healthcare services to correctional systems under contracts in certain states which are also subject to state regulation.Our government contracts include government-sponsored managed care and administrative services contracts through the TRICARE program and certain other healthcare-related government contracts.16Table of ContentsOur state and federal contracts and the regulatory provisions applicable to us generally set forth the requirements for operating in the Medicaid and Medicare sectors, including provisions relating to:•eligibility, enrollment and dis-enrollment processes;•covered services;•eligible providers;•subcontractors;•record-keeping and record retention;•periodic financial and informational reporting;•quality assurance;•accreditation;•health education and wellness and prevention programs;•timeliness of claims payment;•financial standards;•safeguarding of member information;•fraud, waste and abuse detection and reporting;•grievance procedures; and•organization and administrative systems.A health plan or individual health insurance provider's compliance with these requirements is subject to monitoring by state regulators and by CMS. A health plan is also subject to periodic comprehensive quality assurance evaluations by a third-party reviewing organization and generally by the insurance department of the jurisdiction that licenses the health plan. A health plan or individual health insurance provider must also submit reports to various regulatory agencies, including quarterly and annual statutory financial statements and utilization reports.Our health plans operate through individual state contracts, generally with an initial term of one to five years. The contracts often have renewal or extension terms or are renewable through the state's reprocurement process. The contracts generally are subject to termination for cause, an event of default or lack of funding, among other things.Marketplace Contracts We operate in 22 states under federally-facilitated marketplace contracts with CMS and state-based exchanges. Both contract types are renewable on an annual basis.We operate under a contract with the Arkansas Department of Human Services Division of Medical Services and the Arkansas Insurance Department to participate in the Medicaid expansion model that Arkansas has adopted (referred to as "Arkansas Works"). Privacy RegulationsWe are subject to various international, federal, state and local laws and rules regarding the use, security and disclosure of protected health information, personal information, and other categories of confidential or legally protected data that our businesses handle. Such laws and rules include, without limitation, HIPAA, the Federal Trade Commission Act, the Gramm-Leach-Bliley Financial Modernization Act of 1999 (Gramm-Leach-Bliley Act), the General Data Protection Regulation (GDPR) in the European Union (EU), and state privacy and security laws such as the California Confidentiality of Medical Information Act and the California Online Privacy Protection Act. Privacy and security laws and regulations often change due to new or amended legislation, regulations or administrative interpretation. A variety of state and federal regulators enforce these laws, including but not limited to the U.S. Department of Health and Human Services (HHS), the Federal Trade Commission, state attorneys general and other state regulators.HIPAA is designed to improve the portability and continuity of health insurance coverage, simplify the administration of health insurance through standard transactions and ensure the privacy and security of individual health information. Among the requirements of HIPAA are the Administrative Simplification provisions which include: standards for processing health insurance claims and related transactions (Transactions Standards); requirements for protecting the privacy and limiting the use and disclosure of medical records and other personal health information (Privacy Rule); and standards and specifications for safeguarding personal health information which is maintained, stored or transmitted in electronic format (Security Rule). The Health Information Technology for Economic and Clinical Health (HITECH) Act amended certain provisions of HIPAA and enhanced data security obligations for covered entities and their business associates. HITECH also mandated individual notifications in instances of a data breach, provided enhanced penalties for HIPAA violations, and granted enforcement 17Table of Contentsauthority to states' Attorneys General in addition to the HHS Office for Civil Rights. The HIPAA Omnibus Rule further enhanced the changes under the HITECH Acts and the Genetic Information Nondiscrimination Act of 2008 (GINA) which clarified that genetic information is protected under HIPAA and prohibits most health plans from using or disclosing genetic information for underwriting purposes. These regulations also establish significant criminal penalties and civil sanctions for non-compliance. The preemption provisions of HIPAA provide that the federal standards will not preempt state laws that are more stringent than the related federal requirements. The Privacy and Security Rules and HITECH/Omnibus enhancements established requirements to protect the privacy of medical records and safeguard personal health information maintained and used by healthcare providers, health plans, healthcare clearinghouses, and their business associates. The Security Rule requires healthcare providers, health plans, healthcare clearinghouses, and their business associates to implement administrative, physical and technical safeguards to ensure the privacy and confidentiality of health information electronically stored, maintained or transmitted. The HITECH Act and Omnibus Rule enhanced a federal requirement for notification when the security of protected health information is breached. In addition, there are state laws that have been adopted to provide for, among other things, private rights of action for breaches of data security and mandatory notification to persons whose identifiable information is obtained without authorization.The requirements of the Transactions Standards apply to certain healthcare related transactions conducted using "electronic media." Since "electronic media" is defined broadly to include "transmissions that are physically moved from one location to another using portable data, magnetic tape, disk or compact disk media," many communications are considered to be electronically transmitted. Under HIPAA, health plans and providers are required to have the capacity to accept and send all covered transactions in a standardized electronic format. Penalties can be imposed for failure to comply with these requirements. The transaction standards were modified in October 2015 with the implementation of the ICD-10 coding system.In addition, we process and maintain personal card data, particularly in connection with our Marketplace business. As a result, we must maintain compliance with the Payment Card Industry (PCI) Data Security Standard, which is a multifaceted security standard intended to optimize the security of credit, debit and cash card transactions and protect cardholders against misuse of their personal information.Other Fraud, Waste and Abuse LawsInvestigating and prosecuting healthcare fraud, waste and abuse continues to be a top priority for state and federal law enforcement entities. The focus of these efforts has been directed at Medicare, Medicaid, Health Insurance Marketplace and commercial products. The fraud, waste and abuse laws include the federal False Claims Act, which prohibits the known filing of a false claim or the known use of false statements to obtain payment from the federal government. Many states have false claim act statutes that closely resemble the federal False Claims Act. Additional fraud, waste and abuse prohibitions include a wide range of operating activities, such as kickbacks or other inducements for referral of members or for the coverage of products (such as prescription drugs) by a plan, billing for unnecessary medical services by a provider, improper marketing and violation of patient privacy rights. The laws and regulations relating to fraud, waste and abuse and the requirements applicable to health plans, PDPs and providers participating in these programs are complex and change regularly. Compliance with these laws may require substantial resources. We are constantly looking for ways to improve our fraud, waste and abuse detection methods. While we have both prospective and retrospective processes to identify abusive patterns and fraudulent billing, we continue to increase our capabilities to proactively detect inappropriate billing prior to payment.HUMAN CAPITAL RESOURCESAs the pace of change, complexity and uncertainty in the broader environment accelerates, we continue our strong investment in creating a purpose-driven culture and attracting, developing and retaining top talent. We seek out individuals with ambition for extraordinary impact and believe every employee is a leader and is critical to helping us transform the health of communities for those we serve. Our entrepreneurial spirited workforce is driven by a steadfast commitment to a diverse, inclusive and safe workplace, is enabled through robust talent development programs, is supported by competitive compensation, benefits and health and wellness programs, and is optimized by full alignment with our purpose, values, and strategy through meaningful connections between our employees and their communities. As of December 31, 2020, we had approximately 71,300 employees. During fiscal 2020, the number of employees increased by approximately 14,700 or 26%, primarily due to the acquisition of WellCare in 2020. During fiscal 2020, our voluntary turnover 18Table of Contentsrate was less than 10%, which is in line with the insurance industry standard benchmark, which is comprised of certain of our key competitors (AON Salary Increase and Turnover Study – Second Edition (September 2020)). Diversity and InclusionWe believe that a diverse workforce and inclusive environment enables competitive advantage and fuels improved service, innovation and performance with all stakeholders. We thoughtfully engage diverse talent across Centene, preparing women and underrepresented employees for leadership roles, and hiring diverse candidates who have a passion for serving our members and ambition for extraordinary impact.We have a wide range of programs focused on early identification and accelerated development of diverse talent, including our Employee Inclusion Groups (EIGs), which help us further enhance our inclusive workforce culture. These voluntary, employee led groups support the attraction, development and retention of talent at all levels. EIGs provide professional and leadership opportunities, contribute to community engagement initiatives and support business innovation and corporate best practices. Because of their significant value to us, we support EIGs through leadership involvement, work time and space, resources and Executive Mentors. Today, there are over 10,000 participants across all five EIGs providing professional and leadership development opportunities for women, military veterans, individuals with disabilities, LGBTQ+ and multicultural employees. Each EIG offers mentorship programs aligned with our leadership model and bring in unique lived experiences in an effort to ensure we are meeting employees at their level to deliver the best outcomes for their development. EIGs also partake in networking events, training programs, fireside chats and panels addressing current issues and other development opportunities for their members.Our team of talent advisors are responsible for leading the end-to-end search process, and leveraging our resources, tools and technologies to help our hiring leaders carefully consider the capabilities required to continue to propel our organization forward. Our talent advisors receive Advisory and Certified Diversity Recruiter training which are designed to ensure we consistently attract diverse pools of exceptional talent.In 2021, we released our inaugural 2020 Diversity & Inclusion Annual Report, which may be reviewed for more detailed information regarding our Human Capital programs and initiatives. Interested parties can find our 2020 Diversity & Inclusion Annual Report within the Investors section of our website, the URL of which is https://www.centene.com/who-we-are/corporate-facts-reports.html. Nothing on our website, including our Diversity and Inclusion Report or sections thereof, shall be deemed incorporated by reference into this Annual Report.Health, Safety and Well-BeingWe provide our employees and their families with access to a variety of health and wellness programs, including benefits that provide protection and security when events arise that may require time away from work or that impact our employees' financial well-being; that support their physical, mental and well-being health; and that offer choice where possible so they can customize their benefits to meet their needs and the needs of their families. In 2020, when COVID-19 presented an extraordinary threat to the health of our workforce, we responded quickly, equipping nearly 90% of our workforce to work from home within days of the declaration of the pandemic. We also enacted several new benefits, such as: ten days of additional emergency paid sick leave, a technology stipend, in office premium pay, and waived prior authorizations and cost sharing for COVID-19 related employee care. We further supported our workforce by providing assistance to those with school-aged children through a partnership with an online tutoring organization to provide deeply discounted one-on-one tutoring and group and after-school enrichment classes at no cost. We also created an employee resource site to provide well-being resources. Additionally, we established a highly trained, dedicated contact tracing concierge team to support employee’s well-being and provide easy access to HR professionals to respond to COVID-related questions.In addition to workforce benefits and enhanced employee concierge services, we also enacted several new facility modifications and protocols to help ensure the safety of our employees. For instance, while most of our cubicles are already 6x6 feet or larger in dimension, we invested more than $20 million to retrofit with acrylic screens our cubicles, reception and security desks, as well as workstations for additional protection from the spread of respiratory droplets. These protective screens were installed for over 60,000 cubicles across the country. In large campuses, thermal scanning cameras were installed to identify elevated temperatures of all employees and visitors. To promote a healthy distance among colleagues, structured walking paths were created in the hallways of our offices, directional signage has been prepared to guide employees through walking paths, and common areas have been restricted.19Table of ContentsIn a recent COVID-19 survey focused on employee sentiment and our response to COVID-19, 89% of employees responded favorably (agreed or strongly agreed) to our approach across five key areas: leadership, communications, consistency, care for people, and COVID-19 situation. Compensation and BenefitsOur compensation and benefits programs are market competitive and designed to attract and retain qualified employees. Our overall compensation philosophy is to pay for performance by linking the achievement of both Company and individual goals to total compensation. In addition to base pay, these programs (which vary by country/region) include annual bonuses, stock awards, an employee stock purchase plan, and a 401(k) plan. Our benefits cover various aspects of an employee’s life to help them live healthy. These include medical, dental and vision insurance, short- and long-term disability, supplemental accidental death and dismemberment and life insurance, wellness program, flexible spending accounts, parental leave and caregiver leave.We also offer benefits to help employees achieve optimum work-life balance. These include vacation, paid personal and sick time, paid company holidays, paid community volunteer time, an employee assistance program, tuition reimbursement/educational assistance, adoption reimbursement, on-site fitness centers or discount at local fitness centers.Talent DevelopmentThrough our robust talent infrastructure, we continue working to deepen and prepare our talent bench and workforce, which is necessary to support our growth strategy. We believe every employee is a leader and is critical to our success in transforming communities. Our leadership model sets expectations for what it means to lead at Centene and through Centene University, we build skills for how to lead. Centene University is our personalized learning platform and is accessible to all employees, providing both instructor-led and self-directed learning that enables employees to develop their professional and business skills from anywhere and at any time. Our business-led flagship leadership development program, APEX, is a multi-day, instructor-led program, designed to expand mindsets and build capabilities to help our workforce thrive in the future. In 2020, we strengthened our commitment to talent development and activated APEX digital learnings for our full workforce. The asynchronous sessions focused on building skills to thrive in the evolving world of work, including: customer-centricity, digital dexterity, perseverance and resilience, and end-to-end problem solving. We also repositioned our front line leader program to a virtual, instructor-led program, connecting with approximately 5,000 people leaders. In addition to building new workforce skills, we utilize our ongoing enterprise talent reviews, succession planning, career development planning and comprehensive HR analytics to provide insights to senior leaders to inform actions and drive intentional talent results through our People Plans, the integrated human capital component of our annual operating plans.Organizational Culture – Meaningful Connections between Employees and the Communities We ServeWe, our health plans, and our subsidiaries have long been leaders in transforming the health of our members and the communities where they live. We believe in local partnerships and value the innovative programs and services that they provide for underserved and at-risk populations. We attract a workforce that is purpose-driven and passionate about transforming communities and we recognize the importance of volunteering and supporting the communities in which we serve. We support our workforce by providing paid time off benefits for employees to participate in individual and work-related community volunteer programs. Additionally, to support our communities during the pandemic, we established an additional emergency volunteer benefit, which provides medical and behavioral health professional employees with paid volunteer time off for up to 3 months.With a largely remote workforce in 2020, we took additional steps to ensure a highly connected workforce, including new monthly forums for people leaders, new weekly communications for all employees, and new employee programming to engage in transparent dialogue on social issues. More than 92% of our employees responded to the 2020 Shaping Centene Employee Engagement Survey and 88% of employees reported strong engagement, which surpassed the 75th percentile of Fortune 100 benchmark companies. Based on their responses, employees were strongly aligned with our strategy, with 96% understanding our mission and 92% understanding our objectives.20Table of ContentsInformation about our Executive OfficersThe following table sets forth information regarding our executive officers, including their ages, at February 19, 2021:Name Age PositionMichael F. Neidorff 78 Chairman, President and Chief Executive OfficerMark J. Brooks51 Executive Vice President and Chief Information OfficerBrandy L. Burkhalter48 Executive Vice President, Chief Operating OfficerJesse N. Hunter45 Executive Vice President and Chief Strategy OfficerChristopher R. Isaak54 Senior Vice President, Corporate Controller and Chief Accounting OfficerChristopher A. Koster56 Senior Vice President, General Counsel and SecretaryBrent D. Layton53 Executive Vice President, Markets, Products, International, and Chief Business Development OfficerSarah M. London40 Senior Vice President, Technology, Innovation and ModerationJeffrey A. Schwaneke 45 Executive Vice President, Chief Financial OfficerDavid P. Thomas55 Executive Vice President, Markets Michael F. Neidorff. Mr. Neidorff has served as our Chairman, President and Chief Executive Officer since April 2019. From November 2017 to April 2019, he served as our Chairman and Chief Executive Officer. From May 2004 to November 2017, he served as Chairman, President and Chief Executive Officer. From May 1996 to May 2004, he served as President, Chief Executive Officer and as a member of our Board of Directors.Mark J. Brooks. Mr. Brooks has served as our Executive Vice President and Chief Information Officer since November 2017. From April 2016 to November 2017, he served as Senior Vice President and Chief Information Officer. Prior to joining Centene, he served as the Chief Information Officer at Health Net from 2012 to 2016. Brandy L. Burkhalter. Ms. Burkhalter has served as our Executive Vice President, Chief Operating Officer since June 2018. From December 2015 to June 2018, she served as Executive Vice President, Internal Audit & Risk Management. Jesse N. Hunter. Mr. Hunter has served as our Executive Vice President and Chief Strategy Officer since November 2017. From January 2016 to November 2017, he served as Executive Vice President, Products. Christopher R. Isaak. Mr. Isaak has served as our Senior Vice President, Corporate Controller and Chief Accounting Officer since April 2016. Prior to joining Centene, he served as Vice President, Corporate Controller at TTM Technologies from 2015 to 2016 and Vice President, Corporate Controller at Viasystems Group, Inc. from 2006 to 2015 and served as Chief Accounting Officer from 2010 to 2015.Christopher A. Koster. Mr. Koster has served as Senior Vice President, Secretary and General Counsel since February 2020. From February 2017 to February 2020, he served as Senior Vice President, Corporate Services. Prior to joining Centene, Mr. Koster served as Missouri Attorney General for eight years. Brent D. Layton. Mr. Layton has served as our Executive Vice President, Markets, Products, International, and Chief Business Development Officer since January 2021. From July 2016 to December 2020, he served as Executive Vice President and Chief Business Development Officer. From September 2011 to June 2016, he served as Senior Vice President, Business Development.Sarah M. London. Ms. London has served as our Senior Vice President, Technology and Modernization since September 2020. Prior to joining Centene, she served as both Senior Principal and Partner for Optum Ventures from May 2018 to March 2020 and Chief Product Officer of Optum from March 2016 to May 2018. From March 2014 to March 2016, she served as Vice President, Client Management and Operations for Humedica. Jeffrey A. Schwaneke. Mr. Schwaneke has served as our Executive Vice President, Chief Financial Officer since March 2016 and was also our Treasurer from March 2016 to July 2020. From July 2008 to March 2016, he served as our Senior Vice President, Corporate Controller and served as our Chief Accounting Officer from September 2008 to March 2016. 21Table of ContentsDavid P. Thomas. Mr. Thomas has served as our Executive Vice President of Markets since October 2019. From January 2019 through October 2019, he served as President and Chief Executive Officer of Fidelis Care. From May 2018 to December 2018, he served as President of Fidelis Care. He also previously served as Chief Operating Officer for Fidelis Care from January 2012 through April 2018. Available InformationWe are subject to the reporting and information requirements of the Securities Exchange Act of 1934, as amended (Exchange Act) and, as a result, we file periodic reports and other information with the Securities and Exchange Commission, or SEC. We make these filings available on our website free of charge, the URL of which is https://www.centene.com, as soon as reasonably practicable after we electronically file such material with, or furnish it to, the SEC. The SEC maintains a website (https://www.sec.gov) that contains our annual, quarterly and current reports and other information we file electronically with the SEC. Information on our website does not constitute part of this Annual Report on Form 10-K.22Table of ContentsITEM 1A. Risk Factors.You should carefully consider the risks described below before making an investment decision. The trading price of our common stock could decline due to any of these risks, in which case you could lose all or part of your investment. You should also refer to the other information in this filing, including our consolidated financial statements and related notes. The risks and uncertainties described below are those that we currently believe may materially affect our Company. Additional risks and uncertainties that we are unaware of or that we currently deem immaterial also may become important factors that affect our Company. Unless the context otherwise requires, the terms the “Company,” “we,” “us,” “our” or similar terms and “Centene” (i) prior to the closing of the Magellan Acquisition, refer to Centene Corporation, together with its consolidated subsidiaries, without giving effect to the Magellan Acquisition, and (ii) upon and after the closing of the Magellan Acquisition, refer to us, after giving effect to the Magellan Acquisition.Risks Relating to Our BusinessOur business could be adversely affected by the effects of widespread public health pandemics, such as the spread of COVID-19.Public health pandemics or widespread outbreaks of contagious diseases could adversely impact our business. In December 2019, a novel strain of coronavirus (COVID-19) emerged, which has now spread globally, including throughout the United States. The extent to which COVID-19 continues to impact our business will depend on future developments, which are highly uncertain and cannot be predicted with confidence. Factors that may determine the severity of the impact include the duration and scale of the outbreak, new information which may emerge concerning the severity of COVID-19, (including new strains, which may be more contagious, more severe or less responsive to treatment or vaccines), the costs of prevention and treatment of COVID-19 and the potential that we will not receive state and federal government reimbursement of additional expenses incurred by our members who contract or require testing for COVID-19 or who experience other health impacts as a result of the pandemic, employee mobility, productivity and utilization of leave and other benefits, financial and other impacts on the healthcare provider community, disruptions or delays in the supply chain for testing and treatment supplies, protective equipment and other products and services, and the actions to contain COVID-19 or address its impact (including federal, state and local laws, regulations and emergency orders, including directives to remain at home, physically distance or forced business closures as well as the timing and scope of vaccine distribution), among others. Additionally, the spread of COVID-19 has led to disruption and volatility in the global capital markets, which could adversely impact our access to capital, and a decline in interest rates which could reduce our investment income. Finally, the impact of the above items on our state and federal partners could result in program changes or delays or reduced capitation payments to us. We cannot at this time predict the ultimate impact of the COVID-19 pandemic, but it could adversely affect our business, including our financial position, results of operations and/or cash flows.Our Medicare programs are subject to a variety of unique risks that could adversely impact our financial results.If we fail to design and maintain programs that are attractive to Medicare participants; if our Medicare operations are subject to negative outcomes from program audits, sanctions, penalties or other actions; if we do not submit adequate bids in our existing markets or any expansion markets; if our existing contracts are modified or terminated; or if we fail to maintain or improve our quality Star ratings, our current Medicare business and our ability to expand our Medicare operations could be materially and adversely affected, negatively impacting our financial performance. For example, in October 2020, the Centers for Medicare and Medicaid Services (CMS) published updated Medicare Star quality ratings for the 2021 rating year. Approximately 30% of our Medicare members are in a 4 star or above plan for the 2022 bonus year, compared to 46% for the 2021 bonus year and 86% for the 2020 bonus year. Our quality bonus and rebates may be negatively impacted in 2021 and 2022 and the attractiveness of our Medicare Advantage plans may be reduced.There are also specific additional risks under Title XVIII, Part D of the Social Security Act associated with our provision of Medicare Part D prescription drug benefits as part of our Medicare Advantage plan offerings. These risks include potential uncollectibility of receivables, inadequacy of pricing assumptions, inability to receive and process information and increased pharmaceutical costs, as well as the underlying seasonality of this business, and extended settlement periods for claims submissions. Our failure to comply with Part D program requirements can result in financial and/or operational sanctions on our Part D products, as well as on our Medicare Advantage products that offer no prescription drug coverage.Although we do not anticipate that a single-payer national health insurance system will be enacted by the current Congress, members of Congress have proposed several legislative initiatives over various sessions of Congress that would establish some 23Table of Contentsform of a single public or quasi-public agency that organizes healthcare financing, but under which healthcare delivery would remain private. Additionally, the potential impact of the change of administration on healthcare reform efforts is unknown. We are unable to predict the nature and success of these or other initiatives or political changes, which could have an adverse effect on our business.Failure to accurately estimate and price our medical expenses or effectively manage our medical costs or related administrative costs could negatively affect our results of operations, financial position and cash flows. Our profitability depends to a significant degree on our ability to estimate and effectively manage expenses related to health benefits through, among other things, our ability to contract favorably with hospitals, physicians and other healthcare providers. For example, our Medicaid revenue is often based on bids submitted before the start of the initial contract year. If our actual medical expenses exceed our estimates, our Health Benefits Ratio (HBR), or our expenses related to medical services as a percentage of premium revenues, would increase and our profits would decline. Because of the narrow margins of our health plan business, relatively small changes in our HBR can create significant changes in our financial results. Changes in healthcare regulations and practices, the level of utilization of healthcare services, hospital and pharmaceutical costs, disasters, the potential effects of climate change, major epidemics, pandemics or newly emergent diseases (such as COVID-19), new medical technologies, new pharmaceutical compounds, increases in provider fraud and other external factors, including general economic conditions such as inflation and unemployment levels, are generally beyond our control and could reduce our ability to accurately predict and effectively control the costs of providing health benefits. Also, member behavior could continue to be influenced by the uncertainty surrounding the ACA, including ongoing legal challenges to the ACA including the case originally captioned Texas v. United States, which is currently pending before the Supreme Court.Our medical expenses include claims reported but not paid, estimates for claims incurred but not reported, and estimates for the costs necessary to process unpaid claims at the end of each period. Our development of the medical claims liability estimate is a continuous process which we monitor and refine on a monthly basis as claims receipts and payment information as well as inpatient acuity information becomes available. As more complete information becomes available, we adjust the amount of the estimate, and include the changes in estimates in medical expenses in the period in which the changes are identified. Given the uncertainties inherent in such estimates, there can be no assurance that our medical claims liability estimate will be adequate, and any adjustments to the estimate may unfavorably impact our results of operations and may be material.Additionally, when we commence operations in a new state or region or launch a new product, we have limited information with which to estimate our medical claims liability. For a period of time after the inception of the new business, we base our estimates on government-provided historical actuarial data and limited actual incurred and received claims and inpatient acuity information. The addition of new categories of eligible individuals, as well as evolving Health Insurance Marketplace plans, may pose difficulty in estimating our medical claims liability. From time to time in the past, our actual results have varied from our estimates, particularly in times of significant changes in the number of our members. If it is determined that our estimates are significantly different than actual results, our results of operations and financial position could be adversely affected. In addition, if there is a significant delay in our receipt of premiums, our business operations, cash flows, or earnings could be negatively impacted. Risk-adjustment payment systems make our revenue and results of operations more difficult to estimate and could result in retroactive adjustments that have a material adverse effect on our results of operations, financial condition and cash flows.Most of our government customers employ risk-adjustment models to determine the premium amount they pay for each member. This model pays more for members with predictably higher costs according to the health status of each beneficiary enrolled. Premium payments are generally established at fixed intervals according to the contract terms and then adjusted on a retroactive basis. We reassess the estimates of the risk adjustment settlements each reporting period and any resulting adjustments are made to premium revenue. In addition, revisions by our government customers to the risk-adjustment models have reduced, and may continue to reduce, our premium revenue.As a result of the variability of certain factors that determine estimates for risk-adjusted premiums, including plan risk scores, the actual amount of retroactive payments could be materially more or less than our estimates. Consequently, our estimate of our plans’ risk scores for any period, and any resulting change in our accrual of premium revenues related thereto, could have a material adverse effect on our results of operations, financial condition and cash flows. The data provided to our government customers to determine the risk score are subject to audit by them even after the annual settlements occur. These audits may result in the refund of premiums to the government customer previously received by us, which could be significant and would reduce our premium revenue in the year that repayment is required.24Table of ContentsGovernment customers have performed and continue to perform audits of selected plans to validate the provider coding practices under the risk adjustment model used to calculate the premium paid for each member. In 2018, CMS proposed the removal of the fee for service adjuster from the risk adjustment data validation audit methodology. If adopted, this proposal, or any similar CMS rule making initiative, could increase our audit error scores. We anticipate that CMS will continue to conduct audits of our Medicare contracts and contract years on an on-going basis. An audit may result in the refund of premiums to CMS. It is likely that a payment adjustment could occur as a result of these audits; and any such adjustment could have a material adverse effect on our results of operations, financial condition and cash flows.Any failure to adequately price products offered or any reduction in products offered in the Health Insurance Marketplaces may have a negative impact on our results of operations, financial position and cash flow.Due to among other things, the elimination of the individual mandate penalty in the Tax Cuts and Jobs Act (TCJA), we may be adversely selected by individuals who have higher acuity levels than those individuals who selected us in the past and healthy individuals may decide to opt out of the pool altogether. In addition, the risk adjustment provisions of the ACA established to apportion risk amongst insurers may not be effective in appropriately mitigating the financial risks related to the Marketplace product, are subject to a high degree of estimation and variability, and are affected by our members' acuity relative to the membership acuity of other insurers. Further, changes in the competitive marketplace over time may exacerbate the uncertainty in these relatively new markets. For example, competitors seeking to gain a foothold in the changing market may introduce pricing that we may not be able to match, which may adversely affect our ability to compete effectively. Competitors may also choose to exit the market altogether or otherwise suffer financial difficulty, which could adversely impact the pool of potential insured, or require us to increase premium rates. Any significant variation from our expectations regarding acuity, enrollment levels, adverse selection, or other assumptions utilized in setting adequate premium rates could have a material adverse effect on our results of operations, financial position and cash flows.We derive a portion of our cash flow and gross margin from our PDP operations, for which we submit annual bids for participation. The results of our bids could materially affect our results of operations, financial condition and cash flows.A significant portion of our PDP membership is obtained from the auto-assignment of beneficiaries in CMS-designated regions where our PDP premium bids are below benchmarks of other plans’ bids. In general, our premium bids are based on assumptions regarding PDP membership, utilization, drug costs, drug rebates and other factors for each region. Our 2021 PDP bids resulted in 33 of the 34 CMS regions in which we were below the benchmarks, and within the de minimis range in the remaining region, compared with our 2020 PDP bids in which we were below the benchmarks in 32 regions, and within the de minimis range in the remaining two regions. For those regions in which we are within the de minimis range, we will not be eligible to have new members auto-assigned to us, but we will not lose our existing auto-assigned membership.If our future Part D premium bids are not below the CMS benchmarks, we risk losing PDP members who were previously assigned to us and we may not have additional PDP members auto-assigned to us, which could materially reduce our revenue and profits.Our encounter data may be inaccurate or incomplete, which could have a material adverse effect on our results of operations, financial condition, cash flows and ability to bid for, and continue to participate in, certain programs.Our contracts require the submission of complete and correct encounter data. The accurate and timely reporting of encounter data is increasingly important to the success of our programs because more states are using encounter data to determine compliance with performance standards and to set premium rates. We have expended and may continue to expend additional effort and incur significant additional costs to collect or correct inaccurate or incomplete encounter data and have been, and continue to be, exposed to operating sanctions and financial fines and penalties for noncompliance. In some instances, our government clients have established retroactive requirements for the encounter data we must submit. There also may be periods of time in which we are unable to meet existing requirements. In either case, it may be prohibitively expensive or impossible for us to collect or reconstruct this historical data.We may experience challenges in obtaining complete and accurate encounter data, due to difficulties with providers and third-party vendors submitting claims in a timely fashion in the proper format, and with state agencies in coordinating such submissions. As states increase their reliance on encounter data, these difficulties could adversely affect the premium rates we receive and how membership is assigned to us and subject us to financial penalties, which could have a material adverse effect on our results of operations, financial condition, cash flows and our ability to bid for, and continue to participate in, certain programs.25Table of ContentsIf any of our government contracts are terminated or are not renewed on favorable terms or at all, or if we receive an adverse finding or review resulting from an audit or investigation, our business may be adversely affected. A substantial portion of our business relates to the provision of managed care programs and selected services to individuals receiving benefits under governmental assistance or entitlement programs. We provide these and other healthcare services under contracts with government entities in the areas in which we operate. Our government contracts are generally intended to run for a fixed number of years and may be extended for an additional specified number of years if the contracting entity or its agent elects to do so. When our contracts with government entities expire, they may be opened for bidding by competing healthcare providers, and there is no guarantee that our contracts will be renewed or extended. Competitors may buy their way into the market by submitting bids with lower pricing. Even if our responsive bids are successful, the bids may be based upon assumptions or other factors which could result in the contracts being less profitable than we had anticipated. Further, our government contracts contain certain provisions regarding eligibility, enrollment and dis-enrollment processes for covered services, eligible providers, periodic financial and informational reporting, quality assurance, timeliness of claims payment and agreement to maintain a Medicare plan in the state and financial standards, among other things, and are subject to cancellation if we fail to perform in accordance with the standards set by regulatory agencies.We are also subject to various reviews, audits and investigations to verify our compliance with the terms of our contracts with various governmental agencies, as well as compliance with applicable laws and regulations. Any adverse review, audit or investigation could result in, among other things: cancellation of our contracts; refunding of amounts we have been paid pursuant to our contracts; imposition of fines, penalties and other sanctions on us; loss of our right to participate in various programs; increased difficulty in selling our products and services; loss of one or more of our licenses; lowered quality Star ratings; or required changes to the way we do business. In addition, under government procurement regulations and practices, a negative determination resulting from a government audit of our business practices could result in a contractor being fined, debarred and/or suspended from being able to bid on, or be awarded, new government contracts for a period of time.If any of our government contracts are terminated, not renewed, renewed on less favorable terms, or not renewed on a timely basis, or if we receive an adverse finding or review resulting from an audit or investigation, our business and reputation may be adversely impacted, our goodwill could be impaired and our financial position, results of operations or cash flows may be materially affected.We contract with independent third-party vendors and service providers who provide services to us and our subsidiaries or to whom we delegate selected functions. Violations of, or noncompliance with, laws and regulations governing our business by such third parties, or governing our dealings with such parties, could, among other things, subject us to additional audits, reviews and investigations and other adverse effects.Ineffectiveness of state-operated systems and subcontractors could adversely affect our business. A number of our health plans rely on other state-operated systems or subcontractors to qualify, solicit, educate and assign eligible members into managed care plans. The effectiveness of these state operations and subcontractors can have a material effect on a health plan's enrollment in a particular month or over an extended period. When a state implements either new programs to determine eligibility or new processes to assign or enroll eligible members into health plans, or when it chooses new subcontractors, there is an increased potential for an unanticipated impact on the overall number of members assigned to managed care plans.Execution of our growth strategy may increase costs or liabilities, or create disruptions in our business. Our growth strategy includes, without limitation, the acquisition and expansion of health plans participating in government sponsored healthcare programs and specialty services businesses, contract rights and related assets of other health plans both in our existing service areas and in new markets and start-up operations in new markets or new products in existing markets. We continue to pursue opportunistic acquisitions to expand into new geographies and complementary business lines as well as to augment existing operations, and we may be in discussions with respect to one or multiple targets at any given time. Although we review the records of companies or businesses we plan to acquire, it is possible that we could assume unanticipated liabilities or adverse operating conditions, or an acquisition may not perform as well as expected or may not achieve timely profitability. We also face the risk that we will not be able to effectively integrate acquisitions into our existing operations effectively without substantial expense, delay or other operational or financial problems and we may need to divert more management resources to integration than we planned. 26Table of ContentsIn connection with start-up operations and system migrations, we may incur significant expenses prior to commencement of operations and the receipt of revenue. For example, in order to obtain a certificate of authority in most jurisdictions, we must first establish a provider network, have systems in place and demonstrate our ability to administer a state contract and process claims. We may experience delays in operational start dates, including those related to stay-at-home directives and other impacts of COVID-19. As a result of these factors, start-up operations may decrease our profitability. The timing of operating our new East Coast headquarters in Charlotte, and the expected benefits of its completion, may also be negatively impacted as a result of these factors. In addition, we are planning to further expand our business internationally and we will be subject to additional risks, including, but not limited to, political risk, an unfamiliar regulatory regime, currency exchange risk and exchange controls, cultural and language differences, foreign tax issues, and different labor laws and practices. If we are unable to effectively execute our growth strategy, including as a result of the continued impact of COVID-19, our future growth will suffer and our results of operations could be harmed.If competing managed care programs are unwilling to purchase specialty services from us, we may not be able to successfully implement our strategy of diversifying our business lines. We are seeking to diversify our business lines into areas that complement our government sponsored health plan business in order to grow our revenue stream and diversify our business. In order to diversify our business, we must succeed in selling the services of our specialty subsidiaries not only to our managed care plans, but to programs operated by third parties. Some of these third-party programs may compete with us in some markets, and they therefore may be unwilling to purchase specialty services from us. In any event, the offering of these services will require marketing activities that differ significantly from the manner in which we seek to increase revenues from our government sponsored programs. Our ineffectiveness in marketing specialty services to third parties may impair our ability to execute our business strategy. If state regulators do not approve payments of dividends and distributions by our subsidiaries to us, we may not have sufficient funds to implement our business strategy.We principally operate through our health plan subsidiaries. As part of normal operations, we may make requests for dividends and distributions from our subsidiaries to fund our operations. In addition to state corporate law limitations, these subsidiaries are subject to more stringent state insurance and HMO laws and regulations that limit the amount of dividends and distributions that can be paid to us without prior approval of, or notification to, state regulators. If these regulators were to deny or delay our subsidiaries' requests to pay dividends, the funds available to us would be limited, which could harm our ability to implement our business strategy.We derive a significant portion of our premium revenues from operations in a limited number of states, and our results of operations, financial position or cash flows could be materially affected by a decrease in premium revenues or profitability in any one of those states. Operations in a limited number of states have accounted for a significant portion of our premium revenues to date. If we were unable to continue to operate in any of those states or if our current operations in any portion of one of those states were significantly curtailed, our revenues could decrease materially. Our reliance on operations in a limited number of states could cause our revenues and profitability to change suddenly and unexpectedly depending on legislative or other governmental or regulatory actions and decisions, economic conditions and similar factors in those states. For example, states we currently serve may open the bidding for their Medicaid program to other health insurers through a request for proposal process. Our inability to continue to operate in any of the states in which we operate could harm our business. Competition may limit our ability to increase penetration of the markets that we serve.We compete for members principally on the basis of size and quality of provider networks, benefits provided and quality of service. We compete with numerous types of competitors, including other health plans and traditional state Medicaid programs that reimburse providers as care is provided, as well as technology companies, new joint ventures, financial services firms, consulting firms and other non-traditional competitors. In addition, the administration of the ACA has the potential to shift the competitive landscape in our segment.Some of the health plans with which we compete have greater financial and other resources and offer a broader scope of products than we do. In addition, significant merger and acquisition activity has occurred in the managed care industry, as well as complementary industries, such as the hospital, physician, pharmaceutical, medical device and health information systems businesses. To the extent that competition intensifies in any market that we serve, as a result of industry consolidation or otherwise, our ability to retain or increase members and providers, or maintain or increase our revenue growth, pricing 27Table of Contentsflexibility and control over medical cost trends may be adversely affected.If we are unable to maintain relationships with our provider networks, our profitability may be harmed. Our profitability depends, in large part, upon our ability to contract at competitive prices with hospitals, physicians and other healthcare providers. Our provider arrangements with our primary care physicians, specialists and hospitals generally may be canceled by either party without cause upon 90 to 120 days prior written notice. We cannot provide any assurance that we will be able to continue to renew our existing contracts or enter into new contracts on a timely basis or under favorable terms enabling us to service our members profitably. Healthcare providers with whom we contract may not properly manage the costs of, and access to services, be able to provide effective telehealth services, maintain financial solvency, including due to the impact of COVID-19, or avoid disputes with other providers. Any of these events could have a material adverse effect on the provision of services to our members and our operations.In any particular market, physicians and other healthcare providers could refuse to contract, demand higher payments, or take other actions that could result in higher medical costs or difficulty in meeting regulatory or accreditation requirements, among other things. In some markets, certain healthcare providers, particularly hospitals, physician/hospital organizations or multi-specialty physician groups, may have significant market positions or near monopolies that could result in diminished bargaining power on our part. In addition, accountable care organizations, practice management companies, which aggregate physician practices for administrative efficiency and marketing leverage, and other organizational structures that physicians, hospitals and other healthcare providers choose may change the way in which these providers interact with us and may change the competitive landscape. Such organizations or groups of healthcare providers may compete directly with us, which could adversely affect our operations, and our results of operations, financial position and cash flows by impacting our relationships with these providers or affecting the way that we price our products and estimate our costs, which might require us to incur costs to change our operations. Provider networks may consolidate, resulting in a reduction in the competitive environment. In addition, if these providers refuse to contract with us, use their market position to negotiate contracts unfavorable to us or place us at a competitive disadvantage, our ability to market products or to be profitable in those areas could be materially and adversely affected. From time to time, healthcare providers assert or threaten to assert claims seeking to terminate non-cancelable agreements due to alleged actions or inactions by us. If we are unable to retain our current provider contract terms or enter into new provider contracts timely or on favorable terms, our profitability may be harmed. In addition, from time to time, we may be subject to class action or other lawsuits by healthcare providers with respect to claim payment procedures or similar matters. For example, our wholly owned subsidiary, Health Net Life Insurance Company (HNL), is and may continue to be subject to such disputes with respect to HNL's payment levels in connection with the processing of out-of-network provider reimbursement claims for the provision of certain substance abuse related services. HNL expects to vigorously defend its claims payment practices. Nevertheless, in the event HNL receives an adverse finding in any related legal proceeding or from a regulator, or is otherwise required to reimburse providers for these claims at rates that are higher than expected or for claims HNL otherwise believes are unallowable, our financial condition and results of operations may be materially adversely affected. In addition, regardless of whether any such lawsuits brought against us are successful or have merit, they will still be time-consuming and costly and could distract our management's attention. As a result, under such circumstances we may incur significant expenses and may be unable to operate our business effectively.If we are unable to integrate and manage our information systems effectively, our operations could be disrupted. Our operations depend significantly on effective information systems. The information gathered and processed by our information systems assists us in, among other things, monitoring utilization and other cost factors, processing provider claims, and providing data to our regulators. Our healthcare providers also depend upon our information systems for membership verifications, claims status and other information. Our information systems and applications require continual maintenance, upgrading and enhancement to meet our operational needs and regulatory requirements. We regularly upgrade and expand our information systems' capabilities. If we experience difficulties with the transition to or from information systems or do not appropriately integrate, maintain, enhance or expand our information systems, we could suffer, among other things, operational disruptions, loss of existing members and difficulty in attracting new members, regulatory problems and increases in administrative expenses. In addition, our ability to integrate and manage our information systems may be impaired as the result of events outside our control, including acts of nature, such as earthquakes or fires, or acts of terrorists, which may include cyber-attacks by terrorists or other governmental or non-governmental actors. In addition, we may from time to time obtain significant portions of our systems-related or other services or facilities from independent third parties, which may make our operations vulnerable if such third parties fail to perform adequately.28Table of ContentsAn impairment charge with respect to our recorded goodwill and intangible assets could have a material impact on our results of operations. We periodically evaluate our goodwill and other intangible assets to determine whether all or a portion of their carrying values may be impaired, in which case a charge to earnings may be necessary. Changes in business strategy, government regulations or economic or market conditions have resulted and may result in impairments of our goodwill and other intangible assets at any time in the future. Our judgments regarding the existence of impairment indicators are based on, among other things, legal factors, market conditions, and operational performance. For example, the non-renewal of our health plan contracts with the state in which they operate may be an indicator of impairment. If an event or events occur that would cause us to revise our estimates and assumptions used in analyzing the value of our goodwill and other intangible assets, such revision could result in a non-cash impairment charge that could have a material impact on our results of operations in the period in which the impairment occurs.A failure in or breach of our operational or security systems or infrastructure, or those of third parties with which we do business, including as a result of cyber-attacks, could have an adverse effect on our business. Information security risks have significantly increased in recent years in part because of the proliferation of new technologies, the use of the internet and telecommunications technologies to conduct our operations, and the increased sophistication and activities of organized crime, hackers, terrorists and other external parties, including foreign state agents. Our operations rely on the secure processing, transmission and storage of confidential, proprietary and other information in our computer systems and networks. Security breaches may arise from external or internal threats. External breaches include hacking personal information for financial gain, attempting to cause harm or interruption to our operations, or intending to obtain competitive information. We experience attempted external hacking or malicious attacks on a regular basis. We maintain a rigorous system of prevention and detection controls through our security programs; however, our prevention and detection controls may not prevent or identify all such attacks on a timely basis, or at all. Internal breaches may result from inappropriate security access to confidential information by rogue employees, consultants or third party service providers. Any security breach involving the misappropriation, loss or other unauthorized disclosure or use of confidential member information, financial data, competitively sensitive information, or other proprietary data, whether by us or a third party, could have a material adverse effect on our business reputation, financial condition, cash flows, or results of operations.Risks Relating to Regulatory and Legal MattersReductions in funding, changes to eligibility requirements for government sponsored healthcare programs in which we participate and any inability on our part to effectively adapt to changes to these programs could substantially affect our results of operations, financial position and cash flows.The majority of our revenues come from government subsidized healthcare programs including Medicaid, Medicare, TRICARE, CHIP, LTSS, ABD, Foster Care and Health Insurance Marketplace premiums. Under most programs, the base premium rate paid for each program differs, depending on a combination of factors such as defined upper payment limits, a member's health status, age, gender, county or region and benefit mix. Since Medicaid was created in 1965, the federal government and the states have shared the costs for this program, with the federal share currently averaging approximately 60%. We are therefore exposed to risks associated with federal and state government contracting or participating in programs involving a government payor, including but not limited to the general ability of the federal and/or state governments to terminate or modify contracts with them, in whole or in part, without prior notice, for convenience or for default based on performance; potential regulatory or legislative action that may materially modify amounts owed; our dependence upon Congressional or legislative appropriation and allotment of funds and the impact that delays in government payments could have on our operating cash flow and liquidity; and other regulatory, legislative or judicial actions that may have an impact on the operations of government subsidized healthcare programs including ongoing litigation involving the ACA. For example, future levels of funding and premium rates may be affected by continuing government efforts to contain healthcare costs and may further be affected by state and federal budgetary constraints. Governments periodically consider reducing or reallocating the amount of money they spend for Medicaid, Medicare, TRICARE, CHIP, LTSS, ABD and Foster Care. Furthermore, Medicare remains subject to the automatic spending reductions imposed by the Budget Control Act of 2011 and the American Taxpayer Relief Act of 2012 ("sequestration"), subject to a 2% cap, which was extended by the Bipartisan Budget Act of 2019 through 2029. The Coronavirus Aid, Relief, and Economic Security Act of 2020 temporarily suspended the Medicare sequestration for the period of May 1, 2020 through December 31, 2020, while also extending the mandatory sequestration policy by an additional one year, through 2030. The Bipartisan-Bicameral Omnibus COVID Relief Deal passed in December 2020 further extended the suspension of the Medicare sequestration until March 31, 2021.29Table of ContentsIn addition, reductions in defense spending could have an adverse impact on certain government programs in which we currently participate by, among other things, terminating or materially changing such programs, or by decreasing or delaying payments made under such programs. Adverse economic conditions may put pressures on state budgets as tax and other state revenues decrease while the population that is eligible to participate in these programs remains steady or increases, creating more need for funding. We anticipate this will require government agencies to find funding alternatives, which may result in reductions in funding for programs, contraction of covered benefits, and limited or no premium rate increases or premium rate decreases. A reduction (or less than expected increase), a protracted delay, or a change in allocation methodology in government funding for these programs, as well as termination of one or more contracts for the convenience of the government, may materially and adversely affect our results of operations, financial position and cash flows. In addition, if another federal government shutdown were to occur for a prolonged period of time, federal government payment obligations, including its obligations under Medicaid, Medicare, TRICARE, CHIP, LTSS, ABD, Foster Care and the Health Insurance Marketplaces, may be delayed. Similarly, if state government shutdowns were to occur, state payment obligations may be delayed. If the federal or state governments fail to make payments under these programs on a timely basis, our business could suffer, and our financial position, results of operations or cash flows may be materially affected.Payments from government payors may be delayed in the future, which, if extended for any significant period of time, could have a material adverse effect on our results of operations, financial position, cash flows or liquidity. In addition, delays in obtaining, or failure to obtain or maintain, governmental approvals, or moratoria imposed by regulatory authorities, could adversely affect our revenues or membership, increase costs or adversely affect our ability to bring new products to market as forecasted. Other changes to our government programs could affect our willingness or ability to participate in any of these programs or otherwise have a material adverse effect on our business, financial condition or results of operations.Finally, changes in these programs could reduce the number of persons enrolled in or eligible for these programs or increase our administrative or healthcare costs under these programs. For example, maintaining current eligibility levels could cause states to reduce reimbursement or reduce benefits in order for states to afford to maintain eligibility levels. If any state in which we operate were to decrease premiums paid to us or pay us less than the amount necessary to keep pace with our cost trends, it could have a material adverse effect on our results of operations, financial position and cash flows.The implementation of the ACA, as well as potential repeal of, changes to, or judicial challenges to the ACA, could materially and adversely affect our results of operations, financial position and cash flows.The enactment of the ACA in March 2010 transformed the U.S. healthcare delivery system through a series of complex initiatives; however, the implementation of the ACA continues to face administrative, judicial and legislative challenges to repeal or change certain of its significant provisions. Changes to, or repeal of, portions or the entirety of the ACA, as well as judicial interpretations in response to constitutional and other legal challenges, as well as the uncertainty generated by such actual or potential challenges, could materially and adversely affect our business and financial position, results of operations or cash flows. Even if the ACA is not amended or repealed under the current administration, a future administration or members of Congress could continue to propose changes impacting implementation of the ACA, which could materially and adversely affect our financial position or operations.Among the most significant of the ACA's provisions was the establishment of the Health Insurance Marketplace for individuals and small employers to purchase health insurance coverage that included a minimum level of benefits and restrictions on coverage limitations and premium rates, as well as the expansion of Medicaid coverage to all individuals under age 65 with incomes up to 138% of the federal poverty level beginning January 1, 2014, subject to each state's election. The HHS additionally indicated that it would consider a limited number of premium assistance demonstration proposals from states that want to privatize Medicaid expansion. Arkansas was the first state to obtain federal approval to use Medicaid funding to purchase private insurance for low-income residents, and we began operations under the program beginning on January 1, 2014. Several states have obtained Section 1115 waivers to implement the ACA's Medicaid expansion in ways that extend beyond the flexibility provided by the federal law, with additional states pursuing Section 1115 waivers regarding eligibility criteria, benefits, and cost-sharing, and provider payments across their Medicaid programs. Litigation challenging Section 1115 waiver activity for both new and previously approved waivers is expected to continue both through administrative actions and the courts.There have been significant administrative efforts to repeal, or limit implementation of, certain provisions of the ACA through changes in regulations. Such initiatives include repeal of the individual mandate effective in 2019, as well as easing the regulatory restrictions placed on short-term health plans and association health plans (AHPs), which plans often provide fewer benefits than the traditional ACA insurance benefits.30Table of ContentsAdditionally, the U.S. Department of Labor issued a final rule on June 19, 2018 which expanded flexibility regarding the regulation and formation of AHPs provided by small employer groups and associations. On June 13, 2019, the HHS, the U.S. Department of Labor and the U.S. Treasury issued a final rule allowing employers of all sizes that do not offer a group coverage plan to fund a new kind of health reimbursement arrangement (HRA), known as an individual coverage HRA (ICHRA). Beginning January 1, 2020, employees became able to use employer-funded ICHRAs to buy individual-market insurance, including insurance purchased on the public exchanges formed under the ACA.In addition to administrative efforts to expand the flexibility of other insurance plan options that are not required to meet ACA requirements, there have also been efforts to address the ACA's non-deductible tax imposed on health insurers based on prior year net premiums written (the "health insurer fee" or "HIF"). The ACA imposed HIF was $8.0 billion in 2014, and $11.3 billion in each of 2015 and 2016, with increasing annual amounts thereafter. The HIF payable in 2017 was suspended by the Consolidated Appropriations Act for fiscal year 2016; however, a $14.3 billion payment occurred in 2018. Collection of the HIF for 2019 was also suspended, but resumed in 2020 with a $15.5 billion payment. Congress passed a spending bill in December 2019, which would repeal the health insurance tax indefinitely, effective in 2021. If we are not reimbursed by the states for the cost of the HIF (including the associated tax impact), or if we are unable to otherwise adjust our business model to address the current assessment, our results of operations, financial position and cash flows may be materially adversely affected.The constitutionality of the ACA itself continues to face judicial challenge. In December 2018, a partial summary judgment ruling in Texas v. United States of America held that the ACA's individual mandate requirement was essential to the ACA, and without it, the remainder of the ACA was invalid (i.e., that it was not "severable" from the ACA). That decision was appealed to the Fifth Circuit, which ruled in December 2019 that the individual mandate was unconstitutional after Congress set the individual mandate penalty to $0 and remanded the case to the district court for additional analysis on the question of severability. In March 2020, the U.S. Supreme Court agreed to hear the case to review whether the individual mandate is constitutional and, if the individual mandate is unconstitutional, the severability issue. In June 2020, Noel J. Francisco, the then Solicitor General of the United States, together with multiple U.S. Department of Justice colleagues, submitted a brief to the U.S. Supreme Court supporting the argument that the individual mandate is unconstitutional and that the remaining provisions of the ACA are not severable. The U.S. Supreme Court heard oral arguments in November 2020 and a ruling is anticipated in 2021. The ACA remains in effect until judicial review of the decision is concluded. The ultimate content, timing or effect of any potential future legislation or the outcome of the lawsuit cannot be predicted and may be delayed as a result of court closures and reduced court dockets as a result of the COVID-19 pandemic.These changes and other potential changes involving the functioning of the Health Insurance Marketplace as a result of new legislation, regulation, executive action or litigation could impact our business and results of operations.Our business activities are highly regulated and new laws or regulations or changes in existing laws or regulations or their enforcement or application could force us to change how we operate and could harm our business. Our business is extensively regulated by the states in which we operate and by the federal government. In addition, the managed care industry has received negative publicity that has led to increased legislation, regulation, review of industry practices and private litigation in the commercial sector. Such negative publicity may adversely affect our stock price and damage our reputation in various markets. In each of the jurisdictions in which we operate, we are regulated by the relevant insurance, health and/or human services or government departments that oversee the activities of managed care organizations providing or arranging to provide services to Medicaid, Medicare, Health Insurance Marketplace enrollees or other beneficiaries. For example, our health plan subsidiaries, as well as our applicable specialty companies, must comply with minimum statutory capital and other financial solvency requirements, such as deposit and surplus requirements. The frequent enactment of, changes to, or interpretations of laws and regulations could, among other things: force us to restructure our relationships with providers within our network; require us to implement additional or different programs and systems; restrict revenue and enrollment growth; increase our healthcare and administrative costs; impose additional capital and surplus requirements; and increase or change our liability to members in the event of malpractice by our contracted providers. In addition, changes in political party or administrations at the state or federal level in the United States or internationally may change the attitude towards healthcare programs and result in changes to the existing legislative or regulatory environment.Additionally, the taxes and fees paid to federal, state and local governments may increase due to several factors, including: enactment of, changes to, or interpretations of tax laws and regulations, audits by governmental authorities, geographic expansions into higher taxing jurisdictions and the effect of expansions into international markets.31Table of ContentsOur contracts with states may require us to maintain a minimum HBR or may require us to share profits in excess of certain levels. In certain circumstances, our plans may be required to return premiums back to the state in the event profits exceed established levels or HBR does not meet the minimum requirement. Factors that may impact the amount of premium returned to the state include transparent pharmacy pricing and rebate initiatives. Other states may require us to meet certain performance and quality metrics in order to maintain our contract or receive additional or full contractual revenue. The governmental healthcare programs in which we participate are subject to the satisfaction of certain regulations and performance standards. Regulators require numerous steps for continued implementation of the ACA, including the promulgation of a substantial number of potentially more onerous federal regulations. If we fail to effectively implement or appropriately adjust our operational and strategic initiatives with respect to the implementation of healthcare reform, or do not do so as effectively as our competitors, our results of operations may be materially adversely affected. For example, under the ACA, Congress authorized CMS and the states to implement managed care demonstration programs to serve dually eligible beneficiaries to improve the coordination of their care. Participation in these demonstration programs is subject to CMS approval and the satisfaction of conditions to participation, including meeting certain performance requirements. Our inability to improve or maintain adequate quality scores and Star ratings to meet government performance requirements or to match the performance of our competitors could result in limitations to our participation in or exclusion from these or other government programs. Specifically, several of our Medicaid contracts require us to maintain a Medicare health plan. In April 2016, CMS issued final regulations that revised existing Medicaid managed care rules by establishing a minimum MLR standard for Medicaid of 85% and strengthening provisions related to network adequacy and access to care, enrollment and disenrollment protections, beneficiary support information, continued service during beneficiary appeals, and delivery system and payment reform initiatives, among others. CMS subsequently issued a Notice of Proposed Rulemaking on November 8, 2018, advancing CMS' efforts to streamline the Medicaid and CHIP managed care regulatory framework and to pursue a broader strategy to relieve regulatory burdens, support state flexibility and local leadership, and promote transparency, flexibility, and innovation in the delivery of care. On November 13, 2020, CMS finalized revisions to the Medicaid managed care regulations, many of which became effective in December 2020. While not a wholesale revision of the 2016 regulations, the November 2020 final rule adopts changes in areas including network adequacy, beneficiary protections, quality oversight, and the establishment of capitation rates and payment policies. Although we strive to comply with all existing regulations and to meet performance standards applicable to our business, failure to meet these requirements could result in financial fines and penalties. Also, states or other governmental entities may not allow us to continue to participate in their government programs, or we may fail to win procurements to participate in such programs, either of which could materially and adversely affect our results of operations, financial position and cash flows. In addition, as a result of the expansion of our businesses and operations conducted in foreign countries, we face political, economic, legal, compliance, regulatory, operational and other risks and exposures that are unique and vary by jurisdiction. These foreign regulatory requirements with respect to, among other items, environmental, tax, licensing, intellectual property, privacy, data protection, investment, capital, management control, labor relations, and fraud and corruption regulations are different than those faced by our domestic businesses. In addition, we are subject to U.S. laws that regulate the conduct and activities of U.S.-based businesses operating abroad, such as the Foreign Corrupt Practices Act (FCPA). Any failure to comply with laws and regulations governing our conduct outside the United States or to successfully navigate international regulatory regimes that apply to us could adversely affect our ability to market our products and services, which may have a material adverse effect on our business, financial condition and results of operations.Our businesses providing pharmacy benefit management and specialty pharmacy services face regulatory and other risks and uncertainties which could materially and adversely affect our results of operations, financial position and cash flows.We provide pharmacy benefit management (PBM) and specialty pharmacy services, including through our Envolve Pharmacy Solutions product. These businesses are subject to federal and state laws that, among other requirements, govern the relationships of the business with pharmaceutical manufacturers, physicians, pharmacies, customers and consumers. We also conduct business as a mail order pharmacy and specialty pharmacy, which subjects these businesses to extensive federal, state and local laws and regulations. In addition, federal and state legislatures and regulators regularly consider new regulations for the industry that could materially and adversely affect current industry practices, including the receipt or disclosure of rebates from pharmaceutical companies, the development and use of formularies, and the use of average wholesale prices. Our PBM and specialty pharmacy businesses would be materially and adversely affected by an inability to contract on favorable terms with pharmaceutical manufacturers and other suppliers, including with respect to the structuring of rebates and pricing of new specialty and generic drugs. In addition, our PBM and specialty pharmacy businesses could face potential claims in connection with purported errors by our mail order or specialty pharmacies, including in connection with the risks inherent in 32Table of Contentsthe authorization, compounding, packaging and distribution of pharmaceuticals and other healthcare products. Disruptions at any of our mail order or specialty pharmacies due to an event that is beyond our control could affect our ability to process and dispense prescriptions in a timely manner and could materially and adversely affect our results of operations, financial position and cash flows.From time to time, we may become involved in costly and time-consuming litigation and other regulatory proceedings, which require significant attention from our management. From time to time, we are a defendant in lawsuits and regulatory actions and are subject to investigations relating to our business, including, without limitation, medical malpractice claims, claims by members alleging failure to pay for or provide healthcare, claims related to non-payment or insufficient payments for out-of-network services, claims alleging bad faith, investigations regarding our submission of risk adjuster claims, putative securities class actions, protests and appeals related to Medicaid procurement awards, employment-related disputes, including wage and hour claims, submissions to state agencies related to payments or state false claims acts and claims related to the imposition of new taxes, including but not limited to claims that may have retroactive application. Due to the inherent uncertainties of litigation and regulatory proceedings, we cannot accurately predict the ultimate outcome of any such proceedings. An unfavorable outcome could have a material adverse impact on our business and financial position, results of operations and/or cash flows and may affect our reputation. In addition, regardless of the outcome of any litigation or regulatory proceedings, such proceedings are costly and time consuming and require significant attention from our management, and could therefore harm our business and financial position, results of operations or cash flows.If we fail to comply with applicable privacy, security, and data laws, regulations and standards, including with respect to third-party service providers that utilize sensitive personal information on our behalf, our business, reputation, results of operations, financial position and cash flows could be materially and adversely affected. As part of our normal operations, we collect, process and retain confidential member information. We are subject to various federal, state and international laws, regulations, rules and contractual requirements regarding the use and disclosure of confidential member information, including the Health Insurance Portability and Accountability Act of 1996 (HIPAA), the Health Information Technology for Economic and Clinical Health (HITECH) Act of 2009, the Gramm-Leach-Bliley Act, and the European Union's General Data Protection Regulation, which require us to protect the privacy of medical records and safeguard personal health information we maintain and use. Certain of our businesses are also subject to the Payment Card Industry Data Security Standard, which is a multifaceted security standard that is designed to protect credit card account data as mandated by payment card industry entities. Despite our best attempts to maintain adherence to information privacy and security best practices, as well as compliance with applicable laws, rules and contractual requirements, our facilities and systems, and those of our third-party service providers, may be vulnerable to privacy or security breaches, acts of vandalism or theft, malware or other forms of cyber-attack, misplaced or lost data including paper or electronic media, programming and/or human errors or other similar events. In the past, we have had data breaches resulting in disclosure of confidential or protected health information that have not resulted in any material financial loss or penalty to date. For example, in January 2021, we learned that Accellion, a third-party data transfer provider with whom we contract, had a system vulnerability that resulted in unauthorized access to certain sensitive data of our customers, including protected health information, over a period of several days in January 2021 as well as unauthorized access to the data of several of Accellion’s other clients. This incident is still under investigation, but we currently do not believe that it will have a material adverse effect on our business, reputation, results of operations, financial position and cash flows. However, there can be no assurance that the January 2021 incident and other privacy or security breaches will not require us to expend significant resources to remediate any damage, interrupt our operations and damage our business or reputation, subject us to state, federal, or international agency review, and result in enforcement actions, material fines and penalties, litigation or other actions which could have a material adverse effect on our business, reputation, results of operations, financial position and cash flows. In addition, HIPAA broadened the scope of fraud, waste and abuse laws applicable to healthcare companies and established enforcement mechanisms to combat fraud, waste and abuse, including civil and, in some instances, criminal penalties for failure to comply with specific standards relating to the privacy, security and electronic transmission of protected health information. The HITECH Act expanded the scope of these provisions by mandating individual notification in instances of breaches of protected health information, providing enhanced penalties for HIPAA violations, and granting enforcement authority to states' Attorneys General in addition to the HHS Office for Civil Rights. It is possible that Congress may enact additional legislation in the future to increase the amount or application of penalties and to create a private right of action under HIPAA, which could entitle patients to seek monetary damages for violations of the privacy rules.33Table of ContentsIf we fail to comply with the extensive federal and state fraud, waste and abuse laws, our business, reputation, results of operations, financial position and cash flows could be materially and adversely affected.We, along with other companies involved in public healthcare programs, are the subject of federal and state fraud, waste and abuse investigations. The regulations and contractual requirements applicable to participants in these public sector programs are complex and subject to change. Violations of fraud, waste and abuse laws applicable to us could result in civil monetary penalties, criminal fines and imprisonment, and/or exclusion from participation in Medicaid, Medicare, TRICARE, and other federal healthcare programs and federally funded state health programs. Fraud, waste and abuse prohibitions encompass a wide range of activities, including kickbacks for referral of members, incorrect and unsubstantiated billing or billing for unnecessary medical services, improper marketing and violations of patient privacy rights. These fraud, waste and abuse laws include the federal False Claims Act, which prohibits the known filing of a false claim or the known use of false statements to obtain payment from the federal government, and the federal anti-kickback statute, which prohibits the payment or receipt of remuneration to induce referrals or recommendations of healthcare items or services. Many states have fraud, waste and abuse laws, including false claim act and anti-kickback statutes that closely resemble the federal False Claims Act and the federal anti-kickback statute. In addition, the Deficit Reduction Act of 2005 encouraged states to enact state-versions of the federal False Claims Act that establish liability to the state for false and fraudulent Medicaid claims and that provide for, among other things, claims to be filed by qui tam relators (private parties acting on the government's behalf). Federal and state governments have made investigating and prosecuting healthcare fraud, waste and abuse a priority. In the event we fail to comply with the extensive federal and state fraud, waste and abuse laws, our business, reputation, results of operations, financial position and cash flows could be materially and adversely affected.Risks Relating to Conditions in the Financial Markets and EconomyOur investment portfolio may suffer losses which could materially and adversely affect our results of operations or liquidity. We maintain a significant investment portfolio of cash equivalents and short-term and long-term investments in a variety of securities, which are subject to general credit, liquidity, market and interest rate risks and will decline in value if interest rates increase or one of the issuers' credit ratings is reduced. Furthermore, COVID-19 has impacted, and may continue to impact, the global economy resulting in significant market volatility and fluctuating interest rates. As a result, we may experience a reduction in value or loss of our investments, which may have a negative adverse effect on our results of operations, liquidity and financial condition.Adverse credit market conditions may have a material adverse effect on our liquidity or our ability to obtain credit on acceptable terms. In the past, the securities and credit markets have experienced extreme volatility and disruption, which has increased due to the effects of COVID-19. The availability of credit, from virtually all types of lenders, has at times been restricted. In the event we need access to additional capital to pay our operating expenses, fund subsidiary surplus requirements, make payments on or refinance our indebtedness, pay capital expenditures, or fund acquisitions, our ability to obtain such capital may be limited and the cost of any such capital may be significant, particularly if we are unable to access our existing credit facility. Our access to additional financing will depend on a variety of factors such as prevailing economic and credit market conditions, the general availability of credit, the overall availability of credit to our industry, our credit ratings and credit capacity, and perceptions of our financial prospects. Similarly, our access to funds may be impaired if regulatory authorities or rating agencies take negative actions against us. If one or any combination of these factors were to occur, our internal sources of liquidity may prove to be insufficient, and in such case, we may not be able to successfully obtain sufficient additional financing on favorable terms, within an acceptable time, or at all. We have substantial indebtedness outstanding and may incur additional indebtedness in the future. Such indebtedness could reduce our agility and may adversely affect our financial condition.As of December 31, 2020, we had consolidated indebtedness of $16,779 million. We intend to incur additional indebtedness to finance a portion of the consideration for the Magellan Acquisition, and we may further increase our indebtedness in the future.This may have the effect, among other things, of reducing our flexibility to respond to changing business and economic conditions and increasing borrowing costs. Among other things, our revolving credit facility and term loan facility (collectively, the Company Credit Facility) and the indentures governing our notes require us to comply with various covenants that impose restrictions on our operations, 34Table of Contentsincluding our ability to incur additional indebtedness, create liens, pay dividends, make certain investments or other restricted payments, sell or otherwise dispose of substantially all of our assets and engage in other activities. Our Company Credit Facility also requires us to comply with a maximum debt-to-EBITDA ratio and a minimum fixed charge coverage ratio. These restrictive covenants could limit our ability to pursue our business strategies. In addition, any failure by us to comply with these restrictive covenants could result in an event of default under our Credit Facility and, in some circumstances, under the indentures governing our notes, which, in any case, could have a material adverse effect on our financial condition.Changes in the method pursuant to which the LIBOR rates are determined and potential phasing out of LIBOR after 2021 may affect the value of the financial obligations to be held or issued by us that are linked to LIBOR or our results of operations or financial condition.As of December 31, 2020, borrowings under our Company Credit Facility bear interest based upon various reference rates, including LIBOR. On July 27, 2017, the Financial Conduct Authority (the authority that regulates LIBOR) announced that it intends to stop compelling banks to submit rates for the calculation of LIBOR after 2021. On November 30, 2020, ICE Benchmark Administration (IBA), the administrator of LIBOR, announced plans to consult on ceasing the publication of certain U.S. dollar LIBOR rates on December 31, 2021 and to extend the transition for other U.S. dollar LIBOR rates to June 2023. The U.S. Federal Reserve concurrently issued a statement advising banks to stop new U.S. dollar LIBOR issuances by the end of 2021. In light of these recent announcements, the future of LIBOR at this time is uncertain and any changes in the methods by which LIBOR is determined or regulatory activity related to the phasing out of LIBOR could cause LIBOR to perform differently than in the past or cease to exist. The U.S. Federal Reserve, in conjunction with the Alternative Reference Rates Committee, a steering committee comprised of large U.S. financial institutions, announced replacement of U.S. dollar LIBOR with a new index calculated by short-term repurchase agreements, backed by U.S. Treasury securities called the Secured Overnight Financing Rate (SOFR). The first publication of SOFR was released in April 2018. Whether or not SOFR attains market traction as a LIBOR replacement tool remains in question and the future of LIBOR at this time is uncertain. As a result, it is not possible to predict the effect of any changes, establishment of alternative references rates or other reforms to LIBOR that may be enacted in the U.K. or elsewhere. The elimination of LIBOR or any other changes or reforms to the determination or supervision of LIBOR could have an adverse impact on the market for or value of any LIBOR-linked securities, loans, and other financial obligations or extensions of credit held by or due to us or on our overall financial condition or results of operations.Risks Associated with Mergers, Acquisitions, and DivestituresMergers and acquisitions may not be accretive and may cause dilution to our earning per share, which may cause the market price of our common stock to decline.The market price of our common stock is generally subject to volatility, and there can be no assurances regarding the level or stability of our share price at any time. The market price of our common stock may decline as a result of acquisitions, including the Magellan Acquisition, if, among other things, we are unable to achieve the expected cost and revenue synergies or growth in earnings, the operational cost savings estimates in connection with the integration of acquired businesses with ours are not realized as rapidly or to the extent anticipated, the transaction costs related to the acquisitions and integrations are greater than expected or if any financing related to the acquisitions is on unfavorable terms. The market price also may decline if we do not achieve the perceived benefits of the acquisitions, including the Magellan Acquisition, as rapidly or to the extent anticipated by financial or industry analysts or if the effect of the acquisitions on our financial position, results of operations or cash flows is not consistent with the expectations of financial or industry analysts.We may be unable to successfully integrate our existing business with acquired businesses and realize the anticipated benefits of such acquisitions.The success of acquisitions we make, including the Magellan Acquisition, will depend, in part, on our ability to successfully combine the existing business of Centene with such acquired businesses and realize the anticipated benefits, including synergies, cost savings, growth in earnings, innovation and operational efficiencies, from the combinations. If we are unable to achieve these objectives within the anticipated time frame, or at all, the anticipated benefits may not be realized fully or at all, or may take longer to realize than expected and the value of our common stock may be harmed.The integration of acquired businesses, including Magellan Health, with our existing business is a complex, costly and time-consuming process. The integration may result in material challenges, including, without limitation:•the diversion of management's attention from ongoing business concerns and performance shortfalls as a result of the devotion of management's attention to the integration;•managing a larger company;35Table of Contents•maintaining employee morale and retaining key management and other employees;•the possibility of faulty assumptions underlying expectations regarding the integration process;•retaining existing business and operational relationships and attracting new business and operational relationships;•consolidating corporate and administrative infrastructures and eliminating duplicative operations;•coordinating geographically separate organizations;•unanticipated issues in integrating information technology, communications and other systems;•unanticipated changes in federal or state laws or regulations, including the ACA and any regulations enacted thereunder;•unforeseen expenses or delays associated with the acquisition and/or integration; •achieving actual cost savings at the anticipated levels; and •decreases in premiums paid under government sponsored healthcare programs by any state in which we operate.Many of these factors will be outside of our control and any one of them could result in delays, increased costs, decreases in the amount of expected revenues and diversion of management's time and energy, which could materially affect our financial position, results of operations and cash flows. Our ability to successfully manage the expanded business following any given acquisition, including the Magellan Acquisition, will depend, in part, upon management's ability to design and implement strategic initiatives that address not only the integration of two independent stand-alone companies, but also the increased scale and scope of the combined business with its associated increased costs and complexity. There can be no assurances that we will be successful in managing our expanded operations as a result of acquisitions or that we will realize the expected growth in earnings, operating efficiencies, cost savings and other benefits.The financing arrangements that we entered into in connection with the WellCare Acquisition may, under certain circumstances, contain restrictions and limitations that could significantly impact our ability to operate our business.We incurred significant new indebtedness in connection with the WellCare Acquisition. Certain of the agreements governing the indebtedness that we incurred in connection with the WellCare Acquisition contains covenants that, among other things, may, under certain circumstances, place limitations on the dollar amounts paid or other actions relating to:•payments in respect of, or redemptions or acquisitions of, debt or equity issued by us or our subsidiaries, including the payment of dividends on our common stock;•incurring additional indebtedness;•incurring guarantee obligations;•paying dividends;•creating liens on assets;•entering into sale and leaseback transactions;•making investments, loans or advances;•entering into hedging transactions;•engaging in mergers, consolidations or sales of all or substantially all of their respective assets; and•engaging in certain transactions with affiliates. In addition, we are required to maintain a minimum amount of excess availability as set forth in these agreements.Our ability to maintain minimum excess availability in future periods will depend on our ongoing financial and operating performance, which in turn will be subject to economic conditions and to financial, market and competitive factors, many of which are beyond our control. The ability to comply with this covenant in future periods will also depend on our ability to successfully implement its overall business strategy and realize the anticipated benefits of the WellCare Acquisition, including synergies, cost savings, innovation and operational efficiencies.Various risks, uncertainties and events beyond our control could affect our ability to comply with the covenants contained in our financing agreements. Failure to comply with any of the covenants in our existing or future financing agreements could result in a default under those agreements and under other agreements containing cross-default provisions. A default would permit lenders to accelerate the maturity of the debt under these agreements and to foreclose upon any collateral securing the debt. Under these circumstances, we might not have sufficient funds or other resources to satisfy all of its obligations. In addition, the limitations imposed by financing agreements on our ability to incur additional debt and to take other actions might significantly impair its ability to obtain other financing.36Table of ContentsAdditional Risks Associated with the Magellan AcquisitionThe merger with Magellan Health is subject to conditions, some or all of which may not be satisfied, or completed on a timely basis, if at all. Failure to complete the merger with Magellan Health could have adverse effects on our business.The completion of the merger is subject to a number of conditions, including, among others, the receipt of U.S. federal antitrust clearance and certain other required state regulatory approvals, which make the completion of the Magellan Acquisition and timing thereof uncertain. Also, either we or Magellan Health may terminate the merger agreement (Merger Agreement) if the Magellan Acquisition is not consummated by October 4, 2021 (subject to an automatic extension to January 4, 2022 in certain circumstances), except that this right to terminate the Merger Agreement will not be available to any party whose failure to perform, in any material respect, any obligation under the Merger Agreement has been the proximate cause of the failure of the merger to be consummated on or before that date.If the Magellan Acquisition is not completed, our ongoing business may be adversely affected and, without realizing any of the benefits that we could have realized had the Magellan Acquisition been completed, we will be subject to a number of risks, including the following:•the market price of our common stock could decline;•inability to secure financing; •if the Merger Agreement is terminated and our board of directors (Board) seeks another business combination, our stockholders cannot be certain that we will be able to find a party willing to enter into any transaction on terms equivalent to or more attractive than the terms that we and Magellan Health have agreed to in the Merger Agreement;•time and resources committed by our management to matters relating to the Magellan Acquisition could otherwise have been devoted to pursuing other beneficial opportunities;•we may experience negative reactions from the financial markets or from our customers or employees; and•we will be required to pay our costs relating to the Magellan Acquisition, such as legal, accounting, financial advisory and printing fees, whether or not the Magellan Acquisition is completed.In addition, if the Magellan Acquisition is not completed, we could be subject to litigation related to any failure to complete the Magellan Acquisition or related to any enforcement proceeding commenced against us to perform our obligations under the Merger Agreement. If any such risk materializes, it could adversely impact our ongoing business.Similarly, delays in the completion of the Magellan Acquisition could, among other things, result in additional transaction costs, loss of revenue or other negative effects associated with uncertainty about completion of the Magellan Acquisition and cause us not to realize some or all of the benefits that we expect to achieve if the Magellan Acquisition is successfully completed within its expected timeframe. We cannot assure you that the conditions to the closing of the Magellan Acquisition will be satisfied or waived or that the Magellan Acquisition will be consummated.Centene and Magellan Health may be targets of securities class action and derivative lawsuits that could result in substantial costs and may delay or prevent the Magellan Acquisition from being completed.Securities class action lawsuits and derivative lawsuits are often brought against public companies that have entered into merger agreements. Even if the lawsuits are without merit, defending against these claims can result in substantial costs and divert management time and resources. An adverse judgment could result in monetary damages, which could have a negative impact on Centene’s and Magellan Health’s respective liquidity and financial condition. Additionally, if a plaintiff is successful in obtaining an injunction prohibiting completion of the Magellan Acquisition, then that injunction may delay or prevent the Magellan Acquisition from being completed, or from being completed within the expected timeframe, which may adversely affect Centene’s business, financial position and results of operation. Currently, Centene is not aware of any securities class action lawsuits or derivative lawsuits having been filed in connection with the Magellan Acquisition.Completion of the Magellan Acquisition may trigger change in control or other provisions in certain agreements to which Magellan Health or its subsidiaries are a party, which may have an adverse impact on the combined company’s business and results of operations.The completion of the Magellan Acquisition may trigger change in control and other provisions in certain agreements to which Magellan Health or its subsidiaries are a party. If we and Magellan Health are unable to negotiate waivers of those provisions, the counterparties may exercise their rights and remedies under the agreements, potentially terminating the agreements or seeking monetary damages. Even if we and Magellan Health are able to negotiate waivers, the counterparties may require a fee 37Table of Contentsfor such waivers or seek to renegotiate the agreements on terms less favorable to Magellan Health or the combined company. Any of the foregoing or similar developments may have an adverse impact on the combined company’s business and results of operations.General Risk FactorsWe may be unable to attract, retain or effectively manage the succession of key personnel. We are highly dependent on our ability to attract and retain qualified personnel to operate and expand our business. We may be adversely impacted if we are unable to adequately plan for the succession of our executives and senior management. While we have succession plans in place for members of our executive and senior management team, these plans do not guarantee that the services of our executive and senior management team will continue to be available to us. Our ability to replace any departed members of our executive and senior management team or other key employees may be difficult and may take an extended period of time because of the limited number of individuals in the Managed Care and Specialty Services industry with the breadth of skills and experience required to operate and successfully expand a business such as ours. Competition to hire from this limited pool is intense, and we may be unable to hire, train, retain or motivate these personnel. If we are unable to attract, retain and effectively manage the succession plans for key personnel, executives and senior management, our business and financial position, results of operations or cash flows could be harmed. Future issuances and sales of additional shares of preferred or common stock could reduce the market price of our shares of common stock.We may, from time to time, issue additional securities to raise capital or in connection with acquisitions. We often acquire interests in other companies by using a combination of cash and our common stock or just our common stock. Further, shares of preferred stock may be issued from time to time in one or more series as our Board of Directors may from time to time determine each such series to be distinctively designated. The issuance of any such preferred stock could materially adversely affect the rights of holders of our common stock. Any of these events may dilute your ownership interest in our company and have an adverse impact on the price of our common stock.Item 1B. Unresolved Staff CommentsNone.Item 2. PropertiesWe own our corporate office headquarters buildings and land located in St. Louis, Missouri, which is used by each of our reportable segments. We generally lease space in the states where our health plans, specialty companies and claims processing facilities operate. We are required by various insurance and regulatory authorities to have offices in the service areas where we provide benefits. We believe our current facilities and expansion plans are adequate to meet our operational needs for the foreseeable future. Item 3. Legal ProceedingsA description of the legal proceedings to which we and our subsidiaries are a party is contained in Note 18. Contingencies to the consolidated financial statements included in Part II of this Annual Report on Form 10-K, and is incorporated herein by reference. Item 4. Mine Safety DisclosuresNot applicable.38Table of ContentsPART IIItem 5. Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities Market for Common Stock Our common stock has been traded and quoted on the New York Stock Exchange under the symbol "CNC" since October 16, 2003. The high and low prices, as reported by the NYSE, are set forth below for the periods indicated. 2021 Stock Price (through February 19, 2021)2020 Stock Price2019 Stock Price HighLowHighLowHighLowFirst Quarter$70.26 $57.71 $68.64 $43.96 $69.25 $49.56 Second Quarter74.70 53.83 58.25 45.44 Third Quarter68.45 53.60 54.89 42.77 Fourth Quarter72.31 57.56 63.79 41.62 As of February 19, 2021, there were 1,120 holders of record of our common stock. Issuer Purchases of Equity Securities In 2009, our Board of Directors extended our stock repurchase program. The initial program authorized the repurchase of up to 6.7 million shares of our common stock from time to time on the open market or through privately negotiated transactions. In October 2019, our Board of Directors approved a $500 million increase to our Company's stock repurchase program, based on the stock price at the close of the WellCare Acquisition. During the first quarter of 2020, we used proceeds from divestitures to repurchase 8.7 million shares of Centene common stock for $500 million through our stock repurchase program. We have approximately 5.5 million available shares remaining under the program for repurchases as of December 31, 2020. In February 2021, our Board of Directors approved an increase in the Company's existing share repurchase program for its common stock. With the increase, the Company is authorized to repurchase up to $1.0 billion of shares of the Company's common stock, inclusive of the previously approved stock repurchase program. No duration has been placed on the repurchase program. We reserve the right to discontinue the repurchase program at any time.Issuer Purchases of Equity SecuritiesFourth Quarter 2020(shares in thousands)Period Total Number ofSharesPurchased(1)Average PricePaid perShareTotal Numberof SharesPurchased asPart of PubliclyAnnounced Plansor ProgramsMaximumNumber of Sharesthat May Yet BePurchased Underthe Plans orPrograms(2)October 1 – October 31, 20203$65.26 — 5,488November 1 – November 30, 2020464.40 — 5,488December 1 – December 31, 202086761.04 — 5,488Total874$61.07 — 5,488(1) Shares acquired represent shares relinquished to the Company by certain employees for payment of taxes or option cost upon vesting of restricted stock units or option exercise.(2) Our Board of Directors adopted a stock repurchase program which allows for repurchases of up to 14,160 thousand shares. A remaining amount of 5,488 thousand shares are available under the program. No duration has been placed on the repurchase program.39Table of ContentsStock Performance Graph The graph below compares the cumulative total stockholder return on our common stock for the period from December 31, 2015 to December 31, 2020 with the cumulative total return of the New York Stock Exchange Composite Index, the Standard & Poor's Supercomposite Managed Healthcare Index and the Standard & Poor's 500 over the same period. Standard & Poor's 500 is included because our common stock is within the index. The graph assumes an investment of $100 on December 31, 2015 in our common stock (at the last reported sale price on such day), the New York Stock Exchange Composite Index, the Standard & Poor's Supercomposite Managed Healthcare Index, and the Standard & Poor's 500 and assumes the reinvestment of any dividends. December 31,201520162017201820192020Centene Corporation$100.00 $85.87 $153.31 $175.23 $191.09 $182.46 New York Stock Exchange Composite Index100.00 109.01 126.28 112.14 137.16 143.19 S&P Supercomposite Managed Healthcare Index100.00 118.21 168.16 185.45 220.03 252.75 S&P 500100.00 109.54 130.81 122.65 158.07 183.77 Centene Corporation closing stock price$32.90 $28.25 $50.44 $57.65 $62.87 $60.03 Centene Corporation annual stockholder return26.7 %(14.1)%78.5 %14.3 %9.1 %(4.5)%In accordance with the rules of the SEC, the information contained in the Stock Performance Graph on this page shall not be deemed to be "soliciting material," or to be "filed" with the SEC or subject to the SEC's Regulation 14A, or to the liabilities of Section 18 of the Exchange Act, except to the extent that Centene specifically requests that the information be treated as soliciting material or specifically incorporates it by reference into a document filed under the Securities Act, or the Exchange Act. 40Table of ContentsItem 6. Removed and reserved.41Table of ContentsITEM 7. Management's Discussion and Analysis of Financial Condition and Results of OperationsThe following discussion of our financial condition and results of operations should be read in conjunction with our consolidated financial statements and the related notes included elsewhere in this filing. The discussion contains forward-looking statements that involve known and unknown risks and uncertainties, including those set forth under Part I, Item 1A."Risk Factors" of this Form 10-K. The following discussion and analysis does not include certain items related to the year ended December 31, 2018, including year-to-year comparisons between the year ended December 31, 2019 and the year ended December 31, 2018. For a comparison of our results of operations for the fiscal years ended December 31, 2019 and December 31, 2018, see Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations of our Annual Report on Form 10-K for the year ended December 31, 2019, filed with the SEC on February 18, 2020.EXECUTIVE OVERVIEWGeneral We are a leading multi-national healthcare enterprise that is committed to helping people live healthier lives. We take a local approach - with local brands and local teams - to provide fully integrated, high-quality, and cost-effective services to government-sponsored and commercial healthcare programs, focusing on under-insured and uninsured individuals.Results of operations depend on our ability to manage expenses associated with health benefits (including estimated costs incurred) and selling, general and administrative (SG&A) costs. We measure operating performance based upon two key ratios. The health benefits ratio (HBR) represents medical costs as a percentage of premium revenues, excluding premium tax and health insurer fee revenues that are separately billed, and reflects the direct relationship between the premiums received and the medical services provided. The SG&A expense ratio represents SG&A costs as a percentage of premium and service revenues, excluding premium tax and health insurer fee revenues that are separately billed.Our insurance subsidiaries are subject to the Affordable Care Act annual health insurer fee (HIF), absent a HIF moratorium or repeal. We recognize revenue for reimbursement of the HIF, including the "gross-up" to reflect the non-deductibility of the HIF. Collectively, this revenue is recorded as premium tax and health insurer fee revenue in the Consolidated Statements of Operations. For certain products, premium taxes, state assessments and the HIF are not pass-through payments and are recorded as premium revenue and premium tax expense or health insurer fee expense in the Consolidated Statements of Operations. A moratorium suspended the HIF for the 2019 calendar year. Due to the size of the health insurer fee, one of the primary drivers of the year-over-year variances discussed throughout this section is related to the reinstatement of the HIF in 2020. The HIF has been repealed beginning in 2021.WellCare AcquisitionOn January 23, 2020, we acquired all of the issued and outstanding shares of WellCare Health Plans, Inc. (WellCare) (the WellCare Acquisition). The transaction was valued at $19.6 billion, including the assumption of $1.95 billion of outstanding debt. The WellCare Acquisition brought a high-quality Medicare platform and further extended our robust Medicaid offerings. The combination enables us to provide access to more comprehensive and differentiated solutions across more markets with a continued focus on affordable, high-quality, culturally-sensitive healthcare services.Due to the size of the acquisition, one of the primary drivers of the year-over-year variances discussed throughout this section is related to the acquisition of WellCare.Magellan AcquisitionIn January 2021, we announced that we entered into a definitive merger agreement under which we will acquire Magellan Health for $95.00 per share in cash for a total enterprise value of approximately $2.2 billion. The transaction will broaden and deepen our whole health capabilities and establish a leading behavioral health platform. The transaction is subject to clearance under the Hart-Scott Rodino Act, receipt of required state regulatory approvals, the approval of the definitive merger agreement by Magellan Health's stockholders and other customary closing conditions. The transaction is not contingent upon financing. We intend to fund the acquisition primarily through debt financing. The transaction is expected to close in the second half of 2021.AcquisitionsWe continued to execute on our growth strategy through acquisitions during 2020. In the fourth quarter of 2020, we acquired PANTHERx and Apixio. PANTHERx is one of the largest and fastest-growing specialty pharmacies in the United States 42Table of Contentsspecializing in orphan drugs and treating rare diseases. PANTHERx and its management team will continue to operate independently as part of our Envolve Pharmacy Solutions business unit, a total drug management program that includes integrated PBM services and specialty pharmacy solutions to millions of members throughout the United States. Apixio is a healthcare analytics company offering artificial intelligence technology solutions. With this transaction, we will continue to digitize the administration of healthcare and accelerate innovation and modernization across the enterprise. Apixio will remain an operationally independent entity as part of our Health Care Enterprises group to continue bringing value to its clients and the industry, while also realizing the benefits of enhanced scale. COVID-19 Trends and UncertaintiesThe COVID-19 outbreak has created unique and unprecedented challenges. To support our members, providers, employees and the communities we serve, we have taken several actions and made numerous investments related to the COVID-19 crisis. We have extended coverage of COVID-19 screening, testing and treatment services for Medicaid, Medicare and Marketplace members and are waiving all associated member cost share amounts. We are delivering new critical support to Safety Net providers, including Federally Qualified Healthcare Centers (FQHCs), behavioral health providers, and long-term service and support organizations. We continue to address social determinants of health for vulnerable populations during the COVID-19 crisis with a commitment to research and investment in non-medical barriers to achieving quality health outcomes. We developed initiatives designed to support the disability community affected by the pandemic. We created a provider support program to assist our network providers who are seeking benefits from the Small Business Administration (SBA) through the CARES Act. We established a Medical Reserve Leave policy to support clinical employees who want to join a medical reserve force and serve their communities during the COVID-19 pandemic. We are providing additional employee benefits including waiving cost-sharing for COVID-19 related treatment, emergency paid sick leave, and one-time payments to employees in a small number of critical office functions.We have taken significant steps to support our employees to protect their health and safety, while also ensuring that our business can continue to operate and that services continue without disruption. We have implemented our business continuity plans and have taken actions to support our workforce. We have transitioned the vast majority of our employees to work from home, allowing Centene to continue to operate at close to full capacity, while continuing to maintain our internal control framework. As a result, we have experienced and expect continued incremental costs due to investments and actions we have already taken and continued efforts to protect our members, employees and communities we serve. The impact on our business in both the short-term and long-term is uncertain. The outlook for 2021 depends on future developments, including but not limited to: the length and severity of the outbreak (including new strains, which may be more contagious, more severe or less responsive to treatment or vaccines), the effectiveness of containment actions, and the timing around the development of treatments and distribution of vaccinations. The pandemic and these future developments have impacted and will continue to affect our membership and medical utilization. From March 31, 2020 through December 31, 2020, our Medicaid membership has increased by 1.7 million members. The pandemic also has the potential to impact the administration of state and federal healthcare programs, premium rates and risk sharing mechanisms. We continue to have active dialogues with our state partners.Medical utilization continues to normalize as elective procedures and other non-emergent care resume, consistent with our expectations. We have experienced and continue to expect incremental COVID-19 costs as the outbreak continues to spread. In addition, the pandemic has widespread economic impact, driving interest rate decreases and lowering our investment income. The impact of all these items slightly benefited our 2020 results. We are confident we have the team, systems, expertise and financial strength to continue to effectively navigate this challenging pandemic landscape. Regulatory Trends and Uncertainties The United States government, politicians, and healthcare experts continue to discuss and debate various elements of the United States healthcare model. We remain focused on the promise of delivering access to high quality, affordable healthcare to all of our members and believe we are well positioned to meet the needs of the changing healthcare landscape. We have more than three decades of experience, spanning seven presidents from both sides of the aisle, in delivering high-quality healthcare services on behalf of states and the federal government to under-insured and uninsured families, commercial organizations and military families. This expertise has allowed us to deliver cost effective services to our government sponsors and our members. While healthcare experts maintain focus on personalized healthcare technology, we continue to make strategic decisions to accelerate development of new software platforms and analytical capabilities. We continue to believe we have both the capacity and capability to successfully navigate industry changes to the benefit of our members, customers and shareholders. 43Table of ContentsFor additional information regarding regulatory trends and uncertainties, see Part I, Item 1 "Business - Regulation" and Item 1A, "Risk Factors."2020 HighlightsOur financial performance for 2020 is summarized as follows:•Year-end managed care membership of 25.5 million, an increase of 10.3 million members, or 67% over 2019.•Total revenues of $111.1 billion, representing 49% growth year-over-year.•HBR of 86.2% for 2020, compared to 87.3% for 2019.•SG&A expense ratio of 9.5% for 2020, compared to 9.3% for 2019. •Adjusted SG&A expense ratio of 8.9% for 2020, compared to 9.2% for 2019. •Diluted EPS of $3.12 for 2020, compared to $3.14 for 2019.•Adjusted Diluted EPS of $5.00 for 2020, compared to $4.42 for 2019.•Operating cash flows of $5.5 billion, or 3.1 times net earnings, for 2020.A reconciliation from GAAP diluted EPS to Adjusted Diluted EPS is highlighted below, and additional detail is provided under the heading "Non-GAAP Financial Presentation": Year Ended December 31,20202019GAAP diluted EPS attributable to Centene$3.12 $3.14 Amortization of acquired intangible assets 0.95 0.47 Acquisition related expenses 0.86 0.19 Other adjustments (1)0.07 0.62 Adjusted Diluted EPS$5.00 $4.42 (1) Other adjustments include the following items: •2020 - gain related to the divestiture of certain products of our Illinois health plan of $104 million, or $0.10 per diluted share, net of an income tax expense of $0.08; (b) non-cash impairment of our third-party care management software business of $72 million, or $0.10 per diluted share, net of an income tax benefit of $0.02; and (c) debt extinguishment costs of $61 million, or $0.07 per diluted share, net of an income tax benefit of $0.04; and•2019 - non-cash goodwill and intangible asset impairment of $271 million or $0.57 per diluted share, net of an income tax benefit of $0.08 and debt extinguishment costs of $30 million or $0.05 per diluted share, net of an income tax benefit of $0.02.The following items contributed to our revenue and membership growth in 2020:•Arkansas. In March 2019, our Arkansas subsidiary, Arkansas Total Care, assumed full-risk on a Medicaid special needs population comprised of people with high behavioral health needs and individuals with developmental/intellectual disabilities. •Correctional. In July 2020, Centurion commenced a two-year contract with the Kansas Department of Administration to provide healthcare services in the Department of Corrections’ facilities. In April 2020, Centurion began providing medical services, behavioral healthcare, and substance abuse treatment within four prisons and six community corrections centers across the state of Delaware. In July 2019, Centurion began operating under a contract to provide comprehensive healthcare services to inmates housed in Arizona's state prison system, and also began operating under a re-awarded contract to continue the provision of mental and dental health services to the Georgia Department of 44Table of ContentsCorrection's state prison facilities. In February 2019, Centurion began operating under a new contract to provide comprehensive healthcare services to detainees of the Metropolitan Detention Center located in Albuquerque, New Mexico.•Florida. In December 2018, our Florida subsidiary, Sunshine Health, began providing physical and behavioral healthcare services through Florida's Statewide Medicaid Managed Care Program under its new five year contract which was implemented for all 11 regions by February 2019.•Health Insurance Marketplace. In January 2020, we expanded our offerings in the 2020 Health Insurance Marketplace in ten existing markets: Arizona, Florida, Georgia, Kansas, North Carolina, Ohio, South Carolina, Tennessee, Texas, and Washington. •HealthSmart. In May 2019, we acquired HealthSmart, a third party administrator providing customizable and scalable health plan solutions for self-funded employers, universities and colleges, and Native American Tribal Enterprises. Services include plan administration, care management and wellness programs, network, casualty claim, and pharmacy benefit solutions.•Illinois. In July 2020, our Illinois subsidiary, Meridian Health Plan of Illinois, Inc. (Meridian), began serving Medicaid members in Cook County, Illinois, as a result of a Member Transfer Agreement under which Meridian was assigned 100% of NextLevel Health Partners, Inc.’s approximately 54,000 members who access benefits from the Illinois Department of Healthcare and Family Services’ HealthChoice Illinois Program. In February 2020, we began operating in Illinois under an expanded contract for the Medicaid Managed Care Program. The expanded contract includes children who are in need through the Department of Children and Family Services/Youth Care by Illinois Department of Healthcare and Family Services and Foster Care.•Iowa. In July 2019, our Iowa subsidiary, Iowa Total Care, Inc., began operating under a new statewide contract for the IA Health Link Program.•Louisiana. In January 2020, our Louisiana subsidiary, Louisiana HealthCare Connections, began operating under an emergency contract extension in response to protested contract awards. Louisiana’s state procurement officer overturned the Louisiana Department of Health’s plan to award Medicaid contracts to four health plans, excluding our Louisiana subsidiary. According to the chief procurement officer, the state health department failed to follow state law or its own evaluation and bid guidelines in its award.•Medicare. In January 2020, we expanded our Medicare offerings. We entered Nevada and expanded our footprint in twelve existing markets: Arizona, Arkansas, California, Georgia, Kansas, Louisiana, Missouri, New Mexico, New York, Ohio, Pennsylvania, and Texas. •New Hampshire. In September 2019, our New Hampshire subsidiary, NH Healthy Families, began operating under a new five-year contract to continue to provide service to Medicaid enrollees statewide.•Pennsylvania. In January 2018, our Pennsylvania subsidiary, Pennsylvania Health and Wellness, began serving enrollees in the Community HealthChoices program as part of the statewide contract that was fully implemented in January 2020. •QualChoice. In April 2019, we completed the acquisition of QCA Health Plan, Inc. and QualChoice Life and Health Insurance Company, Inc. The acquisition expands our footprint in Arkansas by adding additional members primarily through commercial products.•Spain. In December 2019, our Spanish subsidiary, Ribera Salud, acquired 93% of Hospital Povisa, S.A., a private hospital in the Vigo region of Spain. In June 2019, Primero Salud, acquired additional ownership in Ribera Salud, increasing our ownership in the Spanish healthcare company from 50% to 90%.•Washington. In January 2019, our Washington State subsidiary, Coordinated Care of Washington, began providing managed care services to Apple Health’s Fully Integrated Managed Care beneficiaries in the Greater Columbia, King and Pierce Regions. This integration continued with the addition of the North Sound Region in July 2019.45Table of Contents•WellCare. On January 23, 2020, we completed the WellCare Acquisition. The WellCare Acquisition brought a high-quality Medicare platform and further extended our robust Medicaid offerings. The transaction was valued at $19.6 billion, including the assumption of $1.95 billion of outstanding debt.•In addition, revenue and membership growth was significantly driven by the suspension of eligibility redeterminations and increased unemployment levels as a result of the COVID-19 pandemic, as well as the reinstatement of the health insurer fee in 2020.The growth items listed above were partially offset by the following items:•Effective October 2020, we no longer serve members under the correctional contract in Mississippi.•In September 2020, our Oregon subsidiary, Trillium Community Health Plan, began operating under an expanded contract serving as a coordinated care organization for six counties in the state; however, an additional competitor was added to Lane County. As a result, our membership decreased.•Effective August 2020, we no longer serve members under the Military & Family Life Counseling Program contract.•Effective July 2020, we no longer serve members under the state-wide correctional contract in Vermont.•In January 2020, in connection with the WellCare Acquisition, we completed the divestiture of certain products in our Illinois health plan, including the Medicaid and Medicare Advantage lines of business.•Effective December 2019, we no longer serve members under the state-wide correctional contract in New Mexico.•Beginning in January 2019, Health Net of Arizona, Inc. began discontinuing and non-renewing all of its Employer Group plans for small and large business groups in Arizona. The effective date of coverage termination for existing groups is dependent on remaining renewals; however, coverage is no longer provided to any group policyholders and/or members as of December 31, 2019.We expect the following items to contribute to our revenue or future growth potential: •We expect to realize the full year benefit in 2021 of acquisitions, investments, and business commenced during 2020, as discussed above.•In January 2021, Centene announced that its Oklahoma subsidiary, Oklahoma Complete Health, has been selected by the Oklahoma Health Care Authority (OHCA) for statewide contracts to provide managed care for the SoonerSelect and, on a sole source basis, SoonerSelect Specialty Children's Plan (SCP) (foster care) programs. The state expects to commence the SoonerSelect and SoonerSelect SCP Programs on October 1, 2021.•In January 2021, we began administering the Buckley Prime Service Area Pilot in the Denver, Colorado area, which is a TRICARE pilot program to value-based payment arrangements not currently an option in the fee-for-service T2017 reimbursement model. •In January 2021, we announced that we entered into a definitive merger agreement under which we will acquire Magellan Health for $95.00 per share in cash for a total enterprise value of approximately $2.2 billion. The transaction is subject to clearance under the Hart-Scott Rodino Act, receipt of required state regulatory approvals, the approval of the definitive merger agreement by Magellan Health's stockholders and other customary closing conditions. The transaction is expected to close in the second half of 2021.•In January 2021, we expanded our offerings in the Health Insurance Marketplace. We expanded our Marketplace product, branded Ambetter, in nearly 400 new counties across 13 existing states. In addition, Ambetter-branded Marketplace products is now offered in two new states, New Mexico and Michigan.•In December 2020, we acquired PANTHERx, one of the largest and fastest-growing specialty pharmacies in the United States specializing in orphan drugs and treating rare diseases.•In December 2020, we acquired Apixio Inc., a healthcare analytics company offering artificial intelligence technology solutions. With this transaction, we will continue to digitize the administration of healthcare and accelerate innovation 46Table of Contentsand modernization across the enterprise. •In October 2019, our North Carolina joint venture, Carolina Complete Health, was awarded an additional service area to provide Medicaid managed care services in Region 4. With the addition of this new Region, Carolina Complete Health will provide Medicaid managed care services in three contiguous regions: Region 3, 4 and 5. In February 2019, WellCare was awarded a statewide contract to administer the state’s Medicaid Prepaid Health Plans. The new contracts are expected to commence in mid-2021.The future growth items listed above are partially offset by the following items:•In October 2020, Centers for Medicare and Medicaid Services (CMS) published updated Medicare Star quality ratings for the 2021 rating year. Approximately 30% of our Medicare members are in a 4 star or above plan for the 2022 bonus year, compared to 46% for the 2021 bonus year. Our quality bonus and rebates may be negatively impacted in 2021 and 2022, if we are unable to utilize mitigation strategies.•Beginning in 2021, the health insurer fee has been repealed, which will result in a decrease in revenue.•We expect a decrease in our marketplace membership driven by a reduction in the state of Florida, resulting from price competition in three highly populated counties.•We expect Medicaid eligibility redeterminations to begin on May 1, 2021, resulting in a decrease in membership.MEMBERSHIPFrom December 31, 2019 to December 31, 2020, we increased our managed care membership by 10.3 million, or 67%. The following table sets forth our membership by line of business:December 31,20202019Traditional Medicaid (1)12,055,400 7,573,600 High Acuity Medicaid (2)1,554,700 1,110,000 Total Medicaid13,610,100 8,683,600 Commercial2,633,600 2,331,100 Medicare (3)955,400 359,600 Medicare PDP4,469,400 — International597,700 599,800 Correctional147,200 180,000 Total at-risk membership22,413,400 12,154,100 TRICARE eligibles2,877,900 2,860,700 Non-risk membership231,600 227,000 Total25,522,900 15,241,800 (1) Membership includes TANF, Medicaid Expansion, CHIP, Foster Care and Behavioral Health(2) Membership includes ABD, IDD, LTSS and MMP Duals(3) Membership includes Medicare Advantage and Medicare SupplementThe following table sets forth additional membership statistics, which are included in the membership information above:December 31,20202019Dual-eligible (4) 1,066,800 639,200 Health Insurance Marketplace2,131,600 1,805,200 Medicaid Expansion2,181,400 1,346,700 (4) Membership that is eligible for both Medicaid and Medicare benefits.47Table of ContentsFrom December 31, 2019 to December 31, 2020, our membership increased as a result of:•the WellCare Acquisition;•Medicaid membership growth related to the COVID-19 pandemic;•membership growth in our Health Insurance Marketplace business; and•expansions, new programs and growth in many of our states.48Table of ContentsRESULTS OF OPERATIONSThe following discussion and analysis is based on our Consolidated Statements of Operations, which reflect our results of operations for years ended December 31, 2020, and 2019, respectively, prepared in accordance with generally accepted accounting principles in the United States ($ in millions, except per share data in dollars): 20202019% Change 2019-2020Premium$100,055 $67,439 48 %Service3,745 2,925 28 %Premium and service revenues103,800 70,364 48 %Premium tax and health insurer fee7,315 4,275 71 %Total revenues111,115 74,639 49 %Medical costs86,264 58,862 47 %Cost of services3,303 2,465 34 %Selling, general and administrative expenses9,867 6,533 51 %Amortization of acquired intangible assets719 258 179 %Premium tax expense6,332 4,469 42 %Health insurer fee expense1,476 — n.m.Goodwill and intangible impairment72 271 (73)%Earnings from operations3,082 1,781 73 %Other income (expense):Investment and other income480 443 8 %Debt extinguishment costs(61)(30)(103)%Interest expense(728)(412)(77)%Earnings before income tax expense2,773 1,782 56 %Income tax expense979 473 107 %Net earnings1,794 1,309 37 %Loss attributable to noncontrolling interests14 12 17 %Net earnings attributable to Centene Corporation$1,808 $1,321 37 %Diluted earnings per common share attributable to Centene Corporation:$3.12 $3.14 (1)%n.m.: not meaningful49Table of ContentsYear Ended December 31, 2020 Compared to Year Ended December 31, 2019 Total RevenuesThe following table sets forth supplemental revenue information for the year ended December 31, ($ in millions):20202019% Change 2019-2020Medicaid$74,785 $51,831 44 %Commercial17,071 14,747 16 %Medicare (1)11,976 4,248 182 %Medicare PDP2,403 — n.m.Other4,880 3,813 28 %Total Revenues$111,115 $74,639 49 %(1) Medicare includes Medicare Advantage and Medicare Supplementn.m.: not meaningfulTotal revenues increased 49% in the year ended December 31, 2020, over the corresponding period in 2019, primarily due to the acquisition of WellCare, growth in the Medicaid and Health Insurance Marketplace businesses, and the reinstatement of the health insurer fee in 2020. Additionally, the net effect of the pandemic increased our revenues due to the suspension of Medicaid eligibility redeterminations. The increase was partially offset by the divestiture of our Illinois health plan. During the twelve months ended December 31, 2020, we received premium rate adjustments which yielded a net 1% composite increase across all of our markets.Operating ExpensesMedical CostsResults of operations depend on our ability to manage expenses associated with health benefits and to accurately estimate costs incurred. The HBR represents medical costs as a percentage of premium revenues, excluding premium tax and health insurer fee revenues that are separately billed, and reflects the direct relationship between the premiums received and the medical services provided. The HBR for the year ended December 31, 2020 was 86.2%, a decrease of 110 basis points over the comparable period in 2019. The HBR decrease was primarily attributable to lower medical utilization trends due to the COVID-19 pandemic, the ACA risk corridor receivable settlement and the reinstatement of the health insurer fee. The decrease was partially offset by performance in the Health Insurance Marketplace business, the implementation of retroactive state premium rate adjustments and risk sharing mechanisms, and higher testing and treatment costs associated with COVID-19.Cost of Services Cost of services increased by $838 million in the year ended December 31, 2020, compared to the corresponding period in 2019, primarily attributable to increased volume in our specialty pharmacy business, increased non-specialty pharmacy sales to our recently divested Illinois health plan, and growth from acquired businesses.The cost of service ratio for the year ended December 31, 2020 was 88.2%, compared to 84.3% in 2019. The increase in the cost of service ratio was driven by the results of lower revenue from the shared savings programs in our physician home health business and higher non-specialty pharmacy sales to our recently divested Illinois health plan, which carries a higher cost of service ratio.Selling, General & Administrative ExpensesSG&A increased by $3.3 billion in the year ended December 31, 2020, compared to the corresponding period in 2019. The SG&A increase was primarily due to the addition of the WellCare business, expansions, new programs and growth in many of our states in 2020, and $580 million of acquisition related expense in the year ended December 31, 2020. 50Table of ContentsThe SG&A expense ratio was 9.5% for the year ended December 31, 2020, compared to 9.3% for the year ended December 31, 2019. The 2020 SG&A expense ratio increased due to higher acquisition and integration related expenses primarily due to the WellCare acquisition, the $275 million charitable contribution to our foundation and enhanced growth and profitability initiatives for our Medicare and Health Insurance Marketplace businesses (both as a result of the one-time ACA risk corridor settlement). These items were partially offset by leveraging of expenses over higher revenues as a result of the WellCare acquisition.The Adjusted SG&A expense ratio was 8.9% for the year ended December 31, 2020, compared to 9.2% for the year ended December 31, 2019. The Adjusted SG&A expense ratio benefited from leveraging of expenses over higher revenues as a result of the WellCare acquisition, partially offset by the $275 million charitable contribution to our foundation and enhanced growth and profitability initiatives for our Medicare and Health Insurance Marketplace businesses.Health Insurer Fee ExpenseHealth insurer fee expense was $1.5 billion for the year ended December 31, 2020. As a result of the health insurer fee moratorium, which suspended the health insurance provider fee for the 2019 calendar year, we did not record health insurer fee expense for the year ended December 31, 2019.ImpairmentDuring the first quarter of 2020, we recorded $72 million, or $0.10 per diluted share, of non-cash impairment of our third-party care management software business. In 2019, we recorded $271 million, or $0.57 per diluted share, of non-cash goodwill and intangible asset impairment. Substantially all of the 2019 impairment is associated with our USMM physician home health business and was identified as part of our quarterly review procedures, which included an analysis of new information related to our shared savings programs, slower than expected penetration of the physician home health business model into our Medicaid population, and the related impact to revised forecasts.Other Income (Expense)The following table summarizes the components of other income (expense) for the year ended December 31, ($ in millions): 20202019Investment and other income$480 $443 Debt extinguishment costs(61)(30)Interest expense(728)(412)Other income (expense), net$(309)$1 Investment and other income. Investment and other income increased by $37 million for year ended December 31, 2020 compared to 2019. The increase in investment income in 2020 was due to a $104 million gain related to the divestiture of certain products of our Illinois health plan as part of the previously announced divestiture agreements associated with the WellCare Acquisition as well as overall higher investment balances, partially offset by lower interest rates.Debt extinguishment costs. In October 2020, we redeemed all of the $1.0 billion 4.75% Senior Notes due 2022 (the 2022 Notes) and the $1.2 billion 5.25% Senior Notes due 2025 (the 2025 Notes). We recognized a pre-tax loss on extinguishment of $17 million on the redemption of the 2022 Notes and the 2025 Notes in the fourth quarter of 2020, including the call premiums and write-off of unamortized debt issuance costs. In February 2020, we redeemed all of our outstanding $1.0 billion 6.125% Senior Notes, due February 15, 2024 (the 2024 Notes) and recognized a pre-tax loss on extinguishment of $44 million. The loss includes the call premium, the write-off of unamortized debt issuance costs and the loss on the termination of the $1.0 billion interest rate swap associated with the 2024 Notes. In October 2019, we redeemed the outstanding principal balance on the $1.4 billion 5.625% Senior Notes due February 15, 2021 (the 2021 Notes). We recognized a pre-tax loss on extinguishment of $30 million on the redemption of the 2021 Notes, including the call premium, the write-off of unamortized debt issuance costs and a loss on the termination of the $600 million interest rate swap agreement associated with the notes. Interest expense. Interest expense increased by $316 million in the year ended December 31, 2020, compared to the corresponding period in 2019. The increase is driven by an increase in borrowings related to the issuance of an additional $7.0 billion in senior notes in December 2019 to finance the cash consideration of the WellCare Acquisition as well as the $1.9 billion of WellCare Notes assumed upon acquisition. The increase was also driven by incremental interest expense related to our decision to preserve an additional $1.0 billion of liquidity due to the economic environment created by COVID-19.51Table of ContentsIncome Tax ExpenseFor the year ended December 31, 2020, we recorded income tax expense of $979 million on pre-tax earnings of $2.8 billion, or an effective tax rate of 35.3%. The effective tax rate for the year ended December 31, 2020 reflects the tax impact associated with the Illinois divestiture and the reinstatement of the health insurer fee in 2020, partially offset by a favorable tax settlement. For the year ended December 31, 2019, we recorded income tax expense of $473 million on pre-tax earnings of $1.8 billion, or an effective tax rate of 26.5%, which reflects the impact of the health insurer fee moratorium, partially offset by the non-deductibility of a portion of our non-cash goodwill and intangible impairment recorded in the third quarter of 2019.Segment ResultsThe following table summarizes our consolidated operating results by segment for the year ended December 31, ($ in millions): 20202019% Change2019-2020Total Revenues Managed Care$107,296 $71,379 50 %Specialty Services16,155 13,781 17 %Eliminations(12,336)(10,521)(17)%Consolidated Total$111,115 $74,639 49 %Earnings from Operations Managed Care$3,031 $1,806 68 %Specialty Services51 (25)304 %Consolidated Total$3,082 $1,781 73 %Managed CareTotal revenues increased 50% in the year ended December 31, 2020, compared to the corresponding period in 2019, primarily due to the acquisition of WellCare, growth in the Medicaid and Health Insurance Marketplace businesses, and the reinstatement of the health insurer fee in 2020. Additionally, the net effect of the pandemic increased our revenues due to the suspension of Medicaid eligibility redeterminations. The increase was partially offset by the divestiture of our Illinois health plan. Earnings from operations increased $1.2 billion between years driven by the acquisition of WellCare, lower medical utilization due to the COVID-19 pandemic, and the reinstatement of the health insurer fee in 2020, partially offset by higher acquisition related expenses, retroactive state premium rate adjustments and risk sharing mechanisms, and higher testing and treatment costs associated with COVID-19, particularly in the Health Insurance Marketplace business.Specialty ServicesTotal revenues increased 17% in the year ended December 31, 2020, compared to the corresponding period in 2019, resulting primarily from increased services associated with membership growth in the Managed Care segment, acquisitions and increased volume in our specialty pharmacy business. Earnings from operations increased $76 million between years. Earnings from operations in 2020 was negatively affected by the previously discussed impairment related to our third-party care management software business and the results of the shared savings programs in our physician home health business. Earnings from operations in 2019 were negatively affected by the previously discussed non-cash goodwill and intangible impairment related to our USMM physician home health business.52Table of ContentsLIQUIDITY AND CAPITAL RESOURCESShown below is a condensed schedule of cash flows for the years ended December 31, 2020 and 2019, used in the discussion of liquidity and capital resources ($ in millions). Year Ended December 31, 20202019Net cash provided by operating activities$5,503 $1,483 Net cash used in investing activities(6,955)(1,532)Net cash provided by financing activities260 6,832 Effect of exchange rate changes on cash and cash equivalents18 (2)Net increase in cash, cash equivalents, and restricted cash and equivalents$(1,174)$6,781 Cash Flows Provided by Operating ActivitiesNormal operations are funded primarily through operating cash flows and borrowings under our Revolving Credit Facility. In 2020, operating activities provided cash of $5.5 billion, or 3.1 times net earnings, compared to $1.5 billion in 2019. Cash flow provided by operations in 2020 was due to net earnings, an increase in medical claims liabilities from growth and expansions, and an increase in other long-term liabilities related to minimum MLR payables and a delay in employer payroll tax payments related to the COVID-19 extensions to payment deadlines. Cash flows provided by operations in 2019 was primarily due to net earnings and an increase in medical claims liabilities, primarily resulting from growth in the Health Insurance Marketplace business and the commencement or expansion of the Arkansas, Iowa, New Mexico, and Pennsylvania health plans. Operating cash flows were partially offset by an increase in premium and trade receivables due to the timing of payments from our state customers, as discussed below.Cash flows from operations in each year can be impacted by the timing of payments we receive from our states. As we have seen historically, states may prepay the following month premium payment, which we record as unearned revenue, or they may delay our premium payment, which we record as a receivable. We typically receive capitation payments monthly; however, the states in which we operate may decide to adjust their payment schedules which could positively or negatively impact our reported cash flows from operating activities in any given period. Year Ended December 31, 20202019(Increase) decrease in premium and trade receivables$(52)$(1,076)Increase (decrease) in unearned revenue(528)(9)Net increase (decrease) in operating cash flow$(580)$(1,085)Cash Flows Used in Investing ActivitiesInvesting activities used cash of $7.0 billion for the year ended December 31, 2020 and $1.5 billion in 2019. Cash flows used in investing activities in 2020 primarily consisted of our acquisitions of WellCare, PANTHERx and Apixio, partially offset by divestiture proceeds. Cash flows used in investing activities in 2020 also consisted of net additions to the investment portfolio of our regulated subsidiaries (including transfers from cash and cash equivalents to long-term investments) and capital expenditures.We spent $869 million and $730 million in the years ended December 31, 2020 and 2019, respectively, on capital expenditures for system enhancements, market growth, and corporate headquarters expansions.As of December 31, 2020, our investment portfolio consisted primarily of fixed-income securities with a weighted average duration of 3.3 years. We had unregulated cash and investments of $1.9 billion at December 31, 2020, compared to $7.2 billion at December 31, 2019. Unregulated cash as of December 31, 2019 included the net proceeds from our $7.0 billion senior note issuance in advance of the closing of the WellCare Acquisition. Unregulated cash and investments include private equity investments and company owned life insurance contracts.Cash flows used in investing activities in 2019 primarily consisted of the net additions to the investment portfolio of our regulated subsidiaries (including transfers from cash and cash equivalents to long-term investments) and capital expenditures.53Table of ContentsCash Flows Provided by Financing ActivitiesOur financing activities provided cash of $260 million in 2020, compared to providing cash of $6.8 billion in 2019. During 2020, our net financing activities were due to increased borrowings, partially offset by common stock repurchases. During 2019, our net financing activities primarily related to the proceeds from the issuance of $7.0 billion of senior notes in December 2019 in preparation of the WellCare Acquisition.In connection with the WellCare Acquisition, in January 2020, we completed an exchange offer for $1.2 billion of 5.25% Senior Notes due 2025 and $750 million of 5.375% Senior Notes due 2026 (collectively, the WellCare Notes) issued by WellCare and issued $1.1 billion aggregate principal amount of 5.25% Senior Notes due 2025 and $747 million aggregate principal amount of 5.375% Senior Notes due 2026. Additionally, our wholly owned subsidiary, WellCare Health Plans, Inc., assumed the remaining unexchanged WellCare Notes.In February 2020, we issued $2.0 billion 3.375% Senior Notes due 2030 (the $2.0 billion 2030 Notes). We used the net proceeds from the $2.0 billion 2030 Notes to redeem all of our outstanding 2024 Notes. We recognized a pre-tax loss on extinguishment of $44 million, including the call premium, the write-off of unamortized debt issuance costs and a loss on the termination of the $1.0 billion interest rate swap associated with the 2024 Notes. We intended to use remaining proceeds to redeem our 2022 Notes. The 2022 Notes were redeemed in the fourth quarter in connection with an additional offering of senior notes as further described below, and we decided to increase liquidity with the remaining proceeds of the $2.0 billion 2030 Notes. In February 2020, we terminated the interest rate swap agreements associated with the 2022 Notes and the Senior Notes due January 15, 2025, (the 2025 Notes). The interest rate swaps associated with the 2024 Notes were also terminated in connection with the redemption of those notes as discussed above. In total, we terminated three interest rate swap contracts with a notional amount of $2.1 billion.In May 2020, we completed an exchange offer, whereby we offered to exchange all of the outstanding $2.0 billion 3.375% Senior Notes due February 15, 2030, $1.0 billion 4.75% Senior Notes due 2025, $2.5 billion 4.25% Senior Notes, and $3.5 billion 4.625% Senior Notes due 2029 for identical securities that have been registered under the Securities Act of 1933. In October 2020, we issued $2.2 billion 3.0% Senior Notes due October 2030 (the $2.2 billion 2030 Notes). We used the net proceeds from the offering, together with cash on hand, to redeem all of the 2022 Notes and the $1.2 billion 5.25% Senior Notes due 2025. We recognized a pre-tax loss on extinguishment of $17 million, including the call premium, and the write-off of unamortized debt issuance costs.Liquidity MetricsThe credit agreement underlying our Revolving Credit Facility and Term Loan Facility contains customary covenants as well as financial covenants, including a minimum fixed charge coverage ratio and a maximum debt-to-EBITDA ratio. Our maximum debt-to-EBITDA ratio under the credit agreement may not exceed 3.5 to 1.0, which may, under certain circumstances and subject to certain elections made by us, be increased for certain periods to 4.0 to 1.0. As of December 31, 2020, we had $97 million of borrowings outstanding under our Revolving Credit Facility, $1.5 billion of borrowings outstanding under our Term Loan Facility, and we were in compliance with all covenants. As of December 31, 2020, there were no limitations on the availability of our Revolving Credit Facility as a result of the debt-to-EBITDA ratio.We have a $200 million non-recourse construction loan to fund the expansion of our corporate headquarters. In February 2021, we extended the term of the construction loan for one year. The loan bears interest based on the one month LIBOR plus 2.70% and matures in April 2022. The agreement contains financial and non-financial covenants aligning with the credit agreement governing our Revolving Credit Facility. We have guaranteed completion of the construction project associated with the loan. As of December 31, 2020, we had $180 million in borrowings outstanding under the loan. We had outstanding letters of credit of $129 million as of December 31, 2020, which were not part of our Revolving Credit Facility. The letters of credit bore weighted interest of 0.6% as of December 31, 2020. In addition, we had outstanding surety bonds of $1.1 billion as of December 31, 2020. The indentures governing our various maturities of senior notes contain limited restrictive covenants. As of December 31, 2020, we were in compliance with all covenants. 54Table of ContentsAt December 31, 2020, we had working capital, defined as current assets less current liabilities, of $1.8 billion, compared to $7.4 billion at December 31, 2019. Working capital as of December 31, 2019, reflected the net proceeds from our $7.0 billion senior note issuance in advance of the closing of the WellCare Acquisition. We manage our short-term and long-term investments with the goal of ensuring that a sufficient portion is held in investments that are highly liquid and can be sold to fund short-term requirements as needed. At December 31, 2020, our debt to capital ratio, defined as total debt divided by the sum of total debt and total equity, was 39.3%, compared to 52.0% at December 31, 2019. Excluding $230 million of non-recourse debt, our debt to capital ratio was 39.0% as of December 31, 2020, compared to 51.7% at December 31, 2019. At December 31, 2019, excluding non-recourse debt and the senior notes issued to fund the WellCare Acquisition in advance of closing, our debt to capital was 34.3%. We utilize the debt to capital ratio as a measure, among others, of our leverage and financial flexibility.We have a stock repurchase program authorizing us to repurchase common stock from time to time on the open market or through privately negotiated transactions. We have 5.5 million available shares remaining under the program for repurchases as of December 31, 2020. No duration has been placed on the repurchase program. We reserve the right to discontinue the repurchase program at any time. In 2020, we used proceeds from divestitures to repurchase 8.7 million shares of Centene common stock for $500 million through our stock repurchase program. We did not make any repurchases under this plan during 2019.During the year ended December 31, 2020 and 2019, we received dividends of $1.3 billion and $713 million, respectively, from our regulated subsidiaries. 2021 Expectations During 2021, we expect to receive net dividends of approximately $1.7 billion from our regulated subsidiaries and expect to spend approximately $860 million in capital expenditures primarily associated with system enhancements and market and corporate headquarters expansions. In February 2021, our Board of Directors approved an increase in our existing share repurchase program for our common stock. With the increase, we are authorized to repurchase up to $1.0 billion of shares of our common stock, inclusive of the previously approved stock repurchase program. No duration has been placed on the repurchase program.In February 2021, we issued $2.2 billion 2.50% Senior Notes due 2031 (the 2031 Notes). In conjunction with the 2031 Notes offering, we completed a tender offer (the Tender Offer) to purchase for cash, subject to certain conditions, any and all of the outstanding aggregate principal amount of the $2.2 billion 4.75% Senior Notes due 2025 (the 2025 Notes). We used the net proceeds from the 2031 Notes, together with available cash on hand, to fund the purchase price for the 2025 Notes accepted for purchase in the Tender Offer (approximately 36% of the aggregate principal amount outstanding) and intend to use the remaining proceeds to redeem any of the 2025 Notes that remain outstanding following the Tender Offer, including all premiums, accrued interest and costs and expenses related to the redemption.We have material debt, lease, and short-term medical claims obligations. Refer to Note 10. Debt, Note 11. Leases, and Note 8. Medical Claims Liability, respectively, for further information. In addition, we have material commitments as a result of our Fidelis and Health Net acquisitions. Refer to Note 17. Commitments for detail.In the second half of 2021, we expect to complete the merger with Magellan Health, Inc. for $95.00 per share in cash for a total enterprise value of approximately $2.2 billion. We intend to primarily fund the acquisition through debt financing.Based on our operating plan, we expect that our available cash, cash equivalents and investments, cash from our operations and cash available under our Revolving Credit Facility will be sufficient to finance our general operations and capital expenditures for at least 12 months from the date of this filing. While we are currently in a strong liquidity position and believe we have adequate access to capital, we may elect to increase borrowings on our Revolving Credit Facility. In addition, from time to time we may elect to raise additional funds for these and other purposes, either through issuance of debt or equity, the sale of investment securities or otherwise, as appropriate. In addition, we may strategically pursue refinancing or redemption opportunities to extend maturities and/or improve terms of our indebtedness if we believe such opportunities are favorable to us. 55Table of ContentsREGULATORY CAPITAL AND DIVIDEND RESTRICTIONS Our operations are conducted through our subsidiaries. As managed care organizations, most of our subsidiaries are subject to state regulations and other requirements that, among other things, require the maintenance of minimum levels of statutory capital, as defined by each state, and restrict the timing, payment and amount of dividends and other distributions that may be paid to us. Generally, the amount of dividend distributions that may be paid by a regulated subsidiary without prior approval by state regulatory authorities is limited based on the entity's level of statutory net income and statutory capital and surplus.As of December 31, 2020, our subsidiaries had aggregate statutory capital and surplus of $14.2 billion, compared with the required minimum aggregate statutory capital and surplus requirements of $5.9 billion. During the year ended December 31, 2020, we received $508 million of net dividends from our regulated subsidiaries. For our subsidiaries that file with the National Association of Insurance Commissioners (NAIC), we estimate our Risk Based Capital (RBC) percentage to be in excess of 350% of the Authorized Control Level.Under the California Knox-Keene Health Care Service Plan Act of 1975, as amended ("Knox-Keene"), certain of our California subsidiaries must comply with tangible net equity (TNE) requirements. Under these Knox-Keene TNE requirements, actual net worth less unsecured receivables and intangible assets must be more than the greater of (i) a fixed minimum amount, (ii) a minimum amount based on premiums or (iii) a minimum amount based on healthcare expenditures, excluding capitated amounts. In addition, certain of our California subsidiaries have made certain undertakings to the Department of Managed Health Care to restrict dividends and loans to affiliates, to the extent that the payment of such would reduce such entities' TNE below the required amount as specified in the undertaking.Under the New York State Department of Health Codes, Rules and Regulations Title 10, Part 98, our New York subsidiary must comply with contingent reserve requirements. Under these requirements, net worth based upon admitted assets must equal or exceed a minimum amount based on annual net premium income.The NAIC has adopted rules which set minimum risk-based capital requirements for insurance companies, managed care organizations and other entities bearing risk for healthcare coverage. As of December 31, 2020, each of our health plans was in compliance with the risk-based capital requirements enacted in those states.As a result of the above requirements and other regulatory requirements, certain of our subsidiaries are subject to restrictions on their ability to make dividend payments, loans or other transfers of cash to their parent companies. Such restrictions, unless amended or waived or unless regulatory approval is granted, limit the use of any cash generated by these subsidiaries to pay our obligations. The maximum amount of dividends that can be paid by our insurance company subsidiaries without prior approval of the applicable state insurance departments is subject to restrictions relating to statutory surplus, statutory income and unassigned surplus. As of December 31, 2020, the amount of capital and surplus or net worth that was unavailable for the payment of dividends or return of capital to us was $5.9 billion in the aggregate. RECENT ACCOUNTING PRONOUNCEMENTS For this information, refer to Note 2. Summary of Significant Accounting Policies, in the Notes to the Consolidated Financial Statements, included herein. CRITICAL ACCOUNTING POLICIES AND ESTIMATESOur discussion and analysis of our results of operations and liquidity and capital resources are based on our consolidated financial statements which have been prepared in accordance with GAAP. Our significant accounting policies are more fully described in Note 2. Summary of Significant Accounting Policies, to our consolidated financial statements included elsewhere herein. Our accounting policies regarding intangible assets, medical claims liability and revenue recognition are particularly important to the portrayal of our financial position and results of operations and require the application of significant judgment by our management. As a result, they are subject to an inherent degree of uncertainty. We have reviewed these critical accounting policies and related disclosures with the Audit Committee of our Board of Directors.Goodwill and Intangible Assets We have made several acquisitions that have resulted in our recording of intangible assets. These intangible assets primarily consist of purchased contract rights and customer relationships, provider contracts, trade names, developed technologies, and goodwill. Key assumptions used in the valuation of these intangible assets include, but are not limited to, member attrition rates, contract renewal probabilities, revenue growth rates, expectations of profitability, and discount and royalty rates. We 56Table of Contentsallocate the fair value of purchase consideration to the assets acquired and liabilities assumed based on their fair values at the acquisition date. The excess of the fair value of consideration transferred over the fair value of the net assets acquired is recorded as goodwill. Goodwill is generally attributable to the value of the synergies between the combined companies and the value of the acquired assembled workforce, neither of which qualifies for recognition as an intangible asset. At December 31, 2020, we had $18.7 billion of goodwill and $8.4 billion of other intangible assets. Intangible assets are amortized using the straight-line method over the following periods:Intangible AssetAmortization PeriodPurchased contract rights and customer relationships3 - 21 yearsProvider contracts4 - 15 yearsTrade names7 - 20 yearsDeveloped technologies2 - 7 yearsOur management evaluates whether events or circumstances have occurred that may affect the estimated useful life or the recoverability of the remaining balance of goodwill and other identifiable intangible assets. If the events or circumstances indicate that the remaining balance of the intangible asset or goodwill may be impaired, the potential impairment will be measured based upon the difference between the carrying amount of the intangible asset or goodwill and the fair value of such asset. Our management must make assumptions and estimates, such as the discount factor, future utility and other internal and external factors, in determining the estimated fair values. While we believe these assumptions and estimates are appropriate, other assumptions and estimates could be applied and might produce significantly different results. Goodwill is reviewed annually during the fourth quarter for impairment. In addition, an impairment analysis of intangible assets would be performed based on other factors. These factors include significant changes in membership, financial performance, state funding, medical contracts and provider networks and contracts. If a reporting unit’s carrying amount exceeds its fair value, an entity will record an impairment charge based on that difference. The impairment charge will be limited to the amount of goodwill allocated to that reporting unit. We first assess qualitative factors to determine if a quantitative impairment test is necessary. We generally do not calculate the fair value of a reporting unit unless we determine, based on a qualitative assessment, that it is more likely than not that its fair value is less than its carrying amount. However, in certain circumstances, such as recent acquisitions, we may elect to perform a quantitative assessment without first assessing qualitative factors.Our specialty clinical healthcare business acquired in 2018, with goodwill of $325 million, has experienced short-term decreased profitability due to short-term rate inadequacies and the effect of the COVID-19 pandemic, coupled with immigration restrictions enacted by policy administrators. However, the goodwill is expected to be recovered and there have been no fundamental changes in the business model since the acquisition date. To the extent rates do not improve in the long-term or the new administration does not reverse the immigration restrictions, the reporting unit could be at risk for impairment. Medical Claims Liability Our medical claims liability includes claims reported but not yet paid, or inventory, estimates for claims incurred but not reported, or IBNR, and estimates for the costs necessary to process unpaid claims at the end of each period. We estimate our medical claims liability using actuarial methods that are commonly used by health insurance actuaries and meet Actuarial Standards of Practice. These actuarial methods consider factors such as historical data for payment patterns, cost trends, product mix, seasonality, utilization of healthcare services and other relevant factors. Actuarial Standards of Practice generally require that the medical claims liability estimates be adequate to cover obligations under moderately adverse conditions. Moderately adverse conditions are situations in which the actual claims are expected to be higher than the otherwise estimated value of such claims at the time of estimate. The claims amounts ultimately settled will most likely be different than the estimate that satisfies the Actuarial Standards of Practice. We include in our IBNR an estimate for medical claims liability under moderately adverse conditions which represents the risk of adverse deviation of the estimates in our actuarial method of reserving.We use our judgment to determine the assumptions to be used in the calculation of the required estimates. The assumptions we consider when estimating IBNR include, without limitation, claims receipt and payment experience (and variations in that experience), changes in membership, provider billing practices, healthcare service utilization trends, cost trends, product mix, seasonality, prior authorization of medical services, benefit changes, known outbreaks of disease or increased incidence of 57Table of Contentsillness such as influenza, provider contract changes, changes to fee schedules, and the incidence of high dollar or catastrophic claims.We apply various estimation methods depending on the claim type and the period for which claims are being estimated. For more recent periods, incurred non-inpatient claims are estimated based on historical per member per month claims experience adjusted for known factors. Incurred hospital inpatient claims are estimated based on known inpatient utilization data and prior claims experience adjusted for known factors. For older periods, we utilize an estimated completion factor based on our historical experience to develop IBNR estimates. The completion factor is an actuarial estimate of the percentage of claims that have been received or adjudicated as of the end of a reporting period relative to the estimate of the total ultimate incurred costs for that same period. When we commence operations in a new state or region, we have limited information with which to estimate our medical claims liability. See "Risk Factors - Failure to accurately estimate and price our medical expenses or effectively manage our medical costs or related administrative costs could negatively affect our results of operations, financial position and cash flows." These approaches are consistently applied to each period presented. Additionally, we contract with independent actuaries to review our estimates on a quarterly basis. The independent actuaries provide us with a review letter that includes the results of their analysis of our medical claims liability. We do not solely rely on their report to adjust our claims liability. We utilize their calculation of our claims liability only as additional information, together with management's judgment, to determine the assumptions to be used in the calculation of our liability for claims. Our development of the medical claims liability estimate is a continuous process which we monitor and refine on a monthly basis as additional claims receipts and payment information becomes available. As more complete claims information becomes available, we adjust the amount of the estimates, and include the changes in estimates in medical costs in the period in which the changes are identified. In every reporting period, our operating results include the effects of more completely developed medical claims liability estimates associated with previously reported periods. We consistently apply our reserving methodology from period to period. As additional information becomes known to us, we adjust our actuarial models accordingly to establish medical claims liability estimates. The paid and received completion factors, claims per member per month and per diem cost trend factors are the most significant factors affecting the IBNR estimate. The following table illustrates the sensitivity of these factors and the estimated potential impact on our operating results caused by changes in these factors based on December 31, 2020 data:Completion Factors: (1)Cost Trend Factors: (2)(Decrease)Increasein FactorsIncrease(Decrease) inMedical ClaimsLiabilities(Decrease)Increasein FactorsIncrease(Decrease) inMedical ClaimsLiabilities (in millions)(in millions)(1.00)%$623 (1.00)%$(169)(0.75)466 (0.75)(126)(0.50)310 (0.50)(84)(0.25)155 (0.25)(42)0.25 (154)0.25 42 0.50 (307)0.50 84 0.75 (459)0.75 126 1.00 (610)1.00 169 (1) Reflects estimated potential changes in medical claims liability caused by changes in completion factors.(2) Reflects estimated potential changes in medical claims liability caused by changes in cost trend factors for the most recent periods.While we believe our estimates are appropriate, it is possible future events could require us to make significant adjustments for revisions to these estimates. For example, a 1% increase or decrease in our estimated medical claims liability would have affected net earnings by $80 million for the year ended December 31, 2020, excluding the effect of any return of premium, risk corridor, or minimum MLR programs. The estimates are based on our historical experience, terms of existing contracts, our observance of trends in the industry, information provided by our providers and information available from other outside sources. 58Table of ContentsThe change in medical claims liability is summarized as follows (in millions): Year Ended December 31,202020192018Balance, January 1,$7,473 $6,831 $4,286 Less: reinsurance recoverable20 27 18 Balance, January 1, net7,453 6,804 4,268 Acquisitions3,856 59 1,204 Less: acquired reinsurance recoverable— — 8 Incurred related to:Current year86,765 59,539 46,484 Prior years (501)(677)(427)Total incurred86,264 58,862 46,057 Paid related to:Current year78,838 52,453 41,161 Prior years6,320 5,819 3,556 Total paid85,158 58,272 44,717 Balance, December 31, net12,415 7,453 6,804 Plus: reinsurance recoverable23 20 27 Balance, December 31,$12,438 $7,473 $6,831 Days in claims payable (1)51 45 48 (1) Days in claims payable is a calculation of medical claims liability at the end of the period divided by average expense per calendar day for the fourth quarter of each year.Medical claims are usually paid within a few months of the member receiving service from the physician or other healthcare provider. As a result, the liability generally is described as having a "short-tail," which causes less than 5% of our medical claims liability as of the end of any given year to be outstanding the following year. We believe that substantially all the development of the estimate of medical claims liability as of December 31, 2020 will be known by the end of 2021.Changes in estimates of incurred claims for prior years are primarily attributable to reserving under moderately adverse conditions. Additionally, as a result of minimum HBR and other return of premium programs, approximately $86 million, $49 million and $25 million of the "Incurred related to: Prior years" was recorded as a reduction to premium revenues in 2020, 2019 and 2018, respectively. Further, claims processing initiatives yielded increased claim payment recoveries and coordination of benefits related to prior year dates of service. Changes in medical utilization and cost trends and the effect of population health management initiatives may also contribute to changes in medical claim liability estimates. While we have evidence that population health management initiatives are effective on a case by case basis, these initiatives primarily focus on events and behaviors prior to the incurrence of the medical event and generation of a claim. Accordingly, any change in behavior, leveling of care, or coordination of treatment occurs prior to claim generation and as a result, the costs prior to the population health management initiative are not known by us. Additionally, certain population health management initiatives are focused on member and provider education with the intent of influencing behavior to appropriately align the medical services provided with the member's acuity. In these cases, determining whether the population health management initiative changed the behavior cannot be determined. Because of the complexity of our business, the number of states in which we operate, and the volume of claims that we process, we are unable to practically quantify the impact of these initiatives on our changes in estimates of IBNR.The following are examples of population health management initiatives that may have contributed to the favorable development through lower medical utilization and cost trends: •Appropriate leveling of care for neonatal intensive care unit hospital admissions, other inpatient hospital admissions, and observation admissions, in accordance with InterQual or other criteria. •Management of our pre-authorization list and more stringent review of durable medical equipment and injectibles.•Emergency department program designed to collaboratively work with hospitals to steer non-emergency care away from the costly emergency department setting (through patient education, on-site alternative urgent care settings, etc.).59Table of Contents•Increased emphasis on case management and clinical rounding where case managers are nurses or social workers who are employed by the health plan to assist selected patients with the coordination of healthcare services in order to meet a patient's specific healthcare needs.•Incorporation of disease management which is a comprehensive, multidisciplinary, collaborative approach to chronic illnesses such as asthma.•Prenatal and infant health programs utilized in our Start Smart For Your Baby outreach service.Revenue Recognition Our health plans generate revenues primarily from premiums received from the states in which we operate health plans, premiums received from our members and CMS for our Medicare product, and premiums from members of our commercial health plans. In addition to member premium payments, our Marketplace contracts also generate revenues from subsidies received from CMS. We generally receive a fixed premium per member per month pursuant to our contracts and recognize premium revenues during the period in which we are obligated to provide services to our members at the amount reasonably estimable. In some instances, our base premiums are subject to an adjustment, or risk score, based on the acuity of its membership. Generally, the risk score is determined by the State or CMS analyzing submissions of processed claims data to determine the acuity of our membership relative to the entire state's membership. We estimate the amount of risk adjustment based upon the processed claims data submitted and expected to be submitted to CMS and record revenues on a risk adjusted basis. Some contracts allow for additional premiums related to certain supplemental services provided such as maternity deliveries.Our contracts with states may require us to maintain a minimum HBR or may require us to share profits in excess of certain levels. In certain circumstances, including commercial plans, our plans may be required to return premium to the state or policyholders in the event profits exceed established levels. We estimate the effect of these programs and recognize reductions in revenue in the current period. Other states may require us to meet certain performance and quality metrics in order to receive additional or full contractual revenue. For performance-based contracts, we do not recognize revenue subject to refund until data is sufficient to measure performance.Revenues are recorded based on membership and eligibility data provided by the states or CMS, which is adjusted on a monthly basis by the states or CMS for retroactive additions or deletions to membership data. These eligibility adjustments are estimated monthly and subsequent adjustments are made in the period known. We continuously review and update those estimates as new information becomes available. It is possible that new information could require us to make additional adjustments, which could be significant, to these estimates.Our Medicare Advantage contracts are with CMS. CMS deploys a risk adjustment model which apportions premiums paid to all health plans according to health severity and certain demographic factors. The CMS risk adjustment model pays more for members whose medical history would indicate that they are expected to have higher medical costs. Under this risk adjustment methodology, CMS calculates the risk adjusted premium payment using diagnosis data from hospital inpatient, hospital outpatient, physician treatment settings as well as prescription drug events. We and the healthcare providers collect, compile and submit the necessary and available diagnosis data to CMS within prescribed deadlines. We estimate risk adjustment revenues based upon the diagnosis data submitted and expected to be submitted to CMS and record revenues on a risk adjusted basis.For qualifying low income PDP members, CMS pays for some, or all, of the member's monthly premium. We receive certain Part D prospective subsidy payments from CMS for our PDP members as a fixed monthly per member amount, based on the estimated costs of providing prescription drug benefits over the plan year, as reflected in our bids. Approximately nine to ten months subsequent to the end of the plan year, or later in the case of the coverage gap discount subsidy, a settlement payment is made between CMS and our plans based on the difference between the prospective payments and actual claims experience. Our specialty services generate revenues under contracts with state and federal programs, healthcare organizations and other commercial organizations, as well as from our own subsidiaries. Revenues are recognized when the related services are provided or as ratably earned over the covered period of services. For performance-based measures in our contracts, revenue is recognized as data sufficient to measure performance is available. We recognize revenue related to administrative services under the TRICARE government-sponsored managed care support contract for the DoD's TRICARE program on a straight-line basis over the option period, when the fees become fixed and determinable. The TRICARE contract includes various performance-based measures. For each of the measures, an estimate of the amount that has been earned is made at each interim date, and revenue is recognized accordingly.60Table of ContentsSome states enact premium taxes, similar assessments and provider pass-through payments, collectively premium taxes, and these taxes are recorded as a separate component of both revenues and operating expenses. Additionally, our insurance subsidiaries are subject to the Affordable Care Act annual HIF. The ACA imposed the HIF in 2014, 2015, 2016, 2018 and 2020. The HIF was suspended in 2017 and 2019. Beginning in 2021, the HIF was permanently repealed. If we are able to negotiate reimbursement of portions of these premium taxes or the HIF, we recognize revenue associated with the HIF on a straight-line basis when we have binding agreements for such reimbursements, including the "gross-up" to reflect the HIFs non-tax deductible nature. Collectively, this revenue is recorded as premium tax and health insurer fee revenue in the Consolidated Statements of Operations. For certain products, premium taxes, state assessments and the HIF are not pass-through payments and are recorded as premium revenue and premium tax expense or health insurer fee expense in the Consolidated Statements of Operations.Some states require state directed payments that have minimal risk, but are administered as a premium adjustment. These payments are recorded as premium revenue and medical costs at close to a 100% HBR. We have little visibility to the timing of these payments until they are paid by the state.61Table of ContentsITEM 7A. Quantitative and Qualitative Disclosures About Market RiskINVESTMENTS AND DEBTAs of December 31, 2020, we had short-term investments of $1.6 billion and long-term investments of $13.9 billion, including restricted deposits of $1.1 billion. The short-term investments generally consist of highly liquid securities with maturities between three and 12 months. The long-term investments consist of municipal, corporate and U.S. Treasury securities, government sponsored obligations, life insurance contracts, asset backed securities, equity securities and private equity investments and have maturities greater than one year. Restricted deposits consist of investments required by various state statutes to be deposited or pledged to state agencies. Due to the nature of the states' requirements, these investments are classified as long-term regardless of the contractual maturity date. Substantially all of our investments are subject to interest rate risk and will decrease in value if market rates increase. Assuming a hypothetical and immediate 1% increase in market interest rates at December 31, 2020, the fair value of our fixed income investments would decrease by approximately $319 million. Declines in interest rates over time, including those that have occurred as markets experienced volatility related to the COVID-19 pandemic, will reduce our investment income.For a discussion of the interest rate risk that our investments are subject to, see "Risk Factors – Our investment portfolio may suffer losses which could materially and adversely affect our results of operations or liquidity."62Table of Contents
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+Item 7. under the heading, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in this annual report. Many of the forward-looking statements contained in this annual report may be identified by the use of forward-looking words such as “believe,” “expect,” “anticipate,” “should,” “planned,” “will,” “may,” “intend,” “estimated,” “aim,” “on track,” “target,” “opportunity,” “tentative,” “positioning,” “designed,” “create,” “predict,” “project,” “initiatives,” “seek,” “would,” “could,” “continue,” “ongoing,” “upside,” “increases,” “focused on” and “potential,” among others. Important factors that could cause actual results to differ materially from the forward-looking statements we make in this annual report are set forth in this annual report and in other reports or documents that we file from time to time with the SEC, and include, but are not limited to: •our ability to sustain and grow revenues and cash flow from operations by offering Internet, video, voice, mobile, advertising and other services to residential and commercial customers, to adequately meet the customer experience demands in our service areas and to maintain and grow our customer base, particularly in the face of increasingly aggressive competition, the need for innovation and the related capital expenditures;•the impact of competition from other market participants, including but not limited to incumbent telephone companies, direct broadcast satellite ("DBS") operators, wireless broadband and telephone providers, digital subscriber line (“DSL”) providers, fiber to the home providers and providers of video content over broadband Internet connections; •general business conditions, unemployment levels and the level of activity in the housing sector and economic uncertainty or downturn, including the impacts of the Novel Coronavirus (“COVID-19”) pandemic to our customers, our vendors and local, state and federal governmental responses to the pandemic; •our ability to obtain programming at reasonable prices or to raise prices to offset, in whole or in part, the effects of higher programming costs (including retransmission consents and distribution requirements); •our ability to develop and deploy new products and technologies including mobile products and any other consumer services and service platforms; •any events that disrupt our networks, information systems or properties and impair our operating activities or our reputation;•the effects of governmental regulation on our business including costs, disruptions and possible limitations on operating flexibility related to, and our ability to comply with, regulatory conditions applicable to us;•the ability to hire and retain key personnel;•the availability and access, in general, of funds to meet our debt obligations prior to or when they become due and to fund our operations and necessary capital expenditures, either through (i) cash on hand, (ii) free cash flow, or (iii) access to the capital or credit markets; and•our ability to comply with all covenants in our indentures and credit facilities, any violation of which, if not cured in a timely manner, could trigger a default of our other obligations under cross-default provisions.All forward-looking statements attributable to us or any person acting on our behalf are expressly qualified in their entirety by this cautionary statement. We are under no duty or obligation to update any of the forward-looking statements after the date of this annual report.iiPART IItem 1. Business. Introduction We are a leading broadband connectivity company and cable operator serving more than 31 million customers in 41 states through our Spectrum brand. Over an advanced high-capacity, two-way telecommunications network, we offer a full range of state-of-the-art residential and business services including Spectrum Internet, TV, Mobile and Voice. For small and medium-sized companies, Spectrum Business® delivers the same suite of broadband products and services coupled with special features and applications to enhance productivity, while for larger businesses and government entities, Spectrum Enterprise provides highly customized, fiber-based solutions. Spectrum Reach® delivers tailored advertising and production for the modern media landscape. We also distribute award-winning news coverage, sports and high-quality original programming to our customers through Spectrum Networks and Spectrum Originals. Our network, which we own and operate, passes over 53 million households and small and medium businesses ("SMBs") across the United States. Our core strategy is to use our network to deliver high quality products at competitive prices, combined with outstanding customer service. This strategy, combined with simple, easy to understand pricing and packaging, is central to our goal of growing our customer base while selling more of our core connectivity services, which include both fixed and mobile Internet, video and voice services, to each individual customer. We execute this strategy by managing our operations in a consumer-friendly, efficient and cost-effective manner. Our operating strategy includes insourcing nearly all of our customer care and field operations workforces, which results in higher quality service delivery. While an insourced operating model can increase the field operations and customer care costs associated with individual service transactions, the higher quality nature of insourced labor service transactions significantly reduces the volume of service transactions per customer, more than offsetting the higher investment made in each insourced service transaction. As we reduce the number of service transactions and recurring costs per customer relationship, we continue to provide our customers with products and prices that we believe provide more value than what our competitors offer. The combination of offering high quality, competitively priced products and outstanding service, allows us to both increase the number of customers we serve over our fully deployed network, and to increase the number of products we sell to each customer. This combination also reduces the number of service transactions we perform per relationship, yielding higher customer satisfaction and lower customer churn, resulting in lower costs to acquire and serve customers and greater profitability. We have enhanced our service operations to allow our customers to (1) more frequently interact with us through our customer website and My Spectrum application, online chat and social media, (2) have their services installed at the time and in the manner of their own choosing, including self-installation, and (3) receive a variety of video packages on an increasing number of connected devices including those owned by us and those owned by the customer. By offering our customers growing levels of choices in how they receive and install their services and how they interact with us, we are driving higher overall levels of customer satisfaction and reducing our operating costs and capital expenditures per customer relationship. Ultimately, our operating strategy enables us to offer high quality, competitively priced services profitably, while continuing to invest in new products and services.The capability and functionality of our network continues to grow in a number of areas, especially with respect to wireless connectivity. Our Internet service offers consumers the ability to wirelessly connect to our network using WiFi technology. We estimate that approximately 400 million devices are wirelessly connected to our network through WiFi. In addition, we extend Internet connectivity to our customers beyond the home via our Spectrum Mobile product through our mobile virtual network operator (“MVNO”) reseller agreement with Verizon Communications Inc. ("Verizon"). In 2020, we purchased 210 Citizens Broadband Radio Service (“CBRS”) Priority Access Licenses (“PALs”) within our footprint from the Federal Communications Commission ("FCC"). We intend to use the licenses along with unlicensed CBRS spectrum to build our own fifth generation ("5G") mobile network which we plan to use in combination with our MVNO and WiFi network to enhance our customer’s experience and improve our cost structure.Our principal executive offices are located at 400 Atlantic Street, Stamford, Connecticut 06901. Our telephone number is (203) 905-7801, and we have a website accessible at www.corporate.charter.com. Our Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q and Current Reports on Form 8-K, and all amendments thereto, are available on our website free of charge as soon as reasonably practicable after they have been filed. The information posted on our website is not incorporated into this annual report. 1Corporate Entity Structure The chart below sets forth our entity structure and that of our direct and indirect subsidiaries. The chart does not include all of our affiliates and subsidiaries and, in some cases, we have combined separate entities for presentation purposes. The equity ownership percentages shown below are approximations. Indebtedness amounts shown below are principal amounts as of December 31, 2020. See Note 9 to the accompanying consolidated financial statements contained in “Part II. Item 8. Financial Statements and Supplementary Data,” which also includes the accreted values of the indebtedness described below. 2FootprintWe operate in geographically diverse areas which are managed centrally on a consolidated level. The map below highlights our footprint as of December 31, 2020. Products and Services We offer our customers subscription-based Internet services, video services, and mobile and voice services. Our services are offered to residential and commercial customers on a subscription basis, with prices and related charges based on the types of service selected, whether the services are sold as a “bundle” or on an individual basis, and based on the equipment necessary to receive our services. Bundled services are available to substantially all of our passings, and approximately 56% of our residential customers subscribe to a bundle of services including some combination of our Internet, video and/or voice products. 3The following table summarizes our customer statistics for Internet, video, voice and mobile as of December 31, 2020 and 2019 (in thousands except per customer data and footnotes). Approximate as ofDecember 31,2020 (a)2019 (a)Customer Relationships (b)Residential29,079 27,277 SMB2,051 1,958 Total Customer Relationships 31,130 29,235 Monthly Residential Revenue per Residential Customer (c)$111.15 $112.63 Monthly SMB Revenue per SMB Customer (d)$165.60 $169.90 InternetResidential27,023 24,908 SMB1,856 1,756 Total Internet Customers28,879 26,664 VideoResidential15,639 15,620 SMB561 524 Total Video Customers16,200 16,144 VoiceResidential9,215 9,443 SMB1,224 1,144 Total Voice Customers10,439 10,587 Mobile LinesResidential2,320 1,078 SMB55 4 Total Mobile Lines2,375 1,082 Enterprise Primary Service Units ("PSUs") (e)274 267 (a)We calculate the aging of customer accounts based on the monthly billing cycle for each account. On that basis, as of December 31, 2020 and 2019, customers include approximately 168,400 and 154,200 customers, respectively, whose accounts were over 60 days past due, approximately 17,800 and 13,500 customers, respectively, whose accounts were over 90 days past due, and approximately 11,100 and 10,000 customers, respectively, whose accounts were over 120 days past due. (b)Customer relationships include the number of customers that receive one or more levels of service, encompassing Internet, video and voice services, without regard to which service(s) such customers receive. Customers who reside in residential multiple dwelling units (“MDUs”) and that are billed under bulk contracts are counted based on the number of billed units within each bulk MDU. Total customer relationships exclude enterprise and mobile-only customer relationships.(c)Monthly residential revenue per residential customer is calculated as total residential annual revenue divided by twelve divided by average residential customer relationships during the respective year and excludes mobile revenue and customers.(d)Monthly SMB revenue per SMB customer is calculated as total SMB annual revenue divided by twelve divided by average SMB customer relationships during the respective year and excludes mobile revenue and customers.(e)Enterprise PSUs represent the aggregate number of fiber service offerings counting each separate service offering at each customer location as an individual PSU.4Residential ServicesInternet ServicesOur Spectrum pricing and packaging (“SPP”) offers an entry level Internet download speed of at least 200 megabits per second (“Mbps”) in nearly 75% of our footprint and 100 Mbps across the remainder of our footprint, which among other things, allows several people within a single household to stream high definition (“HD”) video content while simultaneously using our Internet service for other purposes. Additionally, leveraging DOCSIS 3.1 technology, we offer Spectrum Internet Gig (940 Mbps) speed service in nearly all of our footprint. Finally, we offer a security suite with our Internet services which, upon installation by customers, provides protection against computer viruses and spyware and includes parental control features. We offer an in-home WiFi product that provides customers with high performance wireless routers and a managed WiFi service to maximize their in-home wireless Internet experience. During 2020, we continued to roll out our advanced in-home WiFi product and we plan to expand availability from over 65% of our footprint to substantially all by the end of 2021. With advanced in-home WiFi, customers enjoy an optimized WiFi connection and have the ability to view and control their WiFi network with the My Spectrum App allowing them to set schedules for specific devices. Advanced in-home WiFi is built on a software platform that will allow us to integrate and launch additional network based security and control features as well as enhanced speeds for our mobile customers within the home. In 2020, we also launched the option to add Spectrum WiFi Pods to our advanced in-home WiFi product. Spectrum WiFi pods are small, discreet and powerful pods that plug into electrical outlets in the home to deliver additional access points, resulting in more consistent coverage throughout the home. Video Services Our video customers receive a package of programming which generally includes a digital receiver that provides an interactive electronic programming guide with parental controls, access to pay-per-view services, including video on demand (“VOD”) (available to nearly all of our passings) and the ability to view certain video services on third-party devices inside and outside the home. Customers have the option to purchase additional tiers of services, including premium channels which provide original programming, commercial-free movies, sports, and other special event entertainment programming. Substantially all of our video programming is available in high definition. We also offer certain video packages containing a limited number of channels.In the vast majority of our footprint, we offer VOD service which allows customers to select from over 75,000 titles at any time. VOD programming options may be accessed at no additional cost if the content is associated with a customer’s linear subscription, or for a fee on a transactional basis. VOD services are also offered on a subscription basis included in a digital tier premium channel subscription or for a monthly fee. Pay-per-view channels allow customers to pay on a per-event basis to view a single showing of a one-time special sporting event, music concert, or similar event on a commercial-free basis.Our goal is to provide our video customers with the programming they want, when they want it, on any device. Digital video recorder (“DVR”) service enables customers to digitally record programming and to pause and rewind live programming. Customers can also use our Spectrum TV application on Internet Protocol ("IP") devices to watch over 375 channels of cable TV in home and approximately 300 channels out of home and view VOD programming. Customers are increasingly accessing their subscription video content through connected IP devices via our IP network. Our cloud DVR service allows customers to schedule, record and watch their favorite programming anytime from connected IP devices as well as SpectrumTV.com. Our video customers also have access to programmer authenticated applications and websites (known as TV Everywhere services) such as Fox Now, Discovery Go and ESPN. We deploy Spectrum Guide®, our network or “cloud-based” user interface, to new video customers in the majority of our service areas. Spectrum Guide runs on traditional digital receivers but offers a look and feel similar to that of our IP-based Spectrum TV application. Spectrum Guide also provides access to third-party video applications such as Netflix. Voice ServicesWe provide voice communications services using voice over Internet protocol ("VoIP") technology to transmit digital voice signals over our network. Our voice services include unlimited local and long distance calling to the United States, Canada, Mexico and Puerto Rico, voicemail, call waiting, caller ID, call forwarding and other features and offers international calling either by the minute, or through packages of minutes per month. For customers that subscribe to both our voice and video offerings, caller ID on TV is also available in most areas. In early 2021, we launched Call Guard, a new advanced caller ID and robocall blocking solution, for our residential and SMB voice customers. Call Guard reduces customer frustration and improves 5security by blocking malicious calls while ensuring our customers continue to receive the legitimate automated calls they need from schools or healthcare providers.Mobile ServicesOur Spectrum Mobile service is offered to customers subscribing to our Internet service, and runs on Verizon’s mobile network, combined with Spectrum WiFi. In 2020, we launched nationwide 5G service at no incremental cost to our customers enabling them to stream content several times faster and reducing latency when connecting to apps or webpages where 5G coverage exists. In addition, we continue to focus on improving the customer experience and integrating our mobile and Internet products, providing improved WiFi speeds and performance using more than 500,000 of our out of home WiFi access points across our footprint. In addition, we refreshed our device portfolio with new devices including 5G models from Apple, Google and Samsung that include installment plan and trade-in options along with a bring-your-own-device (“BYOD”) program which lowers the costs for our customers switching to Spectrum Mobile from other mobile operators.Commercial Services We offer scalable broadband communications solutions for businesses and carrier organizations of all sizes, selling Internet access, data networking, fiber connectivity to cellular towers and office buildings, video entertainment services and business telephone services. Small and Medium BusinessSpectrum Business offers Internet, voice and video services to SMBs over our hybrid fiber coaxial network. In addition, we offer our Spectrum Mobile service to SMB customers. Spectrum Business includes a full range of video programming and entry-level Internet speeds of 200 Mbps downstream and 10 Mbps upstream in virtually all of our markets. Additionally, customers can upgrade their Internet speeds by purchasing Internet Ultra (600 Mbps downstream) or Internet Gig (940 Mbps downstream). Spectrum Business also includes a set of business services including static IP and business WiFi, e-mail and security, and multi-line telephone services with more than 35 business features including web-based service management, that are generally not available to residential customers. In 2020, we launched Wireless Internet Backup for our SMB customers throughout our footprint. Wireless Internet Backup is designed to enhance and protect Internet service for small- and medium-sized businesses in the event of a network disruption. Enterprise Spectrum Enterprise offers tailored communications products and managed service solutions to larger businesses, as well as high-capacity last-mile data connectivity services to mobile and wireline carriers on a wholesale basis. The Spectrum Enterprise product portfolio includes Internet access (fiber, wireless and coax delivered); Wide Area Network ("WAN") Solutions including Ethernet; SD-WAN and cloud connectivity services that privately and securely connect geographically dispersed customer locations; and managed services which address a wide range of enterprise networking and security challenges. To meet the communications needs of these more sophisticated customers, Spectrum Enterprise also offers an array of voice trunking services and unified messaging/unified communications solutions. In addition, for industries such as hospitality, education and healthcare where specialized video solutions are demanded, Spectrum Enterprise offers a wide range of solutions designed to meet those requirements. Spectrum Enterprise serves businesses nationally by combining its large, serviceable footprint and robust portfolio of fiber lit buildings with a significant wholesale partner network. As a result, these customers benefit by obtaining advanced communications solutions from a single provider who is committed to an exceptional customer experience and who delivers compelling value by simplifying procurement and potentially reducing their costs.Advertising ServicesOur advertising sales division, Spectrum Reach, offers local, regional and national businesses the opportunity to advertise in individual and multiple service areas on cable television networks and advanced advertising platforms. We receive revenues from the sale of local advertising across various platforms for networks such as MTV, CNN and ESPN. In any particular service area, we typically insert local advertising on 40 to 85 channels. Our large footprint provides opportunities for advertising customers to address broader regional audiences from a single provider and thus reach more customers with a single transaction. Our size also provides scale to invest in new technology to create more targeted and addressable advertising capabilities. 6Available advertising time is generally sold by our advertising sales force. In some service areas, we have formed advertising interconnects or entered into representation agreements with other video distributors, including, among others, Verizon, AT&T Inc. (“AT&T”) and Comcast Corporation, under which we sell advertising on behalf of those operators. In other service areas, we enter into representation agreements under which another operator in the area will sell advertising on our behalf. These arrangements enable us and our partners to deliver linear commercials across wider geographic areas, replicating the reach of local broadcast television stations to the extent possible. In addition, we enter into interconnect agreements from time to time with other cable operators, which, on behalf of a number of video operators, sells advertising time to national and regional advertisers in individual or multiple service areas.Additionally, we sell the advertising inventory of our owned and operated local sports and news channels, of our regional sports networks that carry Los Angeles Lakers’ basketball games and other sports programming and of SportsNet LA, a regional sports network that carries Los Angeles Dodgers’ baseball games and other sports programming.In 2020, we continued to expand our deployment of household addressability ("HHA"), which allows for more precise targeting within various parts of our footprint. This will be more widely deployed in 2021. Additionally in the next year, in conjunction with other MVPD’s, Spectrum Reach will enable affiliated cable networks to deploy HHA on their own inventory in our footprints, charging them an enablement fee. We also continued to develop our Ad Portal, which allows small businesses to purchase local cable advertising and/or creative services via our web portal with no sales personnel interaction at a price within their budgets. They join our fully deployed Audience App, which uses our proprietary digital receiver viewership data (all anonymized and aggregated) to optimize linear inventory, and Streaming TV, our expanded Ads Everywhere offering which includes inventory on over-the-top streaming content providers, in our suite of advanced advertising products available to the marketplace.Other ServicesRegional Sports and News Networks We have an agreement with the Los Angeles Lakers for rights to distribute all locally available Los Angeles Lakers’ games through 2033. We broadcast those games on our regional sports network, Spectrum SportsNet. American Media Productions, LLC ("American Media Productions"), an unaffiliated third party, owns SportsNet LA, a regional sports network carrying the Los Angeles Dodgers’ baseball games and other sports programming. In accordance with agreements with American Media Productions, we act as the network’s exclusive affiliate and advertising sales representative and have certain branding and programming rights with respect to the network. In addition, we provide certain production and technical services to American Media Productions. The affiliate, advertising, production and programming agreements continue through 2038. We also own 26.8% of Sterling Entertainment Enterprises, LLC (doing business as SportsNet New York), a New York City-based regional sports network that carries New York Mets’ baseball games as well as other regional sports programming.We manage 31 local news channels, including Spectrum News NY1® and LA1, 24-hour news channels focused on New York City and Los Angeles. Our local news channels provide 24/7 hyperlocal content, focusing on news, programming and storytelling that addresses the deeper needs and interests of the diverse communities and neighborhoods we serve. We also provide the Spectrum News app where customers can read, watch and listen to news stories by our Spectrum News journalists and local partner publications on their mobile device.Pricing of Our Products and Services Our revenues are principally derived from the monthly fees customers pay for the services we provide. We typically charge a one-time installation fee which is sometimes waived or discounted in certain sales channels during certain promotional periods. Our Spectrum pricing and packaging generally offers a standardized price for each tier of service, bundle of services, and add-on service in a service area. We believe SPP:•offers a higher quality and more value-based set of services relative to our competitors, including faster Internet speeds, more HD channels, lower equipment fees and a more transparent pricing structure;•offers simplicity for customers to understand our offers, and for our employees in service delivery;•drives our ability to package more services at the time of sale, thus increasing revenue per customer;•drives higher customer satisfaction, lower service calls and churn; and•allows for gradual price increases at the end of promotional periods.7We sell Internet and video packages with the option to add on voice and mobile services at attractive pricing. Our mobile customers can choose one of two simple ways to pay for data. Customers can choose from unlimited data plans or by-the-gig data usage plans and pricing includes all taxes and fees. All plans include free nationwide talk and text and customers can easily switch between mobile data plans during the month. Customers can also purchase mobile devices and accessory products and have the option to pay for devices under interest-free monthly installment plans. Our Network Technology Our network includes three key components: a national backbone, regional/metro networks and a “last-mile” network. Both our national backbone and regional/metro network components utilize a redundant IP ring/mesh architecture. The national backbone component provides connectivity from regional demarcation points to nationally centralized content, connectivity and services. The regional/metro network components provide connectivity between the regional demarcation points and headends within a specific geographic area and enable the delivery of content and services between these network components.Our last-mile network utilizes a hybrid fiber coaxial cable (“HFC”) architecture, which combines the use of fiber optic cable with coaxial cable. In most systems, we deliver our signals via fiber optic cable from the headend to a group of nodes, and use coaxial cable to deliver the signal from individual nodes to the homes served by that node. For our Spectrum Enterprise customers, fiber optic cable is extended from individual nodes to the customer’s site. For certain new build and MDU sites, we increasingly bring fiber to the customer site. Our design standard allows spare fiber strands to each node to be utilized for additional residential traffic capacity, and enterprise customer needs as they arise. We believe that this hybrid network design provides high capacity and signal quality. HFC architecture benefits include: •bandwidth capacity to enable traditional and two-way video and broadband services;•dedicated bandwidth for two-way services; and•signal quality and high service reliability.Our systems provide a two-way all-digital platform, leveraging DOCSIS 3.1 technology and bandwidth of 750 megahertz or greater, to approximately 100% of our estimated passings. This bandwidth-rich network enables us to offer a large selection of HD channels and Spectrum Internet Gig while providing greater plant security and enabling lower installation and disconnect service truck rolls. We believe as demand for data continues to grow, that with our deployed DOCSIS 3.1 technology, we have the ability to increase speeds and reliability by allocating more of our plant bandwidth to both upstream and downstream IP services in a variety of ways, including moving our video services to MPEG-4 compression, moving more HD video content to switched digital video and more efficiently packaging our non-IP service channels. We are also evaluating additional network upgrades that could be made on the increment giving us the ability to offer multi-gigabit downstream speeds and up to one gigabit upstream speeds all in advance of migrating towards the next standard, DOCSIS 4.0, in which we are currently investing with key vendors and industry participants. In 2020, we purchased 210 CBRS PALs and intend to use the licenses along with unlicensed CBRS spectrum to build our own 5G mobile network on targeted 5G small cell sites leveraging our HFC network providing power and data connectivity to the majority of the sites. These 5G small cells, combined with improving WiFi capabilities, increase speed and reliability along with improving our cost structure. During 2021, we will focus on scaling our systems to actively manage traffic on Spectrum Mobile devices using our MVNO, network through WiFi and future 5G mobile network. In addition, we plan on deploying some targeted 5G small cell sites which will help us learn how to pace our broader multi-year 5G mobile network build-out based on disciplined cost reduction targets.We also participated in phase I of the Rural Digital Opportunity Fund (“RDOF”) auction to further extend our broadband services in states where we currently operate. The purpose of Phase I of RDOF was to bring broadband to unserved areas. Approximately $9.2 billion was awarded nationwide in Phase I of RDOF through a reverse auction process of which we won a bidding process for $1.2 billion in December 2020. We expect to fund our multi-billion dollar fiber-based build-out over a six to eight-year period. This investment will allow us to generate long-term infrastructure-style returns by further taking advantage of the efficiencies of the scale and quality of our network and construction capabilities while offering our high quality products and services to more homes and businesses. We expect newly-served homes will be enabled to engage in distance learning, remote work, telemedicine and other bandwidth-heavy applications that require high speed broadband connectivity. Newly-served rural areas would also benefit from our high-value SPP structure including our voice and mobile offerings, as well as our comprehensive selection of video products. The successful and timely execution of such build-out is dependent on a variety of external factors, including the make-ready and utility pole permitting processes. With fewer homes 8and businesses in these areas, broadband providers need to access multiple poles per home, as opposed to multiple homes per pole in higher-density settings. As a result, pole applications, pole replacement rules and their affiliated issue resolution processes are all factors that can have a significant impact on build-out timing and speed to completion. The RDOF auction rules establish construction milestones for the build-out utilizing RDOF funding. Failure to meet those milestones could subject the company to financial penalties. Management, Customer Operations and Marketing Our operations are centralized, with senior executives responsible for coordinating and overseeing operations, including establishing company-wide strategies, policies and procedures. Sales and marketing, network operations, field operations, customer operations, engineering, advertising sales, human resources, legal, government relations, information technology and finance are all directed at the corporate level. Regional and local field operations are responsible for customer premise service transactions and maintaining and constructing that portion of our network which is located outdoors. Our field operations strategy includes completing a significant portion of our activity with our employees which we find drives consistent and higher quality services. In 2020, our in-house field operations workforce handled approximately 80% of our customer premise service transactions. We continue to focus on improving the customer experience through enhanced product offerings, reliability of services, and delivery of quality customer service. As part of our operating strategy, we insource most of our customer operations workload. Our in-house call centers handle over 90% of our total cable customer service calls. We manage our customer service call centers centrally to ensure a consistent, high quality customer experience. In addition, we route calls by call type to specific agents that only handle such call types, enabling agents to become experts in addressing specific customer needs, creating a better customer experience. Our call center agent desktop interface tool enables virtualization of all call centers thereby better serving our customers. Virtualization allows calls to be routed across our call centers regardless of the location origin of the call, reducing call wait times, and saving costs. We continue to migrate our call centers to full virtualization and expect all our call centers to be fully virtualized by 2022. We also provide customers with the opportunity to interact with us through a variety of forums in addition to telephonic communications, including through our customer website, mobile device applications, online chat and social media. Our customer websites and mobile applications enable customers to pay their bills, manage their accounts, order new services and utilize self-service help and support. In addition, our self-install program has enabled product installations to continue despite COVID-19 social distancing challenges.We sell our residential and commercial services using national brand platforms known as Spectrum, Spectrum Business, Spectrum Enterprise and Spectrum Reach. These brands reflect our comprehensive approach to industry-leading products, driven by speed, performance and innovation. Our marketing strategy emphasizes the sale of our bundled services through targeted direct response marketing programs to existing and potential customers, and increases awareness and the value of the Spectrum brand. Our marketing organization creates and executes marketing programs intended to grow customer relationships, increase the number of services we sell per relationship, retain existing customers and cross-sell additional products to current customers. We monitor the effectiveness of our marketing efforts, customer perception, competition, pricing, and service preferences, among other factors, in order to increase our responsiveness to our customers and to improve our sales and customer retention. The marketing organization manages all residential and SMB sales channels including inbound, direct sales, on-line, outbound telemarketing and stores.Programming We believe that offering a wide variety of video programming choices influences a customer’s decision to subscribe to and retain our cable video services. We obtain basic and premium programming, usually pursuant to written contracts from a number of suppliers. Media corporation and broadcast station group consolidation has, however, resulted in fewer suppliers and additional selling power on the part of programming suppliers. Although an insignificant amount of our programming budget, recently we have begun entering into agreements to co-produce or exclusively license original content which give us the right to provide our customers with certain exclusive content for a period of time.Programming is usually made available to us for a license fee, which is generally paid based on the number of customers to whom we make that programming available. Programming license fees may include “volume” discounts and financial incentives to support the launch of a channel and/or ongoing marketing support, as well as discounts for channel placement or service penetration. For home shopping channels, we typically receive a percentage of the revenue attributable to our 9customers’ purchases. We also offer VOD and pay-per-view channels of movies and events that are subject to a revenue split with the content provider.Our programming costs have historically increased in excess of customary inflationary and cost-of-living type increases. We expect programming costs per customer to increase due to a variety of factors including, annual increases pursuant to our programming contracts, contract renewals with programmers and the carriage of incremental programming, including new services and VOD programming. Increases in the cost of sports programming and the amounts paid for broadcast station retransmission consent have been the largest contributors to the growth in our programming costs over the last few years. Additionally, the demands of large media companies who link carriage of their most popular networks to carriage and cost increases of their less popular networks and who require us to carry their most popular networks to a large percentage of our video subscribers, have limited our flexibility in creating more tailored and cost-sensitive programming packages for consumers. Federal law allows commercial television broadcast stations to make an election between “must-carry” rights and an alternative “retransmission-consent” regime. When a station opts for retransmission-consent, we are not allowed to carry the station’s signal without that station’s permission. Continuing demands by owners of broadcast stations for cash payments at substantial increases over amounts paid in prior years in exchange for retransmission consent will increase our programming costs or require us to cease carriage of popular programming, potentially leading to a loss of customers in affected service areas.Over the past several years, increases in our video service rates have not fully offset the increases in our programming costs, and with the impact of increasing competition and other marketplace factors, we do not expect the increases in our video service rates to fully offset the increase in our programming costs per customer for the foreseeable future. Although we pass along a portion of amounts paid for retransmission consent to the majority of our customers, our inability to fully pass programming cost increases on to our video customers has had, and is expected in the future to have, an adverse impact on our cash flow and operating margins associated with our video product. In order to mitigate reductions of our operating margins due to rapidly increasing programming costs, we continue to review our pricing and programming packaging strategies. Our programming contracts are generally for a fixed period of time, usually for multiple years, and are subject to negotiated renewal. The contracts set to expire in any particular year vary. We will seek to renew these agreements on terms that we believe are favorable. There can be no assurance, however, that these agreements will be renewed on favorable or comparable terms. To the extent that we are unable to reach agreements with certain programmers on terms that we believe are reasonable, we have been, and may in the future be, forced to remove such programming channels from our line-up, which may result in a loss of customers. CompetitionResidential ServicesWe face intense competition for residential customers, both from existing competitors and, as a result of the rapid development of new technologies, services and products, from new entrants. Internet CompetitionOur residential Internet service faces competition across our footprint from fiber-to-the-home ("FTTH"), fiber-to-the-node ("FTTN"), fixed wireless broadband, Internet delivered via satellite and DSL services. AT&T, Frontier Communications Corporation (“Frontier”) fiber optic service (“FiOS" or "Fios") and Verizon’s Fios are our primary FTTH competitors. Given the FTTH deployments of our competitors, launches of broadband services offering 1 gigabit per second (“Gbps”) speed have recently grown. Several competitors, including AT&T, Frontier FiOS, Verizon's Fios, WideOpenWest, Inc. ("WOW") and Google Fiber, deliver 1 Gbps broadband speed in at least a portion of their footprints which overlap our footprint. In several markets, we also face competition from one or more fixed wireless providers which deliver point-to-point Internet connectivity, although generally in areas limited to residential MDUs. Additionally, several mobile network operators have introduced Long Term Evolution (“LTE”) or 5G delivered fixed wireless home Internet service in a limited number of our markets. DSL service is offered across our footprint often at prices lower than our Internet services, although typically at speeds much lower than the minimum speeds we offer as part of SPP. In addition, a growing number of commercial areas, such as retail malls, restaurants and airports, offer WiFi Internet service. Numerous local governments are also considering or actively pursuing publicly subsidized WiFi Internet access networks. These options offer alternatives to cable-based Internet access. We face broadband Internet (defined as at least 25 Mbps) competition from three primary competitors, AT&T, Frontier and Verizon in approximately 33%, 8% and 5% of our operating areas, respectively.10Video CompetitionOur residential video service faces competition from DBS service providers, which have a national footprint and compete in all of our operating areas. DBS providers offer satellite-delivered pre-packaged programming services that can be received by relatively small and inexpensive receiving dishes. DBS providers offer aggressive promotional pricing, exclusive programming (e.g., NFL Sunday Ticket) and video services that are comparable in many respects to our residential video service. Our residential video service also faces competition from large telecommunications companies, primarily Frontier FiOS and Verizon Fios, which offer wireline video services in significant portions of our operating areas.Our residential video service also faces growing competition across our footprint from a number of other sources, including companies that deliver linear network programming, movies and television shows on demand and other video content over broadband Internet connections to televisions, computers, tablets and mobile devices. These competitors include virtual multichannel video programming distributors (“V-MVPDs”) such as Hulu Live, YouTube TV, Sling TV, Philo and AT&T TV. Other online video business models and products have also developed, some offered by programmers that have not traditionally sold programming directly to consumers, including, (i) subscription video on demand (“SVOD”) services such as Netflix, Apple TV+, Amazon Prime, Hulu Plus, Disney+, HBO Max, Peacock, CBS All Access, Starz and Showtime Anytime, (ii) ad-supported free online video products, including YouTube and Pluto TV, some of which offer programming for free to consumers that we currently purchase for a fee, (iii) pay-per-view products, such as iTunes and Amazon Instant, and (iv) additional offerings from mobile providers which continue to integrate and bundle video services and mobile products. Historically, we have generally viewed SVOD online video services as complementary to our own video offering, and we have developed a cloud-based guide that is capable of incorporating video from online video services currently offered in the marketplace. As the proliferation of online video services grows, however, services from V-MVPDs and new direct to consumer offerings, as well as piracy and password sharing, negatively impact the number of customers purchasing our video product.Voice CompetitionOur residential voice service competes with wireless and wireline phone providers across our footprint, as well as other forms of communication, such as text messaging on cellular phones, instant messaging, social networking services, video conferencing and email. We also compete with “over-the-top” phone providers, such as Vonage, Skype, magicJack, Google Voice and Ooma, Inc., as well as companies that sell phone cards at a cost per minute for both national and international service. The increase in the number of different technologies capable of carrying voice services and the number of alternative communication options available to customers as well as the replacement of wireline services by wireless have intensified the competitive environment in which we operate our residential voice service. Mobile CompetitionOur mobile service faces competition from national mobile network operators including AT&T, Verizon and T-Mobile US, Inc. ("T-Mobile"), as well as a variety of regional operators and mobile virtual network operators. Most carriers offer unlimited data packages to customers. Various operators also offer wireless Internet services delivered over networks which they continue to enhance to deliver faster speeds. In April 2020, Sprint Corporation ("Sprint") and T-Mobile merged resulting in one of the nation’s largest mobile carriers, bringing increased competition with a stated intent of pursuing broad 5G network deployment and offering fixed wireless broadband service. AT&T, Verizon and T-Mobile continue to expand 5G mobile services. Additionally, in July 2020, in connection with Dish Network Corporation’s acquisition of Sprint’s prepaid mobile services businesses, the FCC and Department of Justice ("DOJ") have imposed a timeline on Dish Network Corporation (70% by June 2023) for 5G network development and expansion. We also compete for retail activations with other resellers that buy bulk wholesale service from wireless service providers for resale. Regional CompetitorsIn some of our operating areas, other competitors have built networks that offer Internet, video and voice services that compete with our services. For example, in certain service areas, our residential Internet, video and voice services compete with Google Fiber, Cincinnati Bell Inc., Hawaiian Telcom (owned by Cincinnati Bell Inc.), RCN Telecom Services, LLC, Grande Communications Networks, LLC and WOW.11Additional CompetitionIn addition to multi-channel video providers, cable systems compete with other sources of news, information and entertainment, including over-the-air television broadcast reception, live events, movie theaters and the Internet. Competition is also posed by fixed wireless and satellite master antenna television ("SMATV") systems serving MDUs, such as condominiums, apartment complexes, and private residential communities. Business ServicesWe face intense competition across each of our business services product offerings. Our SMB Internet, video, networking and voice services face competition from a variety of providers as described above. Our enterprise solutions also face competition from the competitors described above as well as application-service providers and other telecommunications carriers, such as metro and regional fiber-based carriers. AdvertisingWe face intense competition for advertising revenue across many different platforms and from a wide range of local and national competitors. Advertising competition has increased and will likely continue to increase as new advertising avenues seek to attract the same advertisers. We compete for advertising revenue against, among others, local broadcast stations, national cable and broadcast networks, radio stations, print media and online advertising companies and content providers.Seasonality and Cyclicality Our business is subject to seasonal and cyclical variations. Our results are impacted by the seasonal nature of customers receiving our cable services in college and vacation service areas. Our revenue is subject to cyclical advertising patterns and changes in viewership levels. Our advertising revenue is generally higher in the second and fourth calendar quarters of each year, due in part to increases in consumer advertising in the spring and in the period leading up to and including the holiday season. U.S. advertising revenue is also cyclical, benefiting in even-numbered years from advertising related to candidates running for political office and issue-oriented advertising. Our capital expenditures and trade working capital are also subject to significant seasonality based on the timing of subscriber growth, network programs, specific projects and construction. Regulation and Legislation The following summary addresses the key regulatory and legislative developments affecting the cable industry and our services for both residential and commercial customers. Cable systems and related communications networks and services are extensively regulated by the federal government (primarily the FCC), certain state governments and many local governments. A failure to comply with these regulations could subject us to substantial penalties. Our business can be dramatically impacted by changes to the existing regulatory framework, whether triggered by legislative, administrative, or judicial rulings. Congress and the FCC have frequently revisited the subject of communications regulation and they are likely to do so again in the future. Changes in legislation, regulation and regulatory enforcement are expected to result from the recent political elections. We could be materially disadvantaged in the future if we are subject to new laws, regulations or regulatory actions that do not equally impact our key competitors. For example, Internet-delivered streaming video services compete with our traditional video service, but they are not subject to the same level of federal, state, and local regulation. We cannot provide assurance that the already extensive regulation of our business will not be expanded in the future. In addition, we are subject to Charter-specific conditions regarding certain business practices as a result of the FCC’s approval of the merger in 2016 with Time Warner Cable Inc. ("TWC") and acquisition of Bright House Networks, LLC ("Bright House").Video ServiceMust Carry/Retransmission ConsentThere are two alternative legal methods for carriage of local broadcast television stations on cable systems. Federal “must carry” regulations require cable systems to carry local broadcast television stations upon the request of the local broadcaster. Alternatively, federal law includes “retransmission consent” regulations, by which popular commercial television stations can prohibit cable carriage unless the cable operator first negotiates for “retransmission consent,” which may be conditioned on significant payments or other concessions. Popular stations invoking “retransmission consent” have been demanding 12substantial compensation increases in their recent negotiations with cable operators, thereby significantly increasing our operating costs.Pole AttachmentsThe Communications Act of 1934, as amended (the "Communications Act") requires most utilities owning utility poles to provide cable systems with access to poles and conduits and also subjects the rates charged for this access to either federal or state regulation. The federally regulated rates now applicable to pole attachments used for cable, Internet, and telecommunications services are substantially similar. The FCC's approach does not directly affect the rate in states that self-regulate, but many of those states have substantially the same rate for all communications attachments.Cable Rate RegulationPursuant to federal law, a cable system's video offerings are universally exempt from rate regulation, except for a cable system’s minimum level of video programming service, referred to as “basic service,” and associated equipment. FCC regulations require a local franchise authority interested in regulating rates for basic service and associated equipment to first make an affirmative showing that there is no “effective competition” (as defined under federal law) in the community. Given the competitive nature of our markets, the FCC recently rescinded certifications for the relatively few communities where we had been subject to rate regulation. It is possible that this rescission could be reversed, the competitive situation could change, and that some local franchising authorities may be certified to regulate rates in the future. In addition, the Television Viewer Consumer Protection Act of 2019 and other existing and potential laws and regulations may affect our marketing practices (including our disclosure and itemization of subscriber fees). Other FCC Regulatory MattersThe Communications Act and FCC regulations cover a variety of additional areas applicable to our video services, including, among other things: (1) licensing of systems and facilities, including the grant of various spectrum licenses; (2) equal employment opportunity obligations; (3) customer service standards; (4) technical service standards; (5) mandatory blackouts of certain network and syndicated programming; (6) restrictions on political advertising; (7) restrictions on advertising in children’s programming; (8) ownership restrictions; (9) maintenance of public files; (10) emergency alert systems; (11) inside wiring and exclusive contracts for MDU complexes; (12) disability access, including requirements governing video-description and closed-captioning; (13) competitive availability of cable equipment; (14) the provision of up to 15% of video channel capacity for commercial leased access by unaffiliated third parties; and (15) public, education and government entity access requirements. Each of these regulations restricts our business practices to varying degrees and may impose additional costs on our operations. The FCC regulates spectrum usage in ways that could impact our operations. For example, the FCC has adopted a plan to reallocate certain spectrum for new wireless communications purposes, which could be disruptive to the satellite platform we rely upon to provide our video services. The FCC is also preparing to make additional spectrum available for commercial services, which we might acquire to deliver services in the future. Our ability to access and use such spectrum is uncertain and may be limited by further FCC auction or allocation decisions. New spectrum obtained by other parties could also lead to additional wireless competition to our existing and future services.It is possible that Congress or the FCC will expand or modify its regulation of cable systems and competing services in the future, and we cannot predict at this time how that might impact our business.CopyrightCable systems are subject to a federal compulsory copyright license covering carriage of television and radio broadcast signals. The copyright law provides copyright owners the right to audit our payments under the compulsory license, and the Copyright Office is currently considering modifications to the license’s royalty calculations and reporting obligations. The possible modification or elimination of this license is the subject of continuing legislative proposals and administrative review and could adversely affect our ability to obtain desired broadcast programming.Franchise MattersOur cable systems generally are operated pursuant to nonexclusive franchises, permits, and similar authorizations granted by a municipality or other state or local government entity in order to utilize and cross public rights-of-way. 13Cable franchises generally are granted for fixed terms and in many cases include monetary penalties for noncompliance and may be terminable if the franchisee fails to comply with material provisions. The specific terms and conditions of cable franchises vary significantly between jurisdictions. They generally contain provisions governing cable operations, franchise fees, system construction, maintenance, technical performance, customer service standards, supporting and carrying public access channels, and changes in the ownership of the franchisee. Although local franchising authorities have considerable discretion in establishing franchise terms, certain federal protections benefit cable operators. For example, federal law imposes a 5% cap on franchise fees. In 2019, the FCC clarified that in-kind contribution requirements set forth in cable franchises are subject to the statutory cap on franchise fees, and it reaffirmed that state and local authorities are barred from imposing duplicative franchise and/or fee requirements on franchised cable systems providing non-cable services. An appeal of the FCC’s order is pending in federal court. A number of states have adopted franchising laws that provide for statewide franchising. Generally, state-wide cable franchises are issued for a fixed term, streamline many of the traditional local cable franchise requirements and eliminate local negotiation.The Communications Act provides for an orderly franchise renewal process in which granting authorities may not unreasonably deny renewals. If we fail to obtain renewals of franchises representing a significant number of our customers, it could have a material adverse effect on our consolidated financial condition, results of operations, or our liquidity. Similarly, if a franchising authority’s consent is required for the purchase or sale of a cable system, the franchising authority may attempt to impose more burdensome requirements as a condition for providing its consent. Internet ServiceThe FCC originally classified broadband Internet access services, such as those we offer, as an “information service,” which exempted the service from traditional communications common carrier laws and regulations. In 2015, the FCC reclassified broadband Internet access services as “telecommunications service” and, on that basis, imposed a number of “net neutrality” rules governing the provision of broadband service. In 2017, the FCC reversed its 2015 decision and eliminated the 2015 rules, other than a transparency requirement, which obligates us to disclose performance statistics and other service information to consumers. It is possible that the FCC might again revise its approach to broadband Internet access, or that Congress might enact legislation affecting the rules applicable to the service. The application of new legal requirements to our Internet services could adversely affect our business.The 2017 FCC decision reclassifying Internet access services also ruled that state regulators may not impose obligations similar to federal network neutrality obligations that the FCC eliminated but this blanket prohibition was vacated by the U.S. Court of Appeals in 2019. The court left open the possibility that individual state laws could be deemed preempted on a case by case basis if it is shown that they conflict with federal law. Several states (including California) have adopted state obligations, and additional states may consider the imposition of new regulations on our Internet services, such as rules similar to the network neutrality requirements that were eliminated by the FCC. California’s legislation has been challenged in court, and we cannot predict how the challenge to California’s legislation or challenges to other state legislation will be resolved. In recent years, the FCC has demonstrated an interest in accelerating advancements in, and deployment of, wired and wireless broadband infrastructure, including advanced 5G wireless service. For example, the FCC and many states offer subsidies to companies deploying broadband to areas deemed to be “unserved” or “underserved,” including the recently concluded RDOF auction. We have sought subsidies for our own broadband construction in unserved areas, and we have opposed such subsidies when directed to areas that are already served. Government efforts to subsidize areas that we already serve create regulatory imbalances that could adversely affect our business.Aside from the FCC’s generally applicable regulations, we made certain commitments to comply with the FCC’s order in connection with the FCC’s approval of the merger with TWC and acquisition of Bright House.Wireline Voice ServiceThe FCC has never classified the VoIP wireline telephone services we offer as “telecommunications services” that are subject to traditional federal common carrier regulation, but instead has imposed some of these requirements on a case-by-case basis, such as requirements relating to 911 emergency services (“E911”), Communications Assistance for Law Enforcement Act ("CALEA") (the statute governing law enforcement access to and surveillance of communications), Universal Service Fund contributions, customer privacy and Customer Proprietary Network Information protections, number portability, network outage reporting, rural call completion, disability access, regulatory fees, back-up power obligations, robocall mitigation and 14discontinuance of service. It is possible that the FCC or Congress will impose additional requirements on our VoIP telephone services in the future. Our VoIP telephone services are also subject to certain state and local regulatory fees such as E911 fees and contributions to state universal service funds. Although we believe that VoIP telephone services should otherwise be governed only by federal regulation, some states have attempted to subject cable VoIP services to state level regulation, and at least one state has asserted jurisdiction over our VoIP services. We prevailed on a legal challenge to that state’s assertion of jurisdiction, which was affirmed by a federal appellate court, but that ruling is limited to the seven states in the 8th circuit. Although we have registered with, or obtained certificates or authorizations from the FCC and the state regulatory authorities in those states in which we offer competitive voice services in order to ensure the continuity of our services, it is unclear whether and how these and other ongoing regulatory matters ultimately will be resolved. State regulatory commissions and legislatures in other jurisdictions may continue to consider imposing regulatory requirements on our fixed telephone services.Mobile Service Our Spectrum Mobile service offers mobile Internet access and telephone service. We provide this service as an MVNO using Verizon’s network and our network through Spectrum WiFi. As an MVNO, we are subject to many of the same FCC regulations that apply to facilities-based wireless carriers, as well as certain state or local regulations, including (but not limited to): E911, local number portability, customer privacy, CALEA, universal service fund contribution, robocall mitigation and hearing aid compatibility and safety and emission requirements for mobile devices. Spectrum Mobile’s broadband Internet access service is also subject to the FCC’s transparency rule. The FCC or other regulatory authorities may adopt new or different regulations for MVNOs and/or mobile service providers in the future, or impose new taxes or fees applicable to Spectrum Mobile, which could adversely affect the service offering or our business generally.Privacy and Information Security RegulationThe Communications Act limits our ability to collect, use, and disclose customers’ personally identifiable information for our Internet, video and voice services. We are subject to additional federal, state, and local laws and regulations that impose additional restrictions on the collection, use and disclosure of consumer information. All broadband providers are also obliged by CALEA to configure their networks in a manner that facilitates the ability of state and federal law enforcement, with proper legal process authorized under the Electronic Communications Privacy Act, to obtain records and information concerning our customers, including the content of their communications. Further, the FCC, Federal Trade Commission (“FTC”), and many states regulate and restrict the marketing practices of communications service providers, including telemarketing and sending unsolicited commercial emails. The FTC currently has the authority, pursuant to its general authority to enforce against unfair or deceptive acts and practices, to protect the privacy of Internet service customers, including our use and disclosure of certain customer information. Our operations are also subject to federal and state laws governing information security. In the event of an information security breach, such rules may require consumer and government agency notification and may result in regulatory enforcement actions with the potential of monetary forfeitures. The FCC, the FTC and state attorneys general regularly bring enforcement actions against companies related to information security breaches and privacy violations.Various security standards provide guidance to telecommunications companies in order to help identify and mitigate cybersecurity risks. One such standard is the voluntary framework released by the National Institute for Standards and Technology (“NIST”) in 2014 and updated in 2018, in cooperation with other federal agencies and owners and operators of U.S. critical infrastructure. The NIST cybersecurity framework provides a prioritized and flexible model for organizations to identify and manage cyber risks inherent to their business. It was designed to supplement, not supersede, existing cybersecurity regulations and requirements. Several government agencies have encouraged compliance with the NIST cybersecurity framework, including the FCC, which is also considering expansion of its cybersecurity guidelines or the adoption of cybersecurity requirements. We voluntarily follow NIST as part of our overall cybersecurity program.Many states and local authorities have considered legislative or other actions that would impose restrictions on our ability to collect, use and disclose, and safeguard certain consumer information, particularly with regard to our broadband Internet business. For example, the California Consumer Privacy Act ("CCPA") and Maine’s Act to Protect Privacy of Online Customer Information both became effective in 2020. The CCPA, under certain circumstances, regulates companies’ use and disclosure of the personal information of California residents and authorizes enforcement actions by the California Attorney General and private class actions for data breaches. In addition, effective January 1, 2023, the California Consumer Privacy Rights Act (“CPRA”), adopted by ballot initiative in 2020, will amend the CCPA to impose additional obligations on 15companies that handle the personal information of California residents. The Maine law regulates how Internet service providers use and disclose customers’ personal information and requires Internet service providers to take reasonable measures to protect customers’ personal information. Several other state legislatures are considering the adoption of new data security and cybersecurity legislation that could result in additional network and information security requirements for our business. Congress may also adopt new privacy and data security obligations. We cannot predict whether any of these efforts will be successful or preempted, or how new legislation and regulations, if any, would affect our business.Commitments Related to the 2016 Merger with TWC and Acquisition of Bright HouseIn connection with approval of the 2016 merger with TWC and acquisition of Bright House (the "Transactions"), federal and state regulators imposed a number of post-transaction conditions on us including but not limited to the following.FCC Conditions•Offer settlement-free Internet interconnection to any party that meets the requirements of our Interconnection Policy (available on Charter’s website) on terms generally consistent with the policy for seven years (with a possible reduction to five years from FCC approval in 2016). Pursuant to a judgment by the Federal Appeals Court for the D.C. Circuit, this condition became invalid in October 2020;•Deploy and offer high-speed broadband Internet access service to an additional two million locations over five years. We reported to the FCC in October 2020 that this condition had been satisfied; •Refrain from charging usage-based prices or imposing data caps on any fixed mass market broadband Internet access service plans for seven years;•Offer 30/4 Mbps discounted broadband where technically feasible to eligible customers throughout our service area for four years from the offer’s commencement. Pursuant to a judgment by the Federal Appeals Court for the D.C. Circuit, this condition became invalid in October 2020; and •Continue to provide CableCARDs to any new or existing customer upon request for use in third-party retail devices for four years and continue to support such CableCARDs for seven years (in each case, unless the FCC changes the relevant rules). The obligation to continue to provide CableCARDs expired in May 2020.The FCC conditions also contain a number of compliance reporting requirements.DOJ ConditionsThe DOJ Order prohibits us from entering into or enforcing any agreement with a video programmer that forbids, limits or creates incentives to limit the video programmer’s provision of content to online video distributors ("OVDs"). We will not be able to avail ourselves of other distributors’ most favored nation ("MFN") provisions if they are inconsistent with this prohibition. The DOJ’s conditions are effective for seven years after entry of the final judgment in 2016, although we may petition the DOJ to eliminate the conditions after five years. We do not currently expect to so petition.State ConditionsCertain state regulators, including California, New York, Hawaii and New Jersey also imposed conditions in connection with the approval of the Transactions. These conditions include requirements related to:•Building out our network to certain households and business locations that are not currently served by cable within the designated states;•Offering LifeLine service discounts and low-income broadband to eligible households served within the applicable states;•Investing in service improvement programs and customer service enhancements and maintaining customer-facing jobs within the designated state; and•Complying with reporting requirements.We believe we have either completed or are on track to complete these state requirements.Human Capital Management Successful execution of our strategy is dependent on attracting, developing and retaining key employees and members of our management team. We believe the substantial skills, experience and industry knowledge of our employees and our training of our customer-facing employees benefit our operations and performance. 16There are several ways in which we attract, develop, and retain highly qualified talent, including:•Training and investing in our employees to be masters of their craft. With competitive wages, robust healthcare benefits, a generous retirement program with company match, and opportunities for job training and advancement, our employees develop skills and expertise necessary to build careers. Our Broadband Technician Apprenticeship Program is one of our promising strategies for building our skilled workforce. This program, certified by the U.S. Department of Labor, is aligned with our broadband technician career progression and includes thousands of hours of on-the-job training along with classroom instruction. When enrolled employees complete the program, they are certified broadband technicians.The majority of our employees are customer-facing, interacting with thousands of people every day. In April 2020, we increased our minimum wage from $15 to $16.50 per hour and committed that in 2022 all hourly employees will have a minimum starting rate of $20 per hour. A $20 per hour minimum wage will enable us to build and retain our highly skilled workforce.•Driving a diverse and inclusive culture. We are committed to diversity and inclusion in every aspect of our business. As we strive to deliver high-quality products and services that exceed our customers’ expectations, we embrace the unique perspectives and experiences of our employees and partners and the communities we serve. Our diversity and inclusion efforts are guided by our Executive Steering Committee, External Diversity & Inclusion Council and Diversity & Inclusion team. Charter’s Board of Directors also reviews diversity and inclusion progress annually. We are striving to enhance diversity at every level of our organization, including among our senior leaders. In 2019, we launched five Business Resource Groups (“BRGs”) focused on disability, LGBTQ, multicultural, veterans and women. These voluntary groups connect employees with shared characteristics, life experiences, and interests, and enable them to engage in activities that advance our culture of inclusion and contribute to business success. BRGs empower our team members to grow and succeed by providing networking, mentorship and skill-building opportunities. We are also building momentum with our Charter Inclusion Talks (the "Talks"), which is an internal speaker series built around cultural heritage and identity. The Talks, which are held across our footprint, raise awareness of the many identities and heritages that contribute to our success.•Focusing on a safe and healthy workplace. We value our employees and are committed to providing a safe and healthy workplace. All employees are required to comply with company safety rules and expectations, and are expected to actively contribute to making our company a safer place to work. In response to COVID-19, as one of the Federal Emergency Management Agency's community lifeline sectors, we continue to maintain operations while employing the latest Center for Disease Control and Prevention ("CDC") guidelines to promote the health of our employees. Employees As of December 31, 2020, we had approximately 96,100 active full-time equivalent employees. Item 1A. Risk Factors. Risks Related to Our BusinessWe operate in a very competitive business environment, which affects our ability to attract and retain customers and can adversely affect our business, operations and financial results.The industry in which we operate is highly competitive and has become more so in recent years. In some instances, we compete against companies with fewer regulatory burdens, access to better financing, greater personnel resources, greater resources for marketing, greater and more favorable brand name recognition, and long-established relationships with regulatory authorities and customers. Increasing consolidation in the telecommunications and content industries have provided additional benefits to certain of our competitors, either through access to financing, resources, or efficiencies of scale including the ability to launch new video services.Our Internet service faces competition from the phone companies’ FTTH, FTTN, fixed wireless broadband, Internet delivered via satellite and DSL services. Various operators offer wireless Internet services delivered over networks which they continue to enhance to deliver faster speeds and also continue to expand 5G mobile services. Our voice and mobile services compete 17with wireless and wireline phone providers, as well as other forms of communication, such as text, instant messaging, social networking services, video conferencing and email. Competition from these companies, including intensive marketing efforts with aggressive pricing and exclusive programming may have an adverse impact on our ability to attract and retain customers.Our video service faces competition from a number of sources, including DBS services, and companies that deliver linear network programming, movies and television shows on demand and other video content over broadband Internet connections to televisions, computers, tablets and mobile devices often with password sharing among multiple users and security that makes content susceptible to piracy. Newer products and services, particularly alternative methods for the distribution, sale and viewing of content will likely continue to be developed, further increasing the number of competitors that we face.The increasing number of choices available to audiences, including low-cost or free choices, could negatively impact not only consumer demand for our products and services, but also advertisers’ willingness to purchase advertising from us. We compete for the sale of advertising revenue with television networks and stations, as well as other advertising platforms, such as online media, radio and print. Competition related to our service offerings to businesses continues to increase as well, as more companies deploy more fiber to more buildings, which may negatively impact our growth and/or put pressure on margins. Our failure to effectively anticipate or adapt to new technologies and changes in customer expectations and behavior could significantly adversely affect our competitive position with respect to the leisure time and discretionary spending of our customers and, as a result, affect our business and results of operations. Competition may also reduce our expected growth of future cash flows which may contribute to future impairments of our franchises and goodwill and our ability to meet cash flow requirements, including debt service requirements. For additional information regarding the competition we face, see “Item 1. Business -Competition” and “-Regulation and Legislation.” The ongoing COVID-19 pandemic could materially affect our financial condition and results of operations.The ongoing COVID-19 pandemic has increased economic and demand uncertainty. The current pandemic and continued spread of COVID-19 has caused an economic recession. At this time, we cannot predict the duration of any business disruption and the ultimate impact of COVID-19 on our business, including the depth and duration of the economic impact to household formation and growth, our residential and business customers’ ability to pay for our products and services including the impact of extended unemployment benefits and other stimulus packages and the long-term impact on our business, including from consumer behavior, after the pandemic is over. We expect that some of the COVID-19 programs may result in incremental churn and bad debt in 2021. In addition, there is uncertainty regarding the impact of government emergency declarations, the ability of our suppliers and vendors to provide products and services to us, the pace of new housing construction, changes in business spend in our local and national ad sales business, the effects to our employees’ health and safety and resulting reorientation of our work activities, and the risk of limitations on the deployment and maintenance of our services (including by limiting our customer support and on-site service repairs and installations). The degree to which COVID-19 impacts our results will depend on future developments, which are highly uncertain and cannot be predicted, including, but not limited to, the duration and spread of the outbreak, its severity, the actions to contain the virus or treat its impact, the timing of approval and distribution of vaccines and how quickly and to what extent normal economic and operating conditions can resume.Programming costs per video customer are rising at a faster rate than wages or inflation, and we may not have the ability to reduce or moderate the growth rates of, or pass on to our customers, our increasing programming costs, which would adversely affect our cash flow and operating margins.Video programming has been, and is expected to continue to be, our largest operating expense item. Media corporation and broadcast station group consolidation has resulted in fewer suppliers and additional selling power on the part of programming suppliers. We expect programming rates per video customer will continue to increase due to a variety of factors, including annual increases imposed by programmers with additional selling power as a result of media and broadcast station groups consolidation, increased demands by owners of broadcast stations for payment for retransmission consent or linking carriage of other services to retransmission consent, and additional programming, particularly new services. The inability to fully pass programming cost increases on to our customers has had, and is expected in the future to have, an adverse impact on our cash flow and operating margins associated with the video product. Programming contracts often restrict the structure of the video packages we offer which impacts the affordability and competitive positioning of our video service. The contracts set to expire in any particular year vary. There can be no assurance that these agreements will be renewed on favorable or comparable terms. In addition, a number of programmers have begun to sell their services through alternative distribution channels, including IP-based platforms, which are less secure than our own video distribution platforms. There is growing evidence that these less secure video distribution platforms are leading to video product theft via password sharing among consumers. Password sharing may drive down the number of customers who pay for certain programming, putting programmer revenues at risk, and which in 18turn may cause certain programmers to seek even higher programming fees from us. The ability for consumers to receive the same content for free through such unauthorized channels has devalued our video product which could impact sales, customer retention and our ability to pass through programming costs to consumers, which increases the risk of non-renewal when programmers seek increases. To the extent that we are unable to reach agreement with certain programmers on terms that we believe are reasonable, we have been, and may be in the future, forced to remove such programming channels from our line-up, which may result in a loss of customers. Our failure to carry programming that is attractive to our customers could adversely impact our customer levels, operations and financial results. In addition, if our Internet customers are unable to access desirable content online because content providers block or limit access by our customers as a class, our ability to gain and retain customers, especially Internet customers, may be negatively impacted.Increased demands by owners of some broadcast stations for carriage of other services or payments to those broadcasters for retransmission consent are likely to further increase our programming costs. Federal law allows commercial television broadcast stations to make an election between “must-carry” rights and an alternative “retransmission-consent” regime. When a station opts for the retransmission consent regime, we are not allowed to carry the station’s signal without that station’s permission. In some cases, we carry stations under short-term arrangements while we attempt to negotiate new long-term retransmission agreements. If negotiations with these programmers prove unsuccessful, they could require us to cease carrying their signals, possibly for an indefinite period. Any loss of stations could make our video service less attractive to customers, which could result in less subscription and advertising revenue. In retransmission-consent negotiations, broadcasters often condition consent with respect to one station on carriage of one or more other stations or programming services in which they or their affiliates have an interest. Carriage of these other services, as well as increased fees for retransmission rights, may increase our programming expenses and diminish the amount of capacity we have available to introduce new services, which could have an adverse effect on our business and financial results.Our inability to respond to technological developments and meet customer demand for new products and services could adversely affect our ability to compete effectively.We operate in a highly competitive, consumer-driven and rapidly changing environment. From time to time, we may pursue strategic initiatives to launch products or enhancements to our products. Our success is, to a large extent, dependent on our ability to acquire, develop, adopt, upgrade and exploit new and existing technologies to address consumers’ changing demands and distinguish our services from those of our competitors. We may not be able to accurately predict technological trends or the success of new products and services. If we choose technologies or equipment that are less effective, cost-efficient or attractive to customers than those chosen by our competitors, if technologies or equipment on which we have chosen to rely cease to be available to us on reasonable terms or conditions, if we offer services that fail to appeal to consumers, are not available at competitive prices or that do not function as expected, or we are not able to fund the expenditures necessary to keep pace with technological developments, or if we are no longer able to make our services available to our customers on a third-party device on which a substantial number of customers have relied to access our services, our competitive position could deteriorate, and our business and financial results could suffer.The ability of some of our competitors to introduce new technologies, products and services more quickly than we do may adversely affect our competitive position. Furthermore, advances in technology, decreases in the cost of existing technologies or changes in competitors’ product and service offerings may require us in the future to make additional research and development expenditures or to offer, at no additional charge or at a lower price, certain products and services that we currently offer to customers separately or at a premium. In addition, the uncertainty of our ability, and the costs, to obtain intellectual property rights from third parties could impact our ability to respond to technological advances in a timely and effective manner.Our inability to maintain and expand our upgraded systems and provide advanced services in a timely manner, or to anticipate the demands of the marketplace, could materially adversely affect our ability to attract and retain customers. In addition, as we continue to grow our mobile services using virtual network operator rights from a third party, we expect continued growth-related sales and marketing and other customer acquisition costs as well as negative working capital impacts from the timing of device-related cash flows when we provide devices pursuant to equipment installation plans. We also continue to consider and pursue opportunities in the mobile space which may include the acquisition of additional licensed spectrum and may include entering into or expanding joint ventures or partnerships with wireless or cable providers which may require significant investment. For example, we now hold CBRS PALs to support existing and future mobile services. These licenses are subject to revocation and expiration. Although we expect to be able to maintain and renew these licenses, the loss of one or more licenses could significantly impair our ability to offload mobile traffic and achieve cost reductions. If we are unable to continue to grow our mobile business and achieve the outcomes we expect from our investments in the mobile business, our growth, financial condition and results of operations could be adversely affected.19We depend on third-party service providers, suppliers and licensors; thus, if we are unable to procure the necessary services, equipment, software or licenses on reasonable terms and on a timely basis, our ability to offer services could be impaired, and our growth, operations, business, financial results and financial condition could be materially adversely affected.We depend on a limited number of third-party service providers, suppliers and licensors to supply some of the services, hardware, software and operational support necessary to provide some of our services. Some of our hardware, software and operational support vendors, and service providers represent our sole source of supply or have, either through contract or as a result of intellectual property rights, a position of some exclusivity. If any of these parties breach or terminate or elect not to renew their agreements with us or otherwise fail to perform their obligations in a timely manner, demand exceeds these vendors’ capacity, tariffs are imposed that impact vendors' ability to perform their obligations or significantly increase the amount we pay, they experience operating or financial difficulties, they significantly increase the amount we are required to pay (including demands for substantial non-monetary compensation) for necessary products or services, or they cease production of any necessary product due to lack of demand, profitability or a change in ownership or are otherwise unable to provide the equipment or services we need in a timely manner, at our specifications and at reasonable prices, our ability to provide some services might be materially adversely affected, or the need to procure or develop alternative sources of the affected materials or services might interrupt or delay our ability to serve our customers. In addition, the existence of only a limited number of vendors of key technologies can lead to less product innovation and higher costs. These events could materially and adversely affect our ability to retain and attract customers and our operations, business, financial results and financial condition.Our business may be adversely affected if we cannot continue to license or enforce the intellectual property rights on which our business depends.We rely on patent, copyright, trademark and trade secret laws and licenses and other agreements with our employees, customers, suppliers and other parties to establish and maintain our intellectual property rights in technology and the products and services used in our operations. Also, because of the rapid pace of technological change, we both develop our own technologies, products and services and rely on technologies developed or licensed by third parties. However, any of our intellectual property rights, or the rights of our suppliers, could be challenged or invalidated, or such intellectual property rights may not be sufficient to permit us to take advantage of current industry trends or otherwise to provide competitive advantages, which could result in costly redesign efforts, discontinuance of certain product or service offerings or other competitive harm. We may not be able to obtain or continue to obtain licenses from these third parties on reasonable terms, if at all. In addition, claims of intellectual property infringement could require us to enter into royalty or licensing agreements on unfavorable terms, incur substantial monetary liability or be enjoined preliminarily or permanently from further use of the intellectual property in question, which could require us to change our business practices or offerings and limit our ability to compete effectively. Even unsuccessful claims can be time-consuming and costly to defend and may divert management’s attention and resources away from our business. Infringement claims continue to be brought frequently in the communications and entertainment industries, and we are also often a party to such litigation alleging that certain of our services or technologies infringe the intellectual property rights of others.Various events could disrupt or result in unauthorized access to our networks, information systems or properties and could impair our operating activities and negatively impact our reputation and financial results.Network and information systems technologies are critical to our operating activities, both for our internal uses, such as network management and supplying services to our customers, including customer service operations and programming delivery. Network or information system shutdowns or other service disruptions caused by events such as computer hacking, phishing, dissemination of computer viruses, worms and other destructive or disruptive software, “cyber attacks,” process breakdowns, denial of service attacks and other malicious activity pose increasing risks. Both unsuccessful and successful “cyber attacks” on companies have continued to increase in frequency, scope and potential harm in recent years. While we develop and maintain systems seeking to prevent systems-related events and security breaches from occurring, the development and maintenance of these systems is costly and requires ongoing monitoring and updating as techniques used in such attacks become more sophisticated and change frequently. We, and the third parties on which we rely, may be unable to anticipate these techniques or implement adequate preventive measures. While from time to time attempts have been made to access our network, these attempts have not as yet resulted in any material release of information, degradation or disruption to our network and information systems.Our network and information systems are also vulnerable to damage or interruption from power outages, telecommunications failures, accidents, natural disasters (including extreme weather arising from short-term or any long-term changes in weather patterns), terrorist attacks and similar events. Our system redundancy may be ineffective or inadequate, and our disaster recovery planning may not be sufficient for all eventualities.20Any of these events, if directed at, or experienced by, us or technologies upon which we depend, could have adverse consequences on our network, our customers and our business, including degradation of service, service disruption, excessive call volume to call centers, and damage to our or our customers’ equipment and data. Large expenditures may be necessary to repair or replace damaged property, networks or information systems or to protect them from similar events in the future. Moreover, the amount and scope of insurance that we maintain against losses resulting from any such events or security breaches may not be sufficient to cover our losses or otherwise adequately compensate us for any disruptions to our business that may result. Any such significant service disruption could result in damage to our reputation and credibility, customer dissatisfaction and ultimately a loss of customers or revenue. Any significant loss of customers or revenue, or significant increase in costs of serving those customers, could adversely affect our growth, financial condition and results of operations.Furthermore, our operating activities could be subject to risks caused by misappropriation, misuse, leakage, falsification or accidental release or loss of information maintained in our information technology systems and networks and those of our third-party vendors, including customer, personnel and vendor data. We provide certain confidential, proprietary and personal information to third parties in connection with our business, and there is a risk that this information may be compromised.We process, store, and transmit large amounts of data, including the personal information of our customers. Ongoing increases in the potential for mis-use of personal information, the public’s awareness of the importance of safeguarding personal information, and the volume of legislation that has been adopted or is being considered regarding the protection, privacy, and security of personal information have resulted in increases to our information-related risks. We could be exposed to significant costs if such risks were to materialize, and such events could damage our reputation, credibility and business and have a negative impact on our revenue. We could be subject to regulatory actions and claims made by consumers in private litigations involving privacy issues related to consumer data collection and use practices. We also could be required to expend significant capital and other resources to remedy any such security breach.Our exposure to the economic conditions of our current and potential customers, vendors and third parties could adversely affect our cash flow, results of operations and financial condition.We are exposed to risks associated with the economic conditions of our current and potential customers, the potential financial instability of our customers and their financial ability to purchase our products. If there were a general economic downturn, we may experience increased cancellations or non-payment by our customers or unfavorable changes in the mix of products purchased. This may include an increase in the number of homes that replace their video service with Internet-delivered and/or over-air content, as well as an increase in the number of Internet and voice customers substituting mobile data and voice products for wireline services, which would negatively impact our ability to attract customers, increase rates and maintain or increase revenue. In addition, our ability to gain new customers is dependent to some extent on growth in occupied housing in our service areas, which is influenced by both national and local economic conditions. Weak economic conditions may also have a negative impact on our advertising revenue. These events have adversely affected us in the past, and may adversely affect our cash flow, results of operations and financial condition if a downturn were to occur.In addition, we are susceptible to risks associated with the potential financial instability of the vendors and third parties on which we rely to provide products and services or to which we outsource certain functions. The same economic conditions that may affect our customers, as well as volatility and disruption in the capital and credit markets, also could adversely affect vendors and third parties and lead to significant increases in prices, reduction in output or the bankruptcy of our vendors or third parties upon which we rely. Any interruption in the services provided by our vendors or by third parties could adversely affect our cash flow, results of operation and financial condition.For tax purposes, Charter could experience a deemed ownership change in the future that could limit its ability to use its tax loss carryforwards. Charter had approximately $5.3 billion of federal tax net operating loss carryforwards resulting in a gross deferred tax asset of approximately $1.1 billion as of December 31, 2020. These losses resulted from the operations of Charter Communications Holding Company, LLC ("Charter Holdco") and its subsidiaries and from loss carryforwards received as a result of the merger with TWC. Federal tax net operating loss carryforwards expire in the years 2022 through 2035. In addition, Charter had state tax net operating loss carryforwards resulting in a gross deferred tax asset (net of federal tax benefit) of approximately $223 million as of December 31, 2020. State tax net operating loss carryforwards generally expire in the years 2021 through 2040. In the past, Charter has experienced ownership changes as defined in Section 382 of the Internal Revenue Code of 1986, as amended (the “Code”). In general, an ownership change occurs whenever the percentage of the stock of a corporation owned, 21directly or indirectly, by 5-percent stockholders (within the meaning of Section 382 of the Code) increases by more than 50 percentage points over the lowest percentage of the stock of such corporation owned, directly or indirectly, by such 5-percent stockholders at any time over the preceding three years. As a result, Charter is subject to an annual limitation on the use of its loss carryforwards which existed at November 30, 2009 for the first ownership change, those that existed at May 1, 2013 for the second ownership change, and those created at May 18, 2016 for the third ownership change. The limitation on Charter's ability to use its loss carryforwards, in conjunction with the loss carryforward expiration provisions, could reduce Charter's ability to use a portion of its loss carryforwards to offset future taxable income, which could result in Charter being required to make material cash tax payments. Charter's ability to make such income tax payments, if any, will depend at such time on its liquidity or its ability to raise additional capital, and/or on receipt of payments or distributions from Charter Holdco and its subsidiaries.If Charter were to experience additional ownership changes in the future (as a result of purchases and sales of stock by its 5-percent stockholders, new issuances or redemptions of our stock, certain acquisitions of its stock and issuances, redemptions, sales or other dispositions or acquisitions of interests in its 5-percent stockholders), Charter's ability to use its loss carryforwards could become subject to further limitations. If we are unable to retain key employees, our ability to manage our business could be adversely affected.Our operational results have depended, and our future results will depend, upon the retention and continued performance of our management team. Our ability to retain and hire new key employees for management positions could be impacted adversely by the competitive environment for management talent in the broadband communications industry. The loss of the services of key members of management and the inability or delay in hiring new key employees could adversely affect our ability to manage our business and our future operational and financial results.Risks Related to Our IndebtednessWe have a significant amount of debt and expect to incur significant additional debt, including secured debt, in the future, which could adversely affect our financial health and our ability to react to changes in our business.We have a significant amount of debt and expect to (subject to applicable restrictions in our debt instruments) incur additional debt in the future as we maintain our stated objective of 4.0 to 4.5 times Adjusted EBITDA leverage (net debt divided by the last twelve months Adjusted EBITDA). As of December 31, 2020, our total principal amount of debt was approximately $82.1 billion with a leverage ratio of 4.4 times Adjusted EBITDA. Our significant amount of debt could have consequences, such as:•impact our ability to raise additional capital at reasonable rates, or at all;•make us vulnerable to interest rate increases, in part because approximately 13% of our borrowings as of December 31, 2020 were, and may continue to be, subject to variable rates of interest;•expose us to increased interest expense to the extent we refinance existing debt with higher cost debt;•require us to dedicate a significant portion of our cash flow from operating activities to make payments on our debt, reducing our funds available for working capital, capital expenditures, and other general corporate expenses;•limit our flexibility in planning for, or reacting to, changes in our business, the cable and telecommunications industries, and the economy at large;•place us at a disadvantage compared to our competitors that have proportionately less debt; and•adversely affect our relationship with customers and suppliers.To the extent our current debt amounts increase more than expected, our business results are lower than expected, or credit rating agencies downgrade our debt limiting our access to investment grade markets, the related risks that we now face will intensify.In addition, our variable rate indebtedness may use London Interbank Offering Rate (“LIBOR”) as a benchmark for establishing the rate. The United Kingdom’s Financial Conduct Authority, which regulates LIBOR, has announced that it intends to stop one week and 2 month U.S. Dollar (“USD”) LIBOR rates after 2021 with remaining USD LIBOR rates ceasing to be published on June 30, 2023 (the “FCA Announcement”). In the United States, the Alternative Reference Rates Committee has proposed the Secured Overnight Financing Rate (“SOFR”) as an alternative to LIBOR. It is not presently known whether SOFR or any other alternative reference rates that have been proposed will attain market acceptance as replacements of LIBOR. In addition, the overall financial markets may be disrupted as a result of the phase-out or replacement of LIBOR. Uncertainty as to the nature of 22such phase out and selection of an alternative reference rate, together with disruption in the financial markets, could increase in the cost of our variable rate indebtedness.The agreements and instruments governing our debt contain restrictions and limitations that could significantly affect our ability to operate our business, as well as significantly affect our liquidity.Our credit facilities and the indentures governing our debt contain a number of significant covenants that could adversely affect our ability to operate our business, our liquidity, and our results of operations. These covenants restrict, among other things, our and our subsidiaries’ ability to:•incur additional debt;•repurchase or redeem equity interests and debt;•issue equity;•make certain investments or acquisitions;•pay dividends or make other distributions;•dispose of assets or merge;•enter into related party transactions; and•grant liens and pledge assets.Additionally, the Charter Communications Operating, LLC ("Charter Operating") credit facilities require Charter Operating to comply with a maximum total leverage covenant and a maximum first lien leverage covenant. The breach of any covenants or obligations in our indentures or credit facilities, not otherwise waived or amended, could result in a default under the applicable debt obligations and could trigger acceleration of those obligations, which in turn could trigger cross defaults under other agreements governing our long-term indebtedness. In addition, the secured lenders under our notes and the Charter Operating credit facilities could foreclose on their collateral, which includes equity interests in substantially all of our subsidiaries, and exercise other rights of secured creditors.Risks Related to Ownership Position of Liberty Broadband Corporation and Advance/Newhouse PartnershipLiberty Broadband Corporation ("Liberty Broadband) and Advance/Newhouse Partnership (“A/N”) have governance rights that give them influence over corporate transactions and other matters.Liberty Broadband currently owns a significant amount of Charter Class A common stock and is entitled to certain governance rights with respect to Charter. A/N currently owns Charter Class A common stock and a significant amount of membership interests in our subsidiary Charter Communications Holdings, LLC (“Charter Holdings”), which are convertible into Charter Class A common stock, and is entitled to certain governance rights with respect to Charter. Members of the Charter board of directors include a director who is also an officer and director of Liberty Broadband and directors who are current or former officers and directors of A/N. Mr. Greg Maffei is the President and Chief Executive Officer of Liberty Broadband. Steven Miron is the Chief Executive Officer of A/N and Michael Newhouse is an officer or director of several of A/N’s affiliates. As of December 31, 2020, Liberty Broadband beneficially held approximately 27.23% of Charter’s voting stock and A/N beneficially held approximately 12.71% of Charter’s voting stock. Pursuant to the stockholders agreement between Liberty Broadband, A/N and Charter, Liberty Broadband currently has the right to designate up to three directors as nominees for Charter’s board of directors and A/N currently has the right to designate up to two directors as nominees for Charter’s board of directors. Each of A/N and Liberty Broadband is entitled to nominate at least one director to each of the committees of Charter's board of directors, subject to applicable stock exchange listing rules and certain specified voting or equity ownership thresholds for each of A/N and Liberty Broadband, and provided that the Nominating and Corporate Governance Committee and the Compensation and Benefit Committee each have at least a majority of directors independent from A/N, Liberty Broadband and Charter (referred to as the “unaffiliated directors” in the stockholders agreement).In connection with the closing of the acquisition of Bright House, A/N and Liberty Broadband entered into a proxy agreement pursuant to which A/N granted to Liberty Broadband a 5-year irrevocable proxy expiring in May 2021 (which we refer to as the “A/N proxy”) to vote, subject to certain exceptions, that number of shares of Charter Class A common stock and Charter Class B common stock, in each case held by A/N (such shares are referred to as the “proxy shares”), that will result in Liberty Broadband having voting power in Charter equal to 25.01% of the outstanding voting power of Charter, provided, that the voting power of the proxy shares is capped at 7.0% of the outstanding voting power of Charter. As of December 31, 2020, Liberty Broadband’s voting power in Charter exceeded 25.01% and therefore, the A/N proxy had no impact on Liberty Broadband’s voting power. The stockholders agreement and Charter’s amended and restated certificate of incorporation fixes the size of the board at 13 directors. Liberty Broadband and A/N are required to vote (subject to the applicable voting cap) their 23respective shares of Charter Class A common stock and Charter Class B common stock for the director nominees nominated by the nominating and corporate governance committee of the board of directors, including the respective designees of Liberty Broadband and A/N, and against any other nominees, except that, with respect to the unaffiliated directors, Liberty Broadband and A/N must instead vote in the same proportion as the voting securities are voted by stockholders other than A/N and Liberty Broadband or any group which includes any of them are voted, if doing so would cause a different outcome with respect to the unaffiliated directors. In addition, because Liberty Broadband’s voting power exceeds its voting cap of 25.01%, Liberty Broadband must vote and exercise rights to consent with respect to voting securities held in excess of the voting cap in the same proportion as all other votes cast by stockholders other than A/N and Liberty Broadband with respect to the applicable matter. As a result of their rights under the stockholders agreement and their significant equity and voting stakes in Charter, Liberty Broadband and/or A/N, who may have interests different from those of other stockholders, will be able to exercise substantial influence over certain matters relating to the governance of Charter, including the approval of significant corporate actions, such as mergers and other business combination transactions.The stockholders agreement provides A/N and Liberty Broadband with preemptive rights with respect to issuances of Charter equity in connection with certain transactions, and in the event that A/N or Liberty Broadband exercises these rights, holders of Charter Class A common stock may experience further dilution.The stockholders agreement provides that A/N and Liberty Broadband will have certain contractual preemptive rights over issuances of Charter equity securities in connection with capital raising transactions, merger and acquisition transactions, and in certain other circumstances. Holders of Charter Class A common stock will not be entitled to similar preemptive rights with respect to such transactions. As a result, if Liberty Broadband and/or A/N elect to exercise their preemptive rights, (i) these parties would not experience the dilution experienced by the other holders of Charter Class A common stock, and (ii) such other holders of Charter Class A common stock may experience further dilution of their interest in Charter upon such exercise.Risks Related to Regulatory and Legislative MattersOur business is subject to extensive governmental legislation and regulation, which could adversely affect our business.Regulation of the cable industry has increased cable operators’ operational and administrative expenses and limited their revenues. Cable operators are subject to numerous laws and regulations including those covering the following:•the provision of high-speed Internet service, including net neutrality and transparency rules;•the provision of voice communications;•cable franchise renewals and transfers;•the provisioning and marketing of cable and Internet equipment;•customer and employee privacy and data security;•copyright royalties for retransmitting broadcast signals;•when a cable system must carry a particular broadcast station and when it must first obtain retransmission consent to carry a broadcast station;•limitations on our ability to enter into exclusive agreements with multiple dwelling unit complexes and control our inside wiring;•equal employment opportunity; •emergency alert systems, disability access, pole attachments, commercial leased access and technical standards;•marketing practices, customer service, and consumer protection; and•approval for mergers and acquisitions often accompanied by the imposition of restrictions and requirements on an applicant’s business in order to secure approval of the proposed transaction.Legislators and regulators at all levels of government frequently consider changing, and sometimes do change, existing statutes, rules, regulations, or interpretations thereof, or prescribe new ones. Any future legislative, judicial, regulatory or administrative actions may increase our costs or impose additional restrictions on our businesses. Changes to existing statutes, rules, regulations, or interpretations thereof, or adoption of new ones, could have an adverse effect on our business.There are ongoing efforts to amend or expand the federal, state, and local regulation of some of the services offered over our cable systems, which may compound the regulatory risks we already face. For example, with respect to our retail broadband Internet access service, the FCC has reclassified the service twice in the last few years, with the first change adding federal 24regulatory obligations and the second change largely removing those new regulatory obligations. A change in Administration and a new Congress in 2021 may result in the re-imposition of obligations, through legislation or regulation.Other potential legislative and regulatory changes could adversely impact our business by increasing our costs and competition and limiting our ability to offer services in a manner that that would maximize our revenue potential. These changes could include, for example, the adoption of new privacy restrictions on our collection, use and disclosure of certain customer information, new data security and cybersecurity mandates that could result in additional network and information security requirements for our business, new restraints on our discretion over programming decisions, new restrictions on the rates we charge for video programming and the marketing and packaging of that video programming and other services to consumers, changes to the cable industry’s compulsory copyright license to carry broadcast signals, new requirements to assure the availability of navigation devices (such as digital receivers) from third-party providers, new Universal Service Fund obligations on our provision of Internet service that would add to the cost of that service; increases in government-administered broadband subsidies to rural areas that could result in subsidized overbuilding of our more rural facilities, changes to the FCC's administration of spectrum, and changes in the regulatory framework for VoIP phone service, including the scope of regulatory obligations associated with our VoIP service and our ability to interconnect our VoIP service with incumbent providers of traditional telecommunications service. If any of these such laws or regulations are enacted, they could affect our operations and require significant expenditures. We cannot predict future developments in these areas, and any changes to the regulatory framework for our Internet, video or VoIP services could have a negative impact on our business and results of operations.It remains uncertain what rule changes, if any, will ultimately be adopted by Congress and the FCC and what operating or financial impact any such rules might have on us, including on our programming agreements, customer privacy and the user experience. In addition, the FCC, the FTC, and various state agencies and attorney generals actively investigate industry practices and could impose substantial forfeitures for alleged regulatory violations.Tax legislation and administrative initiatives or challenges to our tax and fee positions could adversely affect our results of operations and financial condition.We operate cable systems in locations throughout the United States and, as a result, we are subject to the tax laws and regulations of federal, state and local governments. From time to time, legislative and administrative bodies change laws and regulations that change our effective tax rate or tax payments. For instance, there are initiatives at the federal level to reverse the corporate tax cuts in the favorable Tax Cuts and Jobs Act of 2017. Certain states and localities have imposed or are considering imposing new or additional taxes or fees on our services or changing the methodologies or base on which certain fees and taxes are computed. Potential changes include additional taxes or fees on our services which could impact our customers, changes to income tax sourcing rules and other changes to general business taxes, central/unit-level assessment of property taxes and other matters that could increase our income, franchise, sales, use and/or property tax liabilities. For example, some local franchising authorities are seeking to impose franchise fee assessments on our broadband Internet access service (in addition to our video service), and more may do so in the future. If they do so, and challenges to such assessments are unsuccessful, it could adversely impact our costs. Although the FCC issued a decision precluding the imposition of such duplicative fees, that favorable decision is currently subject to judicial review. In addition, federal, state and local tax laws and regulations are extremely complex and subject to varying interpretations. There can be no assurance that our tax positions will not be challenged by relevant tax authorities or that we would be successful in any such challenge.Our cable system franchises are subject to non-renewal or termination and are non-exclusive. The failure to renew a franchise or the grant of additional franchises in one or more service areas could adversely affect our business.Our cable systems generally operate pursuant to franchises, permits, and similar authorizations issued by a state or local governmental authority controlling the public rights-of-way. Many franchises establish comprehensive facilities and service requirements, as well as specific customer service standards and monetary penalties for non-compliance. In many cases, franchises are terminable if the franchisee fails to comply with significant provisions set forth in the franchise agreement governing system operations. Franchises are generally granted for fixed terms and must be periodically renewed. Franchising authorities may resist granting a renewal if either past performance or the prospective operating proposal is considered inadequate. Franchise authorities often demand concessions or other commitments as a condition to renewal. In some instances, local franchises have not been renewed at expiration, and we have operated and are operating under either temporary operating agreements or without a franchise while negotiating renewal terms with the local franchising authorities.25We cannot assure you that we will be able to comply with all significant provisions of our franchise agreements and certain of our franchisers have from time to time alleged that we have not complied with these agreements. Additionally, although historically we have renewed our franchises without incurring significant costs, we cannot assure you that we will be able to renew, or to renew as favorably, our franchises in the future. A termination of or a sustained failure to renew a franchise in one or more service areas could adversely affect our business in the affected geographic area.Our cable system franchises are non-exclusive. Consequently, local and state franchising authorities can grant additional franchises to competitors in the same geographic area or operate their own cable systems. In some cases, local government entities and municipal utilities may legally compete with us on more favorable terms. Item 1B. Unresolved Staff Comments.None.Item 2. Properties. Our principal physical assets consist of cable distribution plant and equipment, including signal receiving, encoding and decoding devices, headend reception facilities, distribution systems, and customer premise equipment for each of our cable systems. Our cable plant and related equipment are generally attached to utility poles under pole rental agreements with local public utilities and telephone companies, and in certain locations are buried in underground ducts or trenches. We own or lease real property for signal reception sites, and own our service vehicles.We generally lease space for business offices. Our headend and tower locations are located on owned or leased parcels of land, and we generally own the towers on which our equipment is located. The physical components of our cable systems require maintenance as well as periodic upgrades to support the new services and products we introduce. See “Item 1. Business – Our Network Technology and Customer Premise Equipment.” We believe that our properties are generally in good operating condition and are suitable for our business operations. Item 3. Legal Proceedings. The legal proceedings information set forth in Note 21 to the accompanying consolidated financial statements contained in “Part II.
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+Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”Competition The fast-casual, quick-service, and casual dining segments of the restaurant industry are highly competitive with respect to, among other things, taste, price, food quality and presentation, service, location, convenience, brand reputation, cleanliness, and ambience of each restaurant. Our competition includes a variety of restaurants in each of these segments, including locally-owned restaurants, as well as national and regional chains. Competition from food delivery services, which offer meals from a wide variety of restaurants, also has increased in recent years, particularly during COVID-19, and is expected to continue to increase. Many of our competitors also offer dine-in, carry-out, online, catering, and delivery services. Among our main competitors are restaurant formats that claim to serve higher quality ingredients without artificial flavors, colors and preservatives, and that serve food quickly and at a reasonable price. 6Table of Contents Our Intellectual Property and Trademarks “Chipotle,” “Chipotle Mexican Grill,” “Food With Integrity,” “Responsibly Raised,” “Chipotle Rewards,” and a number of other marks and related designs and logos are U.S. registered trademarks of Chipotle. We have filed trademark applications for a number of additional marks in the U.S. as well. In addition to our U.S. registrations, we have registered trademarks for “Chipotle” and a number of other marks in Canada, the European Union and various other countries, and have filed trademark applications for “Chipotle Mexican Grill,” “Chipotle” and a number of other marks in additional countries. We also believe that the design of our restaurants is our proprietary trade dress and have registered elements of our restaurant design for trade dress protection in the U.S. as well.From time to time, we have taken action against other restaurants that we believe are misappropriating our trademarks, restaurant designs or advertising. Although our policy is to protect and defend vigorously our rights to our intellectual property, we may not be able to adequately protect our intellectual property, which could harm the value of our brand and adversely affect our business. Available Information We maintain a website at www.chipotle.com, including an investor relations section at ir.chipotle.com, on which we routinely post important information, such as webcasts of quarterly earnings calls and other investor events in which we participate or host, and any related materials. Our Code of Ethics and our Code of Conduct for Suppliers also are available in this section of our website. You may access our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to those reports, as well as other reports relating to us that are filed with or furnished to the SEC, free of charge in the investor relations section of our website as soon as reasonably practicable after such material is electronically filed with or furnished to the SEC. The SEC also maintains a website that contains reports, proxy and information statements and other information regarding issuers that file electronically with the SEC at www.sec.gov. The contents of the websites mentioned above are not incorporated into and should not be considered a part of this report. The references to the URLs for these websites are intended to be inactive textual references only.‎ 7Table of Contents ITEM 1A. RISK FACTORS You should carefully consider the risks described below in addition to the other information set forth in this Annual Report on Form 10-K, including the Management’s Discussion and Analysis of Financial Conditions and Results of Operations section and the consolidated financial statements and related notes. If any of the risks and uncertainties described below actually occur or continue to occur, our business, financial condition and results of operations, and the trading price of our common stock could be materially and adversely affected. The risks and uncertainties described below are those that we have identified as material but are not the only risks and uncertainties we face. Our business is also subject to general risks and uncertainties that affect many other companies, including, but not limited to, overall economic and industry conditions and additional risks not currently known to us or that we presently deem immaterial may arise or become material and may negatively impact our business, reputation, financial condition, results of operations or the trading price of our common stock. Risks Related to the Nature of our Restaurant Business and Operating in the Restaurant IndustryFood safety and food-borne illness concerns may have an adverse effect on our business by decreasing sales and increasing costs.Food safety is our top priority, and we dedicate appropriate resources to ensuring that our guests enjoy safe, high-quality food products. Even with strong preventative controls and interventions, food-borne illnesses continue to occur in the restaurant industry because food safety risks cannot be completely eliminated in any restaurant. Incidents may result from the failure of restaurant crew members or suppliers to follow our food safety policies and procedures, or from employees or guests entering our restaurant while ill and contaminating food ingredients or surfaces. Although we monitor and audit all of our programs, we cannot guarantee that each and every individual food item is safely and properly maintained during distribution throughout the supply chain. Regardless of the source or cause, any report of food-borne illness such as E. coli, hepatitis A, norovirus or salmonella, and other food safety issues, including food tampering or contamination, at one of our restaurants could adversely affect our reputation and have a negative impact on our sales. In addition, instances of food-borne illness, food tampering or food contamination that occur solely at competitors’ restaurants could result in negative publicity about the restaurant industry and adversely impact our sales. Social media has dramatically increased the rate at which negative publicity, including actual or perceived food safety incidents, can be disseminated before there is any meaningful opportunity to investigate, respond and address an issue. The occurrence of food-borne illnesses or food safety issues could also adversely affect the price and availability of affected ingredients, resulting in higher costs and lower margins.We may be more susceptible than our competitors to significant adverse consequences arising from food safety incidents due to several highly publicized food safety events in our restaurants and failure to adhere to our food safety standards. From 2015 to 2017, illnesses caused by E. coli bacteria and norovirus were connected to a number of our restaurants and, in 2018, illnesses believed to be caused by C. perfringens bacteria were connected to the food in one of our restaurants. As a result of these incidents and the related negative publicity, our sales and profitability were severely impacted throughout 2016 and from time to time through 2018. Because of consumer perceptions in the wake of these food safety incidents, any future food safety incidents associated with our restaurants—even incidents that would be considered minor at other restaurants—may have a more significant negative impact on our sales and our ability to regain guests. In addition, we may be at a higher risk for food safety incidents than some competitors due to our greater use of fresh, unprocessed produce, handling of raw chicken, our reliance on employees cooking with traditional methods rather than automation, and our avoidance of frozen ingredients. The risk of illnesses associated with our food also may increase due to the growth of our delivery or catering businesses, in which our food is transported and/or served in transportation conditions that are not under our control. All of these factors could have an adverse impact on our ability to attract and retain guests, which could in turn have a material adverse effect on our growth and profitability. The restaurant industry is highly competitive. If we are not able to compete successfully, our business, financial condition and results of operations would be adversely affected.The restaurant industry is highly competitive with respect to taste preferences, price, food quality and selection, customer service, brand reputation, digital engagement, advertising levels and promotional initiatives, and the location, attractiveness and maintenance of restaurants. We also compete with a number of non-traditional market participants, such as convenience stores, grocery stores, coffee shops, meal kit delivery services, and “ghost” or dark kitchens, where meals are prepared at separate takeaway premises rather than a restaurant. Competition from food delivery services has also increased in recent years, particularly during COVID-19, and is expected to continue to increase. Increased competition could have an adverse effect on our sales, profitability and development plans. If consumer or dietary preferences change, if our marketing efforts are unsuccessful, or if our restaurants are unable to compete successfully with other restaurant outlets, our business could be adversely affected. We continue to believe that our commitment to higher-quality and responsibly sourced ingredients gives us a competitive advantage; however, more competitors have made claims related to the quality of their ingredients and lack of artificial flavors, colors and preservatives. The increasing use of these claims by competitors, regardless of the accuracy of such claims, may lessen our differentiation and make it more difficult for us to compete. If we are unable to continue to maintain our distinctiveness and compete effectively, our business, financial condition and results of operations could be adversely affected. 8Table of Contents Our digital business, which accounted for almost half of revenues in 2020, is subject to risks. In 2020, 46.2% of our revenue was derived from digital orders, which includes delivery and customer pickup, compared to 18% of our revenues in 2019. The growth in digital orders is attributable to more guests dining at home due to COVID-19, our expanded partnerships with multiple third-party delivery services and our expansion of Chipotlanes, which is our drive through format for digital order pickups. Depending on which ordering platform a digital order is placed - our platform or the platform of a third-party delivery service – the delivery fee we collect from the guest may be less than the actual delivery cost, which has a negative impact on our profitability. In the fall of 2020, we implemented a menu price increase to partially offset higher delivery costs; however, our higher menu prices may cause some guests to shift their purchases to other restaurants offered on the platform. As our digital business grows, we are increasingly reliant on third-party delivery companies, which maintain control over data regarding guests that use their platform and over the customer experience. If a third-party delivery company driver fails to make timely deliveries or fails to deliver the complete order, our guests may attribute the bad customer experience to Chipotle and could stop ordering from us. The ordering and payment platforms used by these third-parties, or our mobile app or online ordering system, could be interrupted by technological failures, user errors, cyber-attacks or other factors, which could adversely impact sales through these channels and negatively impact our overall sales and reputation. The third-party delivery business is intensely competitive, with a number of players competing for market share, online traffic capital, and delivery drivers. If the third-party delivery companies we utilize cease or curtail operations, increase their fees, or give greater priority or promotions on their platforms to our competitors, our delivery business and our sales may be negatively impacted. The delivery business has been consolidating and may continue to consolidate, and fewer third-party delivery companies may give them more leverage in negotiating the terms and pricing of contracts, which could negatively impact our profits from delivery orders.Our inability or failure to recognize, respond to and effectively manage the accelerated impact of social media could have a material adverse impact on our business. Social media and internet-based communications, including video-sharing, social networking and messaging platforms, give users immediate access to a broad audience. These platforms have dramatically increased the speed of dissemination and accessibility of information, including negative publicity related to food safety incidents and negative guest and employee experiences. Accurate and inaccurate or misleading information can be widely disseminated before there is any meaningful opportunity to respond or address an issue. As a result of our highly publicized food safety incidents in 2015 - 2018, negative social media posts about our business may generate a disproportionately negative response than would be the results at other companies without a similar history. It is impossible to for us to fully predict or control social media backlash to potential issues, which could harm our business, prospects, financial condition, and results of operations, regardless of the information’s accuracy. Use of social media platforms is an important element of our marketing efforts and became increasingly more important during the COVID-19 pandemic. New social media platforms are developing rapidly, and we need to continuously innovate and evolve our social media strategies in order to maintain broad appeal with guests and brand relevance. We also continue to invest in other digital marketing initiatives to reach our guests and build their awareness of, engagement with, and loyalty to us, including our national loyalty program called Chipotle Rewards. These initiatives may not be successful, resulting in expenses incurred without the benefit of higher revenues, increased employee engagement or brand recognition. Other risks associated with the use of social media include improper disclosure of proprietary information, negative comments about us, exposure of personally identifiable information, fraud, hoaxes or malicious dissemination of false information. The inappropriate use of social media by our guests or employees could increase our costs, lead to litigation or result in negative publicity that could damage our reputation.If we do not continue to persuade consumers of the benefits of paying higher prices for our higher-quality food, our sales and results of operations could be hurt. Our success depends in large part on our ability to persuade consumers that food made with ingredients that were raised or grown in accordance with our Food With Integrity principles is worth paying a higher price at our restaurants relative to prices of some of our competitors, particularly quick-service restaurant competitors. Under our Food With Integrity principles, for example, animals must be responsibly raised, and the milk in our sour cream, cheese and queso must come from cows that have not been treated with rBGH, which practices typically are more costly than conventional farming. If we are not able to successfully persuade consumers that consuming food made consistent with our Food With Integrity principles is better for them and the environment, or if consumers are not willing to pay the prices we charge, our sales could be adversely affected, which would negatively impact our results of operations. Risks Related to the COVID-19 PandemicThe novel coronavirus (COVID-19) pandemic has adversely affected and could continue to adversely affect our financial results, operations and outlook for an extended period of time. The novel coronavirus (COVID-19) pandemic, and restrictions imposed by federal, state and local governments in response to the outbreak, have disrupted and will continue to disrupt our business. During 2020, individuals in many areas where we operate our 9Table of Contents restaurants were required to practice social distancing, restricted from gathering in groups and/or mandated to “stay home” except for “essential” purposes. In response to the COVID-19 outbreak and government restrictions, we were required to close some of our restaurants, close many of our dining rooms and offer only takeout and delivery, and/or implement modified work hours. The mobility restrictions, fear of contracting the coronavirus and the sharp increase in unemployment caused by the closure of businesses in response to the COVID-19 outbreak, have adversely affected and will continue to adversely affect our guest traffic, which in turn adversely impacts our liquidity, financial condition or results of operations. Even as and when the mobility restrictions are loosened or lifted, guests may still be reluctant to return to in-restaurant dining and the impact of lost wages due to COVID-19 related unemployment may dampen consumer spending for the foreseeable future. Our restaurant operations have been and could continue to be disrupted by employees who are unable or unwilling to work, whether because of illness, quarantine, fear of contracting COVID-19 or caring for family members due to COVID-19 disruptions or illness. Restaurant closures, limited service options or modified hours of operation due to staffing shortages could materially adversely affect our liquidity, financial condition or results of operations. To protect the health and safety of our employees and guests, we provide face coverings for all restaurant employees, offer enhanced health and welfare benefits, provided temporary wage increases during the initial onset of the pandemic, provide 14 days of paid emergency leave for COVID-related concerns, paid discretionary bonuses to restaurant employees, purchased additional sanitation supplies and personal protective materials, implemented a tamper evident packaging seal for all digital orders, and created a new steward role to sanitize high-traffic restaurant areas. These measures have increased our operating costs and adversely affected our liquidity. The COVID-19 outbreak also has affected and may continue to adversely affect the ability of certain of our suppliers to fulfill their obligations to us, which may negatively affect our restaurant operations. These suppliers include third parties that supply and/or prepare our ingredients, packaging, paper and cleaning products and other necessary operating materials, distribution centers, and logistics and transportation services providers. If our suppliers are unable to fulfill their obligations to us, we could face shortages of food items or other supplies at our restaurants, and our operations and sales could be adversely impacted. We also modified our plans for opening new restaurants and remodeling existing restaurants due to the COVID-19 outbreak. To preserve liquidity, we delayed new restaurant construction and restaurant remodels that were scheduled to begin during the first half of the year, and we limited restaurant remodels to restaurants that do not have a digital make line or Chipotlane. These changes may materially adversely affect our ability to grow our business, particularly if these construction projects are delayed for a significant amount of time. We cannot predict how long the COVID-19 outbreak will last or if it will reoccur even after the vaccines are widely administered, when government restrictions and mandates will be imposed or lifted, or how quickly, if at all, guests will return to their pre-COVID-19 purchasing behaviors, so we cannot predict how long our results of operations and financial performance will be adversely impacted. Risks Related to Labor and Supply ChainIncrease in ingredient and other operating costs, including those caused by climate and/or other sustainability risks, could adversely affect our results of operations. Our profitability depends in part on our ability to anticipate and react to changes in commodity costs, including ingredients, paper, supplies, fuel, utilities and distribution, and other operating costs, including leasing costs and labor. Any volatility in key commodity prices or fluctuation in labor costs could adversely affect our operating results by impacting restaurant profitability. The markets for some of the ingredients we use, such as beef, avocado and chicken, are particularly volatile due to factors such as limited sources, seasonal shifts, climate conditions, industry demand, including as a result of animal disease outbreaks in other parts of the world, international commodity markets, food safety concerns, product recalls and government regulation. Increasing weather volatility or other long-term changes in global weather patterns, including related to global climate change, could have a significant impact on the price or availability of some of our ingredients. These factors are beyond our control and, in many instances, unpredictable. Volatility in prices or disruptions in supply also may result from governmental actions, such as changes in trade-related tariffs or controls, sanctions and counter sanctions, government-mandated closure of our suppliers’ operations, and asset seizures. The cost and disruption of responding to governmental investigations or inquiries, whether or not they have merit, or the impact of these other measures, may impact our results and could cause reputational or other harm.In addition, our supply chain is subject to increased costs arising from the effects of climate change, greenhouse gases and diminishing energy and water resources. The ongoing and long-term costs of these impacts related to climate change and other sustainability related issues could have a material adverse effect on our business and financial condition if not properly mitigated.We also could be adversely impacted by price increases specific to meats raised in accordance with our sustainability and animal welfare criteria, and ingredients grown in accordance with our Food With Integrity specifications, the markets for which are generally smaller and more concentrated than the markets for conventionally raised or grown ingredients. Any increase in the prices of the ingredients most critical to our menu, such as chicken, beef, dairy (for cheese and sour cream), avocados, beans, rice, tomatoes and 10Table of Contents pork, would have a particularly adverse effect on our operating results. If the cost of one or more ingredients significantly increases, we may choose to temporarily suspend serving the menu items that use those ingredients, such as guacamole or one of our proteins, rather than pay the increased cost. Any such changes to our available menu may negatively impact our restaurant traffic and could adversely impact our sales and brand. We can only partially address future price risk through forward contracts, careful planning and other activities, and therefore increases in commodity costs could have an adverse impact on our profitability. Shortages or interruptions in the supply of ingredients could adversely affect our operating results. Our business is dependent on frequent and consistent deliveries of ingredients that comply with our Food With Integrity specifications. We may experience shortages, delays or interruptions in the supply of ingredients and other supplies to our restaurants due to inclement weather, natural disasters, labor issues or other operational disruptions at our suppliers, distributors or transportation providers, or other conditions beyond our control. In addition, we have a single or a limited number of suppliers for some of our ingredients, including certain cuts of beef, tomatoes, tortillas and adobo. Although we believe we have potential alternative suppliers and sufficient reserves of ingredients, shortages or interruptions in our supply of ingredients could adversely affect our financial results. If we fail to comply with various applicable federal and state employment and labor laws and regulations, it could have a material, adverse impact on our business. Various federal and state employment and labor laws and regulations govern our relationships with our employees, and similar laws and regulations apply to our operations outside of the U.S. These laws and regulations relate to matters such as employment discrimination, wage and hour laws, predictive scheduling (“fair workweek”) and “just cause” termination laws, requirements to provide meal and rest periods or other benefits, family leave mandates, requirements regarding working conditions and accommodations to certain employees, citizenship or work authorization and related requirements, insurance and workers’ compensation rules, healthcare laws and anti-discrimination and anti-harassment laws. Complying with these laws and regulations subjects us to substantial expense and non-compliance could expose us to significant liabilities. For example, previously a number of lawsuits have been filed against us alleging violations of federal and state laws regarding employee wages and payment of overtime, meal and rest breaks, employee classification, employee record-keeping and related practices with respect to our employees. We incur legal costs to defend, and we could suffer losses from, these and similar cases, and the amount of such losses or costs could be significant. In addition, several states and localities in which we operate, and the federal government have from time to time enacted minimum wage increases, changes to eligibility for overtime pay, paid sick leave and mandatory vacation accruals, and similar requirements. These changes have increased our labor costs and may have a further negative impact on our labor costs in the future. In addition, several jurisdictions, including New York City, Philadelphia, Chicago, Seattle, Oregon, San Francisco and San Jose, have implemented fair workweek legislation, which impose complex requirements related to scheduling for certain restaurant and retail employees. Other jurisdictions where we operate are considering enacting similar legislation. Several jurisdictions also have implemented sick pay/paid time off legislation, which requires employers to provide paid time off to employees, and “just cause” termination legislation, which restricts companies’ ability to terminate employees unless they can prove “just cause” or a “bona fide economic reason” for the termination. All of these regulations impose additional obligations on us and could increase our costs of doing business. Our failure to comply with any of these laws and regulations could lead to higher employee turnover and negative publicity, and subject us to penalties and other legal liabilities, which could adversely affect our business and results of operations and potentially cause us to close some restaurants in these jurisdictions. In addition, a significant number of our restaurant crew are paid at rates impacted by the applicable minimum wage. To the extent implemented, federal, state and local proposals that increase minimum wage requirements or mandate other employee matters could, to the extent implemented, materially increase our labor and other costs. Several states in which we operate have approved minimum wage increases that are above the federal minimum. As more jurisdictions implement minimum wage increases, we expect our labor costs will continue to increase. Our ability to respond to minimum wage increases by increasing menu prices depends on willingness of our guests to pay the higher prices and our perceived value relative to competitors. Our distributors and suppliers could also be affected by higher minimum wage, benefit standards and compliance costs, which could result in higher costs for goods and services supplied to us.Additionally, while our employees are not currently covered by any collective bargaining agreements, union organizers have engaged in efforts to organize our employees and those of other restaurant companies. If a significant portion of our employees were to become covered by collective bargaining agreements, our labor costs could increase, and it could negatively impact our culture and reduce our flexibility to attract and retain top performing employees. Labor unions have attempted, and likely will continue to attempt, to attract media attention to their organizing efforts in our restaurants, and their organizing efforts include claims that Chipotle mistreats or undervalues its employees. Despite our efforts to provide more accurate information about our policies and practices, these messages may dissuade guests from patronizing our restaurants. 11Table of Contents If we are not able to hire, train, reward and retain qualified restaurant crew and/or if we are not able to appropriately plan our workforce, our growth plan and profitability could be adversely affected. We rely on our restaurant-level employees to consistently provide high-quality food and positive experiences to our guests. In addition, our ability to continue to open new restaurants depends on our ability to recruit, train and retain high-quality crew members to manage and work in our restaurants. Maintaining appropriate staffing in our existing restaurants and hiring and training staff for our new restaurants requires precise workforce planning, which has become more complex due to predictive scheduling (“fair workweek”) laws and “just cause” termination legislation. If we fail to appropriately plan our workforce, it could adversely impact guest satisfaction, operational efficiency and restaurant profitability. In addition, if we fail to adequately monitor and proactively respond to employee dissatisfaction, it could lead to poor guest satisfaction, higher turnover, litigation and unionization efforts. The COVID-19 pandemic has exacerbated staffing complexities for us and other restaurant operators, and during 2020 we were forced to temporarily close some restaurants or limit operating hours due to employee illnesses, fear of contracting COVID or caregiving responsibilities among our restaurant crew. COVID-19 has also resulted in aggressive competition for talent, wage inflation and pressure to improve benefits and workplace conditions to remain competitive. Our failure to recruit and retain new restaurant crew members in a timely manner or higher employee turnover levels all could affect our ability to open new restaurants and grow sales at existing restaurants, and we may experience higher than projected labor costs.Risks Related to IT Systems, Cybersecurity and Data PrivacyCybersecurity breaches or other privacy or data security incidents could result in unauthorized access, theft, modification or destruction of confidential guest, personal employee and other material, confidential information that is stored in our systems or by third parties on our behalf, which may adversely affect our business.A cyber incident generally refers to any intentional attack or an unintentional event that results in unauthorized access to systems to disrupt operations, corrupt data or steal or expose confidential information or intellectual property. A cyber incident that compromises the information of our guests or employees could result in widespread negative publicity, damage to our reputation, a loss of guests, disruption of our business and legal liabilities. As our reliance on technology has grown, the scope and severity of risks posed to our systems from cyber threats has increased. In addition, as more business activities have shifted online and more people are working remotely, including as a result of COVID-19, we have experienced an increase in cybersecurity threats and attempts to breach our security networks. The techniques and sophistication used to conduct cyber-attacks and breaches of information technology systems, as well as the sources and targets of these attacks, change frequently and are often not recognized until attacks are launched or have been in place for a period of time. We continuously monitor and develop our information technology networks and infrastructure to prevent, detect, address and mitigate the risk of unauthorized access, misuse, malware and other events that could have a security impact; however there can be no assurance that these measures will be effective. The majority of our restaurant sales are made by credit or debit cards, and we also maintain personal information regarding our employees and confidential information about our guests and suppliers. We segment our card data environment and employ a cyber security protection program that is based on proven industry frameworks. This program includes but is not limited to cyber security techniques, tactics and procedures, including the deployment of a robust set of security controls, continuous monitoring and detection programs, network protections, vendor selection criteria, secure software development programs and ongoing employee training, awareness and incident response preparedness. In addition, we continuously scan our environment for any vulnerabilities, perform penetration testing, engage third parties to assess effectiveness of our security measures and collaborate with members of the cyber security community. However, there are no assurances that such programs will prevent or detect cyber security breaches. From time to time we have been, and likely will continue to be, the target of cyber and other security threats. For example, some of our guests have experienced account takeover fraud, in which guests use the same log in credentials on multiple websites and, when a third party fraudulently obtains those credentials, they can gain unauthorized access to their accounts and charge food orders to the credit card linked to the account (without accessing credit card data). We may in the future become subject to other legal proceedings or governmental investigations for purportedly fraudulent transactions arising out of the actual or alleged theft of our consumers’ credit or debit card information or if consumer or employee information is obtained by unauthorized persons or used inappropriately. Any such claim or proceeding, or any adverse publicity resulting from such an event, may have a material adverse effect on our business and we may incur significant remediation costs.Cybersecurity breaches also could result in a violation of applicable U.S. and international privacy and other laws, and subject us to private consumer, business partner, or securities litigation and governmental investigations and proceedings, any of which could result in our exposure to material civil or criminal liability. For example, the European Union’s General Data Protection Regulation (“GDPR”) requires companies to meet certain requirements regarding the handling of personal data, including its use, protection and transfer and the ability of persons whose data is stored to correct or delete such data about themselves. Failure to meet the GDPR requirements could result in penalties of up to 4% of annual worldwide revenue. Additionally, the California Privacy Act of 2018 (“CCPA”), which became effective on January 1, 2020, provides a private right of action for data breaches and requires companies that process information on California residents to make new disclosures to consumers about their data collection, use and sharing practices, allow consumers to opt out of certain data sharing with third parties and the right for consumers to request deletion of 12Table of Contents personal information (subject to certain exceptions). If we fail, or are perceived to have failed, to properly respond to security breaches of our or third party’s information technology systems or fail to properly respond to consumer requests under the CCPA, we could experience reputational damage, adverse publicity, loss of consumer confidence, reduced sales and profits, complications in executing our growth initiatives and regulatory and legal risk, including criminal penalties or civil liabilities.Compliance with the GDPR, the CCPA and other current and future applicable international and U.S. privacy, cybersecurity and related laws can be costly and time-consuming. We make significant investments in technology, third-party services and internal personnel to develop and implement systems and processes that are designed to anticipate cyber-attacks and to prevent or minimize breaches of our information technology systems or data loss, but these security measures cannot provide assurance that we will be successful in preventing such breaches or data loss. In addition, media or other reports of existing or perceived security vulnerabilities in our systems or those of our third-party business partners or service providers can also adversely impact our brand and reputation and materially impact our business, even if no breach has been attempted or has occurred. We may incur increased costs to comply with privacy and data protection laws and, if we fail to comply, we could be subject to government enforcement actions, private litigation and adverse publicity. The regulatory environment related to data privacy and cybersecurity is changing at an ever-increasing pace, with new and increasingly rigorous requirements applicable to our business. Complying with newly developed laws and regulations, which are subject to change and uncertain interpretations and may be inconsistent from state to state or country to country, may lead to a decline in guest engagement or cause us to incur substantial costs or modifications to our operations or business practices to comply. We are subject to the European Union’s GDPR, which requires companies to meet certain requirements regarding the handling of personal data, including its use, protection and transfer and the ability of persons whose data is stored to correct or delete such data about themselves. Failure to meet the GDPR requirements could result in penalties of up to 4% of annual worldwide revenue. Additionally, in July 2020, the European Court of Justice’s invalidation of cross-border data transfer mechanisms such as the U.S.-E.U. Privacy Shield and the Standard Contractual Clauses has imposed new uncertainty in privacy compliance and an adverse impact on operational efficiency with our third-party vendors. The Federal Trade Commission and many State Attorneys General are also interpreting federal and state consumer protection laws to impose standards for the online collection, use, dissemination and security of data. Maintaining our compliance with those requirements may limit our ability to obtain data used to provide a more personalized guest experience. The CCPA provides a private right of action for data breaches and requires companies that process information on California residents to make new disclosures to consumers about their data collection, use and sharing practices, allows consumers to opt-out of certain data sharing with third parties and gives consumers the right to request deletion of personal information (subject to certain exceptions). If we fail, or are perceived to have failed, to properly respond to security breaches of our or third party’s information technology systems or fail to properly respond to consumer requests under the CCPA, we could experience regulatory fines, reputational damage, adverse publicity, loss of consumer confidence, reduced sales and profits, complications in executing our growth initiatives and regulatory and legal risk, including criminal penalties or civil liabilities. We rely heavily on information technology systems and failures or interruptions in our IT systems could harm our ability to effectively operate our business and/or result in the loss of guests or employees.We rely heavily on information technology systems, including the point-of-sale and payment processing system in our restaurants, technologies supporting our online ordering, digital and delivery business, technologies that traceback ingredients to suppliers and growers and manage our supply chain, our rewards program, technologies that facilitate marketing initiatives, employee engagement and payroll processing, and various other processes and transactions. Our ability to effectively manage our business and coordinate the procurement, production, distribution, safety and sale of our products depends significantly on the availability, reliability and security of these systems. Many of these critical systems are provided and managed by third parties, and we are reliant on these third-party providers to implement protective measures that ensure the security and availability of their systems. Although we have operational safeguards in place, these safeguards may not be effective in preventing the failure of these third-party systems or platforms to operate effectively and be available. Failures may be caused by various factors, including power outages, catastrophic events, physical theft, computer and network failures, inadequate or ineffective redundancy, problems with transitioning to upgraded or replacement systems or platforms, flaws in third-party software or services, errors or improper use by our employees or the third-party service providers. If any of our critical IT systems were to become unreliable, unavailable, compromised or otherwise fail, and we were unable to recover in a timely manner, we could experience an interruption in our operations that could have a material adverse impact on our profitability. 13Table of Contents Our inability or failure to execute on a comprehensive business continuity plan at our restaurant support centers following a disaster or force majeure event could have a material adverse impact on our business. Many of our corporate systems and processes and corporate support for our restaurant operations are centralized at one location. We have disaster recovery procedures and business continuity plans in place to address crisis-level events, including hurricanes and other natural disasters, and back up and off-site locations for recovery of electronic and other forms of data and information, and the COVID-19 pandemic has provided a limited test of our ability to manage our business remotely. However, if we are unable to fully implement our disaster recovery plans, we may experience delays in recovery of data, inability to perform vital corporate functions, tardiness in required reporting and compliance, failures to adequately support field operations and other breakdowns in normal communication and operating procedures that could have a material adverse effect on our financial condition, results of operation and exposure to administrative and other legal claims. In addition, these threats are constantly evolving, which increases the difficulty of accurately and timely predicting, planning for and protecting against the threat. As a result, our disaster recovery procedures and business continuity plans security may not adequately address all threats we face or protect us from loss.Legal and Regulatory RisksA violation of Chipotle’s Deferred Prosecution Agreement could have an adverse effect on our business and reputation.In April 2020, Chipotle signed a Deferred Prosecution Agreement (the “DPA”), which was filed in the U.S. District Court for the Central District of California, to settle an official criminal investigation conducted by the U.S. Attorney’s Office for the Central District of California, in conjunction with the U.S. Food and Drug Administration’s Office of Criminal Investigations (collectively, the “DOJ”), into company-wide food safety matters that occurred in our restaurants dating back to January 1, 2013. Pursuant to the DPA, the DOJ filed a two-count Class A Misdemeanor Information in the United States District Court for the Central District of California charging Chipotle with adulterating and causing food to be adulterated within the meaning of the Federal Food, Drug and Cosmetic Act (“FDCA”) while such food was held for sale. Under the DPA, Chipotle paid a $25 million fine and is required to enhance and maintain a comprehensive compliance program that is designed to ensure Chipotle complies with all applicable federal and state food safety laws. The DOJ agreed that if Chipotle is in full compliance with all of its obligations under the DPA at the conclusion of the three-year deferred prosecution term, the DOJ will move to dismiss the two-count information filed against Chipotle. Full compliance with the DPA requires, among other things, Chipotle to conduct a root cause analysis of the historic food safety matters, maintain and annually update a comprehensive food safety plan and comply with applicable provisions of the FDCA. Chipotle owns and operates over 2,700 restaurants and we dedicate substantial resources to our food safety program; however, even with strong preventative controls and interventions, food safety risks cannot be completely eliminated in any restaurant. Food safety risks may arise due to possible failures by restaurant crew or suppliers to follow food safety policies and procedures, employees or guests coming to the restaurant while ill or serving contaminated food ingredients. If Chipotle is found to have breached the terms of the DPA, the DOJ may elect to prosecute, or bring a civil action against the company for conduct alleged in the DPA’s Statement of Facts, which could result in additional fines, penalties, and have material adverse impacts on our results of operations. In addition, further action by the DOJ may significantly and adversely affect our brand and reputation, especially in light of our highly publicized food safety incidents in 2015 – 2017. We could be party to litigation or other legal proceedings that could adversely affect our business, results of operations and reputation.We have been and, in the future, we likely will be subject to litigation and other legal proceedings that may adversely affect our business. These legal proceedings may involve claims brought by employees, guests, government agencies, suppliers, shareholders or others through private actions, class actions, administrative proceedings, regulatory actions or other litigation. These legal proceedings may involve allegations of illegal, unfair or inconsistent employment practices, including wage and hour, employment of minors, discrimination, wrongful termination, and vacation and family leave laws; food safety issues including food-borne illness, food contamination and adverse health effects from consumption of our food products; data security or privacy breaches; guest discrimination; personal injury in our restaurants; trademark infringement; violation of the federal securities laws or other concerns. For example, a number of lawsuits have been filed against us alleging violations of federal and state employment laws, including wage and hour claims; and in 2020 we settled an official criminal investigation by the U.S. Attorney’s Office for the Central District of California, in conjunction with the U.S. Food and Drug Administration’s Office of Criminal Investigations, related to company-wide food safety matters dating back to 2013. We could be involved in similar or even more significant litigation and legal proceedings in the future. Even if the allegations against us in current or future legal matters are unfounded or we ultimately are not held liable, the costs to defend ourselves may be significant and the litigation may subject us to substantial settlements, fines, penalties or judgments against us and may divert management's attention away from operating our business, all of which could negatively impact our financial condition and results of operations. Litigation also may generate negative publicity, regardless of whether the allegations are valid, or we ultimately are liable, which could damage our reputation, and adversely impact our sales and our relationship with our employees and guests. 14Table of Contents We are subject to extensive laws, government regulation, and other legal requirements and our failure to comply with existing or new laws and regulations could adversely affect our operational efficiencies, ability to attract and retain talent and results of operations.Our business is subject to extensive federal, state, local and international laws and regulations, including those relating to: preparation, sale and labeling of food, including regulations of the Food and Drug Administration, which oversees the safety of the entire food system, including inspections and mandatory food recalls, menu labeling and nutritional content; employment practices and working conditions, including minimum wage rates, wage and hour practices, Fair Workweek legislation, employment of minors, discrimination, harassment, classification of employees, paid and family leave, workplace safety, immigration and overtime among others;health, sanitation, safety and fire standards and the sale of alcoholic beverages;building and zoning requirements, including state and local licensing and regulation governing the design and operation of facilities and land use; public accommodations and safety conditions, including the Americans with Disabilities Act and similar state laws that give civil rights protections to individuals with disabilities in the context of employment, public accommodations, and other areas; data privacy laws and standards for the protection of personal information, including social security numbers, financial information (including credit card numbers), and health information, and payment card industry standards and requirements;environmental matters, such as emissions and air quality, water consumption, the discharge, storage, handling, release, and disposal of hazardous or toxic substances, and local ordinances restricting the types of packaging we can use in our restaurants; andpublic company compliance, disclosure and governance matters, including accounting and tax regulations, SEC and NYSE disclosure requirements. Compliance with these laws and regulations, and future new laws or changes in these laws or regulations that impose additional requirements, can be costly. Any failure or perceived failure to comply with these laws or regulations could result in, among other things, revocation of required licenses, administrative enforcement actions, fines and civil and criminal liability. Risks Related to Our Growth and Business StrategyIf we are unable to meet our projections for new restaurant openings, or efficiently maintain the attractiveness of our existing restaurants, our profitability could suffer. Our growth strategy depends on our ability to continue to open new restaurants and operate them profitably. Historically, it can take up to 24 months to ramp up the sales and profitability of a new restaurant. During the ramp-up phase, the restaurant’s sales and income are below the levels at which we expect them to normalize and costs may be higher as we train new employees and adjust our food deliveries and preparation to sales trends. If we are unable to build the customer base that we expect or overcome the initial higher costs associated with new restaurants, our new restaurants may not be as profitable as our existing restaurants. Our ability to open and profitably operate new restaurants also is subject to various risks, such as the identification and availability of economically viable locations, the negotiation of acceptable lease terms, the ability to operate with a Chipotlane, the need to obtain all required governmental permits (including zoning approvals and liquor licenses) and to comply with other regulatory requirements, the availability of capable contractors and subcontractors, the ability to meet construction schedules and budgets, the ability to manage labor activities that could delay construction, increases in labor and building material costs, changes in weather or other acts of God that could result in construction delays and adversely affect the results of one or more restaurants for an indeterminate amount of time, our ability to hire and train qualified management personnel and general economic and business conditions. At each potential location, we compete with other restaurants and retail businesses for desirable development sites, construction contractors, management personnel, hourly employees and other resources. If we are unable to successfully manage these risks, we could face increased costs and lower than anticipated sales and earnings in future periods.In addition, in an effort to increase same-restaurant sales and improve our operating performance, we continue to improve our existing restaurants through remodels, upgrades and regular upkeep. If the costs associated with remodels, upgrades or regular upkeep are higher than anticipated, restaurants are closed for remodeling for longer periods than planned or remodeled restaurants do not perform as expected, we may not realize our projected desired return on investment, which could have a negative effect on our operating results. 15Table of Contents Substantially all of our restaurants operate in leased properties subject to long-term leases. If we are unable to secure new leases on favorable terms, terminate unfavorable leases or renew or extend favorable leases, our profitability may suffer. We operate substantially all of our restaurants in leased facilities. It is becoming increasing challenging to locate and secure favorable lease facilities for new restaurants as competition for restaurant sites in our target markets is intense. Development and leasing costs are increasing, particularly for urban locations. These factors could negatively impact our ability to manage our occupancy costs, which may adversely impact our profitability. In addition, any of these factors may be exacerbated by economic factors, which may result in an increased demand for developers and contractors that could drive up our construction and leasing costs. Also, as we open and operate more restaurants, our rate of expansion relative to the size of our existing restaurant base will decline, making it increasingly difficult to achieve levels of sales and profitability growth that we achieved in prior years.From time to time we may close or relocate a restaurant if a current location becomes less profitable as a result of adverse economic conditions or local regulatory compliance in the area. We also have closed some restaurants where the impact of COVID-19 was severe. If the closures continue for a long period of time we may not be able to recover our investment due to the high rental rates. Because substantially all of our restaurants operate in leased facilities, we may incur significant lease termination expenses when we close or relocate a restaurant and are often obligated to continue rent and other lease related payments after restaurant closure. We also may incur significant asset impairment and other charges in connection with closures and relocations. If the lease termination cost is significant, we may decide to keep underperforming restaurants open. Ongoing lease obligations at closed or underperforming restaurant locations could decrease our results of operations. In addition, we may be unable to renew a lease without substantial additional cost at the end of the lease term and expiration of all renewal periods. As a result, we may be required to close or relocate a restaurant, which could subject us to construction and other costs and risks that may have an adverse effect on our operating performance. Our failure to effectively manage our growth could have a negative adverse effect on our business and financial results. As of December 31, 2020, we owned and operated 2,764 Chipotle restaurants and we plan to open a significant number of new restaurants in the next several years. Our existing restaurant management systems, back office technology systems and processes, financial and management controls, information systems and personnel may not be adequate to support our continued growth. To effectively manage a larger number of restaurants, we may need to upgrade and expand our infrastructure and information systems, automate more processes that currently are manual or require manual intervention and hire, train and retain restaurant crew and corporate support staff, all of which may result in increased costs and at least temporary inefficiencies. We also place a lot of importance on our culture, which we believe has been an important contributor to our success, and as we continue to grow, it may be increasingly difficult to maintain our culture. Our failure to sufficiently invest in our infrastructure and information systems and maintain our strong staffing and culture could harm our brand and operating results.A failure to recruit, develop and retain effective leaders or the loss or shortage of personnel with key capacities and skills could impact our strategic growth plans and jeopardize our ability to meet our business performance expectations and growth targets.Our ability to continue to grow our business depends substantially on the contributions and abilities of our executive leadership team and other key management personnel. Changes in senior management could expose us to significant changes in strategic direction and initiatives. A failure to maintain appropriate organizational capacity and capability to support our strategic initiatives or to build adequate bench strength with key skillsets required for seamless succession of leadership, could jeopardize our ability to meet our business performance expectations and growth targets. If we are unable to attract, develop, retain and incentivize sufficiently experienced and capable management personnel, our business and financial results may suffer.The market price of our common stock may be more volatile than the market price of our peers.We believe the market price of our common stock generally has traded at a higher price-earnings ratio than stocks of most of our peer companies as well as the overall market, which typically has reflected market expectations for higher future operating results. At any given point in time, our price-earnings ratio may trade at more than twice the price-earnings ratio of the S&P 500. Also, the trading market for our common stock has been volatile at times, including as a result of adverse publicity events. As a result, if we fail to meet market expectations for our operating results in the future, any resulting decline in the price of our common stock could be significant.General Risk FactorsEconomic and business factors that are largely beyond our control may adversely affect consumer behavior and the results of our operations.Restaurant dining generally is dependent upon consumer discretionary spending, which may be affected by general economic conditions that are beyond our control. For example, international, domestic and regional economic conditions, consumer income levels, financial market volatility, a slow or stagnant pace of economic growth, rising energy costs, rising interest rates, social unrest, and governmental, political and budget concerns or divisions may have a negative effect on consumer confidence and discretionary 16Table of Contents spending. In addition, a new presidential and legislative administration recently took office, and it is not yet known what changes the new administration will make to economic or tax policies and how those policies will impact the economy or consumer discretionary spending. Any significant decrease in our guest traffic or average transactions would negatively impact our financial performance. Any actual or perceived threat of a pandemic or communicable disease, terrorist attack, mass shooting, heightened security requirements, including cybersecurity, or a failure to protect information systems for critical infrastructure, such as the electrical grid and telecommunications systems, could harm our operations, the economy or consumer confidence generally. Any of the above factors or other unfavorable changes in business and economic conditions affecting our guests could increase our costs, reduce traffic in some or all of our restaurants or limit our ability to increase pricing, any of which could lower our profit margins and have a material adverse effect on our sales, financial condition and results of operations. These factors also could cause us to, among other things, reduce the number and frequency of new restaurant openings, close restaurants or delay remodeling of our existing restaurant locations. Further, poor economic conditions may force nearby businesses to shut down, which could reduce traffic to our restaurants or cause our restaurant locations to be less attractive.Our quarterly financial results may fluctuate significantly, including due to factors that are not in our control. Our quarterly financial results may fluctuate significantly and could fail to meet investors’ expectations for various reasons, including: negative publicity about the safety of our food, employment-related issues, litigation or other issues involving our restaurants; fluctuations in supply costs, particularly for our most significant ingredients, and our inability to offset the higher cost with price increases without adversely impacting guest traffic; labor availability and wages of restaurant management and crew; increases in marketing or promotional expenses; the timing of new restaurant openings and related revenues and expenses, and the operating costs at newly opened restaurants; the impact of inclement weather and natural disasters, such as freezes and droughts, which could decrease guest traffic and increase the costs of ingredients; the amount and timing of stock-based compensation;litigation, settlement costs and related legal expenses; tax expenses, asset impairment charges and non-operating costs; andvariations in general economic conditions, including the impact of declining interest rates on our interest income.As a result of any of these factors, results for any one quarter are not necessarily indicative of results to be expected for any other quarter or for any year. Average restaurant sales or comparable restaurant sales in any particular future period may decrease. ITEM 1B. UNRESOLVED STAFF COMMENTS None. ITEM 2. PROPERTIESAs of December 31, 2020, there were 2,768 restaurants operated by Chipotle and our consolidated subsidiaries, 2,764 of which were Chipotle restaurants. Our main office is located at 610 Newport Center Drive, Newport Beach, CA 92660 and our telephone number is (949) 524-4000. We lease our main office and substantially all of the properties on which we operate restaurants. We own 17 properties and operate restaurants on all of them. For additional information regarding the lease terms and provisions, see Note 10. “Leases” in our consolidated financial statements included in
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+Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations for further information. For the year ended December 31, 2020, the distribution of our revenues across our four industry-based business segments was as follows:The services we provide are distributed among a number of clients in each of our business segments. A loss of a significant client or a few significant clients in a particular segment could materially reduce revenues for that segment. The services we provide to our larger clients are often critical to their operations and a termination of our services would typically require an extended transition period with gradually declining revenues. Nevertheless, the volume of work performed for specific clients may vary significantly from year to year. See Note 2 to our consolidated financial statements for additional information related to disaggregation of revenues by client location, service line and contract-type for each of our business segments. 2Table of Contents Services and SolutionsOur services include digital services and solutions, consulting, application services, systems integration, infrastructure services and business process services. Additionally, we develop, license, implement and support proprietary and third-party software products and platforms. Central to our strategy to align with our clients’ need to modernize is our continued investment in four key areas of digital: IoT, AI, experience-driven software engineering and cloud. These four capabilities enable clients to put data at the core of their operations, improve the experiences they offer to their customers, tap into new revenue streams, defend against technology-enabled competitors and reduce costs. In many cases, our clients' new digital systems are built on the backbone of their existing legacy systems. The demand for digital capabilities has continued to increase since the beginning of the COVID-19 pandemic as a result of increased demand for mobile workplace solutions, e-commerce, automation and AI and cybersecurity services and solutions. We believe our deep knowledge of our clients' infrastructure and systems provides us with a significant advantage as we work with them to build new digital capabilities to make their operations more efficient, effective and modern. We deliver all of our services and solutions across our four industry-based business segments to best address our clients' individual needs. In 2020, our services and solutions were organized into three practice areas: Digital Business, Digital Systems and Technology and Digital Business Operations. In January 2021, we strategically combined the Digital Business practice with the Digital Systems and Technology practice to create the new Digital Business & Technology practice. The objective of this change is to simplify our model and align it with the current state of technology.Our consulting professionals work closely with our practice areas to create modern frameworks, platforms and solutions that leverage a wide range of digital technologies across our clients’ businesses to deliver higher levels of efficiency and new value for their customers.Digital Business & TechnologyOur Digital Business & Technology practice helps clients build modern enterprises that deliver exceptional customer experiences that are created at the intersection of cloud and digital. Our clients are able to embrace a new business and technology stack that comprises consumer-grade software, enterprise applications, modernized data and the instrumentation of everything in cloud-first architectures. Combining a technology vision, strategy, roadmap, capabilities, solutions, partnerships, and subject matter expertise, Digital Business & Technology is an integrated growth enabler for commercial markets. Areas of focus within this practice area are:•Interactive, which leverages our global network of studios that help clients craft new experiences; •application modernization, which updates legacy applications using agile methodologies and cloud; •AI and analytics, which drive business growth and efficiencies through a greater understanding of customers and operations; •IoT, which unlocks greater productivity and new business models; •digital advisory, which provides enterprise transformation expertise; •experience-driven software engineering, which designs, engineers and delivers modern business software;•application services;•quality engineering and assurance; and•cloud, infrastructure and security. Digital Business OperationsOur Digital Business Operations practice helps clients rethink their operating models by assessing their existing processes and recommending automation. This allows clients to fundamentally transform their processes while realizing cost savings benefits from these improvements. Areas of focus within this practice area are:•automation, analytics and consulting for business process outsourcing; •platform-based operations; and •core business process operations.We have extensive knowledge of core front office, middle office and back office processes, including finance and accounting, research and analytics, procurement and data management, which we integrate with our industry and technology expertise to deliver targeted business process services and solutions. 3Table of Contents Global Delivery ModelWe utilize a global delivery model, with delivery centers worldwide to provide our full range of services to our clients. Our delivery model includes employees deployed at client sites, local or in-country delivery centers, regional delivery centers and offshore delivery centers, as required to best serve our clients. As we scale our digital services and solutions, we are focused on hiring in the United States and other countries where we deliver services to our clients to expand our in-country delivery capabilities. Our extensive facilities, technology and communications infrastructure are designed to enable the effective collaboration of our global workforce across locations and geographies.CompetitionThe markets for our services are highly competitive, characterized by a large number of participants and subject to rapid change. Competitors may include systems integration firms, contract programming companies, application software companies, cloud computing service providers, traditional consulting firms, professional services groups of computer equipment companies, infrastructure management companies, outsourcing companies and boutique digital companies. Our direct competitors include, among others, Accenture, Atos, Capgemini, Deloitte Digital, DXC Technology, EPAM Systems, Genpact, HCL Technologies, IBM Global Services, Infosys Technologies, Tata Consultancy Services and Wipro. In addition, we compete with numerous smaller local companies in the various geographic markets in which we operate.The principal competitive factors affecting the markets for our services include the provider’s reputation and experience, strategic advisory capabilities, digital services capabilities, performance and reliability, responsiveness to customer needs, financial stability, corporate governance and competitive pricing of services. Accordingly, we rely on the following to compete effectively:•investments to scale our digital services;•our recruiting, training and retention model;•our global delivery model;•an entrepreneurial culture and approach to our work;•a broad client referral base;•investment in process improvement and knowledge capture;•financial stability and good corporate governance;•continued focus on responsiveness to client needs, quality of services and competitive prices; and•project management capabilities and technical expertise.Intellectual PropertyWe provide value to our clients based, in part, on our proprietary innovations, methodologies, software, reusable knowledge capital and other IP assets. We recognize the importance of IP and its ability to differentiate us from our competitors. We seek IP protection for many of our innovations and rely on a combination of patent, copyright and trade secret laws, confidentiality procedures and contractual provisions, to protect our IP. We have registered, and applied for the registration of, U.S. and international trademarks, service marks, and domain names to protect our brands, including our Cognizant brand, which is one of our most valuable assets. We own or are licensed under a number of patents, trademarks and copyrights of varying duration, relating to our products and services. We also have policies requiring our associates to respect the IP rights of others. While our proprietary IP rights are important to our success, we believe our business as a whole is not materially dependent on any particular IP right or any particular group of patents, trademarks, copyrights or licenses, other than our Cognizant brand.Cognizant® and other trademarks appearing in this report are registered trademarks or trademarks of Cognizant and its affiliates in the United States and other countries, or third parties, as applicable. WorkforceWe had approximately 289,500 employees at the end of 2020, with 43,500 in North America, 13,400 in Continental Europe, 6,800 in the United Kingdom and 225,800 in various other locations throughout the rest of the world, including 204,500 in India. This represents a decrease of 3,000 employees as compared to December 31, 2019. We utilize subcontractors to provide additional capacity and flexibility in meeting client demand, though the number of subcontractors has historically been immaterial relative to our employee headcount. We are not party to any significant collective bargaining agreements.4Table of Contents We balance the portion of our employees in the United States and other jurisdictions that rely on visas with consideration of the needs of our business to fulfill client demand and risks to our business from potential changes in immigration laws and regulations that may increase the costs associated with and ability to staff employees on visas to work in-country. Engaging Our People As a global professional services company, Cognizant competes on the basis of the knowledge, experience, insights, skills and talent of its employees and the value they can provide to our clients. We aim for our employees to feel motivated, engaged, and empowered to do their best work through careers they find meaningful. In a market where competition for skilled IT professionals is intense, we focus on the following: •Advancing Diversity & Inclusion: We believe diversity and inclusion are at the heart of our ability to execute successfully and consistently over the long term. A diverse and inclusive workforce strengthens our ability to innovate and to understand our clients’ needs and aspirations.Highlights from our diversity & inclusion efforts include: –Our Global D&I organization is embedded within HR’s Talent & Transformation function to drive accountability through our people processes and systems;–Global D&I training and programs;–Progressive hiring policies, including a diverse candidate pipeline initiative to ensure a more diverse interview slate at the Vice President level and above; and–Seven global affinity groups that welcome, nurture and provide safe spaces in which our employees can share their unique interests and aspirations.Our 2020 engagement survey revealed that all genders are equally engaged, and that D&I gained the second-highest score improvement across categories. •Rewarding and Recognizing High Performance: We aim to create a work environment where every person is inspired to achieve, driven to perform and rewarded for their contributions. We leverage regular, performance-based promotions and merit increases as one lever to engage high-performing talent. During the 2020 cycle, in line with our high performance culture, we were proud to promote employees across all levels and provide merit increases to a significant number of our employees.We regularly monitor employee retention levels and continue to enhance our pay-for-performance approach to improve attrition rates. For the three months ended December 31, 2020, annualized attrition, including both voluntary and involuntary, was 19.0%. Attrition for the years ended December 31, 2020 and 2019, including both voluntary and involuntary, was 20.6% and 21.7%, respectively. Voluntary attrition normally constitutes the significant majority of our attrition. In 2020, we saw elevated levels of involuntary attrition due to our Fit for Growth Plan, including the exit from certain content-related services. We also saw a decrease in voluntary attrition from historic levels in the early stages of the COVID-19 pandemic. Both voluntary and involuntary attrition are weighted towards our more junior employees.•Building New Skills: Clients count on us to know their industries, businesses, and technology environments, readily gain new digital skills and insights, and apply our knowledge to help them increase their competitiveness. We continually reskill and upskill our employees with a focus on building digital skills in areas such as IoT, AI, experience-driven software engineering and cloud.From campus hire training for our entry-level workforce to providing capability assurance programs for professional practitioners, we offer a learning ecosystem for employees at all levels. This includes learning and development, access-from-anywhere learning platforms and a variety of content curation partnerships. Our talent development approach has been recognized by leading learning and development organizations, such as the Association for Talent Development, the Brandon Hall Group and the Learning and Performance Institute. •Leadership Development & Talent Management: Cognizant continuously fosters and builds its pipeline of diverse, high-performing leaders who have the breadth and versatility to drive our growth. To do this, we focus on engaging all levels of senior talent and enabling their success through continuous assessment and high impact development opportunities. 5Table of Contents Highlights include: –Targeted talent programs for key pools that include various training opportunities, digital leadership programs and custom leadership development initiatives;–Fast-tracking high-performing and high-potential leadership talent through personalized assessments, executive coaching and executive education programs;–Accelerating a diverse leadership pipeline through programs like Propel, an initiative focused on priming the next level of women leaders within Cognizant. In just two years, this program has helped us reach 500 women leaders globally through a cohort model supported by executive sponsors, part of our pledge to put 1,000 women through our leadership development program;–Our LEAD@Cognizant partnership with Harvard University is a 4.5-month leadership capability program designed exclusively for Cognizant leaders to learn, practice and internalize how to set the course, connect the dots, inspire followership and deliver results through strategic alignment, collaboration and building high performing teams; and–Periodic talent processes such as talent reviews of our top 4,000 employees at Director level and above, aimed at helping individuals develop in role and prepare for the future, while strengthening our leadership pipeline overall.•Supporting Well-Being at Work and Home: We offer benefits to care for the diverse needs of our associates and keep them feeling resilient, innovative and engaged. These include total compensation programs, health benefits, overall well-being and family care, tax savings programs, income protection and financial planning resources. As we continue to face evolving environmental and health challenges, we continually review and enhance our offerings to improve the competitiveness of our total compensation programs, including our health benefit offerings.Highlights include: –In 2020, we launched WorkFlex, a program to provide employees greater flexibility to complete their required hours outside their standard schedule or to transition to a part-time schedule to accommodate personal priorities;–We offer a variety of benefits to support employee mental health, including a robust Employee Assistance Program. In the United States, we also provide access to third party mental health platforms, including Ginger and eMindful; and–Cognizant has crisis management protocols that are mobilized to protect employee health and safety when necessary. When the COVID-19 pandemic began, our crisis team responded quickly to close and modify offices to meet health and safety protocols, support the transition to working from home, and liaise with employees regarding various concerns.•Measuring and Enhancing Engagement: We regularly assess employee sentiment through third-party engagement surveys. In 2020, 72% of our people participated in the survey. After each survey, we develop and communicate clear action plans to continue to build on our strengths and address shortfalls.Governmental Regulation and Environmental MattersAs a result of the size, breadth and geographic diversity of our business, our operations are subject to a variety of laws and regulations in the jurisdictions in which we operate, including with respect to import and export controls, temporary work authorizations or work permits and other immigration laws, content requirements, trade restrictions, tariffs, taxation, anti-corruption, the environment, government affairs, internal and disclosure control obligations, data privacy, intellectual property, employee and labor relations. For additional information, see Part I, Item 1A. Risk Factors.6Table of Contents Information About Our Executive OfficersThe following table identifies our current executive officers:NameAgeCapacities in Which ServedIn CurrentPosition SinceBrian Humphries (1)47Chief Executive Officer2019Jan Siegmund (2)56Chief Financial Officer2020Robert Telesmanic (3)54Senior Vice President, Controller and Chief Accounting Officer2017Becky Schmitt (4)47Executive Vice President, Chief People Officer2020Malcolm Frank (5)54Executive Vice President and President, Digital Business & Technology2021Balu Ganesh Ayyar (6)59Executive Vice President and President, Digital Business Operations2019Greg Hyttenrauch (7)53Executive Vice President and President, North America 2021Ursula Morgenstern (8)55Executive Vice President and President, Global Growth Markets2020Andrew Stafford (9)56Executive Vice President, Head of Global Delivery2020 (1)Brian Humphries has been our Chief Executive Officer and a member of the Board of Directors since April 2019. Prior to joining Cognizant, he served as Chief Executive Officer of Vodafone Business, a division of Vodafone Group, from 2017 until 2019. Mr. Humphries joined Vodafone from Dell Technologies where he served as President and Chief Operating Officer of Dell’s Infrastructure Solutions Group from 2016 to 2017, President of Dell’s Global Enterprise Solutions from 2014 to 2016, and Vice President and General Manager, EMEA Enterprise Solutions from 2013 to 2014. Before joining Dell, Mr. Humphries was with Hewlett-Packard where his roles from 2008 to 2013 included Senior Vice President, Emerging Markets, Senior Vice President, Strategy and Corporate Development, and Chief Financial Officer of HP Services. The early part of his career was spent with Compaq and Digital Equipment Corporation. Mr. Humphries brings to the Board extensive leadership and global operations management experience from having served at public companies in the technology sector. He holds a bachelor’s degree in Business Administration from the University of Ulster, Northern Ireland.(2)Jan Siegmund has been our Chief Financial Officer since September 2020. Prior to joining Cognizant, Mr. Siegmund spent over 19 years with Automatic Data Processing (ADP), where he served as Corporate Vice President and Chief Financial Officer from 2012 to 2019 and Chief Strategy Officer and President of the Added Value Services Division from 1999 to 2012. He began his career at McKinsey & Company as a Senior Engagement Manager. Mr. Siegmund is a member of the Board of Directors of The Western Union Company, where he is Chair of the Audit Committee. He holds a master’s degree in Industrial Engineering from Technical University Karlsruhe, Germany, a master’s degree in Economics from the University of California, Santa Barbara and a doctorate in Economics from Technical University of Dresden, Germany. (3)Robert Telesmanic has been our Senior Vice President, Controller and Chief Accounting Officer since January 2017, a Senior Vice President since 2010 and our Corporate Controller since 2004. Prior to that, he served as our Assistant Corporate Controller from 2003 to 2004. Prior to joining Cognizant, Mr. Telesmanic spent over 14 years with Deloitte & Touche LLP. Mr. Telesmanic has a Bachelor of Science degree from New York University and an MBA degree from Columbia University.(4)Becky Schmitt has been our Executive Vice President, Chief People Officer since February 2020. Prior to joining Cognizant, Ms. Schmitt was the Chief People Officer of Sam’s Club, a division of Walmart, Inc. from October 2018 through January 2020. Prior to that, she served as SVP, Chief People Officer, US eCommerce & Corporate Functions for Walmart from October 2016 through September 2018 and as VP, HR - Technology from February 2016 until October 2016. Prior to joining Walmart, Ms. Schmitt spent over 20 years with Accenture plc in various human resources roles, culminating in her role as HR Managing Director, North America Business from March 2014 through February 2016. Ms. Schmitt has served as a Board Member at Large for the Girl Scouts National Board since 2017. Ms. Schmitt has a Bachelor of Arts degree from University of Michigan, Ann Arbor. (5)Malcolm Frank has been our Executive Vice President and President, Digital Business & Technology since January 2021. Prior to that, he served as Executive Vice President and President, Digital Business from May 2019 to January 2021, as our Executive Vice President and President, Strategy and Marketing at Cognizant from 2012 to May 2019 and as our Senior Vice President of Strategy and Marketing from 2005 to 2012. Prior to joining Cognizant in 2005, Mr. Frank was a founder and the President and Chief Executive Officer of CXO Systems, Inc., an independent software vendor providing dashboard solutions for senior managers, a founder and the President, Chief Executive Officer and Chairman of NerveWire Inc., a management consulting and systems integration firm, and a founder and executive officer at Cambridge Technology Partners, an information technology professional services firm. Mr. Frank has served on the Board of Directors of Factset Research Systems Inc. since June 2016, where he is a member of the Compensation Committee. He is 7Table of Contents also a member of the Board of Directors of the US-India Strategic Partnership Forum since May 2018. Mr. Frank has a Bachelor of Arts degree in Economics from Yale University.(6)Balu Ganesh Ayyar has been our Executive Vice President and President, Digital Business Operations since August 2019. Prior to joining Cognizant, Mr. Ayyar was the CEO of Mphasis, a global IT services company listed in India, from 2009 to 2017. Prior to Mphasis, Mr. Ayyar spent nearly two decades with Hewlett-Packard, holding a variety of leadership roles across multiple geographies.(7)Greg Hyttenrauch has been our Executive Vice President and President, North America since January 2021. Prior to that he served as our Executive Vice President and President, Cognizant Digital Systems & Technology from December 2019 to January 2021. Prior to joining Cognizant, Mr. Hyttenrauch served as Director, Global Cloud and Security Services for Vodafone from October 2015 to November 2019. Prior to Vodafone, Mr. Hyttenrauch held a variety of senior leadership positions at Capgemini from 2008 to 2015, including Deputy CEO, Global Infrastructure Services, and Global Sales Officer and CEO of the UK and Nordic Outsourcing Business Unit. Before joining Capgemini, Mr. Hyttenrauch held positions with CSC and EDS. He began his career with 13 years in the Canadian military, rising to the rank of captain. Mr. Hyttenrauch holds a bachelor’s degree in Mechanical Engineering from the Royal Military College of Canada and an MBA in International Management from the University of Ottawa.(8)Ursula Morgenstern has been Cognizant’s Executive Vice President and President, Global Growth Markets, which covers all of Cognizant’s markets outside of North America, since December 2020. Prior to joining Cognizant, Ms. Morgenstern spent 16 years with Atos, a multinational IT services and consulting company in various management roles from 2004 to 2020, most recently as Head of Atos Central Europe from April 2020 to October 2020, CEO of Atos Germany from March 2018 to October 2020, and Global Head of Business and Platform Solutions from July 2015 to February 2018. Before Atos, Ms. Morgenstern was a partner with KPMG from 1998 to 2002. Her other previous roles include General Manager of K&V Information Systems from 1996 to 1998 and Project Manager for Kiefer & Veittinger from 1991 to 1996. She holds a bachelor’s degree in Business Management from the University of Mannheim and an MBA from York University (Toronto).(9)Andrew (Andy) Stafford has been our Head of Global Delivery since July 2020. Prior to joining Cognizant, he held a variety of executive positions, including Group Chief Operating Officer of Computacenter PLC from July 2017 to November 2018, and was Global Head of Services and Delivery for Unisys Inc. from April 2016 to May 2017. Mr. Stafford also spent nearly two decades with Accenture, first from 1988 to 1997 and then again from 2005 to 2013, in various leadership roles, the most recent being Senior Managing Director (Global Lead) from July 2012 to November 2013 and Managing Director of the Asia Pacific Region from 2009 to 2012. In between stints at Accenture, he was the Chief Operating Officer at Xchanging from September 2001 to November 2003, Chief Technology Officer at Virgin.com from September 2000 to March 2001, and he also spent time at Deloitte Consulting and Computacenter PLC. He holds a bachelor's degree in Electrical Engineering and Electronics from the University of Manchester Institute of Science and Technology in Manchester, England.None of our executive officers is related to any other executive officer or to any of our Directors. Our executive officers are appointed annually by the Board of Directors and generally serve until their successors are duly appointed and qualified.Corporate HistoryWe began our IT development and maintenance services business in early 1994 as an in-house technology development center for The Dun & Bradstreet Corporation and its operating units. In 1996, we were spun-off from The Dun & Bradstreet Corporation and, in 1998, we completed an initial public offering to become a public company.Available InformationWe make available the following public filings with the SEC free of charge through our website at www.cognizant.com as soon as reasonably practicable after we electronically file such material with, or furnish such material to, the SEC:•our Annual Reports on Form 10-K and any amendments thereto;•our Quarterly Reports on Form 10-Q and any amendments thereto; and•our Current Reports on Form 8-K and any amendments thereto.No information on our website is incorporated by reference into this Form 10-K or any other public filing made by us with the SEC.Table of Contents Item 1A. Risk FactorsWe face various important risks and uncertainties, including those described below, that could adversely affect our business, results of operations and financial condition and, as a result, cause a decline in the trading price of our common stock.Risks Related to our Business and OperationsOur results of operations could be adversely affected by economic and political conditions globally and in particular in the markets in which our clients and operations are concentrated.Global macroeconomic conditions have a significant effect on our business as well as the businesses of our clients. Volatile, negative or uncertain economic conditions could cause our clients to reduce, postpone or cancel spending on projects with us and could make it more difficult for us to accurately forecast client demand and have available the right resources to profitably address such client demand. Clients may reduce demand for services quickly and with little warning, which may cause us to incur extra costs where we have employed more personnel than client demand supports.Our business is particularly susceptible to economic and political conditions in the markets where our clients or operations are concentrated. Our revenues are highly dependent on clients located in the United States and Europe, and any adverse economic, political or legal uncertainties or adverse developments, including due to the uncertainty related to the potential economic and regulatory impacts of the United Kingdom's exit from the European Union, may cause clients in these geographies to reduce their spending and materially adversely impact our business. Many of our clients are in the financial services and healthcare industries, so any decrease in growth or significant consolidation in these industries or regulatory policies that restrict these industries may reduce demand for our services. Economic and political developments in India, where a significant majority of our operations and technical personnel are located, or in other countries where we maintain delivery operations, may also have a significant impact on our business and costs of operations. As a developing country, India has experienced and may continue to experience high inflation and wage growth, fluctuations in gross domestic product growth and volatility in currency exchange rates, any of which could materially adversely affect our cost of operations. Additionally, we benefit from governmental policies in India that encourage foreign investment and promote the ease of doing business, such as tax incentives, and any change in policy or circumstances that results in the elimination of such benefits or degradation of the rule of law, or imposition of new adverse restrictions or costs on our operations could have a material adverse effect on our business, results of operations and financial condition.The COVID-19 pandemic has had a significant and continuing adverse impact upon, and this or other pandemics may have a material adverse impact upon, our business, liquidity, results of operations and financial condition. The ongoing global COVID-19 pandemic has caused and continues to cause significant loss of life and interruption to the global economy and has resulted in the curtailment of activities by businesses and consumers in much of the world as governments and others seek to limit the spread of the disease, including through business and transportation shutdowns and restrictions on people’s movement and congregation. Among other things, many of our and our clients’ offices have been closed and employees have been working from home and many consumer-facing businesses have closed or are operating at a significantly reduced level to observe various social distancing requirements and government-mandated closures. The overall result has been a dramatic reduction in activity in the global economy, a reduction in demand for many products and services and significant adverse impacts to the financial markets, including the trading price of our common stock in the past and potentially in the future.The COVID-19 pandemic has had a significant and continuing adverse impact upon, and this or other pandemics may have a material adverse impact upon, our business, liquidity, results of operations and financial condition, including as a result of the following:•Reduced client demand for services – The vast majority of our business is with clients in the United States, the United Kingdom and other countries in Europe, all regions that have been hard hit by the pandemic. The COVID-19 pandemic has reduced, and other future pandemics could reduce, demand for our services, particularly in regions that have been hit hard by the pandemic and from clients in the retail, consumer goods, travel and hospitality, and communications and media industries, and is likely to continue to result in reduced demand for our services as clients across many industries face reduced demand for their products and services. Among other things, some of our clients have postponed, cancelled or scaled-back existing projects and not entered into or reduced the scope of potential projects, and may continue to do so. •Client pricing pressure, payment term extensions and insolvency risk – As clients face reduced demand for their products and services, reduce their business activity and face increased financial pressure on their businesses, we have faced and may continue to face downward pressure on our pricing and gross margins due to pricing 9Table of Contents concessions to clients and requests from clients to extend payment terms. In addition, some of our clients have requested and may continue to request extended payment terms, which may have an adverse effect on our cash flows from operations. We may also face a significantly elevated risk of client insolvency, bankruptcy or liquidity challenges where we may perform services and incur expenses for which we are not paid.•Delivery challenges – Due to the closures of many of our and our clients’ facilities, including as a result of various orders from national, state or local governments, we have faced and may continue to face, in the near term or in future pandemics, challenges in delivering services to our clients and satisfying contractually agreed upon service levels. The pandemic, particularly in India, but also in the Philippines and other countries where we have near-shore or offshore delivery operations for clients, as well as our in-country offices and offices of clients where our associates may normally work, has impacted and may continue to impact our ability to deliver services to clients. Our work-from-home arrangements for many of our employees may increase our exposure to security breaches or cyberattacks. The ransomware attack we were subject to in April 2020 compounded the challenges we faced in enabling work-from-home arrangements and resulted in setbacks and delays to such efforts. A significant worsening of the pandemic, particularly in India, or another security incident during the pandemic, could materially impair our ability to deliver services to clients to an extent that may have a material adverse impact to our business, liquidity, results of operations and financial condition.•Increased costs – We face increased costs from the pandemic, including as a result of mitigation efforts such as enabling increased work-from-home capabilities and additional health and safety measures.•Diversion of and strain on management and other corporate resources – Addressing the significant personal and business challenges presented by the pandemic, including various business continuity measures and the need to enable work-from-home arrangements for many of our associates, has demanded significant management time and attention and strained other corporate resources, and is expected to continue to do so. Among other things, this may adversely impact our client and associate development and our ability to execute our strategy and various transformation initiatives.•Reduced employee morale and productivity – The significant personal and business challenges presented by a pandemic, including the COVID-19 pandemic, such as the potentially life-threatening health risks to employees and their families and friends, the closures of schools and the unavailability of various services our employees may rely upon, such as childcare, have been and may be a cause of employee morale concerns and may adversely impact employee productivity. The COVID-19 pandemic continues to evolve. The ultimate extent to which the pandemic impacts our business, liquidity, results of operations and financial condition will depend on future developments, which are highly uncertain and cannot be predicted with confidence, including the delivery and effectiveness of vaccines, future mutations of the COVID-19 virus and any resulting impact on the effectiveness of vaccines, the duration and extent of the pandemic and waves of infection, travel restrictions and social distancing, the duration and extent of business closures and business disruptions and the effectiveness of actions taken to contain, treat and prevent the disease. If we or our clients experience prolonged shutdowns or other business disruptions, our business, liquidity, results of operations, financial condition and the trading price of our common stock may be materially adversely affected, and our ability to access the capital markets may be limited. If we are unable to attract, train and retain skilled employees to satisfy client demand, including highly skilled technical personnel and personnel with experience in key digital areas, as well as senior management to lead our business globally, our business and results of operations may be materially adversely affected.Our success is dependent, in large part, on our ability to keep our supply of skilled employees, including project managers, IT engineers and senior technical personnel, in particular those with experience in key digital areas, in balance with client demand around the world and on our ability to attract and retain senior management with the knowledge and skills to lead our business globally. Each year, we must hire tens of thousands of new employees and reskill, retain, and motivate our workforce of hundreds of thousands of employees with diverse skills and expertise in order to serve client demands across the globe, respond quickly to rapid and ongoing technological, industry and macroeconomic developments and grow and manage our business. We also must continue to maintain an effective senior leadership team that, among other things, is effective in executing on our strategic goals and growing our digital business. The loss of senior executives, or the failure to attract, integrate and retain new senior executives as the needs of our business require, could have a material adverse effect on our business and results of operations. Competition for skilled labor is intense and, in some jurisdictions and service areas in which we operate and, in particular, in key digital areas, there are more open positions than qualified persons to fill these positions. Our business has experienced and may continue to experience significant employee attrition, which may cause us to incur increased costs to hire new employees with the desired skills. Costs associated with recruiting and training employees are significant. If we are unable to hire or deploy employees with the needed skillsets or if we are unable to adequately equip our employees with the skills needed, 10Table of Contents this could materially adversely affect our business. Additionally, if we are unable to maintain an employee environment that is competitive and appealing, it could have an adverse effect on engagement and retention, which may materially adversely affect our business.We face challenges related to growing our business organically as well as inorganically through acquisitions, and we may not be able to achieve our targeted growth rates.Achievement of our targeted growth rates requires continued significant organic growth of our business as well as inorganic growth through acquisitions. To achieve such growth, we must, among other things, continue to significantly expand our global operations, increase our product and service offerings, in particular with respect to digital, and scale our infrastructure to support such business growth. Continued business growth increases the complexity of our business and places significant strain on our management, employees, operations, systems, delivery, financial resources, and internal financial control and reporting functions, which we will have to continue to develop and improve to sustain such growth. We must continually recruit and train new employees, retain and reskill, as necessary, existing sales, technical, finance, marketing and management employees with the knowledge, skills and experience that our business model requires and effectively manage our employees worldwide to support our culture, values, strategies and goals. Additionally, we expect to continue pursuing strategic and targeted acquisitions and investments to enhance our offerings of services and solutions or to enable us to expand our talent, experience and capabilities in key digital areas or in particular geographies or industries. We may not be successful in identifying suitable opportunities, completing targeted transactions or achieving the desired results, and such opportunities may divert our management's time and focus away from our core business. We may face challenges in effectively integrating acquired businesses into our ongoing operations and in assimilating and retaining employees of those businesses into our culture and organizational structure. If we are unable to manage our growth effectively, complete acquisitions of the number, magnitude and nature we have targeted, or successfully integrate any acquired businesses into our operations, we may not be able to achieve our targeted growth rates or improve our market share, profitability or competitive position generally or in specific markets or services. We may not be able to achieve our profitability goals and maintain our capital return strategy. Our goals for profitability and capital return rely upon a number of assumptions, including our ability to improve the efficiency of our operations and make successful investments to grow and further develop our business. Our profitability depends on the efficiency with which we run our operations and the cost of our operations, especially the compensation and benefits costs of our employees. We have incurred, and may continue to incur, substantial costs related to implementing our strategy to optimize such costs, and we may not realize the ultimate cost savings that we expect. We may not be able to efficiently utilize our employees if increased regulation, policy changes or administrative burdens of immigration, work visas or client worksite placement prevents us from deploying our employees on a timely basis, or at all, to fulfill the needs of our clients. Increases in wages and other costs may put pressure on our profitability. Fluctuations in foreign currency exchange rates can also have adverse effects on our revenues, income from operations and net income when items denominated in other currencies are translated or remeasured into U.S. dollars for presentation of our consolidated financial statements. We have entered into foreign exchange forward contracts intended to partially offset the impact of the movement of the exchange rates on future operating costs and to mitigate foreign currency risk on foreign currency denominated net monetary assets. However, the hedging strategies that we have implemented, or may in the future implement, to mitigate foreign currency exchange rate risks may not reduce or completely offset our exposure to foreign exchange rate fluctuations and may expose our business to unexpected market, operational and counterparty credit risks. We are particularly susceptible to wage and cost pressures in India and the exchange rate of the Indian rupee relative to the currencies of our client contracts due to the fact that the substantial majority of our employees are in India while our contracts with clients are typically in the local currency of the country where our clients are located. If we are unable to improve the efficiency of our operations, our operating margin may decline and our business, results of operations and financial condition may be materially adversely affected. Failure to achieve our profitability goals could adversely affect our business, financial condition and results of operations.With respect to capital return, our ability and decisions to pay dividends and repurchase shares depend on a variety of factors, including the cash flow generated from operations, our cash and investment balances, our net income, our overall liquidity position, potential alternative uses of cash, such as acquisitions, and anticipated future economic conditions and financial results. Failure to maintain our capital return strategy may adversely impact our reputation with shareholders and shareholders’ perception of our business and the trading price of our common stock.Our failure to meet specified service levels or milestones required by certain of our client contracts may result in our client contracts being less profitable, potential liability for penalties or damages or reputational harm.Many of our client contracts include clauses that tie our compensation to the achievement of agreed-upon performance standards or milestones. Failure to satisfy these requirements could significantly reduce our fees under the contracts, increase the cost to us of meeting performance standards or milestones, delay expected payments, subject us to potential damage claims 11Table of Contents under the contract terms or harm our reputation. The use of new technologies in our offerings can expose us to additional risks if those technologies fail to work as predicted, which could lead to cost overruns, project delays, financial penalties, or damage to our reputation. Clients also often have the right to terminate a contract and pursue damage claims for serious or repeated failure to meet these service commitments. Some of our contracts provide that a portion of our compensation depends on performance measures such as cost-savings, revenue enhancement, benefits produced, business goals attained and adherence to schedule. These goals can be complex and may depend on our clients’ actual levels of business activity or may be based on assumptions that are later determined not to be achievable or accurate. As such, these provisions may increase the variability in revenues and margins earned on those contracts and have in the past, and could in the future, result in significant losses on such contracts.We face intense and evolving competition and significant technological advances that our service offerings must keep pace with in the rapidly changing markets we compete in.The markets we serve and operate in are highly competitive, subject to rapid change and characterized by a large number of participants, as described in “Part I, Item 1. Business-Competition.” In addition to large, global competitors, we face competition in many geographic markets from numerous smaller, local competitors that may have more experience with operations in these markets, have well-established relationships with our desired clients, or be able to provide services and solutions at lower costs or on terms more attractive to clients than we can. Consolidation activity may also result in new competitors with greater scale, a broader footprint or vertical integration that makes them more attractive to clients as a single provider of integrated products and services. In addition, concurrent use by many clients of multiple professional service providers means that we are required to be continually competitive on the quality, scope and pricing of our offerings or face a reduction or elimination of our business.Our success depends on our ability to continue to develop and implement services and solutions that anticipate and respond to rapid and continuing changes in technology to serve the evolving needs of our clients. Examples of areas of significant change include digital-, cloud- and security-related offerings, which are continually evolving, as well as developments in areas such as AI, augmented reality, automation, blockchain, IoT, quantum computing and as-a-service solutions. If we do not sufficiently invest in new technologies, successfully adapt to industry developments and changing demand, and evolve and expand our business at sufficient speed and scale to keep pace with the demands of the markets we serve, we may be unable to develop and maintain a competitive advantage and execute on our growth strategy, which would materially adversely affect our business, results of operations and financial condition. Our relationships with our third party alliance partners, who supply us with necessary components to the services and solutions we offer our clients, are also critical to our ability to provide many of our services and solutions that address client demands. There can be no assurance that we will be able to maintain such relationships. Among other things, such alliance partners may in the future decide to compete with us, form exclusive or more favorable arrangements with our competitors or otherwise reduce our access to their products impairing our ability to provide the services and solutions demanded by clients.We face legal, reputational and financial risks if we fail to protect client and/or Cognizant data from security breaches and/or cyberattacks.In order to provide our services and solutions, we depend on global information technology networks and systems, to process, transmit, host and securely store electronic information (including our confidential information and the confidential information of our clients) and to communicate among our locations around the world and with our clients, suppliers and partners. Security breaches, employee malfeasance, or human or technological error create risks of shutdowns or disruptions of our operations and potential unauthorized access and/or disclosure of our or our clients’ sensitive data, which in turn could jeopardize projects that are critical to our operations or the operations of our clients’ businesses and have other adverse impacts on our business or the business of our clients. Like other global companies, we and the clients and vendors we interact with face threats to data and systems, including by nation state threat actors, perpetrators of random or targeted malicious cyberattacks, computer viruses, malware, worms, bot attacks or other destructive or disruptive software and attempts to misappropriate client information and cause system failures and disruptions. For example, in April 2020, we announced a security incident involving a Maze ransomware attack. The attack resulted in unauthorized access to certain data and caused significant disruption to our business.A security compromise of our information systems, or of those of businesses with which we interact, that results in confidential information being accessed by unauthorized or improper persons, could harm our reputation and expose us to regulatory actions, client attrition due to reputational concerns or otherwise, containment and remediation expenses, and claims brought by our clients or others for breaching contractual confidentiality and security provisions or data protection laws. Monetary damages imposed on us could be significant and may impose costs in excess of insurance policy limits or not be covered by our insurance at all. Techniques used by bad actors to obtain unauthorized access, disable or degrade service, or 12Table of Contents sabotage systems continuously evolve and may not immediately produce signs of intrusion, and we may be unable to anticipate these techniques or to implement adequate preventative measures. In addition, a security breach could require that we expend substantial additional resources related to the security of our information systems, diverting resources from other projects and disrupting our businesses. Any remediation measures that we have taken or that we may undertake in the future in response to the security incident announced in April 2020 or other security threats may be insufficient to prevent future attacks. We are required to comply with increasingly complex and changing data security and privacy regulations in the United States, the United Kingdom, the European Union and in other jurisdictions in which we operate that regulate the collection, use and transfer of personal data, including the transfer of personal data between or among countries. For example, the European Union’s General Data Protection Regulation has imposed stringent compliance obligations regarding the handling of personal data and has resulted in the issuance of significant financial penalties for noncompliance. In the United States, there have been proposals for federal privacy legislation and many new state privacy laws are on the horizon. Recently enacted legislation, such as the California Consumer Privacy Act, and its successor the California Privacy Rights Act that will go into effect on January 1, 2023, impose extensive privacy requirements on organizations governing personal information. Existing U.S. sectoral laws such as the Health Insurance Portability and Accountability Act also impose extensive privacy and security requirements on organizations operating in the healthcare industry, which we serve. Additionally, in India, the Personal Data Protection Bill, 2019 continues to make progress through the Indian Parliament. If enacted in its current form it would impose stringent obligations on the handling of personal data, including certain localization requirements for sensitive data. Other countries have enacted or are considering enacting data localization laws that require certain data to stay within their borders. We may also face audits or investigations by one or more domestic or foreign government agencies or our clients pursuant to our contractual obligations relating to our compliance with these regulations. Complying with changing regulatory requirements requires us to incur substantial costs, exposes us to potential regulatory action or litigation, and may require changes to our business practices in certain jurisdictions, any of which could materially adversely affect our business operations and operating results. If our risk management, business continuity and disaster recovery plans are not effective and our global delivery capabilities are impacted, our business and results of operations may be materially adversely affected and we may suffer harm to our reputation. Our business model is dependent on our global delivery capabilities, which include coordination between our delivery centers in India, our other global and regional delivery centers, the offices of our clients and our associates worldwide. System failures, outages and operational disruptions may be caused by factors outside of our control, such as hostilities, political unrest, terrorist attacks, natural disasters (including events that may be caused or exacerbated by climate change), and public health emergencies and pandemics, such as the COVID-19 pandemic, affecting the geographies where our people, equipment and clients are located. For example, we have substantial global delivery operations in Chennai, India, a city that has experienced severe rains, flooding and droughts in recent years and is at significant risk of increasingly severe natural disasters in future years as a result of climate change. Our risk management, business continuity and disaster recovery plans may not be effective at preventing or mitigating the effects of such disruptions, particularly in the case of catastrophic events or longer term developments, such as the impacts of climate change. Any such disruption may result in lost revenues, a loss of clients and reputational damage, which would have an adverse effect on our business, results of operations and financial condition. A substantial portion of our employees in the United States, United Kingdom, European Union and other jurisdictions rely on visas to work in those areas such that any restrictions on such visas or immigration more generally or increased costs of obtaining such visas or increases in the wages we are required to pay associates on visas may affect our ability to compete for and provide services to clients in these jurisdictions, which could materially adversely affect our business, results of operations and financial condition. A substantial portion of our employees in the United States and in many other jurisdictions, including countries in Europe, rely upon temporary work authorization or work permits, which makes our business particularly vulnerable to changes and variations in immigration laws and regulations, including written changes and policy changes to the manner in which the laws and regulations are interpreted or enforced, and potential enforcement actions and penalties that might cause us to lose access to such visas. The political environment in the United States, the United Kingdom and other countries in recent years has included significant support for anti-immigrant legislation and administrative changes. Many of these recent changes have resulted in, and various proposed changes may result in, increased difficulty in obtaining timely visas that could impact our ability to staff projects, including as a result of visa application rejections and delays in processing applications, and significantly increased costs for us in obtaining visas or as a result of prevailing wage requirements for our associates on visas. For example, in the United States, the prior administration adopted a number of policy changes and executive orders designed to limit immigration and the ability of immigrants to be employed, including increased scrutiny of the issuance of new and the renewal of existing H-1B visa applications and the placement of H-1B visa workers on third party worksites, increases to the prevailing wage requirements that set a minimum level of compensation for visa holders and, for entities where more than 50% of the workers in the United States hold H-1B and L-1 visas, increases in the visa costs for such entities. While a number of 13Table of Contents these policy changes and executive orders were stayed by the courts, the current administration may continue to seek their implementation or the implementation of similar measures in the future and there continues to be political support for potential new laws and regulations that, if adopted, may have a material adverse impact on companies like ours that have a substantial percentage of our employees on visas. Our principal operating subsidiary in the United States had more than 50% of its employees on H-1B or L-1 visas as of December 31, 2020 and, as a result, may be subject to increased costs if any such laws, regulations, policy changes or executive orders go into effect. In the EU, many countries continue to implement new regulations to move into compliance with the EU Directive of 2014 to harmonize immigration rules for intracompany transferees in most EU member states and to facilitate the transfer of managers, specialists and graduate trainees both into and within the region. The changes have had significant impact on mobility programs and have led to new notification and documentation requirements for companies sending employees to EU countries. Recent changes or any additional adverse revisions to immigration laws and regulations in the jurisdictions in which we operate may cause us delays, staffing shortages, additional costs or an inability to bid for or fulfill projects for clients, any of which could have a material adverse effect on our business, results of operations and financial condition.Legal, Regulatory and Legislative Risks Anti-outsourcing legislation, if adopted, and negative perceptions associated with offshore outsourcing could impair our ability to serve our clients and materially adversely affect our business, results of operations and financial condition. The practice of outsourcing services to organizations operating in other countries is a topic of political discussion in the United States, which is our largest market, as well as other regions in which we have clients. For example, measures aimed at limiting or restricting outsourcing by U.S. companies have been put forward for consideration by the U.S. Congress and in state legislatures to address concerns over the perceived association between offshore outsourcing and the loss of jobs domestically. If any such measure is enacted, our ability to provide services to our clients could be impaired. In addition, from time to time there has been publicity about purported negative experiences associated with offshore outsourcing, such as alleged domestic job loss and theft and misappropriation of sensitive client data, particularly involving service providers in India. Current or prospective clients may elect to perform certain services themselves or may be discouraged from utilizing global service delivery providers like us due to negative perceptions that may be associated with using global service delivery models or firms. Any slowdown or reversal of existing industry trends toward global service delivery would seriously harm our ability to compete effectively with competitors that provide the majority of their services from within the country in which our clients operate.We are subject to numerous and evolving legal and regulatory requirements and client expectations in the many jurisdictions in which we operate, and violations of, unfavorable changes in or an inability to meet such requirements or expectations could harm our business.We provide services to clients and have operations in many parts of the world and in a wide variety of different industries, subjecting us to numerous, and sometimes conflicting, laws and regulations on matters as diverse as import and export controls, temporary work authorizations or work permits and other immigration laws, content requirements, trade restrictions, tariffs, taxation, anti-corruption laws (including the FCPA and the U.K. Bribery Act), the environment, government affairs, internal and disclosure control obligations, data privacy, intellectual property, employment and labor relations. We face significant regulatory compliance costs and risks as a result of the size and breadth of our business. For example, we may experience increased costs in 2021 and future years for employment and post-employment benefits in India as a result of the issuance of the Code in late 2020.We are also subject to a wide range of potential enforcement actions, audits or investigations regarding our compliance with these laws or regulations in the conduct of our business, and any finding of a violation could subject us to a wide range of civil or criminal penalties, including fines, debarment, or suspension or disqualification from government contracting, prohibitions or restrictions on doing business, loss of clients and business, legal claims by clients and damage to our reputation. We commit significant financial and managerial resources to comply with our internal control over financial reporting requirements, but we have in the past and may in the future identify material weaknesses or deficiencies in our internal control over financial reporting that cause us to incur incremental remediation costs in order to maintain adequate controls. As another example, in recent years we had to spend significant resources on conducting an internal investigation and cooperating with investigations by the DOJ and the SEC, both concluded in 2019, focused on whether certain payments relating to Company-owned facilities in India were made in violation of the FCPA and other applicable laws.Governmental bodies, investors, clients and businesses are increasingly focused on ESG issues, which has resulted and may in the future continue to result in the adoption of new laws and regulations and changing buying practices. If we fail to 14Table of Contents keep pace with ESG trends and developments or fail to meet the expectations of our clients and investors, our reputation and business could be adversely impacted.Changes in tax laws or in their interpretation or enforcement, failure by us to adapt our corporate structure and intercompany arrangements to achieve global tax efficiencies or adverse outcomes of tax audits, investigations or proceedings could have a material adverse effect on our effective tax rate, results of operations and financial condition.The interpretation of tax laws and regulations in the many jurisdictions in which we operate and the related tax accounting principles are complex and require considerable judgment to determine our income taxes and other tax liabilities worldwide. Tax laws and regulations affecting us and our clients, including applicable tax rates, and the interpretation and enforcement of such laws and regulations are subject to change as a result of economic, political and other factors, and any such changes or changes in tax accounting principles could increase our effective worldwide income tax rate and have a material adverse effect on our net income and financial condition. We routinely review and update our corporate structure and intercompany arrangements, including transfer pricing policies, consistent with applicable laws and regulations, to align with our evolving business operations and provide global tax efficiencies across the numerous jurisdictions, such as the United States, India and the United Kingdom, in which we operate. Failure to successfully adapt our corporate structure and intercompany arrangements to align with our evolving business operations and achieve global tax efficiencies may increase our worldwide effective tax rate and have a material adverse effect on our earnings and financial condition.The following are several examples of changes in tax laws that may impact us:•The Tax Reform Act was enacted in December 2017 and made a number of significant changes to the corporate tax regime in the United States. The U.S. Treasury department continues to issue proposed and final regulations which modify relevant aspects of the new tax regime. •In December 2019, the Government of India enacted the India Tax Law effective retroactively to April 1, 2019 that enables Indian companies to elect to be taxed at a lower income tax rate of 25.17% as compared to the current rate of 34.94%. Once a company elects into the lower income tax rate, that company may not benefit from any tax holidays associated with SEZs and certain other tax incentives, including MAT carryforwards, and may not reverse its election. As of December 31, 2020, we had deferred income tax assets related to the MAT carryforwards of $98 million. See Note 11 to our consolidated financial statements. Our current intent is to elect into the new tax regime once our MAT carryforwards are fully or substantially utilized. Our intent is based on a number of current assumptions and financial projections, and if our intent were to change and we were to opt into the new tax regime at an earlier time, the write-off of any remaining MAT deferred tax assets may materially increase our provision for income taxes and effective income tax rate and decrease our EPS, while the loss of the benefit of the MAT carryforwards may increase our cash tax payments.•The OECD has been working on a Base Erosion and Profit Shifting project and is expected to continue to issue guidelines and proposals that may change numerous long-standing tax principles. The changes recommended by the OECD have been or are being adopted by many of the countries in which we do business and could lead to disagreements among jurisdictions over the proper allocation of profits among them. The OECD has also undertaken a new project focused on “Addressing the Tax Challenges of the Digitalization of the Economy.” This project may impact multinational businesses by implementing a global model for minimum taxation. Similarly, the European Commission and various jurisdictions have introduced proposals to or passed laws that impose a separate tax on specified digital services. These recent and potential future tax law changes create uncertainty and may materially adversely impact our provision for income taxes. Our worldwide effective income tax rate may increase as a result of these recent developments, changes in interpretations and assumptions made, additional guidance that may be issued and ongoing and future actions the Company has or may take with respect to our corporate structure and intercompany arrangements.Additionally, we are subject from time to time to tax audits, investigations and proceedings. Tax authorities have disagreed, and may in the future disagree, with our judgments, and are taking increasingly aggressive positions, including with respect to our intercompany transactions. For example, we are currently involved in an ongoing dispute with the ITD in which the ITD asserts that we owe additional taxes for two transactions by which CTS India repurchased shares from its shareholders, as more fully described in Note 11 to the consolidated financial statements. Adverse outcomes in any such audits, investigations or proceedings could increase our tax exposure and cause us to incur increased expense, which could materially adversely affect our results of operations and financial condition.15Table of Contents Our business subjects us to considerable potential exposure to litigation and legal claims and could be materially adversely affected if we incur legal liability.We are subject to, and may become a party to, a variety of litigation or other claims and suits that arise from time to time in the conduct of our business. Our business is subject to the risk of litigation involving current and former employees, clients, alliance partners, subcontractors, suppliers, competitors, shareholders, government agencies or others through private actions, class actions, whistleblower claims, administrative proceedings, regulatory actions or other litigation. While we maintain insurance for certain potential liabilities, such insurance does not cover all types and amounts of potential liabilities and is subject to various exclusions as well as caps on amounts recoverable. Our client engagements expose us to significant potential legal liability and litigation expense if we fail to meet our contractual obligations or otherwise breach obligations to third parties or if our subcontractors breach or dispute the terms of our agreements with them and impede our ability to meet our obligations to our clients. For example, third parties could claim that we or our clients, whom we typically contractually agree to indemnify with respect to the services and solutions we provide, infringe upon their IP rights. Any such claims of IP infringement could harm our reputation, cause us to incur substantial costs in defending ourselves, expose us to considerable legal liability or prevent us from offering some services or solutions in the future. We may have to engage in legal action to protect our own IP rights, and enforcing our rights may require considerable time, money and oversight, and existing laws in the various countries in which we provide services or solutions may offer only limited protection. We also face considerable potential legal liability from a variety of other sources. Our acquisition activities have in the past and may in the future be subject to litigation or other claims, including claims from employees, clients, stockholders, or other third parties. We have also been the subject of a number of putative securities class action complaints and putative shareholder derivative complaints relating to the matters that were the subject of our now concluded internal investigation into potential violations of the FCPA and other applicable laws, and may be subject to such legal actions for these or other matters in the future. See "Part I, Item 3. Legal Proceedings" for more information. We establish reserves for these and other matters when a loss is considered probable and the amount can be reasonably estimated; however, the estimation of legal reserves and possible losses involves significant judgment and may not reflect the full range of uncertainties and unpredictable outcomes inherent in litigation, and the actual losses arising from particular matters may exceed our estimates and materially adversely affect our results of operations.Item 1B. Unresolved Staff CommentsNone.Item 2. Properties We have sales and marketing offices, innovation labs, and digital design and consulting centers in major business markets, including New York, London, Paris, Melbourne, Singapore, and Sao Paulo, among others, which are used to deliver services to our clients across all four of our business segments. In total, we have offices and operations in more than 85 cities and 35 countries around the world, with our worldwide headquarters located in a leased facility in Teaneck, New Jersey in the United States. We utilize a global delivery model with delivery centers worldwide, including in-country, regional and global delivery centers. We have over 31 million square feet of owned and leased facilities for our delivery centers. Our largest delivery center presence is in India - Chennai (10 million square feet), Hyderabad (4 million square feet), Pune (3 million square feet), Bangalore (3 million square feet) and Kolkata (3 million square feet) - representing 88% of our total delivery centers on a square-foot basis. We also have a significant number of delivery centers in other countries, including the United States, Philippines, Canada, Mexico and countries throughout Europe. We believe our current facilities are adequate to support our operations in the immediate future, and that we will be able to obtain suitable additional facilities on commercially reasonable terms as needed.Item 3. Legal ProceedingsSee Note 15 to our consolidated financial statements.Item 4. Mine Safety DisclosuresNot applicable.16Table of Contents PART IIItem 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity SecuritiesOur Class A common stock trades on the Nasdaq Stock Market under the symbol “CTSH”. As of December 31, 2020, the approximate number of holders of record of our Class A common stock was 114 and the approximate number of beneficial holders of our Class A common stock was 342,100.Cash DividendsDuring 2020, we paid quarterly cash dividends of $0.22 per share, or $0.88 per share in total for the year. In February 2021, our Board of Directors approved a $0.02 increase to our quarterly cash dividends and the Company's declaration of a $0.24 per share dividend with a record date of February 18, 2021 and a payment date of February 26, 2021. We intend to continue to pay quarterly cash dividends in accordance with our capital return plan. Our ability and decisions to pay future dividends depend on a variety of factors, including our cash flow generated from operations, cash and investment balances, net income, overall liquidity position, potential alternative uses of cash, such as acquisitions, and anticipated future economic conditions and financial results. Issuer Purchases of Equity SecuritiesOur stock repurchase program, as amended by our Board of Directors in December 2020, allows for the repurchase of up to $9.5 billion, excluding fees and expenses, of our Class A common stock through open market purchases, including under a 10b5-1 Plan or in private transactions, including through ASR agreements entered into with financial institutions, in accordance with applicable federal securities laws. The repurchase program does not have an expiration date. The timing of repurchases and the exact number of shares to be purchased are determined by management, in its discretion, or pursuant to 10b5-1 Plan, and will depend upon market conditions and other factors.During the three months ended December 31, 2020, we repurchased $721 million of our Class A common stock under our stock repurchase program. The following table sets out the stock repurchase activity under our stock repurchase program during the fourth quarter of 2020 and the approximate dollar value of shares that may yet be purchased under the program as of December 31, 2020. MonthTotal Numberof SharesPurchasedAveragePrice Paidper ShareTotal Number ofShares Purchasedas Part of PubliclyAnnouncedPlans orProgramsApproximateDollar Value of Sharesthat May Yet BePurchased under thePlans or Programs(in millions)October 1, 2020 - October 31, 20205,800,000 $72.56 5,800,000 $1,115 November 1, 2020 - November 30, 20201,700,000 76.77 1,700,000 984 December 1, 2020 - December 31, 20202,122,590 79.85 2,122,590 2,815 Total9,622,590 $74.91 9,622,590 We regularly purchase shares in connection with our stock-based compensation plans as shares of our Class A common stock are tendered by employees for payment of applicable statutory tax withholdings. For the three months ended December 31, 2020, we purchased 0.2 shares at an aggregate cost of $18 million in connection with employee tax withholding obligations. 17Table of Contents Performance GraphThe following graph compares the cumulative total stockholder return on our Class A common stock with the cumulative total return on the S&P 500 Index, Nasdaq-100 Index, S&P 500 Information Technology Index and a Peer Group Index (capitalization weighted) for the period beginning December 31, 2015 and ending on the last day of our last completed fiscal year. The stock performance shown on the graph below is not indicative of future price performance.COMPARISON OF CUMULATIVE TOTAL RETURN(1)(2)Among Cognizant, the S&P 500 Index, the Nasdaq-100 Index, the S&P 500 Information Technology Index(3)and a Peer Group Index(3) (Capitalization Weighted) Company / IndexBasePeriod12/31/1512/31/1612/31/1712/31/1812/31/1912/31/20Cognizant Technology Solutions Corp$100 $93.35 $119.09 $107.59 $106.43 $142.54 S&P 500 Index100 111.96 136.40 130.42 171.49 203.04 Nasdaq-100 Index100 105.89 139.26 137.81 190.13 280.59 S&P 500 Information Technology Index100 113.85 158.06 157.60 236.86 340.83 Peer Group100 104.72 132.79 128.54 168.92 230.02 (1)Graph assumes $100 invested on December 31, 2015 in our Class A common stock, the S&P 500 Index, the Nasdaq-100 Index, the S&P 500 Information Technology Index and the Peer Group Index (capitalization weighted).(2)Cumulative total return assumes reinvestment of dividends.(3)We have constructed a Peer Group Index of other information technology consulting firms. Our peer group consists of Accenture plc., DXC Technology, EPAM Systems Inc., ExlService Holdings Inc., Genpact Limited, Infosys Ltd., Wipro Ltd. and WNS (Holdings) Limited. Beginning in 2020, we have included the S&P 500 Information and Technology Index in our comparison of total return. This index will replace our Peer Group and the Nasdaq-100 Index in future filings as the S&P 500 Information and Technology index is more representative of the broader technology sector in which we operate.18Table of Contents Item 6. Selected Financial Data[Reserved]Item 7. Management’s Discussion and Analysis of Financial Condition and Results of OperationsExecutive SummaryCognizant is one of the world’s leading professional services companies, engineering modern business for the digital era. Our services include digital services and solutions, consulting, application development, systems integration, application testing, application maintenance, infrastructure services and business process services. Digital services have become an increasingly important part of our portfolio, aligning with our clients' focus on becoming data-enabled, customer-centric and differentiated businesses. We are focused on continued investment in four key areas of digital: IoT, AI, experience-driven software engineering and cloud. We tailor our services and solutions to specific industries with an integrated global delivery model that employs client service and delivery teams based at client locations and dedicated global and regional delivery centers.The global COVID-19 pandemic has caused and is continuing to cause significant loss of life and interruption to the global economy, including the curtailment of activities by businesses and consumers in much of the world as governments and others seek to limit the spread of the disease. In response to COVID-19, we have prioritized the safety and well-being of our employees, business continuity for our clients, and supporting the efforts of governments around the world to contain the spread of the virus. In light of our commitment to help our clients as they navigate unprecedented business challenges while protecting the safety of our employees, we have taken numerous steps, and may continue to take further actions, to address the COVID-19 pandemic. We have been working closely with our clients to support them as they implemented their contingency plans, helping them access our services and solutions remotely. We also undertook a significant effort to enable our employees to work from home by providing them with computer and Internet accessibility equipment while seeking to maintain appropriate security protocols. Despite these efforts, in the first half of 2020 we experienced some delays in project fulfillment as delivery, particularly in India and the Philippines, shifted to work-from-home in response to the pandemic. Additionally, as a result of the ongoing pandemic, we experienced reduced client demand, project deferrals, furloughs, and temporary rate concessions, which adversely affected revenues across all of our business segments in 2020. For the year ended December 31, 2020, we incurred $65 million of costs in response to the COVID-19 pandemic, including certain costs incurred to enable our employees to work remotely. In 2020, we incurred costs related to the execution of our multi-year 2020 Fit for Growth Plan aimed at accelerating revenue growth. This plan refined our strategic focus and launched a series of measures to improve our operational and commercial models and optimize our cost structure in order to partially fund investments in key digital areas of IoT, AI, experience-driven software engineering and cloud and advance our growth agenda. The 2020 Fit for Growth Plan included our decision to exit certain content-related services that are not in line with our strategic vision for the Company. The optimization measures that were part of the 2020 Fit for Growth Plan resulted in total charges of $221 million, primarily related to severance and facility exit costs that are expected to generate an annualized savings run rate, before anticipated investments, of approximately $530 million in 2021. See Note 4 to our consolidated financial statements for additional information on these costs, which are reported in the caption "Restructuring charges" in our consolidated statements of operations. We do not expect to incur additional costs related to this plan. The COVID-19 pandemic may adversely impact our ability to realize the benefits of our strategy and various transformation initiatives, including the 2020 Fit for Growth Plan. See Part I, Item 1A. Risk Factors. Our exit from certain content-related services negatively impacted our 2020 revenues by approximately $178 million within our Communications, Media and Technology segment in North America.On April 20, 2020, we announced a security incident involving a Maze ransomware attack. As previously reported in our Quarterly Report on Form 10-Q for the quarter ended June 30, 2020, based on numerous remediation steps that have been undertaken and our continued monitoring of our environment, we believe we have contained the attack and eradicated remnants of the attacker activity from our environment. The lost revenue and containment, investigation, remediation, legal and other costs incurred due to the ransomware attack may exceed our insurance policy limits or may not be covered by insurance at all. Other actual and potential consequences include, but are not limited to, negative publicity, reputational damage, lost trust with customers, regulatory enforcement action, litigation that could result in financial judgments or the payment of settlement amounts and disputes with insurance carriers concerning coverage.In March 2020, the Indian parliament enacted the Budget of India, which contained a number of provisions related to income tax, including a replacement of the DDT, previously due from the dividend payer, with a tax payable by the shareholder receiving the dividend. This provision reduced the tax rate applicable to us for cash repatriated from India. Following this change, during the first quarter of 2020, we limited our indefinite reinvestment assertion to India earnings accumulated in prior 19Table of Contents years. In July 2020, the U.S. Treasury Department and the IRS released final regulations, which became effective in September 2020, that reduced the tax applicable on our accumulated Indian earnings upon repatriation. As a result, during the third quarter of 2020, after a thorough analysis of the impact of these changes in law on the cost of earnings repatriation and considering our strategic decision to increase our investments to accelerate growth in various international markets and expand our global delivery footprint, we reversed our indefinite reinvestment assertion on Indian earnings accumulated in prior years and recorded a $140 million Tax on Accumulated Indian Earnings. The recorded income tax expense reflects the India withholding tax on unrepatriated Indian earnings, which were $5.2 billion as of December 31, 2019, net of applicable U.S. foreign tax credits. On October 28, 2020, our subsidiary in India remitted a dividend of $2.1 billion, which resulted in a net payment of $2.0 billion to its shareholders (non-Indian Cognizant entities), after payment of $106 million of India withholding tax.On October 27, 2020, a jury returned a verdict in our favor in the amount of $854 million, including $570 million punitive damages, in our lawsuit with Syntel, which was initiated in 2015. We expect Syntel to appeal the decision and thus we will not record the gain in our financial statements until it becomes realizable. For more information, see Note 15 to our consolidated financial statements.In the fourth quarter of 2020, we made an offer to settle and exit a large customer engagement in Financial Services in Continental Europe ("Proposed Exit"). The offer includes, among other terms, a proposed payment and the forgiveness of certain receivables. The 2020 impact of the Proposed Exit was a reduction of revenues of $118 million and additional expenses of $33 million, primarily related to the impairment of long-lived assets. The Proposed Exit negatively impacted each of our GAAP and Adjusted Diluted EPS by $0.27 for the year ended December 31, 2020. While the amounts recorded are based on our best estimate of the expected terms of the exit, the negotiations are ongoing and, as such, we may not reach an agreement or the final terms of the agreement that is reached may materially differ from those contemplated in our accounting. In either instance, there could be additional impacts to our statement of operations, financial condition and our cash flows.2020 Financial ResultsThe following table sets forth a summary of our financial results for the years ended December 31, 2020 and 2019:Increase / Decrease 20202019$%(Dollars in millions, except per share data)Revenues$16,652 $16,783 $(131)(0.8)Income from operations2,114 2,453 (339)(13.8)Net income1,392 1,842 (450)(24.4)Diluted EPS2.57 3.29 (0.72)(21.9)Other Financial Information1Adjusted Income From Operations2,394 2,787 (393)(14.1)Adjusted Diluted EPS3.42 3.99 (0.57)(14.3)Our financial results were negatively impacted by our exit from certain content-related services, the Proposed Exit, the ransomware attack and the COVID-19 pandemic. We continue to experience pricing pressure within our core portfolio of services as our clients optimize the cost of supporting their legacy systems and operations. At the same time, clients are adopting and integrating digital technologies and their demand for our digital services and solutions has continued to increase since the beginning of the COVID-19 pandemic as a result of increased demand for mobile workplace solutions, e-commerce, automation and AI and cybersecurity services and solutions.1 Adjusted Income From Operations and Adjusted Diluted EPS are not measurements of financial performance prepared in accordance with GAAP. See “Non-GAAP Financial Measures” for more information and reconciliations to the most directly comparable GAAP financial measures.20Table of Contents The following charts set forth revenues and change in revenues by business segment and geography for the year ended December 31, 2020 compared to the year ended December 31, 2019:Financial ServicesHealthcareIncrease / (Decrease)Increase / (Decrease)Dollars in millionsRevenues$%CC %2Revenues$%CC %2North America$4,013 (124)(3.0)(3.0)$4,181 34 0.8 0.8 United Kingdom463 (21)(4.3)(4.7)157 27 20.8 19.8 Continental Europe629 (99)(13.6)(14.0)434 93 27.3 24.0 Europe - Total1,092 (120)(9.9)(10.3)591 120 25.5 22.9 Rest of World516 (4)(0.8)2.0 80 3 3.9 6.0 Total$5,621 (248)(4.2)(4.0)$4,852 157 3.3 3.1 Products and ResourcesCommunications, Media and TechnologyIncrease / (Decrease)Increase / (Decrease)Dollars in millionsRevenues$%CC %2Revenues$%CC %2North America$2,650 (28)(1.0)(1.0)$1,737 (27)(1.5)(1.5)United Kingdom371 (9)(2.4)(3.0)344 25 7.8 6.8 Continental Europe413 (40)(8.8)(8.7)177 8 4.7 2.1 Europe - Total784 (49)(5.9)(6.1)521 33 6.8 5.2 Rest of World262 3 1.2 4.7 225 28 14.2 20.2 Total$3,696 (74)(2.0)(1.7)$2,483 34 1.4 1.6 Across all our business segments and regions, revenues were negatively impacted by the COVID-19 pandemic and the ransomware attack. Retail, consumer goods, travel and hospitality clients within our Products and Resources segment as well as communications and media clients in our Communications, Media and Technology segment were particularly adversely affected by the pandemic. Revenues in our Financial Services segment in our Continental Europe region were negatively impacted by $118 million due to the Proposed Exit. Additionally, we continued to see certain financial services and healthcare clients transition the support of some of their legacy systems and operations in-house. Revenue growth among our life sciences clients was driven by revenues from Zenith and increased demand for our services among pharmaceutical companies while revenues from our healthcare clients benefited from stronger software license sales. Our manufacturing, logistics, energy and utilities clients within our Products and Resources segment generated revenue growth due to our clients' continued adoption and integration of digital technologies. Revenues among our technology clients in our Communications, Media and Technology segment in the North America region were negatively impacted by approximately $178 million due to our exit from certain content-related services. We continue to see growing demand from our technology clients for other more strategic digital content services. Additionally, the year-over-year change in our revenues included 210 basis points of benefit from our recently completed acquisitions, including Collaborative Solutions, Zenith and Contino.Our operating margin and Adjusted Operating Margin2 decreased to 12.7% and 14.4%, respectively, for the year ended December 31, 2020 from 14.6% and 16.6%, respectively, for the year ended December 31, 2019. Our GAAP and Adjusted Operating Margin2 were adversely impacted by higher incentive-based compensation accrual rates, investments intended to drive organic and inorganic revenue growth, the impact of the Proposed Exit, the decline in revenues brought on by the COVID-19 pandemic and the impact of the ransomware attack on both revenues and costs. These impacts were partially offset by a significant decrease in travel and entertainment expenses due to the COVID-19 pandemic, the cost savings generated as a result of the 2020 Fit for Growth Plan, lower immigration costs and the depreciation of the Indian rupee against the U.S. dollar. In addition, our 2019 GAAP operating margin included a 0.7% negative impact of the incremental accrual in 2019 related to the India Defined Contribution Obligation as discussed in Note 15 to our consolidated financial statements, while our 2020 GAAP operating margin was negatively impacted by COVID-19 Charges.2 Constant currency revenue growth (CC) and Adjusted Operating Margin are not measurements of financial performance prepared in accordance with GAAP. See “Non-GAAP Financial Measures” for more information and a reconciliation to the most directly comparable GAAP financial measure, as applicable.21Table of Contents Business OutlookWe have four strategic priorities as we seek to increase our commercial momentum and accelerate growth. These strategic priorities are:•Accelerating digital - growing our digital business organically and inorganically;•Globalizing Cognizant - growing our business in key international markets and diversifying leadership, capabilities and delivery footprint;•Repositioning our brand - improving our global brand recognition and becoming better known as a global digital partner to the entire C-suite; and •Increasing our relevance to our clients - leading with thought leadership and capabilities to address clients' business needs.We continue to expect the long-term focus of our clients to be on their digital transformation into software-driven, data-enabled, customer-centric and differentiated businesses. As our clients seek to optimize the cost of supporting their legacy systems and operations, our core portfolio of services may be subject to pricing pressure and lower demand due to clients transitioning certain work in-house. At the same time, clients continue to adopt and integrate digital technologies and their demand for our digital operations services and solutions has only increased since the beginning of the COVID-19 pandemic, as demand for mobile workplace solutions, e-commerce, automation and AI and cybersecurity services and solutions has grown.Our clients will likely continue to contend with industry-specific changes driven by evolving digital technologies, uncertainty in the regulatory environment, industry consolidation and convergence as well as international trade policies and other macroeconomic factors, which could affect their demand for our services. The COVID-19 pandemic may continue to negatively impact demand, particularly among our retail, consumer goods, travel and hospitality clients within our Products and Resources segment as well as communications and media clients in our Communications, Media and Technology segment. The significant and evolving nature of the COVID-19 pandemic makes it difficult to estimate its future impact on our ongoing business, results of operations and overall financial performance. See Part I, Item 1A. Risk Factors.As a global professional services company, we compete on the basis of the knowledge, experience, insights, skills and talent of our employees and the value they can provide to our clients. Competition for skilled labor is intense and our success is dependent, in large part, on our ability to keep our supply of skilled employees, in particular those with experience in key digital areas, in balance with client demand around the world. As such, we will continue to focus on recruiting, talent management and employee engagement to attract and retain our employees.We will continue to pursue strategic acquisitions, investments and alliances that will expand our talent, experience and capabilities in key digital areas or in particular geographies or industries.In addition, our future results may be affected by immigration law changes that may impact our ability to do business or significantly increase our costs of doing business, potential tax law changes and other potential regulatory changes, including potentially increased costs in 2021 and future years for employment and post-employment benefits in India as a result of the issuance of the Code in late 2020, as well as costs related to the potential resolution of legal and regulatory matters discussed in Note 15 to our consolidated financial statements. For additional information, see Part I, Item 1A. Risk Factors.22Table of Contents Results of OperationsFor a discussion of our results of operations for the year ended December 31, 2018, including a year-to-year comparison between 2019 and 2018, refer to Part II, Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations" in our Annual Report Form 10-K for the year ended December 31, 2019.The Year Ended December 31, 2020 Compared to The Year Ended December 31, 2019 The following table sets forth certain financial data for the years ended December 31:% of% ofIncrease / Decrease2020Revenues2019Revenues$%(Dollars in millions, except per share data)Revenues$16,652 100.0$16,783 100.0$(131)(0.8)Cost of revenues(1)10,671 64.110,634 63.437 0.3 Selling, general and administrative expenses(1)3,100 18.62,972 17.7128 4.3 Restructuring charges215 1.3217 1.3(2)(0.9)Depreciation and amortization expense552 3.3507 3.045 8.9 Income from operations2,114 12.72,453 14.6(339)(13.8)Other income (expense), net(18)90 (108)(120.0)Income before provision for income taxes2,096 12.62,543 15.2(447)(17.6)Provision for income taxes(704)(643)(61)9.5 Income (loss) from equity method investments— (58)58 (100.0)Net income$1,392 8.4$1,842 11.0$(450)(24.4)Diluted EPS$2.57 $3.29 $(0.72)(21.9)Other Financial Information 3Adjusted Income From Operations and Adjusted Operating Margin$2,394 14.4$2,787 16.6(393)(14.1)Adjusted Diluted EPS$3.42 $3.99 $(0.57)(14.3)(1) Exclusive of depreciation and amortization expense. Revenues - OverallDuring 2020, revenues decreased by $131 million as compared to 2019, representing a decline of 0.8%, or 0.7% on a constant currency basis3. Across all business segments and regions, revenues were negatively impacted by the ransomware attack and the COVID-19 pandemic. In addition, our exit from certain content-related services and the Proposed Exit negatively impacted our revenues by $178 million and $118 million, respectively. We continue to experience pricing pressure within our core portfolio of services as our clients optimize the cost of supporting their legacy systems and operations. At the same time, clients are adopting and integrating digital technologies and their demand for our digital services and solutions has continued to increase since the beginning of the COVID-19 pandemic as a result of increased demand for mobile workplace solutions, e-commerce, automation and AI and cybersecurity services and solutions. Additionally, the year-over-year change in our revenues included 210 basis points of benefit from our recently completed acquisitions, including Collaborative Solutions, Zenith and Contino. Revenues from clients added during 2020, including those related to acquisitions, were $342 million.3 Adjusted Income From Operations, Adjusted Operating Margin, Adjusted Diluted EPS and constant currency revenue growth are not measurements of financial performance prepared in accordance with GAAP. See “Non-GAAP Financial Measures” for more information and reconciliations to the most directly comparable GAAP financial measures, as applicable.23Table of Contents Revenues - Reportable Business SegmentsRevenues by reportable business segment were as follows:20202019Increase / (Decrease)$%CC%4(Dollars in millions)Financial Services$5,621 $5,869 $(248)(4.2)(4.0)Healthcare4,852 4,695 157 3.3 3.1 Products and Resources3,696 3,770 (74)(2.0)(1.7)Communications, Media and Technology2,483 2,449 34 1.4 1.6 Total revenues$16,652 $16,783 $(131)(0.8)(0.7)Financial ServicesRevenues from our Financial Services segment declined 4.2%, or 4.0% on a constant currency basis4, in 2020. Revenues among our insurance clients decreased by $85 million as compared to a decrease of $163 million from our banking clients. The Proposed Exit negatively impacted our revenues from banking clients by $118 million. Revenues from clients added during 2020, including those related to acquisitions, were $70 million. Moderate revenue growth generated by our digital services did not fully offset revenue declines attributable to certain financial services clients who continued to transition the support of some of their legacy systems and operations in-house.HealthcareRevenues from our Healthcare segment grew 3.3%, or 3.1% on a constant currency basis4, in 2020. Revenues in this segment increased by $173 million among our life science clients while revenues from our healthcare clients decreased $16 million. Revenue growth among our life sciences clients was driven by revenues from Zenith and increased demand for our services among pharmaceutical companies. Revenues from our healthcare clients were negatively impacted by the establishment of an offshore captive by a large client, partially offset by the 2019 negative impact of a customer dispute with a healthcare client related to a large volume based contract. Additionally, revenues from our healthcare clients benefited from stronger software license sales in 2020. Revenues from clients added during 2020, including those related to acquisitions, were $50 million. Demand from our healthcare clients may continue to be affected by uncertainty in the regulatory and political environment while demand from our life sciences clients may be affected by industry consolidation. Products and ResourcesRevenues from our Products and Resources segment declined 2.0%, or 1.7% on a constant currency basis4, in 2020. Retail, consumer goods, travel and hospitality clients were particularly adversely affected by the COVID-19 pandemic. Thus, revenue from our travel and hospitality clients and from our retail and consumer goods clients decreased by $126 million and $100 million, respectively. Revenues from our manufacturing, logistics, energy and utilities clients increased by $152 million due to our clients' adoption and integration of digital technologies. Revenues from clients added during 2020, including those related to acquisitions, were $105 million.Communications, Media and TechnologyRevenues from our Communications, Media and Technology segment grew 1.4%, or 1.6% on a constant currency basis4, in 2020. Revenues from our communications and media clients increased $72 million while revenues from our technology clients decreased $38 million. Revenues among our technology clients in this segment were negatively impacted by approximately $178 million due to our exit from certain content-related services. Additionally, revenues were negatively impacted by the COVID-19 pandemic, particularly among our communications and media clients, partially offset by growing demand from our technology clients for other more strategic digital content services. Revenues from clients added during 2020, including those related to acquisitions, were $117 million. 4 Constant currency revenue growth is not a measurement of financial performance prepared in accordance with GAAP. See “Non-GAAP Financial Measures” for more information.24Table of Contents Revenues - Geographic Locations Revenues by geographic market, as determined by client location, were as follows:20202019Increase / (Decrease)$%CC %5(Dollars in millions)North America$12,581 $12,726 $(145)(1.1)(1.1)%United Kingdom1,335 1,313 22 1.7 1.0 %Continental Europe1,653 1,691 (38)(2.2)(3.3)%Europe - Total2,988 3,004 (16)(0.5)(1.4)%Rest of World1,083 1,053 30 2.8 6.4 %Total revenues$16,652 $16,783 $(131)(0.8)(0.7)%North America continues to be our largest market, representing 75.6% of total 2020 revenues. Our North America region was negatively impacted by our exit from certain content-related services in our Communications, Media and Technology segment and the transition of the support of legacy systems for certain financial services and healthcare clients in-house. Our Continental Europe region was negatively impacted by the Proposed Exit, partially offset by growth from our life sciences customers. Revenues in our United Kingdom region have particularly benefited from our recently completed acquisitions. Revenue growth in our Rest of World region was driven by our Communications, Media and Technology clients. Cost of Revenues (Exclusive of Depreciation and Amortization Expense)Our cost of revenues consists primarily of salaries, incentive-based compensation, stock-based compensation expense, employee benefits, project-related immigration and travel for technical personnel, subcontracting and equipment costs relating to revenues. Our cost of revenues increased by 0.3% during 2020 as compared to 2019, increasing as a percentage of revenues to 64.1% in 2020 compared to 63.4% in 2019. The increase in cost of revenues, as a percentage of revenues, was due primarily to an increase in costs related to higher incentive-based compensation accrual rates in 2020 and the impact of the Proposed Exit, the COVID-19 pandemic and the ransomware attack. These impacts were partially offset by a significant decrease in travel and entertainment costs as a result of a reduction in travel due to the COVID-19 pandemic, the cost savings generated as a result of our cost optimization strategy and the depreciation of the Indian rupee against the U.S. dollar. SG&A Expenses (Exclusive of Depreciation and Amortization Expense)SG&A expenses consist primarily of salaries, incentive-based compensation, stock-based compensation expense, employee benefits, immigration, travel, marketing, communications, management, finance, administrative and occupancy costs. SG&A expenses increased by 4.3% during 2020 as compared to 2019, increasing as a percentage of revenues to 18.6% in 2020 as compared to 17.7% in 2019. The increase, as a percentage of revenues, was due primarily to an increase in costs related to higher incentive-based compensation accrual rates in 2020, investments intended to drive organic and inorganic revenue growth and the impacts of the COVID-19 pandemic, the Proposed Exit and the ransomware attack. These negative impacts were partially offset by a significant decrease in travel and entertainment costs as a result of a reduction in travel due to the COVID-19 pandemic and lower immigration costs, in addition to the $117 million incremental accrual in 2019 related to the India Defined Contribution Obligation as discussed in Note 15 to our consolidated financial statements.Restructuring ChargesRestructuring charges consist of our 2020 Fit for Growth Plan and our realignment program. Restructuring charges were $215 million, or 1.3% as a percentage of revenues during 2020, as compared to $217 million, or 1.3% as a percentage of revenues, during 2019. For further detail on our restructuring charges see Note 4 to our consolidated financial statements.Depreciation and Amortization ExpenseDepreciation and amortization expense increased by 8.9% during 2020 as compared to 2019. The increase was due to procurement of additional computer equipment primarily to provision work-from-home arrangements and amortization of intangibles from recently completed acquisitions.5 Constant currency revenue growth is not a measurement of financial performance prepared in accordance with GAAP. See “Non-GAAP Financial Measures” for more information.25Table of Contents Operating Margin - Overall Our operating margin and Adjusted Operating Margin6 decreased to 12.7% and 14.4%, respectively, in 2020 from 14.6% and 16.6%, respectively, during 2019. Our GAAP and Adjusted Operating Margin6 were adversely impacted by higher incentive-based compensation accrual rates, investments intended to drive organic and inorganic revenue growth, the impact of the Proposed Exit, the decline in revenues brought on by the COVID-19 pandemic and the impact of the ransomware attack on both revenues and costs. These impacts were partially offset by a significant decrease in travel and entertainment expenses due to the COVID-19 pandemic, the cost savings generated as a result of the 2020 Fit for Growth Plan, lower immigration costs and the depreciation of the Indian rupee against the U.S. dollar. In addition, our 2019 GAAP operating margin included a 0.7% negative impact of the incremental accrual in 2019 related to the India Defined Contribution Obligation as discussed in Note 15 to our consolidated financial statements, while our 2020 GAAP operating margin was negatively impacted by COVID-19 Charges.Excluding the impact of applicable designated cash flow hedges, the depreciation of the Indian rupee against the U.S. dollar positively impacted our operating margin by approximately 92 basis points or 0.92 percentage points in 2020, while in 2019 the depreciation of the Indian rupee against the U.S. dollar positively impacted our operating margin by approximately 53 basis points or 0.53 percentage points. Each additional 1.0% change in exchange rate between the Indian rupee and the U.S. dollar will have the effect of moving our operating margin by approximately 17 basis points or 0.17 percentage points. We enter into foreign exchange derivative contracts to hedge certain Indian rupee denominated payments in India. These hedges are intended to mitigate the volatility of the changes in the exchange rate between the U.S. dollar and the Indian rupee. The impact of the settlement of our cash flow hedges was immaterial in 2020 and 2019.Our most significant costs are the salaries and related benefits for our employees. These costs are affected by the impact of inflation. In certain regions, competition for professionals with the advanced technical skills necessary to perform our services has caused wages to increase at a rate greater than the general rate of inflation. We finished the year ended December 31, 2020 with approximately 289,500 employees, which is a decrease of 3,000 as compared to December 31, 2019. For the three months ended December 31, 2020, annualized turnover, including both voluntary and involuntary, was approximately 19.0%. Turnover for the years ended December 31, 2020 and 2019, including both voluntary and involuntary, was approximately 20.6% and 21.7%. Voluntary attrition normally constitutes the significant majority of our attrition. In 2020, we saw elevated levels of involuntary attrition due to our Fit for Growth Plan, including the exit from certain content-related services. We also saw a decrease in voluntary attrition from historic levels in the early stages of the COVID-19 pandemic. Both voluntary and involuntary attrition are weighted towards our more junior employees.Segment Operating Profit and MarginSegment operating profit and margin were as follows:2020Operating Margin %2019Operating Margin %Increase /(Decrease)(Dollars in millions)Financial Services$1,449 25.8 $1,605 27.3 $(156)Healthcare1,383 28.5 1,261 26.9 122 Products and Resources1,078 29.2 1,028 27.3 50 Communications, Media and Technology794 32.0 732 29.9 62 Total segment operating profit and margin4,704 28.2 4,626 27.6 78 Less: unallocated costs2,590 2,173 417 Income from operations$2,114 12.7 $2,453 14.6 $(339)Across all our business segments, operating margins benefited from a significant decrease in travel and entertainment costs due to COVID-19 related reductions in travel, cost savings generated by our cost optimization initiatives and the depreciation of the Indian rupee against the U.S. dollar, partially offset by investments intended to drive organic and inorganic revenue growth and the negative impact on revenues of the COVID-19 pandemic and the ransomware attack. The 2020 operating margin in our Financial Services segment was negatively impacted by the Proposed Exit. Additionally, the 2019 operating margin in our Healthcare segment was negatively impacted by client mergers within the segment and a dispute with a customer related to a large volume based contract. The increase in unallocated costs in 2020 compared to 2019 is primarily due 6 Adjusted Operating Margin is not a measurement of financial performance prepared in accordance with GAAP. See “Non-GAAP Financial Measures” for more information and a reconciliation to the most directly comparable GAAP financial measure.26Table of Contents to a smaller shortfall in 2020 than in 2019 of incentive-based compensation as compared to target, COVID-19 Charges and costs related to the ransomware attack, partially offset by the 2019 India Defined Contribution Obligation discussed in Note 15 to our consolidated financial statements.Other Income (Expense), Net Total other income (expense), net consists primarily of foreign currency exchange gains and losses, interest income and interest expense. The following table sets forth total other income (expense), net for the years ended December 31:20202019Increase / Decrease(in millions)Foreign currency exchange (losses) $(53)$(73)$20 (Losses) gains on foreign exchange forward contracts not designated as hedging instruments(63)8 (71)Foreign currency exchange (losses), net(116)(65)(51)Interest income119 176 (57)Interest expense(24)(26)2 Other, net3 5 (2)Total other income (expense), net$(18)$90 $(108)The foreign currency exchange gains and losses were primarily attributed to the remeasurement of the Indian rupee denominated net monetary assets and liabilities in our U.S. dollar functional currency India subsidiaries and, to a lesser extent, the remeasurement of other net monetary assets and liabilities denominated in currencies other than the functional currencies of our subsidiaries. The gains and losses on our foreign exchange forward contracts not designated as hedging instruments related to the realized and unrealized gains and losses on foreign exchange forward contracts entered into to offset foreign currency exposure to non-U.S. dollar denominated net monetary assets and liabilities. As of December 31, 2020, the notional value of our undesignated hedges was $637 million. The decrease in interest income of $57 million was primarily attributable to lower yields in 2020. Provision for Income Taxes The provision for income taxes was $704 million in 2020 and $643 million in 2019. The effective income tax rate increased to 33.6% in 2020 as compared to 25.3% in 2019 primarily driven by the Tax on Accumulated Indian Earnings, the impact of the Proposed Exit, which was not deductible for tax purposes, and the depreciation of the Indian rupee against the U.S. dollar, which resulted in non-deductible foreign currency exchange losses in our consolidated statement of operations. Income (loss) from equity method investmentsIn 2019, we recorded an impairment charge of $57 million on one of our equity method investments as further described in Note 5 to our consolidated financial statements. Net Income Net income was $1,392 million in 2020 and $1,842 million in 2019. Net income as a percentage of revenues decreased to 8.4% in 2020 from 11.0% in 2019. The decrease in net income was driven by lower income from operations, higher foreign currency exchange losses (inclusive of losses on our foreign exchange forward contracts not designated as hedging instruments), lower interest income and a higher provision for income taxes.Non-GAAP Financial Measures Portions of our disclosure include non-GAAP financial measures. These non-GAAP financial measures are not based on any comprehensive set of accounting rules or principles and should not be considered a substitute for, or superior to, financial measures calculated in accordance with GAAP, and may be different from non-GAAP financial measures used by other companies. In addition, these non-GAAP financial measures should be read in conjunction with our financial statements prepared in accordance with GAAP. The reconciliations of our non-GAAP financial measures to the corresponding GAAP measures, set forth below, should be carefully evaluated. Our non-GAAP financial measures, Adjusted Operating Margin, Adjusted Income From Operations and Adjusted Diluted EPS exclude unusual items. Additionally, Adjusted Diluted EPS excludes net non-operating foreign currency exchange gains or losses and the tax impact of all the applicable adjustments. The income tax impact of each item is calculated by applying the 27Table of Contents statutory rate and local tax regulations in the jurisdiction in which the item was incurred. Constant currency revenue growth is defined as revenues for a given period restated at the comparative period’s foreign currency exchange rates measured against the comparative period's reported revenues.We believe providing investors with an operating view consistent with how we manage the Company provides enhanced transparency into our operating results. For our internal management reporting and budgeting purposes, we use various GAAP and non-GAAP financial measures for financial and operational decision-making, to evaluate period-to-period comparisons, to determine portions of the compensation for our executive officers and for making comparisons of our operating results to those of our competitors. Therefore, it is our belief that the use of non-GAAP financial measures excluding certain costs provides a meaningful supplemental measure for investors to evaluate our financial performance. We believe that the presentation of our non-GAAP financial measures along with reconciliations to the most comparable GAAP measure, as applicable, can provide useful supplemental information to our management and investors regarding financial and business trends relating to our financial condition and results of operations.A limitation of using non-GAAP financial measures versus financial measures calculated in accordance with GAAP is that non-GAAP financial measures do not reflect all of the amounts associated with our operating results as determined in accordance with GAAP and may exclude costs that are recurring such as our net non-operating foreign currency exchange gains or losses. In addition, other companies may calculate non-GAAP financial measures differently than us, thereby limiting the usefulness of these non-GAAP financial measures as a comparative tool. We compensate for these limitations by providing specific information regarding the GAAP amounts excluded from our non-GAAP financial measures to allow investors to evaluate such non-GAAP financial measures.The following table presents a reconciliation of each non-GAAP financial measure to the most comparable GAAP measure for the years ended December 31: 2020% ofRevenues2019% ofRevenues(Dollars in millions, except per share data)GAAP income from operations and operating margin$2,114 12.7 %$2,453 14.6 %Realignment charges (1)42 0.3 169 1.0 2020 Fit for Growth Plan restructuring charges (2)173 1.0 48 0.3 COVID-19 Charges (3)65 0.4 — — Incremental accrual related to the India Defined Contribution Obligation (4)— — 117 0.7 Adjusted Income From Operations and Adjusted Operating Margin2,394 14.4 2,787 16.6 GAAP diluted EPS$2.57 $3.29 Effect of above adjustments, pre-tax0.52 0.60 Effect of non-operating foreign currency exchange losses (gains), pre-tax (5)0.22 0.11 Tax effect of above adjustments (6)(0.15)(0.15)Tax on Accumulated Indian Earnings (7)0.26 — Effect of the equity method investment impairment (8)— 0.10 Effect of the India Tax Law (9)— 0.04 Adjusted Diluted EPS$3.42 $3.99 (1) As part of our realignment program, during 2020, we incurred employee retention costs and certain professional services fees and, during 2019, we incurred Executive Transition Costs, employee separation costs, employee retention costs and third party realignment costs. See Note 4 to our consolidated financial statements for additional information. (2) As part of our 2020 Fit for Growth plan, during 2020, we incurred certain employee separation, employee retention and facility exit costs and other charges and, during 2019, we incurred certain employee separation, employee retention and facility exit costs under the plan. See Note 4 to our consolidated financial statements for additional information. 28Table of Contents (3) During 2020, we incurred costs in response to the COVID-19 pandemic including a one-time bonus to our employees at the designation of associate and below in both India and the Philippines, certain costs to enable our employees to work remotely and provide medical staff and extra cleaning services for our facilities. Most of the costs related to the pandemic are reported in "Cost of revenues" in our consolidated statement of operations.(4) In 2019, we recorded an accrual of $117 million related to the India Defined Contribution Obligation as further described in Note 15 to our consolidated financial statements.(5) Non-operating foreign currency exchange gains and losses, inclusive of gains and losses on related foreign exchange forward contracts not designated as hedging instruments for accounting purposes, are reported in "Foreign currency exchange gains (losses), net" in our consolidated statements of operations.(6) Presented below are the tax impacts of each of our non-GAAP adjustments to pre-tax income:For the years ended December 31,20202019(in millions)Non-GAAP income tax benefit (expense) related to:Realignment charges$11 $43 2020 Fit for Growth Plan restructuring charges45 13 COVID-19 Charges17 — Incremental accrual related to the India Defined Contribution Obligation— 31 Foreign currency exchange gains and losses6 (1)(7) In 2020, we reversed our indefinite reinvestment assertion on Indian earnings accumulated in prior years and recorded $140 million in income tax expense.(8) In 2019, we recorded an impairment charge of $57 million on one of our equity investments as further described in Note 5 to our consolidated financial statements. (9) In 2019, we recorded a one-time net income tax expense of $21 million as a result of the enactment of a new tax law in India. Liquidity and Capital ResourcesCash generated from operations has historically been our primary source of liquidity to fund operations and investments to grow our business. As of December 31, 2020, we had cash, cash equivalents and short-term investments of $2,724 million. Additionally, as of December 31, 2020, we had available capacity under our credit facilities of approximately $1,928 million. The following table provides a summary of our cash flows for the years ended December 31:20202019Increase / Decrease(in millions)Net cash provided by (used in):Operating activities$3,299 $2,499 $800 Investing activities(1,238)1,588 (2,826)Financing activities(2,009)(2,569)560 Operating activitiesThe increase in cash generated from operating activities for 2020 compared to 2019 was primarily driven by improved collections on our trade accounts receivable, deferrals of certain payments due to COVID-19 pandemic regulatory relief provided by several jurisdictions in which we operate, and lower incentive-based compensation payouts and cash taxes paid in 2020. We monitor turnover, aging and the collection of trade accounts receivable by client. Our DSO calculation includes trade accounts receivable, net of allowance for doubtful accounts, and contract assets, reduced by the uncollected portion of our deferred revenue. DSO was 70 days as of December 31, 2020 and 73 days as of December 31, 2019. 29Table of Contents Investing activitiesNet cash used in investing activities in 2020 was primarily driven by payments for acquisitions. Net cash provided by investing activities in 2019 was driven by net sales of investments partially offset by payments for acquisitions and outflows for capital expenditures.Financing activitiesThe decrease in cash used in financing activities in 2020 compared to 2019 is primarily due to lower repurchases of common stock in 2020.We have a Credit Agreement providing for a $750 million Term Loan and a $1,750 million unsecured revolving credit facility, which are due to mature in November 2023. We are required under the Credit Agreement to make scheduled quarterly principal payments on the Term Loan. See Note 10 to our consolidated financial statements. During the first quarter of 2020, we borrowed $1.74 billion against our revolving credit facility and repaid this amount in full in the fourth quarter of 2020. We believe that we currently meet all conditions set forth in the Credit Agreement to borrow thereunder, and we are not aware of any conditions that would prevent us from borrowing part or all of the remaining available capacity under the revolving credit facility as of December 31, 2020 and through the date of this filing. As of December 31, 2020, we had no outstanding balance on our revolving credit facility.In February 2020, our India subsidiary renewed its one-year 13 billion Indian rupee ($178 million at the December 31, 2020 exchange rate) working capital facility, which requires us to repay any balances drawn down within 90 days from the date of disbursement. There is a 1.0% prepayment penalty applicable to payments made within 30 days of disbursement. This working capital facility contains affirmative and negative covenants and may be renewed annually in February. As of December 31, 2020, there was no balance outstanding under the working capital facility. During 2020, we returned $2,034 million to our stockholders through $1,554 million in share repurchases under our stock repurchase program and $480 million in dividend payments. Our stock repurchase program, as amended by our Board of Directors in December 2020, allows for the repurchase of an aggregate of up to $9.5 billion, excluding fees and expenses, of our Class A common stock. As of December 31, 2020, we have $2.8 billion, excluding fees and expenses, available for repurchases under the program. Our shares outstanding decreased to 530 million as of December 31, 2020 from 548 million as of December 31, 2019. We review our capital return plan on an on-going basis, considering the potential impacts of COVID-19 pandemic, our financial performance and liquidity position, investments required to execute our strategic plans and initiatives, acquisition opportunities, the economic outlook, regulatory changes and other relevant factors. As these factors may change over time, the actual amounts expended on stock repurchase activity, dividends, and acquisitions, if any, during any particular period cannot be predicted and may fluctuate from time to time. Other Liquidity and Capital Resources Information We seek to ensure that our worldwide cash is available in the locations in which it is needed. As part of our ongoing liquidity assessments, we regularly monitor the mix of our domestic and international cash flows and cash balances. We evaluate on an ongoing basis what portion of the non-U.S. cash, cash equivalents and short-term investments is needed locally to execute our strategic plans and what amount is available for repatriation back to the United States. In March 2020, the Indian parliament enacted the Budget of India, which contained a number of provisions related to income tax, including a replacement of the DDT, previously due from the dividend payer, with a tax payable by the shareholder receiving the dividend. This provision reduced the tax rate applicable to us for cash repatriated from India. Following this change, during the first quarter of 2020, we limited our indefinite reinvestment assertion to India earnings accumulated in prior years. In July 2020, the U.S. Treasury Department and the IRS released final regulations, which became effective in September 2020, that reduced the tax applicable on our accumulated Indian earnings upon repatriation. As a result, during the third quarter of 2020, after a thorough analysis of the impact of these changes in law on the cost of earnings repatriation and considering our strategic decision to increase our investments to accelerate growth in various international markets and expand our global delivery footprint, we reversed our indefinite reinvestment assertion on Indian earnings accumulated in prior years and recorded a $140 million Tax on Accumulated Indian Earnings. The recorded income tax expense reflects the India withholding tax on unrepatriated Indian earnings, which were $5.2 billion as of December 31, 2019, net of applicable U.S. foreign tax credits. On October 28, 2020, our subsidiary in India remitted a dividend of $2.1 billion, which resulted in a net payment of $2.0 billion to its shareholders (non-Indian Cognizant entities), after payment of $106 million of India withholding tax.30Table of Contents We expect our operating cash flows, cash and short-term investment balances, together with our available capacity under our revolving credit facilities, to be sufficient to meet our operating requirements and service our debt for the next twelve months. Our ability to expand and grow our business in accordance with current plans, make acquisitions, meet our long-term capital requirements beyond a twelve-month period and execute our capital return plan will depend on many factors, including the rate, if any, at which our cash flow increases, our ability and willingness to pay for acquisitions with capital stock and the availability of public and private debt and equity financing. We cannot be certain that additional financing, if required, will be available on terms and conditions acceptable to us, if at all.Commitments and ContingenciesCommitmentsAs of December 31, 2020, we had the following obligations and commitments to make future payments under contractual obligations and commercial commitments: Payments due by period TotalLess than1 year1-3 years3-5 yearsMore than5 years (in millions)Long-term debt obligations(1)$703 $38 $665 $— $— Interest on long-term debt(2)19 7 12 — — Finance lease obligations23 11 11 1 — Operating lease obligations1,271 260 398 264 349 Other purchase commitments(3)432 216 184 28 4 Tax Reform Act transition tax478 50 145 283 — Total$2,926 $582 $1,415 $576 $353 (1) Consists of scheduled repayments of our Term Loan.(2) Interest on the Term Loan was calculated at interest rates in effect as of December 31, 2020.(3) Other purchase commitments include, among other things, communications and information technology obligations, as well as other obligations that we cannot cancel or where we would be required to pay a termination fee in the event of cancellation.As of December 31, 2020, we had $193 million of unrecognized income tax benefits. This represents the income tax benefits associated with certain income tax positions on our U.S. and non-U.S. tax returns that have not been recognized on our financial statements due to uncertainty regarding their resolution. The resolution of these income tax positions with the relevant taxing authorities is at various stages, and therefore we are unable to make a reliable estimate of the eventual cash flows by period that may be required to settle these matters.ContingenciesSee Note 15 to our consolidated financial statements for additional information.Off-Balance Sheet ArrangementsOther than our foreign exchange forward and option contracts, there were no off-balance sheet transactions, arrangements or other relationships with unconsolidated entities or other persons in 2020 and 2019 that have, or are reasonably likely to have, a current or future effect on our financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources.Critical Accounting EstimatesManagement’s discussion and analysis of our financial condition and results of operations is based on our accompanying consolidated financial statements that have been prepared in accordance with GAAP. We base our estimates on historical experience, current trends and on various other assumptions that are believed to be relevant at the time our consolidated financial statements are prepared. We evaluate our estimates on a continuous basis. However, the actual amounts may differ from the estimates used in the preparation of our consolidated financial statements. 31Table of Contents We believe the following accounting estimates are the most critical to aid in fully understanding and evaluating our consolidated financial statements as they require the most difficult, subjective or complex judgments, resulting from the need to make estimates about the effect of matters that are inherently uncertain. Changes to these estimates could have a material effect on our results of operations and financial condition. Our significant accounting policies are described in Note 1 to our consolidated financial statements.Revenue Recognition. Revenues related to fixed-price contracts for application development and systems integration services, consulting or other technology services are recognized as the service is performed using the cost to cost method, under which the total value of revenues is recognized on the basis of the percentage that each contract’s total labor cost to date bears to the total expected labor costs. Revenues related to fixed-price application maintenance, testing and business process services are recognized using the cost to cost method, if the right to invoice is not representative of the value being delivered. The cost to cost method requires estimation of future costs, which is updated as the project progresses to reflect the latest available information. Such estimates and changes in estimates involve the use of judgment. The cumulative impact of any revision in estimates is reflected in the financial reporting period in which the change in estimate becomes known. Net changes in estimates of such future costs and contract losses were immaterial to the consolidated results of operations for the periods presented.Income Taxes. Determining the consolidated provision for income tax expense, deferred income tax assets (and related valuation allowance, if any) and liabilities requires significant judgment. We are required to calculate and provide for income taxes in each of the jurisdictions where we operate. Changes in the geographic mix of income before taxes or estimated level of annual pre-tax income can affect our overall effective income tax rate. In addition, transactions between our affiliated entities are arranged in accordance with applicable transfer pricing laws, regulations and relevant guidelines. As a result, and due to the interpretive nature of certain aspects of these laws and guidelines, we have pending applications for APAs before the taxing authorities in some of our most significant jurisdictions. It could take years for the relevant taxing authorities to negotiate and conclude these applications. The consolidated provision for income taxes may change period to period based on changes in facts and circumstances, such as settlements of income tax audits or finalization of our applications for APAs.Our provision for income taxes also includes the impact of reserves established for uncertain income tax positions, as well as the related interest, which may require us to apply judgment to complex issues and may require an extended period of time to resolve. Although we believe we have adequately reserved for our uncertain tax positions, no assurance can be given that the final outcome of these matters will not differ from our recorded amounts. We adjust these reserves in light of changing facts and circumstances, such as the closing of a tax audit. To the extent that the final outcome of these matters differs from the amounts recorded, such differences will impact the provision for income taxes in the period in which such determination is made.Business Combinations, Goodwill and Intangible Assets. Goodwill and intangible assets, including indefinite-lived intangible assets, arise from the accounting for business combinations. We account for business combinations using the acquisition method which requires us to estimate the fair value of identifiable assets acquired, liabilities assumed, including any contingent consideration, and any noncontrolling interest in the acquiree to properly allocate purchase price to the individual assets acquired and liabilities assumed. The allocation of the purchase price utilizes estimates and assumptions in determining the fair values of identifiable assets acquired and liabilities assumed, especially with respect to intangible assets, including the timing and amount of forecasted revenues and cash flows, anticipated growth rates, client attrition rates and the discount rate reflecting the risk inherent in future cash flows.We exercise judgment to allocate goodwill to the reporting units expected to benefit from each business combination. Goodwill is tested for impairment at the reporting unit level on an annual basis and between annual tests if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying value. These events or circumstances could include a significant change in the business climate, regulatory environment, established business plans, operating performance indicators or competition. Evaluation of goodwill for impairment requires judgment, including the identification of reporting units, assignment of assets, liabilities and goodwill to reporting units and determination of the fair value of each reporting unit. We estimate the fair value of our reporting units using a combination of an income approach, utilizing a discounted cash flow analysis, and a market approach, using market multiples. Under the income approach, we estimate projected future cash flows, the timing of such cash flows and long-term growth rates, and determine the appropriate discount rate that reflects the risk inherent in the projected future cash flows. The discount rate used is based on a market participant weighted-average cost of capital and may be adjusted for the relevant risk associated with business-specific characteristics and the uncertainty related to the reporting unit’s ability to execute on the projected future cash flows. Under the market approach, we estimate fair value based on market multiples of revenues and earnings derived from comparable publicly-traded companies with characteristics similar to the reporting unit. The estimates used to calculate the fair value of a reporting unit change from year to year based on 32Table of Contents operating results, market conditions and other factors. Changes in these estimates and assumptions could materially affect the determination of fair value for each reporting unit. We also evaluate indefinite-lived intangible assets for impairment at least annually, or as circumstances warrant. Our 2020 qualitative assessment included the review of relevant macroeconomic factors and entity-specific qualitative factors to determine if it was more-likely-than-not that the fair value of our indefinite-lived intangible assets was below carrying value.Beginning with the first quarter of 2020, COVID-19 negatively affected all major economic and financial markets and, although there is a wide range of possible outcomes and the associated impact is highly dependent on variables that are difficult to forecast, we deemed the deterioration in general economic conditions sufficient to trigger an interim impairment testing of goodwill as of March 31, 2020. Our interim test results as of March 31, 2020 indicated that the fair values of all of our reporting units exceeded their carrying values and thus, no impairment of goodwill existed as of March 31, 2020. Based on our most recent evaluation of goodwill and indefinite-lived intangible assets performed during the fourth quarter of 2020, we concluded that the goodwill and indefinite-lived intangible asset balances in each of our reporting units were not at risk of impairment. We review our finite-lived assets, including our finite-lived intangible assets, for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset group may not be recoverable. We recognize an impairment loss when the sum of the undiscounted expected future cash flows is less than the carrying amount of such asset groups. The impairment loss is determined as the amount by which the carrying amount of the asset group exceeds its fair value. Assessing the fair value of asset groups involves significant estimates and assumptions including estimation of future cash flows, the timing of such cash flows and discount rates reflecting the risk inherent in future cash flows. Contingencies. Loss contingencies are recorded as liabilities when a loss is considered probable and the amount can be reasonably estimated. When a material loss contingency is reasonably possible but not probable, we do not record a liability, but instead disclose the nature and amount of the claim, and an estimate of the loss or range of loss, if such an estimate can be made. Significant judgment is required in the determination of whether an exposure is considered probable and reasonably estimable. Our judgments are subjective and based on the information available from the status of the legal or regulatory proceedings, the merits of our defenses and consultation with in-house and outside legal counsel. As additional information becomes available, we reassess any potential liability related to any pending litigation and may revise our estimates. Such revisions in estimates of any potential liabilities could have a material impact on our results of operations and financial position.Recently Adopted and New Accounting PronouncementsSee Note 1 to our consolidated financial statements for additional information.Forward Looking StatementsThe statements contained in this Annual Report on Form 10-K that are not historical facts are forward-looking statements (within the meaning of Section 21E of the Exchange Act) that involve risks and uncertainties. Such forward-looking statements may be identified by, among other things, the use of forward-looking terminology such as “believe,” “expect,” “may,” “could,” “would,” “plan,” “intend,” “estimate,” “predict,” “potential,” “continue,” “should” or “anticipate” or the negative thereof or other variations thereon or comparable terminology, or by discussions of strategy that involve risks and uncertainties. From time to time, we or our representatives have made or may make forward-looking statements, orally or in writing.Such forward-looking statements may be included in various filings made by us with the SEC, in press releases or in oral statements made by or with the approval of one of our authorized executive officers. These forward-looking statements, such as statements regarding our anticipated future revenues or operating margin, earnings, capital expenditures, impacts to our business, financial results and financial condition as a result of the COVID-19 pandemic, anticipated effective income tax rate and income tax expense, liquidity, access to capital, capital return plan, investment strategies, cost management, realignment program, 2020 Fit for Growth Plan, plans and objectives, including those related to our digital practice areas, investment in our business, potential acquisitions, industry trends, client behaviors and trends, the outcome of regulatory and litigation matters, the incremental accrual related to the India Defined Contribution Obligation, the Proposed Exit and other statements regarding matters that are not historical facts, are based on our current expectations, estimates and projections, management’s beliefs and certain assumptions made by management, many of which, by their nature, are inherently uncertain and beyond our control. Actual results, performance, achievements and outcomes could differ materially from the results expressed in, or anticipated or implied by, these forward-looking statements. There are a number of important factors that could cause our results to differ materially from those indicated by such forward-looking statements, including:•economic and political conditions globally and in particular in the markets in which our clients and operations are concentrated;33Table of Contents •the continuing impact of the COVID-19 pandemic, or other future pandemics, on our business, results of operations, liquidity and financial condition;•our ability to attract, train and retain skilled employees, including highly skilled technical personnel to satisfy client demand and senior management to lead our business globally;•challenges related to growing our business organically as well as inorganically through acquisitions, and our ability to achieve our targeted growth rates;•our ability to achieve our profitability goals and capital return strategy;•our ability to successfully implement our 2020 Fit for Growth Plan and achieve the anticipated benefits from the plan;•our ability to meet specified service levels or milestones required by certain of our contracts;•intense and evolving competition and significant technological advances that our service offerings must keep pace with in the rapidly changing markets we compete in;•legal, reputation and financial risks if we fail to protect client and/or our data from security breaches and/or cyber attacks;•the effectiveness of our risk management, business continuity and disaster recovery plans and the potential that our global delivery capabilities could be impacted;•restrictions on visas, in particular in the United States, United Kingdom and EU, or immigration more generally or increased costs of such visas or the wages we are required to pay associates on visas, which may affect our ability to compete for and provide services to our clients;•risks related to anti-outsourcing legislation, if adopted, and negative perceptions associated with offshore outsourcing, both of which could impair our ability to serve our clients;•risks related to complying with the numerous and evolving legal and regulatory requirements to which we are subject in the many jurisdictions in which we operate; •potential changes in tax laws, or in their interpretation or enforcement, failure by us to adapt our corporate structure and intercompany arrangements to achieve global tax efficiencies or adverse outcomes of tax audits, investigations or proceedings;•potential exposure to litigation and legal claims in the conduct of our business; and•the factors set forth in Part I, in the section entitled “Item 1A. Risk Factors” in this report.You are advised to consult any further disclosures we make on related subjects in the reports we file with the SEC, including this report in the sections titled “Part I, Item 1. Business,” “Part I, Item 1A. Risk Factors” and “Part II, Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.” We undertake no obligation to update or revise any forward-looking statements, whether as a result of new information, future events or otherwise, except as may be required under applicable securities laws.34Table of Contents GlossaryDefined TermDefinition10b5-1 PlanTrading plan adopted pursuant to Rule 10b5-1 of the Exchange Act10th MagnitudePamlico 10th Magnitude Blocker LLC, now known as Cognizant 10th Magnitude Blocker, LLC2009 Incentive PlanCognizant Technology Solutions Corporation Amended and Restated 2009 Incentive Compensation Plan2017 Incentive PlanCognizant Technology Solutions Corporation 2017 Incentive Award PlanAdjusted Diluted EPSAdjusted diluted earnings per shareAIArtificial Intelligence APAAdvance Pricing AgreementASCAccounting Standards CodificationASRAccelerated Stock RepurchaseASUAccounting Standards UpdateBright WolfBright Wolf, LLCBudget of IndiaUnion Budget of India for 2020-2021CCConstant CurrencyCodeThe Code on Social Security, 2020Code ZeroCode Zero, LLCCollaborative SolutionsCollaborative Solutions Holdings, LLCContinoContino Holdings Inc.COVID-19The novel coronavirus diseaseCOVID-19 ChargesCosts directly related to the COVID-19 pandemicCPIConsumer Price IndexCredit AgreementCredit agreement with a commercial bank syndicate dated November 6, 2018Credit Loss StandardASC Topic 326 "Financial Instruments - Credit Losses"CTS IndiaOur principal operating subsidiary in IndiaDDTDividend Distribution TaxD&IDiversity and InclusionDivision BenchDivision Bench of the Madras High CourtDevOpsAgile relationship between development and IT operationsDOJUnited States Department of JusticeDSODays Sales OutstandingEI-TechnologiesEntrepreneurs et Investisseurs Technologies SASEPSEarnings Per ShareESGEnvironmental, social and corporate governanceEUEuropean UnionExchange ActSecurities Exchange Act of 1934, as amendedExecutive Transition CostsCosts associated with our CEO transition and the departure of our President in 2019FASBFinancial Accounting Standards BoardFCPAForeign Corrupt Practices ActGAAPGenerally Accepted Accounting Principles in the United States of AmericaHigh CourtMadras High CourtHRHuman ResourcesInawisdomInawisdom LimitedIndia Defined Contribution ObligationCertain statutory defined contribution obligations of employees and employers in India35Table of Contents India Tax LawNew tax regime enacted by the Government of India effective April 1, 2019IPIntellectual propertyIoTInternet of ThingsIRSInternal Revenue ServiceITInformation TechnologyITDIndian Income Tax DepartmentLevLevementum, LLCLIBORLondon Inter-bank Offered RateLiniumthe ServiceNow business of Ness Digital EngineeringMagenicMagenic Technologies, Inc.MATMinimum Alternative TaxMeritsoftSterling Topco LimitedMustacheMustache, LLCNew Revenue StandardASC Topic 606 "Revenue from Contracts with Customers"New Lease StandardASC Topic 842 “Leases” New SignatureBSI Corporate Holdings, Inc.OECDOrganization for Economic Co-operation and Development Proposed ExitOffer to settle and exit from a large customer engagement in Financial Services in Continental EuropePSUPerformance Stock UnitsPurchase PlanCognizant Technology Solutions Corporation 2004 Employee Stock Purchase Plan, as amended ROURight of UseRSURestricted Stock UnitsSaaSSoftware as a serviceSamlinkOy Samlink AbSECUnited States Securities and Exchange CommissionSCISupreme Court of IndiaServianSVN HoldCo Pty LimitedSEZSpecial Economic ZoneSG&ASelling, general and administrativeSLPSpecial Leave PetitionSyntelSyntel Sterling Best Shores Mauritius Ltd.Tax on Accumulated Indian EarningsThe income tax expense related to the reversal of our indefinite reinvestment assertion on Indian earnings accumulated in prior yearsTax Reform ActTax Cuts and Jobs ActTerm LoanUnsecured term loan under the Credit AgreementTin RoofTin Roof Software, LLCTriZettoThe TriZetto Group, Inc., now known as Cognizant Technology Software Group, Inc.ZenithZenith Technologies Limited36Table of Contents Item 7A. Quantitative and Qualitative Disclosures about Market RiskForeign Currency RiskWe are exposed to foreign currency exchange rate risk in the ordinary course of doing business as we transact or hold a portion of our funds in foreign currencies, particularly the Indian rupee. Accordingly, we periodically evaluate the need for hedging strategies, including the use of derivative financial instruments, to mitigate the effect of foreign currency exchange rate fluctuations and expect to continue to use such instruments in the future to reduce foreign currency exposure to changes in the value of certain foreign currencies. All hedging transactions are authorized and executed pursuant to regularly reviewed policies and procedures.Revenues from our clients in the United Kingdom, Continental Europe and Rest of World represented 8.0%, 9.9% and 6.5%, respectively, of our 2020 revenues, and are typically denominated in currencies other than the U.S. dollar. Accordingly, our revenues may be affected by fluctuations in the exchange rates, primarily the British pound and the Euro, as compared to the U.S. dollar.A significant portion of our costs in India are denominated in the Indian rupee, representing approximately 20.0% of our global operating costs during 2020, and are subject to foreign currency exchange rate fluctuations. These foreign currency exchange rate fluctuations have an impact on our results of operations.We have entered into a series of foreign exchange forward and option contracts that are designated as cash flow hedges of certain Indian rupee denominated payments in India. These U.S. dollar / Indian rupee hedges are intended to partially offset the impact of movement of exchange rates on future operating costs. As of December 31, 2020, the notional value and weighted average contract rates of these contracts by year of maturity were as follows:Notional Value (in millions)Weighted Average Contract Rate (Indian rupee to U.S. dollar)2021$1,470 77.0 2022803 80.7 Total$2,273 78.3 As of December 31, 2020, the net unrealized gain on our outstanding foreign exchange forward and option contracts designated as cash flow hedges was $70 million. Based upon a sensitivity analysis at December 31, 2020, which estimates the fair value of the contracts assuming certain market exchange rate fluctuations, a 10.0% change in the foreign currency exchange rate against the U.S. dollar with all other variables held constant would have resulted in a change in the fair value of our foreign exchange forward and option contracts designated as cash flow hedges of approximately $224 million.A portion of our balance sheet is exposed to foreign currency exchange rate fluctuations, which may result in non-operating foreign currency exchange gains or losses upon remeasurement. In 2020, we reported foreign currency exchange losses, exclusive of hedging losses, of approximately $53 million, which were primarily attributed to the remeasurement of net monetary assets and liabilities denominated in currencies other than the functional currencies of our subsidiaries. We use foreign exchange forward contracts to provide an economic hedge against balance sheet exposure to certain monetary assets and liabilities denominated in currencies other than the functional currency of the subsidiary. We entered into foreign exchange forward contracts scheduled to mature in 2021. At December 31, 2020, the notional value of these outstanding contracts was $637 million and the net unrealized gain was less than $1 million. Based upon a sensitivity analysis of our foreign exchange forward contracts at December 31, 2020, which estimates the fair value of the contracts assuming certain market exchange rate fluctuations, a 10.0% change in the foreign currency exchange rate against the U.S. dollar with all other variables held constant would have resulted in a change in the fair value of approximately $17 million.Interest Rate RiskWe have a Credit Agreement providing for a $750 million unsecured Term Loan and a $1,750 million unsecured revolving credit facility, which are due to mature in November 2023. We are required under the Credit Agreement to make scheduled quarterly principal payments on the Term Loan. The Credit Agreement requires interest to be paid, at our option, at either the ABR or the Eurocurrency Rate (each as defined in the Credit Agreement), plus, in each case, an Applicable Margin (as defined in the Credit Agreement). Initially, the Applicable Margin is 0.875% with respect to Eurocurrency Rate loans and 0.00% with respect to ABR loans. Subsequently, the 37Table of Contents Applicable Margin with respect to Eurocurrency Rate loans may range from 0.75% to 1.125%, depending on our public debt ratings (or, if we have not received public debt ratings, from 0.875% to 1.125%, depending on our Leverage Ratio, which is the ratio of indebtedness for borrowed money to Consolidated EBITDA, as defined in the Credit Agreement). Under the Credit Agreement, we are required to pay commitment fees on the unused portion of the revolving credit facility, which vary based on our public debt ratings (or, if we have not received public debt ratings, on the Leverage Ratio). Thus, our debt exposes us to market risk from changes in interest rates. We performed a sensitivity analysis to determine the effect of interest rate fluctuations on our interest expense. A 10.0% change in interest rates, with all other variables held constant, would have an immaterial effect on our reported interest expense. Information provided by the sensitivity analysis of foreign currency risk and interest rate risk does not necessarily represent the actual changes that would occur under normal market conditions.
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+Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations,” “
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+Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations" ("MD&A"), and "Item 7A. Quantitative and Qualitative Disclosures About Market Risk" herein. Such forward-looking statements include (1) benefits and opportunities stemming from our strategy, strategic position, business model and capabilities, (2) the strength and growth potential of the U.S. market for shared communications infrastructure investment, (3) expectations regarding anticipated growth in the wireless industry, and consumption of and demand for data, including growth in, and factors driving, consumption and demand, (4) potential benefits of our communications infrastructure (on an individual and collective basis) and expectations regarding demand therefore, including potential benefits and continuity of and factors driving such demand, (5) competitive factors affecting our business, (6) expectations regarding construction and acquisition of communications infrastructure, (7) focus on workforce diversity and inclusion, (8) the utilization of our net operating loss carryforwards ("NOLs"), (9) expectations regarding wireless carriers' network investments, (10) expectations regarding continued adoption and increase in usage of high-bandwidth applications by organizations, (11) expected benefits of spectrum auctions, (12) expected use of net proceeds from issuances under the commercial paper program ("CP Program"), (13) our full year 2021 outlook and the 2anticipated growth in our financial results, including future revenues, and the expectations regarding our 2021 capital expenditures, as well as the factors impacting our financial results and the levels of capital expenditures, (14) expectations regarding our capital structure and the credit markets, our availability and cost of capital, capital allocation, our leverage ratio and interest coverage targets, our ability to service our debt and comply with debt covenants, future of LIBOR and any replacement rate thereto, level of available commitment we intend to maintain under our debt instruments, and the plans for and the benefits of any future refinancings, (15) the utility of certain financial measures, including non-GAAP financial measures, (16) expectations related to our ability to remain qualified as a real estate investment trust ("REIT") and the advantages, benefits or impact of, or opportunities created by, our REIT status, (17) adequacy, projected sources and uses of liquidity, (18) expectations related to the impact of tenant consolidation or ownership changes, including the impact from the merger of T-Mobile and Sprint, (19) expectations regarding non-renewals of tenant contracts, (20) our dividend policy and the timing, amount, growth or tax characterization of our dividends, (21) the potential effects of the restatement of our previously issued consolidated financial statements, including any litigation stemming therefrom, (22) the potential impact of the novel coronavirus (COVID-19) pandemic, (23) the potential impact on our business from unforeseen events, (24) the outcome of outstanding litigation and (25) the intended use of net proceeds from our February 2021 issuance of senior unsecured notes. All future dividends are subject to declaration by our board of directors.Such forward-looking statements should, therefore, be considered in light of various risks, uncertainties and assumptions, including prevailing market conditions, risk factors described under "Item 1A. Risk Factors" herein and other factors. Should one or more of these risks or uncertainties materialize, or should underlying assumptions prove incorrect, actual results may vary materially from those expected. Our filings with the SEC are available through the SEC website at www.sec.gov or through our investor relations website at investor.crowncastle.com. We use our investor relations website to disclose information about us that may be deemed to be material. We encourage investors, the media and others interested in us to visit our investor relations website from time to time to review up-to-date information or to sign up for e-mail alerts to be notified when new or updated information is posted on the site.Interpretation and Other InformationAs used herein, the term "including," and any variation thereof, means "including without limitation." The use of the word "or" herein is not exclusive. Unless this 2020 Form 10-K indicates otherwise or the context otherwise requires, the terms, "we," "our," "our company," "the company" or "us" as used in this 2020 Form 10-K refer to Crown Castle International Corp. and its predecessor (organized in 1995), as applicable, each a Delaware corporation (together, "CCIC"), and their subsidiaries. Additionally, unless the context suggests otherwise, references to "U.S." are to the United States of America and Puerto Rico, collectively. On November 19, 2020 the SEC adopted amendments to Items 301, 302 and 303 of Regulation S-K, which became effective on February 10, 2021. Although mandatory compliance is not required until our fiscal year ending December 31, 2021, early adoption is permitted, and we have elected to early adopt amended Items 301, 302 and 303 of Regulation S-K in this 2020 Form 10-K.3PART IItem 1. BusinessOverviewWe own, operate and lease shared communications infrastructure that is geographically dispersed throughout the U.S., including approximately (1) 40,000 towers and other structures, such as rooftops (collectively, "towers"), and (2) 80,000 route miles of fiber primarily supporting small cell networks ("small cells") and fiber solutions. We refer to our towers, fiber and small cells assets collectively as "communications infrastructure," and to our customers on our communications infrastructure as "tenants." Our operating segments consist of (1) Towers and (2) Fiber, which includes both small cells and fiber solutions. Our core business is providing access, including space or capacity, to our shared communications infrastructure via long-term contracts in various forms, including lease, license, sublease and service agreements (collectively, "tenant contracts"). We seek to increase our site rental revenues by adding more tenants on our shared communications infrastructure, which we expect to result in significant incremental cash flows due to our low incremental operating costs. We operate as a REIT for U.S. federal income tax purposes. See "Item 1. Business—REIT Status" and notes 2 and 9 to our consolidated financial statements.Over the last two decades, we have assembled a leading portfolio of towers predominately through acquisitions from large wireless carriers or their predecessors. More recently, both through acquisitions and new construction of small cells and fiber, we have extended our communications infrastructure presence by investing significantly in our Fiber segment. Through our product offerings of towers and small cells, we seek to provide a comprehensive solution to enable our wireless tenants to expand coverage and capacity for wireless networks. Furthermore, within our Fiber segment, we seek to generate cash flow growth and stockholder return by deploying our fiber for both small cells' and fiber solutions' tenants.Approximately 56% and 71% of our towers are located in the 50 and 100 largest U.S. basic trading areas ("BTAs"), respectively. Our towers have a significant presence in each of the top 100 BTAs. We derive approximately 40% of our Towers site rental gross margin from towers located on land that we own, including through fee interests and perpetual easements, and we derive approximately 60% of our Towers site rental gross margin from towers located on land that we lease, sublease, manage or license. The contracts for the land under our towers have an average total remaining life of approximately 36 years (including all renewal terms exercisable at our option), weighted based on Towers site rental gross margin. The majority of our small cells and fiber are located in major metropolitan areas, including a presence within every major U.S. market. The vast majority of our fiber assets are located on public rights-of-way. Our largest tenants are T-Mobile (which merged with Sprint in April 2020), AT&T and Verizon Wireless, which collectively accounted for approximately 76% of our 2020 consolidated site rental revenues (including revenues previously derived from Sprint). See note 14 to our consolidated financial statements for further information regarding our largest tenants. Site rental revenues represented 91% of our 2020 consolidated net revenues, of which approximately 66% and 34% were from our Towers segment and our Fiber segment, respectively. Within our Fiber segment, 70% and 30% of our 2020 Fiber site rental revenues related to fiber solutions and small cells, respectively. The vast majority of our site rental revenues are of a recurring nature and are derived from long-term tenant contracts with our tenants. Our site rental revenues derived from wireless tenants typically result from long-term tenant contracts with (1) initial terms of five to 15 years, (2) multiple renewal periods of five to 10 years each, exercisable at the option of the tenant, (3) limited termination rights for our tenants and (4) monthly rental payments with contractual escalations of the rental price and, in some cases, an additional upfront payment. Our site rental revenues derived from our fiber solutions tenants (including from organizations with high-bandwidth and multi-location demands) typically result from tenant contracts with (1) initial terms that generally vary between three to 20 years and (2) a fixed monthly recurring fee and, in some cases, an additional upfront payment. Exclusive of renewals exercisable at the tenants' option, our tenant contracts have a weighted-average remaining life of approximately five years and represent $27 billion of expected future cash inflows.As part of our effort to provide comprehensive communications infrastructure solutions, as an ancillary business, we also offer certain services primarily relating to our Towers segment, predominately consisting of (1) site development services primarily relating to existing or new tenant equipment installations, including: site acquisition, architectural and engineering, or zoning and permitting (collectively, "site development services") and (2) tenant equipment installation or subsequent augmentations (collectively, "installation services"). 4StrategyAs a leading provider of shared communications infrastructure in the U.S., our strategy is to create long-term stockholder value via a combination of (1) growing cash flows generated from our existing portfolio of communications infrastructure, (2) returning a meaningful portion of our cash generated by operating activities to our common stockholders in the form of dividends and (3) investing capital efficiently to grow cash flows and long-term dividends per share. Our strategy is based, in part, on our belief that the U.S. is the most attractive market for shared communications infrastructure investment with the greatest long-term growth potential. We measure our efforts to create "long-term stockholder value" by the combined payment of dividends to stockholders and growth in our per-share results. The key elements of our strategy are to:•Grow cash flows from our existing communications infrastructure. We are focused on maximizing the recurring site rental cash flows generated from providing our tenants with long-term access to our shared infrastructure assets, which we believe is the core driver of value for our stockholders. Tenant additions or modifications of existing tenant equipment (collectively, "tenant additions") enable our tenants to expand coverage and capacity in order to meet increasing demand for data while generating high incremental returns for our business. We believe our product offerings of towers and small cells provide a comprehensive solution to our wireless tenants' growing network needs through our shared communications infrastructure model, which is an efficient and cost-effective way to serve our tenants. Additionally, we believe our ability to share our fiber assets across multiple tenants to deploy both small cells and offer fiber solutions allows us to generate cash flows and increase stockholder return. •Return cash generated by operating activities to common stockholders in the form of dividends. We believe that distributing a meaningful portion of our cash generated by operating activities appropriately provides common stockholders with increased certainty for a portion of expected long-term stockholder value while still allowing us to retain sufficient flexibility to invest in our business and deliver growth. We believe this decision reflects the translation of the high-quality, long-term contractual cash flows of our business into stable capital returns to common stockholders. •Invest capital efficiently to grow cash flows and long-term dividends per share. In addition to adding tenants to existing communications infrastructure, we seek to invest our available capital, including the net cash generated by our operating activities and external financing sources, in a manner that will increase long-term stockholder value on a risk-adjusted basis. These investments include constructing and acquiring new communications infrastructure that we expect will generate future cash flow growth and attractive long-term returns by adding tenants to those assets over time. Our historical investments have included the following (in no particular order): ◦construction of towers, fiber and small cells; ◦acquisitions of towers, fiber and small cells; ◦acquisitions of land interests (which primarily relate to land assets under towers); ◦improvements and structural enhancements to our existing communications infrastructure; ◦purchases of shares of our common stock from time to time; and ◦purchases, repayments or redemptions of our debt. Our strategy to create long-term stockholder value is based on our belief that there will be considerable future demand for our communications infrastructure based on the location of our assets and the rapid growth in the demand for data. We believe that such demand for our communications infrastructure will continue, will result in growth of our cash flows due to tenant additions on our existing communications infrastructure, and will create other growth opportunities for us, such as demand for newly constructed or acquired communications infrastructure, as described above. Further, we seek to augment the long-term value creation associated with growing our recurring site rental cash flows by offering certain ancillary site development and installation services within our Towers segment.REIT StatusWe operate as a REIT for U.S. federal income tax purposes. As a REIT, we are generally entitled to a deduction for dividends that we pay and therefore are not subject to U.S. federal corporate income tax on our net taxable income that is currently distributed to our stockholders. We may be subject to certain federal, state, local and foreign taxes on our income or assets, including (1) taxes on any undistributed income, (2) taxes related to our taxable REIT subsidiaries ("TRSs"), (3) franchise taxes, (4) property taxes and (5) transfer taxes. In addition, we could, under certain circumstances, be required to pay an excise or penalty tax, which could be significant in amount, in order to utilize one or more relief provisions under the Internal Revenue Code of 1986, as amended ("Code"), to maintain qualification for taxation as a REIT. The Tax Cuts and Jobs Act, which was signed into law in 2017 ("Tax Reform Act"), made substantial changes to the Code. Among the many changes impacting corporations are a significant reduction in the corporate income tax rate, the repeal 5of the corporate alternative minimum tax for years beginning in 2018 and limitations on the deductibility of interest expense. In addition, under the Tax Reform Act, qualified REIT dividends (within the meaning of Section 199A(e)(3) of the Code) constitute a part of a non-corporate taxpayer's "qualified business income amount" and thus our non-corporate U.S. stockholders may be eligible to take a qualified business income deduction in an amount equal to 20% of such dividends received from us. Without further legislative action, the 20% deduction applicable to qualified REIT dividends will expire on January 1, 2026. The Tax Reform Act has not had a material impact on us. The vast majority of our assets and revenues are in the REIT. See notes 2 and 9 to our consolidated financial statements. Additionally, we have included in TRSs certain other assets and operations. Those TRS assets and operations will continue to be subject, as applicable, to federal and state corporate income taxes or to foreign taxes in the jurisdictions in which such assets and operations are located. Our foreign assets and operations (including our tower operations in Puerto Rico) most likely will be subject to foreign income taxes in the jurisdictions in which such assets and operations are located, regardless of whether they are included in a TRS.To remain qualified and be taxed as a REIT, we will generally be required to annually distribute to our stockholders at least 90% of our REIT taxable income, after the utilization of our NOLs (determined without regard to the dividends paid deduction and excluding net capital gain) (see notes 2 and 9 to our consolidated financial statements). Our quarterly common stock dividend will delay the utilization of our NOLs and may cause certain of the NOLs to expire without utilization. See "Item 1A. Risk Factors" for risks associated with our REIT Status. Industry OverviewConsumer demand for data continues to grow due to increases in data consumption and increased penetration of bandwidth-intensive devices. This increase in data consumption is driven by factors such as growth in (1) mobile entertainment (such as mobile video, mobile applications and social networking), (2) mobile internet usage (supporting web browsing and trends in telehealth, remote working and other remote communications), (3) machine-to-machine applications or the "Internet of Things" (such as connected cars and smart city technologies), and (4) the adoption of other bandwidth-intensive applications (such as cloud services and video communications). As a result, consumer wireless devices are trending toward bandwidth-intensive devices, including smartphones, laptops, tablets, wearables and other emerging and embedded devices, and U.S. wireless carriers are among the first carriers in the world to begin offering commercial 5th Generation ("5G") mobile cellular communications services to further support such growth.We expect the following anticipated factors to contribute to potential demand for our communications infrastructure:•consumers' growing wireless data consumption likely resulting in major wireless carriers continuing to upgrade and enhance their networks through the efficient use of both towers and small cells, including in connection with 5G deployments, in an effort to improve network quality and capacity and customer retention or satisfaction; •prior and future potential spectrum auctioned, licensed or made available by the Federal Communications Commission ("FCC") enabling additional wireless carrier network development; •next-generation technologies and new uses for wireless communications may potentially result in new entrants or increased demand in the wireless industry, which may include companies involved in the continued evolution and deployment of the Internet of Things; •the continued adoption of bandwidth-intensive applications could result in demand for high-capacity, multi-location, fiber-based network solutions; and•increased government initiatives to expand broadband infrastructure to support connectivity throughout the U.S.The CompanyVirtually all of our operations in both our Towers and Fiber operating segments are located in the U.S. For more information about our operating segments, see "Item 7. MD&A—General Overview" and note 14 to our consolidated financial statements. Our core business is providing access, including space or capacity, to our shared communications infrastructure via long-term tenant contracts in the U.S. We believe our communications infrastructure is integral to our tenants' networks and organizations. See "Item 1. Business—Strategy."6Towers Segment. We believe towers are the most efficient and cost-effective solution for providing coverage and capacity for wireless carrier network deployments. We acquired ownership interests or exclusive rights to the majority of our towers directly or indirectly from the largest U.S. wireless carriers (or their predecessors) through transactions consummated since 1999, including transactions with (1) AT&T in 2013 ("AT&T Acquisition"), (2) T-Mobile in 2012 ("T-Mobile Acquisition"), (3) Global Signal Inc. in 2007 ("Global Signal Acquisition"), which had originally acquired the majority of its towers from Sprint (prior to Sprint's merger with T-Mobile, which was completed in 2020), (4) companies now part of Verizon Wireless in 1999 and 2000 and (5) companies now part of AT&T in 1999 and 2000. We generally receive monthly rental payments from our Towers tenants pursuant to long-term tenant contracts. Typically, we negotiate initial contract terms of five to 15 years, with multiple renewal periods of five to 10 years each, exercisable at the option of the tenant, and our tenant contracts typically include fixed escalations (which generally exceed expected non-renewals, as discussed below). We strive to negotiate with our existing tenant base for longer contractual terms, which often contain fixed escalation rates. Our Towers tenant contracts, while amended and re-negotiated over time, have historically led to a long-term relationship with tenants on our towers, resulting in a retention rate generally between 97% and 99% each year. In general, each renewable tenant contract automatically renews at the end of its term unless (1) the tenant provides prior notice of its intent not to renew or (2) the contract is amended or re-negotiated. See note 3 to our consolidated financial statements for a tabular presentation of the minimum rental payments due to us by tenants pursuant to tenant contracts without consideration of tenant renewal options.The average monthly rental payment from a new tenant added to towers can vary based on (1) aggregate tenant volume, (2) the region in the U.S. where the tower is located, or (3) the amount of space granted to a tenant, which can be influenced by the physical size, weight and shape of the tenant's antenna installation or related equipment. When possible, we seek to receive rental payment increases in connection with tenant contract amendments, pursuant to which our tenants add antennas or other equipment to our towers on which they already have equipment pursuant to preexisting tenant contracts. Our Towers tenant contracts and pricing are not influenced by whether or not we perform the respective site development or installation services. See "—Services" below for a further discussion of our tower installation services. As of December 31, 2020, the average number of tenants (calculated as a unique license together with any related amendments thereto) per tower is approximately 2.1. The following chart sets forth the number of existing tenants per tower as of December 31, 2020 (see "Item 7. MD&A—Accounting and Reporting Matters—Critical Accounting Policies and Estimates" for a discussion of our impairment evaluation and our towers with no tenants).Fiber Segment. Our Fiber segment includes both small cells and fiber solutions. •Our small cells offload data traffic from towers and bolster our tenants' network capacity where data demand is the greatest and are typically attached to public right-of-way infrastructure, including utility poles and street lights. •We offer certain fiber solutions to organizations with high-bandwidth and multi-location demands. Our fiber solutions provide essential connectivity resources needed to create integrated networks and support organizations. 7Our fiber assets include those we acquired from: (1) NextG Networks, Inc. in 2012 , (2) Quanta Fiber Networks, Inc. in 2015, (3) FPL FiberNet Holdings, LLC and certain other subsidiaries of NextEra Energy, Inc. in 2017, (4) Wilcon Holdings LLC in 2017 and (5) LTS Group Holdings LLC in 2017.We generally receive monthly recurring payments from our Fiber tenants and, in some cases, receive upfront payments, pursuant to tenant contracts. The average monthly rental payment from a new tenant can vary based on the amount or cost of (1) construction for initial and subsequent tenants, (2) fiber strand requirements and supply, (3) equipment at the site, (4) the region in the U.S. where the fiber is located and (5) any upfront payment received. Additional site rental information. For both our Towers and Fiber segments, we have existing master agreements with our largest tenants, including T-Mobile, AT&T and Verizon Wireless. Such agreements provide certain terms (including economic terms) that govern underlying contracts (entered into during the term of the master agreements) regarding the right to use our communications infrastructure by such tenants.Approximately half of our site rental cost of operations consists of Towers ground lease expenses, and the remainder includes fiber access expenses (primarily leases of fiber assets and other access agreements to facilitate our communications infrastructure), property taxes, repairs and maintenance, employee compensation or related benefit costs, and utilities. Assuming current leasing activity levels, our cash operating expenses generally tend to escalate at approximately the rate of inflation. We seek to add tenants to our existing communications infrastructure assets at a low incremental operating cost, delivering high incremental returns to our business. Once constructed, our communications infrastructure portfolio requires minimal sustaining capital expenditures, including maintenance or other non-discretionary capital expenditures, which are typically approximately 2% of net revenues. See note 13 to our consolidated financial statements for a tabular presentation of the rental payments we owe to landlords pursuant to our operating lease agreements.Services. As part of our effort to provide comprehensive communications infrastructure solutions, as an ancillary business, we also offer certain services primarily relating to our Towers segment, predominately consisting of (1) site development services and (2) installation services. For 2020, approximately 65% of our services and other revenues related to installation services, and the remainder predominately related to site development services. We seek to grow our service revenues by capitalizing on (1) increased leasing volumes that may result from carrier network upgrades, (2) promoting site development services, (3) expanding the scope of our services, and (4) focusing on tenant service and deployment speed. We have the capability and expertise to install, with the assistance of our network of subcontractors, equipment or antenna systems for our tenants. We do not always provide the installation services or site development services for our tenants on our communications infrastructure as other service providers also provide these services (see also "—Competition" below). These activities are typically non-recurring and highly competitive, with several competitors in most markets. Typically, our installation services are billed on a cost-plus profit basis and site development services are billed on a fixed fee basis. The terms and pricing of both site development services and installation services are negotiated separately from our tenant contracts.Customers. Our Towers customers are primarily comprised of large wireless carriers that operate national networks.Our Fiber customers generally consist of large wireless carriers and organizations with high-bandwidth and multi-location demands, such as enterprise, government, education, healthcare, wholesale, financial, legal, media and entertainment, content distribution, and energy and utilities customers.8Our three largest tenants are T-Mobile, AT&T and Verizon Wireless. Collectively, these three tenants accounted for approximately 76% of our 2020 site rental revenues (including revenues previously derived from Sprint). See "Item 1A. Risk Factors" for risks associated with our dependence on a small number of customers and note 14 to our consolidated financial statements. For 2020, our site rental revenues by tenant were as follows: (a)Includes revenues previously derived from Sprint. On April 1, 2020, T-Mobile and Sprint announced the completion of their previously disclosed merger.Sales and Marketing. Our sales organization markets our communications infrastructure with the objective of contracting access with tenants to existing communications infrastructure or to new communications infrastructure prior to construction. We seek to become the critical partner and preferred independent communications infrastructure provider for our tenants and increase tenant satisfaction relative to our peers by leveraging our (1) existing unique communications infrastructure footprint, (2) tenant relationships, (3) process-centric approach, (4) technological tools and (5) construction capabilities and expertise.Our sales team is organized based on a variety of factors, including tenant type (such as large wireless carriers, vertical customers and organizations), product offering and geography. A team of national account directors maintains our relationships with our largest tenants. These directors work to develop new business opportunities, as well as to ensure that tenants' communications infrastructure needs are efficiently translated into new contracts for our communications infrastructure. Sales personnel in our local offices develop and maintain relationships with our tenants that are expanding their networks, entering new markets, seeking new or additional communication infrastructure offerings, bringing new technologies to market or requiring maintenance or add-on business. In addition to our full-time sales or marketing staff, a number of senior-level employees spend a significant portion of their time on sales and marketing activities and call on existing or prospective tenants.Competition. We face competition for site rental tenants from various sources, including (1) other independent communications infrastructure owners or operators, including competitors that own, operate, or manage towers, rooftops, broadcast or transmission towers, utility poles, fiber (including non-traditional competitors such as cable providers) or small cells, (2) tenants who elect to self-perform or (3) new alternative deployment methods for communications infrastructure.Some of our largest competitors in the Towers segment are American Tower Corporation and SBA Communications Corporation. Our Fiber segment business competitors can vary significantly based on geography. Some of the larger competitors in the Fiber segment include other owners of fiber, as well as recent and potential entrants into small cells and the fiber solutions business. We believe that location, existing communications infrastructure footprint, deployment speed, quality of service, expertise, reputation, capacity and price have been and will continue to be the most significant competitive factors affecting our businesses. See "Item 1A. Risk Factors" for a discussion of competition in our industry.Competitors to our services offering can include site acquisition consultants, zoning consultants, real estate firms, right-of-way consulting firms, construction companies, tower owners or managers, radio frequency engineering consultants, our tenants' internal staff or contractors, or telecommunications equipment vendors who can provide turnkey site development services through multiple subcontractors. We believe that our tenants base their decisions on the outsourcing of services on criteria such as a company's experience, record of accomplishment, reputation, price and time for completion of a project.9Human CapitalThe people who work for Crown Castle are essential to our ability to execute on our strategy. At January 31, 2021, we employed approximately 4,900 people, all of whom were based in the U.S. Of our total employees, approximately 24% were field workers. From time to time, we also add contingent workers to support our business. We believe attracting, developing and retaining talented employees is paramount to serving our customers and our communities and creating value for our shareholders. Our B3 values (Be Real, Be Accountable and Be an Owner) shape our culture, drive our decision-making and guide our interactions with one another and our customers. For 2020, our voluntary employee turnover rate was approximately 3.5%. Our 2020 annual employee survey indicated strong employee engagement exceeding U.S. company norms.We continue to focus on building a more diverse workforce and a more inclusive community to make our company stronger and more innovative. We actively partner with non-profit and community organizations to create a diverse talent pipeline. In addition, our board of directors is currently comprised of 40% female or racially diverse directors, including each of the four most recently appointed directors.The well-being of our employees is a crucial element of our safety culture, employee engagement and productivity. We offer a competitive total rewards package which includes market-based pay, performance-based annual incentive awards, healthcare and retirement benefits, parental and family leave, holiday and paid time off and tuition assistance. We further invest in our employees' professional growth and development by providing resources and opportunities to hone their skills and expand their subject-matter expertise, which empowers them to advance their careers and enables our business to prosper. We are not a party to any collective bargaining agreements and have not experienced any strikes or work stoppages. See also "Item 7. MD&A⸺General Overview⸺Coronavirus (COVID-19)" for information on the measures we have taken with respect to our workforce in light of the global outbreak of the novel coronavirus (COVID-19).Regulatory and Environmental MattersWe are required to comply with a variety of federal, state and local regulations and laws in the U.S., including FCC and Federal Aviation Administration ("FAA") regulations and those discussed under "—Environmental" below. To date, we have not incurred any material fines or penalties or experienced any material adverse effects to our business as a result of any domestic or international regulations, including any environmental regulations. The summary below is based on regulations currently in effect, and such regulations are subject to review or modification by the applicable governmental authority from time to time. If we fail to comply with applicable laws and regulations, we may be fined or even lose our rights to conduct some of our business.Federal Regulations. Both the FCC and the FAA regulate towers used for wireless communications, radio, or television broadcasting. Such regulations control the siting, construction, modification, lighting, and marking of towers and may, depending on the characteristics of particular towers, require the registration of tower facilities with the FCC and the issuance of determinations confirming no hazard to air traffic. Wireless communications devices operating on towers are separately regulated and independently licensed based upon the particular frequency used. In addition, the FCC and the FAA have developed standards to consider proposals for new or modified tower or antenna structures based upon the height or location, including proximity to airports. Proposals to construct or to modify existing tower or antenna structures above certain heights are reviewed by the FAA to ensure the structure will not present a hazard to aviation, which determination may be conditioned upon compliance with lighting or marking requirements. The FCC requires its licensees to operate communications devices only on towers that comply with FAA rules and are registered with the FCC, if required by its regulations. Where tower lighting is required by FAA regulation, tower owners bear the responsibility of notifying the FAA of any tower lighting outage and ensuring the timely restoration of such outages.State and Local Regulations. The U.S. Telecommunications Act of 1996 amended the Communications Act of 1934 to preserve state and local zoning authorities' jurisdiction over the siting of communications towers and small cells. The law, however, limits state and local zoning authority by prohibiting actions by such authorities that discriminate between different service providers of wireless communications or prohibit altogether (actually or effectively) the provision of wireless communications. Additionally, the law prohibits state and local restrictions based on the environmental effects of radio frequency emissions to the extent the facilities comply with FCC regulations.Local regulations include city and other local ordinances (including subdivision and zoning ordinances), approvals for construction, modification and removal of towers and small cells, and restrictive covenants imposed by community developers. These regulations vary greatly, but typically require us to obtain prior approval from local officials. Local zoning authorities may render decisions that prevent the construction or modification of towers or small cells, or place conditions on such 10construction or modifications that are responsive to community residents' concerns regarding the height, visibility, or other characteristics of such infrastructure. Over the last several years, the FCC has adopted regulations and 28 states have passed legislation intended to expedite and streamline the deployment of wireless networks, including establishing presumptively reasonable timeframes for reviews by local and state governments. Notwithstanding such developments, decisions of local regulatory authorities and utilities in certain jurisdictions may continue to adversely affect deployment timing and cost. Certain of our subsidiaries hold state authorizations, including authorizations to act as competitive local exchange carriers ("CLECs"), to provide intrastate telecommunication services in addition to FCC authorization to provide domestic interstate telecommunication services. State authorizations may help promote access to public rights-of-way, which is beneficial to the timely deployment of fiber and small cells, and often allow us to deploy such infrastructure in locations where zoning restrictions might otherwise delay, restrict, or prevent building or expanding traditional wireless tower and rooftop sites. See "Item 1A. Risk Factors" for additional information regarding rights to our infrastructure.Environmental. We are required to comply with a variety of federal, state and local environmental laws and regulations protecting environmental quality, including air and water quality, and wildlife. To date, we have not incurred any material fines or penalties or experienced any material adverse effects to our business as a result of any domestic or international environmental regulations or matters. See "Item 1A. Risk Factors" for additional information regarding compliance with laws and regulations.The construction of new towers and small cells or, in some cases, their modification in the U.S. may be subject to environmental review under the National Environmental Policy Act of 1969, as amended ("NEPA"), which requires federal agencies to evaluate the environmental impact of major federal actions. NEPA regulations require applicants to investigate the potential environmental impact of the proposed tower or small cells construction. If the FCC determines that the proposed tower or small cells construction or modification presents a significant environmental impact, the FCC is required to prepare an environmental impact statement, which is subject to public comment. Such determination could significantly delay the FCC's approval of the construction or modification.Our operations are also subject to federal, state and local laws and regulations relating to the management, use, storage, disposal, emission, or remediation of, or exposure to, hazardous or non-hazardous substances, materials, or wastes. As an owner, lessee, or operator of real property, we are subject to certain environmental laws that impose strict, joint-and-several liability for the cleanup of on-site or off-site contamination relating to existing or historical operations; or we could also be subject to personal injury or property damage claims relating to such contamination. In general, our tenant contracts prohibit our tenants from using or storing any hazardous substances on our communications infrastructure sites in violation of applicable environmental laws and require our tenants to provide notice of certain environmental conditions caused by them.We are subject to Occupational Safety and Health Administration and similar guidelines regarding employee protection from radio frequency exposure. In recent years, the scientific community has extensively studied low-level radio frequency emissions to determine whether they have any connection to certain negative health effects, such as cancer.We have compliance programs and monitoring projects designed to promote compliance with applicable environmental laws and regulations. Nevertheless, there can be no assurance that the costs of compliance with existing or future environmental laws will not have a material adverse effect on us.Available InformationWe maintain a website at www.crowncastle.com. Our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K (and any amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended ("Exchange Act")), proxy statements and other information about us are made available, free of charge, through the investor relations section of our website at http://investor.crowncastle.com and at the SEC's website at http://sec.gov as soon as reasonably practicable after we electronically file such material with, or furnish it to, the SEC. In addition, our corporate governance guidelines, business practices, ethics policy and financial code of ethics and the charters of our Audit Committee, Compensation Committee and Nominating & Corporate Governance Committee are available through the investor relations section of our website at http://www.crowncastle.com/investors/corporate-governance, and such information is also available in print to any stockholder who requests it. We intend to post to our website any amendments to or waivers from each of the ethics policy and financial code of ethics applicable to our Chief Executive Officer, Chief Financial Officer and Controller that are required to be disclosed.11Item 1A. Risk FactorsYou should carefully consider all of the risks described below, as well as the other information contained in this document, when evaluating your investment in our securities.Risks Relating to Our Business and IndustryOur business depends on the demand for our communications infrastructure, driven primarily by demand for data, and we may be adversely affected by any slowdown in such demand. Additionally, a reduction in the amount or change in the mix of network investment by our tenants may materially and adversely affect our business (including reducing demand for our communications infrastructure or services).Tenant demand for our communications infrastructure depends on consumers' and organizations' demand for data. Additionally, the willingness of our tenants to utilize our communications infrastructure, or renew or extend existing tenant contracts on our communications infrastructure, is affected by numerous factors, including:•availability or capacity of our communications infrastructure or associated land interests;•location of our communications infrastructure;•financial condition of our tenants, including their profitability and availability or cost of capital;•willingness of our tenants to maintain or increase their network investment or changes in their capital allocation strategy;•need for integrated networks and organizations;•availability and cost of spectrum for commercial use;•increased use of network sharing, roaming, joint development, or resale agreements by our tenants;•mergers or consolidations by and among our tenants;•changes in, or success of, our tenants' business models;•governmental regulations and initiatives, including local or state restrictions on the proliferation of communications infrastructure;•cost of constructing communications infrastructure;•our market competition, including tenants that may elect to self-perform;•technological changes, including those (1) affecting the number or type of communications infrastructure needed to provide data to a given geographic area or which may otherwise serve as a substitute or alternative to our communications infrastructure or (2) resulting in the obsolescence or decommissioning of certain existing wireless networks; and•our ability to efficiently satisfy our tenants' service requirements.A slowdown in demand for data or our communications infrastructure may negatively impact our growth or otherwise have a material adverse effect on us. If our tenants or potential tenants are unable to raise adequate capital to fund their business plans, as a result of disruptions in the financial and credit markets or otherwise, they may reduce their spending, which could adversely affect our anticipated growth or the demand for our communications infrastructure or services. The amount, timing, and mix of our tenants' network investment is variable and can be significantly impacted by the various matters described in these risk factors. Changes in tenant network investment typically impact the demand for our communications infrastructure. As a result, changes in tenant plans such as delays in the implementation of new systems, new and emerging technologies (including small cells and fiber solutions), or plans to expand coverage or capacity may reduce demand for our communications infrastructure. Furthermore, the industries in which our tenants operate (particularly those in the wireless industry) could experience a slowdown or slowing growth rates as a result of numerous factors, including a reduction in consumer demand for data or general economic conditions. There can be no assurances that weakness or uncertainty in the economic environment will not adversely impact our tenants or their industries, which may materially and adversely affect our business, including by reducing demand for our communications infrastructure or services. In addition, a slowdown may increase competition for site rental tenants or services. Such an industry slowdown or a reduction in tenant network investment may materially and adversely affect our business. 12A substantial portion of our revenues is derived from a small number of tenants, and the loss, consolidation or financial instability of any of such tenants may materially decrease revenues or reduce demand for our communications infrastructure and services.Our three largest tenants are T-Mobile (which merged with Sprint in April 2020), AT&T and Verizon Wireless. The loss of any one of our largest tenants as a result of consolidation, merger, bankruptcy, insolvency, network sharing, roaming, joint development, resale agreements by our tenants or otherwise may result in (1) a material decrease in our revenues, (2) uncollectible account receivables, (3) an impairment of our deferred site rental receivables, communications infrastructure assets, or intangible assets, or (4) other adverse effects to our business. We cannot guarantee that tenant contracts with our largest tenants will not be terminated or that these tenants will renew their tenant contracts with us. See "Item 7. MD&A—General Overview—Sprint Cancellation" for a discussion of the accelerated contractual rental payments received in the fourth quarter of 2020 resulting from T-Mobile's cancellation of small cells contracted with Sprint prior to its merger with T-Mobile. In addition to our three largest tenants, we also derive a portion of our revenues and anticipated future growth from (1) fiber solutions tenants and (2) new entrants offering or contemplating offering wireless services. Such tenants (including those dependent on government funding) may be smaller or have less financial resources than our three largest tenants, may have business models which may not be successful, or may require additional capital. Consolidation among our tenants will likely result in duplicate or overlapping parts of networks, for example, where they are co-residents on a tower or small cell network, which may result in the termination, non-renewal or re-negotiation of tenant contracts and negatively impact revenues from our communications infrastructure. Due to the long-term nature of our tenant contracts, we generally expect that the impact to our site rental revenues from any termination of our tenant contracts as a result of such potential consolidation would be spread over multiple years. Such consolidation (or potential consolidation) may result in a reduction or slowdown in such tenants' network investment in the aggregate because their expansion plans may be similar. Tenant consolidation could decrease the demand for our communications infrastructure and services, which in turn may result in a reduction in our revenues or cash flows and may trigger a review for impairment of certain long-lived assets. See "Item 1. Business—The Company" and note 14 to our consolidated financial statements for further information regarding our largest tenants. The expansion or development of our business, including through acquisitions, increased product offerings or other strategic growth opportunities, may cause disruptions in our business, which may have an adverse effect on our business, operations or financial results. We seek to expand and develop our business, including through acquisitions, increased product offerings (such as small cells and fiber solutions), or other strategic growth opportunities. In the ordinary course of our business, we review, analyze and evaluate various potential transactions or other activities in which we may engage. Such transactions or activities could be a complex, costly, time-consuming process, or cause disruptions in, increase risk or otherwise negatively impact our business. Among other things, such transactions and activities may: •disrupt our business relationships with our tenants, depending on the nature of or counterparty to such transactions and activities;•divert capital and the time or attention of management away from other business operations, including as a result of post-transaction integration activities;•fail to achieve revenue or margin targets, operational synergies or other benefits contemplated; •increase operational risk or volatility in our business; •not result in the benefits management had expected to realize from such expansion and development activities, or those benefits may take longer to realize than expected; •impact our cost structure and result in the need to hire additional employees; •increase demands on current employees or result in current or prospective employees experiencing uncertainty about their future roles with us, which might adversely affect our ability to retain or attract key employees; or•result in the need for additional TRSs or contributions of certain assets to TRSs, which are subject to federal and state corporate income taxes.Our Fiber segment has expanded rapidly, and the Fiber business model contains certain differences from our Towers business model, resulting in different operational risks. If we do not successfully operate our Fiber business model or identify or manage the related operational risks, such operations may produce results that are lower than anticipated.In recent years, we have allocated a significant amount of capital to our Fiber business, which is a much less mature business for us than our Towers business. Our Fiber segment represented 34% and 33% of our site rental revenues for the years ended December 31, 2020 and 2019, respectively. The business model for our Fiber operations contains certain differences from our business model for our Towers operations, including certain differences relating to tenant base, competition, contract 13terms (including requirements for service level agreements regarding network performance and maintenance), upfront capital requirements, landlord demographics, deployment and ownership of certain network assets, operational oversight requirements, government regulations, growth rates and applicable laws. While our Fiber operations have certain risks that are similar to our Towers operations, they also have certain operational risks (including the scalability of processes) that are different from our Towers business, including:•the use of public rights-of-way and franchise agreements; •the use of poles and conduits owned solely by, or jointly with, third parties; •risks relating to overbuilding; •risks relating to the specific markets in which we choose or plan to operate in;•risks relating to construction hazards, including boring, trenching, utility and maintenance of traffic hazards;•construction management and construction-related billings to tenants;•risks relating to wireless carriers building their own small cell networks, or tenants utilizing their own or alternative fiber assets;•the risk of failing to optimize the use of our finite supply of fiber strands;•damage to our assets and the need to maintain, repair, upgrade and periodically replace our assets;•the risk of failing to properly maintain or operate highly specialized hardware and software;•network data security risks; •the risk of new technologies that could enable tenants to realize the same benefits with less utilization of our fiber; •potential damage to our overall reputation as a communications infrastructure provider; and•the use of CLEC status. In addition, the rate at which tenants adopt or prioritize small cells and fiber solutions may be lower or slower than we anticipate or may cease to exist altogether. Our Fiber operations will also expose us to different safety or liability risks or hazards than our Towers business as a result of numerous factors, including those stemming from the deployment, location or nature of the assets involved. There may be risks and challenges associated with small cells and fiber solutions being comparatively new and emerging technologies that are continuing to evolve, and there may be other risks related to small cells and fiber solutions of which we are not yet aware.Failure to timely, efficiently and safely execute on our construction projects could adversely affect our business.Our construction projects and related contracts can be long-term, complex in nature, costly and challenging to execute. The quality of our performance on such construction projects depends in large part upon our ability to manage (1) the associated tenant relationship and (2) the project itself by timely deploying and properly managing appropriate internal and external project resources. In connection with our construction projects, we generally bear the risk of cost over-runs, labor availability and productivity, and contractor pricing and performance. In addition, the construction projects (including modifications of existing infrastructure) can pose certain safety risks, including:•risks resulting from elevated work, including falling hazards;•risks of third-party non-compliance with safety regulations, industry best practices or other applicable standards;•risks associated with utility hazards; and•risk of potential wildfires, including due to welding, grinding, cutting or other construction activity.Further, investments in newly constructed communications infrastructure may result in lower initial returns compared to returns on our existing communications infrastructure or us not being able to realize future tenant additions at anticipated levels. Additionally, contracts with our tenants for these projects typically specify delivery dates, performance criteria and penalties for our failure to perform. On occasion, we experience unforeseen delays from municipalities and utility companies that result in longer construction timelines than expected, which impact our ability to timely deliver on our projects. Our failure to manage such tenant relationships, project resources, and project milestones in a timely and efficient manner and appropriately manage safety risks could have a material adverse effect on our business. New technologies may reduce demand for our communications infrastructure or negatively impact our revenues.Improvements in the efficiency, architecture, and design of communication networks may reduce the demand for our communications infrastructure. For example, new technologies that may promote network sharing, joint development, backhaul and fronthaul efficiency or resale agreements by our tenants, such as signal combining technologies or network virtualization, may reduce the need for our communications infrastructure. In addition, other technologies, such as WiFi, Distributed Antenna Systems ("DAS"), other small cells, blimps, satellite (such as low earth orbiting) and mesh transmission 14systems may, in the future, serve as substitutes for, or alternatives to, leasing on communications infrastructure that might otherwise be anticipated or expected had such technologies not existed. In addition, new technologies that enhance the range, efficiency and capacity of communication equipment could reduce demand for our communications infrastructure. Any significant reduction in demand for our communications infrastructure resulting from the new technologies may negatively impact our revenues or otherwise have a material adverse effect on us.If we fail to retain rights to our communications infrastructure, including the rights to land under our towers and the right-of-way and other agreements related to our small cells and fiber, our business may be adversely affected.The property interests and other rights to our communications infrastructure, including the land under our towers, are derived from leasehold and sub-leasehold interests, fee interests, easements, licenses, rights-of-way, and franchise and other agreements. A loss of these interests and other rights may interfere with our ability to conduct our business or generate revenues. For various reasons, we may not always have the ability to access, analyze, or verify all information regarding titles or other issues prior to acquiring communications infrastructure. Further, we may not be able to renew ground leases or other agreements on commercially viable terms. Our ability to retain rights to the land on which our towers are located depends on our ability to purchase such land, by acquiring fee interests and perpetual easements, or renegotiate or extend the terms of the agreements relating to such land. Approximately 10% of our Towers site rental gross margin for the year ended December 31, 2020 was derived from towers where the leases for the land under such towers had final expiration dates of less than 10 years. If we are unable to retain rights to the property on which our communications infrastructure is located, our business may be adversely affected. As of December 31, 2020, approximately 53% of our towers were leased or subleased or operated and managed under master leases, subleases, or other agreements with AT&T and T-Mobile (including agreements assumed by T-Mobile in connection with its merger with Sprint). We have the option to purchase these towers at the end of their respective lease terms. We have no obligation to exercise such purchase options. We may not have the required available capital to exercise our right to purchase some or all of these towers at the time these options are exercisable. Even if we do have available capital, we may choose not to exercise our right to purchase these towers or some or all of the T-Mobile or AT&T towers for business or other reasons. In the event that we do not exercise these purchase rights, or are otherwise unable to acquire an interest that would allow us to continue to operate these towers after the applicable period, we will lose the cash flows derived from such towers, which may have a material adverse effect on our business. In the event that we decide to exercise these purchase rights, the benefits of the acquisition of these towers may not exceed the costs, which could adversely affect our business. Additional information concerning these towers and the applicable purchase options as of December 31, 2020 is as follows:•22% of our towers are leased or subleased or operated and managed under a master prepaid lease or other related agreements with AT&T for a weighted-average initial term of approximately 28 years, weighted on Towers site rental gross margin. We have the option to purchase the leased and subleased towers from AT&T at the end of the respective lease or sublease terms for aggregate option payments of approximately $4.2 billion, which payments, if such option is exercised, would be due between 2032 and 2048.•16% of our towers are leased or subleased or operated and managed for an initial period of 32 years (through May 2037) under master leases, subleases or other agreements with T-Mobile (which T-Mobile assumed in connection with its merger with Sprint). We have the option to purchase in 2037 all (but not less than all) of the leased and subleased towers from T-Mobile for approximately $2.3 billion.•15% of our towers are leased or subleased or operated and managed under a master prepaid lease or other related agreements with T-Mobile for a weighted-average initial term of approximately 28 years, weighted on Towers site rental gross margin. We have the option to purchase the leased and subleased towers from T-Mobile at the end of the respective lease or sublease terms for aggregate option payments of approximately $2.0 billion, which payments, if such option is exercised, would be due between 2035 and 2049. In addition, through the T-Mobile Acquisition, another 1% of our towers are subject to a lease and sublease or other related arrangements with AT&T. We have the option to purchase these towers that we do not otherwise already own at the end of their respective lease terms for aggregate option payments of up to approximately $405 million, which payments, if such option is exercised, would be due prior to 2032 (less than $10 million would be due before 2025).Under master lease or master prepaid lease arrangements we have with AT&T and T-Mobile, including agreements assumed by T-Mobile in connection with its merger with Sprint, certain of our subsidiaries lease or sublease, or are otherwise granted the right to manage and operate, towers from bankruptcy remote subsidiaries of such carriers. If one of these bankruptcy remote subsidiaries should become a debtor in a bankruptcy proceeding and is permitted to reject the underlying ground lease, our subsidiaries could lose their interest in the applicable sites. If our subsidiaries were to lose their interest in the applicable sites or if the applicable ground leases were to be terminated, we would lose the cash flow derived from the towers 15on those sites, which may have a material adverse effect on our business. We have similar bankruptcy risks with respect to sites that we operate under management agreements. For our small cells and fiber, we must maintain rights-of-way, franchise, pole attachment, conduit use, fiber use and other agreements to operate our assets. For various reasons, we may not always have the ability to maintain these agreements or obtain future agreements to construct, maintain and operate our fiber assets. Access to rights-of-way may depend on our CLEC status, and we cannot be certain that jurisdictions will (1) recognize such CLEC status or (2) not change their laws concerning CLEC access to rights-of-way. If a material portion of these agreements are terminated or are not renewed, we might be forced to abandon our assets, which may adversely impact our business. In order to operate our assets, we must also maintain fiber agreements that we have with public and private entities. There is no assurance that we will be able to renew these agreements on favorable terms, or at all. If we are unable to renew these agreements on favorable terms, we may face increased costs or reduced revenues.Additionally, in order to expand our communications infrastructure footprint to new locations, we often need to obtain new or additional rights-of-way and other agreements. Our failure to obtain these agreements in a prompt and cost-effective manner may prevent us from expanding our footprint, which may be necessary to meet our contractual obligations to our tenants and could adversely impact our business.Our services business has historically experienced significant volatility in demand, which reduces the predictability of our results.The operating results of our services business for any particular period may experience significant fluctuations given its non-recurring nature and should not necessarily be considered indicative of longer-term results for this activity. Our services business is generally driven by demand for our communications infrastructure and may be adversely impacted by various factors, including:•competition;•the timing, mix and amount of tenant network investments;•the rate and volume of tenant deployment plans;•unforeseen delays or challenges relating to work performed;•economic weakness or uncertainty;•our market share; or•changes in the size, scope, or volume of work performed.If radio frequency emissions from wireless handsets or equipment on our communications infrastructure are demonstrated to cause negative health effects, potential future claims could adversely affect our operations, costs or revenues.The potential connection between radio frequency emissions and certain negative health effects, including some forms of cancer, has been the subject of substantial study by the scientific community in recent years. We cannot guarantee that claims relating to radio frequency emissions will not arise in the future or that the results of such studies will not be adverse to us.Public perception of possible health risks associated with cellular or other wireless connectivity services and wireless technologies (such as 5G) may slow or diminish the growth of wireless companies and deployment of new wireless technologies, which may in turn slow or diminish our growth. In particular, negative public perception of, and regulations regarding, these perceived health risks may slow or diminish the market acceptance of wireless services and technologies. If a connection between radio frequency emissions and possible negative health effects were established, our operations, costs, or revenues may be materially and adversely affected. We currently do not maintain any significant insurance with respect to these matters.We may be vulnerable to security breaches or other unforeseen events that could adversely affect our operations, business, and reputation.Despite existing security measures, certain of our communications infrastructure may be vulnerable to damage, disruptions, or shutdowns due to unauthorized access, computer viruses, cyber-attacks, and other security breaches. An attack attempt or security breach, such as a distributed denial of service attack, could potentially result in (1) interruption or cessation of certain of our services to our tenants, (2) our inability to meet expected levels of service to our tenants, (3) data transmitted over our tenants' networks being compromised or misappropriated, or (4) business or other sensitive data being compromised or misappropriated. We cannot guarantee that our security measures will not be circumvented, resulting in tenant network failures or interruptions that could impact our tenants' network availability and have a material adverse effect on our business, financial condition, or operational results. Additionally, security incidents impacting our tenants, vendors and business partners could result in a material adverse effect on our business. We may be required to expend significant resources to protect against or 16recover from such threats. If an actual or perceived breach of our security occurs, the market perception of the effectiveness of our security measures could be harmed, and we could lose tenants. Further, the perpetrators of cyber-attacks are not restricted to particular groups or persons. These attacks may be committed by our employees or external actors operating in any geography. In addition, our acquisitions, both past and future, may alter our potential exposure to the risks described above. Additionally, we could be negatively impacted by other unforeseen events, such as extreme weather events or natural disasters (including as a result of any potential effects of climate change), or acts of vandalism. There is increasing concern that global climate change is occurring and could result in increased frequency of certain types of natural disasters and extreme weather events. We cannot predict with certainty the rate at which climate change is occurring or the potential direct or indirect impacts of climate change to our business. Any such unforeseen events could, among other things, damage or delay deployment of our communication infrastructure, interrupt or delay service to our tenants or could result in legal claims or penalties, disruption in operations, damage to our reputation, negative market perception, or costly response measures, which could adversely affect our business.While we maintain insurance policies that include coverage in the event of security breaches and other unforeseen events, there can be no assurances that such coverage will be adequate to cover exposure for such incidents.The impact of coronavirus (COVID-19) and related risks could materially affect our financial position, results of operations and cash flows.The global outbreak of the novel coronavirus (COVID-19) was declared a pandemic by the World Health Organization and a national emergency by the U.S. government in March 2020 and has adversely affected the U.S. In response, both the public and private sectors have introduced certain policies and initiatives in an effort to reduce the transmission of COVID-19 ("Initiatives"), such as the imposition of travel restrictions; mandates from federal, state and local authorities to close non-essential businesses and avoid large gatherings of people; quarantine or "shelter-in-place;" and the promotion of social distancing and the adoption of work-from-home and online learning by companies and institutions. In addition, the continued spread of COVID-19 and the resulting Initiatives have led to a significant economic downturn, global supply chain disruptions and volatility in the global capital markets.We have modified, and might further modify, our business practices as a result of the COVID-19 pandemic, the economic and social ramifications of the disease, and the societal and governmental responses in the communities in which we operate. We do not believe that COVID-19 had a material impact on our financial position, results of operations and cash flows for the year ended December 31, 2020. The extent to which the COVID-19 pandemic will affect our financial position, results of operations and cash flows in the future is difficult to predict with certainty and depends on numerous evolving factors, including: the duration, scope and severity of the pandemic; the roll-out of the COVID-19 vaccine and its effectiveness in curbing the spread of the virus; government, social, business and other actions that have been and will be taken in response to the pandemic; and the effect of the pandemic on short- and long-term general economic conditions. Among other things, COVID-19 and the Initiatives could (1) adversely affect the ability of our suppliers and vendors to provide products and services to us; (2) result in decreased demand for our communications infrastructure; (3) make it more difficult for us to serve our tenants, including as a result of delays or suspensions in the issuance of permits or other authorizations needed to conduct our business; and (4) increase our cost of capital and adversely impact our access to capital. Due to factors beyond our knowledge or control, including the duration and severity of COVID-19, as well as third-party actions taken to contain its spread and mitigate its public health effects, at this time we cannot estimate or predict with certainty the impact of COVID-19, the Initiatives or the measures we take in response thereto on our financial position, results of operations and cash flows, particularly over the near- to medium-term, but the impact could be material. See "Item 7. MD&A—General Overview—Coronavirus (COVID-19)" for further information.As a result of competition in our industry, we may find it more difficult to negotiate favorable rates on our new or renewing tenant contracts.Our growth is dependent on our entering into new tenant contracts (including amendments to tenant contracts upon modification of an existing tower, fiber, or small cell installation), as well as renewing or renegotiating tenant contracts when existing tenant contracts terminate. Competition in our industry may make it more difficult for us to attract new tenants, maintain or increase our gross margins, or maintain or increase our market share. In addition, competition (primarily in our fiber solutions business) may, in certain circumstances, cause us to renegotiate certain existing tenant contracts to avoid early contract terminations. We face competition for site rental tenants and associated contractual rates from various sources, including (1) other independent communications infrastructure owners or operators, including those that own, operate, or manage towers, rooftops, broadcast or transmission towers, utility poles, fiber (including non-traditional competitors such as cable providers) or small cells, or (2) new alternative deployment methods for communications infrastructure.17Our Fiber business generally has different competitors than those in our Towers business, including other owners of fiber, as well as new entrants into small cells and fiber solutions, some of which may have larger networks, greater financial resources or more experience in managing such assets than we have.New wireless technologies may not deploy or be adopted by tenants as rapidly or in the manner projected.There can be no assurances that new wireless services or technologies, which may drive demand for our communications infrastructure, will be introduced or deployed as rapidly or in the manner projected by the wireless carriers. In addition, demand or tenant adoption rates for such new technologies may be lower or slower than anticipated for numerous reasons. As a result, growth opportunities or demand for our communications infrastructure arising from such technologies may not be realized at the times or to the extent anticipated.Risks Related to Our Debt and EquityOur substantial level of indebtedness could adversely affect our ability to react to changes in our business, and the terms of our debt instruments limit our ability to take a number of actions that our management might otherwise believe to be in our best interests. In addition, if we fail to comply with our covenants, our debt could be accelerated.We have a substantial amount of indebtedness (approximately $21.2 billion as of February 17, 2021). See "Item 7. MD&A—Liquidity and Capital Resources" for a tabular presentation of our contractual debt maturities. As a result of our substantial indebtedness:•we may be more vulnerable to general adverse economic or industry conditions;•we may find it more difficult to obtain additional financing to fund discretionary investments or other general corporate requirements or to refinance our existing indebtedness;•we are or will be required to dedicate a substantial portion of our cash flows from operations to the payment of principal or interest on our debt, thereby reducing the available cash flows to fund other projects, including the discretionary investments discussed in "Item 1. Business" and "Item 7. MD&A—Liquidity and Capital Resources";•we may have limited flexibility in planning for, or reacting to, changes in our business or in the industry;•we may have a competitive disadvantage relative to other companies in our industry with less debt;•we may be adversely impacted by changes in interest rates;•we may be adversely impacted by changes to credit ratings related to our debt instruments;•we may be required to issue equity securities or securities convertible into equity or sell some of our assets, possibly on unfavorable terms, in order to meet payment obligations;•we may be limited in our ability to take advantage of strategic business opportunities, including communications infrastructure development or mergers and acquisitions; and•we could fail to remain qualified for taxation as a REIT due to limitations on our ability to declare and pay dividends to stockholders as a result of restrictive covenants in our debt instruments. Currently we have debt instruments in place that limit in certain circumstances our ability to incur additional indebtedness, pay dividends, create liens, sell assets, or engage in certain mergers and acquisitions, among other things. In addition, the credit agreement ("Credit Agreement") governing our senior unsecured credit facility, which consists of our senior unsecured term loan A facility and senior unsecured revolving credit facility (collectively, "2016 Credit Facility"), contains financial maintenance covenants. Our ability to comply with these covenants or to satisfy our debt obligations will depend on our future operating performance. If we violate the restrictions in our debt instruments or fail to comply with our financial maintenance covenants, we will be in default under those instruments, which in some cases would cause the maturity of a substantial portion of our long-term indebtedness to be accelerated. Furthermore, if the limits on our ability to pay dividends prevent us from satisfying our REIT distribution requirements, we could fail to remain qualified for taxation as a REIT. If these limits do not jeopardize our qualification for taxation as a REIT but nevertheless prevent us from distributing 100% of our REIT taxable income, we will be subject to federal and state corporate income taxes, and potentially a nondeductible excise tax, on our undistributed taxable income. If our operating subsidiaries were to default on their debt, the trustee could seek to foreclose the collateral securing such debt, in which case we could lose the communications infrastructure and the associated revenues. See "Item 7. MD&A—Liquidity and Capital Resources—Debt Covenants" for a further discussion of our debt covenants. See also our risk factor below associated with our previously identified material weakness in internal controls over financial reporting (which has been remediated) for further discussion of risks that may impact our access to capital markets.CCIC is a holding company that conducts all of its operations through its subsidiaries. Accordingly, CCIC's sources of cash to pay interest or principal on its outstanding indebtedness are distributions relating to its respective ownership interests in its subsidiaries from the net earnings and cash flows generated by such subsidiaries or from proceeds of debt or equity offerings. Earnings and cash flows generated by CCIC's subsidiaries are first applied by such subsidiaries to conduct their operations, including servicing their respective debt obligations, after which any excess cash flows generally may be paid to 18CCIC, in the absence of any special conditions, such as a continuing event of default. However, CCIC's subsidiaries are legally distinct from the holding company and, unless they guarantee such debt, have no obligation to pay amounts due on their debt or to make funds available to us for such payment. We have a substantial amount of indebtedness. In the event we do not repay or refinance such indebtedness, we could face substantial liquidity issues and might be required to issue equity securities or securities convertible into equity securities, or sell some of our assets to meet our debt payment obligations.We have a substantial amount of indebtedness, which, upon final maturity, we will need to refinance or repay. See "Item 7. MD&A—Liquidity and Capital Resources" for a tabular presentation of our contractual debt maturities. There can be no assurances we will be able to refinance our indebtedness (1) on commercially reasonable terms, (2) on terms, including with respect to interest rates, as favorable as our current debt, or (3) at all.Economic conditions and the credit markets have historically experienced, and may continue to experience, periods of volatility, uncertainty, or weakness that could impact (1) the availability or cost of debt financing, including any refinancing of the obligations described above, (2) our ability to draw the full amount of our $5.0 billion senior unsecured revolving credit facility under our 2016 Credit Facility ("2016 Revolver"), that, as of February 17, 2021, has $5.0 billion of undrawn availability, or (3) our ability to issue the full amount of the $1.0 billion commercial paper notes ("Commercial Paper Notes") under our unsecured commercial paper program ("CP Program"), that, as of February 17, 2021, had $150 million outstanding.Borrowings under our 2016 Credit Facility generally bear an interest rate based on the London interbank offered rate ("LIBOR") per annum plus a credit spread based on our senior unsecured credit rating. In July 2017, the United Kingdom's Financial Conduct Authority, which regulates LIBOR, announced that, after 2021, it will stop compelling banks to submit rates for the calculation of LIBOR. Our Credit Agreement contemplates a mechanism for replacing LIBOR with a new benchmark rate (to be agreed upon by us and the administrative agent) for loans made under the 2016 Credit Facility. This mechanism is triggered in the event that LIBOR is no longer published or otherwise available as a benchmark for establishing interest rates for loans. Since the conditions for the implementation of this mechanism have not yet been triggered, we cannot determine with certainty what such replacement rate would be or reasonably predict the potential effect of these changes, other reforms or the establishment of alternative reference rates on our business. The discontinuation, reform or replacement of LIBOR could result in interest rate increases on our 2016 Credit Facility, which could adversely affect our cash flows and operating results. If we are unable to repay or refinance our debt, we cannot guarantee that we will be able to generate enough cash flows from operations or that we will be able to obtain enough capital to service our debt, fund our planned capital expenditures or pay future dividends. In such an event, we could face substantial liquidity issues and might be required to issue equity securities or securities convertible into equity securities, or sell some of our assets to meet our debt payment obligations. Failure to repay or refinance indebtedness when required could result in a default under such indebtedness. If we incur additional indebtedness, any such indebtedness could exacerbate the risks described above.Sales or issuances of a substantial number of shares of our common stock or securities convertible into shares of our common stock may adversely affect the market price of our common stock.Future sales or issuances of common stock or other equity related securities may adversely affect the market price of our common stock, including any shares of our common stock issued to finance capital expenditures, finance acquisitions or repay debt. Our business strategy contemplates access to external financing to fund certain discretionary investments, which may include issuances of common stock or other equity related securities. We maintain an "at-the-market" stock offering program ("2018 ATM Program") through which we may, from time to time, issue and sell shares of our common stock having an aggregate gross sales price of up to $750 million to or through sales agents. As of February 17, 2021, we had approximately $750 million of gross sales of common stock remaining under our 2018 ATM Program. From time to time, we may refresh or implement a new "at-the-market" stock offering program. See note 10 to our consolidated financial statements. As of February 17, 2021, we had approximately 431 million shares of common stock outstanding. We have reserved 8 million of common stock for issuance in connection with awards granted under our stock compensation plan.Further, a small number of common stockholders own a significant percentage of our outstanding common stock. If any one of these common stockholders, or any group of our common stockholders, sells a large quantity of shares of our common stock, or the public market perceives that existing common stockholders might sell a large quantity of shares of our common stock, the market price of our common stock may significantly decline.19Certain provisions of our restated certificate of incorporation ("Charter"), amended and restated by-laws ("by-laws") and operative agreements, and domestic and international competition laws may make it more difficult for a third party to acquire control of us or for us to acquire control of a third party, even if such a change in control would be beneficial to our stockholders.We have a number of anti-takeover devices in place that will hinder takeover attempts or may reduce the market value of our common stock. Our anti-takeover provisions include:•the authority of the board of directors to issue preferred stock without approval of the holders of our common stock; •advance notice requirements for director nominations or actions to be taken at annual meetings; and•a provision that the state courts or, in certain circumstances, the federal courts, in Delaware shall be the sole and exclusive forum for certain actions involving us, our directors, officers, employees and stockholders.Our by-laws permit special meetings of the stockholders to be called only upon the request of our Chief Executive Officer or a majority of the board of directors, and deny stockholders the ability to call such meetings. Such provisions, as well as the provisions of Section 203 of the Delaware General Corporation Law, may impede a merger, consolidation, takeover, or other business combination or discourage a potential acquirer from making a tender offer or otherwise attempting to obtain control of us.In addition, domestic or international competition laws may prevent or discourage us from acquiring communications infrastructure in certain geographical areas or impede a merger, consolidation, takeover, or other business combination or discourage a potential acquirer from making a tender offer or otherwise attempting to obtain control of us.Risks Relating to Corporate ComplianceThe restatement of our previously issued financial statements, the errors that resulted in such restatement, the material weakness that was previously identified in our internal control over financial reporting and the determination that our internal control over financial reporting and disclosure controls and procedures were not effective, could result in loss of investor confidence, shareholder litigation or governmental proceedings or investigations, any of which could cause the market value of our common stock or debt securities to decline or impact our ability to access the capital markets.As discussed in the "Explanatory Note" and note 2 to our consolidated financial statements in our Annual Report on Form 10-K for the year ended December 31, 2019, we identified and disclosed certain errors and determined that our previously issued consolidated financial statements for fiscal years ended December 31, 2017 and 2018, and each of our unaudited condensed consolidated financial statements and related disclosures for the quarterly and year-to-date periods during such years and for the first three quarters of fiscal year 2019, should be restated. Although the Company has restated these financial statements and the previously identified material weakness in the Company's internal control over financial reporting has been remediated, as a result of these errors and restatement, we were and continue to be subject to a number of additional risks and uncertainties, including unanticipated legal fees, litigation, governmental proceedings or investigations, other losses or damages and loss of investor confidence. Lawsuits naming the Company and some of its officers and directors have been filed, and additional lawsuits naming the Company and its officers and directors may be filed in the future. These lawsuits have resulted in, and may result in further, unanticipated legal costs, regardless of the outcome of the litigation. See note 12 to our consolidated financial statements for more information regarding the litigation. We are currently unable to predict the outcome of any such litigation. See "Item 9A. Controls and Procedures" for a discussion of the remediation of previously disclosed material weakness.If we fail to comply with laws or regulations which regulate our business and which may change at any time, we may be fined or even lose our right to conduct some of our business.A variety of federal, state, local, and foreign laws and regulations apply to our business, including those discussed in "Item 1. Business." Failure to comply with applicable requirements may lead to civil or criminal penalties, require us to assume indemnification obligations or breach contractual provisions. We cannot guarantee that existing or future laws or regulations, including federal, state, local, or foreign tax laws, will not adversely affect our business (including our REIT status), increase delays or result in additional costs. We also may incur additional costs as a result of liabilities under applicable laws and regulations, such as those governing environmental and safety matters. These factors may have a material adverse effect on us.Risks Relating to Our REIT StatusFuture dividend payments to our stockholders will reduce the availability of our cash on hand available to fund future discretionary investments, and may result in a need to incur indebtedness or issue equity securities to fund growth 20opportunities. In such event, the then current economic, credit market or equity market conditions will impact the availability or cost of such financing, which may hinder our ability to grow our per share results of operations.During each of the first three quarters of 2020, we paid a common stock dividend of $1.20 per share, totaling approximately $1.5 billion. In October 2020, our board of directors declared a quarterly common stock dividend of $1.33 per share, which represents an increase of 11% from the quarterly common stock dividend declared during each of the first three quarters of 2020. We currently expect our common stock dividends over the next 12 months to be a cumulative amount of at least $5.32 per share, or an aggregate amount of approximately $2.3 billion. Over time, we expect to increase our dividend per share generally commensurate with our realized growth in cash flows. Any future dividends are subject to declaration by our board of directors. See notes 10 and 17 to our consolidated financial statements.We operate as a REIT for U.S. federal income tax purposes. To remain qualified and be taxed as a REIT, we will generally be required to annually distribute at least 90% of our REIT taxable income (determined without regard to the dividends paid deduction, excluding net capital gain and after the utilization of any available NOLs) to our stockholders. Our quarterly cash common stock dividend will delay the utilization of our NOLs and may cause certain of the NOLs to expire without utilization. See also "Item 1. Business—REIT Status" and "Item 7. MD&A—General Overview—Common Stock Dividend." As discussed in "Item 1. MD&A—Business—Strategy," we seek to invest our available capital, including the net cash generated by our operating activities and external financing sources, in a manner that we believe will increase long-term stockholder value on a risk-adjusted basis. Our historical discretionary investments have included the following (in no particular order): construction of communications infrastructure; acquisitions of communications infrastructure; acquisitions of land interests (which primarily relate to land assets under towers); improvements and structural enhancements to our existing communications infrastructure; purchases of shares of our common stock from time to time; and purchases, repayments or redemptions of our debt. External financing, including debt, equity, and equity-related issuances to fund future discretionary investments either (1) may not be available to us or (2) may not be accessible by us at terms that would result in the investment of the net proceeds raised yielding incremental growth in our per share operating results. As a result, future dividend payments may hinder our ability to grow our per share results of operations or otherwise adversely affect our ability to execute our business plan.Remaining qualified to be taxed as a REIT involves highly technical and complex provisions of the Code. Failure to remain qualified as a REIT would result in our inability to deduct dividends to stockholders when computing our taxable income, which would reduce our available cash.As a REIT, we are generally entitled to a deduction for dividends that we pay and therefore are not subject to U.S. federal corporate income tax on our net taxable income that is currently distributed to our common stockholders.While we intend to operate so that we remain qualified as a REIT, given the highly complex nature of the rules governing REITs, the importance of ongoing factual determinations, the possibility of future changes in our circumstances, and the potential impact of future changes to laws and regulations impacting REITs, no assurance can be given that we will qualify as a REIT for any particular year. In addition, the present U.S. federal tax treatment of REITs is subject to change, possibly with retroactive effect, by legislative, judicial or administrative action at any time, and any such change might adversely affect our REIT status or benefits. We cannot predict the impact, if any, that such changes, if enacted, might have on our business. However, it is possible that such changes could adversely affect our business, including our REIT status. If, in any taxable year, we fail to qualify for taxation as a REIT and are not entitled to relief under certain provisions of the Code, then:•we will not be allowed a deduction for dividends paid to stockholders in computing our taxable income;•we will be subject to federal and state income tax, including, for applicable years beginning before January 1, 2018, any applicable alternative minimum tax, on our taxable income at regular corporate rates; and•we would be disqualified from re-electing REIT status for the four taxable years following the year during which we were so disqualified.Although we may have federal NOLs available to reduce any taxable income, to the extent our federal NOLs have been utilized or are otherwise unavailable, any such corporate tax liability could be substantial, would reduce the amount of cash available for other purposes and might necessitate the borrowing of additional funds or the liquidation of some investments to pay any additional tax liability. Accordingly, funds available for investment would be reduced.21Under the Code, for taxable years beginning in or after 2018, no more than 20% of the value of the assets of a REIT may be represented by securities of one or more TRSs. These limitations may affect our ability to make additional investments in non-REIT qualifying operations or assets, or in any operations held through TRSs. The net income of our TRSs is not required to be distributed to us, and income that is not distributed to us generally will not be subject to the REIT income distribution requirement. However, there may be limitations on our ability to accumulate earnings in our TRSs and the accumulation or reinvestment of significant earnings in our TRSs could result in adverse tax treatment. In particular, if the accumulation of cash in our TRSs causes the fair market value of our securities in our TRSs to exceed current or future limitations of the fair market value of our assets at the end of any quarter, then we may fail to remain qualified as a REIT.Complying with REIT requirements, including the 90% distribution requirement, may limit our flexibility or cause us to forgo otherwise attractive opportunities, including certain discretionary investments and potential financing alternatives.To remain qualified and be taxed as a REIT, we are required to satisfy the 90% distribution requirement as described above. We commenced declaring regular quarterly dividends to our common stockholders beginning with the first quarter of 2014. See notes 10 and 17 to our consolidated financial statements. Any such dividends, however, are subject to the determination of and declaration by our board of directors based on then-current and anticipated future conditions, including our earnings, net cash generated by operating activities, capital requirements, financial condition, our relative market capitalization, our existing federal NOLs of approximately $1.5 billion or other factors deemed relevant by our board of directors. To the extent that we satisfy the 90% distribution requirement, but distribute less than 100% of our REIT taxable income (determined without regard to the dividends paid deduction, excluding net capital gain and after the utilization of any available NOLs), we will be subject to federal corporate income tax on our undistributed taxable income. In addition, we will be subject to a 4% nondeductible excise tax if the actual amount that we pay out to our stockholders for a calendar year is less than a minimum amount specified under the Code.From time to time, we may generate REIT taxable income greater than our cash flow as a result of differences in timing between the recognition of taxable income and the actual receipt of cash or the effect of nondeductible capital expenditures, the creation of reserves or required debt or amortization payments. If we do not have other funds available in these situations, we could be required to borrow funds on unfavorable terms, sell assets at disadvantageous prices, or distribute amounts that would otherwise be invested in future acquisitions to make distributions sufficient to enable us to pay out enough of our taxable income to satisfy the REIT dividend requirement and to avoid corporate income tax and the 4% excise tax in a particular year. These alternatives could increase our costs or reduce our equity. Thus, compliance with the REIT requirements may hinder our ability to grow, which could adversely affect the value of our common stock. Furthermore, the REIT dividend requirements may increase the financing we need to fund capital expenditures, future growth, or expansion initiatives, which would increase our total leverage.In addition to satisfying the 90% distribution requirement, to remain qualified as a REIT for tax purposes, we are required to continually satisfy tests concerning, among other things, the sources of our income, the nature and diversification of our assets and the ownership of our capital stock. Compliance with these tests will require us to refrain from certain activities and may hinder our ability to make certain attractive investments, including the purchase of non-qualifying assets, the expansion of non-real estate activities, or investments in the businesses to be conducted by our TRSs, and to that extent, limit our opportunities and our flexibility to change our business strategy. Furthermore, acquisition opportunities in domestic or international markets may be adversely affected if we need or require the target company to comply with some REIT requirements prior to completing any such acquisition. In addition, our status as a REIT may result in investor pressures not to pursue growth opportunities that are not immediately accretive.Moreover, if we fail to comply with certain asset ownership tests, at the end of any calendar quarter, we must correct the failure within 30 days after the end of the calendar quarter or qualify for certain statutory relief provisions to avoid losing our REIT qualification. As a result, we may be required to liquidate assets in adverse market conditions or forgo otherwise attractive investments. These actions may reduce our income and amounts available for distribution to our stockholders.REIT related ownership limitations and transfer restrictions may prevent or restrict certain transfers of our capital stock. In order for us to continue to satisfy the requirements for REIT qualification, our capital stock must be beneficially owned by 100 or more persons during at least 335 days of a taxable year of 12 months or during a proportionate part of a shorter taxable year. Also, not more than 50% of the value of the outstanding shares of our capital stock may be owned, directly or indirectly, by five or fewer "individuals" (as defined in the Code to include certain entities such as private foundations) during the last half of a taxable year. In order to facilitate compliance with the REIT rules, our Charter includes provisions regarding REIT-related ownership limitations and transfer restrictions that generally prohibit any "person" (as defined in our Charter) from beneficially or constructively owning, or being deemed to beneficially or constructively own by virtue of the attribution 22provisions of the Code, more than (1) 9.8%, by value or number of shares, whichever is more restrictive, of the outstanding shares of our common stock, or (2) 9.8% in aggregate value of the outstanding shares of all classes and series of our capital stock. In addition, our Charter provides for certain other ownership limitations and transfer restrictions. Under applicable constructive ownership rules, any shares of capital stock owned by certain affiliated owners generally would be added together for purposes of the ownership limitations. These ownership limitations and transfer restrictions could have the effect of delaying, deferring or preventing a transaction or a change in control of our company that might involve a premium price for our capital stock or otherwise might be in the best interest of our stockholders. CertificationsWe submitted the Chief Executive Officer certification required by Section 303A.12(a) of the New York Stock Exchange ("NYSE") Listed Company Manual, relating to compliance with the NYSE's corporate governance listing standards, to the NYSE on May 29, 2020 with no qualifications. We have included the certifications of our Chief Executive Officer and Chief Financial Officer required by Section 302 of the Sarbanes-Oxley Act of 2002 and related rules as Exhibits 31.1 and 31.2 to this 2020 Form 10-K.23Item 1B. Unresolved Staff CommentsNone.Item 2. PropertiesCommunications Infrastructure We own, lease or manage approximately 40,000 towers geographically dispersed throughout the U.S. Towers are vertical metal structures generally ranging in height from 50 to 300 feet. Our tenants' wireless equipment may be placed on towers, building rooftops and other structures. Our towers are located on tracts of land that support the towers, equipment shelters and, where applicable, guy-wires to stabilize the tower. Additionally, we own or lease approximately 80,000 route miles of fiber primarily supporting our small cells and fiber solutions. The majority of our fiber assets are located in major metropolitan areas. Our small cells and fiber are typically located outdoors and are often attached to public right-of-way infrastructure, including utility poles or street lights. See the following for further information regarding our communications infrastructure:•"Item 1. Business—Overview" for information regarding our tower and fiber portfolios.•"Item 7. MD&A—Liquidity and Capital Resources—Material Cash Requirements" for information regarding our lease obligations.•"Schedule III - Schedule of Real Estate and Accumulated Depreciation" for further information on our productive properties.Approximately 53% of our towers are leased or subleased or operated and managed under master leases, subleases, or other agreements with AT&T and T-Mobile, including agreements assumed by T-Mobile in connection with its merger with Sprint. We have the option to purchase these towers at the end of their respective lease terms. We have no obligation to exercise such purchase options. See note 1 to our consolidated financial statements and "Item 1A. Risk Factors" for a further discussion. Substantially all of our communications infrastructure can accommodate additional tenancy, either as currently constructed or with appropriate modifications. Additionally, if so inclined as a result of a request for a tenant addition, we could generally replace an existing tower with another tower, replace a small cell network antenna with another antenna or overlay additional fiber in order to provide additional coverage or capacity, subject to certain restrictions. OfficesOur principal corporate headquarters is owned and located in Houston, Texas. In addition, we have offices throughout the U.S. in locations convenient for the management and operation of our communications infrastructure, with significant consideration being given to the amount of our communications infrastructure located in a particular area. We believe that our facilities are suitable and adequate to meet our anticipated needs.Item 3. Legal ProceedingsWe are periodically involved in legal proceedings that arise in the ordinary course of business. Most of these proceedings arising in the ordinary course of business involve disputes with landlords, vendors, collection matters involving bankrupt tenants, zoning or siting matters, construction, condemnation, tax, employment, or wrongful termination matters. While the outcome of these matters cannot be predicted with certainty, management does not expect any pending matters to have a material adverse effect on us.See the disclosure in notes 9 and 12 to our consolidated financial statements set forth in Part II, Item 8 of this 2020 Form 10-K.Item 4. Mine Safety DisclosuresN/A24PART II Item 5. Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity SecuritiesMarket Information and HoldersOur common stock is listed and traded on the New York Stock Exchange ("NYSE") under the symbol "CCI." As of February 17, 2021, there were approximately 480 holders of record of our common stock.Dividend PolicyWe operate as a REIT for U.S. federal income tax purposes. To remain qualified and be taxed as a REIT, we will generally be required to annually distribute to our stockholders at least 90% of our REIT taxable income after the utilization of any available NOLs (determined without regard to the dividends paid deduction and excluding net capital gain). See also "Item 1. Business—REIT Status" "Item 1A. Risk Factors," "Item 7. MD&A—General Overview—Common Stock Dividend," "Item 7. MD&A—Liquidity and Capital Resources—Financing Activities—Common Stock" and notes 9 and 10 to our consolidated financial statements.Over time, we expect to increase our dividend per share generally commensurate with our growth in cash flows. The declaration amount and payment of any future dividends, however, are subject to the determination and approval of our board of directors based on then-current or anticipated future conditions, including our earnings, net cash generated by operating activities, capital requirements, financial condition, our relative market capitalization, our existing NOLs, or other factors deemed relevant by our board of directors. In addition, our ability to pay dividends is limited under certain circumstances by the terms of our debt instruments. Issuer Purchases of Equity SecuritiesThe following table summarizes information with respect to purchases of our equity securities during the fourth quarter of 2020:PeriodTotal Number of Shares PurchasedAverage Price Paid per ShareTotal Number of Shares Purchased as Part of Publicly Announced Plans or ProgramsMaximum Number (or Approximate Dollar Value) of Shares that May Yet Be Purchased Under the Plans or Programs(In thousands)October 1 - October 31, 20201 $167.36 — — November 1 - November 30, 20203 161.80 — — December 1 - December 31, 20201 158.57 — — Total5 $162.02 — — We paid approximately $1 million in cash to effect these purchases. The shares purchased relate to shares withheld in connection with the payment of withholding taxes upon vesting of restricted stock units.25Performance GraphThe following performance graph is a comparison of the five-year cumulative total stockholder return on our common stock against the cumulative total return of the S&P 500 Market Index, the Dow Jones U.S. Telecommunications Equipment Index and the FTSE NAREIT All Equity REITs Index for the period commencing December 31, 2015 and ending December 31, 2020. The performance graph assumes an initial investment of $100.00 and the reinvestment of all dividends in our common stock and in each of the indices. The performance graph and related text are based on historical data and are not necessarily indicative of future performance. Years Ended December 31,Company/Index/Market201520162017201820192020Crown Castle International Corp.$100.00 $104.52 $138.93 $141.34 $191.47 $221.35 S&P 500 Market Index100.00 111.96 136.40 130.42 171.49 203.04 DJ U.S. Telecommunications Equipment Index100.00 119.14 146.61 159.12 184.95 189.24 FTSE Nareit All Equity REITs Index100.00 107.59 116.92 112.19 144.35 136.96 The performance graph above and related text are being furnished solely to accompany this 2020 Form 10-K pursuant to Item 201(e) of Regulation S-K, and are not being filed for purposes of Section 18 of the Exchange Act, and are not to be incorporated by reference into any filing of ours, whether made before or after the date hereof, regardless of any general incorporation language in such filing.26Item 6. Selected Financial DataN/AItem 7. Management's Discussion and Analysis of Financial Condition and Results of OperationsGeneral OverviewOverviewWe own, operate and lease shared communications infrastructure. See "Item 1. Business" for a further discussion of our business, including our long-term strategy, our REIT status, certain key terms of our tenant contracts and growth trends in the demand for data. Site rental revenues represented 91% of our 2020 consolidated net revenues. The vast majority of our site rental revenues is of a recurring nature and has been contracted for in prior years.Highlights of Business Fundamentals and Results•We operate as a REIT for U.S. federal income tax purposes (see "Item 1. Business—REIT Status" and notes 2 and 9 to our consolidated financial statements).•Potential growth resulting from the increasing demand for data ◦We expect existing and potential new tenant demand for our communications infrastructure will result from (1) new technologies, (2) increased usage of mobile entertainment, mobile internet, and machine-to-machine applications, (3) adoption of other emerging and embedded wireless devices (including smartphones, laptops, tablets, wearables and other devices), (4) increasing smartphone penetration, (5) wireless carrier focus on expanding both network quality and capacity, including the use of both towers and small cells, (6) the adoption of other bandwidth-intensive applications (such as cloud services and video communications), (7) the availability of additional spectrum and (8) increased government initiatives to support connectivity throughout the U.S.◦We expect U.S. wireless carriers will continue to focus on improving network quality and expanding capacity (including through 5G initiatives) by utilizing a combination of towers and small cells. We believe our product offerings of towers and small cells provide a comprehensive solution to our wireless tenants' growing communications infrastructure needs. ◦We expect organizations will continue to increase the usage of high-bandwidth applications that will require the utilization of more fiber infrastructure and fiber solutions, such as those we provide. ◦Within our Fiber segment, we are able to generate growth and returns for our stockholders by deploying our fiber for both small cells and fiber solutions tenants. ◦Tenant additions on our existing communications infrastructure are achieved at a low incremental operating cost, delivering high incremental returns. ◦Substantially all of our communications infrastructure can accommodate additional tenancy, either as currently constructed or with appropriate modifications.•Returning cash flows provided by operations to stockholders in the form of dividends (see also "Item 1. Business—Strategy")◦During 2020, we paid common stock dividends totaling approximately $2.1 billion. See "Item 7. MD&A—General Overview—Common Stock Dividend" for a discussion of the increase to our quarterly dividend in the fourth quarter of 2020.◦Investing capital efficiently to grow long-term dividends per share •Discretionary capital expenditures of $1.5 billion, predominately resulting from the construction of new communications infrastructure and improvements to existing communications infrastructure in order to support additional tenants. •We expect to continue to construct and acquire new communications infrastructure based on our tenants' needs and generate attractive long-term returns by adding additional tenants over time. •Site rental revenues under long-term tenant contracts◦Initial terms of five to 15 years for site rental revenues derived from wireless tenants, with contractual escalations and multiple renewal periods of five to 10 years each, exercisable at the option of the tenant. ◦Initial terms that generally vary between three to 20 years for site rental revenues derived from our fiber solutions tenants (including from organizations with high-bandwidth and multi-location demands). ◦Weighted-average remaining term of approximately five years, exclusive of renewals exercisable at the tenants' option, currently representing approximately $27 billion of expected future cash inflows.•Majority of our revenues from large wireless carriers 27◦Approximately 76% of our site rental revenues were derived from T-Mobile (including revenues previously derived from Sprint), AT&T and Verizon Wireless. See also "Item 1A. Risk Factors" and note 14 to our consolidated financial statements for a further discussion of our largest customers.•Majority of land interests under our towers under long-term control ◦Approximately 90% of our Towers site rental gross margin and approximately 80% of our Towers site rental gross margin is derived from towers located on land that we own or control for greater than 10 and 20 years, respectively. The aforementioned percentages include towers located on land that is owned, including through fee interests and perpetual easements, which represent approximately 40% of our Towers site rental gross margin.•Majority of our fiber assets are located in major metropolitan areas and are on public rights-of-way. •Minimal sustaining capital expenditure requirements ◦Sustaining capital expenditures represented approximately 2% of net revenues. •Debt portfolio with long-dated maturities extended over multiple years, with the vast majority of such debt having a fixed rate (see notes 7 and 17 to our consolidated financial statements and "Item 7A. Quantitative and Qualitative Disclosures About Market Risk" for a further discussion of our debt)◦After giving effect to our February 2021 issuance of (1) $1.0 billion aggregate principal amount of 1.050% senior unsecured notes due July 2026, (2) $1.0 billion aggregate principal amount of 2.100% senior unsecured notes due April 2031 and (3) $1.25 billion aggregate principal amount of 2.900% senior unsecured notes due April 2041 (collectively, "February 2021 Senior Notes") and the use of the net proceeds therefrom, 92% of our debt has fixed rate coupons.•During 2020, we completed several debt transactions to refinance and extend the maturities of certain of our debt. See notes 7 and 17 to our consolidated financial statements and "Item 7. MD&A—Liquidity and Capital Resources—Financing Activities" for further discussion of our debt transactions.◦As of December 31, 2020, after giving effect to our February 2021 Senior Notes offering and the use of the net proceeds therefrom, our outstanding debt has a weighted average interest rate of 3.2% and weighted average maturity of approximately ten years (assuming anticipated repayment dates where applicable).◦Our debt service coverage and leverage ratios are comfortably within their respective financial maintenance covenants. See "Item 7. MD&A—Liquidity and Capital Resources—Debt Covenants" for a further discussion of our debt covenants.•Significant cash flows from operations ◦Net cash provided by operating activities was $3.1 billion.◦In addition to the positive impact of contractual escalators, we expect to grow our core business of providing access to our communications infrastructure as a result of future anticipated additional demand for our communications infrastructure. Common Stock DividendIn the aggregate, we paid approximately $2.1 billion in common stock dividends in 2020. During each of the first three quarters of 2020, we paid a quarterly common stock dividend of $1.20 per share, totaling approximately $1.5 billion. In October 2020, our board of directors declared a quarterly common stock cash dividend of $1.33 per share, which represents an increase of approximately 11% from the quarterly common stock dividend declared during each of the first three quarters of 2020. We currently expect our common stock dividends over the next 12 months to be a cumulative amount of at least $5.32 per share, or an aggregate amount of approximately $2.3 billion. Over time, we expect to increase our dividend per share generally commensurate with our growth in cash flows. Any future common stock dividends are subject to declaration by our board of directors. See notes 10 and 17 to our consolidated financial statements.Outlook HighlightsThe following are certain highlights of our 2021 outlook that impact our business fundamentals described above.•We expect that, when compared to full year 2020, our full year 2021 site rental revenue growth will be positively impacted by tenant additions, as large wireless carriers and fiber solutions tenants continue to focus on meeting the increasing demand for data. See note 3 to our consolidated financial statements.•We expect to continue to invest a significant amount of our available capital in the form of discretionary capital expenditures for 2021 based on the anticipated returns on such discretionary investments. We expect that our discretionary capital expenditures in 2021 will decrease when compared to 2020 as a result of both (1) the completion of certain fiber expansion projects in 2020, and (2) an expected higher proportion of small cell capital expenditures associated with less capital-intensive tenant additions.•We also expect sustaining capital expenditures of approximately 2% of net revenues for full year 2021, consistent with historical annual levels.28Sprint CancellationDuring the fourth quarter of 2020, T-Mobile notified us that it was cancelling approximately 5,700 small cell nodes initially contracted with Sprint ("Sprint Cancellation") prior to its merger with T-Mobile. The majority of the cancelled small cells were not yet constructed and, upon completion, would have been located at the same locations as other T-Mobile small cells. The Sprint Cancellation resulted in T-Mobile accelerating payment of all contractual rental obligations associated with the approximately 5,700 small cells as well as the payment of capital costs incurred to date.We received approximately $308 million from T-Mobile pursuant to the Sprint Cancellation during the fourth quarter of 2020, and recognized receipt of this payment as "Other operating income" on our consolidated statement of operations and comprehensive income (loss) for the year ended December 31, 2020.Additionally, we previously received upfront payments from Sprint for certain small cells subject to the Sprint Cancellation, which we previously recorded as "Deferred revenues" and "Other long-term liabilities" on our consolidated balance sheet. As a result of the Sprint Cancellation, we recognized the unamortized portion of such upfront payments, or approximately $54 million, as "Other operating income" on our consolidated statement of operations and comprehensive income (loss) for the year ended December 31, 2020.Following the Sprint Cancellation, the Company separately evaluated property and equipment previously recorded related to the cancelled small cells. The Company wrote-off property and equipment deemed to have no alternative future use, and as a result, recognized approximately $63 million as "Asset write-down charges" on the Company's consolidated statement of operations and comprehensive income (loss) for the year ended December 31, 2020.See notes 2 and 15 to our consolidated financial statements for further discussion of the Sprint Cancellation.Coronavirus (COVID-19)In accordance with the U.S. Department of Homeland Security guidance issued in March 2020 designating telecommunications infrastructure and networks as critical infrastructure, we have continued our operations to ensure viability of communications networks, which are essential to public health and safety. To date, we have taken a variety of measures to ensure the availability of our critical infrastructure, promote the health and safety of our employees, and support the communities in which we operate. These measures include requiring work-from-home arrangements for a large portion of our workforce, imposing travel restrictions for our employees where practicable, canceling physical participation in meetings, events and conferences, forming an internal committee to monitor and implement procedures for the return of our workforce to an office setting, and other modifications to our business practices. We will continue to actively monitor the situation and may take further actions as may be required by governmental authorities or that we determine are in the best interests of our employees, tenants, business partners and stockholders. We do not believe that COVID-19 had a material impact on our financial position, results of operations and cash flows during the year ended December 31, 2020. Given our access to various sources of liquidity and no near term debt maturities other than Commercial Paper Notes and principal payments on amortizing debt, we currently anticipate that we will be able to maintain sufficient liquidity as we manage through the current environment. See also "Item 1A. Risk Factors" and "Item 7. MD&A—Liquidity and Capital Resources—Liquidity Position." 29Results of OperationsThe following discussion of our results of operations for 2020 compared to 2019 should be read in conjunction with "Item 1. Business," "Item 7. MD&A—Liquidity and Capital Resources" and our consolidated financial statements. For a discussion of our results of operations and financial condition for 2019 compared to 2018 that is not included in this 2020 Form 10-K, see "Part II, Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations" in our Annual Report on Form 10-K for the year ended December 31, 2019, which was filed with the SEC on March 10, 2020.The following discussion of our results of operations is based on our consolidated financial statements prepared in accordance with GAAP, which require us to make estimates and judgments that affect the reported amounts (see "Item 7. MD&A—Accounting and Reporting Matters—Critical Accounting Policies and Estimates" and note 2 to our consolidated financial statements). See "Item 7. MD&A—Accounting and Reporting Matters—Non-GAAP and Segment Financial Measures" for a discussion of our use of (1) segment site rental gross margin, (2) segment services and other gross margin, (3) segment operating profit, including their respective definitions and (4) Adjusted EBITDA, including its definition and a reconciliation to net income.Our operating segments consist of (1) Towers and (2) Fiber. See note 14 to our consolidated financial statements for further discussion of our operating segments.Highlights of our results of operations for 2020, 2019 and 2018 are depicted below: Years Ended December 31,Percent Change(In millions of dollars)2020201920182020vs.20192019vs.2018Site rental revenues:Towers site rental revenues$3,497 $3,389 $3,196 3 %6 %Fiber site rental revenues1,823 1,704 1,600 7 %7 %Total site rental revenues5,320 5,093 4,796 4 %6 %Site rental gross margin:Towers site rental gross margin(a)2,631 2,525 2,348 4 %8 %Fiber site rental gross margin(a)1,203 1,145 1,075 5 %7 %Services and other gross margin:Towers services and other gross margin(a)71 147 143 (52)%3 %Fiber services and other gross margin(a)8 6 5 33 %20 %Segment operating profit:Towers operating profit(a)2,602 2,576 2,381 1 %8 %Fiber operating profit(a)(b)1,387 956 901 45 %6 %Net income attributable to CCIC stockholders1,056 860 622 23 %38 %Adjusted EBITDA(c)3,706 3,299 3,091 12 %7 % (a)See "Item 7. MD&A—Accounting and Reporting Matters—Non-GAAP and Segment Financial Measures" and note 14 to our consolidated financial statements for our definitions of segment site rental gross margin, segment services and other gross margin and segment operating profit.(b)Fiber operating profit for the year ended December 31, 2020 is inclusive of $362 million of segment other operating income related to the Sprint Cancellation. See "Item 7. MD&A—General Overview—Sprint Cancellation" and notes 2 and 15 to our consolidated financial statements for further information regarding the Sprint Cancellation. (c)See reconciliation of this non-GAAP financial measure to net income (loss) and definition included in "Item 7. MD&A—Accounting and Reporting Matters—Non-GAAP and Segment Financial Measures."302020 and 2019 Total site rental revenues for 2020 grew by $227 million, or 4%, from 2019. This increase was predominately comprised of the factors depicted in the chart below: (In millions of dollars) (a)Includes amortization of upfront payments received from long-term tenants and other deferred credits (commonly referred to as prepaid rent).(b)Represents the contribution from recent acquisitions until the one-year anniversary of the acquisition.Towers site rental revenues for 2020 were $3.5 billion and increased by $108 million, or 3%, from approximately $3.4 billion during 2019. The increase in Towers site rental revenues was impacted by the following items, inclusive of straight-line accounting: tenant additions across our entire portfolio, renewals or extensions of tenant contracts, escalations and non-renewals of tenants contracts. Tenant additions were influenced by our tenants' ongoing efforts to improve network quality and capacity.Fiber site rental revenues for 2020 were $1.8 billion and increased by $119 million, or 7%, from $1.7 billion from 2019. The increase in Fiber site rental revenues was predominately impacted by the increased demand for small cells and fiber solutions. Increased demand for small cells was driven by our tenants' network strategy in an effort to provide capacity and relieve network congestion, and increased demand for fiber solutions was driven by increasing demand for data.The increase in Towers site rental gross margin from 2019 to 2020 was related to the previously-mentioned 3% increase in Towers site rental revenues and relatively fixed costs to operate our towers. The increase in Fiber site rental gross margins was predominately related to the previously-mentioned 7% increase in Fiber site rental revenues.Towers services and other gross margin for 2020 was $71 million and decreased by $76 million, or 52%, from $147 million during 2019, which is a result of a slowdown of carrier activity and the volume and mix of services and other work. Revenues from our services and other offerings are of a variable nature as these revenues are not under long-term contracts.Selling, general and administrative expenses for 2020 were $678 million and increased by $64 million, or 10%, from $614 million during 2019. The increase in selling, general and administrative expenses was primarily related to the growth in our business.Towers operating profit for 2020 increased by $26 million, or 1%, from 2019. The increase in Towers operating profit was primarily related to the growth in our Towers site rental revenues and relatively fixed costs to operate our towers, which was partially offset by the previously-mentioned decrease in Towers services and other gross margin.Fiber operating profit for 2020 increased by $431 million, or 45%, from 2019. The increase in Fiber operating profit was primarily related to $362 million of operating income recognized from the Sprint Cancellation and the previously-mentioned 31growth in our Fiber site rental revenues, partially offset by charges incurred related to a reduction in staffing during the fourth quarter of 2020, comprised of employee severance payments and termination benefits. See "Item 7. MD&A—General Overview—Sprint Cancellation" and notes 2 and 15 to our consolidated financial statements for further information regarding the Sprint Cancellation. See note 2 to our consolidated financial statements for further information regarding the charges incurred related to the reduction in staffing.Depreciation, amortization and accretion was approximately $1.6 billion for 2020 and increased by $36 million, or 2%, from 2019. This increase predominately resulted from a corresponding increase in our gross property and equipment due to capital expenditures. Asset write-down charges for 2020 increased by $55 million from 2019, primarily as a result of the write-off of approximately $63 million in property and equipment which, following the Sprint Cancellation, we deemed to have no alternative future use. See "Item 7. MD&A—General Overview—Sprint Cancellation" and notes 2 and 15 to our consolidated financial statements for further information regarding the Sprint Cancellation.Interest expense and amortization of deferred financing costs were $689 million for 2020 and increased by $6 million, or 1%, from $683 million during 2019. The increase predominately resulted from a corresponding increase in our outstanding indebtedness due to the financing of our discretionary capital expenditures, partially offset by reduction in the variable interest rate on our 2016 Term Loan A and 2016 Revolver due to a lower LIBOR. See note 7 to our consolidated financial statements and "Item 7A. Quantitative and Qualitative Disclosures About Market Risk" for a further discussion of our debt. As a result of repaying certain of our indebtedness in conjunction with our refinancing activities, we incurred losses on retirement of long-term obligations of $95 million and $2 million for the years ended 2020 and 2019, respectively. See note 7 to our consolidated financial statements. The provisions for income taxes for 2020 and 2019 were $20 million and $21 million, respectively. For both 2020 and 2019, the effective tax rate differs from the federal statutory rate predominately due to our REIT status, including the dividends paid deduction. See "Item 1. Business—REIT Status," "Item 7. MD&A—Accounting and Reporting Matters—Critical Accounting Policies and Estimates" and note 9 to our consolidated financial statements. Net income attributable to CCIC stockholders was $1.1 billion during 2020 compared to $860 million during 2019. The increase was predominately related to the previously-mentioned operating income recognized as a result of the Sprint Cancellation and net growth in both our Towers and Fiber segments, partially offset by (1) the previously-mentioned losses on retirement of long-term obligations, (2) decrease in Towers services activity and (3) increases in expenses, including (a) asset write-down charges, (b) selling, general and administrative expenses and (c) depreciation, amortization and accretion.Adjusted EBITDA increased $407 million, or 12%, from 2019 to 2020. The increase was predominately related to the previously-mentioned operating income recognized as a result of the Sprint Cancellation and growth in our site rental activities in both Towers and Fiber segments, partially offset by the previously-mentioned decrease in Towers services activity.32Liquidity and Capital ResourcesOverviewGeneral. Our core business generates revenues under long-term tenant contracts (see "Item 1. Business—Overview" and "Item 7. MD&A—General Overview—Overview") from (1) the largest U.S. wireless carriers and (2) fiber solutions tenants. As a leading provider of shared communications infrastructure in the U.S., our strategy is to create long-term stockholder value via a combination of (1) growing cash flows generated from our portfolio of communications infrastructure, (2) returning a meaningful portion of our cash generated by operating activities to our stockholders in the form of dividends, and (3) investing capital efficiently to grow cash flows and long-term dividends per share. Our strategy is based, in part, on our belief that the U.S. is the most attractive market for shared communications infrastructure investment with the greatest long-term growth potential. We measure our efforts to create "long-term stockholder value" by the combined payment of dividends to stockholders and growth in our per share results. See "Item 1. Business—Strategy" for a further discussion of our strategy. We have engaged, and expect to continue to engage, in discretionary investments that we believe will maximize long-term stockholder value. Our historical discretionary investments include (in no particular order): constructing communications infrastructure, acquiring communications infrastructure, acquiring land interests (which primarily relate to land assets under towers), improving and structurally enhancing our existing communications infrastructure, purchasing shares of our common stock, and purchasing, repaying, or redeeming our debt. We have recently spent, and expect to continue to spend, a significant percentage of our discretionary investments on the construction of small cells and fiber. We seek to fund our discretionary investments with both net cash generated by operating activities and cash available from financing capacity, such as the use of our undrawn availability from the 2016 Revolver, issuances under our CP Program, debt financings and issuances of equity or equity-related securities, including under our 2018 ATM Program. We seek to maintain a capital structure that we believe drives long-term stockholder value and optimizes our weighted-average cost of capital. We target a leverage ratio of approximately five times Adjusted EBITDA and interest coverage of Adjusted EBITDA to interest expense of approximately three times, subject to various factors, such as the availability and cost of capital and the potential long-term return on our discretionary investments. We may choose to increase or decrease our leverage or coverage from these targets for various periods of time. We have no significant contractual debt maturities until 2023 (other than Commercial Paper Notes that may be outstanding from time to time and principal payments on certain outstanding debt). We operate as a REIT for U.S. federal income tax purposes. We expect to continue to pay minimal cash income taxes as a result of our REIT status and our NOLs. See "Item 1. Business—REIT Status" "Item 7. MD&A—General Overview" and note 9 to our consolidated financial statements.Liquidity Position. The following is a summary of our capitalization and liquidity position as of December 31, 2020, after giving effect to our February 2021 Senior Notes offering and the use of the net proceeds therefrom. See "Item 7A. Quantitative and Qualitative Disclosures About Market Risk" and note 7 to our consolidated financial statements for additional information regarding our debt as well as note 10 to our consolidated financial statements for additional information regarding our 2018 ATM Program. (In millions of dollars)Cash, cash equivalents and restricted cash(a)$513 Undrawn 2016 Revolver availability(b)4,677 Debt and other long-term obligations (current and non-current)(c)19,557 Total equity9,316 (a)Inclusive of $5 million included within "Other assets, net" on our consolidated balance sheet.(b)Availability at any point in time is subject to certain restrictions based on the maintenance of financial covenants contained in the 2016 Credit Facility. At any point in time, we intend to maintain available commitments under our 2016 Revolver in an amount at least equal to the amount of outstanding Commercial Paper Notes. See "Item 7. MD&A—Liquidity and Capital Resources—Financing Activities" and "Item 7. MD&A—Liquidity and Capital Resources—Debt Covenants."(c)See "Item 7. MD&A—Liquidity and Capital Resources—Financing Activities" and note 7 to our consolidated financial statements for further information regarding the CP Program.Over the next 12 months: •Our liquidity sources may include (1) cash on hand, (2) net cash generated by our operating activities, (3) undrawn availability under our 2016 Revolver, (4) issuances under our CP Program, and (5) issuances of equity pursuant to our 2018 ATM Program. Our liquidity uses over the next 12 months are expected to include (1) debt service obligations of $129 million (principal payments), (2) cumulative common stock dividend payments expected to be at least $5.32 33per share, or an aggregate amount of approximately $2.3 billion (see "Item 7. MD&A—General Overview—Common Stock Dividend"), and (3) capital expenditures. Additionally, amounts available under the CP Program may be repaid and re-issued from time to time. During the next 12 months, while our liquidity uses are expected to exceed our net cash provided by operating activities, we expect that our liquidity sources described above should be sufficient to cover our expected uses. Historically, from time to time, we have accessed the capital markets to issue debt and equity.•See "Item 7A. Quantitative and Qualitative Disclosures About Market Risk" for a tabular presentation of our debt maturities and a discussion of anticipated repayment dates. Summary Cash Flows Information Years Ended December 31,(In millions of dollars)202020192018Net increase (decrease) in cash, cash equivalents and restricted cashOperating activities$3,055 $2,698 $2,500 Investing activities(1,741)(2,081)(1,793)Financing activities(1,271)(692)(733)Net increase (decrease) in cash, cash equivalents and restricted cash$43 $(75)$(26)Operating Activities. The increase in net cash provided by operating activities of $357 million for 2020 from 2019 was due primarily to (1) payment received as a result of the Sprint Cancellation and (2) growth in our core business, offset by a net decrease from changes in working capital. Changes in working capital contribute to variability in net cash provided by operating activities, largely due to the timing of advanced payments by us and advanced receipts from tenants. We expect to grow our net cash provided by operating activities in the future (exclusive of changes in working capital) if we realize expected growth in our core business. Investing Activities. Net cash used for investing activities for 2020 decreased $340 million from 2019 primarily as a result of decreased discretionary capital expenditures in both our Towers and Fiber segment. Our capital expenditures are categorized as discretionary, integration or sustaining as described below. •Discretionary capital expenditures are made with respect to activities which we believe exhibit sufficient potential to enhance long-term stockholder value. They primarily consist of expansion or development of communications infrastructure (including capital expenditures related to (1) enhancing communications infrastructure in order to add new tenants for the first time or support subsequent tenant equipment augmentations or (2) modifying the structure of a communications infrastructure asset to accommodate additional tenants) and construction of new communications infrastructure. Discretionary capital expenditures also include purchases of land interests (which primarily relates to land assets under towers as we seek to manage our interests in the land beneath our towers), certain technology-related investments necessary to support and scale future customer demand for our communications infrastructure, and other capital projects. The expansion or development of existing communications infrastructure to accommodate new leasing typically varies based on, among other factors: (1) the type of communications infrastructure, (2) the scope, volume, and mix of work performed on the communications infrastructure, (3) existing capacity prior to installation, or (4) changes in structural engineering regulations and standards. Currently, construction of new communications infrastructure is predominately comprised of the construction of small cells and fiber (including certain construction projects that may take 18 to 36 months to complete). Our decisions regarding discretionary capital expenditures are influenced by the availability and cost of capital and expected returns on alternative uses of cash, such as payments of dividends and investments.•Integration capital expenditures consist of those capital expenditures made as a result of integrating acquired companies into our business. •Sustaining capital expenditures consist of those capital expenditures not otherwise categorized as discretionary or integration capital expenditures, such as (1) maintenance capital expenditures on our communications infrastructure assets that enable our tenants' ongoing quiet enjoyment of the communications infrastructure and (2) ordinary corporate capital expenditures.34A summary of our capital expenditures for the last three years is as follows:For the Twelve Months Ended(In millions of dollars)December 31, 2020December 31, 2019December 31, 2018TowersFiberOtherTotalTowersFiberOtherTotalTowersFiberOtherTotalDiscretionary:Purchases of land interests$64 $— $— $64 $53 $— $— $53 $56 $— $— $56 Communications infrastructure improvements and other capital projects(a)257 1,179 38 1,474 452 1,427 — 1,879 349 1,216 — 1,565 Sustaining14 53 19 86 38 46 32 116 35 48 22 105 Integration— — — — — — 9 9 — — 13 13 Total$335 $1,232 $57 $1,624 $543 $1,473 $41 $2,057 $440 $1,264 $35 $1,739 (a)Towers segment includes $113 million, $208 million and $128 million of capital expenditures incurred during the twelve months ended December 31, 2020, 2019 and 2018, respectively, in connection with tenant installations and upgrades on our towers.Capital expenditures decreased from 2019 to 2020 and were primarily impacted by a slowdown in tenant activity in 2020 compared to 2019 as well as the completion of certain large fiber expansion projects during 2020. Our sustaining capital expenditures were approximately 2% of net revenues in 2020, consistent with historical annual levels. See "Item 7. MD&A—General Overview—Outlook Highlights" for a discussion of our expectations surrounding 2021 capital expenditures.Financing Activities. We seek to allocate cash generated by our operations in a manner that will enhance long-term stockholder value, which may include various financing activities such as (in no particular order): (1) paying dividends on our common stock (currently expected to total at least $5.32 per share over the next 12 months, or an aggregate amount of approximately $2.3 billion), (2) purchasing our common stock; or (3) purchasing, repaying, or redeeming our debt. See "Item 7. MD&A—General Overview—Common Stock Dividend," "Item 7. MD&A—Liquidity and Capital Resources—Overview" and notes 7, 10 and 17 to our consolidated financial statements. In 2020, our financing activities predominately related to the following:•paying an aggregate of $2.1 billion in dividends on our common stock;•paying an aggregate of $85 million in dividends on our previously outstanding 6.875% Mandatory Convertible Preferred Stock;•issuing $1.25 billion aggregate principal amount of senior unsecured notes in April 2020, the net proceeds of which we used to repay outstanding indebtedness under the 2016 Revolver; and•issuing $2.5 billion aggregate principal amount of senior unsecured notes in June 2020, the proceeds of which, together with available cash, we used to redeem all of the previously outstanding 3.400% Senior Notes, 2.250% Senior Notes and 4.875% Senior Notes. In 2019, our financing activities predominately related to the following:•paying an aggregate of $1.9 billion in dividends on our common stock; •paying an aggregate of $113 million in dividends on our previously outstanding 6.875% Mandatory Convertible Preferred Stock;•issuing $1.0 billion aggregate principal amount of senior unsecured notes in February 2019, the proceeds of which we used to repay a portion of the outstanding indebtedness under the 2016 Revolver;•establishing a CP Program in April 2019 pursuant to which we may issue short-term, unsecured commercial paper notes. Notes under the CP Program may be issued, repaid and re-issued from time to time, with an aggregate principal amount of Commercial Paper Notes outstanding under the CP Program at any time not to exceed $1.0 billion. The net proceeds of the Commercial Paper Notes are expected to be used for general corporate purposes;•entering into an amendment to the 2016 Credit Facility in June 2019 to (1) increase our commitments under the 2016 Revolver by $750 million for total commitments of $5.0 billion and (2) extend the maturity of the 2016 Credit Facility from June 2023 to June 2024; and35•issuing $900 million aggregate principal amount of senior unsecured notes in August 2019, the proceeds of which we used to repay outstanding indebtedness under the 2016 Revolver and CP Program.Incurrences, Purchases and Repayments of Debt. See note 7 to our consolidated financial statements, "Item 7. MD&A—General Overview" and "Item 7. MD&A—Liquidity and Capital Resources—Overview—Liquidity Position" for further discussion of our recent issuances, purchases, redemptions and repayments of debt. Common Stock. See notes 10 and 17 to our consolidated financial statements for further information regarding our common stock as well as dividends declared and paid. ATM Program. See note 10 to our consolidated financial statements for further information regarding our 2018 ATM Program. As of February 17, 2021, we had approximately $750 million of gross sales of common stock availability remaining on our 2018 ATM Program. Mandatory Convertible Preferred Stock. In July and August 2020, all of our approximately 2 million shares of 6.875% Mandatory Convertible Preferred Stock then outstanding were converted into approximately 14 million shares of our common stock at a conversion rate (based on the applicable market value of our common stock and subject to certain anti-dilutive adjustments) of 8.8043 shares of common stock for each share of 6.875% Mandatory Convertible Preferred Stock. See note 10 to our consolidated financial statements for further discussion of the dividends declared and paid on our previously outstanding 6.875% Mandatory Convertible Preferred Stock during 2020 and the July and August conversions into shares of our common stock. Credit Facility. See note 7 to our consolidated financial statements for further information regarding our 2016 Credit Facility. As of February 17, 2021, there was approximately $5.0 billion in availability under the 2016 Revolver.Commercial Paper Program. See notes 7 and 17 to our consolidated financial statements for further information regarding our CP Program. As of February 17, 2021, the CP Program had $150 million outstanding.Restricted Cash. Pursuant to the indentures governing certain of our operating companies' debt securities, all rental cash receipts of the issuers of these debt instruments and their subsidiaries are restricted and held by an indenture trustee. The restricted cash in excess of required reserve balances is subsequently released to us in accordance with the terms of the indentures. See also note 2 to our consolidated financial statements.36Material Cash RequirementsThe following table summarizes our material cash requirements as of December 31, 2020, after giving effect to our February 2021 Senior Notes offering and the use of the net proceeds therefrom. These material cash requirements relate primarily to our outstanding borrowings or lease obligations for land interests under our towers. The debt maturities reflect contractual maturity dates and do not consider the impact of the principal payments that will commence following the anticipated repayment dates of certain debt (see footnote (b)). (In millions of dollars)Years Ending December 31,Material Cash Requirements20212022202320242025ThereafterTotalsDebt and other long-term obligations(a)$130 $154 $1,958 $1,941 $525 $15,031 $19,739 Interest payments on debt and other long-term obligations(b)(c)603 631 623 574 561 7,239 10,231 Lease obligations(d)546 543 538 532 518 5,842 8,519 Total material cash requirements$1,279 $1,328 $3,119 $3,047 $1,604 $28,112 $38,489 (a)The impact of principal payments that will commence following the anticipated repayment dates of our Tower Revenue Notes is not considered. The Tower Revenue Notes have principal amounts of $300 million, $250 million, $700 million and $750 million, with anticipated repayment dates in 2022, 2023, 2025 and 2028, respectively. See note 7 to our consolidated financial statements for our definition of and additional information regarding the Tower Revenue Notes. (b)If the Tower Revenue Notes are not repaid in full by the applicable anticipated repayment dates, the applicable interest rate increases by approximately 5% per annum and monthly principal payments commence using the Excess Cash Flow (as defined in the indenture governing the applicable Tower Revenue Notes) of the issuers of the Tower Revenue Notes. The Tower Revenue Notes are presented based on their contractual maturity dates ranging from 2042 to 2048 and include the impact of an assumed 5% increase in interest rate that would occur following the anticipated repayment dates but exclude the impact of monthly principal payments that would commence using Excess Cash Flow (as defined in the indenture governing the applicable Tower Revenue Notes) of the issuers of the Tower Revenue Notes. The full year 2020 Excess Cash Flow (as defined in the indenture governing the applicable Tower Revenue Notes) of the issuers of the Tower Revenue Notes was approximately $815 million. We currently expect to refinance these notes on or prior to the respective anticipated repayment dates. (c)Interest payments on the variable rate debt are based on estimated rates currently in effect.(d)Amounts relate primarily to lease obligations for the land on which our towers are located and are based on the assumption that payments will be made for certain renewal periods exercisable at our option that are reasonably certain to be exercised and excludes our contingent payments for operating leases (such as payments based on revenues derived from the communications infrastructure located on the leased asset) as such arrangements are excluded from our operating lease liability. See note 13 to our consolidated financial statements for further discussion of our operating lease obligations. See also the table below summarizing remaining terms to expiration.The following chart summarizes our rights to the land interests under our towers, including renewal terms exercisable at our option, as of December 31, 2020. As of December 31, 2020, the leases for land interests under our towers had an average remaining life of approximately 36 years, weighted based on Towers site rental gross margin. See "Item 1A. Risk Factors" for a discussion of retaining land interests under our towers. (a)Inclusive of fee interests and perpetual easements.(b)For the year ended December 31, 2020, without consideration of the term of the tenant contract.37Debt CovenantsOur Credit Agreement contains financial maintenance covenants. We are currently in compliance with these financial maintenance covenants and, based upon our current expectations, we believe we will continue to comply with our financial maintenance covenants. In addition, certain of our debt agreements contain restrictive covenants that place restrictions on us and may limit our ability to, among other things, incur additional debt and liens, purchase our securities, make capital expenditures, dispose of assets, undertake transactions with affiliates, make other investments, pay dividends or distribute excess cash flow. See note 7 to our consolidated financial statements for further discussion of our debt covenants. See also "Item 1A. Risk Factors" for a discussion of compliance with our debt covenants. The following are ratios applicable to the financial maintenance covenants under the Credit Agreement as of December 31, 2020. Borrower / IssuerFinancial Maintenance Covenant(a)(b)Covenant Level RequirementAs of December 31, 2020CCICTotal Net Leverage Ratio≤ 6.50x5.1xCCICTotal Senior Secured Leverage Ratio≤ 3.50x0.8xCCICConsolidated Interest Coverage Ratio(c)N/AN/A (a)Failure to comply with the financial maintenance covenants would, absent a waiver, result in an event of default under the Credit Agreement.(b)As defined in the Credit Agreement.(c)Applicable solely to the extent that the senior unsecured debt rating by any two of S&P, Moody's and Fitch is lower than BBB-, Baa3 or BBB-, respectively. If applicable, the consolidated interest coverage ratio must be greater than or equal to 2.50.Accounting and Reporting MattersCritical Accounting Policies and EstimatesOur critical accounting policies and estimates are those that we believe (1) are most important to the portrayal of our financial condition and results of operations or (2) require our most difficult, subjective or complex judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain. In many cases, the accounting treatment of a particular transaction is specifically prescribed by GAAP. In other cases, management is required to exercise judgment in the application of accounting principles with respect to particular transactions. The critical accounting policies and estimates for 2020 are not intended to be a comprehensive list of our accounting policies and estimates. See note 2 to our consolidated financial statements for a summary of our significant accounting policies. Lease Accounting — Lessee. For our Towers segment, our lessee arrangements primarily consist of ground leases for land under our towers. Ground leases for land are specific to each site and are generally for an initial term of five to 10 years and are renewable (and cancelable after a notice period) at our option. We also enter into term easements and ground leases in which we prepay the entire term. For our Fiber segment, our lessee arrangements primarily include leases of fiber assets to facilitate our small cells and fiber solutions. The majority of our lease agreements have certain termination rights that provide for cancellation after a notice period and multiple renewal options exercisable at our option. We include certain renewal option periods in the lease term when we determine that the options are reasonably certain to be exercised. For both our Towers and Fiber segments, operating lease expense is recognized on a ratable basis, regardless of whether the payment terms require us to make payments annually, quarterly, monthly, or for the entire term in advance. Certain of our ground lease and fiber lease agreements contain fixed escalation clauses (such as fixed dollar or fixed percentage increases) or inflation-based escalation clauses (such as those tied to the change in consumer price index ("CPI")). If the payment terms include fixed escalator provisions, the effect of such increases is recognized on a straight-line basis. We calculate the straight-line expense over the contract's estimated lease term, including any renewal option periods that we deem reasonably certain to be exercised. We recognize a right-of-use ("ROU") asset and lease liability for each of our operating leases. ROU assets represent our right to use an underlying asset for the estimated lease term, and lease liabilities represent the present value of our future lease payments. In assessing our leases and determining our lease liability at lease commencement or upon modification, we are not able to readily determine the rate implicit for our lessee arrangements and thus use our incremental borrowing rate on a collateralized basis to determine the present value of our lease payments. Our ROU assets are measured as the balance of the lease liability plus any prepaid or accrued lease payments and any unamortized initial direct costs. We review the carrying value of our ROU assets for impairment, similar to our other long-lived assets, whenever events or changes in circumstances indicate that the carrying amounts may not be recoverable. We could record impairments in the 38future if there are changes in (1) long-term market conditions, (2) expected future operating results or (3) the utility of the assets that negatively impact the fair value of our ROU assets.Revenue Recognition. 91% of our total revenue for 2020 consisted of site rental revenues, which are recognized on a ratable basis over the fixed, non-cancelable term of the relevant tenant contract, generally ranging from five to 15 years for site rental revenues derived from wireless tenants and three to 20 years for site rental revenues derived from fiber solutions tenants, regardless of whether the payments from the tenant are received in equal monthly amounts during the life of a tenant contract. Certain of our tenant contracts contain (1) fixed escalation clauses (such as fixed-dollar or fixed-percentage increases) or inflation-based escalation clauses (such as those tied to the change in CPI), (2) multiple renewal periods exercisable at the tenant's option and (3) only limited termination rights at the applicable tenant's option through the current term. If the payment terms call for fixed escalations, upfront payments, or rent-free periods, the revenue is recognized on a straight-line basis over the fixed, non-cancelable term of the tenant contract. When calculating our straight-line rental revenues, we consider all fixed elements of tenant contractual escalation provisions, even if such escalation provisions contain a variable element (such as an escalator tied to an inflation-based index) in addition to a minimum. To the extent we acquire below-market tenant leases for contractual interests with tenants on the acquired communications infrastructure (for example with respect to small cells and fiber), we record the fair value as deferred credits and amortize such deferred credits to site rental revenues over their estimated lease term. Since we recognize revenue on a straight-line basis, a portion of the site rental revenues in a given period represents cash collected or contractually collectible in other periods. Our assets related to straight-line site rental revenues are included in "Other current assets" and "Deferred site rental receivables." Amounts billed or received prior to being earned are deferred and reflected in "Deferred revenues" and "Other long-term liabilities." Amounts to which we have an unconditional right to payment, which are related to both satisfied or partially satisfied performance obligations, are recorded within "Receivables, net" on the consolidated balance sheet. As part of our effort to provide comprehensive communications infrastructure solutions, as an ancillary business, we also offer certain services primarily relating to our Towers segment, which represented 9% of our total revenues for 2020. Services and other revenue consists predominately of (1) site development services primarily relating to existing or new tenant equipment installations, including: site acquisition, architectural and engineering, or zoning and permitting (collectively, "site development services") and (2) tenant equipment installation or subsequent augmentations (collectively, "installation services"). Upon contract commencement, we assess our services to tenants and identify performance obligations for each promise to provide a distinct service. We may have multiple performance obligations for site development services, which primarily include: structural analysis, zoning, permitting and construction drawings. For each of the above performance obligations, services revenues are recognized at completion of the applicable performance obligation, which represents the point at which we believe we have transferred goods or services to the tenant. The revenue recognized is based on an allocation of the transaction price among the performance obligations in a respective contract based on estimated standalone selling price. The transaction price for tower installation services consists of amounts for (1) permanent improvements to our towers that represent a lease component and (2) the performance of the service. Amounts under our tower installation services agreements that represent a lease component are recognized as site rental revenues on a ratable basis over the length of the associated estimated lease term. For the performance of the tower installation service, we have one performance obligation, which is satisfied at the time of the applicable installation or augmentation and recognized as services and other revenues.Since performance obligations are typically satisfied prior to receiving payment from tenants, the unconditional right to payment is recorded within "Receivables, net" on our consolidated balance sheet. The vast majority of our services revenues relates to our Towers segment and generally have a duration of one year or less. Accounting for Acquisitions — General. As described in "Item 1. Business," the majority of our communications infrastructure has been acquired directly or indirectly from the three largest wireless carriers (or their predecessors) through transactions consummated since 1999. We evaluate each of our acquisitions to determine if it should be accounted for as a business combination or as an acquisition of assets. For our business combinations, we allocate the purchase price to the assets acquired and liabilities assumed based on their estimated fair value at the date of acquisition. Any purchase price in excess of the net fair value of the assets acquired and liabilities assumed is allocated to goodwill. See "Item 7. MD&A—Accounting and Reporting Matters—Accounting for Acquisitions—Valuation" below. The determination of the final purchase price allocation could extend over several quarters resulting in the use of preliminary estimates that are subject to adjustment until finalized. Such changes could have a significant impact on our consolidated financial statements. 39Accounting for Acquisitions — Leases. With respect to business combinations that include towers that we lease and operate, such as the AT&T and T-Mobile leased and subleased towers (including towers owned by Sprint prior to its merger with T-Mobile), we evaluate such agreements to determine treatment as finance or operating leases. The evaluation of such agreements for finance or operating lease treatment previously included consideration of each of the lease classification criteria under ASC 840-10-25, namely (1) the transfer of ownership provisions, (2) the existence of bargain purchase options, (3) the length of the remaining lease term, and (4) the present value of the minimum lease payments. With respect to the AT&T Acquisition, T-Mobile Acquisition, and the Sprint towers acquired in the Global Signal Acquisition, we determined that the tower leases were finance leases and the underlying land leases were operating leases based upon the lease term criterion, after considering the fragmentation criteria applicable under ASC 840-10-25 to leases involving both land and buildings (i.e., towers). We determined that the fragmentation criteria was met, and the tower leases could be accounted for as finance leases apart from the land leases, which are accounted for as operating leases, since (1) the fair value of the land in the aforementioned business combinations was greater than 25% of the total fair value of the leased property at inception and (2) the tower lease expirations occur beyond 75% of the estimated economic life of the tower assets.Accounting for Acquisitions — Valuation. As of December 31, 2020, our largest asset was property and equipment, which primarily consists of communications infrastructure, followed by goodwill, operating lease ROU assets and intangible assets. Our identifiable intangible assets predominately relate to the site rental contracts and tenant relationships intangible assets. The fair value of the vast majority of our assets and liabilities is determined by using either:(1)discounted cash flow valuation methods (for estimating identifiable intangibles such as site rental contracts and tenant relationships or operating lease right-of-use assets and lease liabilities acquired); or(2)estimates of replacement costs (for tangible fixed assets such as communications infrastructure).The purchase price allocation requires subjective estimates that, if incorrectly estimated, could be material to our consolidated financial statements, including the amount of depreciation, amortization and accretion expense. The most important estimates for measurement of tangible fixed assets are (1) the cost to replace the asset with a new asset and (2) the economic useful life after giving effect to age, quality, and condition. The most important estimates for measurement of intangible assets are (1) discount rates and (2) timing and amount of cash flows including estimates regarding tenant renewals and cancellations. The most important estimates for measurement of operating lease ROU assets and lease liabilities acquired are (1) present value of our future lease payments, including whether renewals or extensions should be measured, and (2) favorability or unfavorability to the current market terms. With respect to business combinations that include towers that we lease and operate, such as the AT&T, T-Mobile and Sprint (prior to Sprint's merger with T-Mobile, completed on April 1, 2020) leased and subleased towers, we evaluate such agreements to determine treatment as finance or operating leases and identification of any bargain purchase options. We record the fair value of obligations to perform certain asset retirement activities, including requirements, pursuant to our ground leases, easements, and leased facility agreements to remove communications infrastructure or remediate the space upon which certain of our communications infrastructure resides. In determining the fair value of these asset retirement obligations we must make several subjective and highly judgmental estimates such as those related to: (1) timing of cash flows; (2) future costs; (3) discount rates; and (4) the probability of enforcement to remove the towers or small cells or remediate the land. Accounting for Long-Lived Assets — Useful Lives. We are required to make subjective assessments as to the useful lives of our tangible and intangible assets for purposes of determining depreciation, amortization and accretion expense that, if incorrectly estimated, could be material to our consolidated financial statements. Depreciation expense for our property and equipment is computed using the straight-line method over the estimated useful lives of our various classes of tangible assets. The substantial portion of our property and equipment represents the cost of our communications infrastructure, which is generally depreciated with an estimated useful life equal to the shorter of (1) 20 years or (2) the term of the lease (including optional renewals) for the land under our communications infrastructure.The useful life of our intangible assets is estimated based on the period over which the intangible asset is expected to benefit us and gives consideration to the expected useful life of other assets to which the useful life may relate. We review the expected useful lives of our intangible assets on an ongoing basis and adjust if necessary. Amortization expense for intangible assets is computed using the straight-line method over the estimated useful life of each of the intangible assets. The useful life of the site rental contracts and tenant relationships intangible assets is limited by the maximum depreciable life of the communications infrastructure (20 years), as a result of the interdependency of the communications infrastructure and site rental contracts and tenant relationships. In contrast, the site rental contracts and tenant relationships are estimated to provide economic benefits for several decades because of the low rate of tenant cancellations and high rate of renewals experienced to date. Thus, while site rental contracts and tenant relationships are valued based upon the fair value of the site rental contracts 40and tenant relationships which includes assumptions regarding both (1) tenants' exercise of optional renewals contained in the acquired leases and (2) renewals of the acquired leases past the contractual term including exercisable options, the site rental contracts are amortized over a period not to exceed 20 years as a result of the useful life being limited by the depreciable life of the communications infrastructure.Accounting for Long-Lived Assets — Impairment Evaluation. We review the carrying values of property and equipment, intangible assets, or other long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying amounts may not be recoverable. We utilize the following dual grouping policy for purposes of determining the unit of account for testing impairment of the site rental contracts and tenant relationships:(1)we pool site rental contracts and tenant relationships intangible assets and property and equipment into portfolio groups; and(2)we separately pool site rental contracts and tenant relationships by significant tenant or by tenant grouping for individually insignificant tenants, as appropriate.We first pool site rental contracts and tenant relationships intangible assets and property and equipment into portfolio groups for purposes of determining the unit of account for impairment testing, because we view communications infrastructure as portfolios and communications infrastructure in a given portfolio and its related tenant contracts are not largely independent of the other communications infrastructure in the portfolio. We re-evaluate the appropriateness of the pooled groups at least annually. This use of grouping is based in part on (1) our limitations regarding disposal of communications infrastructure, (2) the interdependencies of communications infrastructure portfolios, and (3) the manner in which communications infrastructure is traded in the marketplace. The vast majority of our site rental contracts and tenant relationships intangible assets and property and equipment are pooled into the U.S. owned communications infrastructure group. Secondly, and separately, we pool site rental contracts and tenant relationships by significant tenant or by tenant grouping for individually insignificant tenants, as appropriate, for purposes of determining the unit of account for impairment testing because we associate the value ascribed to site rental contracts and tenant relationships intangible assets to the underlying contracts and related tenant relationships acquired.Our determination that an adverse event or change in circumstance has occurred that indicates that the carrying amounts may not be recoverable will generally involve (1) a deterioration in an asset's financial performance compared to historical results, (2) a shortfall in an asset's financial performance compared to forecasted results, or (3) changes affecting the utility and estimated future demands for the asset. When considering the utility of our assets, we consider events that would meaningfully impact (1) our communications infrastructure or (2) our tenant relationships. For example, consideration would be given to events that impact (1) the structural integrity and longevity of our communications infrastructure or (2) our ability to derive benefit from our existing tenant relationships, including events such as tenant's bankruptcy or insolvency or loss of a significant tenant. During 2020, there were no events or circumstances that caused us to review the carrying value of our intangible assets or property and equipment due in part to our assets performing consistently with or better than our expectations.If the sum of the estimated future cash flows (undiscounted) from an asset, or portfolio group, significant tenant or tenant group (for individually insignificant tenants), as applicable, is less than its carrying amount, an impairment loss may be recognized. If the carrying value were to exceed the undiscounted cash flows, measurement of an impairment loss would be based on the fair value of the asset, which is based on an estimate of discounted future cash flows. The most important estimates for such calculations of undiscounted cash flows are (1) the expected additions of new tenants and equipment on our communications infrastructure and (2) estimates regarding tenant cancellations and renewals of tenant contracts. We could record impairments in the future if changes in long-term market conditions, expected future operating results or the utility of the assets results in changes for our impairment test calculations which negatively impact the fair value of our property and equipment and intangible assets, or if we changed our unit of account in the future.Approximately 2% of our total towers currently have no tenants. We continue to pay operating expenses on these towers in anticipation of obtaining tenants on these towers in the future, primarily because of the demographics and continuing increase in demand for data in the areas around these individual towers. We estimate, based on current visibility, potential tenants on a majority of these towers. To the extent we do not believe there are long-term prospects of obtaining tenants on an individual asset and all other possible avenues for recovering the carrying value have been exhausted, including sale of the asset, we appropriately reduce the carrying value of such assets to fair value.Accounting for Goodwill — Impairment Evaluation. We test goodwill for impairment on an annual basis, regardless of whether adverse events or changes in circumstances have occurred. The annual test begins with goodwill and all intangible assets being allocated to applicable reporting units. We then perform a qualitative assessment to determine whether it is "more likely than not" that the fair value of the reporting unit is less than its carrying amount. If we conclude that it is "more likely than not" that the fair value of a reporting unit is less than its carrying amount, we would be required to perform a quantitative 41goodwill impairment test. If the carrying amount of a reporting unit is greater than its fair value, an impairment loss shall be recognized in an amount equal to such excess, limited to the total amount of goodwill allocated to the reporting unit. Our reporting units are the same as our operating segments (Towers and Fiber). See note 14 to our consolidated financial statements. We performed our most recent annual goodwill impairment test as of October 1, 2020, which resulted in no impairments.See also note 2 to our consolidated financial statements for a discussion of the recently adopted accounting pronouncement related to goodwill impairment evaluation.Deferred Income Taxes. We operate as a REIT for U.S. federal income tax purposes. Our REIT taxable income is generally not subject to federal and state income taxes as a result of the deduction for dividends paid and any usage of our remaining NOLs. Accordingly, the only provision or benefit for federal income taxes for the year ended December 31, 2020 relates to TRSs. Furthermore, as a result of the deduction for dividends paid, some or all of our NOLs related to our REIT may expire without utilization. See "Item 1. Business—REIT Status" for a discussion of the impact of our REIT status. Our TRSs will continue to be subject, as applicable, to federal and state income taxes and foreign taxes in the jurisdictions in which such assets and operations are located. Our ability to utilize our NOLs is dependent, in part, upon us having sufficient future earnings to utilize our NOLs before they expire. If market conditions change materially and we determine that we will be unable to generate sufficient taxable income in the future to utilize our NOLs, we would be required to record an additional valuation allowance, which would reduce our earnings. Such adjustments could cause a material effect on our results of operations for the period of the adjustment. The change in our valuation allowance has no effect on our cash flows. For a further discussion of our benefit (provision) for income taxes, see "Item 7. MD&A—Results of Operations" and note 9 to our consolidated financial statements.Accounting PronouncementsRecently Adopted Accounting Pronouncements. See note 2 to our consolidated financial statements.Recent Accounting Pronouncements Not Yet Adopted. See note 2 to our consolidated financial statements.Non-GAAP and Segment Financial MeasuresIn addition to the non-GAAP financial measures used herein and as discussed in note 14 to our consolidated financial statements, we also provide (1) segment site rental gross margin, (2) segment services and other gross margin, and (3) segment operating profit, which are key measures used by management to evaluate the performance of our operating segments. These segment measures are provided pursuant to GAAP requirements related to segment reporting. We define segment site rental gross margin as segment site rental revenues less segment site rental cost of operations, which excludes stock-based compensation expense and prepaid lease purchase price adjustments recorded in consolidated site rental cost of operations. We define segment services and other gross margin as segment services and other revenues less segment services and other cost of operations, which excludes stock-based compensation expense recorded in consolidated services and other cost of operations. We define segment operating profit as segment site rental gross margin plus segment services and other gross margin, and segment other operating (income) expense, less selling, general and administrative expenses attributable to the respective segment. All of these measurements of profit or loss are exclusive of depreciation, amortization and accretion, which are shown separately. Additionally, certain costs are shared across segments and are reflected in our segment measures through allocations that management believes to be reasonable. We use earnings before interest, taxes, depreciation, amortization and accretion, as adjusted ("Adjusted EBITDA"), which is a non-GAAP financial measure, as an indicator of consolidated financial performance. Our measure of Adjusted EBITDA may not be comparable to similarly titled measures of other companies, including companies in the communications infrastructure sector or other REITs, and is not a measure of performance calculated in accordance with GAAP. Adjusted EBITDA should not be considered in isolation or as a substitute for operating income (loss), net income (loss), net cash provided by (used for) operating, investing and financing activities or other income statement or cash flow statement data prepared in accordance with GAAP and should be considered only as a supplement to net income (loss) computed in accordance with GAAP as a measure of our performance. There are material limitations to using a measure such as Adjusted EBITDA, including the difficulty associated with comparing results among more than one company, including our competitors, and the inability to analyze certain significant items, including depreciation and interest expense, that directly affect our net income or loss. Management compensates for these limitations by considering the economic effect of the excluded expense items independently as well as in connection with their analysis of net income (loss). 42We define Adjusted EBITDA as net income (loss) plus restructuring charges (credits), asset write-down charges, acquisition and integration costs, depreciation, amortization and accretion, amortization of prepaid lease purchase price adjustments, interest expense and amortization of deferred financing costs, (gains) losses on retirement of long-term obligations, net (gain) loss on interest rate swaps, (gains) losses on foreign currency swaps, impairment of available-for-sale securities, interest income, other (income) expense, (benefit) provision for income taxes, cumulative effect of a change in accounting principle, (income) loss from discontinued operations and stock-based compensation expense. The reconciliation of Adjusted EBITDA to our net income (loss) is set forth below.Years Ended December 31,(In millions of dollars)202020192018Net income (loss)$1,056 $860 $622 Adjustments to increase (decrease) net income (loss):Asset write-down charges74 19 26 Acquisition and integration costs10 13 27 Depreciation, amortization and accretion1,608 1,572 1,527 Amortization of prepaid lease purchase price adjustments18 20 20 Interest expense and amortization of deferred financing costs689 683 642 (Gains) losses on retirement of long-term obligations95 2 106 Interest income(2)(6)(5)Other (income) expense5 (1)(1)(Benefit) provision for income taxes20 21 19 Stock-based compensation expense133 116 108 Adjusted EBITDA(a)$3,706 $3,299 $3,091 (a)The above reconciliation excludes the items included in our Adjusted EBITDA definition which are not applicable to the periods shown.We believe Adjusted EBITDA is useful to investors or other interested parties in evaluating our financial performance because:•it is the primary measure used by our management (1) to evaluate the economic productivity of our operations and (2) for purposes of making decisions about allocating resources to, and assessing the performance of, our operations; •although specific definitions may vary, it is widely used by investors or other interested parties in evaluation of the communications infrastructure sector and other REITs to measure financial performance without regard to items such as depreciation, amortization and accretion, which can vary depending upon accounting methods and the book value of assets; •we believe it helps investors and other interested parties meaningfully evaluate and compare the results of our operations (1) from period to period and (2) to our competitors by removing the impact of our capital structure (primarily interest charges from our outstanding debt) and asset base (primarily depreciation, amortization and accretion) from our financial results; and •it is similar to the measure of current financial performance generally used in our debt covenant calculations. Our management uses Adjusted EBITDA:•as a performance goal in employee annual incentive compensation; •as a measurement of financial performance because it assists us in comparing our financial performance on a consistent basis as it removes the impact of our capital structure (primarily interest charges from our outstanding debt) and asset base (primarily depreciation, amortization and accretion) from our operating results; •in presentations to our board of directors to enable it to have the same measurement of financial performance used by management; •for planning purposes, including preparation of our annual operating budget; •as a valuation measure in strategic analyses in connection with the purchase and sale of assets; •in determining self-imposed limits on our debt levels, including the evaluation of our leverage ratio and interest coverage ratio; and •with respect to compliance with our debt covenants, which require us to maintain certain financial ratios that incorporate concepts such as, or similar to, Adjusted EBITDA. 43Item 7A. Quantitative and Qualitative Disclosures About Market RiskOur primary exposures to market risks are related to changes in interest rates, which may adversely affect our results of operations and financial position. We seek to manage exposure to changes in interest rates where economically prudent to do so by utilizing fixed rate debt. Our interest rate risk as of December 31, 2020 relates primarily to the impact of interest rate movements on the following, after giving effect to our February 2021 Senior Notes offering and the use of the net proceeds therefrom:•the potential refinancing of our $19.7 billion in existing debt, compared to $18.2 billion in the prior year;•our $1.5 billion of floating rate debt representing approximately 8% of total debt, compared to 16% in the prior year; and•potential future borrowings of incremental debt, including borrowings under our 2016 Credit Facility and issuances under the CP Program.Potential Refinancing of Existing DebtWe have no significant contractual debt maturities (or anticipated repayment dates on our Tower Revenue Notes) over the next 12 months, other than Commercial Paper Notes and principal payments on certain outstanding debt. As of December 31, 2020 and December 31, 2019, we had no interest rate swaps hedging any refinancings. See below for a tabular presentation of our scheduled contractual debt maturities as of December 31, 2020 and a discussion of anticipated repayment dates. Floating Rate DebtWe manage our exposure to market interest rates on our existing debt by controlling the mix of fixed and floating rate debt. As of December 31, 2020, after giving effect to our February 2021 Senior Notes offering and the use of the net proceeds therefrom, we had $1.5 billion of floating rate debt, none of which had LIBOR floors. As a result, a hypothetical unfavorable fluctuation in market interest rates on our existing debt of 1/8 of a percent point over a 12-month period would increase our interest expense by approximately $2 million. As of December 31, 2019, we had approximately $3.0 billion of floating rate debt, none of which had LIBOR floors. See also "Item 1A. Risk Factors" for a discussion of uncertainty related to the continued use of LIBOR.Potential Future Borrowings of Incremental DebtWe typically do not hedge our exposure to interest rates on potential future borrowings of incremental debt for a substantial period prior to issuance. See "Item 7. MD&A—Liquidity and Capital Resources" regarding our liquidity strategy.44The following table provides information about our market risk related to changes in interest rates, after giving effect to our February 2021 Senior Notes offering and the use of the net proceeds therefrom. The future principal payments and weighted-average interest rates are presented as of December 31, 2020. These debt maturities reflect contractual maturity dates, and do not consider the impact of the principal payments that will commence following the anticipated repayment dates of certain debt (see footnotes (b) and (d)). See note 7 to our consolidated financial statements for additional information regarding our debt. Future Principal Payments and Interest Rates by the Debt Instruments' Contractual Year of Maturity(In millions of dollars)20212022202320242025ThereafterTotalFair Value(a)Fixed rate debt(b)$42 $37 $1,783 $778 $525 $15,030 $18,195 $19,914 Average interest rate(b)(c)(d)4.3 %4.5 %3.6 %3.3 %1.5 %4.0 %3.9 %Variable rate debt(e)$88 $117 $176 $1,163 $— $— $1,544 $1,544 Average interest rate(e)1.3 %1.3 %1.5 %1.8 %— %— %1.7 % (a)The fair value of our debt is based on indicative quotes (that is, non-binding quotes) from brokers that require judgment to interpret market information, including implied credit spreads for similar borrowings on recent trades or bid/ask offers. These fair values are not necessarily indicative of the amount, which could be realized in a current market exchange.(b)The impact of principal payments that will commence following the anticipated repayment dates is not considered. The Tower Revenue Notes have principal amounts of $300 million, $250 million, $700 million and $750 million, with anticipated repayment dates in 2022, 2023, 2025 and 2028, respectively. (c)The average interest rate represents the weighted-average stated coupon rate (see also footnote (d)).(d) If the Tower Revenue Notes are not repaid in full by the applicable anticipated repayment dates, the applicable interest rate increases by approximately 5% per annum and monthly principal payments commence using the Excess Cash Flow (as defined in the indenture governing the applicable Tower Revenue Notes) of the issuers of the Tower Revenue Notes. The Tower Revenue Notes are presented based on their contractual maturity dates ranging from 2042 to 2048 and include the impact of an assumed 5% increase in interest rate that would occur following the anticipated repayment dates but exclude the impact of monthly principal payments that would commence using Excess Cash Flow of the issuers of the Tower Revenue Notes The full year 2020 Excess Cash Flow of the issuers of the Tower Revenue Notes was approximately $815 million. We currently expect to refinance these notes on or prior to the respective anticipated repayment dates. (e) Consists of our senior unsecured term loan A facility ("2016 Term Loan A") and our 2016 Revolver borrowings, each of which matures in 2024. 45
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+Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations. (“MD&A”) The following discussion and analysis should be read in conjunction with the audited consolidated financial statements and related notes included in Item 8 of this 10-K, “Risk Factors” included in Item 1A of this 10-K and the “Cautionary Statement Concerning Forward-Looking Statements” in this 10-K.Overview of BusinessCVS Health Corporation (“CVS Health”), together with its subsidiaries (collectively, the “Company,” “we,” “our” or “us”), is a diversified health services company united around a common purpose of helping people on their path to better health. In an increasingly connected and digital world, we are meeting people wherever they are and changing health care to meet their needs. The Company has more than 9,900 retail locations, approximately 1,100 walk-in medical clinics, a leading pharmacy benefits manager with approximately 105 million plan members, a dedicated senior pharmacy care business serving more than one million patients per year and expanding specialty pharmacy services. We also serve an estimated 34 million people through traditional, voluntary and consumer-directed health insurance products and related services, including expanding Medicare Advantage offerings and a leading standalone Medicare Part D prescription drug plan (“PDP”). The Company believes its innovative health care model increases access to quality care, delivers better health outcomes and lowers overall health care costs.On November 28, 2018 (the “Aetna Acquisition Date”), the Company acquired Aetna Inc. (“Aetna”). As a result of the acquisition of Aetna (the “Aetna Acquisition”), the Company added the Health Care Benefits segment. Certain aspects of Aetna’s operations, including products for which the Company no longer solicits or accepts new customers, such as large case pensions and long-term care insurance products, are included in the Company’s Corporate/Other segment. The consolidated financial statements reflect Aetna’s results subsequent to the Aetna Acquisition Date. The Company has four reportable segments: Pharmacy Services, Retail/LTC, Health Care Benefits and Corporate/Other, which are described below.Overview of the Pharmacy Services SegmentThe Pharmacy Services segment provides a full range of pharmacy benefit management (“PBM”) solutions, including plan design offerings and administration, formulary management, retail pharmacy network management services, mail order pharmacy, specialty pharmacy and infusion services, clinical services, disease management services and medical spend management. The Pharmacy Services segment’s clients are primarily employers, insurance companies, unions, government employee groups, health plans, PDPs, Medicaid managed care plans, plans offered on public health insurance exchanges and private health insurance exchanges and other sponsors of health benefit plans throughout the United States. The Pharmacy Services segment operates retail specialty pharmacy stores, specialty mail order pharmacies, mail order dispensing pharmacies, compounding pharmacies and branches for infusion and enteral nutrition services.Overview of the Retail/LTC SegmentThe Retail/LTC segment sells prescription drugs and a wide assortment of health and wellness products and general merchandise, provides health care services through its MinuteClinic® walk-in medical clinics, provides medical diagnostic testing, administers vaccinations for illnesses such as influenza, COVID-19 and shingles and conducts long-term care pharmacy (“LTC”) operations, which distribute prescription drugs and provide related pharmacy consulting and other ancillary services to long-term care facilities and other care settings. As of December 31, 2020, the Retail/LTC segment operated more than 9,900 retail locations, approximately 1,100 MinuteClinic locations as well as online retail pharmacy websites, LTC pharmacies and on-site pharmacies. For the year ended December 31, 2020, the Company dispensed approximately 27.1% of the total retail pharmacy prescriptions in the United States.Overview of the Health Care Benefits SegmentThe Health Care Benefits segment is one of the nation’s leading diversified health care benefits providers. The Health Care Benefits segment has the information and resources to help members, in consultation with their health care professionals, make more informed decisions about their health care. The Health Care Benefits segment offers a broad range of traditional, voluntary and consumer-directed health insurance products and related services, including medical, pharmacy, dental and behavioral health plans, medical management capabilities, Medicare Advantage and Medicare Supplement plans, PDPs, Medicaid health care management services and health information technology products and services. The Health Care Benefits 66segment also provided workers’ compensation administrative services through its Coventry Health Care Workers’ Compensation business (“Workers’ Compensation business”) prior to the sale of this business on July 31, 2020. The Health Care Benefits segment’s customers include employer groups, individuals, college students, part-time and hourly workers, health plans, health care providers (“providers”), governmental units, government-sponsored plans, labor groups and expatriates. The Company refers to insurance products (where it assumes all or a majority of the risk for medical and dental care costs) as “Insured” and administrative services contract products (where the plan sponsor assumes all or a majority of the risk for medical and dental care costs) as “ASC.” For periods prior to the Aetna Acquisition Date, the Health Care Benefits segment was comprised only of the Company’s SilverScript® PDP business.Overview of the Corporate/Other SegmentThe Company presents the remainder of its financial results in the Corporate/Other segment, which primarily consists of:•Management and administrative expenses to support the Company’s overall operations, which include certain aspects of executive management and the corporate relations, legal, compliance, human resources, information technology and finance departments, expenses associated with the Company’s investments in its transformation and enterprise modernization programs and acquisition-related transaction and integration costs; and•Products for which the Company no longer solicits or accepts new customers such as large case pensions and long-term care insurance products.67COVID-19The COVID-19 pandemic has severely impacted the economies of the U.S. and other countries around the world. Beginning in March 2020, the effects of the COVID-19 pandemic began to emerge in the U.S. The Company executed preparedness plans to maintain continuity of its operations, including transitioning many office-based colleagues to a remote work environment and installing protective equipment in our retail pharmacies. The Company also provided enhanced benefits to its colleagues, including bonuses to frontline colleagues, dependent care financial assistance, paid sick leave for part-time colleagues and paid time off to colleagues who test positive or are quarantined due to exposure to COVID-19. Our strong local presence and scale in communities across the country enabled us to play an indispensable role in the national response to COVID-19, as well as provide seamless support for our customers wherever they needed us: in our CVS locations, in their homes, and virtually. The COVID-19 pandemic had a significant impact on the Company’s operating results for the year ended December 31, 2020, primarily in the Company’s Health Care Benefits and Retail/LTC segments. Health Care Benefits SegmentBeginning in mid-March, the health system experienced a significant reduction in utilization of medical services (“utilization”) that is discretionary and the cancellation of elective medical procedures. Utilization remained below historical levels through April, began to recover in May and June and reached more normal levels in the third and fourth quarters, with select geographies impacted by COVID-19 waves. In response to COVID-19, the Company expanded benefit coverage to its members. These expanded benefits included cost-sharing waivers for COVID-19 related treatments, as well as assistance to members through premium credits, telehealth cost-sharing waivers and other investments. COVID-19 also resulted in a shift in the Company’s medical membership during the year. The Company experienced declines in Commercial membership due to reductions in workforce at our existing customers, substantially offset by increases in Medicaid membership primarily as a result of the suspension of eligibility redeterminations and increased unemployment. Retail/LTC SegmentDuring March 2020, the Company experienced increased prescription volume due to the greater use of 90-day prescriptions and early refills of maintenance medications, as well as increased front store volume as consumers prepared for the COVID-19 pandemic. Beginning in the second quarter and continuing throughout the remainder of the year, the Company experienced reduced customer traffic in its retail pharmacies and MinuteClinic locations due to shelter-in-place orders as well as reduced new therapy prescriptions and decreased long-term care prescription volume as a result of the COVID-19 pandemic. In addition, the Company incurred incremental operating expenses associated with the Company’s COVID-19 pandemic response efforts and waived fees associated with prescription home delivery and associated front store products.During 2020, the Company also played a key role in supporting the local communities in which it operates. The Company offered COVID-19 diagnostic testing at more than 4,000 CVS Pharmacy locations as of December 31, 2020. In addition, the Company launched critical diagnostic testing for the vulnerable senior population in long-term care facilities in partnership with three states. The Company was also selected to administer COVID-19 vaccines in both long-term care facilities and its retail pharmacies. The Company began administering COVID-19 vaccinations in long-term care facilities and in certain of its retail pharmacies during December 2020 and February 2021, respectively, and expects to play a significant role in COVID-19 vaccine administration in the future.The COVID-19 pandemic continues to evolve. We believe COVID-19’s impact on our businesses, operating results, cash flows and/or financial condition primarily will be driven by the geographies impacted and the severity and duration of the pandemic; the pandemic’s impact on the U.S. and global economies and consumer behavior and health care utilization patterns; and the timing, scope and impact of stimulus legislation as well as other federal, state and local governmental responses to the pandemic. Those primary drivers are beyond our knowledge and control. As a result, the impact COVID-19 will have on our businesses, operating results, cash flows and/or financial condition is uncertain, but the impact could be adverse and material. 68Results of OperationsThe following information summarizes the Company’s results of operations for 2020 compared to 2019. For discussion of the Company’s results of operations for 2019 compared to 2018, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2019 filed with the U.S. Securities and Exchange Commission (the “SEC”) on February 18, 2020.Summary of Consolidated Financial ResultsChangeYear Ended December 31, 2020 vs. 20192019 vs. 2018In millions202020192018$%$%Revenues:Products$190,688 $185,236 $183,910 $5,452 2.9 %$1,326 0.7 %Premiums69,364 63,122 8,184 6,242 9.9 %54,938 671.3 %Services7,856 7,407 1,825 449 6.1 %5,582 305.9 %Net investment income798 1,011 660 (213)(21.1)%351 53.2 %Total revenues268,706 256,776 194,579 11,930 4.6 %62,197 32.0 %Operating costs:Cost of products sold163,981 158,719 156,447 5,262 3.3 %2,272 1.5 %Benefit costs55,679 52,529 6,594 3,150 6.0 %45,935 696.6 %Goodwill impairments— — 6,149 — — %(6,149)(100.0)%Operating expenses35,135 33,541 21,368 1,594 4.8 %12,173 57.0 %Total operating costs254,795 244,789 190,558 10,006 4.1 %54,231 28.5 %Operating income13,911 11,987 4,021 1,924 16.1 %7,966 198.1 %Interest expense2,907 3,035 2,619 (128)(4.2)%416 15.9 %Loss on early extinguishment of debt1,440 79 — 1,361 1,722.8 %79 — %Other income(206)(124)(4)(82)(66.1)%(120)(3,000.0)%Income before income tax provision9,770 8,997 1,406 773 8.6 %7,591 539.9 %Income tax provision2,569 2,366 2,002 203 8.6 %364 18.2 %Income (loss) from continuing operations7,201 6,631 (596)570 8.6 %7,227 1,212.6 %Loss from discontinued operations, net of tax(9)— — (9)— %— — %Net income (loss)7,192 6,631 (596)561 8.5 %7,227 1,212.6 %Net (income) loss attributable to noncontrolling interests(13)3 2 (16)(533.3)%1 50.0 %Net income (loss) attributable to CVS Health$7,179 $6,634 $(594)$545 8.2 %$7,228 1,216.8 %Commentary - 2020 compared to 2019Revenues•Total revenues increased $11.9 billion or 4.6% in 2020 compared to 2019. The increase in total revenues was primarily driven by growth in the Health Care Benefits and Retail/LTC segments.•Please see “Segment Analysis” later in this MD&A for additional information about the revenues of the Company’s segments.Operating expenses•Operating expenses increased $1.6 billion or 4.8% in 2020 compared to 2019. Operating expenses as a percentage of total revenues remained consistent at 13.1% in both 2020 and 2019. The increase in operating expenses was primarily due to the reinstatement of the non-deductible health insurer fee (“HIF”) which was $1.0 billion for 2020, incremental operating expenses associated with the Company’s COVID-19 pandemic response efforts and increased operating expenses associated with growth in the business. The increase in operating expenses was partially offset by (i) a $269 million pre-tax gain on the sale of the Workers’ Compensation business, which occurred on July 31, 2020, (ii) the absence of $231 million of store rationalization charges and a $205 million pre-tax loss on the sale of the Company’s Brazilian subsidiary, Drogaria 69Onofre Ltda. (“Onofre”), both recorded in the year ended December 31, 2019, and (iii) the favorable impact of enterprise-wide cost savings initiatives in 2020. •Please see “Segment Analysis” later in this MD&A for additional information about the operating expenses of the Company’s segments.Operating income •Operating income increased $1.9 billion or 16.1% in 2020 compared to 2019. The increase in operating income was primarily due to:•Increased operating income in the Health Care Benefits segment, primarily as a result of the COVID-19 pandemic, pre-tax income of $307 million associated with the receipt of amounts owed to the Company under the Patient Protection and Affordable Care Act and the Health Care and Education Reconciliation Act of 2010 (collectively, the “ACA”) risk corridor program that was previously fully reserved for as payment was uncertain, and the $269 million pre-tax gain on the sale of the Workers’ Compensation business;•Increased operating income in the Pharmacy Services segment, primarily related to improved purchasing economics; and•The favorable impact of enterprise-wide cost savings initiatives in 2020, partially offset by:•Decreased operating income in the Retail/LTC segment, primarily as a result of continued reimbursement pressure and the net adverse impact of the COVID-19 pandemic, partially offset by the absence of $231 million of store rationalization charges and the $205 million pre-tax loss on the sale of Onofre, both recorded in 2019.•Please see “Segment Analysis” later in this MD&A for additional information about the operating income of the Company’s segments.Interest expense•Interest expense decreased $128 million in 2020 compared to 2019, primarily due to lower average debt in 2020. See “Liquidity and Capital Resources” later in this report for additional information.Loss on early extinguishment of debt•During 2020, the loss on early extinguishment of debt relates to the Company’s repayment of $6.0 billion of its outstanding senior notes pursuant to its tender offers for such senior notes in August 2020, which resulted in a loss on early extinguishment of debt of $766 million, and the repayment of $4.5 billion of its outstanding senior notes pursuant to its tender offers for such senior notes in December 2020, which resulted in a loss on early extinguishment of debt of $674 million. During 2019, the loss on early extinguishment of debt relates to the Company’s repayment of $4.0 billion of its outstanding senior notes pursuant to its tender offers for such senior notes in August 2019, which resulted in a loss on early extinguishment of debt of $79 million. See Note 8 ‘‘Borrowings and Credit Agreements’’ included in Item 8 of this 10-K for additional information. Other income•Other income increased $82 million in 2020 compared to 2019. Other income represents pension plan asset returns in excess of interest cost on pension plan obligations. The increase in other income in 2020 was primarily due to lower discount rates in 2020 compared to 2019 when determining the interest cost on the Company’s pension plan obligations as well as strong plan asset returns. Income tax provision•The Company’s effective income tax rate remained consistent at 26.3% in both 2020 and 2019, with the impact of the non-deductible HIF offset by the favorable resolution of certain tax matters in the year ended December 31, 2020.Loss from discontinued operations•In connection with certain business dispositions completed between 1995 and 1997, the Company retained guarantees on store lease obligations for a number of former subsidiaries, including Linens ‘n Things and Bob’s Stores, each of which subsequently filed for bankruptcy. The Company’s loss from discontinued operations in 2020 primarily includes lease-related costs required to satisfy these lease guarantees.•See “Discontinued Operations” in Note 1 ‘‘Significant Accounting Policies’’ and “Lease Guarantees” in Note 16 ‘‘Commitments and Contingencies’’ included in Item 8 of this 10-K for additional information about the Company’s discontinued operations and the Company’s lease guarantees, respectively.70Outlook for 2021With respect to 2021, the Company believes you should consider the following important information:•The Pharmacy Services segment is expected to benefit from continued growth in specialty pharmacy and our ability to drive further improvements in purchasing economics, partially offset by continued price compression.•The Retail/LTC segment is expected to benefit from increased prescription volume, diagnostic testing and improved generic drug purchasing, partially offset by continued reimbursement pressure and operating expenses associated with the Company’s COVID-19 pandemic response efforts. The projected adjusted prescription growth is expected to be driven by the continued successful execution of our patient care programs, the anticipated return of provider visits as we move through the year and vaccination administration. While lower front store traffic has persisted into the first quarter of 2021, we expect front store traffic to increase as we move through the year. •The Health Care Benefits segment is expected to benefit from Medicare membership growth, partially offset by membership declines in our Medicaid products, the adverse impact of the COVID-19 pandemic and the removal of the HIF. The projected MBR is expected to increase compared to 2020, reflecting the return to more normal levels of utilization, the removal of the HIF, lower Medicare risk adjustment revenue and the continued shift in business mix. The COVID-19 pandemic is expected to adversely impact earnings in 2021 due to the regulatory changes included in the Consolidated Appropriations Act of 2021; testing, treatment and vaccination costs; and lower Medicare risk adjustment revenue.•The Company is expected to benefit from the continuation of its enterprise-wide cost savings initiatives that are expected to ramp as we move through the year. Key drivers include:◦The ongoing digitalization of our business along with technology improvements in our operations, ◦Office real estate reductions associated with workforce management changes and ◦Productivity/operational efficiency initiatives within each of the Company’s segments. •Based upon current tax legislation, the Company expects its effective income tax rate to decrease primarily due to the removal of the HIF in 2021. •The Company expects changes to its business environment to continue as elected and other government officials at the national and state levels continue to propose and enact significant modifications to public policy and existing laws and regulations that govern or impact the Company’s businesses.The Company’s current expectations described above are forward-looking statements. Please see “Risk Factors” included in Item 1A of this 10-K and the “Cautionary Statement Concerning Forward-Looking Statements” in this 10-K for information regarding important factors that may cause the Company’s actual results to differ from those currently projected and/or otherwise materially affect the Company.71Segment AnalysisThe following discussion of segment operating results is presented based on the Company’s reportable segments in accordance with the accounting guidance for segment reporting and is consistent with the segment disclosure in Note 17 ‘‘Segment Reporting’’ included in Item 8 of this 10-K.The Company has three operating segments, Pharmacy Services, Retail/LTC and Health Care Benefits, as well as a Corporate/Other segment. The Company’s segments maintain separate financial information, and the Company’s chief operating decision maker (“CODM”) evaluates the segments’ operating results on a regular basis in deciding how to allocate resources among the segments and in assessing segment performance. The CODM evaluates the performance of the Company’s segments based on adjusted operating income, which is defined as operating income (GAAP measure) excluding the impact of amortization of intangible assets and other items, if any, that neither relate to the ordinary course of the Company’s business nor reflect the Company’s underlying business performance. See the reconciliations of operating income (GAAP measure) to adjusted operating income below for further context regarding the items excluded from operating income in determining adjusted operating income. The Company uses adjusted operating income as its principal measure of segment performance as it enhances the Company’s ability to compare past financial performance with current performance and analyze underlying business performance and trends. Non-GAAP financial measures the Company discloses, such as consolidated adjusted operating income, should not be considered a substitute for, or superior to, financial measures determined or calculated in accordance with GAAP.The following is a reconciliation of financial measures of the Company’s segments to the consolidated totals:In millionsPharmacyServices (1)Retail/LTCHealth CareBenefitsCorporate/OtherIntersegmentEliminations (2)ConsolidatedTotals2020Total revenues $141,938 $91,198 $75,467 $426 $(40,323)$268,706 Adjusted operating income (loss)5,688 6,146 6,188 (1,306)(708)16,008 2019Total revenues141,491 86,608 69,604 512 (41,439)256,776 Adjusted operating income (loss)5,129 6,705 5,202 (1,000)(697)15,339 2018Total revenues134,736 83,989 8,962 606 (33,714)194,579 Adjusted operating income (loss)4,955 7,403 528 (856)(769)11,261 _____________________________________________(1)Total revenues of the Pharmacy Services segment include approximately $10.9 billion, $11.5 billion and $11.4 billion of retail co-payments for 2020, 2019 and 2018, respectively. See Note 1 ‘‘Significant Accounting Policies’’ included in Item 8 of this 10-K for additional information about retail co-payments.(2)Intersegment eliminations relate to intersegment revenue generating activities that occur between the Pharmacy Services segment, the Retail/LTC segment and/or the Health Care Benefits segment. 72The following are reconciliations of operating income to adjusted operating income for the years ended December 31, 2020, 2019 and 2018:Year Ended December 31, 2020In millionsPharmacy ServicesRetail/LTCHealth CareBenefitsCorporate/OtherIntersegmentEliminationsConsolidatedTotalsOperating income (loss) (GAAP measure)$5,454 $5,640 $5,166 $(1,641)$(708)$13,911 Non-GAAP adjustments:Amortization of intangible assets (1)234 506 1,598 3 — 2,341 Acquisition-related integration costs (2)— — — 332 — 332 Gain on divestiture of subsidiary (3)— — (269)— — (269)Receipt of fully reserved ACA risk corridor receivable (4)— — (307)— — (307)Adjusted operating income (loss)$5,688 $6,146 $6,188 $(1,306)$(708)$16,008 Year Ended December 31, 2019In millionsPharmacy ServicesRetail/LTCHealth CareBenefitsCorporate/OtherIntersegmentEliminationsConsolidatedTotalsOperating income (loss) (GAAP measure)$4,735 $5,793 $3,639 $(1,483)$(697)$11,987 Non-GAAP adjustments:Amortization of intangible assets (1)394 476 1,563 3 — 2,436 Acquisition-related integration costs (2)— — — 480 — 480 Loss on divestiture of subsidiary (3)— 205 — — — 205 Store rationalization charges (5)— 231 — — — 231 Adjusted operating income (loss)$5,129 $6,705 $5,202 $(1,000)$(697)$15,339 Year Ended December 31, 2018In millionsPharmacy ServicesRetail/LTCHealth CareBenefitsCorporate/OtherIntersegmentEliminationsConsolidatedTotalsOperating income (loss) (GAAP measure)$4,607 $620 $368 $(805)$(769)$4,021 Non-GAAP adjustments:Amortization of intangible assets (1)348 498 160 — — 1,006 Acquisition-related transaction and integration costs (2)— 7 — 485 — 492 Loss on divestiture of subsidiary (3)— 86 — — — 86 Goodwill impairments (6)— 6,149 — — — 6,149 Impairment of long-lived assets (7)— 43 — — — 43 Interest income on financing for the Aetna Acquisition (8)— — — (536)— (536)Adjusted operating income (loss)$4,955 $7,403 $528 $(856)$(769)$11,261 _____________________________________________(1)The Company’s acquisition activities have resulted in the recognition of intangible assets as required under the acquisition method of accounting which consist primarily of trademarks, customer contracts/relationships, covenants not to compete, technology, provider networks and value of business acquired. Definite-lived intangible assets are amortized over their estimated useful lives and are tested for impairment when events indicate that the carrying value may not be recoverable. The amortization of intangible assets is reflected in the Company’s statements of operations in operating expenses within each segment. Although intangible assets contribute to the Company’s revenue generation, the amortization of intangible assets does not directly relate to the underwriting of the Company’s insurance products, the services performed for the Company’s customers or the sale of the Company’s products or services. Additionally, intangible asset amortization expense typically fluctuates based on the size and timing of the Company’s acquisition activity. Accordingly, the Company believes excluding the amortization of intangible assets enhances the Company’s and investors’ ability to compare the Company’s past financial performance with its current performance and to analyze underlying business performance and trends. Intangible asset amortization excluded from the related non-GAAP financial measure represents the entire amount recorded within the Company’s GAAP financial statements, and the revenue generated by the associated intangible assets has not been excluded from the related non-GAAP financial measure. Intangible asset amortization is excluded from the related non-GAAP financial measure because the amortization, unlike the related revenue, is not affected by operations of any particular period unless an intangible asset becomes impaired or the estimated useful life of an intangible asset is revised.73(2)In 2020, 2019 and 2018, acquisition-related transaction and integration costs relate to the Aetna Acquisition. In 2018, acquisition-related integration costs also relate to the acquisition of Omnicare, Inc. (“Omnicare”). The acquisition-related transaction and integration costs are reflected in the Company’s consolidated statements of operations in operating expenses within the Corporate/Other segment and the Retail/LTC segment.(3)In 2020, the gain on divestiture of subsidiary represents the pre-tax gain on the sale of the Workers’ Compensation business, which the Company sold on July 31, 2020 for approximately $850 million. The gain on divestiture is reflected as a reduction in operating expenses in the Company’s consolidated statement of operations within the Health Care Benefits segment. In 2019, the loss on divestiture of subsidiary represents the pre-tax loss on the sale of Onofre, which occurred on July 1, 2019. The loss on divestiture primarily relates to the elimination of the cumulative translation adjustment from accumulated other comprehensive income. In 2018, the loss on divestiture of subsidiary represents the pre-tax loss on the sale of the Company’s RxCrossroads subsidiary for $725 million on January 2, 2018. The losses on divestiture in 2019 and 2018 are reflected in the Company’s consolidated statements of operations in operating expenses within the Retail/LTC segment.(4)In 2020, the Company received $313 million owed to it under the ACA’s risk corridor program that was previously fully reserved for as payment was uncertain. After considering offsetting items such as the ACA’s minimum medical loss ratio (“MLR”) rebate requirements and premium taxes, the Company recognized pre-tax income of $307 million in the Company’s consolidated statement of operations within the Health Care Benefits segment.(5)In 2019, the store rationalization charges relate to the planned closure of 46 underperforming retail pharmacy stores in the second quarter of 2019 and the planned closure of 22 underperforming retail pharmacy stores in the first quarter of 2020. The store rationalization charges primarily relate to operating lease right-of-use asset impairment charges and are reflected in the Company’s consolidated statement of operations in operating expenses within the Retail/LTC segment.(6)In 2018, the goodwill impairments relate to the LTC reporting unit within the Retail/LTC segment. (7)In 2018, impairment of long-lived assets primarily relates to the impairment of property and equipment within the Retail/LTC segment and is reflected in operating expenses in the Company’s consolidated statement of operations.(8)In 2018, the Company recorded interest income of $536 million on the proceeds of the $40 billion of unsecured senior notes it issued in March 2018 to partially fund the Aetna Acquisition. All amounts are for the periods prior to the close of the Aetna Acquisition, which occurred on November 28, 2018, and were recorded within the Corporate/Other segment.74Pharmacy Services SegmentThe following table summarizes the Pharmacy Services segment’s performance for the respective periods:ChangeYear Ended December 31,2020 vs. 20192019 vs. 2018In millions, except percentages202020192018$%$%Revenues:Products$140,950$140,946$134,285$4 — %$6,661 5.0 %Services988545451443 81.3 %94 20.8 %Total revenues141,938141,491134,736447 0.3 %6,755 5.0 %Cost of products sold135,045135,245128,777(200)(0.1)%6,468 5.0 %Operating expenses1,4391,5111,352(72)(4.8)%159 11.8 %Operating expenses as a % of total revenues1.0 %1.1 %1.0 %Operating income$5,454$4,735$4,607$719 15.2 %$128 2.8 %Operating income as a % of total revenues3.8 %3.3 %3.4 %Adjusted operating income (1)$5,688$5,129$4,955$559 10.9 %$174 3.5 %Adjusted operating income as a % of total revenues4.0 %3.6 %3.7 %Revenues (by distribution channel): Pharmacy network (2)$85,045$88,755$87,167$(3,710)(4.2)%$1,588 1.8 %Mail choice (3)56,07152,14147,0493,930 7.5 %5,092 10.8 %Other822595520227 38.2 %75 14.4 %Pharmacy claims processed: (4)Total2,112.92,014.21,889.898.7 4.9 %124.4 6.6 %Pharmacy network (2)1,790.11,704.01,601.486.1 5.1 %102.6 6.4 %Mail choice (3)322.8310.2288.412.6 4.1 %21.8 7.6 %Generic dispensing rate: (4)Total88.2 %88.2 %87.3 %Pharmacy network (2)88.7 %88.7 %87.9 %Mail choice (3)85.3 %85.1 %83.9 %_____________________________________________(1)See “Segment Analysis” above in this MD&A for a reconciliation of operating income (GAAP measure) to adjusted operating income for the Pharmacy Services segment.(2)Pharmacy network is defined as claims filled at retail and specialty retail pharmacies, including the Company’s retail pharmacies and LTC pharmacies, but excluding Maintenance Choice® activity, which is included within the mail choice category. Maintenance Choice permits eligible client plan members to fill their maintenance prescriptions through mail order delivery or at a CVS pharmacy retail store for the same price as mail order.(3)Mail choice is defined as claims filled at a Pharmacy Services mail order facility, which includes specialty mail claims inclusive of Specialty Connect® claims picked up at a retail pharmacy, as well as prescriptions filled at the Company’s retail pharmacies under the Maintenance Choice program.(4)Includes an adjustment to convert 90-day prescriptions to the equivalent of three 30-day prescriptions. This adjustment reflects the fact that these prescriptions include approximately three times the amount of product days supplied compared to a normal prescription.Commentary - 2020 compared to 2019Revenues•Total revenues increased $447 million, or 0.3%, to $141.9 billion in 2020 compared to 2019. The increase was primarily driven by growth in specialty pharmacy and brand inflation, partially offset by continued price compression and changes in net new business mix.75Operating expenses•Operating expenses in the Pharmacy Services segment include selling, general and administrative expenses; depreciation and amortization expense; and expenses related to specialty retail pharmacies, which include store and administrative payroll, employee benefits and occupancy costs.•Operating expenses decreased $72 million, or 4.8%, in 2020 compared to 2019 primarily driven by lower amortization expense in 2020, partially offset by incremental operating expenses associated with growth in the business, including investments in the Company’s growth initiatives.•Operating expenses as a percentage of total revenues remained relatively consistent at 1.0% and 1.1% in 2020 and 2019, respectively. Operating income and adjusted operating income•Operating income increased $719 million, or 15.2%, and adjusted operating income increased $559 million, or 10.9%, in 2020 compared to 2019. The increase in both operating income and adjusted operating income was primarily driven by improved purchasing economics and growth in specialty pharmacy, partially offset by continued price compression. The increase in operating income also was driven by lower amortization expense in 2020.•As you review the Pharmacy Services segment’s performance in this area, you should consider the following important information about the business:•The Company’s efforts to (i) retain existing clients, (ii) obtain new business and (iii) maintain or improve the rebates and/or discounts the Company receives from manufacturers, wholesalers and retail pharmacies continue to have an impact on operating income and adjusted operating income. In particular, competitive pressures in the PBM industry have caused the Company and other PBMs to continue to share with clients a larger portion of rebates and/or discounts received from pharmaceutical manufacturers. In addition, marketplace dynamics and regulatory changes have limited the Company’s ability to offer plan sponsors pricing that includes retail network “differential” or “spread,” and the Company expects these trends to continue. The “differential” or “spread” is any difference between the drug price charged to plan sponsors, including Medicare Part D plan sponsors, by a PBM and the price paid for the drug by the PBM to the dispensing provider.Pharmacy claims processed•Total pharmacy claims processed represents the number of prescription claims processed through our pharmacy benefits manager and dispensed by either our retail network pharmacies or our own mail and specialty pharmacies. Management uses this metric to understand variances between actual claims processed and expected amounts as well as trends in period-over-period results. This metric provides management and investors with information useful in understanding the impact of pharmacy claim volume on segment total revenues and operating results.•The Company’s pharmacy network claims processed on a 30-day equivalent basis increased 5.1% to 1.8 billion claims in 2020 compared to 1.7 billion claims in 2019. The increase in pharmacy network claims processed was primarily driven by net new business.•The Company’s mail choice claims processed on a 30-day equivalent basis increased 4.1% to 322.8 million claims in 2020 compared to 310.2 million claims in 2019. The increase in mail choice claims was primarily driven by net new business and the continued adoption of Maintenance Choice offerings. Generic dispensing rate•Generic dispensing rate is calculated by dividing the Pharmacy Services segment’s generic drug prescriptions processed or filled by its total prescriptions processed or filled. Management uses this metric to evaluate the effectiveness of the business at encouraging the use of generic drugs when they are available and clinically appropriate, which aids in decreasing costs for client members and retail customers. This metric provides management and investors with information useful in understanding trends in segment total revenues and operating results. •The Pharmacy Services segment’s total generic dispensing rate remained consistent at 88.2% in both 2020 and 2019. 76Retail/LTC SegmentThe following table summarizes the Retail/LTC segment’s performance for the respective periods:ChangeYear Ended December 31,2020 vs. 20192019 vs. 2018In millions, except percentages202020192018$%$%Revenues:Products$89,944$85,729$83,175$4,215 4.9 %$2,554 3.1 %Services1,254879814375 42.7 %65 8.0 %Total revenues91,19886,60883,9894,590 5.3 %2,619 3.1 %Cost of products sold 67,28462,68859,9064,596 7.3 %2,782 4.6 %Goodwill impairments——6,149— — %(6,149)(100.0)%Operating expenses18,27418,12717,314147 0.8 %813 4.7 %Operating expenses as a % of total revenues20.0 %20.9 %20.6 %Operating income$5,640$5,793$620$(153)(2.6)%$5,173 834.4 %Operating income as a % of total revenues6.2 %6.7 %0.7 %Adjusted operating income (1)$6,146$6,705$7,403$(559)(8.3)%$(698)(9.4)%Adjusted operating income as a % of total revenues6.7 %7.7 %8.8 %Revenues (by major goods/service lines):Pharmacy$70,176$66,442$64,179$3,734 5.6 %$2,263 3.5 %Front Store19,65519,42219,055233 1.2 %367 1.9 %Other1,367744755623 83.7 %(11)(1.5)%Prescriptions filled (2)1,465.21,417.21,339.148.0 3.4 %78.1 5.8 %Same store sales increase: (3)Total5.6 %3.7 %6.0 %Pharmacy7.0 %4.5 %7.9 %Front Store0.9 %1.1 %0.5 %Prescription volume (2)4.7 %7.2 %9.1 %Generic dispensing rate (2)88.3 %88.3 %87.5 %_____________________________________________(1)See “Segment Analysis” above in this MD&A for a reconciliation of operating income (GAAP measure) to adjusted operating income for the Retail/LTC segment.(2)Includes an adjustment to convert 90‑day prescriptions to the equivalent of three 30‑day prescriptions. This adjustment reflects the fact that these prescriptions include approximately three times the amount of product days supplied compared to a normal prescription.(3)Same store sales and prescription volume represent the change in revenues and prescriptions filled in the Company’s retail pharmacy stores that have been operating for greater than one year, expressed as a percentage that indicates the increase or decrease relative to the comparable prior period. Same store metrics exclude revenues from MinuteClinic, revenues and prescriptions from LTC operations and, in 2019 and 2018, revenues and prescriptions from stores in Brazil. Management uses these metrics to evaluate the performance of existing stores on a comparable basis and to inform future decisions regarding existing stores and new locations. Same-store metrics provide management and investors with information useful in understanding the portion of current revenues and prescriptions resulting from organic growth in existing locations versus the portion resulting from opening new stores.Commentary - 2020 compared to 2019Revenues •Total revenues increased $4.6 billion, or 5.3%, to $91.2 billion in 2020 compared to 2019. The increase was primarily driven by increased prescription volume, COVID-19 diagnostic testing and brand inflation, partially offset by continued reimbursement pressure and the impact of recent generic introductions.•Pharmacy same store sales increased 7.0% in 2020 compared to 2019. The increase was driven by the 4.7% increase in pharmacy same store prescription volume on a 30-day equivalent basis, pharmacy drug mix and brand inflation. These increases were partially offset by continued reimbursement pressure and the impact of recent generic introductions.77•Front store same store sales increased 0.9% in 2020 compared to 2019. The increase was primarily due to increases in consumer health and general merchandise sales.•Other revenues increased 83.7% in 2020 compared to 2019. The increase was primarily due to increased diagnostic testing in response to the COVID-19 pandemic in 2020.Operating expenses•Operating expenses in the Retail/LTC segment include store payroll, store employee benefits, store occupancy costs, selling expenses, advertising expenses, depreciation and amortization expense and certain administrative expenses.•Operating expenses increased $147 million, or 0.8%, in 2020 compared to 2019. The increase was primarily due to incremental operating expenses associated with the Company’s COVID-19 pandemic response efforts, the increased volume described above and investments in the business in 2020. The increase was partially offset by the absence of $231 million of store rationalization charges in connection with the planned closure of underperforming retail pharmacy stores and the $205 million pre-tax loss on the sale of Onofre, both recorded in 2019, as well as the impact of cost savings initiatives in 2020. •Operating expenses as a percentage of total revenues decreased to 20.0% in 2020 compared to 20.9% in 2019. The decrease in operating expenses as a percentage of total revenues was primarily driven by the increases in total revenues described above.Operating income and adjusted operating income•Operating income decreased $153 million, or 2.6%, and adjusted operating income decreased $559 million, or 8.3%, in 2020 compared to 2019. The decrease in both operating income and adjusted operating income was primarily due to continued reimbursement pressure and the net impact of the COVID-19 pandemic, partially offset by the increased pharmacy volume described above and improved generic drug purchasing. The COVID-19 pandemic resulted in reduced operating income and adjusted operating income in 2020 as a result of decreased customer traffic in the segment’s retail pharmacies and MinuteClinic locations and incremental operating expenses associated with the Company’s COVID-19 pandemic response efforts, partially offset by COVID-19 diagnostic testing. The decrease in operating income also was partially offset by the absence of the $231 million of store rationalization charges and the $205 million pre-tax loss on the sale of Onofre, both recorded in 2019.•As you review the Retail/LTC segment’s performance in this area, you should consider the following important information about the business:•The segment’s pharmacy operating income and adjusted operating income have been adversely affected by the efforts of managed care organizations, PBMs and governmental and other third-party payors to reduce their prescription drug costs, including the use of restrictive networks, as well as changes in the mix of business within the pharmacy portion of the Retail/LTC segment. If the reimbursement pressure accelerates, the segment may not be able to grow revenues, and its operating income and adjusted operating income could be adversely affected.•The increased use of generic drugs has positively impacted the segment’s operating income and adjusted operating income but has resulted in third-party payors augmenting their efforts to reduce reimbursement payments to retail pharmacies for prescriptions. This trend, which the Company expects to continue, reduces the benefit the segment realizes from brand-to-generic drug conversions.Prescriptions filled•Prescriptions filled represents the number of prescriptions dispensed through the Retail/LTC segment’s pharmacies. Management uses this metric to understand variances between actual prescriptions dispensed and expected amounts as well as trends in period-over-period results. This metric provides management and investors with information useful in understanding the impact of prescription volume on segment total revenues and operating results.•Prescriptions filled increased 3.4% on a 30-day equivalent basis in 2020 compared to 2019 primarily driven by the continued adoption of patient care programs, partially offset by reduced new therapy prescriptions as a result of the COVID-19 pandemic and decreased long-term care prescription volume.Generic dispensing rate•Generic dispensing rate is calculated by dividing the Retail/LTC segment’s generic drug prescriptions filled by its total prescriptions filled. Management uses this metric to evaluate the effectiveness of the business at encouraging the use of generic drugs when they are available and clinically appropriate, which aids in decreasing costs for client members and retail customers. This metric provides management and investors with information useful in understanding trends in segment total revenues and operating results. •The Retail/LTC segment’s generic dispensing rate remained consistent at 88.3% in both 2020 and 2019. 78Health Care Benefits Segment For periods prior to November 28, 2018 (the Aetna Acquisition Date), the Health Care Benefits segment was comprised only of the Company’s SilverScript PDP business. The following table summarizes the Health Care Benefits segment’s performance for the respective periods:ChangeYear Ended December 31,2020 vs. 20192019 vs. 2018In millions, except percentages and basis points (“bps”)202020192018$%$%Revenues:Products$—$—$164$—— %$(164)(100.0)%Premiums69,30163,0318,1806,2709.9 %54,851 670.6 %Services5,6835,974560(291)(4.9)%5,414 966.8 %Net investment income48359958(116)(19.4)%541 932.8 %Total revenues75,46769,6048,9625,8638.4 %60,642 676.7 %Cost of products sold——147—— %(147)(100.0)%Benefit costs56,08353,0926,6782,9915.6 %46,414 695.0 %MBR (Benefit costs as a % of premium revenues) (1) 80.9 %84.2 %NM(330)bpsNMOperating expenses$14,218$12,873$1,769$1,34510.4 %$11,104 627.7 %Operating expenses as a % of total revenues18.8 %18.5 %19.7 %Operating income$5,166$3,639$368$1,52742.0 %$3,271 888.9 %Operating income as a % of total revenues6.8 %5.2 %4.1 %Adjusted operating income (2)$6,188$5,202$528$98619.0 %$4,674 885.2 %Adjusted operating income as a % of total revenues8.2 %7.5 %5.9 %Premium revenues (by business):Government$48,928$41,818$6,091$7,11017.0 %$35,727586.6 %Commercial20,37321,2132,089(840)(4.0)%19,124915.5 %_____________________________________________(1)For periods prior to the Aetna Acquisition Date, the Health Care Benefits segment was comprised only of the Company’s SilverScript PDP business. Accordingly, the MBR for the year ended December 31, 2018 is not meaningful (“NM”) and is not directly comparable to the MBRs for the years ended December 31, 2020 and 2019.(2)See “Segment Analysis” above in this MD&A for a reconciliation of operating income (GAAP measure) to adjusted operating income for the Health Care Benefits segment.Commentary - 2020 compared to 2019Revenues •Total revenues increased $5.9 billion, or 8.4%, to $75.5 billion in 2020 compared to 2019 primarily driven by membership growth in the Health Care Benefits segment’s Government products, the favorable impact of the reinstatement of the HIF for 2020 and the receipt of $313 million owed to the Company under the ACA’s risk corridor program. These increases were partially offset by the divestitures of Aetna’s standalone PDPs (which the Company retained the financial results of through 2019) and Workers’ Compensation business, membership declines in the segment’s Commercial products and COVID-19 related investments benefiting customers in 2020.Medical Benefit Ratio (“MBR”)•Medical benefit ratio is calculated as benefit costs divided by premium revenues and represents the percentage of premium revenues spent on medical benefits for the Company’s Insured members. Management uses MBR to assess the underlying business performance and underwriting of its insurance products, understand variances between actual results and expected results and identify trends in period-over-period results. MBR provides management and investors with information useful in assessing the operating results of the Company’s Insured Health Care Benefits products.•The Health Care Benefits segment’s MBR decreased 330 basis points from 84.2% to 80.9% in 2020 compared to 2019. The decrease was primarily due to (i) the impact of the COVID-19 pandemic, which resulted in reduced benefit costs due 79to the deferral of elective procedures and other discretionary utilization, partially offset by COVID-19 related investments, testing and treatment costs, (ii) the reinstatement of the HIF for 2020 and (iii) the receipt of amounts owed to the Company under the ACA’s risk corridor program in 2020. Operating expenses•Operating expenses in the Health Care Benefits segment include selling, general and administrative expenses and depreciation and amortization expenses.•Operating expenses increased $1.3 billion in 2020 compared to 2019. The increase in operating expenses was primarily due to the reinstatement of the HIF which was $1.0 billion for 2020 and incremental operating expenses to support the increased membership described above, including operating expenses to support additional Medicaid members onboarded during the first quarter of 2020. The increase was partially offset by the divestitures of Aetna’s standalone PDPs and Workers’ Compensation business, the $269 million pre-tax gain on the sale of the Workers’ Compensation business and the impact of cost savings initiatives in 2020.Operating income and adjusted operating income•Operating income and adjusted operating income increased $1.5 billion and $1.0 billion, respectively, in 2020 compared to 2019. The increase in both operating income and adjusted operating income was primarily driven by the impact of the COVID-19 pandemic, partially offset by the divestitures of Aetna’s standalone PDPs and Workers’ Compensation business. The COVID-19 pandemic resulted in reduced benefit costs due to the deferral of elective procedures and other discretionary utilization, partially offset by COVID-19 related investments, testing and treatment costs. Operating income also includes pre-tax income of $307 million associated with the receipt of amounts owed to the Company under the ACA’s risk corridor program and the $269 million pre-tax gain on the sale of the Workers’ Compensation business in 2020.The following table summarizes the Health Care Benefits segment’s medical membership as of December 31, 2020 and 2019:20202019In thousandsInsuredASC TotalInsuredASCTotalMedical membership:Commercial3,258 13,644 16,902 3,591 14,159 17,750 Medicare Advantage2,705 — 2,705 2,321 — 2,321 Medicare Supplement1,082 — 1,082 881 — 881 Medicaid2,100 623 2,723 1,398 558 1,956 Total medical membership9,145 14,267 23,412 8,191 14,717 22,908 Supplemental membership information:Medicare Prescription Drug Plan (standalone) (1)5,490 5,994 _____________________________________________(1)Represents the Company’s SilverScript PDP membership only. Excludes 2.5 million members as of December 31, 2019 related to Aetna’s standalone PDPs that were sold effective December 31, 2018. The Company retained the financial results of the divested plans through 2019 through a reinsurance agreement. Subsequent to 2019, the Company no longer retains the financial results of the divested plans.Medical Membership•Medical membership represents the number of members covered by the Company’s Insured and ASC medical products and related services at a specified point in time. Management uses this metric to understand variances between actual medical membership and expected amounts as well as trends in period-over-period results. This metric provides management and investors with information useful in understanding the impact of medical membership on segment total revenues and operating results.•Medical membership as of December 31, 2020 of 23.4 million increased 504 thousand compared with December 31, 2019, primarily reflecting increases in Medicaid and Medicare products, partially offset by declines in Commercial products.Medicare UpdateOn April 6, 2020, the U.S. Centers for Medicare & Medicaid Services (“CMS”) issued its final notice detailing final 2021 Medicare Advantage benchmark payment rates (the “Final Notice”). Overall the Company projects the benchmark rates in the Final Notice will increase funding for its Medicare Advantage business, excluding the impact of the HIF in 2020, by approximately 1.8% in 2021 compared to 2020. 80On January 15, 2021, CMS issued its Final Notice detailing final 2022 Medicare Advantage benchmark payment rates. Final 2022 Medicare Advantage rates resulted in an increase in industry benchmark rates of approximately 4.1%.The ACA ties a portion of each Medicare Advantage plan’s reimbursement to the plan’s “star ratings.” Plans must have a star rating of four or higher (out of five) to qualify for bonus payments. CMS released the Company’s 2021 star ratings in October 2020. The Company’s 2021 star ratings will be used to determine which of the Company’s Medicare Advantage plans have ratings of four stars or higher and qualify for bonus payments in 2022. Based on the Company’s membership at December 31, 2020, 83% of the Company’s Medicare Advantage members were in plans with 2021 star ratings of at least four stars, consistent with 83% of the Company’s Medicare Advantage members being in plans with 2020 star ratings of at least four stars based on the Company’s membership at December 31, 2019.Corporate/Other SegmentThe following table summarizes the Corporate/Other segment’s performance for the respective periods:ChangeYear Ended December 31,2020 vs. 20192019 vs. 2018In millions, except percentages202020192018$%$%Revenues:Premiums$63 $91$4$(28)(30.8)%$87 2,175.0 %Services48 9—39 433.3 %9 100.0 %Net investment income315 412602(97)(23.5)%(190)(31.6)%Total revenues426 512606(86)(16.8)%(94)(15.5)%Benefit costs221 28522(64)(22.5)%263 1,195.5 %Operating expenses1,846 1,7101,389136 8.0 %321 23.1 %Operating loss(1,641)(1,483)(805)(158)(10.7)%(678)(84.2)%Adjusted operating loss (1)(1,306)(1,000)(856)(306)(30.6)%(144)(16.8)%_____________________________________________(1)See “Segment Analysis” above in this MD&A for a reconciliation of operating loss (GAAP measure) to adjusted operating loss for the Corporate/Other segment.Commentary - 2020 compared to 2019Revenues•Revenues primarily relate to products for which the Company no longer solicits or accepts new customers, such as large case pensions and long-term care insurance products, that were acquired in the Aetna Acquisition. In 2018, revenues relate primarily to interest income on the proceeds from the financing of the Aetna Acquisition.•Total revenues decreased $86 million in 2020 compared to 2019. The decrease was primarily driven by lower net investment income including an $80 million decrease in net realized capital gains in 2020 compared to 2019.Operating expenses•Operating expenses within the Corporate/Other segment consist of management and administrative expenses to support the Company’s overall operations, which include certain aspects of executive management and the corporate relations, legal, compliance, human resources, information technology and finance departments, expenses associated with the Company’s investments in its transformation and enterprise modernization programs and acquisition-related transaction and integration costs. Subsequent to the Aetna Acquisition Date, segment operating expenses also include operating costs to support the Company’s large case pensions and long-term care insurance products.•Operating expenses increased $136 million in 2020 compared to 2019. The increase was primarily driven by incremental operating expenses associated with the Company’s investments in transformation and its COVID-19 pandemic response efforts, as well as increased charitable contributions in 2020. The increase was partially offset by a $148 million decrease in acquisition-related integration costs compared to the prior year.81Liquidity and Capital ResourcesCash FlowsThe Company maintains a level of liquidity sufficient to allow it to meet its cash needs in the short-term. Over the long term, the Company manages its cash and capital structure to maximize shareholder return, maintain its financial condition and maintain flexibility for future strategic initiatives. The Company continuously assesses its regulatory capital requirements, working capital needs, debt and leverage levels, debt maturity schedule, capital expenditure requirements, dividend payouts, potential share repurchases and future investments or acquisitions. The Company believes its operating cash flows, commercial paper program, credit facilities, sale-leaseback program, as well as any potential future borrowings, will be sufficient to fund these future payments and long-term initiatives. As of December 31, 2020, the Company had approximately $7.9 billion in cash and cash equivalents, approximately $2.2 billion of which was held by the parent company or nonrestricted subsidiaries.The COVID-19 pandemic has severely impacted global economic activity and during the first half of the year caused significant volatility and negative pressure in the capital markets. As a result of the uncertainty generated by COVID-19, on March 31, 2020, the Company issued $4.0 billion aggregate principal amount of unsecured senior notes to enhance its liquidity and strengthen its capital. As markets stabilized, in August 2020, the Company purchased $6.0 billion of its outstanding senior notes through cash tender offers, while issuing $4.0 billion aggregate principal amount of unsecured senior notes. In December 2020, the Company purchased $4.5 billion of its outstanding senior notes through cash tender offers, while issuing $2.0 billion aggregate principal amount of unsecured senior notes. The Company will continue to monitor the severity and duration of the pandemic and its impact on the U.S. and global economies, consumer behavior and health care utilization patterns and our businesses, results of operations, financial condition, and cash flows.The net change in cash, cash equivalents and restricted cash for the years ended December 31, 2020, 2019 and 2018 was as follows:ChangeYear Ended December 31,2020 vs. 20192019 vs. 2018In millions202020192018$%$%Net cash provided by operating activities$15,865 $12,848 $8,865 $3,017 23.5 %$3,983 44.9 %Net cash used in investing activities(5,534)(3,339)(43,285)(2,195)65.7 %39,946 92.3 %Net cash provided by (used in) financing activities(8,155)(7,850)36,819 (305)3.9 %(44,669)(121.3)%Effect of exchange rate changes on cash, cash equivalents and restricted cash— — (4)— — %4 100.0 %Net increase in cash, cash equivalents and restricted cash$2,176 $1,659 $2,395 $517 31.2 %$(736)(30.7)%Commentary - 2020 compared to 2019•Net cash provided by operating activities increased by $3.0 billion in 2020 compared to 2019 due primarily to higher operating income in the Health Care Benefits segment and the deferral of approximately $670 million of certain payroll tax payments to future years, as permitted in response to the COVID-19 pandemic.•Net cash used in investing activities increased by $2.2 billion in 2020 compared to 2019 primarily due to increased net purchases of investments and an increase in cash used for acquisitions, partially offset by $840 million in proceeds from the sale of the Workers’ Compensation business. In addition, cash used in investing activities reflected the following activity:•Gross capital expenditures remained relatively consistent at approximately $2.4 billion and $2.5 billion in 2020 and 2019, respectively. During 2020, approximately 62% of the Company’s total capital expenditures were for technology and other corporate initiatives, 30% were for store, fulfillment and support facilities expansion and improvements and 8% were for new store construction. •Net cash used in financing activities increased slightly to $8.2 billion in 2020 compared to $7.9 billion in 2019. The increase in cash used in finance activities primarily related to an increase in net debt repaid during 2020 compared to 2019.82Included in net cash used in investing activities for the years ended December 31, 2020, 2019 and 2018 was the following store development activity: (1)202020192018Total stores (beginning of year)9,896 9,921 9,803 New and acquired stores (2)156 102 145 Closed stores (2)(90)(127)(27)Total stores (end of year)9,962 9,896 9,921 Relocated stores (2)18 23 34 _____________________________________________(1)Includes retail drugstores and pharmacies within retail chains, primarily in Target Corporation (“Target”) stores.(2)Relocated stores are not included in new and acquired stores or closed stores totals.Short-term BorrowingsCommercial Paper and Back-up Credit FacilitiesThe Company did not have any commercial paper outstanding as of December 31, 2020 or 2019. In connection with its commercial paper program, the Company maintains a $1.0 billion 364-day unsecured back-up revolving credit facility, which expires on May 12, 2021, a $1.0 billion, five-year unsecured back-up revolving credit facility, which expires on May 18, 2022, a $2.0 billion, five-year unsecured back-up revolving credit facility, which expires on May 17, 2023 and a $2.0 billion, five-year unsecured back-up revolving credit facility, which expires on May 16, 2024. The credit facilities allow for borrowings at various rates that are dependent, in part, on the Company’s public debt ratings and require the Company to pay a weighted average quarterly facility fee of approximately 0.03%, regardless of usage. As of December 31, 2020 and 2019, there were no borrowings outstanding under any of the Company’s back-up credit facilities.Federal Home Loan Bank of BostonSince the Aetna Acquisition Date, a subsidiary of the Company is a member of the Federal Home Loan Bank of Boston (the “FHLBB”). As a member, the subsidiary has the ability to obtain cash advances, subject to certain minimum collateral requirements. The maximum borrowing capacity available from the FHLBB as of December 31, 2020 was approximately $925 million. At both December 31, 2020 and 2019, there were no outstanding advances from the FHLBB.Long-term Borrowings2020 NotesOn December 16, 2020, the Company issued $750 million aggregate principal amount of 1.3% unsecured senior notes due August 21, 2027 and $1.25 billion aggregate principal amount of 1.875% unsecured senior notes due February 28, 2031 for total proceeds of approximately $1.99 billion, net of discounts and underwriting fees. The $750 million aggregate principal amount of 1.3% unsecured senior notes represent a further issuance of the Company’s 1.3% unsecured senior notes due August 21, 2027 initially issued in an aggregate principal amount of $1.5 billion on August 21, 2020.On August 21, 2020, the Company issued $1.5 billion aggregate principal amount of 1.3% unsecured senior notes due August 21, 2027, $1.25 billion aggregate principal amount of 1.75% unsecured senior notes due August 21, 2030 and $1.25 billion aggregate principal amount of 2.7% unsecured senior notes due August 21, 2040 (collectively, the “August 2020 Notes”) for total proceeds of approximately $3.97 billion, net of discounts and underwriting fees.On March 31, 2020, the Company issued $750 million aggregate principal amount of 3.625% unsecured senior notes due April 1, 2027, $1.5 billion aggregate principal amount of 3.75% unsecured senior notes due April 1, 2030, $1.0 billion aggregate principal amount of 4.125% unsecured senior notes due April 1, 2040 and $750 million aggregate principal amount of 4.25% unsecured senior notes due April 1, 2050 (collectively, the “March 2020 Notes”) for total proceeds of approximately $3.95 billion, net of discounts and underwriting fees.The net proceeds of these offerings were used for general corporate purposes, which may include working capital, capital expenditures, as well as the repurchase and/or repayment of indebtedness.During March 2020, the Company entered into several interest rate swap transactions to manage interest rate risk. These agreements were designated as cash flow hedges and were used to hedge the exposure to variability in future cash flows resulting from changes in interest rates related to the anticipated issuance of the March 2020 Notes. In connection with the 83issuance of the March 2020 Notes, the Company terminated all outstanding cash flow hedges. The Company paid a net amount of $7 million to the hedge counterparties upon termination, which was recorded as a loss, net of tax, of $5 million in accumulated other comprehensive income and will be reclassified as interest expense over the life of the March 2020 Notes. See Note 13 ‘‘Other Comprehensive Income’’ included in Item 8 of this 10-K for additional information.2019 NotesOn August 15, 2019, the Company issued $1.0 billion aggregate principal amount of 2.625% unsecured senior notes due August 15, 2024, $750 million aggregate principal amount of 3% unsecured senior notes due August 15, 2026 and $1.75 billion aggregate principal amount of 3.25% unsecured senior notes due August 15, 2029 (collectively, the “2019 Notes”) for total proceeds of approximately $3.46 billion, net of discounts and underwriting fees. The net proceeds of the 2019 Notes were used to repay certain of the Company’s outstanding debt.Beginning in July 2019, the Company entered into several interest rate swap and treasury lock transactions to manage interest rate risk. These agreements were designated as cash flow hedges and were used to hedge the exposure to variability in future cash flows resulting from changes in interest rates related to the anticipated issuance of the 2019 Notes. In connection with the issuance of the 2019 Notes, the Company terminated all outstanding cash flow hedges. The Company paid a net amount of $25 million to the hedge counterparties upon termination, which was recorded as a loss, net of tax, of $18 million in accumulated other comprehensive income and will be reclassified as interest expense over the life of the 2019 Notes. See Note 13 ‘‘Other Comprehensive Income’’ included in Item 8 of this 10-K for additional information. Early Extinguishments of DebtIn December 2020, the Company purchased $4.5 billion of its outstanding senior notes through cash tender offers. The senior notes purchased included the following: $113 million of its 4.0% senior notes due 2023, $1.4 billion of its 3.7% senior notes due 2023, $1.0 billion of its 4.1% senior notes due 2025 and $2.0 billion of its 4.3% senior notes due 2028. In connection with the purchase of such senior notes, the Company paid a premium of $619 million in excess of the aggregate principal amount of the senior notes that were purchased, wrote-off $45 million of unamortized deferred financing costs and incurred $10 million in fees, for a total loss on early extinguishment of debt of $674 million.In August 2020, the Company purchased $6.0 billion of its outstanding senior notes through cash tender offers. The senior notes purchased included the following: $723 million of its 4.0% senior notes due 2023, $2.3 billion of its 3.7% senior notes due 2023 and $3.0 billion of its 4.1% senior notes due 2025. In connection with the purchase of such senior notes, the Company paid a premium of $706 million in excess of the aggregate principal amount of the senior notes that were purchased, wrote-off $47 million of unamortized deferred financing costs and incurred $13 million in fees, for a total loss on early extinguishment of debt of $766 million.In August 2019, the Company purchased $4.0 billion of its outstanding senior notes through cash tender offers. The senior notes purchased included the following: $1.3 billion of its 3.125% senior notes due 2020, $723 million of its floating rate notes due 2020, $328 million of its 4.125% senior notes due 2021, $297 million of 4.125% senior notes due 2021 issued by Aetna, $413 million of 5.45% senior notes due 2021 issued by Coventry Health Care, Inc., a wholly-owned subsidiary of Aetna, and $962 million of its 3.35% senior notes due 2021. In connection with the purchase of such senior notes, the Company paid a premium of $76 million in excess of the aggregate principal amount of the senior notes that were purchased, incurred $8 million in fees and recognized a net gain of $5 million on the write-off of net unamortized deferred financing premiums, for a net loss on early extinguishment of debt of $79 million. See Note 8 ‘‘Borrowings and Credit Agreements’’ and Note 12 ‘‘Shareholders’ Equity’’ included in Item 8 of this 10-K for additional information about debt issuances, debt repayments, share repurchases and dividend payments. Derivative Financial InstrumentsThe Company uses derivative financial instruments in order to manage interest rate and foreign exchange risk and credit exposure. The Company’s use of these derivatives is generally limited to hedging risk and has principally consisted of using interest rate swaps, treasury rate locks, forward contracts, futures contracts, warrants, put options and credit default swaps. Debt CovenantsThe Company’s back-up revolving credit facilities, unsecured senior notes and unsecured floating rate notes (see Note 8 ‘‘Borrowings and Credit Agreements’’ included in Item 8 of this 10-K) contain customary restrictive financial and operating covenants. These covenants do not include an acceleration of the Company’s debt maturities in the event of a downgrade in the 84Company’s credit ratings. The Company does not believe the restrictions contained in these covenants materially affect its financial or operating flexibility. As of December 31, 2020, the Company was in compliance with all of its debt covenants.Debt Ratings As of December 31, 2020, the Company’s long-term debt was rated “Baa2” by Moody’s Investors Service, Inc. (“Moody’s”) and “BBB” by Standard & Poor’s Financial Services LLC (“S&P”), and its commercial paper program was rated “P-2” by Moody’s and “A-2” by S&P. The outlook on the Company’s long-term debt is “Stable” by S&P. In December 2020, Moody’s changed the outlook on the Company’s long-term debt from “Negative” to “Stable.” In assessing the Company’s credit strength, the Company believes that both Moody’s and S&P considered, among other things, the Company’s capital structure and financial policies as well as its consolidated balance sheet, its historical acquisition activity and other financial information. Although the Company currently believes its long-term debt ratings will remain investment grade, it cannot guarantee the future actions of Moody’s and/or S&P. The Company’s debt ratings have a direct impact on its future borrowing costs, access to capital markets and new store operating lease costs. Share Repurchase ProgramsDuring the years ended December 31, 2020, 2019 and 2018, the Company did not repurchase any shares of common stock. See Note 12 ‘‘Shareholders’ Equity’’ included in Item 8 of this 10-K for additional information on the Company’s share repurchase program. Quarterly Cash DividendDuring 2020, 2019 and 2018, the quarterly cash dividend was $0.50 per share. CVS Health has paid cash dividends every quarter since becoming a public company and expects to maintain its quarterly dividend of $0.50 per share throughout 2021. Future dividends will depend on the Company’s earnings, capital requirements, financial condition and other factors considered relevant by the Board. Future Cash RequirementsThe following table summarizes certain estimated future cash requirements under the Company’s various contractual obligations at December 31, 2020, in total and disaggregated into current and long-term obligations. The table below does not include future payments of claims to health care providers or pharmacies because certain terms of these payments are not determinable at December 31, 2020 (for example, the timing and volume of future services provided under fee-for-service arrangements and future membership levels for capitated arrangements). In millionsTotalCurrentLong-TermOperating lease liabilities (1)$27,142 $2,688 $24,454 Finance lease liabilities (1)1,812 100 1,712 Contractual lease obligations with Target (2)2,332 — 2,332 Long-term debt (3)64,235 5,405 58,830 Interest payments on long-term debt (3)34,565 2,409 32,156 Other long-term liabilities on the consolidated balance sheets (4) Future policy benefits (5) 5,983 462 5,521 Unpaid claims (5) 2,018 532 1,486 Policyholders’ funds (5) (6)1,870 1,374 496 Total$139,957 $12,970 $126,987 _____________________________________________(1)Refer to Note 6 ‘‘Leases’’ included in Item 8 of this 10-K for additional information regarding the maturity of lease liabilities under operating and finance leases. (2)The Company leases pharmacy and clinic space from Target. See Note 6 ‘‘Leases’’ included in Item 8 of this 10-K for additional information regarding the lease arrangements with Target. Amounts related to such operating and finance leases are reflected within the operating lease liabilities and finance lease liabilities in the table above. Pharmacy lease amounts due in excess of the remaining estimated economic life of the buildings are reflected in the table above assuming equivalent stores continue to operate through the term of the arrangements. (3)Refer to Note 8 ‘‘Borrowings and Credit Agreements’’ included in Item 8 of this 10-K for additional information regarding the maturities of debt principal. Interest payments on long-term debt are calculated using outstanding balances and interest rates in effect on December 31, 2020.(4)Payments of other long-term liabilities exclude Separate Accounts liabilities of approximately $4.9 billion because these liabilities are supported by assets that are legally segregated and are not subject to claims that arise out of the Company’s business.85(5)Total payments of future policy benefits, unpaid claims and policyholders’ funds include $763 million, $2.0 billion and $210 million, respectively, of reserves for contracts subject to reinsurance. The Company expects the assuming reinsurance carrier to fund these obligations and has reflected these amounts as reinsurance recoverable assets on the consolidated balance sheets.(6)Customer funds associated with group life and health contracts of approximately $2.9 billion have been excluded from the table above because such funds may be used primarily at the customer’s discretion to offset future premiums and/or for refunds, and the timing of the related cash flows cannot be determined. Additionally, net unrealized capital gains on debt securities supporting experience-rated products of $135 million, before tax, have been excluded from the table above.Restrictions on Certain PaymentsIn addition to general state law restrictions on payments of dividends and other distributions to stockholders applicable to all corporations, health maintenance organizations (“HMOs”) and insurance companies are subject to further regulations that, among other things, may require those companies to maintain certain levels of equity (referred to as surplus) and restrict the amount of dividends and other distributions that may be paid to their equity holders. These regulations are not directly applicable to CVS Health as a holding company, since CVS Health is not an HMO or an insurance company. In addition, in connection with the Aetna Acquisition, the Company made certain undertakings that require prior regulatory approval of dividends by certain of its HMOs and insurance companies. The additional regulations and undertakings applicable to the Company’s HMO and insurance company subsidiaries are not expected to affect the Company’s ability to service the Company’s debt, meet other financing obligations or pay dividends, or the ability of any of the Company’s subsidiaries to service their debt or other financing obligations. Under applicable regulatory requirements and undertakings, at December 31, 2020, the maximum amount of dividends that may be paid by the Company’s insurance and HMO subsidiaries without prior approval by regulatory authorities was $2.9 billion in the aggregate. The Company maintains capital levels in its operating subsidiaries at or above targeted and/or required capital levels and dividends amounts in excess of these levels to meet liquidity requirements, including the payment of interest on debt and stockholder dividends. In addition, at the Company’s discretion, it uses these funds for other purposes such as funding share and debt repurchase programs, investments in new businesses and other purposes considered advisable. At December 31, 2020 and 2019, the Company held investments of $524 million and $537 million, respectively, that are not accounted for as Separate Accounts assets but are legally segregated and are not subject to claims that arise out of the Company’s business. See Note 3 ‘‘Investments’’ included in Item 8 of this 10-K for additional information on investments related to the 2012 conversion of an existing group annuity contract from a participating to a non-participating contract.Solvency RegulationThe National Association of Insurance Commissioners (the “NAIC”) utilizes risk-based capital (“RBC”) standards for insurance companies that are designed to identify weakly-capitalized companies by comparing each company’s adjusted surplus to its required surplus (the “RBC Ratio”). The RBC Ratio is designed to reflect the risk profile of insurance companies. Within certain ratio ranges, regulators have increasing authority to take action as the RBC Ratio decreases. There are four levels of regulatory action, ranging from requiring an insurer to submit a comprehensive financial plan for increasing its RBC to the state insurance commissioner to requiring the state insurance commissioner to place the insurer under regulatory control. At December 31, 2020, the RBC Ratio of each of the Company’s primary insurance subsidiaries was above the level that would require regulatory action. The RBC framework described above for insurers has been extended by the NAIC to health organizations, including HMOs. Although not all states had adopted these rules at December 31, 2020, at that date, each of the Company’s active HMOs had a surplus that exceeded either the applicable state net worth requirements or, where adopted, the levels that would require regulatory action under the NAIC’s RBC rules. External rating agencies use their own capital models and/or RBC standards when they determine a company’s rating.86Critical Accounting PoliciesThe Company prepares the consolidated financial statements in conformity with generally accepted accounting principles, which require management to make certain estimates and apply judgment. Estimates and judgments are based on historical experience, current trends and other factors that management believes to be important at the time the consolidated financial statements are prepared. On a regular basis, the Company reviews its accounting policies and how they are applied and disclosed in the consolidated financial statements. While the Company believes the historical experience, current trends and other factors considered by management support the preparation of the consolidated financial statements in conformity with generally accepted accounting principles, actual results could differ from estimates, and such differences could be material.Significant accounting policies are discussed in Note 1 ‘‘Significant Accounting Policies’’ included in Item 8 of this 10-K. Management believes the following accounting policies include a higher degree of judgment and/or complexity and, thus, are considered to be critical accounting policies. The Company has discussed the development and selection of these critical accounting policies with the Audit Committee of the Board (the “Audit Committee”), and the Audit Committee has reviewed the disclosures relating to them.Revenue RecognitionPharmacy Services SegmentThe Pharmacy Services segment sells prescription drugs directly through its mail service dispensing pharmacies and indirectly through the Company’s retail pharmacy network. The Company’s pharmacy benefit arrangements are accounted for in a manner consistent with a master supply arrangement as there are no contractual minimum volumes and each prescription is considered a separate purchasing decision and distinct performance obligation transferred at a point in time. PBM services performed in connection with each prescription claim are considered part of a single performance obligation which culminates in the dispensing of prescription drugs.The Company recognizes revenue using the gross method at the contract price negotiated with its clients when the Company has concluded it controls the prescription drug before it is transferred to the client plan members. The Company controls prescriptions dispensed indirectly through its retail pharmacy network because it has separate contractual arrangements with those pharmacies, has discretion in setting the price for the transaction and assumes primary responsibility for fulfilling the promise to provide prescription drugs to its client plan members while also performing the related PBM services.Revenues include (i) the portion of the price the client pays directly to the Company, net of any discounts earned on brand name drugs or other discounts and refunds paid back to the client (see “Drug Discounts” and “Guarantees” below), (ii) the price paid to the Company by client plan members for mail order prescriptions and the price paid to retail network pharmacies by client plan members for retail prescriptions (“retail co-payments”), and (iii) claims based administrative fees for retail pharmacy network contracts. Sales taxes are not included in revenues. The Company recognizes revenue when control of the prescription drugs is transferred to customers, in an amount that reflects the consideration the Company expects to be entitled to receive in exchange for those prescription drugs. The Company has established the following revenue recognition policies for the Pharmacy Services segment:•Revenues generated from prescription drugs sold by mail service dispensing pharmacies are recognized when the prescription drug is delivered to the client plan member. At the time of delivery, the Company has performed substantially all of its performance obligations under its client contracts and does not experience a significant level of returns or reshipments.•Revenues generated from prescription drugs sold by third party pharmacies in the Company’s retail pharmacy network and associated administrative fees are recognized at the Company’s point-of-sale, which is when the claim is adjudicated by the Company’s online claims processing system and the Company has transferred control of the prescription drug and performed all of its performance obligations.For contracts under which the Company acts as an agent or does not control the prescription drugs prior to transfer to the client plan member, revenue is recognized using the net method.Drug DiscountsThe Company records revenue net of manufacturers’ rebates earned by its clients based on their plan members’ utilization of brand-name formulary drugs. The Company estimates these rebates at period-end based on actual and estimated claims data and its estimates of the manufacturers’ rebates earned by its clients. The estimates are based on the best available data at period-end 87and recent history for the various factors that can affect the amount of rebates due to the client. The Company adjusts its rebates payable to clients to the actual amounts paid when these rebates are paid or as significant events occur. Any cumulative effect of these adjustments is recorded against revenues at the time it is identified. Adjustments generally result from contract changes with clients or manufacturers that have retroactive rebate adjustments, differences between the estimated and actual product mix subject to rebates, or whether the brand name drug was included in the applicable formulary. The effect of adjustments between estimated and actual manufacturers’ rebate amounts has not been material to the Company’s operating results or financial condition.GuaranteesThe Company also adjusts revenues for refunds owed to clients resulting from pricing guarantees and performance against defined service and performance metrics. The inputs to these estimates are not subject to a high degree of subjectivity or volatility. The effect of adjustments between estimated and actual pricing and performance refund amounts has not been material to the Company’s operating results or financial condition.Retail/LTC SegmentRetail PharmacyThe Company’s retail drugstores recognize revenue at the time the customer takes possession of the merchandise. For pharmacy sales, each prescription claim is its own arrangement with the customer and is a performance obligation, separate and distinct from other prescription claims under other retail network arrangements. Revenues are adjusted for refunds owed to third party payers resulting from pricing guarantees and performance against defined value-based service and performance metrics. The inputs to these estimates are not subject to a high degree of subjectivity or volatility. The effect of adjustments between estimated and actual pricing and performance refund amounts has not been material to the Company’s operating results or financial condition.Revenue from Company gift cards purchased by customers is deferred as a contract liability until goods or services are transferred. Any amounts not expected to be redeemed by customers (i.e., breakage) are recognized based on historical redemption patterns.Customer returns are not material to the Company’s operating results or financial condition. Sales taxes are not included in revenues.Loyalty and Other ProgramsThe Company’s customer loyalty program, ExtraCare®, consists of two components, ExtraSavingsTM and ExtraBucks® Rewards. ExtraSavings are coupons that are recorded as a reduction of revenue when redeemed as the Company concluded that they do not represent a promise to the customer to deliver additional goods or services at the time of issuance because they are not tied to a specific transaction or spending level. ExtraBucks Rewards are accumulated by customers based on their historical spending levels. Thus, the Company has determined that there is an additional performance obligation to those customers at the time of the initial transaction. The Company allocates the transaction price to the initial transaction and the ExtraBucks Rewards transaction based upon the relative standalone selling price, which considers historical redemption patterns for the rewards. Revenue allocated to ExtraBucks Rewards is recognized as those rewards are redeemed. At the end of each period, unredeemed ExtraBucks Rewards are reflected as a contract liability.The Company also offers a subscription-based membership program, CarePass®, under which members are entitled to a suite of benefits delivered over the course of the subscription period, as well as a promotional reward that can be redeemed for future goods and services. Subscriptions are paid for on a monthly or annual basis at the time of or in advance of the Company delivering the goods and services. Revenue from these arrangements is recognized as the performance obligations are satisfied. Long-term CareRevenue is recognized when control of the promised goods or services is transferred to customers in an amount that reflects the consideration the Company expects to be entitled to receive in exchange for those goods or services. Each prescription claim represents a separate performance obligation of the Company, separate and distinct from other prescription claims under customer arrangements. A significant portion of Long-term Care revenue from sales of pharmaceutical and medical products is reimbursed by the federal Medicare Part D program and, to a lesser extent, state Medicaid programs. The Company monitors its revenues and receivables from these reimbursement sources, as well as long-term care facilities and other third party insurance payors, and reduces revenue at the revenue recognition date to properly account for the variable consideration due to anticipated 88differences between billed and reimbursed amounts. Accordingly, the total revenues and receivables reported in the Company’s consolidated financial statements are recorded at the amount expected to be ultimately received from these payors. Patient co-payments associated with Medicare Part D, certain state Medicaid programs, Medicare Part B and certain third party payors typically are not collected at the time products are delivered or services are rendered, but are billed to the individuals as part of normal billing procedures and subject to normal accounts receivable collections procedures.Walk-In Medical ClinicsFor services provided by the Company’s walk-in medical clinics, revenue recognition occurs for completed services provided to patients, with adjustments taken for third party payor contractual obligations and patient direct bill historical collection rates.Health Care Benefits SegmentHealth Care Benefits revenue is principally derived from insurance premiums and fees billed to customers. Revenue is recognized based on customer billings, which reflect contracted rates per employee and the number of covered employees recorded in the Company’s records at the time the billings are prepared. Billings are generally sent monthly for coverage during the following month. The Company’s billings may be subsequently adjusted to reflect enrollment changes due to member terminations or other factors. These adjustments are known as retroactivity adjustments. In each period, the Company estimates the amount of future retroactivity and adjusts the recorded revenue accordingly. As information regarding actual retroactivity amounts becomes known, the Company refines its estimates and records any required adjustments to revenues in the period in which they arise. A significant difference in the actual level of retroactivity compared to estimated levels would have a significant effect on the Company’s operating results.Premium RevenuePremiums are recognized as revenue in the month in which the enrollee is entitled to receive health care services. Premiums are reported net of an allowance for estimated terminations and uncollectible amounts. Additionally, premium revenue subject to the MLR rebate requirements of the ACA is recorded net of the estimated minimum MLR rebates for the current calendar year. Premiums related to unexpired contractual coverage periods (unearned premiums) are reported as other insurance liabilities on the consolidated balance sheets and recognized as revenue when earned.Some of the Company’s contracts allow for premiums to be adjusted to reflect actual experience or the relative health status of Insured members. Such adjustments are reasonably estimable at the outset of the contract, and adjustments to those estimates are made based on actual experience of the customer emerging under the contract and the terms of the underlying contract.Services RevenueServices revenue relates to contracts that can include various combinations of services or series of services which generally are capable of being distinct and accounted for as separate performance obligations. The Health Care Benefits segment’s services revenue primarily consists of ASC fees received in exchange for performing certain claim processing and member services for ASC members. ASC fee revenue is recognized over the period the service is provided. Some of the Company’s administrative services contracts include guarantees with respect to certain functions, such as customer service response time, claim processing accuracy and claim processing turnaround time, as well as certain guarantees that a plan sponsor’s benefit claim experience will fall within a certain range. With any of these guarantees, the Company is financially at risk if the conditions of the arrangements are not met, although the maximum amount at risk typically is limited to a percentage of the fees otherwise payable to the Company by the customer involved. Each period the Company estimates its obligations under the terms of these guarantees and records its estimate as an offset to services revenues.Accounting for Medicare Part D Revenues include insurance premiums earned by the Company’s PDPs, which are determined based on the PDP’s annual bid and related contractual arrangements with CMS. The insurance premiums include a beneficiary premium, which is the responsibility of the PDP member, and can be subsidized by CMS in the case of low-income members, and a direct premium paid by CMS. Premiums collected in advance are initially recorded within other insurance liabilities and are then recognized ratably as revenue over the period in which members are entitled to receive benefits.Revenues also include a risk-sharing feature of the Medicare Part D program design referred to as the risk corridor. The Company estimates variable consideration in the form of amounts payable to, or receivable from, CMS under the risk corridor, and adjusts revenue based on calculations of additional subsidies to be received from or owed to CMS at the end of the reporting year.89In addition to Medicare Part D premiums, the Company receives additional payments each month from CMS related to catastrophic reinsurance, low-income cost-sharing subsidies and coverage gap benefits. If the subsidies received differ from the amounts earned from actual prescriptions transferred, the difference is recorded in either accounts receivable, net or accrued expenses.Impairments of Debt SecuritiesThe Company regularly reviews its debt securities to determine whether a decline in fair value below the cost basis or carrying value has occurred. If a debt security is in an unrealized loss position and the Company has the intent to sell the security, or it is more likely than not that the Company will have to sell the security before recovery of its amortized cost basis, the amortized cost basis of the security is written down to its fair value and the difference is recognized in net income. If a debt security is in an unrealized loss position and the Company does not have the intent to sell and it is more likely than not that the Company will not have to sell such security before recovery of its amortized cost basis, the Company bifurcates the impairment into credit-related and non-credit related components. The amount of the credit-related component is recorded as an allowance for credit losses and recognized in net income, and the amount of the non-credit related component is included in other comprehensive income. The Company analyzes all facts and circumstances believed to be relevant for each investment when performing this analysis, in accordance with applicable accounting guidance.In evaluating whether a credit related loss exists, the Company considers a variety of factors including: the extent to which the fair value is less than the amortized cost basis; adverse conditions specifically related to the issuer of a security, an industry or geographic area; the payment structure of the security; the failure of the issuer of the security to make scheduled interest or principle payments; and any changes to the rating of the security by a rating agency. During the year ended December 31, 2020, the Company recorded yield-related impairment losses on debt securities of $49 million. During the year ended December 31, 2020, the Company did not record credit-related impairment losses on debt securities. During the year ended December 31, 2019, the Company recorded other-than-temporary impairment (“OTTI”) losses on debt securities of $24 million. There were no material OTTI losses on debt securities for the year ended December 31, 2018.The risks inherent in assessing the impairment of a debt security include the risk that market factors may differ from projections and the risk that facts and circumstances factored into the Company’s assessment may change with the passage of time. Unexpected changes to market factors and circumstances that were not present in past reporting periods are among the factors that may result in a current period decision to sell debt securities that were not impaired in prior reporting periods.Vendor Allowances and Purchase DiscountsVendor and manufacturer receivables were $9.8 billion and $7.9 billion as of December 31, 2020 and 2019, respectively, the majority of which relate to purchase discounts and vendor allowances as described below.Pharmacy Services SegmentThe Pharmacy Services segment receives purchase discounts on products purchased. Contractual arrangements with vendors, including manufacturers, wholesalers and retail pharmacies, normally provide for the Pharmacy Services segment to receive purchase discounts from established list prices in one, or a combination, of the following forms: (i) a direct discount at the time of purchase, (ii) a discount for the prompt payment of invoices or (iii) when products are purchased indirectly from a manufacturer (e.g., through a wholesaler or retail pharmacy), a discount (or rebate) paid subsequent to dispensing. These rebates are recognized when prescriptions are dispensed and are generally calculated and billed to manufacturers within 30 days of the end of each completed quarter. Historically, the effect of adjustments resulting from the reconciliation of rebates recognized to the amounts billed and collected has not been material to the Company’s operating results or financial condition. The Company accounts for the effect of any such differences as a change in accounting estimate in the period the reconciliation is completed. The Pharmacy Services segment also receives additional discounts under its wholesaler contracts if it exceeds contractually defined purchase volumes. In addition, the Pharmacy Services segment receives fees from pharmaceutical manufacturers for administrative services. Purchase discounts and administrative service fees are recorded as a reduction of cost of products sold.Retail/LTC SegmentVendor allowances received by the Retail/LTC segment reduce the carrying cost of inventory and are recognized in cost of products sold when the related inventory is sold, unless they are specifically identified as a reimbursement of incremental costs for promotional programs and/or other services provided. Amounts that are directly linked to advertising commitments are 90recognized as a reduction of advertising expense (included in operating expenses) when the related advertising commitment is satisfied. Any such allowances received in excess of the actual cost incurred also reduce the carrying cost of inventory. The total value of any upfront payments received from vendors that are linked to purchase commitments is initially deferred. The deferred amounts are then amortized to reduce cost of products sold over the life of the contract based upon purchase volume. The total value of any upfront payments received from vendors that are not linked to purchase commitments is also initially deferred. The deferred amounts are then amortized to reduce cost of products sold on a straight-line basis over the life of the related contract.The Company establishes a receivable for vendor income that is earned but not yet received based on historical trends and data. The majority of vendor receivables are collected within the following fiscal quarter. Historically, adjustments to the Company’s vendor receivables resulting from the reconciliation of receivables recognized to the amounts collected have not been material to the Company’s operating results or financial condition.There have not been any material changes in the way the Company accounts for vendor allowances or purchase discounts during the past three years.InventoryInventories are valued at the lower of cost or net realizable value using the weighted average cost method.The value of ending inventory is reduced for estimated inventory losses that have occurred during the interim period between physical inventory counts. Physical inventory counts are taken on a regular basis in each retail store and LTC pharmacy, and a continuous cycle count process is the primary procedure used to validate the inventory balances on hand in each distribution center and mail facility to ensure that the amounts reflected in the consolidated financial statements are properly stated. The Company’s accounting for inventory contains uncertainty since management must use judgment to estimate the inventory losses that have occurred during the interim period between physical inventory counts. When estimating these losses, a number of factors are considered which include historical physical inventory results on a location-by-location basis and current physical inventory loss trends.The total reserve for estimated inventory losses covered by this critical accounting policy was $369 million and $401 million as of December 31, 2020 and 2019, respectively. Although management believes there is sufficient current and historical information available to record reasonable estimates for estimated inventory losses, it is possible that actual results could differ. In order to help investors assess the aggregate risk, if any, associated with the inventory-related uncertainties discussed above, a ten percent (10%) pre-tax change in estimated inventory losses, which is a reasonably likely change, would increase or decrease the total reserve for estimated inventory losses by approximately $37 million as of December 31, 2020.Although management believes that the estimates discussed above are reasonable and the related calculations conform to generally accepted accounting principles, actual results could differ from such estimates, and such differences could be material.Right-of-Use Assets and Lease LiabilitiesThe Company determines if an arrangement contains a lease at the inception of a contract. Right-of-use assets represent the Company’s right to use an underlying asset for the lease term and lease liabilities represent the Company’s obligation to make lease payments arising from the lease. Right-of-use assets and lease liabilities are recognized at the commencement date of the lease, renewal date of the lease or significant remodeling of the lease space based on the present value of the remaining future minimum lease payments. As the interest rate implicit in the Company’s leases is not readily determinable, the Company utilizes its incremental borrowing rate, determined by class of underlying asset, to discount the lease payments. The operating lease right-of-use assets also include lease payments made before commencement and are reduced by lease incentives. The Company’s real estate leases typically contain options that permit renewals for additional periods of up to five years each. For real estate leases, the options to extend are not considered reasonably certain at lease commencement because the Company reevaluates each lease on a regular basis to consider the economic and strategic incentives of exercising the renewal options and regularly opens or closes stores to align with its operating strategy. Generally, the renewal option periods are not included within the lease term and the associated payments are not included in the measurement of the right-of-use asset and lease liability. Similarly, renewal options are not included in the lease term for non-real estate leases because they are not considered reasonably certain of being exercised at lease commencement. Leases with an initial term of 12 months or less are not recorded on the balance sheets, and lease expense is recognized on a straight-line basis over the term of the short-term lease.91For real estate leases, the Company accounts for lease components and nonlease components as a single lease component. Certain real estate leases require additional payments based on sales volume, as well as reimbursement for real estate taxes, common area maintenance and insurance, which are expensed as incurred as variable lease costs. Other real estate leases contain one fixed lease payment that includes real estate taxes, common area maintenance and insurance. These fixed payments are considered part of the lease payment and included in the right-of-use assets and lease liabilities.Long-Lived Asset ImpairmentRecoverability of Definite-Lived AssetsThe Company evaluates the recoverability of long-lived assets, excluding goodwill and indefinite-lived intangible assets, which are tested for impairment using separate tests described below, whenever events or changes in circumstances indicate that the carrying value of such an asset may not be recoverable. The Company groups and evaluates these long-lived assets for impairment at the lowest level at which individual cash flows can be identified. If indicators of impairment are present, the Company first compares the carrying amount of the asset group to the estimated future cash flows associated with the asset group (undiscounted and without interest charges). If the estimated future cash flows used in this analysis are less than the carrying amount of the asset group, an impairment loss calculation is prepared. The impairment loss calculation compares the carrying amount of the asset group to the asset group’s estimated future cash flows (discounted and with interest charges). If required, an impairment loss is recorded for the portion of the asset group’s carrying value that exceeds the asset group’s estimated future cash flows (discounted and with interest charges).The long-lived asset impairment loss calculation contains uncertainty since management must use judgment to estimate each asset group’s future sales, profitability and cash flows. When preparing these estimates, the Company considers historical results and current operating trends and consolidated sales, profitability and cash flow results and forecasts. These estimates can be affected by a number of factors including general economic and regulatory conditions, efforts of third party organizations to reduce their prescription drug costs and/or increased member co-payments, the continued efforts of competitors to gain market share and consumer spending patterns.There were no material impairment charges recognized on long-lived assets in the year ended December 31, 2020. During the year ended December 31, 2019, the Company recorded store rationalization charges of $231 million, primarily related to operating lease right-of-use asset impairment charges. During the year ended December 31, 2018, the Company recognized a $43 million long-lived asset impairment charge, primarily related to the impairment of property and equipment.Recoverability of GoodwillGoodwill represents the excess of amounts paid for acquisitions over the fair value of the net identifiable assets acquired. Goodwill is subject to annual impairment reviews, or more frequent reviews if events or circumstances indicate that the carrying value may not be recoverable. Goodwill is tested for impairment on a reporting unit basis. The impairment test is performed by comparing the reporting unit’s fair value with its net book value (or carrying amount), including goodwill. The fair value of the reporting units is estimated using a combination of a discounted cash flow method and a market multiple method. If the net book value (carrying amount) of the reporting unit exceeds its fair value, the reporting unit’s goodwill is considered to be impaired, and an impairment is recognized in an amount equal to the excess.The determination of the fair value of the reporting units requires the Company to make significant assumptions and estimates. These assumptions and estimates primarily include the selection of appropriate peer group companies; control premiums and valuation multiples appropriate for acquisitions in the industries in which the Company competes; discount rates; terminal growth rates; and forecasts of revenue, operating income, depreciation and amortization, income taxes, capital expenditures and future working capital requirements. When determining these assumptions and preparing these estimates, the Company considers each reporting unit’s historical results and current operating trends; consolidated revenues, profitability and cash flow results and forecasts; and industry trends. The Company’s estimates can be affected by a number of factors, including general economic and regulatory conditions; the risk-free interest rate environment; the Company’s market capitalization; efforts of customers and payers to reduce costs, including their prescription drug costs, and/or increase member co-payments; the continued efforts of competitors to gain market share, consumer spending patterns and the Company’s ability to achieve its revenue growth projections and execute on its cost reduction initiatives. 2020 Goodwill Impairment TestDuring the third quarter of 2020, the Company performed its required annual impairment test of goodwill. The results of this impairment test indicated that there was no impairment of goodwill as of the testing date. The goodwill impairment test resulted in the fair values of all of the Company’s reporting units exceeding their carrying values by significant margins, with the 92exception of the Commercial Business and LTC reporting units, which exceeded their carrying values by approximately 6% and 12%, respectively.In connection with the Aetna Acquisition in November 2018, the Company added the Health Care Benefits segment which included the Commercial Business reporting unit. The transaction was accounted for using the acquisition method of accounting which requires, among other things, the assets acquired and liabilities assumed to be recognized at their fair values at the date of acquisition. As a result, at the time of the acquisition the fair value of the Commercial Business reporting unit was equal to its carrying value. The Company has experienced declines in its Commercial Insured medical membership subsequent to the closing date of the Aetna Acquisition and may continue to do so for a number of reasons, including as a result of the competitive Commercial business environment. In addition, COVID-19 has had and may continue to have an adverse impact on medical membership in the Commercial business due to reductions in workforce at existing customers (including due to business failures) as well as reduced willingness to change benefit providers by prospective customers. The Company’s fair value estimate is sensitive to significant assumptions including changes in medical membership, revenue growth rate, operating income and the discount rate. Although the Company believes the financial projections used to determine the fair value of the Commercial Business reporting unit in the third quarter of 2020 were reasonable and achievable, the challenges described above may affect the Company’s ability to increase medical membership or operating income in the Commercial Business reporting unit at the rate estimated when such goodwill impairment test was performed and may continue to do so. As of December 31, 2020, the goodwill balance in the Commercial Business reporting unit was $26.5 billion.The LTC reporting unit continues to experience industry-wide challenges that have impacted management’s ability to grow the business at the rate that was originally estimated when the Company acquired Omnicare in 2015. Those challenges included lower client retention rates, lower occupancy rates in skilled nursing facilities, the deteriorating financial health of numerous skilled nursing facility customers which resulted in a number of customer bankruptcies in 2018, and continued facility reimbursement pressures. COVID-19 has also had an adverse impact on the financial health of the Company’s long-term care facility customers due to declines in occupancy rates and increased operating expenses. A number of these customers have relied on supplemental liquidity sources such as grants and advance Medicare payments under programs expanded or created under the CARES Act to maintain adequate liquidity during the COVID-19 pandemic and may require additional sources of liquidity throughout the duration of the COVID-19 pandemic.Although the Company believes the financial projections used to determine the fair value of the LTC reporting unit in the third quarter of 2020 were reasonable and achievable, the LTC reporting unit has faced challenges that affect the Company’s ability to grow the LTC reporting unit’s business at the rate estimated when such goodwill impairment test was performed and may continue to do so. These challenges and some of the key assumptions included in the Company’s financial projections to determine the estimated fair value of the LTC reporting unit include client retention rates; occupancy rates in skilled nursing facilities; the financial health of skilled nursing facility customers; facility reimbursement pressures; the Company’s ability to extract cost savings from labor productivity and other initiatives; the geographies impacted and the severity and duration of COVID-19; COVID-19’s impact on health care utilization patterns; and the timing, scope and impact of stimulus legislation as well as other federal, state and local governmental responses to COVID-19. The fair value of the LTC reporting unit also is dependent on market multiples of peer group companies and the risk-free interest rate environment, which impacts the discount rate used in the discounted cash flow valuation method. If the LTC reporting unit does not achieve its forecasts, it is reasonably possible in the near term that the goodwill of the LTC reporting unit could be deemed to be impaired by a material amount. As of December 31, 2020, the goodwill balance in the LTC reporting unit was $431 million.The COVID-19 pandemic severely impacted global economic activity in 2020, including the businesses of some of the Company’s customers, and during the first half of the year caused significant volatility and negative pressure in the capital markets. In addition to adversely affecting the Company’s businesses, which may have a material adverse impact on the Company’s profitability and cash flows, these developments may adversely affect the timing and collectability of payments to the Company from customers, clients, government payers and members as a result of the impact of COVID-19 on them. For further information regarding the potential adverse impact of COVID-19 on the Company, please see “Risk Factors” included in Item 1A of this report. The COVID-19 pandemic continues to evolve. We believe COVID-19’s impact on our businesses, operating results, cash flows and/or financial condition primarily will be driven by the geographies impacted and the severity and duration of the pandemic; the pandemic’s impact on the U.S. and global economies and consumer behavior and health care utilization patterns; and the timing, scope and impact of stimulus legislation as well as other federal, state and local governmental responses to the pandemic. Those primary drivers are beyond our knowledge and control. As a result, the impact COVID-19 will have on our businesses, operating results, cash flows and/or financial condition is uncertain, but the impact could be adverse and material. COVID-19 also may result in legal and regulatory proceedings, investigations and claims against 93us. If the Company’s businesses, results of operations, financial condition and/or cash flows are materially adversely affected, the goodwill of the LTC and Commercial Business reporting units could be deemed to be impaired by a material amount.2019 Goodwill Impairment TestDuring the third quarter of 2019, the Company performed its required annual impairment test of goodwill. The results of this impairment test indicated that there was no impairment of goodwill as of the testing date. The goodwill impairment test resulted in the fair values of all of the Company’s reporting units exceeding their carrying values by significant margins, with the exception of the Commercial Business and LTC reporting units, which exceeded their carrying values by approximately 4% and 9%, respectively.2018 Goodwill Impairment TestsAs discussed in Note 5 ‘‘Goodwill and Other Intangibles’’ included in Item 8 of this 10-K, during 2018, the LTC reporting unit experienced industry-wide challenges that impacted management’s ability to grow the business at the rate that was originally estimated when the Company acquired Omnicare and when the 2017 annual goodwill impairment test was performed. Those challenges include lower client retention rates, lower occupancy rates in skilled nursing facilities, the deteriorating financial health of numerous skilled nursing facility customers which resulted in a number of customer bankruptcies in 2018, and continued facility reimbursement pressures. Following the update of its current and long-term forecast, in June 2018, management determined that there were indicators that the LTC reporting unit’s goodwill may be impaired and, accordingly, management performed an interim goodwill impairment test as of June 30, 2018. The results of that interim impairment test showed that the fair value of the LTC reporting unit was lower than the carrying value, resulting in a $3.9 billion pre-tax goodwill impairment charge in the second quarter of 2018. During the third quarter of 2018, the Company performed its required annual impairment tests of goodwill and concluded there was no impairment of goodwill. The goodwill impairment tests showed that the fair values of the Pharmacy Services and Retail Pharmacy reporting units exceeded their carrying values by significant margins and the fair value of the LTC reporting unit exceeded its carrying value by approximately 2%. During the fourth quarter of 2018, the LTC reporting unit missed its forecast primarily due to operational issues and customer liquidity issues, including one significant customer bankruptcy. Additionally, LTC management submitted updated projected financial results which showed significant additional deterioration primarily due to continued industry and operational challenges, which also caused management to make further updates to its long-term forecast beyond 2019. Based on these updated projections, management determined that there were indicators that the LTC reporting unit’s goodwill may be further impaired and, accordingly, management performed an interim goodwill impairment test during the fourth quarter of 2018. The results of that interim impairment test showed that the fair value of the LTC reporting unit was lower than the carrying value, resulting in an additional $2.2 billion pre-tax goodwill impairment charge in the fourth quarter of 2018. In 2018, the fair value of the LTC reporting unit was determined using a combination of a discounted cash flow method and a market multiple method. In addition to the lower financial projections, changes in risk-free interest rates and lower market multiples of peer group companies also contributed to the amount of the 2018 goodwill impairment charges.Recoverability of Indefinite-Lived Intangible AssetsIndefinite-lived intangible assets are subject to annual impairment reviews, or more frequent reviews if events or circumstances indicate that their carrying value may not be recoverable. Indefinite-lived intangible assets are tested by comparing the estimated fair value of the asset to its carrying value. If the carrying value of the asset exceeds its estimated fair value, an impairment loss is recognized, and the asset is written down to its estimated fair value.The indefinite-lived intangible asset impairment loss calculation contains uncertainty since management must use judgment to estimate fair value based on the assumption that, in lieu of ownership of an intangible asset, the Company would be willing to pay a royalty in order to utilize the benefits of the asset. Fair value is estimated by discounting the hypothetical royalty payments to their present value over the estimated economic life of the asset. These estimates can be affected by a number of factors including general economic conditions, availability of market information and the profitability of the Company. There were no impairment losses recognized on indefinite-lived intangible assets in any of the years ended December 31, 2020, 2019 or 2018.Health Care Costs PayableAt December 31, 2020 and 2019, 77% and 73% respectively, of health care costs payable are estimates of the ultimate cost of (i) services rendered to the Company’s Insured members but not yet reported to the Company and (ii) claims which have been 94reported to the Company but not yet paid (collectively, “IBNR”). Health care costs payable also include an estimate of the cost of services that will continue to be rendered after the financial statement date if the Company is obligated to pay for such services in accordance with contractual or regulatory requirements. The remainder of health care costs payable is primarily comprised of pharmacy and capitation payables, other amounts due to providers pursuant to risk sharing agreements and accruals for state assessments. The Company develops its estimate of IBNR using actuarial principles and assumptions that consider numerous factors. See Note 1 ‘‘Significant Accounting Policies’’ included in Item 8 of this 10-K for additional information on the Company’s reserving methodology.During 2020 and 2019, the Company observed an increase in completion factors relative to those assumed at the prior year end. After considering the claims paid in 2020 and 2019 with dates of service prior to the fourth quarter of the previous year, the Company observed assumed incurred claim weighted average completion factors that were 4 and 27 basis points higher, respectively, than previously estimated, resulting in a decrease of $35 million and $240 million in 2020 and 2019, respectively, in health care costs payable that related to the prior year. The Company has considered the pattern of changes in its completion factors when determining the completion factors used in its estimates of IBNR as of December 31, 2020. However, based on historical claim experience, it is reasonably possible that the Company’s estimated weighted average completion factors may vary by plus or minus 11 basis points from the Company’s assumed rates, which could impact health care costs payable by approximately plus or minus $140 million pretax.Also during 2020 and 2019, the Company observed that health care costs for claims with claim incurred dates of three months or less before the financial statement date were lower than previously estimated. Specifically, after considering the claims paid in 2020 and 2019 with claim incurred dates for the fourth quarter of the previous year, the Company observed health care costs that were 4.0% and 3.2% lower, respectively, for each fourth quarter than previously estimated, resulting in a reduction of $394 million and $284 million in 2020 and 2019, respectively, in health care costs payable that related to prior year.Management considers historical health care cost trend rates together with its knowledge of recent events that may impact current trends when developing estimates of current health care cost trend rates. When establishing reserves as of December 31, 2020, the Company increased its assumed health care cost trend rates for the most recent three months by 9.6% from health care cost trend rates recently observed. Assumed health care cost trend rates during the fourth quarter of 2020 are elevated compared to historical levels due to the impact of COVID-19 pandemic on utilization during 2020. Specifically, beginning in mid-March, the health system experienced a significant reduction in utilization that is discretionary and the cancellation of elective medical procedures. Utilization remained below historical levels through April, began to recover in May and June and reached more normal levels in the third and fourth quarters, with select geographies impacted by COVID-19 waves. Based on historical claim experience, it is reasonably possible that the Company’s estimated health care cost trend rates may vary by plus or minus 3.5% from the assumed rates, which could impact health care costs payable by plus or minus $404 million pretax.Income TaxesThe Company accounts for income taxes using the asset and liability method. Deferred tax assets and liabilities are established for any temporary differences between financial and tax reporting bases and are adjusted as needed to reflect changes in the enacted tax rates expected to be in effect when the temporary differences reverse. Such adjustments are recorded in the period in which changes in tax laws are enacted, regardless of when they are effective. Deferred tax assets are reduced, if necessary, by a valuation allowance to the extent future realization of those losses, deductions or other tax benefits is sufficiently uncertain.Significant judgment is required in determining the provision for income taxes and the related taxes payable and deferred tax assets and liabilities since, in the ordinary course of business, there are transactions and calculations where the ultimate tax outcome is uncertain. Additionally, the Company’s tax returns are subject to audit by various domestic and foreign tax authorities that could result in material adjustments based on differing interpretations of the tax laws. Although management believes that its estimates are reasonable and are based on the best available information at the time the provision is prepared, actual results could differ from these estimates resulting in a final tax outcome that may be materially different from that which is reflected in the consolidated financial statements.The tax benefit from an uncertain tax position is recognized only if it is more likely than not that the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the position. The tax benefits recognized in the consolidated financial statements from such positions are then measured based on the largest benefit that has a greater than 50% likelihood of being realized upon settlement with the related tax authority. Interest and/or penalties related to uncertain tax positions are recognized in the income tax provision. Significant judgment is required in determining uncertain tax positions. The Company has established accruals for uncertain tax positions using its judgment and adjusts these accruals, as warranted, due to changing facts and circumstances.95New Accounting PronouncementsSee Note 1 ‘‘Significant Accounting Policies’’ included in Item 8 of this 10-K for a description of new accounting pronouncements applicable to the Company.96Table of ContentsItem 7A. Quantitative and Qualitative Disclosures About Market Risk.The Company’s earnings and financial condition are exposed to interest rate risk, credit quality risk, market valuation risk, foreign currency risk, commodity risk and operational risk.Evaluation of Interest Rate and Credit Quality RiskThe Company manages interest rate risk by seeking to maintain a tight match between the durations of assets and liabilities when appropriate. The Company manages credit quality risk by seeking to maintain high average credit quality ratings and diversified sector exposure within its debt securities portfolio. In connection with its investment and risk management objectives, the Company also uses derivative financial instruments whose market value is at least partially determined by, among other things, levels of or changes in interest rates (short-term or long-term), duration, prepayment rates, equity markets or credit ratings/spreads. The Company’s use of these derivatives is generally limited to hedging risk and has principally consisted of using interest rate swaps, treasury rate locks, forward contracts, futures contracts, warrants, put options and credit default swaps. These instruments, viewed separately, subject the Company to varying degrees of interest rate, equity price and credit risk. However, when used for hedging, the Company expects these instruments to reduce overall risk.InvestmentsThe Company’s investment portfolio supported the following products at December 31, 2020 and 2019:In millions20202019Experience-rated products $1,037 $1,100 Remaining products22,775 18,587 Total investments$23,812 $19,687 Investment risks associated with experience-rated products generally do not impact the Company’s operating results. The risks associated with investments supporting experience-rated pension and annuity products in the large case pensions business in the Company’s Corporate/Other segment are assumed by the contract holders and not by the Company (subject to, among other things, certain minimum guarantees). Assets supporting experience-rated products may be subject to contract holder or participant withdrawals.The debt securities in the Company’s investment portfolio had an average credit quality rating of A at both December 31, 2020 and 2019 with approximately $6.3 billion and $4.4 billion rated AAA at December 31, 2020 and 2019, respectively. The debt securities that were rated below investment grade (that is, having a credit quality rating below BBB-/Baa3) were $1.9 billion and $1.2 billion at December 31, 2020 and 2019, respectively (of which 2% and 4% at December 31, 2020 and 2019, respectively, supported experience-rated products).At December 31, 2020 and 2019, the Company held $321 million and $333 million, respectively, of municipal debt securities that were guaranteed by third parties, representing 2% of total investments at both December 31, 2020 and 2019. These securities had an average credit quality rating of AA at both December 31, 2020 and 2019 with the guarantee. These securities had an average credit quality rating of A and A+ at December 31, 2020 and 2019, respectively, without the guarantee. The Company does not have any significant concentration of investments with third party guarantors (either direct or indirect).The Company generally classifies debt securities as available for sale, and carries them at fair value on the consolidated balance sheets. At both December 31, 2020 and 2019, less than 1% of debt securities were valued using inputs that reflect the Company’s assumptions (categorized as Level 3 inputs in accordance with accounting principles generally accepted in the United States of America). See Note 4 ‘‘Fair Value’’ included in Item 8 of this 10-K for additional information on the methodologies and key assumptions used to determine the fair value of investments. For additional information related to investments, see Note 3 ‘‘Investments’’ included in Item 8 of this 10-K.The Company regularly reviews debt securities in its portfolio to determine whether a decline in fair value below the cost basis or carrying value has occurred. If a debt security is in an unrealized loss position and the Company has the intent to sell the security, or it is more likely than not that the Company will have to sell the security before recovery of its amortized cost basis, the amortized cost basis of the security is written down to its fair value and the difference is recognized in net income. If a debt security is in an unrealized loss position and the Company does not have the intent to sell and it is more likely than not that the Company will not have to sell such security before recovery of its amortized cost basis, the Company bifurcates the impairment into credit-related and non-credit related components. The amount of the credit-related component is recorded as an allowance 97for credit losses and recognized in net income, and the amount of the non-credit related component is included in other comprehensive income. The impairment of debt securities is considered a critical accounting policy. See ‘‘Critical Accounting Policies - Impairments of Debt Securities” in the MD&A included in Item 7 of this 10-K for additional information.Evaluation of Market Valuation RisksThe Company regularly evaluates its risk from market-sensitive instruments by examining, among other things, levels of or changes in interest rates (short-term or long-term), duration, prepayment rates, equity markets and/or credit ratings/spreads. The Company also regularly evaluates the appropriateness of investments relative to management-approved investment guidelines (and operates within those guidelines) and the business objectives of its portfolios.On a quarterly basis, the Company reviews the impact of hypothetical net losses in its investment portfolio on the Company’s consolidated near-term financial condition, operating results and cash flows assuming the occurrence of certain reasonably possible changes in near-term market rates and prices. Interest rate changes (whether resulting from changes in treasury yields or credit spreads or other factors) represent the most material risk exposure category for the Company. The Company has estimated the impact on the fair value of market sensitive instruments based on the net present value of cash flows using a representative set of likely future interest rate scenarios. The assumptions used were as follows: an immediate increase of 100 basis points in interest rates (which the Company believes represents a moderately adverse scenario) for long-term debt issued by the Company, as well as its interest rate sensitive investments and an immediate decrease of 15% in prices for publicly traded domestic equity securities.Assuming an immediate increase of 100 basis points in interest rates, the theoretical decline in the fair values of market sensitive instruments at December 31, 2020 is as follows:•The fair value of long-term debt issued by the Company would decline by approximately $5.3 billion ($6.7 billion pretax). Changes in the fair value of long-term debt do not impact the Company’s operating results or financial condition.•The theoretical reduction in the fair value of interest rate sensitive investments partially offset by the theoretical reduction in the fair value of interest rate sensitive liabilities would result in a net decline in fair value of approximately $490 million ($615 million pretax) related to continuing non-experience-rated products. Reductions in the fair value of investment securities would be reflected as an unrealized loss in equity, as the Company classifies these debt securities as available for sale. The Company does not record liabilities at fair value.If the value of the Company’s publicly traded domestic equity securities were to decline by 15%, this would result in a net decline in fair value of $5 million ($7 million pretax).Based on overall exposure to interest rate risk and equity price risk, the Company believes that these changes in market rates and prices would not materially affect consolidated near-term financial condition, operating results or cash flows as of December 31, 2020.Evaluation of Foreign Currency and Commodity RiskAt December 31, 2020 and 2019, the Company did not have any material foreign currency exchange rate or commodity derivative instruments in place and believes its exposure to foreign currency exchange rate risk is not material.At December 31, 2020 and 2019, 5.5% and 6.1%, respectively, of the Company’s investment portfolio was comprised of investments that have exposure to the oil and gas industry, with more than half that amount comprised of investment grade rated debt securities. These exposures are experiencing varied degrees of financial strains in the current depressed oil and gas price environment, and the likelihood of the Company’s portfolio incurring additional realized capital losses on these exposures may increase if such depressed prices persist and/or decline further.98Evaluation of Operational RisksThe Company also faces certain operational risks. Those risks include risks related to the COVID-19 pandemic and risks related to information security, including cybersecurity. The spread of COVID-19, or actions taken to mitigate its spread, could have material and adverse effects on our ability to operate our businesses effectively, including as a result of the complete or partial closure of facilities or labor shortages. Disruptions in our supply chains, our distribution chains and/or public and private infrastructure, including communications, financial services and supply chains, could materially and adversely impact our business operations. We have transitioned a significant subset of our colleagues to a remote work environment in an effort to mitigate the spread of COVID-19, as have a significant number of our third-party service providers, which may amplify certain risks to our businesses, including an increased demand for information technology resources, increased risk of phishing and other cyber attacks, increased risk of unauthorized dissemination of sensitive personal information or proprietary or confidential information about us or our medical members or other third-parties and increased risk of business interruptions.The Company and its vendors have experienced diverse cyber attacks and expect to continue to experience cyber attacks going forward. As examples, the Company and its vendors have experienced attempts to gain access to systems, denial of service attacks, attempted malware infections, account takeovers, scanning activity and phishing emails. Attacks can originate from external criminals, terrorists, nation states or internal actors. The Company is dedicating and will continue to dedicate significant resources and incur significant expenses to maintain and update on an ongoing basis the systems and processes that are designed to mitigate the information security risks it faces and protect the security of its computer systems, software, networks and other technology assets against attempts by unauthorized parties to obtain access to confidential information, disrupt or degrade service or cause other damage. The impact of cyber attacks has not been material to the Company’s operations or operating results through December 31, 2020. The Board and its Audit Committee and Nominating and Corporate Governance Committee are regularly informed regarding the Company’s information security policies, practices and status.99Table of Contents
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+Item 7. Management’s Discussion and Analysis of Financial Condition and Results of OperationsThe following discussion and analysis of our financial condition and results of operations should be read in conjunction with the consolidated financial statements and related notes thereto included elsewhere in this Annual Report on Form 10-K. Some of the information contained in this discussion and analysis or set forth elsewhere in this Annual Report on Form 10-K, including information with respect to our plans and strategy for our business, includes forward-looking statements that involve risks and uncertainties, including those described under the heading “Special Note Regarding Forward-Looking Statements.” You should review the disclosure under Part I, Item 1A, “Risk Factors” in this Annual Report on Form 10-K for a discussion of important factors that could cause actual results to differ materially from the results described in or implied by the forward-looking statements contained in the following discussion and analysis. Our fiscal years ended January 31, 2021, January 31, 2020, and January 31, 2019, are referred to herein as fiscal 2021, fiscal 2020, and fiscal 2019, respectively.OverviewWe founded CrowdStrike in 2011 to reinvent security for the cloud era. When we started the company, cyberattackers had a decided, asymmetric advantage over existing security products. We turned the tables on the adversaries by taking a fundamentally new approach that leverages the network effects of crowdsourced data applied to modern technologies such as AI, cloud computing, and graph databases. Realizing that the nature of cybersecurity problems had changed but the solutions had not, we built our CrowdStrike Falcon platform to detect threats and stop breaches.We believe we are defining a new category called the Security Cloud, with the power to transform the security industry much the same way the cloud has transformed the customer relationship management, human resources, and service management industries. With our Falcon platform, we created the first multi-tenant, cloud native, intelligent security solution capable of protecting workloads across on-premise, virtualized, and cloud-based environments running on a variety of endpoints such as desktops, laptops, servers, virtual machines, cloud workloads, cloud containers, mobile, and IoT devices. Our Falcon platform is composed of two tightly integrated proprietary technologies: our easily deployed intelligent lightweight agent and our cloud-based, dynamic graph database called Threat Graph. Our solution benefits from crowdsourcing and economies of scale, which we believe enables our AI algorithms to be uniquely effective. We call this cloud-scale AI. Our single lightweight agent is installed on each endpoint or the cloud workload host and provides local detection and prevention capabilities while also intelligently collecting and streaming high fidelity data to our platform for real-time decision-making. Our Threat Graph processes, correlates, and analyzes this data in the cloud using a combination of AI and behavioral pattern-matching techniques. By analyzing and correlating information across our massive, crowdsourced dataset, we are able to deploy our AI algorithms at cloud-scale and build a more intelligent, effective solution to detect threats and stop breaches that on-premise or single instance cloud products cannot match. Today, we offer 19 cloud modules via a SaaS subscription-based model that spans multiple large markets, including corporate workload security, security and vulnerability management, managed security services, IT operations management, threat intelligence services, identity protection and log management. On June 14, 2019 we closed our initial public offering, or IPO, in which we issued and sold 20,700,000 shares of Class A common stock. The price per share to the public was $34.00. We received aggregate proceeds of $665.1 million from the IPO, net of underwriters’ discounts and commissions and before deducting estimated offering costs of $5.9 million. Upon the closing of the IPO, all shares of our outstanding preferred stock automatically converted into 131,267,586 shares of Class B common stock. In connection with our IPO, all shares of our common stock outstanding prior to our IPO were automatically converted into shares of Class B common stock.In March 2020, the World Health Organization declared the COVID-19 outbreak to be a pandemic. Since then, the COVID-19 pandemic has rapidly spread across the globe and has already resulted in significant volatility, uncertainty, and economic disruption. Thus far, the impact of the pandemic has been modest with some customers, particularly in heavily impacted industries, requesting special billing or payment terms. Our gross retention rate for the fourth quarter of fiscal 2021 remained consistently high and our dollar-based net retention rate once again exceeded 120 percent as we continued to expand module adoption within new and existing customers. In March 2020, we implemented several measures to help protect the health and safety of our employees around the globe including restricting all travel and transitioning 100% of our workforce to be remote. In addition, in response to the uncertain macroeconomic environment, we converted all of our marketable securities to cash and cash equivalents, and as of January 31, 2021, all of our investments were classified as cash.57Table of ContentsWe continue to conduct business as usual with modifications to employee travel, employee work locations, customer interactions, and cancellation of certain marketing events, among other things. We will continue to actively monitor the situation and may take further actions that alter our business operations as may be required by federal, state, or local authorities, or that we determine are in the best interests of our employees, customers, partners, suppliers, and stockholders. The extent to which the COVID-19 pandemic may impact our longer-term operational and financial performance remains uncertain. Furthermore, due to our subscription-based business model, the effect of the COVID-19 pandemic may not be fully reflected in our results of operations until future periods, if at all. The extent of the impact of the COVID-19 pandemic will depend on several factors, including the pace of reopening the economy around the world; the possible resurgence in the spread of the virus; the development cycle of therapeutics and vaccines; the impact on our customers and our sales cycles; the impact on our customer, employee, and industry events; and the effect on our vendors. Please see Part I, Item 1A, “Risk Factors” in this Annual Report on Form 10-K for a further description of the material risks we currently face, including risks related to the COVID-19 pandemic.In March 2020, we launched two initiatives to help our customers quickly onboard new remote workers without sacrificing protection or having to worry about a procurement cycle. This included a surge relief plan that allows our customers to surge the number of endpoints for a limited time. Additionally, we launched a Falcon Prevent for Home Use program that allows our customers’ company administrators to install Falcon Prevent on their employees’ home systems. We believe both of these initiatives have been well received by our customers.On September 30, 2020, we acquired Preempt Security, a privately-held Delaware corporation that developed real-time access control and threat prevention technology (the “Acquisition”). The total consideration transferred was $91.2 million which consisted of $87.4 million in cash and $3.8 million representing the fair value of replacement equity awards attributable to pre-acquisition service. The purchase price was allocated, on a preliminary basis, to identified intangible assets, which include developed technology, customer relationships and trade names, of $16.4 million, net tangible assets acquired of $(0.5) million and goodwill of $75.3 million, representing the excess of the purchase price over the fair value of net tangible and intangible assets acquired. With this acquisition, we plan to offer customers enhanced Zero Trust security capabilities and strengthen our Falcon platform with conditional access technology. The addition of Preempt Security’s technology to the Falcon platform will help customers achieve end-to-end visibility and enforcement on identity data.On January 4, 2021, we amended and restated our existing credit agreement (the “A&R Credit Agreement” and the facility thereunder the “Revolving Facility”) among CrowdStrike, Inc., as borrower, CrowdStrike Holdings, Inc., as guarantor, and Silicon Valley Bank and the other lenders party thereto, providing us with a revolving line of credit of up to $750.0 million, including a letter of credit sub-facility in the aggregate amount of $100.0 million, and a swingline sub-facility in the aggregate amount of $50.0 million. We also have the option to request an incremental facility of up to an additional $250.0 million from one or more of the lenders under the A&R Credit Agreement. The A&R Credit Agreement is guaranteed by all of our material domestic subsidiaries. The maturity date under the A&R Credit Agreement is January 2, 2026. On January 20, 2021, we issued and sold $750.0 million aggregate principal amount of 3.000% Senior Notes due 2029 (the “Senior Notes”). The Senior Notes are guaranteed by one of our subsidiaries, CrowdStrike, Inc., as of the closing date, and thereafter will be guaranteed by any of our domestic subsidiaries that become borrowers or guarantors under our senior secured revolving credit facility. The Senior Notes and the guarantee are general unsecured senior obligations and rank equal in right of payment to all of our existing and future senior indebtedness. Interest will be payable semi-annually at a rate of 3.000% per year. The Senior Notes will mature on February 15, 2029. We may redeem the Senior Notes prior to maturity under certain circumstances. The net proceeds from the debt offering were $739.6 million after deducting the underwriting commissions of $9.4 million and $1.0 million of issuance costs, which were paid as of January 31, 2021.Our Go-To-Market StrategyWe sell subscriptions to our Falcon platform and cloud modules to organizations across multiple industries. We primarily sell subscriptions to our Falcon platform and cloud modules through our direct sales team that leverages our network of channel partners. Our direct sales team is comprised of field sales and inside sales professionals who are segmented by a customer’s number of endpoints.58Table of ContentsWe have a low friction land-and-expand sales strategy. When customers deploy our Falcon platform, they can start with any number of cloud modules and we can activate additional cloud modules in real time on the same agent already deployed on the endpoint. This architecture has also allowed us to begin to offer a free trial of our Falcon Prevent module directly from our website or the AWS Marketplace, and we plan to extend this capability to additional modules in the future. Once customers experience the benefits of our Falcon platform, they often expand their adoption over time by adding more endpoints or purchasing additional modules. We also use our sales team to identify current customers who may be interested in free trials of additional cloud modules, which serves as a powerful driver of our land-and-expand model. By segmenting our sales teams, we can deploy a low-touch sales model that efficiently identifies prospective customers.We began as a solution for large enterprises, but the flexibility and scalability of our Falcon platform has enabled us to seamlessly offer our solution to customers of any size—from those with hundreds of thousands of endpoints to as few as three. We have expanded our sales focus to include any organization without the need to modify our Falcon platform for small and medium sized businesses.A substantial majority of our customers purchase subscriptions with a term of one year. Our subscriptions are generally priced on a per-endpoint and per-module basis. We recognize revenue from our subscriptions ratably over the term of the subscription. We also generate revenue from our incident response and proactive professional services, which are generally priced on a time and materials basis. We view our professional services business primarily as an opportunity to cross-sell subscriptions to our Falcon platform and cloud modules.Certain Factors Affecting Our PerformanceAdoption of Our Solutions. We believe our future success depends in large part on the growth in the market for cloud-based SaaS-delivered endpoint security solutions. Many organizations have not yet abandoned the on-premise legacy products in which they have invested substantial personnel and financial resources to design and maintain. As a result, it is difficult to predict customer adoption rates and demand for our cloud-based solutions.New Customer Acquisition. Our future growth depends in large part on our ability to acquire new customers. If our efforts to attract new customers are not successful, our revenue and rate of revenue growth may decline. We believe that our go-to-market strategy and the flexibility and scalability of our Falcon platform allow us to rapidly expand our customer base. Our incident response and proactive services also help drive new customer acquisitions, as many of these professional services customers subsequently purchase subscriptions to our Falcon platform. Many organizations have not yet adopted cloud-based security solutions, and since our Falcon platform has offerings for organizations of all sizes, worldwide, and across industries, we believe this presents a significant opportunity for growth.Maintain Customer Retention and Increase Sales. Our ability to increase revenue depends in large part on our ability to retain our existing customers and increase the ARR of their subscriptions. We focus on increasing sales to our existing customers by expanding their deployments to more endpoints and selling additional cloud modules for increased functionality. In February 2017, we transitioned our platform from a single offering into highly-integrated offerings of multiple SKU cloud modules. We initially launched this strategy with our IT hygiene, next-generation antivirus, EDR, managed threat hunting, and intelligence modules. We currently have 19 cloud modules that span multiple large markets. Invest in Growth. We believe that our market opportunity is large and requires us to continue to invest significantly in sales and marketing efforts to further grow our customer base, both domestically and internationally. Our open cloud architecture and single data model have allowed us to rapidly build and deploy new cloud modules, and we expect to continue investing in those efforts to further enhance our technology platform and product functionality. In addition to our ongoing investment in research and development, we may also pursue acquisitions of businesses, technologies, and assets that complement and expand the functionality of our Falcon platform, add to our technology or security expertise, or bolster our leadership position by gaining access to new customers or markets. Furthermore, we expect our general and administrative expenses to increase in dollar amount for the foreseeable future given the additional expenses for accounting, compliance, and investor relations as we grow as a public company.59Table of ContentsKey MetricsWe monitor the following key metrics to help us evaluate our business, identify trends affecting our business, formulate business plans, and make strategic decisions.Subscription CustomersWe define a subscription customer as a separate legal entity that has entered into a distinct subscription agreement for access to Falcon platform for which the term has not ended or with which we are negotiating a renewal contract. We do not consider our channel partners as customers, and we treat managed service security providers, who may purchase our products on behalf of multiple companies, as a single customer. While initially we focused our sales and marketing efforts on large enterprises, in recent years we have also increased our sales and marketing to small and medium sized businesses. The following table sets forth the number of our subscription customers as of the dates presented:As of January 31,202120202019Subscription customers9,896 5,431 2,516 Year-over-year growth82 %116 %103 %We added 4,465 net new subscription customers during fiscal 2021, including 64 from the acquisition of Preempt Security, for a total of 9,896 subscription customers as of January 31, 2021, representing 82% growth year-over-year.Annual Recurring Revenue (“ARR”)ARR is calculated as the annualized value of our customer subscription contracts as of the measurement date, assuming any contract that expires during the next 12 months is renewed on its existing terms. To the extent that we are negotiating a renewal with a customer after the expiration of the subscription, we continue to include that revenue in ARR if we are actively in discussion with such an organization for a new subscription or renewal, or until such organization notifies us that it is not renewing its subscription.The following table sets forth our ARR as of the dates presented:As of January 31,202120202019(dollars in thousands)Annual recurring revenue$1,050,051$600,456 $312,656Year-over-year growth75 %92 %121 %ARR increased 75% year-over-year and grew to $1.1 billion as of January 31, 2021, of which $449.6 million was net new ARR added during fiscal 2021, including $6.8 million from the acquisition of Preempt Security.Dollar-Based Net Retention RateOur dollar-based net retention rate compares our ARR from a set of subscription customers against the same metric for those subscription customers from the prior year. Our dollar-based net retention rate reflects customer renewals, expansion, contraction, and churn, and excludes revenue from our incident response and proactive services. We calculate our dollar-based net retention rate as of period end by starting with the ARR from all subscription customers as of 12 months prior to such period end, or Prior Period ARR. We then calculate the ARR from these same subscription customers as of the current period end, or Current Period ARR. Current Period ARR includes any expansion and is net of contraction or churn over the trailing 12 months but excludes revenue from new subscription customers in the current period. We then divide the Current Period ARR by the Prior Period ARR to arrive at our dollar-based net retention rate.60Table of ContentsSince January 2016, our dollar-based net retention rate has consistently exceeded 100% which is primarily attributable to an expansion of endpoints within, and cross-selling additional cloud modules to, our existing subscription customers. Our dollar-based net retention rate can fluctuate from period to period due to large customer contracts in a given period, which may reduce our dollar-based net retention rate in subsequent periods if the customer makes a larger upfront purchase and does not continue to increase purchases.As of January 31,202120202019Dollar-based net retention rate125 %124 %147 %Our dollar-based net retention rate has varied from quarter to quarter due to a number of factors and we expect that trend to continue. In addition, we have seen strong success with our strategy to land bigger deals with more modules, and we are also seeing an acceleration in our acquisition of new customers. While we view these two trends as positive developments, they have a natural trade off on our ability to expand business with existing customers in the near term.Components of Our Results of OperationsRevenueSubscription Revenue. Subscription revenue primarily consists of subscription fees for our Falcon platform and additional cloud modules that are supported by our cloud-based platform. Subscription revenue is driven primarily by the number of subscription customers, the number of endpoints per customer, and the number of cloud modules included in the subscription. We recognize subscription revenue ratably over the term of the agreement, which is generally one to three years. Because the majority of our subscription customers are billed upfront, we have recorded significant deferred revenue. Consequently, a substantial portion of the revenue that we report in each period is attributable to the recognition of deferred revenue relating to subscriptions that we entered into during previous periods. The majority of our customers are invoiced annually in advance or multi-year in advance.Professional Services Revenue. Professional services revenue includes incident response and proactive services, forensic and malware analysis, and attribution analysis. Professional services are generally sold separately from subscriptions to our Falcon platform, although customers frequently enter into a separate arrangement to purchase subscriptions to our Falcon platform at the conclusion of a professional services arrangement. Professional services are available through hourly rate and fixed fee contracts, one-time and ongoing engagements, and retainer-based agreements. For time and materials and retainer-based arrangements, revenue is recognized as services are performed. For fixed fee contracts, we recognize revenue by applying the proportional performance method.Cost of RevenueSubscription Cost of Revenue. Subscription cost of revenue consists primarily of costs related to hosting our cloud-based Falcon platform in data centers, amortization of our capitalized internal-use software, employee-related costs such as salaries and bonuses, stock-based compensation expense, benefits costs associated with our operations and support personnel, software license fees, property and equipment depreciation, amortization of acquired intangibles, and an allocated portion of facilities and administrative costs.As new customers subscribe to our platform and existing subscription customers increase the number of endpoints on our Falcon platform, our cost of revenue will increase due to greater cloud hosting costs related to powering new cloud modules and the incremental costs for storing additional data collected for such cloud modules and employee-related costs. We intend to continue to invest additional resources in our cloud platform and our customer support organizations as we grow our business. The level and timing of investment in these areas could affect our cost of revenue in the future.Professional Services Cost of Revenue. Professional services cost of revenue consists primarily of employee-related costs, such as salaries and bonuses, stock-based compensation expense, technology, property and equipment depreciation, and an allocated portion of facilities and administrative costs.61Table of ContentsGross Profit and Gross MarginGross profit and gross margin have been and will continue to be affected by various factors, including the timing of our acquisition of new subscription customers, renewals from existing subscription customers, sales of additional modules to existing subscription customers, the data center and bandwidth costs associated with operating our cloud platform, the extent to which we expand our customer support and cloud operations organizations, and the extent to which we can increase the efficiency of our technology, infrastructure, and data centers through technological improvements. We expect our gross profit to increase in dollar amount and our gross margin to increase modestly over the long term, although our gross margin could fluctuate from period to period depending on the interplay of these factors. Demand for our incident response services is driven by the number of breaches experienced by non-customers. Also, we view our professional services solutions in the context of our larger business and as a significant lead generator for new subscriptions. Because of these factors, our services revenue and gross margin may fluctuate over time.Operating ExpensesOur operating expenses consist of sales and marketing, research and development and general administrative expenses. For each of these categories of expense, employee-related expenses are the most significant component, which include salaries, employee bonuses, sales commissions, and employer payroll tax. Operating expenses also include an allocated portion of overhead costs for facilities and IT.Sales and Marketing. Sales and marketing expenses primarily consist of employee-related expenses such as salaries, commissions, and bonuses. Sales and marketing expenses also include stock-based compensation; expenses related to our Fal.Con customer conference and other marketing events; an allocated portion of facilities and administrative expenses; amortization of acquired intangibles, and cloud hosting and related services costs related to proof of value efforts. We capitalize and amortize sales commissions and any other incremental payments made upon the initial acquisition of a subscription or upsells to existing customers to sales and marketing expense over the estimated customer life, and amortize any such expenses paid for the renewal of a subscription to sales and marketing expense over the term of the renewal.We expect sales and marketing expenses to increase in dollar amount as we continue to make significant investments in our sales and marketing organization to drive additional revenue, further penetrate the market, and expand our global customer base. However, we anticipate sales and marketing expenses to decrease as a percentage of our total revenue over time, although our sales and marketing expenses may fluctuate as a percentage of our total revenue from period-to-period depending on the timing of these expenses.Research and Development. Research and development expenses primarily consist of employee-related expenses such as salaries and bonuses; stock-based compensation, consulting expenses related to the design; development, testing, and enhancements of our subscription services; and an allocated portion of facilities and administrative expenses. Our cloud platform is software-driven, and our research and development teams employ software engineers in the design, and the related development, testing, certification, and support of these solutions.We expect research and development expenses to increase in dollar amount as we continue to increase investments in our technology architecture and software platform. However, we anticipate research and development expenses to decrease as a percentage of our total revenue over time, although our research and development expenses may fluctuate as a percentage of our total revenue from period-to-period depending on the timing of these expenses.General and Administrative. General and administrative expenses consist of employee-related expenses such as salaries and bonuses; stock-based compensation; and related expenses for our executive, finance, human resources, and legal organizations. In addition, general and administrative expenses include outside legal, accounting, and other professional fees; and an allocated portion of facilities and administrative expenses. As a public company, we expect general and administrative expenses to increase in dollar amount over time. However, we anticipate general and administrative expenses to decrease as a percentage of our total revenue over time although our general and administrative expenses may fluctuate as a percentage of our total revenue from period-to-period depending on the timing of these expenses.62Table of ContentsInterest Expense: Interest Expense consists primarily of interest expense on our secured revolving credit facility, interest expense from amortization of debt issuance costs, and contractual interest expense for our Senior Notes issued in January 2021. We expect interest expense to be higher in fiscal 2022 as a result of the issuance of our Senior Notes.Other Income (Expense), Net. Other income (expense), net, consists primarily of income earned on our cash equivalents and marketable securities; expense related to the fair value of warrants for our redeemable convertible preferred stock and foreign currency transaction gains and losses.Provision for Income Taxes. Provision for income taxes consists of federal and state income taxes in the United States and income taxes and withholding taxes related to customer payments in certain foreign jurisdictions in which we conduct business. We maintain a full valuation allowance on our U.S. federal and state and UK deferred tax assets that we have determined are not realizable on a more likely than not basis.Results of OperationsThe following tables set forth our consolidated statements of operations in dollar amounts and as a percentage of total revenue for each period presented:Year Ended January 31,202120202019( in thousands)RevenueSubscription$804,670 $436,323 $219,401 Professional services69,768 45,090 30,423 Total revenue874,438 481,413 249,824 Cost of revenueSubscription(1)(2)185,212 112,474 69,208 Professional services(1)44,333 29,153 18,030 Total cost of revenue229,545 141,627 87,238 Gross profit644,893 339,786 162,586 Operating expensesSales and marketing(1)(2)401,316 266,595 172,682 Research and development(1)(2)214,670 130,188 84,551 General and administrative(1)(3)121,436 89,068 42,217 Total operating expenses737,422 485,851 299,450 Loss from operations(92,529)(146,065)(136,864)Interest expense(4)(1,559)(442)(428)Other income (expense), net6,219 6,725 (1,418)Loss before provision for income taxes(87,869)(139,782)(138,710)Provision for income taxes4,760 1,997 1,367 Net loss$(92,629)$(141,779)$(140,077)______________________________(1)Includes stock-based compensation expense as follows:Year Ended January 31,202120202019(in thousands)Subscription cost of revenue$11,705 $5,226 $689 Professional services cost of revenue6,005 2,486 205 Sales and marketing50,557 23,919 5,175 Research and development40,274 15,403 7,815 General and administrative41,134 32,906 6,621 Total stock-based compensation expense$149,675 $79,940 $20,505 63Table of Contents(2)Includes amortization of acquired intangible assets as follows:Year Ended January 31,202120202019(in thousands)Subscription cost of revenue$1,057 $323 $327 Sales and marketing362 123 143 Research and development29 41 113 Total amortization of purchased intangibles$1,448 $487 $583 (3)Includes acquisition-related expenses as follows:Year Ended January, 31202120202019(in thousands)General and administrative $3,758 $— $— Total acquisition-related expenses $3,758 $— $— (4) Includes amortization of debt issuance costs and discount as follows:Year Ended January, 31202120202019(in thousands)Interest expense$347 $— $— Total amortization of debt issuance costs and discount$347 $— $— The following table presents the components of our consolidated statements of operations as a percentage of total revenue for the periods presented:Year Ended January 31,202120202019%%%RevenueSubscription92 %91 %88 %Professional services8 %9 %12 %Total revenue100 %100 %100 %Cost of revenueSubscription21 %23 %28 %Professional services5 %6 %7 %Total cost of revenue26 %29 %35 %Gross profit74 %71 %65 %Operating expensesSales and marketing46 %55 %69 %Research and development25 %27 %34 %General and administrative14 %19 %17 %Total operating expenses84 %101 %120 %Loss from operations(11)%(30)%(55)%Interest expense— %— %— %Other income (expense), net1 %1 %(1)%Loss before provision for income taxes(10)%(29)%(56)%Provision for income taxes1 %— %1 %Net loss(11)%(29)%(56)%64Table of ContentsComparison of Fiscal 2021 and Fiscal 2020RevenueThe following shows total revenue from subscriptions and professional services for fiscal 2021, as compared to fiscal 2020:Year EndedJanuary 31,Change20212020$%(dollars in thousands)Subscription$804,670 $436,323 $368,347 84 %Professional services69,768 45,090 24,678 55 %Total revenue$874,438 $481,413 $393,025 82 %Total revenue increased by $393.0 million, or 82%, in fiscal 2021, compared to fiscal 2020. Subscription revenue accounted for 92% of our total revenue in fiscal 2021, and 91% in fiscal 2020. Professional services revenue accounted for 8% of our total revenue in fiscal 2021 and 9% in fiscal 2020.Subscription revenue increased by $368.3 million, or 84%, in fiscal 2021, compared to fiscal 2020. This increase was primarily attributable to the addition of new subscription customers, as we increased our customer base by 82%, from 5,431 subscription customers in fiscal 2020 to 9,896 subscription customers in fiscal 2021. Subscription revenue from new customers, subscription revenue from the renewal of existing customers, and subscription revenue from the sale of additional endpoints and additional modules to existing customers accounted for 33%, 36%, and 31% of total subscription revenue in fiscal 2021, respectively. Subscription revenue from new customers, subscription revenue from the renewal of existing customers, and subscription revenue from the sale of additional endpoints and additional modules to existing customers accounted for 40%, 33%, and 27% of total subscription revenue in fiscal 2020, respectively.Professional services revenue increased by $24.7 million, or 55%, in fiscal 2021, compared to fiscal 2020, and was primarily attributable to an increase in the number of professional service hours performed.The following shows cost of revenue related to subscriptions and professional services for fiscal 2021, as compared to fiscal 2020:Year EndedJanuary 31,Change20212020$%(dollars in thousands)Subscription$185,212 $112,474 $72,738 65 %Professional services44,333 29,153 15,180 52 %Total cost of revenue$229,545 $141,627 $87,918 62 %Total cost of revenue increased by $87.9 million, or 62%, in fiscal 2021, compared to fiscal 2020. Subscription cost of revenue increased by $72.7 million, or 65%, in fiscal 2021, compared to fiscal 2020. The increase in subscription cost of revenue was primarily due to an increase in employee-related expenses of $27.6 million driven by a 74% increase in average headcount, an increase in cloud hosting and related services of $23.3 million driven by increased customer activity, an increase in depreciation of data center equipment of $7.8 million, an increase in stock-based compensation expense of $6.5 million, an increase in allocated overhead costs of $4.1 million, an increase in the amortization of internal use software of $1.6 million, and an increase in employee health insurance expense of $1.4 million, partially offset by a $1.2 million decrease in travel related costs due to the fact that, as a result of the COVID-19 pandemic, a majority of our workforce was working remotely and incurred limited travel costs during fiscal 2021.Professional services cost of revenue increased by $15.2 million, or 52%, in fiscal 2021, compared to fiscal 2020. The increase in professional services cost of revenue was primarily due to an increase in employee-related expenses of $11.4 million driven by an increase in average headcount of 47% and an increase in stock-based compensation expense of $3.5 million, partially offset by a $1.1 million decrease in travel related costs due to the fact that, as a result of the COVID-19 pandemic, a majority of our workforce was working remotely and incurred limited travel costs during fiscal 2021.65Table of ContentsThe following shows gross profit and gross margin for subscriptions and professional services for fiscal 2021, as compared to fiscal 2020.Year EndedJanuary 31,Change20212020$%(dollars in thousands)Subscription gross profit$619,458 $323,849 $295,609 91 %Professional services gross profit25,435 15,937 9,498 60 %Total gross profit$644,893 $339,786 $305,107 90 %Year EndedJanuary 31,Change20212020Subscription gross margin77 %74 %3 %Professional services gross margin36 %35 %2 %Total gross margin74 %71 %3 %Subscription gross margin increased by 3%, in fiscal 2021, compared to fiscal 2020. This increase was a result of continuing to shift more of our operations from third-party cloud service providers to colocation data centers, renegotiating the terms of a third-party cloud service provider contract, and continued optimization of our software development and our cloud database systems, which has resulted in reduced data center usage. This increase in gross margin was also due to the continued expansion of module adoption by our customer base. As of January 31, 2021, 63% of our customer base had adopted four or more modules and 47% of our customer base had adopted five or more modules. As of January 31, 2020, 54% of our customer base had adopted four or more modules and 33% of our customer base had adopted five or more modules. Our “collect once, reuse many” data strategy means that after the first module is paid for and covers the cost of data storage and most computational costs, each additional subscription module carries a higher margin. We expect gross margin to fluctuate quarter to quarter given the timing of turning on new cloud data centers in new geographies to accommodate increased activity and demand.Professional services gross margin increased by 2% in fiscal 2021, compared to fiscal 2020. The increase in professional services gross margin was due to an increase in utilization during fiscal 2021 compared to fiscal 2020Operating ExpensesSales and MarketingThe following shows sales and marketing expenses for fiscal 2021, as compared to fiscal 2020:Year EndedJanuary 31,Change20212020$%(dollars in thousands)Sales and marketing expenses$401,316 $266,595 $134,721 51 %Sales and marketing expenses increased by $134.7 million, or 51%, in fiscal 2021, compared to fiscal 2020. The increase in sales and marketing expenses was primarily due to an increase in employee-related expenses of $82.5 million driven by an increase in sales and marketing average headcount of 40%, an increase in stock-based compensation of $26.6 million, an increase in marketing programs of $21.5 million, an increase in allocated overhead costs of $5.5 million, an increase in employee health insurance expense of $2.0 million, an increase in company events expenses of $1.3 million, and an increase in contract labor costs of $1.1 million, partially offset by a $11.7 million decrease in travel-related costs due to the fact that, as a result of the COVID-19 pandemic, a majority of our workforce was working remotely and incurred limited travel costs during fiscal 2021.66Table of ContentsResearch and DevelopmentThe following shows research and development expenses for fiscal 2021, as compared to fiscal 2020:Year EndedJanuary 31,Change20212020$%(dollars in thousands)Research and development expenses$214,670 $130,188 $84,482 65 %Research and development expenses increased by $84.5 million, or 65% in fiscal 2021, compared to fiscal 2020. This increase was primarily due to an increase in employee-related expenses of $46.7 million driven by an increase in research and development average headcount of 59%, an increase in stock-based compensation of $24.9 million, an increase in cloud hosting and related costs of $7.3 million, an increase in allocated overhead costs of $5.2 million, an increase in depreciation of data center equipment of $3.6 million, and an increase in employee health insurance expense of $1.6 million, partially offset by a $3.1 million decrease in travel-related costs due to the fact that, as a result of the COVID-19 pandemic, a majority of our workforce was working remotely and incurred limited travel costs during fiscal 2021, and a decrease in expenses related to company events of $1.9 million.General and AdministrativeThe following shows general and administrative expenses for fiscal 2021, as compared to fiscal 2020:Year EndedJanuary 31,Change20212020$%(dollars in thousands)General and administrative expenses$121,436 $89,068 $32,368 36 %General and administrative expenses increased by $32.4 million, or 36%, in fiscal 2021, compared to fiscal 2020. The increase in general and administrative expenses was primarily due an increase in employee-related expenses of $12.9 million driven by an increase in general and administrative average headcount of 51%, an increase in stock-based compensation expense of $8.2 million, an increase in consulting expense of $3.9 million primarily due to acquisition related expense and debt issuance costs, an increase in corporate insurance expense of $2.5 million due to an increase in directors and officers insurance as a result of being a public company, an increase in overhead costs of $2.0 million, an increase in accounting expenses of $1.5 million, an increase in business taxes and license fees of $1.4 million, and an increase in legal expenses of $1.3 million, partially offset by a decrease in expenses related to company events of $1.1 million and a decrease of $1.1 million in travel-related costs due to the fact that, as a result of the COVID-19 pandemic, a majority of our workforce was working remotely and incurred limited travel costs during fiscal 2021.Interest Expense and Other Income, NetThe following shows interest and other expense, net, for fiscal 2021, as compared to fiscal 2020:Year EndedJanuary 31,Change20212020$%(dollars in thousands)Interest expense$(1,559)$(442)$(1,117)253 %Other income, net$6,219 $6,725 $(506)(8)%Interest Expense consists primarily of interest expense from the amortization of debt issuance costs and contractual interest expense for our Senior Notes issued in January 2021.67Table of Contents Other income, net, was $6.2 million in fiscal 2021 compared to $6.7 million in fiscal 2020. This decrease of $0.5 million was driven primarily by a decrease in interest income of $6.7 million due to lower prevailing rates in fiscal 2021 compared to fiscal 2020 and a decrease in income from a legal settlement of $1.3 million which occurred during fiscal 2020, partially offset by a decrease in expense related to the fair value of redeemable convertible preferred stock warrants of $6.0 million as the warrants were converted into common stock upon our IPO in June 2019 and an increase in realized gain on marketable securities of $1.3 million due to our having liquidated our portfolio of marketable securities during the first quarter of fiscal 2021 in response to the economic uncertainty surrounding the COVID-19 pandemic.Provision for Income TaxesThe following shows the provision for income taxes for fiscal 2021, as compared to fiscal 2020:Year EndedJanuary 31,Change20212020$%(dollars in thousands)Provision for income taxes$4,760 $1,997 $2,763 138 %The increase in the provision for income taxes of $2.8 million during fiscal 2021 compared to fiscal 2020 was primarily driven by an increase in international taxes from increased activity in certain foreign jurisdictions, withholding taxes related to customer payments, and U.S. income tax expense related to the realized gain on the sale of marketable securities, partially offset by a $0.9 million tax benefit from the acquisition of Preempt Security.Comparison of Fiscal 2020 and Fiscal 2019RevenueThe following shows total revenue from subscriptions and professional services for fiscal 2020, as compared to fiscal 2019:Year EndedJanuary 31,Change20202019$%(dollars in thousands)Subscription$436,323 $219,401 $216,922 99 %Professional services45,090 30,423 14,667 48 %Total revenue$481,413 $249,824 $231,589 93 %Total revenue increased by $231.6 million, or 93%, in fiscal 2020, compared to fiscal 2019. Subscription revenue accounted for 91% of our total revenue in fiscal 2020 and 88% in fiscal 2019. Professional services revenue accounted for 9% of our total revenue in fiscal 2020 and 12% in fiscal 2019.Subscription revenue increased by $216.9 million, or 99%, in fiscal 2020, compared to fiscal 2019. This increase was primarily attributable to the addition of new subscription customers, as we increased our customer base by 116%, from 2,516 subscription customers in fiscal 2019 to 5,431 subscription customers in fiscal 2020. Subscription revenue from new customers, subscription revenue from the renewal of existing customers, and subscription revenue from the sale of additional endpoints and additional modules to existing customers accounted for 40%, 33%, and 27% of total subscription revenue in fiscal 2020, respectively. Subscription revenue from new customers, subscription revenue from the renewal of existing customers, and subscription revenue from the sale of additional endpoints and additional modules to existing customers accounted for 59%, 23%, and 18% of total subscription revenue in fiscal 2019, respectively. Professional services revenue increased by $14.7 million, or 48%, in fiscal 2020, compared to fiscal 2019, and was primarily attributable to an increase in the number of professional service hours performed.68Table of ContentsCost of Revenue, Gross Profit, and Gross MarginThe following shows cost of revenue related to subscriptions and professional services for fiscal 2020, as compared to fiscal 2019:Year EndedJanuary 31,Change20202019$%(dollars in thousands)Subscription$112,474 $69,208 $43,266 63 %Professional services29,153 18,030 11,123 62 %Total cost of revenue$141,627 $87,238 $54,389 62 %Total cost of revenue increased by $54.4 million, or 62%, in fiscal 2020, compared to fiscal 2019. Subscription cost of revenue increased by $43.3 million, or 63%, in fiscal 2020, compared to fiscal 2019. The increase in subscription cost of revenue was primarily due to an increase in employee-related payroll expenses of $17.1 million driven by a 114% increase in average headcount which included significant hiring of customer support employees, an increase in cloud hosting and related services of $10.1 million, an increase in stock-based compensation expense of $4.5 million, an increase in depreciation of data center equipment of $3.8 million, an increase in allocated overhead costs of $3.7 million, an increase in employee health insurance expense of $1.1 million, and an increase in the amortization of capitalized internal use software of $1.0 million.Professional services cost of revenue increased by $11.1 million, or 62%, in fiscal 2020, compared to fiscal 2019. The increase in professional services cost of revenue was primarily due to an increase in employee-related payroll expenses of $6.5 million driven by an increase in average headcount of 53%, an increase in stock-based compensation of $2.3 million, an increase in allocated overhead costs of $0.9 million, and an increase in cloud hosting and related services of $0.4 million.The following shows gross profit and gross margin for subscriptions and professional services for fiscal 2020, as compared to fiscal 2019:Year EndedJanuary 31,Change20202019$%(dollars in thousands)Subscription gross profit$323,849 $150,193 $173,656 116 %Professional services gross profit15,937 12,393 3,544 29 %Total gross profit$339,786 $162,586 $177,200 109 %Year EndedJanuary 31,Change20202019Subscription gross margin74 %68 %6 %Professional services gross margin35 %41 %(6)%Total gross margin71 %65 %6 %Subscription gross margin increased by 6%, in fiscal 2020, compared to fiscal 2019. This increase was a result of moving more of our operations to co-location data centers from third-party cloud service providers and renegotiating the terms of a third-party cloud service provider contract. This increase in gross margin was also due to incentivizing our sales team to drive higher margin subscriptions and efforts to optimize our channel partner programs and the uptake of multiple cloud modules by our customer base. Our “collect once, reuse many” data strategy means that after the first module is paid for and covers the cost of data storage and most computational costs, each additional subscription module carries a higher margin. The decrease in professional services gross margin was due to a decrease in utilization in fiscal 2020 compared to fiscal 2019.69Table of ContentsOperating ExpensesSales and MarketingThe following shows sales and marketing expenses for fiscal 2020, as compared to fiscal 2019:Year EndedJanuary 31,Change20202019$%(dollars in thousands)Sales and marketing expenses$266,595 $172,682 $93,913 54 %Sales and marketing expenses increased by $93.9 million, or 54%, in fiscal 2020, compared to fiscal 2019. The increase in sales and marketing expenses was primarily due to an increase in employee-related payroll expenses of $36.5 million driven by an increase in average sales and marketing headcount of 54%, an increase in stock-based compensation of $18.7 million, an increase in marketing programs of $17.3 million, an increase in allocated overhead costs of $6.8 million, an increase in travel-related costs of $5.4 million, and an increase in employee health insurance expense of $2.2 million. As a result of adopting ASC 606 effective February 1, 2019, our commissions expense in fiscal 2020 was $21.7 million lower than it would have been under ASC 605.Research and DevelopmentThe following shows research and development expenses for fiscal 2020, as compared to fiscal 2019:Year EndedJanuary 31,Change20202019$%(dollars in thousands)Research and development expenses$130,188 $84,551 $45,637 54 %Research and development expenses increased by $45.6 million, or 54%, in fiscal 2020, compared to fiscal 2019. This increase was primarily due to an increase in employee-related payroll expenses of $24.5 million, driven by an increase in average research and development headcount of 45%. In addition, there was an increase of $7.6 million in stock-based compensation expense, an increase in cloud hosting and related costs of $6.3 million, an increase in allocated overhead costs of $3.7 million, an increase in employee health insurance expense of $1.3 million, and an increase in travel-related costs of $1.0 millionGeneral and AdministrativeThe following shows general and administrative expenses for fiscal 2020, as compared to fiscal 2019:Year EndedJanuary 31,Change20202019$%(dollars in thousands)General and administrative expenses$89,068 $42,217 $46,851 111 %General and administrative expenses increased by $46.9 million, or 111%, in fiscal 2020, compared to fiscal 2019. The increase in general and administrative expenses was primarily due to an increase in stock-based compensation expense of $26.9 million and an increase in employee-related payroll expenses of $9.9 million, driven by an increase in average general and administrative headcount of 66%. In addition, there was a $3.6 million increase in corporate insurance expense and a $1.6 million increase in allocated overhead costs.70Table of ContentsInterest Expense and Other Income (Expense), NetThe following shows interest and other expense, net, for fiscal 2020, as compared to fiscal 2019:Year EndedJanuary 31,Change20202019$%(dollars in thousands)Interest expense$(442)$(428)$(14)3 %Other income (expense), net$6,725 $(1,418)$8,143 (574)%Interest expense was essentially unchanged in fiscal 2020 compared to fiscal 2019 and is primarily due to the amortization of debt issuance costs on our $150.0 million loan facility which has not been drawn down.Other income (expense), net, was an income of $6.7 million in fiscal 2020 compared to an expense of $1.4 million in fiscal 2019. This increase in other income of $8.1 million was driven primarily by an increase in interest income of $9.0 million due to increased cash balances in fiscal 2020 as a result of our IPO and income from a legal settlement of $1.3 million, partially offset by an increase in the fair value of the redeemable convertible preferred stock warrants of $2.4 million. These warrants were converted to warrants to purchase common stock in connection with our IPO.Provision for Income TaxesThe following shows provision for income taxes for fiscal 2020, as compared to fiscal 2019:Year EndedJanuary 31,Change20202019$%(dollars in thousands)Provision for income taxes$1,997 $1,367 $630 46 %We had a provision for income taxes of $2.0 million in fiscal 2020 and a provision for income taxes of $1.4 million in fiscal 2019 resulting in an increase in income tax expense of $0.6 million. The increase was driven primarily by an increase in our international income tax expense of $1.0 million due to increased activity in several countries during fiscal 2020, partially offset by an income tax benefit of $0.4 million related to the unrealized gain on our available-for-sale securities. We maintain a full valuation allowance against our deferred tax assets for US federal and state and U.K. income tax purposes.71Table of ContentsNon-GAAP Financial MeasuresIn addition to our results determined in accordance with U.S. generally accepted accounting principles, or GAAP, we believe the following non-GAAP measures are useful in evaluating our operating performance. We use the following non-GAAP financial information to evaluate our ongoing operations and for internal planning and forecasting purposes. We believe that non-GAAP financial measures, may be helpful to investors because such measures provide consistency and comparability with past financial performance and, when taken together with the corresponding GAAP financial measures, provide meaningful supplemental information regarding our performance by excluding certain items that may not be indicative of our business, results of operations, or outlook. However, non-GAAP financial information is presented for supplemental informational purposes only, has limitations as an analytical tool, and should not be considered in isolation or as a substitute for financial information presented in accordance with GAAP. In particular, free cash flow is not a substitute for cash used in operating activities. Additionally, the utility of free cash flow as a measure of our financial performance and liquidity is further limited as it does not represent the total increase or decrease in our cash balance for a given period. In addition, other companies, including companies in our industry, may calculate similarly-titled non-GAAP measures differently or may use other measures to evaluate their performance, all of which could reduce the usefulness of our non-GAAP financial measures as tools for comparison. A reconciliation is provided below for each non-GAAP financial measure to the most directly comparable financial measure stated in accordance with GAAP. Investors are encouraged to review the related GAAP financial measures and the reconciliation of these non-GAAP financial measures to their most directly comparable GAAP financial measures and not rely on any single financial measure to evaluate our business.Non-GAAP Subscription Gross Profit and Non-GAAP Subscription Gross MarginWe define non-GAAP subscription gross profit and non-GAAP subscription gross margin as GAAP subscription gross profit and GAAP subscription gross margin, respectively, excluding stock-based compensation expense and amortization of acquired intangible assets. We believe non-GAAP subscription gross profit and non-GAAP subscription gross margin provide our management and investors consistency and comparability with our past financial performance and facilitate period-to-period comparisons of operations, as these measures eliminate the effects of certain variables unrelated to our overall operating performance.The following table presents a reconciliation of our non-GAAP subscription gross profit to our GAAP subscription gross profit and of our non-GAAP subscription gross margin to our GAAP subscription gross margin as of the periods presented:Year Ended January 31,202120202019(dollars in thousands)GAAP subscription revenue$804,670 $436,323 $219,401 GAAP subscription gross profit$619,458 $323,849 $150,193 Add: Stock-based compensation expense11,705 5,226 689 Add: Amortization of acquired intangible assets1,057 323 327 Non-GAAP subscription gross profit$632,220 $329,398 $151,209 GAAP subscription gross margin77 %74 %68 %Non-GAAP subscription gross margin79 %75 %69 %Non-GAAP Income (Loss) from Operations and Non-GAAP Operating MarginWe define non-GAAP income (loss) from operations and non-GAAP operating margin as GAAP loss from operations and GAAP operating margin, respectively, excluding stock-based compensation expense, amortization of acquired intangible assets, and acquisition-related expenses. We believe non-GAAP income (loss) from operations and non-GAAP operating margin provide our management and investors consistency and comparability with our past financial performance and facilitate period-to-period comparisons of operations, as these metrics generally eliminate the effects of certain variables unrelated to our overall operating performance.72Table of ContentsThe following table presents a reconciliation of our non-GAAP income (loss) from operations to our GAAP loss from operations and our non-GAAP operating margin to our GAAP operating margin as of the periods presented:Year Ended January 31,202120202019(dollars in thousands)GAAP total revenue$874,438 $481,413 $249,824 GAAP loss from operations$(92,529)$(146,065)$(136,864)Add: Stock-based compensation expense149,675 79,940 20,505 Add: Amortization of acquired intangible assets1,448 487 583 Add: Acquisition-related expenses3,758 — — Non-GAAP income (loss) from operations$62,352 $(65,638)$(115,776)GAAP operating margin(11)%(30)%(55)%Non-GAAP operating margin7 %(14)%(46)%Free Cash Flow and Free Cash Flow MarginFree cash flow is a non-GAAP financial measure that we define as net cash provided by (used in) operating activities less purchases of property and equipment and capitalized internal-use software. Free cash flow margin is calculated as free cash flow divided by total revenue. We believe that free cash flow and free cash flow margin are useful indicators of liquidity that provide useful information to management and investors about the amount of cash consumed by our operating activities that is therefore not available to be used for other strategic initiatives. One limitation of free cash flow and free cash flow margin is that they do not reflect our future contractual commitments. Additionally, free cash flow does not represent the total increase or decrease in our cash balance for a given period. In addition, other companies may calculate free cash flow differently or not at all, which reduces the usefulness of free cash flow as a tool for comparison.The following table presents a reconciliation of free cash flow and free cash flow margin to net cash provided by (used in) operating activities:Year Ended January 31,202120202019(dollars in thousands)GAAP total revenue$874,438 $481,413 $249,824 GAAP net cash provided by (used in) operating activities$356,566 $99,943 $(22,968)Less: Purchases of property and equipment(52,799)(80,198)(35,851)Less: Capitalized internal-use software(10,864)(7,289)(6,794)Free cash flow$292,903 $12,456 $(65,613)GAAP net cash provided by (used in) investing activities$495,427 $(629,631)$(142,030)GAAP net cash provided by financing activities$800,135 $706,144 $190,389 GAAP net cash provided by operating activities as a percentage of revenue41 %21 %(9)%Less: Purchases of property and equipment as a percentage of revenue(6)%(17)%(14)%Less: Capitalized internal-use software as a percentage of revenue(1)%(2)%(3)%Free cash flow margin33 %3 %(26)%73Table of ContentsQuarterly Results of OperationsThe following table sets forth our unaudited quarterly statements of operations data for each of the quarters indicated. The unaudited quarterly statements of operations data set forth below have been prepared on the same basis as our audited consolidated financial statements and, in the opinion of management, reflect all adjustments, consisting only of normal recurring adjustments, that are necessary for the fair statement of such data. Our historical results are not necessarily indicative of the results that may be expected in the future, and the results for any quarter are not necessarily indicative of results to be expected for a full year or any other period. The following quarterly financial data should be read in conjunction with our consolidated financial statements and the related notes included elsewhere in this Annual Report on Form 10-K.Three Months EndedJanuary 31, 2021October 31, 2020July 31, 2020April 30, 2020January 31, 2020October 31, 2019July 31, 2019April 30, 2019(in thousands)RevenueSubscription$244,662 $213,530 $184,256 $162,222 $138,537 $114,221 $97,575 $85,990 Professional services20,267 18,930 14,715 15,856 13,572 10,898 10,533 10,087 Total revenue264,929 232,460 198,971 178,078 152,109 125,119 108,108 96,077 Cost of revenueSubscription(1)(2)54,348 49,583 44,037 37,244 34,616 29,221 24,946 23,691 Professional services(1)12,384 11,944 10,354 9,651 8,801 8,134 6,636 5,582 Total cost of revenue66,732 61,527 54,391 46,895 43,417 37,355 31,582 29,273 Gross profit198,197 170,933 144,580 131,183 108,692 87,764 76,526 66,804 Operating expensesSales and marketing(1)(2)112,449 105,602 95,127 88,138 75,803 68,675 65,274 56,843 Research and development(1)(2)66,070 57,539 50,483 40,578 38,691 35,992 31,630 23,875 General and administrative(1)(3)35,481 31,951 28,961 25,043 25,331 21,615 30,261 11,861 Total operating expenses214,000 195,092 174,571 153,759 139,825 126,282 127,165 92,579 Loss from operations(15,803)(24,159)(29,991)(22,576)(31,133)(38,518)(50,639)(25,775)Interest expense(4)(1,049)(193)(174)(143)(145)(132)(164)(1)Other income (expense), net682 272 732 4,533 3,203 3,579 (451)394 Loss before provision for income taxes(16,170)(24,080)(29,433)(18,186)(28,075)(35,071)(51,254)(25,382)Provision for income taxes2,832 451 441 1,036 333 434 635 595 Net loss$(19,002)$(24,531)$(29,874)$(19,222)$(28,408)$(35,505)$(51,889)$(25,977)Net loss per share attributable to common stockholders, basic and diluted$(0.09)$(0.11)$(0.14)$(0.09)$(0.14)$(0.17)$(0.40)$(0.55)Weighted-average shares used in computing net loss per share attributable to common stockholders, basic and diluted221,700 219,401 216,695 213,129 207,565 204,096 130,091 47,205 ____________________________(1)Includes stock-based compensation expense as follows:Three Months EndedJanuary 31, 2021October 31, 2020July 31, 2020April 30, 2020January 31, 2020October 31, 2019July 31, 2019April 30, 2019(in thousands)Subscription cost of revenue$3,849 $3,226 $2,635 $1,995 $2,062 $1,666 $1,233 $265 Professional services cost of revenue2,058 1,551 1,425 971 955 784 644 103 Sales and marketing15,456 12,811 13,603 8,687 8,408 7,355 6,638 1,518 Research and development14,574 11,771 9,029 4,900 5,050 4,696 4,976 681 General and administrative11,777 11,251 11,021 7,085 7,888 7,465 16,368 1,185 Total stock-based compensation expense$47,714 $40,610 $37,713 $23,638 $24,363 $21,966 $29,859 $3,752 74Table of Contents(2) Includes amortization of acquired intangible assets as follows:Three Months EndedJanuary 31, 2021October 31, 2020July 31, 2020April 30, 2020January 31, 2020October 31, 2019July 31, 2019April 30, 2019(in thousands)Subscription cost of revenue$660 $272 $63 $62 $61 $61 $97 $104 Sales and marketing209 91 31 31 31 30 32 30 Research and development— 9 10 10 10 10 10 11 Total amortization of purchased intangibles$869 $372 $104 $103 $102 $101 $139 $145 (3)Includes acquisition-related expenses as follows:Three Months EndedJanuary 31, 2021October 31, 2020July 31, 2020April 30, 2020January 31, 2020October 31, 2019July 31, 2019April 30, 2019(in thousands)General and administrative$1,639 $2,119 $— $— $— $— $— $— Total acquisition-related expenses$1,639 $2,119 $— $— $— $— $— $— (4)Includes amortization of debt issuance costs and discount as follows:Three Months EndedJanuary 31, 2021October 31, 2020July 31, 2020April 30, 2020January 31, 2020October 31, 2019July 31, 2019April 30, 2019(in thousands)Interest expense$347 $— $— $— $— $— $— $— Total amortization of debt issuance costs and discount$347 $— $— $— $— $— $— $— Percentage of Revenue DataThe following table presents the components of our statement of operations as a percentage of total revenue for each of the quarters indicated:Three Months EndedJanuary 31, 2021October 31, 2020July 31, 2020April 30, 2020January 31, 2020October 31, 2019July 31, 2019April 30, 2019RevenueSubscription92 %92 %93 %91 %91 %91 %90 %90 %Professional services8 %8 %7 %9 %9 %9 %10 %10 %Total revenue100 %100 %100 %100 %100 %100 %100 %100 %Cost of revenueSubscription21 %21 %22 %21 %23 %23 %23 %25 %Professional services5 %5 %5 %5 %6 %7 %6 %6 %Total cost of revenue25 %26 %27 %26 %29 %30 %29 %30 %Gross margin75 %74 %73 %74 %71 %70 %71 %70 %Operating expensesSales and marketing42 %45 %48 %49 %50 %55 %60 %59 %Research and development25 %25 %25 %23 %25 %29 %29 %25 %General and administrative13 %14 %15 %14 %17 %17 %28 %12 %Total operating expenses81 %84 %88 %86 %92 %101 %118 %96 %Loss from operations(6)%(10)%(15)%(13)%(20)%(31)%(47)%(27)%Interest expense— %— %— %— %— %— %— %— %Other income (expense), net— %— %— %3 %2 %3 %— %— %Loss before provision for income taxes(6)%(10)%(15)%(10)%(18)%(28)%(47)%(26)%Provision for income taxes1 %— %— %1 %— %— %1 %1 %Net loss(7)%(11)%(15)%(11)%(19)%(28)%(48)%(27)%75Table of ContentsQuarterly Revenue TrendsTotal revenue increased sequentially in each of the quarters presented primarily due to our addition of new customers, as well as sales of additional endpoints and modules to existing customers. We typically receive a higher percentage of our annual orders from new customers, as well as renewal orders from existing customers, in our fourth fiscal quarter as compared to other quarters due to the annual budget approval process of many of our customers. However, because we recognize revenue ratably over the term of our subscription contracts, a substantial portion of the revenue that we report in each period is attributable to orders that we received during previous periods. Consequently, increases or decreases in new sales or renewals in any one period may not be immediately reflected in our revenue for that period and may negatively affect our revenue in future periods. Accordingly, the effect of downturns in sales and market acceptance of our cloud platform, and potential changes in our rate of renewals, may not be fully reflected in our results of operations until future periods. Professional services revenue is dependent upon the number of hours performed in a quarter and can vary from period to period.Quarterly Cost of Revenue TrendsTotal cost of revenue increased sequentially in each of the quarters presented was primarily driven by an increase in employee-related expenses, cloud hosting and related expenses, depreciation of data center equipment, stock-based compensation expenses and amortization of internal-use software.Quarterly Gross Margin TrendsThe overall increase in gross margin over the course of the periods presented was primarily due to the continued expansion of module adoption by our customer base, the continuation to shift more of our operations from third-party cloud service providers to colocation data centers, renegotiating the terms of a third-party cloud service provider contract, and continued optimization of our software development and our cloud database systems, which has resulted in reduced data center usage. Quarterly Expense TrendsOperating expenses generally have increased sequentially for each of the quarters presented, except for the three months ended October 31, 2019, primarily due to increases in employee related expenses associated with increases in our headcount to support our growth and stock-based compensation. We intend to continue to make the significant investments to support our sales and marketing related activities to acquire new customers that we believe will position the Company for future growth. We also intend to invest in research and development efforts to add new features to and enhance the functionality of our existing cloud platform, and to ensure the reliability, availability, and scalability of our solutions. Operating expenses, particularly general and administrative expenses, increased significantly during the three months ended July 31, 2019 due to the stock-based compensation of $17.3 million related to the performance-based vesting condition for our outstanding RSUs being met during the quarter. We expect operating expenses to continue to increase for the foreseeable future. The increase in Other income (expense), net during the three months ended October 31, 2019 was primarily driven by interest income of $4.1 million driven by the investment of the proceeds of our initial public offering. The increase in Other income (expense), net during the three months ended April 30, 2020 was due to a realized gain on the sale of marketable securities of $1.3 million, as a result of liquidating our portfolio of marketable securities in response to the economic uncertainty surrounding the COVID-19 pandemic. The decrease in Other income (expense), net during the three months ended July 31, 2020 was primarily due to a decrease in interest income of $2.8 million due to the liquidation of our portfolio of marketable securities in the prior quarter. The increase in Interest Expense during the three months ended January 31, 2021 was primarily driven by interest and amortization of debt issuance costs related to the $750.0 million Senior Notes issued in December 2020.The increase in the provision for income taxes during the three months ended April 30, 2020 was primarily due to income tax expense of $0.4 million related to the realized gain on the sale of marketable securities. The increase in the provision for income taxes during the three months ended January 31, 2021 was primarily due to an increase in withholding tax related to customer payments, foreign taxes in jurisdictions where we operate, and U.S. state taxes.76Table of ContentsLiquidity and Capital ResourcesIn January 2021, we issued and sold an aggregate principal amount of $750.0 million of 3.000% Senior Notes due 2029. The net proceeds from the debt offering were $739.6 million after deducting the underwriting commissions of $9.4 million and $1.0 million of issuance costs, which were paid as of January 31, 2021. In January 2021, we amended and restated our existing senior secured revolving credit facility and increased the size of the credit facility from $150.0 million to $750.0 million, including a letter of credit sub-facility in the aggregate amount of $100.0 million, and a swingline sub-facility in the aggregate amount of $50.0 million. No amounts were outstanding under the credit facility as of January 31, 2021.In June 2019, upon completion of our IPO, we received net proceeds of $659.2 million, after deducting underwriters’ discounts and commissions and offering expenses of $44.8 million.As of January 31, 2021, we had cash and cash equivalents, consisting of highly liquid bank deposits, of $1.9 billion. During the first quarter of fiscal 2021, we liquidated our entire portfolio of marketable securities largely in response to the global economic uncertainty in conjunction with the COVID-19 pandemic. This resulted in the recognition of a realized gain of $1.3 million. We expect that our existing cash and cash equivalents will be sufficient to meet our anticipated cash needs for working capital and capital expenditures for at least the next 12 months.Since our inception, we have generated operating losses, as reflected in our accumulated deficit of $730.1 million as of January 31, 2021. We expect to continue to incur operating losses for the foreseeable future due to the investments we intend to continue to make, particularly in sales and marketing and research and development. As a result, we may require additional capital resources in the future to execute strategic initiatives to grow our business.We typically invoice our subscription customers annually in advance. Therefore, a substantial source of our cash is from such prepayments, which are included on our consolidated balance sheets as deferred revenue. Deferred revenue primarily consists of billed fees for our subscriptions, prior to satisfying the criteria for revenue recognition, which are subsequently recognized as revenue in accordance with our revenue recognition policy. As of January 31, 2021, we had deferred revenue of $911.9 million, of which $702.0 million was recorded as a current liability and is expected to be recorded as revenue in the next 12 months, provided all other revenue recognition criteria have been met.Cash FlowsThe following table summarizes our cash flows for the periods presented:Year Ended January 31,202120202019(in thousands)Net cash provided by (used in) operating activities$356,566 $99,943 $(22,968)Net cash provided by (used in) investing activities$495,427 $(629,631)$(142,030)Net cash provided by financing activities$800,135 $706,144 $190,389 Operating ActivitiesNet cash provided by operating activities during fiscal 2021 was $356.6 million, which resulted from a net loss of $92.6 million, adjusted for non-cash charges of $263.6 million and net cash inflow of $185.6 million from changes in operating assets and liabilities. Non-cash charges primarily consisted of $149.7 million in stock-based compensation expense, $66.4 million of amortization of deferred contract acquisition costs, $38.7 million of depreciation and amortization, and $7.8 million of non-cash operating lease costs. The net cash inflow from changes in operating assets and liabilities was primarily due to a $338.8 million increase in deferred revenue, a $33.2 million increase in accrued payroll and benefits, a $23.8 million increase in accrued expenses and other current liabilities and a $11.3 million increase in accounts payable, partially offset by $151.0 million increase in deferred contract acquisition costs and a $72.5 million increase in accounts receivable.77Table of ContentsNet cash provided by operating activities during fiscal 2020 was $99.9 million, which resulted from a net loss of $141.8 million, adjusted for non-cash charges of $144.3 million and net cash inflow of $97.5 million from changes in operating assets and liabilities. Non-cash charges primarily consisted of $79.9 million in stock-based compensation expense, $35.5 million of amortization of deferred contract acquisition costs, $23.0 million of depreciation and amortization, and $6.0 million due to the change in the fair value of our redeemable convertible preferred stock warrant liability. The net cash inflow from changes in operating assets and liabilities was primarily due to a $280.8 million increase in deferred revenue and $17.5 million increase in accrued payroll and benefits, partially offset by a $86.6 million increase in deferred contract acquisition costs, $73.1 million increase in accounts receivable and a $43.5 million increase in prepaid expenses and other assets. Net cash used in operating activities during fiscal 2019 was $23.0 million, which resulted from a net loss of $140.1 million, adjusted for non-cash charges of $67.8 million and net cash inflow of $49.3 million from changes in operating assets and liabilities. Non-cash charges primarily consisted of $28.6 million of amortization of deferred commissions, $20.5 million in stock-based compensation expense, $14.8 million of depreciation and amortization, and $3.6 million due to the change in the fair value of our redeemable convertible preferred stock warrant liability. The net cash inflow from changes in operating assets and liabilities was primarily due to a $131.1 million increase in deferred revenue, partially offset by a $45.1 million increase in deferred contract acquisition costs, and a $33.4 million increase in accounts receivable.Investing ActivitiesNet cash provided by investing activities during fiscal 2021 of $495.4 million was primarily due to the sale of marketable securities of $639.6 million and the maturities of marketable securities of $91.6 million, partially offset by our acquisition of Preempt Security, net of cash acquired, of $85.5 million, purchases of marketable securities of $84.9 million, purchases of property and equipment of $52.8 million, and capitalized internal-use software of $10.9 million.Net cash used in investing activities during fiscal 2020 of $629.6 million was primarily due to purchases of marketable securities of $779.7 million, purchases of property and equipment of $80.2 million, and capitalized internal-use software of $7.3 million, partially offset by maturities of marketable securities of $229.0 million and proceeds from sales of marketable securities of $9.6 million.Net cash used in investing activities during fiscal 2019 of $142.0 million was primarily due to purchases of marketable securities of $199.3 million, purchases of property and equipment of $35.9 million, and capitalized internal-use software of $6.8 million, partially offset by maturities of marketable securities of $100.0 million.Financing ActivitiesNet cash provided by financing activities of $800.1 million during fiscal 2021 was primarily due to $739.6 million related to the issuance of our Senior Notes, after deducting the underwriting commissions and issuance costs paid as of January 31, 2021, proceeds from our employee stock purchase plan of $34.3 million, and proceeds from the exercise of stock options of $28.8 million, partially offset by $3.3 million debt issuance costs related to the revolving credit facility.Net cash provided by financing activities of $706.1 million during fiscal 2020 was primarily due to our IPO. On June 14, 2019, we closed our IPO in which we sold 20,700,000 shares of Class A common stock. The shares were sold at a public offering price of $34.00 per share for net proceeds of $665.1 million, after deducting underwriters’ discounts and commissions. In addition, there were proceeds from the exercise of stock options of $21.5 million, proceeds from issuance of common stock under the employee stock purchase plan of $12.4 million, proceeds from issuance of common stock upon exercise of early exercisable stock options of $10.3 million and $2.3 million in claims settlement under Section 16(b) of the Securities Exchange Act of 1934, partially offset by payments of deferred offering costs in the amount of $5.9 million. In December 2019, a security holder paid us $2.3 million to settle a claim under Section 16(b) of the Securities Exchange Act of 1934. Section 16(b) requires certain persons and entities whose securities trading activities result in “short swing” profits to repay such profits to the issuer of the security. This payment was recorded as an increase to stockholders’ equity and as cash provided by financing activities in our consolidated statement of cash flows for the fiscal year ended January 31, 2020.Net cash provided by financing activities of $190.4 million during fiscal 2019 was primarily due to $206.9 million in net proceeds from the issuance of our Series E redeemable convertible preferred stock, $10.0 million in proceeds from our revolving line of credit, and $3.9 million from the exercise of stock options, partially offset by a repayment on our line of credit 78Table of Contentsof $20.0 million, a repayment on our outstanding bank loan of $6.2 million, the repurchase of stock options of $2.3 million, and payments of indemnity holdback and contingent consideration of $2.1 million.Debt ObligationsRevolving Credit FacilityIn April 2019, we entered into a credit agreement with Silicon Valley Bank and other lenders, to provide a revolving line of credit of up to $150.0 million, including a letter of credit sub-facility in the aggregate amount of $10.0 million, and a swingline sub-facility in the aggregate amount of $10.0 million. On January 4, 2021, we amended and restated our existing credit agreement (the “A&R Credit Agreement” and the facility thereunder the “Revolving Facility”) among CrowdStrike, Inc., as borrower, CrowdStrike Holdings, Inc., as guarantor, and Silicon Valley Bank and the other lenders party thereto, providing us with a revolving line of credit of up to $750.0 million, including a letter of credit sub-facility in the aggregate amount of $100.0 million, and a swingline sub-facility in the aggregate amount of $50.0 million. We also have the option to request an incremental facility of up to an additional $250.0 million from one or more of the lenders under the A&R Credit Agreement. The A&R Credit Agreement is guaranteed by all of our material domestic subsidiaries. The A&R Credit Agreement extended the maturity date of April 19, 2022 to January 2, 2026. Under the A&R Credit Agreement, revolving loans may be either Eurodollar Loans or Alternate Base Rate (“ABR”) Loans. Outstanding Eurodollar Loans incur interest at the Eurodollar Rate, which is defined as LIBOR (or any successor thereto), subject to a 0.00% LIBOR floor, plus a margin between 1.50% and 2.00%, depending on our senior secured leverage ratio. Outstanding ABR Loans incur interest at the highest of (a) the Prime Rate, as published by the Wall Street Journal, (b) the federal funds rate in effect for such day plus 0.50%, and (c) the Eurodollar Rate plus 1.00%, in each case plus a margin between (0.25%) and 0.25%, depending on the senior secured leverage ratio. We will be charged a commitment fee of 0.15% to 0.25% per year for committed but unused amounts, depending on the senior secured leverage ratio. The financial covenants require us to maintain a minimum consolidated interest coverage ratio of 3.00:1.00, a maximum senior secured leverage ratio of 3.00:1.00 (through January 31, 2023), and a maximum total leverage ratio of 5.50:1.00 stepping down to 3.50:1.00 over time. We were in compliance with the financial covenants as of January 31, 2021. The A&R Credit Agreement is secured by substantially all of our current and future consolidated assets, property and rights, including, but not limited to, intellectual property, cash, goods, equipment, contractual rights, financial assets, and intangible assets of us and certain of our subsidiaries. The A&R Credit Agreement contains customary covenants limiting our ability and the ability of our subsidiaries to, among other things, dispose of assets, undergo a change in control, merge or consolidate, make acquisitions, incur debt, incur liens, pay dividends, repurchase stock, and make investments, in each case subject to certain exceptions. No amounts were outstanding under the A&R Credit Agreement as of January 31, 2021.Senior NotesOn January 20, 2021, we issued $750.0 million aggregate principal amount of 3.00% Senior Notes maturing in February 2029. The Senior Notes are guaranteed by our subsidiary, CrowdStrike, Inc. and will be guaranteed by each of our existing and future domestic subsidiaries that becomes a borrower or guarantor under our A&R Credit Agreement. The Senior Notes were issued at par and bear interest at a rate of 3.00% per annum. Interest payments are payable semiannually on February 15 and August 15 of each year, commencing on August 15, 2021. We may voluntarily redeem the Senior Notes, in whole or in part, 1) at any time prior to February 15, 2024 at (a) 100.00% of their principal amount, plus a “make whole” premium or (b) with the net cash proceeds received from an equity offering at a redemption price equal to 103.00% of the principal amount, provided the aggregate principal amount of all such redemptions does not exceed 40% of the original aggregate principal amount of the Senior Notes; 2) at any time on or after February 15, 2024 at a prepayment price equal to 101.50% of the principal amount; 3) at any time on or after February 15, 2025 at a prepayment price equal to 100.75% of the principal amount; and 4) at any time on or after February 15, 2026 at a prepayment price equal to 100.00% of the principal amount; in each case, plus accrued and unpaid interest, if any, to but excluding, the date of redemption.The net proceeds from the debt offering were $739.6 million after deducting the underwriting commissions of $9.4 million and $1.0 million of issuance costs, which were paid as of January 31, 2021. An additional $1.6 million of issuance costs are expected to be paid in the first quarter of fiscal 2022. Debt issuance costs of $2.6 million are being amortized to interest 79Table of Contentsexpense using the effective interest method over the term of the Senior Notes. Interest expense related to contractual interest expense and amortization of debt issuance costs was $0.7 million and $0.1 million, respectively, during the fiscal year ended January 31, 2021.In certain circumstances involving change of control events, we will be required to make an offer to repurchase all or, at the holder’s option, any part, of each holder’s Senior Notes at 101% of the aggregate principal amount thereof, plus accrued and unpaid interest, if any, to, but excluding, the repurchase date.The indenture governing the Senior Notes (the “Indenture”) contain covenants limiting our ability and the ability of our subsidiaries to create liens on certain assets to secure debt; grant a subsidiary guarantee of certain debt without also providing a guarantee of the Senior Notes; and consolidate or merge with or into, or sell or otherwise dispose of all or substantially all of our assets to, another person. These covenants are subject to a number of important limitations and exceptions. Certain of these covenants will not apply during any period in which the notes are rated investment grade by two of Fitch Ratings, Inc., Moody’s Investors Service, Inc. and Standard & Poor’s Ratings Services.As of January 31, 2021, we were in compliance with all of our financial covenants under the Indenture associated with the Senior Notes.Supplemental Guarantor Financial InformationOur Senior Notes are guaranteed on a senior, unsecured basis by CrowdStrike, Inc., a wholly owned subsidiary of CrowdStrike Holdings, Inc. (the “subsidiary guarantor,” and together with CrowdStrike Holdings, Inc., the “Obligor Group”). The guarantee is full and unconditional, and is subject to certain conditions for release. For a brief description of the Senior Notes, see the section of this Annual Report on Form 10-K titled “Liquidity and Capital Resources—Senior Notes.” The Company conducts its operations almost entirely through its subsidiaries. Accordingly, the Obligor Group’s cash flow and ability to service the notes will depend on the earnings of the Company’s subsidiaries and the distribution of those earnings to the Obligor Group, whether by dividends, loans or otherwise. Holders of the guaranteed registered debt securities will have a direct claim only against the Obligor Group.Summarized financial information is presented below for the Obligor Group on a combined basis after elimination of intercompany transactions and balances within the Obligor Group and equity in the earnings from and investments in any non-guarantor subsidiary. The summarized financial information of the Obligor Group also includes the amounts of Crowdstrike Services, Inc. which was a separate wholly owned subsidiary of the Company that was merged into Crowdstrike, Inc. on December 31, 2020, therefore becoming part of the Obligor Group prior to the issuance of the Senior Notes. The revenue amounts presented in the summarized financial information include substantially all of the Company’s consolidated revenues, and there are no intercompany revenues from the non-guarantor subsidiaries. This summarized financial information has been prepared and presented pursuant to Regulation S-X Rule 13-01, “Financial Disclosures about Guarantors and Issuers of Guaranteed Securities” and is not intended to present the financial position or results of operations of the Obligor Group in accordance with U.S. GAAP.Statement of operationsYear Ended January 31, 2021(in thousands)Revenue$873,653 Cost of revenue230,045 Operating expenses740,501 Loss from operations(96,893)Net loss(91,707)80Table of ContentsBalance sheetsJanuary 31, 2021(in thousands)Current assets (excluding intercompany receivables from non-Guarantors) $2,249,834 Intercompany receivables from non-Guarantors8,822 Noncurrent assets398,656 Current liabilities834,462 Noncurrent liabilities988,391 Strategic InvestmentsIn July 2019, we agreed to commit up to $10.0 million to a newly formed entity, CrowdStrike Falcon Fund LLC (“Falcon Fund”), in exchange for 50% of the sharing percentage of any distribution by Falcon Fund. Additionally, entities associated with Accel, a holder of more than 5% of our capital stock, also agreed to commit up to $10.0 million to Falcon Fund and collectively own the remaining 50% of the sharing percentage of Falcon Fund. Falcon Fund is in the business of purchasing, selling, investing and trading in minority equity and convertible debt securities of privately-held companies that develop applications that have potential for substantial contribution to CrowdStrike and its platform. Falcon Fund has a duration of ten years which may be extended for three additional years. At dissolution, Falcon Fund will be liquidated and the remaining assets will be distributed to the investors based on their sharing percentage. We have made contributions to Falcon Fund totaling $1.3 million as of January 31, 2021.Contractual Obligations and CommitmentsThe following table summarizes our contractual obligations as of January 31, 2021 and the fiscal years in which these obligations are due:Payments Due by Fiscal YearTotal20222023202420252026Thereafter(in thousands)Real estate arrangements(1)$46,184 $10,187 $10,879 $10,816 $9,973 $4,050 $279 Data center commitments(2)97,781 66,807 10,395 10,719 5,415 3,012 1,433 Other purchase obligations(3)77,225 31,251 24,738 21,222 14 — — Debt obligations(4)750,000 — — — — — 750,000 Interest payments associated with all debt obligations(5)186,563 22,596 22,875 23,257 23,844 25,553 68,438 Total$1,157,753 $130,841 $68,887 $66,014 $39,246 $32,615 $820,150 ______________________________(1)Relates to non-cancellable real estate arrangements where the amounts are reflected on an undiscounted basis. For additional information refer to Note 9, Leases, of our consolidated financial statements included elsewhere in this Annual Report on Form 10-K.(2)Relates to non-cancelable commitments to data center vendors.(3)Relates to non-cancelable purchase commitments with various parties to purchase products and services entered into in the normal course of business.(4)Relates to $750.0 million aggregate principal amount of Senior Notes due in fiscal 2030.(5)Relates to the interest payments associated with the Senior Notes based on the principal amount multiplied by the applicable interest rate. The interest payment under the Revolving Credit Facility for the undrawn balance is payable at 15 bps as a commitment fee based on the daily undrawn balance and we utilized the existing rate for the projected interest payments included in the table above. For additional information refer to Note 5, Debt, of our consolidated financial statements included elsewhere in this Annual Report on Form 10-K.81Table of ContentsThe contractual commitment amounts in the table above are associated with agreements that are enforceable and legally binding. Obligations under contracts, including purchase orders, that we can cancel without a significant penalty are not included in the table above. Purchase orders issued in the ordinary course of business are not included in the table above, as such purchase orders represent authorizations to purchase rather than binding agreements.IndemnificationOur subscription agreements contain standard indemnification obligations. Pursuant to these agreements, we will indemnify, defend, and hold the other party harmless with respect to a claim, suit, or proceeding brought against the other party by a third party alleging that our intellectual property infringes upon the intellectual property of the third party, or results from a breach of our representations and warranties or covenants, or that results from any acts of negligence or willful misconduct. The term of these indemnification agreements is generally perpetual any time after the execution of the agreement. Typically, these indemnification provisions do not provide for a maximum potential amount of future payments we could be required to make. However, in the past we have not been obligated to make significant payments for these obligations and no liabilities have been recorded for these obligations on our consolidated balance sheets as of January 31, 2021 or January 31, 2020.We also agreed to indemnify our directors and certain executive officers for certain events or occurrences, subject to certain limits, while the officer is or was serving at our request in such capacity. The maximum amount of potential future indemnification is unlimited. However, our director and officer insurance policy limits our exposure and enables us to recover a portion of any future amounts paid. Historically, we have not been obligated to make any payments for these obligations and no liabilities have been recorded for these obligations on our consolidated balance sheets as of January 31, 2021 or January 31, 2020.Off-Balance Sheet ArrangementsWe do not have any relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities. We do not have any outstanding derivative financial instruments, off-balance sheet guarantees, interest rate swap transactions, or foreign currency forward contracts.Critical Accounting Policies and EstimatesOur management’s discussion and analysis of financial condition and results of operations is based upon our financial statements and notes to our financial statements, which were prepared in accordance with GAAP. The preparation of the financial statements requires our management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Our management evaluates our estimates on an ongoing basis, including those related to the allowance for doubtful accounts, the carrying value and useful lives of long-lived assets, the fair value of financial instruments, the recognition and disclosure of contingent liabilities, income taxes, and stock-based compensation. We base our estimates and judgments on our historical experience, knowledge of factors affecting our business and our belief as to what could occur in the future considering available information and assumptions that are believed to be reasonable under the circumstances.The accounting estimates we use in the preparation of our financial statements will change as new events occur, more experience is acquired, additional information is obtained and our operating environment changes. Changes in estimates are made when circumstances warrant. Such changes in estimates and refinements in estimation methodologies are reflected in our reported results of operations and, if material, the effects of changes in estimates are disclosed in the notes to our financial statements. By their nature, these estimates and judgments are subject to an inherent degree of uncertainty and actual results could differ materially from the amounts reported based on these estimates.The critical accounting estimates, assumptions and judgments that we believe have the most significant impact on our consolidated financial statements are described below.82Table of ContentsRevenue RecognitionWe adopted ASC 606 on February 1, 2019, using the modified retrospective transition method. Under this method, results for reporting periods beginning on February 1, 2019 are presented under Topic 606, while prior period amounts are not adjusted and continue to be reported in accordance with prior accounting under Topic 605. In accordance with ASC 606, revenue is recognized when a customer obtains control of promised services. The amount of revenue recognized reflects the consideration that we expect to be entitled to receive in exchange for these services. To achieve the core principle of this standard, we apply the following five steps:(1)Identify the contract with a customerWe consider the terms and conditions of contracts with customers and our customary business practices in identifying contracts under ASC 606. We determine we have a contract with a customer when the contract is approved, each party’s rights regarding the services to be transferred can be identified, payment terms for the services can be identified, we have determined that the customer has the ability and intent to pay, and the contract has commercial substance. We apply judgment in determining the customer’s ability and intent to pay, which is based on a variety of factors, including the customer’s historical payment experience or, in the case of a new customer, credit and financial information pertaining to the customer.(2)Identify the performance obligations in the contractPerformance obligations promised in a contract are identified based on the services that will be transferred to the customer that are both capable of being distinct, whereby the customer can benefit from the service either on its own or together with other resources that are readily available from us or from third parties, and are distinct in the context of the contract, whereby the transfer of the services is separately identifiable from other promises in the contract. Our performance obligations consist of (i) subscriptions and (ii) professional services.(3)Determine the transaction priceThe transaction price is determined based on the consideration which we are expected to be entitled to in exchange for transferring services to the customer. Variable consideration is included in the transaction price if it is probable that a significant future reversal of cumulative revenue under the contract will not occur. None of our contracts contain a significant financing component.(4)Allocate the transaction price to performance obligations in the contractIf the contract contains a single performance obligation, the entire transaction price is allocated to the single performance obligation. Contracts that contain multiple performance obligations require an allocation of the transaction price to each performance obligation based on a relative standalone selling price (“SSP”). (5)Recognize revenue when or as performance obligations are satisfiedRevenue is recognized at the time the related performance obligation is satisfied by transferring the promised service to the customer. Revenue is recognized when control of the services is transferred to the customer, in an amount that reflects the consideration expected to be received in exchange for those services. We generate all our revenue from contracts with customers.Subscription RevenueOur Falcon Platform technology solutions are subscription, SaaS offerings designed to continuously monitor, share, and mitigate risks from determined attackers. Customers do not have the right to take possession of the cloud-based software platform. Fees are based on several factors, including the solutions subscribed for by the customer and the number of endpoints purchased by the customer. The subscription fees are typically payable within 30 to 60 days after the execution of the arrangement, and thereafter upon renewal or subsequent installment. We initially record the subscription fees as deferred revenue and recognizes revenue on a straight-line basis over the term of the agreement.83Table of ContentsThe typical subscription term is one to three years. Most of our contracts are non-cancelable over the contractual term. Customers typically have the right to terminate their contracts for cause if we fail to perform in accordance with the contractual terms. Some customers have the option to purchase additional subscription at a stated price. These options generally do not provide a material right as they are priced at our SSP.Professional Services RevenueWe offer several types of professional services including incident response and forensic services, surge forensic and malware analysis, and attribution analysis, which are focused on responding to imminent and direct threats, assessing vulnerabilities, and recommending solutions. These services are distinct from subscription services. Professional services do not result in significant customization of the subscription service. The professional services are available through hourly rate and fixed fee contracts, one-time and ongoing engagements, and retainer-based agreements. Revenue for time and materials arrangements is recognized as services are performed and revenue for fixed fees is recognized on a proportional performance basis as the services are performed.Contracts with Multiple Performance ObligationsSome contracts with customers contain multiple promised services consisting of subscription and professional services that are distinct and accounted for separately. The transaction price is allocated to the separate performance obligations on a relative SSP basis. The SSP is the price at which we would sell promised subscription or professional services separately to a customer. Judgment is required to determine the SSP for each distinct performance obligation. We determine SSP based on our overall pricing objectives, taking into consideration the type of subscription or professional service and the number of endpoints.Variable ConsiderationRevenue from sales is recorded at the net sales price, which is the transaction price, and includes estimates of variable consideration. The amount of variable consideration that is included in the transaction price is constrained and is included in the net sales price only to the extent that it is probable that a significant reversal in the amount of the cumulative revenue will not occur when the uncertainty is resolved.If subscriptions do not meet certain service level commitments, our customers are entitled to receive service credits, and in certain cases, refunds, each representing a form of variable consideration. We have historically not experienced any significant incidents affecting the defined levels of reliability and performance as required by our subscription contracts. Accordingly, any estimated refunds related to these agreements in the consolidated financial statements is not material during the periods presented.We provide rebates and other credits within our contracts with certain resellers, which are estimated based on the most likely amounts expected to be earned or claimed on the related sales transaction. Overall, the transaction price is reduced to reflect our estimate of the amount of consideration to which we are entitled based on the terms of the contract. Estimated rebates and other credits were not material during the periods presented.Stock-Based CompensationWe account accounts for stock-based awards granted to employees and directors based on the awards’ estimated grant date fair value. We estimate the fair value of our stock options using the Black-Scholes option-pricing model. The resulting fair value is recognized on a straight-line basis over the period during which the employee or director is required to provide service in exchange for the award, usually the vesting period, which is generally four years. We account for forfeitures as they occur.Restricted stock units (“RSUs”) granted under the 2011 Plan are subject to a service-based vesting condition and a performance-based vesting condition. The service-based vesting condition is generally satisfied based on one of three vesting schedules: (i) vesting of one-fourth of the RSUs on the first “Company vest date” (defined as March 20, June 20, September 20, or December 20) on or following the one-year anniversary of the vesting commencement date with the remainder of the RSUs vesting in twelve equal quarterly installments thereafter, subject to continued service, (ii) vesting in sixteen equal quarterly installments beginning on December 20, 2018, subject to continued service, or (iii) vesting in eight equal quarterly installments beginning on December 20, 2022, subject to continued service. The performance-based vesting condition is satisfied on the 84Table of Contentsearlier of (i) a change in control, in which the consideration paid to holders of shares is either cash, publicly traded securities, or a combination thereof, or (ii) the first Company vest date to occur following the expiration of the lock-up period upon an IPO, subject to continued service through such change in control or lock-up expiration, as applicable. None of the RSUs vest unless the performance-based vesting condition is satisfied. Upon the completion of the IPO, the performance-based vesting condition was met and we recognized $17.3 million of deferred expense related to RSUs as of that date in its consolidated statement of operations. Upon our IPO, we began issuing RSUs to our employees and these RSUs generally have only a service condition. The service-based vesting condition is generally with a vesting term of four years. The valuation of such RSUs is based solely on the fair value of our stock price on the date of grant. Expense for RSUs that have a service-based condition only are being amortized on a straight-line basis.Performance-based stock units (“PSUs”) granted under the 2019 Plan are subject to a performance-based vesting condition. With regard to the performance conditions, the fair value of new or modified awards is equal to the grant date fair market value of our common stock. PSUs generally vest over a four-year period based on the achievement of specified performance targets and subject to continued service through the applicable vesting dates. The compensation cost is recognized over the requisite service period when it is probable that the performance condition will be satisfied.Business CombinationsWe allocate the fair value of purchase consideration to the tangible assets acquired, liabilities assumed, and intangible assets acquired based on their estimated fair values. The excess of the fair value of purchase consideration over the fair values of these identifiable assets and liabilities is recorded as goodwill. Such valuations require management to make significant estimates and assumptions, especially with respect to intangible assets. Significant estimates in valuing certain intangible assets include, but are not limited to, future expected cash flows from acquired users, acquired technology, trade names from a market participant perspective, useful lives and discount rates. Management’s estimates of fair value are based upon assumptions believed to be reasonable, but which are inherently uncertain and unpredictable and, as a result, actual results may differ from estimates. During the measurement period, which is one year from the acquisition date, we may record adjustments to the assets acquired and liabilities assumed, with the corresponding offset to goodwill. Upon the conclusion of the measurement period, any subsequent adjustments are recorded in the consolidated statement of operations.Strategic InvestmentsIn July 2019, we agreed to commit up to $10.0 million to a newly formed entity, CrowdStrike Falcon Fund LLC (“Falcon Fund”) in exchange for 50% of the sharing percentage of any distribution by Falcon Fund. Entities associated with Accel, a holder of more than 5% of the our capital stock, also agreed to commit up to $10.0 million to Falcon Fund, and collectively own the remaining 50% of the sharing percentage of Falcon Fund. Falcon Fund is in the business of purchasing, selling, investing and trading in minority equity and convertible debt securities of privately-held companies that develop applications that have potential for substantial contribution to CrowdStrike and its platform. We are the manager of the Falcon Fund and control the investment decisions and day-to-day operations and accordingly consolidate the Falcon Fund. Falcon Fund has a duration of ten years and may be extended for three additional years. At dissolution, Falcon Fund will be liquidated and the remaining assets will be distributed to the investors based on their respective sharing percentage. We have made contributions to Falcon Fund totaling $1.3 million as of January 31, 2021. We have elected the measurement alternative for the non-marketable equity investments of the Falcon Fund where eligible. Under the measurement alternative, the equity investments are measured at cost, less any impairment, plus or minus changes resulting from observable price changes in orderly transactions for the identical or a similar investment of the same issuer. The non-marketable equity investments of the Falcon Fund are valued using significant unobservable inputs or data in inactive markets which requires judgment due to the absence of market prices and inherent lack of liquidity. As a result, there could be volatility in our consolidated statements of operations in future periods due to the valuation and timing of identical or similar investments of the same issuer. Income TaxesWe account for income taxes using the asset and liability method. Under this method, deferred tax assets and liabilities are determined based on differences between the financial statement and tax basis of assets and liabilities and net operating loss and credit carryforwards using enacted tax rates in effect for the year in which the differences are expected to reverse. Valuation allowances are established when necessary to reduce deferred tax assets to the amounts expected to be realized.85Table of ContentsWe account for unrecognized tax benefits using a more-likely-than-not threshold for financial statement recognition and measurement of tax positions taken or expected to be taken in a tax return. We establish a liability for tax-related uncertainties based on estimates of whether, and the extent to which, additional taxes will be due. We record an income tax liability, if any, for the difference between the benefit recognized and measured and the tax position taken or expected to be taken on our tax returns. To the extent that the assessment of such tax positions changes, the change in estimate is recorded in the period in which the determination is made. The liability is adjusted considering changing facts and circumstances, such as the outcome of a tax audit. The provision for income taxes includes the impact of liability provisions and changes to the liability that are considered appropriate. We maintain a full valuation allowance against our deferred tax assets in the United States and the U.K., the changes resulted in no material tax expense during the year ended January 31, 2021. We do not expect that changes in the liability for unrecognized tax benefits for the next twelve months will have a material impact on our consolidated financial statements.Operating LeasesWe enter into operating lease arrangements for real estate assets related to office space. We determine if an arrangement is or contains a lease at inception by evaluating various factors, including whether a vendor’s right to substitute an identified asset is substantive. Lease classification is determined at the lease commencement date, which is the date the leased assets are made available for use. Operating leases are included in “Operating lease right-of-use assets”, “Operating lease liabilities, current”, and “Operating lease liabilities, noncurrent” in the consolidated balance sheets. We did not have any financing leases in any of the periods presented.Operating lease right-of-use assets and lease liabilities are recognized at the lease commencement date based on the present value of lease payments over the lease term. Lease payments consist of the fixed payments under the arrangement, less any lease incentives, such as tenant improvement allowances. Variable costs, such as maintenance and utilities based on actual usage, are not included in the measurement of right-to-use assets and lease liabilities but are expensed when the event determining the amount of variable consideration to be paid occurs. As the implicit rate of the leases is not determinable, we use an incremental borrowing rate (“IBR”) based on the information available at the lease commencement date in determining the present value of lease payments. Lease expenses are recognized on a straight-line basis over the lease term.We use the non-cancelable lease term when recognizing the right-of-use (“ROU”) assets and lease liabilities, unless it is reasonably certain that a renewal or termination option will be exercised. We account for lease components and non-lease components as a single lease component.Leases with a term of twelve months or less are not recognized on the consolidated balance sheets but are recognized as expense on a straight-line basis over the term of the lease.JOBS Act Accounting ElectionOn the last business day of our second quarter in fiscal 2021, the aggregate market value of our shares held by non-affiliate stockholders exceeded $700 million. As a result, as of January 31, 2021, we are considered a large accelerated filer as defined in Rule 12b-2 under the Securities Exchange Act of 1934, as amended, or the Exchange Act, and we ceased to be an emerging growth company as defined in the JOBS Act.Recently Issued Accounting PronouncementsSee Note 2, “Summary of Significant Accounting Policies”, of our consolidated financial statements included elsewhere in this Annual Report on Form 10-K for more information about the impact of certain recent accounting pronouncements on our consolidated financial statements.86Table of ContentsItem 7A. Quantitative and Qualitative Disclosures About Market RiskWe have operations in the United States and internationally, and we are exposed to market risk in the ordinary course of business.Interest Rate RiskOur cash and cash equivalents primarily consist of cash on hand and highly liquid investments in corporate debt securities and bank deposits. Our investments are exposed to market risk due to fluctuations in interest rates, which may affect our interest income and the fair value of our investments. As of January 31, 2021, we had cash and cash equivalents of $1.9 billion and no marketable securities. The carrying amount of our cash equivalents reasonably approximates fair value due to the short maturities of these instruments. The primary objectives of our investment activities are the preservation of capital, the fulfillment of liquidity needs, and the fiduciary control of cash and investments. We do not enter into investments for trading or speculative purposes. Due to the short-term nature of our investment portfolio, the effect of a hypothetical 100 basis point change in interest rates would not have had a material effect on the fair market value of our portfolio as of January 31, 2021. We therefore do not expect our results of operations or cash flows to be materially affected by a sudden change in market interest rates. Our debt obligations consist of variety of financial instruments that expose us to interest rate risk, including, but not limited to our revolving credit facility and the Senior Notes. Interest on the revolving credit facility is tied to short term interest rate benchmarks including prime rate or LIBOR. Interest on the term loans is fixed.Foreign Currency RiskTo date, nearly all of our sales contracts have been denominated in U.S. dollars. A portion of our operating expenses are incurred outside the United States, denominated in foreign currencies and subject to fluctuations due to changes in foreign currency exchange rates, particularly changes in the British Pound, Australian Dollar, and Euro. The functional currency of our foreign subsidiaries is that country’s local currency. Foreign currency transaction gains and losses are recorded to Other income (expense), net. During the year ended January 31, 2021, foreign currency exchange rate gain recorded to Other comprehensive income (loss) was $2.6 million. A hypothetical 10% decrease in the U.S. dollar against other currencies would have resulted in an increase in operating loss of approximately $17.2 million for the year ended January 31, 2021. We have not entered into derivative or hedging transactions, but we may do so in the future if our exposure to foreign currency becomes more significant.87Table of Contents
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+Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operations” for information on actions taken by Devon to protect and support its employees during the COVID-19 pandemic. Beyond employee safety, Devon also prioritizes the physical, mental and financial wellness of our employees. We offer competitive health and financial benefits with incentives designed to promote wellbeing. For example, we encourage employees to take advantage of our wellness programs and activities by getting an annual physical exam or completing a financial wellness series at no cost to employees. Employee Compensation, Benefits and Development We strive to attract and retain high-performing individuals across our workforce. One way we do this is by providing competitive compensation and benefits, including annual bonuses; a 401(k) savings plan with a Devon match; stock awards; medical, dental and vision health care coverage; health savings and dependent-care flexible spending accounts; maternity and parental leave for the birth or adoption of a child; an adoption assistance program; alternate work schedules; flexible work hours; part-time work options; telecommuting support; among other benefits. Devon also looks to our core values to build the workforce we need. We develop our employees’ knowledge and creativity and advance continual learning and career development through ongoing performance, training and development conversations. Inclusion and Diversity Devon’s success depends on employees who demonstrate integrity, accountability, perseverance and a passion for building our business and delivering results. Our efforts to create a workforce with these qualities start with offering equal opportunity in all aspects of employment. We do this with employee-led organizations and corporate policies. We promote inclusion and diversity throughout the Company to bring a range of thoughts, experiences and points of view to our problem-solving and decision-making processes. Devon has an Inclusion and Diversity Leadership Team, which consists of senior leaders who support others by coaching, motivating and breaking down barriers. The Inclusion and Diversity Leadership Team works together with Devon’s all-volunteer Inclusion Action Team to proactively increase diversity and inclusion awareness, identify challenges and find innovative ways to achieve Devon’s inclusion and diversity vision and strategy. All Devon employees must act in accordance with our Code of Business Conduct and Ethics (“Code”), which sets forth current business practices and guidance to ensure ongoing compliance. Our Code covers topics such as anti-corruption, harassment, discrimination, privacy, cybersecurity, confidential information and how to report Code violations. On an annual basis, Devon employees are required to acknowledge and agree to abide by our Code, as well as complete a training course on the Code and its related policies. Additionally, our directors, officers and employees are required to comply with policies such as our Zero Tolerance Anti-Harassment Policy, Anti-Corruption Policy and Procedure, Conflicts of Interest Policy and Employee Gifts and Entertainment Declaration Policy. 7 Table of Contents Index to Financial Statements Additional information regarding Devon’s human capital measures and objectives is contained in Devon’s Sustainability Report published on our company website. Information contained in our Sustainability Report is not incorporated by reference into, and does not constitute a part of, this Annual Report on Form 10-K. Oil and Gas Properties WPX Merger Assets On January 7, 2021, Devon and WPX completed an all-stock merger of equals. WPX is an oil and gas exploration and production company with assets in the Delaware Basin in Texas and New Mexico and the Williston Basin in North Dakota. Financial and operational data, such as reserves, production, wells and acreage, provided in this document exclude amounts related to WPX’s assets unless otherwise noted due to the Merger closing subsequent to December 31, 2020. For additional information, please see Note 2 in “
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+ITEM 7.Management’s Discussion and Analysis of Financial Condition and Results of Operations68ITEM 7A.Quantitative and Qualitative Disclosures about Market Risk78
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+Item 7. MD&A. 15 Presented below is a summary of Virginia Power’s actual system output by energy source: Source 2020 2019 2018 Natural gas 48 % 41 % 33 % Nuclear(1) 32 29 29 Purchased power, net 7 17 19 Coal(2) 9 8 13 Renewable and Hydro(3) 4 5 5 Other — — 1 Total 100 % 100 % 100 % (1) Excludes ODEC’s 11.6% undivided ownership interest in North Anna. (2) Excludes ODEC’s 50.0% undivided ownership interest in the Clover power station. (3) Includes solar and biomass. Nuclear Fuel—Virginia Power primarily utilizes long-term contracts to support its nuclear fuel requirements. Worldwide market conditions are continuously evaluated to ensure a range of supply options at reasonable prices which are dependent on the market environment. Current agreements, inventories and spot market availability are expected to support current and planned fuel supply needs. Additional fuel is purchased as required to ensure optimal cost and inventory levels. Fossil Fuel— Virginia Power primarily utilizes natural gas and coal in its fossil fuel plants. All recent fossil fuel plant construction involves natural gas generation. Virginia Power’s natural gas and oil supply is obtained from various sources including purchases from major and independent producers in the Mid-Continent and Gulf Coast regions, purchases from local producers in the Appalachian area and Marcellus and Utica regions, purchases from gas marketers and withdrawals from underground storage fields owned by third parties. Virginia Power manages a portfolio of natural gas transportation contracts (capacity) that provides for reliable natural gas deliveries to its gas turbine fleet, while minimizing costs. Virginia Power’s coal supply is obtained through long-term contracts and short-term spot agreements from domestic suppliers. Biomass— Virginia Power’s biomass supply is obtained through long-term contracts and short-term spot agreements from local suppliers. Purchased Power— Virginia Power purchases electricity from the PJM spot market and through power purchase agreements with other suppliers to provide for utility system load requirements. Seasonality Virginia Power’s earnings vary seasonally as a result of the impact of changes in temperature, the impact of storms and other catastrophic weather events, and the availability of alternative sources for heating on demand by residential and commercial customers. Generally, the demand for electricity peaks during the summer and winter months to meet cooling and heating needs, respectively. An increase in heating degree days for Virginia Power’s electric utility-related operations does not produce the same increase in revenue as an increase in cooling degree days, due to seasonal pricing differentials and because alternative heating sources are more readily available. Nuclear Decommissioning Virginia Power has a total of four licensed, operating nuclear reactors at Surry and North Anna in Virginia. Decommissioning involves the decontamination and removal of radioactive contaminants from a nuclear power station once operations have ceased, in accordance with standards established by the NRC. Amounts collected from ratepayers are placed into trusts and are invested to fund the expected future costs of decommissioning the Surry and North Anna units. Virginia Power believes that the decommissioning funds and their expected earnings for the Surry and North Anna units will be sufficient to cover expected decommissioning costs, particularly when combined with future ratepayer collections and contributions to these decommissioning trusts, if such future collections and contributions are required. This reflects the long-term investment horizon, since the units will not be decommissioned for decades, and a positive long-term outlook for trust fund investment returns. Virginia 16 Power will continue to monitor these trusts to ensure they meet the NRC minimum financial assurance requirements, which may include, if needed, the use of parent company guarantees, surety bonding or other financial instruments recognized by the NRC. The estimated cost to decommission Virginia Power’s four nuclear units is reflected in the table below and is primarily based upon site-specific studies completed in 2019. These cost studies are generally completed every four to five years. The current cost estimates assume decommissioning activities will begin shortly after cessation of operations, which will occur when the operating licenses expire. Under the current operating licenses, Virginia Power is scheduled to decommission the Surry and North Anna units during the period 2032 to 2078. NRC regulations allow licensees to apply for extension of an operating license in up to 20-year increments. In 2018, Virginia Power applied for renewal of its operating licenses for an additional 20 years for the two nuclear units at Surry. Under these renewal applications, the two nuclear units will be allowed to generate electricity through 2052 and 2053, if approved. Virginia Power also submitted a license renewal application for the two units at North Anna in 2020. Under these renewal applications, the two nuclear units will be allowed to generate electricity through 2058 and 2060, if approved. Between the four units, Virginia Power estimates that it could spend approximately $3 billion to $4 billion over the next several years on capital improvements. The existing regulatory framework in Virginia provides rate recovery mechanisms for such costs. The estimated decommissioning costs, funds in trust and current license expiration dates for Surry and North Anna are shown in the following table: NRC license expiration year Most recent cost estimate (2020 dollars)(1) Funds in trusts at December 31, 2020(2) (dollars in millions) Surry Unit 1 2032 $ 818 $ 905 Unit 2 2033 809 892 North Anna Unit 1(3) 2038 733 722 Unit 2(3) 2040 737 678 Total $ 3,097 $ 3,197 (1) The cost estimates shown above reflect reductions for the expected future recovery of certain spent fuel costs based on Virginia Power’s contracts with the DOE for disposal of spent nuclear fuel consistent with the reductions reflected in Virginia Power’s nuclear decommissioning AROs and includes the expectation that 20-year license extensions are approved for all units. (2) Virginia Power did not make any contributions to its nuclear decommissioning trust funds during 2020. (3) North Anna is jointly owned by Virginia Power (88.4%) and ODEC (11.6%). However, Virginia Power is responsible for 89.26% of the decommissioning obligation. Amounts reflect 89.26% of the decommissioning cost for both of North Anna’s units. Also see Notes 9, 14 and 23 to the Consolidated Financial Statements for further information about nuclear decommissioning trust investments, AROs and nuclear decommissioning, respectively. GAS DISTRIBUTION The Gas Distribution Operating Segment of Dominion Energy includes Dominion Energy’s regulated natural gas sales, transportation, gathering, storage and distribution operations in Ohio, West Virginia, North Carolina, Utah, southwestern Wyoming and southeastern Idaho (through East Ohio, Hope, PSNC and Questar Gas) which collectively serve approximately 3.1 million residential, commercial and industrial customers. The Gas Distribution Operating Segment also includes nonregulated renewable natural gas facilities in operation and under development, including Dominion Energy’s investment in Align RNG. See Investments below for additional information regarding the Align RNG investment. Gas Distribution’s growth capital plan includes spending approximately $5 billion from 2021 through 2025 to upgrade existing or add new infrastructure to meet growing energy needs and retain reliability within its service territory as well as investments in renewable natural gas infrastructure projects outside its service territory. Planned capital spending is driven by infrastructure needs from a growing customer base in states with expanding economies, replacing aging assets for reliability, safety and sustainability and meeting demands for natural gas to support the transition from more carbon intensive fuels. Earnings for the Gas Distribution Operating Segment of Dominion Energy primarily result from rates established by the Ohio, West Virginia, North Carolina, Utah, Wyoming and Idaho Commissions. The profitability of these businesses is dependent on their ability, 17 through the rates they are permitted to charge, to recover costs and earn a reasonable return on their capital investments. Variability in earnings primarily results from changes in operating and maintenance expenditures, as well as changes in rates and the economy. Competition Questar Gas and Hope do not currently face direct competition from other distributors of natural gas for residential and commercial customers in their service territories as state regulations in Utah, Wyoming and Idaho for Questar Gas, and West Virginia for Hope, do not allow customers to choose their provider at this time. See State Regulations in Regulation for additional information. East Ohio offers an Energy Choice program, under which residential customers are encouraged to purchase gas directly from retail suppliers or through a community aggregation program and have it delivered by East Ohio. At December 31, 2020, approximately 1.1 million of East Ohio’s 1.2 million Ohio customers were participating in the Energy Choice program. Competition in PSNC’s natural gas distribution operations is generally based on price and convenience. Large commercial and industrial customers often have the ability to switch from natural gas to an alternate fuel, such as propane or fuel oil. Natural gas competes with these alternate fuels based on price. As a result, any significant disparity between supply and demand, either of natural gas or of alternate fuels, and due either to production or delivery disruptions or other factors, will affect price and the ability to retain large commercial and industrial customers. In all of Dominion Energy’s gas service territories, electric utilities offer electricity as a rival energy source and compete for the space heating, water heating and cooking markets. The principal means to compete against alternative fuels is lower prices, and natural gas historically has maintained its price advantage in the residential and commercial markets. Competition for heating as well as general household and small commercial energy needs generally occurs at the initial installation phase when the customer or builder makes the decision as to which types of equipment to install, as a result customers tend to use their chosen energy source for the life of the equipment. Regulation Gas Distribution’s operations, including the rates that it may charge customers, are regulated by the Ohio, West Virginia, North Carolina, Utah, Wyoming and Idaho Commissions as well as PHMSA and the U.S. Department of Transportation. See Federal Regulations and State Regulations in Regulation for more information. Properties For a description of existing facilities see Item 2. Properties. Dominion Energy has the following significant projects under construction or development to better serve utility customers or expand its service offerings within its utility service territory as well as to support its strategy to achieve net zero emissions. East Ohio—In 2008, East Ohio began PIR, aimed at replacing approximately 25% of its pipeline system. In September 2016, the Ohio Commission approved a stipulation filed jointly by East Ohio and the Staff of the Ohio Commission to continue the PIR program and associated cost recovery for another five-year term beginning in 2017, and to permit East Ohio to increase its annual capital expenditures to $200 million by 2018 with a 3% increase per year thereafter subject to the annual cost recovery rate increase caps proposed by East Ohio. In December 2020, East Ohio filed an application with the Ohio Commission to extend the PIR program for an additional five years with continuation of 3% increases per year. See Note 13 to the Consolidated Financial Statements for further information. In 2011, East Ohio began CEP which enables East Ohio to defer depreciation expense, property tax expense and carrying costs on capital investments not covered by its PIR program to expand, upgrade or replace its pipeline system and information technology systems as well as investments necessary to comply with the Ohio Commission or other government regulation. See Note 13 to the Consolidated Financial Statements for further information. Questar Gas— In 2010, Questar Gas began replacing aging high pressure infrastructure under a cost-tracking mechanism that allows it to place into rate base and earn a return on capital expenditures associated with a multi-year natural gas infrastructure-replacement program upon the completion of each project. As part of the 2019 base rate case, the Utah Commission approved an annual spending budget of $72 million for the replacement program, to be adjusted annually for inflation. In 2018, legislation became effective in Utah which is designed to spur economic growth in rural communities without natural gas service. The legislation allows Questar Gas to spend up to $50 million over three years, and up to $125 million over five years, for 18 expansion of distribution facilities to bring natural gas to residential and commercial customers in rural parts of Utah, as approved by the Utah Commission. See Note 13 to Consolidated Financial Statements for more information. The Utah Commission has provided approval for Questar Gas to construct an LNG storage facility with a liquefaction rate of 8.2 million cubic feet per day. The project is expected to cost approximately $200 million, excluding financing costs, and is anticipated to be placed into service in late 2022. PSNC—The North Carolina Commission has authorized PSNC to use a tracker mechanism to recover the incurred capital investment and associated costs of complying with federal standards for pipeline integrity and safety requirements that are not in current base rates. Projected integrity management plan investment, excluding the costs associated with the 2020 project noted below, for the period 2021 to 2023 is expected to be approximately $111 million. During 2019, construction began on 38 miles of transmission pipeline between Franklinton, North Carolina and Clayton, North Carolina, which will provide the capacity necessary to support the growing natural gas demand in PSNC’s service territory. The project is expected to cost approximately $155 million, excluding financing costs, and is anticipated to be placed into service in 2021. During 2020, construction began on 11 miles of transmission pipeline in Buncombe County, NC. After an analysis was performed under the integrity management program, the new transmission line was deemed necessary to offset the capacity losses on the existing line due to lower pressure being utilized in order to meet federal safety requirements. The project is expected to cost approximately $55 million and is anticipated to be placed into service in late 2021. Non-Utility Renewable Natural Gas—In December 2019, Dominion Energy announced the formation of a nationwide partnership with Vanguard Renewables in collaboration with the Dairy Farmers of America to capture methane from dairy farms and convert it into pipeline quality natural gas. Dominion Energy expects to invest $200 million to develop the related assets. During 2020, construction began of a renewable natural gas facility in Greeley, Colorado, expected to cost approximately $70 million, excluding financing costs, and to be placed in service in late 2022. Investments Align RNG—In November 2018, Dominion Energy announced the formation of Align RNG, an equal partnership with Smithfield Foods, Inc. Align RNG expects to invest $500 million to develop assets to capture methane from swine farms across Virginia, North Carolina, Utah, Arizona and California and convert it into pipeline quality natural gas. In July 2020, Align RNG placed its first project, located in Milford, UT, in service and the project produced 11,200 Dths of renewable natural gas through December 31, 2020. Sources of Energy Supply Dominion Energy’s natural gas supply is obtained from various sources including purchases from major and independent producers in the Mid-Continent and Gulf Coast regions, local producers in the Appalachian area, gas marketers and, for Questar Gas specifically, from Wexpro and other producers in the Rocky Mountain region. Wexpro’s gas development and production operations serve over half of Questar Gas’ gas supply requirements in accordance with the Wexpro Agreement and the Wexpro II Agreement, comprehensive agreements with the states of Utah and Wyoming. Seasonality Gas Distribution’s business earnings vary seasonally as a result of the impact of changes in temperature on demand by residential and commercial customers for gas to meet heating needs. Historically, the majority of these earnings have been generated during the heating season which is generally from November to March; however, implementation of rate mechanisms for transportation services for East Ohio, and gas sales for Questar Gas and PSNC have reduced the earnings impact of weather-related fluctuations. DOMINION ENERGY SOUTH CAROLINA The Dominion Energy South Carolina Operating Segment is comprised of DESC’s generation, transmission and distribution of electricity to approximately 758,000 customers in the central, southern and southwestern portions of South Carolina and the distribution of natural gas to approximately 405,000 residential, commercial and industrial customers in South Carolina. DESC’s growth capital plan includes spending approximately $2 billion from 2021 through 2025 to upgrade existing or add new infrastructure to meet growing energy needs within its service territory and maintain reliability. 19 Revenue provided by DESC’s electric distribution operations is based primarily on rates established by the South Carolina Commission. Variability in earnings is driven primarily by changes in rates, weather, customer growth and other factors impacting consumption such as the economy and energy conservation, in addition to operating and maintenance expenditures. DESC’s electric transmission operations serve its electric distribution operations as well as certain wholesale customers. Revenue provided by such electric transmission operations is based on a FERC-approved formula rate mechanism under DESC’s open access transmission tariff or based on retail rates established by the South Carolina Commission. Revenue provided by DESC’s electric generation operations is primarily derived from the sale of electricity generated by its utility generation assets and is based on rates established by the South Carolina Commission. Variability in earnings may arise when revenues are impacted by factors not reflected in current rates, such as the impact of weather, customer demand or the timing and nature of expenses or outages. Electric operations continue to focus on improving service and experience levels while striving to reduce costs and link investments to operational results. SAIDI performance results, excluding major events, were 87 minutes for the three-year average ending 2020, compared to the previous three-year average of 85 minutes. Revenue provided by DESC’s natural gas distribution operations primarily results from rates established by the South Carolina Commission. Variability in earnings results from changes in operating and maintenance expenditures, as well as changes in rates and the demand for services, the availability and prices of alternative fuels and the economy. DESC is a member of the Virginia-Carolinas Reliability Group, one of several geographic divisions within the SERC. The SERC is one of seven regional entities with delegated authority from NERC for the purpose of proposing and enforcing reliability standards approved by NERC. Competition There is no competition for electric distribution or generation service within DESC’s retail electric service territory in South Carolina and no such competition is currently permitted. However, competition from third-party owners for development, construction and ownership of certain transmission facilities in DESC’s service territory is permitted pursuant to Order 1000, subject to state and local siting and permitting approvals. This could result in additional competition to build and own transmission infrastructure in DESC’s service area in the future. Competition in DESC’s natural gas distribution operations is generally based on price and convenience. Large commercial and industrial customers often have the ability to switch from natural gas to an alternate fuel, such as propane or fuel oil. Natural gas competes with these alternate fuels based on price. As a result, any significant disparity between supply and demand, either of natural gas or of alternate fuels, and due either to production or delivery disruptions or other factors, will affect price and the ability to retain large commercial and industrial customers. Regulation DESC’s electric distribution service, including the rates it may charge to jurisdictional customers, is subject to regulation by the South Carolina Commission. DESC’s electric generation operations are subject to regulation by the South Carolina Commission, FERC, the NRC, the EPA, the DOE and various other federal, state and local authorities. DESC’s electric transmission service is primarily regulated by FERC and the DOE. DESC’s gas distribution operations are subject to regulation by the South Carolina Commission, as well as PHMSA, the U.S. Department of Transportation and the South Carolina Office of Regulatory Staff for enforcement of federal and state pipeline safety requirements. See State Regulations and Federal Regulations in Regulation for more information. Properties For a description of existing facilities see Item 2. Properties. DESC has the following significant projects under construction or development to better serve customers or expand its service offerings within its service territory: In 2020, DESC began the upgrade of its electric and gas systems to an AMI whereby smart meters will be installed throughout its service area. DESC has completed the installation of over 132,000 of the planned 1.1 million smart meters. This project is estimated to cost approximately $140 million and will be completed in March 2023. In 2020, DESC continued several electric transmission projects in connection with two new nuclear plants under development by Southern. These transmission projects are required to be in place prior to these plants beginning operations to maintain reliability. 20 These projects, costing approximately $75 million in aggregate, will go into service in phases through 2022. The first phase of approximately six miles was completed in November 2020 with another phase of approximately 13 miles scheduled to be completed in early 2021. Sources of Energy Supply DESC uses a variety of fuels to power its electric generation fleet and purchases power for utility system load requirements. Presented below is a summary of DESC’s actual system output by energy source: Source 2020 2019 2018(1) Natural gas 47 % 46 % 37 % Coal 22 27 35 Nuclear(2) 20 23 20 Renewable and Hydro(3) 11 4 8 Total 100 % 100 % 100 % (1) Dominion Energy did not acquire DESC until January 2019. These amounts represent data obtained as part of the due diligence performed by Dominion Energy prior to the SCANA Combination. (2) Excludes Santee Cooper’s 33.3% undivided ownership interest in Summer. (3) Includes solar. Natural gas— DESC purchases natural gas under contracts with producers and marketers on both a short-term and long-term basis at market-based prices. The gas is delivered to South Carolina through firm transportation agreements with various counterparties, which expire between 2021 and 2084. Coal— DESC primarily obtains coal through short-term and long-term contracts with suppliers located in eastern Kentucky, Tennessee, Virginia and West Virginia. These contracts provide for approximately 2.1 million tons annually. These contracts will expire at various times throughout 2021 and 2022. Spot market purchases may occur when needed or when prices are believed to be favorable. Nuclear— DESC primarily utilizes long-term contracts to support its nuclear fuel requirements. DESC, for itself and as agent for Santee Cooper, and Westinghouse are parties to a fuel alliance agreement and contracts for fuel fabrication and related services. Under these contracts, DESC supplies enriched products to Westinghouse, who in turn supplies nuclear fuel assemblies for Summer. Westinghouse is DESC’s exclusive provider of such fuel assemblies on a cost-plus basis. The fuel assemblies to be delivered under the contracts are expected to supply the nuclear fuel requirements through 2033. In addition, DESC has contracts covering its nuclear fuel needs for uranium, conversion services and enrichment services. These contracts have varying expiration dates through 2024. DESC believes that it will be able to renew these contracts as they expire or enter into similar contractual arrangements with other suppliers of nuclear fuel materials and services and that sufficient capacity for nuclear fuel supplies and processing exists to allow for normal operations of its nuclear generating unit. Current agreements, inventories and spot market availability are expected to support current and planned fuel supply needs. Additional fuel is purchased as required to ensure optimal fuel and inventory levels. Seasonality DESC’s electric distribution and transmission business earnings vary seasonally as a result of the impact of changes in temperature, the impact of storms and other catastrophic weather events and the availability of alternative sources for heating on demand by residential and commercial customers. Generally, the demand for electricity peaks during the summer and winter months to meet cooling and heating needs, respectively. An increase in heating degree days does not produce the same increase in revenue as an increase in cooling degree days, due to seasonal pricing differentials and because alternative heating sources are more readily available. 21 DESC’s gas distribution and storage business earnings vary seasonally as a result of the impact of changes in temperature on demand by residential and commercial customers for gas to meet heating needs. The majority of these earnings are generated during the heating season, which is generally from November to March; however, South Carolina has certain rate mechanisms designed to reduce the impact of weather-related fluctuations. Nuclear Decommissioning DESC has a two-thirds interest in one licensed, operating nuclear reactor at Summer in South Carolina. Decommissioning involves the decontamination and removal of radioactive contaminants from a nuclear power station once operations have ceased, in accordance with standards established by the NRC. Amounts collected from ratepayers are placed into trusts and are invested to fund the expected future costs of decommissioning Summer. DESC believes that the decommissioning funds and their expected earnings will be sufficient to cover expected decommissioning costs, particularly when combined with future ratepayer collections and contributions to this trust. DESC will continue to monitor this trust to ensure that it meets the NRC minimum financial assurance requirements, which may include, if needed, the use of Dominion Energy guarantees, surety bonding or other financial instruments recognized by the NRC. The estimated cost to DESC to decommission its 66.7% ownership in Summer is reflected in the table below and is primarily based upon site-specific studies completed in 2020. These cost studies are generally completed every four to five years. Santee Cooper is responsible for the remaining decommissioning costs, proportionate with its 33.3% ownership in Summer. The cost estimates assume decommissioning activities will begin shortly after cessation of operations, which will occur when the operating license expires. NRC regulations allow licensees to apply for extension of an operating license in up to 20-year increments. DESC is considering an operating license renewal for Summer. The estimated decommissioning costs, funds in trust and current license expiration dates for Summer are shown in the following table: NRC license expiration year Most recent cost estimate (2020 dollars)(1) Funds in trusts at December 31, 2020(2) (dollars in millions) Summer – Unit 1 2042 $ 744 $ 238 (1) The cost estimates shown above reflect reductions for the expected future recovery of certain spent fuel costs based on DESC’s contracts with the DOE for disposal of spent nuclear fuel consistent with the reductions reflected in DESC’s nuclear decommissioning AROs and includes the expectation that a 20-year license extension is obtained. (2) Excludes any funds held in trust by Santee Cooper. DESC made contributions of $3 million to its nuclear decommissioning trust funds during 2020. CONTRACTED ASSETS The Contracted Assets Operating Segment includes the operations of Millstone, and associated energy marketing and price risk activities, Dominion Energy’s nonregulated long-term contracted renewable electric generation fleet and Dominion Energy’s 50% noncontrolling interest in Cove Point. Contracted Asset’s growth capital plan includes spending $2 billion from 2021 through 2025 to expand its renewable generation fleet. The Contracted Assets Operating Segment derives its earnings primarily from Dominion Energy’s nonregulated generation assets, including associated capacity and ancillary services, and from its noncontrolling interest in Cove Point. Variability in earnings provided by Millstone relates to changes in market-based prices received for electricity and capacity as well as the timing, duration and costs of scheduled and unscheduled outages. Approximately half of Millstone’s output is sold under the Millstone 2019 power purchase agreements, which commenced in October 2019. Market-based prices for electricity are largely dependent on commodity prices and the demand for electricity. Capacity prices are dependent upon resource requirements in relation to the supply available (both existing and new) in the forward capacity auctions, which are held approximately three years in advance of the associated delivery year. Dominion Energy manages the electric price volatility of Millstone by hedging a substantial portion of its expected near-term energy sales not subject to the Millstone 2019 power purchase agreements with derivative instruments. Dominion Energy’s nonregulated generation fleet includes numerous renewable generation facilities, including solar generation in operation or development in ten states, including Virginia. The output of these facilities is sold under long-term power purchase agreements with terms generally ranging from 15 to 25 years. Variability in earnings provided by these assets relates to changes in 22 irradiance levels due to changes in weather. See Notes 3 and 10 to the Consolidated Financial Statements for additional information regarding certain solar projects. Competition Contracted Asset’s renewable generation projects are not currently subject to significant competition as the output from these facilities is primarily sold under long-term power purchase agreements with terms generally ranging from 15 to 25 years. However, in the future, such operations may compete with other power generation facilities to serve certain large-scale customers after the power purchase agreements expire. Competition for the nonregulated fleet is impacted by electricity and fuel prices, new market entrants, construction by others of generating assets and transmission capacity, technological advances in power generation, the actions of environmental and other regulatory authorities and other factors. These competitive factors may negatively impact the nonregulated fleet’s ability to profit from the sale of electricity and related products and services. Millstone is dependent on its ability to operate in a competitive environment and does not have a predetermined rate structure that provides for an ROIC. Millstone operates within a functioning RTO and primarily compete on the basis of price. Competitors include other generating assets bidding to operate within the RTO. Millstone competes in the wholesale market with other generators to sell a variety of products including energy, capacity and ancillary services. It is difficult to compare various types of generation given the wide range of fuels, fuel procurement strategies, efficiencies and operating characteristics of the fleet within any given RTO. However, Dominion Energy applies its expertise in operations, dispatch and risk management to maximize the degree to which Millstone is competitive compared to similar assets within the region. Regulation Contracted Assets’ generation fleet is subject to regulation by the NRC, the EPA, the DOE, the Army Corps of Engineers and other federal, state and local authorities. See Regulation, Future Issues and Other Matters in Item 7, MD&A and Notes 13 and 23 to the Consolidated Financial Statements for more information. Properties For a listing of facilities, see Item 2. Properties. Dominion Energy plans to acquire or construct certain solar facilities in the Mid-Atlantic and Midwest. See Note 10 to the Consolidated Financial Statements for more information. Investments Contracted Assets includes Dominion Energy’s 50% noncontrolling interest in Cove Point. Cove Point’s gas transportation, LNG import and storage operations, as well as the Liquefaction Facility’s capacity, are contracted primarily under long-term fixed reservation fee agreements. The Liquefaction Facility has a firm contracted capacity for LNG loading onto ships of approximately 4.6 Mtpa (0.66 bcfe/day) under normal operating conditions and after accounting for maintenance downtime. In addition to the operations of the Liquefaction Facility, Cove Point receives revenue from firm fee-based contractual arrangements, including negotiated rates, for its pipeline operations and certain LNG storage and terminalling services as provided for in FERC-approved tariffs. Variability in earnings results from changes in operating and maintenance expenditures, as well as for its FERC-regulated operations any changes in rates and the demand for services. See Item 2. Properties for a description of Cove Point’s physical assets. See Note 9 to the Consolidated Financial Statements for further information about Dominion Energy’s equity method investment in Cove Point. 23 Sources of Energy Supply Contracted Asset’s renewable fleet utilizes solar energy to power its electric generation while Millstone utilizes nuclear fuel, which is acquired primarily through a series of 5-year contracts, to power its electric generation. In addition, Dominion Energy occasionally purchases electricity from the ISO-NE spot market to satisfy physical forward sale requirements, as described below. Some of these agreements have fixed commitments and are included as contractual obligations in Future Cash Payments for Contractual Obligations and Planned Capital Expenditures in Item 7. MD&A. Seasonality Sales of electricity for Contracted Assets are subject to seasonal variation as a result of the weather, partially mitigated by the Millstone 2019 power purchase agreements. Nuclear Decommissioning Dominion Energy has two licensed, operating nuclear reactors at Millstone in Connecticut. A third Millstone unit ceased operations before Dominion Energy acquired the power station. In May 2013, Dominion Energy ceased operations at its single Kewaunee unit in Wisconsin and commenced decommissioning activities using the SAFSTOR methodology. The planned decommissioning completion date is 2073, which is within the NRC allowed 60-year window. As part of Dominion Energy’s acquisition of both Millstone and Kewaunee, it acquired decommissioning funds for the related units. Any funds remaining in Kewaunee’s trust after decommissioning is completed are required to be refunded to Wisconsin ratepayers. Dominion Energy believes that the amounts currently available in the decommissioning trusts and their expected earnings will be sufficient to cover expected decommissioning costs for the Millstone and Kewaunee units. Dominion Energy will continue to monitor these trusts to ensure they meet the NRC minimum financial assurance requirements, which may include, if needed, the use of parent company guarantees, surety bonding or other financial instruments recognized by the NRC. The most recent site-specific studies completed for Millstone and for Kewaunee were performed in 2019 and 2018, respectively. The estimated decommissioning costs, funds in trust and current license expiration dates for Millstone and Kewaunee are shown in the following table: NRC license expiration year Most recent cost estimate (2020 dollars)(1) Funds in trusts at December 31, 2020(2) (dollars in millions) Millstone Unit 1(3) N/A $ 459 $ 698 Unit 2 2035 666 940 Unit 3(4) 2045 756 917 Kewaunee Unit 1(5) N/A 584 910 Total $ 2,465 $ 3,465 (1) The cost estimates shown above reflect reductions for the expected future recovery of certain spent fuel costs based on Dominion Energy’s contracts with the DOE for disposal of spent nuclear fuel consistent with the reductions reflected in Dominion Energy’s nuclear decommissioning AROs. (2) Dominion Energy did not make any contributions to its nuclear decommissioning trust funds related to Millstone or Kewaunee during 2020. (3) Unit 1 permanently ceased operations in 1998, before Dominion Energy’s acquisition of Millstone. (4) Millstone Unit 3 is jointly owned by Dominion Energy Nuclear Connecticut, Inc., with a 6.53% undivided interest in Unit 3 owned by Massachusetts Municipal and Green Mountain. Decommissioning cost is shown at Dominion Energy’s ownership percentage. At December 31, 2020, the minority owners held $55 million of trust funds related to Millstone Unit 3 that are not reflected in the table above. (5) Permanently ceased operations in 2013. Also see Notes 14 and 23 to the Consolidated Financial Statements for further information about AROs and nuclear decommissioning, respectively, and Note 9 to the Consolidated Financial Statements for information about nuclear decommissioning trust investments. 24 CORPORATE AND OTHER Corporate and Other Segment-Virginia Power Virginia Power’s Corporate and Other segment primarily includes certain specific items attributable to its operating segments that are not included in profit measures evaluated by executive management in assessing the segment’s performance or in allocating resources. Corporate and Other Segment-Dominion Energy Dominion Energy’s Corporate and Other segment includes its corporate, service company and other functions (including unallocated debt) as well as nonregulated retail energy marketing operations, including Dominion Energy’s noncontrolling interest in Wrangler. Corporate and Other includes specific items attributable to Dominion Energy’s operating segments that are not included in profit measures evaluated by executive management in assessing the segments’ performance or in allocating resources. In addition, Corporate and Other includes the net impact of discontinued operations consisting of Dominion Energy’s gas transmission and storage operations as discussed in Note 3 to the Consolidated Financial Statements and its equity investment in Atlantic Coast Pipeline as discussed in Note 9 to the Consolidated Financial Statements. Dominion Energy owns a 20% noncontrolling interest in Wrangler, which was formed in September 2019. Wrangler’s operations, contributed by Dominion Energy in 2020 and 2019, consist of nonregulated natural gas retail energy marketing business serving customers in Ohio and Georgia as well as other southeastern states in the U.S. Dominion Energy expects to contribute its remaining retail energy marketing operations, primarily serving customers in Pennsylvania, to Wrangler by the end of 2021. Dominion Energy owns a 53% noncontrolling interest in Atlantic Coast Pipeline. In July 2020, as a result of the continued permitting delays, growing legal uncertainties and the need to incur significant capital expenditures to maintain project timing before such uncertainties could be resolved, Dominion Energy and Duke Energy announced the cancellation of the Atlantic Coast Pipeline Project. Dominion Energy Questar Pipeline provides gas transportation and storage services in the Rocky Mountain region of the U.S. These operations are currently presented in held-for-sale and discontinued operations effective July 2020 until closing of the Q-Pipe Transaction with BHE, which is expected in early 2021. See Notes 3 and 9 to the Consolidated Financial Statements for more information. REGULATION The Companies are subject to regulation by various federal, state and local authorities, including the state commissions of Virginia, North Carolina, South Carolina, Ohio, West Virginia, Utah, Wyoming and Idaho, SEC, FERC, EPA, DOE, PHMSA, NRC, Army Corps of Engineers and the U.S. Department of Transportation. State Regulations Electric Virginia Power and DESC’s electric utility retail services are subject to regulation by the Virginia and North Carolina Commissions and the South Carolina Commission, respectively. Virginia Power and DESC hold CPCNs which authorize them to maintain and operate their electric facilities already in operation and to sell electricity to customers. However, Virginia Power and DESC may not construct generating facilities or large capacity transmission lines without the prior approval of various state and federal government agencies. In addition, the Virginia Commission and the North Carolina Commission regulate Virginia Power’s and the South Carolina Commission regulates DESC’s transactions with affiliates and transfers of certain facilities. The Virginia, North Carolina and South Carolina Commissions also regulate the issuance of certain securities. Electric Regulation in Virginia The Regulation Act provides for a cost-of-service rate model and permits Virginia Power to seek recovery of costs for new generation projects, including pumped hydroelectricity generation and storage facilities as well as extensions of operating licenses of nuclear power generation facilities, FERC-approved transmission costs, underground distribution lines, certain environmental compliance, conservation and energy efficiency programs and renewable energy facilities and programs through stand-alone riders, and also contains statutory provisions directing Virginia Power to file annual fuel cost recovery cases with the Virginia Commission. In March 2018, the GTSA reinstated base rate reviews on a triennial basis other than the 2021 Triennial Review. In the triennial review proceedings, earnings that are more than 70 basis points above the utility’s authorized ROE that might have been refunded to customers and served as the basis for a reduction in future rates, may be reduced by Virginia Commission-approved investment amounts in qualifying solar or wind generation facilities or electric distribution grid transformation projects that Virginia Power elects 25 to include as a CCRO. The legislation declares that electric distribution grid transformation projects are in the public interest and provides that Virginia Power may seek to recover the costs of such projects through a rider if not the subject of a CCRO. Any costs that are the subject of a CCRO may not be recovered in base rates for the service life of the projects and may not be included in base rates in future triennial review proceedings. In any triennial review in which the Virginia Commission determines that the utility’s earnings are more than 70 basis points above its authorized ROE, base rates are subject to reduction prospectively and customer refunds would be due unless the total CCRO elected by the utility equals or exceeds the amount of earnings in excess of the 70 basis points. In the 2021 Triennial Review, any such rate reduction is limited to $50 million. In April 2020, the VCEA replaced Virginia’s voluntary renewable energy portfolio standard for Virginia Power with a mandatory program setting annual renewable energy portfolio standard requirements based on the percentage of total electric energy sold by Virginia Power, excluding existing nuclear generation and certain new carbon-free resources, reaching 100% by the end of 2045. The VCEA includes related requirements concerning deployment of wind, solar and energy storage resources, as well as provides for certain measures to increase net-metering, including an allocation for low-income customers, incentivizes energy efficiency programs and directs Virginia to participate in a carbon trading program. See Note 13 to the Consolidated Financial Statements for additional information. Electric Regulation in North Carolina Virginia Power’s retail electric base rates in North Carolina are regulated on a cost-of-service/rate-of-return basis subject to North Carolina statutes and the rules and procedures of the North Carolina Commission. North Carolina base rates are set by a process that allows Virginia Power to recover its operating costs and an ROIC. If retail electric earnings exceed the authorized ROE established by the North Carolina Commission, retail electric rates may be subject to review and possible reduction by the North Carolina Commission, which may decrease Virginia Power’s future earnings. Additionally, if the North Carolina Commission does not allow recovery of costs incurred in providing service on a timely basis, Virginia Power’s future earnings could be negatively impacted. Fuel rates are subject to revision under annual fuel cost adjustment proceedings. Virginia Power’s transmission service rates in North Carolina are regulated by the North Carolina Commission as part of Virginia Power’s bundled retail service to North Carolina customers. See Note 13 to the Consolidated Financial Statements for additional information. Electric Regulation in South Carolina DESC’s retail electric base rates in South Carolina are regulated on a cost-of-service/rate-of-return basis subject to South Carolina statutes and the rules and procedures of the South Carolina Commission. South Carolina base rates are set by a process that allows DESC to recover its operating costs and an ROIC. If retail electric earnings exceed the authorized ROE established by the South Carolina Commission, retail electric rates may be subject to review and possible reduction, which may decrease DESC’s future earnings. Additionally, if the South Carolina Commission does not allow recovery of costs incurred in providing service on a timely basis, DESC’s future earnings could be negatively impacted. Fuel costs are reviewed annually by the South Carolina Commission, as required by statute, and fuel rates are subject to revision in these annual fuel proceedings. DESC offers to its retail electric customers several DSM programs designed to assist customers in reducing their demand for electricity and improving their energy efficiency. DESC submits annual filings to the South Carolina Commission related to these programs. As actual DSM program costs are incurred, they are deferred as regulatory assets and recovered through a rider approved by the South Carolina Commission. The rider also provides for recovery of any net lost revenues and for a shared savings incentive. Pursuant to the SCANA Merger Approval Order, DESC is recovering capital costs and a return on capital cost rate base related to the NND Project over a 20-year period through a capital cost rider. The capital cost rider also provides for the return to retail electric customers of certain amounts associated with the NND Project. Revenue from the capital cost rider component of retail electric rates will continue to decline over the 20-year period as capital cost rate base is reduced. See Notes 3 and 13 to the Consolidated Financial Statements for additional information. Gas Questar Gas and Wexpro’s natural gas development, production, transportation, and distribution services, including the rates it may charge its customers, are regulated by the state commissions of Utah, Wyoming and Idaho. East Ohio’s natural gas distribution services, including the rates it may charge its customers, are regulated by the Ohio Commission. Hope’s natural gas distribution services, including the rates it may charge its customers, are regulated by the West Virginia Commission. DESC and PSNC’s natural 26 gas distribution services, including the rates they may charge their customers, are regulated by the South Carolina Commission and North Carolina Commission, respectively. Gas Regulation in Utah, Wyoming and Idaho Questar Gas is subject to regulation of rates and other aspects of its business by the Utah, Wyoming and Idaho Commissions. The Idaho Commission has contracted with the Utah Commission for rate oversight of Questar Gas’ operations in a small area of southeastern Idaho. When necessary, Questar Gas seeks general base rate increases to recover increased operating costs and a fair return on rate base investments. Base rates are set based on the cost-of-service by rate class. Base rates for Questar Gas are designed primarily based on rate design methodology in which the majority of operating costs are recovered through volumetric charges. The volumetric charges for the residential and small commercial customers in Utah and Wyoming are subject to revenue decoupling and adjusted for changes in usage per customer. Questar Gas makes routine separate filings with the Utah and Wyoming Commissions to reflect changes in the costs of purchased gas. A large portion of these purchased gas costs are subject to rate recovery through the Wexpro Agreement and Wexpro II Agreement. Costs that are expected to be recovered in future rates are deferred as regulatory assets. The purchased gas recovery filings generally cover a prospective twelve-month period. Approved increases or decreases in gas cost recovery rates result in increases or decreases in revenues with corresponding increases or decreases in net purchased gas cost expenses. The Utah Commission has approved a standalone cost recovery mechanism to recover specified costs and a return for infrastructure projects between general base rate cases. See Note 13 to the Consolidated Financial Statements for additional information. Gas Regulation in Ohio East Ohio is subject to regulation of rates and other aspects of its business by the Ohio Commission. When necessary, East Ohio seeks general base rate increases to recover increased operating costs and a fair return on rate base investments. Base rates are set based on the cost-of-service by rate class. A straight-fixed-variable rate design, in which the majority of operating costs are recovered through a monthly charge rather than a volumetric charge, is utilized to establish rates for a majority of East Ohio’s customers pursuant to a 2008 rate case settlement. East Ohio makes routine filings with the Ohio Commission to reflect changes in the costs of gas purchased for operational balancing on its system. These purchased gas costs are subject to rate recovery through a mechanism that ensures dollar for dollar recovery of prudently incurred costs. Costs that are expected to be recovered in future rates are deferred as regulatory assets. The rider filings cover unrecovered gas costs plus prospective annual demand costs. Increases or decreases in gas cost rider rates result in increases or decreases in revenues with corresponding increases or decreases in net purchased gas cost expenses. The Ohio Commission has also approved several stand-alone cost recovery mechanisms to recover specified costs and a return for infrastructure, information technology and integrity or compliance-related projects between general base rate cases. See Note 13 to the Consolidated Financial Statements for additional information. Gas Regulation in West Virginia Hope is subject to regulation of rates and other aspects of its business by the West Virginia Commission. When necessary, Hope seeks general base rate increases to recover increased operating costs and a fair return on rate base investments. Base rates are set based on the cost-of-service by rate class. Base rates for Hope are designed primarily based on rate design methodology in which the majority of operating costs are recovered through volumetric charges. Hope makes routine separate filings with the West Virginia Commission to reflect changes in the costs of purchased gas. The majority of these purchased gas costs are subject to rate recovery through a mechanism that ensures dollar for dollar recovery of prudently incurred costs. Costs that are expected to be recovered in future rates are deferred as regulatory assets. The purchased gas cost recovery filings generally cover a prospective twelve-month period. Approved increases or decreases in gas cost recovery rates result in increases or decreases in revenues with corresponding increases or decreases in net purchased gas cost expenses. 27 The West Virginia Commission has also approved a stand-alone cost recovery mechanism to recover specified costs and a return for infrastructure projects between general base rate cases. See Note 13 to the Consolidated Financial Statements for additional information. Gas Regulation in North Carolina PSNC is subject to regulation of rates and other aspects of its business by the North Carolina Commission. When necessary, PSNC seeks general base rate increases to recover increased operating costs and a fair return on rate base investments. Base rates are set based on the cost-of-service by rate class. Base rates for PSNC are designed primarily based on rate design methodology in which the majority of operating costs are recovered through volumetric charges. The volumetric charges for the residential and commercial customers are subject to revenue decoupling and adjusted for changes in usage per customer. PSNC makes routine separate filings with the North Carolina Commission to reflect changes in the costs of purchased gas. PSNC’s purchased gas adjustment allows it to recover from customers all prudently incurred gas costs, including transportation costs, and certain related uncollectible expenses. Costs that are expected to be recovered in future rates are deferred as regulatory assets. The purchased gas recovery filings are made periodically to reflect prospective costs and recovery. Approved increases or decreases in gas cost recovery rates result in increases or decreases in revenues with corresponding increases or decreases in net purchased gas cost expenses. The North Carolina Commission has also approved a stand-alone cost recovery mechanism to recover specified capital costs and a return for pipeline integrity management infrastructure projects between general base rate cases. In connection with the SCANA Combination, PSNC agreed not to file an application for a general rate case with the North Carolina Commission before April 2021 other than for rate adjustments as described above. See Note 13 to the Consolidated Financial Statements for additional information. Gas Regulation in South Carolina DESC is subject to regulation of rates and other aspects of its natural gas distribution service by the South Carolina Commission. DESC provides retail natural gas service to customers in areas in which it has received authorization from the South Carolina Commission and in municipalities in which it holds a franchise. DESC’s base rates can be adjusted annually, pursuant to the Natural Gas Rate Stabilization Act, for recovery of costs related to natural gas infrastructure. Base rates are set based on the cost-of-service by rate class approved by the South Carolina Commission in the latest general rate case. Base rates for DESC are based primarily on a rate design methodology in which the majority of operating costs are recovered through volumetric charges. DESC also utilizes a weather normalization adjustment to adjust its base rates during the winter billing months for residential and commercial customers to mitigate the effects of unusually cold or warm weather. DESC’s natural gas tariffs include a purchased gas adjustment that provides for the recovery of prudently incurred gas costs, including transportation costs. DESC is authorized to adjust its purchased gas rates monthly and makes routine filings with the South Carolina Commission to provide notification of changes in these rates. Costs that are under or over recovered are deferred as regulatory assets or liabilities, respectively, and considered in subsequent purchased gas adjustments. The purchased gas adjustment filings generally cover a prospective twelve-month period. Increases or decreases in purchased gas costs can result in corresponding changes in purchased gas adjustment rates and the revenue generated by those rates. The South Carolina Commission reviews DESC’s gas purchasing policies and practices, including its administration of the purchased gas adjustment, annually. See Note 13 to the Consolidated Financial Statements for additional information. Federal Regulations Federal Energy Regulatory Commission Electric Under the Federal Power Act, FERC regulates wholesale sales and transmission of electricity in interstate commerce by public utilities. Virginia Power purchases and, under its market-based rate authority, sells electricity in the PJM wholesale market and sells electricity to wholesale purchasers in Virginia and North Carolina. Dominion Energy’s nonregulated generators sell electricity in the PJM, CAISO and ISO-NE wholesale markets, and to wholesale purchasers in the states of Virginia, North Carolina, Indiana, Ohio, Connecticut, Tennessee, Georgia, California, South Carolina and Utah, under Dominion Energy’s market-based sales tariffs 28 authorized by FERC or pursuant to FERC authority to sell as a qualified facility. DESC may make wholesale sales at market-based rates outside its balancing authority pursuant to its market-based sales tariff authorized by FERC. In addition, Virginia Power and DESC have FERC approved tariffs to sell wholesale power at capped rates based on their respective embedded cost of generation. These cost-based sales tariffs could be used to sell to loads within or outside Virginia Power and DESC’s respective service territories. Any such sales are voluntary. The Companies are subject to FERC’s Standards of Conduct that govern conduct between transmission function employees of interstate gas and electricity transmission providers and the marketing function employees of their affiliates. The rule defines the scope of transmission and marketing-related functions that are covered by the standards and is designed to prevent transmission providers from giving their affiliates undue preferences. The Companies are also subject to FERC’s affiliate restrictions that (1) prohibit power sales between nonregulated plants and utility plants without first receiving FERC authorization, (2) require the nonregulated and utility plants to conduct their wholesale power sales operations separately, and (3) prohibit utilities from sharing market information with nonregulated plant operating personnel. The rules are designed to prohibit utilities from giving the nonregulated plants a competitive advantage. EPACT included provisions to create an Electric Reliability Organization, which is required to promulgate mandatory reliability standards governing the operation of the bulk power system in the U.S. FERC has certified NERC as the Electric Reliability Organization and also issued an initial order approving many reliability standards that went into effect in 2007. Entities that violate standards will be subject to fines of up to $1.3 million per day, per violation and can also be assessed non-monetary penalties, depending upon the nature and severity of the violation. The Companies plan and operate their facilities in compliance with approved NERC reliability requirements. The Companies’ employees participate on various NERC committees, track the development and implementation of standards, and maintain proper compliance registration with NERC’s regional organizations. The Companies anticipate incurring additional compliance expenditures over the next several years because of the implementation of new cybersecurity programs. In addition, NERC has redefined critical assets which expanded the number of assets subject to NERC reliability standards, including cybersecurity assets. NERC continues to develop additional requirements specifically regarding supply chain standards and control centers that impact the bulk electric system. While the Companies expect to incur additional compliance costs in connection with NERC requirements and initiatives, such expenses are not expected to significantly affect results of operations. In April 2008, FERC granted an application for Virginia Power’s electric transmission operations to establish a forward-looking formula rate mechanism that updates transmission rates on an annual basis and approved an ROE effective as of January 1, 2008. The formula rate is designed to recover the expected revenue requirement for each calendar year and is updated based on actual costs. The FERC-approved formula method, which is based on projected costs, allows Virginia Power to earn a current return on its growing investment in electric transmission infrastructure. In October 2011, FERC issued an order approving the settlement of DESC’s formula rate that updates transmission rates on an annual basis, including its ROE. The formula rate is designed to recover the expected revenue requirement for the calendar year and is updated annually based on actual costs. This FERC accepted formula rate enables DESC to earn a return on its investment in electric transmission infrastructure. Gas FERC regulates the transportation and sale for resale of natural gas in interstate commerce under the Natural Gas Act of 1938 and the Natural Gas Policy Act of 1978, as amended. Under the Natural Gas Act, FERC has authority over rates, terms and conditions of services performed by Dominion Energy Questar Pipeline. Dominion Energy’s remaining interstate gas transmission and storage activities, which are currently classified as held for sale, are conducted on an open access basis, in accordance with certificates, tariffs and service agreements on file with FERC and FERC regulations. Dominion Energy operates in compliance with FERC standards of conduct, which prohibit the sharing of certain non-public transmission information or customer specific data by its interstate gas transmission and storage companies with non-transmission function employees. Pursuant to these standards of conduct, Dominion Energy also makes certain informational postings available on Dominion Energy’s website. See Note 3 to the Consolidated Financial Statements for a discussion of the Q-Pipe Transaction. 29 Nuclear Regulatory Commission All aspects of the operation and maintenance of the Companies’ nuclear power stations are regulated by the NRC. Operating licenses issued by the NRC are subject to revocation, suspension or modification, and the operation of a nuclear unit may be suspended if the NRC determines that the public interest, health or safety so requires. From time to time, the NRC adopts new requirements for the operation and maintenance of nuclear facilities. In many cases, these new regulations require changes in the design, operation and maintenance of existing nuclear facilities. If the NRC adopts such requirements in the future, it could result in substantial increases in the cost of operating and maintaining the Companies’ nuclear generating units. See Note 23 to the Consolidated Financial Statements for further information. The NRC also requires the Companies to decontaminate their nuclear facilities once operations cease. This process is referred to as decommissioning, and the Companies are required by the NRC to be financially prepared. For information on decommissioning trusts, see Dominion Energy Virginia-Nuclear Decommissioning, Dominion Energy South Carolina-Nuclear Decommissioning, and Contracted Assets-Nuclear Decommissioning above and Notes 3 and 9 to the Consolidated Financial Statements. See Note 23 to the Consolidated Financial Statements for information on spent nuclear fuel. Safety Regulations Dominion Energy is also subject to the Pipeline Safety Improvement Act of 2002 and the Pipeline Safety, Regulatory Certainty and Job Creation Act of 2011, which mandate inspections of interstate and intrastate natural gas transmission and storage pipelines, particularly those located in areas of high-density population. Dominion Energy has evaluated its natural gas transmission and storage properties, as required by the U.S. Department of Transportation regulations under these Acts, and has implemented a program of identification, testing and potential remediation activities. These activities are ongoing. The Companies are subject to a number of federal and state laws and regulations, including Occupational Safety and Health Administration, and comparable state statutes, whose purpose is to protect the health and safety of workers. The Companies have an internal safety, health and security program designed to monitor and enforce compliance with worker safety requirements, which is routinely reviewed and considered for improvement. The Companies believe that they are in material compliance with all applicable laws and regulations related to worker health and safety. Notwithstanding these preventive measures, incidents may occur that are outside of the Companies’ control. Environmental Regulations Each of the Companies’ operating segments is subject to substantial laws, regulations and compliance costs with respect to environmental matters. In addition to imposing continuing compliance obligations, these laws and regulations authorize the imposition of significant penalties for noncompliance, including fines, injunctive relief and other sanctions. The cost of complying with applicable environmental laws, regulations and rules is material to the Companies. If compliance expenditures and associated operating costs are not recoverable from customers through regulated rates (in regulated businesses) or market prices (in unregulated businesses), those costs could adversely affect future results of operations and cash flows. The Companies have applied for or obtained the necessary environmental permits for the construction and operation of their facilities. Many of these permits are subject to reissuance and continuing review. For a discussion of significant aspects of these matters, including current and planned capital expenditures relating to environmental compliance required to be discussed in this Item, see Environmental Matters in Future Issues and Other Matters in Item 7. MD&A. Additional information can also be found in Note 23 to the Consolidated Financial Statements. Global Climate Change The Companies support a federal climate change program that would provide a consistent, economy-wide approach to addressing this issue. Regardless of federal action, the Companies are reducing their GHG emissions while meeting the growing needs of their customers. In 2020, Virginia enacted the VCEA which addresses climate change matters such as the reduction of GHG emissions and renewable energy portfolio standards. Dominion Energy’s CEO and executive operational leadership within each operating segment are responsible for compliance with the laws and regulations governing environmental matters, including GHG emissions, and Dominion Energy’s Board of Directors receives periodic updates on these matters. See State Regulations—Electric—Electric Regulation in Virginia above, Environmental Strategy below, Environmental Matters in Future Issues and Other Matters in Item 7. MD&A and Note 23 to the Consolidated Financial Statements for information on climate change legislation and regulation. 30 Air The CAA is a comprehensive program utilizing a broad range of regulatory tools to protect and preserve the nation’s air quality. Regulated emissions include, but are not limited to, carbon, methane, VOC, NOX, other GHGs, mercury, other toxic metals, hydrogen chloride, SO2 and particulate matter. At a minimum, delegated states are required to establish regulatory programs to address all requirements of the CAA. However, states may choose to develop regulatory programs that are more restrictive. Many of the Companies’ facilities are subject to the CAA’s permitting and other requirements. Water The CWA is a comprehensive program requiring a broad range of regulatory tools including a permit program to authorize and regulate discharges to surface waters with strong enforcement mechanisms. The CWA and analogous state laws impose restrictions and strict controls regarding discharges of effluent into surface waters and require permits to be obtained from the EPA or the analogous state agency for those discharges. Containment berms and similar structures may be required to help prevent accidental releases. Dominion Energy must comply with applicable CWA requirements at its current and former operating facilities. Stormwater related to construction activities is also regulated under the CWA and by state and local stormwater management and erosion and sediment control laws. From time to time, Dominion Energy’s projects and operations may impact tidal and non-tidal wetlands. In these instances, Dominion Energy must obtain authorization from the appropriate federal, state and local agencies prior to impacting wetlands. The authorizing agency may impose significant direct or indirect mitigation costs to compensate for such impacts to wetlands. Waste and Chemical Management Dominion Energy is subject to various federal and state laws and implementing regulations governing the management, storage, treatment, reuse and disposal of waste materials and hazardous substances, including the Resource Conservation and Recovery Act of 1976, CERCLA, the Emergency Planning and Community Right-to-Know Act of 1986 and the Toxic Substances Control Act of 1976. Dominion Energy’s operations and construction activities, including activities associated with oil and gas production and gas storage wells, generate waste. Across Dominion Energy, completion water is disposed at commercial disposal facilities. Produced water is either hauled for disposal, evaporated or injected into company and third-party owned underground injection wells. Wells drilled in tight-gas-sand and shale reservoirs require hydraulic-fracture stimulation to achieve economic production rates and recoverable reserves. The majority of Wexpro’s current and future production and reserve potential is derived from reservoirs that require hydraulic-fracture stimulation to be commercially viable. Currently, all well construction activities, including hydraulic-fracture stimulation and management and disposal of hydraulic fracturing fluids, are regulated by federal and state agencies that review and approve all aspects of gas- and oil-well design and operation. Protected Species The ESA and analogous state laws prohibit activities that can result in harm to specific species of plants and animals, as well as impacts to the habitat on which those species depend. In addition to ESA programs, the Migratory Bird Treaty Act of 1918 and Bald and Golden Eagle Protection Act establish broader prohibitions on harm to protected birds. Many of the Companies’ facilities are subject to requirements of the ESA, Migratory Bird Treaty Act of 1918 and Bald and Golden Eagle Protection Act. The ESA and Bald and Golden Eagle Protection Act require potentially lengthy coordination with the state and federal agencies to ensure potentially affected species are protected. Ultimately, the suite of species protections may restrict company activities to certain times of year, project modifications may be necessary to avoid harm, or a permit may be needed for unavoidable taking of the species. The authorizing agency may impose mitigation requirements and costs to compensate for harm of a protected species or habitat loss. These requirements and time of year restrictions can result in adverse impacts on project plans and schedules such that the Companies’ businesses may be materially affected. Other Regulations Other significant environmental regulations to which the Companies are subject include federal and state laws protecting graves, sacred sites, historic sites and cultural resources, including those of American Indian tribal nations and tribal communities. These can result in compliance and mitigation costs as well as potential adverse effects on project plans and schedules such that the Companies’ businesses may be materially affected. 31 ENVIRONMENTAL STRATEGY Dominion Energy has set a goal to achieve net zero emissions by 2050. This goal covers carbon and methane emissions from both electric generation and natural gas operations. As part of the net zero commitment, Dominion Energy has specifically committed to cut methane emissions from its natural gas infrastructure operations by 65% by 2030 and by 80% by 2040, in each case relative to 2010 emissions. To reach net zero emissions, in the near term Dominion Energy is seeking extension of the licenses of its zero-carbon nuclear fleet in Virginia, rapidly expanding wind and solar generation, investing in carbon-beneficial renewable natural gas, expanding its industry-leading methane emissions-reduction programs, and using low-carbon natural gas to support the integration of wind and solar generation facilities into the grid. The strategy to meet these objectives consists of three major elements which will significantly reduce GHG emissions: • Clean energy diversity; • Innovation and energy infrastructure modernization; and • Conservation and energy efficiency. Over the long term, Dominion Energy’s ability to achieve net zero emissions will require supportive legislative and regulatory policies, advancements in technology, and broader investments across the economy. Dominion Energy will pursue solutions, including pilot programs, of technologies such as large-scale battery storage, carbon capture and storage, small modular reactors and hydrogen if and when they become technologically and economically feasible. Environmental Justice Dominion Energy seeks to build partnerships and engage with local communities, stakeholders and customers on environmental issues important to them, including environmental justice considerations such as fair treatment, inclusive involvement and effective communication. Dominion Energy commits to increase inclusiveness of its stakeholder engagement on decisions regarding the siting and operation of energy infrastructure. Dominion Energy strives to include to all people and communities, regardless of race, color, national origin, or income to ensure a diversity of views in our public engagement process. Transparency As part of its broader commitment to transparency, Dominion Energy increased its disclosures around carbon and methane emissions. Dominion Energy discloses its environmental commitments, policies and initiatives in a Sustainability and Corporate Responsibility Report as well as a Climate Report in addition to other reports included on Dominion Energy’s dedicated Environmental, Social and Governance website. Clean Energy Diversity To achieve its net zero commitment, Dominion Energy is pursuing a diverse mix of cleaner, more efficient and lower-emitting methods of generating and delivering energy, while advancing aggressive voluntary measures to continue dramatically reducing emissions from traditional generation and delivery. Over the past two decades, Dominion Energy has changed the fuel mix it uses to generate electricity, as well as improved the systems that make up its natural gas operations, to achieve a cleaner future. In addition to reducing GHG emissions, Dominion Energy’s environmental strategy has also resulted in measurable reductions of other air pollutants such as NOX, SO2 and mercury and reduced the amount of coal ash generated and the amount of water withdrawn. Dominion Energy achieved GHG and other air pollutant reductions by implementing an integrated environmental strategy that addresses electric energy production and delivery and energy management. As part of this strategy, Dominion Energy has retired, or committed to retire, several of its fossil fuel electric generating facilities, including those powered by coal, oil and gas with the replacement of this capacity coming from the development of renewable energy facilities. Renewable energy is an important component of a diverse and reliable energy mix. Dominion Energy continues to add utility-scale solar capacity and currently has the third largest utility-owned solar fleet in the U.S. with 2.2 GW in operations across 10 states as of December 31, 2020. Dominion Energy also has approximately 2.5 GW of solar generating capacity under development, including agreements for acquisitions of projects, for facilities expected to commence commercial operations in 2021 through 2025 in Virginia, South Carolina and Ohio, representing approximately $4.7 billion of investment. Dominion Energy expects to continue to make 32 significant investments in solar generation to achieve its target of 13.4 GW generating capacity in-service by the end of 2035. In addition, Dominion Energy is pursuing offshore wind with the 2.6 GW Coastal Virginia Offshore Wind Commercial project, expected to be placed in service by the end of 2026, along with the Coastal Virginia Offshore Wind Pilot project which achieved commercial operation in January 2021. Dominion Energy is pursuing renewable natural gas through its investment in Align RNG, which is developing projects to capture and convert methane emissions from swine farms, and Vanguard Renewables in collaboration with the Dairy Farmers of America to develop projects to capture and convert methane emissions from dairy farms across the U.S. Preservation of Dominion Energy’s existing carbon-free baseload nuclear generation is also an important component of Dominion Energy’s GHG emissions reduction strategy. Accordingly, Virginia Power has commenced the process to extend the operating licenses for its four nuclear units at Surry and North Anna. See Operating Segments and Item 2. Properties for additional information. Innovation and Energy Infrastructure Modernization One of the pillars of Dominion Energy’s net zero strategy is a focus on innovation as way to advance technology and sustainability. This includes investing in and building upon previously proven technology, including large-scale battery storage, hydrogen, advanced nuclear technology and carbon capture technology. Further, Dominion Energy’s growth capital plan from 2021 through 2025 includes a focus on upgrading the electric system in Virginia through investments in additional renewable generation facilities, smart meters, customer information platform, intelligent grid devices and associated control systems, physical and cyber security investments, strategic undergrounding and energy conservation programs. Dominion Energy also plans to upgrade its gas and electric transmission and distribution networks and meet environmental requirements and standards set by various regulatory bodies. These enhancements are aimed at meeting Dominion Energy’s continued goal of providing safe, reliable service while addressing increasing electricity consumption and making Dominion Energy’s system more responsive to customers’ desire to more efficiently manage their energy consumption as well as more adaptive to renewable generation resources and battery technologies. Dominion Energy has also implemented infrastructure improvements and improved operational practices to reduce the GHG emissions for its natural gas facilities. Dominion Energy is also pursuing the construction or upgrade of regulated infrastructure in its natural gas businesses. Dominion Energy has made voluntary commitments as part of the EPA’s Natural Gas STAR Methane Challenge Program to continue to reduce methane emissions as part of these improvements. Dominion Energy is also a member of the EPA’s voluntary Natural Gas STAR Program, which the entities acquired in the SCANA Combination are expected to join in 2021. In addition, Dominion Energy is a member of the One Future Coalition, an industry group with members pledging to limit methane emissions to below 1% of gas throughput across the entire natural gas value chain. See Operating Segments for additional information. Conservation and Energy Efficiency Conservation and load management play a significant role in meeting the growing demand for electricity and natural gas, while also helping to reduce the environmental footprint of Dominion Energy’s customers. Dominion Energy offers various efficiency programs designed to reduce energy consumption in Virginia, North Carolina, Ohio, South Carolina, Utah and Wyoming, including programs such as: • Energy audits and assessments; • Incentives for customers to upgrade or install certain energy efficient measures and/or systems; • Weatherization assistance to help income-eligible customers reduce their energy usage; • Home energy planning, which provides homeowners with a step-by-step roadmap to efficiency improvements to reduce gas usage; and • Rebates for installing high-efficiency equipment. GHG Emissions Dominion Energy’s integrated environmental strategy supports a reduction in GHG emissions. Through 2019, Dominion Energy has reduced carbon emissions from its electric generating units (based on ownership percentage) by 57% since 2005 and reduced methane 33 emissions from its natural gas infrastructure operations by 25% since 2010. Dominion Energy’s 2020 emissions data is not yet available. Emissions for fiscal year 2019 include the assets acquired as a part of the SCANA Combination, such as DESC’s electric generation operations and DESC and PSNC’s natural gas operations. Dominion Energy’s 2019 emissions data presented below also includes the operations of gas transmission and distribution operations sold or to be sold to BHE as part of the GT&S Transaction and the Q-Pipe Transaction. Dominion Energy has been reporting GHG emissions, including carbon, methane, N2O and SF6, from its natural gas infrastructure, electric generation and power delivery operations to the EPA since 2011 under the EPA mandatory GHG Reporting Program. Dominion Energy’s Corporate GHG Inventory used for reporting purposes follows methodologies specified in the EPA’s Mandatory GHG Reporting Rule, 40 Code of Federal Regulations Part 98 for calculating emissions, as well as approved industry protocols. In its annual Corporate GHG Inventory, Dominion Energy also voluntarily includes carbon and methane emission estimates from smaller sources that are not required to be included under the EPA’s mandatory GHG Reporting Program, including smaller electric generation, natural gas compressor stations and other sources. Dominion Energy’s Corporate GHG Inventory also includes emissions sources Dominion Energy voluntarily reports to various programs it participates in. As a result, Dominion Energy’s reported methane emissions in its Corporate GHG Inventory are higher than what is reported to the EPA. Total CO2 equivalent emissions reported under Dominion Energy’s Corporate GHG Inventory were 36.9 million metric tons in 2019. Reported CO2 equivalent emissions include CO2, CH4, N2O, and SF6 emissions from Dominion Energy’s electric generation operations, electric transmission and distribution operations, and natural gas operations. • For Dominion Energy’s electric generation operations, total CO2 equivalent emissions (based on ownership percentage) were 31.9 million metric tons in 2019, including 9.9 million metric tons from DESC and 22.0 million metric tons from Virginia Power. • For Dominion Energy’s electric transmission and distribution operations, direct CO2 equivalent emissions were 0.05 million metric tons in 2019. • For Dominion Energy’s natural gas assets, total CO2 equivalent emissions were 4.95 million metric tons in 2019. Dominion Energy’s 2019 GHG emissions as reported under various subparts of the EPA’s Mandatory GHG Reporting Program as of December 31, 2020, are as follows: Natural Gas Operations – 2019 Emissions Segment Subpart W CH4 Emissions Subpart C CH4 Emissions Subparts W & C CH4 Emissions Subparts W & C CO2 Emissions Subparts W & C N2O Emissions (metric tons) Distribution 34,735 34,735 2,123 Production 17,168 17,168 10,951 0.02 Transmission pipelines 4,576 4,576 73 Transmission compressor stations 2,722 12 2,734 650,859 1.22 Gathering and boosting 3,083 3,083 93,352 0.19 Storage 1,542 5 1,547 261,741 0.49 LNG import/export 111 21 132 1,166,479 2.14 Processing 91 91 2,168 0.01 Total 64,028 38 64,066 2,187,746 4.07 34 Electric Generation Operations – 2019 Emissions Company Subparts C & D CO2 Emissions Subparts C & D CH4 Emissions Subparts C & D N2O Emissions (metric tons) Virginia Power(1) 19,051,753 17,096 27,863 DESC 9,855,332 10,239 16,239 Total 28,907,085 27,335 44,102 (1) Virginia Power totals include biomass, which were not included in the Corporate GHG inventory. Electric Transmission and Distribution Operations – 2019 Emissions Company(1) Subpart DD SF6 Emissions Subpart DD SF6 as CO2 Equivalent Emissions (metric tons) Virginia Power 2 38,338 (1) DESC does not trigger EPA mandatory GHG reporting. CYBERSECURITY In an effort to reduce the likelihood and severity of cyber intrusions, the Companies have a comprehensive cybersecurity program designed to protect and preserve the confidentiality, integrity and availability of data and systems, including oversight by the Board of Directors as well as the finance and risk oversight board committee. The Companies are subject to mandatory cybersecurity regulatory requirements, interface regularly with a wide range of external organizations and participate in classified briefings to maintain an awareness of current cybersecurity threats and vulnerabilities. The Companies’ current security posture and regulatory compliance efforts are intended to address the evolving and changing cyber threats. See Item 1A. Risk Factors for additional information. 35 Item 1A. Risk Factors The Companies’ businesses are influenced by many factors that are difficult to predict, involve uncertainties that may materially affect actual results and are often beyond their control. A number of these factors have been identified below. For other factors that may cause actual results to differ materially from those indicated in any forward-looking statement or projection contained in this report, see Forward-Looking Statements in Item 7. MD&A. Regulatory, Legislative and Legal Risks The rates of the Companies’ principal electric transmission, distribution and generation operations and gas distribution operations are subject to regulatory review. Revenue provided by the Companies’ electric transmission, distribution and generation operations and by gas distribution operations is based primarily on rates approved by state and federal regulatory agencies. The profitability of the Companies’ businesses is dependent on their ability, through the rates that they are permitted to charge, to recover costs and earn a reasonable rate of return on their capital investment. At the federal level, the Companies’ wholesale rates for electric transmission service are regulated by FERC. Rates for electric transmission services are updated annually according to a FERC-approved formula rate mechanism, and may be subject to additional prospective adjustments and retroactive corrections. A failure by the Companies to support these rates could result in rate decreases from current rate levels, which could adversely affect the Companies’ results of operations, cash flows and financial condition. At the state level, Virginia Power’s retail base rates, terms and conditions for generation and distribution services to customers in Virginia are reviewed by the Virginia Commission in a proceeding that involves the determination of Virginia Power’s actual earned ROE during a historic test period, and the determination of Virginia Power’s authorized ROE prospectively. The GTSA reinstated triennial reviews commencing with the 2021 Triennial Review. Under certain circumstances described in the Regulation Act, Virginia Power may be required to refund a portion of its earnings to customers through a refund process and to reduce its rates. Additionally, Virginia Power’s ability to utilize CCROs for certain qualifying projects as provided for in the GTSA may be limited if the Virginia Commission does not approve such projects. Virginia Power makes assessments throughout the review period and will record a regulatory liability for refunds and/or CCRO benefits to customers in any period it is determined probable, which could be material to the Companies’ results of operations in the period recognized and to cash flows on completion of any triennial review. In states other than Virginia, the Companies’ retail electric base rates for generation and distribution services to customers are regulated on a cost-of-service/rate-of-return basis subject to the statutes, rules and procedures of such states. Dominion Energy’s rates for gas distribution to retail customers are similarly regulated at the state level. If retail electric or gas earnings exceed the returns established by state utility commissions, retail electric rates or gas rates may be subject to review and possible reduction, which may decrease the Companies’ future earnings. Additionally, if any state utility commission does not allow recovery through base rates, on a timely basis, of costs incurred in providing service, the Company’s future earnings could be negatively impacted. Under certain circumstances, state utility regulators may impose a moratorium on increases to retail base rates for a specified period of time, which could delay recovery of costs incurred in providing service. Additionally, governmental officials, stakeholders and advocacy groups may challenge any of these regulatory reviews. Such challenges may lengthen the time, complexity and costs associated with such regulatory reviews. The Companies’ generation business may be negatively affected by possible FERC actions that could change market design in the wholesale markets or affect pricing rules or revenue calculations in the RTO markets. The Companies’ generation stations operating in RTO markets sell capacity, energy and ancillary services into wholesale electricity markets regulated by FERC. The wholesale markets allow these generation stations to take advantage of market price opportunities, but also expose them to market risk. Properly functioning competitive wholesale markets depend upon FERC’s continuation of clearly identified market rules. From time to time FERC may investigate and authorize RTOs to make changes in market design. FERC also periodically reviews the Companies’ authority to sell at market-based rates. Material changes by FERC to the design of the wholesale markets or its interpretation of market rules, the Companies’ authority to sell power at market-based rates, or changes to pricing rules or rules involving revenue calculations, could adversely impact the future results of the Companies’ generation business. For example, in December 2019, FERC issued an order on PJM’s Minimum Offer Price Rule proposals finding the PJM tariff unjust and unreasonable and directed PJM to expand the Minimum Offer Price Rule to all existing and new generation resources benefitting from a state subsidy to address the effects of state subsidies on new and existing resources on the PJM capacity market. The expanded Minimum Offer Price Rule will set a floor price on new and existing renewable and non-renewable state subsidized resources that do not seek a FERC exemption, increasing their risk of failing to clear the capacity auction and not obtaining a capacity payment and obligation. In addition, changes to the interpretation and application of FERC’s market manipulation rules may occur from time to time. A failure to comply with these market manipulation rules could lead to civil and criminal penalties. 36 The Companies are subject to complex governmental regulation, including tax regulation, that could adversely affect their results of operations and subject the Companies to monetary penalties. The Companies’ operations are subject to extensive federal, state and local regulation and require numerous permits, approvals and certificates from various governmental agencies. Such laws and regulations govern the terms and conditions of the services we offer, our relationships with affiliates, protection of our critical electric infrastructure assets and pipeline safety, among other matters. These operations are also subject to legislation governing taxation at the federal, state and local level. They must also comply with environmental legislation and associated regulations. Management believes that the necessary approvals have been obtained for existing operations and that the businesses are conducted in accordance with applicable laws. The Companies’ businesses are subject to regulatory regimes which could result in substantial monetary penalties if any of the Companies is found not to be in compliance, including mandatory reliability standards and interaction in the wholesale markets. New laws or regulations, the revision or reinterpretation of existing laws or regulations, changes in enforcement practices of regulators, or penalties imposed for non-compliance with existing laws or regulations may result in substantial additional expense. Recent legislative and regulatory changes that are impacting the Companies include the VCEA, the 2017 Tax Reform Act and tariffs imposed on imported solar panels by the U.S. government in 2018. Through the SCANA Combination, Dominion Energy acquired SCANA and DESC which have been and continue to be subject to numerous legal proceedings and ongoing governmental investigations and examinations. While a significant portion of the federal and state legal proceedings and governmental investigations have been settled, SCANA and DESC remain defendants in multiple lawsuits and investigations relating to the decision to abandon construction at the NND Project. Among other things, the lawsuits and investigations allege misrepresentation, failure to properly manage the NND Project, unfair trade practices and violation of anti-trust laws. Additionally, pursuant to the SCANA Merger Agreement and applicable indemnification agreements, SCANA is indemnifying former directors and officers of SCANA and DESC who are defendants in federal and state legal proceedings relating to the decision to abandon construction at the NND Project and the subsequent SCANA Combination. Among other things, the lawsuits allege breaches of various fiduciary duties. The outcome of these legal proceedings, investigations and examinations, including settlements, is uncertain and may adversely affect Dominion Energy’s financial condition or results of operation. Environmental Risks Compliance with federal and/or state requirements imposing limitations on GHG emissions or efficiency improvements, as well as Dominion Energy’s commitment to achieve net zero emissions by 2050, may result in significant compliance costs, could result in certain of the Companies’ existing electric generation units being uneconomical to maintain or operate and may depend upon technological advancements which may be beyond the Companies’ control. Virginia has adopted the VCEA which establishes renewable energy and CO2 reduction targets for Virginia Power’s generation fleet and grid operations, including the requirement that 100% of Virginia Power’s electricity come from zero-carbon generation by the end of 2045. The legislation mandates the development of 16,100 MW of solar or onshore wind capacity by the end of 2035, 5,200 MW of offshore wind capacity before 2035, and 2,700 MW of energy storage by the end of 2035. The VCEA also directs Virginia Power to participate in a program consistent with RGGI, requiring the purchase of carbon credits to offset emissions from Virginia Power’s generating fleet within the state. Cost recovery for these initiatives will require approval by the Virginia Commission which may be denied or materially altered to the detriment of the Companies. In addition, permitting and other project execution challenges may hinder Virginia Power’s ability to meet the requirements of the VCEA. The Companies could face similar risks if there is further legislation at the federal and/or state level mandating additional limitations on GHG emissions or requiring additional efficiency improvements. In February 2020, Dominion Energy announced its commitment to achieve net zero emissions by 2050. To meet this commitment, the Companies expect to construct new electric generation facilities, including renewable facilities such as wind and solar, and to seek the extension of operating licenses for the Companies’ nuclear generation facilities. The Companies also need to depend on technological improvements not currently in commercial development. Additionally, actions taken in furtherance of Dominion Energy’s net zero commitment may impact existing generation facilities, including as a result of fuel switching and/or the retirement of high-emitting generation facilities and their potential replacement with lower-emitting generation facilities. Further, the ability to realize this commitment will require the Companies to be able to obtain significant financing. These efforts will require approvals from various regulatory bodies for the siting and construction of such new facilities and a determination by the applicable state commissions that costs related to the construction are prudent. Given these and other uncertainties associated with the implementation of Dominion Energy’s net zero commitment, the Companies cannot estimate the aggregate effect of future actions taken in furtherance of this commitment on their results of operations or financial condition or on their customers. However, such actions could render additional existing generation facilities uneconomical to operate, result in the impairment of assets, or otherwise adversely affect the Companies’ results of operations, financial performance or liquidity. There are also potential impacts on Dominion Energy’s natural gas business from its net zero emissions commitment as well as federal or state GHG regulations which may require further GHG emission reductions from the natural gas sector which, in addition to 37 resulting in increased costs, could affect demand for natural gas. Additionally, GHG requirements could result in increased demand for energy conservation and renewable products, which could impact the natural gas business. Dominion Energy’s renewable natural gas projects, expected to be a key component of Dominion Energy’s environmental strategy, require approvals from various regulatory bodies for the siting and construction of such facilities. The Companies’ operations and construction activities are subject to a number of environmental laws and regulations which impose significant compliance costs on the Companies. The Companies’ operations and construction activities are subject to extensive federal, state and local environmental statutes, rules and regulations relating to air quality, water quality, waste management, natural resources, and health and safety. Compliance with these legal requirements requires the Companies to commit significant capital toward permitting, emission fees, environmental monitoring, installation and operation of environmental control equipment and purchase of allowances and/or offsets. Additionally, the Companies could be responsible for expenses relating to remediation and containment obligations, including at sites where they have been identified by a regulatory agency as a potentially responsible party. Expenditures relating to environmental compliance have been significant in the past, and the Companies expect that they will remain significant in the future. Certain facilities have become uneconomical to operate and have been shut down, converted to new fuel types or sold. These types of events could occur again in the future. We expect that existing environmental laws and regulations may be revised and/or new laws may be adopted including regulation of GHG emissions which could have an impact on the Companies’ business (risks relating to regulation of GHG emissions from existing fossil fuel-fired electric generating units are discussed in more detail below). In addition, further regulation of air quality and GHG emissions under the CAA may be imposed on the natural gas sector. The Companies are also subject to federal water and waste regulations, including regulations concerning cooling water intake structures, coal combustion by-product handling and disposal practices, wastewater discharges from steam electric generating stations, management and disposal of hydraulic fracturing fluids and the potential further regulation of polychlorinated biphenyls. Compliance costs cannot be estimated with certainty due to the inability to predict the requirements and timing of implementation of any new environmental rules or regulations. Other factors which affect the ability to predict future environmental expenditures with certainty include the difficulty in estimating clean-up costs and quantifying liabilities under environmental laws that impose joint and several liabilities on all responsible parties. However, such expenditures, if material, could make the Companies’ facilities uneconomical to operate, result in the impairment of assets, or otherwise adversely affect the Companies’ results of operations, financial performance or liquidity. The Companies are subject to risks associated with the disposal and storage of coal ash. The Companies historically produced and continue to produce coal ash, or CCRs, as a by-product of their coal-fired generation operations. The ash is stored and managed in impoundments (ash ponds) and landfills located at 11 different facilities, eight of which are at Virginia Power. The EPA has issued regulations concerning the management and storage of CCRs, which Virginia has adopted. These CCR regulations require the Companies to make additional capital expenditures and increase operating and maintenance expenses. In addition, the Companies will incur expenses and other costs associated with closing, corrective action and ongoing monitoring of certain ash ponds. The Companies also may face litigation concerning their coal ash facilities. Further, while the Companies operate their ash ponds and landfills in compliance with applicable state safety regulations, a release of coal ash with a significant environmental impact could result in remediation costs, civil and/or criminal penalties, claims, litigation, increased regulation and compliance costs, and reputational damage, and could impact the financial condition of the Companies. Construction Risks The Companies’ infrastructure build and expansion plans often require regulatory approval, including environmental permits, before commencing construction and completing projects. The Companies may not complete the facility construction, pipeline, conversion or other infrastructure projects that they commence, or they may complete projects on materially different terms, costs or timing than initially estimated or anticipated, and they may not be able to achieve the intended benefits of any such project, if completed. A number of large and small scale projects have been announced, including pipelines, electric transmission lines, facility expansions or renewed licensing, conversions and other infrastructure developments or construction. Additional projects may be considered in the future. The Companies compete for projects with companies of varying size and financial capabilities, including some that may have competitive advantages. Commencing construction on announced and future projects may require approvals from applicable state and federal agencies, and such approvals could include mitigation costs which may be material to the Companies. Projects may not be able to be completed on time or in accordance with our estimated costs as a result of weather conditions, delays in obtaining or failure to obtain regulatory approvals, delays in obtaining key materials, labor difficulties, difficulties with partners or potential partners, a decline in the credit strength of counterparties or vendors, or other factors beyond the Companies’ control. For example, Dominion Energy has been involved with projects which have experienced certain 38 delays in obtaining and maintaining permits necessary for construction along with construction delays due to judicial actions which impacted the cost and schedule such as the Atlantic Coast Pipeline Project and ultimately led to its cancellation. Even if facility construction, pipeline, expansion, electric transmission line, conversion and other infrastructure projects are completed, the total costs of the projects may be higher than anticipated and the performance of the business of the Companies following completion of the projects may not meet expectations. Start-up and operational issues can arise in connection with the commencement of commercial operations at our facilities. Such issues may include failure to meet specific operating parameters, which may require adjustments to meet or amend these operating parameters. Additionally, the Companies may not be able to timely and effectively integrate the projects into their operations and such integration may result in unforeseen operating difficulties or unanticipated costs. Further, regulators may disallow recovery of some of the costs of a project if they are deemed not to be prudently incurred. Any of these or other factors could adversely affect the Companies’ ability to realize the anticipated benefits from the facility construction, pipeline, electric transmission line, expansion, conversion and other infrastructure projects. The development, construction and commissioning of several large-scale infrastructure projects simultaneously involves significant execution risk. To achieve Dominion Energy’s commitment to net zero emissions by 2050 and comply with the requirements of the VCEA, the Companies are currently simultaneously developing or constructing several electric generation projects, including Subsequent License Renewal projects at Surry and North Anna, the Coastal Virginia Offshore Wind projects and various solar projects. Several of the Companies’ key projects are increasingly large-scale, complex and being constructed in constrained geographic areas or in unfamiliar environments such as the marine environment for the Coastal Virginia Offshore Wind projects. The advancement of the Companies’ ventures is also affected by the interventions, litigation or other activities of stakeholder and advocacy groups, some of which oppose natural gas-related and energy infrastructure projects. For example, certain stakeholder groups oppose solar farms due to the increasing quantities of land tracts required for these facilities. Given that these projects provide the foundation for the Companies’ strategic growth plan, if the Companies are unable to obtain or maintain the required approvals, develop the necessary technical expertise, allocate and coordinate sufficient resources, adhere to budgets and timelines, effectively handle public outreach efforts, or otherwise fail to successfully execute the projects, there could be an adverse impact to the Companies’ financial position, results of operations and cash flows. Failure to comply with regulatory approval conditions or an adverse ruling in any future litigation could adversely affect the Companies’ ability to execute their business plan. The Companies are dependent on their contractors for the successful and timely completion of large-scale infrastructure projects. The construction of such projects is expected to take several years, is typically confined within a limited geographic area or difficult environments and could be subject to delays, cost overruns, labor disputes and other factors that could cause the total cost of the project to exceed the anticipated amount and adversely affect the Companies’ financial performance and/or impair the Companies’ ability to execute the business plan for the project as scheduled. Further, an inability to obtain financing or otherwise provide liquidity for the projects on acceptable terms could negatively affect the Companies’ financial condition, cash flows, the projects’ anticipated financial results and/or impair the Companies’ ability to execute the business plan for the projects as scheduled. Operational Risks The Companies’ financial performance and condition can be affected by changes in the weather, including the effects of global climate change. Fluctuations in weather can affect demand for the Companies’ services. For example, milder than normal weather can reduce demand for electricity and gas distribution services. In addition, severe weather or acts of nature, including hurricanes, winter storms, earthquakes, floods and other natural disasters can stress systems, disrupt operation of the Companies’ facilities and cause service outages, production delays and property damage that require incurring additional expenses. Changes in weather conditions can result in reduced water levels or changes in water temperatures that could adversely affect operations at some of the Companies’ power stations. Furthermore, the Companies’ operations could be adversely affected and their physical plant placed at greater risk of damage should changes in global climate produce, among other possible conditions, unusual variations in temperature and weather patterns, resulting in more intense, frequent and extreme weather events, abnormal levels of precipitation and, for operations located on or near coastlines, a change in sea level or sea temperatures. Due to the location of the Companies’ electric utility service territories and a number of its other facilities in the eastern portions of the states of South Carolina, North Carolina and Virginia which are frequently in the path of hurricanes, we experience the consequences of these weather events to a greater degree than many of our industry peers. The Companies’ operations are subject to operational hazards, equipment failures, supply chain disruptions and personnel issues which could negatively affect the Companies. Operation of the Companies’ facilities involves risk, including the risk of potential breakdown or failure of equipment or processes due to aging infrastructure, fuel supply, pipeline integrity or transportation disruptions, accidents, labor disputes or work stoppages by employees, acts of terrorism or sabotage, construction delays or cost 39 overruns, shortages of or delays in obtaining equipment, material and labor, operational restrictions resulting from environmental limitations and governmental interventions, changes to the environment and performance below expected levels. The Companies’ businesses are dependent upon sophisticated information technology systems and network infrastructure, the failure of which could prevent them from accomplishing critical business functions. Because the Companies’ transmission facilities, pipelines and other facilities are interconnected with those of third parties, the operation of their facilities and pipelines could be adversely affected by unexpected or uncontrollable events occurring on the systems of such third parties. Operation of the Companies’ facilities below expected capacity levels could result in lost revenues and increased expenses, including higher maintenance costs. Unplanned outages of the Companies’ facilities and extensions of scheduled outages due to mechanical failures or other problems occur from time to time and are an inherent risk of the Companies’ business. Unplanned outages typically increase the Companies’ operation and maintenance expenses and may reduce their revenues as a result of selling less output or may require the Companies to incur significant costs as a result of operating higher cost units or obtaining replacement output from third parties in the open market to satisfy forward energy and capacity or other contractual obligations. Moreover, if the Companies are unable to perform their contractual obligations, penalties or liability for damages could result. In addition, there are many risks associated with the Companies’ principal operations and the transportation and storage of natural gas including nuclear accidents, fires, explosions, uncontrolled release of natural gas and other environmental hazards, pole strikes, electric contact cases, the collision of third party equipment with pipelines and avian and other wildlife impacts. Such incidents could result in loss of human life or injuries among employees, customers or the public in general, environmental pollution, damage or destruction of facilities or business interruptions and associated public or employee safety impacts, loss of revenues, increased liabilities, heightened regulatory scrutiny and reputational risk. Further, the location of natural gas pipelines and associated distribution facilities, or electric generation, transmission, substations and distribution facilities near populated areas, including residential areas, commercial business centers and industrial sites, could increase the level of damages resulting from these risks. The Companies’ financial results can be adversely affected by various factors driving supply and demand for electricity and gas and related services. Technological advances required by federal laws mandate new levels of energy efficiency in end-use devices, including lighting, furnaces and electric heat pumps and could lead to declines in per capita energy consumption. Additionally, certain regulatory and legislative bodies have introduced or are considering requirements and/or incentives to reduce energy consumption by a fixed date. Further, Virginia Power’s business model is premised upon the cost efficiency of the production, transmission and distribution of large-scale centralized utility generation. However, advances in distributed generation technologies, such as solar cells, gas microturbines, battery storage and fuel cells, may make these alternative generation methods competitive with large-scale utility generation, and change how customers acquire or use our services. Virginia Power has an exclusive franchise to serve retail electric customers in Virginia. However, Virginia’s Retail Access Statutes allow certain electric generation customers exceptions to this franchise. As market conditions change, Virginia Power’s customers may further pursue exceptions and Virginia Power’s exclusive franchise may erode. Reduced energy demand or significantly slowed growth in demand due to customer adoption of energy efficient technology, conservation, distributed generation, regional economic conditions, or the impact of additional compliance obligations, unless substantially offset through regulatory cost allocations, could adversely impact the value of the Companies’ business activities. The Companies may be materially adversely affected by negative publicity. From time to time, political and public sentiment in connection with significant transactions and infrastructure projects, such as the SCANA Merger and the abandonment of the NND Project, may result in a significant amount of adverse press coverage and other adverse public statements affecting the Companies. While the Atlantic Coast Pipeline project was cancelled in July 2020 and several of the legal proceedings and governmental investigations relating to the abandonment of the NND Project have been resolved, there is a risk that lingering negative publicity may continue. Additionally, any failure by the Companies to realize voluntary targets set with respect to the reduction of GHG emissions or other long-term goals could lead to adverse press coverage and other adverse public statements affecting the Companies. Adverse press coverage and other adverse statements, whether or not driven by political or public sentiment, may also result in investigations by regulators, legislators and law enforcement officials or in legal claims. Addressing any adverse publicity, governmental scrutiny or enforcement or other legal proceedings is time consuming and expensive and, regardless of the factual basis for the assertions being made, can have a negative impact on the reputation of the Companies, on the morale and performance of their employees and on their relationships with their respective regulators, customers and commercial counterparties. It may also have a negative impact on the Companies’ ability to take timely advantage of various business and market opportunities. The direct and indirect effects of negative publicity, and the demands of responding to and addressing it, may have a material adverse effect on the Companies’ business, financial condition and results of operations. Dominion Energy’s nonregulated generation business operates in a challenging market, which could adversely affect its results of operations and future growth. The success of Dominion Energy’s contracted generation business depends upon favorable market 40 conditions including the ability to sell power at prices sufficient to cover its operating costs. Dominion Energy operates in active wholesale markets that expose it to price volatility for electricity and nuclear fuel as well as the credit risk of counterparties. Dominion Energy attempts to manage its price risk by entering into long-term power purchase agreements with customers as well as hedging transactions, including short-term and long-term fixed price sales and purchase contracts. The failure of Dominion Energy to maintain, renew or replace its existing long-term contracts on similar terms or with counterparties with similar credit profiles could result in a loss of revenue and/or decreased earnings and cash flows for Dominion Energy. In these wholesale markets, the spot market price of electricity for each hour is generally determined by the cost of supplying the next unit of electricity to the market during that hour. In many cases, the next unit of electricity supplied would be provided by generating stations that consume fossil fuels, primarily natural gas. Consequently, the open market wholesale price for electricity generally reflects the cost of natural gas plus the cost to convert the fuel to electricity. Therefore, changes in the price of natural gas generally affect the open market wholesale price of electricity. To the extent Dominion Energy does not enter into long-term power purchase agreements or otherwise effectively hedge its output, these changes in market prices could adversely affect its financial results. Dominion Energy purchases nuclear fuel primarily under long-term contracts. Dominion Energy is exposed to nuclear fuel cost volatility for the portion of its nuclear fuel obtained through short-term contracts or on the spot market, including as a result of market supply shortages. Nuclear fuel prices can be volatile and the price that can be obtained for power produced may not change at the same rate as nuclear fuel costs, thus adversely impacting Dominion Energy’s financial results. In addition, in the event that any of the contracted generation facilities experience a forced outage, Dominion Energy may not receive the level of revenue it anticipated. Dominion Energy conducts certain operations through partnership arrangements involving third-party investors which may limit Dominion Energy’s operational flexibility or result in an adverse impact on its financial results. Certain of Dominion Energy’s operations are conducted through entities subject to partnership arrangements under which Dominion Energy has significant influence but does not control the operations of such entities or in which Dominion Energy’s control over such entities may be subject to certain rights of third-party investors. Accordingly, while Dominion Energy may have a certain level of control or influence over these entities, it may not have unilateral, or any, control over the day-to-day operations of these entities or over decisions that may have a material financial impact on the partnership participants, including Dominion Energy. In each case such partnership arrangements operate in accordance with their respective governance documents, and Dominion Energy is dependent upon third parties satisfying their respective obligations, including, as applicable, funding of their required share of capital expenditures. Such third-party investors have their own interests and objectives which may differ from those of Dominion Energy and, accordingly, disputes may arise amongst the owners of such partnership arrangements that may result in delays, litigation or operational impasses. For example, Dominion Energy has a noncontrolling 50% interest in Cove Point following the sale of a 25% controlling interest to BHE in November 2020. This controlling interest allows BHE to make decisions affecting Cove Point’s ability to retain its long-term contracts. Cove Point is a party to certain contracts that allow a regulated service provider and a customer to mutually agree to sign a contract for service at a “negotiated rate” which may be above or below the FERC regulated, cost-based recourse rate for that service. These “negotiated rate” contracts are not generally subject to adjustment for increased costs which could be produced by inflation or other factors relating to the specific facilities being used to perform the services. Any shortfall of revenue as a result of these “negotiated rate” contracts could decrease Cove Point’s earnings and cash flows. The inability to maintain or renew such contracts on favorable terms may have a material impact to Dominion Energy’s results of operations, financial position or cash flows. Dominion Energy is also dependent upon BHE for managing counterparty credit risk relating to Cove Point’s terminal services agreements for its liquefied natural gas export/liquefaction facility. While the counterparties’ obligations are supported by parental guarantees and letters of credit, there is no assurance that such credit support would be sufficient to satisfy the obligations in the event of a counterparty default. In addition, if a controversy arises under either terminal services agreement resulting in a judgment in Cove Point’s favor, Cove Point may need to seek to enforce a final U.S. court judgment in a foreign tribunal, which could involve a lengthy process. Accordingly, there is no assurance that BHE may pursue remedies in the event of default in the same manner as Dominion Energy would if it had unilateral control over such decisions. In addition, for certain contracted generation solar facilities in which Dominion Energy maintains a controlling interest, third-party investors hold certain protective rights. These rights may impact the ability of Dominion Energy to make certain decisions, such as the retention or distribution of available cash, significant acquisitions or dispositions of assets by those entities or the ability to sell or transfer its ownership interests. Hostile cyber intrusions could severely impair the Companies’ operations, lead to the disclosure of confidential information, damage the reputation of the Companies and otherwise have an adverse effect on the Companies’ business. The Companies own assets deemed as critical infrastructure, the operation of which is dependent on information technology systems. Further, the computer systems that run the Companies’ facilities are not completely isolated from external networks. There appears to be an increasing level of activity, sophistication and maturity of threat actors, in particular nation state actors, that wish to disrupt the U.S. bulk power system and the U.S. gas transmission or distribution system. Such parties could view the Companies’ computer systems, 41 software or networks as attractive targets for cyber attack. For example, malware has been designed to target software that runs the nation’s critical infrastructure such as power transmission grids and gas pipelines. In addition, the Companies’ businesses require that they and their vendors collect and maintain sensitive customer data, as well as confidential employee and shareholder information, which is subject to electronic theft or loss. A successful cyber attack on the systems that control the Companies’ electric generation, electric transmission or distribution assets could severely disrupt business operations, preventing the Companies from serving customers or collecting revenues. The breach of certain business systems could affect the Companies’ ability to correctly record, process and report financial information. A major cyber incident could result in significant expenses to investigate and repair security breaches or system damage and could lead to litigation, fines, other remedial action, heightened regulatory scrutiny and damage to the Companies’ reputation. In addition, the misappropriation, corruption or loss of personally identifiable information and other confidential data at the Companies or one of their vendors could lead to significant breach notification expenses and mitigation expenses such as credit monitoring. If a significant breach were to occur, the reputation of the Companies also could be adversely affected. While the Companies maintain property and casualty insurance, along with other contractual provisions, that may cover certain damage caused by potential cyber incidents, all damage and claims arising from such incidents may not be covered or may exceed the amount of any insurance available. For these reasons, a significant cyber incident could materially and adversely affect the Companies’ business, financial condition and results of operations. War, acts and threats of terrorism, intentional acts and other significant events could adversely affect the Companies’ operations. The Companies cannot predict the impact that any future terrorist attacks or retaliatory military or other action may have on the energy industry in general or on the Companies’ businesses in particular. Any such future attacks or retaliatory action may adversely affect the Companies’ operations in a variety of ways, including by disrupting the power, fuel and other markets in which the Companies operate or requiring the implementation of additional, more costly security guidelines and measures. The Companies’ infrastructure facilities, including nuclear facilities and projects under construction, could be direct targets or indirect casualties of an act of terror or other physical attack. Any physical compromise of the Companies’ facilities could adversely affect the Companies’ ability to generate, purchase, transmit or distribute electricity, distribute natural gas or otherwise operate their respective facilities in the most efficient manner or at all. In addition, the amount and scope of insurance coverage maintained against losses resulting from any such attack may not be sufficient to cover such losses or otherwise adequately compensate for any business disruptions that could result. Instability in financial markets as a result of terrorism, war, intentional acts, pandemic, credit crises, recession or other factors could result in a significant decline in the U.S. economy and/or increase the cost or limit the availability of insurance or adversely impact the Companies’ ability to access capital on acceptable terms. Failure to attract and retain key executive officers and an appropriately qualified workforce could have an adverse effect on the Companies’ operations. The Companies’ business strategy is dependent on their ability to recruit, retain and motivate employees. The Companies’ key executive officers are the Executive Chairman, CEO, CFO, COO and presidents and those responsible for financial, operational, legal, regulatory and accounting functions. Competition for skilled management employees in these areas of the Companies’ business operations is high. Certain events, such as an aging workforce, mismatch of skill set, or unavailability of contract resources may lead to operating challenges and increased costs. The challenges include lack of resources, loss of knowledge base and the length of time required for skill development. In this case, costs, including costs for contractors to replace employees, productivity costs and safety costs, may rise. Failure to hire and adequately train replacement employees, including the transfer of significant internal historical knowledge and expertise to new employees, or future availability and cost of contract labor may adversely affect the ability to manage and operate the Companies’ business. In addition, certain specialized knowledge is required of the Companies’ technical employees for construction and operation of transmission, generation and distribution assets. The Companies’ inability to attract and retain these employees could adversely affect their business and future operating results. Nuclear Generation Risks The Companies have substantial ownership interests in and operate nuclear generating units; as a result, each may incur substantial costs and liabilities. The Companies’ nuclear facilities are subject to operational, environmental, health and financial risks such as the on-site storage of spent nuclear fuel, the ability to dispose of such spent nuclear fuel, the ability to maintain adequate reserves for decommissioning, limitations on the amounts and types of insurance available, potential operational liabilities and extended outages, the costs of replacement power, the costs of maintenance and the costs of securing the facilities against possible terrorist attacks. The Companies maintain decommissioning trusts and external insurance coverage to minimize the financial exposure to these risks; however, it is possible that future decommissioning costs could exceed amounts in the decommissioning trusts and/or damages could exceed the amount of insurance coverage. If the Companies’ decommissioning trust funds are insufficient, and they are 42 not allowed to recover the additional costs incurred through insurance or regulatory mechanisms, their results of operations could be negatively impacted. The Companies’ nuclear facilities are also subject to complex government regulation which could negatively impact their results of operations. The NRC has broad authority under federal law to impose licensing and safety-related requirements for the operation of nuclear generating facilities. In the event of noncompliance, the NRC has the authority to impose fines, set license conditions, shut down a nuclear unit, or take some combination of these actions, depending on its assessment of the severity of the situation, until compliance is achieved. Revised safety requirements promulgated by the NRC could require the Companies to make substantial expenditures at their nuclear plants. In addition, although the Companies have no reason to anticipate a serious nuclear incident at their plants, if an incident did occur, it could materially and adversely affect their results of operations and/or financial condition. A major incident at a nuclear facility anywhere in the world, such as the nuclear events in Japan in 2011, could cause the NRC to adopt increased safety regulations or otherwise limit or restrict the operation or licensing of domestic nuclear units. Financial, Economic and Market Risks Changing rating agency requirements could negatively affect the Companies’ growth and business strategy. In order to maintain appropriate credit ratings to obtain needed credit at a reasonable cost in light of existing or future rating agency requirements, the Companies may find it necessary to take steps or change their business plans in ways that may adversely affect their growth and earnings. A reduction in the Companies’ credit ratings could result in an increase in borrowing costs, loss of access to certain markets, or both, thus adversely affecting operating results and could require the Companies to post additional collateral in connection with some of its price risk management activities. An inability to access financial markets and, in the case of Dominion Energy, obtain cash from subsidiaries could adversely affect the execution of the Companies’ business plans. The Companies rely on access to short-term money markets and longer-term capital markets as significant sources of funding and liquidity for business plans with increasing capital expenditure needs, normal working capital and collateral requirements related to hedges of future sales and purchases of energy-related commodities. Deterioration in the Companies’ creditworthiness, as evaluated by credit rating agencies or otherwise, or declines in market reputation either for the Companies or their industry in general, or general financial market disruptions outside of the Companies’ control could increase their cost of borrowing or restrict their ability to access one or more financial markets. Market disruptions could stem from general market disruption due to general credit market or political events, the planned phase out of LIBOR by the end of 2023 or the reform or replacement of other benchmark rates, the failure of financial institutions on which the Companies rely or the bankruptcy of an unrelated company. Increased costs and restrictions on the Companies’ ability to access financial markets may be severe enough to affect their ability to execute their business plans as scheduled. Dominion Energy is a holding company that conducts all of its operations through its subsidiaries. Accordingly, Dominion Energy’s ability to execute its business plan is further subject to the earnings and cash flows of its subsidiaries and the ability of its subsidiaries to pay dividends or advance or repay funds to it, which may, from time to time, be subject to certain contractual restrictions or restrictions imposed by regulators. Market performance, interest rates and other changes may decrease the value of the Companies’ decommissioning trust funds and Dominion Energy’s benefit plan assets or increase Dominion Energy’s liabilities, which could then require significant additional funding. The performance of the capital markets affects the value of the assets that are held in trusts to satisfy future obligations to decommission the Companies’ nuclear plants and under Dominion Energy’s pension and other postretirement benefit plans. The Companies have significant obligations in these areas and hold significant assets in these trusts. These assets are subject to market fluctuation and will yield uncertain returns, which may fall below expected return rates. With respect to decommissioning trust funds, a decline in the market value of these assets may increase the funding requirements of the obligations to decommission the Companies’ nuclear plants or require additional NRC-approved funding assurance. A decline in the market value of the assets held in trusts to satisfy future obligations under Dominion Energy’s pension and other postretirement benefit plans may increase the funding requirements under such plans. Additionally, changes in interest rates will affect the liabilities under Dominion Energy’s pension and other postretirement benefit plans; as interest rates decrease, the liabilities increase, potentially requiring additional funding. Further, changes in demographics, including increased numbers of retirements or changes in mortality assumptions, may also increase the funding requirements of the obligations related to the pension and other postretirement benefit plans. If the decommissioning trust funds and benefit plan assets are negatively impacted by market fluctuations or other factors, the Companies’ results of operations, financial condition and/or cash flows could be negatively affected. 43 The use of derivative instruments could result in financial losses and liquidity constraints. The Companies use derivative instruments, including futures, swaps, forwards, options and FTRs, to manage commodity, currency and financial market risks. In addition, Dominion Energy purchases and sells commodity-based contracts for hedging purposes. The Dodd-Frank Act was enacted into law in July 2010 in an effort to improve regulation of financial markets. The CEA, as amended by Title VII of the Dodd-Frank Act, requires certain over-the-counter derivatives, or swaps, to be cleared through a derivatives clearing organization and, if the swap is subject to a clearing requirement, to be executed on a designated contract market or swap execution facility. Non-financial entities that use swaps to hedge or mitigate commercial risk, often referred to as end users, may elect the end-user exception to the CEA’s clearing requirements. The Companies have elected to exempt their swaps from the CEA’s clearing requirements. If, as a result of changes to the rulemaking process, the Companies’ derivative activities are not exempted from the clearing, exchange trading or margin requirements, the Companies could be subject to higher costs due to decreased market liquidity or increased margin payments. In addition, the Companies’ swap dealer counterparties may attempt to pass-through additional trading costs in connection with changes to or the elimination of rulemaking that implements Title VII of the Dodd-Frank Act. Future impairments of goodwill or other intangible assets or long-lived assets may have a material adverse effect on the Companies’ results. Goodwill is evaluated for impairment annually or more frequently if an event or circumstance occurs that would more likely than not reduce the fair value of a reporting unit below its carrying amount. Other intangible assets and long-lived assets are evaluated for impairment on an annual basis or more frequently whenever events or circumstances indicate that an asset’s carrying value may not be recoverable. If Dominion Energy’s goodwill, including the goodwill recorded in connection with the SCANA Combination, or the Companies’ other intangible assets or long-lived assets are in the future determined to be impaired, the applicable Company would be required during the period in which the impairment is determined to record a noncash charge to earnings that may have a material adverse effect on the Company’s results. Exposure to counterparty performance may adversely affect the Companies’ financial results of operations. The Companies are exposed to credit risks of their counterparties and the risk that one or more counterparties may fail or delay the performance of their contractual obligations, including but not limited to payment for services. Some of Dominion Energy’s operations are conducted through partnership arrangements, as noted above. Counterparties could fail or delay the performance of their contractual obligations for a number of reasons, including the effect of regulations on their operations. Defaults or failure to perform by customers, suppliers, contractors, joint venture partners, financial institutions or other third parties may adversely affect the Companies’ financial results. Public health crises and epidemics or pandemics, such as COVID-19, could adversely affect the Companies’ business, results of operations, financial condition, liquidity and/or cash flows. The effects of the continued outbreak of the COVID-19 pandemic and related government responses could include extended disruptions to supply chains and capital markets, reduced labor availability and productivity and a prolonged reduction in economic activity. The effects could also have a variety of adverse impacts on the Companies, including reduced demand for energy, particularly from commercial and industrial customers, impairment of goodwill or long-lived assets and diminished ability of the Companies to access funds from financial institutions and capital markets. There remains uncertainty regarding the extent and duration of measures to try to contain the virus, such as travel bans and restrictions, quarantines, shelter-in-place orders and shutdowns. Such restrictions may cause operational interruptions and delays in construction projects, which, in the case of renewable energy projects, could delay the expected in-service dates of these projects and financial statement impact of the investment tax credits associated with these projects. For the duration of the outbreak of COVID-19, voluntary suspension, or potential legislative or government action, such as legislation enacted in Virginia in November 2020, may limit the Companies’ ability to collect on overdue accounts or disconnect services for non-payment, which may cause a decrease in the Companies’ results of operations and cash flows. Item 1B. Unresolved Staff Comments None. 44 Item 2. Properties As of December 31, 2020, Dominion Energy owned its principal executive office in Richmond, Virginia and five other corporate offices. Dominion Energy also leases corporate offices in Richmond, Virginia and other cities in which its subsidiaries operate. Virginia Power shares Dominion Energy’s principal executive office in Richmond, Virginia. In addition, Virginia Power leases certain buildings and equipment. Dominion Energy’s assets consist primarily of its investments in its subsidiaries, the principal properties of which are described below by operating segment. Certain of Virginia Power’s properties are subject to the lien of the Indenture of Mortgage securing its First and Refunding Mortgage Bonds. There were no bonds outstanding as of December 31, 2020; however, by leaving the indenture open, Virginia Power retains the flexibility to issue mortgage bonds in the future. Certain of Dominion Energy’s nonregulated generation facilities are also subject to liens. Additionally, DESC’s bond indenture, which secures its First Mortgage Bonds, constitutes a direct mortgage lien on substantially all of its electric utility property. DOMINION ENERGY VIRGINIA Virginia Power has approximately 6,700 miles of electric transmission lines of 69 kV or more located in North Carolina, Virginia and West Virginia. Portions of Virginia Power’s electric transmission lines cross national parks and forests under permits entitling the federal government to use, at specified charges, any surplus capacity that may exist in these lines. While Virginia Power owns and maintains its electric transmission facilities, they are a part of PJM, which coordinates the planning, operation, emergency assistance and exchange of capacity and energy for such facilities. In addition, Virginia Power’s electric distribution network includes approximately 58,900 miles of distribution lines, exclusive of service level lines, in Virginia and North Carolina. The grants for most of its electric lines contain rights-of-way that have been obtained from the apparent owners of real estate, but underlying titles have not been examined. Where rights-of-way have not been obtained, they could be acquired from private owners by condemnation, if necessary. Many electric lines are on publicly-owned property, where permission to operate can be revoked. In addition, Virginia Power owns 473 substations. Dominion Energy also owns various solar facilities, primarily at schools in Virginia, with an aggregate generation capacity of 9 MW. The following tables list Virginia Power’s generating units and capability as of December 31, 2020. 45 VIRGINIA POWER UTILITY GENERATION Plant Location Net Summer Capability (MW) Percentage Net Summer Capability Gas Greensville County (CC) Greensville County, VA 1,629 Brunswick County (CC) Brunswick County, VA 1,376 Warren County (CC) Warren County, VA 1,370 Ladysmith (CT) Ladysmith, VA 783 Bear Garden (CC) Buckingham County, VA 622 Remington (CT) Remington, VA 622 Possum Point (CC) Dumfries, VA 573 Chesterfield (CC) Chester, VA 392 Elizabeth River (CT) Chesapeake, VA 330 Gordonsville Energy (CC) Gordonsville, VA 218 Gravel Neck (CT) Surry, VA 170 Darbytown (CT) Richmond, VA 168 Total Gas 8,253 41 % Coal Mt. Storm Mt. Storm, WV 1,621 Chesterfield(1) Chester, VA 1,014 Virginia City Hybrid Energy Center Wise County, VA 610 Clover Clover, VA 439 (2) Total Coal 3,684 18 Nuclear Surry Surry, VA 1,676 North Anna Mineral, VA 1,672 (3) Total Nuclear 3,348 17 Hydro Bath County Warm Springs, VA 1,808 (4) Gaston Roanoke Rapids, NC 220 Roanoke Rapids Roanoke Rapids, NC 95 Other 1 Total Hydro 2,124 10 Oil Yorktown(1) Yorktown, VA 790 Gravel Neck (CT) Surry, VA 198 Darbytown (CT) Richmond, VA 168 Rosemary (CC) Roanoke Rapids, NC 160 Possum Point (CT) Dumfries, VA 72 Low Moor (CT) Covington, VA 48 Northern Neck (CT) Lively, VA 47 Chesapeake (CT) Chesapeake, VA 39 Total Oil 1,522 7 Solar(5) Colonial Trail West Surry County, VA 142 Spring Grove Surry County, VA 98 Whitehouse Solar Louisa County, VA 20 Woodland Solar Isle of Wight County, VA 19 Scott Solar Powhatan, VA 17 Total Solar 296 1 Biomass Altavista(6) Altavista, VA 51 Polyester(6) Hopewell, VA 51 Southampton(6) Southampton, VA 51 Total Biomass 153 1 Various Mt. Storm (CT) Mt. Storm, WV 11 — 19,391 Power Purchase Agreements 917 5 Total Utility Generation 20,308 100 % Note: (CT) denotes combustion turbine and (CC) denotes combined cycle. (1) Will be retired after it meets its capacity obligation in 2023. See Note 2 to the Consolidated Financial Statements for additional information. (2) Excludes 50% undivided interest owned by ODEC. (3) Excludes 11.6% undivided interest owned by ODEC. (4) Excludes 40% undivided interest owned by Allegheny Generating Company, a subsidiary of FirstEnergy Corp. (5) All solar facilities are alternating current. (6) In accordance with the VCEA, these units will be retired no later than 2028. 46 VIRGINIA POWER NON-JURISDICTIONAL GENERATION Plant Location Net Summer Capability (MW) Solar(1) Gutenberg Garysburg, NC 80 Grasshopper Mecklenburg County, VA 80 Pecan Pleasant Hill, NC 75 Chestnut Halifax County, NC 75 Gloucester Gloucester County, VA 20 Montross Westmoreland County, VA 20 Morgans Corner Pasquotank County, NC 20 Remington Fauquier County, VA 20 Oceana Virginia Beach, VA 18 Hollyfield Manquin, VA 17 Puller Topping, VA 15 Total Non-Jurisdictional Generation 440 (1) All solar facilities are alternating current. GAS DISTRIBUTION Gas Distribution’s network is located in Ohio, West Virginia, North Carolina, Utah, southwestern Wyoming and southeastern Idaho. This network includes approximately 75,500 miles of distribution mains and related service facilities which are supported by approximately 5,700 miles of transmission, gathering and storage pipeline. The right-of-way grants for many natural gas pipelines have been obtained from the actual owners of real estate, as underlying titles have been examined. Where rights-of-way have not been obtained, they could be acquired from private owners by condemnation, if necessary. Many natural gas pipelines are on publicly-owned property, where company rights and actions are determined on a case-by-case basis, with results that range from reimbursed relocation to revocation of permission to operate. East Ohio’s integrated underground storage facilities have more than 60 bcf of working gas capacity to serve base and peak demand. PSNC owns one LNG facility that stores the liquefied equivalent of 1.0 bcf of natural gas, can regasify approximately 10% of its storage capacity per day and can liquefy less than 1% of its storage capacity per day. DOMINION ENERGY SOUTH CAROLINA DESC has approximately 3,800 miles and 26,700 miles of electric transmission and distribution lines, respectively, exclusive of service level lines, in South Carolina. The grants for most of DESC’s electric lines contain rights-of-way that have been obtained from the apparent owners of real estate, but underlying property titles have not been examined. Where rights-of-way have not been obtained, they could be acquired from private owners by condemnation, if necessary. Many electric lines are on publicly-owned property, where permission to operate can be revoked. In addition, DESC owns 442 substations. DESC’s natural gas system includes approximately 18,700 miles of distribution mains and related service facilities, which are supported by approximately 500 miles of transmission pipeline. DESC owns two LNG facilities, one located near Charleston, South Carolina, and the other in Salley, South Carolina. The Charleston facility can store the liquefied equivalent of 1.0 bcf of natural gas, can regasify approximately 6% of its storage capacity per day and can liquefy less than 1% of its storage capacity per day. The Salley facility can store the liquefied equivalent of 0.9 bcf of natural gas and can regasify approximately 10% of its storage capacity per day. The Salley facility has no liquefying capabilities. 47 The following table lists DESC’s generating units and capability as of December 31, 2020. Plant Location Net Summer Capability (MW) Percentage Net Summer Capability Gas Jasper (CC) (1) Hardeeville, SC 852 Columbia Energy Center (CC) (1) Gaston, SC 519 Urquhart (CC) (1) Beech Island, SC 458 McMeekin Irmo, SC 250 Hagood (CT) (1) Charleston, SC 126 Urquhart Unit 3 Beech Island, SC 95 Urquhart (CT) Beech Island, SC 87 Parr (CT) (1) Jenkinsville, SC 60 Coit (CT) (1) Columbia, SC 26 Williams (CT) (1) Goose Creek, SC 20 Total Gas(2) 2,493 41 % Coal Williams Goose Creek, SC 605 Cope (3) Cope, SC 415 Wateree Eastover, SC 342 Total Coal 1,362 22 Hydro Fairfield Jenkinsville, SC 576 Saluda Irmo, SC 190 Other Various 18 Total Hydro 784 13 Nuclear Summer Jenkinsville, SC 652 (4) 10 5,291 Power Purchase Agreements 846 (5) 14 Total Utility Generation 6,137 100 % Note: (CT) denotes combustion turbine and (CC) denotes combined cycle. (1) Capable of burning fuel oil as a secondary source. (2) Excludes the Hardeeville gas combustion turbine which currently does not have any net summer capability. (3) Capable of burning natural gas as a secondary source. (4) Excludes 33.3% undivided interest owned by Santee Cooper. (5) Includes 157MW from agreements with certain solar facilities within Contracted Assets. CONTRACTED ASSETS Contracted Assets includes Dominion Energy’s 50% noncontrolling interest in Cove Point. The Cove Point LNG Facility has an operational peak regasification daily send-out capacity of approximately 1.8 million Dths and an aggregate LNG storage capacity of approximately 14.6 bcfe. In addition, Cove Point has a small liquefier that has the potential to create approximately 15,000 Dths/day. The Liquefaction Facility consists of one LNG train with a nameplate outlet capacity of 5.25 Mtpa. Cove Point has authorization from the DOE to export up to 0.77 bcfe/day (approximately 5.75 Mtpa) should the Liquefaction Facility perform better than expected. In addition, Cove Point operates a 136-mile natural gas pipeline that connects the Cove Point LNG Facility to interstate natural gas pipelines. 48 The following table lists Contracted Assets’ generating units and capability as of December 31, 2020. Plant Location Net Summer Capability (MW) Percentage Net Summer Capability Nuclear Millstone Waterford, CT 2,001 (1) Total Nuclear 2,001 58 % Solar(2) Escalante I, II and III Beaver County, UT 120 (3) Amazon Solar Farm Virginia – Southampton Newsoms, VA 100 (4) Hardin I Hardin County, OH 97 Amazon Solar Farm Virginia – Accomack Oak Hall, VA 80 (4) Greensville Greensville County, VA 80 Innovative Solar 37 Morven, NC 79 (4) Wilkinson Pantego, NC 74 Seabrook Beaufort County, SC 73 Moffett Solar 1 Ridgeland, SC 71 (4) Granite Mountain East and West Iron County, UT 65 (3) Summit Farms Solar Moyock, NC 60 (4) Enterprise Iron County, UT 40 (3) Iron Springs Iron County, UT 40 (3) Pavant Solar Holden, UT 34 (5) Camelot Solar Mojave, CA 30 (5) Midway II Calipatria, CA 30 (4) Indy I, II and III Indianapolis, IN 20 (5) Amazon Solar Farm Virginia – Buckingham Cumberland, VA 20 (4) Amazon Solar Farm Virginia – Correctional Barhamsville, VA 20 (4) Hecate Cherrydale Cape Charles, VA 20 (4) Amazon Solar Farm Virginia – Sussex Drive Stoney Creek, VA 20 (4) Amazon Solar Farm Virginia – Scott II Powhatan, VA 20 (4) Cottonwood Solar Kings and Kern Counties, CA 16 (5) Myrtle Suffolk, VA 15 Adams East Solar Tranquility, CA 13 (5) Alamo Solar San Bernardino, CA 13 (5) CID Solar Corcoran, CA 13 (5) Imperial Valley Solar Imperial County, CA 13 (5) Kansas Solar Lenmore, CA 13 (5) Kent South Solar Lenmore, CA 13 (5) Maricopa West Solar Kern County, CA 13 (5) Old River One Solar Bakersfield, CA 13 (5) Richland Solar Jeffersonville, GA 13 (5) West Antelope Solar Lancaster, CA 13 (5) Catalina 2 Solar Kern County, CA 12 (5) Mulberry Solar Selmer, TN 11 (5) Selmer Solar Selmer, TN 11 (5) Columbia 2 Solar Mojave, CA 10 (5) Hecate Energy Clarke County White Post, VA 10 (4) Ridgeland Solar Farm I Ridgeland, SC 10 (4) Other Various 56 (4) (5) Total Solar 1,474 42 Total Nonregulated Generation 3,475 100 % (1) Excludes 6.53% undivided interest in Unit 3 owned by Massachusetts Municipal and Green Mountain. (2) All solar facilities are alternating current. (3) Excludes 50% noncontrolling interest owned by GIP. Dominion Energy’s interest is subject to a lien securing Dominion Solar Projects III, Inc.’s debt. (4) Dominion Energy’s interest is subject to a lien securing Eagle Solar’s debt. (5) Excludes 33% noncontrolling interest owned by Terra Nova Renewable Partners. Dominion Energy’s interest is subject to a lien securing SBL Holdco’s debt. 49 Item 3. Legal Proceedings From time to time, the Companies are parties to various legal, environmental or other regulatory proceedings, including in the ordinary course of business. SEC regulations require disclosure of certain environmental matters when a governmental authority is a party to the proceedings and such proceedings involve potential monetary sanctions that the Companies reasonably believe will exceed a specified threshold. Pursuant to the SEC regulations, the Companies use a threshold of $1 million for such proceedings. See Notes 13 and 23 to the Consolidated Financial Statements, which information is incorporated herein by reference, for discussion of certain legal, environmental and other regulatory proceedings to which the Companies are a party. Item 4. Mine Safety Disclosures Not applicable. 50 Information about our Executive Officers Information concerning the executive officers of Dominion Energy, each of whom is elected annually, is as follows: Name and Age Business Experience Past Five Years(1) Thomas F. Farrell, II (66) Executive Chairman of the Board of Directors from October 2020 to present; President and CEO from April 2007 to September 2020. Robert M. Blue (53) President and CEO from October 2020 to present; Director from November 2020 to present; Executive Vice President and Co-COO from December 2019 to September 2020; Executive Vice President and President & CEO—Power Delivery Group from May 2017 to November 2019; Senior Vice President and President & CEO—Dominion Virginia Power from January 2017 to May 2017; Senior Vice President—Law, Regulation & Policy from February 2016 to December 2016; Senior Vice President—Regulation, Law, Energy Solutions and Policy from May 2015 to January 2016. James R. Chapman (51) Executive Vice President, CFO and Treasurer from January 2019 to present; Senior Vice President, CFO and Treasurer from November 2018 to December 2018; Senior Vice President—Mergers & Acquisitions and Treasurer from February 2016 to October 2018; Vice President—Corporate Finance and Mergers & Acquisitions and Assistant Treasurer from May 2015 to January 2016. Diane Leopold (54) Executive Vice President and COO from October 2020 to present; Executive Vice President and Co-COO from December 2019 to September 2020; Executive Vice President and President & CEO—Gas Infrastructure Group from May 2017 to November 2019; Senior Vice President and President & CEO—Dominion Energy from January 2017 to May 2017; President of East Ohio from January 2014 to September 2020. Edward H. Baine (47) President—Dominion Energy Virginia from October 2020 to present; Senior Vice President—Power Delivery of Virginia Power from December 2019 to September 2020; Senior Vice President—Distribution of Virginia Power from February 2016 to November 2019; Senior Vice President—Transmission and Customer Service of Virginia Power from June 2015 to January 2016. P. Rodney Blevins (56) President—Dominion Energy South Carolina from December 2019 to present; President & Chief Executive Officer—Southeast Energy Group from January 2019 to November 2019; Senior Vice President and Chief Information Officer from January 2014 to December 2018. Carlos M. Brown (46) Senior Vice President, General Counsel and Chief Compliance Officer from December 2019 to present; Senior Vice President and General Counsel from January 2019 to November 2019; Vice President and General Counsel from January 2017 to December 2018; Deputy General Counsel—Litigation, Labor, and Employment of DES from July 2016 to December 2016; Director—Power Generation Station II of DES from July 2015 to June 2016. Michele L. Cardiff (53) Senior Vice President, Controller and CAO from October 2020 to present; Vice President, Controller and CAO from April 2014 to September 2020. William L. Murray (53) Senior Vice President—Corporate Affairs & Communications from February 2019 to present; Vice President—State & Electric Public Policy of DES from May 2017 to January 2019; Senior Policy Director—Public Policy of DES from April 2016 to May 2017; Managing Director—Corporate Public Policy of DES from June 2007 to March 2016. Donald R. Raikes (58) President—Gas Distribution of Dominion Energy from December 2019 to present and of Hope, East Ohio, PSNC, and Questar Gas from October 2019 to September 2020; President of Hope, East Ohio, PSNC, and Questar Gas from October 2020 to present; Senior Vice President—Gas Transmission Operations of DCP, Dominion Energy Midstream and Dominion Energy Questar Pipeline from February 2019 to September 2019; Senior Vice President—Dominion Midstream Operations of DCP, Dominion Energy Midstream and Dominion Energy Questar Pipeline from August 2017 to January 2019; Senior Vice President—Pipeline Customer Service & Business Development of DCP and DETI from May 2017 to August 2017; Senior Vice President—Customer Service and Business Development of DCP and DETI from November 2014 to May 2017. 51 Name and Age Business Experience Past Five Years(1) Daniel G. Stoddard (58) Senior Vice President, Chief Nuclear Officer and President—Contracted Assets from September 2020 to present; Senior Vice President, Chief Nuclear Officer and President—Contracted Generation from December 2019 to August 2020; Senior Vice President and Chief Nuclear Officer of Virginia Power from October 2016 to present; Senior Vice President—Nuclear Operations of Virginia Power from May 2011 to September 2016. (1) All positions held at Dominion Energy, unless otherwise noted. Any service listed for Virginia Power, DETI, East Ohio, Hope, PSNC, Questar Gas, Dominion Energy Midstream, Dominion Energy Questar Pipeline, DCP and DES reflects service at a current or previous subsidiary of Dominion Energy. 52 Part II Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities DOMINION ENERGY Dominion Energy’s common stock is listed on the NYSE under the ticker symbol D. At February 12, 2021, there were approximately 130,000 record holders of Dominion Energy’s common stock. The number of record holders is comprised of individual shareholder accounts maintained on Dominion Energy’s transfer agent records and includes accounts with shares held in (1) certificate form, (2) book-entry in the Direct Registration System and (3) book-entry under Dominion Energy Direct®. Discussions of expected dividend payments required by this Item are contained in Liquidity and Capital Resources in Item 7. MD&A. Purchases of Equity Securities Period Total Number of Shares (or Units) Purchased Average Price Paid per Share (or Unit)(4) Total Number of Shares (or Units) Purchased as Part of Publicly Announced Plans or Programs Maximum Number (or Approximate Dollar Value) of Shares (or Units) that May Yet Be Purchased under the Plans or Programs(5) 10/1/20-10/31/20 52,079 (1) $ 78.59 — $ 0.62 billion 11/1/20-11/30/20 3,049,613 (2) 80.36 3,029,827 1.48 billion 12/1/20-12/31/20 7,387,403 (3) 76.22 7,387,403 0.92 billion Total 10,489,095 $ 77.44 10,417,230 $ 0.92 billion (1) Represents shares of common stock that were tendered by employees to satisfy tax withholding obligations on vested restricted stock. (2) Includes (i) 19,786 shares of common stock that were tendered by employees to satisfy tax withholding obligations on vested restricted stock;(ii) 1,647,192 shares of common stock purchased in open market transactions for an aggregate of approximately $132 million; and (iii) 1,382,635 shares of common stock delivered upon the completion of the purchase periods under two prepaid accelerated share repurchase agreements entered into by Dominion Energy in September 2020. (3) Includes (i) 2,045,345 shares of common stock purchased in open market transactions for an aggregate of approximately $163 million and (ii) 5,342,058 shares of common stock delivered to Dominion Energy under an accelerated share repurchase program. Dominion Energy entered into a prepaid accelerated share repurchase agreement with a financial institution in December 2020 to purchase $400 million in shares of common stock. No additional shares will be delivered under this agreement as the repurchase period ended in December 2020. (4) Represents the weighted-average price paid per share. (5) In July 2020, the Dominion Energy Board of Directors authorized the repurchase of up to $3.0 billion in shares of common stock and rescinded its prior repurchase authorization approved in February 2005 and modified in June 2007. Dominion Energy completed repurchases under this authorization in December 2020. In November 2020, the Dominion Energy Board of Directors authorized the repurchase of up to $1.0 billion of shares of common stock in addition to the repurchase program authorized in July 2020. This repurchase program has no expiration date or price or volume targets and may be modified suspended or terminated at any time. Shares may be purchased through open market or privately negotiated transactions or otherwise at the discretion of management subject to prevailing market conditions, applicable securities laws and other factors. VIRGINIA POWER There is no established public trading market for Virginia Power’s common stock, all of which is owned by Dominion Energy. Virginia Power intends to pay quarterly cash dividends in 2021 but is neither required to nor restricted, except as described in Note 21 to the Consolidated Financial Statements, from making such payments. 53 Item 6. Selected Financial Data The following table should be read in conjunction with the Consolidated Financial Statements included in Item 8. Financial Statements and Supplementary Data. Dominion Energy’s Consolidated Financial Statements include the results of operations acquired in the SCANA Combination effective January 2019. DOMINION ENERGY Year Ended December 31,(1) 2020(2) 2019(3) 2018(4) 2017(5) 2016(6) (millions, except per share amounts) Operating revenue $ 14,172 $ 14,401 $ 11,199 $ 11,004 $ 10,320 Net income from continuing operations attributable to Dominion Energy 1,583 653 2,087 2,707 1,809 Net income from continuing operations attributable to Dominion Energy per common share-basic 1.83 0.79 3.19 4.26 2.93 Net income from continuing operations attributable to Dominion Energy per common share-diluted 1.82 0.75 3.19 4.26 2.93 Dividends declared per common share 3.45 3.67 3.34 3.035 2.80 Total assets 95,905 103,823 77,914 76,585 71,610 Long-term debt(7) 33,957 28,998 27,075 26,951 26,271 (1) Operating revenue, net income and earnings per share exclude amounts presented in discontinued operations related to the gas transmission and storage operations sold to, or under contract to be sold to, BHE as well as Dominion Energy’s investment in Atlantic Coast Pipeline. Long-term debt excludes amounts reflected as held-for-sale. See Note 3 to Dominion Energy’s Consolidated Financial Statements for more information regarding the amounts presented as discontinued operations or held-for-sale. (2) Includes $559 million after-tax charge associated primarily with the planned early retirement of certain electric generation facilities, $496 million of after-tax charges for an impairment attributable to Dominion Energy’s interests in certain nonregulated solar generation facilities and a contract termination in connection with the sale of Fowler Ridge, $191 million of after-tax charges for expected CCRO and customer arrears forgiveness for Virginia utility customers and $93 million of after-tax charges associated with litigation acquired in the SCANA Combination, partially offset by a $264 million after-tax net gain related to nuclear decommissioning trust funds. (3) Includes merger and integration-related costs associated with the SCANA Combination of $1.8 billion after-tax (inclusive of $756 million after-tax charge for refunds of amounts previously collected for the NND Project, $480 million after-tax charge for litigation acquired in the SCANA Combination and $286 million after-tax charge related to a voluntary retirement program), $585 million after-tax charges associated primarily with the planned early retirement of certain electric generation facilities, automated meter reading infrastructure and the termination of a contract with a non-utility generator, partially offset by a $429 million after-tax net gain related to nuclear decommissioning trust funds. (4) Includes $568 million after-tax gains on sales of certain nonregulated generation facilities and equity method investments partially offset by $164 million after-tax charge related to the impairment of certain gathering and processing assets and a $160 million after-tax charge associated with Virginia legislation enacted in March 2018 that required one-time rate credits of certain amounts to utility customers. (5) Includes $851 million of tax benefits resulting from the remeasurement of deferred income taxes to the new corporate income tax rate, partially offset by $96 million of after-tax charges associated with equity method investments in wind-powered generation facilities. (6) Includes a $122 million after-tax charge related to future ash pond and landfill closure costs at certain utility generation facilities. (7) Includes finance leases. 54 Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations MD&A discusses Dominion Energy’s results of operations and general financial condition and Virginia Power’s results of operations. MD&A should be read in conjunction with Item 1. Business and the Consolidated Financial Statements in
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+Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.”Pending Guidon AcquisitionOn December 18, 2020, we and Diamondback E&P LLC, our wholly owned subsidiary, entered into a definitive, purchase and sale agreement with Guidon Operating LLC, or Guidon, and certain of Guidon’s affiliates to acquire approximately 32,500 net acres in the Northern Midland Basin and certain related oil and natural gas assets, which we refer to as the Pending Guidon Acquisition. Consideration for the Pending Guidon Acquisition consists of $375 million in cash and 10.6 million shares of our common stock, subject to adjustment. The Pending Guidon Acquisition is expected to close on February 26, 2021.COVID-19On March 11, 2020, the World Health Organization characterized the global outbreak of the novel strain of coronavirus, COVID-19, as a “pandemic.” To limit the spread of COVID-19, governments have taken various actions including the issuance of stay-at-home orders and social distancing guidelines, causing some businesses to suspend operations and a reduction in demand for many products from direct or ultimate customers. Although many stay-at-home orders have expired and certain restrictions on conducting business have been lifted, the COVID-19 pandemic resulted in a widespread health crisis and a swift and unprecedented reduction in international and U.S. economic activity which, in turn, has adversely affected the demand for oil and natural gas and caused significant volatility and disruption of the financial markets. In early March 2020, oil prices dropped sharply, and then continued to decline reaching negative levels. During 2020, the average NYMEX WTI futures contract price for crude oil and condensate was $39.34 per barrel and the average Henry Hub futures contract price for natural gas was $2.13 per million British thermal units (MMBtu), representing decreases of 31% and 16%, respectively, from the comparable average futures prices during 2019. These decreases were the result of multiple factors affecting supply and demand in global oil and natural gas markets, including actions taken by OPEC members and other exporting nations impacting commodity price and production levels and a significant decrease in demand due to the ongoing COVID-19 pandemic. While OPEC members and certain other nations agreed in April 2020 to cut production and subsequently extended such production cuts through December 2020, which helped to reduce a portion of the excess supply in the market and improve crude oil prices, they agreed to increase production by 500,000 barrels per day beginning in January 2021. We cannot predict if or when commodity prices will stabilize and at what levels.As a result of the reduction in crude oil demand caused by factors discussed above, in 2020, we lowered our 2020 capital budget and production guidance, curtailed near term production and reduced rig count, all of which may be subject to further reductions or curtailment if the commodity markets and macroeconomic conditions worsen. Although we have restored curtailed production, actions taken in response to the COVID-19 pandemic and depressed commodity pricing environment have had and are expected to continue to have an adverse effect on our business, financial results and cash flows. For additional details, see “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations—Overview.”Given the dynamic nature of the events described above, we cannot reasonably estimate the period of time that the ongoing COVID-19 pandemic, the depressed commodity prices, the reduced demand for oil and the adverse macroeconomic conditions will persist, the full extent of the impact they will have on our industry and our business, financial condition, results of operations or cash flows, or the pace or extent of any subsequent recovery.Our Business Strategy Our business strategy is to continue to profitably grow our business through the following: •Grow production and reserves by developing our oil-rich resource base. We intend to drill and develop our acreage base in an effort to maximize its value and resource potential. Through the conversion of our undeveloped reserves to developed reserves, we will seek to increase our production, reserves and cash flow while generating favorable returns on invested capital. •Leverage our experience operating in the Permian Basin. Our executive team, which has an average of over 25 years of industry experience per person and significant experience in the Permian Basin, intends to continue to seek ways to maximize hydrocarbon recovery by refining and enhancing our drilling and completion techniques. Our focus on efficient drilling and completion techniques is an important part of the continuous 2Table of Contentsdrilling program we have planned for our significant inventory of identified potential drilling locations. We believe that the experience of our executive team in deviated and horizontal drilling and completions has helped reduce the execution risk normally associated with these complex well paths. In addition, our completion techniques are continually evolving as we evaluate and implement hydraulic fracturing practices that have and are expected to continue to increase recovery and reduce completion costs. Our executive team regularly evaluates our operating results against those of other operators in the area in an effort to benchmark our performance against the best performing operators and evaluate and adopt best practices. •Enhance returns through our low cost development strategy and focus on continuous improvement in operational, capital allocation and cost efficiencies. Our acreage position is generally in contiguous blocks which allows us to develop this acreage efficiently with a “manufacturing” strategy that takes advantage of economies of scale and uses centralized production and fluid handling facilities. We are the operator of approximately 98% of our acreage. This operational control allows us to manage more efficiently the pace of development activities and the gathering and marketing of our production and control operating costs and technical applications, including horizontal development. Our average 84% working interest in our acreage allows us to realize the majority of the benefits of these activities and cost efficiencies. •Pursue strategic acquisitions with substantial resource potential. We have a proven history of acquiring leasehold positions in the Permian Basin that have substantial oil-weighted resource potential. Our executive team, with its extensive experience in the Permian Basin, has what we believe is a competitive advantage in identifying acquisition targets and a proven ability to evaluate resource potential. Most recently, in December 2020, we entered into the merger agreement with QEP to acquire QEP in an all-stock transaction valued at approximately $2.2 billion, including QEP’s net debt of $1.6 billion as of September 30, 2020. The pending merger, upon closing, will add material Tier-1 Midland Basin inventory. In December 2020, we also entered into a definitive purchase and sale agreement with Guidon and certain of Guidon’s affiliates to acquire approximately 32,500 net acres in the Northern Midland Basin and certain related oil and natural gas assets. We regularly review acquisition opportunities and intend to pursue acquisitions that meet our strategic and financial targets. •Maintain financial flexibility. We seek to maintain a conservative financial position. As of December 31, 2020, our borrowing base was set at $2.0 billion and we had $1.98 billion available for borrowing. As of December 31, 2020, Viper LLC had $84 million in outstanding borrowings, and $496 million available for borrowing, under its revolving credit facility. As of December 31, 2020, Rattler LLC had $79 million in outstanding borrowings, and $521 million available for borrowing, under its revolving credit facility.Our Strengths We believe that the following strengths will help us achieve our business goals: •Oil rich resource base in one of North America’s leading resource plays. All of our leasehold acreage is located in one of the most prolific oil plays in North America, the Permian Basin in West Texas. The majority of our current properties are well positioned in the core of the Permian Basin. Our production for the year ended December 31, 2020 was approximately 60% oil, 20% natural gas liquids and 20% natural gas. As of December 31, 2020, our estimated net proved reserves were comprised of approximately 58% oil, 22% natural gas liquids and 20% natural gas.•Multi-year drilling inventory in one of North America’s leading oil resource plays. We have identified a multi-year inventory of potential drilling locations for our oil-weighted reserves that we believe provides attractive growth and return opportunities. At an assumed price of approximately $60.00 per Bbl WTI, we currently have approximately 10,413 gross (6,863 net) identified economic potential horizontal drilling locations on our acreage based on our evaluation of applicable geologic and engineering data. These gross identified economic potential horizontal locations have an average lateral length of approximately 8,200 feet, with the actual length depending on lease geometry and other considerations. These locations exist across most of our acreage blocks and in multiple horizons. The ultimate inter-well spacing may vary from these distances due to different factors, which would result in a higher or lower location count. In addition, we have approximately 3,610 square miles of proprietary 3-D seismic data covering our acreage. This data facilitates the evaluation of our existing drilling inventory and provides insight into future development activity, including additional horizontal drilling opportunities and strategic leasehold acquisitions. 3Table of Contents•Experienced, incentivized and proven management team. Our executive team has a proven track record of executing on multi-rig development drilling programs and extensive experience in the Permian Basin. In addition, our executive team has significant experience with both drilling and completing horizontal wells in addition to horizontal well reservoir and geologic expertise, which is of strategic importance as we expand our horizontal drilling activity. •Favorable operating environment. We have focused our drilling and development operations in the Permian Basin, one of the longest operating hydrocarbon basins in the United States, with a long and well-established production history and developed infrastructure. We believe that the geological and regulatory environment of the Permian Basin is more stable and predictable, and that we are faced with less operational risks in the Permian Basin as compared to emerging hydrocarbon basins. •High degree of operational control. We are the operator of approximately 98% of our Permian Basin acreage. This operating control allows us to better execute on our strategies of enhancing returns through operational and cost efficiencies and increasing ultimate hydrocarbon recovery by seeking to continually improve our drilling techniques, completion methodologies and reservoir evaluation processes. Additionally, as the operator of substantially all of our acreage, we retain the ability to increase or decrease our capital expenditure program based on commodity price outlooks. This operating control also enables us to obtain data needed for efficient exploration of horizontal prospects. •Access to midstream infrastructure and gathering and transportation pipelines. Through our publicly traded subsidiary Rattler, we have secured access to midstream infrastructure and crude oil gathering and transportation pipelines tailored to our expected production growth ramp in order to allow us the operational flexibility to execute on our growth plan. Rattler is the primary provider of midstream services to us with an acreage dedication that spans a total of approximately 395,000 gross acres across all of Rattler’s service lines and over the core of the Midland and Delaware Basins. Our Properties Location and Land The Permian Basin area covers a significant portion of western Texas and eastern New Mexico and is considered one of the major producing basins in the United States. As of December 31, 2020, our total acreage position in the Permian Basin was approximately 449,642 gross (378,678 net) acres, which consisted primarily of approximately 215,956 gross (194,591 net) acres in the Midland Basin and approximately 192,697 gross (152,587 net) acres in the Delaware Basin. We are the operator of approximately 98% of this Permian Basin acreage. In addition, our publicly traded subsidiary Viper owns mineral interests underlying approximately 787,264 gross acres and 24,350 net royalty acres in the Permian Basin and Eagle Ford Shale. Approximately 52% of these net royalty acres are operated by us. We have been developing multiple pay intervals in the Permian Basin through horizontal drilling and believe that there are opportunities to target additional intervals throughout the stratigraphic column. We believe our significant experience drilling, completing and operating horizontal wells will allow us to efficiently develop our remaining inventory and ultimately target other horizons that have limited development to date. The following table presents horizontal producing wells in which we have a working interest in as of December 31, 2020:BasinNumber of Horizontal WellsMidland1,408 Delaware917 Other55 Total(1)2,380 (1) Of these 2,380 total horizontal producing wells, we are the operator of 1,694 wells and have a non-operated working interest in 686 additional wells.4Table of ContentsThe following table presents the average number of days in which we were able to drill our horizontal wells to total depth specified below during the year ended December 31, 2020:Average Days to Total DepthMidland Basin7,500 foot lateral12 10,000 foot lateral13 13,000 foot lateral17 Delaware Basin7,500 foot lateral16 10,000 foot lateral18 13,000 foot lateral26 Further advances in drilling and completion technology may result in economic development of zones that are not currently viable.Further, our subsidiary Rattler is focused on ownership, operation, development and acquisition of the midstream infrastructure assets in the Midland and Delaware Basins of the Permian Basin. As of December 31, 2020, Rattler owned and operated 927 miles of crude oil gathering pipelines, natural gas gathering pipelines and a fully integrated water system on acreage that overlays our seven core Midland and Delaware Basin development areas. To facilitate the transportation of water and hydrocarbon volumes away from the producing wellhead to ensuring the efficient operations of a crude oil or natural gas well, Rattler’s midstream infrastructure includes a network of gathering pipelines that collect and transport crude oil, natural gas and produced water from our operations in the Midland and Delaware Basins. As of December 31, 2020, Rattler also owned (i) a 10% equity interest in EPIC Crude Holdings LP, which owns and operates a long-haul crude oil pipeline from the Permian Basin and the Eagle Ford Shale to Corpus Christi, Texas that is capable of transporting approximately 600,000 Bbl/d, which began full operations in April 2020 and is referred to as the EPIC pipeline, (ii) a 10% equity interest in Gray Oak Pipeline, LLC, which owns and operates a long-haul crude oil pipeline that is capable of transporting 900,000 Bbl/d from the Permian Basin and the Eagle Ford Shale to points alongside the Texas Gulf Coast, including a marine terminal connection in Corpus Christi, Texas, which began full operations in April 2020 and is referred to as the Gray Oak pipeline, (iii) a 4% equity interest in Wink to Webster Pipeline LLC, which is developing a crude oil pipeline that upon full commercial operations expected in the fourth quarter of 2021 will be capable of transporting approximately 1,500,000 Bbl/d from origin points at Wink and Midland in the Permian Basin for delivery to multiple Houston area locations, (iv) a 60% equity interest in OMOG JV LLC, which operates approximately 235 miles of crude oil gathering and regional transportation pipelines and approximately 200,000 barrels of crude oil storage in Midland, Martin, Andrews and Ector Counties, Texas and (v) a 50% equity interest in Amarillo Rattler LLC, which owns and operates the Yellow Rose gas gathering and processing system with estimated total capacity of 40,000 Mcf/d and over 84 miles of gathering and regional transportation pipelines in Dawson, Martin and Andrews Counties, Texas. For additional information regarding our equity method investments as of December 31, 2020, see Note 10—Equity Method Investments to our consolidated financial statements included elsewhere in this Annual Report.Rattler also owns and operates certain real estate assets in Midland, Texas including the Fasken Center which has over 421,000 net rentable square feet within its two office towers.Area History Our proved reserves are located in the Permian Basin of West Texas, in particular in the Clearfork, Spraberry, Bone Spring, Wolfcamp, Strawn, Atoka and Barnett formations. The Spraberry play was initiated with production from several new field discoveries in the late 1940s and early 1950s. It was eventually recognized that a regional productive trend was present, as fields were extended and coalesced over a broad area in the central Midland Basin. Development in the Spraberry play was sporadic over the next several decades due to typically low productive rate wells, with economics being dependent on oil prices and drilling costs. 5Table of ContentsThe Wolfcamp formation is a long-established reservoir in West Texas, first found in the 1950s as wells aiming for deeper targets occasionally intersected slump blocks or debris flows with good reservoir properties. Exploration using 2-D seismic data located additional fields, but it was not until the use of 3-D seismic data in the 1990s that the greater extent of the Wolfcamp formation was revealed. The additional potential of the shales within this formation as reservoir rather than just source rocks was not recognized until very recently. By mid-2010, approximately half of the rigs active in the Permian Basin were drilling wells in the Permian Spraberry, Dean and Wolfcamp formations, which we collectively refer to as the Wolfberry play. Since then we and most other operators are almost exclusively drilling horizontal wells in the development of unconventional reservoirs in the Permian Basin. As of December 31, 2020, we held working interests in 4,326 gross (3,401 net) producing wells and only royalty interests in 4,553 additional wells.GeologyThe Greater Permian Basin formed as an area of rapid Pennsylvanian-Permian subsidence in response to dynamic structural influence of the Marathon Uplift and Ancestral Rockies. It is one of the most productive sedimentary basins in the U.S., with established oil and natural gas production from several stacked reservoirs of varying age ranges, most notably Permian aged sediments. In particular, the Permian aged Wolfcamp, Spraberry and Bone Spring Formations have been heavily targeted for several decades. First, through vertical comingling of these zones and, more recently, through horizontal exploitation of each individual horizon. Prior to deposition of the Wolfcamp, Spraberry and Bone Spring Formations, the area of the present-day Permian Basin was a continuous sedimentary feature called the Tabosa Basin. During this time, Ordovician, Silurian, Devonian and Mississippian sediments were laid down in a primarily open marine, shelf setting. However, some time frames saw more restrictive settings that were conducive to the deposition of organically rich mudstone such as the Devonian Woodford and Mississippian Barnett/Meramec. These formations are important sources and, more recently, reservoirs within the present-day Greater Permian Basin. The Spraberry and Bone Spring Formations were deposited as siliciclastic and carbonate turbidites and debris flows along with pelagic mudstones in a deep-water, basinal environment, while the Wolfcamp reservoirs consist of debris-flow, grain-flow and fine-grained pelagic sediments, which were also deposited in a basinal setting. The best carbonate reservoirs within the Wolfcamp, Spraberry and Bone Spring are generally found in close proximity to the Central Basin Platform, while mudstone reservoirs thicken basin-ward, away from the Central Basin Platform. The mudstone within these reservoirs is organically rich, which when buried to sufficient depth for thermal maturation, became the source of the hydrocarbons found both within the mudstones themselves and in the interbedded conventional clastic and carbonate reservoirs. Due to this complexity, the Wolfcamp, Spraberry and Bone Spring intervals are a hybrid reservoir system that contains characteristics of both unconventional and conventional reservoirs. We have successfully developed several hybrid reservoir intervals within the Clearfork, Spraberry/Bone Spring, Wolfcamp and Barnett/Meramec formations since we began horizontal drilling in 2012. The mudstones and some clastics exhibit low permeabilities which necessitate the need for hydraulic fracture stimulation to unlock the vast storage of hydrocarbons in these targets.We possess, or are in the process of acquiring, 3-D seismic data over substantially all of our major asset areas. Our extensive geophysical database currently includes approximately 3,610 square miles of 3-D data. This data will continue to be utilized in the development of our horizontal drilling program and identification of additional resources to be exploited.Production Status During the year ended December 31, 2020, net production from our acreage was 109,921 MBOE, or an average of 300,331 BOE/d, of which approximately 60% was oil, 20% was natural gas liquids and 20% was natural gas. Recent and Future Activity During 2021, we expect to complete an estimated 215 to 235 gross (197 to 215 net) operated horizontal wells on our acreage. We currently estimate that our capital expenditures in 2021 for drilling and infrastructure will be between $1.4 billion and $1.6 billion, consisting of $1.2 billion to $1.4 billion for horizontal drilling and completions including non-operated activity, $60 million to $80 million for midstream investments, excluding joint venture investments, and $70 million to $90 million will be spent on infrastructure and other expenditures, excluding the cost of any leasehold and mineral interest acquisitions. During the year ended December 31, 2020, we drilled 208 gross (195 net) and completed 171 gross (159 net) operated horizontal wells. During the year ended December 31, 2020, our capital expenditures for drilling, completing and equipping wells were $1.6 billion. In addition, we spent $248 million for oil and natural gas midstream and infrastructure.6Table of ContentsWe were operating eight drilling rigs at December 31, 2020 and currently intend to operate between eight and 12 rigs on average in 2021. We will continue monitoring the ongoing commodity price environment and expect to retain the financial flexibility to adjust our drilling and completion plans in response to market conditions. Based on our evaluation of applicable geologic and engineering data, we currently have approximately 10,413 gross (6,863 net) identified economic potential horizontal drilling locations in multiple horizons on our acreage at an assumed price of approximately $60.00 per Bbl WTI. With our current development plan, we expect to continue our strong PUD conversion ratio in 2021 by converting an estimated 30% of our PUDs to a proved developed category and developing approximately 80% of the consolidated 2020 year-end PUD reserves by the end of 2023.Oil and Natural Gas Data Proved Reserves Evaluation and Review of Reserves Our historical reserve estimates as of December 31, 2020, 2019 and 2018 were prepared by Ryder Scott with respect to our assets and those of Viper. Ryder Scott is an independent petroleum engineering firm. The technical persons responsible for preparing our proved reserve estimates meet the requirements with regards to qualifications, independence, objectivity and confidentiality set forth in the Standards Pertaining to the Estimating and Auditing of Oil and Gas Reserves Information promulgated by the Society of Petroleum Engineers. Ryder Scott is a third-party engineering firm and does not own an interest in any of our properties and is not employed by us on a contingent basis. Under SEC rules, proved reserves are those quantities of oil and natural gas that, by analysis of geoscience and engineering data, can be estimated with reasonable certainty to be economically producible from a given date forward, from known reservoirs and under existing economic conditions, operating methods and government regulations prior to the time at which contracts providing the right to operate expire, unless evidence indicates that renewal is reasonably certain, regardless of whether deterministic or probabilistic methods are used for the estimation. If deterministic methods are used, the SEC has defined reasonable certainty for proved reserves as a “high degree of confidence that the quantities will be recovered.” All of our proved reserves as of December 31, 2020 were estimated using a deterministic method. The estimation of reserves involves two distinct determinations. The first determination results in the estimation of the quantities of recoverable oil and natural gas and the second determination results in the estimation of the uncertainty associated with those estimated quantities in accordance with the definitions established under SEC rules. The process of estimating the quantities of recoverable oil and natural gas reserves relies on the use of certain generally accepted analytical procedures. These analytical procedures fall into three broad categories or methods: (1) performance-based methods, (2) volumetric-based methods and (3) analogy. These methods may be used singularly or in combination by the reserve evaluator in the process of estimating the quantities of reserves. Approximately 90% of the proved producing reserves attributable to producing wells were estimated by performance methods. These performance methods include, but may not be limited to, decline curve analysis, which utilized extrapolations of available historical production and pressure data. The remaining 10% of the proved producing reserves were estimated by analogy, or a combination of performance and analogy methods. The analogy method was used where there were inadequate historical performance data to establish a definitive trend and where the use of production performance data as a basis for the reserve estimates was considered to be inappropriate. All proved developed non-producing and undeveloped reserves were estimated by the analogy method. To estimate economically recoverable proved reserves and related future net cash flows, Ryder Scott considered many factors and assumptions, including the use of reservoir parameters derived from geological, geophysical and engineering data which cannot be measured directly, economic criteria based on current costs and the SEC pricing requirements and forecasts of future production rates. To establish reasonable certainty with respect to our estimated proved reserves, the technologies and economic data used in the estimation of our proved reserves included production and well test data, downhole completion information, geologic data, electrical logs, radioactivity logs, core analyses, available seismic data and historical well cost and operating expense data. The process of estimating oil, natural gas and natural gas liquids reserves is complex and requires significant judgment, as discussed in “Item 1A. Risk Factors” of this report. As a result, we maintain an internal staff of petroleum engineers and geoscience professionals who worked closely with our independent reserve engineers to ensure the integrity, accuracy and timeliness of the data used to calculate our proved reserves relating to our assets in the Permian Basin. Our internal technical team members met with our independent reserve engineers periodically during the period covered by the reserve reports to discuss the assumptions and methods used in the proved reserve estimation process. We provide historical 7Table of Contentsinformation to the independent reserve engineers for our properties such as ownership interest, oil and natural gas production, well test data, commodity prices and operating and development costs. Our Executive Vice President–Chief Engineer is primarily responsible for overseeing the preparation of all our reserve estimates. Our Executive Vice President–Chief Engineer is a petroleum engineer with over 30 years of reservoir and operations experience and our geoscience staff has an average of approximately 20 years of industry experience per person. Our technical staff uses historical information for our properties such as ownership interest, oil and natural gas production, well test data, commodity prices and operating and development costs. The preparation of our proved reserve estimates is completed in accordance with our internal control procedures. These procedures, which are intended to ensure reliability of reserve estimations, include the following: •review and verification of historical production data, which data is based on actual production as reported by us; •preparation of reserve estimates by our Executive Vice President–Chief Engineer or under his direct supervision; •review by our Executive Vice President–Chief Engineer of all of our reported proved reserves at the close of each quarter, including the review of all significant reserve changes and all new proved undeveloped reserves additions; •direct reporting responsibilities by our Executive Vice President–Chief Engineer to our Chief Executive Officer; •verification of property ownership by our land department; and •no employee’s compensation is tied to the amount of reserves booked. The following table presents our estimated net proved oil and natural gas reserves as of December 31, 2020, 2019 and 2018 (including those attributable to Viper), based on the reserve reports prepared by Ryder Scott in accordance with the rules and regulations of the SEC. All of our proved reserves included in the reserve reports are located in the continental United States. As of December 31, 2020, none of our total proved reserves were classified as proved developed non-producing. As of December 31,202020192018Estimated Proved Developed Reserves:Oil (MBbls)443,464 457,083 403,051 Natural gas (MMcf)1,085,035 824,760 705,084 Natural gas liquids (MBbls)192,495 165,173 125,509 Total (MBOE)816,798 759,716 646,074 Estimated Proved Undeveloped Reserves:Oil (MBbls)315,937 253,820 223,885 Natural gas (MMcf)522,029 294,051 343,565 Natural gas liquids (MBbls)96,701 65,030 64,782 Total (MBOE)499,643 367,859 345,928 Estimated Net Proved Reserves:Oil (MBbls)759,401 710,903 626,936 Natural gas (MMcf)1,607,064 1,118,811 1,048,649 Natural gas liquids (MBbls)289,196 230,203 190,291 Total (MBOE)(1)1,316,441 1,127,575 992,001 Percent proved developed62%67%65%(1)Estimates of reserves as of December 31, 2020, 2019 and 2018 were prepared using an average price equal to the unweighted arithmetic average of hydrocarbon prices received on a field-by-field basis on the first day of each month within the 12-month periods ended December 31, 2020, 2019 and 2018, respectively, in accordance with SEC guidelines. Reserve estimates do not include any value for probable or possible reserves that may exist, nor do they include any value for undeveloped acreage. The reserve estimates represent our net revenue interest in our properties, all of which are located within the continental United States. Although we believe these estimates are reasonable, actual future production, cash flows, taxes, development expenditures, operating expenses and quantities of recoverable oil and natural gas reserves may vary substantially from these estimates. See “Item 1A. Risk Factors” for a discussion of risks and uncertainties associated with our estimates of proved reserves and related factors, and see Note 20—Supplemental Information on Oil and Natural Gas Operations for further discussion of our reserve estimates and pricing.8Table of ContentsProved Undeveloped Reserves (PUDs) As of December 31, 2020, our proved undeveloped reserves totaled 315,937 MBbls of oil, 522,029 MMcf of natural gas and 96,701 MBbls of natural gas liquids, for a total of 499,643 MBOE. PUDs will be converted from undeveloped to developed as the applicable wells begin production.The following table includes the changes in PUD reserves for 2020 (MBOE):Beginning proved undeveloped reserves at December 31, 2019367,859 Undeveloped reserves transferred to developed(89,133)Revisions(15,742)Purchases964 Divestitures(14)Extensions and discoveries235,709 Ending proved undeveloped reserves at December 31, 2020499,643 The increase in proved undeveloped reserves was primarily attributable to extensions of 220,023 MBOE from 277 gross (236 net) wells in which we have a working interest and 15,686 MBOE from 299 gross wells in which Viper owns royalty interests. Of the 277 gross working interest wells, 98 were in the Delaware Basin. Transfers of 89,133 MBOE from undeveloped to developed reserves were the result of drilling or participating in 102 gross (94 net) horizontal wells in which we have a working interest and 82 gross wells in which we have a royalty interest or mineral interest through Viper. We own a working interest in 78 of the 82 gross Viper wells. Downward revisions of 15,742 MBOE were the result of (i) negative revisions of 4,226 MBOE due to lower product pricing, which were partially offset by positive revisions of 1,494 MBoe associated with a reduction in lease operating expenses, resulting in a total negative pricing revision of 2,732 MBOE, and (ii) PUD downgrades of 26,329 MBOE are primarily from changes in the corporate development plan. These negative revisions were offset with positive revisions of 13,319 MBOE associated with less gas flaring and a corresponding increase in shrunk gas and natural gas liquid recoveries.Costs incurred relating to the development of PUDs were approximately $381 million during 2020. Estimated future development costs relating to the development of PUDs are projected to be approximately $676 million in 2021, $764 million in 2022, $859 million in 2023 and $531 million in 2024. Since our formation in 2011, our average drilling costs and drilling times have been reduced, and we believe we will continue to realize cost savings and experience lower relative drilling and completion costs as we convert PUDs into proved developed reserves in upcoming years.As of December 31, 2020, all of our proved undeveloped reserves are scheduled to be developed within five years from the date they were initially recorded.9Table of ContentsWe have identified a multi-year inventory of potential drilling locations for our oil-weighted reserves that we believe provides attractive growth and return opportunities. At an assumed price of approximately $60.00 per Bbl WTI, we currently have approximately 10,413 gross (6,863 net) identified economic potential horizontal drilling locations on our acreage based on our evaluation of applicable geologic and engineering data. The following table presents the number of identified economic potential horizontal drilling locations by basin:Number of Identified Economic Potential Horizontal Drilling LocationsMidland BasinLower Spraberry(1)1,015Middle Spraberry(2)1,074Wolfcamp A(3)909Wolfcamp B(3)1,006Other2,111Total Midland Basin6,115Delaware Basin2nd Bone Springs(4)8703rd Bone Springs(4)1,222Wolfcamp A(5)854Wolfcamp B(6)755Other597Total Delaware Basin4,298Total10,413(1)Our current location count is based on 660 foot to 880 foot spacing in Midland, Martin, northeast Andrews, Howard and Glasscock counties, depending on the prospect area and 880 foot spacing in all other counties.(2)Our current location count is based on 660 foot spacing in Midland, Martin and northeast Andrews counties, depending on the prospect area and 880 foot spacing in all other counties.(3)Our current location count is based on 660 foot to 880 foot spacing in Midland, Martin, northeast Andrews, Howard and Glasscock counties, depending on the prospect area and 880 foot spacing in all other counties.(4)Our current location count is based on 880 foot to 1,320 foot spacing. (5)Our current location count is based on 880 foot to 1,056 foot spacing. 10Table of ContentsOil and Natural Gas Production Prices and Production Costs Production and Price HistoryThe following tables set forth information regarding our net production of oil, natural gas and natural gas liquids by basin for each of the periods indicated:Midland BasinDelaware BasinOther(1)(2)Total(in thousands)Production Data:Year Ended December 31, 2020Oil (MBbls)38,313 27,703 166 66,182 Natural gas (MMcf)68,529 61,606 414 130,549 Natural gas liquids (MBbls)12,597 9,295 89 21,981 Total (MBoe)62,332 47,266 324 109,921 Year Ended December 31, 2019Oil (MBbls)41,156 25,951 1,411 68,518 Natural gas (MMcf)48,109 48,447 1,057 97,613 Natural gas liquids (MBbls)10,485 7,826 187 18,498 Total (MBoe)59,659 41,852 1,774 103,285 Year Ended December 31, 2018Oil (MBbls)24,698 9,288 381 34,367 Natural gas (MMcf)21,674 12,416 579 34,669 Natural gas liquids (MBbls)5,493 1,866 106 7,465 Total (MBoe)33,803 13,223 584 47,610 (1)Production data for the years ended December 31, 2020 and 2019 includes the Central Basin Platform, the Eagle Ford Shale and the Rockies.(2)Production data for the year ended December 31, 2018 includes the Eagle Ford Shale.The following table sets forth certain price and cost information for each of the periods indicated: Year Ended December 31,202020192018Average Prices:Oil ($ per Bbl)$36.41 $51.87 $54.66 Natural gas ($ per Mcf)$0.82 $0.68 $1.76 Natural gas liquids ($ per Bbl)$10.87 $14.42 $25.47 Combined ($ per BOE)$25.07 $37.63 $44.73 Oil, hedged ($ per Bbl)(1)$40.34 $51.96 $51.20 Natural gas, hedged ($ per MMbtu)(1)$0.67 $0.86 $1.72 Natural gas liquids, hedged ($ per Bbl)(1)$10.83 $15.20 $25.46 Average price, hedged ($ per BOE)(1)$27.26 $38.00 $42.20 Average Costs per BOE:Lease operating expenses$3.87 $4.74 $4.31 Production and ad valorem taxes1.77 2.40 2.79 Gathering and transportation expense1.27 0.86 0.55 General and administrative - cash component0.46 0.54 0.79 Total operating expense - cash$7.37 $8.54 $8.44 General and administrative - non-cash component$0.34 $0.46 $0.57 Depletion11.30 13.54 12.50 Interest expense, net1.79 1.66 1.83 Merger and integration expense— — 0.77 Total expenses$13.43 $15.66 $15.67 11Table of Contents(1)Hedged prices reflect the effect of our commodity derivative transactions on our average sales prices and includes gains and losses on cash settlements for matured commodity derivatives, which we do not designate for hedge accounting.Wells Drilled and Completed in 2020The following table sets forth the total number of operated horizontal wells drilled and completed during the year ended December 31, 2020:Year Ended December 31, 2020DrilledCompletedAreaGrossNetGrossNetMidland Basin133 125 93 85 Delaware Basin75 70 78 74 Total208 195 171 159 As of December 31, 2020, we operated the following wells:Vertical WellsHorizontal WellsTotalAreaGrossNetGrossNetGrossNetMidland Basin1,745 1,641 1,102 1,008 2,847 2,649 Delaware Basin25 22 592 557 617 579 Total1,770 1,663 1,694 1,565 3,464 3,228 Productive Wells As of December 31, 2020, we owned an average unweighted 79% working interest in 4,326 gross (3,401 net) productive wells and an average 1.8% royalty interest in 4,553 additional wells. Through our subsidiary Viper, we own an average 3.8% net revenue interest in 7,167 gross productive wells. Productive wells consist of producing wells and wells capable of production, including natural gas wells awaiting pipeline connections to commence deliveries and oil wells awaiting connection to production facilities. Gross wells are the total number of producing wells in which we have an interest, and net wells are the sum of our fractional working interests owned in gross wells. The following table sets forth information regarding productive wells by basin as of December 31, 2020:Gross WellsNet WellsOilNatural GasTotalOilNatural GasTotalMidland Basin5,397 29 5,426 2,740 10 2,750 Delaware Basin1,904 158 2,062 630 19 649 Other1,316 75 1,391 2 — 2 Total productive wells8,617 262 8,879 3,372 29 3,401 12Table of ContentsDrilling Results The following tables set forth information with respect to the number of wells completed during the periods indicated by basin. Each of these wells was drilled in the Permian Basin of West Texas. The information should not be considered indicative of future performance, nor should it be assumed that there is necessarily any correlation between the number of productive wells drilled, quantities of reserves found or economic value. Productive wells are those that produce commercial quantities of hydrocarbons, whether or not they produce a reasonable rate of return. Year Ended December 31, 2020Midland BasinDelaware BasinTotalGrossNetGrossNetGrossNetDevelopment:Productive87 81 26 25 113 106 Dry— — — — — — Exploratory:Productive46 44 49 45 95 89 Dry— — — — — — Total:Productive133 125 75 70 208 195 Dry— — — — — — Year Ended December 31, 2019Midland BasinDelaware BasinTotalGrossNetGrossNetGrossNetDevelopment:Productive75 68 31 28 106 96 Dry— — — — — — Exploratory:Productive96 86 128 114 224 200 Dry— — — — — — Total:Productive171 154 159 142 330 296 Dry— — — — — — Year Ended December 31, 2018Midland BasinDelaware BasinTotalGrossNetGrossNetGrossNetDevelopment:Productive67 58 21 20 88 78 Dry— — — — — — Exploratory:Productive50 43 38 35 88 78 Dry— — — — — — Total:Productive117 101 59 55 176 156 Dry— — — — — — As of December 31, 2020, we had 20 gross (19 net) operated wells in the process of drilling and 151 gross (141 net) in the process of completion or waiting on completion.13Table of ContentsAcreage The following table sets forth information as of December 31, 2020 relating to our leasehold acreage:Developed Acreage(1)Undeveloped AcreageTotal Acreage(2)BasinGrossNetGrossNetGrossNetMidland119,073 99,751 96,883 94,840 215,956 194,591 Delaware103,712 77,263 88,985 75,324 192,697 152,587 Exploration107 107 38,097 28,838 38,204 28,945 Conventional Permian40 38 2,745 2,517 2,785 2,555 Total222,932 177,159 226,710 201,519 449,642 378,678 (1)Does not include undrilled acreage held by production under the terms of the lease. Large portions of the acreage that are considered developed under SEC guidelines are developed with vertical wells or horizontal wells that are in a single horizon. We believe much of this acreage has significant remaining development potential in one or more intervals with horizontal wells.(2)Does not include Viper’s mineral interests but does include leasehold acres that we own underlying our mineral interests.Undeveloped acreage expirations As of December 31, 2020, the following gross and net undeveloped acres are set to expire over the next four years based on their contractual lease maturities unless (i) production is established within the spacing units covering the acreage or (ii) the lease is renewed or extended under continuous drilling provisions prior to the contractual expiration dates. Acres ExpiringDelawareMidlandExploratoryTotalGross NetGrossNetGrossNetGrossNet202113,727 8,149 24,099 21,093 23,474 22,063 61,300 51,305 20229,634 1,063 3,294 813 659 165 13,587 2,041 2023966 410 1,951 1,597 — — 2,917 2,007 2024370 59 — — — — 370 59 Total24,697 9,681 29,344 23,503 24,133 22,228 78,174 55,412 Title to Properties As is customary in the oil and natural gas industry, we initially conduct only a cursory review of the title to our properties. At such time as we determine to conduct drilling operations on those properties, we conduct a thorough title examination and perform curative work with respect to significant defects prior to commencement of drilling operations. To the extent title opinions or other investigations reflect title defects on those properties, we are typically responsible for curing any title defects at our expense. We generally will not commence drilling operations on a property until we have cured any material title defects on such property. We have obtained title opinions on substantially all of our producing properties and believe that we have satisfactory title to our producing properties in accordance with standards generally accepted in the oil and natural gas industry. Prior to completing an acquisition of producing oil and natural gas leases, we perform title reviews on the most significant leases and, depending on the materiality of properties, we may obtain a title opinion, obtain an updated title review or opinion or review previously obtained title opinions. Our oil and natural gas properties are subject to customary royalty and other interests, liens for current taxes and other burdens which we believe do not materially interfere with the use of or affect our carrying value of the properties. Marketing and Customers We typically sell production to a relatively small number of customers, as is customary in the exploration, development and production business. For the year ended December 31, 2020, four purchasers each accounted for more than 10% of our revenue. For each of the years ended December 31, 2019 and 2018, three purchasers each accounted for more than 10% of our revenue. We do not require collateral and do not believe the loss of any single purchaser would materially impact our operating results, as crude oil and natural gas are fungible products with well-established markets and numerous purchasers. For additional information regarding our customer concentrations, see Note 3—Revenue from Contracts with Customers included in notes to the consolidated financial statements included elsewhere in this Annual Report.14Table of ContentsDelivery CommitmentsCertain of our firm sales agreements for oil include delivery commitments that specify the delivery of a fixed and determinable quantity. We believe our current production and reserves are sufficient to fulfill these delivery commitments and we expect such reserves will continue to be the primary means of fulfilling our future commitments. However, these contracts provide the options of delivering third-party volumes or paying a monetary shortfall penalty if production is inadequate to satisfy our commitment. For additional information regarding commitments, see Note 17—Commitments and Contingencies included in notes to the consolidated financial statements included elsewhere in this Annual Report.Competition The oil and natural gas industry is intensely competitive, and in our upstream segment, we compete with other companies that have greater resources. Many of these companies not only explore for and produce oil and natural gas, but also carry on midstream and refining operations and market petroleum and other products on a regional, national or worldwide basis. These companies may be able to pay more for productive oil and natural gas properties and exploratory prospects or to define, evaluate, bid for and purchase a greater number of properties and prospects than our financial or human resources permit. In addition, these companies may have a greater ability to continue exploration activities during periods of low oil and natural gas market prices. Our larger or more integrated competitors may be able to absorb the burden of existing, and any changes to, federal, state and local laws and regulations more easily than we can, which would adversely affect our competitive position. Our ability to acquire additional properties and to discover reserves in the future will be dependent upon our ability to evaluate and select suitable properties and to consummate transactions in a highly competitive environment. In addition, because we have fewer financial and human resources than many companies in our industry, we may be at a disadvantage in bidding for exploratory prospects and producing oil and natural gas properties. Further, oil and natural gas compete with other forms of energy available to customers, primarily based on price. These alternate forms of energy include electricity, coal and fuel oils. Changes in the availability or price of oil and natural gas or other forms of energy, as well as business conditions, conservation, legislation, regulations and the ability to convert to alternate fuels and other forms of energy may affect the demand for oil and natural gas. In our midstream operations segment, as Rattler seeks to expand its crude oil, natural gas and water-related midstream services, it faces a high level of competition, including major integrated crude oil and natural gas companies, interstate and intrastate pipelines and companies that gather, compress, treat, process, transport, store or market oil and natural gas. As Rattler seeks to expand to provide midstream services to third party producers, it similarly faces a high level of competition. Competition is often the greatest in geographic areas experiencing robust drilling by producers and during periods of high commodity prices for crude oil, natural gas or natural gas liquids. Within the acreage dedicated by Rattler to us, Rattler does not compete with other midstream companies to provide us with midstream services as a result of our relationship and long-term dedications to Rattler’s midstream assets. However, we may continue to use third party service providers for certain midstream services within such dedicated acreage until the expiration or termination of certain pre-existing dedications.Transportation During the initial development of our fields we evaluate all gathering and delivery infrastructure in the areas of our production. Currently, a majority of our production in the Midland and Delaware Basins are transported to purchasers by pipeline. The following table presents the average percentage of produced oil sold by pipeline and the average percentage of produced water connected to saltwater disposals by pipeline:Midland BasinDelaware BasinTotal% of produced oil sold by pipeline95 %93 %94 %% of produced water transported by pipeline97 %98 %98 %We have entered into multiple fee-based commercial agreements with Rattler, each with an initial term ending in 2034, utilizing Rattler’s infrastructure assets or its planned infrastructure assets to provide an array of essential services critical to our upstream operations in the Delaware and Midland Basins. Our agreements with Rattler include a total of approximately 395,000 gross acres across all Rattler’s service lines across the Midland and Delaware Basins.15Table of ContentsOil and Natural Gas Leases The typical oil and natural gas lease agreement covering our properties provides for the payment of royalties to the mineral owner for all oil and natural gas produced from any wells drilled on the leased premises. The lessor royalties and other leasehold burdens on our properties generally range from 12.5% to 30.0%, resulting in a net revenue interest to us generally ranging from 70.0% to 87.5%. Seasonal Nature of Business Generally, demand for oil increases during the summer months and decreases during the winter months while natural gas decreases during the summer months and increases during the winter months. Certain natural gas users utilize natural gas storage facilities and purchase some of their anticipated winter requirements during the summer, which can lessen seasonal demand fluctuations. In our exploration and production business, seasonal weather conditions, such as, for example, the recent severe winter storms in the Permian Basin, and lease stipulations can limit our drilling and producing activities and other oil and natural gas operations in a portion of our operating areas. These seasonal anomalies can pose challenges for meeting our well drilling objectives and can increase competition for equipment, supplies and personnel during the spring and summer months, which could lead to shortages and increase costs or delay operations. In our midstream operations business, the volumes of condensate produced at Rattler’s processing facilities fluctuate seasonally, with volumes generally increasing in the winter months and decreasing in the summer months as a result of the physical properties of natural gas and comingled liquids. Severe or prolonged summers may adversely affect our results of operations in the midstream operations segment.RegulationOil and natural gas operations such as ours are subject to various types of legislation, regulation and other legal requirements enacted by governmental authorities. This legislation and regulation affecting the oil and natural gas industry is under constant review for amendment or expansion. Some of these requirements carry substantial penalties for failure to comply. The regulatory burden on the oil and natural gas industry increases our cost of doing business and, consequently, affects our profitability.Environmental Matters and RegulationOur oil and natural gas exploration, development and production operations are subject to stringent laws and regulations governing the discharge of materials into the environment or otherwise relating to environmental protection. Numerous federal, state and local governmental agencies, such as the EPA, issue regulations that often require difficult and costly compliance measures that carry substantial administrative, civil and criminal penalties and may result in injunctive obligations for non-compliance. These laws and regulations may require the acquisition of a permit before drilling commences, restrict the types, quantities and concentrations of various substances that can be released into the environment in connection with drilling and production activities, limit or prohibit construction or drilling activities on certain lands lying within wilderness, wetlands, ecologically or seismically sensitive areas, and other protected areas, require action to prevent or remediate pollution from current or former operations, such as plugging abandoned wells or closing pits, result in the suspension or revocation of necessary permits, licenses and authorizations, require that additional pollution controls be installed and impose substantial liabilities for pollution resulting from our operations or related to our owned or operated facilities. Liability under such laws and regulations is often strict (i.e., no showing of “fault” is required) and can be joint and several. Moreover, it is not uncommon for neighboring landowners and other third parties to file claims for personal injury and property damage allegedly caused by the release of hazardous substances, hydrocarbons or other waste products into the environment. Changes in environmental laws and regulations occur frequently, and any changes that result in more stringent and costly pollution control or waste handling, storage, transport, disposal or cleanup requirements could materially and adversely affect our operations and financial position, as well as the oil and natural gas industry in general. Our management believes that we are in substantial compliance with applicable environmental laws and regulations and we have not experienced any material adverse effect from compliance with these environmental requirements. This trend, however, may not continue in the future.Waste Handling. The Resource Conservation and Recovery Act, or the RCRA, as amended, and comparable state statutes and regulations promulgated thereunder, affect oil and natural gas exploration, development and production activities by imposing requirements regarding the generation, transportation, treatment, storage, disposal and cleanup of hazardous and non-hazardous wastes. With federal approval, the individual states administer some or all of the provisions of the RCRA, sometimes in conjunction with their own, more stringent requirements. Although most wastes associated with the exploration, development and production of crude oil and natural gas are exempt from regulation as hazardous wastes under the RCRA, such wastes may constitute “solid wastes” that are subject to the less stringent non-hazardous waste requirements. Moreover, the EPA or state or local governments may adopt more stringent requirements for the handling of non-hazardous wastes or 16Table of Contentscategorize some non-hazardous wastes as hazardous for future regulation. Indeed, legislation has been proposed from time to time in Congress to re-categorize certain oil and natural gas exploration, development and production wastes as “hazardous wastes.” Also, in December 2016, the EPA agreed in a consent decree to review its regulation of oil and natural gas waste. However, in April 2019, the EPA concluded that revisions to the federal regulations for the management of oil and natural gas waste are not necessary at this time. Any changes in such laws and regulations could have a material adverse effect on our capital expenditures and operating expenses. Administrative, civil and criminal penalties can be imposed for failure to comply with waste handling requirements. We believe that we are in substantial compliance with applicable requirements related to waste handling, and that we hold all necessary and up-to-date permits, registrations and other authorizations to the extent that our operations require them under such laws and regulations. Although we do not believe the current costs of managing our wastes, as presently classified, to be significant, any legislative or regulatory reclassification of oil and natural gas exploration and production wastes could increase our costs to manage and dispose of such wastes.Remediation of Hazardous Substances. The Comprehensive Environmental Response, Compensation and Liability Act, as amended, which we refer to as CERCLA or the “Superfund” law, and analogous state laws, generally impose liability, without regard to fault or legality of the original conduct, on classes of persons who are considered to be responsible for the release of a “hazardous substance” into the environment. These persons include the current owner or operator of a contaminated facility, a former owner or operator of the facility at the time of contamination, and those persons that disposed or arranged for the disposal of the hazardous substance at the facility. Under CERCLA and comparable state statutes, persons deemed “responsible parties” are subject to strict liability that, in some circumstances, may be joint and several for the costs of removing or remediating previously disposed wastes (including wastes disposed of or released by prior owners or operators) or property contamination (including groundwater contamination), for damages to natural resources and for the costs of certain health studies. In addition, it is not uncommon for neighboring landowners and other third parties to file claims for personal injury and property damage allegedly caused by the hazardous substances released into the environment. In the course of our operations, we use materials that, if released, would be subject to CERCLA and comparable state statutes. Therefore, governmental agencies or third parties may seek to hold us responsible under CERCLA and comparable state statutes for all or part of the costs to clean up sites at which such “hazardous substances” have been released. Water Discharges. The Federal Water Pollution Control Act of 1972, as amended, also known as the “Clean Water Act,” or the CWA, the Safe Drinking Water Act, the Oil Pollution Act, or the OPA, and analogous state laws and regulations promulgated thereunder impose restrictions and strict controls regarding the unauthorized discharge of pollutants, including produced waters and other gas and oil wastes, into navigable waters of the United States, as well as state waters. The discharge of pollutants into regulated waters is prohibited, except in accordance with the terms of a permit issued by the EPA or the state. Spill prevention, control and countermeasure plan requirements under federal law require appropriate containment berms and similar structures to help prevent the contamination of navigable waters in the event of a petroleum hydrocarbon tank spill, rupture or leak. The CWA and regulations implemented thereunder also prohibit the discharge of dredge and fill material into regulated waters, including jurisdictional wetlands, unless authorized by an appropriately issued permit. On June 29, 2015, the EPA and the U.S. Army Corps of Engineers, or the Corps, jointly promulgated final rules redefining the scope of waters protected under the CWA. However, on October 22, 2019, the agencies published a final rule to repeal the 2015 rules. The 2015 rule and the 2019 repeal are subject to several ongoing legal challenges. Also, on April 21, 2020, the EPA and the Corps published a final rule replacing the 2015 rule, and significantly reducing the waters subject to federal regulation under the CWA. As a result of such recent developments, substantial uncertainty exists regarding the scope of waters protected under the CWA. Several state and environmental groups have challenged the replacement rule and, on January 20, 2021, the Biden Administration directed the EPA and the Corps to review the rule. To the extent the rules expand the range of properties subject to the CWA’s jurisdiction, we could face increased costs and delays with respect to obtaining permits for dredge and fill activities in wetland areas.The EPA has also adopted regulations requiring certain oil and natural gas exploration and production facilities to obtain individual permits or coverage under general permits for storm water discharges. In addition, on June 28, 2016, the EPA published a final rule prohibiting the discharge of wastewater from onshore unconventional oil and natural gas extraction facilities to publicly owned wastewater treatment plants, which regulations are discussed in more detail below under the caption “–Regulation of Hydraulic Fracturing.” Costs may be associated with the treatment of wastewater or developing and implementing storm water pollution prevention plans, as well as for monitoring and sampling the storm water runoff from certain of our facilities. Some states also maintain groundwater protection programs that require permits for discharges or operations that may impact groundwater conditions. 17Table of ContentsThe OPA is the primary federal law for oil spill liability. The OPA contains numerous requirements relating to the prevention of and response to petroleum releases into waters of the United States, including the requirement that operators of offshore facilities and certain onshore facilities near or crossing waterways must develop and maintain facility response contingency plans and maintain certain significant levels of financial assurance to cover potential environmental cleanup and restoration costs. The OPA subjects owners of facilities to strict liability that, in some circumstances, may be joint and several for all containment and cleanup costs and certain other damages arising from a release, including, but not limited to, the costs of responding to a release of oil to surface waters. Non-compliance with the CWA or the OPA may result in substantial administrative, civil and criminal penalties, as well as injunctive obligations. We believe we are in material compliance with the requirements of each of these laws.Air Emissions. The federal Clean Air Act, or the CAA, as amended, and comparable state laws and regulations, regulate emissions of various air pollutants through the issuance of permits and the imposition of other requirements. The EPA has developed, and continues to develop, stringent regulations governing emissions of air pollutants at specified sources. New facilities may be required to obtain permits before work can begin, and existing facilities may be required to obtain additional permits and incur capital costs in order to remain in compliance. For example, on August 16, 2012, the EPA published final regulations under the federal CAA that establish new emission controls for oil and natural gas production and processing operations, which are discussed in more detail below in “—Regulation of Hydraulic Fracturing.” Also, on May 12, 2016, the EPA issued a final rule regarding the criteria for aggregating multiple small surface sites into a single source for air-quality permitting purposes applicable to the oil and natural gas industry. This rule could cause small facilities, on an aggregate basis, to be deemed a major source, thereby triggering more stringent air permitting processes and requirements. These laws and regulations may increase the costs of compliance for some facilities we own or operate, and federal and state regulatory agencies can impose administrative, civil and criminal penalties for non-compliance with air permits or other requirements of the federal CAA and associated state laws and regulations. We believe that we are in substantial compliance with all applicable air emissions regulations and that we hold all necessary and valid construction and operating permits for our operations. Obtaining or renewing permits has the potential to delay the development of oil and natural gas projects. Climate Change. In recent years, federal, state and local governments have taken steps to reduce emissions of greenhouse gases. The EPA has finalized a series of greenhouse gas monitoring, reporting and emissions control rules for the oil and natural gas industry, and the U.S. Congress has, from time to time, considered adopting legislation to reduce emissions. Almost one-half of the states have already taken measures to reduce emissions of greenhouse gases primarily through the development of greenhouse gas emission inventories and/or regional greenhouse gas cap-and-trade programs. In addition, states have imposed increasingly stringent requirements related to the venting or flaring of gas during oil and natural gas operations. For example, on November 4, 2020, the Texas Railroad Commission adopted new guidance on when flaring is permissible, requiring operators to submit more specific information to justify the need to flare or vent gas.At the international level, in December 2015, the United States participated in the 21st Conference of the Parties of the United Nations Framework Convention on Climate Change in Paris, France. The resulting Paris Agreement calls for the parties to undertake “ambitious efforts” to limit the average global temperature, and to conserve and enhance sinks and reservoirs of greenhouse gases. The Agreement went into effect on November 4, 2016. The Agreement establishes a framework for the parties to cooperate and report actions to reduce greenhouse gas emissions. Although the United States withdrew from the Paris Agreement effective November 4, 2020, President Biden issued an Executive Order on January 20, 2021 to rejoin the Paris Agreement, which went into effect on February 19, 2021. The United States has indicated its plan to announce in advance of an April 22, 2021 climate summit its nationally determined contribution, or its commitment to reduce its national greenhouse gas emissions to meet this objective. Furthermore, many state and local leaders have stated their intent to intensify efforts to support the commitments set forth in the international accord. Restrictions on emissions of methane or carbon dioxide that may be imposed could adversely impact the demand for, price of, and value of our products and reserves. As our operations also emit greenhouse gases directly, current and future laws or regulations limiting such emissions could increase our own costs. At this time, it is not possible to accurately estimate how potential future laws or regulations addressing greenhouse gas emissions would impact our business. In addition, there have also been efforts in recent years to influence the investment community, including investment advisors and certain sovereign wealth, pension and endowment funds promoting divestment of fossil fuel equities and pressuring lenders to limit funding to companies engaged in the extraction of fossil fuel reserves. Such environmental activism and initiatives aimed at limiting climate change and reducing air pollution could interfere with our business activities, operations and ability to access capital. Furthermore, claims have been made against certain energy companies alleging that greenhouse gas emissions from oil and natural gas operations constitute a public nuisance under federal and/or state common law. As a result, private individuals or public entities may seek to enforce environmental laws and regulations against us and could allege personal injury, property damages or other liabilities. While our business is not a party to any 18Table of Contentssuch litigation, we could be named in actions making similar allegations. An unfavorable ruling in any such case could significantly impact our operations and could have an adverse impact on our financial condition. Moreover, climate change may be associated with extreme weather conditions such as more intense hurricanes, thunderstorms, tornadoes and snow or ice storms, as well as rising sea levels. Another possible consequence of climate change is increased volatility in seasonal temperatures. Some studies indicate that climate change could cause some areas to experience temperatures substantially hotter or colder than their historical averages. Extreme weather conditions, such as, for example, the recent severe winter storms in the Permian Basin, can interfere with our production and increase our costs and damage resulting from extreme weather may not be fully insured. However, at this time, we are unable to determine the extent to which climate change may lead to increased storm or weather hazards affecting our operations. Regulation of Hydraulic FracturingHydraulic fracturing is an important common practice that is used to stimulate production of hydrocarbons from tight formations, including shales. The process, which involves the injection of water, sand and chemicals under pressure into formations to fracture the surrounding rock and stimulate production, is typically regulated by state oil and natural gas commissions. However, legislation has been proposed in recent sessions of Congress to amend the Safe Drinking Water Act to repeal the exemption for hydraulic fracturing from the definition of “underground injection,” to require federal permitting and regulatory control of hydraulic fracturing, and to require disclosure of the chemical constituents of the fluids used in the fracturing process. Furthermore, several federal agencies have asserted regulatory authority over certain aspects of the process. For example, the EPA has taken the position that hydraulic fracturing with fluids containing diesel fuel is subject to regulation under the Underground Injection Control program, specifically as “Class II” Underground Injection Control wells under the Safe Drinking Water Act.On June 28, 2016, the EPA published a final rule prohibiting the discharge of wastewater from onshore unconventional oil and natural gas extraction facilities to publicly owned wastewater treatment plants. The EPA is also conducting a study of private wastewater treatment facilities (also known as centralized waste treatment, or CWT, facilities) accepting oil and natural gas extraction wastewater. The EPA is collecting data and information related to the extent to which CWT facilities accept such wastewater, available treatment technologies (and their associated costs), discharge characteristics, financial characteristics of CWT facilities, and the environmental impacts of discharges from CWT facilities. On August 16, 2012, the EPA published final regulations under the federal CAA that establish new air emission controls for oil and natural gas production and natural gas processing operations. Specifically, the EPA’s rule package includes New Source Performance standards to address emissions of sulfur dioxide and volatile organic compounds and a separate set of emission standards to address hazardous air pollutants frequently associated with oil and natural gas production and processing activities. The final rules seek to achieve a 95% reduction in volatile organic compounds emitted by requiring the use of reduced emission completions or “green completions” on all hydraulically-fractured wells constructed or refractured after January 1, 2015. The rules also establish specific new requirements regarding emissions from compressors, controllers, dehydrators, storage tanks and other production equipment. The EPA received numerous requests for reconsideration of these rules from both industry and the environmental community, and court challenges to the rules were also filed. In response, the EPA has issued, and will likely continue to issue, revised rules responsive to some of the requests for reconsideration. In particular, on May 12, 2016, the EPA amended its regulations to impose new standards for methane and volatile organic compounds emissions for certain new, modified, and reconstructed equipment, processes, and activities across the oil and natural gas sector. However, in a March 28, 2017 executive order, the Trump Administration directed the EPA to review the 2016 regulations and, if appropriate, to initiate a rulemaking to rescind or revise them consistent with the stated policy of promoting clean and safe development of the nation’s energy resources, while at the same time avoiding regulatory burdens that unnecessarily encumber energy production. Accordingly, on August 13, 2020, the EPA issued final amendments to the 2012 and 2016 New Source Performance standards to ease regulatory burdens, including rescinding standards applicable to transmission or storage segments and eliminating methane requirements altogether. Various state, municipal and environmental groups have challenged the amendments and, on January 20, 2021, President Biden issued an executive order directing the EPA to review the amendments consistent with several policy objective, including reducing greenhouse gas emissions. Thus substantial uncertainty exists regarding the scope of the New Source Performance standards for oil and natural gas operations. The 2012 and 2016 New Source Performance standards, to the extent implemented, as well as any future laws and their implementing regulations, may require us to obtain pre-approval for the expansion or modification of existing facilities or the construction of new facilities expected to produce air emissions, impose stringent air permit requirements, or mandate the use of specific equipment or technologies to control emissions. 19Table of ContentsFurthermore, there are certain governmental reviews either underway or being proposed that focus on environmental aspects of hydraulic fracturing practices. On December 13, 2016, the EPA released a study examining the potential for hydraulic fracturing activities to impact drinking water resources, finding that, under some circumstances, the use of water in hydraulic fracturing activities can impact drinking water resources. Also, on February 6, 2015, the EPA released a report with findings and recommendations related to public concern about induced seismic activity from disposal wells. The report recommends strategies for managing and minimizing the potential for significant injection-induced seismic events. Other governmental agencies, including the U.S. Department of Energy, the U.S. Geological Survey, and the U.S. Government Accountability Office, have evaluated or are evaluating various other aspects of hydraulic fracturing. These ongoing or proposed studies could spur initiatives to further regulate hydraulic fracturing, and could ultimately make it more difficult or costly for us to perform fracturing and increase our costs of compliance and doing business. Several states, including Texas, and local jurisdictions, have adopted, or are considering adopting, regulations that could restrict or prohibit hydraulic fracturing in certain circumstances, impose more stringent operating standards and/or require the disclosure of the composition of hydraulic fracturing fluids. The Texas Legislature adopted legislation, effective September 1, 2011, requiring oil and natural gas operators to publicly disclose the chemicals used in the hydraulic fracturing process. The Texas Railroad Commission adopted rules and regulations implementing this legislation that apply to all wells for which the Texas Railroad Commission issues an initial drilling permit after February 1, 2012. The law requires that the well operator disclose the list of chemical ingredients subject to the requirements of OSHA for disclosure on an internet website and also file the list of chemicals with the Texas Railroad Commission with the well completion report. The total volume of water used to hydraulically fracture a well must also be disclosed to the public and filed with the Texas Railroad Commission. Also, in May 2013, the Texas Railroad Commission adopted rules governing well casing, cementing and other standards for ensuring that hydraulic fracturing operations do not contaminate nearby water resources. The rules took effect in January 2014. Additionally, on October 28, 2014, the Texas Railroad Commission adopted disposal well rule amendments designed, among other things, to require applicants for new disposal wells that will receive non-hazardous produced water and hydraulic fracturing flowback fluid to conduct seismic activity searches utilizing the U.S. Geological Survey. The searches are intended to determine the potential for earthquakes within a circular area of 100 square miles around a proposed new disposal well. The disposal well rule amendments, which became effective on November 17, 2014, also clarify the Texas Railroad Commission’s authority to modify, suspend or terminate a disposal well permit if scientific data indicates a disposal well is likely to contribute to seismic activity. The Texas Railroad Commission has used this authority to deny permits for waste disposal wells. There has been increasing public controversy regarding hydraulic fracturing with regard to the use of fracturing fluids, induced seismic activity, impacts on drinking water supplies, use of water and the potential for impacts to surface water, groundwater and the environment generally. A number of lawsuits and enforcement actions have been initiated across the country implicating hydraulic fracturing practices. If new laws or regulations that significantly restrict hydraulic fracturing are adopted, such laws could make it more difficult or costly for us to perform fracturing to stimulate production from tight formations as well as make it easier for third parties opposing the hydraulic fracturing process to initiate legal proceedings based on allegations that specific chemicals used in the fracturing process could adversely affect groundwater. In addition, if hydraulic fracturing is further regulated at the federal, state or local level, our fracturing activities could become subject to additional permitting and financial assurance requirements, more stringent construction specifications, increased monitoring, reporting and recordkeeping obligations, plugging and abandonment requirements and also to permitting delays and potential increases in costs. Such changes could cause us to incur substantial compliance costs, and compliance or the consequences of any failure to comply by us could have a material adverse effect on our financial condition and results of operations. At this time, it is not possible to estimate the impact on our business of newly enacted or potential federal, state or local laws governing hydraulic fracturing.Endangered SpeciesThe federal Endangered Species Act, or ESA, and analogous state laws restrict activities that may affect listed endangered or threatened species or their habitats. If endangered species are located in areas where we operate, our operations or any work performed related to them could be prohibited or delayed or expensive mitigation may be required. While some of our operations may be located in areas that are designated as habitats for endangered or threatened species, we believe that we are in compliance with the ESA. On August 12, 2019, the U.S. Fish and Wildlife Service and the National Oceanic and Atmospheric Administration’s National Marine Fisheries Service jointly published final rules that, among other things, tighten the critical habitat designation process and eliminate certain automatic protections for threatened species going forward. Nevertheless, the designation of previously unprotected species in areas where we operate as threatened or endangered could result in the imposition of restrictions on our operations and consequently have a material adverse effect on our business.20Table of ContentsOther Regulation of the Oil and Natural Gas IndustryThe oil and natural gas industry is extensively regulated by numerous federal, state and local authorities. Legislation affecting the oil and natural gas industry is under constant review for amendment or expansion, frequently increasing the regulatory burden. Also, numerous departments and agencies, both federal and state, are authorized by statute to issue rules and regulations that are binding on the oil and natural gas industry and its individual members, some of which carry substantial penalties for failure to comply. Although the regulatory burden on the oil and natural gas industry increases our cost of doing business and, consequently, affects our profitability, these burdens generally do not affect us any differently or to any greater or lesser extent than they affect other companies in the industry with similar types, quantities and locations of production. The availability, terms and cost of transportation significantly affect sales of oil and natural gas. The interstate transportation and sale for resale of oil and natural gas is subject to federal regulation, including regulation of the terms, conditions and rates for interstate transportation, storage and various other matters, primarily by FERC. Federal and state regulations govern the price and terms for access to oil and natural gas pipeline transportation. FERC’s regulations for interstate oil and natural gas transmission in some circumstances may also affect the intrastate transportation of oil and natural gas. Although oil and natural gas prices are currently unregulated, Congress historically has been active in the area of oil and natural gas regulation. We cannot predict whether new legislation to regulate oil and natural gas might be proposed, what proposals, if any, might actually be enacted by Congress or the various state legislatures, and what effect, if any, the proposals might have on our operations. Sales of condensate and oil and natural gas liquids are not currently regulated and are made at market prices. Drilling and Production. Our operations are subject to various types of regulation at the federal, state and local level. These types of regulation include requiring permits for the drilling of wells, drilling bonds and reports concerning operations. The state, and some counties and municipalities, in which we operate also regulate one or more of the following; the location of wells; the method of drilling and casing wells; the timing of construction or drilling activities, including seasonal wildlife closures; the rates of production or “allowables”; the surface use and restoration of properties upon which wells are drilled; the plugging and abandoning of wells; and notice to, and consultation with, surface owners and other third parties. State laws regulate the size and shape of drilling and spacing units or proration units governing the pooling of oil and natural gas properties. Some states allow forced pooling or integration of tracts to facilitate exploration while other states rely on voluntary pooling of lands and leases. In some instances, forced pooling or unitization may be implemented by third parties and may reduce our interest in the unitized properties. In addition, state conservation laws establish maximum rates of production from oil and natural gas wells, generally prohibit the venting or flaring of natural gas and impose requirements regarding the ratability of production. These laws and regulations may limit the amount of oil and natural gas we can produce from our wells or limit the number of wells or the locations at which we can drill. Moreover, each state generally imposes a production or severance tax with respect to the production and sale of oil, natural gas and natural gas liquids within its jurisdiction. States do not regulate wellhead prices or engage in other similar direct regulation, but we cannot assure you that they will not do so in the future. The effect of such future regulations may be to limit the amounts of oil and natural gas that may be produced from our wells, negatively affect the economics of production from these wells or to limit the number of locations we can drill. Federal, state and local regulations provide detailed requirements for the plugging and abandonment of wells, closure or decommissioning of production facilities and pipelines and for site restoration in areas where we operate. Although the Corps does not require bonds or other financial assurances, some state agencies and municipalities do have such requirements. Natural Gas Sales and Transportation. Historically, federal legislation and regulatory controls have affected the price of the natural gas we produce and the manner in which we market our production. FERC has jurisdiction over the transportation and sale for resale of natural gas in interstate commerce by natural gas companies under the Natural Gas Act of 1938 and the Natural Gas Policy Act of 1978. Since 1978, various federal laws have been enacted which have resulted in the complete removal of all price and non-price controls for sales of domestic natural gas sold in “first sales,” which include all of our sales of our own production. Under the Energy Policy Act of 2005, FERC has substantial enforcement authority to prohibit the manipulation of natural gas markets and enforce its rules and orders, including the ability to assess substantial civil penalties. 21Table of ContentsFERC also regulates interstate natural gas transportation rates and service conditions and establishes the terms under which we may use interstate natural gas pipeline capacity, which affects the marketing of natural gas that we produce, as well as the revenues we receive for sales of our natural gas and release of our natural gas pipeline capacity. Commencing in 1985, FERC promulgated a series of orders, regulations and rule makings that significantly fostered competition in the business of transporting and marketing gas. Today, interstate pipeline companies are required to provide nondiscriminatory transportation services to producers, marketers and other shippers, regardless of whether such shippers are affiliated with an interstate pipeline company. FERC’s initiatives have led to the development of a competitive, open access market for natural gas purchases and sales that permits all purchasers of natural gas to buy gas directly from third-party sellers other than pipelines. However, the natural gas industry historically has been very heavily regulated; therefore, we cannot guarantee that the less stringent regulatory approach currently pursued by FERC and Congress will continue indefinitely into the future nor can we determine what effect, if any, future regulatory changes might have on our natural gas related activities. Under FERC’s current regulatory regime, transmission services are provided on an open-access, non-discriminatory basis at cost-based rates or negotiated rates. Gathering service, which occurs upstream of jurisdictional transmission services, is regulated by the states onshore and in state waters. Although its policy is still in flux, FERC has in the past reclassified certain jurisdictional transmission facilities as non-jurisdictional gathering facilities, which has the tendency to increase our costs of transporting gas to point-of-sale locations. Natural Gas Gathering. Although FERC has not made a formal determination with respect to the facilities Rattler LLC considers to be natural gas gathering pipelines, Rattler believes that its natural gas gathering pipelines meet the traditional tests that FERC has used to determine that pipelines perform primarily a gathering function and are, therefore, not subject to FERC jurisdiction. The distinction between FERC-regulated interstate transportation services and federally unregulated gathering services, however, has been the subject of substantial litigation, and FERC determines whether facilities are gathering facilities on a case-by-case basis, so the classification and regulation of gathering facilities is subject to change based on future determinations by FERC, the courts or Congress. If FERC were to consider the status of an individual facility and determine that the facility or services provided by it are not exempt from FERC regulation under the Natural Gas Act of 1938, or NGA, and that the facility provides interstate transportation service, the rates for, and terms and conditions of, services provided by such facility would be subject to regulation by FERC under the NGA or the Natural Gas Policy Act, or NGPA. Such regulation could decrease revenue, increase operating costs and, depending upon the facility in question, adversely affect results of operations and cash flow. In addition, if any of the facilities were found to have provided services or otherwise operated in violation of the NGA or NGPA, this could result in the imposition of substantial civil penalties, as well as a requirement to disgorge revenues collected for such services in excess of the maximum rates established by FERC.Even though Rattler LLC considers its natural gas gathering pipelines to be exempt from the jurisdiction of FERC under the NGA, FERC regulation of interstate natural gas transportation pipelines may indirectly impact gathering services. FERC’s policies and practices across the range of its natural gas regulatory activities, including, for example, its policies on interstate open access transportation, ratemaking, capacity release and market center promotion may indirectly affect intrastate markets and gathering services. In recent years, FERC has pursued pro-competitive policies in its regulation of interstate natural gas pipelines. However, there can be no assurance that the FERC will continue to pursue this approach as it considers matters such as pipeline rates and rules and policies that may indirectly affect the natural gas gathering services.Natural gas gathering may receive greater regulatory scrutiny at the state level; therefore, Rattler LLC’s natural gas gathering operations could be adversely affected should they become subject to the application of state regulation of rates and services. Gathering operations could also be subject to safety and operational regulations relating to the design, construction, testing, operation, replacement and maintenance of gathering facilities. We cannot predict what effect, if any, such changes might have on Rattler’s or our operations, but additional capital expenditures and increased operating costs may result depending on future legislative and regulatory changes.Oil Sales and Transportation. Sales of crude oil, condensate and natural gas liquids are not currently regulated and are made at negotiated prices. Nevertheless, Congress could reenact price controls in the future. Our crude oil sales are affected by the availability, terms and cost of transportation. The transportation of oil in common carrier pipelines is also subject to rate regulation. FERC regulates interstate oil pipeline transportation rates under the Interstate Commerce Act, and our subsidiary Rattler LLC has a tariff on file with FERC to perform gathering service in interstate commerce. Intrastate oil pipeline transportation rates are subject to regulation by state regulatory commissions. The basis for intrastate oil pipeline regulation, and the degree of regulatory oversight and scrutiny given to intrastate oil pipeline rates, varies from state to state. Insofar as effective interstate and intrastate rates are equally applicable to all comparable shippers, we believe that the regulation of oil transportation rates will not affect our operations in any materially different way than such regulation will affect the operations of our competitors. 22Table of ContentsFurther, interstate and intrastate common carrier oil pipelines, including our subsidiary Rattler LLC, must provide service on a non-discriminatory basis. Under this open access standard, common carriers must offer service to all shippers requesting service on the same terms and under the same rates. When oil pipelines operate at full capacity, access is governed by prorationing provisions set forth in the pipelines’ published tariffs. Accordingly, we believe that access to oil pipeline transportation services generally will be available to us to the same extent as to our competitors.Safety and Maintenance Regulation. In our midstream operations, Rattler LLC is subject to regulation by the U.S. Department of Transportation, or DOT, under the Hazardous Liquids Pipeline Safety Act of 1979, or HLPSA, and comparable state statutes with respect to design, installation, testing, construction, operation, replacement and management of pipeline facilities. HLPSA covers petroleum and petroleum products, including natural gas liquids and condensate, and requires any entity that owns or operates pipeline facilities to comply with such regulations, to permit access to and copying of records and to file certain reports and provide information as required by the United States Secretary of Transportation. These regulations include potential fines and penalties for violations. We believe that we are in compliance in all material respects with these HLPSA regulations.Rattler LLC is also subject to the Natural Gas Pipeline Safety Act of 1968, or NGPSA, and the Pipeline Safety Improvement Act of 2002. The NGPSA regulates safety requirements in the design, construction, operation and maintenance of natural gas pipeline facilities while the Pipeline Safety Improvement Act establishes mandatory inspections for all United States crude oil and natural gas transportation pipelines and some gathering pipelines in high-consequence areas within ten years. DOT, through the Pipeline and Hazardous Materials Safety Administration, or PHMSA, has developed regulations implementing the Pipeline Safety Improvement Act that requires pipeline operators to implement integrity management programs, including more frequent inspections and other safety protections in areas where the consequences of potential pipeline accidents pose the greatest risk to people and their property.The Pipeline Safety and Job Creation Act, enacted in 2011, and the Protecting our Infrastructure of Pipelines and Enhancing Safety Act of 2016, also known as the PIPES Act, enacted in 2016, amended the HLPSA and NGPSA and increased safety regulation. The Pipeline Safety and Job Creation Act doubles the maximum administrative fines for safety violations from $100,000 to $200,000 for a single violation and from $1.0 million to $2.0 million for a related series of violations (now increased for inflation to $218,647 and $2,186,465, respectively), and provides that these maximum penalty caps do not apply to civil enforcement actions, establishes additional safety requirements for newly constructed pipelines, and requires studies of certain safety issues that could result in the adoption of new regulatory requirements for existing pipelines, including the expansion of integrity management, use of automatic and remote-controlled shut-off valves, leak detection systems, sufficiency of existing regulation of gathering pipelines, use of excess flow valves, verification of maximum allowable operating pressure, incident notification, and other pipeline-safety related requirements. The PIPES Act ensures that the PHMSA completes the Pipeline Safety and Job Creation Act requirements; reforms PHMSA to be a more dynamic, data-driven regulator; and closes gaps in federal standards.PHMSA has undertaken rulemakings to address many areas of this legislation. For example, on October 1, 2019, PHMSA published final rules to expand its integrity management requirements and impose new pressure testing requirements on regulated pipelines, including certain segments outside High Consequence Areas. The rules, once effective, also extend reporting requirements to certain previously unregulated gathering lines. The safety enhancement requirements and other provisions of the Pipeline Safety and Job Creation Act and the PIPES Act, as well as any implementation of PHMSA rules thereunder and/or related rule making proceedings, could require us to install new or modified safety controls, pursue additional capital projects or conduct maintenance programs on an accelerated basis, any or all of which tasks could result in our incurring increased operating costs that could have a material adverse effect on our results of operations or financial position. In addition, any material penalties or fines issued to us under these or other statutes, rules, regulations or orders could have an adverse impact on our business, financial condition, results of operation and cash flow.States are largely preempted by federal law from regulating pipeline safety but may assume responsibility for enforcing intrastate pipeline regulations at least as stringent as the federal standards, and many states have undertaken responsibility to enforce the federal standards. The Railroad Commission of Texas is the agency vested with intrastate natural gas pipeline regulatory and enforcement authority in Texas. The Commission’s regulations adopt by reference the minimum federal safety standards for the transportation of natural gas. In addition, on December 17, 2019, the Commission adopted rules requiring that operators of gathering lines take 'appropriate' actions to fix safety hazards. We do not anticipate any significant problems in complying with applicable federal and state laws and regulations in Texas. Our gathering pipelines have ongoing inspection and compliance programs designed to keep the facilities in compliance with pipeline safety and pollution control requirements.23Table of ContentsIn addition, we are subject to the requirements of the federal Occupational Safety and Health Act, or OSHA, and comparable state statutes, whose purpose is to protect the health and safety of workers. Moreover, the OSHA hazard communication standard, the EPA community right-to-know regulations under Title III of the federal Superfund Amendment and Reauthorization Act and comparable state statutes require that information be maintained concerning hazardous materials used or produced in our operations and that this information be provided to employees, state and local government authorities and citizens. Rattler LLC and the entities in which it owns an interest are also subject to OSHA Process Safety Management regulations, which are designed to prevent or minimize the consequences of catastrophic releases of toxic, reactive, flammable or explosive chemicals. These regulations apply to any process which involves a chemical at or above specified thresholds, or any process which involves flammable liquid or gas, pressurized tanks, caverns and wells in excess of 10,000 pounds at various locations. Flammable liquids stored in atmospheric tanks below their normal boiling point without the benefit of chilling or refrigeration are exempt from these standards. Also, the Department of Homeland Security and other agencies such as the EPA continue to develop regulations concerning the security of industrial facilities, including crude oil and natural gas facilities. We are subject to a number of requirements and must prepare Federal Response Plans to comply. We must also prepare Risk Management Plans under the regulations promulgated by the EPA to implement the requirements under the CAA to prevent the accidental release of extremely hazardous substances. We have an internal program of inspection designed to monitor and enforce compliance with safeguard and security requirements. We believe that we are in compliance in all material respects with all applicable laws and regulations relating to safety and security.State Regulation. Texas regulates the drilling for, and the production, gathering and sale of, oil and natural gas, including imposing severance taxes and requirements for obtaining drilling permits. Texas currently imposes a 4.6% severance tax on oil production and a 7.5% severance tax on natural gas production. States also regulate the method of developing new fields, the spacing and operation of wells and the prevention of waste of oil and natural gas resources. States may regulate rates of production and may establish maximum daily production allowables from oil and natural gas wells based on market demand or resource conservation, or both. States do not regulate wellhead prices or engage in other similar direct economic regulation, but we cannot assure you that they will not do so in the future. The effect of these regulations may be to limit the amount of oil and natural gas that may be produced from our wells and to limit the number of wells or locations we can drill.The petroleum industry is also subject to compliance with various other federal, state and local regulations and laws. Some of those laws relate to resource conservation and equal employment opportunity. We do not believe that compliance with these laws will have a material adverse effect on us. Operational Hazards and Insurance The oil and natural gas industry involves a variety of operating risks, including the risk of fire, explosions, blow outs, pipe failures and, in some cases, abnormally high pressure formations which could lead to environmental hazards such as oil spills, natural gas leaks and the discharge of toxic gases. If any of these should occur, we could incur legal defense costs and could be required to pay amounts due to injury, loss of life, damage or destruction to property, natural resources and equipment, pollution or environmental damage, regulatory investigation and penalties and suspension of operations. In accordance with what we believe to be industry practice, we maintain insurance against some, but not all, of the operating risks to which our business is exposed. We currently have insurance policies for onshore property (oil lease property/production equipment) for selected locations, rig physical damage protection, control of well protection for selected wells, comprehensive general liability, commercial automobile, workers compensation, pollution liability (claims made coverage with a policy retroactive date), excess umbrella liability and other coverage. Our insurance is subject to exclusion and limitations, and there is no assurance that such coverage will fully or adequately protect us against liability from all potential consequences, damages and losses. Any of these operational hazards could cause a significant disruption to our business. A loss not fully covered by insurance could have a material adverse effect on our financial position, results of operations and cash flows. See Item 1A. “Risk Factors–Risks Related to the Oil and Natural Gas Industry and Our Business–Operating hazards and uninsured risks may result in substantial losses and could prevent us from realizing profits.” We reevaluate the purchase of insurance, policy terms and limits annually. Future insurance coverage for our industry could increase in cost and may include higher deductibles or retentions. In addition, some forms of insurance may become unavailable in the future or unavailable on terms that we believe are economically acceptable. No assurance can be given that we will be able to maintain insurance in the future at rates that we consider reasonable and we may elect to maintain minimal or no insurance coverage. We may not be able to secure additional insurance or bonding that might be required by new governmental regulations. This may cause us to restrict our operations, which might severely impact our 24Table of Contentsfinancial position. The occurrence of a significant event, not fully insured against, could have a material adverse effect on our financial condition and results of operations. Generally, we also require our third-party vendors to sign master service agreements in which they agree to indemnify us for injuries and deaths of the service provider’s employees as well as contractors and subcontractors hired by the service provider. Human CapitalWe have developed a culture grounded upon the solid foundation of our core values—leadership, integrity, excellence, people and teamwork—that are adhered to throughout our company. We set a high bar for all of our employees in terms of how they operate and interact, both within the office and out in the field. We challenge them to identify new ways to foster a better future for themselves and for us.As of December 31, 2020, we had approximately 732 full time employees. None of our employees are represented by labor unions or covered by any collective bargaining agreements. We also utilize independent contractors and consultants involved in land, technical, regulatory and other disciplines to assist our full-time employees. Diversity and InclusionEqual employment opportunity is one of our core tenets and, as such, our employment decisions are based on merit, qualifications, competencies and contributions. We actively seek to attract and retain an increasingly diverse workforce and continue to cultivate an inclusive and respectful work environment. We deeply value the perspectives and experiences from our diverse team and are proud of our team, rich in a range of ethnic, cultural and ideological backgrounds. Nearly a third of our employees are women and 25% self-identify as ethnic minorities. We have taken various actions during 2020 to increase the diversity in our candidate pool, and broaden our outreach, particularly within our intern program, through various student organizations to support this inclusion effort. Health and SafetyProtecting employees, the public and the environment is a top priority in our operations and in the way we manage our assets. We are focused on minimizing the risk of workplace incidents and preparing for emergencies as an indelible element of our corporate responsibility. We also strive to comply with all applicable health, safety and environmental standards, laws and regulations.Through a unified orientation initiative called Basin United, we and other oil and natural gas operators have committed to reduce injuries and fatalities in our industry. We are aligning our employees and independent contractors around the International Association of Oil & Gas Producers Life Saving Rules, safety culture improvements, safety leadership actions and human performance principles. We also involve employees from all operational levels on our Safety Committee, which provides suggested improvements to the overall safety program, recommended preventative measures based on reviewing vehicle and personnel incidents, safety and environmental audits at operational locations and audit and oversight of the Diamondback Hazard Communication Program, in accordance with OSHA regulations.From 2016 through 2020, we had zero employee work-related fatalities. Our employee OSHA recordable cases, comprising work-related injuries and illnesses that require medical treatment beyond first aid, totaled three in 2020, flat from three in 2019. Our employee total recordable incident rate (TRIR) in 2020 was flat from 2019 and lost-time incident rate (LTIR) decreased in 2020. We have set a short-term target of maintaining an employee TRIR of 0.5 or less.Training and DevelopmentWe support employees in pursuing training opportunities to expand their professional skills. Our internal course offerings in 2020 included a wide array of topics such as Excel Power Lunch, Performance Management, COVID-19 Safety Training, as well as various and extensive safety and other compliance training sessions. In 2020, our team completed nearly 8,000 hours of training. Additionally, our people also undergo training and education each year on regulatory compliance, industry standards and innovative opportunities to effectively manage the challenges of developing our resources.25Table of ContentsOur FacilitiesOur corporate headquarters is located at the Fasken Center in Midland, Texas. We also lease additional office space in Houston, Texas, Midland, Texas and Oklahoma City, Oklahoma.Availability of Company ReportsOur annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and all amendments to those reports are available free of charge on the Investor Relations page of our website at www.diamondbackenergy.com as soon as reasonably practicable after such material is electronically filed with, or furnished to, the SEC. Information contained on, or connected to, our website is not incorporated by reference into this Annual Report and should not be considered part of this or any other report that we file with or furnish to the SEC.Risk Factors SummaryThe following is a summary of the principal risks that could adversely affect our business, operations and financial results. Please refer to Item 1A “Risk Factors” of this Form 10-K below for additional discussion of the risks summarized in this Risk Factors Summary.Risks Relating to the Pending Merger and to Diamondback Following the Completion of the Pending Merger•The pending merger may not be completed and the merger agreement may be terminated in accordance with its terms, which could negatively impact the price of our common stock and our results.•We will incur significant transaction and merger-related costs in connection with the pending merger.•We and our subsidiaries will have substantial indebtedness after giving effect to the pending merger, which may limit our financial flexibility and adversely affect our financial results.•An adverse ruling in the pending or any future lawsuits relating to the merger could result in an injunction preventing the completion of the merger and/or substantial costs to us and QEP.•We may not achieve the intended benefits of the pending merger or do so within the intended timeframe, and it may not be accretive, and may be dilutive, to our earnings per share.•The market price of our common stock will continue to fluctuate after the pending merger is completed, and may decline if the benefits of the pending merger do not meet the expectations of financial analysts.•Following the completion of the pending merger, we may incorporate QEP’s hedging activities into our business and, as a result, may be exposed to additional commodity price risks arising from such hedges.•The combined company may record goodwill and other intangible assets that could become impaired and result in material non-cash charges to the results of operations of the combined company in the future.•The combined company may not be able to retain customers or suppliers, and customers or suppliers may seek to modify contractual obligations with the combined company, either of which could have an adverse effect on the combined company’s business and operations.Risks Related to the Oil and Natural Gas Industry and Our Business•Our business and operations have been and will likely continue to be adversely affected by the ongoing COVID-19 pandemic.•Market conditions and particularly volatility in prices for oil and natural gas may continue to adversely affect our revenue, cash flows, profitability, growth, production and the present value of our estimated reserves.•We may be unable to obtain needed capital or financing on satisfactory terms or at all to fund our acquisitions or development activities, which could lead to a loss of properties and a decline in our oil and natural gas reserves and future production. •Our failure to successfully identify, complete and integrate pending and future acquisitions of properties or businesses could reduce our earnings, and title defects in the properties in which we invest may lead to losses.•Our identified potential drilling locations are susceptible to uncertainties that could materially alter the occurrence or timing of their drilling.•Despite our hedging activities, we may be adversely affected by continuing and prolonged declines in the price of oil and may be exposed to other risks, including counterparty credit risk.•If production from our Permian Basin acreage decreases, we may fail to meet our obligations to deliver specified quantities of oil under our oil purchase contract, which may adversely affect our operations.•The inability of one or more of our customers to meet their obligations, or loss of one or more of our significant purchasers, may adversely affect our financial results.•Our method of accounting for investments in oil and natural gas properties may result in impairment of asset value. 26Table of Contents•Any material inaccuracies in these reserve estimates or underlying assumptions will materially affect the quantities and present value of our reserves.•We are vulnerable to risks associated with our primary operations concentrated in a single geographic area.•If transportation or other facilities, certain of which we do not control, or rigs, equipment, raw materials, oil services or personnel are unavailable, our operations could be interrupted and our revenues reduced.•Our operations are subject to various governmental laws and regulations which require compliance that can be burdensome and expensive and may impose restrictions on our operations.•Recent and future U.S. tax legislation may adversely affect our business, results of operations, financial condition and cash flow.•Drilling for and producing oil and natural gas are high-risk activities with many uncertainties that may result in a total loss of investment and adversely affect our business, financial condition or results of operations.•A terrorist attack or armed conflict could harm our business and could adversely affect our business.•A cyber incident could result in information theft, data corruption, operational disruption and/or financial loss. Risks Related to Our Indebtedness•Our substantial level of indebtedness could adversely affect our financial condition and prevent us from fulfilling our obligations under our indebtedness, and we and our subsidiaries may be able to incur substantial additional indebtedness in the future.•A reduction in availability under our revolving credit facility and the inability to otherwise obtain financing for our capital programs could require us to curtail our capital expenditures.•Restrictive covenants in certain of our existing and future debt instruments may limit our ability to respond to changes in market conditions or pursue business opportunities.•We depend on our subsidiaries for dividends, distributions and other payments.•If we experience liquidity concerns, we could face a downgrade in our debt ratings which could restrict our access to, and negatively impact the terms of, current or future financings or trade credit.•Borrowings under our, Viper LLC’s and Rattler LLC’s revolving credit facilities expose us to interest rate risk. Risks Related to Our Common Stock•The corporate opportunity provisions in our certificate of incorporation could enable affiliates of ours to benefit from corporate opportunities that might otherwise be available to us.•If the price of our common stock fluctuates significantly, your investment could lose value.•The declaration of dividends and any repurchases of our common stock are each within the discretion of our board of directors, and there is no guarantee that we will pay any dividends on or repurchases of our common stock in the future or at levels anticipated by our stockholders.•A change of control could limit our use of net operating losses.•If our operating results do not meet expectations of securities or industry analysts, our stock price could decline.•We may issue preferred stock whose terms could adversely affect the voting power or value of our common stock.•Provisions in our certificate of incorporation and bylaws and Delaware law make it more difficult to effect a change in control of the company, which could adversely affect the price of our common stock.27Table of ContentsITEM 1A. RISK FACTORSThe nature of our business activities subjects us to certain hazards and risks. The following is a summary of some of the material risks relating to our business activities. Other risks are described in Item 1. “Business and Properties,” Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and Item 7A. “Quantitative and Qualitative Disclosures About Market Risk.” These risks are not the only risks we face. We could also face additional risks and uncertainties not currently known to us or that we currently deem to be immaterial. If any of these risks actually occurs, it could materially harm our business, financial condition or results of operations and the trading price of our shares could decline.Risks Relating to the Pending MergerThe pending merger may not be completed and the merger agreement may be terminated in accordance with its terms. Failure to complete the pending merger could negatively impact the price of shares of our common stock and our future businesses and financial results.The pending merger is subject to a number of conditions that must be satisfied, including the approval by QEP stockholders of the merger agreement proposal, or, to the extent permitted by applicable law, waived, in each case prior to the completion of the pending merger. The conditions to the completion of the pending merger, some of which are beyond our control, may not be satisfied or waived in a timely manner or at all, and, accordingly, the pending merger may be delayed or may not be completed. In addition, if the pending merger is not completed by June 30, 2021, or, in certain instances, on or before September 30, 2021, either we or QEP may choose not to proceed with the pending merger by terminating the merger agreement, and the parties can mutually decide to terminate the merger agreement at any time, before or after stockholder approval. Further, either we or QEP may elect to terminate the merger agreement in certain other circumstances specified in the merger agreement. If the transactions contemplated by the merger agreement are not completed for any reason, our ongoing business, financial condition and financial results may be adversely affected. Without realizing any of the benefits of having completed the transactions, we will be subject to a number of risks, including the following:•we may be required to pay our costs relating to the transactions, which are substantial, such as legal, accounting, financial advisory and printing fees, whether or not the transactions are completed; •time and resources committed by our management to matters relating to the transactions could otherwise have been devoted to pursuing other beneficial opportunities;•we may experience negative reactions from financial markets, including negative impacts on the price of our common stock, including to the extent that the current market price reflects a market assumption that the transactions will be completed;•we may experience negative reactions from employees, customers or vendors; and•since the merger agreement restricts the conduct of our business prior to completion of the pending merger, we may not have been able to take certain actions during the pendency of the merger that would have benefitted us as an independent company and the opportunity to take such actions may no longer be available.We will be subject to business uncertainties while the merger is pending, which could adversely affect our business.Uncertainty about the effect of the pending merger on employees, industry contacts and business partners may have an adverse effect on us. These uncertainties may impair our ability to attract, retain and motivate key personnel until the pending merger is completed and for a period of time thereafter and could cause industry contacts, business partners and others that deal with us to seek to change their existing business relationships with us. In addition, the merger agreement restricts the parties to the merger agreement from entering into certain corporate transactions and taking other specified actions without the consent of the other party. These restrictions may prevent us from pursuing attractive business opportunities that may arise prior to the completion of the pending merger.We will incur significant transaction and merger-related costs in connection with the pending merger, which may be in excess of those anticipated by us. We have incurred and expect to continue to incur a number of non-recurring costs associated with negotiating and completing the pending merger, combining the operations of the two companies and achieving desired synergies. These fees and costs have been, and will continue to be, substantial. The substantial majority of non-recurring expenses will consist of transaction costs related to the pending merger and include, among others, employee retention costs, fees paid to financial, legal and accounting advisors, severance and benefit costs and filing fees. 28Table of ContentsWe will also incur transaction fees and costs related to the integration of the companies, which may be substantial. Moreover, we may incur additional unanticipated expenses in connection with the pending merger and the integration, including costs associated with any stockholder litigation related to the pending merger. Although we expect that the elimination of duplicative costs, as well as the realization of other efficiencies related to the integration of the businesses, should allow us to offset integration-related costs over time, this net benefit may not be achieved in the near term, or at all. The costs described above, as well as other unanticipated costs and expenses, could have a material adverse effect on the financial condition and operating results of the combined company following the completion of the pending merger.We and our subsidiaries will have substantial indebtedness after giving effect to the pending merger, which may limit our financial flexibility and adversely affect our financial results.Under the merger agreement, QEP’s outstanding debt (other than its existing credit facility) will remain outstanding, which debt, as of December 31, 2020 was approximately $1.6 billion and consisted of amounts outstanding under QEP’s senior notes. As of December 31, 2020, we had total long-term debt of approximately $5.6 billion, consisting primarily of the amounts outstanding under our revolving credit facility, our senior unsecured notes, the notes issued by our subsidiary Energen Corporation, the senior notes issued by our publicly traded subsidiaries, Viper and Rattler, and the amounts outstanding under Viper’s and Rattler’s revolving credit facilities. Our pro forma indebtedness as of December 31, 2020, assuming consummation of the pending merger had occurred on such date and QEP’s senior notes remain outstanding, would have been approximately $7.4 billion, representing an increase in comparison to our indebtedness on a recent historical basis. We believe that post-merger we will retain our investment grade credit ratings and retire the combined company’s pro forma debt at a faster rate than either company would have been able to do absent the pending merger. However, any increase in our indebtedness could have adverse effects on our financial condition and results of operations, including:•increasing difficulty to satisfy our obligations with respect to our debt obligations, including any repurchase obligations that may arise thereunder;•diverting a significant portion of our cash flows to service our indebtedness, which could reduce the funds available to us for operations and other purposes;•increasing our vulnerability to general adverse economic and industry conditions;•placing us at a competitive disadvantage compared to our competitors that are less leveraged and, therefore, may be able to take advantage of opportunities that we would be unable to pursue due to our indebtedness;•limiting our ability to access the capital markets to raise capital on favorable terms;•impairing our ability to obtain additional financing in the future for working capital, capital expenditures, acquisitions, general corporate or other purposes; and•increasing our vulnerability to interest rate increases, as our borrowings under our revolving credit facility are at variable interest rates.We believe that the combined company will have flexibility to repay, refinance, repurchase, redeem, exchange or otherwise terminate large portions of our outstanding debt obligations. However, there can be no guarantee that we would be able to execute such refinancings on favorable terms or at all, and a high level of indebtedness increases the risk that we may default on our debt obligations, including from the debt obligations of QEP. Our ability to meet our debt obligations and to reduce our level of indebtedness depends on our future performance. Our future performance depends on many factors independent of the pending merger, some of which are beyond our control, such as general economic conditions and oil and natural gas prices. We may not be able to generate sufficient cash flows to pay the interest on our debt, and future working capital, borrowings or equity financing may not be available to pay or refinance such debt.Lawsuits have been filed against QEP, us, Merger Sub and the members of the QEP board in connection with the merger and additional lawsuits may be filed in the future. An adverse ruling in any such lawsuit could result in an injunction preventing the completion of the merger and/or substantial costs to us and QEP.Securities class action lawsuits and derivative lawsuits are often brought against public companies that have entered into acquisition, merger or other business combination agreements like the merger agreement. Even if such a lawsuit is without merit, defending against these claims can result in substantial costs and divert management time and resources. As of February 22, 2021, nine individual lawsuits have been filed by purported QEP stockholders in United States District Courts in connection with the proposed merger. All nine lawsuits name QEP and the members of the QEP board as defendants, and two of the nine lawsuits name us and Merger Sub as defendants. The complaints allege, among other things, that the registration statements relating to the merger on Form S-4 filed by us on January 22, 2021, as amended on Form S-4/A filed on February 3, 2021, and the Schedule 14A Definitive Proxy Statement filed by QEP on February 10, 2021 fail to provide certain allegedly material information concerning the proposed merger in violation of Sections 14(a) and 20(a) of the Exchange Act and Rule 14a-9 promulgated thereunder. In addition to these allegations, some of the complaints allege that the merger consideration to be received by the QEP stockholders in the merger is unfair because the value of the QEP common 29Table of Contentsstock is in excess of the value of the merger consideration, that the "no solicitation" clause in the merger agreement is improper and that the termination fee contemplated by the merger agreement is excessive. Some of the complaints also assert a breach of fiduciary duty claim under state law against individual QEP board members. Among other remedies, the plaintiffs seek to enjoin the completion of the proposed merger, a recission of the completed merger or rescissory damages, an accounting of damages suffered by the plaintiff, an award of plaintiff’s expenses and attorney’s fees, and other relief.Each of us and QEP believes that the allegations in the complaints are without merit. Additional lawsuits arising out of the merger may also be filed in the future.One of the conditions to the closing of the merger is that no injunction by any governmental entity having jurisdiction over us, QEP or Merger Sub has been entered and continues to be in effect and no law has been adopted, in either case that prohibits the closing of the merger. Consequently, if a plaintiff is successful in obtaining an injunction prohibiting completion of the merger, that injunction may delay or prevent the merger from being completed within the expected timeframe or at all, which may adversely affect our business, financial position and results of operations.Additionally, there can be no assurance that any of the defendants will be successful in the outcome of the lawsuits filed thus far or any potential future lawsuits. The defense or settlement of any lawsuit or claim that remains unresolved at the time the merger is completed may adversely affect our business, financial condition, results of operations and cash flows.Risk Factors Relating to Diamondback Following the Completion of the Pending MergerThe integration of QEP into our business may not be as successful as anticipated, and we may not achieve the intended benefits or do so within the intended timeframe. The pending merger involves numerous operational, strategic, financial, accounting, legal, tax and other risks, potential liabilities associated with the acquired businesses, and uncertainties related to design, operation and integration of QEP’s internal control over financial reporting. Difficulties in integrating QEP into our business may result in us performing differently than expected, operational challenges, or the failure to realize anticipated expense-related efficiencies. Potential difficulties that may be encountered in the integration process include, among others: •the inability to successfully integrate QEP into our business in a manner that permits us to achieve the full revenue and cost savings anticipated from the pending merger;•complexities associated with managing the larger, more complex, integrated business;•not realizing anticipated operating synergies; •integrating personnel from the two companies and the loss of key employees; •potential unknown liabilities and unforeseen expenses, delays or regulatory conditions associated with the pending merger; •integrating relationships with industry contacts and business partners; •performance shortfalls as a result of the diversion of management’s attention caused by completing the pending merger and integrating QEP’s operations into our operations; and•the disruption of, or the loss of momentum in, ongoing business or inconsistencies in standards, controls, procedures and policies. Additionally, the success of the pending merger will depend, in part, on our ability to realize the anticipated benefits and cost savings from combining our and QEP’s businesses, including operational and other synergies that we believe the combined company will achieve. The anticipated benefits and cost savings of the pending merger may not be realized fully or at all, may take longer to realize than expected, or could have other adverse effects that we do not currently foresee.Our results may suffer if we do not effectively manage our expanded operations following the pending merger. The success of the pending merger will depend, in part, on our ability to realize the anticipated benefits and cost savings from combining our and QEP’s businesses, including the need to integrate the operations and business of QEP into our existing business in an efficient and timely manner, to combine systems and management controls and to integrate relationships with customers, vendors, industry contacts and business partners. The anticipated benefits and cost savings of the pending merger may not be realized fully or at all, may take longer to realize than expected or could have other adverse effects that we do not currently foresee. Some of the assumptions that we have made, such as the achievement of operating synergies, may not be realized. There could also be unknown liabilities and unforeseen expenses associated with the pending merger that were not discovered in the due diligence review conducted by each company prior to entering into the merger agreement.30Table of ContentsThe pending merger may not be accretive, and may be dilutive, to our earnings per share, which may negatively affect the market price of our common stock. Because shares of our common stock will be issued in the pending merger, it is possible that, although we currently expect the merger to be accretive to earnings per share, the merger may be dilutive to our earnings per share, which could negatively affect the market price of our common stock. In connection with the completion of the pending merger, based on the number of issued and outstanding shares of QEP common stock as of February 22, 2021 and the number of outstanding QEP equity awards currently estimated to be payable in our common stock following the merger, we will issue up to approximately 12.4 million shares of our common stock. The issuance of these new shares of our common stock could have the effect of depressing the market price of our common stock, through dilution of earnings per share or otherwise. Any dilution of, or delay of any accretion to, our earnings per share could cause the price of shares of our common stock to decline or increase at a reduced rate. Furthermore, our current stockholders may not wish to continue to invest in the additional operations of the combined company, or for other reasons may wish to dispose of some or all of their interests in the combined company, and as a result may seek to sell their shares of our common stock following, or in anticipation of, completion of the pending merger. The merger agreement does not restrict the ability of former QEP stockholders to sell such shares of our common stock following completion of the pending merger. Therefore, these sales (or the perception that these sales may occur), coupled with the increase in the outstanding number of shares of our common stock, may affect the market for, and the market price of, our common stock in an adverse manner.If the pending merger is completed and our stockholders, including former QEP stockholders, sell substantial amounts of our common stock in the public market following the consummation of the pending merger, the market price of our common stock may decrease. These sales might also make it more difficult for us to raise capital by selling equity or equity-related securities at a time and price that it otherwise would deem appropriate.The market price of our common stock will continue to fluctuate after the pending merger, and may decline if the benefits of the pending merger do not meet the expectations of financial analysts.Upon completion of the pending merger, holders of QEP common stock who receive merger consideration will become holders of shares of our common stock. The market price of our common stock may fluctuate significantly following completion of the pending merger and holders of QEP common stock could lose some or all of the value of their investment in our common stock. In addition, the stock market has recently experienced significant price and volume fluctuations which could, if such fluctuations continue to occur, have a material adverse effect on the market for, or liquidity of, our common stock, regardless of our actual operating performance.The market price of our common stock may be affected by factors different from those that historically have affected QEP common stock or our common stock. Our business differs from that of QEP in certain respects, and, accordingly, our financial position or results of operations and/or cash flows after the pending merger is completed, as well as the market price of our common stock, may be affected by factors different from those currently affecting our financial position or results of operations and/or cash flows as an independent standalone company.Following the completion of the pending merger, we may incorporate QEP’s hedging activities into our business and, as a result, may be exposed to additional commodity price risks arising from such hedges.To mitigate its exposure to changes in commodity prices, QEP hedges oil and natural gas prices from time to time, primarily through the use of certain derivative instruments. If we assume QEP’s existing derivative instruments or if QEP enters into additional derivative instruments prior to the completion of the pending merger, we will bear the economic impact of the contracts following the completion of the pending merger. Actual crude oil and natural gas prices may differ from the combined company’s expectations and, as a result, such derivative instruments may have a negative impact on our business.The combined company may record goodwill and other intangible assets that could become impaired and result in material non-cash charges to the results of operations of the combined company in the future.The pending merger will be accounted for as an acquisition by us in accordance with GAAP. Under the acquisition method of accounting, the assets and liabilities of QEP and its subsidiaries will be recorded, as of completion of the pending merger, at their respective fair values and added to those of us. Our reported financial condition and results of operations for the periods after completion of the pending merger will reflect QEP balances and results after completion of the pending 31Table of Contentsmerger but will not be restated retroactively to reflect the historical financial position or results of operations of QEP and its subsidiaries for periods prior to the completion of the pending merger.Under the acquisition method of accounting, the total purchase price will be allocated to QEP’s tangible assets and liabilities and identifiable intangible assets based on their fair values as of the date of completion of the pending merger. The excess of the purchase price over those fair values will be recorded as goodwill. We expect that the pending merger may result in the creation of goodwill based upon the application of the acquisition method of accounting. To the extent goodwill or intangibles are recorded and the values become impaired, the combined company may be required to recognize material non-cash charges relating to such impairment. The combined company’s operating results may be significantly impacted from both the impairment and underlying trends in the business that triggered the impairment.The combined company may not be able to retain customers or suppliers, and customers or suppliers may seek to modify contractual obligations with the combined company, either of which could have an adverse effect on the combined company’s business and operations. Third parties may terminate or alter existing contracts or relationships with us as a result of the pending merger. As a result of the pending merger, the combined company may experience impacts on relationships with customers and suppliers that may harm the combined company’s business and results of operations. Certain customers or suppliers may seek to terminate or modify contractual obligations following the completion of the pending merger whether or not contractual rights are triggered as a result of the pending merger. There can be no guarantee that customers and suppliers will remain with or continue to have a relationship with the combined company or do so on the same or similar contractual terms following the closing of the pending merger. If any customers or suppliers seek to terminate or modify contractual obligations or discontinue their relationships with the combined company, then the combined company’s business and results of operations may be harmed. If the combined company’s suppliers were to seek to terminate or modify an arrangement with the combined company, then the combined company may be unable to procure necessary supplies or services from other suppliers in a timely and efficient manner and on acceptable terms, or at all.QEP also has contracts with vendors, landlords, licensors and other business partners which may require QEP to obtain consent from these other parties in connection with the pending merger. If these consents cannot be obtained, the combined company may suffer a loss of potential future revenue, incur costs and/or lose rights that may be material to the business of the combined company. In addition, third parties with whom Diamondback or QEP currently have relationships may terminate or otherwise reduce the scope of their relationship with either party in anticipation of the closing of the pending merger. Any such disruptions could limit the combined company’s ability to achieve the anticipated benefits of the pending merger. The adverse effect of any such disruptions could also be exacerbated by a delay in the completion of the pending merger or by a termination of the merger agreement.Declaration, payment and amounts of dividends, if any, distributed to our stockholders will be uncertain. Although we have paid cash dividends on our common stock in the past, our board of directors may determine not to declare dividends in the future or may reduce the amount of dividends paid in the future. Any payment of future dividends will be at the discretion of our board of directors and will depend on our results of operations, financial condition, cash requirements, future prospects and other considerations that our board of directors deems relevant.Risks Related to the Oil and Natural Gas Industry and Our BusinessOur business and operations have been and will likely continue to be adversely affected by the ongoing COVID-19 pandemic.The spread of COVID-19 caused, and is continuing to cause, severe disruptions in the worldwide and U.S. economies, including contributing to the reduced global and domestic demand for oil and natural gas, which has had and will likely continue to have an adverse effect on our business, financial condition and results of operations. Moreover, since the beginning of January 2020, the COVID-19 pandemic has caused significant disruption in the financial markets both globally and in the United States. The continued spread of COVID-19 could also negatively impact the availability of key personnel necessary to conduct our business. If COVID-19 continues to spread or the response to contain or mitigate the COVID-19 pandemic through the development and availability of effective treatments and vaccines, including the vaccines recently approved by the FDA for emergency use in the U.S., is unsuccessful, we could continue to experience material adverse effects on our business, financial condition and results of operations. Due to the rapid development and fluidity of this situation, we cannot make any prediction as to the ultimate material adverse impact of the COVID -19 pandemic on our business, financial condition and results of operations. 32Table of ContentsThe sharp decline in oil and natural gas prices and continued volatility in the oil and natural gas markets have negatively impacted, and are likely to continue to negatively impact, our exploration and production activities, which has adversely impacted our business, financial condition and results of operations. In addition, lower oil and natural gas prices may adversely affect the borrowing base under our revolving credit facility and estimates of our proved reserves.In early March 2020, oil prices dropped sharply and then continued to decline reaching negative levels. This was a result of multiple factors affecting the supply and demand in global oil and natural gas markets, including actions taken by OPEC members and other exporting nations impacting commodity price and production levels and a significant decrease in demand due to the ongoing COVID-19 pandemic. While OPEC members and certain other nations agreed in April 2020 to cut production and subsequently extended such production cuts through December 2020, which helped to reduce a portion of the excess supply in the market and improve crude oil prices, they agreed to increase production by 500,000 barrels per day beginning in January 2021. As a result, downward pressure on commodity prices has continued and could continue for the foreseeable future. We cannot predict if or when commodity prices will stabilize and at what levels.As a result of the reduction in crude oil demand caused by factors discussed above, we lowered our 2020 capital budget and production guidance, curtailed near term production and reduced our rig count, all of which may be subject to further reductions or curtailments if the commodity markets and macroeconomic conditions worsen. Although we have restored our curtailed production, actions taken in response to the COVID-19 pandemic and depressed commodity pricing environment have had and are expected to continue to have an adverse effect on our business, financial results and cash flows.Based on the results of the quarterly ceiling test, we were required to record an impairment on our proved oil and natural gas interests for the year ended December 31, 2020. If commodity prices fall below current levels, we may be required to record impairments in future periods and such impairments could be material. Further, if commodity prices decrease, our production, proved reserves and cash flows will be adversely impacted.Other significant factors that are likely to continue to affect commodity prices in future periods include, but are not limited to, the effect of U.S. energy, monetary and trade policies, U.S. and global political and economic developments, including the Biden Administration’s energy and environmental policies and the impact of the ongoing COVID-19 pandemic on conditions in the U.S. oil and natural gas industry, all of which are beyond our control.Our results of operations may be also adversely impacted by any future government rule, regulation or order that may impose production limits, as well as pipeline capacity and storage constraints, in the Permian Basin where we operate.We cannot predict the ultimate impact of these factors on our business, financial condition and results of operation.Increased costs of capital could adversely affect our business.Our business could be harmed by factors such as the availability, terms and cost of capital, increases in interest rates or a reduction in our credit rating. Changes in any one or more of these factors could cause our cost of doing business to increase, limit our access to capital, limit our ability to pursue acquisition opportunities, reduce our cash flows available for drilling and place us at a competitive disadvantage. Continuing disruptions and volatility in the global financial markets may lead to an increase in interest rates or a contraction in credit availability impacting our ability to finance our activities. A significant reduction in the availability of credit could materially and adversely affect our ability to achieve our business strategy and cash flows. Market conditions for oil and natural gas, and particularly volatility in prices for oil and natural gas, have in the past adversely affected, and may in the future adversely affect, our revenue, cash flows, profitability, growth, production and the present value of our estimated reserves.Our revenues, operating results, profitability, future rate of growth and the carrying value of our oil and natural gas properties depend significantly upon the prevailing prices for oil and natural gas. Historically, oil and natural gas prices have been volatile and are subject to fluctuations in response to changes in supply and demand, market uncertainty and a variety of additional factors that are beyond our control, including; the domestic and foreign supply of oil and natural gas; the level of prices and expectations about future prices of oil and natural gas; the level of global oil and natural gas exploration and production; the cost of exploring for, developing, producing and delivering oil and natural gas; the price and quantity of foreign imports; political and economic conditions in oil producing countries, including the Middle East, Africa, South America and Russia; the ability of members of the Organization of Petroleum Exporting Countries to agree to and maintain oil price and production controls; speculative trading in crude oil and natural gas derivative contracts; the level of consumer 33Table of Contentsproduct demand; extreme weather conditions and other natural disasters; risks associated with operating drilling rigs; technological advances affecting energy consumption; the price and availability of alternative fuels; domestic and foreign governmental regulations and taxes; the continued threat of terrorism and the impact of military and other action, including U.S. military operations in the Middle East; global or national health concerns, including the outbreak of pandemic or contagious disease, such as COVID-19; the proximity, cost, availability and capacity of oil and natural gas pipelines and other transportation facilities; and overall domestic and global economic conditions. These factors and the volatility of the energy markets make it extremely difficult to predict future oil and natural gas price movements with any certainty. During 2020, NYMEX WTI prices ranged from $(37.63) to $63.27 per Bbl and the NYMEX Henry Hub price of natural gas ranged from $1.48 to $3.35 per MMBtu. If the prices of oil and natural gas decline further, our operations, financial condition and level of expenditures for the development of our oil and natural gas reserves may be materially and adversely affected. In addition, lower oil and natural gas prices may reduce the amount of oil and natural gas that we can produce economically. This may result in our having to make substantial downward adjustments to our estimated proved reserves. If this occurs or if our production estimates change or our exploration or development activities are curtailed, full cost accounting rules may require us to write-down, as a non-cash charge to earnings, the carrying value of our oil and natural gas properties. Reductions in our reserves could also negatively impact the borrowing base under our revolving credit facility, which could further limit our liquidity and ability to conduct additional exploration and development activities.A significant portion of our net leasehold acreage is undeveloped, and that acreage may not ultimately be developed or become commercially productive, which could cause us to lose rights under our leases as well as have a material adverse effect on our oil and natural gas reserves and future production and, therefore, our future cash flow and income. A significant portion of our net leasehold acreage is undeveloped, or acreage on which wells have not been drilled or completed to a point that would permit the production of commercial quantities of oil and natural gas regardless of whether such acreage contains proved reserves. In addition, many of our oil and natural gas leases require us to drill wells that are commercially productive, and if we are unsuccessful in drilling such wells, we could lose our rights under such leases. Our future oil and natural gas reserves and production and, therefore, our future cash flow and income are highly dependent on successfully developing our undeveloped leasehold acreage. Our development and exploration operations and our ability to complete acquisitions require substantial capital and we may be unable to obtain needed capital or financing on satisfactory terms or at all, which could lead to a loss of properties and a decline in our oil and natural gas reserves. The oil and natural gas industry is capital intensive. We make and expect to continue to make substantial capital expenditures in our business and operations for the exploration for and development, production and acquisition of oil and natural gas reserves. In 2020, our total capital expenditures, including expenditures for drilling, infrastructure and additions to midstream assets, were approximately $1.9 billion. Our 2021 capital budget for drilling, completion and infrastructure, including investments in water disposal infrastructure and gathering line projects, is currently estimated to be approximately $1.4 billion to $1.6 billion, representing a decrease of 50% from our 2020 capital budget. Since completing our initial public offering in October 2012, we have financed capital expenditures primarily with borrowings under our revolving credit facility, cash generated by operations and the net proceeds from public offerings of our common stock and the senior notes.We intend to finance our future capital expenditures for our drilling operations with cash flow from operations, while future acquisitions may also be funded from operations as well as proceeds from offerings of our debt and equity securities and borrowings under our revolving credit facility. Our cash flow from operations and access to capital are subject to a number of variables, including; our proved reserves; the volume of oil and natural gas we are able to produce from existing wells; the prices at which our oil and natural gas are sold; our ability to acquire, locate and produce economically new reserves; and our ability to borrow under our credit facility.We cannot assure you that our operations and other capital resources will provide cash in sufficient amounts to maintain planned or future levels of capital expenditures. Further, our actual capital expenditures in 2021 could exceed our capital expenditure budget. In the event our capital expenditure requirements at any time are greater than the amount of capital we have available, we could be required to seek additional sources of capital, which may include traditional reserve base borrowings, debt financing, joint venture partnerships, production payment financings, sales of assets, offerings of debt or equity securities or other means. We cannot assure you that we will be able to obtain debt or equity financing on terms favorable to us, or at all. 34Table of ContentsIf we are unable to fund our capital requirements, we may be required to curtail our operations relating to the exploration and development of our prospects, which in turn could lead to a possible loss of properties and a decline in our oil and natural gas reserves, or we may be otherwise unable to implement our development plan, complete acquisitions or take advantage of business opportunities or respond to competitive pressures, any of which could have a material adverse effect on our production, revenues and results of operations. In addition, a delay in or the failure to complete proposed or future infrastructure projects could delay or eliminate potential efficiencies and related cost savings. Our success depends on finding, developing or acquiring additional reserves. Our future success depends upon our ability to find, develop or acquire additional oil and natural gas reserves that are economically recoverable. Our proved reserves will generally decline as reserves are depleted, except to the extent that we conduct successful exploration or development activities or acquire properties containing proved reserves, or both. To increase reserves and production, we undertake development, exploration and other replacement activities or use third parties to accomplish these activities. We have made, and expect to make in the future, substantial capital expenditures in our business and operations for the development, production, exploration and acquisition of oil and natural gas reserves. We may not have sufficient resources to acquire additional reserves or to undertake exploration, development, production or other replacement activities, such activities may not result in significant additional reserves and we may not have success drilling productive wells at low finding and development costs. If we are unable to replace our current production, the value of our reserves will decrease, and our business, financial condition and results of operations would be adversely affected. Furthermore, although our revenues may increase if prevailing oil and natural gas prices increase significantly, our finding costs for additional reserves could also increase. Our failure to successfully identify, complete and integrate pending and future acquisitions of properties or businesses could reduce our earnings and slow our growth. There is intense competition for acquisition opportunities in our industry. The successful acquisition of producing properties requires an assessment of several factors, including; recoverable reserves, future oil and natural gas prices and their applicable differentials, operating costs, and potential environmental and other liabilities.The accuracy of these assessments is inherently uncertain, and we may not be able to identify attractive acquisition opportunities. In connection with these assessments, we perform a review of the subject properties that we believe to be generally consistent with industry practices. Our review will not reveal all existing or potential problems nor will it permit us to become sufficiently familiar with the properties to assess fully their deficiencies and capabilities. Inspections may not always be performed on every well, and environmental problems, such as groundwater contamination, are not necessarily observable even when an inspection is undertaken. Even when problems are identified, the seller may be unwilling or unable to provide effective contractual protection against all or part of the problems. Even if we do identify attractive acquisition opportunities, we may not be able to complete the acquisition or do so on commercially acceptable terms.Competition for acquisitions may increase the cost of, or cause us to refrain from, completing acquisitions. Our ability to complete acquisitions is dependent upon, among other things, our ability to obtain debt and equity financing and, in some cases, regulatory approvals. If these acquisitions include geographic regions in which we do not currently operate, as in the case of the pending merger with QEP, we could be subject to unforeseen operating difficulties and difficulties in coordinating geographically dispersed operations, personnel and facilities. In addition, if we enter into new geographic markets, we may be subject to additional and unfamiliar legal and regulatory requirements. Compliance with regulatory requirements may impose substantial additional obligations on us and our management, cause us to expend additional time and resources in compliance activities and increase our exposure to penalties or fines for non-compliance with such additional legal requirements. Further, the success of any completed acquisition will depend on our ability to integrate effectively the acquired business into our existing operations. The process of integrating acquired businesses may involve unforeseen difficulties and may require a disproportionate amount of our managerial and financial resources. In addition, possible future acquisitions may be larger and for purchase prices significantly higher than those paid for earlier acquisitions. No assurance can be given that we will be able to identify additional suitable acquisition opportunities, negotiate acceptable terms, obtain financing for acquisitions on acceptable terms or successfully acquire identified targets. Our failure to achieve consolidation savings, to integrate the acquired businesses and assets into our existing operations successfully or to minimize any unforeseen operational difficulties could have a material adverse effect on our financial condition and results of operations. The inability to effectively manage the integration of acquisitions, including our pending acquisitions, could reduce our focus on subsequent acquisitions and current operations, which, in turn, could negatively impact our earnings and growth. Our financial position and results of operations may fluctuate significantly from period to period, based on whether or not significant acquisitions are completed in particular periods. 35Table of ContentsWe may incur losses as a result of title defects in the properties in which we invest. It is our practice in acquiring oil and natural gas leases or interests not to incur the expense of retaining lawyers to examine the title to the mineral interest. Rather, we rely upon the judgment of oil and gas lease brokers or landmen who perform the fieldwork in examining records in the appropriate governmental office before attempting to acquire a lease in a specific mineral interest. The existence of a material title deficiency can render a lease worthless and can adversely affect our results of operations and financial condition.Prior to the drilling of an oil or natural gas well, however, it is the normal practice in our industry for the person or company acting as the operator of the well to obtain a preliminary title review to ensure there are no obvious defects in title to the well. Frequently, as a result of such examinations, certain curative work must be done to correct defects in the marketability of the title, and such curative work entails expense. Our failure to cure any title defects may delay or prevent us from utilizing the associated mineral interest, which may adversely impact our ability in the future to increase production and reserves. Additionally, undeveloped acreage has greater risk of title defects than developed acreage. If there are any title defects or defects in the assignment of leasehold rights in properties in which we hold an interest, we will suffer a financial loss. Our project areas, which are in various stages of development, may not yield oil or natural gas in commercially viable quantities. Our project areas are in various stages of development, ranging from project areas with current drilling or production activity to project areas that consist of recently acquired leasehold acreage or that have limited drilling or production history. If future wells or the wells in the process of being completed do not produce sufficient revenues to return a profit or if we drill dry holes in the future, our business may be materially affected. Our identified potential drilling locations, which are part of our anticipated future drilling plans, are susceptible to uncertainties that could materially alter the occurrence or timing of their drilling. At an assumed price of approximately $60.00 per Bbl WTI, we currently have approximately 10,413 gross (6,863 net) identified economic potential horizontal drilling locations in multiple horizons on our acreage. As of December 31, 2020, only 628 of our gross identified potential horizontal drilling locations were attributed to proved reserves. These drilling locations, including those without proved undeveloped reserves, represent a significant part of our growth strategy. Our ability to drill and develop these locations depends on a number of uncertainties, including the availability of capital, construction of infrastructure, inclement weather, regulatory changes and approvals, oil and natural gas prices, costs, drilling results and the availability of water. Further, our identified potential drilling locations are in various stages of evaluation, ranging from locations that are ready to drill to locations that will require substantial additional interpretation. In addition, we have identified approximately 2,708 horizontal drilling locations in intervals in which we have drilled very few or no wells, which are necessarily more speculative and based on results from other operators whose acreage may not be consistent with ours. We cannot predict in advance of drilling and testing whether any particular drilling location will yield oil or natural gas in sufficient quantities to recover drilling or completion costs or to be economically viable. The use of technologies and the study of producing fields in the same area will not enable us to know conclusively prior to drilling whether oil or natural gas will be present or, if present, whether oil or natural gas will be present in sufficient quantities to be economically viable. Even if sufficient amounts of oil or natural gas exist, we may damage the potentially productive hydrocarbon bearing formation or experience mechanical difficulties while drilling or completing the well, possibly resulting in a reduction in production from the well or abandonment of the well. If we drill additional wells that we identify as dry holes in our current and future drilling locations, our drilling success rate may decline and materially harm our business. Through December 31, 2020, we are the operator of, have participated in, or have acquired working interest in a total of 2,380 horizontal wells completed on our acreage, we cannot assure you that the analogies we draw from available data from these or other wells, more fully explored locations or producing fields will be applicable to our drilling locations. Further, initial production rates reported by us or other operators in the Permian Basin may not be indicative of future or long-term production rates. Because of these uncertainties, we do not know if the potential drilling locations we have identified will ever be drilled or if we will be able to produce oil or natural gas from these or any other potential drilling locations. As such, our actual drilling activities may materially differ from those presently identified, which could adversely affect our business. Multi-well pad drilling may result in volatility in our operating results. We utilize multi-well pad drilling where practical. Because wells drilled on a pad are not brought into production until all wells on the pad are drilled and completed and the drilling rig is moved from the location, multi-well pad drilling delays the commencement of production, which may cause volatility in our operating results.36Table of ContentsOur acreage must be drilled before lease expiration, generally within three to five years, in order to hold the acreage by production. In a highly competitive market for acreage, failure to drill sufficient wells to hold acreage may result in a substantial lease renewal cost or, if renewal is not feasible, loss of our lease and prospective drilling opportunities. Leases on oil and natural gas properties typically have a term of three to five years, after which they expire unless, prior to expiration, production is established within the spacing units covering the undeveloped acres. The cost to renew such leases may increase significantly, and we may not be able to renew such leases on commercially reasonable terms or at all. Any reduction in our current drilling program, either through a reduction in capital expenditures or the unavailability of drilling rigs, could result in the loss of acreage through lease expirations. In addition, in order to hold our current leases expiring in 2021, we will need to operate at least a one-rig program. We cannot assure you that we will have the liquidity to deploy these rigs in this time frame, or that commodity prices will warrant operating such a drilling program. Any such losses of leases could materially and adversely affect the growth of our asset basis, cash flows and results of operations. We have entered into commodity price derivatives for a portion of our production. Although we have hedged a portion of our estimated 2021 and 2022 production, we may still be adversely affected by continuing and prolonged declines in the price of oil and may be exposed to other risks, including counterparty credit risk. We use commodity price derivatives to reduce price volatility associated with certain of our oil and natural gas sales. To the extent that the prices of oil and natural gas remain at current levels or decline further, we may not be able to economically hedge future production at the same level as our current hedges, and our results of operations and financial condition may be negatively impacted. At settlement, market prices for commodities may exceed the contract prices in our commodity price derivatives agreements, resulting in our need to make significant cash payments to our counterparties. Further, by using commodity derivative instruments, we expose ourselves to credit risk if we are in a positive position at contract settlement and the counterparty fails to perform under the terms of the derivative contract. We do not require collateral from our counterparties. For additional information regarding our outstanding derivative contracts as of December 31, 2020, see Note 15—Derivatives to our consolidated financial statements included elsewhere in this report.If production from our Permian Basin acreage decreases due to decreased developmental activities, production related difficulties or otherwise, we may fail to meet our obligations to deliver specified quantities of oil under our oil purchase contract, which will result in deficiency payments to the counterparty and may have an adverse effect on our operations.We are a party to long-term crude oil agreements under which, subject to certain terms and conditions, we are obligated to deliver specified quantities of oil to such companies. Our maximum delivery obligation under these agreements varies for different periods and depends in some cases upon certain conditions beyond our control. If production from our Permian Basin acreage decreases due to decreased developmental activities, as a result of the low commodity price environment, production related difficulties or otherwise, we may be unable to meet our obligations under our oil purchase agreements, which may result in deficiency payments to certain counterparties or a default under such agreements and may have an adverse effect on our company.The inability of one or more of our customers to meet their obligations may adversely affect our financial results. In addition to credit risk related to receivables from commodity derivative contracts, our principal exposure to credit risk is through receivables from joint interest owners on properties we operate (approximately $56 million at December 31, 2020) and receivables from purchasers of our oil and natural gas production (approximately $281 million at December 31, 2020). Joint interest receivables arise from billing entities that own partial interests in the wells we operate. These entities participate in our wells primarily based on their ownership in leases on which we wish to drill. We are generally unable to control which co-owners participate in our wells. We are also subject to credit risk due to the concentration of our oil and natural gas receivables with several significant customers. For the year ended December 31, 2020, four purchasers each accounted for more than 10% of our revenue. For each of the years ended December 31, 2019 and 2018, three purchasers each accounted for more than 10% of our revenue. This concentration of customers may impact our overall credit risk in that these entities may be similarly affected by changes in economic and other conditions. Current economic circumstances may further increase these risks. We do not require our customers to post collateral. The inability or failure of our significant customers or joint working interest owners to meet their obligations to us or their insolvency or liquidation may materially adversely affect our financial results. 37Table of ContentsOur method of accounting for investments in oil and natural gas properties may result in impairment of asset value. We account for our oil and natural gas producing activities using the full cost method of accounting. Accordingly, all costs incurred in the acquisition, exploration and development of proved oil and natural gas properties, including the costs of abandoned properties, dry holes, geophysical costs and annual lease rentals are capitalized. We also capitalize direct operating costs for services performed with internally owned drilling and well servicing equipment. All general and administrative corporate costs unrelated to drilling activities are expensed as incurred. Sales or other dispositions of oil and natural gas properties are accounted for as adjustments to capitalized costs, with no gain or loss recorded unless the ratio of cost to proved reserves would significantly change. Income from services provided to working interest owners of properties in which we also own an interest, to the extent they exceed related costs incurred, are accounted for as reductions of capitalized costs of oil and natural gas properties. Depletion of evaluated oil and natural gas properties is computed on the units of production method, whereby capitalized costs plus estimated future development costs are amortized over total proved reserves. The average depletion rate per barrel equivalent unit of production was $11.30, $13.54 and $12.62 for the years ended December 31, 2020, 2019 and 2018, respectively. Depletion for oil and natural gas properties for the years ended December 31, 2020, 2019 and 2018 was $1.2 billion, $1.4 billion and $595 million, respectively. The net capitalized costs of proved oil and natural gas properties are subject to a full cost ceiling limitation in which the costs are not allowed to exceed their related estimated future net revenues discounted at 10%. To the extent capitalized costs of evaluated oil and natural gas properties, net of accumulated depreciation, depletion, amortization and impairment, exceed the discounted future net revenues of proved oil and natural gas reserves, the excess capitalized costs are charged to expense. We use the unweighted arithmetic average first day of the month price for oil and natural gas for the 12-month period preceding the calculation date in estimating discounted future net revenues. An impairment on proved oil and natural gas properties of $6.0 billion and $790 million was recorded for the years ended December 31, 2020 and 2019, respectively. No impairments on proved oil and natural gas properties were recorded for the year ended December 31, 2018. See Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Critical Accounting Policies and Estimates—Method of accounting for oil and natural gas properties” for a more detailed description of our method of accounting. Our estimated reserves and EURs are based on many assumptions that may turn out to be inaccurate. Any material inaccuracies in these reserve estimates or underlying assumptions will materially affect the quantities and present value of our reserves. Oil and natural gas reserve engineering is not an exact science and requires subjective estimates of underground accumulations of oil and natural gas and assumptions concerning future oil and natural gas prices, production levels, ultimate recoveries and operating and development costs. As a result, estimated quantities of proved reserves, projections of future production rates and the timing of development expenditures may be incorrect. The EURs for our horizontal wells are based on management’s internal estimates. Over time, we may make material changes to reserve estimates taking into account the results of actual drilling, testing and production. Also, certain assumptions regarding future oil and natural gas prices, production levels and operating and development costs may prove incorrect. Any significant variance from these assumptions to actual figures could greatly affect our estimates of reserves, the economically recoverable quantities of oil and natural gas attributable to any particular group of properties, the classifications of reserves based on risk of recovery and estimates of future net cash flows. A substantial portion of our reserve estimates are made without the benefit of a lengthy production history, which are less reliable than estimates based on a lengthy production history. Numerous changes over time to the assumptions on which our reserve estimates are based, as described above, often result in the actual quantities of oil and natural gas that we ultimately recover being different from our reserve estimates. Reserve estimates do not include any value for probable or possible reserves that may exist, nor do they include any value for unproved undeveloped acreage. The reserve estimates represent our net revenue interest in our properties.The timing of both our production and our incurrence of costs in connection with the development and production of oil and natural gas properties will affect the timing of actual future net cash flows from proved reserves. The standardized measure of our estimated proved reserves and our PV-10 are not necessarily the same as the current market value of our estimated proved oil reserves. The present value of future net cash flow from our proved reserves, or standardized measure, and our related PV-10 calculation, may not represent the current market value of our estimated proved oil reserves. In accordance with SEC requirements, we base the estimated discounted future net cash flow from our estimated proved reserves on the 12-month average oil index prices, calculated as the unweighted arithmetic average for the first-day-of-the-month price for each month and costs in effect as of the date of the estimate, holding the prices and costs constant throughout the life of the properties. 38Table of ContentsActual future prices and costs may differ materially from those used in the net present value estimate, and future net present value estimates using then current prices and costs may be significantly less than current estimates. In addition, the 10% discount factor we use when calculating discounted future net cash flow for reporting requirements in compliance with the Financial Accounting Standard Board Codification 932, “Extractive Activities—Oil and Gas,” may not be the most appropriate discount factor based on interest rates in effect from time to time and risks associated with us or the oil and natural gas industry in general. The development of our proved undeveloped reserves may take longer and may require higher levels of capital expenditures than we currently anticipate. Approximately 38% of our total estimated proved reserves as of December 31, 2020, were proved undeveloped reserves and may not be ultimately developed or produced. Recovery of proved undeveloped reserves requires significant capital expenditures and successful drilling operations. The reserve data included in the reserve reports of our independent petroleum engineers assume that substantial capital expenditures are required to develop such reserves. We cannot be certain that the estimated costs of the development of these reserves are accurate, that development will occur as scheduled or that the results of such development will be as estimated. Delays in the development of our reserves, increases in costs to drill and develop such reserves, or further decreases in commodity prices will reduce the future net revenues of our estimated proved undeveloped reserves and may result in some projects becoming uneconomical. In addition, delays in the development of reserves could force us to reclassify certain of our proved reserves as unproved reserves. Our producing properties are located in the Permian Basin of West Texas, making us vulnerable to risks associated with operating in a single geographic area. In addition, we have a large amount of proved reserves attributable to a small number of producing horizons within this area. Our producing properties are currently geographically concentrated in the Permian Basin of West Texas. As a result of this concentration, we may be disproportionately exposed to the impact of regional supply and demand factors, delays or interruptions of production from wells in this area caused by governmental regulation, processing or transportation capacity constraints, availability of equipment, facilities, personnel or services market limitations or interruption of the processing or transportation of crude oil, natural gas or natural gas liquids and extreme weather conditions, such as the recent severe winter storms in the Permian Basin, and their adverse impact on production volumes, availability of electrical power, road accessibility and transportation facilities. In addition, the effect of fluctuations on supply and demand may become more pronounced within specific geographic oil and natural gas producing areas such as the Permian Basin, which may cause these conditions to occur with greater frequency or magnify the effects of these conditions. Due to the concentrated nature of our portfolio of properties, a number of our properties could experience any of the same conditions at the same time, resulting in a relatively greater impact on our results of operations than they might have on other companies that have a more diversified portfolio of properties. Such delays or interruptions could have a material adverse effect on our financial condition and results of operations. In addition to the geographic concentration of our producing properties described above, as of December 31, 2020, most of our proved reserves are concentrated in the Wolfberry play in the Midland Basin. This concentration of assets within a small number of producing horizons exposes us to additional risks, such as changes in field-wide rules and regulations that could cause us to permanently or temporarily shut-in all of our wells within a field. We depend upon several significant purchasers for the sale of most of our oil and natural gas production. The loss of one or more of these purchasers could, among other factors, limit our access to suitable markets for the oil and natural gas we produce. The availability of a ready market for any oil and/or natural gas we produce depends on numerous factors beyond the control of our management, including but not limited to the extent of domestic production and imports of oil, the proximity and capacity of natural gas pipelines, the availability of skilled labor, materials and equipment, the effect of state and federal regulation of oil and natural gas production and federal regulation of natural gas sold in interstate commerce. In addition, we depend upon several significant purchasers for the sale of most of our oil and natural gas production. For the year ended December 31, 2020, four purchasers each accounted for more than 10% of our revenue. For each of the years ended December 31, 2019 and 2018, three purchasers each accounted for more than 10% of our revenue. We cannot assure you that we will continue to have ready access to suitable markets for our future oil and natural gas production. The loss of one or more of these customers, and our inability to sell our production to other customers on terms we consider acceptable, could materially and adversely affect our business, financial condition, results of operations and cash flow.39Table of ContentsThe unavailability, high cost or shortages of rigs, equipment, raw materials, supplies, oilfield services or personnel may restrict our operations. The oil and natural gas industry is cyclical, which can result in shortages of drilling rigs, equipment, raw materials (particularly sand and other proppants), supplies and personnel. When shortages occur, the costs and delivery times of rigs, equipment and supplies increase and demand for, and wage rates of, qualified drilling rig crews also rise with increases in demand. We cannot predict whether these conditions will exist in the future and, if so, what their timing and duration will be. In accordance with customary industry practice, we rely on independent third party service providers to provide most of the services necessary to drill new wells. If we are unable to secure a sufficient number of drilling rigs at reasonable costs, our financial condition and results of operations could suffer, and we may not be able to drill all of our acreage before our leases expire. In addition, we do not have long-term contracts securing the use of our existing rigs, and the operator of those rigs may choose to cease providing services to us. Shortages of drilling rigs, equipment, raw materials (particularly sand and other proppants), supplies, personnel, trucking services, tubulars, fracking and completion services and production equipment could delay or restrict our exploration and development operations, which in turn could impair our financial condition and results of operations. Our operations are substantially dependent on the availability of water. Restrictions on our ability to obtain water may have an adverse effect on our financial condition, results of operations and cash flows. Water is an essential component of deep shale oil and natural gas production during both the drilling and hydraulic fracturing processes. Historically, we have been able to purchase water from local land owners for use in our operations. Over the past several years, Texas has experienced extreme drought conditions. As a result of this severe drought, some local water districts have begun restricting the use of water subject to their jurisdiction for hydraulic fracturing to protect local water supply. If we are unable to obtain water to use in our operations from local sources, or we are unable to effectively utilize flowback water, we may be unable to economically drill for or produce oil and natural gas, which could have an adverse effect on our financial condition, results of operations and cash flows. We may have difficulty managing growth in our business, which could adversely affect our financial condition and results of operations. Our business operations have grown substantially since our initial public offering in October 2012 and we expect our business operations to continue to grow in the future. As we expand our activities and increase the number of projects we are evaluating or in which we participate, there will be additional demands on our financial, technical, operational and management resources. The failure to continue to upgrade our technical, administrative, operating and financial control systems or the occurrences of unexpected expansion difficulties, including the failure to recruit and retain experienced managers, geologists, engineers and other professionals in the oil and natural gas industry, could have a material adverse effect on our business, financial condition and results of operations and our ability to timely execute our business plan. We have incurred losses from operations during certain periods since our inception and may do so in the future. Our development of and participation in an increasingly larger number of drilling locations has required and will continue to require substantial capital expenditures. The uncertainty and risks described in this report may impede our ability to economically find, develop and acquire oil and natural gas reserves. As a result, we may not be able to achieve or sustain profitability or positive cash flows from our operating activities in the future. Part of our strategy involves drilling in existing or emerging shale plays using the latest available horizontal drilling and completion techniques; therefore, the results of our planned exploratory drilling in these plays are subject to risks associated with drilling and completion techniques and drilling results may not meet our expectations for reserves or production. Our operations involve utilizing the latest drilling and completion techniques as developed by us and our service providers. Risks that we face while drilling include, but are not limited to, landing our well bore in the desired drilling zone, staying in the desired drilling zone while drilling horizontally through the formation, running our casing the entire length of the well bore and being able to run tools and other equipment consistently through the horizontal well bore. Risks that we face while completing our wells include, but are not limited to, being able to fracture stimulate the planned number of stages, being able to run tools the entire length of the well bore during completion operations and successfully cleaning out the well bore after completion of the final fracture stimulation stage. In addition, to the extent we engage in horizontal drilling, those activities may adversely affect our ability to successfully drill in one or more of our identified vertical drilling locations. Furthermore, certain of the new techniques we are adopting, such as infill drilling and multi-well pad drilling, may cause irregularities or interruptions in production due to, in the case of infill drilling, offset wells being shut in and, in the case of 40Table of Contentsmulti-well pad drilling, the time required to drill and complete multiple wells before any such wells begin producing. The results of our drilling in new or emerging formations are more uncertain initially than drilling results in areas that are more developed and have a longer history of established production. Newer or emerging formations and areas often have limited or no production history and consequently we are less able to predict future drilling results in these areas. Ultimately, the success of these drilling and completion techniques can only be evaluated over time as more wells are drilled and production profiles are established over a sufficiently long time period. If our drilling results are less than anticipated or we are unable to execute our drilling program because of capital constraints, lease expirations, access to gathering systems, and/or declines in natural gas and oil prices, the return on our investment in these areas may not be as attractive as we anticipate. Further, as a result of any of these developments we could incur material write-downs of our oil and natural gas properties and the value of our undeveloped acreage could decline in the future. Conservation measures and technological advances could reduce demand for oil and natural gas. Fuel conservation measures, alternative fuel requirements, increasing consumer demand for alternatives to oil and natural gas, technological advances in fuel economy and energy generation devices could reduce demand for oil and natural gas. The impact of the changing demand for oil and natural gas services and products may have a material adverse effect on our business, financial condition, results of operations and cash flows. The marketability of our production is dependent upon transportation and other facilities, certain of which we do not control. If these facilities are unavailable, our operations could be interrupted and our revenues reduced. The marketability of our oil and natural gas production depends in part upon the availability, proximity and capacity of transportation facilities owned by third parties. Our oil production is transported from the wellhead to our tank batteries by our gathering system, which interconnects with third party pipelines. Our natural gas production is generally transported by our gathering lines from the wellhead to an interconnection point with the purchaser. We do not control third party transportation facilities and our access to them may be limited or denied. Insufficient production from our wells to support the construction of pipeline facilities by our purchasers or a significant disruption in the availability of our or third party transportation facilities or other production facilities could adversely impact our ability to deliver to market or produce our oil and natural gas and thereby cause a significant interruption in our operations. For example, on certain occasions we have experienced high line pressure at our tank batteries with occasional flaring due to the inability of the gas gathering systems in the areas in which we operate to support the increased production of natural gas in the Permian Basin. If, in the future, we are unable, for any sustained period, to implement acceptable delivery or transportation arrangements or encounter production related difficulties, we may be required to shut in or curtail production. In addition, the amount of oil and natural gas that can be produced and sold may be subject to curtailment in certain other circumstances outside of our control, such as pipeline interruptions due to maintenance, excessive pressure, ability of downstream processing facilities to accept unprocessed gas, physical damage to the gathering or transportation system or lack of contracted capacity on such systems. The curtailments arising from these and similar circumstances may last from a few days to several months, and in many cases, we are provided with limited, if any, notice as to when these circumstances will arise and their duration. Any such shut in or curtailment, or an inability to obtain favorable terms for delivery of the oil and natural gas produced from our fields, would adversely affect our financial condition and results of operations. Our operations are subject to various governmental laws and regulations which require compliance that can be burdensome and expensive. Our oil and natural gas operations are subject to various federal, state and local governmental regulations that may be changed from time to time in response to economic and political conditions. Matters subject to regulation include discharge permits for drilling operations, drilling bonds, reports concerning operations, the spacing of wells, unitization and pooling of properties and taxation. From time to time, regulatory agencies have imposed price controls and limitations on production by restricting the rate of flow of oil and natural gas wells below actual production capacity to conserve supplies of oil and natural gas. In addition, the production, handling, storage, transportation, remediation, emission and disposal of oil and natural gas, by-products thereof and other substances and materials produced or used in connection with oil and natural gas operations are subject to regulation under federal, state and local laws and regulations primarily relating to protection of human health and the environment. Failure to comply with these laws and regulations may result in the assessment of sanctions, including administrative, civil or criminal penalties, permit revocations, requirements for additional pollution controls and injunctions limiting or prohibiting some or all of our operations. Further, these laws and regulations imposed strict requirements for water and air pollution control and solid waste management. Significant expenditures may be required to comply with governmental laws and regulations applicable to us. In addition, federal and state legislation and regulatory initiatives relating to hydraulic fracturing could result in increased costs and additional operating restrictions or delays. Even if federal regulatory burdens temporarily ease, the historic trend of more expansive and stricter environmental legislation and 41Table of Contentsregulations may continue in the long-term, and at the state and local levels. See Item 1. “Business—Regulation” for a detailed description of certain laws and regulations that affect us. Restrictions on drilling activities intended to protect certain species of wildlife may adversely affect our ability to conduct drilling activities in some of the areas where we operate. Oil and natural gas operations in our operating areas can be adversely affected by seasonal or permanent restrictions on drilling activities designed to protect various wildlife. Seasonal restrictions may limit our ability to operate in protected areas and can intensify competition for drilling rigs, oilfield equipment, services, supplies and qualified personnel, which may lead to periodic shortages when drilling is allowed. These constraints and the resulting shortages or high costs could delay our operations and materially increase our operating and capital costs. Permanent restrictions imposed to protect threatened or endangered species could prohibit drilling in certain areas or require the implementation of expensive mitigation measures. The designation of previously unprotected species in areas where we operate as threatened or endangered could cause us to incur increased costs arising from species protection measures or could result in limitations on our exploration and production activities that could have an adverse impact on our ability to develop and produce our reserves. Derivatives reform legislation and related regulations could have an adverse effect on our ability to hedge risks associated with our business.The July 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act, which we refer to as Dodd-Frank Act, provides for federal oversight of the over-the-counter derivatives market and entities that participate in that market and mandates that the Commodity Futures Trading Commission, which we refer to as the CFTC, the SEC, and federal regulators of financial institutions, which we refer to as the Prudential Regulators, adopt rules or regulations implementing the Dodd-Frank Act and providing definitions of terms used in the Dodd-Frank Act. The Dodd-Frank Act establishes margin requirements and requires clearing and trade execution practices for certain market participants and may result in certain market participants needing to curtail or cease their derivatives activities.Although some of the rules necessary to implement the Dodd-Frank Act remain to be adopted, the CFTC, the SEC and the Prudential Regulators have issued many rules to implement the Dodd-Frank Act, including a rule, which we refer to as the Mandatory Clearing Rule, requiring clearing of hedges, or swaps, that are subject to it (currently, only certain interest rate and credit default swaps, a rule, which we refer to as the End User Exception, establishing an “end user” exception to the Mandatory Clearing Rule, a rule, which we refer to as the Margin Rule, setting forth collateral requirements in connection with swaps that are not cleared and also an exception to the Margin Rule for end users that are not financial end users, which exception we refer to as the Non-Financial End User Exception, and a rule imposing position limits, which we refer to as the Position Limit Rule, and also an exception to the Position Limit Rule for swaps that constitute a “bona fide hedging transaction or position” within the definition of such term under the Position Limit Rule, subject to the party claiming the exemption complying with the applicable filing, recordkeeping and reporting requirements of the Position Limit Rule, which we refer to as the Bona Fide Hedging Exception.We qualify for the End User Exception to the Mandatory Clearing Rule, we qualify for the Non-Financial End User Exception and will not be required to post margin in connection with uncleared swaps under the Margin Rule, and each of our existing and anticipated hedging positions constitutes a “bona fide hedging transaction or position” under the Position Limit Rule and we intend to undertake the filing, recordkeeping and reporting necessary to utilize the Bona Fide Hedging Exception under the Position Limit Rule, so we do not expect to be directly affected by any of such rules. However, most if not all of our hedge counterparties will be subject to mandatory clearing in connection with their hedging activities with parties who do not qualify for the End User Exception and will be required to post margin in connection with their hedging activities with other swap dealers, major swap participants, financial end users and other persons that do not qualify for the Non-Financial End User Exception. In addition, the European Union and other non-U.S. jurisdictions have enacted laws and regulations (including laws and regulations giving the European Union financial authorities the power to write-down amounts we may be owed on hedging agreements with counterparties subject to such laws and regulations and/or require that we accept equity interests in such counterparties in lieu of cash in satisfaction of such amounts), which we refer to collectively as Foreign Regulations, which may apply to our transactions with counterparties subject to such Foreign Regulations, which we refer to as Foreign Counterparties, and the U.S. adopted law and rules, which we call the U.S. Resolution Stay Rules, clarifying similar rights of U.S. banking authorities with respect to banking institutions subject to their regulation. The Dodd-Frank Act, the rules which have been adopted and not vacated, the Limit Rule and the U.S. Resolution Stay Rules could significantly increase the cost of our derivative contracts, materially alter the terms of our derivative contracts, reduce the availability of derivatives to us that we have historically used to protect against risks that we encounter in our business, reduce our ability to monetize or restructure our existing derivative contracts and increase our exposure to less creditworthy counterparties. The Foreign Regulations could have similar effects. If we reduce our use of derivatives as a result of the Dodd-Frank Act and regulation, the U.S. Resolution Stay Rules and Foreign Regulations, our results of operations may 42Table of Contentsbecome more volatile and our cash flows may be less predictable, which could adversely affect our ability to plan for and fund capital expenditures. Finally, the Dodd-Frank Act was intended, in part, to reduce the volatility of oil and natural gas prices, which some legislators attributed to speculative trading in derivatives and commodity contracts related to oil and natural gas. Our revenues could therefore be adversely affected if a consequence of the Dodd-Frank Act and regulations is to lower commodity prices. Any of these consequences could have a material adverse effect on us, our financial condition and our results of operations.Recently enacted U.S. tax legislation as well as future U.S. tax legislation may adversely affect our business, results of operations, financial condition and cash flow. From time to time, legislation has been proposed that, if enacted into law, would make significant changes to U.S. federal and state income tax laws affecting the oil and natural gas industry, including (i) eliminating the immediate deduction for intangible drilling and development costs, (ii) the repeal of the percentage depletion allowance for oil and natural gas properties; and (iii) an extension of the amortization period for certain geological and geophysical expenditures. No accurate prediction can be made as to whether any such legislative changes will be proposed or enacted in the future or, if enacted, what the specific provisions or the effective date of any such legislation would be. These proposed changes in the U.S. tax law, if adopted, or other similar changes that would impose additional tax on our activities or reduce or eliminate deductions currently available with respect to natural gas and oil exploration, development or similar activities, could adversely affect our business, results of operations, financial condition and cash flow.If third party pipelines or other facilities interconnected to Rattler LLC’s midstream systems become partially or fully unavailable, or if the volumes we gather or treat do not meet the quality requirements of such pipelines or facilities, our midstream operations could be adversely affected.Our subsidiary Rattler LLC’s midstream systems are connected to other pipelines or facilities, the majority of which are owned by third parties. The continuing operation of such third party pipelines or facilities is not within our control. If any of these pipelines or facilities becomes unable to transport, treat or process natural gas or crude oil, or if the volumes we gather or transport do not meet the quality requirements of such pipelines or facilities, our midstream operations could be adversely affected.We operate in areas of high industry activity, which may affect our ability to hire, train or retain qualified personnel needed to manage and operate our assets.Our operations and drilling activity are concentrated in the Permian Basin in West Texas, an area in which industry activity has increased rapidly. As a result, demand for qualified personnel in this area, and the cost to attract and retain such personnel, has increased over the past few years due to competition and may increase substantially in the future. Moreover, our competitors may be able to offer better compensation packages to attract and retain qualified personnel than we are able to offer.Any delay or inability to secure the personnel necessary for us to continue or complete our current and planned development activities could lead to a reduction in production volumes. Any such negative effect on production volumes, or significant increases in costs, could have a material adverse effect on our business, financial condition and results of operations.We rely on a few key employees whose absence or loss could adversely affect our business. Many key responsibilities within our business have been assigned to a small number of employees. The loss of their services could adversely affect our business. In particular, the loss of the services of one or more members of our executive team, including our Chief Executive Officer, Travis D. Stice, could disrupt our operations. We do not have employment agreements with our executives and may not be able to assure their retention. Further, we do not maintain “key person” life insurance policies on any of our employees. As a result, we are not insured against any losses resulting from the death of our key employees. Drilling for and producing oil and natural gas are high-risk activities with many uncertainties that may result in a total loss of investment and adversely affect our business, financial condition or results of operations. Our drilling activities are subject to many risks. For example, we cannot assure you that new wells drilled by us will be productive or that we will recover all or any portion of our investment in such wells. Drilling for oil and natural gas often involves unprofitable efforts, not only from dry wells but also from wells that are productive but do not produce sufficient oil or natural gas to return a profit at then realized prices after deducting drilling, operating and other costs. The seismic data and 43Table of Contentsother technologies we use do not allow us to know conclusively prior to drilling a well that oil or natural gas is present or that it can be produced economically. The costs of exploration, exploitation and development activities are subject to numerous uncertainties beyond our control, and increases in those costs can adversely affect the economics of a project. Further, our drilling and producing operations may be curtailed, delayed, canceled or otherwise negatively impacted as a result of other factors, including; unusual or unexpected geological formations; loss of drilling fluid circulation; title problems; facility or equipment malfunctions; unexpected operational events; shortages or delivery delays of equipment and services; compliance with environmental and other governmental requirements; and adverse weather conditions.Any of these risks can cause substantial losses, including personal injury or loss of life, damage to or destruction of property, natural resources and equipment, pollution, environmental contamination or loss of wells and other regulatory penalties. Our development and exploratory drilling efforts and our well operations may not be profitable or achieve our targeted returns. Historically, we have acquired significant amounts of unproved property in order to further our development efforts and expect to continue to undertake acquisitions in the future. Development and exploratory drilling and production activities are subject to many risks, including the risk that no commercially productive reservoirs will be discovered. We acquire unproved properties and lease undeveloped acreage that we believe will enhance our growth potential and increase our earnings over time. However, we cannot assure you that all prospects will be economically viable or that we will not abandon our investments. Additionally, we cannot assure you that unproved property acquired by us or undeveloped acreage leased by us will be profitably developed, that new wells drilled by us in prospects that we pursue will be productive or that we will recover all or any portion of our investment in such unproved property or wells. Operating hazards and uninsured risks may result in substantial losses and could prevent us from realizing profits. Our operations are subject to all of the hazards and operating risks associated with drilling for and production of oil and natural gas, including the risk of fire, explosions, blowouts, surface cratering, uncontrollable flows of natural gas, oil and formation water, pipe or pipeline failures, abnormally pressured formations, casing collapses and environmental hazards such as oil spills, gas leaks and ruptures or discharges of toxic gases. In addition, our operations are subject to risks associated with hydraulic fracturing, including any mishandling, surface spillage or potential underground migration of fracturing fluids, including chemical additives. The occurrence of any of these events could result in substantial losses to us due to injury or loss of life, severe damage to or destruction of property, natural resources and equipment, pollution or other environmental damage, clean-up responsibilities, regulatory investigations and penalties, suspension of operations and repairs required to resume operations. We endeavor to contractually allocate potential liabilities and risks between us and the parties that provide us with services and goods, which include pressure pumping and hydraulic fracturing, drilling and cementing services and tubular goods for surface, intermediate and production casing. Under our agreements with our vendors, to the extent responsibility for environmental liability is allocated between the parties, (i) our vendors generally assume all responsibility for control and removal of pollution or contamination which originates above the surface of the land and is directly associated with such vendors’ equipment while in their control and (ii) we generally assume the responsibility for control and removal of all other pollution or contamination which may occur during our operations, including pre-existing pollution and pollution which may result from fire, blowout, cratering, seepage or any other uncontrolled flow of oil, gas or other substances, as well as the use or disposition of all drilling fluids. In addition, we generally agree to indemnify our vendors for loss or destruction of vendor-owned property that occurs in the well hole (except for damage that occurs when a vendor is performing work on a footage, rather than day work, basis) or as a result of the use of equipment, certain corrosive fluids, additives, chemicals or proppants. However, despite this general allocation of risk, we might not succeed in enforcing such contractual allocation, might incur an unforeseen liability falling outside the scope of such allocation or may be required to enter into contractual arrangements with terms that vary from the above allocations of risk. As a result, we may incur substantial losses which could materially and adversely affect our financial condition and results of operations. In accordance with what we believe to be customary industry practice, we historically have maintained insurance against some, but not all, of our business risks. Our insurance may not be adequate to cover any losses or liabilities we may suffer. Also, insurance may no longer be available to us or, if it is, its availability may be at premium levels that do not justify its purchase. The occurrence of a significant uninsured claim, a claim in excess of the insurance coverage limits maintained by us or a claim at a time when we are not able to obtain liability insurance could have a material adverse effect on our ability to conduct normal business operations and on our financial condition, results of operations or cash flow. In addition, we may not be able to secure additional insurance or bonding that might be required by new governmental regulations. This may cause us to restrict our operations, which might severely impact our financial position. We may also be liable for 44Table of Contentsenvironmental damage caused by previous owners of properties purchased by us, which liabilities may not be covered by insurance. Since hydraulic fracturing activities are part of our operations, we maintain insurance to protect against claims made for bodily injury and property damage, and that insurance includes coverage for clean-up costs stemming from a sudden and accidental pollution event. However, we may not have coverage if we are unaware of the pollution event and unable to report the “occurrence” to our insurance company within the time frame required under our insurance policy. We have limited coverage for gradual, long-term pollution events. In addition, these policies do not provide coverage for all liabilities, and we cannot assure you that the insurance coverage will be adequate to cover claims that may arise, or that we will be able to maintain adequate insurance at rates we consider reasonable. A loss not fully covered by insurance could have a material adverse effect on our financial position, results of operations and cash flows. Our use of 2-D and 3-D seismic data is subject to interpretation and may not accurately identify the presence of oil and natural gas, which could adversely affect the results of our drilling operations. Even when properly used and interpreted, 2-D and 3-D seismic data and visualization techniques are only tools used to assist geoscientists in identifying subsurface structures and hydrocarbon indicators and do not enable the interpreter to know whether hydrocarbons are, in fact, present in those structures. In addition, the use of 3-D seismic and other advanced technologies requires greater predrilling expenditures than traditional drilling strategies, and we could incur losses as a result of such expenditures. As a result, our drilling activities may not be successful or economical. We may not be able to keep pace with technological developments in our industry. The oil and natural gas industry is characterized by rapid and significant technological advancements and introductions of new products and services using new technologies. As others use or develop new technologies, we may be placed at a competitive disadvantage or may be forced by competitive pressures to implement those new technologies at substantial costs. In addition, other oil and natural gas companies may have greater financial, technical and personnel resources that allow them to enjoy technological advantages and that may in the future allow them to implement new technologies before we can. We may not be able to respond to these competitive pressures or implement new technologies on a timely basis or at an acceptable cost. If one or more of the technologies we use now or in the future were to become obsolete, our business, financial condition or results of operations could be materially and adversely affected. We are subject to certain requirements of Section 404 of the Sarbanes-Oxley Act. If we fail to comply with the requirements of Section 404 or if we or our auditors identify and report material weaknesses in internal control over financial reporting, our investors may lose confidence in our reported information and our stock price may be negatively affected.We are required to comply with certain provisions of Section 404 of the Sarbanes-Oxley Act of 2002, or Sarbanes-Oxley Act. Section 404 requires that we document and test our internal control over financial reporting and issue management’s assessment of our internal control over financial reporting. This section also requires that our independent registered public accounting firm opine on those internal controls. If we fail to comply with the requirements of Section 404 of the Sarbanes-Oxley Act, or if we or our auditors identify and report material weaknesses in internal control over financial reporting, the accuracy and timeliness of the filing of our annual and quarterly reports may be materially adversely affected and could cause investors to lose confidence in our reported financial information, which could have a negative effect on the trading price of our common stock. In addition, a material weakness in the effectiveness of our internal control over financial reporting could result in an increased chance of fraud and the loss of customers, reduce our ability to obtain financing and require additional expenditures to comply with these requirements, each of which could have a material adverse effect on our business, results of operations and financial condition.Increased costs of capital could adversely affect our business. Our business could be harmed by factors such as the availability, terms and cost of capital, increases in interest rates or a reduction in our credit rating. Changes in any one or more of these factors could cause our cost of doing business to increase, limit our access to capital, limit our ability to pursue acquisition opportunities, reduce our cash flows available for drilling and place us at a competitive disadvantage. Continuing disruptions and volatility in the global financial markets may lead to an increase in interest rates or a contraction in credit availability impacting our ability to finance our activities. We require continued access to capital. A significant reduction in the availability of credit could materially and adversely affect our ability to achieve our planned growth and cash flows. 45Table of ContentsThe results of the 2020 U.S. presidential and congressional elections may create regulatory uncertainty for the oil and natural gas industry. Changes in environmental laws could increase our operating costs and adversely impact our business, financial condition and cash flows.The results of the 2020 U.S. presidential election, as well as a closely divided Congress, may create regulatory uncertainty in the oil and natural gas industry. During his first weeks in office, President Biden has issued several executive orders promoting various programs and initiatives designed to, among other things, curtail climate change, control the release of methane from new and existing oil and natural gas operations, and pause new oil and natural gas leasing on public lands. It remains unclear what additional actions President Biden will take and what support he will have for any potential legislative changes from Congress. Further, it is uncertain to what extent any new environmental laws or regulations, or any repeal of existing environmental laws or regulations, may affect our business or operations. However, such actions could significantly increase our operating costs or impair our ability to explore and develop other projects, which could adversely impact our business, financial condition and cash flows.Our operations depend heavily on electrical power, internet and telecommunication infrastructure and information and computer systems. If any of these systems are compromised or unavailable, our business could be adversely affected.We are heavily dependent on electrical power, internet and telecommunications infrastructure and our information systems and computer-based programs, including our well operations information, seismic data, electronic data processing and accounting data. If any of such infrastructure, systems or programs were to fail or become unavailable or compromised, or create erroneous information in our hardware or software network infrastructure, our ability to safely and effectively operate our business will be limited and any such consequence could have a material adverse effect on our business. A terrorist attack or armed conflict could harm our business. Terrorist activities, anti-terrorist efforts and other armed conflicts involving the United States or other countries may adversely affect the United States and global economies and could prevent us from meeting our financial and other obligations. If any of these events occur, the resulting political instability and societal disruption could reduce overall demand for oil and natural gas causing a reduction in our revenues. Oil and natural gas related facilities could be direct targets of terrorist attacks, and our operations could be adversely impacted if infrastructure integral to our customers’ operations is destroyed or damaged. Costs for insurance and other security may increase as a result of these threats, and some insurance coverage may become more difficult to obtain, if available at all. We are subject to cyber security risks. A cyber incident could occur and result in information theft, data corruption, operational disruption and/or financial loss. The oil and natural gas industry has become increasingly dependent on digital technologies to conduct certain exploration, development, production, and processing activities. For example, the oil and natural gas industry depends on digital technologies to interpret seismic data, manage drilling rigs, production equipment and gathering systems, conduct reservoir modeling and reserves estimation, and process and record financial and operating data. At the same time, cyber incidents, including deliberate attacks or unintentional events, have increased. The U.S. government has issued public warnings that indicate that energy assets might be specific targets of cyber security threats. Our technologies, systems, networks, and those of our vendors, suppliers and other business partners, may become the target of cyberattacks or information security breaches that could result in the unauthorized release, gathering, monitoring, misuse, loss or destruction of proprietary and other information, or other disruption of our business operations. In addition, certain cyber incidents, such as surveillance, may remain undetected for an extended period. Our systems for protecting against cyber security risks may not be sufficient. As cyber incidents continue to evolve, we may be required to expend additional resources to continue to modify or enhance our protective measures or to investigate and remediate any vulnerability to cyber incidents. We maintain specialized insurance for possible liability resulting from a cyberattack on our assets, however, we cannot assure you that the insurance coverage will be adequate to cover claims that may arise, or that we will be able to maintain adequate insurance at rates we consider reasonable. A loss not fully covered by insurance could have a material adverse effect on our financial position, results of operations and cash flows. 46Table of ContentsRisks Related to Our Indebtedness References in this section to “us, “we” or “our” shall mean Diamondback Energy, Inc. and Diamondback O&G LLC, collectively, unless otherwise specified. We have relied in the past, and we may rely from time to time in the future, on borrowings under our revolving credit facility to fund a portion of our capital expenditures. Unless we are able to repay borrowings under the revolving credit facility with cash flow from operations and proceeds from equity or debt offerings, implementing our capital programs may require an increase in our total leverage through additional debt issuances. In addition, a reduction in availability under our revolving credit facility and the inability to otherwise obtain financing for our capital programs could require us to curtail our capital expenditures.We have historically relied on availability under our revolving credit facility to fund a portion of our capital expenditures. We expect that we will continue to fund a portion of our capital expenditures with borrowings under the revolving credit facility, cash flow from operations and the proceeds from debt and equity offerings. In the past, we have created availability under the revolving credit facility by repaying outstanding borrowings with the proceeds from debt or equity offerings. We cannot assure you that we will choose to or be able to access the capital markets to repay any such future borrowings. Instead, we may be required or choose to finance our capital expenditures through additional debt issuances, which would increase our total amount of debt outstanding. If the availability under the revolving credit facility were reduced, and we were otherwise unable to secure other sources of financing, we may be required to curtail our capital expenditures, which could limit our ability to fund our drilling activities and acquisitions or otherwise finance the capital expenditures necessary to replace our reserves.Our substantial level of indebtedness could adversely affect our financial condition and prevent us from fulfilling our obligations under our indebtedness. As of December 31, 2020, we had total consolidated outstanding principal indebtedness of $5.8 billion, including $4.6 billion outstanding under our senior notes and $23 million outstanding under our revolving credit facility, and we had $1.98 billion available for borrowing under our revolving credit facility. As of December 31, 2020, Viper LLC, one of our subsidiaries, had $84 million in outstanding borrowings, and $496 million available for borrowing, under its revolving credit facility and $480 million outstanding under its 5.375% Senior Notes due 2027. As of December 31, 2020, Rattler LLC, one of our subsidiaries, had $79 million in outstanding borrowings, and $521 million available for borrowing, under its revolving credit facility and $500 million outstanding under its 5.625% Senior Notes due 2025.We may in the future incur significant additional indebtedness under our revolving credit facility or otherwise in order to make acquisitions, to develop our properties or for other purposes. Our level of indebtedness could have important consequences to you and affect our operations in several ways, including the following: our high level of indebtedness could make it more difficult for us to satisfy our obligations with respect to our debt instruments, including any repurchase obligations that may arise thereunder; a significant portion of our cash flows could be used to service our indebtedness, which could reduce the funds available to us for operations and other purposes; our high level of debt could increase our vulnerability to general adverse economic and industry conditions; the covenants contained in the agreements governing certain of our outstanding indebtedness will limit our ability to borrow additional funds, dispose of assets, pay dividends and make certain investments; our high level of debt may place us at a competitive disadvantage compared to our competitors that are less leveraged and, therefore, may be able to take advantage of opportunities that our indebtedness would prevent us from pursuing; our debt covenants may also limit management’s discretion in operating our business and our flexibility in planning for, and reacting to, changes in the economy and in our industry; our high level of debt could limit our ability to access the capital markets to raise capital on favorable terms; our high level of debt may impair our ability to obtain additional financing in the future for working capital, capital expenditures, acquisitions, general corporate or other purposes; and we may be vulnerable to interest rate increases, as our borrowings under our revolving credit facility are at variable interest rates. We may still be able to incur substantial additional indebtedness in the future, which could further exacerbate the risks that we and our subsidies face.Restrictive covenants in certain of our existing and future debt instruments may limit our ability to respond to changes in market conditions or pursue business opportunities.Certain of our debt instruments contain, and the terms of any future indebtedness may contain, restrictive covenants that limit our ability to, among other things: incur or guarantee additional indebtedness; make certain investments; create 47Table of Contentsliens; sell or transfer assets; issue preferred stock; merge or consolidate with another entity; pay dividends or make other distributions; create unrestricted subsidiaries; and engage in transactions with affiliates.Under our revolving credit facility we are allowed, among other things, to designate one or more of our subsidiaries as “unrestricted subsidiaries” that are not subject to certain restrictions contained in the revolving credit facility. Under our revolving credit facility, we designated Viper, Viper’s general partner, Viper’s subsidiary, Rattler, Rattler’s general partner and Rattler’s subsidiaries as unrestricted subsidiaries, and upon such designation, they were automatically released from any and all obligations under the revolving credit facility, including the related guaranty. Further Viper, Viper’s general partner, Viper’s subsidiaries, Rattler, Rattler’s general partner and Rattler’s subsidiaries are designated as unrestricted subsidiaries under the indentures governing our outstanding senior notes.We and our subsidiaries may be prevented from taking advantage of business opportunities that arise because of the limitations imposed on us by the restrictive covenants and financial covenants contained in our and our subsidiaries’ debt instruments. As an example, our revolving credit facility requires us to maintain a total net debt to capitalization ratio. The requirement that we and our subsidiaries comply with these provisions may materially adversely affect our and our subsidiaries ability to react to changes in market conditions, take advantage of business opportunities we believe to be desirable, obtain future financing, fund needed capital expenditures or withstand a continuing or future downturn in our business.A breach of any of these restrictive covenants could result in default under the applicable debt instrument. If default occurs under our revolving credit facility, the lenders thereunder may elect to declare all borrowings outstanding, together with accrued interest and other fees, to be immediately due and payable, which would result in an event of default under the indentures governing our senior notes. The lenders will also have the right in these circumstances to terminate any commitments they have to provide further borrowings. If the indebtedness under our revolving credit facility and our senior notes were to be accelerated, we cannot assure you that our assets would be sufficient to repay in full that indebtedness.Our indebtedness is structurally subordinated to the indebtedness and other liabilities of our subsidiaries, and our obligations are not obligations of any of our subsidiaries.Our senior indebtedness obligations are obligations exclusively of Diamondback Energy, Inc. and Diamondback O&G LLC, and not of any of our other subsidiaries. None of our subsidiaries is a guarantor of our senior indebtedness. Any assets of our subsidiaries will not be directly available to satisfy the claims of our creditors, including lenders under our revolving credit facility and holders of the senior notes. Except to the extent we are a creditor with recognized claims against our subsidiaries, all claims of creditors of our subsidiaries will have priority over our equity interests in such subsidiaries (and therefore the claims of our creditors, including lenders under our revolving credit facility and holders of the senior notes) with respect to the assets of such subsidiaries. Even if we are recognized as a creditor of one or more of our subsidiaries, our claims would still be effectively subordinated to any security interests in the assets of any such subsidiary and to any indebtedness or other liabilities of any such subsidiary senior to our claims. Consequently, our senior indebtedness will be structurally subordinated to all indebtedness and other liabilities of any of our subsidiaries and any subsidiaries that we may in the future acquire or establish. For additional information regarding our subsidiaries outstanding debt as of December 31, 2020, see Note 11—Debt to our consolidated financial statements included elsewhere in this report.Servicing our indebtedness requires a significant amount of cash, and we may not have sufficient cash flow from our business to pay our substantial indebtedness.Our ability to make scheduled payments of the principal, to pay interest on or to refinance our indebtedness, including our senior notes, depends on our future performance, which is subject to economic, financial, competitive and other factors beyond our control. Our business may not generate cash flow from operations in the future sufficient to service our debt and make necessary capital expenditures. If we are unable to generate such cash flow, we may be required to adopt one or more alternatives, such as reducing or delaying capital expenditures, selling assets, restructuring debt or obtaining additional equity capital on terms that may be onerous or highly dilutive. However, we cannot assure you that undertaking alternative financing plans, if necessary, would allow us to meet our debt obligations. In the absence of such cash flows, we could have substantial liquidity problems and might be required to sell material assets or operations to attempt to meet our debt service and other obligations. The indenture governing the 2025 Senior Notes restricts our ability to use the proceeds from asset sales. We may not be able to consummate those asset sales to raise capital or sell assets at prices that we believe are fair, and proceeds that we do receive may not be adequate to meet any debt service obligations then due. Our ability to refinance our indebtedness will depend on the capital markets and our financial condition at the time. We may not be able to engage in any of these activities or engage in these activities on desirable terms, which could result in a default on our debt obligations and have an adverse effect on our financial condition.48Table of ContentsWe depend on our subsidiaries for dividends, distributions and other payments.We depend on our subsidiaries for dividends, distributions and other payments. We are a legal entity separate and distinct from our operating subsidiaries. There are statutory and regulatory limitations on the payment of dividends or distributions by certain of our subsidiaries to us. If our subsidiaries are unable to make dividend or distribution payments to us and sufficient cash or liquidity is not otherwise available, we may not be able to make dividend payments to our stockholders or principal and interest payments on our outstanding indebtedness.We and our subsidiaries may still be able to incur substantial additional indebtedness in the future, which could further exacerbate the risks that we and our subsidiaries face.We and our subsidiaries may be able to incur substantial additional indebtedness in the future. The terms of our and our subsidiaries’ revolving credit facilities and the indentures restrict, but in each case do not completely prohibit, us from doing so. Further, the indentures governing our and our subsidiaries’ notes allow us to issue additional notes, incur certain other additional debt and to have subsidiaries that do not guarantee the senior notes and which may incur additional debt, which would be structurally senior to the senior notes. In addition, the indentures governing the senior notes do not prevent us from incurring other liabilities that do not constitute indebtedness. If we or a guarantor incur any additional indebtedness that ranks equally with the senior notes (or with the guarantees thereof), including additional unsecured indebtedness or trade payables, the holders of that indebtedness will be entitled to share ratably with holders of the senior notes in any proceeds distributed in connection with any insolvency, liquidation, reorganization, dissolution or other winding-up of us or a guarantor. If new debt or other liabilities are added to our current debt levels, the related risks that we and our subsidiaries now face could intensify.If we experience liquidity concerns, we could face a downgrade in our debt ratings which could restrict our access to, and negatively impact the terms of, current or future financings or trade credit.Our ability to obtain financings and trade credit and the terms of any financings or trade credit is, in part, dependent on the credit ratings assigned to our debt by independent credit rating agencies. We cannot provide assurance that any of our current ratings will remain in effect for any given period of time or that a rating will not be lowered or withdrawn entirely by a rating agency if, in its judgment, circumstances so warrant. Factors that may impact our credit ratings include debt levels, planned asset purchases or sales and near-term and long-term production growth opportunities, liquidity, asset quality, cost structure, product mix and commodity pricing levels. A ratings downgrade could adversely impact our ability to access financings or trade credit and increase our borrowing costs.Borrowings under our, Viper LLC’s and Rattler LLC’s revolving credit facilities expose us to interest rate risk. Our earnings are exposed to interest rate risk associated with borrowings under our and our subsidiaries’ revolving credit facilities. The terms of our and our subsidiaries’ revolving credit facilities provide for interest on borrowings at a floating rate equal to an alternate base rate tied to LIBOR. LIBOR tends to fluctuate based on multiple facts, including general short-term interest rates, rates set by the U.S. Federal Reserve and other central banks, the supply of and demand for credit in the London interbank market and general economic conditions. We use interest rate swaps to reduce interest rate exposure with respect to our floating rate debt. Our weighted average interest rate on borrowings under our revolving credit facility was 2.02% during the year ended December 31, 2020. Viper LLC’s weighted average interest rate on borrowings from its revolving credit facility was 2.20% during the year ended December 31, 2020. Rattler LLC’s weighted average interest rate on borrowings from its revolving credit facility was 2.10% during the year ended December 31, 2020. If interest rates increase, so will our interest costs, which may have a material adverse effect on our results of operations and financial condition. On July 27, 2017, the U.K. Financial Conduct Authority (the authority that regulates LIBOR) announced that it intends to stop compelling banks to submit rates for the calculation of LIBOR after 2021. It is unclear whether new methods of calculating LIBOR will be established or if LIBOR will continue to exist after 2021. The U.S. Federal Reserve, in conjunction with the Alternative Reference Rates Committee, is considering replacing U.S. dollar LIBOR with a newly created index. It is not possible to predict the effect of these changes, other reforms or the establishment of alternative reference rates in the United States or elsewhere.49Table of ContentsRisks Related to Our Common Stock The corporate opportunity provisions in our certificate of incorporation could enable affiliates of ours to benefit from corporate opportunities that might otherwise be available to us. Subject to the limitations of applicable law, our certificate of incorporation, among other things; permits us to enter into transactions with entities in which one or more of our officers or directors are financially or otherwise interested; permits any of our stockholders, officers or directors to conduct business that competes with us and to make investments in any kind of property in which we may make investments; and provides that if any director or officer of one of our affiliates who is also one of our officers or directors becomes aware of a potential business opportunity, transaction or other matter (other than one expressly offered to that director or officer in writing solely in his or her capacity as our director or officer), that director or officer will have no duty to communicate or offer that opportunity to us, and will be permitted to communicate or offer that opportunity to such affiliates and that director or officer will not be deemed to have (i) acted in a manner inconsistent with his or her fiduciary or other duties to us regarding the opportunity or (ii) acted in bad faith or in a manner inconsistent with our best interests. These provisions create the possibility that a corporate opportunity that would otherwise be available to us may be used for the benefit of one of our affiliates. We have engaged in the past and may in the future engage in transactions with our affiliates. The terms of such transactions and the resolution of any conflicts that may arise may not always be in our or our stockholders’ best interests. In the past, we have engaged in transactions with affiliated companies and may do so again in the future. These transactions, and the resolution of any conflicts that may arise in connection with such related party transactions, including pricing, duration or other terms of service, may not always be in our or our stockholders’ best interests.If the price of our common stock fluctuates significantly, your investment could lose value. Although our common stock is listed on the Nasdaq Global Select Market, we cannot assure you that an active public market will continue for our common stock. If an active public market for our common stock does not continue, the trading price and liquidity of our common stock will be materially and adversely affected. If there is a thin trading market or “float” for our stock, the market price for our common stock may fluctuate significantly more than the stock market as a whole. Without a large float, our common stock would be less liquid than the stock of companies with broader public ownership and, as a result, the trading prices of our common stock may be more volatile. In addition, in the absence of an active public trading market, investors may be unable to liquidate their investment in us. Furthermore, the stock market is subject to significant price and volume fluctuations, and the price of our common stock could fluctuate widely in response to several factors, including; our quarterly or annual operating results; changes in our earnings estimates; investment recommendations by securities analysts following our business or our industry; additions or departures of key personnel; changes in the business, earnings estimates or market perceptions of our competitors; our failure to achieve operating results consistent with securities analysts’ projections; changes in industry, general market or economic conditions; and announcements of legislative or regulatory changes. The stock market has experienced extreme price and volume fluctuations in recent years that have significantly affected the quoted prices of the securities of many companies, including companies in our industry. The changes often appear to occur without regard to specific operating performance. The price of our common stock could fluctuate based upon factors that have little or nothing to do with our company and these fluctuations could materially reduce our stock price. The declaration of dividends and any repurchases of our common stock are each within the discretion of our board of directors based upon a review of relevant considerations, and there is no guarantee that we will pay any dividends on or repurchase shares of our common stock in the future or at levels anticipated by our stockholders. On February 13, 2018, we initiated payment of quarterly cash dividends on our common stock payable beginning with the first quarter of 2018. The decision to pay any future dividends, however, is solely within the discretion of, and subject to approval by, our board of directors. Our board of directors’ determination with respect to any such dividends, including the record date, the payment date and the actual amount of the dividend, will depend upon our profitability and financial condition, contractual restrictions, restrictions imposed by applicable law and other factors that the board deems relevant at the time of such determination. Based on its evaluation of these factors, the board of directors may determine not to declare a dividend, or declare dividends at rates that are less than currently anticipated, either of which could reduce returns to our stockholders.50Table of ContentsIn May 2019, our board of directors approved a stock repurchase program to acquire up to $2 billion of our outstanding common stock through December 31, 2020. This repurchase program is at the discretion of our board of directors and may be suspended from time to time, modified, extended or discontinued by our board of directors at any time. The repurchase program was suspended beginning in the first quarter of 2020 and expired on December 31, 2020.A change of control could limit our use of net operating losses.As of December 31, 2020, we had a net operating loss, or NOL, carry forward of approximately $2.3 billion for federal income tax purposes. If we were to experience an “ownership change,” as determined under Section 382 of the Code, our ability to offset taxable income arising after the ownership change with NOLs generated prior to the ownership change would be limited, possibly substantially. In general, an ownership change would establish an annual limitation on the amount of our pre-change NOLs that we could utilize to offset our taxable income in any future taxable year to an amount generally equal to the value of our stock immediately prior to the ownership change multiplied by an interest rate periodically promulgated by the IRS referred to as the long-term tax-exempt rate. In general, an ownership change will occur if there is a cumulative increase in the ownership of our stock totaling more than 50 percentage points by one or more “5% shareholders” (as defined in the Code) at any time during a rolling three-year period.If securities or industry analysts do not publish research or reports about our business, if they adversely change their recommendations regarding our stock or if our operating results do not meet their expectations, our stock price could decline. The trading market for our common stock will be influenced by the research and reports that industry or securities analysts publish about us or our business. If one or more of these analysts cease coverage of our company or fail to publish reports on us regularly, we could lose visibility in the financial markets, which in turn could cause our stock price or trading volume to decline. Moreover, if one or more of the analysts who cover our company downgrade our stock or if our operating results do not meet their expectations, our stock price could decline. We may issue preferred stock whose terms could adversely affect the voting power or value of our common stock. Our certificate of incorporation authorizes us to issue, without the approval of our stockholders, one or more classes or series of preferred stock having such designations, preferences, limitations and relative rights, including preferences over our common stock respecting dividends and distributions, as our board of directors may determine. The terms of one or more classes or series of preferred stock could adversely impact the voting power or value of our common stock. For example, we might grant holders of preferred stock the right to elect some number of our directors in all events or on the happening of specified events or the right to veto specified transactions. Similarly, the repurchase or redemption rights or liquidation preferences we might assign to holders of preferred stock could affect the residual value of the common stock. Provisions in our certificate of incorporation and bylaws and Delaware law make it more difficult to effect a change in control of the company, which could adversely affect the price of our common stock.The existence of some provisions in our certificate of incorporation and bylaws and Delaware corporate law could delay or prevent a change in control of our company, even if that change would be beneficial to our stockholders. Our certificate of incorporation and bylaws contain provisions that may make acquiring control of our company difficult, including; provisions regulating the ability of our stockholders to nominate directors for election or to bring matters for action at annual meetings of our stockholders; limitations on the ability of our stockholders to call a special meeting and act by written consent; the ability of our board of directors to adopt, amend or repeal bylaws, and the requirement that the affirmative vote of holders representing at least 66 2/3% of the voting power of all outstanding shares of capital stock be obtained for stockholders to amend our bylaws; the requirement that the affirmative vote of holders representing at least 66 2/3% of the voting power of all outstanding shares of capital stock be obtained to remove directors; the requirement that the affirmative vote of holders representing at least 66 2/3% of the voting power of all outstanding shares of capital stock be obtained to amend our certificate of incorporation; and the authorization given to our board of directors to issue and set the terms of preferred stock without the approval of our stockholders. 51Table of ContentsThese provisions also could discourage proxy contests and make it more difficult for you and other stockholders to elect directors and take other corporate actions. As a result, these provisions could make it more difficult for a third party to acquire us, even if doing so would benefit our stockholders, which may limit the price that investors are willing to pay in the future for shares of our common stock. ITEM 1B. UNRESOLVED STAFF COMMENTSNone.ITEM 3. LEGAL PROCEEDINGSWe are a party to various legal proceedings, disputes and claims arising in the course of our business, including those that arise from interpretation of federal and state laws and regulations affecting the natural gas and crude oil industry, personal injury claims, title disputes, royalty disputes, contract claims, contamination claims relating to oil and natural gas exploration and development and environmental claims, including claims involving assets previously sold to third parties and no longer part of our current operations. While the ultimate outcome of the pending proceedings, disputes or claims, and any resulting impact on us, cannot be predicted with certainty, we believe that none of these matters, if ultimately decided adversely, will have a material adverse effect on our financial condition, cash flows or results of operations.For additional information regarding contingencies, see Note 17—Commitments and Contingencies included in notes to the consolidated financial statements included elsewhere in this Annual Report.ITEM 4. MINE SAFETY DISCLOSURESNot applicable.PART IIITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIESListing and Holders of RecordOur common stock is listed on the Nasdaq Global Select Market under the symbol “FANG”. There were 2,564 holders of record of our common stock on February 19, 2021.Dividend Policy On February 13, 2018, we announced the initiation of an annual cash dividend in the amount of $0.50 per share of our common stock payable quarterly which began with the first quarter of 2018. Beginning with the first quarter of 2019, the annual cash dividend was set at $0.75 per share of our common stock. Then, beginning with the fourth quarter of 2019, the annual cash dividend was increased to $1.50 per share for our common stock and, beginning with the fourth quarter of 2020, the annual cash dividend was further increased to $1.60 per share of our common stock. The decision to pay any future dividends is solely within the discretion of, and subject to approval by, our board of directors. Our board of directors’ determination with respect to any such dividends, including the record date, the payment date and the actual amount of the dividend, will depend upon our profitability and financial condition, contractual restrictions, restrictions imposed by applicable law and other factors that the board deems relevant at the time of such determination. Unregistered Sales of Equity SecuritiesAs previously disclosed in our Current Report on Form 8-K filed with the SEC on December 21, 2020, we entered into a definitive purchase and sale agreement, dated as of December 18, 2020, with Guidon and certain of Guidon’s affiliates to acquire approximately 32,500 net acres in the Northern Midland Basin and certain related oil and gas assets. Consideration for the Pending Guidon Acquisition consists of $375 million in cash and 10.6 million shares of our common stock, subject to adjustment. The shares to be issued in the Pending Guidon Acquisition will be issued in reliance upon the exemption from the registration requirements of the Securities Act provided by Section 4(a)(2) of the Securities Act as sales by an issuer not involving any public offering. We have agreed to file with the SEC, and use our reasonable best efforts to cause to be declared effective, a shelf registration statement registering for resale these shares within 60 days following the closing of the Pending Guidon Acquisition, which is expected to occur on February 26, 2021.52Table of ContentsRepurchases of Equity SecuritiesOur common stock repurchase activity for the three months ended December 31, 2020 was as follows:PeriodTotal Number of Shares PurchasedAverage Price Paid Per Share(1)Total Number of Shares Purchased as Part of Publicly Announced PlanApproximate Dollar Value of Shares that May Yet Be Purchased Under the Plan(2)($ in millions, except per share amounts, shares in thousands)October 1, 2020 - October 31, 2020—$— —$1,304 November 1, 2020 - November 30, 2020—$— —$1,304 December 1, 2020 - December 31, 2020—$— —$— Total—$— —(1)The average price paid per share is net of any commissions paid to repurchase stock.(2)In May 2019, our board of directors approved a stock repurchase program to acquire up to $2 billion of our outstanding common stock through December 31, 2020. This repurchase program was suspended beginning in the first quarter of 2020 and expired on December 31, 2020. ITEM 6. SELECTED FINANCIAL DATA[Reserved.]53Table of ContentsITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSThe following discussion and analysis should be read in conjunction with our consolidated financial statements and notes thereto appearing elsewhere in this Annual Report. The following discussion contains “forward-looking statements” that reflect our future plans, estimates, beliefs, and expected performance. Actual results and the timing of events may differ materially from those contained in these forward-looking statements due to a number of factors. See Item 1A. “Risk Factors” and “Cautionary Statement Regarding Forward-Looking Statements.” OverviewWe operate in two operating segments: (i) the upstream segment, which is engaged in the acquisition, development, exploration and exploitation of unconventional, onshore oil and natural gas reserves primarily in the Permian Basin in West Texas and (ii) through our subsidiary, Rattler, the midstream operations segment, which is focused on ownership, operation, development and acquisition of the midstream infrastructure assets in the Midland and Delaware Basins of the Permian Basin.Upstream OperationsIn our upstream segment, our activities are primarily directed at the horizontal development of the Wolfcamp and Spraberry formations in the Midland Basin and the Wolfcamp and Bone Spring formations in the Delaware Basin. We intend to continue to develop our reserves and increase production through development drilling and exploitation and exploration activities on our multi-year inventory of identified potential drilling locations and through acquisitions that meet our strategic and financial objectives, targeting oil-weighted reserves.As of December 31, 2020, we had approximately 378,678 net acres, which primarily consisted of approximately 194,591 net acres in the Midland Basin and approximately 152,587 net acres in the Delaware Basin. As of December 31, 2020, we had an estimated 10,413 gross horizontal locations that we believe to be economic at $60.00 per Bbl WTI.In addition, our publicly traded subsidiary Viper owns mineral interests underlying approximately 787,264 gross acres and 24,350 net royalty acres in the Permian Basin and Eagle Ford Shale. Approximately 52% of these net royalty acres are operated by us.Midstream OperationsIn our midstream operations segment, Rattler’s crude oil infrastructure assets consist of gathering pipelines and metering facilities, which collectively gather crude oil for its customers. Rattler’s facilities gather crude oil from horizontal and vertical wells in our ReWard, Spanish Trail, Pecos and Fivestones areas within the Permian Basin. Rattler’s natural gas gathering and compression system consists of gathering pipelines, compression and metering facilities, which collectively service the production from our Pecos area assets within the Permian Basin. Rattler’s water sourcing and distribution assets consists of water wells, frac pits, pipelines and water treatment facilities, which collectively gather and distribute water from Permian Basin aquifers to the drilling and completion sites through buried pipelines and temporary surface pipelines. Rattler’s gathering and disposal system spans approximately 517 miles and consists of gathering pipelines along with produced water disposal, or PWD, wells and facilities which collectively gather and dispose of produced water from operations throughout our Permian Basin acreage.We have entered into multiple fee-based commercial agreements with Rattler, each with an initial term ending in 2034, utilizing Rattler’s infrastructure assets or its planned infrastructure assets to provide an array of essential services critical to our upstream operations in the Delaware and Midland Basins. Our agreements with Rattler include substantial acreage dedications.2020 Transactions and Recent DevelopmentsCOVID-19 and Collapse in Commodity Prices On March 11, 2020, the World Health Organization characterized the global outbreak of the novel strain of coronavirus, COVID-19, as a “pandemic.” To limit the spread of COVID-19, governments have taken various actions including the issuance of stay-at-home orders and social distancing guidelines, causing some businesses to suspend operations and a reduction in demand for many products from direct or ultimate customers. Although many stay-at-home orders have expired and certain restrictions on conducting business have been lifted, the COVID-19 pandemic resulted in a 54Table of Contentswidespread health crisis and a swift and unprecedented reduction in international and U.S. economic activity which, in turn, has adversely affected the demand for oil and natural gas and caused significant volatility and disruption of the financial markets.In early March 2020, oil prices dropped sharply and continued to decline reaching negative levels. During 2020, the posted price for the WTI price for crude oil ranged from $(37.63) to $63.27 per barrel, or Bbl, and the NYMEX Henry Hub price of natural gas ranged from $1.48 to $3.35 per MMBtu. On January 29, 2021, the NYMEX WTI price for crude oil was $52.20 per Bbl and the NYMEX Henry Hub price of natural gas was $2.56 per MMBtu. In response to recent volatility in commodity prices, many producers have reduced their capital expenditure budgets. This was a result of multiple factors affecting the supply and demand in global oil and natural gas markets, including actions taken by OPEC members and other exporting nations impacting commodity price and production levels and a significant decrease in demand due to the ongoing COVID-19 pandemic. While OPEC members and certain other nations agreed in April 2020 to cut production and subsequently extended such production cuts through December 2020, which helped to reduce a portion of the excess supply in the market and improve crude oil prices, they agreed to increase production by 500,000 barrels per day beginning in January 2021. We cannot predict if or when commodity prices will stabilize and at what levels.As a result of the reduction in crude oil demand caused by factors discussed above, in 2020, we lowered our 2020 capital budgets and production guidance, curtailed near term production and reduced rig count, all of which may be subject to further reductions or curtailment if the commodity markets and macroeconomic conditions worsen. Although we have restored curtailed production, actions taken in response to the COVID-19 pandemic and depressed commodity pricing environment have had and are expected to continue to have an adverse effect on our business, financial results and cash flows.In addition, as a result of the sharp decline in commodity prices in early March 2020, and the continued depressed oil pricing throughout the second and third quarters of 2020, we recorded $6.0 billion of aggregate non-cash ceiling test impairments for the year ended December 31, 2020. These impairment charges adversely affected our results of operations but did not reduce our cash flows. If the trailing 12-month commodity prices continue to fall as compared to the commodity prices used in prior quarters, we will have material write downs in subsequent quarters. Our production, proved reserves and cash flows will also be adversely impacted. Our results of operations may be further adversely impacted by any government rule, regulation or order that may impose production limits, as well as pipeline capacity and storage constraints, in the Permian Basin where we operate. Given the dynamic nature of these events, we cannot reasonably estimate the period of time that the COVID-19 pandemic, the depressed commodity prices and the adverse macroeconomic conditions will persist, the full extent of the impact they will have on our industry and our business, financial condition, results of operations or cash flows, or the pace or extent of any subsequent recovery.Pending Merger with QEP Resources, Inc. On December 20, 2020, we, QEP and the Merger Sub, entered into the merger agreement under which the Merger Sub will be merged with and into QEP, with QEP surviving as our wholly owned subsidiary. If the pending merger is completed, each QEP stockholder will receive, in exchange for each share of QEP common stock held by such stockholder immediately prior to the closing of the pending merger, 0.050 of a share of our common stock. The completion of the pending merger is subject to satisfaction or waiver of certain customary mutual closing conditions, including the receipt of the required approvals from QEP’s stockholders. The pending merger is expected to close shortly following the special meeting of the QEP stockholders, which is scheduled for March 16, 2021, subject to QEP stockholder approval and other customary closing conditions. See “Items 1 and 2. Business and Properties—Overview—Pending Merger with QEP Resources, Inc.” for additional information regarding the pending merger.We expect that the pending merger will:•add material Tier-1 Midland Basin inventory;•be accretive on all relevant 2021 per share metrics including cash flow per share, free cash flow per share and leverage, before accounting for synergies; •lower 2021 reinvestment ratio and enhance ability to generate free cash flow, de-lever and return capital to our stockholders; and•realize significant, tangible annual synergies of $60 to $80 million comprised of general and administrative expense savings, cost of capital and interest expense savings, improved capital efficiency from high-graded development of 55Table of Contentscombined acreage, physical adjacencies to increase lateral lengths and significant adjacent Permian Basin midstream assets.In addition, we expect to maintain our investment grade credit ratings following the completion of the pending merger.Pending Guidon AcquisitionOn December 18, 2020, we entered into a definitive purchase and sale agreement with Guidon and certain of Guidon’s affiliates to acquire approximately 32,500 net acres in the Northern Midland Basin and certain related oil and natural gas assets, which we refer to as the Pending Guidon Acquisition. Consideration for the Pending Guidon Acquisition consists of $375 million in cash and 10.6 million shares of our common stock, subject to adjustment. The cash portion of this transaction is expected to be funded through a combination of cash on hand and borrowings under our credit facility. The Pending Guidon Acquisition is expected to close on February 26, 2021.Fourth Quarter 2020 Dividend Declaration and IncreaseOn February 18, 2021, our board of directors declared a cash dividend for the fourth quarter of 2020 of $0.40 per share of common stock, payable on March 11, 2021 to our stockholders of record at the close of business on March 4, 2021, representing a 6.7% increase per share from the previously paid quarterly dividend.Implementation of Viper’s Common Unit Repurchase ProgramOn November 6, 2020, the board of directors of Viper’s general partner approved an expansion of Viper’s return of capital program with the implementation of a common unit repurchase program to acquire up to $100 million of Viper’s outstanding common units through December 31, 2021. During the year ended December 31, 2020, Viper repurchased approximately $24 million of its common units under its repurchase program. As of December 31, 2020, $76 million remained available for use to repurchase common units under Viper’s common unit repurchase program.Implementation of Rattler’s Common Unit Repurchase ProgramOn October 29, 2020, the board of directors of Rattler’s general partner approved a common unit repurchase program to acquire up to $100 million of Rattler’s outstanding common units through December 31, 2021. During the year ended December 31, 2020, Rattler repurchased approximately $15 million of its common stock under its repurchase program. As of December 31, 2020, $85 million remained available for use to repurchase common units under Rattler’s common unit repurchase program.May 2020 Notes OfferingOn May 26, 2020, we completed a notes offering of $500 million in aggregate principal amount of our 4.750% Senior Notes due 2025, which we refer to as the May 2020 Notes. We received net proceeds of approximately $496 million from the offering of the May 2020 Notes which we used to, among other things, make an equity contribution to Energen to purchase $209 million in aggregate principal amount of Energen’s 4.625% senior notes pursuant to a tender offer. For additional information regarding this notes offering, see “—Liquidity and Capital Resources—Indebtedness—The May 2020 Notes and Tender Offer for Energen’s 4.625% Senior Notes and Repurchase of Energen’s 7.35% Medium-term Notes” below.Rattler Notes OfferingOn July 14, 2020, Rattler completed an offering, which we refer to as the Rattler Notes Offering, of its 5.625% senior notes due 2025 in the aggregate principal amount of $500 million, which we refer to as the Rattler Notes. Rattler received net proceeds of approximately $490 million from the Rattler Notes Offering and loaned the gross proceeds of the Rattler Notes Offering to Rattler LLC to pay down borrowings under its revolving credit facility. For additional information regarding the Rattler Notes Offering, see “—Liquidity and Capital Resources—Indebtedness—Rattler’s Notes” below.56Table of ContentsOperational UpdateOur development program is focused entirely within the Permian Basin, where we continue to focus on long-lateral multi-well pad development. Our horizontal development consists of multiple targeted intervals, primarily within the Wolfcamp and Spraberry formations in the Midland Basin and the Wolfcamp and Bone Springs formations in the Delaware Basin.As of December 31, 2020, we were operating eight drilling rigs and currently intend to operate between eight and 12 drilling rigs in 2021 on average across our current acreage position in the Midland and Delaware Basins.In the Midland Basin, we continued to have positive results across our core development areas located within Midland, Martin, Howard, Glasscock and Andrews counties, where development has primarily focused on drilling long-lateral, multi-well pads targeting the Spraberry and Wolfcamp formations.In the Delaware Basin, we have now drilled and completed a significant number of wells in Pecos, Reeves and Ward counties targeting the Wolfcamp A, which we believe has been de-risked across a significant portion of our total acreage position and remains our primary development target. In 2021, we expect to focus development on these areas. In the fourth quarter of 2020, we executed on our business strategy, providing a foundation for continued solid operational performance in 2021. We are starting to see the benefits from our strategy to cut activity and high-grade development focusing on our most productive areas in terms of capital efficiency and early-time well performance. While the impact of the recent winter storms in the Permian Basin on the first quarter 2021 production is expected to be significant (ranging from four to five days of total net production lost), we expect to overcome this adverse impact for the full year 2021. Well costs and cash operating costs remain near all-time lows, providing for increased returns to our stockholders as commodity prices have risen in recent months. In 2021, we intend to continue to focus on low cost operations and best in class execution and currently plan to hold our fourth quarter 2020 production flat while generating free cash flow used to pay dividends and pay down debt. To combat potential fluctuation in service costs, we have worked to implement new and more efficient drilling and completions methodologies and will continue to seek opportunities to control additional well cost where possible. Our 2021 drilling and completion budget accounts for capital costs that we expect to occur during the year.In 2021, we remain focused on navigating our industry challenges by staying disciplined, improving our industry-leading cost structure, maintaining production and increasing environmental transparency. Environmental Responsibility Initiatives and HighlightsIn February 2021, we announced significant enhancements to our commitment to environmental, social responsibility and governance, or ESG, performance and disclosure, including Scope 1 and methane emission intensity reduction targets. Our goals include the reduction of our Scope 1 greenhouse gas intensity by at least 50% and methane intensity by at least 70%, in each case by 2024 from the 2019 levels. To further underscore our commitment to carbon neutrality, we are also implementing our “Net Zero Now” initiative under which, effective January 1, 2021, every hydrocarbon molecule we produce is anticipated to be produced with zero Scope 1 emissions. To the extent our greenhouse gas and methane intensity targets do not eliminate our carbon footprint, we intend to purchase carbon credits to offset the remaining emissions. We also plan to increase the weighting of ESG metrics in our annual short-term incentive compensation plan to motivate our executives to advance our environmental responsibility goals.With respect to flaring, we flared 0.9% of our gross natural gas production in the fourth quarter of 2020. For the full year ended 2020, we flared 2.0% of our gross natural gas production, down 64% from 2019.2021 Capital BudgetWe have currently budgeted 2021 total capital spend of $1.4 billion to $1.6 billion, consisting of $1.2 billion to $1.4 billion for horizontal drilling and completions including non-operated activity, $60 million to $80 million for midstream investments, excluding joint venture investments, and $70 million to $90 million for infrastructure and other expenditures, excluding the cost of any leasehold and mineral interest acquisitions. We expect to drill and complete 215 to 235 gross horizontal wells in 2021. Should commodity prices weaken, we intend to act responsibly and, consistent with our prior practices, reduce capital spending. If commodity prices strengthen, we intend to grow oil production within our 2021 budget, pay down indebtedness and return cash to our stockholders. 57Table of ContentsResults of Operations For a discussion of the results of operations for the year ended December 31, 2019 as compared to the year ended December 31, 2018, please refer to “Part II, Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations" in our Annual Report on Form 10-K for the year ended December 31, 2019 (filed with the SEC on February 27, 2020), which discussion is incorporated in this report by reference from such prior report on Form 10-K. The following table sets forth selected historical operating data for the periods indicated:Year Ended December 31,20202019Revenues (in millions):Oil sales$2,410 $3,554 Natural gas sales107 66 Natural gas liquid sales239 267 Total oil, natural gas and natural gas liquid revenues$2,756 $3,887 Production Data (in thousands):Oil (MBbls)66,182 68,518 Natural gas (MMcf)130,549 97,613 Natural gas liquids (MBbls)21,981 18,498 Combined volumes (MBOE)109,921 103,285 Daily oil volumes (BO/d)180,825 187,721 Daily combined volumes (BOE/d)300,331 282,972 Average Prices:Oil ($ per Bbl)$36.41 $51.87 Natural gas ($ per Mcf)$0.82 $0.68 Natural gas liquids ($ per Bbl)$10.87 $14.42 Combined ($ per BOE)$25.07 $37.63 Oil, hedged ($ per Bbl)(1)$40.34 $51.96 Natural gas, hedged ($ per MMbtu)(1)$0.67 $0.86 Natural gas liquids, hedged ($ per Bbl)(1)$10.83 $15.20 Average price, hedged ($ per BOE)(1)$27.26 $38.00 (1)Hedged prices reflect the effect of our commodity derivative transactions on our average sales prices and include gains and losses on cash settlements for matured commodity derivatives, which we do not designate for hedge accounting. Hedged prices exclude gains or losses resulting from the early settlement of commodity derivative contracts.Production DataSubstantially all of our revenues are generated through the sale of oil, natural gas and natural gas liquids production. The following tables set forth our production data for the years ended December 31, 2020 and 2019:Year Ended December 31,20202019Oil (MBbls)60 %66 %Natural gas (MMcf)20 %16 %Natural gas liquids (MBbls)20 %18 %100 %100 %58Table of ContentsComparison of the Years Ended December 31, 2020 and 2019 Oil, Natural Gas and Natural Gas Liquids Revenues. Our revenues are a function of oil, natural gas and natural gas liquids production volumes sold and average sales prices received for those volumes. The net dollar effect of the change in prices are shown below:Change in pricesProduction volumes(1)Total net dollar effect of change(in millions)Effect of changes in price:Oil$(15.46)66,182 $(1,023)Natural gas$0.14 130,549 $18 Natural gas liquids$(3.55)21,981 $(77)Total revenues due to change in price$(1,082)Change in production volumes(1)Prior period average pricesTotal net dollar effect of change(in millions)Effect of changes in production volumes:Oil(2,336)$51.87 $(121)Natural gas32,936 $0.68 $22 Natural gas liquids3,483 $14.42 $50 Total change in revenues$(49)$(1,131)(1)Production volumes are presented in MBbls for oil and natural gas liquids and MMcf for natural gas. Our oil, natural gas and natural gas liquids revenues decreased by approximately $1.1 billion, or 29%, to $2.8 billion for the year ended December 31, 2020 from $3.9 billion for the year ended December 31, 2019, largely attributable to lower oil average sales prices resulting from the impact of the COVID-19 pandemic and other volatility in global commodity prices as discussed in “—COVID-19 and collapse in Commodity Prices” above.Average daily production sold increased by 17,359 BOE/d to 300,331 BOE/d during the year ended December 31, 2020 from 282,972 BOE/d during the year ended December 31, 2019, primarily due to an increase in natural gas liquids and natural gas production, which was partially offset by temporarily curtailing a portion of our oil production volumes during 2020 in response to the sudden drop in demand and prices for oil stemming from the COVID-19 pandemic. Midstream Services Revenue. The following table shows midstream services revenue for the years ended December 31, 2020 and 2019:Year Ended December 31,20202019(in millions)Midstream services$50 $64 Our midstream services revenue represents fees charged to our joint interest owners and third parties for the transportation of oil and natural gas along with water gathering and related disposal facilities. Midstream services revenue decreased by $14 million for the year ended December 31, 2020 as compared to the year ended December 31, 2019 primarily due to a reduction in sourced water volumes due to the lower level of drilling and completion activity in 2020.Lease Operating Expenses. The following table shows lease operating expenses for the years ended December 31, 2020 and 2019:Year Ended December 31,20202019(in millions, except per BOE amounts)AmountPer BOEAmountPer BOELease operating expenses$425 $3.87 $490 $4.74 59Table of ContentsLease operating expenses for the year ended December 31, 2020 as compared to the year ended December 31, 2019 decreased by $65 million, or $0.87 per BOE. Lease operating expenses decreased due to a reduction in work over and well maintenance activity through overall efficiencies gained, as well as improvements in infrastructure which reduced power generation costs and trucking fees. In addition to these efficiencies we have seen a reduction in service pricing in 2020, driven by the reduction in current industry activity levels. We expect service pricing may increase in future periods, particularly if current industry activity levels increase.Production and Ad Valorem Tax Expense. The following table shows production and ad valorem tax expense for the years ended December 31, 2020 and 2019:Year Ended December 31,20202019(in millions, except per BOE amounts)AmountPer BOEAmountPer BOEProduction taxes$135 $1.23 $184 $1.78 Ad valorem taxes60 0.54 64 0.62 Total production and ad valorem expense$195 $1.77 $248 $2.40 Production taxes as a % of oil, natural gas, and natural gas liquids revenue4.9 %4.7 %In general, production taxes are directly related to production revenues and are based upon current year commodity prices. Production taxes for the year ended December 31, 2020 as compared to the year ended December 31, 2019 decreased by $49 million, or $0.55 per BOE, due to current year commodity prices. Production taxes as a percentage of production revenues remained consistent for the year ended December 31, 2020 compared to the year ended December 31, 2019.Gathering and Transportation Expense. The following table shows gathering and transportation expense for the year ended December 31, 2020 and 2019:Year Ended December 31,20202019(in millions, except per BOE amounts)AmountPer BOEAmountPer BOEGathering and transportation expense$140 $1.27 $88 $0.86 For the year ended December 31, 2020, the per BOE increases for gathering and transportation expenses are primarily attributable to recording minimum volume commitment fees in 2020, as well as an increase in fees for our gas production and an overall change in our product mix, with gas and natural gas liquids production becoming a greater percentage of overall production.Midstream Services Expense. The following table shows midstream services expense for the years ended December 31, 2020 and 2019:Year Ended December 31,20202019(in millions)Midstream services expense$105 $91 Midstream services expense represents costs incurred to operate and maintain our oil and natural gas gathering and transportation systems, natural gas lift, compression infrastructure and water transportation facilities. Midstream services expense for the year ended December 31, 2020 as compared to the year ended December 31, 2019 increased by $14 million primarily due to increased volume and build out of the Rattler systems. 60Table of ContentsDepreciation, Depletion and Amortization. The following table provides the components of our depreciation, depletion and amortization expense for the years ended December 31, 2020 and 2019:Year Ended December 31,(in millions, except BOE amounts)20202019Depletion of proved oil and natural gas properties$1,242 $1,398 Depreciation of midstream assets44 33 Depreciation of other property and equipment18 16 Depreciation, depletion and amortization expense$1,304 $1,447 Oil and natural gas properties depletion per BOE$11.30 $13.54 The decrease in depletion of proved oil and natural gas properties of $156 million for the year ended December 31, 2020 as compared to the year ended December 31, 2019 resulted primarily from a reduction in the average depletion rate for our oil and natural gas properties in 2020, which stemmed from a decrease in the net book value of our properties due to the full cost ceiling impairments recorded in the first three quarters of 2020 as well as lower production levels in 2020 as compared to 2019.Impairment of Oil and Natural Gas Properties. As a result of the decline in commodity prices during 2020 and 2019, we recorded non-cash ceiling test impairments for the years ended December 31, 2020 and 2019 of $6.0 billion and $790 million, respectively, which is included in accumulated depletion, depreciation, amortization and impairment on our consolidated balance sheet. The impairment charges affected our results of operations but did not reduce cash flow. In addition to commodity prices, our production rates, levels of proved reserves, future development costs, transfers of unevaluated properties and other factors will determine our actual ceiling test calculation and impairment analysis in future periods. If the trailing 12-month commodity prices continue to fall as compared to the commodity prices used in prior quarters, we will continue to have material write-downs in subsequent quarters. General and Administrative Expenses. The following table shows general and administrative expenses for the years ended December 31, 2020 and 2019:Year Ended December 31,20202019(in millions, except per BOE amounts)AmountPer BOEAmountPer BOEGeneral and administrative expenses$51 $0.46 $56 $0.54 Non-cash stock-based compensation37 0.34 48 0.46 Total general and administrative expenses$88 $0.80 $104 $1.00 General and administrative expenses for the year ended December 31, 2020 as compared to the year ended December 31, 2019 decreased by $16 million primarily due to a decrease in non-cash stock-based compensation.Net Interest Expense. The following table shows net interest expense for the years ended December 31, 2020 and 2019:Year Ended December 31,20202019(in millions)Interest expense, net$197 $172 Net interest expense increased by $25 million for the year ended December 31, 2020 as compared to the year ended December 31, 2019. This increase was primarily due to an increase in borrowings resulting from the issuance of the May 2020 Notes and the Rattler Notes. See Note 11—Debt for further details regarding outstanding borrowings and interest expense. 61Table of ContentsDerivatives. The following table shows the net gain (loss) on derivative instruments and the net cash received (paid) on settlements of derivative instruments for the years ended December 31, 2020 and 2019:Year Ended December 31,20202019(in millions)Gain (loss) on derivative instruments, net$(81)$(108)Net cash received (paid) on settlements$250 $80 Our earnings are affected by the changes in value of our derivatives portfolio between periods and the related cash settlements of those derivatives. To the extent the future commodity price outlook declines between measurement periods, we will have mark-to-market gains; while to the extent future commodity price outlook increases between measurement periods, we will have mark-to-market losses.Net cash received (paid) on settlements of derivative instruments for the years ended December 31, 2020 and 2019 include cash received on contracts terminated prior to their contractual maturity of $17 million related to commodity contracts and $43 million related to interest rate swap contracts, respectively.Provision for (Benefit from) Income Taxes. The following table shows the provision for (benefit from) income taxes for the years ended December 31, 2020 and 2019:Year Ended December 31,20202019(in millions)Provision for (benefit from) income taxes$(1,104)$47 The change in our income tax provision was primarily due to the pre-tax loss for the year ended December 31, 2020 as compared to pre-tax income for the year ended December 31, 2019, and the impact of recording a valuation allowance on Viper’s deferred tax assets during the year ended December 31, 2020. Liquidity and Capital Resources Historically, our primary sources of liquidity have been cash flows from operations, proceeds from our public equity offerings, borrowings under our revolving credit facility and proceeds from the issuance of the senior notes. Our primary uses of capital have been for the acquisition, development and exploration of oil and natural gas properties. As we pursue our business and financial strategy, we regularly consider which capital resources, including cash flow and equity and debt financings, are available to meet our future financial obligations, planned capital expenditure activities and liquidity requirements. Our future ability to grow proved reserves and production will be highly dependent on the capital resources available to us. Continued prolonged volatility in the capital, financial and/or credit markets due to the COVID-19 pandemic, the depressed commodity markets and/or adverse macroeconomic conditions may limit our access to, or increase our cost of, capital or make capital unavailable on terms acceptable to us or at all.Liquidity and Cash Flow Our cash flows for the years ended December 31, 2020 and 2019 are presented below: Year Ended December 31,20202019(in millions)Net cash provided by (used in) operating activities$2,118 $2,739 Net cash provided by (used in) investing activities(2,101)(3,888)Net cash provided by (used in) financing activities(37)1,062 Net change in cash$(20)$(87)62Table of ContentsOperating Activities Our operating cash flow is sensitive to many variables, the most significant of which is the volatility of prices for the oil and natural gas we produce. Prices for these commodities are determined primarily by prevailing market conditions. Regional and worldwide economic activity, weather and other substantially variable factors influence market conditions for these products. These factors are beyond our control and are difficult to predict. See “–Sources of our revenue” and Item 1A. “Risk Factors” above.Net cash provided by operating activities decreased to $2.1 billion for the year ended December 31, 2020 as compared to $2.7 billion for the year ended December 31, 2019, primarily due to a decline in our oil and natural gas revenues, which was partially offset by a decrease in lease operating expenses and other operating expenses and an increase in cash received on settlements of our derivative contracts.Investing Activities The purchase and development of oil and natural gas properties and related assets, and contributions to our equity method investments accounted for the majority of our $2.1 billion and $3.9 billion in cash outlays for investing activities during the years ended December 31, 2020 and 2019, respectively. Contributions to equity method investments decreased to $102 million for the year ended December 31, 2020 as compared to $485 million for the year ended December 31, 2019 as construction of both the EPIC Pipeline and Gray Oak Pipeline, which required substantial capital in 2019, was completed during April 2020. As of December 31, 2020, Rattler’s anticipated future capital commitments for its equity method investments total $72 million in the aggregate. For additional information regarding our equity method investments, see Note 10—Equity Method Investments included in notes to the consolidated financial statements included elsewhere in this Annual Report.Capital Expenditure ActivitiesOur capital expenditures excluding acquisitions and equity method investments (on a cash basis) were as follows for the specified period:Year Ended December 31,20202019(in millions)Drilling, completions and non-operated additions to oil and natural gas properties(1)(2)$1,611 $2,557 Infrastructure additions to oil and natural gas properties108 120 Additions to midstream assets140 244 Total$1,859 $2,921 (1) During the year ended December 31, 2020, in conjunction with our development program, we drilled 208 gross (195 net) operated horizontal wells, of which 75 gross (70 net) wells were in the Delaware Basin and the remaining wells were in the Midland Basin, and turned 171 gross (159 net) operated horizontal wells to production, of which 78 gross (74 net) wells were in the Delaware Basin and the remaining wells were in the Midland Basin.(2) During the year ended December 31, 2019, in conjunction with our development program, we drilled 330 gross (296 net) operated horizontal wells, of which 159 gross (142 net) wells were in the Delaware Basin and the remaining wells were in the Midland Basin, and turned 317 gross (289 net) operated horizontal wells to production, of which 139 gross (126 net) wells were in the Delaware Basin and the remaining wells were in the Midland Basin.Financing Activities During the year ended December 31, 2020, the amount used in financing activities was primarily attributable to $348 million of repayments, net of borrowings, on our credit facilities, $239 million in aggregate repayments on the Energen Notes and Viper Notes, $236 million in dividends paid to stockholders, $98 million of share repurchases as part of our stock repurchase program, and $93 million in distributions to non-controlling interest. These cash outlays were partially offset by net proceeds of $997 million from the issuance of the May 2020 Notes and the Rattler Notes during 2020. During the year ended December 31, 2019, the amount provided by financing activities was primarily attributable to $341 million in net proceeds from Viper’s public offering completed on March 1, 2019, $720 million in net proceeds from the Rattler Offering, $39 million in proceeds from joint ventures and $2.2 billion in proceeds from the December 2019 Notes, net of repayments, partially offset by $1.4 billion of repayments, net of borrowings, under our credit facility, $44 million of premium on debt extinguishment, $122 million of distributions to our non-controlling interest, $13 million of share 63Table of Contentsrepurchases for tax withholdings, $593 million of share repurchases as part of our stock repurchase program and $112 million of dividends to stockholders.IndebtednessSecond Amended and Restated Credit Facility At December 31, 2020, the maximum credit amount available under our credit agreement was $2.0 billion and the maturity date is November 1, 2022. As of December 31, 2020, we had approximately $23 million of outstanding borrowings under our revolving credit facility, which we believe provides ample availability for future borrowings, including funding for the cash portion of the Guidon acquisition in the first quarter of 2021. As of December 31, 2020, there was an aggregate of $3 million in letters of credit outstanding under our credit agreement, which reduce available borrowings on a dollar for dollar basis. The weighted average interest rate on the credit agreement was 2.02% for the year ended December 31, 2020. The credit agreement contains a financial covenant that requires us to maintain a total net debt to capitalization ratio (as defined in the credit agreement) of no more than 65%. Our non-guarantor restricted subsidiaries may incur debt for borrowed money in an aggregate principal amount up to 15% of consolidated net tangible assets (as defined in the credit agreement) and we and our restricted subsidiaries may incur liens if the aggregate amount of debt secured by such liens does not exceed 15% of consolidated net tangible assets.At December 31, 2020, we were in compliance with all financial maintenance covenants under the credit agreement, as then in effect. The lenders may accelerate all of the indebtedness under our revolving credit facility upon the occurrence and during the continuance of any event of default. The credit agreement contains customary events of default, including non-payment, breach of covenants, materially incorrect representations, cross-default, bankruptcy and change of control. The May 2020 Notes and Tender Offer for Energen’s 4.625% Senior Notes and Repurchase of Energen’s 7.35%Medium-term NotesOn May 26, 2020, we completed a registered offering of $500 million in aggregate principal amount of our 4.750% Senior Notes due 2025. Interest on the May 2020 Notes accrues from May 26, 2020, and is payable in cash semi-annually on May 31 and November 30 of each year, beginning November 30, 2020. The May 2020 Notes mature on May 31, 2025. We received net proceeds of approximately $496 million from the offering.We used the net proceeds, among other things, to make an equity contribution to Energen to purchase $209 million in aggregate principal amount of Energen’s 4.625% senior notes pursuant to a tender offer. As of December 31, 2020, $191 million in aggregate principal amount of Energen’s 4.625% senior notes remained outstanding.During the third quarter of 2020, we repurchased all $10 million in principal amount of Energen’s outstanding 7.350% medium-term notes due on July 28, 2027 at a price of 120% of the aggregate principal amount.For additional information, see Note 11—Debt included in notes to the consolidated financial statements included elsewhere in this Annual Report.Energen NotesOn November 29, 2018, Energen became our wholly owned subsidiary and remained the issuer of an aggregate principal amount of $530 million in notes, which we refer to as the Energen Notes. As of December 31, 2020, the aggregate principal amount of the Energen Notes had been reduced to $311 million consisting of: (a) $191 million aggregate principal amount of 4.625% senior notes due on September 1, 2021, (b) $100 million of 7.125% notes due on February 15, 2028, and (c) $20 million of 7.32% notes due on July 28, 2022.For additional information regarding the Energen Notes, See Note 11—Debt included in notes to the consolidated financial statements included elsewhere in this Annual Report.Viper’s Credit Agreement The Viper credit agreement provides for a revolving credit facility in the maximum credit amount of $2.0 billion and a borrowing base based on Viper LLC’s oil and natural gas reserves and other factors (the “borrowing base”) of $580 million, subject to scheduled semi-annual and other elective borrowing base redeterminations. The borrowing base is scheduled to be re-determined semi-annually with effective dates of May 1st and November 1st, and was reaffirmed at $580 million by the 64Table of Contentslenders during the regularly scheduled (semi-annual) fall 2020 redetermination in November 2020. As of December 31, 2020, Viper LLC had $84 million of outstanding borrowings and $496 million available for future borrowings under the Viper credit agreement. During the year ended December 31, 2020, the weighted average interest rate on Viper’s revolving credit facility was 2.20%. As of December 31, 2020, Viper LLC was in compliance with all financial maintenance covenants under the Viper credit agreement, as then in effect.Viper’s NotesOn October 16, 2019, Viper completed an offering in which it issued its 5.375% Senior Notes due 2027 in aggregate principal amount of $500 million. Viper received net proceeds of approximately $490 million from the notes offering and loaned the gross proceeds to Viper LLC to pay down borrowings under the Viper credit agreement. Interest on the Viper notes accrues at a rate of 5.375% per annum, payable semi-annually on May 1 and November 1 of each year, commencing on May 1, 2020. The Viper notes will mature on November 1, 2027. During the year ended December 31, 2020, Viper repurchased $20 million of outstanding principal of the Viper notes at a cash price ranging from 97.5% to 98.5% of the aggregate principal amount, which resulted in an immaterial gain on extinguishment of debt, and $480 million in aggregate principal amount remained outstanding at December 31, 2020. See additional discussion in Note 11—Debt included in notes to the consolidated financial statements included elsewhere in this Annual Report. Rattler’s Credit AgreementIn connection with the Rattler Offering, Rattler, as parent, and Rattler LLC, as borrower, entered into a credit agreement, dated May 28, 2019, with Wells Fargo Bank, as administrative agent, and a syndicate of banks, as lenders party thereto, which we refer to as the Rattler credit agreement.The Rattler credit agreement provides for a revolving credit facility in the maximum credit amount of $600 million and has a maturity date of May 28, 2024. As of December 31, 2020, Rattler LLC had $79 million of outstanding borrowings and $521 million available for future borrowings under the Rattler credit agreement. During the year ended December 31, 2020, the weighted average interest rate on the Rattler LLC revolving credit facility was 2.10%.As of December 31, 2020, Rattler LLC was in compliance with all financial maintenance covenants under the Rattler credit agreement. Rattler’s NotesOn July 14, 2020, Rattler completed an offering of $500 million in aggregate principal amount of its 5.625% Senior Notes due 2025, or the Rattler Notes Offering. Interest on the Rattler notes is payable on January 15 and July 15 of each year, beginning on January 15, 2021. The Rattler notes mature on July 15, 2025. Rattler received net proceeds of approximately $490 million from the Rattler Notes Offering. Rattler loaned the gross proceeds to Rattler LLC under the terms of a subordinated promissory note, dated as of July 14, 2020. The promissory note requires Rattler LLC to repay the intercompany loan to Rattler on the same terms and in the same amounts as the Rattler notes and has the same maturity date, interest rate, change of control repurchase and redemption provisions. Rattler LLC used the proceeds from the Rattler Notes Offering to repay a portion of the outstanding borrowings under the Rattler credit agreement.For additional information regarding our indebtedness, see Note 11—Debt included in notes to the consolidated financial statements included elsewhere in this Annual Report. Capital Requirements and Sources of Liquidity Our board of directors approved a 2021 capital budget for drilling, midstream and infrastructure of $1.4 billion to $1.6 billion, representing a decrease of 50% from our 2020 capital budget. We estimate that, of these expenditures, approximately:•$1.2 billion to $1.4 billion will be spent on drilling and completing 215 to 235 gross (197 to 215 net) horizontal wells across our operated leasehold acreage in the Northern Midland and Southern Delaware Basins, with an average lateral length of approximately 10,100 feet; 65Table of Contents•$60 million to $80 million will be spent on midstream infrastructure, excluding joint venture investments; and•$70 million to $90 million will be spent on infrastructure and other expenditures, excluding the cost of any leasehold and mineral interest acquisitions.We do not have a specific acquisition budget since the timing and size of acquisitions cannot be accurately forecasted.During the year ended December 31, 2020, we spent $1.6 billion on drilling and completion, $140 million on midstream, $108 million on infrastructure and $58 million on non-operated properties, for total capital expenditures of $1.9 billion.In May 2019, our board of directors approved a stock repurchase program to acquire up to $2 billion of our outstanding common stock through December 31, 2020. We repurchased approximately $98 million of our common stock under this program during the year ended December 31, 2020, prior to the program’s expiration.The amount and timing of our capital expenditures are largely discretionary and within our control. We could choose to defer a portion of these planned capital expenditures depending on a variety of factors, including but not limited to the success of our drilling activities, prevailing and anticipated prices for oil and natural gas, the availability of necessary equipment, infrastructure and capital, the receipt and timing of required regulatory permits and approvals, seasonal conditions, drilling and acquisition costs and the level of participation by other interest owners. We are currently operating eight drilling rigs and nine completion crews. We will continue monitoring commodity prices and overall market conditions and can adjust our rig cadence up or down in response to changes in commodity prices and overall market conditions.Based upon current oil and natural gas prices and production expectations for 2021, we believe our cash flows from operations, cash on hand and borrowings under our revolving credit facility will be sufficient to fund our operations through year-end 2021. However, future cash flows are subject to a number of variables, including the level of oil and natural gas production and prices, and significant additional capital expenditures will be required to more fully develop our properties. Further, our 2021 capital expenditure budget does not allocate any funds for leasehold interest and property acquisitions.We monitor and adjust our projected capital expenditures in response to the results of our drilling activities, changes in prices, availability of financing, drilling and acquisition costs, industry conditions, the timing of regulatory approvals, the availability of rigs, contractual obligations, internally generated cash flow and other factors both within and outside our control. If we require additional capital, we may seek such capital through traditional reserve base borrowings, joint venture partnerships, production payment financing, asset sales, offerings of debt and or equity securities or other means. We cannot assure you that the needed capital will be available on acceptable terms or at all. If we are unable to obtain funds when needed or on acceptable terms, we may be required to curtail our drilling programs, which could result in a loss of acreage through lease expirations. In addition, we may not be able to complete acquisitions that may be favorable to us or finance the capital expenditures necessary to replace our reserves. If there is a decline in commodity prices, our revenues, cash flows, results of operations, liquidity and reserves may be materially and adversely affected.Guarantor Financial InformationAs of December 31, 2020, Diamondback O&G LLC is the sole guarantor under the December 2019 Notes Indenture governing the December 2019 Notes, the May 2020 Notes and the 2025 Indenture governing the 2025 Senior Notes. Guarantees are “full and unconditional,” as that term is used in Regulation S-X, Rule 3-10(b)(3), except that such guarantees will be released or terminated in certain circumstances set forth in the December 2019 Notes Indenture and the 2025 Indenture, such as, with certain exceptions, (1) in the event Diamondback O&G LLC (or all or substantially all of its assets) is sold or disposed of, (2) in the event Diamondback O&G LLC ceases to be a guarantor of or otherwise be an obligor under certain other indebtedness, and (3) in connection with any covenant defeasance, legal defeasance or satisfaction and discharge of the relevant indenture.Diamondback O&G LLC’s guarantees of the December 2019 Notes, the May 2020 Notes and the 2025 Senior Notes are senior unsecured obligations and rank senior in right of payment to any of its future subordinated indebtedness, equal in right of payment with all of its existing and future senior indebtedness, including its obligations under its revolving credit facility, and effectively subordinated to any of its existing and future secured indebtedness, to the extent of the value of the collateral securing such indebtedness.66Table of ContentsThe rights of holders of the Senior Notes against Diamondback O&G LLC may be limited under the U.S. Bankruptcy Code or state fraudulent transfer or conveyance law. Each guarantee contains a provision intended to limit Diamondback O&G LLC’s liability to the maximum amount that it could incur without causing the incurrence of obligations under its guarantee to be a fraudulent conveyance. However, there can be no assurance as to what standard a court will apply in making a determination of the maximum liability of Diamondback O&G LLC. Moreover, this provision may not be effective to protect the guarantee from being voided under fraudulent conveyance laws. There is a possibility that the entire guarantee may be set aside, in which case the entire liability may be extinguished.The following tables present summarized financial information for Diamondback Energy, Inc., as the parent, and Diamondback O&G LLC, as the guarantor subsidiary, on a combined basis after elimination of (i) intercompany transactions and balances between the parent and the guarantor subsidiary and (ii) equity in earnings from and investments in any subsidiary that is a non-guarantor. The information is presented in accordance with the requirements of Rule 13-01 under the SEC’s Regulation S-X. The financial information may not necessarily be indicative of results of operations or financial position had the guarantor subsidiary operated as an independent entity.December 31, 2020Summarized Balance Sheets:(in millions)Assets:Current assets$308 Property and equipment, net$6,934 Other noncurrent assets$6 Liabilities:Current liabilities$355 Intercompany accounts payable, non-guarantor subsidiary$335 Long-term debt$4,293 Other noncurrent liabilities$886 Year Ended December 31, 2020Summarized Statement of Operations:(in millions)Revenues$1,618 Income (loss) from operations$(3,466)Net income (loss)$(2,344)67Table of ContentsContractual ObligationsThe following table summarizes our contractual obligations and commitments as of December 31, 2020:Payments Due by Period20212022-20232024-2025ThereafterTotal(in millions)Secured revolving credit facility(1)$— $23 $— $— $23 Senior notes191 20 2,300 2,100 4,611 Interest expense related to the senior notes(2)181 342 279 212 1,014 DrillCo Agreement— — — 79 79 Viper's secured revolving credit facility(1)— 84 — — 84 Viper's senior notes— — — 480 480 Interest expense related to Viper's senior notes26 52 52 52 182 Rattler's secured revolving credit facility(1)— — 79 — 79 Rattler's senior notes— — 500 — 500 Interest expense related to Rattler's senior notes28 56 55 — 139 Asset retirement obligations(3)1 — — 108 109 Drilling commitments(4)29 — — — 29 Sand supply agreements18 36 36 5 95 Transportation commitments60 111 95 133 399 Equity method investment capital contributions(5)57 15 — — 72 Produced water disposal commitments5 9 9 33 56 Operating lease obligations(6)6 3 — — 9 $602 $751 $3,405 $3,202 $7,960 (1)Includes the outstanding principal amount under the revolving credit facilities, the table does not include commitment fees, interest expense or other fees payable under this floating rate facility as we cannot predict the timing of future borrowings and repayments or interest rates to be charged.(2)Interest represents the scheduled cash payments on the senior notes and Energen Notes.(3)Amounts represent our estimates of future asset retirement obligations. Because these costs typically extend many years into the future, estimating these future costs requires management to make estimates and judgments that are subject to future revisions based upon numerous factors, including the rate of inflation, changing technology and the political and regulatory environment. See Note 9—Asset Retirement Obligations in the notes to the consolidated financial statements included elsewhere in this Annual Report. (4)Drilling commitments represent future minimum expenditure commitments for drilling rig services under contracts to which the Company was a party on December 31, 2020.(5)Timing of when capital commitments will be requested can vary.(6)Operating lease obligations represent future commitments for building, equipment and vehicle leases. The table above does not include estimated deficiency fees related to certain volume commitments as they are based off future volume deliveries and differences from market pricing which we cannot predict. Critical Accounting Policies and EstimatesThe discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. Certain amounts included in or affecting our consolidated financial statements and related disclosures must be estimated by our management, requiring certain assumptions to be made with respect to values or conditions that cannot be known with certainty at the time the consolidated financial statements are prepared. These estimates and assumptions affect the amounts we report for assets and liabilities and our disclosure of contingent assets and liabilities at the date of the consolidated financial statements. Critical accounting policies cover accounting estimates that are inherently uncertain because the future resolution of such matters is unknown and actual results could differ from those estimates.68Table of ContentsAny effects on our business, financial position or results of operations resulting from revisions to these estimates are recorded in the period in which the facts that give rise to the revision become known. Significant items subject to such estimates and assumptions include (i) the method of accounting for our oil and natural gas properties, (ii) estimates of proved oil and gas reserves and related present value estimates of future net cash flows therefrom, (iii) impairments of the carrying value of oil and natural gas properties, (iv) fair value estimates of commodity derivatives and (v) estimates of income taxes.Below, we have provided expanded discussion of our more significant accounting policies, estimates and judgments.Method of accounting for oil and natural gas propertiesWe account for our oil and natural gas producing activities using the full cost method of accounting. Accordingly, all costs incurred in the acquisition, exploration and development of proved oil and natural gas properties, including the costs of abandoned properties, dry holes, geophysical costs and annual lease rentals are capitalized. We also capitalize direct operating costs for services performed with internally owned drilling and well servicing equipment. Internal costs capitalized to the full cost pool represent management’s estimate of costs incurred directly related to exploration and development activities such as geological and other administrative costs associated with overseeing the exploration and development activities. All internal costs unrelated to drilling activities are expensed as incurred. Sales or other dispositions of oil and natural gas properties are accounted for as adjustments to capitalized costs, with no gain or loss recorded unless the ratio of cost to proved reserves would significantly change. Income from services provided to working interest owners of properties in which we also own an interest, to the extent they exceed related costs incurred, are accounted for as reductions of capitalized costs of oil and natural gas properties. Depletion of evaluated oil and natural gas properties is computed on the units of production method, whereby capitalized costs plus estimated future development costs are amortized over total proved reserves. If our production remains at approximately the same level from year to year, depletion expense may be significantly different if our estimate of remaining reserves or future development costs changes significantly.Costs associated with unevaluated properties are excluded from the full cost pool until we have made a determination as to the existence of proved reserves. We assess all items classified as unevaluated property on an annual basis for possible impairment. We assess properties on an individual basis or as a group if properties are individually insignificant. The assessment includes consideration of the following factors, among others: intent to drill; remaining lease term; geological and geophysical evaluations; drilling results and activity; the assignment of proved reserves; and the economic viability of development if proved reserves are assigned. During any period in which these factors indicate an impairment, the cumulative drilling costs incurred to date for such property and all or a portion of the associated leasehold costs are transferred to the full cost pool and are then subject to amortization.Oil and natural gas reserve quantities and standardized measure of future net revenueOur independent engineers and technical staff prepare our estimates of oil and natural gas reserves and associated future net revenues. The SEC has defined proved reserves as the estimated quantities of oil and natural gas which geological and engineering data demonstrate with reasonable certainty to be recoverable in future years from known reservoirs under existing economic and operating conditions. The process of estimating oil and natural gas reserves is complex, requiring significant decisions in the evaluation of available geological, geophysical, engineering and economic data. The data for a given property may also change substantially over time as a result of numerous factors, including additional development activity, evolving production history and a continual reassessment of the viability of production under changing economic conditions. As a result, material revisions to existing reserve estimates occur from time to time. Although every reasonable effort is made to ensure that reserve estimates reported represent the most accurate assessments possible, the subjective decisions and variances in available data for various properties increase the likelihood of significant changes in these estimates. If such changes are material, they could significantly affect future amortization of capitalized costs and result in impairment of assets that may be material.There are numerous uncertainties inherent in estimating quantities of proved oil and natural gas reserves. Oil and natural gas reserve engineering is a subjective process of estimating underground accumulations of oil and natural gas that cannot be precisely measured and the accuracy of any reserve estimate is a function of the quality of available data and of engineering and geological interpretation and judgment. Results of drilling, testing and production subsequent to the date of the estimate may justify revision of such estimate. Accordingly, reserve estimates are often different from the quantities of oil and natural gas that are ultimately recovered.69Table of ContentsImpairmentUnder the full cost method of accounting, we are required to perform a ceiling test each quarter. The test determines a limit, or ceiling, on the book value of the proved oil and natural gas properties. Net capitalized costs are limited to the lower of unamortized cost net of deferred income taxes, or the cost center ceiling. The cost center ceiling is defined as the sum of (a) estimated future net revenues, discounted at 10% per annum, from proved reserves, based on the trailing 12-month unweighted average of the first-day-of-the-month price, adjusted for any contract provisions and excluding the estimated abandonment costs for properties with asset retirement obligations recorded on the balance sheet, (b) the cost of properties not being amortized, if any, and (c) the lower of cost or market value of unproved properties included in the cost being amortized, including related deferred taxes for differences between the book and tax basis of the oil and natural gas properties. If the net book value, including related deferred taxes, exceeds the ceiling, an impairment or non-cash write-down is required. Impairments of our evaluated oil and natural gas properties are not reversible.DerivativesFrom time to time, we have used energy derivatives for the purpose of mitigating the risk resulting from fluctuations in the market price of crude oil and natural gas. We exercise significant judgment in determining the types of instruments to be used, the level of production volumes to include in our commodity derivative contracts, the prices at which we enter into commodity derivative contracts and the counterparties’ creditworthiness. We have not designated our derivative instruments as hedges for accounting purposes and, as a result, mark our derivative instruments to fair value and recognize the cash and non-cash change in fair value on derivative instruments for each period in the consolidated statements of operations. We are also required to recognize our derivative instruments on the consolidated balance sheets as assets or liabilities at fair value with such amounts classified as current or long-term based on their anticipated settlement dates. The accounting for the changes in fair value of a derivative depends on the intended use of the derivative and resulting designation, and is generally determined using established index prices and other sources which are based upon, among other things, futures prices and time to maturity. These fair values are recorded by netting asset and liability positions, including any deferred premiums, that are with the same counterparty and are subject to contractual terms which provide for net settlement. Changes in the fair values of our commodity derivative instruments have a significant impact on our net income because we follow mark-to-market accounting and recognize all gains and losses on such instruments in earnings in the period in which they occur. Income TaxesThe amount of income taxes we record requires interpretations of complex rules and regulations of federal, state, and provincial tax jurisdictions. We use the asset and liability method of accounting for income taxes, under which deferred tax assets and liabilities are recognized for the future tax consequences of (1) temporary differences between the financial statement carrying amounts and the tax bases of existing assets and liabilities and (2) operating loss and tax credit carryforwards. Deferred income tax assets and liabilities are based on enacted tax rates applicable to the future period when those temporary differences are expected to be recovered or settled. The effect of a change in tax rates on deferred tax assets and liabilities is recognized in income in the period the rate change is enacted. A valuation allowance is provided for deferred tax assets when it is more likely than not the deferred tax assets will not be realized. The accruals for deferred tax assets and liabilities are often based on assumptions that are subject to a significant amount of judgment by management. These assumptions and judgments are reviewed and adjusted as facts and circumstances change. Material changes to our income tax accruals may occur in the future based on the progress of ongoing audits, changes in legislation or resolution of pending matters.See Note 2—Summary of Significant Accounting Policies of the notes to the consolidated financial statements included elsewhere in this Annual Report for a full discussion of our significant accounting policies.Recent Accounting PronouncementsFor information regarding recent accounting pronouncements, See Note 2—Summary of Significant Accounting Policies included in notes to the consolidated financial statements included elsewhere in this Annual Report.70Table of ContentsOff-Balance Sheet ArrangementsWe had no off-balance sheet arrangements as of December 31, 2020. Please read Note 17—Commitments and Contingencies included in notes to the consolidated financial statements included elsewhere in this Form 10-K for a discussion of our commitments and contingencies, some of which are not recognized in the balance sheets under GAAP.ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKCommodity Price Risk Our major market risk exposure in our exploration and production business is in the pricing applicable to our oil and natural gas production. Realized pricing is primarily driven by the prevailing worldwide price for crude oil and spot market prices applicable to our natural gas production. Pricing for oil and natural gas production has been volatile and unpredictable for several years, and we expect this volatility to continue in the future. The prices we receive for production depend on many factors outside of our control.We use derivatives, including swaps, basis swaps, swaptions, roll hedges and costless collars, to reduce price volatility associated with certain of our oil and natural gas sales. At December 31, 2020, we had a net liability derivative position of $255 million related to our commodity price risk derivatives. Utilizing actual derivative contractual volumes under our commodity price derivatives as of December 31, 2020, a 10% increase in forward curves associated with the underlying commodity would have increased the net liability position to $284 million, an increase of $29 million, while a 10% decrease in forward curves associated with the underlying commodity would have decreased the net liability derivative position to $226 million, a decrease of $29 million. However, any cash derivative gain or loss would be substantially offset by a decrease or increase, respectively, in the actual sales value of production covered by the derivative instrument.In our midstream operations business, we have indirect exposure to commodity price risk in that persistent low commodity prices may cause us or Rattler’s other customers to delay drilling or shut in production, which would reduce the volumes available for gathering and processing by our infrastructure assets. If we or Rattler’s other customers delay drilling or temporarily shut in production due to persistently low commodity prices or for any other reason, our revenue in the midstream operations segment could decrease, as Rattler’s commercial agreements do not contain minimum volume commitments.For additional information on our open commodity derivative instruments at December 31, 2020, see Note 15—Derivatives.Counterparty and Customer Credit Risk Our principal exposures to credit risk are due to the concentration of receivables from the sale of our oil and natural gas production (approximately $281 million at December 31, 2020), and to a lesser extent, receivables resulting from joint interest receivables (approximately $56 million at December 31, 2020). We do not require our customers to post collateral, and the inability of our significant customers to meet their obligations to us due to their liquidity issues, bankruptcy, insolvency or liquidation may adversely affect our financial results. For the year ended December 31, 2020, four purchasers each accounted for more than 10% of our revenue. For each of the years ended December 31, 2019 and 2018, three purchasers each accounted for more than 10% of our revenue. No other customer accounted for more than 10% of our revenue during these periods. Our allowances for credit losses were insignificant at December 31, 2020.Joint operations receivables arise from billings to entities that own partial interests in the wells we operate. These entities participate in our wells primarily based on their ownership in leases on which we intend to drill. We have little ability to control whether these entities will participate in our wells.The ongoing COVID-19 pandemic, depressed commodity pricing environment and adverse macroeconomic conditions may enhance our customer credit risk.71Table of ContentsInterest Rate Risk We are subject to market risk exposure related to changes in interest rates on our indebtedness under our revolving credit facility. The terms of our revolving credit facility provide for interest on borrowings at a floating rate equal to an alternative base rate (which is equal to the greatest of the prime rate, the Federal Funds effective rate plus 0.5% and 3-month LIBOR plus 1.0%) or LIBOR, in each case plus the applicable margin. The applicable margin ranges from 0.125% to 1.0% per annum in the case of the alternative base rate and from 1.125% to 2.0% per annum in the case of LIBOR, in each case depending on the amount of the loan outstanding in relation to the borrowing base. Historically, we have used interest rate swaps and treasury locks to reduce our exposure to variable rate interest payments associated with our revolving credit facility.The following table summarizes the Company’s interest rate swaps as of December 31, 2020:TypeEffective DateContractual Termination DateNotional Amount (in millions)Interest RateInterest Rate SwapDecember 31, 2024December 31, 2054$250 1.692 %Interest Rate SwapDecember 31, 2024December 31, 2054$250 1.8361 %Interest Rate SwapDecember 31, 2024December 31, 2054$250 1.852 %Interest Rate SwapDecember 31, 2024December 31, 2054$250 1.722 %For additional information on our variable interest rate debt at December 31, 2020, see Note 11—Debt. See Note 18—Subsequent Events for discussion of derivative transactions which occurred subsequent to December 31, 2020.
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+ITEM 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.Management’s discussion and analysis of financial condition and results of operations is a supplement to and should be read in conjunction with the accompanying consolidated financial statements and related notes. This section provides additional information regarding our businesses, current developments, results of operations, cash flows, financial condition, contractual commitments and critical accounting policies.A discussion of our results of operations and liquidity for fiscal 2019 compared to fiscal 2018 can be found under Item 7 in our Annual Report on Form 10-K for the fiscal year ended December 31, 2019, filed on February 27, 2020, which is available free of charge on the SEC’s website at www.sec.gov and our Investor Relations website at ir.corporate.discovery.com.BUSINESS OVERVIEWWe are a global media company that provides content across multiple distribution platforms, including linear platforms such as pay-TV, FTA and broadcast television, our authenticated GO applications, digital distribution arrangements, content licensing arrangements and DTC subscription products. For a discussion of our global portfolio of networks and joint ventures see our business overview set forth in Item 1, “Business” in this Annual Report on Form 10-K.Our content spans genres including survival, natural history, exploration, sports, general entertainment, home, food, travel, heroes, adventure, crime and investigation, health and kids. We have an extensive library of content and own most rights to our content and footage, which enables us to leverage our library to quickly launch brands and services into new markets and on new platforms. Our content can be re-edited and updated in a cost-effective manner to provide topical versions of subject matter that can be utilized around the world on a variety of platforms.We aim to invest in high-quality content for our networks and brands with the objective of building viewership, optimizing distribution revenue, capturing advertising revenue, and creating or repositioning branded channels and business to sustain long-term growth and occupy a desired content niche with strong consumer appeal. Our strategy is to maximize the distribution, ratings and profit potential of each of our branded networks. In addition to growing distribution and advertising revenues for our branded networks, we have extended content distribution across new platforms, including brand-aligned websites, online streaming, mobile devices, VOD, and broadband channels, which provide promotional platforms for our television content and serve as additional outlets for advertising and distribution revenue. Audience ratings are a key driver in generating advertising revenue and creating demand on the part of cable television operators, DTH satellite operators, telecommunication service providers, and other content distributors who deliver our content to their customers.Although we utilize certain brands and content globally, we classify our operations in two reportable segments: U.S. Networks, consisting principally of domestic television networks and digital content services, and International Networks, consisting primarily of international television networks and digital content services. Our segment presentation aligns with our management structure and the financial information management uses to make decisions about operating matters, such as the allocation of resources and business performance assessments. For further discussion of financial information for our segments and the geographical areas in which we do business, our content development activities, and revenues see our business overview set forth in Item 1, “Business” and Note 23 to the consolidated financial statements included in Item 8, “Financial Statements and Supplementary Data” in this Annual Report on Form 10-K. Impact of COVID-19On March 11, 2020, the World Health Organization declared the COVID-19 outbreak to be a global pandemic. COVID-19 continues to spread throughout the world, and the duration and severity of its effects and associated economic disruption remain uncertain. Restrictions on social and commercial activity in an effort to contain the virus have had, and are expected to continue to have, a significant adverse impact upon many sectors of the U.S. and global economy, including the media industry. We continue to closely monitor the impact of COVID-19 on all aspects of our business and geographies, including the impact on our customers, employees, suppliers, vendors, distribution and advertising partners, production facilities, and various other third parties.Beginning in the second quarter of 2020, demand for our advertising products and services decreased due to economic disruptions from limitations on social and commercial activity. These economic disruptions and the resulting effect on the Company slightly eased during the second half of 2020, but the pandemic continued to impact demand through the end of 2020 and this decreased demand is expected to continue into 2021. Many of our third-party production partners that were shut down during most of the second quarter of 2020 due to COVID-19 restrictions came back online in the third quarter of 2020 and, as a result, we have incurred additional costs to comply with various governmental regulations and implement certain safety measures for our employees, talent, and partners. Additionally, certain sporting events that we have rights to were cancelled or postponed, thereby eliminating or deferring the related revenues and expenses, including the Tokyo 2020 Olympic Games, which were postponed to 2021. The postponement of the Olympic Games deferred both Olympic-related revenues and significant expenses from fiscal year 2020 to fiscal year 2021.38In response to the impact of the pandemic, we employed and continue to employ innovative production and programming strategies, including producing content filmed by our on-air talent and seeking viewer feedback on which content to air. We continue to pursue a number of cost savings initiatives which began during the third and fourth quarters of 2020 and believe will offset a portion of anticipated revenue losses and deferrals, through the implementation of travel, marketing, production and other operating cost reductions, including personnel reductions, restructurings and resource reallocations to align our expense structure to ongoing changes within the industry. We also implemented remote work arrangements effective mid-March 2020 and, to date, these arrangements have not materially affected our ability to operate our business.In addition, we implemented several measures to preserve sufficient liquidity in the near term. During March 2020, we drew down $500 million under our $2.5 billion revolving credit facility to increase our cash position and maximize flexibility in light of the current uncertainty surrounding the impact of COVID-19. In addition, in April 2020, we entered into an amendment to our revolving credit facility, which increased flexibility under our financial covenants and issued $1.0 billion aggregate principal amount of senior notes due May 2030 and $1.0 billion aggregate principal amount of Senior Notes due May 2050. The proceeds from the notes were used to fund a tender offer for $1.5 billion of certain Senior Notes with maturities ranging from 2021 through 2023 and to repay the $500 million outstanding under our revolving credit facility.In light of the impact of COVID-19, we assessed goodwill, other intangibles, deferred tax assets, programming assets, and accounts receivable for recoverability based upon latest estimates and judgments with respect to expected future operating results, ultimate usage of content and latest expectations with respect to expected credit losses. We recorded goodwill and other intangible assets impairment charges of $124 million for our Asia-Pacific reporting unit during 2020. Adjustments to reflect increased expected credit losses were not material. Further, hedged transactions were assessed and we have concluded such transactions remain probable of occurrence. Due to significant uncertainty surrounding the impact of COVID-19, management’s judgments could change in the future. The effects of the pandemic may have further negative impacts on our financial position, results of operations, and cash flows. However, the current level of uncertainty over the economic and operational impacts of COVID-19 means the related financial impact cannot be reasonably and fully estimated at this time.The nature and extent of COVID-19’s effects on our operations and results will depend on future developments, which are highly uncertain and cannot be predicted, including new information that may emerge concerning the severity and the extent of future surges of COVID-19, vaccine distribution and other actions to contain the virus or treat its impact, among others. We will continue to monitor COVID-19 and its impact on our business results and financial condition. Our consolidated financial statements reflect management’s latest estimates and assumptions that affect the reported amounts of assets and liabilities and related disclosures as of the date of the consolidated financial statements and reported amounts of revenue and expenses during the reporting periods presented. Actual results may differ significantly from these estimates and assumptions.In the United States, the Coronavirus Aid, Relief, and Economic Security Act (“CARES Act”) was enacted on March 27, 2020, and the Consolidated Appropriations Act, 2021 was enacted on December 27, 2020. As of December 31, 2020, we do not expect the CARES Act or the Consolidated Appropriations Act, 2021 to have a material effect on our financial position and results of operations. We continue to monitor other relief measures taken by the U.S. and other governments around the world.39RESULTS OF OPERATIONSItems Impacting ComparabilityThe impact of exchange rates on our business is an important factor in understanding period-to-period comparisons of our results. For example, our international revenues are favorably impacted as the U.S. dollar weakens relative to other foreign currencies, and unfavorably impacted as the U.S. dollar strengthens relative to other foreign currencies. We believe the presentation of results on a constant currency basis (ex-FX), in addition to results reported in accordance with GAAP provides useful information about our operating performance because the presentation ex-FX excludes the effects of foreign currency volatility and highlights our core operating results. The presentation of results on a constant currency basis should be considered in addition to, but not a substitute for, measures of financial performance reported in accordance with GAAP. The ex-FX change represents the percentage change on a period-over-period basis adjusted for foreign currency impacts. The ex-FX change is calculated as the difference between the current year amounts translated at a baseline rate, which is a spot rate for each of our currencies determined early in the fiscal year as part of our forecasting process (the “2020 Baseline Rate”), and the prior year amounts translated at the same 2020 Baseline Rate. In addition, consistent with the assumption of a constant currency environment, our ex-FX results exclude the impact of our foreign currency hedging activities, as well as realized and unrealized foreign currency transaction gains and losses. Results on a constant currency basis, as we present them, may not be comparable to similarly titled measures used by other companies. Consolidated Results of Operations – 2020 vs. 2019Our consolidated results of operations for 2020 and 2019 were as follows (in millions).Year Ended December 31,20202019% Change% Change (ex-FX)Revenues:Advertising $5,583 $6,044 (8)%(7)%Distribution4,866 4,835 1 %1 %Other222 265 (16)%(17)%Total revenues10,671 11,144 (4)%(4)%Costs of revenues, excluding depreciation and amortization3,860 3,819 1 %1 %Selling, general and administrative2,722 2,788 (2)%(1)%Depreciation and amortization1,359 1,347 1 %1 %Impairment of goodwill and other intangible assets124 155 (20)%(21)%Restructuring and other charges91 26 NMNMTotal costs and expenses8,156 8,135 — %— %Operating income2,515 3,009 (16)%(15)%Interest expense, net(648)(677)(4)%Loss on extinguishment of debt(76)(28)NMLoss from equity investees, net(105)(2)NMOther income (expense), net42 (8)NMIncome before income taxes1,728 2,294 (25)%Income tax expense(373)(81)NMNet income1,355 2,213 (39)%Net income attributable to noncontrolling interests(124)(128)(3)%Net income attributable to redeemable noncontrolling interests(12)(16)(25)%Net income available to Discovery, Inc.$1,219 $2,069 (41)%NM - Not meaningful40RevenuesOur advertising revenue is generated across multiple platforms and consists of consumer advertising, which is sold primarily on a national basis in the U.S. and on a pan-regional or local-language feed basis outside the U.S. Advertising contracts generally have a term of one year or less. Advertising revenue is dependent upon a number of factors, including the stage of development of television markets, the popularity of FTA television, the number of subscribers to our channels, viewership demographics, the popularity of our content and our ability to sell commercial time over a group of channels. Revenue from advertising is subject to seasonality, market-based variations, the mix in sales of commercial time between the upfront and scatter markets, and general economic conditions. Advertising revenue is typically highest in the second and fourth quarters. In some cases, advertising sales are subject to ratings guarantees that require us to provide additional advertising time if the guaranteed audience levels are not achieved. We also generate revenue from the sale of advertising through our digital products on a stand-alone basis and as part of advertising packages with our television networks.Advertising revenue decreased 8% in 2020. Excluding the impact of foreign currency fluctuations, advertising revenue decreased 7%. The decrease was primarily attributable to a decline in demand stemming from the COVID-19 pandemic at both U.S. and International Networks.Distribution revenue consists principally of fees from affiliates for distributing our linear networks, supplemented by revenue earned from SVOD content licensing and other emerging forms of digital distribution. The largest component of distribution revenue is comprised of linear distribution services for rights to our networks from cable, DTH satellite and telecommunication service providers. We have contracts with distributors representing most cable and satellite service providers around the world, including the largest operators in the U.S. and major international distributors. Distribution revenues are largely dependent on the rates negotiated in the agreements, the number of subscribers that receive our networks or content, the number of platforms covered in the distribution agreement, and the market demand for the content that we provide. From time to time, renewals of multi-year carriage agreements include significant year one market adjustments to re-set subscriber rates, which then increase at rates lower than the initial increase in the following years. In some cases, we have provided distributors launch incentives, in the form of cash payments or free periods, to carry our networks. Distribution revenue also includes fees charged for bulk content arrangements and other subscription services for episodic content. These digital distribution revenues are impacted by the quantity, as well as the quality, of the content we provide.As reported and excluding the impact of foreign currency fluctuations, distribution revenue increased 1% in 2020 primarily attributable to changes in contractual affiliate rates at U.S. Networks and International Networks.Other revenue decreased 16% in 2020. Excluding the impact of foreign currency fluctuations, other revenue decreased 17%.Costs of RevenuesOur principal component of costs of revenues is content expense. Content expense includes television series, television specials, films, sporting events and digital products. The costs of producing a content asset and bringing that asset to market consist of film costs, participation costs, exploitation costs and manufacturing costs.As reported and excluding the impact of foreign currency fluctuations, costs of revenues increased 1% in 2020 primarily attributable to increases in content amortization from investments to support our next generation initiatives at U.S. Networks.Selling, General and AdministrativeSelling, general and administrative expenses consist principally of employee costs, marketing costs, research costs, occupancy and back office support fees. Selling, general and administrative expenses decreased 2% in 2020. Excluding the impact of foreign currency fluctuations, selling, general and administrative decreased 1%. The decrease was primarily attributable to a reduction in travel costs as a result of COVID-19 and lower marketing-related expenses, partially offset by an increase in personnel costs to support our next generation platforms, including discovery+.Depreciation and AmortizationDepreciation and amortization expense includes depreciation of fixed assets and amortization of finite-lived intangible assets. As reported and excluding the impact of foreign currency fluctuations, depreciation and amortization increased 1% in 2020. The increase was primarily attributable to an increase in capital expenditures.Impairment of Goodwill and Other Intangible AssetsImpairment of goodwill and other intangible assets was $124 million and $155 million in 2020 and 2019. 41Restructuring and Other ChargesRestructuring and other charges were $91 million and $26 million in 2020 and 2019. Restructuring and other charges primarily include employee termination costs and other cost reduction efforts.Interest Expense, netInterest expense decreased 4% in 2020. The decrease was primarily attributable to a lower average debt balance in 2020, a more favorable interest rate profile on our outstanding senior notes, and incremental interest income related to the change in fair value of our cross-currency swaps. Loss on Extinguishment of DebtIn 2020, we repurchased $1.5 billion aggregate principal amount of DCL's and Scripps Networks' senior notes. The repurchase resulted in a loss on extinguishment of debt of $76 million. The loss included $67 million of net premiums to par value and $9 million of other charges.Loss from Equity Investees, net We reported losses from our equity method investees of $105 million in 2020 compared to losses of $2 million in 2019. The changes are attributable to the Company's share of earnings and losses from its equity investees. Other Income (Expense), net The table below presents the details of other income (expense), net (in millions).Year Ended December 31,20202019Foreign currency (losses) gains, net$(115)$17 Gain on sale of investment with readily determinable fair value101 — Gains (losses) on derivatives not designated as hedges29 (52)Change in the value of investments with readily determinable fair value28 (26)Expenses from debt modification(11)— Interest income10 22 Gain on sale of equity method investments2 13 Remeasurement gain on previously held equity interest— 14 Other (expense) income, net(2)4 Total other income (expense), net$42 $(8)Income Taxes The following table reconciles our effective income tax rate to the U.S. federal statutory income tax rate.Year Ended December 31,20202019Pre-tax income at U.S. federal statutory income tax rate$363 21 %$482 21 %State and local income taxes, net of federal tax benefit(10)— %27 1 %Effect of foreign operations7 — %(21)(1)%Noncontrolling interest adjustment(29)(2)%(30)(1)%Impairment of goodwill25 2 %32 1 %Deferred tax adjustment (22)(1)%— — %Non-deductible compensation17 1 %22 1 %Change in uncertain tax positions17 1 %3 — %Legal entity restructuring, deferred tax impact— — %(445)(19)%Renewable energy investments tax credits— — %(1)— %Other, net$5 — %$12 1 %Income tax expense$373 22 %$81 4 %42Income tax expense was $373 million and $81 million, and our effective tax rate was 22% and 4% for 2020 and 2019. The increase in income tax expense in 2020 was primarily attributable to the discrete, one-time, non-cash deferred tax benefit of $445 million from legal entity restructurings that was recorded in 2019. Additionally, the increase in income tax expense in 2020 was attributable to an increase in provision for uncertain tax positions and an increase in the effect of foreign operations. Those increases were partially offset by a decrease in pre-tax book income, a tax benefit from a favorable multi-year state resolution, and a favorable deferred tax adjustment in the U.S. that was recorded in 2020.Segment Results of Operations – 2020 vs. 2019We evaluate the operating performance of our operating segments based on financial measures such as revenues and Adjusted OIBDA. Adjusted OIBDA is defined as operating income excluding: (i) employee share-based compensation, (ii) depreciation and amortization, (iii) restructuring and other charges, (iv) certain impairment charges, (v) gains and losses on business and asset dispositions, (vi) certain inter-segment eliminations related to production studios, (vii) third-party transaction costs directly related to the acquisition and integration of Scripps Networks and other transactions, and (viii) other items impacting comparability, such as the non-cash settlement of a withholding tax claim. We use this measure to assess the operating results and performance of our segments, perform analytical comparisons, identify strategies to improve performance, and allocate resources to each segment. We believe Adjusted OIBDA is relevant to investors because it allows them to analyze the operating performance of each segment using the same metric management uses. We exclude share-based compensation, restructuring and other charges, certain impairment charges, gains and losses on business and asset dispositions, and acquisition and integration costs from the calculation of Adjusted OIBDA due to their impact on comparability between periods. We also exclude the depreciation of fixed assets and amortization of intangible assets, as these amounts do not represent cash payments in the current reporting period. Certain corporate expenses and inter-segment eliminations related to production studios are excluded from segment results to enable executive management to evaluate segment performance based upon the decisions of segment executives.Adjusted OIBDA should be considered in addition to, but not a substitute for, operating income, net income and other measures of financial performance reported in accordance with U.S. generally accepted accounting principles (“GAAP”). 43The table below presents our Adjusted OIBDA by segment, with a reconciliation of consolidated net income available to Discovery, Inc. to Adjusted OIBDA (in millions).Year Ended December 31,20202019% ChangeNet income available to Discovery, Inc.$1,219 $2,069 (41)%Net income attributable to redeemable noncontrolling interests12 16 (25)%Net income attributable to noncontrolling interests124 128 (3)%Income tax expense373 81 NMIncome before income taxes1,728 2,294 (25)%Other (income) expense, net(42)8 NMLoss from equity investees, net105 2 NMLoss on extinguishment of debt76 28 NMInterest expense, net648 677 (4)%Operating income2,515 3,009 (16)%Depreciation and amortization1,359 1,347 1 %Impairment of goodwill and other intangible assets124 155 (20)%Employee share-based compensation99 137 (28)%Restructuring and other charges91 26 NMTransaction and integration costs6 26 (77)%Loss on asset disposition2 — NMSettlement of a withholding tax claim— (29)NMAdjusted OIBDA$4,196 $4,671 (10)%Adjusted OIBDA:U.S. Networks3,975 4,117 (3)%International Networks723 1,057 (32)%Corporate, inter-segment eliminations, and other(502)(503)— %Adjusted OIBDA$4,196 $4,671 (10)%44The table below presents the calculation of Adjusted OIBDA (in millions).Year Ended December 31,20202019% ChangeRevenue:U.S. Networks$6,949 $7,092 (2)%International Networks3,713 4,041 (8)%Corporate, inter-segment eliminations, and other9 11 (18)%Total revenue10,671 11,144 (4)%Costs of revenues, excluding depreciation and amortization3,860 3,819 1 %Selling, general and administrative (a)2,615 2,654 (1)%Adjusted OIBDA$4,196 $4,671 (10)%(a) Selling, general and administrative expenses exclude employee share-based compensation, third-party transaction and integration costs related to the acquisition of Scripps Networks and other transactions, and for 2019, exclude the settlement of a withholding tax claim.U.S. NetworksThe table below presents, for our U.S. Networks segment, revenues by type, certain operating expenses, and Adjusted OIBDA (in millions).Year Ended December 31,20202019Change %Revenues:Advertising$4,012 $4,245 (5)%Distribution2,852 2,739 4 %Other85 108 (21)%Total revenues6,949 7,092 (2)%Costs of revenues, excluding depreciation and amortization1,843 1,800 2 %Selling, general and administrative1,131 1,175 (4)%Adjusted OIBDA3,975 4,117 (3)%Depreciation and amortization899 950 Restructuring and other charges41 15 Inter-segment eliminations 4 7 Operating income$3,031 $3,145 RevenuesAdvertising revenue decreased 5% in 2020 primarily attributable to softer demand stemming from the COVID-19 pandemic, secular declines in the pay-TV ecosystem and, to a lesser extent, lower overall ratings and a decline in inventory, partially offset by increases in pricing and the continued monetization of content offerings on our next generation platforms (such as our GO suite of TVE applications and DTC subscription products).Distribution revenue increased 4% in 2020 primarily attributable to increases in contractual affiliate rates and certain non-recurring items, partially offset by a decline in linear subscribers. Excluding these non-recurring items, distribution revenue increased 3% in 2020. Total portfolio subscribers at December 31, 2020 were 5% lower than at December 31, 2019, while subscribers to our fully distributed networks were 3% lower than the prior year.Other revenue decreased $23 million in 2020.Costs of RevenuesCosts of revenues increased 2% in 2020 primarily attributable to increases in content amortization from investments to support our next generation initiatives, partially offset by a reduction in production projects as a result of COVID-19 and a non-recurring reserve release established in purchase accounting. Content expense was $1.6 billion and $1.5 billion in 2020 and 2019.45Selling, General and AdministrativeSelling, general and administrative expenses decreased 4% in 2020 primarily attributable to a reduction in travel costs as a result of COVID-19 and lower marketing-related expenses, partially offset by an increase in personnel costs to support our next generation platforms, including discovery+.Adjusted OIBDAAdjusted OIBDA decreased 3% in 2020.International NetworksThe following table presents, for our International Networks segment, revenues by type, certain operating expenses, and Adjusted OIBDA (in millions).Year Ended December 31,20202019Change %Change % (ex-FX)Revenues:Advertising $1,571 $1,799 (13)%(12)%Distribution2,014 2,096 (4)%(3)%Other128 146 (12)%(15)%Total revenues3,713 4,041 (8)%(7)%Costs of revenues, excluding depreciation and amortization2,004 2,016 (1)%(1)%Selling, general and administrative986 968 2 %3 %Adjusted OIBDA723 1,057 (32)%(28)%Depreciation and amortization374 328 Impairment of goodwill and other intangible assets124 155 Restructuring and other charges29 20 Transaction and integration costs 4 — Inter-segment eliminations 1 20 Settlement of a withholding tax claim— (29)Operating income$191 $563 RevenuesAdvertising revenue decreased 13% in 2020. Excluding the impact of foreign currency fluctuations, advertising revenue decreased 12%. The decreases were attributable to a decline in demand stemming from the COVID-19 pandemic and the discontinuation of pay-TV distribution with certain European operators.Distribution revenue decreased 4% in 2020. Excluding the impact of foreign currency fluctuations, distribution revenue decreased 3%. The decreases were primarily attributable to lower contractual affiliate rates, the discontinuation of pay-TV distribution with certain European operators, and a disruption in the number of sporting events in Europe due to COVID-19, partially offset by higher next generation revenues due to subscriber growth.Other revenue decreased $18 million in 2020. Excluding the impact of foreign currency fluctuations, other revenue decreased $22 million.Costs of RevenuesAs reported and excluding the impact of foreign currency fluctuations, costs of revenues decreased 1% in 2020. The decreases were primarily attributable to a reduction in the number of sporting events in Europe due to COVID-19. Content expense, excluding the impact of foreign currency fluctuations, was $1.3 billion for 2020 and 2019.Selling, General and AdministrativeSelling, general and administrative expenses increased 2% in 2020. Excluding the impact of foreign currency fluctuations, selling, general, and administrative expenses increased 3%. The increases were primarily attributable to higher personnel costs to support our next generation platforms, partially offset by a reduction in travel costs as a result of COVID-19.46Adjusted OIBDAAdjusted OIBDA decreased 32% in 2020. Excluding the impact of foreign currency fluctuations, adjusted OIBDA decreased 28%.Corporate, Inter-segment Eliminations, and OtherThe following table presents our unallocated corporate amounts including certain operating expenses, and Adjusted OIBDA (in millions).Year Ended December 31,20202019% ChangeRevenues$9 $11 (18)%Costs of revenues, excluding depreciation and amortization13 3 NMSelling, general and administrative498 511 (3)%Adjusted OIBDA(502)(503)— %Employee share-based compensation99 137 Depreciation and amortization86 69 Restructuring and other charges21 (9)Transaction and integration costs 2 26 Loss on asset disposition2 — Inter-segment eliminations(5)(27)Operating loss$(707)$(699)Corporate operations primarily consist of executive management, administrative support services, substantially all of our share-based compensation and transaction and integration costs related to the acquisition of Scripps Networks and other transactions. LIQUIDITY AND CAPITAL RESOURCESLiquiditySources of CashHistorically, we have generated a significant amount of cash from operations. During 2020, we funded our working capital needs primarily through cash flows from operations. As of December 31, 2020, we had $2.1 billion of cash and cash equivalents on hand. We are a well-known seasoned issuer and have the ability to conduct registered offerings of securities, including debt securities, common stock and preferred stock, on short notice, subject to market conditions. Access to sufficient capital from the public market is not assured. We also have a $2.5 billion revolving credit facility and commercial paper program described below.Beginning in February 2020, the COVID-19 pandemic began adversely affecting the availability of borrowings in the commercial paper market. In addition, during the year ended December 31, 2020, we implemented several measures that we believed would preserve sufficient liquidity in the near term in response to the impact of COVID-19, as discussed further below.•Debt2020 Senior Notes ActivityDuring 2020, we commenced five separate private offers to exchange (the “Exchange Offers”) any and all of Discovery Communications, LLC's ("DCL"), our wholly-owned subsidiary, outstanding 5.000% Senior Notes due 2037, 6.350% Senior Notes due 2040, 4.950% Senior Notes due 2042, 4.875% Senior Notes due 2043 and 5.200% Senior Notes due 2047 (collectively, the “Old Notes”) for one new series of DCL 4.000% Senior Notes due September 2055 (the “New Notes”). We completed the Exchange Offers in September 2020, by exchanging $1.4 billion aggregate principal amount of the Old Notes validly tendered and accepted by us pursuant to the Exchange Offers, for $1.7 billion aggregate principal amount of the New Notes (before debt discount of $318 million). The New Notes are fully and unconditionally guaranteed by us and Scripps Networks on an unsecured and unsubordinated basis. The Exchange Offers were accounted for as a debt modification and, as a result, third-party issuance costs totaling $11 million were expensed as incurred.47Also during 2020, we completed offers to purchase for cash (the “Cash Offers”) the Old Notes. Approximately $22 million aggregate principal amount of the Old Notes were validly tendered and accepted for purchase by us pursuant to the Cash Offers, for total cash consideration of $27 million, plus accrued interest. The Cash Offers resulted in a loss on extinguishment of debt of $5 million.Finally, during 2020, DCL issued $2.0 billion aggregate principal amount of senior notes due in 2030 and 2050. All of DCL's outstanding senior notes are fully and unconditionally guaranteed on an unsecured and unsubordinated basis by Discovery and Scripps Networks and contain certain covenants, events of default and other customary provisions. DCL used the proceeds from the offering to fund a tender offer for $1.5 billion aggregate principal amount of DCL's and Scripps Networks' senior notes, which resulted in a loss on extinguishment of debt of $71 million, and to repay the $500 million outstanding under our revolving credit facility described below.2019 Senior Notes ActivityDuring 2019, DCL issued $1.5 billion aggregate principal of senior notes (the "2029 Notes and 2049 Notes"). Revolving Credit Facility and Commercial PaperWe have access to a $2.5 billion revolving credit facility. Borrowing capacity under this credit facility is reduced by the outstanding borrowings under our commercial paper program. During March 2020, we drew down $500 million under the revolving credit facility to increase our cash position and maximize flexibility in light of the uncertainty surrounding the impact of COVID-19 and such amount was repaid during the second quarter of 2020. All obligations of DCL and the other borrowers under the revolving credit facility are unsecured and are fully and unconditionally guaranteed by Discovery. The credit agreement governing the revolving credit facility (the “Credit Agreement”) contains customary representations, warranties and events of default, as well as affirmative and negative covenants. In the second quarter of 2020, to preserve flexibility in the current environment, we amended certain provisions of the Credit Agreement, including modifying the financial covenants to reset the Maximum Consolidated Leverage Ratio. (See Note 8 to the accompany consolidated financial statements.) As of December 31, 2020, we were in compliance with all covenants and there were no events of default under the Credit Agreement. Under our commercial paper program and subject to market conditions, DCL may issue unsecured commercial paper notes guaranteed by Discovery and Scripps Networks from time to time up to an aggregate principal amount outstanding at any given time of $1.5 billion, including up to $500 million of Euro-denominated borrowings. The maturities of these notes vary but may not exceed 397 days. The notes may be issued at a discount or at par, and interest rates vary based on market conditions and the credit rating assigned to the notes at the time of issuance. As of December 31, 2020, we had no outstanding commercial paper borrowings. Borrowings under the commercial paper program reduce the borrowing capacity under the revolving credit facility described above.Uses of CashOur primary uses of cash include the creation and acquisition of new content, capital expenditures, business acquisitions, repurchases of our capital stock, income taxes, personnel costs, principal and interest payments on our outstanding senior notes, and funding for various equity method and other investments, including next generation initiatives.•Content AcquisitionWe plan to continue to invest significantly in the creation and acquisition of new content. Additional information regarding contractual commitments to acquire content is set forth in "Commitments and Off-Balance Sheet Arrangements" in this Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations."•Capital Expenditures and Investments in Next Generation InitiativesWe effected capital expenditures of $402 million in 2020, including amounts capitalized to support our next generation platforms, such as discovery+. In addition, we expect to continue to incur significant costs to develop and market discovery+ in the future.•Investments and Business CombinationsWe made business acquisitions of $39 million and $73 million in 2020 and 2019. During 2020, we purchased $250 million of time deposit investments.48Our uses of cash have included investments in various equity investments. We provide funding to our investees from time to time. We contributed $181 million and $254 million in 2020 and 2019, for investments in and advances to our investees.•Redeemable Noncontrolling Interest and Noncontrolling InterestDue to business combinations, we also have redeemable equity balances of $383 million, which may require the use of cash in the event holders of noncontrolling interests put their interests to the Company beginning in 2021. Distributions to redeemable noncontrolling interests and noncontrolling interests totaled $254 million and $250 million in 2020 and 2019.•Common Stock RepurchasesHistorically, we have funded our stock repurchases through a combination of cash on hand, cash generated by operations and the issuance of debt. In February 2020, our Board of Directors authorized additional stock repurchases of up to $2 billion upon completion of our existing $1 billion authorization announced in May 2019. Under the new stock repurchase authorization, management is authorized to purchase shares from time to time through open market purchases at prevailing prices or privately negotiated purchases subject to market conditions and other factors. (See Note 12 to the accompanying consolidated financial statements.) During 2020 and 2019, we repurchased $969 million and $633 million of our Series C common stock.•Income Taxes and InterestWe expect to continue to make payments for income taxes and interest on our outstanding senior notes. During 2020 and 2019, we made cash payments of $641 million and $562 million for income taxes and $673 million and $708 million for interest on our outstanding debt.•Debt2020 Debt ActivityIn addition to the tender offers for $1.5 billion aggregate principal amount of DCL's and Scripps Networks' senior notes and repayment of the $500 million outstanding under our revolving credit facility described above, during 2020 we repaid $600 million of senior notes as they came due. We have an additional $335 million of senior notes coming due in June 2021, which will be redeemed on March 21, 2021. 2019 Debt ActivityDuring 2019, we used the net proceeds from the issuance of the 2029 Notes and 2049 Notes to redeem and repurchase $1.3 billion aggregate principal amount of senior notes. The repayment resulted in a loss on extinguishment of debt of $23 million.Also during 2019, we redeemed $411 million aggregate principal senior notes, made open market bond repurchases of $55 million, resulting in a loss on extinguishment of debt of $5 million, and redeemed $900 million of senior notes and floating rate notes as they came due.Cash FlowsChanges in cash and cash equivalents were as follows (in millions).Year Ended December 31,20202019Cash, cash equivalents, and restricted cash, beginning of period$1,552 $986 Cash provided by operating activities2,739 3,399 Cash used in investing activities(703)(438)Cash used in financing activities(1,549)(2,357)Effect of exchange rate changes on cash, cash equivalents, and restricted cash83 (38)Net change in cash, cash equivalents, and restricted cash570 566 Cash, cash equivalents, and restricted cash, end of period$2,122 $1,552 49Operating ActivitiesCash provided by operating activities was $2.7 billion and $3.4 billion in 2020 and 2019. The decrease was primarily attributable to a decrease in net income excluding non-cash items and, to a lesser extent, a negative fluctuation in working capital activity, primarily due to the timing of payments, partially offset by an increase in receivables collected.Investing ActivitiesCash used in investing activities was $703 million and $438 million in 2020 and 2019. The increase in cash used in investing activities was primarily driven by the purchase of $250 million in time deposit investments in 2020 and, to a lesser extent, an increase in purchases of property and equipment to support our next generation platforms, including discovery+, partially offset by a reduction in investments in and advances to equity investments.Financing ActivitiesCash used in financing activities was $1.5 billion and $2.4 billion in 2020 and 2019. The decrease in cash used in financing activities was primarily attributable to lower net repayments and incremental borrowings of senior notes and the change in net activity under the revolving credit facility, partially offset by an increase in repurchases of stock.Capital ResourcesAs of December 31, 2020, capital resources were comprised of the following (in millions). December 31, 2020 TotalCapacityOutstandingLetters ofCreditOutstandingIndebtednessUnusedCapacityCash and cash equivalents$2,091 $— $— $2,091 Revolving credit facility and commercial paper program2,500 — — 2,500 Senior notes (a)15,848 — 15,848 — Total$20,439 $— $15,848 $4,591 (a) Interest on senior notes is paid annually, semi-annually or quarterly. Our senior notes outstanding as of December 31, 2020 had interest rates that ranged from 1.90% to 6.35% and will mature between 2021 and 2055.We expect that our cash balance, cash generated from operations and availability under the Credit Agreement will be sufficient to fund our cash needs for the next twelve months. Our borrowing costs and access to capital markets can be affected by short and long-term debt ratings assigned by independent rating agencies which are based, in part, on our performance as measured by credit metrics such as interest coverage and leverage ratios.As of December 31, 2020, we held $161 million of our $2.1 billion of cash and cash equivalents in our foreign subsidiaries. The 2017 Tax Act features a participation exemption regime with current taxation of certain foreign income and imposes a mandatory repatriation toll tax on unremitted foreign earnings. Notwithstanding the U.S. taxation of these amounts, we intend to continue to reinvest these funds outside of the U.S. Our current plans do not demonstrate a need to repatriate them to the U.S. However, if these funds are needed in the U.S., we would be required to accrue and pay non-U.S. taxes to repatriate them. The determination of the amount of unrecognized deferred income tax liability with respect to these undistributed foreign earnings is not practicable.Summarized Guarantor Financial Information Basis of PresentationEach of the Company, DCL, Discovery Communications Holding LLC (“DCH”) and/or Scripps Networks has the ability to conduct registered offerings of debt securities under the Company’s shelf registration statement. As of December 31, 2020, all of the Company’s outstanding registered senior notes have been issued by DCL, a wholly owned subsidiary of the Company and guaranteed by the Company and Scripps Networks, except for $32 million of senior notes outstanding as of December 31, 2020 that have been issued by Scripps Networks and are not guaranteed. (See Note 8 to the accompanying consolidated financial statements.) DCL primarily includes the Discovery Channel and TLC networks in the U.S. DCL is a wholly owned subsidiary of DCH. The Company wholly owns DCH through a 33 1/3% direct ownership interest and a 66 2/3% indirect ownership interest through Discovery Holding Company (“DHC”), a wholly owned subsidiary of the Company. Scripps Networks is 100% owned by the Company.50The tables below present the summarized financial information as combined for Discovery, Inc. (the “Parent”), Scripps Networks and DCL (collectively, the “Obligors”). All guarantees of DCL's senior notes (the “Note Guarantees”) are full and unconditional, joint and several and unsecured, and cover all payment obligations arising under the senior notes. DCH currently is not an issuer or guarantor of any securities and therefore is not included in the summarized financial information included herein.Note Guarantees issued by Scripps Networks or any subsidiary of the Parent that in the future issues a Note Guarantee (each, a “Subsidiary Guarantor”) may be released and discharged (i) concurrently with any direct or indirect sale or disposition of such Subsidiary Guarantor or any interest therein, (ii) at any time that such Subsidiary Guarantor is released from all of its obligations under its guarantee of payment by DCL, (iii) upon the merger or consolidation of any Subsidiary Guarantor with and into DCL or the Parent or another Subsidiary Guarantor, or upon the liquidation of such Subsidiary Guarantor and (iv) other customary events constituting a discharge of the Obligors’ obligations.Summarized Financial Information During 2020, the Company early adopted Rule 13-01 of the SEC's Regulation S-X. In lieu of providing separate unaudited financial statements for the Parent and Scripps Networks as a Subsidiary Guarantor, the Company has included the accompanying summarized combined financial information of the Obligors after the elimination of intercompany transactions and balances among the Obligors and the elimination of equity in earnings from and investments in any subsidiary of the Parent that is a non-guarantor (in millions).December 31, 2020Current assets$2,308 Non-guarantor intercompany trade receivables, net217 Noncurrent assets5,905 Current liabilities915 Noncurrent liabilities16,500 Year Ended December 31, 2020Revenues$2,036 Operating income1,041 Net income162 Net income available to Discovery, Inc.146 Additional information regarding the changes in our outstanding indebtedness and the significant terms and provisions of our revolving credit facility and outstanding indebtedness is discussed in Note 8 to the accompanying consolidated financial statements included in Item 8, “Financial Statements and Supplementary Data” in this Annual Report on Form 10-K.51COMMITMENTS AND OFF-BALANCE SHEET ARRANGEMENTSObligationsAs of December 31, 2020, our significant contractual obligations, including related payments due by period, were as follows (in millions).Payments Due by PeriodTotalLess than 1 Year1-3 Years3-5 YearsMore than 5 YearsLong-term debt:Principal payments$15,848 $335 $1,587 $2,293 $11,633 Interest payments10,646 646 1,242 1,111 7,647 Finance lease obligations263 64 103 54 42 Operating lease obligations859 91 145 121 502 Content5,053 1,698 1,105 1,113 1,137 Other1,297 576 567 85 69 Total$33,966 $3,410 $4,749 $4,777 $21,030 The above table does not include certain long-term obligations as the timing or the amount of the payments cannot be predicted. The current portion of the liability for cash-settled share-based compensation awards was $37 million as of December 31, 2020. Additionally, reserves for unrecognized tax benefits have been excluded from the above table because we are unable to predict reasonably the ultimate amount or timing of settlement. Our unrecognized tax benefits totaled $348 million as of December 31, 2020. The above table also does not include DCL's revolving credit facility that allows DCL and certain designated foreign subsidiaries of DCL to borrow up to $2.5 billion, including a $100 million sublimit for the issuance of standby letters of credit and a $50 million sublimit for Euro-denominated swing line loans. Borrowing capacity under this agreement is reduced by the outstanding borrowings under the commercial paper program. As of December 31, 2020, the revolving credit facility agreement provided for a maturity date of August 2022 and the option for up to two additional 364-day renewal periods.From time to time we may provide our equity method investees additional funding that has not been committed to as of December 31, 2020 based on unforeseen investee opportunities or cash flow needs.Long-term DebtPrincipal payments on long-term debt reflect the repayment of our outstanding senior notes, at face value, assuming repayment will occur upon maturity. Interest payments on our outstanding senior notes are projected based on their contractual rate and maturity.Finance Lease ObligationsWe acquire satellite transponders and other equipment through multi-year finance lease arrangements. Principal payments on finance lease obligations reflect amounts due under our finance lease agreements. Interest payments on our outstanding finance lease obligations are based on the stated or implied rate in our finance lease agreements.Operating Lease ObligationsWe obtain office space and equipment under multi-year lease arrangements. Most operating leases are not cancelable prior to their expiration. Payments for operating leases represent the amounts due under the agreements assuming the agreements are not canceled prior to their expiration.Purchase ObligationsContent purchase obligations include commitments and liabilities associated with third-party producers and sports associations for content that airs on our television networks. Production contracts generally require: purchase of a specified number of episodes; payments over the term of the license; and include both programs that have been delivered and are available for airing and programs that have not yet been produced or sporting events that have not yet taken place. If the content is ultimately never produced, our commitments expire without obligation. The commitments disclosed above exclude content liabilities recognized on the consolidated balance sheet. We expect to enter into additional production contracts and content licenses to meet our future content needs.52Other purchase obligations include agreements with certain vendors and suppliers for the purchase of goods and services whereby the underlying agreements are enforceable, legally binding and specify all significant terms. Significant purchase obligations include transmission services, television rating services, marketing research, employment contracts, equipment purchases, and information technology and other services. We have contracts that do not require the purchase of fixed or minimum quantities and generally may be terminated with a 30-day to 60-day advance notice without penalty, and are not included in the table above past the 30-day to 60-day advance notice period. Amounts related to employment contracts include base compensation and do not include compensation contingent on future events.Put RightsWe have granted put rights to certain consolidated subsidiaries, which have been excluded from the table above since we are unable to reasonably predict the ultimate amount or timing of any payment. We recorded the carrying value of the noncontrolling interest in the equity associated with the put rights as a component of redeemable noncontrolling interest in the amount of $383 million. (See Note 11 to the accompanying consolidated financial statements.)Pension ObligationsWe sponsor a qualified defined benefit pension plan (“Pension Plan”) that covers certain U.S.-based employees. We also have a non-qualified Supplemental Executive Retirement Plan (“SERP”). Contractual commitments summarized in the contractual obligations table include payments to meet minimum funding requirements of our Pension Plan in 2021 and estimated benefit payments for our SERP. Payments for the SERP have been estimated over a ten-year period. While benefit payments under these plans are expected to continue beyond 2030, we believe it is not practicable to estimate payments beyond this period.Noncontrolling InterestThe Food Network and Cooking Channel are operated and organized under the terms of the TV Food Network Partnership (the "Partnership"). We hold interests in the Partnership, along with another noncontrolling owner. During the fourth quarter of 2020, the Partnership agreement was extended and specifies a dissolution date of December 31, 2022. If the term of the Partnership is not extended prior to that date, the Partnership agreement permits us, as holder of 80% of the applicable votes, to reconstitute the Partnership and continue its business. If for some reason the Partnership is not continued, it will be required to limit its activities to winding up, settling debts, liquidating assets and distributing proceeds to the partners in proportion to their partnership interests.Off-Balance Sheet ArrangementsWe have no material off-balance sheet arrangements (as defined in Item 303(a)(4) of Regulation S-K) that have or are reasonably likely to have a current or future effect on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources.RELATED PARTY TRANSACTIONSIn the ordinary course of business, we enter into transactions with related parties, primarily the Liberty Entities and our equity method investees. Information regarding transactions and amounts with related parties is discussed in Note 21 to the accompanying consolidated financial statements included in Item 8, “Financial Statements and Supplementary Data” in this Annual Report on Form 10-K.NEW ACCOUNTING AND REPORTING PRONOUNCEMENTSWe adopted certain accounting and reporting standards during 2020. Information regarding our adoption of new accounting and reporting standards is discussed in Note 2 to the accompanying consolidated financial statements included in Item 8, “Financial Statements and Supplementary Data” in this Annual Report on Form 10-K.53CRITICAL ACCOUNTING POLICIES AND ESTIMATESOur consolidated financial statements are prepared in accordance with GAAP, which requires management to make estimates, judgments and assumptions that affect the amounts reported in the consolidated financial statements included in Item 8, "Financial Statements and Supplementary Data" in this Annual Report on Form 10-K and accompanying notes. Management considers an accounting policy to be critical if it is material to reporting our financial condition and results of operations, and if it requires significant judgment and estimates on the part of management in its application. The development and selection of these critical accounting policies have been determined by management and the related disclosures have been reviewed with the Audit Committee of the Board of Directors of the Company. We believe the following accounting policies are critical to our business operations and the understanding of our results of operations and involve the more significant judgments and estimates used in the preparation of our consolidated financial statements.Uncertain Tax PositionsWe are subject to income taxes in numerous U.S. and foreign jurisdictions. From time to time, we engage in transactions or takes filing positions in which the tax consequences may be uncertain and may recognize tax liabilities based on estimates of whether additional taxes and interest will be due. We establish a reserve for uncertain tax positions unless we determine that such positions are more likely than not to be sustained upon examination based on their technical merits, including the resolution of any appeals or litigation processes. We include interest and where appropriate, potential penalties, in our tax reserves. This assessment relies on estimates and assumptions and may involve a series of complex judgments about future events including the status and results of income tax audits with the relevant tax authorities. Significant judgment is exercised in evaluating all relevant information, the technical merits of the tax positions, and the accurate measurement of uncertain tax positions when determining the amount of reserve and whether positions taken on our tax returns are more likely than not to be sustained. This also involves the use of significant estimates and assumptions with respect to the potential outcome of positions taken on tax returns that may be reviewed by tax authorities.Goodwill and Intangible AssetsGoodwill is allocated to our reporting units, which are our operating segments or one level below our operating segments (the component level). Reporting units are determined by the discrete financial information available for the component and whether it is regularly reviewed by segment management. Components are aggregated into a single reporting unit if they share similar economic characteristics. Our reporting units are as follows: U.S. Networks, Europe, Latin America, and Asia-Pacific.We evaluate our goodwill for impairment annually as of October 1 or earlier upon the occurrence of substantive unfavorable changes in economic conditions, industry trends, costs, cash flows, or ongoing declines in market capitalization. If we believe that as a result of our qualitative assessment it is not more likely than not that the fair value of a reporting unit is greater than its carrying amount, a quantitative impairment test is required. The quantitative impairment test requires significant judgment in determining the fair value of the reporting units. We determine the fair value of our reporting units by using a combination of the income approach, which incorporates the use of the discounted cash flow (“DCF”) method and the market multiple approach, which incorporates the use of EBITDA multiples based on market data. For the DCF method, we use projections specific to the reporting unit, as well as those based on general economic conditions, which require the use of significant estimates and assumptions. Determining fair value specific to each reporting unit requires the Company to exercise judgment when selecting the appropriate discount rates, control premiums, terminal growth rates, assumed tax rates, relevant comparable company earnings multiples and the amount and timing of expected future cash flows, including revenue growth rates and profit margins. The cash flows employed in the DCF analysis for each reporting unit are based on the reporting unit's budget, long range plan, and recent operating performance. Discount rate assumptions are based on an assessment of the risk inherent in the future cash flows of the respective reporting unit and market conditions. 542020 Impairment AnalysisWe concluded that the continued impacts of COVID-19 on the operating results of the Europe reporting unit represented a triggering event in the second quarter of 2020. During the second quarter, we performed a quantitative goodwill impairment analysis for our Europe reporting unit using a DCF valuation model. A market-based valuation model was not weighted in the analysis given the significant volatility in the equity markets. Significant judgments and assumptions in the DCF model included the amount and timing of future cash flows, including revenue growth rates, long-term growth rates of 2%, and a discount rate ranging from 10% to 10.5%. The estimated fair value of the Europe reporting unit exceeded its carrying value and, therefore, no impairment was recorded.Also during the second quarter of 2020, we determined that it was more likely than not that the fair value was greater than the carrying value for all other reporting units with the exception of the Asia-Pacific reporting unit. We performed a quantitative goodwill impairment analysis for the Asia-Pacific reporting unit and determined that the estimated fair value did not exceed its carrying value, which resulted in a pre-tax impairment charge to write-off the remaining $36 million goodwill balance during the second quarter of 2020. The impairment charge was not deductible for tax purposes. Significant judgments and assumptions included the amount and timing of future cash flows, including revenue growth rates, long-term growth rates ranging from 2% to 2.5%, and a discount rate of 11%. The cash flows employed in the DCF analysis for the Asia-Pacific reporting unit were based on the reporting unit’s budget and long-term business plan. The determination of fair value of our Asia-Pacific reporting unit represents a Level 3 fair value measurement in the fair value hierarchy due to its use of internal projections and unobservable measurement inputs. The goodwill impairment charge did not have an impact on the calculation of our financial covenants under our debt arrangements.During the third quarter of 2020, we realigned our International Networks management reporting structure. As a result, Australia and New Zealand, which were previously included in the Europe reporting unit, are now included in the Asia-Pacific reporting unit, including the associated goodwill. As a result of this realignment, we performed a quantitative goodwill impairment analysis for our Europe and Asia-Pacific reporting units using a DCF valuation model. A market-based valuation model was not weighted in the analysis given the significant volatility in the equity markets. Significant judgments and assumptions in the DCF model included the amount and timing of future cash flows, including revenue growth rates, long-term growth rates of 2% for Europe and 2% to 2.5% for Asia-Pacific, and a discount rate ranging from 10% to 10.5% for Europe and 11% for Asia-Pacific. The estimated fair value of both the Europe and Asia-Pacific reporting units exceeded their carrying values and, therefore, no impairment was recorded.During the fourth quarter of 2020, we performed our annual qualitative goodwill impairment assessment for all reporting units and we determined that it was more likely than not that the fair value of those reporting units exceeded their carrying values, except for our Europe and Asia-Pacific reporting units. Given limited headroom of below 20% in its Europe and Asia-Pacific reporting units during the third quarter of 2020, we performed a quantitative goodwill impairment analysis for each of these reporting units using a DCF valuation model. A market-based valuation model was not weighted in the analysis due to significant volatility in the reporting units' equity markets. The quantitative goodwill impairment analysis for our Europe reporting unit indicated that the estimated fair value exceeded its carry value by approximately 20% and, therefore, no impairment was recorded. Significant judgments and assumptions included the amount and timing of future cash flows, including revenue growth rates, long-term growth rate of 2%, and discount rates ranging from 10.5% to 11%. We noted that a 1.0% increase in the discount rate and a 0.5% decrease in the long-term growth rate would not have resulted in an impairment loss. As of December 31, 2020, the carrying value of goodwill assigned to the Europe reporting unit was $1.9 billion. The quantitative impairment analysis for our Asia-Pacific reporting unit indicated that estimated fair value did not exceed its carrying value, which resulted in a pre-tax impairment charge to write-off the remaining $85 million goodwill balance. The impairment was a result of increased cost projections for this region committed to during the fourth quarter of 2020 as part of our global discovery+ rollout strategy. The impairment charge was not deductible for tax purposes. Significant judgments and assumptions included the amount and timing of future cash flows, including revenue growth rates, long-term growth rates ranging from 2% to 2.5%, and a discount rate of 11%. The cash flows employed in the DCF analysis for the Asia-Pacific reporting unit were based on the reporting unit’s budget and long-term business plan. The determination of fair value of our Asia-Pacific reporting unit represents a Level 3 fair value measurement in the fair value hierarchy due to its use of internal projections and unobservable measurement inputs. The goodwill impairment charge did not have an impact on the calculation of our financial covenants under our debt arrangements.55Content RightsContent rights principally consist of television series, specials, films and sporting events. Costs of produced and coproduced content consist of development costs, acquired production costs, direct production costs, certain production overhead costs and participation costs and is capitalized if we have previously generated revenues from similar content in established markets and the content will be used and revenues will be generated for a period of at least one year.Linear content amortization expense for each period is recognized based on the revenue forecast model, which approximates the proportion that estimated distribution and advertising revenues for the current period represent in relation to the estimated remaining total lifetime revenues. Digital content amortization for each period is recognized based on estimated viewing patterns as there are no direct revenues to associate to the individual content assets and therefore, number of views is most representative of the use of the title. Judgment is required to determine the useful lives and amortization patterns of our content assets.Critical assumptions used in determining content amortization include: (i) the grouping of content with similar characteristics, (ii) the application of a quantitative revenue forecast model or viewership model based on the adequacy of historical data, (iii) determining the appropriate historical periods to utilize and the relative weighting of those historical periods in the forecast model, (iv) assessing the accuracy of our forecasts and (v) incorporating secondary streams. We then consider the appropriate application of the quantitative assessment given forecasted content use, expected content investment and market trends. Content use and future revenues may differ from estimates based on changes in expectations related to market acceptance, network affiliate fee rates, advertising demand, the number of cable and satellite television subscribers receiving our networks, the number of subscribers to our digital services, and program usage. Accordingly, we continually review our estimates and planned usage and revise our assumptions if necessary. ConsolidationWe have ownership and other interests in and contractual arrangements with various entities, including corporations, partnerships, and limited liability companies. For each such entity, we evaluate our ownership, other interests and contractual arrangements to determine whether we should consolidate the entity or account for its interest as an investment at inception and upon reconsideration events. As part of its evaluation, we initially determine whether the entity is a variable interest entity ("VIE"). Management evaluates key considerations through a qualitative and quantitative analysis in determining whether an entity is a VIE including whether (i) the entity has sufficient equity to finance its activities without additional financial support from other parties, (ii) the ability or inability to make significant decisions about the entity’s operations, and (iii) the proportionality of voting rights of investors relative to their obligations to absorb the expected losses (or receive the expected returns) of the entity. If the entity is a VIE and if we have a variable interest in the entity, we use judgment in determining if we are the primary beneficiary and are thus required to consolidate the entity. In making this determination, we evaluate whether we or another party involved with the VIE (1) has the power to direct the activities of the VIE that most significantly impact the VIE’s economic performance and (2) has the obligation to absorb losses of or receive benefits from the VIE that could be significant to the VIE.If it is concluded that an entity is not a VIE, we consider our proportional voting interests in the entity and consolidate majority-owned subsidiaries in which a controlling financial interest is maintained. A controlling financial interest is determined by majority ownership and the absence of substantive third-party participation rights. Key factors we consider in determining the presence of substantive third-party participation rights include, but are not limited to, control of the board of directors, budget approval or veto rights, or operational rights that significantly impact the economic performance of the business such as programming, creative development, marketing, and selection of key personnel. Ownership interests in unconsolidated entities for which we have significant influence are accounted for as equity method.Revenue RecognitionAs described in Note 2, we generate advertising revenues primarily from advertising sold on our television networks and websites and distribution revenues from fees charged to distributors of its network content, which include cable, direct-to-home satellite, telecommunications and digital service providers and bundled long-term content arrangements, as well as through DTC subscription services.Revenue contracts with our advertising customers may include multiple distinct performance obligations. For example, linear and digital advertising contracts may include the airing of spots and/or the satisfaction of an audience guarantee. For such contracts, judgment is required in allocating the contract value to the individual performance obligations based on their relative standalone selling prices. Various factors such as prior transactions, rate cards and other market indicators are used to determine the standalone selling price of each performance obligation and accordingly, how much revenue is allocated to each performance obligation. For these contracts, revenue recorded when each performance obligation has been satisfied and value has been transferred to the customer.56A substantial portion of the advertising contracts in the U.S. and certain international markets guarantee the advertiser a minimum audience level that either the program in which their advertisements are aired or the advertisement will reach. These advertising campaigns are considered to represent a single, distinct performance obligation. For such contracts, judgement is required in measuring progress across the Company’s single performance obligation. Various factors such as pricing specific to the channel, daypart and targeted demographic, as well as estimated audience guarantees, are considered in determining how to appropriately measure progress across the campaigns. Revenues are ultimately recognized based on the audience level delivered multiplied by the average price per impression. See Item 1A, "Risk Factors" for details on all significant risks that could impact our ability to successfully grow our cash flows. For an in-depth discussion of each of our significant accounting policies, including our critical accounting policies and further information regarding estimates and assumptions involved in their application, see Note 2 to the accompanying consolidated financial statements included in Item 8, “Financial Statements and Supplementary Data” in this Annual Report on Form 10-K.ITEM 7A. Quantitative and Qualitative Disclosures about Market Risk.Our financial position, earnings and cash flows are exposed to market risks and can be affected by, among other things, economic conditions, interest rate changes, foreign currency fluctuations, and changes in the market values of investments. We have established policies, procedures and internal processes governing our management of market risks and the use of financial instruments to manage our exposure to such risks.Interest RatesWe are exposed to the impact of interest rate changes primarily through our actual and potential borrowing activities. During the year ended December 31, 2020, we had access to a $2.5 billion revolving credit facility, which had no outstanding borrowings as of December 31, 2020. We also have access to a commercial paper program, which had no outstanding borrowings as of December 31, 2020. The interest rate on borrowings under the revolving credit facility is variable based on an underlying index and DCL's then-current credit rating for its publicly traded debt. The revolving credit facility matures in August 2022 and the option for up to two additional 364-day renewal periods. As of December 31, 2020, we had outstanding debt with a book value of $15.8 billion under various public senior notes with fixed interest rates.Our current objectives in managing exposure to interest rate changes are to limit the impact of interest rates on earnings and cash flows. To achieve these objectives, we may enter into variable interest rate swaps, effectively converting fixed rate borrowings to variable rate borrowings indexed to LIBOR in order to reduce the amount of interest paid. We may also enter into fixed rate forward starting swaps to limit the impact of volatility in interest rates for future issuances of fixed rate debt. As of December 31, 2020, we had entered into forward starting interest rate swap agreements with a notional value of $2 billion for the future issuances of fixed rate debt.As of December 31, 2020, the fair value of our outstanding public senior notes was $18.7 billion. The fair value of our long-term debt may vary as a result of market conditions and other factors. A change in market interest rates will impact the fair market value of our fixed rate debt. The potential change in fair value of these senior notes from a 100 basis-point increase in quoted interest rates across all maturities, often referred to as a parallel shift in the yield curve, would be a decrease in fair value of approximately $1.7 billion as of December 31, 2020.Foreign Currency Exchange RatesWe transact business globally and are subject to risks associated with changing foreign currency exchange rates. Market risk refers to the risk of loss arising from adverse changes in foreign currency exchange rates. The risk of loss can be assessed from the perspective of adverse changes in fair values, cash flows and future earnings. Our International Networks segment operates from hubs in EMEA, Latin America and Asia. Cash is primarily managed from five global locations with net earnings reinvested locally and working capital requirements met from existing liquid funds. To the extent such funds are not sufficient to meet working capital requirements, drawdowns in the appropriate local currency are available from intercompany borrowings or drawdowns from our revolving credit facility. The earnings of certain international operations are expected to be reinvested in those businesses indefinitely. 57The functional currency of most of our international subsidiaries is the local currency. We are exposed to foreign currency risk to the extent that we enter into transactions denominated in currencies other than our subsidiaries’ respective functional currencies ("non-functional currency risk"). Such transactions include affiliate and ad sales arrangements, content arrangements, equipment and other vendor purchases and intercompany transactions. Changes in exchange rates with respect to amounts recorded in our consolidated balance sheets related to these items will result in unrealized foreign currency transaction gains and losses based upon period-end exchange rates. We also record realized foreign currency transaction gains and losses upon settlement of the transactions. Moreover, we will experience fluctuations in our revenues, costs and expenses solely as a result of changes in foreign currency exchange rates. We also are exposed to unfavorable and potentially volatile fluctuations of the U.S. dollar, which is our reporting currency, against the currencies of our operating subsidiaries when their respective financial statements are translated into U.S. dollars for inclusion in our consolidated financial statements. Cumulative translation adjustments are recorded in accumulated other comprehensive loss as a separate component of equity. Any increase or decrease in the value of the U.S. dollar against any foreign functional currency of one of our operating subsidiaries will cause us to experience unrealized foreign currency translation gains or losses with respect to amounts already invested in such foreign currencies. Accordingly, we may experience a negative impact on our net income (loss), other comprehensive income (loss) and equity with respect to our holdings solely as a result of changes in foreign currency. The majority of our foreign currency exposure is to the Euro, Polish zloty, and the British Pound. We may enter into spot, forward and option contracts that change in value as foreign currency exchange rates change to hedge certain exposures associated with affiliate revenue, the cost for producing or acquiring content, certain intercompany transactions or in connection with forecasted business combinations. These contracts hedge forecasted foreign currency transactions in order to mitigate fluctuations in our earnings and cash flows associated with changes in foreign currency exchange rates. Our objective in managing exposure to foreign currency fluctuations is to reduce volatility of earnings and cash flows. The net fair market value of our foreign currency derivative instruments intended to hedge future cash flows held at December 31, 2020 was a liability value of $24 million. Most of our non-functional currency risks related to our revenue, operating expenses and capital expenditures were not hedged as of December 31, 2020. We generally do not hedge against the risk that we may incur non-cash losses upon the translation of the financial statements of our subsidiaries and affiliates into U.S. dollars.DerivativesWe may use derivative financial instruments to modify our exposure to exogenous events and market risks from changes in foreign currency exchange rates, interest rates, and the fair value of investments with readily determinable fair values. We do not use derivative financial instruments unless there is an underlying exposure. While derivatives are used to mitigate cash flow risk and the risk of declines in fair value, they also limit potential economic benefits to our business in the event of positive shifts in foreign currency exchange rates, interest rates and market values. We do not hold or enter into financial instruments for speculative trading purposes.Market Values of InvestmentsIn addition to derivatives, we had investments in entities accounted as equity method investments, equity investments, and other highly liquid instruments, such as money market and mutual funds, that are accounted for at fair value. (See Note 4 and Note 5 to the accompanying consolidated financial statements.) Investments in mutual funds include both fixed rate and floating rate interest earning securities that carry a degree of interest rate risk. Fixed rate securities may have their fair market value adversely impacted due to a rise in interest rates, while floating rate securities may produce less income than predicted if interest rates fall. Due in part to these factors, our income from such investments may decrease in the future.58
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+ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSManagement’s discussion and analysis of financial condition and results of operations is provided as a supplement to, and should be read in conjunction with, the consolidated financial statements and related notes to enhance the understanding of the Company’s operations and present business environment. Components of management’s discussion and analysis of financial condition and results of operations include:•Overview•Analysis of Operations•Result of Operations•Supplemental Unaudited Pro Forma Combined Financial Information •Segment Results•Liquidity and Capital Resources•Outlook•Recent Accounting Pronouncements•Critical Accounting Estimates•Long-Term Employee Benefits•Environmental MattersOVERVIEWAs of December 31, 2020, the Company has $6 billion of working capital and over $2.5 billion in cash and cash equivalents. The Company expects its cash and cash equivalents, cash generated from operations, and ability to access the debt capital markets to provide sufficient liquidity and financial flexibility to meet the liquidity requirements associated with its continued operations. In response to the uncertainty surrounding the extent and duration of the COVID-19 pandemic, the Company has also taken additional measures throughout the year to further ensure its liquidity and capital resources. The Company continually assesses its liquidity position, including possible sources of incremental liquidity, in light of the current economic environment, capital market conditions and Company performance. On February 1, 2021, DuPont completed the separation and distribution of the Nutrition & Biosciences business (the “N&B Business”), and merger of Nutrition & Biosciences, Inc. (“N&B”), a DuPont subsidiary formed to hold the N&B Business, with a subsidiary of IFF. The distribution was effected through an exchange offer (the “Exchange Offer”) where, on the terms and subject to the conditions of the Exchange Offer, eligible participating DuPont stockholders had the option to tender all, some or none of their shares of common stock, par value $0.01 per share, of DuPont (the “DuPont Common Stock”) for a number of shares of common stock, par value $0.01 per share, of N&B (the “N&B Common Stock”) and which resulted in all shares of N&B Common Stock being distributed to DuPont stockholders that participated in the Exchange Offer. The consummation of the Exchange Offer was followed by the merger of N&B with a wholly owned subsidiary of IFF, with N&B surviving the merger as a wholly owned subsidiary of IFF (the “N&B Merger” and, together with the Exchange Offer, the “N&B Transaction”). In connection with the N&B Transaction, N&B made a one-time cash payment of approximately $7.3 billion (the “Special Cash Payment”) to DuPont. The company used a portion of the proceeds to retire its $3 billion term loan facilities on February 1, 2021 and will use the proceeds to fund the redemption, in accordance with their terms, of the $2 billion May 2020 Notes issuance. See discussion below and within “Liquidity and Capital Resources” for more information.DWDP MergerEffective August 31, 2017, pursuant to the merger of equals transactions contemplated by the Agreement and Plan of Merger, dated as of December 11, 2015, as amended on March 31, 2017 ("DWDP Merger Agreement"), The Dow Chemical Company ("TDCC") and E. I. du Pont de Nemours and Company ("EID") each merged with subsidiaries of DowDuPont Inc. ("DowDuPont") and, as a result, TDCC and EID became subsidiaries of DowDuPont (the "DWDP Merger"). Prior to the DWDP Merger, DowDuPont did not conduct any business activities other than those required for its formation and matters contemplated by the DWDP Merger Agreement. TDCC was determined to be the accounting acquirer in the DWDP Merger.DowDuPont completed a series of internal reorganizations and realignment steps in order to separate into three, independent, publicly traded companies - one for each of its agriculture, materials science and specialty products businesses. DowDuPont formed two wholly owned subsidiaries: Dow Inc. ("Dow," formerly known as Dow Holdings Inc.), to serve as a holding company for its materials science business, and Corteva, Inc. ("Corteva"), to serve as a holding company for its agriculture business.32Table of ContentsDWDP DistributionsOn April 1, 2019, the Company completed the separation of the materials science business through the spin-off of Dow Inc., including Dow’s subsidiary TDCC (the “Dow Distribution”). On June 1, 2019, the Company completed the separation of the agriculture business through the spin-off of Corteva including Corteva’s subsidiary EID, (the “Corteva Distribution and together with the Dow Distribution, the “DWDP Distributions”). Following the Corteva Distribution, the Company holds the specialty products business. On June 1, 2019, DowDuPont changed its registered name from "DowDuPont Inc." to "DuPont de Nemours, Inc." doing business as "DuPont" (the "Company"). Beginning on June 3, 2019, the Company's common stock is traded on the NYSE under the ticker symbol "DD." The results of operations of DuPont for the 2019 and 2018 periods presented reflect the historical financial results of Dow and Corteva as discontinued operations, as applicable. The cash flows and comprehensive income related to Dow and Corteva have not been segregated and are included in the Consolidated Statements of Cash Flows and Consolidated Statements of Comprehensive Income, respectively, for the applicable period. Unless otherwise indicated, the information in the notes to the Consolidated Financial Statements refer only to DuPont's continuing operations and do not include discussion of balances or activity of Dow or Corteva.The statements of operations and pro forma statements of operations included in this report and as discussed below include costs previously allocated to the materials science and agriculture businesses that did not meet the definition of expenses related to discontinued operations in accordance with Financial Accounting Standards Codification 205, "Presentation of Financial Statements" ("ASC 205") and thus are reflected in the Company's results of continuing operations. A significant portion of these costs relate to TDCC and consist of leveraged services provided through service centers, as well as other corporate overhead costs related to information technology, finance, manufacturing, research & development, sales & marketing, supply chain, human resources, sourcing & logistics, legal and communications, public affairs & government affairs functions. These costs are no longer incurred by the Company following the DWDP Distributions. N&B TransactionOn December 31, 2020, DuPont commenced the Exchange Offer which expired at one minute past 11:59 PM ET on January 29, 2021. Pursuant to the Exchange Offer, on February 1, 2021, DuPont accepted approximately 197.4 million shares of DuPont Common Stock in exchange for about 141.7 million shares of N&B Common Stock. The closing of the N&B Merger followed on February 1, 2021 after satisfaction of certain other conditions, including the receipt of the Special Cash Payment. In the N&B Merger, each share of N&B common stock was automatically converted into the right to receive one share of IFF common stock, par value $0.125 per share (“IFF Common Stock”). See Note 25 to the Consolidated Financial Statements for more information.At December 31, 2020, the financial results of the N&B Business are included in continuing operations for all periods presented. 2021 Segment RealignmentDuPont’s worldwide operations are managed through global businesses, which are currently reported in five reportable segments: Electronics & Imaging; Nutrition & Biosciences; Transportation & Industrial; Safety & Construction; and Non-Core. In conjunction with the closing of the N&B Transaction on February 1, 2020, the Company announced changes to its reportable segments (the “2021 Segment Realignment”). These changes result in the following:•Realignment of certain businesses from Transportation & Industrial to Electronics & Imaging•Dissolution of the Non-Core segment with the businesses to be divested and previously divested reflected in Corporate•Realignment of the remaining Non-Core businesses to Transportation & Industrial In addition, the following name changes will occur:•Electronic & Imaging will be renamed Electronics & Industrial •Transportation & Industrial will be renamed Mobility & Materials•Safety & Construction will be renamed Water & ProtectionThe changes became effective February 1, 2021 and the Company will report financial results under this new structure beginning in the first quarter of 2021. The results included in Management’s Discussion and Analysis of Financial Condition and Results of Operations are not reflective of the 2021 Segment Realignment. 33Table of ContentsANALYSIS OF OPERATIONSCOVID-19 The novel coronavirus (“COVID-19”) pandemic has resulted in significant economic disruption and continues to adversely impact the broader global economy, including certain of the Company’s customers and suppliers. The ultimate extent of the effects of the COVID-19 pandemic on the Company is highly uncertain and will depend on future developments and the effects could exist for an extended period of time even after the pandemic subsides.During 2020, the Company benefited from strong demand in certain key end-markets, principally electronics, water filtration, health & wellness and personal protection. Although results reflect notable improvement in automotive markets, along with residential construction, in the second half of 2020 compared to the first half of 2020, the COVID-19 pandemic adversely impacted demand in aerospace, commercial construction, oil & gas, and select industrial end-markets. In response to this uncertainty, the Company delayed certain capital investments in select sectors throughout the year. Nutrition & Biosciences FinancingIn the third quarter of 2020, N&B completed an offering of $6.25 billion of senior unsecured notes (the “N&B Notes Offering”). The net proceeds of approximately $6.2 billion from the N&B Notes Offering were deposited into an escrow account and at December 31, 2020 are reflected as restricted cash in the Company’s consolidated financial statements. In the first quarter of 2020, N&B entered into a senior unsecured term loan agreement in the amount of $1.25 billion split evenly between three- and five-year facilities.See Note 14 of the Consolidated Financial Statements for additional information.DivestituresIn the fourth quarter of 2020, the Company entered into a definitive agreement to sell its Biomaterials business unit, which includes the Company's equity method investment in DuPont Tate & Lyle Bio Products. In January 2021, the Company entered into separate definitive agreements to sell its Clean Technologies and Solamet® businesses. These divestitures, subject to regulatory approval and customary closing conditions, are expected to close in the first half of 2021. In the third quarter of 2020, the Company completed the sale of its trichlorosilane business (“TCS Business”) along with its equity ownership interest in DC HSC Holdings LLC and Hemlock Semiconductor L.L.C. (the "HSC Group,” and together with the TCS Business, the “TCS/HSC Disposal Group” and the sale of the TCS/HSC Disposal Group, the “TCS/HSC Disposal”) to the HSC Group, both of which were part of the Non-Core segment. The TCS/HSC Disposal resulted in a net pre-tax benefit of $396 million ($236 million net of tax) which was recorded in “Sundry income (expense) – net” in the Company’s Consolidated Statements of Operations. In the first quarter of 2020, the Company completed the sale of its Compound Semiconductor Solutions business unit, a part of the Electronics & Imaging segment, to SK Siltron, for approximately $420 million. The sale resulted in a pre-tax gain of $197 million ($102 million net of tax) recorded in "Sundry income (expense) - net" in the Company's Consolidated Statements of Operations.In the third quarter of 2019, the Company completed the sale and separation of its Sustainable Solutions business unit, a part of the Non-Core segment, to Gyrus Capital. The sale resulted in a pre-tax gain of $28 million ($22 million net of tax) which was recorded in "Sundry income (expense) - net" in the Company's Consolidated Statements of Operations.See Note 3 of the Consolidated Financial Statements for additional information.Joint Settlement AgreementOn January 22, 2021, the Company, Corteva, EID and Chemours entered into a binding Memorandum of Understanding (the “MOU”), pursuant to which the parties have agreed to share certain costs associated with potential future liabilities related to alleged historical releases of certain PFAS arising out of pre-July 1, 2015 conduct (“eligible PFAS costs”) until the earlier to occur of (i) December 31, 2040, (ii) the day on which the aggregate amount of qualified spend (as defined in the MOU) is equal to $4 billion or (iii) a termination in accordance with the terms of the MOU. The parties have agreed that, during the term of this sharing arrangement, Chemours will bear 50% of any qualified spend and the Company and Corteva shall together bear 50% of any qualified spend. As of December 31, 2020, the Company has recorded a liability of $59 million in connection with the cost sharing arrangement related to future eligible PFAS costs. 34Table of ContentsOn January 21, 2021, EID and Chemours entered into settlement agreements with plaintiffs’ counsel representing the Ohio MDL plaintiffs providing for a settlement of cases and claims in the Ohio MDL totaling $83 million in cash with each of the Company and EID contributing approximately $27 million and Chemours contributing approximately $29 million. As of December 31, 2020, the Company has recorded an indemnification liability of $27 million related to the settlement.Total pre-tax charges of $86 million ($66 million after-tax) related to both of the above matters are reflected as a loss from discontinued operations for the year ended December 31, 2020 in the Company's Consolidated Statements of Operations.Goodwill, Long-Lived Asset and Indefinite-Lived Asset ImpairmentsDuring the third quarter of 2020, multiple triggering events occurred requiring the Company to perform impairment analyses associated with its Non-Core segment. As a result of the analyses performed, the Company recorded aggregate pre-tax, non-cash goodwill impairment charges of $183 million recognized in "Goodwill impairment charges" and aggregate pre-tax, non-cash asset impairment charges of $370 million recognized in “Restructuring and asset related charges - net” in the Consolidated Statements of Operations. During the second quarter of 2020, continued near-term demand weakness in global automotive production resulting from the COVID-19 pandemic, along with revised views of recovery based on third party market information, served as a triggering event requiring the Company to perform an impairment analysis of the goodwill associated with its Transportation & Industrial reporting unit. As a result of the analysis performed, the Company recorded pre-tax, non-cash goodwill impairment charges of $2,498 million recognized in "Goodwill impairment charges" in the Consolidated Statements of Operations. In connection with the Transportation & Industrial impairment analysis, the Company also recorded pre-tax, non-cash impairment charges of $21 million related to indefinite-lived intangible assets recognized in “Restructuring and asset related charges - net” in the Consolidated Statements of Operations. During the first quarter of 2020, the Company was required to perform interim impairment tests of its goodwill and long-lived assets as expectations of proceeds related to certain potential divestitures within the Non-Core segment gave rise to fair value indicators and, thus, served as triggering events. As a result of the analysis performed, the Company recorded pre-tax, non-cash impairment charges related to goodwill of $533 million. The charges were recognized in "Goodwill impairment charge" in the Consolidated Statements of Operations. The Company also recorded pre-tax, non-cash impairment charges of $270 million related to long-lived assets. The charges were recognized in “Restructuring and asset related charges - net” in the Consolidated Statements of Operations. During the second quarter of 2019, the Company was required to perform interim impairment tests of its goodwill due to the internal distribution of the specialty products legal entities from EID to DowDuPont (the "Internal SP Distribution") and the Second Quarter Segment Realignment. As a result of the analyses performed, the Company recorded pre-tax, non-cash impairment charges during the year ended December 31, 2019, totaling $1,175 million, of which $933 million related to the Nutrition & Biosciences segment and $242 million related to the Non-Core segment. The charges were recognized in "Goodwill impairment charges" in the Consolidated Statements of Operations. See Notes 5 and 13 of the Consolidated Financial Statements.Equity Method Investment ImpairmentDuring the second quarter of 2019, in connection with the Internal SP Distribution and the impairment of the Industrial Biosciences reporting unit, the Company performed an impairment analysis on the reporting unit's equity method investments. As a result of the analysis performed, the Company recorded pre-tax, non-cash impairment charges of $63 million to write-down the value of an equity method investment. The charge was recognized in "Restructuring and asset related charges - net" in the Consolidated Statements of Operations. See Note 5 of the Consolidated Financial Statements.Dividends On February 12, 2020, the Board of Directors declared a first quarter dividend of $0.30 per share, paid on March 16, 2020, to shareholders of record on February 28, 2020. On April 29, 2020, the Company announced that its Board of Directors declared a second quarter dividend of $0.30 per share, paid on June 15, 2020, to shareholders of record on May 29, 2020. On June 25, 2020, the Company announced that its Board of Directors declared a third quarter dividend of $0.30 per share, paid on September 15, 2020, to shareholders of record on July 31, 2020. On October 14, 2020, the Company announced that its Board of Directors declared a fourth quarter dividend of $0.30 per share, paid on December 15, 2020, to shareholders of record on November 30, 2020. 35Table of ContentsShare Buyback ProgramOn June 1, 2019, the Company's Board of Directors approved a $2 billion share buyback program, which expires on June 1, 2021. During the year ended December 31, 2020, the Company repurchased and retired 6.1 million shares for $232 million. As of the year ended December 31, 2020, the Company had repurchased and retired 16.9 million shares under this program at a total cost of $982 million.Restructuring Programs2020 Restructuring ProgramDuring the first quarter of 2020, the Company approved restructuring actions designed to capture near-term cost reductions and to further simplify certain organizational structures in anticipation of the N&B Transaction (the "2020 Restructuring Program"). For the year ended December 31, 2020, the Company recorded a pre-tax charge related to the 2020 Restructuring Program of $179 million, recognized in "Restructuring and asset related charges - net" in the Company's Consolidated Statements of Operations. At December 31, 2020, total liabilities related to the program were $68 million, which represents expected future cash payments related to this program for the payment of severance and related benefits. The 2020 Restructuring Program was considered substantially complete at December 31, 2020.2019 Restructuring ProgramDuring the second quarter of 2019 and in connection with the ongoing integration activities, DuPont approved restructuring actions to simplify and optimize certain organizational structures following the completion of the DWDP Distributions (the "2019 Restructuring Program"). The Company recorded pre-tax restructuring charges of $140 million inception-to-date, consisting of severance and related benefit costs of $106 million and asset related charges of $34 million, recognized in "Restructuring and asset related charges - net" in the Company's Consolidated Statements of Operations. At December 31, 2020, total liabilities related to the program were $18 million, which represents expected future cash payments related to this program for the payment of severance and related benefits. The 2019 Restructuring Program was considered substantially complete at June 30, 2020.DowDuPont Cost Synergy ProgramIn September and November 2017, the Company approved post-merger restructuring actions under the DowDuPont Cost Synergy Program (the “Synergy Program”), adopted by the DowDuPont Board of Directors. The Synergy Program was designed to integrate and optimize the organization following the DWDP Merger and in preparation for the DWDP Distributions. The Company recorded pre-tax restructuring charges of $492 million inception-to-date, consisting of severance and related benefit costs of $213 million, asset related charges of $212 million and contract termination charges of $67 million. The DowDuPont Cost Synergy program the program was considered substantially complete at June 30, 2020. 36Table of ContentsRESULTS OF OPERATIONSSummary of Sales ResultsFor the Years Ended December 31, In millions202020192018Net sales$20,397 $21,512 $22,594 Sales Variances by Segment and Geographic Region - As ReportedFor the Year Ended December 31, 2020For the Year Ended December 31, 2019Percentage change from prior yearLocal Price & Product MixCurrencyVolumePortfolio & OtherTotalLocal Price & Product MixCurrencyVolume Portfolio & OtherTotalElectronics & Imaging(1)%— %8 %— %7 %— %(1)%(1)%— %(2)%Nutrition & Biosciences1 (1)— — — 1 (2)— (1)(2)Transportation & Industrial(4)— (11)— (15)3 (2)(10)— (9)Safety & Construction2 — (8)2 (4)3 (1)— (4)(2)Non-Core3 — (14)(11)(22)1 (2)(11)(3)(15)Total— %— %(4)%(1)%(5)%2 %(2)%(4)%(1)%(5)%U.S. & Canada(1)%— %(7)%(1)%(9)%2 %— %(3)%— %(1)%EMEA 1— — (9)— (9)3 (5)(4)(4)(10)Asia Pacific(1)— 2 — 1 1 (1)(4)— (4)Latin America4 (5)(9)(1)(11)3 (3)(3)(1)(4)Total— %— %(4)%(1)%(5)%2 %(2)%(4)%(1)%(5)%1. Europe, Middle East and Africa. 2020 versus 2019The Company reported net sales for the year ended December 31, 2020 of $20.4 billion, down 5 percent from $21.5 billion for the year ended December 31, 2019, due to a 4 percent decrease in volume and a 1 percent decline due to portfolio actions. Local price and product mix and currency remained flat. Volume declined across all geographic regions with the exception of Asia Pacific where it increased 2 percent. Volume gains in Electronics & Imaging (up 8 percent) were more than offset by declines in Non-Core (down 14 percent), Transportation & Industrial (down 11 percent) and Safety & Construction (down 8 percent). Portfolio and other changes contributed 1 percent of the sales decrease which impacted Non-Core (down 11 percent) offset by Safety & Construction (up 2 percent). Currency was flat compared with the same period last year in all segments with the exception of Nutrition & Bioscience (down 1 percent). Local price increased in Latin America (up 4 percent) and in Non-Core (up 3 percent) and Safety & Construction (up 2 percent).2019 versus 2018The Company reported net sales for the year ended December 31, 2019 of $21.5 billion, down 5 percent from $22.6 billion for the year ended December 31, 2018, due to a 4 percent decrease in volume, a 2 percent unfavorable currency impact and a 1 percent decline in portfolio actions slightly offset by a 2 percent increase in local price. Volume declined across all geographic regions and all segments with the exception of Nutrition & Biosciences and Safety & Construction which were both flat. The most notable volume decreases were in Non-Core (down 11 percent) and Transportation & Industrial (down 10 percent). Currency was down 2 percent compared with last year, driven primarily by EMEA currencies (down 5 percent). Local price was up 2 percent compared with last year. Local price increased in all geographic regions and in all segments except Electronics & Imaging (flat). Portfolio and other changes contributed 1 percent of the sales decrease which impacted Safety & Construction (down 4 percent; within EMEA), Non-Core (down 3 percent) and Nutrition & Biosciences (down 1 percent). Cost of SalesCost of sales was $13.5 billion for the year ended December 31, 2020, down from $14.1 billion for the year ended December 31, 2019. Cost of sales decreased for the year ended December 31, 2020 primarily due to lower sales volume, cost synergies, and the absence in 2020 of costs previously allocated to the materials science and agriculture businesses that did not meet the definition of expenses related to discontinued operations in accordance with ASC 205 and therefore remained as costs of continuing operations for periods prior to the DWDP Distributions, offset by approximately $245 million of charges associated with temporarily idling several manufacturing plants to align supply with demand due to COVID-19, driven primarily by the Transportation & Industrial segment.Cost of sales as a percentage of net sales for the year ended December 31, 2020 was 66 percent compared with 65 percent for the year ended December 31, 2019.37Table of ContentsFor the year ended December 31, 2019, cost of sales was $14.1 billion, down from $15.3 billion for the year ended December 31, 2018. Cost of sales decreased for the year ended December 31, 2019 primarily due to lower sales volume, cost synergies, portfolio actions related to current year divestitures, currency impacts, and lower costs previously allocated to the materials science and agriculture businesses that did not meet the definition of expenses related to discontinued operations in accordance with ASC 205 and therefore remained as costs of continuing operations for periods prior to the DWDP Distributions. Cost of sales as a percentage of net sales for the year ended December 31, 2019 was 65 percent compared with 68 percent for the year ended December 31, 2018.Research and Development Expense ("R&D")R&D expense was $860 million for the year ended December 31, 2020, $955 million for the year ended December 31, 2019, and $1,070 million for the year ended December 31, 2018. R&D as a percentage of net sales was 4 percent for both the years ended December 31, 2020 and 2019, and 5 percent for the year December 31, 2018. The decrease in R&D costs in 2020 compared to 2019 was due to productivity actions as well as the absence of R&D costs previously allocated to the materials science and agriculture businesses that did not meet the definition of expenses related to discontinued operations in accordance with ASC 205 and therefore remained as a cost of continuing operations for periods prior to the DWDP Distributions. The decrease in R&D costs in 2019 compared to 2018 was primarily due to lower R&D costs previously allocated to the materials science and agriculture businesses that did not meet the definition of expenses related to discontinued operations in accordance with ASC 205 and therefore remained as costs of continuing operations for periods prior to the DWDP Distributions.Selling, General and Administrative Expenses ("SG&A")For the year ended December 31, 2020, SG&A expenses totaled $2,235 million, down from $2,663 million in the year ended December 31, 2019 and $3,028 million for the year ended December 31, 2018. SG&A as a percentage of net sales was 11 percent, 12 percent, and 13 percent for the years ended December 31, 2020, 2019, and 2018, respectively.The decrease in SG&A costs in 2020 compared to 2019 was due to productivity actions, temporarily reducing costs due to COVID-19 restrictions, overall reducing spending, and the absence of SG&A costs previously allocated to the materials science and agriculture businesses that did not meet the definition of expenses related to discontinued operations in accordance with ASC 205 and therefore remained as costs of continuing operations for periods prior to the DWDP Distributions. The decrease in SG&A costs in 2019 compared to 2018 was due to cost synergies and lower SG&A costs previously allocated to the materials science and agriculture businesses that did not meet the definition of expenses related to discontinued operations in accordance with ASC 205 and therefore remained as costs of continuing operations for periods prior to the DWDP Distributions. Amortization of IntangiblesAmortization of intangibles was $2,119 million, $1,050 million, and $1,044 million for the years ended December 31, 2020, 2019, and 2018, respectively. The increase in amortization in 2020 compared with 2019 was primarily due to the amortization of the Nutrition and Biosciences tradename that was reclassified to definite-lived intangibles in the fourth quarter of 2019 in connection with the N&B Transaction. Amortization in 2019 compared with 2018 was relatively flat. See Note 13 to the Consolidated Financial Statements for additional information on intangible assets.Restructuring and Asset Related Charges - NetRestructuring and asset related charges - net were $849 million, $314 million, and $147 million for the years ended December 31, 2020, 2019 and 2018, respectively. The activity for the year ended December 31, 2020 included a $588 million impairment charge related to long-lived assets and a $52 million impairment charge related to indefinite-lived intangible assets in the Non-Core segment, a $21 million impairment charge related to indefinite-lived intangible assets in the Transportation & Industrial segment, a $179 million charge related to the 2020 Restructuring Program, a $2 million charge related to the 2019 Restructuring Program and a $7 million charge related to the DowDuPont Cost Synergy Program. The charges for the year ended December 31, 2019 included a charge of $138 million related to the 2019 Restructuring Program, a $113 million charge related to the DowDuPont Cost Synergy Program, and a $63 million impairment charge related to an equity method investment. The charges for the year ended December 31, 2018 related to the Synergy Program. See Note 5 to the Consolidated Financial Statements for additional information.38Table of ContentsGoodwill Impairment ChargesGoodwill impairment charges were $3,214 million and $1,175 million for the years ended December 31, 2020 and 2019, respectively. For the year ended December 31, 2020, goodwill impairment charges relate to the Transportation & Industrial and Non-Core segments. For the year ended December 31, 2019, goodwill impairment charges relate to the Nutrition & Biosciences and Non-Core segments. There were no goodwill related impairments in the year ended December 31, 2018. See Note 13 to the Consolidated Financial Statements for additional information.Integration and Separation CostsIntegration and separation costs were $594 million in 2020, $1,342 million in 2019 and $1,887 million in 2018. Integration and separation costs primarily reflect costs related to the N&B Transaction, which began in the fourth quarter of 2019, the post-DWDP Merger integration, and activities related to the DWDP Distributions. The decline was primarily related to the timing of the DWDP Distributions. Equity in Earnings of Nonconsolidated AffiliatesThe Company's share of the earnings of nonconsolidated affiliates was $191 million, $84 million, and $447 million for the years ended December 31, 2020, 2019 and 2018, respectively. The increase in earnings of nonconsolidated affiliates for the year ended December 31, 2020 compared to the prior year is due to higher HSC Group equity earnings in the first half of 2020, driven mainly by customer settlements in the second quarter of 2020. The decrease in earnings of nonconsolidated affiliates for the year ended December 31, 2019 compared to the year ended December 31, 2018 was primarily due to lower equity earnings from the HSC Group for the year ended December 31, 2019. For the year ended December 31, 2019 lower equity earnings from the HSC Group was mainly attributable to asset impairment charges, partially offset by benefits associated with customer contract settlements. Sundry Income (Expense) - NetSundry income (expense) - net includes a variety of income and expense items such as foreign currency exchange gains or losses, interest income, dividends from investments, gains and losses on sales of investments and assets, non-operating pension and other post-employment benefit plan credits or costs, and certain litigation matters. Sundry income (expense) - net for the year ended December 31, 2020 was $675 million compared with $153 million and $92 million in the years ended December 31, 2019 and 2018, respectively.The year ended December 31, 2020 included a net pre-tax benefit of $396 million associated with the TCS/HSC Disposal as discussed above, a pre-tax gain of $197 million related to the sale of the Compound Semiconductor Solutions business unit in the Electronics & Imaging segment, miscellaneous income of $47 million, and income related to non-operating pension and other post-employment benefit plans of $32 million, partially offset by foreign currency exchange losses of $56 million.The year ended December 31, 2019 included a net gain on sale of assets and investments of $157 million, income related to non-operating pension and other post-employment benefit plans of $74 million, and interest income of $55 million partially offset by foreign currency exchange losses of $110 million and miscellaneous expenses of $23 million which includes a $48 million charge reflecting a reduction in gross proceeds from lower withholding taxes related to a prior year legal settlement. The net gain on sale of assets includes income of $92 million related to a sale of assets within the Electronics & Imaging segment and as well as a gain of $28 million related to the sale of the Sustainable Solutions business unit within the Non-Core segment.The year ended December 31, 2018 included income related to non-operating pension and other post-employment benefit plans of $96 million, miscellaneous income of $83 million and interest income of $39 million, partially offset by foreign currency exchange losses of $93 million and loss on divestiture and change in joint venture ownership of $41 million. The foreign currency exchange losses included a $50 million foreign currency exchange loss related to adjustments to foreign currency exchange contracts as a result of U.S. tax reform. The loss on divestitures and change in joint venture ownership include a $14 million loss on the divestiture of the European XPS STYROFOAMTM business (related to Safety & Construction) and a $27 million negative impact for adjustments related to the Dow Silicones ownership restructure (related to Non-Core).See Notes 6 to the Consolidated Financial Statements for additional information.Interest ExpenseInterest expense was $767 million, $668 million, and $55 million for the years ended December 31, 2020, 2019, and 2018, respectively. The increase in interest expense in 2020 compared to 2019 primarily relates to financing costs associated with the N&B Transaction and the May Debt Offering, partially offset by reduced borrowing rates on floating rate debt. For the year ended December 31, 2018, there was less than one quarter of interest expense as the Company did not have outstanding 39Table of Contentsborrowings until the 2018 Senior Notes issuance in the fourth quarter of 2018. Refer to Note 14 to the Consolidated Financial Statements for additional information.(Benefit from) Provision for Income Taxes on Continuing OperationsThe Company's effective tax rate fluctuates based on, among other factors, where income is earned and the level of income relative to tax attributes. For the year ended December 31, 2020, the Company's effective tax rate was 0.8 percent on a pre-tax loss from continuing operations of $2,897 million. The effective tax rate for the year ended December 31, 2020, was principally the result of a non-tax-deductible goodwill impairment charge impacting the Non-Core segment in the first and third quarter and a non-tax-deductible goodwill impairment charge impacting the Transportation and Industrial segment in the second quarter, coupled with an allocation of non-tax-deductible goodwill related to the TCS/HSC Disposal. See Note 13 for more information regarding the goodwill impairment charges. The underlying factors affecting the Company’s overall tax rate are summarized in Note 7 to the Consolidated Financial Statements.For the year ended December 31, 2019, the Company's effective tax rate was (29.5) percent on a pre-tax loss from continuing operations of $474 million. The effective tax rate was principally the result of the non-tax-deductible goodwill impairment charges impacting the Nutrition & Biosciences and Non-Core segments. For the year ended December 31, 2018, the Company's effective tax rate was 32.6 percent on pre-tax income from continuing operations of $600 million. The effective tax was favorably impacted by the geographic mix of earnings but was more than offset by a $67 million charge associated with a valuation allowance recorded against the net deferred tax asset position of the Company’s legal entity in Brazil related to the separated agriculture business.(Loss) Income from Discontinued Operations, Net of TaxLoss from discontinued operations, net of tax was $49 million for the year ended December 31, 2020, compared to income from discontinued operations, net of tax of $1,214 million and $3,595 million for the years ended December 31, 2019 and 2018, respectively. For the year ended December 31, 2020, loss from discontinued operations, net of tax primarily related to litigation matters, partially offset by a gain related to the DWDP Tax Matters Agreement. For the year ended December 31, 2019 and 2018, income from discontinued operations, net of tax primarily related to the DWDP Distributions. The decrease each year is attributable to the timing of the DWDP Distributions. Refer to Notes 3 and 15 to the Consolidated Financial Statements for additional information.Net Income Attributable to Noncontrolling InterestsNet income attributable to noncontrolling interests, including the portion attributable to discontinued operations, was $28 million, $102 million, and $155 million, for the years ended December 31, 2020, 2019, and 2018 respectively. Net income attributable to noncontrolling interests of continuing operations was $28 million, $30 million, and $39 million, for the years ended December 31, 2020, 2019, and 2018 respectively. 40Table of ContentsSUPPLEMENTAL UNAUDITED PRO FORMA COMBINED FINANCIAL INFORMATION The following supplemental unaudited pro forma financial information (the “unaudited pro forma financial statements”) was derived from DuPont’s Consolidated Financial Statements, adjusted to give effect to certain events directly attributable to the DWDP Distributions. In contemplation of the DWDP Distributions and to achieve the respective credit profiles of each of the current companies, in the fourth quarter of 2018, DowDuPont borrowed $12.7 billion under the 2018 Senior Notes and entered the Term Loan Facilities with an aggregate principal amount of $3.0 billion. Additionally, DuPont issued approximately $1.4 billion in commercial paper in May 2019 in anticipation of the Corteva Distribution (the “Funding CP Issuance” together with the 2018 Senior Notes and the Term Loan Facilities, the "DWDP Financings"). The unaudited pro forma financial statements below were prepared in accordance with Article 11 of Regulation S-X. The historical consolidated financial information has been adjusted to give effect to pro forma events that are (1) directly attributable to the DWDP Distributions and the DWDP Financings (collectively the "DWDP Transactions"), (2) factually supportable and (3) with respect to the statements of operations, expected to have a continuing impact on the results. The unaudited pro forma statements of operations for the years ended December 31, 2019 and 2018 give effect to the pro forma events as if the DWDP Transactions had occurred on January 1, 2018. There were no pro forma adjustments for the year ended December 31, 2020.Restructuring or integration activities or other costs following the DWDP Distributions that may be incurred to achieve cost or growth synergies of DuPont are not reflected. The unaudited pro forma statements of operations provides shareholders with summary financial information and historical data that is on a basis consistent with how DuPont reports current financial information. The unaudited pro forma financial statements are presented for informational purposes only, and do not purport to represent what DuPont's results of operations or financial position would have been had the DWDP Transactions occurred on the dates indicated, nor do they purport to project the results of operations or financial position for any future period or as of any future date.Unaudited Pro Forma Combined Statement of Operations20192018In millions, except per share amountsDuPont 1Pro Forma Adjustments2Pro FormaDuPont 1Pro Forma Adjustments2Pro FormaNet sales$21,512 $— $21,512 $22,594 $— $22,594 Cost of sales14,056 22 14,078 15,302 74 15,376 Research and development expenses955 — 955 1,070 — 1,070 Selling, general and administrative expenses2,663 — 2,663 3,028 — 3,028 Amortization of intangibles1,050 — 1,050 1,044 — 1,044 Restructuring and asset related charges - net314 — 314 147 — 147 Goodwill impairment charges1,175 — 1,175 — — — Integration and separation costs1,342 (173)1,169 1,887 (493)1,394 Equity in earnings of nonconsolidated affiliates84 — 84 447 — 447 Sundry income (expense) - net153 — 153 92 — 92 Interest expense668 29 697 55 629 684 (Loss) Income from continuing operations before income taxes(474)122 (352)600 (210)390 Provision for income taxes on continuing operations 140 30 170 195 (42)153 (Loss) Income from continuing operations, net of tax(614)92 (522)405 (168)237 Net income attributable to noncontrolling interests of continuing operations30 — 30 39 — 39 Net (loss) income from continuing operations attributable to DuPont$(644)$92 $(552)$366 $(168)$198 Per common share data:(Loss) Income per common share from continuing operations - basic $(0.86)$(0.74)$0.46 $0.24 (Loss) Income per common share from continuing operations - diluted $(0.86)$(0.74)$0.45 $0.23 Weighted-average common shares outstanding - basic746.3 746.3 767.0 767.0 Weighted-average common shares outstanding - diluted746.3 746.3 771.8 771.8 1. See the Company's historical U.S. GAAP Consolidated Statements of Operations.2. Certain pro forma adjustments were made to illustrate the estimated effects of the DWDP Transactions, assuming that the DWDP Transactions had occurred on January 1, 2018. The adjustments include the impact to "Cost of sales" of different pricing than historical intercompany and intracompany practices related to various supply agreements entered into with the Dow Distribution, adjustments to "Integration and separation costs" to eliminate one time transaction costs directly attributable to the DWDP Distributions, and adjustments to "Interest expense" to reflect the impact of the Financings. 41Table of ContentsSEGMENT RESULTSPrior to April 1, 2019, the Company's measure of profit / loss for segment reporting purposes is pro forma Operating EBITDA as this is the manner in which the Company's chief operating decision maker ("CODM") assessed performance and allocates resources. The Company defines pro forma Operating EBITDA as pro forma earnings (i.e. pro forma "Income (loss) from continuing operations before income taxes") before interest, depreciation, amortization, non-operating pension / other post-employment benefits (“OPEB”) / charges, and foreign exchange gains/losses, excluding the impact of costs historically allocated to the materials science and agriculture businesses that did not meet the criteria to be recorded as discontinued operations and adjusted for significant items. Effective April 1, 2019, the Company's measure of profit/loss for segment reporting purposes is Operating EBITDA as this is the manner in which the Company's chief operating decision maker ("CODM") assesses performance and allocates resources. The Company defines Operating EBITDA as earnings (i.e., “Income from continuing operations before income taxes") before interest, depreciation, amortization, non-operating pension / OPEB benefits / charges, and foreign exchange gains / losses, adjusted for significant items.Pro forma adjustments were determined in accordance with Article 11 of Regulation S-X. Pro forma financial information is based on the Consolidated Financial Statements of DuPont, adjusted to give effect to the impact of certain items directly attributable to the DWDP Distributions, and the Term Loan Facilities, the 2018 Senior Notes and the Funding CP Issuance (together, the "DWDP Financings"), including the use of proceeds from such Financings (collectively the "DWDP Transactions"). The historical consolidated financial information has been adjusted to give effect to pro forma events that are (1) directly attributable to the DWDP Transactions, (2) factually supportable and (3) with respect to the statements of operations, expected to have a continuing impact on the results. Events that are not expected to have a continuing impact on the combined results are excluded from the pro forma adjustments. Those pro forma adjustments include the impact of various supply agreements entered into in connection with the Dow Distribution ("supply agreements") and are adjustments to "Cost of sales." The impact of these supply agreements are reflected in pro forma Operating EBITDA for the periods noted above as they are included in the measure of profit/loss reviewed by the CODM in order to show meaningful comparability among periods while assessing performance and making resource allocation decisions. Refer to the Supplemental Unaudited Pro Forma Combined Financial Information section for further information. 42Table of ContentsELECTRONICS & IMAGINGThe Electronics & Imaging segment is a leading global supplier of differentiated materials and systems for a broad range of consumer electronics including mobile devices, television monitors, personal computers and electronics used in a variety of industries. The segment is a leading provider of materials and solutions for the fabrication of semiconductors and integrated circuits, and provides innovative metallization processes for metal finishing, decorative, and industrial applications as well as films and laminate materials for a broad range of uses in printed circuit board and other electronic industry applications. Electronics & Imaging is a leading provider of photopolymer plates and platemaking systems used in flexographic printing and digital inks for textile, commercial and home-office printing applications. In addition, the segment provides cutting-edge materials for the manufacturing of rigid and flexible displays for organic light emitting diode ("OLED"), and other display applications. Electronics & ImagingFor the Years Ended December 31,In millions202020192018Net sales$3,814 $3,554 $3,635 Operating EBITDA 1$1,210 $1,147 $1,210 Equity earnings$35 $24 $23 1.For the year ended December 31, 2019 and 2018 operating EBITDA is on a pro forma basis. Electronics & ImagingFor the Years Ended December 31,Percentage change from prior year20202019Change in Net Sales from Prior Period due to:Local price & product mix(1)%— %Currency— (1)Volume8 (1)Portfolio & other— — Total7 %(2)%2020 Versus 2019Electronics & Imaging net sales were $3,814 million for the year ended December 31, 2020, up from $3,554 million for the year ended December 31, 2019. Net sales increased due to a 8 percent volume increase partially offset by a 1 percent decrease in local price. Volume growth was driven by Semiconductor Technologies with continued strength and new technology in logic and foundry and increased demand in the memory segment. Volume growth within Interconnect Solutions was driven by increased material content in next-generation smartphones. Within Image Solutions, volume growth in OLED materials for displays and digital printing inks for the consumer segment offset weakness in flexographic plates and commercial printing and textile inks. Volume grew significantly in Asia Pacific. Operating EBITDA was $1,210 million for the year ended December 31, 2020, up 5 percent compared with pro forma Operating EBITDA of $1,147 million for the year ended December 31, 2019 as volume growth, productivity and higher equity income more than offset higher raw material logistic costs and lower gains related to asset sales.2019 Versus 2018Electronics & Imaging net sales were $3,554 million for the year ended December 31, 2019, down from $3,635 million for the year ended December 31, 2018 due to a 1 percent volume decline and a 1 percent unfavorable currency impact, primarily in Asia Pacific and EMEA. Volume decreased overall as Semiconductor Technologies and Interconnect Solutions declines more than offset volume gains in Image Solutions. Within Semiconductor Technologies, weakened demand in the memory sector was partially offset by increased volumes related to semiconductor packaging materials. Demand for advanced materials for smartphones remained strong but overall volumes in Interconnect Solutions were down due to soft circuit board demand. Volume growth in Image Solutions reflects increased demand for OLED materials partially offset by volume declines in flexographic printing. Pro forma Operating EBITDA was $1,147 million for the year ended December 31, 2019, down 5 percent compared with $1,210 million for the year ended December 31, 2018, as higher raw material costs, volume declines and an unfavorable currency impact more than offset cost synergies and income associated with an asset sale.43Table of ContentsNUTRITION & BIOSCIENCESThe Nutrition & Biosciences segment is an innovation-driven and customer-focused segment that provides solutions for the global food and beverage, dietary supplements, pharma, home and personal care, energy, and animal nutrition markets. The segment is one of the world's largest producers of specialty ingredients, developing and manufacturing solutions for the global food and beverage, dietary supplements and pharmaceutical markets. Additionally, the segment is an industry pioneer and innovator that works with customers to improve the performance, productivity and sustainability of their products and processes, through differentiated technology in ingredients applications, fermentation, biotechnology, chemistry and manufacturing process excellence.Nutrition & BiosciencesFor the Years Ended December 31,In millions202020192018Net sales$6,059 $6,076 $6,216 Operating EBITDA 1$1,523 $1,406 $1,420 Equity earnings$4 $(1)$(1)1.For the year ended December 31, 2019 and 2018 operating EBITDA is on a pro forma basis.Nutrition & BiosciencesFor the Years Ended December 31,Percentage change from prior year20202019Change in Net Sales from Prior Period due to:Local price & product mix1 %1 %Currency(1)(2)Volume— — Portfolio & other— (1)Total— %(2)%2020 Versus 2019Nutrition & Biosciences net sales were $6,059 million for the year ended December 31, 2020, or essentially flat compared with $6,076 million for the year ended December 31, 2019. A 1 percent increase in local price was offset by a 1 percent unfavorable currency impact. Volume remained flat. Food & Beverage volume declined due to decreased demand in food service and sweeteners, partially offset by higher demand for plant-based meat. Health & Biosciences volume gains were driven by probiotics along with strong demand in home & personal care and animal nutrition, offset by declined demand in biorefinery and microbial control. Pharma Solutions volume gains were driven by increased demand in key products.Operating EBITDA was $1,523 million for the year ended December 31, 2020, up 8 percent compared with pro forma Operating EBITDA of $1,406 million for the year ended December 31, 2019 due to a cost productivity actions, favorable product mix led by Health & Biosciences, and pricing gains.2019 Versus 2018Nutrition & Biosciences net sales were $6,076 million for the year ended December 31, 2019, down from $6,216 million for the year ended December 31, 2018, due to a 2 percent unfavorable currency impact, primarily in EMEA and Latin America, and a 1 percent decrease from portfolio actions partially offset by a 1 percent increase in local price. Volume was flat year over year as volume gains in Food & Beverage, primarily in cellulosics from growing demand in the meat alternatives and high protein nutritional beverages, was offset by declines in Health & Biosciences due to continued market-driven softness in biorefineries and decreased volume related to home and personal care applications which were partially offset by strength in food enzymes.Pro forma Operating EBITDA was $1,406 million for the year ended December 31, 2019, down 1 percent compared with $1,420 million for the year ended December 31, 2018 as unfavorable impacts related to product mix and currency were partially offset by cost synergies, productivity actions and pricing gains.44Table of ContentsTRANSPORTATION & INDUSTRIALThe Transportation & Industrial segment provides high-performance engineering resins, adhesives, silicones, lubricants and parts to engineers and designers in the transportation, electronics, healthcare, industrial and consumer end-markets to enable systems solutions for demanding applications and environments. The segment delivers a broad range of polymer-based high-performance materials in its product portfolio, including elastomers and thermoplastic and thermoset engineering polymers which are used by customers to fabricate components for mechanical, chemical and electrical systems. In addition, the segment produces innovative engineering polymer solutions, high performance parts, specialty silicones and differentiated adhesive technologies to meet customer specifications in automotive, aerospace, electronics, industrial, healthcare and consumer markets. Transportation & Industrial is a global leader of advanced materials that provide technologies that differentiate customers’ products with improved performance characteristics enabling the transition to hybrid-electric-connected vehicles, high speed high frequency connectivity and smart healthcare.Transportation & IndustrialFor the Years Ended December 31,In millions202020192018Net sales$4,189 $4,950 $5,422 Operating EBITDA 1$916 $1,313 $1,518 Equity earnings$4 $4 $1 1.For the year ended December 31, 2019 and 2018 operating EBITDA is on a pro forma basis.Transportation & IndustrialFor the Years Ended December 31,Percentage change from prior year20202019Change in Net Sales from Prior Period due to:Local price & product mix(4)%3 %Currency— (2)Volume(11)(10)Portfolio & other— — Total(15)%(9)%2020 Versus 2019Transportation & Industrial net sales were $4,189 million for the year ended December 31, 2020, down from $4,950 million for the year ended December 31, 2019 due to a 11 percent decrease in volume and a 4 percent decrease in local price. Volume declines were due to the impact of the COVID-19 pandemic on the automotive industry and the other key industrial markets.Operating EBITDA was $916 million for the year ended December 31, 2020, down 30 percent compared with pro forma Operating EBITDA of $1,313 million for the year ended December 31, 2019 driven primarily by price and volume declines due to the COVID-19 pandemic and approximately $170 million in charges associated with temporarily idling several manufacturing plants to align supply with demand.2019 Versus 2018Transportation & Industrial net sales were $4,950 million for the year ended December 31, 2019, down from $5,422 million for the year ended December 31, 2018. The change in net sales was due to a 10 percent decrease in volume and a 2 percent unfavorable currency impact, primarily in EMEA and Asia Pacific, which more than offset a 3 percent increase in local price. Volume declines were primarily due to destocking in the automotive channel and decreased demand in automotive and electronics markets in Asia Pacific and EMEA. Local price increased across all regions and primarily in Mobility Solutions. Pro forma Operating EBITDA was $1,313 million for the year ended December 31, 2019, down 14 percent compared with $1,518 million for the year ended December 31, 2018 as volume declines, higher raw material costs and an unfavorable currency impact were partially offset by pricing gains and cost synergies.45Table of ContentsSAFETY & CONSTRUCTIONSafety & Construction is the global leader in providing innovative engineered products and integrated systems for a number of industries including, worker safety, water purification and separation, transportation, energy, medical packaging and building materials. Safety & Construction addresses the growing global needs of businesses, governments and consumers for solutions that make life safer, healthier and better. By uniting market-driven science and engineering with the strength of highly regarded brands, the segment strives to bring new products and solutions to solve customers' needs faster, better and more cost effectively.Safety & ConstructionFor the Years Ended December 31,In millions202020192018Net sales$4,993 $5,201 $5,294 Operating EBITDA 1$1,351 $1,419 $1,283 Equity earnings$26 $27 $24 1.For the year ended December 31, 2019 and 2018 operating EBITDA is on a pro forma basis.Safety & ConstructionFor the Years Ended December 31,Percentage change from prior year20202019Change in Net Sales from Prior Period due to:Local price & product mix2 %3 %Currency— (1)Volume(8)— Portfolio & other2 (4)Total(4)%(2)%2020 Versus 2019Safety & Construction net sales were $4,993 million for the for the year ended December 31, 2020, down from $5,201 million for the year ended December 31, 2019 as a 2 percent increase in local price and 2 percent increase in portfolio were more than offset by a 8 percent volume decline. The portfolio impact reflects the recent acquisitions in the Water Solutions business. Volume growth in the segment was led by gains in Water Solutions and TYVEK® protective garment sales within Safety Solutions which were more than offset by weakened demand in end markets for NOMEX® and KEVLAR®. Shelter Solutions volume declined due to the COVID-19 pandemic and the resulting impact on commercial construction activity.Operating EBITDA was $1,351 million for the year ended December 31, 2020, down 5 percent compared with pro forma Operating EBITDA of $1,419 million for the year ended December 31, 2019 due to lower volumes, the absence of licensing income, and costs associated with idling facilities more than offsetting pricing gains, improved product mix, and productivity actions.2019 Versus 2018Safety & Construction net sales were $5,201 million for the year ended December 31, 2019, down from $5,294 million for the year ended December 31, 2018 as portfolio declines of 4 percent and a 1 percent unfavorable impact from currency in all regions more than offset a 3 percent increase in local price. The portfolio impact reflects the prior year divestiture of the European XPS STYROFOAM™ business on December 1, 2018. Local price increased across all businesses and in all regions.Volume was flat compared with the prior year as volume growth in Water Solutions was offset by declines in Safety Solutions and Shelter Solutions. Water Solutions volume gains were driven by strong demand for ion exchange and reverse osmosis membranes mainly in the industrial market. Safety Solutions volume declined as a result of supply constraints and planned maintenance downtime which more than offset TYVEK® volume gains from increased demand in the personal protection market. Volume declines in Shelter Solutions were primarily due to weakness in the construction market. Pro forma Operating EBITDA was $1,419 million for the year ended December 31, 2019, up 11 percent compared with $1,283 million for the year ended December 31, 2018 due to local price gains, cost synergies, productivity improvements and volume gains partially offset by an unfavorable impact from currency.46Table of ContentsNON-COREThe Non-Core segment is a leading global supplier of key materials for the manufacturing of photovoltaic cells and panels, including innovative metallization pastes, backsheet materials and silicone encapsulants and adhesives. The segment provides materials used in components and films for consumer electronics, automotive, and aerospace markets. Additionally, the segment provides sustainable materials and services for sulfuric acid production and regeneration technologies, alkylation technology for production of clean, high-octane gasoline, and a comprehensive suite of aftermarket service and solutions offerings, including safety consulting and services, to improve the safety, productivity, and sustainability of organizations across a range of industries. The Non-Core segment is also a leading producer of specialty biotechnology materials for carpet and apparel markets as well as polyester films for the healthcare, photovoltaics, electronics, packaging and labels, and electrical insulation industries. Until its sale in the third quarter of 2020, the segment also includes the Company's share of the results of the HSC Group, a U.S.-based group of companies that manufacture and sell polycrystalline silicon products for the photovoltaic and semiconductor industries. Non-CoreFor the Years Ended December 31,In millions202020192018Net sales$1,342 $1,731 $2,027 Operating EBITDA 1$168 $512 $702 Equity earnings 2$122 $258 $400 1. For the year ended December 31, 2019 and 2018 operating EBITDA is on a pro forma basis.2. Excludes a net charge primarily related to a joint venture in the Non-Core segment.Non-CoreFor the Years Ended December 31,Percentage change from prior year20202019Change in Net Sales from Prior Period due to:Local price & product mix3 %1 %Currency— (2)Volume(14)(11)Portfolio & other(11)(3)Total(22)%(15)%2020 Versus 2019Non-Core net sales were $1,342 million for the year ended December 31, 2020, down from $1,731 million for the year ended December 31, 2019 due to a 14 percent decrease in volume and an 11 percent portfolio decline which more than offset a 3 percent increase in local price. The portfolio decline was driven by the third quarter 2020 sale of the trichlorosilane ("TCS") business within Photovoltaic & Advanced Materials and the third quarter 2019 sale of the Sustainable Solutions business. Volume declines were driven by declines in demand for trichlorosilanes, TEDLAR® aircraft films, biomaterials due to weakened demand in carpet and apparel markets, and lower volumes in Clean Technologies.Operating EBITDA was $168 million for the year ended December 31, 2020, down 67 percent compared with pro forma Operating EBITDA of $512 million for the year ended December 31, 2019 due to declines in customer settlements, volume declines, the absence of the gain on the sale of the Sustainable Solutions business, and the absence of earnings from the Sustainable Solutions, TCS, and HSC businesses.2019 Versus 2018Non-Core net sales were $1,731 million for the year ended December 31, 2019, down from $2,027 million for the year ended December 31, 2018 due to a 11 percent decrease in volume, a 3 percent portfolio decline and a 2 percent unfavorable impact from currency, primarily in Asia Pacific, which more than offset a 1 percent increase in local price. Portfolio declines were due to the sale of the Sustainable Solutions business in the third quarter of 2019. Volume declines in Photovoltaic & Advanced Materials were driven by weak demand for trichlorosilanes due to low polysilicon production and lower paste sales in electronic component end markets. Biomaterials volume declines were primarily a result of a slow-down in demand in the carpet and apparel markets.Pro forma Operating EBITDA was $512 million for the year ended December 31, 2019, down 27 percent compared with $702 million for the year ended December 31, 2018 as a result of volume declines, lower HSC Group equity earnings due to lower customer settlements, and unfavorable impacts from currency and portfolio actions, which were partially offset by cost synergies and a gain on the sale of the Sustainable Solutions business.47Table of ContentsLIQUIDITY & CAPITAL RESOURCES The Company continually reviews its sources of liquidity and debt portfolio and may make adjustments to one or both to ensure adequate liquidity and increase the Company’s optionality and financing efficiency as it relates to financing cost and balancing terms/maturities. The Company’s primary source of incremental liquidity is cash flows from operating activities. COVID-19 continues to impact the broader global economy, including negatively impacting economic growth and creating disruption and volatility in the global financial and capital markets, which could result in increases in the cost of capital and/or adversely impact the availability of and access to capital, which could negatively affect DuPont’s liquidity. Management expects the generation of cash from operations and the ability to access the debt capital markets and other sources of liquidity will continue to provide sufficient liquidity and financial flexibility to meet the Company’s and its subsidiaries obligations as they come due; however, DuPont is unable to predict the extent of COVID-19 related impacts which depends on highly uncertain and unpredictable future developments, including the duration and spread of the COVID-19 outbreak, and the speed and extent of the resumption of normal economic and operating conditions. In light of this uncertainty, the Company has taken steps to further ensure liquidity and capital resources, as discussed below.In millionsDecember 31, 2020December 31, 2019Cash and cash equivalents 1$2,544 $1,540 Total debt 2$21,811 $17,447 1.The net proceeds of approximately $6.2 billion from the N&B Notes Offering were recorded within non-current “Restricted cash” in the Consolidated Balance Sheets at December 31, 2020 and thus are not included in "Cash and cash equivalents" as presented in the table above.2.This includes $6.25 billion of debt obligations associated with the N&B Notes Offering.The Company's cash and cash equivalents at December 31, 2020 and December 31, 2019 were $2.5 billion and $1.5 billion, respectively, of which $1.8 billion at December 31, 2020 and $1.4 billion at December 31, 2019 were held by subsidiaries in foreign countries, including United States territories. For each of its foreign subsidiaries, the Company makes an assertion regarding the amount of earnings intended for permanent reinvestment, with the balance available to be repatriated to the United States. Total debt at December 31, 2020 and December 31, 2019 was $21.8 billion and $17.4 billion, respectively. The increase was primarily due to the N&B Notes Offering and the May Debt Offering. This increase was partially offset by the repayment of the notes due in November 2020 and a decline in commercial paper.As of December 31, 2020, the Company is contractually obligated to make future cash payments of $21,958 million and $9,235 million associated with principal and interest, respectively, on debt obligations. Related to the principal balance, $5 million will be due in the next twelve months and the remainder will be due subsequent to 2021. Related to interest, $754 million will be due in the next twelve months and the remainder will be due subsequent to 2021. The majority of interest obligations will be due in 2026 or later. The obligations associated with the N&B Notes Offering were separated from the Company on February 1, 2021, upon consummation of the N&B Transaction. This resulted in $6,250 million of principal, mostly due subsequent to 2025, and related $2,637 million of future interest obligations being separated from the Company.Term Loan and Revolving Credit Facilities In November 2018, the Company entered into a term loan agreement that establishes two term loan facilities in the aggregate principal amount of $3 billion, (the “Term Loan Facilities”) as well as a five-year $3 billion revolving credit facility (the “Five-Year Revolving Credit Facility”). Effective May 2, 2019, the Company fully drew the two Term Loan Facilities in the aggregate principal amount of $3 billion and the Five-Year Revolving Credit Facility became effective and available. The Five-Year Revolving Credit Facility is generally expected to remain undrawn, and serve as a backstop to the Company’s commercial paper and letter of credit issuance. In June 2019, the Company entered into a 364-day $750 million revolving credit facility (the “Old 364-Day Revolving Credit Facility”). In April 2020, the Company entered into a $1 billion 364-day revolving credit facility (the “$1B Revolving Credit Facility"). The $1B Revolving Credit Facility replaced the Old 364-Day Revolving Credit Facility, improving the Company’s liquidity position in response to near term uncertainties. As of the effectiveness of the $1B Revolving Credit Facility, the Old 364-Day Revolving Credit Facility was terminated. The $1B Revolving Credit facility may be used for general corporate purposes.On February 1, 2021, the Company terminated its fully drawn $3 billion Term Loan Facilities. The termination triggered the repayment of the aggregate outstanding principal amount of $3 billion, plus accrued and unpaid interest through and including January 31, 2021. The Company funded the repayment with proceeds from the Special Cash Payment.48Table of ContentsMay Debt OfferingOn May 1, 2020, the Company completed an underwritten public offering of senior unsecured notes (the “May 2020 Notes”) in the aggregate principal amount of $2 billion of 2.169 percent fixed rate Notes due May 1, 2023 (the “May Debt Offering”). The proceeds from the May Debt Offering were used by the Company to repay the Company’s $0.5 billion in floating rate notes due November 2020 and $1.5 billion of 3.77 percent fixed-rate notes due November 2020. Upon consummation of the N&B Transaction, the special mandatory redemption feature of the May Debt Offering was triggered, requiring the Company to redeem all of the May 2020 Notes at a redemption price equal to 100% of the aggregate principal amount of the May 2020 Notes plus accrued and unpaid interest. The Company intends to redeem the May 2020 Notes in May 2021 and will fund the redemption with proceeds from the Special Cash Payment. Commercial PaperIn April 2019, DuPont authorized a $3 billion commercial paper program (the “DuPont Commercial Paper Program”). At December 31, 2020, the Company had no issuances outstanding of commercial paper ($1.8 billion at December 31, 2019). The Company’s issuance under the Commercial Paper Program in 2019 included the issuance of $1.4 billion (the “Funding CP Issuance”) in May 2019 in anticipation of the Corteva Distribution, as well as borrowings for general corporate purposes.Nutrition & Biosciences Financing In January 2020, N&B entered into a senior unsecured term loan agreement in the amount of $1.25 billion split evenly between three- and five-year facilities ("N&B Term Loan Facilities"). On September 16, 2020 (the “Offering Date”), N&B completed an offering in the aggregate principal amount of $6.25 billion of senior unsecured notes in six series, comprised of the following (collectively, the “N&B Notes Offering" and together with the N&B Term Loan Facilities, the “Permanent Financing”): $300 million aggregate principal amount of 0.697% Senior Notes due 2022; $1.0 billion aggregate principal amount of 1.230% Senior Notes due 2025; $1.2 billion aggregate principal amount of 1.832% Senior Notes due 2027; $1.5 billion aggregate principal amount of 2.300% Senior Notes due 2030; $750 million aggregate principal amount of 3.268% Senior Notes due 2040; and $1.5 billion aggregate principal amount of 3.468% Senior Notes due 2050. The net proceeds of approximately $6.2 billion from the N&B Notes Offering were deposited into an escrow account.On February 1, 2021, upon consummation of the N&B Transaction, the proceeds from the Permanent Financing were used to make the Special Cash Payment and to pay the related financing fees and expenses. At this time, the net proceeds from the N&B Notes Offering were released from escrow. The obligations and liabilities associated with the Permanent Financing were also separated from the Company upon consummation of the N&B Transaction. Credit RatingsThe Company's credit ratings impact its access to the debt capital markets and cost of capital. The Company remains committed to maintaining a strong financial position with a balanced financial policy focused on maintaining a strong investment-grade rating and driving shareholder value and remuneration. At January 31, 2021, DuPont's credit ratings were as follows:Credit RatingsLong-Term RatingShort-Term RatingOutlookStandard & Poor’sBBB+A-2StableMoody’s Investors ServiceBaa1P-2StableFitch RatingsBBB+F-2StableThe Company's indenture covenants include customary limitations on liens, sale and leaseback transactions, and mergers and consolidations, subject to certain limitations. The 2018 Senior Notes also contain customary default provisions. The Term Loan Facilities, the Five-Year Revolving Credit Facility and the $1B Revolving Credit Facility contain a financial covenant, typical for companies with similar credit ratings, requiring that the ratio of Total Indebtedness to Total Capitalization for the Company and its consolidated subsidiaries not exceed 0.60. At December 31, 2020, the Company was in compliance with this financial covenant.49Table of ContentsSummary of Cash FlowsThe Company’s cash flows from operating, investing and financing activities, as reflected in the Consolidated Statements of Cash Flows, are summarized in the following table. The cash flows related to the materials science and agriculture businesses have not been segregated and are included in the Consolidated Statements of Cash Flows for the years ended December 31, 2019 and 2018.Cash Flow Summary202020192018In millionsCash provided by (used for):Operating activities$4,095 $1,409 $4,731 Investing activities$(202)$(2,313)$(2,462)Financing activities$3,238 $(11,550)$(1,918)Effect of exchange rate changes on cash, cash equivalents and restricted cash$67 $9 $(344)Cash, cash equivalents and restricted cash in discontinued operations$— $— $5,431 Cash Flows from Operating ActivitiesCash provided by operating activities was $4,095 million and $1,409 million for the years ended December 31, 2020 and 2019, respectively. Cash provided by operating activities increased in 2020 compared with 2019, primarily due to a release of cash from net working capital in 2020 versus a use of cash for net working capital in the prior period, partially offset by lower earnings versus the prior period. Cash provided by operating activities for the year ended December 31, 2018 was $4,731 million. Cash provided by operating activities decreased in 2019 compared to 2018, primarily driven by the impact of the DWDP Distributions of the materials science and agriculture businesses to period earnings, partially offset by a decrease in the use of cash for net working capital versus the prior period.Net Working CapitalDecember 31, 2020December 31, 2019In millions (except ratio)Current assets$10,877 $9,999 Current liabilities4,699 8,346 Net working capital$6,178 $1,653 Current ratio2.31:11.20:1Cash Flows from Investing ActivitiesCash used for investing activities in 2020 was $202 million compared to cash used for investing of $2,313 million in 2019. The decrease in cash used was primarily attributable to lower capital expenditures and an increase in proceeds from sales of property and businesses, partially offset by a decrease in proceeds from sales and maturities of investments. Cash used for investing activities in 2018 was $2,462 million primarily driven by capital expenditures and purchases of investments, which were partially offset by proceeds from sales and maturities of investments and proceeds from interests in trade accounts receivable conduits.Capital expenditures totaled $1,194 million for the year ended December 31, 2020, $2,472 million for the year ended December 31, 2019, and $3,837 million for the year ended December 31, 2018. The Company expects 2021 capital expenditures to be approximately $825 million. The Company may adjust its spending throughout the year as economic conditions develop.Cash Flows from Financing ActivitiesCash provided by financing activities in 2020 was $3,238 million compared to cash used by financing activities of $11,550 million in 2019. The difference in cash flows from financing activities in 2020 versus the prior year is primarily driven by the increase in proceeds from the issuance of long-term debt, largely related to the N&B Transaction, as well as the impact of the DWDP Distributions of the materials science and agriculture businesses to cash balances in 2019, partially offset by the increased use of cash in decreasing short-term notes payable. Cash used for financing activities in 2018 was $1,918 million. The primary driver of the difference in cash used for financing activities between 2019 and 2018 is the increased proceeds in issuance of long-term debt in 2018 and the impact of the DWDP Distributions of the materials science and agriculture businesses to cash balances in 2019.50Table of ContentsDividendsThe following table provides dividends paid to common shareholders for the years ended December 31, 2020, 2019, and 2018: Dividends PaidDecember 31, 2020December 31, 2019December 31, 2018In millionsDividends paid, per common share $1.20 $2.16 $4.56 Dividends paid to common stockholders 1$882 $1,611 $3,491 1.The 2019 and 2018 dividends include dividends paid to DowDuPont common stockholders prior to the DWDP Distributions.Share Buyback ProgramsOn June 1, 2019, the Company's Board of Directors authorized a $2 billion share buyback program, which expires on June 1, 2021. As of December 31, 2020, the Company had repurchased 16.9 million shares under this program since inception at a total cost of $982 million, including 6.1 million shares repurchased and retired for $232 million during the year ended December 31, 2020.Under this program, the Company has remaining authorization to repurchase and retire about $1 billion of its common stock in the open market or privately negotiated deals. The timing and amount of any share repurchases will be determined by the Company based on its evaluation of market conditions and other factors.See Part II, Item 5. Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities and Note 17 to the Consolidated Financial Statements, for additional information. Pension and Other Post-Employment PlansTDCC and EID did not merge their pension plans and other post-employment benefit plans as a result of the DWDP Merger. TDCC and EID had defined benefit pension plans in the United States and a number of other countries. Subsequent to the DWDP Distributions, the Company retained defined benefit pension plans in a number of other countries but does not have any qualified defined benefit pension plan in the United States.The Company's funding policy is to contribute to defined benefit pension plans based on pension funding laws and local country requirements. Contributions exceeding funding requirements may be made at the Company's discretion. The Company expects to contribute approximately $100 million to its pension plans in 2021. The amount and timing of the Company’s actual future contributions will depend on applicable funding requirements, discount rates, investment performance, plan design, and various other factors, separations and distributions. See Note 19 to the Consolidated Financial Statements for additional information concerning the Company’s pension plans.TDCC's funding policy was to contribute to plans when pension laws and/or economics either require or encourage funding. Prior to the Dow Distribution, TDCC made discretionary contributions exceeding funding requirements. In 2018 TDCC contributed $1,656 million to its pension plans, including contributions to fund benefit payments for its non-qualified pension plans. In the third quarter of 2018, TDCC made $1,100 million discretionary contributions to their principal U.S. pension plans, which are included in the 2018 contribution amounts above. The discretionary contributions were based on TDCC's funding policies, which permit discretionary contributions to defined benefit pension plans when economics encourage funding, and reflected considerations relating to tax deductibility and capital structure. During the three months of 2019, TDCC made contributions of $103 million to TDCC plans that were separated with Dow after the DWDP Distributions. As of December 31, 2020, the Company is contractually obligated to make future cash payments of $1,416 million related to pension and other post-employment benefit plans. $106 million will be due in the next twelve months and the remainder will be due subsequent to 2021 with the majority due subsequent to 2025.EID's funding policy was to contribute to defined benefit pension plans based on pension funding laws and local country requirements. Prior to the Corteva Distribution, EID made discretionary contributions exceeding funding requirements. EID contributed $1,308 million, including discretionary contributions of $1,100 million to its principal U.S. pension plans in 2018. These contributions included contributions to fund benefit payments for non-qualified pension plans. The discretionary contributions were based on EID's funding policies, which permit discretionary contributions to defined benefit pension plans when economics encourage funding, and reflected considerations relating to tax deductibility and capital structure. During the five months of 2019, EID made $36 million contributions to plans that were separated from the Company in conjunction with the Corteva Distribution. 51Table of ContentsRestructuringIn March 2020, the Company approved restructuring actions designed to capture near-term cost reductions and to further simplify certain organizational structures in anticipation of the N&B Transaction. As a result of these actions, the Company recorded pre-tax restructuring charges of $179 million inception-to-date, consisting of severance and related benefit costs of $129 million and asset related charges of $50 million. Actions associated with the 2020 Restructuring Program are considered substantially complete. Future cash payments related to the 2020 Restructuring Program are anticipated to be $68 million primarily related to the payment of severance and related benefits.In June 2019, DuPont approved restructuring actions to simplify and optimize certain organizational structures following the completion of the DWDP Distributions. As a result of these actions, the Company has recorded pre-tax restructuring charges of $140 million inception-to-date, consisting of severance and related benefit costs of $106 million, and asset related charges of $34 million. Actions associated with this program are considered substantially complete. Future cash payments related to the 2019 Restructuring Program are anticipated to be $18 million and relate to the payment of severance and related benefits. In September and November 2017, the Company approved post-merger restructuring actions under the DowDuPont Cost Synergy Program, adopted by the DowDuPont Board of Directors. The Synergy Program was designed to integrate and optimize the organization following the DWDP Merger and in preparation for the DWDP Distributions whereby the Company has recorded pre-tax restructuring charges attributable to the continuing operations of DuPont of $492 million inception-to-date, consisting of severance and related benefit costs of $213 million, asset related charges of $212 million and contract termination and other charges of $67 million. The activities related to the Synergy Program are expected to result in additional cash expenditures of $20 million and relate primarily to the payment of severance and related benefit costs. Actions associated with the Synergy Program, including employee separations, are considered substantially complete.See Note 5 to the Consolidated Financial Statements for more information on the Company's restructuring programs.Other Off-balance Sheet ArrangementsCertain Guarantee ContractsGuarantees arise in the ordinary course of business from relationships with customers and nonconsolidated affiliates when the Company undertakes an obligation to guarantee the performance of others if specific triggering events occur. At December 31, 2020 and December 31, 2019, the Company had directly guaranteed $189 million and $187 million, respectively, of such obligations. Additional information related to the guarantees of the Subsidiaries can be found in the “Guarantees” section of Note 15 to the Consolidated Financial Statements.The MOU Cost Sharing AgreementIn connection with the cost sharing arrangement entered into as part of the MOU, the companies agreed to establish an escrow account to address potential future PFAS costs. Subject to the terms of the arrangement, contributions to the escrow account will be made by Chemours, DuPont and Corteva, annually over an eight-year period. Over such period, Chemours will deposit a total of $500 million into the account and DuPont and Corteva, together, will deposit an additional $500 million pursuant to the terms of their existing Letter Agreement. The Company is contractually obligated to make deposits to the escrow account of $50 million no later than September 30, 2021. Additional information regarding the MOU and funding of the escrow account can be found in Note 15 to the Consolidated Financial Statements.Other Contractual ObligationsAs of December 31, 2020, the Company is contractually obligated to make future cash payments of $1,191 million and $809 million related to purchase and lease obligations, respectively. Related to purchases, $372 million will be due in the next twelve months and the remainder will be due subsequent to 2021. Related to leases, $186 million will be due in the next twelve months and remainder will be due subsequent to 2021. As of December 31, 2020, the Company is contractually obligated to make future cash payments of $188 million related to other miscellaneous obligations, the majority of which is due subsequent to 2021.52Table of ContentsOUTLOOK In 2021, the Company expects demand to remain strong for semiconductors, smartphones, protective garments, water and residential construction, along with continued improvements in automotive markets. This anticipated strong demand, along with benefits from our continued cost actions, are expected to drive earnings improvement. In addition, the Company is expected to benefit from a lower share count resulting from the Exchange Offer and lower interest expense resulting from the pay down of Commercial Paper and the pay down of the Term Loan Facilities and May 2020 Notes, both funded by proceeds from the Special Cash Payment.RECENT ACCOUNTING PRONOUNCEMENTS See Note 2 to the Consolidated Financial Statements for a description of recent accounting pronouncements. CRITICAL ACCOUNTING ESTIMATESThe Company's significant accounting policies are more fully described in Note 1 to the Consolidated Financial Statements. Management believes that the application of these policies on a consistent basis enables the Company to provide the users of the financial statements with useful and reliable information about the Company's operating results and financial condition.The preparation of the Consolidated Financial Statements in conformity with generally accepted accounting principles ("GAAP") in the United States of America requires management to make estimates and assumptions that affect the reported amounts, including, but not limited to, receivable and inventory valuations, impairment of tangible and intangible assets, long-term employee benefit obligations, income taxes, restructuring liabilities, environmental matters and litigation. Management's estimates are based on historical experience, facts and circumstances available at the time and various other assumptions that are believed to be reasonable. The Company reviews these matters and reflects changes in estimates as appropriate. Management believes that the following represent some of the more critical judgment areas in the application of the Company's accounting policies which could have a material effect on the Company's financial position, liquidity or results of operations.Pension PlansAccounting for employee benefit plans involves numerous assumptions and estimates. Discount rate and expected return on plan assets are two critical assumptions in measuring the cost and benefit obligation of the Company's pension plans. Management reviews these two key assumptions when plans are re-measured. These and other assumptions are updated periodically to reflect the actual experience and expectations on a plan specific basis as appropriate. As permitted by GAAP, actual results that differ from the assumptions are accumulated on a plan by plan basis and to the extent that such differences exceed 10 percent of the greater of the plan's benefit obligation or the applicable plan assets, the excess is amortized over the average remaining service period of active employees or the average remaining life expectancy of the inactive participants if all or almost all of a plan’s participants are inactive.For the majority of the benefit plans, the Company utilizes the Aon AA corporate bond yield curves to determine the discount rate, applicable to each country, at the measurement date. The Company establishes strategic asset allocation percentage targets and appropriate benchmarks for significant asset classes in accordance with the laws and practices of those countries. Where appropriate, asset-liability studies are also taken into consideration. For plans, the long-term expected return on plan assets pension expense is determined using the fair value of assets.The following table highlights the potential impact on the Company's pre-tax earnings due to changes in certain key assumptions with respect to the Company's pension plans based on assets and liabilities at December 31, 2020:Pre-tax Earnings Benefit (Charge)(Dollars in millions)1/4 PercentagePointIncrease1/4 PercentagePointDecreaseDiscount rate$(1)$(2)Expected rate of return on plan assets10 (10)Additional information with respect to pension plans, liabilities and assumptions is discussed under "Long-term Employee Benefits" beginning on page 57 and in Note 19 to the Consolidated Financial Statements.53Table of ContentsLegal ContingenciesThe Company's results of operations could be affected by significant litigation adverse to the Company, including product liability claims, patent infringement and antitrust claims, and claims for third party property damage or personal injury stemming from alleged environmental torts. The Company records accruals for legal matters when the information available indicates that it is probable that a liability has been incurred and the amount of the loss can be reasonably estimated. Management makes adjustments to these accruals to reflect the impact and status of negotiations, settlements, rulings, advice of counsel and other information and events that may pertain to a particular matter. Predicting the outcome of claims and lawsuits and estimating related costs and exposure involves substantial uncertainties that could cause actual costs to vary materially from estimates. In making determinations of likely outcomes of litigation matters, management considers many factors. These factors include, but are not limited to, the nature of specific claims including unasserted claims, the Company's experience with similar types of claims, the jurisdiction in which the matter is filed, input from outside legal counsel, the likelihood of resolving the matter through alternative dispute resolution mechanisms, and the matter's current status. Considerable judgment is required in determining whether to establish a litigation accrual when an adverse judgment is rendered against the Company in a court proceeding. In such situations, the Company will not recognize a loss if, based upon a thorough review of all relevant facts and information, management believes that it is probable that the pending judgment will be successfully overturned on appeal. A detailed discussion of significant litigation matters is contained in Note 15 to the Consolidated Financial Statements.Income TaxesThe breadth of the Company's operations and the global complexity of tax regulations require assessments of uncertainties and judgments in estimating taxes the Company will ultimately pay. The final taxes paid are dependent upon many factors, including negotiations with taxing authorities in various jurisdictions, outcomes of tax litigation and resolution of disputes arising from federal, state and international tax audits in the normal course of business. The resolution of these uncertainties may result in adjustments to the Company's tax assets and tax liabilities. It is reasonably possible that changes to the Company’s global unrecognized tax benefits could be significant; however, due to the uncertainty regarding the timing of completion of audits and possible outcomes, a current estimate of the range of increases or decreases that may occur within the next twelve months cannot be made.Deferred income taxes result from differences between the financial and tax basis of the Company's assets and liabilities and are adjusted for changes in tax rates and tax laws when changes are enacted. Valuation allowances are recorded to reduce deferred tax assets when it is more likely than not that a tax benefit will not be realized. Significant judgment is required in evaluating the need for and magnitude of appropriate valuation allowances against deferred tax assets. The realization of these assets is dependent on generating future taxable income, as well as successful implementation of various tax planning strategies. For example, changes in facts and circumstances that alter the probability that the Company will realize deferred tax assets could result in recording a valuation allowance, thereby reducing the deferred tax asset and generating a deferred tax expense in the relevant period. In some situations, these changes could be material. At December 31, 2020, the Company had a net deferred tax liability balance of $2.7 billion, net of a valuation allowance of $0.7 billion. Realization of deferred tax assets is expected to occur over an extended period of time. As a result, changes in tax laws, assumptions with respect to future taxable income, and tax planning strategies could result in adjustments to deferred tax assets. See Note 7 to the Consolidated Financial Statements for additional details related to the deferred tax liability balance.GoodwillThe assets and liabilities of acquired businesses are measured at their estimated fair values at the dates of acquisition. The excess of the purchase price over the estimated fair value of the net assets acquired, including identified intangibles, is recorded as goodwill. The determination and allocation of fair value to the assets acquired and liabilities assumed is based on various assumptions and valuation methodologies requiring considerable management judgment, including estimates based on historical information, current market data and future expectations. The Company’s significant assumptions in these analyses include, but are not limited to, future cash flow projections (with probability weighting applied when applicable), the weighted average cost of capital, the terminal growth rate, and the tax rate for the income approach, and metrics of publicly traded companies or historically completed transactions of comparable businesses for the market approach. The Company will also apply a weighting to the market approach and income approach to determine the fair value. When applicable, third party purchase offers may be utilized to measure fair value under the market approach. Although the estimates are deemed reasonable by management based on information available at the dates of acquisition, those estimates are inherently uncertain.Assessment of the potential impairment of goodwill, other intangible assets, property, plant and equipment, investments in nonconsolidated affiliates, and other assets is an integral part of the Company's normal ongoing review of operations. Testing for potential impairment of these assets is significantly dependent on numerous assumptions and reflects management's best estimates at a particular point in time. The dynamic economic environments in which the Company's diversified product lines operate, and key economic and product line assumptions with respect to projected selling prices, market growth and inflation 54Table of Contentsrates, can significantly affect the outcome of impairment tests. Estimates based on these assumptions may differ significantly from actual results. Changes in factors and assumptions used in assessing potential impairments can have a significant impact on the existence and magnitude of impairments, as well as the time in which such impairments are recognized. In addition, the Company continually reviews its diverse portfolio of assets to ensure they are achieving their greatest potential and are aligned with the Company's growth strategy. Strategic decisions involving a particular group of assets may trigger an assessment of the recoverability of the related assets. Such an assessment could result in impairment losses.The Company performs goodwill impairment testing at the reporting unit level which is defined as the operating segment or one level below the operating segment. One level below the operating segment, or component, is a business in which discrete financial information is available and regularly reviewed by segment management. The Company aggregates certain components into reporting units based on economic similarities. The Company tests goodwill for impairment annually (during the fourth quarter), or more frequently when events or circumstances indicate it is more likely than not that the fair value of the reporting unit has declined below its carrying value. As of the date of the annual impairment test, the Company identified twelve reporting units, of which seven have goodwill assigned. Two of those reporting units were reclassified as held for sale disposal groups as of the date of the annual impairment test. Of those two reporting units, one has goodwill assigned and is presented in “Assets held for sale” in the Consolidated Balance Sheet. The held for sale disposal groups are recorded at the lower of carrying amount or fair value less cost to sell each reporting period the disposal group is reclassified as held for sale. For purposes of goodwill impairment testing, the Company has the option to first perform qualitative testing to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying value. The qualitative evaluation is an assessment of factors, including reporting unit or asset specific operating results and cost factors, as well as industry, market and macroeconomic conditions, to determine whether it is more likely than not (more than 50%) that the fair value of a reporting unit or asset is less than the respective carrying amount, including goodwill. If the Company chooses not to complete a qualitative assessment for a given reporting unit or if the initial assessment indicates that it is more likely than not that the carrying value of a reporting unit exceeds its estimated fair value, additional quantitative testing is required.If additional quantitative testing is performed, an impairment loss is recognized in the amount by which the carrying value of the reporting unit exceeds its fair value, limited to the amount of goodwill at the reporting unit. The Company determined fair values for each of the reporting units using a combination of the income approach and market approach. Under the income approach, fair value is determined based on the present value of estimated future cash flows, discounted at an appropriate risk-adjusted rate. The Company uses its internal forecasts to estimate future cash flows and includes an estimate of long-term future growth rates based on its most recent views of the long-term outlook for each reporting unit. The discounted cash flow valuations are completed using the following key assumptions: projected revenue growth rates; discount rates; tax rates; and terminal values. The Company applies probability-weighted scenarios to the income approach to determine the concluded fair value of the reporting unit given the uncertainty in the current economic environment to determine the concluded fair value, where applicable. These key assumptions are determined through evaluation of the Company as a whole and underlying business fundamentals and industry risk. Actual results may differ from those assumed in the Company’s forecasts. The Company derives its discount rates using a capital asset pricing model and analyzing published rates for industries relevant to its reporting units to estimate the cost of equity financing. The Company uses discount rates that are commensurate with the risks and uncertainty inherent in the respective reporting units and in its internally developed forecasts. Discount rates used in the Company’s reporting unit valuations ranged from 8% to 9.5%.Under the market approach, the Company used the Guideline Public Company Method ("GPCM"). The selected peer sets were based on close competitors and reviews of analysts' reports, public filings, and industry research related to firms operating in the respective reporting units industries. In selecting the EBIT/EBITDA multiples and determining the fair value, the Company considered the size, growth, and profitability of each reporting unit versus the relevant guideline public companies.Estimating the fair value of reporting units requires the use of estimates and significant judgments that are based on a number of factors including actual operating results. It is reasonably possible that the judgments and estimates described above could change in future periods. 2020 Interim Goodwill Impairment Testing During the third quarter of 2020, multiple triggering events occurred requiring the Company to perform impairment analyses associated with its Non-Core segment. As a result of the analyses performed, the Company recorded aggregate pre-tax, non-cash goodwill impairment charges of $183 million recognized in "Goodwill impairment charges" in the Consolidated Statements of Operations.55Table of ContentsDuring the second quarter of 2020, continued near-term demand weakness in global automotive production resulting from the COVID-19 pandemic, along with revised views of recovery based on third party market information, served as a triggering event requiring the Company to perform an impairment analysis of the goodwill associated with its Transportation & Industrial reporting unit. As a result of the analysis performed, the Company recorded pre-tax, non-cash goodwill impairment charges of $2,498 million recognized in "Goodwill impairment charges" in the Consolidated Statements of Operations. During the first quarter of 2020, the Company was required to perform interim impairment tests of its goodwill and long-lived assets as expectations of proceeds related to certain potential divestitures within the Non-Core segment gave rise to fair value indicators and, thus, served as triggering events. As a result of the analysis performed, the Company recorded pre-tax, non-cash impairment charges related to goodwill of $533 million. The charges were recognized in "Goodwill impairment charge" in the Consolidated Statements of Operations. The Company’s analyses above use a combination of the discounted cash flow models (a form of the income approach) utilizing Level 3 unobservable inputs and the market approach. The Company’s significant assumptions in these analyses include, but are not limited to, future cash flow projections, the weighted average cost of capital, the terminal growth rate, and the tax rate. The Company’s estimates of future cash flows are based on current regulatory and economic climates, recent operating results, and planned business strategies. These estimates could be negatively affected by changes in federal, state, or local regulations or economic downturns. Future cash flow estimates are, by their nature, subjective and actual results may differ materially from the Company’s estimates. If the Company’s ongoing estimates of future cash flows are not met, the Company may have to record additional impairment charges in future periods. The Company also uses the Guideline Public Company Method, a form of the market approach (utilizing Level 3 unobservable inputs), which is derived from metrics of publicly traded companies or historically completed transactions of comparable businesses. The selection of comparable businesses is based on the markets in which the reporting units operate giving consideration to risk profiles, size, geography, and diversity of products and services. When applicable, third party purchase offers may be utilized to measure fair value. For further information see Note 13 to the Consolidated Financial Statements.2020 Annual Goodwill Impairment Testing In the fourth quarter of 2020, the Company performed its annual goodwill impairment testing by applying the qualitative assessment to four of its reporting units and the quantitative assessment to two of its reporting units. For the reporting units tested under the qualitative assessment, the Company considered various qualitative factors that would have affected the estimated fair value of the reporting units, and the results of the qualitative assessments indicated that it is not more likely than not that the fair values of the reporting units were less than their carrying values. For the reporting units tested under the quantitative assessment, the results indicated that, the estimated fair values of the reporting units exceeded their carrying values. The dynamic economic environments in which the Company's diversified product lines operate, and key economic and product line assumptions with respect to projected selling prices, market growth and inflation rates, can significantly affect the outcome of impairment tests. Estimates based on these assumptions may differ significantly from actual results. Impairment and Disposals of Long-Lived AssetsThe Company evaluates the carrying value of long-lived assets (collectively the “asset group”) to be held and used when events or changes in circumstances indicate the carrying value may not be recoverable. Such reviews are performed in accordance with ASC 360. The carrying value of a long-lived asset group is considered impaired when the anticipated future undiscounted cash flows to be derived from the asset group over the remaining economic life of the asset group’s primary asset are separately identifiable and are less than its carrying value. In that event, a loss is recognized based on the amount by which the carrying value exceeds the fair value of the long-lived asset group. Fair value of the asset group is determined using a combination of a discounted cash flow model and/or market approach. Long-lived assets to be disposed of by sale, if material, are classified as held for sale and reported at the lower of carrying amount or fair value less cost to sell, and depreciation is ceased. Long-lived assets to be disposed of other than by sale are classified as held and used until they are disposed of and reported at the lower of carrying amount or fair value. Depreciation is recognized over the remaining useful life of the assets.56Table of ContentsLONG-TERM EMPLOYEE BENEFITSThe Company has various obligations to its employees and retirees. The Company maintains retirement-related programs in many countries that have a long-term impact on the Company's earnings and cash flows. These plans are typically defined benefit pension plans. The Company has a few medical, dental and life insurance benefits for employees, pensioners and survivors and for employees (other post-employment benefits or "OPEB" plans). Pension coverage for employees of the Company's non-U.S. consolidated subsidiaries is provided, to the extent deemed appropriate, through separate plans. The Company regularly explores alternative solutions to meet its global pension obligations in the most cost effective manner possible as demographics, life expectancy and country-specific pension funding rules change. Where permitted by applicable law, the Company reserves the right to change, modify or discontinue its plans that provide pension, medical, dental and life insurance. Benefits under defined benefit pension plans are based primarily on years of service and employees' pay near retirement. Pension benefits are paid primarily from trust funds established to comply with applicable laws and regulations of the sovereign country in which the pension plan operates. Unless required by law, the Company does not make contributions that are in excess of tax deductible limits. The actuarial assumptions and procedures utilized are reviewed periodically by the plans' actuaries to provide reasonable assurance that there will be adequate funds for the payment of benefits. Thus, there is not necessarily a direct correlation between pension funding and pension expense. In general, however, improvements in plans' funded status tends to moderate subsequent funding needs.The Company contributed $28 million, $497 million, and $93 million to its funded pension plans for the years ended December 31, 2020, December 31, 2019, and December 31, 2018, respectively.The Company does maintain one U.S. pension benefit plan. This plan is a separate unfunded plan and these benefits are paid to employees from operating cash flows. The Company's remaining pension plans with no plan assets are paid from operating cash flows. The Company made benefit payments of $70 million, $71 million, and $61 million to its unfunded plans for the years ended December 31, 2020, December 31, 2019, and December 31, 2018, respectively.The Company's OPEB plans are unfunded and the cost is paid from operating cash flows. Pre-tax cash requirements to cover payments for the Company's OPEB plans was $3 million for the year ended December 31, 2020 and $1 million for the years ended December 31, 2019 and December 31, 2018, respectively.In 2021, the Company expects to contribute approximately $100 million to its funded pension plans and its remaining plans with no plan assets, and about $6 million for its OPEB plans. The amount and timing of actual future contributions will depend on applicable funding requirements, discount rates, investment performance, plan design, and various other factors.The Company's income can be significantly affected by pension and defined contribution charges/(benefits) as well as OPEB costs. The following table summarizes the extent to which the Company's income for the years ended December 31, 2020, December 31, 2019, and December 31, 2018 was affected by pre-tax charges related to long-term employee benefits:For the Years EndedIn millionsDecember 31, 2020December 31, 2019December 31, 2018Long-term employee benefit plan charges$155 $98 $75 The above charges (benefit) for pension and OPEB are determined as of the beginning of each period. See "Pension Plans and Other Post-Employment Benefits" under the Critical Accounting Estimates section beginning on page 53 of this report for additional information on determining annual expense.For 2021, long term employee benefit expense from continuing operations is expected to decrease by about $20 million. The decrease is mainly due to lower interest cost and higher expected return on plan assets.57Table of ContentsENVIRONMENTAL MATTERSThe Company operates global manufacturing, product handling and distribution facilities that are subject to a broad array of environmental laws and regulations. Such rules are subject to change by the implementing governmental agency, and the Company monitors these changes closely. Company policy requires that all operations fully meet or exceed legal and regulatory requirements. In addition, the Company implements voluntary programs to reduce air emissions, minimize the generation of hazardous waste, decrease the volume of water use and discharges, increase the efficiency of energy use and reduce the generation of persistent, bioaccumulative and toxic materials. Management has noted a global upward trend in the amount and complexity of proposed chemicals regulation. The costs to comply with complex environmental laws and regulations, as well as internal voluntary programs and goals, are significant and will continue to be significant for the foreseeable future. The Company has incurred environmental remediation costs of $6 million, $28 million, and $15 million for the years ended December 31, 2020, 2019 and 2018, respectively. Based on existing facts and circumstances, management does not believe that year-over-year changes, if any, in environmental expenses charged to current operations will have a material impact on the Company's financial position, liquidity or results of operations. Annual expenditures in the near term are not expected to vary significantly from the range of such expenditures experienced in the past few years. Longer term, expenditures are subject to considerable uncertainty and may fluctuate significantly. Environmental Operating Costs As a result of its operations, the Company incurs costs for pollution abatement activities including waste collection and disposal, installation and maintenance of air pollution controls and wastewater treatment, emissions testing and monitoring, and obtaining permits. The Company also incurs costs related to environmental related research and development activities including environmental field and treatment studies as well as toxicity and degradation testing to evaluate the environmental impact of products and raw materials.Remediation Accrual Changes in the remediation accrual balance are summarized below:(Dollars in millions) Balance at December 31, 2018$51 Remediation payments(12)Net increase in remediation accrual28 Net change, indemnification 110 Balance at December 31, 2019$77 Remediation payments(5)Net increase in remediation accrual6 Net change, indemnification 12 Balance at December 31, 2020$80 1.Represents the net change in indemnified remediation obligations based on activity pursuant to the DWDP Separation and Distribution Agreement and Letter Agreement as discussed below and in Notes 3 and 15 to the Consolidated Financial Statements. This is not inclusive of the accrual of $59 million related to eligible PFAS costs associated with the MOU. Considerable uncertainty exists with respect to environmental remediation costs, and, under adverse changes in circumstances, the potential liability may range up to $170 million above the amount accrued as of December 31, 2020. However, based on existing facts and circumstances, management does not believe that any loss, in excess of amounts accrued, related to remediation activities at any individual site will have a material impact on the financial position, liquidity or results of operations of the Company. Pursuant to the DWDP Separation and Distribution Agreement and the Letter Agreement discussed in Notes 3 and 15 to the Consolidated Financial Statements, the Company indemnifies Dow and Corteva for certain environmental matters. The Company has recorded an indemnification liability of $44 million corresponding to the Company's accrual balance related to these matters at December 31, 2020. The indemnification liability is included in the total remediation accrual liability of $80 million. Environmental Capital Expenditures Capital expenditures for environmental projects, either required by law or necessary to meet the Company’s internal environmental goals, were $43 million for the year ended December 31, 2020. The Company currently estimates expenditures for environmental-related capital projects to be approximately $48 million in 2021.58Table of ContentsClimate ChangeThe Company believes that climate change is an important global issue that presents risks and opportunities. For instance, the Company continuously evaluates opportunities for existing and new product and service offerings to meet the anticipated demands of a low-carbon economy. In 2019, the Company announced nine new sustainability goals, including an Acting on Climate goal to achieve a 30 percent reduction in absolute greenhouse gas (GHG) emissions by 2030 and carbon neutral operations by 2050. DuPont reports on its progress against these goals in its annual sustainability report. The Company is actively engaged in efforts to develop constructive public policies to reduce GHG emissions and encourage lower-carbon forms of energy. Such policies may bring higher operating costs as well as greater revenue and margin opportunities. Legislative efforts to control or limit GHG emissions could affect the Company's energy source and supply choices as well as increase the cost of energy and raw materials derived from fossil fuels. Such efforts are also anticipated to provide the business community with greater certainty for the regulatory future, help guide investment decisions, and drive growth in demand for low-carbon and energy-efficient products, technologies, and services. Similarly, demand is expected to grow for products that facilitate adaptation to a changing climate. However, the current unsettled policy environment in the U.S., where many company facilities are located, adds an element of uncertainty to business decisions, particularly those relating to long-term capital investments.In addition, significant differences in regional or national approaches could present challenges in a global marketplace. An effective global climate policy framework will help drive the market changes that are needed to stimulate and efficiently deploy new innovations in science and technology, while maintaining open and competitive global markets.SustainabilityIn October 2019, DuPont announced its fifth-generation sustainability strategy — nine ambitious priorities that reflect the Company's best opportunity to make a positive impact in the world while advancing our business objectives. The ten-year strategy prioritizes global challenges such as climate change, water stewardship, advancing circular economy and processes, improving health and safety, and more. With these goals, DuPont committed to using the Company's strength in innovation to advance progress on several of the United Nations’ Sustainable Development Goals (SDGs), increasing resiliency and reducing environmental and social impacts across value chains, and ensuring people are put at the center of all our work. 59Table of ContentsITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKThe Company’s global operations are exposed to financial market risks relating to fluctuations in foreign currency exchange rates, commodity prices, and interest rates. The Company has established a variety of programs including the use of derivative instruments and other financial instruments to manage the exposure to financial market risks as to minimize volatility of financial results. In the ordinary course of business, the Company enters into derivative instruments to hedge its exposure to foreign currency, interest rate and commodity price risks under established procedures and controls. For additional information on these derivatives and related exposures, see Note 21 to the Consolidated Financial Statements. Decisions regarding whether or not to hedge a given commitment are made on a case-by-case basis, taking into consideration the amount and duration of the exposure, market volatility and economic trends. Foreign currency exchange contracts are also used, from time to time, to manage near-term foreign currency cash requirements.Foreign Currency Exchange Rate Risks The Company has significant international operations resulting in a large number of currency transactions that result from international sales, purchases, investments and borrowings. The primary currencies for which the Company has an exchange rate exposure are the European euro ("EUR"), Chinese renminbi, and Japanese yen. The Company uses forward exchange contracts to offset its net exposures, by currency, related to the foreign currency denominated monetary assets and liabilities of its operations. In addition to the contracts disclosed in Note 21 to the Consolidated Financial Statements, from time to time, the Company will enter into foreign currency exchange contracts to establish with certainty the U.S. dollar ("USD") amount of future firm commitments denominated in a foreign currency.The following table illustrates the fair values of outstanding foreign currency contracts at December 31, 2020, and the effect on fair values of a hypothetical adverse change in the foreign exchange rates that existed at December 31, 2020. The sensitivities for foreign currency contracts are based on a 10 percent adverse change in foreign exchange rates. Fair ValueAsset/(Liability)Fair ValueSensitivityIn millionsDecember 31, 2020December 31, 2020Foreign currency contracts$(9)$(219)Since the Company's risk management programs are highly effective, the potential loss in value for each risk management portfolio described above would be largely offset by changes in the value of the underlying exposure.Concentration of Credit Risk The Company maintains cash and cash equivalents, marketable securities, derivatives and certain other financial instruments with various financial institutions. These financial institutions are generally highly rated and geographically dispersed and the Company has a policy to limit the dollar amount of credit exposure with any one institution.As part of the Company's financial risk management processes, it continuously evaluates the relative credit standing of all of the financial institutions that service DuPont and monitors actual exposures versus established limits. The Company has not sustained credit losses from instruments held at financial institutions.The Company's sales are not materially dependent on any single customer. As of December 31, 2020, no one individual customer balance represented more than five percent of the Company's total outstanding receivables balance. Credit risk associated with its receivables balance is representative of the geographic, industry and customer diversity associated with the Company's global product lines.The Company also maintains strong credit controls in evaluating and granting customer credit. As a result, it may require that customers provide some type of financial guarantee in certain circumstances. Length of terms for customer credit varies by industry and region.
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+Item 7.Management’s Discussion and Analysis of Results of Operations and Financial ConditionRESULTS OF OPERATIONS(Tables present dollars in millions, except per-share data)GeneralManagement’s discussion and analysis of results of operations and financial condition is intended to assist the reader in understanding and assessing significant changes and trends related to the results of operations and financial position of our consolidated company. This discussion and analysis should be read in conjunction with the consolidated financial statements and accompanying footnotes in Item 8 of Part II of this Annual Report on Form 10-K. Certain statements in this Item 7 of Part II of this Annual Report on Form 10-K constitute forward-looking statements. Various risks and uncertainties, including those discussed in "Forward-Looking Statements" and Item 1A, “Risk Factors,” may cause our actual results, financial position, and cash generated from operations to differ materially from these forward-looking statements.Executive OverviewThis section provides an overview of our financial results, recent product and late-stage pipeline developments, and other matters affecting our company and the pharmaceutical industry. Earnings per share (EPS) data are presented on a diluted basis.COVID-19 PandemicIn response to the COVID-19 pandemic, we have been focused on maintaining a reliable supply of our medicines; reducing the strain on the medical system; developing treatments for COVID-19; protecting the health, safety, and well-being of our employees; supporting our communities; and ensuring affordability of and access to our medicines, particularly insulin.We have experienced negative impacts to our underlying business due to the COVID-19 pandemic, including decreases in new prescriptions as a result of fewer patient visits to physician’s offices to begin or change treatment, changes in payer segment mix, and the use of patient affordability programs in the United States (U.S.) due to rising unemployment. Additionally, we have experienced, and may continue to experience, decreased demand as a result of lack of normal access and fewer in-person interactions by patients and our employees with the healthcare system. In certain locations in the U.S. and around the world with COVID-19 outbreaks, we temporarily halted in-person interactions by our employees with healthcare providers and increased virtual interactions. While in-person interactions have resumed in many locations, we may decide to halt such activity in the future and, in those cases, expect to resume such interactions as it is safe to do so and in compliance with applicable guidance and requirements. We may experience additional pricing pressures resulting from the financial strain of the COVID-19 pandemic on government-funded healthcare systems around the world. We remain committed to discovering and developing new treatments for the patients we serve. At the beginning of the COVID-19 pandemic, we paused new clinical trial starts and enrollment in new trials in order to reduce the strain on the medical system, and we have resumed this activity in our clinical trials. However, significant delays or unexpected issues, such as higher discontinuation rates or delays accumulating data, affecting the timing, conduct, or regulatory review of our clinical trials, could adversely affect our ability to commercialize some assets in our product pipeline if the COVID-19 pandemic continues for a protracted period. 34In regards to COVID-19 therapies, the U.S. Food and Drug Administration (FDA) granted Emergency Use Authorizations (EUA) for bamlanivimab and bamlanivimab and etesevimab administered together for higher-risk patients who have been recently diagnosed with mild-to-moderate COVID-19 and for baricitinib in combination with remdesivir in hospitalized COVID-19 patients. We are actively working with a variety of organizations, including governmental agencies, to facilitate access to our COVID-19 treatments in various countries. However, we face unique risks and uncertainties in our development, manufacture, and uptake of potential treatments for COVID-19, including vulnerability to supply chain disruptions, higher manufacturing costs, difficulties in manufacturing sufficient quantities of our therapies, restrictions on administration that limit widespread and timely access to our therapies, and risks related to handling, return, and/or refund of product after delivery by us. Expedited authorization processes, including our EUAs for bamlanivimab and bamlanivimab and etesevimab administered together, have allowed restricted distribution of products with less than typical safety and efficacy data, and additional data that become available may call into question the safety or effectiveness of our COVID-19 therapies. Additionally, the availability of superior or competitive therapies, or preventative measures, such as vaccines, coupled with the transient nature of pandemics, could negatively impact or eliminate demand for our COVID-19 therapies. In addition, we may be required to accept returns of certain product previously shipped pursuant to EUAs if the relevant EUA is revoked or terminated. Mutations or the spread of other variants of the coronavirus could also render our therapies ineffective. Any of these risks could prevent us from recouping our substantial investments in the research, development, and manufacture of our COVID-19 therapies. Our ability to continue to operate without significant negative impacts will in part depend on our ability to protect our employees and our supply chain. We have taken steps to protect our employees worldwide, with particular measures in place for those working in our manufacturing sites and distribution facilities. For 2020, we were able to largely maintain our normal operations. However, uncertainty resulting from the COVID-19 pandemic could have an adverse impact on our manufacturing operations, global supply chain, and distribution systems, which could impact our ability to produce and distribute our products and the ability of third parties on which we rely to fulfill their obligations to us, and could increase our expenses.Although the COVID-19 pandemic has affected our operations and demand for our products, it has not negatively impacted our liquidity position. We expect to continue to generate cash flows to meet our short-term liquidity needs and to have access to liquidity via the short-term and long-term debt markets. We also have not observed any material impairments of our assets or significant changes in the fair value of assets due to the COVID-19 pandemic.The degree to which the COVID-19 pandemic will continue to impact our business operations, financial results, and liquidity will depend on future developments, is highly uncertain, and cannot be predicted due to, among other things, the duration and severity of the pandemic, the actions taken to reduce its transmission, including widespread availability of vaccines, and the speed with which, and extent to which, more stable economic and operating conditions resume. Should the COVID-19 pandemic and any associated recession or depression continue for a prolonged period, our results of operations, financial condition, liquidity, and cash flows could be materially impacted by lower revenues and profitability and a lower likelihood of effectively and efficiently developing and launching new medicines. See “Risk Factors” in Part I, Item 1A of this Annual Report on Form 10-K for additional information on risk factors that could impact our results.Elanco Animal Health (Elanco) DispositionOn March 11, 2019, we completed the disposition of our remaining 80.2 percent ownership of Elanco common stock through a tax-free exchange offer. As a result, we recognized a gain on the disposition of approximately $3.7 billion in the first quarter of 2019 and now operate as a single segment. See Note 19 to the consolidated financial statements for further discussion. 35Financial ResultsThe following table summarizes our key operating results:Year Ended December 31Percent Change20202019Revenue$24,539.8 $22,319.5 10Gross margin19,056.5 17,598.3 8Gross margin as a percent of revenue77.7 %78.8 %Operating expense$12,206.9 $11,808.8 3Acquired in-process research and development 660.4 239.6 NMAsset impairment, restructuring, and other special charges131.2 575.6 (77)Income before income taxes7,229.9 5,265.9 37Income taxes1,036.2 628.0 65Net income from continuing operations6,193.7 4,637.9 34Net income6,193.7 8,318.4 (26)EPS from continuing operations6.79 4.96 37EPS6.79 8.89 (24)NM - not meaningfulRevenue increased in 2020 driven by increased volume, partially offset by lower realized prices. Operating expenses, defined as the sum of research and development and marketing, selling, and administrative expenses, increased in 2020, driven primarily by approximately $450 million of development expenses for COVID-19 therapies. The decreases in net income and EPS in 2020 were driven primarily by the approximately $3.7 billion gain recognized on the disposition of Elanco in 2019, partially offset by higher gross margin and higher other income in 2020. The following highlighted items affect comparisons of our 2020 and 2019 financial results:2020Acquired in-process research and development (IPR&D) (Note 3 to the consolidated financial statements)•We recognized acquired IPR&D charges of $660.4 million resulting from the acquisitions of Disarm Therapeutics, Inc. (Disarm) and a pre-clinical stage company as well as collaborations with Innovent Biologics, Inc. (Innovent), Sitryx Therapeutics Limited (Sitryx), Fochon Pharmaceuticals, Ltd. (Fochon), AbCellera Biologics Inc. (AbCellera), Evox Therapeutics Ltd (Evox), and Shanghai Junshi Biosciences Co., Ltd. (Junshi Biosciences). Asset Impairment, Restructuring, and Other Special Charges (Note 5 to the consolidated financial statements)•We recognized charges of $131.2 million primarily related to severance costs incurred as a result of actions taken worldwide to reduce our cost structure, as well as acquisition and integration costs incurred as part of the acquisition of Dermira, Inc. (Dermira).Other-Net, (Income) Expense (Note 18 to the consolidated financial statements)•We recognized $1.44 billion of net investment gains on equity securities. 2019 Acquired IPR&D (Note 3 to the consolidated financial statements)•We recognized acquired IPR&D charges of $239.6 million resulting from collaborations with AC Immune SA (AC Immune), Centrexion Therapeutics Corporation (Centrexion), ImmuNext, Inc. (ImmuNext), and Avidity Biosciences, Inc. (Avidity). Asset Impairment, Restructuring, and Other Special Charges (Note 5 to the consolidated financial statements)•We recognized charges of $575.6 million primarily associated with the accelerated vesting of Loxo Oncology, Inc. (Loxo) employee equity awards as part of the acquisition of Loxo.36Other-Net, (Income) Expense (Note 18 to the consolidated financial statements)•We recognized $401.2 million of net investment gains on equity securities. •We recognized a gain of $309.8 million on the sale of our antibiotics business in China. •We recognized a debt extinguishment loss of $252.5 million related to the repurchase of debt. Net Income from Discontinued Operations (Note 19 to the consolidated financial statements)•We recognized a gain related to the disposition of Elanco of approximately $3.7 billion.Late-Stage PipelineOur long-term success depends on our ability to continually discover or acquire, develop, and commercialize innovative new medicines. We currently have approximately 45 candidates in clinical development or under regulatory review, and a larger number of projects in the discovery phase.The following new molecular entities (NMEs) and diagnostic agent are currently in Phase III clinical trials or have been submitted for regulatory review or have received first regulatory approval in the U.S., Europe, or Japan in 2020. In addition, the following table includes certain NMEs currently in Phase II clinical trials. The following table reflects the status of these NMEs and diagnostic agent, including certain other developments since January 1, 2020.CompoundIndicationStatus DevelopmentsCOVID-19 Therapies BamlanivimabCOVID-19Emergency Use AuthorizationThe FDA granted EUA for higher-risk patients recently diagnosed with mild-to-moderate COVID-19 in the fourth quarter of 2020. Announced in January 2021 that a Phase III trial met the primary and all key secondary endpoints. Additional Phase III trials are ongoing. Bamlanivimab and etesevimab administered togetherCOVID-19Emergency Use AuthorizationAnnounced in January 2021 that a Phase III trial met the primary and all key secondary endpoints. The FDA granted EUA for higher-risk patients recently diagnosed with mild-to-moderate COVID-19 in January 2021. Additional Phase III trials are ongoing. We intend to submit to the FDA for approval in the second half of 2021. EndocrinologyUltra-rapid Lispro (Lyumjev®)Type 1 and 2 diabetesLaunchedLaunched in Japan in the second quarter of 2020 and in the U.S. and Europe in the third quarter of 2020. Tirzepatide Type 2 diabetesPhase IIIAnnounced in the fourth quarter of 2020 and in February 2021 that Phase III trials met the primary and all key secondary endpoints. Additional Phase III trials are ongoing.ObesityPhase III trials are ongoing.Nonalcoholic steatohepatitis Phase IIPhase II trial is ongoing. Basal Insulin-FcType 1 and 2 diabetesPhase IIPhase II trials are ongoing.37CompoundIndicationStatus DevelopmentsImmunologyLebrikizumab(1)Atopic dermatitisPhase IIIAcquired in Dermira acquisition in February 2020. The FDA granted Fast Track designation(2). Phase III trials are ongoing.MirikizumabCrohn's DiseasePhase IIIPhase III trials are ongoing. PsoriasisAnnounced in the third quarter of 2020 that Phase III trials met the primary and all key secondary endpoints. Additional Phase III trials are ongoing. Ulcerative colitisPhase III trials are ongoing.CXCR1/2 Ligands Monoclonal AntibodyHidradenitis SuppurativaPhase IIPhase II trial initiated in the third quarter of 2020. IL-2 ConjugateSystemic Lupus ErythematosusPhase IIPhase II trial is ongoing.NeuroscienceLasmiditan (Reyvow®)Acute treatment of migraineLaunchedReceived Schedule V classification from the Drug Enforcement Agency and launched in the U.S. in the first quarter of 2020. Submitted in Europe and Japan in the fourth quarter of 2020.Flortaucipir (TauvidTM)Alzheimer's disease diagnosticLaunchedLaunched in the U.S. in the fourth quarter of 2020. Tanezumab(3)Osteoarthritis painSubmittedSubmitted to the FDA in 2019. The FDA intends to hold an Advisory Committee meeting, expected to occur in March 2021, to discuss the submission. Cancer painPhase IIIPhase III trial is ongoing.SolanezumabPreclinical Alzheimer's diseasePhase IIIAnnounced in the first quarter of 2020 that a Phase III trial for people with dominantly inherited Alzheimer's disease (DIAD) did not meet the primary endpoint. We do not plan to pursue submission for DIAD. Phase III trial is ongoing for Anti-Amyloid Treatment in Asymptomatic Alzheimer's.DonanemabAlzheimer’s diseasePhase IIAnnounced in January 2021 that a Phase II trial met the primary endpoint. Additional Phase II trials are ongoing. Epiregulin/TGFa mAbChronic painPhase IIPhase II trials initiated in the third quarter of 2020. PACAP38 AntibodyChronic painPhase IIPhase II trial initiated in the fourth quarter of 2020. SSTR4 Agonist Chronic pain Phase IIPhase II trials initiated in the fourth quarter of 2020. ZagotenemabAlzheimer’s diseasePhase IIPhase II trial is ongoing. OncologySelpercatinib (Retevmo®)Thyroid cancerLaunchedGranted accelerated approval(4) by the FDA based on Phase II data and launched in the U.S. in the second quarter of 2020. Submitted in Japan in the fourth quarter of 2020. Granted conditional marketing authorisation(4) in Europe in February 2021. Phase III trials are ongoing. Lung cancerLOXO-305Hematological cancersPhase IIPhase II trial initiated in the second quarter of 2020. Presented positive data at the American Society of Hematology Annual Meeting in the fourth quarter of 2020. (1) In collaboration with Almirall, S.A. (Almirall) in Europe.(2) Fast Track designation is designated to expedite the development and review of new therapies to treat serious conditions and address unmet medical needs.(3) In collaboration with Pfizer, Inc. (4) Continued approval may be contingent on verification and description of clinical benefit in confirmatory Phase III trials.38As part of our collaboration with Innovent, we plan to pursue registration of sintilimab injection (Tyvyt®) in the U.S. and other markets. Our pipeline also contains several new indication line extension (NILEX) products. The following certain NILEX products are currently in Phase II or Phase III clinical testing, have been submitted for regulatory review, or have received first regulatory approval in the U.S., Europe, or Japan for use in the indication described in 2020. The following table reflects the status of certain NILEX products, including certain other developments since January 1, 2020:CompoundIndicationStatusDevelopmentsEndocrinologyEmpagliflozin (Jardiance®)(1)Heart failure with reduced ejection fractionSubmittedSubmitted in the U.S., Europe and Japan in the fourth quarter of 2020.Chronic kidney diseasePhase IIIGranted FDA Fast Track designation(2). Phase III trials are ongoing.Heart failure with preserved ejection fractionImmunologyBaricitinib (Olumiant®)Atopic dermatitisApprovedAnnounced in the first quarter of 2020 that a Phase III trial met the primary and all key secondary endpoints. Submitted in the U.S. in the second quarter of 2020. Approved in Europe in the third quarter of 2020 and in Japan in the fourth quarter of 2020.COVID-19Emergency Use AuthorizationThe FDA granted EUA in combination with remdesivir in hospitalized COVID-19 patients in the fourth quarter of 2020.Alopecia areataPhase IIIThe FDA granted Breakthrough Therapy designation(3). Phase III trials are ongoing.Systemic lupus erythematosusPhase III trials are ongoing. OncologyAbemaciclib (Verzenio®)Adjuvant breast cancerSubmittedAnnounced in the second quarter of 2020 that a Phase III trial met the primary endpoint. Submitted in the U.S. and Europe in the fourth quarter of 2020. Prostate cancerPhase IIPhase II trials are ongoing. (1) In collaboration with Boehringer Ingelheim. (2) Fast Track designation is designated to expedite the development and review of new therapies to treat serious conditions and address unmet medical needs.(3) Breakthrough Therapy designation is designed to expedite the development and review of potential medicines that are intended to treat a serious condition where preliminary clinical evidence indicates that the treatment may demonstrate substantial improvement over available therapy on a clinically significant endpoint.39There are many difficulties and uncertainties inherent in pharmaceutical research and development and the introduction of new products, as well as a high rate of failure inherent in new drug discovery and development. To bring a drug from the discovery phase to market can take over a decade and often costs in excess of $2 billion. Failure can occur at any point in the process, including in later stages after substantial investment. As a result, most funds invested in research programs will not generate financial returns. New product candidates that appear promising in development may fail to reach the market or may have only limited commercial success because of efficacy or safety concerns, inability to obtain or maintain necessary regulatory approvals or payer reimbursement or coverage, limited scope of approved uses, changes in the relevant treatment standards or the availability of new or better competitive products, difficulty or excessive costs to manufacture, or infringement of the patents or intellectual property rights of others. Regulatory agencies continue to establish high hurdles for the efficacy and safety of new products. Delays and uncertainties in drug approval processes can result in delays in product launches and lost market opportunity. In addition, it can be very difficult to predict revenue growth rates of new products. We manage research and development spending across our portfolio of potential new medicines. A delay in, or termination of, any one project will not necessarily cause a significant change in our total research and development spending. Due to the risks and uncertainties involved in the research and development process, we cannot reliably estimate the nature, timing, and costs of the efforts necessary to complete the development of our research and development projects, nor can we reliably estimate the future potential revenue that will be generated from any successful research and development project. Each project represents only a portion of the overall pipeline, and none is individually material to our consolidated research and development expense. While we do accumulate certain research and development costs on a project level for internal reporting purposes, we must make significant cost estimations and allocations, some of which rely on data that are neither reproducible nor validated through accepted control mechanisms. Therefore, we do not have sufficiently reliable data to report on total research and development costs by project, by preclinical versus clinical spend, or by therapeutic category.Other MattersPatent MattersWe depend on patents or other forms of intellectual property protection for most of our revenue, cash flows, and earnings. Our formulation patents for Forteo® expired in December 2018, and our use patents expired in August 2019 in major European markets and the U.S. Both the formulation patent and the use patent expired in August 2019 in Japan. We expect further volume decline as a result of the anticipated entry of generic and biosimilar competition following the loss of patent exclusivity in these markets. In the aggregate, we expect that the decline in revenue will have a material adverse effect on our consolidated results of operations and cash flows.The Alimta® vitamin regimen patents, which we expect to provide us with patent protection for Alimta through June 2021 in Japan and major European countries, and through May 2022 in the U.S., have been challenged in each of these jurisdictions. In the U.S., most challenges have been finally resolved in our favor, and one remains in active litigation. We and Eagle Pharmaceuticals, Inc. (Eagle) reached an agreement in December 2019 to settle all pending litigation, allowing Eagle a limited initial entry into the market with its product starting February 2022 (up to an approximate three-week supply) and subsequent unlimited entry starting April 2022. We expect that the entry of generic competition in the U.S. either from an unfavorable outcome to the patent challenge or following the loss of patent exclusivity, will cause a rapid and severe decline in revenue and have a material adverse effect on our consolidated results of operations and cash flows.40We are aware that several companies have received approval to market generic versions of pemetrexed in major European markets and that generic competitors may choose to attempt a launch at risk. Following a final decision in the Supreme Court of Germany in July 2020 overturning the lower court and upholding the validity of our Alimta patent, several generics that were on the market at risk in Germany left. We have removed the remaining generics from the market in Germany by obtaining preliminary injunctions in our favor. In September 2020, the Paris Court of First Instance in France issued a final decision upholding the validity of our Alimta patent and found infringement by Fresenius Kabi France and Fresenius Kabi Groupe France’s (collectively, Kabi) pemetrexed product. The court issued an injunction against Kabi and provisionally awarded us damages. In January 2021, that same court issued a preliminary injunction against Zentiva France S.A.S. (Zentiva), the last remaining company with a generic pemetrexed product on the French market, and provisionally awarded us damages. In October 2020, the Court of Appeal of the Netherlands overturned a lower court decision and ruled that our Alimta patent is valid and infringed and reinstated an injunction against Kabi, thereby removing Kabi's pemetrexed product from the Netherlands market. Kabi has appealed this decision to the Netherlands Supreme Court. Kabi's generic pemetrexed product was the only at risk generic on the market in the Netherlands. Our vitamin regimen patents have also been challenged in other smaller European jurisdictions. We expect that further entry of generic competition for Alimta in major European markets following either the loss of effective patent protection or of patent exclusivity will cause a rapid and severe decline in revenue. See Note 16 to the consolidated financial statements for a more detailed account of the legal proceedings currently pending in the U.S., Europe, and Japan regarding, among others, our Alimta patents.The compound patent for Humalog® (insulin lispro) has expired in major markets. Global regulators have different legal pathways to approve similar versions of insulin lispro. A competitor launched a similar version of insulin lispro in certain European markets in 2017 and in the U.S. in the second quarter of 2018. While it is difficult to estimate the severity of the impact of insulin lispro products entering the market, we do not expect and have not experienced a rapid and severe decline in revenue; however, we expect additional pricing pressure and some loss of market share that would continue over time.Our compound patent protection for Cymbalta® expired in Japan in January 2020. We expect generics to enter the market in mid-2021. We expect that the entry of generic competition will cause a rapid and severe decline in revenue and will have a material adverse effect on our consolidated results of operations and cash flows.Foreign Currency Exchange RatesAs a global company with substantial operations outside the U.S., we face foreign currency risk exposure from fluctuating currency exchange rates, primarily the U.S. dollar against the euro and Japanese yen. While we seek to manage a portion of these exposures through hedging and other risk management techniques, significant fluctuations in currency rates can have a material impact, either positive or negative, on our revenue, cost of sales, and operating expenses. While there is uncertainty in the future movements in foreign exchange rates, fluctuations in these rates could negatively impact our future consolidated results of operations and cash flows. Trends Affecting Pharmaceutical Pricing, Reimbursement, and AccessU.S.In the U.S., public concern over access to and affordability of pharmaceuticals continues to drive the regulatory and legislative debate. These policy and political issues increase the risk that taxes, fees, rebates, or other cost control measures may be enacted to manage federal and state budgets. Key health policy initiatives affecting biopharmaceuticals include:•the Coronavirus Aid, Relief, and Economic Security (CARES) Act and subsequent stimulus bills that focus on ensuring availability and access to lifesaving drugs during a public health crisis, •foreign reference pricing in Medicare and private insurance,•modifications to Medicare Parts B and D,•provisions that would allow the Department of Health and Human Services (HHS) to negotiate prices for biologics and drugs in Medicare,•a reduction in biologic data exclusivity,41•proposals related to Medicaid prescription drug coverage and manufacturer drug rebates,•proposals that would require biopharmaceutical manufacturers to disclose proprietary drug pricing information, and•state-level proposals related to prescription drug prices and reducing the cost of pharmaceuticals purchased by government health care programs.On July 24, 2020 and September 13, 2020, former U.S. President Donald Trump signed Executive Orders related to the 340B Prescription Drug Program, rebate reform in Medicare Part D, drug importation including insulin, and foreign reference pricing in Medicare Part B and Part D. Although their current status is unclear given the change in presidential administration, these Executive Orders, if implemented, could have a material adverse impact on our future consolidated results of operations, liquidity, and financial position. On September 1, 2020, Lilly announced it would distribute all 340B ceiling priced products directly to covered entities and their child sites only. Lilly provides 340B discounts to a contract pharmacy only if it is a wholly owned subsidiary of a covered entity, if a covered entity does not have an in-house pharmacy or, in the case of insulin, if the subject covered entity and its contract pharmacies agree to pass along the discount to patients without any markup for dispensing fees and without billing insurance or collecting duplicate discounts. Lilly has been transparent with regulators on its distribution activity and continues to comply with all 340B program requirements. Certain covered entities and their trade associations have threatened litigation, questioning whether Lilly’s program, and similar actions by other manufacturers, violate 340B program requirements. On October 9, 2020, three covered entities sued HHS and the Health Resources and Services Administration (HRSA) in the U.S. District Court for the District of Columbia seeking to compel the agencies to take enforcement action against Lilly and three other companies, among other requested relief. On October 21, 2020, a trade association representing certain covered entities sued HHS in the same court seeking to compel the agency to promulgate administrative dispute resolution regulations. On December 11, 2020, a number of associations and entities filed suit against HHS in the U.S. District Court for the Northern District of California requesting immediate enforcement of the contract pharmacy guidance. On December 31, 2020, the General Counsel of HHS issued an advisory opinion alleging that honoring contract pharmacy agreements is mandatory. In January 2021, Lilly filed suit against HHS, the Secretary of HHS, the HRSA, and the Administrator of the HRSA in the U.S. District Court for the Southern District of Indiana seeking a declaratory judgment that HHS's attempt to require manufacturers to permit contract pharmacy distribution is unlawful and a preliminary injunction enjoining implementation of the alternative dispute resolution process created by defendants and, with it, their application of the advisory opinion, and other related relief. The cases are pending and the impact of these cases and any subsequent litigation is uncertain. See Note 16 to the consolidated financial statements for additional information. California and several other states have enacted legislation related to prescription drug pricing transparency and it is unclear the effect this legislation will have on our business. Several states have also passed importation legislation, including Colorado, Florida, Maine, New Hampshire, New Mexico, and Vermont. As of late 2020 several of these states were actively working with the former presidential administration to implement an importation program from Canada. On November 22, 2020, Florida announced it submitted a proposed importation plan to the U.S. In 2020, HHS and the FDA also took several actions to advance state importation initiatives, including issuing requests for proposals for personal importation and reimportation of insulin and a final rule on the Importation of Prescription Drugs. Additionally, on November 27, 2020, the Canadian Minister of Health issued an interim order to ensure that participation in bulk importation frameworks, such as the one recently established by the U.S., does not cause or exacerbate a drug shortage in Canada. We continue to review these state proposals and legislation, as well as federal rules and guidance published by HHS and the FDA, the impact of which is uncertain at this time. Currently, it is unclear if the current presidential administration will adopt any of the importation initiatives put forth by the former presidential administration. We will continue to monitor and assess these developments.42In the private sector, consolidation and integration among healthcare providers significantly affects the competitive marketplace for pharmaceuticals. Health plans, pharmacy benefit managers, wholesalers, and other supply chain stakeholders have been consolidating into fewer, larger entities, thus enhancing their purchasing strength and importance. Private third-party insurers, as well as governments, typically maintain formularies that specify coverage (the conditions under which drugs are included on a plan's formulary) and reimbursement (the associated out-of-pocket cost to the consumer) to control costs by negotiating discounted prices in exchange for formulary inclusion. Formulary placement can lead to reduced usage of a drug for the relevant patient population due to coverage restrictions, such as prior authorizations and formulary exclusions, or due to reimbursement limitations that result in higher consumer out-of-pocket cost, such as non-preferred co-pay tiers, increased co-insurance levels, and higher deductibles. Consequently, pharmaceutical companies compete for formulary placement not only on the basis of product attributes such as efficacy, safety profile, or patient ease of use, but also by providing rebates. Value-based agreements, where pricing is based on achievement (or not) of specified outcomes, are another tool that may be utilized between payers and pharmaceutical companies as formulary placement and pricing are negotiated. Price is an increasingly important factor in formulary decisions, particularly in treatment areas in which the payer has taken the position that multiple branded products are therapeutically comparable. We expect these downward pricing pressures will continue to negatively affect our consolidated results of operations. In addition to formulary placement, changes in insurance designs continue to drive greater consumer cost-sharing through high deductible plans and higher co-insurance or co-pays. We continue to invest in patient affordability solutions (resulting in lower revenue) in an effort to assist patients in affording their medicines.The main coverage expansion provisions of the Affordable Care Act (ACA) are currently in effect through both state-based exchanges and the expansion of Medicaid. A trend has been the prevalence of benefit designs containing high out-of-pocket costs for patients, particularly for pharmaceuticals. In addition to the coverage expansions, many employers in the commercial market continue to evaluate strategies such as private exchanges and wider use of consumer-driven health plans to reduce their healthcare liabilities over time. Federal legislation, litigation, or administrative actions to repeal or modify some or all of the provisions of the ACA could have a material adverse effect on our consolidated results of operations and cash flows. At the same time, the broader paradigm shift towards performance-based reimbursement and the launch of several value-based purchasing initiatives have placed demands on the pharmaceutical industry to offer products with proven real-world outcomes data and a favorable economic profile.InternationalInternational operations also are generally subject to extensive price and market regulations. Cost-containment measures exist in a number of countries, including additional price controls and mechanisms to limit reimbursement for our products. Such policies are expected to increase in impact and reach, given the pressures on national and regional health care budgets that come from a growing, aging population and ongoing economic challenges. As additional reforms are finalized, we will assess their impact on future revenues. In addition, governments in many emerging markets are becoming increasingly active in expanding health care system offerings. Given the budget challenges of increasing health care coverage for citizens, policies may be proposed that promote generics and biosimilars only and reduce current and future access to branded pharmaceutical products. The COVID-19 pandemic is also creating additional pressure on health systems worldwide. As a result, cost containment and other measures may intensify as governments manage and emerge from the pandemic. Tax MattersWe are subject to income taxes and various other taxes in the U.S. and in many foreign jurisdictions; therefore, changes in both domestic and international tax laws or regulations could affect our effective tax rate, results of operations, and cash flows. Countries around the world, including the U.S., are actively considering and enacting tax law changes. The current presidential administration's tax proposal contains significant changes, including the rate at which income of U.S. companies would be taxed. Further, actions taken with respect to tax-related matters by associations such as the Organisation for Economic Co-operation and Development and the European Commission could influence tax policy in countries in which we operate. In addition, global tax authorities routinely examine our tax returns and are expected to become more aggressive in their examinations of profit allocations among jurisdictions, which could affect our anticipated tax liabilities. 43AcquisitionsWe strategically invest in external research and technologies that we believe complement and strengthen our own efforts. These investments can take many forms, including acquisitions, strategic alliances, collaborations, investments, and licensing arrangements. We view our business development activity as an important way to achieve our strategies, as we seek to bolster our pipeline and enhance shareholder value. We continuously evaluate business development transactions that have the potential to strengthen our business.In 2019, we acquired all shares of Loxo for a purchase price of $6.92 billion, net of cash acquired. Under the terms of the agreement, we acquired a pipeline of investigational medicines, including selpercatinib, an oral RET inhibitor, and LOXO-305, an oral BTK inhibitor. In the second quarter of 2020, the FDA approved selpercatinib (Retevmo) under its Accelerated Approval regulations and continued approval may be contingent upon verification and description of clinical benefit in confirmatory trials. In 2020, we acquired all shares of Dermira for a purchase price of $849.3 million, net of cash acquired. Under terms of the agreement, we acquired lebrikizumab, a novel, investigational, monoclonal antibody being evaluated for the treatment of moderate-to-severe atopic dermatitis. Lebrikizumab was granted Fast Track designation from the FDA. We also acquired Qbrexza® cloth, a medicated cloth for the topical treatment of primary axillary hyperhidrosis (uncontrolled excessive underarm sweating).In January 2021, we acquired all shares of Prevail Therapeutics Inc. (Prevail) for a purchase price of approximately $880 million in cash plus one non-tradable contingent value right (CVR). The CVR entitles Prevail stockholders to up to an additional approximately $160 million payable, subject to certain terms and conditions, upon the first regulatory approval of a Prevail product in one of the following countries: U.S., Japan, United Kingdom, Germany, France, Italy, or Spain. Under the terms of the agreement, we acquired a biotechnology company developing potentially disease-modifying AAV9-based gene therapies for patients with neurodegenerative diseases. See Note 3 to the consolidated financial statements for further discussion regarding our recent acquisitions.44Operating Results—2020 RevenueThe following table summarizes our revenue activity by region:Year EndedDecember 31,20202019Percent ChangeU.S.$14,229.3 $12,722.6 12Outside U.S.10,310.5 9,596.8 7Revenue$24,539.8 $22,319.5 10Numbers may not add due to rounding.The following are components of the change in revenue compared with the prior year:2020 vs. 2019U.S.Outside U.S.ConsolidatedVolume17 %13 %15 %Price(5)%(6)%(5)%Foreign exchange rates— %— %— %Percent change12 %7 %10 %Numbers may not add due to rounding.In the U.S., the revenue increase in 2020 was driven by increased volume primarily for Trulicity®, bamlanivimab, and Taltz®. Excluding bamlanivimab revenue, U.S. revenue grew 5 percent. The increase in revenue due to volume was partially offset by a decrease in realized prices. The decrease in realized prices in the U.S. was primarily driven by increased rebates to gain and maintain broad commercial access across the portfolio and, to a lesser extent, unfavorable segment mix and changes to estimates for rebates and discounts, most notably impacting Humalog. The decrease in realized prices in the U.S. was partially offset by modest list price increases and lower utilization in the 340B segment. Outside the U.S., the revenue increase in 2020 was driven by increased volume primarily for Tyvyt, Trulicity, Alimta, and Olumiant. The increase in revenue due to volume was partially offset by lower realized prices primarily for Tyvyt and Alimta. The increase in volume and decrease in realized prices for Tyvyt and Alimta was driven primarily by their inclusion in government reimbursement programs in China. 45The following table summarizes our revenue activity in 2020 compared with 2019:Year EndedDecember 31, 20202019ProductU.S.Outside U.S.TotalTotalPercent ChangeTrulicity$3,835.9 $1,232.2 $5,068.1 $4,127.8 23Humalog(1)1,485.6 1,140.3 2,625.9 2,820.7 (7)Alimta1,265.3 1,064.7 2,329.9 2,115.8 10Taltz1,288.5 500.0 1,788.5 1,366.4 31Humulin®866.4 393.2 1,259.6 1,290.1 (2)Jardiance(2)620.8 533.0 1,153.8 944.2 22Basaglar®842.3 282.1 1,124.4 1,112.6 1Forteo510.3 536.0 1,046.3 1,404.7 (26)Cyramza®381.9 650.8 1,032.6 925.1 12Verzenio618.2 294.4 912.7 579.7 57Bamlanivimab(3)850.0 21.2 871.2 — NMCymbalta42.1 725.6 767.7 725.4 6Olumiant63.8 575.0 638.9 426.9 50Cialis®61.8 545.4 607.1 890.5 (32)Erbitux®480.1 56.3 536.4 543.4 (1)Zyprexa®46.1 360.5 406.5 418.7 (3)Emgality®325.9 37.0 362.9 162.5 NMTrajenta®(4)95.6 263.0 358.5 590.6 (39)Other products548.7 1,099.8 1,648.8 1,874.4 (12)Revenue$14,229.3 $10,310.5 $24,539.8 $22,319.5 10Numbers may not add due to rounding.NM - Not meaningful(1) Humalog revenue includes insulin lispro.(2) Jardiance revenue includes Glyxambi®, Synjardy®, and Trijardy® XR.(3) Bamlanivimab sales are pursuant to EUA. (4) Trajenta revenue includes Jentadueto®.Revenue of Trulicity, a treatment for type 2 diabetes and to reduce the risk of major adverse cardiovascular events in adult patients with type 2 diabetes and established cardiovascular disease or multiple cardiovascular risk factors, increased 22 percent in the U.S., driven by increased volume, partially offset by lower realized prices primarily due to higher contracted rebates. Revenue outside the U.S. increased 27 percent, primarily driven by increased volume.Revenue of Humalog, an injectable human insulin analog for the treatment of diabetes, decreased 11 percent in the U.S., driven by lower realized prices, partially offset by higher demand. Revenue outside the U.S. decreased 1 percent, primarily driven by the unfavorable impact of foreign exchange rates. Included in the revenue of Humalog in the U.S. are our own insulin lispro authorized generics, which began launching in the second quarter of 2019 in order to lower out-of-pocket costs for patients. While it is difficult to estimate the severity of the impact of similar insulin lispro products entering the market, we do not expect and have not experienced a rapid severe decline in revenue. However, due to the impact of competition and due to pricing pressure in the U.S. and some international markets, we expect some price decline and loss of market share to continue over time.Revenue of Alimta, a treatment for various cancers, increased 4 percent in the U.S., primarily driven by higher realized prices. Revenue outside the U.S. increased 19 percent, primarily driven by increased volume in China and Germany, partially offset by lower realized prices. We will lose our patent protection for Alimta in Japan and major European countries in June 2021. We expect the limited entry of generic competition in the U.S. starting February 2022 and subsequent unlimited entry starting April 2022. We expect that the entry of generic competition following the loss of exclusivity will cause a rapid and severe decline in revenue. See "Results of Operations - Executive Overview - Other Matters" for more information.46Revenue of Taltz, a treatment for moderate-to-severe plaque psoriasis, active psoriatic arthritis, ankylosing spondylitis, and active non-radiographic axial spondyloarthritis, increased 27 percent in the U.S., primarily driven by increased demand. Revenue outside the U.S. increased 43 percent, primarily driven by increased volume. Revenue of Humulin, an injectable human insulin for the treatment of diabetes, decreased 2 percent in the U.S., driven by lower realized prices, partially offset by higher volume. Revenue outside the U.S. decreased 4 percent, driven by decreased volume and the unfavorable impact of foreign exchange rates, partially offset by higher realized prices.Revenue of Jardiance, a treatment for type 2 diabetes and to reduce the risk of cardiovascular death in adult patients with type 2 diabetes and established cardiovascular disease, increased 10 percent in the U.S., driven by increased volume. Revenue outside the U.S. increased 41 percent, driven primarily by increased volume. See Note 4 to the consolidated financial statements for information regarding our collaboration with Boehringer Ingelheim involving Jardiance.Revenue of Basaglar, a long-acting human insulin analog for the treatment of diabetes, decreased 4 percent in the U.S., driven by lower realized prices. Revenue outside the U.S. increased 19 percent, driven primarily by increased volume. See Note 4 to the consolidated financial statements for information regarding our collaboration with Boehringer Ingelheim involving Basaglar. A competitor launched a similar version of glargine in the U.S. in 2020. Due to the impact of competitive pressures, we expect some price decline and loss of market share over time. Revenue of Forteo, an injectable treatment for osteoporosis in postmenopausal women and men at high risk for fracture and for glucocorticoid-induced osteoporosis in men and postmenopausal women, decreased 21 percent in the U.S., primarily driven by decreased demand. Revenue outside the U.S. decreased 29 percent, driven by decreased volume and, to a lesser extent, lower realized prices. We expect further volume declines as a result of the anticipated entry of generic and biosimilar competition due to the loss of patent exclusivity in the U.S., Japan, and major European markets. See "Executive Overview - Other Matters - Patent Matters" for more information. Revenue of Cyramza, a treatment for various cancers, increased 14 percent in the U.S., driven primarily by increased demand and, to a lesser extent, higher realized prices. Revenue outside the U.S. increased 10 percent, driven primarily by increased volume. Revenue of Verzenio, a treatment for HR+, HER2- metastatic breast cancer, increased 36 percent in the U.S., driven by increased demand and, to a lesser extent, higher realized prices. Revenue outside the U.S. increased $169.5 million driven by higher volume.Gross Margin, Costs, and ExpensesGross margin as a percent of revenue was 77.7 percent in 2020, a decrease of 1.1 percentage points compared with 2019, primarily due to the impact of lower realized prices on revenue, the unfavorable effect of foreign exchange rates on international inventories sold, and higher intangibles amortization expense related to Retevmo, partially offset by charges in 2019 resulting from the withdrawal of Lartruvo® and greater manufacturing efficiencies. Gross margin percent for 2020 was also negatively impacted as a result of bamlanivimab sales in the fourth quarter of 2020. Research and development expenses increased 9 percent to $6.09 billion in 2020, driven primarily by approximately $450 million of development expenses for COVID-19 therapies. Excluding these expenses related to COVID-19 therapies, research and development expenses were relatively flat. Marketing, selling, and administrative expenses decreased 1 percent to $6.12 billion in 2020 primarily due to lower marketing activity.We recognized acquired IPR&D charges of $660.4 million in 2020 resulting from the acquisitions of Disarm and a pre-clinical stage company as well as collaborations with Innovent, Sitryx, Fochon, AbCellera, Evox, and Junshi Biosciences. In 2019, we recognized acquired IPR&D charges of $239.6 million resulting from collaborations with AC Immune, Centrexion, ImmuNext, and Avidity.47We recognized asset impairment, restructuring, and other special charges of $131.2 million in 2020. The charges were primarily related to severance costs incurred as a result of actions taken worldwide to reduce our cost structure, as well as acquisition and integration costs incurred as part of the acquisition of Dermira. In 2019, we recognized $575.6 million of asset impairment, restructuring, and other special charges primarily associated with the accelerated vesting of Loxo employee equity awards as part of the acquisition of Loxo.Other—net, (income) expense was income of $1.17 billion in 2020 compared to income of $291.6 million in 2019 primarily driven by higher net gains on investment securities.Our effective tax rate was 14.3 percent in 2020, compared with an effective tax rate of 11.9 percent in 2019 driven by net discrete tax benefits in 2019. Operating Results—2019 For a discussion of our results of operations pertaining to 2019 and 2018 see Item 7, "Management's Discussion and Analysis of Results of Operations and Financial Condition" in our Annual Report on Form 10-K for the year ended December 31, 2019.48FINANCIAL CONDITION AND LIQUIDITYWe believe our available cash and cash equivalents, together with our ability to generate operating cash flow and our access to short-term and long-term borrowings, are sufficient to fund our existing and planned capital requirements, which include: •working capital requirements, including related to employee payroll, clinical trials, manufacturing materials, and taxes;•capital expenditures;•share repurchases and dividends;•repayment of outstanding short-term and long-term borrowings; •contributions to our defined benefit pension and retiree health benefit plans;•milestone and royalty payments; and•potential business development activities, including acquisitions, strategic alliances, collaborations, investments, and licensing arrangements.Our management continuously evaluates our liquidity and capital resources, including our access to external capital, to ensure we can adequately and efficiently finance our capital requirements. As of December 31, 2020, our material cash requirements primarily related to purchases of goods and services to produce our products and conduct our operations, capital equipment expenditures, dividends, repayment of outstanding borrowings, the remaining obligations for the one-time repatriation transition tax (also known as the 'Toll Tax') from the Tax Cuts and Jobs Act (2017 Tax Act), leases, unfunded commitments to invest in venture capital funds, and retirement benefits (see Notes 11, 14, 10, 7, and 15 to the consolidated financial statements). We anticipate our cash requirements related to ordinary course purchases of goods and services and capital equipment expenditures will be consistent with our past levels relative to revenues. Cash and cash equivalents increased to $3.66 billion as of December 31, 2020, compared with $2.34 billion at December 31, 2019. Net cash provided by operating activities was $6.50 billion in 2020, compared with $4.84 billion in 2019. Net cash provided by operating activities in 2019 included approximately $360 million of cash paid to settle the accelerated vesting of Loxo employee equity awards (see Note 5 to the consolidated financial statements). Refer to the consolidated statements of cash flows for additional details on the significant sources and uses of cash for the years ended December 31, 2020 and 2019. In addition to our cash and cash equivalents, we held total investments of $2.99 billion and $2.06 billion as of December 31, 2020 and 2019, respectively. See Note 7 to the consolidated financial statements for additional details.In February 2020, we completed our acquisition of Dermira for $18.75 per share, or approximately $1.1 billion, which was funded through cash on hand and the issuance of commercial paper. In February 2019, we completed our acquisition of Loxo for $235 per share or approximately $6.9 billion, which was funded through a mixture of cash and debt. See Note 3 to the consolidated financial statements for additional information.As of December 31, 2020, total debt was $16.60 billion, an increase of $1.28 billion compared with $15.32 billion at December 31, 2019. The increase primarily related to the net proceeds from the issuance of $1.00 billion of 2.25 percent fixed-rate notes in May 2020, as well as the net proceeds from the issuance of an additional $250.0 million of 2.25 percent fixed-rate notes and the issuance of $850.0 million of 2.50 percent fixed-rate notes in August 2020. We used the net proceeds from the sale of these notes for general corporate purposes, which included the repayment of outstanding commercial paper used to fund a portion of the purchase price for our acquisition of Dermira. See Note 11 to the consolidated financial statements for additional information. As of December 31, 2020, we had a total of $5.24 billion of unused committed bank credit facilities, $5.00 billion of which is available to support our commercial paper program. See Note 11 to the consolidated financial statements for additional details. We believe that amounts accessible through existing commercial paper markets should be adequate to fund any short-term borrowing needs.For the 135th consecutive year, we distributed dividends to our shareholders. Dividends of $2.96 per share and $2.58 per share were paid in 2020 and 2019, respectively. In the fourth quarter of 2020, effective for the dividend to be paid in the first quarter of 2021, the quarterly dividend was increased to $0.85 per share, resulting in an indicated annual rate for 2021 of $3.40 per share.Capital expenditures of $1.39 billion during 2020, compared to $1.03 billion in 2019.49In 2020, we repurchased $500.0 million of shares under our $8.00 billion share repurchase program authorized in June 2018. As of December 31, 2020, we had $1.00 billion remaining under this program. See Note 13 to the consolidated financial statements for additional details.On March 11, 2019, we completed the disposition of our remaining 80.2 percent ownership of Elanco common stock through a tax-free exchange offer, which resulted in a reduction in shares of our common stock outstanding by approximately 65 million as of that date.In January 2021, we completed our acquisition of Prevail for $22.50 per share, or approximately $880 million in cash, plus one non-tradable CVR that entitles Prevail stockholders to up to an additional $4.00 per share in cash (or an aggregate of approximately $160 million) payable, subject to certain terms and conditions. This acquisition was funded primarily through cash on hand and the issuance of commercial paper. See Note 3 to the consolidated financial statements for additional information. See "Results of Operations - Executive Overview - Other Matters - Patent Matters" for information regarding recent and upcoming losses of patent protection.Both domestically and abroad, we continue to monitor the potential impacts of the economic environment; the creditworthiness of our wholesalers and other customers, including foreign government-backed agencies and suppliers; the uncertain impact of health care legislation; and various international government funding levels. In the normal course of business, our operations are exposed to fluctuations in interest rates, currency values, and fair values of equity securities. These fluctuations can vary the costs of financing, investing, and operating. We seek to address a portion of these risks through a controlled program of risk management that includes the use of derivative financial instruments. The objective of this risk management program is to limit the impact on earnings of fluctuations in interest and currency exchange rates. All derivative activities are for purposes other than trading.Our primary interest rate risk exposure results from changes in short-term U.S. dollar interest rates. In an effort to manage interest rate exposures, we strive to achieve an acceptable balance between fixed and floating rate debt positions and may enter into interest rate derivatives to help maintain that balance. Based on our overall interest rate exposure at December 31, 2020 and 2019, including derivatives and other interest rate risk-sensitive instruments, a hypothetical 10 percent change in interest rates applied to the fair value of the instruments as of December 31, 2020 and 2019, respectively, would not have a material impact on earnings, cash flows, or fair values of interest rate risk-sensitive instruments over a one-year period.Our foreign currency risk exposure results from fluctuating currency exchange rates, primarily the U.S. dollar against the euro and Japanese yen. We face foreign currency exchange exposures when we enter into transactions arising from subsidiary trade and loan payables and receivables denominated in foreign currencies. We also face currency exposure that arises from translating the results of our global operations to the U.S. dollar at exchange rates that have fluctuated from the beginning of the period. We may enter into foreign currency forward or option derivative contracts to reduce the effect of fluctuating currency exchange rates (principally the euro and the Japanese yen). Our corporate risk-management policy outlines the minimum and maximum hedge coverage of such exposures. Gains and losses on these derivative contracts offset, in part, the impact of currency fluctuations on the existing assets and liabilities. We periodically analyze the fair values of the outstanding foreign currency derivative contracts to determine their sensitivity to changes in foreign exchange rates. A hypothetical 10 percent change in exchange rates (primarily against the U.S. dollar) applied to the fair values of our outstanding foreign currency derivative contracts as of December 31, 2020 and 2019, would not have a material impact on earnings, cash flows, or financial position over a one-year period. This sensitivity analysis does not consider the impact that hypothetical changes in exchange rates would have on the underlying foreign currency denominated transactions.Our fair value risk exposure relates primarily to our public equity investments and to equity investments that do not have readily determinable fair values. As of December 31, 2020 and 2019, our carrying values of these investments were $2.04 billion and $1.12 billion, respectively. A hypothetical 20 percent change in fair value of the equity instruments would have impacted other-net, (income) expense by $407.6 million and $224.7 million as of December 31, 2020 and 2019, respectively. 50We have no off-balance sheet arrangements that have a material current effect or that are reasonably likely to have a material future effect on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures, or capital resources. We acquire and collaborate on potential products still in development and enter into research and development arrangements with third parties that often require milestone and royalty payments to the third party contingent upon the occurrence of certain future events linked to the success of the asset in development. Milestone payments may be required contingent upon the successful achievement of an important point in the development life cycle of the pharmaceutical product (e.g., approval for marketing by the appropriate regulatory agency or upon the achievement of certain sales levels). If required by the arrangement, we may make royalty payments based upon a percentage of the sales of the product in the event that regulatory approval for marketing is obtained. Individually, these arrangements are generally not material in any one annual reporting period. However, if milestones for multiple products covered by these arrangements were reached in the same reporting period, the aggregate expense or aggregate milestone payments made could be material to our results of operations or cash flows, respectively, in that period. See Note 4 to the consolidated financial statements for additional details. These arrangements often give us the discretion to unilaterally terminate development of the product, which would allow us to avoid making the contingent payments; however, we are unlikely to cease development if the compound successfully achieves milestone objectives. We also note that, from a business perspective, we view these payments as positive because they signify that the product is successfully moving through development and is now generating or is more likely to generate cash flows from sales of products.51APPLICATION OF CRITICAL ACCOUNTING ESTIMATESIn preparing our financial statements in accordance with accounting principles generally accepted in the U.S. (GAAP), we must often make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues, expenses, and related disclosures. Some of those judgments can be subjective and complex, and consequently actual results could differ from those estimates. For any given individual estimate or assumption we make, it is possible that other people applying reasonable judgment to the same facts and circumstances could develop different estimates. We believe that, given current facts and circumstances, it is unlikely that applying any such other reasonable judgment would cause a material adverse effect on our consolidated results of operations, financial position, or liquidity for the periods presented in this report. Our most critical accounting estimates have been discussed with our audit committee and are described below.Revenue Recognition and Sales Return, Rebate, and Discount AccrualsWe recognize revenue primarily from two different types of contracts, product sales to customers (net product revenue) and collaborations and other arrangements. For product sales to customers, provisions for returns, rebates and discounts are established in the same period the related product sales are recognized. To determine the appropriate transaction price for our product sales at the time we recognize a sale to a direct customer, we estimate any rebates or discounts that ultimately will be due to the direct customer and other customers in the distribution chain under the terms of our contracts. Significant judgments are required in making these estimates. The largest of our sales rebate and discount amounts are rebates associated with sales covered by managed care, Medicare, Medicaid, and chargeback contracts in the U.S. In determining the appropriate accrual amount, we consider our historical rebate payments for these programs by product as a percentage of our historical sales as well as any significant changes in sales trends (e.g., patent expiries and product launches), an evaluation of the current contracts for these programs, the percentage of our products that are sold via these programs, and our product pricing.Refer to Note 2 to the consolidated financial statements for further information on revenue recognition and sales return, rebate, and discount accruals.Revenue recognized from collaborations and other arrangements will include our share of profits from the collaboration, as well as royalties, upfront and milestone payments we receive under these types of contracts.Financial Statement ImpactWe believe that our accruals for sales returns, rebates, and discounts are reasonable and appropriate based on current facts and circumstances. Our global rebate and discount liabilities are included in sales rebates and discounts on our consolidated balance sheet. Our global sales return liability is included in other current liabilities and other noncurrent liabilities on our consolidated balance sheet. As of December 31, 2020, a 5 percent change in our global sales return, rebate, and discount liability would have led to an approximate $313 million effect on our income before income taxes. The portion of our global sales return, rebate, and discount liability resulting from sales of our products in the U.S. was approximately 90 percent as of December 31, 2020 and 2019.The following represents a roll-forward of our most significant U.S. sales return, rebate, and discount liability balances, including managed care, Medicare, Medicaid, chargebacks, and patient assistance programs:(Dollars in millions)20202019Sales return, rebate, and discount liabilities, beginning of year$4,635.5 $4,670.9 Reduction of net sales(1) 18,668.4 15,490.2 Cash payments(17,903.9)(15,525.6)Sales return, rebate, and discount liabilities, end of year$5,400.0 $4,635.5 (1) Adjustments of the estimates for these returns, rebates, and discounts to actual results were less than 2 percent of consolidated net sales for each of the years presented.52Product Litigation Liabilities and Other ContingenciesBackground and UncertaintiesProduct litigation liabilities and other contingencies are, by their nature, uncertain and based upon complex judgments and probabilities. The factors we consider in developing our product litigation liability reserves and other contingent liability amounts include the merits and jurisdiction of the litigation, the nature and the number of other similar current and past matters, the nature of the product and the current assessment of the science subject to the litigation, and the likelihood of settlement and current state of settlement discussions, if any. In addition, we accrue for certain product liability claims incurred, but not filed, to the extent we can formulate a reasonable estimate of their costs based primarily on historical claims experience and data regarding product usage. We accrue legal defense costs expected to be incurred in connection with significant product liability contingencies when both probable and reasonably estimable.We also consider the insurance coverage we have to diminish the exposure for periods covered by insurance. In assessing our insurance coverage, we consider the policy coverage limits and exclusions, the potential for denial of coverage by the insurance company, the financial condition of the insurers, and the possibility of and length of time for collection. Due to a very restrictive market for product liability insurance, we are self-insured for product liability losses for all our currently marketed products. In addition to insurance coverage, we consider any third-party indemnification to which we are entitled or under which we are obligated. With respect to our third-party indemnification rights, these considerations include the nature of the indemnification, the financial condition of the indemnifying party, and the possibility of and length of time for collection.The litigation accruals and environmental liabilities and the related estimated insurance recoverables have been reflected on a gross basis as liabilities and assets, respectively, on our consolidated balance sheets.AcquisitionsBackground and UncertaintiesTo determine whether acquisitions or licensing transactions should be accounted for as a business combination or as an asset acquisition, we make certain judgments, which include assessing whether the acquired set of activities and assets would meet the definition of a business under the relevant accounting rules. If the acquired set of activities and assets meets the definition of a business, assets acquired and liabilities assumed are required to be recorded at their respective fair values as of the acquisition date. The excess of the purchase price over the fair value of the acquired net assets, where applicable, is recorded as goodwill. If the acquired set of activities and assets does not meet the definition of a business, the transaction is recorded as an acquisition of assets and, therefore, any acquired IPR&D that does not have an alternative future use is charged to expense at the acquisition date, and goodwill is not recorded. Refer to Note 3 to the consolidated financial statements for additional information. The judgments made in determining estimated fair values assigned to assets acquired and liabilities assumed in a business combination, as well as estimated asset lives, can materially affect our consolidated results of operations. The fair values of intangible assets, including acquired IPR&D, are determined using information available near the acquisition date based on estimates and assumptions that are deemed reasonable by management. Significant estimates and assumptions include, but are not limited to, probability of technical success, revenue growth and discount rate. Depending on the facts and circumstances, we may deem it necessary to engage an independent valuation expert to assist in valuing significant assets and liabilities. The fair values of identifiable intangible assets are primarily determined using an "income method," as described in Note 8 to the consolidated financial statements.53Impairment of Indefinite-Lived and Long-Lived AssetsBackground and UncertaintiesWe review the carrying value of long-lived assets (both intangible and tangible) for potential impairment on a periodic basis and whenever events or changes in circumstances indicate the carrying value of an asset (or asset group) may not be recoverable. We identify impairment by comparing the projected undiscounted cash flows to be generated by the asset (or asset group) to its carrying value. If an impairment is identified, a loss is recorded equal to the excess of the asset’s net book value over its fair value, and the cost basis is adjusted.Goodwill and indefinite-lived intangible assets are reviewed for impairment at least annually, or more frequently if impairment indicators are present, by first assessing qualitative factors to determine whether it is more likely than not that the fair value of the intangible asset is less than its carrying amount. If we conclude it is more likely than not that the fair value is less than the carrying amount, a quantitative test that compares the fair value of the intangible asset to its carrying value is performed to determine the amount of any impairment.Several methods may be used to determine the estimated fair value of acquired IPR&D, all of which require multiple assumptions. We utilize the “income method,” as described in Note 8 to the consolidated financial statements.For acquired IPR&D assets, the risk of failure has been factored into the fair value measure and there can be no certainty that these assets ultimately will yield a successful product, as discussed previously in “Results of Operations - Executive Overview - Late-Stage Pipeline." The nature of the pharmaceutical business is high-risk and requires that we invest in a large number of projects to maintain a successful portfolio of approved products. As such, it is likely that some acquired IPR&D assets will become impaired in the future.Estimates of future cash flows, based on what we believe to be reasonable and supportable assumptions and projections, require management’s judgment. Actual results could vary materially from these estimates.Retirement Benefits AssumptionsBackground and UncertaintiesDefined benefit pension plan and retiree health benefit plan costs include assumptions for the discount rate, expected return on plan assets, and retirement age. These assumptions have a significant effect on the amounts reported. In addition to the analysis below, see Note 15 to the consolidated financial statements for additional information regarding our retirement benefits.Annually, we evaluate the discount rate and the expected return on plan assets in our defined benefit pension and retiree health benefit plans. We use an actuarially determined, plan-specific yield curve of high quality, fixed income debt instruments to determine the discount rates. In evaluating the expected return on plan assets, we consider many factors, with a primary analysis of current and projected market conditions, asset returns and asset allocations (approximately 65 percent of which are growth investments); and the views of leading financial advisers and economists. We may also review our historical assumptions compared with actual results, as well as the discount rates and expected return on plan assets of other companies, where applicable. In evaluating our expected retirement age assumption, we consider the retirement ages of our past employees eligible for pension and medical benefits together with our expectations of future retirement ages.Annually, we determine the fair value of the plan assets in our defined benefit pension and retiree health benefit plans. Approximately 35 percent of our plan assets are in hedge funds and private equity-like investment funds (collectively, alternative assets). We value these alternative investments using significant unobservable inputs or using the net asset value reported by the counterparty, adjusted as necessary. Inputs include underlying net asset values, discounted cash flows valuations, comparable market valuations, and adjustments for currency, credit, liquidity and other risks.54Financial Statement ImpactIf the 2020 discount rate for the U.S. defined benefit pension and retiree health benefit plans (U.S. plans) were to change by a quarter percentage point, income before income taxes would change by $21.6 million. If the 2020 expected return on plan assets for U.S. plans were to change by a quarter percentage point, income before income taxes would change by $28.8 million. If our assumption regarding the 2020 expected age of future retirees for U.S. plans were adjusted by one year, our income before income taxes would be affected by $52.0 million. The U.S. plans, including Puerto Rico, represent approximately 75 percent and 80 percent of the total projected benefit obligation and total plan assets, respectively, at December 31, 2020.Adjustments to the fair value of plan assets are not recognized in pension and retiree health benefit expense in the year that the adjustments occur. Such changes are deferred, along with other actuarial gains and losses, and are amortized into expense over the expected remaining service life of employees.Income TaxesBackground and UncertaintiesWe prepare and file tax returns based upon our interpretation of tax laws and regulations, and we record estimates based upon these interpretations. Our tax returns are routinely subject to examination by various taxing authorities, which could result in future tax, interest, and penalty assessments. Inherent uncertainties exist in estimates of many tax positions due to changes in tax law resulting from legislation and regulation as concluded through the various jurisdictions’ tax court systems. We recognize the tax benefit from an uncertain tax position only if it is more likely than not that the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the position. The tax benefits recognized in the financial statements from such a position are measured based on the largest benefit that has a greater than 50 percent likelihood of being realized upon ultimate resolution. The amount of unrecognized tax benefits is adjusted for changes in facts and circumstances. For example, adjustments could result from changes to existing tax law, the issuance of regulations by the taxing authorities, new information obtained during a tax examination, or resolution of a tax examination. We believe our estimates for uncertain tax positions are appropriate and sufficient to pay assessments that may result from examinations of our tax returns. We recognize both accrued interest and penalties related to unrecognized tax benefits in income tax expense.We have recorded valuation allowances against certain of our deferred tax assets, primarily those that have been generated from net operating losses and tax credit carryforwards in certain taxing jurisdictions. In evaluating whether we would more likely than not recover these deferred tax assets, we have not assumed future taxable income in the jurisdictions associated with these carryforwards where history does not support such an assumption. Implementation of tax planning strategies to recover these deferred tax assets or to generate future taxable income in these jurisdictions could lead to the reversal of all or a portion of these valuation allowances and a reduction of income tax expense.Financial Statement ImpactAs of December 31, 2020, a 5 percent change in the amount of uncertain tax positions and the valuation allowance would result in a change in net income of $83.4 million and $40.8 million, respectively.LEGAL AND REGULATORY MATTERS Information relating to certain legal proceedings can be found in Note 16 to the consolidated financial statements and is incorporated here by reference.FINANCIAL EXPECTATIONS FOR 2021 For the full year of 2021, we expect EPS to be in the range of $7.10 to $7.75, which excludes estimated acquisition and integration costs related to the acquisition of Prevail. We anticipate total revenue between $26.5 billion and $28.0 billion, including an estimated $1 billion to $2 billion of revenue from COVID-19 therapies. Revenue growth is expected to be driven by volume from Trulicity, Taltz, Verzenio, Jardiance, Olumiant, Cyramza, Emgality, Tyvyt, and Retevmo, as well as by COVID-19 therapies. Revenue growth is expected to be partially offset by lower revenue for products that have lost patent exclusivity. We expect mid-single digit net price declines globally in 2021. In the U.S., we expect low-to-mid-single digit net price declines, driven primarily by increased rebates to maintain broad commercial access and segment mix, partially offset by lower utilization in the 340B segment. Outside the U.S., we expect net price declines in China, Japan, and Europe. 55We anticipate that gross margin as a percent of revenue will be approximately 77 percent in 2021. Research and development expenses are expected to be in the range of $6.5 billion to $6.7 billion, including approximately $300 million to $400 million of continued investment in COVID-19 therapies. Marketing, selling, and administrative expenses are expected to be in the range of $6.2 billion to $6.4 billion. Other—net, (income) expense is expected to be expense in the range of $200 million to $300 million. The 2021 effective tax rate is expected to be approximately 15 percent.Item 7A.Quantitative and Qualitative Disclosures About Market RiskYou can find quantitative and qualitative disclosures about market risk (e.g., interest rate risk) at Item 7, “Management’s Discussion and Analysis - Financial Condition and Liquidity.” That information is incorporated by reference herein.56
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+ITEM 7. Management's Discussion and Analysis of Financial Condition and Results of OperationsOverviewEOG Resources, Inc., together with its subsidiaries (collectively, EOG), is one of the largest independent (non-integrated) crude oil and natural gas companies in the United States with proved reserves in the United States, Trinidad and China. EOG operates under a consistent business and operational strategy that focuses predominantly on maximizing the rate of return on investment of capital by controlling operating and capital costs and maximizing reserve recoveries. Pursuant to this strategy, each prospective drilling location is evaluated by its estimated rate of return. This strategy is intended to enhance the generation of cash flow and earnings from each unit of production on a cost-effective basis, allowing EOG to deliver long-term growth in shareholder value and maintain a strong balance sheet. EOG implements its strategy primarily by emphasizing the drilling of internally generated prospects in order to find and develop low-cost reserves. Maintaining the lowest possible operating cost structure, coupled with efficient and safe operations and robust environmental stewardship practices and performance, is integral in the implementation of EOG's strategy.EOG realized a net loss of $605 million during 2020 as compared to net income of $2,735 million for 2019. At December 31, 2020, EOG's total estimated net proved reserves were 3,220 million barrels of oil equivalent (MMBoe), a decrease of 109 MMBoe from December 31, 2019. During 2020, net proved crude oil and condensate and natural gas liquids (NGLs) reserves decreased by 108 million barrels (MMBbl), and net proved natural gas reserves decreased by 9 billion cubic feet or 1 MMBoe, in each case from December 31, 2019.Recent Developments Commodity Prices. The COVID-19 pandemic and the measures being taken to address and limit the spread of the virus have adversely affected the economies and financial markets of the world, resulting in an economic downturn that has negatively impacted, and may continue to negatively impact, global demand and prices for crude oil and condensate, NGLs and natural gas. See ITEM 1A, Risk Factors for further discussion. In early March 2020, due to the failure of the members of the Organization of the Petroleum Exporting Countries and Russia (OPEC+) to reach an agreement on individual crude oil production limits, Saudi Arabia unilaterally reduced the sales price of its crude oil and announced that it would increase its crude oil production. The combination of these actions, and the effects of the COVID-19 pandemic on crude oil demand, resulted in significantly lower commodity prices in March and April 2020. In April 2020, the members of OPEC+ reached an agreement to cut crude oil production beginning in May 2020 and extending through April 2022 with the quantity of the production cuts decreasing over time. Subsequent indications of conformity with these agreed-upon production cuts by OPEC+, combined with the evolving impacts of COVID-19 on crude oil demand, have resulted in gradually-improving market conditions. In the second half of 2020, crude oil prices increased, but remain significantly below average prices in 2019, as a result of the continuing rebalancing of crude oil supply resulting from the actions of OPEC+ and the continuing effect of the COVID-19 pandemic on global demand. In addition, NGL and natural gas prices have recovered to pre-pandemic levels.In response to the commodity price environment in 2020, EOG reduced activity across its operating areas and decreased its total capital expenditures. EOG also elected to reduce crude oil production, by delaying initial production from new wells and shutting-in or otherwise curtailing existing production. In early 2021, the members of OPEC+ met and agreed to taper off certain of their production curtailments (agreed to in April 2020) through March 2021. Subsequent to the meeting, Saudi Arabia announced that it would unilaterally cut its production by an additional one million barrels per day in February 2021 and March 2021. These announcements have had a positive impact on crude oil prices.As a result of the many uncertainties associated with (i) the world economic environment, (ii) the COVID-19 pandemic and its continuing effect on the economies and financial markets of the world and (iii) any future actions by the members of OPEC+, and the effect of these uncertainties on worldwide supplies of, and demand for, crude oil and condensate, NGLs and natural gas, EOG is unable to predict what changes may occur in crude oil and condensate, NGLs and natural gas prices in the future. However, prices for crude oil and condensate, NGLs and natural gas have historically been volatile, and this volatility is expected to continue. For related discussion, see ITEM 1A, Risk Factors.EOG will continue to monitor future market conditions and adjust its capital allocation strategy and production outlook accordingly in order to maximize shareholder value while maintaining its strong financial position.332020 Election. In November 2020, Joseph R. Biden Jr. was elected President of the United States. On January 27, 2021, President Biden issued Executive Order 14008 entitled "Tackling the Climate Crisis at Home and Abroad," directing the Secretary of the Interior, to the extent consistent with applicable law and in consultation with other agencies and stakeholders, to (i) pause approval of new oil and natural gas leases on federal lands or in offshore waters pending completion of a comprehensive review and reconsideration of federal oil and gas permitting and leasing practices and (ii) consider whether to adjust royalties associated with oil and gas resources extracted from federal lands and offshore waters to account for corresponding climate costs. In addition, new or revised rules, regulations and policies may be issued, and new legislation may be proposed, during the current administration that could impact the oil and gas exploration and production industry. Such rules, regulations, policies and legislation may affect, among other things, (i) permitting for oil and gas drilling on federal lands, (ii) the leasing of federal lands for oil and gas development, (iii) the regulation of greenhouse gas emissions and/or other climate change-related matters associated with oil and gas operations, (iv) the use of hydraulic fracturing on federal lands, (v) the calculation of royalty payments in respect of oil and gas production from federal lands and (vi) U.S. federal income tax laws applicable to oil and gas exploration and production companies. See "Regulation" in ITEM 1, Business and ITEM 1A, Risk Factors for further discussion.EOG will continue to monitor and assess any actions that could impact the oil and gas industry, to determine the impact on its business and operations, and take appropriate actions where necessary.OperationsSeveral important developments have occurred since January 1, 2020.United States. EOG's efforts to identify plays with large reserve potential have proven to be successful. EOG continues to drill numerous wells in large acreage plays, which in the aggregate have contributed substantially to, and are expected to continue to contribute substantially to, EOG's crude oil and condensate, NGLs and natural gas production. EOG has placed an emphasis on applying its horizontal drilling and completion expertise to unconventional crude oil and liquids-rich reservoirs.During 2020, EOG continued to focus on increasing drilling, completion and operating efficiencies gained in prior years. Such efficiencies, combined with new innovation and decreased service costs, resulted in lower operating, drilling and completion costs in 2020. In addition, EOG continued to evaluate certain potential crude oil and condensate, NGLs and natural gas exploration and development prospects and to look for opportunities to add drilling inventory through leasehold acquisitions, farm-ins, exchanges or tactical acquisitions. On a volumetric basis, as calculated using a ratio of 1.0 barrel of crude oil and condensate or NGLs to 6.0 thousand cubic feet of natural gas, crude oil and condensate and NGLs production accounted for approximately 76% and 77% of United States production during 2020 and 2019, respectively. During 2020, drilling and completion activities occurred primarily in the Delaware Basin play, Eagle Ford play and Rocky Mountain area. EOG's major producing areas in the United States are in New Mexico and Texas. In the second quarter of 2020, EOG delayed initial production from most newly-completed wells and shut in some existing production. During the third quarter of 2020, EOG resumed the process of initiating production from completed wells, and the legacy wells that were shut-in were largely brought back on-line. See ITEM 1, Business - Exploration and Production for further discussion.Trinidad. In Trinidad, EOG continues to deliver natural gas under existing supply contracts. Several fields in the South East Coast Consortium Block, Modified U(a) Block, Block 4(a), Modified U(b) Block, the Banyan Field and the Sercan Area have been developed and are producing natural gas, which is sold to the National Gas Company of Trinidad and Tobago Limited and its subsidiary, and crude oil and condensate which is sold to Heritage Petroleum Company Limited. In 2020, EOG drilled three net wells and completed two net wells in Trinidad. The remaining net well made a discovery that is being evaluated.Other International. In the Sichuan Basin, Sichuan Province, China, EOG continues to work with its partner, PetroChina, under the Production Sharing Contract and other related agreements, to ensure uninterrupted production. All natural gas produced from the Baijaochang Field is sold under a long-term contract to PetroChina. In 2020, EOG entered into two agreements related to exploration and production rights in the Sultanate of Oman (Oman). One agreement resulted in EOG acquiring exploration and production rights to Block 36 within Oman. The second agreement was a farm-in agreement allowing EOG to share in exploration and production rights within Block 49. Pursuant to that agreement, EOG participated in the drilling of one gross exploratory well which was in progress as of December 31, 2020.In March 2020, EOG began the process of exiting its Canada operations.34EOG continues to evaluate other select crude oil and natural gas opportunities outside the United States, primarily by pursuing exploitation opportunities in countries where indigenous crude oil and natural gas reserves have been identified.Capital StructureOne of management's key strategies is to maintain a strong balance sheet with a consistently below average debt-to-total capitalization ratio as compared to those in EOG's peer group. EOG's debt-to-total capitalization ratio was 22% at December 31, 2020 and 19% at December 31, 2019. As used in this calculation, total capitalization represents the sum of total current and long-term debt and total stockholders' equity. On April 1, 2020, EOG repaid upon maturity the $500 million aggregate principal amount of its 2.45% Senior Notes due 2020.On April 14, 2020, EOG closed on its offering of $750 million aggregate principal amount of its 4.375% Senior Notes due 2030 and $750 million aggregate principal amount of its 4.950% Senior Notes due 2050 (together, the Notes). EOG received net proceeds of $1.48 billion from the issuance of the Notes, which were used to repay the 4.40% Senior Notes due 2020 when they matured on June 1, 2020 (see below), and for general corporate purposes, including the funding of capital expenditures.On June 1, 2020, EOG repaid upon maturity the $500 million aggregate principal amount of its 4.40% Senior Notes due 2020.On February 1, 2021, EOG repaid upon maturity the $750 million aggregate principal amount of its 4.100% Senior Notes due 2021.During 2020, EOG funded $4.0 billion ($386 million of which was non-cash) in exploration and development and other property, plant and equipment expenditures (excluding asset retirement obligations), repaid $1.0 billion aggregate principal amount of long-term debt and paid $821 million in dividends to common stockholders, primarily by utilizing net cash provided from its operating activities, net proceeds of $1.48 billion from the issuance of the Notes and net proceeds of $192 million from the sale of assets.Total anticipated 2021 capital expenditures are estimated to range from approximately $3.7 billion to $4.1 billion, excluding acquisitions and non-cash transactions. The majority of 2021 expenditures will be focused on United States crude oil drilling activities. EOG has significant flexibility with respect to financing alternatives, including borrowings under its commercial paper program, bank borrowings, borrowings under its senior unsecured revolving credit facility, joint development agreements and similar agreements and equity and debt offerings.Management continues to believe EOG has one of the strongest prospect inventories in EOG's history. When it fits EOG's strategy, EOG will make acquisitions that bolster existing drilling programs or offer incremental exploration and/or production opportunities. 35Results of OperationsThe following review of operations for each of the three years in the period ended December 31, 2020, should be read in conjunction with the consolidated financial statements of EOG and notes thereto beginning on page F-1.Operating Revenues and OtherDuring 2020, operating revenues decreased $6,348 million, or 37%, to $11,032 million from $17,380 million in 2019. Total wellhead revenues, which are revenues generated from sales of EOG's production of crude oil and condensate, NGLs and natural gas, decreased $4,291, or 37%, to $7,290 million in 2020 from $11,581 million in 2019. Revenues from the sales of crude oil and condensate and NGLs in 2020 were approximately 89% of total wellhead revenues compared to 90% in 2019. During 2020, EOG recognized net gains on the mark-to-market of financial commodity derivative contracts of $1,145 million compared to net gains of $180 million in 2019. Gathering, processing and marketing revenues decreased $2,777 million during 2020, to $2,583 million from $5,360 million in 2019. Net losses on asset dispositions of $47 million in 2020 were primarily due to the sales of proved properties and non-cash property exchanges of unproved leasehold in Texas and New Mexico and the disposition of the Marcellus Shale assets compared to net gains on asset dispositions of $124 million in 2019.36Wellhead volume and price statistics for the years ended December 31, 2020, 2019 and 2018 were as follows:Year Ended December 31202020192018Crude Oil and Condensate Volumes (MBbld) (1)United States408.1 455.5 394.8 Trinidad1.0 0.6 0.8 Other International (2)0.1 0.1 4.3 Total409.2 456.2 399.9 Average Crude Oil and Condensate Prices ($/Bbl) (3) United States$38.65 $57.74 $65.16 Trinidad30.20 47.16 57.26 Other International (2)43.08 57.40 71.45 Composite38.63 57.72 65.21 Natural Gas Liquids Volumes (MBbld) (1)United States136.0 134.1 116.1 Other International (2)— — — Total136.0 134.1 116.1 Average Natural Gas Liquids Prices ($/Bbl) (3) United States$13.41 $16.03 $26.60 Other International (2)— — — Composite13.41 16.03 26.60 Natural Gas Volumes (MMcfd) (1)United States1,040 1,069 923 Trinidad180 260 266 Other International (2)32 37 30 Total1,252 1,366 1,219 Average Natural Gas Prices ($/Mcf) (3) United States$1.61 $2.22 $2.88 Trinidad2.57 2.72 2.94 Other International (2)4.66 4.44 4.08 Composite1.83 2.38 2.92 Crude Oil Equivalent Volumes (MBoed) (4)United States717.5 767.8 664.7 Trinidad30.9 44.0 45.1 Other International (2)5.4 6.2 9.4 Total753.8 818.0 719.2 Total MMBoe (4)275.9 298.6 262.5 (1) Thousand barrels per day or million cubic feet per day, as applicable.(2)Other International includes EOG's United Kingdom, China and Canada operations. The United Kingdom operations were sold in the fourth quarter of 2018.(3)Dollars per barrel or per thousand cubic feet, as applicable. Excludes the impact of financial commodity derivative instruments (see Note 12 to Consolidated Financial Statements).(4)Thousand barrels of oil equivalent per day or million barrels of oil equivalent, as applicable; includes crude oil and condensate, NGLs and natural gas. Crude oil equivalent volumes are determined using a ratio of 1.0 barrel of crude oil and condensate or NGLs to 6.0 thousand cubic feet of natural gas. MMBoe is calculated by multiplying the MBoed amount by the number of days in the period and then dividing that amount by one thousand.372020 compared to 2019. Wellhead crude oil and condensate revenues in 2020 decreased $3,827 million, or 40%, to $5,786 million from $9,613 million in 2019, due primarily to a lower composite average wellhead crude oil and condensate price ($2,860 million) and a decrease in production ($967 million). EOG's composite wellhead crude oil and condensate price for 2020 decreased 33% to $38.63 per barrel compared to $57.72 per barrel in 2019. Wellhead crude oil and condensate production in 2020 decreased 10% to 409 MBbld as compared to 456 MBbld in 2019. The decreased production was primarily in the Eagle Ford and the Rocky Mountain area, partially offset by increased production in the Permian Basin.NGLs revenues in 2020 decreased $116 million, or 15%, to $668 million from $784 million in 2019 primarily due to a lower composite average wellhead NGLs price ($130 million), partially offset by an increase in production ($13 million). EOG's composite average wellhead NGLs price decreased 16% to $13.41 per barrel in 2020 compared to $16.03 per barrel in 2019. NGL production in 2020 increased 1% to 136 MBbld as compared to 134 MBbld in 2019. The increased production was primarily in the Permian Basin, partially offset by decreased production in the Eagle Ford.Wellhead natural gas revenues in 2020 decreased $347 million, or 29%, to $837 million from $1,184 million in 2019, primarily due to a lower composite wellhead natural gas price ($251 million) and a decrease in natural gas deliveries ($96 million). EOG's composite average wellhead natural gas price decreased 23% to $1.83 per Mcf in 2020 compared to $2.38 per Mcf in 2019. Natural gas deliveries in 2020 decreased 8% to 1,252 MMcfd as compared to 1,366 MMcfd in 2019. The decrease in production was primarily due to lower natural gas volumes in Trinidad, the Marcellus Shale and the Rocky Mountain area, partially offset by increased production of associated natural gas from the Permian Basin.During 2020, EOG recognized net gains on the mark-to-market of financial commodity derivative contracts of $1,145 million, which included net cash received for settlements of crude oil, NGL and natural gas financial derivative contracts of $1,071 million. During 2019, EOG recognized net gains on the mark-to-market of financial commodity derivative contracts of $180 million, which included net cash received for settlements of crude oil and natural gas financial derivative contracts of $231 million. Gathering, processing and marketing revenues are revenues generated from sales of third-party crude oil, NGLs and natural gas, as well as fees associated with gathering third-party natural gas and revenues from sales of EOG-owned sand. Purchases and sales of third-party crude oil and natural gas may be utilized in order to balance firm transportation capacity with production in certain areas and to utilize excess capacity at EOG-owned facilities. EOG sells sand in order to balance the timing of firm purchase agreements with completion operations and to utilize excess capacity at EOG-owned facilities. Marketing costs represent the costs to purchase third-party crude oil, natural gas and sand and the associated transportation costs, as well as costs associated with EOG-owned sand sold to third parties.Gathering, processing and marketing revenues less marketing costs in 2020 decreased $124 million compared to 2019, primarily due to lower margins on crude oil and condensate marketing activities. The margin on crude oil marketing activities in 2020 was negatively impacted by the price decline for crude oil in inventory awaiting delivery to customers and EOG's decision early in the second quarter of 2020 to reduce commodity price volatility by selling May and June 2020 deliveries under fixed price arrangements.2019 compared to 2018. Wellhead crude oil and condensate revenues in 2019 increased $96 million, or 1%, to $9,613 million from $9,517 million in 2018, due primarily to an increase in production ($1,351 million); partially offset by a lower composite average wellhead crude oil and condensate price ($1,255 million). EOG's composite wellhead crude oil and condensate price for 2019 decreased 11% to $57.72 per barrel compared to $65.21 per barrel in 2018. Wellhead crude oil and condensate production in 2019 increased 14% to 456 MBbld as compared to 400 MBbld in 2018. The increased production was primarily in the Permian Basin and the Eagle Ford.NGLs revenues in 2019 decreased $343 million, or 30%, to $784 million from $1,127 million in 2018 primarily due to a lower composite average wellhead NGLs price ($518 million), partially offset by an increase in production ($175 million). EOG's composite average wellhead NGLs price decreased 40% to $16.03 per barrel in 2019 compared to $26.60 per barrel in 2018. NGL production in 2019 increased 16% to 134 MBbld as compared to 116 MBbld in 2018. The increased production was primarily in the Permian Basin.Wellhead natural gas revenues in 2019 decreased $118 million, or 9%, to $1,184 million from $1,302 million in 2018, primarily due to a lower composite wellhead natural gas price ($280 million), partially offset by an increase in natural gas deliveries ($162 million). EOG's composite average wellhead natural gas price decreased 18% to $2.38 per Mcf in 2019 compared to $2.92 per Mcf in 2018. Natural gas deliveries in 2019 increased 12% to 1,366 MMcfd as compared to 1,219 MMcfd in 2018. The increase in production was primarily due to higher deliveries in the United States resulting from increased production of associated natural gas from the Permian Basin and higher natural gas volumes in South Texas. 38During 2019, EOG recognized net gains on the mark-to-market of financial commodity derivative contracts of $180 million, which included net cash received for settlements of crude oil and natural gas financial derivative contracts of $231 million. During 2018, EOG recognized net losses on the mark-to-market of financial commodity derivative contracts of $166 million, which included net cash paid for settlements of crude oil and natural gas financial derivative contracts of $259 million. Gathering, processing and marketing revenues less marketing costs in 2019 decreased $18 million compared to 2018, primarily due to lower margins on crude oil and condensate marketing activities, partially offset by higher margins on natural gas marketing activities.Operating and Other Expenses2020 compared to 2019. During 2020, operating expenses of $11,576 million were $2,105 million lower than the $13,681 million incurred during 2019. The following table presents the costs per barrel of oil equivalent (Boe) for the years ended December 31, 2020 and 2019: 20202019Lease and Well$3.85 $4.58 Transportation Costs2.66 2.54 Depreciation, Depletion and Amortization (DD&A) -Oil and Gas Properties11.85 12.25 Other Property, Plant and Equipment0.47 0.31 General and Administrative (G&A)1.75 1.64 Net Interest Expense0.74 0.62 Total (1)$21.32 $21.94 (1)Total excludes gathering and processing costs, exploration costs, dry hole costs, impairments, marketing costs and taxes other than income.The primary factors impacting the cost components of per-unit rates of lease and well, transportation costs, DD&A, G&A and net interest expense for 2020 compared to 2019 are set forth below. See "Operating Revenues and Other" above for a discussion of production volumes.Lease and well expenses include expenses for EOG-operated properties, as well as expenses billed to EOG from other operators where EOG is not the operator of a property. Lease and well expenses can be divided into the following categories: costs to operate and maintain crude oil and natural gas wells, the cost of workovers and lease and well administrative expenses. Operating and maintenance costs include, among other things, pumping services, salt water disposal, equipment repair and maintenance, compression expense, lease upkeep and fuel and power. Workovers are operations to restore or maintain production from existing wells.Each of these categories of costs individually fluctuates from time to time as EOG attempts to maintain and increase production while maintaining efficient, safe and environmentally responsible operations. EOG continues to increase its operating activities by drilling new wells in existing and new areas. Operating and maintenance costs within these existing and new areas, as well as the costs of services charged to EOG by vendors, fluctuate over time. Lease and well expenses of $1,063 million in 2020 decreased $304 million from $1,367 million in 2019 primarily due to lower operating and maintenance costs in the United States ($157 million) and in Canada ($25 million), lower workovers expenditures in the United States ($103 million) and lower lease and well administrative expenses in the United States ($12 million). Lease and well expenses decreased in the United States primarily due to decreased operating activities resulting from decreased production, efficiency improvements and service cost reductions.Transportation costs represent costs associated with the delivery of hydrocarbon products from the lease or an aggregation point on EOG's gathering system to a downstream point of sale. Transportation costs include transportation fees, the cost of compression (the cost of compressing natural gas to meet pipeline pressure requirements), the cost of dehydration (the cost associated with removing water from natural gas to meet pipeline requirements), gathering fees and fuel costs.39Transportation costs of $735 million in 2020 decreased $23 million from $758 million in 2019 primarily due to decreased transportation costs in the Fort Worth Basin Barnett Shale ($27 million), the Rocky Mountain area ($24 million) and the Eagle Ford ($20 million), partially offset by increased transportation costs in the Permian Basin ($56 million).DD&A of the cost of proved oil and gas properties is calculated using the unit-of-production method. EOG's DD&A rate and expense are the composite of numerous individual DD&A group calculations. There are several factors that can impact EOG's composite DD&A rate and expense, such as field production profiles, drilling or acquisition of new wells, disposition of existing wells and reserve revisions (upward or downward) primarily related to well performance, economic factors and impairments. Changes to these factors may cause EOG's composite DD&A rate and expense to fluctuate from period to period. DD&A of the cost of other property, plant and equipment is generally calculated using the straight-line depreciation method over the useful lives of the assets. DD&A expenses in 2020 decreased $350 million to $3,400 million from $3,750 million in 2019. DD&A expenses associated with oil and gas properties in 2020 were $390 million lower than in 2019 primarily due to a decrease in production in the United States ($222 million) and Trinidad ($22 million) and lower unit rates in the United States ($150 million). Unit rates in the United States decreased primarily due to upward reserve revisions and reserves added at lower costs as a result of increased efficiencies. DD&A expenses associated with other property, plant and equipment in 2020 were $40 million higher than in 2019 primarily due to an increase in expense related to gathering and storage assets and equipment.G&A expenses of $484 million in 2020 decreased $5 million from $489 million in 2019 primarily due to decreased employee-related expenses ($43 million) and professional and other services ($7 million), partially offset by idle equipment and termination fees ($46 million).Net interest expense of $205 million in 2020 was $20 million higher than 2019 primarily due to the issuance of the Notes in April 2020 ($51 million) and lower capitalized interest ($7 million), partially offset by repayment in June 2019 of the $900 million aggregate principal amount of 5.625% Senior Notes due 2019 ($21 million), repayment in June 2020 of the $500 million aggregate principal amount of 4.40% Senior Notes due 2020 ($13 million) and repayment in April 2020 of the $500 million aggregate principal amount of 2.45% Senior Notes due 2020 ($10 million).Gathering and processing costs represent operating and maintenance expenses and administrative expenses associated with operating EOG's gathering and processing assets as well as natural gas processing fees and certain NGLs fractionation fees paid to third parties. EOG pays third parties to process the majority of its natural gas production to extract NGLs. Gathering and processing costs decreased $20 million to $459 million in 2020 compared to $479 million in 2019 primarily due to decreased operating costs in the Eagle Ford ($16 million) and decreased gathering and processing fees in the Eagle Ford ($9 million) and the Fort Worth Basin Barnett Shale ($5 million); partially offset by increased gathering and processing fees in the Permian Basin ($15 million).Exploration costs of $146 million in 2020 increased $6 million from $140 million in 2019 primarily due to increased geological and geophysical expenditures in the United States ($15 million), partially offset by decreased general and administrative expenses in the United States ($8 million).Impairments include: amortization of unproved oil and gas property costs as well as impairments of proved oil and gas properties; other property, plant and equipment; and other assets. Unproved properties with acquisition costs that are not individually significant are aggregated, and the portion of such costs estimated to be nonproductive is amortized over the remaining lease term. Unproved properties with individually significant acquisition costs are reviewed individually for impairment. When circumstances indicate that a proved property may be impaired, EOG compares expected undiscounted future cash flows at a DD&A group level to the unamortized capitalized cost of the asset. If the expected undiscounted future cash flows, based on EOG's estimates of (and assumptions regarding) future crude oil, NGLs and natural gas prices, operating costs, development expenditures, anticipated production from proved reserves and other relevant data, are lower than the unamortized capitalized cost, the capitalized cost is reduced to fair value. Fair value is generally calculated by using the Income Approach described in the Fair Value Measurement Topic of the Financial Accounting Standards Board's Accounting Standards Codification (ASC). In certain instances, EOG utilizes accepted offers from third-party purchasers as the basis for determining fair value.40The following table represents impairments for the years ended December 31, 2020 and 2019 (in millions): 20202019Proved properties$1,268 $207 Unproved properties472 220 Other assets300 91 Firm commitment contracts60 — Total$2,100 $518 Impairments of proved properties were primarily due to the write-down to fair value of legacy and non-core natural gas and crude oil and combo plays in 2020 and legacy natural gas assets in 2019. Taxes other than income include severance/production taxes, ad valorem/property taxes, payroll taxes, franchise taxes and other miscellaneous taxes. Severance/production taxes are generally determined based on wellhead revenues, and ad valorem/property taxes are generally determined based on the valuation of the underlying assets.Taxes other than income in 2020 decreased $322 million to $478 million (6.6% of wellhead revenues) from $800 million (6.9% of wellhead revenues) in 2019. The decrease in taxes other than income was primarily due to decreased severance/production taxes in the United States ($232 million), decreased ad valorem/property taxes in the United States ($51 million) and a state severance tax refund ($27 million).Other income, net, was $10 million in 2020 compared to other income, net, of $31 million in 2019. The decrease of $21 million in 2020 was primarily due to a decrease in interest income.In response to the economic impacts of the COVID-19 pandemic, the President of the United States signed the Coronavirus Aid, Relief, and Economic Security Act (the CARES Act) into law on March 27, 2020. The CARES Act provides economic support to individuals and businesses through enhanced loan programs, expanded unemployment benefits, and certain payroll and income tax relief, among other provisions. The primary tax benefit of the CARES Act for EOG was the acceleration of approximately $150 million of additional refundable alternative minimum tax (AMT) credits into tax year 2019. These credits originated from AMT paid by EOG in years prior to 2018 and were reflected as a deferred tax asset and a non-current receivable as of December 31, 2019 since they had been expected to either offset future current tax liabilities or be refunded on a declining balance schedule through 2021. The $150 million of additional refundable AMT credits was received in July 2020.Further pandemic relief was contained in the Consolidated Appropriations Act of 2021 (the CA Act) which was signed into law by the President of the United States on December 27, 2020. In addition, the CA Act provided government funding and limited corporate income tax relief primarily related to making permanent or extending certain tax provisions, none of which were a material benefit for EOG.EOG recognized an income tax benefit of $135 million in 2020 compared to an income tax provision of $810 million in 2019, primarily due to decreased pretax income. The net effective tax rate for 2020 decreased to 18% from 23% in 2019. The lower effective tax rate is mostly due to taxes attributable to EOG's foreign operations and increased stock-based compensation tax deficiencies.412019 compared to 2018. During 2019, operating expenses of $13,681 million were $875 million higher than the $12,806 million incurred during 2018. The following table presents the costs per Boe for the years ended December 31, 2019 and 2018: 20192018Lease and Well$4.58 $4.89 Transportation Costs2.54 2.85 Depreciation, Depletion and Amortization (DD&A) -Oil and Gas Properties12.25 12.65 Other Property, Plant and Equipment0.31 0.44 General and Administrative (G&A)1.64 1.63 Net Interest Expense0.62 0.93 Total (1)$21.94 $23.39 (1)Total excludes gathering and processing costs, exploration costs, dry hole costs, impairments, marketing costs and taxes other than income.The primary factors impacting the cost components of per-unit rates of lease and well, transportation costs, DD&A, G&A and net interest expense for 2019 compared to 2018 are set forth below. See "Operating Revenues and Other" above for a discussion of production volumes.Lease and well expenses of $1,367 million in 2019 increased $84 million from $1,283 million in 2018 primarily due to higher operating and maintenance costs ($76 million) and higher lease and well administrative expenses ($29 million) in the United States, partially offset by lower operating and maintenance costs in the United Kingdom ($15 million) due to the sale of operations in the fourth quarter of 2018 and in Canada ($11 million). Lease and well expenses increased in the United States primarily due to increased operating activities resulting in increased production.Transportation costs of $758 million in 2019 increased $11 million from $747 million in 2018 primarily due to increased transportation costs in the Permian Basin ($91 million) and South Texas ($11 million), partially offset by decreased transportation costs in the Eagle Ford ($77 million) and the Fort Worth Basin Barnett Shale ($13 million).DD&A expenses in 2019 increased $315 million to $3,750 million from $3,435 million in 2018. DD&A expenses associated with oil and gas properties in 2019 were $337 million higher than in 2018 primarily due to an increase in production in the United States ($489 million), partially offset by lower unit rates in the United States ($119 million) and the sale of the United Kingdom operations in the fourth quarter of 2018 ($33 million). Unit rates in the United States decreased primarily due to upward reserve revisions and reserves added at lower costs as a result of increased efficiencies.G&A expenses of $489 million in 2019 increased $62 million from $427 million in 2018 primarily due to increased employee-related expenses ($48 million) and increased information systems costs ($8 million) resulting from expanded operations.Net interest expense of $185 million in 2019 was $60 million lower than 2018 primarily due to repayment of the $900 million aggregate principal amount of 5.625% Senior Notes due 2019 in June 2019 ($30 million) and the $350 million aggregate principal amount of 6.875% Senior Notes due 2018 in October 2018 ($18 million) and an increase in capitalized interest ($14 million). Gathering and processing costs increased $42 million to $479 million in 2019 compared to $437 million in 2018 primarily due to increased operating costs and fees in the Permian Basin ($52 million), the Rocky Mountain area ($13 million) and South Texas ($5 million); partially offset by decreased operating costs in the United Kingdom ($33 million) due to the sale of operations in the fourth quarter of 2018.Exploration costs of $140 million in 2019 decreased $9 million from $149 million in 2018 primarily due to decreased geological and geophysical expenditures in the Trinidad ($17 million), partially offset by increased general and administrative expenses in the United States ($7 million).42The following table represents impairments for the years ended December 31, 2019 and 2018 (in millions): 20192018Proved properties$207 $121 Unproved properties220 173 Other assets91 49 Inventories— 4 Total$518 $347 Impairments of proved properties were primarily due to the write-down to fair value of legacy natural gas assets in 2019 and 2018. Taxes other than income in 2019 increased $28 million to $800 million (6.9% of wellhead revenues) from $772 million (6.5% of wellhead revenues) in 2018. The increase in taxes other than income was primarily due to an increase in ad valorem/property taxes ($53 million), partially offset by an increase in credits available to EOG in 2019 for state incentive severance tax rate reductions ($12 million) and a decrease in severance/production taxes ($12 million) primarily as a result of decreased wellhead revenues, all in the United States.Other income, net, was $31 million in 2019 compared to other income, net, of $17 million in 2018. The increase of $14 million in 2019 was primarily due to an increase in interest income ($14 million) and an increase in foreign currency transaction gains ($9 million), partially offset by an increase in deferred compensation expense ($4 million).EOG recognized an income tax provision of $810 million in 2019 compared to an income tax provision of $822 million in 2018, primarily due to decreased pretax income, partially offset by the absence of tax benefits from certain tax reform measurement-period adjustments. The net effective tax rate for 2019 increased to 23% from 19% in the prior year, primarily due to the absence of tax benefits from certain tax reform measurement-period adjustments.Capital Resources and LiquidityCash FlowThe primary sources of cash for EOG during the three-year period ended December 31, 2020, were funds generated from operations, net proceeds from the issuance of long-term debt, net cash received from settlements of commodity derivative contracts and proceeds from asset sales. The primary uses of cash were funds used in operations; exploration and development expenditures; repayments of debt; dividend payments to stockholders and other property, plant and equipment expenditures.2020 compared to 2019. Net cash provided by operating activities of $5,008 million in 2020 decreased $3,155 million from $8,163 million in 2019 primarily due to a decrease in wellhead revenues ($4,291 million); unfavorable changes in working capital and other assets and liabilities ($166 million); a decrease in gathering, processing and marketing revenues less marketing costs ($124 million) and an increase in net cash paid for income taxes ($86 million); partially offset by an increase in cash received for settlements of commodity derivative contracts ($840 million) and a decrease in cash operating expenses ($641 million).Net cash used in investing activities of $3,348 million in 2020 decreased by $2,829 million from $6,177 million in 2019 primarily due to a decrease in additions to oil and gas properties ($2,908 million); an increase in proceeds from the sale of assets ($52 million); a decrease in additions to other property, plant and equipment ($49 million); and a decrease in other investing activities ($10 million); partially offset by an unfavorable change in working capital associated with investing activities ($190 million).Net cash used in financing activities of $359 million in 2020 included repayments of long-term debt ($1,000 million), cash dividend payments ($821 million), repayment of finance lease liabilities ($19 million) and purchases of treasury stock in connection with stock compensation plans ($16 million). Cash provided by financing activities in 2020 included long-term debt borrowings ($1,484 million) and proceeds from stock options exercised and employee stock purchase plan activity ($16 million). 432019 compared to 2018. Net cash provided by operating activities of $8,163 million in 2019 increased $394 million from $7,769 million in 2018 primarily reflecting an increase in cash received for settlements of commodity derivative contracts ($490 million), a decrease in net cash paid for income taxes ($367 million) and favorable changes in working capital and other assets and liabilities ($122 million); partially offset by a decrease in wellhead revenues ($365 million) and an increase in cash operating expenses ($202 million).Net cash used in investing activities of $6,177 million in 2019 increased by $7 million from $6,170 million in 2018 primarily due to an increase in additions to oil and gas properties ($313 million), a decrease in proceeds from the sale of assets ($87 million) and an increase in additions to other property, plant and equipment ($33 million); partially offset by favorable changes in working capital associated with investing activities ($416 million) and a decrease in other investing activities ($10 million).Net cash used in financing activities of $1,513 million in 2019 included repayments of long-term debt ($900 million), cash dividend payments ($588 million) and purchases of treasury stock in connection with stock compensation plans ($25 million). Cash provided by financing activities in 2019 included proceeds from stock options exercised and employee stock purchase plan activity ($18 million). Total ExpendituresThe table below sets out components of total expenditures for the years ended December 31, 2020, 2019 and 2018 (in millions): 202020192018Expenditure CategoryCapitalExploration and Development Drilling$2,664 $4,951 $4,935 Facilities347 629 625 Leasehold Acquisitions (1)265 276 488 Property Acquisitions (2)135 380 124 Capitalized Interest31 38 24 Subtotal3,442 6,274 6,196 Exploration Costs146 140 149 Dry Hole Costs13 28 5 Exploration and Development Expenditures3,601 6,442 6,350 Asset Retirement Costs117 186 70 Total Exploration and Development Expenditures3,718 6,628 6,420 Other Property, Plant and Equipment (3)395 272 286 Total Expenditures$4,113 $6,900 $6,706 (1)Leasehold acquisitions included $197 million, $98 million and $291 million related to non-cash property exchanges in 2020, 2019 and 2018, respectively.(2)Property acquisitions included $15 million, $52 million and $71 million related to non-cash property exchanges in 2020, 2019 and 2018, respectively.(3)Other property, plant and equipment included non-cash additions of $174 million, primarily related to finance lease transactions for storage facilities, and $49 million, primarily related to a finance lease transaction in the Permian Basin, in 2020 and 2018, respectively.44Exploration and development expenditures of $3,601 million for 2020 were $2,841 million lower than the prior year. The decrease was primarily due to decreased exploration and development drilling expenditures in the United States ($2,309 million), decreased facilities expenditures ($282 million) and decreased property acquisitions ($245 million), partially offset by increased exploration and development drilling expenditures in Trinidad ($27 million). The 2020 exploration and development expenditures of $3,601 million included $2,905 million in development drilling and facilities, $530 million in exploration, $135 million in property acquisitions and $31 million in capitalized interest. The 2019 exploration and development expenditures of $6,442 million included $5,513 million in development drilling and facilities, $511 million in exploration, $380 million in property acquisitions and $38 million in capitalized interest. The 2018 exploration and development expenditures of $6,350 million included $5,546 million in development drilling and facilities, $656 million in exploration, $124 million in property acquisitions and $24 million in capitalized interest. The level of exploration and development expenditures, including acquisitions, will vary in future periods depending on energy market conditions and other economic factors. EOG believes it has significant flexibility and availability with respect to financing alternatives and the ability to adjust its exploration and development expenditure budget as circumstances warrant. While EOG has certain continuing commitments associated with expenditure plans related to its operations, such commitments are not expected to be material when considered in relation to the total financial capacity of EOG.Commodity Derivative TransactionsCrude Oil Derivative Contracts. Prices received by EOG for its crude oil production generally vary from U.S. New York Mercantile Exchange (NYMEX) West Texas Intermediate (WTI) prices due to adjustments for delivery location (basis) and other factors. EOG has entered into crude oil basis swap contracts in order to fix the differential between Intercontinental Exchange (ICE) Brent pricing and pricing in Cushing, Oklahoma (ICE Brent Differential). Presented below is a comprehensive summary of EOG's ICE Brent Differential basis swap contracts through February 18, 2021. The weighted average price differential expressed in $/Bbl represents the amount of addition to Cushing, Oklahoma, prices for the notional volumes expressed in Bbld covered by the basis swap contracts. ICE Brent Differential Basis Swap Contracts Volume (Bbld)Weighted Average Price Differential($/Bbl)2020May 2020 (closed)10,000 $4.92 EOG has also entered into crude oil basis swap contracts in order to fix the differential between pricing in Houston, Texas, and Cushing, Oklahoma (Houston Differential). Presented below is a comprehensive summary of EOG's Houston Differential basis swap contracts through February 18, 2021. The weighted average price differential expressed in $/Bbl represents the amount of addition to Cushing, Oklahoma, prices for the notional volumes expressed in Bbld covered by the basis swap contracts.Houston Differential Basis Swap Contracts Volume (Bbld)Weighted Average Price Differential($/Bbl)2020May 2020 (closed)10,000 $1.55 45EOG has also entered into crude oil swaps in order to fix the differential in pricing between the NYMEX calendar month average and the physical crude oil delivery month (Roll Differential). Presented below is a comprehensive summary of EOG's Roll Differential basis swap contracts through February 18, 2021. The weighted average price differential expressed in $/Bbl represents the amount of net addition (reduction) to delivery month prices for the notional volumes expressed in Bbld covered by the swap contracts.Roll Differential Basis Swap Contracts Volume (Bbld)Weighted Average Price Differential($/Bbl)2020February 1, 2020 through June 30, 2020 (closed)10,000 $0.70 July 1, 2020 through September 30, 2020 (closed)88,000 (1.16)October 1, 2020 through December 31, 2020 (closed)66,000 (1.16)2021February 2021 (closed)30,000 $0.11 March 1, 2021 through December 31, 2021125,000 0.17 2022January 1, 2022 through December 31, 2022125,000 $0.15 In May 2020, EOG entered into crude oil Roll Differential basis swap contracts for the period from July 1, 2020 through September 30, 2020, with notional volumes of 22,000 Bbld at a weighted average price differential of $(0.43) per Bbl, and for the period from October 1, 2020 through December 31, 2020, with notional volumes of 44,000 Bbld at a weighted average price differential of $(0.73) per Bbl. These contracts partially offset certain outstanding Roll Differential basis swap contracts for the same time periods and volumes at a weighted average price differential of $(1.16) per Bbl. EOG paid net cash of $3.2 million for the settlement of these contracts. The offsetting contracts were excluded from the above table.Presented below is a comprehensive summary of EOG's crude oil NYMEX WTI price swap contracts through February 18, 2021, with notional volumes expressed in Bbld and prices expressed in $/Bbl.Crude Oil NYMEX WTI Price Swap Contracts Volume (Bbld)Weighted Average Price ($/Bbl)2020January 1, 2020 through March 31, 2020 (closed)200,000 $59.33 April 1, 2020 through May 31, 2020 (closed)265,000 51.36 2021January 2021 (closed)151,000 $50.06 February 1, 2021 through March 31, 2021201,000 51.29 April 1, 2021 through June 30, 2021150,000 51.68 July 1, 2021 through September 30, 2021150,000 52.71 46In April and May 2020, EOG entered into crude oil NYMEX WTI price swap contracts for the period from June 1, 2020 through June 30, 2020, with notional volumes of 265,000 Bbld at a weighted average price of $33.80 per Bbl, for the period from July 1, 2020 through July 31, 2020, with notional volumes of 254,000 Bbld at a weighted average price of $33.75 per Bbl, for the period from August 1, 2020 through September 30, 2020, with notional volumes of 154,000 Bbld at a weighted average price of $34.18 per Bbl and for the period from October 1, 2020 through December 31, 2020, with notional volumes of 47,000 Bbld at a weighted average price of $30.04 per Bbl. These contracts offset the remaining crude oil NYMEX WTI price swap contracts for the same time periods and volumes at a weighted average price of $51.36 per Bbl for the period from June 1, 2020 through June 30, 2020, $42.36 per Bbl for the period from July 1, 2020 through July 31, 2020, $50.42 per Bbl for the period from August 1, 2020 through September 30, 2020 and $31.00 per Bbl for the period from October 1, 2020 through December 31, 2020. EOG received net cash of $364.0 million for the settlement of these contracts. The offsetting contracts were excluded from the above table.Presented below is a comprehensive summary of EOG's crude oil ICE Brent price swap contracts through February 18, 2021, with notional volumes expressed in Bbld and prices expressed in $/Bbl.Crude Oil ICE Brent Price Swap Contracts Volume (Bbld)Weighted Average Price ($/Bbl)2020April 2020 (closed)75,000 $25.66 May 2020 (closed)35,000 26.53 NGLs Derivative Contracts. Presented below is a comprehensive summary of EOG's Mont Belvieu propane (non-TET) price swap contracts through February 18, 2021, with notional volumes expressed in Bbld and prices expressed in $/Bbl.Mont Belvieu Propane Price Swap Contracts Volume (Bbld)Weighted Average Price ($/Bbl)2020January 1, 2020 through February 29, 2020 (closed)4,000 $21.34 March 1, 2020 through April 30, 2020 (closed)25,000 17.922021January 2021 (closed)15,000 $29.44 February 1, 2021 through December 31, 202115,000 29.44In April and May 2020, EOG entered into Mont Belvieu propane price swap contracts for the period from May 1, 2020 through December 31, 2020, with notional volumes of 25,000 Bbld at a weighted average price of $16.41 per Bbl. These contracts offset the remaining Mont Belvieu propane price swap contracts for the same time period with notional volumes of 25,000 Bbld at a weighted average price of $17.92 per Bbl. EOG received net cash of $9.2 million for the settlement of these contracts. The offsetting contracts were excluded from the above table.47Natural Gas Derivative Contracts. Presented below is a comprehensive summary of EOG's natural gas NYMEX Henry Hub price swap contracts through February 18, 2021, with notional volumes sold (purchased) expressed in million British thermal units (MMBtu) per day (MMBtud) and prices expressed in dollars per MMBtu ($/MMBtu). In January 2021, EOG executed the early termination provision granting EOG the right to terminate certain 2022 natural gas NYMEX Henry Hub price swap contracts with notional volumes of 20,000 MMBtud at a weighted average price of $2.75 per MMBtu for the period from January 1, 2022 through December 31, 2022. EOG received net cash of $0.6 million for the settlement of these contracts.Natural Gas NYMEX Henry Hub Price Swap Contracts Volume (MMBtud)Weighted Average Price ($/MMBtu)2021April 1, 2021 through September 30, 2021(70,000)$2.64 2022January 1, 2022 through December 31, 2022 (closed)20,000 $2.75 In December 2020 and January 2021, EOG entered into natural gas NYMEX Henry Hub price swap contracts for the period from January 1, 2021 through March 31, 2021, with notional volumes of 500,000 MMBtud at a weighted average price of $2.43 per MMBtu and for the period from April 1, 2021 through December 31, 2021, with notional volumes of 500,000 MMBtud at a weighted average price of $2.83 per MMBtu. These contracts offset the remaining natural gas NYMEX Henry Hub price swap contracts for the same time periods with notional volumes of 500,000 MMBtud at a weighted average price of $2.99 per MMBtu. EOG received net cash of $16.5 million through February 18, 2021, for the settlement of certain of these contracts, and expects to receive net cash of $30.3 million during the remainder of 2021 for the settlement of the remaining contracts. The offsetting contracts were excluded from the above table.Presented below is a comprehensive summary of EOG's natural gas Japan Korea Marker (JKM) price swap contracts through February 18, 2021, with notional volumes expressed in MMBtud and prices expressed in $/MMBtu.Natural Gas JKM Price Swap Contracts Volume (MMBtud)Weighted Average Price ($/MMBtu)2021April 1, 2021 through September 30, 202170,000 $6.65 48EOG has entered into natural gas collar contracts, which establish ceiling and floor prices for the sale of notional volumes of natural gas as specified in the collar contracts. The collars require that EOG pay the difference between the ceiling price and the Henry Hub Index Price in the event the Henry Hub Index Price is above the ceiling price. The collars grant EOG the right to receive the difference between the floor price and the Henry Hub Index Price in the event the Henry Hub Index Price is below the floor price. In March 2020, EOG executed the early termination provision granting EOG the right to terminate certain 2020 natural gas collar contracts with notional volumes of 250,000 MMBtud at a weighted average ceiling price of $2.50 per MMBtu and a weighted average floor price of $2.00 per MMBtu for the period from April 1, 2020 through July 31, 2020. EOG received net cash of $7.8 million for the settlement of these contracts. Presented below is a comprehensive summary of EOG's natural gas collar contracts through February 18, 2021, with notional volumes expressed in MMBtud and prices expressed in $/MMBtu.Natural Gas Collar ContractsWeighted Average Price ($/MMBtu) Volume (MMBtud)Ceiling PriceFloor Price2020April 1, 2020 through July 31, 2020 (closed)250,000 $2.50 $2.00 In April 2020, EOG entered into natural gas collar contracts for the period from August 1, 2020 through October 31, 2020, with notional volumes of 250,000 MMBtud at a ceiling price of $2.50 per MMBtu and a floor price of $2.00 per MMBtu. These contracts offset the remaining natural gas collar contracts for the same time period with notional volumes of 250,000 MMBtud at a ceiling price of $2.50 per MMBtu and a floor price of $2.00 per MMBtu. EOG received net cash of $1.1 million for the settlement of these contracts. The offsetting contracts were excluded from the above table.Prices received by EOG for its natural gas production generally vary from NYMEX Henry Hub prices due to adjustments for delivery location (basis) and other factors. EOG has entered into natural gas basis swap contracts in order to fix the differential between pricing in the Rocky Mountain area and NYMEX Henry Hub prices (Rockies Differential). Presented below is a comprehensive summary of EOG's Rockies Differential basis swap contracts through February 18, 2021. The weighted average price differential expressed in $/MMBtu represents the amount of reduction to NYMEX Henry Hub prices for the notional volumes expressed in MMBtud covered by the basis swap contracts.Rockies Differential Basis Swap Contracts Volume (MMBtud)Weighted Average Price Differential ($/MMBtu)2020January 1, 2020 through December 31, 2020 (closed)30,000 $0.55 49EOG has also entered into natural gas basis swap contracts in order to fix the differential between pricing at the Houston Ship Channel (HSC) and NYMEX Henry Hub prices (HSC Differential). In March 2020, EOG executed the early termination provision granting EOG the right to terminate certain 2020 HSC Differential basis swaps with notional volumes of 60,000 MMBtud at a weighted average price differential of $0.05 per MMBtu for the period from April 1, 2020 through December 31, 2020. EOG paid net cash of $0.4 million for the settlement of these contracts. Presented below is a comprehensive summary of EOG's HSC Differential basis swap contracts through February 18, 2021. The weighted average price differential expressed in $/MMBtu represents the amount of reduction to NYMEX Henry Hub prices for the notional volumes expressed in MMBtud covered by the basis swap contracts.HSC Differential Basis Swap Contracts Volume (MMBtud)Weighted Average Price Differential ($/MMBtu)2020January 1, 2020 through December 31, 2020 (closed)60,000 $0.05 EOG has also entered into natural gas basis swap contracts in order to fix the differential between pricing at the Waha Hub in West Texas and NYMEX Henry Hub prices (Waha Differential). Presented below is a comprehensive summary of EOG's Waha Differential basis swap contracts through February 18, 2021. The weighted average price differential expressed in $/MMBtu represents the amount of reduction to NYMEX Henry Hub prices for the notional volumes expressed in MMBtud covered by the basis swap contracts.Waha Differential Basis Swap Contracts Volume (MMBtud)Weighted Average Price Differential ($/MMBtu)2020January 1, 2020 through April 30, 2020 (closed)50,000 $1.40 In April 2020, EOG entered into Waha Differential basis swap contracts for the period from May 1, 2020 through December 31, 2020, with notional volumes of 50,000 MMBtud at a weighted average price differential of $0.43 per MMBtu. These contracts offset the remaining Waha Differential basis swap contracts for the same time period with notional volumes of 50,000 MMBtud at a weighted average price differential of $1.40 per MMBtu. EOG paid net cash of $11.9 million for the settlement of these contracts. The offsetting contracts were excluded from the above table.FinancingEOG's debt-to-total capitalization ratio was 22% at December 31, 2020, compared to 19% at December 31, 2019. As used in this calculation, total capitalization represents the sum of total current and long-term debt and total stockholders' equity.At December 31, 2020 and 2019, respectively, EOG had outstanding $5,640 million and $5,140 million aggregate principal amount of senior notes which had estimated fair values of $6,505 million and $5,452 million, respectively. The estimated fair value of debt was based upon quoted market prices and, where such prices were not available, other observable inputs regarding interest rates available to EOG at year-end. EOG's debt is at fixed interest rates. While changes in interest rates affect the fair value of EOG's senior notes, such changes do not expose EOG to material fluctuations in earnings or cash flow.During 2020, EOG funded its capital program and operations primarily by utilizing cash provided by operating activities, issuance of the Notes and proceeds from asset sales. While EOG maintains a $2.0 billion revolving credit facility to back its commercial paper program, there were no borrowings outstanding at any time during 2020 and the amount outstanding at year-end was zero. EOG considers the availability of its $2.0 billion senior unsecured revolving credit facility, as described in Note 2 to Consolidated Financial Statements, to be sufficient to meet its ongoing operating needs.5051Contractual ObligationsThe following table summarizes EOG's contractual obligations at December 31, 2020 (in millions): Contractual Obligations (1)Total20212022-20232024-20252026 & BeyondCurrent and Long-Term Debt$5,640 $750 $1,250 $500 $3,140 Interest Payments on Long-Term Debt2,297 207 366 309 1,415 Finance Leases (2)239 36 60 56 87 Operating Leases (2)1,039 323 344 166 206 Leases Effective, Not Commenced (2)100 14 28 22 36 Transportation and Storage Service Commitments (3)6,665 964 1,830 1,296 2,575 Purchase and Service Obligations1,258 429 497 143 189 Total Contractual Obligations$17,238 $2,723 $4,375 $2,492 $7,648 (1)This table does not include the liability for unrecognized tax benefits, EOG's pension or postretirement benefit obligations or liability for dismantlement, abandonment and asset retirement obligations (see Notes 6, 7 and 15, respectively, to Consolidated Financial Statements). These amounts are excluded because they are subject to estimates and the timing of settlement is unknown.(2)For more information on contracts that meet the definition of a lease under ASU 2016-02, see Note 18 to Consolidated Financial Statements.(3)Amounts exclude transportation and storage service commitments that meet the definition of a lease. Amounts shown are based on current transportation and storage rates and the foreign currency exchange rates used to convert Canadian dollars into United States dollars at December 31, 2020. Management does not believe that any future changes in these rates before the expiration dates of these commitments will have a material adverse effect on the financial condition or results of operations of EOG.Off-Balance Sheet ArrangementsEOG does not participate in financial transactions that generate relationships with unconsolidated entities or financial partnerships. Such entities or partnerships, often referred to as variable interest entities (VIE) or special purpose entities (SPE), are generally established for the purpose of facilitating off-balance sheet arrangements or other limited purposes. EOG was not involved in any unconsolidated VIE or SPE financial transactions or any other "off-balance sheet arrangement" (as defined in Item 303(a)(4)(ii) of Regulation S-K) during any of the periods covered by this report and currently has no intention of participating in any such transaction or arrangement in the foreseeable future.Foreign Currency Exchange Rate RiskDuring 2020, EOG was exposed to foreign currency exchange rate risk inherent in its operations in foreign countries, including Trinidad, China and Canada. EOG continues to monitor the foreign currency exchange rates of countries in which it is currently conducting business and may implement measures to protect against foreign currency exchange rate risk.52Outlook Pricing. Crude oil, NGLs and natural gas prices have been volatile, and this volatility is expected to continue. As a result of the many uncertainties associated with the world political environment, worldwide supplies of, and demand for, crude oil and condensate, NGLs and natural gas, the availabilities of other worldwide energy supplies and the relative competitive relationships of the various energy sources in the view of consumers, EOG is unable to predict what changes may occur in crude oil and condensate, NGLs, natural gas, ammonia and methanol prices in the future. The market price of crude oil and condensate, NGLs and natural gas in 2021 will impact the amount of cash generated from EOG's operating activities, which will in turn impact EOG's financial position. As of February 18, 2021, the average 2021 NYMEX crude oil and natural gas prices were $57.51 per barrel and $2.98 per MMBtu, respectively, representing an increase of 46% for crude oil and an increase of 43% for natural gas from the average NYMEX prices in 2020. See ITEM 1A, Risk Factors.Including the impact of EOG's crude oil and NGL derivative contracts (exclusive of basis swaps) and based on EOG's tax position, EOG's price sensitivity in 2021 for each $1.00 per barrel increase or decrease in wellhead crude oil and condensate price, combined with the estimated change in NGL price, is approximately $99 million for net income and $127 million for pretax cash flows from operating activities. Including the impact of EOG's natural gas derivative contracts and based on EOG's tax position and the portion of EOG's anticipated natural gas volumes for 2021 for which prices have not been determined under long-term marketing contracts, EOG's price sensitivity for each $0.10 per Mcf increase or decrease in wellhead natural gas price is approximately $31 million for net income and $40 million for pretax cash flows from operating activities. For information regarding EOG's crude oil, NGLs and natural gas financial commodity derivative contracts through February 18, 2021, see "Commodity Derivative Transactions" above.Capital. EOG plans to continue to focus a substantial portion of its exploration and development expenditures in its major producing areas in the United States. In particular, EOG will be focused on United States crude oil drilling activity in its Delaware Basin, Eagle Ford and Rocky Mountain area where it generates its highest rates-of-return. To further enhance the economics of these plays, EOG expects to continue to improve well performance and lower drilling and completion costs through efficiency gains and lower service costs. In addition, EOG expects to spend a portion of its anticipated 2021 capital expenditures on leasing acreage and evaluating new prospects. The total anticipated 2021 capital expenditures of approximately $3.7 billion to $4.1 billion, excluding acquisitions and non-cash transactions, is structured to maintain EOG's strategy of capital discipline by funding its exploration, development and exploitation activities primarily from available internally generated cash flows and cash on hand. EOG has significant flexibility with respect to financing alternatives, including borrowings under its commercial paper program, bank borrowings, borrowings under its $2.0 billion senior unsecured revolving credit facility and equity and debt offerings. Operations. In 2021, total crude oil production is expected to remain at fourth quarter 2020 levels. In 2021, EOG expects to continue to focus on reducing operating costs through efficiency improvements.53Summary of Critical Accounting PoliciesEOG prepares its financial statements and the accompanying notes in conformity with accounting principles generally accepted in the United States, which require management to make estimates and assumptions about future events that affect the reported amounts in the financial statements and the accompanying notes. EOG identifies certain accounting policies as critical based on, among other things, their impact on EOG's financial condition, results of operations or liquidity, and the degree of difficulty, subjectivity and complexity in their application. Critical accounting policies cover accounting matters that are inherently uncertain because the future resolution of such matters is unknown. Management routinely discusses the development, selection and disclosure of each of the critical accounting policies. Following is a discussion of EOG's most critical accounting policies:Proved Oil and Gas ReservesEOG's engineers estimate proved oil and gas reserves in accordance with United States Securities and Exchange Commission (SEC) regulations, which directly impact financial accounting estimates, including depreciation, depletion and amortization and impairments of proved properties and related assets. Proved reserves represent estimated quantities of crude oil and condensate, NGLs and natural gas that geological and engineering data demonstrate, with reasonable certainty, to be recoverable in future years from known reservoirs under economic and operating conditions existing at the time the estimates were made. The process of estimating quantities of proved oil and gas reserves is complex, requiring significant subjective decisions in the evaluation of available geological, engineering and economic data for each reservoir. The data for a given reservoir may also change substantially over time as a result of numerous factors including, but not limited to, additional development activity, evolving production history and continual reassessment of the viability of production under varying economic conditions. Consequently, material revisions (upward or downward) to existing reserve estimates may occur from time to time. For related discussion, see ITEM 1A, Risk Factors, and "Supplemental Information to Consolidated Financial Statements."Oil and Gas Exploration and Development CostsEOG accounts for its crude oil and natural gas exploration and production activities under the successful efforts method of accounting. Oil and gas exploration costs, other than the costs of drilling exploratory wells, are expensed as incurred. The costs of drilling exploratory wells are capitalized pending determination of whether EOG has discovered commercial quantities of proved reserves. If commercial quantities of proved reserves are not discovered, such drilling costs are expensed. In some circumstances, it may be uncertain whether commercial quantities of proved reserves have been discovered when drilling has been completed. Such exploratory well drilling costs may continue to be capitalized if the estimated reserve quantity is sufficient to justify its completion as a producing well and sufficient progress in assessing the reserves and the economic and operating viability of the project is being made. Costs to develop proved reserves, including the costs of all development wells and related equipment used in the production of crude oil and natural gas, are capitalized.Depreciation, Depletion and Amortization for Oil and Gas PropertiesThe quantities of estimated proved oil and gas reserves are a significant component of EOG's calculation of depreciation, depletion and amortization expense, and revisions in such estimates may alter the rate of future expense. Holding all other factors constant, if reserves are revised upward or downward, earnings will increase or decrease, respectively.Depreciation, depletion and amortization of the cost of proved oil and gas properties is calculated using the unit-of-production method. The reserve base used to calculate depreciation, depletion and amortization for leasehold acquisition costs and the cost to acquire proved properties is the sum of proved developed reserves and proved undeveloped reserves. With respect to lease and well equipment costs, which include development costs and successful exploration drilling costs, the reserve base includes only proved developed reserves. Estimated future dismantlement, restoration and abandonment costs, net of salvage values, are taken into account.Oil and gas properties are grouped in accordance with the provisions of the Extractive Industries - Oil and Gas Topic of the ASC. The basis for grouping is a reasonable aggregation of properties with a common geological structural feature or stratigraphic condition, such as a reservoir or field.Depreciation, depletion and amortization rates are updated quarterly to reflect the addition of capital costs, reserve revisions (upwards or downwards) and additions, property acquisitions and/or property dispositions and impairments.54Depreciation and amortization of other property, plant and equipment is calculated on a straight-line basis over the estimated useful life of the asset.ImpairmentsOil and gas lease acquisition costs are capitalized when incurred. Unproved properties with acquisition costs that are not individually significant are aggregated, and the portion of such costs estimated to be nonproductive is amortized over the remaining lease term. Unproved properties with individually significant acquisition costs are reviewed individually for impairment. If the unproved properties are determined to be productive, the appropriate related costs are transferred to proved oil and gas properties. Lease rentals are expensed as incurred.When circumstances indicate that proved oil and gas properties may be impaired, EOG compares expected undiscounted future cash flows at a depreciation, depletion and amortization group level to the unamortized capitalized cost of the asset. If the expected undiscounted future cash flows, based on EOG's estimates of (and assumptions regarding) future crude oil and natural gas prices, operating costs, development expenditures, anticipated production from proved reserves and other relevant data, are lower than the unamortized capitalized cost, the capitalized cost is reduced to fair value. Fair value is generally calculated using the Income Approach described in the Fair Value Measurement Topic of the ASC. In certain instances, EOG utilizes accepted offers from third-party purchasers as the basis for determining fair value. Estimates of undiscounted future cash flows require significant judgment, and the assumptions used in preparing such estimates are inherently uncertain. In addition, such assumptions and estimates are reasonably likely to change in the future. Crude oil, NGLs and natural gas prices have exhibited significant volatility in the past, and EOG expects that volatility to continue in the future. During the five years ended December 31, 2020, WTI crude oil spot prices have fluctuated from approximately $(36.98) per barrel to $77.41 per barrel, and Henry Hub natural gas spot prices have ranged from approximately $1.33 per MMBtu to $6.24 per MMBtu. Market prices for NGLs are influenced by the components extracted, including ethane, propane, butane and natural gasoline, among others, and the respective market pricing for each component. EOG uses the five-year NYMEX futures strip for WTI crude oil and Henry Hub natural gas and the five-year Oil Price Information Services futures strip for NGLs components (in each case as of the applicable balance sheet date) as a basis to estimate future crude oil, NGLs and natural gas prices. EOG's proved reserves estimates, including the timing of future production, are also subject to significant assumptions and judgment, and are frequently revised (upwards and downwards) as more information becomes available. Proved reserves are estimated using a trailing 12-month average price, in accordance with SEC rules. In the future, if any combination of crude oil prices, NGLs prices, natural gas prices, actual production or operating costs diverge negatively from EOG's current estimates, impairment charges and downward adjustments to our estimated proved reserves may be necessary.Income TaxesIncome taxes are accounted for using the asset and liability approach. Under this approach, deferred tax assets and liabilities are recognized based on anticipated future tax consequences attributable to differences between financial statement carrying amounts of assets and liabilities and their respective tax basis. EOG assesses the realizability of deferred tax assets and recognizes valuation allowances as appropriate. Significant assumptions used in estimating future taxable income include future crude oil, NGLs and natural gas prices and levels of capital reinvestment. Changes in such assumptions or changes in tax laws and regulations could materially affect the recognized amounts of valuation allowances.Stock-Based CompensationIn accounting for stock-based compensation, judgments and estimates are made regarding, among other things, the appropriate valuation methodology to follow in valuing stock compensation awards and the related inputs required by those valuation methodologies. Assumptions regarding expected volatility of EOG's common stock, the level of risk-free interest rates, expected dividend yields on EOG's common stock, the expected term of the awards, expected volatility in the price of shares and composition of EOG's peer companies and other valuation inputs are subject to change. Any such changes could result in different valuations and thus impact the amount of stock-based compensation expense recognized on the Consolidated Statements of Income and Comprehensive Income.55Information Regarding Forward-Looking StatementsThis Annual Report on Form 10-K includes forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. All statements, other than statements of historical facts, including, among others, statements and projections regarding EOG's future financial position, operations, performance, business strategy, goals, returns and rates of return, budgets, reserves, levels of production, capital expenditures, costs and asset sales, statements regarding future commodity prices and statements regarding the plans and objectives of EOG's management for future operations, are forward‐looking statements. EOG typically uses words such as "expect," "anticipate," "estimate," "project," "strategy," "intend,“ "plan," "target," "aims," "goal," "may," "will," "focused on," "should" and "believe" or the negative of those terms or other variations or comparable terminology to identify its forward‐looking statements. In particular, statements, express or implied, concerning EOG's future operating results and returns or EOG's ability to replace or increase reserves, increase production, generate returns and rates of return, replace or increase drilling locations, reduce or otherwise control operating costs and capital expenditures, generate cash flows, pay down or refinance indebtedness, or pay and/or increase dividends are forward‐looking statements. Forward-looking statements are not guarantees of performance. Although EOG believes the expectations reflected in its forward-looking statements are reasonable and are based on reasonable assumptions, no assurance can be given that these assumptions are accurate or that any of these expectations will be achieved (in full or at all) or will prove to have been correct. Moreover, EOG's forward-looking statements may be affected by known, unknown or currently unforeseen risks, events or circumstances that may be outside EOG's control. Important factors that could cause EOG's actual results to differ materially from the expectations reflected in EOG's forward-looking statements include, among others:•the timing, extent and duration of changes in prices for, supplies of, and demand for, crude oil and condensate, natural gas liquids, natural gas and related commodities; •the extent to which EOG is successful in its efforts to acquire or discover additional reserves; •the extent to which EOG is successful in its efforts to (i) economically develop its acreage in, (ii) produce reserves and achieve anticipated production levels and rates of return from, (iii) decrease or otherwise control its drilling, completion, operating and capital costs related to, and (iv) maximize reserve recovery from, its existing and future crude oil and natural gas exploration and development projects and associated potential and existing drilling locations;•the extent to which EOG is successful in its efforts to market its production of crude oil and condensate, natural gas liquids, and natural gas;•security threats, including cybersecurity threats and disruptions to our business and operations from breaches of our information technology systems, physical breaches of our facilities and other infrastructure or breaches of the information technology systems, facilities and infrastructure of third parties with which we transact business; •the availability, proximity and capacity of, and costs associated with, appropriate gathering, processing, compression, storage, transportation, refining, and export facilities; •the availability, cost, terms and timing of issuance or execution of, and competition for, mineral licenses and leases and governmental and other permits and rights-of-way, and EOG's ability to retain mineral licenses and leases;•the impact of, and changes in, government policies, laws and regulations, including any changes or other actions which may result from the recent U.S. elections and change in U.S. administration and including tax laws and regulations; climate change and other environmental, health and safety laws and regulations relating to air emissions, disposal of produced water, drilling fluids and other wastes, hydraulic fracturing and access to and use of water; laws and regulations affecting the leasing of acreage and permitting for oil and gas drilling and the calculation of royalty payments in respect of oil and gas production; laws and regulations imposing additional permitting and disclosure requirements, additional operating restrictions and conditions or restrictions on drilling and completion operations and on the transportation of crude oil and natural gas; laws and regulations with respect to derivatives and hedging activities; and laws and regulations with respect to the import and export of crude oil, natural gas and related commodities; •EOG's ability to effectively integrate acquired crude oil and natural gas properties into its operations, fully identify existing and potential problems with respect to such properties and accurately estimate reserves, production and drilling, completing and operating costs with respect to such properties;•the extent to which EOG's third-party-operated crude oil and natural gas properties are operated successfully and economically;•competition in the oil and gas exploration and production industry for the acquisition of licenses, leases and properties, employees and other personnel, facilities, equipment, materials and services; •the availability and cost of employees and other personnel, facilities, equipment, materials (such as water and tubulars) and services;•the accuracy of reserve estimates, which by their nature involve the exercise of professional judgment and may therefore be imprecise;56•weather, including its impact on crude oil and natural gas demand, and weather-related delays in drilling and in the installation and operation (by EOG or third parties) of production, gathering, processing, refining, compression, storage, transportation, and export facilities;•the ability of EOG's customers and other contractual counterparties to satisfy their obligations to EOG and, related thereto, to access the credit and capital markets to obtain financing needed to satisfy their obligations to EOG;•EOG's ability to access the commercial paper market and other credit and capital markets to obtain financing on terms it deems acceptable, if at all, and to otherwise satisfy its capital expenditure requirements;•the extent to which EOG is successful in its completion of planned asset dispositions;•the extent and effect of any hedging activities engaged in by EOG;•the timing and extent of changes in foreign currency exchange rates, interest rates, inflation rates, global and domestic financial market conditions and global and domestic general economic conditions;•the duration and economic and financial impact of epidemics, pandemics or other public health issues, including the COVID-19 pandemic;•geopolitical factors and political conditions and developments around the world (such as the imposition of tariffs or trade or other economic sanctions, political instability and armed conflict), including in the areas in which EOG operates;•the use of competing energy sources and the development of alternative energy sources;•the extent to which EOG incurs uninsured losses and liabilities or losses and liabilities in excess of its insurance coverage;•acts of war and terrorism and responses to these acts; and•the other factors described under ITEM 1A, Risk Factors of this Annual Report on Form 10-K and any updates to those factors set forth in EOG's subsequent Quarterly Reports on Form 10-Q or Current Reports on Form 8-K. In light of these risks, uncertainties and assumptions, the events anticipated by EOG's forward-looking statements may not occur, and, if any of such events do, we may not have anticipated the timing of their occurrence or the duration or extent of their impact on our actual results. Accordingly, you should not place any undue reliance on any of EOG's forward-looking statements. EOG's forward-looking statements speak only as of the date made, and EOG undertakes no obligation, other than as required by applicable law, to update or revise its forward-looking statements, whether as a result of new information, subsequent events, anticipated or unanticipated circumstances or otherwise.ITEM 7A. Quantitative and Qualitative Disclosures About Market RiskThe information required by this Item is incorporated by reference from Item 7 of this report, specifically the information set forth under the captions "Commodity Derivative Transactions," "Financing," "Foreign Currency Exchange Rate Risk" and "Outlook" in "Management's Discussion and Analysis of Financial Condition and Results of Operations - Capital Resources and Liquidity."
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+ITEM 7. Management's Discussion and Analysis of Financial Condition and Results of OperationsThe following commentary should be read in conjunction with the financial statements and related notes contained elsewhere in this Annual Report on Form 10-K. The information in this discussion contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. Such statements are based upon current expectations that involve risks and uncertainties. Any statements contained herein that are not statements of historical fact may be deemed to be forward-looking statements. For example, the words "believes," "anticipates," "plans," "expects," "intends" and similar expressions are intended to identify forward-looking statements. Our actual results and the timing of certain events may differ significantly from the results discussed in the forward-looking statements. Factors that might cause such a discrepancy include, but are not limited to, those discussed in "Liquidity and Capital Resources" and "Risk Factors" elsewhere in this Annual Report on Form 10-K. All forward-looking statements in this document are based on information available to us as of the date hereof and we assume no obligation to update any such forward-looking statements.Item 7 of this Form 10-K focuses on discussion of 2020 and 2019 items as well as 2020 results as compared to 2019 results. For the discussion of 2018 items and 2019 results as compared to 2018 results, please refer to Item 7 of our 2019 Form 10-K as filed with the SEC on February 21, 2020.Our management's discussion and analysis of financial condition and results of operations is intended to assist readers in understanding our financial information from our management's perspective and is presented as follows:•Overview•Results of Operations•Non-GAAP Financial Measures•Liquidity and Capital Resources•Contractual Obligations and Off-Balance-Sheet Arrangements•Critical Accounting Policies and Estimates•Recent Accounting PronouncementsOverview Equinix is a global digital infrastructure company, enabling digital leaders to harness a trusted platform to bring together and interconnect the foundational infrastructure that powers their success. Equinix enables today’s businesses to access all the right places, partners and possibilities they need to accelerate their advantage. Global enterprises, service providers and business ecosystems of industry partners rely on Equinix IBX data centers and 51Table of Contentsexpertise around the world for the safe housing of their critical IT equipment and to protect and connect the world's most valued information assets. They also look to Platform Equinix® for the ability to directly and securely interconnect to the networks, clouds and content that enable today's information-driven global digital economy. Recent Equinix IBX data center openings and acquisitions, as well as xScaleTM data center investments, have expanded our total global footprint to 227 IBXs, including two xScaleTM data centers and the MC1 data center that were held in unconsolidated joint ventures, across 63 markets around the world. Equinix offers the following solutions:•premium data center colocation;•interconnection and data exchange solutions;•edge services for deploying networking, security and hardware; and•remote expert support and professional services.Our interconnected data centers around the world allow our customers to increase information and application delivery performance to users, and quickly access distributed IT infrastructures and business and digital ecosystems, while significantly reducing costs. The Equinix global platform and the quality of our IBX data centers, interconnection offerings and edge services have enabled us to establish a critical mass of customers. As more customers choose Platform Equinix, for bandwidth cost and performance reasons it benefits their suppliers and business partners to colocate in the same data centers. This adjacency creates a “network effect” that enables our customers to capture the full economic and performance benefits of our offerings. These partners, in turn, pull in their business partners, creating a "marketplace" for their services. Our global platform enables scalable, reliable and cost-effective interconnection that increases data traffic exchange while lowering overall cost and increasing flexibility. Our focused business model is built on our critical mass of enterprise and service provider customers and the resulting "marketplace" effect. This global platform, combined with our strong financial position, continues to drive new customer growth and bookings.Historically, our market was served by large telecommunications carriers who have bundled their products and services with their colocation offerings. The data center market landscape has evolved to include private and vendor-neutral MTDC providers, hyperscale cloud providers, managed infrastructure and application hosting providers, and systems integrators. It is estimated that Equinix is one of more than 1,200 companies that provide MTDC offerings around the world. Each of these data center solutions providers can bundle various colocation, interconnection and network offerings and outsourced IT infrastructure solutions. We are able to offer our customers a global platform that reaches 26 countries with the industry’s largest and most active ecosystem of partners in our sites, proven operational reliability, improved application performance and a highly scalable set of offerings.The cabinet utilization rate represents the percentage of cabinet space billed versus total cabinet capacity, which is used to measure how efficiently we are managing our cabinet capacity. Our cabinet utilization rate varies from market to market among our IBX data centers across the Americas, EMEA and Asia-Pacific regions. Our cabinet utilization rates were approximately 79%, as of December 31, 2020 and 2019. Excluding the impact of our IBX data center expansion projects that have opened during the last 12 months, our cabinet utilization rate would have increased to approximately 80% as of December 31, 2020. We continue to monitor the available capacity in each of our selected markets. To the extent we have limited capacity available in a given market, it may limit our ability for growth in that market. We perform demand studies on an ongoing basis to determine if future expansion is warranted in a market. In addition, power and cooling requirements for most customers are growing on a per unit basis. As a result, customers are consuming an increasing amount of power per cabinet. Although we generally do not control the amount of power our customers draw from installed circuits, we have negotiated power consumption limitations with certain high power-demand customers. This increased power consumption has driven us to build out our new IBX data centers to support power and cooling needs twice that of previous IBX data centers. We could face power limitations in our IBX data centers, even though we may have additional physical cabinet capacity available within a specific IBX data center. This could have a negative impact on the available utilization capacity of a given IBX data center, which could have a negative impact on our ability to grow revenues, affecting our financial performance, results of operations and cash flows.In 2019, we closed our EMEA Joint Venture with GIC to develop and operate xScaleTM data centers to serve the needs of the growing hyperscale data center market, including the world's largest cloud service providers. Upon closing, the EMEA Joint Venture acquired certain data center sites, including the London 10 data center, Paris 8 data center and few data center sites in London and Frankfurt, with the opportunity to add additional facilities in the future. In 2020, we sold the Paris 9 data center to the EMEA Joint Venture. In addition, we closed our Asia-Pacific Joint Venture with GIC in APAC to develop and operate xScaleTM data centers. Upon closing, the Asia-Pacific Joint 52Table of ContentsVenture acquired Osaka 2, Tokyo 12, and Tokyo 14 data center development sites in the APAC region, with the opportunity to add additional facilities in the future.Strategically, we will continue to look at attractive opportunities to grow our market share and selectively improve our footprint and offerings. As was the case with our recent expansions and acquisitions, our expansion criteria will be dependent on a number of factors, including but not limited to demand from new and existing customers, quality of the design, power capacity, access to networks, clouds and software partners, capacity availability in the current market location, amount of incremental investment required by us in the targeted property, automation capabilities, developer talent pool, lead-time to break even on a free cash flow basis and in-place customers. Like our recent expansions and acquisitions, the right combination of these factors may be attractive to us. Depending on the circumstances, these transactions may require additional capital expenditures funded by upfront cash payments or through long-term financing arrangements in order to bring these properties up to Equinix standards. Property expansion may be in the form of purchases of real property, long-term leasing arrangements or acquisitions. Future purchases, construction or acquisitions may be completed by us or with partners or potential customers to minimize the outlay of cash, which can be significant.Revenue:Our business is based on a recurring revenue model comprised of colocation and related interconnection and managed infrastructure offerings. We consider these offerings recurring because our customers are generally billed on a fixed and recurring basis each month for the duration of their contract, which is generally one to three years in length. Our recurring revenues have comprised more than 90% of our total revenues during the past three years. In addition, during the past three years, more than 80% of our monthly recurring revenue bookings came from existing customers, contributing to our revenue growth. Our largest customer accounted for approximately 3% of our recurring revenues for the years ended December 31, 2020, 2019 and 2018. Our 50 largest customers accounted for approximately 39%, 39% and 38%, respectively, of our recurring revenues for the years ended December 31, 2020, 2019 and 2018.Our non-recurring revenues are primarily comprised of installation services related to a customer's initial deployment and professional services we perform. These services are considered to be non-recurring because they are billed typically once, upon completion of the installation or the professional services work performed. The majority of these non-recurring revenues are typically billed on the first invoice distributed to the customer in connection with their initial installation. However, revenues from installation services are deferred and recognized ratably over the period of the contract term. Additionally, revenue from contract settlements, when a customer wishes to terminate their contract early, is generally treated as a contract modification and recognized ratably over the remaining term of the contract, if any. As a percentage of total revenues, we expect non-recurring revenues to represent less than 10% of total revenues for the foreseeable future. Operating Expenses:Cost of Revenues. The largest components of our cost of revenues are depreciation, rental payments related to our leased IBX data centers, utility costs, including electricity, bandwidth access, IBX data center employees' salaries and benefits, including stock-based compensation, repairs and maintenance, supplies and equipment and security. A majority of our cost of revenues is fixed in nature and should not vary significantly from period to period, 53Table of Contentsunless we expand our existing IBX data centers or open or acquire new IBX data centers. However, there are certain costs that are considered more variable in nature, including utilities and supplies that are directly related to growth in our existing and new customer base. We expect the cost of our utilities, specifically electricity, will generally increase in the future on a per-unit or fixed basis, in addition to the variable increase related to the growth in consumption by our customers. In addition, the cost of electricity is generally higher in the summer months, as compared to other times of the year. To the extent we incur increased utility costs, such increased costs could materially impact our financial condition, results of operations and cash flows. Furthermore, to the extent we incur increased electricity or other costs as a result of either climate change policies or the physical effects of climate change, such increased costs could materially impact our financial condition, results of operations and cash flows. Sales and Marketing. Our sales and marketing expenses consist primarily of compensation and related costs for sales and marketing personnel, including stock-based compensation, amortization of contract costs, marketing programs, public relations, promotional materials and travel, as well as bad debt expense and amortization of customer relationship intangible assets.General and Administrative. Our general and administrative expenses consist primarily of salaries and related expenses, including stock-based compensation, accounting, legal and other professional service fees, and other general corporate expenses, such as our corporate regional headquarters office leases and some depreciation expense on back office systems.Taxation as a REIT We elected to be taxed as a REIT for U.S. federal income tax purposes beginning with our 2015 taxable year. As of December 31, 2020, our REIT structure included all of our data center operations in the U.S., Canada (with the exception of our data center in Ottawa), Mexico, Japan, Singapore and the data center operations in EMEA with the exception of Bulgaria, the United Arab Emirates, and the data center operations outside Amsterdam in the Netherlands. Our data center operations in other jurisdictions are operated as TRSs. We included our investment interest in the EMEA and Asia-Pacific Joint Ventures in our REIT structure.As a REIT, we generally are permitted to deduct from our U.S. federal taxable income the dividends we pay to our stockholders. The income represented by such dividends is not subject to U.S. federal income taxes at the entity level but is taxed, if at all, at the stockholder level. Nevertheless, the income of our TRSs which hold our U.S. operations that may not be REIT compliant is subject to U.S. corporate federal and state income taxes, as applicable. Likewise, our foreign subsidiaries continue to be subject to foreign income taxes in jurisdictions in which they hold assets or conduct operations, regardless of whether held or conducted through TRSs or through QRSs. We are also subject to a separate U.S. federal corporate income tax on any gain recognized from a sale of a REIT asset where our basis in the asset is determined by reference to the basis of the asset in the hands of a C corporation (such as an asset held by us or a QRS following the liquidation or other conversion of a former TRS). This built-in-gains tax is generally applicable to any disposition of such an asset during the five-year period after the date we first owned the asset as a REIT asset to the extent of the built-in-gain based on the fair market value of such asset on the date we first held the asset as a REIT asset. If we fail to remain qualified for U.S. federal income taxation as a REIT, we will be subject to U.S. federal income taxes at regular corporate income tax rates. In addition, should we have net income from "prohibited transactions," we will be subject to tax on this income at a 100% rate. "Prohibited transactions," for this purpose, are defined as dispositions, at a gain, of inventory or property held primarily for sale to customers in the ordinary course of a trade or business other than dispositions of foreclosure property and other than dispositions excepted by statutory safe harbors. Even if we remain qualified for U.S. federal income taxation as a REIT, we may be subject to some federal, state, local and foreign taxes on our income and property in addition to taxes owed with respect to our TRSs' operations. In particular, while state income tax regimes often parallel the U.S. federal income tax regime for REITs, many states do not completely follow federal rules, and some may not follow them at all.We continue to monitor our REIT compliance in order to maintain our qualification for U.S. federal income taxation as a REIT. For this and other reasons, as necessary, we may convert some of our data center operations in other countries into the REIT structure in future periods.On each of March 18, June 17, September 23, and December 9, 2020 we paid quarterly cash dividends of $2.66 per share. We expect the amount of our applicable dividends and other applicable distributions to equal or exceed the REIT taxable income that we recognized in 2020.54Table of ContentsThe Impact of the ongoing COVID-19 pandemic on Our Results and OperationsIn December 2019, a novel strain of coronavirus, referred to as Coronavirus disease 2019, or COVID-19, emerged. In February 2020, the World Health Organization (WHO) raised the COVID-19 threat from high to very high, and in March 2020, the WHO characterized COVID-19 as a global pandemic. The global pandemic and the efforts implemented to address the pandemic, including the issuance of “shelter-in-place” orders and social distancing guidelines, have impacted major economic and financial markets globally.Many of our IBX data centers have been identified as "essential businesses" or "critical infrastructure" by local governments for purposes of remaining open during the COVID-19 pandemic. All of our IBX data centers remain operational at the time of filing of this Annual Report on Form 10-K. We have activated our business continuity plans globally with the goal of providing seamless operations throughout our facilities, including provisions for ensuring all data centers remain staffed and fully operational and that our IBXs are equipped with the necessary equipment and supplies. We have implemented precautionary measures to minimize the risk of operational impact and to protect the health and safety of our employees, customers, partners and communities. These include implementing tools such as an appointment-based system to control timing and frequency of visits while also encouraging our customers to leverage our IBX technicians via Smart Hands, our remote operational support service, in order to restrict visits and minimize the number of people and the amount of time spent in our IBX facilities. Most of our corporate offices remain closed as a result of the pandemic and we instructed our non-IBX employees in these offices to work from home until further notice. We have announced a phased plan for return-to-office for non-IBX attached sites and have been following this plan to open certain offices with occupancy limits as local conditions allow. Additionally, we have decided to continue to limit employee travel and postpone or virtualize global events in response to the COVID-19 pandemic.We are experiencing some construction delays, however, to date, the construction delays and additional costs are insignificant relative to the overall project duration and budget. Equipment for construction projects which are scheduled to be placed in the near future has been ordered, and is currently being manufactured or delivered with minimal delays. We are actively monitoring our vendors and suppliers to evaluate any anticipated changes in equipment availability or delivery timetables. We have redundancies built into our supply chain of vendors and, to the best of our ability, we keep a stock of critical items on site to ensure repairs can be completed. To date, we have not observed any significant disruption to our IBX data center operations due to supply chain impacts from the COVID-19 pandemic. During the year ended December 31, 2020, the COVID-19 pandemic did not have a material impact on our results of operations. The majority of our revenue is derived from large companies across a diverse set of industries. Customers operating in sectors more drastically impacted by the COVID-19 pandemic, such as retail, travel, and energy, made up an insignificant percentage of our revenue. Smart Hands service revenues declined during the year ended December 31, 2020, as we waived Smart Hands service fees from the affected customers in certain circumstances during the first few months of the pandemic. We ceased to waive Smart Hands service fees for most customers as of June 30, 2020. We assessed realized and potential credit deterioration of our customers due to changes in the macroeconomic environment, considered the potential for payment term revision requests, and as a result, increased our allowance for credit losses for accounts receivable by an insignificant amount for the year ended December 31, 2020. We also incurred one-time cash bonuses and compensation expense of $8.6 million for our IBX employees as well as other employees to support their work-from-home requirements during the first quarter of 2020. We have experienced some travel expense savings during the year ended December 31, 2020 resulting from travel restrictions imposed in response to the COVID-19 pandemic.Looking ahead, the full impact of the ongoing COVID-19 pandemic on our future financial condition or results of operations remains uncertain and will depend on a number of factors, including the duration and potential cyclicity of the health crisis and further public policy actions to be taken in response, as well as the continued impact of the pandemic on the global economy and our customers and vendors. Our past results may not be indicative of our future performance and historical trends may differ materially.For additional details regarding the risks to our business from the ongoing COVID-19 pandemic, refer to Part I, Item 1A. Risk Factors included elsewhere in this Annual Report on Form 10-K.2020 Highlights:•In January, we redeemed the remaining $343.7 million principal amount of the 5.375% Senior Notes due 2022. See Note 11 within the Consolidated Financial Statements.55Table of Contents•In January, we completed the acquisition of three data centers in Mexico from Axtel for a total purchase consideration of approximately $189.0 million. See Note 3 within the Consolidated Financial Statements. •In March, we completed the Packet Acquisition, a leading bare metal automation platform for a total purchase consideration of approximately $290.3 million. See Note 3 within the Consolidated Financial Statements.•In March, we borrowed a total of $250.0 million under our Revolving Facility, which was fully repaid in May. As of December 31, 2020, the amount available to borrow under the Revolving Facility was approximately $1.9 billion. See Note 11 within the Consolidated Financial Statements.•In April, we entered into a credit agreement which provided for senior unsecured 364-day term loan facilities in an aggregate principal amount of $750.0 million. On April 15, 2020, we borrowed $391.0 million, as well as €100.0 million or $109.8 million at the exchange rate in effect on that date. In May and June, we repaid all amounts outstanding under the 364-day term loan facilities. See Note 11 within the Consolidated Financial Statements.•In April, we entered into an agreement to form a second joint venture in the form of a limited liability partnership with GIC to develop and operate xScaleTM data centers in APAC. In the third quarter of 2020, we recorded an impairment charge of $7.3 million, reducing the carrying value of the three Japan development sites to be sold, Osaka 2, Tokyo 12, and Tokyo 14, to the estimated fair value less cost to sell. On December 17, 2020, we closed the Asia-Pacific Joint Venture transaction which included the sale of the three development sites in exchange for $209.8 million of cash proceeds and $15.6 million of receivables. We recognized an insignificant gain on the sale of these xScaleTM data center facilities to the Asia-Pacific Joint Venture. See Note 5 and Note 6 within the Consolidated Financial Statements.•In May, we issued and sold 2,587,500 shares of common stock in a public offering for net proceeds of approximately $1,683.1 million, after deducting underwriting discounts, commissions and offering expenses. See Note 12 within the Consolidated Financial Statements.•In June, we issued $2.6 billion in Senior Notes due 2025, 2027, 2030 and 2050. In July, using a portion of the proceeds, we redeemed all of our outstanding €750.0 million 2.875% Senior Notes due 2024 and $1.1 billion 5.875% Senior Notes due 2026. See Note 11 within the Consolidated Financial Statements.•In August, we entered into an agreement to purchase the India operations of GPX Global Systems, Inc. ("GPX India"), representing two data centers in Mumbai, India, for approximately $161.0 million in an all-cash transaction (the “GPX India Acquisition”). The GPX India Acquisition is expected to close in the second quarter of 2021, subject to customary closing conditions including regulatory approval. See Note 3 within the Consolidated Financial Statements.•In the fourth quarter, we completed the acquisition of 13 data center sites in Canada, and their operations from Bell, for a total combined purchase consideration of approximately C$931.7 million, or $702.0 million at the exchange rates in effect on the transaction dates. See Note 3 within the Consolidated Financial Statements.•In October, we issued $1.85 billion in Senior Notes due in 2025, 2028 and 2051. On October 23, 2020, using a portion of the net proceeds, we redeemed all of our outstanding €1.0 billion aggregate principal amount 2.875% Senior Notes due 2025, as well as €0.5 billion of our outstanding €1.0 billion aggregate principal amount 2.875% Senior Notes due 2026. See Note 11 within the Consolidated Financial Statements.•In September, we entered into an agreement to sell the Paris 9 ("PA9") data center to the EMEA Joint Venture. The assets and liabilities of the data center, which was included within our EMEA region, were classified as held for sale as of September 30, 2020. The transaction was completed on December 15, 2020 for a total consideration of $131.5 million, which is comprised of net cash proceeds of $124.6 million, a contract asset with a fair value of $5.6 million and an insignificant amount of contingent consideration that is receivable upon completion of certain performance milestones. See Note 5 and Note 6 within the Consolidated Financial Statements.•During 2020, we had sold 415,512 shares of our common stock for approximately $298.3 million in proceeds, net of payment of commissions and other offering expenses under the 2018 ATM Program, reaching the capacity of this program and subsequently closed. In October, we launched a new ATM program, under which we may offer and sell from time to time up to an aggregate of $1.5 billion of our common stock in "at the market" transactions (the "2020 ATM Program"). As of December 31, 2020 we had not sold any shares under the 2020 ATM Program. See Note 12 within the Consolidated Financial Statements.56Table of ContentsResults of OperationsOur results of operations for the year ended December 31, 2020 include the results of operations from the acquisitions of 12 data center sites across Canada from Bell from October 1, 2020 and one additional data center acquired from Bell from November 2, 2020, Packet from March 2, 2020 and three data centers in Mexico from Axtel from January 8, 2020. Our results of operations for the year ended December 31, 2019 include the results of operations from the acquisition of the AM11 data center from April 18, 2019 within the EMEA region.In order to provide a framework for assessing our performance excluding the impact of foreign currency fluctuations, we supplement the year-over-year actual change in results of operations with comparative changes on a constant currency basis. Presenting constant currency results of operations is a non-GAAP financial measure. See “Non-GAAP Financial Measures” below for further discussion. Years ended December 31, 2020 and 2019 Revenues. Our revenues for the years ended December 31, 2020 and 2019 were generated from the following revenue classifications and geographic regions (dollars in thousands):Years Ended December 31,% Change2020%2019%ActualConstant CurrencyAmericas:Recurring revenues$2,582,800 43%$2,456,368 44%5%7%Non-recurring revenues124,958 2%131,359 3%(5)%(4)%2,707,758 45%2,587,727 47%5%6%EMEA:Recurring revenues1,864,720 31%1,680,746 30%11%12%Non-recurring revenues131,669 2%125,698 2%5%3%1,996,389 33%1,806,444 32%11%12%Asia-Pacific:Recurring revenues1,210,510 20%1,101,072 20%10%10%Non-recurring revenues83,888 2%66,897 1%25%24%1,294,398 22%1,167,969 21%11%10%Total:Recurring revenues5,658,030 94%5,238,186 94%8%9%Non-recurring revenues340,515 6%323,954 6%5%4%$5,998,545 100%$5,562,140 100%8%9%57Table of ContentsRevenues (dollars in thousands)Americas Revenues. During the year ended December 31, 2020, Americas revenue increased by 5% (6% on a constant currency basis). Growth in Americas revenues was primarily due to:•approximately $78.0 million of incremental revenues from the Bell, Packet, and Axtel acquisitions;•$21.0 million of incremental revenues generated from our recently-opened IBX data centers or IBX data center expansions; and•an increase in orders from both our existing customers and new customers during the period.The increase was partially offset by lower non-recurring revenues, primarily due to decreases in EIS products sales and lower revenues from Smart Hands products in 2020 as we restricted visits to our IBX facilities and waived certain Smart Hands service fees from the affected customers during the COVID-19 pandemic.EMEA Revenues. During the year ended December 31, 2020, EMEA revenue increased by 11% (12% on a constant currency basis). Growth in EMEA revenues was primarily due to:•approximately $26.9 million of incremental revenues generated from our recently-opened IBX data centers or IBX data center expansions; and•an increase in orders from both our existing customers and new customers during the period.The increase was partially offset by:•a net decrease of $43.5 million of realized cash flow hedge gains from foreign currency forward contracts.Asia-Pacific Revenues. During the year ended December 31, 2020, Asia-Pacific revenue increased by 11% (10% on a constant currency basis). Growth in Asia-Pacific revenue was primarily due to:•approximately $19.8 million of incremental revenues generated from our recently-opened IBX data centers or IBX data center expansions;•higher non-recurring revenues, primarily due to increases in EIS products sales; and•an increase in orders from both our existing customers and new customers during the period.58Table of ContentsCost of Revenues. Our cost of revenues for the years ended December 31, 2020 and 2019 were split among the following geographic regions (dollars in thousands):Years Ended December 31,% Change2020%2019%ActualConstant CurrencyAmericas$1,248,141 41%$1,146,639 41%9%11%EMEA1,094,335 36%1,017,580 36%8%8%Asia-Pacific731,864 23%645,965 23%13%13%Total$3,074,340 100%$2,810,184 100%9%10%Cost of Revenues (dollars in thousands; percentages indicate expenses as a percentage of revenues)Americas Cost of Revenues. During the year ended December 31, 2020, Americas cost of revenues increased by 9% (11% on a constant currency basis). The increase in our Americas cost of revenues was primarily due to:•approximately $64.4 million of incremental cost of revenues from the Bell, Packet, and Axtel acquisitions; •$9.8 million of higher utilities cost driven by IBX data center expansions and integration, primarily in U.S.;•$9.6 million of higher compensation costs, including salaries, bonuses and stock-based compensation, primarily due to headcount growth and additional bonuses paid to IBX employees for supporting our business during the COVID-19 pandemic;•$7.9 million of higher property tax costs driven by IBX data center expansions;•$5.8 million of higher accretion and depreciation costs driven by IBX data center expansions; and•$5.2 million of higher consulting services and office expense, primarily due to project integration and additional spending on personal protective equipment for our IBX employees in response to the COVID-19 pandemic.EMEA Cost of Revenues. During the year ended December 31, 2020, EMEA cost of revenues increased by 8% (and also 8% on a constant currency basis). The increase in our EMEA cost of revenues was primarily due to:•$42.8 million of higher depreciation expenses driven by IBX data center expansions in Germany, the United Kingdom, the Netherlands, United Arab Emirates, and France;•$25.9 million of higher compensation costs, including salaries, bonuses and stock-based compensation, primarily due to headcount growth and additional bonuses to IBX employees for supporting our business during the COVID-19 pandemic;•$17.7 million of higher utilities costs driven by increased utility usage to support IBX data center expansions and utility price increases, primarily in Germany and France;59Table of Contents•$12.3 million of higher consulting services and office expense, primarily due to project integration and additional spending on personal protective equipment for our IBX employees in response to the COVID-19 pandemic; and•$9.4 million of higher rent and facilities costs and repairs and maintenance expense, primarily in the United Kingdom, Germany, France, and the Netherlands.This increase was partially offset by:•$15.5 million decrease in realized cash flow hedge losses from foreign currency forward contracts;•$8.8 million of lower other expenses, as there was a general contractor bankruptcy during the year ended December 31, 2019, which resulted in incremental legal claim charges in the prior year; and•$8.3 million of net decrease in other cost of revenue, primarily due to lower costs related to decreased EIS revenues in Germany and the United Kingdom.Asia-Pacific Cost of Revenues. During the year ended December 31, 2020, Asia-Pacific cost of revenues increased by 13% (and also 13% on a constant currency basis). The increase in our Asia-Pacific cost of revenues was primarily due to:•$42.0 million of higher depreciation expense, primarily from IBX data center expansions in Australia, Singapore, Japan, and Hong Kong;•$14.6 million of higher utilities costs, primarily driven by expansions and higher utility usage in Hong Kong, Japan, and Singapore;•$9.0 million of higher costs from increased EIS revenues, primarily in Japan;•$8.4 million of higher compensation costs, including salaries, bonuses and stock-based compensation, primarily due to headcount growth and additional bonuses to IBX employees for supporting our business during the COVID-19 pandemic;•$6.6 million of higher taxes, licenses, and insurance, primarily driven by IBX data center expansions in Singapore, Australia, and Japan; and•$5.3 million of repairs and maintenance, primarily due to increases of maintenance projects in Japan and Australia. This increase was partially offset by:•$4.8 million of lower office, rent and facility expenses due to lower computer hardware costs and lower equipment lease activity in Japan.We expect Americas, EMEA and Asia-Pacific cost of revenues to increase in line with the growth of our business, including from the impacts of acquisitions.60Table of ContentsSales and Marketing Expenses. Our sales and marketing expenses for the years ended December 31, 2020 and 2019 were split among the following geographic regions (dollars in thousands):Years ended December 31,% Change2020%2019%ActualConstant CurrencyAmericas$457,551 64%$401,034 62%14%15%EMEA162,365 23%157,718 24%3%4%Asia-Pacific98,440 13%92,294 14%7%6%Total$718,356 100%$651,046 100%10%11%Sales and Marketing Expenses(dollars in thousands; percentages indicate expenses as a percentage of revenues)Americas Sales and Marketing Expenses. During the year ended December 31, 2020, Americas sales and marketing expenses increased by 14% (15% on a constant currency basis). The increase in our Americas sales and marketing expenses was primarily due to:•$42.9 million of higher compensation costs, including sales compensation, salaries and stock-based compensation, partially due to additional compensation expenses incurred related to our recent acquisitions and headcount growth; •$10.6 million of higher advertising and promotions expenses primarily due to higher spending in online advertising, digital marketing strategies and digital consultancy;•$5.4 million of higher consulting services primarily due to higher fees and an increase in business deals; and•$5.1 million of higher amortization expenses related to customer relationship intangibles acquired from our recent acquisitions.This increase was partially offset by:•$6.4 million decrease in travel and entertainment expenses resulting from travel restrictions imposed in response to the COVID-19 pandemic.EMEA Sales and Marketing Expenses. During the year ended December 31, 2020, EMEA sales and marketing increased by 3% (4% on a constant currency basis). The increase in our EMEA sales and marketing expenses was primarily due to:•$16.1 million of higher compensation costs, including sales compensation, salaries and stock-based compensation, partially due to additional compensation expenses incurred related to headcount growth.61Table of ContentsThis increase was partially offset by:•$4.7 million decrease in amortization expense driven by certain intangibles being fully amortized in the current year;•$4.1 million decrease in travel and entertainment expenses resulting from travel restrictions imposed in response to the COVID-19 pandemic; and•$2.7 million decrease of realized cash flow hedge losses from foreign currency forward contracts.Asia-Pacific Sales and Marketing Expenses. During the year ended December 31, 2020, Asia-Pacific sales and marketing increased by 7% (6% on a constant currency basis). The increase in our Asia-Pacific sales and marketing expenses was primarily due to:•$9.8 million increase in compensation costs, including sales compensation, salaries and stock-based compensation and headcount growth.This increase was partially offset by:•$3.5 million decrease in travel and entertainment expenses resulting from travel restrictions imposed in response to the COVID-19 pandemic.We anticipate that we will continue to invest in Americas, EMEA and Asia-Pacific sales and marketing initiatives and expect our Americas, EMEA and Asia-Pacific sales and marketing expenses to increase in line with the growth of our business. We also expect travel and entertainment expenses to increase once travel restrictions that were imposed in response to the COVID-19 pandemic are reduced. Additionally, given that certain global sales and marketing functions are located within the U.S., we expect Americas sales and marketing expenses as a percentage of revenues to be higher than our other regions.General and Administrative Expenses. Our general and administrative expenses for the years ended December 31, 2020 and 2019 were split among the following geographic regions (dollars in thousands):Years Ended December 31,% Change2020%2019%ActualConstant CurrencyAmericas$782,038 72%$641,261 69%22%23%EMEA203,619 19%198,892 21%2%3%Asia-Pacific105,324 9%94,865 10%11%11%Total$1,090,981 100%$935,018 100%17%17%62Table of ContentsGeneral and Administrative Expenses (dollars in thousands; percentages indicate expenses as a percentage of revenues)Americas General and Administrative Expenses. During the year ended December 31, 2020, Americas general and administrative expenses increased by 22% (23% on a constant currency basis). The increase in our Americas general and administrative expenses was primarily due to:•$80.3 million of higher compensation costs, including salaries, bonuses, and stock-based compensation related to recent acquisitions and headcount growth;•$25.2 million of higher depreciation expense associated with the Axtel and Packet acquisitions and the implementation of certain systems to support the integration and growth of our business;•$20.2 million of higher consulting expenses in support of our business growth;•$16.9 million of higher office expenses due to additional computer software, hardware, and support services;•$4.6 million of higher third party services and other operating expenses due to higher project costs; and•$3.4 million of higher taxes, licenses, and insurance, primarily due to the Axtel and Packet acquisitions.This increase was partially offset by:•$12.1 million net decrease due to lower travel and entertainment expenses resulting from travel restrictions imposed in response to the COVID-19 pandemic.EMEA General and Administrative Expenses. During the year ended December 31, 2020, EMEA general and administrative expenses increased by 2% (3% on a constant currency basis). The increase in our EMEA general and administrative expenses was primarily due to:•$24.4 million of higher compensation costs, including salaries, bonuses, and stock-based compensation, primarily due to headcount growth.This increase was partially offset by:•$6.0 million of lower travel and entertainment, resulting from travel restrictions imposed in response to the COVID-19 pandemic;•$5.5 million of lower other operating expenses, primarily due to the favorable determination of a legal claim;•$3.4 million of lower consulting expenses primarily related to lower accounting and tax fees; and•$3.2 million decrease of realized cash flow hedge losses from foreign currency forward contracts.Asia-Pacific General and Administrative Expenses. During the year ended December 31, 2020, Asia-Pacific general and administrative expenses increased by 11% (and also 11% on a constant currency basis). The increase in our Asia-Pacific general and administrative expense was primarily due to:63Table of Contents•$5.7 million of higher compensation costs, including salaries, bonuses, and stock-based compensation, primarily due to headcount growth;•$3.8 million of higher rent and facility costs, primarily due to additional rent expenses in Singapore; and•$3.5 million of higher office and consulting costs, primarily due to increase in hardware, software, supplies and fees resulting from the response to the COVID-19 pandemic.This increase was partially offset by:•$3.6 million of lower travel and entertainment expenses resulting from travel restrictions imposed in response to the COVID-19 pandemic.Going forward, although we are carefully monitoring our spending, we expect Americas, EMEA and Asia-Pacific general and administrative expenses to increase as we continue to further scale our operations to support our growth, including investments in our back office systems and investments to maintain our qualification for taxation as a REIT and to integrate recent acquisitions. We also expect travel and entertainment expenses to increase once travel restrictions that were imposed in response to the COVID-19 pandemic are reduced. Additionally, given that our corporate headquarters is located within the U.S., we expect Americas general and administrative expenses as a percentage of revenues to continue to be higher than our other regions.Transaction Costs. During the year ended December 31, 2020, we recorded transaction costs totaling $55.9 million primarily related to costs incurred in connection with the acquisitions of Bell, Packet, and Axtel, as well as the costs incurred in connection with the formation of the Asia-Pacific Joint Venture. During the year ended December 31, 2019, we recorded transaction costs totaling $24.8 million, primarily related to costs incurred in connection with the formation of the new EMEA Joint Venture.Impairment Charges. During the year ended December 31, 2020, we recorded impairment charges totaling $7.3 million in the Asia-Pacific region as a result of the fair value adjustment of the Asia-Pacific Joint venture xScaleTM data centers, which were classified as held for sale assets before they were sold on December 17, 2020. During the year ended December 31, 2019, we recorded impairment charges totaling $15.8 million in the Americas region primarily as a result of the fair value adjustment for the New York 12 ("NY12") data center, which was classified as a held for sale asset before it was sold in October 2019.Gain on Asset Sales. During the year ended December 31, 2020, we did not record a significant amount of gain on asset sales. During the year ended December 31, 2019, we recorded gain on asset sales of $44.3 million primarily relating to the sale of both the London 10 and Paris 8 data centers, as well as certain construction development and leases in London and Frankfurt, as part of the closing of the EMEA Joint Venture.Income from Operations. Our income from operations for the years ended December 31, 2020 and 2019 was split among the following geographic regions (dollars in thousands):Years Ended December 31,% Change2020%2019%ActualConstant CurrencyAmericas$178,454 17%$413,936 35%(57)%(54)%EMEA531,530 50%421,786 36%26%32%Asia-Pacific342,944 33%333,909 29%3%5%Total$1,052,928 100%$1,169,631 100%(10)%(8)%Americas Income from Operations. During the year ended December 31, 2020, Americas income from operations decreased by 57% (54% on a constant currency basis). The decrease in our Americas income from operations was primarily due to higher operating expenses as a percentage of revenues and higher transaction costs in connection with the recent acquisitions. Namely, a large increase in general and administrative expenses was primarily driven by higher compensation costs and consulting expenses, which were in part related to recent acquisitions, higher office expenses and depreciation expense, and payments made in response to the COVID-19 pandemic. EMEA Income from Operations. During the year ended December 31, 2020, EMEA income from operations increased by 26% (32% on a constant currency basis). The increase in our EMEA income from operations was 64Table of Contentsprimarily due to higher revenues as a result of our IBX data center expansion activity and organic growth, as described above, as well as lower operating expenses as a percentage of revenues.Asia-Pacific Income from Operations. During the year ended December 31, 2020, Asia-Pacific income from operations increased by 3% (5% on a constant currency basis). The increase in our Asia-Pacific income from operations was primarily due to higher revenues as a result of our IBX data center expansion activity, acquisition and organic growth as described above.Interest Income. Interest income was $8.7 million and $27.7 million for the years ended December 31, 2020 and 2019, respectively. The average yield for the year ended December 31, 2020 was 0.43% versus 1.85% for the year ended December 31, 2019. Interest Expense. Interest expense decreased to $406.5 million for the year ended December 31, 2020 from $479.7 million for the year ended December 31, 2019, primarily attributable to the redemption of legacy high yield Senior Notes due 2022, 2024, 2025, and 2026, partially offset by the issuance of new Senior Notes due 2025, 2027, 2028, 2030, 2050 and 2051. Due to the issuance and redemption of debt for the year ended December 31, 2020, the effective interest rate decreased from December 31, 2019. During the years ended December 31, 2020 and 2019, we capitalized $26.8 million and $32.2 million, respectively, of interest expense to construction in progress.Other Income. We recorded net other income of $6.9 million and $27.8 million for the years ended December 31, 2020 and 2019, respectively. Other income is primarily comprised of foreign currency exchange gains and losses during the periods.Loss on Debt Extinguishment. During the year ended December 31, 2020, we recorded $145.8 million of loss on debt extinguishment primarily related to the redemption of the Senior Notes due 2022, 2024, 2025, and 2026.During the year ended December 31, 2019, we recorded $52.8 million of loss on debt extinguishment primarily related to the redemption of the Senior Notes due 2022, 2023 and 2025.Income Taxes We operate as a REIT for U.S. federal income tax purposes. As a REIT, we are generally not subject to U.S. federal income taxes on our taxable income distributed to stockholders. We intend to distribute or have distributed the entire taxable income generated by the operations of our REIT and QRSs for the tax years ended December 31, 2020 and 2019, respectively. As such, other than tax attributable to built-in-gains recognized, state income taxes, and foreign income and withholding taxes, no provision for income taxes has been included for the REIT and its QRSs in the accompanying consolidated financial statements for the years ended December 31, 2020 and 2019. We have made TRS elections for some of our subsidiaries in and outside the U.S. In general, a TRS may provide services that would otherwise be considered impermissible for REITs to provide and may hold assets that may not be REIT compliant.U.S. income taxes for the TRS entities located in the U.S. and foreign income taxes for our foreign operations regardless of whether the foreign operations are operated as QRSs or TRSs have been accrued, as necessary, for the years ended December 31, 2020 and 2019.For the years ended December 31, 2020 and 2019, we recorded $146.2 million and $185.4 million of income tax expenses, respectively. Our effective tax rates were 28.3% and 26.8%, respectively, for the years ended December 31, 2020 and 2019.Adjusted EBITDA. Adjusted EBITDA is a key factor in how we assess the operating performance of our segments and develop regional growth strategies such as IBX data center expansion decisions. We define adjusted EBITDA as income or loss from operations excluding depreciation, amortization, accretion, stock-based compensation expense, restructuring charges, impairment charges, transaction costs and gain on asset sales. See "Non-GAAP Financial Measures" below for more information about adjusted EBITDA and a reconciliation of adjusted EBITDA to income or loss from operations. Our adjusted EBITDA for the years ended December 31, 2020 and 2019 was split among the following geographic regions (dollars in thousands):65Table of ContentsYears Ended December 31,% Change2020%2019%ActualConstant CurrencyAmericas$1,186,022 42 %$1,237,622 46 %(4)%(3)%EMEA974,246 34 %827,980 31 %18 %19 %Asia-Pacific692,630 24 %622,125 23 %11 %11 %Total$2,852,898 100 %$2,687,727 100 %6 %7 %Americas Adjusted EBITDA. During the year ended December 31, 2020, Americas adjusted EBITDA decreased by 4% (3% on a constant currency basis). The decrease in our Americas adjusted EBITDA was primarily due to the increase in compensation expenses, consulting expenses and office expenses.EMEA Adjusted EBITDA. During the year ended December 31, 2020, EMEA adjusted EBITDA increased by 18% (19% on a constant currency basis). The increase in our EMEA adjusted EBITDA was primarily due to higher revenues as a result of our IBX data center expansion activity and organic growth, as described above.Asia-Pacific Adjusted EBITDA. During the year ended December 31, 2020, Asia-Pacific adjusted EBITDA increased by 11% (and also 11% on a constant currency basis). The increase in our Asia-Pacific adjusted EBITDA was primarily due to higher revenues as a result of our IBX data center expansion activity and organic growth as described above.Non-GAAP Financial MeasuresWe provide all information required in accordance with GAAP, but we believe that evaluating our ongoing operating results may be difficult if limited to reviewing only GAAP financial measures. Accordingly, we use non-GAAP financial measures to evaluate our operations. Non-GAAP financial measures are not a substitute for financial information prepared in accordance with GAAP. Non-GAAP financial measures should not be considered in isolation, but should be considered together with the most directly comparable GAAP financial measures and the reconciliation of the non-GAAP financial measures to the most directly comparable GAAP financial measures. We have presented such non-GAAP financial measures to provide investors with an additional tool to evaluate our results of operations in a manner that focuses on what management believes to be our core, ongoing business operations. We believe that the inclusion of these non-GAAP financial measures provides consistency and comparability with past reports and provides a better understanding of the overall performance of the business and ability to perform in subsequent periods. We believe that if we did not provide such non-GAAP financial information, investors would not have all the necessary data to analyze Equinix effectively. Investors should note that the non-GAAP financial measures used by us may not be the same non-GAAP financial measures, and may not be calculated in the same manner, as those of other companies. Investors should therefore exercise caution when comparing non-GAAP financial measures used by us to similarly titled non-GAAP financial measures of other companies. Our primary non-GAAP financial measures, adjusted EBITDA and adjusted funds from operations ("AFFO"), exclude depreciation expense as these charges primarily relate to the initial construction costs of our IBX data centers and do not reflect our current or future cash spending levels to support our business. Our IBX data centers are long-lived assets and have an economic life greater than 10 years. The construction costs of an IBX data center do not recur with respect to such data center, although we may incur initial construction costs in future periods with respect to additional IBX data centers, and future capital expenditures remain minor relative to our initial investment. This is a trend we expect to continue. In addition, depreciation is also based on the estimated useful lives of our IBX data centers. These estimates could vary from actual performance of the asset, are based on historical costs incurred to build out our IBX data centers and are not indicative of current or expected future capital expenditures. Therefore, we exclude depreciation from our results of operations when evaluating our operations. 66Table of ContentsIn addition, in presenting adjusted EBITDA and AFFO, we exclude amortization expense related to acquired intangible assets. Amortization expense is significantly affected by the timing and magnitude of our acquisitions and these charges may vary in amount from period to period. We exclude amortization expense to facilitate a more meaningful evaluation of our current operating performance and comparisons to our prior periods. We exclude accretion expense, both as it relates to asset retirement obligations as well as accrued restructuring charge liabilities, as these expenses represent costs which we believe are not meaningful in evaluating our current operations. We exclude stock-based compensation expense, as it can vary significantly from period to period based on share price, the timing, size and nature of equity awards. As such, we, and many investors and analysts, exclude stock-based compensation expense to compare our results of operations with those of other companies. We also exclude restructuring charges. The restructuring charges relate to our decisions to exit leases for excess space adjacent to several of our IBX data centers, which we did not intend to build out, or our decision to reverse such restructuring charges. We also exclude impairment charges related to certain long-lived assets. The impairment charges are related to expense recognized whenever events or changes in circumstances indicate that the carrying amount of long-lived assets are not recoverable. We also exclude gain or loss on asset sales as it represents profit or loss that is not meaningful in evaluating the current or future operating performance. Finally, we exclude transaction costs from AFFO and adjusted EBITDA to allow more comparable comparisons of our financial results to our historical operations. The transaction costs relate to costs we incur in connection with business combinations and the formation of joint ventures, including advisory, legal, accounting, valuation, and other professional or consulting fees. Such charges generally are not relevant to assessing the long-term performance of the company. In addition, the frequency and amount of such charges vary significantly based on the size and timing of the transactions. Management believes items such as restructuring charges, impairment charges, gain or loss on asset sales and transaction costs are non-core transactions; however, these types of costs may occur in future periods.Adjusted EBITDAThe following table shows the reconciliation from income from operations to adjusted EBITDA (in thousands):Years Ended December 31,202020192018Income from operations$1,052,928 $1,169,631 $977,383 Depreciation, amortization, and accretion expense1,427,010 1,285,296 1,226,741 Stock-based compensation expense311,020 236,539 180,716 Transaction costs55,935 24,781 34,413 Impairment charges7,306 15,790 — Gain on asset sales(1,301)(44,310)(6,013)Adjusted EBITDA$2,852,898 $2,687,727 $2,413,240 Our adjusted EBITDA results have improved each year in the EMEA and Asia-Pacific regions in total dollars due to the improved operating results discussed earlier in "Results of Operations", as well as the nature of our business model consisting of a recurring revenue stream. The increases in adjusted EBITDA results for the EMEA and Asia-Pacific regions were partially offset by the decrease in the AMER region, as noted above.Funds from Operations ("FFO") and AFFOWe use FFO and AFFO, which are non-GAAP financial measures commonly used in the REIT industry. FFO is calculated in accordance with the standards established by the National Association of Real Estate Investment Trusts. FFO represents net income (loss), excluding gain (loss) from the disposition of real estate assets, depreciation and amortization on real estate assets and adjustments for unconsolidated joint ventures' and non-controlling interests' share of these items.In presenting AFFO, we exclude certain items that we believe are not good indicators of our current or future operating performance. AFFO represents FFO excluding depreciation and amortization expense on non-real estate assets, accretion, stock-based compensation, restructuring charges, impairment charges, transaction costs, an installation revenue adjustment, a straight-line rent expense adjustment, a contract cost adjustment, amortization of deferred financing costs and debt discounts and premiums, gain (loss) on debt extinguishment, an income tax expense adjustment, recurring capital expenditures, net income (loss) from discontinued operations, net of tax, and adjustments from FFO to AFFO for unconsolidated joint ventures' and noncontrolling interests' share of these items. The adjustments for installation revenue, straight-line rent expense and contract costs are intended to isolate the 67Table of Contentscash activity included within the straight-lined or amortized results in the consolidated statement of operations. We exclude the amortization of deferred financing costs and debt discounts and premiums as these expenses relate to the initial costs incurred in connection with debt financings that have no current or future cash obligations. We exclude gain (loss) on debt extinguishment since it generally represents the write-off of initial costs incurred in connection with debt financings or a cost that is incurred to reduce future interest costs and is not a good indicator of our current or future operating performance. We include an income tax expense adjustment, which represents the non-cash tax impact due to changes in valuation allowances, uncertain tax positions and deferred taxes that do not relate to current period's operations. We deduct recurring capital expenditures, which represent expenditures to extend the useful life of its IBX data centers or other assets that are required to support current revenues. We also exclude net income (loss) from discontinued operations, net of tax, which represents results that may not recur and are not a good indicator of our current future operating performance.Our FFO and AFFO were as follows (in thousands): Years Ended December 31,202020192018Net income$370,074 $507,245 $365,359 Net gain (loss) attributable to non-controlling interests(297)205 — Net income attributable to Equinix369,777 507,450 365,359 Adjustments:Real estate depreciation924,064 845,798 883,118 (Gain) loss on disposition of real estate property4,063 (39,337)4,643 Adjustments for FFO from unconsolidated joint ventures2,726 645 — FFO$1,300,630 $1,314,556 $1,253,120 Years Ended December 31,202020192018FFO$1,300,630 $1,314,556 $1,253,120 Adjustments:Installation revenue adjustment(125)11,031 10,858 Straight-line rent expense adjustment10,787 8,167 7,203 Contract cost adjustment(35,675)(40,861)(20,358)Amortization of deferred financing costs and debt discounts and premiums15,739 13,042 13,618 Stock-based compensation expense311,020 236,539 180,716 Non-real estate depreciation expense300,258 242,761 140,955 Amortization expense199,047 196,278 203,416 Accretion expense (adjustment)3,641 459 (748)Recurring capital expenditures(160,637)(186,002)(203,053)Loss on debt extinguishment145,804 52,825 51,377 Transaction costs55,935 24,781 34,413 Impairment charges7,306 15,790 — Income tax expense adjustment33,220 39,676 (12,420)Adjustments for AFFO from unconsolidated joint ventures2,195 2,080 — AFFO$2,189,145 $1,931,122 $1,659,097 Our AFFO results have improved due to the improved operating results discussed earlier in "Results of Operations," as well as due to the nature of our business model which consists of a recurring revenue stream and a cost structure which has a large base that is fixed in nature as discussed earlier in "Overview."68Table of ContentsConstant Currency PresentationOur revenues and certain operating expenses (cost of revenues, sales and marketing and general and administrative expenses) from our international operations have represented and will continue to represent a significant portion of our total revenues and certain operating expenses. As a result, our revenues and certain operating expenses have been and will continue to be affected by changes in the U.S. dollar against major international currencies. During the year ended December 31, 2020 as compared to the same period in 2019, the U.S. dollar was stronger relative to the Brazilian real, Singapore dollar and Australian dollar, which resulted in an unfavorable foreign currency impact on revenue, operating income and adjusted EBITDA, and a favorable foreign currency impact on operating expenses. During the year ended December 31, 2020 as compared to the same period in 2019, the U.S. dollar was weaker relative to the Japanese yen, Hong Kong dollar, Euro, and British pound, which resulted in a favorable foreign currency impact on revenue, operating income and adjusted EBITDA, and an unfavorable foreign currency impact on operating expenses. In order to provide a framework for assessing how each of our business segments performed excluding the impact of foreign currency fluctuations, we present period-over-period percentage changes in our revenues and certain operating expenses on a constant currency basis in addition to the historical amounts as reported. Our constant currency presentation excludes the impact of our foreign currency cash flow hedging activities. Presenting constant currency results of operations is a non-GAAP financial measure and is not meant to be considered in isolation or as an alternative to GAAP results of operations. However, we have presented this non-GAAP financial measure to provide investors with an additional tool to evaluate our results of operations. To present this information, our current period revenues and certain operating expenses from entities reporting in currencies other than the U.S. dollar are converted into U.S. dollars at constant exchange rates rather than the actual exchange rates in effect during the respective periods (i.e. average rates in effect for the year ended December 31, 2019 are used as exchange rates for the year ended December 31, 2020 when comparing the year ended December 31, 2020 with the year ended December 31, 2019). Liquidity and Capital ResourcesAs of December 31, 2020, our total indebtedness was comprised of debt and lease obligations totaling approximately $12.6 billion (gross of debt issuance cost, debt discount, plus mortgage premium) consisting of:•approximately $9.3 billion of principal from our senior notes;•approximately $1.9 billion from our finance lease liabilities; and •$1.4 billion of principal from our loans payable and mortgage.During 2020, we completed the following significant financing activities:•issued and sold 415,512 shares of common stock under our ATM Program, for proceeds of approximately $298.3 million, net of payment of commissions and other offering expenses;•issued and sold 2,587,500 shares of common stock for net proceeds of approximately $1.7 billion;•borrowed and repaid $0.8 billion under our revolving credit facility and the 364-day term loan facilities; and •issued $4.4 billion of our Senior Notes, net of debt discounts, and repaid $4.1 billion of legacy high yield Senior Notes and $300.0 million of Infomart Senior Notes.As of December 31, 2020, we had $1.6 billion of cash, cash equivalents and short-term investments. In addition to our cash and investment portfolio, we had $1.9 billion of additional liquidity available to us from our $2.0 billion revolving facility and general access to both public and private debt and the equity capital markets. We also have additional liquidity available to us from our ATM programs, under which we may offer and sell from time to time our common stock in "at the market" transactions. As of December 31, 2020, we had completed sales under the ATM program that was previously launched in December 2018. On October 30, 2020, we launched a new ATM program allowing for aggregate sales of up to $1.5 billion (the "2020 ATM Program"). No sales have been made under the 2020 ATM Program to date.Besides any further financing activity we may pursue, customer collections are our primary source of cash. We believe we have a strong customer base, and have continued to experience relatively strong collections. We believe we have sufficient cash, coupled with anticipated cash generated from operating activities and external financing sources, to meet our operating requirements, including repayment of the current portion of our debt as it becomes due, distribution of dividends and completion of our publicly-announced acquisition and expansion projects. We also believe that our financial resources will allow us to manage future possible impact of the ongoing COVID-19 69Table of Contentspandemic on our business operations for the foreseeable future, which could include reductions in revenue and delays in payments from customers and partners. As we continue to grow, we may pursue additional expansion opportunities, primarily the build out of new IBX data centers, in certain of our existing markets which are at or near capacity within the next year, as well as potential acquisitions and joint ventures. We may elect to access the equity or debt markets from time to time opportunistically, particularly if financing is available on attractive terms. We will continue to evaluate our operating requirements and financial resources in light of future developments, including those relating to the ongoing COVID-19 pandemic.Sources and Uses of CashYears Ended December 31,20202019(in thousands)Net cash provided by operating activities$2,309,826 $1,992,728 Net cash used in investing activities(3,426,972)(1,944,567)Net cash provided by financing activities815,526 1,202,082 Operating ActivitiesOur cash provided by our operations is generated by colocation, interconnection, managed infrastructure and other revenues. Our primary uses of cash from our operating activities include compensation and related costs, interest payments, other general corporate expenditures and taxes. The increase in net cash provided by operating activities during 2020 compared to 2019 was primarily due to improved results of operations offset by increases in cash paid for cost of revenues and operating expenses.Investing ActivitiesThe net cash used in investing activities for the year ended December 31, 2020 was primarily due to capital expenditures of $2.3 billion as a result of our expansion activity, purchases of real estate of $200.2 million, business acquisitions of Bell, Packet and Axtel for $1.2 billion, and purchases of investments of $127.8 million, partially offset by proceeds from the sale of assets to the Asia-Pacific and EMEA Joint Ventures of $334.4 million and proceeds from sales of investments of $29.4 million. The net cash used in investing activities for the year ended December 31, 2019 was primarily due to capital expenditures of $2.1 billion as a result of our expansion activity, purchases of real estate of $169.2 million, the AM11 data center acquisition of $34.1 million, and purchases of investments of $60.9 million, partially offset by proceeds from the sale of assets, primarily due to the sale of assets to the EMEA Joint Venture, of $358.8 million and proceeds from sales of investments of $40.4 million.We anticipate our IBX data center expansion construction activity will be similar or increase from our 2020 levels. If the opportunity to expand is greater than planned and we have sufficient funding to pursue such expansion opportunities, we may further increase the level of capital expenditure to support this growth as well as pursue additional business and real estate acquisitions or joint ventures.Financing ActivitiesNet cash provided by financing activities during 2020 was primarily due to:•the issuance of $4.4 billion in Senior Notes due 2025, 2027, 2028, 2030, 2050 and 2051;•the sale and issuance of 2,587,500 shares of common stock in a public offering for net proceeds of approximately $1.7 billion, net of underwriting discounts, commissions and offering expenses; •borrowings under the revolving credit facility of $250.0 million and the 364-Day term loan facilities of $500.8 million;•the sale of 415,512 shares of common stock under the ATM Program, for net proceeds of $298.3 million; and•proceeds from employee awards of $62.1 million.The proceeds were partially offset by:70Table of Contents•the redemption of $4.1 billion in Senior Notes due 2022, 2024, 2025 and 2026;•the repayment of $300.0 million of 5.0% Infomart Senior Notes according to the repayment terms;•dividend distributions of $947.9 million;•repayments of finance lease liabilities totaling $115.3 million;•repayments of mortgage and loans payable totaling $829.5 million, primarily from the repayments of the revolving credit facility and the 364-Day term loan facilities;•payments of debt extinguishment costs of $111.7 million, primarily related to redemption premium paid to redeem legacy high yield Senior Notes due 2022, 2024, 2025 and 2026; and•payments of debt issuance costs of $42.2 million.Net cash provided by financing activities during 2019 was primarily due to:•the issuance of $2.8 billion in Senior Notes due 2024, 2026 and 2029;•the sale and issuance of 2,985,575 shares of common stock in a public equity offering and receipt of net proceeds of approximately $1.2 billion, net of underwriting discounts, commissions and offering expenses;•the sale of 903,555 shares under our ATM Program, for net proceeds of $447.5 million; and•proceeds from employee awards of $52.0 million.The proceeds were partially offset by:•the redemption of $1.9 billion in Senior Notes due 2022, 2023 and 2025;•the repayment of $300.0 million of 5.0% Infomart Senior Notes according to the repayment terms;•dividend distributions of $836.2 million;•repayments of finance lease liabilities of $126.5 million;•repayments of mortgage and loans payable of $73.2 million;•payments of debt extinguishment costs of $43.3 million, primarily related to redemption premium paid to redeem Senior Notes due 2022, 2023 and 2025; and•payments of debt issuance costs of $23.3 million.Contractual Obligations and Off-Balance-Sheet ArrangementsWe lease a majority of our IBX data centers and certain equipment under long-term lease agreements. The following represents our debt maturities, financings, leases and other contractual commitments as of December 31, 2020 (in thousands):20212022202320242025ThereafterTotalTerm loans and other loans payable (1)$82,289 $1,253,106 $6,896 $6,395 $4,605 $19,540 $1,372,831 Senior notes (1)150,000 — — 1,000,000 1,200,000 6,911,050 9,261,050 Interest (2)282,022 274,769 253,705 253,503 227,073 1,201,943 2,493,015 Finance leases (3)232,415 221,058 215,909 213,186 209,424 1,928,094 3,020,086 Operating leases (3)199,291 205,411 188,724 176,626 165,437 1,032,186 1,967,675 Other contractual commitments (4)1,635,300 213,610 95,809 48,843 41,395 362,031 2,396,988 Asset retirement obligations (5)3,993 14,013 5,986 7,436 8,243 74,098 113,769 $2,585,310 $2,181,967 $767,029 $1,705,989 $1,856,177 $11,528,942 $20,625,414 (1)Represents principal and unamortized mortgage premium only. (2)Represents interest on mortgage payable, loans payable, senior notes and term loans based on their respective interest rates as of December 31, 2020, as well as the credit facility fee for the revolving credit facility.(3)Represents lease payments under finance and operating lease arrangements, including renewal options that are certain to be exercised.(4)Represents off-balance sheet arrangements. Other contractual commitments are described below.71Table of Contents(5)Represents liability, net of future accretion expense.As of December 31, 2020, we were contractually committed for $1.1 billion of unaccrued capital expenditures, primarily for IBX equipment not yet delivered and labor not yet provided in connection with the work necessary to complete construction and open IBX data center expansion projects prior to making them available to customers for installation. This amount, which is expected to be paid during 2021 and thereafter, is reflected in the table above as "other contractual commitments."We had other non-capital purchase commitments in place as of December 31, 2020, such as commitments to purchase power in select locations and other open purchase orders, which contractually bind us for goods, services or arrangements to be delivered or provided during 2021 and beyond. Such other purchase commitments as of December 31, 2020, which total $1.3 billion, are also reflected in the table above as "other contractual commitments."Other commitmentsIn connection with certain of our leases and other contracts requiring deposits, we entered into 37 irrevocable letters of credit totaling $74.6 million under the revolving credit facility. These letters of credit were provided in lieu of cash deposits. If the landlords for these IBX leases decide to draw down on these letters of credit triggered by an event of default under the lease, we will be required to fund these letters of credit either through cash collateral or borrowing under the revolving credit facility. These contingent commitments are not reflected in the table above.We had accrued liabilities related to uncertain tax positions totaling approximately $169.7 million as of December 31, 2020. These liabilities, which are reflected on our balance sheet, are not reflected in the table above since it is unclear when these liabilities will be paid.In connection with the EMEA Joint Venture which closed in October 2019, we committed to make future equity contributions to the EMEA Joint Venture of €13.8 million and £6.6 million, or $25.8 million in total at the exchange rate in effect on December 31, 2020, to fund the EMEA Joint Venture’s future development until 2022, which are not reflected in the table above. In connection with the sale of the PA9 data center, which closed in December 2020, we also has a commitment to the EMEA Joint Venture to complete a residual portion of the PA9 center for an estimated cost of €14.5 million or $17.7 million in total at the exchange rate in effect on December 31, 2020, which is reimbursable upon completion and is not reflected in the table above.We also committed to make future equity contributions to the Asia-Pacific Joint Venture, which was closed on December 17, 2020. As of December 31, 2020, we had future equity contribution commitments of ¥6.3 billion, or $60.7 million in total at the exchange rate in effect on December 31, 2020, which is not reflected in the table above.Additionally, we entered into lease agreements with various landlords primarily for data center spaces and ground leases which have not yet commenced as of December 31, 2020. These leases will commence between fiscal years 2021 and 2022 with lease terms of 10 to 49 years and a total lease commitment of approximately $684.1 million, which is not reflected in the table above. Other Off-Balance-Sheet ArrangementsWe have various guarantor arrangements with both our directors and officers and third parties, including customers, vendors and business partners. As of December 31, 2020, there were no significant liabilities recorded for these arrangements. For additional information, see "Guarantor Arrangements" in Note 15 within the Consolidated Financial Statements.Critical Accounting Policies and EstimatesOur consolidated financial statements are prepared in accordance with U.S. GAAP. The preparation of our financial statements requires management to make estimates and assumptions about future events that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. On an ongoing basis, management evaluates the accounting policies, assumptions, estimates and judgments to ensure that our consolidated financial statements are presented fairly and in accordance with GAAP. Management bases its 72Table of Contentsassumptions, estimates and judgments on historical experience, current trends and various other factors that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. However, because future events and their effects cannot be determined with certainty, actual results may differ from these assumptions and estimates, and such differences could be material.Our significant accounting policies are discussed in Note 1 to Consolidated Financial Statements in Item 8 of this Annual Report on Form 10-K. Management believes that the following accounting policies and estimates are the most critical to aid in fully understanding and evaluating our consolidated financial statements, and they require significant judgments, resulting from the need to make estimates about the effect of matters that are inherently uncertain:• Accounting for income taxes;• Accounting for business combinations;• Accounting for impairment of goodwill; • Accounting for property, plant and equipment; and• Accounting for leases.73Table of ContentsDescriptionJudgments and UncertaintiesEffect if Actual Results Differ from AssumptionsAccounting for Income Taxes.Deferred tax assets and liabilities are recognized based on the future tax consequences attributable to temporary differences that exist between the financial statement carrying value of assets and liabilities and their respective tax bases, and tax attributes such as operating loss, capital loss and tax credit carryforwards on a taxing jurisdiction basis. We measure deferred tax assets and liabilities using enacted tax rates that will apply in the years in which we expect the temporary differences to be recovered or settled. The accounting standard for income taxes requires a reduction of the carrying amounts of deferred tax assets by recording a valuation allowance if, based on the available evidence, it is more likely than not (defined by the accounting standard as a likelihood of more than 50%) that such assets will not be realized.A tax benefit from an uncertain income tax position may be recognized in the financial statements only if it is more likely than not that the position is sustainable, based solely on its technical merits and consideration of the relevant taxing authority's widely understood administrative practices and precedents. We recognize interest and penalties related to unrecognized tax benefits within income tax benefit (expense) in the consolidated statements of operations.The valuation of deferred tax assets requires judgment in assessing the likely future tax consequences of events that have been recognized in our financial statements or tax returns. Our accounting for deferred tax consequences represents our best estimate of those future tax consequences. In assessing the need for a valuation allowance, we consider both positive and negative evidence related to the likelihood of realization of the deferred tax assets. If, based on the weight of that available evidence, it is more likely than not the deferred tax assets will not be realized, we record a valuation allowance. The weight given to the positive and negative evidence is commensurate with the extent to which the evidence may be objectively verified.This assessment, which is completed on a taxing jurisdiction basis, takes into account a number of types of evidence, including the following: 1) the nature, frequency and severity of current and cumulative financial reporting losses, 2) sources of future taxable income and 3) tax planning strategies.In assessing the tax benefit from an uncertain income tax position, the tax position that meets the more-likely-than-not recognition threshold is initially and subsequently measured as the largest amount of tax benefit that is greater than a 50% likelihood of being realized upon ultimate settlement with a taxing authority that has full knowledge of all relevant information.For purposes of the quarterly REIT asset tests, we estimate the fair market value of assets within our QRSs and TRSs using a discounted cash flow approach, by calculating the present value of forecasted future cash flows. We apply discount rates based on industry benchmarks relative to the market and forecasting risks. Other significant assumptions used to estimate the fair market value of assets in QRSs and TRSs include projected revenue growth, projected operating margins and projected capital expenditure. We revisit significant assumptions periodically to reflect any changes due to business or economic environment.As of December 31, 2020 and 2019, we had net total deferred tax liabilities of $224.0 million and $211.4 million, respectively. As of December 31, 2020 and 2019, we had a total valuation allowance of $82.3 million and $57.8 million, respectively. If and when we increase or reduce our valuation allowances, it may have an unfavorable or favorable impact, respectively, to our financial position and results of operations in the periods when such determinations are made. We will continue to assess the need for our valuation allowances, by jurisdiction, in the future. During the year ended December 31, 2020, we provided full valuation allowances against certain deferred tax assets acquired in Canada and the Netherlands that are not expected to be realizable in the foreseeable future. During the year ended December 31, 2019, we released the full valuation allowances against the deferred tax assets of one of our Brazilian legal entities due to the evidence of achieving sustainable profitability. For the Metronode Acquisition, we increased the valuation allowance that was assessed in prior year as a result of finalizing the provisional estimates related to the realizability of certain deferred tax assets. As of December 31, 2020 and 2019, we had unrecognized tax benefits of $207.8 million and $173.7 million, respectively, exclusive of interest and penalties. During the year ended December 31, 2020, the unrecognized tax benefit increased by $34.1 million primarily due to integrations in the EMEA region, which was partially offset by the recognition of unrecognized tax benefits related to our tax positions in a few countries as a result of a lapse in statutes of limitations and the partial payment related to the UK integration. During the year ended December 31, 2019, the unrecognized tax benefit increased by $22.8 million primarily due to integrations, which was partially offset by the recognition of unrecognized tax benefits related to our tax positions in France as a result of a lapse in statutes of limitations and the partial payment of the Metronode pre-acquisition tax audit assessment which was fully indemnified by the seller. The unrecognized tax benefits of $207.8 million as of December 31, 2020, of which $33.8 million is subject to an indemnification agreement, if subsequently recognized, will affect our effective tax rate favorably at the time when such a benefit is recognized.74Table of ContentsDescriptionJudgments and UncertaintiesEffect if Actual Results Differ from AssumptionsAccounting for Business CombinationsIn accordance with the accounting standard for business combinations, we allocate the purchase price of an acquired business to its identifiable assets and liabilities based on estimated fair values. The excess of the purchase price over the fair value of the assets acquired and liabilities assumed, if any, is recorded as goodwill. We use all available information to estimate fair values. We typically engage outside appraisal firms to assist in determining the fair value of identifiable intangible assets such as customer contracts, leases and any other significant assets or liabilities and contingent consideration, as well as the estimated useful life of intangible assets. We adjust the preliminary purchase price allocation, as necessary, up to one year after the acquisition closing date if we obtain more information regarding asset valuations and liabilities assumed.Our purchase price allocation methodology contains uncertainties because it requires assumptions and management's judgment to estimate the fair value of assets acquired and liabilities assumed at the acquisition date. Key judgments used to estimate the fair value of intangible assets include projected revenue growth and operating margins, discount rates, customer attrition rates, as well as the estimated useful life of intangible assets. Management estimates the fair value of assets and liabilities based upon quoted market prices, the carrying value of the acquired assets and widely accepted valuation techniques, including discounted cash flows and market multiple analyses. Our estimates are inherently uncertain and subject to refinement. Unanticipated events or circumstances may occur which could affect the accuracy of our fair value estimates, including assumptions regarding industry economic factors and business strategies. During the last three years, we have completed a number of business combinations, including the acquisition of Bell Data Centers in Canada in the fourth quarter of 2020, Packet in March 2020, Axtel in Mexico in January 2020, Switch Datacenters' AMS1 data center business in Amsterdam, Netherlands in April 2019, and the Metronode Acquisition and the Infomart Dallas Acquisition in April 2018. The purchase price allocation for these acquisitions has been finalized, except for the Bell acquisition.As of December 31, 2020 and 2019, we had net intangible assets of $2.2 billion and $2.1 billion, respectively. We recorded amortization expense for intangible assets of $199.0 million, $196.3 million and $203.4 million for the years ended December 31, 2020, 2019 and 2018, respectively. We do not believe there is a reasonable likelihood that there will be a material change in the estimates or assumptions we used to complete the purchase price allocations and the fair value of assets acquired and liabilities assumed. However, if actual results are not consistent with our estimates or assumptions, we may be exposed to losses or gains that could be material, which would be recorded in our consolidated statements of operations in 2020 or beyond. 75Table of ContentsDescriptionJudgments and UncertaintiesEffect if Actual Results Differ from AssumptionsAccounting for Impairment of Goodwill and Other Intangible AssetsIn accordance with the accounting standard for goodwill and other intangible assets, we perform goodwill and other intangible assets impairment reviews annually, or whenever events or changes in circumstances indicate that the carrying value of an asset may not be recoverable. We complete the annual goodwill impairment assessment for the Americas, EMEA and Asia-Pacific reporting units to determine if the fair values of the reporting units exceeded their carrying values. We perform a review of other intangible assets for impairment by assessing events or changes in circumstances that indicate the carrying amount of an asset may not be recoverable. To perform annual goodwill impairment assessment, we elected to assess qualitative factors to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying value. This analysis requires assumptions and estimates before performing the quantitative goodwill impairment test, where the assessment requires assumptions and estimates derived from a review of our actual and forecasted operating results, approved business plans, future economic conditions and other market data. Additionally, we periodically review our assessment of our reporting units to determine if changes in facts and circumstances warrant changes to our conclusions. There were no specific factors present in 2020 or 2019 that indicated a potential goodwill impairment. We performed our annual review of other intangible assets by assessing if there were events or changes in circumstances indicating that the carrying amount of an asset may not be recoverable, such as a significant decrease in market price of an asset, a significant adverse change in the extent or manner in which an asset is being used, a significant adverse change in legal factors or business climate that could affect the value of an asset or a continuous deterioration of our financial condition. This assessment requires assumptions and estimates derived from a review of our actual and forecasted operating results, approved business plans, future economic conditions and other market data. There were no specific events in 2020 or 2019 that indicated a potential impairment.As of December 31, 2020, goodwill attributable to the Americas, the EMEA and the Asia-Pacific reporting units was $2.2 billion, $2.6 billion and $0.6 billion, respectively.Future events, changing market conditions and any changes in key assumptions may result in an impairment charge. While we have not recorded an impairment charge against our goodwill to date, the development of adverse business conditions in our Americas, EMEA or Asia-Pacific reporting units, such as higher than anticipated customer churn or significantly increased operating costs, or significant deterioration of our market comparables that we use in the market approach, could result in an impairment charge in future periods.The balance of our other intangible assets, net, for the year ended December 31, 2020 and 2019 was $2.2 billion and $2.1 billion, respectively. While we have not recorded an impairment charge against our other intangible assets to date, future events or changes in circumstances, such as a significant decrease in market price of an asset, a significant adverse change in the extent or manner in which an asset is being used, a significant adverse change in legal factors or business climate, may result in an impairment charge in future periods. Any potential impairment charge against our goodwill and other intangible assets would not exceed the amounts recorded on our consolidated balance sheets.76Table of ContentsDescriptionJudgments and UncertaintiesEffect if Actual Results Differ from AssumptionsAccounting for Property, Plant and EquipmentWe have a substantial amount of property, plant and equipment recorded on our consolidated balance sheet. The vast majority of our property, plant and equipment represent the costs incurred to build out or acquire our IBX data centers. Our IBX data centers are long-lived assets. We depreciate our property, plant and equipment using the straight-line method over the estimated useful lives of the respective assets (subject to the term of the lease in the case of leased assets or leasehold improvements and integral equipment located in leased properties). Accounting for property, plant and equipment includes determining the appropriate period in which to depreciate such assets, assessing such assets for potential impairment, capitalizing interest during periods of construction and assessing the asset retirement obligations required for certain leased properties that require us to return the leased properties back to their original condition at the time we decide to exit a leased property.Judgments are required in arriving at the estimated useful life of an asset and changes to these estimates would have significant impact on our financial position and results of operations. When we lease a property for our IBX data centers, we generally enter into long-term arrangements with initial lease terms of at least 8-10 years and with renewal options generally available to us. In the next several years, a number of leases for our IBX data centers will come up for renewal. As we start approaching the end of these initial lease terms, we will need to reassess the estimated useful lives of our property, plant and equipment. In addition, we may find that our estimates for the useful lives of non-leased assets may also need to be revised periodically. We periodically review the estimated useful lives of certain of our property, plant and equipment and changes in these estimates in the future are possible. The assessment of long-lived assets for impairment requires assumptions and estimates of undiscounted and discounted future cash flows. These assumptions and estimates require significant judgment and are inherently uncertain.As of December 31, 2020 and 2019, we had property, plant and equipment of $14.5 billion and $12.2 billion, respectively. During the years ended December 31, 2020, 2019 and 2018, we recorded depreciation expense of $1.2 billion, $1.1 billion, and $1.0 billion, respectively. While we evaluated the appropriateness, we did not revise the estimated useful lives of our property, plant and equipment during the years ended December 31, 2020, 2019 and 2018. Further changes in our estimated useful lives of our property, plant and equipment could have a significant impact on our results of operations.Accounting for LeasesA significant portion of our data center spaces, office spaces and equipment are leased. Each time we enter into a new lease or lease amendments, we analyze each lease or lease amendment for the proper accounting, including determining if an arrangement is or contains a lease at inception and making assessment of the leased properties to determine if they are operating or finance leases. Determination of accounting treatment, including the result of the lease classification test for each new lease or lease amendment, is dependent on a variety of judgments, such as identification of lease and non-lease components, allocation of total consideration between lease and non-lease components, determination of lease term, including assessing the likelihood of lease renewals, valuation of leased property, and establishing the incremental borrowing rate to calculate the present value of the minimum lease payment for the lease test. The judgments used in the accounting for leases are inherently subjective; different assumptions or estimates could result in different accounting treatment for a lease.Lease assumptions and estimates are determined and applied at the inception of the leases or at the lease modification date. As of both December 31, 2020 and 2019, operating right-of-use ("ROU") lease assets were at $1.5 billion and operating lease liabilities were at $1.5 billion . As of December 31, 2020 and 2019, finance ROU assets were $1.7 billion and $1.3 billion, respectively, and finance lease liabilities were $1.9 billion and $1.5 billion, respectively. For the years ended December 31, 2020, 2019 and 2018, we recorded the finance lease cost of $233.9 million and $193.6 million, respectively, and recorded rent expense of approximately $217.3 million, $219.0 million and $185.4 million, respectively.Recent Accounting PronouncementsSee "Recent Accounting Pronouncements" in Note 1 within the Consolidated Financial Statements.77Table of ContentsITEM 7A. Quantitative and Qualitative Disclosures About Market RiskMarket Risk The following discussion about market risk involves forward-looking statements. Actual results could differ materially from those projected in the forward-looking statements. We may be exposed to market risks related to changes in interest rates and foreign currency exchange rates and fluctuations in the prices of certain commodities, primarily electricity.The uncertainty that exists with respect to the economic impact of the ongoing COVID-19 pandemic introduced significant volatility in the financial markets. See Part I, Item 1A. Risk Factors for additional information regarding potential risks to our business, financial condition and results of operations related to the ongoing COVID-19 pandemic.We employ foreign currency forward and option contracts, cross-currency interest rate swaps and interest rate locks for the purpose of hedging certain specifically identified exposures. The use of these financial instruments is intended to mitigate some of the risks associated with fluctuations in currency exchange and interest rates, but does not eliminate such risks. We do not use financial instruments for trading or speculative purposes.Investment Portfolio RiskWe maintain an investment portfolio of various holdings, types, and maturities that is prioritized on meeting REIT asset requirements. All of our marketable securities are recorded on our consolidated balance sheets at fair value with changes in fair values recognized in net income. We consider various factors in determining whether we should recognize an impairment charge for our securities, including the length of time and extent to which the fair value has been less than our cost basis and our intent and ability to hold the investment for a period of time sufficient to allow for any anticipated recovery. We anticipate that we will recover the entire cost basis of these securities and have determined that no other-than-temporary impairments associated with credit losses were required to be recognized during the year ended December 31, 2020.As of December 31, 2020, our investment portfolio of cash equivalents and marketable securities consisted of money market funds, certificates of deposits and publicly traded equity securities. The amount in our investment portfolio that could be susceptible to market risk totaled $615.6 million.Interest Rate Risk We are exposed to interest rate risk related to our outstanding debt. An immediate 10% increase or decrease in current interest rates from their position as of December 31, 2020 would not have a material impact on our interest expense due to the fixed coupon rate on the majority of our debt obligations. However, the interest expense associated with our senior credit facility and term loans, that bear interest at variable rates, could be affected. For every 100 basis point change in interest rates, our annual interest expense could increase by a total of approximately $10.9 million or decrease by a total of approximately $0.2 million based on the total balance of our primary borrowings under the Term Loan Facility as of December 31, 2020. As of December 31, 2020, we had no outstanding interest rate derivative hedges against our debt obligations. However, we may enter into interest rate hedging agreements in the future to mitigate our exposure to interest rate risk.The fair value of our long-term fixed interest rate debt is subject to interest rate risk. Generally, the fair value of fixed interest rate debt will increase as interest rates fall and decrease as interest rates rise. These interest rate changes may affect the fair value of the fixed interest rate debt but do not impact our earnings or cash flows. The fair value of our mortgage and loans payable and 5.000% Infomart Senior Notes, which are not traded in the market, is estimated by considering our credit rating, current rates available to us for debt of the same remaining maturities and the terms of the debt. The fair value of our other senior notes, which are traded in the market, was based on quoted market prices. The following table represents the carrying value and estimated fair value of our mortgage and loans payable and senior notes as of (in thousands):78Table of ContentsDecember 31, 2020December 31, 2019Carrying Value (1)Fair ValueCarrying Value (1)Fair ValueMortgage and loans payable$1,370,970 $1,379,129 $1,370,118 $1,378,429 Senior notes9,261,050 9,705,486 9,029,211 9,339,497 (1)The carrying value is gross of debt issuance cost, debt discount and debt premium.Foreign Currency Risk A significant portion of our revenue is denominated in U.S. dollars, however, approximately 59% of our revenues and 53% of our operating costs are attributable to Brazil, Mexico, Canada, Colombia and the EMEA and Asia-Pacific regions, and a large portion of those revenues and costs are denominated in a currency other than the U.S. dollar, primarily the Euro, British pound, Japanese yen, Singapore dollar, Hong Kong dollar, Australian dollar and Brazilian real. To help manage the exposure to foreign currency exchange rate fluctuations, we have implemented a number of hedging programs, in particular:•a cash flow hedging program to hedge the forecasted revenues and expenses in our EMEA region;•a balance sheet hedging program to hedge the remeasurement of monetary assets and liabilities denominated in foreign currencies; and•a net investment hedging program to hedge the long term investments in our foreign subsidiaries. Our hedging programs reduce, but do not entirely eliminate, the impact of currency exchange rate movements on our consolidated balance sheets, statements of operations and statements of cash flows. We have entered into various foreign currency debt obligations. As of December 31, 2020, the total principal amount of foreign currency debt obligations was $1.9 billion, including $611.1 million denominated in Euro, $589.7 million denominated in British Pound, $408.5 million denominated in Japanese Yen and $293.9 million denominated in Swedish Krona. As of December 31, 2020, we have designated $1.9 billion of the total principal amount of foreign currency debt obligations as net investment hedges against our net investments in foreign subsidiaries. For a net investment hedge, changes in the fair value of the hedging instrument designated as a net investment hedge are recorded as a component of other comprehensive income (loss) in the consolidated balance sheets. Fluctuations in the exchange rates between these foreign currencies and the U.S. Dollar will impact the amount of U.S. Dollars that we will require to settle the foreign currency debt obligations at maturity. If the U.S. Dollar would have been weaker or stronger by 10% in comparison to these foreign currencies as of December 31, 2020, we estimate our obligation to cash settle the principal of these foreign currency debt obligations in U.S. Dollars would have increased or decreased by approximately $211.5 million and $173.0 million, respectively. We also entered into cross-currency interest rate swaps where we receive a fixed amount of U.S. Dollars and pay a fixed amount of Euros. As of December 31, 2020 and 2019, the total notional amounts of U.S. Dollar to Euro cross-currency interest rate swap contracts were $3.3 billion and $750.0 million, respectively. The cross-currency interest rate swaps are designated as hedges of our net investment in European operations and changes in the fair value of these swaps are recorded as a component of accumulated other comprehensive income (loss) in the consolidated balance sheet. If the U.S. Dollar weakened or strengthened by 10% in comparison to Euro, we would have recorded an additional loss of $409.6 million or gain of $337.3 million, respectively, within accumulated other comprehensive income (loss) as of December 31, 2020. The U.S. Dollar weakened relative to certain of the currencies of the foreign countries in which we operate during the year ended December 31, 2020. This has impacted our consolidated financial position and results of operations during this period, including the amount of revenues that we reported. Continued strengthening or weakening of the U.S. Dollar will continue to impact us in future periods. With the existing cash flow hedges in place, a hypothetical additional 10% strengthening of the U.S. dollar during the year ended December 31, 2020 would have resulted in a reduction of our revenues and operating expenses, including depreciation and amortization expenses, by approximately $171.1 million and $169.7 million, respectively.79Table of ContentsWith the existing cash flow hedges in place, a hypothetical additional 10% weakening of the U.S. dollar during the year ended December 31, 2020 would have resulted in an increase of our revenues and operating expenses, including depreciation and amortization expenses, by approximately $209.2 million and $207.4 million, respectively.We may enter into additional hedging activities in the future to mitigate our exposure to foreign currency risk as our exposure to foreign currency risk continues to increase due to our growing foreign operations; however, we do not currently intend to eliminate all foreign currency transaction exposure.Commodity Price RiskCertain operating costs incurred by us are subject to price fluctuations caused by the volatility of underlying commodity prices. The commodities most likely to have an impact on our results of operations in the event of price changes are electricity, supplies and equipment used in our IBX data centers. We closely monitor the cost of electricity at all of our locations. We have entered into several power contracts to purchase power at fixed prices in certain locations in the Australia, Brazil, Bulgaria, Canada, China, Finland, France, Germany, Ireland, Italy, Japan, the Netherlands, Poland, Portugal, Singapore, Spain, Sweden, Switzerland, the United Kingdom and the U.S..In addition, as we are building new, or expanding existing, IBX data centers, we are subject to commodity price risk for building materials related to the construction of these IBX data centers, such as steel and copper. In addition, the lead-time to procure certain pieces of equipment, such as generators, is substantial. Any delays in procuring the necessary pieces of equipment for the construction of our IBX data centers could delay the anticipated openings of these new IBX data centers and, as a result, increase the cost of these projects.We do not currently employ forward contracts or other financial instruments to address commodity price risk other than the power contracts discussed above.
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+Item 7. Management's Discussion and Analysis of Financial Condition and Results of OperationsEVERSOURCE ENERGY AND SUBSIDIARIES The following discussion and analysis should be read in conjunction with our consolidated financial statements and related combined notes included in this combined Annual Report on Form 10-K. References in this combined Annual Report on Form 10-K to "Eversource," the "Company," "we," "us," and "our" refer to Eversource Energy and its consolidated subsidiaries. All per-share amounts are reported on a diluted basis. The consolidated financial statements of Eversource, NSTAR Electric and PSNH and the financial statements of CL&P are herein collectively referred to as the "financial statements." Our discussion of fiscal year 2020 compared to fiscal year 2019 is included herein. Unless expressly stated otherwise, for discussion and analysis of fiscal year 2018 items and fiscal year 2019 compared to fiscal year 2018, please refer to Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operations, in our combined 2019 Annual Report on Form 10-K, which is incorporated herein by reference.Refer to the Glossary of Terms included in this combined Annual Report on Form 10-K for abbreviations and acronyms used throughout this Management's Discussion and Analysis of Financial Condition and Results of Operations. The only common equity securities that are publicly traded are common shares of Eversource. The earnings and EPS of each business discussed below do not represent a direct legal interest in the assets and liabilities of such business but rather represent a direct interest in our assets and liabilities as a whole. EPS by business is a financial measure not recognized under GAAP, calculated by dividing the Net Income Attributable to Common Shareholders of each business by the weighted average diluted Eversource common shares outstanding for the period. Our earnings discussion also includes non-GAAP financial measures referencing our 2020 earnings and EPS excluding certain acquisition costs related to our purchase of the assets of Columbia Gas of Massachusetts and our 2019 earnings and EPS excluding the impairment charge for the NPT project.We use these non-GAAP financial measures to evaluate and provide details of earnings results by business and to more fully compare and explain our 2020 and 2019 results without including these items. We believe the acquisition costs and the NPT impairment charge are not indicative of our ongoing costs and performance. Due to the nature and significance of these items on Net Income Attributable to Common Shareholders, we believe that the non-GAAP presentation is a more meaningful representation of our financial performance and provides additional and useful information to readers of this report in analyzing historical and future performance of our business. These non-GAAP financial measures should not be considered as alternatives to reported Net Income Attributable to Common Shareholders or EPS determined in accordance with GAAP as indicators of operating performance.Financial Condition and Business AnalysisExecutive SummaryThe following items in this executive summary are explained in more detail in this combined Annual Report on Form 10-K:Earnings Overview and Future Outlook:•We earned $1.21 billion, or $3.55 per share, in 2020, compared with $909.1 million, or $2.81 per share, in 2019. Our 2020 results include after-tax acquisition costs related to our purchase of the assets of Columbia Gas of Massachusetts (CMA) of $32.1 million, or $0.09 per share. Excluding those acquisition costs, we earned $1.24 billion, or $3.64 per share, in 2020. Our 2019 results include an after-tax impairment charge of $204.4 million, or $0.64 per share, related to our former investment in the NPT project. Excluding the NPT impairment charge, we earned $1.11 billion, or $3.45 per share, in 2019.•Our electric distribution segment earned $544.0 million, or $1.60 per share, in 2020, compared with $513.3 million, or $1.59 per share, in 2019. Our natural gas distribution segment earned $134.1 million, or $0.40 per share, in 2020, compared with $96.2 million, or $0.30 per share, in 2019. Our water distribution segment earned $41.2 million, or $0.12 per share, in 2020, compared with $34.9 million, or $0.11 per share, in 2019.•Our electric transmission segment earned $502.5 million, or $1.48 per share, in 2020, compared with $256.5 million, or $0.79 per share, in 2019. Excluding the after-tax NPT impairment charge of $204.4 million, or $0.64 per share, our electric transmission segment earned $460.9 million, or $1.43 per share, in 2019. •Eversource parent and other companies had a net loss of $16.6 million, or $0.05 per share, in 2020, compared with earnings of $8.2 million, or $0.02 per share, in 2019. Excluding acquisition costs, Eversource parent and other companies earned $14.0 million, or $0.04 per share, in 2020.•We currently project 2021 non-GAAP earning guidance of between $3.81 per share and $3.93 per share, which excludes the impact of integration costs related to our purchase of the natural gas distribution assets of CMA. We also project that our long-term EPS growth rate through 2025 from our regulated utility businesses will be in the upper half of the 5 to 7 percent range.26•The outbreak of COVID-19 has not resulted in significant operational or earnings impacts. We believe that we have in place, or are developing, successful mechanisms with our state regulatory commissions that allow, or will allow, us to recover our incremental costs associated with COVID-19, which include uncollectible customer receivable expenses. We are continuing to closely monitor the COVID-19 pandemic, and we continue to operate under our pandemic response plan.Liquidity:•Cash flows provided by operating activities totaled $1.68 billion in 2020, compared with $2.01 billion in 2019. Investments in property, plant and equipment totaled $2.94 billion in 2020 and $2.91 billion in 2019. Cash totaled $106.6 million as of December 31, 2020, compared with $15.4 million as of December 31, 2019. Our available borrowing capacity under our commercial paper programs totaled $1.40 billion as of December 31, 2020.•In 2020, we issued 11,960,000 common shares, which resulted in proceeds of $929.0 million, net of issuance costs.•In 2020, we issued $2.76 billion of new long-term debt, consisting of $1.55 billion by Eversource parent, $400 million by CL&P, $400 million by NSTAR Electric, $150 million by PSNH, $190 million by NSTAR Gas, and $70 million by Yankee Gas. Proceeds from these new issuances were used primarily to fund a portion of the purchase price for the CMA asset acquisition and to pay short-term borrowings at Eversource parent, refinance investments in eligible green expenditures at NSTAR Electric, and to refinance existing indebtedness, fund capital expenditures and for general corporate purposes at CL&P, PSNH, NSTAR Gas and Yankee Gas. •In 2020, we issued dividends totaling $2.27 per common share, compared with dividends of $2.14 per common share in 2019. On February 9, 2021, our Board of Trustees approved a common share dividend payment of $0.6025 per share, payable on March 31, 2021 to shareholders of record as of March 4, 2021. The 2021 dividend represents an increase of 6.2 percent over the dividend paid in December 2020. •We project to make capital expenditures of $17.03 billion from 2021 through 2025, of which we expect $10.90 billion to be in our electric and natural gas distribution segments, $4.31 billion to be in our electric transmission segment and $0.78 billion to be in our water distribution segment. We also project to invest $1.05 billion in information technology and facilities upgrades and enhancements. These projections do not include any expected investments related to offshore wind projects. Strategic and Regulatory Items:•On October 9, 2020, Eversource completed the acquisition of certain assets and liabilities that comprised NiSource’s natural gas distribution business in Massachusetts, CMA, for a cash purchase price of $1.1 billion, plus a target working capital amount of $69.6 million, which is subject to adjustment to reflect actual working capital as of the closing date. On October 7, 2020, the DPU approved the rate plan related to the acquisition. The approved rate stabilization plan includes base distribution rate increases of $13 million on November 1, 2021 and $10 million on November 1, 2022. The settlement agreement includes two rate base resets during an eight-year rate plan, occurring on November 1, 2024 and November 1, 2027. •On December 15, 2020, the NHPUC approved an October 9, 2020 settlement agreement that included a permanent rate increase of $45.0 million effective January 1, 2021 at PSNH. PSNH was also permitted three step increases, effective January 1, 2021, August 1, 2021, and August 1, 2022, to reflect plant additions in calendar years 2019, 2020 and 2021, respectively. The settlement agreement allowed for the effect of the permanent rate increase to be extended back to the temporary rate period. In lieu of a customer rate increase for this recoupment of revenue, the NHPUC directed a portion of the total EDIT regulatory liability to offset bill impacts to customers. •On October 30, 2020, the DPU approved an NSTAR Gas base distribution rate increase of $23.0 million effective November 1, 2020. NSTAR Gas' 2019 plant additions are allowed recovery beginning on November 1, 2021. •In January 2021, BOEM released its Draft Environmental Impact Statement (EIS) for the South Fork Wind project, which assessed the environmental, social, and economic impacts of constructing the project.Impact of COVID-19 COVID-19 has adversely affected workers and the economy and caused volatility in the financial markets. Due to the inherent uncertainty of the unprecedented and evolving situation, we continue to closely monitor how COVID-19 related developments affect Eversource. Based on available information, we have not experienced significant impacts directly related to the pandemic that have adversely affected our current operations or results of operations. The extent of the impact to us in the future will vary and depend in large part on the duration, scope and severity of the pandemic and the timing and extent of COVID-19 relief legislation, and the resulting impact on economic, health care and capital market conditions. The future impact will also depend on the outcome of planned proceedings before our state regulatory commissions to recover our incremental costs associated with COVID-19, which include uncollectible customer receivable expenses.27Operational: We provide a critical service to our customers and have taken extensive measures to maintain its safety and reliability. We have implemented our company-wide pandemic plan, which guides our emergency response, business continuity, and the precautionary measures we are taking to ensure the safety, health, and well-being of our employees, our customers, and our communities. We continue to adjust our company-wide pandemic plan to address various scenarios, including reduced workforce levels and limited mutual aid in the event of a significant storm event, and have implemented protective measures to mitigate the impact of COVID-19 on our workforce. We have implemented work from home policies where appropriate, resulting in nearly half of our employees working remotely. For our employees performing essential functions that are required onsite, such as field crews and system operations, we have taken significant safety measures, including establishing social distancing measures, the use of personal protective equipment, increasing facility sanitization efforts, and enabling critical operations to be shifted to different control center locations if necessary. At this time, our workforce staffing levels continue to enable us to safely and reliably deliver our critical services to customers.We continue to prepare for the re-entry of our employees working remotely. Our re-entry plan includes a multi-phase approach that is measured and gradual. The plan is informed by public health guidance with the safety of our employees and customers as our highest priority. We are in the early phase of our re-entry plan and have returned fewer than 100 remote employees to the workplace. We have had increased short duration return to work for critical business needs, such as storm response and essential training. State and federal guidelines, external conditions, and critical business priorities continue to inform the pace of our re-entry plan. Significant health and safety measures and pandemic protocols will remain in place, including social distancing requirements, the use of personal protective equipment, sanitization efforts and employee training, for all employees currently working onsite and specific plans have been developed for our eventual re-entry to the workplace.In mid-March, we suspended non-critical work inside customer premises, which included energy audits inside our customers’ homes and businesses. These activities resumed in early July with the implementation of new health and safety guidelines for the restart of energy efficiency services to customers. This delay did not have a significant impact on our 2020 spending levels or incentives earned. As of the date of our filing, we do not expect a significant impact on our 2021 energy efficiency program spending and efforts, which assumes the continuation of energy efficiency programs throughout 2021. Actual energy efficiency spending levels will depend on the extent and duration of the pandemic.Among the states we serve, COVID-19 had initially spread in a rapid manner in Connecticut and Massachusetts during the outbreak that began in mid-March. During the summer, these states had seen a decrease in the infection rate and daily confirmed cases, as well as more capacity in hospitals, and improved testing availability and contact tracing, as compared to the initial outbreak. Beginning in October, the spread of COVID-19 began to increase at a significant pace, surpassing infection levels from the initial outbreak, peaking in December 2020 and January 2021 in each of the states we serve. Since those peak levels, there has been a downward trend in the daily confirmed cases, infection rates and positive test rates.Financial: Overall, our future financial position, results of operations, and cash flows could be negatively impacted by COVID-19 as it relates to the collectability of customer receivables and customer payment plans, elimination of late payment revenues, lower sales volumes primarily from PSNH's commercial and industrial customers, energy efficiency spending levels and incentives earned, and increased expenses for cleaning and supplies for personal protective equipment. Other potential negative financial impacts relate to market volatility on our equity and debt securities, access to, as well as cost of, capital resources, and the ability of various third-party vendors and suppliers to fulfill their obligations.As of December 31, 2020, our allowance for uncollectible customer receivable balance of $358.9 million, of which $194.8 million relates to hardship accounts that are specifically recovered in rates charged to customers, adequately reflected the collection risk and net realizable value for our receivables. We continue to evaluate the adequacy of the uncollectible allowance based on an ongoing assessment of accounts receivable collections and customer payment trends, economic conditions, delinquency statistics, aging-based quantitative assessments, the impact on residential customer bills because of energy usage and change in rates, flexible payment plans and financial hardship arrearage management programs being offered to customers, and COVID-19 developments, including any potential federal governmental pandemic relief programs and the expansion of unemployment benefit initiatives, which help to mitigate the potential for increasing customer account delinquencies. Additionally, management considered past economic declines and corresponding uncollectible reserves as part of the current assessment. This evaluation has shown that our operating companies have experienced an increase in aged receivables and some lower cash collections from customers because of the moratorium on disconnections and the economic slowdown resulting from the COVID-19 pandemic. Based upon the evaluation performed, in 2020, we increased the allowance for uncollectible accounts for amounts incurred as a result of COVID-19 by $31.5 million for Eversource ($2.8 million for CL&P, $11.0 million for NSTAR Electric, $2.3 million for PSNH and $15.4 million at our natural gas businesses). These COVID-19 related uncollectible amounts were deferred either as incremental regulatory costs or deferred through existing regulatory tracking mechanisms that recover uncollectible energy supply costs, as we believe it is probable that these costs will ultimately be recovered from customers in rates. We believe that we have in place, or are developing, successful mechanisms with our state regulatory commissions that allow, or will allow, us to recover our incremental costs associated with COVID-19, which include uncollectible customer receivable expenses, while balancing the impact on our customers’ bills and our operating cash flows. In March 2020, Connecticut, Massachusetts and New Hampshire each established moratoria on disconnections of residential and commercial customers for non-payment for utility service. In all three states, a moratorium for lower income hardship residential customers will remain in place through the normal state regulated winter moratorium that ends in the spring of 2021. In Connecticut and New Hampshire, the moratorium for all remaining customers has expired. In Massachusetts, the moratorium on commercial utility disconnections ended on September 1, 2020 and the moratorium on residential non-hardship disconnections was extended to April 1, 2021. 28We continue to work closely with our state regulatory commissions and consumer advocates on customer assistance measures, including payment plan options in order to mitigate the impact on customer rates in the future, as well as financial hardship and arrearage management programs for those customers who are unable to pay their utility bills. We developed these long-term solutions for customers in order to help minimize the extent of the impact of COVID-19 on customer receivable balances and customers’ affordability in light of the current financial impact they may experience. Our operating companies also eliminated late payment charges beginning in March 2020, with New Hampshire being the only state with a defined restart date of April 1, 2021. In 2020, we have waived $6.1 million of late payment charges that would have otherwise been recognized within revenues as a benefit to pre-tax earnings.For the year ended December 31, 2020, net incremental costs incurred as a result of COVID-19 totaled $35.2 million and related to uncollectible expense that impacts earnings, facilities and fleet cleaning, sanitizing costs and supplies for personal protective equipment, net of cost savings. We have deferred $24.0 million of these net incremental COVID-19 costs on the balance sheet, of which $15.8 million of that deferral related to uncollectible expense that impacts earnings and $8.2 million related to cleaning and supplies for personal protective equipment. Incremental COVID-19 expenses that reduced pre-tax earnings totaled $11.1 million on the statement of income. For further information on Connecticut, Massachusetts and New Hampshire COVID-19-related regulatory developments, see "Regulatory Developments and Rate Matters - COVID-19 Regulatory Dockets" included in this Management’s Discussion and Analysis.An extended economic slowdown has resulted in lower demand for electricity, natural gas and/or water by our commercial and industrial customers. However, fluctuations in retail sales volumes for CL&P, NSTAR Electric, Yankee Gas, NSTAR Gas, EGMA, and our Connecticut water distribution business do not materially impact earnings due to their respective state regulatory commission-approved distribution revenue decoupling mechanisms. Overall, our risk of exposure to lower demand and resulting lost sales revenues is limited as our regulated utilities are under cost-of-service rates with revenue decoupling mechanisms (with the exception of PSNH) and a significant portion of uncollectible expenses are tracked for ultimate recovery. Our revenue decoupling mechanisms allow us to recover an annual revenue stream that is decoupled from actual customer usage, and each is reconciled each year as part of our annual decoupling filing in each respective jurisdiction.We continue to monitor Eversource parent’s and our operating companies’ ability to access the global capital and credit markets. At the onset of the pandemic in the United States, liquidity in the commercial paper credit market began to deteriorate rapidly. However, federal legislative actions, including actions taken by the Federal Reserve, have provided sufficient liquidity and stabilization of the credit markets. An extended economic slowdown could result in Eversource parent and our operating companies finding difficulty in accessing necessary capital resources and incurring higher costs for those capital resources. At this time, based on available information and the current market trends, we believe we will continue to have access to needed liquidity and capital resources to successfully execute our projected capital expenditures and strategies. We expect our existing borrowing availability under our commercial paper programs, our existing revolving credit facilities that serve to backstop those commercial paper programs, in addition to access to the debt and equity markets, will be sufficient to meet our future liquidity and capital resource needs.Earnings OverviewConsolidated: Below is a summary of our earnings by business, which also reconciles the non-GAAP financial measures of consolidated non-GAAP earnings and EPS, as well as EPS by business, to the most directly comparable GAAP measures of consolidated Net Income Attributable to Common Shareholders and diluted EPS. For the Years Ended December 31,202020192018(Millions of Dollars, Except Per Share Amounts)AmountPer ShareAmountPer ShareAmountPer ShareNet Income Attributable to Common Shareholders (GAAP)$1,205.2 $3.55 $909.1 $2.81 $1,033.0 $3.25 Regulated Companies (non-GAAP)$1,223.3 $3.60 $1,105.3 $3.43 $1,006.7 $3.17 Eversource Parent and Other Companies (non-GAAP)14.0 0.04 8.2 0.02 26.3 0.08 Non-GAAP Earnings$1,237.3 $3.64 $1,113.5 $3.45 $1,033.0 $3.25 Acquisition-Related Costs (after-tax) (1)(32.1)(0.09)— — — — Impairment of Northern Pass Transmission (after-tax)— — (204.4)(0.64)— — Net Income Attributable to Common Shareholders (GAAP)$1,205.2 $3.55 $909.1 $2.81 $1,033.0 $3.25 29Regulated Companies: Our regulated companies comprise the electric distribution, electric transmission, natural gas distribution and water distribution segments. A summary of our segment earnings and EPS is as follows: For the Years Ended December 31, 202020192018(Millions of Dollars, Except Per Share Amounts)AmountPer ShareAmountPer ShareAmountPer ShareNet Income - Regulated Companies (GAAP)$1,221.8 $3.60 $900.9 $2.79 $1,006.7 $3.17 Electric Distribution$544.0 $1.60 $513.3 $1.59 $455.4 $1.44 Electric Transmission, excluding Northern Pass Transmission impairment (Non-GAAP)502.5 1.48 460.9 1.43 427.2 1.34 Natural Gas Distribution, excluding Acquisition-Related Costs (non-GAAP)135.6 0.40 96.2 0.30 93.2 0.29 Water Distribution41.2 0.12 34.9 0.11 30.9 0.10 Net Income - Regulated Companies (Non-GAAP)$1,223.3 $3.60 $1,105.3 $3.43 $1,006.7 $3.17 Acquisition-Related Costs (after-tax) (1)(1.5)— — — — — Impairment of Northern Pass Transmission (after-tax)— — (204.4)(0.64)— — Net Income - Regulated Companies (GAAP)$1,221.8 $3.60 $900.9 $2.79 $1,006.7 $3.17 (1) These costs are associated with our acquisition and integration of the assets of Columbia Gas of Massachusetts. Additional integration costs related primarily to the integration and transition of systems, are expected in 2021.Our electric distribution segment earnings increased $30.7 million in 2020, as compared to 2019, due primarily to base distribution rate increases at CL&P effective May 1, 2020 and May 1, 2019, at NSTAR Electric effective January 1, 2020, and at PSNH effective July 1, 2019, higher earnings from CL&P's capital tracker mechanism due to increased electric system improvements, and the impact of the PSNH rate settlement agreement approved in December 2020. The earnings increase was partially offset by higher operations and maintenance expense (primarily attributable to higher storm restoration costs), higher depreciation expense, higher property tax expense, higher interest expense, and the absence of the 2019 recognition of carrying charges on PSNH's 2013 through 2016 storm costs approved for recovery. Our electric transmission segment earnings increased $246.0 million in 2020, as compared to 2019, due primarily to the absence in 2020 of the 2019 impairment of NPT, which resulted in an after-tax charge of $204.4 million, or $0.64 per share. Excluding the NPT impairment charge, earnings increased $41.6 million in 2020, as compared to 2019, due primarily to a higher transmission rate base as a result of our continued investment in our transmission infrastructure and a higher benefit from the annual billing and cost reconciliation filing with FERC.Our natural gas distribution segment earnings increased $37.9 million in 2020, as compared to 2019, due primarily to base distribution rate increases at Yankee Gas effective January 1, 2020 and at NSTAR Gas effective November 1, 2020, the addition of Eversource Gas Company of Massachusetts (EGMA), higher earnings from capital tracker mechanisms due to continued investments in natural gas infrastructure, and lower interest expense due to a property tax settlement. EGMA's natural gas distribution business earned $13.9 million from October 9, 2020 through December 31, 2020. The earnings increase was partially offset by higher operations and maintenance expense and higher depreciation expense.Our water distribution segment earnings increased $6.3 million in 2020, as compared to 2019, due primarily to an after-tax gain of $3.5 million on the sale of the water system and treatment plant of the Hingham, Massachusetts business, higher revenues from our Connecticut business' capital tracker mechanism due to increased infrastructure improvements, and a gain on the sale of land, partially offset by higher property tax expense and a higher effective tax rate. Eversource Parent and Other Companies: Eversource parent and other companies earnings decreased $24.8 million in 2020, as compared to 2019, due primarily to the costs of the CMA asset acquisition recorded at Eversource parent of $30.6 million in 2020. Excluding the CMA asset acquisition costs, earnings increased $5.8 million due primarily to a higher return at Eversource Service as a result of increased investments in property, plant and equipment, and lower employee-related costs, partially offset by lower unrealized gains associated with our equity method investment in a renewable energy fund. LiquidityCash totaled $106.6 million as of December 31, 2020, compared with $15.4 million as of December 31, 2019.Short-Term Debt - Commercial Paper Programs and Credit Agreements: Eversource parent has a $2.00 billion commercial paper program allowing Eversource parent to issue commercial paper as a form of short-term debt. Eversource parent, CL&P, PSNH, NSTAR Gas, Yankee Gas and Aquarion Water Company of Connecticut are parties to a five-year $1.45 billion revolving credit facility, which terminates on December 6, 2024. On October 21, 2020, Eversource parent and EGMA entered into a short-term $550 million revolving credit facility, which terminates on October 20, 2021. These revolving credit facilities serve to backstop Eversource parent's $2.00 billion commercial paper program.NSTAR Electric has a $650 million commercial paper program allowing NSTAR Electric to issue commercial paper as a form of short-term debt. NSTAR Electric is also a party to a five-year $650 million revolving credit facility, which terminates on December 6, 2024. The revolving credit facility serves to backstop NSTAR Electric's $650 million commercial paper program.30The amount of borrowings outstanding and available under the commercial paper programs were as follows:Borrowings Outstanding as of December 31,Available Borrowing Capacity as of December 31,Weighted-Average Interest Rate as of December 31,(Millions of Dollars)202020192020201920202019Eversource Parent Commercial Paper Program $1,054.3 $1,224.9 $945.7 $225.1 0.25 %1.98 %NSTAR Electric Commercial Paper Program 195.0 10.5 455.0 639.5 0.16 %1.63 %There were no borrowings outstanding on the revolving credit facilities as of December 31, 2020 or 2019. On May 15, 2020, CL&P and PSNH entered into uncommitted line of credit agreements, which will expire by May 14, 2021. The CL&P agreements total $450 million and the PSNH agreements total $300 million. There are no borrowings outstanding on either the CL&P or PSNH uncommitted line of credit agreements as of December 31, 2020.Amounts outstanding under the commercial paper programs are included in Notes Payable and classified in current liabilities on the Eversource and NSTAR Electric balance sheets, as all borrowings are outstanding for no more than 364 days at one time. Intercompany Borrowings: Eversource parent uses its available capital resources to provide loans to its subsidiaries to assist in meeting their short-term borrowing needs. Eversource parent records intercompany interest income from its loans to subsidiaries, which is eliminated in consolidation. Intercompany loans from Eversource parent to its subsidiaries are eliminated in consolidation on Eversource's balance sheets. As of December 31, 2020, there were intercompany loans from Eversource parent to PSNH of $46.3 million, and to a subsidiary of NSTAR Electric of $21.3 million. As of December 31, 2019, there were intercompany loans from Eversource parent to CL&P of $63.8 million, to PSNH of $27.0 million, and to a subsidiary of NSTAR Electric of $30.3 million. Intercompany loans from Eversource parent are included in Notes Payable to Eversource Parent and classified in current liabilities on the respective subsidiary's balance sheets. Long-Term Debt Issuance Authorizations: On January 27, 2020, the DPU approved NSTAR Gas' request for authorization to issue up to $270 million in long-term debt through December 31, 2021. On July 31, 2020, the NHPUC approved PSNH's request for authorization to issue up to $200 million in long-term debt through December 31, 2020. On December 14, 2020, NSTAR Electric filed a petition with the DPU for authorization to issue $1.6 billion in long-term debt through December 31, 2023. On December 16, 2020, Aquarion Water Company of Connecticut filed an application with PURA for authorization to issue $100 million in long-term debt through December 31, 2021. Long-Term Debt Issuances and Repayments: The following table summarizes long-term debt issuances and repayments:(Millions of Dollars)Issuance/(Repayment)Issue Date or Repayment DateMaturity DateUse of Proceeds for Issuance/Repayment InformationCL&P:0.75% Series A First Mortgage Bonds$400.0 December 2020December 2025Refinanced short-term borrowings, funded capital expenditures and working capitalNSTAR Electric:3.95% 2020 Debentures400.0 March 2020April 2030Refinanced investments in eligible green expenditures, which were previously financed in 2018 and 20195.10% Series E Senior Notes(95.0)March 2020March 2020Paid at maturityPSNH:2.40% Series U First Mortgage Bonds150.0 August 2020September 2050Refinanced short-term borrowings, funded capital expenditures and working capitalOther:Eversource Parent 3.45% Series P Senior Notes350.0 January 2020January 2050Paid short-term borrowingsEversource Parent 3.45% Series P Senior Notes (1)300.0 August 2020January 2050 (2)Eversource Parent 0.80% Series Q Senior Notes300.0 August 2020August 2025 (2)Eversource Parent 1.65% Series R Senior Notes600.0 August 2020August 2030 (2)Eversource Parent 2.50% Series I Senior Notes(450.0)February 2021March 2021Paid on par call date in advance of maturity dateNSTAR Gas 4.46% Series N First Mortgage Bonds(125.0)January 2020January 2020Paid at maturityNSTAR Gas 2.33% Series R First Mortgage Bonds75.0 May 2020May 2025Refinanced existing indebtedness, funded capital expenditures and for general corporate purposesNSTAR Gas 3.15% Series S First Mortgage Bonds115.0 May 2020May 2050Refinanced existing indebtedness, funded capital expenditures and for general corporate purposesNSTAR Gas 9.95% Series J First Mortgage Bonds(25.0)December 2020December 2020Paid at maturityYankee Gas 4.87% Series K First Mortgage Bonds(50.0)April 2020April 2020Paid at maturityYankee Gas 2.90% Series R First Mortgage Bonds70.0 September 2020September 2050Refinanced existing indebtedness, funded capital expenditures and for general corporate purposesAquarion Water Company of Massachusetts, Inc. and Aquarion Water Capital of Massachusetts, Inc. various term loans and general mortgage bonds(32.2)July 2020VariousRedeemed long-term debt in conjunction with the sale of assets to the Town of Hingham, Massachusetts(1) These senior notes are part of the same series issued by Eversource parent in January 2020. The aggregate outstanding principal amount of these senior notes is now $650 million.31(2) The proceeds from these Eversource parent issuances funded a portion of the purchase price for the CMA asset acquisition and refinanced short-term borrowings.In January 2021, PSNH provided a redemption notice to the holders of the PSNH 4.050% Series Q First Mortgage Bonds that PSNH will redeem the $122 million of bonds on March 1, 2021, the par call date, in advance of the June 1, 2021 maturity date.Rate Reduction Bonds: PSNH's RRB payments consist of principal and interest and are paid semi-annually. PSNH paid $43.2 million of RRB principal payments and $20.2 million of interest payments in 2020, and $52.3 million of RRB principal payments and $26.8 million of interest payments in 2019.Common Share Issuances and 2019 Forward Sale Agreement: On June 15, 2020, Eversource completed an equity offering of 6,000,000 common shares at a price per share of $86.26. Eversource used the net proceeds of this offering to fund a portion of the purchase of the assets of CMA that closed on October 9, 2020. The issuance of these common shares resulted in proceeds of $509.2 million, net of issuance costs.In June 2019, Eversource completed an equity offering consisting of 5,980,000 common shares issued directly by the Company and 11,960,000 common shares issuable pursuant to a forward sale agreement with an investment bank. Under the forward sale agreement, 11,960,000 common shares were borrowed from third parties and sold by the underwriters. The forward sale agreement allowed Eversource, at its election and prior to May 29, 2020, to physically settle the forward sale agreement by issuing common shares in exchange for net proceeds at the then-applicable forward sale price specified by the agreement (initially, $71.48 per share) or, alternatively, to settle the forward sale agreement in whole or in part through the delivery or receipt of shares or cash. The forward sale price was subject to adjustment daily based on a floating interest rate factor and would decrease in respect of certain fixed amounts specified in the agreement, such as dividends.Eversource issued 6,000,000 common shares under the forward sale agreement in December 2019. On March 23, 2020, Eversource physically settled a portion of the forward sale agreement by delivering 1,500,000 common shares in exchange for net proceeds of $105.7 million. Subsequently, on March 26, 2020, Eversource physically settled the remaining portion of the forward sale agreement by delivering 4,460,000 common shares in exchange for net proceeds of $314.1 million. The forward sale price used to determine the cash proceeds received by Eversource was calculated based on the initial forward sale price, as adjusted in accordance with the forward sale agreement.The March and June 2020 common share issuances of 5,960,000 and 6,000,000, respectively, resulted in total proceeds of $929.0 million, net of issuance costs. The June and December 2019 common share issuances of 5,980,000 and 6,000,000, respectively, resulted in total proceeds of $852.3 million. These issuances were reflected in shareholders’ equity and as financing activities on the statements of cash flows.Issuances of shares under the forward sale agreement were classified as equity transactions. Accordingly, no amounts relating to the forward sale agreement were recorded in the financial statements until settlements took place. Prior to any settlements, the only impact of the forward sale agreement to the financial statements was the inclusion of incremental shares within the calculation of diluted EPS using the treasury stock method. See Note 21, "Earnings Per Share," to the financial statements for information on the forward sale agreement’s impact on the calculation of diluted EPS.Eversource used the net proceeds received from the direct issuance of common shares and the net proceeds received from settlement of the forward sale agreement to repay short-term debt under the commercial paper program, to partially fund the purchase of the assets of CMA, to fund capital spending and clean energy initiatives, and for general corporate purposes. Cash Flows: Cash flows provided by operating activities totaled $1.68 billion in 2020, compared with $2.01 billion in 2019. Operating cash flows were unfavorably impacted by the timing of cash collections on our accounts receivable, the timing of collections for regulatory tracking mechanisms primarily related to transmission costs and the impact of the CL&P temporary rate suspension, and cash payments made in 2020 for storm restoration costs of approximately $196 million related to Tropical Storm Isaias. Also contributing to the unfavorable impact was the absence of $68.8 million in DOE Phase IV proceeds received by CYAPC and YAEC in 2019. Partially offsetting these unfavorable impacts were the favorable timing of cash payments made on our accounts payable, the absence of a $29.0 million payment made in 2019 to the DOE by CYAPC to partially settle its pre-1983 spent nuclear fuel obligation, and a decrease of $10.3 million in Pension and PBOP contributions made in 2020, as compared to 2019.Our receivables, net of reserves, on the balance sheet have increased $206.5 million ($58.3 million at CL&P, $56.3 million at NSTAR Electric, and $20.0 million at PSNH) in 2020, as compared to 2019, due primarily to an increase in delinquent receivables from customers attributable to the moratorium on disconnections and the economic slowdown resulting from the COVID-19 pandemic. Receivables, net of reserves, also increased due to the addition of EGMA of $65.8 million as of December 31, 2020. Cash flows provided by operating activities totaled $2.01 billion in 2019, compared with $1.83 billion in 2018. The increase in operating cash flows was due primarily to a decrease in 2019 of approximately $148 million of major storm restoration cost payments, $116 million in lower payments made in 2019 to the DOE by CYAPC to partially settle its pre-1983 spent nuclear fuel obligation, and a $73.2 million decrease in pension and PBOP cash contributions made in 2019, as compared to 2018. Also contributing to the increase were $102.8 million of lower income tax payments made in 2019, as compared to 2018, $68.8 million in DOE Phase IV litigation proceeds received by CYAPC and YAEC in 2019, and the timing of cash collections on our accounts receivables. Partially offsetting these favorable impacts were the timing of collections for regulatory tracking mechanisms, which were significantly impacted by the timing of collections of purchased power and transmission costs at NSTAR Electric, and the timing of accounts payable cash payments and other working capital items. 32In 2020, we paid cash dividends of $744.7 million and issued non-cash dividends of $22.8 million in the form of treasury shares, totaling dividends of $767.5 million, or $2.27 per common share. In 2019, we paid cash dividends of $663.2 million and issued non-cash dividends of $22.8 million in the form of treasury shares, totaling dividends of $686.0 million, or $2.14 per common share. Our quarterly common share dividend payment was $0.5675 per share in 2020, as compared to $0.535 per share in 2019. On February 9, 2021, our Board of Trustees approved a common share dividend payment of $0.6025 per share, payable on March 31, 2021 to shareholders of record as of March 4, 2021. The 2021 dividend represents an increase of 6.2 percent over the dividend paid in December 2020.Beginning in 2019, Eversource issues treasury shares to satisfy awards under the Company's incentive plans, shares issued under the dividend reinvestment and share purchase plan, and matching contributions under the Eversource 401k Plan.In 2020, CL&P, NSTAR Electric and PSNH paid $69.5 million, $262.0 million and $22.3 million, respectively, in common stock dividends to Eversource parent. Investments in Property, Plant and Equipment on the statements of cash flows do not include amounts incurred on capital projects but not yet paid, cost of removal, AFUDC related to equity funds, and the capitalized and deferred portions of pension and PBOP expense. In 2020, investments for Eversource, CL&P, NSTAR Electric and PSNH were $2.94 billion, $834.0 million, $907.0 million and $342.6 million, respectively. On October 9, 2020, Eversource completed the CMA asset acquisition for a cash purchase price of $1.1 billion plus a target working capital amount of $69.6 million, which is subject to adjustment to reflect actual working capital as of the closing date. The purchase price included in investing cash outflows on the statement of cash flows of $1.11 billion reflects the payment to NiSource, which excludes restricted cash accounts Eversource funded of $56.8 million. For further information, see "Business Development and Capital Expenditures - Acquisition of Assets of Columbia Gas of Massachusetts" included in this Management’s Discussion and Analysis. Eversource, CL&P, NSTAR Electric and PSNH each uses its available capital resources to fund its respective construction expenditures, meet debt requirements, pay operating costs, including storm-related costs, pay dividends, and fund other corporate obligations, such as pension contributions. Eversource's regulated companies recover their electric, natural gas and water distribution construction expenditures as the related project costs are depreciated over the life of the assets. This impacts the timing of the revenue stream designed to fully recover the total investment plus a return on the equity and debt used to finance the investments. The current growth in Eversource's construction expenditures utilizes a significant amount of cash for projects that have a long-term return on investment and recovery period, totaling approximately $2.94 billion in cash capital spend in 2020. In addition, Eversource's investments in its offshore wind business totaled $237.8 million in 2020, which are recognized as long-term assets. These factors have resulted in current liabilities exceeding current assets by $1.78 billion, $316.3 million, and $271.3 million at Eversource, NSTAR Electric and PSNH, respectively, as of December 31, 2020. As of December 31, 2020, $1.02 billion of Eversource's long-term debt, including $450.0 million, $250.0 million, $282.0 million, and $40.2 million for Eversource parent, NSTAR Electric, PSNH, and Aquarion, respectively, will mature within the next 12 months. The current portion of long-term debt on the Eversource balance sheet also includes $31.0 million related to fair value adjustments from our various business combinations that will be amortized within the next 12 months and have no cash flow impact. Eversource, with its strong credit ratings, has several options available in the financial markets to repay or refinance these maturities with the issuance of new long-term debt. Eversource, CL&P, NSTAR Electric and PSNH will reduce their short-term borrowings with operating cash flows or with the issuance of new long-term debt, determined by considering capital requirements and maintenance of Eversource's credit rating and profile. We expect the future operating cash flows of Eversource, CL&P, NSTAR Electric and PSNH, along with our existing borrowing availability and access to both debt and equity markets, will be sufficient to meet any working capital and future operating requirements, and capital investment forecasted opportunities.Credit Ratings: A summary of our corporate credit ratings and outlooks by S&P, Moody's, and Fitch is as follows: S&PMoody'sFitch CurrentOutlookCurrentOutlookCurrentOutlookEversource ParentA-StableBaa1StableBBB+StableCL&PAStableA3StableA- StableNSTAR ElectricAStableA1StableA StablePSNHAStableA3StableA-StableA summary of the current credit ratings and outlooks by S&P, Moody's, and Fitch for senior unsecured debt of Eversource parent and NSTAR Electric, and senior secured debt of CL&P and PSNH is as follows: S&PMoody'sFitch CurrentOutlookCurrentOutlookCurrentOutlookEversource ParentBBB+StableBaa1StableBBB+ StableCL&PA+StableA1StableA+StableNSTAR ElectricAStableA1StableA+StablePSNHA+StableA1StableA+ Stable33Business Development and Capital ExpendituresOur consolidated capital expenditures, including amounts incurred but not paid, cost of removal, AFUDC, and the capitalized and deferred portions of pension and PBOP expense (all of which are non-cash factors), totaled $3.06 billion in 2020, $3.06 billion in 2019, and $2.86 billion in 2018. These amounts included $239.1 million in 2020, $239.0 million in 2019, and $184.6 million in 2018 related to information technology and facilities upgrades and enhancements, primarily at Eversource Service and The Rocky River Realty Company.Electric Transmission Business: Our consolidated electric transmission business capital expenditures decreased by $75.8 million in 2020, as compared to 2019. A summary of electric transmission capital expenditures by company is as follows: For the Years Ended December 31,(Millions of Dollars)202020192018CL&P$402.9 $459.5 $465.5 NSTAR Electric366.8 379.7 334.3 PSNH193.9 190.4 194.2 NPT— 9.8 29.4 Total Electric Transmission Segment$963.6 $1,039.4 $1,023.4 Eastern Massachusetts Transmission Projects: These projects consist of a portfolio of electric transmission upgrades in southern New Hampshire, northern Massachusetts and continuing into the greater Boston metropolitan area, of which 28 upgrades are in Eversource's service territory (two in New Hampshire and 26 in Massachusetts). The two New Hampshire upgrades, including the Merrimack Valley Reliability Project, have been placed in service, and 23 Massachusetts upgrades have been placed in service. On December 17, 2019, the Massachusetts Siting Board issued a favorable decision on the Sudbury-Hudson Reliability Project, the last project requiring such approval. On January 17, 2020, the Town of Sudbury and Protect Sudbury, a community group, appealed the decision to the Massachusetts Supreme Judicial Court. Oral arguments are scheduled for March 1, 2021. The majority of remaining upgrades are under construction and are expected to be placed in service in 2022. We estimate our portion of the investment will be approximately $750 million, of which $525 million has been spent and capitalized through December 31, 2020.Southeastern Massachusetts Transmission Projects: These projects consist of a portfolio of electric transmission and substation upgrades in southeastern Massachusetts, including Cape Cod, required to reinforce the Southeastern Massachusetts transmission system and bring the system into compliance with applicable national and regional reliability standards. ISO-NE reassessed the need for projects that had yet to be constructed and reconfirmed the need for the majority of the originally identified reinforcements in July 2020. Twelve upgrades in Eversource's service territory were reconfirmed, and a single upgrade was deemed to no longer be required. Of the twelve upgrades, four require siting approvals from the Massachusetts regulatory agencies, of which one has received approval, two are before the agencies and one, a joint project with National Grid, has yet to be filed. Three substation projects will be permitted locally, three projects are under construction and two projects have been placed in-service. We estimate our portion of the investment will be approximately $175 million, of which $28 million has been spent and capitalized through December 31, 2020.Hartford-Area Transmission Projects: This portfolio of projects consisted of 27 projects in the Hartford, Connecticut area. In the third quarter of 2020, the final projects were placed in service and as of December 31, 2020, CL&P has spent and capitalized $303 million in costs associated with this portfolio. Additional restoration costs in the first quarter of 2021 will bring the total investment to approximately $304 million.Seacoast Reliability Project: The Seacoast Reliability Project consisted of a 13-mile, 115kV transmission line within several New Hampshire communities, using a combination of overhead, underground and underwater line designs that helped meet the growing demand for electricity in the Seacoast region. The project was placed in service on May 29, 2020 and resulted in an investment of approximately $124 million.Ready Path Solution: The Ready Path Solution was chosen in 2020 by ISO-NE as part of the first competitive solicitation for reliability upgrades in New England to meet the energy shortfall that will be created with the retirement of the Mystic Generating Station in Massachusetts in 2024. Our portion of the portfolio consists of installing new equipment at Eversource’s existing North Cambridge Substation with an estimated investment of approximately $14 million. The project is advancing permitting and engineering with construction scheduled to start in 2021.All project costs are anticipated to be fully recoverable through transmission rates.34Distribution Business: A summary of distribution capital expenditures is as follows:For the Years Ended December 31,(Millions of Dollars) CL&P NSTAR Electric PSNH Total Electric Natural GasWater Total 2020Basic Business$233.4 $195.1 $52.4 $480.9 $88.2 $10.9 $580.0 Aging Infrastructure179.9 237.1 80.2 497.2 391.3 115.5 1,004.0 Load Growth and Other77.8 110.8 21.3 209.9 65.6 0.8 276.3 Total Distribution491.1 543.0 153.9 1,188.0 545.1 127.2 1,860.3 Solar— 1.4 — 1.4 — — 1.4 Total$491.1 $544.4 $153.9 $1,189.4 $545.1 127.2 $1,861.7 2019Basic Business$228.7 $201.0 $47.3 $477.0 $71.2 $15.0 $563.2 Aging Infrastructure224.5 255.5 90.8 570.8 315.2 93.9 979.9 Load Growth and Other59.6 89.4 16.8 165.8 66.8 1.5 234.1 Total Distribution512.8 545.9 154.9 1,213.6 453.2 110.4 1,777.2 Solar— 7.5 — 7.5 — — 7.5 Total$512.8 $553.4 $154.9 $1,221.1 $453.2 $110.4 $1,784.7 2018Basic Business$256.3 $217.7 $69.3 $543.3 $72.9 $17.0 $633.2 Aging Infrastructure151.6 133.3 73.0 357.9 280.2 81.1 719.2 Load Growth and Other79.7 94.3 15.6 189.6 51.4 3.6 244.6 Total Distribution487.6 445.3 157.9 1,090.8 404.5 101.7 1,597.0 Solar and Other— 53.4 0.9 54.3 — — 54.3 Total$487.6 $498.7 $158.8 $1,145.1 $404.5 $101.7 $1,651.3 For the electric distribution business, basic business includes the purchase of meters, tools, vehicles, information technology, transformer replacements, equipment facilities, and the relocation of plant. Aging infrastructure relates to reliability and the replacement of overhead lines, plant substations, underground cable replacement, and equipment failures. Load growth and other includes requests for new business and capacity additions on distribution lines and substation additions and expansions.For the natural gas distribution business, basic business addresses daily operational needs including meters, pipe relocations due to public works projects, vehicles, and tools. Aging infrastructure projects seek to improve the reliability of the system through enhancements related to cast iron and bare steel replacement of main and services, corrosion mediation, and station upgrades. Load growth and other reflects growth in existing service territories including new developments, installation of services, and expansion.For the water distribution business, basic business addresses daily operational needs including periodic meter replacement, water main relocation, facility maintenance, and tools. Aging infrastructure relates to reliability and the replacement of water mains, regulators, storage tanks, pumping stations, wellfields, reservoirs, and treatment facilities. Load growth and other reflects growth in our service territory, including improvements of acquisitions, installation of new services, and interconnections of systems.Acquisition of Assets of Columbia Gas of Massachusetts: On October 9, 2020, Eversource acquired certain assets and liabilities that comprised NiSource’s natural gas distribution business in Massachusetts, which was previously doing business as CMA, pursuant to an asset purchase agreement (the Agreement) entered into on February 26, 2020 between Eversource and NiSource Inc. (NiSource). The cash purchase price was $1.1 billion, plus a target working capital amount of $69.6 million, which is subject to adjustment to reflect actual working capital as of the closing date that has not yet been finalized. Eversource financed the asset acquisition through a combination of debt and equity issuances in a ratio that was consistent with our consolidated capital structure. The natural gas distribution assets acquired from CMA were assigned to EGMA, an indirect wholly-owned subsidiary of Eversource formed in 2020. The LNG assets acquired from CMA were assigned to Hopkinton LNG Corp. EGMA distributes natural gas to approximately 332,000 residential, commercial and industrial customers with over 5,000 miles of natural gas distribution pipeline across more than 60 communities in Massachusetts, adding to the approximately 303,000 natural gas customers that Eversource already serves in Massachusetts. The transaction required approval by the DPU, the Maine Public Utilities Commission, the FERC, and the Federal Communications Commission, and review under the Hart-Scott-Rodino Act. 35The liabilities assumed by Eversource under the Agreement specifically excluded any liabilities (past or future) arising out of, or related to, the fires and explosions that occurred on September 13, 2018 in Lawrence, Andover and North Andover, Massachusetts related to the delivery of natural gas by CMA, including certain subsequent events, all as described and in the DPU's Order on Scope dated December 23, 2019 (D.P.U. 19-141) (the Greater Lawrence Incident or GLI). The liabilities assumed also excluded any further emergency events prior to the closing of the acquisition related to the restoration and reconstruction with respect to the GLI, including any losses arising out of, or related to, any litigation, demand, cause of action, claim, suit, investigation, proceeding, indemnification agreements or rights. Eversource did not assume any of CMA's or NiSource Inc.'s third party debt obligations or notes payable. EGMA Rate Settlement Agreement: On October 7, 2020, the DPU approved a rate settlement agreement, which requested approval of the February 26, 2020 asset purchase agreement between Eversource and NiSource, as well as a rate stabilization plan, among other items. The settlement agreement included an authorized regulatory ROE of 9.70 percent as of January 1, 2021, a 53.25 percent equity component of its capital structure, and established rate base equal to $995 million as of the closing on October 9, 2020. The approved rate stabilization plan includes base distribution rate increases of $13 million on November 1, 2021 and $10 million on November 1, 2022. The settlement agreement includes two rate base resets during an eight-year rate plan, occurring on November 1, 2024 and November 1, 2027. The two rate base resets adjust distribution rates to account for capital additions (including the roll-in of GSEP capital additions), depreciation expense, property taxes, and return on rate base for capital additions placed into service through December 31, 2023, for the first rate base reset occurring on November 1, 2024, and through December 31, 2026, for the second rate base reset occurring on November 1, 2027. Notwithstanding the two distribution rate increases, the two rate base reset provisions, and potential adjustments for qualifying exogenous events, EGMA agreed not to file for an increase or redesign of distribution base rates effective prior to November 1, 2028. The settlement agreement also permits EGMA to seek recovery of both transaction and integration costs as a result of the asset acquisition after December 31, 2026, subject to DPU review and approval, and subject to certain conditions, such as demonstrating savings resulting from the acquisition.Projected Capital Expenditures: A summary of the projected capital expenditures for the regulated companies' electric transmission and for the total electric distribution, natural gas distribution and water distribution for 2021 through 2025, including information technology and facilities upgrades and enhancements on behalf of the regulated companies, is as follows: Years(Millions of Dollars)202120222023202420252021 - 2025TotalCL&P Transmission$443 $264 $204 $206 $173 $1,290 NSTAR Electric Transmission469 462 426 331 385 2,073 PSNH Transmission153 189 223 224 153 942 Total Electric Transmission$1,065 $915 $853 $761 $711 $4,305 Electric Distribution$1,269 $1,309 $1,353 $1,289 $1,229 $6,449 Natural Gas Distribution824 925 974 937 789 4,449 Total Electric and Natural Gas Distribution$2,093 $2,234 $2,327 $2,226 $2,018 $10,898 Water Distribution$149 $143 $154 $162 $171 $779 Information Technology and All Other$217 $249 $211 $194 $176 $1,047 Total$3,524 $3,541 $3,545 $3,343 $3,076 $17,029 The projections do not include investments related to offshore wind projects. Actual capital expenditures could vary from the projected amounts for the companies and years above.Offshore Wind Business: Our offshore wind business includes ownership interests in North East Offshore and Bay State Wind, which together hold PPAs and contracts for the Revolution Wind, South Fork Wind and Sunrise Wind projects, as well as offshore leases issued by BOEM. Our offshore wind projects are being developed and constructed through a joint and equal partnership with Ørsted. This partnership also participates in new procurement opportunities for offshore wind energy in the Northeast U.S. Eversource has a 50 percent ownership interest in North East Offshore, which holds the Revolution Wind and South Fork Wind projects, as well as a 257 square-mile ocean lease off the coasts of Massachusetts and Rhode Island. Eversource also has a 50 percent ownership interest in Bay State Wind, which holds the Sunrise Wind project. Bay State Wind's separate 300-square-mile ocean lease is located approximately 25 miles south of the coast of Massachusetts adjacent to the North East Offshore area. In aggregate, the Bay State Wind and the North East Offshore ocean lease sites jointly-owned by Eversource and Ørsted could eventually develop at least 4,000 MW of clean, renewable offshore wind energy. As of December 31, 2020, Eversource's total equity investment balance in its offshore wind business was $887.1 million, an increase of $237.8 million, as compared to 2019. We are preparing our final project designs and advancing the appropriate federal, state and local siting and permitting processes along with our offshore wind partner, Ørsted, all of which is competitively sensitive. We currently expect to make investments in our offshore wind business of approximately $300 million to $500 million during 2021, subject to advancing our final project designs and federal, state and local permitting processes.36The following table provides a summary of the Eversource and Ørsted major projects with announced contracts:Wind ProjectState ServicingSize (MW)Term (Years)Price per MWhPricing TermsContract StatusRevolution WindRhode Island40020$98.43Fixed price contract; no price escalationApprovedRevolution WindConnecticut30420(1)Fixed price contracts; no price escalationApprovedSouth Fork WindNew York (LIPA)9020$160.332 percent average price escalationApprovedSouth Fork WindNew York (LIPA)4020$86.252 percent average price escalation(3)Sunrise WindNew York (NYSERDA)88025$110.37 (2)Fixed price contract; no price escalationApproved(1) The pricing for the Revolution Wind contracts in Connecticut has not been publicly disclosed. (2) Index Offshore Wind Renewable Energy Certificate (OREC) strike price.(3) The Long Island Power Authority (LIPA) agreed to expand the original 20-year PPA from 90 MW to 130 MW through an amendment to the original agreement. The amendment is awaiting final approval from the New York Comptroller's Office. Our offshore wind projects are subject to receipt of federal, state and local approvals necessary to construct and operate the projects. The federal permitting process is governed by BOEM, and state approvals are required from New York, Rhode Island and Massachusetts. Significant delays in the siting and permitting process resulting from the timeline for obtaining approval from BOEM and the state and local agencies, as well as the impact of COVID-19, could adversely impact the timing of these projects' in-service dates. Federal Siting and Permitting Process: The South Fork Wind project has commenced the federal siting and permitting process with the filing of its Construction Operations Plan (COP) application with BOEM in 2018. The first major milestone in the BOEM review process is an issuance of a Notice of Intent to complete an Environmental Impact Statement (NOI), which South Fork Wind received in 2018. In August 2020, we received the final review schedule from BOEM regarding South Fork Wind’s COP approval. In January 2021, BOEM released its Draft Environmental Impact Statement (EIS) for the South Fork Wind project, which assessed the environmental, social, and economic impacts of constructing the project. Identified impacts were negligible to major adverse impacts to marine and terrestrial archaeological resources and to historic, and non-historic visual resources from project construction and operations. The Draft EIS also analyzed four alternatives to be evaluated as part of the process. Each of the identified alternative configurations had a similar level of environmental impacts, and if an alternative configuration was selected, the South Fork Wind project would still meet the contractual output under its PPA. A Final EIS is expected in the third quarter of 2021 and a final decision is expected in January 2022.Based on BOEM’s final review schedule and final United States Army Corps of Engineers approval, we expect to start construction on South Fork in early 2022. South Fork Wind is designated as a “Covered Project” pursuant to Title 41 of the Fixing America’s Surface Transportation Act (FAST41) and a Major Infrastructure Project under Section 3(e) of Executive Order 13807, which provides greater federal attention on meeting the project’s permitting timelines. Revolution Wind and Sunrise Wind filed their COP applications with BOEM in March 2020 and September 2020, respectively. Both projects received FAST41 designation in 2020. We are awaiting BOEM to outline its timeline for completing the review of each of the Revolution Wind and Sunrise Wind COPs in an NOI, which we expect to receive in 2021.State and Local Siting and Permitting Process: South Fork Wind commenced the New York state siting process in 2018. On September 17, 2020, South Fork Wind filed a Joint Proposal in the New York State Article VII siting application. Amongst other things, the Joint Proposal included proposed mitigations to certain environmental, community and construction impacts associated with constructing electrical infrastructure. South Fork Wind was initially joined by PSEG Long Island and several citizens advocacy organizations. On October 9, 2020, the Joint Proposal was signed by the New York Departments of Public Service, Environmental Conservation, Transportation and State as well as the Office of Parks, Recreation and Historic Preservation. Hearings in the state siting process concluded in December 2020 and a decision is expected in mid-2021.On September 10, 2020, the Town of East Hampton and the East Hampton Town Trustees announced that they had reached an agreement with South Fork Wind to issue the necessary easements and other real estate rights necessary to construct the South Fork Wind project. The Town approved the easements on January 21, 2021 and Trustees approved the lease on January 25, 2021.State permitting applications in Rhode Island for Revolution Wind and in New York for Sunrise Wind were filed in December 2020. The Revolution Wind application was deemed complete on January 22, 2021 and the preliminary hearing is set for March 22, 2021. Projected In-Service Dates: Based on BOEM’s confirmed permit schedule outlining when BOEM will complete its review of the South Fork Wind COP, we now expect the South Fork Wind project to be in-service by the end of 2023. For Revolution Wind and Sunrise Wind, we do not have a definitive timeline on when we will receive BOEM’s NOIs. At this time, we believe that it is unlikely that the projected in-service dates of the end of 2023 and the end of 2024 for Revolution Wind and Sunrise Wind, respectively, will be met. We are currently awaiting the receipt of BOEM’s NOIs for Revolution Wind and Sunrise Wind, which we expect to receive in 2021, in order to conclude on projected in-service dates. 37FERC Regulatory MattersFERC ROE Complaints: Four separate complaints were filed at the FERC by combinations of New England state attorneys general, state regulatory commissions, consumer advocates, consumer groups, municipal parties and other parties (collectively, the Complainants). In each of the first three complaints, filed on October 1, 2011, December 27, 2012, and July 31, 2014, respectively, the Complainants challenged the NETOs' base ROE of 11.14 percent that had been utilized since 2005 and sought an order to reduce it prospectively from the date of the final FERC order and for the separate 15-month complaint periods. In the fourth complaint, filed April 29, 2016, the Complainants challenged the NETOs' base ROE billed of 10.57 percent and the maximum ROE for transmission incentive (incentive cap) of 11.74 percent, asserting that these ROEs were unjust and unreasonable. The ROE originally billed during the period October 1, 2011 (beginning of the first complaint period) through October 15, 2014 consisted of a base ROE of 11.14 percent and incentives up to 13.1 percent. On October 16, 2014, the FERC set the base ROE at 10.57 percent and the incentive cap at 11.74 percent for the first complaint period. This was also effective for all prospective billings to customers beginning October 16, 2014. This FERC order was vacated on April 14, 2017 by the U.S. Court of Appeals for the D.C. Circuit (the Court). All amounts associated with the first complaint period have been refunded. Eversource has recorded a reserve of $39.1 million (pre-tax and excluding interest) for the second complaint period as of both December 31, 2020 and 2019. This reserve represents the difference between the billed rates during the second complaint period and a 10.57 percent base ROE and 11.74 percent incentive cap. The reserve consisted of $21.4 million for CL&P, $14.6 million for NSTAR Electric and $3.1 million for PSNH as of both December 31, 2020 and 2019. On October 16, 2018, FERC issued an order on all four complaints describing how it intends to address the issues that were remanded by the Court. FERC proposed a new framework to determine (1) whether an existing ROE is unjust and unreasonable and, if so, (2) how to calculate a replacement ROE. Initial briefs were filed by the NETOs, Complainants and FERC Trial Staff on January 11, 2019 and reply briefs were filed on March 8, 2019. The NETOs' brief was supportive of the overall ROE methodology determined in the October 16, 2018 order provided the FERC does not change the proposed methodology or alter its implementation in a manner that has a material impact on the results. The FERC order included illustrative calculations for the first complaint using FERC's proposed frameworks with financial data from that complaint. Those illustrative calculations indicated that for the first complaint period, for the NETOs, which FERC concludes are of average financial risk, the preliminary just and reasonable base ROE is 10.41 percent and the preliminary incentive cap on total ROE is 13.08 percent. If the results of the illustrative calculations were included in a final FERC order for each of the complaint periods, then a 10.41 percent base ROE and a 13.08 percent incentive cap would not have a significant impact on our financial statements for all of the complaint periods. These preliminary calculations are not binding and do not represent what we believe to be the most likely outcome of a final FERC order.On November 21, 2019, FERC issued Opinion No. 569 affecting the two pending transmission ROE complaints against the Midcontinent ISO (MISO) transmission owners, in which FERC adopted a new methodology for determining base ROEs. Various parties sought rehearing. On December 23, 2019, the NETOs filed supplementary materials in the NETOs' four pending cases to respond to this new methodology because of the uncertainty of the applicability to the NETOs' cases. On May 21, 2020, the FERC issued its order in Opinion No. 569-A on the rehearing of the MISO transmission owners' cases, in which FERC again changed its methodology for determining the MISO transmission owners' base ROEs. Various parties appealed the MISO transmission owners' opinion. On November 19, 2020, the FERC issued Opinion No. 569-B denying rehearing of Opinion No. 569-A and reaffirmed the methodology previously adopted in Opinion No. 569-A. The new methodology differs significantly from the methodology proposed by FERC in its October 16, 2018 order to determine the NETOs' base ROEs in its four pending cases. Given the significant uncertainty regarding the applicability of the FERC opinions in the MISO transmission owners' two complaint cases to the NETOs' pending four complaint cases, Eversource concluded that there is no reasonable basis for a change to the reserve or recognized ROEs for any of the complaint periods at this time. As well, Eversource cannot reasonably estimate a range of any gain or loss for any of the four complaint proceedings at this time.Eversource, CL&P, NSTAR Electric and PSNH currently record revenues at the 10.57 percent base ROE and incentive cap at 11.74 percent established in the October 16, 2014 FERC order. A change of 10 basis points to the base ROE used to establish the reserves would impact Eversource’s after-tax earnings by an average of approximately $3 million for each of the four 15-month complaint periods. From the date of a final FERC order, a change of 10 basis points to the base ROE would impact Eversource’s 2021 after-tax earnings by approximately $5 million, or $0.01 per share, per year, and will increase slightly over time as we continue to invest in our transmission infrastructure.FERC Notice of Inquiry on ROE: On March 21, 2019, FERC issued a Notice of Inquiry (NOI) seeking comments from all stakeholders on FERC's policies for evaluating ROEs for electric public utilities, and interstate natural gas and oil pipelines. On June 26, 2019, the NETOs jointly filed comments supporting the methodology established in the FERC’s October 16, 2018 order with minor enhancements going forward. The NETOs jointly filed reply comments in the FERC ROE NOI on July 26, 2019. On May 12, 2020, the NETOs filed supplemental comments in the NOI ROE docket. At this time, Eversource cannot predict how this proceeding will affect its transmission ROEs.38FERC Notice of Inquiry and Proposed Rulemaking on Transmission Incentives: On March 21, 2019, FERC issued an NOI seeking comments on FERC's policies for implementing electric transmission incentives. On June 26, 2019, Eversource filed comments requesting that FERC retain policies that have been effective in encouraging new transmission investment and remain flexible enough to attract investment in new and emerging transmission technologies. Eversource filed reply comments on August 26, 2019. On March 20, 2020, FERC issued a Notice of Proposed Rulemaking (NOPR) on transmission incentives. The NOPR intends to revise FERC’s electric transmission incentive policies to reflect competing uses of transmission due to generation resource mix, technological innovation and shifts in load patterns. FERC proposes to grant transmission incentives based on measurable project economics and reliability benefits to consumers rather than its current project risks and challenges framework. On July 1, 2020, Eversource filed comments generally supporting the NOPR. At this time, Eversource cannot predict how these proceedings will affect its transmission incentives. FERC Transmission Transparency Settlement: On December 28, 2015, FERC initiated a proceeding to review the NETOs' regional and local transmission formula rates due to a lack of transparency, finding that the formula rates appeared to lack sufficient details to determine how costs are derived and recovered in rates. Parties engaged in further settlement negotiations and reached an agreement in principle on October 22, 2019. On June 15, 2020, the NETOs filed an uncontested Settlement Agreement with FERC, which was signed by all six New England state regulatory commissions, New England States Committee on Electricity, New England Municipals and all the NETOs. On December 28, 2020, the FERC issued an order approving the Settlement Agreement, which establishes annual formula rate transparency procedures effective June 15, 2021, implements a new regional and local rate structure effective January 1, 2022, and contains a rate moratorium through December 31, 2024. Regulatory Developments and Rate MattersElectric, Natural Gas and Water Utility Base Distribution Rates: Each Eversource utility subsidiary is subject to the regulatory jurisdiction of the state in which it operates: CL&P, Yankee Gas and Aquarion operate in Connecticut and are subject to PURA regulation; NSTAR Electric, NSTAR Gas, EGMA and Aquarion operate in Massachusetts and are subject to DPU regulation; and PSNH and Aquarion operate in New Hampshire and are subject to NHPUC regulation. The regulated companies' distribution rates are set by their respective state regulatory commissions, and their tariffs include mechanisms for periodically adjusting their rates for the recovery of specific incurred costs. In Connecticut, electric and natural gas utilities are required to file a distribution rate case, or for PURA to initiate a rate review, within four years of the last rate case. CL&P's and Yankee Gas' distribution rates were each established in 2018 PURA-approved rate case settlement agreements. Aquarion is not required to initiate a rate review with the PURA on a set schedule. Aquarion rates were established in a 2013 PURA-approved rate case.In Massachusetts, electric distribution companies are required to file at least one distribution rate case every five years, and natural gas local distribution companies to file at least one distribution rate case every 10 years, and those companies are limited to one settlement agreement in any 10-year period. NSTAR Electric's distribution rates were established in a 2017 DPU-approved rate case. NSTAR Gas' distribution rates were established in an October 2020 DPU-approved rate case. EGMA's distribution rates were established in an October 2020 DPU-approved rate settlement agreement. Aquarion is not required to initiate a rate review with the DPU. Aquarion rates were established in a 2018 DPU-approved rate case.In New Hampshire, PSNH's distribution rates were established in a December 2020 NHPUC-approved rate case settlement agreement. Aquarion rates were established in a 2013 NHPUC-approved rate case, further revised in 2016. On December 18, 2020, Aquarion filed an application with the NHPUC for a permanent increase in base rates, effective February 1, 2021.See "Regulatory Developments and Rate Matters - Massachusetts" and "- New Hampshire," as well as "Business Development and Capital Expenditures – Acquisition of Assets of Columbia Gas of Massachusetts" in this Management's Discussion and Analysis of Financial Condition and Results of Operations, for more information on the NSTAR Gas, PSNH and EGMA 2020 rate approvals.Electric, Natural Gas and Water Utility Retail Rates: The Eversource electric distribution companies obtain and resell power to retail customers who choose not to buy energy from a competitive energy supplier. The natural gas distribution companies procure natural gas for firm and seasonal customers. These energy supply procurement costs are recovered from customers in energy supply rates that are approved by the respective state regulatory commission. The rates are reset periodically and are fully reconciled to their costs. Each electric and natural gas distribution company fully recovers its energy supply costs through approved regulatory rate mechanisms on a timely basis and, therefore, such costs have no impact on earnings.The electric and natural gas distribution companies also recover certain other costs on a fully reconciling basis through regulatory commission-approved cost tracking mechanisms and, therefore, recovery of these costs has no impact on earnings. Costs recovered through cost tracking mechanisms include, among others, energy efficiency program costs, electric retail transmission charges, electric restructuring and stranded costs (including securitized RRB charges), and additionally for our Massachusetts companies, pension and PBOP benefits and net metering for distributed generation. The reconciliation filings compare the total actual costs allowed to revenue requirements related to these services and the difference between the costs incurred (or the rate recovery allowed) and the actual costs allowed is deferred and included, to be either recovered or refunded, in future customer rates. These cost tracking mechanisms also include certain incentives earned, return on rate base and on capital tracking mechanisms, and carrying charges that are billed in rates to customers, which do impact earnings.39COVID-19 Regulatory Dockets: In Connecticut, PURA opened a docket to address COVID-19 developments, including issuing orders on March 18, 2020, April 29, 2020 and May 15, 2020 that authorized electric, natural gas and water utilities to establish a regulatory asset for COVID-19 uncollectible customer receivable expenses and costs associated with the related orders. PURA’s April 29, 2020 order, as supplemented on May 15, 2020, also allowed the inclusion of working capital costs in the regulatory asset, and authorized electric, natural gas and water utilities to establish a payment plan program designed to assist any customer who requests financial assistance during the COVID-19 pandemic. On July 10, 2020, PURA denied a request from a coalition of large industrial customers to reduce or suspend certain electric and natural gas charges during the COVID-19 pandemic. In Massachusetts, on July 31, 2020, the DPU approved and adopted a coalition of electric, natural gas and water utilities’ comprehensive Customer Assistance Plan involving extended payment plans and waiver of late fees, extended plans under available arrearage management plans (AMPs), and continuation of the Shut-Off Moratorium. On September 3, 2020, the DPU approved the 2020 small commercial arrearage forgiveness program (AFP) proposed by the electric and natural gas distribution companies. In its interim order dated December 31, 2020, the DPU established certain cost tracking and data reporting requirements for the distribution companies and will allow each company to record, defer, and track incremental cost areas, subject to the DPU’s final determination of the ratemaking treatment in D.P.U. 20-58 and D.P.U. 20-91. In D.P.U. 20-91, the DPU will adjudicate the contested cost-recovery provisions identified in the Ratemaking Proposal and consider proposals to expand alternative customer bill payment options. The distribution companies’ Ratemaking Proposal for COVID-19 financial-related impacts includes recovery requests for each of the following five cost categories: (1) cash working capital; (2) arrearage forgiveness; (3) bad debt; (4) COVID-19 O&M expenses; and (5) waived fees.In New Hampshire, on October 5, 2020, the NHPUC approved an agreement governing collections and disconnection activities, deposit activities, flexible payment plans, and special arrangements for income-qualified customers for all New Hampshire utilities including Eversource’s electric and water utilities. The terms of that agreement continue through at least April 2021. Also, on August 18, 2020, the NHPUC Staff recommended that utilities in New Hampshire be permitted to create a regulatory asset for waived fees and incremental bad debt related to the COVID-19 pandemic. On November 13, 2020, the NHPUC Staff revised its recommendation arguing that waived fees should not be included in any regulatory asset related to the COVID-19 pandemic. The New Hampshire utilities disputed that recommendation on December 4, 2020, and on December 16, 2020, the NHPUC Staff renewed its November 13, 2020 recommendation. The NHPUC has yet to act on that recommendation. For information on COVID-19-related regulatory deferrals recorded and COVID-19 charges incurred, see "Impact of COVID-19" included in this Management’s Discussion and Analysis. Storm Event:On August 4, 2020, Tropical Storm Isaias caused catastrophic damage to our electric distribution system, which resulted in significant amounts and durations of customer outages, primarily in Connecticut. In terms of customer outages, this storm was one of the worst in CL&P’s history. PURA has opened an investigation into CL&P's response to Tropical Storm Isaias. PURA will also investigate the prudence of costs incurred by CL&P to restore service as part of its response. CL&P is fully participating in PURA’s investigations and believes that these storm restoration costs were prudently incurred and meet the criteria for cost recovery. As a result, management does not expect the storm costs to have a material impact on the results of operations of Eversource or CL&P. Based on current estimates, the storm resulted in deferred storm restoration costs on our balance sheets of approximately $228 million at CL&P and $245 million at Eversource as of December 31, 2020. The estimated cost of restoration will change as additional cost information becomes available, final storm costs are deferred or capitalized, and post-storm restoration work is completed. The majority of incremental storm costs relate to third-party vendors that are external field crews needed to restore power and address municipal priorities. CL&P’s current estimate of total storm costs includes its projection of the cost of such vendors, but that estimate will change as CL&P receives and examines all storm related invoices.Connecticut:CL&P Storm Investigation: On August 7, 2020, PURA issued a notice that it had opened a docket to investigate the preparation for and response to Tropical Storm Isaias by Connecticut utilities, including CL&P. Hearings were completed in January 2021 and a final decision is currently expected on April 28, 2021. If the April 28, 2021 final decision concludes that CL&P failed to comply with applicable storm performance standards, then a separate proceeding will be initiated on May 7, 2021 to examine if and what amount of any civil penalty could potentially be imposed on CL&P, with a final decision currently anticipated on July 14, 2021. CL&P Rate Suspension: On July 31, 2020, PURA temporarily suspended its June 26, 2020 approval of certain delivery rate components effective July 1, 2020, and ordered CL&P to restore rates to those in effect as of June 30, 2020 in order to allow PURA time to reexamine the rates to ensure that CL&P is not over-collecting revenues in the short-term. Rates were adjusted effective August 1, 2020. PURA indicated that this was due to the convergence of a number of recent events, including the COVID-19 crisis and its corresponding effect on customer energy usage, as well as the warmer than normal weather in July. On December 2, 2020, PURA issued a final decision in which it adjusted the timing of the annual rate adjustments for the Revenue Decoupling Mechanism Charge, the Transmission Adjustment Clause charge, the Non-Bypassable Federally Mandated Congestion Charge, and the Electric System Improvements Tracker so that these rates take effect on May 1st of each year, as opposed to the current process of adjusting rates each January 1 and July 1. The final decision also modified the calculation of carrying charges and shifted the timing of recovery to rely on more actual versus forecasted information, among other changes.40The temporary suspension of rates has resulted in a current period under-recovery of costs, which results in an increase to our regulatory assets, with no impact on the statement of income other than carrying charges, and a delay in the collection of our costs. Massachusetts:NSTAR Electric Distribution Rates: As part of an inflation-based mechanism, NSTAR Electric submitted its third annual Performance BasedRate Adjustment filing on September 15, 2020 and the DPU approved a $29.9 million increase to base distribution rates on December 30, 2020 for effect on January 1, 2021.NSTAR Gas Rate Case: On October 30, 2020, the DPU approved a base distribution rate increase of $23.0 million effective November 1, 2020, compared to the original request of $38.0 million. NSTAR Gas' 2019 plant additions are allowed recovery beginning on November 1, 2021. Thus, the reduced revenue requirement reflects the removal of this recovery, among other adjustments. The DPU also approved NSTAR Gas' proposal to continue its ongoing Gas System Enhancement Program (GSEP), the inclusion of GSEP investments since 2015 into base rates, and the implementation of a 10-year performance-based ratemaking plan, which includes an inflation-based adjustment mechanism to annual base distribution rates. The decision allows an authorized regulatory ROE of 9.9 percent on a capital structure including 54.77 percent equity. The decision also approves a geothermal pilot program. The impact of the rate case decision resulted in a pre-tax charge to earnings in 2020 of $2.7 million at NSTAR Gas, primarily due to certain plant-related disallowances.Sale of Water System: On July 31, 2020, we sold our water system and treatment plant that supplies water to the towns of Hingham, Hull and North Cohasset to the town of Hingham, Massachusetts. Net property, plant and equipment of $63.9 million and goodwill of $23.6 million were included in determining the gain on sale. Proceeds from the sale were $110.5 million, with a pre-tax gain of $16.0 million (after-tax gain of $3.5 million) recognized within Operations and Maintenance Expense on the statement of income for the year ended December 31, 2020. The assets and liabilities associated with the sale of the business were previously reflected in the Water Distribution segment and reporting unit.New Hampshire:PSNH Distribution Rates: On June 27, 2019, the NHPUC approved a settlement agreement that was reached by PSNH, the NHPUC Staff, the Office of the Consumer Advocate, and another settling party, to implement a temporary annual base distribution rate increase of $28.3 million. Although new rates were implemented on August 1, 2019 to customers, the provisions of the temporary base distribution rate increase were effective July 1, 2019. The settlement agreement also permitted PSNH to recover approximately $68.5 million in unrecovered storm costs over a five-year period beginning August 1, 2019, with debt carrying charges, which is included in the temporary rate increase.On May 28, 2019, PSNH filed an application with the NHPUC for a permanent increase in base distribution rates of approximately $70 million, effective July 1, 2020, which included the temporary rate increase request. Temporary rates remained in effect with a reconciliation of permanent rates retroactive to July 1, 2019 once permanent rates were set. On December 15, 2020, the NHPUC approved an October 9, 2020 settlement agreement on permanent rates between PSNH and all parties to the proceeding. The NHPUC approved a permanent rate increase of $45.0 million effective January 1, 2021, inclusive of the temporary rate increase referenced above. PSNH was also permitted three step increases, effective January 1, 2021, August 1, 2021, and August 1, 2022, to reflect plant additions in calendar years 2019, 2020 and 2021, respectively. On December 23, 2020, the NHPUC approved the first step adjustment for 2019 plant in service to recover a revenue requirement of $10.6 million, subject to reconciliation after completion of an audit, effective January 1, 2021. The settlement agreement also established an authorized regulatory ROE of 9.3 percent with a 54.4 percent common equity ratio in PSNH’s capital structure and provided for a new tracker to recover regulatory assessments, vegetation management costs, property tax costs, and lost distribution revenue attributable to net metering. In addition, base distribution rates were adjusted to reflect the refund of EDIT from the Tax Cuts and Jobs Act of 2017. The settlement agreement allowed for the effect of the permanent rate increase to be extended back to the temporary rate period. In lieu of a customer rate increase for this recoupment of revenue, the NHPUC directed a portion of the total EDIT regulatory liability to offset bill impacts to customers. The impact of the settlement agreement resulted in an after-tax benefit to earnings in 2020 of $11.0 million at Eversource ($7.2 million at PSNH), due primarily to the reconciliation of permanent rates back to the temporary rate period resulting in a reduction of the EDIT regulatory liability, which reduced Income Tax Expense on the statement of income, and the allowed recovery of previously expensed costs. The earnings impact was partially offset by the negative impact from the over-refunding of the change in the 2018 federal corporate income tax rate as a result of the Tax Cuts and Jobs Act of 2017 that was reflected in temporary rates, which reduced Operating Revenues on the statement of income. PSNH Generation Asset Divestiture-Related Costs: On May 15, 2020, the NHPUC Audit Staff issued a final report on the audit of PSNH’s generation asset divestiture-related costs and resulting securitized and stranded costs. The findings in the audit report as well as other aspects of the divestiture process were further investigated by NHPUC Staff through the discovery phase, which was completed in July 2020. On September 30, 2020, PSNH filed a settlement agreement on the generation asset divestiture-related costs with the NHPUC Audit Staff. The settlement agreement resolved all issues with respect to PSNH’s divestiture of its generating assets and the recovery of $12.0 million of divestiture-related costs incurred above the $635.7 million amount previously securitized. On December 17, 2020, the NHPUC approved the additional $12.0 million proposed in the settlement agreement to be recovered over a one-year period through the SCRC rate beginning February 1, 2021. 41Legislative and Policy MattersFederal: On March 27, 2020, President Trump signed the $2.2 trillion bipartisan Coronavirus Aid, Relief, and Economic Security (CARES) Act. Among other provisions, the CARES Act provides for loans and other benefits to small and large businesses, expanded unemployment insurance, direct payments to those with wages middle-income and below, new appropriations funding for health care and other priorities, and tax changes like deferrals of employer payroll tax liabilities coupled with an employee retention tax credit and rollbacks of Tax Cuts and Jobs Act of 2017 limitations on net operating losses and certain business interest limitation. For the year ended December 31, 2020, we have recorded a tax liability of approximately $39 million related to the deferral of employer payroll tax liability provision. Fifty percent of the deferral of employer payroll tax liability must be paid by December 31, 2021 and the remaining amount by December 31, 2022. Other than the cash flow benefit described, the CARES Act did not have a material impact. On December 27, 2020, President Trump signed into law H.R. 133, the “Consolidated Appropriations Act, 2021.” The House of Representatives and Senate previously passed the bill with overwhelming support. The legislation includes tax extenders as part of Division EE, the “Taxpayer Certainty and Disaster Tax Relief Act of 2020.” The provisions within the law include the extension of the Investment Tax Credit (ITC) for solar at 26 percent for facilities the construction of which begins through the end of 2022, at 22 percent for facilities the construction of which begins in 2023, and postponement of the date after which solar facilities placed in service receive only a 10 percent ITC to December 31, 2025, the extension of the ITC at 30 percent (with no phase-down) to offshore wind if construction begins by December 31, 2025 (qualifying offshore wind includes facilities located in the inland navigable waters or in the coastal waters of the U.S.), and the extension and expansion of the CARES Act employee retention tax credit for the period from January 1, 2021 through June 30, 2021, including increasing the credit rate from 50 percent to 70 percent of qualified wages, and increasing the per-employee creditable wages limit from $10,000 per year to $10,000 for each quarter. The tax credit provision impacts to Eversource are still being evaluated but are a significant positive development for the Company and provides the opportunity to generate additional tax credits in its renewable energy projects when the projects become operational.Massachusetts: On January 28, 2021, the Massachusetts Legislature approved legislation which permits electric or natural gas distribution companies to assist Massachusetts municipalities in responding to the risks of climate change by owning solar facilities equal to up to 10 percent of the total installed solar generating capacity in Massachusetts as of July 31, 2020. Such facilities may be paired with energy storage where feasible to do so. This legislation is anticipated to allow each of Eversource’s Massachusetts operating companies to own up to approximately 280 MWs of solar generating facilities in addition to the 70 MWs previously constructed at NSTAR Electric. Connecticut: On October 8, 2020, Connecticut enacted Public Act 20-5 (House Bill Number 7006), September Special Session (the Act). The Act, among other things, (1) requires PURA to open a proceeding by June 1, 2021 to begin to evaluate and eventually implement performance based regulation for electric distribution companies, and permits PURA to open a proceeding to consider such regulation for natural gas and water companies; (2) extends deadlines for PURA to issue final decisions in rate cases, change of control transactions and financing proceedings to be more consistent with timeframes in many other U.S. jurisdictions; (3) increases the maximum potential penalty for noncompliance with storm performance standards from 2.5 percent to 4 percent of annual electric distribution company revenue; and (4) directed PURA to open a proceeding by January 1, 2021 to evaluate and decide when bill credits should be paid to electric customers who lose service in future storms, including when waivers of these criteria will be granted to utilities. PURA opened a docket on December 29, 2020 to evaluate when bill credits would be paid for new storms after July 1, 2021. This law has no impact on storm response, costs or impacts prior to July 1, 2021. Critical Accounting PoliciesThe preparation of financial statements in conformity with GAAP requires management to make estimates, assumptions and, at times, difficult, subjective or complex judgments. Changes in these estimates, assumptions and judgments, in and of themselves, could materially impact our financial position, results of operations or cash flows. Our management discusses with the Audit Committee of our Board of Trustees significant matters relating to critical accounting policies. Our critical accounting policies are discussed below. See the combined notes to our financial statements for further information concerning the accounting policies, estimates and assumptions used in the preparation of our financial statements. Regulatory Accounting: Our regulated companies are subject to rate regulation that is based on cost recovery and meets the criteria for application of accounting guidance for rate-regulated operations, which considers the effect of regulation on the timing of the recognition of certain revenues and expenses. The regulated companies' financial statements reflect the effects of the rate-making process. The rates charged to the customers of our regulated companies are designed to collect each company's costs to provide service, plus a return on investment. The application of accounting guidance for rate-regulated enterprises results in recording regulatory assets and liabilities. Regulatory assets represent the deferral of incurred costs that are probable of future recovery in customer rates. Regulatory assets are amortized as the incurred costs are recovered through customer rates. In some cases, we record regulatory assets before approval for recovery has been received from the applicable regulatory commission. We must use judgment to conclude that costs deferred as regulatory assets are probable of future recovery. We base our conclusion on certain factors, including, but not limited to, regulatory precedent. Regulatory liabilities represent either revenues received from customers to fund expected costs that have not yet been incurred or probable future refunds to customers.We use judgment when recording regulatory assets and liabilities; however, regulatory commissions can reach different conclusions about the recovery of costs, and those conclusions could have a material impact on our financial statements. We believe it is probable that each of the regulated companies will recover its respective investments in long-lived assets and the regulatory assets that have been recorded. If we determine that we can no longer apply the accounting guidance applicable to rate-regulated enterprises, or that we cannot conclude it is probable that costs will be recovered from customers in future rates, the applicable costs would be charged to net income in the period in which the determination is made.42Pension, SERP and PBOP: We sponsor Pension, SERP and PBOP Plans to provide retirement benefits to our employees. For each of these plans, several significant assumptions are used to determine the projected benefit obligation, funded status and net periodic benefit cost. These assumptions include the expected long-term rate of return on plan assets, discount rate, compensation/progression rate and mortality and retirement assumptions. We evaluate these assumptions at least annually and adjust them as necessary. Changes in these assumptions could have a material impact on our financial position, results of operations or cash flows. Expected Long-Term Rate of Return on Plan Assets: In developing the expected long-term rate of return, we consider historical and expected returns, as well as input from our consultants. Our expected long-term rate of return on assets is based on assumptions regarding target asset allocations and corresponding expected rates of return for each asset class. We routinely review the actual asset allocations and periodically rebalance the investments to the targeted asset allocations. For the year ended December 31, 2020, our expected long-term rate-of-return assumption used to determine our pension and PBOP expense was 8.25 percent for the Eversource Service plans and 7 percent for the Aquarion plans. For the forecasted 2021 pension and PBOP expense, an expected long-term rate of return of 8.25 percent for the Eversource Service plans and 7 percent for the Aquarion plans will be used reflecting our target asset allocations.Discount Rate: Payment obligations related to the Pension, SERP and PBOP Plans are discounted at interest rates applicable to the expected timing of each plan's cash flows. The discount rate that was utilized in determining the pension, SERP and PBOP obligations was based on a yield-curve approach. This approach utilizes a population of bonds with an average rating of AA based on bond ratings by Moody's, S&P and Fitch, and uses bonds with above median yields within that population. As of December 31, 2020, the discount rates used to determine the funded status were within a range of 2.4 percent to 2.7 percent for the Pension and SERP Plans, and within a range of 2.5 percent to 2.6 percent for the PBOP Plans. As of December 31, 2019, the discount rates used were within a range of 3.0 percent to 3.4 percent for the Pension and SERP Plans, and within a range of 3.2 percent to 3.3 percent for the PBOP Plans. The decrease in the discount rates used to calculate the funded status resulted in an increase to the Pension and PBOP Plans' liability of $603.0 million and $68.3 million, respectively, as of December 31, 2020. The Company uses the spot rate methodology for the service and interest cost components of Pension, SERP and PBOP expense because it provides a relatively precise measurement by matching projected cash flows to the corresponding spot rates on the yield curve. The discount rates used to estimate the 2020 expense were within a range of 2.6 percent to 3.5 percent for the Pension and SERP Plans, and within a range of 2.7 percent to 3.6 percent for the PBOP Plans. Mortality Assumptions: Assumptions as to mortality of the participants in our Pension, SERP and PBOP Plans are a key estimate in measuring the expected payments a participant may receive over their lifetime and the corresponding plan liability we need to record. In 2020, a revised scale for the mortality table was released, and we utilized it in our measurements.Compensation/Progression Rate: This assumption reflects the expected long-term salary growth rate, including consideration of the levels of increases built into collective bargaining agreements, and impacts the estimated benefits that Pension and SERP Plan participants receive in the future. As of December 31, 2020 and 2019, the compensation/progression rates used to determine the funded status were within a range of 3.5 percent to 4 percent. Health Care Cost: The Eversource Service PBOP Plan is not subject to health care cost trends. As of December 31, 2020, for the Aquarion PBOP Plan, the health care trend rate for pre-65 retirees is 6.3 percent, with an ultimate rate of 5 percent in 2023, and for post-65 retirees, the health care trend rate and ultimate rate is 3.5 percent. Actuarial Determination of Expense: Pension, SERP and PBOP expense is determined by our actuaries and consists of service cost and prior service cost, interest cost based on the discounting of the obligations, and amortization of actuarial gains and losses, offset by the expected return on plan assets. Actuarial gains and losses represent the amortization of differences between assumptions and actual information or updated assumptions. Pre-tax net periodic benefit expense for the Pension and SERP Plans was $56.9 million, $63.7 million and $39.6 million for the years ended December 31, 2020, 2019 and 2018, respectively. For the PBOP Plans, there was net periodic PBOP income of $51.6 million, $41.5 million and $45.0 million for the years ended December 31, 2020, 2019 and 2018, respectively. The expected return on plan assets is determined by applying the assumed long-term rate of return to the Pension and PBOP Plan asset balances. This calculated expected return is compared to the actual return or loss on plan assets at the end of each year to determine the investment gains or losses to be immediately reflected in unamortized actuarial gains and losses. Forecasted Expenses and Expected Contributions: We estimate that expense in 2021 for the Pension and SERP Plans will be approximately $28 million and income in 2021 for the PBOP Plans will be approximately $58 million. Pension, SERP and PBOP expense for subsequent years will depend on future investment performance, changes in future discount rates and other assumptions, and various other factors related to the populations participating in the plans. Our policy is to fund the Pension Plans annually in an amount at least equal to the amount that will satisfy all federal funding requirements. We contributed $109.6 million to the Pension Plans in 2020. We currently estimate contributing $130.0 million to the Pension Plans in 2021. It is our policy to fund the PBOP Plans annually through tax deductible contributions to external trusts. We contributed $1.9 million to the PBOP Plans in 2020. We currently estimate contributing $2.8 million to the PBOP Plans in 2021.43Sensitivity Analysis: The following represents the hypothetical increase to the Pension Plans' (excluding the SERP Plans) reported annual cost and a decrease to the PBOP Plans' reported annual income as a result of a change in the following assumptions by 50 basis points:(Millions of Dollars)Increase in Pension Plan CostDecrease in PBOP Plan IncomeAssumption ChangeAs of December 31,As of December 31,Eversource2020201920202019Lower expected long-term rate of return$25.0 $22.9 $4.5 $4.1 Lower discount rate25.4 21.7 1.7 1.7 Higher compensation rate8.8 8.7 N/AN/AGoodwill: We recorded goodwill on our balance sheet associated with previous mergers and acquisitions, which totaled $4.45 billion as of December 31, 2020. We have identified our reporting units for purposes of allocating and testing goodwill as Electric Distribution, Electric Transmission, Natural Gas Distribution and Water Distribution. Electric Distribution and Electric Transmission reporting units include carrying values for the respective components of CL&P, NSTAR Electric and PSNH. The Natural Gas Distribution reporting unit includes the carrying values of NSTAR Gas, Yankee Gas and EGMA. We recorded $42 million of goodwill arising from the acquisition of CMA on October 9, 2020. The Water Distribution reporting unit includes the Aquarion water utility businesses. As of December 31, 2020, goodwill was allocated to the reporting units as follows: $2.54 billion to Electric Distribution, $577 million to Electric Transmission, $441 million to Natural Gas Distribution and $884 million to Water Distribution. We are required to test goodwill balances for impairment at least annually by considering the fair values of the reporting units, which requires us to use estimates and judgments. We have selected October 1st of each year as the annual goodwill impairment test date. Goodwill impairment is deemed to exist if the carrying amount of a reporting unit exceeds its estimated fair value. If goodwill were deemed to be impaired, it would be written down in the current period to the extent of the impairment. We performed an impairment test of goodwill as of October 1, 2020 for the Electric Distribution, Electric Transmission, Natural Gas Distribution and Water Distribution reporting units. This evaluation required the consideration of several factors that impact the fair value of the reporting units, including conditions and assumptions that affect the future cash flows of the reporting units. Key considerations include discount rates, utility sector market performance and merger transaction multiples, and internal estimates of future cash flows and net income. The 2020 goodwill impairment assessment resulted in a conclusion that goodwill is not impaired and no reporting unit is at risk of a goodwill impairment. The fair value of the reporting units was substantially in excess of carrying value.Long-Lived Assets: Impairment evaluations of long-lived assets, including property, plant and equipment and other assets, involve a significant degree of estimation and judgment, including identifying circumstances that indicate an impairment may exist. Impairment analysis is required when events or changes in circumstances indicate that the carrying value of a long-lived asset may not be recoverable. Indicators of potential impairment include a deteriorating business climate, unfavorable regulatory action, decline in value that is other than temporary in nature, plans to dispose of a long-lived asset significantly before the end of its useful life, and accumulation of costs that are in excess of amounts allowed for recovery. The review of long-lived assets for impairment utilizes significant assumptions about operating strategies and external developments, including assessment of current and projected market conditions that can impact future cash flows.Impairment of Northern Pass Transmission: Northern Pass was Eversource's planned 1,090 MW HVDC transmission line that would have interconnected from the Québec-New Hampshire border to Franklin, New Hampshire and an associated alternating current radial transmission line between Franklin and Deerfield, New Hampshire. As a result of a final decision received on July 19, 2019 from the New Hampshire Supreme Court, whereby the court denied Northern Pass’ appeal and affirmed the NHSEC’s denial of Northern Pass’ siting application on NPT, Eversource concluded that construction of NPT was no longer probable and that there was no constructive path forward for the project. In 2019, Eversource terminated the project and permanently abandoned any further development. Based on the conclusion that the construction of Northern Pass was no longer probable, Eversource recorded an impairment charge in 2019 for all of the project costs associated with Northern Pass, which were primarily engineering design, siting, permitting and legal costs, along with appropriate allowances for funds used during construction, and recognized a receivable for certain cost reimbursement agreements. Additionally, Eversource recorded an impairment charge associated with the land acquired to construct Northern Pass in order to recognize the land at its estimated fair value based on assessed values and transaction costs. In total, this resulted in a pre-tax impairment charge of $239.6 million within Operating Income on the statement of income for the year ended December 31, 2019, and was reflected in the Electric Transmission segment. The after-tax impact of the impairment charge was $204.4 million, or $0.64 per share, after giving effect to the estimated fair value of the related land, reimbursement agreements, and the impact of expected income tax benefits associated with the impairment charge. As a result of the decision to terminate the NPT project and permanently abandon any further development, Eversource does not expect any future cash expenditures associated with this project. Equity Method Investments: Investments in affiliates where we have the ability to exercise significant influence, but not control, over an investee are initially recognized as an equity method investment at cost. Any differences between the cost of an investment and the amount of underlying equity in net assets of an investee are considered basis differences and are determined based upon the estimated fair values of the investee's identifiable assets and liabilities. For our offshore wind equity method investment, basis differences are related to intangible assets for PPAs that will be amortized over the term of the PPAs, and equity method goodwill that are not amortized. Capitalized interest associated with our offshore wind equity method investment is included in the investment balance. 44Equity method investments are assessed for impairment when conditions exist that indicate that the fair value of the investment is less than book value. If the decline in value is considered to be other-than-temporary, the investment is written down to its estimated fair value, which establishes a new cost basis in the investment. Impairment evaluations involve a significant degree of judgment and estimation, including identifying circumstances that indicate an impairment may exist and developing an estimate of undiscounted future cash flows. In 2020, Eversource recorded an other-than-temporary impairment of $2.8 million within Other Income, Net on the statement of income, related to a write-off of an investment within a renewable energy fund.In 2018, Eversource recorded an other-than-temporary impairment of $32.9 million within Other Income, Net on our statement of income, related to Access Northeast, an equity method investment. Eversource identified a September 2018 non-Eversource natural gas series of explosions in eastern Massachusetts, compounded by an adverse legislative environment, as negative evidence that indicated potential impairment of our investment in Access Northeast. In 2018, management determined that the future cash flows of the Access Northeast project were uncertain and could no longer be reasonably estimated and that the book value of our equity method investment was not recoverable. On April 1, 2019, pursuant to a provision in the partnership agreement jointly entered into by Eversource, Enbridge, Inc. and National Grid plc, through Algonquin Gas Transmission, LLC, the Access Northeast project was terminated. Income Taxes: Income tax expense is estimated for each of the jurisdictions in which we operate and is recorded each quarter using an estimated annualized effective tax rate. This process to record income tax expense involves estimating current and deferred income tax expense or benefit and the impact of temporary differences resulting from differing treatment of items for financial reporting and income tax return reporting purposes. Such differences are the result of timing of the deduction for expenses, as well as any impact of permanent differences, non-tax deductible expenses, or other items that directly impact income tax expense as a result of regulatory activity (flow-through items). The temporary differences and flow-through items result in deferred tax assets and liabilities that are included in the balance sheets.We also account for uncertainty in income taxes, which applies to all income tax positions previously filed in a tax return and income tax positions expected to be taken in a future tax return that have been reflected on our balance sheets. The determination of whether a tax position meets the recognition threshold under applicable accounting guidance is based on facts and circumstances available to us. Pursuant to the Tax Cuts and Jobs Act of 2017, Eversource had remeasured its existing deferred federal income tax balances to reflect the decrease in the U.S. federal corporate income tax rate from 35 percent to 21 percent. The remeasurement resulted in provisional regulated excess accumulated deferred income tax (excess ADIT or EDIT) liabilities that will benefit our customers in future periods. As of December 31, 2020, these EDIT liabilities were estimated to be approximately $2.78 billion and were included in regulatory liabilities on the balance sheet. Eversource's regulated companies are in the process of, or will be, refunding the EDIT liabilities to customers based on orders issued by applicable state regulatory commissions. The refund of these regulatory liabilities to customers will generally be made over the same period as the remaining useful lives of the underlying assets that gave rise to the ADIT liabilities.Accounting for Environmental Reserves: Environmental reserves are accrued when assessments indicate it is probable that a liability has been incurred and an amount can be reasonably estimated. Increases to estimates of environmental liabilities could have an adverse impact on earnings. We estimate these liabilities based on findings through various phases of the assessment, considering the most likely action plan from a variety of available remediation options (ranging from no action required to full site remediation and long-term monitoring), current site information from our site assessments, remediation estimates from third party engineering and remediation contractors, and our prior experience in remediating contaminated sites. If a most likely action plan cannot yet be determined, we estimate the liability based on the low end of a range of possible action plans. A significant portion of our environmental sites and reserve amounts relate to former MGP sites that were operated several decades ago and manufactured natural gas from coal and other processes, which resulted in certain by-products remaining in the environment that may pose a potential risk to human health and the environment, for which we may have potential liability. Estimates are based on the expected remediation plan. Our estimates are subject to revision in future periods based on actual costs or new information from other sources, including the level of contamination at the site, the extent of our responsibility or the extent of remediation required, recently enacted laws and regulations or a change in cost estimates. Fair Value Measurements: We follow fair value measurement guidance that defines fair value as the price that would be received for the sale of an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date (an exit price). We have applied this guidance to our Company's derivative contracts that are not elected or designated as "normal purchases or normal sales" (normal), to marketable securities held in trusts, and to our investments in our Pension and PBOP Plans. Fair value measurements are also incorporated into the accounting for goodwill, long-lived assets, equity method investments, and AROs, and in the valuation of the acquisition of CMA in 2020. The fair value measurement guidance was also applied in estimating the fair value of preferred stock, long-term debt and RRBs.Changes in fair value of our derivative contracts are recorded as Regulatory Assets or Liabilities, as we recover the costs of these contracts in rates charged to customers. These valuations are sensitive to the prices of energy and energy-related products in future years for which markets have not yet developed and assumptions are made. We use quoted market prices when available to determine the fair value of financial instruments. When quoted prices in active markets for the same or similar instruments are not available, we value derivative contracts using models that incorporate both observable and unobservable inputs. Significant unobservable inputs utilized in the models include energy and energy-related product prices for future years for long-dated derivative contracts and market volatilities. Discounted cash flow valuations incorporate estimates of premiums or discounts, reflecting risk-adjusted profit that would be required by a market participant to arrive at an exit price, using available historical market transaction information. Valuations of derivative contracts also reflect our estimates of nonperformance risk, including credit risk. 45Other MattersAccounting Standards: For information regarding new accounting standards, see Note 1C, "Summary of Significant Accounting Policies - Accounting Standards," to the financial statements.Contractual Obligations and Commercial Commitments: Information regarding our contractual obligations and commercial commitments as of December 31, 2020, is summarized annually through 2025 and thereafter as follows: Eversource (Millions of Dollars)20212022202320242025ThereafterTotalLong-term debt maturities (a)$1,022.2 $1,175.2 $1,658.2 $1,049.9 $1,400.0 $9,807.9 $16,113.4 Rate reduction bond maturities43.2 43.2 43.2 43.2 43.2 324.1 540.1 Estimated interest payments on existing debt (b)542.8 510.6 478.4 437.3 391.0 4,541.4 6,901.5 Operating leases (c)11.4 9.0 6.4 4.5 3.4 36.2 70.9 Finance leases(c)7.2 5.7 4.9 4.8 4.7 60.7 88.0 Funding of pension obligations (d) (e)130.0 — — — — — 130.0 Funding of PBOP obligations (d) (e)2.8 — — — — — 2.8 Estimated future annual long-term contractual costs (f)1,328.8 1,218.6 1,096.1 1,052.3 1,023.0 5,451.8 11,170.6 Total (g)$3,088.4 $2,962.3 $3,287.2 $2,592.0 $2,865.3 $20,222.1 $35,017.3 CL&P (Millions of Dollars)20212022202320242025ThereafterTotalLong-term debt maturities (a)$— $— $400.0 $139.8 $400.0 $2,975.5 $3,915.3 Estimated interest payments on existing debt (b)156.2 156.2 151.2 146.2 135.2 1,884.0 2,629.0 Operating leases (c)0.2 0.1 — — — — 0.3 Finance leases (c)1.5 — — — — — 1.5 Funding of pension obligations (d) (e)78.9 — — — — — 78.9 Estimated future annual long-term contractual costs (f)588.3 661.5 684.6 674.9 647.7 2,755.8 6,012.8 Total (g)$825.1 $817.8 $1,235.8 $960.9 $1,182.9 $7,615.3 $12,637.8 (a) Long-term debt maturities exclude the CYAPC pre-1983 spent nuclear fuel obligation, net unamortized premiums, discounts and debt issuance costs, and other fair value adjustments.(b) Estimated interest payments on fixed-rate debt are calculated by multiplying the coupon rate on the debt by its scheduled notional amount outstanding for the period of measurement. (c) The operating and finance lease obligations include interest.(d) Amounts are not included on our balance sheets. (e) These amounts represent expected pension and PBOP contributions for 2021. Future contributions will vary depending on many factors, including the performance of existing plan assets, valuation of the plans' liabilities and long-term discount rates. (f) Other than certain derivative contracts held by the regulated companies, these obligations are not included on our balance sheets. (g) Does not include other long-term liabilities recorded on our balance sheet, such as environmental reserves, employee medical insurance, workers compensation and long-term disability insurance reserves, ARO liability reserves and other reserves, as we cannot make reasonable estimates of the timing of payments. Also, does not include amounts not included on our balance sheets for future funding of Eversource's equity method investments, as we cannot make reasonable estimates of the periods or the investment contributions.For further information regarding our contractual obligations and commercial commitments, see Note 7, "Asset Retirement Obligations," Note 8, "Short-Term Debt," Note 9, "Long-Term Debt," Note 10, "Rate Reduction Bonds and Variable Interest Entities," Note 11A, "Employee Benefits - Pension Benefits and Postretirement Benefits Other Than Pension," Note 13, "Commitments and Contingencies," and Note 14, "Leases," to the financial statements.46RESULTS OF OPERATIONS – EVERSOURCE ENERGY AND SUBSIDIARIESThe following provides the amounts and variances in operating revenues and expense line items in the statements of income for Eversource for the years ended December 31, 2020 and 2019 included in this Annual Report on Form 10-K: For the Years Ended December 31,(Millions of Dollars)20202019Increase/(Decrease)Operating Revenues$8,904.4 $8,526.5 $377.9 Operating Expenses: Purchased Power, Fuel and Transmission2,987.8 3,040.2 (52.4)Operations and Maintenance1,480.3 1,363.1 117.2 Depreciation981.4 885.3 96.1 Amortization177.7 195.4 (17.7)Energy Efficiency Programs535.8 501.4 34.4 Taxes Other Than Income Taxes752.7 711.0 41.7 Impairment of Northern Pass Transmission— 239.6 (239.6)Total Operating Expenses6,915.7 6,936.0 (20.3)Operating Income1,988.7 1,590.5 398.2 Interest Expense538.4 533.2 5.2 Other Income, Net108.6 132.8 (24.2)Income Before Income Tax Expense1,558.9 1,190.1 368.8 Income Tax Expense346.2 273.5 72.7 Net Income1,212.7 916.6 296.1 Net Income Attributable to Noncontrolling Interests7.5 7.5 — Net Income Attributable to Common Shareholders$1,205.2 $909.1 $296.1 Operating RevenuesSales Volumes: A summary of our retail electric GWh sales volumes, our firm natural gas MMcf sales volumes, and our water MG sales volumes, and percentage changes, is as follows: ElectricFirm Natural GasWater Sales Volumes (GWh)PercentageDecreaseSales Volumes (MMcf)PercentageIncreaseSales Volumes (MG)Percentage(Decrease)/Increase202020192020201920202019Traditional7,675 7,685 (0.1)%— — — %2,011 2,161 (6.9)%Decoupled and Special Contracts (1)(2)42,531 43,934 (3.2)%112,756 107,806 4.6 %23,122 21,370 8.2 %Total Sales Volumes50,206 51,619 (2.7)%112,756 107,806 4.6 %25,133 23,531 6.8 %(1) Special contracts are unique to Yankee Gas natural gas distribution customers who take service under such an arrangement and generally specify the amount of distribution revenue to be paid to Yankee Gas regardless of the customers' usage.(2) The 2020 firm natural gas sales volumes include the addition of EGMA beginning October 9, 2020. Weather, fluctuations in energy supply costs, conservation measures (including utility-sponsored energy efficiency programs), and economic conditions affect customer energy usage and water consumption. Industrial sales volumes are less sensitive to temperature variations than residential and commercial sales volumes. In our service territories, weather impacts both electric and water sales volumes during the summer and both electric and natural gas sales volumes during the winter; however, natural gas sales volumes are more sensitive to temperature variations than electric sales volumes. Customer heating or cooling usage may not directly correlate with historical levels or with the level of degree-days that occur.Fluctuations in retail electric sales volumes at PSNH impact earnings ("Traditional" in the table above). For CL&P, NSTAR Electric, NSTAR Gas, EGMA, Yankee Gas, and our Connecticut water distribution business, fluctuations in retail sales volumes do not materially impact earnings due to their respective regulatory commission-approved distribution revenue decoupling mechanisms ("Decoupled" in the table above). These distribution revenues are decoupled from their customer sales volumes, which breaks the relationship between sales volumes and revenues recognized.47Operating Revenues: Operating Revenues by segment increased in 2020, as compared to 2019, as follows:(Millions of Dollars)Increase/(Decrease)Electric Distribution$155.8 Natural Gas Distribution146.5 Electric Transmission147.1 Water Distribution0.8 Other207.4 Eliminations(279.7)Total Operating Revenues$377.9 Electric and Natural Gas Distribution Revenues:Base Distribution Revenues:•Base electric distribution revenues increased $97.5 million in 2020, as compared to 2019, due primarily to the impact of CL&P's base distribution rate increases effective May 1, 2020 and May 1, 2019, which include recovery of storm costs and certain other items that do not impact earnings, the NSTAR Electric base distribution rate increase effective January 1, 2020, and the impact of the PSNH temporary base distribution rate increase effective July 1, 2019, which includes recovery of storm costs and certain other items that do not impact earnings.•The increase in total electric distribution revenues was partially offset by the impact of the December 2020 PSNH settlement agreement driven by the negative impact from the over-refunding of the change in the 2018 federal corporate income tax rate as a result of the Tax Cuts and Jobs Act of 2017 that was reflected in temporary rates. •Base natural gas distribution revenues increased $34.3 million in 2020, as compared to 2019, due primarily to base distribution rate increases at Yankee Gas effective January 1, 2020 and at NSTAR Gas effective November 1, 2020.Tracked Distribution Revenues: Tracked distribution revenues consist of certain costs that are recovered from customers in retail rates through regulatory commission-approved cost tracking mechanisms and therefore, recovery of these costs has no impact on earnings. However, tracked revenues do include certain incentives earned, return on rate base and on capital tracking mechanisms, and carrying charges that are billed in rates to customers, which do impact earnings. Costs recovered through cost tracking mechanisms include, among others, energy supply and natural gas supply procurement and other energy-related costs, electric retail transmission charges, energy efficiency program costs, electric restructuring and stranded cost recovery revenues (including securitized RRB charges), and additionally for the Massachusetts utilities, pension and PBOP benefits and net metering for distributed generation. Tracked revenues also include wholesale market sales transactions, such as sales of energy and energy-related products into the ISO-NE wholesale electricity market and the sale of RECs to various counterparties.Tracked distribution revenues increased/(decreased) in 2020, as compared to 2019, due primarily to the following:(Millions of Dollars)Electric DistributionNatural Gas DistributionRetail Tariff Tracked Revenues:Energy supply procurement$(211.8)$(49.3)CL&P FMCC120.5 N/AOther distribution tracking mechanisms36.3 30.9 Wholesale Market Sales Revenue111.6 (19.5)The decrease in energy supply procurement within electric distribution was driven primarily by lower average prices, partially offset by higher average supply-related sales volumes in 2020, as compared to 2019. The increase in the CL&P FMCC regulatory tracking mechanism revenues and the increase in wholesale market sales revenue within electric distribution was due primarily to the new Millstone PPA entered into by CL&P in 2019, as required by regulation. Beginning in the fourth quarter of 2019, CL&P sells the energy purchased from Millstone Nuclear Power Station (Millstone) into the wholesale market and uses the proceeds from the energy sales to offset a portion of the contract costs. The net costs under the contract are recovered from customers in the FMCC rate.The addition of EGMA increased total operating revenues at the natural gas distribution segment by $154.8 million.Electric Transmission Revenues: Electric transmission revenues increased $147.1 million in 2020, as compared to 2019, due primarily to a higher transmission rate base as a result of our continued investment in our transmission infrastructure and a higher benefit from the annual billing and cost reconciliation filing with FERC.Other Revenues and Eliminations: Other revenues primarily include the revenues of Eversource's service company, most of which are eliminated in consolidation. Eliminations are also primarily related to the Eversource electric transmission revenues that are derived from ISO-NE regional transmission charges to the distribution businesses of CL&P, NSTAR Electric and PSNH that recover the costs of the wholesale transmission business.48Purchased Power, Fuel and Transmission expense includes costs associated with purchasing electricity and natural gas on behalf of our customers. These electric and natural gas supply costs are recovered from customers in rates through commission-approved cost tracking mechanisms, which have no impact on earnings (tracked costs). Purchased Power, Fuel and Transmission expense decreased in 2020, as compared to 2019, due primarily to the following:(Millions of Dollars)Increase/(Decrease)Purchased Power Costs$48.1 Natural Gas Costs(7.9)Transmission Costs(6.3)Eliminations(86.3)Total Purchased Power, Fuel and Transmission$(52.4)The increase in purchased power expense at the electric distribution business in 2020 as compared to 2019, was driven primarily by the impact of energy purchases from the new Millstone PPA and higher average supply-related sales volumes, partially offset by lower average prices. The decrease in natural gas supply costs at our natural gas distribution business was due primarily to lower average prices and lower average sales volumes, partially offset by the addition of EGMA natural gas supply costs as a result of the CMA asset acquisition of $58.8 million.The decrease in transmission costs in 2020, as compared to 2019, was primarily the result of a decrease in the retail transmission cost deferral, which reflects the actual costs of transmission service compared to estimated amounts billed to customers. This was partially offset by an increase in Local Network Service charges, which reflect the cost of transmission service provided by Eversource over our local transmission network, and an increase in costs billed by ISO-NE that support regional grid investments.Operations and Maintenance expense includes tracked costs and costs that are part of base electric, natural gas and water distribution rates with changes impacting earnings (non-tracked costs). Operations and Maintenance expense increased in 2020, as compared to 2019, due primarily to the following:(Millions of Dollars)Increase/(Decrease)Base Electric Distribution (Non-Tracked Costs):Storm restoration costs$29.8 Shared corporate costs (including computer software depreciation at Eversource Service)22.6 COVID-19 Costs9.5 Employee-related expenses, including labor and benefits(12.9)Operations-related expenses, including vegetation management, vehicles, and outside services(5.7)Other non-tracked operations and maintenance(8.3)Total Base Electric Distribution (Non-Tracked Costs)35.0 Tracked Costs (Electric Distribution and Electric Transmission) - Increase due to higher transmission expenses of $26.3 million and increase of $24.0 million due to higher pension tracking mechanism deferral55.8 Total Electric Distribution and Electric Transmission90.8 Natural Gas Distribution:Base (Non-Tracked) Costs, excluding EGMA - Increase due primarily to higher shared corporate costs of $10.1 million and $6.3 million for COVID-19 costs, partially offset by lower employee-related expenses of $7.5 million13.3 Tracked Costs, excluding EGMA4.2 EGMA Operations and Maintenance - due to CMA asset acquisition40.1 Total Natural Gas Distribution 57.6 Water Distribution:Gain on sale of Hingham water system(16.0)Other0.9 Total Water Distribution(15.1)Parent and Other Companies and Eliminations:Eversource Parent and Other Companies - other operations and maintenance83.9 Acquisition costs related to CMA42.1 Eliminations(142.1)Total Operations and Maintenance$117.2 Depreciation expense increased in 2020, as compared to 2019, due to higher utility plant in service balances, and due to the addition of EGMA utility plant balances as a result of the CMA asset acquisition of $10.9 million. Amortization expense includes the deferrals of energy supply, energy-related costs and other costs that are included in certain regulatory commission-approved cost tracking mechanisms, and the amortization of certain costs as those costs are collected in rates. These deferrals adjust expense to match the corresponding revenues. Energy supply and energy-related costs are recovered from customers in rates and have no impact on earnings. Amortization decreased in 2020, as compared to 2019, due to the deferrals for the under recovery of energy purchases related to the Millstone PPA at CL&P and due to the deferral of other energy supply and energy-related costs.49Energy Efficiency Programs expense increased in 2020, as compared to 2019, due primarily to the deferral adjustment at CL&P, PSNH and NSTAR Gas, which reflects the actual costs of energy efficiency programs compared to the amounts billed to customers and the timing of the recovery of energy efficiency costs. The increase was also due to the addition of EGMA energy efficiency program costs as a result of the CMA asset acquisition of $14.4 million. The increase was partially offset by a decrease in spending on certain large energy efficiency projects in 2020, compared to 2019 at NSTAR Electric, due to timing. The costs for the majority of the state energy policy initiatives and expanded energy efficiency programs are recovered from customers in rates and have no impact on earnings.Taxes Other Than Income Taxes expense increased in 2020, as compared to 2019, due primarily to an increase in property taxes as a result of higher utility plant balances and higher Connecticut gross earnings taxes at CL&P, and due to the addition of EGMA property taxes as a result of the CMA asset acquisition of $9.7 million. The increase was partially offset by a decrease of $21.4 million related to CL&P's remittance of energy efficiency funds to the State of Connecticut. Energy efficiency funds collected from customers after July 1, 2019 are no longer subject to remittance to the State of Connecticut. The increase was also partially offset by a decrease in property tax at NSTAR Gas relating to the resolution of disputed property taxes for prior years.Impairment of Northern Pass Transmission reflects an impairment charge of $239.6 million that was recorded in the second quarter of 2019 as a result of the July 19, 2019 New Hampshire Supreme Court decision. The after-tax impact of this impairment charge was $204.4 million.Interest Expense increased in 2020, as compared to 2019, due primarily to an increase in interest on long-term debt as a result of new debt issuances ($27.3 million) and higher amortization of debt discounts and premiums, net ($4.6 million), partially offset by a decrease in interest on notes payable ($16.9 million), a decrease in interest expense at NSTAR Gas relating to the resolution of disputed property taxes for prior years ($5.7 million), and an increase in capitalized AFUDC related to debt funds and other capitalized interest ($3.6 million).Other Income, Net decreased in 2020, as compared to 2019, due primarily to a decrease in equity in earnings related to Eversource's equity method investments ($28.0 million), the absence in 2020 of the recognition of the equity component of the carrying charges related to PSNH storm costs recorded in interest income in the first quarter of 2019 ($5.2 million) and lower AFUDC related to equity funds ($3.0 million), partially offset by an increase related to pension, SERP and PBOP non-service income components ($13.1 million).Income Tax Expense increased in 2020, as compared to 2019, due primarily to higher pre-tax earnings ($23.5 million), higher state taxes ($12.6 million), by the absence in 2020 of the impairment of NPT ($35.2 million), by a decrease in tax planning benefits ($9.5 million), the sale of Hingham water system ($12.5 million), return to provision adjustments ($3.3 million), and an increase in items that impact our tax rate as a result of regulatory treatment (flow-through items) and permanent differences ($4.1 million), partially offset by an increase in share-based payment excess tax benefits ($5.1 million), an increase in amortization of EDIT ($11.3 million), and a decrease in valuation allowance ($11.6 million).50RESULTS OF OPERATIONS – THE CONNECTICUT LIGHT AND POWER COMPANYNSTAR ELECTRIC COMPANY AND SUBSIDIARYPUBLIC SERVICE COMPANY OF NEW HAMPSHIRE AND SUBSIDIARIESThe following provides the amounts and variances in operating revenues and expense line items in the statements of income for CL&P, NSTAR Electric and PSNH for the years ended December 31, 2020 and 2019 included in this Annual Report on Form 10-K: For the Years Ended December 31,CL&PNSTAR ElectricPSNH(Millions of Dollars)20202019Increase20202019Increase/(Decrease)20202019Increase/(Decrease)Operating Revenues$3,547.5 $3,232.6 $314.9 $2,941.1 $3,044.6 $(103.5)$1,079.1 $1,065.9 $13.2 Operating Expenses: Purchased Power and Transmission1,369.2 1,188.2 181.0 879.2 1,064.3 (185.1)364.1 398.4 (34.3)Operations and Maintenance572.9 549.2 23.7 534.1 468.4 65.7 219.3 211.0 8.3 Depreciation320.7 301.2 19.5 319.5 296.5 23.0 100.4 93.7 6.7 Amortization of Regulatory Assets, Net58.4 51.6 6.8 83.2 103.7 (20.5)52.8 57.7 (4.9)Energy Efficiency Programs141.5 118.2 23.3 264.0 289.2 (25.2)37.6 26.0 11.6 Taxes Other Than Income Taxes344.4 342.5 1.9 206.8 195.6 11.2 81.6 62.6 19.0 Total Operating Expenses2,807.1 2,550.9 256.2 2,286.8 2,417.7 (130.9)855.8 849.4 6.4 Operating Income740.4 681.7 58.7 654.3 626.9 27.4 223.3 216.5 6.8 Interest Expense153.6 151.4 2.2 130.5 114.2 16.3 58.1 60.7 (2.6)Other Income, Net20.8 17.6 3.2 52.0 44.6 7.4 13.8 19.2 (5.4)Income Before Income Tax Expense607.6 547.9 59.7 575.8 557.3 18.5 179.0 175.0 4.0 Income Tax Expense149.7 137.0 12.7 130.8 125.3 5.5 31.7 41.0 (9.3)Net Income$457.9 $410.9 $47.0 $445.0 $432.0 $13.0 $147.3 $134.0 $13.3 Operating RevenuesSales Volumes: A summary of our retail electric GWh sales volumes is as follows: For the Years Ended December 31, 20202019DecreasePercentCL&P 20,113 20,719 (606)(2.9)%NSTAR Electric22,418 23,215 (797)(3.4)%PSNH7,675 7,685 (10)(0.1)%Fluctuations in retail electric sales volumes at PSNH impact earnings. For CL&P and NSTAR Electric, fluctuations in retail electric sales volumes do not impact earnings due to their respective regulatory commission-approved distribution revenue decoupling mechanisms.Operating Revenues: Operating Revenues, which consist of base distribution revenues and tracked revenues further described below, increased $314.9 million at CL&P and $13.2 million at PSNH, and decreased $103.5 million at NSTAR Electric in 2020, as compared to 2019.Base Distribution Revenues:•CL&P's distribution revenues increased $40.0 million due primarily to the impact of its base distribution rate increases effective May 1, 2020 and May 1, 2019, which include recovery of storm costs and certain other items that do not impact earnings.•NSTAR Electric's distribution revenues increased $32.6 million due primarily to the impact of its base distribution rate increase effective January 1, 2020.•PSNH's distribution revenues increased $24.9 million due primarily to the impact of its temporary base distribution rate increase effective July 1, 2019, which includes recovery of storm costs and certain other items that do not impact earnings.•The increase in PSNH’s total distribution revenues was partially offset by the impact of the December 2020 settlement agreement driven by the negative impact from the over-refunding of the change in the 2018 federal corporate income tax rate as a result of the Tax Cuts and Jobs Act of 2017 that was reflected in temporary rates. Tracked Revenues: Tracked distribution revenues consist of certain costs that are recovered from customers in retail rates through regulatory commission-approved cost tracking mechanisms and therefore, recovery of these costs has no impact on earnings. However, tracked revenues do include certain incentives earned, return on rate base and on capital tracking mechanisms, and carrying charges that are billed in rates to customers, which do impact earnings. Costs recovered through cost tracking mechanisms include, among others, energy supply procurement and other energy-related costs, retail transmission charges, energy efficiency program costs, electric restructuring and stranded cost recovery revenues (including securitized RRB charges), and additionally for NSTAR Electric, pension and PBOP benefits and net metering for distributed generation. Tracked revenues also include wholesale market sales transactions, such as sales of energy and energy-related products into the ISO-NE wholesale electricity market and the sale of RECs to various counterparties.51Tracked revenues increased/(decreased) in 2020, as compared to 2019, due primarily to the following:(Millions of Dollars)CL&PNSTAR ElectricPSNHRetail Tariff Tracked Revenues:Energy supply procurement$(58.7)$(116.7)$(36.4)CL&P FMCC120.5 — — Other distribution tracking mechanisms38.2 (17.6)15.7 Wholesale Market Sales Revenue125.0 (14.7)1.3 The decrease in energy supply procurement at CL&P and PSNH reflects lower average prices, partially offset by higher average supply-related sales volumes in 2020, as compared to 2019. The decrease in energy supply procurement at NSTAR Electric reflects both lower average prices and lower average supply-related sales volumes for 2020, as compared to 2019.The increase in the CL&P FMCC regulatory tracking mechanism revenues and the increase in wholesale market sales revenue was due primarily to the new Millstone PPA entered into by CL&P in 2019, as required by regulation. Beginning in the fourth quarter of 2019, CL&P sells the energy purchased from Millstone into the wholesale market and uses the proceeds from the energy sales to offset a portion of the contract costs. The net costs under the contract are recovered from customers in the FMCC rate.Transmission Revenues: Transmission revenues increased $61.7 million at CL&P, $54.2 million at NSTAR Electric and $31.2 million at PSNH in 2020, as compared to 2019, due primarily to a higher transmission rate base as a result of our continued investment in our transmission infrastructure and a higher benefit from the annual billing and cost reconciliation filing with FERC.Eliminations: Eliminations are primarily related to the Eversource electric transmission revenues that are derived from ISO-NE regional transmission charges to the distribution businesses of CL&P, NSTAR Electric and PSNH that recover the costs of the wholesale transmission business. The impact of eliminations decreased revenues by $13.1 million at CL&P, $44.0 million at NSTAR Electric and $20.7 million at PSNH in 2020, as compared to 2019.Purchased Power and Transmission expense includes costs associated with purchasing electricity on behalf of CL&P, NSTAR Electric and PSNH's customers. These energy supply costs are recovered from customers in rates through commission-approved cost tracking mechanisms, which have no impact on earnings (tracked costs). Purchased Power and Transmission expense increased/(decreased) in 2020, as compared to 2019, due primarily to the following:(Millions of Dollars)CL&PNSTAR ElectricPSNHPurchased Power Costs$233.0 $(141.9)$(43.0)Transmission Costs(36.6)0.8 29.5 Eliminations(15.4)(44.0)(20.8)Total Purchased Power and Transmission$181.0 $(185.1)$(34.3)Purchased Power Costs: Included in purchased power costs are the costs associated with providing electric generation service supply to all customers who have not migrated to third party suppliers and the cost of energy purchase contracts, as required by regulation.•The increase at CL&P was due primarily to the new Millstone PPA energy purchases and higher average supply-related sales volumes, partially offset by lower average prices. •The decrease at NSTAR Electric was due primarily to lower expense related to the procurement of energy supply resulting from lower average prices and lower average supply-related sales volumes. •The decrease at PSNH was due primarily to lower expense related to the procurement of energy supply resulting from lower average prices, partially offset by higher average supply-related sales volumes.Transmission Costs: Included in transmission costs are charges that recover the cost of transporting electricity over high-voltage lines from generation facilities to substations, including costs allocated by ISO-NE to maintain the wholesale electric market. •The decrease in transmission costs at CL&P was due primarily to a reduction to the retail transmission cost deferral, which reflects the actual costs of transmission service compared to estimated amounts billed to customers. This was partially offset by an increase in Local Network Service charges, which reflects the cost of transmission service provided by Eversource over our local transmission network, and an increase in costs billed by ISO-NE that support regional grid investments.•The increase in transmission costs at PSNH was primarily the result of an increase in Local Network Service charges, an increase in costs billed by ISO-NE that support regional grid investments, and an increase in the retail transmission cost deferral.52Operations and Maintenance expense includes tracked costs and costs that are part of base distribution rates with changes impacting earnings (non-tracked costs). Operations and Maintenance expense increased in 2020, as compared to 2019, due primarily to the following:(Millions of Dollars)CL&PNSTAR ElectricPSNHBase Electric Distribution (Non-Tracked Costs): Storm restoration costs$11.4 $9.0 $9.4 Shared corporate costs (including computer software depreciation at Eversource Service)8.3 11.6 2.7 COVID-19 Costs3.9 3.8 1.8 Employee-related expenses, including labor and benefits(5.1)(6.0)(1.8)Operations-related expenses, including vegetation management, vehicles, and outside services(5.2)0.2 (0.7)Other non-tracked operations and maintenance(11.9)6.7 1.9 Total Base Electric Distribution (Non-Tracked Costs)1.4 25.3 13.3 Tracked Costs:Transmission expenses10.3 15.6 0.4 Other tracked operations and maintenance12.0 24.8 (5.4)Total Tracked Costs22.3 40.4 (5.0)Total Operations and Maintenance$23.7 $65.7 $8.3 Depreciation expense increased in 2020, as compared to 2019, for CL&P, NSTAR Electric and PSNH due to higher net plant in service balances. Amortization of Regulatory Assets, Net expense includes the deferrals of energy supply, energy-related costs and other costs that are included in certain regulatory-approved cost tracking mechanisms, and the amortization of certain costs as those costs are collected in rates. These deferrals adjust expense to match the corresponding revenues. Energy supply and energy-related costs are recovered from customers in rates and have no impact on earnings. Amortization of Regulatory Assets, Net increased at CL&P and decreased at NSTAR Electric and PSNH in 2020, as compared to 2019, due primarily to the deferrals of energy supply and energy-related costs, which can fluctuate from period to period based on the timing of costs incurred and related rate changes to recover these costs. Energy Efficiency Programs expense includes costs of various state energy policy initiatives and expanded energy efficiency programs that are recovered from customers in rates, most of which have no impact on earnings. Energy Efficiency Programs expense increased/decreased in 2020, as compared to 2019, due primarily to the following:•The increase at CL&P and PSNH was due to the deferral adjustment, which reflects actual costs of energy efficiency programs compared to the estimated amounts billed to customers, and the timing of the recovery of energy efficiency costs. •The decrease at NSTAR Electric was due to the timing of spending on certain large energy efficiency projects in 2020, as compared to 2019.Taxes Other Than Income Taxes increased in 2020, as compared to 2019, due primarily to the following:•The increase at CL&P was related to higher property taxes as a result of a higher utility plant balance, higher gross earnings taxes, and the absence in 2020 of a use tax refund received in 2019, partially offset by a decrease of $21.4 million relating to the remittance of energy efficiency funds to the State of Connecticut. Energy efficiency funds collected from customers after July 1, 2019 are no longer subject to remittance to the State of Connecticut. •The increases at NSTAR Electric and PSNH were due to higher property taxes as a result of higher utility plant balances offset against some favorable property tax resolutions with a number of communities.Interest Expense increased/decreased in 2020, as compared to 2019, due primarily to the following:•The increase at CL&P was due to higher interest on long-term debt ($6.6 million), partially offset by a decrease in interest expense on regulatory deferrals ($2.0 million), a decrease in interest on short-term notes payable ($1.2 million), and lower amortization of debt discounts and premiums, net ($0.9 million).•The increase at NSTAR Electric was due to higher interest on long-term debt ($12.9 million), an increase in interest expense on regulatory deferrals ($7.4 million), and a decrease in capitalized AFUDC related to debt funds ($1.4 million), partially offset by a decrease in interest on short-term notes payable ($3.6 million).•The decrease at PSNH was due to a decrease in interest expense on regulatory deferrals ($2.3 million) and a decrease in RRB interest expense ($1.4 million), partially offset by higher amortization of debt discounts and premiums, net ($0.8 million) and a decrease in capitalized AFUDC related to debt funds ($0.6 million).53Other Income, Net increased/decreased in 2020, as compared to 2019, due primarily to the following:•The increase at CL&P was due to an increase related to pension, SERP and PBOP non-service income components ($3.3 million), an increase in AFUDC related to equity funds ($0.6 million), and higher interest income ($0.5 million), partially offset by a decrease in investment income ($1.2 million). •The increase at NSTAR Electric was due primarily to an increase related to pension, SERP and PBOP non-service income components ($5.8 million) and an increase in AFUDC related to equity funds ($1.7 million).•The decrease at PSNH was due primarily to lower interest income ($8.1 million), which includes the absence in 2020 of the recognition of the equity component of the carrying charges related to storm costs recorded in interest income in 2019 ($5.2 million), partially offset by an increase related to pension, SERP and PBOP non-service income components ($2.1 million) and an increase in AFUDC related to equity funds ($0.8 million).Income Tax Expense increased/decreased in 2020, as compared to 2019, due primarily to the following:•The increase at CL&P was due primarily to higher pre-tax earnings ($12.6 million), higher state taxes ($2.8 million), and return to provision adjustments ($1.2 million), partially offset by items that impact our tax rate as a result of regulatory treatment (flow-through items) and permanent differences ($0.5 million), an increase in share-based payment excess tax benefits ($1.8 million), and a decrease in a valuation allowance ($1.6 million).•The increase at NSTAR Electric was due primarily to higher pre-tax earnings ($3.9 million), higher state taxes ($0.7 million), a decrease in amortization of EDIT ($2.5 million), and return to provision adjustments ($0.5 million), partially offset by items that impact our tax rate as a result of regulatory treatment (flow-through items) and permanent differences ($0.3 million), and an increase in share-based payment excess tax benefits ($1.8 million).•The decrease at PSNH was due primarily to lower state taxes ($2.0 million), an increase in amortization of EDIT ($11.4 million), and an increase in share-based payment excess tax benefits ($0.6 million), partially offset by higher pre-tax earnings ($0.6 million), return to provision adjustments ($1.7 million), and items that impact our tax rate as a result of regulatory treatment (flow-through items) and permanent differences ($2.4 million).EARNINGS SUMMARYCL&P's earnings increased $47.0 million in 2020, as compared to 2019, due primarily to the base distribution rate increases effective May 1, 2020 and May 1, 2019, an increase in transmission earnings driven by a higher transmission rate base, and higher earnings from its capital tracker mechanism due to increased electric system improvements. The earnings increase was partially offset by higher depreciation expense, higher property tax expense, and higher interest expense.NSTAR Electric's earnings increased $13.0 million in 2020, as compared to 2019, due primarily to the base distribution rate increase effective January 1, 2020, an increase in transmission earnings driven by a higher transmission rate base, and higher energy efficiency incentives earned. The earnings increase was partially offset by higher operations and maintenance expense, higher interest expense, higher depreciation expense, and higher property tax expense.PSNH's earnings increased $13.3 million in 2020, as compared to 2019, due primarily to the temporary base distribution rate increase effective July 1, 2019, an increase in transmission earnings driven by a higher transmission rate base, and the impact of the PSNH rate settlement agreement approved in December 2020 that was due primarily to the reconciliation of permanent rates back to the temporary rate period. The settlement agreement primarily resulted in a benefit to income tax expense for the reduction of the EDIT regulatory liability, partially offset by a reduction in revenues driven by the negative impact from the over-refunding of the change in the 2018 federal corporate income tax rate as a result of the Tax Cuts and Jobs Act of 2017 that was reflected in temporary rates. The earnings increase was partially offset by higher operations and maintenance expense, higher property tax expense, and the absence of the 2019 recognition of carrying charges on its 2013 through 2016 storm costs approved for recovery.LIQUIDITYCash Flows: CL&P had cash flows provided by operating activities of $397.1 million in 2020, as compared to $726.4 million in 2019. The decrease in operating cash flows was due primarily to cash payments made in 2020 for storm restoration costs of approximately $180 million related to Tropical Storm Isaias and the timing of cash payments made on our accounts payable. In addition, the timing of collections for regulatory tracking mechanisms, which includes the impact of the CL&P temporary rate suspension, the timing of cash collections on our accounts receivable, and the timing of other working capital items contributed to the decrease in operating cash flows. Partially offsetting these unfavorable impacts was lower income tax payments made of $69.7 million in 2020, as compared to 2019. NSTAR Electric had cash flows provided by operating activities of $525.8 million in 2020, as compared to $698.3 million in 2019. The decrease in operating cash flows was due primarily to the timing of collections for regulatory tracking mechanisms primarily related to transmission costs, the timing of cash collections on our accounts receivable, a $32.8 million increase in income tax payments made in 2020, as compared to 2019, and the timing of other working capital items. Partially offsetting these unfavorable impacts were the timing of cash payments on our accounts payable and a $5.7 million decrease in Pension and PBOP contributions made in 2020, as compared to 2019. 54PSNH had cash flows provided by operating activities of $218.7 million in 2020, as compared to $274.4 million in 2019. The decrease in operating cash flows was due primarily to the timing of cash collections on our accounts receivable and an increase in income tax payments made of $30.8 million in 2020, as compared to 2019. Also contributing to the decrease were the timing of collections for regulatory tracking mechanisms and an increase of $4.1 million in Pension contributions made in 2020, as compared to 2019. Partially offsetting these unfavorable impacts was the timing of cash payments on our accounts payable. Receivables, net of reserves, on the balance sheets have increased $58.3 million at CL&P, $56.3 million at NSTAR Electric, and $20.0 million at PSNH in 2020, as compared to 2019, due primarily to an increase in delinquent receivables from customers attributable to the moratorium on disconnections and the economic slowdown resulting from the COVID-19 pandemic. For further information on CL&P's, NSTAR Electric's and PSNH's liquidity and capital resources, see "Liquidity" and "Business Development and Capital Expenditures" included in this Management's Discussion and Analysis of Financial Condition and Results of Operations.Item 7A. Quantitative and Qualitative Disclosures about Market RiskMarket Risk InformationCommodity Price Risk Management: Our regulated companies enter into energy contracts to serve our customers, and the economic impacts of those contracts are passed on to our customers. Accordingly, the regulated companies have no exposure to loss of future earnings or fair values due to these market risk-sensitive instruments. Eversource's Energy Supply Risk Committee, comprised of senior officers, reviews and approves all large-scale energy related transactions entered into by its regulated companies.Other Risk Management ActivitiesWe have an Enterprise Risk Management (ERM) program for identifying the principal risks of the Company. Our ERM program involves the application of a well-defined, enterprise-wide methodology designed to allow our Risk Committee, comprised of our senior officers of the Company, to identify, categorize, prioritize, and mitigate the principal risks to the Company. The ERM program is integrated with other assurance functions throughout the Company including Compliance, Auditing, and Insurance to ensure appropriate coverage of risks that could impact the Company. In addition to known risks, ERM identifies emerging risks to the Company, through participation in industry groups, discussions with management and in consultation with outside advisers. Our management then analyzes risks to determine materiality, likelihood and impact, and develops mitigation strategies. Management broadly considers our business model, the utility industry, the global economy, climate change, sustainability and the current environment to identify risks. The Finance Committee of the Board of Trustees is responsible for oversight of the Company's ERM program and enterprise-wide risks as well as specific risks associated with insurance, credit, financing, investments, pensions and overall system security including cyber security. The findings of the ERM process are periodically discussed with the Finance Committee of our Board of Trustees, as well as with other Board Committees or the full Board of Trustees, as appropriate, including reporting on how these issues are being measured and managed. However, there can be no assurances that the ERM process will identify or manage every risk or event that could impact our financial position, results of operations or cash flows.Interest Rate Risk Management: We manage our interest rate risk exposure in accordance with our written policies and procedures by maintaining a mix of fixed and variable rate long-term debt. As of December 31, 2020, all of our long-term debt except for $11.7 million of fees and interest due for CYAPC's spent nuclear fuel disposal costs, was at a fixed interest rate. Credit Risk Management: Credit risk relates to the risk of loss that we would incur as a result of non-performance by counterparties pursuant to the terms of our contractual obligations. We serve a wide variety of customers and transact with suppliers that include IPPs, industrial companies, natural gas and electric utilities, oil and natural gas producers, financial institutions, and other energy marketers. Margin accounts exist within this diverse group, and we realize interest receipts and payments related to balances outstanding in these margin accounts. This wide customer and supplier mix generates a need for a variety of contractual structures, products and terms that, in turn, require us to manage the portfolio of market risk inherent in those transactions in a manner consistent with the parameters established by our risk management process.Our regulated companies are subject to credit risk from certain long-term or high-volume supply contracts with energy marketing companies. Our regulated companies manage the credit risk with these counterparties in accordance with established credit risk practices and monitor contracting risks, including credit risk. As of December 31, 2020, our regulated companies held collateral (letters of credit or cash) of $10.0 million from counterparties related to our standard service contracts. As of December 31, 2020, Eversource had $34.6 million of cash posted with ISO-NE related to energy transactions. For further information on cash collateral deposited and posted with counterparties, see Note 1O, "Summary of Significant Accounting Policies - Supplemental Cash Flow Information," to the financial statements.If the respective unsecured debt ratings of Eversource or its subsidiaries were reduced to below investment grade by either Moody's or S&P, certain of Eversource's contracts would require additional collateral in the form of cash to be provided to counterparties and independent system operators. Eversource would have been and remains able to provide that collateral. 55
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+ITEM 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations, (c) Part II,
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+Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations.Information required by this Item is presented in “Management's Discussion and Analysis of Financial Condition and Results of Operations” of this Form 10-K.Item 7A. Quantitative and Qualitative Disclosures about Market Risk. Information regarding market risk is presented in “Market Risk Disclosure” of this Form 10-K.
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+Item 7. Management's Discussion and Analysis of Financial Condition and Results of OperationsThe following discussion and analysis presents the factors that had a material effect on our results of operations during the two years ended December 31, 2020. Also discussed is our financial position as of December 31, 2020. You should read this discussion in conjunction with the historical consolidated financial statements and related notes included elsewhere in this Form 10-K. For a discussion related to the results of operations for 2019 compared to 2018 and a discussion related to our consolidated cash flows for 2019 compared to 2018, refer to Part II, Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations" in our 2019 Annual Report on Form 10–K filed with the Securities and Exchange Commission on February 14, 2020. OverviewWe are the global leader in patient-focused medical innovations for structural heart disease, as well as critical care and surgical monitoring. Driven by a passion to help patients, we partner with the world's leading clinicians and researchers and invest in research and development to transform care for those impacted by structural heart disease or who require 21Table of Contentshemodynamic monitoring during surgery or in intensive care. We conduct operations worldwide and are managed in the following geographical regions: United States, Europe, Japan, and Rest of World. Our products are categorized into the following main areas: Transcatheter Aortic Valve Replacement ("TAVR"), Transcatheter Mitral and Tricuspid Therapies ("TMTT"), Surgical Structural Heart ("Surgical"), and Critical Care. On May 7, 2020, our Board of Directors declared a three-for-one stock split of our outstanding shares of common stock effected in the form of a stock dividend, distributed on May 29, 2020 to stockholders of record on May 18, 2020. We distributed two newly issued shares of common stock to holders of record of each share of common stock to effect the stock split. All applicable share and per-share amounts in this “Management’s Discussion and Analysis of Financial Condition and Results of Operations” have been retroactively adjusted to give effect to this stock split.Financial Highlights and COVID-19In March 2020, the World Health Organization categorized the Coronavirus disease 2019 ("COVID-19") as a pandemic. COVID-19 continues to spread throughout the United States and other countries across the world, and the duration and severity of its effects are currently unknown. The global pandemic has adversely impacted and is likely to further adversely impact nearly all aspects of our business and markets, including our workforce and the operations of our customers, suppliers, and business partners. Our priority has been to support our clinician partners, protect the well-being of our employees, and maintain continuous access to our life-saving technologies while offering front-line in-hospital support. Our manufacturing operations have continued to respond to impacts related to COVID-19, and we have been able to supply our technologies around the world. Across the organization, we are proactively managing inventory, assessing alternative logistics options, and closely monitoring the supply of components. TAVR and Surgical procedure volumes varied greatly since the middle of March 2020 by geography, and even by hospital, as patients and their physicians analyzed the trade-off between aortic stenosis and their concern for COVID-19. In the last few weeks of the first quarter of 2020, procedure volumes related to our TAVR and Surgical products dropped significantly. Beginning in the second quarter of 2020, procedure volumes improved. In the second quarter of 2020, we also started to progressively resume patient enrollment in all clinical trials that were voluntarily paused or slowed at the end of the first quarter of 2020. While we saw improvements to pre-COVID levels when we resumed enrollment, procedure volumes and enrollment in our clinical trials have since been negatively impacted due to a resurgence of COVID-19 in late 2020. Even though health systems adapted to the challenge, the resurgence of COVID-19 late in 2020 continued to impact these patients who need care. In Critical Care, there was greater demand in Europe and the United States for our pressure monitoring products, but demand for other Critical Care products began to decrease at the end of the first quarter of 2020 due to COVID-19, and that trend continued through the fourth quarter of 2020. Despite the challenges associated with COVID-19, our net sales for 2020 were $4.4 billion, representing an increase of $38.3 million over 2019, driven by sales growth of our TAVR products. 22Table of ContentsOur gross profit increase in 2020 was driven by a charge of $73.1 million recorded in 2019, primarily comprised of the write off of inventory related to strategic decisions regarding our TAVR portfolio, including the decision to discontinue our CENTERA program. The decrease in our diluted earnings per share in 2020 was driven by an after-tax charge of $305.1 million to settle certain patent litigation related to transcatheter mitral and tricuspid repair products. Healthcare Environment, Opportunities, and ChallengesThe medical technology industry is highly competitive and continues to evolve. Our success is measured both by the development of innovative products and the value we bring to our stakeholders. We are committed to developing new technologies and providing innovative patient care, and we are committed to defending our intellectual property in support of those developments. While some evidence collection was slowed due to the COVID-19 pandemic, we and the clinical community are committed to continuing our trials and generating robust evidence. In 2020, we invested 17.3% of our net sales in research and development. The following is a summary of important developments during 2020:•in response to the urgent COVID-19 response around the globe, we temporarily paused new enrollments in our active pivotal clinical trials of transcatheter mitral and tricuspid therapies, which began resuming in the second quarter of 2020;•we received CE Mark for the Edwards PASCAL transcatheter valve repair system for the treatment of European patients with tricuspid regurgitation;•we received Chinese regulatory approval for the Edwards SAPIEN 3 transcatheter heart valve for the treatment of severe, symptomatic aortic stenosis patients at high risk for or unable to undergo open-heart surgery;•we reached an agreement with Abbott to settle all outstanding patent disputes between the companies in cases related to transcatheter mitral and tricuspid repair products;•we received FDA approval for the KONECT RESILIA aortic valved conduit, the first ready-to-implant solution for bio-Bentall procedures, a complex surgery that involves replacement of a patient's aortic valve, aortic root, and the ascending aorta.•we treated our first patient in the RESTORE clinical trial, which will evaluate the safety and effectiveness of the investigational HARPOON Beating Heart Mitral Valve Repair System in the United States and Canada.We are dedicated to generating robust clinical, economic, and quality of life evidence increasingly expected by patients, clinicians, and payors in the current healthcare environment, with the goal of encouraging the adoption of innovative new medical therapies that demonstrate superior outcomes.Results of OperationsNet Sales by Major Regions(dollars in millions) Years Ended December 31,Change 20202019$%United States$2,516.8 $2,532.7 $(15.9)(0.6)%Europe973.6 941.2 32.4 3.4 %Japan460.1 444.7 15.4 3.5 %Rest of World435.8 429.4 6.4 1.5 %International1,869.5 1,815.3 54.2 3.0 %Total net sales$4,386.3 $4,348.0 $38.3 0.9 %International net sales include the impact of foreign currency exchange rate fluctuations. The impact of foreign currency exchange rate fluctuations on net sales is not necessarily indicative of the impact on net income due to the corresponding effect of foreign currency exchange rate fluctuations on international manufacturing and operating costs, and our hedging activities. For more information, see "Quantitative and Qualitative Disclosures About Market Risk."23Table of ContentsNet Sales by Product Group(dollars in millions) Years Ended December 31,Change 2020 2019$%Transcatheter Aortic Valve Replacement$2,857.3 $2,737.9 $119.4 4.4 %Transcatheter Mitral and Tricuspid Therapies41.8 28.2 13.6 48.5 %Surgical Heart Valve Therapy761.8 841.7 (79.9)(9.5)%Critical Care725.4 740.2 (14.8)(2.0)%Total net sales$4,386.3 $4,348.0 $38.3 0.9 %Transcatheter Aortic Valve ReplacementThe increase in net sales of TAVR products was due primarily to higher sales of the Edwards SAPIEN 3 Ultra System following its regulatory approval in the United States (December 2018) and in Europe (November 2018). The adoption of the Edwards SAPIEN 3 Ultra System continued to be very positive in 2020. However, our sales in 2020 were negatively impacted by the COVID-19 pandemic, and these challenges have continued in early 2021. Our procedure volumes dropped significantly beginning in March 2020 due to COVID-19, and began to steadily improve beginning in May 2020. In the first quarter of 2020, to ensure the safety of our employees and clinician partners from the threat of COVID-19, we decided to pause proctoring at centers that were not already trained on the Edwards SAPIEN 3 Ultra System. In the second quarter of 2020, we resumed proctoring. 24Table of ContentsTranscatheter Mitral and Tricuspid TherapiesThe increase in net sales of TMTT products was due primarily to sales in Europe of the Edwards PASCAL transcatheter valve repair system, which received CE Mark in February 2019. Our sales in 2020 were negatively impacted by the COVID-19 pandemic. Our procedure volumes for PASCAL dropped significantly in March 2020 due to COVID-19, and began to improve beginning in May 2020.At the end of March 2020, we temporarily paused new enrollments in our active pivotal clinical trials of transcathetermitral and tricuspid therapies in response to the COVID-19 response around the globe. In the second quarter of 2020, we beganresuming enrollments. However, due to a resurgence of COVID-19 in late 2020, we are experiencing a negative impact to clinical trial enrollment. In May 2020, we received CE Mark for the PASCAL Ace implant system for mitral and tricuspid repair.Surgical Structural HeartThe decrease in net sales of Surgical products was due primarily to decreased sales of aortic tissue valves, primarily in the United States and Europe, due to the impact of COVID-19. The ongoing adoption of TAVR also contributed to the decrease in United States surgical aortic valve sales. These decreases were partially offset by increased sales of the INSPIRIS RESILIA 25Table of Contentsaortic valve and the KONECT aortic valved conduit, primarily in the United States. Increased and improved management of intensive care unit capacity, as well as prioritization of heart surgery in many hospitals, contributed to rebounding procedure volumes late in the second quarter of 2020. In the fourth quarter of 2020, hospitals experienced an influx of COVID-19 patients, limiting surgical valve procedures. In Europe, our HARPOON Beating Heart Mitral Valve Repair System became available commercially at the end of 2019, and the first commercial case was successfully completed in Europe in the second quarter of 2020. In addition, we received FDA approval in April 2020 to begin our U.S. pivotal investigational device exemption study. HARPOON offers the potential for earlier treatment of degenerative mitral valve disease, with faster recovery and more consistent outcomes for surgical patients. Critical CareThe decrease in net sales of Critical Care products was driven by a decline in sales of our enhanced surgical recovery products, primarily in the United States, as many surgical procedures were delayed due to COVID-19 beginning in March 2020. We also experienced a decline in orders of our HemoSphere advanced monitoring platform in the United States as hospitals limited their capital spending due to COVID-19. These decreases in net sales were partially offset by increased demand for our pressure monitoring products, primarily in Europe and the United States, as COVID-19 hospitalizations increased. In addition, our sales in 2020 and 2019 included $22.6 million and $16.8 million, respectively, related to CAS Medical Systems, Inc. ("CASMED"), which we acquired on April 18, 2019. CASMED is a medical technology company dedicated to non-invasive monitoring of tissue oxygenation in the brain. 26Table of ContentsGross ProfitOur gross profit was higher as a percentage of net sales in 2020 compared to 2019. In 2019, our gross profit was reduced by $73.1 million due to the decision to discontinue our CENTERA program, resulting in a 1.7 percentage point increase in 2020 compared to 2019. This increase was partially offset by a) a 1.0 percentage point decrease in 2020 due to the impact of foreign currency exchange rate fluctuations, net of hedging, and b) incremental costs associated with COVID-19.Selling, General, and Administrative ("SG&A") ExpensesThe decrease in SG&A expenses in 2020 compared to 2019 was due primarily to a) decreased sales, marketing and travel-related expense associated with COVID-19 and b) lower performance-based compensation, partially offset by increased sales and marketing expenses related to transcatheter structural heart field personnel, primarily in the United States.27Table of ContentsResearch and Development ("R&D") ExpensesThe increase in R&D expenses in 2020 compared to 2019 was due primarily to a) investments in our transcatheter mitral and tricuspid therapies and our aortic valve replacement programs and b) costs associated with discontinuing our SUTRAFIX program. These increases were partially offset by a) decreased spending on transcatheter aortic valve clinical trials and b) decreased performance-based compensation. Intellectual Property Litigation Expenses, netWe incurred intellectual property litigation expenses, including settlements and external legal costs, of $405.4 million and $33.4 million during 2020 and 2019, respectively. On July 12, 2020, we reached an agreement with Abbott Laboratories and its direct and indirect subsidiaries ("Abbott") to, among other things, settle all outstanding patent disputes between the companies (the “Settlement Agreement”) in cases related to transcatheter mitral and tricuspid repair products. See Note 18 to the "Consolidated Financial Statements" for additional information. The Settlement Agreement resulted in us recording an estimated $367.9 million pre-tax charge and related liability in June 2020 related to past damages. In addition, we will incur royalty expenses through May 2024 totaling an estimated $100 million. We made a one-time $100.0 million payment to Abbott in July 2020, and will make quarterly payments in future years. Change in Fair Value of Contingent Consideration Liabilities, netThe change in fair value of contingent consideration liabilities resulted in expense of $13.6 million in 2020 and income of $6.1 million in 2019. The expense in 2020 was primarily driven by the accretion of interest due to the passage of time and adjustments to discount rates, partially offset by changes in the projected probability and timing of milestone achievements, and the projected timing of cash inflows. The income in 2019 was due primarily to longer product development timelines, which reduced the probability of milestone achievements, partially offset by the accretion of interest due to the passage of time and discount rate adjustments.Special Charges (Gain), netFor information on special charges and gains, see Note 4 to the "Consolidated Financial Statements."Interest ExpenseInterest expense was $15.8 million and $20.7 million in 2020 and 2019, respectively. The decrease in interest expense resulted primarily from higher capitalized interest due to facilities construction. 28Table of ContentsInterest IncomeInterest income was $23.4 million and $32.2 million in 2020 and 2019, respectively. The decrease in interest income resulted primarily from lower average interest rates, partially offset by a higher average investment balance. Other Income, net(in millions) Years Ended December 31, 20202019Foreign exchange gains, net$(12.3)$(5.9)Gain on investments(0.6)(0.5)Non-service cost components of net periodic pension benefit cost0.4 0.2 Other1.0 (2.0)Total other income, net$(11.5)$(8.2) The net foreign exchange gains relate to the foreign currency fluctuations in our global trade and intercompany receivable and payable balances, offset by the gains and losses on derivative instruments intended as an economic hedge of those exposures.The gain on investments represents our net share of gains and losses in investments accounted for under the equity method, and realized gains and losses on investments in equity securities. The non-service cost components of net periodic pension benefit cost includes the costs of our defined benefit plans that are not attributed to services rendered by eligible employees during the year, such as interest costs, expected return on plan assets, and amortization of actuarial gains or losses. Provision for Income Taxes Years Ended December 31,Change 2020 2019$%Provision for income taxes93.3 119.6 (26.3)(22.0)%Effective tax rate10.2 %10.3 %Our effective income tax rate in 2020 and 2019 was 10.2% and 10.3%, respectively. Our effective tax rate for 2020 decreased slightly in comparison to 2019 primarily due to the tax benefit from the Settlement Agreement with Abbott (see Notes 3 and 18 to the "Consolidated Financial Statements"), partially offset by the increase in the U.S. tax on global intangible low-taxed income and the decrease in the tax benefit from employee share-based compensation. In 2020, the difference between our 10.2% effective tax rate and the Federal statutory rate of 21% was primarily due to a) foreign earnings taxed at lower rates, b) Federal and California research and development credits, and c) the tax benefit from employee share-based compensation.As of December 31, 2020, we have $145.1 million of California research expenditure tax credits that we expect to use in future periods. The credits may be carried forward indefinitely. Based upon anticipated future taxable income, we expect that it is more likely than not that all California research expenditure tax credits will be utilized, although the utilization of the full benefit is expected to occur over a number of years and into the distant future.As of December 31, 2020, gross uncertain tax positions were $281.8 million. We estimate that these liabilities would be reduced by $95.1 million from offsetting tax benefits associated with the correlative effects of potential transfer pricing adjustments, state income taxes, and timing adjustments. The net amount of $186.7 million, if not required, would favorably affect our effective tax rate. We strive to resolve open matters with each tax authority at the examination level and could reach agreement with a tax authority at any time. While we have accrued for matters we believe are more likely than not to require settlement, the final outcome with a tax authority may result in a tax liability that is more or less than that reflected in the consolidated financial statements. Furthermore, we may later decide to challenge any assessments, if made, and may exercise our right to appeal. The 29Table of Contentsuncertain tax positions are reviewed quarterly and adjusted as events occur that affect potential liabilities for additional taxes, such as lapsing of applicable statutes of limitations, proposed assessments by tax authorities, negotiations between tax authorities, identification of new issues, and issuance of new legislation, regulations, or case law. We believe that adequate amounts of tax and related penalty and interest have been provided in income tax expense for any adjustments that may result from our uncertain tax positions. At December 31, 2020, all material state, local, and foreign income tax matters have been concluded for years through 2015. While not material, we continue to address matters in Wisconsin and India for years from 2010. During 2018, we executed an Advance Pricing Agreement (“APA”) between the United States and Switzerland governments for tax years 2009 through 2020 covering various, but not all, transfer pricing matters. The unagreed transfer pricing matters, namely Surgical Structural Heart and Transcatheter Aortic Valve Replacement intercompany royalty transactions, then reverted to Internal Revenue Service ("IRS") Examination for further consideration as part of the respective years' regular tax audit. In addition, we signed agreements during 2018 with the IRS to settle open tax years 2009 through 2014, including all transfer pricing matters for those years and the tax treatment of a portion of a litigation settlement payment received in 2014. The IRS began its examination of the 2015 and 2016 tax years during the fourth quarter of 2018 and later added the 2017 tax year to this audit cycle during the first quarter of 2019. The IRS audit field work for the 2015 through 2017 tax years was substantially completed during the fourth quarter of 2020, except for transfer pricing matters. As a result, certain intercompany transactions covering tax years 2015 through 2020 that were not resolved under the APA program remain subject to IRS examination, and those transactions and related tax positions remain uncertain as of December 31, 2020. The IRS has signaled that it may be preparing proposed audit adjustments related to these intercompany transactions for the 2015 through 2017 tax years which, if issued, could be provided to us during 2021. We have considered this information in our evaluation of our reserves for uncertain tax positions. These unresolved transfer pricing matters, net of any correlative repatriation tax adjustment, may be significant to our consolidated financial statements. Based on the information currently available and numerous possible outcomes, we cannot reasonably estimate what, if any, changes to our existing uncertain tax positions may occur in the next 12 months and, therefore, have continued to record the gross uncertain tax positions as a long-term liability.We intend to file to renew the APA between the United States and Switzerland for the years 2021 and forward. In addition, we executed other APAs as follows: during 2017, an APA between the United States and Japan covering tax years 2015 through 2019; and during 2018, APAs between Japan and Singapore and between Switzerland and Japan covering tax years 2015 through 2019. We have filed to renew these APAs related to Japan for the years 2020 and forward. The execution of some or all of these APAs depends on a number of variables outside of our control.We have received tax incentives in certain non-U.S. tax jurisdictions, the primary benefit for which will expire in 2029. The tax reductions as compared to the local statutory rates were $189.2 million ($0.30 per diluted share) and $157.6 million ($0.25 per diluted share) for the years ended December 31, 2020 and 2019, respectively. Liquidity and Capital ResourcesOur sources of cash liquidity include cash and cash equivalents, short-term investments, amounts available under credit facilities, and cash from operations. We believe that these sources are sufficient to fund the current requirements of working capital, capital expenditures, and other financial commitments for the next twelve months from the financial statement issuance date. However, we periodically consider various financing alternatives and may, from time to time, seek to take advantage of favorable interest rate environments or other market conditions. The Tax Cuts and Jobs Act of 2017 (the "2017 Act"), which was signed into law on December 22, 2017, included extensive changes to the international tax regime. The 2017 Act required a deemed repatriation of post-1986 undistributed foreign earnings and profits. The one-time transition tax liability, as adjusted, is payable in five remaining annual installments, as outlined in the contractual obligations table below. As of December 31, 2020, we had a remaining tax obligation of $238.7 million related to the deemed repatriation. See Note 17 to the "Consolidated Financial Statements" for additional information about the one-time transition tax. As of December 31, 2020, cash and cash equivalents and short-term investments held in the United States and outside the United States were $618.8 million and $783.8 million, respectively. During 2020, we repatriated cash of $600.0 million. We 30Table of Contentsassert that $1.1 billion of our foreign earnings continue to be permanently reinvested and our intent is to repatriate $599.8 million of our foreign earnings as of December 31, 2020. On July 12, 2020, we reached the Settlement Agreement with Abbott to settle all outstanding patent disputes between the companies in cases related to transcatheter mitral and tricuspid repair products. The Settlement Agreement resulted in us recording an estimated $367.9 million pretax charge in June 2020 related to past damages. In addition, we will incur royalty expenses through May 2024 totaling an estimated $100 million. We made a one-time $100.0 million payment to Abbott in July 2020, and will make quarterly payments in future years. For further information, see Notes 3 and 18 to the "Consolidated Financial Statements."On April 18, 2019, we acquired CASMED for an aggregate cash purchase price of $2.45 per share of common stock, or $100.8 million. For more information, see Note 8 to the "Consolidated Financial Statements."Certain of our business acquisitions involve contingent consideration arrangements. Payment of additional consideration in the future may be required, contingent upon the acquired company reaching certain performance milestones, such as attaining specified revenue levels or obtaining regulatory approvals. For further information, see Note 8 to the "Consolidated Financial Statements."We have a Five-Year Credit Agreement ("the Credit Agreement") which matures on April 28, 2023. The Credit Agreement provides up to an aggregate of $750.0 million in borrowings in multiple currencies. Subject to certain terms and conditions, we may increase the amount available under the Credit Agreement by up to an additional $250.0 million in the aggregate. As of December 31, 2020, there were no borrowings outstanding under the Credit Agreement. The Credit Agreement is unsecured and contains various financial and other covenants, including a maximum leverage ratio, as defined in the Credit Agreement. The Company was in compliance with all covenants at December 31, 2020.In June 2018, we issued $600.0 million of 4.3% fixed-rate unsecured senior notes (the "2018 Notes") due June 15, 2028. We may redeem the 2018 Notes, in whole or in part, at any time and from time to time at specified redemption prices. As of December 31, 2020, we have not elected to redeem any of the 2018 Notes. As of December 31, 2020, the total carrying value of our 2018 Notes was $595.0 million. For further information on our debt, see Note 10 to the "Consolidated Financial Statements." From time to time, we repurchase shares of our common stock under share repurchase programs authorized by the Board of Directors. We consider several factors in determining when to execute share repurchases, including, among other things, expected dilution from stock plans, cash capacity, and the market price of our common stock. During 2020, under the Board authorized repurchase programs, we repurchased a total of 3.0 million shares at an aggregate cost of $614.7 million, and as of December 31, 2020, we had remaining authority to purchase $625.0 million of our common stock. For further information, see Note 14 to the "Consolidated Financial Statements." In February 2021, we entered into an accelerated share repurchase agreement to repurchase $250.0 million of our common stock. For further information, see Note 22 to the "Consolidated Financial Statements."Consolidated Cash Flows - For the twelve months ended December 31, 2020 and 2019 Net cash flows provided by operating activities of $1.1 billion for 2020 decreased $128.6 million from 2019 due primarily to lower operating profits in 2020 and a payment of $100.0 million for a litigation settlement, partially offset by a payment of $180.0 million in 2019 for a litigation settlement.31Table of ContentsNet cash used in investing activities of $531.1 million in 2020 consisted primarily of capital expenditures of $407.0 million and net purchases of investments of $87.6 million. Net cash used in investing activities of $595.8 million in 2019 consisted primarily of a) capital expenditures of $254.4 million, b) net purchases of investments of $174.9 million, c) a $100.2 million net cash payment associated with the acquisition of CASMED, d) a $35.0 million payment for an option to acquire a company, and e) a $24.0 million payment to acquire certain early-stage transcatheter intellectual property and associated clinical and regulatory experience.We currently anticipate making capital expenditures of approximately $350 million in 2021 as we continue to invest in our operations.Net cash used in financing activities of $486.9 million in 2020 consisted primarily of purchases of treasury stock of $625.4 million, partially offset by proceeds from stock plans of $140.5 million.Net cash used in financing activities of $115.6 million in 2019 consisted primarily of purchases of treasury stock of $263.3 million, partially offset by proceeds from stock plans of $160.5 million.Contractual ObligationsA summary of all of our contractual obligations and commercial commitments as of December 31, 2020 is as follows (in millions): Payments Due by PeriodContractual ObligationsTotalYear 1Years 2-3Years 4-5After 5YearsDebt$600.0 $— $— $— $600.0 Operating leases108.1 30.0 35.1 14.9 28.1 Interest on debt148.9 20.5 40.5 39.4 48.5 Transition tax on unremitted foreign earnings and profits (a)238.7 25.1 72.2 141.4 — Litigation settlement obligation (minimum payments)250.0 50.0 100.0 100.0 — Pension obligations (b)2.5 2.5 — — — Purchase and other commitments (c)26.7 13.7 9.7 1.5 1.8 Total contractual cash obligations (d), (e)$1,374.9 $141.8 $257.5 $297.2 $678.4 _______________________________________________________________________________(a) As of December 31, 2020, we had recorded $238.7 million of income tax liabilities related to the one-time transition tax that resulted from the enactment of the 2017 Act. The transition tax is due in eight annual installments, with the first annual installment paid in 2018, the second annual installment paid in 2019 and the third annual installment paid in 2020. The remaining installment amounts will be equal to 8% of the total liability, payable in fiscal years 2021 through 2022, 15% in fiscal year 2023, 20% in fiscal year 2024, and 25% in fiscal year 2025. See Note 17 to the "Consolidated Financial Statements" for additional information about the one-time transition tax.(b) The amount included in "Less Than 1 Year" reflects anticipated contributions to our various pension plans. Anticipated contributions beyond one year are not determinable. The total accrued benefit liability for our pension plans recognized as of December 31, 2020 was $52.9 million. This amount is impacted by, among other items, pension expense funding levels, changes in plan demographics and assumptions, and investment returns on plan assets. Therefore, we are unable to make a reasonably reliable estimate of the amount and period in which the liability might be paid, and did not include this amount in the contractual obligations table. See Note 13 to the "Consolidated Financial Statements" for further information.(c) Purchase and other commitments consists primarily of open purchase orders for the acquisition of goods and services in the normal course of business. We have excluded open purchase orders with a remaining term of less than one year. For certain purchase and other commitments, such as commitments to fund equity method or other investments, the timing of the payment is not certain. In these cases, the maturity dates in the table reflect our best estimates.(d) As of December 31, 2020, the gross liability for uncertain tax positions, including interest, was $301.2 million and relates primarily to transfer pricing matters. During 2018, we executed an APA between the United States and Switzerland governments for tax years 2009 through 2020 covering various but not all transfer pricing matters. As a result, certain 32Table of Contentsintercompany transactions covering tax years 2015 through 2020 that were not resolved under the APA program remain subject to IRS examination, and those transactions and related tax positions remain uncertain as of the balance sheet date. These unresolved transfer pricing matters may be significant to our consolidated financial statements, and the final outcome of the negotiations is uncertain. Management believes that adequate amounts of tax and related penalty and interest have been provided in income tax expense for any adjustments that may result for our uncertain tax positions. We are unable to make a reasonably reliable estimate of the amount and period in which the liability might be paid, and did not include this amount in the contractual obligations table.(e) We acquire assets still in development, enter into research and development arrangements, acquire businesses, and sponsor certain clinical trials that often require milestone, royalty, or other future payments to third-parties, contingent upon the occurrence of certain future events. In situations where we have no ability to influence the achievement of the milestone or otherwise avoid the payment, we have included those payments in the table above. However, we have excluded from the table contingent milestone payments and other contingent liabilities for which we cannot reasonably predict future payments or for which we can avoid making payment by unilaterally deciding to stop development of a product or cease progress of a clinical trial. We estimate that these contingent payments could be up to $810.0 million if all milestones or other contingent obligations are met. This amount includes certain milestone-based contingent obligations that may be paid through a combination of cash and issuance of common stock, and certain sales-based royalties in excess of minimum payment thresholds related to litigation settlements. Critical Accounting Policies and EstimatesOur results of operations and financial position are determined based upon the application of our accounting policies, as discussed in the notes to the "Consolidated Financial Statements." Certain of our accounting policies represent a selection among acceptable alternatives under GAAP. In evaluating our transactions, management assesses all relevant GAAP and chooses the accounting policy that most accurately reflects the nature of the transactions.The application of accounting policies requires the use of judgment and estimates. These matters that are subject to judgments and estimation are inherently uncertain, and different amounts could be reported using different assumptions and estimates. Management uses its best estimates and judgments in determining the appropriate amount to reflect in the consolidated financial statements, using historical experience and all available information. We also use outside experts where appropriate. We apply estimation methodologies consistently from year to year.We believe the following are the critical accounting policies which could have the most significant effect on our reported results and require subjective or complex judgments by management.Revenue RecognitionWhen we recognize revenue from the sale of our products, the amount of consideration we ultimately receive varies depending upon the return terms, sales rebates, discounts, and other incentives that we may offer, which are accounted for as variable consideration when estimating the amount of revenue to recognize. The estimate of variable consideration requires significant judgment. We include estimated amounts in the transaction price to the extent it is probable that a significant reversal of cumulative revenue recognized will not occur when the uncertainty associated with the variable consideration is resolved. The estimates of variable consideration and determination of whether to include estimated amounts in the transaction price are based largely upon an assessment of historical payment experience, historical relationship to revenues, estimated customer inventory levels, and current contract sales terms with direct and indirect customers. Product returns are typically not significant because returns are generally not allowed unless the product is damaged at time of receipt. If the historical data and inventory estimates used to calculate the variable consideration do not approximate future activity, our financial position, results of operations, and cash flows could be impacted.In addition, in limited circumstances, we may allow customers to return previously purchased products, such as for next-generation product offerings. For these transactions, we defer recognition of revenue on the sale of the earlier generation product based upon an estimate of the amount of product to be returned when the next-generation products are shipped to the customer. Uncertain timing of next-generation product approvals, variability in product launch strategies, product recalls, and variation in product utilization all affect the estimates related to sales returns and could cause actual returns to differ from these estimates.Our sales adjustment related to distributor rebates given to our United States distributors represents the difference between our sales price to the distributor and the negotiated price to be paid by the end-customer. We validate the distributor rebate accrual quarterly through either a review of the inventory reports obtained from our distributors or an estimate of the 33Table of Contentsdistributor's inventory. This distributor inventory information is used to verify the estimated liability for future distributor rebate claims based on historical rebates and contract rates. We periodically monitor current pricing trends and distributor inventory levels to ensure the credit for future distributor rebates is fairly stated.Excess and Obsolete InventoryThe valuation of our inventory requires us to estimate excess, obsolete, and expired inventory. We base our provisions for excess, obsolete, and expired inventory on our estimates of forecasted net sales. A significant change in the timing or level of demand for our products as compared to forecasted amounts may result in recording additional allowances for excess, obsolete, and expired inventory in the future. In addition, our industry is characterized by rapid product development and frequent new product introductions. Uncertain timing of next-generation product approvals, variability in product launch strategies, product recalls, increasing levels of consigned inventory, and variation in product utilization all affect our estimates related to excess, obsolete, and expired inventory.Intangible Assets and Long-lived AssetsWe acquire intangible assets in connection with business combinations and asset purchases. The acquired intangible assets are recorded at fair value, which is determined based on a discounted cash flow analysis. The determination of fair value requires significant estimates, including, but not limited to, the amount and timing of projected future cash flows, the discount rate used to discount those cash flows, the assessment of the asset's life cycle, including the timing and expected costs to complete in-process projects, and the consideration of legal, technical, regulatory, economic, and competitive risks.In-process research and development assets acquired in business combinations is reviewed for impairment annually, or whenever an event occurs or circumstances change that would indicate the carrying amount may be impaired. Additionally, management reviews the carrying amounts of other intangible and long-lived assets whenever events or circumstances indicate that the carrying amounts of an asset may not be recoverable. The impairment reviews require significant estimates about fair value, including estimation of future cash flows, selection of an appropriate discount rate, and estimates of long-term growth rates.Contingent Consideration We record contingent consideration resulting from a business combination at its fair value on the acquisition date. We determine the fair value of the contingent consideration based primarily on the following factors: •discount rates used to present value the projected cash flows;•the probability of success of clinical events and regulatory approvals, and/or meeting commercial milestones; •projected payment dates; and•volatility of future revenue.On a quarterly basis, we revalue these obligations and record changes in their fair value as an adjustment to earnings. Changes to contingent consideration obligations can result from adjustments to discount rates, accretion of the discount rates due to the passage of time, changes in our estimates of the likelihood or timing of achieving development or commercial milestones, changes in the probability of certain clinical events, or changes in the assumed probability associated with regulatory approval. The assumptions related to determining the value of contingent consideration include a significant amount of judgment, and any changes in the underlying estimates could have a material impact on the amount of contingent consideration expense recorded in any given period.34Table of ContentsIncome TaxesThe determination of our provision for income taxes requires significant judgment, the use of estimates, and the interpretation and application of complex tax laws. Realization of certain deferred tax assets, primarily tax credits, net operating loss and other carryforwards, is dependent upon generating sufficient taxable income in the appropriate jurisdiction prior to the expiration of the carryforward periods. Failure to achieve forecasted taxable income in the applicable taxing jurisdictions could affect the ultimate realization of deferred tax assets and could result in an increase in our effective tax rate on future earnings.We have made an accounting policy election to recognize the U.S. tax effects of global intangible low-taxed income as a component of income tax expense in the period the tax arises. We are subject to income taxes in the United States and numerous foreign jurisdictions. Our income tax returns are periodically audited by domestic and foreign tax authorities. These audits include questions regarding our tax filing positions, including the timing and amount of deductions and the allocation of income amongst various tax jurisdictions. We evaluate our tax positions and establish liabilities in accordance with the applicable accounting guidance on uncertainty in income taxes. Significant judgment is required in evaluating our uncertain tax positions, including estimating the ultimate resolution to intercompany pricing controversies between countries when there are numerous possible outcomes. We review these tax uncertainties quarterly and adjust the liability as events occur that affect potential liabilities for additional taxes, such as the progress of tax audits, lapsing of applicable statutes of limitations, negotiations between tax authorities, identification of new issues, and issuance of new legislation, regulations, or case law.For additional details on our income taxes, see Note 2 and Note 17 to the "Consolidated Financial Statements."Stock-based CompensationWe measure and recognize compensation expense for all stock-based awards based on estimated fair values. Stock-based awards consist of stock options, service-based restricted stock units, market-based restricted stock units, performance-based restricted stock units, and employee stock purchase subscriptions. The fair value of each option award and employee stock purchase subscription is estimated on the date of grant using the Black-Scholes option valuation model. The fair value of market-based restricted stock units is determined using a Monte Carlo simulation model, which uses multiple input variables to determine the probability of satisfying the market condition requirements. The Black-Scholes and Monte Carlo models require various highly judgmental assumptions, including stock price volatility, risk-free interest rate, and expected option term. For performance-based restricted stock units, expense is recognized if and when we conclude that it is probable that the performance condition will be achieved, which requires judgment. Stock-based compensation expense is recorded net of estimated forfeitures. Judgment is required in estimating the stock awards that will ultimately be forfeited. If actual results differ significantly from these estimates, stock-based compensation expense and our results of operations would be impacted.Legal ContingenciesWe are or may be a party to, or may otherwise be responsible for, pending or threatened lawsuits including those related to products and services currently or formerly manufactured or performed, as applicable, by us, workplace and employment matters, matters involving real estate, our operations or health care regulations, or governmental investigations. We accrue for loss contingencies to the extent that we conclude that it is probable that a loss will be incurred and the amount of the loss can be reasonably estimated. These matters raise difficult and complex factual and legal issues and are subject to many uncertainties, including, but not limited to, the facts and circumstances of each particular case or claim, the jurisdiction in which each suit is brought, and differences in applicable law. As such, significant judgment is required in determining our legal accruals. We describe our legal proceedings in Note 18 to the "Consolidated Financial Statements."New Accounting StandardsInformation regarding new accounting standards is included in Note 2 to the "Consolidated Financial Statements."Item 7A. Quantitative and Qualitative Disclosures About Market RiskOur business and financial results are affected by fluctuations in world financial markets, including changes in currency exchange rates and interest rates. We manage these risks through a combination of normal operating and financing activities and derivative financial instruments. We do not use derivative financial instruments for trading or speculative purposes.35Table of ContentsInterest Rate RiskOur exposure to market risk for changes in interest rates relates primarily to our investment portfolio and our long-term debt. Our investment strategy is focused on preserving capital and supporting our liquidity requirements, while earning a reasonable market return. We invest in a variety of debt securities, primarily time deposits, commercial paper, U.S. and foreign government and agency securities, asset-backed securities, corporate debt securities, and municipal debt securities. The market value of our investments may decline if current market interest rates rise. As of December 31, 2020, we had $985.9 million of investments in debt securities which had an average remaining term to maturity of approximately 1.56 years. Taking into consideration the average maturity of our debt securities, a hypothetical 0.5% to 1.0% absolute increase in interest rates at December 31, 2020 would have resulted in a $7.8 million to $15.6 million decrease in the fair value of these investments. Such a decrease would only result in a realized loss if we choose or are forced to sell the investments before the scheduled maturity, which we currently do not anticipate.For more information related to investments, see Note 7 to the "Consolidated Financial Statements."We are also exposed to interest rate risk on our debt obligations. As of December 31, 2020, we had $600.0 million of Notes outstanding that carry a fixed rate, and also had available a $750.0 million Credit Agreement that carries a variable interest rate based on the London interbank offered rate ("LIBOR"). As of December 31, 2020, there were no borrowings outstanding under the Credit Agreement. Based on our December 31, 2020 variable debt levels, a hypothetical 1.0% absolute increase in floating market interest rates would not have impacted our interest expense since we had no variable debt outstanding during the year. As of December 31, 2020, a hypothetical 1.0% absolute increase in market interest rates would decrease the fair value of the fixed-rate debt by approximately $43.2 million. This hypothetical change in interest rates would not impact the interest expense on the fixed-rate debt.For more information related to outstanding debt obligations, see Note 10 to the "Consolidated Financial Statements."Currency RiskWe are exposed to foreign currency risks that arise from normal business operations. These risks include the translation of local currency balances and results of our non-United States subsidiaries into United States dollars, currency gains and losses related to intercompany and third-party transactions denominated in currencies other than a subsidiary's functional currency, and currency gains and losses associated with intercompany loans. Our principal currency exposures relate to the Euro and the Japanese yen. Our objective is to minimize the volatility of our exposure to these risks through a combination of normal operating and financing activities and the use of derivative financial instruments in the form of foreign currency forward exchange contracts and cross currency swap contracts. The total notional amount of our derivative financial instruments entered into for foreign currency management purposes at December 31, 2020 was $1.8 billion. A hypothetical 10% increase/decrease in the value of the United States dollar against all hedged currencies would increase/decrease the fair value of these derivative contracts by $141.5 million. Any gains or losses on the fair value of derivative contracts would generally be offset by gains and losses on the underlying transactions, so the net impact would not be significant to our financial condition or results of operations.For more information related to outstanding foreign exchange contracts, see Note 2 and Note 12 to the "Consolidated Financial Statements."Credit RiskDerivative financial instruments involve credit risk in the event the financial institution counterparty should default. It is our policy to execute such instruments with major financial institutions that we believe to be creditworthy. At December 31, 2020, all derivative financial instruments were with bank counterparties assigned investment grade ratings by national rating agencies. We further diversify our derivative financial instruments among counterparties to minimize exposure to any one of these entities. We have not experienced a counterparty default and do not anticipate any non-performance by our current derivative counterparties.Concentrations of RiskWe invest excess cash in a variety of debt securities, and diversify the investments between financial institutions. Our investment policy limits the amount of credit exposure to any one issuer.36Table of ContentsIn the normal course of business, we provide credit to customers in the health care industry, perform credit evaluations of these customers, and maintain allowances for potential credit losses, which have historically been adequate compared to actual losses. In 2020, we had no customers that represented 10% or more of our total net sales or accounts receivable, net.Investment RiskWe are exposed to investment risks related to changes in the underlying financial condition and credit capacity of certain of our investments. As of December 31, 2020, we had $985.9 million of investments in debt securities of various companies, of which $766.5 million were long-term. In addition, we had $35.1 million of investments in equity instruments of public and private companies. Should these companies experience a decline in financial performance, financial condition or credit capacity, or fail to meet certain development milestones, including as a result of the impact from COVID-19 on their business or operations or otherwise, a decline in the investments' value may occur, resulting in unrealized or realized losses.37Table of Contents
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+ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSThe following combined MD&A should be read in conjunction with the consolidated financial statements and accompanying notes in this combined annual report on Form 10-K. None of the registrants make any representation as to information related solely to Evergy, Evergy Kansas Central or Evergy Metro other than itself.The following MD&A generally discusses 2020 and 2019 items and year-to-year comparisons between 2020 and 2019. Discussions of 2018 items and year-to-year comparisons between 2019 and 2018 can be found in MD&A in Part II, Item 7, of the Evergy Companies' combined annual report on Form 10-K for the fiscal year ended December 31, 2019.EVERGY, INC.EXECUTIVE SUMMARYEvergy is a public utility holding company incorporated in 2017 and headquartered in Kansas City, Missouri. Evergy operates primarily through the following wholly-owned direct subsidiaries listed below. •Evergy Kansas Central is an integrated, regulated electric utility that provides electricity to customers in the state of Kansas. Evergy Kansas Central has one active wholly-owned subsidiary with significant operations, Evergy Kansas South. •Evergy Metro is an integrated, regulated electric utility that provides electricity to customers in the states of Missouri and Kansas.•Evergy Missouri West is an integrated, regulated electric utility that provides electricity to customers in the state of Missouri.•Evergy Transmission Company owns 13.5% of Transource with the remaining 86.5% owned by AEP Transmission Holding Company, LLC, a subsidiary of AEP. Transource is focused on the development of competitive electric transmission projects. Evergy Transmission Company accounts for its investment in Transource under the equity method. 33Table of Contents Evergy Kansas Central also owns a 50% interest in Prairie Wind, which is a joint venture between Evergy Kansas Central and subsidiaries of AEP and Berkshire Hathaway Energy Company. Prairie Wind owns a 108-mile, 345 kV double-circuit transmission line that provides transmission service in the SPP. Evergy Kansas Central accounts for its investment in Prairie Wind under the equity method.Evergy Kansas Central, Evergy Kansas South, Evergy Metro and Evergy Missouri West conduct business in their respective service territories using the name Evergy. Collectively, the Evergy Companies have approximately 15,400 MWs of owned generating capacity and renewable power purchase agreements and engage in the generation, transmission, distribution and sale of electricity to approximately 1.6 million customers in the states of Kansas and Missouri. The Evergy Companies assess financial performance and allocate resources on a consolidated basis (i.e., operate in one segment).StrategyEvergy expects to continue operating its integrated utilities within the currently existing regulatory frameworks. In August 2020, Evergy announced a five-year Sustainability Transformation Plan, or STP, to optimize and enhance value creation for shareholders, customers, communities and employees. Significant elements of the plan include:•targeting a reduction of approximately $330 million of operating and maintenance expense by 2024 from 2018 adjusted operating and maintenance expense (non-GAAP) (see "Non-GAAP Measures" within this Executive Summary for a reconciliation of this non-GAAP measure to the most directly comparable GAAP measure);•targeting a reduction of approximately $145 million of fuel and purchased power expense between 2019 and 2024; and•targeting approximately $8.9 billion of expected base capital investments through 2024. Of this amount, Evergy estimates approximately $2.9 billion to qualify for PISA in Missouri, and approximately $1.9 billion to be focused on FERC-jurisdictional improvements. See "Liquidity and Capital Resources; Capital Expenditures", for further information regarding Evergy's projected capital expenditures through 2024.The STP also enhances Evergy's efforts to mitigate future strategic risk through the responsible and accelerated reduction of CO2 emissions. In 2020, Evergy achieved a reduction of CO2 emissions of approximately 50% from 2005 levels and announced a goal to achieve an 80% reduction from 2005 levels by 2050. The STP has the potential to reduce CO2 emissions by as much as 85% by 2030 compared to 2005 levels. The STP includes steps that would expedite CO2 emission reductions by pursuing constructive legislative and regulatory recovery mechanisms to facilitate the retirement of coal-fired generation and expansion of Evergy's wind and solar footprint, while maintaining reliability. The pace of CO2 emission reductions will ultimately be defined by continued collaboration with stakeholders as part of Evergy's triennial integrated resource plan. Furthermore, the trajectory and timing for reaching this goal could be impacted by political, legal and regulatory actions and applicable technology developments.See "Cautionary Statements Regarding Certain Forward-Looking Information" and Part I, Item 1A, Risk Factors, for additional information.Agreements with Elliott Investment Management L.P. and Bluescape Energy Partners, LLCOn February 25, 2021, Evergy entered into separate agreements with Bluescape Energy Partners, LLC, (Bluescape) Elliott Investment Management L.P. (Elliott) and affiliates of Elliott. As part of the agreement with Bluescape (the Bluescape Agreement), C. John Wilder, Executive Chairman of Bluescape, and Mary L. Landrieu, former U.S. Senator for Louisiana, will join the Evergy Board effective as of March 1, 2021. In addition, pursuant to a securities purchase agreement, by and between Evergy and an affiliate of Bluescape, dated as of February 25, 2021 (the Bluescape Investment Agreement), Bluescape has agreed to purchase 2,269,447 shares of Evergy’s common stock for approximately $113.2 million and will receive a warrant to purchase up to 3,950,000 additional shares of Evergy’s common stock, in each case subject to satisfaction of customary closing conditions, 34Table of Contents including the expiration of the waiting period under the Hart-Scott-Rodino Antitrust Improvements Act of 1976. The warrant will have a term of three years and an exercise price equal to $64.70. Each of Bluescape and Elliott also agreed to customary standstill, voting and other provisions in connection with the foregoing. The foregoing summaries of the Bluescape Agreement and the Bluescape Investment Agreement are qualified in their entirety by reference to the Bluescape Agreement and the Bluescape Investment Agreement, respectively, a copy of which is attached as Exhibit 10.1 and Exhibit 10.2, respectively, to Evergy’s Current Report on Form 8-K filed on February 26, 2021 and are incorporated herein by reference.Impact of COVID-19The COVID-19 pandemic has had, and may continue to have, a significant impact on the way that the Evergy Companies conduct their operations, including the implementation of social distancing and other preventative protocols and the direction of employees to work remotely when possible. Further, the spread of COVID-19 has resulted in efforts to contain the virus, such as quarantines, restrictions on travel, closures and the reduced operations of businesses, governmental agencies and other institutions. The pandemic, along with the efforts to contain the virus, has caused and could continue to cause an economic slowdown or recession, result in significant disruptions or reductions in various public, commercial or industrial activities and cause employee absences. In the states of Missouri and Kansas as well as certain counties and municipalities within the Evergy Companies' service territory, "stay-at-home" orders were in effect for parts of 2020 and could be implemented again in the future.Governmental mandates that restrict the operation of businesses, governmental agencies and other institutions continue to remain in effect and a substantial portion of the Evergy Companies' service territory is also required to utilize preventative measures such as the wearing of face coverings while in public areas. The announcement in late 2020 of multiple COVID-19 vaccines with high expected effectiveness rates could serve to mitigate both the severity and ongoing duration of the COVID-19 outbreak. However, both the magnitude and timing of the impact of the COVID-19 vaccines is not yet known and could be subject to multiple factors including the available supply of vaccine, the vaccine adoption rate by the general public and the achievement of the vaccines' expected effectiveness rates. Management cannot foresee whether the outbreak of COVID-19 will be effectively contained, nor can it predict the severity and ongoing duration of its impact.During 2020, Evergy experienced an overall reduction in demand and shift of usage away from customers with relatively higher load requirements, such as industrial and commercial customers, towards customers with relatively lower load requirements, such as residential customers. In 2020, approximately 39% of Evergy's total revenues came from residential customers and approximately 45% came from commercial and industrial customers, compared with approximately 37% from residential customers and 47% from commercial and industrial customers in 2019. The KCC and MPSC have established different prices for the Evergy Companies' residential, commercial and industrial customers and a similar change in demand across each customer class will have a different impact on earnings. As a result, the impacts to Evergy's earnings from a reduction in demand from industrial and commercial customers have been partially offset by an increase in demand from residential customers.The Evergy Companies have also temporarily implemented policies, and in the future may implement additional policies, that are intended to ease the financial burden of the pandemic on customers. These policies, such as temporarily extending payment options and offering incentives for customer payments on overdue balances as well as the elimination of late payment fees and disconnections for non-payment, could lead to lower levels of operating cash flows compared to historical levels for the Evergy Companies. In addition, these policies, along with lower electric sales as a result of the overall reduction in demand discussed above, could also lead to the additional repayment of portions of the Evergy Companies' borrowings under receivable sale facilities. Finally, the Evergy Companies have incurred, and will continue to incur, expenses related to monitoring the COVID-19 pandemic and modifying operations in response to the pandemic that are recorded in operating and maintenance expense.In May 2020, Evergy Kansas Central, Evergy Metro and Evergy Missouri West filed joint requests for AAOs with the KCC and MPSC, as applicable, that would allow for the extraordinary costs and lost revenues incurred by the 35Table of Contents companies, net of any COVID-19-related savings, as a result of the COVID-19 pandemic to be considered for future recovery from customers as part of their next rate cases. The KCC approved the AAO request in July 2020.In October 2020, Evergy Metro and Evergy Missouri West entered into a non-unanimous stipulation and agreement with the MPSC staff and other intervenors that would allow Evergy Metro and Evergy Missouri West to defer to a regulatory asset certain net incremental costs incurred associated with the COVID-19 pandemic for consideration in their next rate cases. The MPSC approved the AAO request in January 2021. Evergy's management is actively monitoring the evolving impact of COVID-19 on its results of operations and developments affecting its workforce and suppliers and will take additional actions as it believes are warranted. The situation is continuously evolving and future impacts may materialize that are not yet known. Accordingly, the extent to which COVID-19 and the factors noted above may impact the results of operations, financial position, cash flows and liquidity of the Evergy Companies will depend on future developments that are highly uncertain and cannot be predicted, including new information concerning the severity and ongoing duration of the COVID-19 outbreak and the actions taken to contain it or to seek recovery of its impact, among others.See "Cautionary Statements Regarding Certain Forward-Looking Information" and Part I, Item 1A, Risk Factors, for additional information.February 2021 Winter Weather EventIn February 2021, much of the central and southern United States, including the service territories of the Evergy Companies, experienced a significant winter weather event that resulted in extremely cold temperatures over a multi-day period. This winter weather event resulted in an increase in the demand for natural gas used by the Evergy Companies for generating electricity and also contributed to the limited availability of other generation resources, including coal and renewables, within the SPP Integrated Marketplace. The Evergy Companies are members of the SPP and, as a result, principally sell and purchase power through the SPP’s Integrated Marketplace for the Evergy Companies’ retail electric customers. These circumstances resulted in higher than normal market prices for both natural gas and power for the duration of the winter weather event. Evergy estimates that as part of the winter weather event, it experienced an increase in natural gas and purchased power costs, net of wholesale revenues, of approximately $300 million. This $300 million increase in net fuel and purchased power costs was primarily driven by a $260 million increase in costs at Evergy Missouri West and a $100 million increase at Evergy Kansas Central, partially offset by a $60 million net increase in wholesale revenues at Evergy Metro. These amounts represent preliminary estimates and are still under development. Further, the final amount of purchased power costs incurred by the Evergy Companies is subject to final settlement pricing by the SPP Integrated Marketplace, which is currently expected to take an additional 30 to 45 days, though the ultimate timing is uncertain.The Evergy Companies have fuel recovery mechanisms in their Kansas and Missouri jurisdictions, as applicable, that allow them to defer substantially all of any increased fuel and purchased power costs, net of wholesale revenues, to a regulatory asset for future recovery from customers. Further, in February 2021, the KCC issued an emergency order that would allow the Evergy Companies, as applicable, to defer to a regulatory asset any extraordinary costs incurred to continue providing electric service during the winter weather event for consideration in future rate proceedings. While the Evergy Companies expect to recover substantially all of any increased fuel and purchased power costs related to the winter weather event from customers, it is possible that the timing of the cost recovery could be delayed or spread over a longer than typical recovery timeframe by the KCC or the MPSC given the extraordinary nature of the winter weather event.The Evergy Companies also engage in limited non-regulated energy marketing activities in various regional power markets that have historically not had a significant impact on the Evergy Companies’ results of operations. As a result of the elevated market prices experienced in regional power markets in February 2021 across the central and southern United States driven by the winter weather event discussed above, the Evergy Companies currently expect that their energy marketing margins will be higher in 2021 compared with historical results. 36Table of Contents The full financial statement impact of the winter weather event is unknown and cannot be estimated at this time due in part to the timing of market settlement data. The Evergy Companies believe they have sufficient liquidity to pay any outstanding balances or fulfill collateral posting requirements related to purchases made during the winter storm event and to operate their retail electric businesses through their cash on hand and master credit facility with available borrowing capacity as of February 25, 2021 of approximately $2 billion.Regulatory ProceedingsSee Note 5 to the consolidated financial statements for information regarding regulatory proceedings.Earnings OverviewThe following table summarizes Evergy's net income and diluted earnings per share (EPS).2020Change2019(millions, except per share amounts)Net income attributable to Evergy, Inc.$618.3 $(51.6)$669.9 Earnings per common share, diluted2.72 (0.07)2.79 Net income attributable to Evergy, Inc. decreased in 2020, compared to 2019, primarily due to lower retail sales driven by unfavorable weather and a decrease in weather-normalized commercial and industrial demand primarily due to temporary business closures and hours of operation and capacity limitations as a result of COVID-19 that were partially offset by an increase in weather-normalized residential demand and higher depreciation expense and higher interest expense; partially offset by lower operating and maintenance expenses in 2020. Diluted EPS decreased in 2020 compared to 2019, primarily due to the decrease in net income attributable to Evergy discussed above, partially offset by a lower number of diluted weighted average common shares outstanding in 2020, which increased EPS by $0.14 for 2020.For additional information regarding the change in net income, refer to the Evergy Results of Operations section within this MD&A. Adjusted Earnings (non-GAAP) and Adjusted EPS (non-GAAP)Evergy's adjusted earnings (non-GAAP) and adjusted EPS (non-GAAP) for 2020 were $705.5 million or $3.10 per share, respectively. For 2019, Evergy's adjusted earnings (non-GAAP) and adjusted EPS (non-GAAP) were $694.0 million or $2.89 per share, respectively. In addition to net income attributable to Evergy, Inc. and diluted EPS, Evergy's management uses adjusted earnings (non-GAAP) and adjusted EPS (non-GAAP) to evaluate earnings and EPS without the costs resulting from rebranding, voluntary severance, advisor expenses and the revaluation of deferred tax assets and liabilities from a change in the Kansas corporate income tax rate.Non-GAAP MeasuresAdjusted Earnings and Adjusted EPSAdjusted earnings (non-GAAP) and adjusted EPS (non-GAAP) are intended to enhance an investor's overall understanding of results. Adjusted earnings (non-GAAP) and adjusted EPS (non-GAAP) are used internally to measure performance against budget and in reports for management and the Evergy Board. Adjusted earnings (non-GAAP) and adjusted EPS (non-GAAP) are financial measures that are not calculated in accordance with GAAP and may not be comparable to other companies' presentations or more useful than the GAAP information provided elsewhere in this report. 37Table of Contents The following table provides a reconciliation between net income attributable to Evergy, Inc. and diluted EPS as determined in accordance with GAAP and adjusted earnings (non-GAAP) and adjusted EPS (non-GAAP).Earnings (Loss)Earnings (Loss) per Diluted ShareEarnings (Loss)Earnings (Loss) per Diluted Share20202019(millions, except per share amounts)Net income attributable to Evergy, Inc.$618.3 $2.72 $669.9 $2.79 Non-GAAP reconciling items:Rebranding costs, pre-tax(a)— — 12.1 0.05 Voluntary severance costs, pre-tax(b)66.3 0.29 19.8 0.08 Advisor expenses, pre-tax(c)32.3 0.14 — — Income tax benefit(d)(25.2)(0.11)(7.8)(0.03)Kansas corporate income tax change(e)13.8 0.06 — — Adjusted earnings (non-GAAP)$705.5 $3.10 $694.0 $2.89 (a)Reflects external costs incurred to rebrand the legacy Westar Energy and KCP&L utility brands to Evergy and are included in operating and maintenance expense on the consolidated statements of comprehensive income. (b)Reflects severance costs incurred associated with certain voluntary severance programs at the Evergy Companies and are included in operating and maintenance expense on the consolidated statements of comprehensive income. (c)Reflects advisor expenses incurred associated with strategic planning and are included in operating and maintenance expense on the consolidated statements of comprehensive income. (d)Reflects an income tax effect calculated at a statutory rate of approximately 26%, with the exception of certain non-deductible items. (e)Reflects the revaluation of Evergy Kansas Central's, Evergy Metro's and Evergy Missouri West's deferred income tax assets and liabilities from the Kansas corporate income tax rate change and are included in income tax expense on the consolidated statements of comprehensive income. 38Table of Contents 2018 Adjusted Operating and Maintenance ExpenseThe following table provides a reconciliation between 2018 operating and maintenance expense and 2018 pro forma operating and maintenance expense as determined in accordance with GAAP and 2018 adjusted operating and maintenance expense (non-GAAP). Evergy's 2018 adjusted operating and maintenance expense (non-GAAP) is used as the base for targeted operating and maintenance expense reductions by 2024 as part of Evergy's STP.(millions)2018 Operating and maintenance expense$1,115.8 Pro forma adjustments(a):Great Plains Energy operating and maintenance expense prior to the merger317.9 Non-recurring merger costs and other(101.3)2018 Pro forma operating and maintenance expense$1,332.4 Non-GAAP reconciling items:Voluntary severance costs(b)(23.5)Deferral of merger transition costs(c)28.5 Inventory write-offs at retiring generating units(d)(31.0)2018 Adjusted operating and maintenance expense (non-GAAP)$1,306.4 (a)Reflects pro forma adjustments made in accordance with Article 11 of Regulation S-X and ASC 805 - Business Combinations. See Note 2 to the consolidated financial statements in the Evergy Companies' combined 2018 Annual Report on Form 10-K for further information regarding these adjustments. (b)Reflects severance costs incurred associated with certain voluntary severance programs at the Evergy Companies and are included in operating and maintenance expense on the 2018 consolidated statements of comprehensive income in the Evergy Companies' combined 2018 Annual Report on Form 10-K. (c)Reflects the portion of the $47.8 million deferral of merger transition costs to a regulatory asset in June 2018 that related to costs incurred prior to 2018. The remaining merger transition costs included within the $47.8 million deferral were both incurred and deferred in 2018 and did not impact earnings. This item is included in operating and maintenance expense on the 2018 consolidated statements of comprehensive income in the Evergy Companies' combined 2018 Annual Report on Form 10-K. (d)Reflects obsolete inventory write-offs for Evergy Kansas Central's Unit 7 at Tecumseh Energy Center, Units 3 and 4 at Murray Gill Energy Center, Units 1 and 2 at Gordon Evans Energy Center, Evergy Metro's Montrose Station and Evergy Missouri West's Sibley Station and are included in operating and maintenance expense on the 2018 consolidated statements of comprehensive income in the Evergy Companies' combined 2018 Annual Report on Form 10-K. ENVIRONMENTAL MATTERSSee Note 15 to the consolidated financial statements for information regarding environmental matters.RELATED PARTY TRANSACTIONSSee Note 17 to the consolidated financial statements for information regarding related party transactions.CRITICAL ACCOUNTING POLICIES AND ESTIMATESThe preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect reported amounts and related disclosures. Management considers an accounting estimate to be critical if it requires assumptions to be made that were uncertain at the time the estimate was made and changes in the estimate, or different estimates that could have been used, could have a material impact on Evergy's results of operations and financial position. Management has identified the following accounting policies as critical to the understanding of Evergy's results of operations and financial position. Management has discussed the development and selection of these critical accounting policies with the Audit Committee of the Evergy Board.PensionsEvergy incurs significant costs in providing non-contributory defined pension benefits. The costs are measured using actuarial valuations that are dependent upon numerous factors derived from actual plan experience and assumptions of future plan experience.39Table of Contents Pension costs are impacted by actual employee demographics (including age, life expectancies, compensation levels and employment periods), earnings on plan assets, the level of contributions made to the plan, and plan amendments. In addition, pension costs are also affected by changes in key actuarial assumptions, including anticipated rates of return on plan assets and the discount rates used in determining the projected benefit obligation and pension costs.The assumed rate of return on plan assets was developed based on the weighted-average of long-term returns forecast for the expected portfolio mix of investments held by the plan. The assumed discount rate was selected based on the prevailing market rate of fixed income debt instruments with maturities matching the expected timing of the benefit obligation. These assumptions, updated annually at the measurement date, are based on management's best estimates and judgment; however, material changes may occur if these assumptions differ from actual events. See Note 10 to the consolidated financial statements for information regarding the assumptions used to determine benefit obligations and net costs.The following table reflects the sensitivities associated with a 0.5% increase or a 0.5% decrease in key actuarial assumptions for Evergy's qualified pension plans. Each sensitivity reflects the impact of the change based on a change in that assumption only. Impact onImpact onProjected2021Change inBenefitPensionActuarial assumptionAssumptionObligationExpense(millions)Discount rate0.5 %increase$(221.2)$(21.9)Rate of return on plan assets0.5 %increase— (8.2)Rate of compensation0.5 %increase59.6 10.8 Discount rate0.5 %decrease255.5 24.4 Rate of return on plan assets0.5 %decrease— 8.2 Rate of compensation0.5 %decrease(51.6)(10.0)Pension expense for Evergy Kansas Central, Evergy Metro and Evergy Missouri West is recorded in accordance with rate orders from the KCC and MPSC. The orders allow the difference between pension costs under GAAP and pension costs for ratemaking to be recorded as a regulatory asset or liability with future ratemaking recovery or refunds, as appropriate. In 2020, Evergy's pension expense was $129.5 million under GAAP and $159.1 million for ratemaking. The impact on 2021 pension expense in the table above reflects the impact on GAAP pension costs. Under the Evergy Companies' rate agreements, any increase or decrease in GAAP pension expense is deferred to a regulatory asset or liability for future ratemaking treatment. See Note 10 to the consolidated financial statements for additional information regarding the accounting for pensions.Market conditions and interest rates significantly affect the future assets and liabilities of the plan. It is difficult to predict future pension costs, changes in pension liability and cash funding requirements due to the inherent uncertainty of market conditions.Revenue RecognitionEvergy recognizes revenue on the sale of electricity to customers over time as the service is provided in the amount it has the right to invoice. Revenues recorded include electric services provided but not yet billed by Evergy. Unbilled revenues are recorded for kWh usage in the period following the customers' billing cycle to the end of the month. This estimate is based on net system kWh usage less actual billed kWhs. Evergy's estimated unbilled kWhs are allocated and priced by regulatory jurisdiction across the rate classes based on actual billing rates. Evergy's unbilled revenue estimate is affected by factors including fluctuations in energy demand, weather, line losses and 40Table of Contents changes in the composition of customer classes. See Note 4 to the consolidated financial statements for the balance of unbilled receivables for Evergy as of December 31, 2020 and 2019.Regulatory Assets and LiabilitiesEvergy has recorded assets and liabilities on its consolidated balance sheets resulting from the effects of the ratemaking process, which would not otherwise be recorded under GAAP. Regulatory assets represent incurred costs that are probable of recovery from future revenues. Regulatory liabilities represent future reductions in revenues or refunds to customers.Management regularly assesses whether regulatory assets and liabilities are probable of future recovery or refund by considering factors such as decisions by the MPSC, KCC or FERC in Evergy's rate case filings; decisions in other regulatory proceedings, including decisions related to other companies that establish precedent on matters applicable to Evergy; and changes in laws and regulations. If recovery or refund of regulatory assets or liabilities is not approved by regulators or is no longer deemed probable, these regulatory assets or liabilities are recognized in the current period results of operations. Evergy's continued ability to meet the criteria for recording regulatory assets and liabilities may be affected in the future by restructuring and deregulation in the electric industry or changes in accounting rules. In the event that the criteria no longer applied to all or a portion of Evergy's operations, the related regulatory assets and liabilities would be written off unless an appropriate regulatory recovery mechanism were provided. Additionally, these factors could result in an impairment on utility plant assets. See Note 5 to the consolidated financial statements for additional information. Impairments of Assets and GoodwillLong-lived assets are required to be reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable as prescribed under GAAP.Accounting rules require goodwill to be tested for impairment annually and when an event occurs indicating the possibility that an impairment exists. The goodwill impairment test consists of comparing the fair value of a reporting unit to its carrying amount, including goodwill, to identify potential impairment. In the event that the carrying amount exceeds the fair value of the reporting unit, an impairment loss is recognized for the difference between the carrying amount of the reporting unit and its fair value. Evergy's consolidated operations are considered one reporting unit for assessment of impairment, as management assesses financial performance and allocates resources on a consolidated basis. The annual impairment test for the $2,336.6 million of goodwill from the Great Plains Energy and Evergy Kansas Central merger was conducted as of May 1, 2020. The fair value of the reporting unit substantially exceeded the carrying amount, including goodwill. As a result, there was no impairment of goodwill. The determination of fair value for the reporting unit consisted of two valuation techniques: an income approach consisting of a discounted cash flow analysis and a market approach consisting of a determination of reporting unit invested capital using a market multiple derived from the historical earnings before interest, income taxes, depreciation and amortization and market prices of the stock of peer companies. The results of the two techniques were evaluated and weighted to determine a point within the range that management considered representative of fair value for the reporting unit, which involves a significant amount of management judgment. The discounted cash flow analysis is most significantly impacted by two assumptions: estimated future cash flows and the discount rate applied to those cash flows. Management determines the appropriate discount rate to be based on the reporting unit's weighted average cost of capital (WACC). The WACC takes into account both the return on equity authorized by the KCC and MPSC and after-tax cost of debt. Estimated future cash flows are based on Evergy's internal business plan, which assumes the occurrence of certain events in the future, such as the outcome of future rate filings, future approved rates of return on equity, anticipated returns of and earnings on future capital investments, continued recovery of cost of service and the renewal of certain contracts. Management also makes assumptions regarding the run rate of operations, maintenance and general and administrative costs based on the expected outcome of the aforementioned events. Should the actual outcome of some or all of these assumptions differ significantly from the current assumptions, revisions to current cash flow assumptions could cause the fair 41Table of Contents value of the Evergy reporting unit under the income approach to be significantly different in future periods and could result in a future impairment charge to goodwill. The market approach analysis is most significantly impacted by management's selection of relevant peer companies as well as the determination of an appropriate control premium to be added to the calculated invested capital of the reporting unit, as control premiums associated with a controlling interest are not reflected in the quoted market price of a single share of stock. Management determines an appropriate control premium by using an average of control premiums for recent acquisitions in the industry. Changes in results of peer companies, selection of different peer companies and future acquisitions with significantly different control premiums could result in a significantly different fair value of the Evergy reporting unit.Income TaxesIncome taxes are accounted for using the asset/liability approach. Deferred tax assets and liabilities are determined based on the temporary differences between the financial reporting and tax bases of assets and liabilities, applying enacted statutory tax rates in effect for the year in which the differences are expected to reverse. Deferred investment tax credits are amortized ratably over the life of the related property. Deferred tax assets are also recorded for net operating losses, capital losses and tax credit carryforwards. Evergy is required to estimate the amount of taxes payable or refundable for the current year and the deferred tax liabilities and assets for future tax consequences of events reflected in Evergy's consolidated financial statements or tax returns. Actual results could differ from these estimates for a variety of reasons including changes in income tax laws, enacted tax rates and results of audits by taxing authorities. This process also requires management to make assessments regarding the timing and probability of the ultimate tax impact from which actual results may differ. Evergy records valuation allowances on deferred tax assets if it is determined that it is more likely than not that the asset will not be realized. See Note 20 to the consolidated financial statements for additional information.Asset Retirement ObligationsEvergy has recognized legal obligations associated with the disposal of long-lived assets that result from the acquisition, construction, development or normal operation of such assets. Concurrent with the recognition of the liability, the estimated cost of the ARO incurred at the time the related long-lived assets were either acquired, placed in service or when regulations establishing the obligation became effective is also recorded to property, plant and equipment, net on the consolidated balance sheets. The recording of AROs for regulated operations has no income statement impact due to the deferral of the adjustments through the establishment of a regulatory asset or an offset to a regulatory liability.Evergy initially recorded AROs at fair value for the estimated cost to decommission Wolf Creek (94% indirect share), retire wind generating facilities, dispose of asbestos insulating material at its power plants, remediate ash disposal ponds and close ash landfills, among other items. ARO refers to a legal obligation to perform an asset retirement activity in which the timing and/or method of settlement may be conditional on a future event that may or may not be within the control of the entity. In determining Evergy's AROs, assumptions are made regarding probable future disposal costs and the timing of their occurrence. A change in these assumptions could have a significant impact on Evergy's AROs reflected on its consolidated balance sheets.As of December 31, 2020 and 2019, Evergy had recorded AROs of $941.9 million and $674.1 million, respectively. See Note 7 to the consolidated financial statements for more information regarding Evergy's AROs.EVERGY RESULTS OF OPERATIONS Evergy's results of operations and financial position are affected by a variety of factors including rate regulation, fuel costs, weather, customer behavior and demand, the economy and competitive forces. Substantially all of Evergy's revenues are subject to state or federal regulation. This regulation has a significant impact on the price the Evergy Companies charge for electric service. Evergy's results of operations and financial position are affected by its ability to align overall spending, both operating and capital, within the frameworks established by its regulators. 42Table of Contents Wholesale revenues are impacted by, among other factors, demand, cost and availability of fuel and purchased power, price volatility, available generation capacity, transmission availability and weather. The Evergy Companies primarily use coal and uranium for the generation of electricity for their customers and also purchase power through renewable power purchase agreements or on the open market. The prices for fuel used in generation or the market price of power purchases can fluctuate significantly due to a variety of factors including supply, demand, weather and the broader economic environment. Evergy Kansas Central, Evergy Metro and Evergy Missouri West have fuel recovery mechanisms in their Kansas and Missouri jurisdictions, as applicable, that allow them to defer and subsequently recover or refund, through customer rates, substantially all of the variance in net energy costs from the amount set in base rates without a general rate case proceeding. Weather significantly affects the amount of electricity that Evergy's customers use as electricity sales are seasonal. As summer peaking utilities, the third quarter typically accounts for the greatest electricity sales by the Evergy Companies. Hot summer temperatures and cold winter temperatures prompt more demand, especially among residential and commercial customers, and to a lesser extent, industrial customers. Mild weather reduces customer demand. Energy efficiency investments by customers and the Evergy Companies also can affect the demand for electric service. Through the Missouri Energy Efficiency Investment Act (MEEIA), Evergy Metro and Evergy Missouri West offer energy efficiency and demand side management programs to their Missouri retail customers and recover program costs, throughput disincentive, and as applicable, certain earnings opportunities in retail rates through a rider mechanism. The Evergy Companies' taxes other than income taxes, of which property taxes are a significant component, can fluctuate significantly due to a variety of factors, including changes in taxable values and property tax rates. Evergy Kansas Central and Evergy Metro's Kansas jurisdiction have property tax surcharges that allow them to defer and subsequently recover or refund, through customer rates, substantially all of the variance in property tax costs from the amounts set in base rates without a general rate case proceeding.See "Executive Summary - Impact of COVID-19" for information regarding the effects of COVID-19 on Evergy's results of operation and financial position. The following table summarizes Evergy's comparative results of operations.2020Change2019 (millions)Operating revenues$4,913.4 $(234.4)$5,147.8 Fuel and purchased power1,099.0 (166.0)1,265.0 SPP network transmission costs263.2 11.9 251.3 Operating and maintenance1,163.0 (55.5)1,218.5 Depreciation and amortization880.1 18.4 861.7 Taxes other than income tax364.2 (1.3)365.5 Income from operations1,143.9 (41.9)1,185.8 Other expense, net(36.1)2.9 (39.0)Interest expense383.9 9.9 374.0 Income tax expense102.2 5.2 97.0 Equity in earnings of equity method investees, net of income taxes8.3 (1.5)9.8 Net income630.0 (55.6)685.6 Less: Net income attributable to noncontrolling interests11.7 (4.0)15.7 Net income attributable to Evergy, Inc.$618.3 $(51.6)$669.9 43Table of Contents Evergy Utility Gross Margin and MWh SalesUtility gross margin is a financial measure that is not calculated in accordance with GAAP. Utility gross margin, as used by the Evergy Companies, is defined as operating revenues less fuel and purchased power costs and amounts billed by the SPP for network transmission costs. Expenses for fuel and purchased power costs, offset by wholesale sales margin, are subject to recovery through cost adjustment mechanisms. As a result, changes in fuel and purchased power costs are offset in operating revenues with minimal impact on net income. In addition, SPP network transmission costs fluctuate primarily due to investments by SPP members for upgrades to the transmission grid within the SPP RTO. As with fuel and purchased power costs, changes in SPP network transmission costs are mostly reflected in the prices charged to customers with minimal impact on net income. See Note 3 to the consolidated financial statements for additional information regarding the manner in which Evergy reflects SPP revenues and expenses.Management believes that utility gross margin provides a meaningful basis for evaluating the Evergy Companies' operations across periods because utility gross margin excludes the revenue effect of fluctuations in these expenses. Utility gross margin is used internally to measure performance against budget and in reports for management and the Evergy Board. Utility gross margin should be viewed as a supplement to, and not a substitute for, income from operations, which is the most directly comparable financial measure prepared in accordance with GAAP. The Evergy Companies' definition of utility gross margin may differ from similar terms used by other companies.The following table summarizes Evergy's utility gross margin and MWhs sold.Revenues and ExpensesMWhs SoldUtility Gross Margin2020Change20192020Change2019Retail revenues(millions)(thousands)Residential$1,909.2 $1.1 $1,908.1 15,483 (9)15,492 Commercial1,641.7 (139.9)1,781.6 16,995 (1,300)18,295 Industrial588.7 (32.9)621.6 8,243 (327)8,570 Other retail revenues38.5 (8.6)47.1 132 (7)139 Total electric retail4,178.1 (180.3)4,358.4 40,853 (1,643)42,496 Wholesale revenues264.0 (63.5)327.5 14,860 711 14,398 Transmission revenues318.5 9.3 309.2 N/AN/AN/AOther revenues152.8 0.1 152.7 N/AN/AN/AOperating revenues4,913.4 (234.4)5,147.8 55,713 (932)56,894 Fuel and purchased power(1,099.0)166.0 (1,265.0)SPP network transmission costs(263.2)(11.9)(251.3)Utility gross margin (a)3,551.2 (80.3)3,631.5 Operating and maintenance(1,163.0)55.5 (1,218.5)Depreciation and amortization(880.1)(18.4)(861.7)Taxes other than income tax(364.2)1.3 (365.5)Income from operations$1,143.9 $(41.9)$1,185.8 (a) Utility gross margin is a non-GAAP financial measure. See explanation of utility gross margin above.Evergy's utility gross margin decreased $80.3 million in 2020, compared to 2019, driven by:•a $71.4 million decrease primarily due to lower retail sales driven by unfavorable weather (cooling degree days decreased 5% and heating degree days decreased 11%) and a decrease in weather-normalized commercial and industrial demand primarily due to temporary business closures and hours of operation and capacity limitations resulting from government restrictions to slow the spread of COVID-19 in 2020, partially offset by an increase in weather-normalized residential demand;•a $14.4 million decrease in revenue recognized for the MEEIA earnings opportunity in 2020 related to the achievement of certain customer energy savings levels in the second cycle of Evergy Metro's and Evergy Missouri West's MEEIA programs; and44Table of Contents •a $5.9 million decrease related to Evergy Kansas Central's and Evergy Metro's transmission delivery charge (TDC) riders in 2020; partially offset by•a $7.6 million increase in Evergy Metro's and Evergy Missouri West's MEEIA throughput disincentive in 2020 primarily driven by the cumulative amount of customer energy savings achieved in the second and third cycles of Evergy Metro's and Evergy Missouri West's MEEIA programs; and•a $3.8 million increase for recovery of programs costs for energy efficiency programs under MEEIA in 2020, which have a direct offset in operating and maintenance expense.Operating and MaintenanceEvergy's operating and maintenance expense decreased $55.5 million in 2020, compared to 2019, primarily driven by:•a $44.2 million decrease in transmission and distribution operating and maintenance expense primarily due to $13.1 million of costs at Evergy Metro and Evergy Missouri West incurred from storms that occurred in January 2019, a $6.9 million decrease due to lower vegetation management expense at Evergy Kansas Central and Evergy Metro in 2020 and lower labor expense in 2020;•a $37.4 million decrease in various administrative and general operating and maintenance expenses primarily driven by:◦a $15.5 million decrease in labor and employee benefits expense that included lower employee headcount in 2020;◦an $8.9 million decrease in outside services expenses including lower consulting and legal fees at Evergy Kansas Central and Evergy Metro in 2020; and◦a $3.7 million decrease in property insurance expense due to a higher annual refund of nuclear insurance premiums received by Evergy Kansas Central and Evergy Metro in 2020 related to their ownership interest in Wolf Creek;•a $27.2 million decrease in plant operating and maintenance expense at fossil-fuel generating units primarily due to:◦a $14.5 million decrease at Evergy Metro driven by a $12.4 million decrease primarily due to outages at Hawthorn Station, Iatan Station and La Cygne Unit 2 as well as lower employee headcount in 2020; and◦a $8.3 million decrease at Evergy Kansas Central primarily due to an $8.4 million write-off of a regulatory asset for costs incurred during the Jeffrey Energy Center (JEC) lease extension in 2019, a $6.0 million decrease related to maintenance outages at JEC, La Cygne Unit 2 and Lawrence Energy Center as well as lower employee headcount in 2020; partially offset by a $3.9 million asset write-off in 2020; and•$12.1 million of external costs incurred to rebrand the legacy Westar Energy and KCP&L utility brands to Evergy in 2019; partially offset by•a $46.7 million increase in voluntary severance expenses due to a $39.3 million increase at Evergy Kansas Central, Evergy Metro and Evergy Missouri West related to Evergy voluntary exit programs in 2020 and $7.4 million of voluntary severance expenses incurred in 2020 by Evergy Kansas Central and Evergy Metro related to Wolf Creek voluntary exit programs;•$32.3 million of advisor expenses incurred in 2020 by Evergy associated with strategic planning; and•a $3.8 million increase in program costs for energy efficiency programs under MEEIA in 2020, which have a direct offset in revenue.45Table of Contents Depreciation and AmortizationEvergy's depreciation and amortization increased $18.4 million in 2020, compared to 2019, primarily driven by capital additions at Evergy Kansas Central and Evergy Metro.Other Expense, NetEvergy's other expense, net decreased $2.9 million in 2020, compared to 2019, primarily driven by:•a $15.0 million decrease due to higher Evergy Kansas Central and Evergy Metro equity allowance for funds used during construction (AFUDC) in 2020 primarily driven by lower short-term debt and higher construction work in progress balances in 2020; partially offset by •a $10.3 million increase due to recording lower Evergy Kansas Central corporate-owned life insurance (COLI) benefits in 2020; and•a $2.9 million increase primarily due to higher Evergy Metro pension non-service costs in 2020.Interest ExpenseEvergy's interest expense increased $9.9 million in 2020, compared to 2019, primarily driven by:•a $35.3 million increase due to the issuance of Evergy's $1.6 billion of senior notes in September 2019; •a $6.6 million net increase due to the issuance of Evergy Kansas Central's $500.0 million of 3.45% first mortgage bonds (FMBs) in April 2020, which increased interest expense by $12.6 million, partially offset by a $6.0 million decrease due to the repayment of Evergy Kansas Central's $250.0 million of 5.10% FMBs in May 2020; and•a $5.4 million increase due to the issuance of Evergy Metro's $400.0 million of 2.25% Mortgage Bonds in May 2020; partially offset by•a $29.5 million decrease primarily due to Evergy's borrowings under its $1.0 billion term loan credit agreement in 2019 and lower commercial paper balances and weighted-average interest rates on short-term borrowings at Evergy Kansas Central and Evergy Metro in 2020; •a $4.6 million net decrease due to the repayment of Evergy Metro's $400.0 million of 7.15% Mortgage Bonds at maturity in April 2019, which decreased interest expense by $8.5 million, partially offset by a $3.9 million increase due to Evergy Metro's issuance of $400.0 million of 4.125% Mortgage Bonds in March 2019; and•a $3.1 million net decrease due to the repayment of Evergy Kansas South's $300.0 million of 6.70% FMBs at maturity in June 2019, which decreased interest expense by $9.2 million, partially offset by a $6.1 million increase due to the issuance of Evergy Kansas Central's $300.0 million of 3.25% FMBs in August 2019.Income Tax ExpenseEvergy's income tax expense increased $5.2 million in 2020, compared to 2019, driven by a $13.8 million net increase due to the revaluation of deferred income tax assets and liabilities in the second quarter of 2020 due to the change in the Kansas corporate income tax rate, a $5.8 million valuation allowance reversal in 2019 primarily related to alternative minimum tax (AMT) credits and the expiration of certain state NOL carryforwards and a $3.9 million increase due to lower wind and other income tax credits in 2020; partially offset by a $13.3 million decrease due to lower Evergy pre-tax income in 2020 and a $5.1 million decrease due to flow-through items primarily driven by higher amortization of excess deferred income taxes.See Note 20 to the consolidated financial statements for more information regarding the change in the Kansas corporate income tax rate.EVERGY SIGNIFICANT BALANCE SHEET CHANGES(December 31, 2020 compared to December 31, 2019)•Evergy's cash and cash equivalents increased $121.7 million primarily due to proceeds from the issuance of Evergy Metro's $400.0 million of 2.25% Mortgage Bonds in May 2020 and the issuance of Evergy 46Table of Contents Kansas Central's $500.0 million of 3.45% FMBs in April 2020 after the redemption of Evergy Kansas Central's $250.0 million of 5.10% FMBs in May 2020 and the repayment of certain short-term borrowings.•Evergy's income tax receivable decreased by $22.6 million primarily due to Evergy's receipt of a federal AMT tax credit refund in the third quarter of 2020.•Evergy's current maturities of long-term debt increased $185.3 million primarily due to the reclassification of Evergy's $350.0 million of 4.85% Senior Notes and Evergy Missouri West's $80.9 million of 8.27% Senior Notes from long-term to current, partially offset by the repayment of Evergy Kansas Central's $250.0 million of 5.10% FMBs in May 2020.•Evergy's notes payable and commercial paper decreased $246.9 million primarily due to a $199.2 million decrease at Evergy Kansas Central and a $199.3 million decrease at Evergy Metro due to the repayment of short-term borrowings with funds from operations and with the issuance of Evergy Kansas Central's $500.0 million of 3.45% FMBs in April 2020 and Evergy Metro's $400.0 million of 2.25% Mortgage Bonds in May 2020, partially offset by a $180.0 million increase at Evergy, Inc. due to cash borrowings under its master credit facility.•Evergy's accounts payable increased $125.2 million primarily due to the timing of cash payments, including for property tax payments, at Evergy Kansas Central and Evergy Metro.•Evergy's regulatory liabilities - current decreased $37.2 million primarily due to a $30.2 million decrease in Evergy Kansas Central's regulatory liability for its fuel recovery mechanism due to refunds exceeding over-collections. •Evergy's asset retirement obligations - current decreased $31.1 million primarily due to settlements incurred in 2020 and the expected timing of remediation at several Evergy Kansas Central and Evergy Metro ash ponds.•Evergy's unamortized investment tax credits decreased $188.7 million primarily due to the revaluation of certain Kansas income tax credits due to the exemption of Evergy Kansas Central from Kansas corporate income tax beginning in 2021. See Note 20 to the consolidated financial statements for additional information. •Evergy's asset retirement obligation - long-term increased $298.9 million primarily due to a $259.1 million increase due to the change in estimate of Evergy's ARO relating to the decommissioning of Wolf Creek. LIQUIDITY AND CAPITAL RESOURCES Evergy relies primarily upon cash from operations, short-term borrowings, debt and equity issuances and its existing cash and cash equivalents to fund its capital requirements. Evergy's capital requirements primarily consist of capital expenditures, payment of contractual obligations and other commitments and the payment of dividends to shareholders.Capital SourcesCash Flows from OperationsEvergy's cash flows from operations are driven by the regulated sale of electricity. These cash flows are relatively stable but the timing and level of these cash flows can vary based on weather and economic conditions, future regulatory proceedings, the timing of cash payments made for costs recoverable under regulatory mechanisms and the time such costs are recovered, and unanticipated expenses such as unplanned plant outages and storms.Short-Term BorrowingsAs of December 31, 2020, Evergy had $2.2 billion of available borrowing capacity from its master credit facility. The available borrowing capacity under the master credit facility consisted of $249.3 million for Evergy, Inc., $933.0 million for Evergy Kansas Central, $600.0 million for Evergy Metro and $383.0 million for Evergy Missouri West. Evergy Kansas Central's, Evergy Metro's and Evergy Missouri West's borrowing capacity under the master 47Table of Contents credit facility also supports their issuance of commercial paper. See Note 12 to the consolidated financial statements for more information regarding the master credit facility. Along with cash flows from operations and receivable sales facilities, Evergy generally uses borrowings under its master credit facility and the issuance of commercial paper to meet its day-to-day cash flow requirements. Long-Term Debt and Equity IssuancesFrom time to time, Evergy issues long-term debt and equity to repay short-term debt, refinance maturing long-term debt and finance growth. As of December 31, 2020 and 2019, Evergy’s capital structure, excluding short-term debt, was as follows:December 3120202019Common equity47%49%Long-term debt, including VIEs53%51%Under stipulations with the MPSC and KCC, Evergy, Evergy Kansas Central and Evergy Metro are required to maintain common equity at not less than 35%, 40% and 40%, respectively, of total capitalization. The master credit facility and certain debt instruments of the Evergy Companies also contain restrictions that require the maintenance of certain capitalization and leverage ratios. As of December 31, 2020, the Evergy Companies were in compliance with these covenants.Significant Debt IssuancesSee Note 13 to the consolidated financial statements for information regarding significant debt issuances.Equity IssuanceSee Note 18 to the consolidated financial statements for information regarding Evergy's securities purchase agreement with Bluescape to purchase Evergy's common stock in 2021.Credit RatingsThe ratings of the Evergy Companies' debt securities by the credit rating agencies impact the Evergy Companies' liquidity, including the cost of borrowings under their master credit facility and in the capital markets. The Evergy Companies view maintenance of strong credit ratings as vital to their access to and cost of debt financing and, to that end, maintain an active and ongoing dialogue with the agencies with respect to results of operations, financial position and future prospects. While a decrease in these credit ratings would not cause any acceleration of the Evergy Companies' debt, it could increase interest charges under the master credit facility. A decrease in credit ratings could also have, among other things, an adverse impact, which could be material, on the Evergy Companies' access to capital, the cost of funds, the ability to recover actual interest costs in state regulatory proceedings, the type and amounts of collateral required under supply agreements and Evergy's ability to provide credit support for its subsidiaries. 48Table of Contents As of February 25, 2021, the major credit rating agencies rated the Evergy Companies' securities as detailed in the following table.Moody'sS&P GlobalInvestors Service(a)Ratings(a)EvergyOutlookStableStableCorporate Credit Rating--A-Senior Unsecured DebtBaa2BBB+Short-Term Rating--A-2Evergy Kansas CentralOutlookStableStableCorporate Credit RatingBaa1A-Senior Secured DebtA2ACommercial PaperP-2A-2Evergy Kansas SouthOutlookStableStableCorporate Credit RatingBaa1A-Senior Secured Debt--AShort-Term RatingP-2A-2Evergy MetroOutlookStableStableCorporate Credit RatingBaa1ASenior Secured DebtA2A+Senior Unsecured Debt--ACommercial PaperP-2A-1Evergy Missouri WestOutlookStableStableCorporate Credit RatingBaa2A-Senior Unsecured Debt Baa2A-Commercial Paper P-2--(a)A securities rating is not a recommendation to buy, sell or hold securities and may be subject to revision or withdrawal at any time by the assigning rating agency.Shelf Registration Statements and Regulatory AuthorizationsEvergyIn November 2018, Evergy filed an automatic shelf registration statement providing for the sale of unlimited amounts of securities with the SEC, which expires in November 2021.Evergy Kansas CentralIn November 2018, Evergy Kansas Central filed an automatic shelf registration statement providing for the sale of unlimited amounts of unsecured debt securities and FMBs with the SEC, which expires in November 2021.Evergy MetroIn November 2018, Evergy Metro filed an automatic shelf registration statement providing for the sale of unlimited amounts of unsecured notes and mortgage bonds with the SEC, which expires in November 2021.49Table of Contents The following table summarizes the regulatory short-term and long-term debt financing authorizations for Evergy Kansas Central, Evergy Kansas South, Evergy Metro and Evergy Missouri West and the remaining amount available under these authorizations as of December 31, 2020.Type of AuthorizationCommissionExpiration DateAuthorization AmountAvailable Under AuthorizationEvergy Kansas Central & Evergy Kansas South(in millions)Short-Term DebtFERCDecember 2022$1,250.0$1,200.0Evergy MetroShort-Term DebtFERCDecember 2022$1,250.0$1,250.0Evergy Missouri WestShort-Term DebtFERCDecember 2022$750.0$585.0Long-Term Debt(a)FERCFebruary 2023$1,000.0$1,000.0(a) Evergy Missouri West's application for long-term debt authority with FERC was approved in February 2021.In addition to the above regulatory authorizations, the Evergy Kansas Central, Evergy Kansas South and Evergy Metro mortgages each contain provisions restricting the amount of FMBs or mortgage bonds, as applicable, that can be issued by each entity. Evergy Kansas Central, Evergy Kansas South and Evergy Metro must comply with these restrictions prior to the issuance of additional FMBs, mortgage bonds or other secured indebtedness.Under the Evergy Kansas Central mortgage, the issuance of FMBs is subject to limitations based on the amount of bondable property additions. In addition, so long as any bonds issued prior to January 1, 1997, remain outstanding, the mortgage prohibits additional FMBs from being issued, except in connection with certain refundings, unless Evergy Kansas Central’s unconsolidated net earnings available for interest, depreciation and property retirement (which, as defined, does not include earnings or losses attributable to the ownership of securities of subsidiaries), for a period of 12 consecutive months within 15 months preceding the issuance, are not less than the greater of twice the annual interest charges on or 10% of the principal amount of all FMBs outstanding after giving effect to the proposed issuance. As of December 31, 2020, $780.6 million principal amount of additional FMBs could be issued under the most restrictive provisions in the mortgage, except in connection with certain refundings.Under the Evergy Kansas South mortgage, the amount of FMBs authorized is limited to a maximum of $3.5 billion and the issuance of FMBs is subject to limitations based on the amount of bondable property additions. In addition, the mortgage prohibits additional FMBs from being issued, except in connection with certain refundings, unless Evergy Kansas South's net earnings before income taxes and before provision for retirement and depreciation of property for a period of 12 consecutive months within 15 months preceding the issuance are not less than either two and one-half times the annual interest charges on or 10% of the principal amount of all Evergy Kansas South FMBs outstanding after giving effect to the proposed issuance. As of December 31, 2020, approximately $2,828.6 million principal amount of additional Evergy Kansas South FMBs could be issued under the most restrictive provisions in the mortgage, except in connection with certain refundings.Under the General Mortgage Indenture and Deed of Trust dated as of December 1, 1986, as supplemented (Evergy Metro Mortgage Indenture), additional Evergy Metro mortgage bonds may be issued on the basis of 75% of property additions or retired bonds. As of December 31, 2020, approximately $4,733.1 million principal amount of additional Evergy Metro mortgage bonds could be issued under the most restrictive provisions in the mortgage.Cash and Cash EquivalentsAt December 31, 2020, Evergy had approximately $144.9 million of cash and cash equivalents on hand.50Table of Contents Capital RequirementsCapital ExpendituresEvergy requires significant capital investments and expects to need cash for the STP as well as other utility construction programs designed to improve and expand facilities related to providing electric service, which include, but are not limited to, expenditures to develop new transmission lines and improvements to power plants, transmission and distribution lines and equipment. See "Executive Summary - Strategy", above for further information regarding the STP. Evergy's capital expenditures were $1,560.3 million, $1,210.1 million and $1,069.7 million in 2020, 2019 and 2018, respectively.Capital expenditures projected for the next five years, excluding AFUDC and including costs of removal, are detailed in the following table. This capital expenditure plan is subject to continual review and change.20212022202320242025(millions)Generating facilities - new renewable generation$— $— $337.0 $338.0 $— Generating facilities - other319.0 306.0 264.0 186.0 236.0 Transmission facilities629.0 590.0 567.0 513.0 734.0 Distribution facilities648.0 656.0 481.0 487.0 624.0 General facilities284.0 283.0 248.0 214.0 256.0 Total capital expenditures$1,880.0 $1,835.0 $1,897.0 $1,738.0 $1,850.0 Contractual Obligations and Other CommitmentsIn the course of its business activities, the Evergy Companies enter into a variety of contracts and commercial commitments. Some of these result in direct obligations reflected on Evergy's consolidated balance sheets while others are commitments, some firm and some based on uncertainties, not reflected in Evergy's underlying consolidated financial statements. The information in the following table is provided to summarize Evergy's cash obligations and commercial commitments.Payment due by period20212022202320242025After 2025TotalLong-term debt(millions)Principal$432.0 $387.5 $439.5 $800.0 $636.0 $6,906.8 $9,601.8 Interest350.2 327.1 311.9 302.6 282.6 4,201.3 5,775.7 Long-term debt of VIEsPrincipal18.8 — — — — — 18.8 Interest0.2 — — — — — 0.2 Lease commitmentsOperating leases18.5 15.3 12.2 10.4 7.9 37.3 101.6 Finance leases8.8 7.3 6.6 5.3 4.6 42.4 75.0 Pension and other post-retirement plans (a)135.7 135.7 135.7 135.7 135.7 (a)678.5 Purchase commitmentsFuel311.2 118.3 134.6 97.6 88.4 94.0 844.1 Power62.4 62.6 63.2 57.6 58.0 349.7 653.5 Other135.4 25.7 19.3 23.6 21.9 86.0 311.9 Total contractual commitments (a)$1,473.2 $1,079.5 $1,123.0 $1,432.8 $1,235.1 $11,717.5 $18,061.1 (a) Evergy expects to make contributions to the pension and other post-retirement plans beyond 2025 but the amounts are not yet determined. Long-term debt includes current maturities. Long-term debt principal excludes $84.9 million of unamortized net discounts and debt issuance costs and a $110.4 million fair value adjustment recorded in connection with purchase 51Table of Contents accounting for the Great Plains Energy and Evergy Kansas Central merger that was completed in June 2018. Variable rate interest obligations are based on rates as of December 31, 2020. Operating lease commitments include leases for office buildings, computer equipment, operating facilities, vehicles and rail cars to serve jointly-owned generating units where Evergy Kansas Central or Evergy Metro is the managing partner and is reimbursed by other joint-owners for its proportionate share of the cost. Finance lease commitments include obligations for both principal and interest.Evergy expects to contribute $135.7 million to the pension and other post-retirement plans in 2021, of which the majority is expected to be paid by Evergy Kansas Central and Evergy Metro. Additional contributions to the plans are expected beyond 2025 in amounts at least sufficient to meet the greater of Employee Retirement Income Security Act of 1974, as amended (ERISA) or regulatory funding requirements; however, these amounts have not yet been determined. Amounts for years after 2021 are estimates based on information available in determining the amount for 2021. Actual amounts for years after 2021 could be significantly different than the estimated amounts in the table above.Fuel commitments consist of commitments for nuclear fuel, coal and coal transportation costs. Power commitments consist of certain commitments for renewable energy under power purchase agreements, capacity purchases and firm transmission service. Other represents individual commitments entered into in the ordinary course of business.Evergy has other insignificant long-term liabilities recorded on its consolidated balance sheet at December 31, 2020, which do not have a definitive cash payout date and are not included in the table above.Common Stock DividendsThe amount and timing of dividends payable on Evergy's common stock are within the sole discretion of the Evergy Board. The amount and timing of dividends declared by the Evergy Board will be dependent on considerations such as Evergy's earnings, financial position, cash flows, capitalization ratios, regulation, reinvestment opportunities and debt covenants. Evergy targets a long-term dividend payout ratio of 60% to 70% of earnings. See Note 1 to the consolidated financial statements for information on the common stock dividend declared by the Evergy Board in February 2021.The Evergy Companies also have certain restrictions stemming from statutory requirements, corporate organizational documents, covenants and other conditions that could affect dividend levels. See Note 18 to the consolidated financial statements for further discussion of restrictions on dividend payments.Off-Balance Sheet ArrangementsIn the ordinary course of business, Evergy and certain of its subsidiaries enter into various agreements providing financial or performance assurance to third parties on behalf of certain subsidiaries. Such agreements include, for example, guarantees and letters of credit. These agreements are entered into primarily to support or enhance the creditworthiness otherwise attributed to a subsidiary on a stand-alone basis, thereby facilitating the extension of sufficient credit to accomplish the subsidiary's intended business purposes. The majority of these agreements guarantee Evergy's own future performance, so a liability for the fair value of the obligation is not recorded.At December 31, 2020, Evergy has provided $140.0 million of credit support for certain of its subsidiaries as follows:•Evergy direct guarantees to Evergy Kansas Central and Evergy Metro counterparties for certain fuel supply contracts totaling $48.0 million, which expire in 2027; and•Evergy's guarantee of Evergy Missouri West long-term debt totaling $92.0 million, which includes debt with maturity dates ranging from 2021 to 2023.Evergy has also guaranteed Evergy Missouri West's short-term debt, including its commercial paper program. At December 31, 2020, Evergy Missouri West had $65.0 million of commercial paper outstanding. None of the 52Table of Contents guaranteed obligations are subject to default or prepayment if Evergy Missouri West's credit ratings were downgraded.The Evergy Companies also have off-balance sheet arrangements in the form of letters of credit entered into in the ordinary course of business. Cash FlowsThe following table presents Evergy's cash flows from operating, investing and financing activities. 20202019(millions)Cash flows from operating activities$1,753.8 $1,749.0 Cash flows from (used in) investing activities(1,533.7)(1,080.3)Cash flows used in financing activities(98.4)(805.8)Cash Flows from Operating ActivitiesEvergy's cash flows from operating activities increased $4.8 million in 2020 compared to 2019 primarily driven by:•a $99.5 million increase due to the the timing of cash payments made to taxing authorities for property tax payments as well as various suppliers and other service providers for goods and services purchased in the ordinary course of business;•a $64.3 million one-time refund made to certain Evergy Metro and Evergy Missouri West customers in 2019 reflecting customer benefits associated with the Tax Cuts and Jobs Act;•a $41.3 million increase in cash receipts for net tax refunds in 2020 primarily driven by a $57.2 million increase in refunds related to federal AMT credits;•$34.6 million in payments made for a Wolf Creek refueling outage in 2019; and •an $8.8 million decrease in payments made for rebranding costs in 2020 related to rebranding the legacy Westar Energy and KCP&L utility brands to Evergy in 2019; partially offset by•a $185.6 million decrease in cash receipts for retail electric sales in 2020 primarily driven by lower retail sales as a result of unfavorable weather and a decrease in weather-normalized commercial and industrial demand primarily due to temporary business closures and hours of operation and capacity limitations resulting from government restrictions to slow the spread of COVID-19 in 2020;•a $38.1 million increase in interest payments in 2020 primarily due to payments made in March and September of 2020 on Evergy's $1.6 billion of senior notes issued in September 2019; and •$27.6 million in cash payments to advisors associated with strategic planning in 2020.Cash Flows used in Investing ActivitiesEvergy's cash flows used in investing activities increased $453.4 million in 2020 compared to 2019 primarily driven by:•a $350.2 million increase in additions to property, plant and equipment due to increases at Evergy Kansas Central, Evergy Metro and Evergy Missouri West of $122.9 million, $120.4 million and $107.0 million, respectively, primarily due to increased spending for a variety of capital projects including transmission infrastructure additions, customer meters and a customer billing system; and•a decrease of $95.8 million in proceeds from COLI investments, primarily from Evergy Kansas Central due to a higher number of policy settlements in 2019.53Table of Contents Cash Flows used in Financing ActivitiesEvergy's cash flows used in financing activities decreased $707.4 million in 2020 compared to 2019 primarily driven by:•$1,628.7 million of common stock repurchased as a result of Evergy's share repurchase program in 2019;•a $450.0 million decrease in retirements of long-term debt, net due to Evergy Metro's repayment of $400.0 million of 7.15% Mortgage Bonds in April 2019 and Evergy Kansas South's repayment of its $300.0 million of 6.70% FMBs in June 2019; partially offset by Evergy Kansas Central's repayment of its $250.0 million of 5.10% FMBs in May 2020;•a $72.7 million decrease in the repayment of borrowings against cash surrender value of corporate-owned life insurance primarily due to a higher number of policy settlements in 2019; and•a $69.8 million payment for the settlement of an interest rate swap accounted for as a cash flow hedge of Evergy's $800.0 million of 2.90% Senior Notes issued in September 2019; partially offset by•a $1,483.9 million decrease in proceeds from long-term debt, net primarily due to Evergy's issuance of $800.0 million of 2.45% Senior Notes and $800.0 million of 2.90% Senior Notes in September 2019.EVERGY KANSAS CENTRAL, INC.MANAGEMENT'S NARRATIVE ANALYSIS OF RESULTS OF OPERATIONSThe below results of operations and related discussion for Evergy Kansas Central is presented in a reduced disclosure format in accordance with General Instruction (I)(2)(a) to Form 10-K.The following table summarizes Evergy Kansas Central's comparative results of operations. 2020Change2019 (millions)Operating revenues$2,418.1 $(89.3)$2,507.4 Fuel and purchased power427.6 (65.4)493.0 SPP network transmission costs263.2 11.9 251.3 Operating and maintenance513.6 (16.9)530.5 Depreciation and amortization453.1 9.3 443.8 Taxes other than income tax193.3 1.0 192.3 Income from operations567.3 (29.2)596.5 Other expense, net(12.7)0.2 (12.9)Interest expense167.6 (9.4)177.0 Income tax expense155.8 103.7 52.1 Equity in earnings of equity method investees, net of income taxes4.6 — 4.6 Net income235.8 (123.3)359.1 Less: Net income attributable to noncontrolling interests11.7 (4.0)15.7 Net income attributable to Evergy Kansas Central, Inc.$224.1 $(119.3)$343.4 54Table of Contents Evergy Kansas Central Utility Gross Margin and MWh SalesThe following table summarizes Evergy Kansas Central's utility gross margin and MWhs sold. Revenues and ExpensesMWhs Sold2020Change20192020Change2019Retail revenues(millions)(thousands)Residential$801.2 $7.3 $793.9 6,491 31 6,460 Commercial665.6 (43.5)709.1 6,875 (524)7,399 Industrial379.9 (21.4)401.3 5,242 (380)5,622 Other retail revenues17.7 (3.3)21.0 41 (4)45 Total electric retail1,864.4 (60.9)1,925.3 18,649 (877)19,526 Wholesale revenues215.4 (24.5)239.9 7,851 311 7,540 Transmission revenues287.3 14.0 273.3 N/AN/AN/AOther revenues51.0 (17.9)68.9 N/AN/AN/AOperating revenues2,418.1 (89.3)2,507.4 26,500 (566)27,066 Fuel and purchased power(427.6)65.4 (493.0)SPP network transmission costs(263.2)(11.9)(251.3)Utility gross margin (a)1,727.3 (35.8)1,763.1 Operating and maintenance(513.6)16.9 (530.5)Depreciation and amortization(453.1)(9.3)(443.8)Taxes other than income tax(193.3)(1.0)(192.3)Income from operations$567.3 $(29.2)$596.5 (a)Utility gross margin is a non-GAAP financial measure. See explanation of utility gross margin under Evergy's Results of Operations.Evergy Kansas Central's utility gross margin decreased $35.8 million in 2020, compared to 2019, driven by: •a $27.2 million decrease primarily due to lower retail sales driven by unfavorable weather (cooling degree days decreased 5% and heating degree days decreased 10%) and a decrease in weather-normalized commercial and industrial demand primarily due to temporary business closures and hours of operation and capacity limitations resulting from government restrictions to slow the spread of COVID-19 in 2020, partially offset by an increase in weather-normalized residential demand; and•an $8.6 million decrease related to Evergy Kansas Central's TDC rider in 2020.Evergy Kansas Central Operating and MaintenanceEvergy Kansas Central's operating and maintenance expense decreased $16.9 million in 2020, compared to 2019, primarily driven by: •a $13.6 million decrease in transmission and distribution operating and maintenance expense primarily due to lower labor expense in 2020 and a $3.4 million decrease due to lower vegetation management expense in 2020; •a $13.2 million decrease in various administrative and general operating and maintenance expenses primarily driven by a $15.4 million decrease in labor and employee benefits expense that included lower employee headcount in 2020 and a $1.9 million decrease in property insurance expense due to a higher annual refund of nuclear insurance premiums received by Evergy Kansas Central related to its indirect ownership interest in Wolf Creek; and•an $8.3 million decrease in plant operating and maintenance expense at fossil-fuel generating units primarily due to an $8.4 million write-off of a regulatory asset for costs incurred during the JEC lease extension in 2019, a $6.0 million decrease related to maintenance outages at JEC, La Cygne Unit 2 and Lawrence Energy Center as well as lower employee headcount in 2020; partially offset by a $3.9 million asset write-off in 2020; partially offset by55Table of Contents •a $22.8 million increase in voluntary severance expenses due to a $19.1 million increase related to Evergy voluntary exit programs in 2020 and $3.7 million of voluntary severance expenses incurred in 2020 related to Wolf Creek voluntary exit programs.Evergy Kansas Central Depreciation and AmortizationEvergy Kansas Central's depreciation and amortization expense increased $9.3 million in 2020, compared to 2019, primarily driven by capital additions. Evergy Kansas Central Interest ExpenseEvergy Kansas Central's interest expense decreased $9.4 million in 2020, compared to 2019, primarily driven by:•an $11.9 million decrease due to lower commercial paper balances and weighted-average interest rates on short-term borrowings in 2020; and•a $3.1 million net decrease due to the repayment of Evergy Kansas South's $300.0 million of 6.70% FMBs at maturity in June 2019, which decreased interest expense by $9.2 million, partially offset by a $6.1 million increase due to the issuance of Evergy Kansas Central's $300.0 million of 3.25% FMBs in August 2019; partially offset by•a $6.6 million net increase due to the issuance of Evergy Kansas Central's $500.0 million of 3.45% FMBs in April 2020, which increased interest expense by $12.6 million, partially offset by a $6.0 million decrease due to the repayment of Evergy Kansas Central's $250.0 million of 5.10% FMBs in May 2020.Evergy Kansas Central Income Tax ExpenseEvergy Kansas Central's income tax expense increased $103.7 million in 2020, compared to 2019, primarily driven by a $109.0 million net increase due to the revaluation of deferred income tax assets and liabilities in the second quarter of 2020 due to the change in the Kansas corporate income tax rate, partially offset by a $5.2 million decrease due to lower pre-tax income in 2020. See Note 20 to the consolidated financial statements for more information regarding the change in the Kansas corporate income tax rate.EVERGY METRO, INC.MANAGEMENT'S NARRATIVE ANALYSIS OF RESULTS OF OPERATIONSThe below results of operations and related discussion for Evergy Metro is presented in a reduced disclosure format in accordance with General Instruction (I)(2)(a) to Form 10-K.The following table summarizes Evergy Metro's comparative results of operations. 2020Change2019 (millions)Operating revenues$1,705.6 $(100.9)$1,806.5 Fuel and purchased power416.1 (66.0)482.1 Operating and maintenance407.5 (44.4)451.9 Depreciation and amortization326.1 7.7 318.4 Taxes other than income tax121.6 (6.0)127.6 Income from operations434.3 7.8 426.5 Other expense, net(14.9)0.9 (15.8)Interest expense113.6 (6.2)119.8 Income tax expense7.1 (28.6)35.7 Net income$298.7 $43.5 $255.2 56Table of Contents Evergy Metro Utility Gross Margin and MWh SalesThe following table summarizes Evergy Metro's utility gross margin and MWhs sold. Revenues and ExpensesMWhs Sold2020Change20192020Change2019Retail revenues(millions)(thousands)Residential$714.7 2.3 $712.4 5,430 5 5,425 Commercial717.1 (69.0)786.1 7,028 (595)7,623 Industrial128.8 (8.1)136.9 1,695 (18)1,713 Other retail revenues11.7 (4.6)16.3 71 (4)75 Total electric retail1,572.3 (79.4)1,651.7 14,224 (612)14,836 Wholesale revenues35.0 (35.9)70.9 5,957 (141)6,098 Transmission revenues13.9 (3.6)17.5 N/AN/AN/AOther revenues84.4 18.0 66.4 N/AN/AN/AOperating revenues1,705.6 (100.9)1,806.5 20,181 (753)20,934 Fuel and purchased power(416.1)66.0 (482.1)Utility gross margin (a)1,289.5 (34.9)1,324.4 Operating and maintenance(407.5)44.4 (451.9)Depreciation and amortization(326.1)(7.7)(318.4)Taxes other than income tax (121.6)6.0 (127.6)Income from operations$434.3 $42.7 $426.5 (a) Utility gross margin is a non-GAAP financial measure. See explanation of utility gross margin under Evergy's Results of Operations.Evergy Metro's utility gross margin decreased $34.9 million in 2020, compared to 2019, driven by:•a $35.4 million decrease primarily due to lower retail sales driven by unfavorable weather (cooling degree days decreased 5% and heating degree days decreased 12%) and a decrease in weather-normalized commercial and industrial demand primarily due to temporary business closures and hours of operation and capacity limitations resulting from government restrictions to slow the spread of COVID-19 in 2020, partially offset by an increase in weather-normalized residential demand; and•a $6.4 million decrease in revenue recognized for the MEEIA earnings opportunity in 2020 related to the achievement of certain customer energy savings levels in the second cycle of Evergy Metro's MEEIA program; partially offset by•a $4.4 million increase in MEEIA throughput disincentive in 2020 primarily driven by the cumulative amount of customer energy savings achieved in the second and third cycles of Evergy Metro's MEEIA program; and•a $2.5 million increase for recovery of programs costs for energy efficiency programs under MEEIA, which have a direct offset in operating and maintenance expense. Evergy Metro Operating and MaintenanceEvergy Metro's operating and maintenance expense decreased $44.4 million in 2020, compared to 2019, primarily driven by:•a $26.7 million decrease in transmission and distribution operating and maintenance expense primarily due to $11.7 million of costs incurred from storms that occurred in January 2019, a $3.5 million decrease due to lower vegetation management expense in 2020 and lower labor expense in 2020;•a $14.0 million decrease in various administrative and general operating and maintenance expenses primarily due to a $4.7 million decrease in credit loss expense due to lower levels of customer disconnections in 2020, a $3.9 million decrease in outside services expenses including lower consulting and legal fees in 2020 and a $1.8 million decrease in property insurance expense due to a higher annual refund of nuclear insurance premiums received by Evergy Metro related to its ownership interest in Wolf Creek in the first quarter of 2020; and57Table of Contents •a $14.5 million decrease in plant operating and maintenance expense at fossil-fuel generating units driven by a $12.4 million decrease primarily due to outages at Hawthorn Station, Iatan Station and La Cygne Unit 2 as well as lower employee headcount in 2020; partially offset by•a $17.8 million increase in voluntary severance expenses due to a $14.1 million increase related to Evergy voluntary exit programs in 2020 and $3.7 million of voluntary severance expenses incurred in 2020 related to Wolf Creek voluntary exit programs; and•a $2.5 million increase in program costs for energy efficiency programs under MEEIA, which have a direct offset in revenue. Evergy Metro Depreciation and AmortizationEvergy Metro's depreciation and amortization increased $7.7 million in 2020, compared to 2019, primarily driven by capital additions.Evergy Metro Other Expense, NetEvergy Metro's other expense, net decreased $0.9 million in 2020, compared to the same period in 2019, primarily driven by:•a $5.8 million increase in equity AFUDC in 2020 primarily driven by lower short-term debt and higher construction work in progress balances in 2020; partially offset by•a $3.3 million increase in pension non-service costs in 2020. Evergy Metro Interest ExpenseEvergy Metro's interest expense decreased $6.2 million in 2020, compared to 2019, primarily driven by:•a $4.6 million net decrease due to the repayment of Evergy Metro's $400.0 million of 7.15% Mortgage Bonds at maturity in April 2019, which decreased interest expense by $8.5 million, partially offset by a $3.9 million increase due to Evergy Metro's issuance of $400.0 million of 4.125% Mortgage Bonds in March 2019; and•a $3.8 million decrease due to lower commercial paper balances and weighted-average interest rates on short-term borrowings in 2020; partially offset by•a $5.4 million increase due to the issuance of Evergy Metro's $400.0 million of 2.25% Mortgage Bonds in May 2020.Evergy Metro Income Tax ExpenseEvergy Metro's income tax expense decreased $28.6 million in 2020, compared to 2019, primarily driven by a $32.2 million net decrease due to the revaluation of deferred income tax assets and liabilities in the second quarter of 2020 due to the change in the Kansas corporate income tax rate, partially offset by a $3.9 million increase due to higher pre-tax income in 2020. See Note 20 to the consolidated financial statements for more information regarding the change in the Kansas corporate income tax rate.ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK In the ordinary course of business, Evergy faces risks that are either non-financial or non-quantifiable. Such risks principally include business, legal, operational and credit risks and are not represented in the following analysis. See Part I, Item 1A, Risk Factors and Part II, Item 7, MD&A for further discussion of risk factors.The Evergy Companies are exposed to market risks associated with commodity price and supply, interest rates and security prices. Commodity price risk is the potential adverse price impact related to the purchase or sale of electricity and energy-related products. Credit risk is the potential adverse financial impact resulting from non-performance by a counterparty of its contractual obligations. Interest rate risk is the potential adverse financial 58Table of Contents impact related to changes in interest rates. In addition, Evergy's investments in trusts to fund nuclear plant decommissioning and to fund non-qualified retirement benefits give rise to security price risk. Management has established risk management policies and strategies to reduce the potentially adverse effects that the volatility of the markets may have on Evergy's operating results. During the ordinary course of business, the Evergy Companies' hedging strategies are reviewed to determine the hedging approach deemed appropriate based upon the circumstances of each situation. Though management believes its risk management practices are effective, it is not possible to identify and eliminate all risk. Evergy could experience losses, which could have a material adverse effect on its results of operations or financial position, due to many factors, including unexpectedly large or rapid movements or disruptions in the energy markets, regulatory-driven market rule changes and/or bankruptcy or non-performance of customers or counterparties, and/or failure of underlying transactions that have been hedged to materialize.Hedging Strategies From time to time, Evergy utilizes derivative instruments to execute risk management and hedging strategies. Derivative instruments, such as futures, forward contracts, swaps or options, derive their value from underlying assets, indices, reference rates or a combination of these factors. These derivative instruments include negotiated contracts, which are referred to as over-the-counter derivatives, and instruments listed and traded on an exchange. Commodity Price RiskThe Evergy Companies engage in the wholesale and retail sale of electricity as part of their regulated electric operations in addition to limited energy marketing activities. These activities expose the Evergy Companies to risks associated with the price of electricity and other energy-related products. Exposure to these risks is affected by a number of factors including the quantity and availability of fuel used for generation and the quantity of electricity customers consume. Customers' electricity usage could also vary from year to year based on the weather or other factors. Quantities of fossil fuel used for generation vary from year to year based on the availability, price and deliverability of a given fuel type as well as planned and unplanned outages at facilities that use fossil fuels. Evergy's exposure to fluctuations in these factors is limited by the cost-based regulation of its regulated operations in Kansas and Missouri as these operations are typically allowed to recover substantially all of these costs through fuel recovery mechanisms. While there may be a delay in timing between when these costs are incurred and when they are recovered through rates, changes from year to year generally do not have a material impact on operating results.Interest Rate Risk Evergy manages interest rate risk and short- and long-term liquidity by limiting its exposure to variable interest rate debt to a percentage of total debt, diversifying maturity dates and, from time to time, entering into interest rate hedging transactions. At December 31, 2020, 3% of Evergy's long-term debt was variable rate debt. Evergy also has short-term borrowings and current maturities of fixed rate debt that are exposed to interest rate risk. Evergy computes and presents information regarding the sensitivity to changes in interest rates for variable rate debt and current maturities of fixed rate debt by assuming a 100-basis-point change in the current interest rates applicable to such debt over the remaining time the debt is outstanding.Evergy had $1,038.7 million of variable rate debt, including notes payable, commercial paper and current maturities of fixed rate debt as of December 31, 2020. A 100-basis-point change in interest rates applicable to this debt would impact income before income taxes on an annualized basis by approximately $6.2 million.Credit RiskEvergy is exposed to counterparty credit risk largely in the form of accounts receivable from its retail and wholesale electric customers and through executory contracts with market risk exposure. The credit risk associated with accounts receivable from retail and wholesale customers is largely mitigated by Evergy's large number of individual customers spread across diverse customer classes and the ability to recover bad debt expense in customer rates. The Evergy Companies maintain credit policies and employ credit risk control mechanisms, such as letters of credit, when necessary to minimize their overall credit risk and monitor exposure.59Table of Contents Investment RiskEvergy maintains trust funds, as required by the NRC, to fund its 94% share of decommissioning the Wolf Creek nuclear power plant and also maintains trusts to fund pension benefits as well as certain non-qualified retirement benefits. As of December 31, 2020, these funds were primarily invested in a diversified mix of equity and debt securities and reflected at fair value on Evergy's balance sheet. The equity securities in the trusts are exposed to price fluctuations in equity markets and the value of debt securities are exposed to changes in interest rates and other market factors. As nuclear decommissioning costs are currently recovered in customer rates, Evergy defers both realized and unrealized gains and losses for these securities as an offset to its regulatory liability for decommissioning Wolf Creek and as such, fluctuations in the value of these securities do not impact earnings. A significant decline in the value of pension or non-qualified retirement assets could require Evergy to increase funding of its pension plans in future periods, which could adversely affect cash flows in those periods. In addition, a decline in the fair value of these plan assets, in the absence of additional cash contributions to the plans by Evergy, could increase the amount of pension cost required to be recorded in future periods by Evergy.60Table of Contents
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+Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations'.24Table of ContentsFastenal Company Common Stock Comparative Performance GraphSet forth below is a graph comparing, for the five years ended December 31, 2020, the yearly cumulative total shareholder return on our common stock with the yearly cumulative total shareholder return of the S&P 500 Index and the Dow Jones US Industrial Suppliers Index. The comparison of total shareholder returns in the performance graph assumes that $100 was invested on December 31, 2015 in Fastenal Company, the S&P 500 Index, and the Dow Jones US Industrial Suppliers Index, and that dividends were reinvested when and as paid.Comparison of Five-Year Cumulative Total Return Among Fastenal Company, the S&P 500 Index, and the Dow Jones US Industrial Suppliers Index201520162017201820192020Fastenal Company$100.00118.51141.82139.60202.47276.51S&P 500 Index100.00111.96136.40130.42171.49203.04Dow Jones US Industrial Suppliers Index100.00122.84128.08124.99165.27208.95Note - The graph and index table above were obtained from Zacks SEC Compliance Services Group.ITEM 6.SELECTED FINANCIAL DATAIncorporated herein by reference is Ten-Year Selected Financial Data on pages 4 and 5 of Fastenal's 2020 Annual Report to Shareholders of which this Form 10-K forms a part, a portion of which is filed as Exhibit 13 to this annual report on Form 10-K.25Table of ContentsITEM 7.MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSThe following is management's discussion and analysis of certain significant factors which have affected our financial position and operating results during the periods included in the accompanying consolidated financial statements and should be read in conjunction with those consolidated financial statements. This section of this 10-K generally discusses 2020 and 2019 items and year-to-year comparisons between 2020 and 2019. Discussions of 2018 items and year-to-date comparisons between 2019 and 2018 that are not included in this Form 10-K, can be found in 'Management's Discussion and Analysis of Financial Condition and Results of Operations' in Part II, Item 7 of our annual report on Form 10-K for the fiscal year ended December 31, 2019.Business and Operational OverviewFastenal is a North American leader in the wholesale distribution of industrial and construction supplies. We distribute these supplies through a network of over 3,200 in-market locations. Most of our customers are in the manufacturing and non-residential construction markets. The manufacturing market includes sales of products for both original equipment manufacturing (OEM), where our products are consumed in the final products of our customers, and manufacturing, repair and operations (MRO), where are products are consumed to support the facilities and ongoing operations of our customers. The non-residential construction market includes general, electrical, plumbing, sheet metal, and road contractors. Other users of our products include farmers, truckers, railroads, oil exploration companies, oil production and refinement companies, mining companies, federal, state, and local governmental entities, schools, and certain retail trades. Geographically, our branches, Onsite locations, and customers are primarily located in North America.It is helpful to appreciate several aspects of our marketplace: (1) It's big. We estimate the North American marketplace for industrial supplies is in excess of $140 billion per year (and we have expanded beyond North America) and no company has a significant portion of this market. (2) Many of the products we sell are individually inexpensive, but the cost and time to manage, procure, and transport these products can be quite meaningful. (3) Purchasing professionals often expend disproportionate effort managing the high stock keeping unit (SKU) count of low-volume, low value MRO supplies which is better allocated to their higher volume, higher value OEM supplies. (4) Many customers prefer to reduce their number of suppliers to simplify their business, while also utilizing various technologies and models (including our local branches when they need something quickly or unexpectedly) to improve availability and reduce waste. (5) We believe the markets are efficient. To us, this means we can grow our market share if we provide the greatest value to our customer.Our approach to addressing these aspects of our marketplace is captured in our motto Growth through Customer Service. The concept of growth is simple: find more customers every day and increase our activity with them. However, execution is hard work. First, we recruit service-minded individuals to support our customers and their business. Second, we operate in a decentralized fashion to help identify the greatest value for our customers. Third, we have a great team behind our customer-facing resources to operate efficiently and to help identify new business solutions. Fourth, we strive to generate strong profits, which produce the cash flow necessary to fund our growth and to support the needs of our customers. Lastly, we identify drivers that allow us to get closer to our customers and gain market share. We believe our ability to grow is amplified if we can serve our customers at the closest economic point of contact. At one point, the closest economic point of contact was the local branch. Today, in many cases, we have moved the branch inside the customers' facility. We also are frequently positioned right at the point of consumption within customers' facilities through our suite of FMI devices and capabilities. Therefore, our focus centers on understanding our customers' day, their opportunities, and their obstacles. By doing these things every day, Fastenal remains a growth-centric organization.Impact of COVID-19 on Our BusinessIn the second quarter of 2020, the impacts of the COVID-19 pandemic on our business were dramatic in two respects. First, local and national actions taken, such as stay-at-home mandates, reduced business activity sharply as many customers either closed their locations or operated at significantly diminished capacity. This effect was illustrated in a significant decline in sales for our fastener products. Second, social actions taken to mitigate the effects of the pandemic produced significant demand for personal protection equipment (PPE) and sanitation products, generating significant sales of such products not only to certain traditional customers but also to state and local government entities as well as front line responders. This effect was illustrated by a significant increase in sales for our safety products. During that period, improved sales of PPE and sanitation products more than offset the general economic weakness. These dynamics affected our business throughout the second quarter of 2020, but the effects were greatest in April, with sequential improvements in May and June as business restrictions gradually eased.The pandemic continued to have a significant impact on our business in the third and fourth quarters of 2020. The marketplace broadly, and Fastenal specifically, continued to operate with certain modifications to balance re-opening with employee and customer safety. However, most of the markets in which we operate began to normalize in the second half of 2020. This improved the outlook of the manufacturing and construction customers that support our traditional branch and Onsite business and moderated the level of demand for PPE and sanitation products that we experienced at the onset of the pandemic. We 26Table of Contentsbelieve that the sequential gains in economic activity that we experienced in the latter part of the second quarter of 2020 continued through the third and fourth quarters of 2020, although the rate of improvement remains gradual.Consistent with broader social trends, we have taken steps to safeguard the health of our employees. This includes closing branch and corporate facilities to outside personnel, adjusting work schedules to maximize social distance, creating space between work areas, providing ample PPE and cleaning supplies, having formal policies for mitigation in the event of cases of illness, utilizing technologies where work duties allow to enable work from home capabilities, and utilizing technologies such as vending and mobility to create social distancing. Due to these precautions, our operations have continued to function effectively, including our internal controls over financial reporting.While there are exceptions, our customers have largely continued to operate their businesses despite a continued high rate of viral infections that exist as of this date, in contrast to the second quarter of 2020 when many temporarily suspended operations. Still, there remains significant uncertainty concerning the magnitude of the impact and duration of the COVID-19 pandemic. Factors deriving from the COVID-19 response that have or may negatively impact sales and gross margin in the future include, but are not limited to: limitations on the ability of our suppliers to manufacture, or procure from manufacturers, the products we sell, or to meet delivery requirements and commitments; limitations on the ability of our employees to perform their work due to illness caused by the pandemic or local, state, or federal orders requiring employees to remain at home; limitations on the ability of carriers to deliver our products to customers; limitations on the ability of our customers to conduct their business and purchase our products and services; and limitations on the ability of our customers to pay us on a timely basis. With respect to liquidity, as of the end of 2020, we have substantially all of our $700.0 bank revolver available for use in the event that the need arises.We will continue to actively monitor the situation and may take further actions that alter our business operations as may be required by federal, state, or local authorities or that we determine are in the best interests of our employees, customers, suppliers, and shareholders. While we are unable to determine or predict the nature, duration, or scope of the overall impact the COVID-19 pandemic will have on our business, results of operations, liquidity, or capital resources, we believe that it is important to share where our company stands today, how our response to COVID-19 is progressing, and how our operations and financial condition may change as the fight against COVID-19 progresses.Executive OverviewNet sales increased $313.7, or 5.9%, in 2020 relative to 2019. Our gross profit increased $52.3, or 2.1%, in 2020 relative to 2019, and as a percentage of net sales declined to 45.5% in 2020 from 47.2% in 2019. Our operating income increased $84.5, or 8.0%, in 2020 relative to 2019, and as a percentage of net sales increased to 20.2% in 2020 from 19.8% in 2019. Our net earnings in 2020 were $859.1, an increase of 8.6% when compared to 2019. Our diluted net earnings per share were $1.49 in 2020 compared to $1.38 in 2019, an increase of 8.4%.Although we continued to market our growth drivers in 2020, COVID-19 created an environment that was not conducive to the level of signings we would have expected under normal business conditions. At the same time, significant resources shifted to focus on rapidly and efficiently securing, transporting, and providing PPE to new and existing customers that found themselves managing short-term crisis conditions brought on by the pandemic. These dynamics produced signings of just 223 new Onsite customer locations and 16,417 new industrial vending devices in 2020. Those same dynamics also produced very strong daily sales growth of 51.0% in our safety product line and 129.7% from government and healthcare customers in the period, which more than offset the low growth driver signings and weak activity in our traditional manufacturing and construction customer base.27Table of ContentsThe table below summarizes our absolute and full-time equivalent (FTE; based on 40 hours per week) employee headcount, our investments in in-market locations (defined as the sum of the total number of public branch locations and the total number of active Onsite locations), and industrial vending devices at the end of the periods presented and the percentage change compared to the end of the prior period.Q42020Q42019Twelve-month% ChangeIn-market locations - absolute employee headcount12,680 13,977 -9.3 %In-market locations - FTE employee headcount11,260 12,236-8.0 %Total absolute employee headcount20,365 21,948 -7.2 %Total FTE employee headcount17,836 18,968-6.0 %Number of public branch locations2,003 2,114-5.3 %Number of active Onsite locations1,265 1,11413.6 %Number of in-market locations3,268 3,2281.2 %Ratio of in-market location FTE headcount to in-market locations3:14:1Industrial vending devices (installed count) (1)95,733 89,9376.4 %Ratio of industrial vending devices to in-market locations29:128:1(1) This number primarily represents devices which principally dispense product and produce product revenues, and excludes approximately 15,000 devices that are part of a locker lease program where the devices are principally used for the check-in/check-out of equipment.During the last twelve months, we reduced our total FTE employee headcount by 1,132. This reflects a decline in our in-market FTE employee headcount of 976, as well as declines in headcount at our distribution centers and manufacturing operations. These reductions are primarily related to efforts to manage expenses in response to weaker demand from traditional manufacturing and construction customers resulting from the COVID-19 pandemic. This was only partly offset by additions in non-branch selling and support roles. The latter most significantly reflects an increase in personnel in Information Technology, which includes the addition of employees from our acquisition of certain assets of Apex, as well as roles to support customer acquisition and implementation, particularly as it relates to our growth drivers and to support general corporate functions.We opened twelve branches and closed 123 branches, net of conversions, in 2020. We activated 257 Onsite locations and closed 106, net of conversions, in 2020. The number of closings reflects both normal churn in our business, whether due to redefining or exiting customer relationships, the shutting or relocation of a customer facility, or a customer decision, as well as our ongoing review of underperforming locations. Our in-market network forms the foundation of our business strategy, and we will continue to open or close locations as is deemed necessary to sustain and improve our network, support our growth drivers, and manage our operating expenses.Results of OperationsThe following sets forth consolidated statements of earnings information (as a percentage of net sales) for the periods ended December 31: 202020192018Net sales100.0 %100.0 %100.0 %Gross profit45.5 %47.2 %48.3 %Operating and administrative expenses25.3 %27.4 %28.2 %Gain on sale of property and equipment0.0 %0.0 %0.0 %Operating income20.2 %19.8 %20.1 %Net interest expense-0.2 %-0.3 %-0.3 %Earnings before income taxes20.1 %19.6 %19.9 %Note – Amounts may not foot due to rounding difference.28Table of ContentsNet SalesNote – Daily sales are defined as the total net sales for the period divided by the number of business days (in the United States) in the period. The table below sets forth net sales and daily sales for the periods ended December 31, and changes in such sales from the prior period to the more recent period:202020192018Net sales$5,647.3 5,333.7 4,965.1 Percentage change5.9 %7.4 %13.1 %Business days255 254 254 Daily sales$22.1 21.0 19.5 Percentage change5.5 %7.4 %13.1 %Daily sales impact of currency fluctuations-0.1 %-0.3 %0.1 %Daily sales impact of acquisitions0.0 %0.1 %0.4 %The increase in net sales noted above for 2020 was a function primarily of higher unit sales for safety products, specifically pandemic-related sales of PPE. The effect of higher prices during the period were not material. The increase in net sales noted above for 2019 was a result of higher unit sales and, to a lesser degree, higher prices. Higher product prices in 2019 were a result of actions taken to offset increases in product costs, and we believe these increases contributed 0.9% to 1.0% to sales growth during 2019.Higher unit sales in 2020 were heavily influenced by actions taken by governments and businesses around the world to address COVID-19, which influenced the period in a couple of ways. First, by virtue of our ability to source and transport PPE, we were able to supply the needs of governments, first responders, and businesses as they worked to mitigate the effects of the pandemic on our communities and normalize business activity under more stringent safety protocols. This generated significant PPE sales through the year. We believe the best proxies for this trend was daily sales growth of our safety products of 51.0% and daily sales growth to our government and healthcare customers of 129.7%. Second, we managed the effects of business closures, disruption in labor forces and supply chains, and a reduction in general business activity that was a by-product of the responses of governments and businesses to the pandemic. The impact of this is best illustrated by several metrics. For instance, United States Industrial Production, which is published by the Federal Reserve, decreased 7.1% in 2020. Based on the large proportion of our sales that are derived from the United States, we believe United States Industrial Production is a good proxy for the state of our marketplace and that the significant decline in this metric is consistent with the weakness we experienced in our traditional manufacturing and construction markets. This was also reflected in the daily sales of fasteners, which is our most cyclical product line. Daily sales of fasteners declined 7.2% in 2020. Although traditional manufacturing and construction business activity has gradually, but steadily, improved from depressed second quarter of 2020 levels, it did remain negative through the year. Taking these two variables together, higher unit sales of PPE more than offset the decline in unit sales in our traditional manufacturing and construction business, resulting in higher net unit sales in 2020.Our growth drivers did not contribute meaningfully to higher unit sales in 2020, which we believe is largely a function of difficulties gaining access to customers and facilities due to social distancing and safety guidelines in response to COVID-19. We signed 16,417 industrial vending devices during 2020, a decrease of 24.9% from 2019. This did increase our installed base to 95,733 devices at the end of 2020, an increase of 6.4% over 2019, but this increase was not sufficient to offset reduced throughput per device. As a result, sales through our vending devices declined at a low single-digit rate during 2020. We activated 257 new Onsite locations in 2020, a decrease of 17.6% over 2019. This allowed us to increase our active sites to 1,265 at the end of 2020, an increase of 13.6% over 2019, but this increase was not sufficient to offset significant sales declines in our older, more established Onsite locations. As a result, sales through our Onsite locations declined at a low single-digit rate during 2020. We did experience growth in our National Account customers of 6.7% in 2020 compared to 2019, though this was due to the sale of PPE to customers navigating the challenges of operating during a pandemic.The higher unit sales in 2019 resulted primarily from two sources. First was higher underlying market demand, as illustrated by U.S. Industrial Production, which increased 0.8% in 2019, and daily sales of fasteners, which grew 5.5% in 2019. It is notable, however, that underlying demand in 2019 began strong but weakened throughout the year. Referring again to U.S. Industrial Production, it increased 2.9% in the first quarter of 2019 but decreased 0.9% in the fourth quarter of 2019. The slowing in these metrics from the start to the end of 2019 mirrored the slowing growth we experienced in our unit sales over the same period.A relatively greater contributor to our growth in 2019 was the success of our growth initiatives. We signed 21,857 industrial vending devices during 2019. While this represented a slight decrease in signings of 1.0% from 2018, it also contributed to growth in our installed base to 89,937 vending devices at the end of 2019, an increase of 10.8% over 2018. Growth in our installed base was primarily responsible for sales growth through our vending devices in the mid-teens during 2019. We signed 362 new Onsite locations in 2019, an increase of 7.7% over 2018, and had 1,114 active sites on December 31, 2019, an increase 29Table of Contentsof 24.6% over December 31, 2018. Growth in our number of active sites was primarily responsible for sales growth through our Onsites in the mid-teens during 2019. The contribution of new national account contracts and strong penetration of existing national account customers resulted in daily sales from our national account customers growing 11.9% in 2019 compared to 2018.Sales by Product LineThe approximate mix of sales from fasteners, safety supplies, and all other product lines was as follows:202020192018Fasteners29.9%34.2%34.9%Safety supplies25.5%17.9%17.2%Other product lines44.6%47.9%47.9%Shifts in product mix in 2020 largely reflects the factors that impacted our sales growth in the period. Specifically, strong demand for PPE generated strong sales growth in our safety products, while weak trends in underlying conditions affected our traditional manufacturing and construction customers resulting in a sales decline in our fastener products. The effect on other products was relatively muted, as certain lines benefited from pandemic-related demand (such as janitorial products), while others were negatively impacted by underlying demand (such as metalcutting and material handling). Shifts in product mix in 2019 were based on more traditional factors. The decrease in our fastener sales as a percentage of total sales arises from two factors. First, we believe non-fastener products represent a larger market opportunity than fasteners, and that we are relatively under-represented in this market. Over time, this has led to faster growth in the non-fastener product lines, a trend amplified by the growth of our industrial vending program through which we sell primarily non-fastener products. We believe this factor impacted 2019 and will continue to promote a lower mix of fasteners in our total sales over time. Second, the weakening industrial production environment had a disproportionately negative effect on fastener sales, particularly OEM fasteners sales, relative to non-fastener sales (which relates more to plant operations than production). This weakness is more of a cyclical factor than a structural one, and as such was relevant in 2020 (albeit overwhelmed by pandemic-related effects) and 2019.Annual Sales Changes, Sequential Trends, and End Market PerformanceThis section focuses on three distinct views of our business – annual sales changes by month, sequential trends, and end market performance. The first discussion regarding sales changes by month provides a good mechanical view of our business. The second discussion provides a framework for understanding the sequential trends (that is, comparing a month to the immediately preceding month, and also looking at the cumulative change from an earlier benchmark month) in our business. Finally, we believe the third discussion regarding end market performance provides insight into activities with our various types of customers.Annual Sales Changes, by MonthDuring the months noted below, all of our selling locations, when combined, had daily sales growth rates of (compared to the same month in the preceding year): Jan.Feb.Mar.Apr.MayJuneJulyAug.Sept.Oct.Nov.Dec.20203.6 %4.7 %0.2 %6.7 %14.8 %9.5 %2.6 %2.5 %2.2 %4.1 %6.8 %9.3 %201913.3 %10.5 %12.7 %7.4 %9.5 %7.0 %6.1 %6.3 %5.8 %4.3 %5.7 %1.0 %201812.0 %14.8 %13.1 %13.4 %12.5 %13.5 %12.0 %13.7 %13.5 %12.4 %12.3 %14.5 %Sequential TrendsWe find it helpful to think about the monthly sequential changes in our business using the analogy of climbing a stairway – This stairway has several predictable landings where there is a pause in the sequential gain (i.e. April, July, and October to December), but generally speaking, climbs from January to October. The October landing then establishes the benchmark for the start of the next year.History has identified these landings in our business cycle. They generally relate to months where certain holidays impair business days and/or seasons impact certain end markets, particularly non-residential construction. The first landing centers on Easter and the Good Friday holiday that precedes it, which alternates between March and April (Good Friday occurred in April in 2020 and 2019, occurred in March during 2018, and will fall in April in 2021), the second landing centers on July 4th, and the third landing centers on the approach of winter with its seasonal impact on primarily our non-residential construction business and with the Christmas/New Year holidays. The holidays we noted impact the trends because they either move from month-to-month or because they move around during the week.30Table of ContentsThe table below shows the pattern to the sequential change in our daily sales. The line labeled 'Benchmark' is a historical average of our sequential daily sales change for the trailing five year average (2015-2019). We believe this time frame serves to show the historical pattern and could serve as a benchmark for current performance. The '2020', '2019', and '2018' lines represent our actual sequential daily sales changes. The '20Delta', '19Delta', and '18Delta' lines indicate the difference between the 'Benchmark' and the actual results in the respective year. Under normal circumstances, the sequential trends shown below are directly linked to fluctuations in our end markets. Further, in any given month it is possible to get significant deviation from the benchmark. However, we do not believe that fully explains the exaggerated delta between the sequential rates of change and the benchmark from March 2020 to July 2020. We believe deviation of this duration and order of magnitude is uncharacteristic in our business and is related to the dramatic impacts of the pandemic in that period.It is important to note that these benchmarks are historical averages. In a year where demand is strong, our daily sales growth rates will tend to have more months that exceed the benchmark than fall below it. In a year where demand is weak, we will tend to have more months that fall short of the benchmark than exceed it. In both cases, there is a random element that makes it difficult to know how any single month will perform. Jan.(1)Feb.Mar.Apr.MayJuneJulyAug.Sept.Oct.Cumulative Change from Jan. to Oct.Benchmark-1.0 %1.2 %3.1 %0.1 %1.7 %1.8 %-3.4 %3.3 %2.2 %-2.5 %7.5 %2020-1.3 %2.5 %-0.3 %3.9 %10.4 %-3.3 %-10.5 %3.8 %2.9 %-2.6 %5.5 %20Delta-0.3 %1.3 %-3.4 %3.8 %8.7 %-5.1 %-7.0 %0.5 %0.6 %-0.1 %-2.0 %2019-0.5 %1.4 %4.2 %-2.4 %2.5 %1.4 %-4.4 %3.9 %3.1 %-4.4 %4.9 %19Delta0.4 %0.2 %1.1 %-2.5 %0.8 %-0.4 %-1.0 %0.6 %0.9 %-1.9 %-2.6 %2018-1.3 %4.0 %2.1 %2.4 %0.6 %3.7 %-3.6 %3.8 %3.6 %-3.0 %13.9 %18Delta-0.3 %2.8 %-1.0 %2.3 %-1.1 %2.0 %-0.2 %0.5 %1.3 %-0.5 %6.4 %(1) The January figures represent the percentage change from the previous October, whereas the remaining figures represent the percentage change from the previous month.Note – Amounts may not foot due to rounding difference.A graph of the sequential daily sales change patterns discussed above, starting with a base of '100' in the previous October and ending with the next October, would be as follows:31Table of ContentsEnd Market PerformanceWe estimate approximately 65% of our business has historically been with customers engaged in some type of manufacturing, a significant subset of which finds its way into the heavy equipment market. The daily sales growth (contraction) rates to these manufacturing customers, when compared to the same period in the prior year, were as follows: Q1Q2Q3Q4Annual20203.0 %-9.4 %-4.7 %1.7 %-2.5 %201913.4 %9.1 %7.7 %5.1 %8.8 %201814.3 %13.3 %13.0 %13.3 %13.5 %Our manufacturing business consists of two subsets: the industrial production business (this is business where we supply products that become part of the finished goods produced by our customers and is sometimes referred to as OEM - original equipment manufacturing) and the maintenance portion (this is business where we supply products that maintain the facility or the equipment of our customers engaged in manufacturing and is sometimes referred to as MRO - maintenance, repair, and operations). The industrial business is more fastener centered, while the maintenance portion is represented by all product categories.The best way to understand the change in our industrial production business is to examine the results in our fastener product line (which, under normal business conditions, represents 30% to 35% of our business) which is heavily influenced by changes in our business with heavy equipment manufacturers. From a company perspective, daily sales growth (contraction) rates of fasteners, when compared to the same period in the prior year, were as follows (note: this information includes all end markets):Q1Q2Q3Q4Annual2020-2.6 %-16.4 %-6.9 %-2.3 %-7.2 %201911.8 %5.5 %3.0 %1.8 %5.5 %201811.8 %11.1 %10.8 %11.3 %11.2 %The daily sales growth (contraction) rates of fasteners noted in the table above for first quarter of 2018, include 3.7 percentage points attributable to Mansco (acquired on March 31, 2017).By contrast, the best way to understand the change in the maintenance portion of the manufacturing business is to examine the results in our non-fastener product lines. From a company perspective, daily sales growth rates of non-fasteners, when compared to the same period in the prior year, were as follows (note: this information includes all end markets):Q1Q2Q3Q4Annual20206.0 %25.6 %7.8 %11.2 %12.7 %201912.7 %9.5 %8.0 %5.1 %8.8 %201814.5 %14.8 %14.9 %14.6 %14.7 %Two product lines, safety and janitorial, accounted for approximately half of total non-fastener sales and saw a meaningful increase in sales in 2020 due to demand generated in response to the COVID-19 pandemic. As a result, the change in our non-fastener lines in 2020 did not provide as much insight into the trends of our traditional manufacturing and construction customers as is typically the case. Still, we have sold non-fastener products through multiple cycles that do not include a pandemic and believe we can make several observations. Generally speaking, our non-fastener business is not immune to the impact of industrial cycles. However, we would typically expect it to outperform our fastener business in any cycle. This reflects three things: the non-fastener market is larger than the fastener market, we are underpenetrated in the non-fastener market relative to the fastener market, and industrial vending lends itself to sales of non-fastener products. This is what we experienced in 2019. The outperformance of our non-fastener business was far more dramatic in 2020 than can be explained by our traditional drivers of outperformance, and reflects the impact of COVID-19 on our sales of safety products, specifically PPE, and janitorial products, such as sanitizer and wipes.Our non-residential construction and reseller customers have historically represented 20% to 25% of our business, though in 2020 it was slightly below the bottom of this range. The daily sales growth (contraction) rates to these customers, when compared to the same period in the prior year, were as follows: Q1Q2Q3Q4Annual2020-1.2 %-10.0 %-11.5 %-8.3 %-7.8 %201912.1 %6.0 %0.6 %0.7 %4.7 %201811.7 %17.6 %19.2 %16.4 %16.3 %32Table of ContentsOur non-residential construction and reseller business is heavily influenced by manufacturing, oil and gas, and infrastructure spending. In 2020 and 2019, the poor and slowing production environment, respectively and as described above, and the accompanying worsening trends for commodities such as metals and energy, caused the growth in our non-residential construction and reseller customers to slow. In 2020, this was exacerbated by project suspensions as many states and regions shut down activity in an effort to control the pandemic.Gross ProfitThe gross profit percentage during each period was as follows: Q1Q2Q3Q4Annual202046.6 %44.5 %45.3 %45.6 %45.5 %201947.7 %46.9 %47.2 %46.9 %47.2 %201848.7 %48.7 %48.1 %47.7 %48.3 %Our gross profit, as a percentage of net sales, was 45.5% in 2020 and 47.2% in 2019. The gross profit percentage for 2020 decreased by 170 basis points based on three items. (1) A decline in product margin for safety and other products, which itself reflects several trends. First, in the second quarter of 2020 in order to procure supplies we utilized unfamiliar supply chains and prioritized speed of acquisition over efficiency, resulting in lower margins. Second, in the third and fourth quarters of 2020 certain pandemic related products became oversupplied, and profits on our inventory fell (masks) while other products were in such short supply that cost rose (gloves). We mitigated these effects as the year progressed, but did not eliminate them. Third, mix within these categories was negative to margin, as in general COVID-related products had lower margins and increased in the mix. (2) A change in product mix. Fasteners are our largest and highest gross profit margin product line due to the high transaction cost surrounding the sourcing and supply of the product for customers. Our fastener product line declined to 29.9% of sales in 2020 from 34.2% of sales in 2019. (3) Overhead and organizational expenses. This includes the negative impact that reduced sales for certain product lines has on vendor rebates, clearance efforts to remove older and slower moving inventory, and the deleverage of certain fixed and period costs related to cyclical weakness in our traditional manufacturing and construction markets. These three adverse variables were partly offset by a better cost profile for our captive fleet. We operate our own fleet of trucks for moving product between suppliers, our distribution centers, and our in-market locations. We believe this provides us a competitive advantage in terms of our ability to move product efficiently and quickly, but there is a cost to supporting and maintaining these assets. During periods of economic weakness, it can become more difficult to charge freight to offset these costs and/or the relatively stable cost profile of these assets could result in deleverage. We successfully mitigated these challenges in 2020 by reducing movement and labor costs.During 2019, our gross profit as a percentage of net sales decreased when compared to the prior year. The decrease was primarily caused by three variables. (1) A change in product and customer mix, as we experienced the combination of relatively slow net sales growth in our fastener product line and relatively faster net sales growth to our largest customers, for which National Accounts is a good proxy and which tend to have lower margins. (2) We experienced rising freight expense as a result of costs related to transporting products, particularly shipping fees, driver wages, and fuel. (3) We experienced an increase in the cost of our products due to generalized inflation and tariffs resulting from disputes between the United States and its trade partners. We implemented several actions to mitigate the impact of these cost increases in 2019, including price increases. For the full year, the net impact of these actions was minor. However, the impact through the year differed, with a larger negative impact on the gross profit percentage in the first half of 2019 and a relatively modest impact in the second half of 2019.Operating and Administrative ExpensesOur operating and administrative expenses (including the gain on sales of property and equipment), as a percentage of net sales, improved to 25.3% in 2020 from 27.3% in 2019. This improvement was a function of the growth in employee-related, occupancy-related, and all other operating and administrative expenses being more modest than the growth in sales. Employee-related expenses improved the ratio of operating and administrative expenses as a percentage of sales by 140 to 145 basis points in 2020 from 2019. Occupancy-related expenses improved the ratio of operating and administrative expenses as a percentage of sales by 25 to 30 basis points in 2020 from 2019. All other operating and administrative expenses improved the ratio of operating and administrative expenses as a percentage of sales by 40 to 45 basis points in 2020 from 2019.Our operating and administrative expenses (including the gain on sales of property and equipment), as a percentage of net sales, improved to 27.3% in 2019 from 28.2% in 2018. This improvement was a function of the growth in employee-related, occupancy-related, and all other operating and administrative expenses being more modest than the growth in sales. Employee-related expenses improved the ratio of operating and administrative expenses as a percentage of sales by 40 to 45 basis points in 2019 from 2018. Occupancy-related expenses improved the ratio of operating and administrative expenses as a percentage of sales by 20 to 25 basis points in 2019 from 2018. All other operating and administrative expenses improved the ratio of operating and administrative expenses as a percentage of sales by 20 to 25 basis points in 2019 from 2018.33Table of ContentsThe growth (contraction) in employee-related, occupancy-related, and all other operating and administrative expenses (including the gain on sales of property and equipment) compared to the same periods in the preceding year, is outlined in the table below.Approximate Percentage of Total Operating and Administrative ExpensesTwelve-month Period202020192018Employee-related expenses68% to 73%(1)-2.0 %5.1 %11.1 %Occupancy-related expenses15% to 20%0.3 %2.8 %5.0 %All other operating and administrative expenses10% to 15%-7.2 %1.5 %5.2 %(1) Employee-related expenses fell within a range of 68-73% of our total operating and administrative expenses during 2020. During 2019, employee-related expenses fell within a range of 65-70% of our total operating and administrative expenses.Employee-related expenses include: (1) payroll (which includes cash compensation, stock option expense, and profit sharing), (2) health care, (3) personnel development, and (4) social taxes.Our employee-related expenses decreased in 2020 from 2019. This was related to: a decrease in full-time equivalent (FTE) headcount and related base wages and employment taxes related to efforts to reduce costs given weak demand in our traditional manufacturing and construction markets; lower bonuses and commissions given weak demand in our traditional manufacturing and construction markets; and reduced costs associated with the Fastenal School of Business as training shifted from in-person to online. This was only partly offset by an increase in our profit sharing contribution and health care costs. Our employee-related expenses increased in 2019 from 2018. This was related to: (1) an increase in FTE headcount related to efforts to support growth in our business, (2) higher performance bonuses and commissions due to growth in net sales and net earnings, (3) an increase in our profit sharing contribution and options awards, (4) increases in hourly base wages, and (5) increased health care costs.The table below summarizes the percentage change in our FTE headcount at the end of the periods presented compared to the end of the prior period:Twelve-month Period202020192018In-market locations (branches & Onsites)-8.0 %0.2 %5.7 %Non-in-market selling (1)5.4 %5.3 %3.3 %Selling subtotal-6.2 %0.8 %5.4 %Distribution/Transportation-10.5 %2.2 %12.2 %Manufacturing-9.9 %-2.7 %12.0 %Administration (2)8.7 %8.5 %7.3 %Non-selling subtotal-5.2 %3.1 %10.9 %Total-6.0 %1.4 %6.8 %(1) Our non-in-market selling employee count has grown in recent years due to an increased focus on resources to support our growth drivers, particularly Onsite and national account growth(2) Administration primarily includes our Sales Support, Information Technology, Finance and Accounting, Human Resources, and senior leadership roles and functions. Our administrative employee count has grown in recent years due to an increased focus on technology capabilities. For example, 66.7% of the increase in administrative employees in 2020 over 2019 related to our additions to our information technology teams. Occupancy-related expenses include: (1) building rent and depreciation, (2) building utility costs, (3) equipment related to our branches and distribution locations, and (4) industrial vending equipment (we consider the vending equipment, excluding leased locker equipment, to be a logical extension of our in-market operations and classify the depreciation and repair costs as occupancy expenses).Our occupancy-related expenses increased slightly in 2020 from 2019. This was primarily due to higher depreciation related to facility expansions completed in 2019, partly offset by lower utility costs in our branches. Our occupancy-related expenses increased in 2019 from 2018. This was related primarily to: higher depreciation as a result of facility expansions completed during the year; and increases to industrial vending equipment.34Table of ContentsAll other operating and administrative expenses include: (1) selling-related transportation, (2) information technology (IT) expenses, (3) general corporate expenses, which consists of legal expenses, general insurance expenses, travel and marketing expenses, etc., and (4) the gain on sales of property and equipment.Combined, all other operating and administrative expenses decreased in 2020 from 2019. This was related to: lower selling-related freight expenses due to reduced travel as a result of COVID-related restrictions, the rationalization of our branch fleet, and significantly reduced travel and meal expenses due to reduced travel as a result of COVID-related restrictions. This was partly offset by higher spending on information technology. Combined, all other operating and administrative expenses increased in 2019 from 2018. This was related to: higher spending on information technology; and higher selling-related freight expense.Net Interest ExpenseOur net interest expense was $9.1 in 2020 compared to $13.6 in 2019, and $12.3 in 2018. The decrease in 2020, when compared to 2019, was due to a slightly lower average debt balance paired with substantially lower interest rates. During the year, we increased the debt held under our Master Note Agreement to $405.0 as a means of fixing a portion of our debt and freeing up borrowing capacity under our revolver. This debt has various maturities and interest rates, which collectively are at attractive levels. The increase in 2019, when compared to 2018, was mainly caused by higher average interest rates and a higher average debt balance during the period.Income TaxesWe recorded income tax expense of $273.6 in 2020, or 24.2% of earnings before income taxes. Our income tax expense was reduced by $5.3 due to discrete items mainly relating to benefits associated with the exercise of stock options and changes in the reserve for uncertain tax positions.We recorded income tax expense of $252.8 in 2019, or 24.2% of earnings before income taxes. Our income tax expense was reduced by $2.6 as a result of applying guideline clarifications issued by the IRS on certain aspects of tax reform, as well as tax benefits associated with the exercise of stock options. This reduced our tax rate in the period by 30 basis points.Net EarningsNet earnings, net earnings per share (EPS), the percentage change in net earnings, and the percentage change in EPS, were as follows:Dollar Amounts20202019 2018 (1)Net earnings$859.1 790.9 751.9 Basic EPS1.50 1.38 1.31 Diluted EPS1.49 1.38 1.31 Percentage Change20202019 2018 (1)Net earnings8.6 %5.2 %29.9 %Basic EPS8.5 %5.3 %30.5 %Diluted EPS8.4 %5.2 %30.5 %202020192018Tax Rate24.2 %24.2 %23.8 %(1) As a result of the Tax Act, discrete tax items benefited our net earnings by $7.1 during 2018. During 2020 and 2019, net earnings increased, primarily due to stronger sales and higher operating profits, and were only partly offset by an increase in income tax expense. The increase in basic and diluted earnings per share also reflected the purchase of our shares of common stock in 2020.35Table of ContentsLiquidity and Capital ResourcesNet Cash Provided by Operating ActivitiesNet cash provided by operating activities in dollars and as a percentage of net earnings were as follows:202020192018Net cash provided$1,101.8 842.7 674.2 % of net earnings128.3 %106.5 %89.7 %In 2020, the increase in our operating cash flow as a percentage of net earnings is due to working capital assets and liabilities being a modest source of cash in 2020, as opposed to a significant use of cash in 2019. This includes the deferral of $30.0 in payroll taxes resulting from the CARES Act and a timing-related higher accounts payable balance. In 2019, the increase in our operating cash flow as a percentage of net earnings reflects a reduced drag from working capital investment than what was experienced in 2018 and, to a lesser degree, higher net income.Trade Working Capital AssetsTrade working capital assets are highlighted below. The annual dollar change and the annual percentage change were as follows:Dollar change20202019Accounts receivable, net$27.6 27.5 Inventories(28.9)87.7 Trade working capital$(1.2)115.2 Accounts payable14.2 (0.7) Trade working capital, net(15.4)115.9 Annual percentage change20202019Accounts receivable, net3.7 %3.9 %Inventories(2.1)%6.9 % Trade working capital(0.1)%5.8 %Accounts payable7.3 %(0.4)% Trade working capital, net(0.8)%6.4 %Note – Amounts may not foot due to rounding difference.In 2020, the annual growth in net accounts receivable reflects growth in sales, mitigated by the substantial increase in sales to government customers, which tended to have shorter payment terms in 2020, and strong collections at year end. In 2019, the annual growth in net accounts receivable reflects not only our growth in sales, but also the fact that our growth is being driven disproportionately by our national accounts program where our customers tend to have longer payment terms than our customer base as a whole. Growth was also relatively stronger with customers outside the U.S., which similarly tend to have longer payment terms than our customer base as a whole. The rate of growth in receivables did slow throughout 2019, largely reflecting the impact on receivables of softer business activity.Our inventory balances over time will respond to business activity, though various factors produce a looser relationship to our monthly sales patterns than we tend to experience in accounts receivable. One reason for this is cyclical. We source significant quantities of product from overseas, and the lead time involved in procuring these products is typically longer than the visibility we have into future monthly sales patterns. As a result, trends in our inventory will often lag trends in economic conditions. A second reason is our growth drivers, including our FMI offerings, Onsite channel, and international expansion, all of which tend to require significant investments in inventory. In 2020, our inventories decreased, reflecting a number of factors, including reduced stocking needs on the part of our traditional manufacturing and construction customers due to weak business activity, reduced vending and Onsite signings, and good execution on initiatives aimed at improving our inventory balances. This was partly offset by COVID-related PPE balances that we added in the second quarter of 2020 and have been declining over the second half of 2020, but we had no such PPE inventory in the preceding year. In 2019, our inventories increased to support higher sales, reflecting large increases in the number of installed vending devices and active Onsite locations, and from inflation and tariffs.36Table of ContentsIn 2020, the annual growth in accounts payable reflected primarily the timing of certain payments that slipped out of the fourth quarter of 2020 and into the first quarter of 2021. In 2019, the slight decrease in accounts payable came as a result of softer year end business activity.The approximate percentage mix of inventory stocked at our selling locations versus our distribution center and manufacturing locations was as follows at year end:202020192018Selling locations59 %60 %61 %Distribution center and manufacturing locations41 %40 %39 %Total100 %100 %100 %Net Cash Used in Investing ActivitiesNet cash used in investing activities in dollars and as a percentage of net earnings were as follows:202020192018Net cash used$281.7 239.7 173.9 % of net earnings32.8 %30.3 %23.1 %The changes in net cash used in investing activities in 2020 were primarily related to an increase of $125.0 for the purchase of certain assets of Apex Industrial Technologies LLC, which was partly offset by changes in our net capital expenditures. The changes in net cash used in investing activities in 2019 was primarily related to changes in our net capital expenditures.Property and equipment expenditures typically consist primarily of: (1) purchases related to industrial vending, (2) purchases of property and equipment related to expansion of and enhancements to distribution centers, (3) spending on software and hardware for our information processing systems, (4) the addition of fleet vehicles, (5) expansion, improvement or investment in certain owned or leased branch properties, and (6) the addition of manufacturing and warehouse equipment. Disposals of property and equipment consisted of the planned disposition of certain pick-up trucks, distribution vehicles, and trailers in the normal course of business.Set forth below is a recap of our 2020, 2019, and 2018 net capital expenditures in dollars and as a percentage of net sales and net earnings:202020192018Manufacturing, warehouse and packaging equipment, industrial vending equipment, and facilities$91.5 172.7 110.7 Shelving and related supplies for in-market location openings and for product expansion at existing in-market locations15.7 12.3 9.6 Data processing software and equipment31.4 31.1 30.9 Real estate and improvements to branch locations16.1 8.9 12.9 Vehicles13.4 21.4 12.2 Purchases of property and equipment168.1 246.4 176.3 Proceeds from sale of property and equipment(10.6)(6.6)(9.5)Net capital expenditures157.5 239.8 166.8 % of net sales2.8 %4.5 %3.4 %% of net earnings18.3 %30.3 %22.2 %Our net capital expenditures decreased in 2020, when compared to 2019. We reduced capital spending expectations early in 2020 across most tracked categories as financial uncertainty related to the pandemic response emerged. The decline relates to lower spending on facility capacity and equipment following our investments in 2019, lower spending for vending devices as a result of our acquisition of certain assets of Apex and lower signings, lower spending on our captive fleet, and lower spending for manufacturing equipment. Our net capital expenditures increased in 2019, when compared to 2018, primarily due to increased spending on hub property and equipment, both to expand current capacity and for potential future expansion, higher spending on vending devices to support the growth of our industrial vending program, and investment in our trucking assets.37Table of ContentsWe expect our net capital expenditures in 2021 to be within a range of $170.0 to $200.0. This increase from 2020 relates to increased spending for a non-hub construction project in Winona to support growth, higher maintenance spending across most tracked categories following tighter spending control in 2020, and lower anticipated proceeds from asset sales. These factors will be slightly offset by lower spending on vending devices due to a full year of lower unit cost following our acquisition of certain assets of Apex. We anticipate funding our capital expenditure needs with cash generated from operations, from available cash and cash equivalents, and, if necessary, from our borrowing capacity. Net Cash Used in Financing Activities Net cash used in financing activities in dollars and as a percentage of net earnings were as follows:202020192018Net cash used$754.4 595.1 446.5 % of net earnings87.8 %75.2 %59.4 %The fluctuations in net cash used in financing activities are due to changes in the level of our dividend payments and in the level of common stock purchases. These amounts were partially offset by the exercise of stock options and net payments (proceeds) from debt obligations. These items in dollars and as a percentage of earnings were as follows:202020192018Dividends paid$803.4 498.6 441.9 % of net earnings93.5 %63.0 %58.8 %Common stock purchases52.0 — 103.0 % of net earnings6.1 %— 13.7 %Total returned to shareholders$855.4 498.6 544.9 % of net earnings99.6 %63.0 %72.5 %Proceeds from the exercise of stock options$(41.0)(58.5)(13.4)% of net earnings-4.8 %-7.4 %-1.8 %Cash payments (proceeds), net$(60.0)155.0 (85.0)% of net earnings-7.0 %19.6 %-11.3 %Net cash used$754.4 595.1 446.5 % of net earnings87.8 %75.2 %59.4 %Stock PurchasesIn 2020, we purchased 1,600,000 shares of our common stock at an average price of approximately $32.54. In 2019, we did not purchase any shares of our common stock. In 2018, we purchased 4,000,000 shares of our common stock at an average price of approximately $25.75 per share.DividendsWe declared a quarterly dividend of $0.28 per share on January 19, 2021. In 2020, we paid aggregate annual dividends per share of $1.40. This included $1.00 in regular quarterly dividends and a $0.40 special dividend paid in December 2020 as a result of our high cash balances and favorable financial outlook. In 2019, we paid aggregate annual dividends per share of $0.87.38Table of ContentsDebtIn order to fund the considerable cash needed to expand our industrial vending business, expand capacity and increase the use of automation in our distribution centers, pay dividends, and, in 2020, to purchase our common stock, pre-pay vendors to secure access to critical products during the pandemic, and acquire certain assets of Apex Industrial Technologies LLC, we have borrowed under our Credit Facility and our Master Note Agreement in recent periods.Our borrowings under the Credit Facility and Master Note Agreement peaked during each quarter of 2020 and 2019 as follows: Peak borrowings20202019First quarter$470.0 585.0 Second quarter640.0 535.0 Third quarter445.0 530.0 Fourth quarter495.0 445.0 As of December 31, 2020, we had no loans outstanding under the Credit Facility and had contingent obligations from letters of credit outstanding under the Credit Facility in an aggregate face amount of $36.3. As of December 31, 2020, we had loans outstanding under the Master Note Agreement of $405.0. Descriptions of our Credit Facility and Master Note Agreement are contained in Note 10 of the Notes to Consolidated Financial Statements. Unremitted Foreign EarningsApproximately $186.8 of cash and cash equivalents are held by non-U.S. subsidiaries. These funds may create foreign currency translation gains or losses depending on the functional currency of the entity holding the cash. We have considered the financial requirements of each foreign subsidiary and our parent company and will continue to reinvest these funds to support our expansion activities outside the U.S., even after taking into consideration the deemed repatriation and transition tax under the Tax Act. The income tax impact of repatriating cash associated with investments in foreign subsidiaries is discussed in Note 8 of the Notes to Consolidated Financial Statements. Effects of InflationIn 2020, we experienced changing price levels for COVID-related supplies, with inflation for certain products that were in short supply (e.g., nitrile gloves) and deflation for certain products that became oversupplied (e.g., disposable masks). These were event-specific circumstances related to the pandemic. As it related to the non-COVID environment, we experienced stable product costs through 2020 relative to 2019. We experienced higher product costs through 2019 relative to 2018 as a result of generalized inflation and tariffs, though the impact of these items did moderate later in the year as economic activity slowed and conditions around trade stabilized. We took actions during the year to mitigate the effects of higher product costs, including increasing product prices. These actions were not able to offset the pressure we experienced on our gross profit percentage in the first half of 2019, but were more effective at doing so in the second half of 2019.Critical Accounting Policies and EstimatesIn preparing our consolidated financial statements in conformity with U.S. GAAP, we must make decisions that impact the reported amounts of assets, liabilities, revenues and expenses, and the related disclosures. Such decisions include the selection of the appropriate accounting principles to be applied and the assumptions on which to base accounting estimates. In reaching such decisions, we apply judgments based on our understanding and analysis of relevant circumstances, historical experience, and actuarial valuations. Actual amounts could differ from those estimated at the time the consolidated financial statements are prepared.Our most significant accounting policies, including Revenue Recognition and Inventories, are described in Note 1 of the Notes to Consolidated Financial Statements. Some of those significant accounting policies require us to make difficult, subjective, or complex judgments, or estimates. An accounting estimate is considered to be critical if it meets both of the following criteria: (i) the estimate requires assumptions about matters that are highly uncertain at the time the accounting estimate is made, and (ii) different estimates reasonably could have been used, or changes in the estimate that are reasonably likely to occur from period to period may have a material impact on the presentation of our financial condition, changes in financial condition, or results of operations. Our most critical accounting estimates include the following:Allowance for Credit Losses – This reserve is for accounts receivable balances that are potentially uncollectible. The allowance for credit losses is based on an income statement approach which adjusts the ending balance sheet to take into consideration expected losses over the contractual lives of the receivables, considering factors such as historical data as a basis for future expected losses. If business or economic conditions change, our estimates and assumptions may be adjusted as deemed appropriate. Historically, actual required reserves have not varied materially from estimated amounts.39Table of ContentsInventory valuation – The valuation of inventory is based on an analysis of inventory trends including reviews of inventory levels, sales information, and the on-hand quantities relative to the sales history for the product. Our methodology for estimating whether adjustments are necessary is continually evaluated for factors including significant changes in product demand, market conditions, condition of the inventory, or liquidation value. If business or economic conditions change, our estimates and assumptions may be adjusted as deemed appropriate. Historically, actual required adjustments have not varied materially from estimated amounts.General insurance reserves – These reserves are for general claims related to workers' compensation, property and casualty losses, and other general liability self-insured losses. The reserves are based on an analysis of reported claims and claims incurred but not yet reported related to our historical claim trends. We perform ongoing reviews of our insured and uninsured risks and use this information to establish appropriate reserve levels. We analyze historical trends, claims experience, and loss development patterns to ensure the appropriate loss development factors are applied to the incurred costs associated with the claims made. Historically, actual required reserves have not varied materially from estimated amounts.New Accounting PronouncementsA description of new accounting pronouncements is contained in Note 1 of the Notes to Consolidated Financial Statements. Geographic InformationInformation regarding our revenues and long-lived assets by geographic area is contained in Note 3 and Note 4 of the Notes to Consolidated Financial Statements. Risks related to our foreign operations are described earlier in this Form 10-K under the heading 'Forward-Looking Statements' and 'Item 1A. Risk Factors'.Certain Contractual ObligationsAs of December 31, 2020, we had outstanding long-term debt and facilities, equipment, and vehicles leased under operating leases. Our future obligations to pay principal of and interest on such long-term debt and to make minimum lease payments under such operating leases are as follows:Total20212022 and 20232024 and 2025After 2025Principal of long-term debt$405.0 40.0 105.0 135.0 125.0 Interest on long-term debt(1)47.8 10.8 18.8 10.5 7.7 Operating leases(2)256.4 98.0 115.7 37.2 5.5 Total$709.2 148.8 239.5 182.7 138.2 (1) Interest on the long-term debt outstanding under our Credit Facility was calculated using the interest rates and balances at December 31, 2020.(2) Amounts include lease liabilities for pick-up truck leases, which typically have a non-cancelable lease term of less than one year and are not included on the consolidated balance sheets as an operating lease right-of-use asset.Purchase orders and contracts for the purchase of inventory and other goods and services are not included in the table above. Our purchase orders are based on current distribution needs and are fulfilled by our suppliers within short time horizons. We do not have significant agreements for the purchase of inventory or other goods or services specifying minimum order quantities.Liabilities for uncertain tax positions have been excluded from the table above due to the uncertainty surrounding the ultimate settlement and timing of these liabilities, which we believe will be immaterial. A discussion of income taxes is contained in Note 8 of the Notes to Consolidated Financial Statements.40Table of ContentsITEM 7A.QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKSWe are exposed to certain market risks from changes in foreign currency exchange rates, commodity steel pricing, commodity energy prices, and interest rates. Changes in these factors cause fluctuations in our earnings and cash flows. We evaluate and manage exposure to these market risks as follows:Foreign currency exchange rates – Foreign currency fluctuations can affect our net investments, our operations in countries other than the U.S., and earnings denominated in foreign currencies. Historically, our primary exchange rate exposure has been with the Canadian dollar against the United States dollar. Our estimated net earnings exposure for foreign currency exchange rates was not material at year end. We have not historically hedged our foreign currency risk given that exposure to date has not been material. In 2020, changes in foreign currency exchange rates reduced our reported net sales by $5.7 with the estimated effect on our net earnings being immaterial.Commodity steel pricing – We buy and sell various types of steel products; these products consist primarily of different types of threaded fasteners and related hardware. We are exposed to the impacts of commodity steel pricing and our related ability to pass through the impacts to our end customers. During 2020, the price of commodity steel as reflected in many market indexes fell sharply early in the year as business activity declined in response to actions to address the COVID-19 pandemic, recovered sharply as business activity rebounded, and finished 2020 above the preceding year end levels. During 2019, the price of commodity steel as reflected in many market indexes declined.Commodity energy prices – We have market risk for changes in prices of oil, gasoline, diesel fuel, natural gas, and electricity. Prices for gasoline and diesel were mostly lower over the course of 2020 as business activity declined in response to actions to address the COVID-19 pandemic. As a result, we experienced lower fuel costs through most of 2020. In 2019, prices for gasoline and diesel were stable in the early part of the year, but began to decline in the latter part of the year with slowing economic activity. As a result, we experienced stable fuel costs through 2019. Fossil fuels are also often a key feedstock for chemicals and plastics that comprise a key raw material for many products that we sell. Although fuel prices were lower through much of 2020, we experienced stable, not lower, prices for products with high chemical or plastic content. Stable fuel costs in 2019 resulted in stable product costs. We believe that over time these risks are mitigated in part by our ability to pass freight and product costs to our customers, the efficiency of our trucking distribution network, and the ability, over time, to manage our occupancy costs related to the heating and cooling of our facilities through better efficiency. In 2020, our estimated net earnings exposure for commodity energy prices was immaterial.Interest rates - Loans under our Credit Facility bear interest at floating rates tied to LIBOR (or, if LIBOR is no longer available, at a replacement rate to be determined by the administrative agent for the Credit Facility and consented to by us). As a result, changes in LIBOR can affect our operating results and liquidity to the extent we do not have effective interest rate swap arrangements in place. We have not historically used interest rate swap arrangements to hedge the variable interest rates under our Credit Facility. A one percentage point increase in LIBOR in 2020 would have resulted in approximately $1.3 of additional interest expense. A description of our Credit Facility is contained in Note 10 of the Notes to Consolidated Financial Statements.41Table of Contents
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+ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSThe following is Management’s Discussion and Analysis of Financial Condition and Results of Operations of certain significant factors that have affected Fifth Third Bancorp’s (the “Bancorp” or “Fifth Third”) financial condition and results of operations during the periods included in the Consolidated Financial Statements, which are a part of this filing. Reference to the Bancorp incorporates the parent holding company and all consolidated subsidiaries. The Bancorp’s banking subsidiary is referred to as the Bank.OVERVIEWThis overview of MD&A highlights selected information in the financial results of the Bancorp and may not contain all of the information that is important to you. For a more complete understanding of trends, events, commitments, uncertainties, liquidity, capital resources and critical accounting policies and estimates, you should carefully read this entire document. Each of these items could have an impact on the Bancorp’s financial condition, results of operations and cash flows. In addition, refer to the Glossary of Abbreviations and Acronyms in this report for a list of terms included as a tool for the reader of this Annual Report on Form 10-K. The abbreviations and acronyms identified therein are used throughout this MD&A, as well as the Consolidated Financial Statements and Notes to Consolidated Financial Statements.Net interest income, net interest margin, net interest rate spread and the efficiency ratio are presented in MD&A on an FTE basis. The FTE basis adjusts for the tax-favored status of income from certain loans and securities held by the Bancorp that are not taxable for federal income tax purposes. The Bancorp believes this presentation to be the preferred industry measurement of net interest income as it provides a relevant comparison between taxable and non-taxable amounts. The FTE basis for presenting net interest income is a non-GAAP measure. For further information, refer to the Non-GAAP Financial Measures section of MD&A.The Bancorp’s revenues are dependent on both net interest income and noninterest income. For the year ended December 31, 2020, net interest income on an FTE basis and noninterest income provided 63% and 37% of total revenue, respectively. The Bancorp derives the majority of its revenues within the U.S. from customers domiciled in the U.S. Revenue from foreign countries and external customers domiciled in foreign countries was immaterial to the Consolidated Financial Statements for the year ended December 31, 2020. Changes in interest rates, credit quality, economic trends and the capital markets are primary factors that drive the performance of the Bancorp. As discussed later in the Risk Management section of MD&A, risk identification, measurement, monitoring, control and reporting are important to the management of risk and to the financial performance and capital strength of the Bancorp.Net interest income is the difference between interest income earned on assets such as loans, leases and securities, and interest expense incurred on liabilities such as deposits, other short-term borrowings and long-term debt. Net interest income is affected by the general level of interest rates, the relative level of short-term and long-term interest rates, changes in interest rates and changes in the amount and composition of interest-earning assets and interest-bearing liabilities. Generally, the rates of interest the Bancorp earns on its assets and pays on its liabilities are established for a period of time. The change in market interest rates over time exposes the Bancorp to interest rate risk through potential adverse changes to net interest income and financial position. The Bancorp manages this risk by continually analyzing and adjusting the composition of its assets and liabilities based on their payment streams and interest rates, the timing of their maturities and their sensitivity to changes in market interest rates. Additionally, in the ordinary course of business, the Bancorp enters into certain derivative transactions as part of its overall strategy to manage its interest rate and prepayment risks. The Bancorp is also exposed to the risk of loss on its loan and lease portfolio as a result of changing expected cash flows caused by borrower credit events, such as loan defaults and inadequate collateral.Noninterest income is derived from service charges on deposits, commercial banking revenue, wealth and asset management revenue, card and processing revenue, mortgage banking net revenue, leasing business revenue, other noninterest income and net securities gains or losses. Noninterest expense includes compensation and benefits, technology and communications costs, net occupancy expense, leasing business expense, equipment expense, card and processing expense, marketing expense and other noninterest expense.COVID-19 Global PandemicThe COVID-19 pandemic has introduced significant economic uncertainty during the year ended December 31, 2020. To address concerns that COVID-19 may overwhelm the health care system, states across the U.S. declared lockdowns that restricted social gatherings and ordered temporary closures of businesses deemed non-essential. Despite the partial lifting of these measures in some of the states in the Bancorp’s geographic footprint, the recent fluctuations in the number of COVID-19 cases mean that it remains unknown when there will be a return to normal economic activity. During the year ended December 31, 2020, the Bancorp observed the impact of the pandemic on its business. The decline of asset prices, reduction in interest rates, widening of credit spreads, borrower and counterparty credit deterioration and market volatility had the most immediate negative impacts on current performance. Although the Bancorp is unable to estimate the extent of the impact, the continuing pandemic and related global economic crisis will adversely impact its future operating results. As the cases of COVID-19 continued to rise, the disruption in the financial markets led the FRB to enact unprecedented policies to offset forced liquidations and restore liquidity in the financial markets. The FRB cut rates to the zero lower bound, announced unlimited purchases of treasuries along with agency mortgage-backed securities and commercial mortgage-backed securities, and established several facilities designed to support the smooth functioning of credit markets.52 Fifth Third BancorpTable of Contents MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSGovernment Response to the COVID-19 PandemicCongress, the FRB and the other U.S. state and federal financial regulatory agencies have taken actions to mitigate disruptions to economic activity and financial stability resulting from the COVID-19 pandemic. The descriptions below summarize certain significant government actions taken in response to the COVID-19 pandemic. The descriptions are qualified in their entirety by reference to the particular statutory or regulatory provisions or government programs summarized.The CARES ActThe Coronavirus Aid, Relief and Economic Security (“CARES”) Act was signed into law on March 27, 2020 and has subsequently been amended several times, including by the Consolidated Appropriations Act, 2021. Among other provisions, the CARES Act includes funding for the SBA to expand lending, relief from certain U.S. GAAP requirements to allow COVID-19-related loan modifications to not be categorized as TDRs and a range of incentives to encourage deferment, forbearance or modification of consumer credit and mortgage contracts. One of the key CARES Act programs is the Paycheck Protection Program, which has temporarily expanded the SBA’s business loan guarantee program. Paycheck Protection Program loans are available to a broader range of entities than ordinary SBA loans, require deferral of principal and interest repayment, and the loan may be forgiven if the borrower demonstrates that the loan proceeds were used for qualified payroll costs and certain other expenses. The Paycheck Protection Program was expanded to permit a second round of funding, including for certain borrowers who have already received a PPP loan, subject to certain conditions. The CARES Act contains additional protections for homeowners and renters of properties with federally-backed mortgages, including a 60-day moratorium on the initiation of foreclosure proceedings beginning on March 18, 2020 and a 120-day moratorium on initiating eviction proceedings effective March 27, 2020. Borrowers of federally-backed mortgages have the right under the CARES Act to request up to 360 days of forbearance on their mortgage payments if they experience financial hardship directly or indirectly due to the COVID-19 public health emergency. The Federal Housing Administration, Fannie Mae and Freddie Mac have independently extended their moratorium on foreclosures and evictions for single-family federally backed mortgages until at least June 30, 2021. Also pursuant to the CARES Act, the U.S. Treasury has the authority to provide loans, guarantees and other investments in support of eligible businesses, states and municipalities affected by the economic effects of COVID-19. Some of these funds have been used to support several FRB programs and facilities described below or additional programs or facilities that are established by its authority under Section 13(3) of the Federal Reserve Act which meet certain criteria.FRB ActionsThe FRB has taken a range of actions to support the flow of credit to households and businesses. For example, on March 15, 2020, the FRB reduced the target range for the federal funds rate to 0 to 0.25% and announced that it would increase its holdings of U.S. Treasury securities and agency mortgage-backed securities and begin purchasing agency commercial mortgage-backed securities. The FRB has also encouraged depository institutions to borrow from the discount window and has lowered the primary credit rate for such borrowing by 150 basis points while extending the term of such loans up to 90 days. Reserve requirements have been reduced to zero as of March 26, 2020.In addition, the FRB established a range of facilities and programs to support the U.S. economy and U.S. marketplace participants in response to economic disruptions associated with COVID-19. Through these facilities and programs, the FRB, relying on its authority under Section 13(3) of the Federal Reserve Act, has taken steps to directly or indirectly purchase assets from, or make loans to, U.S. companies, financial institutions, municipalities and other market participants.FRB facilities and programs that expired as of December 31, 2020 included:•Main Street New Loan Facility, a Main Street Priority Loan Facility, and a Main Street Expanded Loan Facility to purchase loan participations, under specified conditions, from banks lending to small and medium U.S. businesses;•Primary Market Corporate Credit Facility to purchase corporate bonds directly from, or make loans directly to, eligible participants;•Secondary Market Corporate Credit Facility to purchase corporate bonds trading in secondary markets, including from exchange-traded funds, that were issued by eligible participants;•Term Asset-Backed Securities Loan Facility to make loans secured by asset-backed securities; and•Municipal Liquidity Facility to purchase bonds directly from U.S. state, city and county issuers.FRB facilities and programs that remain active include:•Paycheck Protection Program Liquidity Facility to provide financing related to Paycheck Protection Program loans made by banks;•Primary Dealer Credit Facility to provide liquidity to primary dealers through a secured lending facility;•Commercial Paper Funding Facility to purchase the commercial paper of certain U.S. issuers; and•Money Market Mutual Fund Liquidity Facility to purchase certain assets from, or make loans to, financial institutions providing financing to eligible money market mutual funds.For commercial and consumer customers, Fifth Third has provided a host of relief options, including loan covenant relief, loan maturity extensions, payment deferrals, forbearances and fee waivers. 53 Fifth Third BancorpTable of Contents MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSPaycheck Protection ProgramAs previously discussed, the Bancorp is participating in the SBA’s Paycheck Protection Program which was created by the CARES Act on March 27, 2020. As of December 31, 2020, the Bancorp held approximately 24,000 loans with a carrying amount of $4.8 billion under the program. For further discussion on Fifth Third’s hardship relief programs as a result of the COVID-19 pandemic, refer to the Credit Risk Management subsection of the Risk Management section of MD&A and Note 1 of the Notes to Consolidated Financial Statements.Senior Notes OfferingsOn January 31, 2020, the Bank issued and sold, under its bank notes program, $1.25 billion in aggregate principal amount of senior fixed-rate notes. The bank notes consisted of $650 million of 1.80% senior fixed-rate notes, with a maturity of three years, due on January 30, 2023; and $600 million of 2.25% senior fixed-rate notes, with a maturity of seven years, due on February 1, 2027.On May 5, 2020, the Bancorp issued and sold $1.25 billion in aggregate principal amount of senior fixed-rate notes. The notes consisted of $500 million of 1.625% senior fixed-rate notes, with a maturity of three years, due on May 5, 2023; and $750 million of 2.55% senior fixed-rate notes, with a maturity of seven years, due on May 5, 2027. For more information on the senior notes offerings, including disclosure on the redemption options, refer to Note 18 of the Notes to Consolidated Financial Statements.Preferred Stock OfferingOn July 30, 2020, the Bancorp issued in a registered public offering 350,000 depositary shares, representing 14,000 shares of 4.50% fixed-rate reset non-cumulative perpetual preferred stock, Series L, for net proceeds of approximately $346 million. Each preferred share has a $25,000 liquidation preference. For more information on the preferred stock offering, including disclosure on the redemption options, refer to Note 25 of the Notes to Consolidated Financial Statements.LIBOR TransitionIn July 2017, the Chief Executive of the United Kingdom Financial Conduct Authority (the “FCA”), which regulates LIBOR, announced that FCA will stop persuading or compelling banks to submit rates for the calculation of LIBOR to the administrator of LIBOR after 2021. Since then, central banks around the world, including the Federal Reserve, have commissioned working groups of market participants and official sector representatives with the goal of finding suitable replacements for LIBOR. The Bancorp has substantial exposure to LIBOR-based products within its commercial lending, commercial deposits, business banking, consumer lending and capital markets lines of business as well as corporate treasury function. It is expected that a transition away from the widespread use of LIBOR to alternative reference rates for new financial contracts will occur by the end of 2021. On November 30, 2020, the Federal Reserve, OCC, and FDIC issued a public statement that the administrator of LIBOR announced it will consult on an extension of publication of certain U.S. Dollar (“USD”) LIBOR tenors until June 30, 2023, which would allow additional legacy USD LIBOR contracts to mature before the succession of LIBOR. The administrator has not yet announced the results of its consultation. Although the full impact of LIBOR reforms and actions remains unclear, the Bancorp continues to prepare to transition from LIBOR to these alternative reference rates. In the United States, it is likely that LIBOR-priced transactions and products will transfer to the Secured Overnight Financing Rate (“SOFR”). There are risks inherent with the transition to any alternative rate such as SOFR as the rates may behave differently than LIBOR in reaction to monetary, market and economic events. .The Bancorp’s LIBOR transition plan is organized around key work streams, including continued engagement with central banks and industry working groups and regulators, active client engagement, comprehensive review of legacy documentation, internal operational and technological readiness, and risk management, among other things, to facilitate the transition to alternative reference rates.For a further discussion of the various risks the Bancorp faces in connection with the expected replacement of LIBOR on its operations, see “Risk Factors—Market Risks—The replacement of LIBOR could adversely affect Fifth Third’s revenue or expenses and the value of those assets or obligations.” in Item 1A. Risk Factors of this Annual Report on Form 10-K.Key Performance IndicatorsThe Bancorp, as a banking institution, utilizes various key indicators of financial condition and operating results in managing and monitoring the performance of the business. In addition to traditional financial metrics, such as revenue and expense trends, the Bancorp monitors other financial measures that assist in evaluating growth trends, capital strength and operational efficiencies. The Bancorp analyzes these key performance indicators against its past performance, its forecasted performance and with the performance of its peer banking institutions. These indicators may change from time to time as the operating environment and businesses change.The following are key performance indicators used by management to make operating decisions and evaluate capital utilization:•CET1 Capital Ratio: CET1 capital divided by risk-weighted assets as defined by the Basel III standardized approach to risk-weighting of assets54 Fifth Third BancorpTable of Contents MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS•Return on Average Tangible Common Equity (non-GAAP): Tangible net income available to common shareholders divided by average tangible common equity•Efficiency Ratio: Noninterest expense divided by the sum of net interest income on an FTE basis (non-GAAP) and noninterest income •Earnings Per Share, Diluted: Net income allocated to common shareholders divided by average common shares outstanding after the effect of dilutive stock-based awards•Nonperforming Portfolio Assets Ratio: Nonperforming portfolio assets divided by portfolio loans and leases and OREO•Return on Average Assets: Net income divided by average assets•Loan-to-Deposit Ratio: Total loans divided by total depositsTABLE 1: Condensed Consolidated Statements of IncomeFor the years ended December 31 ($ in millions, except per share data)20202019201820172016Interest income (FTE)(a)$5,585 6,271 5,199 4,515 4,218 Interest expense790 1,457 1,043 691 578 Net Interest Income (FTE)(a)4,795 4,814 4,156 3,824 3,640 Provision for credit losses1,097 471 207 261 366 Net Interest Income After Provision for Credit Losses (FTE)(a)3,698 4,343 3,949 3,563 3,274 Noninterest income2,830 3,536 2,790 3,224 2,696 Noninterest expense4,718 4,660 3,958 3,782 3,737 Income Before Income Taxes (FTE)(a)1,810 3,219 2,781 3,005 2,233 Fully taxable equivalent adjustment13 17 16 26 25 Applicable income tax expense370 690 572 799 665 Net Income1,427 2,512 2,193 2,180 1,543 Less: Net income attributable to noncontrolling interests— — — — (4)Net Income Attributable to Bancorp1,427 2,512 2,193 2,180 1,547 Dividends on preferred stock104 93 75 75 75 Net Income Available to Common Shareholders$1,323 2,419 2,118 2,105 1,472 Earnings per share - basic$1.84 3.38 3.11 2.86 1.92 Earnings per share - diluted$1.83 3.33 3.06 2.81 1.91 Cash dividends declared per common share$1.08 0.94 0.74 0.60 0.53 (a)These are non-GAAP measures. For further information, refer to the Non-GAAP Financial Measures section of MD&A.Earnings SummaryThe Bancorp’s net income available to common shareholders for the year ended December 31, 2020 was $1.3 billion, or $1.83 per diluted share, which was net of $104 million in preferred stock dividends. The Bancorp’s net income available to common shareholders for the year ended December 31, 2019 was $2.4 billion, or $3.33 per diluted share, which was net of $93 million in preferred stock dividends.Net interest income on an FTE basis (non-GAAP) was $4.8 billion for both the years ended December 31, 2020 and 2019. Net interest income was negatively impacted by decreases in yields on average interest-earning assets of 108 bps. The decreases in yields on average interest-earning assets were primarily driven by lower yields on total average loans and leases primarily as a result of decreases in yields on average commercial and industrial loans, average commercial mortgage loans, average commercial construction loans and average home equity of 98 bps, 127 bps, 172 bps and 126 bps, respectively, from the year ended December 31, 2019. The decrease in yields on total average loans and leases for the year ended December 31, 2020 was primarily due to a decrease in market rates, impacting the Bancorp’s portfolios of floating interest rate loans, which are primarily LIBOR- and Prime-based. Net interest income was also negatively impacted by increases in average interest checking deposits and average money market deposits of $10.2 billion and $4.0 billion, respectively, from the year ended December 31, 2019. These negative impacts were partially offset by decreases in rates paid on average interest-bearing liabilities of 73 bps. The decreases in rates paid on average interest-bearing liabilities were primarily driven by decreases in rates paid on average interest checking deposits, average money market deposits and average long-term debt of 81 bps, 76 bps and 48 bps, respectively, from the year ended December 31, 2019. Net interest income also benefited from increases in average commercial and industrial loans, average indirect secured consumer loans and average commercial mortgage loans of $3.6 billion, $2.1 billion and $1.1 billion, respectively, from the year ended December 31, 2019. Net interest income for the year ended December 31, 2020 compared to the year ended December 31, 2019 was adversely impacted by lower market interest rates due to the FOMC decisions to lower the target range of the federal funds rate and the Federal Reserve's bond purchase programs. During the years ended December 31, 2020 and 2019, net interest income included $57 million and $65 million, respectively, of amortization and accretion of premiums and discounts on acquired loans and leases and assumed deposits and long-term debt from acquisitions. Net interest margin on an FTE basis (non-GAAP) was 2.78% for the year ended December 31, 2020 compared to 3.31% for the year ended December 31, 2019.Effective January 1, 2020, the Bancorp adopted ASU 2016-13 which established a new approach for estimating credit losses on certain types of financial instruments. The Bancorp recognized an initial increase to the ACL of approximately $653 million upon adoption of ASU 2016-13 on January 1, 2020, which included $171 million from the non-PCD loan portfolio resulting from the MB Financial, Inc. acquisition. The provision for credit losses was $1.1 billion for the year ended December 31, 2020 compared to $471 million for the prior year. The increase in provision expense for the year ended December 31, 2020 compared to the prior year was primarily due to an increase in the ACL 55 Fifth Third BancorpTable of Contents MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSreflecting deterioration in the macroeconomic environment as a result of the impact of the COVID-19 pandemic and the resulting impact of this environment on commercial borrowers as reflected in increased levels of commercial criticized assets. The increase in the provision for credit losses also reflected the impact of the change in methodology for estimating credit losses from the incurred loss methodology to the expected credit loss methodology beginning in the first quarter of 2020. Net losses charged off as a percent of average portfolio loans and leases were 0.42% and 0.35% for the years ended December 31, 2020 and 2019, respectively. At December 31, 2020, nonperforming portfolio assets as a percent of portfolio loans and leases and OREO increased to 0.79% compared to 0.62% at December 31, 2019. For further discussion on credit quality refer to the Credit Risk Management subsection of the Risk Management section of MD&A as well as Note 7 of the Notes to Consolidated Financial Statements.Noninterest income decreased $706 million for the year ended December 31, 2020 compared to the year ended December 31, 2019 primarily due to a decrease in other noninterest income, partially offset by increases in commercial banking revenue, wealth and asset management revenue and mortgage banking net revenue. Other noninterest income decreased $853 million for the year ended December 31, 2020 compared to the year ended December 31, 2019 primarily due to the $562 million gain on sale of Worldpay, Inc. shares recognized during the first quarter of 2019 and a decrease of $272 million in the income from the TRA associated with Worldpay, Inc primarily driven by a $345 million gain recognized in the fourth quarter of 2019 from the Worldpay, Inc. TRA transaction. Commercial banking revenue increased $68 million for the year ended December 31, 2020 compared to the year ended December 31, 2019 primarily driven by increases in institutional sales and bridge fees of $68 million and $10 million, respectively, partially offset by a decrease in loan syndication fees of $20 million. Wealth and asset management revenue increased $33 million for the year ended December 31, 2020 compared to the year ended December 31, 2019 primarily due to increases of $16 million in both private client service fees and broker income. Mortgage banking net revenue increased $33 million for the year ended December 31, 2020 compared to the year ended December 31, 2019 primarily due to an increase of $140 million in origination fees and gains on loan sales, partially offset by an increase of $103 million in net negative valuation adjustments. Noninterest expense increased $58 million for the year ended December 31, 2020 compared to the year ended December 31, 2019 primarily due to an increase in compensation and benefits expense, partially offset by decreases in technology and communications expense and marketing expense. The Bancorp recognized $16 million of merger-related expenses related to the MB Financial, Inc. acquisition for the year ended December 31, 2020 compared to $222 million for the year ended December 31, 2019. Compensation and benefits expense increased $172 million for the year ended December 31, 2020 compared to the year ended December 31, 2019 primarily due to strategic hiring and the impact of raising the Bancorp’s minimum wage in the fourth quarter of 2019, as well as increases in incentive compensation driven by strong performance in fees related to business growth during the year ended December 31, 2020. Technology and communications expense decreased $60 million for the year ended December 31, 2020 compared to the year ended December 31, 2019 primarily driven by decreased integration and conversion costs related to the acquisition of MB Financial, Inc. Marketing expense decreased $58 million for the year ended December 31, 2020 compared to the year ended December 31, 2019 primarily due to the impact of the COVID-19 pandemic, which resulted in a pause or slowdown in numerous marketing campaigns, including running less advertising as well as the suspension of cash bonus and other account acquisition programs.For more information on net interest income, noninterest income and noninterest expense, refer to the Statements of Income Analysis section of MD&A.Capital SummaryThe Bancorp calculated its regulatory capital ratios under the Basel III standardized approach to risk-weighting of assets and pursuant to the five-year transition provision option to phase in the effects of CECL on regulatory capital as of December 31, 2020. As of December 31, 2020, the Bancorp’s capital ratios, as defined by the U.S. banking agencies, were: •CET1 capital ratio: 10.34%;•Tier I risk-based capital ratio: 11.83%;•Total risk-based capital ratio: 15.08%;•Tier I leverage ratio: 8.49%56 Fifth Third BancorpTable of Contents MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSNON-GAAP FINANCIAL MEASURESThe following are non-GAAP financial measures which provide useful insight to the reader of the Consolidated Financial Statements but should be supplemental to primary U.S. GAAP measures and should not be read in isolation or relied upon as a substitute for the primary U.S. GAAP measures.The FTE basis adjusts for the tax-favored status of income from certain loans and securities held by the Bancorp that are not taxable for federal income tax purposes. The Bancorp believes this presentation to be the preferred industry measurement of net interest income as it provides a relevant comparison between taxable and non-taxable amounts.The following table reconciles the non-GAAP financial measures of net interest income on an FTE basis, interest income on an FTE basis, net interest margin, net interest rate spread and the efficiency ratio to U.S. GAAP:TABLE 2: Non-GAAP Financial Measures - Financial Measures and Ratios on an FTE basisFor the years ended December 31 ($ in millions)202020192018Net interest income (U.S. GAAP)$4,782 4,797 4,140 Add: FTE adjustment13 17 16 Net interest income on an FTE basis (1)$4,795 4,814 4,156 Interest income (U.S. GAAP)$5,572 6,254 5,183 Add: FTE adjustment13 17 16 Interest income on an FTE basis (2)$5,585 6,271 5,199 Interest expense (3)$790 1,457 1,043 Noninterest income (4)2,830 3,536 2,790 Noninterest expense (5)4,718 4,660 3,958 Average interest-earning assets (6)172,688 145,404 128,905 Average interest-bearing liabilities (7)119,018 104,708 89,959 Ratios:Net interest margin on an FTE basis (1) / (6)2.78 %3.31 3.22 Net interest rate spread on an FTE basis ((2) / (6)) - ((3) / (7))2.57 2.92 2.87 Efficiency ratio on an FTE basis (5) / ((1) + (4))61.9 55.8 57.0 The Bancorp believes return on average tangible common equity is an important measure for comparative purposes with other financial institutions, but is not defined under U.S. GAAP, and therefore is considered a non-GAAP financial measure. This measure is useful for evaluating the performance of a business as it calculates the return available to common shareholders without the impact of intangible assets and their related amortization.The following table reconciles the non-GAAP financial measure of return on average tangible common equity to U.S. GAAP:TABLE 3: Non-GAAP Financial Measures - Return on Average Tangible Common EquityFor the years ended December 31 ($ in millions)20202019Net income available to common shareholders (U.S. GAAP)$1,323 2,419 Add: Intangible amortization, net of tax38 35 Tangible net income available to common shareholders (1)$1,361 2,454 Average Bancorp shareholders’ equity (U.S. GAAP)$22,555 19,902 Less: Average preferred stock1,916 1,470 Average goodwill4,258 3,888 Average intangible assets172 169 Average tangible common equity (2)$16,209 14,375 Return on average tangible common equity (1) / (2)8.4 %17.1 The Bancorp considers various measures when evaluating capital utilization and adequacy, including the tangible equity ratio and tangible common equity ratio, in addition to capital ratios defined by the U.S. banking agencies. These calculations are intended to complement the capital ratios defined by the U.S. banking agencies for both absolute and comparative purposes. Because U.S. GAAP does not include capital ratio measures, the Bancorp believes there are no comparable U.S. GAAP financial measures to these ratios. These ratios are not formally 57 Fifth Third BancorpTable of Contents MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSdefined by U.S. GAAP or codified in the federal banking regulations and, therefore, are considered to be non-GAAP financial measures. The Bancorp encourages readers to consider its Consolidated Financial Statements in their entirety and not to rely on any single financial measure.The following table reconciles non-GAAP capital ratios to U.S. GAAP:TABLE 4: Non-GAAP Financial Measures - Capital RatiosAs of December 31 ($ in millions)20202019Total Bancorp Shareholders’ Equity (U.S. GAAP)$23,111 21,203 Less: Preferred stock2,116 1,770 Goodwill4,258 4,252 Intangible assets139 201 AOCI2,601 1,192 Tangible common equity, excluding AOCI (1)13,997 13,788 Add: Preferred stock2,116 1,770 Tangible equity (2)$16,113 15,558 Total Assets (U.S. GAAP)$204,680 169,369 Less: Goodwill4,258 4,252 Intangible assets139 201 AOCI, before tax3,292 1,509 Tangible assets, excluding AOCI (3)$196,991 163,407 Ratios:Tangible equity as a percentage of tangible assets (2) / (3)8.18 %9.52 Tangible common equity as a percentage of tangible assets (1) / (3)7.11 8.44 58 Fifth Third BancorpTable of Contents MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSRECENT ACCOUNTING STANDARDSNote 1 of the Notes to Consolidated Financial Statements provides a discussion of the significant new accounting standards applicable to the Bancorp during 2020 and the expected impact of significant accounting standards issued, but not yet required to be adopted.CRITICAL ACCOUNTING POLICIESThe Bancorp’s Consolidated Financial Statements are prepared in accordance with U.S. GAAP. Certain accounting policies require management to exercise judgment in determining methodologies, economic assumptions and estimates that may materially affect the Bancorp’s financial position, results of operations and cash flows. The Bancorp’s critical accounting policies include the accounting for the ALLL, reserve for unfunded commitments, valuation of servicing rights, fair value measurements, goodwill and legal contingencies. On January 1, 2020, the Bancorp adopted ASU 2016-13 (“Financial Instruments—Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments”) and its related subsequent amendments, along with ASU 2017-04 (“Intangibles—Goodwill and Other (Topic 350): Simplifying the Test for Goodwill Impairment”). For additional information about these ASUs and their impacts on the Bancorp, refer to Note 1 of the Notes to Consolidated Financial Statements. As a result of the adoption of these ASUs, the accounting policies for the ALLL, reserve for unfunded commitments and goodwill have been updated as of January 1, 2020, and the related policies that were in effect for periods prior to January 1, 2020 are provided in the Critical Accounting Policies Applicable Prior to January 1, 2020 section below. There have been no other material changes to the valuation techniques or models described below during the year ended December 31, 2020.ALLLThe Bancorp disaggregates its portfolio loans and leases into portfolio segments for purposes of determining the ALLL. The Bancorp’s portfolio segments include commercial, residential mortgage and consumer. The Bancorp further disaggregates its portfolio segments into classes for purposes of monitoring and assessing credit quality based on certain risk characteristics. For an analysis of the Bancorp’s ALLL by portfolio segment and credit quality information by class, refer to Note 7 of the Notes to Consolidated Financial Statements.The Bancorp maintains the ALLL to absorb the amount of credit losses that are expected to be incurred over the remaining contractual terms of the related loans and leases. Contractual terms are adjusted for expected prepayments but are not extended for expected extensions, renewals or modifications except in circumstances where the Bancorp reasonably expects to execute a TDR with the borrower or where certain extension or renewal options are embedded in the original contract and not unconditionally cancellable by the Bancorp. Accrued interest receivable on loans is presented in the Consolidated Financial Statements as a component of other assets. When accrued interest is deemed to be uncollectible (typically when a loan is placed on nonaccrual status), interest income is reversed. The Bancorp follows established policies for placing loans on nonaccrual status, so uncollectible accrued interest receivable is reversed in a timely manner. As a result, the Bancorp has elected not to measure an allowance for credit losses for accrued interest receivable. For additional information on the Bancorp’s accounting policies related to nonaccrual loans and leases, refer to Note 1 of the Notes to Consolidated Financial Statements.Credit losses are charged and recoveries are credited to the ALLL. The ALLL is maintained at a level the Bancorp considers to be adequate and is based on ongoing quarterly assessments and evaluations of the collectability of loans and leases, including historical credit loss experience, current and forecasted market and economic conditions and consideration of various qualitative factors that, in management’s judgment, deserve consideration in estimating expected credit losses. Provisions for credit losses are recorded for the amounts necessary to adjust the ALLL to the Bancorp’s current estimate of expected credit losses on portfolio loans and leases. The Bancorp’s strategy for credit risk management includes a combination of conservative exposure limits significantly below legal lending limits and conservative underwriting, documentation and collections standards. The strategy also emphasizes diversification on a geographic, industry and customer level, regular credit examinations and quarterly management reviews of large credit exposures and loans experiencing deterioration of credit quality.The Bancorp’s methodology for determining the ALLL requires significant management judgment and includes an estimate of expected credit losses on a collective basis for groups of loans and leases with similar risk characteristics and specific allowances for loans and leases which are individually evaluated.Larger commercial loans and leases included within aggregate borrower relationship balances exceeding $1 million that exhibit probable or observed credit weaknesses, as well as loans that have been modified in a TDR, are individually evaluated for an ALLL. The Bancorp considers the current value of collateral, credit quality of any guarantees, the guarantor’s liquidity and willingness to cooperate, the loan or lease structure and other factors when determining the amount of the ALLL. Other factors may include the borrower’s susceptibility to risks presented by the forecasted macroeconomic environment, the industry and geographic region of the borrower, size and financial condition of the borrower, cash flow and leverage of the borrower and the Bancorp’s evaluation of the borrower’s management. Significant management judgment is required when evaluating which of these factors are most relevant in individual circumstances, and when estimating the amount of expected credit losses based on those factors. When loans and leases are individually evaluated, allowances are determined based on management’s estimate of the borrower’s ability to repay the loan or lease given the availability of collateral and other sources of cash flow, as well as an evaluation of legal options available to the Bancorp. Allowances for individually evaluated loans and leases that are collateral-dependent are typically measured based on the fair value of the underlying collateral, less expected costs to sell where applicable. Individually evaluated loans and leases that are not collateral-dependent are measured based on the present value of expected future cash flows discounted at the loan’s effective interest rate. The Bancorp evaluates the collectability of both principal and interest when assessing the need for a loss accrual. Specific allowances on individually evaluated commercial loans and leases, including TDRs, are reviewed quarterly and adjusted as necessary based on changing borrower and/or collateral conditions and actual collection and charge-off experience.59 Fifth Third BancorpTable of Contents MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSExpected credit losses are estimated on a collective basis for loans and leases that are not individually evaluated. These include commercial loans and leases that do not meet the criteria for individual evaluation as well as homogeneous loans in the residential mortgage and consumer portfolio segments. For collectively evaluated loans and leases, the Bancorp uses models to forecast expected credit losses based on the probability of a loan or lease defaulting, the expected balance at the estimated date of default and the expected loss percentage given a default. The estimate of the expected balance at the time of default considers prepayments and, for loans with available credit, expected utilization rates. The Bancorp’s expected credit loss models were developed based on historical credit loss experience and observations of migration patterns for various credit risk characteristics (such as internal credit risk grades, external credit ratings or scores, delinquency status, loan-to-value trends, etc.) over time, with those observations evaluated in the context of concurrent macroeconomic conditions. The Bancorp developed its models from historical observations capturing a full economic cycle when possible.The Bancorp’s expected credit loss models consider historical credit loss experience, current market and economic conditions, and forecasted changes in market and economic conditions if such forecasts are considered reasonable and supportable. Generally, the Bancorp considers its forecasts to be reasonable and supportable for a period of up to three years from the estimation date. For periods beyond the reasonable and supportable forecast period, expected credit losses are estimated by reverting to historical loss information without adjustment for changes in economic conditions. This reversion is phased in over a two-year period. The Bancorp evaluates the length of its reasonable and supportable forecast period, its reversion period and reversion methodology at least annually, or more often if warranted by economic conditions or other circumstances.The Bancorp also considers qualitative factors in determining the ALLL. These considerations inherently require significant management judgment to determine the appropriate factors to be considered and the extent of their impact on the ALLL estimate. Qualitative factors are used to capture characteristics in the portfolio that impact expected credit losses but that are not fully captured within the Bancorp’s expected credit loss models. These include adjustments for changes in policies or procedures in underwriting, monitoring or collections, lending and risk management personnel and results of internal audit and quality control reviews. These may also include adjustments, when deemed necessary, for specific idiosyncratic risks such as geopolitical events, natural disasters and their effects on regional borrowers and changes in product structures. Qualitative factors may also be used to address the impacts of unforeseen events on key inputs and assumptions within the Bancorp’s expected credit loss models, such as the reasonable and supportable forecast period, changes to historical loss information or changes to the reversion period or methodology. When evaluating the adequacy of allowances, consideration is also given to regional geographic concentrations and the closely associated effect that changing economic conditions may have on the Bancorp’s customers.Overall, the collective evaluation process requires significant management judgment when determining the estimation methodology and inputs into the models, as well as in evaluating the reasonableness of the modeled results and the appropriateness of qualitative adjustments. The Bancorp’s forecasts of market and economic conditions and the internal risk grades assigned to loans and leases in the commercial portfolio segment are examples of inputs to the expected credit loss models that require significant management judgment. These inputs have the potential to drive significant variability in the resulting ALLL.Refer to the Allowance for Credit Losses subsection of the Risk Management section of MD&A for a discussion on the Bancorp’s ALLL sensitivity analysis.Reserve for Unfunded CommitmentsThe reserve for unfunded commitments is maintained at a level believed by management to be sufficient to absorb estimated expected credit losses related to unfunded credit facilities and is included in other liabilities in the Consolidated Balance Sheets. The determination of the adequacy of the reserve is based upon expected credit losses over the remaining contractual life of the commitments, taking into consideration the current funded balance and estimated exposure over the reasonable and supportable forecast period. This process takes into consideration the same risk elements that are analyzed in the determination of the adequacy of the Bancorp’s ALLL, as previously discussed. Net adjustments to the reserve for unfunded commitments are included in the provision for credit losses in the Consolidated Statements of Income.Valuation of Servicing RightsWhen the Bancorp sells loans through either securitizations or individual loan sales in accordance with its investment policies, it often obtains servicing rights. The Bancorp may also purchase servicing rights. The Bancorp has elected to measure all existing classes of its residential mortgage servicing rights at fair value at each reporting date with changes in the fair value of servicing rights reported in earnings in the period in which the changes occur. Servicing rights are valued using internal OAS models. Significant management judgment is necessary to identify key economic assumptions used in estimating the fair value of the servicing rights including the prepayment speeds of the underlying loans, the weighted-average life, the OAS and the weighted-average coupon rate, as applicable. The primary risk of material changes to the value of the servicing rights resides in the potential volatility in the economic assumptions used, particularly the prepayment speeds. In order to assist in the assessment of the fair value of servicing rights, the Bancorp obtains external valuations of the servicing rights portfolio from third parties and participates in peer surveys that provide additional confirmation of the reasonableness of key assumptions utilized in the internal OAS model. For additional information on servicing rights, refer to Note 14 of the Notes to Consolidated Financial Statements.60 Fifth Third BancorpTable of Contents MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSFair Value MeasurementsThe Bancorp measures certain financial assets and liabilities at fair value in accordance with U.S. GAAP, which defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. The Bancorp employs various valuation approaches to measure fair value including the market, income and cost approaches. The market approach uses prices or relevant information generated by market transactions involving identical or comparable assets or liabilities. The income approach involves discounting future amounts to a single present amount and is based on current market expectations about those future amounts. The cost approach is based on the amount that currently would be required to replace the service capacity of the asset.U.S. GAAP establishes a fair value hierarchy which prioritizes the inputs to valuation techniques used to measure fair value into three broad levels. The fair value hierarchy gives the highest priority to quoted prices in active markets for identical assets or liabilities (Level 1) and the lowest priority to unobservable inputs (Level 3). A financial instrument’s categorization within the fair value hierarchy is based upon the lowest level of input that is significant to the instrument’s fair value measurement. For additional information on the fair value hierarchy and fair value measurements, refer to Note 1 of the Notes to Consolidated Financial Statements.The Bancorp’s fair value measurements involve various valuation techniques and models, which involve inputs that are observable, when available. Valuation techniques and parameters used for measuring assets and liabilities are reviewed and validated by the Bancorp on a quarterly basis. Additionally, the Bancorp monitors the fair values of significant assets and liabilities using a variety of methods including the evaluation of pricing runs and exception reports based on certain analytical criteria, comparison to previous trades and overall review and assessments for reasonableness. The level of management judgment necessary to determine fair value varies based upon the methods used in the determination of fair value. Financial instruments that are measured at fair value using quoted prices in active markets (Level 1) require minimal judgment. The valuation of financial instruments when quoted market prices are not available (Levels 2 and 3) may require significant management judgment to assess whether quoted prices for similar instruments exist, the impact of changing market conditions including reducing liquidity in the capital markets and the use of estimates surrounding significant unobservable inputs. Table 5 provides a summary of the fair value of financial instruments carried at fair value on a recurring basis and the amounts of financial instruments valued using Level 3 inputs.TABLE 5: Fair Value SummaryAs of ($ in millions)December 31, 2020December 31, 2019BalanceLevel 3 BalanceLevel 3 Assets carried at fair value$43,079 878 40,446 1,194 As a percent of total assets21 %— 24 1 Liabilities carried at fair value$1,527 209 890 171 As a percent of total liabilities1 %— 1 — Refer to Note 29 of the Notes to Consolidated Financial Statements for further information on fair value measurements including a description of the valuation methodologies used for significant financial instruments.GoodwillBusiness combinations entered into by the Bancorp typically include the recognition of goodwill. U.S. GAAP requires goodwill to be tested for impairment at the Bancorp’s reporting unit level on an annual basis, which for the Bancorp is September 30, and more frequently if events or circumstances indicate that there may be impairment. Refer to Note 1 of the Notes to Consolidated Financial Statements for a discussion on the methodology used by the Bancorp to assess goodwill for impairment.Impairment exists when a reporting unit’s carrying amount of goodwill exceeds its implied fair value. In testing goodwill for impairment, U.S. GAAP permits the Bancorp to first assess qualitative factors to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount. In this qualitative assessment, the Bancorp evaluates events and circumstances which may include, but are not limited to, the general economic environment, banking industry and market conditions, the overall financial performance of the Bancorp, the performance of the Bancorp’s common stock, the key financial performance metrics of the Bancorp’s reporting units and events affecting the reporting units to determine if it is not more likely than not that the fair value of a reporting unit is less than its carrying amount. If the quantitative impairment test is required or the decision to bypass the qualitative assessment is elected, the Bancorp performs the goodwill impairment test by comparing the fair value of a reporting unit with its carrying amount, including goodwill. If the carrying amount of the reporting unit exceeds its fair value, an impairment loss is recognized in an amount equal to that excess, limited to the total amount of goodwill allocated to that reporting unit. A recognized impairment loss cannot be reversed in future periods even if the fair value of the reporting unit subsequently recovers.The fair value of a reporting unit is the price that would be received to sell the unit as a whole in an orderly transaction between market participants at the measurement date. As none of the Bancorp’s reporting units are publicly traded, individual reporting unit fair value determinations cannot be directly correlated to the Bancorp’s stock price. The determination of the fair value of a reporting unit is a subjective process that involves the use of estimates and judgments, particularly related to cash flows, the appropriate discount rates and an applicable control premium. The Bancorp employs an income-based approach, utilizing the reporting unit’s forecasted cash flows (including a terminal value approach to estimate cash flows beyond the final year of the forecast) and the reporting unit’s estimated cost of equity as the 61 Fifth Third BancorpTable of Contents MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSdiscount rate. Significant management judgment is necessary in the preparation of each reporting unit’s forecasted cash flows surrounding expectations for earnings projections, growth and credit loss expectations and actual results may differ from forecasted results. Additionally, the Bancorp determines its market capitalization based on the average of the closing price of the Bancorp’s stock during the month including the measurement date, incorporating an additional control premium, and compares this market-based fair value measurement to the aggregate fair value of the Bancorp’s reporting units in order to corroborate the results of the income approach. Refer to Note 11 of the Notes to Consolidated Financial Statements for further information regarding the Bancorp’s goodwill.Legal ContingenciesThe Bancorp and its subsidiaries are parties to numerous claims and lawsuits as well as threatened or potential actions or claims concerning matters arising from the conduct of its business activities. The outcome of claims or litigation and the timing of ultimate resolution are inherently difficult to predict and significant judgment may be required in the determination of both the probability of loss and whether the amount of the loss is reasonably estimable. The Bancorp’s estimates are subjective and are based on the status of legal and regulatory proceedings, the merit of the Bancorp’s defenses and consultation with internal and external legal counsel. An accrual for a potential litigation loss is established when information related to the loss contingency indicates both that a loss is probable and that the amount of loss can be reasonably estimated. Refer to Note 20 of the Notes to Consolidated Financial Statements for further information regarding the Bancorp’s legal proceedings.Critical Accounting Policies Applicable Prior to January 1, 2020The following paragraphs describe the portions of the Bancorp’s critical accounting policies that were applicable prior to January 1, 2020 but were updated in conjunction with the prospective adoption of ASU 2016-13 and ASU 2017-04 on January 1, 2020. The following paragraphs do not include the portions of the respective policies that were not affected by the adoption of these new accounting standards. Refer to Note 1 of the Notes to Consolidated Financial Statements for additional information.ALLLThe Bancorp maintained the ALLL to absorb probable loan and lease losses inherent in its portfolio segments. The ALLL was maintained at a level the Bancorp considered to be adequate and was based on ongoing quarterly assessments and evaluations of the collectability and historical loss experience of loans and leases. Credit losses were charged and recoveries were credited to the ALLL. Provisions for loan and lease losses were based on the Bancorp’s review of the historical credit loss experience and such factors that, in management’s judgment, deserved consideration under existing economic conditions in estimating probable credit losses. The Bancorp’s methodology for determining the ALLL required significant management judgment and was based on historical loss rates, current credit grades, specific allocation on loans modified in a TDR and impaired commercial credits above specified thresholds and other qualitative adjustments. Allowances on individual commercial loans and leases, TDRs and historical loss rates were reviewed quarterly and adjusted as necessary based on changing borrower and/or collateral conditions and actual collection and charge-off experience. An unallocated allowance was maintained to recognize the imprecision in estimating and measuring losses when evaluating allowances for pools of loans and leases.Larger commercial loans and leases included within aggregate borrower relationship balances exceeding $1 million that exhibited probable or observed credit weaknesses, as well as loans that had been modified in a TDR, were subject to individual review for impairment. The Bancorp considered the current value of collateral, credit quality of any guarantees, the guarantor’s liquidity and willingness to cooperate, the loan or lease structure and other factors when evaluating whether an individual loan or lease was impaired. Other factors might include the industry and geographic region of the borrower, size and financial condition of the borrower, cash flow and leverage of the borrower and the Bancorp’s evaluation of the borrower’s management. When individual loans and leases were impaired, allowances were determined based on management’s estimate of the borrower’s ability to repay the loan or lease given the availability of collateral and other sources of cash flow, as well as an evaluation of legal options available to the Bancorp. Allowances for impaired loans and leases were measured based on the present value of expected future cash flows discounted at the loan’s effective interest rate, fair value of the underlying collateral or readily observable secondary market values. The Bancorp evaluated the collectability of both principal and interest when assessing the need for a loss accrual.Historical credit loss rates were applied to commercial loans and leases that were not impaired or were impaired, but smaller than the established threshold of $1 million and thus not subject to specific allowance allocations. The loss rates were derived from migration analyses for several portfolio stratifications, which tracked the historical net charge-off experience sustained on loans and leases according to their internal risk grade. The risk grading system utilized for allowance analysis purposes encompassed ten categories, which were based on regulatory guidance for credit risk systems.Homogenous loans in the residential mortgage and consumer portfolio segments were not individually risk graded. Rather, standard credit scoring systems and delinquency monitoring were used to assess credit risks and allowances were established based on the expected net charge-offs. Loss rates were based on the trailing twelve-month net charge-off history by loan category. Historical loss rates were adjusted for certain prescriptive and qualitative factors that, in management’s judgment, were necessary to reflect losses inherent in the portfolio. The prescriptive loss rate factors included adjustments for delinquency trends, LTV trends, refreshed FICO score trends and product mix.62 Fifth Third BancorpTable of Contents MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSThe Bancorp also considered qualitative factors in determining the ALLL. These included adjustments for changes in policies or procedures in underwriting, monitoring or collections, economic conditions, portfolio mix, lending and risk management personnel, results of internal audit and quality control reviews, collateral values, geographic concentrations, estimated loss emergence period and specific portfolio loans backed by enterprise valuations and private equity sponsors. The Bancorp considered home price index trends in its footprint and the volatility of collateral valuation trends when determining the collateral value qualitative factor.Reserve for unfunded commitmentsThe reserve for unfunded commitments was maintained at a level believed by management to be sufficient to absorb estimated probable losses related to unfunded credit facilities and was included in other liabilities in the Consolidated Balance Sheets. The determination of the adequacy of the reserve was based upon an evaluation of the unfunded credit facilities, including an assessment of historical commitment utilization experience, credit risk grading and historical loss rates based on credit grade migration. This process took into consideration the same risk elements that were analyzed in the determination of the adequacy of the Bancorp’s ALLL, as previously discussed. Net adjustments to the reserve for unfunded commitments were included in provision for credit losses in the Consolidated Statements of Income.GoodwillImpairment existed when a reporting unit’s carrying amount of goodwill exceeded its implied fair value. In testing goodwill for impairment, U.S. GAAP permitted the Bancorp to first assess qualitative factors to determine whether it was more likely than not that the fair value of a reporting unit was less than its carrying amount. In this qualitative assessment, the Bancorp evaluated events and circumstances which might include, but were not limited to, the general economic environment, banking industry and market conditions, the overall financial performance of the Bancorp, the performance of the Bancorp’s common stock, the key financial performance metrics of the Bancorp’s reporting units and events affecting the reporting units. If, after assessing the totality of events and circumstances, the Bancorp determined it was not more likely than not that the fair value of a reporting unit was less than its carrying amount, then performing the two-step impairment test would be unnecessary. However, if the Bancorp concluded otherwise or elected to bypass the qualitative assessment, it would then be required to perform the first step (Step 1) of the goodwill impairment test, and continue to the second step (Step 2), if necessary. Step 1 of the goodwill impairment test compared the fair value of a reporting unit with its carrying amount, including goodwill. If the carrying amount of the reporting unit exceeded its fair value, Step 2 of the goodwill impairment test was necessary to measure the amount of impairment loss, which was equal to any excess of the carrying amount of goodwill over its implied fair value with such loss limited to the carrying amount of goodwill.The fair value of a reporting unit was the price that would be received to sell the unit as a whole in an orderly transaction between market participants at the measurement date. As none of the Bancorp’s reporting units were publicly traded, individual reporting unit fair value determinations could not be directly correlated to the Bancorp’s stock price. To determine the fair value of a reporting unit, the Bancorp employed an income-based approach, utilizing the reporting unit’s forecasted cash flows (including a terminal value approach to estimate cash flows beyond the final year of the forecast) and the reporting unit’s estimated cost of equity as the discount rate. Significant management judgment was necessary in the preparation of each reporting unit’s forecasted cash flows surrounding expectations for earnings projections, growth and credit loss expectations. Additionally, the Bancorp determined its market capitalization based on the average of the closing price of the Bancorp’s stock during the month including the measurement date, incorporating an additional control premium, and compared this market-based fair value measurement to the aggregate fair value of the Bancorp’s reporting units in order to corroborate the results of the income approach.63 Fifth Third BancorpTable of Contents MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSSTATEMENTS OF INCOME ANALYSISNet Interest IncomeNet interest income is the interest earned on loans and leases (including yield-related fees), securities and other short-term investments less the interest incurred on core deposits (includes transaction deposits and other time deposits) and wholesale funding (includes certificates $100,000 and over, other deposits, federal funds purchased, other short-term borrowings and long-term debt). The net interest margin is calculated by dividing net interest income by average interest-earning assets. Net interest rate spread is the difference between the average yield earned on interest-earning assets and the average rate paid on interest-bearing liabilities. Net interest margin is typically greater than net interest rate spread due to the interest income earned on those assets that are funded by noninterest-bearing liabilities, or free funding, such as demand deposits or shareholders’ equity.Tables 6 and 7 present the components of net interest income, net interest margin and net interest rate spread for the years ended December 31, 2020, 2019 and 2018, as well as the relative impact of changes in the average balance sheet and changes in interest rates on net interest income. Nonaccrual loans and leases and loans and leases held for sale have been included in the average loan and lease balances. Average outstanding securities balances are based on amortized cost with any unrealized gains or losses included in average other assets.Net interest income on an FTE basis (non-GAAP) was $4.8 billion for both the years ended December 31, 2020 and 2019. Net interest income was negatively impacted by decreases in yields on average interest-earning assets of 108 bps. The decreases in yields on average interest-earning assets were primarily driven by lower yields on total average loans and leases primarily as a result of decreases in yields on average commercial and industrial loans, average commercial mortgage loans, average commercial construction loans and average home equity of 98 bps, 127 bps, 172 bps and 126 bps, respectively, from the year ended December 31, 2019. The decrease in yields on total average loans and leases for the year ended December 31, 2020 was primarily due to a decrease in market rates, impacting the Bancorp’s portfolios of floating interest rate loans, which are primarily LIBOR- and Prime-based. The Bancorp’s portfolios of fixed interest rate loans also decreased in yield as a result of increased refinance activity and lower reinvestment yields due to lower overall market rates. Net interest income was also negatively impacted by increases in average interest checking deposits and average money market deposits of $10.2 billion and $4.0 billion, respectively, from the year ended December 31, 2019. These negative impacts were partially offset by decreases in rates paid on average interest-bearing liabilities of 73 bps. The decreases in rates paid on average interest-bearing liabilities were primarily driven by decreases in rates paid on average interest checking deposits, average money market deposits and average long-term debt of 81 bps, 76 bps and 48 bps, respectively, from the year ended December 31, 2019. Net interest income also benefited from increases in average commercial and industrial loans, average indirect secured consumer loans and average commercial mortgage loans of $3.6 billion, $2.1 billion and $1.1 billion, respectively, from the year ended December 31, 2019. The increase in average commercial and industrial loans was primarily as a result of PPP loans originated during the year ended December 31, 2020.Net interest income for the year ended December 31, 2020 compared to the year ended December 31, 2019 was adversely impacted by the FOMC decisions to lower the target range of the federal funds rate and the Federal Reserve’s bond purchase programs. During the years ended December 31, 2020 and 2019, net interest income included $57 million and $65 million, respectively, of amortization and accretion of premiums and discounts on acquired loans and leases and assumed deposits and long-term debt from acquisitions. Net interest rate spread on an FTE basis (non-GAAP) was 2.57% during the year ended December 31, 2020 compared to 2.92% during the year ended December 31, 2019. Yields on average interest-earning assets decreased 108 bps, partially offset by a 73 bps decrease in rates paid on average interest-bearing liabilities for the year ended December 31, 2020 compared to the year ended December 31, 2019.Net interest margin on an FTE basis (non-GAAP) was 2.78% for the year ended December 31, 2020 compared to 3.31% for the year ended December 31, 2019. Net interest margin was negatively impacted by lower market interest rates, a $19.8 billion increase in low-yielding reserves held at the FRB reported in other short-term investments and the previously mentioned growth in PPP loans. These negative impacts were partially offset by increases in average free funding balances as average demand deposits increased $12.8 billion and average shareholders’ equity increased $2.6 billion compared to the year ended December 31, 2019. Net interest margin results are expected to remain suppressed as a result of increased liquidity levels in the form of excess cash balances, which are expected to remain at elevated levels driven by the amount of fiscal stimulus that has increased the banking industry’s balance sheets, including the Bancorp’s.Interest income on an FTE basis (non-GAAP) from loans and leases decreased $632 million from the year ended December 31, 2019 driven by the previously mentioned decreases in yields on average loans and leases, partially offset by increases in average commercial and industrial loans, average indirect secured consumer loans and average commercial mortgage loans as well as the impact of accelerated PPP fees recognized upon loan forgiveness during the year ended December 31, 2020. For more information on the Bancorp’s loan and lease portfolio, refer to the Loans and Leases subsection of the Balance Sheet Analysis section of MD&A. Interest income on an FTE basis (non-GAAP) from investment securities and other short-term investments decreased $54 million from the year ended December 31, 2019 primarily due to decreases in yields on average other short-term investments and average taxable securities, partially offset by increases in average balances.Interest expense on core deposits decreased $518 million from the year ended December 31, 2019 primarily due to decreases in the cost of average interest-bearing core deposits to 28 bps for the year ended December 31, 2020 from 96 bps for the year ended December 31, 2019. The decreases in the cost of average interest-bearing core deposits were primarily due to the previously mentioned decreases in the rates paid 64 Fifth Third BancorpTable of Contents MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSon average interest checking deposits and average money market deposits. Refer to the Deposits subsection of the Balance Sheet Analysis section of MD&A for additional information on the Bancorp’s deposits.Interest expense on average wholesale funding decreased $149 million for the year ended December 31, 2020 compared to the year ended December 31, 2019 primarily due to the previously mentioned decreases in rates paid on average long-term debt as well as decreases in rates paid on average other short-term borrowings and average certificates $100,000 and over, in addition to a decrease in the average balance of certificates $100,000 and over. Refer to the Borrowings subsection of the Balance Sheet Analysis section of MD&A for additional information on the Bancorp’s borrowings. During the year ended December 31, 2020, average wholesale funding represented 18% of average interest-bearing liabilities compared to 21% for the year ended December 31, 2019. For more information on the Bancorp’s interest rate risk management, including estimated earnings sensitivity to changes in market interest rates, see the Interest Rate and Price Risk Management subsection of the Risk Management section of MD&A.65 Fifth Third BancorpTable of Contents MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSTABLE 6: Consolidated Average Balance Sheet and Analysis of Net Interest Income on an FTE Basis For the years ended December 31202020192018($ in millions)AverageBalanceRevenue/CostAverageYield/RateAverageBalanceRevenue/CostAverageYield/RateAverageBalanceRevenue/CostAverageYield/RateAssets:Interest-earning assets:Loans and leases:(a)Commercial and industrial loans$53,814 1,954 3.63 %$50,168 2,313 4.61 %$42,668 1,826 4.28 %Commercial mortgage loans11,011 391 3.54 9,905 476 4.81 6,661 298 4.47 Commercial construction loans5,509 201 3.65 5,174 278 5.37 4,793 240 5.01 Commercial leases3,038 104 3.43 3,578 119 3.31 3,795 108 2.84 Total commercial loans and leases73,372 2,650 3.61 68,825 3,186 4.63 57,917 2,472 4.27 Residential mortgage loans17,828 622 3.49 17,337 635 3.66 16,150 580 3.59 Home equity5,679 222 3.90 6,286 324 5.16 6,631 326 4.92 Indirect secured consumer loans12,454 490 3.93 10,345 423 4.08 8,993 304 3.38 Credit card2,230 260 11.64 2,437 304 12.49 2,280 279 12.25 Other consumer loans2,848 192 6.76 2,564 196 7.63 1,905 132 6.94 Total consumer loans41,039 1,786 4.35 38,969 1,882 4.83 35,959 1,621 4.51 Total loans and leases$114,411 4,436 3.88 %$107,794 5,068 4.70 %$93,876 4,093 4.36 %Securities:Taxable$36,109 1,114 3.08 %$35,429 1,160 3.28 %$33,487 1,079 3.22 %Exempt from income taxes(a)233 6 2.61 41 2 3.97 66 2 3.37 Other short-term investments21,935 29 0.13 2,140 41 1.91 1,476 25 1.68 Total interest-earning assets$172,688 5,585 3.23 %$145,404 6,271 4.31 %$128,905 5,199 4.03 %Cash and due from banks2,978 2,748 2,200 Other assets20,933 16,903 12,203 Allowance for loan and lease losses(2,369)(1,119)(1,125)Total assets$194,230 $163,936 $142,183 Liabilities and Equity:Interest-bearing liabilities:Interest checking deposits$46,890 126 0.27 %$36,658 396 1.08 %$29,818 252 0.85 %Savings deposits16,440 10 0.06 14,041 22 0.16 13,330 14 0.10 Money market deposits29,879 88 0.29 25,879 272 1.05 21,769 162 0.74 Foreign office deposits185 — 0.21 209 1 0.63 363 1 0.33 Other time deposits4,118 47 1.14 5,470 98 1.79 4,106 59 1.44 Total interest-bearing core deposits97,512 271 0.28 82,257 789 0.96 69,386 488 0.70 Certificates $100,000 and over3,337 50 1.49 4,504 97 2.14 2,426 41 1.69 Other deposits71 1 0.76 265 6 2.27 476 9 1.94 Federal funds purchased385 2 0.58 1,267 29 2.26 1,509 30 1.97 Other short-term borrowings1,709 14 0.81 1,046 28 2.67 1,611 29 1.82 Long-term debt16,004 452 2.82 15,369 508 3.30 14,551 446 3.06 Total interest-bearing liabilities$119,018 790 0.66 %$104,708 1,457 1.39 %$89,959 1,043 1.16 %Demand deposits47,111 34,343 32,634 Other liabilities5,546 4,897 3,603 Total liabilities$171,675 $143,948 $126,196 Total equity$22,555 $19,988 $15,987 Total liabilities and equity$194,230 $163,936 $142,183 Net interest income (FTE)(b)$4,795 $4,814 $4,156 Net interest margin (FTE)(b)2.78 %3.31 %3.22 %Net interest rate spread (FTE)(b)2.57 2.92 2.87 Interest-bearing liabilities to interest-earning assets68.92 72.01 69.79 (a)The FTE adjustments included in the above table were $13, $17 and $16 for the years ended December 31, 2020, 2019, and 2018, respectively.(b)Net interest income (FTE), net interest margin (FTE) and net interest rate spread (FTE) are non-GAAP measures. For further information, refer to the Non-GAAP Financial Measures section of MD&A.66 Fifth Third BancorpTable of Contents MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSTABLE 7: Changes in Net Interest Income Attributable to Volume and Yield/Rate(a)For the years ended December 312020 Compared to 20192019 Compared to 2018($ in millions)VolumeYield/RateTotalVolumeYield/RateTotalAssets:Interest-earning assets:Loans and leases:Commercial and industrial loans$159 (518)(359)338 149 487 Commercial mortgage loans50 (135)(85)154 24 178 Commercial construction loans17 (94)(77)20 18 38 Commercial leases(19)4 (15)(6)17 11 Total commercial loans and leases207 (743)(536)506 208 714 Residential mortgage loans17 (30)(13)43 12 55 Home equity(28)(74)(102)(17)15 (2)Indirect secured consumer loans83 (16)67 50 69 119 Credit card(24)(20)(44)20 5 25 Other consumer loans20 (24)(4)50 14 64 Total consumer loans68 (164)(96)146 115 261 Total loans and leases$275 (907)(632)652 323 975 Securities:Taxable$23 (69)(46)63 18 81 Exempt from income taxes5 (1)4 — — — Other short-term investments58 (70)(12)12 4 16 Total change in interest income$361 (1,047)(686)727 345 1,072 Liabilities:Interest-bearing liabilities:Interest checking deposits$88 (358)(270)65 79 144 Savings deposits3 (15)(12)— 8 8 Money market deposits37 (221)(184)35 75 110 Foreign office deposits— (1)(1)(1)1 — Other time deposits(21)(30)(51)22 17 39 Total interest-bearing core deposits107 (625)(518)121 180 301 Certificates $100,000 and over(22)(25)(47)43 13 56 Other deposits(2)(3)(5)(4)1 (3)Federal funds purchased(13)(14)(27)(5)4 (1)Other short-term borrowings12 (26)(14)(12)11 (1)Long-term debt20 (76)(56)25 37 62 Total change in interest expense$102 (769)(667)168 246 414 Total change in net interest income$259 (278)(19)559 99 658 (a)Changes in interest not solely due to volume or yield/rate are allocated in proportion to the absolute dollar amount of change in volume and yield/rate.Provision for Credit LossesThe Bancorp provides as an expense an amount for expected credit losses within the loan and lease portfolio and the portfolio of unfunded loan commitments and letters of credit that is based on factors discussed in the Critical Accounting Policies section of MD&A. The provision is recorded to bring the ALLL and reserve for unfunded commitments to a level deemed appropriate by the Bancorp to cover losses expected in the portfolios. Actual credit losses on loans and leases are charged against the ALLL. The amount of loans and leases actually removed from the Consolidated Balance Sheets are referred to as charge-offs. Net charge-offs include current period charge-offs less recoveries on previously charged-off loans and leases.The provision for credit losses was $1.1 billion for the year ended December 31, 2020 compared to $471 million for the prior year. The increase in provision expense for the year ended December 31, 2020 compared to the prior year was primarily due to an increase in the ACL reflecting deterioration in the macroeconomic environment as a result of the impact of the COVID-19 pandemic and the resulting impact of this environment on commercial borrowers as reflected in increased levels of commercial criticized assets. The increase in the provision for credit losses also reflected the impact of the change in methodology for estimating credit losses from the incurred loss methodology to the expected credit loss methodology beginning in the first quarter of 2020.The ALLL increased $1.3 billion from December 31, 2019 to $2.5 billion at December 31, 2020. At December 31, 2020, the ALLL as a percent of portfolio loans and leases increased to 2.25%, compared to 1.10% at December 31, 2019. The reserve for unfunded commitments increased $28 million from December 31, 2019 to $172 million at December 31, 2020. The ACL as a percent of portfolio loans and leases increased to 2.41% at December 31, 2020, compared to 1.23% at December 31, 2019. These increases reflect the adoption of ASU 2016-13 67 Fifth Third BancorpTable of Contents MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSwhich resulted in a combined increase to the ALLL and reserve for unfunded commitments of approximately $653 million, as well as the previously mentioned items impacting the provision for credit losses.Refer to the Credit Risk Management subsection of the Risk Management section of MD&A as well as Note 7 of the Notes to Consolidated Financial Statements for more detailed information on the provision for credit losses, including an analysis of loan and lease portfolio composition, nonperforming assets, net charge-offs and other factors considered by the Bancorp in assessing the credit quality of the loan and lease portfolio, ALLL and reserve for unfunded commitments.Noninterest IncomeNoninterest income decreased $706 million for the year ended December 31, 2020 compared to the year ended December 31, 2019. The following table presents the components of noninterest income:TABLE 8: Components of Noninterest IncomeFor the years ended December 31 ($ in millions)20202019201820172016Service charges on deposits$559 565 549 554 558 Commercial banking revenue528 460 408 386 400 Wealth and asset management revenue520 487 444 419 404 Card and processing revenue352 360 329 313 319 Mortgage banking net revenue320 287 212 224 285 Leasing business revenue276 270 114 63 134 Other noninterest income211 1,064 803 1,261 586 Securities gains (losses), net62 40 (54)2 10 Securities gains (losses), net - non-qualifying hedges on MSRs2 3 (15)2 — Total noninterest income$2,830 3,536 2,790 3,224 2,696 Service charges on depositsService charges on deposits decreased $6 million for the year ended December 31, 2020 compared to the year ended December 31, 2019 driven by a decrease of $32 million in consumer deposit fees due to lower overdraft occurrences as a result of the impact of COVID-19 financial assistance and fiscal stimulus programs, partially offset by an increase of $26 million in commercial deposit fees.Commercial banking revenueCommercial banking revenue increased $68 million for the year ended December 31, 2020 compared to the year ended December 31, 2019 primarily driven by increases in institutional sales and bridge fees of $68 million and $10 million, respectively, partially offset by a decrease in loan syndication fees of $20 million. Wealth and asset management revenueWealth and asset management revenue increased $33 million for the year ended December 31, 2020 compared to the year ended December 31, 2019 primarily due to increases of $16 million in both private client service fees and broker income. The Bancorp’s trust and registered investment advisory businesses had approximately $434 billion and $413 billion in total assets under care as of December 31, 2020 and 2019, respectively, and managed $54 billion and $49 billion in assets for individuals, corporations and not-for-profit organizations as of December 31, 2020 and 2019, respectively.Card and processing revenueCard and processing revenue decreased $8 million for the year ended December 31, 2020 compared to the year ended December 31, 2019 primarily driven by a decrease in customer spend volume as a result of reduced economic activity related to government-mandated shutdowns of local economies and other COVID-related impacts, partially offset by lower reward costs.Mortgage banking net revenueMortgage banking net revenue increased $33 million for the year ended December 31, 2020 compared to the year ended December 31, 2019.68 Fifth Third BancorpTable of Contents MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSThe following table presents the components of mortgage banking net revenue:TABLE 9: Components of Mortgage Banking Net RevenueFor the years ended December 31 ($ in millions)202020192018Origination fees and gains on loan sales$315 175 100 Net mortgage servicing revenue:Gross mortgage servicing fees263 267 216 Net valuation adjustments on MSRs and free-standing derivatives purchased to economically hedge MSRs(258)(155)(104)Net mortgage servicing revenue5 112 112 Total mortgage banking net revenue$320 287 212 Origination fees and gains on loan sales increased $140 million for the year ended December 31, 2020 compared to the year ended December 31, 2019 primarily driven by an increase in originations and gain on sale margins due to the lower interest rate environment. Residential mortgage loan originations increased to $15.9 billion for the year ended December 31, 2020 from $11.6 billion for the year ended December 31, 2019.Net mortgage servicing revenue decreased $107 million for the year ended December 31, 2020 compared to the year ended December 31, 2019 primarily due to an increase in net negative valuation adjustments of $103 million as well as a decrease in gross mortgage servicing fees of $4 million. Refer to Table 10 for the components of net valuation adjustments on the MSR portfolio and the impact of the non-qualifying hedging strategy.TABLE 10: Components of Net Valuation Adjustments on MSRsFor the years ended December 31 ($ in millions)202020192018Changes in fair value and settlement of free-standing derivatives purchased to economically hedge the MSR portfolio$307 221 (21)Changes in fair value:Due to changes in inputs or assumptions(311)(203)42 Other changes in fair value(254)(173)(125)Net valuation adjustments on MSRs and free-standing derivatives purchased to economically hedge MSRs$(258)(155)(104)Mortgage rates decreased during the years ended December 31, 2020 and 2019 which caused modeled prepayment speeds to rise. Additionally, mortgage swap spreads widened during the year ended December 31, 2020 which caused modeled OAS assumptions to increase. For the years ended December 31, 2020 and 2019, the fair value of the MSR portfolio decreased $311 million and $203 million, respectively, due to changes to inputs to the valuation model, including prepayment speeds and OAS assumptions, and decreased $254 million and $173 million, respectively, due to the impact of contractual principal payments and actual prepayment activity. Further detail on the valuation of MSRs can be found in Note 14 of the Notes to Consolidated Financial Statements. The Bancorp maintains a non-qualifying hedging strategy to manage a portion of the risk associated with changes in the valuation of the MSR portfolio. Refer to Note 15 of the Notes to Consolidated Financial Statements for more information on the free-standing derivatives used to economically hedge the MSR portfolio.In addition to the derivative positions used to economically hedge the MSR portfolio, the Bancorp acquires various securities as a component of its non-qualifying hedging strategy. The Bancorp recognized net gains of $2 million and $3 million during the years ended December 31, 2020 and 2019, respectively, recorded in securities gains (losses), net - non-qualifying hedges on MSRs in the Bancorp’s Consolidated Statements of Income.The Bancorp’s total residential mortgage loans serviced at December 31, 2020 and 2019 were $86.6 billion and $98.4 billion, respectively, with $68.8 billion and $80.7 billion, respectively, of residential mortgage loans serviced for others.Leasing business revenueLeasing business revenue increased $6 million for the year ended December 31, 2020 compared to the year ended December 31, 2019 primarily driven by increases in lease syndication fees and operating lease income of $9 million and $5 million, respectively, partially offset by a decrease in lease remarketing fees of $8 million. 69 Fifth Third BancorpTable of Contents MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSOther noninterest incomeThe following table presents the components of other noninterest income:TABLE 11: Components of Other Noninterest IncomeFor the years ended December 31 ($ in millions)202020192018Private equity investment income$75 65 63 Income from the TRA associated with Worldpay, Inc.74 346 20 BOLI income63 60 56 Cardholder fees44 58 56 Consumer loan and lease fees20 23 23 Banking center income20 22 21 Insurance income20 19 20 Loss on swap associated with the sale of Visa, Inc. Class B Shares(103)(107)(59)Net losses on disposition and impairment of bank premises and equipment(31)(23)(43)Gain on sale of Worldpay, Inc. shares— 562 205 Equity method income from interest in Worldpay Holding, LLC— 2 1 Gain related to Vantiv, Inc.’s acquisition of Worldpay Group plc.— — 414 Other, net29 37 26 Total other noninterest income$211 1,064 803 Other noninterest income decreased $853 million for the year ended December 31, 2020 compared to the year ended December 31, 2019 primarily due to the gain on sale of Worldpay, Inc. shares recognized during the first quarter of 2019 and a decrease in the income from the TRA associated with Worldpay, Inc. The Bancorp recognized a $562 million gain related to the sale of Worldpay, Inc. shares during the first quarter of 2019. Income from the TRA associated with Worldpay Inc. decreased $272 million from the year ended December 31, 2019 primarily driven by a $345 million gain recognized in the fourth quarter of 2019 from the Worldpay, Inc. TRA transaction. For additional information, refer to Note 21 of the Notes to Consolidated Financial Statements. Noninterest ExpenseNoninterest expense increased $58 million for the year ended December 31, 2020 compared to the year ended December 31, 2019 primarily due to an increase in compensation and benefits expense, partially offset by decreases in technology and communications expense and marketing expense.The following table presents the components of noninterest expense:TABLE 12: Components of Noninterest ExpenseFor the years ended December 31 ($ in millions)20202019201820172016Compensation and benefits$2,590 2,418 2,115 1,989 1,951 Technology and communications362 422 285 245 234 Net occupancy expense350 332 292 295 299 Leasing business expense140 133 76 87 86 Equipment expense130 129 123 117 118 Card and processing expense121 130 123 129 132 Marketing expense104 162 147 114 104 Other noninterest expense921 934 797 806 813 Total noninterest expense$4,718 4,660 3,958 3,782 3,737 Efficiency ratio on an FTE basis(a)61.9 %55.8 57.0 53.7 59.0 (a)This is a non-GAAP measure. For further information, refer to the Non-GAAP Financial Measures section of MD&A.The Bancorp recognized $16 million and $222 million of merger-related expenses for the years ended December 31, 2020 and 2019, respectively. 70 Fifth Third BancorpTable of Contents MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSThe following table provides a summary of merger-related expenses recorded in noninterest expense:TABLE 13: Merger-Related ExpensesFor the years ended December 31 ($ in millions)20202019Compensation and benefits$4 90 Technology and communications6 71 Net occupancy expense4 13 Equipment expense— 1 Card and processing expense— 1 Marketing expense— 7 Other noninterest expense2 39 Total$16 222 Compensation and benefits expense increased $172 million for the year ended December 31, 2020 compared to the year ended December 31, 2019 primarily due to strategic hiring and the impact of raising the Bancorp’s minimum wage in the fourth quarter of 2019, as well as increases in incentive compensation driven by strong performance in fees related to business growth during the year ended December 31, 2020. Compensation and benefits expense for the year ended December 31, 2020 included $10 million of special payments to employees providing essential banking services through the COVID-19 pandemic. Full-time equivalent employees totaled 19,872 at December 31, 2020 compared to 19,869 at December 31, 2019.Technology and communications expense decreased $60 million for the year ended December 31, 2020 compared to the year ended December 31, 2019 primarily driven by decreased integration and conversion costs related to the acquisition of MB Financial, Inc.Marketing expense decreased $58 million for the year ended December 31, 2020 compared to the year ended December 31, 2019 primarily due to the impact of the COVID-19 pandemic, which resulted in a pause or slowdown in numerous marketing campaigns, including running less advertising as well as the suspension of cash bonus and other account acquisition programs.The following table presents the components of other noninterest expense:TABLE 14: Components of Other Noninterest ExpenseFor the years ended December 31 ($ in millions)202020192018Loan and lease$162 142 112 FDIC insurance and other taxes118 81 119 Losses and adjustments100 102 61 Data processing75 70 57 Professional service fees49 70 67 Intangible amortization48 45 5 Postal and courier36 38 35 Donations36 30 21 Travel27 68 52 Recruitment and education21 28 32 Insurance15 14 13 Supplies13 14 13 Other, net221 232 210 Total other noninterest expense$921 934 797 Other noninterest expense decreased $13 million for the year ended December 31, 2020 compared to the year ended December 31, 2019 primarily due to decreases in travel expense and professional service fees, partially offset by increases in FDIC insurance and other taxes and loan and lease expense.Travel expense decreased $41 million for the year ended December 31, 2020 compared to the year ended December 31, 2019 primarily due to reduced business travel as a direct result of the COVID-19 pandemic. Professional service fees decreased $21 million for the year ended December 31, 2020 compared to the year ended December 31, 2019 primarily due to decreases in acquisition costs, consulting fees and legal expenses. FDIC insurance and other taxes increased $37 million for the year ended December 31, 2020 compared to the year ended December 31, 2019 primarily as a result of an increase in the assessment rate due to a change in asset mix as well as an increase in the assessment base. Loan and lease expense increased $20 million for the year ended December 31, 2020 compared to the year ended December 31, 2019 primarily due to an increase in loan closing expenses.71 Fifth Third BancorpTable of Contents MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSApplicable Income TaxesApplicable income tax expense for all periods includes the benefit from tax-exempt income, tax-advantaged investments, certain gains on sales of leveraged leases that are exempt from federal taxation and tax credits (and other related tax benefits), partially offset by the effect of proportional amortization of qualifying LIHTC investments and certain nondeductible expenses. The tax credits are primarily associated with the Low-Income Housing Tax Credit program established under Section 42 of the IRC, the New Markets Tax Credit program established under Section 45D of the IRC, the Rehabilitation Investment Tax Credit program established under Section 47 of the IRC and the Qualified Zone Academy Bond program established under Section 1397E of the IRC. The effective tax rates for the years ended December 31, 2020 and 2019 were primarily impacted by $175 million and $160 million, respectively, of low-income housing tax credits and other tax benefits and $27 million and $40 million, respectively, of tax benefits from tax exempt income, and were partially offset by $150 million and $140 million, respectively, of proportional amortization related to qualifying LIHTC investments. The decrease in the effective tax rate for the year ended December 31, 2020 from 2019 was attributable to a decrease in state income taxes.The Bancorp’s income before income taxes, applicable income tax expense and effective tax rate are as follows:TABLE 15: Applicable Income TaxesFor the years ended December 31 ($ in millions)20202019201820172016Income before income taxes$1,797 3,202 2,765 2,979 2,208 Applicable income tax expense370 690 572 799 665 Effective tax rate20.6 %21.6 20.7 26.8 30.1 72 Fifth Third BancorpTable of Contents MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSBUSINESS SEGMENT REVIEWThe Bancorp reports on four business segments: Commercial Banking, Branch Banking, Consumer Lending and Wealth and Asset Management. Additional information on each business segment is included in Note 32 of the Notes to Consolidated Financial Statements. Results of the Bancorp’s business segments are presented based on its management structure and management accounting practices. The structure and accounting practices are specific to the Bancorp; therefore, the financial results of the Bancorp’s business segments are not necessarily comparable with similar information for other financial institutions. The Bancorp refines its methodologies from time to time as management’s accounting practices and businesses change.The Bancorp manages interest rate risk centrally at the corporate level. By employing an FTP methodology, the business segments are insulated from most benchmark interest rate volatility, enabling them to focus on serving customers through the origination of loans and acceptance of deposits. The FTP methodology assigns charge and credit rates to classes of assets and liabilities, respectively, based on the estimated amount and timing of cash flows for each transaction. Assigning the FTP rate based on matching the duration of cash flows allocates interest income and interest expense to each business segment so its resulting net interest income is insulated from future changes in benchmark interest rates. The Bancorp’s FTP methodology also allocates the contribution to net interest income of the asset-generating and deposit-providing businesses on a duration-adjusted basis to better attribute the driver of the performance. As the asset and liability durations are not perfectly matched, the residual impact of the FTP methodology is captured in General Corporate and Other. The charge and credit rates are determined using the FTP rate curve, which is based on an estimate of Fifth Third’s marginal borrowing cost in the wholesale funding markets. The FTP curve is constructed using the U.S. swap curve, brokered CD pricing and unsecured debt pricing.The Bancorp adjusts the FTP charge and credit rates as dictated by changes in interest rates for various interest-earning assets and interest-bearing liabilities and by the review of behavioral assumptions, such as prepayment rates on interest-earning assets and the estimated durations for indeterminate-lived deposits. Key assumptions, including the credit rates provided for deposit accounts, are reviewed annually. Credit rates for deposit products and charge rates for loan products may be reset more frequently in response to changes in market conditions. In general, the charge rates on assets have declined since December 31, 2019 as they were affected by the prevailing level of interest rates and by the duration and repricing characteristics of the portfolio. The credit rates for deposit products also declined due to lower interest rates and modified assumptions. Thus, net interest income for asset-generating business segments improved while deposit-providing business segments were negatively impacted during the year ended December 31, 2020.The Bancorp’s methodology for allocating provision for credit losses expense to the business segments includes charges or benefits associated with changes in criticized commercial loan levels in addition to actual net charge-offs experienced by the loans and leases owned by each business segment. Provision for credit losses expense attributable to loan and lease growth and changes in ALLL factors is captured in General Corporate and Other. The financial results of the business segments include allocations for shared services and headquarters expenses. Additionally, the business segments form synergies by taking advantage of relationship depth opportunities and funding operations by accessing the capital markets as a collective unit.The following table summarizes net income (loss) by business segment:TABLE 16: Net Income (Loss) by Business SegmentFor the years ended December 31 ($ in millions)202020192018Income Statement DataCommercial Banking$387 1,424 1,139 Branch Banking251 860 702 Consumer Lending117 92 (1)Wealth and Asset Management102 112 97 General Corporate and Other570 24 256 Net income$1,427 2,512 2,193 73 Fifth Third BancorpTable of Contents MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSCommercial BankingCommercial Banking offers credit intermediation, cash management and financial services to large and middle-market businesses and government and professional customers. In addition to the traditional lending and depository offerings, Commercial Banking products and services include global cash management, foreign exchange and international trade finance, derivatives and capital markets services, asset-based lending, real estate finance, public finance, commercial leasing and syndicated finance.The following table contains selected financial data for the Commercial Banking segment:TABLE 17: Commercial BankingFor the years ended December 31 ($ in millions)202020192018Income Statement DataNet interest income (FTE)(a)$1,916 2,377 1,729 Provision for (benefit from) credit losses1,050 183 (26)Noninterest income: Commercial banking revenue524 455 402 Service charges on deposits343 308 273 Leasing business revenue276 270 114 Other noninterest income158 154 128 Noninterest expense:Compensation and benefits557 466 344 Leasing business expense140 133 76 Other noninterest expense1,024 1,022 843 Income before income taxes (FTE)446 1,760 1,409 Applicable income tax expense(a)(b)59 336 270 Net income$387 1,424 1,139 Average Balance Sheet DataCommercial loans and leases, including held for sale$66,552 65,475 54,748 Demand deposits24,352 16,424 16,560 Interest checking deposits25,769 18,259 12,203 Savings and money market deposits6,695 4,904 4,128 Other time deposits and certificates $100,000 and over154 332 377 Foreign office deposits184 209 362 (a)Includes FTE adjustments of $13, $17 and $16 for the years ended December 31, 2020, 2019 and 2018, respectively.(b)Applicable income tax expense for all periods includes the tax benefit from tax-exempt income, tax-advantaged investments and tax credits partially offset by the effect of certain nondeductible expenses. Refer to the Applicable Income Taxes subsection of the Statements of Income Analysis section of MD&A for additional information.Comparison of the year ended 2020 with 2019Net income was $387 million for the year ended December 31, 2020 compared to net income of $1.4 billion for the year ended December 31, 2019. The decrease in net income was primarily driven by an increase in provision for credit losses, a decrease in net interest income on an FTE basis as well as an increase in noninterest expense partially offset by an increase in noninterest income.Net interest income on an FTE basis decreased $461 million from the year ended December 31, 2019 primarily driven by decreases in yields on average commercial loans and leases as well as decreases in FTP credit rates on demand deposits, interest checking deposits and savings and money market deposits. These negative impacts were partially offset by decreases in FTP charge rates on loans and leases as well as decreases in rates paid on average interest checking deposits and average savings and money market deposits.Provision for credit losses increased $867 million from the year ended December 31, 2019 primarily driven by an increase in commercial criticized asset levels as well as increases in net charge-offs on commercial and industrial loans, commercial mortgage loans and commercial leases. Net charge-offs as a percent of average portfolio loans and leases increased to 35 bps for the year ended December 31, 2020 compared to 14 bps for the year ended December 31, 2019.Noninterest income increased $114 million from the year ended December 31, 2019 driven by increases in commercial banking revenue, service charges on deposits and leasing business revenue. Commercial banking revenue increased $69 million from the year ended December 31, 2019 primarily due to increases in institutional sales and bridge fees partially offset by a decrease in loan syndication fees. Service charges on deposits increased $35 million from the year ended December 31, 2019 primarily due to an increase in commercial deposit fees primarily due to lower earnings credit rates. Leasing business revenue increased $6 million from the year ended December 31, 2019 primarily driven by increases in lease syndication fees and operating lease income partially offset by a decrease in lease remarketing fees.74 Fifth Third BancorpTable of Contents MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSNoninterest expense increased $100 million from the year ended December 31, 2019 driven by increases in compensation and benefits and leasing business expense. Compensation and benefits increased $91 million from the year ended December 31, 2019 due to an increase in personnel costs primarily as a result of the MB Financial, Inc. acquisition at the end of the first quarter of 2019 and an increase in incentive compensation driven by strong performance in fees related to business growth during the year ended December 31, 2020, as well as strategic hiring. Leasing business expense increased $7 million from the year ended December 31, 2019 primarily due to an increase in operating lease expense driven by the MB Financial, Inc. acquisition at the end of the first quarter of 2019. Average commercial loans and leases increased $1.1 billion from the year ended December 31, 2019 primarily due to increases in average commercial mortgage loans and average commercial construction loans partially offset by a decrease in average commercial leases. Average commercial mortgage loans increased $1.1 billion from the year ended December 31, 2019 primarily as a result of increases in loan originations and permanent financing from the Bancorp’s commercial construction loan portfolio. Average commercial construction loans increased $360 million from the year ended December 31, 2019 primarily as a result of increased line of credit utilization as well as lower levels of payoffs. Average commercial leases decreased $541 million from the year ended December 31, 2019 primarily as a result of a planned reduction in indirect non-relationship-based lease originations.Average core deposits increased $17.2 billion from the year ended December 31, 2019 primarily due to increases in average demand deposits, average interest checking deposits and average savings and money market deposits. Average interest checking deposits increased $7.5 billion, average demand deposits increased $7.9 billion and average savings and money market deposits increased $1.8 billion from the year ended December 31, 2019. These increases were primarily as a result of higher average balances per commercial customer account due to increased liquidity levels in the current economic environment. Comparison of the year ended 2019 with 2018Net income was $1.4 billion for the year ended December 31, 2019 compared to net income of $1.1 billion for the year ended December 31, 2018. The increase in net income was driven by increases in net interest income on an FTE basis and noninterest income partially offset by increases in noninterest expense and provision for credit losses. Net interest income on an FTE basis increased $648 million from the year ended December 31, 2018 primarily driven by increases in both average balances and yields on commercial loans and leases, increases in FTP credits on interest checking deposits and increases in FTP credit rates on demand deposits. These increases were partially offset by increases in FTP charges on loans and leases and increases in both average balances and rates paid on interest checking deposits.Provision for credit losses increased $209 million from the year ended December 31, 2018 driven by the impact of an increase in criticized asset levels partially offset by a decrease in net charge-offs on commercial and industrial loans. Net charge-offs as a percent of average portfolio loans and leases decreased to 14 bps for the year ended December 31, 2019 compared to 18 bps for the year ended December 31, 2018.Noninterest income increased $270 million from the year ended December 31, 2018 driven by increases in leasing business revenue, commercial banking revenue, service charges on deposits and other noninterest income. Leasing business revenue increased $156 million from the year ended December 31, 2018 primarily due to increases in operating lease income, leasing business solutions revenue and lease remarketing fees partially offset by a decrease in lease syndication fees. Commercial banking revenue increased $53 million from the year ended December 31, 2018 driven by increases in institutional sales revenue and business lending fees. Service charges on deposits increased $35 million from the year ended December 31, 2018 primarily driven by an increase in commercial deposit fees. Other noninterest income increased $26 million from the year ended December 31, 2018 primarily due to increases in card and processing revenue and private equity investment income.Noninterest expense increased $358 million from the year ended December 31, 2018 due to increases in other noninterest expense, compensation and benefits and leasing business expense. Other noninterest expense increased $179 million from the year ended December 31, 2018 primarily due to increases in corporate overhead allocations, intangible amortization expense and losses and adjustments. Compensation and benefits increased $122 million from the year ended December 31, 2018 due to increases in base compensation and incentive compensation primarily as a result of the MB Financial, Inc. acquisition as well as an increase in employee benefits expense. Leasing business expense increased $57 million from the year ended December 31, 2018 primarily due to an increase in operating lease expense.Average commercial loans and leases increased $10.7 billion from the year ended December 31, 2018 primarily due to increases in average commercial and industrial loans and average commercial mortgage loans. Average commercial and industrial loans increased $7.4 billion from the year ended December 31, 2018 primarily as a result of the acquisition of MB Financial, Inc. as well as an increase in loan originations. Average commercial mortgage loans increased $3.2 billion from the year ended December 31, 2018 as a result of the acquisition of MB Financial, Inc. and increases in loan originations as well as permanent financing from the Bancorp’s commercial construction loan portfolio.Average core deposits increased $6.6 billion from the year ended December 31, 2018 primarily driven by increases in average interest checking deposits and average savings and money market deposits partially offset by decreases in average foreign office deposits and average demand deposits. Average interest checking deposits increased $6.1 billion from the year ended December 31, 2018 primarily due to balance migration from demand deposit accounts and an increase in average balances per commercial customer account as well as the acquisition of MB Financial, Inc. Average savings and money market deposits increased $776 million from the year ended December 31, 2018 primarily 75 Fifth Third BancorpTable of Contents MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSdue to the acquisition of MB Financial, Inc. and an increase in average balances per commercial customer account. Average foreign office deposits decreased $153 million from the year ended December 31, 2018 driven by balance migration into interest checking deposits. Average demand deposits decreased $136 million from the year ended December 31, 2018 primarily driven by balance migration into interest checking deposits partially offset by the acquisition of MB Financial, Inc.Branch BankingBranch Banking provides a full range of deposit and loan products to individuals and small businesses through 1,134 full-service banking centers. Branch Banking offers depository and loan products, such as checking and savings accounts, home equity loans and lines of credit, credit cards and loans for automobiles and other personal financing needs, as well as products designed to meet the specific needs of small businesses, including cash management services.The following table contains selected financial data for the Branch Banking segment:TABLE 18: Branch BankingFor the years ended December 31 ($ in millions)202020192018Income Statement DataNet interest income$1,667 2,371 2,034 Provision for credit losses231 224 171 Noninterest income: Card and processing revenue283 285 266 Service charges on deposits215 260 275 Wealth and asset management revenue172 158 150 Other noninterest income81 99 63 Noninterest expense:Compensation and benefits649 601 536 Net occupancy and equipment expense217 221 225 Card and processing expense116 123 121 Other noninterest expense887 915 846 Income before income taxes318 1,089 889 Applicable income tax expense67 229 187 Net income$251 860 702 Average Balance Sheet DataConsumer loans$12,777 13,200 13,034 Commercial loans, including held for sale2,268 2,170 1,938 Demand deposits19,755 15,802 14,336 Interest checking deposits12,608 10,716 10,187 Savings and money market deposits37,030 33,173 29,473 Other time deposits and certificates $100,000 and over5,370 7,532 5,348 Comparison of the year ended 2020 with 2019Net income was $251 million for the year ended December 31, 2020 compared to net income of $860 million for the year ended December 31, 2019. The decrease was driven by decreases in net interest income and noninterest income as well as increases in noninterest expense and provision for credit losses.Net interest income decreased $704 million from the year ended December 31, 2019 primarily due to decreases in FTP credit rates on core deposits and FTP credits on certificates $100,000 and over as well as decreases in yields on and average balances of home equity and credit card. These negative impacts were partially offset by decreases in the rates paid on average interest-bearing deposits as well as decreases in FTP charge rates on loans and leases. Provision for credit losses increased $7 million from the year ended December 31, 2019 primarily due to an increase in commercial criticized asset levels as well as an increase in net charge-offs on commercial and industrial loans partially offset by decreases in net charge-offs on other consumer loans, credit card and home equity. Net charge-offs as a percent of average portfolio loans and leases decreased to 135 bps for the year ended December 31, 2020 compared to 144 bps for the year ended December 31, 2019.Noninterest income decreased $51 million from the year ended December 31, 2019 primarily driven by decreases in service charges on deposits and other noninterest income partially offset by an increase in wealth and asset management revenue. Service charges on deposits decreased $45 million from the year ended December 31, 2019 driven by decreases in both consumer deposit fees and commercial deposit fees. Other noninterest income decreased $18 million from the year ended December 31, 2019 primarily driven by a decrease in cardholder 76 Fifth Third BancorpTable of Contents MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSfees and an increase in net losses on disposition and impairment of bank premises and equipment. Wealth and asset management revenue increased $14 million from the year ended December 31, 2019 primarily driven by increases in broker income and private client service fees.Noninterest expense increased $9 million from the year ended December 31, 2019 primarily due to an increase in compensation and benefits partially offset by decreases in other noninterest expense and card and processing expense. Compensation and benefits increased $48 million from the year ended December 31, 2019 driven by increases in base compensation, employee benefits expense and incentive compensation. Other noninterest expense decreased $28 million from the year ended December 31, 2019 primarily driven by decreases in marketing expense and losses and adjustments partially offset by increases in corporate overhead allocations and FDIC insurance and other taxes. Card and processing expense decreased $7 million from the year ended December 31, 2019 primarily driven by a decrease in customer spend volume.Average consumer loans decreased $423 million from the year ended December 31, 2019 primarily driven by a decrease in average home equity as payoffs exceeded loan originations as well as a decrease in average credit card driven by the negative economic impacts from the COVID-19 pandemic, including reductions in the number of active accounts as well as higher paydowns relative to spend per active account. These decreases were partially offset by an increase in average other consumer loans primarily as a result of increases in loan originations.Average deposits increased $7.5 billion from the year ended December 31, 2019 primarily driven by increases in average demand deposits, average savings and money market deposits and average interest checking deposits partially offset by decreases in average other time deposits and certificates $100,000 and over. Average demand deposits increased $4.0 billion, average savings and money market deposits increased $3.9 billion and average interest checking deposits increased $1.9 billion from the year ended December 31, 2019 primarily as a result of higher balances per customer account due to uncertainty regarding the COVID-19 pandemic, fiscal stimulus and decreased consumer spending. Average other time deposits and certificates $100,000 and over decreased $2.2 billion from the year ended December 31, 2019 primarily due to lower offering rates on certificates less than $100,000 as well as a decrease in average certificates $100,000 and over from the year ended December 31, 2019. Comparison of the year ended 2019 with 2018Net income was $860 million for the year ended December 31, 2019 compared to net income of $702 million for the year ended December 31, 2018. The increase was driven by increases in net interest income and noninterest income partially offset by increases in noninterest expense and provision for credit losses. Net interest income increased $337 million from the year ended December 31, 2018. The increase was primarily due to increases in FTP credits on core deposits and certificates $100,000 and over as well as increases in average balances of other consumer loans and credit card. These benefits were partially offset by increases in both the rates paid on and average balances of savings and money market deposits and other time deposits and certificates $100,000 and over as well as an increase in FTP charge rates on loans and leases. Provision for credit losses increased $53 million from the year ended December 31, 2018 primarily due to increases in net charge-offs on credit card and other consumer loans. Net charge-offs as a percent of average portfolio loans and leases increased to 144 bps for the year ended December 31, 2019 compared to 114 bps for the year ended December 31, 2018. Noninterest income increased $48 million from the year ended December 31, 2018 driven by increases in other noninterest income, card and processing revenue and wealth and asset management revenue partially offset by a decrease in service charges on deposits. Other noninterest income increased $36 million from the year ended December 31, 2018 primarily due to the impact of impairment on bank premises and equipment recognized during 2018. Card and processing revenue increased $19 million from the year ended December 31, 2018 primarily driven by increases in the number of actively used cards and customer spend volume. Wealth and asset management revenue increased $8 million from the year ended December 31, 2018 primarily driven by increases in broker income and private client service fees. Service charges on deposits decreased $15 million from the year ended December 31, 2018 due to a decrease in consumer deposit fees partially offset by an increase in commercial deposit fees.Noninterest expense increased $132 million from the year ended December 31, 2018 primarily due to increases in other noninterest expense and compensation and benefits. Other noninterest expense increased $69 million from the year ended December 31, 2018 primarily due to increases in corporate overhead allocations, intangible amortization expense and loan and lease expense partially offset by a decrease in FDIC insurance and other taxes. Compensation and benefits increased $65 million from the year ended December 31, 2018 due to higher base compensation primarily as a result of the MB Financial, Inc. acquisition as well as increases in employee benefits expense and incentive compensation.Average consumer loans increased $166 million from the year ended December 31, 2018 primarily driven by an increase in average other consumer loans of $649 million primarily due to growth in point-of-sale loan originations. This increase was partially offset by decreases in average home equity loans of $303 million and average residential mortgage loans of $259 million as payoffs exceeded loan production. Average core deposits increased $7.0 billion from the year ended December 31, 2018 primarily driven by growth in average savings and money market deposits of $3.7 billion and growth in average demand deposits of $1.5 billion. These increases were primarily due to the acquisition of MB Financial, Inc. as well as promotional product offerings, which drove consumer customer acquisition and growth in 77 Fifth Third BancorpTable of Contents MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSbalances from existing customers. The increase in average core deposits also included an increase in interest checking deposits of $529 million from the year ended December 31, 2018 primarily as a result of the acquisition of MB Financial, Inc. Average other time deposits and certificates $100,000 and over increased $2.2 billion from the year ended December 31, 2018 primarily as a result of the acquisition of MB Financial, Inc. as well as promotional product offerings, which drove increased production.Consumer LendingConsumer Lending includes the Bancorp’s residential mortgage, automobile and other indirect lending activities. Residential mortgage activities within Consumer Lending include the origination, retention and servicing of residential mortgage loans, sales and securitizations of those loans and all associated hedging activities. Residential mortgages are primarily originated through a dedicated sales force and through third-party correspondent lenders. Automobile and other indirect lending activities include extending loans to consumers through automobile dealers, motorcycle dealers, powersport dealers, recreational vehicle dealers and marine dealers.The following table contains selected financial data for the Consumer Lending segment:TABLE 19: Consumer LendingFor the years ended December 31 ($ in millions)202020192018Income Statement DataNet interest income$381 325 237 Provision for credit losses34 49 42 Noninterest income:Mortgage banking net revenue307 279 206 Other noninterest income12 17 (1)Noninterest expense:Compensation and benefits221 196 192 Other noninterest expense297 259 210 Income (loss) before income taxes148 117 (2)Applicable income tax expense (benefit)31 25 (1)Net income (loss)$117 92 (1)Average Balance Sheet DataResidential mortgage loans, including held for sale$13,182 13,027 11,803 Home equity192 220 243 Indirect secured consumer loans12,273 10,109 8,676 Comparison of the year ended 2020 with 2019Net income was $117 million for the year ended December 31, 2020 compared to net income of $92 million for the year ended December 31, 2019. The increase was primarily driven by increases in net interest income and noninterest income as well as a decrease in provision for credit losses partially offset by an increase in noninterest expense.Net interest income increased $56 million from the year ended December 31, 2019 primarily driven by increases in average indirect secured consumer loans and decreases in FTP charge rates on loans and leases partially offset by decreases in FTP credit rates on demand deposits and yields on average residential mortgage loans and average indirect secured consumer loans.Provision for credit losses decreased $15 million from the year ended December 31, 2019 primarily driven by a decrease in net charge-offs on indirect secured consumer loans. Net charge-offs as a percent of average portfolio loans and leases decreased to 14 bps for the year ended December 31, 2020 compared to 22 bps for the year ended December 31, 2019.Noninterest income increased $23 million from the year ended December 31, 2019 driven by an increase in mortgage banking net revenue primarily due to an increase in origination fees and gains on loan sales, partially offset by a decrease in net mortgage servicing revenue. Refer to the Noninterest Income subsection of the Statements of Income Analysis section of MD&A for additional information on the fluctuations in mortgage banking net revenue.Noninterest expense increased $63 million from the year ended December 31, 2019 due to increases in other noninterest expense and compensation and benefits. Other noninterest expense increased $38 million from the year ended December 31, 2019 primarily driven by an increase in corporate overhead allocations partially offset by a decrease in OREO expense. Compensation and benefits increased $25 million from the year ended December 31, 2019 primarily due to increases in base compensation and incentive compensation resulting from the increased mortgage origination activity for the year ended December 31, 2020.Average consumer loans increased $2.3 billion from the year ended December 31, 2019 primarily due to increases in average indirect secured consumer loans and average residential mortgage loans. Average indirect secured consumer loans increased $2.2 billion from the year ended December 31, 2019 primarily due to loan production exceeding payoffs. Average residential mortgage loans increased $155 million from the 78 Fifth Third BancorpTable of Contents MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSyear ended December 31, 2019 driven by the repurchase of certain loans from GNMA that were in forbearance programs partially offset by higher runoff due to payoffs exceeding loan originations.Comparison of the year ended 2019 with 2018Net income was $92 million for the year ended December 31, 2019 compared to a net loss of $1 million for the year ended December 31, 2018. The increase was driven by increases in noninterest income and net interest income partially offset by increases in noninterest expense and provision for credit losses. Net interest income increased $88 million from the year ended December 31, 2018 primarily driven by increases in both yields on and average balances of indirect secured consumer loans and residential mortgage loans as well as an increase in FTP credits on demand deposits. These benefits were partially offset by increases in FTP charges on loans and leases.Provision for credit losses increased $7 million from the year ended December 31, 2018 primarily driven by an increase in net charge-offs on indirect secured consumer loans partially offset by a decrease in net charge-offs on residential mortgage loans. Net charge-offs as a percent of average portfolio loans and leases increased to 22 bps for the year ended December 31, 2019 compared to 21 bps for the year ended December 31, 2018.Noninterest income increased $91 million from the year ended December 31, 2018 driven by increases in mortgage banking net revenue and other noninterest income. Mortgage banking net revenue increased $73 million from the year ended December 31, 2018 primarily driven by an increase in origination fees and gains on loan sales. Refer to the Noninterest Income subsection of the Statements of Income Analysis section of MD&A for additional information on the fluctuations in mortgage banking net revenue. Other noninterest income increased $18 million from the year ended December 31, 2018 primarily due to the recognition of $3 million of gains on securities acquired as a component of the Bancorp’s non-qualifying hedging strategy of MSRs during the year ended December 31, 2019 compared to the recognition of $15 million of losses during the year ended December 31, 2018.Noninterest expense increased $53 million from the year ended December 31, 2018 primarily due to an increase in other noninterest expense primarily driven by increases in corporate overhead allocations, loan and lease expense and losses and adjustments.Average consumer loans increased $2.6 billion from the year ended December 31, 2018 primarily driven by increases in average indirect secured consumer loans and average residential mortgage loans. Average indirect secured consumer loans increased $1.4 billion from the year ended December 31, 2018 primarily driven by the acquisition of MB Financial, Inc. and higher loan production exceeding payoffs. Average residential mortgage loans increased $1.2 billion from the year ended December 31, 2018 primarily driven by the acquisition of MB Financial, Inc.79 Fifth Third BancorpTable of Contents MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSWealth and Asset ManagementWealth and Asset Management provides a full range of investment alternatives for individuals, companies and not-for-profit organizations. Wealth and Asset Management is made up of four main businesses: FTS, an indirect wholly-owned subsidiary of the Bancorp; Fifth Third Insurance Agency; Fifth Third Private Bank; and Fifth Third Institutional Services. FTS offers full service retail brokerage services to individual clients and broker-dealer services to the institutional marketplace. Fifth Third Insurance Agency assists clients with their financial and risk management needs. Fifth Third Private Bank offers wealth management strategies to high net worth and ultra-high net worth clients through wealth planning, investment management, banking, insurance, trust and estate services. Fifth Third Institutional Services provides advisory services for institutional clients including middle market businesses, non-profits, states and municipalities.The following table contains selected financial data for the Wealth and Asset Management segment:TABLE 20: Wealth and Asset ManagementFor the years ended December 31 ($ in millions)202020192018Income Statement DataNet interest income$139 182 182 Provision for credit losses3 — 12 Noninterest income:Wealth and asset management revenue498 469 429 Other noninterest income28 20 27 Noninterest expense:Compensation and benefits218 217 202 Other noninterest expense315 312 302 Income before income taxes129 142 122 Applicable income tax expense27 30 25 Net income$102 112 97 Average Balance Sheet DataLoans and leases, including held for sale$3,659 3,580 3,421 Core deposits10,967 9,701 9,332 Comparison of the year ended 2020 with 2019Net income was $102 million for the year ended December 31, 2020 compared to net income of $112 million for the year ended December 31, 2019. The decrease in net income was primarily driven by a decrease in net interest income partially offset by an increase in noninterest income.Net interest income decreased $43 million for the year ended December 31, 2020 compared to the year ended December 31, 2019 primarily driven by decreases in FTP credit rates on deposits as well as decreases in yields on average loans and leases. These negative impacts were partially offset by decreases in the rates paid on average interest checking deposits and average savings and money market deposits as well as decreases in FTP charge rates on loans and leases.Provision for credit losses increased $3 million from the year ended December 31, 2019 primarily driven by an increase in net charge-offs on residential mortgage loans.Noninterest income increased $37 million from the year ended December 31, 2019 due to increases in wealth and asset management revenue and other noninterest income. Wealth and asset management revenue increased $29 million from the year ended December 31, 2019 primarily as a result of increases in broker income, private client service fees and institutional fees. Other noninterest income increased $8 million from the year ended December 31, 2019 primarily due to a loss on sale of a business recognized during the year ended December 31, 2019.Noninterest expense increased $4 million from the year ended December 31, 2019 primarily due to an increase in other noninterest expense driven by an increase in corporate overhead allocations partially offset by a decrease in travel expense.Average loans and leases increased $79 million from the year ended December 31, 2019 primarily driven by increases in average residential mortgage loans and average other consumer loans as a result of higher loan production, partially offset by a decrease in average commercial and industrial loans as payoffs exceeded new loan production.Average core deposits increased $1.3 billion from the year ended December 31, 2019 primarily due to increases in average interest checking deposits and average savings and money market deposits as a result of higher balances per customer account due to the current economic environment.80 Fifth Third BancorpTable of Contents MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSComparison of the year ended 2019 with 2018Net income was $112 million for the year ended December 31, 2019 compared to net income of $97 million for the year ended December 31, 2018. The increase in net income was driven by an increase in noninterest income as well as a decrease in provision for credit losses partially offset by an increase in noninterest expense.Net interest income remained flat for the year ended December 31, 2019 compared to the year ended December 31, 2018. Net interest income was positively impacted by increases in FTP credits on interest checking deposits and savings and money market deposits as well as increases in both yields on and average balances of loans and leases. These positive impacts were offset by an increase in the rates paid on interest checking deposits as well as an increase in FTP charges on loans and leases.Provision for credit losses decreased $12 million from the year ended December 31, 2018 driven by a decrease in net charge-offs on commercial and industrial loans. This decrease was partially offset by the impact of the benefit of lower criticized asset levels for the year ended December 31, 2018. Noninterest income increased $33 million from the year ended December 31, 2018 due to an increase in wealth and asset management revenue partially offset by a decrease in other noninterest income. Wealth and asset management revenue increased $40 million from the year ended December 31, 2018 primarily due to an increase in private client service fees driven by increased sales production and strong market performance as well as the full-year benefit from acquisitions in 2018 and the acquisition of MB Financial, Inc. Other noninterest income decreased $7 million from the year ended December 31, 2018 primarily due to a loss on sale of a business recognized during the second quarter of 2019.Noninterest expense increased $25 million from the year ended December 31, 2018 due to increases in compensation and benefits and other noninterest expense. Compensation and benefits increased $15 million from the year ended December 31, 2018 primarily due to higher base compensation driven by the full-year impact from acquisitions in 2018 and the acquisition of MB Financial, Inc. Other noninterest expense increased $10 million from the year ended December 31, 2018 primarily driven by an increase in corporate overhead allocations partially offset by a decrease in FDIC insurance and other taxes.Average loans and leases increased $159 million from the year ended December 31, 2018 primarily due to an increase in average residential mortgage loans driven by the acquisition of MB Financial, Inc., partially offset by a decrease in average commercial and industrial loans as payoffs exceeded new loan production.Average core deposits increased $369 million from the year ended December 31, 2018 primarily due to an increase in average interest checking deposits primarily as a result of the acquisition of MB Financial, Inc. as well as an increase in average savings and money market deposits.General Corporate and OtherGeneral Corporate and Other includes the unallocated portion of the investment securities portfolio, securities gains and losses, certain non-core deposit funding, unassigned equity, unallocated provision for credit losses expense or a benefit from the reduction of the ACL, the payment of preferred stock dividends and certain support activities and other items not attributed to the business segments.Comparison of the year ended 2020 with 2019Net interest income increased $1.1 billion from the year ended December 31, 2019 primarily driven by decreases in FTP credit rates on deposits allocated to the business segments, increases in interest income on loans and leases and decreases in interest expense on long-term debt, federal funds purchased, deposits and other short-term borrowings. These positive impacts were partially offset by decreases in the benefit related to FTP charge rates on loans and leases and a decrease in interest income on taxable securities.The benefit from credit losses was $221 million for the year ended December 31, 2020 compared to a provision for credit losses of $15 million for the year ended December 31, 2019. The decrease for the year ended December 31, 2020 was primarily driven by an increase in the allocation of provision expense to the business segments due to an increase in commercial criticized asset levels, partially offset by an increase in the ACL reflecting deterioration in the macroeconomic environment as a result of the impact of the COVID-19 pandemic and the resulting impact of this environment on commercial borrowers. The change in provision for credit losses also reflected the impact of the change in methodology for estimating credit losses from the incurred loss methodology to the expected credit loss methodology beginning in the first quarter of 2020.Noninterest income decreased $819 million from the year ended December 31, 2019 primarily due to the recognition of a $74 million gain from the TRA associated with Worldpay, Inc. for the year ended December 31, 2020 compared to the recognition of a $562 million gain related to the sale of Worldpay, Inc. shares in addition to the recognition of a $345 million gain from the Worldpay, Inc. TRA transaction during the year ended December 31, 2019. These negative impacts were partially offset by the recognition of securities gains of $62 million for the year ended December 31, 2020 compared to securities gains of $40 million for the year ended December 31, 2019.81 Fifth Third BancorpTable of Contents MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSNoninterest expense decreased $108 million from the year ended December 31, 2019 primarily driven by a decrease in technology and communications expense and an increase in corporate overhead allocations from General Corporate and Other to the other business segments, as well as decreases in travel expense, marketing expense and consulting fees, partially offset by increases in net occupancy expense and FDIC insurance and other taxes.Comparison of the year ended 2019 with 2018Net interest income decreased $415 million from the year ended December 31, 2018 primarily driven by an increase in FTP credits on deposits allocated to the business segments and increases in interest expense on long-term debt. These negative impacts were partially offset by an increase in the benefit related to FTP charges on loans and leases and an increase in interest income on taxable securities.Provision for credit losses increased $7 million from the year ended December 31, 2018 primarily due to increases in both outstanding loan balances and unfunded commitments in 2019, exclusive of loans and leases acquired in the MB Financial, Inc. acquisition. This was partially offset by an increase in the allocation of provision expense to the business segments driven by an increase in commercial criticized asset levels.Noninterest income increased $309 million from the year ended December 31, 2018 primarily driven by the recognition of a $562 million gain on the sale of Worldpay, Inc. shares for the year ended December 31, 2019 in addition to a $345 million gain recognized in the fourth quarter of 2019 from the Worldpay, Inc. TRA transaction compared to a $205 million gain on the sale of Worldpay, Inc. shares for the year ended December 31, 2018 and a $414 million gain recognized in the first quarter of 2018 related to Vantiv, Inc.’s acquisition of Worldpay Group plc. The increase from the year ended December 31, 2018 also included securities gains of $40 million during the year ended December 31, 2019 compared to securities losses of $54 million during the year ended December 31, 2018. These positive impacts were partially offset by an increase in the loss on the swap associated with the sale of Visa, Inc. Class B Shares. The Bancorp recognized negative valuation adjustments of $107 million related to the Visa total return swap for the year ended December 31, 2019 compared to negative valuation adjustments of $59 million during the year ended December 31, 2018.Noninterest expense increased $139 million from the year ended December 31, 2018. The increase was primarily due to increases in technology and communications expense, compensation and benefits and net occupancy expense driven by merger-related expenses as a result of the acquisition of MB Financial, Inc. partially offset by an increase in corporate overhead allocations from General Corporate and Other to the other business segments. Refer to the Noninterest Expense subsection of the Statements of Income Analysis section of MD&A for additional information on merger-related expenses.82 Fifth Third BancorpTable of Contents MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSFOURTH QUARTER REVIEWThe Bancorp’s 2020 fourth quarter net income available to common shareholders was $569 million, or $0.78 per diluted share, compared to net income available to common shareholders of $562 million, or $0.78 per diluted share, for the third quarter of 2020 and net income available to common shareholders of $701 million, or $0.96 per diluted share, for the fourth quarter of 2019.Net interest income on an FTE basis (non-GAAP) was $1.2 billion for the fourth quarter of 2020, an increase of $12 million from the third quarter of 2020 and a decrease of $47 million from the fourth quarter of 2019. The increase from the third quarter of 2020 was primarily driven by lower core deposit and wholesale borrowing costs, an increase in accelerated PPP fees recognized upon loan forgiveness and elevated investment portfolio prepayment penalty proceeds, partially offset by the impact of lower commercial loan balances and a decline in mortgage rates. The decrease from the fourth quarter of 2019 was primarily driven by lower yields and lower balances on commercial loans, partially offset by lower deposits costs, the favorable impact of previously executed cash flow hedges and growth from PPP loans. Net interest income for the fourth quarter of 2020 included $12 million of amortization and accretion of premiums and discounts on acquired loans and leases and assumed deposits and long-term debt from acquisitions compared to $13 million in the third quarter of 2020 and $18 million in the fourth quarter of 2019.Noninterest income was $787 million for the fourth quarter of 2020, an increase of $65 million compared to the third quarter of 2020 and a decrease of $248 million compared to the fourth quarter of 2019. The increase from the third quarter of 2020 was primarily due to an increase in other noninterest income, partially offset by decreases in mortgage banking net revenue and net securities gains. The decrease compared to the fourth quarter of 2019 was primarily driven by decreases in other noninterest income and mortgage banking net revenue.Service charges on deposits were $146 million for the fourth quarter of 2020, an increase of $2 million compared to the previous quarter and a decrease of $3 million compared to the fourth quarter of 2019. The increase from the third quarter of 2020 was primarily due to an increase in consumer deposit fees. The decrease compared to the fourth quarter of 2019 was primarily due to a decrease in consumer deposit fees, partially offset by an increase in commercial deposit fees.Commercial banking revenue was $141 million for the fourth quarter of 2020, an increase of $16 million compared to the third quarter of 2020 and $14 million compared to the fourth quarter of 2019. The increase from the previous quarter was primarily driven by increases in institutional sales and loan syndication fees, partially offset by lower corporate bond fees. The increase compared to the fourth quarter of 2019 was primarily driven by increases in institutional sales and corporate bond fees.Mortgage banking net revenue was $25 million for the fourth quarter of 2020, a decrease of $51 million compared to the third quarter of 2020 and $48 million compared to the fourth quarter of 2019. The decrease in mortgage banking net revenue compared to the third quarter of 2020 was primarily driven by lower origination fees and gains on loan sales resulting from a decrease in originations, the decision to retain certain mortgages originated during the fourth quarter of 2020 and margin compression. The decrease in mortgage banking net revenue compared to the fourth quarter of 2019 was primarily driven by an increase in net negative valuation adjustments on MSRs and higher prepayment speeds. Mortgage banking net revenue is affected by net valuation adjustments, which include MSR valuation adjustments caused by fluctuating OAS, earning rates and prepayment speeds, as well as mark-to-market adjustments on free-standing derivatives used to economically hedge the MSR portfolio. Net negative valuation adjustments on MSRs were $88 million and $83 million in the fourth and third quarters of 2020, respectively, and $47 million in the fourth quarter of 2019. Residential mortgage originations for the fourth quarter of 2020 were $3.9 billion, compared with $4.5 billion in the previous quarter and $3.8 billion the fourth quarter of 2019. Originations for the fourth quarter of 2020 resulted in gains of $47 million on mortgages sold, compared with gains of $93 million for the previous quarter and $49 million for the fourth quarter of 2019. Gross mortgage servicing fees were $66 million in both the fourth and third quarters of 2020 and $72 million in the fourth quarter of 2019.Wealth and asset management revenue was $133 million for the fourth quarter of 2020, an increase of $1 million from the previous quarter and $4 million from the fourth quarter of 2019. The increase from the third quarter of 2020 was primarily driven by higher personal asset management revenue and brokerage income, partially offset by lower institutional trust fees. The increase compared to the fourth quarter of 2019 was primarily driven by higher personal asset management revenue and brokerage income.Card and processing revenue was $92 million for both the fourth and third quarters of 2020 and was $3 million lower than the fourth quarter of 2019. The decrease from the fourth quarter of 2019 was primarily driven by lower commercial and consumer card spend volumes, partially offset by lower reward costs.Leasing business revenue was $69 million for the fourth quarter of 2020, a decrease of $8 million from the third quarter of 2020 and $2 million from the fourth quarter of 2019. The decrease from the third quarter of 2020 was primarily driven by a decrease in business solutions revenue. The decrease compared to the fourth quarter of 2019 was primarily driven by decreases in lease remarketing fees and operating lease income.Other noninterest income was $168 million for the fourth quarter of 2020, an increase of $142 million compared to the third quarter of 2020 and a decrease of $214 million from the fourth quarter of 2019. The increase from the third quarter of 2020 was primarily driven by an increase in private equity investment income as well as income from the TRA associated with Worldpay, Inc. recognized during the fourth 83 Fifth Third BancorpTable of Contents MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSquarter of 2020. The decrease compared to the fourth quarter of 2019 was primarily due to a decrease in the income recognized from the TRA associated with Worldpay, Inc. driven by the Worldpay, Inc. transaction in the fourth quarter of 2019, partially offset by an increase in private equity investment income. For additional information on the Worldpay, Inc. transaction, refer to Note 21 of the Notes to Consolidated Financial Statements. The net gains on investment securities were $14 million for the fourth quarter of 2020, $51 million for the third quarter of 2020 and $10 million for the fourth quarter of 2019. Net losses on securities held as non-qualifying hedges for MSRs were $1 million for both the fourth and third quarters of 2020 as well as the fourth quarter of 2019.Noninterest expense was $1.2 billion for the fourth quarter of 2020, an increase of $75 million from the previous quarter and $76 million from the fourth quarter of 2019. The increase in noninterest expense from the previous quarter was primarily due to increases in compensation and benefits expense and other noninterest expense. Compensation and benefits expense increased from the prior quarter primarily due to increases in incentive compensation driven by strong performance in fees related to business growth during the fourth quarter of 2020, partially offset by a decrease in base compensation. Other noninterest expense increased from the prior quarter primarily driven by an increase in donations expense, partially offset by a decrease in losses and adjustments. The increase in noninterest expense compared to the fourth quarter of 2019 was primarily driven by an increase in compensation and benefits expense, partially offset by decreases in marketing expense, technology and communications expenses and other noninterest expense. Compensation and benefits expense increased from the fourth quarter of 2019 primarily due to increases in incentive compensation, base compensation and employee benefits expense. Marketing expense decreased from the fourth quarter of 2019 primarily due to the impact of the COVID-19 pandemic which resulted in a pause or slowdown in numerous marketing campaigns. Technology and communications expense decreased from the fourth quarter of 2019 primarily attributable to non-recurring integration and conversion costs incurred in the fourth quarter of 2019. Other noninterest expense decreased from the fourth quarter of 2019 primarily driven by decreases in losses and adjustments and travel expense, partially offset by increases in FDIC insurance and other taxes.The ALLL as a percentage of portfolio loans and leases was 2.25% as of December 31, 2020 compared to 2.32% as of September 30, 2020 and 1.10% as of December 31, 2019. The benefit from credit losses was $13 million in the fourth quarter of 2020 compared with $15 million in the third quarter of 2020, and a provision for credit losses of $162 million in the fourth quarter of 2019. Net losses charged-off were $118 million in the fourth quarter of 2020, or 43 bps of average portfolio loans and leases on an annualized basis, compared with net losses charged-off of $101 million in the third quarter of 2020 and $113 million in the fourth quarter of 2019.TABLE 21: Quarterly Information (unaudited)20202019For the three months ended ($ in millions, except per share data)December, 31September, 30June,30March,31December, 31September, 30June,30March,31Net interest income(a)$1,185 1,173 1,203 1,233 1,232 1,246 1,250 1,086 (Benefit from) provision for credit losses(13)(15)485 640 162 134 85 90 Noninterest income787 722 650 671 1,035 740 660 1,101 Noninterest expense1,236 1,161 1,121 1,200 1,160 1,159 1,243 1,097 Net income604 581 195 46 734 549 453 775 Net income available to common shareholders569 562 163 29 701 530 427 760 Earnings per share, basic$0.79 0.78 0.23 0.04 0.97 0.72 0.57 1.14 Earnings per share, diluted$0.78 0.78 0.23 0.04 0.96 0.71 0.57 1.12 (a)Amounts presented on an FTE basis. The FTE adjustment was $3 for the three months ended December 31, 2020, September 30, 2020 and June 30, 2020 and $4 for the three months ended March 31, 2020. The FTE adjustment was $4 for both the three months ended December 31, 2019 and September 30, 2019, $5 for the three months ended June 30, 2019 and $4 for the three months ended March 31, 2019.COMPARISON OF THE YEAR ENDED 2019 WITH 2018The Bancorp’s net income available to common shareholders for the year ended December 31, 2019 was $2.4 billion, or $3.33 per diluted share, which was net of $93 million in preferred stock dividends. The Bancorp’s net income available to common shareholders for the year ended December 31, 2018 was $2.1 billion, or $3.06 per diluted share, which was net of $75 million in preferred stock dividends.The provision for credit losses was $471 million for the year ended December 31, 2019 compared to $207 million for the same period in the prior year. The increase in provision expense for the year ended December 31, 2019 compared to the prior year was primarily due to increases in specific reserves on certain impaired commercial loans and the level of commercial criticized assets as well as increases in both outstanding loan balances and unfunded commitments in 2019, exclusive of loans and leases acquired in the MB Financial, Inc. acquisition. The ALLL increased $99 million from December 31, 2018 to $1.2 billion at December 31, 2019. At December 31, 2019, the ALLL as a percent of portfolio loans and leases decreased to 1.10%, compared to 1.16% at December 31, 2018. This decrease reflects the impact of the MB Financial, Inc. acquisition, which added approximately $13.4 billion in portfolio loans and leases at the acquisition date. Loans acquired 84 Fifth Third BancorpTable of Contents MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSby the Bancorp through a purchase business combination are recorded at fair value as of the acquisition date. The Bancorp did not carry over the acquired company’s ALLL, nor did the Bancorp add to its existing ALLL as part of purchase accounting. The reserve for unfunded commitments increased $13 million from December 31, 2018 to $144 million at December 31, 2019. This increase reflects the impact of the MB Financial, Inc. acquisition, which included approximately $8 million in reserves for unfunded commitments at the acquisition date.Net interest income on an FTE basis (non-GAAP) was $4.8 billion and $4.2 billion for the years ended December 31, 2019 and 2018, respectively. Net interest income was positively impacted by increases in average commercial and industrial loans and average commercial mortgage loans from the year ended December 31, 2018. Additionally, net interest income benefited from an increase in yields on average loans and leases from the year ended December 31, 2018. These positive impacts were partially offset by increases in both the rates paid on and balances of average interest-bearing core deposits and average long-term debt as well as an increase in average certificates $100,000 and over for the year ended December 31, 2019 compared to the year ended December 31, 2018. Additionally, net interest income was negatively impacted by the August 2019, September 2019 and October 2019 decisions of the FOMC to lower the target range of the federal funds rate. Net interest income for the year ended December 31, 2019 included $65 million of amortization and accretion of premiums and discounts on acquired loans and leases and assumed deposits and long-term debt from acquisitions. Net interest margin on an FTE basis (non-GAAP) was 3.31% for the year ended December 31, 2019 compared to 3.22% for the year ended December 31, 2018.Noninterest income increased $746 million for the year ended December 31, 2019 compared to the year ended December 31, 2018 primarily due to increases in other noninterest income, leasing business revenue, mortgage banking net revenue, commercial banking revenue and wealth and asset management revenue. Other noninterest income increased $261 million for the year ended December 31, 2019 compared to the year ended December 31, 2018 primarily due to the recognition of gains on the sale of Worldpay Inc. shares driven by the Bancorp’s sale of shares during the first quarter of 2019, an increase in the income from the TRA associated with Worldpay, Inc. and a decrease in the net losses on disposition and impairment of bank premises and equipment. These benefits were partially offset by the gain related to Vantiv, Inc.’s acquisition of Worldpay Group plc. recognized during the first quarter of 2018 as well as an increase in the loss on the swap associated with the sale of Visa, Inc. Class B Shares. Leasing business revenue increased $156 million for the year ended December 31, 2019 compared to the year ended December 31, 2018. The increase from the prior year was primarily driven by increases in operating lease income, leasing business solutions revenue and lease remarketing fees of $67 million, $50 million and $44 million, respectively. The increase in leasing business solutions revenue was driven by the acquisition of MB Financial, Inc. Mortgage banking net revenue increased $75 million for the year ended December 31, 2019 compared to the year ended December 31, 2018 primarily due to a $75 million increase in origination fees and gains on loan sales due to the lower interest rate environment. Commercial banking revenue increased $52 million for the year ended December 31, 2019 compared to the year ended December 31, 2018. The increase from the prior year was primarily driven by increases in institutional sales revenue and business lending fees of $26 million and $21 million, respectively. Wealth and asset management revenue increased $43 million for the year ended December 31, 2019 compared to the year ended December 31, 2018 primarily due to an increase of $37 million in private client service fees. This increase was driven by increased sales production and strong market performance as well as the full-year benefit from acquisitions in 2018 and the acquisition of MB Financial, Inc.Noninterest expense increased $702 million for the year ended December 31, 2019 compared to the year ended December 31, 2018 primarily due to increases in compensation and benefits expense, other noninterest expense and technology and communications expense. Compensation and benefits expense increased $303 million for the year ended December 31, 2019 compared to the year ended December 31, 2018 driven by $90 million in merger-related expenses for the year ended December 31, 2019, the addition of personnel costs from the acquisition of MB Financial, Inc. and higher deferred compensation expense. Other noninterest expense increased $137 million for the year ended December 31, 2019 compared to the year ended December 31, 2018 and included the impact of an increase of $23 million in merger-related expenses related to the acquisition of MB Financial, Inc. as well as increases in intangible amortization expense, losses and adjustments and loan and lease expense, partially offset by a decrease in FDIC insurance and other taxes. Technology and communications expense increased $137 million for the year ended December 31, 2019 compared to the year ended December 31, 2018 driven by $71 million in merger-related expenses for the year ended December 31, 2019, as well as increased investment in contemporizing information technology architecture, mitigating information security risks and growth initiatives. 85 Fifth Third BancorpTable of Contents MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSBALANCE SHEET ANALYSISLoans and LeasesThe Bancorp classifies its commercial loans and leases based upon primary purpose and consumer loans based upon product or collateral. Table 22 summarizes end of period loans and leases, including loans and leases held for sale and Table 23 summarizes average total loans and leases, including average loans and leases held for sale. TABLE 22: Components of Total Loans and Leases (including loans and leases held for sale)As of December 31 ($ in millions)20202019201820172016Commercial loans and leases:Commercial and industrial loans(a)$49,895 50,677 44,407 41,170 41,736 Commercial mortgage loans10,609 10,964 6,977 6,610 6,904 Commercial construction loans5,815 5,090 4,657 4,553 3,903 Commercial leases2,954 3,363 3,600 4,068 3,974 Total commercial loans and leases69,273 70,094 59,641 56,401 56,517 Consumer loans:Residential mortgage loans(b)20,393 17,988 16,041 16,077 15,737 Home equity5,183 6,083 6,402 7,014 7,695 Indirect secured consumer loans13,653 11,538 8,976 9,112 9,983 Credit card2,007 2,532 2,470 2,299 2,237 Other consumer loans3,014 2,723 2,342 1,559 680 Total consumer loans44,250 40,864 36,231 36,061 36,332 Total loans and leases$113,523 110,958 95,872 92,462 92,849 Total portfolio loans and leases (excluding loans and leases held for sale)(c)$108,782 109,558 95,265 91,970 92,098 (a)Includes $4.8 billion, as of December 31, 2020, related to the SBA’s Paycheck Protection Program.(b)Includes $39, as of December 31, 2020, of residential mortgage loans previously sold to GNMA for which the Bancorp is deemed to have regained effective control over under ASC Topic 860, but did not exercise its option to repurchase. Refer to Note 17 of the Notes to Consolidated Financial Statements for further information.(c)Subsequent to the Bancorp's earnings release furnished in a Form 8-K on January 21, 2021, the Bancorp reclassified $178 of loans from portfolio loans and leases to loans and leases held for sale because it was determined that those loans met the criteria for classification as held for sale as of December 31, 2020.Total loans and leases, including loans and leases held for sale, increased $2.6 billion, or 2%, from December 31, 2019. The increase from December 31, 2019 was the result of an increase of $3.4 billion, or 8%, in consumer loans partially offset by a decrease of $821 million, or 1%, in commercial loans and leases.Commercial loans and leases decreased $821 million from December 31, 2019 due to decreases in commercial and industrial loans, commercial leases and commercial mortgage loans, partially offset by an increase in commercial construction loans. Commercial and industrial loans decreased $782 million, or 2%, from December 31, 2019 primarily as a result of a decrease in revolving line of credit utilization, the strategic exit of certain relationships as well as payoffs outpacing production, partially offset by loans originated under the SBA’s Paycheck Protection Program during 2020. Commercial leases decreased $409 million, or 12%, from December 31, 2019 primarily as a result of a planned reduction in indirect non-relationship-based lease originations. Commercial mortgage loans decreased $355 million, or 3%, from December 31, 2019 as payoffs exceeded loan originations. Commercial construction loans increased $725 million, or 14%, from December 31, 2019 primarily as a result of increased line of credit utilization as well as lower levels of payoffs.Consumer loans increased $3.4 billion from December 31, 2019 due to increases in residential mortgage loans, indirect secured consumer loans and other consumer loans, partially offset by decreases in home equity and credit card. Residential mortgage loans increased $2.4 billion, or 13%, from December 31, 2019 primarily due to increases in residential mortgage loans held for sale as the Bancorp purchased $2.1 billion of government-guaranteed loans in forbearance programs and also repurchased certain loans from GNMA that were in forbearance programs. These increases were partially offset by payoffs exceeding loan originations on portfolio loans. Indirect secured consumer loans increased $2.1 billion, or 18%, from December 31, 2019 primarily as a result of loan production exceeding payoffs. Other consumer loans increased $291 million, or 11%, from December 31, 2019 primarily as a result of the purchase of a portfolio of point-of-sale loans as well as increases in loan originations. Home equity decreased $900 million, or 15%, from December 31, 2019 as payoffs exceeded loan originations. Credit card decreased $525 million, or 21%, from December 31, 2019 primarily due to the economic impacts from the COVID-19 pandemic, including reductions in the number of active accounts as well as higher net paydowns per active account.86 Fifth Third BancorpTable of Contents MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSTABLE 23: Components of Average Loans and Leases (including average loans and leases held for sale)For the years ended December 31 ($ in millions)20202019201820172016Commercial loans and leases:Commercial and industrial loans$53,814 50,168 42,668 41,577 43,184 Commercial mortgage loans11,011 9,905 6,661 6,844 6,899 Commercial construction loans5,509 5,174 4,793 4,374 3,648 Commercial leases3,038 3,578 3,795 4,011 3,916 Total commercial loans and leases73,372 68,825 57,917 56,806 57,647 Consumer loans:Residential mortgage loans17,828 17,337 16,150 16,053 15,101 Home equity5,679 6,286 6,631 7,308 7,998 Indirect secured consumer loans12,454 10,345 8,993 9,407 10,708 Credit card2,230 2,437 2,280 2,141 2,205 Other consumer loans2,848 2,564 1,905 1,016 661 Total consumer loans41,039 38,969 35,959 35,925 36,673 Total average loans and leases$114,411 107,794 93,876 92,731 94,320 Total average portfolio loans and leases (excluding loans and leases held for sale)$112,993 106,840 93,216 92,068 93,426 Average loans and leases, including average loans and leases held for sale, increased $6.6 billion, or 6%, from December 31, 2019 as the result of a $4.5 billion, or 7%, increase in average commercial loans and leases as well as a $2.1 billion, or 5%, increase in average consumer loans.Average commercial loans and leases increased $4.5 billion from December 31, 2019 due to increases in average commercial and industrial loans, average commercial mortgage loans and average commercial construction loans, partially offset by a decrease in average commercial leases. Average commercial and industrial loans increased $3.6 billion, or 7%, from December 31, 2019 primarily driven by the aforementioned increases in Paycheck Protection Program loans. Average commercial mortgage loans increased $1.1 billion, or 11%, from December 31, 2019 primarily as a result of increases in loan originations and permanent financing from the Bancorp’s commercial construction loan portfolio. Average commercial construction loans increased $335 million, or 6%, from December 31, 2019 primarily as a result of increased line of credit utilization as well as lower levels of payoffs. Average commercial leases decreased $540 million, or 15%, from December 31, 2019 primarily as a result of a planned reduction in indirect non-relationship-based lease originations.Average consumer loans increased $2.1 billion from December 31, 2019 due to increases in average indirect secured consumer loans, average residential mortgage loans and average other consumer loans, partially offset by decreases in average home equity and average credit card. Average indirect secured consumer loans increased $2.1 billion, or 20%, from December 31, 2019 primarily due to loan production exceeding payoffs. Average residential mortgage loans increased $491 million, or 3%, from December 31, 2019 primarily driven by the repurchase of certain loans from GNMA that were in forbearance programs, partially offset by higher runoff due to payoffs exceeding loan originations. Average other consumer loans increased $284 million, or 11%, from December 31, 2019 primarily as a result of increases in loan originations. Average home equity decreased $607 million, or 10%, from December 31, 2019 as payoffs exceeded loan originations. Average credit card decreased $207 million, or 8%, from December 31, 2019 driven by the negative economic impacts from the COVID-19 pandemic, including reductions in the number of active accounts as well as higher net paydowns per active account.Investment SecuritiesThe Bancorp uses investment securities as a means of managing interest rate risk, providing collateral for pledging purposes and for liquidity risk management. Total investment securities were $38.4 billion and $36.9 billion at December 31, 2020 and December 31, 2019, respectively. The taxable available-for-sale debt and other investment securities portfolio had an effective duration of 4.4 years at December 31, 2020 compared to 5.1 years at December 31, 2019.Debt securities are classified as available-for-sale when, in management’s judgment, they may be sold in response to, or in anticipation of, changes in market conditions. Securities that management has the intent and ability to hold to maturity are classified as held-to-maturity and reported at amortized cost. Debt securities are classified as trading when bought and held principally for the purpose of selling them in the near term. At December 31, 2020, the Bancorp’s investment portfolio consisted primarily of AAA-rated available-for-sale debt and other securities. The Bancorp held an immaterial amount in below-investment grade available-for-sale debt and other securities at both December 31, 2020 and 2019. Upon adoption of ASU 2016-13 on January 1, 2020, the Bancorp evaluates available-for-sale debt and other securities in an unrealized loss position to determine whether all or a portion of the unrealized loss on such securities is a credit loss. If credit losses are identified, they are generally recognized as an allowance for credit losses (a contra account to the amortized cost basis of the securities) with the periodic change in the allowance recognized in earnings. Prior to January 1, 2020, investment securities were evaluated for OTTI with any identified OTTI recognized as a charge to income and a direct reduction of the amortized cost basis of the securities.87 Fifth Third BancorpTable of Contents MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSAt December 31, 2020, the Bancorp completed its evaluation of the available-for-sale debt and other securities in an unrealized loss position and did not recognize an allowance for credit losses. The Bancorp did not recognize provision expense for the year ended December 31, 2020 related to available-for-sale debt and other securities in an unrealized loss position. During the year ended December 31, 2019, the Bancorp recognized $1 million of OTTI on its available-for-sale debt and other securities, included in securities gains (losses), net, in the Consolidated Statements of Income. The following table summarizes the end of period components of investment securities:TABLE 24: Components of Investment SecuritiesAs of December 31 ($ in millions)20202019201820172016Available-for-sale debt and other securities (amortized cost basis):U.S. Treasury and federal agencies securities$74 74 98 98 547 Obligations of states and political subdivisions securities17 18 2 43 44 Mortgage-backed securities:Agency residential mortgage-backed securities(a)11,147 13,746 16,403 15,281 15,525 Agency commercial mortgage-backed securities16,745 15,141 10,770 10,113 9,029 Non-agency commercial mortgage-backed securities3,323 3,242 3,305 3,247 3,076 Asset-backed securities and other debt securities3,152 2,189 1,998 2,183 2,106 Other securities(b)524 556 552 612 607 Total available-for-sale debt and other securities$34,982 34,966 33,128 31,577 30,934 Held-to-maturity securities (amortized cost basis):Obligations of states and political subdivisions securities$9 15 16 22 24 Asset-backed securities and other debt securities2 2 2 2 2 Total held-to-maturity securities$11 17 18 24 26 Trading debt securities (fair value):U.S. Treasury and federal agencies securities$81 2 16 12 23 Obligations of states and political subdivisions securities10 9 35 22 39 Agency residential mortgage-backed securities30 55 68 395 8 Asset-backed securities and other debt securities439 231 168 63 15 Total trading debt securities$560 297 287 492 85 Total equity securities (fair value)$313 564 452 439 416 (a)Includes interest-only mortgage-backed securities recorded at fair value with fair value changes recorded in securities gains (losses), net in the Consolidated Statements of Income.(b)Other securities consist of FHLB, FRB and DTCC restricted stock holdings that are carried at cost.On an amortized cost basis, available-for-sale debt and other securities were 19% and 24% of total interest-earning assets at December 31, 2020 and 2019, respectively. The estimated weighted-average life of the debt securities in the available-for-sale debt and other securities portfolio was 5.7 and 6.6 years at December 31, 2020 and 2019, respectively. In addition, at December 31, 2020 and 2019 the debt securities in the available-for-sale debt and other securities portfolio had a weighted-average yield of 3.05% and 3.22%, respectively.Information presented in Table 25 is on a weighted-average life basis, anticipating future prepayments. Yield information is presented on an FTE basis and is computed using amortized cost balances and reflects the impact of prepayments. Maturity and yield calculations for the total available-for-sale debt and other securities portfolio exclude other securities that have no stated yield or maturity. Total net unrealized gains on the available-for-sale debt and other securities portfolio were $2.5 billion at December 31, 2020 compared to $1.1 billion at December 31, 2019. The fair value of investment securities is impacted by interest rates, credit spreads, market volatility and liquidity conditions. The fair value of investment securities generally increases when interest rates decrease or when credit spreads contract.88 Fifth Third BancorpTable of Contents MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSTABLE 25: Characteristics of Available-for-Sale Debt and Other SecuritiesAs of December 31, 2020 ($ in millions)Amortized CostFair ValueWeighted-AverageLife (in years)Weighted-AverageYieldU.S. Treasury and federal agencies securities:Average life 1 – 5 years$74 78 2.12.12 %Total$74 78 2.12.12 %Obligations of states and political subdivisions securities:Average life of 1 year or less— — 0.15.90 Average life 1 – 5 years17 17 2.21.81 Total$17 17 2.21.82 %Agency residential mortgage-backed securities:Average life of 1 year or less551 565 0.64.14 Average life 1 – 5 years5,347 5,666 3.33.18 Average life 5 – 10 years4,510 4,864 6.73.01 Average life greater than 10 years739 812 14.02.97 Total$11,147 11,907 5.23.15 %Agency commercial mortgage-backed securities:(a)Average life of 1 year or less45 47 0.32.80 Average life 1 – 5 years7,104 7,623 3.23.11 Average life 5 – 10 years7,146 7,912 7.43.25 Average life greater than 10 years2,450 2,639 13.22.61 Total$16,745 18,221 6.43.09 %Non-agency commercial mortgage-backed securities:Average life of 1 year or less36 36 0.52.38 Average life 1 – 5 years2,836 3,055 3.73.20 Average life 5 – 10 years451 499 5.83.26 Total$3,323 3,590 4.03.20 %Asset-backed securities and other debt securities:Average life of 1 year or less175 176 0.54.26 Average life 1 – 5 years1,211 1,233 2.63.07 Average life 5 – 10 years1,340 1,336 6.81.94 Average life greater than 10 years426 431 13.91.16 Total$3,152 3,176 5.82.39 %Other securities524 524 Total available-for-sale debt and other securities$34,982 37,513 5.73.05 %(a)Taxable-equivalent yield adjustments included in the above table are 0.08% and 0.01% for securities with an average life greater than 10 years and in total, respectively.Other Short-Term InvestmentsOther short-term investments primarily include overnight interest-earning investments, including reserves held at the FRB. The Bancorp uses other short-term investments as part of its liquidity risk management tools. Other short-term investments were $33.4 billion and $2.0 billion at December 31, 2020 and December 31, 2019, respectively. The increase of $31.4 billion from December 31, 2019 was primarily attributable to deposit growth during the year ended December 31, 2020. DepositsThe Bancorp’s deposit balances represent an important source of funding and revenue growth opportunity. The Bancorp continues to focus on core deposit growth in its retail and commercial franchises by improving customer satisfaction, building full relationships and offering competitive rates. Average core deposits represented 74% and 71% of the Bancorp’s average asset funding base at December 31, 2020 and 2019, respectively.89 Fifth Third BancorpTable of Contents MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSThe following table presents the end of period components of deposits:TABLE 26: Components of DepositsAs of December 31 ($ in millions)20202019201820172016Demand$57,711 35,968 32,116 35,276 35,782 Interest checking47,270 40,409 34,058 27,703 26,679 Savings18,258 14,248 12,907 13,425 13,941 Money market30,650 27,277 22,597 20,097 20,749 Foreign office143 221 240 484 426 Total transaction deposits154,032 118,123 101,918 96,985 97,577 Other time3,023 5,237 4,490 3,775 3,866 Total core deposits157,055 123,360 106,408 100,760 101,443 Certificates $100,000 and over(a)2,026 3,702 2,427 2,402 2,378 Total deposits$159,081 127,062 108,835 103,162 103,821 (a)Includes $1.3 billion, $2.1 billion, $1.2 billion, $1.3 billion and $1.3 billion of institutional, retail and wholesale certificates $250,000 and over at December 31, 2020, 2019, 2018, 2017 and 2016, respectively.Core deposits increased $33.7 billion, or 27%, from December 31, 2019, driven by an increase in transaction deposits, partially offset by a decrease in other time deposits. Transaction deposits increased $35.9 billion, or 30%, from December 31, 2019 primarily due to increases in demand deposits, interest checking deposits, savings deposits and money market deposits. Demand deposits increased $21.7 billion, or 60%, from December 31, 2019 primarily as a result of higher balances per commercial customer account due to increased liquidity levels in the form of excess cash balances driven by the amount of fiscal stimulus during the year ended December 31, 2020 as well as balance migration from interest checking deposits. Interest checking deposits increased $6.9 billion, or 17%, from December 31, 2019 primarily as a result of higher balances per customer account due to the previously mentioned increased liquidity levels in the current economic environment, partially offset by the aforementioned balance migration into demand deposits. Savings deposits increased $4.0 billion, or 28%, and money market deposits increased $3.4 billion, or 12%, from December 31, 2019 primarily as a result of higher balances per customer account due to uncertainty regarding the COVID-19 pandemic, fiscal stimulus as well as higher demand for low-risk investment alternatives and decreased consumer spending. Other time deposits decreased $2.2 billion, or 42%, from December 31, 2019 primarily due to lower offering rates on certificates less than $100,000.Certificates $100,000 and over decreased $1.7 billion, or 45%, from December 31, 2019, primarily due to a decrease in certificates of deposit issued since December 31, 2019.The following table presents the components of average deposits for the years ended December 31:TABLE 27: Components of Average Deposits($ in millions)20202019201820172016Demand$47,111 34,343 32,634 35,093 35,862 Interest checking46,890 36,658 29,818 26,382 25,143 Savings16,440 14,041 13,330 13,958 14,346 Money market29,879 25,879 21,769 20,231 19,523 Foreign office185 209 363 388 497 Total transaction deposits140,505 111,130 97,914 96,052 95,371 Other time4,118 5,470 4,106 3,771 4,010 Total core deposits144,623 116,600 102,020 99,823 99,381 Certificates $100,000 and over(a)3,337 4,504 2,426 2,564 2,735 Other deposits71 265 476 277 333 Total average deposits$148,031 121,369 104,922 102,664 102,449 (a)Includes $2.2 billion, $2.6 billion, $1.1 billion, $1.4 billion and $1.5 billion of average institutional, retail and wholesale certificates $250,000 and over during the years ended December 31, 2020, 2019, 2018, 2017 and 2016, respectively.On an average basis, core deposits increased $28.0 billion, or 24%, from December 31, 2019 due to an increase of $29.4 billion, or 26%, in average transaction deposits, partially offset by a decrease of $1.4 billion, or 25%, in average other time deposits. The increase in average transaction deposits was driven by increases in average demand deposits, average interest checking deposits, average money market deposits and average savings deposits. Average demand deposits increased $12.8 billion, or 37%, from December 31, 2019 primarily as a result of higher average balances per commercial customer account due to the previously mentioned increased liquidity levels in the current economic environment in the form of excess cash balances driven by the amount of fiscal stimulus as well as balance migration from interest checking deposits. Average interest checking deposits increased $10.2 billion, or 28%, from December 31, 2019 primarily as a result of higher average balances per customer account due to the previously mentioned increased liquidity levels in the current economic environment in the form of 90 Fifth Third BancorpTable of Contents MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSexcess cash balances driven by the amount of fiscal stimulus partially offset by the aforementioned balance migration into demand deposits. Average money market deposits increased $4.0 billion, or 15%, and average savings deposits increased $2.4 billion, or 17% from December 31, 2019 primarily as a result of higher average balances per customer account due to the previously mentioned increased liquidity levels in the current economic environment as well as higher demand for low-risk investment alternatives and decreased consumer spending amidst uncertainty regarding the COVID-19 pandemic. Average other time deposits decreased primarily due to lower offering rates on certificates less than $100,000.Average certificates $100,000 and over decreased $1.2 billion, or 26%, from December 31, 2019 primarily due to a decrease in average certificates of deposit issued since December 31, 2019. Average other deposits decreased $194 million, or 73%, from December 31, 2019 primarily due to a decrease in average Eurodollar trade deposits. Contractual MaturitiesThe contractual maturities of certificates $100,000 and over as of December 31, 2020 are summarized in the following table:TABLE 28: Contractual Maturities of Certificates $100,000 and Over($ in millions)Next 3 months$586 3-6 months1,032 6-12 months211 After 12 months197 Total certificates $100,000 and over$2,026 The contractual maturities of other time deposits and certificates $100,000 and over as of December 31, 2020 are summarized in the following table:TABLE 29: Contractual Maturities of Other Time Deposits and Certificates $100,000 and Over($ in millions)Next 12 months$4,413 13-24 months355 25-36 months128 37-48 months73 49-60 months59 After 60 months21 Total other time deposits and certificates $100,000 and over$5,049 BorrowingsThe Bancorp accesses a variety of short-term and long-term funding sources. Borrowings with original maturities of one year or less are classified as short-term and include federal funds purchased and other short-term borrowings. Total average borrowings as a percent of average interest-bearing liabilities were 15% at December 31, 2020 compared to 17% at December 31, 2019.The following table summarizes the end of period components of borrowings:TABLE 30: Components of BorrowingsAs of December 31 ($ in millions)20202019201820172016Federal funds purchased$300 260 1,925 174 132 Other short-term borrowings1,192 1,011 573 4,012 3,535 Long-term debt14,973 14,970 14,426 14,904 14,388 Total borrowings$16,465 16,241 16,924 19,090 18,055 Total borrowings increased $224 million, or 1%, from December 31, 2019 due to increases in other short-term borrowings, federal funds purchased and long-term debt. Other short-term borrowings increased $181 million from December 31, 2019 primarily as a result of increases in securities sold under repurchase agreements driven by an increase in commercial customer activity. The level of other short-term borrowings can fluctuate significantly from period to period depending on funding needs and the sources that are used to satisfy those needs. For further information on the components of other short-term borrowings, refer to Note 17 of the Notes to Consolidated Financial Statements. Federal funds purchased increased $40 million from December 31, 2019 primarily due to an increase in commercial customer activity. Long-term debt increased $3 million from December 31, 2019 primarily driven by the issuance of $1.25 billion of unsecured senior fixed-rate bank notes in January of 2020, the issuance of $1.25 billion of unsecured senior fixed-rate notes in May of 2020 and $133 million of fair value adjustments associated with interest rate swaps hedging long-term debt during the year ended December 31, 2020. These increases were partially offset by the maturity of $1.1 billion of unsecured senior fixed-rate notes, the maturity of $750 million of unsecured 91 Fifth Third BancorpTable of Contents MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSsenior fixed-rate bank notes, the maturity of $300 million of unsecured senior floating-rate bank notes and $568 million of paydowns on long-term debt associated with automobile loan securitizations during the year ended December 31, 2020. For additional information regarding the long-term debt issuances, refer to Note 18 of the Notes to Consolidated Financial Statements. The following table summarizes the components of average borrowings:TABLE 31: Components of Average BorrowingsFor the years ended December 31 ($ in millions)20202019201820172016Federal funds purchased$385 1,267 1,509 557 506 Other short-term borrowings1,709 1,046 1,611 3,158 2,845 Long-term debt16,004 15,369 14,551 13,804 15,394 Total average borrowings$18,098 17,682 17,671 17,519 18,745 Total average borrowings increased $416 million, or 2%, compared to December 31, 2019 due to increases in average other short-term borrowings and average long-term debt, partially offset by a decrease in average federal funds purchased. Average other short-term borrowings increased $663 million compared to December 31, 2019 driven primarily by an increase in FHLB advances attributable to short-term advances executed during the early stages of the COVID-19 pandemic. Average long-term debt increased $635 million compared to December 31, 2019 primarily driven by the issuances of $1.25 billion of unsecured senior fixed-rate bank notes and $1.25 billion of unsecured senior fixed-rate notes during the year ended December 31, 2020 and the issuance of $750 million of unsecured senior fixed-rate notes in the fourth quarter in 2019. These increases were partially offset by the maturity of $1.1 billion of unsecured senior fixed-rate notes, the maturity of $750 million of unsecured senior fixed-rate bank notes, the maturity of $300 million of unsecured senior floating-rate bank notes and $568 million of paydowns on long-term debt associated with automobile loan securitizations since December 31, 2019. Average federal funds purchased decreased $882 million compared to December 31, 2019 primarily due to lower short-term funding needs given core deposit growth. Information on the average rates paid on borrowings is discussed in the Net Interest Income subsection of the Statements of Income Analysis section of MD&A. In addition, refer to the Liquidity Risk Management subsection of the Risk Management section of MD&A for a discussion on the role of borrowings in the Bancorp’s liquidity management.92 Fifth Third BancorpTable of Contents MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSRISK MANAGEMENT - OVERVIEWEffective risk management is critical to the Bancorp’s ongoing success and ensures that the Bancorp operates in a safe and sound manner, complies with applicable laws and regulations and safeguards the Bancorp’s brand and reputation. Risks are inherent in the Bancorp’s business, and the Bancorp is responsible for managing these risks effectively to deliver through-the-cycle value and performance for the Bancorp’s shareholders, customers, employees and communities.Fifth Third’s Risk Management Framework, which is approved annually by the Capital Committee, ERMC, RCC and the Board of Directors, includes the following key elements:•The Bancorp ensures transparency and escalation of risk through defined risk policies and a governance structure that includes the Risk and Compliance Committee of the Board of Directors, the Enterprise Risk Management Committee and other management-level risk committees and councils.•The Bancorp establishes a risk appetite in alignment with its strategic, financial and capital plans. The Bancorp’s risk appetite is defined using quantitative metrics and qualitative measures to ensure prudent risk taking and drive balanced decision making. The Bancorp’s goal is to ensure that aggregate residual risks do not exceed the Bancorp’s risk appetite, and that risks taken are supportive of the Bancorp’s portfolio diversification and profitability objectives. The Board and executive management define the risk appetite, which is considered in the development of business strategies and forms the basis for risk management.•The core principles that define the Bancorp’s risk appetite are as follows:◦To act with integrity in all activities.◦To understand the risks taken and ensure that they are in alignment with the Bancorp’s business strategies and risk appetite. ◦To avoid risks that cannot be understood, managed or monitored.◦To provide transparency of risk to the Bancorp’s management and Board by escalating risks and issues as necessary. ◦To ensure Fifth Third’s products and services are aligned to the Bancorp’s core customer base and are designed, delivered and maintained to provide value and benefit to the Bancorp’s customers and to Fifth Third.◦Not to offer products or services that are not appropriate or suitable for the Bancorp’s customers.◦Focus on providing operational excellence by providing reliable, accurate, and efficient services to meet the Bancorp’s customers’ needs.◦To maintain a strong financial position to ensure the Bancorp meets its strategic objectives through all economic cycles and is able to access the capital markets at all times, even under stressed conditions.◦To protect the Bancorp’s reputation by thoroughly understanding the consequences of business strategies, products and processes.◦To conduct the Bancorp’s business in compliance with all applicable laws, rules and regulations and in alignment with internal policies and procedures. •Fifth Third’s core values and culture provide the foundation for sound risk management practices by establishing expectations for appropriate conduct and accountability across the organization. All employees are expected to conduct themselves in alignment with Fifth Third’s Code of Business Conduct & Ethics, which may be found on www.53.com, while carrying out their responsibilities. Fifth Third’s Corporate Responsibility and Reputation Committee provides oversight of business conduct policies, programs and strategies, and monitors reporting of potential misconduct, trends or themes across the enterprise. Prudent risk management is a responsibility that is expected from all employees and is a foundational element of Fifth Third’s culture.•The Bancorp manages eight defined risk types to a prescribed appetite. The risk types are credit risk, liquidity risk, interest rate risk, price risk, legal and regulatory compliance risk, operational risk, reputational risk and strategic risk.•Fifth Third’s Risk Management Process provides a consistent and integrated approach for managing risks. The five components of the Risk Management Process are: identify, assess, manage, monitor and report. The Bancorp has also established processes and programs to manage and report concentration risks, to ensure robust talent, compensation and performance management and to aggregate risks across the enterprise.Fifth Third drives accountability for managing risk through its Three Lines of Defense structure:•The first line of defense is comprised of front line units that create risk and are accountable for managing risk. These groups are the Bancorp’s primary risk takers and are responsible for implementing effective internal controls and maintaining processes for identifying, assessing, controlling and mitigating the risks associated with their activities consistent with established risk appetite and limits. The first line of defense also includes business units that provide information technology, operations, servicing, processing or other support.•The second line of defense, or Independent Risk Management, consists of Risk Management, Compliance and Credit Review. The second line is responsible for developing frameworks and policies to govern risk-taking activities, overseeing risk-taking of the organization, advising on controlling that risk and providing input on key risk decisions. Risk Management complements the front line’s management of risk-taking activities through its monitoring and reporting responsibilities, including adherence to the risk appetite. Additionally, Risk Management is responsible for identifying, measuring, monitoring, controlling and reporting on aggregate risks enterprise-wide.•The third line of defense is Internal Audit, which provides oversight of the first and second lines of defense, and independent assurance to the Board on the effectiveness of governance, risk management and internal controls.93 Fifth Third BancorpTable of Contents MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSCREDIT RISK MANAGEMENTThe objective of the Bancorp’s credit risk management strategy is to quantify and manage credit risk on an aggregate portfolio basis, as well as to limit the risk of loss resulting from the failure of a borrower or counterparty to honor its financial or contractual obligations to the Bancorp. The Bancorp’s credit risk management strategy is based on three core principles: conservatism, diversification and monitoring. The Bancorp believes that effective credit risk management begins with conservative lending practices which are described below. These practices include the use of intentional risk-based limits for single name exposures and counterparty selection criteria designed to reduce or eliminate exposure to borrowers who have higher than average default risk and defined weaknesses in financial performance. The Bancorp carefully designed and monitors underwriting, documentation and collection standards. The Bancorp’s credit risk management strategy also emphasizes diversification on a geographic, industry and customer level as well as ongoing portfolio monitoring and timely management reviews of large credit exposures and credits experiencing deterioration of credit quality. Credit officers with the authority to extend credit are delegated specific authority amounts, the utilization of which is closely monitored. Underwriting activities are centrally managed, and ERM manages the policy and the authority delegation process directly. The Credit Risk Review function provides independent and objective assessments of the quality of underwriting and documentation, the accuracy of risk grades and the charge-off, nonaccrual and reserve analysis process. The Bancorp’s credit review process and overall assessment of the adequacy of the allowance for credit losses is based on quarterly assessments of the estimated losses expected in the loan and lease portfolio. The Bancorp uses these assessments to promptly identify potential problem loans or leases within the portfolio, maintain an adequate allowance for credit losses and record any necessary charge-offs. The Bancorp defines potential problem loans and leases as those rated substandard that do not meet the definition of a nonaccrual loan or a restructured loan. Refer to Note 7 of the Notes to Consolidated Financial Statements for further information on the Bancorp’s credit grade categories, which are derived from standard regulatory rating definitions. In addition, stress testing is performed on various commercial and consumer portfolios utilizing various models. For certain portfolios, such as real estate and leveraged lending, stress testing is performed by Credit department personnel at the individual loan level during credit underwriting.The following tables provide a summary of potential problem portfolio loans and leases:TABLE 32: Potential Problem Portfolio Loans and LeasesAs of December 31, 2020 ($ in millions)CarryingValueUnpaidPrincipalBalanceExposureCommercial and industrial loans$2,641 2,651 3,687 Commercial mortgage loans784 798 792 Commercial construction loans240 240 252 Commercial leases72 72 72 Total potential problem portfolio loans and leases$3,737 3,761 4,803 TABLE 33: Potential Problem Portfolio Loans and LeasesAs of December 31, 2019 ($ in millions)CarryingValueUnpaidPrincipalBalanceExposureCommercial and industrial loans$1,100 1,120 1,488 Commercial mortgage loans342 390 342 Commercial construction loans75 82 84 Commercial leases61 61 61 Total potential problem portfolio loans and leases$1,578 1,653 1,975 In addition to the individual review of larger commercial loans that exhibit probable or observed credit weaknesses, the commercial credit review process includes the use of two risk grading systems. The first of these risk grading systems encompasses ten categories, which are based on regulatory guidance for credit risk systems. These ratings are used by the Bancorp to monitor and manage its credit risk. The Bancorp also maintains a dual risk rating system for credit approval and pricing, portfolio monitoring and capital allocation that includes a “through-the-cycle” rating philosophy for assessing a borrower’s creditworthiness. A “through-the-cycle” rating philosophy uses a grading scale that assigns ratings based on average default rates through an entire business cycle for borrowers with similar financial performance. The dual risk rating system includes thirteen probabilities of default grade categories and an additional eleven grade categories for estimating losses given an event of default. The probability of default and loss given default evaluations are not separated in the ten-category regulatory risk rating system.The Bancorp has also developed models to estimate expected credit losses as part of the Bancorp’s adoption of ASU 2016-13 “Measurement of Credit Losses on Financial Instruments” on January 1, 2020. For loans and leases that are collectively evaluated, the Bancorp utilizes these models to forecast expected credit losses over a reasonable and supportable forecast period based on the probability of a loan or lease defaulting, the expected balance at the estimated date of default and the expected loss percentage given a default. Refer to Note 1 of the Notes to Consolidated Financial Statements for additional information about the Bancorp’s processes for developing these models, estimating credit losses for periods beyond the reasonable and supportable forecast period and for estimating credit losses for individually evaluated loans.94 Fifth Third BancorpTable of Contents MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSFor the commercial portfolio segment, the estimated probabilities of default are primarily based on the probability of default ratings assigned under the through-the-cycle dual risk rating system and historical observations of how those ratings migrate to a default over time in the context of macroeconomic conditions. For loans with available credit, the estimate of the expected balance at the time of default considers expected utilization rates, which are primarily based on macroeconomic conditions and the utilization history of similar borrowers under those economic conditions. The estimates for loss severity are primarily based on collateral type and coverage levels and the susceptibility of those characteristics to changes in macroeconomic conditions.For collectively evaluated loans in the consumer and residential mortgage portfolio segments, the Bancorp’s expected credit loss models primarily utilize the borrower’s FICO score and delinquency history in combination with macroeconomic conditions when estimating the probability of default. The estimates for loss severity are primarily based on collateral type and coverage levels and the susceptibility of those characteristics to changes in macroeconomic conditions. The expected balance at the estimated date of default is also especially impactful in the expected credit loss models for portfolio classes which generally have longer terms (such as residential mortgage loans and home equity) and portfolio classes containing a high concentration of loans with revolving privileges (such as credit card and home equity). The estimate of the expected balance at the time of default considers expected prepayment and utilization rates where applicable, which are primarily based on macroeconomic conditions and the utilization history of similar borrowers under those economic conditions. The Bancorp also utilizes various scoring systems, analytical tools and portfolio performance monitoring processes to assess the credit risk of the consumer and residential mortgage portfolios.Overview Financial markets began the year optimistic as the signing of the Phase I trade between China and the U.S. lifted investor expectations for global growth in 2020. In February, the onset of the COVID-19 pandemic and the related shutdown of the economy led to a dramatic repricing of financial markets. From mid-February to late March 2020 the S&P 500 declined 34%, the 10-year Treasury fell to all-time lows, investment grade credit spreads widened 350 basis points, and the U.S. dollar appreciated strongly versus other currencies. In response to the economic and financial market dislocations, unprecedented fiscal and monetary policies were implemented to offset the economic shock. These policies along with the development of multiple vaccines helped support the recovery from the COVID-19 pandemic as the year progressed.Economic recovery continued in the fourth quarter of 2020 as accommodative monetary policy and additional fiscal stimulus supported economic activity while the beginning of COVID-19 vaccinations in December 2020 supported the risk on sentiment in financial markets. The Federal Reserve maintained their commitment to keeping the target rate for federal funds at 0% to 0.25% for the foreseeable future while continuing to expand their balance sheet holdings by at least $80 billion of treasuries and $40 billion of agency mortgage-backed securities per month. At the December 2020 FOMC meeting, federal officials indicated balance sheet purchases would continue at the current pace “until substantial further progress has been made toward the Committee’s maximum employment and price stability goals.” In December 2020, the federal government enacted legislation that provides additional relief for individuals, businesses and hospitals in response to the economic distress caused by the COVID-19 pandemic. The $900 billion relief legislation included an extension of the Federal Pandemic Unemployment Compensation program, a new round of stimulus checks for individuals, a second round of the Paycheck Protection Program, assistance for schools and the transportation sector and funding to assist states with COVID-19 testing and vaccine distribution. Although COVID-19 cases rose to new records in December 2020, along with hospitalizations and deaths, the start of the vaccination process supported investors’ expectations for an end of the pandemic in 2021. In addition, the results of the federal elections in November 2020 supported investors’ expectations of additional fiscal stimulus and a robust recovery in the second half of 2021. The bullish sentiment led to yield curve steepening in the treasury market, all-time high equity valuations, tighter credit spreads and flatter credit curves. The housing market remained robust as low mortgage rates and tight inventory levels supported the strongest home price growth since 2014, while the S&P 500 increased 12.15% in the fourth quarter of 2020 and 18.40% for the year ended December 31, 2020. With the rise in asset prices, household net worth reached a record at the end of the third quarter of 2020, up approximately 7% year-over-year. Lastly, the U.S. employment picture continued to improve during the fourth quarter of 2020 as the unemployment rate declined from 7.8% to 6.7% despite the new COVID-19 lockdown restrictions which led to higher unemployment claims and a loss in jobs in the most recent employment report. COVID-19 Hardship Relief ProgramsIn response to the COVID-19 pandemic, beginning in March 2020, the Bancorp began providing financial hardship relief to borrowers that were negatively impacted by the pandemic and its related economic impacts. For retail borrowers, these relief programs included three-month payment deferrals for non-real estate secured and unsecured portfolios, six-month payment deferrals for home equity loans and lines of credit and six-month forbearances for residential mortgages. The Bancorp also temporarily waived fees for certain products and services, suspended initiating any new repossession actions on vehicles and suspended all residential foreclosure activity. In most cases, these offers are not classified as TDRs and do not result in loans being placed on nonaccrual status. The fee waiver, repossession suspension and payment deferral programs for non-real estate secured and unsecured and home equity loans and lines of credit were discontinued early in the third quarter of 2020. However, new programs to assist consumer customers are now being offered to meet the uniqueness of the current economic environment. These primarily include a short-term hardship program which allows for a reduced payment amount for six months with full payments resuming thereafter or placement into a loan modification program that could include permanent rate reductions or maturity extensions. 95 Fifth Third BancorpTable of Contents MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSThe Bancorp currently plans to continue to offer the six-month forbearance program for its residential mortgage borrowers in alignment with the forbearances offered for federally-backed mortgage loans under the provisions of the CARES Act. Upon completion of the initial six-month forbearance period for residential mortgage loans, borrowers may request to extend the forbearance period for an additional period of up to six months. Additionally, the Bancorp will continue to follow the specific GSE guidance for other non-forbearance related COVID-19 pandemic relief programs when servicing its residential mortgage portfolio. These programs include traditional loan modifications and/or deferral of past due payments to the maturity of the loan. The Bancorp continues to suspend residential foreclosure activity in alignment with GSE practices. The Bancorp will also be responsive to any legislative changes related to foreclosure activity. The Bancorp has also offered a variety of relief options to its commercial borrowers that have been impacted by the COVID-19 pandemic. While these offers are individually negotiated and tailored to each borrower’s specific facts and circumstances, the most commonly offered relief measures include temporary covenant waivers and/or deferrals of principal and/or interest payments for up to 90 days. After the deferral program, a customer may have the option to resume normal payments, enter into a formal loan modification program or restructure the loan arrangement.For loans that receive a payment deferral or forbearance under these hardship relief programs, the Bancorp continues to accrue interest and recognize interest income during the period of the deferral. Depending on the terms of each program, all or a portion of this accrued interest may be paid directly by the borrower (either during the relief period, at the end of the relief period or at maturity of the loan) or added to the customer’s outstanding balance. For certain programs, the maturity date of the loan may also be extended by the number of payments deferred. Interest income will continue to be recognized at the original contractual interest rate unless that rate is concurrently modified upon entering the relief program (in which case, the modified rate would be used to recognize interest).For commercial leases that receive payment deferrals under the Bancorp’s COVID-19 pandemic hardship relief programs, the Bancorp will continue to recognize interest income during the deferral period, but the yield will be recalculated based on the timing and amount of remaining payments over the remaining lease term. The revised yield will be used for prospectively recognizing interest income and adjusting the net investment in the lease. The Bancorp’s hardship relief programs for commercial leases affect the timing of payments but do not generally result in an increase in the rights of the lessor or the obligations of the lessee. Therefore, the Bancorp has elected to forego certain requirements that would typically apply for lease modifications when accounting for the effects of the hardship relief programs. Refer to the Regulatory Developments Related to the COVID-19 Pandemic section of Note 1 of the Notes to Consolidated Financial Statements for further information.As of December 31, 2020, the Bancorp had discontinued new enrollments for its consumer hardship relief programs except for the residential mortgage forbearance program previously discussed. The remaining consumer loans that were in an active relief period as of December 31, 2020 primarily consisted of borrowers who were previously enrolled in a hardship relief program and then subsequently requested additional assistance. These extended assistance periods generally provide reduced payments for a period of up to six months and are expected to be substantially complete in the first quarter of 2021. As previously discussed, residential mortgage borrowers may receive a total forbearance of up to one year so borrowers will be in active relief periods for a longer period of time. However, the Bancorp currently expects most of its residential mortgage loans to exit forbearance in the first half of 2021.96 Fifth Third BancorpTable of Contents MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSThe following table provides a summary of portfolio loans and leases as of December 31, 2020, by class, that have received payment deferrals or forbearances as part of the Bancorp’s COVID-19 pandemic hardship relief programs:TABLE 34: Summary of Portfolio Loans and Leases Enrolled In Hardship Relief ProgramsAmortized Cost Basis of Loans and LeasesPast Due(c)Completed Relief PeriodIn Active Relief Period(a)Total that Have Received Payment Relief(b)December 31, 2020 ($ in millions)Current(c)30-89 Days90 Days or MoreTotal Past DueCommercial loans:Commercial and industrial loans$1,355 10 1,365 1,347 14 4 18 Commercial mortgage owner-occupied loans564 16 580 575 4 1 5 Commercial mortgage nonowner-occupied loans1,081 97 1,178 1,125 27 26 53 Commercial construction loans470 15 485 485 — — — Commercial leases91 — 91 91 — — — Residential mortgage loans(b)859 615 1,474 1,243 53 178 231 Consumer loans:Home equity195 11 206 183 15 8 23 Indirect secured consumer loans(d)771 216 987 922 49 16 65 Credit card110 25 135 109 12 14 26 Other consumer loans95 14 109 103 4 2 6 Total portfolio loans and leases$5,591 1,019 6,610 6,183 178 249 427 (a)Includes loans and leases that are still in the initial payment relief period (primarily residential mortgage and home equity loans) and loans that have requested additional relief.(b)Excludes $921 of loans previously sold to GNMA that the Bancorp had the option to repurchase as a result of forbearance, $882 of which were repurchased and are classified as held for sale.(c)For loans which are still in an active relief period, past due status is based on the borrower's status as of March 1, 2020, as adjusted based on the borrower’s compliance with modified loan terms.(d)Indirect secured consumer loans which are still in an active relief period as of December 31, 2020 are required to make payments but at a reduced amount from original contractual terms.As of December 31, 2020, $1.5 billion of the Bancorp’s residential mortgage loans had been enrolled in a COVID-19 forbearance program (either active or completed). These loans had a weighted-average FICO score of approximately 690 and a weighted-average origination LTV of approximately 81%. Approximately 60% of these borrowers made at least one payment since entering forbearance, and 84% of balances are reported as current as of December 31, 2020. The Bancorp had $615 million of these loans in an active relief period as of December 31, 2020 and these loans had a weighted-average FICO score of approximately 660 and a weighted-average origination LTV of approximately 83%. Approximately one third of borrowers in an active forbearance period have made at least one payment since entering forbearance and approximately 85% of the residential mortgage loans still in an active relief period have completed the initial six-month forbearance period and have requested an extended forbearance for up to an additional six months.97 Fifth Third BancorpTable of Contents MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSCommercial Portfolio The Bancorp’s credit risk management strategy seeks to minimize concentrations of risk through diversification. The Bancorp has commercial loan concentration limits based on industry, lines of business within the commercial segment, geography and credit product type. The risk within the commercial loan and lease portfolio is managed and monitored through an underwriting process utilizing detailed origination policies, continuous loan level reviews, monitoring of industry concentration and product type limits and continuous portfolio risk management reporting.The Bancorp provides loans to a variety of customers ranging from large multinational firms to middle market businesses, sole proprietors and high net worth individuals. The origination policies for commercial and industrial loans outline the risks and underwriting requirements for loans to businesses in various industries. Included in the policies are maturity and amortization terms, collateral and leverage requirements, cash flow coverage measures and hold limits. The Bancorp aligns credit and sales teams with specific industry expertise to better monitor and manage different industry segments of the portfolio.Certain industries have experienced increased stress due to the COVID-19 pandemic. These include consumer-driven industries that require gathering or congregation such as leisure and recreation (including casinos, restaurants, sports, fitness, hotels and other industries), non-essential retail and leisure travel (primarily including airlines and cruise lines). Certain segments of the healthcare industry (including skilled nursing, physician offices and surgery/outpatient centers, among others) have also been impacted by the pandemic given delays and restrictions on in-person visits and elective procedures. The following table presents industries impacted the most severely within the Bancorp’s commercial and industrial and commercial real estate loan portfolios as of December 31, 2020:TABLE 35: Industries Impacted the Most Severely by the COVID-19 Pandemic($ in millions)BalanceExposureIndustry Classification(b)Commercial and industrial loans:(a)Leisure and recreation(c)$3,827 7,254 Accommodation and food / Entertainment and recreationHealthcare834 1,560 HealthcareRetail - non-essential690 3,043 Retail tradeLeisure travel416 585 Transportation and warehousingTotal commercial and industrial loans5,767 12,442 Commercial real estate loans:Leisure and recreation(c)2,225 2,568 Accommodation and food / Entertainment and recreationHealthcare1,647 2,025 HealthcareRetail - non-essential1,242 1,335 Real estateTotal commercial real estate loans5,114 5,928 Total$10,881 18,370 (a)Excludes PPP loans.(b)As defined by the North American Industry Classification System.(c)Balances include exposures to casinos, restaurants, sports, fitness, hotels and other.Additionally, the Bancorp’s energy loan portfolio of $2.6 billion for oil and gas production and related industries was also impacted by significant declines in oil prices during the year ended December 31, 2020.98 Fifth Third BancorpTable of Contents MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSThe following table provides detail on commercial loans and leases by industry classification (as defined by the North American Industry Classification System), by loan size and by state, illustrating the diversity and granularity of the Bancorp’s commercial loans and leases:TABLE 36: Commercial Loan and Lease Portfolio (excluding loans and leases held for sale)20202019As of December 31 ($ in millions)OutstandingExposureNonaccrualOutstandingExposureNonaccrualBy Industry:Real estate$11,416 16,865 143 11,320 16,993 9 Manufacturing10,699 21,986 68 11,996 22,079 87 Financial services and insurance6,868 15,113 — 7,214 15,398 — Business services5,344 9,114 66 5,170 8,579 75 Healthcare5,168 7,874 41 4,984 7,206 38 Wholesale trade4,204 7,990 25 4,502 7,715 17 Accommodation and food4,166 6,600 35 3,745 6,525 21 Retail trade3,651 8,871 6 3,948 8,255 39 Communication and information3,128 5,802 39 3,166 5,567 2 Transportation and warehousing2,846 4,596 13 2,880 4,996 12 Construction2,631 6,053 4 2,526 5,327 4 Mining2,626 4,171 94 3,046 4,966 37 Entertainment and recreation2,248 3,537 84 1,905 3,327 40 Other services1,362 1,770 7 1,224 1,662 4 Utilities1,162 3,011 — 991 2,672 — Public administration880 1,428 — 782 1,107 — Agribusiness394 616 10 344 554 9 Other127 129 2 151 153 3 Individuals77 123 1 64 128 — Total$68,997 125,649 638 69,958 123,209 397 By Loan Size:Less than $1 million7 %5 10 4 3 10 $1 million to $5 million9 7 18 9 7 22 $5 million to $10 million7 6 14 7 6 11 $10 million to $25 million18 16 27 20 17 27 $25 million to $50 million24 23 31 24 24 30 Greater than $50 million35 43 — 36 43 — Total100 %100 100 100 100 100 By State:Illinois14 %12 28 15 12 18 Ohio11 12 4 10 11 6 Florida8 7 1 7 7 6 Michigan6 6 7 6 6 7 Indiana4 4 1 4 4 2 Georgia3 4 7 3 4 11 North Carolina3 2 3 3 3 10 Tennessee2 3 1 3 3 1 Kentucky2 2 4 2 2 9 Other47 48 44 47 48 30 Total100 %100 100 100 100 100 The origination policies for commercial real estate outline the risks and underwriting requirements for owner and nonowner-occupied and construction lending. Included in the policies are maturity and amortization terms, maximum LTVs, minimum debt service coverage ratios, construction loan monitoring procedures, appraisal requirements, pre-leasing requirements (as applicable), pro forma analysis requirements and interest rate sensitivity. The Bancorp requires a valuation of real estate collateral, which may include third-party appraisals, be performed at the time of origination and renewal in accordance with regulatory requirements and on an as-needed basis when market conditions justify. Although the Bancorp does not back test these collateral value assumptions, the Bancorp maintains an appraisal review department to order and review third-party appraisals in accordance with regulatory requirements. Collateral values on criticized assets with relationships exceeding $1 million are reviewed quarterly to assess the appropriateness of the value ascribed in the assessment of charge-offs and specific reserves.99 Fifth Third BancorpTable of Contents MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSThe Bancorp assesses all real estate and non-real estate collateral securing a loan and considers all cross-collateralized loans in the calculation of the LTV ratio. The following tables provide detail on the most recent LTV ratios for commercial mortgage loans greater than $1 million, excluding commercial mortgage loans that are individually evaluated. The Bancorp does not typically aggregate the LTV ratios for commercial mortgage loans less than $1 million.TABLE 37: Commercial Mortgage Loans Outstanding by LTV, Loans Greater Than $1 MillionAs of December 31, 2020 ($ in millions)LTV > 100%LTV 80-100%LTV < 80%Commercial mortgage owner-occupied loans$121 310 3,209 Commercial mortgage nonowner-occupied loans51 72 4,757 Total$172 382 7,966 TABLE 38: Commercial Mortgage Loans Outstanding by LTV, Loans Greater Than $1 MillionAs of December 31, 2019 ($ in millions)LTV > 100%LTV 80-100%LTV < 80% Commercial mortgage owner-occupied loans$126 393 3,199 Commercial mortgage nonowner-occupied loans58 107 4,562 Total$184 500 7,761 The Bancorp views non-owner-occupied commercial real estate as a higher credit risk product compared to some other commercial loan portfolios due to the higher volatility of the industry.The following tables provide an analysis of nonowner-occupied commercial real estate loans by state (excluding loans held for sale):TABLE 39: Nonowner-Occupied Commercial Real Estate (excluding loans held for sale)(a)As of December 31, 2020 ($ in millions)For the Year EndedDecember 31, 2020OutstandingExposure90 Days Past DueNonaccrualNet Charge-offsBy State:Illinois$2,844 3,375 1 45 6 Ohio1,405 1,990 — 4 — Florida1,132 1,668 — — — North Carolina854 1,124 — 2 — Michigan810 926 — 1 — Indiana580 1,029 — — — Georgia424 924 — 1 — All other states2,981 4,539 — 25 35 Total$11,030 15,575 1 78 41 (a)Included in commercial mortgage loans and commercial construction loans in the Loans and Leases subsection of the Balance Sheet Analysis section of MD&A. TABLE 40: Nonowner-Occupied Commercial Real Estate (excluding loans held for sale)(a)As of December 31, 2019 ($ in millions)For the Year EndedDecember 31, 2019OutstandingExposure90 Days Past DueNonaccrualNet Charge-offsBy State:Illinois$3,097 3,639 6 — 2 Ohio1,402 1,861 — 1 — Florida951 1,605 — — — North Carolina635 1,040 — — — Michigan714 849 — — — Indiana582 865 — — — Georgia351 897 — — — All other states2,883 4,569 — — — Total$10,615 15,325 6 1 2 (a)Included in commercial mortgage loans and commercial construction loans in the Loans and Leases subsection of the Balance Sheet Analysis section of MD&A. 100 Fifth Third BancorpTable of Contents MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSConsumer Portfolio Consumer credit risk management utilizes a framework that encompasses consistent processes for identifying, assessing, managing, monitoring and reporting credit risk. These processes are supported by a credit risk governance structure that includes Board oversight, policies, risk limits and risk committees.The Bancorp’s consumer portfolio is materially comprised of five categories of loans: residential mortgage loans, home equity, indirect secured consumer loans, credit card and other consumer loans. The Bancorp has identified certain credit characteristics within these five categories of loans which it believes represent a higher level of risk compared to the rest of the consumer loan portfolio. The Bancorp does not update LTVs for the consumer portfolio subsequent to origination except as part of the charge-off process for real estate secured loans. Credit risk management continues to closely monitor the indirect secured consumer portfolio performance, which includes automobile loans. The automobile market has exhibited industry-wide gradual loosening of credit standards such as lower FICOs, longer terms and higher LTVs. The Bancorp has adjusted credit standards focused on improving risk-adjusted returns while maintaining credit risk tolerance. The Bancorp actively manages the automobile portfolio through concentration limits, which mitigate credit risk through limiting the exposure to lower FICO scores, higher advance rates and extended term originations. Additionally, the Bancorp enhanced its credit underwriting guidelines across the entire consumer portfolio in response to the economic stress created by the COVID-19 pandemic. The Bancorp routinely and consistently evaluates underwriting practices to align with economic conditions as part of standard risk management protocols. The Bancorp will continue to evaluate these practices based on underlying economic factors and internal considerations. Residential mortgage portfolio The Bancorp manages credit risk in the residential mortgage portfolio through underwriting guidelines that limit exposure to higher LTVs and lower FICO scores. Additionally, the portfolio is governed by concentration limits that ensure geographic, product and channel diversification. The Bancorp may also package and sell loans in the portfolio. The Bancorp does not originate residential mortgage loans that permit customers to defer principal payments or make payments that are less than the accruing interest. The Bancorp originates both fixed-rate and ARM loans. Within the ARM portfolio approximately $559 million of ARM loans will have rate resets during the next twelve months. Of these resets, 6% are expected to experience an increase in rate, with an average increase of approximately 0.4%. Underlying characteristics of these borrowers are relatively strong with a weighted-average origination DTI of 32% and weighted-average origination LTV of 71%. Certain residential mortgage products have contractual features that may increase credit exposure to the Bancorp in the event of a decline in housing values. These types of mortgage products offered by the Bancorp include loans with high LTVs, multiple loans secured by the same collateral that when combined result in an LTV greater than 80% and interest-only loans. The Bancorp has deemed residential mortgage loans with greater than 80% LTVs and no mortgage insurance as loans that represent a higher level of risk. Portfolio residential mortgage loans from 2010 and later vintages represented 94% of the portfolio as of December 31, 2020 and had a weighted-average origination LTV of 73% and a weighted-average origination FICO of 762. In response to the COVID-19 pandemic, the Bancorp has provided forbearances for up to six months for customers who are experiencing a hardship related to COVID-19, with an option for borrowers to extend the forbearance period for an additional period of up to six months upon request. Additionally, the Bancorp has maintained tighter credit underwriting guidelines for new originations, raising the minimum FICO score at origination to 680 and lowering the maximum allowable LTV to 80%. For further information on reporting of past due loans, refer to Note 1 of the Notes to Consolidated Financial Statements.The following table provides an analysis of the residential mortgage portfolio loans outstanding by LTV at origination:TABLE 41: Residential Mortgage Portfolio Loans by LTV at Origination20202019As of December 31 ($ in millions)OutstandingWeighted-Average LTVOutstandingWeighted-Average LTVLTV ≤ 80%$11,336 65.2 %$12,100 66.3 %LTV > 80%, with mortgage insurance(a)2,535 95.5 2,373 95.2 LTV > 80%, no mortgage insurance2,057 91.1 2,251 93.1 Total$15,928 73.9 %$16,724 74.3 %(a)Includes loans with both borrower and lender paid mortgage insurance.101 Fifth Third BancorpTable of Contents MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSThe following tables provide an analysis of the residential mortgage portfolio loans outstanding by state with a greater than 80% LTV at origination and no mortgage insurance:TABLE 42: Residential Mortgage Portfolio Loans, LTV Greater Than 80% at Origination, No Mortgage InsuranceAs of December 31, 2020 ($ in millions)For the Year EndedDecember 31, 2020Outstanding90 Days Past DueNonaccrualNet Charge-offsBy State:Ohio$459 4 4 2 Illinois410 3 1 — Florida306 1 2 — Michigan180 2 1 — Indiana147 1 1 — North Carolina139 2 — — Kentucky92 1 — — All other states324 3 2 — Total$2,057 17 11 2 TABLE 43: Residential Mortgage Portfolio Loans, LTV Greater Than 80% at Origination, No Mortgage InsuranceAs of December 31, 2019 ($ in millions)For the Year EndedDecember 31, 2019Outstanding90 Days Past DueNonaccrualNet Charge-offs (Recoveries)By State:Ohio$482 3 4 1 Illinois468 2 3 1 Florida305 2 1 (1)Michigan217 2 1 — Indiana175 1 1 — North Carolina139 — 2 — Kentucky93 — — — All other states372 3 3 1 Total$2,251 13 15 2 Home equity portfolio The Bancorp’s home equity portfolio is primarily comprised of home equity lines of credit. Beginning in the first quarter of 2013, the Bancorp’s newly originated home equity lines of credit have a 10-year interest-only draw period followed by a 20-year amortization period. The home equity line of credit previously offered by the Bancorp was a revolving facility with a 20-year term, minimum payments of interest-only and a balloon payment of principal at maturity. Peak maturity years for the balloon home equity lines of credit are 2025 to 2028 and approximately 23% of the balances mature before 2025.The ALLL provides coverage for expected losses in the home equity portfolio. The allowance attributable to the portion of the home equity portfolio that has not been restructured in a TDR is determined on a pooled basis using a probability of default, loss given default and exposure at default model framework to generate expected losses. The expected losses for the home equity portfolio are dependent upon loan delinquency, FICO scores, LTV, loan age and their historical correlation with macroeconomic variables including unemployment and the home price index. The expected losses generated from models are adjusted by certain qualitative adjustment factors to reflect risks associated with current conditions and trends. The qualitative factors include adjustments for changes in policies or procedures in underwriting, monitoring or collections, economic conditions, portfolio mix, lending and risk management personnel, results of internal audit and quality control reviews, collateral values and geographic concentrations.The home equity portfolio is managed in two primary groups: loans outstanding with a combined LTV greater than 80% and those loans with an LTV of 80% or less based upon appraisals at origination. For additional information on these loans, refer to Table 45 and Table 46. Of the total $5.2 billion of outstanding home equity loans:•80% reside within the Bancorp’s Midwest footprint of Ohio, Michigan, Kentucky, Indiana and Illinois as of December 31, 2020;•39% are in senior lien positions and 61% are in junior lien positions at December 31, 2020;•78% of non-delinquent borrowers made at least one payment greater than the minimum payment during the year ended December 31, 2020; and•The portfolio had a weighted-average refreshed FICO score of 748 at December 31, 2020.102 Fifth Third BancorpTable of Contents MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSThe Bancorp actively manages lines of credit and makes adjustments in lending limits when it believes it is necessary based on FICO score deterioration and property devaluation. The Bancorp does not routinely obtain appraisals on performing loans to update LTVs after origination. However, the Bancorp monitors the local housing markets by reviewing various home price indices and incorporates the impact of the changing market conditions in its ongoing credit monitoring processes. For junior lien home equity loans which become 60 days or more past due, the Bancorp tracks the performance of the senior lien loans in which the Bancorp is the servicer and utilizes consumer credit bureau attributes to monitor the status of the senior lien loans that the Bancorp does not service. If the senior lien loan is found to be 120 days or more past due, the junior lien home equity loan is placed on nonaccrual status unless both loans are well-secured and in the process of collection. Additionally, if the junior lien home equity loan becomes 120 days or more past due and the senior lien loan is also 120 days or more past due, the junior lien home equity loan is assessed for charge-off. Refer to the Analysis of Nonperforming Assets subsection of the Risk Management section of MD&A for more information.The Bancorp has enhanced its credit underwriting guidelines on new home equity originations in response to the COVID-19 pandemic, raising the minimum FICO score at origination to 720, lowering the maximum LTV to 80% and instituting more stringent verification of employment requirements. Additionally, applicants must have a Fifth Third deposit relationship to be considered for approval.The following table provides an analysis of home equity portfolio loans outstanding disaggregated based upon refreshed FICO score:TABLE 44: Home Equity Portfolio Loans Outstanding by Refreshed FICO Score20202019As of December 31 ($ in millions)Outstanding% of Total Outstanding% of Total Senior Liens:FICO ≤ 659$174 3 %$219 4 %FICO 660-719284 6 330 5 FICO ≥ 7201,546 30 1,732 28 Total senior liens2,004 39 2,281 37 Junior Liens:FICO ≤ 659339 6 446 7 FICO 660-719610 12 716 12 FICO ≥ 7202,230 43 2,640 44 Total junior liens3,179 61 3,802 63 Total$5,183 100 %$6,083 100 %The Bancorp believes that home equity portfolio loans with a greater than 80% combined LTV present a higher level of risk. The following table provides an analysis of the home equity portfolio loans outstanding in a senior and junior lien position by LTV at origination:TABLE 45: Home Equity Portfolio Loans Outstanding by LTV at Origination20202019As of December 31 ($ in millions)OutstandingWeighted-Average LTVOutstandingWeighted-Average LTVSenior Liens:LTV ≤ 80%$1,728 53.8 %$1,964 53.8 %LTV > 80%276 89.1 317 88.8 Total senior liens2,004 58.8 2,281 58.9 Junior Liens:LTV ≤ 80%1,864 66.5 2,213 66.8 LTV > 80%1,315 89.8 1,589 89.7 Total junior liens3,179 77.1 3,802 77.4 Total$5,183 69.8 %$6,083 70.3 %103 Fifth Third BancorpTable of Contents MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSThe following tables provide an analysis of home equity portfolio loans outstanding by state with a combined LTV greater than 80% at origination:TABLE 46: Home Equity Portfolio Loans Outstanding with an LTV Greater than 80% at OriginationAs of December 31, 2020 ($ in millions)For the Year EndedDecember 31, 2020OutstandingExposure90 DaysPast DueNonaccrualNet Charge-offs (Recoveries)By State:Ohio$493 1,109 — 9 1 Michigan283 590 — 4 (1)Illinois251 468 2 7 — Indiana148 318 — 3 — Kentucky126 280 — 1 — Florida113 220 — 3 — All other states177 347 — 4 — Total$1,591 3,332 2 31 — TABLE 47: Home Equity Portfolio Loans Outstanding with an LTV Greater than 80% at OriginationAs of December 31, 2019 ($ in millions)For the Year EndedDecember 31, 2019OutstandingExposure90 Day Past DueNonaccrual Net Charge-offs By State:Ohio$610 1,269 — 10 3 Michigan356 674 — 7 1 Illinois263 486 — 5 3 Indiana182 365 — 4 1 Kentucky155 321 — 2 — Florida132 246 — 3 1 All other states208 389 — 4 1 Total$1,906 3,750 — 35 10 Indirect secured consumer portfolio The indirect secured consumer portfolio is comprised of $12.6 billion of automobile loans and $1.0 billion of indirect motorcycle, powersport, recreational vehicle and marine loans as of December 31, 2020. The concentration of lower FICO (≤659) origination balances remained within targeted credit risk tolerance during the year ended December 31, 2020. All concentration and guideline changes are monitored monthly to ensure alignment with original credit performance and return projections. The following table provides an analysis of indirect secured consumer portfolio loans outstanding disaggregated based upon FICO score atorigination:TABLE 48: Indirect Secured Consumer Portfolio Loans Outstanding by FICO Score at Origination20202019As of December 31 ($ in millions) Outstanding% of TotalOutstanding% of TotalFICO ≤ 659$417 3 %$508 4 %FICO 660-7193,568 26 3,449 30 FICO ≥ 7209,668 71 7,581 66 Total$13,653 100 %$11,538 100 %As of December 31, 2020, 94% of the indirect secured consumer loan portfolio is comprised of automobile loans, powersport loans and motorcycle loans. It is a common industry practice to advance on these types of loans an amount in excess of the collateral value due to the inclusion of negative equity trade-in, maintenance/warranty products, taxes, title and other fees paid at closing. The Bancorp monitors its exposure to these higher risk loans. The remainder of the indirect secured consumer loan portfolio is comprised of marine and recreational vehicle loans. The Bancorp’s credit policies limit the maximum advance rate on these to 100% of collateral value.In response to the COVID-19 pandemic, the Bancorp enhanced its credit underwriting guidelines for indirect automobile originations. These enhancements include lowering maximum advance rates to 110%, raising the minimum FICO score at origination to 650, raising internal 104 Fifth Third BancorpTable of Contents MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSscore cutoffs and tightening capacity to repay standards. Revised credit underwriting guidelines have also been implemented in the marine, recreational vehicle and powersport channels, raising the minimum FICO score at origination and reducing the maximum allowable advance.The following table provides an analysis of indirect secured consumer portfolio loans outstanding by LTV at origination: TABLE 49: Indirect Secured Consumer Portfolio Loans Outstanding by LTV at Origination20202019As of December 31 ($ in millions)OutstandingWeighted-Average LTVOutstandingWeighted-Average LTVLTV ≤ 100%$9,371 80.3 %$7,420 81.3 %LTV > 100%4,282 112.7 4,118 113.4 Total$13,653 90.8 %$11,538 93.1 %The following table provides an analysis of the Bancorp’s indirect secured consumer portfolio loans outstanding with an LTV at origination greater than 100% as of and for the years ended: TABLE 50: Indirect Secured Consumer Portfolio Loans Outstanding with an LTV Greater than 100% at Origination($ in millions)Outstanding90 Days Past Due and AccruingNonaccrualNet Charge-offs December 31, 2020$4,282 6 10 26 December 31, 20194,118 7 4 37 Credit card portfolio The credit card portfolio consists of predominantly prime accounts with 97% of balances existing within the Bancorp’s footprint at both December 31, 2020 and December 31, 2019. At December 31, 2020 and 2019, 69% and 67%, respectively, of the outstanding balances were originated through branch-based relationships with the remainder coming from direct mail campaigns and online acquisitions.Card origination strategies have also been revised in response to the COVID-19 pandemic. The minimum FICO score at origination was raised to 720 with a qualifying Fifth Third deposit relationship requirement. New customer prospect marketing has also been suspended.The following table provides an analysis of credit card portfolio loans outstanding disaggregated based upon FICO score at origination:TABLE 51: Credit Card Portfolio Loans Outstanding by FICO Score at Origination 20202019As of December 31 ($ in millions)Outstanding% of TotalOutstanding% of TotalFICO ≤ 659$94 5 %$107 4 %FICO 660-719654 32 834 33 FICO ≥ 7201,259 63 1,591 63 Total$2,007 100 %$2,532 100 %Other consumer portfolio loans Other consumer portfolio loans are comprised of secured and unsecured loans originated through the Bancorp’s branch network as well as point-of-sale loans originated in connection with third-party financial technology companies. The Bancorp had $285 million in unfunded commitments associated with loans originated in connection with third-party financial technology companies as of December 31, 2020. The Bancorp closely monitors the credit performance of point-of-sale loans which, for the Bancorp, is impacted by certain credit loss protection coverage provided by the third-party financial technology companies. In response to the COVID-19 pandemic, the minimum FICO score at origination for unsecured loans originated through Fifth Third has been raised to 720. The minimum FICO scores at originations for loans originated through third parties is now set at 680. Additionally, for Fifth Third originated unsecured loans, a qualifying Fifth Third deposit relationship is now required.The following table provides an analysis of other consumer portfolio loans outstanding by product type:TABLE 52: Other Consumer Portfolio Loans Outstanding by Product Type 20202019As of December 31 ($ in millions)Outstanding% of TotalOutstanding% of TotalUnsecured$683 23 %$783 29 %Other secured774 26 530 19 Point-of-sale1,557 51 1,410 52 Total$3,014 100 %$2,723 100 %105 Fifth Third BancorpTable of Contents MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSAnalysis of Nonperforming Assets Nonperforming assets include nonaccrual loans and leases for which ultimate collectability of the full amount of the principal and/or interest is uncertain; restructured commercial, credit card and certain consumer loans which have not yet met the requirements to be classified as a performing asset; restructured consumer loans which are 90 days past due based on the restructured terms unless the loan is both well-secured and in the process of collection; and certain other assets, including OREO and other repossessed property. A summary of nonperforming assets is included in Table 53. For further information on the Bancorp’s policies related to accounting for delinquent and nonperforming loans and leases, refer to the Nonaccrual Loans and Leases section of Note 1 of the Notes to Consolidated Financial Statements. Nonperforming assets were $870 million at December 31, 2020 compared to $687 million at December 31, 2019. At December 31, 2020, $6 million of nonaccrual loans were held for sale, compared to $7 million at December 31, 2019.Nonperforming portfolio assets as a percent of portfolio loans and leases and OREO were 0.79% as of December 31, 2020 compared to 0.62% as of December 31, 2019. Nonaccrual loans and leases secured by real estate were 36% of nonaccrual loans and leases as of December 31, 2020 compared to 35% as of December 31, 2019.Portfolio commercial nonaccrual loans and leases were $638 million at December 31, 2020, an increase of $241 million from December 31, 2019. Portfolio consumer nonaccrual loans were $196 million at December 31, 2020, a decrease of $25 million from December 31, 2019. Refer to Table 54 for a rollforward of the portfolio nonaccrual loans and leases.OREO and other repossessed property was $30 million at December 31, 2020, compared to $62 million at December 31, 2019. The Bancorp recognized $7 million and $6 million in losses on the transfer, sale or write-down of OREO properties during the years ended December 31, 2020 and 2019, respectively. During the years ended December 31, 2020 and 2019, approximately $38 million and $35 million, respectively, of interest income would have been recognized if the nonaccrual and renegotiated loans and leases on nonaccrual status had been current in accordance with their original terms. Although these values help demonstrate the costs of carrying nonaccrual credits, the Bancorp does not expect to recover the full amount of interest as nonaccrual loans and leases are generally carried below their principal balance.106 Fifth Third BancorpTable of Contents MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSTABLE 53: Summary of Nonperforming Assets and Delinquent Loans and LeasesAs of December 31 ($ in millions)20202019201820172016Nonaccrual portfolio loans and leases:Commercial and industrial loans$230 118 54 144 302 Commercial mortgage loans82 21 9 12 27 Commercial construction loans— 1 — — — Commercial leases7 26 18 — 2 Residential mortgage loans(a)25 12 10 17 17 Home equity52 55 56 56 55 Indirect secured consumer loans9 1 — — — Other consumer loans2 2 1 — — Nonaccrual portfolio restructured loans and leases:Commercial and industrial loans243 220 139 132 176 Commercial mortgage loans75 9 4 14 14 Commercial construction loans1 — — — — Commercial leases— 2 4 4 2 Residential mortgage loans(a)35 79 12 13 17 Home equity34 39 13 18 18 Indirect secured consumer loans7 6 1 1 2 Credit card32 27 27 26 28 Total nonaccrual portfolio loans and leases(b)834 618 348 437 660 OREO and other repossessed property(c)30 62 47 52 78 Total nonperforming portfolio loans and leases and OREO864 680 395 489 738 Nonaccrual loans held for sale5 — — 5 4 Nonaccrual restructured loans held for sale1 7 16 1 9 Total nonperforming assets$870 687 411 495 751 Portfolio loans and leases 90 days past due and still accruing:Commercial and industrial loans$39 11 4 3 4 Commercial mortgage loans8 15 2 — — Commercial leases1 — — — — Residential mortgage loans(a)70 50 38 57 49 Home equity2 1 — — — Indirect secured consumer loans10 10 12 10 9 Credit card31 42 37 27 22 Other consumer loans2 1 — — — Total portfolio loans and leases 90 days past due and still accruing$163 130 93 97 84 Nonperforming portfolio assets as a percent of portfolio loans and leases and OREO0.79 %0.62 0.41 0.53 0.80 ALLL as a percent of nonperforming portfolio assets284 177 279 245 170 ACL as a percent of nonperforming portfolio assets304 198 317 274 190 (a)Information for all periods presented excludes advances made pursuant to servicing agreements for GNMA mortgage pools whose repayments are insured by the FHA or guaranteed by the VA. These advances were $317, $261, $195, $290 and $312 as of December 31, 2020, 2019, 2018, 2017 and 2016, respectively. The Bancorp recognized losses of $3, $4, $5, $5 and $6 for the years ended December 31, 2020, 2019, 2018, 2017 and 2016, respectively.(b)Includes $29, $16, $6, $3 and $4 of nonaccrual government insured commercial loans whose repayments are insured by the SBA at December 31, 2019, 2019, 2018, 2017 and 2016, respectively, of which $17, $11, $2, $3 and $1 were restructured nonaccrual government insured commercial loans at December 31, 2020, 2019, 2018, 2017 and 2016, respectively.(c)Upon completion of Fifth Third Bank’s conversion to a national charter in 2019, the Bancorp conformed to OCC guidance with regard to branch-related real estate no longer intended to be used for banking purposes. The impact of the change resulted in an increase to OREO of approximately $30 million with an offsetting reduction to bank premises and equipment.107 Fifth Third BancorpTable of Contents MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSThe following tables provide a rollforward of portfolio nonaccrual loans and leases, by portfolio segment:TABLE 54: Rollforward of Portfolio Nonaccrual Loans and LeasesFor the year ended December 31, 2020 ($ in millions)CommercialResidential Mortgage ConsumerTotal Balance, beginning of period$397 91 130 618 Transfers to nonaccrual status794 136 170 1,100 Transfers to accrual status(34)(149)(85)(268)Transfers to held for sale(46)— — (46)Loan paydowns/payoffs(216)(8)(47)(271)Transfers to OREO(1)(7)— (8)Charge-offs(282)(3)(34)(319)Draws/other extensions of credit26 — 2 28 Balance, end of period$638 60 136 834 TABLE 55: Rollforward of Portfolio Nonaccrual Loans and LeasesFor the year ended December 31, 2019 ($ in millions)CommercialResidential MortgageConsumerTotalBalance, beginning of period$228 22 98 348 Transfers to nonaccrual status456 107 176 739 Acquired nonaccrual loans8 — — 8 Transfers to accrual status— (20)(72)(92)Transfers to held for sale(17)— — (17)Loan paydowns/payoffs(165)(9)(30)(204)Transfers to OREO(5)(7)(4)(16)Charge-offs(127)(2)(38)(167)Draws/other extensions of credit19 — — 19 Balance, end of period$397 91 130 618 Troubled Debt Restructurings A loan is accounted for as a TDR if the Bancorp, for economic or legal reasons related to the borrower’s financial difficulties, grants a concession to the borrower that it would not otherwise consider. TDRs include concessions granted under reorganization, arrangement or other provisions of the Federal Bankruptcy Act. A TDR typically involves a modification of terms such as a reduction of the stated interest rate or remaining principal amount of the loan, a reduction of accrued interest or an extension of the maturity date at a stated interest rate lower than the current market rate for a new loan with similar risk.At the time of modification, the Bancorp maintains certain consumer loan TDRs (including certain residential mortgage loans, home equity loans and other consumer loans) on accrual status, provided there is reasonable assurance of repayment and performance according to the modified terms based upon a current, well-documented credit evaluation. Loans discharged in a Chapter 7 bankruptcy and not reaffirmed by the borrower are classified as collateral-dependent TDRs and placed on nonaccrual status regardless of the borrower’s payment history or capacity to repay in the future. These loans are returned to accrual status provided there is a sustained payment history of twelve months after bankruptcy and collectability is reasonably assured for all remaining contractual payments. Commercial loans modified as part of a TDR are maintained on accrual status provided there is a sustained payment history of six months or greater prior to the modification in accordance with the modified terms and all remaining contractual payments under the modified terms are reasonably assured of collection. TDRs of commercial loans and credit card loans that do not have a sustained payment history of six months or greater in accordance with the modified terms remain on nonaccrual status until a six-month payment history is sustained. Refer to the Regulatory Developments Related to the COVID-19 Pandemic section of Note 1 of the Notes to Consolidated Financial Statements for additional information on loans that were modified related to the COVID-19 pandemic but not classified as TDRs.Consumer restructured loans on accrual status totaled $796 million and $965 million at December 31, 2020 and 2019, respectively. As of December 31, 2020, the percentage of restructured residential mortgage loans, home equity loans, and credit card loans that are past due 30 days or more from their modified terms were 27%, 19% and 31%, respectively. 108 Fifth Third BancorpTable of Contents MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSThe following tables summarize portfolio TDRs by loan type and delinquency status:TABLE 56: Accruing and Nonaccruing Portfolio TDRsAccruing(d)As of December 31, 2020 ($ in millions)Current30-89 DaysPast Due90 Days or More Past DueNonaccruing(c)Total Commercial loans(a)$92 — — 319 411 Residential mortgage loans(b)462 32 102 35 631 Home equity171 7 — 34 212 Indirect secured consumer loans5 — — 7 12 Credit card15 2 — 32 49 Total$745 41 102 427 1,315 (a)Excludes restructured nonaccrual loans held for sale.(b)Information includes advances made pursuant to servicing agreements for GNMA mortgage pools whose repayments are insured by the FHA or guaranteed by the VA. As of December 31, 2020, these advances represented $276 of current loans, $28 of 30-89 days past due loans and $78 of 90 days or more past due loans.(c)Excludes approximately $3 of residential mortgage loans that were modified prior to repurchase.(d)Excludes approximately $142 of residential mortgage loans that were modified prior to repurchase.TABLE 57: Accruing and Nonaccruing Portfolio TDRsAccruingAs of December 31, 2019 ($ in millions)Current30-89 DaysPast Due90 Days orMore Past DueNonaccruingTotal Commercial loans(a)$23 — — 231 254 Residential mortgage loans(b)552 49 134 79 814 Home equity199 8 — 39 246 Indirect secured consumer loans6 — — 6 12 Credit card14 3 — 27 44 Total(c)$794 60 134 382 1,370 (a)Excludes restructured nonaccrual loans held for sale.(b)Information includes advances made pursuant to servicing agreements for GNMA mortgage pools whose repayments are insured by the FHA or guaranteed by the VA. As of December 31, 2020, these advances represented $321 of current loans, $40 of 30-89 days past due loans and $109 of 90 days or more past due loans.(c)Upon completion of Fifth Third Bank’s conversion to a national charter, the Bancorp conformed to OCC guidance with regard to non-reaffirmed loans included in Chapter 7 bankruptcy filings to be accounted for as TDRs and collateral dependent loans regardless of payment history and capacity to pay in the future. The impact of the change resulted in an increase to TDRs of approximately $105, of which $83 were transferred to nonaccrual status.Analysis of Net Loan Charge-offs Net charge-offs were 42 bps and 35 bps of average portfolio loans and leases for the years ended December 31, 2020 and 2019, respectively. Table 58 provides a summary of credit loss experience and net charge-offs as a percentage of average portfolio loans and leases outstanding by loan category. The ratio of commercial loan and lease net charge-offs to average portfolio commercial loans and leases increased to 36 bps during the year ended December 31, 2020, compared to 16 bps during the year ended December 31, 2019. The increase was primarily due to increases in net charge-offs on commercial and industrial loans and commercial mortgage loans of $95 million and $47 million, respectively.The ratio of consumer loan net charge-offs to average portfolio consumer loans decreased to 52 bps for the year ended December 31, 2020 compared to 68 bps for the year ended December 31, 2019. The decrease was primarily due to decreases in net charge-offs on indirect secured consumer loans and other consumer loans of $18 million and $15 million, respectively. The decreases for the year ended December 31, 2020 included the impact of government stimulus programs and the Bancorp’s hardship programs.109 Fifth Third BancorpTable of Contents MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSTABLE 58: Summary of Credit Loss ExperienceFor the years ended December 31 ($ in millions)20202019201820172016Losses charged-off:Commercial and industrial loans$(210)(120)(151)(136)(205)Commercial mortgage loans(46)— (5)(16)(22)Commercial construction loans— — — — — Commercial leases(26)(7)(1)(2)(5)Residential mortgage loans(9)(9)(13)(15)(19)Home equity(14)(28)(23)(32)(41)Indirect secured consumer loans(67)(81)(63)(58)(54)Credit card(147)(156)(125)(94)(89)Other consumer loans(a)(92)(109)(69)(28)(21)Total losses charged-off$(611)(510)(450)(381)(456)Recoveries of losses previously charged-off:Commercial and industrial loans$12 17 19 25 33 Commercial mortgage loans1 2 6 4 7 Commercial construction loans— — — — 1 Commercial leases3 — — — 1 Residential mortgage loans7 5 6 8 9 Home equity9 10 11 13 14 Indirect secured consumer loans35 31 23 21 19 Credit card21 22 24 10 9 Other consumer loans(a)52 54 31 2 1 Total recoveries of losses previously charged-off$140 141 120 83 94 Net losses charged-off:Commercial and industrial loans$(198)(103)(132)(111)(172)Commercial mortgage loans(45)2 1 (12)(15)Commercial construction loans— — — — 1 Commercial leases(23)(7)(1)(2)(4)Residential mortgage loans(2)(4)(7)(7)(10)Home equity(5)(18)(12)(19)(27)Indirect secured consumer loans(32)(50)(40)(37)(35)Credit card(126)(134)(101)(84)(80)Other consumer loans(40)(55)(38)(26)(20)Total net losses charged-off$(471)(369)(330)(298)(362)Net losses charged-off as a percent of average portfolio loans and leases:Commercial and industrial loans0.37 %0.20 0.31 0.27 0.40 Commercial mortgage loans0.41 (0.02)(0.01)0.17 0.23 Commercial construction loans— — — — (0.01)Commercial leases0.76 0.21 0.03 0.06 0.10 Total commercial loans and leases0.36 %0.16 0.23 0.22 0.33 Residential mortgage loans0.02 0.03 0.04 0.04 0.07 Home equity0.08 0.28 0.17 0.26 0.33 Indirect secured consumer loans0.26 0.48 0.45 0.39 0.33 Credit card5.63 5.49 4.44 3.93 3.69 Other consumer loans1.39 2.16 1.93 2.57 2.93 Total consumer loans0.52 %0.68 0.56 0.49 0.48 Total net losses charged-off as a percent of average portfolio loans and leases0.42 %0.35 0.35 0.32 0.39 (a)For the years ended December 31, 2020 and 2019, the Bancorp recorded $42 and $48, respectively, in both losses charged-off and recoveries of losses charged-off related to customer defaults on point-of-sale consumer loans for which the Bancorp obtained recoveries under third-party credit enhancements.Allowance for Credit Losses The allowance for credit losses is comprised of the ALLL and the reserve for unfunded commitments. As further described in Note 1 of the Notes to Consolidated Financial Statements, the Bancorp adopted ASU 2016-13 on January 1, 2020 which established a new approach for estimating credit losses on certain types of financial instruments. After adoption of this amended guidance, the Bancorp maintains the ALLL to absorb the amount of credit losses that are expected to be incurred over the remaining contractual terms of the related loans and leases (as adjusted for prepayments and reasonably expected TDRs). The Bancorp’s methodology for determining the ALLL includes an estimate of 110 Fifth Third BancorpTable of Contents MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSexpected credit losses on a collective basis for groups of loans and leases with similar risk characteristics and specific allowances for loans and leases which are individually evaluated. For collectively evaluated loans and leases, the Bancorp uses quantitative models to forecast expected credit losses based on the probability of a loan or lease defaulting, the expected balance at the estimated date of default and the expected loss percentage given a default. The Bancorp’s expected credit loss models consider historical credit loss experience, current market and economic conditions, and forecasted changes in market and economic conditions if such forecasts are considered reasonable and supportable.The Bancorp also considers qualitative factors in determining the ALLL. Qualitative adjustments are used to capture characteristics in the portfolio that impact expected credit losses which are not fully captured within the Bancorp’s expected credit loss models. These factors include adjustments for changes in policies or procedures in underwriting, monitoring or collections, lending and risk management personnel and results of internal audit and quality control reviews. In addition, the qualitative adjustment framework can be utilized to address specific idiosyncratic risks such as geopolitical events, natural disasters or changes in current economic conditions that are not reflected in the quantitative credit loss models, and their effects on regional borrowers and changes in product structures. Qualitative factors may also be used to address the impacts of unforeseen events on key inputs and assumptions within the Bancorp’s expected credit loss models, such as the reasonable and supportable forecast period, changes to historical loss information or changes to the reversion period or methodology.Refer to Note 1 of the Notes to Consolidated Financial Statements for discussion of the accounting policies for the ALLL and reserve for unfunded commitments for periods prior to January 1, 2020.In addition to the ALLL, the Bancorp maintains a reserve for unfunded commitments recorded in other liabilities in the Consolidated Balance Sheets. The methodology used to determine the adequacy of this reserve is similar to the Bancorp’s methodology for determining the ALLL. The provision for unfunded commitments is included in the provision for credit losses in the Consolidated Statements of Income.For the commercial portfolio segment, the estimates for probability of default are primarily based on internal ratings assigned to each commercial borrower on a 13-point scale and historical observations of how those ratings migrate to a default over time in the context of macroeconomic conditions. For loans with available credit, the estimate of the expected balance at the time of default considers expected utilization rates, which are primarily based on macroeconomic conditions and the utilization history of similar borrowers under those economic conditions. The estimates for loss severity are primarily based on collateral type and coverage levels and the susceptibility of those characteristics to changes in macroeconomic conditions.For collectively evaluated loans in the consumer and residential mortgage portfolio segments, the Bancorp’s expected credit loss models primarily utilize the borrower’s FICO score and delinquency history in combination with macroeconomic conditions when estimating the probability of default. The estimates for loss severity are primarily based on collateral type and coverage levels and the susceptibility of those characteristics to changes in macroeconomic conditions. The expected balance at the estimated date of default is also especially impactful in the expected credit loss models for portfolio classes which generally have longer terms (such as residential mortgage loans and home equity) and portfolio classes containing a high concentration of loans with revolving privileges (such as credit card and home equity). The estimate of the expected balance at the time of default considers expected prepayment and utilization rates where applicable, which are primarily based on macroeconomic conditions and the utilization history of similar borrowers under those economic conditions.Day 1 Adoption ImpactUpon adoption of ASU 2016-13 on January 1, 2020, the Bancorp used three forward-looking economic scenarios during the reasonable and supportable forecast period in its expected credit loss models to address the inherent imprecision in macroeconomic forecasting. Each of the three scenarios was developed by a third party that is subject to the Bancorp’s Third-Party Risk Management program including oversight by the Bancorp’s independent model risk management group. The scenarios included a most likely outcome (Baseline) and two less probable scenarios with one being more favorable than the Baseline and the other being less favorable. The more favorable alternative scenario (Upside) depicted a stronger near-term growth outlook while the less favorable outlook (Downside) depicted a moderate recession. The Baseline scenario was assigned a probability weighting of 80% with each of the Upside and Downside scenarios being assigned a 10% weighting.The Baseline scenario was developed such that the expectation is that the economy will perform better than the projection 50% of the time and worse than the projection 50% of the time. The Upside scenario was developed such that there is a 10% probability that the economy will perform better than the projection and a 90% probability that it will perform worse. The Downside scenario was developed such that there is a 90% probability that the economy will perform better than the projection and a 10% probability that it will perform worse.December 31, 2020 ACLThe ACL as of December 31, 2020 was impacted by several factors, including general improvement in the economic outlook. As a result, the Bancorp incorporated a combination of quantitative model-based estimates and qualitative overlays. For the quantitative estimates, the Bancorp incorporated three scenarios developed by the third party in November 2020 that included estimates of the expected impacts of the changes in economic conditions caused by the COVID-19 pandemic. The Baseline scenario was assigned a probability weighting of 60%, with a more favorable scenario (Upside) assigned a probability weighting of 20% and a less favorable scenario (Downside) assigned a probability of 20%. The Baseline scenario utilized by the Bancorp assumes additional stimulus enacted in the first quarter of 2021 including 111 Fifth Third BancorpTable of Contents MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSunemployment and individual benefits, but no aid to state and local governments. GDP growth is expected to be at a 3.1% annualized rate in 2021 and at a 4.1% annualized rate in 2022. The Baseline scenario also assumes a 7.2% unemployment rate through the fourth quarter of 2020 with an average unemployment rate of 8.2% in the first half of 2021. The Upside scenario assumes that the COVID-19 crisis resolves sooner than anticipated, with businesses returning to full operation sooner than expected and an increase in consumer spending. In this scenario, housing prices rise by 3.7% (compared to 0.4% in the Baseline) during 2021. Upside real GDP growth is expected to be 6.6% in 2021, and a full-employment rate is expected to be achieved by mid-2022, a year earlier than Baseline. The Downside scenario reflects no additional federal fiscal stimulus, which causes an increase in unemployment to above 10% by the end of 2021. This scenario shows annual average GDP growth of 0% in 2021 and 2.3% in 2022 and housing prices decreasing by 10% through 2021.The Bancorp’s quantitative credit loss models are sensitive to changes in economic forecast assumptions over the reasonable and supportable forecast period. Applying a 100% probability weighting to the Downside scenario rather than using the probability-weighted three scenario approach would result in an increase in the quantitative ACL of approximately $897 million. This sensitivity calculation only reflects the impact of changing the probability weighting of the scenarios in the quantitative credit loss models and excludes any additional considerations associated with the qualitative component of the ACL that might be warranted in the circumstance.At December 31, 2020, the qualitative component of the ACL included consideration of certain factors that represent emerging risks specifically associated with the current economic environment and the COVID-19 pandemic. These considerations resulted in qualitative adjustments to increase the ACL, primarily related to volatility in short-term unemployment rates, commercial borrowers experiencing prolonged distress, commercial borrowers in certain industries which have been severely impacted by the COVID-19 pandemic and consumer borrowers that deferred contractual payments under COVID-19 forbearance or hardship programs. TABLE 59: Changes in Allowance for Credit LossesFor the years ended December 31 ($ in millions)2020(b)2019(c)2018(c)2017(c)2016(c)ALLL:Balance, beginning of period$1,202 1,103 1,196 1,253 1,272 Impact of adoption of ASU 2016-13643 — — — — Losses charged-off(a)(611)(510)(450)(381)(456)Recoveries of losses previously charged-off(a)140 141 120 83 94 Provision for loan and lease losses1,079 468 237 261 343 Deconsolidation of a VIE— — — (20)— Balance, end of period$2,453 1,202 1,103 1,196 1,253 Reserve for unfunded commitments:Balance, beginning of period$144 131 161 161 138 Impact of adoption of ASU 2016-1310 — — — — Reserve for acquired unfunded commitments— 8 — — — Provision for (benefit from) the reserve for unfunded commitments18 5 (30)— 23 Balance, end of period$172 144 131 161 161 (a)For the years ended December 31, 2020 and 2019, the Bancorp recorded $42 and $48, respectively, in both losses charged-off and recoveries of losses charged-off related to customer defaults on point-of-sale consumer loans for which the Bancorp obtained recoveries under third-party credit enhancements.(b)The ALLL and Reserve for unfunded commitments were calculated under the expected loss methodology upon the adoption of ASU 2016-13 on January 1, 2020.(c)The ALLL and Reserve for unfunded commitments were calculated under the incurred loss methodology for periods ending prior to January 1, 2020.As shown in Table 60, the ALLL as a percent of portfolio loans and leases was 2.25% at December 31, 2020, compared to 1.10% at December 31, 2019. The ALLL was $2.5 billion and $1.2 billion at December 31, 2020 and 2019, respectively. 112 Fifth Third BancorpTable of Contents MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSTABLE 60: Attribution of Allowance for Loan and Lease Losses to Portfolio Loans and LeasesAs of December 31 ($ in millions)2020(a)2019(b)2018(b)2017(b)2016(b)Attributed ALLL:Commercial and industrial loans$901 561 515 651 718 Commercial mortgage loans402 87 80 65 82 Commercial construction loans124 45 32 23 16 Commercial leases29 17 18 14 15 Residential mortgage loans294 73 81 89 96 Home equity201 37 36 46 58 Indirect secured consumer loans131 53 42 38 42 Credit card252 168 156 117 102 Other consumer loans119 40 33 33 12 Unallocated N/A121 110 120 112 Total ALLL$2,453 1,202 1,103 1,196 1,253 Portfolio loans and leases:Commercial and industrial loans$49,665 50,542 44,340 41,170 41,676 Commercial mortgage loans10,602 10,963 6,974 6,604 6,899 Commercial construction loans5,815 5,090 4,657 4,553 3,903 Commercial leases2,915 3,363 3,600 4,068 3,974 Residential mortgage loans15,928 16,724 15,504 15,591 15,051 Home equity5,183 6,083 6,402 7,014 7,695 Indirect secured consumer loans13,653 11,538 8,976 9,112 9,983 Credit card2,007 2,532 2,470 2,299 2,237 Other consumer loans3,014 2,723 2,342 1,559 680 Total portfolio loans and leases$108,782 109,558 95,265 91,970 92,098 Attributed ALLL as a percent of respective portfolio loans and leases:Commercial and industrial loans1.81 %1.11 1.16 1.58 1.72 Commercial mortgage loans3.79 0.79 1.15 0.98 1.19 Commercial construction loans2.13 0.88 0.69 0.51 0.41 Commercial leases0.99 0.51 0.50 0.34 0.38 Residential mortgage loans1.85 0.44 0.52 0.57 0.64 Home equity3.88 0.61 0.56 0.66 0.75 Indirect secured consumer loans0.96 0.46 0.47 0.42 0.42 Credit card12.56 6.64 6.32 5.09 4.56 Other consumer loans3.95 1.47 1.41 2.12 1.76 Unallocated (as a percent of portfolio loans and leases) N/A0.11 0.12 0.13 0.12 Total ALLL as a percent of portfolio loans and leases2.25 %1.10 1.16 1.30 1.36 Total ACL as a percent of portfolio loans and leases2.41 1.23 1.30 1.48 1.54 (a)The ALLL and ACL were calculated under the expected loss methodology upon the adoption of ASU 2016-13 on January 1, 2020.(b)The ALLL and ACL were calculated under the incurred loss methodology for periods ending prior to January 1, 2020.As previously mentioned, the Bancorp adopted ASU 2016-13 on January 1, 2020. Based on portfolio characteristics and economic conditions and expectations as of January 1, 2020, the Bancorp recorded a combined increase to the ALLL and reserve for unfunded commitments on January 1, 2020 of approximately $653 million upon the adoption of ASU 2016-13. The increase in the ALLL at the date of adoption was primarily attributable to longer duration home equity and residential mortgage loans.The Bancorp’s ALLL may vary significantly from period to period after the adoption date as it will be based on changes in economic conditions, economic forecasts and the composition and credit quality of the Bancorp’s loan and lease portfolio. The adoption of ASU 2016-13 will also have an impact on the provision for credit losses in periods after adoption, which could differ materially from historical trends. For additional information on ASU 2016-13, refer to Note 1 of the Notes to Consolidated Financial Statements.113 Fifth Third BancorpTable of Contents MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSINTEREST RATE AND PRICE RISK MANAGEMENT Interest rate risk is the risk to earnings or capital arising from movement of interest rates. This risk primarily impacts the Bancorp’s income categories through changes in interest income on earning assets and the cost of interest-bearing liabilities, and through fee items that are related to interest sensitive activities such as mortgage origination and servicing income and through earnings credits earned on commercial deposits that offset commercial deposit fees. Price risk is the risk to earnings or capital arising from changes in the value of financial instruments and portfolios due to movements in interest rates, volatilities, foreign exchange rates, equity prices and commodity prices. Management considers interest rate risk a prominent market risk in terms of its potential impact on earnings. Interest rate risk may occur for any one or more of the following reasons:•Assets and liabilities mature or reprice at different times;•Short-term and long-term market interest rates change by different amounts; or•The expected maturities of various assets or liabilities shorten or lengthen as interest rates change.In addition to the direct impact of interest rate changes on NII and interest-sensitive fees, interest rates can impact earnings through their effect on loan and deposit demand, credit losses, mortgage origination volumes, the value of servicing rights and other sources of the Bancorp’s earnings. Changes in interest rates and other market factors can impact earnings through changes in the value of portfolios, if not appropriately hedged. Stability of the Bancorp’s net income is largely dependent upon the effective management of interest rate risk and to a lesser extent price risk. Management continually reviews the Bancorp’s on- and off-balance sheet composition, earnings flows, and hedging strategies and models interest rate risk and price risk exposures, and possible actions to manage these risks, given numerous possible future interest rate and market factor scenarios. A series of Policy Limits and Key Risk Indicators are employed to ensure that risks are managed within the Bancorp’s risk tolerance for interest rate risk and price risk.In addition to the traditional forms of interest rate risk discussed in this section, the Bancorp is exposed to interest rate risk associated with the retirement and replacement of LIBOR. For more information on the LIBOR transition, refer to the Overview section of MD&A. The Commercial and Wealth and Asset Management lines of business manage price risk for capital markets sales and trading activities related to their respective businesses. The Mortgage line of business manages price risk for the origination and sale of conforming residential mortgage loans to government agencies and government-sponsored enterprises. The Bancorp’s Treasury department manages interest rate risk and price risk for all other activities. Independent oversight is provided by ERM, and key risk indicators and Board-approved policy limits are used to ensure risks are managed within the Bancorp’s risk tolerance.The Bancorp’s Market Risk Management Committee, which includes senior management representatives, is accountable to the ERMC, provides oversight and monitors price risk for the capital markets sales and trading activities. The Bancorp’s ALCO, which includes senior management representatives and is accountable to the ERMC, provides oversight and monitors interest rate and price risks for Mortgage and Treasury activities. Net Interest Income Sensitivity The Bancorp employs a variety of measurement techniques to identify and manage its interest rate risk, including the use of an NII simulation model to analyze the sensitivity of NII to changes in interest rates. The model is based on contractual and estimated cash flows and repricing characteristics for all of the Bancorp’s assets, liabilities and off-balance sheet exposures and incorporates market-based assumptions regarding the effect of changing interest rates on the prepayment rates of certain assets and attrition rates of certain liabilities. The model also includes senior management’s projections of the future volume and pricing of each of the product lines offered by the Bancorp as well as other pertinent assumptions. Actual results may differ from simulated results due to timing, magnitude and frequency of interest rate changes, deviations from projected assumptions, as well as from changes in market conditions and management strategies. As of December 31, 2020, the Bancorp’s interest rate risk exposure is governed by a risk framework that utilizes the change in NII over 12-month and 24-month horizons assuming a 200 bps parallel ramped increase in interest rates. Given the unlikely probability associated with a potential negative rate environment, the Bancorp does not have a policy limit for scenarios that include negative rates. Therefore, the Bancorp has no policy limit for a scenario with a decrease in interest rates currently in effect as the Federal Funds target range is currently between zero and 25 basis points. However, the Bancorp routinely analyzes various potential and extreme scenarios, including ramps, shocks and non-parallel shifts in rates, including negative rate scenarios, to assess where risks to net interest income persist or develop as changes in the balance sheet and market rates evolve. Additionally, the Bancorp routinely evaluates its exposures to changes in the bases between interest rates. The ongoing COVID-19 pandemic has caused significant changes to interest rates, volatilities, and the composition of the Bancorp’s balance sheet, including significant increases in deposit funding related to stimulus programs, which has resulted in an excess liquidity position. The excess liquidity is likely to continue negatively impacting net interest margin if short-term interest rates hold steady or move lower, but may be partially offset by the amortization of fees related to PPP loans and investment opportunities should the yield curve continue steepening.In order to recognize the risk of noninterest-bearing demand deposit balance run-off in a rising interest rate environment, the Bancorp’s NII sensitivity modeling assumes that approximately $5 billion of additional demand deposit balances run-off over 24 months above what is included in senior management’s baseline projections for each 100 bps increase in short-term market interest rates. Similarly, the Bancorp’s NII sensitivity modeling incorporates approximately $5 billion of incremental growth in noninterest-bearing deposit balances over 24 months 114 Fifth Third BancorpTable of Contents MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSabove senior management’s baseline projections for each 100 bps decrease in short-term market interest rates. The incremental balance run-off and growth are modeled to flow into and out of funding products that reprice in conjunction with short-term market rate changes and reflect the Bank’s excess liquidity position. Another important deposit modeling assumption is the amount by which interest-bearing deposit rates will increase or decrease when market interest rates increase or decrease. This deposit repricing sensitivity is known as the beta, and it represents the expected amount by which Bancorp deposit rates will change for a given change in short-term market rates. The Bancorp’s NII sensitivity modeling assumes a weighted-average rising-rate interest-bearing deposit beta of 70% at December 31, 2020, which is approximately 10 to 30 percentage points higher than the average beta that the Bancorp experienced in the FRB tightening cycles from June 2004 to June 2006 and from December 2015 to December 2018. In the event of further rate cuts by the FRB into negative territory, the Bancorp’s NII sensitivity modeling assumes a weighted-average falling-rate interest-bearing deposit beta of 35% at December 31, 2020 while maintaining that deposit rates themselves will not become negative. In addition, the modeling assumes there is no lag between the timing of changes in market rates and the timing of deposit repricing despite such timing lags having occurred in prior rate cycles. The Bancorp continually evaluates the sensitivity of its interest rate risk measures to these important deposit modeling assumptions. The Bancorp also regularly monitors the sensitivity of other important modeling assumptions, such as loan and security prepayments and early withdrawals on fixed-rate customer liabilities. The following table shows the Bancorp’s estimated NII sensitivity profile and ALCO policy limits as of December 31:TABLE 61: Estimated NII Sensitivity Profile and ALCO Policy Limits20202019 % Change in NII (FTE)ALCO Policy Limits% Change in NII (FTE) ALCO Policy LimitsChange in Interest Rates (bps)12 Months 13-24 Months 12 Months 13-24 Months 12 Months 13-24 Months 12 Months 13-24 Months + 200 Ramp over 12 months2.93 %7.73(4.00)(6.00)(0.22)3.94(4.00)(6.00)+ 100 Ramp over 12 months1.694.95N/AN/A(0.16)2.07N/AN/A–25 Ramp over 3 months(1.93)(2.88)N/AN/AN/AN/AN/AN/A–100 Ramp over 12 monthsN/AN/AN/AN/A(2.66)(7.90)(8.00)(12.00)At December 31, 2020, the Bancorp’s NII would benefit in both year one and year two under the parallel rate ramp increases. The Bancorp maintains an asymmetric NII sensitivity profile, which is attributable to the level of floating-rate assets, including the predominantly floating-rate commercial loan portfolio, exceeding the level of floating-rate liabilities due to the increased amount of deposit rates near zero in this low interest rate environment and other fixed-rate borrowings. Reductions in the yield of the commercial loan portfolio would be expected to be only partially offset by a decline in the cost of interest-bearing deposits in a falling-rate scenario. However, proactive management of the securities and derivatives portfolios has reduced the ongoing near-term risk to declining market rates and provided significant protection from the decline in rates experienced as the COVID-19 pandemic unfolded. The changes in the estimated NII sensitivity profile compared to December 31, 2019 were primarily attributable to the impact of the current near-zero interest rate environment on the previously discussed interest rate profile and the significant increase in noninterest-bearing and low-cost interest-bearing deposits. The down rate scenarios were also impacted by the higher composition of low-cost deposits hitting their floor rates more quickly in the current-year scenarios due to the low-rate environment.Tables 62 and 63 provide the sensitivity of the Bancorp’s estimated NII profile at December 31, 2020 to changes to certain deposit balance and deposit repricing sensitivity (betas) assumptions.The following table includes the Bancorp’s estimated NII sensitivity profile with an immediate $1 billion decrease and an immediate $1 billion increase in demand deposit balances as of December 31, 2020: TABLE 62: Estimated NII Sensitivity Profile at December 31, 2020 with a $1 Billion Change in Demand Deposit Assumption% Change in NII (FTE)Immediate $1 Billion Balance DecreaseImmediate $1 Billion Balance IncreaseChange in Interest Rates (bps)12 Months 13-24 Months 12 Months 13-24 Months + 200 Ramp over 12 months2.71 %7.28 3.15 8.19 + 100 Ramp over 12 months1.58 4.72 1.80 5.18 –25 Ramp over 3 months(1.98)(2.94)(1.88)(2.82)115 Fifth Third BancorpTable of Contents MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSThe following table includes the Bancorp’s estimated NII sensitivity profile with a 25% increase and a 25% decrease to the corresponding deposit beta assumptions as of December 31, 2020:TABLE 63: Estimated NII Sensitivity Profile at December 31, 2020 with Deposit Beta Assumptions Changes% Change in NII (FTE)Betas 25% Higher(a)Betas 25% Lower(b)Change in Interest Rates (bps)12 Months13-24 Months 12 Months 13-24 Months + 200 Ramp over 12 months(0.95)%0.65 6.81 14.81 + 100 Ramp over 12 months(0.25)1.44 3.62 8.46 –25 Ramp over 3 months(1.80)(2.77)(2.08)(3.01)(a)Includes weighted-average rising-rate and falling-rate interest-bearing deposit betas of 87% and 44%, respectively.(b)Includes weighted-average rising-rate and falling-rate interest-bearing deposit betas of 52% and 27%, respectively..Economic Value of Equity Sensitivity The Bancorp also uses EVE as a measurement tool in managing interest rate risk. Whereas the NII sensitivity analysis highlights the impact on forecasted NII on an FTE basis (non-GAAP) over one and two-year time horizons, EVE is a point-in-time analysis of the economic sensitivity of current positions that incorporates all cash flows over their estimated remaining lives. The EVE of the balance sheet is defined as the discounted present value of all asset and net derivative cash flows less the discounted value of all liability cash flows. Due to this longer horizon, the sensitivity of EVE to changes in the level of interest rates is a measure of longer-term interest rate risk. EVE values only the current balance sheet and does not incorporate the balance growth assumptions used in the NII sensitivity analysis. As with the NII simulation model, assumptions about the timing and variability of existing balance sheet cash flows are critical in the EVE analysis. Particularly important are assumptions driving loan and security prepayments and the expected balance attrition and pricing of indeterminate-lived deposits. The following table shows the Bancorp’s estimated EVE sensitivity profile as of December 31:TABLE 64: Estimated EVE Sensitivity Profile20202019Change in Interest Rates (bps)% Change in EVEALCO Policy Limit% Change in EVEALCO Policy Limit+ 200 Shock(0.05)%(12.00)(5.12)(12.00)+ 100 Shock0.64 N/A(2.01)N/A–25 Shock(0.92)N/AN/AN/A–150 Shock N/A N/A(6.07)(12.00)The EVE sensitivity is neutral in a +200 bps rising-rate scenario at December 31, 2020. The changes in the estimated EVE sensitivity profile from December 31, 2019 were primarily related to the low-rate environment, growth in noninterest-bearing and low-cost interest-bearing deposits and the shorter expected lives of prepayable, fixed-rate assets due to the decrease in market interest rates. These items were partially offset by continued repositioning of the investment portfolio into securities with less principal cash flows in the near term.While an instantaneous shift in interest rates is used in this analysis to provide an estimate of exposure, the Bancorp believes that a gradual shift in interest rates would have a much more modest impact. Since EVE measures the discounted present value of cash flows over the estimated lives of instruments, the change in EVE does not directly correlate to the degree that earnings would be impacted over a shorter time horizon (e.g., the current fiscal year). Further, EVE does not take into account factors such as future balance sheet growth, changes in product mix, changes in yield curve relationships and changing product spreads that could mitigate or exacerbate the impact of changes in interest rates. The NII simulations and EVE analyses do not necessarily include certain actions that management may undertake to manage risk in response to actual changes in interest rates. The Bancorp regularly evaluates its exposures to a static balance sheet forecast, LIBOR, Prime Rate and other basis risks, yield curve twist risks and embedded options risks. In addition, the impacts on NII on an FTE basis and EVE of extreme changes in interest rates are modeled, wherein the Bancorp employs the use of yield curve shocks and environment-specific scenarios.Use of Derivatives to Manage Interest Rate Risk An integral component of the Bancorp’s interest rate risk management strategy is its use of derivative instruments to minimize significant fluctuations in earnings caused by changes in market interest rates. Examples of derivative instruments that the Bancorp may use as part of its interest rate risk management strategy include interest rate swaps, interest rate floors, interest rate caps, forward contracts, forward starting interest rate swaps, options, swaptions and TBA securities.Tables 65 and 66 show all swap and floor positions that are utilized for purposes of managing the Bancorp’s exposures to the variability of interest rates. These positions are used to convert the contractual interest rate index of agreed-upon amounts of assets and liabilities (i.e., 116 Fifth Third BancorpTable of Contents MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSnotional amounts) to another interest rate index or to hedge forecasted transactions for the variability in cash flows attributable to the contractually specified interest rate. The volume, maturity and mix of portfolio swaps change frequently as the Bancorp adjusts its broader interest rate risk management objectives and the balance sheet positions to be hedged. For further information, including the notional amount and fair values of these derivatives, refer to Note 15 of the Notes to Consolidated Financial Statements. The following tables present additional information about the interest rate swaps and floors used in Fifth Third’s asset and liability management activities: TABLE 65: Weighted-Average Maturity, Receive Rate and Pay Rate on Qualifying Hedging InstrumentsAs of December 31, 2020 ($ in millions)Notional Amount Fair ValueRemaining (years) Receive/ Strike Rate IndexInterest rate swaps – cash flow – receive-fixed$8,000 14 3.03.02 %1 MLInterest rate swaps – fair value – receive-fixed1,955 528 8.15.35 1 ML / 3 MLTotal interest rate swaps$9,955 542 Interest rate floors – cash flow – receive-fixed$3,000 244 4.02.25 1 MLTABLE 66: Weighted-Average Maturity, Receive Rate and Pay Rate on Qualifying Hedging InstrumentsAs of December 31, 2019 ($ in millions)Notional Amount Fair ValueRemaining (years) Receive/Strike Rate IndexInterest rate swaps – cash flow – receive-fixed$7,000 (2)3.93.00 %1 MLInterest rate swaps – cash flow – receive-fixed – forward starting(a)1,000 — 5.03.20 1 MLInterest rate swaps – fair value – receive-fixed2,705 393 6.84.41 1 ML / 3 MLTotal interest rate swaps$10,705 391 Interest rate floors – cash flow – receive-fixed$3,000 115 5.02.25 1 ML(a)Forward starting swaps became effective January 2, 2020.Additionally, as part of its overall risk management strategy relative to its residential mortgage banking activities, the Bancorp enters into forward contracts accounted for as free-standing derivatives to economically hedge IRLCs that are also considered free-standing derivatives. The Bancorp economically hedges its exposure to residential mortgage loans held for sale through the use of forward contracts and mortgage options as well. See the Residential Mortgage Servicing Rights and Price Risk section for the discussion of the use of derivatives to economically hedge this exposure. The Bancorp also enters into derivative contracts with major financial institutions to economically hedge market risks assumed in interest rate derivative contracts with commercial customers. Generally, these contracts have similar terms in order to protect the Bancorp from market volatility. Credit risk arises from the possible inability of the counterparties to meet the terms of their contracts, which the Bancorp minimizes through collateral arrangements, approvals, limits and monitoring procedures. The Bancorp has risk limits and internal controls in place to help ensure excessive risk is not being taken in providing this service to customers. These controls include an independent determination of interest rate volatility and credit equivalent exposure on these contracts and counterparty credit approvals performed by independent risk management. For further information, including the notional amount and fair values of these derivatives, refer to Note 15 of the Notes to Consolidated Financial Statements.Portfolio Loans and Leases and Interest Rate Risk Although the Bancorp’s portfolio loans and leases contain both fixed and floating/adjustable-rate products, the rates of interest earned by the Bancorp on the outstanding balances are generally established for a period of time. The interest rate sensitivity of loans and leases is directly related to the length of time the rate earned is established. 117 Fifth Third BancorpTable of Contents MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSThe following table summarizes the carrying value of the Bancorp’s portfolio loans and leases expected cash flows, excluding interest receivable, as of December 31, 2020:TABLE 67: Portfolio Loans and Leases Expected Cash Flows(a)($ in millions)Less than 1 Year1-5 Years Over 5 YearsTotal Commercial and industrial loans$23,547 25,118 999 49,665 Commercial mortgage loans3,973 5,722 907 10,602 Commercial construction loans2,966 2,737 112 5,815 Commercial leases829 1,547 539 2,915 Total commercial loans and leases31,315 35,124 2,557 68,997 Residential mortgage loans(b)4,009 6,803 5,116 15,928 Home equity1,421 2,805 957 5,183 Indirect secured consumer loans4,639 8,160 854 13,653 Credit card401 1,606 — 2,007 Other consumer loans1,727 1,123 164 3,014 Total consumer loans12,197 20,497 7,091 39,785 Total portfolio loans and leases$43,512 55,621 9,648 108,782 (a)Expected cash flows from portfolio loans and leases do not reflect changes in timing due to hardship programs offered in response to the COVID-19 pandemic which are not expected to be significant.(b)Includes residential mortgage loans previously sold to GNMA for which the Bancorp is deemed to have regained effective control over under ASC Topic 860, but did not exercise its option to repurchase.The following table displays a summary of expected cash flows, excluding interest receivable, occurring after one year for both fixed and floating/adjustable-rate loans and leases as of December 31, 2020: TABLE 68: Portfolio Loans and Leases Expected Cash Flows Occurring After One Year(a)Interest Rate($ in millions)Fixed Floating or AdjustableCommercial and industrial loans$3,164 22,953 Commercial mortgage loans1,461 5,168 Commercial construction loans46 2,803 Commercial leases2,086 — Total commercial loans and leases6,757 30,924 Residential mortgage loans(b)9,510 2,409 Home equity370 3,392 Indirect secured consumer loans9,000 14 Credit card244 1,362 Other consumer loans1,018 269 Total consumer loans20,142 7,446 Total portfolio loans and leases$26,899 38,370 (a)Expected cash flows from portfolio loans and leases do not reflect changes in timing due to hardship programs offered in response to the COVID-19 pandemic which are not expected to be significant.(b)Includes residential mortgage loans previously sold to GNMA for which the Bancorp is deemed to have regained effective control over under ASC Topic 860, but did not exercise its option to repurchase.Residential Mortgage Servicing Rights and Price Risk The fair value of the residential MSR portfolio was $656 million and $993 million at December 31, 2020 and December 31, 2019, respectively. The value of servicing rights can fluctuate sharply depending on changes in interest rates and other factors. Generally, as interest rates decline and loans are prepaid to take advantage of refinancing, the total value of existing servicing rights declines because no further servicing fees are collected on repaid loans. The Bancorp maintains a non-qualifying hedging strategy relative to its mortgage banking activity in order to manage a portion of the risk associated with changes in the value of its MSR portfolio as a result of changing interest rates. Mortgage rates decreased during the years ended December 31, 2020 and 2019 which caused modeled prepayment speeds to rise. The fair value of the MSR portfolio decreased $311 million and $203 million, respectively, due to changes to inputs to the valuation model, including prepayment speeds and OAS assumptions, and decreased $254 million and $173 million, respectively, due to the impact of contractual principal payments and actual prepayment activity for the years ended December 31, 2020 and 2019. The Bancorp recognized net gains of $309 million and $224 million, respectively, on its non-qualifying hedging strategy during the years ended December 31, 2020 and 2019. These amounts included net gains of $2 million and $3 million during the years ended December 31, 2020 and 2019, respectively, on securities related to the Bancorp’s non-qualifying hedging strategy. The Bancorp may adjust its hedging strategy to reflect its assessment of the composition of its MSR portfolio, the cost of hedging and the anticipated effectiveness of the hedges 118 Fifth Third BancorpTable of Contents MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSgiven the economic environment. Refer to Note 14 of the Notes to Consolidated Financial Statements for further discussion on servicing rights and the instruments used to hedge price risk on MSRs.Foreign Currency Risk The Bancorp may enter into foreign exchange derivative contracts to economically hedge certain foreign denominated loans. The derivatives are classified as free-standing instruments with the revaluation gain or loss being recorded in other noninterest income in the Consolidated Statements of Income. The balance of the Bancorp’s foreign denominated loans at December 31, 2020 and 2019 was $655 million and $880 million, respectively. The Bancorp also enters into foreign exchange contracts for the benefit of commercial customers to hedge their exposure to foreign currency fluctuations. Similar to the hedging of price risk from interest rate derivative contracts entered into with commercial customers, the Bancorp also enters into foreign exchange contracts with major financial institutions to economically hedge a substantial portion of the exposure from client driven foreign exchange activity. The Bancorp has risk limits and internal controls in place to help ensure excessive risk is not being taken in providing this service to customers. These controls include an independent determination of currency volatility and credit equivalent exposure on these contracts, counterparty credit approvals and country limits performed by independent risk management. Commodity Risk The Bancorp also enters into commodity contracts for the benefit of commercial customers to hedge their exposure to commodity price fluctuations. Similar to the hedging of foreign exchange and price risk from interest rate derivative contracts, the Bancorp also enters into commodity contracts with major financial institutions to economically hedge a substantial portion of the exposure from client driven commodity activity. The Bancorp may also offset this risk with exchange-traded commodity contracts. The Bancorp has risk limits and internal controls in place to help ensure excessive risk is not taken in providing this service to customers. These controls include an independent determination of commodity volatility and credit equivalent exposure on these contracts and counterparty credit approvals performed by independent risk management.119 Fifth Third BancorpTable of Contents MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSLIQUIDITY RISK MANAGEMENT The goal of liquidity management is to provide adequate funds to meet changes in loan and lease demand, unexpected levels of deposit withdrawals and other contractual obligations. Mitigating liquidity risk is accomplished by maintaining liquid assets in the form of cash and investment securities, maintaining sufficient unused borrowing capacity in the debt markets and delivering consistent growth in core deposits. A summary of certain obligations and commitments to make future payments under contracts is included in Note 19 of the Notes to Consolidated Financial Statements. The Bancorp’s Treasury department manages funding and liquidity based on point-in-time metrics as well as forward-looking projections, which incorporate different sources and uses of funds under base and stress scenarios. Liquidity risk is monitored and managed by the Treasury department with independent oversight provided by ERM, and a series of Policy Limits and Key Risk Indicators are established to ensure risks are managed within the Bancorp’s risk tolerance. The Bancorp maintains a contingency funding plan that provides for liquidity stress testing, which assesses the liquidity needs under varying market conditions, time horizons, asset growth rates and other events. The contingency plan provides for ongoing monitoring of unused borrowing capacity and available sources of contingent liquidity to prepare for unexpected liquidity needs and to cover unanticipated events that could affect liquidity. The contingency plan also outlines the Bancorp’s response to various levels of liquidity stress and actions that should be taken during various scenarios. Liquidity risk is monitored and managed for both Fifth Third Bancorp and its subsidiaries. The Bancorp receives substantially all of its liquidity from dividends from its subsidiaries, primarily Fifth Third Bank, National Association. Subsidiary dividends are supplemented with term debt to enable the Bancorp to maintain sufficient liquidity to meet its cash obligations, including debt service and scheduled maturities, common and preferred dividends, unfunded commitments to subsidiaries and other planned capital actions in the form of share repurchases. Liquidity resources are more limited at the Bancorp, making its liquidity position more susceptible to market disruptions. Bancorp liquidity is assessed using a cash coverage horizon, ensuring the entity maintains sufficient liquidity to withstand a period of sustained market disruption while meeting its anticipated obligations over an extended stressed horizon. The Bancorp’s ALCO, which includes senior management representatives and is accountable to the ERMC, monitors and manages liquidity and funding risk within Board-approved policy limits. In addition to the risk management activities of ALCO, the Bancorp has a liquidity risk management function as part of ERM that provides independent oversight of liquidity risk management.Sources of Funds The Bancorp’s primary sources of funds relate to cash flows from loan and lease repayments, payments from securities related to sales and maturities, the sale or securitization of loans and leases and funds generated by core deposits, in addition to the use of public and private debt offerings.Table 67 of the Interest Rate and Price Risk Management subsection of the Risk Management section of MD&A illustrates the expected maturities from loan and lease repayments. Of the $37.5 billion of securities in the Bancorp’s available-for-sale debt and other securities portfolio at December 31, 2020, $4.6 billion in principal and interest is expected to be received in the next 12 months and an additional $5.0 billion is expected to be received in the next 13 to 24 months. For further information on the Bancorp’s securities portfolio, refer to the Investment Securities subsection of the Balance Sheet Analysis section of MD&A. Asset-driven liquidity is provided by the Bancorp’s ability to sell or securitize loans and leases. In order to reduce the exposure to interest rate fluctuations and to manage liquidity, the Bancorp has developed securitization and sale procedures for several types of interest-sensitive assets. A majority of the long-term, fixed-rate single-family residential mortgage loans underwritten according to FHLMC or FNMA guidelines are sold for cash upon origination. Additional assets such as certain other residential mortgage loans, certain commercial loans, home equity loans, automobile loans and other consumer loans are also capable of being securitized or sold. The Bancorp sold or securitized loans and leases totaling $12.3 billion during the year ended December 31, 2020 compared to $9.7 billion during the year ended December 31, 2019. For further information, refer to Note 13 and Note 14 of the Notes to Consolidated Financial Statements.Core deposits have historically provided the Bancorp with a sizeable source of relatively stable and low-cost funds. The Bancorp’s average core deposits and average shareholders’ equity funded 86% and 83% of its average total assets for the years ended December 31, 2020 and 2019, respectively. In addition to core deposit funding, the Bancorp also accesses a variety of other short-term and long-term funding sources, which include the use of the FHLB system. Certificates $100,000 and over and certain deposits in the Bancorp’s foreign branch located in the Cayman Islands are wholesale funding tools utilized to fund asset growth. Management does not rely on any one source of liquidity and manages availability in response to changing balance sheet needs. As of December 31, 2020, $4.7 billion of debt or other securities were available for issuance under the current Bancorp’s Board of Directors’ authorizations and the Bancorp is authorized to file any necessary registration statements with the SEC to permit ready access to the public securities markets; however, access to these markets may depend on market conditions. During the year ended December 31, 2020, the Bancorp issued and sold $1.25 billion in aggregate principal amount of senior fixed-rate notes and issued in a registered public offering 350,000 depositary shares, representing 14,000 shares of 4.50% fixed-rate reset non-cumulative perpetual preferred stock, Series L, for net proceeds of approximately $346 million.120 Fifth Third BancorpTable of Contents MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSAs of December 31, 2020, the Bank’s global bank note program had a borrowing capacity of $25.0 billion, of which $19.1 billion was available for issuance. During the year ended December 31, 2020, the Bank issued and sold $1.25 billion in aggregate principal amount of senior fixed-rate notes. Additionally, at December 31, 2020, the Bank had approximately $44.0 billion of borrowing capacity available through secured borrowing sources including the FRB and FHLB. Current Liquidity PositionThe COVID-19 pandemic has significantly impacted the economic environment, although financial markets, initially supported by Federal Reserve programs, have been stable and well-functioning following the onset of the crisis and the early monetary and fiscal response. During 2020, the Bancorp’s core deposit funding increased, while revolving line of credit utilization and portfolio loans and leases decreased. As a result, the Bancorp maintains a strong liquidity profile driven by strong core deposit funding and over $100 billion in current available liquidity. The Bancorp is managing liquidity prudently in the current environment and maintains a liquidity profile focused on core deposit and stable long-term funding sources which allows for the effective management of concentration and rollover risk.As of December 31, 2020, the Bancorp has sufficient liquidity to meet contractual obligations and all preferred and common dividends without accessing the capital markets or receiving upstream dividends from the Bank subsidiary for 32 months.Credit Ratings The cost and availability of financing to the Bancorp and Bank are impacted by its credit ratings. A downgrade to the Bancorp’s or Bank’s credit ratings could affect its ability to access the credit markets and increase its borrowing costs, thereby adversely impacting the Bancorp’s or Bank’s financial condition and liquidity. Key factors in maintaining high credit ratings include a stable and diverse earnings stream, strong credit quality, strong capital ratios and diverse funding sources, in addition to disciplined liquidity monitoring procedures. The Bancorp’s and Bank’s credit ratings are summarized in Table 69. The ratings reflect the ratings agency’s view on the Bancorp’s and Bank’s capacity to meet financial commitments.* *As an investor, you should be aware that a security rating is not a recommendation to buy, sell or hold securities, that it may be subject to revision or withdrawal at any time by the assigning rating organization and that each rating should be evaluated independently of any other rating. Additional information on the credit rating ranking within the overall classification system is located on the website of each credit rating agency. TABLE 69: Agency RatingsAs of February 26, 2021 Moody’s Standard and Poor’s Fitch DBRSFifth Third Bancorp: Short-term borrowings No rating A-2 F1 R-1LSenior debt Baa1 BBB+ A- ASubordinated debt Baa1 BBB BBB+ ALFifth Third Bank, National Association: Short-term borrowings P-2 A-2 F1 R-1MShort-term deposit P-1 No rating F1 No ratingLong-term deposit Aa3 No rating A AHSenior debt A3 A- A- AHSubordinated debt Baa1 BBB+ BBB+ ARating Agency Outlook for Fifth Third Bancorp and Fifth Third Bank, National Association: Stable Stable NegativeNegative121 Fifth Third BancorpTable of Contents MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSOPERATIONAL RISK MANAGEMENT Operational risk is the risk to current or projected financial condition and resilience arising from inadequate or failed internal processes or systems, human errors or misconduct or adverse external events that are neither market- nor credit-related. Operational risk is inherent in the Bancorp’s activities and can manifest itself in various ways, including fraudulent acts, business interruptions, inappropriate behavior of employees, unintentional failure to comply with applicable laws and regulations, poor design or delivery of products and services, cyber-security or physical security incidents and privacy breaches or failure of third parties to perform in accordance with their arrangements. These events could result in financial losses, litigation and regulatory fines, as well as other damage to the Bancorp. The Bancorp’s risk management goal is to keep operational risk at appropriate levels consistent with the Bancorp’s risk appetite, financial strength, the characteristics of its businesses, the markets in which it operates and the competitive and regulatory environment to which it is subject.To control, monitor and govern operational risk, the Bancorp maintains an overall Risk Management Framework which comprises governance oversight, risk assessment, capital measurement, monitoring and reporting as well as a formal three lines of defense approach. ERM is responsible for prescribing the framework to the lines of business and corporate functions and providing independent oversight of its implementation (second line of defense). Business Controls groups are in place in each of the lines of business to ensure consistent implementation and execution of managing day-to-day operational risk (first line of defense).The Bancorp’s risk management framework consists of five integrated components, including identifying, assessing, managing, monitoring and independent governance reporting of risk. The corporate Operational Risk Management function within Enterprise Risk is responsible for developing and overseeing the implementation of the Bancorp’s approach to managing operational risk. This includes providing governance, awareness and training, tools, guidance and oversight to support implementation of key risk programs and systems as they relate to operational risk management, such as risk and control self-assessments, new product/initiative risk reviews, key risk indicators, Third-Party Risk Management, cyber-security risk management and review of operational losses. The function is also responsible for developing reports that support the proactive management of operational risk across the enterprise. The lines of business and corporate functions are responsible for managing the operational risks associated with their areas in accordance with the risk management framework. The framework is intended to enable the Bancorp to function with a sound and well-controlled operational environment. These processes support the Bancorp’s goals to minimize future operational losses and strengthen the Bancorp’s performance by maintaining sufficient capital to absorb operational losses that are incurred.The Bancorp also maintains a robust information security program to support the management of cyber-security risk within the organization with a focus on prevention, detection and recovery processes. Fifth Third utilizes a wide array of techniques to secure its operations and proprietary information such as Board-approved policies and programs, network monitoring and testing, access controls and dedicated security personnel. Fifth Third has adopted the National Institute of Standards and Technology Cybersecurity Framework for the management and deployment of cyber-security controls and is an active participant in the financial sector information sharing organization structure, known as the Financial Services Information Sharing and Analysis Center. To ensure resiliency of key Bancorp functions, Fifth Third also employs redundancy protocols that include a robust business continuity function that works to mitigate any potential impacts to Fifth Third customers and its systems.Fifth Third also focuses on the reporting and escalation of operational control issues to senior management and the Board of Directors. The Operational Risk Committee is the key committee that oversees and supports Fifth Third in the management of operational risk across the enterprise. The Operational Risk Committee reports to the ERMC, which reports to the Risk and Compliance Joint Committee of the Board of Directors of Fifth Third Bancorp and Fifth Third Bank, National Association.The COVID-19 pandemic has created heightened operational risks and impacts to the Bancorp, including risks related to new systems and processes to support remote work strategies, new customer hardship programs and functions that cannot be fully executed by outsourced service providers. Additionally, increased external threats have increased fraud and cyber-security risks. These risks continue to be carefully managed and monitored to ensure effective controls are in place, with appropriate oversight and governance by the second line of defense. Fifth Third has a defined pandemic plan and robust business continuity management process, which have been leveraged to support the continuity of processes across the Bank. Fifth Third’s operational risk management team has been actively engaged to oversee and evaluate business changes required to ensure continuity of critical business services with the focus on impacts to customers and Bancorp employees.122 Fifth Third BancorpTable of Contents MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSLEGAL AND REGULATORY COMPLIANCE RISK MANAGEMENT Legal and regulatory compliance risk is the risk of legal or regulatory sanctions, financial loss or damage to reputation as a result of noncompliance with (i) applicable laws, regulations, rules and other regulatory requirements (including but not limited to the risk of consumers experiencing economic loss or other legal harm as a result of noncompliance with consumer protection laws, regulations and requirements); (ii) internal policies and procedures, standards of best practice or codes of conduct; and (iii) principles of integrity and fair dealing applicable to Fifth Third’s activities and functions. Legal risks include the risk of actions against the institution that result in unenforceable contracts, lawsuits, legal sanctions, or adverse judgments, which disrupt or otherwise negatively affect the operations or condition of the institution. Failure to effectively manage such risks can elevate the risk level or manifest itself as other types of key risks, including reputational or operational risk. Fifth Third focuses on managing legal and regulatory compliance risk in accordance with the Bancorp’s integrated risk management framework, which ensures consistent processes for identifying, assessing, managing, monitoring and reporting risks. The Bancorp’s risk management goal is to keep compliance risk at appropriate levels, consistent with the Bancorp’s risk appetite.To mitigate such risks, Compliance Risk Management provides independent oversight to foster consistency and sufficiency in the execution of the program, and ensures that lines of business and support functions are adequately identifying, assessing and monitoring legal and regulatory compliance risks and adopting proper mitigation strategies. Moreover, such strategies are modified from time to time to respond to new or emerging risks in the environment. Compliance Risk Management and the Legal Division provide guidance to the lines of business and enterprise functions, which are ultimately responsible for managing such risks associated with their areas. The Chief Compliance Officer is responsible for formulating and directing the strategy, development, implementation, communication and maintenance of the Compliance Risk Management program, which implements key compliance processes, including but not limited to, executive- and board-level governance and reporting routines, compliance-related policies, risk assessments, key risk indicators, issues tracking, regulatory change management, and regulatory compliance testing and monitoring. Compliance Risk Management and the Legal Division partner with the Financial Crimes Division to oversee anti-money laundering processes, and Compliance Risk Management also partners with the Community and Economic Development team to oversee the Bancorp’s compliance with the Community Reinvestment Act.Fifth Third also reports and escalates legal and regulatory compliance issues to senior management and the Board of Directors. The Management Compliance Committee, which is chaired by the Chief Compliance Officer, is the key committee that oversees and supports Fifth Third in the management of compliance risk across the enterprise. The Management Compliance Committee oversees Bancorp-wide compliance issues, industry best practices, legislative developments, regulatory concerns and other leading indicators of legal and regulatory compliance risk. The Management Compliance Committee reports to the ERMC, which reports to the Risk and Compliance Joint Committee of the Board of Directors of Fifth Third Bancorp and Fifth Third Bank, National Association.123 Fifth Third BancorpTable of Contents MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSCAPITAL MANAGEMENT Management regularly reviews the Bancorp’s capital levels to help ensure it is appropriately positioned under various operating environments. The Bancorp has established a Capital Committee which is responsible for making capital plan recommendations to management. These recommendations are reviewed by the ERMC and the annual capital plan is approved by the Board of Directors. The Capital Committee is responsible for execution and oversight of the capital actions of the capital plan. Regulatory Capital Ratios The Basel III Final Rule sets minimum regulatory capital ratios as well as defines the measure of “well-capitalized” for insured depository institutions. TABLE 70: Prescribed Capital RatiosMinimumWell-CapitalizedCET1 capital:Fifth Third Bancorp4.50 %N/AFifth Third Bank, National Association4.50 6.50 Tier I risk-based capital:Fifth Third Bancorp6.00 6.00 Fifth Third Bank, National Association6.00 8.00 Total risk-based capital:Fifth Third Bancorp8.00 10.00 Fifth Third Bank, National Association8.00 10.00 Tier I leverage:Fifth Third Bancorp4.00 N/AFifth Third Bank, National Association4.00 5.00 The Bancorp was subject to a capital conservation buffer of 2.5%, in addition to the minimum capital ratios, in order to avoid limitations on certain capital distributions and discretionary bonus payments to executive officers through September 30, 2020. On October 1, 2020, the Bancorp became subject to the stress capital buffer requirement which replaced the capital conservation buffer. During each supervisory stress testing cycle, the FRB uses the Bancorp’s supervisory stress test to determine its stress capital buffer, subject to a floor of 2.5%. On August 7, 2020, the FRB provided the Bancorp a final stress capital buffer requirement of 2.5% which is effective for the period of October 1, 2020 to September 30, 2021. After evaluating the Bancorp’s capital plan which was re-submitted on November 5, 2020, the FRB may update the Bancorp’s stress capital buffer until March 31, 2021. The Bancorp exceeded these “capital conservation buffer” and “stress capital buffer” ratios for all periods presented.In April 2018, the federal banking regulators proposed transitional arrangements to permit banking organizations to phase in the day-one impact of the adoption of ASU 2016-13, referred to as CECL, on regulatory capital over a period of three years. The proposed rule was adopted as final effective July 1, 2019. The phase-in provisions of the final rule are optional for a banking organization that experiences a reduction in retained earnings due to CECL adoption as of the beginning of the fiscal year in which the banking organization adopts CECL. A banking organization that elects the phase-in provisions of the final rule for regulatory capital purposes must phase in 25% of the transitional amounts impacting regulatory capital in the first year of adoption of CECL, 50% in the second year, 75% in the third year, with full impact beginning in the fourth year.In March 2020, the banking agencies issued an interim final rule for additional transitional relief to regulatory capital related to the impact of the adoption of CECL given the disruption in economic activity caused by the COVID-19 pandemic. The interim final rule provides banking organizations that adopt CECL in the 2020 calendar year with the option to delay for two years the estimated impact of CECL on regulatory capital, followed by the aforementioned three-year transition period to phase out the aggregate amount of benefit during the initial two-year delay for a total five-year transition. The estimated impact of CECL on regulatory capital (modified CECL transitional amount) is calculated as the sum of the day-one impact on retained earnings upon adoption of CECL (CECL transitional amount) and the calculated change in the ACL relative to the day-one ACL upon adoption of CECL multiplied by a scaling factor of 25%. The scaling factor is used to approximate the difference in the ACL under CECL relative to the incurred loss methodology. The modified CECL transitional amount will be calculated each quarter for the first two years of the five-year transition. The amount of the modified CECL transition amount will be fixed as of December 31, 2021 and that amount will be subject to the three-year phase out.The Bancorp adopted ASU 2016-13 on January 1, 2020 and elected the five-year transition phase-in option for the impact of CECL on regulatory capital with its regulatory filings as of March 31, 2020. The impact of the modified CECL transition amount on the Bancorp’s regulatory capital at December 31, 2020 was an increase in capital of approximately $630 million. On a fully phased-in basis, the Bancorp’s CET1 ratio would be reduced by 39 basis points as of December 31, 2020. For additional information on ASU 2016-13, refer to Note 1 of the Notes to Consolidated Financial Statements.On July 22, 2019, the federal banking regulators published the Regulatory Capital Simplification final rule in the Federal Register. Under the final rule, non-advanced approach banks, such as the Bancorp, will be subject to simpler regulatory capital requirements for mortgage 124 Fifth Third BancorpTable of Contents MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSservicing assets, certain deferred tax assets arising from temporary differences and investments in the capital of unconsolidated financial institutions than those currently applied. The final rule increases the deduction threshold for mortgage servicing assets, certain deferred tax assets arising from temporary differences and investments in the capital of unconsolidated financial institutions from 10% to 25% of CET1, but increases the risk-weighted assets percentage for the non-deducted elements from 100% to 250%. The final rule pertaining to these regulatory capital elements was effective on April 1, 2020.The following table summarizes the Bancorp’s capital ratios as of December 31:TABLE 71: Capital Ratios($ in millions)20202019201820172016Average total Bancorp shareholders’ equity as a percent of average assets11.61 %12.14 11.23 11.69 11.57 Tangible equity as a percent of tangible assets(a)(c)(d)8.18 9.52 9.63 9.79 9.72 Tangible common equity as a percent of tangible assets(a)(c)(d)7.11 8.44 8.71 8.83 8.77 Regulatory capital:CET1 capital(b)$14,682 13,847 12,534 12,517 12,426 Tier I capital(b)16,797 15,616 13,864 13,848 13,756 Total regulatory capital(b)21,412 19,661 17,723 17,887 17,972 Risk-weighted assets141,974 142,065 122,432 117,997 119,632 Regulatory capital ratios:(b)CET1 capital10.34 %9.75 10.24 10.61 10.39 Tier I risk-based capital11.83 10.99 11.32 11.74 11.50 Total risk-based capital15.08 13.84 14.48 15.16 15.02 Tier I leverage(d)8.49 9.54 9.72 10.01 9.90 (a)These are non-GAAP measures. For further information, refer to the Non-GAAP Financial Measures section of MD&A.(b)Regulatory capital ratios as of December 31, 2020 are calculated pursuant to the five-year transition provision option to phase in the effects of CECL on regulatory capital.(c)Excludes AOCI.(d)The decrease in these capital ratios is primarily attributable to the Bancorp’s growth of assets during the year ended December 31, 2020.Capital Planning In 2011, the FRB adopted the capital plan rule, which requires BHCs with consolidated assets of $50 billion or more to submit annual capital plans to the FRB for review. Under the rule, these capital plans must include detailed descriptions of the following: the BHC’s internal processes for assessing capital adequacy; the policies governing capital actions such as common stock issuances, dividends and share repurchases; and all planned capital actions over a nine-quarter planning horizon. Furthermore, each BHC must report to the FRB the results of stress tests conducted by the BHC under a number of scenarios that assess the sources and uses of capital under baseline and stressed economic conditions.On October 10, 2019, the Federal Reserve Board adopted final rules to tailor certain prudential standards for large domestic and foreign banking organizations. As a result of the EPS Tailoring Rule, the Bancorp is subject to category IV standards, under which the Bancorp is no longer required to file semi-annual, company-run stress tests with the FRB and publicly disclose the results. As an institution subject to category IV standards, the Bancorp is subject to the FRB’s supervisory stress tests every two years, the Board capital plan rule and FR Y-14 reporting requirements. The supervisory stress tests are forward-looking quantitative evaluations of the impact of stressful economic and financial market conditions on the Bancorp's capital. The Bancorp became subject to category IV standards on December 31, 2019, and the requirements outlined above apply to the stress test cycle that started on January 1, 2020. As noted above, the Bancorp remains subject to the Board’s capital plan rule, and its requirement to develop and maintain a capital plan, and the Board of Directors of the Bancorp must review and approve the capital plan.On March 4, 2020, the Bancorp was informed by the FRB that the deadline to submit the required information related to its capital plan within the FR Y-14A was extended until April 5, 2021, with the exception of the information contained in Schedule C – Regulatory Capital Instruments. The information contained in Schedule C remained due on or before April 6, 2020, which the Bancorp submitted as required.In June 2019, the Bancorp announced its capital distribution capacity of approximately $2 billion for the period of July 1, 2019 through June 30, 2020. This included the ability to execute share repurchases up to $1.24 billion as well as increase quarterly common stock dividends by up to $0.03 per share. These distributions were governed under the FRB’s 2019 extended stress test process for BHCs with less than $250 billion of total consolidated assets. On March 16, 2020, the Bancorp announced it was temporarily suspending share repurchases that it had capacity to execute under the 2019 CCAR plan. The decision on share repurchases is consistent with Fifth Third’s objective to use the Bancorp’s capital and liquidity to provide support to individuals, businesses and the broader economy through lending and other important services. Fifth Third did not execute any open market or accelerated share repurchases in 2020.In June 2020, the FRB took several actions in connection with its announcement of stress test results in light of the uncertainty caused by the COVID-19 pandemic. Specifically, for the third quarter of 2020, the FRB required large banking organizations, including the Bancorp, to 125 Fifth Third BancorpTable of Contents MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSsuspend share repurchases, cap dividend payments to the amount paid during the second quarter of 2020, and further limit dividends according to a formula based on recent income. The FRB also required large banking organizations, including the Bancorp, to reevaluate their longer-term capital plans, and such organizations will be required to update and resubmit their capital plans later this year to reflect current stresses caused by the COVID-19 pandemic. The FRB may conduct additional analysis each quarter to determine if adjustments to this response are appropriate.In September 2020, the Bancorp was informed by the FRB that the capital plan resubmission due date was November 2, 2020, which the Bancorp submitted, as required. Additionally, on September 30, 2020 the FRB extended the third quarter of 2020 restrictions on share repurchases and dividends to the fourth quarter of 2020, and dividends remained limited according to a formula based on recent income.In December 2020, in connection with its announcement of the stress test resubmission results, the FRB extended the fourth quarter of 2020 restrictions on share repurchases and dividends to the first quarter of 2021, with modifications. Specifically, the Bancorp is authorized to pay dividends and execute share repurchases according to a formula based on recent income provided the Bancorp does not increase the amount of its dividend. For further information on a subsequent event related to an accelerated share repurchase transaction, refer to Note 33 of the Notes to Consolidated Financial Statements.Preferred Stock Transactions On July 30, 2020, the Bancorp issued in a registered public offering 350,000 depositary shares, representing 14,000 shares of 4.50% fixed-rate reset non-cumulative perpetual preferred stock, Series L, for net proceeds of approximately $346 million. Each preferred share has a $25,000 liquidation preference. For more information on the preferred stock offering, including disclosure on the redemption options, refer to Note 25 of the Notes to Consolidated Financial Statements.Dividend Policy and Stock Repurchase Program The Bancorp’s common stock dividend policy and stock repurchase program reflect its earnings outlook, desired payout ratios, the need to maintain adequate capital levels, the ability of its subsidiaries to pay dividends and the need to comply with safe and sound banking practices as well as meet regulatory requirements and expectations. The Bancorp declared dividends per common share of $1.08 and $0.94 during the years ended December 31, 2020 and 2019, respectively.The following table summarizes shares authorized for repurchase as part of publicly announced plans or programs:TABLE 72: Share RepurchasesFor the years ended December 3120202019Shares authorized for repurchase at January 176,437,348 60,564,282 Additional authorizations— 80,474,957 Share repurchases(a)— (64,601,891)Shares authorized for repurchase at December 3176,437,348 76,437,348 Average price paid per share(a)$— 26.05 (a)Excludes 1,915,872 and 2,693,318 shares repurchased during the years ended December 31, 2020 and 2019, respectively, in connection with various employee compensation plans. These purchases are not included in the calculation for average price paid per share and do not count against the maximum number of shares that may yet be repurchased under the Board of Directors’ authorization.126 Fifth Third BancorpTable of Contents MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSOFF-BALANCE SHEET ARRANGEMENTSIn the ordinary course of business, the Bancorp enters into financial transactions that are considered off-balance sheet arrangements as they involve varying elements of interest rate, price, credit and liquidity risk in excess of the amounts recognized in the Bancorp’s Consolidated Balance Sheets. The Bancorp’s off-balance sheet arrangements include commitments, contingent liabilities, guarantees and transactions with non-consolidated VIEs. A brief discussion of these transactions is as follows:CommitmentsThe Bancorp has certain commitments to make future payments under contracts, including commitments to extend credit, forward contracts related to residential mortgage loans held for sale, letters of credit, purchase obligations, capital commitments for private equity investments and capital expenditures. Refer to Note 19 of the Notes to Consolidated Financial Statements for additional information on commitments.Contingent Liabilities and GuaranteesThe Bancorp has performance obligations upon the occurrence of certain events provided in certain contractual arrangements, including residential mortgage loans sold with representation and warranty provisions. Refer to Note 19 of the Notes to Consolidated Financial Statements for additional information on contingent liabilities and guarantees.Transactions with Non-consolidated VIEsThe Bancorp engages in a variety of activities that involve VIEs, which are legal entities that lack sufficient equity to finance their activities, or the equity investors of the entities as a group lack any of the characteristics of a controlling interest. The investments in those entities in which the Bancorp was determined not to be the primary beneficiary but holds a variable interest in the entity are accounted for under the equity method of accounting or other accounting standards as appropriate and not consolidated. Refer to Note 13 of the Notes to Consolidated Financial Statements for additional information on non-consolidated VIEs.127 Fifth Third BancorpTable of Contents MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSCONTRACTUAL OBLIGATIONS AND OTHER COMMITMENTSThe Bancorp has certain obligations and commitments to make future payments under contracts. The aggregate contractual obligations and commitments at December 31, 2020 are shown in Table 73. As of December 31, 2020, the Bancorp had unrecognized tax benefits that, if recognized, would impact the effective tax rate in future periods. Due to the uncertainty of the amounts to be ultimately paid as well as the timing of such payments, all uncertain tax liabilities that have not been paid have been excluded from the following table. For further detail on the impact of income taxes, refer to Note 22 of the Notes to Consolidated Financial Statements.TABLE 73: Contractual Obligations and Other CommitmentsAs of December 31, 2020 ($ in millions)Less than 1year1-3 years 3-5 years Greater than5 yearsTotalContractually obligated payments due by period: Deposits with no stated maturity(a)(b)$154,032 — — — 154,032 Long-term debt(a)(c)3,162 3,164 3,997 4,650 14,973 Time deposits(a)(d)4,413 483 132 21 5,049 Forward contracts related to residential mortgage loans held for sale(f)2,903 — — — 2,903 Short-term borrowings(a)(e)1,492 — — — 1,492 Operating lease obligations(g)86 155 123 246 610 Partnership investment commitments(h)223 188 30 37 478 Purchase obligations and capital expenditures(j)76 135 59 — 270 Finance lease obligations(g)18 35 27 78 158 Pension benefit payments(i)18 35 34 66 153 Total contractually obligated payments due by period$166,423 4,195 4,402 5,098 180,118 Other commitments by expiration period: Commitments to extend credit(k)$26,372 23,567 16,997 7,646 74,582 Letters of credit(l)1,098 565 318 1 1,982 Total other commitments by expiration period$27,470 24,132 17,315 7,647 76,564 (a)Interest-bearing obligations are principally used to fund interest-earning assets. Interest charges on contractual obligations were excluded from reported amounts, as the potential cash outflows would have corresponding cash inflows from interest-earning assets.(b)Includes demand, interest checking, savings, money market and foreign office deposits. For additional information, refer to the Deposits subsection of the Balance Sheet Analysis section of MD&A.(c)Includes debt obligations with an original maturity of greater than one year. Refer to Note 18 of the Notes to Consolidated Financial Statements for additional information on these debt instruments.(d)Includes other time deposits and certificates $100,000 and over. For additional information, refer to the Deposits subsection of the Balance Sheet Analysis section of MD&A.(e)Includes federal funds purchased and borrowings with an original maturity of less than one year. For additional information, refer to Note 17 of the Notes to Consolidated Financial Statements.(f)Refer to Note 15 of the Notes to Consolidated Financial Statements for additional information on forward contracts to sell residential mortgage loans.(g)Refer to Note 10 of the Notes to Consolidated Financial Statements for additional information on lease obligations.(h)Includes LIHTC investments. For additional information, refer to Note 13 of the Notes to Consolidated Financial Statements.(i)Refer to Note 23 of the Notes to Consolidated Financial Statements for additional information on pension obligations.(j)Represents agreements to purchase goods or services and includes commitments to various general contractors for work related to banking center construction.(k)Commitments to extend credit are agreements to lend, typically having fixed expiration dates or other termination clauses that may require payment of a fee. Many of the commitments to extend credit may expire without being drawn upon. The total commitment amounts include capital commitments for private equity investments and do not necessarily represent future cash flow requirements. For additional information, refer to Note 19 of the Notes to Consolidated Financial Statements.(l)Letters of credit are conditional commitments issued to guarantee the performance of a customer to a third party. For additional information, refer to Note 19 of the Notes to Consolidated Financial Statements.ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK This information is set forth in the Interest Rate and Price Risk Management section of Item 7 of this Report on pages 114-119 and is incorporated herein by reference. This information contains certain statements that we believe are forward-looking statements. Refer to page 19 for cautionary information regarding forward-looking statements.
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+Item 7. "Management's Discussion and Analysis of Financial Condition and Results of Operations" for additional information pertaining to the impact of increased environmental regulations on coal supply.System DemandThe maximum hourly demand for each of the Utilities was:System Demand202020192018(in MWs)OE5,598 5,494 5,604 Penn889 946 950 CEI4,253 4,188 4,301 TE2,265 2,787 2,367 JCP&L5,902 6,056 5,977 ME2,976 2,974 3,026 PN2,908 3,020 2,993 MP2,114 2,121 2,089 PE2,905 3,609 3,498 WP3,827 4,012 3,879 Supply PlanCertain of the Utilities have default service obligations to provide power to non-shopping customers who have elected to continue to receive service under regulated retail tariffs. The volume of these sales can vary depending on the level of shopping that occurs. Supply plans vary by state and by service territory. JCP&L’s default service, or BGS supply, is secured through a statewide competitive procurement process approved by the NJBPU. Default service for the Ohio Companies, Pennsylvania Companies and PE's Maryland jurisdiction are provided through a competitive procurement process approved by the PUCO (under ESP IV), PPUC (under the DSP) and MDPSC (under the SOS), respectively. If any supplier fails to deliver power to any one of those Utilities’ service areas, the Utility serving that area may need to procure the required power in the market in their role as the default LSE. West Virginia electric generation continues to be regulated by the WVPSC.4Regional ReliabilityAll of FirstEnergy's facilities are located within the PJM Region and operate under the reliability oversight of a regional entity known as RFC. This regional entity operates under the oversight of NERC in accordance with a delegation agreement approved by FERC.CompetitionWithin FirstEnergy’s Regulated Distribution segment, generally there is no competition for electric distribution service in the Utilities’ respective service territories in Ohio, Pennsylvania, West Virginia, Maryland, New Jersey and New York. Additionally, there has traditionally been no competition for transmission service in PJM. However, pursuant to FERC’s Order No. 1000 and subject to state and local siting and permitting approvals, non-incumbent developers now can compete for certain PJM transmission projects in the service territories of FirstEnergy’s Regulated Transmission segment. This could result in additional competition to build transmission facilities in the Regulated Transmission segment’s service territories while also allowing the Regulated Transmission segment the opportunity to seek to build facilities in non-incumbent service territories.SeasonalityThe sale of electric power is generally a seasonal business, and weather patterns can have a material impact on FirstEnergy’s operating results. Demand for electricity in our service territories historically peaks during the summer and winter months. Accordingly, FirstEnergy’s annual results of operations and liquidity position may depend disproportionately on its operating performance during the summer and winter. Mild weather conditions may result in lower power sales and consequently lower earnings.Human CapitalFirstEnergy focuses on a number of human capital resources, measures, and objectives in managing its business, including: safety, diversity and inclusion, employee development, and compensation and benefits. Collectively, these focus areas may be material to understanding its business under certain circumstances. Employees and Collective Bargaining Agreements As of December 31, 2020, FirstEnergy had 12,153 employees located in the United States as follows:TotalEmployeesBargainingUnitEmployeesFESC4,419 630 OE1,135 754 CEI902 603 TE373 277 Penn188 131 JCP&L1,330 1,027 ME644 466 PN752 485 MP1,131 753 PE534 333 WP745 477 Total12,153 5,936 As of December 31, 2020, the IBEW, the UWUA and the OPEIU unions collectively represented approximately half of FirstEnergy’s employees. There are 15 CBAs between FirstEnergy’s subsidiaries and its unions, which have three, four- or five-year terms. In 2020, FirstEnergy’s subsidiaries reached new agreements with 3 UWUA locals, covering 550 employees, and 1 OPEIU local, covering 77 employees.Safety Safety is a core value of FirstEnergy. FirstEnergy employees have the power and responsibility to keep each other safe and eliminate life-changing events, which are injuries that have life-changing impacts or fatal results. Safety metrics, such as injuries that result in days away or restricted time and life-changing events, are regularly monitored, internally reported, and are included in our annual incentive compensation program to reinforce that a safe work environment is crucial to FirstEnergy’s success. 5FirstEnergy continues to shift its focus from achieving low OSHA rates to proactively identifying and mitigating life-changing event exposure. This shift in focus strengthens FirstEnergy’s safety-first culture by aligning our leadership around the same goal and driving safer decisions from an engaged workforce who puts safety first. To support that shift, FirstEnergy is transitioning from leader and employee training and exposure control concepts to a safety management system that cultivates job site exposure identification and mitigation to prevent life-changing events. Further, FirstEnergy continues to expand its “Leading with Safety” experiences with its employees to achieve excellence in personal, contractor and public safety. Additionally, FirstEnergy’s employees’ well-being is essential to its core value of safety. FirstEnergy is taking a well-informed, decisive and measured response to the COVID-19 pandemic, as recommended by medical experts, to protect the health and safety of our employees and the public, while also continuing to serve our customers. FirstEnergy continues to provide flexibility for approximately 7,000 of its 12,000 employees to work from home. Pandemic safety and cleaning protocols were implemented for those workers who have continued to report to a FirstEnergy work location during this public health emergency, ensuring FirstEnergy employees can report directly to job sites and work with the same small group of employees every day. FirstEnergy developed a COVID-19 medical screening process under which a medical staff consisting of nurses, doctors and non-medical intake teams were assembled to manage COVID-19 related exposures, illnesses and quarantines; perform contact tracing; and ultimately safely return employees to work. FirstEnergy continues to implement state health directives as they emerge and adjusts its procedures as needed to continue to keep its employees safe.Diversity and InclusionFirstEnergy seeks to expand the diversity of its team and create an inclusive workplace where employees feel valued, motivated and empowered to drive FirstEnergy’s success. Diversity and inclusion metrics are included in FirstEnergy’s annual incentive compensation program to emphasize that a diverse and inclusive work environment at FirstEnergy drives better service for customers, strong operational performance, innovation and a rewarding work experience for its employees.Affirmative steps taken at FirstEnergy to promote the core value of diversity and inclusion includes:•FirstEnergy sponsors an executive diversity and inclusion council consisting of senior management and other leaders across the company.•A cross-functional working group oversees the development and implementation of diversity and inclusion action plans company-wide.•Additional teams of employees are embedded throughout FirstEnergy to implement local actions supporting diversity and inclusion.•FirstEnergy’s employees have established multiple employee business resource groups, known as "EBRGs," to further support diversity and inclusion objectives through networking, mentoring, coaching, recruiting, development and community outreach.•Employees are provided ongoing training and education on a variety of diversity and inclusion topics.•FirstEnergy has enhanced the recruiting processes to increase the number of diverse candidates considered for open positions and expand the diversity of teams interviewing those candidates.Employee DevelopmentFirstEnergy’s employees are empowered to take ownership of their careers with increased openness into FirstEnergy’s internal and external hiring process and greater availability of tools and processes that support career management, talent reviews, succession planning and leadership selection. FirstEnergy is committed to preparing its high-performing workforce for the future and helping employees reach their full potential. That means developing employee skills and competencies and preparing emerging and experienced leaders for future management responsibilities.Understanding FirstEnergy’s rapidly changing industry and strategy is key to employees’ ability to support FirstEnergy’s mission and meet its customers’ evolving needs. In 2020, FirstEnergy launched FE University as an initiative to brand and create synergies among FirstEnergy’s many employee development and training initiatives. Key FirstEnergy development programs include: •a mentoring program,•Discover FE, which is designed to broaden and deepen knowledge of FirstEnergy and the electric utility industry generally, •new supervisor and manager program,•experienced leader program, and•Power Systems Institute, an award-winning program for recruiting and developing the next generation of highly trained, dedicated and motivated line and substation workers.Compensation and BenefitsFirstEnergy’s total rewards program is designed to attract, motivate, retain and reward employees for their role in the success of FirstEnergy. The base pay program is designed to provide individual base pay levels that balance an employee’s value to FirstEnergy with comparable jobs at peer companies. FirstEnergy is committed to ensuring that our internal policies and processes support pay equity. The annual incentive compensation program is designed to reward the achievement of near-term 6corporate and business unit objectives. Additionally, FirstEnergy’s long-term incentive compensation program is designed to reward eligible employees for FirstEnergy’s achievement of longer-term goals intended to drive shareholder value and growth. In addition to base pay and incentive compensation plans, FirstEnergy offers a comprehensive benefits program, including a 401(k) Savings Plan and a defined benefit Pension Plan.7Information About Our Executive Officers (as of February 18, 2021)NameAgePositions Held During Past Five YearsDatesS. E. Strah57President and Acting Chief Executive Officer (A) (B)2020-PresentSenior Vice President and Chief Financial Officer (A) (B) (C) (E)2018-2020President (D)2017-2018President (E)2016-2018Senior Vice President & President, FirstEnergy Utilities (B)*-2018President (C)*-2018H. Park59Senior Vice President and Chief Legal Officer (A)2021-PresentLimNexus, Partner and General Counsel2019-2021Latham & Watkins, Of Counsel2017-2019PG&E Corporation, Senior Vice President and Special Counsel to Chairman2017Senior Vice President and General Counsel*-2017K. Jon Taylor47Senior Vice President and Chief Financial Officer (A) (B) (C) (E)2020-PresentVice President, Utility Operations (B)2019-2020President (D)2019-2020President, Ohio Operations (B)2018-2019Vice President (C) 2018-2019Vice President and Controller (E)2016-2018Vice President and Controller (C) *-2018Vice President, Controller and Chief Accounting Officer (A) (B)*-2018Vice President and Controller (D) (G)*-2017Vice President and Controller (F)*-2016C. L. Walker55Senior Vice President and Chief Human Resources Officer (B)2019-presentVice President, Human Resources (B)2018-2019Executive Director, Talent Management (B)2016-2018G. D. Benz61Senior Vice President, Strategy (B)*-presentJ. J. Lisowski39Vice President, Controller and Chief Accounting Officer (A) (B)2018-presentVice President and Controller (C) (E)2018-presentController and Treasurer (G)2017-2018Controller and Treasurer (F)2016-2018Assistant Controller (E)2016-2017Assistant Controller (A) (B) (C) (D) (F) (G)*-2017S. L. Belcher52Senior Vice President and President, FirstEnergy Utilities (B)2018-presentPresident (C) (E)2018-presentPresident and Chief Nuclear Officer (G)*-2018President, FirstEnergy Nuclear Operating Company (B)*-2017* Indicates position held at least since January 1, 2016(A) Denotes position held at FE(B) Denotes position held at FESC(C) Denotes position held at the Ohio Companies, the Pennsylvania Companies, MP, PE, FET, KATCo, TrAIL and ATSI(D) Denotes position held at AGC(E) Denotes position held at MAIT(F) Denotes position held at FES and FG(G) Denotes position held at FENOCFirstEnergy Website and Other Social Media Sites and ApplicationsFirstEnergy's Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, amendments to those reports, and all other documents filed with or furnished to the SEC pursuant to Section 13(a) of the Securities Exchange Act of 1934 are made available free of charge on or through the "Investors" page of FirstEnergy’s website at www.firstenergycorp.com. These documents are also available to the public from commercial document retrieval services and the website maintained by the SEC at www.sec.gov.These SEC filings are posted on the website as soon as reasonably practicable after they are electronically filed with or furnished to the SEC. Additionally, FirstEnergy routinely posts additional important information, including press releases, investor presentations, investor factbooks and notices of upcoming events under the "Investors" section of FirstEnergy’s website and recognizes FirstEnergy’s website as a channel of distribution to reach public investors and as a means of disclosing material non-public information for complying with disclosure obligations under Regulation FD. Investors may be notified of postings to the website by signing up for email alerts and RSS feeds on the "Investors" page of FirstEnergy's website. FirstEnergy also uses Twitter® and Facebook® as additional channels of distribution to reach public investors and as a supplemental means of disclosing material non-public information for complying with its disclosure obligations under Regulation FD. Information contained on FirstEnergy’s website, Twitter® handle or Facebook® page, and any corresponding applications of those sites, shall not be deemed incorporated into, or to be part of, this report.8ITEM 1A. RISK FACTORS We operate in a business environment that involves significant risks, many of which are beyond our control. Management regularly evaluates the most significant risks of its businesses and reviews those risks with the Board of Directors and appropriate Committees of the Board. The following risk factors and all other information contained in this report should be considered carefully when evaluating FirstEnergy. These risk factors could affect our financial results and cause such results to differ materially from those expressed in any forward-looking statements made by or on behalf of us. Below, we have identified risks we consider material. Additional information on risk factors is included in “Item 1. Business,” “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations,” and in other sections of this Form 10-K that include forward-looking and other statements involving risks and uncertainties that could impact our business and financial results. Risks Associated with the Ongoing InvestigationsWe Have Received Requests for Information Related to Government Investigations. The Investigations and Related Litigation Could Have a Material Adverse Effect on our Reputation, Business, Financial Condition, Results of Operations, Liquidity or Cash FlowsOn July 21, 2020, we received subpoenas for records from the U.S. Attorney’s Office for the S.D. Ohio requesting the production of information concerning an investigation surrounding HB 6 involving the now former Ohio House Speaker Larry Householder and other individuals and entities allegedly affiliated with Mr. Householder. Following the announcement of the investigation surrounding HB 6, certain of our stockholders and customers filed several lawsuits against us and certain current and former directors, officers and other employees. In addition, on August 10, 2020, the SEC, through its Division of Enforcement, issued an order directing an investigation of possible securities laws violations by FirstEnergy, and on September 1, 2020, issued subpoenas to FirstEnergy and certain of its officers. We are cooperating with the U.S. Attorney’s Office and the SEC in their investigations. See Note 15, “Commitments, Guarantees and Contingencies,” of the Notes to Consolidated Financial Statements, for additional details on the government investigation and subsequent litigation surrounding the investigation of HB 6.The investigations and related litigation could divert management’s focus and have resulted, and could continue to result in substantial investigation expenses, and the commitment of substantial corporate resources. The outcome of the government investigations and related litigation is inherently uncertain. If one or more legal matters, including the ongoing investigation, were resolved against us, our reputation, business, financial condition, results of operations, liquidity or cash flows may be adversely affected. Further, such an outcome could result in criminal liabilities, deferred prosecution agreements, significant monetary damages and fines, remedial corporate measures or other relief against us that could adversely impact our operations; in addition, certain of those outcomes could adversely impact our ability to maintain compliance with the covenants under our credit facilities or result in an event of default thereunder. These matters are likely to continue to have an adverse impact on the trading prices of our securities.We are unable to predict the outcome, duration, scope, result or related costs of the investigations and related litigation and, therefore, any of these risks could impact us significantly beyond expectations. Moreover, we are unable to predict the potential for any additional investigations or litigation, any of which could exacerbate these risks or expose us to potential criminal or civil liabilities, sanctions or other remedial measures, and could have a material adverse effect on our reputation, business, financial condition, results of operations, liquidity or cash flows. We Have Received Requests for Information Related to Government Investigations. Related Potential Adverse Impacts on Federal or State Regulatory Matters Could Have a Material Adverse Effect on our Reputation, Business, Financial Condition, Results of Operations, Liquidity or Cash FlowsOn July 21, 2020, we received subpoenas for records from the U.S. Attorney’s Office for the S.D. Ohio requesting the production of information concerning an investigation surrounding HB 6 involving the now former Ohio House Speaker Larry Householder and other individuals and entities allegedly affiliated with Mr. Householder. On January 26, 2021, staff of FERC’s Division of Investigations issued a letter directing FirstEnergy to preserve and maintain all documents and information related to an ongoing audit being conducted by FERC’s Division of Audits and Accounting, including activities relating to lobbying and governmental affairs activities concerning HB 6. We are cooperating with the FERC in the ongoing audit and document preservation request. See Note 14, "Regulatory Matters," and Note 15, “Commitments, Guarantees and Contingencies,” of the Notes to Consolidated Financial Statements, for additional details on the government investigation and regulatory matters related to the investigation of HB 6.We are subject to comprehensive regulation by various federal, state and local regulatory agencies that significantly influence our operating environment. As previously disclosed, among the matters considered with respect to the determination by the committee of independent members of the Board of Directors to terminate certain former members of senior management for violating certain FirstEnergy policies and its code of conduct related to a payment of approximately $4 million made in early 2019 in connection with the termination of a purported consulting agreement, as amended, which had been in place since 2013. The counterparty to such agreement was an entity associated with an individual who subsequently was appointed to a full-time role as an Ohio government official directly involved in regulating the Ohio Companies, including with respect to distribution rates. FirstEnergy believes that payments under the consulting agreement may have been for purposes other than those represented 9within the consulting agreement. The matter is a subject of the ongoing internal investigation related to the government investigations.Any appearance of non-compliance with anti-corruption laws, as well as any alleged failures to comply with anti-corruption laws, could have an adverse impact on our reputation or relationships with regulatory authorities, and result in a material inquiry or investigation by such federal, state and local regulatory agencies, and result in adverse rulings against us, which could have a material adverse impact on our financial condition, operating results and operations. For example, there are several regulatory matters associated with the ongoing governmental investigations including, but not limited to, the following: •On September 15, 2020, the PUCO opened a new proceeding to review the political and charitable spending by the Ohio Companies in support of HB 6 and the subsequent referendum effort, directing the Ohio Companies to show cause, demonstrating that the costs of any political or charitable spending in support of HB 6, or the subsequent referendum effort, were not included, directly or indirectly, in any rates or charges paid by ratepayers. •On November 4, 2020, the PUCO initiated an additional corporate separation audit as a result of the termination of certain members of senior management. •On December 30, 2020, the PUCO reinstated the requirement that the Ohio Companies file a distribution rate case by May 31, 2024, which requirement had previously been eliminated by the PUCO in November 2019. •Also on December 30, 2020, the PUCO reopened the DMR audit docket, and directed PUCO staff to solicit a third-party auditor and conduct a full review of the DMR to ensure funds collected from ratepayers through the DMR were only used for the purposes established in ESP IV.•On January 26, 2021, staff of FERC's Division of Investigations issued a letter directing FirstEnergy to preserve and maintain all documents and information related to an ongoing audit being conducted by FERC's Division of Audits and Accounting, including activities related to lobbying and governmental affairs activities concerning HB 6. •In connection with the partial settlement with the OAG and other parties, the Ohio Companies filed an application with the PUCO on February 1, 2021, to set the respective decoupling riders (Rider CSR) to zero and, in a related action, the Ohio Companies will not seek to recover lost distribution revenue from residential and commercial customers; as a result, FirstEnergy recognized a $108 million pre-tax charge ($84 million after-tax) in the fourth quarter of 2020 and $77 million (pre-tax) of which is associated with forgoing collection of lost distribution revenue.While FirstEnergy is committed to pursuing an open dialogue with stakeholders in an appropriate manner with respect to the numerous regulatory proceedings currently underway, the rates our Utilities and transmission operating companies are allowed to charge may be decreased as a result of actions taken by FERC or by a state regulatory commission to which our Utilities is subject to jurisdiction, whether as a result of the ongoing government investigations, the appearance of non-compliance with anti-corruption laws, or otherwise. Also, in connection with the internal investigation, FirstEnergy recently identified certain transactions, which, in some instances, extended back ten years or more, including vendor services, that were either improperly classified, misallocated to certain of the Utilities and Transmission Companies, or lacked proper supporting documentation. These transactions resulted in amounts collected from customers that were immaterial to FirstEnergy, and the Utilities and Transmission Companies will be working with the appropriate regulatory agencies to address these amounts.We are unable to predict the adverse impacts on federal or state regulatory matters, including with respect to rates, and, therefore, any of these risks could impact us significantly beyond expectations. Moreover, we are unable to predict the potential for any additional regulatory actions, any of which could exacerbate these risks or expose us to adverse outcomes in pending or future rate cases, and could have a material adverse effect on our reputation, business, financial condition, results of operations, liquidity or cash flows.We Have Identified a Material Weakness in our Internal Controls over Financial Reporting. If We Fail to Remediate such Material Weakness or Otherwise Fail to Develop, Implement and Maintain Effective Internal Controls in Future Periods, Our Ability to Report Our Financial Condition and Results of Operations Accurately and on a Timely Basis Could Be Adversely AffectedOur management is responsible for establishing and maintaining adequate internal control over financial reporting. Internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements in accordance with generally accepted accounting principles.As previously disclosed, a committee of independent members of our Board of Directors is directing an internal investigation related to ongoing government investigations. In connection with our internal investigation, such committee determined that certain former members of senior management, including our former chief executive officer, violated certain FirstEnergy policies and our code of conduct. Such former members of senior management did not maintain and promote a control environment with an appropriate tone of compliance in certain areas of FirstEnergy’s business, nor sufficiently promote, monitor or enforce adherence to certain FirstEnergy policies and its code of conduct. Furthermore, certain former members of senior management did not reasonably ensure that relevant information was communicated within our organization and not withheld from our independent directors, our Audit Committee, and our independent auditor. Among the matters considered with respect to the determination by the committee of independent members of the Board of Directors that certain former members of senior management violated certain FirstEnergy policies and its code of conduct related to a payment of approximately $4 million made in early 2019 in connection with the termination of a purported consulting agreement, as amended, which had been in place 10since 2013. The counterparty to such agreement was an entity associated with an individual who subsequently was appointed to a full-time role as an Ohio government official directly involved in regulating the Ohio Companies, including with respect to distribution rates. FirstEnergy believes that payments under the consulting agreement may have been for purposes other than those represented within the consulting agreement. The matter is a subject of the ongoing internal investigation related to the government investigations.During the preparation of FirstEnergy’s financial statements as of and for the quarter ended September 30, 2020, FirstEnergy identified a material weakness in that these certain former members of senior management did not set an appropriate tone at the top as discussed above, which are inconsistent with the standards to which FirstEnergy’s Board of Directors and senior management are committed.This control deficiency did not result in a material misstatement of our annual or interim consolidated financial statements. However, this control deficiency could have resulted in material misstatements to the annual or interim consolidated financial statements that would not have been prevented or detected. Accordingly, our management has concluded that this control deficiency constitutes a material weakness.A material weakness is a deficiency, or a combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of our annual or interim financial statements will not be prevented or detected on a timely basis.We are in the process of remediating the identified material weakness in our internal control over financial reporting.We cannot assure you that we will adequately remediate the material weakness or that additional material weaknesses in our internal controls will not be identified in the future. All internal control systems, no matter how well designed, have inherent limitations. Therefore, even those internal control systems determined to be effective can provide only a level of reasonable assurance with respect to financial statement preparation and presentation. Any failure to maintain or implement required new or improved controls, or any difficulties we encounter in the implementation, could result in additional material weaknesses, or could result in material misstatements in our financial statements. These misstatements could result in restatements of our financial statements, cause us to fail to meet our reporting obligations or cause investors to lose confidence in our reported financial information. Further, if we are unable to maintain adequate internal control over financial reporting, we may be unable to report our financial information on a timely basis, may violate applicable stock exchange listing rules or suffer other adverse regulatory consequences and may breach the covenants under our credit facilities. There could also be a negative reaction in the price of our common stock due to a loss of investor confidence in us and the reliability of our financial statements. See “Item 9a. Controls and Procedures” included elsewhere in this Annual Report on Form 10-K for a discussion of the material weakness and our remediation plans.Failure to Comply with Debt Covenants in our Credit Agreements or Conditions Could Adversely Affect our Ability to Execute Future Borrowings and/or Require Early Repayment, and Could Restrict our Ability to Obtain Additional or Replacement Financing on Acceptable Terms or at AllOur debt and credit agreements contain various financial and other covenants including a consolidated debt to total capitalization ratio of no more than 65% measured at the end of each fiscal quarter.Our credit agreements contain certain negative and affirmative covenants. Our ability to comply with the covenants and restrictions contained in our FE credit facility and FET credit facility may be affected by events related to the ongoing government investigations or otherwise.On November 17, 2020, we and certain of our subsidiaries entered into amendments to the FE credit facility and the FET credit facility, respectively. The amendments provide for modifications and/or waivers of: (i) certain representations and warranties and (ii) certain affirmative and negative covenants, contained therein, which allowed FirstEnergy to regain compliance with such provisions. The non-compliance for which the waiver was necessary stemmed from the payment of approximately $4 million made in early 2019 in connection with the termination of a purported consulting agreement, as amended, which had been in place since 2013 with an entity associated with an individual who subsequently was appointed to a full-time role as an Ohio government official directly involved in regulating the Ohio Companies, including with respect to distribution rates. Among other things, the amendment to the FE credit facility reduces the sublimit applicable to FE to $1.5 billion, and the amendments increased certain tiers of pricing applicable to borrowings under the credit facilities. In addition, we may be required to seek additional covenant waivers in future periods, and there can be no assurance that we will be able to obtain such waivers on favorable terms, or at all.A breach of any of the covenants contained in our credit agreements, including any breach related to alleged failures to comply with anti-corruption and anti-bribery laws, could result in an event of default under such agreements, and we would not be able to access our credit facilities for additional borrowings and letters of credit while any default exists. Upon the occurrence of such an event of default, all amounts outstanding under our credit facilities, which was $2.2 billion as of February 15, 2021, could be declared to be immediately due and payable and all applicable commitments to extend further credit could be terminated. If indebtedness under our credit facilities is accelerated, there can be no assurance that we will have sufficient assets to repay the 11indebtedness. In addition, certain events, including but not limited to any covenant breach related to alleged failures to comply with anti-corruption and anti-bribery laws, an event of default under our credit agreements, and the acceleration of applicable commitments under such facilities could restrict our ability to obtain additional or replacement financing on acceptable terms or at all. The operating and financial restrictions and covenants in our credit facilities and any future financing agreements may adversely affect our ability to finance future operations or capital needs or to engage in other business activities.Risks Associated with the Global PandemicThe COVID-19 Global Pandemic Has Impacted Us and Could Have an Adverse Effect on Our Business, Results of Operations, Cash Flows and Financial ConditionThe outbreak of COVID-19 has become a global pandemic and has impacted FirstEnergy. For instance, FirstEnergy’s Utilities discontinued power shutoffs as of March 13, 2020, across its five-state service territory and ceased billing for certain late payment charges, and while some of these have been rescinded, similar actions could occur in the future. Furthermore, in response to the pandemic and related mitigation measures, FirstEnergy has implemented its pandemic plan as well as other precautionary measures on behalf of its customers and employees, including supporting remote work opportunities for most of its employees. While FirstEnergy believes that all these measures have been necessary or appropriate, they have resulted in additional costs and may adversely impact its business and results of operation in the future or expose it to additional unknown risks.Although it is not possible to predict the ultimate impact of COVID-19, including on FirstEnergy’s business, results of operations, cash flows or financial positions, such impacts that may be material include, but are not limited to: (i) lower commercial and industrial customer demand for electricity, (ii) impacts of rapidly-changing governmental and public health directives to contain and combat the pandemic together with executive and legislative initiatives imposing a moratorium on utility disconnections, (iii) increased credit risk, including increased failure or delay by customers to make their utility payments, (iv) reduced availability and productivity of its employees, (v) increased operational risks as a result of remote work arrangements, including the potential effects on internal controls, as well as cybersecurity risks and increased vulnerability to security breaches, information technology disruptions and other similar events, (vi) delays and disruptions in the availability of and timely delivery of materials and components used in its operations, as well as increased costs for such materials and components, (vii) continued volatility in market prices for our securities, and (viii) hampering our ability to access funds from financial institutions and the capital markets on the same or reasonably similar terms as were available to FirstEnergy before the COVID-19 pandemic. To the extent the duration of any of these conditions extends for a longer period of time, the adverse impact will generally be more severe.Risks Associated with Regulation of Our Distribution and Transmission BusinessesWe are Focusing on Growing Our Regulated Transmission and Regulated Distribution Operations. Whether This Investment Strategy Will Deliver the Desired Result Is Subject to Certain Risks Which Could Adversely Affect Our Results of Operations and Financial ConditionWe focus on capitalizing on investment opportunities available to our Regulated Transmission and Regulated Distribution operations as we focus on delivering enhanced customer service and reliability. The success of these efforts will depend, in part, on successful recovery of our transmission investments. Factors that may affect rate recovery of our transmission investments include: (1) FERC’s timely approval of rates to recover such investments; (2) whether the investments are included in PJM's RTEP; (3) FERC's evolving policies with respect to incentive rates for transmission assets; (4) FERC's evolving policies with respect to the calculation of the base ROE component of transmission rates; (5) consideration and potential impact of the objections of those who oppose such investments and their recovery; and (6) timely development, construction, and operation of the new facilities.The success of these efforts will also depend, in part, on any future distribution rate cases or other filings seeking cost recovery for distribution system enhancements in the states where our Utilities operate and transmission rate filings at FERC. Any denial of, or delay in, the approval of any future distribution or transmission rate requests could restrict us from fully recovering our cost of service, may impose risks on the Regulated Distribution and Regulated Transmission operations, and could have a material adverse effect on our regulatory strategy, results of operations and financial condition.Our efforts also could be impacted by our ability to finance the proposed expansion projects while maintaining adequate liquidity. There can be no assurance that our investment strategy in our Regulated Transmission and Regulated Distribution operations will deliver the desired result which could adversely affect our results of operations and financial condition.Complex and Changing Government Regulations and Actions, Including Those Associated with Rates, Could Have a Negative Impact on Our Business, Financial Condition, Results of Operations and Cash FlowsWe are subject to comprehensive regulation by various federal, state and local regulatory agencies that significantly influence our operating environment. Changes in, or reinterpretations of, existing laws or regulations, or the imposition of new laws or regulations, could require us to incur additional costs or change the way we conduct our business, and therefore could have a material adverse impact on our results of operations and financial condition.12Our Utilities and Transmission Companies currently provide service at rates approved by one or more regulatory commissions. Thus, the rates the Utilities and Transmission Companies are allowed to charge may be decreased as a result of actions taken by FERC or by a state regulatory commission in the states in which our Utilities operate. Also, these rates may not be set to recover such applicable utility's expenses at any given time. Additionally, there may also be a delay between the timing of when costs are incurred and when costs are recovered, if at all. For example, we may be unable to timely recover the costs for our energy efficiency investments or expenses and additional capital or lost revenues resulting from the implementation of aggressive energy efficiency programs. While rate regulation is premised on providing an opportunity to earn a reasonable return on invested capital and recovery of operating expenses, there can be no assurance that the applicable regulatory commission will determine that all of our costs have been prudently incurred or that the regulatory process in which rates are determined will always result in rates that will produce full recovery of our costs in a timely manner. Further, there can be no assurance that we will retain the expected recovery in future rate cases.State Rate Regulation May Delay or Deny Full Recovery of Costs and Impose Risks on Our Operations. Any Denial of or Delay in Cost Recovery Could Have an Adverse Effect on Our Business, Results of Operations, Liquidity, Cash Flows and Financial ConditionEach of the Utilities' retail rates are set by its respective regulatory agency for utilities in the state in which it operates - in Maryland by the MDPSC, in New Jersey by the NJBPU, in Ohio by the PUCO, in Pennsylvania by the PPUC, in West Virginia by the WVPSC and in New York by the NYPSC - through traditional, cost-based regulated utility ratemaking. As a result, any of the Utilities may not be permitted to recover its costs and, even if it is able to do so, there may be a significant delay between the time it incurs such costs and the time it is allowed to recover them. Factors that may affect outcomes in the distribution rate cases include: (i) the value of plant in service; (ii) authorized rate of return; (iii) capital structure (including hypothetical capital structures); (iv) depreciation rates; (v) the allocation of shared costs, including consolidated deferred income taxes and income taxes payable across the Utilities; (vi) regulatory approval of rate recovery mechanisms for capital spending programs; and (vii) the accuracy of forecasts used for ratemaking purposes in "future test year" cases.FirstEnergy can provide no assurance that any base rate request filed by any of the Utilities will be granted in whole or in part. Any denial of, or delay in, any base rate request could restrict the applicable utility from fully recovering its costs of service, may impose risks on its operations, and may negatively impact its results of operations, cash flows and financial condition. In addition, to the extent that any of the Utilities seeks rate increases after an extended period of frozen or capped rates, pressure may be exerted on the applicable legislators and regulators to take steps to control rate increases, including through some form of rate increase moderation, reduction or freeze. Any related public discourse and debate can increase uncertainty associated with the regulatory process, the level of rates and revenues that are ultimately obtained, and the ability of the Utility to recover costs. Such uncertainty may restrict operational flexibility and resources, reduce liquidity and increase financing costs.Federal Rate Regulation May Delay or Deny Full Recovery of Costs and Impose Risks on Our Operations. Any Denial or Reduction of, or Delay in Cost Recovery Could Have an Adverse Effect on Our Business, Results of Operations, Cash Flows and Financial ConditionFERC policy currently permits recovery of prudently incurred costs associated with cost-of-service-based wholesale power rates and the expansion and updating of transmission infrastructure within its jurisdiction. FERC’s policies on recovery of transmission costs continue to evolve, evidenced by ongoing proceedings to determine an appropriate ROE methodology to determine transmission ROEs and whether FERC’s existing policies on transmission rate incentives should be revised. If FERC were to adopt a different policy regarding recovery of transmission costs or if there is any resulting delay in cost recovery, our strategy of investing in transmission could be affected. If FERC were to lower the rate of return it has authorized for FirstEnergy's cost-based wholesale power rates or transmission investments and facilities, it could reduce future earnings and cash flows, and adversely impact our financial condition. We Could be Subject to Higher Costs and/or Penalties Related to Mandatory Reliability Standards Set by NERC/FERC or Changes in the Rules of Organized Markets, Which Could Have an Adverse Effect on our Financial ConditionOwners, operators, and users of the bulk electric system are subject to mandatory reliability standards promulgated by NERC and approved by FERC. The standards are based on the functions that need to be performed to ensure that the bulk electric system operates reliably. NERC, RFC and FERC can be expected to continue to refine existing reliability standards as well as develop and adopt new reliability standards. Compliance with modified or new reliability standards may subject us to higher operating costs and/or increased capital expenditures. If we were found not to be in compliance with the mandatory reliability standards, we could be subject to sanctions, including substantial monetary penalties. FERC has authority to impose penalties up to and including $1.3 million per day for failure to comply with these mandatory electric reliability standards.In addition to direct regulation by FERC, we are also subject to rules and terms of participation imposed and administered by various RTOs and ISOs that can have a material adverse impact on our business. For example, the independent market monitors of ISOs and RTOs may impose bidding and scheduling rules to curb the perceived potential for exercise of market power and to ensure the markets function appropriately. Such actions may materially affect our ability to sell, and the price we 13receive for, our energy and capacity. In addition, PJM may direct our transmission-owning affiliates to build new transmission facilities to meet PJM's reliability requirements or to provide new or expanded transmission service under the PJM Tariff.We may be allocated a portion of the cost of transmission facilities built by others due to changes in RTO transmission rate design. We may be required to expand our transmission system according to decisions made by an RTO rather than our own internal planning processes. Various proposals and proceedings before FERC may cause transmission rates to change from time to time. In addition, RTOs have been developing rules associated with the allocation and methodology of assigning costs associated with improved transmission reliability, reduced transmission congestion and firm transmission rights that may have a financial impact on us.As a member of an RTO, we are subject to certain additional risks, including those associated with the allocation among members of losses caused by unreimbursed defaults of other participants in that RTO’s market and those associated with complaint cases filed against the RTO that may seek refunds of revenues previously earned by its members.In June and July 2020, as part of the PJM stakeholder process, certain competing amendments to the PJM Tariff were filed. The PJM TOs filed amendments that clarified responsibility as between PJM and the PJM TOs for planning for transmission facilities that are at the end of their useful life. Certain load groups filed competing amendments that would transfer authority for such planning from the PJM TOs to PJM. PJM supported the PJM TOs' filing and opposed the load groups' filing. In a series of decisions beginning in August 2020 and running through December 2020, FERC approved the PJM TOs' amendments, and rejected the loads' amendments. Certain of the load groups have filed a petition for review of FERC's decision before the D.C. Circuit and such appeal is currently pending. It is reasonable to believe that the PJM load interests will continue their efforts to limit transmission owner discretion in planning and investing in transmission assets, and further regulatory and appellate cases are expected. The inability to control the investment planning process could adversely affect our business operations, including the Energizing the Future program. In addition, the inability to control the investment planning process for our transmission business could adversely affect our results of operations and our financial condition.Risks Associated with Environmental and Climate MattersMandatory Renewable Portfolio Requirements, Energy Efficiency and Peak Demand Reduction Mandates and Energy Price Increases Could Negatively Impact Our Financial ResultsWhere federal or state legislation mandates the use of renewable and alternative fuel sources, such as wind, solar, biomass and geothermal and such legislation does not also provide for adequate cost recovery, it could result in significant changes in our business, including material increases in REC purchase costs, purchased power costs and capital expenditures. Such mandatory renewable portfolio requirements may have an adverse effect on our financial condition and results of operations.A number of regulatory and legislative bodies have introduced requirements and/or incentives to reduce peak demand and energy consumption. Such conservation programs could result in load reduction and adversely impact our financial results in different ways. We currently have energy efficiency riders in place in certain of our states to recover the cost of these programs either at or near a current recovery time frame in the states where we operate.In our regulated operations, conservation could negatively impact us depending on the regulatory treatment of the associated impacts. Should we be required to invest in conservation measures that result in reduced sales from effective conservation, regulatory lag in adjusting rates for the impact of these measures could have a negative financial impact. We have already been adversely impacted by reduced electric usage due in part to energy conservation efforts such as the use of efficient lighting products such as CFLs, halogens and LEDs. We could also be adversely impacted if any future energy price increases result in a decrease in customer usage. We are unable to determine what impact, if any, conservation and increases in energy prices will have on our financial condition or results of operations.Additionally, failure to meet regulatory or legislative requirements to reduce energy consumption or otherwise increase energy efficiency could result in penalties that could adversely affect our financial results. We Have Coal-Fired Generation Capacity, Which Exposes Us to Risk from Regulations Relating to Coal, GHGs and CCRs and Could Lead to Increased Costs or the Need to Spend Significant Resources to Defend Allegations of ViolationApproximately 82% of FirstEnergy's generation capacity is coal-fired, totaling 3,160 MW, increasing to 88% upon completion of the Yards Creek sale. Historically, coal-fired generating plants have greater exposure to the costs of complying with federal, state and local environmental statutes, rules and regulations relating to air emissions, including GHGs and CCR disposal, than other types of electric generation facilities. These legal requirements and any future initiatives could impose substantial additional costs and, in the case of GHG requirements, could raise uncertainty about the future viability of fossil fuels, particularly coal, as an energy source for new and existing electric generation facilities and could require our coal-fired generation plants to curtail generation or cease to generate. Failure to comply with any such existing or future legal requirements may also result in the assessment of fines and penalties. Significant resources also may be expended to defend against allegations of violations of any such requirements.14The EPA is Conducting NSR Investigations at Generating Plants that We Currently or Formerly Owned, the Results of Which Could Negatively Impact Our Results of Business Operations, Cash Flows and Financial ConditionWe may be subject to risks from changing or conflicting interpretations of existing laws and regulations, including, for example, the applicability of the EPA's NSR programs. Under the CAA, modification of our generation facilities in a manner that results in increased emissions could subject our existing generation facilities to the far more stringent new source standards applicable to new generation facilities.The EPA has taken the view that many companies, including many energy producers, have been modifying emissions sources in violation of NSR standards during work considered by the companies to be routine maintenance. The EPA has investigated alleged violations of the NSR standards at certain of our existing and former generating facilities. We intend to vigorously pursue and defend our position, but we are unable to predict their outcomes. If NSR and similar requirements are imposed on our generation facilities, in addition to the possible imposition of fines, compliance could entail significant capital investments in pollution control technology, which could have an adverse impact on our business, results of operations, cash flows and financial condition.Costs of Compliance with Environmental Laws are Significant, and the Cost of Compliance with New Environmental Laws, Including Limitations on GHG Emissions Related to Climate Change, Could Adversely Affect Cash Flows and Financial ConditionOur operations are subject to extensive federal, state and local environmental statutes, rules and regulations. Compliance with these legal requirements requires us to incur costs for, among other things, installation and operation of pollution control equipment, emissions monitoring and fees, remediation and permitting at our facilities. These expenditures have been significant in the past and may increase in the future. We may be forced to shut down other facilities or change their operating status, either temporarily or permanently, if we are unable to comply with these or other existing or new environmental requirements, or if the expenditures required to comply with such requirements are unreasonable.Moreover, new environmental laws or regulations including, but not limited to GHG Emissions, CWA effluent limitations imposing more stringent water discharge regulations, or other changes to existing environmental laws or regulations may materially increase our costs of compliance or accelerate the timing of capital expenditures. Our compliance strategy, including but not limited to, our assumptions regarding estimated compliance costs, although reasonably based on available information, may not successfully address future relevant standards and interpretations. If we fail to comply with environmental laws and regulations or new interpretations of longstanding requirements, even if caused by factors beyond our control, that failure could result in the assessment of civil or criminal liability and fines. In addition, any alleged violation of environmental laws and regulations may require us to expend significant resources to defend against any such alleged violations. Due to the uncertainty of control technologies available to reduce GHG emissions, any legal obligation that requires substantial reductions of GHG emissions could result in substantial additional costs, adversely affecting cash flows and profitability, and raise uncertainty about the future viability of fossil fuels, particularly coal, as an energy source for new and existing electric generation facilities.We Are or May Be Subject to Environmental Liabilities, Including Costs of Remediation of Environmental Contamination at Current or Formerly Owned Facilities, Which Could Have a Material Adverse effect on Our Results of Operations and Financial ConditionWe may be subject to liability under environmental laws for the costs of remediating environmental contamination of property now or formerly owned or operated by us and of property contaminated by hazardous substances that we may have generated regardless of whether the liabilities arose before, during or after the time we owned or operated the facilities. We are currently involved in a number of proceedings relating to sites where hazardous substances have been released and we may be subject to additional proceedings in the future. We also have current or previous ownership interests in sites associated with the production of gas and the production and delivery of electricity for which we may be liable for additional costs related to investigation, remediation and monitoring of these sites. Remediation activities associated with our former MGP operations are one source of such costs. Citizen groups or others may bring litigation over environmental issues including claims of various types, such as property damage, personal injury, and citizen challenges to compliance decisions on the enforcement of environmental requirements, such as opacity and other air quality standards, which could subject us to penalties, injunctive relief and the cost of litigation. We cannot predict the amount and timing of all future expenditures (including the potential or magnitude of fines or penalties) related to such environmental matters, although we expect that they could be material. In addition, there can be no assurance that any liabilities, losses or expenditures we may incur related to such environmental liabilities or contamination will be covered under any applicable insurance policies or that the amount of insurance will be adequate.In some cases, a third party who has acquired assets from us has assumed the liability we may otherwise have for environmental matters related to the transferred property. If the transferee fails to discharge the assumed liability or disputes its responsibility, a regulatory authority or injured person could attempt to hold us responsible, and our remedies against the transferee may be limited by the financial resources of the transferee.15The Risks Associated with Climate Change May Have an Adverse Impact on Our Business Operations, Financial Condition and Cash FlowsPhysical risks of climate change, such as more frequent or more extreme weather events, changes in temperature and precipitation patterns, and other related phenomena, could affect some, or all, of our operations. Severe weather or other natural disasters could be destructive, which could result in increased costs, including supply chain costs. An extreme weather event within the Utilities' service areas can also directly affect their capital assets, causing disruption in service to customers due to downed wires and poles or damage to other operating equipment. Further, as extreme weather conditions increase system stress, we may incur costs relating to additional system backup or service interruptions, and in some instances, we may be unable to recover such costs. For all of these reasons, these physical risks could have an adverse financial impact on our business operations, financial condition and cash flows. Climate change poses other financial risks as well. To the extent weather conditions are affected by climate change, customers’ energy use could increase or decrease depending on the duration and magnitude of the changes. Increased energy use due to weather changes may require us to invest in additional system assets and purchase additional power. Additionally, decreased energy use due to weather changes may affect our financial condition through decreased rates, revenues, margins or earnings.We Could be Exposed to Private Rights of Action Relating to Environmental Matters Seeking Damages Under Various State and Federal Law Theories Which Could Have an Adverse Impact on Our Results of Operations, Financial Condition, Cash Flows and Business OperationsPrivate individuals may seek to enforce environmental laws and regulations against us and could allege personal injury, property damages or other relief. For example, claims have been made against certain energy companies alleging that CO2 emissions from power generating facilities constitute a public nuisance under federal and/or state common law. While FirstEnergy is not a party to this litigation, it, and/or one of its subsidiaries, could be named in other actions making similar allegations. An unfavorable ruling in any such case could result in the need to make modifications to our coal-fired plants or reduce emissions, suspend operations or pay money damages or penalties. Adverse rulings in these or other types of actions could have an adverse impact on our results of operations, cash flows and financial condition and could significantly impact our business operations.We Are and May Become Subject to Legal Claims Arising from the Presence of Asbestos or Other Regulated Substances at Some of Our Facilities that May Have an Adverse Impact on our Business Operations, Financial Condition and Cash FlowsWe have been named as a defendant in pending asbestos litigations involving multiple plaintiffs and multiple defendants, in several states. The majority of these claims arise out of alleged past exposures by contractors (and in Pennsylvania, former employees) at both currently and formerly owned electric generation plants. In addition, asbestos and other regulated substances are, and may continue to be, present at currently owned facilities where suitable alternative materials are not available. We believe that any remaining asbestos at our facilities is contained and properly identified in accordance with applicable governmental regulations, including OSHA. The continued presence of asbestos and other regulated substances at these facilities, however, could result in additional actions being brought against us. This is further complicated by the fact that many diseases, such as mesothelioma and cancer, have long latency periods in which the disease process develops, thus making it impossible to accurately predict the types and numbers of such claims in the near future. While insurance coverages exist for many of these pending asbestos litigations, others have no such coverages, resulting in FirstEnergy being responsible for all defense expenditures, as well as any settlements or verdict payouts.Risks Related to Business Operations GenerallyTemperature Variations as well as Severe Weather Conditions or other Natural Disasters Could Have an Adverse Impact on Our Results of Operations and Financial ConditionWeather conditions directly influence the demand for electric power. Demand for power generally peaks during the summer and winter months, with market prices also typically peaking at that time. Overall operating results may fluctuate based on weather conditions. In addition, we have historically sold less power, and consequently received less revenue, when weather conditions are milder. Severe weather, such as tornadoes, hurricanes, ice or snowstorms, droughts, high winds or other natural disasters, may cause outages and property damage that may require us to incur additional costs that are generally not insured and that may not be recoverable from customers. The effect of the failure of our facilities to operate as planned under these conditions would be particularly burdensome during a peak demand period and could have an adverse effect on our financial condition and results of operations.We Are Subject to Financial Performance Risks from Regional and General Economic Cycles as Well as Heavy Industries such as Shale Gas, Automotive and SteelOur business follows economic cycles. Economic conditions impact the demand for electricity and declines in the demand for electricity will reduce our revenues. The regional economy in which our Utilities operate is influenced by conditions in industries 16in our business territories, e.g. shale gas, automotive, chemical, steel and other heavy industries, and as these conditions change, our revenues will be impacted.We Are Subject to Risks Arising from the Operation of Our Power Plants and Transmission and Distribution Equipment Which Could Reduce Revenues, Increase Expenses and Have a Material Adverse Effect on Our Business, Financial Condition and Results of OperationsOperation of generation, transmission and distribution facilities involves risk, including the risk of potential breakdown or failure of equipment or processes due to aging infrastructure, fuel supply or transportation disruptions, accidents, labor disputes or work stoppages by employees, human error in operations or maintenance, acts of terrorism or sabotage, construction delays or cost overruns, shortages of or delays in obtaining equipment, material and labor, operational restrictions resulting from environmental requirements and governmental interventions, and performance below expected levels. In addition, weather-related incidents and other natural disasters can disrupt generation, transmission and distribution delivery systems. Because our transmission facilities are interconnected with those of third parties, the operation of our facilities could be adversely affected by unexpected or uncontrollable events occurring on the systems of such third parties.Failure to Provide Safe and Reliable Service and Equipment Could Result in Serious Injury or Loss of Life That May Harm Our Business Reputation and Adversely Affect Our Operating ResultsWe are committed to provide safe and reliable service and equipment in our franchised service territories. Meeting this commitment requires the expenditure of significant capital resources. However, our employees, contractors and the general public may be exposed to dangerous environments due to the nature of our operations. Failure to provide safe and reliable service and equipment due to various factors, including equipment failure, accidents and weather, could result in serious injury or loss of life that may harm our business reputation and adversely affect our operating results through reduced revenues, increased capital and operating costs, litigation or the imposition of penalties/fines or other adverse regulatory outcomes.Cyber-Attacks, Data Security Breaches and Other Disruptions to Our Information Technology Systems Could Compromise Our Business Operations, Critical and Proprietary Information and Employee and Customer Data, Which Could Have a Material Adverse Effect on Our Business, Results of Operations, Financial Condition and ReputationIn the ordinary course of our business, we depend on information technology systems that utilize sophisticated operational systems and network infrastructure to run all facets of our generation, transmission and distribution services. Additionally, we store sensitive data, intellectual property and proprietary or personally identifiable information regarding our business, employees, shareholders, customers, suppliers, business partners and other individuals in our data centers and on our networks. The secure maintenance of information and information technology systems is critical to our operations.Over the last several years, there has been an increase in the frequency of cyber-attacks by terrorists, hackers, international activist organizations, countries and individuals. These and other unauthorized parties may attempt to gain access to our network systems or facilities, or those of third parties with whom we do business in many ways, including directly through our network infrastructure or through fraud, trickery, or other forms of deceiving our employees, contractors and temporary staff. Additionally, our information and information technology systems may be increasingly vulnerable to data security breaches, damage and/or interruption due to viruses, human error, malfeasance, faulty password management or other malfunctions and disruptions. Further, hardware, software, or applications we develop or procure from third parties may contain defects in design or manufacture or other problems that could unexpectedly compromise information and/or security.Despite security measures and safeguards we have employed, including certain measures implemented pursuant to mandatory NERC Critical Infrastructure Protection standards, our infrastructure may be increasingly vulnerable to such attacks as a result of the rapidly evolving and increasingly sophisticated means by which attempts to defeat our security measures and gain access to our information technology systems may be made. Also, we may be at an increased risk of a cyber-attack and/or data security breach due to the nature of our business.Any such cyber-attack, data security breach, damage, interruption and/or defect could: (i) disable our generation, transmission (including our interconnected regional transmission grid) and/or distribution services for a significant period of time; (ii) delay development and construction of new facilities or capital improvement projects; (iii) adversely affect our customer operations; (iv) corrupt data; and/or (v) result in unauthorized access to the information stored in our data centers and on our networks, including, company proprietary information, supplier information, employee data, and personal customer data, causing the information to be publicly disclosed, lost or stolen or result in incidents that could result in economic loss and liability and harmful effects on the environment and human health, including loss of life. Additionally, because our generation, transmission and distribution services are part of an interconnected system, disruption caused by a cybersecurity incident at another utility, electric generator, RTO, or commodity supplier could also adversely affect our operations.Although we maintain cyber insurance and property and casualty insurance, there can be no assurance that liabilities or losses we may incur, including as a result of cybersecurity-related litigation, will be covered under such policies or that the amount of insurance will be adequate. Further, as cyber threats become more difficult to detect and successfully defend against, there can 17be no assurance that we can implement adequate preventive measures, accurately assess the likelihood of a cyber-incident or quantify potential liabilities or losses. Also, we may not discover any data security breach and loss of information for a significant period of time after the data security breach occurs.For all of these reasons, any such cyber incident could result in significant lost revenue, the inability to conduct critical business functions and serve customers for a significant period of time, the use of significant management resources, legal claims or proceedings, regulatory penalties, significant remediation costs, increased regulation, increased capital costs, increased protection costs for enhanced cybersecurity systems or personnel, damage to our reputation and/or the rendering of our internal controls ineffective, all of which could materially adversely affect our business, results of operations, financial condition and reputation.Physical Acts of War, Terrorism or Other Attacks on any of Our Facilities or Other Infrastructure Could Have an Adverse Effect on Our Business, Results of Operations, Cash Flows and Financial ConditionAs a result of the continued threat of physical acts of war, terrorism, or other attacks in the United States, our electric generation, fuel storage, transmission and distribution facilities and other infrastructure, including power plants, transformer and high voltage lines and substations, or the facilities or other infrastructure of an interconnected company, could be direct targets of, or indirect casualties of, an act of war, terrorism, or other attack, which could result in disruption of our ability to generate, purchase, transmit or distribute electricity for a significant period of time, otherwise disrupt our customer operations and/or result in incidents that could result in harmful effects on the environment and human health, including loss of life. Any such disruption or incident could result in a significant decrease in revenue, significant additional capital and operating costs, including costs to implement additional security systems or personnel to purchase electricity and to replace or repair our assets over and above any available insurance reimbursement, higher insurance deductibles, higher premiums and more restrictive insurance policies, legal claims or proceedings, greater regulation with higher attendant costs, generally, and significant damage to our reputation, which could have a material adverse effect on our business, results of operations, cash flows and financial condition.Capital Improvements and Construction Projects May Not be Completed Within Forecasted Budget, Schedule or Scope Parameters or Could be Canceled Which Could Adversely Affect Our Business and Results of OperationsOur business plan calls for execution of extensive capital investments in transmission and distribution, including but not limited to our Energizing the Future transmission expansion program. We also anticipate spending up to $1.7 billion per year in distribution capital expenditures through 2023. We may be exposed to the risk of substantial price increases in, or the adequacy or availability of, the costs of labor and materials used in construction, nonperformance of equipment and increased costs due to delays, including delays relating to the procurement of permits or approvals, adverse weather or environmental matters. We engage numerous contractors and enter into a large number of construction agreements to acquire the necessary materials and/or obtain the required construction-related services. As a result, we are also exposed to the risk that these contractors and other counterparties could breach their obligations to us. Such risk could include our contractors’ inabilities to procure sufficient skilled labor as well as potential work stoppages by that labor force. Should the counterparties to these arrangements fail to perform, we may be forced to enter into alternative arrangements at then-current market prices that may exceed our contractual prices, with resulting delays in those and other projects. Although our agreements are designed to mitigate the consequences of a potential default by the counterparty, our actual exposure may be greater than these mitigation provisions. Also, because we enter into construction agreements for the necessary materials and to obtain the required construction related services, any cancellation by FirstEnergy of a construction agreement could result in significant termination payments or penalties. Any delays, increased costs or losses or cancellation of a construction project could adversely affect our business and results of operations, particularly if we are not permitted to recover any such costs in rates.The Outcome of Litigation, Arbitration, Mediation, and Similar Proceedings Involving Our Business, or That of One or More of Our Operating Subsidiaries, Is Unpredictable and an Adverse Decision in Any Material Proceeding Could Have a Material Adverse Effect on Our Financial Condition and Results of OperationsWe are involved in a number of litigation, arbitration, mediation, and similar proceedings. These and other matters may divert financial and management resources that would otherwise be used to benefit our operations. Further, no assurances can be given that the resolution of these matters will be favorable to us. If certain matters were ultimately resolved unfavorably to us, the results of operations and financial condition of FirstEnergy could be materially adversely impacted.In addition, we are sometimes subject to investigations and inquiries by various state and federal regulators due to the heavily regulated nature of our industry. Any material inquiry or investigation could potentially result in an adverse ruling against us, which could have a material adverse impact on our financial condition and operating results.We Face Certain Human Resource Risks Associated with Potential Labor Disruptions and/or With the Availability of Trained and Qualified Labor to Meet Our Future Staffing RequirementsWe are continually challenged to find ways to balance the retention of our aging skilled workforce while recruiting new talent to mitigate losses in critical knowledge and skills due to retirements. Additionally, a significant number of our physical workforce are 18represented by unions. While we believe that our relations with our employees are generally fair, we cannot provide assurances that the company will be completely free of labor disruptions such as work stoppages, work slowdowns, union organizing campaigns, strikes, lockouts or that any labor disruption will be favorably resolved. Mitigating these risks could require additional financial commitments and the failure to prevent labor disruptions and retain and/or attract trained and qualified labor could have an adverse effect on our business.Significant Increases in Our Operation and Maintenance Expenses, Including Our Health Care and Pension Costs, Could Adversely Affect Our Future Earnings and LiquidityWe continually focus on limiting, and reducing where possible, our operation and maintenance expenses. However, we expect to continue to face increased cost pressures related to operation and maintenance expenses, including in the areas of health care and pension costs. We have experienced health care cost inflation in recent years, and we expect our cash outlay for health care costs, including prescription drug coverage, to continue to increase despite measures that we have taken requiring employees and retirees to bear a higher portion of the costs of their health care benefits. The measurement of our expected future health care and pension obligations and costs is highly dependent on a variety of assumptions, many of which relate to factors beyond our control. These assumptions include investment returns, interest rates, discount rates, health care cost trends, benefit design changes, salary increases, the demographics of plan participants and regulatory requirements. While we anticipate that our operation and maintenance expenses will continue to increase, if actual results differ materially from our assumptions, our costs could be significantly higher than expected which could adversely affect our results of operations, financial condition and liquidity.Changes in Technology and Regulatory Policies May Make Our Facilities Significantly Less Competitive and Adversely Affect Our Results of OperationsTraditionally, electricity is generated at large, central station generation facilities. This method results in economies of scale and lower unit costs than newer generation technologies such as fuel cells, microturbines, windmills and photovoltaic solar cells. It is possible that advances in newer generation technologies will make newer generation technologies more cost-effective, or that changes in regulatory policy will create benefits that otherwise make these newer generation technologies even more competitive with central station electricity production. To the extent that newer generation technologies are connected directly to load, bypassing the transmission and distribution systems, potential impacts could include decreased transmission and distribution revenues, stranded assets and increased uncertainty in load forecasting and integrated resource planning and could adversely affect our business and results of operations.Energy Companies are Subject to Adverse Publicity Causing Less Favorable Regulatory and Legislative Outcomes Which Could have an Adverse Impact on Our BusinessEnergy companies, including the Utilities and Transmission Companies, have been the subject of criticism on matters including the reliability of their distribution services and the speed with which they are able to respond to power outages, such as those caused by storm damage. Adverse publicity of this nature, as well as negative publicity associated with the operation or bankruptcy of nuclear and/or coal-fired facilities or proceedings seeking regulatory recoveries may cause less favorable legislative and regulatory outcomes and damage our reputation, which could have an adverse impact on our business.Risks Associated with Markets and Financial MattersInterest Rates and/or a Credit Rating Downgrade Could Negatively Affect Our or Our Subsidiaries' Financing Costs, Ability to Access Capital and Requirement to Post CollateralWe have near-term exposure to interest rates from outstanding indebtedness indexed to variable interest rates, and we have exposure to future interest rates to the extent we seek to raise debt in the capital markets to meet maturing debt obligations and fund construction or other investment opportunities. Past disruptions in capital and credit markets have resulted in higher interest rates on new publicly issued debt securities, increased costs for certain of our variable interest rate debt securities and failed remarketing of variable interest rate tax-exempt debt issued to finance certain of our facilities. Similar future disruptions could increase our financing costs and adversely affect our results of operations. Also, interest rates could change as a result of economic or other events that are beyond our risk management processes. As a result, we cannot always predict the impact that our risk management decisions may have if actual events lead to greater losses or costs that our risk management positions were intended to hedge. Although we employ risk management techniques to hedge against interest rate volatility, significant and sustained increases in market interest rates could materially increase our financing costs and negatively impact our reported results of operations.We rely on access to bank and capital markets as sources of liquidity for cash requirements not satisfied by cash from operations. Additional downgrades in FirstEnergy or FirstEnergy subsidiaries' credit ratings from the nationally recognized credit rating agencies, particularly to levels below investment grade, could negatively affect our ability to access the bank and capital markets, especially in a time of uncertainty in either of those markets, and may require us to post cash collateral to support outstanding commodity positions in the wholesale market, as well as available letters of credit and other guarantees. Furthermore, additional downgrades could increase the cost of such capital by causing us to incur higher interest rates and fees 19associated with such capital. Additional rating downgrades would further increase our interest expense on certain of FirstEnergy's long-term debt obligations and would also further increase the fees we pay on our various existing credit facilities, thus increasing the cost of our working capital. Such additional rating downgrades could also negatively impact our ability to grow our regulated businesses or execute on our business strategies by substantially increasing the cost of, or limiting access to, capital.In addition, events related to the ongoing government investigations may expose us to higher interest rates for additional indebtedness, whether as a result of ratings downgrades or otherwise, and could restrict our ability to obtain additional or replacement financing on acceptable terms or at all. See “Failure to Comply with Debt Covenants in our Credit Agreements or Conditions Could Adversely Affect our Ability to Execute Future Borrowings and/or Require Early Repayment, and Could Restrict our Ability to Obtain Additional or Replacement Financing on Acceptable Terms or at All.”Financial Risks Associated with Owning Coal-Fired Generation may have an Adverse Impact on our Business Operations, Financial Condition and Cash Flows86% of MP's generation fleet, totaling 3,093 MWs, is coal-fired. Recently, certain members of the investment community have adopted investment policies promoting the divestment of coal-fired generation or otherwise limiting new investments in coal-fired generation. The impact of such efforts may adversely affect the demand for and price of our common stock and impact our and MP's access to the capital and financial markets. Further, certain insurance companies have established policies limiting coal-related underwriting and investment. Consequently, these policies aimed at coal-fired generation could have a material adverse impact on our business operations, financial condition, and cash flows. Our Results of Operations and Financial Condition May be Adversely Affected by the Volatility in Pension and OPEB Expenses Due to Capital Market Performance and Other Changes FirstEnergy recognizes in income the change in the fair value of plan assets and net actuarial gains and losses for its pension and OPEB plans. This adjustment is recognized in the fourth quarter of each year and whenever a plan is determined to qualify for a remeasurement, resulting in greater volatility in pension and OPEB expenses and may materially impact our results of operations.Our financial statements reflect the values of the assets held in trust to satisfy our obligations under pension and OPEB plans. Certain of the assets held in these trusts do not have readily determinable market values. Changes in the estimates and assumptions inherent in the value of these assets could affect the value of the trusts. If the value of the assets held by the trusts declines by a material amount, our funding obligation to the trusts could materially increase. These assets are subject to market fluctuations and will yield uncertain returns, which may fall below our projected return rates. Forecasting investment earnings and costs to pay future pension and other obligations requires significant judgment and actual results may differ significantly from current estimates. Capital market conditions that generate investment losses or that negatively impact the discount rate and increase the present value of liabilities may have significant impacts on the value of the pension and other trust funds, which could require significant additional funding and negatively impact our results of operations and financial position.In the Event of Volatility or Unfavorable Conditions in the Capital and Credit Markets, Our Business, Including the Immediate Availability and Cost of Short-Term Funds for Liquidity Requirements, Our Ability to Meet Long-Term Commitments and the Competitiveness and Liquidity of Energy Markets May be Adversely Affected, Which Could Negatively Impact Our Results of Operations, Cash Flows and Financial ConditionWe rely on the capital markets to meet our financial commitments and short-term liquidity needs if internal funds are not available from our operations. We also use letters of credit provided by various financial institutions to support our hedging operations. We also deposit cash in short-term investments. In the event of volatility in the capital and credit markets, our ability to draw on our credit facilities and cash may be adversely affected. Our access to funds under those credit facilities is dependent on the ability of the financial institutions that are parties to the facilities to meet their funding commitments. Those institutions may not be able to meet their funding commitments if they experience shortages of capital and liquidity or if they experience excessive volumes of borrowing requests within a short period of time. Any delay in our ability to access those funds, even for a short period of time, could have a material adverse effect on our results of operations and financial condition.Should there be fluctuations in the capital and credit markets as a result of uncertainty, changing or increased regulation, reduced alternatives or failures of significant foreign or domestic financial institutions or foreign governments, our access to liquidity needed for our business could be adversely affected. Unfavorable conditions could require us to take measures to conserve cash until the markets stabilize or until alternative credit arrangements or other funding for our business needs can be arranged. Such measures could include deferring capital expenditures, changing hedging strategies to reduce collateral-posting requirements, and reducing or eliminating future dividend payments or other discretionary uses of cash.Energy markets depend heavily on active participation by multiple counterparties, which could be adversely affected should there be disruptions in the capital and credit markets. Reduced capital and liquidity and failures of significant institutions that participate in the energy markets could diminish the liquidity and competitiveness of energy markets that are important to our business. Perceived weaknesses in the competitive strength of the energy markets could lead to pressures for greater regulation of those 20markets or attempts to replace those market structures with other mechanisms for the sale of power, including the requirement of long-term contracts, which could have a material adverse effect on our results of operations and cash flows.Our Use of Non-Derivative and Derivative Contracts to Mitigate Risks Could Result in Financial Losses That May Negatively Impact Our Financial ResultsWe may use a variety of non-derivative and derivative instruments, such as swaps, options, futures and forwards, to manage our financial market risks. In the absence of actively quoted market prices and pricing information from external sources, the valuation of some of these derivative instruments involves management’s judgment or use of estimates. As a result, changes in the underlying assumptions or use of alternative valuation methods could affect the reported fair value of some of these contracts. Also, we could recognize financial losses as a result of volatility in the market value of these contracts if a counterparty fails to perform or if there is limited liquidity of these contracts in the market.The Anticipated Phasing Out of LIBOR after 2021 Could Adversely Affect our Financial ResultsA portion of FirstEnergy’s indebtedness bears interest at fluctuating interest rates, primarily based on LIBOR. LIBOR tends to fluctuate based on general interest rates, rates set by the U.S. Federal Reserve and other central banks, the supply of and demand for credit in the London interbank market and general economic conditions. FirstEnergy has not hedged its interest rate exposure with respect to its floating rate debt. Accordingly, FirstEnergy’s interest expense for any particular period will fluctuate based on LIBOR and other variable interest rates. On July 27, 2017, the Financial Conduct Authority (the authority that regulates LIBOR) announced that it intends to stop compelling banks to submit rates for the calculation of LIBOR after 2021. It is unclear whether new methods of calculating LIBOR will be established such that it continues to exist after 2021, and there is considerable uncertainty regarding the publication of LIBOR beyond 2021. The U.S. Federal Reserve, in conjunction with the Alternative Reference Rates Committee, is considering replacing U.S. dollar LIBOR with a newly created index (the secured overnight financing rate or SOFR), calculated based on repurchase agreements backed by treasury securities. It is not possible to predict the effect of these changes, other reforms or the establishment of alternative reference rates in the United Kingdom, the United States or elsewhere. To the extent these interest rates increase, interest expense will increase. If sources of capital for FirstEnergy are reduced, capital costs could increase materially. Restricted access to capital markets and/or increased borrowing costs could have an adverse effect on our results of operations, cash flows, financial condition and liquidity. We Must Rely on Cash from Our Subsidiaries and Any Restrictions on The Utilities and Transmission Companies’ Ability to Pay Dividends or Make Cash Payments to Us May Adversely Affect Our Cash Flows and Financial ConditionWe are a holding company and our investments in our subsidiaries are our primary assets. Substantially all of our business is conducted by our subsidiaries. Consequently, our cash flow, including our ability to pay dividends and service debt, is dependent on the operating cash flows of our subsidiaries and their ability to upstream cash to the holding company. Any inability of our subsidiaries to pay dividends or make cash payments to us may adversely affect our cash flows and financial condition.Additionally, the Utilities and Transmission Companies are regulated by various state utility and federal commissions that generally possess broad powers to ensure that the needs of utility customers are being met. Those state and federal commissions could attempt to impose restrictions on the ability of the Utilities and Transmission Companies to pay dividends or otherwise restrict cash payments to us.We Cannot Assure Common Shareholders that Future Dividend Payments Will be Made, or if Made, in What Amounts They May be PaidOur Board of Directors will continue to regularly evaluate our common stock dividend and determine whether to declare a dividend, and an appropriate amount thereof, each quarter taking into account such factors as, among other things, our earnings, financial condition and cash flows from subsidiaries, as well as general economic and competitive conditions. We cannot assure common shareholders that dividends will be paid in the future, or that, if paid, dividends will be at the same amount or with the same frequency as in the past.Certain FirstEnergy Companies Have Guaranteed the Performance of Third Parties, Which May Result in Substantial Costs or the Incurrence of Additional Debt and Adversely Affect Our Results of Operations, Cash Flows and Financial ConditionCertain FirstEnergy companies have issued guarantees of the performance of others, which obligates such FirstEnergy companies to perform in the event that the third parties do not perform. For instance, FE is a guarantor under a syndicated senior secured term loan facility, under which Global Holding's outstanding principal balance is approximately $108 million at December 31, 2020. In the event of non-performance by the third parties, FirstEnergy could incur substantial cost to fulfill this obligation and other obligations under such guarantees. Such performance guarantees could have a material adverse impact on our financial position and operating results.Additionally, with respect to FEV's investment in Global Holding, it could require additional capital from its owners, including FEV, to fund operations and meet its obligations under its term loan facility. These capital requirements could be significant and if other partners do not fund the additional capital, resulting in FEV increasing its equity ownership and obtaining the ability to direct the 21significant activities of Global Holding, FEV may be required to consolidate Global Holding, increasing FirstEnergy's debt by $108 million.The Tax Characterization of Our Distributions to Shareholders Will FluctuateWhen we make distributions to shareholders, we are required to subsequently determine and report the tax characterization of those distributions for purposes of shareholders’ income taxes. Whether a distribution is characterized as a dividend or a return of capital (and possible capital gain) depends upon an internal tax calculation to determine earnings and profits for income tax purposes (E&P). E&P should not be confused with earnings or net income under GAAP. Further, after we report the expected tax characterization of distributions we have paid, the actual characterization could vary from our expectation with the result that holders of our common stock could incur different income tax liabilities than expected.In general, distributions are characterized as dividends to the extent the amount of such distributions do not exceed our calculation of current or accumulated E&P. Distributions in excess of current and accumulated E&P may be treated as a non-taxable return of capital. Generally, a non-taxable return of capital will reduce an investor’s basis in our stock for federal tax purposes, which will impact the calculation of gain or loss when the stock is sold.Our internal calculation of E&P can be impacted by a variety of factors. FirstEnergy exhausted its accumulated E&P in the second half of the 2019 tax year. This elimination of accumulated E&P will make it more likely that at least a portion of our current or future distributions will be characterized for shareholders’ tax purposes as a return of capital. Upon such characterization, shareholders are urged to consult their own tax advisors regarding the income tax treatment of our distributions to them.ITEM 1B. UNRESOLVED STAFF COMMENTSNone.ITEM 2. PROPERTIESThe first mortgage indentures for the Ohio Companies, Penn, MP, PE and WP constitute direct first liens on substantially all of the respective physical property, subject only to excepted encumbrances, as defined in the first mortgage indentures. See Note 11, "Capitalization," of the Notes to Consolidated Financial Statements for information concerning financing encumbrances affecting certain of the Utilities’ properties.FirstEnergy controls the following generation sources as of December 31, 2020, shown in the table below. Except for the OVEC participation referenced in the footnotes to the table, the Regulated Distribution segment generating units are owned by either JCP&L or MP.Plant (Location)UnitTotalCorp/OtherRegulated DistributionNet Demonstrated Capacity (MW)Super-critical Coal-fired: Harrison (Haywood, WV)1-31,984 — 1,984 Fort Martin (Maidsville, WV)1-21,098 — 1,098 3,082 — 3,082 Sub-critical and Other Coal-fired:OVEC (Cheshire, OH) (Madison, IN)1-1178 (1)67 11 Pumped-storage Hydro: Bath County (Warm Springs, VA)1-6487 (2)— 487 Yards Creek (Blairstown Twp., NJ)1-3210 (3)— 210 697 — 697 Total 3,857 67 3,790 (1)Represents AE Supply's 3.01% and MP's 0.49% entitlement based on their participation in OVEC.(2)Represents AGC's 16.25% undivided interest in Bath County. The station is operated by VEPCO.(3)Represents JCP&L’s 50% ownership interest, which is being sold pursuant to an asset purchase agreement dated April 6, 2020, with the sale anticipated being completed in the first quarter of 2021.The above generating plants and load centers are connected by a transmission system with various voltage ratings ranging from 23 kV to 500 kV. FirstEnergy's overhead and underground transmission lines aggregate 24,035 circuit miles.The Utilities’ electric distribution systems include 272,531 miles of overhead pole line and underground conduit carrying primary, secondary and street lighting circuits. FirstEnergy owns substations with a total installed transformer capacity of 155,920,348 kV-amperes.All of FirstEnergy's transmission, distribution and generation assets operate in PJM.22FirstEnergy’s distribution and transmission systems as of December 31, 2020, consist of the following:DistributionLines(1)TransmissionLines(1)SubstationTransformerCapacity(2)kV AmperesOE67,852 — 7,202,811 Penn13,644 — 915,584 CEI33,073 — 9,219,531 TE19,141 — 2,723,706 JCP&L23,750 2,595 21,326,473 ME19,014 — 4,765,730 PN27,716 — 6,694,735 ATSI(3)— 7,894 38,131,082 WP25,114 4,322 14,298,948 MP22,616 2,611 13,213,643 PE20,611 2,086 10,537,204 TrAIL— 262 13,835,000 MAIT— 4,265 13,055,901 Total272,531 24,035 155,920,348 (1)Circuit Miles(2)Top rating of in-service power transformers only. Excludes grounding banks, station power transformers, and generator and customer-owned transformers.(3)Represents transmission line assets of 69 kV and greater located in the service territories of the Ohio Companies and Penn.ITEM 3. LEGAL PROCEEDINGSReference is made to Note 14, "Regulatory Matters," and Note 15, "Commitments, Guarantees and Contingencies," of the Notes to Consolidated Financial Statements for a description of certain legal proceedings involving FirstEnergy.ITEM 4. MINE SAFETY DISCLOSURESNot applicable.PART IIITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIESCOMMON STOCKThe common stock of FirstEnergy Corp. is listed on the New York Stock Exchange under the symbol “FE” and is traded on other registered exchanges.HOLDERS OF COMMON STOCKThere were 67,527 holders of 543,117,533 shares of FE’s common stock as of December 31, 2020, and 67,252 holders of 543,215,090 shares of FE's common stock as of January 31, 2021. We have historically paid quarterly cash dividends on our common stock. Dividend payments are subject to declaration by the Board and future dividend decisions determined by the Board may be impacted by earnings growth, cash flows, credit metrics and other business conditions. Information regarding retained earnings available for payment of cash dividends is given in Note 11, "Capitalization," of the Notes to Consolidated Financial Statements.23SHAREHOLDER RETURNThe following graph shows the total cumulative return from a $100 investment on December 31, 2015, in FE’s common stock compared with the total cumulative returns of EEI’s Index of Investor-Owned Electric Utility Companies and the S&P 500. FirstEnergy had no transactions regarding purchases of FE common stock during the fourth quarter of 2020.FirstEnergy does not have any publicly announced plan or program for share purchases.ITEM 6. [RESERVED]24ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSForward-Looking Statements: This Form 10-K includes forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 based on information currently available to management. Such statements are subject to certain risks and uncertainties and readers are cautioned not to place undue reliance on these forward-looking statements. These statements include declarations regarding management's intents, beliefs and current expectations. These statements typically contain, but are not limited to, the terms “anticipate,” “potential,” “expect,” "forecast," "target," "will," "intend," “believe,” "project," “estimate," "plan" and similar words. Forward-looking statements involve estimates, assumptions, known and unknown risks, uncertainties and other factors that may cause actual results, performance or achievements to be materially different from any future results, performance or achievements expressed or implied by such forward-looking statements, which may include the following (see Glossary of Terms for definitions of capitalized terms):•The results of the ongoing internal investigation matters and evaluation of our controls framework and remediation of our material weakness in internal control over financial reporting.•The risks and uncertainties associated with government investigations regarding HB 6 and related matters including potential adverse impacts on federal or state regulatory matters including, but not limited to, matters relating to rates.•The risks and uncertainties associated with litigation, arbitration, mediation and similar proceedings.•Legislative and regulatory developments, including, but not limited to, matters related to rates, compliance and enforcement activity.•The ability to accomplish or realize anticipated benefits from strategic and financial goals, including, but not limited to, maintaining financial flexibility, overcoming current uncertainties and challenges associated with the ongoing governmental investigations, executing our transmission and distribution investment plans, controlling costs, improving our credit metrics, strengthening our balance sheet and growing earnings.•Economic and weather conditions affecting future operating results, such as a recession, significant weather events and other natural disasters, and associated regulatory events or actions in response to such conditions.•Mitigating exposure for remedial activities associated with retired and formerly owned electric generation assets.•The extent and duration of COVID-19 and the impacts to our business, operations and financial condition resulting from the outbreak of COVID-19 including, but not limited to, disruption of businesses in our territories, volatile capital and credit markets, legislative and regulatory actions, the effectiveness of our pandemic and business continuity plans, the precautionary measures we are taking on behalf of our customers, contractors and employees, our customers’ ability to make their utility payment and the potential for supply-chain disruptions.•The potential of non-compliance with debt covenants in our credit facilities due to matters associated with the government investigations regarding HB 6 and related matters.•The ability to access the public securities and other capital and credit markets in accordance with our financial plans, the cost of such capital and overall condition of the capital and credit markets affecting us, including the increasing number of financial institutions evaluating the impact of climate change on their investment decisions. •Actions that may be taken by credit rating agencies that could negatively affect either our access to or terms of financing or our financial condition and liquidity.•Changes in assumptions regarding economic conditions within our territories, the reliability of our transmission and distribution system, or the availability of capital or other resources supporting identified transmission and distribution investment opportunities.•Changes in customers’ demand for power, including, but not limited to, the impact of climate change or energy efficiency and peak demand reduction mandates.•Changes in national and regional economic conditions affecting us and/or our major industrial and commercial customers or others with which we do business.•The risks associated with cyber-attacks and other disruptions to our information technology system, which may compromise our operations, and data security breaches of sensitive data, intellectual property and proprietary or personally identifiable information.•The ability to comply with applicable reliability standards and energy efficiency and peak demand reduction mandates.•Changes to environmental laws and regulations, including, but not limited to, those related to climate change.•Changing market conditions affecting the measurement of certain liabilities and the value of assets held in our pension trusts and other trust funds, or causing us to make contributions sooner, or in amounts that are larger, than currently anticipated.•Labor disruptions by our unionized workforce.•Changes to significant accounting policies.•Any changes in tax laws or regulations, or adverse tax audit results or rulings.•The risks and other factors discussed from time to time in our SEC filings.Dividends declared from time to time on our common stock during any period may in the aggregate vary from prior periods due to circumstances considered by our Board of Directors at the time of the actual declarations. A security rating is not a recommendation to buy or hold securities and is subject to revision or withdrawal at any time by the assigning rating agency. Each rating should be evaluated independently of any other rating.25These forward-looking statements are also qualified by, and should be read together with, the risk factors included in (a) Item 1A. Risk Factors, (b) Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations, and (c) other factors discussed herein and in FirstEnergy's other filings with the SEC. The foregoing review of factors also should not be construed as exhaustive. New factors emerge from time to time, and it is not possible for management to predict all such factors, nor assess the impact of any such factor on our business or the extent to which any factor, or combination of factors, may cause results to differ materially from those contained in any forward-looking statements. We expressly disclaim any obligation to update or revise, except as required by law, any forward-looking statements contained herein or in the information incorporated by reference as a result of new information, future events or otherwise.26FIRSTENERGY CORP.MANAGEMENT’S DISCUSSION AND ANALYSIS OFFINANCIAL CONDITION AND RESULTS OF OPERATIONSFIRSTENERGY’S BUSINESSFE and its subsidiaries are principally involved in the transmission, distribution and generation of electricity through its reportable segments, Regulated Distribution and Regulated Transmission.The Regulated Distribution segment distributes electricity through FirstEnergy’s ten utility operating companies, serving approximately six million customers within 65,000 square miles of Ohio, Pennsylvania, West Virginia, Maryland, New Jersey and New York, and purchases power for its POLR, SOS, SSO and default service requirements in Ohio, Pennsylvania, New Jersey and Maryland. This segment also controls 3,790 MWs of regulated electric generation capacity located primarily in West Virginia, Virginia and New Jersey, of which, 210 MWs are related to the Yards Creek generating station that is being sold pursuant to an asset purchase agreement as further discussed below. The segment's results reflect the costs of securing and delivering electric generation from transmission facilities to customers, including the deferral and amortization of certain related costs.The service areas of, and customers served by, FirstEnergy's regulated distribution utilities as of December 31, 2020, are summarized below:CompanyArea ServedCustomers Served (In thousands)OECentral and Northeastern Ohio1,060 PennWestern Pennsylvania169 CEINortheastern Ohio755 TENorthwestern Ohio314 JCP&LNorthern, Western and East Central New Jersey1,147 MEEastern Pennsylvania580 PNWestern Pennsylvania and Western New York588 WPSouthwest, South Central and Northern Pennsylvania734 MPNorthern, Central and Southeastern West Virginia395 PEWestern Maryland and Eastern West Virginia426 6,168 The Regulated Transmission segment provides transmission infrastructure owned and operated by the Transmission Companies and certain of FirstEnergy's utilities (JCP&L, MP, PE and WP) to transmit electricity from generation sources to distribution facilities. The segment's revenues are primarily derived from forward-looking formula rates at the Transmission Companies as well as stated transmission rates at MP, PE and WP; although as explained in Note 14, "Regulatory Matters", effective January 1, 2021, subject to refund, MP's, PE's and WP's existing stated rates became forward-looking formula rates. JCP&L previously had stated transmission rates, however, effective January 1, 2020, JCP&L implemented forward-looking formula rates, subject to refund, pending further hearing and settlement proceedings. Both forward-looking formula and stated rates recover costs that FERC determines are permitted to be recovered and provide a return on transmission capital investment. Under forward-looking formula rates, the revenue requirement is updated annually based on a projected rate base and projected costs, which is subject to an annual true-up based on actual costs. Revenue requirements under stated rates are calculated annually by multiplying the highest one-hour peak load in each respective transmission zone by the approved, stated rate in that zone. The segment's results also reflect the net transmission expenses related to the delivery of electricity on FirstEnergy's transmission facilities.Corporate/Other reflects corporate support costs not charged to FE's subsidiaries, including FE’s retained Pension and OPEB assets and liabilities of the FES Debtors, interest expense on FE’s holding company debt and other businesses that do not constitute an operating segment. Additionally, reconciling adjustments for the elimination of inter-segment transactions and discontinued operations are included in Corporate/Other. As of December 31, 2020, 67 MWs of electric generating capacity, representing AE Supply's OVEC capacity entitlement, was included in continuing operations of Corporate/Other. As of December 31, 2020, Corporate/Other had approximately $8.2 billion of FE holding company debt. 27EXECUTIVE SUMMARYFirstEnergy is a forward-thinking fully regulated electric utility focused on stable and predictable earnings and cash flow from its regulated business units - Regulated Distribution and Regulated Transmission - through delivering enhanced customer service and reliability that supports FE's dividend.On July 21, 2020, a complaint and supporting affidavit containing federal criminal allegations were unsealed against the now former Ohio House Speaker Larry Householder and other individuals and entities allegedly affiliated with Mr. Householder. Also, on July 21, 2020, and in connection with the investigation, FirstEnergy received subpoenas for records from the U.S. Attorney’s Office for the S.D. Ohio. FirstEnergy was not aware of the criminal allegations, affidavit or subpoenas before July 21, 2020. In addition to the subpoenas referenced above, the OAG, certain FE shareholders and FirstEnergy customers filed several lawsuits against FirstEnergy and certain current and former directors, officers and other employees, each relating to the allegations against the now former Ohio House Speaker Larry Householder and other individuals and entities allegedly affiliated with Mr. Householder. In addition, on August 10, 2020, the SEC, through its Division of Enforcement, issued an order directing an investigation of possible securities laws violations by FE, and on September 1, 2020, issued subpoenas to FE and certain FE officers.As previously disclosed, a committee of independent members of the Board of Directors is directing an internal investigation related to ongoing government investigations. In connection with FirstEnergy’s internal investigation, such committee determined on October 29, 2020, to terminate FirstEnergy’s Chief Executive Officer, Charles E. Jones, together with two other executives: Dennis M. Chack, Senior Vice President of Product Development, Marketing, and Branding; and Michael J. Dowling, Senior Vice President of External Affairs. Each of these terminated executives violated certain FirstEnergy policies and its code of conduct. These executives were terminated as of October 29, 2020. Such former members of senior management did not maintain and promote a control environment with an appropriate tone of compliance in certain areas of FirstEnergy’s business, nor sufficiently promote, monitor or enforce adherence to certain FirstEnergy policies and its code of conduct. Furthermore, certain former members of senior management did not reasonably ensure that relevant information was communicated within our organization and not withheld from our independent directors, our Audit Committee, and our independent auditor. Among the matters considered with respect to the determination by the committee of independent members of the Board of Directors that certain former members of senior management violated certain FirstEnergy policies and its code of conduct related to a payment of approximately $4 million made in early 2019 in connection with the termination of a purported consulting agreement, as amended, which had been in place since 2013. The counterparty to such agreement was an entity associated with an individual who subsequently was appointed to a full-time role as an Ohio government official directly involved in regulating the Ohio Companies, including with respect to distribution rates. FirstEnergy believes that payments under the consulting agreement may have been for purposes other than those represented within the consulting agreement. Immediately following these terminations, the independent members of its Board appointed Mr. Steven E. Strah to the position of Acting Chief Executive Officer and Mr. Christopher D. Pappas, a current member of the Board, to the temporary position of Executive Director, each effective as of October 29, 2020. Mr. Donald T. Misheff will continue to serve as Non-Executive Chairman of the Board. Additionally, on November 8, 2020, Robert P. Reffner, Senior Vice President and Chief Legal Officer, and Ebony L. Yeboah-Amankwah, Vice President, General Counsel, and Chief Ethics Officer, were separated from FirstEnergy due to inaction and conduct that the Board determined was influenced by the improper tone at the top. The matter is a subject of the ongoing internal investigation as it relates to the government investigations.Also, in connection with the internal investigation, FirstEnergy recently identified certain transactions, which, in some instances, extended back ten years or more, including vendor services, that were either improperly classified, misallocated to certain of the Utilities and Transmission Companies, or lacked proper supporting documentation. These transactions resulted in amounts collected from customers that were immaterial to FirstEnergy, and the Utilities and Transmission Companies will be working with the appropriate regulatory agencies to address these amounts.On January 31, 2021, FirstEnergy reached a partial settlement with the OAG and other parties regarding decoupling, which resulted in the Ohio Companies requesting PUCO approval to set the respective decoupling riders (Rider CSR) to zero effective February 9, 2021. While the partial settlement with the OAG focused specifically on decoupling, the Ohio Companies will of their own accord not seek to recover lost distribution revenue from residential and commercial customers. FirstEnergy is committed to pursuing an open dialogue in an appropriate manner with respect to a number of regulatory proceedings currently underway, including several audits, and multi-year SEET and ESP quadrennial review, among other matters. FirstEnergy believes a holistic, transparent discussion with the PUCO staff, and interested stakeholders in the regulatory process, is an important step towards removing uncertainties about regulatory concerns in Ohio and critical to re-establishing trust in FirstEnergy and restoring its reputation.The Board has formed a new sub-committee of our Audit committee to, together with the Board, assess FirstEnergy’s compliance program and implement potential changes, as appropriate. In addition, in his role of Executive Director, Mr. Pappas assisted the FirstEnergy leadership team with execution of strategic initiatives, engage with FirstEnergy’s external stakeholders, and support the development of enhanced controls and governance policies and procedures. Additionally, on February 17, 2021, the Board appointed Mr. John Somerhalder to the positions of Vice Chairperson of the Board and Executive Director, each effective as of March 1, 2021, increasing the size of the Board from 10 to 11 members. Mr. Somerhalder has been elected to serve for a term expiring at the Company's 2021 Annual Meeting of Shareholders and until his successor shall have been 28elected. Mr. Donald T. Misheff will continue to serve as Non-Executive Chairman of the Board. Mr. Pappas, who was named to the temporary role of Executive Director in October 2020, will continue to serve on the Board of the Company as an independent director. Mr. Somerhalder will help lead efforts to enhance the company's reputation.Despite the many disruptions FirstEnergy is currently facing, the leadership team remains committed and focused on executing its strategy and running the business. See “Outlook - Other Legal Proceedings” below for additional details on the government investigation and subsequent litigation surrounding the investigation of HB 6. See also “Outlook - State Regulation - Ohio” below for details on the PUCO proceeding reviewing political and charitable spending and legislative activity in response to the investigation of HB 6. The outcome of the government investigations, PUCO proceedings, legislative activity, and any of these lawsuits is uncertain and could have a material adverse effect on FE’s or its subsidiaries’ financial condition, results of operations and cash flows. FirstEnergy is considering reductions to its Regulated Distribution and Regulated Transmission capital investment plans and reductions to operating expenses, as well as changes to its planned equity issuances, to allow for flexibility should a fine or other regulatory actions be imposed as a result of the government investigations.FirstEnergy is also working to improve how it conducts business and serve its customers. To address opportunities for improvement, FirstEnergy kicked off a new initiative to make process and cultural improvements across our entire organization that will keep FirstEnergy moving forward in a positive direction. Called "FE Forward," the initiative will play a critical first step in our transformation journey as it looks to align business practices with our values and behaviors. FirstEnergy will do this by reviewing policies and practices as well as the structure and processes around how decisions are made. FirstEnergy expects that this project will not only help FirstEnergy overcome current uncertainties and challenges, but it will further our goal of creating a truly sustainable company and provide opportunities to reinvest in our employees and customers. The initial phase of FE Forward, which is expected to go through the first quarter of 2021, will involve a comprehensive assessment that will pinpoint the areas of opportunity across all business units and outline the project's scope.The outbreak of COVID-19 is a global pandemic. FirstEnergy is taking steps to mitigate known risks and is continuously evaluating the rapidly evolving situation based on guidance from governmental officials and public health experts. The full impact on FirstEnergy’s business from the COVID-19 pandemic, including the governmental and regulatory responses, is unknown at this time and difficult to predict. FirstEnergy provides a critical and essential service to its customers and the health and safety of FirstEnergy’s employees, contractors and customers are its first priority. FirstEnergy is effectively managing its operations, while still providing flexibility for approximately 7,000 of its 12,000 employees to work from home.Beginning March 13, 2020, FirstEnergy temporarily suspended customer disconnections for nonpayment and ceased collection activities as a result of the ongoing pandemic. Starting September 15, 2020, certain FirstEnergy utilities began non-residential disconnections for non-payment, and began the same on October 5, 2020 for residential disconnections. FirstEnergy is actively monitoring the impact COVID-19 is having on customers’ receivable balances, which include increasing arrears balance since the pandemic has begun. Additionally, FirstEnergy has incurred, and it is expected to incur for the foreseeable future, incremental uncollectible and other COVID-19 related expenses. Such incrementally incurred COVID-19 pandemic related expenses consist of additional costs that FirstEnergy is incurring to protect its employees, contractors and customers, and to support social distancing requirements. These costs include, but are not limited to, new or added benefits provided to employees, the purchase of additional personal protection equipment and disinfecting supplies, additional facility cleaning services, initiated programs and communications to customers on utility response, and increased technology expenses to support remote working, where possible. The Ohio Companies and JCP&L had existing regulatory mechanisms in place prior to the outbreak of COVID-19, where incremental uncollectible expenses are able to be recovered through riders with no material impact to earnings. Additionally, in response to the COVID-19 pandemic, the MDPSC, NJBPU and WVPSC issued orders allowing PE, JCP&L and MP to track and create a regulatory asset for future recovery of incremental costs, including uncollectible expenses, incurred as a result of the pandemic. In Pennsylvania, the PPUC authorized utilities to track all prudently incurred incremental costs arising from COVID-19, and to create a regulatory asset for future recovery of incremental uncollectible expense incurred as a result of COVID-19 above what is included in the Pennsylvania Companies’ existing rates.FirstEnergy is continuously monitoring its supply chain and is working closely with essential vendors to understand the continued impact of COVID-19 to its business and does not currently expect disruptions in its ability to deliver service to customers or any material impact to its capital spending plan. FirstEnergy’s Distribution and Transmission revenues benefit from geographic and economic diversity across a five-state service territory. Two-thirds of base distribution revenues come from the residential customer class. FirstEnergy’s commercial and industrial revenues are primarily fixed and demand-based, rather than volume-based. As a result of this, FirstEnergy’s Distribution and Transmission investments provide stable and predictable earnings. However, due to the actions taken by state governments in our service territories limiting certain commercial and industrial activities, FirstEnergy’s residential load has increased, while commercial and industrial loads have declined; however, the magnitude of future load trends are currently unknown and difficult to predict. FirstEnergy believes it is well positioned to manage the economic slowdown resulting from the COVID-19 pandemic. However, the situation remains fluid and future impacts to FirstEnergy, that are presently unknown or unanticipated, may occur.FE and the Utilities and FET and certain of its subsidiaries participate in two separate five-year syndicated revolving credit facilities providing for aggregate commitments of $3.5 billion, which are available until December 6, 2022. Under the FE credit facility, an aggregate amount of $2.5 billion is available to be borrowed, repaid and reborrowed, subject to separate borrowing sublimits for each borrower including FE and its regulated distribution subsidiaries. Under the FET credit facility, an aggregate 29amount of $1.0 billion is available to be borrowed, repaid and reborrowed under a syndicated credit facility, subject to separate borrowing sublimits for each borrower including FE's transmission subsidiaries. On November 17, 2020, FE and the Utilities and FET and certain of its subsidiaries entered into amendments to the FE credit facility and the FET credit facility, respectively. The amendments provide for modifications and/or waivers of: (i) certain representations and warranties, and (ii) certain affirmative and negative covenants, contained therein, which allowed FirstEnergy to regain compliance with such provisions. In addition, among other things, the amendment to the FE credit facility reduces the sublimit applicable to FE to $1.5 billion, and the amendments increased certain tiers of pricing applicable to borrowings under the credit facilities.On November 23, 2020, FE and its regulated distribution subsidiaries, JCP&L, ME, Penn, TE and WP, borrowed $950 million in the aggregate under the FE Revolving Facility, bringing the outstanding principal balance under the FE Revolving Facility to $1.2 billion, with $1.3 billion of remaining availability under the FE Revolving Facility. On November 23, 2020, FET and its regulated transmission subsidiary, ATSI, borrowed $1 billion in the aggregate under the FET Revolving Facility, bringing the outstanding principal balance under the FET Revolving Facility to $1 billion, with no remaining availability under the FET Revolving Facility. FE, FET and certain of their respective subsidiaries increased their borrowings under the Revolving Facilities as a proactive measure to increase their respective cash positions and preserve financial flexibility. In 2020, FirstEnergy continues to execute its regulated growth plans, through the following achievements and plans:•Implemented forward-looking rates, subject to refund, at JCP&L effective January 1, 2020,•In October 2020, the NJBPU approved JCP&L’s distribution base rate case settlement agreement, resulting in, among other things, a $94 million increase in annual base distribution revenues,•Filed for rider recovery of smart meters in NJ, to be deployed beginning in 2023 with a total program cost estimated at $732 million,•PAPUC-approved DSIC waiver for Penn, which increased the cap from 5% to 7.5% on March 12, 2020,•Completed final step of FirstEnergy’s strategy to exit the competitive generation business with FES Debtors’ emergence from bankruptcy on February 27, 2020, •Integrated resource plan filing in West Virginia made on December 30, 2020,•Issued Climate Position and Strategy Statement, including a pledge to be carbon neutral by 2050, and•FERC approval that converted the existing stated transmission rates of MP, PE and WP to a forward-looking formula transmission rate, effective January 1, 2021.With an operating territory of 65,000 square miles, the scale and diversity of the ten Utilities that comprise the Regulated Distribution business uniquely position this business for growth through opportunities for additional investment. Over the past several years, Regulated Distribution has experienced rate base growth through investments that have improved reliability and added operating flexibility to the distribution infrastructure, which provide benefits to the customers and communities those Utilities serve. Additionally, this business is exploring other opportunities for growth, including investments in electric system improvement and modernization projects to increase reliability and improve service to customers, as well as exploring opportunities in customer engagement that focus on the electrification of customers’ homes and businesses by providing a full range of products and services. With approximately 24,500 miles of transmission lines in operation, the Regulated Transmission business is the centerpiece of FirstEnergy’s regulated investment strategy with, 100% of its capital investments recovered under forward-looking formula rates at the Transmission Companies effective January 1, 2021. Regulated Transmission has also experienced significant growth as part of its Energizing the Future transmission plan with plans to invest up to $7 billion in capital from 2018 to 2023. FirstEnergy believes there are incremental investment opportunities for its existing transmission infrastructure of over $20 billion beyond those identified through 2023, which are expected to strengthen grid and cyber-security and make the transmission system more reliable, robust, secure and resistant to extreme weather events, with improved operational flexibility. While FirstEnergy continues to have customer-focused investment opportunities across its distribution and transmission businesses of up to $3 billion annually, it has discontinued providing a long-term compound annual growth rate until there is further clarity regarding Ohio regulatory matters and the ongoing government investigations.In November 2018, the Board of Directors approved a dividend policy that includes a targeted payout ratio. Dividend payments are subject to declaration by the Board and future dividend decisions determined by the Board may be impacted by earnings, cash flows, credit metrics and other business conditions, including the risk and uncertainties of the government investigations.In November 2020, FirstEnergy published its Climate Story which includes our climate position and strategy, as well as a new comprehensive and ambitious greenhouse gas emission goal. FirstEnergy pledged to achieve carbon neutrality by 2050 and set an interim goal for a 30% reduction in greenhouse gases within the company’s direct operational control by 2030, based on 2019 levels. In addition, FirstEnergy has also set a fleet electrification goal in which beginning in 2021, FirstEnergy plans for 100% of new purchases for our light duty and aerial truck fleet to be electric or hybrid vehicles, creating a path to 30% fleet electrification by 2030. Also, in 2021, FirstEnergy will seek approval to construct a solar generation source of at least 50 MWs in West Virginia. Future resource plans to achieve carbon reductions, including any determination of retirement dates of our regulated coal-fired generating facilities, will be developed by working collaboratively with regulators in West Virginia. Determination of the useful life 30of our regulated coal-fired generating facilities could result in changes in depreciation, and/or continued collection of net plant in rates after retirement, securitization, sale, impairment or regulatory disallowances. If MP is unable to recover these costs, it could have a material adverse effect on FE and/or MP’s financial condition, results of operations, and cash flow.In January 2021, our updated Strategic Plan – Powered by our Core Values & Behaviors was published. This comprehensive update provides a vision of our company’s path forward in an evolving electric industry. It also articulates significant new goals that will help us achieve our long-term strategic commitments in a transparent, sustainable and responsible manner. The $2.5 billion equity issuance in 2018 strengthened FirstEnergy’s balance sheet and supported the company’s transition to a fully regulated utility company. The shares of preferred stock participated in the dividend paid on common stock on an as-converted basis and were non-voting except in certain limited circumstances. Because of this equity issuance, FirstEnergy does not currently anticipate the need to issue additional equity through 2021 and expects to issue, subject to, among other things, market conditions, pricing terms and business operations, up to $600 million of equity annually in 2022 and 2023, including approximately $100 million in equity for its regular stock investment and employee benefit plans. FirstEnergy's expectations regarding the amount and timing of any potential equity issuances are subject to, among other matters, the ongoing government investigations and related lawsuits. On March 31, 2018, the FES Debtors announced that, in order to facilitate an orderly financial restructuring, they filed voluntary petitions under Chapter 11 of the United States Bankruptcy Code with the Bankruptcy Court. In September 2018, the Bankruptcy Court approved a FES Bankruptcy settlement agreement by and among FirstEnergy, two groups of key FES creditors (collectively, the FES Key Creditor Groups), the FES Debtors and the UCC. The FES Bankruptcy settlement agreement resolved certain claims by FirstEnergy against the FES Debtors, all claims by the FES Debtors and the FES Key Creditor Groups against FirstEnergy, as well as releases from third parties who voted in favor of the FES Debtors' plan of reorganization, in return for among other things, a cash payment of $853 million upon emergence. The FES Bankruptcy settlement was conditioned on the FES Debtors confirming and effectuating a plan of reorganization acceptable to FirstEnergy. On February 18, 2020, the FES Debtors and FirstEnergy entered into an IT Access Agreement that provided IT support to enable the FES Debtors to emerge from bankruptcy prior to full IT separation by the FES Debtors. As part of the IT Access Agreement, the FES Debtors and FirstEnergy resolved, among other things, the on-going reconciliation of outstanding tax sharing payments for tax years 2018, 2019 and 2020 for a total of $125 million. On February 25, 2020, the Bankruptcy Court approved the IT Access Agreement. On February 27, 2020, the FES Debtors effectuated their plan, emerged from bankruptcy and FirstEnergy tendered the settlement payments totaling $853 million and the $125 million tax sharing payment to the FES Debtors, with no material impact to net income in 2020. As contemplated under the FES Bankruptcy settlement agreement, AE Supply entered into an agreement on December 31, 2018, to transfer the 1,300 MW Pleasants Power Station and related assets to FG, while retaining certain specified liabilities. Under the terms of the agreement, FG acquired the economic interests in Pleasants as of January 1, 2019, and AE Supply operated Pleasants until ownership was transferred on January 30, 2020. AE Supply will continue to provide access to the McElroy's Run CCR impoundment facility, which was not transferred, and FE will provide guarantees for certain retained environmental liabilities of AE Supply, including the McElroy’s Run CCR impoundment facility.As of June 30, 2020, FirstEnergy had substantially ceased providing post-emergence services to FES Debtors under the terms of the amended and restated shared services agreement. In connection with the FES Debtors emergence from bankruptcy, FirstEnergy entered into an amended separation agreement with the FES Debtors to implement the separation of FES Debtors and their businesses from FirstEnergy.The emergence of the FES Debtors from bankruptcy represents the final step in FirstEnergy’s previously announced strategy to exit the competitive generation business and become a fully regulated utility company with a stronger balance sheet, solid cash flows and more predictable earnings.The Form 10-K discusses 2020 and 2019 items and year-over-year comparisons between 2020 and 2019. Discussions of 2018 items and year-over-year comparisons between 2019 and 2018 that are not included in this Form 10-K can be found in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Part II, Item 7 of the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2019, filed with the SEC on February 10, 2020.31RESULTS OF OPERATIONSThe financial results discussed below include revenues and expenses from transactions among FirstEnergy’s business segments. A reconciliation of segment financial results is provided in Note 17, "Segment Information," of the Notes to Consolidated Financial Statements.Net income by business segment was as follows:(In millions, except per share amounts)For the Years Ended December 31,Increase (Decrease)2020201920182020 vs 20192019 vs 2018Net Income By Business Segment: Regulated Distribution$959 $1,076 $1,242 $(117)$(166)Regulated Transmission464 447 397 17 50 Corporate/Other(420)(619)(617)199 (2)Income from Continuing Operations$1,003 $904 $1,022 $99 $(118) Discontinued Operations76 8 326 68 (318)Net Income$1,079 $912 $1,348 $167 $(436)Earnings per share of common stock Basic - Continuing Operations$1.85 $1.69 $1.33 $0.16 $0.36 Basic - Discontinued Operations0.14 0.01 0.66 0.13 (0.65) Basic - Net Income Attributable to $1.99 $1.70 $1.99 $0.29 $(0.29) Common Stockholders Earnings per share of common stock Diluted - Continuing Operations$1.85 $1.67 $1.33 $0.18 $0.34 Diluted - Discontinued Operations0.14 0.01 0.66 0.13 (0.65) Diluted - Net Income Attributable to $1.99 $1.68 $1.99 $0.31 $(0.31) Common Stockholders32Summary of Results of Operations — 2020 Compared with 2019Financial results for FirstEnergy’s business segments for the years ended December 31, 2020 and 2019, were as follows:2020 Financial ResultsRegulated DistributionRegulated TransmissionCorporate/Other and Reconciling AdjustmentsFirstEnergy Consolidated (In millions)Revenues: Electric$9,130 $1,613 $(139)$10,604 Other233 17 (64)186 Total Revenues9,363 1,630 (203)10,790 Operating Expenses: Fuel369 — — 369 Purchased power2,687 — 14 2,701 Other operating expenses3,178 282 (169)3,291 Provision for depreciation896 313 65 1,274 Amortization (deferral) of regulatory assets, net(64)11 — (53)General taxes770 232 44 1,046 Total Operating Expenses7,836 838 (46)8,628 Operating Income (Loss)1,527 792 (157)2,162 Other Income (Expense): Miscellaneous income, net332 30 70 432 Pension and OPEB mark-to-market adjustment(323)(40)(114)(477)Interest expense(501)(219)(345)(1,065)Capitalized financing costs37 39 1 77 Total Other Expense(455)(190)(388)(1,033)Income (Loss) Before Income Taxes (Benefits)1,072 602 (545)1,129 Income taxes (benefits)113 138 (125)126 Income (Loss) From Continuing Operations959 464 (420)1,003 Discontinued Operations, net of tax— — 76 76 Net Income (Loss)$959 $464 $(344)$1,079 332019 Financial ResultsRegulated DistributionRegulated TransmissionCorporate/Other and Reconciling AdjustmentsFirstEnergy Consolidated (In millions)Revenues: Electric$9,452 $1,510 $(128)$10,834 Other246 16 (61)201 Total Revenues9,698 1,526 (189)11,035 Operating Expenses: Fuel497 — — 497 Purchased power2,910 — 17 2,927 Other operating expenses2,836 272 (156)2,952 Provision for depreciation863 284 73 1,220 Amortization (deferral) of regulatory assets, net(89)10 — (79)General taxes760 209 39 1,008 Total Operating Expenses7,777 775 (27)8,525 Operating Income (Loss)1,921 751 (162)2,510 Other Income (Expense): Miscellaneous income, net174 15 54 243 Pension and OPEB mark-to-market adjustment(290)(47)(337)(674)Interest expense(495)(192)(346)(1,033)Capitalized financing costs37 33 1 71 Total Other Expense(574)(191)(628)(1,393)Income (Loss) Before Income Taxes (Benefits)1,347 560 (790)1,117 Income taxes (benefits)271 113 (171)213 Income (Loss) From Continuing Operations1,076 447 (619)904 Discontinued Operations, net of tax— — 8 8 Net Income (Loss)$1,076 $447 $(611)$912 34Changes Between 2020 and 2019 Financial ResultsIncrease (Decrease)Regulated DistributionRegulated TransmissionCorporate/Other and Reconciling AdjustmentsFirstEnergy Consolidated (In millions)Revenues: Electric$(322)$103 $(11)$(230)Other(13)1 (3)(15)Total Revenues(335)104 (14)(245)Operating Expenses: Fuel(128)— — (128)Purchased power(223)— (3)(226)Other operating expenses342 10 (13)339 Provision for depreciation33 29 (8)54 Amortization (deferral) of regulatory assets, net25 1 — 26 General taxes10 23 5 38 Total Operating Expenses59 63 (19)103 Operating Income (Loss)(394)41 5 (348)Other Income (Expense): Miscellaneous income, net158 15 16 189 Pension and OPEB mark-to-market adjustment(33)7 223 197 Interest expense(6)(27)1 (32)Capitalized financing costs— 6 — 6 Total Other Expense119 1 240 360 Income (Loss) Before Income Taxes (Benefits)(275)42 245 12 Income taxes (benefits)(158)25 46 (87)Income (Loss) From Continuing Operations(117)17 199 99 Discontinued Operations, net of tax— — 68 68 Net Income (Loss)$(117)$17 $267 $167 35Regulated Distribution — 2020 Compared with 2019Regulated Distribution's net income decreased $117 million in 2020, as compared to 2019, primarily resulting from the charge associated with the impairment of an Ohio regulatory asset in 2020, as further discussed below, higher pension and OPEB mark-to-market adjustments, lower weather-related customer usage, the absence of the DMR revenues that ended in July 2019, and higher operating and maintenance expenses including the impact of non-deferred COVID-19 costs, partially offset by lower pension and OPEB non-service costs, higher revenues from incremental riders in Ohio and Pennsylvania and increased weather-adjusted residential sales due to the impact of COVID-19.Revenues —The $335 million decrease in total revenues resulted from the following sources:For the Years Ended December 31,Revenues by Type of Service20202019Decrease(In millions)Distribution services (1)$5,302 $5,314 $(12)Generation sales:Retail3,577 3,727 (150)Wholesale251 411 (160)Total generation sales3,828 4,138 (310)Other233 246 (13)Total Revenues$9,363 $9,698 $(335)(1) Includes $43 million and $181 million of ARP revenues for the years ended December 31, 2020 and 2019, respectively. Distribution services revenues decreased $12 million in 2020, as compared to 2019, primarily resulting from the charge associated with the impairment of an Ohio regulatory asset in 2020, as further discussed below, the absence of the New Jersey storm recovery rider and DMR revenues that ended in July 2019, lower weather-related customer usage, the expiration of a NUG contract and lower commercial and industrial sales due to the impact of COVID-19, partially offset by higher rates associated with incremental riders in Ohio and Pennsylvania, including the recovery of distribution capital investment programs and transmission expenses, increased weather-adjusted residential sales due to the impact of COVID-19 and the implementation of the New Jersey Zero Emission Program in June 2019. Distribution services by customer class are summarized in the following table:For the Years Ended December 31,Electric Distribution MWH Deliveries20202019Increase (Decrease)(In thousands)Residential54,978 54,159 1.5 %Commercial(1)34,811 37,888 (8.1)%Industrial52,034 55,649 (6.5)%Total Electric Distribution MWH Deliveries141,823 147,696 (4.0)% (1) Includes street lighting.Distribution services to residential customers primarily reflects an increase in weather-adjusted load due to the impact of COVID-19, partially offset by lower weather-related usage. Deliveries to commercial customers reflects lower weather-related usage and the impact of COVID-19. Heating degree days were 6% below 2019 and 10% below normal. Cooling degree days were 1% below 2019, and 14% above normal. Deliveries to industrial customers were also negatively impacted due to the impact of COVID-19, contributing to lower steel, mining, and educational services customer usage, partially offset by higher shale customer usage.36The following table summarizes the price and volume factors contributing to the $310 million decrease in generation revenues in 2020, as compared to 2019:Source of Change in Generation Revenues(Decrease) (In millions)Retail: Change in sales volumes$(54)Change in prices(96) (150)Wholesale:Change in sales volumes(94)Change in prices(3)Capacity revenue(63) (160)Change in Generation Revenues$(310)Retail generation revenues decreased $150 million, primarily due to lower weather-related usage, partially offset by an increase in weather-adjusted residential load due to the impact of COVID-19 and decreased customer shopping in Pennsylvania and New Jersey. Total generation provided by alternative suppliers as a percentage of total MHW deliveries decreased to 64% from 66% in Pennsylvania and to 47% from 48% in New Jersey. The decrease in retail generation prices primarily resulted from lower non-shopping generation auction rates in New Jersey and Pennsylvania.Wholesale generation revenues decreased $160 million, primarily due to decreased volumes associated with lower economic dispatch of MP’s generating units, resulting from low spot market energy prices and an increase in the number of planned outages as compared to 2019, the expiration of a NUG contract and lower capacity revenues. The difference between current wholesale generation revenues and certain energy costs incurred are deferred for future recovery or refund, with no material impact to earnings.Operating Expenses —Total operating expenses increased $59 million primarily due to the following:•Fuel expense decreased $128 million in 2020, as compared to 2019, primarily due to lower unit costs and lower fuel consumption as a result of economic dispatch and an increase in the number of planned outages as compared to 2019.•Purchased power costs decreased $223 million in 2020, as compared to 2019, primarily due to lower prices and capacity expenses, the absence of the termination of Morgantown Energy Associates PPA and decreased purchases resulting from the expiration of a NUG contract, partially offset by the implementation of the New Jersey Zero Emission Program in June 2019 and an increase in the number of planned outages as compared to 2019.Source of Change in Purchased PowerIncrease (Decrease) (In millions)PurchasesChange due to unit costs$(185)Change due to volumes21 (164) Capacity expense(59)Change in Purchased Power Costs$(223)•Other operating expenses increased $342 million primarily due to:•Higher incremental uncollectible and other COVID-19 related expenses of $157 million, of which $99 millionwas deferred for future recovery.•Higher storm restoration costs of $75 million, which were mostly deferred for future recovery, resulting in nomaterial impact on current period earnings.37•Higher network transmission expenses of $49 million. These costs are deferred for future recovery, resulting inno material impact on current period earnings.•Higher pension and OPEB service costs of $33 million.•Higher employee benefit costs of approximately $30 million.•Higher other operating and maintenance expense of $40 million, primarily associated with increased material and contractor spend and an additional planned generation outage in 2020,•Lower energy efficiency program costs of $42 million, which are deferred for future recovery, resulting in no material impact on earnings.•Depreciation expense increased $33 million, primarily due to a higher asset base.•Net amortization (deferral) of regulatory assets increased $25 million, primarily due to lower generation and transmission deferrals including the absence of the termination of the Morgantown Energy Associates PPA, the recovery of distribution investment programs and lower energy efficiency related costs, partially offset by the deferral of higher storm restoration costs, and uncollectible and other COVID-19 related costs.•General taxes increased $10 million primarily due to higher Ohio property taxes and payroll taxes.Other Expense —Total other expense decreased $119 million, primarily due to lower pension and OPEB non-service costs, partially offset by a $33 million increase in pension and OPEB mark-to-market adjustments, higher interest expense from debt issuances primarily at WP and MP, and increased borrowings under the Revolving Facilities. The 2020 mark-to-market adjustment resulted from a decrease in the discount rate used to measure benefit obligations, partially offset by higher than expected asset returns.Income Taxes Regulated Distribution’s effective tax rate was 10.5% and 20.1% for 2020 and 2019, respectively. The change in the effective tax rate was primarily due to the recognition of $52 million in deferred gains relating to prior intercompany transfers of generation assets that were triggered by the deconsolidation of the FES Debtors from FirstEnergy’s consolidated federal income tax group as a result of their emergence from bankruptcy in the first quarter of 2020. Additionally, FirstEnergy recorded a $40 million benefit related to reversals of certain tax regulatory liabilities resulting from the transfer of TMI-2.Regulated Transmission — 2020 Compared with 2019Regulated Transmission's operating results increased $17 million in 2020, as compared to 2019, primarily resulting from the impact of a higher rate base at ATSI, MAIT, and JCPL, and higher capitalized financing costs, partially offset by higher interest expense at FET and a true-up of the forward-looking formula rate at ATSI and MAIT.Revenues —Total revenues increased $104 million in 2020, as compared to 2019, primarily due to the recovery of incremental operating expenses and a higher rate base at ATSI, MAIT and JCP&L, partially offset by the impact of a true-up of the forward-looking rate.Revenues by transmission asset owner are shown in the following table:For the Years Ended December 31,Revenues by Transmission Asset Owner20202019Increase(In millions)ATSI$809 $758 $51 TrAIL255 251 4 MAIT254 227 27 JCP&L178 160 18 Other134 130 4 Total Revenues$1,630 $1,526 $104 Operating Expenses —Total operating expenses increased $63 million in 2020, as compared to 2019, primarily due to higher property taxes and depreciation due to a higher asset base. The majority of operating expenses are recovered through formula rates, resulting in no material impact on current period earnings.38Income Taxes —Regulated Transmission’s effective tax rate was 22.9% and 20.2% for 2020 and 2019, respectively due to changes in the amortization of excess deferred income taxes and the absence of certain tax benefits recognized in 2019. Corporate/Other — 2020 Compared with 2019Financial results from Corporate/Other and reconciling adjustments resulted in a $199 million increase in income from continuing operations for 2020 compared to 2019, primarily due to a $223 million decrease in the pension and OPEB mark-to-market adjustment, $10 million tax benefits from accelerated amortization of certain investment tax credits and lower other Pension and OPEB non-service costs. These were partially offset by higher other operating expenses from investigation-related costs and lower returns on certain equity method investments.For the years ended December 31, 2020 and 2019, FirstEnergy recorded income from discontinued operations, net of tax, of $76 million and $8 million, respectively. The change in discontinued operations, net of tax was primarily due to lower settlement-related expenses with the FES Debtors, including adjustments to the estimated worthless stock deduction and Intercompany Tax Allocation Agreement, as well as the acceleration of net pension and OPEB prior service credits in 2020 and the absence of tax expense in 2019 associated with non-deductible interest.REGULATORY ASSETS AND LIABILITIESRegulatory assets represent incurred costs that have been deferred because of their probable future recovery from customers through regulated rates. Regulatory liabilities represent amounts that are expected to be credited to customers through future regulated rates or amounts collected from customers for costs not yet incurred. FirstEnergy, the Utilities and the Transmission Companies net their regulatory assets and liabilities based on federal and state jurisdictions. Management assesses the probability of recovery of regulatory assets at each balance sheet date and whenever new events occur. Factors that may affect probability relate to changes in the regulatory environment, issuance of a regulatory commission order or passage of new legislation. Management applies judgment in evaluating the evidence available to assess the probability of recovery of regulatory assets from customers, including, but not limited to evaluating evidence related to precedent for similar items at FirstEnergy and information on comparable companies within similar jurisdictions, as well as assessing progress of communications between FirstEnergy and regulators. Certain of these regulatory assets, totaling approximately $117 million and $111 million as of December 31, 2020 and December 31, 2019, respectively, are recorded based on prior precedent or anticipated recovery based on rate making premises without a specific order, of which, $79 million and $73 million as of December 31, 2020 and December 31, 2019, respectively, are being sought for recovery in a formula rate amendment filing at ATSI that is pending before FERC. See Note 14, "Regulatory Matters" for additional information.The following table provides information about the composition of net regulatory assets and liabilities as of December 31, 2020 and December 31, 2019, and the changes during the year ended December 31, 2020: Net Regulatory Assets (Liabilities) by SourceDecember 31,2020December 31,2019Change (In millions)Customer payables for future income taxes$(2,369)$(2,605)$236 Nuclear decommissioning and spent fuel disposal costs(102)(197)95 Asset removal costs(721)(756)35 Deferred transmission costs316 298 18 Deferred generation costs104 214 (110)Deferred distribution costs136 155 (19)Contract valuations41 51 (10)Storm-related costs748 551 197 Uncollectible and COVID-19 related costs97 3 94 Other6 25 (19)Net Regulatory Liabilities included on the Consolidated Balance Sheets$(1,744)$(2,261)$517 39The following is a description of the regulatory assets and liabilities described above:Customer payables for future income taxes - Reflects amounts to be recovered or refunded through future rates to pay income taxes that become payable when rate revenue is provided to recover items such as AFUDC-equity and depreciation of property, plant and equipment for which deferred income taxes were not recognized for ratemaking purposes, including amounts attributable to tax rate changes such as tax reform. These amounts are being amortized over the period in which the related deferred tax assets reverse, which is generally over the expected life of the underlying asset.Nuclear decommissioning and spent fuel disposal costs - Reflects a regulatory liability representing amounts collected from customers and placed in external trusts including income, losses and changes in fair value thereon (as well as accretion of the related ARO) primarily for the future decommissioning of TMI-2 and spent nuclear fuel disposal costs. As further discussed below, TMI-2, along with the NDT and related decommissioning liabilities, was transferred to TMI-2 Solutions, LLC, a subsidiary of EnergySolutions, LLC, on December 18, 2020, and therefore the related regulatory liabilities were written off. The remaining balance as of December 31, 2020, reflects liabilities for spent nuclear fuel disposal costs from former nuclear generating facilities, Oyster Creek and TMI-2.Asset removal costs - Primarily represents the rates charged to customers that include a provision for the cost of future activities to remove assets, including obligations for which an ARO has been recognized, that are expected to be incurred at the time of retirement.Deferred transmission costs - Principally represents differences between revenues earned based on actual costs for the formula-rate Transmission Companies and the amounts billed. Amounts are recorded as a regulatory asset or liability and recovered or refunded, respectively, in subsequent periods.Deferred generation costs - Primarily relates to regulatory assets associated with the securitized recovery of certain electric customer heating discounts, fuel and purchased power regulatory assets at the Ohio Companies (amortized through 2034) as well as the ENEC at MP and PE. MP and PE recover net power supply costs, including fuel costs, purchased power costs and related expenses, net of related market sales revenue through the ENEC. The ENEC rate is updated annually.Deferred distribution costs - Primarily relates to the Ohio Companies' deferral of certain expenses resulting from distribution and reliability related expenditures, including interest (amortized through 2036), which are recorded as a regulatory asset or liability and recovered or refunded, respectively, in subsequent periods.Contract valuations - Includes the amortization of purchase accounting adjustments at PE which were recorded in connection with the Allegheny Energy, Inc. merger representing the fair value of NUG purchased power contracts (amortized over the life of the contracts through 2030).Storm-related costs - Relates to the recovery of storm costs, which vary by jurisdiction. Approximately $167 million and $193 million are currently being recovered through rates as of December 31, 2020 and 2019, respectively.Uncollectible and COVID-19 related costs - Includes the deferral of prudently incurred incremental costs arising from COVID-19, including uncollectible expenses under new and existing riders prior to the pandemic.The following table provides information about the composition of net regulatory assets that do not earn a current return as of December 31, 2020 and 2019, of which approximately $195 million and $228 million, respectively, are currently being recovered through rates over varying periods, through 2068, depending on the nature of the deferral and the jurisdiction:Regulatory Assets by Source Not Earning a Current ReturnDecember 31,2020December 31,2019Change(in millions)Deferred transmission costs$29 $27 $2 Deferred generation costs5 15 (10)Storm-related costs654 471 183 COVID-19 related costs66 — 66 Other35 32 3 Regulatory Assets Not Earning a Current Return$789 $545 $244 40CAPITAL RESOURCES AND LIQUIDITYFirstEnergy’s business is capital intensive, requiring significant resources to fund operating expenses, construction expenditures, scheduled debt maturities and interest payments, dividend payments, and contributions to its pension plan.The $2.5 billion equity issuance in 2018 strengthened FirstEnergy’s balance sheet and supported the company’s transition to a fully regulated utility company. The shares of preferred stock participated in the dividend paid on common stock on an as-converted basis and were non-voting except in certain limited circumstances. Because of this equity issuance, FirstEnergy does not currently anticipate the need to issue additional equity through 2021 and expects to issue, subject to, among other things, market conditions, pricing terms and business operations, up to $600 million of equity annually in 2022 and 2023, including approximately $100 million in equity for its regular stock investment and employee benefit plans. FirstEnergy's expectations regarding the amount and timing of any potential equity issuances are subject to, among other matters, the ongoing government investigations and related lawsuits. In addition to this equity investment, FE and its distribution and transmission subsidiaries expect their existing sources of liquidity to remain sufficient to meet their respective anticipated obligations. In addition to internal sources to fund liquidity and capital requirements for 2021 and beyond, FE and its distribution and transmission subsidiaries expect to rely on external sources of funds. Short-term cash requirements not met by cash provided from operations are generally satisfied through short-term borrowings. Long-term cash needs may be met through the issuance of long-term debt by FE and certain of its distribution and transmission subsidiaries to, among other things, fund capital expenditures and refinance short-term and maturing long-term debt, subject to market conditions and other factors.On February 1, 2019, FirstEnergy made a $500 million voluntary cash contribution to the qualified pension plan. FirstEnergy expects no required contributions until 2022. With an operating territory of 65,000 square miles, the scale and diversity of the ten Utilities that comprise the Regulated Distribution business uniquely position this business for growth through opportunities for additional investment. Over the past several years, Regulated Distribution has experienced rate base growth through investments that have improved reliability and added operating flexibility to the distribution infrastructure, which provide benefits to the customers and communities those Utilities serve. Additionally, this business is exploring other opportunities for growth, including investments in electric system improvement and modernization projects to increase reliability and improve service to customers, as well as exploring opportunities in customer engagement that focus on the electrification of customers’ homes and businesses by providing a full range of products and services. Capital expenditures for 2019 and 2020 and forecasted expenditures for 2021, 2022, and 2023 by reportable segment are included below: Reportable Segment2019 Actual2020 Actual2021Forecast2022Forecast2023Forecast (In millions)Regulated Distribution$1,698$1,756$1,725$1,745$1,680Regulated Transmission1,189 1,150 1,200 1,200 - 1,450 1,200 - 1,450 Corporate/Other105 80 90 80 75 Total$2,992$2,986Up to $3,015Up to $3,025 - $3,275Up to $2,955 - $3,205FirstEnergy believes there are incremental investment opportunities for its existing transmission infrastructure of over $20 billion beyond those identified through 2023, which are expected to strengthen grid and cyber-security and make the transmission system more reliable, robust, secure and resistant to extreme weather events, with improved operational flexibility.In alignment with FirstEnergy’s strategy to invest in its Regulated Transmission and Regulated Distribution segments as a fully regulated company, FirstEnergy is focused on maintaining balance sheet strength and flexibility. Specifically, at the regulated businesses, regulatory authority has been obtained for various regulated distribution and transmission subsidiaries to issue and/or refinance debt. Any financing plans by FE or any of its consolidated subsidiaries, including the issuance of equity and debt, and the refinancing of short-term and maturing long-term debt are subject to market conditions and other factors. No assurance can be given that any such issuances, financing or refinancing, as the case may be, will be completed as anticipated or at all. Any delay in the completion of financing plans could require FE or any of its consolidated subsidiaries to utilize short-term borrowing capacity, which could impact available liquidity. In addition, FE and its consolidated subsidiaries expect to continually evaluate any planned financings, which may result in changes from time to time. On March 31, 2018, the FES Debtors announced that, in order to facilitate an orderly financial restructuring, they filed voluntary petitions under Chapter 11 of the United States Bankruptcy Code with the Bankruptcy Court. In September 2018, the Bankruptcy Court approved a FES Bankruptcy settlement agreement by and among FirstEnergy, two groups of key FES creditors 41(collectively, the FES Key Creditor Groups), the FES Debtors and the UCC. The FES Bankruptcy settlement agreement resolved certain claims by FirstEnergy against the FES Debtors, all claims by the FES Debtors and the FES Key Creditor Groups against FirstEnergy, as well as releases from third parties who voted in favor of the FES Debtors' plan of reorganization, in return for among other things, a cash payment of $853 million upon emergence. The FES Bankruptcy settlement was conditioned on the FES Debtors confirming and effectuating a plan of reorganization acceptable to FirstEnergy. On February 18, 2020, the FES Debtors and FirstEnergy entered into an IT Access Agreement that provided IT support to enable the FES Debtors to emerge from bankruptcy prior to full IT separation by the FES Debtors. As part of the IT Access Agreement, the FES Debtors and FirstEnergy resolved, among other things, the on-going reconciliation of outstanding tax sharing payments for tax years 2018, 2019 and 2020 for a total of $125 million. On February 25, 2020, the Bankruptcy Court approved the IT Access Agreement. On February 27, 2020, the FES Debtors effectuated their plan, emerged from bankruptcy and FirstEnergy tendered the settlement payments totaling $853 million and the $125 million tax sharing payment to the FES Debtors, with no material impact to net income in 2020. The outbreak of COVID-19 is a global pandemic. FirstEnergy is continuously evaluating the global pandemic and taking steps to mitigate known risks. FirstEnergy is actively monitoring the continued impact COVID-19 is having on its customers’ receivable balances, which include increasing arrears balances since the pandemic has begun. FirstEnergy has incurred, and it is expected to incur for the foreseeable future, incremental uncollectible and other COVID-19 pandemic related expenses. COVID-19 related expenses consist of additional costs that FirstEnergy is incurring to protect its employees, contractors and customers, and to support social distancing requirements. These costs include, but are not limited to, new or added benefits provided to employees, the purchase of additional personal protection equipment and disinfecting supplies, additional facility cleaning services, initiated programs and communications to customers on utility response, and increased technology expenses to support remote working, where possible. The full impact on FirstEnergy’s business from the COVID-19 pandemic, including the governmental and regulatory responses, is unknown at this time and difficult to predict. FirstEnergy provides a critical and essential service to its customers and the health and safety of its employees, contractors and customers is its first priority. FirstEnergy is continuously monitoring its supply chain and is working closely with essential vendors to understand the continued impact the COVID-19 pandemic is having on its business, however, FirstEnergy does not currently expect disruptions in its ability to deliver service to customers or any material impact on its capital spending plan. FirstEnergy continues to effectively manage operations during the pandemic in order to provide critical service to customers and believes it is well positioned to manage through the economic slowdown. FirstEnergy Distribution and Transmission revenues benefit from geographic and economic diversity across a five-state service territory, which also allows for flexibility with capital investments and measures to maintain sufficient liquidity over the next twelve months. However, the situation remains fluid and future impacts to FirstEnergy that are presently unknown or unanticipated may occur. Furthermore, the likelihood of an impact to FirstEnergy, and the severity of any impact that does occur, could increase the longer the global pandemic persists. On July 21, 2020, a complaint and supporting affidavit containing federal criminal allegations were unsealed against the now former Ohio House Speaker Larry Householder and other individuals and entities allegedly affiliated with Mr. Householder. Also, on July 21, 2020, and in connection with the investigation, FirstEnergy received subpoenas for records from the U.S. Attorney’s Office for the S.D. Ohio. FirstEnergy was not aware of the criminal allegations, affidavit or subpoenas before July 21, 2020. In addition to the subpoenas referenced above, the OAG, certain FE shareholders and FirstEnergy customers filed several lawsuits against FirstEnergy and certain current and former directors, officers and other employees, each relating to the allegations against the now former Ohio House Speaker Larry Householder and other individuals and entities allegedly affiliated with Mr. Householder. In addition, on August 10, 2020, the SEC, through its Division of Enforcement, issued an order directing an investigation of possible securities laws violations by FE, and on September 1, 2020, issued subpoenas to FE and certain FE officers.The Board has formed a new sub-committee of our Audit committee to, together with the Board, assess FirstEnergy’s compliance program and implement potential changes, as appropriate. In addition, in his role of Executive Director, Mr. Pappas assisted the FirstEnergy leadership team with execution of strategic initiatives, engage with FirstEnergy’s external stakeholders, and support the development of enhanced controls and governance policies and procedures. Additionally, on February 17, 2021, the Board appointed Mr. John Somerhalder to the positions of Vice Chairperson of the Board and Executive Director, each effective as of March 1, 2021, increasing the size of the Board from 10 to 11 members. Mr. Somerhalder has been elected to serve for a term expiring at the Company's 2021 Annual Meeting of Shareholders and until his successor shall have been elected. Mr. Donald T. Misheff will continue to serve as Non-Executive Chairman of the Board. Mr. Pappas, who was named to the temporary role of Executive Director in October 2020, will continue to serve on the Board of the Company as an independent director. Mr. Somerhalder will help lead efforts to enhance the company's reputation.Despite the many disruptions FirstEnergy is currently facing, the leadership team remains committed and focused on executing its strategy and running the business. See “Outlook - Other Legal Proceedings” below for additional details on the government investigation and subsequent litigation surrounding the investigation of HB 6. See also “Outlook - State Regulation - Ohio” below for details on the PUCO proceeding reviewing political and charitable spending and legislative activity in response to the investigation of HB 6. The outcome of the government investigations, PUCO proceedings, legislative activity, and any of these lawsuits is uncertain and could have a material adverse effect on FE’s or its subsidiaries’ financial condition, results of operations and cash flows. FirstEnergy is considering reductions to its Regulated Distribution and Regulated Transmission capital 42investment plans and reductions to operating expenses, as well as changes to its planned equity issuances, to allow for flexibility should a fine or other regulatory actions be imposed as a result of the government investigations.FirstEnergy is also working to improve how it conducts business and serve its customers. To address opportunities for improvement, FirstEnergy kicked off a new initiative to make process and cultural improvements across our entire organization that will keep FirstEnergy moving forward in a positive direction. Called "FE Forward," the initiative will play a critical first step in our transformation journey as it looks to align business practices with our values and behaviors. FirstEnergy will do this by reviewing policies and practices as well as the structure and processes around how decisions are made. FirstEnergy expects that this project will not only help FirstEnergy overcome current uncertainties and challenges, but it will further our goal of creating a truly sustainable company and provide opportunities to reinvest in our employees and customers. The initial phase of FE Forward, which is expected to go through the first quarter of 2021, will involve a comprehensive assessment that will pinpoint the areas of opportunity across all business units and outline the project's scope.As further discussed below, in connection with a partial settlement with the OAG and other parties, the Ohio Companies filed an application with the PUCO on February 1, 2021, to set the respective decoupling riders (Rider CSR) to zero. While the partial settlement with the OAG focused specifically on decoupling, the Ohio Companies will of their own accord not seek to recover lost distribution revenue from residential and commercial customers. FirstEnergy is committed to pursuing an open dialogue with stakeholders in an appropriate manner with respect to the numerous regulatory proceedings currently underway as further discussed herein. As a result of the partial settlement, and the decision to not seek lost distribution revenue, FirstEnergy recognized a $108 million pre-tax charge ($84 million after-tax) in the fourth quarter of 2020, and $77 million (pre-tax) of which is associated with forgoing collection of lost distribution revenue. FirstEnergy does not believe a refund for previously collected amounts under decoupling, which was approximately $18 million, is probable. Furthermore, as FirstEnergy would not have financially benefited from the Clean Air Fund included in HB 6, which is the mechanism to provide support to nuclear energy in Ohio, there is no expected additional impact to FirstEnergy due to any repeal of that provision of HB 6.As of December 31, 2020, FirstEnergy’s net deficit in working capital (current assets less current liabilities) was primarily due to accounts payable, short-term borrowings, and accrued interest, taxes, compensation and benefits. FirstEnergy believes its cash from operations and available liquidity will be sufficient to meet its current working capital needs.Short-Term Borrowings / Revolving Credit FacilitiesFE and the Utilities and FET and certain of its subsidiaries participate in two separate five-year syndicated revolving credit facilities providing for aggregate commitments of $3.5 billion, which are available until December 6, 2022. Under the FE credit facility, an aggregate amount of $2.5 billion is available to be borrowed, repaid and reborrowed, subject to separate borrowing sublimits for each borrower including FE and its regulated distribution subsidiaries. Under the FET credit facility, an aggregate amount of $1.0 billion is available to be borrowed, repaid and reborrowed under a syndicated credit facility, subject to separate borrowing sublimits for each borrower including FE's transmission subsidiaries. Borrowings under the credit facilities may be used for working capital and other general corporate purposes, including intercompany loans and advances by a borrower to any of its subsidiaries. Generally, borrowings under each of the credit facilities are available to each borrower separately and mature on the earlier of 364 days from the date of borrowing or the commitment termination date, as the same may be extended. Each of the credit facilities contains financial covenants requiring each borrower to maintain a consolidated debt-to-total-capitalization ratio (as defined under each of the credit facilities) of no more than 65%, and 75% for FET, measured at the end of each fiscal quarter. FirstEnergy’s revolving credit facilities bear interest at fluctuating interest rates, primarily based on LIBOR. LIBOR tends to fluctuate based on general interest rates, rates set by the U.S. Federal Reserve and other central banks, the supply of and demand for credit in the London interbank market and general economic conditions. FirstEnergy has not hedged its interest rate exposure with respect to its floating rate debt. Accordingly, FirstEnergy’s interest expense for any particular period will fluctuate based on LIBOR and other variable interest rates. On July 27, 2017, the Financial Conduct Authority (the authority that regulates LIBOR) announced that it intends to stop compelling banks to submit rates for the calculation of LIBOR after 2021. It is unclear whether new methods of calculating LIBOR will be established such that it continues to exist after 2021, and there is considerable uncertainty regarding the publication of LIBOR beyond 2021. The U.S. Federal Reserve, in conjunction with the Alternative Reference Rates Committee, is considering replacing U.S. dollar LIBOR with a newly created index, calculated based on repurchase agreements backed by treasury securities. It is not possible to predict the effect of these changes, other reforms or the establishment of alternative reference rates in the United Kingdom, the United States or elsewhere. To the extent these interest rates increase, interest expense will increase. If sources of capital for FirstEnergy are reduced, capital costs could increase materially. Restricted access to capital markets and/or increased borrowing costs could have an adverse effect on our results of operations, cash flows, financial condition and liquidity.On November 17, 2020, FE and the Utilities and FET and certain of its subsidiaries entered into amendments to the FE credit facility and the FET credit facility, respectively. The amendments provide for modifications and/or waivers of: (i) certain representations and warranties, and (ii) certain affirmative and negative covenants, contained therein, which allowed FirstEnergy to regain compliance with such provisions. In addition, among other things, the amendment to the FE credit facility reduces the 43sublimit applicable to FE to $1.5 billion, and the amendments increased certain tiers of pricing applicable to borrowings under the credit facilities.On November 23, 2020, FE and its regulated distribution subsidiaries, JCP&L, ME, Penn, TE and WP, borrowed $950 million in the aggregate under the FE Revolving Facility, bringing the outstanding principal balance under the FE Revolving Facility to $1.2 billion, with $1.3 billion of remaining availability under the FE Revolving Facility. On November 23, 2020, FET and its regulated transmission subsidiary, ATSI, borrowed $1 billion in the aggregate under the FET Revolving Facility, bringing the outstanding principal balance under the FET Revolving Facility to $1 billion, with no remaining availability under the FET Revolving Facility. FE, FET and certain of their respective subsidiaries increased their borrowings under the Revolving Facilities as a proactive measure to increase their respective cash positions and preserve financial flexibility. FirstEnergy had $2.2 billion and $1.0 billion of short-term borrowings as of December 31, 2020 and 2019, respectively. FirstEnergy’s available liquidity from external sources as of February 15, 2021, was as follows: Borrower(s)TypeMaturityCommitmentAvailable Liquidity (In millions)FirstEnergy(1)RevolvingDecember 2022$2,500 $1,296 FET(2)RevolvingDecember 20221,000 — Subtotal$3,500 $1,296 Cash and cash equivalents— 1,792 Total$3,500 $3,088 (1)FE and the Utilities. Available liquidity includes impact of $4 million of LOCs issued under various terms.(2)Includes FET and the Transmission Companies.The following table summarizes the borrowing sublimits for each borrower under the facilities, the limitations on short-term indebtedness applicable to each borrower under current regulatory approvals and applicable statutory and/or charter limitations as of January 31, 2021:BorrowerFirstEnergy RevolvingCredit FacilitySublimitFET RevolvingCredit FacilitySublimitRegulatory andOther Short-Term Debt Limitations (In millions) FE$1,500 $— $— (1)FET— 1,000 — (1)OE500 — 500 (2)CEI500 — 500 (2)TE300 — 300 (2)JCP&L500 — 500 (2)ME500 — 500 (2)PN300 — 300 (2)WP200 — 200 (2)MP500 — 500 (2)PE150 — 150 (2)ATSI— 500 500 (2)Penn100 — 100 (2)TrAIL— 400 400 (2)MAIT— 400 400 (2)(1)No limitations.(2)Includes amounts which may be borrowed under the regulated companies' money pool.Subject to each borrower’s sublimit, $250 million of the FE credit facility and $100 million of the FET credit facility, is available for the issuance of LOCs (subject to borrowings drawn under the Facilities) expiring up to one year from the date of issuance. The stated amount of outstanding LOCs will count against total commitments available under each of the Facilities and against the applicable borrower’s borrowing sublimit.The Facilities do not contain provisions that restrict the ability to borrow or accelerate payment of outstanding advances in the event of any change in credit ratings of the borrowers. Pricing is defined in “pricing grids,” whereby the cost of funds borrowed 44under the Facilities is related to the credit ratings of the company borrowing the funds. Additionally, borrowings under each of the Facilities are subject to the usual and customary provisions for acceleration upon the occurrence of events of default, including a cross-default for other indebtedness in excess of $100 million.As of December 31, 2020, the borrowers were in compliance with the applicable debt-to-total-capitalization ratio covenants in each case as defined under the respective Facilities. FirstEnergy Money Pools FirstEnergy’s utility operating subsidiary companies also have the ability to borrow from each other and FE to meet their short-term working capital requirements. Similar but separate arrangements exist among FirstEnergy’s unregulated companies with AE Supply, FE, FET, FEV and certain other unregulated subsidiaries. FESC administers these money pools and tracks surplus funds of FE and the respective regulated and unregulated subsidiaries, as the case may be, as well as proceeds available from bank borrowings. Companies receiving a loan under the money pool agreements must repay the principal amount of the loan, together with accrued interest, within 364 days of borrowing the funds. The rate of interest is the same for each company receiving a loan from their respective pool and is based on the average cost of funds available through the pool. The average interest rate for borrowings in 2020 was 0.89% per annum for the regulated companies’ money pool and 1.19% per annum for the unregulated companies’ money pool. Long-Term Debt Capacity FE's and its subsidiaries' access to capital markets and costs of financing are influenced by the credit ratings of their securities. The following table displays FE’s and its subsidiaries’ credit ratings as of February 15, 2021:Corporate Credit RatingSenior SecuredSenior UnsecuredOutlook/Watch (1)IssuerS&PMoody’sFitchS&PMoody’sFitchS&PMoody’sFitchS&PMoody’sFitchFEBBBa1BB+BBBa1 BB+CW-NNNAGCBBBaa2BBB-CW-NSNATSIBBA3BBB- BB+A3BBBCW-NSNCEIBBBaa2BBB-BBBA3BBB+ BB+Baa2BBBCW-NNNFETBBBaa2BB+BBBaa2 BB+CW-NNNJCP&LBBA3BBB- BB+A3BBBCW-NSNMEBBA3BBB- BB+A3BBBCW-NSNMAITBBA3BBB- BB+A3BBBCW-NSNMPBBBaa2BBB-BBBA3BBB+ BB+Baa2CW-NSNOEBBA3BBB-BBBA1BBB+ BB+A3BBBCW-NNNPN BBBaa1BBB- BB+Baa1BBBCW-NSNPenn BBA3BBB-BBBA1BBB+CW-NSNPEBBBaa2BBB-BBBA3BBB+CW-NSNTEBBBaa1BBB-BBBA2BBB+CW-NNNTrAILBBA3BBB- BB+A3BBBCW-NSNWP BBA3BBB-BBBA1BBB+CW-NSN (1) S = Stable, P = Positive, N = Negative, CW-N = CreditWatch with Negative implicationsOn May 27, 2020, Moody’s upgraded the issuer and senior unsecured ratings of JCP&L to A3 from Baa1 and the rating outlook was changed to stable.On July 23, 2020, S&P placed the ratings of FE and its subsidiaries on CreditWatch with negative implications.On July 24, 2020, Moody’s revised FE’s ratings outlook to negative from stable. FE’s Baa3 corporate credit rating and Baa3 senior unsecured rating were affirmed.On July 28, 2020, Fitch revised FE and its subsidiaries, with the exception of MP, AGC and PE, ratings outlook to negative from stable. The outlook of MP, AGC and PE is stable. Fitch also affirmed FE and its subsidiary ratings.On August 14, 2020, Moody’s affirmed OE’s A3 senior unsecured and issuer ratings and Penn’s A3 issuer rating. The outlooks were changed to stable from positive.45On October 30, 2020, Fitch downgraded FE and FET’s issuer default ratings and senior unsecured ratings one notch to BBB- from BBB. Fitch also downgraded FE’s subsidiaries issuer default ratings one notch to BBB from BBB+, except for PE, MP, and AGC, whose ratings were affirmed at BBB. Senior unsecured issue ratings for the subsidiaries were downgraded one notch, where applicable, to BBB+ from A-. Senior secured issue ratings for the subsidiaries were downgraded one notch, where applicable, to A- from A. The rating outlook is negative for FE and its subsidiaries.On October 30, 2020, S&P downgraded FE and its subsidiaries issuer credit ratings two notches to BB+ from BBB, except for AGC which was lowered to BB from BBB-. The senior unsecured issue ratings of FE and FET were changed one notch to BB+ from BBB-. The senior unsecured issue ratings of the subsidiaries, where applicable, were lowered one notch to BBB- from BBB. Additionally, the senior secured issue ratings of the subsidiaries, where applicable, were lowered one notch to BBB+ from A-. The ratings on FE and its subsidiaries remain on CreditWatch with negative implications.On November 20, 2020, Fitch downgraded the issuer default rating (IDR) and senior unsecured ratings of FE and FET one notch, to BB+ from BBB-. The IDRs of the remaining subsidiaries were also lowered one notch to BBB- from BBB, the senior unsecured ratings were lowered (where applicable) one notch to BBB from BBB+, and the senior secured ratings were lowered (where applicable) one notch to BBB+ from A-. The outlook for FE and its subsidiaries remains negative. On November 24, 2020, Moody’s downgraded the ratings of FE Corp, including its senior unsecured rating to Ba1 from Baa3. Moody’s also assigned a Ba1 Corporate Family Rating to FE and withdrew FE’s Baa3 Issuer Rating. The outlook for FE remains negative. Additionally, the outlooks for OE, TE, CE, and FET were changed to negative from stable.On November 24, 2020, S&P downgraded FE and its subsidiaries issuer credit ratings to BB from BB+ and affirmed the BB issuer credit rating of AGC. The senior unsecured ratings on FE and FET were lowered to BB from BB+. The subsidiary senior unsecured ratings were lowered, where applicable, to BB+ from BBB-, and the senior secured ratings, where applicable, were lowered to BBB from BBB+. The ratings remain on CreditWatch Negative.On December 17, 2020, Moody’s assigned senior secured ratings of A3 to PE and A1 to WP. On December 21, 2020, S&P assigned senior secured ratings of BBB to PE, Penn and WP.As of December 31, 2020, $20 million of collateral has been posted by FE or its subsidiaries, of which, $19 million was posted as a result of the credit rating downgrades in the fourth quarter of 2020.The applicable undrawn and drawn margin on the FE and FET credit facilities are subject to ratings-based pricing grids. The applicable fee paid on the undrawn commitments under the FE and FET credit facilities are based on FE and FET’s senior unsecured non-credit enhanced debt ratings as determined by S&P and Moody’s. The fee paid on actual borrowings are determined based on each borrower’s senior unsecured non-credit enhanced debt ratings as determined by S&P and Moody’s.The interest rate payable on approximately $3.85 billion in FE’s senior unsecured notes are subject to adjustments from time to time if the ratings on the notes from any one or more of S&P, Moody’s and Fitch decreases to a rating set forth in the applicable documents. Generally a one-notch downgrade by the applicable rating agency may result in a 25 bps coupon rate increase beginning at BB, Ba1, and BB+ for S&P, Moody’s and Fitch, respectively, to the extent such rating is applicable to the series of outstanding senior unsecured notes, during the next interest period, subject to an aggregate cap of 2% from issuance interest rate.Debt capacity is subject to the consolidated debt-to-total-capitalization limits in the credit facilities previously discussed. As of December 31, 2020, FE and its subsidiaries could issue additional debt of approximately $4.8 billion, or incur a $2.6 billion reduction to equity, and remain within the limitations of the financial covenants required by the FE credit facility. Changes in Cash PositionAs of December 31, 2020, FirstEnergy had $1,734 million of cash and cash equivalents and approximately $67 million of restricted cash compared to $627 million of cash and cash equivalents and approximately $52 million of restricted cash as of December 31, 2019, on the Consolidated Balance Sheets. Cash Flows From Operating ActivitiesFirstEnergy's most significant sources of cash are derived from electric service provided by its distribution and transmission operating subsidiaries. Beyond the cash settlement and tax sharing payments to the FES Debtors in 2020, and pension contribution in 2019, the most significant use of cash from operating activities is buying electricity to serve non-shopping customers and paying fuel suppliers, employees, tax authorities, lenders and others for a wide range of materials and services.Net cash provided from operating activities was $1,423 million during 2020, $2,467 million during 2019 and $1,410 million during 2018.462020 compared with 2019Cash flows from operations decreased $1,044 million in 2020 as compared with 2019. The year-over-year change in cash from operations is primarily due to the $978 million cash settlement and tax sharing payments made to the FES Debtors upon their emergence in February 2020, an increase to accounts receivable customer balances due to the impact of COVID-19, and higher storm restoration costs, partially offset by the absence of a $500 million cash contribution to the qualified pension plan in 2019. FirstEnergy's Consolidated Statements of Cash Flows combine cash flows from discontinued operations with cash flows from continuing operations within each cash flow category. The following table summarizes the major classes of operating cash flow items from discontinued operations for the years ended December 31, 2020, 2019 and 2018: For the Years Ended December 31,(In millions)202020192018CASH FLOWS FROM OPERATING ACTIVITIES:Income from discontinued operations$76 $8 $326 Gain on disposal, net of tax (76)(59)(435)Depreciation and amortization, including nuclear fuel, regulatory assets, net, intangible assets and deferred debt-related costs— — 110 Deferred income taxes and investment tax credits, net— 47 61 Unrealized (gain) loss on derivative transactions — — (10)47Cash Flows From Financing ActivitiesCash provided from financing activities was $2,607 million, $656 million, and $1,394 million in 2020, 2019, and 2018, respectively. The following table summarizes new equity and debt financing, redemptions, repayments, make-whole premiums paid on debt redemptions short-term borrowings and dividends:For the Years Ended December 31,Securities Issued or Redeemed / Repaid202020192018 (In millions)New Issues Preferred stock issuance$— $— $1,616 Common stock issuance— — 850 Unsecured notes3,250 1,850 850 PCRBs— — 74 FMBs175 450 50 Term loan— — 500 $3,425 $2,300 $3,940 Redemptions / Repayments Unsecured notes$(250)$(725)$(555)PCRBs— — (216)FMBs(50)(1)(325)Term loan(750)— (1,450)Senior secured notes(64)(63)(62) $(1,114)$(789)$(2,608)Tender premiums paid on debt redemptions$— $— $(89)Short-term borrowings, net$1,200 $— $950 Preferred stock dividend payments$— $(6)$(61)Common stock dividend payments$(845)$(814)$(711)On February 20, 2020, FE issued $1.75 billion in senior unsecured notes in three separate series: (i) $300 million aggregate principal amount of 2.050% Notes, Series A, due 2025, (ii) $600 million aggregate principal amount of 2.650% Notes, Series B, due 2030 and (iii) $850 million aggregate principal amount of 3.400% Notes, Series C, due 2050. Proceeds from the issuance of the notes, together with cash on hand, were used: (i) to repay the entire $750 million two-year term loan due September 2021, (ii) to make the $853 million in bankruptcy settlement payments and $125 million tax sharing agreement payment with the FES Debtors as discussed above, (iii) to repay $250 million of the $1 billion outstanding 364-day term loan due September 2020, and (iv) for working capital needs and general corporate purposes.On March 31, 2020, MAIT issued $125 million of 3.60% senior unsecured notes due 2032 and $125 million of 3.70% senior unsecured notes due 2035. Proceeds from the issuance of the notes were used: (i) to refinance existing debt, (ii) for capital expenditures, and (iii) for general corporate purposes.On April 20, 2020, PN issued $125 million of 3.61% senior unsecured notes due 2032 and $125 million of 3.71% senior unsecured notes due 2035. Proceeds of the issuance of the notes were used: (i) to refinance indebtedness, including short-term borrowings incurred under the FirstEnergy regulated money pool to repay a portion of the $250 million aggregate principle amount of PN’s 5.20% Senior Notes due April 1, 2020, (ii) to fund capital expenditures, (iii) to fund general corporate purposes, or (iv) for any combination of the above.On June 8, 2020, FE issued $750 million in senior unsecured notes in two separate series: (i) $300 million aggregate principal amounts of 1.600% Notes, Series A, due 2026 and (ii) $450 million aggregate principal amount of 2.250% Notes, Series B, due 2030. Proceeds from the issuance of the notes were used to repay all amounts outstanding under the 364-day term loan due September 2020.48On June 29, 2020, PE issued $75 million of 2.67% FMBs due 2032 and $100 million of 3.43% FMBs due 2051. Proceeds of the issuance of the FMBs were used to repay short-term borrowings under the FirstEnergy regulated money pool, to fund capital expenditures, and for general corporate purposes.On July 20, 2020, CEI issued $150 million of 2.77% senior unsecured notes due 2034 and $100 million of 3.23% senior unsecured notes due 2040. Proceeds from the issuance of the notes were used to refinance existing short-term borrowings, to fund capital expenditures, and for general corporate purposes. Cash Flows From Investing ActivitiesCash used for investing activities in 2020 principally represented cash used for property additions. The following table summarizes investing activities for 2020, 2019 and 2018: For the Years Ended December 31,Cash Used for (Provided from) Investing Activities202020192018(In millions)Property Additions:Regulated Distribution$1,514 $1,473 $1,411 Regulated Transmission1,067 1,090 1,104 Corporate/Other76 102 160 Proceeds from asset sales(2)(47)(425)Investments22 38 54 Notes receivable from affiliated companies— — 500 Asset removal costs224 217 218 Other7 — (4)$2,908 $2,873 $3,018 FirstEnergy's Consolidated Statements of Cash Flows combines cash flows from discontinued operations with cash flows from continuing operations within each cash flow category. The following table summarizes the major classes of investing cash flow items from discontinued operations for the years ended December 31, 2020, 2019 and 2018: For the Years Ended December 31,(In millions)202020192018CASH FLOWS FROM INVESTING ACTIVITIES:Property additions$— $— $(27)Sales of investment securities held in trusts— — 109 Purchases of investment securities held in trusts— — (122)49CONTRACTUAL OBLIGATIONSAs of December 31, 2020, FirstEnergy's estimated undiscounted cash payments under existing contractual obligations that it considers firm obligations are as follows: Contractual ObligationsTotal20212022-20232024-2025Thereafter(In millions)Long-term debt(1)$22,377 $132 $2,337 $3,269 $16,639 Short-term borrowings2,200 2,200 — — — Interest on long-term debt(2)12,808 999 1,874 1,647 8,288 Operating leases(3)366 50 95 74 147 Finance leases(3)61 18 23 8 12 Fuel and purchased power(4)3,049 499 883 652 1,015 Capital expenditures(5)2,028 548 778 702 — Pension funding870 — 399 471 — Total$43,759 $4,446 $6,389 $6,823 $26,101 (1)Excludes unamortized discounts and premiums, fair value accounting adjustments and finance leases.(2)Interest on variable-rate debt based on rates as of December 31, 2020.(3)See Note 8, "Leases," of the Notes to Consolidated Financial Statements.(4)Amounts under contract with fixed or minimum quantities based on estimated annual requirements.(5)Amounts represent committed capital expenditures as of December 31, 2020.Excluded from the table above are estimates for the cash outlays from power purchase contracts entered into by most of the Utilities and under which they procure the power supply necessary to provide generation service to their customers who do not choose an alternative supplier. Although actual amounts will be determined by future customer behavior and consumption levels, management currently estimates these cash outlays will be approximately $2.7 billion in 2021.The table above also excludes regulatory liabilities (see Note 14, "Regulatory Matters"), AROs (see Note 13, "Asset Retirement Obligations"), reserves for litigation, injuries and damages, environmental remediation, and annual insurance premiums since the amount and timing of the cash payments are uncertain. The table also excludes accumulated deferred income taxes and investment tax credits since cash payments for income taxes are determined based primarily on taxable income for each applicable fiscal year.50GUARANTEES AND OTHER ASSURANCESFirstEnergy has various financial and performance guarantees and indemnifications which are issued in the normal course of business. These contracts include performance guarantees, stand-by letters of credit, debt guarantees, surety bonds and indemnifications. FirstEnergy enters into these arrangements to facilitate commercial transactions with third parties by enhancing the value of the transaction to the third party. The maximum potential amount of future payments FirstEnergy and its subsidiaries could be required to make under these guarantees as of December 31, 2020, was approximately $1.7 billion, as summarized below:Guarantees and Other AssurancesMaximum Exposure (In millions)FE's Guarantees on Behalf of its Consolidated SubsidiariesAE Supply asset sales(1)$570 Deferred compensation arrangements475 Fuel related contracts and other7 1,052 FE's Guarantees on Other AssurancesGlobal Holding Facility108 Deferred compensation arrangements146 Surety Bonds328 LOCs and other 16 598 Total Guarantees and Other Assurances$1,650 (1)As a condition to closing AE Supply's sale of four natural gas generating plants and an approximately 59% portion of AGC's interest in the Bath Power Station, FE provided the purchaser two limited three-year guarantees totaling $555 million of certain obligations of AE Supply and AGC, which by their terms expire in May 2021. In addition, as a condition to closing AE Supply's transfer of Pleasants Power Station and as contemplated under the FES Bankruptcy settlement agreement, FE has provided two additional guarantees for certain retained liabilities of AE Supply, the first totaling up to $15 million for certain environmental liabilities associated with Pleasants Power Station, and the second being limited solely to environmental liabilities for the McElroy's Run CCR impoundment facility, for which an ARO of $46 million is reflected on FirstEnergy's Consolidated Balance Sheet, and which is not reflected on the table above.Collateral and Contingent-Related FeaturesIn the normal course of business, FE and its subsidiaries may enter into physical or financially settled contracts for the sale and purchase of electric capacity, energy, fuel and emission allowances. Certain agreements contain provisions that require FE or its subsidiaries to post collateral. This collateral may be posted in the form of cash or credit support with thresholds contingent upon FE's or its subsidiaries' credit rating from each of the major credit rating agencies. The collateral and credit support requirements vary by contract and by counterparty.As of December 31, 2020, $20 million of collateral has been posted by FE or its subsidiaries, of which, $19 million was posted as a result of the credit rating downgrades in the fourth quarter of 2020, as further discussed above.These credit-risk-related contingent features stipulate that if the subsidiary were to be downgraded or lose its investment grade credit rating (based on its senior unsecured debt rating), it would be required to provide additional collateral. The following table discloses the potential additional credit rating contingent contractual collateral obligations as of December 31, 2020:Potential Collateral ObligationsUtilities and FETFETotal(In millions)Contractual Obligations for Additional CollateralUpon Further Downgrade$37 $— $37 Surety Bonds (Collateralized Amount)(1)55 258 313 Total Exposure from Contractual Obligations$92 $258 $350 (1) Surety Bonds are not tied to a credit rating. Surety Bonds' impact assumes maximum contractual obligations, which is ordinarily 100% of the face amount of the surety bond except with the respect to $39 million of surety obligations for which the collateral obligation is capped at 60% of the face amount, and typical obligations require 30 days to cure. 51Other Commitments and ContingenciesFE is a guarantor under a $120 million syndicated senior secured term loan facility due November 12, 2024, under which Global Holding's outstanding principal balance is $108 million as of December 31, 2020. Signal Peak, Global Rail, Global Mining Group, LLC and Global Coal Sales Group, LLC, each being a direct or indirect subsidiary of Global Holding, and FE continue to provide their joint and several guaranties of the obligations of Global Holding under the facility.In connection with the facility, 69.99% of Global Holding's direct and indirect membership interests in Signal Peak, Global Rail and their affiliates along with FEV's and WMB Marketing Ventures, LLC's respective 33-1/3% membership interests in Global Holding, are pledged to the lenders under the current facility as collateral.MARKET RISK INFORMATIONFirstEnergy uses various market risk sensitive instruments, including derivative contracts, primarily to manage the risk of price and interest rate fluctuations. FirstEnergy’s Risk Policy Committee, comprised of members of senior management, provides general oversight for risk management activities throughout the company.Commodity Price RiskFirstEnergy has limited exposure to financial risks resulting from fluctuating commodity prices, including prices for electricity, natural gas, coal and energy transmission. FirstEnergy's Risk Management Committee is responsible for promoting the effective design and implementation of sound risk management programs and oversees compliance with corporate risk management policies and established risk management practice.The valuation of derivative contracts is based on observable market information. As of December 31, 2020, FirstEnergy has a net liability of $3 million in non-hedge derivative contracts that are related to FTRs at certain of the Utilities. FTRs are subject to regulatory accounting and do not impact earnings.Equity Price RiskAs of December 31, 2020, the FirstEnergy pension plan assets were allocated approximately as follows: 23% in equity securities, 35% in fixed income securities, 7% in hedge funds, 4% in insurance-linked securities, 9% in real estate, 5% in private equity and 17% in cash and short-term securities. A decline in the value of pension plan assets could result in additional funding requirements. FirstEnergy’s funding policy is based on actuarial computations using the projected unit credit method. On February 1, 2019, FirstEnergy made a $500 million voluntary cash contribution to the qualified pension plan. As a result of this contribution and pension investment performance returns to date, FirstEnergy expects no required contributions until 2022. As of December 31, 2020, FirstEnergy's OPEB plan assets were allocated approximately 55% in equity securities, 28% in fixed income securities and 17% in cash and short-term securities. Investment markets experienced elevated market volatility during 2020 as a result of the U.S. general election and the COVID-19 pandemic. In order to reduce the effect of market volatility on the plan's funded status and to preserve capital gains experienced during the first half of 2020, approximately $1.4 billion of return-seeking assets were sold (including approximately $800 million of equity securities) during the third quarter of 2020. These assets are expected be reinvested in return seeking investments (including equity securities) during 2021, which will more consistently align the pension and OPEB trust portfolios to the company’s target asset allocations. See Note 5, "Pension and Other Post-Employment Benefits," of the Notes to Consolidated Financial Statements for additional details on FirstEnergy's pension and OPEB plans. During 2020, FirstEnergy's pension and OPEB plan assets gained approximately 14.8% and 13.2%, respectively, as compared to an annual expected return on plan assets of 7.50%. On February 27, 2020, FirstEnergy remeasured its plan assets, and from that date through December 31, 2020, FirstEnergy's pension and OPEB plan assets gained approximately 11.6% and 12.5%, respectively. 52Interest Rate RiskFirstEnergy’s exposure to fluctuations in market interest rates is reduced since a significant portion of debt has fixed interest rates, as noted in the table below. FirstEnergy is subject to the inherent interest rate risks related to refinancing maturing debt by issuing new debt securities.Comparison of Carrying Value to Fair ValueYear of Maturity20212022202320242025There-afterTotalFair Value(In millions)Assets:Investments Other Than Cash and Cash Equivalents:Fixed Income$— $— $— $— $— $276 $276 $401 Average interest rate— %— %— %— %— %4.0 %4.0 %Liabilities:Long-term Debt:Fixed rate$132 $1,143 $1,194 $1,246 $2,023 $16,639 $22,377 $25,465 Average interest rate3.7 %4.1 %4.1 %4.7 %3.8 %4.6 %4.5 %FirstEnergy recognizes net actuarial gains or losses for its pension and OPEB plans in the fourth quarter of each fiscal year and whenever a plan is determined to qualify for a remeasurement. A primary factor contributing to these actuarial gains and losses are changes in the discount rates used to value pension and OPEB obligations as of the measurement date and the difference between expected and actual returns on the plans’ assets. CREDIT RISKCredit risk is the risk that FirstEnergy would incur a loss as a result of nonperformance by counterparties of their contractual obligations. FirstEnergy maintains credit policies and procedures with respect to counterparty credit (including requirement that counterparties maintain specified credit ratings) and require other assurances in the form of credit support or collateral in certain circumstance in order to limit counterparty credit risk. In addition, in response to the COVID-19 pandemic, FirstEnergy has increased reviews of counterparties, customers and industries that have been negatively impacted, which could affect meeting contractual obligations with FirstEnergy. FirstEnergy has concentrations of suppliers and customers among electric utilities, financial institutions and energy marketing and trading companies. These concentrations may impact FirstEnergy's overall exposure to credit risk, positively or negatively, as counterparties may be similarly affected by changes in economic, regulatory or other conditions. In the event an energy supplier of the Ohio Companies, Pennsylvania Companies, JCP&L or PE defaults on its obligation, the affected company would be required to seek replacement power in the market. In general, subject to regulatory review or other processes, it is expected that appropriate incremental costs incurred by these entities would be recoverable from customers through applicable rate mechanisms, thereby mitigating the financial risk for these entities. FirstEnergy's credit policies to manage credit risk include the use of an established credit approval process, daily credit mitigation provisions, such as margin, prepayment or collateral requirements, and surveys to determine negative impacts to essential vendors as a result of the COVID-19 pandemic. FirstEnergy and its subsidiaries may request additional credit assurance, in certain circumstances, in the event that the counterparties' credit ratings fall below investment grade, their tangible net worth falls below specified percentages or their exposures exceed an established credit limit. OUTLOOKCARES ACTOn March 27, 2020, President Trump signed into law the CARES Act, an economic stimulus package in response to the COVID-19 pandemic containing several corporate income tax provisions, including making remaining AMT credits immediately refundable; providing a 5-year carryback of NOLs generated in tax years 2018, 2019, and 2020, and removing the 80% taxable income limitation on utilization of those NOLs if carried back to prior tax years or utilized in tax years beginning before 2021; and temporarily liberalizing the interest deductibility rules under Section 163(j) of the Tax Act, by raising the adjusted taxable income limitation from 30% to 50% for tax years 2019 and 2020 and giving taxpayers the election of using 2019 adjusted taxable income for purposes of computing 2020 interest deductibility. FirstEnergy has applied for refund of its remaining approximately $18 million refundable AMT credits. FirstEnergy does not expect to generate additional income tax refunds from the carryback of NOLs and expects interest to be fully deductible in the 2020 consolidated federal income tax return and going forward. FirstEnergy does not currently expect the other provisions of the CARES Act to have a material effect on current income tax expense or the realizability of deferred income tax assets.53On July 28, 2020, the IRS issued final regulations implementing interest expense deduction limitation rules under section 163(j) of the Internal Revenue Code. The final regulations changed certain rules on the computation of interest expense and limitation amount, as well as rules relevant to status as a regulated utility business and the allocation of consolidated group interest expense between utility and non-utility businesses. After reviewing the final regulations, FirstEnergy recorded a true-up to prior years’ reserve estimates during the third quarter of 2020, which did not have a material impact to FirstEnergy’s income statement. On January 6, 2021, the IRS released an additional set of final regulations under Section 163(j) primarily addressing partnership, real estate, and certain controlled foreign corporation issues, which do not materially impact FirstEnergy. STATE REGULATIONEach of the Utilities' retail rates, conditions of service, issuance of securities and other matters are subject to regulation in the states in which it operates - in Maryland by the MDPSC, in New Jersey by the NJBPU, in Ohio by the PUCO, in Pennsylvania by the PPUC, in West Virginia by the WVPSC and in New York by the NYPSC. The transmission operations of PE in Virginia, ATSI in Ohio, and the Transmission Companies in Pennsylvania are subject to certain regulations of the VSCC, PUCO and PPUC, respectively. In addition, under Ohio law, municipalities may regulate rates of a public utility, subject to appeal to the PUCO if not acceptable to the utility. Further, if any of the FirstEnergy affiliates were to engage in the construction of significant new transmission facilities, depending on the state, they may be required to obtain state regulatory authorization to site, construct and operate the new transmission facility. The following table summarizes the key terms of distribution rate orders in effect for the Utilities:CompanyRates EffectiveAllowed Debt/EquityAllowed ROECEIMay 200951% / 49%10.5%ME(1)January 201748.8% / 51.2%Settled(2)MPFebruary 201554% / 46%Settled(2)JCP&L(3)January 201755% / 45%9.6%OEJanuary 200951% / 49%10.5%PE (West Virginia)February 201554% / 46%Settled(2)PE (Maryland)March 201947% / 53%9.65%PN(1)January 201747.4% / 52.6%Settled(2)Penn(1)January 201749.9% / 50.1%Settled(2)TEJanuary 200951% / 49%10.5%WP(1)January 201749.7% / 50.3%Settled(2)(1) Reflects filed debt/equity as final settlement/orders do not specifically include capital structure. (2) Commission-approved settlement agreements did not disclose ROE rates. (3) On October 28, 2020, the NJBPU approved JCP&L's distribution rate case settlement with an allowed ROE of 9.6% and a 48.56% debt / 51.44% equity capital structure. Rates are effective for customers on November 1, 2021, but beginning January 1, 2021, JCP&L will offset the impact to customers' bills by amortizing an $86 million regulatory liability. MARYLANDPE operates under MDPSC approved base rates that were effective as of March 23, 2019. PE also provides SOS pursuant to a combination of settlement agreements, MDPSC orders and regulations, and statutory provisions. SOS supply is competitively procured in the form of rolling contracts of varying lengths through periodic auctions that are overseen by the MDPSC and a third-party monitor. Although settlements with respect to SOS supply for PE customers have expired, service continues in the same manner until changed by order of the MDPSC. PE recovers its costs plus a return for providing SOS. The EmPOWER Maryland program requires each electric utility to file a plan to reduce electric consumption and demand 0.2% per year, up to the ultimate goal of 2% annual savings, for the duration of the 2018-2020 and 2021-2023 EmPOWER Maryland program cycles, to the extent the MDPSC determines that cost-effective programs and services are available. PE's approved 2018-2020 EmPOWER Maryland plan continues and expands upon prior years' programs, and adds new programs, for a projected total cost of $116 million over the three-year period. PE recovers program costs through an annually reconciled surcharge, with most costs subject to a five-year amortization. Maryland law only allows for the utility to recover lost distribution revenue attributable to energy efficiency or demand reduction programs through a base rate case proceeding, and to date, such recovery has not been sought or obtained by PE. On September 1, 2020, PE filed its proposed plan for the 2021-2023 EmPOWER Maryland program cycle. The new plan largely continues PE’s existing programs and is estimated to cost approximately $148 million over the three-year period. The MDPSC approved the plan on December 18, 2020. On January 19, 2018, PE filed a joint petition along with other utility companies, work group stakeholders and the MDPSC electric vehicle work group leader to implement a statewide electric vehicle portfolio in connection with a 2016 MDPSC proceeding to consider an array of issues relating to electric distribution system design, including matters relating to electric vehicles, distributed energy resources, advanced metering infrastructure, energy storage, system planning, rate design, and impacts on low-income customers. PE proposed an electric vehicle charging infrastructure program at a projected total cost of 54$12 million, to be recovered over a five-year amortization. On January 14, 2019, the MDPSC approved the petition subject to certain reductions in the scope of the program. The MDPSC approved PE’s compliance filing, which implements the pilot program, with minor modifications, on July 3, 2019. On August 24, 2018, PE filed a base rate case with the MDPSC, which it supplemented on October 22, 2018, to update the partially forecasted test year with a full twelve months of actual data. The rate case requested an annual increase in base distribution rates of $19.7 million, plus creation of an EDIS to fund four enhanced service reliability programs. In responding to discovery, PE revised its request for an annual increase in base rates to $17.6 million. The proposed rate increase reflected $7.3 million in annual savings for customers resulting from the recent federal tax law changes. On March 22, 2019, the MDPSC issued a final order that approved a rate increase of $6.2 million, approved three of the four EDIS programs for four years, directed PE to file a new depreciation study within 18 months, and ordered the filing of a new base rate case in four years to correspond to the ending of the approved EDIS programs. On September 22, 2020, PE filed its depreciation study reflecting a depreciation expense of $36.2 million, which represented a slight increase, and as a result, is seeking difference in depreciation be deferred for future recovery in PE’s next base rate case. The MDPSC has set the matter for hearing and delegated it to a public utility law judge. On November 6, 2020, an order was issued scheduling evidentiary hearings in April 2021. On January 29, 2021, the Maryland Office of People's Counsel filed testimony recommending a reduction in depreciation expense of $10.8 million, and the staff of the MDPSC filed testimony recommending a reduction of $9.6 million. PE's rebuttal testimony is due on March 2, 2021. Maryland’s Governor issued an order on March 16, 2020, forbidding utilities from terminating residential service or charging late fees for non-payment for the duration of the COVID-19 pandemic. On April 9, 2020, the MDPSC issued an order allowing utilities to track and create a regulatory asset for future recovery of all prudently incurred incremental costs arising from the COVID-19 pandemic, including incremental uncollectible expense, incurred from the date of the Governor’s order (or earlier if the utility could show that the expenses related to suspension of service terminations). On July 8, 2020, the MDPSC issued a notice opening a public conference to collect information from utilities and other stakeholders about the impacts of the COVID-19 pandemic on the utilities and their customers. The MDPSC subsequently issued orders allowing Maryland electric and gas utilities to resume residential service terminations for non-payment on November 15, 2020, subject to various restrictions, and clarifying that utilities could resume charging late fees on October 1, 2020. NEW JERSEYJCP&L operates under NJBPU approved rates that were effective as of January 1, 2017. JCP&L provides BGS for retail customers who do not choose a third-party EGS and for customers of third-party EGSs that fail to provide the contracted service. All New Jersey EDCs participate in this competitive BGS procurement process and recover BGS costs directly from customers as a charge separate from base rates.On April 18, 2019, pursuant to the May 2018 New Jersey enacted legislation establishing a ZEC program to provide ratepayer funded subsidies of New Jersey nuclear energy supply, the NJBPU approved the implementation of a non-bypassable, irrevocable ZEC charge for all New Jersey electric utility customers, including JCP&L’s customers. Once collected from customers by JCP&L, these funds will be remitted to eligible nuclear energy generators. In December 2017, the NJBPU issued proposed rules to modify its current CTA policy in base rate cases to: (i) calculate savings using a five-year look back from the beginning of the test year; (ii) allocate savings with 75% retained by the company and 25% allocated to ratepayers; and (iii) exclude transmission assets of electric distribution companies in the savings calculation, which were published in the NJ Register in the first quarter of 2018. JCP&L filed comments supporting the proposed rulemaking. On January 17, 2019, the NJBPU approved the proposed CTA rules with no changes. On May 17, 2019, the Rate Counsel filed an appeal with the Appellate Division of the Superior Court of New Jersey. Oral Argument is scheduled for March 10, 2021. JCP&L is contesting this appeal but is unable to predict the outcome of this matter. Also, in December 2017, the NJBPU approved its IIP rulemaking. The IIP creates a financial incentive for utilities to accelerate the level of investment needed to promote the timely rehabilitation and replacement of certain non-revenue producing components that enhance reliability, resiliency, and/or safety. On May 8, 2019, the NJBPU approved a stipulation of settlement submitted by JCP&L, Rate Counsel, NJBPU staff and New Jersey Large Energy Users Coalition to implement JCP&L’s infrastructure plan, JCP&L Reliability Plus. The plan provides that JCP&L will invest up to approximately $97 million in capital investments beginning on June 1, 2019 through December 31, 2020, to enhance the reliability and resiliency of JCP&L’s distribution system and reduce the frequency and duration of power outages. JCP&L shall seek recovery of the capital investment through an accelerated cost recovery mechanism, provided for in the rules, that includes a revenue adjustment calculation and a process for two rate adjustments. The NJBPU approved adjusted rates that took effect on March 1, 2020. As further discussed below, JCP&L will recover the IIP capital investments, which totaled $97 million, as part of its distribution base rate case. On February 18, 2020, JCP&L submitted a filing with the NJBPU requesting a distribution base rate increase of $186.9 million on an annual basis, which represents an overall average increase in JCP&L rates of 7.8%. The filing seeks to recover certain costs associated with providing safe and reliable electric service to JCP&L customers, along with recovery of previously incurred storm costs. JCP&L proposed a rate effective date of March 19, 2020. The NJBPU issued orders suspending JCP&L’s proposed rates 55until November 19, 2020. JCP&L filed updates to the requested distribution base rate in both June and July 2020, resulting in JCP&L seeking a total annual distribution base rate increase of approximately $185 million. On October 16, 2020, the parties submitted a stipulation of settlement to the administrative law judge, providing for, among other things, a $94 million annual base distribution revenues increase for JCP&L based on an ROE of 9.6%, which will become effective for customers on November 1, 2021. Until the rates become effective, and starting on January 1, 2021, JCP&L is permitted to amortize an existing regulatory liability totaling approximately $86 million to offset the base rate increase that otherwise would have occurred in this period. The parties also agreed that the actual net gain from the sale of JCP&L’s interest in the Yards Creek pumped-storage hydro generation facility in New Jersey (210 MWs), as further discussed below, shall be applied to reduce JCP&L’s existing regulatory asset for previously deferred storm costs. Lastly, the parties agreed that $95.1 million of Reliability Plus capital investment for projects through December 31, 2020 is included in rate base effective December 31, 2020, with a final prudence review of only those capital investment projects from July 1, 2020 through December 31, 2020 to occur in January 2021. On October 22, 2020, the administrative law judge entered an initial decision adopting the settlement. On October 28, 2020, the NJBPU approved the settlement and directed an upcoming management audit for JCP&L. On January 4, 2021, JCP&L submitted its review of storm costs as required under the stipulation of settlement. On January 15, 2021, JCP&L filed a written report for its Reliability Plus projects placed in service from July 1, 2020 through December 31, 2020, also as required under the stipulation of settlement. On April 6, 2020, JCP&L signed an asset purchase agreement with Yards Creek Energy, LLC, a subsidiary of LS Power to sell its 50% interest in the Yards Creek pumped-storage hydro generation facility. Subject to terms and conditions of the agreement, the base purchase price is $155 million. On July 31, 2020, FERC approved the transfer of JCP&L’s interest in the hydroelectric operating license. On October 8, 2020, FERC issued an order authorizing the transfer of JCP&L’s ownership interest in the hydroelectric facilities. On October 28, 2020, the NJBPU approved the sale of Yards Creek. Completion of the transaction is subject to several closing conditions; there can be no assurance that all closing conditions will be satisfied or that the transaction will be consummated. JCP&L currently anticipates closing of the transaction to occur during the first quarter of 2021. Assets held for sale on FirstEnergy’s Consolidated Balance Sheets associated with the transaction consist of property, plant and equipment of $45 million, which is included in the regulated distribution segment.On August 27, 2020, JCP&L filed an AMI Program with the NJBPU, which proposes the deployment of approximately 1.2 million advanced meters over a three-year period beginning on January 1, 2023, at a total cost of approximately $418 million, including the pre-deployment phase. The 3-year deployment is part of the 20-year AMI Program that is expected to cost a total of approximately $732 million and proposes a cost recovery mechanism through a separate AMI tariff rider. On January 13, 2021, a procedural schedule was established, which includes evidentiary hearings the week of May 24, 2021. On June 10, 2020, the NJBPU issued an order establishing a framework for the filing of utility-run energy efficiency and peak demand reduction programs in accordance with the New Jersey Clean Energy Act. Under the established framework, JCP&L will recover its program investments over a ten year amortization period and its operations and maintenance expenses on an annual basis, be eligible to receive lost revenues on energy savings that resulted from its programs and be eligible for incentives or subject to penalties based on its annual program performance, beginning in the fifth year of its program offerings. On September 25, 2020, JCP&L filed its energy efficiency and peak demand reduction program. JCP&L’s program consists of 11 energy efficiency and peak demand reduction programs and subprograms to be run from July 1, 2021 through June 30, 2024. The program also seeks approval of cost recovery totaling approximately $230 million as well as lost revenues associated with the energy savings resulting from the programs. While a procedural order has been established in this matter, on January 20, 2021, JCP&L filed a letter requesting a suspension of the procedural schedule to allow for settlement discussions. The Clean Energy Act contemplates a final order from the NJBPU by May 2, 2021.On July 2, 2020, the NJBPU issued an order allowing New Jersey utilities to track and create a regulatory asset for future recovery of all prudently incurred incremental costs arising from the COVID-19 pandemic beginning March 9, 2020 through September 30, 2021, or until the Governor issues an order stating that the COVID-19 pandemic is no longer in effect. New Jersey utilities can request recovery of such regulatory asset in a stand-alone COVID-19 regulatory asset filing or future base rate case. On August 21, 2020, the Governor of New Jersey issued a press release announcing that the New Jersey utilities agreed to extend their voluntary moratorium preventing shutoffs to both residential and commercial customers during the COVID-19 pandemic until October 15, 2020. On October 15, 2020, the Governor issued an Executive Order prohibiting utilities from terminating service to any residential gas, electric, public and private water customer, through March 15, 2021, requiring the reconnection of certain customers, and disallowing the charging of late payment charges or reconnection fees during the public health emergency. On October 28, 2020, the NJBPU issued an order expanding the scope of the proceeding to examine all pandemic issues, including recovery of the COVID-19 regulatory assets, by way of a generic proceeding. On November 30, 2020, JCP&L submitted comments.The recent credit rating actions taken on October 28, 2020, by S&P and Fitch triggered a requirement from various NJBPU orders that JCP&L file a mitigation plan, which was filed on November 5, 2020, to demonstrate that JCP&L has sufficient liquidity to meet its BGS obligations. On December 11, 2020, the NJBPU held a public hearing on the mitigation plan. Written comments on JCP&L’s mitigation plan were submitted on January 8, 2021. 56OHIOThe Ohio Companies operate under base distribution rates approved by the PUCO effective in 2009. The Ohio Companies’ residential and commercial base distribution revenues were decoupled, through a mechanism that took effect on February 1, 2020 and under which the Ohio Companies billed customers until February 9, 2021, to the base distribution revenue and lost distribution revenue associated with energy efficiency and peak demand reduction programs recovered as of the twelve-month period ending on December 31, 2018. The Ohio Companies currently operate under ESP IV effective June 1, 2016, and continuing through May 31, 2024, that continues the supply of power to non-shopping customers at a market-based price set through an auction process. ESP IV also continues the DCR rider, which supports continued investment related to the distribution system for the benefit of customers, with increased revenue caps of $20 million per year from June 1, 2019 through May 31, 2022; and $15 million per year from June 1, 2022 through May 31, 2024. In addition, ESP IV includes: (1) continuation of a base distribution rate freeze through May 31, 2024; (2) the collection of lost distribution revenue associated with energy efficiency and peak demand reduction programs, which is discussed further below; (3) a goal across FirstEnergy to reduce CO2 emissions by 90% below 2005 levels by 2045; and (4) contributions, totaling $51 million to: (a) fund energy conservation programs, economic development and job retention in the Ohio Companies’ service territories; (b) establish a fuel-fund in each of the Ohio Companies’ service territories to assist low-income customers; and (c) establish a Customer Advisory Council to ensure preservation and growth of the competitive market in Ohio. ESP IV further provided for the Ohio Companies to collect through the DMR $132.5 million annually for three years beginning in 2017, grossed up for federal income taxes, resulting in an approved amount of approximately $168 million annually in 2018 and 2019. On appeal, the SCOH, on June 19, 2019, reversed the PUCO’s determination that the DMR is lawful, and remanded the matter to the PUCO with instructions to remove the DMR from ESP IV. The PUCO entered an order directing the Ohio Companies to cease further collection through the DMR, credit back to customers a refund of the DMR funds collected since July 2, 2019 and remove the DMR from ESP IV. On July 15, 2019, OCC filed a Notice of Appeal with the SCOH, challenging the PUCO’s exclusion of the DMR revenues from the determination of the existence of significantly excessive earnings under ESP IV for calendar year 2017 for OE and claiming a $42 million refund is due to OE customers. On December 1, 2020, the SCOH reversed the PUCO’s exclusion of the DMR revenues from the determination of the existence of significantly excessive earnings under ESP IV for OE for calendar year 2017, and remanded the case to the PUCO with instructions to conduct new proceedings which includes the DMR revenues in the analysis, determines the threshold against which the earned return is measured, and makes other necessary determinations. FirstEnergy is unable to predict the outcome of these proceedings but has not deemed a liability probable as of December 31, 2020. On July 23, 2019, Ohio enacted HB 6, which established support for nuclear energy supply in Ohio. In addition to the provisions supporting nuclear energy, HB 6 included provisions implementing a decoupling mechanism for Ohio electric utilities and ending current energy efficiency program mandates on December 31, 2020, provided that statewide energy efficiency mandates are achieved as determined by the PUCO. On February 26, 2020, the PUCO ordered a wind-down of statutorily required energy efficiency programs to commence on September 30, 2020, that the programs terminate on December 31, 2020, with the Ohio Companies' existing portfolio plans extended through 2020 without changes. On November 21, 2019, the Ohio Companies applied to the PUCO for approval of a decoupling mechanism, which would set residential and commercial base distribution related revenues at the levels collected in 2018. As such, those base distribution revenues would no longer be based on electric consumption, which allows continued support of energy efficiency initiatives while also providing revenue certainty to the Ohio Companies. On January 15, 2020, the PUCO approved the Ohio Companies’ decoupling application, and the decoupling mechanism took effect on February 1, 2020. Legislation has been introduced in the first quarter of 2021 to, among other things, repeal parts of HB 6, the legislation that established support for nuclear energy supply in Ohio, provided for a decoupling mechanism for Ohio electric utilities, and provided for the ending of current energy efficiency program mandates. As further discussed below, in connection with a partial settlement with the OAG and other parties, the Ohio Companies filed an application with the PUCO on February 1, 2021, to set the respective decoupling riders (Rider CSR) to zero. While the partial settlement with the OAG focused specifically on decoupling, the Ohio Companies will of their own accord not seek to recover lost distribution revenue from residential and commercial customers. FirstEnergy is committed to pursuing an open dialogue with stakeholders in an appropriate manner with respect to the numerous regulatory proceedings currently underway as further discussed herein. As a result of the partial settlement, and the decision to not seek lost distribution revenue, FirstEnergy recognized a $108 million pre-tax charge ($84 million after-tax) in the fourth quarter of 2020, and $77 million (pre-tax) of which is associated with forgoing collection of lost distribution revenue. FirstEnergy does not believe a refund for previously collected amounts under decoupling, which was approximately $18 million, is probable. Furthermore, as FirstEnergy would not have financially benefited from the Clean Air Fund included in HB 6, which is the mechanism to provide support to nuclear energy in Ohio, there is no expected additional impact to FirstEnergy due to any repeal of that provision of HB 6.On July 17, 2019, the PUCO approved, with no material modifications, a settlement agreement that provides for the implementation of the Ohio Companies’ first phase of grid modernization plans, including the investment of $516 million over three years to modernize the Ohio Companies’ electric distribution system, and for all tax savings associated with the Tax Act to flow back to customers. The settlement had broad support, including PUCO staff, the OCC, representatives of industrial and commercial customers, a low-income advocate, environmental advocates, hospitals, competitive generation suppliers and other parties.57In March 2020, the PUCO issued entries directing utilities to review their service disconnection and restoration policies and suspend, for the duration of the COVID-19 pandemic, otherwise applicable requirements that may impose a service continuity hardship or service restoration hardship on customers. The Ohio Companies are utilizing their existing approved cost recovery mechanisms where applicable to address the financial impacts of these directives. On July 31, 2020, the Ohio Companies filed with the PUCO their transition plan and requests for waivers to allow for the safe resumption of normal business operations, including service disconnections for non-payment. On September 23, 2020, the PUCO approved the Ohio Companies’ transition plan, including approval of the resumption of service disconnections for non-payment, which the Ohio Companies began on October 5, 2020.On July 29, 2020, the PUCO consolidated the Ohio Companies’ Applications for determination of the existence of significantly excessive earnings, or SEET, under ESP IV for calendar years 2018 and 2019, which had been previously filed on July 15, 2019, and May 15, 2020, respectively, and set a procedural schedule with evidentiary hearings scheduled for October 29, 2020. The calculations included in the Ohio Companies’ SEET filings for calendar years 2018 and 2019 demonstrate that the Ohio Companies did not have significantly excessive earnings, however, FirstEnergy and the Ohio Companies are unable to predict the PUCO’s ultimate determination of the applications. On August 3, 2020, the OCC filed an interlocutory appeal asking the PUCO to stay the SEET proceeding until the SCOH determines whether DMR should be excluded from the SEET, as further discussed above. Furthermore, on January 21, 2021, Senate Bill 10 was introduced, which would repeal legislation passed in 2019 that permitted the Ohio Companies to file their SEET results on a consolidated basis instead of on an individual company basis. On September 4, 2020, the PUCO opened its quadrennial review of ESP IV, consolidated it with the Ohio Companies’ 2018 and 2019 SEET Applications, and set a procedural schedule for the consolidated matters. On October 29, 2020, the PUCO issued an entry extending the deadline for the Ohio Companies to file quadrennial review of ESP IV testimony to March 1, 2021, with the evidentiary hearings to commence no sooner than May 3, 2021. On January 12, 2021, the PUCO consolidated these matters with the determination of the existence of significantly excessive earnings under ESP IV for calendar year 2017, which the SCOH had remanded to the PUCO. On September 8, 2020, the OCC filed motions in the Ohio Companies’ corporate separation audit and DMR audit dockets, requesting the PUCO to open an investigation and management audit, hire an independent auditor, and require FirstEnergy to show it did not improperly use money collected from consumers or violate any utility regulatory laws, rules or orders in its activities regarding HB 6. The Ohio Companies’ filed a response in opposition to the OCC’s motions on September 23, 2020. On December 30, 2020, in response to the OCC's motion, the PUCO reopened the DMR audit docket, and directed PUCO staff to solicit a third-party auditor and conduct a full review of the DMR to ensure funds collected from ratepayers through the DMR were only used for the purposes established in ESP IV. Deadlines relating to the selection of the auditor and the issuance of the final audit report have not yet been set.On September 15, 2020, the PUCO opened a new proceeding to review the political and charitable spending by the Ohio Companies in support of HB 6 and the subsequent referendum effort, directing the Ohio Companies to show cause, demonstrating that the costs of any political or charitable spending in support of HB 6, or the subsequent referendum effort, were not included, directly or indirectly, in any rates or charges paid by ratepayers. The Ohio Companies filed a response on September 30, 2020, stating that any political and charitable spending in support of HB 6 or the subsequent referendum were not included in rates or charges paid for by its customers. Several parties requested that the PUCO broaden the scope of the review of political and charitable spending.In connection with an on-going audit of the Ohio Companies’ policies and procedures relating to the code of conduct rules between affiliates, on November 4, 2020, the PUCO initiated an additional corporate separation audit as a result of the FirstEnergy leadership transition announcement made on October 29, 2020, as further discussed below. The additional audit is to ensure compliance by the Ohio Companies and their affiliates with corporate separation laws and the Ohio Companies’ corporate separation plan. The additional audit is for the period from November 2016 through October 2020, with a final audit report to be filed in June 2021. On January 27, 2021, the PUCO selected an auditor. On November 24, 2020, the Environmental Law and Policy Center filed motions to vacate the PUCO’s orders in proceedings related to the Ohio Companies’ settlement that provides for the implementation of the first phase of grid modernization plans and for all tax savings associated with the Tax Act to flow back to customers, the Ohio Companies’ energy efficiency portfolio plans for the period from 2013 through 2016, and the Ohio Companies’ application for a two-year extension of the DMR, on the grounds that the former Chairman of the PUCO should have recused himself in these matters. On December 30, 2020, the PUCO denied the motions, and reinstated the requirement under ESP IV that the Ohio Companies file a base distribution rate case by May 31, 2024, the end of ESP IV, which the Ohio Companies had indicated they would not oppose. In the fourth quarter of 2020, motions were filed with the PUCO requesting that the PUCO amend the Ohio Companies’ riders for collecting charges required by HB 6, which the Ohio Companies are further required to remit to other Ohio electric distribution utilities or to the State Treasurer, to provide for refunds in the event HB 6 is repealed. The Ohio Companies contested the motions, which are pending before the PUCO.58On December 7, 2020, the Citizens’ Utility Board of Ohio filed a complaint with the PUCO against the Ohio Companies. The complaint alleges that the Ohio Companies’ new charges resulting from HB 6, and any increased rates resulting from proceedings over which the former PUCO Chairman presided, are unjust and unreasonable, and that the Ohio Companies violated Ohio corporate separation laws by failing to operate separately from unregulated affiliates. The complaint requests, among other things, that any rates authorized by HB 6 or authorized by the PUCO in a proceeding over which the former Chairman presided be made refundable; that the Ohio Companies be required to file a new distribution rate case at the earliest possible date; and that the Ohio Companies’ corporate separation plans be modified to introduce institutional controls. The Ohio Companies are contesting the complaint.On December 9, 2020, the Ohio Manufacturers’ Association Energy Group filed an appeal to the SCOH challenging the PUCO’s generic order directing the form of rider all Ohio electric distribution utilities must charge to recover the costs of the HB 6 Clean Air Fund. The appeal contends that the PUCO erred in adopting the rate design for the riders, in establishing the riders during ongoing proceedings and investigations related to HB 6, and in not requiring electric distribution utilities to include refund language in the rider tariffs. On December 30, 2020, the PUCO vacated its generic order establishing the Clean Air Fund riders, as required by a preliminary injunction issued by the Court of Common Pleas of Franklin County, Ohio. On January 11, 2021, the SCOH granted a joint application of the Ohio Manufacturers' Association Energy Group and the PUCO and dismissed the appeal. See “Outlook - Other Legal Proceedings” below for additional details on the government investigation and subsequent litigation surrounding the investigation of HB 6.PENNSYLVANIAThe Pennsylvania Companies operate under rates approved by the PPUC, effective as of January 27, 2017. These rates were adjusted for the net impact of the Tax Act, effective March 15, 2018. The net impact of the Tax Act for the period January 1, 2018 through March 14, 2018 was separately tracked and its treatment will be addressed in a future rate proceeding. The Pennsylvania Companies operate under DSPs for the June 1, 2019 through May 31, 2023 delivery period, which provide for the competitive procurement of generation supply for customers who do not choose an alternative EGS or for customers of alternative EGSs that fail to provide the contracted service. Under the 2019-2023 DSPs, supply will be provided by wholesale suppliers through a mix of 3, 12 and 24-month energy contracts, as well as two RFPs for 2-year SREC contracts for ME, PN and Penn.Pursuant to Pennsylvania Act 129 of 2008 and PPUC orders, Pennsylvania EDCs implement energy efficiency and peak demand reduction programs. The Pennsylvania Companies’ Phase III EE&C plans for the June 2016 through May 2021 period, which were approved in March 2016, with expected costs up to $390 million, are designed to achieve the targets established in the PPUC’s Phase III Final Implementation Order with full recovery through the reconcilable EE&C riders. On June 18, 2020, the PPUC entered a Final Implementation Order for a Phase IV EE&C Plan, operating from June 2021 through May 2026. The Final Implementation Order set demand reduction targets, relative to 2007 to 2008 peak demands, at 2.9% MW for ME, 3.3% MW for PN, 2.0% MW for Penn, and 2.5% MW for WP; and energy consumption reduction targets, as a percentage of the Pennsylvania Companies’ historic 2009 to 2010 reference load at 3.1% MWH for ME, 3.0% MWH for PN, 2.7% MWH for Penn, and 2.4% MWH for WP. The Pennsylvania Companies’ Phase IV plans were filed November 30, 2020. A settlement has been reached in this matter, and a joint petition seeking approval of that settlement by the parties was filed on February 16, 2021. A PPUC decision on the settlement is expected in March 2021. Pennsylvania EDCs may file with the PPUC for approval of an LTIIP for infrastructure improvements and costs related to highway relocation projects, after which a DSIC may be approved to recover LTIIP costs. On August 30, 2019, the Pennsylvania Companies filed Petitions for approval of new LTIIPs for the five-year period beginning January 1, 2020 and ending December 31, 2024 for a total capital investment of approximately $572 million for certain infrastructure improvement initiatives. On January 16, 2020, the PPUC approved the LTIIPs without modification. The Pennsylvania Companies’ approved DSIC riders for quarterly cost recovery went into effect July 1, 2016. On August 30, 2019, Penn filed a Petition seeking approval of a waiver of the statutory DSIC cap of 5% of distribution rate revenue and approval to increase the maximum allowable DSIC to 11.81% of distribution rate revenue for the five-year period of its proposed LTIIP. On March 12, 2020, an order was entered approving a settlement by all parties to that case which provides for a temporary increase in the recoverability cap from 5% to 7.5%, to expire on the earlier of the effective date of new base rates following Penn’s next base rate case or the expiration of its LTIIP II program. Following the Pennsylvania Companies’ 2016 base rate proceedings, the PPUC ruled in a separate proceeding related to the DSIC mechanisms that the Pennsylvania Companies were not required to reflect federal and state income tax deductions related to DSIC-eligible property in DSIC rates, which decision was appealed by the Pennsylvania OCA to the Pennsylvania Commonwealth Court. The Commonwealth Court reversed the PPUC’s decision and remanded the matter to require the Pennsylvania Companies to revise their tariffs and DSIC calculations to include ADIT and state income taxes. On April 7, 2020, the Pennsylvania Supreme Court issued an order granting Petitions for Allowance of Appeal by both the PPUC and the Pennsylvania Companies of the Commonwealth Court’s Opinion and Order. Briefs and Reply Briefs of the parties were filed, and oral argument before the Supreme Court was held on October 21, 2020. An adverse ruling by the Pennsylvania Supreme Court is not expected to result in a material impact to FirstEnergy. 59The PPUC issued an order on March 13, 2020, forbidding utilities from terminating service for non-payment for the duration of the COVID-19 pandemic. On May 13, 2020, the PPUC issued a Secretarial letter directing utilities to track all prudently incurred incremental costs arising from the COVID-19 pandemic, and to create a regulatory asset for future recovery of incremental uncollectibles incurred as a result of the COVID-19 pandemic and termination moratorium. On October 13, 2020, the PPUC entered an order lifting the service termination moratorium effective November 9, 2020, subject to certain additional notification, payment procedures and exceptions, and permits the Pennsylvania Companies to create a regulatory asset for all incremental expenses associated with their compliance with the order.WEST VIRGINIAMP and PE provide electric service to all customers through traditional cost-based, regulated utility ratemaking and operate under rates approved by the WVPSC effective February 2015. MP and PE recover net power supply costs, including fuel costs, purchased power costs and related expenses, net of related market sales revenue through the ENEC. MP's and PE's ENEC rate is updated annually.On March 13, 2020, the WVPSC urged all utilities to suspend utility service terminations except where necessary as a matter of safety or where requested by the customer. On May 15, 2020, the WVPSC issued an order to authorize MP and PE to record a deferral of additional, extraordinary costs directly related to complying with the various COVID-19 government shut-down orders and operational precautions, including impacts on uncollectible expense and cash flow related to temporary discontinuance of service terminations for non-payment and any credits to minimum demand charges associated with business customers adversely impacted by shut-downs or temporary closures related to the pandemic. MP and PE resumed disconnection activity for commercial and industrial customers on September 15, 2020, and for residential customers on November 4, 2020. On August 28, 2020, MP and PE filed with the WVPSC their annual ENEC case requesting a decrease in ENEC rates of $55 million beginning January 1, 2021, representing a 4% decrease in rates compared to those in effect on August 28, 2020. The decrease in the ENEC rates is net of recovering approximately $10.5 million in previously deferred, incremental uncollectible and other related costs resulting from the COVID-19 pandemic. The WVPSC approved a unanimous settlement by the parties on December 16, 2020 with rates effective January 1, 2021. Also, on August 28, 2020, MP and PE filed with the WVPSC for recovery of costs associated with modernization and improvement program for their coal-fired boilers. The proposed annual revenue increase for these environmental compliance projects is $5 million beginning January 1, 2021. The WVPSC approved a unanimous settlement by the parties on December 16, 2020 approving the recovery of those costs. On December 30, 2020, MP and PE filed an integrated resource plan with the WVPSC. The plan projects a small capacity deficit but an energy surplus in MP’s and PE’s supply resources when compared with current WV load demand and projects the capacity deficit growing over the next 15 years. The plan does not recommend additional supply-side resources with a possible exception for small utility-scale solar resources and recommends that the capacity deficit be met through the PJM capacity market. MP currently expects to seek approval in 2021 to construct solar generation sources of up to 50 MWs.On December 30, 2020, MP and PE filed with the WVPSC a determination of the rate impact of the Tax Act with respect to ADIT. The filing proposes an annual revenue reduction of $2.6 million annually, effective January 1, 2022, with reconciliation and any resulting adjustments incorporated into the annual ENEC proceedings.FERC REGULATORY MATTERSUnder the FPA, FERC regulates rates for interstate wholesale sales, transmission of electric power, accounting and other matters, including construction and operation of hydroelectric projects. With respect to their wholesale services and rates, the Utilities, AE Supply and the Transmission Companies are subject to regulation by FERC. FERC regulations require JCP&L, MP, PE, WP and the Transmission Companies to provide open access transmission service at FERC-approved rates, terms and conditions. Transmission facilities of JCP&L, MP, PE, WP and the Transmission Companies are subject to functional control by PJM and transmission service using their transmission facilities is provided by PJM under the PJM Tariff. 60The following table summarizes the key terms of rate orders in effect for transmission customer billings for FirstEnergy's transmission owner entities:CompanyRates EffectiveCapital StructureAllowed ROEATSIJanuary 1, 2015Actual (13-month average)10.38%JCP&LJanuary 2020(1)Actual (13-month average)(1)10.80%(1)MPMarch 21, 2018(2)(4)Settled(2)(3)Settled(2)(3)PE March 21, 2018(2)(4)Settled(2)(3)Settled(2)(3)WP March 21, 2018(2)(4)Settled(2)(3)Settled(2)(3)MAITJuly 1, 2017Lower of Actual (13-month average) or 60%10.3%TrAILJuly 1, 2008Actual (year-end)12.7% (TrAIL the Line & Black Oak SVC)11.7% (All other projects)(1) As filed in docket ER20-227, effective on January 1, 2020, which has been accepted by FERC, subject to refund, pending further hearing and settlement procedures. The settlement agreement that was filed on February 2, 2021, seeking approval by FERC sets JCP&L's Allowed ROE at 10.2%. (2) Effective on January 1, 2021, MP, PE, and WP have implemented a forward-looking formula rate, which has been accepted by FERC, subject to refund, pending further hearing and settlement procedures. (3) FERC-approved settlement agreements did not specify. (4) See FERC Actions on Tax Act below.FERC regulates the sale of power for resale in interstate commerce in part by granting authority to public utilities to sell wholesale power at market-based rates upon showing that the seller cannot exert market power in generation or transmission or erect barriers to entry into markets. The Utilities and AE Supply each have been authorized by FERC to sell wholesale power in interstate commerce at market-based rates and have a market-based rate tariff on file with FERC, although in the case of the Utilities major wholesale purchases remain subject to review and regulation by the relevant state commissions. Federally enforceable mandatory reliability standards apply to the bulk electric system and impose certain operating, record-keeping and reporting requirements on the Utilities, AE Supply, and the Transmission Companies. NERC is the ERO designated by FERC to establish and enforce these reliability standards, although NERC has delegated day-to-day implementation and enforcement of these reliability standards to six regional entities, including RFC. All of the facilities that FirstEnergy operates are located within the RFC region. FirstEnergy actively participates in the NERC and RFC stakeholder processes, and otherwise monitors and manages its companies in response to the ongoing development, implementation and enforcement of the reliability standards implemented and enforced by RFC. FirstEnergy believes that it is in material compliance with all currently effective and enforceable reliability standards. Nevertheless, in the course of operating its extensive electric utility systems and facilities, FirstEnergy occasionally learns of isolated facts or circumstances that could be interpreted as excursions from the reliability standards. If and when such occurrences are found, FirstEnergy develops information about the occurrence and develops a remedial response to the specific circumstances, including in appropriate cases “self-reporting” an occurrence to RFC. Moreover, it is clear that NERC, RFC and FERC will continue to refine existing reliability standards as well as to develop and adopt new reliability standards. Any inability on FirstEnergy's part to comply with the reliability standards for its bulk electric system could result in the imposition of financial penalties, or obligations to upgrade or build transmission facilities, that could have a material adverse effect on its financial condition, results of operations and cash flows. ATSI Transmission Formula Rate On May 1, 2020, ATSI filed amendments to its formula rate to recover regulatory assets for certain costs that ATSI incurred as a result of its 2011 move from MISO to PJM, certain costs allocated to ATSI by FERC for transmission projects that were constructed by other MISO transmission owners, certain income tax-related adjustments, including, but not limited to impacts from the Tax Act discussed further below, and certain costs for transmission-related vegetation management programs. The amount on FirstEnergy’s Consolidated Balance Sheet for these regulatory assets was approximately $79 million and $73 million, as of December 31, 2020 and December 31, 2019, respectively. Per prior FERC orders, ATSI included a “cost-benefit study” to support recovery of ATSI’s costs to move to PJM, and the MISO transmission project costs that were allocated to ATSI. Certain intervenors filed protests of the formula rate amendments on May 29, 2020, and ATSI filed a reply on June 15, 2020. On June 30, 2020, FERC issued an initial order accepting the tariff amendments subject to refund, suspending the effective date for five months to be effective December 1, 2020, and setting the matter for hearing and settlement proceedings. ATSI is engaged in settlement negotiations with the other parties to the formula rate amendments proceeding. 61FERC Actions on Tax Act On March 15, 2018, FERC initiated proceedings on the question of how to address possible changes to ADIT and bonus depreciation as a result of the Tax Act. Such possible changes could impact FERC-jurisdictional rates, including transmission rates. On November 21, 2019, FERC issued a final rule (Order No. 864). Order No. 864 requires utilities with transmission formula rates to update their formula rate templates to include mechanisms to (i) deduct any excess ADIT from or add any deficient ADIT to their rate base; (ii) raise or lower their income tax allowances by any amortized excess or deficient ADIT; and (iii) incorporate a new permanent worksheet into their rates that will annually track information related to excess or deficient ADIT. Per FERC directives, ATSI submitted its compliance filing on May 1, 2020. MAIT submitted its compliance filing on June 1, 2020. Certain intervenors filed protests of the compliance filings, to which ATSI and MAIT responded. On October 28, 2020, FERC staff requested additional information about ATSI’s proposed rate base adjustment mechanism, and ATSI submitted the requested information on November 25, 2020. On May 15, 2020, TrAIL submitted its compliance filing and on June 1, 2020, PATH submitted its required compliance filing. These compliance filings each remain pending before FERC. MP, WP and PE (as holders of a “stated” transmission rate) are addressing these requirements in the transmission formula rates amendments that were filed on October 29, 2020. JCP&L is addressing these requirements as part of its pending transmission formula rate case. Transmission ROE Methodology FERC’s methodology for calculating electric transmission utility ROE has been in transition as a result of an April 14, 2017 ruling by the D.C. Circuit that vacated FERC’s then-effective methodology. On May 21, 2020, FERC issued Opinion No. 569-A that changed FERC’s ROE methodology. Under this methodology FERC established an ROE that is based on three financial models – discounted cash flow, capital-asset pricing, and risk premium – to calculate a composite zone of reasonableness. FERC noted that utilities could, in utility-specific proceedings, ask to have the expected earnings methodology included in calculating the utility’s authorized ROE. FERC also noted that, going forward, it will divide that zone into three equal parts, to be used for high risk, normal risk, and low risk utilities. A given utility will be assigned to one of these three parts of the zone of reasonableness, and its ROE will be set at the median or midpoint of the other utilities that are in the applicable third of the zone. FirstEnergy filed a request for rehearing, which FERC denied on July 22, 2020. On November 19, 2020, FERC issued Opinion No. 569-B, which affirmed the Opinion No. 569-A rulings. FirstEnergy initiated, but subsequently withdrew, appeals of these orders. Appeals of Opinion Nos. 569, 569-A and 569-B are pending before the D.C. Circuit. Any changes to FERC’s transmission rate ROE and incentive policies would be applied on a prospective basis. On March 20, 2020, FERC initiated a rulemaking proceeding on the transmission rate incentives provisions of Section 219 of the 2005 Energy Policy Act. Initial comments were submitted July 1, 2020, and reply comments were filed on July 16, 2020. FirstEnergy participated through EEI and through a consortium of PJM Transmission Owners. This proceeding is pending before FERC.JCP&L Transmission Formula Rate On October 30, 2019, JCP&L filed tariff amendments with FERC to convert JCP&L’s existing stated transmission rate to a forward-looking formula transmission rate. JCP&L requested that the tariff amendments become effective January 1, 2020. On December 19, 2019, FERC issued its initial order in the case, allowing JCP&L to transition to a forward-looking formula rate as of January 1, 2020 as requested, subject to refund, pending further hearing and settlement proceedings. JCP&L and the parties to the FERC proceeding subsequently were able to reach settlement, and on February 2, 2021, a settlement agreement was filed for approval by FERC. Allegheny Power Zone Transmission Formula Rate FilingsOn October 29, 2020, MP, PE and WP filed tariff amendments with FERC to convert their existing stated transmission rate to a forward-looking formula transmission rate, effective January 1, 2021. In addition, on October 30, 2020, KATCo filed a proposed new tariff to establish a forward-looking formula rate and requested that the new rate become effective January 1, 2021. In its filing, KATCo explained that while it currently owns no transmission assets, it may build new transmission facilities in the Allegheny zone, and that it may seek required state and federal authorizations to acquire transmission assets from PE and WP by January 1, 2022. These transmission rate filings were approved by FERC on December 31, 2020, subject to refund, pending further hearing and settlement proceedings. MP, PE and WP, and KATCo are engaged in settlement negotiations with the other parties to the formula rate proceedings. KATCo will be included in the Regulated Transmission reportable segment.ENVIRONMENTAL MATTERSVarious federal, state and local authorities regulate FirstEnergy with regard to air and water quality, hazardous and solid waste disposal, and other environmental matters. While FirstEnergy's environmental policies and procedures are designed to achieve compliance with applicable environmental laws and regulations, such laws and regulations are subject to periodic review and potential revision by the implementing agencies. FirstEnergy cannot predict the timing or ultimate outcome of any of these reviews or how any future actions taken as a result thereof may materially impact its business, results of operations, cash flows and financial condition. 62Clean Air ActFirstEnergy complies with SO2 and NOx emission reduction requirements under the CAA and SIP(s) by burning lower-sulfur fuel, utilizing combustion controls and post-combustion controls and/or using emission allowances. CSAPR requires reductions of NOx and SO2 emissions in two phases (2015 and 2017), ultimately capping SO2 emissions in affected states to 2.4 million tons annually and NOx emissions to 1.2 million tons annually. CSAPR allows trading of NOx and SO2 emission allowances between power plants located in the same state and interstate trading of NOx and SO2 emission allowances with some restrictions. The D.C. Circuit ordered the EPA on July 28, 2015, to reconsider the CSAPR caps on NOx and SO2 emissions from power plants in 13 states, including West Virginia. This follows the 2014 U.S. Supreme Court ruling generally upholding the EPA’s regulatory approach under CSAPR but questioning whether the EPA required upwind states to reduce emissions by more than their contribution to air pollution in downwind states. The EPA issued a CSAPR update rule on September 7, 2016, reducing summertime NOx emissions from power plants in 22 states in the eastern U.S., including West Virginia, beginning in 2017. Various states and other stakeholders appealed the CSAPR update rule to the D.C. Circuit in November and December 2016. On September 13, 2019, the D.C. Circuit remanded the CSAPR update rule to the EPA citing that the rule did not eliminate upwind states’ significant contributions to downwind states’ air quality attainment requirements within applicable attainment deadlines. Depending on the outcome of the appeals, the EPA’s reconsideration of the CSAPR update rule and how the EPA and the states ultimately implement CSAPR, the future cost of compliance may materially impact FirstEnergy's operations, cash flows and financial condition. In February 2019, the EPA announced its final decision to retain without changes the NAAQS for SO2, specifically retaining the 2010 primary (health-based) 1-hour standard of 75 PPB. As of December 31, 2020, FirstEnergy has no power plants operating in areas designated as non-attainment by the EPA. In March 2018, the State of New York filed a CAA Section 126 petition with the EPA alleging that NOx emissions from nine states (including West Virginia) significantly contribute to New York’s inability to attain the ozone NAAQS. The petition seeks suitable emission rate limits for large stationary sources that are affecting New York’s air quality within the three years allowed by CAA Section 126. On September 20, 2019, the EPA denied New York’s CAA Section 126 petition. On October 29, 2019, the State of New York appealed the denial of its petition to the D.C. Circuit. On July 14, 2020, the D.C. Circuit reversed and remanded the New York petition to the EPA for further consideration. FirstEnergy is unable to predict the outcome of these matters or estimate the loss or range of loss.Climate ChangeThere are a number of initiatives to reduce GHG emissions at the state, federal and international level. Certain northeastern states are participating in the RGGI and western states led by California, have implemented programs, primarily cap and trade mechanisms, to control emissions of certain GHGs. Additional policies reducing GHG emissions, such as demand reduction programs, renewable portfolio standards and renewable subsidies have been implemented across the nation. At the international level, the United Nations Framework Convention on Climate Change resulted in the Kyoto Protocol requiring participating countries, which does not include the U.S., to reduce GHGs commencing in 2008 and has been extended through 2020. The Obama Administration submitted in March 2015, a formal pledge for the U.S. to reduce its economy wide GHG emissions by 26 to 28 percent below 2005 levels by 2025. In 2015, FirstEnergy set a goal of reducing company-wide CO2 emissions by at least 90 percent below 2005 levels by 2045. As of December 31, 2018, FirstEnergy has reduced its CO2 emissions by approximately 62 percent. In September 2016, the U.S. joined in adopting the agreement reached on December 12, 2015, at the United Nations Framework Convention on Climate Change meetings in Paris. The Paris Agreement’s non-binding obligations to limit global warming to below two degrees Celsius became effective on November 4, 2016. On June 1, 2017, the Trump Administration announced that the U.S. would cease all participation in the Paris Agreement. On January 20, 2021, President Biden signed an executive order re-adopting the agreement on behalf of the U.S. FirstEnergy cannot currently estimate the financial impact of climate change policies, although potential legislative or regulatory programs restricting CO2 emissions, or litigation alleging damages from GHG emissions, could require material capital and other expenditures or result in changes to its operations. In December 2009, the EPA released its final “Endangerment and Cause or Contribute Findings for GHG under the Clean Air Act,” concluding that concentrations of several key GHGs constitutes an "endangerment" and may be regulated as "air pollutants" under the CAA and mandated measurement and reporting of GHG emissions from certain sources, including electric generating plants. The EPA released its final CPP regulations in August 2015 to reduce CO2 emissions from existing fossil fuel fired EGUs and finalized separate regulations imposing CO2 emission limits for new, modified, and reconstructed fossil fuel fired EGUs. Numerous states and private parties filed appeals and motions to stay the CPP with the D.C. Circuit in October 2015. On February 9, 2016, the U.S. Supreme Court stayed the rule during the pendency of the challenges to the D.C. Circuit and U.S. Supreme Court. On March 28, 2017, an executive order, entitled “Promoting Energy Independence and Economic Growth,” instructed the EPA to review the CPP and related rules addressing GHG emissions and suspend, revise or rescind the rules if appropriate. On October 16, 2017, the EPA issued a proposed rule to repeal the CPP. On June 19, 2019, the EPA repealed the CPP and replaced it with the ACE rule that establishes guidelines for states to develop standards of performance to address GHG emissions from existing coal-fired power plants. On January 19, 2021, the D.C. Circuit remanded the ACE rule declaring 63that the EPA was “arbitrary and capricious” in its rule making, as such, the ACE rule is no longer in effect and all actions thus far taken by States to implement the federally mandated rule are now null and void. The D.C. Circuit decision is subject to legal challenge. Depending on the outcomes of further appeals and how any final rules are ultimately implemented, the future cost of compliance may be material. Clean Water ActVarious water quality regulations, the majority of which are the result of the federal CWA and its amendments, apply to FirstEnergy's facilities. In addition, the states in which FirstEnergy operates have water quality standards applicable to FirstEnergy's operations. The EPA finalized CWA Section 316(b) regulations in May 2014, requiring cooling water intake structures with an intake velocity greater than 0.5 feet per second to reduce fish impingement when aquatic organisms are pinned against screens or other parts of a cooling water intake system to a 12% annual average and requiring cooling water intake structures exceeding 125 million gallons per day to conduct studies to determine site-specific controls, if any, to reduce entrainment, which occurs when aquatic life is drawn into a facility's cooling water system. Depending on any final action taken by the states with respect to impingement and entrainment, the future capital costs of compliance with these standards may be material. On September 30, 2015, the EPA finalized new, more stringent effluent limits for the Steam Electric Power Generating category (40 CFR Part 423) for arsenic, mercury, selenium and nitrogen for wastewater from wet scrubber systems and zero discharge of pollutants in ash transport water. The treatment obligations were to phase-in as permits are renewed on a five-year cycle from 2018 to 2023. However, on April 13, 2017, the EPA granted a Petition for Reconsideration and on September 18, 2017, the EPA postponed certain compliance deadlines for two years. On August 31, 2020, the EPA issued a final rule revising the effluent limits for discharges from wet scrubber systems, retaining the zero-discharge standard for ash transport water, (with some limited discharge allowances), and extending the deadline for compliance to December 31, 2025 for both. In addition, the EPA allows for less stringent limits for sub-categories of generating units based on capacity utilization, flow volume from the scrubber system, and unit retirement date. Depending on the outcome of appeals, how final rules are ultimately implemented and the compliance options MP elects to take with the new rules, the compliance with these standards, which could include capital expenditures at the Ft. Martin and Harrison power stations, may be substantial and changes to MP’s operations at those power stations may also result. On September 29, 2016, FirstEnergy received a request from the EPA for information pursuant to CWA Section 308(a) for information concerning boron exceedances of effluent limitations established in the NPDES Permit for the former Mitchell Power Station’s Mingo landfill, owned by WP. On November 1, 2016, WP provided an initial response that contained information related to a similar boron issue at the former Springdale Power Station’s landfill. The EPA requested additional information regarding the Springdale landfill and on November 15, 2016, WP provided a response and intends to fully comply with the Section 308(a) information request. On March 3, 2017, WP proposed to the PA DEP a re-route of its wastewater discharge to eliminate potential boron exceedances at the Springdale landfill. On January 29, 2018, WP submitted an NPDES permit renewal application to PA DEP proposing to re-route its wastewater discharge to eliminate potential boron exceedances at the Mingo landfill. On February 20, 2018, the DOJ issued a letter and tolling agreement on behalf of the EPA alleging violations of the CWA at the Springdale and Mingo landfills while seeking to enter settlement negotiations in lieu of filing a complaint. The EPA has proposed a penalty of $900,000 to settle alleged past boron exceedances at both facilities. Negotiations are continuing and WP is unable to predict the outcome of this matter. Regulation of Waste DisposalFederal and state hazardous waste regulations have been promulgated as a result of the RCRA, as amended, and the Toxic Substances Control Act. Certain CCRs, such as coal ash, were exempted from hazardous waste disposal requirements pending the EPA's evaluation of the need for future regulation.In April 2015, the EPA finalized regulations for the disposal of CCRs (non-hazardous), establishing national standards for landfill design, structural integrity design and assessment criteria for surface impoundments, groundwater monitoring and protection procedures and other operational and reporting procedures to assure the safe disposal of CCRs from electric generating plants. On September 13, 2017, the EPA announced that it would reconsider certain provisions of the final regulations. On July 17, 2018, the EPA Administrator signed a final rule extending the deadline for certain CCR facilities to cease disposal and commence closure activities, as well as, establishing less stringent groundwater monitoring and protection requirements. On August 21, 2018, the D.C. Circuit remanded sections of the CCR Rule to the EPA to provide additional safeguards for unlined CCR impoundments that are more protective of human health and the environment. On December 2, 2019, the EPA published a proposed rule accelerating the date that certain CCR impoundments must cease accepting waste and initiate closure to August 31, 2020. The proposed rule allows for an extension of the closure deadline based on meeting proscribed site-specific criteria. On July 29, 2020, the EPA published a final rule revising the date that certain CCR impoundments must cease accepting waste and initiate closure to April 11, 2021. The final rule allows for an extension of the closure deadline based on meeting proscribed site-specific criteria. On November 30, 2020, AE Supply submitted a closure deadline extension request to the EPA seeking to extend the closure date until 2024 of McElroy's Run CCR impoundment facility, for which AE Supply continues to provide access to FG. 64FE or its subsidiaries have been named as potentially responsible parties at waste disposal sites, which may require cleanup under the CERCLA. Allegations of disposal of hazardous substances at historical sites and the liability involved are often unsubstantiated and subject to dispute; however, federal law provides that all potentially responsible parties for a particular site may be liable on a joint and several basis. Environmental liabilities that are considered probable have been recognized on the Consolidated Balance Sheets as of December 31, 2020, based on estimates of the total costs of cleanup, FirstEnergy's proportionate responsibility for such costs and the financial ability of other unaffiliated entities to pay. Total liabilities of approximately $107 million have been accrued through December 31, 2020. Included in the total are accrued liabilities of approximately $67 million for environmental remediation of former MGP and gas holder facilities in New Jersey, which are being recovered by JCP&L through a non-bypassable SBC. FE or its subsidiaries could be found potentially responsible for additional amounts or additional sites, but the loss or range of losses cannot be determined or reasonably estimated at this time. OTHER LEGAL PROCEEDINGSUnited States v. Larry Householder, et al.On July 21, 2020, a complaint and supporting affidavit containing federal criminal allegations were unsealed against the now former Ohio House Speaker Larry Householder and other individuals and entities allegedly affiliated with Mr. Householder. Also, on July 21, 2020, and in connection with the investigation, FirstEnergy received subpoenas for records from the U.S. Attorney’s Office for the S.D. Ohio. FirstEnergy was not aware of the criminal allegations, affidavit or subpoenas before July 21, 2020. No contingency has been reflected in FirstEnergy’s consolidated financial statements as a loss is neither probable, nor is a loss or range of a loss reasonably estimable.Legal Proceedings Relating to United States v. Larry Householder, et al.In addition to the subpoenas referenced above under “—United States v. Larry Householder, et. al.”, certain FE stockholders and FirstEnergy customers filed several lawsuits against FirstEnergy and certain current and former directors, officers and other employees, and the complaints in each of these suits is related to allegations in the complaint and supporting affidavit relating to HB 6 and the now former Ohio House Speaker Larry Householder and other individuals and entities allegedly affiliated with Mr. Householder.•Owens v. FirstEnergy Corp. et al. and Frand v. FirstEnergy Corp. et al. (Federal District Court, S.D. Ohio); on July 28, 2020 and August 21, 2020, purported stockholders of FE filed putative class action lawsuits against FE and certain FE officers, purportedly on behalf of all purchasers of FE common stock from February 21, 2017 through July 21, 2020, asserting claims under Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder, alleging misrepresentations or omissions by FirstEnergy concerning its business and results of operations. These actions have been consolidated and a lead plaintiff has been appointed by the court.•Gendrich v. Anderson, et al. and Sloan v. Anderson, et al. (Common Pleas Court, Summit County, OH); on July 26, 2020 and July 31, 2020, respectively, purported stockholders of FE filed shareholder derivative action lawsuits against certain FE directors and officers, alleging, among other things, breaches of fiduciary duty. These actions have been consolidated.•Miller v. Anderson, et al. (Federal District Court, N.D. Ohio); Bloom, et al. v. Anderson, et al.; Employees Retirement System of the City of St. Louis v. Jones, et al.; Electrical Workers Pension Fund, Local 103, I.B.E.W. v. Anderson et al.; Massachusetts Laborers Pension Fund v. Anderson et al.; The City of Philadelphia Board of Pensions and Retirement v. Anderson et al.; Atherton v. Dowling et al; Behar v. Anderson, et al. (U.S. District Court, S.D. Ohio, all actions have been consolidated); beginning on August 7, 2020, purported stockholders of FE filed shareholder derivative actions alleging the board and officers breached their fiduciary duties and committed violations of Section 14(a) of the Securities Exchange Act of 1934. The cases in the Southern District of Ohio have been consolidated and co-lead plaintiffs have been appointed by the court.•Smith v. FirstEnergy Corp. et al., Buldas v. FirstEnergy Corp. et al., and Hudock and Cameo Countertops, Inc. v. FirstEnergy Corp. et al. (Federal District Court, S.D. Ohio); on July 27, 2020, July 31, 2020, and August 5, 2020, respectively, purported customers of FirstEnergy filed putative class action lawsuits against FE and FESC, as well as certain current and former FirstEnergy officers, alleging civil Racketeer Influenced and Corrupt Organizations Act violations and related state law claims. These actions have been consolidated.•State of Ohio ex rel. Dave Yost, Ohio Attorney General v. FirstEnergy Corp., et al. and City of Cincinnati and City of Columbus v. FirstEnergy Corp. (Common Pleas Court, Franklin County, OH); on September 23, 2020 and October 27, 2020, the OAG and the cities of Cincinnati and Columbus, respectively, filed complaints against several parties including FE, each alleging civil violations of the Ohio Corrupt Activity Act in connection with the passage of HB 6. The OAG sought a preliminary injunction to prevent each of the defendants, including FE, through the end of 2020, from: (i) contributing to any groups whose purpose is to keep or modify HB 6; (ii) making any public statements for or against any repeal or modification legislation concerning HB 6; (iii) lobbying, consulting, or advising on these matters; or (iv) contributing to any Ohio legislative candidates. The court denied the OAG’s request for preliminary injunctive relief on October 2, 2020. On January 13, 2021, the OAG filed a motion for a temporary restraining order and preliminary injunction against FirstEnergy seeking to enjoin FirstEnergy from collecting the Ohio Companies' decoupling rider. On January 31, 2021, FE reached a partial settlement with the OAG and the cities of Cincinnati and Columbus with respect 65to the temporary restraining order and preliminary injunction request and related issues. In connection with the partial settlement, the Ohio Companies filed an application on February 1, 2021, with the PUCO to set their respective decoupling riders (Rider CSR) to zero. On February 2, 2021, the PUCO approved the application of the Ohio Companies setting the rider to zero and no additional customer bills will include new decoupling rider charges after February 8, 2021. The cities of Dayton and Toledo have also been added as plaintiffs to the action. These actions have been consolidated. •Emmons v. FirstEnergy Corp. et al. (Common Pleas Court, Cuyahoga County, OH); on August 4, 2020, a purported customer of FirstEnergy filed a putative class action lawsuit against FE, FESC, OE, TE and CEI, along with FES, alleging several causes of action, including negligence and/or gross negligence, breach of contract, unjust enrichment, and unfair or deceptive consumer acts or practices. On October 1, 2020, plaintiffs filed a First Amended Complaint, adding as a plaintiff a purported customer of FirstEnergy and alleging a civil violation of the Ohio Corrupt Activity Act and civil conspiracy against FE, FESC and FES.The plaintiffs in each of the above cases, seek, among other things, to recover an unspecified amount of damages (unless otherwise noted). In addition, on August 10, 2020, the SEC, through its Division of Enforcement, issued an order directing an investigation of possible securities laws violations by FE, and on September 1, 2020, issued subpoenas to FE and certain FE officers. Further, on January 26, 2021, staff of FERC's Division of Investigations issued a letter directing FirstEnergy to preserve and maintain all documents and information related to an ongoing audit being conducted by FERC's Division of Audits and Accounting, including activities related to lobbying and governmental affairs activities concerning HB 6. The outcome of any of these lawsuits, investigations and audit are uncertain and could have a material adverse effect on FE’s or its subsidiaries’ financial condition, results of operations and cash flows. No contingency has been reflected in FirstEnergy’s consolidated financial statements as a loss is neither probable, nor is a loss or range of a loss reasonably estimable.Internal Investigation Relating to United States v. Larry Householder, et al.As previously disclosed, a committee of independent members of the Board of Directors is directing an internal investigation related to ongoing government investigations. In connection with FirstEnergy’s internal investigation, such committee determined on October 29, 2020, to terminate FirstEnergy’s Chief Executive Officer, Charles E. Jones, together with two other executives: Dennis M. Chack, Senior Vice President of Product Development, Marketing, and Branding; and Michael J. Dowling, Senior Vice President of External Affairs. Each of these terminated executives violated certain FirstEnergy policies and its code of conduct. These executives were terminated as of October 29, 2020. Such former members of senior management did not maintain and promote a control environment with an appropriate tone of compliance in certain areas of FirstEnergy’s business, nor sufficiently promote, monitor or enforce adherence to certain FirstEnergy policies and its code of conduct. Furthermore, certain former members of senior management did not reasonably ensure that relevant information was communicated within our organization and not withheld from our independent directors, our Audit Committee, and our independent auditor. Among the matters considered with respect to the determination by the committee of independent members of the Board of Directors that certain former members of senior management violated certain FirstEnergy policies and its code of conduct related to a payment of approximately $4 million made in early 2019 in connection with the termination of a purported consulting agreement, as amended, which had been in place since 2013. The counterparty to such agreement was an entity associated with an individual who subsequently was appointed to a full-time role as an Ohio government official directly involved in regulating the Ohio Companies, including with respect to distribution rates. FirstEnergy believes that payments under the consulting agreement may have been for purposes other than those represented within the consulting agreement. Immediately following these terminations, the independent members of its Board appointed Mr. Steven E. Strah to the position of Acting Chief Executive Officer and Mr. Christopher D. Pappas, a current member of the Board, to the temporary position of Executive Director, each effective as of October 29, 2020. Mr. Donald T. Misheff will continue to serve as Non-Executive Chairman of the Board. Additionally, on November 8, 2020, Robert P. Reffner, Senior Vice President and Chief Legal Officer, and Ebony L. Yeboah-Amankwah, Vice President, General Counsel, and Chief Ethics Officer, were separated from FirstEnergy due to inaction and conduct that the Board determined was influenced by the improper tone at the top. The matter is a subject of the ongoing internal investigation as it relates to the government investigations.Nuclear Plant MattersOn October 15, 2019, JCP&L, ME, PN and GPUN executed an asset purchase and sale agreement with TMI-2 Solutions, LLC, a subsidiary of EnergySolutions, LLC, concerning the transfer and dismantlement of TMI-2. This transfer of TMI-2 to TMI-2 Solutions, LLC will include the transfer of: (i) the ownership and operating NRC licenses for TMI-2; (ii) the external trusts for the decommissioning and environmental remediation of TMI-2; and (iii) related liabilities. On August 10, 2020, JCP&L, ME, PN, GPUN, TMI-2 Solutions, LLC, and the PA DEP reached a settlement agreement regarding the decommissioning of TMI-2. On December 2, 2020, the NJBPU issued an order approving the transfer and sale under the conditions requested by Rate Counsel and agreed to by JCP&L. Also, on December 2, 2020, the NRC issued its order approving the license transfer as requested. With the receipt of all required regulatory approvals, the transaction was consummated on December 18, 2020. See Note 1, "Organization and Basis of Presentation," for additional discussion.FES Bankruptcy On March 31, 2018, FES, including its consolidated subsidiaries, FG, NG, FE Aircraft Leasing Corp., Norton Energy 66Storage L.L.C. and FGMUC, and FENOC filed voluntary petitions for bankruptcy protection under Chapter 11 of the United States Bankruptcy Code in the Bankruptcy Court and emerged on February 27, 2020. See Note 3, "Discontinued Operations," for additional discussion. Other Legal Matters There are various lawsuits, claims (including claims for asbestos exposure) and proceedings related to FirstEnergy's normal business operations pending against FE or its subsidiaries. The loss or range of loss in these matters is not expected to be material to FE or its subsidiaries. The other potentially material items not otherwise discussed above are described under Note 14, "Regulatory Matters." FirstEnergy accrues legal liabilities only when it concludes that it is probable that it has an obligation for such costs and can reasonably estimate the amount of such costs. In cases where FirstEnergy determines that it is not probable, but reasonably possible that it has a material obligation, it discloses such obligations and the possible loss or range of loss if such estimate can be made. If it were ultimately determined that FE or its subsidiaries have legal liability or are otherwise made subject to liability based on any of the matters referenced above, it could have a material adverse effect on FE's or its subsidiaries' financial condition, results of operations and cash flows.CRITICAL ACCOUNTING POLICIES AND ESTIMATESFirstEnergy prepares consolidated financial statements in accordance with GAAP. Application of these principles often requires a high degree of judgment, estimates and assumptions that affect financial results. FirstEnergy's accounting policies require significant judgment regarding estimates and assumptions underlying the amounts included in the financial statements. Additional information regarding the application of accounting policies is included in the Notes to Consolidated Financial Statements.Revenue RecognitionFirstEnergy follows the accrual method of accounting for revenues, recognizing revenue for electricity that has been delivered to customers but not yet billed through the end of the accounting period. The determination of electricity sales to individual customers is based on meter readings, which occur on a systematic basis throughout the month. At the end of each month, electricity delivered to customers since the last meter reading is estimated and a corresponding accrual for unbilled sales is recognized. The determination of unbilled sales and revenues requires management to make estimates regarding electricity available for retail load, transmission and distribution line losses, demand by customer class, applicable billing demands, weather-related impacts, number of days unbilled and tariff rates in effect within each customer class. FirstEnergy has elected the optional invoice practical expedient for most of its revenues and utilizes the optional short-term contract exemption for transmission revenues due to the annual establishment of revenue requirements, which eliminates the need to provide certain revenue disclosures regarding unsatisfied performance obligations. See Note 2, "Revenue," for additional information. Regulatory AccountingFirstEnergy’s Regulated Distribution and Regulated Transmission segments are subject to regulations that set the prices (rates) the Utilities and the Transmission Companies are permitted to charge customers based on costs that the regulatory agencies determine are permitted to be recovered. At times, regulators permit the future recovery through rates of costs that would be currently charged to expense by an unregulated company. This ratemaking process results in the recording of regulatory assets and liabilities based on anticipated future cash inflows and outflows. Management applies judgment in evaluating the evidence available to assess the probability of recovery of regulatory assets from customers, including, but not limited to evaluating evidence related to precedent for similar items experienced at the Company and comparable companies within similar jurisdictions, as well as assessing progress of communications between the Company and regulators. Certain regulatory assets are recorded based on prior precedent or anticipated recovery based on rate making premises without a specific rate order. FirstEnergy regularly reviews these assets to assess their ultimate recoverability within the approved regulatory guidelines. Impairment risk associated with these assets relates to potentially adverse legislative, judicial or regulatory actions in the future. See Note 14, "Regulatory Matters," for additional information.FirstEnergy reviews the probability of recovery of regulatory assets at each balance sheet date and whenever new events occur. Similarly, FirstEnergy records regulatory liabilities when a determination is made that a refund is probable or when ordered by a commission. Factors that may affect probability include changes in the regulatory environment, issuance of a regulatory commission order or passage of new legislation. If recovery of a regulatory asset is no longer probable, FirstEnergy will write off that regulatory asset as a charge against earnings. FirstEnergy considers the entire regulatory asset balance as the unit of account for the purposes of balance sheet classification rather than the next years recovery and as such net regulatory assets and liabilities are presented in the non-current section on the FirstEnergy Consolidated Balance Sheets.67Pension and OPEB AccountingFirstEnergy provides noncontributory qualified defined benefit pension plans that cover substantially all of its employees and non-qualified pension plans that cover certain employees. The plans provide defined benefits based on years of service and compensation levels. Under the cash-balance portion of the pension plan (for employees hired on or after January 1, 2014), FirstEnergy makes contributions to eligible employee retirement accounts based on a pay credit and an interest credit.FirstEnergy provides a minimum amount of noncontributory life insurance to retired employees in addition to optional contributory insurance. Health care benefits, which include certain employee contributions, deductibles and co-payments, are also available upon retirement to certain employees, their dependents and, under certain circumstances, their survivors. FirstEnergy recognizes the expected cost of providing pension and OPEB to employees and their beneficiaries and covered dependents from the time employees are hired until they become eligible to receive those benefits. FirstEnergy also has obligations to former or inactive employees after employment, but before retirement, for disability-related benefits.FirstEnergy recognizes a pension and OPEB mark-to-market adjustment for the change in the fair value of plan assets and net actuarial gains and losses annually in the fourth quarter of each fiscal year and whenever a plan is determined to qualify for a remeasurement. The remaining components of pension and OPEB expense, primarily service costs, interest on obligations, assumed return on assets and prior service costs, are recorded on a monthly basis.Under the approved bankruptcy settlement agreement discussed above, upon emergence, FES and FENOC employees ceased earning years of service under the FirstEnergy pension and OPEB plans. The emergence on February 27, 2020, triggered a remeasurement of the affected pension and OPEB plans and as a result, FirstEnergy recognized a non-cash, pre-tax pension and OPEB mark-to-market adjustment of approximately $423 million in the first quarter of 2020. The first quarter 2020 pension and OPEB mark-to-market adjustment primarily reflects a 38 bps decrease in the discount rate used to measure benefit obligations from December 31, 2019, partially offset by a slightly higher than expected return on assets. In the fourth quarter 2020, FirstEnergy recognized a $54 million pension and OPEB mark-to-market adjustment, primarily reflecting a 29 bps decrease in the discount rate used to measure benefit obligations from February 27, 2020, partially offset by higher than expected return on assets. Of the $54 million, approximately $21 million was allocated to certain of the Transmission Companies that are expected to be recovered through formula transmission rates. The annual pension and OPEB mark-to-market adjustments for the years ended December 31, 2020, 2019, and 2018 were $477 million (including the $423 million in the first quarter of 2020 described above), $676 million, and $145 million, respectively. Of these amounts, approximately $2 million and $1 million are included in discontinued operations for the years ended December 31, 2019, and 2018, respectively. Furthermore, of these annual pension and OPEB mark-to-market amounts, approximately $40 million, $47 million and $8 million were allocated to certain of the Transmission Companies and expected to be recovered through formula transmission rates, respectively. In selecting an assumed discount rate, FirstEnergy considers currently available rates of return on high-quality fixed income investments expected to be available during the period to maturity of the pension and OPEB obligations. The assumed discount rates for pension were 2.67%, 3.34% and 4.44% as of December 31, 2020, 2019 and 2018, respectively. The assumed discount rates for OPEB were 2.45%, 3.18% and 4.30% as of December 31, 2020, 2019 and 2018, respectively.Effective in 2019, FirstEnergy changed the approach utilized to estimate the service cost and interest cost components of net periodic benefit cost for pension and OPEB plans. Historically, FirstEnergy estimated these components utilizing a single, weighted average discount rate derived from the yield curve used to measure the benefit obligation. FirstEnergy has elected to use a spot rate approach in the estimation of the components of benefit cost by applying specific spot rates along the full yield curve to the relevant projected cash flows, as this provides a better estimate of service and interest costs by improving the correlation between projected benefit cash flows to the corresponding spot yield curve rates. This election was considered a change in estimate and, accordingly, accounted for prospectively, and did not have a material impact on FirstEnergy's financial statements. FirstEnergy’s assumed rate of return on pension plan assets considers historical market returns and economic forecasts for the types of investments held by the pension trusts. In 2020, FirstEnergy’s qualified pension and OPEB plan assets experienced gains of $1,225 million or 14.7%, compared to gains of $1,492 million, or 20.2% in 2019, and losses of $371 million, or (4)% in 2018 and assumed a 7.50% rate of return on plan assets in 2020, 2019 and 2018, which generated $651 million, $569 million and $605 million of expected returns on plan assets, respectively. The expected return on pension and OPEB assets is based on the trusts’ asset allocation targets and the historical performance of risk-based and fixed income securities. The gains or losses generated as a result of the difference between expected and actual returns on plan assets will decrease or increase future net periodic pension and OPEB cost as the difference is recognized annually in the fourth quarter of each fiscal year or whenever a plan is determined to qualify for remeasurement. The expected return on plan assets for 2021 is 7.50%.During 2020, the Society of Actuaries published new mortality tables that include more current data than the RP-2014 tables as well as new improvement scales. An analysis of FirstEnergy pension and OPEB plan mortality data indicated the use of the Pri-2012 mortality table with projection scale MP-2020 was most appropriate. As such, the Pri-2012 mortality table with projection scale MP-2020 was utilized to determine the 2020 benefit cost and obligation as of December 31, 2020 for the FirstEnergy pension and OPEB plans. The impact of using the Pri-2012 mortality table with projection scale MP-2020 resulted in a decrease 68to the projected benefit obligation of approximately $74 million and $2 million for the pension and OPEB plans, respectively, and was included in the 2020 pension and OPEB mark-to-market adjustment.FirstEnergy expects its 2021 pre-tax net periodic benefit credit to be approximately $267 million based upon the following assumptions: Assumptions PensionOPEBService cost weighted-average discount rate 3.10 %3.03 %Interest cost weighted-average discount rate 2.58 %1.66 %Expected long-term return on plan assets7.50 %7.50 %The following table reflects the portion of pension and OPEB costs that were charged to expense, including any pension and OPEB mark-to-market adjustments, in the three years ended December 31, 2020, 2019, and 2018:Postemployment Benefits Expense (Credits)202020192018 (In millions)Pension$254 $622 $247 OPEB(47)(21)(45)Total$207 $601 $202 Health care cost trends continue to increase and will affect future OPEB costs. The composite health care trend rate assumptions were approximately 6.0%-5.5% in 2020 and 2019, gradually decreasing to 4.5% in later years. In determining FirstEnergy’s trend rate assumptions, included are the specific provisions of FirstEnergy’s health care plans, the demographics and utilization rates of plan participants, actual cost increases experienced in FirstEnergy’s health care plans, and projections of future medical trend rates. The effects on 2021 pension and OPEB net periodic benefit costs from changes in key assumptions are as follows:Increase in Net Periodic Benefit Costs from Adverse Changes in Key AssumptionsAssumptionAdverse ChangePensionOPEBTotal (In millions)Discount rateDecrease by 0.25%$400 $16 $416 Long-term return on assetsDecrease by 0.25%$22 $1 $23 Health care trend rateIncrease by 1.0%N/A$16 $16 See Note 5, "Pension and Other Postemployment Benefits," for additional information. Income Taxes FirstEnergy records income taxes in accordance with the liability method of accounting. Deferred income taxes reflect the net tax effect of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts recognized for tax purposes. Investment tax credits, which were deferred when utilized, are being amortized over the recovery period of the related property. Deferred income tax liabilities related to temporary tax and accounting basis differences and tax credit carryforward items are recognized at the statutory income tax rates in effect when the liabilities are expected to be paid. Deferred tax assets are recognized based on income tax rates expected to be in effect when they are settled.FirstEnergy accounts for uncertainty in income taxes in its financial statements using a benefit recognition model with a two-step approach, a more-likely-than-not recognition criterion and a measurement attribute that measures the position as the largest amount of tax benefit that is greater than 50% likely of being ultimately realized upon settlement. If it is not more likely than not that the benefit will be sustained on its technical merits, no benefit will be recorded. Uncertain tax positions that relate only to timing of when an item is included on a tax return are considered to have met the recognition threshold. FirstEnergy recognizes interest expense or income related to uncertain tax positions by applying the applicable statutory interest rate to the difference between the tax position recognized and the amount previously taken, or expected to be taken, on the tax return. FirstEnergy includes net interest and penalties in the provision for income taxes. See Note 7, "Taxes," for additional information on FirstEnergy income taxes.69NEW ACCOUNTING PRONOUNCEMENTSSee Note 1, "Organization and Basis of Presentation," for a discussion of new accounting pronouncements.ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKThe information required by Item 7A relating to market risk is set forth in Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations."70
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+Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations - Business Trends and Conditions."3Table of ContentRevenue by SegmentThe table below summarizes our revenue by reporting segment (in millions): 202020192018Merchant Solutions$3,767 $1,942 $208 Banking Solutions5,944 5,592 5,416 Capital Market Solutions2,440 2,318 2,258 Corporate and Other401 481 541 Total Consolidated Revenue$12,552 $10,333 $8,423 Merchant Solutions ("Merchant")The Merchant segment is focused on serving merchants of all sizes globally, enabling them to accept electronic payments, including card-based payments, contactless card and mobile wallet, originated at a physical point of sale, as well as card-not-present payments in eCommerce and mobile environments. Merchant services include all aspects of payment processing, including authorization and settlement, customer service, chargeback and retrieval processing, electronic payment transaction reporting and network fee and interchange management. Merchant also includes value-added services, such as security and fraud prevention solutions, advanced data analytics and information management solutions, foreign currency management and numerous funding options. Merchant serves clients in over 140 countries. Our Merchant clients are highly-diversified, including global enterprises, national retailers, and small- to medium-sized businesses. The Merchant segment utilizes broad and varied distribution channels, including direct sales forces and multiple referral partner relationships that provide us with a growing and diverse client base.Our solutions in this segment include the following:•Merchant Acquiring. Our merchant acquiring solutions primarily provide point-of-sale payment processing for merchants of all sizes with a focus on large multi-national enterprises. Our solutions provide payment acceptance from various payment types, including but not limited to debit, credit, EMV (Europay, MasterCard and Visa), contactless and loyalty point redemption. •Integrated Payments. Our integrated payment solutions primarily leverage an independent software vendor ("ISV") partnership model where FIS provides the merchant acquiring capabilities for the ISV partner across several industry verticals and sub-verticals. These solutions also include merchant acquiring for payment facilitators ("PayFacs"), which consolidates multiple sub-merchant accounts under a master merchant identification number ("MID") account. •Global eCommerce. Our global eCommerce solutions provide card-not-present merchant acquiring capabilities to merchants looking to sell their goods and services digitally. Our platforms enable both domestic and international capabilities and can provide a customizable and scalable solution to our merchants with best-in-class authorization rates. Banking Solutions ("Banking")The Banking segment is focused on serving all sizes of financial institutions with core processing software, transaction processing software and complementary applications and services, many of which interact directly with the core processing applications. We sell these solutions and services on either a bundled or stand-alone basis. Clients in this segment include global financial institutions, U.S. regional and community banks, credit unions and commercial lenders, as well as government institutions and other commercial organizations. Banking serves clients in more than 100 countries. We provide our clients integrated solutions characterized by multi-year processing contracts that generate highly recurring revenue. The predictable nature of cash flows generated from the Banking segment provides opportunities for further investments in innovation, integration, information and security, and compliance in a cost-effective manner. The results in this segment included the Reliance Trust Company of Delaware business through its divestiture on December 31, 2018 and the Company's Brazilian Venture business through its divestiture as part of the joint venture unwinding transaction on December 31, 2018 (see Note 19 to the consolidated financial statements). 4Table of ContentOur solutions in this segment include the following:•Core Processing and Ancillary Applications. Our core processing software applications are designed to run banking processes for our financial institution clients, including deposit and lending systems, customer management, and other central management systems, serving as the system that clients use to maintain the primary records of their customer accounts. Our diverse selection of market-focused core systems enables FIS to compete effectively in a wide range of markets. We continue to invest in our core modernization efforts to further differentiate our offerings for the long term. We also offer a number of services that are ancillary to the primary applications listed above, including branch automation, back-office support systems and compliance support. •Digital, including Internet, Mobile and eBanking. Our comprehensive suite of retail delivery applications enables financial institutions to integrate and streamline customer-facing operations and back-office processes, thereby improving customer interaction across all channels (e.g., branch offices, internet, ATM, mobile, and call centers). FIS' focus on consumer access has driven significant market innovation in this area, with multi-channel and multi-host solutions and a strategy that provides tight integration of services and a seamless customer experience. We have been providing our large regional banking customers in the U.S. with Digital One, an integrated digital banking platform, and are now adding functionality and offering Digital One to our community bank clients. Digital One is integrated into several of the core banking platforms offered by FIS and is also offered to customers of non-FIS core banking systems.•Fraud, Risk Management and Compliance. Our decision solutions offer a spectrum of options that cover the account lifecycle from helping to identify qualified account applicants to managing existing customer accounts and fraud. Our applications include know-your-customer, new account decisioning and opening, account and transaction management, fraud management and collections. Our risk management services use our proprietary risk management models and data sources to assist in detecting fraud and assessing the risk of opening a new account. Our systems use a combination of advanced authentication procedures, predictive analytics, artificial intelligence modeling and proprietary and shared databases to assess and detect fraud risk for deposit transactions for financial institutions. •Electronic Funds Transfer and Network. Our electronic funds transfer and debit card processing businesses offer settlement and card management solutions for financial institution card issuers. We provide traditional ATM-based debit network access through NYCE, other branded networks, and emerging real-time payment alternatives. Our networks connect millions of cards and point-of-sale locations nationwide, providing consumers with secure, real-time access to their money. Also through our networks, clients such as financial institutions, retailers and independent ATM operators can capitalize on the efficiency, consumer convenience and security of electronic real-time payments, real-time account-to-account transfers, and strategic alliances such as surcharge-free ATM network arrangements.•Card and Retail Payment. Our card and retail payment technology and services allow clients to issue VISA®, MasterCard® or other payment network branded credit and debit cards or other electronic payment cards for use by both consumer and business accounts. Card transactions continue to increase as a percentage of total point-of-sale payments, which fuels continuing demand for card-related services. We offer EMV integrated circuit cards, often referred to as smart cards or chip cards, as well as a variety of stored-value card types and loyalty/reward programs, including our Premium Payback service that allows our financial institution customers to use loyalty points at a variety of merchant point-of-sale systems. Our integrated services range from card production and activation to processing to an extensive range of fraud management services and value-added loyalty programs designed to increase card usage and fee-based revenue for financial institutions and merchants. The majority of our programs are full service, including most of the operations and support necessary for an issuer to operate a credit card program. We do not make credit decisions for our card issuing clients. We are also a leading provider of prepaid card services, which include digital cards, gift cards and reloadable cards, with end-to-end solutions for development, processing and administration of stored-value programs, including government benefit programs. Our closed-loop gift card solutions and loyalty programs provide merchants compelling solutions to drive consumer loyalty. •Wealth and Retirement. We provide wealth and retirement solutions that help banks, trust companies, brokerage firms, insurance firms, retirement plan professionals, benefit administrators and independent advisors acquire, service and grow their client relationships. We provide solutions for client acquisition, transaction management, trust accounting and recordkeeping that can be deployed stand-alone or as part of an integrated wealth or retirement platform, or on an outsourced basis.5Table of Content•Item Processing and Output Services. Our item processing services furnish financial institutions with the technology needed to capture data from checks, transaction tickets and other items; image and sort items; process exceptions through keying; and perform balancing, archiving and the production of statements. Our item processing services are performed at one of our multiple item processing centers located throughout the U.S. or on-site at client locations. Our extensive solutions include distributed (i.e., non-centralized) data capture, mobile deposit capture, check and remittance processing, fraud detection, and document and report management. Clients encompass banks and corporations of all sizes, from de novo banks to the largest financial institutions and corporations. We offer a number of output services that are ancillary to the primary solutions we provide, including print and mail capabilities, document composition software and solutions, and card personalization fulfillment services. Our print and mail services offer complete computer output solutions for the creation, management and delivery of print and fulfillment needs. We provide our card personalization fulfillment services for branded credit cards and branded and non-branded debit and prepaid cards.Capital Market Solutions ("Capital Markets")The Capital Markets segment is focused on serving global financial services clients with a broad array of buy- and sell-side solutions. Clients in this segment operate in more than 100 countries and include asset managers, buy- and sell-side securities brokerage and trading firms, insurers, private equity firms, and other commercial organizations. Our buy- and sell-side solutions include a variety of mission-critical applications for recordkeeping, data and analytics, trading, financing and risk management. Capital Markets clients purchase our solutions and services in various ways including licensing and managing technology "in-house," using consulting and third-party service providers, as well as procuring fully outsourced end-to-end solutions. Our long-established relationships with many of these financial and commercial institutions generate significant recurring revenue. We have made, and continue to make, investments in modern platforms; advanced technologies, such as cloud delivery, open APIs, machine learning and artificial intelligence; and regulatory technology to support our Capital Markets clients. Our solutions in this segment include the following:•Securities Processing and Finance. Our offerings help financial institutions to increase the efficiency, transparency and control of their back-office trading operations, post-trade processing and settlement including derivative solutions, risk management, securities lending, syndicated lending, tax processing, and regulatory compliance. The breadth of our offerings also facilitates advanced business intelligence and market data distribution based on our extensive market data access.•Global Trading. Our trading solutions provide trade execution, data and network solutions to financial institutions, corporations and municipalities in North America, Europe and other global markets across a variety of asset classes. Our trade execution and network solutions help both buy- and sell-side firms improve execution quality, decrease overall execution costs and address today's trade connectivity challenges.•Asset Management and Insurance. We offer solutions that help institutional investors, insurance companies, hedge funds, private equity firms, fund administrators and securities transfer agents improve both investment decision-making and operational efficiency, while managing risk and increasing transparency. Our asset management solutions support every stage of the investment process, from research and portfolio management, to valuation, risk management, compliance, investment accounting, transfer agency and client reporting. Our insurance solutions help support front-office and back-office functions including actuarial risk calculations, policy administration and financial and investment accounting and reporting for a variety of insurance lines, including life and health, annuities and pensions, property and casualty, and reinsurance.•Corporate Liquidity. Our corporate liquidity solutions help chief financial officers and treasurers manage working capital by reducing risk and improving communication and response time between a company's buyers, suppliers, banks and other stakeholders. Our end-to-end collaborative financial management framework helps bring together receivables, treasury and payments for a single view of cash and risk, which helps our clients optimize business processes for enhanced liquidity management. Corporate and OtherThe Corporate and Other segment consists of corporate overhead expense, certain leveraged functions and miscellaneous expenses that are not included in the operating segments, as well as certain non-strategic businesses that we plan to wind down or sell. The overhead and leveraged costs relate to corporate marketing, corporate finance and accounting, human resources, 6Table of Contentlegal, and amortization of acquisition-related intangibles and other costs, such as acquisition and integration expenses, that are not considered when management evaluates revenue-generating segment performance. Sales and Marketing We have experienced sales personnel with expertise in particular solutions and markets as well as across our various client segments—Merchant, Banking and Capital Markets. We believe that focusing our expertise on clients in specific markets (e.g., global financial institutions, North American financial institutions, North American merchants, etc.) and tailoring integrated solution sets of particular value to participants in those markets enables us to leverage opportunities to cross-sell and up-sell. We target the majority of our potential clients via direct and/or indirect field sales, as well as inbound and outbound lead generation, telesales and virtual sales efforts.Our global marketing team develops and leads the execution of the Merchant, Banking and Capital Markets strategic marketing plans in support of the segments' reputation and relationship building goals in addition to their revenue and profitability goals. Key components of our strategic plans include brand management and digital enablement; market and competitive research; capturing client preferences; thought leadership; integrated go-to-market programs; internal communications and readiness; journalist, social media and industry analyst relations; client events; trade shows; high-touch client programs; demand generation campaigns; account- and deal-based marketing programs; collateral development and management across digital and online channels; and the commercialization of new products to market. Patents, Copyrights, Trademarks and Other Intellectual PropertyIn general, we own the intellectual property and proprietary rights that are necessary for the conduct of our business and important to our future success, including trademarks, trade names, trade secrets, copyrights and patents. We license certain items from third parties under arms-length agreements for varying terms, including some "open source" licenses. Although we acquired the trademarks and trade names used by SunGard as part of our 2015 acquisition of SunGard and its subsidiaries, we note that following the split-off of the Availability Services ("AS") business by SunGard in 2014, AS has the right to use the Sungard Availability Services name, which does not include the right to use the SunGard name or its derivatives.We rely on a combination of contractual restrictions, internal security practices, patents, trade secrets, copyrights and applicable law to establish and protect our software, technology and expertise worldwide. We rely on trademark law to protect our rights in our brands. We intend to continue taking appropriate measures to protect our intellectual property rights, including by legal action when necessary and appropriate. CompetitionThe markets for our solutions and services are intensely competitive. Depending on the business line, in our Merchant, Banking and Capital Markets segments, our primary competitors include internal technology or software development departments within financial institutions or other large companies, merchant acquirers, global eCommerce providers, global and regional companies providing payment services, third-party payment processors, securities exchanges, asset managers, card associations, clearing networks or associations, trust companies, independent computer services firms, companies that develop and deploy software applications, companies owned by global banks selling new competitive solutions, companies that provide customized development, implementation and support services, emerging technology innovators, and business process outsourcing companies. Many of these companies compete with us across multiple solutions, markets and geographies. Some of these competitors possess greater financial, sales and marketing resources than we do. Competitive factors impacting the success of our services across our segments include the quality of the technology-based application or service, application features and functions, ease of delivery and integration, the ability to maintain, enhance and support the applications or services, price and overall relationship management. We believe we compete favorably in each of these categories. In addition, we believe our domain expertise, combined with our ability to offer multiple applications, services and integrated solutions to individual clients, enhances our competitiveness against companies with more limited offerings. Our ability to innovate and scale digital payments and services during the COVID-19 pandemic has been a competitive advantage as well.Research and Development Our research and development activities primarily relate to the modernization of our proprietary core systems and the design and development of next generation digital solutions, processing systems, software applications and risk management platforms. We expect to continue our practice of investing an appropriate level of resources to maintain, enhance and extend the functionality of our proprietary systems and software applications, to develop new and innovative software applications and 7Table of Contentsystems to address emerging technology trends in response to the needs of our clients and to enhance the capabilities of our outsourcing infrastructure. In addition, we intend to offer services compatible with new and emerging delivery channels.As part of our research and development process, we evaluate current and emerging technology for compatibility with our existing and future software platforms. To this end, we engage with various hardware and software vendors in the evaluation of various infrastructure components. Where appropriate, we use third-party technology components in the development of our software applications and service offerings. In the case of nearly all of our third-party software, enterprise license agreements exist for the third-party component and either alternative suppliers exist or transfer rights exist to ensure the continuity of supply. As a result, we are not materially dependent upon any third-party technology components. Third-party software may be used for highly specialized business functions, which we may not be able to develop internally within time and budget constraints. Additionally, third-party software may be used for commodity-type functions within a technology platform environment. We work with our clients to determine the appropriate timing and approach to introducing technology or infrastructure changes to our applications and services. During the years ended December 31, 2020, 2019 and 2018, we incurred research and development costs that were non-capitalizable of approximately 3% to 4% of revenue.Government RegulationOur services are subject to a broad range of complex federal, state, and international regulations and requirements, as well as requirements under the rules of self-regulatory organizations including, without limitation, federal truth-in-lending and truth-in-savings rules, state money transmission laws, state cybersecurity protection laws, data protection and privacy laws, usury laws, laws governing state trust charters, the Equal Credit Opportunity Act, the Electronic Funds Transfer Act, the Fair Credit Reporting Act, the Fair Debt Collection Practices Act, the Bank Service Company Act, the Bank Secrecy Act, the USA Patriot Act, the Internal Revenue Code, the Employee Retirement Income Security Act, the Health Insurance Portability and Accountability Act, the Community Reinvestment Act and the Dodd-Frank Wall Street Reform and Consumer Protection Act (the "Dodd-Frank Act"), the Securities Exchange Act of 1934, the Investment Advisors Act of 1940 (the "1940 Act"), anti-corruption laws including the U.S. Foreign Corrupt Practices Act and U.K. Bribery Act, the rules and regulations of the Financial Industry Regulatory Authority ("FINRA"), the Securities and Exchange Commission ("SEC"), the Federal Financial Institutions Examination Council ("FFIEC"), the Consumer Financial Protection Bureau ("CFPB"), the Financial Conduct Authority in the U.K. ("FCA") and the Payment Systems Regulator in the U.K. ("PSR"), De Nederlandsche Bank ("DNB") in the Netherlands, the Ministry of Economy, Trade and Industry in Japan ("METI") and state financial services regulators (including enforcement of state cybersecurity laws). The compliance of our services and applications with these and other applicable laws and regulations depends on a variety of factors, including the manner in which our clients use them. In some cases, we are directly subject to regulatory oversight and examination. In other cases, our clients are contractually responsible for determining what is required of them under applicable laws and regulations and utilize our solutions and services to achieve compliance with those laws and regulations. In either case, the failure of our services to comply with applicable laws and regulations may result in suspension or revocation of the permission-based regulatory licenses, restrictions on our ability to provide those services, the imposition of civil fines and/or criminal penalties, and/or reputational damage. Further, regulatory authorities have the power to, among other things, enjoin "unsafe or unsound" practices, require affirmative actions to correct any violation or practice, issue administrative orders that can be judicially enforced and direct the sale of subsidiaries or other assets. We may be adversely affected by increased regulatory scrutiny or related negative publicity. The principal areas of regulation impacting our business are the following:•Oversight by Banking Regulators. As a provider of electronic data processing and back-office services to financial institutions, FIS is subject to regulatory oversight and examination by the FFIEC, including the Federal Deposit Insurance Corporation ("FDIC"), the Office of the Comptroller of the Currency ("OCC"), the Board of Governors of the Federal Reserve System ("FRB"), the National Credit Union Administration ("NCUA") and the CFPB as part of the Multi-Regional Data Processing Servicer ("MDPS") program. The MDPS program includes technology suppliers that provide mission critical applications for a large number of financial institutions that are regulated by multiple regulatory agencies. Periodic information technology examination assessments are performed using FFIEC Interagency guidelines to identify potential risks that could adversely affect serviced financial institutions, determine compliance with applicable laws and regulations that affect the services provided to financial institutions and ensure the services we provide to financial institutions do not create systemic risk to the banking system or impact the safe and sound operation of the financial institutions we process. In addition, independent auditors annually review several of our operations to provide reports on internal controls for our clients. We are also subject to review and examination by state and international regulatory authorities under state and foreign laws and rules that regulate many of the same activities that are described above, including electronic data processing, payments and back-office services for financial institutions and the use of consumer information. 8Table of ContentOur U.S.-based wealth and retirement business holds a charter in the state of Georgia which makes us subject to the regulatory compliance requirements of the Georgia Department of Banking and Finance. As a result, we are also authorized to provide trust services in various additional states subject to additional applicable state regulations. •Oversight by Securities Regulators. Our subsidiary that conducts our broker-dealer business in the U.S. is registered as a broker-dealer with the SEC, is a member of FINRA, and is registered as a broker-dealer in numerous states. Our broker-dealer is subject to regulation and oversight by the SEC. In addition, FINRA, a self-regulatory organization that is subject to oversight by the SEC, adopts and enforces rules governing the conduct, and examines the activities, of its member firms, including our broker-dealer. State securities regulators, the Municipal Securities Rulemaking Board, and various exchanges, including the New York Stock Exchange, also have regulatory or oversight authority over our broker-dealer. Broker-dealers are subject to regulations that cover all aspects of the securities business, including sales methods, trade practices among broker-dealers, public and private securities offerings, use and safekeeping of customers’ funds and securities, capital structure, record keeping, the financing of customers’ purchases and the conduct and qualifications of directors, officers and employees. In particular, as a registered broker-dealer and member of a self-regulatory organization, we are subject to the SEC’s uniform net capital rule, Rule 15c3-1. Rule 15c3-1 specifies the minimum level of net capital a broker-dealer must maintain and also requires that a significant part of a broker-dealer’s assets be kept in relatively liquid form. The SEC and various self-regulatory organizations impose rules that require notification when net capital falls below certain predefined criteria, limit the ratio of subordinated debt to equity in the regulatory capital composition of a broker-dealer and constrain the ability of a broker-dealer to expand its business under certain circumstances. Additionally, the SEC’s uniform net capital rule imposes certain requirements that may have the effect of prohibiting a broker-dealer from distributing or withdrawing capital and requiring prior notice to the SEC for certain withdrawals of capital. Our subsidiaries also include an SEC-registered transfer agent. Our registered transfer agent is subject to the Securities Exchange Act of 1934 and the rules and regulations promulgated thereunder. These laws and regulations generally grant the SEC and other supervisory bodies broad administrative powers to address non-compliance with regulatory requirements. Sanctions that may be imposed for non-compliance with these requirements include the suspension of individual employees, limitations on engaging in certain activities for specified periods of time or for specified types of clients, the revocation of registrations, other censures and significant fines. Subsidiaries engaged in activities outside the U.S. are regulated by various government agencies in the particular jurisdiction where they are chartered, incorporated and/or conduct their business activity. For example, pursuant to the U.K. Financial Services and Markets Act 2000 ("FSMA"), certain of our subsidiaries are subject to regulations promulgated and administered by the FCA. The FSMA and rules promulgated thereunder govern all aspects of the U.K. investment business, including sales, research and trading practices, provision of investment advice, use and safekeeping of client funds and securities, regulatory capital, recordkeeping, margin practices and procedures, approval standards for individuals, anti-money laundering, periodic reporting and settlement procedures. •Payment Services Oversight. Our payment services business is a technology service provider to U.S. financial institutions and is, therefore, subject to oversight and examination by the FFIEC. Our payment services businesses are also subject to regulation, supervision, and enforcement authority of numerous governmental and regulatory bodies in the jurisdictions in which they operate, which include the CFPB, the DNB in the Netherlands, the METI in Japan, and the FCA and the PSR in the U.K. These various regulatory regimes require compliance in respect of many aspects of our payment services business including without limitation corporate governance and oversight functions, capital requirements, liquidity, safeguarding, fee regulation adherence, technology and cyber resilience, anti-money laundering and sanctions. Because the PSR is an economic regulator in the U.K., it has the power to issue directions in relation to the functioning of the card acquiring market in the U.K. Further, the European Commission is conducting a review of the Regulation of the European Parliament and the Council on interchange fees for card-based payment transactions ("IFR") to examine the appropriateness of the levels of interchange fees, the level of entry of new players, new technology and the impact of innovative business models on the market. The European Union ("E.U.") has overall authority to enforce and establish new standards or guidance which may require banks and authorized payments providers in our Merchant business to modify current pricing and fee structures, and the E.U. could choose to exercise such authority prior to or after conclusion of such review.•Privacy and Data Protection. The Company is subject to an increasing number of privacy and data protection laws, regulations and directives globally (referred to collectively as "Privacy Laws"), many of which place restrictions on the 9Table of ContentCompany's ability to efficiently transfer, access and use personal data across its business. The legislative and regulatory landscape for privacy and data protection continues to evolve. Our financial institution clients operating in the U.S. are required to comply with privacy regulations imposed under the Gramm-Leach-Bliley Act (referred to as "GLBA") and numerous similar state laws. GLBA and those state laws place restrictions on the use of non-public personal information. All financial institutions must disclose detailed privacy policies to their customers and offer them the opportunity to direct the financial institution not to share information with third parties. The regulations under GLBA, however, permit financial institutions to share information with non-affiliated parties who perform services for the financial institutions. As a provider of services to financial institutions, we are required to comply with the privacy laws and are bound by the same limitations on disclosure of the information received from our clients as apply to the financial institutions themselves. A determination that there have been violations of privacy laws could expose us to significant damage awards, fines and other penalties that could, individually or in the aggregate, materially harm our business and reputation.In July 2016, the European Commission formally approved and adopted the EU-US Privacy Shield, providing a compliance framework for organizations to transfer personal data regarding citizens of the E.U. to the U.S. On July 16, 2020, the Court of Justice of the European Union ("CJEU") published its decision in the case of Data Protection Commissioner v Facebook Ireland Ltd, Maximilian Schrems (known as the "Schrems II" case). In Schrems II, the CJEU completely invalidated the EU-US Privacy Shield, but the Standard Contractual Clauses ("SCC's") remain valid. While we had certified certain lines of business under the Privacy Shield, we have chosen to adopt E.U. SCC's published by the European Commission as the primary basis for the export of data from the E.U. to the U.S. and were not significantly affected by this decision. The European Data Protection Board ("EDPB") is working on regulatory guidance in light of Schrems II, but such guidance has not yet been finalized.The E.U.'s General Data Protection Regulation ("GDPR"), which became effective on May 25, 2018, applies to all organizations processing the personal data of individuals in the E.U., regardless of where such organization is based. The GDPR has heightened our data protection compliance obligations, impacted our businesses' collection, processing and retention of personal data and imposed stricter standards for reporting data breaches. The GDPR also imposes significant penalties for non-compliance. The Company is also subject to the California Consumer Privacy Act ("CCPA"), which came into effect on January 1, 2020, and provides California residents additional data protection rights including the right to be informed about the personal information collected by third parties and the use of that personal information. Further, certain operations of the Company became subject to the Brazilian General Personal Data Protection Act in August 2020. The Company has adopted a comprehensive global privacy program to assess and manage these evolving risks and continues to monitor new data privacy laws throughout the jurisdictions in which we do business, including data localization requirements in applicable jurisdictions. In addition, our businesses are increasingly subject to laws and regulations relating to surveillance, encryption and data onshoring in the jurisdictions in which we operate. Compliance with these laws and regulations may require us to change our technology for information security, operational infrastructure, policies and procedures, which could be time-consuming and costly.•Money Transfer. Elements of our cash access and money transmission businesses are registered as a Money Services Business and are subject to the USA Patriot Act and reporting requirements of the Bank Secrecy Act and U.S. Treasury Regulations. These businesses may also be subject to certain state and local licensing requirements. The Financial Crimes Enforcement Network, state attorneys general, and other agencies have enforcement responsibility over laws relating to money laundering, currency transmission, and licensing. In applicable states, we have obtained money transmitter licenses. However, changes to state money transmission laws and regulations, including changing interpretations and the implementation of new or varying regulatory requirements, may result in the need for additional or expanded money transmitter licenses, additional capital allocations or changes in the way in which we deliver certain services. We are also subject to certain economic and trade sanctions programs that are administered by the U.S. Treasury's Office of Foreign Assets Control (referred to as "OFAC"), which prohibit or restrict transactions to or from or dealings with specified countries, their governments, and in certain circumstances, their nationals, and with individuals and entities that are specially-designated nationals of those countries, narcotics traffickers, and terrorists or terrorist organizations. Similar anti-money laundering laws apply to movements of currency and payments through electronic 10Table of Contenttransactions and to dealings with persons specified in lists maintained by the country equivalents to OFAC in several other countries. We have implemented policies, procedures, and internal controls that are designed to comply with the regulations and economic sanctions programs administered by OFAC, as well as all other applicable anti-money laundering laws and regulations. •Consumer Reporting and Protection. Our decision solutions subsidiary, ChexSystems, maintains a database of consumer information used to provide various account opening services including credit scoring analysis and is subject to the Federal Fair Credit Reporting Act ("FCRA") and similar state laws. The FCRA regulates consumer reporting agencies ("CRAs"), including ChexSystems, and governs the accuracy, fairness, and privacy of information in the files of CRAs that engage in the practice of assembling or evaluating certain information relating to consumers for certain specified purposes. CRAs are required to follow reasonable procedures to assure maximum possible accuracy of information concerning the individual about whom the report relates and if a consumer disputes the accuracy of any information in the consumer’s file, to conduct a reasonable investigation within statutory timelines. The FCRA imposes many other requirements on CRAs and users of consumer report information. Regulatory enforcement of the FCRA is under the purview of the United States Federal Trade Commission, the CFPB, and state attorneys general, acting alone or in concert with one another. In furtherance of our objectives of data accuracy, fair treatment of consumers, protection of consumers' personal information, and compliance with these laws, we have made considerable investment to maintain a high level of security for our computer systems in which consumer data resides, and we maintain consumer relations call centers to facilitate accurate and timely handling of consumer requests for information and handling disputes. We also are focused on ensuring our operating environments safeguard and protect consumer's personal information in compliance with these laws. Our consumer reporting and consumer-facing businesses are subject to CFPB Bulletin 2013-7 (a successor to the former Regulation AA - Unfair Deceptive Acts or Practices), which defines Unfair, Deceptive or Abusive Acts or Practices ("UDAAP"). This specific bulletin states that UDAAPs can cause significant financial injury to consumers, erode consumer confidence, and undermine fair competition in the financial marketplace. Original creditors and other covered persons and service providers under the Dodd-Frank Act involved in collecting debt related to any consumer financial product or service are subject to the prohibition against UDAAPs in the Dodd-Frank Act.•Debt Collection. Our collection services are subject to the Federal Fair Debt Collection Practices Act and various state collection laws and licensing requirements. The Federal Trade Commission, as well as state attorneys general and other agencies, have enforcement responsibility over the collection laws, as well as the various credit reporting laws.•Anti-Corruption. FIS is subject to applicable anti-corruption laws, such as the U.S. Foreign Corrupt Practices Act and the U.K. Bribery Act, in the jurisdictions in which it operates. Anti-corruption laws generally prohibit offering, promising, giving, or authorizing others to give anything of value, either directly or indirectly, to a government official or private party in order to influence official action or otherwise gain an unfair business advantage, such as to obtain or retain business. FIS has implemented policies, procedures, training and internal controls that are designed to comply with such laws, rules and regulations.The foregoing list of laws and regulations to which our Company is subject is not exhaustive, and the regulatory framework governing our operations changes continuously. Enactment of new laws and regulations may increasingly affect the operations of our business, directly and indirectly, which could result in substantial regulatory compliance costs, litigation expense, adverse publicity, and/or loss of revenue.Information SecurityGlobally, attacks on information technology systems continue to grow in frequency, complexity and sophistication. This is a trend we expect to continue. Such attacks have become a point of focus for individuals, businesses and governmental entities. The objectives of these attacks include, among other things, gaining unauthorized access to systems to facilitate financial fraud, disrupt operations, cause denial of service events, corrupt data, and steal non-public information. These circumstances present both a threat and an opportunity for FIS. As part of our business, we electronically receive, process, store and transmit a wide range of confidential information, including sensitive customer information and personal consumer data. We also operate payment, cash access and prepaid card systems. FIS remains focused on making strategic investments in information security to protect our clients and our information systems. This includes both capital expenditures and operating expenses on hardware, software, personnel and consulting services. We also participate in industry and governmental initiatives to improve information security for our clients. Through 11Table of Contentthe expertise we have gained with this ongoing focus and involvement, we have developed fraud, security, risk management and compliance solutions to target this growth opportunity in the financial services industry.For more information on Information Security, see "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations."Human Capital ManagementEmployee PopulationAs of December 31, 2020, we had more than 62,000 employees, including approximately 38,000 employees principally employed outside of the U.S. None of our U.S. workforce currently is unionized. Approximately 9,000 of our employees, primarily in Brazil and the U.K., are represented by labor unions or works councils.Health and Safety The health and safety of our employees is a key priority. At the beginning of the COVID-19 pandemic, we activated our company-wide Pandemic Plan. We equipped more than 95% of our workforce with the necessary technology and connectivity to work remotely. We instituted safety protocols and procedures throughout our facilities for essential employees who continued to work on site. In addition, we expanded our employee benefits to include telemedicine, paid time off for employees impacted by COVID-19 to deal with personal illness or have time off to care for family members, and to expand FIS Cares globally to assist our colleagues in need. The Company also offers webinars and other online resources to enable employees to focus on their physical, emotional, and social well-being. Corporate CultureOur culture stems from embracing our corporate values as we work together to win as one team, lead with integrity and strive to be the change for our colleagues, clients and communities. The Company believes that inclusion and diversity are at the core of our corporate values. The diversity of our workforce helps us use our collective strengths to innovate and deliver the best products and solutions for our clients. Our Board of Directors and senior leaders are united in championing inclusion and diversity within our workforce through their leadership in prioritizing equality and diversity in our human resource decision making throughout the Company. The Company sponsors Inclusion Networks, which are led by employees who share common backgrounds and experiences. These groups support their members while promoting the Company's overall goal of fostering an inclusive work environment. Current FIS Inclusion Networks include Women, Black, Latinx, Disability, LGBTQ+, Rising Professionals, Veterans, and Working Families, and we have added a governance layer of an Inclusion and Diversity Council which includes participation and leadership by senior executives of the Company. The Chief Executive Officer and the Chief People Officer regularly update the Company's Board of Directors on human capital management and inclusion and diversity initiatives.Talent ManagementOur colleagues are primary stakeholders in our organization, and we are strategic in attracting talent that adds to our collective strengths to innovate and deliver an exemplary client experience. We have an inclusive culture where employees receive the development needed to grow their careers and deliver high-quality outcomes. Our practices include a comprehensive performance feedback culture that includes quarterly performance reviews, access to a variety of online and self-paced learning resources, as well as virtual and face-to-face development offerings, targeted development programs for high-potential and senior management employees, opportunities to apply for open roles to move within the Company and executive-level succession planning.Available InformationOur website address is www.fisglobal.com. We make our Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, and Current Reports on Form 8-K, and any amendments to those reports, available, free of charge, on that website as soon as reasonably practicable after we file or furnish them to the SEC. Our Corporate Governance Policy and Code of Business Conduct and Ethics are also available on our website and are available in print, free of charge, to any shareholder who mails a request to the Corporate Secretary, Fidelity National Information Services, Inc., 601 Riverside Avenue, Jacksonville, FL 32204 USA. Other corporate governance-related documents can be found at our website as well. However, the information found on our website is not a part of this or any other report.12Table of ContentItem 1A. Risk FactorsIn addition to the normal risks of business, we are subject to significant risks and uncertainties, including those listed below and others described elsewhere in this Annual Report on Form 10-K. Any of the risks described herein could result in a significant adverse effect on our results of operations and financial condition.Risks Related to Our Business and OperationsThe extent to which the COVID-19 pandemic and measures taken in response thereto impact our business, results of operations, liquidity and financial condition will depend on future developments, which are highly uncertain and are difficult to predict. Global health concerns relating to the COVID-19 pandemic and related government actions taken to reduce the spread of the virus have been weighing on the macroeconomic environment, and the pandemic has significantly increased economic uncertainty and reduced economic activity, including consumer and business spending. The pandemic has continued to result in government authorities implementing numerous measures to try to contain the virus, such as travel bans and restrictions, quarantines, shelter-in-place or total lock-down orders and business limitations and shutdowns. Governments around the globe have taken steps to mitigate some of the more severe anticipated economic effects of the virus, but there can be no assurance that such steps will be effective or achieve their desired results in a timely fashion.As U.S. and foreign governmental authorities imposed social distancing, shelter-in-place or total lock-down orders, spending declined, most notably in discretionary spending verticals, including travel, airlines and restaurants, resulting in a rapid deterioration in payments volume and transaction trends on a worldwide basis beginning in March 2020, which adversely impacted revenue in our payments businesses that earn transaction-based fees. As such restrictions eased in the second and third quarters, spending increased, and the impact on our transaction-based fees rebounded in our Banking and Merchant segments, except for areas such as travel and hospitality, which remained largely restricted. In the fourth quarter, some restrictions were re-imposed based upon a resurgence of the COVID-19 pandemic in many areas of the U.S. and Europe, which resulted in an adverse impact on payments volumes and transactions over those anticipated following the easing of restrictions in the prior two quarters. In addition, we have experienced some slowdown in corporate decision-making on sales and implementation of our solutions, as well as on software licenses and professional services. These changes in spending affected our business, results of operations and financial condition starting in the second quarter of 2020 through the end of the year and will likely continue to have such an impact, although the magnitude and duration of their ultimate effect is not possible to predict. The distribution of vaccines against COVID-19 beginning in late December could curtail the impact of the pandemic in 2021, although the timing remains uncertain.We may experience additional pandemic-related financial impacts due to a number of operational factors, including:•increased risk of merchant and card issuer failures and credit settlement and chargeback risk;•increased risk of meeting client service contractual obligations due to government lock-down or other orders where it is not possible to provide certain client-facing services from home or to promptly transfer them to other locations, causing potential loss of revenue or contractual penalties due to failure to meet service level requirements as well as potential legal disputes and associated costs regarding force majeure or other related contract defenses;•increased cyber and payment fraud risk related to COVID-19, as cybercriminals attempt to profit from the disruption, given increased online banking, e-commerce and other online activity;•challenges to the availability and reliability of our solutions and services due to changes to normal operations, including the possibility of one or more clusters of COVID-19 cases occurring at our data centers, contact centers or operations centers, affecting our employees or affecting the systems or employees of our clients or other third parties on which we depend;•an increased volume of unanticipated client and regulatory requests for information and support, or additional regulatory requirements, which could require additional resources and costs to address, including, for example, government initiatives to reduce or eliminate payments costs or fees to merchants;•continued incremental costs directly related to COVID-19, although their magnitude is uncertain; and•the general impact of recession and instability of markets across the globe.The spread of COVID-19 has caused us to modify our business practices (including restricting employee travel, developing social distancing plans for our employees and cancelling physical participation in meetings, events and conferences and replacing them, where possible, with virtual meetings, events and conferences). There is no certainty that such measures will be sufficient to mitigate all of the risks posed by the virus or will otherwise be satisfactory to government authorities. Further, the ability of our senior management and employees to get to work has been disrupted across multiple locations, whether in their 13Table of Contentown offices or at client sites, due, among other things, to government work and travel restrictions, including mandatory shutdowns. Where appropriate and plausible under local conditions, we have moved the work from affected locations. Most of our employees are currently working remotely, where they may not be as effective.In addition, we have extended at times during 2020 higher-than-usual levels of credit to our merchant clients as part of funds settlement in connection with payments to their customers, for, among other things, refunds for cancelled trips and events. If the speed of repayments to us by our merchant clients is substantially slower than expected over an extended period of time, or if our merchant clients cease operations such that we are unable to collect on the credit advanced by us for these payments or for any chargeback liability, it could have a material adverse effect on our liquidity, results of operations and financial condition.The extent to which the COVID-19 pandemic impacts our business, results of operations and financial condition will depend on future developments, which are highly uncertain and are difficult to predict, including, but not limited to, the duration and spread of the pandemic, its severity, the actions to contain the virus or treat its impact, and how quickly and to what extent normal economic and operating conditions can resume. We may experience materially adverse impacts to our business as a result of the pandemic's global economic impact, including the availability of credit and our ability to comply with the covenants of our credit agreement, adverse impacts on our liquidity, the ability to meet our deleveraging targets, and any recession that has occurred or may occur in the future. Such impacts may also have a material effect on one or more of the estimates and assumptions used to evaluate goodwill impairment and could result in future goodwill impairment. Additionally, COVID-19 may have a material effect on our ability to pay our quarterly dividends at current levels or at all, although it has not yet.There are no comparable recent events that provide guidance as to the effect the spread and duration of COVID-19 as a global pandemic may have, and, as a result, the ultimate impact of the pandemic is highly uncertain and subject to change. We do not yet know the full extent of the impacts on our business, our operations or the global economy as a whole. However, the impacts of the pandemic could have a material adverse effect on our results of operations, liquidity or financial condition and heighten many of our known risks described in the remainder of this "Risk Factors" section.Security breaches or attacks, or our failure to comply with information security laws or regulations or industry security requirements, could harm our business by disrupting delivery of services and damaging the reputation of FIS and could result in a breach of one or more client contracts. FIS electronically receives, processes, stores and transmits sensitive business information of its clients. In addition, FIS collects personal consumer data, such as names and addresses, social security numbers, driver's license numbers, cardholder data and payment history records. Such information is necessary to support our clients' transaction processing and to conduct our check authorization and collection businesses. The uninterrupted operation of information systems, as well as the confidentiality of the customer/consumer information that resides on such systems, is critical to the successful operation of FIS. For that reason, cybersecurity is one of the principal operational risks FIS faces as a provider of services to financial institutions. If FIS fails to maintain an adequate security infrastructure, adapt to emerging security threats, or implement sufficient security standards and technology to protect against security breaches, the confidentiality of the information FIS secures could be compromised. Unauthorized access to the computer systems or databases of FIS could result in the theft or publication of confidential information, the deletion or modification of records, damages from legal actions from clients and/or their customers, or otherwise cause interruptions in FIS' operations and damage to its reputation. These risks are greater with increased information transmission over the internet, the increasing level of sophistication posed by cyber criminals, nation state-sponsored cyber attacks and the integration of FIS systems with those of acquired companies such as Worldpay.As a provider of services to financial institutions and a provider of card processing services, FIS is bound by the same limitations on disclosure of the information FIS receives from clients as apply to the clients themselves. If FIS fails to comply with these regulations and industry security requirements, it could be exposed to damages from legal actions from clients and/or their customers, governmental proceedings, governmental notice requirements, and the imposition of significant fines or prohibitions on card processing services. In addition, if more restrictive privacy laws, rules or industry security requirements are adopted in the future on the federal or state level, or by a specific industry body, they could have an adverse impact on FIS through increased costs or restrictions on business processes. Any inability to prevent security or privacy breaches, or the perception that such breaches may occur, could cause existing clients to lose confidence in FIS systems and terminate their agreements with FIS, inhibit FIS' ability to attract new clients, result in increasing regulation, or bring about other adverse consequences from the government agencies that regulate FIS.14Table of ContentEntity mergers or consolidations and business failures in the banking and financial services industry could adversely affect our business by eliminating some of our existing and potential clients and making us more dependent on a more limited number of clients.There has been and continues to be substantial consolidation activity in the banking and financial services industry. In addition, certain financial institutions that experienced negative operating results, including some of our clients, have failed. These consolidations and failures reduce our number of potential clients and may reduce our number of existing clients, which could adversely affect our revenue, even if the events do not reduce the aggregate activities of the consolidated entities. Further, if our clients or our partners across any of our businesses fail and/or merge with or are acquired by other entities that are not our clients or our partners, or that use fewer of our services, they may discontinue or reduce use of our services. It is also possible that larger financial institutions resulting from consolidations would have greater leverage in negotiating terms or could decide to perform in-house some or all of the services we currently provide or could provide. Any of these developments could have an adverse effect on our business, results of operations and financial condition.If we fail to innovate or adapt our services to changes in technology or in the marketplace, or if our ongoing efforts to upgrade or implement our technology are not successful, we could lose clients, or our clients could lose customers, and we could have difficulty attracting new clients for our services.The markets for our services are characterized by constant technological changes, frequent introductions of new services and evolving industry standards. Our future success will be significantly affected by our ability to enhance our current solutions and develop and introduce new solutions and services that address the increasingly sophisticated needs of our clients and their customers. In addition, as more of our revenue and market demand shifts to software as a service ("SaaS"), business process as a service ("BPaaS"), cloud, and new emerging technologies, the need to keep pace with rapid technology changes becomes more acute. These initiatives carry the risks associated with any new solution development effort, including cost overruns, delays in delivery and implementation, and performance issues. There can be no assurance that we will be successful in developing, marketing and selling new solutions or enhancements that meet these changing demands. Any of these developments could have an adverse impact on our future revenue and/or business prospects.We operate in a competitive business environment; if we are unable to compete effectively, our results of operations and financial condition may be adversely affected.The market for our services is intensely competitive. Our competitors in Banking and Capital Markets vary in size and in the scope and breadth of the solutions and services they offer. Some of our competitors have substantial resources. We face direct competition from third parties, and because many of our larger potential clients have historically developed their key applications in-house and therefore view their system requirements from a make-versus-buy perspective, we also often compete against our potential clients' in-house capacities. In addition, the markets in which we compete have recently attracted increasing competition from smaller start-ups with emerging technologies which are receiving increasing investments, global banks (and businesses controlled by combinations of global banks) and global internet companies that are introducing competitive solutions and services into the marketplace, particularly in the payments area. Emerging technologies and increased competition may also have the effect of unbundling bank solutions and result in displacing solutions we are currently providing from our legacy systems. International competitors are also now targeting and entering the U.S. market with greater force. There can be no assurance that we will be able to compete successfully against current or future competitors or that the competitive pressures we face in the markets in which we operate will not materially adversely affect our business, financial condition, and results of operations. In the Merchant business, our competitors include financial institutions and well-established payment processing companies. In this business, our U.S. competitors that are financial institutions or are affiliated with financial institutions may not incur the sponsorship costs we incur for registration with the payment networks. Accordingly, these competitors may be able to offer more attractive fees to our current and prospective clients or other services that we do not provide. Competition could result in a loss of existing clients and greater difficulty attracting new clients. Furthermore, if competition causes us to reduce the fees we charge in order to attract or retain clients, there is no assurance we can successfully control our costs in order to maintain our profit margins. One or more of these factors could have a material adverse effect on FIS' business, financial condition and results of operations.FIS is currently facing new competitive pressure from non-traditional payment processors and other parties entering the payments industry, which may compete in one or more of the functions performed in processing merchant transactions. These competitors have significant financial resources and robust networks and are highly regarded by consumers. If these competitors gain a greater share of total electronic payments transactions, or if we are unable to successfully react to changes in 15Table of Contentthe industry spurred by the entry of these new market participants, then it could have a material adverse effect on FIS' business, financial condition and results of operations. See "Item 1. Business, Competition."Global economic, political and other conditions, including business cycles and consumer confidence, may adversely affect our clients or trends in consumer spending, which may adversely impact the demand for our services and our revenue and profitability.A significant portion of our revenue is derived from transaction processing fees. The global transaction processing industries depend heavily upon the overall level of consumer, business and government spending. Any change in economic factors, including a sustained deterioration in general economic conditions or consumer confidence, particularly in the U.S., or increases in interest rates in key countries in which we operate may adversely affect consumer spending, consumer debt levels and credit and debit card usage, and as a result, adversely affect our financial performance by reducing the number or average purchase amount of transactions that we service.When there is a slowdown or downturn in the economy, a drop in stock market levels or trading volumes, or an event that disrupts the financial markets, our business and financial results, particularly with respect to our Capital Markets segment, may suffer for a number of reasons. Customers may react to worsening conditions by reducing their capital expenditures in general or by specifically reducing their information technology spending. In addition, customers may curtail or discontinue trading operations, delay or cancel information technology projects, or seek to lower their costs by renegotiating vendor contracts. Moreover, competitors may respond to market conditions by lowering prices and attempting to lure away our customers to lower cost solutions. Any further protective trade policies or actions taken by the U.S. may also result in other countries reducing, or making more expensive, services permitted to be provided by U.S.-based companies. If any of these circumstances remain in effect for an extended period of time, there could be a material adverse effect on our financial results. Our results may fluctuate from period to period because of the lengthy and unpredictable sales cycle for our software, changes in our mix of licenses and services, activity by competitors, and customer budgeting, operational requirements or renewal cycles. Particularly with respect to our Capital Markets segment, our operating results may fluctuate from period to period and be difficult to predict in a particular period due to the timing and magnitude of software license sales and other factors. We offer a number of our software solutions on a license basis, which means that the customer has the right to run the software on its own or a third party's hardware. We generally recognize license revenue when the license contract is signed, the software is delivered, and the term has begun. The value of the license often depends on a number of customer-specific factors, such as the number of customer locations, users or accounts. The sales cycle for a software license may be lengthy and take unexpected turns. Thus, it is difficult to predict when software sales will occur or how much revenue they will generate. Because there are few incremental costs associated with software sales, our operating results may fluctuate from quarter to quarter and year to year due to the timing and magnitude of software sales. Conversion of clients from licenses to BPaaS solutions, while resulting in longer-term contracts, may result in uneven short-term results as one-time license fees are replaced by recurring revenue. Our results may also vary as a result of pricing pressures, increased cost of equipment, the evolving and unpredictable markets in which our solutions and services are sold, changes in accounting principles, and competitors' new solutions or services. Failure to obtain new clients or renew client contracts on favorable terms could adversely affect results of operations and financial condition.We may face pricing pressure in obtaining and retaining our clients. Larger clients in particular may use their value and negotiating leverage to seek price reductions from us when they renew a contract, when a contract is extended, or when the client's business has significant volume changes. Larger clients may also reduce services if they decide to move services in-house. Further, our smaller and mid-size clients may also exert pricing pressure, particularly upon renewal, due to competition or other economic needs or pressures being experienced by the client. On some occasions, this pricing pressure results in lower revenue from a client than we had anticipated based on our previous agreement with that client. This reduction in revenue could adversely affect our business, operating results and financial condition.Our business and operating results could be adversely affected if we experience business interruptions, errors or failure in connection with our or third-party information technology and communication systems and other software and hardware used in connection with our business, if we experience defects or design errors in the software solutions we offer, or more generally, if the third-party vendors we rely upon are unwilling or unable to provide the services we need to effectively operate our business.16Table of ContentMany of our services are based on sophisticated software and computing systems, and we may encounter delays when developing new technology solutions and services. Further, the technology solutions underlying our services have occasionally contained, and may in the future contain, undetected errors or defects when first introduced or when new versions are released. In addition, we may experience difficulties in installing or integrating our technologies on platforms used by our clients, or our clients may cancel a project after we have expended significant effort and resources to complete an installation. Finally, our systems and operations could be exposed to damage or interruption from fire, natural disaster, power loss, telecommunications failure, unauthorized entry and computer viruses. Defects in our technology solutions, errors or delays in the processing of electronic transactions, or other difficulties could result in (i) interruption of business operations; (ii) delay in market acceptance; (iii) additional development and remediation costs; (iv) diversion of technical and other resources; (v) loss of clients; (vi) negative publicity; or (vii) exposure to liability claims. Any one or more of the foregoing could have an adverse effect on our business, financial condition and results of operations. Although we attempt to limit our potential liability through controls, including system redundancies, security controls, application development and testing controls, and disclaimers and limitation-of-liability provisions in our license and client agreements, we cannot be certain that these measures will always be successful in preventing disruption or limiting our liability.Further, most of the solutions we offer are very complex software systems that are regularly updated. No matter how careful the design and development, complex software often contains errors and defects when first introduced and when major new updates or enhancements are released. If errors or defects are discovered in current or future solutions, then we may not be able to correct them in a timely manner, if at all. In our development of updates and enhancements to our software solutions, we may make a major design error that makes the solution operate incorrectly or less efficiently. The failure of software to properly perform could result in the Company and its clients being subjected to losses or liability, including censures, fines, or other sanctions by the applicable regulatory authorities, and we could be liable to parties who are financially harmed by those errors. In addition, such errors could cause the Company to lose revenue, lose clients or damage its reputation.Our Merchant business has made progress toward implementation of a new proprietary global acquiring platform project begun by Worldpay. As we continue to implement this project, through the migration of existing merchant customers and onboarding of new merchant customers to the platform, the scale and complexity associated with this project presents the increased potential for service level delays or disruptions in the processing of transactions, telecommunications failures or other difficulties. Such delays or disruptions could result in reputational harm, loss of business and increased operational or technological costs.In addition, we generally depend on a number of third parties, both in the United States and internationally, to supply elements of our systems, computers, research and market data, connectivity, communication network infrastructure, other equipment and related support and maintenance. We cannot be certain that any of these third parties will be able to continue providing these services to effectively meet our evolving needs. If our vendors, or in certain cases vendors of our customers, fail to meet their obligations, provide poor or untimely service, or we are unable to make alternative arrangements for the provision of these services, then we may in turn fail to provide our services or to meet our obligations to our customers, and our business, financial condition and operating results could be adversely affected. Federal, state and foreign rules may result in business changes for certain of our businesses and clients; these have had, and further could have, an adverse effect on our financial condition, revenue, results of operations, or prospects for future growth and overall business.The Dodd-Frank Act represented a comprehensive overhaul of the regulations governing the financial services industry within the U.S. The Dodd-Frank Act established the CFPB and provided the CFPB with rulemaking authority with respect to certain federal consumer protection statutes as well as examination and supervisory authority over consumer reporting agencies, including ChexSystems.The CFPB continues to establish rules and regulations for regulating financial and non-financial institutions and providers to those institutions to ensure adequate protection of consumer privacy and to ensure consumers are not impacted by deceptive business practices. These rules and regulations govern our clients or potential clients and also govern certain of our businesses. These regulations have resulted, and may further result, in the need for FIS to make capital investments to modify our solutions and services to facilitate our clients' and potential clients' compliance, as well as to deploy additional processes or reporting to comply with these regulations. The new Biden administration in Washington has projected that it may expand the reach of this agency. In the future, we may be subject to additional expense to ensure continued compliance with applicable laws and regulations and to investigate, defend and/or remedy actual or alleged violations. Further, requirements of these regulations have resulted, and could further result, in changes in our business practices, our clients' business practices and those of other marketplace participants that may alter the delivery of services to consumers, which have impacted, and could further impact, the demand for our software and services as well as alter the types or volume of transactions that we process on behalf of our 17Table of Contentclients. As a result, these requirements, or proposed or future requirements, could have an adverse impact on our financial condition, revenue, results of operations, prospects for future growth and overall business.The New York Department of Financial Services has enacted rules that require covered financial institutions to establish and maintain cybersecurity programs. These rules subject FIS to additional regulation and require us to adopt additional business practices that could also require additional capital expenditures or impact our operating results. Changes to state money transmission laws and regulations, including changing interpretations and the implementation of new or varying regulatory requirements, may result in the need for additional money transmitter licenses. These changes could result in increased costs of compliance, as well as fines or penalties.One of our subsidiaries is an SEC registered broker-dealer in the U.S. and is subject to the financial and operational rules of FINRA, and others are authorized by the FCA to conduct certain regulated business in the U.K. Domestic and foreign regulatory and self-regulatory organizations, such as the SEC, FINRA, and the FCA, can, among other things, fine, censure, issue cease-and-desist orders against, and suspend or expel a broker-dealer or its officers or employees for failure to comply with the many laws and regulations that govern brokerage activities. Regulations affecting the brokerage industry may change, which could adversely affect our financial results. We are exposed to certain risks relating to the execution services provided by our brokerage operations to our customers and counterparties, which include other broker-dealers, active traders, hedge funds, asset managers, and other institutional and non-institutional clients. These risks include, but are not limited to, customers or counterparties failing to pay for or deliver securities, trading errors, the inability or failure to settle trades, and trade execution system failures. As trading in the U.S. securities markets has become more automated, the potential impact of a trading error or a rapid series of errors caused by a computer or human error or a malicious act has become greater. In our other businesses, we generally can disclaim liability for trading losses that may be caused by our software, but in our brokerage operations, we may not be able to limit our liability for trading losses or failed trades even when we are not at fault. As a result, we may suffer losses that are disproportionately large compared to the relatively modest profit contributions of our brokerage operations. Moreover, the legislative and regulatory landscape for financial crimes compliance continues to evolve, and any failure to comply with such laws could expose us to liability and/or reputational damage. Financial crimes laws may be interpreted and applied inconsistently from country to country and impose inconsistent or conflicting requirements. Complying with varying jurisdictional requirements could increase the costs and complexity of compliance and associated recordkeeping costs or require us to change our business practices in a manner adverse to our business.The Company is subject to regulation, supervision, and enforcement authority of numerous governmental and regulatory bodies in the jurisdictions in which it operates.Because the Company is a technology service provider to U.S. financial institutions, it is subject to regular oversight and examination by the Federal Banking Agencies ("FBA"), each of which is a member of the FFIEC, an inter-agency body of federal banking regulators. The FBA have broad discretion in the implementation, interpretation and enforcement of banking and consumer protection laws and use the FFIEC's uniform principles, standards and report forms in their review of bank service providers like FIS. A failure to comply with these laws, or a failure to meet the supervisory expectations of the banking regulators, could result in adverse action against the Company. The regulators have the power to, among other things, enjoin "unsafe or unsound" practices; require affirmative actions to correct any violation or practice; issue administrative orders that can be judicially enforced; direct the sale of subsidiaries or other assets; and assess civil money penalties.The Company is also subject to ongoing supervision by regulatory and governmental bodies across the world, including economic and conduct regulators, such as the FCA and PSR in the U.K., the DNB in the Netherlands, and regulatory and governmental bodies responsible for issuing anti-money laundering, anti-bribery, and global economic sanctions regulations. These various regulatory regimes require compliance across many aspects of our merchant activities in respect of capital requirements, safeguarding, training, authorization and supervision of personnel, systems, processes and documentation. We also have business operations that store, process or transmit consumer information or have direct relationships with consumers that are obligated to comply with regulations, including, but not limited to, the FCRA, the Federal Fair Debt Collection Practices Act and applicable privacy requirements. In addition, our wealth and retirement business holds a charter in the state of Georgia, which exposes us to further regulatory compliance requirements of the Georgia Department of Banking and Finance. The U.S. wealth and retirement business is required to hold certain levels of regulatory capital as defined by the state banking regulator in Georgia. In the U.K., our Merchant business, as well as our Platform Securities and broker-dealer businesses, are regulated by the FCA and are also subject to further regulatory capital requirements. 18Table of ContentIf we fail to comply with relevant regulations, then we risk reputational damage, potential civil and criminal sanctions, fines or other action imposed by regulatory or governmental authorities, including the potential suspension or revocation of the permission-based regulatory licenses which authorize the Company to provide core services to customers. We are also involved, from time to time, in regulatory investigations, reviews and proceedings (both formal and informal) by regulatory authorities regarding our businesses, certain of which may result in adverse settlements, fines, penalties, injunctions or other relief. This could result in an adverse effect on FIS' business, reputation and customer relationships, which in turn could adversely affect its financial position and performance.Many of our clients are subject to a regulatory environment and to industry standards that may change in a manner that reduces the types or volume of solutions or services we provide or may reduce the type or number of transactions in which our clients engage, and therefore reduce our revenue.Our clients are subject to a number of government regulations and industry standards with which our services must comply. Our clients must ensure that our services and related solutions work within the extensive and evolving regulatory and industry requirements applicable to them. Federal, state, foreign or industry authorities could adopt laws, rules or regulations affecting our clients' businesses that could lead to increased operating costs and could reduce the convenience and functionality of our services, possibly resulting in reduced market acceptance. In addition, action by regulatory authorities relating to credit availability, data usage, privacy, or other related regulatory developments could have an adverse effect on our clients and, therefore, could have a material adverse effect on our financial condition, revenue, results of operations, prospects for future growth and overall business. Elimination of regulatory requirements could also adversely affect the sales of our solutions designed to help clients comply with complex regulatory environments.Our revenue relating to all aspects of the sale of services to members of Visa, MasterCard and other payment networks is dependent upon our continued certification and sponsorship, and the loss or suspension of certification or sponsorship could adversely affect our business.In order to provide our card processing services, we must be certified (including applicable sponsorship) by Visa, MasterCard, American Express, Discover and other similar organizations. These certifications are dependent upon our continued adherence to the standards of the issuing bodies and sponsoring member banks. The member financial institutions, some of which are our competitors, set the standards with which we must comply. If we fail to comply with these standards we could be fined, our certifications could be suspended, or our registration could be terminated. The suspension or termination of our certifications, or any changes in, or the enforcement of, the rules and regulations governing or relating to the businesses of Visa, MasterCard or other payment networks, could result in a reduction in revenue or increased costs of operation for us, which in turn could have a material adverse effect on our business.In order to provide merchant transaction processing services in the U.S. and certain other jurisdictions, we are registered through our bank sponsorships with the Visa, MasterCard and other payment networks as service providers for member institutions. As a result, FIS and many of its clients are subject to payment network rules. If FIS or its associated participants do not comply with the payment network requirements, the payment networks could seek to fine FIS, suspend FIS or terminate its registrations. Our Merchant business has occasionally received notices of noncompliance and fines, which have typically related to excessive chargebacks by a merchant or data security failures on the part of a merchant. If FIS is unable to recover fines from, or pass through costs to, its merchants or other associated participants, then FIS would experience a financial loss. The termination of its registration, or any changes in the payment network rules that would impair FIS' registrations, could require the Company to stop providing payment network services to the Visa, MasterCard or other payment networks, which would have a material adverse effect on FIS' business, financial condition and results of operations.Outside of the U.S., our Merchant business primarily provides acquiring and processing services directly through international credit and debit card networks run by Visa, MasterCard and other payment networks. In order to access the card networks, the Company must maintain the relevant jurisdictional operating licenses or memberships. In some markets where it is not feasible or possible for the Company to have a direct acquiring license with a card network, we have a relationship with a local financial institution sponsor. As part of the Company's registration with card networks (either directly or indirectly through local sponsors), the Company is subject to operating rules, including mandatory technology requirements, promulgated by the card networks that could subject the Company and its customers to a variety of fines and penalties, as well as suspension and termination of membership or access.These agreements in the U.S. and elsewhere with bank sponsors give such sponsors substantial discretion in approving certain aspects of our business practices in our Merchant business, including our solicitation, application and qualification procedures for merchants and the terms of our agreements with merchants. Our financial institution sponsors' discretionary actions under these agreements could have a material adverse effect on our business, financial condition and results of 19Table of Contentoperations. We also rely on various financial institutions to provide clearing services in connection with our settlement activities. Without these sponsorships or clearing services agreements in our Merchant business, we would not be able to process Visa, MasterCard and other payment network transactions or settle transactions in relevant markets, including the U.S., which would have a material adverse effect on FIS' business, financial condition and results of operations. Furthermore, FIS' financial results could be adversely affected if the costs associated with such sponsorships or clearing services agreements increase.Changes in the contracts, rules or standards of networks, or relevant legal or regulatory scrutiny of pricing practices, could adversely affect FIS' business, financial condition and results of operations.From time to time, card and debit networks increase the interchange fees that they charge. At their sole discretion, our financial institution sponsors have the right to pass any increases in interchange and other fees on to us, and they have consistently done so in the past. While we are generally permitted under the contracts with our merchants to pass these fee increases along to our merchants through corresponding increases in our processing fees, if we cannot continue to do so due to contractual or regulatory requirements or competitive pressures, the inability to pass through such fees could have a material adverse effect on FIS' business, financial condition and results of operations. Additionally, in order to access the card networks directly, as our Merchant business does primarily outside the U.S., we must pay card network membership fees, which are subject to change from time to time, and which we may be unable to pass along to our merchant clients, potentially resulting in FIS absorbing a portion or all of such increases in the future.Furthermore, the rules and regulations of the various card associations and networks prescribe certain capital requirements. Any increase in the capital level required would further limit our use of capital for other purposes. Moreover, as payment networks become more dependent on proprietary technology, modify their technological approach or operating practices, and/or seek to provide value added services to issuers and merchants, there is heightened risk that rules and standards may be governed by their own self-interest, or the self-interest of third parties with influence over them, which could materially impact FIS' competitive position and operations.Interchange fees and pricing practices have been receiving significant legal and regulatory scrutiny worldwide. The resulting changes that could occur from proposed regulations or other forms of enforcement could alter the fees charged by us, card associations and debit networks worldwide. Such changes could have an adverse impact on our business or financial condition and results of operations. Privacy laws and regulations have required and will further require FIS to adopt new business practices and contractual provisions in existing and new contracts which may require transitional and incremental expenses which may impact our future operating results. New privacy laws, such as the GDPR in the E.U., continue to develop in unpredictable ways. The Company is also subject to the California Consumer Privacy Act and the Brazilian General Personal Data Protection Act. Failure to comply with these new laws could result in significant penalties, damage to our brand and loss of business. The Company has incurred, and will continue to incur, costs to comply with these new laws. There are also several additional privacy laws being considered by state legislatures, the federal legislature and countries around the world; as a result, a more substantial compliance effort with varying regimes in different jurisdictions is considered probable in the future, which will increase the costs and complexities of the business. Moreover, privacy laws may be interpreted and applied inconsistently from country to country and impose inconsistent or conflicting requirements. Complying with varying jurisdictional requirements could increase the costs and complexity of compliance and associated recordkeeping costs or require us to change our business practices in a manner adverse to our business and incur additional costs. Data localization requirements in evolving data protection laws could also increase the cost and alter the approach to housing data around the world. In addition, our businesses are increasingly subject to laws and regulations relating to surveillance, encryption and data onshoring in the jurisdictions in which we operate. Compliance with these laws and regulations may require us to change our technology for information security, operational infrastructure, policies and procedures, which could be time-consuming and costly.High profile payment card industry or digital banking security breaches could impact consumer payment behavior patterns in the future and reduce our card payment transaction volumes. We are unable to predict whether or when high profile card payment or digital banking security breaches will occur and if they occur, whether consumers will transact less on their payment cards or reduce their digital banking service. If consumers transact less on cards issued by our clients or reduce digital banking services and we are not able to adapt to offer our clients alternative technologies, then our revenue and related earnings could be adversely affected.20Table of ContentMisappropriation of our intellectual property and proprietary rights or a finding that our patents are invalid could impair our competitive position.Our ability to compete depends in some part upon our proprietary solutions and technology. Despite our efforts to protect our proprietary rights, unauthorized parties may attempt to copy aspects of our services or to obtain and use information that we regard as proprietary or challenge the validity of our patents with governmental authorities. Policing unauthorized use of our proprietary rights is difficult. We cannot make any assurances that the steps we have taken will prevent misappropriation of technology or that the agreements entered into for that purpose will be enforceable. Effective patent, trademark, service mark, copyright, and trade secret protection may not be available in every country in which our applications and services are made available online. Misappropriation of our intellectual property or potential litigation concerning such matters could have an adverse effect on our results of operations or financial condition. As we increase our international business, we are subject to further risks of misappropriation of our intellectual property risks in countries which have laws which are less protective of intellectual property or are enforced in a less protective manner.If our applications or services are found to infringe the proprietary rights of others, then we may be required to change our business practices and may also become subject to significant costs and monetary penalties.As our information technology applications and services develop, we are increasingly subject to infringement claims. Any claims, whether with or without merit, could (i) be expensive and time-consuming to defend; (ii) result in an injunction or other equitable relief which could cause us to cease making, licensing or using applications that incorporate the challenged intellectual property; (iii) require us to redesign our applications, if feasible; (iv) divert management's attention and resources; and (v) require us to enter into royalty or licensing agreements in order to obtain the right to use necessary technologies or pay damages resulting from any infringing use.Some of our solutions contain "open source" software, and any failure to comply with the terms of one or more of these open source licenses could adversely affect our business. We use a limited amount of software licensed by its authors or other third parties under so-called "open source" licenses and may continue to use such software in the future. Some of these licenses contain requirements that we make available source code for modifications or derivative works we create based upon the open source software and that we license such modifications or derivative works under the terms of a particular open source license or other license granting third parties certain rights of further use. By the terms of certain open source licenses, we could be required to release the source code of our proprietary software if we combine our proprietary software with open source software in a certain manner. Additionally, the terms of many open source licenses have not been interpreted by U.S. or other courts, and there is a risk that these licenses could be construed in a manner that could impose unanticipated conditions or restrictions on our ability to commercialize our solutions. In addition to risks related to license requirements, usage of open source software can lead to greater risks than use of third-party commercial software, as open source licensors generally do not provide warranties or controls on origin of the software. We have established processes to help alleviate these risks, including a review process for screening requests from our development organizations for the use of open source, but we cannot be sure that all open source is submitted for approval prior to use in our solutions. In addition, many of the risks associated with usage of open source cannot be eliminated, and could, if not properly addressed, adversely affect our business.Lack of system integrity, fraudulent payments, credit quality, and undetected errors related to funds settlement or the availability of clearing services could result in a financial loss.We settle funds on behalf of financial institutions, other businesses and consumers and receive funds from clients, card issuers, payment networks and consumers on a daily basis for a variety of transaction types. Transactions facilitated by us include debit card, credit card, electronic bill payment transactions, banking payments and check clearing that supports consumers, financial institutions and other businesses. These payment activities rely upon the technology infrastructure that facilitates the verification of activity with counterparties, the facilitation of the payment as well as the detection or prevention of fraudulent payments. If our continuity of operations, integrity of processing, or ability to detect or prevent fraudulent payments were compromised, this could result in a financial loss to us. In addition, we rely on various financial institutions to provide Automated Clearing House ("ACH") services in support of funds settlement for certain of our solutions. If we are unable to obtain such ACH services in the future, that could have a material adverse effect on our business, financial position and results of operations. In addition, we may issue credit to consumers, financial institutions or other businesses as part of the funds settlement. A default on this credit by a counterparty could result in a financial loss to us. Furthermore, if one of our clients for which we facilitate settlement suffers a fraudulent event due to a deficiency in their controls, we may suffer a financial loss if the client does not have sufficient capital to cover the loss.21Table of ContentFraud by merchants or others could have a material adverse effect on FIS' business, financial condition and results of operations.In our Merchant business, we face potential liability for fraudulent electronic payment transactions initiated by merchants, third parties or other associated participants. Examples of merchant fraud include when a merchant or other party knowingly accepts payment by a stolen or counterfeit credit, debit or prepaid card, card number or other credentials; records a false sales transaction utilizing a stolen or counterfeit card or credentials; processes an invalid card; or intentionally fails to deliver the merchandise or services sold in an otherwise valid transaction. In the event a dispute between a cardholder and a merchant is not resolved in favor of the merchant, the transaction is normally charged back to the merchant, and the purchase price is credited or otherwise refunded to the cardholder and FIS is required to collect from the merchant. Failure to effectively manage risk and prevent fraud or other criminal activity could increase FIS' chargebacks or other liability. Increases in chargebacks or other liabilities due to merchant failures or otherwise could have a material adverse effect on FIS' business, financial condition and results of operations. The U.K.'s exit from membership in the E.U. could cause disruption to and create uncertainty surrounding our business.Our Merchant business has a significant amount of business in, and services clients in, the U.K. We also have other business and operations in the U.K. and the E.U. The U.K. left the E.U. ("Brexit") on January 31, 2020, pursuant to the terms of a withdrawal agreement concluded between the U.K. Government and the Council of the E.U. The withdrawal agreement included a transition period until December 31, 2020, during which time the U.K. followed the E.U.'s rules and regulations and remained in the single market and customs union while the future terms of the U.K.’s relationship with the E.U. were being negotiated. That transition period has now ended. On December 24, 2020, the U.K. and the E.U. announced they had struck a new bilateral trade and cooperation deal governing the future relationship between the U.K. and the E.U. (the "Trade and Cooperation Agreement"), which sets out the principles of the relationship between the E.U. and the U.K. following the end of the transition period. The Trade and Cooperation Agreement was formally approved by the 27 Member States of the E.U. on December 29, 2020, and was formally approved by the U.K. Parliament on December 30, 2020. As of the date of this Annual Report on Form 10-K, the European Commission has proposed to apply the Trade and Cooperation Agreement on a provisional basis for a limited time until February 28, 2021, by which time the Trade and Cooperation Agreement must be approved by the European Parliament. The Trade and Cooperation Agreement provides clarity in respect of the intended shape of the future relationship between the U.K. and the E.U. and some detailed matters of trade and cooperation. However, there remain unavoidable uncertainties related to Brexit, and although the potential impact of Brexit on our business cannot be fully assessed until the new relationship between the U.K. and E.U. is developed and defined, and the U.K. negotiates, concludes and implements successor trading arrangements with other countries, Brexit is likely to result in ongoing political, legal and economic uncertainty in the U.K. and wider European markets. Such uncertainty could cause volatility in currency exchange rates, in interest rates, and in E.U., U.K. or worldwide political, regulatory, economic or market conditions and could contribute to instability in political institutions, regulatory agencies, and financial markets, and may cause clients to closely monitor their costs and reduce their spending on our solutions and services.In particular, the economies of the U.K. and E.U. Member States, and individual businesses operating in one or more of those jurisdictions, may be adversely affected by the restrictions on the ability to provide cross-border services from the U.K. into the E.U. and vice versa, the introduction of non-tariff (and, in the future, potentially tariff) barriers, customs checks and/or duties, changes in tax (including withholding tax), restrictions on the movements of employees and restrictions on the transfer of personal data. In addition, there are likely to be changes in the legal rights and obligations of commercial parties across all industries, particularly in the services sector (including financial services), following the U.K.'s exit from the E.U. despite the Trade and Cooperation Agreement. Any delays with the approval of the Trade and Cooperation Agreement by the European Parliament, its potentially problematic provisions or its potentially uncertain interpretation could adversely and significantly affect European or worldwide economic or market conditions and may contribute to instability in global financial and foreign exchange markets, and could lead to legal uncertainty and divergent national laws and regulations. Any of these effects of Brexit, and others which cannot be anticipated, could adversely affect our business, business opportunities, financial condition, cash flows and operating results.Our business is subject to the risks of international operations, including movements in foreign currency exchange rates.The international operations of FIS represented approximately 24% of our total 2020 revenue and are largely conducted in currencies other than the U.S. Dollar, including the British Pound Sterling, Euro, Brazilian Real, and Indian Rupee. As a result of the Worldpay acquisition, FIS has significantly expanded its international presence by offering merchant acquiring, including eCommerce, services outside of the U.S., including in the U.K. and E.U. countries, where Worldpay's principal non-U.S. 22Table of Contentoperations are currently located. Our business and financial results could be adversely affected due to a variety of factors, including the following:•changes in a specific country or region's political and cultural climate or economic condition, including change in governmental regime;•unexpected or unfavorable changes in foreign laws, regulatory requirements and related interpretations;•difficulty of effective enforcement of contractual provisions in local jurisdictions;•inadequate intellectual property protection in foreign countries;•trade-protection measures, import or export licensing requirements such as Export Administration Regulations promulgated by the U.S. Department of Commerce and fines, penalties or suspension or revocation of export privileges;•trade sanctions imposed by the U.S. or other governments with jurisdictional authority over our business operations;•the effects of applicable and potentially adverse foreign tax law changes;•significant adverse changes in foreign currency exchange rates;•lesser enforcement of intellectual property laws and protections internationally;•longer accounts receivable cycles;•managing a geographically dispersed workforce; •trade treaties, tariffs or agreements that could adversely affect our ability to do business in affected countries; and•compliance with the U.S. Foreign Corrupt Practices Act ("FCPA") and the Office of Foreign Assets Control regulations, particularly in emerging markets.As we expand our international operations, more of our clients may pay us in foreign currencies. Conducting business in currencies other than the U.S. Dollar subjects us to fluctuations in foreign currency exchange rates that can negatively impact our results, period to period, including relative to analyst estimates or guidance. Our primary exposure to movements in foreign currency exchange rates relates to foreign currencies in Europe, including the U.K., Brazil and parts of Asia. The U.S. Dollar value of our net investments in foreign operations, the periodic conversion of foreign-denominated earnings to the U.S. Dollar (our reporting currency), and our results of operations and, in some cases, cash flows, could be adversely affected in a material manner by movements in foreign currency exchange rates. These risks could cause an adverse effect on the business, financial position and results of operations of the Company.Failure to comply with anti-bribery and anti-corruption laws could subject us to penalties and other adverse consequences.We are subject to the FCPA, the U.K. Bribery Act and other anti-bribery, anti-corruption and anti-money laundering laws in various countries around the world. The FCPA, the U.K. Bribery Act and similar applicable laws generally prohibit companies, as well as their officers, directors, employees and third-party intermediaries, business partners and agents, from making improper payments or providing other improper things of value to government officials or other persons for the purpose of obtaining or retaining business abroad or otherwise obtaining favorable treatment. The FCPA also requires that U.S. public companies maintain books and records that fairly and accurately reflect transactions and maintain an adequate system of internal accounting controls. We conduct business in many foreign countries, including a number of countries with developing economies, and many of our employees, third-party intermediaries and agents in such countries may have direct or indirect interactions with officials and employees of government agencies, state owned or affiliated entities and other third parties where we may be held liable if they take actions in violation of these laws, even if we do not explicitly authorize them. Although our policies and procedures require compliance with these laws and are designed to facilitate compliance with these laws, we do business in many countries all over the world and cannot assure that our employees, contractors or agents somewhere in the world will not take actions in violation of applicable laws or our policies, for which we may be ultimately held responsible. In the event that we believe or have reason to believe that our employees, contractors or agents have or may have violated such laws, we may be required to investigate or to have outside counsel investigate the relevant facts and circumstances. Detecting, investigating and resolving actual or alleged violations can be extensive and require a significant diversion of time, resources and attention from senior management. Further, we cannot assure that any such investigation will successfully uncover all relevant facts and circumstances. Any violation of the FCPA, the U.K. Bribery Act or other applicable anti-bribery or anti-corruption laws could result in whistleblower complaints, adverse media coverage, investigations, loss of export privileges, and criminal or civil sanctions, penalties and fines, any of which could adversely affect our business, results of operations or financial condition.23Table of ContentWe have businesses in emerging markets that may experience significant economic volatility.We have operations in emerging markets, primarily in Latin America, India, Southeast Asia, the Middle East and Africa. These emerging market economies tend to be more volatile than the more established markets we serve in North America and Europe, which could add volatility to our future revenue and earnings. Acts of war or terrorism, international conflicts, political instability, natural disasters, or widespread outbreak of an illness could negatively affect various aspects of our business, including our workforce and our business partners, make it more difficult and expensive to meet our obligations to our customers, and result in reduced revenue from our customers.Our global operations are susceptible to global events, including acts or threats of war or terrorism, international conflicts, political instability and natural disasters. We are also susceptible to a widespread outbreak of an illness or other health issue, such as the ongoing COVID-19 outbreak. These events can spread to different locations across the globe and can have an adverse effect on the global economy, reducing consumer and corporate spending upon which our revenue depends. Individual employees can become ill, quarantined, or otherwise unable to work and/or travel due to health reasons or governmental restrictions. Some of our operations are in countries where the effects of a widespread illness could be magnified due to health care systems that are less well-developed than in the U.S. The occurrence of any of these events, including the potential future effects of the COVID-19 outbreak, could have an adverse effect on our business results and financial condition.Failure to attract and retain skilled technical employees or senior management personnel could harm our ability to grow.Our future success depends upon our ability to attract and retain highly-skilled technical personnel. Because the development of our solutions and services requires knowledge of computer hardware, operating system software, system management software and application software, our technical personnel must be proficient in a number of disciplines. Competition for such technical personnel is intense, and our failure to hire and retain talented personnel could have a material adverse effect on our business, operating results and financial condition.Our future growth will also require sales and marketing, financial and administrative personnel to develop and support new solutions and services, to enhance and support current solutions and services and to expand operational and financial systems. There can be no assurance that we will be able to attract and retain the necessary personnel to accomplish our growth strategies, and we may experience constraints that could adversely affect our ability to satisfy client demand in a timely fashion.Our ability to maintain compliance with applicable laws, rules and regulations and to manage and monitor the risks facing our business relies upon the ability to maintain skilled compliance, security, risk and audit professionals. Competition for such skill sets is intense, and our failure to hire and retain talented personnel could have an adverse effect on our internal control environment and impact our operating results.Our senior management team has significant experience in the financial services industry and the loss of this leadership could have an adverse effect on our business, operating results and financial condition. Further, the loss of this leadership may have an adverse impact on senior management's ability to provide effective oversight and strategic direction for all key functions within the Company, which could impact our future business, operating results and financial condition.We are the subject of various legal proceedings that could have an adverse effect on our revenue and profitability.We are involved in various litigation matters in the ordinary course of business, including in some instances class-action cases and patent infringement litigation. If we are unsuccessful in our defense of litigation matters, we may be forced to pay damages and/or change our business practices, any of which could have an adverse effect on our business and results of operations. Unfavorable resolution of tax contingencies or unfavorable future tax law changes could adversely affect our tax expense.Our tax returns and positions are subject to review and audit by federal, state, local and international taxing authorities. An unfavorable outcome to a tax audit could result in higher tax expense and could negatively impact our effective tax rate, financial position, results of operations and cash flows in the current and/or future periods. Unfavorable future tax law changes could result in negative impacts. In addition, tax-law amendments in the U.S. and other jurisdictions could significantly impact how U.S. multinational corporations are taxed. Although we cannot predict whether or in what form such legislation will pass, if enacted it could have an adverse effect on our business and financial results. 24Table of ContentA material weakness in our internal controls could have a material adverse effect on us. Effective internal controls are necessary for us to provide reasonable assurance with respect to our financial reports and to adequately mitigate risk of fraud. If we cannot provide reasonable assurance with respect to our financial reports and adequately mitigate risk of fraud, our reputation and operating results could be harmed. Internal control over financial reporting may not prevent or detect misstatements because of its inherent limitations, including the possibility of human error, the circumvention or overriding of controls, or fraud. Therefore, even effective internal controls can provide only reasonable assurance with respect to the preparation and fair presentation of financial statements. In addition, projections of any evaluation of effectiveness of internal control over financial reporting to future periods are subject to the risk that the control may become inadequate because of changes in conditions or that the degree of compliance with the policies or procedures may deteriorate. A material weakness is a deficiency, or combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of the Company's annual or interim financial statements will not be prevented or detected on a timely basis. A material weakness in our internal control over financial reporting could adversely impact our ability to provide timely and accurate financial information. If we are unable to report financial information timely and accurately or to maintain effective disclosure controls and procedures, we could adversely affect our business prospects.Risks Related to Business Combinations and VenturesStrategic transactions, including acquisitions and divestitures, involve significant risks and uncertainties that could adversely affect our business, financial condition, results of operations and cash flows.Strategic acquisitions and divestitures we have made in the past, and may make in the future, present significant risks and uncertainties that could adversely affect our business, financial condition, results of operations and cash flows. These risks include the following:•Difficulty in evaluating potential acquisitions, including the risk that our due diligence does not identify or fully assess valuation issues, potential liabilities or other acquisition risks;•Difficulty and expense in integrating newly acquired businesses and operations, including combining solution and service offerings, and in entering into new markets in which we are not experienced, in an efficient and cost-effective manner while maintaining adequate standards, controls and procedures, and the risk that we encounter significant unanticipated costs or other problems associated with integration;•Difficulty and expense in consolidating and rationalizing IT infrastructure and integrating acquired software;•Challenges in achieving strategic objectives, cost savings and other benefits expected from acquisitions;•Risk that our markets do not evolve as anticipated and that the strategic acquisitions and divestitures do not prove to be those needed to be successful in those markets;•Risk that acquired systems expose us to cybersecurity and other data security risks;•Costs to reach appropriate standards to protect against cybersecurity and other data security risks or timeline to achieve such standards may exceed those estimated in diligence;•Risk that acquired companies are subject to new regulatory regimes or oversight where we have limited experience that may result in additional compliance costs and potential regulatory penalties;•Risk that we assume or retain, or that companies we have acquired have assumed or retained or otherwise become subject to, significant liabilities that exceed the limitations of any applicable indemnification provisions or the financial resources of any indemnifying parties;•Risk that indemnification related to businesses divested or spun-off that we may be required to provide or otherwise bear may be significant and could negatively impact our business;•Risk of exposure to potential liabilities arising out of applicable state and federal fraudulent conveyance laws and legal distribution requirements from spin-offs in which we or companies we have acquired were involved;•Risk that we may be responsible for U.S. federal income tax liabilities related to acquisitions or divestitures;•Risk that we are not able to complete strategic divestitures on satisfactory terms and conditions, including non-competition arrangements applicable to certain of our business lines, or within expected time frames;•Potential loss of key employees or customers of the businesses acquired or to be divested; and•Risk of diverting the attention of senior management from our existing operations.We have substantial goodwill and other intangible assets recorded as a result of acquisitions, and a severe or extended economic downturn could cause these assets to become impaired, requiring write-downs that would reduce our operating income.As of December 31, 2020, goodwill aggregated to $53.3 billion, or 64% of total assets, and intangible assets with finite useful lives aggregated to $13.9 billion, or 17% of total assets. Current accounting rules require goodwill to be assessed for 25Table of Contentimpairment at least annually or whenever changes in circumstances indicate potential impairment and require intangible assets with finite useful lives to be reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount may not be recoverable. Factors that may be considered a change in circumstance include significant underperformance relative to historical or projected future operating results, a significant decline in our stock price and market capitalization, and negative industry or economic trends. We recorded $94 million in goodwill impairment related to certain non-strategic businesses in the Corporate and Other segment during the fourth quarter of 2020. No other impairment was identified during the year ended December 31, 2020, for goodwill and other intangible assets. If worldwide or U.S. economic conditions decline significantly with negative impacts to bank spending and consumer behavior, or if other business or market changes impact our outlook, then the carrying amount of our goodwill and other intangible assets may no longer be recoverable, and we may be required to record an impairment charge, which would have a negative impact on our results of operations. We will continue to monitor the fair value of our goodwill and other intangible assets as well as our market capitalization and the impact of any economic downturn on our business to determine if there is an impairment in future periods. Risks Related to Our IndebtednessOur existing debt levels and future levels under existing facilities and debt service requirements may adversely affect FIS, including our financial condition or business flexibility and prevent us from fulfilling our obligations under our outstanding indebtedness.As of December 31, 2020, we had total debt of approximately $20.0 billion. This level of debt or any increase in our debt level could adversely affect our business, financial condition, operating results and operational flexibility, including the following: (i) the debt level may cause us to have difficulty borrowing money in the future for working capital, capital expenditures, acquisitions or other purposes; (ii) our debt level may limit operational flexibility and our ability to pursue business opportunities and implement certain business strategies; (iii) some of our debt has a variable rate of interest, which exposes us to the risk of increased interest rates; (iv) we have a higher level of debt than some of our competitors or potential competitors, which may cause a competitive disadvantage and may reduce flexibility in responding to changing business and economic conditions, including increased competition and vulnerability to general adverse economic and industry conditions; (v) there are significant maturities on our debt that we may not be able to repay at maturity or that may be refinanced at higher rates; and (vi) if we fail to satisfy our obligations under our outstanding debt or fail to comply with the financial or other restrictive covenants contained in the indenture governing our senior notes, or our credit facility, an event of default could result that could cause all of our debt to become due and payable.We may be adversely affected by changes in LIBOR reporting practices or the method in which LIBOR is determined.As of December 31, 2020, we had outstanding approximately $251 million of borrowings under our Revolving Credit Facility, an interest rate swap with a $1.0 billion notional amount designated as a fair value hedge, and a cross-currency interest rate swap with a $206 million notional amount designated as a net investment hedge that are indexed to the London Interbank Offered Rate ("LIBOR"). On July 27, 2017, the FCA announced its intention to stop persuading or compelling banks to submit rates for calibration of LIBOR to the administrator of LIBOR after 2021. On November 30, 2020, the ICE Benchmark Administration Limited announced its plan to extend the date that most U.S. LIBOR values would cease being computed from December 31, 2021 to June 30, 2023. It is not possible to predict the further effect of the rules or policies of the FCA, any changes in the methods by which LIBOR is determined, or any other reforms to LIBOR that may be enacted in the U.K., the E.U. or elsewhere. Any such developments may cause LIBOR to perform differently than in the past, or cease to exist. In addition, any other legal or regulatory changes made by the FCA, ICE Benchmark Administration Limited, the European Money Markets Institute (formerly Euribor-EBF), the European Commission or any other successor governance or oversight body, or future changes adopted by such body, in the method by which LIBOR is determined or the transition from LIBOR to a successor benchmark rate may result in, among other things, a sudden or prolonged increase or decrease in LIBOR, a delay in the publication of LIBOR, and changes in the rules or methodologies in LIBOR, which may discourage market participants from continuing to administer or to participate in LIBOR's determination, and, in certain situations, could result in LIBOR no longer being determined and published. If a published U.S. Dollar LIBOR rate is unavailable after 2021, the interest rates on our debt which is indexed to LIBOR will be determined using various alternative methods, any of which may result in interest obligations which are more than, or do not otherwise correlate over time with, the payments that would have been made on such debt if U.S. Dollar LIBOR were available in its current form. Further, the same costs and risks that may lead to the discontinuation or unavailability of U.S. Dollar LIBOR may make one or more of the alternative methods impossible or impracticable to determine. Any of these proposals or consequences could have a material adverse effect on our financing costs.Our Euro- and GBP-denominated indebtedness has increased in recent years; accordingly, we have increased exposure to fluctuations in the Euro-USD and GBP-USD exchange rates, which could negatively affect our cost to service or refinance our Euro- and GBP-denominated debt securities. 26Table of ContentIn recent years, our indebtedness denominated in Euro or GBP has significantly increased as a result of our issuance of senior notes of varying maturities and our issuance of Euro-denominated commercial paper. At December 31, 2020, the Company had outstanding approximately €7.8 billion aggregate principal amount of Euro-denominated senior notes, approximately €702 million aggregate principal amount of Euro-denominated commercial paper and approximately £1.9 billion aggregate principal amount of GBP-denominated senior notes, or the combined equivalent of approximately $12.9 billion aggregate principal amount.Following the acquisition of Worldpay, we have increased our revenue and cash flows denominated in Euro and GBP. Although we currently have substantial available cash flows in excess of the projected debt service requirements on our existing Euro and GBP-denominated debt, we cannot assure that we will be always be able to continue generating earnings in Euros and GBP in amounts sufficient, taking into account the funding requirements and other needs of our business, to make payments of interest and/or repayment of principal on our Euro and GBP senior debt, or to permit us to economically borrow in those currencies if needed to refinance our existing Euro and GBP debt. If our cash flows in Euros or GBP are insufficient for such purposes, we may need to exchange U.S. Dollars or funds in other currencies to make such payments, which could result in increased costs to us in the event of adverse changes in currency exchange rates. We have utilized and expect to continue to utilize foreign currency forward contracts and other hedges on a limited basis in an effort to mitigate currency risk, but we cannot assure that such hedging arrangements will be effective or will remain available to us on acceptable terms, or at all. In addition, we cannot predict economic and market conditions (including prevailing interest rates and foreign currency exchange rates) at the applicable times when our various series of Euro and GBP senior debt are scheduled to mature, nor can there be any assurance that we would be able to refinance any series of our Euro and GBP senior debt in those currencies on acceptable terms at any such time, all of which could have an adverse financial impact on us. Rising interest rates could increase our borrowing costs.Our exposure to market risk for changes in interest rates relates to our short-term commercial paper borrowings, Revolving Credit Facility and interest rate derivatives. In the future, we may have additional borrowings under existing or new variable-rate debt. Increases in interest rates on variable-rate debt would increase our interest expense. A rising interest rate environment could increase the cost of refinancing existing debt and incurring new debt, which could have an adverse effect on our financing costs. Credit ratings, if lowered below investment grade, would adversely affect our cost of funds and liquidity.The Company maintains investment grade credit ratings from the major U.S. rating agencies on its senior unsecured debt (S&P BBB, Moody's Baa2, Fitch BBB), as well as its commercial paper program (S&P A-2, Moody's P-2, Fitch F2). Failure to maintain investment grade rating levels could adversely affect the Company's cost of funds and liquidity and access to certain capital markets but would not have an adverse effect on the Company's ability to access its existing Revolving Credit Facility. Please note that a security rating is not a recommendation to buy, sell or hold securities, that it may be subject to revision or withdrawal at any time by the assigning rating organization, and that each rating should be evaluated independently of any other rating.Statement Regarding Forward-Looking InformationThe statements contained in this Form 10-K or in our other documents or in oral presentations or other management statements that are not purely historical are forward-looking statements within the meaning of the U.S. federal securities laws. Statements that are not historical facts, including statements about anticipated financial outcomes, including any earnings guidance or projections of the Company, projected revenue or expense synergies, business and market conditions, outlook, foreign currency exchange rates, deleveraging plans, expected dividends and share repurchases, the Company's sales pipeline and anticipated profitability and growth, as well as other statements about our expectations, beliefs, intentions, or strategies regarding the future, or other characterizations of future events or circumstances, are forward-looking statements. In many cases, forward-looking statements can be identified by terminology such as "may," "will," "should," "expect," "plan," "anticipate," "believe," "estimate," "predict," "potential," or "continue," or the negative of these terms and other comparable terminology. These statements relate to future events and our future results and involve a number of risks and uncertainties. Forward-looking statements are based on management's beliefs as well as assumptions made by, and information currently available to, management.Actual results, performance or achievement could differ materially from those contained in these forward-looking statements. The risks and uncertainties to which forward-looking statements are subject include the following, without limitation:27Table of Content•the outbreak or recurrence of COVID-19 and measures to reduce its spread, including the impact of governmental or voluntary actions such as business shutdowns and stay-at-home orders;•the duration, including any recurrence, of the COVID-19 pandemic and its impacts, including the general impact of an economic recession, reductions in consumer and business spending, and instability of the financial markets across the globe;•the economic and other impacts of COVID-19 on our clients which affect the sales of our solutions and services and the implementation of such solutions;•the risk of losses in the event of defaults by merchants (or other parties) to which we extend credit in our card settlement operations or in respect of any chargeback liability, either of which could adversely impact liquidity and results of operations;•changes in general economic, business and political conditions, including those resulting from COVID-19 or other pandemics, intensified international hostilities, acts of terrorism, changes in either or both the U.S. and international lending, capital and financial markets and currency fluctuations; •the risk that the Worldpay transaction will not provide the expected benefits or that we will not be able to achieve the revenue synergies anticipated;•the risk that other acquired businesses will not be integrated successfully or that the integration will be more costly or more time-consuming and complex than anticipated; •the risk that cost savings and other synergies anticipated to be realized from other acquisitions may not be fully realized or may take longer to realize than expected; •the risks of doing business internationally; •the effect of legislative initiatives or proposals, statutory changes, governmental or other applicable regulations and/or changes in industry requirements, including privacy and cybersecurity laws and regulations; •the risks of reduction in revenue from the elimination of existing and potential customers due to consolidation in, or new laws or regulations affecting, the banking, retail and financial services industries or due to financial failures or other setbacks suffered by firms in those industries; •changes in the growth rates of the markets for our solutions; •failures to adapt our solutions to changes in technology or in the marketplace; •internal or external security breaches of our systems, including those relating to unauthorized access, theft, corruption or loss of personal information and computer viruses and other malware affecting our software or platforms, and the reactions of customers, card associations, government regulators and others to any such events; •the risk that implementation of software, including software updates, for customers or at customer locations or employee error in monitoring our software and platforms may result in the corruption or loss of data or customer information, interruption of business operations, outages, exposure to liability claims or loss of customers; •the reaction of current and potential customers to communications from us or regulators regarding information security, risk management, internal audit or other matters;•the risk that 2020 election results in the U.S. may result in additional regulation and additional regulatory and tax costs;•competitive pressures on pricing related to the decreasing number of community banks in the U.S., the development of new disruptive technologies competing with one or more of our solutions, increasing presence of international competitors in the U.S. market and the entry into the market by global banks and global companies with respect to certain competitive solutions, each of which may have the impact of unbundling individual solutions from a comprehensive suite of solutions we provide to many of our customers;•the failure to innovate in order to keep up with new emerging technologies, which could impact our solutions and our ability to attract new, or retain existing, customers; •an operational or natural disaster at one of our major operations centers;•failure to comply with applicable requirements of payment networks or changes in those requirements;•fraud by merchants or bad actors; and •other risks detailed elsewhere in the "Risk Factors" section of this report and in our other filings with the SEC.Other unknown or unpredictable factors also could have a material adverse effect on our business, financial condition, results of operations and prospects. Accordingly, readers should not place undue reliance on our forward-looking statements. These forward-looking statements are inherently subject to uncertainties, risks and changes in circumstances that are difficult to predict. Except as required by applicable law or regulation, we do not undertake (and expressly disclaim) any obligation and do not intend to publicly update or review any of our forward-looking statements, whether as a result of new information, future events or otherwise. Item 1B. Unresolved Staff CommentsNone.28Table of ContentItem 2. PropertiesFIS' corporate headquarters is located at 601 Riverside Avenue, Jacksonville, Florida. In addition, FIS owns or leases support centers, data processing facilities and other facilities at approximately 150 locations. We believe our facilities and equipment are generally well maintained and are in good operating condition. We believe that the equipment we own and our various facilities are adequate for our present and foreseeable business needs. Item 3. Legal ProceedingsIn the ordinary course of business, the Company is involved in various pending and threatened litigation matters related to its business and operations, some of which include claims for punitive or exemplary damages. The Company believes no such currently pending or threatened actions are likely to have a material adverse effect on its consolidated financial position. With respect to litigation in which the Company is involved generally, please note the following:•These matters raise difficult and complicated factual and legal issues and are subject to many uncertainties and complexities.•The Company reviews all of its litigation on an ongoing basis and follows the authoritative provision for accounting for contingencies when making accrual and disclosure decisions. A liability must be accrued if (a) it is probable that a liability has been incurred and (b) the amount of loss can be reasonably estimated. If one of these criteria has not been met, disclosure is required when there is at least a reasonable possibility that a material loss may be incurred. When assessing reasonably possible and probable outcomes, the Company bases decisions on the assessment of the ultimate outcome following all appeals. Legal fees associated with defending litigation matters are expensed as incurred.See Note 16 to the consolidated financial statements for information about certain legal matters and indemnifications and warranties.Item 4. Mine Safety DisclosuresNot applicable.PART IIItem 5. Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity SecuritiesOur common stock trades on the New York Stock Exchange under the ticker symbol "FIS." As of January 31, 2021, there were approximately 10,746 shareholders of record of our common stock.We currently expect to continue to pay quarterly dividends. However, the amount, declaration and payment of future dividends is at the discretion of the Board of Directors and depends on, among other things, our investment opportunities, results of operations, financial condition, cash requirements, future prospects, and other factors that may be considered relevant by our Board of Directors, including legal and contractual restrictions. In January 2021, the Board of Directors approved a dividend increase of 11% to $0.39 per share per quarter beginning with the first quarter of 2021. A regular quarterly dividend of $0.39 per common share is payable on March 26, 2021, to shareholders of record as of the close of business on March 12, 2021. Item 12 of Part III contains information concerning securities authorized for issuance under our equity compensation plans.The existing plan authorizing share repurchases approved by the Board of Directors in 2017 expired as of December 31, 2020. Management temporarily suspended share repurchases during 2020 as a result of the Worldpay transaction to accelerate debt repayment. In January 2021, our Board of Directors approved a new share repurchase program under which it authorized the Company to repurchase up to 100 million shares of our common stock at management's discretion from time to time on the open market or in privately negotiated transactions and through Rule 10b5-1 plans. The new repurchase program has no expiration date and may be suspended for periods, amended or discontinued at any time.The graph below compares the cumulative 5-year total return of holders of Fidelity National Information Services, Inc.'s common stock with the cumulative total returns of the S&P 500 index and S&P Supercap Data Processing & Outsourced 29Table of ContentServices index. The graph assumes that the value of the investment in our common stock and in each index (including reinvestment of dividends) was $100 on December 31, 2015, and tracks it through December 31, 2020. 12/1512/1612/1712/1812/1912/20Fidelity National Information Services, Inc.100.00126.64159.61176.08241.54248.20S&P 500100.00111.96136.40130.42171.49203.04S&P Supercap Data Processing & Outsourced Services100.00108.12150.73171.58247.35307.17The stock price performance included in this graph is not necessarily indicative of future stock price performance.Item 6. Selected Financial DataThe selected financial data set forth below constitutes historical financial data of FIS and should be read in conjunction with "Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations" and "
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+ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSFortive Corporation (the “Company,” “we,” “our,” and “us”) is a provider of essential technologies for connected workflow solutions across a range of attractive end-markets. Our well-known brands hold leading positions in intelligent operating solutions, precision technologies, and advanced healthcare solutions. Our businesses design, develop, service, manufacture, and market professional and engineered products, software, and services for a variety of end markets, building upon leading brand names, innovative technologies, and significant market positions. Our research and development, manufacturing, sales, distribution, service, and administrative facilities are located in more than 50 countries across North America, Asia Pacific, Europe, and Latin America.This MD&A is designed to provide a reader of our financial statements with a narrative from the perspective of management. Our MD&A is divided into seven sections:•Basis of Presentation •Overview•Results of Operations•Financial Instruments and Risk Management•Liquidity and Capital Resources•Critical Accounting Estimates•New Accounting StandardsBASIS OF PRESENTATIONOn October 9, 2020, we completed the separation of our former Industrial Technologies segment (the “Separation”) by distributing 80.1% of the outstanding shares of Vontier Corporation (“Vontier”), the entity we created to hold the corresponding businesses, to Fortive stockholders on a pro rata basis. To effect the Separation, the Company distributed to its stockholders two shares of Vontier common stock for every five shares of the Company’s common stock outstanding held on September 25, 2020, the record date for the distribution, with the Company retaining 19.9% of the shares of Vontier common stock immediately following the Separation (the “Retained Vontier Shares”). On January 19, 2021, we completed an exchange of all of the Retained Vontier Shares as part of a non-cash debt-for-equity exchange that reduced outstanding indebtedness of Fortive by $1.1 billion.25Table of ContentsThe accounting requirements for reporting the Separation of Vontier as a discontinued operation were met when the Separation was completed. Accordingly, the accompanying consolidated financial statements for all periods presented reflect the results of the Vontier business as a discontinued operation. Fortive did not retain a controlling interest in Vontier and therefore the fair value of the Retained Vontier Shares and subsequent fair value changes are included in our assets of and results from continuing operations, respectively. The subsequent change in the fair value of the Retained Vontier Shares and the resulting gain will be recorded in the first quarter of 2021. On March 7, 2018, we entered into a definitive agreement to combine four of our operating companies from our Automation & Specialty platform (the “A&S Business”) with Altra Industrial Motion Corp. (“Altra”) in a tax-efficient Reverse Morris Trust transaction. On October 1, 2018, we completed the split-off of the A&S Business and have presented the results of operations of the A&S Business in our Consolidated Statements of Earnings, and the related assets and liabilities in the Consolidated Balance Sheets as discontinued operations. These changes have been applied to all periods presented. Unless otherwise noted, amounts, percentages, and discussion for all periods included in Management’s Discussion and Analysis reflect the results of operations and financial condition from our continuing operations. Refer to Note 4 to our consolidated financial statements for additional information on discontinued operations.In light of the Vontier Separation, we changed our internal reporting structure on the first day of the fourth quarter, September 26, 2020, to reflect organizational and leadership changes that allow us to better assess the operational performance of and allocate resources to our businesses. Our chief operating decision maker assesses performance and allocates resources based on our new operating segments, which are also our new reportable segments. Our new reportable segments are comprised of Intelligent Operating Solutions, Precision Technologies, and Advanced Healthcare Solutions. Refer to Note 19 to our consolidated financial statements for additional information about our reportable segments.The discussion of historical information in Management’s Discussion and Analysis has been recast to reflect the new reportable segments of our continuing operations. OVERVIEWGeneralFortive is a multinational business with global operations with approximately 47% of our sales derived from customers outside the United States in 2020. As a company with global operations, our businesses are affected by worldwide, regional, and industry-specific economic and political factors. Our geographic and industry diversity, as well as the range of products, software, and services we offer, typically help limit the impact of any one industry or the economy of any single country (except for the United States) on our operating results. Given the broad range of products manufactured, software and services provided, and geographies served, we do not use any indices other than general economic trends to predict the overall outlook for the Company. Our individual businesses monitor key competitors and customers, including their sales, to the extent possible, to gauge relative performance and the outlook for the future.As a result of our geographic and industry diversity, we face a variety of opportunities and challenges, including technological development in most of the markets we serve, the expansion and evolution of opportunities in high-growth markets, trends and costs associated with a global labor force, and consolidation of our competitors. We define high-growth markets as developing markets of the world experiencing extended periods of accelerated growth in gross domestic product and infrastructure which include Eastern Europe, the Middle East, Africa, Latin America, and Asia with the exception of Japan and Australia. We operate in a highly competitive business environment in most markets, and our long-term growth and profitability will depend, in particular, on our ability to expand our business across geographies and market segments, identify, consummate, and integrate appropriate acquisitions, develop innovative and differentiated new products, services, and software, expand and improve the effectiveness of our sales force, continue to reduce costs and improve operating efficiency and quality, attract relevant talent and retain, grow, and empower our talented workforce, and effectively address the demands of an increasingly regulated environment. We are making significant investments, organically and through acquisitions, to address technological change in the markets we serve and to improve our manufacturing, research and development, and customer-facing resources in order to be responsive to our customers throughout the world.In this report, references to sales from existing businesses refers to sales from operations calculated according to generally accepted accounting principles in the United States (“GAAP”) but excluding (1) the impact from acquired businesses and purchase accounting adjustments (2) the impact of currency translation. References to sales attributable to acquisitions or acquired businesses refer to GAAP sales from acquired businesses recorded prior to the first anniversary of the acquisition less the amount of sales attributable to certain divested businesses or product lines not considered discontinued operations prior to the first anniversary of the divestiture. The portion of sales attributable to the impact of currency translation is calculated as the difference between (a) the period-to-period change in sales (excluding sales impact from acquired businesses) and (b) the 26Table of Contentsperiod-to-period change in sales (excluding sales impact from acquired businesses) after applying the current period foreign exchange rates to the prior year period. Sales from existing businesses should be considered in addition to, and not as a replacement for or superior to, sales, and may not be comparable to similarly titled measures reported by other companies.Management believes that reporting the non-GAAP financial measure of sales from existing businesses provides useful information to investors by helping identify underlying growth trends in our business and facilitating comparisons of our sales performance with our performance in prior and future periods and to our peers. We exclude the effect of acquisitions and divestiture related items because the nature, size, and number of such transactions can vary dramatically from period to period and between us and our peers. We exclude the effect of currency translation from sales from existing businesses because the impact of currency translation is not under management’s control and is subject to volatility. Management believes the exclusion of the effect of acquisitions and divestitures and currency translation may facilitate the assessment of underlying business trends and may assist in comparisons of long-term performance. References to sales volume refer to the impact of both price and unit sales.Business Performance and OutlookBusiness PerformanceA novel strain of coronavirus was first identified in December 2019, and subsequently declared a pandemic by the World Health Organization in March 2020 (“COVID-19”). This outbreak has surfaced in nearly all regions around the world, resulting in governments implementing strict measures to help contain or mitigate the spread of the virus, including quarantines, “shelter in place,” and “stay at home” orders, travel restrictions, school and commercial facility closures, re-opening restrictions, among others (collectively “virus control measures”). These virus control measures have led to slowdowns or shutdowns for businesses deemed both “essential” and “non-essential” in affected areas, causing significant disruption in the financial markets both globally and in the United States, most notably during the first half of 2020. The majority of our essential production facilities around the world were open during 2020, and as of the date of this Report, all of our locations are open and operating.Given our businesses operate globally, have diverse customers, and serve multiple end-markets, COVID-19 impacted our businesses and operating results during 2020 directly with reduced year-over-year demand from customers operating in non-essential end-markets and indirectly with reduced demand created by macroeconomic disruption or disruption in adjacent end-markets. These disruptions impacted our operating results most severely during the second quarter of 2020 and we have realized sequential improvement in demand across all of our businesses and geographies since. For the year-ended December 31, 2020, aggregate year-over-year sales increased 1.5% as our continued application and deployment of the Fortive Business System and incremental sales from our recently acquired companies more than off-set declines in demand from our existing businesses. Sales from existing businesses decreased 5.9% during the year ended December 31, 2020 as compared to the comparable period of 2019 reflecting the broad impacts of the COVID-19 pandemic, as virus control measures were deployed in most regions and particularly impacted our results in the second quarter of 2020, with sequential improvement each quarter thereafter, including a slight year-over-year increase in demand from existing businesses during the fourth quarter. Sales that management considers recurring revenue represented approximately 40% of our total sales during the year-ended December 31, 2020 and increased approximately 11% year-over-year, including sales from our existing software as a service (“SAAS”) businesses that increased at a rate in the mid-teens year-over-year. Geographically, year-over-year sales from existing businesses during the year ended December 31, 2020 declined at a mid-single digit rate in both developed markets and high-growth markets, respectively, which was driven by a high-single digit rate decline in North America and Latin America, a mid-single digit rate decline in Asia, and a low-single digit rate decline in Western Europe. Year-over-year sales from existing businesses grew slightly in China during the year ended December 31, 2020. 2021 OutlookAs a result of the COVID-19 pandemic, overall global conditions have been volatile and uncertain. While our results in the fourth quarter of 2020 indicate positive, broad-based momentum across our portfolio, economic uncertainties continue to exist. The impact of the COVID-19 pandemic on our future results will depend on the length, severity, and recurrence of virus control measures and the availability of antiviral medications and distribution and administration of vaccinations, both of which are uncertain. We plan to continue deploying the Fortive Business System to help drive near-term performance and maximize cash flow generation amidst this uncertainty. Given the diverse nature of our businesses and the end-markets they serve, we believe certain of our businesses will continue being resilient against the broad COVID-19 impacts in the first quarter of 2021, while we believe others will continue being 27Table of Contentsrelatively more sensitive, with varied rates of continued recovery as virus control measures remain in place. The businesses we believe will continue being relatively more resilient include our businesses with a greater proportion of recurring revenue, including our SAAS businesses that provide critical workflow solutions to their customers, certain healthcare businesses, and those with longer business cycles with strong backlogs. We believe our businesses that are more dependent on short-cycle industrial demand and production dynamics will continue to sequentially improve but continue experiencing a somewhat challenging environment. As such, we expect year-over-year global demand for our products and services in both the first quarter of 2021 and year ended December 31, 2021 to grow at a mid-single digit rate.Despite the virus control measures in place in geographies critical to our supply chain, we have successfully implemented solutions to support our operations and have not experienced significant production material shortages, supply chain constraints, or distribution limitations impacting our operations as of the date of this Report; however, in light of the uncertainty of the COVID-19 pandemic severity and duration, we are continuing to evaluate and monitor the condition of our supply chain, including the financial health of our suppliers and their ability to access raw materials and other key inputs and may experience shortages, constraints, or disruptions during the first quarter of 2021 or in future periods.We are closely monitoring the health of our employees, and continue to implement safety protocols at our facilities to help ensure their health and safety. In addition, we continue to monitor our suppliers and customers and their ability to maintain production capacity to meet our operational requirements. Individuals contracting or being exposed to COVID-19, or who are unable to report to work due to virus control measures, may significantly disrupt production throughout our supply chain and negatively impact our sales channels. Further, our customers may be directly impacted by business curtailments or weak market conditions, and may not be willing or able to accept shipments of products, may cancel orders, and may not be able to pay us on a timely basis.To mitigate the impact of the economic conditions from the COVID-19 pandemic as well as any escalation of geopolitical uncertainties related to governmental policies toward international trade, monetary and fiscal policies, and relations between the U.S. and China, we will continue applying and deploying the Fortive Business System to actively manage our supply chain, drive operating efficiencies, and continue to collaborate with our customers and suppliers to minimize disruption to their businesses. Additionally, we will continue actively managing our working capital to maximize cash flows and cost efficiency and assess market conditions, taking actions as we deem necessary to appropriately position our businesses in light of the economic environment and geopolitical uncertainties.While COVID-19 has created volatility and uncertainty in the financial markets, we have not experienced a significant impact on our financial position, liquidity, and ability to meet our debt covenants as of the filing date of this Report; however, we continue to monitor the financial markets and general global economic conditions. If further changes in financial markets or other areas of the economy adversely affect our access to the capital markets, we would expect to rely on a combination of available cash and existing available capacity under our credit facilities to provide short-term funding. Refer to the “Liquidity and Capital Resources” section for additional discussion. Completed Divestitures, Acquisitions, and Business Combinations2020On October 9, 2020, we completed the Separation by distributing 80.1% of the outstanding shares of Vontier to our stockholders on a pro rata basis. To effect the Separation, we distributed to our stockholders two shares of Vontier common stock for every five shares of Fortive common stock outstanding held on September 25, 2020, the record date for the distribution, and retained 19.9% of the shares of Vontier common stock immediately following the Separation. The accounting requirements for reporting the Separation of Vontier as a discontinued operation were met when the Separation was completed.On September 29, 2020, Vontier entered into a credit agreement (the “Credit Agreement”) with a syndicate of banks, consisting of a three-year, $800 million senior unsecured delayed draw term loan facility (the “Three-Year Term Loans”), a two-year, $1 billion senior unsecured delayed draw term loan facility (the “Two-Year Term Loans” and together with the Three-Year Term Loans, the “Term Loans”) and a three-year, $750 million senior unsecured multi-currency revolving credit facility (the “Revolving Credit Facility” and, together with the Term Loans, the “Credit Facilities”). On the Distribution Date, Vontier drew down the full $1.8 billion available under the Term Loans. Vontier used the proceeds from the Term Loans to make payments to the Company, with $1.6 billion used as part of the consideration for the contribution of certain assets and liabilities to Vontier by the Company in connection with the Separation and $202 million used as an adjustment for excess cash balances remaining with Vontier (collectively, the “Cash Consideration”). The Company will apply the Cash Consideration to repay certain outstanding indebtedness, interest on certain debt instruments, and to pay certain of the Company’s regular, quarterly cash dividends. Refer to Note 11 to the consolidated financial statements for the description of the debt repayments made.28Table of ContentsIn preparation for and executing the Separation, the Company incurred $84 million and $35 million in Vontier stand-up and separation-related transaction costs during the years ended December 31, 2020 and 2019, respectively, which have been reclassified to discontinued operations in the accompanying consolidated financial statements. These stand-up and separation-related costs primarily relate to professional and advisory fees associated with preparation of regulatory filings and separation activities within finance, tax, legal, and information system functions.In connection with the Separation, Fortive and Vontier entered into various agreements to effect the Separation and provide a framework for Vontier’s relationship with Fortive after the Separation, including a transition services agreement, an employee matters agreement, a tax matters agreement, an intellectual property matters agreement, a Fortive Business System (“FBS”) license agreement, and a stockholder’s and registration rights agreement. These agreements govern the separation between Fortive and Vontier of the assets, employees, liabilities, and obligations (including its investments, property, and employee benefits and tax-related assets and liabilities) of Fortive and its subsidiaries attributable to periods prior to, at, and after Vontier’s separation, and also govern certain relationships between Fortive and Vontier after the Separation.2019Advanced Sterilization Products AcquisitionOn April 1, 2019 (the “Principal Closing Date”), we acquired the Advanced Sterilization Products business (“ASP”) of Johnson & Johnson, a New Jersey corporation (“Johnson & Johnson”) for an aggregate purchase price of $2.7 billion (the “Transaction”), subject to certain post-closing adjustments set forth in a Stock and Asset Purchase Agreement, dated effective as of June 6, 2018, between the Company and Ethicon, Inc., a New Jersey corporation (“Ethicon”) and a wholly owned subsidiary of Johnson & Johnson. ASP engages in the research, development, manufacture, marketing, distribution, and sale of low-temperature terminal sterilization and high-level disinfection products.On the Principal Closing Date, we paid $2.7 billion in cash and obtained the transferred assets and assumed liabilities in 20 countries (“Principal Countries”), general patent and trademark assignments, and all transferred equity interests in ASP. ASP has operations in an additional 39 countries (“Non-Principal Countries”). The transferred assets and liabilities associated with these operations close when requirements of country-specific agreements or regulatory approvals are satisfied.The $2.7 billion purchase price was paid in exchange for ASP’s businesses in both Principal and Non-Principal Countries. As of December 31, 2020 we have closed 20 Principal Countries and 34 Non-Principal Countries that, in aggregate, accounted for more than 99% of the preliminary valuation of ASP. The remaining five Non-Principal Countries represent less than 1% of the preliminary valuation of ASP, or $10.1 million, which is included as a prepaid asset in Other assets in the Consolidated Balance Sheet. As each Non-Principal Country closes, we reduce the prepaid asset and record the fair value of the assets acquired and liabilities assumed. All of the provisional goodwill associated with the Transaction is included in goodwill in our Advanced Healthcare Solutions segment at December 31, 2020, and the majority of the provisional goodwill is tax deductible. In addition, the Company entered into a transition services agreement with Johnson & Johnson for certain administrative and operational services (“TSA”) with Principal Countries and distribution agreements in the Non-Principal Countries. Under the distribution agreements, ASP sells finished goods to Ethicon at prices agreed by the parties. ASP recognizes these sales as revenue when the conditions for revenue recognition are met. Following the sale of finished goods by ASP, Ethicon obtains title of the finished goods, has full authority to sell and market the finished goods to end customers as it sees fit, and retains any revenue and profit from sale. As of December 31, 2020, ASP had exited the TSAs and substantially all of the distribution agreements. ASP expects to close the remaining Non-Principal countries in early 2021. Other Acquisitions and InvestmentsIn addition to the acquisition of ASP, during 2019, we acquired four businesses including Intelex Technologies and Pruftechnik, both of which complement existing businesses in our Intelligent Operation Solutions segment, and Censis Technologies within our Advanced Healthcare Solutions segment, for total consideration of $1.2 billion in cash, net of cash acquired. We recorded an aggregate of $781 million of goodwill related to these acquisitions.Combination of the Tektronix Video Business with TelestreamOn July 20, 2019, we completed the combination of the Tektronix Video test and monitoring equipment business (“Tektronix Video Business”) with Telestream, LLC (the “Combined Business”), a portfolio company of Genstar Capital LLC. We recognized a pretax gain of $41 million upon the combination, and hold a 33% equity stake in the Combined Business. This transaction did not meet the criteria for discontinued operations reporting, and therefore the operating results of the Tektronix Video Business prior to the combination with Telestream are included in continuing operations for all periods presented. Additionally, the loss from our equity investment in the Combined Business is included in Other non-operating expenses, net in 29Table of Contentsthe accompanying Consolidated Statement of Earnings. Refer to Note 4 to our consolidated financial statements for additional information.2018Gordian AcquisitionOn July 27, 2018, we acquired TGG Ultimate Holdings, Inc. and its subsidiaries, including The Gordian Group, Inc. (“Gordian”), a privately-held, leading provider of construction cost data, software, and service, for a total purchase price of $778 million net of cash acquired (the “Gordian Acquisition”). Gordian’s comprehensive offerings serve the entire building lifecycle and provide workflow solutions designed to optimize every stage of an asset owner’s construction and maintenance needs, including connecting the owner and contractors in the same exchange and providing access to cost and facility metrics databases via a subscription-based model. We recorded $435 million of goodwill related to the Gordian Acquisition.Accruent AcquisitionOn September 6, 2018, we acquired Athena SuperHoldCo, Inc., including Accruent, LLC (“Accruent”), a privately-held, leading provider of facilities asset management software, for a total purchase price of approximately $2.0 billion net of acquired cash (the “Accruent Acquisition”). Accruent is a recognized leader in the facilities asset management industry, combining deep domain and industry capabilities with an integrated, cloud-based framework that provides insights spanning the full lifecycle of real estate, facilities, and asset management. Accruent serves over 10,000 global customers, and helps assure clients fulfill the mission of their organization by extending the lifecycle of assets, monitoring full compliance, and reducing safety risks. We recorded $1.2 billion of goodwill related to the Accruent Acquisition.Divestiture of A&S BusinessOn March 7, 2018, we entered into a definitive agreement to combine four of our operating companies from our Automation & Specialty platform (the “A&S Business”) with Altra Industrial Motion Corp. (“Altra”) in a tax-efficient Reverse Morris Trust transaction. The A&S Business includes the market-leading brands of Kollmorgen, Thomson, Portescap and Jacobs Vehicle Systems, and generated approximately $900 million in revenue for the year ended December 31, 2017. On October 1, 2018, we completed the split-off of the A&S Business. The total consideration received was $2.7 billion and consisted of (i) $1.3 billion through a fully-subscribed exchange offer, in which we accepted and subsequently retired 15,824,931 shares of our own common stock from our stockholders in exchange for 35,000,000 shares of common stock of Stevens Holding Company, Inc.; (ii) $1.0 billion in cash paid to us for the direct sales of certain assets and liabilities of the A&S Business; (iii) $250 million as part of a non-cash debt-for-debt exchange that reduced outstanding indebtedness of Fortive, which is inclusive of accrued interest and fees; and (iv) $150 million in cash paid to us by Stevens Holding Company, Inc. as a dividend. The results of the A&S Business are reported as discontinued operations for all periods presented, which includes the after-tax gain on the transaction of $1.9 billion.RESULTS OF OPERATIONSComponents of Sales Growth 2020 vs. 20192019 vs. 2018Total revenue growth (GAAP)1.5 %20.1 %Existing businesses (Non-GAAP)(5.9)%(0.5)%Acquisitions (Non-GAAP)7.3 %22.2 %Currency exchange rates (Non-GAAP)0.1 %(1.6)%Refer to Intelligent Operating Solutions, Precision Technologies and Advanced Healthcare Solutions sections below for further discussion of year-over-year sales growth.Operating Profit MarginsOperating profit margins were 11.6% for the year ended December 31, 2020, an increase of 190 basis points as compared to 9.7% in 2019. Year-over-year operating profit margin comparisons were favorably impacted by:•Operating expense savings from broad cost reduction efforts and price increases, and to a lesser extent, lower year-over-year material costs and incremental year-over-year cost savings associated with productivity improvement initiatives, which were partially offset by lower year-over-year sales volumes from existing businesses — favorable 50 basis points30Table of Contents•The year-over-year effect of acquired businesses, including amortization, and acquisition-related fair value adjustments to deferred revenue and inventory which were less in 2020 than the fair value adjustments recognized in 2019 — favorable 30 basis points•The year-over-year effect of acquisition-related transaction costs, as the costs related to our acquisition and integration of ASP in 2019 were greater than the costs recognized in the comparable period in 2020 — favorable 90 basis points•The year-over-year effect of amortization from existing businesses — favorable 10 basis points•The incremental year-over-year net effect of restructuring actions — favorable 10 basis pointsOperating profit margins were 9.7% for the year ended December 31, 2019, a decrease of 730 basis points as compared to 17.0% in 2018. Year-over-year operating profit margin comparisons were favorably impacted by: •The year-over-year effect of amortization from existing businesses — favorable 50 basis pointsYear-over-year operating profit margin comparisons were unfavorably impacted by:•Lower sales volumes from existing businesses, increased material costs associated primarily with inflationary pressures and recently enacted tariffs, and changes in currency exchange rates, which were partially offset by price increases and incremental year-over-year cost savings associated with productivity improvement initiatives — unfavorable 90 basis points•The incremental year-over-year net dilutive effect of acquired businesses, including amortization and acquisition-related fair value adjustments to deferred revenue and inventory — unfavorable 560 basis points•The incremental year-over-year net dilutive effect of restructuring actions — unfavorable 70 basis points•Acquisition-related transaction costs, as the costs related to our acquisition and integration of ASP in 2019 were greater than the costs associated with the ASP, Gordian, and Accruent acquisitions in 2018 — unfavorable 60 basis pointsBusiness Segments and Geographic Area ResultsSales by business segment and geographic area for the year ended December 31 are as follows ($ in millions):202020192018SegmentsIntelligent Operating Solutions$1,883.7 $1,898.9 $1,576.3 Precision Technologies1,651.3 1,808.4 1,901.4 Advanced Healthcare Solutions1,099.4 856.6 322.7 Total$4,634.4 $4,563.9 $3,800.4 Geographic areaUnited States$2,436.6 $2,394.2 $1,875.8 China534.1 501.2 476.8 All other (each country individually less than 5% of total sales)1,663.7 1,668.5 1,447.8 Total$4,634.4 $4,563.9 $3,800.4 INTELLIGENT OPERATING SOLUTIONSOur Intelligent Operating Solutions segment provides leading solutions to accelerate industrial and facility reliability and performance, as well as compliance and safety across a range of vertical end markets, including manufacturing, process industries, healthcare, utilities and power, communications and electronics, among others. The businesses in our Intelligent Operating Solutions segment provide a broad and differentiated offering of instrumentation, sensors, software, and services to address these critical workflows for our customers. 31Table of ContentsIntelligent Operating Solutions Selected Financial Data For the Year Ended December 31($ in millions)202020192018Sales$1,883.7 $1,898.9 $1,576.3 Operating profit317.8 289.0 350.3 Depreciation28.0 40.8 38.9 Amortization151.1 141.7 58.8 Operating profit as a % of sales16.9 %15.2 %22.2 %Depreciation as a % of sales1.5 %2.1 %2.5 %Amortization as a % of sales8.0 %7.5 %3.7 %Components of Sales Growth2020 vs. 20192019 vs. 2018Total revenue growth (GAAP)(0.8)%20.5 %Existing businesses (Non-GAAP)(7.2)%1.1 %Acquisitions (Non-GAAP)6.4 %21.2 %Currency exchange rates (Non-GAAP)— %(1.8)%2020 COMPARED TO 2019Year-over-year sales of products and services from existing businesses of Intelligent Operating Solutions declined 7.2% during the year ended December 31, 2020. The results were driven by declines in demand for portable gas detection instruments, on-premise software license and professional service offerings, and demand from our industrial channel partners, all of which were impacted by COVID-19 in both direct and adjacent end markets. Partially offsetting these declines was increased demand for our industrial imaging products and certain of our critical workflow, safety, and maintenance SAAS product offerings. Despite the year-over-year declines in demand from our industrial channel partners, we realized sequential improvement in both the third and fourth quarters of 2020 from the low point in the second quarter of 2020, and expect to return to year-over-year growth in the first quarter of 2021.Geographically, demand from existing businesses in Intelligent Operating Solutions decreased on a year-over-year basis in both developed and high-growth markets as growth in Asia, led by Japan and China, was more than offset by declines in North America, Western Europe, and Latin America.Price increases are reflected as a component of the change in sales from existing businesses, and year-over-year price increases in the segment contributed 1.1% to sales growth during 2020 as compared to 2019.Operating profit margin increased 170 basis points during 2020 as compared to 2019. Year-over-year operating profit margin comparisons were favorably impacted by:•Operating expense savings from broad cost reduction efforts, price increases, lower year-over-year material costs and incremental year-over-year cost savings associated with productivity improvement initiatives, which were partially offset by lower year-over-year sales volumes from existing businesses — favorable 40 basis points•The year-over-year effect of acquired businesses, including amortization, and acquisition-related fair value adjustments to deferred revenue and inventory which were less in 2020 than the fair value adjustments recognized in 2019 — favorable 80 basis points•The year-over-year effect of acquisition-related transaction costs, as the costs related to our acquisitions in 2020 were less than the costs recognized in the comparable period in 2019 — favorable 60 basis pointsYear-over-year operating profit margin comparisons were unfavorably impacted by:•The year-over-year dilutive effect of amortization from existing businesses — unfavorable 10 basis points322019 COMPARED TO 2018Year-over-year sales of products and services from existing businesses of Intelligent Operating Solutions grew 1.1% during 2019 as compared to 2018 as growth in demand for portable gas detection and facilities maintenance offerings was mostly offset by slowing demand from our industrial end markets in North America.Geographically, demand from existing businesses in Intelligent Operating Solutions increased on a year-over-year basis in both developed and high-growth markets, as year-over-year growth in North America and Asia more than offset declines in Europe.Price increases are reflected as a component of the change in sales from existing businesses, and year-over-year price increases contributed 1.9% to sales growth during 2019 as compared to 2018.Operating profit margin decreased 700 basis points during 2019 as compared to 2018. Year-over-year operating profit margin comparisons were favorably impacted by:•Acquisition-related transaction costs, as the costs related to our acquisition of Gordian and Accruent in 2019 were less than the costs recognized in the comparable period in 2018 — favorable 90 basis points•The year-over-year effect of amortization from existing businesses — favorable 60 basis pointsYear-over-year operating profit margin comparisons were unfavorably impacted by:•An unfavorable sales mix and lower sales volumes from existing businesses, increased material costs associated primarily with inflationary pressures and recently enacted tariffs, and changes in currency exchange rates, which were partially offset by price increases and incremental year-over-year cost savings associated with productivity improvement initiatives — unfavorable 80 basis points•The incremental year-over-year net dilutive effect of acquired businesses, including amortization and acquisition-related fair value adjustments to deferred revenue and inventory — unfavorable 700 basis points•The incremental year-over-year net dilutive net effect of restructuring actions — unfavorable 70 basis pointsPRECISION TECHNOLOGIESOur Precision Technologies segment supplies technologies to a broad set of vertical end markets, enabling our customers to accelerate the development of innovative products and solutions. We provide our customers with electrical test and measurement instruments and services, energetic material devices, and a broad portfolio of sensor and control system solutions. Precision Technologies Selected Financial Data For the Year Ended December 31($ in millions)202020192018Sales$1,651.3 $1,808.4 $1,901.4 Operating profit321.7 324.6 381.5 Depreciation25.8 26.7 27.2 Amortization17.2 20.4 22.4 Operating profit as a % of sales19.5 %17.9 %20.1 %Depreciation as a % of sales1.6 %1.5 %1.4 %Amortization as a % of sales1.0 %1.1 %1.2 %Components of Sales Growth2020 vs. 20192019 vs. 2018Total revenue growth (GAAP)(8.7)%(4.9)%Existing businesses (Non-GAAP)(7.7)%(2.2)%Acquisitions (Non-GAAP)(1.3)%(1.5)%Currency exchange rates (Non-GAAP)0.3 %(1.2)%Table of Contents2020 COMPARED TO 2019Year-over-year sales of products and services from existing businesses of Precision Technologies declined 7.7% during 2020. The year-over-year decline in demand was largely driven by the impacts of COVID-19 in both direct and adjacent end markets, specifically for test and measurement instruments, declines in demand for sensors in the industrial end market, and a decline in shipments of our energetic materials, which was partially offset by increased demand in the medical end market for ventilator components and for critical environments supporting COVID-19 patient treatment efforts. We have realized sequential improvement in demand from the low point in the second quarter of 2020, and returned to sales growth from existing businesses in the fourth quarter of 2020. We expect to continue experiencing year-over-year growth in the first quarter of 2021.Geographically, demand from existing businesses in Precision Technologies decreased on a year-over-year basis in both developed and high-growth markets, as growth in Latin America was more than offset by declines in North America, Asia, and Western Europe.Price increases are reflected as a component of the change in sales from existing businesses, and year-over-year price increases contributed 1.8% to sales growth in the segment during 2020 as compared to 2019. Operating profit margin increased 160 basis points during 2020 as compared to 2019. Year-over-year operating profit margin comparisons were favorably impacted by:•Operating expense savings from broad cost reduction efforts and price increases, and to a lesser extent lower year-over-year material costs, incremental year-over-year cost savings associated with productivity improvement initiatives, and foreign currency exchange rates, which were partially offset by lower year-over-year sales volumes from existing businesses — favorable 120 basis points•The incremental year-over-year net effect of restructuring actions — favorable 50 basis points•The year-over-year effect of amortization from existing businesses — favorable 10 basis pointsYear-over-year operating profit margin comparisons were unfavorably impacted by:•The year-over-year net dilutive effect of the combination of the Tektronix video business with Telestream — unfavorable 20 basis points2019 COMPARED TO 2018Year-over-year sales of products and services from existing businesses of Precision Technologies declined 2.2% during 2019, as increased demand in our energetic materials business and for sensors in the medical end market was more than offset by declines in demand for high-performance oscilloscopes, Keithley products, electrical grid condition-based monitoring equipment, and sensing products in the industrial end market. Geographically, demand from existing businesses in Precision Technologies decreased on a year-over-year basis in both developed and high-growth markets, as year-over-year growth in Japan was more than offset by declines in all other significant geographies.Price increases are reflected as a component of the change in sales from existing businesses, and year-over-year price increases contributed 1.2% to sales growth during 2019 as compared to 2018.Operating profit margin decreased 220 basis points during 2019 as compared to 2018. Year-over-year operating profit margin comparisons were unfavorably impacted by:•Lower sales volumes from existing businesses and changes in currency exchange rates, which were partially offset by price increases, a favorable sales mix, lower material costs, and incremental year-over-year cost savings associated with productivity improvement initiatives — unfavorable 70 basis points•The year-over-year net dilutive effect of the combination of the Tektronix video business with Telestream — unfavorable 40 basis points•The incremental year-over-year net dilutive effect of restructuring actions — unfavorable 110 basis points34Table of ContentsAdvanced Healthcare Solutions Selected Financial DataOur Advanced Healthcare Solutions segment serves healthcare customers with enabling products and services for critical activities that help ensure safe, efficient, and timely healthcare. Through the Advanced Healthcare Solutions segment, we provide broad hardware and software portfolio offerings optimized around our end-users’ most critical workflows, including instrument and device reprocessing, instrument tracking, cell therapy equipment design and manufacturing, biomedical test tools, radiation safety monitoring, and asset management. For the Year Ended December 31($ in millions)202020192018Sales$1,099.4 $856.6 $322.7 Operating profit2.1 (72.0)5.3 Depreciation18.1 11.4 0.5 Amortization141.6 98.9 23.3 Operating profit as a % of sales0.2 %(8.4)%1.6 %Depreciation as a % of sales1.6 %1.3 %0.2 %Amortization as a % of sales12.9 %11.5 %7.2 %Components of Sales Growth2020 vs. 20192019 vs. 2018Total revenue growth (GAAP)28.3 %165.4 %Existing businesses (Non-GAAP)0.6 %1.5 %Acquisitions (Non-GAAP)27.8 %166.2 %Currency exchange rates (Non-GAAP)(0.1)%(2.3)%2020 COMPARED TO 2019Year-over-year sales of products and services from existing businesses of Advanced Healthcare Solutions increased 0.6% during 2020 as increased demand for cell therapy equipment design and manufacturing, radiation safety monitoring, and surgical instrument tracking SAAS products was mostly offset by a decrease in demand for consumables from our ASP business driven by a decline in elective surgical procedure volumes. Year-over-year demand for sterilization capital equipment increased slightly during 2020 as compared to 2019. Several of our Advanced Healthcare Solutions businesses are impacted by elective surgical procedure volumes, and year-over-year, elective surgical procedure volumes declined at a high-single digit rate across most major geographic markets, at rates that varied throughout the year based on COVID-19 patient hospitalizations and virus control measures in place. We expect surgical procedure volumes to improve when COVID-19 patient hospitalizations are lower and virus control measures ease.Geographically, demand from existing businesses in Advanced Healthcare Solutions increased in developed markets and decreased in high-growth markets, as growth in Western Europe and China was more than offset by declines in North America, the Middle East, and Japan.Price increases are reflected as a component of the change in sales from existing businesses, and year-over-year price increases contributed 0.8% to sales growth during 2020 as compared to 2019. Operating profit margin increased 860 basis points during 2020 as compared to 2019. Year-over-year operating profit margin comparisons were favorably impacted by:•Operating expense savings from broad cost reduction efforts and price increases, and to a lesser extent, lower year-over-year material costs, incremental year-over-year cost savings associated with productivity improvement initiatives, and foreign currency exchange rates, that more than offset lower year-over-year sales volumes from existing businesses and an unfavorable sales mix — favorable 40 basis points•The year-over-year effect of amortization from existing businesses – favorable 250 basis points•The incremental year-over-year effect of acquired businesses, including amortization and acquisition-related fair value adjustments to deferred revenue and inventory which were less in 2020 than in 2019 — favorable 160 basis points35Table of Contents•Acquisition-related transaction costs, as the costs related to our acquisition and integration of ASP and Censis in 2020 were less than the costs recognized in the comparable period in 2019 — favorable 450 basis pointsYear-over-year operating profit margin comparisons were unfavorably impacted by:•The incremental year-over-year net dilutive effect of restructuring actions — unfavorable 40 basis points2019 COMPARED TO 2018Year-over-year sales of products and services from existing businesses of Advanced Healthcare Solutions increased 1.5% during 2019 as compared to 2018, as increased demand for radiation safety monitoring was partially offset by declines in cell therapy equipment design and manufacturing.Geographically, demand from existing businesses in Advanced Health Solutions increased on a year-over-year basis in both developed and high-growth markets, as year-over-year growth in North America and Asia was partially offset declines in Europe.Sales of products and services from recently acquired businesses of Advanced Health Solutions, contributed 166.2% to overall sales growth in 2019 and were driven by ASP. ASP sales for the year, as compared to the comparable period prior to Fortive ownership, increased low-single digits which was attributable to growth in China and Japan.Price increases are reflected as a component of the change in sales from existing businesses, and year-over-year price increases contributed 0.1% to sales growth during 2019 as compared to 2018.Operating profit margin decreased 1,000 basis points during 2019 as compared to 2018. Year-over-year operating profit margin comparisons were favorably impacted by:•The year-over-year effect of amortization from existing businesses – favorable 460 basis points•Acquisition-related transaction costs, as the costs related to our acquisition and integration of ASP in 2018 were greater than the costs in 2019 — favorable 200 basis pointsYear-over-year operating profit margin comparisons were unfavorably impacted by:•An unfavorable sales mix, which was partially offset by higher year-over-year sales volumes, price increases, and incremental year-over-year cost savings associated with productivity improvement initiatives — unfavorable 40 basis points•The incremental year-over-year net dilutive effect of acquired businesses, including amortization and acquisition-related fair value adjustments to deferred revenue and inventory — unfavorable 1,620 basis pointsCOST OF SALES AND GROSS PROFIT For the Year Ended December 31($ in millions)202020192018Sales$4,634.4 $4,563.9 $3,800.4 Cost of sales(2,025.9)(2,080.7)(1,614.2)Gross profit2,608.5 2,483.2 2,186.2 Gross profit margin56.3 %54.4 %57.5 %The year-over-year decrease in cost of sales during 2020 as compared to 2019 is due primarily to lower year-over-year sales volumes from existing businesses, lower year-over-year material costs, year-over-year net cost savings associated with restructuring and productivity improvement initiatives, and changes in currency exchange rates, which were partially offset by incremental cost of sales from our recently acquired businesses. The year-over-year increase in gross profit and 190 basis point increase in gross profit margin during 2020 as compared to 2019 is due primarily to the favorable impacts of pricing improvements from existing businesses, incremental year-over-year net cost savings associated with restructuring and productivity improvement initiatives, material cost and supply chain improvement actions, and changes in currency exchange rates, which were partially offset by lower year-over-year sales volumes.The year-over-year increase in cost of sales during 2019 as compared to 2018 is due primarily to the incremental cost of sales from our recently acquired businesses, increased material costs associated primarily with inflationary pressures and tariffs 36Table of Contentsenacted during the year, and restructuring charges, which were partially offset by lower year-over-year sales volumes from existing businesses, incremental year-over-year cost savings associated with productivity improvement initiatives and material cost and supply chain improvement actions. Changes in currency exchange rates decreased costs of sales in 2019.The year-over-year increase in gross profit during 2019 as compared to 2018 is due primarily to the favorable impact of pricing improvements from existing businesses, sales volumes from our recently acquired businesses, year-over-year cost savings associated with productivity improvement initiatives, and material cost and supply chain improvement actions.The 310 basis point year-over-year decrease in gross profit margin during 2019 as compared to 2018 is due primarily to acquisition-related fair value adjustments to deferred revenue and inventory, and increased material costs associated primarily with inflationary pressures and recently enacted tariffs which more than offset the favorable impact of pricing improvements from existing businesses and year-over-year cost savings associated with productivity improvement initiatives.OPERATING EXPENSES For the Year Ended December 31($ in millions)202020192018Sales$4,634.4 $4,563.9 $3,800.4 Selling, general, and administrative (“SG&A”) expenses1,748.4 1,719.0 1,262.8 Research and development (“R&D”) expenses320.7 320.3 278.1 SG&A as a % of sales37.7 %37.7 %33.2 %R&D as a % of sales6.9 %7.0 %7.3 %SG&A expenses increased during 2020 as compared to 2019 due primarily to higher amortization and incremental expenses from our recently acquired businesses that were mostly offset by broad cost reduction efforts that reduced labor expenses to better align with reductions in demand during the second and third quarter of 2020, primarily through the use of furloughs and reductions in salaried compensation costs, as well as other reductions in discretionary spending. To a lesser extent, year-over-year SG&A expenses were reduced by changes in foreign currency exchange rates and year-over-year net cost savings associated with restructuring and productivity improvement initiatives. SG&A expenses as a percentage of sales were relatively consistent year-over-year.SG&A expenses increased during 2019 as compared to 2018 and SG&A expenses as a percentage of sales increased 450 basis points in 2019 as compared to 2018 due primarily to higher amortization and incremental expenses from our recently acquired businesses, costs associated with the acquisition and integration of ASP, restructuring actions, and sales and marketing growth initiatives, partially offset by cost savings associated with productivity improvement initiatives.R&D expenses (consisting principally of internal and contract engineering personnel costs) increased slightly during 2020 as compared to 2019 due to incremental expenses from recently acquired businesses. On a year-over-year basis, R&D expenses as a percentage of sales decreased 10 basis points in 2020 as compared to 2019 as investments in our product development initiatives grew at rate largely consistent with sales. R&D expenses (consisting principally of internal and contract engineering personnel costs) increased during 2019 as compared to 2018 due to investments in our product development initiatives and incremental expenses from recently acquired businesses. On a year-over-year basis, R&D expenses as a percentage of sales decreased 30 basis points in 2019 as compared to 2018 as incremental sales from our recently acquired businesses increased at a faster rate than R&D investments.INTEREST COSTSFor a discussion of our outstanding indebtedness, refer to Note 11 to the accompanying consolidated financial statements.Interest expense, net of $149 million was recorded during 2020 compared to $143 million during 2019 and $77 million during 2018. Year-over-year interest expense increased in 2020 and 2019 due to higher average debt balances during the year. In the event that additional liquidity is required, particularly in connection with acquisitions, we may enter into additional borrowings under our commercial paper programs or credit facilities, and/or access the capital markets. If we enter into such additional financing transactions, the amount of annual interest expense will increase.UNREALIZED GAIN ON INVESTMENT IN VONTIER CORPORATIONOn October 9, 2020, we completed the Vontier separation and retained 19.9% of the shares of Vontier common stock immediately following the Separation. We did not retain a controlling interest in Vontier and therefore the subsequent fair value changes of the Retained Vontier Shares are included in our results from continuing operations. At December 31, 2020, the 37Table of ContentsRetained Vontier Shares were remeasured at fair value based on Vontier’s closing stock price, with unrealized gains of $1.1 billion recorded in the Consolidated Statement of Earnings.On January 19, 2021, we completed an exchange of all of the Retained Vontier Shares as part of a non-cash debt-for-equity exchange that reduced outstanding indebtedness of Fortive by $1.1 billion. INCOME TAXESGeneralIncome tax expense and deferred tax assets and liabilities reflect management’s assessment of future taxes expected to be paid on items reflected in our financial statements. We record the tax effect of discrete items and items that are reported net of their tax effects in the period in which they occur.On December 22, 2017, the U.S. enacted comprehensive tax reform commonly referred to as the Tax Cuts and Jobs Act (the “TCJA”). The U.S. Government continues to issue significant amounts of TCJA guidance and we expect that to continue for the foreseeable future. The Company is actively monitoring the impact of new Treasury Regulations. Any future adjustments resulting from retrospective guidance issued will be considered as discrete income tax expense or benefit in the interim period the guidance is issued.Our effective tax rate can be affected by, among others, changes in the mix of earnings in countries with differing statutory tax rates (including as a result of business acquisitions and dispositions), changes in the valuation of deferred tax assets and liabilities, accruals related to contingent tax liabilities and period-to-period changes in such accruals, the results of audits and examinations of previously filed tax returns (as discussed below), the expiration of statutes of limitations, the implementation of tax planning strategies, tax rulings, court decisions, settlements with tax authorities, and changes in tax laws.Further changes in the tax laws of foreign jurisdictions could arise as a result of the base erosion and profit shifting project undertaken by the Organisation for Economic Co-operation and Development (“OECD”), which represents a coalition of member countries. The OECD has issued significant global tax policy changes that include both expanded reporting as well as technical global tax policy changes. Many countries in which we operate have implemented tax law and administrative changes that align with many aspects of the OECD policy guidelines. The breadth of this project may impact all multinational businesses by potentially redefining jurisdictional taxation rights, and could materially impact the law for transfer pricing and permanent establishment taxation. We have taken measures to address the requirements of these changes in global tax policy. The Company will continue to monitor and evaluate the impact of these new OECD developments.We conduct business globally, and, as part of our global business, we file numerous income tax returns in the U.S. federal, state, and foreign jurisdictions. After the TCJA, our ability to obtain a tax benefit in certain countries that continue to have lower statutory tax rates than the United States is dependent on our levels of taxable income in such foreign countries. We believe that a change in the statutory tax rate of any individual foreign country would not have a material effect on our financial statements given the geographic dispersion of our taxable income.The amount of income taxes we pay is subject to audit by federal, state, and foreign tax authorities, which may result in proposed assessments. The Company is subject to examination in the United States, various states and foreign jurisdiction for the tax years 2010 to 2020. We review our global tax positions on a quarterly basis. Based on these reviews, the results of discussions and resolutions of matters with certain tax authorities, tax rulings and court decisions, and the expiration of statutes of limitations reserves for contingent tax liabilities are accrued or adjusted as necessary. For a discussion of risks related to these and other tax matters, please refer to “Item 1A. Risk Factors.” We are routinely examined by various domestic and international taxing authorities. In connection with the Separation of Fortive from Danaher on July 1, 2016 (the “Separation”), we entered into the Agreements with Danaher, including a tax matters agreement. The tax matters agreement distinguishes between the treatment of tax matters for “Joint” filings compared to “separate” filings prior to the Separation. “Joint” filings involve legal entities, such as those in the United States, that include operations from both Danaher and the Company. By contrast, “separate” filings involve certain entities (primarily outside of the United States), that exclusively include either Danaher’s or the Company’s operations, respectively. In accordance with the tax matters agreement, the Company is liable for and has indemnified Danaher against all income tax liabilities involving “separate” filings for the periods prior to the Separation. During 2018, the Company entered into a Tax Matters Agreement in connection with the split-off of the A&S Business. The Company remains liable for pre-disposition income tax liabilities related to the A&S Business.38Table of ContentsIn connection with the separation of Vontier, we entered into a tax matters agreement with Vontier. The tax matters agreement distinguishes between the treatment of tax matters for “joint” filings compared to “separate” filings prior to the Separation. “Joint” filings involve legal entities, such as those in the United States, that include operations from both Vontier and the Company. By contrast, “separate” filings involve certain entities (primarily outside of the United States), that exclusively include either Vontier’s or the Company’s operations, respectively. In accordance with the tax matters agreement, the Company remains liable for all income tax liabilities involving “joint” filings and Vontier has agreed to indemnify the Company against all income tax liabilities involving “separate” filings for periods prior to the Separation.Comparison of the Years Ended December 31, 2020, 2019, and 2018Our effective tax rate for the years ended December 31, 2020, 2019, and 2018 was 3.7%, 20.4% and 13.4%, respectively.Our effective tax rate for 2020 differs from the U.S. federal statutory rate of 21% due primarily to the effect of the TCJA U.S. federal permanent differences, the impact of credits and deductions provided by law, earnings outside the United States that are indefinitely reinvested and taxed at rates lower than the U.S. federal statutory rate, offset by tax costs associated with repatriating a portion of our previously reinvested earnings outside of the United States, and a permanent difference on the unrealized gain on our Retained Vontier Shares due to the tax-free treatment of our disposition of the shares through the Debt-for-Equity Exchange that was completed on January 19, 2021. The Debt-for-Equity Exchange included an exchange of all of our Vontier common stock owned as of December 31, 2020.Our effective tax rate for 2019 differs from the U.S. federal statutory rate of 21% due primarily to the effect of the TCJA U.S. federal permanent differences, the impact of credits and deductions provided by law, and earnings outside the United States that are indefinitely reinvested and taxed at rates lower than the U.S. federal statutory rate. Our effective tax rate for 2018 differs from the U.S. federal statutory rate of 21% due primarily to the effect of the TCJA U.S. federal permanent differences, the impact of credits and deductions provided by law, earnings outside the United States that are taxed at rates lower than the U.S. federal statutory rate, and the effect of adjustments to the provision estimates recorded in 2017 related to the TCJA as permitted under the SEC Staff Accounting Bulletin No. 118 (“SAB 118”) issued on December 22, 2017.COMPREHENSIVE INCOMEComprehensive income increased by $895 million in 2020 as compared to 2019, due to an increase in net earnings of $874 million, including both continuing and discontinued operations, favorable changes in foreign currency translation adjustments of $13 million, and favorable changes in pension benefit adjustments of $8 million. The increase in net earnings from 2019 to 2020 was due to the recognition of a $1.1 billion unrealized gain on the Retained Vontier Shares.Comprehensive income decreased by $2.0 billion in 2019 as compared to 2018, due to a decrease in net earnings of $2.2 billion, including both continuing and discontinued operations, which were partially offset by favorable changes in foreign currency translation adjustments of $178 million and unfavorable changes in pension benefit adjustments of $24 million. The decrease in net earnings from 2018 to 2019 was due to the recognition of a $1.9 billion gain in 2018 related to the divestiture of the A&S Business. FINANCIAL INSTRUMENTS AND RISK MANAGEMENTWe are exposed to market risk from changes in interest rates, foreign currency exchange rates, credit risk and commodity prices, each of which could impact our financial statements. We generally address our exposure to these risks through our normal operating and financing activities. In addition, our broad-based business activities help to reduce the impact that volatility in any particular area or related areas may have on our operating profit as a whole.Interest Rate RiskWe manage interest cost using a mixture of fixed-rate and variable-rate debt. A change in interest rates on long-term debt impacts the fair value of our fixed-rate long-term debt but not our earnings or cash flows because the interest on such debt is fixed. Generally, the fair market value of fixed-rate debt will increase as interest rates fall and decrease as interest rates rise. As of December 31, 2020, an increase of 100 basis points in interest rates would have decreased the fair value of our fixed-rate long-term debt by approximately $166 million. As of December 31, 2020, our variable-rate debt obligations consisted primarily of term loan borrowings (refer to Note 11 to the consolidated financial statements for information regarding our outstanding indebtedness as of December 31, 2020). As a result, our primary interest rate exposure results from changes in short-term interest rates. The annual effective rate associated 39Table of Contentswith our outstanding 2020 Delayed-Draw Term Loan and 2021 Term Loan for the year ended December 31, 2020 was 1.89% and 1.88%, respectively, and we recorded interest expense of $28.3 million on these variable-rate obligations. A hypothetical 10 basis points increase in market interest rates as of December 31, 2020 on our variable-rate debt obligations as of December 31, 2020 would have increased our interest expense by $1.4 million in 2020. The 2021 Term Loan was extinguished as part of the debt-for-equity exchange on January 19, 2021 and the 2020 Delayed-Draw Term Loan was repaid on January 21, 2021.Foreign Currency Exchange Rate RiskWe face transactional exchange rate risk from transactions with customers in countries outside of the United States and from intercompany transactions between affiliates. Transactional exchange rate risk arises from the purchase and sale of goods and services in currencies other than our functional currency or the functional currency of an applicable subsidiary. We also face translational exchange rate risk related to the translation of financial statements of our foreign operations into U.S. dollars, our functional currency. Costs incurred and sales recorded by subsidiaries operating outside of the United States are translated into U.S. dollars using exchange rates effective during the respective period. As a result, we are exposed to movements in the exchange rates of various currencies against the U.S. dollar. The effect of a change in currency exchange rates on our net investment in international subsidiaries is reflected in the accumulated other comprehensive income (loss) component of equity. A 10% depreciation in major currencies relative to the U.S. dollar as of December 31, 2020 would have resulted in a reduction of foreign currency-denominated net assets and stockholders’ equity of approximately $185 million.Currency exchange rates favorably impacted 2020 reported sales by 0.1% as compared to 2019, as the U.S. dollar was, on average, weaker against most major currencies during 2020 as compared to exchange rate levels during 2019. If the exchange rates in effect as of December 31, 2020 were to prevail throughout 2021, currency exchange rates would positively impact 2021 estimated sales by approximately 2.0% relative to our performance in 2020. In general, additional weakening of the U.S. dollar against other major currencies would further positively impact our sales and results of operations on an overall basis and any strengthening of the U.S. dollar against other major currencies would adversely impact our sales and results of operations.We have generally accepted the exposure to exchange rate movements without using derivative financial instruments to manage this risk. Both positive and negative movements in currency exchange rates against the U.S. dollar will therefore continue to affect the reported amount of sales, profit, and assets and liabilities in our consolidated financial statements.Credit RiskWe are exposed to potential credit losses in the event of nonperformance by counterparties to our financial instruments. Financial instruments that potentially subject us to credit risk consist of cash and highly-liquid investment grade cash equivalents and receivables from customers. We place cash and cash equivalents with various high-quality financial institutions throughout the world and exposure is limited at any one institution. Although we typically do not obtain collateral or other security to secure these obligations, we regularly monitor the third party depository institutions that hold our cash and cash equivalents. We emphasize safety and liquidity of principal over yield on those funds. In addition, concentrations of credit risk arising from receivables from customers are limited due to the diversity of our customers. Our businesses perform credit evaluations of their customers’ financial conditions as appropriate and also obtain collateral or other security when appropriate.Commodity Price RiskFor a discussion of risks relating to commodity prices, refer to “Item 1A. Risk Factors.”LIQUIDITY AND CAPITAL RESOURCESWe assess our liquidity in terms of our ability to generate cash to fund our operating, investing, and financing activities. We generate substantial cash from operating activities and believe that our operating cash flow and other sources of liquidity, which consist of access to short-term loans, commercial paper, and our revolving credit facility, in addition to short-term liquidity benefits provided by cash repatriation will be sufficient to allow us to continue funding and investing in our existing businesses, consummate strategic acquisitions, make interest and principal payments on our outstanding indebtedness, fulfill our contractual obligations, and manage our capital structure on a short and long-term basis. On March 27, 2020, the U.S. federal government enacted the Coronavirus Aid, Relief, and Economic Security Act (the “CARES Act”), an emergency economic stimulus package in response to the COVID-19 outbreak which, among other things, contains numerous income tax provisions. Some of these tax provisions are expected to be effective retroactively for years ending before the date of enactment. We anticipate the provisions of the CARES Act will impact income tax in 2020; however, we have not identified material impacts to the tax provision as of December 31, 2020. Additionally, the CARES Act will continue providing us with short-term liquidity and other potential tax impacts that we are continuing to evaluate. During 2020, 40Table of Contentswe deferred remittance of approximately $35 million in payroll tax payments, half of which will be due on December 31, 2021 and the remaining portion on December 31, 2022. While COVID-19 created volatility and uncertainty in the financial markets during 2020, we have not realized a significant impact on our financial position, liquidity, and ability to meet our debt covenants as of the filing date of this Report; however, we continue to monitor the capital markets and general global economic conditions. The financial markets worldwide, including the United States, have been impacted by COVID-19 and this volatility and disruption during the first half of 2020 impacted broad access to the capital markets and pricing on new indebtedness. Our credit facilities, including our revolving credit facility, are predominately with institutions that, to date, have been relatively unaffected by the disruption. However, the distress in thefinancial markets during the first half of 2020 resulted in volatility and disruption in the commercial paper market, and as a result of the volatility and disruption, we refinanced all of our outstanding commercial paper with borrowings under our $750 million, 364-day delayed-draw term loan (the “2021 Term Loan”) as detailed below. We may utilize our commercial paper programs as a source of liquidity if and when the commercial paper markets are reliable and attractive in the future.2020 Financing and Capital TransactionsIn prior periods, we generally satisfied any short-term liquidity needs that are not met through operating cash flows and available cash through issuances of commercial paper under our U.S. dollar and Euro-denominated commercial paper programs (“Commercial Paper Programs”). Due to the volatility and disruption in the commercial paper markets during the first six months of 2020, we temporarily reduced our reliance on this source of funding, and consequently paid down and refinanced our outstanding commercial paper with the 2021 Term Loan. Credit support for the Commercial Paper Programs is provided by a five-year $2.0 billion senior unsecured revolving credit facility that expires on November 30, 2023 (the “Revolving Credit Facility”) which, to the extent not otherwise providing credit support for the commercial paper programs, can also be used for working capital and other general corporate purposes. As of December 31, 2020, no borrowings were outstanding under the Revolving Credit Facility.On April 24, 2020, we amended (the “Amendments”) the credit agreement for each of our (i) $500 million delayed draw term loan facility, which has been repaid as of December 31, 2020 (“2020 Term Loan”), (ii) $1.0 billion delayed draw term loan facility, with $1.0 billion in principal amount outstanding as of December 31, 2020 (the “2020 Delayed-Draw Term Loan”), (iii) $750 million delayed draw term loan facility, with $400 million in principal amount outstanding as of December 31, 2020 (“2021 Term Loan”), and (iv) $2.0 billion Revolving Credit Facility, with no borrowings thereunder as of December 31, 2020 as follows:•For any four fiscal quarters ending in the periods noted below (each an “Adjusted Four Quarters”) that end prior to the maturity date of the applicable facility, the maximum permitted consolidated net leverage ratio of consolidated net funded indebtedness to consolidated EBITDA was increased from 3.50 to 1.00 to, (i) with respect to the four fiscal quarters ending June 26, 2020, September 25, 2020, December 31, 2020, or April 2, 2021, 4.75 to 1.00, (ii) with respect to the four fiscal quarters ending July 2, 2021, 4.5 to 1.0, (iii) with respect to the four fiscal quarters ending October 1, 2021, 4.25 to 1.0 and (iv) with respect to the four fiscal quarters ending December 31, 2021, 3.75 to 1.0; provided however, that for any four fiscal quarters that are not an Adjusted Four Quarters, the maximum permitted consolidated net leverage ratio remains at 3.5 to 1.0, as may be increased to 4.0 to 1.0 following a material acquisition (the “Unadjusted Maximum Ratio”).•The maturity date for the 2020 Delayed-Draw Term Loan was extended from August 28, 2020 to May 30, 2021.•From April 24, 2020 to December 31, 2021, the minimum London inter-bank offered rate (“LIBOR”) for each of the facilities will increase from 0% to 0.25%, and the minimum base rate for each of the facilities will increase from 1.00% to 1.25%. In addition, with respect to the Revolving Credit Facility and for any Adjusted Four Quarters in which the consolidated net leverage ratio is greater than the Unadjusted Maximum Ratio, the applicable margin (as determined based on our long-term debt credit rating) for any LIBOR rate loans will increase from a range of 80.5 and 117.5 basis points to a range of 118.0 and 155.0 basis points and for any base rate loans from a range of 0.0 and 17.5 basis points to a range of 18.0 and 55.0 basis points. Furthermore, with respect to the 2020 Delayed-Draw Term Loan, the applicable margin (as determined based on our long-term debt credit rating) for any LIBOR rate loans will increase from a range of 75.0 and 97.5 basis points to a range of 155.0 and 180.0 basis points and for any base rate loans from 0.0 to a range of 55.0 and 80.0 basis points.•From April 24, 2020 to December 31, 2021, the maximum principal amount of secured indebtedness, other than certain types of secured indebtedness expressly permitted under each credit agreement, is decreased from 15% of our consolidated net assets (when added together with indebtedness incurred or guaranteed by any of our subsidiaries) to 11.25% of our consolidated net assets (when added together with indebtedness incurred or guaranteed by any of our subsidiaries). 41Table of ContentsIn connection with the Amendments, we incurred approximately $6.5 million of fees. Our credit facility agreements require, among others, that we maintain certain financial covenants and we were in compliance with all of our financial covenants on December 31, 2020.During 2020, we completed the following financing and capital transactions:•On February 25, 2020, we extended the maturity of the 2020 Delayed-Draw Term Loan to August 28, 2020. Additionally, on April 24, 2020 we further extended the maturity to May 30, 2021. We were in compliance with our covenants both before and after the extension. The 2020 Delayed-Draw Term Loan was not callable and remained prepayable at our option.•On February 26, 2020, we prepaid $250 million and on October 9, 2020, we repaid the remaining $250 million of the 2020 Term Loan. The fees associated with both prepayments were immaterial. •On March 23, 2020, we entered into a credit facility agreement that provided for the 2021 Term Loan in an aggregate principal amount of $425 million. On the same day, we drew down $375 million available under the 2021 Term Loan. We subsequently increased the size of this facility by $325 million on April 3, 2020, and drew the additional $375 million in April 2020, resulting in an outstanding amount of $750 million. We paid approximately $2 million in debt issuance costs associated with the 2021 Term Loan. The borrowings from this credit facility were used for settlement of outstanding commercial paper. The 2021 Term Loan bore interest at a variable rate equal to LIBOR plus a ratings-based margin currently at 155 basis points. As of December 31, 2020 borrowings under this facility bore an interest rate of 1.80% per annum. The 2021 Term Loan was due on March 19, 2021 and prepayable at our option. We are not permitted to re-borrow once the term loan is repaid. The terms and conditions, including covenants, applicable to the 2021 Term Loan, are substantially similar to those applicable to our Revolving Credit Facility. •On October 9, 2020, we repaid $350 million of the outstanding $750 million of the 2021 Term Loan. The fees associated with the prepayment were immaterial.•On October 15, 2020, we repaid the outstanding ¥13.8 billion balance of the Yen variable interest rate term loan due 2022 which approximated $131 million.•On November 13, 2020, we redeemed for cash all $750 million aggregate principal of our outstanding 2.35% Senior Notes due 2021 (the “Notes”) in accordance with the terms of the indenture governing the Notes. In connection with the transaction, we wrote-off the remaining unamortized deferred financing costs of $0.7 million and recorded a loss on extinguishment of $8 million.Subsequent EventsOn January 19, 2021, we completed a non-cash exchange (the “Debt-for-Equity Exchange”) of 33,507,410 shares of common stock of Vontier, representing all of the Retained Vontier Shares, for $1.1 billion in aggregate principal amount of indebtedness of the Company held by Goldman Sachs & Co., including (i) all $400 million in term loan outstanding under the 2021 Term Loan and (ii) $683.2 million of the $1.0 billion in term loan outstanding under the 2020 Delayed-Draw Term Loan. On January 21, 2021, we repaid the remaining $316.8 million outstanding of the 2020 Delayed-Draw Term Loan using the cash proceeds received from Vontier in the Separation. The fees associated with the prepayment were immaterial.On February 9, 2021, we repurchased $281 million of the 0.875% Convertible Senior Notes due 2022 (the “Convertible Notes”) using the remaining cash proceeds received from Vontier in the Separation and other cash on hand. In connection with the repurchase, we will record a loss on extinguishment in the first quarter of 2021.2019 Financing and Capital TransactionsDuring 2019, we completed the following financing and capital transactions:•On February 22, 2019, we issued $1.4 billion in aggregate principal amount of our Convertible Notes, including $187.5 million in aggregate principal amount resulting from an exercise in full of an over-allotment option. The Convertible Notes were sold in a private placement to certain initial purchasers for resale to qualified institutional buyers pursuant to Rule 144A under the Securities Act of 1933. The Convertible Notes bear interest at a rate of 0.875% per year, payable semiannually in arrears on February 15 and August 15 of each year, beginning on August 15, 2019. The Convertible Notes mature on February 15, 2022, unless earlier repurchased or converted in accordance with their terms prior to such date. As a result of the Separation and in accordance with the anti-dilution provisions of the Convertible Notes, effective October 9, 2020, the Convertible Notes are convertible into shares of our common stock at an adjusted conversion rate of 10.9568 shares per $1,000 principal amount of Convertible Notes (which is equivalent to an initial conversion price of $91.27 per share), subject to future adjustment upon the occurrence of certain events. Upon conversion of the Convertible Notes, holders will receive cash, 42Table of Contentsshares of our common stock, or a combination thereof, at Fortive’s election. Our current intention is to settle such conversions through cash up to the principal amount of the converted Convertible Notes and, if applicable, through shares of our common stock for conversion value, if any, in excess of the principal amount of the converted Convertible Notes. Of the $1.4 billion in proceeds received from the issuance of the Convertible Notes, $1.3 billion was classified as debt and $102.2 million was classified as equity, using an assumed effective interest rate of 3.38%. Debt issuance costs of $24.3 million were proportionately allocated to debt and equity. The discount at issuance was $102.2 million and is being amortized over a three-year period. •On February 28, 2019, we prepaid the remaining $400.0 million outstanding principal and accrued interest under the Delayed-Draw Term Loan due 2019. The prepayment fees associated with this payment were immaterial.•On March 1, 2019, we entered into a credit facility agreement that provides for a 364-day delayed-draw term loan facility (“2020 Delayed-Draw Term Loan”) in an aggregate principal amount of $1.0 billion. On March 20, 2019, we drew down the full $1.0 billion available under the 2020 Delayed-Draw Term Loan in order to fund, in part, the ASP acquisition. The original maturity date of the 2020 Delayed-Draw Term Loan was February 28, 2020; however on February 25, 2020, we extended the maturity date to August 28, 2020. The 2020 Delayed-Draw Term Loan was prepayable at our option. We are not permitted to re-borrow once the term loan is repaid. The terms and conditions, including covenants, applicable to the 2020 Delayed-Draw Term Loan are substantially similar to those applicable to the Revolving Credit Facility.•On June 15, 2019 we repaid the remaining outstanding principal of $55.3 million of our 1.80% senior unsecured notes.•On October 25, 2019, we entered into a credit facility agreement that provides for a 364-day term loan facility (“2020 Term Loan”) in an aggregate principal amount of $300 million. On October 25, 2019, we drew down the full $300 million available under the 2020 Term Loan in order to fund, in part, the Censis acquisition. We subsequently increased the size of this facility by $200 million on November 8, 2019 and drew the additional amount on the same day resulting in an outstanding amount of $500 million. The 2020 Term Loan was due on October 23, 2020 and prepayable at our option. On February 26, 2020, we prepaid $250 million of the 2020 Term Loan and on October 9, 2020, we repaid the remaining $250 million of the 2020 Term Loan. The fees associated with both prepayments were immaterial. We are not permitted to re-borrow once the term loan is repaid. The terms and conditions, including covenants, applicable to the 2020 Term Loan are substantially similar to those applicable to the Revolving Credit Facility. 2018 Financing and Capital TransactionsDuring 2018, we completed the following financing and capital transactions:•On June 29, 2018, we issued 1,380,000 shares of 5.0% Mandatory Convertible Preferred Stock, Series A (“MCPS”) with a par value of $0.01 per share and liquidation preference of $1,000 per share, which included the exercise of an over-allotment option in full to purchase 180,000 shares. We received net $1.34 billion in proceeds from the issuance of the MCPS, excluding $43 million of issuance costs. We used the net proceeds from the issuance of MCPS to fund our acquisition activities and for general corporate purposes, including repayment of debt, working capital and capital expenditures. Each then outstanding share of MCPS will convert automatically on July 1, 2021 into between 10.9041 and 13.3575 common shares, subject to further anti-dilution adjustments.•On July 20, 2018, we prepaid $325 million of our outstanding U.S dollar variable interest rate term loan due in 2019, and on October 5, 2018, we prepaid the remaining $175 million of the outstanding balance. The prepayment fees associated with these payments were immaterial.•On August 22, 2018, we entered into a credit facility agreement that provides for a 364-day delayed-draw term loan facility (“Delayed-Draw Term Loan due 2019”) with an aggregate principal amount of $1.75 billion. On September 5, 2018, we drew down the full $1.75 billion available under the Delayed-Draw Term Loan due 2019 in order to fund, in part, the Accruent Acquisition. The Delayed-Draw Term Loan bears interest at a variable rate equal to the LIBOR plus a ratings-based margin currently at 75 basis points. The Delayed-Draw Term Loan due 2019 was prepayable at our option, and we are not permitted to re-borrow once the term loan is repaid. On September 26, 2018 and November 21, 2018, we repaid $400 million of and $950 million of this loan, respectively. •On October 1, 2018, in connection with the debt-for-debt exchange in the split-off of the A&S Business, we retired $244.7 million of our 1.80% senior unsecured notes due in 2019.•On November 30, 2018 we entered into an amended and restated agreement (“the Credit Agreement”) extending the availability period of the Revolving Credit Facility to November 30, 2023 and increased the facility to $2.0 billion. 43Table of ContentsThe Revolving Credit Facility is subject to a one year extension option at our request and with the consent of the lenders. The Credit Agreement also contains an option permitting us to request an increase in the amounts available under the Credit Agreement of up to an aggregate additional $1.0 billion. Overview of Cash Flows and LiquidityFollowing is an overview of our cash flows and liquidity: Year Ended December 31,($ in millions)202020192018Total operating cash provided by continuing operations$977.7 $702.0 $684.1 Cash paid for acquisitions, net of cash received$(40.4)$(3,939.8)$(2,778.6)Payments for additions to property, plant and equipment(75.7)(74.5)(69.9)Proceeds from sale of property5.3 — — All other investing activities— — 2.2 Total investing cash used in continuing operations$(110.8)$(4,014.3)$(2,846.3)Net proceeds from (repayments of) commercial paper borrowings$(1,141.9)$494.8 $(266.1)Proceeds from borrowings (maturities greater than 90 days), net of $8 million and $24 million of issuance costs in 2020 and 2019, respectively741.7 2,913.2 1,741.3 Repayment of borrowings (maturities greater than 90 days)(1,730.8)(455.3)(1,850.0)Proceeds from issuance of mandatory convertible preferred stock, net of $43 million of issuance costs— — 1,337.4 Payment of common stock cash dividend to shareholders(94.4)(93.8)(96.6)Payment of mandatory convertible preferred stock cash dividend to shareholders(69.0)(69.0)(34.9)Net cash consideration received from Vontier Separation1,598.0 — — All other financing activities20.7 23.2 42.1 Total financing cash (used in) provided by continuing operations $(675.7)$2,813.1 $873.2 Operating ActivitiesOperating cash flows from continuing operations can fluctuate significantly from period-to-period as working capital needs and the timing of payments for income taxes, pension funding, and other items impact reported cash flows.Operating cash flows from continuing operations were approximately $978 million in 2020, an increase of $276 million, or approximately 39%, as compared to 2019. This year-over-year change in operating cash flows from continuing operations was primarily attributable to the following factors:•2020 operating cash flows were impacted by higher net earnings from continuing operations as compared to 2019, which were driven by a year-over-year increase in operating profits of $96 million and a year-over-year increase in interest expense of $6 million primarily associated with our financing activities. The year-over-year increase in operating profit was partially offset by an increase in depreciation and amortization expenses of $43 million largely attributable to our recently acquired businesses. Further, the year-over-year increase in net earnings for 2020 was impacted by the recognition of a $1.1 billion unrealized gain on the Retained Vontier Shares. Depreciation, amortization, and the unrealized gain are non-cash expenses that impact earnings without a corresponding impact to operating cash flows.•The aggregate of accounts receivable, inventories, and trade accounts payable provided $93 million of operating cash flows during 2020 compared to using $59 million of cash during 2019. The amount of cash flow generated from or used by the aggregate of accounts receivable, inventories, and trade accounts payable depends upon how effectively we manage the cash conversion cycle, which effectively represents the number of days that elapse from the day we pay for the purchase of raw materials and components to the collection of cash from our customers, and can be significantly impacted by the timing of collections and payments in a period.•The aggregate of prepaid expenses and other assets and accrued expenses and other liabilities provided $208 million of cash in 2020 as compared to providing $148 million in 2019. The year over year change was largely driven by the timing of tax payments and various employee benefit accruals.44Table of ContentsOperating cash flows from continuing operations were approximately $702 million in 2019, an increase of $18 million, or approximately 3%, as compared to 2018. This year-over-year change in operating cash flows from continuing operations was primarily attributable to the following factors:•2019 operating cash flows were impacted by lower net earnings from continuing operations as compared to 2018. Net earnings for 2019 were impacted by a year-over-year decrease in operating profits of $201 million and a year-over-year increase in interest expense of $65 million primarily associated with our financing activities, which was partially offset by a $41 million non-cash gain on the combination of the Tektronix Video Business with Telestream. The year-over-year decrease in operating profit was attributable to an increase in depreciation and amortization expenses of $167 million largely attributable to our recently acquired businesses. Depreciation and amortization are non-cash expenses that decrease earnings without a corresponding impact to operating cash flows.•The aggregate of accounts receivable, inventories, and trade accounts payable used $59 million of operating cash flows during 2019 compared to using $10 million of cash during 2018. The amount of cash flow generated from or used by the aggregate of accounts receivable, inventories, and trade accounts payable depends upon how effectively we manage the cash conversion cycle, which effectively represents the number of days that elapse from the day we pay for the purchase of raw materials and components to the collection of cash from our customers, and can be significantly impacted by the timing of collections and payments in a period.•The aggregate of prepaid expenses and other assets and accrued expenses and other liabilities provided $148 million of cash in 2019 as compared to providing $15 million in 2018. The year over year change was largely driven by the timing of tax payments and various employee benefit accruals.Investing ActivitiesInvesting cash flows from continuing operations consist primarily of cash paid for acquisitions and capital expenditures. Net cash used in investing activities from continuing operations was approximately $111 million during 2020 compared to approximately $4.0 billion and $2.8 billion of net cash used in 2019 and 2018, respectively. For a discussion of our acquisitions refer to “—Overview.”Capital expenditures are made primarily for increasing capacity, replacing equipment, supporting product development initiatives, improving information technology systems, and purchase of equipment that is used in revenue arrangements with customers. Capital expenditures totaled $76 million in 2020, $75 million in 2019, and $70 million in 2018. We expect capital spending to be between approximately $75 million and $85 million in 2021, though actual expenditures will ultimately depend on business conditions. Financing Activities and IndebtednessFinancing cash flows from continuing operations consist primarily of cash flows associated with the issuance of equity, the issuance and repayments of debt and commercial paper, payments of quarterly cash dividends to shareholders, and cash consideration received from the Vontier Separation. Financing activities from continuing operations used cash of $676 million in 2020 compared to generating $2.8 billion and $873 million of cash in 2019 and 2018, respectively. In 2020, we made net repayments of $1.1 billion of commercial paper borrowings, $500 million of our 2020 Term Loan, $750 million of our 2.35% Senior Notes due 2021, and ¥13.8 billion of our Yen variable interest rate term loan due 2022 which approximated $131 million, which were partially offset by $1.6 billion in net cash consideration received from the Separation and the net proceeds we received from the issuance of our 2021 Term Loan of $350 million. During the year ended December 31, 2020, we paid $163 million of cash dividends to common shareholders and holders of our MCPS.Refer to “—Liquidity and Capital Resources” section above for a description of our financing activities in 2020, 2019, and 2018.We generally expect to satisfy any short-term liquidity needs that are not met through operating cash flows and available cash primarily through issuances of commercial paper under the Commercial Paper Programs and term loans. While COVID-19 created volatility and uncertainty in the commercial paper market, we may utilize our commercial paper programs as a source of liquidity if and when the commercial paper markets are reliable and attractive in the future. Credit support for the Commercial Paper Programs is provided by the Revolving Credit Facility.The carrying value of total debt outstanding as of December 31, 2020 was approximately $4.2 billion. We had $2.0 billion available under the Revolving Credit Facility as of December 31, 2020. Refer to Note 11 to the consolidated financial statements for information regarding our financing activities and indebtedness.The availability of the Revolving Credit Facility as a standby liquidity facility to repay maturing commercial paper is an important factor in maintaining the existing credit ratings of the Commercial Paper Programs when we have outstanding 45Table of Contentsborrowings. As of December 31, 2020, we had no borrowings outstanding under our commercial paper program. We expect to limit any future borrowings under the Revolving Credit Facility to amounts that would leave sufficient credit available under the facility to allow us to borrow, if needed, to repay any outstanding commercial paper as it matures.In 2019, we received net proceeds from the issuance of commercial paper under the Commercial Paper Programs of $495 million, received proceeds from borrowings of $2.9 billion, repaid $455 million of borrowings, and paid $163 million of cash dividends to shareholders. DividendsOn November 5, 2020, we declared a regular quarterly dividend of $0.07 per common share paid on December 28, 2020 to holders of record on November 27, 2020. In addition, we declared a regular quarterly cash dividend of $12.50 per share of our 5.00% Mandatory Convertible Preferred Stock, Series A, payable to preferred stockholders of record on December 15, 2020. The dividend to preferred shareholders was paid on December 31, 2020.Aggregate cash payments for the dividends paid to shareholders during the year ended December 31, 2020 were $163 million and were recorded as dividends to shareholders in the Consolidated Statement of Changes in Equity and the Consolidated Statement of Cash Flows.On January 26, 2021, we declared a regular quarterly cash dividend of $0.07 per share payable on March 26, 2021 to common stockholders of record on February 26, 2021 and a regular quarterly cash dividend of $12.50 per share on our MCPS payable on April 1, 2021 to preferred stockholders of record on March 15, 2021.Cash and Cash RequirementsCashAs of December 31, 2020, we held approximately $1.8 billion of cash and cash equivalents that were invested in highly liquid investment-grade instruments with a maturity of 90 days or less with an annual effective rate of approximately 0.30%. Approximately 60% of our cash at December 31, 2020 was held in the U.S. We have cash requirements to support working capital needs, capital expenditures and acquisitions, pay interest and service debt, pay taxes and any related interest or penalties, fund our pension plans as required, pay dividends to shareholders, and support other business needs or objectives. With respect to our cash requirements, we generally intend to use available cash and internally generated funds to meet these cash requirements, but in the event that additional liquidity is required, particularly in connection with acquisitions, we may also borrow under our commercial paper programs or credit facilities or enter into new credit facilities and either borrow directly thereunder or use such credit facilities to backstop additional borrowing capacity under our commercial paper programs. We also may from time to time access the capital markets, including to take advantage of favorable interest rate environments or other market conditions.Given the impact of the COVID-19 pandemic and resulting market conditions in the U.S., we have updated our assertion for previously unremitted earnings from 2019 and prior periods due to new facts and circumstances that we did not face in prior periods. The TCJA eliminated the U.S. tax cost for qualified repatriation beginning in 2018 but foreign cumulative earnings remain subject to foreign remittance taxes. During the year ended December 31, 2020, we provided foreign remittance taxes of $13 million on the repatriation of $310 million of previously unremitted earnings from 2019 and prior periods.We have made an assertion regarding the amount of current earnings that we do not intend to repatriate due to local working capital needs, local law restrictions, high foreign remittance costs, previous investments in physical assets and acquisitions, or future growth needs. For most of our foreign operations, we make an assertion regarding the amount of earnings in excess of intended repatriation that are expected to be held for indefinite reinvestment. The amount of foreign remittance taxes that may be applicable to such earnings is not readily determinable given local law restrictions that may apply to a portion of such earnings, unknown changes in foreign tax law that may occur during the applicable restriction periods caused by applicable local corporate law for cash repatriation, and the various tax planning alternatives we could employ if we repatriated these earnings.Cash RequirementsThe following table sets forth a summary of our short-term and long-term cash requirements as of December 31, 2020 under (1) long-term debt principal and interest obligations, (2) leases, (3) purchase obligations and (4) other long-term liabilities reflected 46Table of Contentson our balance sheet under GAAP. Certain of our acquisitions may involve the potential payment of contingent consideration. The table below does not reflect any such obligations, as the timing and amounts of any such payments are uncertain.($ in millions)TotalDue within one year of December 31, 2020Due later than one year from December 31, 2020Debt and leases:Long-term debt principal payments$4,287.5 $1,400.0 $2,887.5 Interest payments on long-term debt (a)778.3 72.0 706.3 Operating lease obligations (b)221.7 49.9 171.8 Other:Purchase obligations (c)359.0 245.7 113.3 Other liabilities reflected on the balance sheet under GAAP (d)(e)2,133.3 899.9 1,233.4 Total$7,779.8 $2,667.5 $5,112.3 (a) Interest payments on long-term debt are projected for future periods using the interest rates in effect as of December 31, 2020. Certain of these projected interest payments may differ in the future based on changes in market interest rates.(b) Includes future lease payments for operating leases having initial noncancelable lease terms in excess of one year. (c) Consist of agreements to purchase goods or services that are enforceable and legally binding on us and that specify all significant terms, including fixed or minimum quantities to be purchased, fixed, minimum or variable price provisions, and the approximate timing of the transaction.(d) Primarily consist of obligations under product service and warranty policies and allowances, performance and operating cost guarantees, estimated environmental remediation costs, self-insurance and litigation claims, post-retirement benefits, pension benefit obligations, net tax liabilities, and deferred compensation obligations. The timing of cash flows associated with these obligations is based upon management’s estimates over the terms of these arrangements and is largely based upon historical experience.(e) Includes non-contractual obligations of $228 million of noncurrent gross unrecognized tax benefits. However, the timing of these liabilities is uncertain, and therefore, they have been included in the “due later than one year from December 31, 2020” column. The amounts also includes our obligation under the TCJA for the transition tax on cumulative foreign earnings and profits, which we expect to pay over eight years. Refer to Note 14 to the consolidated financial statements for additional information on unrecognized tax benefits.In addition to the obligations noted above, we have issued guarantees, consisting primarily of outstanding standby letters of credit, bank guarantees, and performance and bid bonds, in connection with certain arrangements with vendors, customers, financing counterparties, and governmental entities to secure our obligations and/or performance requirements related to specific transactions. These guarantees are not recorded on our balance sheet and $61 million in commitments expire within one year of December 31, 2020 and $26 million later than one year from December 31, 2020.During 2020, we contributed $1 million and $11 million to our U.S. and non-U.S. defined benefit pension plans, respectively. During 2021, our cash contribution requirements for our U.S. and non-U.S. defined benefit pension plans are expected to be approximately $1 million and $12 million, respectively. The ultimate amounts we will contribute depend upon, among other things, legal requirements, underlying asset returns, the plan’s funded status, the anticipated tax deductibility of the contribution, local practices, market conditions, interest rates, and other factors.As of December 31, 2020 we expect to have sufficient liquidity to satisfy our cash needs for the foreseeable future, including our cash needs in the United States.Legal ProceedingsPlease refer to Note 16 to the consolidated financial statements for information regarding legal proceedings and contingencies, and for a discussion of risks related to legal proceedings and contingencies, refer to “Item 1A. Risk Factors.”CRITICAL ACCOUNTING ESTIMATESManagement’s discussion and analysis of our financial condition and results of operations is based upon our consolidated financial statements, which have been prepared in accordance with GAAP. The preparation of these financial statements requires management to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. We base these estimates and judgments on historical 47Table of Contentsexperience, the current economic environment, and on various other assumptions that are believed to be reasonable under the circumstances. Actual results may differ materially from these estimates and judgments.We believe the following accounting estimates are most critical to an understanding of our financial statements. Estimates are considered to be critical if they meet both of the following criteria: (1) the estimate requires assumptions about material matters that are uncertain at the time the estimate is made, and (2) material changes in the estimate are reasonably likely from period to period. For a detailed discussion on the application of these and other accounting estimates, refer to Note 2 to the consolidated financial statements.Accounts Receivable: In June 2016, the FASB issued ASU No. 2016-13, Financial Instruments-Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments (“ASU 2016-13”), which amended the impairment model by requiring entities to use a forward-looking approach, based on expected losses, to estimate credit losses on certain types of financial instruments, including trade accounts and unbilled receivables. On January 1, 2020, we adopted ASU 2016-13 and recognized in our Consolidated Balance Sheet as of January 1, 2020 an increase in the allowance for trade accounts, financing, and unbilled receivables of $40.0 million, of which $11.5 million related to our continuing operations, with a corresponding net of tax adjustment to beginning retained earnings of $31.3 million.Results for reporting periods beginning January 1, 2020 reflect the adoption of ASU 2016-13, while prior period amounts were not adjusted and continue to be reported in accordance with our historical accounting practices. Prior to the adoption of ASU 2016-13 on January 1, 2020, we recognized an allowance for incurred losses when they were probable based on many quantitative and qualitative factors, including delinquency. After the adoption of ASU 2016-13, we measure our allowance to reflect expected credit losses over the remaining contractual life of the asset. We pool assets with similar risk characteristics for this measurement based on attributes that may include asset type, duration, and/or credit risk rating. The future expected losses of each pool are estimated based on numerous quantitative and qualitative factors reflecting management’s estimate of collectibility over the remaining contractual life of the pooled assets, including:•duration; •historical, current, and forecasted future loss experience by asset type; •historical, current, and forecasted delinquency and write-off trends; •historical, current, and forecasted economic conditions; and •historical, current, and forecasted credit risk.We regularly perform detailed reviews of our trade accounts and unbilled receivable portfolios to determine if changes in the aforementioned qualitative and quantitative factors have impacted the adequacy of the allowances.Volatility and uncertainty in overall global economic conditions and worldwide capital markets as a result of the COVID-19 pandemic may negatively impact our customers’ ability to pay and, as a result, may increase the difficulty in collecting trade accounts and unbilled receivables. We did not realize notable increases in loss rates and delinquencies during the year ended December 31, 2020, and given the nature of our portfolio of receivables, our historical experience during times of challenging economic conditions, and our forecasted future impact of COVID-19 on our customer’s ability to pay, we did not record material provisions for credit losses as a result of the COVID-19 pandemic during the year ended December 31, 2020. If the financial condition of our customers were to deteriorate beyond our current estimates, resulting in an impairment of their ability to make payments, we would be required to write-off additional receivable balances, which would adversely impact our net earnings and financial condition. In order to evaluate the sensitivity of the estimates used in the calculation of our allowance, we applied a hypothetical 10% decrease in anticipated collectibility, noting that our allowance would increase by $4 million with a corresponding charge to SG&A.Expected credit losses of the assets originated during the year ended December 31, 2020, as well as changes to expected losses during the same periods, are recognized in earnings for the year ended December 31, 2020.Inventories: We record inventory at the lower of cost or net realizable value, which is the estimated selling price in the ordinary course of business, less reasonably predictable costs of completion, disposal and transportation. We estimate the net realizable value of our inventory based on assumptions of future demand and related pricing. Estimating the net realizable value of inventory is inherently uncertain because levels of demand, technological advances, and pricing competition in many of our markets can fluctuate significantly from period to period due to circumstances beyond our control. If actual market conditions are less favorable than those we projected, we could be required to reduce the value of our inventory, which would adversely impact our financial statements. In order to evaluate the sensitivity of the estimates used in the calculation of the net realizable value of our inventory, we applied a hypothetical 10% decrease to the anticipated realization, noting that our inventory would 48Table of Contentsdecrease by $8 million with a corresponding charge to Cost of goods sold. Refer to Note 5 to the consolidated financial statements for detailed information regarding our inventory balances as of December 31, 2020.Acquired Intangibles and Goodwill: Our business acquisitions typically result in the recognition of goodwill, in-process R&D, and other intangible assets, which affect the amount of future period amortization expense and possible impairment charges that we may incur. Refer to Notes 2, 3 and 7 to the consolidated financial statements for a description of our policies relating to goodwill, acquired intangibles, and acquisitions.In performing our goodwill impairment testing, we estimate the fair value of our reporting units primarily using a market based approach. We estimate fair value based on multiples of earnings before interest, taxes, depreciation, and amortization (“EBITDA”) determined by current trading market multiples of earnings for companies operating in businesses similar to each of our reporting units, in addition to recent market available sale transactions of comparable businesses. In evaluating the estimates derived by the market based approach, we make judgments about the relevance and reliability of the multiples by considering factors unique to our reporting units, including operating results, business plans, economic projections, anticipated future cash flows, and transactions and marketplace data as well as judgments about the comparability of the market proxies selected. In certain circumstances we also evaluate other factors including results of the estimated fair value utilizing a discounted cash flow analysis (i.e., an income approach), market positions of the businesses, comparability of market sales transactions, and financial and operating performance in order to validate the results of the market approach. The discounted cash flow model requires judgmental assumptions about projected revenue growth, future operating margins, discount rates, and terminal values. There are inherent uncertainties related to these assumptions and management’s judgment in applying them to the analysis of goodwill impairment.In 2020, we had five reporting units for goodwill impairment testing in continuing operations. Reporting units resulting from recent acquisitions generally present the highest risk of impairment. We believe the impairment risk associated with these reporting units generally decreases as we integrate these businesses and better position them for potential future earnings growth. As of the date of the 2020 annual impairment test, the carrying value of goodwill in each reporting unit ranged from $171 million to $3.2 billion. Our annual goodwill impairment analysis in 2020 indicated that, in all instances, the fair values of our reporting units exceeded their carrying values and consequently did not result in an impairment charge. The excess of the estimated fair value over carrying value (expressed as a percentage of carrying value for the respective reporting unit) for each of our reporting units as of the annual testing date ranged from approximately 50% to approximately 675%. In order to evaluate the sensitivity of the fair value calculations used in the goodwill impairment test, we applied a hypothetical 10% decrease to the fair values of each reporting unit and compared those hypothetical values to the reporting unit carrying values. Based on this hypothetical 10% decrease, the excess of the estimated fair value over carrying value (expressed as a percentage of carrying value for the respective reporting unit) for each of our reporting units ranged from approximately 30% to approximately 600%. We evaluated other factors relating to the fair value of the reporting units, including, as applicable, results of the estimated fair value using an income approach, market positions of the businesses, comparability of market sales transactions and financial and operating performance, and concluded no impairment charges were required. We review identified intangible assets for impairment whenever events or changes in circumstances indicate that the related carrying amounts may not be recoverable. Determining whether an impairment loss occurred requires a comparison of the carrying amount to the sum of undiscounted cash flows expected to be generated by the asset. We also test intangible assets with indefinite lives at least annually for impairment. These analyses require management to make judgments and estimates about future revenues, expenses, market conditions, and discount rates related to these assets.If actual results are not consistent with management’s estimates and assumptions, goodwill and other intangible assets may be overstated and a charge would need to be taken against net earnings which would adversely affect our financial statements.Contingent Liabilities: As discussed in Note 16 to the consolidated financial statements, we are, from time to time, subject to a variety of litigation and similar contingent liabilities incidental to our business (or the business operations of previously owned entities). We recognize a liability for any contingency that is known or probable of occurrence and reasonably estimable. These assessments require judgments concerning matters such as litigation developments and outcomes, the anticipated outcome of negotiations, the number of future claims, and the cost of both pending and future claims. In addition, because most contingencies are resolved over long periods of time, liabilities may change in the future due to various factors, including those discussed in Note 16 to the consolidated financial statements. If the reserves we established with respect to these contingent liabilities are inadequate, we would be required to incur an expense equal to the amount of the loss incurred in excess of the reserves, which would adversely affect our financial statements.Revenue Recognition: We derive revenues from the sale of products and services. Revenue is recognized when control over the promised products or services is transferred to the customer in an amount that reflects the consideration that we expect to receive in exchange for those goods or services. In determining if control has transferred, we consider whether certain 49Table of Contentsindicators of the transfer of control are present, such as the transfer of title, present right to payment, significant risks and rewards of ownership, and customer acceptance when acceptance is not a formality. To determine the consideration that the customer owes us, we make judgments regarding the amount of customer allowances and rebates, consisting primarily of volume discounts and other short-term incentive programs. Refer to Note 2 to the consolidated financial statements for a description of our revenue recognition policies. If our judgments regarding revenue recognition prove incorrect, our reported revenues in particular periods may be adversely affected. Historically, our estimates of revenue have been materially correct.Stock-Based Compensation: For a description of our stock-based compensation accounting practices, refer to Note 17 to the consolidated financial statements. Determining the appropriate fair value model and calculating the fair value of certain stock-based payment awards require subjective assumptions, including the expected life of the awards, stock price volatility, and expected forfeiture rate. Given our limited trading history following the separation from Danaher, stock price volatility used to calculate the fair value of stock options in the post-separation period was estimated based on an average historical stock price volatility of a group of peer companies. Beginning August 2018, expected volatility was based on a weighted average blend of our historical stock price volatility from July 2, 2016 (the date of the Danaher separation) through the stock option grant date and the average historical stock price volatility of a group of peer companies for the expected term of the options. The assumptions used in calculating the fair value of stock-based payment awards represent our best estimates, but these estimates involve inherent uncertainties and the application of judgment. If actual results are not consistent with our assumptions and estimates, our equity-based compensation expense could be materially different in the future. Pension and Other Post Employment Benefits: For a description of our pension accounting practices, refer to Note 12 to the consolidated financial statements. Certain of our U.S. and non-U.S. employees participate in noncontributory defined benefit pension plans. Calculations of the amount of pension costs and obligations depend on the assumptions used in the actuarial valuations, including assumptions regarding discount rates, expected return on plan assets, rates of salary increases, health care cost trend rates, mortality rates, and other factors. If the assumptions used in calculating pension and other post-retirement benefits costs and obligations are incorrect or if the factors underlying the assumptions change (as a result of differences in actual experience, changes in key economic indicators, or other factors), our financial statements could be materially affected. A 50 basis point reduction in the discount rates used for the plans during 2020 would have increased the net obligation by $30 million from the amounts recorded in the financial statements as of December 31, 2020.Our plan assets consist of various insurance contracts, equity and debt securities as determined by the administrator of each plan. The estimated long-term rate of return for the plans was determined on a plan by plan basis based on the nature of the plan assets and ranged from 1.25% to 4.86%. If the expected long-term rate of return on plan assets during 2020 was reduced by 50 basis points, pension expense in 2020 would have increased by $1 million ($1 million on an after-tax basis).Income Taxes: For a description of our income tax accounting policies, refer to Note 2 and Note 14 to the consolidated financial statements. In accordance with GAAP, deferred tax assets and liabilities are determined based on the difference between the financial statement and tax basis of assets and liabilities using enacted rates expected to be in effect during the year in which the differences reverse. Deferred tax assets generally represent items that can be used as a tax deduction or credit in our tax return in future years for which the tax benefit has already been reflected in our Consolidated Statements of Earnings. Deferred tax liabilities generally represent items that have already been taken as a deduction on our tax return but have not yet been recognized as an expense in our Consolidated Statements of Earnings. The effect on deferred tax assets and liabilities due to a change in tax rates is recognized in income tax expense in the period that includes the enactment date. Our deferred tax assets are reduced by a valuation allowance if, based on the weight of available evidence, it is more likely than not (a likelihood of more than 50 percent) that some portion or all of the deferred tax assets will not be realized. We evaluate the realizability of deferred income tax assets for each of the jurisdictions in which we operate. If we experience cumulative pretax income in a particular jurisdiction in the three-year period including the current and prior two years, we normally conclude that the deferred income tax assets will more likely than not be realizable and no valuation allowance is recognized, unless known or planned operating developments would lead management to conclude otherwise. However, if we experience cumulative pretax losses in a particular jurisdiction in the three-year period including the current and prior two years, we then consider a series of factors in the determination of whether the deferred income tax assets can be realized. These factors include historical operating results, known or planned operating developments, the period of time over which certain temporary differences will reverse, consideration of the utilization of certain deferred income tax liabilities, tax law carryback capability in the particular country, and prudent and feasible tax planning strategies. After evaluation of these factors, if the deferred income tax assets are expected to be realized within the tax carryforward period allowed for that specific country, we would conclude that no valuation allowance would be required. To the extent that the deferred income tax assets exceed the amount that is expected to be realized within the tax carryforward period for a particular jurisdiction, we establish a valuation allowance.50Table of ContentsWe recognize tax benefits from uncertain tax positions only if, in our assessment, it is more likely than not that the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the position. The tax benefits recognized in the financial statements from such positions are measured based on the largest benefit that has a greater than 50% likelihood of being realized upon ultimate settlement. Judgment is required in evaluating tax positions and determining income tax provisions. We re-evaluate the technical merits of our tax positions and may recognize an uncertain tax benefit in certain circumstances, including when: (i) a tax audit is completed; (ii) applicable tax laws change, including a tax case ruling or legislative guidance; or (iii) the applicable statute of limitations expires. We recognize potential accrued interest and penalties with unrecognized tax positions in income tax expense.In addition, we are routinely examined by various domestic and international taxing authorities. The amount of income taxes we pay is subject to audit by federal, state, and foreign tax authorities, which may result in proposed assessments (see “-Results of Operations - Income Taxes” and Note 14 to the consolidated financial statements). We review our global tax positions on a quarterly basis. Based on these reviews, the results of discussions and resolutions of matters with certain tax authorities, tax rulings, and court decisions and the expiration of statutes of limitations reserves for contingent tax liabilities are accrued or adjusted as necessary.An increase in our 2020 effective tax rate of 1.0% would have resulted in an additional income tax provision for the fiscal year ended December 31, 2020 of $15 million.NEW ACCOUNTING STANDARDSFor a discussion of new accounting standards relevant to our businesses, refer to Note 2 to the consolidated financial statements.ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK The information required by this item is included under “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.”51Table of Contents
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+Item 7. Management’s Discussion and Analysis of Financial Conditions and Results of Operations.” Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of their date. If any of management’s assumptions prove incorrect or should unanticipated circumstances arise, the Company’s actual results could materially differ from those anticipated by such forward-looking statements. The differences could be caused by a number of factors or combination of factors including, but not limited to, those factors identified under Item 1A “Risk Factors.” Readers are strongly encouraged to consider those factors when evaluating any forward-looking statements concerning the Company. Except as may be required by law, the Company does not undertake to update any forward-looking statements in this Annual Report to reflect future events or developments. 3 Part I Item 1. Business Company Overview For more than 30 years, Garmin Ltd. and subsidiaries (together, the “Company”) has pioneered new wireless devices and applications that are designed for people who live an active lifestyle, many of which feature location technology such as Global Positioning System (GPS). Garmin serves five primary markets, auto, aviation, fitness, marine, and outdoor, and we design, develop, manufacture, market, and distribute a diverse family of hand-held, wearable, portable, and fixed-mount GPS-enabled products and other navigation, communications, sensor-based and information products for these markets. Since the inception of its business, Garmin has delivered over 235 million products, which included more than 15 million products delivered during fiscal 2020. Available Information Garmin’s annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, proxy statement and Forms 3, 4 and 5 filed by Garmin’s directors and executive officers and all amendments to those reports will be made available free of charge through the Investor Relations section of Garmin’s website (http://www.garmin.com) as soon as reasonably practicable after such material is electronically filed with, or furnished to, the Securities and Exchange Commission (the “SEC”). The SEC maintains a website (http://www.sec.gov) that contains reports, proxy and information statements, and other information regarding issuers that file electronically with the SEC. The reference to Garmin’s website address does not constitute incorporation by reference of the information contained on this website, and such information should not be considered part of this report on Form 10-K or in any other report or document we file with the SEC, and any references to our website are intended to be inactive textual references only. This discussion of Garmin Ltd. ("Garmin" or the "Company") should be read in conjunction with, and is qualified by reference to, “Management's Discussion and Analysis of Financial Condition and Results of Operations” under Item 7 herein and the information set forth in response to Item 101 of Regulation S-K in such Item 7 is incorporated herein by reference in partial response to this Item 1. Products Garmin offers a broad range of solutions across its reported segments as outlined below. In general, Garmin believes that its products are known for their value, high performance, ease of use, innovation, and ergonomics. Many of the Company’s products utilize Global Positioning System (GPS) and other global navigation satellite systems (GNSS) receivers as a product feature that can be utilized in a variety of applications, including navigation, global positioning and tracking. GPS is a United States owned satellite network constellation that supports global positioning and navigation, providing precise geographic location and related data to both commercial and government GPS receivers. Commercial access to GPS is provided free of charge. In addition to GPS, other global navigation satellite systems (GNSS) utilized by Garmin products include Japan’s MTSAT-based Satellite Augmentation System (MSAS), the European Geostationary Navigation Overlay Service (EGNOS) aviation Safety of Life (SoL) service, the Russian Global Navigation Satellite System (GLONASS), the European Union Galileo system (Galileo), and the Chinese BeiDou Navigation Satellite System (BDS). Some of Garmin’s products utilize a combination of global navigation satellite systems to improve navigational fix, which results in improved accuracy. On a subscription basis, certain Garmin products offer access to the Iridium satellite network, a synchronized constellation of 66 low Earth orbit (LEO) satellites offering global data communication coverage. Iridium’s use of this constellation gives it the ability to span the entire globe, offering 100 percent coverage worldwide to enable reliable satellite-based communication. 4 Fitness Garmin offers a broad range of products designed for use in health, wellness, and fitness activities. Garmin currently offers the following product categories within the Fitness segment to consumers around the world: • Running and Multi-sport Watches: Garmin running and multi-sport watches are offered under the Forerunner® product series. The Forerunner series offers GPS-enabled watches with features unique to each model. Depending on the model, features include wrist-based heart rate monitoring, wrist-based pulse oximeter, music storage capabilities, mapping capabilities, and Garmin Pay™ contactless payment. • Cycling Products: Garmin cycling products include cycling computers, power meters, bike radars, and smart lights. Additionally, Garmin offers Tacx® indoor training equipment including smart and basic trainers, and a smart bike. • Activity Tracking and Smartwatch Devices: Garmin offers a wide range of activity tracking devices and smartwatch devices. The Garmin product offerings include activity tracking fitness bands, GPS-enabled smartwatches, and fashion-forward hybrid smartwatches with analog style displays. The activity tracking and smartwatch devices offered by Garmin are the vívomove® series, vívoactive® series, vívosmart® series, vívofit® series, vívosport® series, and the Venu®. Each series of activity tracking and smartwatch devices offered has unique features, all to enhance and promote healthy and active lifestyles. Features of the activity tracking and smartwatch devices, depending on the series and model, include Garmin Pay, music storage capabilities, and 24/7 health monitoring. • Fitness and Cycling Accessories: Garmin offers a wide range of fitness and cycling accessories including chest strap heart rate monitors, cycling speed and cadence sensors, and smart scales. • Garmin Connect and Garmin Connect Mobile: Garmin Connect™ and Garmin Connect™ Mobile are web and mobile platforms where users can track and analyze their fitness, activities and workouts, and wellness data. In addition, users can share their accomplishments, create training groups and group challenges, and get feedback and encouragement from the Connect community. • Connect IQ: The Connect IQ™ application development platform enables third parties to create a variety of applications that run on a wide assortment of Garmin devices. Connect IQ provides developers with an easy-to-use software development kit (SDK) to facilitate development efforts in creating watch faces, applications, widgets, and data fields. These third-party applications are available for download by Garmin users via their mobile phone or computer and run on their compatible Garmin wearable, bike computer, golf device, or outdoor handheld. Outdoor Garmin offers a broad range of products designed for use in outdoor activities. Garmin currently offers the following product categories within the Outdoor segment to consumers around the world: • Adventure Watches: Garmin adventure watches include the fēnix® series, Instinct® series, tactix® series, the Descent™ series, and the MARQ® collection. The fenix series offers premium multisport smartwatches with features such as wrist-based heart rate monitoring, wrist-based pulse oximeter, music storage capabilities, preloaded full-color topographical maps, Garmin Pay™, and solar charging, depending on model. The Instinct series offers a rugged and reliable outdoor GPS smartwatch with built-in sports apps, heart rate sensor, smart connectivity and wellness data. The tactix series provides preloaded full-color topographical maps and tactical-inspired features. The Descent series are watch style dive computers that offer divers GPS navigation, multiple dive modes, support for up to six gasses, as well as integrated air pressure monitoring. The MARQ series is a collection of six luxury smart tool watches with premium materials and features unique to each watch. • Outdoor Handhelds: Garmin offers outdoor handhelds under the Oregon®, Rino®, Montana®, eTrex®, GPSMAP®, Foretrex® and inReach® product lines. Handhelds range from basic waypoints navigation 5 capabilities to advanced color touchscreen devices offering barometric altimeter, 3-axis compass, camera, preloaded maps, wi-fi and smartphone connectivity, two-way satellite communication and other features. Each series of products is designed to serve various price points. Handhelds with inReach include global satellite technology which, when combined with an active subscription, offers 2-way text messaging, S.O.S. capabilities and weather forecasts while anywhere in the world. • Golf Devices: Garmin golf devices are offered under the Approach® product line. The Approach series includes handhelds, wearables, club sensors, and laser ranging devices. Over 41,000 preloaded worldwide golf courses are available to be utilized on certain Garmin golf devices. Handheld and wearable golf devices provide yardage distances to the front, back, and middle of the green. In addition to course maps, the Approach G80 handheld device utilizes radar to provide swing metrics including estimated carry and roll, club head speed, ball speed, smash factor, and swing tempo. • Dog Tracking and Training Devices: Garmin offers a variety of dog tracking and training devices, including those under the Astro®, Alpha®, PRO, BarkLimiter™, and Delta® product lines. Marine Garmin is a leading manufacturer of recreational marine electronics and offers a broad range of products. Garmin currently offers the following product categories within the Marine segment to consumers around the world: • Chartplotters and Multi-Function Displays (MFDs): Garmin offers numerous chartplotters/MFDs under the GPSMAP® and ECHOMAP™ product lines. The offerings range from 4-inch portable and fix-mounted products to 24-inch fully integrated Glass Helm offerings and include wireless connectivity to the ActiveCaptain® mobile app. • Cartography: Garmin is a premier supplier of cartography for the recreational marine market. Including the Garmin-owned Navionics® branded charting products, Garmin is a leading supplier of recreational marine content for most major chartplotters and MFDs on the market. • Fishfinders: Garmin offers an advanced line of fishfinders, the Striker™ series, which incorporate GPS technology enabling Quickdraw™ Contours, and wireless features through the ActiveCaptain and StrikerCast mobile apps. • SONAR: Garmin also offers the Panoptix™ all seeing sonar smart transducer line. Panoptix LiveScope™ provides real-time, high-resolution images that can be seen in downward, perspective, and forward-looking views for locating the fish and seeing what is coming before you get there. The Panoptix line also offers detailed 3D underwater views of fish and structure under your boat. Garmin’s CHIRP “black-box” sounders and “smart transducers” interface with Garmin MFDs to enhance their utility by providing the deep-water sounders and fish finder functions in a remote mounted package. • Autopilot Systems: Garmin offers full-featured marine autopilot systems designed for sailboats and powerboats. The systems incorporate such features as Garmin’s patented Shadow Drive™ technology, which automatically disengages the autopilot if the helm is turned, remote steering and speed control, and integration with the Volvo Penta IPS steering and propulsion system. Garmin has also introduced steer-by-wire autopilot capabilities for various steering systems. • RADAR: Garmin offers high-tech solid state Fantom™ radar with MotionScope™ Doppler technology, lowering system power consumption and increasing reliability, while greatly improving situational awareness of the captain. Fantom radars are available in both radomes and open array radar products with compatibility to any network-compatible Garmin chartplotter. Garmin also offers a full line of magnetron radars up to 25kW of transmit power. • Instruments: Garmin offers NMEA 2000 and NMEA 0183 compliant instrument displays and sensors that show data from multiple remote sources on one screen. • VHF Communication Radios: Garmin offers a full line-up of marine VHF radios and AIS transceivers with the latest feature sets including integrated GPS receivers for the communication needs of all 6 types of mariners. Garmin radios are NMEA 2000 compatible and offer multi-station support, and monitor all AIS channels. • Handhelds and Wearable Devices: Garmin offers the quatix® series wearable, GPS-enabled smartwatches designed for mariners, which include marine features for navigation, sailing, stereo control, and autopilot functions. Garmin also offers floating marine GPS handhelds with wireless data transfer between compatible units and preloaded cartography. Some handhelds contain built-in InReach® satellite communication and support Connect IQ™ applications. • Sailing: Garmin has integrated many basic and advanced sailing features into our MFD and instrument systems. These SailAssist™ features include enhanced wind rose with true and apparent wind data, pre-race guidance, synchronized race timer, virtual starting line, time to burn and lay line data fields. • Entertainment: Garmin’s entertainment brand, Fusion®, consists of marine audio head units, speakers and amplifiers. These products are designed specifically for the marine or RV environments and support many connectivity options for integrating with MFDs, smartphones, and Garmin wearables. • Digital Switching: Garmin offers digital switching products under the EmpirBus™ product line. The Garmin EmpirBus products provide power distribution and control solutions for marine and RV applications which enable advanced logic controls and smart electrical systems to enhance features in a boat or RV. The system features fully customizable graphics and user interface that can be controlled through Garmin’s marine multi-function displays and RV OEM products. • Trolling Motors: Garmin offers the Force™ Trolling Motor, a powerful, efficient scissor-lift style trolling motor with built-in CHIRP and Ultra High-Definition ClearVü and SideVü sonar. The Force product line also connects wirelessly to Garmin chartplotters/MFDs to provide navigation, autopilot, and anchor lock integration. Aviation Garmin designs, manufactures and markets a wide range of innovative aircraft avionics solutions to the broad and diverse aviation sector. Avionics are sold directly into original equipment manufacturer (OEM) applications as well as through Garmin’s worldwide dealer network for retrofit installations on existing aircraft. Garmin has developed growth-minded products and technologies serving general aviation, business aviation, rotorcraft, and experimental/light sport markets. Our solutions are available for all aircraft categories and classes; from small piston and electric-powered general aviation aircraft, to large business jet aircraft, as well as a wide-ranging variety of helicopters serving critical public service and oil and gas missions, to name a few. Garmin also provides innovative products and software-as-a-service solutions to other markets such as commercial air-carrier, military and defense, and Advanced Air Mobility / eVTOL. By offering products such as Commercial Off-The-Shelf (COTS) and mission-optimized solutions to military and defense contractors/customers, and products tested and optimized for high duty cycle commercial aviation operations, Garmin is emerging as a strong competitor in these rapidly evolving business spaces. Garmin currently offers the following products, systems, and services to the global aviation market: • Integrated Flight Decks: Known for defining the integrated flight deck (IFD) space in general aviation and light business aviation applications, Garmin offers OEM and retrofit IFD systems scaled for any size aircraft and rotorcraft, featuring communication and navigation, weather information, terrain and traffic awareness and avoidance, aircraft performance, and automated safety solutions. • Electronic Flight Displays and Instrumentation: Garmin flight display and instrument solutions can serve as primary and back-up instruments, which also provide a wealth of valuable information in the cockpit, dramatically increasing situational awareness and capability. • Navigation and Communication Products: Garmin offers a wide range of integrated and stand-alone GPS and VHF navigation and communication products, with a variety of capabilities, available for all market segments. 7 • Automatic Flight Control Systems and Safety-Enhancing Technologies: Garmin offers scalable flight control systems with unique integrated safety features for aircraft and rotorcraft. Our Autopilot and Autonomí™ safety-enhancing solutions cover the entire spectrum of aircraft, from large-cabin business jets and helicopters, to light general aviation aircraft. Garmin’s award-winning Autoland system will autonomously land the aircraft in the event the pilot is not able to do so. We also offer an innovative smart rudder bias system that can help the pilot maintain control of a twin-engine aircraft in the event of an engine failure. • Audio Control Systems: Garmin produces a broad array of cutting-edge audio panels, including panel-mount and remote-mounted units, incorporating features such as Bluetooth connectivity, voice command technology, and integrated intercoms. • Engine Indication Systems: Garmin offers a variety of advanced engine indication systems for piston and turbine-powered aircraft with comprehensive data-logging capabilities as well as wireless offloading, cloud storage and analysis capability through our flyGarmin.com online services portal. • Traffic Awareness and Avoidance Solutions: Garmin offers an array of traffic advisory and collision avoidance systems, including TAS and TCAS / ACAS solutions, with applications in all types of aircraft. • ADS-B and Transponders: Garmin offers a full lineup of ADS-B and transponder solutions, including ADS-B “Out” compliant solutions as well as ADS-B “In” and Bluetooth capable units that allow pilots to connect to their mobile device to display ADS-B traffic and weather. • Weather Information and Avoidance Solutions: Garmin offers multiple weather solutions, including onboard Doppler digital radar products, along with satellite-based SiriusXM, ground-based ADS-B, as well as Garmin Connext® global satellite weather options. • Datalink and Connectivity: Garmin datalink and connectivity solutions allow pilots to download global weather data, communication via text/voice, as well as select mobile apps to transfer flight plans, manage database subscriptions, and stream weather and traffic data from installed avionics solutions. • Portable GPS Navigators and Wearables: Garmin offers portable GPS navigators, smartwatches for pilots, satellite communicators, and portable traffic and weather solutions, providing pilots tools they can take with them from aircraft to aircraft. • Services: Garmin offers a variety of services products to the aviation market. Web and mobile app-based products offered via FltPlan.com and our Garmin Pilot™ electronic flight bag application, help pilots plan, file, fly, and log flights and offer a wealth of information across all phases of flights. Business and commercial aviation customers also benefit from our safety management system, runway analysis and performance data, weight and balance, obstacle clearance, load planning, and navigation database solutions. Garmin continues to provide industry leading product support, and offers a wide selection of databases, training products, extended warranties, and subscription services for all aviation segments. Auto Garmin designs and develops products for use in the auto market that are offered to customers around the world. Auto OEM • Original Equipment Manufacturer (OEM) Solutions: Garmin has cultivated key relationships with leading automobile manufacturers to be the provider of a variety of hardware and software solutions for their vehicles. These range from embedded computing models and infotainment systems that provide a broad range of functionality, to integrated camera solutions, embedded navigation solutions, and precise positioning technology solutions. These support not only the infotainment system in the vehicle, but also key advanced driver-assistance systems (ADAS) functionality as well. 8 Consumer Auto • Personal Navigation Devices (PNDs): Garmin is a leading manufacturer of PNDs in the following categories, which include features such as large screens, Amazon Alexa integration, integrated traffic receivers for traffic avoidance, map updates, spoken street names, voice activated navigation, speed limit indication, lane assist with PhotoReal junction views (thousands of high-quality photos of actual upcoming junctions), Bluetooth hands-free capability, and driver awareness alerts: • Consumer PND: The Drive series offers traditional PNDs for a wide range of consumers. • Motorcycle: The zūmo® series offers motorcycle-specific features. • Truck and fleet: The dēzl™ series offers over-the-road trucking features while the Garmin fleet™ series delivers an integrated tracking and dispatch fleet system. • RV: The RV series offers features specific to the RV enthusiast. • Offroad: The Overlander® is a rugged, all-terrain navigator with topography maps for off-road guidance. • Racing: The Garmin Catalyst™ is an industry-first racing coach and driving performance optimizer. • Camera: The Garmin Dash Cam™ series offers GPS-enabled dash cams that provide high-quality video recording, automatic saving of video footage with G-sensor incident detection, and forward collision and lane departure warnings. Dash cams are offered as compact, standalone cameras that can be mounted to a car windshield. Garmin also offers wireless backup cameras that can be utilized with compatible PNDs to display camera footage behind the vehicle. Sales and Marketing Garmin’s distribution strategy is to support a broad and diverse network of sales channels for our products while maintaining high quality standards to ensure end-user satisfaction. Our products are sold in approximately 100 countries through a large worldwide network of independent retailers, online retailers, dealers, distributors, installation and repair shops, as well as through original equipment manufacturers (OEMs). We also offer products through our online webshop, www.garmin.com. No single customer’s purchases represented 10% or more of Garmin’s consolidated net sales in the years ended December 26, 2020, December 28, 2019, and December 29, 2018. Marketing support is provided geographically from Garmin’s offices around the world. Competition We operate in highly competitive markets, though competitive conditions vary among our diverse target markets and geographies. Garmin believes the principal competitive factors impacting the market for its products are design, functionality, quality and reliability, customer service, brand, price, time-to-market and availability. Garmin believes that it generally competes favorably in each of these areas and as such, is generally a significant competitor in each of our major markets. Garmin believes that its principal competitors for fitness products are Apple, Bryton, Elite, Fitbit, Huami, Huawei, Polar, Samsung, Sigma Sports, Suunto, Wahoo Fitness, and Xiaomi. Garmin believes that its principal competitors for outdoor product lines are Casio, Dogtra, Shearwater Research, Globalstar, SportDOG, Suunto, TAG Heuer, Tissot, and Vista Outdoor. For marine products, Garmin believes that its principal competitors are Flir Systems, Furuno, Johnson Outdoors, and Navico. Garmin considers its principal avionics competitors to be Aspen Avionics, Avidyne Corporation, CMC Electronics, Raytheon, Dynon Avionics, ForeFlight, Genesys Aerosystems, Honeywell Aerospace & Defense, Innovative Solutions and Support Inc., L-3 Avionics Systems, Safran SA, Thales, and Universal Avionics Systems Corporation. Garmin believes that its principal competitor for consumer automotive products is TomTom N.V., and Rand McNally. Garmin believes that its principal competitors for auto OEM infotainment solutions are Alpine Electronics, Harman International Industries, Continental, Bosch, the Mitsubishi Group, and Panasonic Corporation. 9 Research and Development Garmin’s product innovations are driven by its strong emphasis on research and development and the close partnership between Garmin’s engineering and manufacturing teams. Garmin’s products are created by its engineering and development staff. Garmin’s manufacturing staff includes manufacturing process engineers who work closely with Garmin’s design engineers to ensure manufacturability and manufacturing cost control for its products. Garmin’s development staff includes industrial designers, as well as software engineers, electrical engineers, mechanical engineers, and cartographic engineers. Garmin believes the industrial design of its products has played an important role in Garmin’s success. Manufacturing and Operations Garmin believes one of its core competencies and strengths is its vertically integrated manufacturing capabilities at its Taiwan facilities in Xizhi, Jhongli and LinKou, its China facility in Yangzhou, its Netherlands facility in Oegstgeest, its Poland facility in Wroclaw, and at its U.S. facilities in Olathe, Kansas and Salem, Oregon. Garmin believes that its ownership and operation of its own manufacturing facilities and distribution networks provides significant capability and flexibility to address the breadth and depth of resources necessary to serve its diverse products and markets. Specifically, Garmin believes that its vertical integration of its manufacturing capabilities provides advantages to product cost, quality, and time to market. Cost: Garmin’s manufacturing resources rapidly and iteratively prototype designs, concepts, products and processes, achieving higher efficiency, resulting in lower cost. Garmin’s vertical integration approach enables leveraging of manufacturing resources across high, mid and low volume products. Sharing of these resources across product lines favorably affects Garmin’s costs to produce its range of products, with lower volume products realizing the economies of scale of higher volume products. The ownership and integration of its resources allows Garmin to optimize the design for manufacturing of its products, yielding improved cost. Quality: Garmin’s automation and advanced production processes provide in-service robustness and consistent reliability standards that enable Garmin to maintain strict process and quality control of the products manufactured, thereby improving the overall quality of our products. Additionally, the immediate feedback throughout the manufacturing processes is provided to the development teams, providing integrated continuous improvement throughout design and supply chain. Time to Market: Garmin uses multi-disciplinary teams of design engineers, process engineers, and supply chain specialists to develop products, allowing them to quickly move from concept to manufacturing. This integrated ownership provides inherent flexibility to enable faster time to market. Garmin’s design, manufacturing, distribution, and service functions in its U.S., Taiwan, China and U.K. facilities are certified to ISO 9001, an international quality standard developed by the International Organization for Standardization. Garmin’s automotive operations in Taiwan, China, U.K., and Olathe have achieved IATF 16949 certification, a quality standard for automotive suppliers. Garmin’s Olathe and Salem aviation operations have achieved certification to AS9100, the quality standard for the aviation industry. Garmin International, Inc., Garmin (Europe) Ltd., and Garmin Corporation have also achieved certification of their environmental management systems to the ISO 14001 standard, recognizing Garmin’s systems and processes which minimize or prevent harmful effects on the environment and continually strive to improve its environmental performance. Materials Although most components essential to Garmin’s business are generally available from multiple sources, certain key components are currently obtained by the Company from single or limited sources, which subjects Garmin to supply and pricing risks. Many of these and other key components that are available from multiple sources, including, but not limited to, NAND flash memory, dynamic random access memory (DRAM), GPS chipsets and certain LCDs, are subject, at times, to industry-wide shortages and commodity pricing fluctuations. 10 Garmin and other participants in the personal computer, tablet, mobile communication, automotive, aviation electronics, and consumer electronics industries also compete for various components with other industries that have experienced increased demand for their products. In addition, Garmin uses some custom components that are not common to the rest of the personal computer, tablet, mobile communication, and consumer electronics industries. New products introduced by the Company often utilize custom components available from only one source until Garmin has evaluated whether there is a need for, and subsequently qualifies, additional suppliers. When a component or product uses new technologies, initial capacity constraints may exist until the suppliers’ yields have matured or manufacturing capacity has increased. Garmin makes efforts to manage risks in these areas through the use of supply agreements and safety stock for strategically important components. Seasonality Our net sales are subject to seasonal fluctuation. Sales of our consumer products are generally higher in the fourth quarter due to increased demand during the holiday buying season, and, to a lesser extent, the second quarter due to increased demand during the spring and summer season. Sales of consumer products are also influenced by the timing of the release of new products. Our auto OEM and aviation products do not experience much seasonal variation, but are more influenced by the timing of auto program manufacturing, aircraft certifications, regulatory mandates, and the release of new products when the initial demand is typically the strongest. Intellectual Property Our success and ability to compete is dependent in part on our proprietary technology. We rely on a combination of patent, copyright, trademark and trade secret laws, as well as confidentiality agreements, to establish and protect our proprietary rights. In addition, Garmin often relies on licenses of intellectual property for use in its business. As of January 28, 2021, Garmin has been issued over 1,450 patents throughout the world and holds more than 930 trademark registrations. The duration of patents varies in accordance with the provisions of applicable local law. We believe that our continued success depends on the intellectual skills of our employees and their ability to continue to innovate. Garmin will continue to file and prosecute patent applications when appropriate to attempt to protect Garmin’s rights in its proprietary technologies. There is no assurance that our current patents, or patents which we may later acquire, may successfully withstand any challenge, in whole or in part. It is also possible that any patent issued to us may not provide us with any competitive advantages, or that the patents of others will preclude us from manufacturing and marketing certain products. Despite our efforts to protect our proprietary rights, unauthorized parties may attempt to copy aspects of our products or to obtain and use information that we regard as proprietary. Litigation may be necessary in the future to enforce our intellectual property rights, to protect our trade secrets, to determine the validity and scope of the proprietary rights of others or to defend against claims of infringement or invalidity. Regulations The telecommunications industry is highly regulated, and the regulatory environment in which Garmin operates is subject to change. In accordance with the United States’ Federal Communications Commission (FCC) rules and regulations, wireless transceiver products are required to be certified by the FCC and comparable authorities in foreign countries where they are sold. Garmin’s products sold in Europe are required to comply with relevant directives of the European Commission. A delay in receiving required certifications for new products, or enhancements to Garmin’s products, or losing certification for Garmin’s existing products could adversely affect our business. In addition, aviation products that are intended for installation in “type certificated aircraft” are required to be certified by the Federal Aviation Administration (FAA), its European counterpart, the European Aviation Safety Agency, and other comparable organizations before they can be used in an aircraft. 11 Because Garmin Corporation, one of the Company’s principal subsidiaries, is located in Taiwan, foreign exchange control laws and regulations of Taiwan with respect to remittances into and out of Taiwan may have an impact on Garmin’s operations. The Taiwan Foreign Exchange Control Statute, and regulations thereunder, provides that all foreign exchange transactions must be executed by banks designated to handle such business by the Ministry of Finance of Taiwan and by the Central Bank of the Republic of China (Taiwan), also referred to as the CBC. Current regulations favor trade-related foreign exchange transactions. Consequently, foreign currency earned from exports of merchandise and services may now be retained and used freely by exporters, while all foreign currency needed for the import of merchandise and services may be purchased freely from the designated foreign exchange banks. Aside from trade-related foreign exchange transactions, Taiwan companies and residents may, without foreign exchange approval, remit outside and into Taiwan foreign currencies of up to $50 million and $5 million respectively, or their equivalent, each calendar year. Currency conversions within the limits are processed by the designated banks and do not have to be reviewed and approved by the CBC. The above limits apply to remittances involving a conversion between Taiwan Dollars and U.S. Dollars or other foreign currencies. The CBC typically approves foreign exchange in excess of the limits if a party applies with the CBC for review and presents legitimate business reasons justifying the currency conversion. A requirement is also imposed on all enterprises to register all medium and long-term foreign debt with the CBC. Environmental Matters Garmin’s operations are subject to various environmental laws, including laws addressing air and water pollution and management of hazardous substances and wastes. Substantial noncompliance with applicable environmental laws could have a material adverse effect on our business. Capital expenditures for environmental controls are included in our normal capital budget. Historically, capital expenditures associated with environmental controls have not been material and compliance with environmental laws has not had a material impact on the Company’s competitive position. Many of Garmin's products are subject to laws relating to the chemical and material composition of our products and their energy efficiency. Garmin is also subject to laws requiring manufacturers to be financially responsible for collection, recovery and recycling of wastes from certain electronic products. Compliance with current environmental laws does not have a material impact on our business, but the impact of future enactment of environmental laws cannot yet be fully determined and could be substantial. Garmin has implemented multiple Environmental Management System (EMS) policies in accordance with the International Organization for Standardization (ISO) 14001 standard for Environmental Health and Safety Management. Garmin’s EMS policies set forth practices, standards, and procedures to ensure compliance with applicable environmental laws and regulations at Garmin’s Kansas headquarters facility, Garmin’s European headquarters facility, and Garmin’s Taiwan and China manufacturing facilities. Garmin continues to strive to reduce our carbon footprint by increasing our environmental sustainability efforts. Our manufacturing locations have implemented increased recycling processes that keep all obsolete Garmin manufactured material from entering the waste stream. Additionally, our most recently completed facility in Olathe, Kansas has been constructed with energy efficient considerations, including reduced water consumption, LED lighting, and reflective roofing to deflect solar radiation. Human Capital Successful execution of our strategy is dependent on attracting, developing, and retaining key employees and members of our management team. To facilitate talent attraction and retention, we strive to provide opportunities for our employees to grow and develop in their careers, supported by generous compensation and benefits, and through programs that build connections between our employees and their communities. 12 As of December 26, 2020, the Company had approximately 16,000 full and part-time employees worldwide, of whom approximately 6,000 were in the Americas region, 7,800 were in APAC, and 2,200 were in EMEA. Garmin’s vertical integration model enables us to provide a variety of opportunities across many different professions including engineering, human resources, information technology, marketing, sales, and operations. The Company’s products are created by its engineering and development staff, which numbered approximately 4,900 people worldwide as of December 26, 2020. Garmin’s manufacturing staff, which numbered approximately 6,100 people worldwide as of December 26, 2020, includes manufacturing process engineers who work closely with Garmin’s design engineers to ensure manufacturability and manufacturing cost control for its products. Garmin respects the right of all employees to form and join an association to represent their interests as employees, to organize, and to bargain collectively or individually. We also respect any employee’s choice to refrain from joining a union. Except for some of Garmin’s employees in Sweden, none of Garmin’s employees are represented by a labor union and none of Garmin's North American or Taiwan employees are covered by a collective bargaining agreement. We believe our efforts in managing our workforce have been effective, as evidenced by a strong company culture and positive relations between the Company and our employees. We offer a range of robust benefits to our employees that enable us to attract and retain leading talent. In addition to salaries, these programs (which vary by country/region) include stock awards, retirement plans, healthcare and insurance benefits, health savings and flexible spending accounts, paid time off, family leave, and an Employee Stock Purchase Plan, which provides employees an opportunity to acquire company ownership for a discounted price. We also invest significant resources in our talent development programs to provide employees with the training and education they need to help achieve their career goals, build relevant skills, and lead their organizations. Employee Resource Groups provide opportunities for employees to connect, network, and become involved in community engagement initiatives. We support local community engagement initiatives where we have a business presence, and we provide opportunities for employees to give back to those communities. One such initiative is through active engagement in Science, Technology, Engineering, and Math (“STEM”) community outreach programs. Our strategic aim in these educational programs is to educate and encourage local students to pursue careers in the engineering field, especially those in underrepresented groups, which we believe benefits not only our company but the overall industry. Item 1A. Risk Factors The risks described below are not the only ones facing our company. Additional risks and uncertainties not presently known to us or that we currently believe to be immaterial may also impair our business operations. If any of the following risks occur, our business, financial condition or operating results could be materially adversely affected. Risks Related to the Company If we are not successful in the continued development, timely manufacture, and introduction of new products or product categories, demand for our products could decrease to the extent that lost sales and profits, or losses, from declining segments or product categories are not entirely offset. We expect that a significant portion of our future revenue will continue to be derived from sales of newly introduced products. This is particularly important to replace sales and profits lost, or losses incurred, in declining segments or product categories. The market for our products is characterized by rapidly changing technology, evolving industry standards and changes in customer needs. If we fail to introduce new products, or to modify or improve our existing products, in response to changes in technology, industry standards or customer needs, our products could rapidly become less competitive or obsolete. We must continue to make significant investments in research and development in order to continue to develop new products, enhance existing products and achieve market acceptance for such products. However, there can be no assurance that development stage products will be successfully completed or, if developed, will achieve significant customer acceptance. 13 If we are unable to successfully develop and introduce competitive new products, and enhance our existing products, our future results of operations would be adversely affected. Our pursuit of necessary technology may require substantial time and expense. We may need to license new technologies to respond to technological change. These licenses may not be available to us on terms that we can accept or may materially change the gross profits that we are able to obtain on our products. We may not succeed in adapting our products to new technologies as they emerge. Development and manufacturing schedules for technology products are difficult to predict, and there can be no assurance that we will achieve timely initial customer shipments of new products. The timely availability of these products in volume and their acceptance by customers are important to our future success. Any future challenges related to new products, whether due to product development delays, manufacturing delays, lack of market acceptance, delays in regulatory approval, or otherwise, could have a material adverse effect on our results of operations. If we are unable to compete effectively with existing or new competitors, our resulting loss of competitive position could result in price reductions, fewer customer orders, reduced margins and loss of market share. The markets for many of our products are highly competitive, and we expect competition to increase in the future. Some of our competitors have significantly greater financial, technical and marketing resources than we do. These competitors may be able to respond more rapidly to new or emerging technologies or changes in customer requirements. They may also be able to devote greater resources to the development, promotion and sale of their products or secure better product positioning with retailers. Increased competition could result in price reductions, fewer customer orders, reduced margins and loss of market share. Our failure to compete successfully against current or future competitors could seriously harm our business, financial condition and results of operations. Public health emergencies or outbreaks of epidemics, pandemics, or contagious diseases have had and will likely continue to have significant impacts on our business. Widespread public health emergencies or outbreaks of epidemics, pandemics, or contagious diseases, such as the COVID-19 pandemic, have had, and will likely continue to have, significant impacts on our business. The COVID-19 pandemic continues to rapidly evolve, creating disruption and uncertainty around the world, which has resulted in, and we expect will continue to result in, reduced overall demand for certain of our products and other operational impacts. There are unknown factors, such as the duration and severity of the pandemic, the nature and length of actions taken by governments, businesses and individuals to contain or mitigate its impact, the severity and duration of the economic impact caused by the pandemic, the uncertainty surrounding the efficacy, distribution and uptake of vaccines, along with the effectiveness of our response, that may affect the magnitude of effects to our business operations, results of operations, and its ultimate impact on our financial condition. Demand for certain of our products has been, and is expected to continue to be, adversely affected in several ways. Consumers have been and may continue to be less able or less likely to purchase certain of our products due to economic hardships, governmental restrictions affecting them and the retail outlets that sell our products, voluntary behavior changes associated with public health guidance, the prioritization of other goods and services by online retailers that sell our products, restrictions on the ability of online retailers to ship products to certain areas, the cancellation of trade shows and other events that are otherwise important in the marketing and sale of our products, and the potential failure and closure of retail outlets and online retailers that sell our products. Certain of our sales and distribution offices have experienced and may again experience temporary closure due to governmental restrictions. Additional or prolonged closures of certain sales and distribution offices could affect our ability to market and distribute products to meet customer demand. The adverse impacts of the pandemic have created economic stress in the global marketplace, high levels of unemployment, loss of income and/or wealth for some individuals, and general economic uncertainty. These conditions have affected and are expected to continue to affect the willingness or ability of customers to purchase certain of our products or those of original equipment manufacturers in which our products are installed. Our supply chain may also be adversely impacted by COVID-19. We may be unable to procure, or experience delays in procuring, certain components from our suppliers, and the cost of procuring components could increase. Reduced demand for certain of our products has resulted in, and may continue to result in, reduced utilization of certain of our manufacturing facilities and higher per-unit costs for certain products. Certain of our manufacturing facilities may also experience inopportune temporary closures or reduced hours, which could adversely affect the costs incurred to produce our products and our ability to meet demand. 14 COVID-19 has had and will continue to have several other operational impacts on our business, which will or may include employees working remotely, temporarily ceasing operations in some offices due to government restrictions, business travel restrictions, and the cancellation of events that are otherwise important in the development, marketing and sale of our products. These changes in our business operations may result in reduced efficiency and lower productivity. We have incurred and are expected to continue to incur increased costs as we provide additional benefits to assist our employees during the COVID-19 pandemic and provide a safe and healthy workplace for employees who continue to work in our facilities. Similar operational and financial hardships on our business partners may result in aged or uncollectable receivables, and the reduced demand for certain of our products could result in obsolescence of certain inventory. If the economy experiences a sustained downturn of significant proportion that impacts portions of our business, we may also need to incur the costs and organizational impacts of personnel restructuring. Additional risks and impacts associated with COVID-19 including gross margin fluctuation, foreign currency fluctuations, successful continued product development, impacts to our key personnel, and dependencies on third party suppliers, may be heightened as a result of the COVID-19 pandemic. There are further unknown risks and impacts due to the uncertainty and rapidly evolving nature of the pandemic including, but not limited to, uncertainty around the evolution of the pandemic, the unprecedented imposition of preventative measures by governments that impact the economy and normal operations of a business and the timing and manner of relaxation of those measures. Potential future health emergencies may present risks and impacts similar to the ongoing COVID-19 pandemic. If we are unable to manage these risks and uncertainties, our business, financial condition, and results of operations could be materially impacted. Maturation or contraction of the market for wearable devices or categories of these devices could adversely affect our revenue and profits. We have experienced growth in sales and profits in our outdoor and fitness segments, which in recent years have benefited from increased sales of wearable devices. If the overall wearable device market declines, or categories of devices within the wearable device market decline significantly, our business, financial condition or operating results could be materially adversely affected. We depend on third party suppliers and licensors, some of which are sole source, for content, technology, and components used in our products. Our production and business would be seriously harmed if these suppliers are not able to meet our demand and alternative sources are not available, or if the costs of components rise. We are dependent on third party suppliers for various components used in our current products. Some of the components that we procure from third party suppliers include semiconductors and electroluminescent panels, liquid crystal displays, memory chips, batteries and microprocessors. The cost, quality and availability of components are essential to the successful production and sale of our products. Some components we use are from sole source suppliers. Certain application-specific integrated circuits incorporating our proprietary designs are manufactured for us by sole source suppliers. Alternative sources may not be currently available for these sole source components. We have and may continue to experience shortages of certain components. In addition, a shortage in supply of components may result in an increase of the costs of available components. If suppliers are unable to meet our demand for components on a timely basis or if we are unable to obtain an alternative source, or if the price of the alternative source is prohibitive, our ability to maintain timely and cost-effective production of our products would be seriously harmed. We are committed to make significant investments in auto OEM for the foreseeable future, which could negatively impact total Company profits and shareholder value if we fail to become profitable. We have been awarded several tier-one and tier-two auto OEM supplier contracts. To fulfill the associated program commitments, we are investing significantly in facilities, research and development, and other operating expenses and we will continue to do so in the coming years. Gross margins associated with these auto OEM programs are lower than the gross margins realized by the Company as a whole in recent periods. If we are not successful in winning additional contract awards or substantially leveraging our investments, periods of lower operating income or operating losses in the auto OEM segment could continue to negatively impact total Company profits and may negatively impact shareholder value if we fail to become profitable. 15 We rely on information technology systems for our business operations. Failures or disruptions, including security breaches or cyber attacks, to our information technology systems may harm our reputation and adversely affect our business and result of operations. Our information technology systems allow for our daily business operations to operate efficiently and effectively. These systems assist in our business processes, including, but not limited to, communications, financial management, supply chain management, manufacturing, order processing, shipping and billing, and providing services and support to our customers. Additionally, we electronically maintain sensitive data, including our intellectual property and confidential and proprietary information and that of our business partners. We also electronically maintain personal information of our users and employees. The secure processing, maintenance and transmission of this information is important to our operations. A disruption to any of these processes can adversely affect our business and results of operations. Furthermore, a breach of our security systems and procedures or those of our vendors could result in significant data losses or theft of our intellectual property or confidential and proprietary information or that of our business partners, as well as our users’ or employees' personal information. We have technology and processes in place to detect and respond to data security incidents. However, because the techniques used to obtain unauthorized access, disable or degrade service, or sabotage systems change frequently and may be difficult to detect for long periods of time, we may be unable to anticipate these techniques or implement adequate preventive measures. In addition, hardware, software or applications we develop or procure from third parties may contain defects in design or manufacture or other problems that could unexpectedly compromise information security. Unauthorized parties have also attempted, and may in the future attempt, to gain access to our systems or facilities through fraud, trickery or other forms of deceiving our customers and employees. Accordingly, we have been and may in the future be unable to anticipate these techniques or to implement adequate security barriers or other preventative measures, or if such measures are implemented, and even with appropriate training conducted in support of such measures, human errors may still occur. It is virtually impossible for us to entirely mitigate this risk. A party, whether internal or external, who is able to circumvent our security measures could misappropriate information. Actual or anticipated attacks and risks have caused and are expected to continue to cause us to incur increasing costs, including costs to deploy additional personnel and protection technologies, to conduct additional employee training, and to engage third party security experts and consultants. If we fail to reasonably maintain the security of our intellectual property or confidential and proprietary information or that of our business partners, or if we fail to reasonably maintain the security of the personal information of our users or employees, we may suffer significant reputational and financial losses and our results of operations, cash flows, financial condition, and liquidity may be adversely affected. In addition, a system breach could result in other negative consequences, including disruption of internal operations and loss of functionality of critical systems and online services, and may subject us to private litigation, government investigations, regulatory proceedings, enforcement actions, and cause us to incur potentially significant liability, damages, or remediation costs. Although we maintain cyber insurance coverage that, subject to policy terms and conditions and a significant self-insured retention, is designed to address certain aspects of cyber risks, such insurance coverage may be insufficient to cover all losses or all types of claims that may arise in the continually evolving area of cyber risk. The Company was the victim of a cyber attack that encrypted some of our systems on July 23, 2020. As a result, many of our online services were interrupted including website functions, customer support, customer facing applications, and company communications. We immediately began to assess the nature of the attack and started remediation. Based on our due diligence and independent forensic analysis, we have no indication that any customer data was accessed, lost or stolen. Additionally, the functionality of Garmin products was not affected, other than the ability to access online services. The impact of this outage to our operations and financial results was not material, and we do not expect it to have material impacts on future periods. However, we may still suffer negative consequences, including certain of those described in the paragraphs above, beyond our current expectations. Our annual and quarterly financial statements will reflect fluctuations in foreign currency translation. The operation of our subsidiaries in global markets results in exposure to movements in currency exchange rates. We have experienced significant foreign currency gains and losses due to the strengthening and weakening of the U.S. Dollar relative to certain other currencies. The potential of volatile foreign exchange rate fluctuations in the future could have a significant effect on our results of operations. We have not historically used financial instruments to hedge our foreign currency exchange rate risks. 16 The currencies that typically create a majority of our exchange rate exposure are the Taiwan Dollar, Euro, British Pound Sterling, Australian Dollar, Chinese Yuan, and Japanese Yen. The Taiwan Dollar is the functional currency of Garmin Corporation, the Euro is the functional currency of several subsidiaries, and the U.S. Dollar is the functional currency of Garmin (Europe) Ltd., although some transactions and balances are denominated in British Pounds. Other legal entities primarily use the local currency as the functional currency. Due to the relative size of entities with other functional currencies, fluctuations of other currencies are not expected to have a material impact on our financial statements. We translate income and expense activity at the approximate rate of exchange at the transaction date, and all assets and liabilities at the rate of exchange in effect at the balance sheet date. Income and expense activity in a currency other than the U.S. Dollar can be impacted by exchange rate variations over time. The majority of our consolidated foreign currency gain or loss is typically driven by exchange rate impacts on the significant cash, receivables, and payables held in a currency other than the functional currency at a given legal entity. Such gain or loss will create variations in our earnings per share. However, because there is minimal cash impact caused by such exchange rate variations, management will continue to focus on our operating performance before the impact of foreign currency gains and losses. Changes in applicable tax laws or resolutions of tax disputes could result in adverse tax consequences to the Company. Our tax positions could be adversely impacted by changes to tax laws, tax treaties, or tax regulations or the interpretation or enforcement thereof by any tax authority in which we file income tax returns, particularly in the US, Switzerland, Taiwan, and UK. We cannot predict the outcome of any specific legislative proposals. Global taxing standards continue to evolve as a result of the Organization for Economic Co-Operation and Development (OECD) recommendations aimed at preventing perceived base erosion and profit shifting (BEPS) by multinational corporations. While these recommendations do not change tax law, the countries where we operate may implement legislation or take unilateral actions which may result in adverse effects to our income tax provision and financial statements. Partially to respond to recent and continuing changes to global tax standards, we initiated an intercompany transaction which migrates ownership of certain consumer products intellectual property from Switzerland to the United States, which is the primary location of research, development and executive management. Due to the subjectivity inherent in transfer pricing associated with this intercompany transaction, we are pursuing an advanced pricing agreement with relevant jurisdictions to provide certainty regarding the pricing. However, we are unable to predict the outcome of the final advanced pricing agreement and related negotiations, which could materially and/or adversely impact our income tax provision, net income or cash flows for periods during negotiation and upon finalization. Significant judgment is required in determining our global provision for income taxes. In the ordinary course of our business, there are many transactions and calculations where the ultimate tax determination is uncertain, most notably in the area of transfer pricing. We are regularly under audit by tax authorities. Although we believe our tax estimates are reasonable, the final determination of tax audits and any related litigation could be materially different from our historical income tax provisions and accruals. The results of an audit or litigation could have a material effect on our income tax provision, net income, or cash flows in the period or periods for which that determination is made. Changes to trade regulations, including trade restrictions, sanctions, or tariffs, could significantly harm our results of operations. We manufacture goods in the People’s Republic of China, also referred to as the PRC, and import certain materials from the PRC that are used to manufacture goods in the United States. The imposition of additional governmental controls or regulations that create new or enhanced restrictions on free trade, trade sanctions, or tariffs, particularly those applicable to materials or goods from the PRC, could have a substantial adverse effect on our business, results of operations, and financial condition. 17 Economic, regulatory, and political conditions and uncertainty could adversely affect our revenue and profits. Our revenue and profits depend significantly on general economic conditions and the demand for products in the markets in which we compete. We have operations outside the United States that make up a significant portion of our total revenue, which can present challenges depending on economic and geopolitical conditions on both a global and regional scale. Economic weakness or constrained consumer and business spending has resulted in periods of decreased revenue in the past, and could in the future result in decreased revenue and problems with our ability to manage inventory levels and collect customer receivables. In addition, financial difficulties experienced by our retailers and OEM customers have resulted, and could result in the future, in significant bad debt write-offs and additions to reserves in our receivables and could have an adverse effect on our results of operations. We may experience unique economic and political risks associated with companies that operate in Taiwan. Our principal manufacturing facilities, where we manufacture most of our consumer products, are located in Taiwan. Relations between Taiwan and the PRC and other factors affecting the political or economic conditions of Taiwan in the future, could materially affect our business, financial condition and results of operations and the market price and the liquidity of our shares. The PRC asserts sovereignty over all of China, including Taiwan, certain other islands, and all of mainland China. The PRC government does not recognize the legitimacy of the Taiwan government. Although significant economic and cultural relations exist between Taiwan and the PRC, the PRC government has indicated that it may use military force to gain control over Taiwan in certain circumstances, such as the declaration of independence by Taiwan. The United States' relations with Taiwan are governed by the 1979 Taiwan Relations Act, which signifies when the U.S. switched diplomatic recognition from Taiwan to the PRC, referred to as the "one-China" policy. Deviations from the "one-China" policy could lead to adverse changes in China-U.S. and China-Taiwan relations and could adversely affect our operations in Taiwan in the future. If we do not correctly anticipate demand for our products, we may not be able to secure sufficient quantities or cost-effective production of our products or we could have costly excess production or inventories. We have generally been able to increase or decrease production to meet fluctuations in demand. However, the demand for our products depends on many factors and may be difficult to forecast. We expect that it will become more difficult to forecast demand as we introduce and support a diverse product portfolio, competition in the market for our products intensifies and the markets for some of our products mature. Significant unanticipated fluctuations in demand could cause the following problems in our operations: • If demand increases beyond what we forecast, we would have to rapidly increase production. We would depend on suppliers to provide additional volumes of components and those suppliers might not be able to increase production rapidly enough to meet unexpected demand. • Rapid increases in production levels to meet unanticipated demand could result in higher costs for manufacturing and supply of components, higher freight costs associated with urgent distribution of the products, and other expenses. These higher costs could lower our profit margins. Further, if production is increased rapidly, manufacturing quality could decline, which may also lower our margins and reduce customer satisfaction. • If forecasted demand does not develop, we could have excess inventories of finished products and components, which would use cash and could lead to write-offs of some or all of the excess inventories. Lower than forecasted demand could also result in excess manufacturing capacity or reduced manufacturing efficiencies at our facilities, which could result in lower margins. 18 The effects of the United Kingdom’s withdrawal from the European Union (“Brexit”), including trade agreements, are not yet known and the uncertainty creates challenges and risks which could have a material effect on our business and results of operations. The United Kingdom (UK) formally left the European Union (EU) on January 31, 2020, and a transition period through December 31, 2020 was established to allow the UK and EU to negotiate the terms of the UK’s withdrawal. As a result, the UK is no longer part of the European Single Market and European Union Customs Union effective January 1, 2021. The UK and EU signed the EU–UK Trade and Cooperation Agreement (TCA) in December 2020, which has been applied provisionally since January 1, 2021 until it is ratified by all parties to the agreement. Under the TCA, there is no longer the free movement of goods or people between the UK and the EU, which has resulted and could continue to result in certain delays in the shipment of these goods. The long-term risks of Brexit include economic recessions in the UK or other European markets and currency instability for both the British Pound Sterling and the Euro. We have operations in the UK, including offices and a distribution facility, and several EU member states. Brexit therefore has impacted and will continue to impact our operations. While these impacts have not yet been material to our business operations, results of operations, and financial condition, risks such as slow or inefficient border clearance, prolonged economic recession, and currency fluctuations could have material adverse effects in the future. Our intellectual property rights are important to our operations, and we could suffer loss if they infringe upon others’ rights or are infringed upon by others. We rely on a combination of patents, copyrights, trademarks and trade secrets, confidentiality provisions and licensing arrangements to establish and protect our proprietary rights. To this end, we hold rights to a number of patents and registered trademarks and regularly file applications to attempt to protect our rights in new technology and trademarks. However, there is no guarantee that our patent applications will become issued patents, or that our trademark applications will become registered trademarks. In addition, effective copyright, patent and trade secret protection may be unavailable, limited or not applied for in certain countries. Moreover, even if approved, our patents or trademarks may thereafter be successfully challenged by others or otherwise become invalidated for a variety of reasons. Thus, any patents or trademarks we currently have or may later acquire may not provide us a significant competitive advantage. The value of our products relies substantially on our technical innovation in fields in which there are many patent filings. Third parties may claim that we or our customers (some of whom are indemnified by us) are infringing their intellectual property rights. For example, individuals and groups may purchase intellectual property assets for the purpose of asserting claims of infringement and attempting to extract settlements from us or our customers. The number of these claims has increased in recent years and may continue to increase in the future. Such claims could have a material adverse effect on our business and financial condition. From time to time we receive letters alleging infringement of patents, trademarks or other intellectual property rights and we have been, and currently are, a defendant in lawsuits alleging patent infringement. Litigation concerning patents or other intellectual property is costly and time consuming. We may seek licenses from such parties, but they could refuse to grant us a license or demand commercially unreasonable terms. Such infringement claims could also cause us to incur substantial liabilities and to suspend or permanently cease the use of critical technologies or processes or the production or sale of major products. We may become subject to significant product liability costs. If our products malfunction or contain errors or defects, we could be subject to significant liability for personal injury and property damage and, under certain circumstances, could be subject to a judgment for punitive damages. We maintain insurance against accident-related risks involving our products. However, there can be no assurance that such insurance would be sufficient to cover the cost of damages to others or that such insurance will continue to be available at commercially reasonable rates. In addition, insurance coverage may not cover awards of punitive damages and may not cover the cost of associated legal fees and defense costs, which could result in lower margins. If we are unable to maintain sufficient insurance to cover product liability costs or if our insurance coverage does not cover the award, this could have a material adverse impact on our business, financial condition and results of operations. 19 We have claims and lawsuits against us that may result in adverse outcomes. We are subject to a variety of claims and lawsuits. Adverse outcomes in some or all of these claims may result in significant monetary damages or injunctive relief that could adversely affect our ability to conduct our business. Litigation and other claims are subject to inherent uncertainties and the outcomes can be difficult to predict. Management may not adequately reserve for a contingent liability, or we may suffer unforeseen liabilities, which could then impact the results of a financial period. A material adverse impact on our consolidated financial statements could occur for the period in which the effect of an unfavorable final outcome becomes probable and reasonably estimable and could harm our results of operations and financial condition. Continued declines in consumer auto revenue could negatively impact the carrying value of the goodwill associated with the reporting unit. We experienced substantial growth through 2008 in our auto segment as PNDs became mass-market consumer electronics in both Europe and North America. The consumer auto market has been declining as competing technologies emerged and market saturation occurred. Navigation technologies have been incorporated into and become more prevalent in competing devices such as mobile handsets, tablets, and new automobiles through factory-installed systems. The acceptance by consumers of these alternative solutions has negatively impacted sales and profits in the consumer auto segment. There is no assurance that the decline in sales will end, and thus no assurance that we can continue to generate profits from the consumer auto segment, which could put some or all of the goodwill associated with the consumer auto reporting unit at further risk of impairment. Our products may contain undetected security vulnerabilities, which could result in damage to our reputation, lost revenue, diverted development resources and increased warranty claims, and litigation. Undiscovered vulnerabilities in our products could expose them to hackers or other unscrupulous third parties who develop and deploy viruses and other malicious software programs that could attack our products. Actual or perceived security vulnerabilities in our products could harm our reputation and lead some customers to return products, to reduce or delay future purchases, or use competing products. Our business is subject to a variety of United States and international laws, regulations and other legal obligations regarding data protection. We collect, store, process, and use personal information and other user data. Our users’ personal information may include, among other information, names, addresses, phone numbers, email addresses, payment account information, height, weight, age, gender, heart rates, sleeping patterns, GPS-based location, and activity patterns. Regulatory authorities and legislative bodies around the world, including in the United States, have enacted or are considering enacting a number of legislative and regulatory proposals concerning data protection. These laws continue to develop and may be inconsistent from jurisdiction to jurisdiction. Complying with these various laws could cause us to incur substantial costs or require us to change our business practices in a manner adverse to our business. Noncompliance could result in significant penalties, governmental investigations and regulatory proceedings, litigation, harm to our brand, and a decrease in the use of our products and services. Many of these laws provide for significant penalties. Under the General Data Protection Regulation in the European Union, for example, potential penalties can be as high as 4% of a company’s total global revenue. Gross margins for our products may fluctuate or erode. Gross margins in some of our segments are volatile and could decline in the future due to competitive price reductions that are not fully offset by material cost reductions. In addition, our overall gross margin may fluctuate from period to period due to a number of factors, including product mix, competition and unit volumes. In particular, the average selling prices of a specific product tend to decrease over that product’s life. To offset such decreases, we intend to rely primarily on component cost reduction, obtaining yield improvements and corresponding cost reductions in the manufacturing of existing products and on introducing new products that incorporate advanced features and therefore can be sold at higher average selling prices. However, there can be no assurance that we will be able to obtain any such yield improvements or cost reductions or introduce any such new products in the future. To the extent that such cost reductions and new product introductions do not occur in a timely manner or our products do not achieve market acceptance, our business, financial condition and results of operations could be materially adversely affected. 20 Changes in our United States federal income tax classification, or that of our subsidiaries, could result in adverse tax consequences to our 10% or greater U.S. shareholders. The Tax Cuts and Jobs Act (the “2017 Act”) signed on December 22, 2017 may have changed the consequences to U.S. shareholders that own, or are considered to own, as a result of the attribution rules, ten percent or more of the voting power or value of the stock of a non-U.S. corporation (a 10% U.S. shareholder) under the U.S. federal income tax law applicable to owners of U.S. controlled foreign corporations (“CFCs”). The 2017 Act repealed Internal Revenue Code Section 958(b)(4), which, unless clarified in future regulations or other guidance, may result in classification of certain of the Company’s foreign subsidiaries as CFCs with respect to any single 10% U.S. shareholder. This may be the result without regard to whether 10% U.S. shareholders together own, directly or indirectly, more than fifty percent of the voting power or value of the Company as was the case under prior rules. Additional tax consequences to 10% U.S. shareholders of a CFC may result from other provisions of the 2017 Act. For example, the 2017 Act added Section 951A which requires a 10% U.S. shareholder of a CFC to include in income its pro-rata share of the global intangible low-taxed income (GILTI) of the CFC. The 2017 Act also eliminated the requirement in Section 951(a) necessitating that a foreign corporation be considered a CFC for an uninterrupted period of at least 30 days in order for a 10% U.S. shareholder to have a current income inclusion. From time to time, the Company may elect to employ antidilutive measures such as a stock buyback program. These measures could inadvertently create additional 10% U.S. shareholders and thus trigger adverse tax consequences for those shareholders as described above. We urge shareholders to consult their individual tax advisers for advice regarding the 2017 Act revisions to the U.S. federal income tax law applicable to owners of CFCs given the current uncertainty regarding their scope of applicability. Some of our products are subject to governmental regulation or certification. Failure to obtain required certifications of our products on a timely basis, either due to government shutdown or other delays in the certification process, could harm our business. Federal Aviation Administration (FAA) certification is required for all of our aviation products that are intended for installation in type-certificated aircraft. To the extent required, certification is an expensive and time-consuming process that requires significant focus and resources. An inability to obtain, or excessive delay in obtaining, such certifications could have an adverse effect on our ability to introduce new products and, for certain aviation OEM products, our customers’ ability to sell airplanes. Delays in our obtaining certification for our aviation products have resulted and may in the future result in our being required to pay compensation to our customers. Additionally, failure of the United States Congress to appropriate funds for FAA operations that results in a shutdown of FAA operations or furloughing of FAA employees, due to partial or complete government shutdowns or otherwise, could result in delays in the required FAA certification of our avionics products and in the production, sale and registration of aircraft that use our avionics products. Therefore, such inabilities or delays could have a material adverse effect on our business and financial results. In addition, we cannot assure that our certified products will not be decertified. Any such decertification could have an adverse effect on our operating results. In addition, in accordance with FCC rules and regulations, wireless transceiver products are required to be certified by the FCC in the United States and comparable authorities in foreign countries where they are sold. Garmin’s products sold in Europe are required to comply with relevant directives of the European Commission. A delay in receiving required certifications for new products, or enhancements to Garmin’s products, or losing certification for Garmin’s existing products could adversely affect our business. 21 Our business may suffer if we are not able to hire and retain sufficient qualified personnel or if we lose our key personnel. Our future success depends partly on the continued contribution of our key executive, engineering, sales, marketing, manufacturing and administrative personnel. We currently do not have employment agreements with any of our key executive officers. Swiss law prohibits us from paying severance payments to our senior executive officers, which may impair our ability to recruit for these positions. We do not have key person life insurance on any of our key executive officers and do not currently intend to obtain such insurance. The loss of the services of any of our senior level management, or other key employees, could harm our business. Recruiting and retaining the skilled personnel we require to maintain and grow our market position may be difficult. For example, in recent years there has been a global shortage of qualified engineers who are necessary for us to design and develop new products, and therefore, it has sometimes been challenging to recruit such personnel. If we fail to hire and retain qualified employees, we may not be able to maintain and expand our business. Our quarterly operating results are subject to fluctuations and seasonality. Our operating results are difficult to predict. Our future quarterly operating results may fluctuate significantly. If such operating results decline, the price of our stock could decline. As we have expanded our operations, our operating expenses, particularly our research and development costs, have increased as a percentage of our sales in some periods. If revenues decrease and we continue to increase research and development costs, our operating results would be negatively affected. Historically, our revenues have been lower in the first quarter of each fiscal year as many of our devices are highly consumer-oriented, and consumer buying is traditionally lower in this quarter. Sales of certain of our auto, fitness, marine, and outdoor products tend to be higher in our second fiscal quarter due to increased consumer spending for such products in the spring season and travel season. Sales of many of our consumer products also have been higher in our fourth fiscal quarter due to increased consumer spending patterns on electronic devices during the holiday season. We rely on independent dealers and distributors to sell our products, and disruption to these channels would harm our business. Because we sell many of our products to independent dealers and distributors, we are subject to many risks, including risks related to their inventory levels and support for our products. In particular, our dealers and distributors maintain significant levels of our products in their inventories. If dealers and distributors attempt to reduce their levels of inventory or if they do not maintain sufficient levels to meet customer demand, our sales could be negatively impacted. Many of our dealers and distributors also sell products offered by our competitors. If our competitors offer our dealers and distributors more favorable terms, those dealers and distributors may de-emphasize or decline to carry our products. In the future, we may not be able to retain or attract a sufficient number of qualified dealers and distributors. If we are unable to maintain successful relationships with dealers and distributors or to expand our distribution channels, our business will suffer. We may pursue strategic acquisitions, investments, strategic partnerships or other ventures, and our business could be materially harmed if we fail to successfully identify, evaluate, complete, and integrate such transactions. We continually evaluate acquisition opportunities and opportunities to make investments in complementary businesses, technologies, services or products, or to enter into strategic partnerships with parties who can provide access to those assets, additional product or services offerings, additional distribution or marketing synergies or additional industry expertise. We may not be able to identify suitable acquisition, investment or strategic partnership candidates, or if we do identify suitable candidates in the future, we may not be able to complete those transactions on commercially favorable terms, or at all. 22 Any past or future acquisition could also result in difficulties assimilating acquired employees, operations, and products and diversion of capital and management’s attention away from other business issues and opportunities. Integration of acquired companies may result in problems related to integration of technology and inexperienced management teams. Due diligence performed prior to closing acquisitions may not uncover certain risks or liabilities that could materially impact our business and financial results. In addition, the key personnel of the acquired company may decide not to work for us. We may not successfully integrate internal controls, compliance under the Sarbanes-Oxley Act of 2002, the GDPR and other corporate governance and regulatory matters, operations, personnel or products related to acquisitions we may make in the future. If we fail to successfully integrate such transactions, our business could be materially harmed. Many of our products rely on the Global Positioning System and other Global Satellite Navigation Systems (GNSS). The Global Positioning System (GPS) is a satellite-based navigation and positioning system consisting of a constellation of orbiting satellites. The satellites and their ground control and monitoring stations are maintained and operated by the United States Department of Defense. The Department of Defense does not currently charge users for access to the satellite signals. These satellites and their ground support systems are complex electronic systems subject to electronic and mechanical failures and possible sabotage. GPS satellites have a limited lifespan and are subject to damage by the hostile space environment in which they operate. While many of the original satellites deployed by the U.S. have been in operation for more than 20 years, the U.S. Space Force and Missile Systems Center continue to launch new satellites to replace retired and aged satellites. Despite ongoing efforts to repair, maintain and replace non-operational satellites, if a significant number of satellites were to become inoperable, there could be a substantial delay before they are replaced with new satellites. A reduction in the number of operating satellites may impair the current utility of GPS and the growth of current and additional market opportunities. Furthermore, as GPS satellites and ground control segments are being modernized, software updates can cause problems. We depend on public access to open technical specifications in advance of GPS updates. GPS is operated by the U.S. Government, which is committed to maintenance and improvement of GPS; however, if the policy were to change, and commercial access to GPS was no longer supported by the U.S. Government, or if user fees were imposed, it could have a material adverse effect on our business, results of operations, and financial condition. Some of our products also use signals from Satellite Based Augmentation Systems (SBAS) that augment GPS, such as the U.S. Wide Area Augmentation System (WAAS), Japanese MTSAT-based Satellite Augmentation System (MSAS), and European Geostationary Navigation Overlay Service (EGNOS). Any curtailment of SBAS operating capability could result in decreased user capability for many of our aviation products, thereby impacting our markets. Some of our products also use satellite signals from Russia’s GLONASS, Japan’s MSAS, EGNOS’ aviation SoL service, the European Union Galileo system, and the Chinese BDS. National or European authorities may provide preferential access to signals to companies associated with their markets, including our competitors, which could harm our competitive position. Use of non-US GNSS signals may also be subject to FCC waiver requirements and to restrictions based upon international trade or geopolitical considerations. If we are unable to develop timely and competitive commercial products using these systems, or obtain timely and equal access to service signals, it could result in lost revenue. Our business is subject to disruptions and uncertainties caused by geopolitical instability, war or terrorism. Acts of war or acts of terrorism, especially any directed at the GPS signals, could have a material adverse impact on our business, operating results, and financial condition. The threat of terrorism and war and heightened security and military response to this threat, or any future acts of terrorism, may cause a redeployment of the satellites used in GPS or interruptions of the system. To the extent that such interruptions have an effect on sales of our products, this could have a material adverse effect on our business, results of operations, and financial condition. 23 A shut down of airspace or imposition of restrictions on general aviation would harm our business. The shutdown of airspace could cause reduced sales of our general aviation products and delays in the shipment of our products manufactured in our Taiwan manufacturing facilities to our global distribution facilities, thereby adversely affecting our ability to supply new and existing products to our dealers and distributors. Any reallocation or repurposing of radio frequency spectrum could cause harmful interference with the reception of Global Positioning System signals. This interference could harm our business. Our Global Positioning System technology is dependent on the use of the Standard Positioning Service (SPS) provided by the U.S. Government’s GPS satellites. GPS operates in radio frequency bands that are globally allocated for radio navigation satellite services. International allocations of radio frequency are made by the International Telecommunications Union (ITU), a specialized technical agency of the United Nations. These allocations are further governed by radio regulations that have treaty status and which may be subject to modification every two to three years by the World Radio Communication Conference. Each country also has regulatory authority on how each band is used. In the United States, the FCC and the National Telecommunications and Information Administration (NTIA) share responsibility for radio frequency allocations and spectrum usage regulations. Any ITU or national reallocation of radio frequency spectrum, including frequency band segmentation or sharing of spectrum, or other modifications of the permitted uses of relevant frequency bands, may materially and adversely affect the utility and reliability of our products and have significant negative impacts on our business and our customers. Natural disasters, catastrophic events, or climate change could affect our financial results. Natural disasters and extreme weather events, such as tsunamis, typhoons, floods, wildfires, or earthquakes, could occur in a region where we have a manufacturing or warehousing facility which would cause disruptions in our business operations or loss of inventory. Global climate change could also result in certain types of natural disasters occurring more frequently or with more intense effects. For descriptions and locations of our principal properties, see Item 2, “Properties”. These events could also have an impact on our suppliers and affect our supply chain. If our backup and recovery plans are not sufficient to minimize business disruption and if our insurance is not sufficient to recover the costs associated with these types of events, our financial results could be adversely affected. Climate change can also pose a risk to our business due to evolving regulatory and legislative measures surrounding climate change. The U.S. Environmental Protection Agency regulates greenhouse gas emissions under the authority granted to it under the Clean Air Act. U.S. Congress, in addition to other regulatory authorities and legislative bodies around the world, could pass further legislation to mandate greenhouse gas emission reduction, implement cap-and-trade programs, or promote renewable energy and energy efficiency. Such measures could influence mobility and transportation trends, which could decrease the demand for certain of our products. If climate change has impacts on natural disasters or the regulatory environment as discussed above, it could result in a change in demand for certain products in markets that we serve, including auto, aviation, and marine. If we fail to adjust our product and service offerings to respond to new opportunities driven by changes in regulation and/or consumer preferences, it could have an adverse effect on our financial results. Because it is uncertain what laws and regulations will be enacted, we cannot predict the potential impact of such laws and regulations on our future consolidated financial condition, results of operations or cash flows. 24 Risks Relating to Our Shares The volatility of our stock price could adversely affect investment in our common shares. The market price of our shares has been, and may continue to be, highly volatile. During 2020, the closing price of our shares ranged from a low of $63.63 to a high of $122.85. A variety of factors could cause the price of our shares to fluctuate, perhaps substantially, including: • new products or product enhancements by us or our competitors; • general conditions in the worldwide economy, including fluctuations in interest rates and global currency exchange rates; • announcements of technological innovations; • product obsolescence and our ability to manage product transitions; • developments in our relationships with our customers and suppliers; • the availability, pricing and timeliness of delivery of components, such as flash memory and liquid crystal displays, used in our products; • quarterly fluctuations in our actual or anticipated operating results; • changes in applicable tax laws and tax rates; • developments in patents or other intellectual property rights and litigation; • announcements and rumors of developments related to our business, our competitors, our suppliers or the markets in which we compete; • research reports or opinions issued by securities analysts or brokerage houses related to Garmin, our competitors, our suppliers or our customers; • any significant acts of terrorism against the United States, Taiwan or significant markets where we sell our products; and • other factors as discussed in the previously listed risks. In addition, in recent years the stock market in general and the markets for shares of technology companies in particular, have experienced extreme price fluctuations which have often been unrelated to the operating performance of affected companies. Any such fluctuations in the future could adversely affect the market price of our common shares. Our officers and directors exert substantial influence over us. As of January 26, 2021, members of our Board of Directors and our executive officers, together with their respective immediate family members and entities that may be deemed affiliates of or related to such persons or entities, beneficially owned approximately 22% of our outstanding shares. Accordingly, these shareholders may be able to determine the outcome of corporate actions requiring shareholder approval, such as mergers and acquisitions and shareholder proposals. This level of ownership may have a significant effect in delaying, deferring, or preventing a change in control of Garmin and may adversely affect the voting and other rights of other holders of our common shares. The rights of our shareholders are governed by Swiss law. The rights of our shareholders are governed by Swiss law and Garmin Ltd.’s articles of association. The rights of shareholders under Swiss law differ from the rights of shareholders of companies incorporated in other jurisdictions. For example, Swiss law allows our shareholders acting at a shareholders’ meeting to authorize share capital that can be issued by the board of directors without approval of a shareholders’ meeting, but this authorization is limited to 50% of the existing registered share capital and must be renewed at a shareholders’ meeting at least every two years for it to continue to be available. Additionally, subject to specified exceptions, including the exceptions described in our articles of association, Swiss law grants preemptive rights to existing shareholders to subscribe for new issuances of shares and other securities. Swiss law also does not provide as much flexibility in the various terms that can attach to different classes of shares as the laws of some other jurisdictions. Swiss law also reserves for approval by shareholders certain corporate actions over which a board of directors would have authority in some other jurisdictions. For example, Swiss law provides that dividends and other distributions must be approved by shareholders at the general meeting of shareholders. These Swiss law requirements relating to our capital management may limit our flexibility, and situations may arise where greater flexibility would have provided substantial benefits to our shareholders. 25 We have limited capital reserves from which to make distributions or repurchase shares without subjecting our shareholders to Switzerland withholding tax. As of December 26, 2020, we had CHF 5,214 million of unappropriated capital contribution reserves available from which the Company may make dividend payments or utilize to repurchase shares for which no withholding tax applies. At the time this reserve balance has been returned to shareholders through dividends or share repurchases, a Swiss federal withholding tax of 35% will generally be applicable to any dividends paid to shareholders. The withholding tax must be withheld from the gross distribution and paid to the Swiss federal Tax Administration. A holder that qualifies for benefits under a double tax treaty may be able to recover partial withholding tax. For example, a U.S holder that qualifies for benefits under the Convention between the United States of America and the Swiss Confederation for the Avoidance of Double Taxation with Respect to Taxes on Income may apply for a refund of the tax withheld in excess of the 15% treaty rate (or in excess of the 5% reduced treaty rate for qualifying corporate shareholders with at least 10% participation in our voting stock, or for a full refund in case of qualified pension funds). After we have exhausted our remaining capital contribution reserves by appropriating them for dividends or share repurchases, any dividends paid by the Company will generally be subject to a Swiss federal withholding tax at 35%. However, there can be no assurance that our shareholders will approve a dividend out of capital contribution reserves, or that Swiss withholding rules will not be changed in the future or that a change in Swiss law will not adversely affect us or our shareholders, in particular as a result of distributions out of capital contribution reserves becoming subject to additional corporate law or other restrictions. If we are unable to pay a dividend out of capital contribution reserves, we may not be able to make distributions without subjecting our shareholders to Swiss withholding taxes. Under current Swiss tax law, repurchases of shares for the purposes of capital reduction are treated as a partial liquidation subject to 35% Swiss withholding tax on the difference between the par value and the repurchase price. However, the portion of the repurchase price that is attributed to capital contribution reserves of the shares repurchased will not be subject to the Swiss withholding tax. Therefore, repurchase of our own shares further limits the amount of capital reserves available for distributions to shareholders free of Swiss withholding taxes. No partial liquidation treatment applies and no withholding tax is triggered if the shares are not repurchased for cancellation but held by us as treasury shares to the extent sufficient capital reserves are available. However, should we not resell such treasury shares within six years and there is not sufficient capital contribution reserves, the withholding tax becomes due at the end of the six-year period. There is uncertainty as to our shareholders’ ability to enforce certain foreign civil liabilities in Switzerland and Taiwan. We are a Swiss company and a substantial portion of our assets are located outside the United States, particularly in Taiwan. As a result, it may be difficult to effect service of process within the United States upon us. In addition, there is uncertainty as to whether the courts of Switzerland or Taiwan would recognize or enforce judgments of United States courts obtained against us predicated upon the civil liability provisions of the securities laws of the United States or any state thereof, or be competent to hear original actions brought in Switzerland or Taiwan against us predicated upon the securities laws of the United States or any state thereof. We have certain limitations on our ability to repurchase and hold our own shares. Under Swiss law we have certain limitations on our ability to repurchase and hold our own shares. We and our subsidiaries may only repurchase and hold our own shares to the extent that sufficient freely distributable reserves (including contributed surplus as determined for Swiss tax and statutory purposes) are available. The aggregate par value of our registered shares held by us and our subsidiaries may not exceed 10% of our registered share capital. We may repurchase our registered shares beyond the statutory limit of 10%, however, if our shareholders have adopted a resolution at a general meeting of shareholders authorizing the board of directors to repurchase registered shares in an amount in excess of 10% and the repurchased shares are dedicated for cancellation. Any restriction on our ability to repurchase our shares could make our stock less attractive to investors. Item 1B.Unresolved Staff Comments None. 26 Item 2.Properties Garmin and its subsidiaries own a majority of their principal properties and lease certain other properties. Depending on location, the properties could be used for manufacturing, warehousing, research and development, office space, or a combination of activities. Garmin’s principal properties are described below: Garmin International, Inc. owns and occupies facilities of approximately 1,990,000 square feet on approximately 107 acres at 1200 East 151st Street, Olathe, Kansas, U.S. where the majority of product design and development work is conducted, the majority of aviation panel-mount products are manufactured, and products are warehoused, distributed, and supported for North, Central and South America. The 1,990,000 square feet includes a newly constructed 775,000 square foot manufacturing and distribution center. In connection with the bond financings for the facility in Olathe and the expansions of that facility, the City of Olathe holds the legal title to the Olathe facilities, which are leased to Garmin’s subsidiaries by the City. Upon the payment in full of the outstanding bonds, the City of Olathe is obligated to transfer title to Garmin’s subsidiaries for the aggregate sum of $200. Garmin International, Inc. has purchased all the outstanding bonds and expects to continue to hold the bonds until maturity in order to benefit from property tax abatement. Garmin International, Inc. leases 148,000 square feet of land at New Century Airport at 1 New Century Pkwy, Gardner, Kansas, U.S. under a ground lease and occupies two aircraft hangars on this land, one of which is owned (47,000 square feet) and the other leased (53,000 square feet). Both properties serve as flight test and certification facilities that are used in development and certification of aviation products. Garmin AT, Inc. leases approximately 18 acres of land at 2345 Turner Road SE, Salem, Oregon, U.S. under a ground lease. The current term of this ground lease ends in 2030, but Garmin AT, Inc. has the option to extend the ground lease until 2050. Garmin AT, Inc. owns and occupies a 115,000 square foot facility for office and manufacturing use and a 33,000 square foot aircraft hangar that serves as a flight test and certification facility on this land. Garmin AT, Inc. also owns and occupies an additional 66,000 square foot facility on the same property for customer support and research and development activities. Garmin Corporation owns and occupies a 247,000 square foot facility at No. 68, Zhangshu 2nd Road, Xizhi Dist., New Taipei City, Taiwan, a 185,000 square foot facility at No.97, Sec. 1, Xintai 5th Rd., Xizhi Dist., New Taipei City, Taiwan, a 224,000 square foot facility at No. 24 Beiyuan Road, Jhongli, Tao-Yang County, Taiwan, and a 576,000 square foot facility at No. 270 Huaya 2nd Road, LinKou, Tao-Yang County, Taiwan. Garmin China YangZhou Co., Ltd. leases a 204,000 square foot manufacturing facility at No. 122, Jinshan Road, Bali Town, Yangzhou, Jiangsu, People’s Republic of China. These facilities are used for the manufacturing and warehousing of most of Garmin’s auto, fitness, marine, and outdoor products, as well as portable aviation products. These facilities are also used for research and development activities and marketing and support of products for Asia Pacific countries. Garmin (Europe) Ltd. owns and occupies a 155,000 square foot building located at Liberty House, Hounsdown Business Park, Southampton, U.K., used as offices and a distribution facility. Tacx B.V. owns and occupies a 291,000 square foot facility located at De Boeg 2, 2343 MA Oegstgeest, Netherlands. This facility is used for design and development, manufacturing, and warehousing of indoor training products. Garmin Wroclaw sp. zo.o leases a 319,000 square foot facility located at Ul. Ryszarda Chomicza 2, 55-040 Biskupice Podgórne, Poland. This facility is used for the manufacturing of certain auto OEM products, as well as distribution of other Garmin products in the region. Garmin also owns and leases other properties around the world that are not described above and used for office space, warehousing, and retail. 27 Item 3. Legal Proceedings In the normal course of business, the Company and its subsidiaries are parties to various legal claims, actions, and complaints, including matters involving patent infringement, other intellectual property, product liability, customer claims and various other risks. It is not possible to predict with certainty whether or not the Company and its subsidiaries will ultimately be successful in any of these legal matters, or if not, what the impact might be. However, the Company’s management does not expect that the results in any of these legal proceedings will have a material adverse effect on the Company’s results of operations, financial position or cash flows. The Company settled or resolved certain matters during the fiscal year ended December 26, 2020 that did not individually or in the aggregate have a material impact on the Company’s financial condition or results of operations. Item 4. Mine Safety Disclosure None. Information about our Executive Officers Pursuant to General Instruction G(3) of Form 10-K and instruction 3 to paragraph (b) of Item 401 of Regulation S-K, the following list is included as an unnumbered Item in Part I of this Annual Report on Form 10-K in lieu of being included in the Company’s Definitive Proxy Statement in connection with its annual meeting of shareholders scheduled for June 4, 2021. Dr. Min H. Kao, age 72, has served as Executive Chairman of Garmin Ltd. since January 2013 and was previously Chairman of Garmin Ltd. from August 2004 to December 2012 and Co-Chairman of Garmin Ltd. from August 2000 to August 2004. He served as Chief Executive Officer of Garmin Ltd. from August 2002 to December 2012 and previously served as Co-Chief Executive Officer from August 2000 to August 2002. Dr. Kao served as a director and officer of various subsidiaries of the Company from August 1990 until January 2013. Dr. Kao holds Ph.D. and MS degrees in Electrical Engineering from the University of Tennessee and a BS degree in Electrical Engineering from National Taiwan University. Clifton A. Pemble, age 55, has served as a director of Garmin Ltd. since August 2004. He has served as President and Chief Executive Officer of Garmin Ltd. since January 2013. Previously, he served as President and Chief Operating Officer of Garmin Ltd. from October 2007 to December 2012. Previously, he was Vice President, Engineering of Garmin International, Inc. from 2005 to October 2007, Director of Engineering of Garmin International, Inc. from 2003 to 2005, Software Engineering Manager of Garmin International, Inc. from 1995 to 2002, and a Software Engineer with Garmin International, Inc. from 1989 to 1995. Mr. Pemble has served as a director and officer of various Garmin subsidiaries since August 2003. Mr. Pemble holds BA degrees in Mathematics and Computer Science from MidAmerica Nazarene University. 28 Douglas G. Boessen, age 58, has served as Chief Financial Officer and Treasurer of Garmin Ltd. since July 2014. He previously served as Chief Financial Officer of EiKO Global, LLC from September 2013 to May 2014, as well as Collective Brands, Inc. from November 1997 to November 2012. Mr. Boessen has served as a director and officer of various Garmin subsidiaries since July 2014. Mr. Boessen is a certified public accountant and holds a BS degree in Business from the University of Central Missouri and is a graduate of the executive development program at Northwestern University’s Kellogg Graduate School of Management. Andrew R. Etkind, age 65, has served as Vice President, General Counsel and Secretary of Garmin Ltd. since June 2009. He was previously General Counsel and Secretary of Garmin Ltd. from August 2000 to June 2009. He has been Vice President and General Counsel of Garmin International, Inc. since July 2007, General Counsel since February 1998, and Secretary since October 1998. Mr. Etkind has served as a director and officer of various Garmin subsidiaries since December 2001. Mr. Etkind holds BA, MA and LLM degrees from Cambridge University, England and a JD degree from the University of Michigan Law School. All executive officers are elected by and serve at the discretion of the Company’s Board of Directors. None of the executive officers have an employment agreement with the Company. There are no arrangements or understandings between the executive officers and any other person pursuant to which he or she was or is to be selected as an officer. There is no family relationship among any of the executive officers. 29 PART II Item 5. Market for the Company’s Common Shares, Related Shareholder Matters and Issuer Purchases of Equity Securities Garmin’s shares have traded on The Nasdaq Stock Market, LLC under the symbol “GRMN” since its initial public offering on December 8, 2000 (the “IPO”). As of January 31, 2021, there were 199 shareholders of record. The Board of Directors approved a share repurchase program on February 13, 2015, authorizing the Company to repurchase up to $300 million of the Company’s shares as market and business conditions warrant. The share repurchase authorization expired on December 31, 2017. The Company made no repurchases of shares during the years ended December 26, 2020, December 28, 2019, and December 29, 2018. See Note 11 in the Notes to the Consolidated Financial Statements for additional information regarding the share repurchase plan. We refer you to Item 12 of this report under the caption “Equity Compensation Plan Information” for certain equity plan information required to be disclosed by Item 201(d) of Regulation S-K. Stock Performance Graph This performance graph shall not be deemed ‘‘filed’’ with the SEC or subject to Section 18 of the Securities Exchange Act of 1934, nor shall it be deemed incorporated by reference in any of our filings under the Securities Act of 1933, as amended. 30 The graph below matches Garmin Ltd.'s cumulative 5-Year total shareholder return on common stock with the cumulative total returns of the Nasdaq Composite index and the Nasdaq 100 index. The graph tracks the performance of a $100 investment in our common stock and in each index (with the reinvestment of all dividends) from December 31, 2015 (“12/15”) to December 31, 2020 (“12/20”). 12/15 12/16 12/17 12/18 12/19 12/20 Garmin Ltd. 100.00 136.60 174.28 191.41 302.68 380.74 NASDAQ Composite 100.00 108.87 141.13 137.12 187.44 271.64 NASDAQ 100 100.00 107.27 142.67 142.72 199.03 296.31 The stock price performance included in this graph is not necessarily indicative of future stock price performance. 31 Item 6. Selected Financial Data The following table sets forth selected consolidated financial data of the Company. The selected consolidated balance sheet data as of December 26, 2020 and December 28, 2019 and the selected consolidated statements of income data for the years ended December 26, 2020, December 28, 2019, and December 29, 2018 were derived from the Company’s audited Consolidated Financial Statements and the related notes thereto which are included in Item 8 of this annual report on Form 10-K. The selected consolidated balance sheet data as of December 29, 2018, December 30, 2017, and December 31, 2016 and the selected consolidated statements of income data for the years ended December 30, 2017 and December 31, 2016 were derived from the Company’s audited Consolidated Financial Statements, not included herein. The information set forth below is not necessarily indicative of the results of future operations and should be read together with "Management's Discussion and Analysis of Financial Condition and Results of Operations" and the Consolidated Financial Statements and notes to those statements included in Items 7 and 8 in Part II of this Form 10-K. The Company adopted Accounting Standards Update No. 2014-09, Revenue from Contracts with Customers (Topic 606) effective beginning with the Company’s first quarter of 2018. Adoption of the new revenue recognition standard was applied using the full retrospective method, and information for prior periods within Item 6 in Part II of this Form 10-K have been restated accordingly. In the table presented below, the selected consolidated statements of income and selected balance sheet data for the years ended December 30, 2017 and December 31, 2016 have been restated in accordance with the Company’s adoption of the new revenue recognition standard. 32 Years ended (1) Dec. 26, 2020 Dec. 28, 2019 Dec. 29, 2018 Dec. 30, 2017 Dec. 31, 2016 (in thousands, except per share data) Consolidated Statements of Income Data: Net sales $ 4,186,573 $ 3,757,505 $ 3,347,444 $ 3,121,560 $ 3,045,797 Gross profit 2,481,336 2,233,976 1,979,719 1,797,941 1,688,525 Operating income 1,054,240 945,586 778,343 683,637 632,864 Net income (2) 992,324 952,486 694,080 709,007 517,724 Net income per share: Diluted $ 5.17 $ 4.99 $ 3.66 $ 3.76 $ 2.73 Weighted average common shares outstanding: Diluted 191,895 190,899 189,734 188,732 189,343 Dividends declared per share (3) $ 2.44 $ 2.28 $ 2.12 $ 2.04 $ 2.04 Balance Sheet Data (at end of Period): Cash, cash equivalents, and marketable securities $ 2,977,259 $ 2,609,505 $ 2,714,844 $ 2,313,208 $ 2,327,120 Total assets 7,031,373 6,166,799 5,382,858 4,948,289 4,484,549 Total debt — — — — — Total stockholders’ equity 5,516,116 4,793,496 4,162,974 3,852,419 3,453,259 (1) Our fiscal year-end is the last Saturday of the calendar year and does not always fall on December 31. All years presented contain 52 weeks, excluding fiscal 2016 which includes 53 weeks. (2) The following significant items are included in the Net income line that may affect comparability: In 2020, a $14.3 million tax benefit was recognized resulting from the release of uncertain tax position reserves associated with a 2014 intercompany restructuring, partially offset by income tax expense of $11.0 million resulting from the revaluation of certain Switzerland tax assets related to the Switzerland tax reform transitional measures; In 2019, a $118.0 million income tax benefit was recognized resulting from the revaluation and step-up of certain Switzerland tax assets as a result of the enactment of Switzerland Federal and Schaffhausen cantonal tax reform and related transitional measures; In 2017, a $180.0 million income tax benefit was recognized, primarily related to the revaluation of certain Switzerland deferred tax assets resulting from the Company's election to align Switzerland corporate tax positions with global tax initiatives, partially offset by $22.6 million of income tax expense due to the expiration of certain share-based awards. (3) Dividends declared per share refers to the cash dividend per share that has been approved by shareholders in the given fiscal year. See Note 2 - Summary of Significant Accounting Policies, Dividends for additional detail. 33 Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations The following discussion and analysis of our financial condition and results of operations focuses on and is intended to clarify the results of our operations, certain changes in our financial position, liquidity, capital structure and business developments for the periods covered by the Consolidated Financial Statements included in this Form 10-K. This discussion should be read in conjunction with, and is qualified by reference to, the other related information including, but not limited to, the audited Consolidated Financial Statements (including the notes thereto), the description of our business, all as set forth in this Form 10-K, as well as the risk factors discussed above in Item 1A. This section provides discussion and a year-to-year comparison for the fiscal years ended December 26, 2020 and December 28, 2019. Discussion regarding our results of operations for the fiscal year ended December 29, 2018 and a year-to-year comparison between the fiscal years ended December 28, 2019 and December 29, 2018 can be found in Item 7 of our Annual Report on Form 10-K for the fiscal year ended December 28, 2019. As previously noted, the discussion set forth below, as well as other portions of this Form 10-K, contain statements concerning potential future events. Readers can identify these forward-looking statements by their use of such verbs as “expects,” “anticipates,” “believes” or similar verbs or conjugations of such verbs. If any of our assumptions on which the statements are based prove incorrect or should unanticipated circumstances arise, our actual results could materially differ from those anticipated by such forward-looking statements. The differences could be caused by a number of factors or combination of factors including, but not limited to, those discussed above in Item 1A. Readers are strongly encouraged to consider those factors when evaluating any such forward-looking statement. Except as may be required by law, we do not undertake to update any forward-looking statements in this Form 10-K. Garmin’s fiscal year is a 52-53 week period ending on the last Saturday of the calendar year. Fiscal years 2020, 2019 and 2018 contained 52 weeks. Unless otherwise stated, all years and dates refer to the Company’s fiscal year and fiscal periods. Unless the context otherwise requires, references in this document to "we," "us," "our" and similar terms refer to Garmin Ltd. and its subsidiaries. Unless otherwise indicated, dollar amounts set forth in the tables are in thousands, except per share data. Overview We are a leading worldwide provider of navigation, communications and information devices, most of which are enabled by Global Positioning System, or GPS, technology. Garmin is organized in the six operating segments of auto OEM, aviation, consumer auto, fitness, marine, and outdoor. The Company’s Chief Executive Officer, who has been identified as the Chief Operating Decision Maker (CODM), allocates resources and assesses performance of each operating segment individually. The aviation, fitness, marine, and outdoor operating segments represent reportable segments. The auto OEM and consumer auto operating segments, which serve the auto market, do not meet the quantitative thresholds to separately qualify as reportable segments, and they are therefore reported together in an “all other” category captioned as auto. Auto, aviation, fitness, marine, and outdoor are collectively referred to as our reported segments. The operating segments offer products through our network of subsidiary distributors and independent dealers and distributors, our own webshop, as well as through various auto, aviation, and marine OEMs. Each of the operating segments is managed separately. The consumer auto operating segment was previously referred to as our auto PND operating segment. We have revised the name of this operating segment to reflect the evolution of the product lines and focus of that part of our business. The name change did not impact the composition or operating results of the segment. Since our first products were delivered in 1991, we have generated positive income from consolidated operations each year and have funded our growth from these profits. 34 Impacts of COVID-19 The COVID-19 pandemic has created disruption and uncertainty in the global economy and has affected our business, suppliers, and customers. Our operating segments were not all impacted equally, as COVID-19 had an unfavorable impact on net sales and profitability of the auto and aviation segments during fiscal year 2020. However, the diversity of our business and product offerings helped mitigate the impacts to our consolidated net sales and operating income. With pre-existing fundamentals such as trade credit insurance, direct online sales through our webshops, direct fulfillment arrangements with certain retailers, our strong cash and marketable securities position, market and product diversity, a vertically integrated business model, and ample inventory on hand, we were well-positioned to mitigate the initial impacts of COVID-19. While COVID-19 continues to evolve into a complicated and prolonged global pandemic, we have implemented further mitigation measures, such as initiating additional direct fulfillment arrangements with retailers, mitigating single source supplier dependencies, enhancing cleaning and sanitation within our facilities to maintain a healthy and safe environment for essential on-site functions, boosting functionality and security of technology for employees who are working from home, and fostering the safe reintegration of our on-site workforce. These mitigation efforts complement our top priorities of ensuring the health and safety of our employees and continuing to serve our customers. Additional benefits have been provided to many of our employees, including increased flexible work arrangements, remote work access, and flexible paid leave policies. We have also focused on mitigating impacts to operating income and liquidity by monitoring our expense structure and balance sheet, reducing and prioritizing certain discretionary operating expenses and capital expenditures, and slowing the number of new employees hired. Sustained adverse impacts to us, our suppliers or our customers may affect the future valuation of certain assets and therefore may increase the likelihood of an impairment charge, write-off, write-down, reserve, or accelerated expense associated with such assets, including marketable securities, accounts receivable, inventories, prepaid expenses, property and equipment, tax assets, goodwill, indefinite and finite-lived intangible assets, capitalized preproduction design and development costs, and other assets. Although we believe we have taken appropriate actions to help mitigate risks associated with COVID-19 as described above, the duration and magnitude of COVID-19 impacts to our business operations and financial results may be affected by a number of factors including uncertainty regarding the evolution of the pandemic, the imposition or relaxation of government restrictions on business and social gathering activities, voluntary behavior changes associated with public health guidance, the efficacy, distribution and uptake of vaccines, and those presented above in Item 1A. Risk Factors of this Annual Report. Critical Accounting Policies and Estimates General Our discussion and analysis of financial condition and results of operations are based upon the Company’s Consolidated Financial Statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The presentation of these financial statements requires management to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On an on-going basis, we evaluate our estimates, including those related to customer sales programs and incentives, product returns, bad debts, inventories, investments, intangible assets, income taxes, warranty obligations, and contingencies and litigation. We base our estimates on historical experience and various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. 35 Goodwill We allocate goodwill to reporting units in proportion to the expected benefit from each business combination. Each of the Company’s operating segments (auto OEM, aviation, consumer auto, fitness, marine, and outdoor) represents a distinct reporting unit. Goodwill is tested for impairment at the reporting unit level on an annual basis and between annual tests if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying value. These events or circumstances could include a significant change in the operating performance indicators, competition, or expectations about future market or economic conditions. Application of the goodwill impairment test requires significant judgment, including the identification of reporting units, assignment of assets and liabilities to reporting units, assignment of goodwill to reporting units, and determination of the fair value of each reporting unit. The fair value of each reporting unit is estimated through the use of a discounted cash flow methodology. This analysis requires significant assumptions, including discount rate, projected future revenues, projected future operating margins, and terminal growth rates. The estimates used to calculate the fair value of a reporting unit change from year to year based on operating results, market conditions, and other factors. Changes in these estimates and assumptions could materially affect the determination of fair value and goodwill impairment for each reporting unit. Unrecognized Income Tax Benefits We recognize liabilities associated with uncertain income tax positions, including those related to transfer pricing, based on our estimate of whether, and the extent to which, additional taxes will be due. We recognize the tax benefits from an uncertain tax position only if payment of these amounts ultimately proves to be not required or it is more likely than not that the tax position will be sustained upon examination by the taxing authorities, based on the technical merits of the position. The tax benefits recognized in the financial statements from such positions are measured based on the largest amount of benefit that is more likely than not to be realized upon ultimate settlement. Assessing uncertain tax positions requires significant judgment, including the evaluation of unique facts and circumstances and the interpretation of laws and regulations, especially the assessment of pricing analyses that may produce various ranges of outcomes. Variations in the actual outcome of these future tax consequences could materially impact our consolidated financial statements. Other For further information on the Company’s critical accounting policies, refer to the discussion in the Notes to the Consolidated Financial Statements as indicated in the table below: Intangible Assets Note 2 - Summary of Significant Accounting Policies Income Taxes Note 2 - Summary of Significant Accounting Policies & Note 6 - Income Taxes Revenue Recognition Note 2 - Summary of Significant Accounting Policies & Note 13 - Revenue Product Warranty Note 2 - Summary of Significant Accounting Policies Legal and Other Contingencies Note 2 - Summary of Significant Accounting Policies & Note 4 - Commitments and Contingencies 36 Accounting Terms and Characteristics Net Sales Our net sales are primarily generated through sales to our retail partners, dealer and distributor network, our own webshop, and to original equipment manufacturers (OEMs). Refer to the Revenue Recognition discussion in Note 2 to the Consolidated Financial Statements. We aim to achieve a quick turnaround on orders we receive from our retail, dealer, and distributor customers. Certain arrangements with OEM customers are entered into at the beginning of an aircraft or vehicle life cycle with the intent to fulfill customer purchasing requirements for the entire production life, although there are generally no firm volume commitments, and sales are therefore generated on an order-by-order basis. As a result, we do not believe backlog information is material to the understanding of our business. Net sales are subject to seasonal fluctuation. Typically, sales of our consumer products are highest in the fourth quarter due to increased demand during the holiday buying season, and in the second quarter, due to increased demand during the spring and summer season. Our auto OEM and aviation products do not experience much seasonal variation but are more influenced by the timing of auto program manufacturing, aircraft certifications, regulatory mandates, and the release of new products when the initial demand is typically the strongest. Cost of Sales/Gross Profit Raw material costs are our most significant component of cost of goods sold. Our existing practice of performing the design and manufacture of our products in-house has enabled us to source components from different suppliers and, where possible, to redesign our products to leverage lower cost components. We believe that our flexible production model allows our factories to experience relatively low costs of manufacturing. In general, products manufactured in Taiwan have been our highest volume products. Our manufacturing labor costs historically have been lower in Taiwan and China than in Olathe and Salem. Sales price variability has had and can be expected to have an effect on our gross profit. Our gross profit is dependent on segment mix, and to a lesser extent, product mix within each segment. Advertising Expense Our advertising expenses consist primarily of costs for media advertising, cooperative advertising with our retail partners, point of sale displays, and sponsorships. Selling, General and Administrative Expenses Our selling, general and administrative expenses consist primarily of: • salaries for sales, marketing and product support personnel; • salaries and related costs for executives and administrative personnel; • marketing, and other brand building costs; • finance and legal costs; • human resource costs; • information systems and infrastructure costs; • travel and related costs; and • occupancy and other overhead costs. 37 Research and Development The majority of our research and development costs represent engineering personnel costs, costs of test equipment and components used in product and prototype development, and outside product development costs. We are committed to increasing the level of innovative design and development of new products as we strive for expanded ability to serve our existing consumer and aviation markets as well as new auto OEM programs and new markets for active lifestyle products. Income Taxes We have experienced a relatively low effective income tax rate due to the proportion of our income generated by entities in tax jurisdictions with low statutory rates. Results of Operations The following table sets forth our results of operations as a percentage of net sales during the periods shown (the table may not foot due to rounding): 52-Weeks Ended 52-Weeks Ended 52-Weeks Ended December 26, 2020 December 28, 2019 December 29, 2018 Net sales 100 % 100 % 100 % Cost of goods sold 41 % 41 % 41 % Gross profit 59 % 59 % 59 % Operating expenses: Advertising 4 % 4 % 5 % Selling, general and administrative 14 % 14 % 14 % Research and development 17 % 16 % 17 % Total operating expenses 34 % 34 % 36 % Operating income 25 % 25 % 23 % Other income (expense), net 1 % 1 % 1 % Income before income taxes 26 % 26 % 25 % Provision (benefit) for income taxes 2 % 1 % 4 % Net income 24 % 25 % 21 % The table below sets forth our results of operations through operating income for each of our five reported segments and supplemental information for the consumer auto and auto OEM operating segments that management believes is useful. The Company’s CODM uses operating income as the measure of profit or loss, combined with other measures, to assess segment performance and allocate resources. Operating income represents net sales less costs of goods sold and operating expenses. Net sales are directly attributed to each segment. Most costs of goods sold and the majority of operating expenses are also directly attributed to each segment, while certain other costs of goods sold and operating expenses are allocated to the segments in a manner appropriate to the specific facts and circumstances of the expenses being allocated. For each line item in the table below, the total of the reported segments’ amounts equals the amount in the consolidated statements of income data included in Item 6. As indicated in Note 8 to the Consolidated Financial Statements, the methodology used to allocate certain selling, general, and administrative expenses was refined at the beginning of the 2019 fiscal year. The amounts presented below for the 52-weeks ended December 29, 2018 are presented here as they were originally reported. For comparative purposes, we estimate operating income for the 52-weeks ended December 29, 2018 would have been approximately $18 million less for aviation, approximately $11 million more for marine, approximately $7 million more for outdoor, and not significantly different for auto and fitness. 38 Auto 52-Weeks Ended December 26, 2020 Fitness Outdoor Marine Aviation Total Auto Consumer Auto Auto OEM Net sales $ 1,317,498 $ 1,128,081 $ 657,848 $ 622,820 $ 460,326 $ 275,493 $ 184,833 Cost of goods sold 619,959 388,304 273,398 169,812 253,764 135,629 118,135 Gross profit 697,539 739,777 384,450 453,008 206,562 139,864 66,698 Advertising expense 66,157 49,957 21,549 2,921 10,582 10,387 195 Selling, general and administrative expenses 190,109 143,714 94,376 76,504 65,542 40,094 25,448 Research and development expense 122,389 105,021 92,801 236,380 149,094 47,919 101,175 Total operating expenses 378,655 298,692 208,726 315,805 225,218 98,400 126,818 Operating income (loss) $ 318,884 $ 441,085 $ 175,724 $ 137,203 $ (18,656 ) $ 41,464 $ (60,120 ) 52-Weeks Ended December 28, 2019 Fitness Outdoor Marine Aviation Total Auto Consumer Auto Auto OEM Net sales $ 1,047,527 $ 917,567 $ 508,850 $ 735,458 $ 548,103 $ 365,511 $ 182,592 Cost of goods sold 514,923 319,124 205,901 192,073 291,508 193,293 98,215 Gross profit 532,604 598,443 302,949 543,385 256,595 172,218 84,377 Advertising expense 71,772 52,171 20,411 5,667 14,435 14,174 261 Selling, general and administrative expenses 159,793 124,650 90,352 65,663 78,110 53,444 24,666 Research and development expense 109,181 87,581 82,310 219,112 107,182 41,301 65,881 Total operating expenses 340,746 264,402 193,073 290,442 199,727 108,919 90,808 Operating income (loss) $ 191,858 $ 334,041 $ 109,876 $ 252,943 $ 56,868 $ 63,299 $ (6,431 ) 52-Weeks Ended December 29, 2018 Fitness Outdoor Marine Aviation Total Auto Consumer Auto Auto OEM Net sales $ 858,329 $ 809,883 $ 441,560 $ 603,459 $ 634,213 $ 425,684 $ 208,529 Cost of goods sold 386,565 281,629 182,804 153,307 363,420 245,822 117,598 Gross profit 471,764 528,254 258,756 450,152 270,793 179,862 90,931 Advertising expense 64,707 46,041 18,284 7,207 19,155 18,803 352 Selling, general and administrative expenses 135,096 120,588 97,682 36,139 88,672 71,265 17,407 Research and development expense 90,216 71,115 79,446 202,060 124,968 46,653 78,315 Total operating expenses 290,019 237,744 195,412 245,406 232,795 136,721 96,074 Operating income (loss) $ 181,745 $ 290,510 $ 63,344 $ 204,746 $ 37,998 $ 43,141 $ (5,143 ) Net Sales Net Sales 52-Weeks Ended December 26, 2020 Year-over-Year Change 52-Weeks Ended December 28, 2019 Year-over-Year Change 52-Weeks Ended December 29, 2018 Fitness $ 1,317,498 26 % $ 1,047,527 22 % $ 858,329 Percentage of Total Net Sales 31 % 28 % 26 % Outdoor 1,128,081 23 % 917,567 13 % 809,883 Percentage of Total Net Sales 27 % 24 % 24 % Marine 657,848 29 % 508,850 15 % 441,560 Percentage of Total Net Sales 16 % 13 % 13 % Aviation 622,820 (15 %) 735,458 22 % 603,459 Percentage of Total Net Sales 15 % 20 % 18 % Auto 460,326 (16 %) 548,103 (14 %) 634,213 Percentage of Total Net Sales 11 % 15 % 19 % Consumer Auto 275,493 (25 %) 365,511 (14 %) 425,684 Percentage of Total Net Sales 7 % 10 % 13 % Auto OEM 184,833 1 % 182,592 (12 %) 208,529 Percentage of Total Net Sales 4 % 5 % 6 % Total $ 4,186,573 11 % $ 3,757,505 12 % $ 3,347,444 39 Net sales increased 11% in 2020 when compared to the year-ago period. All operating segments had an increase in revenue except for aviation and consumer auto. Fitness revenue represented the largest portion of our revenue mix in 2020 at 31% compared to 28% in 2019. Total unit sales decreased 1.3% to 15.4 million units in 2020 from 15.6 million units in 2019. Fitness, outdoor, marine, and auto OEM revenues increased 26%, 23%, 29%, and 1%, respectively, when compared to the year-ago period. The fitness revenue increase was primarily driven by strong demand for advanced wearables and cycling products. The outdoor revenue increase was driven by sales growth across multiple product categories, primarily led by adventure watches. Marine revenue increases were driven by sales growth across all product categories, led primarily by chartplotters and SONAR products. The auto OEM revenue increase was driven by sales growth in new auto OEM programs. Aviation revenue decreased 15% from the year-ago period, due to fewer shipments to OEM customers and reduced contributions from ADS-B products. Consumer auto revenue decreased 25% from the year-ago period, primarily due to the ongoing personal navigation device market contraction. Gross Profit Gross Profit 52-Weeks Ended December 26, 2020 Year-over-Year Change 52-Weeks Ended December 28, 2019 Year-over-Year Change 52-Weeks Ended December 29, 2018 Fitness $ 697,539 31 % $ 532,604 13 % $ 471,764 Percentage of Segment Net Sales 53 % 51 % 55 % Outdoor 739,777 24 % 598,443 13 % 528,254 Percentage of Segment Net Sales 66 % 65 % 65 % Marine 384,450 27 % 302,949 17 % 258,756 Percentage of Segment Net Sales 58 % 60 % 59 % Aviation 453,008 (17 %) 543,385 21 % 450,152 Percentage of Segment Net Sales 73 % 74 % 75 % Auto 206,562 (19 %) 256,595 (5 %) 270,793 Percentage of Segment Net Sales 45 % 47 % 43 % Consumer Auto 139,864 (19 %) 172,218 (4 %) 179,862 Percentage of Segment Net Sales 51 % 47 % 42 % Auto OEM 66,698 (21 %) 84,377 (7 %) 90,931 Percentage of Segment Net Sales 36 % 46 % 44 % Total $ 2,481,336 11 % $ 2,233,976 13 % $ 1,979,719 Percentage of Total Net Sales 59 % 59 % 59 % Gross profit dollars in fiscal year 2020 increased 11%, primarily due to the increase in net sales compared to the year-ago period. Consolidated gross margin was relatively flat compared to fiscal year 2019. The fitness and consumer auto gross margin increases of 210 basis points and 365 basis points, respectively, were primarily attributable to product mix. Gross margin remained relatively flat within the outdoor segment. The marine and aviation gross margin decreases of 110 basis points and 115 basis points, respectively, were primarily attributable to product mix. The auto OEM gross margin decrease of 1,010 basis points was primarily attributable to product mix associated with growth in new auto OEM programs. This product mix and associated gross margin trend is generally expected to continue into 2021 and beyond. Advertising Expenses Advertising 52-Weeks Ended December 26, 2020 Year-over-Year Change 52-Weeks Ended December 28, 2019 Year-over-Year Change 52-Weeks Ended December 29, 2018 Fitness $ 66,157 (8 %) $ 71,772 11 % $ 64,707 Percentage of Segment Net Sales 5 % 7 % 8 % Outdoor 49,957 (4 %) 52,171 13 % 46,041 Percentage of Segment Net Sales 4 % 6 % 6 % Marine 21,549 6 % 20,411 12 % 18,284 Percentage of Segment Net Sales 3 % 4 % 4 % Aviation 2,921 (48 %) 5,667 (21 %) 7,207 Percentage of Segment Net Sales 0 % 1 % 1 % Auto 10,582 (27 %) 14,435 (25 %) 19,155 Percentage of Segment Net Sales 2 % 3 % 3 % Consumer Auto 10,387 (27 %) 14,174 (25 %) 18,803 Percentage of Segment Net Sales 4 % 4 % 4 % Auto OEM 195 (25 %) 261 (26 %) 352 Percentage of Segment Net Sales 0 % 0 % 0 % Total $ 151,166 (8 %) $ 164,456 6 % $ 155,394 Percentage of Total Net Sales 4 % 4 % 5 % 40 Advertising expense decreased 8% in absolute dollars and decreased slightly as a percent of revenue in fiscal year 2020 compared to fiscal year 2019. The overall decrease in absolute dollars was primarily attributable to decreased media advertising in fitness and outdoor and decreased cooperative advertising in consumer auto. These decreases were partially offset by increased cooperative advertising expense in fitness, outdoor, and marine. Advertising expenses in all operating segments decreased slightly as a percent of revenue compared to the prior year. Selling, General and Administrative Expenses Selling, General & Admin. Expenses 52-Weeks Ended December 26, 2020 Year-over-Year Change 52-Weeks Ended December 28, 2019 Year-over-Year Change 52-Weeks Ended December 29, 2018 Fitness $ 190,109 19 % $ 159,793 18 % $ 135,096 Percentage of Segment Net Sales 14 % 15 % 16 % Outdoor 143,714 15 % 124,650 3 % 120,588 Percentage of Segment Net Sales 13 % 14 % 15 % Marine 94,376 4 % 90,352 (8 %) 97,682 Percentage of Segment Net Sales 14 % 18 % 22 % Aviation 76,504 17 % 65,663 82 % 36,139 Percentage of Segment Net Sales 12 % 9 % 6 % Auto 65,542 (16 %) 78,110 (12 %) 88,672 Percentage of Segment Net Sales 14 % 14 % 14 % Consumer Auto 40,094 (25 %) 53,444 (25 %) 71,265 Percentage of Segment Net Sales 15 % 15 % 17 % Auto OEM 25,448 3 % 24,666 42 % 17,407 Percentage of Segment Net Sales 14 % 14 % 8 % Total $ 570,245 10 % $ 518,568 8 % $ 478,177 Percentage of Total Net Sales 14 % 14 % 14 % Selling, general and administrative expense increased 10% in absolute dollars and was relatively flat as a percent of revenue when compared to the prior year. The absolute dollar increase was primarily attributable to information technology costs and personnel related expenses. As noted above and in Note 8 to the Consolidated Financial Statements, the Company refined its methodology to allocate certain selling, general and administrative expenses at the beginning of the 2019 fiscal year. The prior year amounts are presented here as originally reported. For comparative purposes, we estimate selling, general and administrative expenses for fiscal year 2018 would have been approximately $18 million more for aviation, approximately $11 million less for marine, approximately $7 million less for outdoor, and not significantly different for fitness and auto. Research and Development Expense Research & Development 52-Weeks Ended December 26, 2020 Year-over-Year Change 52-Weeks Ended December 28, 2019 Year-over-Year Change 52-Weeks Ended December 29, 2018 Fitness $ 122,389 12 % $ 109,181 21 % $ 90,216 Percentage of Segment Net Sales 9 % 10 % 11 % Outdoor 105,021 20 % 87,581 23 % 71,115 Percentage of Segment Net Sales 9 % 10 % 9 % Marine 92,801 13 % 82,310 4 % 79,446 Percentage of Segment Net Sales 14 % 16 % 18 % Aviation 236,380 8 % 219,112 8 % 202,060 Percentage of Segment Net Sales 38 % 30 % 33 % Auto 149,094 39 % 107,182 (14 %) 124,968 Percentage of Segment Net Sales 32 % 20 % 20 % Consumer Auto 47,919 16 % 41,301 (11 %) 46,653 Percentage of Segment Net Sales 17 % 11 % 11 % Auto OEM 101,175 54 % 65,881 (16 %) 78,315 Percentage of Segment Net Sales 55 % 36 % 38 % Total $ 705,685 17 % $ 605,366 7 % $ 567,805 Percentage of Total Net Sales 17 % 16 % 17 % 41 Research and development expense increased 17% in absolute dollars when compared to the year-ago period and increased slightly as a percent of revenue. The absolute dollar increase was primarily due to engineering personnel costs across all of our operating segments and other expenses related to auto OEM programs. The auto OEM increase in absolute dollars and as a percent of revenue was primarily attributable to higher engineering personnel costs and other expenses related to investments in auto OEM programs and a lower proportion of such costs being contractually reimbursable in fiscal year 2020. This trend of increasing auto OEM research and development expense is expected to continue in 2021 as we expect higher total costs and the majority of costs will not be contractually reimbursable. Operating Income Operating Income 52-Weeks Ended December 26, 2020 Year-over-Year Change 52-Weeks Ended December 28, 2019 Year-over-Year Change 52-Weeks Ended December 29, 2018 Fitness $ 318,884 66 % $ 191,858 6 % $ 181,745 Percentage of Segment Net Sales 24 % 18 % 21 % Outdoor 441,085 32 % 334,041 15 % 290,510 Percentage of Segment Net Sales 39 % 36 % 36 % Marine 175,724 60 % 109,876 73 % 63,344 Percentage of Segment Net Sales 27 % 22 % 14 % Aviation 137,203 (46 %) 252,943 24 % 204,746 Percentage of Segment Net Sales 22 % 34 % 34 % Auto (18,656 ) (133 %) 56,868 50 % 37,998 Percentage of Segment Net Sales (4 %) 10 % 6 % Consumer Auto 41,464 (34 %) 63,299 47 % 43,141 Percentage of Segment Net Sales 15 % 17 % 10 % Auto OEM (60,120 ) 835 % (6,431 ) 25 % (5,143 ) Percentage of Segment Net Sales (33 %) (4 %) (2 %) Total $ 1,054,240 11 % $ 945,586 21 % $ 778,343 Percentage of Total Net Sales 25 % 25 % 23 % Total operating income increased 11% in absolute dollars and was relatively flat as a percent of revenue when compared to fiscal year 2019. The growth in total operating income on an absolute dollar basis was the result of revenue growth as discussed above. Operating income, in absolute dollars and as a percent of revenue, decreased in aviation primarily due to a decline in sales compared to the year-ago period. Auto OEM experienced an operating loss in fiscal year 2020, and we expect this trend of an operating loss to continue in 2021, primarily due to a lower gross margin and increased expense associated with certain programs, as described above. Other Income (Expense) Other Income (Expense) 52-Weeks Ended December 26, 2020 52-Weeks Ended December 28, 2019 52-Weeks Ended December 29, 2018 Interest income $ 37,002 $ 52,817 $ 47,147 Foreign currency (losses) 2,825 (16,799 ) (7,616 ) Other income 9,343 5,618 5,373 Total $ 49,170 $ 41,636 $ 44,904 The average returns on cash and investments, including interest and capital gain/loss returns during the 52-weeks ended December 26, 2020 and December 28, 2019, were 1.4% and 2.0%, respectively. Interest income decreased primarily due to lower yields on fixed-income securities. 42 Foreign currency gains and losses for the Company are typically driven by movements of a number of currencies in relation to the U.S. Dollar. The Taiwan Dollar is the functional currency of Garmin Corporation, the Euro is the functional currency of several subsidiaries, and the U.S. Dollar is the functional currency of Garmin (Europe) Ltd., although some transactions and balances are denominated in British Pounds. Other notable currency exposures include the Australian Dollar, and Chinese Yuan. The majority of the Company’s consolidated foreign currency gain or loss is typically driven by the significant cash and marketable securities, receivables and payables held in a currency other than the functional currency at a given legal entity. The $2.8 million currency gain recognized in fiscal 2020 was primarily due to the U.S. Dollar weakening against the Euro, Australian Dollar, Chinese Yuan, and British Pound Sterling, partially offset by the U.S. Dollar weakening against the Taiwan Dollar. During fiscal 2020, the U.S. Dollar weakened 9.2% against the Euro, 9.4% against the Australian Dollar, 7.2% against the Chinese Yuan, and 3.6% against the British Pound Sterling, resulting in gains of $21.1 million, $6.5 million, $2.9 million, and $2.6 million, respectively, while the U.S. Dollar weakened 7.1% against the Taiwan Dollar, resulting in a loss of $32.2 million. The remaining net currency gain of $1.9 million is related to the timing of transactions and impacts of other currencies, each of which was individually immaterial. The $16.8 million currency loss recognized in fiscal 2019 was primarily due to the U.S. Dollar strengthening against the Euro and weakening against the Taiwan Dollar, offset by the U.S. Dollar weakening against the British Pound Sterling. During fiscal 2019, the U.S. Dollar strengthened 2.3% against the Euro and weakened 1.5% against the Taiwan Dollar, resulting in losses of $9.3 million and $7.1 million, respectively, while the U.S. Dollar weakened 2.9% against the British Pound Sterling, resulting in a gain of $2.8 million. The remaining net currency loss of $3.2 million is related to the timing of transactions and impacts of other currencies, each of which was individually immaterial. Income Tax Provision Income tax expense for the fiscal year ended December 26, 2020 was $111.1 million compared to income tax expense of $34.7 million for the fiscal year ended December 28, 2019, representing a net increase of $76.4 million. Contributing to the year-over-year increase in income tax expense in fiscal year 2020 was an income tax benefit of $118.0 million recognized in fiscal year 2019 associated with the revaluation and step-up of certain Switzerland tax assets as a result of the October 2019 enactment of Switzerland federal and Schaffhausen cantonal tax reform and related transitional measures. A revaluation of these assets performed in the fourth quarter of 2020 resulted in an $11.0 million income tax expense in fiscal year 2020. In connection with these transitional measures included in Switzerland tax reform, a reduced income tax rate will be utilized on certain Switzerland taxable income for up to five years. The Company also recognized a $14.3 million income tax benefit in fiscal 2020 due to the release of uncertain tax position reserves associated with a 2014 intercompany restructuring. Excluding the aforementioned $11.0 million income tax expense and $14.3 million income tax benefit in fiscal 2020, and the $118.0 million tax benefit in fiscal 2019, income tax expense for fiscal years 2020 and 2019 was $114.4 million and $152.7 million, respectively. In this comparison, income tax expense for fiscal year 2020 was lower primarily due to a transaction initiated by the Company in February 2020 between wholly-owned subsidiaries to migrate ownership of certain intellectual property from Switzerland to the United States, the primary location of research, development, and executive management. The migration, which includes a multi-year intercompany license of intellectual property, has resulted in a favorable shift of income mix by jurisdiction and a reduction in expense related to uncertain tax positions. During the term of the license agreement, this transaction is expected to continue to result in a lower effective income tax rate as compared to the fiscal year 2019 effective income tax rate, excluding the $118.0 million income tax benefit in 2019 described above. The Company is pursuing an Advance Pricing Agreement between relevant jurisdictions related to this transaction. At the end of the license agreement, a higher percentage of income will be recognized in the United States. Net Income As a result of the various factors noted above net income increased 4% to $992.3 million from $952.5 million in the prior year. 43 Liquidity and Capital Resources As of December 26, 2020, we had approximately $3.0 billion of cash, cash equivalents, and marketable securities. We primarily use cash flow from operations, and expect that future cash requirements may be used, to fund our capital expenditures, support our working capital requirements, pay dividends, and fund strategic acquisitions. We believe that our existing cash balances and cash flow from operations will be sufficient to meet our short- and long-term projected working capital needs, capital expenditures, and other cash requirements. It is management’s goal to invest the on-hand cash in accordance with the investment policy, which has been approved by the Company’s Board of Directors. The investment policy’s primary purpose is to preserve capital, maintain an acceptable degree of liquidity, and maximize yield within the constraint of low credit risk. Garmin’s average interest rate returns on cash and investments during fiscal 2020, 2019, and 2018 were approximately 1.4%, 2.0% and 1.9%, respectively. The fair value of our securities varies from period to period due to changes in interest rates, in the performance of the underlying collateral, and in the credit performance of the underlying issuer, among other factors. See Note 8 for additional information regarding marketable securities. Operating Activities 52-Weeks Ended 52-Weeks Ended 52-Weeks Ended December 26, 2020 December 28, 2019 December 29, 2018 Net cash provided by operating activities $ 1,135,267 $ 698,549 $ 919,520 The $436.7 million increase in cash provided by operating activities in fiscal year 2020 compared to fiscal year 2019 was due to a decrease in cash used in working capital of $294.3 million (which included an increase of $14.5 million in net receipts of accounts receivable, a decrease of $198.9 million in cash paid for inventory, a decrease of $13.6 million net cash used for income taxes, and a decrease of $92.0 million net cash used in other activities primarily driven by prior year payments associated with an amendment to a license agreement, partially offset by an increase of $24.7 million net cash used in accounts payable). Additional changes were due to the year-over-year increase in net income of $39.8 million and an increase in other non-cash adjustments to net income of $102.6 million primarily driven by a prior year income tax benefit of $118.0 million associated with the revaluation and step-up of certain Switzerland tax assets. Investing Activities 52-Weeks Ended 52-Weeks Ended 52-Weeks Ended December 26, 2020 December 28, 2019 December 29, 2018 Net cash used in investing activities $ (260,524 ) $ (450,746 ) $ (307,503 ) The $190.2 million decrease in cash used in investing activities in fiscal year 2020 compared to fiscal year 2019 was primarily due to a decrease in cash payments for acquisitions of $151.6 million, an increase in net redemptions of marketable securities of $104.2 million, and partially offset by increased net purchases of property and equipment of $65.9 million. Financing Activities 52-Weeks Ended 52-Weeks Ended 52-Weeks Ended December 26, 2020 December 28, 2019 December 29, 2018 Net cash used in financing activities $ (461,760 ) $ (416,028 ) $ (286,161 ) The $45.7 million increase in cash used in financing activities in fiscal year 2020 compared to fiscal year 2019 was primarily due to an increase in dividend payments of $33.4 million. Our declared dividend has increased from $0.53 per share for the four calendar quarters beginning in June 2018 to $0.57 per share for the four calendar quarters beginning in June 2019, and to $0.61 per share for the four calendar quarters beginning in June 2020. 44 Contractual Obligations and Commercial Commitments As of December 26, 2020, operating leases comprise the substance of the Company’s commercial commitments with long-term scheduled payments, as summarized below: Payments due by period Contractual Obligations Total Less than 1 year 1-3 years 3-5 years More than 5 years Operating Leases $ 107,859 $ 22,900 $ 36,965 $ 24,965 $ 23,029 The Company is party to certain other commitments, which include purchases of raw materials, capital expenditures, advertising, and other indirect purchases in connection with conducting our business. The aggregate amount of purchase orders and other commitments open as of December 26, 2020 was approximately $880.0 million. We cannot determine the aggregate amount of such purchase orders that represent contractual obligations because purchase orders may represent authorizations to purchase rather than binding agreements. Our purchase orders are generally based on our current needs and are typically fulfilled within short periods of time. We may be required to make significant cash outlays related to unrecognized tax benefits. However, due to the uncertainty of the timing of future cash flows associated with our unrecognized tax benefits, we are unable to make reasonably reliable estimates of the period of cash settlement, if any, with the respective taxing authorities. Accordingly, unrecognized tax benefits of $85.0 million as of December 26, 2020, have been excluded from the contractual obligations table above. For further information related to unrecognized tax benefits, see Note 2 – Summary of Significant Accounting Policies, Income Taxes and Note 6 – Income Taxes to the Consolidated Financial Statements included in this Report. Off-Balance Sheet Arrangements We do not have any off-balance sheet arrangements. Item 7A. Quantitative and Qualitative Disclosures About Market Risk Market Sensitivity We have market risk primarily in connection with the pricing of our products and services and the purchase of raw materials. Product pricing and raw materials costs are both significantly influenced by semiconductor market conditions. Historically, during cyclical industry downturns, we have been able to offset pricing declines for our products through a combination of improved product mix and success in obtaining price reductions in raw materials costs. Inflation We do not believe that inflation has had a material effect on our business, financial condition or results of operations. If our costs were to become subject to significant inflationary pressures, we may not be able to fully offset such higher costs through price increases. Our inability or failure to do so could adversely affect our business, financial condition and results of operations. Foreign Currency Exchange Rate Risk The operation of Garmin’s subsidiaries in international markets results in exposure to movements in currency exchange rates. We have experienced significant foreign currency gains and losses due to the strengthening and weakening of the U.S. dollar. The potential of volatile foreign exchange rate fluctuations in the future could have a significant effect on our results of operations. The Company has not historically hedged its foreign currency exchange rate risks. 45 The currencies that create a majority of the Company’s exchange rate exposure are the Taiwan Dollar, Euro, British Pound Sterling, Australian Dollar, Chinese Yuan, and Japanese Yen. Garmin Corporation, headquartered in Xizhi, Taiwan, uses the local currency as the functional currency. The Company translates all assets and liabilities at year‐end exchange rates and income and expense accounts at average rates during the year. In order to minimize the effect of the currency exchange fluctuations on our net assets, we have elected to retain most of our Taiwan subsidiary’s cash and investments denominated in U.S. Dollars. Most European subsidiaries use the Euro as the functional currency. The functional currency of our largest European subsidiary, Garmin (Europe) Ltd. remains the U.S. Dollar, and as some transactions occur in British Pounds Sterling or Euros, foreign currency gains or losses have been realized historically related to the movements of those currencies relative to the U.S. Dollar. The Company believes that gains and losses may become more material in the future as our European presence grows. During fiscal year 2020, the Company incurred a net foreign currency gain of $2.8 million. The U.S. Dollar weakening against the Euro, Australian Dollar, Chinese Yuan, and British Pound Sterling was partially offset by the U.S. Dollar weakening against the Taiwan Dollar. During fiscal 2020, the U.S. Dollar weakened 9.2% against the Euro, 9.4% against the Australian Dollar, 7.2% against the Chinese Yuan, and 3.6% against the British Pound Sterling, resulting in gains of $21.1 million, $6.5 million, $2.9 million, and $2.6 million, respectively, while the U.S. Dollar weakened 7.1% against the Taiwan Dollar, resulting in a loss of $32.2 million. The remaining net currency gain of $1.9 million was related to the timing of transactions and impacts of other currencies, each of which was individually immaterial. These and other currency moves during fiscal year 2020 also resulted in a currency translation adjustment of $107.7 million within Accumulated other comprehensive income. We assessed the Company’s exposure to movements in currency exchange rates by performing a sensitivity analysis of adverse changes in exchange rates and the corresponding impact to our results of operations. Based on monetary assets and liabilities denominated in currencies other than respective functional currencies as of December 26, 2020 and December 28, 2019, hypothetical and reasonably possible adverse changes of 10% for the Taiwan Dollar, Euro, and British Pound Sterling would have resulted in an adverse impact on income before income taxes of approximately $84 million and $90 million at December 26, 2020 and December 28, 2019. Interest Rate Risk We have no outstanding long-term debt as of December 26, 2020. We, therefore, have no meaningful debt-related interest rate risk. We are exposed to interest rate risk in connection with our investments in marketable securities. As interest rates change, the unrealized gains and losses associated with those securities will fluctuate accordingly. The Company’s investment policy targets low risk investments with the objective of minimizing the potential risk of principal loss. The Company does not intend to sell securities in an unrealized loss position and it is not more likely than not that the Company will be required to sell such investments before recovery of their amortized costs bases, which may be maturity. During 2020 and 2019, the Company did not record any material impairment charges on its outstanding securities. We assessed the Company’s exposure to interest rate risk by performing a sensitivity analysis of a parallel shift in the yield curve and the corresponding impact to the Company’s portfolio of marketable securities. Based on balance sheet positions as of December 26, 2020 and December 28, 2019, the hypothetical and reasonably possible 100 basis point increases in interest rates across all securities would have resulted in declines in portfolio fair market value of approximately $34 million and $35 million at December 26, 2020 and December 28, 2019, respectively. Such losses would only be realized if the Company sold the investments prior to maturity. 46
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+ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. The purpose of this Management’s Discussion and Analysis (“MD&A”) is to facilitate an understanding of significant factors influencing the operating results, financial condition and cash flows of Gartner, Inc. Additionally, the MD&A conveys our expectations of the potential impact of known trends, events or uncertainties that may impact future results. You should read this discussion in conjunction with our consolidated financial statements and related notes included in this Annual Report on Form 10-K. Historical results and percentage relationships are not necessarily indicative of operating results for future periods. References to “Gartner,” the “Company,” “we,” “our” and “us” in this MD&A are to Gartner, Inc. and its consolidated subsidiaries.This MD&A provides an analysis of our consolidated financial results, segment results and cash flows for 2020 and 2019 under the headings “Results of Operations,” “Segment Results” and “Liquidity and Capital Resources.” For a similar detailed discussion comparing 2019 and 2018, refer to those headings under Item 7., “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” in our Annual Report on Form 10-K for the year ended December 31, 2019.FORWARD-LOOKING STATEMENTSIn addition to historical information, this Annual Report on Form 10-K contains certain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. Forward-looking statements are any statements other than statements of historical fact, including statements regarding our expectations, beliefs, hopes, intentions, projections or strategies regarding the future. In some cases, forward-looking statements can be identified by the use of words such as “may,” “will,” “expect,” “should,” “could,” “believe,” “plan,” “anticipate,” “estimate,” “predict,” “potential,” “continue” or other words of similar meaning.We operate in a very competitive and rapidly changing environment that involves numerous known and unknown risks and uncertainties, some of which are beyond our control. Although we believe that the expectations reflected in any of our forward-looking statements are reasonable, actual results could differ materially from those projected or assumed in any of our forward-looking statements. Our future quarterly and annual revenues, operating income, results of operations and cash flows, as well as any forward-looking statement, are subject to change and to inherent risks and uncertainties, such as those disclosed or incorporated by reference in our filings with the Securities and Exchange Commission. Important factors that could cause our actual results, performance and achievements, or industry results to differ materially from estimates or projections contained in our forward-looking statements include, among others, the following: uncertainty of the magnitude, duration, geographic reach and impact on the global economy of the COVID-19 pandemic; the current, and uncertain future, impact of the COVID-19 pandemic and governments’ responses to it on our business, growth, reputation, projections, prospects, financial condition, operations, cash flows, and liquidity; the adequacy or effectiveness of steps we take to respond to the crisis, including cost reduction or other mitigation programs; our ability to recover potential claims under our event cancellation insurance; the timing of our Gartner Symposium/Xpo series that normally occurs during the fourth quarter (but was cancelled in 2020 as a result of the COVID-19 pandemic), as well as of our other conferences and meetings; our ability to achieve and effectively manage growth, including our ability to integrate our acquisitions and consummate and integrate future acquisitions; our ability to pay our debt obligations; our ability to maintain and expand our products and services; our ability to expand or retain our customer base; our ability to grow or sustain revenue from individual customers; our ability to attract and retain a professional 20staff of research analysts and consultants as well as experienced sales personnel upon whom we are dependent; our ability to achieve continued customer renewals and achieve new contract value, backlog and deferred revenue growth in light of competitive pressures; our ability to carry out our strategic initiatives and manage associated costs; our ability to successfully compete with existing competitors and potential new competitors; our ability to enforce and protect our intellectual property rights; additional risks associated with international operations, including foreign currency fluctuations; the UK’s exit from the European Union and its impact on our results; the impact of restructuring and other charges on our businesses and operations; cybersecurity incidents; general economic conditions; changes in macroeconomic and market conditions and market volatility (including developments and volatility arising from the COVID-19 pandemic), including interest rates and the effect on the credit markets and access to capital; risks associated with the creditworthiness, budget cuts, and shutdown of governments and agencies; the impact of changes in tax policy and heightened scrutiny from various taxing authorities globally; uncertainty from the expected discontinuance of LIBOR and transition to any other interest rate benchmark; changes to laws and regulations; and other risks and uncertainties. The potential fluctuations in our operating income could cause period-to-period comparisons of operating results not to be meaningful and could provide an unreliable indication of future operating results. A description of the risk factors associated with our business is included under “Risk Factors” in Item 1A. of this Annual Report on Form 10-K, which is incorporated herein by reference.Forward-looking statements are subject to risks, estimates and uncertainties that could cause actual results to differ materially from those discussed in, or implied by, the forward-looking statements, and are currently, or in the future could be, amplified by the COVID-19 pandemic. Factors that might cause such a difference include, but are not limited to, those listed above or described under “Risk Factors” in Item 1A of this Annual Report on Form 10-K. Readers should not place undue reliance on these forward-looking statements, which reflect management’s opinion only as of the date on which they were made. Forward-looking statements in this Annual Report on Form 10-K speak only as of the date hereof, and forward-looking statements in documents attached that are incorporated by reference speak only as of the date of those documents. Except as required by law, we disclaim any obligation to review or update these forward-looking statements to reflect events or circumstances as they occur.BUSINESS OVERVIEWGartner, Inc. (NYSE: IT) is the world’s leading research and advisory company and a member of the S&P 500. We equip business leaders with indispensable insights, advice and tools to achieve their mission–critical priorities today and build the successful organizations of tomorrow. We believe our unmatched combination of expert-led, practitioner-sourced and data-driven research steers clients toward the right decisions on the issues that matter most. We are a trusted advisor and an objective resource for more than 14,000 enterprises in more than 100 countries — across all major functions, in every industry and enterprise size.Gartner delivers its products and services globally through three business segments – Research, Conferences and Consulting, as described below.•Research provides trusted, objective insights and advice on the mission-critical priorities of leaders across all functional areas of an enterprise through reports, briefings, proprietary tools, access to our research experts, peer networking services and membership programs that enable our clients to drive organizational performance.•Conferences provides business professionals across an organization the opportunity to learn, share and network. From our Gartner Symposium/Xpo series, to industry-leading conferences focused on specific business roles and topics, to peer-driven sessions, our offerings enable attendees to experience the best of Gartner insight and advice.•Consulting combines the power of Gartner market-leading research with custom analysis and on-the-ground support to help chief information officers and other senior executives driving technology-related strategic initiatives move confidently from insight to action.COVID-19 ImpactThe coronavirus disease (“COVID-19”) pandemic has affected nearly every region in the world and has created significant uncertainties and disruption in the global economy. Gartner is closely monitoring the pandemic-related developments, and our highest priority is the health and safety of our associates, clients, vendors, partners, and other stakeholders. We are working closely with our clients to provide best in class COVID-19 related research to assist them in achieving their mission critical priorities.21As a result of the COVID-19 pandemic, we have temporarily closed Gartner offices (including our corporate headquarters) in the United States, United Kingdom, India, and several other impacted locations around the world and implemented significant travel restrictions. Although we have plans to reopen most offices in the fall of 2021, reopening is subject to many factors outside of our control. As a result, we cannot predict for certain when or how we will begin to lift the actions put in place as part of our business continuity plans, including work from home protocols and travel restrictions. We have seen negative impacts to all of our segments with Conferences being the most impacted. On March 25, 2020, we announced the cancellation of all in-person conferences through August 2020. On July 2, 2020, we announced the cancellation of all in-person conferences for the remainder of 2020. We held 15 virtual conferences during the second half of 2020, and plan on holding approximately 20 virtual conferences from February 2021 through August 2021. These virtual conferences are expected to result in significantly less revenue and gross contribution, but we believe aid in client retention and engagement. The safety of our associates and clients remain our top priority so future in-person conferences will be held only if we determine the relevant impacts of COVID-19 have sufficiently receded in the jurisdictions where our conferences are to be held. As of December 31, 2020, we had approximately $16 million recorded in Prepaid expenses and other current assets on the balance sheet related to cancelled conferences. We expect to recover the majority of these and potential termination costs for future conferences through either force majeure clauses in our vendor contracts, other arrangements with vendors or event cancellation insurance claims. For cancelled conferences, our event cancellation insurance enables us to receive an amount up to the lost contribution margin per conference plus incurred expenses. Our event cancellation insurance provides up to $170 million in coverage for 2020 with the right to reinstate that amount one time if those limits are utilized. The insurer has contested our right to reinstate limits and to include in reinstated limits conferences cancelled due to COVID-19. We are in litigation with the insurer on these issues. The timing of receiving the proceeds from these insurance claims is uncertain so we will not record any insurance claims in excess of expenses incurred until the receipt of the insurance proceeds.Our Research segment has continued to experience a slowdown as contract value (CV) growth was 4.5% in the fourth quarter of 2020 compared to 10.6%, 7.0% and 5.3% in the first, second and third quarters of 2020, respectively. CV growth slowed late in the first quarter as the global virus response led to lower new business growth and lower retention rates. However, because our revenue and CV have been historically stable and predictable as a result of our subscription-based business model, we only experienced a modest decrease in Research revenue growth in 2020 compared to that in 2019. Slower CV growth in 2020 however will lead to slower research revenue growth in 2021. Nonetheless, we believe that our emphasis on producing business and technology insight into every major business function in the enterprise will continue to drive client engagement and satisfaction with our Research products.Our Consulting segment was only moderately impacted by the COVID-19 pandemic as many engagements are being performed by associates working remotely. Labor based consulting weakened late in the first quarter due to the pandemic. This weakness continued in the remainder of 2020 due to weaker demand which will likely continue into 2021. In connection with the cancellation of the majority of 2020 conferences and the weaker demand in our Consulting segment noted above, in the second quarter of 2020, we implemented workforce reductions. We incurred an aggregate of approximately $18 million in costs relating to these workforce reductions during the year ended December 31, 2020. $16 million has been paid during the year ended December 31, 2020, and we expect the majority of the remaining charges to be paid out in the first half of 2021.In response to the pandemic’s impacts to our business, we implemented cost avoidance initiatives in the first half of 2020 including significant limitations on hiring and third-party spending, reductions to discretionary spending and elimination of non-essential travel and re-prioritization of capital expenditures. We began to restore certain investments in the business during the second half of 2020 and will likely continue these investments in 2021 and future periods.22BUSINESS MEASUREMENTSWe believe that the following business measurements are important performance indicators for our business segments:BUSINESS SEGMENTBUSINESS MEASUREMENTResearchTotal contract value represents the value attributable to all of our subscription-related contracts. It is calculated as the annualized value of all contracts in effect at a specific point in time, without regard to the duration of the contract. Total contract value primarily includes Research deliverables for which revenue is recognized on a ratable basis, as well as other deliverables (primarily Conferences tickets) for which revenue is recognized when the deliverable is utilized. Comparing contract value year-over-year not only measures the short-term growth of our business, but also signals the long-term health of our Research subscription business since it measures revenue that is highly likely to recur over a multi-year period. Our total contract value consists of Global Technology Sales contract value, which includes sales to users and providers of technology, and Global Business Sales contract value, which includes sales to all other functional leaders.Client retention rate represents a measure of client satisfaction and renewed business relationships at a specific point in time. Client retention is calculated on a percentage basis by dividing our current clients, who were also clients a year ago, by all clients from a year ago. Client retention is calculated at an enterprise level, which represents a single company or customer.Wallet retention rate represents a measure of the amount of contract value we have retained with clients over a twelve-month period. Wallet retention is calculated on a percentage basis by dividing the contract value of our current clients, who were also clients a year ago, by the total contract value from a year ago, excluding the impact of foreign currency exchange. When wallet retention exceeds client retention, it is an indication of retention of higher-spending clients, or increased spending by retained clients, or both. Wallet retention is calculated at an enterprise level, which represents a single company or customer.ConferencesNumber of destination conferences represents the total number of hosted virtual or in-person conferences completed during the period. Single day, local meetings are excluded.Number of destination conferences attendees represents the total number of people who attend virtual or in-person conferences. Single day, local meetings are excluded.ConsultingConsulting backlog represents future revenue to be derived from in-process consulting and measurement engagements.Utilization rate represents a measure of productivity of our consultants. Utilization rates are calculated for billable headcount on a percentage basis by dividing total hours billed by total hours available to bill.Billing rate represents earned billable revenue divided by total billable hours.Average annualized revenue per billable headcount represents a measure of the revenue generating ability of an average billable consultant and is calculated periodically by multiplying the average billing rate per hour times the utilization percentage times the billable hours available for one year. 23EXECUTIVE SUMMARY OF OPERATIONS AND FINANCIAL POSITION We have executed a strategy since 2005 to drive revenue and earnings growth. The fundamentals of our strategy include a focus on creating extraordinary research insight, delivering innovative and highly differentiated product offerings, building a strong sales capability, providing world class client service with a focus on client engagement and retention, and continuously improving our operational effectiveness.We had total revenues of $4.1 billion in 2020, a decrease of 3% compared to 2019 both on a reported basis and excluding the foreign currency impact. Net income increased to $266.7 million in 2020 from $233.3 million in 2019 and, as a result, diluted earnings per share was $2.96 in 2020 compared to $2.56 in 2019.Research revenues increased to $3.6 billion in 2020, an increase of 7% compared to 2019 both on a reported basis and excluding the foreign currency impact. The Research gross contribution margin was 72% and 70% in 2020 and 2019, respectively. Total contract value was $3.6 billion at December 31, 2020, an increase of 4% compared to December 31, 2019 on a foreign currency neutral basis.Conferences revenues decreased to $120.1 million in 2020, a decrease of 75% compared to 2019 both on a reported basis and excluding the foreign currency impact. The Conferences gross contribution margin was 48% and 51% in 2020 and 2019, respectively. We held 5 in-person and 15 virtual conferences in 2020, and 72 in-person conferences in 2019.Consulting revenues decreased to $376.4 million in 2020, a decrease of 4% compared to 2019 on a reported basis and 5% excluding the foreign currency impact. The Consulting gross contribution margin was 31% and 30% in 2020 and 2019, respectively. Backlog was $100.3 million at December 31, 2020.Cash provided by operating activities was $903.3 million and $565.4 million during 2020 and 2019, respectively. As of December 31, 2020, we had $712.6 million of cash and cash equivalents and approximately $1.0 billion of available borrowing capacity on our revolving credit facility. During 2020, we repurchased 1.2 million shares of the Company’s common stock for an aggregate purchase price of approximately $176.3 million.CRITICAL ACCOUNTING POLICIES AND ESTIMATESThe preparation of our consolidated financial statements requires the application of appropriate accounting policies and the use of estimates. Our significant accounting policies are described in Note 1 — Business and Significant Accounting Policies in the Notes to Consolidated Financial Statements. Management considers the policies discussed below to be critical to an understanding of our consolidated financial statements because their application requires complex and subjective management judgments and estimates. Specific risks for these critical accounting policies are also described below.The preparation of our consolidated financial statements requires us to make estimates and assumptions about future events. We develop our estimates using both current and historical experience, as well as other factors, including the general economic environment and actions we may take in the future. We adjust such estimates when facts and circumstances dictate. However, our estimates may involve significant uncertainties and judgments and cannot be determined with precision. In addition, these estimates are based on our best judgment at a point in time and, as such, they may ultimately differ materially from actual results. Ongoing changes in our estimates could be material and would be reflected in the Company’s consolidated financial statements in future periods.Our critical accounting policies are described below.Accounting for leases — On January 1, 2019, we adopted Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) Topic 842, Leases (“ASC 842”). We determine if an arrangement contains a lease at the inception of a contract. We consider an arrangement a lease if the arrangement transfers the right to control the use of an identified asset for a period of time in exchange for consideration. We have operating leases, but do not have material financing leases. Lease right-of-use assets represent the right to use an underlying asset for the lease term, and lease liabilities represent the obligation to make payments arising from the lease agreement. These assets and liabilities are recognized at the commencement of the lease based upon the present value of the future minimum lease payments over the lease term. The lease term reflects the non-cancelable period of the lease together with periods covered by an option to extend or terminate the lease when it is reasonably certain that we will exercise such option. Changes in the lease term assumption could impact the right-of-use assets and lease liabilities recognized on the balance sheet. As our leases typically do not contain a readily determinable implicit rate, we determine the present value of the lease liability using our incremental borrowing rate at the lease commencement date based on the lease term.24Note 1 — Business and Significant Accounting Policies and Note 7 — Leases in the Notes to Consolidated Financial Statements provide additional information regarding the Company’s leases and the adoption of ASC 842.Revenue recognition — On January 1, 2018, we adopted ASC Topic 606, Revenue from Contracts with Customers.Our revenue by significant source is accounted for as follows:•Research revenues are mainly derived from subscription contracts for research products. The related revenues are deferred and recognized ratably over the applicable contract term. Fees derived from assisting organizations in selecting the right business software for their needs are recognized when the leads are provided to vendors.•Conferences revenues are deferred and recognized upon the completion of the related conference or meeting.•Consulting revenues are principally generated from fixed fee and time and materials engagements. Revenues from fixed fee contracts are recognized as we work to satisfy our performance obligations. Revenues from time and materials engagements are recognized as work is delivered and/or services are provided. Revenues related to contract optimization engagements are contingent in nature and are only recognized upon satisfaction of all conditions related to their payment.The majority of our Research contracts are billable upon signing, absent special terms granted on a limited basis from time to time. Research contracts are generally non-cancelable and non-refundable, except for government contracts that may have cancellation or fiscal funding clauses. It is our policy to record the amount of a subscription contract that is billable as a fee receivable at the time the contract is signed with a corresponding amount as deferred revenue because the contract represents a legally enforceable claim.Note 1 — Business and Significant Accounting Policies and Note 9 — Revenue and Related Matters in the Notes to Consolidated Financial Statements provide additional information regarding our revenues. Goodwill and other intangible assets — When we acquire a business, we determine the fair value of the assets acquired and liabilities assumed on the date of acquisition, which may include a significant amount of intangible assets such as customer relationships, software and content, as well as goodwill. When determining the fair values of the acquired intangible assets, we consider, among other factors, analyses of historical financial performance and an estimate of the future performance of the acquired business. The fair values of the acquired intangible assets are primarily calculated using an income approach that relies on discounted cash flows. This method starts with a forecast of the expected future net cash flows for the asset and then adjusts the forecast to present value by applying a discount rate that reflects the risk factors associated with the cash flow streams. We consider this approach to be the most appropriate valuation technique because the inherent value of an acquired intangible asset is its ability to generate future income. In a typical acquisition, we engage a third-party valuation expert to assist us with the fair value analyses for acquired intangible assets.Determining the fair values of acquired intangible assets requires us to exercise significant judgment. We select reasonable estimates and assumptions based on evaluating a number of factors, including, but not limited to, marketplace participants, consumer awareness and brand history. Additionally, there are significant judgments inherent in discounted cash flows such as estimating the amount and timing of projected future cash flows, the selection of discount rates, hypothetical royalty rates and contributory asset capital charges. Specifically, the selected discount rates are intended to reflect the risk inherent in the projected future cash flows generated by the underlying acquired intangible assets.Determining an acquired intangible asset’s useful life also requires significant judgment and is based on evaluating a number of factors, including, but not limited to, the expected use of the asset, historical client retention rates, consumer awareness and trade name history, as well as any contractual provisions that could limit or extend an asset's useful life.The Company’s goodwill is evaluated in accordance with FASB ASC Topic 350, which requires goodwill to be assessed for impairment at least annually and whenever events or changes in circumstances indicate that the carrying value of goodwill may not be recoverable. In addition, an impairment evaluation of our amortizable intangible assets may also be performed if events or circumstances indicate potential impairment. Among the factors that could trigger an impairment review are current operating results that do not align with our annual plan or historical performance; changes in our strategic plans or the use of our assets; restructuring charges or other changes in our business segments; competitive pressures and changes in the general economy or in the markets in which we operate; and a significant decline in our stock price and our market capitalization relative to our net book value.25When performing our annual assessment of the recoverability of goodwill, we initially perform a qualitative analysis evaluating whether any events or circumstances occurred or exist that provide evidence that it is more likely than not that the fair value of any of our reporting units is less than the related carrying amount. If we do not believe that it is more likely than not that the fair value of any of our reporting units is less than the related carrying amount, then no quantitative impairment test is performed. However, if the results of our qualitative assessment indicate that it is more likely than not that the fair value of a reporting unit is less than its respective carrying amount, then we perform a two-step quantitative impairment test.Evaluating the recoverability of goodwill requires judgments and assumptions regarding future trends and events. As a result, both the precision and reliability of our estimates are subject to uncertainty. Among the factors that we consider in our qualitative assessment are general economic conditions and the competitive environment; actual and projected reporting unit financial performance; forward-looking business measurements; and external market assessments. To determine the fair values of our reporting units for a quantitative analysis, we typically utilize detailed financial projections, which include significant variables, such as projected rates of revenue growth, profitability and cash flows, as well as assumptions regarding discount rates, the Company’s weighted average cost of capital and other data.Our most recent annual impairment test of goodwill was a qualitative analysis conducted during the quarter ended September 30, 2020 that indicated no impairment. Subsequent to completing our 2020 annual impairment test, no events or changes in circumstances were noted that required an interim goodwill impairment test. Note 1 — Business and Significant Accounting Policies and Note 3 — Goodwill and Intangible Assets in the Notes to Consolidated Financial Statements provide additional information regarding the Company’s goodwill and amortizable intangible assets.Accounting for income taxes — The Company uses the asset and liability method of accounting for income taxes. We estimate our income taxes in each of the jurisdictions where the Company operates. This process involves estimating our current tax expense or benefit together with assessing temporary differences resulting from differing treatment of items for tax and accounting purposes. These differences result in deferred tax assets and liabilities, which are included in our consolidated balance sheets. When assessing the realizability of deferred tax assets, we consider if it is more likely than not that some or all of the deferred tax assets will not be realized. In making this assessment, we consider the availability of loss carryforwards, projected reversals of deferred tax liabilities, projected future taxable income, and ongoing prudent and feasible tax planning strategies. The Company recognizes the tax benefit from an uncertain tax position only if it is more likely than not that the tax position will be sustained based on the technical merits of the position. Recognized tax positions are measured at the largest amount of benefit with greater than a 50% likelihood of being realized. The Company uses estimates in determining the amount of unrecognized tax benefits associated with uncertain tax positions. Significant judgment is required in evaluating tax law and measuring the benefits likely to be realized. Uncertain tax positions are periodically re-evaluated and adjusted as more information about their ultimate realization becomes available.Accounting for stock-based compensation — The Company accounts for stock-based compensation awards in accordance with FASB ASC Topics 505 and 718 and SEC Staff Accounting Bulletins No. 107 and No. 110. The Company recognizes stock-based compensation expense, which is based on the fair value of the award on the date of grant, over the related service period. Note 10 — Stock-Based Compensation in the Notes to Consolidated Financial Statements provides additional information regarding stock-based compensation. Determining the appropriate fair value model and calculating the fair value of stock-based compensation awards requires the use of certain subjective assumptions, including the expected life of a stock-based compensation award and the Company’s common stock price volatility. In addition, determining the appropriate periodic stock-based compensation expense requires management to estimate the likelihood of the achievement of certain performance targets. The assumptions used in calculating the fair values of stock-based compensation awards and the related periodic expense represent management’s best estimates, which involve inherent uncertainties and the application of judgment. As a result, if circumstances change and the Company deems it necessary in the future to modify the assumptions it made or to use different assumptions, or if the quantity and nature of the Company’s stock-based compensation awards changes, then the amount of expense may need to be adjusted and future stock-based compensation expense could be materially different from what has been recorded in the current period.A change in any of the terms or conditions of stock-based compensation awards is accounted for as a modification of the award. Incremental compensation cost is measured as the excess, if any, of the fair value of the modified award over the fair value of the original award immediately before its terms are modified, measured based on the fair value of the awards at the modification date. For vested awards, we recognize incremental compensation cost in the period the modification occurs. For unvested awards, we recognize any incremental compensation expense at the modification date or ratably over the requisite remaining service period, as appropriate. If the fair value of the modified award is lower than the fair value of the original award immediately before modification, the minimum compensation cost we recognize is the cost of the original award.26RESULTS OF OPERATIONSConsolidated ResultsThe table below presents an analysis of selected line items and year-over-year changes in our Consolidated Statements of Operations for the years indicated (in thousands). Year Ended December 31, 2020Year Ended December 31, 2019Increase (Decrease)Percentage Increase(Decrease)Total revenues$4,099,403 $4,245,321 $(145,918)(3)%Costs and expenses: Cost of services and product development1,345,024 1,550,568 (205,544)(13) Selling, general and administrative2,038,963 2,103,424 (64,461)(3) Depreciation93,925 82,066 11,859 14 Amortization of intangibles125,059 129,713 (4,654)(4) Acquisition and integration charges6,282 9,463 (3,181)(34)Operating income490,150 370,087 120,063 32 Interest expense, net(113,549)(99,805)13,744 14 Loss from divested operations — (2,075)2,075 nmLoss on extinguishment of debt(44,814)— (44,814)nmOther (expense) income, net(5,654)7,532 (13,186)>(100)Less: Provision for income taxes59,388 42,449 16,939 40 Net income$266,745 $233,290 $33,455 14 %nm = not meaningful Total revenues for 2020 were $4.1 billion, a decrease of $145.9 million, or 3% compared to 2019 both on a reported basis and excluding the foreign currency impact. The tables below present (i) revenues by geographic region (based on where the sale is fulfilled) and (ii) revenues by segment for the years indicated (in thousands).Primary Geographic MarketYear Ended December 31, 2020Year Ended December 31, 2019Increase (Decrease)Percentage Increase(Decrease)United States and Canada$2,637,824 $2,734,490 $(96,666)(4)%Europe, Middle East and Africa966,273 996,004 (29,731)(3)Other International 495,306 514,827 (19,521)(4)Total revenues$4,099,403 $4,245,321 $(145,918)(3)%SegmentYear Ended December 31, 2020Year Ended December 31, 2019Increase (Decrease)Percentage Increase(Decrease)Research$3,602,892 $3,374,548 $228,344 7 %Conferences120,140 476,869 (356,729)(75)Consulting376,371 393,904 (17,533)(4)Total revenues$4,099,403 $4,245,321 $(145,918)(3)%Refer to the section of this MD&A below entitled “Segment Results” for a discussion of revenues and results by segment.Cost of services and product development was $1.3 billion in 2020, a decrease of $205.5 million compared to 2019, or 13% on both a reported basis and excluding the foreign currency impact. The decrease in Cost of services and product development was primarily due to decreased costs related to cancellations of conferences during fiscal year 2020 in response to the COVID-19 pandemic, lower travel and entertainment costs during the year as well as the implementation of various cost avoidance 27initiatives, which was partially offset by higher payroll and benefits costs. Cost of services and product development as a percent of revenues was 33% and 37% during 2020 and 2019, respectively.Selling, general and administrative (“SG&A”) expense was $2.0 billion in 2020, a decrease of $64.5 million compared to 2019, or 3% on both a reported basis and excluding the foreign currency impact. The decrease in SG&A expense was primarily due to reduced internal meetings, travel and entertainment costs and corporate expenses, partially offset by higher payroll related expenses. There was a decrease in the number of quota-bearing sales associates in Global Technology Sales and Global Business Sales to 3,089 and 846, respectively, at December 31, 2020. On a combined basis, the total number of quota-bearing sales associates decreased by 5% when compared to December 31, 2019. SG&A expense as a percent of revenues was 50% during both 2020 and 2019.Depreciation increased by 14% during 2020 compared to 2019. This increase was due to additional investments, including new leasehold improvements as additional office space went into service, and capitalized software.Amortization of intangibles decreased by 4% during 2020 compared to 2019 due to certain intangible assets that became fully amortized in 2020 and 2019.Acquisition and integration charges declined by $3.2 million during 2020 compared to 2019. This decrease was the result of the Company having completed one minor acquisition in late 2019 and no acquisitions in 2020.Operating income was $490.2 million and $370.1 million during 2020 and 2019, respectively. The increase in operating income was due to reduced Cost of services and product development and SG&A expense, partially offset by lower revenue, primarily in our Conferences segment.Interest expense, net increased by $13.7 million during 2020 compared to 2019. The increase was primarily due to higher weighted average annual effective rates related to the replacement of expired interest rate swaps with interest rate swaps containing higher effective interest rates in late 2019. Additionally, we wrote off $1.8 million of deferred financing fees related to the prepayment of $787.9 million on the Term Loan A facility under the 2016 Credit Agreement during the year ended December 31, 2020.Loss from divested operations of $2.1 million in 2019 was primarily due to adjustments of certain working capital balances related to the Company’s 2018 divestitures. Note 2 — Acquisitions and Divestitures in the Notes to Consolidated Financial Statements provides additional information regarding the Company’s 2018 divestitures.Loss on extinguishment of debt during the year ended December 31, 2020 was related to the early redemption premium and write-off of deferred financing fees on our redemption of the 2025 Notes on September 28, 2020.Other (expense) income, net for the years presented herein included the net impact of foreign currency gains and losses from our hedging activities, as well as sales of certain state tax credits and the recognition of other tax incentives. Other (expense) income, net for the year ended December 31, 2020 also included the release of $10.3 million from Accumulated other comprehensive loss, net related to forecasted interest payments that were no longer probable on our interest rate swap contracts, due to the prepayment of $787.9 million under the Company’s Term Loan A facility and repayment of all amounts outstanding under our revolving credit facility on our 2016 Credit Agreement. During 2020, Other (expense) income, net also included a $2.2 million gain on de-designated interest rate swaps. During 2019, Other (expense) income, net also included a pretax gain of $9.1 million from the Company’s sale of a minority equity investment.The provision for income taxes was $59.4 million and $42.4 million during 2020 and 2019, respectively, with an effective income tax rate of 18.2% in 2020 and 15.4% in 2019. The Company completed intercompany sales of certain intellectual property in both 2020 and 2019. As a result, the Company recorded net tax benefits of approximately $28.3 million and $38.1 million during 2020 and 2019, respectively. These benefits represent the value of future tax deductions for amortization of the assets in the acquiring jurisdiction. In July 2020, the Company completed an intercompany contribution of a significant amount of intellectual property. The Company’s intellectual property footprint continues to evolve and may result in tax rate volatility in the future. Note 12 — Income Taxes in the Notes to Consolidated Financial Statements provides additional information regarding the Company’s income taxes.Net income was $266.7 million and $233.3 million during 2020 and 2019, respectively. Additionally, our diluted net income per share increased by $0.40 in 2020 compared to 2019. These year-over-year changes reflect: the increase in our 2020 operating income, partially offset by: (i) the loss on extinguishment of debt; (ii) higher Interest expense, net and Other (expense) income, net; and (iii) a higher effective income tax rate in 2020 compared to 2019. 28SEGMENT RESULTSWe evaluate reportable segment performance and allocate resources based on gross contribution margin. Gross contribution is defined as operating income or loss excluding certain Cost of services and product development expenses, SG&A expenses, Depreciation, Amortization of intangibles, and Acquisition and integration charges. Gross contribution margin is defined as gross contribution as a percent of revenues.Reportable SegmentsThe Company’s reportable segments are as follows:•Research provides trusted, objective insights and advice on the mission-critical priorities of leaders across all functional areas of an enterprise through reports, briefings, proprietary tools, access to our research experts, peer networking services and membership programs that enable our clients to drive organizational performance.•Conferences provides business professionals across an organization the opportunity to learn, share and network. From our Gartner Symposium/Xpo series, to industry-leading conferences focused on specific business roles and topics, to peer-driven sessions, our offerings enable attendees to experience the best of Gartner insight and advice.•Consulting combines the power of Gartner market-leading research with custom analysis and on-the-ground support to help chief information officers and other senior executives driving technology-related strategic initiatives move confidently from insight to action.The sections below present the results of the Company’s three reportable business segments.Research As Of And For The Year Ended December 31, 2020As Of And For The Year Ended December 31, 2019Increase(Decrease)PercentageIncrease(Decrease)Financial Measurements: Revenues (1)$3,602,892 $3,374,548 $228,3447 %Gross contribution (1)$2,597,852 $2,351,720 $246,13210 %Gross contribution margin72 %70 %2 points— Business Measurements: Global Technology Sales (2):Contract value (1), (3)$2,909,000 $2,801,000 $108,0004 %Client retention 83 %82 %1 point— Wallet retention 98 %104 %(6) points— Global Business Sales (2):Contract value (1), (3) $696,000 $649,000 $47,0007 %Client retention 83 %82 %1 point— Wallet retention101 %101 %—— (1)Dollars in thousands.(2)Global Technology Sales includes sales to users and providers of technology. Global Business Sales includes sales to all other functional leaders.(3)Contract values are on a foreign exchange neutral basis. Contract values as of December 31, 2019 have been calculated using the same foreign currency rates as 2020.Research revenues increased by $228.3 million during 2020 compared to 2019, or 7% on both a reported basis and excluding the foreign currency impact. The gross contribution margin was 72% in 2020 compared to 70% in 2019. The increase in revenues during 2020 was primarily due to the same factors driving the trend in our Research contract value, which are discussed below. The improvement in margin was primarily due to the growth in revenue and a decline in travel and entertainment expenses due to COVID-19 travel restrictions. 29Total contract value increased to $3.6 billion at December 31, 2020, or 4% compared to December 31, 2019 on a foreign currency neutral basis. Global Technology Sales (“GTS”) contract value increased by 4% at December 31, 2020 when compared to December 31, 2019. The increase in GTS contract value was due to new business from new and existing clients. By industry, GTS contract value growth was led by technology, retail and services. Global Business Sales (“GBS”) contract value increased by 7% year-over-year, also primarily driven by new business from new and existing clients. GBS contract value growth was led by the healthcare and technology industries. The sales, finance and human resources practices all recorded double-digit contract value growth for the year.GTS client retention was 83% and 82% as of December 31, 2020 and 2019, respectively, while wallet retention was 98% and 104%, respectively. GBS client retention was 83% and 82% as of December 31, 2020 and 2019, respectively, while wallet retention was 101% as of both December 31, 2020 and 2019. The number of GTS client enterprises was flat at December 31, 2020 when compared to December 31, 2019, while GBS client enterprises declined by 9%.Conferences As Of And For The Year Ended December 31, 2020As Of And For The Year Ended December 31, 2019Increase(Decrease)PercentageIncrease(Decrease)Financial Measurements: Revenues (1)$120,140 $476,869 $(356,729)(75)%Gross contribution (1)$57,302 $241,757 $(184,455)(76)%Gross contribution margin48 %51 %(3) points— Business Measurements: Number of destination conferences (2)2072(52)(72)%Number of destination conferences attendees (2) 42,27385,750(43,477)(51)%(1)Dollars in thousands.(2)Includes both virtual and in-person conferences. Single day, local meetings are excluded.In response to the COVID-19 pandemic, we cancelled all in-person conferences from March 2020 through at least August 2021, and pivoted to producing virtual conferences with a focus on maximizing the value we deliver to our clients. During 2020, we successfully held 5 in-person conferences prior to the COVID-19 pandemic and 15 virtual conferences during the second half of the year. We began holding virtual Evanta conferences during the second quarter of 2020. Conferences revenues decreased by $356.7 million during 2020 compared to 2019, or 75% on both a reported basis and excluding the foreign currency impact. The segment gross contribution margin was 48% and 51% in 2020 and 2019, respectively. The lower gross contribution margin during 2020 was primarily due to the impact of COVID-19 noted above.Consulting As Of And For The Year Ended December 31, 2020As Of And For The Year Ended December 31, 2019Increase(Decrease)PercentageIncrease(Decrease)Financial Measurements: Revenues (1)$376,371 $393,904 $(17,533)(4)%Gross contribution (1)$115,744 $118,450 $(2,706)(2)%Gross contribution margin31 %30 %1 point— Business Measurements: Backlog (1), (2)$100,300 $115,700 $(15,400)(13)%Average billable headcount768784(16)(2)%Consultant utilization61 %62 %(1) point— Average annualized revenue per billable headcount (1)$368 $373 $(5)(1)%30(1)Dollars in thousands.(2)Backlog is on a foreign currency neutral basis. Backlog as of December 31, 2019 has been calculated using the same foreign currency rates as 2020.Consulting revenues decreased 4% during 2020 compared to 2019 on a reported basis and 5% excluding the foreign currency impact. The decrease in revenues on a reported basis was due to a 6% decrease in labor-based consulting, partially offset by a 3% increase in contract optimization. Contract optimization revenue may vary significantly and, as such, 2020 revenues may not be indicative of future results. The segment gross contribution margin was 31% and 30% in 2020 and 2019, respectively. The increase in gross contribution margin during 2020 was primarily due to benefits derived from certain cost-reduction initiatives, including a decline in travel and entertainment expenses due to COVID-19 travel restrictions.Backlog decreased by $15.4 million, or 13%, from December 31, 2019 to December 31, 2020. The $100.3 million of backlog at December 31, 2020 represented approximately four months of backlog, which is in line with our operational target.LIQUIDITY AND CAPITAL RESOURCESWe finance our operations through cash generated from our operating activities and borrowings. Note 6 — Debt in the Notes to Consolidated Financial Statements provides additional information regarding the Company’s outstanding debt obligations. At December 31, 2020, we had $712.6 million of cash and cash equivalents and approximately $1.0 billion of available borrowing capacity on the revolving credit facility under our 2020 Credit Agreement. We believe that the Company has adequate liquidity to meet its currently anticipated needs for at least the next twelve months. As a cautionary measure, we elected to suspend our share repurchase activity in March 2020. We resumed share repurchase activity in December 2020.We have historically generated significant cash flows from our operating activities. Our operating cash flow has been continuously maintained by the leverage characteristics of our subscription-based business model in our Research segment, which is our largest business segment and historically has constituted a significant portion of our total revenues. The majority of our Research customer contracts are paid in advance and, combined with a strong customer retention rate and high incremental margins, has resulted in continuously strong operating cash flow. Cash flow generation has also benefited from our ongoing efforts to improve the operating efficiencies of our businesses as well as a focus on the optimal management of our working capital as we increase sales.Our cash and cash equivalents are held in numerous locations throughout the world with 56% held overseas at December 31, 2020. The Company intends to reinvest substantially all of its accumulated undistributed foreign earnings, except in instances where repatriation would result in minimal additional tax. As a result of the U.S. Tax Cuts and Jobs Act of 2017, we believe that the income tax impact if such earnings were repatriated would be minimal.The table below summarizes the changes in the Company’s cash balances for the years indicated (in thousands). Year Ended December 31,Increase(Decrease) 20202019Cash provided by operating activities$903,278 $565,436 $337,842 Cash used in investing activities(83,888)(160,885)76,997 Cash used in financing activities(416,224)(285,992)(130,232)Net increase in cash and cash equivalents and restricted cash403,166 118,559 284,607 Effects of exchange rates 28,581 3,614 24,967 Beginning cash and cash equivalents and restricted cash280,836 158,663 122,173 Ending cash and cash equivalents $712,583 $280,836 $431,747 OperatingCash provided by operating activities was $903.3 million and $565.4 million in 2020 and 2019, respectively. The year-over-year increase was primarily due to (i) higher pre-tax income in 2020, (ii) improved collections, (iii) an increase in Accounts payable and accrued and other liabilities due to increased accrued payroll, fringe benefits and customer deposits and (iv) reduced income tax payments, offset by higher interest payments due to timing.Investing31Cash used in investing activities was $83.9 million and $160.9 million in 2020 and 2019, respectively. The decrease from 2019 to 2020 was the result of reduced capital spending in response to the COVID-19 pandemic. FinancingCash used in financing activities was $416.2 million and $286.0 million in 2020 and 2019, respectively. During 2020, we repaid a net $148.0 million on our revolving credit facility under the 2016 Credit Agreement, paid a net $58.5 million in debt principal repayments, borrowed $5.0 million on our revolving credit facility under the 2020 Credit Agreement and used $176.3 million of cash for share repurchases. Additionally, we paid $25.8 million in deferred financing fees related to our financing activities and $30.8 million in early redemption premium payments related to the repayment of our 2025 Notes. Note 6 — Debt in the Notes to Consolidated Financial Statements provides additional information regarding the Company’s financing activities in 2020. During 2019, the Company borrowed $5.0 million, repaid a net $7.0 million on our revolving credit facility under the 2016 Credit Agreement, paid a net $102.6 million in debt principal repayments and used $199.0 million for share repurchases.OBLIGATIONS AND COMMITMENTSDebtAs of December 31, 2020, the Company had $2.0 billion of principal amount of debt outstanding. Note 6 — Debt in the Notes to Consolidated Financial Statements provides additional information regarding the Company’s outstanding debt obligations.Off-Balance Sheet ArrangementsThrough December 31, 2020, the Company has not entered into any material off-balance sheet arrangements or transactions with unconsolidated entities or other persons.Contractual Cash CommitmentsThe table below summarizes the Company’s future contractual cash commitments as of December 31, 2020 (in thousands).Commitment DescriptionDue In Less Than1 YearDue In 2-3YearsDue In 4-5YearsDue In More Than5 YearsTotalDebt – principal and interest (1)$109,753 $244,849 $504,002 $1,863,749 $2,722,353 Operating leases (2)149,032 272,638 240,866 569,316 1,231,852 Deferred compensation arrangements (3)8,129 14,884 8,808 62,717 94,538 Other (4)32,891 48,306 18,455 30,621 130,273 Totals$299,805 $580,677 $772,131 $2,526,403 $4,179,016 (1)Principal repayments of the Company’s debt obligations were classified in the above table based on the contractual repayment dates. Interest payments were based on the effective interest rates as of December 31, 2020, including the effects of the Company’s interest rate swap contracts. Note 6 — Debt in the Notes to Consolidated Financial Statements provides information regarding the Company’s debt obligations and interest rate swap contracts.(2)The Company leases various facilities, automobiles, computer equipment and other assets under non-cancelable operating lease agreements expiring between 2021 and 2038. The total commitment excludes approximately $325.4 million of estimated future cash receipts from the Company’s subleasing arrangements. Note 1 — Business and Significant Accounting Policies and Note 7 — Leases in the Notes to Consolidated Financial Statements provide additional information regarding the Company’s leases.(3)The Company has supplemental deferred compensation arrangements with certain of its employees. Amounts payable with known payment dates have been classified in the above table based on those scheduled payment dates. Amounts payable whose payment dates are unknown have been included in the Due In More Than 5 Years category because the Company cannot determine when the amounts will be paid. Note 15 — Employee Benefits in the Notes to Consolidated Financial Statements provides additional information regarding the Company’s supplemental deferred compensation arrangements.(4)Other includes: (i) contractual commitments (a) for software, telecom and other services and (b) to secure sites for our Conferences business; (ii) amounts due for share repurchase transactions that occurred in late December 2020 but were 32settled in cash in January 2021; and (iii) projected cash contributions to the Company’s defined benefit pension plans. Note 15 — Employee Benefits in the Notes to Consolidated Financial Statements provides additional information regarding the Company’s defined benefit pension plans.In addition to the contractual cash commitments included in the above table, the Company has other payables and liabilities that may be legally enforceable but are not considered contractual commitments. Information regarding the Company’s payables and liabilities is included in Note 5 — Accounts Payable and Accrued and Other Liabilities in the Notes to Consolidated Financial Statements.QUARTERLY FINANCIAL DATA The tables below present our quarterly operating results for the two-year period ended December 31, 2020.2020(In thousands, except per share data)FirstSecondThirdFourthRevenues$1,018,891 $973,135 $994,618 $1,112,759 Operating income124,718 99,651 87,650 178,131 Net income (1), (2)75,097 55,077 16,964 119,607 Net income per share (1), (2), (3): Basic $0.84 $0.62 $0.19 $1.34 Diluted $0.83 $0.61 $0.19 $1.33 2019(In thousands, except per share data)FirstSecondThirdFourthRevenues$970,444 $1,070,882 $1,000,502 $1,203,493 Operating income48,799 116,002 69,147 136,139 Net income (2)20,795 103,406 41,388 67,701 Net income per share (2), (3): Basic $0.23 $1.15 $0.46 $0.76 Diluted $0.23 $1.13 $0.46 $0.75 (1)In conjunction with the issuance of the 2030 Notes, the Company redeemed all of the 2025 Notes on September 28, 2020 for cash, and the Company recorded $30.8 million of charges for the early redemption premium and $14.0 million of charges for the write-off of deferred financing costs related to the 2025 Notes and the 2016 Credit Agreement, which were recorded in Loss on extinguishment of debt on the Consolidated Statements of Operations.(2)During 2020 and 2019, the Company recorded a net tax benefit of approximately $28.3 million and $38.1 million, respectively, related to intercompany sales of certain intellectual property, which increased our basic and diluted net income per share by approximately $0.31 and $0.42 per share for the second quarter of 2020 a and 2019, respectively. Note 12 — Income Taxes in the Notes to Consolidated Financial Statements provides additional information regarding the tax impact of our intercompany sale of certain intellectual property.(3)The aggregate of the four quarters’ basic and diluted net income per share may not equal the reported full calendar year amounts due to the effects of share repurchases, dilutive equity compensation and rounding.RECENTLY ISSUED ACCOUNTING STANDARDSThe FASB has issued accounting standards that had not yet become effective as of December 31, 2020 and may impact the Company’s consolidated financial statements or its disclosures in future periods. Note 1 — Business and Significant Accounting Policies in the Notes to Consolidated Financial Statements provides information regarding those accounting standards.33ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.INTEREST RATE RISK As of December 31, 2020, the Company had $2.0 billion in total debt principal outstanding. Note 6 — Debt in the Notes to Consolidated Financial Statements provides additional information regarding the Company’s outstanding debt obligations.Approximately $0.4 billion of the Company’s total debt outstanding as of December 31, 2020 was based on a floating base rate of interest, which potentially exposes the Company to increases in interest rates. However, we reduce our overall exposure to interest rate increases through our interest rate swap contracts, which effectively convert the floating base interest rates on all of our variable rate borrowings to fixed rates. FOREIGN CURRENCY RISK A significant portion of our revenues are typically derived from sales outside of the United States. Among the major foreign currencies in which we conduct business are the Euro, the British Pound, the Japanese Yen, the Australian dollar and the Canadian dollar. The reporting currency of our Consolidated Financial Statements is the U.S. dollar. As the values of the foreign currencies in which we operate fluctuate over time relative to the U.S. dollar, the Company is exposed to both foreign currency translation and transaction risk.Translation risk arises as our foreign currency assets and liabilities are translated into U.S. dollars because the functional currencies of our foreign operations are generally denominated in the local currency. Adjustments resulting from the translation of these assets and liabilities are deferred and recorded as a component of stockholders’ equity. A measure of the potential impact of foreign currency translation can be determined through a sensitivity analysis of our cash and cash equivalents. At December 31, 2020, we had $712.6 million of cash and cash equivalents, with a substantial portion denominated in foreign currencies. If the exchange rates of the foreign currencies we hold all changed in comparison to the U.S. dollar by 10%, the amount of cash and cash equivalents we would have reported on December 31, 2020 could have increased or decreased by approximately $54 million. The translation of our foreign currency revenues and expenses historically has not had a material impact on our consolidated earnings because movements in and among the major currencies in which we operate tend to impact our revenues and expenses fairly equally. However, our earnings could be impacted during periods of significant exchange rate volatility, or when some or all of the major currencies in which we operate move in the same direction against the U.S. dollar. Transaction risk arises when we enter into a transaction that is denominated in a currency that may differ from the local functional currency. As these transactions are translated into the local functional currency, a gain or loss may result, which is recorded in current period earnings. We typically enter into foreign currency forward exchange contracts to mitigate the effects of some of this foreign currency transaction risk. Our outstanding foreign currency forward exchange contracts as of December 31, 2020 had an immaterial net unrealized loss.CREDIT RISK Financial instruments that potentially subject the Company to concentration of credit risk consist primarily of short-term, highly liquid investments classified as cash equivalents, fees receivable, interest rate swap contracts and foreign currency forward exchange contracts. The majority of the Company’s cash and cash equivalents, interest rate swap contracts and foreign currency forward exchange contracts are with large investment grade commercial banks. Fees receivable balances deemed to be collectible from customers have limited concentration of credit risk due to our diverse customer base and geographic dispersion.
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+Item 7. MD&A for discussion on changes in market share by region. 2Table of ContentsGENERAL MOTORS COMPANY AND SUBSIDIARIESAs discussed above, total vehicle sales and market share data provided in the table above includes fleet vehicles. Certain fleet transactions, particularly sales to daily rental car companies, are generally less profitable than retail sales to end customers. The following table summarizes estimated fleet sales and those sales as a percentage of total vehicle sales (vehicles in thousands): Years Ended December 31,202020192018GMNA493 741 740 GMI351 498 478 Total fleet sales844 1,239 1,218 Fleet sales as a percentage of total vehicle sales12.4 %16.1 %14.5 %Product Pricing Several methods are used to promote our products, including the use of dealer, retail and fleet incentives such as customer rebates and finance rate support. The level of incentives is dependent upon the level of competition in the markets in which we operate and the level of demand for our products. Cyclical and Seasonal Nature of Business The market for vehicles is cyclical and depends in part on general economic conditions, credit availability and consumer spending. Vehicle markets are also seasonal. Production varies from month to month. Vehicle model changeovers occur throughout the year as a result of new market entries. Relationship with Dealers We market vehicles and automotive parts worldwide primarily through a network of independent authorized retail dealers. These outlets include distributors, dealers and authorized sales, service and parts outlets. The number of authorized dealerships were 4,697 in GMNA and 7,661 in GMI at December 31, 2020.We and our joint ventures enter into a contract with each authorized dealer agreeing to sell to the dealer one or more specified product lines at wholesale prices and granting the dealer the right to sell those vehicles to retail customers from an approved location. Our dealers often offer more than one GM brand at a single dealership in a number of our markets. Authorized dealers offer parts, accessories, service and repairs for GM vehicles in the product lines that they sell using GM parts and accessories. Our dealers are authorized to service GM vehicles under our limited warranty program, and those repairs are made only with GM parts. Our dealers generally provide their customers with access to credit or lease financing, vehicle insurance and extended service contracts provided by GM Financial and other financial institutions. The quality of GM dealerships and our relationship with our dealers and distributors are critical to our success given that dealers maintain the primary sales and service interface with the end consumer of our products. In addition to the terms of our contracts with our dealers, we are regulated by various country and state franchise laws and regulations that may supersede those contractual terms and impose specific regulatory requirements and standards for initiating dealer network changes, pursuing terminations for cause and other contractual matters. Research, Product and Business Development and Intellectual Property Costs for research, manufacturing engineering, product engineering and design and development activities primarily relate to developing new products or services or improving existing products or services, including activities related to vehicle and greenhouse gas (GHG) emissions control, improved fuel economy, electrification, autonomous vehicles, and the safety of drivers and passengers. Research and development expenses were $6.2 billion, $6.8 billion and $7.8 billion in the years ended December 31, 2020, 2019 and 2018. Product Development The Product Development organization is responsible for designing and integrating vehicle and propulsion components while aiming to maximize part sharing across multiple vehicle segments. Global teams in Design, Program Management, Component & Subsystem Engineering, Product Integrity, Safety, Propulsion Systems and Purchasing & Supply Chain collaborate to meet customer requirements and maximize global economies of scale.Our global vehicle architecture development is headquartered at our Global Technical Center in Warren, Michigan. Cross-segment part sharing is an essential enabler to optimize our current vehicle portfolio, as we expect that more than 75% of our global sales volume will come from five vehicle architectures by mid-decade. We will continue to leverage our current architecture portfolio to accommodate our customers around the world while achieving our financial goals.Battery Electric Vehicles We have committed to an all-electric future and are investing in multiple technologies offering increasing levels of vehicle electrification with a core focus on zero emission battery electric vehicles as part of our long-term strategy to reduce petroleum consumption and GHG emissions. We currently offer the Chevrolet Bolt EV, which has an 3Table of ContentsGENERAL MOTORS COMPANY AND SUBSIDIARIESEnvironmental Protection Agency (EPA)-estimated range of 259 miles on a full charge with the 2020 model year. We have also announced our all-new Ultium battery electric architecture capable of more than 400 miles of GM-estimated range on a full charge that will launch on the upcoming GMC Hummer EV in 2021, followed by the Cadillac LYRIQ in 2022 and additional models by 2025. This new platform will be flexible, allowing quick response to customer preferences with a shorter design and development lead time compared to our internal combustion engine vehicles. Ultium will be leveraged across multiple brands and vehicle sizes, styles and drive configurations. Our new electric vehicle assembly facilities will include Detroit-Hamtramck Assembly, renamed "Factory ZERO". In January 2020, we announced a $2.2 billion investment in our Factory ZERO assembly plant, which is being re-tooled into a fully-dedicated electric vehicle facility to produce the GMC Hummer EV, Cruise Origin, a shared self-driving vehicle, and other electric vehicles. In October 2020, we also announced a $2.0 billion investment in our Spring Hill Manufacturing facility in Tennessee, where we will build the Cadillac LYRIQ. In addition, we have announced plans to mass-produce battery cells for these and other future battery electric vehicles at Ultium Cells LLC (an equally owned joint venture with LG Chem, Ltd.) in Lordstown, Ohio.To support mass market adoption of electric vehicles, we are working to ensure that our customers will have access to comprehensive charging solutions. For personal vehicles, this means strategically addressing charging needs at home, the workplace and in public locations. For fleet vehicles, this means turnkey charging solutions and fleet and facility energy management services. We have announced collaborative work with several charge network operators to filter real-time data on their respective networks and charge station health into our Energy Assist feature within the myChevrolet app, currently available to Chevrolet Bolt EV drivers. In January 2021, we announced a new business, BrightDrop, which will offer an ecosystem of electric first-to-last mile products, software and services designed to help delivery and logistics companies deliver goods more efficiently. In addition, we plan to invest approximately CAD $1.0 billion to convert our CAMI manufacturing plant in Ingersoll, Ontario to produce the BrightDrop EV600 electric cargo van. Autonomous Technology We expect autonomous technology to lead to a future of zero crashes, zero emissions and zero congestion. We believe that building all-electric vehicles with autonomous capabilities integrated from the beginning, rather than through retrofits, is the most efficient way to unlock the tremendous potential societal benefits of self-driving cars. In January 2020, the Cruise Origin was unveiled by Cruise which is being co-developed by GM, Cruise and Honda Motor Company, Ltd. (Honda). The Cruise Origin will be built on General Motors’ all-new modular architecture, powered by the Ultium battery system. In October 2020, Cruise received a permit from the California Department of Motor Vehicles to remove back-up drivers from Cruise AV test vehicles in San Francisco and subsequently began truly driverless testing. Also in October 2020, GM and Cruise announced they will file an exemption petition with the National Highway Traffic Safety Administration (NHTSA) seeking regulatory approval for the Origin’s deployment, and have withdrawn an earlier exemption petition that was limited to the Cruise AVs derived from the Chevrolet Bolt platform. In January 2021, we announced that Microsoft Corporation (Microsoft) will join us and other investors in a $2.2 billion investment in Cruise. Cruise may continue to opportunistically seek additional funding in this round in 2021. Given the potential of all-electric self-driving vehicles to help save lives, reshape our cities and reduce emissions, the goal of Cruise is to deliver its self-driving services as soon as possible, with safety being the gating metric.Alternative Fuel Vehicles We believe alternative fuels offer significant potential to reduce petroleum consumption and resulting GHG emissions in the transportation sector. By leveraging experience and capability developed around these technologies in our global operations, we continue to develop FlexFuel vehicles that can run on ethanol-gasoline blend fuels as well as technologies that support compressed natural gas and liquefied petroleum gas. We offer several 2021 model year FlexFuel vehicles in the U.S. and Canada to retail and fleet customers capable of operating on gasoline, E85 ethanol or any combination of the two. We also support the development of biodiesel blend fuels, which are alternative diesel fuels produced from renewable sources.Hydrogen Fuel Cell Technology Another part of our long-term strategy toward electrification and the reduction of petroleum consumption and GHG emissions is our commitment to the development of our Hydrotec hydrogen fuel cell technology. We believe hydrogen fuel cells will play an important role in many automotive applications, such as commercial vehicles, where customers will derive additional benefits from the ability to refuel quickly, extended range, and suitability for heavier payloads and central refueling of large fleets. GM is also evaluating promising fuel cell end-use applications for aerospace, stationary backup power and mobile power. In addition, GM and Honda, through their long-term strategic alliance to collaborate in research and advanced engineering efforts on fuel cell systems, are developing and commercializing fuel cell systems with production scheduled for the early 2020s. In January 2021, we announced an agreement to supply our Hydrotec fuel cell power cubes to Navistar for use in its production model fuel cell electric vehicle.4Table of ContentsGENERAL MOTORS COMPANY AND SUBSIDIARIESOnStar and Vehicle Connectivity We offer OnStar and connected services to more than 22 million connected vehicles globally through subscription-based and complimentary services. We are among the leaders in the industry with significant global real-world experience in delivering connected services and advanced safety features. OnStar provides safety and security services for retail and fleet customers, including automatic crash response, emergency services, roadside assistance, crisis assist, stolen vehicle assistance and turn-by-turn navigation. We also offer a variety of connected services, including mobile applications for owners to remotely control certain vehicle features and electric vehicle owners to locate charging stations, on-demand vehicle diagnostics, GM Smart Driver, GM Marketplace in-vehicle commerce, Amazon Alexa in-vehicle voice, connected navigation, SiriusXM with 360L and 4G LTE wireless connectivity. We also offer Super Cruise, the industry's first hands-free driver assistance feature for enabled roads, which is powered by vehicle connectivity by means of a Super Cruise subscription. The Super Cruise plan enables real-time GPS and mapping updates and connects the vehicle to an OnStar emergency advisor for situations in which a driver is non-responsive to escalating alerts. Super Cruise will be expanded to be included on 22 models by 2023. Additionally, we have announced plans to integrate Google's Voice Assistant, navigation and app ecosystem into GM infotainment systems beginning in 2021. Intellectual Property We are constantly innovating and hold a significant number of patents, copyrights, trade secrets and other intellectual property that protect those innovations in numerous countries. While no single piece of intellectual property is individually material to our business as a whole, our intellectual property is important to our operations and continued technological development. Additionally, we hold a number of trademarks and service marks that are very important to our identity and recognition in the marketplace. Raw Materials, Services and Supplies We purchase a wide variety of raw materials, parts, supplies, energy, freight, transportation and other services from numerous suppliers to manufacture our products. The raw materials primarily include steel, aluminum, resins, copper, lead and precious metals. We have not experienced any significant shortages of raw materials and normally do not carry substantial inventories of these raw materials in excess of levels reasonably required to meet our production requirements. Costs are expected to remain elevated due to the price of commodities and the continuing existence of tariffs. We purchase systems, components and parts from suppliers. A global semiconductor supply shortage is having wide-ranging effects across multiple industries, particularly the automotive industry. Refer to Item 1A. Risk Factors for further discussion of this risk.In some instances, we purchase systems, components, parts and supplies from a single source and may be at an increased risk for supply disruptions. The inability or unwillingness of these sources to provide us with parts and supplies could have a material adverse effect on our production capacity. Combined purchases from our two largest suppliers were approximately 11% of our total purchases in each of the years ended December 31, 2020 and 2019, and approximately 12% of our total purchases in the year ended December 31, 2018. Refer to Item 1A. Risk Factors for further discussion of these risks. Environmental and Regulatory MattersAutomotive Criteria Emissions Control Our products are subject to laws and regulations globally that require us to control certain non-GHG automotive emissions, including vehicle and engine exhaust emission standards, vehicle evaporative emission standards and onboard diagnostic (OBD) system requirements. Emission requirements have become more stringent as a result of stricter standards and new diagnostic requirements that have come into force in many markets around the world, often with very little harmonization. While we believe all of our products are designed and manufactured in material compliance with substantially all vehicle emissions requirements, regulatory authorities may conduct ongoing evaluations of products from all manufacturers. The U.S. federal government, through the EPA, imposes stringent exhaust and evaporative emission control requirements on vehicles sold in the U.S. The California Air Resources Board (CARB) likewise imposes stringent exhaust and evaporative emission standards. These emission control standards will likely increase the time and mileage periods over which manufacturers are responsible for a vehicle's emission performance. The Clean Air Act permits states that have areas with air quality compliance issues to adopt California emission standards in lieu of federal requirements. Fourteen states and the District of Columbia have adopted California emission standards, and there is a possibility that additional U.S. jurisdictions could adopt California emission requirements in the future.The Canadian federal government's current vehicle pollutant emission requirements are generally aligned with U.S. federal requirements. 5Table of ContentsGENERAL MOTORS COMPANY AND SUBSIDIARIESEach model year we must obtain certification that our vehicles and heavy-duty engines will meet emission requirements of the EPA before we can sell vehicles in the U.S. and Canada, and of CARB before we can sell vehicles in California and other states that have adopted the California emission requirements. In 2019, certain areas within China began implementation of the China 6 emission standard (China 6) requirements. China 6 combines elements of both European Union (EU) and U.S. standards and increases the time and mileage periods over which manufacturers are responsible for a vehicle's emission performance. Nationwide implementation of China 6a for new registrations occurred in January 2021, and the more stringent China 6b is expected to be implemented in July 2023. For additional information, refer to Item 1A. Risk Factors.Brazil has approved a set of national emissions standards referred to as L7, to be implemented in 2022, and L8, to be implemented from 2025 onward. L7 standards include exhaust tailpipe gases, durability for emissions, evaporative emissions and noise limits, additional OBD requirements and a phase-in for onboard refueling vapor recovery systems. L8 standards include real drive emission targets for real driving emissions and reduce corporate exhaust limits every two years until 2031. Some of the requirements are aligned with those of the EPA. As a result of the sale of the Opel/Vauxhall Business, GM’s vehicle presence in Europe is smaller, but GM may still be affected by actions taken by regulators related both to Opel/Vauxhall vehicles sold before the sale of the Opel/Vauxhall Business as well as to other vehicles GM continues to sell in Europe. In the EU, increased scrutiny of compliance with emissions standards may result in changes to these standards, including implementation of real driving emissions tests, as well as stricter interpretations or redefinition of these standards and more rigorous enforcement. For example, our former German subsidiary has participated in continuing discussions with German and European authorities concerning emissions control systems. For additional information, refer to Note 22 to our consolidated financial statements.Automotive Fuel Economy and Greenhouse Gas Emissions In the U.S., NHTSA promulgates and enforces Corporate Average Fuel Economy (CAFE) standards for three separate fleets: domestically produced cars, imported cars and light-duty trucks. Manufacturers are subject to substantial civil penalties if they fail to meet the applicable CAFE standard in any model year, after considering all available credits for the preceding five model years, expected credits for the three succeeding model years and credits obtained from other manufacturers. In addition to federal CAFE standards, the EPA promulgates and enforces GHG emission standards, which are effectively fuel economy standards because the majority of vehicle GHG emissions are carbon dioxide emissions that are emitted in direct proportion to the amount of fuel consumed by a vehicle. In March 2020, the EPA and NHTSA issued a rule setting fuel economy and GHG emissions standards for the light-duty vehicles through the 2026 model year, which is currently being challenged through litigation. On January 25, 2021, President Biden issued Executive Order 13990, directing the EPA and NHTSA to, by July 2021, consider publishing a proposed rule suspending, revising, or rescinding those standards, and has also permitted the Department of Justice to seek to stay or dispose of litigation challenging those standards. The EPA and NHTSA also regulate the fuel efficiency and GHG emissions of medium- and heavy-duty vehicles, imposing more stringent standards over time.In addition, CARB has asserted the right to promulgate and enforce its own state GHG standards for motor vehicles, and other states have asserted the right to adopt CARB's standards. CARB regulations previously stated that compliance with the EPA light-duty program is deemed compliance with CARB standards. However, on December 12, 2018, CARB amended this regulation to state that, in the event the EPA were to alter federal GHG stringency, which it now has, compliance with the EPA's GHG emissions standards will no longer be deemed compliance with CARB's separate requirements. In September 2019, NHTSA and the EPA issued a rule asserting that California is preempted from regulating GHG emissions, which is currently being challenged through litigation. As a result, depending on the outcome of the federal CAFE and GHG rulemakings and related litigation and the finality of CARB's regulatory amendment, in the future GM might be required to meet California GHG standards that are different than the EPA standards.CARB has also imposed the requirement that increasing percentages of Zero Emission Vehicles (ZEVs) must be sold in California. The Clean Air Act permits states to adopt California emission standards, and 11 have adopted the ZEV requirements. In September 2019, the EPA revoked the waiver it had granted to California that permitted its ZEV program, and NHTSA also asserted preemption of California's ZEV program. Both the EPA and NHTSA's actions are currently being challenged through litigation. Depending on the outcome of that litigation, there is a possibility that additional U.S. jurisdictions could adopt California ZEV requirements in the future. On January 25, 2021, President Biden issued Executive Order 13990, directing EPA and NHTSA to, by April 2021, consider publishing a proposed rule suspending, revising, or rescinding EPA and NHTSA's September 2019 actions, and has also permitted the Department of Justice to stay or dispose of litigation related to preemption of state GHG and ZEV standards. On 6Table of ContentsGENERAL MOTORS COMPANY AND SUBSIDIARIESFebruary 1, 2021, the Department of Justice filed a motion seeking to hold these preemption cases in abeyance pending implementation of Executive Order 13990. In Canada, light- and heavy-duty GHG regulations are currently patterned after the EPA GHG emissions standards. However, the Canadian government is conducting a mid-term review of its 2022 to 2025 model year light-duty GHG standards and there is an increased risk that future Canadian light-duty GHG regulations may not be aligned with the revised EPA regulations. In addition, the Canadian province of Quebec has ZEV requirements regulating the 2018 to 2025 model years largely based on California program requirements. The province of British Columbia also finalized similar ZEV regulations in July 2020 that cover the 2020 to 2039 model years. There is also the risk that the federal government or other provinces in Canada may pursue the implementation of additional ZEV requirements in the future. China has two fuel economy requirements for passenger vehicles: an individual vehicle pass-fail type approval requirement and a fleet average fuel consumption requirement. With a focus on the fleet average program, the current China Phase 4 fleet average fuel consumption requirement, which went into effect in 2016, is based on curb weight with full compliance required by 2020. China Phase 4 has continued subsidies for plug-in hybrid, battery electric and fuel cell vehicles, which are referred to as New Energy Vehicles (NEVs). Subsidies for NEV have been extended to the end of 2022. China Phase 5 has been developed with a planned start in 2021 and full compliance is required by 2025. In addition, China has established an NEV Mandate that will require passenger car manufacturers to produce a certain volume of NEVs to generate credits in 2019 and beyond to offset internal combustion engine vehicle production volume. The number of credits per car is based on the level of electric range and energy efficiency, with the goal of increasing NEV volume penetrations. Uncommitted NEV credits may be used to assist compliance with the fleet average fuel consumption requirement. China has issued NEV credit targets between 2019 and 2023 and is setting new NEV credit targets aiming at further increasing volumes of NEVs in 2024 and 2025. In Brazil, the Secretary of Industry and Development promulgates and enforces CAFE standards and has enforced a new CAFE program for the period October 2020 to September 2026 and October 2026 to September 2032 for light-duty and mid-size trucks and sport utility vehicles (SUVs), including diesel vehicles, imposing more stringent standards for each period. Regulators in other jurisdictions have already adopted or are developing fuel economy or carbon dioxide regulations. If regulators in these jurisdictions seek to impose and enforce standards that are misaligned with market conditions, we may be forced to take various actions to increase market support programs for certain vehicles and curtail production of others in order to achieve compliance. We regularly evaluate our current and future product plans and strategies for compliance with fuel economy and GHG regulations.Industrial Environmental Control Our operations are subject to a wide range of environmental protection laws including those regulating air emissions, water discharge, waste management and environmental cleanup. Certain environmental statutes require that responsible parties fund remediation actions regardless of fault, legality of original disposal or ownership of a disposal site. Under certain circumstances these laws impose joint and several liability as well as liability for related damages to natural resources. To mitigate the effects of our worldwide operations on the environment, we are embracing sustainability programs focused on reducing GHG emissions, water consumption and discharge and waste disposal. At December 31, 2020, 81% of waste materials generated in our manufacturing facilities across the globe are composted, reused or recycled. We estimate that our waste reduction program diverted 1.0 million metric tons of waste from landfills in 2020, and resulted in 4.6 million metric tons of GHG emissions avoided in global manufacturing operations.In addition to reducing our impact on the environment, our waste reduction commitments generate income from the sale of production by-products, reduce our use of raw materials and help to reduce the risks and financial liabilities associated with waste disposal.We continue our efforts to increase our use of renewable energy, improve our energy efficiency and work to drive growth and scale of renewables. We are committed to meeting the electricity needs of our operations worldwide with renewable energy by 2035, pulling forward our previous commitment by five years, and plan to be carbon neutral by 2040 in our global products and operations, supported by a commitment to science-based targets. In addition to our carbon goals, the company worked with the Environmental Defense Fund to develop a shared vision of an all-electric future and an aspiration to eliminate tailpipe emissions from new light-duty vehicles by 2035. Through December 31, 2020, we implemented projects and signed renewable energy contracts globally that brought our total renewable energy capacity to over one gigawatt by 2023, which represents approximately 60% of our U.S. electricity use and over 40% of our global electricity use. In 2019, we executed our largest 7Table of ContentsGENERAL MOTORS COMPANY AND SUBSIDIARIESgreen tariff to date with DTE Energy Company, sourcing 300,000 megawatt hours of renewable energy that will begin supplying us in early 2021. Additionally, in 2020 we executed our largest power purchase agreement to date, with 180 megawatts of solar electricity supplying our U.S. operations starting in 2023. We continue to seek opportunities for a diversified renewable energy portfolio including wind, solar, and landfill gas. In 2020, Energy Star certified two assembly plants, one in Canada through Natural Resources Canada and one in the U.S. as well as five buildings in the U.S. for superior energy management. We also met the EPA Energy Star Challenge for Industry (EPA Challenge) at six additional sites by reducing energy intensity an average of 14% at these sites within three years. To meet the EPA Challenge, industrial sites must reduce energy intensity by 10% within a five year period. In total, 69 GM-owned manufacturing sites have met the EPA Challenge, with many sites achieving the goal multiple times for a total of 129 recognitions. Additionally, we received recognition from the U.S. Department of Energy (DOE) of 50001 Ready status for 25 facilities. The U.S. DOE 50001 Ready program is a self-guided approach for facilities to establish an energy management system and self-attest to the structure of ISO 50001, a voluntary global standard for energy management systems in industrial, commercial and institutional facilities. These sustainability efforts reduce our operational expenses and are part of our approach to improve the sustainability of our operations by aligning our business strategy with aggressive environmental goals and reduction targets, collecting accurate data, and publicly reporting progress against our targets. Chemical Regulations We continually monitor the implementation of chemical regulations to maintain compliance and evaluate their effect on our business, suppliers and the automotive industry.Globally, governmental agencies continue to introduce new legislation and regulations related to the selection and use of chemicals by mandating broad prohibitions or restrictions and implementing green chemistry, life cycle analysis and product stewardship initiatives. These initiatives give broad regulatory authority to ban or restrict the use of certain chemical substances and potentially affect automobile manufacturers' responsibilities for vehicle components at the end of a vehicle's life, as well as chemical selection for product development and manufacturing. Global treaties and initiatives such as the Stockholm, Basel and Rotterdam Conventions on Chemicals and Waste and the Minamata Convention on Mercury, are driving chemical regulations across signatory countries. In addition, more global jurisdictions are establishing substance standards with regard to Vehicle Interior Air Quality.Chemical regulations are increasing in North America. In the U.S. the EPA is moving forward with risk analysis and management of high priority chemicals under the authority of the 2016 Lautenberg Chemical Safety for the 21st Century Act, and several U.S. states have chemical management regulations that can affect vehicle design such as the California and Washington laws banning the use of copper in brake friction material. Chemical restrictions in Canada continue to steadily progress as a result of Environment and Climate Change Canada's Chemical Management Plan to assess existing substances and implement risk management controls on any chemical deemed toxic. China prohibits the use of several chemical substances in vehicles. There are also various regulations in China stipulating the requirements for chemical management. Among other things, these regulations restrict the use, import and export of various chemical substances. The failure of our joint venture partners or our suppliers to comply with these regulations could disrupt production in China or prevent our joint venture partners from selling the affected products in the China market.These emerging laws and regulations will potentially lead to increases in costs and supply chain complexity. We believe that we are materially in compliance with substantially all of these requirements or expect to be materially in compliance by the required dates.Vehicle Safety U.S. Requirements The National Traffic and Motor Vehicle Safety Act of 1966 (the Safety Act) regulates the vehicles and items of motor vehicle equipment that we manufacture and sell. The Safety Act prohibits the sale in the United States of any new vehicle or equipment that does not conform to applicable federal motor vehicle safety standards established by NHTSA. Meeting or exceeding the many safety standards is costly as global compliance and non-governmental assessment requirements continue to evolve and grow more complex, and lack harmonization globally. The Safety Act further requires that if we or NHTSA determine a vehicle or an item of vehicle equipment does not comply with a safety standard, or that vehicle or equipment contains a defect that poses an unreasonable safety risk, we must conduct a safety recall to remedy that condition in the affected vehicles. Should we or NHTSA determine a safety defect or noncompliance issue exists with respect to any of our vehicles, the cost of such recall campaigns could be substantial. 8Table of ContentsGENERAL MOTORS COMPANY AND SUBSIDIARIESOther National Requirements Outside of the U.S., many countries have established vehicle safety standards and regulations and are likely to adopt additional, more stringent requirements in the future. The European General Safety Regulation has introduced UN-ECE regulations, which are required for the European Type Approval process. Globally, governments generally have been adopting UN-ECE based regulations with some variations to address local concerns. Any difference between North American and UN-ECE based regulations can add complexity and costs to vehicle development, and we continue to support efforts to harmonize regulations to reduce complexity. New safety and recall requirements in various countries around the world, including in China, Brazil, and Gulf Cooperation Council countries, also may add substantial costs and complexity to our safety and field action activities globally. In Canada, vehicle regulatory requirements are currently aligned with U.S. regulations; however, under the Canadian Motor Vehicle Safety Act, recall thresholds are different and the Minister of Transport has broad powers to order manufacturers to submit a notice of defect or non-compliance when the Minister considers it to be in the interest of safety. Further, various governments are beginning to mandate e-Call and other features that can be market-specific and add complexity and increase our cost of compliance globally. Crash Test Ratings and New Car Assessment Programs Organizations in various regions around the world, including in the U.S., rate and compare motor vehicles through various New Car Assessment Programs (NCAPs) to provide consumers and businesses with additional information about the safety of new vehicles. NCAPs use crash tests and other evaluations that are different than what is required by applicable regulations, and use stars to rate vehicle safety, with five stars awarded for the highest rating and one for the lowest. Achieving high NCAP ratings, which can vary by country and region, can add complexity and cost to vehicles. Automotive Financing - GM Financial GM Financial is our global captive automotive finance company and our global provider of automobile finance solutions. GM Financial conducts its business in North America, South America and through joint ventures in China. GM Financial provides retail loan and lease lending across the credit spectrum. Additionally, GM Financial offers commercial lending products to dealers including floorplan financing, which is lending to finance new and used vehicle inventory; and dealer loans, which are loans to finance improvements to dealership facilities, to provide working capital, and to purchase and/or finance dealership real estate. Other commercial lending products include financing for parts and accessories, dealer fleets and storage centers.In North America, GM Financial offers a sub-prime lending program. The program is primarily offered to consumers with a FICO score or its equivalent of less than 620 who have limited access to automobile financing through banks and credit unions and is expected to sustain a higher level of credit losses than prime lending. GM Financial generally seeks to fund its operations in each country through local sources to minimize currency and country risk. GM Financial primarily finances its loan, lease and commercial origination volume through the use of secured and unsecured credit facilities, through securitization transactions and through the issuance of unsecured debt in the capital markets.9Table of ContentsGENERAL MOTORS COMPANY AND SUBSIDIARIESHuman Capital The foundation of GM’s business is our vision – a world with zero crashes, zero emissions and zero congestion. Our people are our most valuable asset, and we must continue to attract and retain the best talent in the world in order to achieve this vision. As a result, we strive to create a Workplace of Choice to attract, retain and develop top talent by adhering to a responsible employer philosophy, which includes, among other things, commitments to create job opportunities, pay workers fairly, ensure safety and well-being, and promote diversity, equity and inclusion. Fundamental to these commitments are our company values. Our eight GM behaviors are the foundation of our culture; and how we behave encompasses key measures of our performance, including the visible ways we conduct ourselves as we work with one another.Diversity, equity and inclusion At GM, we are committed to fostering a culture of diversity, equity and inclusion. In every moment, we must decide what we can do – individually and collectively – to drive meaningful deliberate change. GM’s unwavering position includes a commitment to inclusion, an unequivocal condemnation of intolerance, and a commitment to stand up against injustice. Our ability to meet the needs of a diverse and global customer base is tied closely to the behaviors of the people within our company, which is why we are committed to fostering a culture that celebrates our differences.10Table of ContentsGENERAL MOTORS COMPANY AND SUBSIDIARIESBased on these longstanding values, our Chairman and CEO, Mary Barra, chairs an Inclusion Advisory Board (IAB) of 11 internal and external leaders who guide our work to improve diversity and inclusion in our company. The purpose of the IAB is to consult with GM’s Senior Leadership Team with the long-term goal of inspiring the company to be inclusive through our words, deeds and culture.We also have a number of programs and partnerships aimed at enhancing our culture of inclusion throughout the company. For example, we have 11 voluntary, employee-led resource groups that provide a forum for diverse employees and allies from a variety of different backgrounds to share experiences and express concerns. Each group also works to attract new talent to our company and offers employees opportunities to support our company’s diversity initiatives within the community.In addition, we are expanding our partnerships with organizations aimed at supporting our ongoing efforts to increase the representation of women and minorities in our workplace. Through our participation in the OneTen organization and Business Roundtable Multiple Pathways initiative, for example, we are specifically aiming to build more robust pipelines for skills-based hiring into our company. Working in concert with local organizations, such efforts are intended to create new pathways to employment for individuals without four-year degrees, provide training opportunities for advancement, and create a more flexible and inclusive talent pipeline.Develop and Retain Talented People Today, we compete for talent against other automotive companies and, increasingly, against businesses in other sectors, such as technology. To win and keep talent, we must provide a workplace culture that encourages employee behaviors aligned with our values, fulfills their long-term individual aspirations and achieves full engagement. In furtherance of this goal, we invest significant resources to retain and develop our talent. In addition to mentoring and networking opportunities, we offer a vast array of career development resources to help develop, grow and enable employees to make the most of their careers at GM. Such resources include, among other things, the Technical Education Program, which offers our employees an opportunity to complete corporate strategically aligned degrees and certificate programs at leading universities, our Learning Management System with access to ongoing learning resources to augment and enrich employees’ professional development and Percipio Resources, which provides our employees with access to a full range of videos, books, and eBooks to develop and enhance skills. Employees in some of our technical roles also have the opportunity to participate in the GM Technical Learning University — a training and upskilling program designed to expand and update the technical prowess of our workforce.Safety and well-being The safety and well-being of our employees is also a critical component of our ability to transform the future of personal mobility. At GM, we pride ourselves on our commitment to live values that return people home safely – Every Person, Every Site, Every Day. Our unwavering commitment to safety is manifested through empowering employees to “Speak Up for Safety” through various means without fear of retaliation. The well-being of our employees is equally as important to entice and stimulate creativity and innovation. In addition to traditional healthcare, paid time off, paid parental leave, wellness programs, flextime scheduling and telecommuting arrangements and retirement benefits, including a 401(k) matching program, GM offers a variety of benefits and resources to support employees physical and mental health, including on-site fitness facilities and a health concerns hotline, which help us both attract talent and reap the benefits of a healthier workforce. 11Table of ContentsGENERAL MOTORS COMPANY AND SUBSIDIARIESEmployees At December 31, 2020, we employed approximately 87,000 (56%) hourly employees and approximately 68,000 (44%) salaried employees. At December 31, 2020, approximately 46,000 (49%) of our U.S. employees were represented by unions, a majority of which were represented by the International Union, United Automobile, Aerospace and Agriculture Implement Workers of America (UAW). The following table summarizes worldwide employment (in thousands): December 31, 2020GMNA(a)112 GMI34 GM Financial9 Total Worldwide155 U.S. - Salaried48 U.S. - Hourly46 __________ (a)Includes Cruise.Information About our Executive Officers As of February 10, 2021, the names and ages of our executive officers and their positions with GM are as follows: Name (Age)Present GM Position (Effective Date)Positions Held During the Past Five Years (Effective Date)Mary T. Barra (59)Chairman and Chief Executive Officer (2016)Julian Blissett (54)Executive Vice President and President, GM China (2020)Senior Vice President, International Operations (2019)Vice President, Executive Shanghai GM (2014)Stephen K. Carlisle (58)Executive Vice President and President, North America (2020)Senior Vice President and President, Cadillac (2018)President and Managing Director, GM Canada (2015)Craig B. Glidden (63)Executive Vice President and General Counsel (2015)Christopher T. Hatto (50)Vice President, Global Business Solutions and Chief Accounting Officer (2020)Vice President, Controller and Chief Accounting Officer (2018)Chief Financial Officer, U.S. Sales Operations (2016)Paul A. Jacobson (49)Executive Vice President and Chief Financial Officer (2020)Delta Air Lines, Executive Vice President — Chief Financial Officer (2013)Gerald Johnson (58) Executive Vice President, Global Manufacturing (2019)Vice President, North America Manufacturing and Labor Relations (2017)Vice President of Operational Excellence (2014)Randall D. Mott (64)Executive Vice President, Global Information Technology and Chief Information Officer (2019)Senior Vice President, Global Information Technology and Chief Information Officer (2013)Douglas L. Parks (59)Executive Vice President, Global Product Development, Purchasing and Supply Chain (2019)Vice President, Autonomous and Electric Vehicles (2017)Vice President, Autonomous Technology and Vehicle Execution (2016)Mark L. Reuss (57)President (2019)Executive Vice President and President, Global Product Development Group and Cadillac (2018)Executive Vice President, Global Product Development, Purchasing & Supply Chain (2014)Matthew Tsien (60)Executive Vice President and Chief Technology Officer (2020)Executive Vice President and President, GM China (2014)There are no family relationships between any of the officers named above and there is no arrangement or understanding between any of the officers named above and any other person pursuant to which he or she was selected as an officer. Each of the officers named above was elected by the Board of Directors to hold office until his or her successor is elected and qualified or until his or her earlier resignation or removal. Website Access to Our Reports Our internet website address is www.gm.com. In addition to the information about us and our subsidiaries contained in this 2020 Form 10-K, information about us can be found on our website including information on our corporate governance principles and practices. Our Investor Relations website at https://investor.gm.com contains a significant 12Table of ContentsGENERAL MOTORS COMPANY AND SUBSIDIARIESamount of information about us, including financial and other information for investors. We encourage investors to visit our website, as we frequently update and post new information about our company on our website and it is possible that this information could be deemed to be material information. Our website and information included in or linked to our website are not part of this 2020 Form 10-K.Our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended (Exchange Act), are available free of charge through our website as soon as reasonably practicable after they are electronically filed with or furnished to the Securities and Exchange Commission (SEC). The SEC maintains a website that contains reports, proxy and information statements, and other information regarding our filings at http://www.sec.gov. * * * * * * *Item 1A. Risk FactorsWe have listed below the most material risk factors applicable to us. These risk factors are not necessarily in the order of importance or probability of occurrence:Risks related to our competition and strategyIf we do not deliver new products, services and customer experiences in response to increased competition and changing consumer preferences in the automotive industry, our business could suffer. We believe that the automotive industry will continue to experience significant change in the coming years, particularly as traditional automotive original equipment manufacturers (OEMs) shift resources to the development of electric vehicles. In addition to our traditional competitors, we must also be responsive to the entrance of non-traditional participants in the automotive industry. Industry participants are disrupting the historic business model of our industry through the introduction of new technologies, products, services, direct-to-consumer sales channels, methods of transportation and vehicle ownership. It is a strategic imperative that we succeed in driving the technological disruption occurring in our industry, including consumer adoption of electric vehicles and commercialization of autonomous vehicles. To successfully execute our long-term strategy, we must continue to develop new products and services, including products and services that are outside of our historically core business, such as autonomous and electric vehicles, digital services and transportation as a service. The process of designing and developing new technology, products and services is complex, costly and uncertain and requires extensive capital investment and the ability to retain and recruit the best talent. There can be no assurance that advances in technology will occur in a timely or feasible way, that others will not acquire similar or superior technologies sooner than we do, or that we will acquire technologies on an exclusive basis or at a significant price advantage. If we do not adequately prepare for and respond to new kinds of technological innovations, market developments and changing customer needs, our sales, profitability and long-term competitiveness may be harmed.Our ability to maintain profitability is dependent upon our ability to timely fund and introduce new and improved vehicle models, including electric vehicles, that are able to attract a sufficient number of consumers. We operate in a very competitive industry with market participants routinely introducing new and improved vehicle models and features designed to meet rapidly evolving consumer expectations. Producing new and improved vehicle models, including electric vehicles, that preserve our reputation for designing, building and selling safe, high-quality cars and trucks is critical to our long-term profitability. Successful launches of our new vehicles are critical to our short-term profitability. The new vehicle development process generally takes two years or more, and a number of factors may lengthen that time period. Because of this product development cycle and the various elements that may contribute to consumers’ acceptance of new vehicle designs, including competitors’ product introductions, technological innovations, fuel prices, general economic conditions, infrastructure and changes in quality, safety, reliability and styling demands and preferences, an initial product concept or design may not result in a vehicle that generates sales in sufficient quantities and at high enough prices to be profitable. Our high proportion of fixed costs, both due to our significant investment in property, plant and equipment as well as other requirements of our collective bargaining agreements, which limit our flexibility to adjust personnel costs to changes in demands for our products, may further exacerbate the risks associated with incorrectly assessing demand for our vehicles.Our near-term profitability is dependent upon the success of our current line of full-size SUVs and pickup trucks. While we offer a portfolio of cars, crossovers, SUVs and trucks, and we have announced significant plans to design, build and sell a broad portfolio of electric vehicles, we currently recognize higher profit margins on our SUVs and trucks. Our near-term success is dependent upon our ability to sell higher margin vehicles in sufficient volumes. Any near-term shift in consumer preferences toward smaller, more fuel-efficient vehicles, whether as a result of increases in the price of oil or any sustained shortage of oil, including as a result of global political instability, concerns about climate change or other reasons, could weaken the demand for our higher margin vehicles. More stringent fuel economy regulations could also impact our ability to sell these vehicles.13Table of ContentsGENERAL MOTORS COMPANY AND SUBSIDIARIESWe operate in a highly competitive industry that has excess manufacturing capacity, and attempts by our competitors to sell more vehicles could have a significant negative effect on our vehicle pricing, market share and operating results. The global automotive industry is highly competitive in terms of the quality, innovation, new technologies, pricing, fuel economy, reliability, safety, customer service and financial services offered. Additionally, overall manufacturing capacity in the industry far exceeds current demand. Many manufacturers, including GM, have relatively high fixed labor costs as well as limitations on their ability to close facilities and reduce fixed costs. In light of such excess capacity and high fixed costs, many industry participants have attempted to sell more vehicles by providing subsidized financing or leasing programs, offering marketing incentives or reducing vehicle prices. As a result, we may be required to offer similar incentives that may result in vehicle prices that do not offset cost increases or the impact of adverse currency fluctuations, which could affect our profitability. Our competitors may also seek to benefit from economies of scale by consolidating or entering into other strategic agreements such as alliances or joint ventures intended to enhance their competitiveness.Manufacturers in countries that have lower production costs, such as China and India, have become competitors in key emerging markets and have announced their intention to export their products to established markets as a low-cost alternative to established entry-level automobiles. In addition, foreign governments may decide to implement tax and other policies that favor their domestic manufacturers at the expense of international manufacturers, including GM and its joint venture partners. These actions have had, and are expected to continue to have, a significant negative effect on our vehicle pricing, market share and operating results.Our long-term strategy is dependent upon our ability to deliver a broad portfolio of electric vehicles that will drive consumer adoption. The production and profitable sale of electric vehicles has become increasingly important to our long-term business as we accelerate our transition to an all-electric future. In 2020, we announced the commitment of $27 billion in investments in electric and autonomous vehicle technologies through 2025, with plans to launch 30 new electric vehicle models globally in that timeframe. Our electric vehicle strategy is dependent on our ability to deliver a broad portfolio of electric vehicles; reduce the costs associated with the manufacture of electric vehicles; increase vehicle range and the energy density of our batteries; license and monetize our proprietary platforms; develop new software and services; and leverage our scale, manufacturing capabilities and synergies with existing internal combustion engine vehicles. In addition, consumer adoption of electric vehicles will be critical to the success of our strategy. Consumer adoption of electric vehicles could be impacted by numerous factors, including the breadth of the portfolio of electric vehicles available; perceptions about electric vehicle features, quality, safety, performance and cost relative to internal combustion engine vehicles; the range over which electric vehicles may be driven on a full battery charge; availability of high fuel-economy internal combustion engine vehicles; volatility in the cost of fuel; government regulations and economic incentives; and the proliferation of a robust, open-standard electric vehicle charging ecosystem. If we are unable to successfully deliver on our electric vehicle strategy, it could materially and adversely affect our results of operations, financial condition and growth prospects.Our autonomous vehicle strategy is dependent upon our ability to successfully mitigate unique technological, operational, and regulatory risks. In recent years, we announced significant investments in autonomous vehicle technologies, including in GM Cruise Holdings LLC (Cruise Holdings), our majority-owned subsidiary that is responsible for the development and commercialization of autonomous vehicle technology. Our autonomous vehicle operations are capital intensive and subject to a variety of risks inherent with the development of new technologies, including our ability to continue to develop self-driving software and hardware, such as Light Detection and Ranging (LiDAR) sensors and other components; access to sufficient capital, including with respect to additional Softbank funding; risks related to the manufacture of purpose-built autonomous vehicles; and significant competition from both established automotive companies and technology companies, some of which may have more resources and capital to devote to autonomous vehicle technologies than we do. In addition, we face risks related to the commercial deployment of autonomous vehicles on our targeted timeline or at all, including consumer acceptance, achievement of adequate safety and other performance standards and compliance with uncertain, evolving and potentially conflicting federal and state or provincial regulations. To the extent accidents, cybersecurity breaches or other adverse events associated with our autonomous driving systems occur, we could be subject to liability, government scrutiny and further regulation, and it could deter consumer adoption of autonomous vehicle technology. Any of the foregoing could materially and adversely affect our results of operations, financial condition and growth prospects.Risks related to our operationsThe COVID-19 pandemic may disrupt our business and operations, which could materially adversely impact our business, financial condition, liquidity and results of operations. Pandemics, epidemics or disease outbreaks in the U.S. or globally may disrupt our business, which could materially affect our results of operations, financial condition, liquidity and future expectations. The COVID-19 outbreak has caused significant disruption to the global economy, including the automotive industry, and has had a material impact on our business as discussed in detail in Part II, Item 7. MD&A. However, the full extent to which the COVID-19 pandemic will impact our operations will depend on future developments, including the duration and severity of the outbreak, any subsequent outbreaks and the timing and efficacy of any available vaccines. Future developments are highly uncertain and cannot be predicted with confidence and may adversely impact our global supply chain and global manufacturing operations and cause us to again suspend our operations in the U.S. and elsewhere. In particular, if 14Table of ContentsGENERAL MOTORS COMPANY AND SUBSIDIARIESCOVID-19 continues to spread or re-emerges, particularly in North America where our profits are most concentrated, resulting in a prolonged period of travel, commercial, social and other similar restrictions, we could experience among other things: (1) global supply disruptions; (2) labor disruptions; (3) an inability to manufacture; (4) an inability to sell to our customers; (5) a decline in showroom traffic and customer demand during and following the pandemic; (6) customer defaults on automobile loans and leases; (7) lower than expected pricing on vehicles sold at auction; and (8) an impaired ability to access credit and the capital markets. We may also be subject to enhanced legal risks, including potential litigation related to the COVID-19 pandemic. We also have substantial cash requirements going forward, including: (1) ongoing cash costs including payments associated with previously announced vehicle recalls, the settlements of multi-district litigation and other recall-related contingencies, payments to service debt and other long-term obligations, including mandatory contributions to our pension plans; and (2) capital expenditures and payments for engineering and product development activities. Our ability to meet these cash requirements may be negatively impacted by the ongoing COVID-19 pandemic. Any resulting financial impact cannot be reasonably estimated at this time, but the COVID-19 pandemic could have a material impact on our business, financial condition and results of operations going forward. For a further discussion of the impact of the COVID-19 pandemic on our liquidity, refer to the “Liquidity and Capital Resources” section in Part II, Item 7. MD&A.Our business is highly dependent upon global automobile market sales volume, which can be volatile. Because we have a high proportion of relatively fixed structural costs, small changes in sales volume can have a disproportionately large effect on our profitability. A number of economic and market conditions drive changes in new vehicle sales, including the availability and prices of used vehicles, levels of unemployment, availability of affordable financing, fluctuations in the cost of fuel, consumer confidence, real estate values, political unrest, the occurrence of a contagious disease or illness, including COVID-19 (see “The COVID-19 pandemic may disrupt our business and operations, which could materially adversely impact our business, financial condition, liquidity and results of operations” in this Item 1A, Risk Factors), barriers to trade and other global economic conditions. For a discussion of economic and market trends, see the "Overview" section in Part II, Item 7. MD&A.Our significant business in China subjects us to unique operational, competitive and regulatory risks. Maintaining a strong position in the Chinese market is a key component of our global growth strategy. Our business in China is subject to aggressive competition from many of the largest global manufacturers and numerous domestic manufacturers as well as non-traditional market participants, such as domestic technology companies. In addition, our success in China depends upon our ability to adequately address unique market and consumer preferences driven by advancements related to electric vehicles, infotainment and other new technologies. Our ability to fully deploy our technologies in China may be impacted by evolving laws and regulations in the U.S. and China. Increased competition, increased U.S.-China trade restrictions and weakening economic conditions in China, among other things, may result in price reductions, reduced sales, profitability and margins, and challenges to gain or hold market share. In addition, Chinese regulators have implemented increasingly aggressive “green” policy initiatives requiring OEMs to reduce the average emissions and average fuel consumption of their products and to achieve quotas for the sale of electric vehicles, which have challenging lead times.Certain risks and uncertainties of doing business in China are solely within the control of the Chinese government, and Chinese law regulates the scope of our investments and business conducted within China. In order to maintain access to the Chinese market, we may be required to comply with significant technical and other regulatory requirements that are unique to the Chinese market, at times with challenging lead times to implement such requirements. These actions may increase the cost of doing business in China and reduce our profitability.A significant amount of our operations are conducted by joint ventures that we cannot operate solely for our benefit. Many of our operations, primarily in China and Korea as well as our battery manufacturing operations with LG Chem, are carried out by joint ventures. In joint ventures we share ownership and management of a company with one or more parties who may not have the same goals, strategies, priorities or resources as we do and may compete with us outside the joint venture. Joint ventures are intended to be operated for the equal benefit of all co-owners, rather than for our exclusive benefit. Operating a business as a joint venture often requires additional organizational formalities as well as time-consuming procedures for sharing information and making decisions that must further take into consideration our partners' interests. In joint ventures we are required to foster our relationships with our co-owners as well as promote the overall success of the joint venture, and if a co-owner changes, relationships deteriorate or strategic objectives diverge, our success in the joint venture may be materially adversely affected. The benefits from a successful joint venture are shared among the co-owners, therefore we do not receive all the benefits from our successful joint ventures.In addition, because we share ownership and management with one or more parties, we may have limited control over the actions of a joint venture, particularly when we own a minority interest. As a result, we may be unable to prevent violations of applicable laws or other misconduct by a joint venture or the failure to satisfy contractual obligations by one or more parties. Moreover, a joint venture may not follow the same requirements regarding compliance, internal controls and internal control over financial reporting that we follow. To the extent another party makes decisions that negatively impact the joint venture or internal control issues arise within the joint venture, we may have to take responsive actions, or we may be subject to penalties, fines or other punitive actions for these activities.15Table of ContentsGENERAL MOTORS COMPANY AND SUBSIDIARIESThe international scale and footprint of our operations expose us to additional risks. We manufacture, sell and service products globally and rely upon an integrated global supply chain to deliver the raw materials, components, systems and parts that we need to manufacture our products. Our global operations subject us to extensive domestic and foreign legal and regulatory requirements, and a variety of other political, economic and regulatory risks including: (1) changes in government leadership; (2) changes in labor, employment, tax, privacy, environmental and other laws, regulations or government policies impacting our overall business model or practices or restricting our ability to manufacture, purchase or sell products consistent with market demand and our business objectives; (3) political pressures to change any aspect of our business model or practices or that impair our ability to source raw materials, services, components, systems and parts, or manufacture products on competitive terms in a manner consistent with our business objectives; (4) political instability, civil unrest or government controls over certain sectors; (5) political and economic tensions between governments and changes in international trade policies, including restrictions on the repatriation of dividends or in the export of technology, especially between China and the U.S.; (6) more detailed inspections or new or higher tariffs, for example, on products imported into or exported from the U.S., including under Section 232 of the Trade Expansion Act of 1962, Section 301 of the U.S. Trade Act of 1974, or other trade measures; (7) new barriers to entry or domestic preference procurement requirements, including changes to, withdrawals from or impediments to implementing free trade agreements (for example, the United States-Mexico-Canada Agreement), or preferences of foreign nationals for domestically manufactured products; (8) changes in foreign currency exchange rates, particularly in Brazil and Argentina, and interest rates; (9) economic downturns or significant changes in conditions in the countries in which we operate; (10) differing local product preferences and product requirements, including government certification requirements related to, among other things, fuel economy, vehicle emissions and safety; (11) impact of changes to and compliance with U.S. and foreign countries’ export controls, economic sanctions and other similar measures; (12) liabilities resulting from U.S. and foreign laws and regulations, including, but not limited to, those related to the Foreign Corrupt Practices Act and certain other anti-corruption laws; (13) differing labor regulations, requirements and union relationships; (14) differing dealer and franchise regulations and relationships; (15) difficulties in obtaining financing in foreign countries for local operations; and (16) natural disasters, public health crises, including the occurrence of a contagious disease or illness, such as COVID-19 (see “The COVID-19 pandemic may disrupt our business and operations, which could materially adversely impact our business, financial condition, liquidity and results of operations” in this Item 1A, Risk Factors), and other catastrophic events.Any significant disruption at one of our manufacturing facilities could disrupt our production schedule. We assemble vehicles at various facilities around the world. Our facilities are typically designed to produce particular models for particular geographic markets. No single facility is designed to manufacture our full range of vehicles. In some cases, certain facilities produce products, systems, components and parts that disproportionately contribute a greater degree to our profitability than others and create significant interdependencies among manufacturing facilities around the world. Should these or other facilities become unavailable either temporarily or permanently for any number of reasons, including labor disruptions, the occurrence of a contagious disease or illness, such as COVID-19 (see “The COVID-19 pandemic may disrupt our business and operations, which could materially adversely impact our business, financial condition, liquidity and results of operations” in this Item 1A, Risk Factors), or catastrophic weather events, the inability to manufacture at the affected facility may result in harm to our reputation, increased costs, lower revenues and the loss of customers. In particular, substantially all of our hourly employees are represented by unions and covered by collective bargaining agreements that must be negotiated from time-to-time, often at the local facility level, which increases our risk of work stoppages. We may not be able to easily shift production to other facilities or to make up for lost production. Any new facility needed to replace an inoperable manufacturing facility would need to comply with the necessary regulatory requirements, need to satisfy our specialized manufacturing requirements and require specialized equipment.Any disruption in our suppliers’ operations could disrupt our production schedule. Our automotive operations are dependent upon the continued ability of our suppliers to deliver the systems, components, raw materials and parts that we need to manufacture our products. Our use of “just-in-time” manufacturing processes allows us to maintain minimal inventory. As a result, our ability to maintain production is dependent upon our suppliers delivering sufficient quantities of systems, components, raw materials and parts on time to meet our production schedules. In some instances, we purchase systems, components, raw materials and parts that are ultimately derived from a single source and may be at an increased risk for supply disruptions. Any number of factors, including labor disruptions, catastrophic weather events, the occurrence of a contagious disease or illness, such as COVID-19 (see “The COVID-19 pandemic may disrupt our business and operations, which could materially adversely impact our business, financial condition, liquidity and results of operations” in this Item 1A, Risk Factors), contractual or other disputes, unfavorable economic or industry conditions, delivery delays or other performance problems or financial difficulties or solvency problems, could disrupt our suppliers’ operations and lead to uncertainty in our supply chain or cause supply disruptions for us, which could, in turn, disrupt our operations, including the production of certain higher margin vehicles. If the COVID-19 pandemic continues to spread or re-emerges and results in a prolonged period of travel, commercial, social and other similar restrictions, we could experience continued and/or additional global supply disruptions. If we experience supply disruptions, we may not be able to develop alternate sourcing quickly. Any disruption of our production schedule caused by an unexpected shortage of systems, components, raw materials or parts even for a relatively short period of time could cause us to alter production schedules or suspend production entirely, which could cause a loss of revenues, which would adversely affect our operations.16Table of ContentsGENERAL MOTORS COMPANY AND SUBSIDIARIESIn particular, a global semiconductor supply shortage is having wide-ranging effects across multiple industries, particularly the automotive industry, and it has impacted multiple suppliers that incorporate semiconductors into the parts they supply to us. As a result, the semiconductor supply shortage has had, and will continue to have, an impact on our vehicle production, and we anticipate it will have a material impact on our performance in 2021.High prices of raw materials or other inputs used by us and our suppliers could negatively impact our profitability. Increases in prices for raw materials or other inputs that we and our suppliers use in manufacturing products, systems, components and parts, such as steel, precious metals, non-ferrous metals, critical minerals or other similar raw materials, may lead to higher production costs for parts, components and vehicles. Changes in trade policies and tariffs, fluctuations in supply and demand and other economic and political factors may continue to create pricing pressure for raw materials and other inputs. This could, in turn, negatively impact our future profitability because we may not be able to pass all of those costs on to our customers or require our suppliers to absorb such costs.We may continue to restructure our operations in the U.S. and various other countries and initiate additional cost reduction actions, but we may not succeed in doing so. Since 2017, we have undertaken restructuring actions to lower our operating costs in response to difficult market and operating conditions in various parts of the world, including the U.S., Canada, Korea, Southeast Asia, India, Australia and New Zealand and Europe. As we continue to assess our performance throughout our regions, we may take additional restructuring actions to rationalize our operations, which may result in material asset write-downs or impairments and reduce our profitability in the periods incurred. In addition, we are continuing to implement a number of operating effectiveness initiatives to improve productivity and reduce costs. In addition, these restructuring actions subject us to increased risks of labor unrest or strikes, supplier, dealer, or other third-party litigation, regulator claims or proceedings, negative publicity and business disruption. Failure to realize anticipated savings or benefits from our restructuring and/or cost reduction actions could have a material adverse effect on our business, liquidity and cash flows.Risks related to our intellectual property, cybersecurity, information technology and data management practicesCompetitors may independently develop products and services similar to ours, and there are no guarantees that GM’s intellectual property rights would prevent competitors from independently developing or selling those products and services. There may be instances where, notwithstanding our intellectual property position, competitive products or services may impact the value of our brands and other intangible assets, and our business may be adversely affected. Moreover, although GM takes reasonable steps to maintain the confidentiality of GM proprietary information, there can be no assurance that such efforts will completely deter or prevent misappropriation or improper use of our technology. We sometimes face attempts to gain unauthorized access to our information technology networks and systems for the purpose of improperly acquiring our trade secrets or confidential business information. The theft or unauthorized use or publication of our trade secrets and other confidential business information as a result of such an incident could adversely affect our competitive position. In addition, we may be the target of patent enforcement actions by third parties, including aggressive and opportunistic enforcement claims by non-practicing entities. Regardless of the merit of such claims, responding to infringement claims can be expensive and time-consuming. Although we have taken steps to mitigate such risks, if we are found to have infringed any third-party intellectual property rights, we could be required to pay substantial damages, or we could be enjoined from offering some of our products and services.Security breaches and other disruptions to information technology systems and networked products, including connected vehicles, owned or maintained by us, GM Financial, or third-party vendors or suppliers on our behalf, could interfere with our operations and could compromise the confidentiality of private customer data or our proprietary information. We rely upon information technology systems and manufacture networked products, some of which are managed by third parties, to process, transmit and store electronic information, and to manage or support a variety of our business processes, activities and products. Additionally, we and GM Financial collect and store sensitive data, including intellectual property and proprietary business information (including that of our dealers and suppliers), as well as personally identifiable information of our customers and employees, in data centers and on information technology networks (including networks that may be controlled or maintained by third parties). The secure operation of these systems and products, and the processing and maintenance of the information processed by these systems and products, is critical to our business operations and strategy. Further, customers using our systems rely on the security of our infrastructure, including hardware and other elements provided by third parties, to ensure the reliability of our products and the protection of their data. Despite security measures and business continuity plans, these systems and products may be vulnerable to damage, disruptions or shutdowns caused by attacks by hackers, computer viruses, malware (including “ransomware”), phishing attacks or breaches due to errors or malfeasance by employees, contractors and others who have access to these systems and products. The occurrence of any of these events could compromise the confidentiality, operational integrity and accessibility of these systems and products and the data that resides within them. Similarly, such an occurrence could result in the compromise or loss of the information processed by these systems and products. Such events could result in, among other things, the loss of proprietary data, interruptions or delays in our business operations and damage to our reputation. In addition, such events could increase the risk of claims alleging that we are non-17Table of ContentsGENERAL MOTORS COMPANY AND SUBSIDIARIEScompliant with applicable laws or regulations, subjecting us to potential liability or regulatory penalties and related costs under laws protecting the privacy of personal information; disrupt our operations; or reduce the competitive advantage we hope to derive from our investment in advanced technologies. We have experienced such events in the past and, although past events were immaterial, future events may occur and may be material.Security breaches and other disruptions of our in-vehicle systems could impact the safety of our customers and reduce confidence in GM and our products. Our vehicles contain complex information technology systems. These systems control various vehicle functions including engine, transmission, safety, steering, navigation, acceleration, braking, window and door lock functions. We have designed, implemented and tested security measures intended to prevent unauthorized access to these systems. However, hackers have reportedly attempted, and may attempt in the future, to gain unauthorized access to modify, alter and use such systems to gain control of, or to change, our vehicles’ functionality, user interface and performance characteristics, or to gain access to data stored in or generated by the vehicle. Any unauthorized access to or control of our vehicles or their systems could adversely impact the safety of our customers or result in legal claims or proceedings, liability or regulatory penalties. New laws, such as the new data law in Massachusetts that would permit third-party access to vehicle data and related systems, could expose our vehicles and vehicle systems to third-party access without appropriate security measures in place, leading to new safety and security risks for our customers and reducing customer trust and confidence in our products. In addition, regardless of their veracity, reports of unauthorized access to our vehicles or their systems could negatively affect our brand and harm our reputation, which could impact our business and operating results.Our enterprise data practices, including the collection, use, sharing, and security of the Personal Identifiable Information of our customers, employees and suppliers, are subject to increasingly complex, restrictive and punitive regulations in all key market regions. Under these regulations, the failure to maintain compliant data practices could result in consumer complaints and regulatory inquiry, resulting in civil or criminal penalties, as well as brand impact or other harm to our business. In addition, increased consumer sensitivity to real or perceived failures in maintaining acceptable data practices could damage our reputation and deter current and potential users or customers from using our products and services. Because many of these laws are new, there is little clarity as to their interpretation, as well as a lack of precedent for the scope of enforcement. The cost of compliance with these laws and regulations will be high and is likely to increase in the future. For example, the California Consumer Protection Act became effective in 2020, obligating companies to quickly respond to consumer requests to delete, disclose and stop selling personal information of California residents, with significant fines for noncompliance. Other U.S. states are considering similar laws, with some considering private rights of action for consumers that would allow consumers to bring claims directly against GM for mishandling their data. In Europe in 2020, the Court of Justice for the EU invalidated mechanisms for transferring personal information out of the EU, leading to a wave of potential new barriers for data sharing between the EU and, among other countries, the U.S. In Canada, both the federal government and certain provinces have also proposed new legislation imposing significant and unprecedented obligations, fines and liabilities regarding data handling. Overcoming these new barriers is likely to increase our costs and drive new complexity in our operations.Risks related to government regulations and litigationOur operations and products are subject to extensive laws, regulations and policies, including those related to vehicle emissions, fuel economy standards and greenhouse gas emissions, that can significantly increase our costs and affect how we do business. We are significantly affected by governmental regulations on a global basis that can increase costs related to the production of our vehicles and affect our product portfolio, particularly regulations relating to emissions, fuel economy standards and greenhouse gas emissions. Meeting or exceeding many of these regulations is costly and often technologically challenging, especially because the standards are not harmonized across jurisdictions. We anticipate that the number and extent of these and other regulations, laws and policies, and the related costs and changes to our product portfolio, may increase significantly in the future, primarily out of concern for the environment (including concerns about global climate change and its impact). These government regulatory requirements, among others, could significantly affect our plans for global product development and, given the uncertainty surrounding enforcement and regulatory definitions and interpretations, may result in substantial costs, including civil or criminal penalties. In addition, an evolving but un-harmonized emissions and fuel economy regulatory framework may limit or dictate the types of vehicles we sell and where we sell them, which can affect our revenues. Refer to the “Environmental and Regulatory Matters” section of Item 1. Business for further information on regulatory and environmental requirements.We expect that to comply with fuel economy and emission control requirements, we will be required to sell a significant volume of electric vehicles, and potentially develop and implement new technologies for conventional internal combustion engines, all at increased costs. There are limits on our ability to achieve fuel economy improvements over a given time frame, primarily relating to the cost and effectiveness of available technologies, lack of sufficient consumer acceptance of new technologies and of changes in vehicle mix, lack of willingness of consumers to absorb the additional costs of new technologies, the appropriateness (or lack thereof) of certain technologies for use in particular vehicles, the widespread availability (or lack thereof) of supporting infrastructure for new technologies and the human, engineering and financial resources necessary to deploy new technologies across a wide range of products and powertrains in a short time. There is no 18Table of ContentsGENERAL MOTORS COMPANY AND SUBSIDIARIESassurance that we will be able to produce and sell vehicles that use such new technologies on a profitable basis or that our customers will purchase such vehicles in the quantities necessary for us to comply with these regulatory programs.In the current uncertain regulatory framework, environmental liabilities for which we may be responsible and that are not reasonably estimable could be substantial. Alleged violations of safety, fuel economy or emissions standards could result in legal proceedings, the recall of one or more of our products, negotiated remedial actions, fines, restricted product offerings or a combination of any of those items. Any of these actions could have a material adverse effect on our operations, including facility idling, reduced employment, increased costs and loss of revenue.In addition, many of our advanced technologies, including autonomous vehicles, present novel issues with which domestic and foreign regulators have only limited experience, and will be subject to evolving regulatory frameworks. Any current or future regulations in these areas could impact whether and how these technologies are designed and integrated into our products, and may ultimately subject us to increased costs and uncertainty.We could be materially adversely affected by unusual or significant litigation, governmental investigations or other proceedings. We are subject to legal proceedings involving various issues, including product liability lawsuits, class action litigations alleging product defects, emissions litigation (both in the U.S. and elsewhere), stockholder litigation, labor and employment litigation in various countries (including U.S., Canada, Korea and Brazil), claims and actions arising from restructurings, divestitures of operations and assets and proceedings related to the Ignition Switch Recall. In addition, we are subject to governmental proceedings and investigations. A negative outcome in one or more of these legal proceedings could result in the imposition of damages, including punitive damages, substantial fines, significant reputational harm, civil lawsuits and criminal penalties, interruptions of business, modification of business practices, equitable remedies and other sanctions against us or our personnel as well as significant legal and other costs. For a further discussion of these matters refer to Note 16 to our consolidated financial statements.The costs and effect on our reputation of product safety recalls and alleged defects in products and services could materially adversely affect our business. Government safety standards require manufacturers to remedy certain product safety defects through recall campaigns and vehicle repurchases. Under these standards, we could be subject to civil or criminal penalties or may incur various costs, including significant costs for repairs made at no cost to the consumer. At present, the costs we incur in connection with these recalls typically include the cost of the part being replaced and labor to remove and replace the defective part. The costs to complete a recall could be exacerbated to the extent that such action relates to a global platform. Concerns about the safety of our products, including advanced technologies like autonomous vehicles, whether raised internally or by regulators or consumer advocates, and whether or not based on scientific evidence or supported by data, can result in product delays, recalls, lost sales, governmental investigations, regulatory action, private claims, lawsuits and settlements and reputational damage. These circumstances can also result in damage to brand image, brand equity and consumer trust in our products and ability to lead the disruption occurring in the automotive industry.We currently source a variety of systems, components, raw materials and parts from third parties. From time to time these items may have performance or quality issues that could harm our reputation and cause us to incur significant costs, particularly if the affected items relate to global platforms or involve defects that are identified years after production. Our ability to recover costs associated with recalls or other campaigns caused by parts or components purchased from suppliers may be limited by the suppliers’ financial condition or a number of other reasons or defenses.We may incur additional tax expense or become subject to additional tax exposure. We are subject to the tax laws and regulations of the U.S. and numerous other jurisdictions in which we do business. Many judgments are required in determining our worldwide provision for income taxes and other tax liabilities, and we are regularly under audit by the U.S. Internal Revenue Service and other tax authorities, which may not agree with our tax positions. In addition, our tax liabilities are subject to other significant risks and uncertainties, including those arising from potential changes in laws and regulations in the countries in which we do business, the possibility of adverse determinations with respect to the application of existing laws, changes in our business or structure and changes in the valuation of our deferred tax assets and liabilities. Any unfavorable resolution of these and other uncertainties may have a significant adverse impact on our tax rate and results of operations. If our tax expense were to increase, or if the ultimate determination of our taxes owed is for an amount in excess of amounts previously accrued, our operating results, cash flows and financial condition could be adversely affected.Risks related to Automotive Financing - GM Financial We rely on GM Financial to provide financial services to our customers and dealers globally. GM Financial faces a number of business, economic and financial risks that could impair its access to capital and negatively affect its business and operations, which in turn could impede its ability to provide leasing and financing to customers and commercial lending to our dealers. Any reduction in GM Financial’s ability to provide such financial services would negatively affect our efforts to support additional sales of our vehicles and expand our market penetration among customers and dealers.19Table of ContentsGENERAL MOTORS COMPANY AND SUBSIDIARIESThe primary factors that could adversely affect GM Financial’s business and operations and reduce its ability to provide financing services at competitive rates include the sufficiency, availability and cost of sources of financing, including credit facilities, securitization programs and secured and unsecured debt issuances; the performance of loans and leases in its portfolio, which could be materially affected by charge-offs, delinquencies and prepayments; wholesale auction values of used vehicles; vehicle return rates and the residual value performance on vehicles GM Financial leases to customers; fluctuations in interest rates and currencies; competition for customers from commercial banks, credit unions and other financing and leasing companies; and changes to regulation, supervision, enforcement and licensing across various jurisdictions.In addition, a substantial portion of GM Financial’s indebtedness bears interest at variable interest rates, primarily based on USD-LIBOR. The U.K. Financial Conduct Authority, which regulates LIBOR, has announced that it will no longer persuade or compel banks to submit rates for the calculation of LIBOR after 2021. It is unknown whether any banks will continue to voluntarily submit rates for the calculation of LIBOR, or whether LIBOR will continue to be published by its administrator based on these submissions or on any other basis, after 2021. At this time, it is not possible to predict the effect that these developments or any discontinuance, modification or other reforms may have on LIBOR, other benchmarks or floating–rate debt instruments, including GM Financial’s floating–rate debt. Any such discontinuance, modification, alternative reference rates or other reforms may materially adversely affect interest rates on GM Financial’s current or future indebtedness. There is a risk that the discontinuation of LIBOR will impact GM Financial's ability to manage interest rate risk effectively without an adequate replacement. Further, as an entity operating in the financial services sector, GM Financial is required to comply with a wide variety of laws and regulations that may be costly to adhere to and may affect our consolidated operating results. Compliance with these laws and regulations requires that GM Financial maintain forms, processes, procedures, controls and the infrastructure to support these requirements, and these laws and regulations often create operational constraints both on GM Financial’s ability to implement servicing procedures and on pricing. Laws in the financial services industry are designed primarily for the protection of consumers. The failure to comply with these laws could result in significant statutory civil and criminal penalties, monetary damages, attorneys’ fees and costs, possible revocation of licenses and damage to reputation, brand and valued customer relationships.Risks related to defined benefit pension plansOur defined benefit pension plans are currently underfunded and our pension funding requirements could increase significantly due to a reduction in funded status as a result of a variety of factors, including weak performance of financial markets, declining interest rates, changes in laws or regulations, or changes in assumptions or investments that do not achieve adequate returns. Our employee benefit plans currently hold a significant amount of equity and fixed income securities. A detailed description of the investment funds and strategies and our potential funding requirements are disclosed in Note 15 to our consolidated financial statements, which also describes significant concentrations of risk to the plan investments.Our future funding requirements for our defined benefit pension plans depend upon the future performance of assets placed in trusts for these plans, the level of interest rates used to determine funding levels, the level of benefits provided for by the plans and any changes in laws and regulations. Future funding requirements generally increase if the discount rate decreases or if actual asset returns are lower than expected asset returns, assuming other factors are held constant. We estimate future contributions to these plans using assumptions with respect to these and other items. Changes to those assumptions could have a significant effect on future contributions.There are additional risks due to the complexity and magnitude of our investments. Examples include implementation of significant changes in investment policy, insufficient market liquidity in particular asset classes and the inability to quickly rebalance illiquid and long-term investments.Factors that affect future funding requirements for our U.S. defined benefit plans generally affect the required funding for non-U.S. plans. Certain plans outside the U.S. do not have assets and therefore the obligation is funded as benefits are paid. If local legal authorities increase the minimum funding requirements for our non-U.S. plans, we could be required to contribute more funds, which could negatively affect our liquidity and financial condition.* * * * * * *Item 1B. Unresolved Staff CommentsNone.* * * * * * *20Table of ContentsGENERAL MOTORS COMPANY AND SUBSIDIARIESItem 2. Properties At December 31, 2020, we had over 100 locations in the U.S. (excluding our automotive financing operations and dealerships), which are primarily for manufacturing, assembly, distribution, warehousing, engineering and testing. We, our subsidiaries or associated companies in which we own an equity interest own most of these properties and/or lease a portion of these properties. Leased properties are primarily composed of warehouses and administration, engineering and sales offices.We have manufacturing, assembly, distribution, office or warehousing operations in 29 countries, including equity interests in associated companies, which perform manufacturing, assembly or distribution operations. The major facilities outside the U.S., which are principally vehicle manufacturing and assembly operations, are located in Argentina, Brazil, Canada, China, Colombia, Mexico and South Korea.GM Financial owns or leases facilities for administration and regional credit centers. GM Financial has 37 facilities, of which 24 are located in the U.S. The major facilities outside the U.S. are located in Brazil, Canada, China and Mexico. * * * * * * *Item 3. Legal ProceedingsThe discussion under "Litigation-Related Liability and Tax Administrative Matters" in Note 16 to our consolidated financial statements is incorporated by reference into this Part I - Item 3.* * * * * * *Item 4. Mine Safety DisclosuresNot applicable.* * * * * * *PART IIItem 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity SecuritiesMarket Information Shares of our common stock are publicly traded on the New York Stock Exchange under the symbol "GM". Holders At January 29, 2021, we had 1.4 billion issued and outstanding shares of common stock held by 471 holders of record.21Table of ContentsGENERAL MOTORS COMPANY AND SUBSIDIARIESStock Performance Graph The following graph compares the performance of our common stock to the Standard & Poor's 500 Stock Index and the Dow Jones Automobile & Parts Titans 30 Index for the last five years. It assumes $100 was invested on December 31, 2015, with dividends being reinvested. The following table summarizes stock performance graph data points in dollars:Years ended December 31, 201520162017201820192020General Motors Company$100$107$132$112$128$148S&P 500 Stock Index $100$112$136$130$171$203Dow Jones Automobile & Parts Titans 30 Index $100$98$118$93$106$16022Table of ContentsGENERAL MOTORS COMPANY AND SUBSIDIARIESPurchases of Equity Securities The following table summarizes our purchases of common stock in the three months ended December 31, 2020:Total Number of Shares Purchased(a)Weighted Average Price Paid per ShareTotal Number of Shares Purchased Under Announced Programs(b)Approximate Dollar Value of Shares That May Yet be Purchased Under Announced ProgramsOctober 1, 2020 through October 31, 202038,520 $30.97 — $3.3 billionNovember 1, 2020 through November 30, 202026,509 $45.06 — $3.3 billionDecember 1, 2020 through December 31, 202029,198 $41.62 — $3.3 billionTotal94,227 $38.23 — __________(a) Shares purchased consist of shares delivered by employees or directors to us for the payment of taxes resulting from issuance of common stock upon the vesting of Restricted Stock Units (RSUs) and Performance Stock Units (PSUs) relating to compensation plans. In June 2017 our shareholders approved the 2017 Long Term Incentive Plan, which authorizes awards of stock options, stock appreciation rights, RSUs, PSUs or other stock-based awards to selected employees, consultants, advisors, and non-employee Directors of the Company. Refer to Note 23 to our consolidated financial statements for additional details on employee stock incentive plans.(b) In January 2017, we announced that our Board of Directors had authorized the purchase of up to an additional $5.0 billion of our common stock with no expiration date. * * * * * * *Item 6. Selected Financial DataNot applicable.* * * * * * *Item 7. Management’s Discussion and Analysis of Financial Condition and Results of OperationsThis MD&A should be read in conjunction with the accompanying audited consolidated financial statements and notes. Forward-looking statements in this MD&A are not guarantees of future performance and may involve risks and uncertainties that could cause actual results to differ materially from those projected. Refer to the "Forward-Looking Statements" section of this MD&A and Part I, Item 1A. Risk Factors for a discussion of these risks and uncertainties. The discussion of our financial condition and results of operations for the year ended December 31, 2018 included in Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations in our Annual Report on Form 10-K for the year ended December 31, 2019 is incorporated by reference into this MD&A. Non-GAAP Measures Unless otherwise indicated, our non-GAAP measures discussed in this MD&A are related to our continuing operations and not our discontinued operations. Our non-GAAP measures include: earnings before interest and taxes (EBIT)-adjusted, presented net of noncontrolling interests; earnings before income taxes (EBT)-adjusted for our GM Financial segment; earnings per share (EPS)-diluted-adjusted; effective tax rate-adjusted (ETR-adjusted); return on invested capital-adjusted (ROIC-adjusted) and adjusted automotive free cash flow. Our calculation of these non-GAAP measures may not be comparable to similarly titled measures of other companies due to potential differences between companies in the method of calculation. As a result, the use of these non-GAAP measures has limitations and should not be considered superior to, in isolation from, or as a substitute for, related U.S. GAAP measures. These non-GAAP measures allow management and investors to view operating trends, perform analytical comparisons and benchmark performance between periods and among geographic regions to understand operating performance without regard to items we do not consider a component of our core operating performance. Furthermore, these non-GAAP measures allow investors the opportunity to measure and monitor our performance against our externally communicated targets and evaluate the investment decisions being made by management to improve ROIC-adjusted. Management uses these measures in its financial, investment and operational decision-making processes, for internal reporting and as part of its forecasting and budgeting processes. Further, our Board of Directors uses certain of these and other measures as key metrics to determine management performance under our performance-based compensation plans. For these reasons we believe these non-GAAP measures are useful for our investors. 23Table of ContentsGENERAL MOTORS COMPANY AND SUBSIDIARIESEBIT-adjusted EBIT-adjusted is presented net of noncontrolling interests and is used by management and can be used by investors to review our consolidated operating results because it excludes automotive interest income, automotive interest expense and income taxes as well as certain additional adjustments that are not considered part of our core operations. Examples of adjustments to EBIT include but are not limited to impairment charges on long-lived assets and other exit costs resulting from strategic shifts in our operations or discrete market and business conditions; costs arising from the ignition switch recall and related legal matters; and certain currency devaluations associated with hyperinflationary economies. For EBIT-adjusted and our other non-GAAP measures, once we have made an adjustment in the current period for an item, we will also adjust the related non-GAAP measure in any future periods in which there is an impact from the item. Our corresponding measure for our GM Financial segment is EBT-adjusted because interest income and interest expense are part of operating results when assessing and measuring the operational and financial performance of the segment. EPS-diluted-adjusted EPS-diluted-adjusted is used by management and can be used by investors to review our consolidated diluted EPS results on a consistent basis. EPS-diluted-adjusted is calculated as net income attributable to common stockholders-diluted less income (loss) from discontinued operations on an after-tax basis, adjustments noted above for EBIT-adjusted and certain income tax adjustments divided by weighted-average common shares outstanding-diluted. Examples of income tax adjustments include the establishment or reversal of significant deferred tax asset valuation allowances. ETR-adjusted ETR-adjusted is used by management and can be used by investors to review the consolidated effective tax rate for our core operations on a consistent basis. ETR-adjusted is calculated as Income tax expense less the income tax related to the adjustments noted above for EBIT-adjusted and the income tax adjustments noted above for EPS-diluted-adjusted divided by Income before income taxes less adjustments. When we provide an expected adjusted effective tax rate, we do not provide an expected effective tax rate because the U.S. GAAP measure may include significant adjustments that are difficult to predict. ROIC-adjusted ROIC-adjusted is used by management and can be used by investors to review our investment and capital allocation decisions. We define ROIC-adjusted as EBIT-adjusted for the trailing four quarters divided by ROIC-adjusted average net assets, which is considered to be the average equity balances adjusted for average automotive debt and interest liabilities, exclusive of finance leases; average automotive net pension and other postretirement benefits (OPEB) liabilities; and average automotive net income tax assets during the same period.Adjusted automotive free cash flow Adjusted automotive free cash flow is used by management and can be used by investors to review the liquidity of our automotive operations and to measure and monitor our performance against our capital allocation program and evaluate our automotive liquidity against the substantial cash requirements of our automotive operations. We measure adjusted automotive free cash flow as automotive operating cash flow from continuing operations less capital expenditures adjusted for management actions. Management actions can include voluntary events such as discretionary contributions to employee benefit plans or nonrecurring specific events such as a closure of a facility that are considered special for EBIT-adjusted purposes. Refer to the “Liquidity and Capital Resources” section of this MD&A for additional information.24Table of ContentsGENERAL MOTORS COMPANY AND SUBSIDIARIESThe following table reconciles Net income attributable to stockholders under U.S. GAAP to EBIT-adjusted: Years Ended December 31,202020192018Net income attributable to stockholders$6,427 $6,732 $8,014 Loss from discontinued operations, net of tax— — 70 Income tax expense 1,774 769 474 Automotive interest expense1,098 782 655 Automotive interest income(241)(429)(335)AdjustmentsGMI restructuring(a)683 — 1,138 Ignition switch recall and related legal matters(b)(130)— 440 Cadillac dealer strategy(c)99 — — Transformation activities(d)— 1,735 1,327 GM Brazil indirect tax recoveries(e)— (1,360)— FAW-GM divestiture(f)— 164 — Total adjustments652 539 2,905 EBIT-adjusted$9,710 $8,393 $11,783 ________(a)These adjustments were excluded because of a strategic decision to rationalize our core operations by exiting or significantly reducing our presence in various international markets to focus resources on opportunities expected to deliver higher returns. The adjustments primarily consist of dealer restructurings, asset impairments, inventory provisions and employee separation charges in Australia, New Zealand, Thailand and India in the year ended December 31, 2020 and employee separation charges, asset impairments and supplier claims in Korea in the year ended December 31, 2018.(b)These adjustments were excluded because of the unique events associated with the ignition switch recall, which included various investigations, inquiries and complaints from constituents. (c)This adjustment was excluded because it relates to strategic activities to transition certain Cadillac dealers from the network as part of Cadillac's electric vehicle strategy.(d)These adjustments were excluded because of a strategic decision to accelerate our transformation for the future to strengthen our core business, capitalize on the future of personal mobility, and drive significant cost efficiencies. The adjustments primarily consist of accelerated depreciation, supplier-related charges, pension and other curtailment charges and employee-related separation charges in the year ended December 31, 2019 and primarily employee separation charges and accelerated depreciation in the year ended December 31, 2018.(e)This adjustment was excluded because of the unique events associated with decisions rendered by the Superior Judicial Court of Brazil resulting in retrospective recoveries of indirect taxes.(f)This adjustment was excluded because we divested our joint venture FAW-GM Light Duty Commercial Vehicle Co., Ltd. (FAW-GM), as a result of a strategic decision by both shareholders, allowing us to focus our resources on opportunities expected to deliver higher returns.25Table of ContentsGENERAL MOTORS COMPANY AND SUBSIDIARIESThe following table reconciles diluted earnings per common share under U.S. GAAP to EPS-diluted-adjusted:Years Ended December 31,202020192018AmountPer ShareAmountPer ShareAmountPer ShareDiluted earnings per common share$6,247 $4.33 $6,581 $4.57 $7,916 $5.53 Diluted loss per common share – discontinued operations— — — — 70 0.05 Adjustments(a)652 0.46 539 0.38 2,905 2.03 Tax effect on adjustments(b)(70)(0.05)(188)(0.13)(416)(0.29)Tax adjustments(c)236 0.16 — — (1,111)(0.78)EPS-diluted-adjusted$7,065 $4.90 $6,932 $4.82 $9,364 $6.54 ________(a) Refer to the reconciliation of Net income attributable to stockholders under U.S. GAAP to EBIT-adjusted within this section of the MD&A for adjustment details. (b) The tax effect of each adjustment is determined based on the tax laws and valuation allowance status of the jurisdiction to which the adjustment relates. (c) In the year ended December 31, 2020, the adjustment consists of tax expense related to the establishment of a valuation allowance against deferred tax assets in Australia and New Zealand. This adjustment was excluded because significant impacts of valuation allowances are not considered part of our core operations. In the year ended December 31, 2018, the adjustment consists of: (1) a non-recurring tax benefit related to foreign earnings; and (2) tax effects related to U.S. tax reform legislation. The following table reconciles our effective tax rate under U.S. GAAP to ETR-adjusted: Years Ended December 31,202020192018Income before income taxesIncome tax expenseEffective tax rateIncome before income taxesIncome tax expenseEffective tax rateIncome before income taxesIncome tax expenseEffective tax rateEffective tax rate$8,095 $1,774 21.9 %$7,436 $769 10.3 %$8,549 $474 5.5 %Adjustments(a)652 70 545 188 2,946 416 Tax adjustments(b)(236)— 1,111 ETR-adjusted$8,747 $1,608 18.4 %$7,981 $957 12.0 %$11,495 $2,001 17.4 %__________(a) Refer to the reconciliation of Net income attributable to stockholders under U.S. GAAP to EBIT-adjusted within this section of the MD&A for adjustment details. Net income attributable to noncontrolling interests for these adjustments is included in the years ended December 31, 2019 and 2018. The tax effect of each adjustment is determined based on the tax laws and valuation allowance status of the jurisdiction to which the adjustment relates. (b) Refer to the reconciliation of diluted earnings per common share under U.S. GAAP to EPS-diluted-adjusted within this section of the MD&A for adjustment details.We define return on equity (ROE) as Net income (loss) attributable to stockholders for the trailing four quarters divided by average equity for the same period. Management uses average equity to provide comparable amounts in the calculation of ROE. The following table summarizes the calculation of ROE (dollars in billions):Years Ended December 31,202020192018Net income (loss) attributable to stockholders$6.4 $6.7 $8.0 Average equity(a)$43.3 $43.7 $37.4 ROE14.9 %15.4 %21.4 %_______(a) Includes equity of noncontrolling interests where the corresponding earnings (loss) are included in Net income (loss) attributable to stockholders. 26Table of ContentsGENERAL MOTORS COMPANY AND SUBSIDIARIESThe following table summarizes the calculation of ROIC-adjusted (dollars in billions): Years Ended December 31,202020192018EBIT-adjusted(a)$9.7 $8.4 $11.8 Average equity(b)$43.3 $43.7 $37.4 Add: Average automotive debt and interest liabilities (excluding finance leases)27.8 14.9 14.4 Add: Average automotive net pension & OPEB liability17.6 16.7 18.3 Less: Average automotive net income tax asset(24.0)(23.5)(22.7)ROIC-adjusted average net assets$64.7 $51.8 $47.4 ROIC-adjusted15.0 %16.2 %24.9 %________(a) Refer to the reconciliation of Net income attributable to stockholders under U.S. GAAP to EBIT-adjusted within this section of the MD&A.(b) Includes equity of noncontrolling interests where the corresponding earnings (loss) are included in EBIT-adjusted. Overview Our vision for the future is a world with zero crashes, zero emissions and zero congestion, which guides our growth-focused investment in electrification, self-driving vehicles and new products and services. The all-electric future we are building integrates our technology, scale and manufacturing expertise to drive growth, profitability and deliver world-class customer interactions. Our strategy includes product leadership in electric vehicles and autonomous vehicles, continued leadership in trucks and SUVs, and developing and monetizing new software and services. We will execute our strategy with a diverse team and a steadfast commitment to good citizenship through sustainable operations and a leading health and safety culture.The COVID-19 pandemic and government actions and measures taken to prevent its spread continue to affect our operations. In response to COVID-19, we previously suspended the majority of our global manufacturing operations and our Automotive China JVs’ manufacturing operations. By May 2020, we had resumed our global manufacturing operations. Government-imposed restrictions on businesses, operations and travel and the related economic uncertainty have impacted demand for our vehicles in most of our global markets. During the first half of 2020, we executed a number of austerity measures, including aggressive actions to reduce costs and preserve liquidity, such as limiting advertising and other third-party spending, suspending our dividend on common shares, deferring salaried employee compensation and delaying non-critical projects, including certain future product programs. As production has returned to normal levels, the majority of the austerity measures we put into place have normalized. The extent of COVID-19’s impact on our future operations, liquidity and the demand for our products will depend upon, among other things, the duration and severity of the outbreak or subsequent outbreaks, related government responses, such as required physical distancing or restrictions on business operations and travel, the pace of recovery of economic activity and the impact to consumers, the effectiveness of available vaccines and any potential supply disruptions, all of which are uncertain and difficult to predict in light of the rapidly evolving landscape. Refer to Part I, Item 1A. Risk Factors for a full discussion of the risks associated with the COVID-19 pandemic.The automotive industry and GM are currently experiencing a global semiconductor supply shortage. The supply shortage has impacted multiple suppliers that incorporate semiconductors into the parts they supply to us. We expect the semiconductor supply shortage will have a short-term impact on our business. We do not expect this shortage to impact our growth and electric vehicle initiatives, we will continue prioritizing full-size trucks, SUVs and electric vehicles. Refer to Part I, Item 1A. Risk Factors for further discussion of these risks.For the year ending December 31, 2021, we expect EPS-diluted and EPS-diluted-adjusted of between $4.50 and $5.25, Net income attributable to stockholders of between $6.8 billion and $7.6 billion and EBIT-adjusted of between $10.0 billion and $11.0 billion, inclusive of the impact of the semiconductor supply shortage. We do not consider the potential future impact of adjustments on our expected financial results. We estimate the short-term semiconductor supply shortage to have a net EBIT-adjusted impact of approximately $1.5 billion to $2.0 billion in the year ending December 31, 2021.27Table of ContentsGENERAL MOTORS COMPANY AND SUBSIDIARIESThe following table reconciles expected Net income attributable to stockholders under U.S. GAAP to expected EBIT-adjusted (dollars in billions):Year Ending December 31, 2021Net income attributable to stockholders$ 6.8-7.6Income tax expense 2.2-2.4Automotive interest expense, net1.0 EBIT-adjusted(a)$ 10.0-11.0________(a)We do not consider the potential future impact of adjustments on our expected financial results.We also face continuing market, operating and regulatory challenges in several countries across the globe due to, among other factors, weak economic conditions, competitive pressures, our product portfolio offerings, heightened emissions standards, labor disruptions, foreign exchange volatility, rising material prices, evolving trade policy and political uncertainty. Refer to Part I, Item 1A. Risk Factors for a discussion of these challenges. In November 2018, we announced plans to accelerate steps to improve our overall business performance, including the reorganization of global product development staffs, the realignment of manufacturing capacity in response to market-related volume declines in passenger cars and a reduction of our salaried workforce. We achieved $4.5 billion in cost savings primarily from reductions in Automotive and other cost of sales and Automotive and other selling, general and administrative expense in our consolidated financial statements, inclusive of $0.2 billion of savings related to the wind-down of Holden sales, design and engineering operations and sale of our vehicle and powertrain manufacturing facilities in Thailand. We previously announced plans to reduce capital expenditures from approximately $8.5 billion to approximately $7.0 billion on a normalized run-rate basis. As a result of re-timing 2020 spending due to pandemic-related austerity measures into 2021 and a strategic decision to accelerate investments in our all-electric future beginning in 2021, we expect that our annual capital expenditures will exceed $7.0 billion through at least 2023. As we continue to assess our performance and the needs of our evolving business, additional restructuring and rationalization actions could be required. These actions could give rise to future asset impairments or other charges, which may have a material impact on our operating results.GMNA Industry sales in North America were 17.7 million units in the year ended December 31, 2020, representing a decrease of 16.2% compared to the corresponding period in 2019. U.S. industry sales were 14.9 million units in the year ended December 31, 2020, representing a decrease of 14.7% compared to the corresponding period in 2019. As described above, the COVID-19 pandemic has resulted in a contraction of total North America industry volumes in 2020. Dealer inventory remains constrained for several critical vehicles, including our full-size trucks.Our total vehicle sales in the U.S., our largest market in North America, were 2.5 million units for a market share of 17.1% in the year ended December 31, 2020, representing an increase of 0.6 percentage points compared to the corresponding period in 2019. We continue to lead the U.S. industry in market share. As discussed above, in response to COVID-19, we suspended production across our manufacturing facilities in March 2020. By May 2020, we had resumed critical manufacturing operations and reached normalized production levels in June 2020. We continue to follow physical distancing guidance, enhanced deep cleaning procedures and provide personal protective equipment to protect our employees. We estimate GMNA's breakeven point at the U.S. industry level to be in the range of 10.0 to 11.0 million units. The extent of COVID-19's impact on industry volumes in 2021 will ultimately depend upon, among other things, the duration and severity of the outbreak or subsequent outbreaks, related government responses, the pace of recovery of economic activity and the impact to consumers, the effectiveness of available vaccines and any potential supply disruptions, all of which are uncertain and difficult to predict in light of the rapidly evolving landscape. GMI Industry sales in China were 24.9 million units in the year ended December 31, 2020, representing a decrease of 1.9% compared to the corresponding period in 2019. Our total vehicle sales in China were 2.9 million units for a market share of 11.6% in the year ended December 31, 2020, representing a decrease of 0.5 percentage points compared to the corresponding period in 2019. While we have observed a recovery of the market as the impact of the COVID-19 pandemic in China subsides, the ongoing global macro-economic impact of COVID-19 and geopolitical tensions may continue to place pressure on China's 28Table of ContentsGENERAL MOTORS COMPANY AND SUBSIDIARIESautomotive industry. Our Automotive China JVs generated equity income of $0.5 billion in the year ended December 31, 2020. Although a continuation of a competitive industry, pricing pressures and a more challenging regulatory environment related to emissions, fuel consumption and new energy vehicles will continue to place pressure on our operations in China, we will continue to build upon our strong brands, network, and partnerships in China as well as continue to drive improvements in vehicle mix and cost. Outside of China, industry sales were 21.1 million units in the year ended December 31, 2020, representing a decrease of 18.0% compared to the corresponding period in 2019, primarily due to the global macroeconomic impact of COVID-19. Our total vehicle sales were 1.0 million units for a market share of 4.7% in the year ended December 31, 2020, representing a decrease of 0.1 percentage points compared to the corresponding period in 2019.In the year ended December 31, 2020, restructuring actions in GMI were related to the wind-down of Holden sales, design and engineering operations in Australia and New Zealand, with cessation of Holden vehicle sales by 2021, the sale of our vehicle and powertrain manufacturing facilities in Thailand, and the execution of a binding term sheet to sell our manufacturing facilities in India. These actions were taken to strengthen the Company's core business and focus investment on other opportunities that will derive the greatest returns for shareholders and support investment in future technologies. We recorded charges of $0.7 billion in the year ended December 31, 2020. We also recorded deferred tax charges of $0.2 billion in the year ended December 31, 2020. The charges were primarily considered special for EBIT-adjusted, EPS-diluted-adjusted and adjusted automotive free cash flow purposes. We intend to continue to provide servicing and spare parts to customers for an extended period of time in Australia, New Zealand, Thailand and India. Refer to Note 18 to our consolidated financial statements for additional information related to these restructuring actions.Cruise We are actively testing our autonomous vehicles in the U.S. Gated by safety and regulation, we continue to make significant progress towards commercialization of a network of on-demand autonomous vehicles in the U.S.Automotive Financing - GM Financial Summary and Outlook We believe that offering a comprehensive suite of financing products will generate incremental sales of our vehicles, drive incremental GM Financial earnings and help support our sales throughout various economic cycles. GM Financial's leasing program is exposed to residual values, which are heavily dependent on used vehicle prices. Used vehicle prices increased approximately 3% in 2020 compared to 2019, primarily due to low new vehicle inventory, largely driven by the suspension of manufacturing operations as a result of the COVID-19 pandemic, creating strong demand for used vehicles, which resulted in gains on terminations of leased vehicles of $1.3 billion in GM Financial interest, operating and other expenses in the year ended December 31, 2020, compared to gains of $0.7 billion in the corresponding period in 2019. Further, vehicles sold during 2020 were carried at lower net book values, resulting from increased depreciation rates recorded in anticipation of reduced residual values throughout 2020. In 2021, GM Financial expects used vehicle prices to decline by an amount in the low single digits on a percentage basis as compared to 2020 levels as supply and demand dynamics normalize. The following table summarizes the estimated residual value based on GM Financial's most recent estimates and the number of units included in GM Financial Equipment on operating leases, net by vehicle type (units in thousands):December 31, 2020December 31, 2019Residual ValueUnitsPercentageResidual ValueUnitsPercentageCrossovers$16,334 964 65.5 %$15,950 972 60.5 %Trucks7,455 275 18.7 %7,256 288 18.0 %SUVs3,435 92 6.3 %3,917 108 6.7 %Cars1,949 140 9.5 %3,276 238 14.8 %Total$29,173 1,471 100.0 %$30,399 1,606 100.0 %GM Financial's penetration of our retail sales in the U.S. increased to 45% in the year ended December 31, 2020 from 43% in 2019. Penetration levels vary depending on incentive financing programs available and competing third-party financing products in the market. GM Financial's prime loan originations as a percentage of total loan originations in North America increased to 73% in 2020 from 68% in 2019. In the year ended December 31, 2020, GM Financial's revenue consisted of leased vehicle income of 69%, retail finance charge income of 26%, and commercial finance charge income of 3%. Consolidated Results We review changes in our results of operations under five categories: volume, mix, price, cost and other. Volume measures the impact of changes in wholesale vehicle volumes driven by industry volume, market share and changes in dealer stock levels. Mix measures the impact of changes to the regional portfolio due to product, model, trim, 29Table of ContentsGENERAL MOTORS COMPANY AND SUBSIDIARIEScountry and option penetration in current year wholesale vehicle volumes. Price measures the impact of changes related to Manufacturer’s Suggested Retail Price and various sales allowances. Cost primarily includes: (1) material and freight; (2) manufacturing, engineering, advertising, administrative and selling and warranty expense; and (3) non-vehicle related activity. Other primarily includes foreign exchange and non-vehicle related automotive revenues as well as equity income or loss from our nonconsolidated affiliates. Refer to the regional sections of this MD&A for additional information. Total Net Sales and Revenue Years Ended December 31,Favorable/ (Unfavorable)Variance Due To20202019%VolumeMixPriceOther(Dollars in billions)GMNA$96,733 $106,366 $(9,633)(9.1)%$(15.1)$2.7 $3.3 $(0.5)GMI11,586 16,111 (4,525)(28.1)%$(4.4)$1.2 $0.5 $(1.8)Corporate350 220 130 59.1 %$0.1 Automotive 108,669 122,697 (14,028)(11.4)%$(19.6)$3.9 $3.8 $(2.2)Cruise103 100 3 3.0 %$— GM Financial13,831 14,554 (723)(5.0)%$(0.7)Eliminations/reclassifications(118)(114)(4)(3.5)%$— $— Total net sales and revenue$122,485 $137,237 $(14,752)(10.7)%$(19.6)$3.9 $3.8 $(2.9)Refer to the regional sections of this MD&A for additional information on volume, mix and price.Automotive and Other Cost of Sales Years Ended December 31,Favorable/ (Unfavorable)Variance Due To20202019%VolumeMixCostOther(Dollars in billions)GMNA$83,886 $94,582 $10,696 11.3 %$11.0 $(2.2)$1.8 $— GMI12,515 14,967 2,452 16.4 %$4.0 $(0.9)$(1.6)$1.0 Corporate310 81 (229)n.m.$(0.2)$— Cruise829 1,026 197 19.2 %$0.2 Eliminations(1)(5)(4)(80.0)%$— $— Total automotive and other cost of sales$97,539 $110,651 $13,112 11.8 %$15.0 $(3.1)$0.2 $1.0 ________n.m. = not meaningfulThe most significant element of our Automotive and other cost of sales is material cost, which makes up approximately two-thirds of the total amount. The remaining portion includes labor costs, depreciation and amortization, engineering, freight and product warranty and recall campaigns.Factors that most significantly influence a region's profitability are industry volume, market share, and the relative mix of vehicles (trucks, crossovers, cars) sold. Variable profit is a key indicator of product profitability. Variable profit is defined as revenue less material cost, freight, the variable component of manufacturing expense and warranty and recall-related costs. Vehicles with higher selling prices generally have higher variable profit. Refer to the regional sections of this MD&A for additional information on volume and mix.In the year ended December 31, 2020, favorable Cost was primarily due to: (1) charges of $1.7 billion primarily related to accelerated depreciation and supplier-related charges resulting from transformation activities in 2019; (2) favorable cost of $1.5 billion primarily due to the impact of COVID-19, inclusive of the suspension of production and austerity measures as well as cost savings associated with transformation activities and savings related to the wind-down of Holden sales, design and engineering operations and sale of our vehicle and powertrain manufacturing facilities in Thailand; and (3) decreased costs of $0.3 billion related to parts and accessories sales; partially offset by (4) a benefit of $1.4 billion related to the retrospective recoveries of indirect taxes in Brazil in 2019; (5) increased material and freight costs of $0.9 billion; (6) charges of $0.7 billion 30Table of ContentsGENERAL MOTORS COMPANY AND SUBSIDIARIESprimarily related to dealer restructuring charges, property and intangible asset impairments, inventory provisions and employee separation charges in Australia, New Zealand, Thailand and India; and (7) increased costs of $0.4 billion primarily due to the Takata Corporation (Takata) recall of $1.1 billion partially offset by decreased other campaign and warranty-related costs. In the year ended December 31, 2020 favorable Other was due to the foreign currency effect resulting from the weakening of the Brazilian Real and other currencies against the U.S. Dollar.Automotive and Other Selling, General and Administrative ExpenseYears Ended December 31,Year Ended2020 vs. 2019 Change202020192018Favorable/ (Unfavorable)%Automotive and other selling, general and administrative expense$7,038 $8,491 $9,650 $1,453 17.1 %In the year ended December 31, 2020, Automotive and other selling, general and administrative expense decreased primarily due to decreased advertising and other costs of $1.4 billion primarily related to the impact of COVID-19, inclusive of austerity measures and cost savings associated with transformation activities.Interest Income and Other Non-operating Income, netYears Ended December 31,Year Ended2020 vs. 2019 Change202020192018Favorable/ (Unfavorable)%Interest income and other non-operating income, net$1,885 $1,469 $2,596 $416 28.3 %In the year ended December 31, 2020, Interest income and other non-operating income, net increased primarily due to increased non-service pension income of $0.3 billion.Income Tax ExpenseYears Ended December 31,Year Ended2020 vs. 2019 Change202020192018Favorable/ (Unfavorable)%Income tax expense$1,774 $769 $474 $(1,005)n.m.________n.m. = not meaningfulIn the year ended December 31, 2020, Income tax expense increased primarily due to changes in valuation allowance, an increase in pre-tax income, and the absence of U.S. tax benefits from foreign activity.For the year ended December 31, 2020 our ETR-adjusted was 18.4%. We expect our adjusted effective tax rate to be approximately 24% for the year ending December 31, 2021. Refer to Note 17 to our consolidated financial statements for additional information related to Income tax expense.GM North America Years Ended December 31,Favorable/ (Unfavorable)Variance Due To20202019%VolumeMixPriceCostOther(Dollars in billions)Total net sales and revenue$96,733 $106,366 $(9,633)(9.1)%$(15.1)$2.7 $3.3 $(0.5)EBIT-adjusted$9,071 $8,204 $867 10.6 %$(4.1)$0.5 $3.3 $1.3 $(0.1)EBIT-adjusted margin9.4 %7.7 %1.7 %(Vehicles in thousands)Wholesale vehicle sales2,707 3,214 (507)(15.8)%31Table of ContentsGENERAL MOTORS COMPANY AND SUBSIDIARIESGMNA Total Net Sales and Revenue In the year ended December 31, 2020, Total net sales and revenue decreased primarily due to: (1) decreased net wholesale volumes across most vehicle lines as a result of suspending production due to the COVID-19 pandemic, partially offset by lost production volumes associated with the UAW strike in 2019; and (2) unfavorable Other primarily due to decreased sales of parts and accessories due to the COVID-19 pandemic and foreign currency effect resulting from the weakening of the Mexican Peso against the U.S. Dollar; partially offset by (3) favorable price primarily due to full-size SUVs, pickup trucks and crossover vehicles; and (4) favorable mix associated with decreased sales of passenger cars and crossover vehicles, improved mix associated with our new full-size pickup trucks, partially offset by decreased sales of full-size SUVs. GMNA EBIT-Adjusted The most significant factors that influence profitability are industry volume and market share. While not as significant as industry volume and market share, another factor affecting profitability is the relative mix of vehicles sold. Trucks, crossovers and cars sold currently have a variable profit of approximately 160%, 60% and 30% of our GMNA portfolio on a weighted-average basis.In the year ended December 31, 2020, EBIT-adjusted increased primarily due to: (1) favorable price; (2) favorable Cost due to savings in advertising, manufacturing, engineering and other administrative and selling of $2.1 billion, inclusive of the suspension of production and austerity measures in response to the COVID-19 pandemic as well as transformation activities; partially offset by increased material and freight cost of $0.7 billion, and increased costs of $0.4 billion primarily due to the Takata recall of $1.1 billion partially offset by decreased other campaigns and warranty-related costs; and (3) favorable mix; partially offset by (4) decreased net wholesale volumes. GM InternationalYears Ended December 31,Favorable/ (Unfavorable)Variance Due To20202019%VolumeMixPriceCostOther(Dollars in billions)Total net sales and revenue$11,586 $16,111 $(4,525)(28.1)%$(4.4)$1.2 $0.5 $(1.8)EBIT (loss)-adjusted$(528)$(202)$(326)n.m.$(0.5)$0.3 $0.6 $0.2 $(0.9)EBIT (loss)-adjusted margin(4.6)%(1.3)%(3.3)%Equity income — Automotive China$512 $1,132 $(620)(54.8)%EBIT (loss)-adjusted — excluding Equity income$(1,040)$(1,334)$294 22.0 %(Vehicles in thousands)Wholesale vehicle sales663 995 (332)(33.4)%________n.m. = not meaningfulThe vehicle sales of our Automotive China JVs are not recorded in Total net sales and revenue. The results of our joint ventures are recorded in Equity income, which is included in EBIT (loss)-adjusted above.GMI Total Net Sales and Revenue In the year ended December 31, 2020, Total net sales and revenue decreased primarily due to: (1) decreased wholesale volumes primarily due to lower industry volumes due to the COVID-19 pandemic primarily in South America and lower volumes in Asia/Pacific inclusive of the wind-down of our vehicle sales operations in Australia, New Zealand and Thailand; (2) unfavorable Other primarily due to the foreign currency effect resulting from the weakening of the Brazilian Real and Argentine Peso against the U.S. Dollar and decreased components, parts and accessories sales; partially offset by (3) favorable mix primarily in Brazil; and (4) favorable pricing across multiple vehicle lines in Argentina and Brazil. GMI EBIT (loss)-Adjusted In the year ended December 31, 2020, EBIT (loss)-adjusted increased primarily due to: (1) unfavorable volume; (2) unfavorable Other primarily due to decreased equity income and the foreign currency effect resulting from the weakening of the Brazilian Real and Argentine Peso against the U.S. Dollar; partially offset by (3) favorable pricing; (4) favorable mix primarily in Brazil and Asia/Pacific; and (5) favorable Cost primarily due to decreased advertising and engineering expenses, inclusive of savings related to the wind-down of Holden sales, design and engineering operations and sale of our vehicle and powertrain manufacturing facilities in Thailand, partially offset by increased material cost.32Table of ContentsGENERAL MOTORS COMPANY AND SUBSIDIARIESWe view the Chinese market as important to our global growth strategy and are employing a multi-brand strategy. In the coming years we plan to leverage our global architectures to increase the number of product offerings under the Buick, Chevrolet and Cadillac brands in China and continue to grow our business under the local Baojun and Wuling brands. We operate in the Chinese market through a number of joint ventures and maintaining strong relationships with our joint venture partners is an important part of our China growth strategy.The following table summarizes certain key operational and financial data for the Automotive China JVs (vehicles in thousands): Years Ended December 31,202020192018Wholesale vehicle sales including vehicles exported to markets outside of China3,029 3,244 4,030 Total net sales and revenue$38,736 $39,123 $50,316 Net income$1,239 $2,258 $3,992 December 31, 2020December 31, 2019Cash and cash equivalents$8,980 $6,257 Debt$313 $109 CruiseYears Ended December 31,2020 vs. 2019 Change202020192018Favorable/ (Unfavorable)%Total net sales and revenue(a)$103 $100 $— $3 3.0 %EBIT (loss)-adjusted$(887)$(1,004)$(728)$117 11.6 %________(a) Reclassified to Interest income and other non-operating income, net in our consolidated income statement in each of the years ended December 31, 2020 and 2019. Cruise EBIT (Loss)-Adjusted In the year ended December 31, 2020, EBIT (loss)-adjusted decreased primarily due to a reduction in developmental costs as we progress towards the commercialization of a network of on-demand autonomous vehicles in the U.S., partially offset by an increase in administrative expense. GM FinancialYears Ended December 31,2020 vs. 2019 Change202020192018Amount%Total revenue$13,831 $14,554 $14,016 $(723)(5.0)%Provision for loan losses$881 $726 $642 $155 21.3 %EBT-adjusted$2,702 $2,104 $1,893 $598 28.4 %Average debt outstanding (dollars in billions)$91.4 $91.2 $85.1 $0.2 0.2 %Effective rate of interest paid3.3 %4.0 %3.8 %(0.7)%GM Financial Revenue In the year ended December 31, 2020, Total revenue decreased primarily due to decreased leased vehicle income of $0.5 billion primarily due to a decrease in the size of the leased vehicle portfolio and decreased investment income of $0.1 billion resulting from a decline in benchmark interest rates.GM Financial EBT-Adjusted In the year ended December 31, 2020, EBT-adjusted increased primarily due to: (1) decreased interest expense of $0.6 billion due to a lower effective rate of interest on debt resulting from a decline in benchmark interest rates; (2) decreased leased vehicle expenses net of decreased leased vehicle income of $0.3 billion primarily due to increased leased vehicle termination gains, due to the outperformance of used vehicle prices compared to residual value estimates and a decrease in the size of the leased vehicle portfolio; partially offset by (3) increased provision for loan losses of $0.2 billion primarily due to increased expected charge-offs as a result of the forecasted economic impact of the COVID-19 pandemic, inclusive of new CECL standard impacts.33Table of ContentsGENERAL MOTORS COMPANY AND SUBSIDIARIESLiquidity and Capital Resources As described in the “Overview” section of this MD&A, the COVID-19 pandemic has had a material impact on our financial results and it may have a material impact on future periods, including our cash flows from operating activities and liquidity. The extent of the impact of COVID-19 on our liquidity will depend upon, among other things, the duration and severity of the outbreak or subsequent outbreaks, related government responses, such as required physical distancing or restrictions on business operations and travel, the pace of recovery of economic activity and the impact to consumers, the effectiveness of available vaccines and any potential supply disruptions, all of which are uncertain and difficult to predict. Refer to Part I, Item 1A. Risk Factors for a full discussion of the risks associated with the COVID-19 pandemic.During 2020, to preserve financial flexibility in light of the uncertainty in global markets resulting from the COVID-19 pandemic, we borrowed $15.9 billion under our revolving credit facilities, extended a portion of our revolving credit facilities for an additional year, issued $4.0 billion in senior unsecured notes and entered into a new unsecured 364-day, $2.0 billion revolving credit facility. We repaid all amounts drawn under the revolving credit facilities as of December 31, 2020. See the "Automotive Liquidity" section of this MD&A for additional information on these liquidity actions. Despite the uncertainty resulting from the COVID-19 pandemic, we believe our current levels of cash, cash equivalents, and marketable debt securities, available borrowing capacity under our revolving credit facilities and other liquidity actions currently available to us are sufficient to meet our liquidity requirements. We also maintain access to the capital markets and may issue debt or equity securities, which may provide an additional source of liquidity. We have substantial cash requirements going forward, which we plan to fund through our total available liquidity, cash flows from operating activities and additional liquidity measures, if determined to be necessary. The following summarizes aggregated information about our material short and long-term cash requirements from our known contractual and other obligations: Payments Due by Period20212022-20232024-20252026 and afterTotalAutomotive debt$1,199 $2,619 $2,618 11,260 17,696 Automotive Financing debt35,742 34,579 14,417 7,277 92,015 Automotive interest payments(a)947 1,807 1,532 8,439 12,725 Automotive Financing interest payments(b)2,072 2,329 955 443 5,799 Operating lease obligations266 436 312 498 1,512 Material2,496 1,593 71 18 4,178 __________(a)Amounts include automotive interest payments based on contractual terms and current interest rates on our debt and finance lease obligations. Automotive interest payments based on variable interest rates were determined using the interest rate in effect at December 31, 2020.(b)GM Financial interest payments were determined using the interest rate in effect at December 31, 2020 for floating rate debt and the contractual rates for fixed rate debt. GM Financial interest payments on floating rate tranches of the securitization notes payable were converted to a fixed rate based on the floating rate plus any expected hedge payments.Our known current material uses of cash include, among other possible demands: (1) capital expenditures of approximately $9.0 billion to $10.0 billion in 2021 in addition to payments for engineering and product development activities; (2) payments associated with previously announced vehicle recalls, the settlements of the multi-district litigation and any other recall-related contingencies; and (3) payments to service debt and other long-term obligations, including discretionary and mandatory contributions to our pension plans. Our material future uses of cash, which may vary from time to time based on market conditions and other factors, are focused on the three objectives of our capital allocation program: (1) grow our business at an average target ROIC-adjusted rate of 20% or greater; (2) maintain a strong investment-grade balance sheet, including a target average automotive cash balance of $18 billion; and (3) after the first two objectives are met, return available cash to shareholders. Our senior management evaluates our capital allocation program on an ongoing basis and recommends any modifications to the program to our Board of Directors, not less than once annually.Our liquidity plans are subject to a number of risks and uncertainties, including those described in the "Forward-Looking Statements" section of this MD&A and Part I, Item 1A. Risk Factors, some of which are outside of our control. 34Table of ContentsGENERAL MOTORS COMPANY AND SUBSIDIARIESWe continue to monitor and evaluate opportunities to strengthen our competitive position over the long term while maintaining a strong investment-grade balance sheet. These actions may include opportunistic payments to reduce our long-term obligations, as well as the possibility of acquisitions, dispositions, investments with joint venture partners and strategic alliances that we believe would generate significant advantages and substantially strengthen our business. In January 2017, we announced that our Board of Directors had authorized the purchase of up to $5.0 billion of our common stock with no expiration date, as part of our common stock repurchase program. We have completed $1.7 billion of the $5.0 billion program through December 31, 2020.Cash flows occur amongst our Automotive, Cruise and GM Financial operations that are eliminated when we consolidate our cash flows. Such eliminations include, among other things, collections by Automotive on wholesale accounts receivables financed by dealers through GM Financial, payments between Automotive and GM Financial for accounts receivables transferred by Automotive to GM Financial, loans to Automotive from GM Financial, dividends issued by GM Financial to Automotive and Automotive cash injections in Cruise. The presentation of Automotive liquidity, Cruise liquidity and GM Financial liquidity presented below includes the impact of cash transactions amongst the sectors that are ultimately eliminated in consolidation.Automotive Liquidity Total available liquidity includes cash, cash equivalents, marketable debt securities and funds available under credit facilities. The amount of available liquidity is subject to seasonal fluctuations and includes balances held by various business units and subsidiaries worldwide that are needed to fund their operations. We manage our liquidity primarily at our treasury centers as well as at certain of our significant consolidated overseas subsidiaries. Over 90% of our cash and marketable debt securities were managed within North America and at our regional treasury centers at December 31, 2020. We have used and will continue to use other methods including intercompany loans to utilize these funds across our global operations as needed.Our cash equivalents and marketable debt securities balances are primarily denominated in U.S. Dollars and include investments in U.S. government and agency obligations, foreign government securities, time deposits, corporate debt securities and mortgage and asset-backed securities. Our investment guidelines, which we may change from time to time, prescribe certain minimum credit worthiness thresholds and limit our exposures to any particular sector, asset class, issuance or security type. The majority of our current investments in debt securities are with A/A2 or better rated issuers. We use credit facilities as a mechanism to provide additional flexibility in managing our global liquidity. At December 31, 2019, the total size of our credit facilities was $17.5 billion, which consisted principally of three revolving credit facilities. In May 2020, as an additional source of available liquidity, we entered into a fourth facility, increasing the size of our credit facilities to $18.5 billion. These facilities consist of a three-year, $4.0 billion facility that includes a letter of credit sub-facility of $1.1 billion, a five-year, $10.5 billion facility, a three-year, $2.0 billion transformation facility and a 364-day, $2.0 billion revolving credit facility entered into in May 2020. Total borrowing capacity under our automotive credit facilities does not include a 364-day, $2.0 billion facility designated for exclusive use by GM Financial. In April 2020, we renewed our 364-day, $2.0 billion facility designated for exclusive use by GM Financial for an additional 364-day term and extended $3.6 billion of the three-year, $4.0 billion facility for an additional year expiring in April 2022. The remaining portion will expire in April 2021, unless extended. As part of the extension of the three-year, $4.0 billion facility, we agreed not to execute any share repurchases while we have any outstanding borrowings under the revolving credit facilities, except for the three-year, $2.0 billion transformation facility. In addition, we are restricted from paying dividends on our common shares if outstanding borrowings under the revolving credit facilities exceed $5.0 billion, with the exception of the three-year, $2.0 billion transformation facility.In 2020, we borrowed $3.4 billion against our three-year, $4.0 billion facility, $2.0 billion against our three-year, $2.0 billion transformation facility and $10.5 billion against our five-year, $10.5 billion facility. We repaid all amounts drawn under the revolving credit facilities as of December 31, 2020. We had letters of credit outstanding under our sub-facility of $0.3 billion and $0.2 billion at December 31, 2020 and 2019. If available capacity permits, GM Financial has access to our revolving credit facilities, except for the three-year, $2.0 billion transformation facility and the new 364-day $2.0 billion facility. GM Financial did not have borrowings outstanding against our revolving credit facilities at December 31, 2020 and 2019. Refer to Note 13 to our consolidated financial statements for additional information on credit facilities. We had intercompany loans from GM Financial of $0.4 billion and $0.5 billion at 35Table of ContentsGENERAL MOTORS COMPANY AND SUBSIDIARIESDecember 31, 2020 and 2019, which primarily consisted of commercial loans to dealers we consolidate, and we had no intercompany loans to GM Financial. Refer to Note 5 of our consolidated financial statements for additional information.In May 2020, we issued $4.0 billion in aggregate principal amount of senior unsecured notes with a weighted average interest rate of 6.11% and maturity dates ranging from 2023 to 2027. The notes are governed by a sixth supplemental indenture and the same base indenture that governs our existing notes, which contains terms and covenants customary for these types of securities, including a limitation on the amount of certain secured debt we may incur. The net proceeds from the issuance of these senior unsecured notes provide additional financial flexibility and will be used for general corporate purposes. In August 2020, we repaid $0.5 billion of our floating rate senior unsecured debt upon maturity. Several of our loan facilities, including our revolving credit facilities, require compliance with certain financial and operational covenants as well as regular reporting to lenders. We have reviewed our covenants in effect as of December 31, 2020 and determined we are in compliance and expect to remain in compliance in the future. GM Financial's Board of Directors declared and paid dividends of $0.8 billion and $0.4 billion on its common stock in 2020 and 2019. Future dividends from GM Financial will depend on a number of factors including business and economic conditions, its financial condition, earnings, liquidity requirements and leverage ratio. The following table summarizes our available liquidity (dollars in billions): December 31, 2020December 31, 2019Automotive cash and cash equivalents$14.2 $13.4 Marketable debt securities8.1 3.9 Automotive cash, cash equivalents and marketable debt securities22.3 17.3 Cruise cash and cash equivalents(a)0.8 2.3 Cruise marketable debt securities(a)0.9 0.3 Available liquidity24.0 19.9 Available under credit facilities18.2 17.3 Total available liquidity$42.2 $37.2 __________ (a)Amounts are designated exclusively for the use of Cruise. Refer to Note 20 to our consolidated financial statements for further details.The following table summarizes the changes in our Automotive available liquidity (excluding Cruise, dollars in billions): Year Ended December 31, 2020Operating cash flow$7.5 Capital expenditures(5.3)Dividends paid and payments to purchase common stock(0.6)Issuance of senior unsecured notes4.0 Repayment of senior unsecured notes(0.5)Other non-operating(a)(0.1)Increase in available credit facilities0.9 Total change in automotive available liquidity$5.9 __________ (a)Amount includes $0.5 billion of net payments on other debt including finance leases and several other insignificant items, partially offset by $0.6 billion of proceeds from the sale of our remaining shares in Lyft.36Table of ContentsGENERAL MOTORS COMPANY AND SUBSIDIARIESAutomotive Cash Flow (Dollars in billions)Years Ended December 31,2020 vs. 2019 Change202020192018Operating ActivitiesIncome from continuing operations$5.0 $5.8 $7.1 $(0.8)Depreciation, amortization and impairment charges5.5 6.7 6.1 (1.2)Pension and OPEB activities(1.6)(1.5)(3.4)(0.1)Working capital(1.7)(2.2)0.7 0.5 Accrued and other liabilities and income taxes(1.4)(1.5)1.9 0.1 Other1.7 0.1 (0.7)1.6 Net automotive cash provided by operating activities$7.5 $7.4 $11.7 $0.1 In the year ended December 31, 2020, the increase in Net automotive cash provided by operating activities was primarily due to: (1) payments of $1.1 billion in the prior year related to transformation activities; (2) working capital; (3) higher dividends received from GM Financial of $0.4 billion; and (4) several other insignificant items; partially offset by (5) unwind of sales incentives of $1.8 billion; and (6) lower dividends received from our nonconsolidated affiliates of $0.7 billion.Years Ended December 31,2020 vs. 2019 Change202020192018Investing ActivitiesCapital expenditures$(5.3)$(7.5)$(8.7)$2.2 Acquisitions and liquidations of marketable securities, net(a)(3.6)2.4 2.3 (6.0)GM investment in Cruise— (0.7)(1.1)0.7 Other0.1 0.2 (0.2)(0.1)Net automotive cash used in investing activities$(8.8)$(5.6)$(7.7)$(3.2)__________ (a)Amount includes $0.6 billion and $0.3 billion of proceeds from the sale of our shares in Lyft in the year ended December 31, 2020 and 2019.In the year ended December 31, 2020, capital expenditures decreased primarily due to the delay of non-critical projects, including certain future product programs, in response to the COVID-19 pandemic. Cash used in acquisitions and liquidations of marketable securities, net increased due to the increased purchases of marketable securities with proceeds from the issuance of debt in response to the COVID-19 pandemic and increased liquidations of marketable securities for strike-related liquidity needs during 2019.Years Ended December 31,2020 vs. 2019 Change202020192018Financing ActivitiesNet proceeds (payments) from short-term debt$(0.5)$0.5 $(1.4)$(1.0)Issuance of senior unsecured notes4.0 — 2.1 4.0 Repayment of senior unsecured notes(0.5)— — (0.5)Dividends paid and payments to purchase common stock(0.6)(2.2)(2.3)1.6 Proceeds from KDB investment in GM Korea— — 0.7 — Other(0.3)(0.4)(0.6)0.1 Net automotive cash provided by (used in) financing activities$2.1 $(2.1)$(1.5)$4.2 37Table of ContentsGENERAL MOTORS COMPANY AND SUBSIDIARIESAdjusted Automotive Free Cash Flow We measure adjusted automotive free cash flow as automotive operating cash flow from continuing operations less capital expenditures adjusted for management actions. For the year ended December 31, 2020, net automotive cash provided by operating activities under U.S. GAAP was $7.5 billion, capital expenditures were $5.3 billion and adjustments for management actions, primarily related to GMI restructuring, were $0.3 billion. For the year ended December 31, 2019, net automotive cash provided by operating activities under U.S. GAAP was $7.4 billion, capital expenditures were $7.5 billion and adjustments for management actions, primarily related to transformation activities, were $1.2 billion.Status of Credit Ratings We receive ratings from four independent credit rating agencies: DBRS Limited (DBRS), Fitch Ratings (Fitch), Moody's Investor Service (Moody's) and Standard & Poor's (S&P). All four credit rating agencies currently rate our corporate credit at investment grade. The following table summarizes our credit ratings at January 29, 2021:CorporateRevolving Credit FacilitiesSenior UnsecuredOutlookDBRSBBBBBBN/ANegativeFitchBBB-BBB-BBB-StableMoody'sInvestment GradeBaa2Baa3NegativeS&PBBBBBBBBBNegativeCruise Liquidity The changes in our Cruise available liquidity in the year ended December 31, 2020 were primarily driven by operating cash flow. In January 2021, Cruise Holdings issued Class G Preferred Shares in exchange for $2.2 billion from Microsoft and other investors, including $1.0 billion from General Motors Holdings LLC. Refer to Note 26 to our consolidated financial statements for additional information. When Cruise's autonomous vehicles are ready for commercial deployment, Softbank Vision Fund (AIV M2), L.P. (The Vision Fund) is obligated to purchase additional convertible preferred shares (Cruise Preferred Shares) for $1.35 billion.Cruise Cash Flow (Dollars in billions)Years Ended December 31,2020 vs. 2019 Change202020192018Net cash used in operating activities$(0.8)$(0.8)$(0.6)$— Net cash used in investing activities$(0.7)$(0.3)$(0.1)$(0.4)Net cash provided by financing activities$— $1.1 $3.0 $(1.1)In the year ended December 31, 2020, Net cash provided by financing activities decreased primarily due to a reduction in the issuance of preferred shares.Automotive Financing – GM Financial Liquidity GM Financial's primary sources of cash are finance charge income, leasing income and proceeds from the sale of terminated leased vehicles, net distributions from credit facilities, securitizations, secured and unsecured borrowings and collections and recoveries on finance receivables. GM Financial's primary uses of cash are purchases of retail finance receivables and leased vehicles, the funding of commercial finance receivables, repayment or repurchases of secured and unsecured debt, funding credit enhancement requirements in connection with securitizations and secured credit facilities, interest costs, operating expenses and dividend payments. The following table summarizes GM Financial's available liquidity (dollars in billions): December 31, 2020December 31, 2019Cash and cash equivalents$5.1 $3.3 Borrowing capacity on unpledged eligible assets19.0 17.5 Borrowing capacity on committed unsecured lines of credit0.5 0.3 Borrowing capacity on revolving credit facility, exclusive to GM Financial2.0 2.0 Total GM Financial available liquidity$26.6 $23.1 38Table of ContentsGENERAL MOTORS COMPANY AND SUBSIDIARIESIn the year ended December 31, 2020, available liquidity increased primarily due to an increase in cash and cash equivalents and available borrowing capacity on unpledged eligible assets, resulting from the issuance of securitization transactions, unsecured debt and preferred stock. GM Financial structures liquidity to support at least six months of GM Financial's expected net cash outflows, including new originations, without access to new debt financing transactions or other capital markets activity. GM Financial has access to $16.5 billion of our revolving credit facilities with exclusive access to the 364-day, $2.0 billion facility. Refer to the "Automotive Liquidity" section of this MD&A for additional details. We have a support agreement with GM Financial which, among other things, establishes commitments of funding from us to GM Financial. This agreement also provides that we will continue to own all of GM Financial’s outstanding voting shares so long as any unsecured debt securities remain outstanding at GM Financial. In addition, we are required to use our commercially reasonable efforts to ensure GM Financial remains a subsidiary borrower under our corporate revolving credit facilities. Credit Facilities In the normal course of business, in addition to using its available cash, GM Financial utilizes borrowings under its credit facilities, which may be secured or unsecured, and GM Financial repays these borrowings as appropriate under its cash management strategy. At December 31, 2020, secured, committed unsecured and uncommitted unsecured credit facilities totaled $26.2 billion, $0.5 billion and $1.5 billion with advances outstanding of $3.7 billion, an insignificant amount and $1.5 billion. GM Financial Cash Flow (Dollars in billions)Years Ended December 31,2020 vs. 2019 Change202020192018Net cash provided by operating activities$8.0 $8.1 $7.4 $(0.1)Net cash used in investing activities$(9.3)$(5.0)$(17.5)$(4.3)Net cash provided by (used in) financing activities$2.4 $(3.5)$11.1 $5.9 In the year ended December 31, 2020, Net cash provided by operating activities decreased primarily due to: (1) a decrease in leased vehicle income of $0.5 billion; and (2) a decrease in derivative collateral posting activities of $0.1 billion; partially offset by (3) a decrease in interest paid of $0.5 billion.In the year ended December 31, 2020, Net cash used in investing activities increased primarily due to: (1) increased purchases of finance receivables of $4.9 billion; and (2) decreased collections and recoveries on finance receivables of $0.7 billion; partially offset by (3) decreased purchases of leased vehicles of $1.2 billion.In the year ended December 31, 2020, Net cash provided by financing activities increased primarily due to: (1) an increase in borrowings of $22.2 billion; and (2) issuance of preferred stock of $0.5 billion; partially offset by (3) an increase in debt repayments of $16.4 billion; and (4) an increase in dividend payments of $0.4 billion. Off-Balance Sheet Arrangements Not applicable.Contractual Obligations and Other Long-Term Liabilities Not applicable. Critical Accounting Estimates The consolidated financial statements are prepared in conformity with U.S. GAAP, which requires the use of estimates, judgments and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses in the periods presented. We believe the accounting estimates employed are appropriate and the resulting balances are reasonable; however, due to the inherent uncertainties in developing estimates, actual results could differ from the original estimates, requiring adjustments to these balances in future periods. Refer to Note 2 to our consolidated financial statements for our significant accounting policies related to our critical accounting estimates.39Table of ContentsGENERAL MOTORS COMPANY AND SUBSIDIARIESProduct Warranty and Recall Campaigns The estimates related to product warranties are established using historical information on the nature, frequency and average cost of claims of each vehicle line or each model year of the vehicle line and assumptions about future activity and events. When little or no claims experience exists for a model year or a vehicle line, the estimate is based on comparable models. We accrue the costs related to product warranty at the time of vehicle sale and we accrue the estimated cost of recall campaigns when they are probable and estimable, which is generally at the time of sale.The estimates related to recall campaigns accrued at the time of vehicle sale are established by applying a paid loss approach that considers the number of historical recall campaigns and the estimated cost for each recall campaign. These estimates consider the nature, frequency and magnitude of historical recall campaigns, and use key assumptions including the number of historical periods and the weighting of historical data in the reserve studies. Costs associated with recall campaigns not accrued at the time of vehicle sale are estimated based on the estimated cost of repairs and the estimated vehicles to be repaired. Depending on part availability and time to complete repairs we may, from time to time, offer courtesy transportation at no cost to our customers. These estimates are re-evaluated on an ongoing basis and based on the best available information. Revisions are made when necessary based on changes in these factors. The estimated amount accrued for recall campaigns at the time of vehicle sale is most sensitive to the estimated number of recall events, the number of vehicles per recall event, the assumed number of vehicles that will be brought in by customers for repair (take rate) and the cost per vehicle for each recall event. The estimated cost of a recall campaign that is accrued on an individual basis is most sensitive to our estimated assumed take rate that is primarily developed based on our historical take rate experience. A 10% increase in the estimated take rate for all recall campaigns would increase the estimated cost by approximately $0.4 billion.Actual experience could differ from the amounts estimated requiring adjustments to these liabilities in future periods. Due to the uncertainty and potential volatility of the factors contributing to developing estimates, changes in our assumptions could materially affect our results of operations.Sales Incentives The estimated effect of sales incentives offered to dealers and end customers is recorded as a reduction of Automotive net sales and revenue at the time of sale. There may be numerous types of incentives available at any particular time. Incentive programs are generally specific to brand, model or sales region and are for specified time periods, which may be extended. Significant factors used in estimating the cost of incentives include type of program, forecasted sales volume, product mix, and the rate of customer acceptance of incentive programs, all of which are estimated based on historical experience and assumptions concerning future customer behavior and market conditions. A change in any of these factors affecting the estimate could have a significant effect on recorded sales incentives. A 10% increase in the cost of incentives would increase the sales incentive liability by approximately $0.3 billion. Subsequent adjustments to incentive estimates are possible as facts and circumstances change over time, which could affect the revenue previously recognized in Automotive net sales and revenue.GM Financial Allowance for Loan Losses The GM Financial retail finance receivables portfolio consists of smaller-balance, homogeneous loans that are carried at amortized cost, net of allowance for loan losses. The allowance for loan losses on retail finance receivables reflects net credit losses expected to be incurred over the remaining life of the retail finance receivables, which have a weighted average remaining life of approximately two years. We forecast net credit losses based on relevant information about past events, current conditions and forecast economic performance. We believe that the allowance is adequate to cover expected credit losses on the retail finance receivables; however, because the allowance for loan losses is based on estimates, there can be no assurance that the ultimate charge-off amount will not exceed such estimates or that our credit loss assumptions will not increase.GM Financial incorporates assumptions about forecast charge-off recovery rates and overall economic performance in its allowance estimate. Used vehicle prices rebounded in the second half of 2020 after decreasing in March and April 2020, and recoveries outperformed the forecast. Therefore, GM Financial increased its recovery rate forecast as of December 31, 2020. Each 5% relative decrease/increase in the forecast recovery rates could increase/decrease our allowance for loan losses by approximately $0.1 billion. GM Financial updated its forecast of economic performance in March 2020, following the onset of the COVID-19 pandemic, and has continued to monitor and update the forecast through December 31, 2020. At December 31, 2020, the weightings applied to the economic forecast scenarios considered resulted in an allowance for loan losses on the retail finance receivables portfolio of $1.9 billion. Using different possible weightings that GM Financial could apply to the economic forecast scenarios 40Table of ContentsGENERAL MOTORS COMPANY AND SUBSIDIARIESresult in an allowance for loan losses ranging from $1.8 billion to $2.0 billion. Actual economic data and recovery rates that are lower than those forecasted by GM Financial could result in an increase to the allowance for loan losses.The GM Financial commercial finance receivables portfolio consists of floorplan financing as well as dealer loans, which are loans to finance improvements to dealership facilities, to provide working capital, and to purchase and/or finance dealership real estate. The allowance for loan losses on commercial finance receivables is also based on estimates that, effective January 1, 2020, include historical loss experience for the consolidated portfolio, as well as the forecast for industry vehicle sales. There can be no assurance that the ultimate charge-off amount will not exceed such estimates or that GM Financial's credit loss assumptions will not increase.Valuation of GM Financial Equipment on Operating Lease Assets and Residuals GM Financial has investments in leased vehicles recorded as operating leases, which relate to vehicle leases to retail customers with lease terms that typically range from two to five years. At lease inception an estimate is made of the expected residual value at the end of the lease term. The expected residual value is based on third-party data that considers various data points and assumptions, including, but not limited to, recent auction values, the expected future volume of returning leased vehicles, used vehicle prices, manufacturer incentive programs and fuel prices. Realization of the residual values is dependent on the future ability to market the vehicles under prevailing market conditions. The customer is obligated to make payments during the lease term for the difference between the purchase price and the contract residual value plus a money factor. However, since the customer is not obligated to purchase the vehicle at the end of the contract, GM Financial is exposed to a risk of loss to the extent the customer returns the vehicle prior to or at the end of the lease term and the value of the vehicle is lower than the residual value estimated at lease inception. The following table summarizes vehicles included in GM Financial equipment on operating leases, net (vehicles in thousands):December 31, 2020December 31, 2019Crossovers964 972 Trucks275 288 SUVs92 108 Cars140 238 Total1,471 1,606 At December 31, 2020, the estimated residual value of GM Financial's leased vehicles was $29.2 billion. Depreciation reduces the carrying value of each leased asset in GM Financial's operating lease portfolio over time from its original acquisition value to its expected residual value at the end of the lease term. GM Financial updated the residual value estimates on the operating lease portfolio to reflect the decrease in forecasted used vehicle prices in March 2020, following the onset of the COVID-19 pandemic, and has continued to monitor and update the residual value estimates through December 31, 2020. Used vehicle prices rebounded in the second half of 2020 after decreasing in March and April 2020, and sales proceeds on terminated leased vehicles outperformed the residual value estimates during the year ended December 31, 2020. Accordingly, GM Financial increased the residual value estimates at December 31, 2020, which will result in a prospective decrease in the depreciation rate over the remaining term of the leased vehicle portfolio. If used vehicle prices decrease, GM Financial would increase depreciation expense and/or record an impairment charge on the lease portfolio. If an impairment exists, GM Financial would determine any shortfall in recoverability of the leased vehicle asset groups by year, make and model. Recoverability is calculated as the excess of: (1) the sum of remaining lease payments plus estimated residual value; over (2) leased vehicles, net less deferred revenue. Alternatively, if used vehicle prices outperform GM Financial's latest estimates, it may record gains on sales of off-lease vehicles and/or decreased depreciation expense. 41Table of ContentsGENERAL MOTORS COMPANY AND SUBSIDIARIESThe following table illustrates the effect of a 1% relative change in the estimated residual values at December 31, 2020, which could increase or decrease depreciation expense over the remaining term of the leased vehicle portfolio, holding all other assumptions constant (dollars in millions):Impact to Depreciation Expense2021$198 202272 202321 2024 and thereafter1 Total$292 Changes to residual values are rarely simultaneous across all maturities and segments, and also may impact return rates. If a decrease in residual values is concentrated among specific asset groups, the decrease could result in an immediate impairment charge. GM Financial reviewed the leased vehicle portfolio for indicators of impairment and determined that no impairment indicators were present at December 31, 2020 and 2019.Used vehicle prices increased approximately 3% in 2020 compared to 2019, primarily due to low new vehicle inventory, largely driven by the suspension of manufacturing operations as a result of the COVID-19 pandemic, creating strong demand for used vehicles. In 2021, GM Financial expects used vehicle prices to decline by an amount in the low single digits on a percentage basis compared to 2020 levels as supply and demand dynamics normalize.Pension and OPEB Plans Our defined benefit pension plans are accounted for on an actuarial basis, which requires the selection of various assumptions, including an expected long-term rate of return on plan assets, a discount rate, mortality rates of participants and expectation of mortality improvement. Our pension obligations include Korean statutory pension payments that are valued on a walk away basis. The expected long-term rate of return on U.S. plan assets that is utilized in determining pension expense is derived from periodic studies, which include a review of asset allocation strategies, anticipated future long-term performance of individual asset classes, risks using standard deviations and correlations of returns among the asset classes that comprise the plans' asset mix. While the studies give appropriate consideration to recent plan performance and historical returns, the assumptions are primarily long-term, prospective rates of return. In December 2020, an investment policy study was completed for the U.S. pension plans. As a result of changes to our capital market assumptions, the weighted-average long-term rate of return on assets decreased from 5.9% at December 31, 2019 to 5.6% at December 31, 2020. The expected long-term rate of return on plan assets used in determining pension expense for non-U.S. plans is determined in a similar manner to the U.S. plans.Another key assumption in determining net pension and OPEB expense is the assumed discount rate used to discount plan obligations. We estimate the assumed discount rate for U.S. plans using a cash flow matching approach, which uses projected cash flows matched to spot rates along a high quality corporate bond yield curve to determine the weighted-average discount rate for the calculation of the present value of cash flows. We apply the individual annual yield curve rates instead of the assumed discount rate to determine the service cost and interest cost, which more specifically links the cash flows related to service cost and interest cost to bonds maturing in their year of payment. The Society of Actuaries (SOA) issued mortality improvement tables in the three months ended December 31, 2020. We incorporated these SOA mortality improvement tables into our December 31, 2020 measurement of U.S. pension and OPEB plans' benefit obligations. The change in these assumptions decreased the December 31, 2020 U.S. pension and OPEB plans’ obligations by $0.7 billion.Significant differences in actual experience or significant changes in assumptions may materially affect the pension obligations. The effects of actual results differing from assumptions and the changing of assumptions are included in unamortized net actuarial gains and losses that are subject to amortization to pension expense over future periods. The unamortized pre-tax actuarial loss on our pension plans was $8.4 billion and $6.7 billion at December 31, 2020 and 2019. The year-over-year change is primarily due to a decrease in discount rates partially offset by higher than expected asset returns. 42Table of ContentsGENERAL MOTORS COMPANY AND SUBSIDIARIESThe underfunded status of the U.S. pension plans remained unchanged in the year ended December 31, 2020 at $5.4 billion primarily due to: (1) the unfavorable effect of a decrease in discount rates of $5.6 billion; and (2) service and interest costs of $1.9 billion; partially offset by (3) a favorable effect of actual returns on plan assets of $6.6 billion; and (4) changes in mortality improvement assumptions and demographic gains of $0.9 billion.The following table illustrates the sensitivity to a change in certain assumptions for the pension plans, holding all other assumptions constant:U.S. Plans(a)Non-U.S. Plans(a)Effect on 2021 Pension ExpenseEffect on December 31, 2020 PBOEffect on 2021 Pension ExpenseEffect on December 31, 2020 PBO25 basis point decrease in discount rate-$81+$1,707-$1+$66925 basis point increase in discount rate+$103-$1,634+$1-$63425 basis point decrease in expected rate of return on assets+$142N/A +$32N/A25 basis point increase in expected rate of return on assets-$142N/A -$32N/A__________(a)The sensitivity does not include the effects of the individual annual yield curve rates applied for the calculation of the service and interest cost.Refer to Note 15 to our consolidated financial statements for additional information on pension contributions, investment strategies, assumptions, the change in benefit obligations and related plan assets, pension funding requirements and future net benefit payments. Refer to Note 2 to our consolidated financial statements for a discussion of the inputs used to determine fair value for each significant asset class or category. Valuation of Deferred Tax Assets The ability to realize deferred tax assets depends on the ability to generate sufficient taxable income within the carryback or carryforward periods provided for in the tax law for each applicable tax jurisdiction. The assessment regarding whether a valuation allowance is required or should be adjusted is based on an evaluation of possible sources of taxable income and also considers all available positive and negative evidence factors. Our accounting for the valuation of deferred tax assets represents our best estimate of future events. Changes in our current estimates due to unanticipated market conditions and governmental legislative actions or events, could have a material effect on our ability to utilize deferred tax assets. Refer to Note 17 to our consolidated financial statements for additional information on the composition of valuation allowances.Forward-Looking Statements This report and the other reports filed by us with the SEC from time to time, as well as statements incorporated by reference herein and related comments by our management, may include "forward-looking statements" within the meaning of the U.S. federal securities laws. Forward-looking statements are any statements other than statements of historical fact. Forward-looking statements represent our current judgment about possible future events and are often identified by words like “aim,” “anticipate,” “appears,” “approximately,” “believe,” “continue,” “could,” “designed,” “effect,” “estimate,” “evaluate,” “expect,” “forecast,” “goal,” “initiative,” “intend,” “may,” “objective,” “outlook,” “plan,” “potential,” “priorities,” “project,” “pursue,” “seek,” “should,” “target,” “when,” “will,” “would,” or the negative of any of those words or similar expressions. In making these statements, we rely on assumptions and analysis based on our experience and perception of historical trends, current conditions and expected future developments as well as other factors we consider appropriate under the circumstances. We believe these judgments are reasonable, but these statements are not guarantees of any future events or financial results, and our actual results may differ materially due to a variety of important factors, many of which are beyond our control. These factors, which may be revised or supplemented in subsequent reports we file with the SEC, include, among others, the following: (1) our ability to deliver new products, services and customer experiences in response to increased competition and changing consumer preferences in the automotive industry; (2) our ability to timely fund and introduce new and improved vehicle models, including electric vehicles, that are able to attract a sufficient number of consumers; (3) the success of our crossovers, SUVs and full-size pickup trucks; (4) our highly competitive industry, which is characterized by excess manufacturing capacity and the use of incentives, and the introduction of new and improved vehicle models by our competitors; (5) our ability to deliver a broad portfolio of electric vehicles and drive increased consumer adoption; (6) the unique technological, operational, regulatory and competitive risks related to the timing and commercialization of autonomous vehicles; (7) the ongoing COVID-19 pandemic; (8) global automobile market sales volume, which can be volatile; (9) our significant business in China, which is subject to unique operational, competitive, regulatory and economic risks; (10) our joint ventures, which we cannot operate solely for our benefit and over which we may have limited control; (11) the international scale and footprint of our operations, which exposes us to a variety of unique political, economic, 43Table of ContentsGENERAL MOTORS COMPANY AND SUBSIDIARIEScompetitive and regulatory risks, including the risk of changes in government leadership and laws (including labor, tax and other laws), political instability and economic tensions between governments and changes in international trade policies, new barriers to entry and changes to or withdrawals from free trade agreements, public health crises, including the occurrence of a contagious disease or illness, such as the COVID-19 pandemic, changes in foreign exchange rates and interest rates, economic downturns in the countries in which we operate, differing local product preferences and product requirements, changes to and compliance with U.S. and foreign countries' export controls and economic sanctions, differing labor regulations, requirements and union relationships, differing dealer and franchise regulations and relationships, and difficulties in obtaining financing in foreign countries; (12) any significant disruption, including any work stoppages, at any of our manufacturing facilities; (13) the ability of our suppliers to deliver parts, systems and components without disruption and at such times to allow us to meet production schedules; (14) prices of raw materials used by us and our suppliers; (15) our ability to successfully and cost-effectively restructure our operations in the U.S. and various other countries and initiate additional cost reduction actions with minimal disruption; (16) the possibility that competitors may independently develop products and services similar to ours, or that our intellectual property rights are not sufficient to prevent competitors from developing or selling those products or services; (17) our ability to manage risks related to security breaches and other disruptions to our information technology systems and networked products, including connected vehicles and in-vehicle systems; (18) our ability to comply with increasingly complex, restrictive and punitive regulations relating to our enterprise data practices, including the collection, use, sharing and security of the Personal Identifiable Information of our customers, employees, or suppliers; (19) our ability to comply with extensive laws, regulations and policies applicable to our operations and products, including those relating to fuel economy and emissions and autonomous vehicles; (20) costs and risks associated with litigation and government investigations; (21) the costs and effect on our reputation of product safety recalls and alleged defects in products and services; (22) any additional tax expense or exposure; (23) our continued ability to develop captive financing capability through GM Financial; and (24) any significant increase in our pension funding requirements. For a further discussion of these and other risks and uncertainties, refer to Part I, Item 1A. Risk Factors.We caution readers not to place undue reliance on forward-looking statements. Forward-looking statements speak only as of the date they are made, and we undertake no obligation to update publicly or otherwise revise any forward-looking statements, whether as a result of new information, future events or other factors, except where we are expressly required to do so by law.* * * * * * *Item 7A. Quantitative and Qualitative Disclosures About Market RiskThe overall financial risk management program is under the responsibility of the Chief Financial Officer with support from the Financial Risk Council, which reviews and, where appropriate, approves strategies to be pursued to mitigate these risks. The Financial Risk Council comprises members of our management and functions under the oversight of the Audit Committee and Finance Committee of the Board of Directors. The Audit Committee and Finance Committee assist and guide the Board of Directors in its oversight of our financial and risk management strategies. A risk management control framework is utilized to monitor the strategies, risks and related hedge positions in accordance with the policies and procedures approved by the Financial Risk Council. Our financial risk management policy is designed to protect against risk arising from extreme adverse market movements on our key exposures. Automotive The following analyses provide quantitative information regarding exposure to foreign currency exchange rate risk, interest rate risk and equity price risk. Sensitivity analysis is used to measure the potential loss in the fair value of financial instruments with exposure to market risk. The models used assume instantaneous, parallel shifts in exchange rates and interest rate yield curves. For options and other instruments with nonlinear returns, models appropriate to these types of instruments are utilized to determine the effect of market shifts. There are certain shortcomings inherent in the sensitivity analyses presented, primarily due to the assumption that interest rates change in a parallel fashion and that spot exchange rates change instantaneously. In addition, the analyses are unable to reflect the complex market reactions that normally would arise from the market shifts modeled and do not contemplate the effects of correlations between foreign currency exposures and offsetting long-short positions in currency or other exposures, such as interest rates, which may significantly reduce the potential loss in value.Foreign Currency Exchange Rate Risk We have foreign currency exposures related to buying, selling and financing in currencies other than the functional currencies of our operations. At December 31, 2020, our most significant foreign currency exposures were between the U.S. Dollar and the Canadian Dollar, Korean Won, Euro, Chinese Yuan, Brazilian Real and Mexican Peso. Derivative instruments such as foreign currency forwards, swaps and options are primarily used to hedge 44Table of ContentsGENERAL MOTORS COMPANY AND SUBSIDIARIESexposures with respect to forecasted revenues, costs and commitments denominated in foreign currencies. Such contracts had remaining maturities of up to 12 months at December 31, 2020. The net fair value liability of financial instruments with exposure to foreign currency risk was $0.9 billion and $1.4 billion at December 31, 2020 and 2019. These amounts are calculated utilizing a population of foreign currency exchange derivatives and foreign currency denominated debt and exclude the offsetting effect of foreign currency cash, cash equivalents and other assets. The potential loss in fair value for such financial instruments from a 10% adverse change in all quoted foreign currency exchange rates would have been $0.1 billion and $0.2 billion at December 31, 2020 and 2019.We are exposed to foreign currency risk due to the translation and remeasurement of the results of certain international operations into U.S. Dollars as part of the consolidation process. We had foreign currency derivatives with notional amounts of $2.2 billion and $5.1 billion at December 31, 2020 and 2019. The fair value of these derivative financial instruments was insignificant. Fluctuations in foreign currency exchange rates can therefore create volatility in the results of operations and may adversely affect our financial condition.The following table summarizes the amounts of automotive foreign currency translation and transaction and remeasurement (gains) losses:Years Ended December 31,20202019Translation losses recorded in Accumulated other comprehensive loss$387 $32 Transaction and remeasurement (gains) losses recorded in earnings$209 $(77)Interest Rate Risk We are subject to market risk from exposure to changes in interest rates related to certain financial instruments, primarily debt, finance lease obligations and certain marketable debt securities. We did not have any interest rate swap positions to manage interest rate exposures in our automotive operations at December 31, 2020 and 2019. The fair value of debt and finance leases was $21.6 billion and $15.9 billion at December 31, 2020 and 2019. The potential increase in fair value resulting from a 10% decrease in quoted interest rates would have been $0.7 billion and $0.6 billion at December 31, 2020 and 2019. We had marketable debt securities of $9.0 billion and $4.2 billion classified as available-for-sale at December 31, 2020 and 2019. The potential decrease in fair value from a 50 basis point increase in interest rates would have had an insignificant effect at December 31, 2020 and 2019.Equity Price Risk We are subject to equity price risk due to market price volatility primarily related to our investment in PSA warrants. The fair value of investments with exposure to equity price risk was $1.2 billion and $1.5 billion at December 31, 2020 and 2019. Our investment in PSA warrants is valued based on a Black-Scholes formula. We estimate that a 10% adverse change in quoted security prices in PSA Group would impact our investment by $0.1 billion at December 31, 2020 and 2019.Automotive Financing - GM FinancialInterest Rate Risk Fluctuations in market interest rates can affect GM Financial's gross interest rate spread, which is the difference between interest earned on finance receivables and interest paid on debt. GM Financial is exposed to interest rate risks as financial assets and liabilities have different characteristics that may impact financial performance. These differences may include tenor, yield, re-pricing timing, and prepayment expectations. Typically retail finance receivables and leases purchased by GM Financial earn fixed interest and commercial finance receivables originated by GM Financial earn variable interest. GM Financial funds its business with variable or fixed rate debt. The variable rate debt is subject to adjustments to reflect prevailing market interest rates. To help mitigate interest rate risk or mismatched funding, GM Financial may employ hedging.Quantitative Disclosure GM Financial measures the sensitivity of its net interest income to changes in interest rates by using interest rate scenarios that assume a hypothetical, instantaneous parallel shift of one hundred basis points in all interest rates across all maturities, as well as a base case that assumes that rates perform at the current market forward curve. However, interest rate changes are rarely instantaneous or parallel and rates could move more or less than the one percentage point assumed in our analysis. Therefore, the actual impact to net interest income could be higher or lower than the results detailed in 45Table of ContentsGENERAL MOTORS COMPANY AND SUBSIDIARIESthe table below. These interest rate scenarios are purely hypothetical and do not represent our view of future interest rate movements. At December 31, 2020, GM Financial was asset-sensitive, meaning that more assets than liabilities were expected to re-price within the next twelve months. During a period of rising interest rates, the interest earned on assets would increase more than the interest paid on liabilities, which would initially increase net interest income. During a period of falling interest rates, net interest income would be expected to initially decrease. At December 31, 2019, GM Financial was liability-sensitive, meaning that more liabilities than assets were expected to re-price within the next twelve months. During a period of rising interest rates, the interest paid on liabilities would increase more than the interest earned on assets, which would initially decrease net interest income. During a period of falling interest rates, net interest income would be expected to initially increase.GM Financial's net interest income sensitivity increased in 2020 as compared to 2019 primarily due to an increased proportion of rate sensitive asset exposure relative to rate sensitive liability exposure. GM Financial's hedging strategies approved by its global asset liability committee are used to manage interest rate risk within policy guidelines. The following table presents GM Financial's net interest income sensitivity to interest rate movement:Years Ended December 31,20202019One hundred basis points instantaneous increase in interest rates$29.7 $(4.6)One hundred basis points instantaneous decrease in interest rates(a)$(29.7)$4.6 __________(a) Net interest income sensitivity given a one hundred basis point decrease in interest rates requires an assumption of negative interest rates in markets where existing interest rates are below one percent.Additional Model Assumptions The sensitivity analysis presented is GM Financial's best estimate of the effect of the hypothetical interest rate scenarios; however, actual results could differ. The estimates are also based on assumptions including the amortization and prepayment of the finance receivable portfolio, originations of finance receivables and leases, refinancing of maturing debt, replacement of maturing derivatives and exercise of options embedded in debt and derivatives. The prepayment projections are based on historical experience. If interest rates or other factors change, actual prepayment experience could be different than projected.Foreign Currency Exchange Rate Risk GM Financial is exposed to foreign currency risk due to the translation and remeasurement of the results of certain international operations into U.S. Dollars as part of the consolidation process. Fluctuations in foreign currency exchange rates can therefore create volatility in the results of operations and may adversely affect GM Financial's financial condition. GM Financial primarily finances its receivables and leased assets with debt in the same currency. When a different currency is used GM Financial may use foreign currency swaps to convert substantially all of its foreign currency debt obligations to the local currency of the receivables and leased assets to minimize any impact to earnings. As a result, GM Financial believes its market risk exposure relating to changes in currency exchange rates at December 31, 2020 was insignificant.GM Financial had foreign currency swaps with notional amounts of $7.6 billion and $6.2 billion at December 31, 2020 and 2019. The net fair value of these derivative financial instruments was an asset of $0.4 billion and an insignificant amount at December 31, 2020 and 2019.The following table summarizes GM Financial's foreign currency translation and transaction and remeasurement (gains) losses:Years Ended December 31,20202019Translation (gains) losses recorded in Accumulated other comprehensive loss$82 $(5)Transaction and remeasurement gains, net recorded in earnings$(6)$(8)* * * * * * *46Table of ContentsREPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM To the Shareholders and the Board of Directors of General Motors CompanyOpinion on the Financial StatementsWe have audited the accompanying consolidated balance sheets of General Motors Company and subsidiaries (the Company) as of December 31, 2020 and 2019, the related consolidated statements of income, comprehensive income, cash flows, and equity for each of the three years in the period ended December 31, 2020, and the related notes (collectively referred to as the “financial statements”). In our opinion, the financial statements present fairly, in all material respects, the financial position of the Company at December 31, 2020 and 2019, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2020, in conformity with U.S. generally accepted accounting principles.We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (PCAOB), the Company's internal control over financial reporting as of December 31, 2020, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework) and our report dated February 10, 2021 expressed an unqualified opinion thereon.Basis for OpinionThese financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on the Company’s financial statements based on our audits. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether due to error or fraud. Our audits included performing procedures to assess the risks of material misstatement of the financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements. We believe that our audits provide a reasonable basis for our opinion.Critical Audit MattersThe critical audit matters communicated below are matters arising from the current period audit of the financial statements that were communicated or required to be communicated to the audit committee and that: (1) relate to accounts or disclosures that are material to the financial statements and (2) involved our especially challenging, subjective or complex judgments. The communication of critical audit matters does not alter in any way our opinion on the financial statements, taken as a whole, and we are not, by communicating the critical audit matters below, providing separate opinions on the critical audit matters or on the accounts or disclosures to which they relate. Product warranty and recall campaignsDescription of the matterAs discussed in Note 12 to the financial statements, the liabilities for product warranty and recall campaigns amount to $8.2 billion at December 31, 2020. The Company accrues for costs related to product warranty at the time of vehicle sale and accrues the estimated cost of recall campaigns when they are probable and estimable, which is generally at the time of sale.Auditing these liabilities involved a high degree of subjectivity in evaluating management’s estimates, due to the size, uncertainties, and potential volatility related to the estimated liabilities. Management’s estimates consider historical claims experience, including the nature, frequency, and average cost of claims of each vehicle line or each model year of the vehicle line, and the key assumptions of historical data being predictive of future activity and events, in particular, the number of historical periods used and the weighing of historical data in the reserve studies.47Table of ContentsHow we addressed the matter in our auditWe evaluated the design and tested the operating effectiveness of internal controls over the Company’s product warranty and recall campaign processes. We tested internal controls over management’s review of the valuation models and significant assumptions for product warranty and recall including the warranty claims forecasted based on the frequency and average cost per warranty claim for product warranty, and the cost estimates related to recall campaigns. Our audit also included the evaluation of controls that address the completeness and accuracy of the data utilized in the valuation models.Our audit procedures related to product warranty and recall campaigns also included, among others, evaluating the Company’s estimation methodology, the related significant assumptions and underlying data, and performing analytical procedures to corroborate cost per vehicle based on historical claims data. Furthermore, we performed sensitivity analyses to evaluate the significant judgments made by management, including cost estimates to evaluate the impact on reserves from changes in assumptions. We performed analysis over the vehicle lines and model years that had little or no claims experience to ensure the vehicle and model substitutions are comparable. We also involved actuarial specialists to evaluate the methodologies and assumptions, and to test the actuarial calculations used by the Company.Sales incentivesDescription of the matterAutomotive sales and revenue represents the amount of consideration to which the Company expects to be entitled in exchange for transferring goods or providing services, which is net of dealer and customer sales incentives the Company expects to pay. As discussed in Note 2 to the financial statements, provisions for dealer and customer incentives are recorded as a reduction to Automotive net sales and revenue at the time of vehicle sale. The liabilities for dealer and customer allowances, claims and discounts amount to $7.3 billion at December 31, 2020. Auditing the estimate of sales incentives involved a high degree of judgment. Significant factors used by the Company in estimating its liability for retail incentives include type of program, forecasted sales volumes, product mix, and the rate of customer acceptance of incentive programs, all of which are estimated based on historical experience and assumptions concerning future customer behavior and market conditions. The Company’s estimation model reflects the best estimate of the total incentive amount that the Company reasonably expects to pay at the time of sale. The estimated cost of incentives is forward-looking, and could be materially affected by future economic and market conditions.How we addressed the matter in our auditWe evaluated the design and tested the operating effectiveness of internal controls over the Company’s sales incentive process, including management’s review of the estimation model, the significant assumptions (e.g., incentive cost per unit, customer take rate, and market conditions), and the data inputs used in the model. Our audit procedures included, among others, the performance of analytical procedures to develop an independent range of the liability for retail incentives as of the balance sheet date. Our independent range was developed for comparison to the Company’s recorded liability, and is based on historical claims, forecasted spend, and the specific vehicle mix of current dealer stock. In addition, we performed sensitivity analyses over the cost per unit assumption developed by management to evaluate the impact on the liability resulting from a change in the assumption. Lastly, we assessed management’s forecasting process by performing quarterly hindsight analyses to assess the adequacy of prior forecasts.Valuation of GM Financial Equipment on Operating LeasesDescription of the matterGM Financial has recorded investments in vehicles leased to retail customers under operating leases. As discussed in Note 2 to the financial statements, at the beginning of the lease, management establishes an expected residual value for each vehicle at the end of the lease term. The Company’s estimated residual value of leased vehicles at the end of lease term was $29.2 billion as of December 31, 2020. 48Table of ContentsAuditing management’s estimate of the residual value of leased vehicles involved a high degree of judgment. Management’s estimate is based, in part, on third-party data which considers inputs including recent auction values and significant assumptions regarding the expected future volume of leased vehicles that will be returned to the Company, used car prices, manufacturer incentive programs and fuel prices. Realization of the residual values is dependent on the future ability to market the vehicles under future prevailing market conditions.How we addressed the matter in our auditWe evaluated the design and tested the operating effectiveness of the Company’s controls over the lease residual estimation process, including controls over management’s review of residual value estimates obtained from the Company’s third-party provider and other significant assumptions. Our procedures also included, among others, independently recalculating depreciation related to equipment on operating leases and performing sensitivity analyses related to significant assumptions. We also performed hindsight analyses to assess the propriety of management’s estimate of residual values, as well as tested the completeness and accuracy of data from underlying systems and data warehouses that are used in the estimation models./s/ ERNST & YOUNG LLPWe have served as the Company's auditor since 2017.Detroit, MichiganFebruary 10, 202149Table of ContentsREPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM To the Shareholders and the Board of Directors of General Motors Company Opinion on Internal Control over Financial ReportingWe have audited General Motors Company and subsidiaries’ internal control over financial reporting as of December 31, 2020, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework) (the COSO criteria). In our opinion, General Motors Company and subsidiaries (the Company) maintained, in all material respects, effective internal control over financial reporting as of December 31, 2020, based on the COSO criteria.We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (PCAOB), the consolidated balance sheets of the Company as of December 31, 2020 and 2019, the related consolidated statements of income, comprehensive income, cash flows and equity for each of the three years in the period ended December 31, 2020, and the related notes and our report dated February 10, 2021 expressed an unqualified opinion thereon.Basis for OpinionThe Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Management’s Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.We conducted our audit in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects.Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.Definition and Limitations of Internal Control Over Financial ReportingA company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate./s/ ERNST & YOUNG LLPDetroit, MichiganFebruary 10, 202150Table of ContentsGENERAL MOTORS COMPANY AND SUBSIDIARIES
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+Item 7. Management's Discussion and Analysis of Financial Condition and Results of OperationsThe following discussion and analysis of our financial condition and results of operations should be read together with our financial statements and related notes included in "Financial Statements and Supplementary Data." Some of the information contained in this discussion and analysis, including information with respect to our plans and strategies for our business, includes forward-looking statements involving significant risks and uncertainties. As a result of many factors, such as those set forth in "Risk Factors," actual results may differ materially from the results described in, or implied by, these forward-looking statements.This section generally discusses 2020 and 2019 items and year-to-year comparisons between 2020 and 2019. Discussion of 2018 items and comparisons between 2019 and 2018 that are not included in this Form 10-K can be found in "Management's Discussion and Analysis of Financial Condition and Results of Operations" in our Form 10-K for the year ended December 31, 2019, and are incorporated by reference herein and considered part of this Form 10-K only to the extent referenced.(Throughout this discussion and analysis, dollars are in millions, excluding ARPU, and shares are in thousands.)COVID-19 PandemicAs discussed in "Our Response to the COVID-19 Pandemic," we have implemented a variety of measures to attempt to minimize its impact on our business, including a restructuring announced in June 2020 to address the sustainability of our U.S. outbound sales and operations, which is further described in Note 13 to our financial statements. While the pandemic did not have a material impact on our 2020 results, the extent to which it may impact our future financial results and operations will depend on future developments. Such developments, which are highly uncertain and cannot be predicted, may include the emergence of new information concerning the severity of the outbreak and the domestic and international actions being taken to contain and treat it. Due to the speed with which the situation continues to evolve, we are currently unable to fully determine the extent of its impact on our business, but the impact could be material to any future period affected either directly or indirectly by this pandemic. We are actively monitoring the pandemic and the potential impacts it may have on our financial position, results of operations and cash flows in the future. See "Risk Factors" for additional information on the risks we may face associated with COVID-19.OverviewWe are the global market leader in domain registration. As of December 31, 2020, approximately 88% of our customers had purchased a domain from us and we had 82.7 million domains under management. Based on information reported in VeriSign's Domain Name Industry Brief, we had over 22% of the world's domains registered as of September 30, 2020.We also offer hosting, presence and business applications products and services (products) enhancing our value proposition by enabling our customers to create, manage and syndicate their, or their customers', digital identities. These products are often purchased in conjunction with, or subsequent to, an initial domain registration. As we have grown, these products have become increasingly important parts of our business, constituting approximately 54% of total revenue in 2020.Financial HighlightsBelow are key financial highlights for 2020, with comparisons to 2019.•Total revenue of $3,316.7 million, an increase of 11.0%, or approximately 11.4% on a constant currency basis(1).•International revenue of $1,105.4 million, an increase of 9.6%, or approximately 10.9% on a constant currency basis(1).•Total bookings(2) of $3,775.5 million, an increase of 11.0%, or approximately 11.6% on a constant currency basis(1).•Net loss of $494.1 million, which includes a $674.7 million charge incurred in connection with the settlement of our obligations under the TRAs, as discussed in Note 16 to our financial statements.•Net cash provided by operating activities of $764.6 million, an increase of 5.7%.(1) Discussion of constant currency is set forth in "Quantitative and Qualitative Disclosures about Market Risk."(2) A reconciliation of total bookings to total revenue, its most directly comparable GAAP financial measure, is set forth in "Reconciliation of Bookings" below.57Table of ContentsOur Financial ModelWe have developed a stable and predictable business model driven by efficient customer acquisition, high customer retention rates and increasing lifetime spend. We grew our total customers from 17.3 million as of December 31, 2017 to 20.6 million as of December 31, 2020, through a combination of our industry leading products built on a single cloud platform, brand advertising, direct marketing efforts, customer referrals, world-class customer care and acquisitions. In each of the five years ended December 31, 2020, our customer retention rate exceeded 85%, and in 2020, our retention rate for customers who had been with us for over three years was more than 93%. We believe the breadth and depth of our product offerings and the high quality and responsiveness of our customer care team build strong relationships with our customers and are key to our high level of customer retention.We generate bookings and revenue from sales of product subscriptions, including domain products, hosting and presence products and business applications products. We offer our subscriptions on a variety of terms, which average approximately one year, but can range from monthly to multi-annual terms of up to ten years depending on the product. We monitor total bookings as we typically collect payment at the time of sale and recognize revenue ratably over the term of our customer contracts. Accordingly, we believe total bookings is an indicator of the expected growth in our revenue and is a supplemental measure of the operating performance of our business. See "Reconciliation of Bookings" below for a reconciliation of total bookings to total revenue.Domains. We generated 46% of our 2020 total revenue from the sale of domain products, primarily from domain registrations and renewals, aftermarket domain sales and domain add-ons such as domain protection. Total revenue from domain products grew at a CAGR of 12.7% over the three years ended December 31, 2020.Hosting and Presence. We generated 36% of our 2020 total revenue from the sale of hosting and presence products, primarily from a variety of website hosting products, website security products and website building products, which generally have higher margins than conventional domain registrations. Total revenue from hosting and presence products grew at a CAGR of 12.3% over the three years ended December 31, 2020.Business Applications. We generated 18% of our 2020 total revenue from the sale of business applications products, primarily from third-party productivity applications, which generally also have higher margins than conventional domain registrations. Total revenue from business applications products grew at a CAGR of 22.5% over the three years ended December 31, 2020.Revenue derived from each of our product categories has increased in each of the last three years, with many of our non-domains products growing faster in recent periods.In each of the five years ended December 31, 2020, greater than 85% of our total revenue, excluding the impact of purchase accounting, was generated by customers who were also customers in the prior year. To track our growth and the stability of our customer base, we monitor, among other things, revenue, retention rates and average revenue per user (ARPU) generated by our annual customer cohorts over time, as well as corresponding marketing and advertising spend. We define an annual customer cohort to include each customer who first became a customer during a calendar year. For example, in 2014, we acquired 2.9 million gross customers, who we collectively refer to as our 2014 cohort, and spent $165 million in marketing and advertising expenses. By the end of 2020, the 2014 cohort had generated an aggregate of $1,472 million of total bookings and we expect this cohort will continue to generate bookings and revenue in the future. For the five years ended December 31, 2020, the average annual bookings retention rate of the 2014 cohort was approximately 94%. To calculate a cohort's bookings retention rate, we compare the number of active customers within a specific cohort as of the end of the current year to the number of customers that were in the cohort in the year of acquisition. Over this period, ARPU, excluding the impact of purchase accounting, for the 2014 cohort grew from $79 in 2015 to $181 in 2020, representing a CAGR of 18%. We selected the 2014 cohort for this analysis because we believe it is representative of the spending patterns and revenue impact of our other cohorts. We believe our cohort analysis is important to illustrate the long-term value of our customers.58Table of ContentsResults of OperationsThe following table sets forth our results of operations for the periods presented and as a percentage of our total revenue for those periods. The period-to-period comparison of financial results is not necessarily indicative of future results.Year Ended December 31,202020192018$% of Total Revenue$% of Total Revenue$% of Total RevenueRevenue: Domains$1,515.1 45.7 %$1,351.6 45.2 %$1,220.3 45.9 %Hosting and presence1,200.6 36.2 %1,126.5 37.7 %1,017.6 38.2 %Business applications601.0 18.1 %510.0 17.1 %422.2 15.9 %Total revenue3,316.7 100.0 %2,988.1 100.0 %2,660.1 100.0 %Costs and operating expenses:Cost of revenue (excluding depreciation and amortization)1,158.6 34.9 %1,026.8 34.3 %893.9 33.6 %Technology and development560.4 16.9 %492.6 16.5 %434.0 16.3 %Marketing and advertising438.5 13.2 %345.6 11.6 %291.4 11.0 %Customer care316.9 9.6 %348.7 11.7 %323.1 12.1 %General and administrative323.8 9.8 %362.1 12.1 %334.0 12.6 %Restructuring charges43.6 1.3 %— — %— — %Depreciation and amortization202.7 6.1 %209.7 7.0 %234.1 8.8 %Total costs and operating expenses3,044.5 91.8 %2,785.5 93.2 %2,510.5 94.4 %Operating income272.2 8.2 %202.6 6.8 %149.6 5.6 %Interest expense(91.3)(2.8)%(92.1)(3.1)%(98.4)(3.7)%Loss on debt extinguishment— — %(14.8)(0.5)%— — %Tax receivable agreements liability adjustment(674.7)(20.3)%8.7 0.3 %14.9 0.6 %Other income (expense), net(1.6)— %22.0 0.7 %6.9 0.3 %Income (loss) before income taxes(495.4)(14.9)%126.4 4.2 %73.0 2.8 %Benefit for income taxes1.3 — %12.0 0.4 %9.0 0.3 %Net income (loss)(494.1)(14.9)%138.4 4.6 %82.0 3.1 %Less: net income attributable to non-controlling interests1.0 — %1.4 — %4.9 0.2 %Net income (loss) attributable to GoDaddy Inc.$(495.1)(14.9)%$137.0 4.6 %$77.1 2.9 %Operating MetricsIn addition to our results determined in accordance with GAAP, we believe the following operating metrics are useful as supplements in evaluating our ongoing operational performance and help provide an enhanced understanding of our business:Year Ended December 31, 202020192018Total bookings$3,775.5 $3,401.2 $3,011.5 Total customers at period end (in thousands)20,646 19,274 18,518 Average revenue per user$166 $158 $148 59Table of ContentsTotal bookings. Total bookings represents cash receipts from the sale of products to customers in a given period adjusted for products where we recognize revenue on a net basis and without giving effect to certain adjustments, primarily net refunds granted in the period. Total bookings provides valuable insight into the sales of our products and the performance of our business since we typically collect payment at the time of sale and recognize revenue ratably over the term of our customer contracts. We report total bookings without giving effect to refunds granted in the period because refunds often occur in periods different from the period of sale for reasons unrelated to the marketing efforts leading to the initial sale. Accordingly, by excluding net refunds, we believe total bookings reflects the effectiveness of our sales efforts in a given period.Total customers. We define a customer as an individual or entity, as of the end of a period, having an account with one or more paid product subscriptions. A single user may be counted as a customer more than once if they maintain paid subscriptions in multiple accounts. Total customers is one way we measure the scale of our business and is an important part of our ability to increase our revenue base.Average revenue per user. We calculate ARPU as total revenue during the preceding 12 month period divided by the average of the number of total customers at the beginning and end of the period. ARPU provides insight into our ability to sell additional products to customers, though the impact to date has been muted due to our continued growth in total customers.Reconciliation of BookingsThe following table reconciles total bookings to total revenue, its most directly comparable GAAP financial measure:Year Ended December 31, 202020192018Total revenue $3,316.7 $2,988.1 $2,660.1 Change in deferred revenue(1)210.5 180.5 163.2 Net refunds 247.3 233.4 192.6 Other 1.0 (0.8)(4.4)Total bookings $3,775.5 $3,401.2 $3,011.5 _________________________________(1) Change in deferred revenue also includes the impact of realized gains or losses from the hedging of bookings in foreign currencies.Comparison of 2020 and 2019 RevenueWe generate substantially all of our revenue from sales of subscriptions, including domain registrations and renewals, hosting and presence products and business applications products. Our subscription terms average one year, but can range from monthly terms to multi-annual terms of up to ten years depending on the product. We generally collect the full amount of subscription fees at the time of sale, while revenue is recognized over the period in which the performance obligations are satisfied, which is generally over the contract term. Revenue is presented net of refunds, and we maintain a reserve to provide for refunds granted to customers.Domains revenue primarily consists of revenue from the sale of domain registration subscriptions, aftermarket domain sales and domain add-ons such as domain protection. Domain registrations provide a customer with the exclusive use of a domain during the applicable contract term. After the contract term expires, unless renewed, the customer can no longer access the domain.Hosting and presence revenue primarily consists of revenue from the sale of subscriptions for website hosting, website security and website building products.Business applications revenue primarily consists of revenue from the sale of subscriptions for third-party productivity applications, email accounts, email marketing tools and telephony solutions.60Table of ContentsThe following table presents our revenue for the periods indicated:Year Ended December 31,2020 to 20192019 to 2018202020192018$ change% change$ change% changeDomains$1,515.1 $1,351.6 $1,220.3 $163.5 12 %$131.3 11 %Hosting and presence1,200.6 1,126.5 1,017.6 74.1 7 %108.9 11 %Business applications601.0 510.0 422.2 91.0 18 %87.8 21 %Total revenue$3,316.7 $2,988.1 $2,660.1 $328.6 11 %$328.0 12 %The 11.0% increase in total revenue was driven by the 7.1% growth in total customers, the 5.1% growth in ARPU as well as incremental revenue from acquisitions completed in 2020. The increase in customers impacted each of our revenue lines, as the additional customers purchased subscriptions across our product portfolio. These increases were partially offset by the impact of adverse movements in foreign currency exchange rates.Domains. The 12.1% increase in domains revenue was primarily driven by the increase in domains under management from 79.6 million as of December 31, 2019 to 82.7 million as of December 31, 2020, incremental revenue from acquisitions completed in 2020 and increased aftermarket domain sales and international growth. Domains under management in 2020 was impacted by: (i) approximately 0.8 million domains added from an acquisition and (ii) the expiration of approximately 1.0 million .uk domains for which we provided free initial registration to the owners of the associated third-level domains (e.g. .co.uk) following the 2017 launch of the .uk ccTLD.Hosting and presence. The 6.6% increase in hosting and presence revenue was primarily driven by increased demand for our website building and website security products, partially offset by the adverse impact of lower demand for certain higher-priced subscriptions, such as GoDaddy Social, as a result of the economic disruption resulting from the COVID-19 pandemic.Business applications. The 17.8% increase in business applications revenue was primarily driven by increased customer adoption of our productivity solutions as well as an increase in customers purchasing higher product tiers.BookingsThe following table presents our total bookings for the periods indicated: Year Ended December 31,2020 to 20192019 to 2018 202020192018$ change% change$ change% changeTotal bookings(1)$3,775.5 $3,401.2 $3,011.5 $374.3 11 %$389.7 13 %_________________________________(1) A reconciliation of total bookings to total revenue, its most directly comparable GAAP financial measure, is set forth in "Reconciliation of Bookings" above.The 11.0% increase in total bookings was primarily driven by increases in total customers and domains under management, increased aftermarket domain sales, broadened customer adoption of non-domain products and acquisitions completed in 2020, partially offset by the negative impact the economic disruption resulting from the COVID-19 pandemic had on subscriptions for certain of our higher-priced services as well as the adverse impact of movements in foreign currency exchange rates.61Table of ContentsCosts and Operating ExpensesCost of revenueCosts of revenue are the direct costs incurred in connection with selling an incremental product to our customers. Substantially all cost of revenue relates to domain registration fees, payment processing fees, third-party commissions and licensing fees for third-party productivity applications. Similar to our billing practices, we pay domain costs at the time of purchase for the life of each subscription, but recognize the costs of service ratably over the term of our customer contracts. The terms of registry pricing are established by agreements between registries and registrars, and can vary significantly depending on the top-level domain. We expect cost of revenue to increase in absolute dollars in future periods related to the expansion of our domains business, higher sales of third-party productivity applications and growth in our customer base. However, cost of revenue may fluctuate as a percentage of total revenue, depending on the mix of products sold in a particular period. Subsequent to our acquisition of the registry operations of Neustar in August 2020, we no longer incur domain registration fees on purchases of former Neustar TLDs. Year Ended December 31,2020 to 20192019 to 2018 202020192018$ change% change$ change% changeCost of revenue $1,158.6 $1,026.8 $893.9 $131.8 13 %$132.9 15 %The 12.8% increase in cost of revenue was primarily attributable to higher domain costs driven by increases in domains under management and aftermarket domain sales, increased software licensing fees resulting from higher sales of productivity solutions and increased payment processing fees resulting from our bookings growth.Technology and developmentTechnology and development expenses represent the costs associated with the creation, development and distribution of our products and websites. These expenses primarily consist of personnel costs associated with the design, development, deployment, testing, operation and enhancement of our products, as well as costs associated with the data centers and systems infrastructure supporting those products, excluding depreciation expense. We expect technology and development expense to increase in absolute dollars as we continue to invest in product development and migrate our infrastructure to a cloud-based third-party provider. Technology and development expenses may fluctuate as a percentage of total revenue depending on our level of investment in additional personnel and the pace of our infrastructure transition. Year Ended December 31,2020 to 20192019 to 2018 202020192018$ change% change$ change% changeTechnology and development $560.4 $492.6 $434.0 $67.8 14 %$58.6 14 %As discussed in our 2019 Form 10-K, we recorded a $7.2 million reduction in equity-based compensation expense in 2019 to correct an error related to the accounting for certain PSUs in prior periods. Excluding this correction, technology and development expenses increased 12.1%, primarily as a result of increased personnel costs driven by higher average headcount associated with our continued investment in product development and increased technology costs associated with the growth of our business and our migration to a cloud-based infrastructure.Marketing and advertisingMarketing and advertising expenses represent the costs associated with attracting and acquiring customers, primarily consisting of fees paid to third parties for marketing and advertising campaigns across a variety of channels. These expenses also include personnel costs and affiliate program commissions. We expect marketing and advertising expenses to fluctuate depending on both the mix of internal and external marketing resources used, the size and scope of our future campaigns and the level of discretionary investments we make in marketing to drive future sales. Year Ended December 31,2020 to 20192019 to 2018 202020192018$ change% change$ change% changeMarketing and advertising $438.5 $345.6 $291.4 $92.9 27 %$54.2 19 %62Table of ContentsThe 26.9% increase in marketing and advertising expenses was primarily attributable to increased discretionary spending and personnel costs associated with additional marketing investments we made in 2020 to capture increased demand for certain of our products during the COVID-19 pandemic.Customer careCustomer care expenses represent the costs to guide and service our customers, primarily consisting of personnel costs. We expect customer care expenses to fluctuate depending on the level of personnel required to support our business. Year Ended December 31,2020 to 20192019 to 2018 202020192018$ change% change$ change% changeCustomer care $316.9 $348.7 $323.1 $(31.8)(9)%$25.6 8 %The 9.1% decrease in customer care expenses was primarily due to the headcount reductions related to the restructuring plan implemented during the second quarter of 2020, as further discussed below, in conjunction with operating efficiencies gained as we scale our business and increase our use of alternative methods of customer interaction. We expect these expenses to remain lower in the short-term as a result of the headcount reductions associated with the restructuring.General and administrativeGeneral and administrative expenses primarily consist of personnel costs for our administrative functions, professional service fees, office rent for all locations, all employee travel expenses, acquisition-related expenses and other general costs. We expect general and administrative expenses to fluctuate depending on the level of personnel and other administrative costs required to support our business as well as the significance of any strategic acquisitions we choose to pursue. Year Ended December 31,2020 to 20192019 to 2018 202020192018$ change% change$ change% changeGeneral and administrative $323.8 $362.1 $334.0 $(38.3)(11)%$28.1 8 %General and administrative, adjusted for certain items described below$333.8 $350.1 $334.0 $(16.3)(5)%$16.1 5 %The following items are included in general and administrative expenses in the periods indicated:•As discussed in Note 12 to our financial statements, we recorded an $18.1 million legal settlement accrual in 2019. During 2020, we reduced the settlement accrual by an aggregate of $10.0 million.•As discussed in our 2019 Form 10-K, we recorded a $6.1 million reduction in equity-based compensation expense in 2019 to correct an error related to the accounting for certain PSUs in prior periods.Excluding the items described above, the 4.7% decrease in general and administrative expenses was primarily driven by lower travel and other general costs, partially offset by an increase in acquisition-related expenses.Restructuring chargesThe $43.6 million in restructuring charges in 2020 were incurred pursuant to a restructuring plan implemented in June 2020, as further discussed in Note 13 to our financial statements. We implemented the restructuring to address the sustainability of our U.S. outbound sales and operations, which faced challenges with respect to soft customer demand for certain higher-priced, do-it-for-you services such as GoDaddy Social. These challenges were exacerbated by the economic disruption resulting from the COVID-19 pandemic.Restructuring charges included: (i) $14.6 million in severance and related benefits to be paid to, or on behalf of, the approximately 470 employees who were involuntarily terminated and the approximately 110 employees who voluntarily did not accept alternate roles with us, as well as professional fees incurred in connection with the restructuring; (ii) a $27.9 million impairment of operating lease assets associated with the closure of our leased offices in Austin, Texas; and (iii) $1.1 million of accelerated depreciation and operating lease assets amortization related to the office closures. We do not expect to incur any significant additional charges related to this restructuring.63Table of ContentsDepreciation and amortizationDepreciation and amortization expenses consist of charges relating to the depreciation of the property and equipment used in our operations and the amortization of acquired intangible assets. These expenses may increase or decrease in absolute dollars in future periods depending on our future level of capital investments in hardware and other equipment as well as the significance of any future acquisitions. Year Ended December 31,2020 to 20192019 to 2018 202020192018$ change% change$ change% changeDepreciation and amortization $202.7 $209.7 $234.1 $(7.0)(3)%$(24.4)(10)%The 3.3% decrease in depreciation and amortization expenses resulted from assets that became fully depreciated, partially offset by the impact of increased amortization expense related to acquisitions completed in 2020.Interest expense Year Ended December 31,2020 to 20192019 to 2018 202020192018$ change% change$ change% changeInterest expense $91.3 $92.1 $98.4 $(0.8)(1)%$(6.3)(6)%The 0.9% decrease in interest expense was driven by more favorable effective interest rates on our variable rate borrowings, partially offset by the issuance of additional long-term debt in August 2020.Loss on debt extinguishmentIn 2019, we recognized a loss on debt extinguishment of $14.8 million, primarily related to the $600.0 million partial prepayment of term loan borrowings with the proceeds of the issuance of the Senior Notes. See Note 9 to our financial statements for additional discussion.Tax receivable agreements liability adjustmentIn 2020, we recorded a $674.7 million charge as a result of the settlement of our obligations under the TRAs, as further described below and in Note 16 to our financial statements.Liquidity and Capital ResourcesOverviewOur principal sources of liquidity have been cash flow generated from operations, long-term debt borrowings and stock option exercises. Our principal uses of cash have been to fund operations, acquisitions and capital expenditures, as well as to make mandatory principal and interest payments on our long-term debt and to repurchase shares of our Class A common stock.In general, we seek to deploy our capital in a prioritized manner focusing first on requirements for our operations, then on growth investments, and finally on equity holder returns. Our strategy is to deploy capital from any potential source, whether debt, equity or internally generated cash, depending on the adequacy and availability of the source of capital and which source may be used most efficiently and at the lowest cost at such time. Therefore, while cash from operations is our primary source of operating liquidity and we believe our internally-generated cash flows are sufficient to support our day-to-day operations, we may use a variety of capital sources to fund our needs for less predictable investment decisions such as strategic acquisitions and share repurchases.We have incurred significant long-term debt to fund acquisitions and the settlement of the TRAs (as further discussed below) as well as for our working capital needs, and as a result, we are limited as to how we conduct our business and may be unable to raise additional debt or equity financing to compete effectively or to take advantage of new business opportunities, strategic acquisitions or share repurchases. However, the restrictions under our long-term debt agreements are subject to a number of qualifications and may be amended with the consent of the lenders and the holders of the Senior Notes, as applicable.64Table of ContentsWe believe our existing cash and cash equivalents and cash generated by operating activities will be sufficient to meet our anticipated operating cash needs for at least the next 12 months. However, our future capital requirements will depend on many factors, including our growth rate, macroeconomic activity, the length and severity of business disruptions associated with the COVID-19 pandemic, the timing and extent of spending to support domestic and international development efforts, continued brand development and advertising spend, the level of customer care and general and administrative activities, the introduction of new and enhanced product offerings, the costs to support new and replacement capital equipment, the completion of strategic acquisitions or share repurchases and other factors. Some of the factors that may influence our operations are not within our control, such as general economic conditions and the length and severity of the ongoing COVID-19 pandemic. Although there is uncertainty related to the potential impact of COVID-19 on our future results, we believe our business model and the strength of our balance sheet have well positioned us to manage our business through this crisis. However, we will continue to monitor our liquidity position. Should we pursue additional strategic acquisitions or share repurchases, we may need to raise additional capital, which may be in the form of long-term debt or equity financings.Credit Facility and Senior NotesOur long-term debt obligations consist of the Credit Facility and the Senior Notes. In August 2020, we increased our borrowings under the Credit Facility through the issuance of an additional $750.0 million in term loans, which were used to partially fund the payments associated with the settlement of our obligations under the TRAs, as discussed below. See Note 9 to our financial statements for additional information regarding our long-term debt.Our long-term debt agreements contain covenants restricting, among other things, our ability, or the ability of our subsidiaries, to incur indebtedness, issue certain types of equity, incur liens, enter into fundamental changes including mergers and consolidations, sell assets, make restricted payments including dividends, distributions and investments, prepay junior indebtedness and engage in operations other than in connection with acting as a holding company, subject to customary exceptions. As of December 31, 2020, we were in compliance with all such covenants and had no amounts drawn on our revolving credit loan. We currently have no reason to believe we will be unable to satisfy these covenants; however, the economic disruption resulting from the COVID-19 pandemic has made it more difficult to forecast our future results.As further discussed in Note 10 to our financial statements, we have hedged a portion of our long-term debt through the use of cross-currency and interest rate swap derivative instruments. These instruments help us manage and mitigate our risk of exposure to changes in foreign currency exchange rates and interest rates. See "Quantitative and Qualitative Disclosures About Market Risk" for additional discussion of our hedging activities.Tax Receivable AgreementsAs discussed in Note 16 to our financial statements, we entered into settlement and release agreements with respect to four of the TRAs and an amendment to the fifth TRA, pursuant to which settled all of our obligations under the TRAs in exchange for aggregate payments totaling $850.0 million, of which $849.8 million was paid during 2020. Upon payment, we were released from all obligations to the parties to the TRAs, including the holders of unexchanged LLC Units. The settlement payments were funded with a combination of cash and the proceeds from the issuance of the new term loans discussed above.By entering into the TRA Settlement Agreements, we were able to achieve an attractive return by settling our obligations under the TRAs at a significant discount to the approximately $1.8 billion in estimated payments we would have potentially otherwise made under these agreements, assuming we are able to fully utilize the relevant acquired tax benefits.Share Repurchase ProgramsOur Board has authorized a $500.0 million share repurchase program, as described in Note 5 to our financial statements. During 2019 and 2020, we repurchased a total of 7,125 and 9,986 shares of our Class A common stock in the open market, respectively, pursuant to our previous share repurchase programs, for an aggregate purchase price of $458.6 million and $541.7 million, respectively, including commissions. As of December 31, 2020, we have $500.0 million remaining available under our current share repurchase program.65Table of ContentsAcquisitionsSee Note 3 to our financial statements for a discussion of cash payments made in connection with acquisitions completed in 2020.In February 2021, we acquired Poynt Co. for $329.2 million in cash paid at closing and an additional $45.0 million in deferred cash payments subject to certain performance and employment conditions over the three years subsequent to the closing date. Poynt offers a suite of products allowing small businesses to sell and accept payments anywhere, including point-of-sale systems, payments, invoicing and transaction management.RestructuringAs discussed in Note 13 to our financial statements, we implemented a restructuring plan in June 2020 to address the sustainability of our U.S. outbound sales and operations. Cash payments of $14.4 million related to the restructuring were made during 2020, and no material amounts remain as of December 31, 2020.Cash FlowsThe following table summarizes our cash flows for the periods indicated: Year Ended December 31, 202020192018Net cash provided by operating activities$764.6 $723.4 $559.8 Net cash used in investing activities(482.3)(135.3)(254.8)Net cash provided by (used in) financing activities(581.7)(456.9)47.0 Effect of exchange rate changes on cash and cash equivalents1.8 (0.8)(2.3)Net increase (decrease) in cash and cash equivalents$(297.6)$130.4 $349.7 Operating ActivitiesOur primary source of cash from operating activities has been cash collections from our customers. We expect cash inflows from operating activities to be primarily affected by increases in total bookings. Our primary uses of cash from operating activities have been for domain registration costs paid to registries, licensing fees related to third-party productivity solutions, personnel costs, discretionary marketing and advertising costs, technology and development costs and interest payments. We expect cash outflows from operating activities to be affected by the timing of payments we make to registries and increases in personnel and other operating costs as we continue to grow our business and increase our international presence.Net cash provided by operating activities increased $41.2 million from $723.4 million in 2019 to $764.6 million in 2020, primarily driven by our bookings growth.Investing ActivitiesOur investing activities primarily consist of strategic acquisitions and purchases of property and equipment to support the overall growth of our business. We expect our investing cash flows to be affected by the timing of payments we make for capital expenditures and the strategic acquisition or other growth opportunities we decide to pursue.Net cash used in investing activities increased $347.0 million from $135.3 million in 2019 to $482.3 million in 2020, primarily due to a $384.4 million increase in spending for business acquisitions, partially offset by a $21.1 million decrease in capital expenditures and a $27.9 million increase in net inflows from short-term investments.Financing ActivitiesOur financing activities primarily consist of long-term debt borrowings, the repayment of principal on long-term debt, stock option exercises and share repurchases.66Table of ContentsNet cash used in financing activities increased $124.8 million from $456.9 million in 2019 to $581.7 million in 2020, primarily due to $849.8 million in TRA settlement payments in 2020 and an $83.1 million increase in share repurchases, partially offset by the receipt of $746.3 million in net proceeds from the issuance of new term loans and a $54.3 million decrease in acquisition contingent consideration payments.Deferred RevenueSee Note 7 to our financial statements for details regarding the expected future recognition of deferred revenue.Contractual ObligationsThe following table summarizes our material contractual obligations and commitments as of December 31, 2020:Total PaymentsPayments due by period1 year2-3 years4-5 years5+ yearsLong-term debt, including current maturities(1)$3,153.6 $32.5 $65.0 $1,747.5 $1,308.6 Interest on long-term debt(2)455.1 86.0 169.9 105.8 93.4 Operating leases(3)253.6 50.8 63.2 50.2 89.4 Service agreements(4)208.2 83.3 112.5 12.3 0.1 Total material contractual obligations$4,070.5 $252.6 $410.6 $1,915.8 $1,491.5 _________________________________(1) See Note 9 to our financial statements for information regarding the terms of our long-term debt agreements.(2) Interest on long-term debt excludes both the amortization of deferred debt issuance costs and original issue discount and the expected benefits associated with our interest rate swap arrangements. Interest on our variable rate debt is calculated using the rate in effect at December 31, 2020.(3) See Note 11 to our financial statements for information regarding our operating lease commitments. The amounts include the imputed interest component of our operating lease liabilities.(4) See Note 12 to our financial statements for information regarding our service agreement commitments.Off-Balance Sheet ArrangementsAs of December 31, 2020 and 2019, we had no off-balance sheet arrangements that had, or which are reasonably likely to have, a material effect on our financial statements.Critical Accounting Policies and EstimatesWe prepare our financial statements in accordance with GAAP, and in doing so, we make estimates, assumptions and judgments affecting the reported amounts of assets, liabilities, revenues and expenses, as well as the related disclosure of contingent assets and liabilities. We base our estimates, assumptions and judgments on historical experience and on various other factors we believe to be reasonable under the circumstances, and we evaluate these estimates, assumptions and judgments on an ongoing basis. Different assumptions and judgments would change the estimates used in the preparation of our financial statements, which, in turn, could change our results from those reported. We refer to estimates, assumptions and judgments of this type as our critical accounting policies and estimates, which we discuss further below. We review our critical accounting policies and estimates with the audit and finance committee of our board of directors on an annual basis.See Note 2 to our financial statements for a summary of our significant accounting policies.Revenue RecognitionWe recognize revenue when control of the promised products is transferred to a customer, in an amount reflecting the consideration we expect to be entitled to in exchange for those products. Payments received in advance of our performance are recorded as deferred revenue. Revenue is recognized net of allowances for returns and transaction-based taxes collected.We generally sell our products with a right of return, which we account for as variable consideration when estimating the amount of revenue to recognize. Refunds are estimated at contract inception using the expected value method based on historical refund experience and updated each reporting period as additional information becomes available. Our annual refund rate has ranged from 6.4% to 6.9% of total bookings from 2018 to 2020.67Table of ContentsWe may sell multiple products to customers at the same time. For example, we may design a customer website and separately offer other products such as hosting and a SSL certificate, or a customer may combine a domain registration with other products such as Websites + Marketing or email. Judgment may be required in determining whether products are considered distinct performance obligations that should be accounted for separately or as one combined performance obligation. The majority of our revenue arrangements consist of multiple performance obligations, with revenue recognized over the period in which each performance obligation is satisfied, which is generally over the contract term.For arrangements with multiple performance obligations, we allocate revenue to each distinct performance obligation based on its relative stand-alone selling price (SSP). Our process for determining SSP requires judgment and considers multiple factors that may vary over time depending upon the unique facts and circumstances related to each performance obligation. We determine SSP based on prices charged to customers for individual products, taking into consideration other factors, which may include (i) historical and expected discounting practices; (ii) the size, volume and term length of transactions; (iii) customer demographics; (iv) the geographic areas in which our products are sold; and (v) our overall go-to-market strategy.We sell our products directly to customers and also through a network of resellers. In certain cases, we act as a reseller of products provided by others. The determination of gross or net revenue recognition is reviewed on a product-by-product basis and is dependent on whether we act as principal or agent in the transaction.See Notes 2 and 7 to our financial statements for additional information regarding revenue recognition and deferred revenue.Business CombinationsWe include the results of operations of acquired businesses in our financial statements as of the respective dates of acquisition. Accounting for business combinations requires us to make significant estimates and assumptions, especially at the acquisition date, with respect to tangible and intangible assets acquired, liabilities assumed and pre-acquisition contingencies. The purchase price, including estimates of the fair value of contingent consideration when applicable, is allocated to the tangible and intangible assets acquired and the liabilities assumed based on their estimated fair values on the respective acquisition dates, with the excess recorded as goodwill. Critical estimates used in valuing certain acquired intangible assets include, but are not limited to, future expected cash flows (primarily from customer relationships and developed technology) and discount rates.Contingent consideration liabilities, which relate to future earn-out payments associated with our acquisitions, are generally valued using discounted cash flow valuation methods. Critical estimates used in valuing these liabilities include estimated operating results scenarios for the applicable performance periods, probability weightings assigned to operating results scenarios and discount rates.We use our best estimates and assumptions to determine acquisition-date fair values. These estimates are inherently uncertain and subject to refinement. We continue to collect information and reevaluate our preliminary estimates and assumptions and record any qualifying measurement period adjustments to goodwill. Contingent consideration is adjusted to fair value in subsequent periods as an increase or decrease in general and administrative expenses.See Notes 2 and 3 to our financial statements for additional information regarding business combinations.Goodwill and Indefinite-Lived Intangible AssetsWe make estimates, assumptions and judgments when valuing goodwill and other intangible assets in connection with the initial purchase price allocations of business combinations, as well as when evaluating the recoverability of our goodwill and other intangible assets on an ongoing basis. We assess our goodwill and indefinite-lived intangible assets for impairment at least annually during the fourth quarter. We will also perform an assessment at other times if and when events or changes in circumstances indicate the carrying value of these assets may not be recoverable.We perform our impairment assessment based on qualitative analysis, which includes considering various factors including macroeconomic conditions, industry and market conditions and our historical and projected operating results. If, based on our qualitative analysis, we were to determine it is more-likely-than-not the fair value of our single reporting unit is less than its carrying amount, we would record an impairment loss for the amount equal to such excess. 68Table of ContentsOur qualitative analyses during 2020, 2019 and 2018 did not indicate any impairment. As of December 31, 2020, we believe such assets are recoverable; however, there can be no assurances these assets will not be impaired in future periods. Any future impairment charges could adversely impact our results of operations.See Notes 2 and 4 to our financial statements for additional information regarding goodwill and indefinite-lived intangible assets.Income TaxesWe are subject to U.S. federal, state and foreign income taxes with respect to our allocable share of any taxable income or loss of Desert Newco, as well as any stand-alone income or loss we generate. Significant judgment is required in determining our provision or benefit for income taxes and in evaluating uncertain tax positions.We account for income taxes under the asset and liability method, which requires the recognition of DTAs and DTLs for the expected future tax consequences of events included in our financial statements. Under this method, we determine DTAs and DTLs on the basis of the differences between the financial statement and tax bases of assets and liabilities by using enacted tax rates in effect for the year in which the differences are expected to reverse. The effect of a change in tax rates on DTAs and DTLs is recognized in income in the period in which the enactment date occurs.We recognize DTAs to the extent we believe these assets are more-likely-than-not to be realized. In making such a determination, we consider all available positive and negative evidence, including future reversals of existing taxable temporary differences, projected future taxable income, tax planning strategies and recent results of operations.We recognize tax benefits from uncertain tax positions only if it is more-likely-than-not the tax position will be sustained on examination by the taxing authorities based on the technical merits of the position. The tax benefits recognized from such positions are measured based on the largest benefit having a greater than 50% likelihood of being realized.See Notes 2 and 15 to our financial statements for additional information regarding income taxes and the considerations that could lead to a release of substantially all of the valuation allowance against our DTAs.Indirect TaxesWe are subject to indirect taxation in some, but not all, of the various states and foreign jurisdictions in which we and our subsidiaries conduct business. Laws and regulations attempting to subject communications and commerce conducted over the Internet to various indirect taxes are becoming more prevalent, both in the U.S. and internationally, and may impose additional burdens on us in the future. Increased regulation could negatively affect our business directly, as well as the businesses of our customers. Taxing authorities may impose indirect taxes on the Internet-related revenue we generate based on regulations currently being applied to similar, but not directly comparable, industries. There are many transactions and calculations where the ultimate indirect tax determination is uncertain. In addition, domestic and international indirect taxation laws, or interpretations thereof, are subject to change.The calculation of our reserve for indirect taxes involves significant management estimates and is based on an ongoing analysis of our business activities, revenues subject to indirect taxes and applicable regulations. Although we believe our indirect tax estimates and associated liabilities are reasonable, the final determination of indirect tax audits, litigation or settlements could be materially different than the amounts established for indirect tax contingencies.See Note 12 to our financial statements for additional information regarding indirect taxes.Loss ContingenciesWe are subject to the possibility of various loss contingencies arising from uncertain and unresolved matters in the ordinary course of business and from events or actions by others having the potential to result in a future loss. Such contingencies may include, but are not limited to, intellectual property claims, putative class actions, commercial and consumer protection claims, labor and employment claims, breach of contract claims, regulatory proceedings, product service level commitments and losses resulting from other events and developments. We consider the likelihood of loss, the impairment of an asset or the incurrence of a liability, as well as our ability to reasonably estimate the amount of loss, in determining loss contingencies.69Table of ContentsWhen a loss is considered probable and reasonably estimable, we record a liability in the amount of our best estimate for the ultimate loss. When there appears to be a range of possible costs with equal likelihood, a liability is recorded based on the low-end of such range. However, the likelihood of a loss with respect to a particular contingency is often difficult to predict and determining a meaningful estimate of the loss or a range of loss may not be practicable based on the information available and the potential effect of future events and decisions by third parties impacting the ultimate resolution of the contingency. It is also not uncommon for such matters to be resolved over many years, during which time relevant developments and new information must be continuously evaluated to determine both the likelihood of potential loss and whether it is possible to reasonably estimate a range of possible loss. When a loss is probable but a reasonable estimate cannot be made, disclosure is provided. Disclosure is also provided when it is reasonably possible a loss will be incurred or when it is reasonably possible the amount of a loss will exceed the recorded amounts.We regularly review all contingencies to determine whether the likelihood of loss has changed and to assess whether a reasonable estimate of the loss or range of loss can be made. Development of a meaningful estimate of loss, or a range of potential loss, is complex when the outcome is directly dependent on negotiations with, or decisions by, third parties such as regulatory agencies, court systems in various jurisdictions and other interested parties. Such factors bear directly on whether it is possible to reasonably estimate a range of potential loss and boundaries of high and low estimates. Until the final resolution of such matters, there may be an exposure to loss in excess of the amounts recorded, and such amounts could be material. Should any of our estimates and assumptions change or prove to have been incorrect, it could have a material impact on our business, operating results or financial condition.See Note 12 to our financial statements for additional information regarding loss contingencies.Recent Accounting PronouncementsFor information regarding recent accounting pronouncements, see Note 2 to our financial statements.Item 7A. Quantitative and Qualitative Disclosures About Market RiskWe are exposed to market risk in the ordinary course of business. Market risk represents the risk of loss that may impact our financial position due to adverse changes in financial market prices and rates. Our market risk exposure is primarily a result of fluctuations in foreign currency exchange rates and variable interest rates. Consequently, we may employ policies and procedures to mitigate such risks, including the use of derivative financial instruments, which are discussed in more detail in Note 10 to our financial statements. We do not enter into derivative transactions for speculative or trading purposes.As a result of the use of derivative instruments, we are exposed to the risk that counterparties to our contracts may fail to meet their contractual obligations. To mitigate such counterparty credit risk, we enter into contracts only with carefully selected financial institutions based upon ongoing evaluations of their creditworthiness. As a result, we do not believe we are exposed to any undue concentration of counterparty risk with respect to our derivative contracts as of December 31, 2020.The uncertainty related to the economic impact of the global COVID-19 pandemic has introduced significant volatility in the financial markets. We are actively monitoring this situation and its potential impacts on our business.Foreign Currency RiskWe manage our exposure to changes in foreign currency exchange rates through the use of foreign exchange forward contracts and cross-currency swap contracts. See Note 10 to our financial statements for a summary of the notional amounts and fair values of such arrangements. The effect of a hypothetical 10% change in foreign currency exchange rates applicable to our business would not have had a material impact on our cash and cash equivalents.Foreign Exchange Forward ContractsA portion of our bookings, revenue and operating expenses is denominated in foreign currencies, which are subject to exchange rate fluctuations. Our most significant foreign currency exposures are the Euro, the British pound, the Indian Rupee and the Canadian dollar. Our reported bookings, revenues and operating results may be impacted by fluctuations in foreign currency exchange rates. Fluctuations in exchange rates may also cause us to recognize transaction gains and losses in our statements of operations; however, to date, such amounts have not been material. As our international operations continue to grow, our exposure to fluctuations in exchange rates will increase, which may increase the costs associated with this growth. During 2020, our total bookings growth in constant currency would have been approximately 60 basis points higher and our total revenue 70Table of Contentsgrowth would have been approximately 40 basis points higher. Constant currency is calculated by translating bookings and revenue for each month in the current period using the foreign currency exchange rate for the corresponding month in the prior period, excluding any hedging gains or losses realized during the period.From time-to-time, we may utilize foreign exchange forward contracts to manage the volatility of our bookings and revenue related to foreign currency transactions. These forward contracts reduce, but do not eliminate, the impact of adverse currency exchange rate fluctuations. We generally designate these forward contracts as cash flow hedges for accounting purposes. Changes in the intrinsic value of designated hedges are recorded as a component of accumulated other comprehensive income (loss) (AOCI). Gains and losses, once realized, are recorded as a component of AOCI and are amortized to revenue over the same period in which the underlying hedged amounts are recognized. At December 31, 2020, the realized and unrealized losses included in AOCI related to designated hedges were $2.0 million and $15.7 million, respectively.Cross-Currency Swap ContractIn order to manage variability due to movements in foreign currency exchange rates related to a Euro-denominated intercompany loan, we entered into a five-year cross-currency swap in April 2017. The cross-currency swap, which matures on April 3, 2022, had a notional amount of €1,196.7 million at December 31, 2020 and converts the fixed rate Euro-denominated interest and principal receipts on the intercompany loan into fixed U.S. dollar interest and principal receipts. The cross-currency swap, which is designated as a cash flow hedge and recognized as an asset or liability at fair value, effectively creates a fixed-rate U.S. dollar intercompany loan from a fixed rate Euro-denominated intercompany loan, thereby reducing our exposure to fluctuations between the Euro and U.S. dollar. Changes to the fair value of the cross-currency swap due to changes in the value of the U.S. dollar relative to the Euro would be largely offset by the net change in the fair values of the underlying hedged items.Interest Rate RiskInterest rate risk reflects our exposure to movements in interest rates associated with our variable-rate debt. See Note 9 to our financial statements for additional information regarding our long-term debt.Total borrowings under our 2024 Term Loans were $1,807.4 million as of December 31, 2020. These borrowings bear interest at a rate equal to, at our option, either (a) LIBOR plus 1.75% per annum or (b) 0.75% per annum plus the highest of (i) the Federal Funds Rate plus 0.5%, (ii) the Prime Rate or (iii) one-month LIBOR plus 1.0%.Total borrowings under our 2027 Term Loans were $746.2 million as of December 31, 2020. These borrowings bear interest at a rate equal to, at our option, either (a) LIBOR plus 2.50% per annum or (b) 1.5% per annum plus the highest of (i) the Federal Funds Rate plus 0.5%, (ii) the Prime Rate or (iii) one-month LIBOR plus 1.0% .All LIBOR-based interest rates under the Credit Facility are subject to a 0.0% floor on LIBOR.In April 2017, we entered into a five-year pay-fixed rate, receive-floating rate interest rate swap arrangement to effectively convert a portion of the variable rate borrowings under the 2024 Term Loans to a fixed rate of 5.44%. This interest rate swap, the notional amount of which was $1,275.8 million at December 31, 2020, matures on April 3, 2022.In August 2020, in conjunction with the issuance of the 2027 Term Loans, we entered into seven-year pay-fixed rate, receive-floating rate interest rate swap arrangements to effectively convert the variable one-month LIBOR interest rate on the 2027 Term Loans borrowings to a fixed rate of 0.705%. These interest rate swaps, which mature on August 10, 2027, had an aggregate notional amount of $746.2 million at December 31, 2020.The objective of our interest rate swaps, all of which are designated as cash flow hedges, is to manage the variability of cash flows in the interest payments related to the portion of variable-rate debt designated as being hedged.For the balance of our long-term debt not subject to interest rate swaps, the effect of a hypothetical 10% change in interest rates would not have had a material impact on our interest expense.71Table of Contents
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+ITEM 7. Management’s Discussion and Analysis of Financial Condition and Results of OperationsThe information set forth in this Item 7 is intended to provide readers with an understanding of our financial condition, changes in financial condition and results of operations. We will discuss and provide our analysis in the following order: •COVID-19 Update•2020 Transaction Overview•Dividends•Results of Operations•Liquidity and Capital Resources•Contractual Obligations•Off-Balance Sheet Arrangements•Inflation•Non-GAAP Financial Measure Reconciliations•Critical Accounting Policies•Recent Accounting PronouncementsCOVID-19 UpdateBeginning in late 2019, a novel strain of Coronavirus (“COVID-19”) began to spread throughout the world, including the United States, ultimately being declared a pandemic by the World Health Organization. Global health concerns and increased efforts to reduce the spread of the COVID-19 pandemic have prompted federal, state, and local governments to restrict normal daily activities, and have resulted in travel bans, quarantines, school closings, “shelter-in-place” orders requiring individuals to remain in their homes other than to conduct essential services or activities, as well as business limitations and shutdowns, which resulted in closure of many businesses deemed to be non-essential. Although some of these restrictions have since been lifted or scaled back, certain restrictions remain in place and any future surges of COVID-19 may lead to other restrictions being re-implemented in response to efforts to reduce the spread. In addition, our tenants, operators and borrowers are facing significant cost increases as a result of increased health and safety measures, including increased staffing demands for patient care and sanitation, as well as increased usage and inventory of critical medical supplies and personal protective equipment. These health and safety measures, which may remain in place for a significant amount of time or be re-imposed from time to time, continue to place a substantial strain on the business operations of many of our tenants, operators, and borrowers.Senior HousingWithin our SHOP and CCRC properties, occupancy rates have declined since the onset of the pandemic, a trend that may continue during the pandemic and for some period thereafter as a result of a reduction in, or in some cases prohibitions on, new tenant move-ins due to stricter move-in criteria, lower inquiry volumes, and reduced in-person tours, as well as incidences of COVID-19 outbreaks at our facilities or the perception that outbreaks may occur. Outbreaks, which directly affect our residents and the employees at our senior housing facilities, have and could continue to materially and adversely disrupt operations, as well as cause significant reputational harm to us, our operators, and our tenants. As of February 8, 2021, we had current confirmed resident COVID-19 cases at 85 of our 95 senior housing properties, since the beginning of the pandemic. Our senior housing property operators are also experiencing significant cost increases as a result of higher staffing hours and compensation, the implementation of increased health and safety measures and protocols, and increased usage and inventory of critical medical supplies and personal protective equipment. At our SHOP and CCRC facilities, we bear these significant cost increases.42Table of ContentsWe and/or our operators temporarily suspended redevelopment across our senior housing portfolio due to “shelter-in-place” orders and local, state, and federal directives, except for certain life safety and essential projects. Although some of these projects have been allowed to restart with infection control protocols in place, future local, state, or federal orders could cause us to re-suspend the work. Other projects remain suspended and we do not know when we will be able to restart construction. In locations where construction continues, construction workers are following applicable guidelines, including appropriate social distancing, limitations on large group gatherings in close proximity, and increased sanitation efforts, which has slowed the pace of construction. These protective actions do not, however, eliminate the risk that outbreaks caused or spread by such activities may occur and impact our tenants, operators and residents. In addition, our planned dispositions may not occur within the expected time or at all because of buyer terminations or withdrawals related to the pandemic, capital constraints, inability to tour properties, or other factors relating to the pandemic.The ultimate impact of the pandemic on senior housing generally and the public perception of senior housing as a desirable residential setting depend on a number of factors that are unknown at this time, including, but not limited to: (i) the course and severity of the pandemic; (ii) responses of public and private health authorities; and (iii) the timing, distribution, and health effects of vaccines and other treatments.Medical Office PortfolioWithin our medical office portfolio, many physician practices and affiliated hospitals initially delayed or discontinued nonessential surgeries and procedures due to “shelter-in-place” orders and other health and safety measures, which negatively impacted their cash flows during part of 2020. These restrictions have now been lifted in the majority of our markets and operations are at or near pre-pandemic levels. However, we expect that planned move-outs will be delayed during the COVID-19 pandemic, which is expected to slightly increase short-term retention in this portfolio.We implemented a deferred rent program during the second and third quarters of 2020 that was limited to certain non-health system and non-hospital tenants in good standing, which reduced our cash collections during those months, although we required that the deferred rent be repaid ratably by the end of 2020. Under this program, we agreed to defer approximately $6 million of rent through December 31, 2020, substantially all of which had been collected as of December 31, 2020. We may also implement a deferred rent program for future periods. Life Science PortfolioWithin our life science portfolio, we have numerous tenants that are working tirelessly to address critical research and testing needs in the fight against COVID-19. We are focused on providing our tenants with the necessary space to complete their critical work and are in continuous contact with our tenants regarding how we can help them meet their needs. Through December 31, 2020, we had provided approximately $1 million of rent deferrals to our life science tenants, all of which was required to be repaid by the end of 2020. As of December 31, 2020, all of the deferred rent had been collected.However, within our life science portfolio, we may experience a decline in leasing activity at certain points during the COVID-19 pandemic. As a result of governmental restrictions on business activities in the greater San Francisco and Boston areas, we temporarily suspended development, redevelopment, and tenant improvement projects at many of our life science properties, resulting in delayed deliveries and project completions. Though we have been able to continue or re-start these projects, we remain subject to future governmental restrictions that may again suspend these projects. Even when these projects continue, we have been experiencing losses in efficiency as a result of the implementation of health and safety protocols related to social distancing and proper hygiene and sanitization.LiquidityWe believe that we are well positioned to manage the short-term and long-term impacts of the COVID-19 pandemic and the measures to slow its spread while working closely with our tenants, operators, and borrowers as they navigate the pandemic. We had approximately $2.51 billion of liquidity available, including $2.26 billion borrowing capacity under our bank line of credit facility and $259 million of cash and cash equivalents, as of February 8, 2021. While a future downgrade in our credit ratings would adversely impact our cost of borrowing, we believe we continue to have access to the unsecured debt markets. We could also seek to enter into one or more secured debt financings, issue additional securities, including under our 2020 ATM Program (as defined below), or dispose of certain additional assets to fund future operating costs, capital expenditures, or acquisitions, although no assurances can be made in this regard. 43Table of ContentsFuture Rent CollectionsThe impact of COVID-19 on the ability of our tenants to pay rent in the future is currently unknown. We have, and will continue to monitor the credit quality of each of our tenants and write-off straight-line rent and accounts receivable, as necessary. In the event we conclude that substantially all of a tenant’s straight-line rent or accounts receivable is not probable of collection in the future, such amounts will be written off, which could have a material impact on our future results of operations.Employee UpdateWe have taken, and will continue to take, proactive measures to provide for the well-being of our workforce. We have maximized our systems infrastructure as well as virtual and remote working technologies for our employees, including our executive team, to ensure productivity and connectivity internally, as well as with key third-party relationships. The extent of the impact of the COVID-19 pandemic on our business and financial results will depend on future developments, including the duration, severity, and spread of COVID-19, health and safety actions taken to contain its spread, any new surges of COVID-19, the severity of outbreak of new strains of COVID-19, the timing and distribution of vaccines and other treatments, and how quickly and to what extent normal economic and operating conditions can resume within the markets in which we operate, each of which are highly uncertain at this time and outside of our control.2020 Transaction OverviewSouth San Francisco Land Site Acquisition In October 2020, we executed a definitive agreement to acquire approximately 12 acres of land for $128 million. The acquisition site is located in South San Francisco, CA, adjacent to two sites currently held by us as land for future development. We made a $10 million nonrefundable deposit upon completing due diligence in November 2020 and expect to close the transaction in 2021.Cambridge Discovery Park AcquisitionIn December 2020, we acquired three life science facilities in Cambridge, Massachusetts for $610 million and a 49% unconsolidated joint venture interest in a fourth property on the same campus for $54 million. Midwest MOB AcquisitionIn October 2020, we acquired a portfolio of seven MOBs located in Indiana, Missouri, and Illinois, for $169 million.Scottsdale Gateway AcquisitionIn July 2020, we acquired one MOB in Scottsdale, Arizona, for $27 million. The Post AcquisitionIn April 2020, we acquired a life science campus in Waltham, Massachusetts for $320 million. Master Transaction and Cooperation Agreement with BrookdaleIn January 2020, Healthpeak and Brookdale Senior Living Inc. (“Brookdale”) completed certain of the transactions governed by the previously announced Master Transactions and Cooperation Agreement (the “2019 MTCA”), which includes a series of transactions related to the previously jointly owned 15-campus CCRC portfolio (the “CCRC JV”) and the portfolio of senior housing properties that were triple-net leased to Brookdale. Specifically, the following transactions were completed on January 31, 2020:•We acquired Brookdale’s 51% interest in 13 of the 15 communities in the CCRC JV based on a valuation of $1.06 billion (the “CCRC Acquisition”) and transitioned management (under new management agreements) of those 13 communities to Life Care Services LLC (“LCS”);•We paid Brookdale $100 million to terminate the previous management agreements related to those 13 communities;•Brookdale acquired 18 of the triple-net lease properties (the “Brookdale Acquisition Assets”) from us for cash proceeds of $385 million;•The remaining 24 triple-net lease properties, which were subsequently sold in January 2021 (see Senior Housing Portfolio Sales below), were restructured into a single master lease with 2.4% annual rent escalators and a maturity date of December 31, 2027 (the “2019 Amended Master Lease”);•A portion of annual rent (amount in excess of 6.5% of sales proceeds) related to 14 of the 18 Brookdale Acquisition Assets was reallocated to the remaining properties under the 2019 Amended Master Lease; and44Table of Contents•Brookdale paid down $20 million of future rent under the 2019 Amended Master Lease.Senior Housing Portfolio Sales•In December 2020, we sold a portfolio of ten senior housing triple-net assets for $358 million.•In November 2020, we entered into definitive agreements to sell a portfolio of 13 SHOP assets for $334 million. We sold 12 of the assets for $312 million in December 2020 and provided the buyer with financing of $61 million on four of the assets sold. We expect to sell the final asset during the first half of 2021, upon completion of the license transfer process.•In October 2020, we entered into a definitive agreement to sell seven SHOP assets for $115 million. We received a $3 million nonrefundable deposit and expect to close the transaction during the first half of 2021.•In November 2020, we entered into a definitive agreement to sell 32 SHOP and 2 senior housing triple-net assets for $744 million. We received a $35 million nonrefundable deposit upon completion of due diligence in December 2020, sold the 32 SHOP assets in January 2021 for $664 million, and provided the buyer with financing of $410 million. The two senior housing triple-net assets are expected to sell during the first half of 2021, upon completion of the license transfer process.•In January 2021, we sold 24 senior housing assets under a triple-net lease with Brookdale for $510 million.•In January 2021, we sold a portfolio of 16 SHOP assets for $230 million and provided the buyer with financing of $150 million.•In February 2021, we sold eight senior housing assets in a triple-net lease with Harbor Retirement Associates for $132 million.Other Real Estate Transactions•In addition to the sales discussed above, during the year ended December 31, 2020, we sold the following: (i) 23 SHOP assets for $190 million, (ii) 21 senior housing triple-net assets for $428 million (inclusive of the 18 facilities sold to Brookdale under the 2019 MTCA), (iii) 11 MOBs for $136 million (inclusive of the exercise of a purchase option by one of our tenants to acquire 3 MOBs), (iv) two MOB land parcels for $3 million, and 1 asset from other non-reportable segments for $1 million.•In February 2020, we sold a hospital under a DFL for $82 million.•In December 2020, we acquired one hospital in Dallas, Texas for $34 million.•During the year ended December 31, 2020, we converted: (i) 13 senior housing triple-net assets with Capital Senior Living Corporation (“CSL”) to a RIDEA structure, with CSL remaining as the manager, (ii) 1 senior housing triple-net asset with CSL to a RIDEA structure with Discovery Senior Living, LLC as the operator, (iii) 2 senior housing triple-net assets with HRA Senior Living (“HRA”) to a RIDEA structure, with HRA remaining as the manager, and (iv) 1 senior housing triple-net asset with Brookdale to a RIDEA structure.Financing Activities•During the year ended December 31, 2020, we utilized the forward provisions under the at-the-market equity offering program established in February 2019 (the “2019 ATM Program”) to allow for the sale of up to an aggregate of 2.0 million shares of our common stock at an initial weighted average net price of $35.23 per share, after commissions.•During the year ended December 31, 2020, we settled all 32.5 million shares previously outstanding under (i) ATM forward contracts and (ii) a 2019 forward equity sales agreement at a weighted average net price of $32.73 per share, after commissions, resulting in net proceeds of $1.06 billion.•In June 2020, we completed a public offering of $600 million aggregate principal amount of 2.88% senior unsecured notes due in 2031 (the “2031 Notes”).•In June 2020, using a portion of the net proceeds from the 2031 Notes offering, we repurchased $250 million aggregate principal amount of our 4.25% senior unsecured notes due in 2023.•In July 2020, using an additional portion of the net proceeds from the 2031 Notes offering, we redeemed all $300 million aggregate principal amount of our 3.15% senior unsecured notes due in 2022.•During the first quarter of 2021, we repurchased $112 million aggregate principal amount of our 4.25% senior unsecured notes due in 2023, $201 million aggregate principal amount of our 4.20% senior unsecured notes due in 2024, and $469 million aggregate principal amount of our 3.88% senior unsecured notes due in 2024.45Table of ContentsDevelopment Activities •As part of the development program with HCA Healthcare Inc., at December 31, 2020, we had four MOB developments, all of which are on-campus, under contract with an aggregate total estimated cost of $117 million.•At December 31, 2020, we had five life science development projects in process with an aggregate total estimated cost of $855 million.DividendsQuarterly cash dividends paid during 2020 aggregated to $1.48 per share. On February 9, 2021, our Board of Directors declared a quarterly cash dividend of $0.30 per common share. The dividend will be paid on March 5, 2021 to stockholders of record as of the close of business on February 22, 2021.Results of OperationsWe evaluate our business and allocate resources among our reportable business segments: (i) life science, (ii) medical office, and (iii) CCRC. Under the life science and medical office segments, we invest through the acquisition and development of life science facilities, MOBs, and hospitals, which generally require a greater level of property management. Our CCRCs are operated through RIDEA structures. We have other non-reportable segments that are comprised primarily of interests in an unconsolidated senior housing joint venture and debt investments. We evaluate performance based upon property adjusted net operating income (“Adjusted NOI” or “Cash NOI”) in each segment. The accounting policies of the segments are the same as those described in the summary of significant accounting policies (see Note 2 to the Consolidated Financial Statements).In conjunction with classifying our senior housing triple-net and SHOP portfolios as discontinued operations as of December 31, 2020, the results of operations related to those portfolios are no longer presented in reportable business segments. Accordingly, results of operations of those portfolios are not included in the reportable business segment analysis below. Refer to Note 5 to the Consolidated Financial Statements for further information regarding discontinued operations.Non-GAAP Financial MeasuresNet Operating IncomeNOI and Adjusted NOI are non-U.S. generally accepted accounting principles (“GAAP”) supplemental financial measures used to evaluate the operating performance of real estate. NOI is defined as real estate revenues (inclusive of rental and related revenues, resident fees and services, income from direct financing leases, and government grant income and exclusive of interest income), less property level operating expenses (which exclude transition costs); NOI excludes all other financial statement amounts included in net income (loss) as presented in Note 16 to the Consolidated Financial Statements. Adjusted NOI is calculated as NOI after eliminating the effects of straight-line rents, DFL non-cash interest, amortization of market lease intangibles, termination fees, actuarial reserves for insurance claims that have been incurred but not reported, and the impact of deferred community fee income and expense. NOI and Adjusted NOI include our share of income (loss) generated by unconsolidated joint ventures and exclude noncontrolling interests’ share of income (loss) generated by consolidated joint ventures. Adjusted NOI is oftentimes referred to as “Cash NOI.” Management believes NOI and Adjusted NOI are important supplemental measures because they provide relevant and useful information by reflecting only income and operating expense items that are incurred at the property level and present them on an unlevered basis. We use NOI and Adjusted NOI to make decisions about resource allocations, to assess and compare property level performance, and to evaluate our Same-Store (“SS”) performance, as described below. We believe that net income (loss) is the most directly comparable GAAP measure to NOI and Adjusted NOI. NOI and Adjusted NOI should not be viewed as alternative measures of operating performance to net income (loss) as defined by GAAP since they do not reflect various excluded items. Further, our definitions of NOI and Adjusted NOI may not be comparable to the definitions used by other REITs or real estate companies, as they may use different methodologies for calculating NOI and Adjusted NOI. For a reconciliation of NOI and Adjusted NOI to net income (loss) by segment, refer to Note 16 to the Consolidated Financial Statements.Operating expenses generally relate to leased medical office and life science properties, as well as SHOP and CCRC facilities. We generally recover all or a portion of our leased medical office and life science property expenses through tenant recoveries. We present expenses as operating or general and administrative based on the underlying nature of the expense. 46Table of ContentsSame-StoreSame-Store NOI and Adjusted (Cash) NOI information allows us to evaluate the performance of our property portfolio under a consistent population by eliminating changes in the composition of our consolidated portfolio of properties. Same-Store Adjusted NOI excludes amortization of deferred revenue from tenant-funded improvements and certain non-property specific operating expenses that are allocated to each operating segment on a consolidated basis. Properties are included in Same-Store once they are stabilized for the full period in both comparison periods. Newly acquired operating assets are generally considered stabilized at the earlier of lease-up (typically when the tenant(s) control(s) the physical use of at least 80% of the space) or 12 months from the acquisition date. Newly completed developments and redevelopments are considered stabilized at the earlier of lease-up or 24 months from the date the property is placed in service. Properties that experience a change in reporting structure, such as a conversion from a triple-net lease to a RIDEA reporting structure, are considered stabilized after 12 months in operations under a consistent reporting structure. A property is removed from Same-Store when it is classified as held for sale, sold, placed into redevelopment, experiences a casualty event that significantly impacts operations, a change in reporting structure or operator transition has been agreed to, or a significant tenant relocates from a Same-Store property to a non Same-Store property and that change results in a corresponding increase in revenue. We do not report Same-Store metrics for our other non-reportable segments.For a reconciliation of Same-Store to total portfolio Adjusted NOI and other relevant disclosures by segment, refer to our Segment Analysis below.Funds From Operations ("FFO")FFO encompasses NAREIT FFO and FFO as Adjusted, each of which is described in detail below. We believe FFO applicable to common shares, diluted FFO applicable to common shares, and diluted FFO per common share are important supplemental non-GAAP measures of operating performance for a REIT. Because the historical cost accounting convention used for real estate assets utilizes straight-line depreciation (except on land), such accounting presentation implies that the value of real estate assets diminishes predictably over time. Since real estate values instead have historically risen and fallen with market conditions, presentations of operating results for a REIT that use historical cost accounting for depreciation could be less informative. The term FFO was designed by the REIT industry to address this issue. NAREIT FFO. FFO, as defined by the National Association of Real Estate Investment Trusts (“NAREIT”), is net income (loss) applicable to common shares (computed in accordance with GAAP), excluding gains or losses from sales of depreciable property, including any current and deferred taxes directly associated with sales of depreciable property, impairments of, or related to, depreciable real estate, plus real estate and other real estate-related depreciation and amortization, and adjustments to compute our share of NAREIT FFO and FFO as Adjusted (see below) from joint ventures. Adjustments for joint ventures are calculated to reflect our pro-rata share of both our consolidated and unconsolidated joint ventures. We reflect our share of NAREIT FFO for unconsolidated joint ventures by applying our actual ownership percentage for the period to the applicable reconciling items on an entity by entity basis. For consolidated joint ventures in which we do not own 100%, we reflect our share of the equity by adjusting our NAREIT FFO to remove the third party ownership share of the applicable reconciling items based on actual ownership percentage for the applicable periods. Our pro-rata share information is prepared on a basis consistent with the comparable consolidated amounts, is intended to reflect our proportionate economic interest in the operating results of properties in our portfolio and is calculated by applying our actual ownership percentage for the period. We do not control the unconsolidated joint ventures, and the pro-rata presentations of reconciling items included in NAREIT FFO do not represent our legal claim to such items. The joint venture members or partners are entitled to profit or loss allocations and distributions of cash flows according to the joint venture agreements, which provide for such allocations generally according to their invested capital. The presentation of pro-rata information has limitations, which include, but are not limited to, the following: (i) the amounts shown on the individual line items were derived by applying our overall economic ownership interest percentage determined when applying the equity method of accounting and do not necessarily represent our legal claim to the assets and liabilities, or the revenues and expenses and (ii) other companies in our industry may calculate their pro-rata interest differently, limiting the usefulness as a comparative measure. Because of these limitations, the pro-rata financial information should not be considered independently or as a substitute for our financial statements as reported under GAAP. We compensate for these limitations by relying primarily on our GAAP financial statements, using the pro-rata financial information as a supplement. NAREIT FFO does not represent cash generated from operating activities in accordance with GAAP, is not necessarily indicative of cash available to fund cash needs and should not be considered an alternative to net income (loss). We compute NAREIT FFO in accordance with the current NAREIT definition; however, other REITs may report NAREIT FFO differently or have a different interpretation of the current NAREIT definition from ours. 47Table of ContentsFFO as Adjusted. In addition, we present NAREIT FFO on an adjusted basis before the impact of non-comparable items including, but not limited to, transaction-related items, impairments (recoveries) of non-depreciable assets, losses (gains) from the sale of non-depreciable assets, restructuring and severance related charges, prepayment costs (benefits) associated with early retirement or payment of debt, litigation costs (recoveries), casualty-related charges (recoveries), foreign currency remeasurement losses (gains), deferred tax asset valuation allowances, and changes in tax legislation (“FFO as Adjusted”). Transaction-related items include transaction expenses and gains/charges incurred as a result of mergers and acquisitions and lease amendment or termination activities. Prepayment costs (benefits) associated with early retirement of debt include the write-off of unamortized deferred financing fees, or additional costs, expenses, discounts, make-whole payments, penalties or premiums incurred as a result of early retirement or payment of debt. Management believes that FFO as Adjusted provides a meaningful supplemental measurement of our FFO run-rate and is frequently used by analysts, investors, and other interested parties in the evaluation of our performance as a REIT. At the same time that NAREIT created and defined its FFO measure for the REIT industry, it also recognized that “management of each of its member companies has the responsibility and authority to publish financial information that it regards as useful to the financial community.” We believe stockholders, potential investors, and financial analysts who review our operating performance are best served by an FFO run-rate earnings measure that includes certain other adjustments to net income (loss), in addition to adjustments made to arrive at the NAREIT defined measure of FFO. FFO as Adjusted is used by management in analyzing our business and the performance of our properties and we believe it is important that stockholders, potential investors, and financial analysts understand this measure used by management. We use FFO as Adjusted to: (i) evaluate our performance in comparison with expected results and results of previous periods, relative to resource allocation decisions, (ii) evaluate the performance of our management, (iii) budget and forecast future results to assist in the allocation of resources, (iv) assess our performance as compared with similar real estate companies and the industry in general, and (v) evaluate how a specific potential investment will impact our future results. Other REITs or real estate companies may use different methodologies for calculating an adjusted FFO measure, and accordingly, our FFO as Adjusted may not be comparable to those reported by other REITs. For a reconciliation of net income (loss) to NAREIT FFO and FFO as Adjusted and other relevant disclosure, refer to “Non-GAAP Financial Measures Reconciliations” below.Adjusted FFO (“AFFO”)AFFO is defined as FFO as Adjusted after excluding the impact of the following: (i) amortization of deferred compensation expense, (ii) amortization of deferred financing costs, net, (iii) straight-line rents, (iv) deferred income taxes, (v) amortization of acquired market lease intangibles, net, (vi) non-cash interest related to DFLs and lease incentive amortization (reduction of straight-line rents), (vii) actuarial reserves for insurance claims that have been incurred but not reported, and (viii) deferred revenues, excluding amounts amortized into rental income that are associated with tenant funded improvements owned/recognized by us and up-front cash payments made by tenants to reduce their contractual rents. Also, AFFO: (i) is computed after deducting recurring capital expenditures, including second generation leasing costs and second generation tenant and capital improvements and (ii) includes lease restructure payments and adjustments to compute our share of AFFO from our unconsolidated joint ventures. Certain prior period amounts in the “Non-GAAP Financial Measures Reconciliation” below for AFFO have been reclassified to conform to the current period presentation. More specifically, recurring capital expenditures, including second generation leasing costs and second generation tenant and capital improvements ("AFFO capital expenditures") excludes our share from unconsolidated joint ventures (reported in “other AFFO adjustments”). Adjustments for joint ventures are calculated to reflect our pro-rata share of both our consolidated and unconsolidated joint ventures. We reflect our share of AFFO for unconsolidated joint ventures by applying our actual ownership percentage for the period to the applicable reconciling items on an entity by entity basis. We reflect our share for consolidated joint ventures in which we do not own 100% of the equity by adjusting our AFFO to remove the third party ownership share of the applicable reconciling items based on actual ownership percentage for the applicable periods (reported in “other AFFO adjustments”). See FFO for further disclosure regarding our use of pro-rata share information and its limitations. Other REITs or real estate companies may use different methodologies for calculating AFFO, and accordingly, our AFFO may not be comparable to those reported by other REITs. Although our AFFO computation may not be comparable to that of other REITs, management believes AFFO provides a meaningful supplemental measure of our performance and is frequently used by analysts, investors, and other interested parties in the evaluation of our performance as a REIT. We believe AFFO is an alternative run-rate earnings measure that improves the understanding of our operating results among investors and makes comparisons with: (i) expected results, (ii) results of previous periods, and (iii) results among REITs more meaningful. AFFO does not represent cash generated from operating activities determined in accordance with GAAP and is not necessarily indicative of cash available to fund cash needs as it excludes the following items which generally flow through our cash flows from operating activities: (i) adjustments for changes in working capital or the actual timing of the payment of income or expense items that are accrued in the period, (ii) transaction-related costs, (iii) litigation settlement expenses, (iv) severance-related expenses, and (v) actual cash receipts from interest income recognized on loans receivable (in contrast to our AFFO adjustment to exclude non-cash interest and depreciation related to our investments in direct financing leases). Furthermore, AFFO is adjusted for recurring capital expenditures, which are generally not considered when determining cash flows from operations or liquidity. AFFO is a non-GAAP supplemental financial measure and should not be considered as an alternative to net income (loss) determined in 48Table of Contentsaccordance with GAAP. For a reconciliation of net income (loss) to AFFO and other relevant disclosure, refer to “Non-GAAP Financial Measures Reconciliations” below.Comparison of the Year Ended December 31, 2020 to the Year Ended December 31, 2019 and the Year Ended December 31, 2019 to the Year Ended December 31, 2018Overview(1)2020 and 2019The following table summarizes results for the years ended December 31, 2020 and 2019 (dollars in thousands):Year Ended December 31,20202019ChangeNet income (loss) applicable to common shares $411,147 $43,987 $367,160 NAREIT FFO693,367 780,307 (86,940)FFO as Adjusted874,188 864,352 9,836 AFFO772,705 745,820 26,885 _______________________________________(1)For the reconciliation of non-GAAP financial measures, see “Non-GAAP Financial Measure Reconciliations” below.Net income (loss) applicable to common shares (“net income (loss)”) increased primarily as a result of the following:•an increase in other income, net as a result of: (i) a gain upon change of control related to the acquisition of the outstanding equity interests in 13 CCRCs from Brookdale during the first quarter of 2020, (ii) a gain on sale related to the sale of a hospital underlying a DFL during the first quarter of 2020, and (iii) government grant income received under the Coronavirus Aid, Relief and Economic Security Act (“CARES Act”) during 2020;•an increase in net gain on sales of real estate during 2020;•an increase in interest income, primarily as a result of new loans and additional funding of existing loans;•a decrease in loss on debt extinguishments;•an increase in income tax benefit as a result of (i) the above-mentioned acquisition of Brookdale’s interest in 13 CCRCs and related management termination fee expense paid to Brookdale in connection with transitioning management to LCS during the first quarter of 2020 and (ii) the extension of the net operating loss carryback provided by the CARES Act, partially offset by additional income tax expense due to a deferred tax asset valuation allowance; and•NOI generated from: (i) 2019 and 2020 acquisitions of real estate, (ii) development and redevelopment projects placed in service during 2019 and 2020, and (iii) new leasing activity in 2019 and 2020 (including the impact to straight-line rents).The increase in net income (loss) was partially offset by:•a reduction in income related to assets sold during 2019 and 2020;•additional expense due to the management termination fee paid to Brookdale in connection with transitioning management of 13 CCRCs to LCS during the first quarter of 2020;•additional expenses and decreased occupancy in our SHOP and CCRC assets related to COVID-19;•a reduction in equity income (loss) from unconsolidated joint ventures during 2020 primarily due to our share of net losses from an unconsolidated joint venture owning 19 senior housing assets that was formed in December 2019;•increased depreciation and amortization expense as a result of: (i) assets acquired during 2019 and 2020, (ii) the acquisition of Brookdale’s interest in and consolidation of 13 CCRCs during the first quarter of 2020, and (iii) development and redevelopment projects placed into service during 2019 and 2020, partially offset by dispositions of real estate throughout 2019 and 2020; and•increased credit losses related to loans receivable as a result of: (i) adopting the current expected credit losses model required under Accounting Standards Update (“ASU”) No. 2016-13, Measurement of Credit Losses on Financial Instruments (“ASU 2016-13”), (ii) new loans funded during 2020, and (iii) the impact of COVID-19 on expected credit losses.49Table of ContentsNAREIT FFO decreased primarily as a result of the aforementioned events impacting net income (loss), except for the following, which are excluded from NAREIT FFO: •net gain on sales of depreciable real estate; •the gain upon change of control related to the acquisition of Brookdale’s interest in 13 CCRCs; and•depreciation and amortization expense.FFO as Adjusted increased primarily as a result of the aforementioned events impacting NAREIT FFO, except for the following, which are excluded from FFO as Adjusted:•deferred tax asset valuation allowance;•net gain on sales of assets underlying DFLs and non-depreciable assets, such as land;•losses on debt extinguishment; and•the increase in credit losses.AFFO increased primarily as a result of the aforementioned events impacting FFO as Adjusted, except for the impact of straight-line rents and the increase in deferred tax benefit, which are excluded from AFFO.2019 and 2018The following table summarizes results for the years ended December 31, 2019 and 2018 (dollars in thousands):Year Ended December 31,20192018ChangeNet income (loss) applicable to common shares $43,987 $1,058,424 $(1,014,437)NAREIT FFO780,307 780,189 118 FFO as Adjusted864,352 857,233 7,119 AFFO745,820 746,397 (577)Net income (loss) applicable to common shares (“net income (loss)”) decreased primarily as a result of the following:•a reduction in NOI as a result of asset sales during 2018 and 2019;•a larger net gain on sales of real estate during 2018 compared to 2019, primarily related to the sale of our Shoreline Technology Center life science campus in November 2018;•increased depreciation and amortization expense as a result of: (i) assets acquired during 2018 and 2019, (ii) development and redevelopment projects placed into service during 2018 and 2019, and (iii) the conversion of 14 senior housing triple-net assets from a DFL to a RIDEA structure in 2019, partially offset by decreased depreciation and amortization from asset sales during 2018 and 2019; •an increase in loss on debt extinguishments, resulting from redemptions and repurchases of senior unsecured notes in 2019; and•increased impairment charges on real estate assets recognized during 2019 compared to 2018.The decrease in net income (loss) was partially offset by:•increased NOI from: (i) annual rent escalations, (ii) 2018 and 2019 acquisitions, and (iii) development and redevelopment projects placed in service during 2018 and 2019;•a reduction in interest expense as a result of debt repayments during 2018 and 2019; and•an increase in other income, primarily resulting from: (i) a gain upon change of control of 19 SHOP assets in 2019, and (ii) a loss on consolidation of seven care homes in the U.K. during the first quarter of 2018, partially offset by a gain upon change of control related to the acquisition of the outstanding equity interests in three life science joint ventures in November 2018.50Table of ContentsNAREIT FFO increased primarily as a result of the aforementioned events impacting net income (loss), except for the following, which are excluded from NAREIT FFO: •gains on sales of real estate, including related tax impacts;•depreciation and amortization expense; •impairments charges on real estate assets; and•gains and losses upon change of control.FFO as Adjusted increased primarily as a result of the aforementioned events impacting NAREIT FFO, except for losses on debt extinguishment, which are excluded from FFO as Adjusted.AFFO decreased primarily as a result of the aforementioned events impacting FFO as Adjusted, except for the impact of straight-line rents, which is excluded from AFFO. The decrease in AFFO was also partially due to increased AFFO capital expenditures during 2019.Segment AnalysisThe following tables provide selected operating information for our Same-Store and total property portfolio for each of our reportable segments. For the year ended December 31, 2020, our Same-Store consists of 341 properties representing properties acquired or placed in service and stabilized on or prior to January 1, 2019 and that remained in operations under a consistent reporting structure through December 31, 2020. For the year ended December 31, 2019, our Same-Store consisted of 334 properties acquired or placed in service and stabilized on or prior to January 1, 2018 and that remained in operations under a consistent reporting structure through December 31, 2019. Our total property portfolio consisted of 457, 453, and 516 properties at December 31, 2020, 2019, and 2018, respectively.51Table of ContentsLife Science2020 and 2019The following table summarizes results at and for the years ended December 31, 2020 and 2019 (dollars and square feet in thousands, except per square foot data):SSTotal Portfolio(1)20202019Change20202019ChangeRental and related revenues$342,486 $329,024 $13,462 $569,296 $440,784 $128,512 Healthpeak’s share of unconsolidated joint venture total revenues— — — 448 — 448 Noncontrolling interests' share of consolidated joint venture total revenues(146)(140)(6)(239)(187)(52)Operating expenses(81,364)(79,186)(2,178)(138,005)(107,472)(30,533)Healthpeak's share of unconsolidated joint venture operating expenses— — — (137)— (137)Noncontrolling interests' share of consolidated joint venture operating expenses48 45 3 72 59 13 Adjustments to NOI(2)(1,758)(5,568)3,810 (20,133)(22,103)1,970 Adjusted NOI$259,266 $244,175 $15,091 411,302 311,081 100,221 Less: non-SS Adjusted NOI(152,036)(66,906)(85,130)SS Adjusted NOI$259,266 $244,175 $15,091 Adjusted NOI % change6.2 %Property count(3)95 95 140 134 End of period occupancy96.8 %95.5 %96.3 %96.0 %Average occupancy96.4 %96.2 %96.0 %96.7 %Average occupied square feet5,825 5,819 8,724 7,288 Average annual total revenues per occupied square foot$58 $56 $63 $57 Average annual base rent per occupied square foot(4)$47 $44 $50 $45 _______________________________________(1)Total Portfolio includes results of operations from disposed properties through the disposition date. (2)Represents adjustments to NOI in accordance with the Company’s definition of Adjusted NOI. Refer to “Non-GAAP Measures” above for definitions of NOI and Adjusted NOI. (3)From our 2019 presentation of Same-Store, we removed one life science facility that was placed in redevelopment and one life science facility related to a significant tenant relocation. (4)Base rent does not include tenant recoveries, additional rents in excess of floors and non-cash revenue adjustments (i.e., straight-line rents, amortization of market lease intangibles, DFL non-cash interest, and deferred revenues).Same-Store Adjusted NOI increased primarily as a result of the following:•annual rent escalations;•new leasing activity; and•mark-to-market lease renewals.Total Portfolio Adjusted NOI increased primarily as a result of the aforementioned impacts to Same-Store and the following Non-Same-Store impacts:•NOI from (i) increased occupancy in developments and redevelopments placed into service in 2019 and 2020 and (ii) acquisitions in 2019 and 2020; partially offset by•decreased NOI from the placement of facilities into redevelopment in 2019 and 2020.52Table of Contents2019 and 2018The following table summarizes results at and for the years ended December 31, 2019 and 2018 (dollars and square feet in thousands, except per square foot data):SSTotal Portfolio(1)20192018Change20192018ChangeRental and related revenues$293,400 $276,996 $16,404 $440,784 $395,064 $45,720 Healthpeak’s share of unconsolidated joint venture total revenues— — — — 4,328 (4,328)Noncontrolling interests' share of consolidated joint venture total revenues(77)(79)2 (187)(117)(70)Operating expenses(69,422)(65,017)(4,405)(107,472)(91,742)(15,730)Healthpeak's share of unconsolidated joint venture operating expenses— — — — (1,131)1,131 Noncontrolling interests' share of consolidated joint venture operating expenses20 22 (2)59 44 15 Adjustments to NOI(2)(1,944)(2,829)885 (22,103)(9,718)(12,385)Adjusted NOI$221,977 $209,093 $12,884 311,081 296,728 14,353 Less: non-SS Adjusted NOI(89,104)(87,635)(1,469)SS Adjusted NOI$221,977 $209,093 $12,884 Adjusted NOI % change6.2 %Property count(3)93 93 134 124 End of period occupancy96.6 %96.1 %96.0 %96.6 %Average occupancy96.2 %94.9 %96.7 %95.1 %Average occupied square feet5,415 5,345 7,288 7,194 Average annual total revenues per occupied square foot$54 $51 $57 $55 Average annual base rent per occupied square foot(4)$43 $41 $45 $44 _______________________________________(1)Total Portfolio includes results of operations from disposed properties through the disposition date. (2)Represents adjustments to NOI in accordance with the Company’s definition of Adjusted NOI. Refer to “Non-GAAP Measures” above for definitions of NOI and Adjusted NOI. (3)From our 2018 presentation of Same-Store, we removed one life science facility that was sold, two life science facilities that were placed into redevelopment, and one life science facility related to a casualty event.(4)Base rent does not include tenant recoveries, additional rents in excess of floors and non-cash revenue adjustments (i.e., straight-line rents, amortization of market lease intangibles, DFL non-cash interest, and deferred revenues).Same-Store Adjusted NOI increased primarily as a result of the following:•new leasing activity;•mark-to-market lease renewals;•increased occupancy; and•annual rent escalations.Total Portfolio Adjusted NOI increased primarily as a result of the aforementioned increases to Same-Store and the following Non-Same-Store impacts:•NOI from (i) increased occupancy in developments and redevelopments placed into service in 2018 and 2019 and (ii) acquisitions in 2019; partially offset by•decreased NOI from facilities sold in 2018 and 2019 and the placement of facilities into redevelopment in 2019.53Table of ContentsMedical Office2020 and 2019The following table summarizes results at and for the years ended December 31, 2020 and 2019 (dollars and square feet in thousands, except per square foot data):SSTotal Portfolio(1)20202019Change20202019ChangeRental and related revenues$533,842 $527,192 $6,650 $612,678 $604,505 $8,173 Income from direct financing leases8,575 8,387 188 9,720 16,666 (6,946)Healthpeak’s share of unconsolidated joint venture total revenues2,683 2,720 (37)2,772 2,810 (38)Noncontrolling interests' share of consolidated joint venture total revenues(34,098)(33,460)(638)(34,597)(33,998)(599)Operating expenses(175,325)(175,192)(133)(204,008)(201,620)(2,388)Healthpeak's share of unconsolidated joint venture operating expenses(1,128)(1,107)(21)(1,129)(1,107)(22)Noncontrolling interests' share of consolidated joint venture operating expenses10,281 10,045 236 10,282 10,109 173 Adjustments to NOI(2)(5,861)(6,564)703 (5,544)(4,602)(942)Adjusted NOI$338,969 $332,021 $6,948 390,174 392,763 (2,589)Less: non-SS Adjusted NOI(51,205)(60,742)9,537 SS Adjusted NOI$338,969 $332,021 $6,948 Adjusted NOI % change2.1 %Property count(3)246 246 281 281 End of period occupancy92.5 %92.9 %90.4 %92.3 %Average occupancy92.5 %92.6 %91.3 %92.3 %Average occupied square feet18,488 18,506 20,448 20,736 Average annual total revenues per occupied square foot$29 $29 $30 $30 Average annual base rent per occupied square foot(4)$25 $25 $26 $26 _______________________________________(1)Total Portfolio includes results of operations from disposed properties through the disposition date. (2)Represents adjustments to NOI in accordance with the Company’s definition of Adjusted NOI. Refer to “Non-GAAP Measures” above for definitions of NOI and Adjusted NOI. (3)From our 2019 presentation of Same-Store, we removed 10 MOBs that were sold, 6 MOBs that were classified as held for sale, and3 MOBs that were placed into redevelopment.(4)Base rent does not include tenant recoveries, additional rents in excess of floors and non-cash revenue adjustments (i.e., straight-line rents, amortization of market lease intangibles, DFL non-cash interest, and deferred revenues).Same-Store Adjusted NOI increased primarily as a result of the following:•mark-to-market lease renewals; and•annual rent escalations; partially offset by•lower parking income.Total Portfolio Adjusted NOI decreased primarily as a result of MOB sales during 2019 and 2020, partially offset by the aforementioned increases to Same-Store and the following Non-Same-Store impacts:•NOI from our 2019 and 2020 acquisitions; and•increased occupancy in former redevelopment and development properties that have been placed into service.54Table of Contents2019 and 2018The following table summarizes results at and for the years ended December 31, 2019 and 2018 (dollars and square feet in thousands, except per square foot data):SSTotal Portfolio(1)20192018Change20192018ChangeRental and related revenues$510,623 $499,227 $11,396 $604,505 $580,050 $24,455 Income from direct financing leases16,665 16,349 316 16,666 16,349 317 Healthpeak’s share of unconsolidated joint venture total revenues2,720 2,606 114 2,810 2,695 115 Noncontrolling interests' share of consolidated joint venture total revenues(18,140)(17,689)(451)(33,998)(18,042)(15,956)Operating expenses(162,996)(159,772)(3,224)(201,620)(195,362)(6,258)Healthpeak's share of unconsolidated joint venture operating expenses(1,107)(1,052)(55)(1,107)(1,053)(54)Noncontrolling interests' share of consolidated joint venture operating expenses5,288 5,288 — 10,109 4,591 5,518 Adjustments to NOI(2)(3,641)(5,232)1,591 (4,602)(5,953)1,351 Adjusted NOI$349,412 $339,725 $9,687 392,763 383,275 9,488 Less: non-SS Adjusted NOI(43,351)(43,550)199 SS Adjusted NOI$349,412 $339,725 $9,687 Adjusted NOI % change2.9 %Property count(3)241 241 281 283 End of period occupancy93.2 %93.5 %92.3 %92.7 %Average occupancy93.2 %93.4 %92.3 %92.6 %Average occupied square feet18,016 18,014 20,736 20,329 Average annual total revenues per occupied square foot$29 $29 $30 $29 Average annual base rent per occupied square foot(4)$25 $25 $26 $25 _______________________________________(1)Total Portfolio includes results of operations from disposed properties through the disposition date. (2)Represents adjustments to NOI in accordance with the Company’s definition of Adjusted NOI. Refer to “Non-GAAP Measures” above for definitions of NOI and Adjusted NOI. (3)From our 2018 presentation of Same-Store, we removed eight MOBs that were sold, three MOBs that were placed into redevelopment, and two MOBs that were classified as held for sale.(4)Base rent does not include tenant recoveries, additional rents in excess of floors and non-cash revenue adjustments (i.e., straight-line rents, amortization of market lease intangibles, DFL non-cash interest, and deferred revenues).Same-Store Adjusted NOI increased primarily as a result of the following:•mark-to-market lease renewals; and•annual rent escalations. Total Portfolio Adjusted NOI increased primarily as a result of the aforementioned increases to Same-Store and the following Non-Same-Store impacts:•2018 and 2019 acquisitions; and•increased occupancy in former development and redevelopment properties placed into service; partially offset by•dispositions during 2018 and 2019.55Table of ContentsContinuing Care Retirement Community2020 and 2019The following table summarizes results at and for the years ended December 31, 2020 and 2019 (dollars in thousands, except per unit data):SS(1)Total Portfolio(2)20202019Change20202019ChangeResident fees and services$— $— $— $436,494 $3,010 $433,484 Government grant income(3)— — — 16,198 — 16,198 Healthpeak’s share of unconsolidated joint venture total revenues— — — 35,392 211,377 (175,985)Healthpeak's share of unconsolidated joint venture government grant income— — — 920 — 920 Operating expenses— — — (440,528)(2,215)(438,313)Healthpeak's share of unconsolidated joint venture operating expenses— — — (32,125)(170,473)138,348 Adjustments to NOI(4)— — — 97,072 16,985 80,087 Adjusted NOI$— $— $— 113,423 58,684 54,739 Less: non-SS Adjusted NOI(113,423)(58,684)(54,739)SS Adjusted NOI$— $— $— Adjusted NOI % change— %Property count— — 17 17 Average occupancy— %— %81.4 %85.6 %Average capacity (units)(5)— — 8,323 7,310 Average annual rent per unit$— $— $63,252 $64,337 _______________________________________(1)All CCRC properties are excluded from the Same-Store population as they experienced a change in reporting structure, underwent an operator transition during the periods presented, or are classified as held for sale. As such, no Same-Store results are presented in the table above.(2)Total Portfolio includes results of operations from disposed properties and properties that transferred segments through the disposition or transfer date. (3)Represents government grant income received under the CARES Act, which is recorded in other income (expense), net in the consolidated statements of operations.(4)Represents adjustments to NOI in accordance with the Company’s definition of Adjusted NOI. Refer to “Non-GAAP Measures” above for definitions of NOI and Adjusted NOI. (5)Represents average capacity as reported by the respective tenants or operators for the 12-month period.Total Portfolio Adjusted NOI increased primarily as a result of the following:•the acquisition of the remaining 51% interest in 13 communities previously held in a joint venture during the first quarter of 2020; and•the transfer of two CCRC properties that converted from triple-net leases to RIDEA structures during the fourth quarter of 2019.56Table of Contents2019 and 2018The following table summarizes results at and for the years ended December 31, 2019 and 2018 (dollars in thousands, except per unit data):SSTotal Portfolio(1)20192018Change20192018ChangeResident fees and services$— $— $— $3,010 $— $3,010 Healthpeak’s share of unconsolidated joint venture total revenues— — — 211,377 206,221 5,156 Operating expenses— — — (2,215)— (2,215)Healthpeak's share of unconsolidated joint venture operating expenses— — — (170,473)(166,414)(4,059)Adjustments to NOI(3)— — — 16,985 15,504 1,481 Adjusted NOI$— $— $— 58,684 55,311 3,373 Less: non-SS Adjusted NOI(58,684)(55,311)(3,373)SS Adjusted NOI$— $— $— Adjusted NOI % change— %Property count— — 17 15 Average occupancy— %— %85.6 %85.8 %Average capacity (units)(4)— — 7,310 7,263 Average annual rent per unit$— $— $64,337 $62,531 _____________________________________(1)All CCRC properties are excluded from the Same-Store population as they experienced a change in reporting structure, underwent an operator transition during the periods presented, or are classified as held for sale. As such, no Same-Store results are presented in the table above.(2)Total Portfolio includes results of operations from disposed properties and properties that transferred segments through the disposition or transfer date. (3)Represents adjustments to NOI in accordance with the Company’s definition of Adjusted NOI. Refer to “Non-GAAP Measures” above for definitions of NOI and Adjusted NOI. (4)Represents average capacity as reported by the respective tenants or operators for the 12-month period.Total Portfolio Adjusted NOI increased as a result of the transfer of two CCRC properties that converted from triple-net leases to RIDEA structures during the fourth quarter of 2019 and an increase in our share of Total Portfolio Adjusted NOI from the CCRC JV.57Table of ContentsOther Income and Expense ItemsThe following table summarizes results for the years ended December 31, 2020, 2019 and 2018 (in thousands):Year Ended December 31,2020 vs.2019 vs.20202019201820192018Interest income$16,553 $9,844 $10,406 $6,709 $(562)Interest expense218,336 217,612 261,280 724 (43,668)Depreciation and amortization553,949 435,191 404,681 118,758 30,510 General and administrative93,237 92,966 96,702 271 (3,736)Transaction costs18,342 1,963 1,137 16,379 826 Impairments and loan loss reserves (recoveries), net42,909 17,708 10,917 25,201 6,791 Gain (loss) on sales of real estate, net90,350 (40)831,368 90,390 (831,408)Loss on debt extinguishments(42,912)(58,364)(44,162)15,452 (14,202)Other income (expense), net234,684 165,069 13,425 69,615 151,644 Income tax benefit (expense)9,423 5,479 4,396 3,944 1,083 Equity income (loss) from unconsolidated joint ventures(66,599)(6,330)(5,755)(60,269)(575)Income (loss) from discontinued operations267,746 (115,408)236,256 383,154 (351,664)Noncontrolling interests’ share in continuing operations(14,394)(14,558)(12,294)164 (2,264)Noncontrolling interests’ share in discontinued operations(296)27 (87)(323)114 Interest income Interest income increased for the year ended December 31, 2020 primarily as a result of new loans and additional funding of existing loans.Interest expense Interest expense decreased for the year ended December 31, 2019 primarily as a result of senior unsecured notes repurchases and redemptions during 2018 and 2019, partially offset by senior unsecured notes issued during 2019.Depreciation and amortization expense Depreciation and amortization expense increased for the year ended December 31, 2020 primarily as a result of: (i) the acquisition of Brookdale’s interest in and consolidation of 13 CCRCs during the first quarter of 2020, (ii) assets acquired during 2019 and 2020, and (iii) development and redevelopment projects placed into service during 2019 and 2020. The increase was partially offset by dispositions of real estate throughout 2019 and 2020.Depreciation and amortization expense increased for the year ended December 31, 2019 primarily as a result of (i) assets acquired during 2018 and 2019 and (ii) development and redevelopment projects placed into service during 2018 and 2019, partially offset by dispositions of real estate throughout 2018 and 2019.General and administrative expenseGeneral and administrative expenses decreased for the year ended December 31, 2019 primarily as a result of decreased severance and related charges, driven by the departure of our former Executive Chairman in March 2018, partially offset by higher compensation costs in 2019.Transaction costsTransaction costs increased for the year ended December 31, 2020 primarily as a result of costs associated with the transition of 13 CCRCs from Brookdale to LCS in January 2020.Impairments and loan loss reserves (recoveries), net The impairment charges recognized in each period vary depending on facts and circumstances related to each asset and are impacted by negotiations with potential buyers, current operations of the assets, and other factors. 58Table of ContentsImpairments and loan loss reserves (recoveries), net increased for the year ended December 31, 2020 primarily as a result of: (i) an increase related to buildings we intend to demolish and (ii) an increase in credit losses under the current expected credit losses model (which we began using in conjunction with our adoption of ASU 2016-13 on January 1, 2020).Impairments and loan loss reserves (recoveries), net increased for the year ended December 31, 2019 as a result of additional assets being impaired under the held-for-sale impairment model.Gain (loss) on sales of real estate, netDuring the year ended December 31, 2020, we sold: (i) 11 MOBs, (ii) 2 MOB land parcels, and (iii) 1 facility from the other non-reportable segment, resulting in total gain on sales of $90 million.During the year ended December 31, 2019, we sold: (i) our remaining 49% interest in our U.K. joint venture, (ii) 11 MOBs, (iii) 1 life science asset, (iv) 1 undeveloped life science land parcel, and (v) 1 facility from other non-reportable segments, resulting in no material gain or loss on sale.During the year ended December 31, 2018, we sold: (i) a 51% interest in substantially all the U.K. assets previously owned by the Company, (ii) 16 life science assets, and (iii) 4 MOBs, resulting in total gain on sales of $831 million. Loss on debt extinguishmentsRefer to Note 11 to the Consolidated Financial Statements for information regarding unsecured note repurchases, repayments, and redemptions and the associated loss on debt extinguishments recognized. Other income (expense), netOther income (expense), net increased for the year ended December 31, 2020 primarily as a result of: (i) a gain upon change of control related to the acquisition of the outstanding equity interest in 13 CCRCs from Brookdale during the first quarter of 2020; (ii) a gain on sale related to the sale of a hospital underlying a DFL during the first quarter of 2020; and (iii) government grant income received under the CARES Act during 2020. The increase was partially offset by a gain upon change of control recognized in 2019 related to a senior housing joint venture with a sovereign wealth fund (see Note 4 to the Consolidated Financial Statements). Other income (expense), net increased for the year ended December 31, 2019 primarily as a result of (i) a gain upon change of control recognized in 2019 related to a senior housing joint venture with a sovereign wealth fund and (ii) a loss upon change of control of seven U.K. care homes in March 2018 (see Note 19 to the Consolidated Financial Statements). The increase in other income (expense), net was partially offset by a gain upon change of control related to the acquisition of the outstanding equity interests in three life science joint ventures in November 2018.Income tax benefit (expense)Income tax benefit increased for the year ended December 31, 2020 primarily as a result of the tax benefits related to the purchase of Brookdale’s interest in 13 of the 15 communities in the CCRC JV, including the management termination fee expense paid to Brookdale in connection with transitioning management of 13 CCRCs to LCS, and the extension of the net operating loss carryback period provided by the CARES Act, partially offset by a deferred tax asset valuation allowance and corresponding income tax expense recognized in 2020.Equity income (loss) from unconsolidated joint venturesEquity income from unconsolidated joint ventures decreased for the year ended December 31, 2020 primarily as a result of our share of net losses from an unconsolidated joint venture owning 19 SHOP assets that was formed in December 2019, partially offset by no longer recognizing the operating results of 13 CCRCs in equity income (loss) from unconsolidated joint ventures as we acquired Brookdale’s interest and now consolidate those facilities. The decrease is further offset by our share of a gain on sale of one asset in an unconsolidated joint venture during the first quarter of 2020.Equity income from unconsolidated joint ventures decreased for the year ended December 31, 2019 primarily as a result of an impairment charge recognized related to one asset classified as held-for-sale in the CCRC JV (see Note 9 to the Consolidated Financial Statements) and the sale of our equity method investment in RIDEA II in June 2018, partially offset by additional equity income from our previously-held investment in the U.K. JV.59Table of ContentsIncome (loss) from discontinued operationsIncome from discontinued operations increased for the year ended December 31, 2020 primarily as a result of: (i) increased gain on sales of real estate from the disposal of multiple senior housing portfolios during 2019 and 2020; (ii) decreased depreciation and amortization expense due to assets being disposed of or classified as held for sale throughout 2019 and 2020 and assets that were fully depreciated in 2019 and 2020; (iii) government grant income received under the CARES Act during 2020; and (iv) NOI from acquisitions during 2019. The increase in income (loss) from discontinued operations was partially offset by: (i) decreased NOI from dispositions of real estate during 2019 and 2020 and (ii) increased expenses and decreased occupancy related to COVID-19. Income (loss) from discontinued operations decreased for the year ended December 31, 2019 primarily as a result of: (i) decreased gain on sales of real estate; (ii) increased impairment charges due to additional asset being classified as held for sale in 2019; (iii) increased depreciation and amortization expense due to acquisitions of real estate during 2018 and 2019; (iv) decreased NOI from dispositions of real estate during 2018 and 2019. The decrease in income (loss) from discontinued operations was partially offset by: (i) increased other income (expense), net from a gain upon change of control related to consolidating a senior housing joint venture in 2019 and (ii) additional NOI from acquisitions during 2018 and 2019.Liquidity and Capital ResourcesWe anticipate that our cash flow from operations, available cash balances, and cash from our various financing activities will be adequate for at least the next 12 months for purposes of: (i) funding recurring operating expenses; (ii) meeting debt service requirements; and (iii) satisfying our distributions to our stockholders and non-controlling interest members. During the year ended December 31, 2020, distributions to common shareholders and noncontrolling interest holders exceeded cash flows from operations by approximately $66 million. Distributions were made using a combination of cash flows from operations, funds available under our bank line of credit and commercial paper program, proceeds from the sale of properties, and other sources of cash available to us. Our principal investing liquidity needs for the next 12 months are to:•fund capital expenditures, including tenant improvements and leasing costs and•fund future acquisition, transactional and development activities.We anticipate satisfying these future investing needs using one or more of the following:•cash flow from operations; •sale of, or exchange of ownership interests in, properties or other investments;•borrowings under our bank line of credit and commercial paper program;•issuance of additional debt, including unsecured notes, term loans, and mortgage debt; and/or•issuance of common or preferred stock or its equivalent.Our ability to access the capital markets impacts our cost of capital and ability to refinance maturing indebtedness, as well as our ability to fund future acquisitions and development through the issuance of additional securities or secured debt. Credit ratings impact our ability to access capital and directly impact our cost of capital as well. For example, our bank line of credit and term loan accrue interest at a rate per annum equal to LIBOR plus a margin that depends upon the credit ratings of our senior unsecured long term debt. We also pay a facility fee on the entire revolving commitment that depends upon our credit ratings. As of February 8, 2021, we had long-term credit ratings of Baa1 from Moody’s and BBB+ from S&P Global and Fitch, and short-term credit ratings of P-2, A-2 and F2 from Moody's, S&P Global, and Fitch, respectively.A downgrade in credit ratings by Moody’s, S&P Global, and Fitch may have a negative impact on the interest rates and facility fees for our bank line of credit and term loan. While a downgrade in our credit ratings would adversely impact our cost of borrowing, we believe we continue to have access to the unsecured debt markets, and we could also seek to enter into one or more secured debt financings, issue additional securities, including under our 2020 ATM Program (as defined below), or dispose of certain assets to fund future operating costs, capital expenditures, or acquisitions, although no assurances can be made in this regard. Refer to “COVID-19 Update” above for a more comprehensive discussion of the potential impact of COVID-19 on our business.60Table of ContentsCash Flow SummaryThe following summary discussion of our cash flows is based on the Consolidated Statements of Cash Flows and is not meant to be an all-inclusive discussion of the changes in our cash flows for the periods presented below. The following table sets forth changes in cash flows (in thousands):Year Ended December 31,202020192018Net cash provided by (used in) operating activities$758,431 $846,073 $848,709 Net cash provided by (used in) investing activities(1,007,700)(1,448,778)1,829,279 Net cash provided by (used in) financing activities246,450 647,271 (2,620,536)Operating Cash FlowsOperating cash flow decreased $88 million between the years ended December 31, 2020 and 2019 primarily as the result of: (i) the termination fee paid to Brookdale in connection with the CCRC Acquisition; (ii) assets sold during 2019 and 2020, and (iii) additional expenses and decreased occupancy in our SHOP and CCRC assets related to COVID-19. The decrease in operating cash flow is partially offset by: (i) 2019 and 2020 acquisitions, (ii) annual rent increases, (iii) new leasing activity; (iv) developments and redevelopments placed in service during 2019 and 2020, and (v) increased interest received from new loan investments.Operating cash flow decreased $3 million between the years ended December 31, 2019 and 2018 primarily as the result of: (i) dispositions during 2018 and 2019 and (ii) occupancy declines and higher labor costs within our SHOP assets. The decrease in operating cash flow is partially offset by: (i) 2018 and 2019 acquisitions, (ii) annual rent increases, (iii) developments and redevelopments placed in service during 2018 and 2019, and (iv) decreased interest paid as a result of debt repayments during 2018 and 2019. Our cash flow from operations is dependent upon the occupancy levels of our buildings, rental rates on leases, our tenants’ performance on their lease obligations, the level of operating expenses, and other factors.Investing Cash FlowsThe following are significant investing activities for the year ended December 31, 2020:•received net proceeds of $1.5 billion primarily from (i) sales of real estate assets (including real estate assets under DFLs) and (ii) sales and repayments of loans receivable; and•made investments of $2.5 billion primarily related to the (i) acquisition, development, and redevelopment of real estate and (ii) funding of loan investments.The following are significant investing activities for the year ended December 31, 2019:•received net proceeds of $976 million primarily from: (i) sales of real estate assets (including real estate assets under DFLs), (ii) the sale of our investment in the U.K. JV, and (iii) the sale of a 46.5% interest in 19 previously consolidated SHOP assets; and•made investments of $2.4 billion primarily related to the (i) acquisition, development, and redevelopment of real estate and (ii) funding of loan investments.The following are significant investing activities for the year ended December 31, 2018:•received net proceeds of $2.9 billion primarily from: (i) sales of real estate assets, (ii) the sale of RIDEA II, (iii) the sale of the Tandem Mezzanine Loan, and (iv) the U.K. JV transaction; and•made investments of $1.1 billion primarily for the acquisition and development of real estate.Financing Cash FlowsThe following are significant financing activities for the year ended December 31, 2020:•made net borrowings of $16 million primarily under our bank line of credit, commercial paper, and senior unsecured notes (including debt extinguishment costs);•paid cash dividends on common stock of $787 million; and•issued common stock of $1.1 billion.61Table of ContentsThe following are significant financing activities for the year ended December 31, 2019:•made net borrowings of $573 million primarily under our bank line of credit, commercial paper, term loan, and senior unsecured notes (including debt extinguishment costs);•paid cash dividends on common stock of $720 million; and•issued common stock of $796 million.The following are significant financing activities for the year ended December 31, 2018:•repaid $2.4 billion of debt under our: (i) bank line of credit, (ii) term loan, (iii) senior unsecured notes (including debt extinguishment costs) and (iv) mortgage debt;•paid cash dividends on common stock of $697 million;•paid $83 million for distributions to and purchases of noncontrolling interests, primarily related to our acquisition of Brookdale’s noncontrolling interest in RIDEA I;•raised net proceeds of $218 million from the issuances of common stock, primarily from our at-the-market equity program; and•received proceeds of $300 million for issuances of noncontrolling interests.Discontinued OperationsOperating, investing, and financing cash flows in our Consolidated Statements of Cash Flows are reported inclusive of both cash flows from continuing operations and cash flows from discontinued operations. Certain significant cash flows from discontinued operations are disclosed in Note 18 to the Consolidated Financial Statements. The absence of future cash flows from discontinued operations is not expected to significantly impact our liquidity, as the proceeds from senior housing triple-net and SHOP dispositions are expected to be used to pay down debt and invest in additional real estate in our other business lines. Additionally, we have multiple other sources of liquidity that can be utilized in the future, as needed. Refer to the Liquidity and Capital Resources section above for additional information regarding our liquidity.DebtSenior Unsecured NotesIn June 2020, we completed a public offering of $600 million in aggregate principal amount of our 2031 Notes.In June 2020, using a portion of the net proceeds from the 2031 Notes offering, we repurchased $250 million aggregate principal amount of our 4.25% senior unsecured notes due in 2023.In July 2020, using an additional portion of the net proceeds from the 2031 Notes offering, we redeemed all $300 million of our 3.15% senior unsecured notes due in 2022.From January 1, 2021 to February 8, 2021, we repurchased $112 million aggregate principal amount of our 4.25% senior unsecured notes due in 2023, $201 million aggregate principal amount of our 4.20% senior unsecured notes due in 2024, and $469 million aggregate principal amount of our 3.88% senior unsecured notes due in 2024.See Note 11 to the Consolidated Financial Statements for additional information about our outstanding debt.Approximately 94%, 94%, and 99% of our consolidated debt, excluding debt classified as liabilities related to assets held for sale and discontinued operations, net, was fixed rate debt as of December 31, 2020, 2019 and 2018, respectively. At December 31, 2020, our fixed rate debt and variable rate debt had weighted average interest rates of 3.85% and 0.85%, respectively. At December 31, 2019, our fixed rate debt and variable rate debt had weighted average interest rates of 3.94% and 2.58%, respectively. At December 31, 2018, our fixed rate debt and variable rate debt had weighted average interest rates of 4.04% and 2.12%, respectively. We had $36 million, $42 million and $43 million of variable rate debt swapped to fixed through interest rate swaps as of December 31, 2020, 2019 and 2018, respectively, which is reported in liabilities related to assets held for sale and discontinued operations, net. For a more detailed discussion of our interest rate risk, see “Quantitative and Qualitative Disclosures About Market Risk” in Item 3 below.62Table of ContentsEquityAt December 31, 2020, we had 538 million shares of common stock outstanding, equity totaled $7.3 billion, and our equity securities had a market value of $16.5 billion.At December 31, 2020, non-managing members held an aggregate of five million units in seven limited liability companies (“DownREITs”) for which we are the managing member. The DownREIT units are exchangeable for an amount of cash approximating the then-current market value of shares of our common stock or, at our option, shares of our common stock (subject to certain adjustments, such as stock splits and reclassifications). At December 31, 2020, the outstanding DownREIT units were convertible into approximately seven million shares of our common stock.At-The-Market ProgramIn February 2020, we terminated our previous at-the-market equity offering program and concurrently established a new at-the-market equity offering program (the “2020 ATM Program”). In addition to the issuance and sale of shares of our common stock, we may also enter into one or more forward sales agreements with sales agents for the sale of our shares of common stock under our 2020 ATM Program.During the year ended December 31, 2020, the Company settled all 16.8 million shares previously outstanding under ATM forward contracts at a weighted average net price of $31.38 per share, after commissions, resulting in net proceeds of $528 million. At December 31, 2020, approximately $1.25 billion of our common stock remained available for sale under the 2020 ATM Program. Actual future sales of our common stock will depend upon a variety of factors, including but not limited to market conditions, the trading price of our common stock, and our capital needs. We have no obligation to sell any of the remaining shares under our 2020 ATM Program.Other than in connection with settlement of ATM forward contracts described above, during the year ended December 31, 2020, we did not issue any shares of our common stock under our 2020 ATM Program. See Note 13 to the Consolidated Financial Statements for additional information about our 2020 ATM Program and our previous at-the-market equity offering program.Shelf RegistrationIn May 2018, we filed a prospectus with the SEC as part of a registration statement on Form S-3, using an automatic shelf registration process. This shelf registration statement expires in May 2021 and at or prior to such time, we expect to file a new shelf registration statement. Under the “shelf” process, we may sell any combination of the securities described in the prospectus through one or more offerings. The securities described in the prospectus include common stock, preferred stock, depositary shares, debt securities and warrants.63Table of ContentsContractual ObligationsThe following table summarizes our material contractual payment obligations and commitments, excluding obligations and commitments related to assets classified as discontinued operations, at December 31, 2020 (in thousands):Total(1)20212022-20232024-2025More thanFive YearsBank line of credit$— $— $— $— $— Commercial paper129,590 129,590 — — — Term loan250,000 — — 250,000 — Senior unsecured notes5,750,000 — 300,000 2,500,000 2,950,000 Mortgage debt(2)216,780 13,015 94,717 6,259 102,789 Construction loan commitments(3)11,137 11,137 — — — Lease and other contractual commitments(4)109,126 94,124 15,002 — — Development commitments(5)196,749 180,846 15,247 656 — Ground and other operating leases536,223 11,349 23,196 19,622 482,056 Interest(6)1,649,566 233,954 457,063 332,007 626,542 Total$8,849,171 $674,015 $905,225 $3,108,544 $4,161,387 _______________________________________(1)Excludes $4 million of development commitments, $4 million of ground and other operating leases, and $111 million of interest related to assets classified as discontinued operations. See Note 5 to the Consolidated Financial Statements for further information regarding discontinued operations.(2)Excludes mortgage debt on assets held for sale and discontinued operations of $319 million and mortgage debt from unconsolidated joint ventures.(3)Represents loan commitments to finance development and redevelopment projects.(4)Represents our commitments, as lessor, under signed leases and contracts for operating properties and includes allowances for tenant improvements and leasing commissions. Excludes allowances for tenant improvements related to developments in progress for which we have executed an agreement with a general contractor to complete the tenant improvements (recognized in the "Development commitments" line). (5)Represents construction and other commitments for developments in progress and includes allowances for tenant improvements of $28 million that we have provided as a lessor.(6)Interest on variable-rate debt is calculated using rates in effect at December 31, 2020.Off-Balance Sheet ArrangementsWe own interests in certain unconsolidated joint ventures as described in Note 9 to the Consolidated Financial Statements. Except in limited circumstances, our risk of loss is limited to our investment in the joint venture and any outstanding loans receivable. We have no other material off-balance sheet arrangements that we expect would materially affect our liquidity and capital resources except those described above under “Contractual Obligations”.InflationOur leases often provide for either fixed increases in base rents or indexed escalators, based on the Consumer Price Index or other measures, and/or additional rent based on increases in the tenants’ operating revenues. Most of our MOB leases require the tenant to pay a share of property operating costs such as real estate taxes, insurance and utilities. Substantially all of our senior housing triple-net, life science, and remaining other leases require the tenant or operator to pay all of the property operating costs or reimburse us for all such costs. We believe that inflationary increases in expenses will be offset, in part, by the tenant or operator expense reimbursements and contractual rent increases described above.64Table of ContentsNon-GAAP Financial Measure ReconciliationsFunds From OperationsThe following is a reconciliation from net income (loss) applicable to common shares, the most directly comparable financial measure calculated and presented in accordance with GAAP, to NAREIT FFO, FFO as Adjusted and AFFO (in thousands, except per share data):Year Ended December 31,20202019201820172016Net income (loss) applicable to common shares $411,147 $43,987 $1,058,424 $413,013 $626,549 Real estate related depreciation and amortization697,143 659,989 549,499 534,726 572,998 Healthpeak's share of real estate related depreciation and amortization from unconsolidated joint ventures 105,090 60,303 63,967 60,058 49,043 Noncontrolling interests' share of real estate related depreciation and amortization(19,906)(20,054)(11,795)(15,069)(21,001)Other real estate-related depreciation and amortization2,766 6,155 6,977 9,364 11,919 Loss (gain) on sales of depreciable real estate, net(550,494)(22,900)(925,985)(356,641)(164,698)Healthpeak's share of loss (gain) on sales of depreciable real estate, net, from unconsolidated joint ventures(9,248)(2,118)— (1,430)(16,332)Noncontrolling interests' share of gain (loss) on sales of depreciable real estate, net(3)335 — — 224 Loss (gain) upon change of control, net(1)(159,973)(166,707)(9,154)— — Taxes associated with real estate dispositions(2)(7,785)— 3,913 (5,498)60,451 Impairments (recoveries) of depreciable real estate, net224,630 221,317 44,343 22,590 — NAREIT FFO applicable to common shares693,367 780,307 780,189 661,113 1,119,153 Distributions on dilutive convertible units and other6,662 6,592 — — 8,732 Diluted NAREIT FFO applicable to common shares$700,029 $786,899 $780,189 $661,113 $1,127,885 Weighted average shares outstanding - diluted NAREIT FFO536,562 494,335 470,719 468,935 471,566 Impact of adjustments to NAREIT FFO:Transaction-related items(3)$128,619 $15,347 $11,029 $62,576 $96,586 Other impairments (recoveries) and other losses (gains), net(4)(22,046)10,147 7,619 92,900 — Restructuring and severance related charges(5)2,911 5,063 13,906 5,000 16,965 Loss on debt extinguishments42,912 58,364 44,162 54,227 46,020 Litigation costs (recoveries)232 (520)363 15,637 3,081 Casualty-related charges (recoveries), net469 (4,106)— 10,964 — Foreign currency remeasurement losses (gains)153 (250)(35)(1,043)585 Valuation allowance on deferred tax assets(6)31,161 — — — — Tax rate legislation impact(7)(3,590)— — 17,028 — Total adjustments$180,821 $84,045 $77,044 $257,289 $163,237 FFO as Adjusted applicable to common shares$874,188 $864,352 $857,233 $918,402 $1,282,390 Distributions on dilutive convertible units and other6,490 6,396 (198)6,657 12,849 Diluted FFO as Adjusted applicable to common shares$880,678 $870,748 $857,035 $925,059 $1,295,239 Weighted average shares outstanding - diluted FFO as Adjusted536,562 494,335 470,719 473,620 473,340 FFO as Adjusted applicable to common shares$874,188 $864,352 $857,233 $918,402 $1,282,390 Amortization of deferred compensation17,368 14,790 14,714 13,510 15,581 Amortization of deferred financing costs10,157 10,863 12,612 14,569 20,014 Straight-line rents(29,316)(28,451)(23,138)(23,933)(27,560)AFFO capital expenditures(93,579)(108,844)(106,193)(113,471)(88,953)Lease restructure payments1,321 1,153 1,195 1,470 16,604 CCRC entrance fees(8)— 18,856 17,880 21,385 21,287 Deferred income taxes(15,647)(18,972)(18,744)(15,490)(13,692)Other AFFO adjustments(9)8,213 (7,927)(9,162)(12,722)(9,975)AFFO applicable to common shares772,705 745,820 746,397 803,720 1,215,696 Distributions on dilutive convertible units and other6,662 6,591 — — 13,088 Diluted AFFO applicable to common shares$779,367 $752,411 $746,397 $803,720 $1,228,784 Weighted average shares outstanding - diluted AFFO536,562 494,335 470,719 468,935 473,340 65Table of ContentsYear Ended December 31,20202019201820172016Diluted earnings per common share$0.77 $0.09 $2.24 $0.88 $1.34 Depreciation and amortization1.47 1.43 1.30 1.25 1.30 Loss (gain) on sales of depreciable real estate, net(1.05)(0.04)(1.96)(0.76)(0.38)Loss (gain) upon change of control, net(1)(0.30)(0.34)(0.02)— — Taxes associated with real estate dispositions(2)(0.01)— 0.01 (0.01)0.13 Impairments (recoveries) of depreciable real estate, net0.42 0.45 0.09 0.05 — Diluted NAREIT FFO per common share$1.30 $1.59 $1.66 $1.41 $2.39 Transaction-related items(3)0.24 0.03 0.02 0.13 0.20 Other impairments (recoveries) and other losses (gains), net(4)(0.04)0.02 0.02 0.20 — Restructuring and severance related charges(5)0.01 0.01 0.03 0.01 0.04 Loss on debt extinguishments0.08 0.12 0.09 0.11 0.10 Litigation costs (recoveries)— — — 0.03 0.01 Casualty-related charges (recoveries), net— (0.01)— 0.02 — Valuation allowance on deferred tax assets(6)0.06 — — — — Tax rate legislation impact(7)(0.01)— — 0.04 — Diluted FFO as Adjusted per common share$1.64 $1.76 $1.82 $1.95 $2.74 _______________________________________(1)For the year ended December 31, 2020, includes a $170 million gain upon consolidation of 13 CCRCs in which we acquired Brookdale's interest and began consolidating during the first quarter of 2020. For the year ended December 31, 2019, includes a $161 million gain upon deconsolidation of 19 previously consolidated SHOP assets that were contributed into a new unconsolidated senior housing joint venture with a sovereign wealth fund. For the year ended December 31, 2018, represents the gain upon consolidation related to the acquisition of our partner's interests in four previously unconsolidated life science assets, partially offset by the loss upon consolidation of seven U.K. care homes. Gains and losses upon change of control are included in other income (expense), net in the consolidated statements of operations.(2)For the year ended December 31, 2016, represents income tax expense associated with the state built-in gain tax payable upon the disposition of specific real estate assets, of which $49 million relates to the HCR ManorCare, Inc. ("HCRMC") real estate portfolio that we spun-off in 2016. (3)For the year ended December 31, 2020, includes the termination fee and transition fee expenses related to terminating the management agreements with Brookdale for 13 CCRCs and transitioning those communities to LCS, partially offset by the tax benefit related to those expenses. The expenses related to terminating management agreements are included in operating expenses in the consolidated statements of operations. For the year ended December 31, 2017, includes $55 million of net non-cash charges related to the right to terminate certain triple-net leases and management agreements in conjunction with the 2017 Brookdale Transactions. For the year ended December 31, 2016, primarily relates to the spin-off of Quality Care Properties, Inc.(4)For the year ended December 31, 2020, includes reserves for loan losses under the current expected credit losses accounting standard in accordance with Accounting Standards Codification 326, Financial Instruments – Credit Losses ("ASC 326"). The year ended December 31, 2020 also includes a gain on sale of a hospital that was in a DFL and the impairment of an undeveloped MOB land parcel, which was sold during the third quarter. For the year ended December 31, 2019, represents the impairment of 13 senior housing triple-net facilities under DFLs recognized as a result of entering into sales agreements. For the year ended December 31, 2018, primarily relates to the impairment of an undeveloped life science land parcel classified as held for sale, partially offset by an impairment recovery upon the sale of a mezzanine loan investment in March 2018. For the year ended December 31, 2017, relates to $144 million of impairments on our Tandem Mezzanine Loan, net of a $51 million impairment recovery upon the sale of a senior notes investment.(5)For the year ended December 31, 2018, primarily relates to the departure of our former Executive Chairman and corporate restructuring activities. For the year ended December 31, 2017, primarily relates to the departure of our former Chief Accounting Officer. For the year ended December 31, 2016, primarily relates to the departure of our former President and Chief Executive Officer.(6)For the year ended December 31, 2020, represents the valuation allowance and corresponding income tax expense related to deferred tax assets that are no longer expected to be realized as a result of our plan to dispose of our SHOP portfolio. We determined we were unlikely to hold the assets long enough to realize the future value of certain deferred tax assets generated by the net operating losses of our taxable REIT subsidiaries.(7)For the year ended December 31, 2020, represents the tax benefit from the CARES Act, which extended the net operating loss carryback period to five years. For the year ended December 31, 2017, represents the remeasurement of deferred tax assets and liabilities as a result of the Tax Cuts and Jobs Act that was signed into legislation on December 22, 2017. (8)In connection with the acquisition of the remaining 51% interest in the CCRC JV in January 2020, we consolidated the 13 communities in the CCRC JV and recorded the assets and liabilities at their acquisition date relative fair values, including the CCRC contract liabilities associated with previously collected non-refundable entrance fees. In conjunction with increasing those CCRC contract liabilities to their fair value, we concluded that we will no longer adjust for the timing difference between non-refundable entrance fees collected and amortized as we believe the amortization of these fees is a meaningful representation of how we satisfy the performance obligations of the fees. As such, upon consolidation of the CCRC assets, we no longer exclude the difference between CCRC entrance fees collected and amortized from the calculation of AFFO. For comparative periods presented, the adjustment continues to represent our 49% share of non-refundable entrance fees collected by the CCRC JV, net of reserves and net of CCRC JV entrance fee amortization.(9)Primarily includes our share of AFFO capital expenditures from unconsolidated joint ventures, partially offset by noncontrolling interests' share of AFFO capital expenditures from consolidated joint ventures. For the year ended December 31, 2020, includes an increase to insurance claims that have been incurred but not yet reported on the 13 CCRCs in which we acquired Brookdale's interest and began consolidating during the first quarter of 2020 and senior housing triple-net assets that transitioned to RIDEA structures during the year. 66Table of ContentsCritical Accounting PoliciesThe preparation of financial statements in conformity with U.S. GAAP requires our management to use judgment in the application of accounting policies, including making estimates and assumptions. We base estimates on the best information available to us at the time, our experience and on various other assumptions believed to be reasonable under the circumstances. These estimates affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenue and expenses during the reporting periods. If our judgment or interpretation of the facts and circumstances relating to various transactions or other matters had been different, it is possible that different accounting would have been applied, resulting in a different presentation of our consolidated financial statements. From time to time, we re-evaluate our estimates and assumptions. In the event estimates or assumptions prove to be different from actual results, adjustments are made in subsequent periods to reflect more current estimates and assumptions about matters that are inherently uncertain. For a more detailed discussion of our significant accounting policies, see Note 2 to the Consolidated Financial Statements. Below is a discussion of accounting policies that we consider critical in that they may require complex judgment in their application or require estimates about matters that are inherently uncertain.Principles of ConsolidationThe consolidated financial statements include the accounts of Healthpeak Properties, Inc., our wholly-owned subsidiaries, and joint ventures and variable interest entities (“VIEs”) that we control, through voting rights or other means. We consolidate investments in VIEs when we are the primary beneficiary of the VIE. A variable interest holder is considered to be the primary beneficiary of a VIE if it has the power to direct the activities that most significantly impact the entity’s economic performance and has the obligation to absorb losses of, or the right to receive benefits from, the entity that could potentially be significant to the VIE.We make judgments about which entities are VIEs based on an assessment of whether: (i) the equity investment at risk is insufficient to finance that entity’s activities without additional subordinated financial support, (ii) substantially all of an entity’s activities either involve or are conducted on behalf of an investor that has disproportionately few voting rights, or (iii) the equity investors as a group lack any of the following: (a) the power through voting or similar rights to direct the activities of an entity that most significantly impact the entity’s economic performance, (b) the obligation to absorb the expected losses of an entity, or (c) the right to receive the expected residual returns of an entity. Criterion (iii) above is generally applied to limited partnerships and similarly structured entities by assessing whether a simple majority of the limited partners hold substantive rights to participate in the significant decisions of the entity or have the ability to remove the decision maker or liquidate the entity without cause. If neither of those criteria are met, the entity is a VIE.We continually assess whether events have occurred that require us to reconsider the initial determination of whether an entity is a VIE. Such events include, but are not limited to: (i) a change to the contractual arrangements of the entity or in the ability of a party to exercise its participation or kick-out rights, (ii) a change to the capitalization structure of the entity, or (iii) acquisitions or sales of interests that constitute a change in control. When a reconsideration event occurs, we reassess whether the entity is a VIE.We also make judgments with respect to our level of influence or control over an entity and whether we are (or are not) the primary beneficiary of a VIE. Consideration of various factors includes, but is not limited to:•which activities most significantly impact the entity’s economic performance, and our ability to direct those activities;•our form of ownership interest; •our representation on the entity’s governing body;•the size and seniority of our investment; •our ability to manage our ownership interest relative to other interest holders; and•our ability and the rights of other investors to participate in policy making decisions, replace the manager, and/or liquidate the entity, if applicable. Our ability to correctly assess our influence or control over an entity when determining the primary beneficiary of a VIE affects the presentation of these entities in our consolidated financial statements. When we perform a reassessment of the primary beneficiary at a date other than at inception of the VIE, our assumptions may be different and may result in the identification of a different primary beneficiary.67Table of ContentsIf we determine that we are the primary beneficiary of a VIE, our consolidated financial statements include the operating results of the VIE rather than the results of our variable interest in the VIE. We require VIEs to provide us timely financial information and review the internal controls of VIEs to determine if we can rely on the financial information it provides. If a VIE has deficiencies in its internal controls over financial reporting, or does not provide us with timely financial information, it may adversely impact the quality and/or timing of our financial reporting and our internal controls over financial reporting.Revenue RecognitionLease ClassificationAt the inception of a new lease arrangement, including new leases that arise from amendments, we assess the terms and conditions to determine the proper lease classification. For leases entered into prior to January 1, 2019, the lease arrangement was classified as an operating lease if none of the following criteria were met: (i) transfer of ownership to the lessee prior to or shortly after the end of the lease term, (ii) the lessee had a bargain purchase option during or at the end of the lease term, (iii) the lease term was equal to 75% or more of the underlying property’s economic life, or (iv) the present value of future minimum lease payments (excluding executory costs) was equal to 90% or more of the estimated fair value of the leased asset. If one of the four criteria was met and the minimum lease payments were determined to be reasonably predictable and collectible, the lease arrangement was generally accounted for as a DFL. Concurrent with our adoption of Accounting Standards Update ("ASU") No. 2016-02, Leases (“ASU 2016-02”) on January 1, 2019, we began classifying a lease entered into subsequent to adoption as an operating lease if none of the following criteria are met: (i) transfer of ownership to the lessee by the end of the lease term, (ii) lessee has a purchase option during or at the end of the lease term that it is reasonably certain to exercise, (iii) the lease term is for the major part of the remaining economic life of the underlying asset, (iv) the present value of future minimum lease payments is equal to substantially all of the fair value of the underlying asset, or (v) the underlying asset is of such a specialized nature that it is expected to have no alternative use to us at the end of the lease term.If the assumptions utilized in the above classification assessments were different, our lease classification for accounting purposes may have been different; thus the timing and amount of our revenue recognized would have been impacted, which may be material to our consolidated financial statements.Rental and Related RevenuesWe recognize rental revenue for operating leases on a straight-line basis over the lease term when collectibility of all minimum lease payments is probable and the tenant has taken possession or controls the physical use of a leased asset. If the lease provides for tenant improvements, we determine whether the tenant improvements are owned by the tenant or us. When we are the owner of the tenant improvements, the tenant is not considered to have taken physical possession or have control of the leased asset until the tenant improvements are substantially complete. When the tenant is the owner of the tenant improvements, any tenant improvement allowance funded is treated as a lease incentive and amortized as a reduction of revenue over the lease term. The determination of ownership of a tenant improvement is subject to significant judgment. If our assessment of the owner of the tenant improvements was different, the timing and amount of our revenue recognized would be impacted.Certain leases provide for additional rents that are contingent upon a percentage of the facility’s revenue in excess of specified base amounts or other thresholds. Such revenue is recognized when actual results reported by the tenant, or estimates of tenant results, exceed the base amount or other thresholds. The recognition of additional rents requires us to make estimates of amounts owed and, to a certain extent, is dependent on the accuracy of the facility results reported to us. Our estimates may differ from actual results, which could be material to our consolidated financial statements.Resident Fees and ServicesResident fee revenue is recorded when services are rendered and includes resident room and care charges, community fees and other resident charges. Residency agreements are generally for a term of 30 days to one year, with resident fees billed monthly, in advance. Revenue for certain care related services is recognized as services are provided and is billed monthly in arrears.Certain of our CCRCs are operated as entrance fee communities, which typically require a resident to pay an upfront entrance fee that includes both a refundable portion and non-refundable portion. When we receive a nonrefundable entrance fee, it is recognized as deferred revenue and amortized into revenue over the estimated stay of the resident.68Table of ContentsCredit LossesWe continuously assess the collectibility of operating lease straight-line rent receivables. If it is no longer probable that substantially all future minimum lease payments will be received, the straight-line rent receivable balance is written off and recognized as a decrease in revenue in that period. We monitor the liquidity and creditworthiness of our tenants and operators on a continuous basis. This evaluation considers industry and economic conditions, property performance, credit enhancements, and other factors. We exercise judgment in this assessment and consider payment history and current credit status in developing these estimates. These estimates may differ from actual results, which could be material to our consolidated financial statements.Loans receivable and DFLs (collectively, “finance receivables”), are reviewed and assigned an internal rating of Performing, Watch List, or Workout. Finance receivables that are deemed Performing meet all present contractual obligations, and collection and timing of all amounts owed is reasonably assured. Watch List finance receivables are defined as finance receivables that do not meet the definition of Performing or Workout. Workout finance receivables are defined as finance receivables in which we have determined, based on current information and events, that: (i) it is probable we will be unable to collect all amounts due according to the contractual terms of the agreement, (ii) the tenant, operator, or borrower is delinquent on making payments under the contractual terms of the agreement, and (iii) we have commenced action or anticipate pursuing action in the near term to seek recovery of our investment.Finance receivables are placed on nonaccrual status when management determines that the collectibility of contractual amounts is not reasonably assured (the asset will have an internal rating of either Watch List or Workout). Further, we perform a credit analysis to support the tenant’s, operator’s, borrower’s, and/or guarantor’s repayment capacity and the underlying collateral values. We use the cash basis method of accounting for finance receivables placed on nonaccrual status unless one of the following conditions exist whereby we utilize the cost recovery method of accounting: (i) if we determine that it is probable that we will only recover the recorded investment in the finance receivable, net of associated allowances or charge-offs (if any) or (ii) we cannot reasonably estimate the amount of an impaired finance receivable. For cash basis method of accounting we apply payments received, excluding principal paydowns, to interest income so long as that amount does not exceed the amount that would have been earned under the original contractual terms. For cost recovery method of accounting any payment received is applied to reduce the recorded investment. Generally, we return a finance receivable to accrual status when all delinquent payments become current under the terms of the loan or lease agreements and collectibility of the remaining contractual loan or lease payments is reasonably assured.Prior to the adoption of ASU No. 2016-13, Measurement of Credit Losses on Financial Instruments (“ASU 2016-13”) on January 1, 2020, allowances were established for finance receivables on an individual basis utilizing an estimate of probable losses, if they were determined to be impaired. Finance Receivables were impaired when it was deemed probable that we would be unable to collect all amounts due in accordance with the contractual terms of the loan or lease. An allowance was based upon our assessment of the lessee’s or borrower’s overall financial condition, economic resources, payment record, the prospects for support from any financially responsible guarantors and, if appropriate, the net realizable value of any collateral. These estimates considered all available evidence, including the expected future cash flows discounted at the finance receivable’s effective interest rate, fair value of collateral, general economic conditions and trends, historical and industry loss experience, and other relevant factors, as appropriate. If a finance receivable was deemed partially or wholly uncollectible, the uncollectible balance was charged off against the allowance in the period in which the uncollectible determination has been made.Subsequent to adopting ASU 2016-13 on January 1, 2020, we began using a loss model that relies on future expected credit losses, rather than incurred losses, as was required under historical U.S. GAAP. Under the new model, we are required to recognize future credit losses expected to be incurred over the life of a finance receivable at inception of that instrument. The model emphasizes historical experience and future market expectations to determine a loss to be recognized at inception. However, the model continues to be applied on an individual basis and rely on counter-party specific information to ensure the most accurate estimate is recognized.69Table of ContentsReal EstateWe make estimates as part of our process for allocating a purchase price to the various identifiable assets and liabilities of an acquisition based upon the relative fair value of each asset or liability. The most significant components of our allocations are typically buildings as-if-vacant, land, and in-place leases. In the case of allocating fair value to buildings and intangibles, our fair value estimates will affect the amount of depreciation and amortization we record over the estimated useful life of each asset acquired. In the case of allocating fair value to in-place leases, we make our best estimates based on our evaluation of the specific characteristics of each tenant’s lease. Factors considered include estimates of carrying costs during hypothetical expected lease-up periods, market conditions, and costs to execute similar leases. Our assumptions affect the amount of future revenue and/or depreciation and amortization expense that we will recognize over the remaining useful life for the acquired in-place leases.Certain of our acquisitions involve the assumption of contract liabilities. We typically estimate the fair value of contract liabilities by applying a reasonable profit margin to the total discounted estimated future costs associated with servicing the contract. We consider a variety of market and contract-specific conditions when making assumptions that impact the estimated fair value of the contract liability.A variety of costs are incurred in the development and leasing of properties. After determination is made to capitalize a cost, it is allocated to the specific component of a project that is benefited. Determination of when a development project is substantially complete and capitalization must cease involves a degree of judgment. The costs of land and buildings under development include specifically identifiable costs. The capitalized costs include pre-construction costs essential to the development of the property, development costs, construction costs, interest costs, real estate taxes, and other costs incurred during the period of development. We consider a construction project to be considered substantially complete and available for occupancy and cease capitalization of costs upon the completion of the related tenant improvements.Assets Held for Sale and Discontinued OperationsWe classify a real estate property as held for sale when: (i) management has approved the disposal, (ii) the property is available for sale in its present condition, (iii) an active program to locate a buyer has been initiated, (iv) it is probable that the property will be disposed of within one year, (v) the property is being marketed at a reasonable price relative to its fair value, and (vi) it is unlikely that the disposal plan will significantly change or be withdrawn. If an asset is classified as held for sale, it is reported at the lower of its carrying value or fair value less costs to sell and no longer depreciated. We classify a loan receivable as held for sale when we no longer have the intent and ability to hold the loan receivable for the foreseeable future or until maturity. If a loan receivable is classified as held for sale, it is reported at the lower of amortized cost or fair value.A discontinued operation represents: (i) a component of an entity or group of components that has been disposed of or is classified as held for sale in a single transaction and represents a strategic shift that has or will have a major effect on our operations and financial results or (ii) an acquired business that is classified as held for sale on the date of acquisition. Examples of a strategic shift may include disposing of: (i) a separate major line of business, (ii) a separate major geographic area of operations, or (iii) other major parts of the Company.Impairment of Long-Lived AssetsWe assess the carrying value of our real estate assets and related intangibles (“real estate assets”) when events or changes in circumstances indicate that the carrying value may not be recoverable. Recoverability of real estate assets is measured by comparing the carrying amount of the real estate assets to the respective estimated future undiscounted cash flows. The expected future undiscounted cash flows reflect external market factors and are probability-weighted to reflect multiple possible cash-flow scenarios, including selling the assets at various points in the future. Additionally, the estimated future undiscounted cash flows are calculated utilizing the lowest level of identifiable cash flows that are largely independent of the cash flows of other assets and liabilities. In order to review our real estate assets for recoverability, we make assumptions regarding external market conditions (including capitalization rates and growth rates), forecasted cash flows and sales prices, and our intent with respect to holding or disposing of the asset. If our analysis indicates that the carrying value of the real estate assets is not recoverable on an undiscounted cash flow basis, we recognize an impairment charge for the amount by which the carrying value exceeds the fair value of the real estate asset.70Table of ContentsDetermining the fair value of real estate assets, including assets classified as held-for-sale, involves significant judgment and generally utilizes market capitalization rates, comparable market transactions, estimated per-unit or per square foot prices, negotiations with prospective buyers, and forecasted cash flows (lease revenue rates, expense rates, growth rates, etc.). Our ability to accurately predict future operating results and resulting cash flows, and estimate fair values, impacts the timing and recognition of impairments. While we believe our assumptions are reasonable, changes in these assumptions may have a material impact on our consolidated financial statements. Investments in Unconsolidated Joint VenturesThe initial carrying value of investments in unconsolidated joint ventures is based on the amount paid to purchase the joint venture interest, the fair value of assets contributed to the joint venture, or the fair value of the assets prior to the sale of interests in the joint venture. We evaluate our equity method investments for impairment by first reviewing for indicators of impairment based on the performance of the underlying real estate assets held by the joint venture. If an equity-method investment shows indicators of impairment, we compare the fair value of the investment to the carrying value. If we determine there is a decline in the fair value of our investment in an unconsolidated joint venture below its carrying value and it is other-than-temporary, an impairment charge is recorded. The determination of the fair value of investments in unconsolidated joint ventures and as to whether a deficiency in fair value is other-than-temporary involves significant judgment. Our estimates consider all available evidence including, as appropriate, the present value of the expected future cash flows, discounted at market rates, general economic conditions and trends, severity and duration of a fair value deficiency, and other relevant factors. Capitalization rates, discount rates, and credit spreads utilized in our valuation models are based on rates we believe to be within a reasonable range of current market rates for the respective investments. While we believe our assumptions are reasonable, changes in these assumptions may have a material impact on our consolidated financial statements.Income TaxesAs part of the process of preparing our consolidated financial statements, significant management judgment is required to evaluate our compliance with REIT requirements. Our determinations are based on interpretation of tax laws and our conclusions may have an impact on the income tax expense recognized. Adjustments to income tax expense may be required as a result of: (i) audits conducted by federal, state, and local tax authorities, (ii) our ability to qualify as a REIT, (iii) the potential for built-in gain recognition, and (iv) changes in tax laws. Adjustments required in any given period are included within the income tax provision.We are required to evaluate our deferred tax assets for realizability and recognize a valuation allowance, which is recorded against its deferred tax assets, if it is more likely than not that the deferred tax assets will not be realized. We consider all available evidence in its determination of whether a valuation allowance for deferred tax assets is required. Recent Accounting PronouncementsSee Note 2 to the Consolidated Financial Statements for the impact of new accounting standards.ITEM 7A. Quantitative and Qualitative Disclosures About Market RiskWe are exposed to various market risks, including the potential loss arising from adverse changes in interest rates. We use derivative and other financial instruments in the normal course of business to mitigate interest rate risk. We do not use derivative financial instruments for speculative or trading purposes. Derivatives are recorded on the consolidated balance sheets at fair value (see Note 22 to the Consolidated Financial Statements).To illustrate the effect of movements in the interest rate markets, we performed a market sensitivity analysis on our hedging instruments. We applied various basis point spreads to the underlying interest rate curves of the derivative portfolio in order to determine the change in fair value. Assuming a one percentage point change in the underlying interest rate curve, the estimated change in fair value of each of the underlying derivative instruments would not be material. Interest Rate RiskAt December 31, 2020, our exposure to interest rate risk is primarily on our variable rate debt. At December 31, 2020, $36 million of our variable-rate debt was hedged by interest rate swap transactions. The interest rate swaps are designated as cash flow hedges, with the objective of managing the exposure to interest rate risk by converting the interest rates on our variable-rate debt to fixed interest rates.71Table of ContentsInterest rate fluctuations will generally not affect our future earnings or cash flows on our fixed rate debt and assets until their maturity or earlier prepayment and refinancing. If interest rates have risen at the time we seek to refinance our fixed rate debt, whether at maturity or otherwise, our future earnings and cash flows could be adversely affected by additional borrowing costs. Conversely, lower interest rates at the time of refinancing may reduce our overall borrowing costs. However, interest rate changes will affect the fair value of our fixed rate instruments. At December 31, 2020, a one percentage point increase or decrease in interest rates would change the fair value of our fixed rate debt by approximately $369 million and $401 million, respectively, and would not materially impact earnings or cash flows. Additionally, a one percentage point increase or decrease in interest rates would change the fair value of our fixed rate debt investments by approximately $2 million and would not materially impact earnings or cash flows. Conversely, changes in interest rates on variable rate debt and investments would change our future earnings and cash flows, but not materially impact the fair value of those instruments. Assuming a one percentage point change in the interest rate related to our variable-rate debt and variable-rate investments, and assuming no other changes in the outstanding balance at December 31, 2020, our annual interest expense and interest income would increase by approximately $3 million and $1 million, respectively.Market RiskWe have investments in marketable debt securities classified as held-to-maturity because we have the positive intent and ability to hold the securities to maturity. Held-to-maturity securities are recorded at amortized cost and adjusted for the amortization of premiums and discounts through maturity. We consider a variety of factors in evaluating an other-than-temporary decline in value, such as: the length of time and the extent to which the market value has been less than our current adjusted carrying value, the issuer’s financial condition, capital strength and near-term prospects, any recent events specific to that issuer and economic conditions of its industry, and our investment horizon in relationship to an anticipated near-term recovery in the market value, if any. At December 31, 2020, both the fair value and carrying value of marketable debt securities was $20 million.72Table of Contents
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diff --git a/HUNT J B TRANSPORT SERVICES INC_10-K_2021-02-23 00:00:00_728535-0001437749-21-003667.html b/HUNT J B TRANSPORT SERVICES INC_10-K_2021-02-23 00:00:00_728535-0001437749-21-003667.html
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+ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion of our results of operations and financial condition should be read in conjunction with our financial statements and related notes in
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+Item 7.Management’s Discussion and Analysis of Financial Condition and Results of Operations47Introduction47Executive Overview47Discussion of Results of Operations51Risk Management and Capital:56Credit Risk58Market Risk74MSR and Price Risk78Liquidity Risk78Operational Risk83Compliance Risk84Capital84Business Segment Discussion87Results for the Fourth Quarter91Additional Disclosures97Item 7A.Quantitative and Qualitative Disclosures About Market Risk101
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+Item 7.BacklogAs of December 31, 2020 and 2019, our total backlog was approximately $46.0 billion and $46.5 billion, respectively. We expect approximately 17% of backlog at December 31, 2020, to be converted into sales in 2021. Raw Materials The most significant material we use is steel. Other materials we use in large quantities include paint, aluminum, pipe, electrical cable, and fittings. All of these materials are currently available in adequate supply. In connection with our U.S. Government contracts, we are required to procure certain materials and component parts from supply sources approved by the U.S. Government. For long-term contracts, we generally solicit price quotations for many of our material requirements from multiple suppliers to ensure competitive pricing. While we have not generally been dependent upon any one supply source, we currently have only one supplier for certain component parts as a result of consolidation in the defense industry. We believe these single source suppliers, as well as our overall supplier base, are adequate to meet our foreseeable needs. We have mitigated some supply risk by negotiating long-term agreements with certain raw material suppliers. In addition, we have mitigated price risk related to raw material purchases through certain contractual arrangements with customers. Governmental Regulation and SupervisionWe operate in heavily regulated markets and must comply with a variety of laws and regulations relating to the award, administration, and performance of U.S. Government contracts, as well as legal and regulatory requirements affecting cyber security, environmental protection, and our nuclear operations. Government contracting requirements increase our contract performance costs and compliance costs and risks. See Risk Factors in Item 1A.We are overseen and audited by the U.S. Government and its agencies, including the U.S. Navy's Supervisor of Shipbuilding, the Defense Contract Audit Agency ("DCAA"), and the Defense Contract Management Agency ("DCMA"). These agencies evaluate our contract performance, cost structures, and compliance with applicable laws, regulations, and standards, as well as the adequacy of our business systems and processes relative to U.S. Government requirements. Our business systems subject to audit or review include our accounting systems, purchasing systems, government property management systems, estimating systems, earned value management systems, and material management accounting systems. If an audit uncovers improper or illegal activities, we may be subject to administrative, civil, or criminal proceedings, which could result in fines, penalties, repayments, or compensatory, treble, or other damages. Certain U.S. Government findings against a contractor can also lead to suspension or debarment from future U.S. Government contracts or the loss of export privileges. In addition, any costs we incur that are determined to be unallowable or improperly allocated to a specific contract will not be recovered or must be refunded if already reimbursed. The U.S. Government has the ability to decrease or withhold contract payments if it determines significant deficiencies exist in one or more of our business systems. The U.S. Government has, in certain instances, withheld contract payments upon its assessment that deficiencies exist with one or more of our business systems. Although this has not materially impacted the timing of our cash receipts in the past, any such action by the U.S. Government in the future could have a material impact on the timing of our cash receipts.The U.S. Government generally has the ability to terminate contracts, in whole or in part, with little or no prior notice, for convenience or for default based upon performance. In the event of termination of a contract for convenience, a contractor is normally able to recover costs already incurred on the contract and profit on those costs up to the amount authorized under the contract, but not the remaining profit that would have been earned had the contract been completed. Such a termination could also result in the cancellation of future work on the related program. A 5termination resulting from our default could expose us to various liabilities, including excess re-procurement costs, and could have a material effect on our ability to compete for future contracts. Our contracts with the U.S. Government may result in Requests for Equitable Adjustments ("REAs"), which represent requests for the U.S. Government to make appropriate adjustments to contract terms, including pricing, delivery schedule, technical requirements, or other affected terms, due to changes in the original contract requirements and resulting delays and disruption in contract performance for which the U.S. Government is responsible. We submit and negotiate REAs in the ordinary course of business, and large REAs are not uncommon at the conclusion of both new construction and RCOH activities. REAs are not considered claims under the Contract Disputes Act of 1978, although they may be converted to such claims if we cannot reach agreement with the U.S. Government. In cases where there are multiple suppliers, contracts for the construction and conversion of U.S. Navy ships and submarines are generally subject to competitive bidding. In evaluating proposed prices, the U.S. Navy sometimes requires bidders to submit information on pricing, estimated costs of completion, and anticipated profit margins to enable the Navy to assess cost realism. The U.S. Navy uses this information and other data to determine an estimated cost for each bidder. U.S. Government regulations determine contractor costs that are allowable and therefore recoverable from the government, and certain costs are not allowable and therefore are not recoverable. The U.S. Government also regulates the methods by which allowable costs, including overhead, are allocated to government contracts. Our business, including contracts with U.S. Government agencies and subcontracts with other prime contractors, are subject to a variety of laws and regulations, including the Federal Acquisition Regulation ("FAR"), the Defense Federal Acquisition Regulation Supplement ("DFARS"), the Truth in Negotiations Act, the Procurement Integrity Act, the False Claims Act, U.S. Cost Accounting Standards ("CAS"), the International Traffic in Arms Regulations promulgated under the Arms Export Control Act, the Close the Contractor Fraud Loophole Act, and the Foreign Corrupt Practices Act. A noncompliance determination by a government agency may result in reductions in contract values, contract modifications or terminations, penalties, fines, repayments, compensatory, treble, or other damages, or suspension or debarment. We are also subject to evolving cyber security and data privacy and protection laws and regulations, which increase compliance risks and costs and may affect our competitiveness, cause reputational harm, and expose us to substantial fines and other penalties.Environmental ComplianceOur manufacturing operations are subject to federal, state, and local laws and regulations relating to the protection of the environment. We accrue estimated costs to perform environmental remediation when we determine it is probable we will incur expenses in the future, in amounts we can reasonably estimate, to address environmental conditions at currently or formerly owned or leased operating facilities, or at sites where we are named a Potentially Responsible Party ("PRP") by the U.S. Environmental Protection Agency ("EPA") or similarly designated by another environmental agency. The inherent difficulties in estimating future environmental remediation costs, resulting from uncertainties regarding the extent of required remediation, determination of legally responsible parties, and the status of laws and regulations and their interpretations, can cause our estimated remediation costs to change.We assess the potential impact on our financial statements of future environmental remediation costs by estimating, on a site-by-site basis, the range of reasonably possible remediation costs that we could incur, taking into account currently available information at each site, the current state of technology, and our prior experience remediating contaminated sites. We review our estimates periodically and adjust them to reflect changes in facts, technology, and legal circumstances. We record accruals for environmental remediation costs on an undiscounted basis in the accounting period in which it becomes probable we have incurred a liability and the costs can be reasonably estimated. We record related insurance recoveries only when we determine that collection is probable, and we do not include any litigation costs related to environmental matters in our environmental remediation accrual.We either expense or capitalize environmental expenditures as appropriate. Capitalized expenditures relate to long-lived improvements in current operating facilities. We accrue environmental remediation costs at sites involving multiple parties based upon our expected share of liability, taking into account the financial viability of other jointly liable parties. We may incur remediation costs exceeding our accrued amount if other PRPs do not pay their allocable share of remediation costs, which could have a material effect on our business, financial position, results of operations, or cash flows. 6As of December 31, 2020, our probable estimable future costs for environmental remediation were immaterial. In addition, we cannot reasonably estimate remediation costs at certain of our potential environmental remediation sites. Although information gained as remediation progresses may materially affect our accrued liability, we do not anticipate that future remediation expenditures will have a material effect on our financial position, results of operations, or cash flows. We believe we are in material compliance with environmental laws and regulations, and historical environmental compliance costs have not been material to our business. We could be affected by new environmental laws or regulations, including any laws and regulations enacted in response to concerns over climate change, other aspects of the environment, or natural resources. We have made investments we believe are necessary to comply with environmental laws, but we expect to incur future capital and operating costs to comply with current and future environmental laws and regulations. We do not currently believe such costs will have a material effect on our financial position, results of operations, or cash flows. Our nuclear operations are subject to various safety related requirements imposed by the U.S. Navy, the DoE, and the U.S. Nuclear Regulatory Commission. In the event of noncompliance, these agencies may increase regulatory oversight, impose fines, or shut down our operations, depending on their assessment of the severity of the noncompliance. In addition, new or revised security and safety requirements imposed by the U.S. Navy, the DoE, and the Nuclear Regulatory Commission could necessitate substantial capital and other expenditures. Subject to certain requirements and limitations, our contracts with the U.S. Navy and the DoE generally provide for indemnity by the U.S. Government for losses resulting from our nuclear operations. For our commercial nuclear operations, we rely primarily on insurance carried by nuclear facility operators for risk mitigation, and we maintain limited insurance coverage for losses in excess of the coverage of facility operators.CompetitionIn our primary business of designing, building, overhauling, and repairing military ships, we primarily compete with General Dynamics and, in the case of certain shipbuilding programs, smaller shipyards. The smaller shipyards sometimes team with large defense contractors. Intense competition related to programs, resources, funding, and long operating cycles are key characteristics of both our business and the shipbuilding defense industry in general. It is common industry practice to share work on major programs among a number of companies. A company competing to be a prime contractor may, upon ultimate award of the contract to another party, become a subcontractor for the prime contracting party. It is not uncommon to compete for a contract award with a peer company and, simultaneously, serve as a supplier to or a customer of such competitor on other contracts. The nature of major defense programs, conducted under binding long-term contracts, allows companies that perform well to benefit from a level of program continuity not common in many industries.We believe we are well-positioned in our markets. Because we are the only company currently capable of building, refueling, and inactivating the U.S. Navy's nuclear-powered aircraft carriers, we believe we are in a strong competitive position to be awarded each contract to perform such activities. Even so, the government periodically revisits whether refueling of nuclear-powered aircraft carriers should be performed in private or public facilities. If a U.S. Government owned shipyard were to become capable and engaged in the refueling of nuclear-powered aircraft carriers, our market position could be significantly and adversely affected.While we have competed with another large defense contractor to build large deck amphibious ships, we are currently the only builder of large deck amphibious assault ships and expeditionary warfare ships for the U.S. Navy, including LHAs and LPDs. We are also the sole builder of NSCs for the U.S. Coast Guard. We are one of only two companies currently designing and building nuclear-powered submarines for the U.S. Navy, and we are party to long-term teaming agreements with the other company for the production of both Virginia class (SSN 774) fast attack nuclear submarines and Columbia class (SSBN 826) ballistic missile submarines. We are one of only two companies that builds the U.S. Navy's current fleet of Arleigh Burke class (DDG 51) destroyers and are strongly positioned to be awarded future contracts for these types of ships as well. Our success in the shipbuilding defense industry depends upon our ability to develop, market, and produce our products and services at costs consistent with the U.S. Navy's budget, as well as our ability to provide the workforce, technologies, facilities, equipment, and financial capacity needed to deliver those products and services with maximum efficiency.7We compete with a variety of companies in the provision of services to the government and energy markets.Human Capital ResourcesHII recognizes that our employees are our most important assets and serve as the foundation for our ability to achieve financial and strategic objectives. Our employees are critical to driving operational execution, meeting customer expectations, providing strong financial performance, advancing innovation, and maintaining a strong quality and compliance program. Our leaders believe each employee contributes to our success. We have approximately 42,000 employees. We are the largest industrial employer in Virginia and the largest private employer in Mississippi. We employ individuals specializing in 19 crafts and trades, with approximately 6,700 engineers and designers and approximately 2,800 employees with advanced degrees. Our workforce contains many third-, fourth-, and fifth-generation employees, and approximately 1,500 employees with more than 40 years of continuous service. Employees in our shipbuilding segments with more than 40 years of continuous service achieve the honor of “Master Shipbuilder.” As of December 31, 2020, we had 1,281 Master Shipbuilders at Newport News and 226 at Ingalls. We also employ more than 6,500 veterans across the enterprise.In addition, over 1,100 apprentices are enrolled in more than 27 crafts and advanced programs at our two shipbuilding divisions. From nuclear pipe welders to senior executives, we employ approximately 4,400 apprentice school alumni, comprised of 3,100 at Newport News and 1,350 at Ingalls.Approximately 50% of our employees are covered by a total of eight collective bargaining agreements and one site stabilization agreement. Newport News has three collective bargaining agreements covering represented employees, which expire in November 2021, December 2022, and April 2024.The collective bargaining agreement that expires in November 2021 covers approximately 50% of Newport News employees. Newport News craft workers employed at the Kesselring Site near Saratoga Springs, New York are represented under an indefinite DoE site agreement. Ingalls has five collective bargaining agreements covering represented employees, all of which expire in March 2022. Approximately 25 Technical Solutions employees at various locations are represented by unions and perform work under collective bargaining agreements. We have not experienced a work stoppage in more than 21 years at NNS and more than 13 years at Ingalls. We are committed to working effectively with our existing unions and believe our relationship with our represented employees is satisfactory. The success and growth of our business depends in large part on our ability to attract, retain, and develop a skilled and diverse workforce of talented and high-performing employees at all levels of our organization. To succeed in the markets in which we compete for labor, we have developed key workforce development, recruitment, and retention strategies and objectives that we focus on as part of the overall management of our business. These strategies and objectives form the pillars of our human capital management framework and are advanced through the following programs, policies, and initiatives:Competitive Pay and Benefits - Our compensation programs are designed to ensure we have the ability to attract, retain, and motivate employees to achieve our objectives.•We provide employee base wages and salaries that are competitive and consistent with employee positions, skill levels, experience, knowledge, and geographic location.•We utilize nationally recognized surveys and outside compensation and benefits consulting firms to independently evaluate the effectiveness of our employee and executive compensation and benefit programs and to provide benchmarking against our peers within the industry. •The structure of our executive compensation programs balances incentive earnings for both short-term and long-term performance, and we align our executive long-term equity compensation metrics with long-term shareholder interests.•Employees are eligible for health insurance, paid and unpaid leaves, 401(k) plans, and life and disability/accident insurance coverage. We also offer a variety of benefits that allow employees to select the options that meet their needs, including: annual leave/paid time off; paid holidays, flexible work arrangements/schedules; telemedicine; parental leave; transgender medical coverage; and a wellness program that includes physical, mental, and financial wellness components. We also fund the operation of Family Health Centers near our two shipyards, which provide a full range of medical, lab, pharmacy, dental, physical therapy, and vision services.8Recruitment, Training, and Workforce Development - Our three segments hire thousands of employees each year. In 2020, we hired more than 6,000 new employees. To help us meet this large demand for talent, we have worked to create, develop, and maintain multiple talent pipelines. One of the key components of our approach to workforce development is to “grow our own”. We operate two apprentice schools, one at Ingalls and one at Newport News. The Newport News Apprentice School was founded in 1919, and the Ingalls Apprentice School was founded in 1952. The two apprentice schools combined have graduated over 14,000 graduates since their inceptions. The schools are nationally renowned and are critical to training both our craft/trades and technical workforces, as well as developing the future leaders of our company. The Ingalls Apprentice School has partnered with the Mississippi Gulf Coast Community College to permit their apprentices to earn credits toward an associate’s degree. The Newport News Apprentice School has partnered with two community colleges, as well as Old Dominion University, to enable apprentices to earn a bachelor’s degree in Mechanical Engineering, Electrical Engineering, or Modeling & Simulation. In addition to operating our own apprentice schools, we have developed and nurtured multiple partnerships with state and local governments, pre-k education providers, primary/secondary school districts, community colleges, and four-year colleges and universities, as well as post-graduate institutions. We also make significant investments through monetary contributions, leadership time, and employee volunteer hours to support these critical partnerships. We maintain effective partnerships with colleges and universities, military bases for transitioning veterans, and regional community colleges to enable us to recruit and hire engineering, IT, and other technical talent. Working closely with state and local government leaders, we have successfully facilitated local, regional, and state-wide workforce development and education initiatives that include pre-K programs, high school trades programs/talent development labs, pre-hire trades/technical community college programs, interns/co-ops with colleges and universities, adult trades programs, veterans and military spouses training programs, and unemployed/underemployed training programs.We view our workforce development process as a “leadership factory” and have developed a robust and effective succession planning process that ensures continuity in our leadership ranks. Since our founding in 2011, we have followed our succession plans 80% of the time when replacing a vacancy in an existing vice president position, and we have filled 75% of newly created vice president positions with internal hires.Environmental, Health & Safety (“EH&S”) - The health, safety, and well-being of our employees, together with protection of the environment in the communities in which we operate, is one of our core values and rooted in our culture across the enterprise. We prioritize, manage, and carefully track safety performance and integrate sound environmental, safety, and health practices to make a meaningful difference in every facet of our operations, particularly at our shipbuilding segments and at DoE sites on which Technical Solutions segment employees work. Safety goals are included in operational metrics for purposes of the Newport News and Ingalls compensation programs. We also use a wide variety of training courses, pre-job “Take Five” crew talks, medical surveillance programs, and employee involvement efforts to keep our workforce focused on EH&S. At Newport News and Ingalls, a key component of our EH&S program is the utilization of health and safety teams, which are comprised of production and maintenance employees and front-line managers whose goal is to educate, engage, and empower our workforce toward a culture that strives to reduce injury, illness, and environmental impacts. We employ programs focused on identifying, reporting, and abating near misses and other programs that aim to recognize, evaluate, and control hazards.During 2020, we tracked several metrics related to occupational injuries as one of several methods to monitor our safety performance. One of the key metrics is Total Case Rate (“TCR”), which is the number of Occupational Safety and Health Administration ("OSHA") recordable injuries per 100 equivalent employees. The TCR for Newport News was 4.77 in 2020, compared to 4.67 in 2019, and the TCR at Ingalls was 6.35 in 2020, compared to 6.59 in 2019. Newport News also tracks Days Away, Restricted or Transferred (“DART”), which is the number of OSHA recordable cases in which the employee is unable to work, cannot work due to a restriction, or can work with a restriction as a result of an injury per 100 equivalent employees. DART at Newport News was 3.41 in 2020, compared to 3.01 in 2019. Ingalls tracks two other safety metrics: Lost Time Case Rate (“LTCR”), which is the number of employees that lost work time per 100 employees, and Lost Work Day Rate (“LWDR”), which is the number of lost workdays per 9100 full-time employees. The LTCR and LWDR at Ingalls were 2.53 and 56.37, respectively, in 2020 and 2.39 and 56.82, respectively, in 2019. We also track the number of implemented safety improvements year over year. We implemented over 2,300 safety improvements in 2020, compared to more than 1,800 in 2019.In connection with the outbreak of COVID-19, the DoD designated Newport News and Ingalls as critical infrastructure industry. Our production and support workforce therefore continued in-person work at our facilities to provide vital products and services to our government customers, while many of our employees in support and administrative functions have effectively worked remotely since mid-March 2020. Prior to the COVID-19 pandemic, less than 400 of our employees regularly worked remotely, and at our peak, more than 11,300 employees were working remotely.In response to the COVID-19 pandemic and related mitigation measures, we implemented changes in March 2020 to protect our employees and customers and support appropriate health and safety protocols. For example, we began temperature screening and on-site testing for COVID-19 for employees entering our shipyards, implemented extensive cleaning and sanitation processes for our shops, ships, and offices, re-engineered how some work was performed in order to support social distancing requirements, and implemented broad work-from-home initiatives for employees in our support and administrative functions. Corporate Values - We operate on a set of values that are shared with all employees: Integrity, Safety, Respect, Engagement, Responsibility, and Performance. "Always doing the right thing" is an essential belief at HII. That tone starts at the top and permeates through the culture of the company. It is a set of core values, standards, and behaviors that guide employee commitment to the highest ethical standards and serves as the underlying framework for all of our human capital strategies.Advancing and Celebrating Diversity and Inclusion (“D&I”) - We believe we gain a key competitive advantage by building a workforce community that values contributions and perspectives from a variety of backgrounds, skills, and experiences regardless of race, ethnicity, color, religion, sex, disability, nationality, or other differentiation, and our leaders leverage the differences within their teams. We also believe D&I is vital to our ability to grow and innovate in an ever-changing, fast-paced environment. Our diverse and inclusive workplace encourages different perspectives and ideas, which we believe enables better business decisions. The following are highlights of our D&I program:•Employee Resource Groups (“ERGs”) are a key component of our corporate culture and an important part of our diversity and inclusion strategy. We currently sponsor 15 ERG’s, which are employee-led and open to all employees, including: African American Shipbuilders Association, Asian & Pacific Islander Shipbuilding Association, Generational Integration Focus Team, Hispanic Outreach & Leadership Alliance, Women in Shipbuilding Enterprise, Ingalls Shipbuilders Equality Alliance, Shipbuilders Together Realizing Inclusion, Diversity and Equality, and the Veterans Employee Resource Group.•We have established D&I Councils at our Corporate Office and at each of our three segments, which provide strategic direction, guidance, and advocacy for our D&I initiatives and advancements. These councils are led by senior executives and include high-performing employees and leaders from across our enterprise.•We have a long history of participation in a number of annual national diversity conferences, including Black Engineer of the Year Awards, Society of Hispanic Engineers and Professionals, Society of Asian Scientists and Engineers, Society of Women Engineers, Great Minds in STEM, Hispanic Engineers National Achievement Award Conference, Women of Color STEM Conference, and the National Society of Black Engineers Convention. These events provide recruitment, recognition, and development opportunities for our diverse workforce.Employee Engagement - Since 2006, we have conducted an annual anonymous engagement survey of our workforce, both non-represented and represented. Administered and analyzed by an independent third-party, the survey results are reviewed by our executive team and other senior leaders at our three segments. The results of this engagement survey are also shared with individual managers and employees, who are then tasked with discussing the results with their teams and working together to set goals and implement actions to improve employee engagement and performance. Over 79% of our workforce participated in the 2020 engagement survey. We believe that, at the individual employee level, engagement is about taking ownership of your work and work processes. At the enterprise level, engagement is about creating an inclusive and highly collaborative culture where we all care about and encourage each other’s success, and supporting the opportunity to create more value and transform our business for the future.10Available InformationOur Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, and Current Reports on Form 8-K, as well as any amendments to those reports, are available free of charge through our website after we file them with the Securities and Exchange Commission ("SEC"). You can learn more about us by reviewing our SEC filings on the investor relations page on our website at www.huntingtoningalls.com.The SEC also maintains a website at www.sec.gov that contains reports, proxy statements, and other information about SEC registrants, including us. Forward-Looking StatementsStatements in this Annual Report on Form 10-K and in our other filings with the SEC, as well as other statements we may make from time to time, other than statements of historical fact, constitute "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements involve risks and uncertainties that could cause our actual results to differ materially from those expressed in these statements. Factors that may cause such differences include:•Changes in government and customer priorities and requirements (including government budgetary constraints, shifts in defense spending, and changes in customer short-range and long-range plans);•Our ability to estimate our future contract costs and perform our contracts effectively;•Changes in procurement processes and government regulations and our ability to comply with such requirements;•Our ability to deliver our products and services at an affordable life cycle cost and compete within our markets;•Natural and environmental disasters and political instability;•Our ability to execute our strategic plan, including with respect to share repurchases, dividends, capital expenditures, and strategic acquisitions;•Adverse economic conditions in the United States and globally;•Health epidemics, pandemics and similar outbreaks, including the COVID-19 pandemic; •Changes in key estimates and assumptions regarding our pension and retiree health care costs;•Security threats, including cyber security threats, and related disruptions; and•Other risk factors discussed herein and in our other filings with the SEC.There may be other risks and uncertainties that we are unable to predict at this time or that we currently do not expect to have a material adverse effect on our business, and we undertake no obligation to update or revise any forward-looking statements. You should not place undue reliance on any forward looking statements that we may make.11Item 1A. Risk FactorsAn investment in our common stock or debt securities involves risks and uncertainties. We seek to identify, manage, and mitigate risks to our business, but risk and uncertainty cannot be eliminated or necessarily predicted. You should consider the following factors carefully, in addition to the other information contained in this Annual Report on Form 10-K, before deciding to purchase our securities.Industry and Economic Risk FactorsWe depend on the U.S. Government for substantially all of our business, and risks that arise from conducting business with the U.S. Government could have a material adverse effect on our financial position, results of operations, or cash flows.Our business consists primarily of the design, construction, repair, and maintenance of nuclear-powered ships and non-nuclear ships for the U.S. Navy and coastal defense surface ships for the U.S. Coast Guard, as well as the refueling and overhaul and inactivation of nuclear-powered ships for the U.S. Navy. We also provide fleet sustainment services to the U.S. Navy, IT and mission-based solutions for the DoD and intelligence and federal civilian customers, and nuclear management and operations and environmental management services for the DoE and DoD. Substantially all of our revenues in 2020 were derived from products and services sold to the U.S. Government, and we expect this to continue in the foreseeable future. In addition, substantially all of our backlog as of December 31, 2020, was U.S. Government related. Our U.S. Government contracts are subject to various risks, including customer political and budgetary constraints and processes, changes in customer short term and long term strategic plans, the timing of contract awards, significant changes in contract scheduling, intense contract and funding competition, difficulty forecasting costs and schedules for bids on developmental and sophisticated technical work, and contractor suspension or debarment in the event of certain legal or regulatory violations. Any of these factors could affect our business with the U.S. Government, which would have a material adverse effect on our financial position, results of operations, or cash flows.Significant delays or reductions in appropriations for our programs, changes in customer priorities, and potential contract terminations could have a material adverse effect on our financial position, results of operations, or cash flows.We are directly dependent upon Congressional funding of U.S. Navy, U.S. Coast Guard, and other government agency programs. The funding of U.S. Government programs is subject to Congressional budget authorization and appropriation processes. For certain programs, Congress appropriates funds on a fiscal year basis even though a program may be performed over several fiscal years. As a result, a program may be funded initially on a partial basis and receive additional funding only as Congress makes additional appropriations. If we incur costs in excess of existing funding on a contract, we may not recover those costs unless and until additional funds are appropriated. We cannot predict the extent to which total funding or funding for individual programs will be included, increased, or reduced as part of the annual budget process or through continuing resolutions or individual supplemental appropriations.The impact of Congressional actions to reduce the federal debt and resulting pressures on federal spending could adversely affect the total funding of individual contracts or funding for individual programs and delay purchasing or payment decisions by our customers. Long-term uncertainty exists with respect to overall levels of defense spending across the future years' defense plans. It is likely that U.S. Government discretionary spending levels, including defense spending, will continue to be subject to significant pressure. For additional information relating to the U.S. defense budget, see the Business Environment section of Management’s Discussion and Analysis of Financial Condition and Results of Operations in Item 7.Demand for our products and services can also be affected by shifts in customer priorities resulting from changes in military strategy and planning. In response to the need for less expensive alternatives and the increasing proliferation of advanced weapons, future strategy reassessments by the DoD may result in decreased demand for our shipbuilding programs, including our aircraft carrier programs. For the year ended December 31, 2020, our aircraft carrier programs accounted for approximately 33% of our consolidated revenue. We cannot predict the impact of changes to customer priorities on existing, follow-on, replacement, or future programs. A shift of priorities to programs in which we do not participate and related reductions in funding for or the termination of programs in which we do participate could have a material adverse effect on our financial position, results of operations, or cash flows.12 The U.S. Government generally has the ability to terminate contracts, in whole or in part, with little or no prior notice, for convenience or for default based upon performance. In the event of termination of a contract for the U.S. Government's convenience, a contractor is normally able to recover costs already incurred on the contract and profit on those costs up to the amount authorized under the contract, but not the profit that would have been earned had the contract been completed. Such a termination could also result in the cancellation of future work on the related program. A termination resulting from our default can expose us to various liabilities, including excess re-procurement costs, and could negatively affect our ability to compete for future contracts. Any contract termination could have a material adverse effect on our financial condition, results of operations, or cash flows.Changes to Department of Defense business practices could have a material effect on DoD's procurement process and adversely impact our current programs and potential new awards.Our industry has experienced, and we expect will continue to experience, significant changes to business practices resulting from greater focus on affordability, efficiencies, business systems, recovery of costs, and a reprioritization of defense funds to key areas for future defense spending. These initiatives and changes to procurement practices may change the way U.S. Government contracts are solicited, negotiated, and managed, which may affect whether and how we pursue opportunities to provide our products and services to the U.S. Government, including the terms and conditions under which we do so, which may have an adverse impact on our business, financial condition, results of operations, and cash flows. Changes in procurement practices favoring incentive-based fee arrangements, different award fee criteria, non-traditional contract provisions, and government contract negotiation offers that mandate what our costs should be may affect our profitability and predictability of our profit rates. The U.S. Government is also pursuing alternatives to shift additional responsibility and performance risks to the contractor. In addition to the DoD's business practice initiatives, the DCMA and DCAA have implemented cost recovery/cost savings initiatives to prioritize cost recovery/savings. As a result of certain of these initiatives, we have experienced and may continue to experience a higher number of audits and/or lengthened periods of time required to close open audits. Moreover, the thresholds for certain allowable costs, including compensation costs, have been significantly reduced, and the allowability of other types of costs are being challenged, debated, and, in certain cases, modified. Significant changes to the thresholds for allowable costs or the allowability of certain costs could adversely affect our financial position, results of operations, or cash flows.Competition within our markets or an increase in bid protests may reduce our revenues and market share. U.S. defense spending levels are uncertain and difficult to predict. A longer term reduction in shipbuilding activity by the U.S. Navy, evidenced by the reduction in fleet size from 566 ships in 1989 to 296 ships as of December 31, 2020, has resulted in workforce reductions but little infrastructure consolidation. The general result has been fewer contracts awarded to the same fixed number of shipyards. Five major private United States shipyards, two of which we own, plus many other smaller private shipyards compete for contracts to construct, overhaul, repair, and convert naval vessels. Additionally, our products, such as aircraft carriers, submarines, amphibious assault ships, surface combatants, and other ships, compete for funding with each other, as well as with other defense products and services. We expect competition for future shipbuilding programs to be intense.We compete with another large defense contractor for contracts to build surface combatants, submarines, and large deck amphibious ships, and smaller shipyards have entered the market for surface combatants. We may compete in the future with the same contractor and other shipyards to build new and different classes of ships, as well as ships for which we are currently the sole source, including expeditionary warfare and amphibious assault ships. Moreover, reductions in U.S. defense spending that reduce the demand for the types of ships we build and services we provide increase our risk exposure to market competition. If we are unable to continue to compete successfully against our current or future competitors, we may experience lower revenues and market share, which could negatively impact our financial condition, results of operations, or cash flows.Although we are the only company currently capable of refueling nuclear-powered aircraft carriers, two existing U.S. Government-owned shipyards may be able to refuel nuclear-powered aircraft carriers if substantial investments in facilities, personnel, and training were made. U.S. Government-owned shipyards currently engage in the refueling, overhaul, and inactivation of Los Angeles class (SSN 688) submarines and are capable of repairing and overhauling non-nuclear ships. If a U.S. Government-owned shipyard became capable and engaged in the refueling of nuclear-powered aircraft carriers, our financial position, results of operations, or cash flows could be adversely affected.13 We also compete in the shipbuilding engineering, planning, and design market with companies that provide engineering support services. Such competition increases the risk we may not be the successful bidder on future U.S. Navy engineering proposals, including aircraft carrier research and development, submarine design, and surface combatant and amphibious assault ship program contracts. Our competitive environment is also affected by bid protests from unsuccessful bidders on new program awards. As the competitive environment intensifies, the number of bid protests may increase. Bid protests can result in an award decision being overturned, requiring a re-bid of the contract. Even when a bid protest does not result in a re-bid, resolution of the matter typically extends the time until contract performance can begin, which can reduce our earnings in the period in which the contract would otherwise be performed.Changes in estimates used in contract accounting could affect our profitability and our overall financial position. Contract accounting requires judgments relative to assessing risks, estimating contract revenues and costs, and making assumptions regarding schedule and technical issues. The size and nature of many of our contracts make the estimation of total revenues and costs at completion complicated and subject to many variables. For new shipbuilding programs, we estimate, negotiate, and contract for construction of ships that are not completely designed, which subjects our risk assessments, revenue and cost estimates, and assumptions regarding schedule and technical issues to the variability of the final ship design and evolving scope of work. Our judgment, estimation, and assumption processes are significant to our contract accounting, and materially different amounts can result if different assumptions are used or if actual events differ from our assumptions. Future changes in assumptions, circumstances, or estimates may have a material adverse effect on our future financial position, results of operations, or cash flows. See Critical Accounting Policies, Estimates, and Judgments in Item 7.Our debt exposes us to certain risks.As of December 31, 2020, we had $1.7 billion of debt under our senior notes and $1.7 billion of additional borrowing capacity under our primary credit agreement and 364-day credit agreement (the “Credit Facilities”). Our Credit Facilities also allow us to solicit lenders to provide incremental financing capacity in an aggregate amount not to exceed $1 billion, and the indentures governing our senior notes do not limit our incurrence of debt. The amount of our existing debt, combined with our ability to incur significant amounts of debt in the future, could have important consequences, including:•Increasing our vulnerability to adverse economic or industry conditions;•Requiring us to dedicate a portion of our cash flow from operations to payments on our debt, thereby reducing the availability of our cash flow to fund working capital, capital expenditures, strategic initiatives, and general corporate purposes; •Increasing our vulnerability to, and limiting our flexibility in planning for, or reacting to, changes in our business or the industries in which we operate; •Exposing us to the risk of higher interest rates on borrowings under our Credit Facilities and commercial paper program, which are subject to variable rates of interest; •Placing us at a competitive disadvantage compared to our competitors that have less debt; and •Limiting our ability to borrow additional funds. The interest rate on variable rate indebtedness under our Credit Facilities is based upon the London Interbank Offered Rate (“LIBOR”). LIBOR has been the subject of national, international, and other regulatory guidance and proposals for reform. In July 2017, the Chief Executive of the U.K. Financial Conduct Authority (the “FCA”), which regulates LIBOR, announced that the FCA will no longer persuade or compel banks to submit rates for the calculation of the LIBOR benchmark after 2021. It appears likely that LIBOR will be discontinued or modified after 2021. We cannot predict the consequences of the discontinuance of the LIBOR benchmark, but any successor benchmark rate to LIBOR could increase the cost of our variable rate indebtedness.14Business and Operational Risk FactorsCost growth on flexibly priced contracts that does not result in higher contract value due from customers reduces our profit and exposes us to the potential loss of future business.Our operating income is adversely affected when we incur certain contract costs or certain increases in contract costs that cannot be billed to customers. Cost growth can occur if expenses to complete a contract increase due to technical challenges, manufacturing difficulties, delays, workforce-related issues, or inaccurate estimates used for the initial calculation of contract costs. Reasons may include labor unavailability or reduced productivity, the nature and complexity of the work performed, the timeliness and availability of materials, major subcontractor performance or product quality issues, performance delays, availability and timing of funding from the customer, and natural disasters. The process of estimating contract costs requires significant judgment and expertise. A significant increase in contract costs from our original cost estimates on one or more contracts could have a material adverse effect on our financial position, results of operations, or cash flows. Our ability to recover costs and realize profits on contracts with our U.S. Government customers depends upon the type of contract under which we are performing. Our U.S. Government business is currently performed under firm fixed-price, fixed-price incentive, cost-type, and time and material contracts. Under firm fixed price contracts, we agree to perform the specified work for a pre-determined price. To the extent our actual costs vary from the estimates upon which the price was negotiated, we will generate more or less profit or could incur a loss. Some firm fixed-price contracts have a performance-based component under which we may earn incentive payments or incur financial penalties based upon our performance. Fixed-price incentive contracts provide for reimbursement of the contractor’s allowable costs incurred in performance of the contract, subject to a cost-share limit that impacts the profit on the contract. Cost-type contracts provide for the payment of allowable costs incurred during performance of the contract plus a fee up to a ceiling based on the amount that has been funded. Under time and material contracts, we are paid for direct labor hours incurred at specified hourly rates plus material costs. See the Contract section under Management's Discussion and Analysis of Financial Condition and Results of Operations in Item 7 for descriptions of the types of contracts that comprise our business.Approximately 55% of our revenues in 2020 were generated under fixed price incentive contracts, approximately 38% were generated under cost-type contracts, approximately 4% were generated under time and material contracts, and approximately 3% were generated under firm fixed-price contracts. Our failure to perform to customer expectations and contract requirements may result in reduced fees or losses and affect our financial performance. Under each type of contract, if we are unable to control costs, our operating results could be adversely affected, particularly if we are unable to justify an increase in contract value to our customers. Cost overruns or the failure to perform on existing programs also may adversely affect our ability to retain existing programs and win future contract awards. To the extent our mix of contract types changes in the future, our ability to recover our costs and realize profits on our contracts could be negatively affected. Our earnings and profitability depend upon our ability to perform our contracts. When agreeing to contract terms, we make assumptions and projections about future conditions and events, many of which extend over long periods. Our assumptions and projections are based upon our assessments of the productivity and availability of labor, the complexity of the work to be performed, the cost and availability of materials, the impact of delayed performance, the timing of product deliveries, and other matters. We may experience significant variances from our assumptions and projections, contract performance schedule delays, and variances in the timing of our product deliveries. If our actual experience differs significantly from our assumptions or projections or we incur unanticipated contract costs, the profitability of the related contracts may be adversely affected.Our earnings and profitability depend, in part, upon subcontractor performance and raw material and component availability and pricing. We rely on third parties to provide raw materials, major components and sub-systems, hardware elements, and sub-assemblies for our products and to perform certain services we provide to our customers, and to do so in compliance with applicable laws and regulations. Disruptions and performance problems caused by our suppliers and subcontractors, or misalignments between our contractual obligations to our customers and our agreements with our subcontractors and suppliers, could have an adverse effect on our ability to meet our commitments to customers. Our ability to satisfy our obligations on a timely basis could be adversely affected if one or more of our 15suppliers or subcontractors are unable to provide agreed-upon products or materials or perform agreed-upon services in a timely, compliant and cost-effective manner or they otherwise fail to satisfy contractual requirements. The inability of our suppliers or subcontractors to meet expectations could also result in the need for us to transition to alternate parties, which could result in significant incremental cost and delay, or the need for us to provide other supplemental support to our existing suppliers and subcontractors. Our costs to manufacture our products can increase over the terms of our contracts, including as a result of increases in material costs. Although we may be protected from increases in material costs through contract cost escalation provisions, the difference in basis between our actual material costs and industry indices may expose us to cost recovery risk. In addition, significant delays in deliveries of key raw materials, which may occur as a result of availability or pricing, could have a material adverse effect on our financial position, results of operations, or cash flows. In some cases, only one supplier may exist for certain components and parts required to manufacture our products. The inability of a sole source supplier to provide a necessary component or part on a timely, compliant, and cost-effective basis could increase our contract cost and affect our ability to perform our contract.Our procurement practices are intended to provide quality materials and services to support our programs and to reduce the likelihood of our procurement of unauthorized, non-compliant, or deficient materials and services. We rely on our subcontractors and suppliers to comply with applicable laws, regulations, and the expectations set forth in the HII Supplier Code of Conduct in connection with the materials and services we procure. In some circumstances, we rely on representations and certifications from our subcontractors and suppliers regarding their compliance. We also conduct technical assessments, inspections, and audits, as necessary, with subcontractors and suppliers. Notwithstanding the actions we take to mitigate the risk of receiving materials and services that fail to meet specifications or requirements, subcontractors and suppliers sometimes provide us with unauthorized, non-compliant, or deficient materials and services.Our inability to procure, or a significant delay in acquiring, necessary raw materials, components, or parts, the failure of our subcontractors or suppliers to comply with applicable laws and regulations, inaccurate certifications from our subcontractors and suppliers regarding their compliance, or noncompliant materials, components, or parts from our subcontractors and suppliers could have a material adverse effect on our financial position, results of operations, or cash flows.Our future success depends, in part, on our ability to deliver our products and services at an affordable life cycle cost, requiring us to develop and maintain technologies, facilities, equipment, and a qualified workforce to meet the needs of current and future customers.Shipbuilding is a long cycle business, and our success depends on quality, cost, and schedule performance on our contracts. In turn, our performance depends upon our ability to develop and maintain the workforce, technologies, facilities, equipment, and financial capacity to deliver our products and services at an affordable life cycle cost. If we fail to maintain our competitive position in these areas, we could lose future contracts to our competitors, which could have a material adverse effect on our financial position, results of operations, or cash flows.Our operating results are heavily dependent upon our ability to attract and retain at competitive costs a sufficient number of engineers and other employees with the necessary skills and security clearances. At the same time, future revenues and costs impact our ability to maintain a qualified workforce. Development and maintenance of the necessary nuclear related skills and the challenges of hiring and training a qualified workforce can be a limitation on our business. If qualified personnel become scarce, we could experience higher labor, recruiting, or training costs to attract and retain qualified employees, or, if we fail to attract and retain qualified personnel, we could experience difficulties performing our contracts and competing for new contract awards.16Many of our contracts include performance obligations that require innovative design capabilities or state-of-the-art manufacturing expertise, include new technologies, or are dependent upon factors not wholly within our control, and failure to meet performance expectations could adversely affect our profitability and future prospects. We design, develop, and manufacture products and provide services that often involve innovative designs, new technologies, and complex manufacturing processes. Problems and delays with product development, technology implementation, manufacturing, or delivery of subcontractor components or services as a result of issues with design, technology, licensing and intellectual property rights, labor, learning curve assumptions, or materials and parts could prevent us from satisfying contractual requirements. First-in-class ships, also known as lead ships, usually include new technologies supplied by the U.S. Navy or other contractors or developed by us. Problems developing or implementing these new technologies or design changes in the construction process can lead to delays in the design and construction schedule. The risks associated with new technologies or mid-construction design changes can both increase the cost of a ship and delay delivery. Delays in receipt of necessary customer information can also cause inefficiencies in the construction process, increase costs, and put the delivery schedule at risk, which can adversely affect our profitability and future prospects. Our products cannot always be tested and proven and are otherwise subject to unforeseen problems, including premature failure of elements that cannot be accessed for repair or replacement, substandard quality or workmanship, and unexpected degradation of product performance. These failures could result in loss of life or property and could negatively affect our results of operations by causing unanticipated expenses not covered by insurance or customer indemnification, diversion of management attention to respond to unforeseen problems, loss of follow-on work, and, in the case of certain contracts, reimbursement to the customer of contract costs and fee payments previously received. We periodically experience quality issues with respect to products and services that we sell to our U.S. Government customers. These issues can and have required significant resources to determine the source of the deficiencies and implement corrective actions. We may discover quality issues in the future related to our products and services that require analysis and corrective action. Such issues and our responses and corrective actions could have a material adverse effect on our financial position, results of operations, or cash flows.Changes in key estimates and assumptions, such as discount rates and assumed long-term returns on assets, actual investment returns on our pension plan assets, and legislative and regulatory actions could significantly affect our financial position, results of operations, and cash flows. Our pension and retiree health care costs are dependent upon significant judgment regarding various estimates and assumptions, particularly with respect to the discount rate and expected long-term rates of return on plan assets, which to a large extent are reflective of the financial markets and economic conditions. Changes to these estimates and assumptions and differences between expected and actual returns on plan assets could significantly impact our retirement related expense, the funded status of benefit plans, and contributions to our defined benefit pension and other postretirement benefit plans, which could have material adverse effects on our financial position, results of operations, or cash flows. Additionally, pension cost recoveries under CAS for our U.S. Government contracts occur in different periods from those in which pension expense is recognized under accounting principles generally accepted in the United States ("GAAP") or the periods in which we make contributions to our benefit plans, and changes to estimates and assumptions and differences between expected and actual returns could adversely affect the timing of those pension cost recoveries.Our business is subject to disruption caused by natural disasters, environmental disasters, and other events that could have a material adverse effect on our financial position, results of operations, or cash flows. We have significant operations located in regions of the United States that have been and may in the future be exposed to damaging storms, such as hurricanes and floods, and environmental disasters, such as oil spills. Natural disasters can disrupt our workforce, electrical and other power distribution networks, computer and internet operations and accessibility, and critical industrial infrastructure needed for normal business operations, which can adversely affect our contract performance and, as a result, our financial results. Environmental disasters, 17particularly oil spills in waterways and bodies of water we use for transporting and testing our ships, can cause schedule delays under our contracts with the U.S. Navy and the U.S. Coast Guard.Damage and disruption resulting from natural and environmental disasters may be significant. Should insurance or other risk transfer mechanisms be unavailable or insufficient to recover material costs associated with natural or environmental disasters or other events, we could experience a material adverse effect on our financial position, results of operations, or cash flows. See Our insurance coverage may be inadequate to cover all of our significant risks or our insurers may deny coverage of material losses we incur, which could adversely affect our profitability and financial position. Our suppliers and subcontractors are also subject to natural and environmental disasters that could affect their ability to deliver products or services or otherwise perform their contracts. Performance failures by our subcontractors due to natural or environmental disasters may adversely affect our ability to perform our contracts, which could reduce our profitability in the event damages or other costs are not recoverable from the subcontractor, the customer, or insurers. Such events could also result in a termination of the prime contract and have an adverse effect on our ability to compete for future contracts.In addition to the events described above, operation of our facilities may be disrupted by civil unrest, acts of sabotage or terrorism, and other local security issues. Such events may require us to incur greater costs for security or to shut down operations for a period of time.We face various risks related to health epidemics, pandemics and similar outbreaks, which may have material adverse effects on our business, financial position, results of operations and/or cash flows.We face various risks related to health epidemics, pandemics and similar outbreaks, including the global outbreak of COVID-19. Such risks include disruptions or restrictions on our employees’ ability to work or work effectively, as well as temporary closures of our facilities or the facilities of our customers or suppliers. We have experienced higher employee absentee rates as a result of COVID-19, which has impacted our operations and financial results. Higher absentee rates attributable to COVID-19, including because of illness, quarantines, government actions, facility closures, or other restrictions resulting from COVID-19, have impacted and may continue to impact performance on our contracts and have increased and may continue to increase our costs. These impacts may continue, and the cost increases may not be fully recoverable under our contracts or adequately covered by insurance, which could impact our profitability. For example, after our reinsurers failed to acknowledge coverage for various losses related to COVID-19, we filed a complaint in state court in Vermont seeking a judgment declaring that our business interruption and other losses associated with COVID-19 are covered by our property insurance program. Although we believe that our position is well-founded, no assurance can be provided regarding the ultimate resolution of this matter. See Note 15: Investigations, Claims, and Litigation.COVID-19 has also further caused disruption in our supply chain, caused delays in, and limited the ability of, the U.S. Government and other customers to perform, including in making timely decisions on contract awards, impacted investment performance, and caused other unpredictable events. Some or all of these impacts might continue into the future. In addition, COVID-19 has led to disruption and volatility in the global capital markets, which increases the cost of capital and adversely impacts access to capital.COVID-19 has impacted our business and results of operations, and the extent to which COVID-19 will impact our business, results of operations, and financial condition in the future is uncertain and will depend upon future developments. As a result, we cannot predict the full impact of COVID-19, but it could materially affect our business, financial position, results of operations, and/or cash flows in the future.Our business could suffer if we are unsuccessful in negotiating new collective bargaining agreements. Approximately 50% of our employees are covered by a total of eight collective bargaining agreements and one site stabilization agreement. Newport News has three collective bargaining agreements covering represented employees, which expire in November 2021, December 2022, and April 2024. The collective bargaining agreement that expires in November 2021 covers approximately 50% of Newport News employees. Newport News craft workers employed at the Kesselring Site near Saratoga Springs, New York are represented under an indefinite DoE site agreement. Ingalls has five collective bargaining agreements covering represented employees, all of which expire in March 2022. Approximately 25 Technical Solutions employees at various locations are represented by unions and perform work under collective bargaining agreements.18Collective bargaining agreements generally expire after three to five years and are subject to renegotiation at that time. While we believe we maintain good relationships with our represented workers, it is possible we may experience difficulties renegotiating expiring collective bargaining agreements. We have experienced in the past work stoppages, strikes, and other labor disruptions associated with the collective bargaining of new labor agreements. If we experience such events in the future, we could incur additional expenses or work delays that could adversely affect programs served by employees who are covered by collective bargaining agreements.We could be negatively impacted by security threats, including cyber security threats, and related disruptions. As a defense contractor, we rely on our information technology infrastructure to process, transmit, and store electronic information, including classified and other sensitive information of the U.S. Government. While we maintain stringent information security policies and protocols and implement security controls and complementary cyber security technologies in compliance with industry requirements, we face substantial cyber security threats to our information technology infrastructure, including threats to our and the U.S. Government's proprietary and classified information from advanced nation state threat actors, sophisticated cybercrime syndicates, hacktivists, and insiders. While we implement countermeasures to address the risks posed by these threats, external and internal threat actors continuously seek to evade our cyber security countermeasures to gain unauthorized and unlawful access to our information technology infrastructure, assets, and data. Our information technology infrastructure is critical to the efficient operation of our business and essential to our ability to perform day-to-day operations. Breaches of our information technology or physical facilities could cause us to incur significant recovery and restoration expenses; degrade performance on existing contracts; and expose us to reputational damage, potential liability, or the loss of current or future contracts, including work on sensitive or classified systems for the U.S. Government, any of which could have a material adverse effect on our operations, financial position, results of operations, or cash flows.Our suppliers, subcontractors, and other business partners also face cyber security and other security threats. Although we undertake cooperative efforts with our customers, suppliers, subcontractors, and other business partners to assist them with understanding the threats they face and potential cyber security countermeasures to defend against potential cyber-attacks, other security threats, and business disruptions, we rely substantially on the safeguards implemented by these organizations, which may affect the security of our information. These organizations have varying levels of cyber security expertise and safeguards, and their relationships with U.S. Government contractors may increase the likelihood that they are targeted by the same cyber security threats we face.Changes in future business conditions could cause business investments, recorded goodwill, and/or purchased intangible assets to become impaired, resulting in substantial losses and write-downs that would reduce our operating income. As part of our business strategy, we acquire non-controlling and controlling interests in businesses. We make acquisitions and investments following careful analysis and due diligence to achieve a desired return or strategic objective. Business acquisitions involve estimates, assumptions, and judgments to determine acquisition prices, which are allocated among acquired assets, including goodwill, based upon fair market values. Notwithstanding our acquisition and business integration efforts, actual operating results of acquired businesses may vary significantly from expectations. In such events, we may be required to write down our carrying value of the related goodwill and/or purchased intangible assets. In addition, declines in the trading price of our common stock or the market as a whole can result in goodwill and/or purchased intangible asset impairment charges associated with our existing businesses.As of December 31, 2020, goodwill and purchased intangible assets from prior business acquisitions accounted for approximately 20% and 6%, respectively, of our total assets. We evaluate goodwill values for impairment annually, or when evidence of potential impairment exists. We also evaluate the values of purchased intangible assets when evidence of potential impairment exists. The impairment tests are based on several factors requiring judgments. As a general matter, a significant decrease in expected cash flows or changes in market conditions may indicate potential impairment of recorded goodwill or purchased intangible assets. 19Adverse equity market conditions that result in a decline in market multiples and the trading price of our common stock, or other events, such as reductions in future contract awards or significant adverse changes in our operating margins or the operating results of acquired businesses that vary significantly from projected results on which purchase prices are based, could result in an impairment of goodwill or other intangible assets. Any such developments that result in goodwill or intangible asset impairment charges could have a material adverse effect on our financial position or results of operations.Legal and Regulatory Risk FactorsAs a U.S. Government contractor, we are heavily regulated and could be adversely affected by changes in regulations or negative findings from a U.S. Government audit or investigation. As a U.S. Government contractor, we must comply with significant regulatory requirements, including those relating to award, administration, and performance of U.S. Government contracts, as well as legal and regulatory requirements affecting cyber security, environmental protection and our nuclear operations. Government contracting requirements increase our contract performance and compliance costs and risks and change on a routine basis. In addition, our nuclear operations are subject to an enhanced regulatory environment, which results in further performance and compliance requirements and higher costs. New laws, regulations, or procurement requirements, or changes to existing ones (including, for example, regulations related to recovery of compensation costs, cyber security, counterfeit parts, specialty metals, and conflict minerals), can increase our performance and compliance costs and risks and reduce our profitability. We are overseen and audited by the U.S. Government and its various agencies, including the U.S. Navy's Supervisor of Shipbuilding, the DCAA, and the DCMA. These agencies evaluate our contract performance, cost structures, and compliance with applicable laws, regulations, and standards, as well as the adequacy of our business systems and processes relative to U.S. Government requirements. If an audit uncovers improper or illegal activities, we may be subject to administrative, civil, or criminal proceedings, which could result in fines, penalties, repayments, or compensatory, treble, or other damages. Certain U.S. Government findings against a contractor can also lead to suspension or debarment from future U.S. Government contracts or the loss of export privileges. Allegations of impropriety can also cause significant reputational damage.The U.S. Government also has the ability to decrease or withhold contract payments if it determines significant deficiencies exist in one or more of our business systems. The U.S. Government has, in certain instances, withheld contract payments upon its assessment that deficiencies exist with one or more of our business systems, which can have a material impact on the timing of our cash receipts.The U.S. Government has, from time to time, recommended that certain of our contract prices be reduced, or that certain costs allocated to our contracts be disallowed, which sometimes involve substantial dollar amounts. In response to U.S. Government audits, investigations, and inquiries, we have also in the past made adjustments to our contract prices and costs allocated to our government contracts. Such audits, investigations, and inquiries may result in future reductions of our contract prices. Costs we incur that are determined to be unallowable or improperly allocated to a specific contract will not be recovered or must be refunded if previously reimbursed. We must comply with a variety of federal laws and regulations, including the FAR, the DFARS, the Truth in Negotiations Act, the False Claims Act, the Procurement Integrity Act, the International Traffic in Arms Regulations promulgated under the Arms Export Control Act, the Close the Contractor Fraud Loophole Act, the Foreign Corrupt Practices Act, and CAS. If a determination is made that we engaged in illegal activities or we are not presently responsible, as defined under the FAR, we may be subject to reductions in contract values, contract modifications or terminations, penalties, fines, repayments, compensatory, treble, or other damages, or suspension or debarment, any of which could have a material adverse effect on our financial position, results of operations, or cash flows. In addition, cyber security and data privacy and protection laws and regulations are evolving and present increasing compliance challenges, which increase our costs and may affect our competitiveness, cause reputational harm, and expose us to substantial fines or other penalties.20Unforeseen environmental costs could have a material adverse effect on our financial position, results of operations, or cash flows. Our operations are subject to and affected by federal, state, and local environmental protection laws and regulations. In addition, we could be affected by future laws or regulations, including those imposed in response to concerns over climate change, other aspects of the environment, or natural resources. We expect to incur future capital and operating costs to comply with current and future environmental laws and regulations, and such costs could be substantial, depending on the future proliferation of environmental rules and regulations and the extent to which we discover currently unknown environmental conditions. Shipbuilding operations require the use of hazardous materials. Our shipyards also generate significant quantities of wastewater, which we treat before discharging in accordance with applicable permits. To manage these materials, our shipyards have an extensive network of above ground and underground storage tanks, some of which have leaked and required remediation in the past. In addition, our handling of hazardous materials has sometimes resulted in spills in our shipyards and occasionally in adjacent rivers and waterways in which we operate. Various federal, state, and local environmental laws and regulations impose restrictions on the discharge of pollutants into the environment and establish standards for the transportation, storage, and disposal of toxic and hazardous wastes. Substantial fines, penalties, and criminal sanctions may be imposed for noncompliance, and certain environmental laws impose joint and several "strict liability" for remediation of spills and releases of oil and hazardous substances. Such laws and regulations impose liability upon a party for environmental cleanup and remediation costs and damage without regard to negligence or fault on the part of such party and could expose us to liability for the conduct of or conditions caused by third parties. In addition to fines, penalties, and criminal sanctions, environmental laws and regulations may require the installation of costly pollution control equipment or operational changes to limit pollution emissions or discharges and/or to decrease the likelihood of accidental hazardous material releases. We anticipate incurring future costs to comply with federal and state environmental laws and regulations related to the cleanup of pollutants released into the environment. Moreover, if we violate the Clean Air Act or the Clean Water Act, the facility or facilities involved in the violation could be placed by the EPA on the "Excluded Parties List" maintained by the General Services Administration, which would continue until the EPA concluded the cause of the violation was cured. Facilities on the "Excluded Parties List" are prohibited from working on any U.S. Government contract. The adoption of new environmental laws and regulations, stricter enforcement of existing laws and regulations, imposition of new cleanup requirements, discovery of previously unknown or more extensive contamination, litigation involving environmental matters, our inability to recover related costs under our government contracts, or the financial insolvency of other responsible parties could cause us to incur costs that could have a material adverse effect on our financial position, results of operations, or cash flows.Our reputation and our ability to conduct business may be impacted by the improper conduct of employees, agents, or business partners. Our compliance program includes detailed compliance plans and related compliance controls, policies, procedures, and training designed to prevent and detect misconduct by employees, agents, business partners, and others working on our behalf, including suppliers and subcontractors, that would violate the laws of the jurisdictions in which we operate, including laws governing payments to government officials, the protection of export controlled or classified information, cost accounting and billing, competition, and data privacy. We have been impacted in the past by the misconduct of employees and business partners, and we may not prevent all such misconduct in the future by our employees, agents, business partners, and others working on our behalf, including suppliers and subcontractors. Moreover, the risk of improper conduct may be expected to increase as we expand our operations into foreign jurisdictions. Any improper actions by our employees, agents, business partners, and others working on our behalf, including suppliers and subcontractors, could subject us to administrative, civil, or criminal investigations and monetary and non-monetary penalties, including suspension or debarment, which could have a material adverse effect on our financial position, results of operations, or cash flows. Any such improper actions could also cause us significant reputational damage.21Our nuclear operations subject us to environmental, regulatory, financial, and other risks. The design, construction, refueling and overhaul, repair, and inactivation of nuclear-powered aircraft carriers and nuclear-powered submarines, our nuclear facilities used to support such activities, our nuclear operations at DoE sites, and our activities in the commercial nuclear market subject us to various risks, including:•Potential liabilities relating to harmful effects on the environment and human health resulting from nuclear operations and the storage, handling, and disposal of radioactive materials, including nuclear assemblies and their components;•Unplanned expenditures relating to maintenance, operations, security, and repairs, including repairs required by the U.S. Navy, the Nuclear Regulatory Commission, or the DoE;•Reputational damage;•Potential liabilities arising out of a nuclear incident whether or not it is within our control; and•Regulatory noncompliance and loss of authorizations or indemnifications necessary for our operations.Failure to properly store, handle and dispose of nuclear materials could pose a health risk to humans and wildlife and could cause personal injury and property damage, including environmental contamination. If a nuclear accident were to occur, its severity could be significantly affected by the volume of the materials and the speed of remedial actions taken by us and emergency response personnel, as well as other factors beyond our control, such as weather and wind conditions. Actions we might take in response to an accident could result in significant costs.Our nuclear operations are subject to various safety related requirements imposed by the U.S. Navy, the DoE, and the Nuclear Regulatory Commission. In the event of noncompliance, these agencies may increase regulatory oversight, impose fines, or shut down our operations, depending on their assessment of the severity of the noncompliance. In addition, new or revised security and safety requirements imposed by the U.S. Navy, DoE, and Nuclear Regulatory Commission could require substantial capital and other expenditures. Subject to certain requirements and limitations, our contracts with the U.S. Navy and DoE generally provide for indemnity by the U.S. Government for costs arising out of or resulting from our nuclear operations. We may not, however, be indemnified for all liabilities we may incur in connection with our nuclear operations. To mitigate risks related to our commercial nuclear operations, we rely primarily on insurance carried by nuclear facility operators and our own limited insurance for losses in excess of the coverage of facility operators. Such insurance, however, may not be sufficient to cover our costs in the event of an accident or business interruption relating to our commercial nuclear operations, which could have a material adverse effect on our financial position, results of operations, or cash flows.We are subject to claims and litigation that could ultimately be resolved against us, requiring future material cash payments and/or future material charges against our operating income, materially impairing our financial position or cash flows. The size, nature, and complexity of our business make it highly susceptible to claims and litigation. We are subject to various administrative, civil, and criminal litigation, environmental claims, income tax proceedings, compliance proceedings, customer claims, and investigations, which could divert financial and management resources and result in fines, penalties, compensatory, treble or other damages, or nonmonetary sanctions. Government regulations also provide that certain allegations against a contractor may lead to suspension or debarment from government contracts or suspension of export privileges. Suspension or debarment could have a material adverse effect on us because of our reliance on government contracts and authorizations. Litigation, claims, or investigations, if ultimately resolved against us, could have a material adverse effect on our financial position, results of operations, or cash flows. Any litigation, claim, or investigation, even if fully indemnified or insured, could negatively impact our reputation among our customers and the public and make it more difficult for us to compete effectively or acquire adequate insurance in the future. 22We may be unable to adequately protect our intellectual property rights, which could affect our ability to compete. We own patents, trademarks, copyrights, and other forms of intellectual property related to our business, and we license intellectual property rights to and from third parties. The U.S. Government generally receives non-exclusive licenses to certain intellectual property we develop in the performance of U.S. Government contracts, and the U.S. Government may use or authorize others to use such intellectual property. The U.S. Government is taking increasingly aggressive positions both as to the intellectual property to which they believe government use rights apply and to the acquisition of broad license rights. If the U.S. Government is successful in these efforts, our intellectual property on which we depend to compete and our access to and use of certain supplier intellectual property could be negatively affected. We also rely upon proprietary technology, information, processes, and know-how that are not protected by patents. We seek to protect this information through trade secret or confidentiality agreements with our employees, consultants, subcontractors, and other parties, as well as through other measures. These agreements and other measures may not, however, adequately protect the trade secrets on which we depend to compete.Our intellectual property is also subject to challenge, invalidation, misappropriation, or circumvention by third parties. In the event of infringement of our intellectual property rights, breach of a confidentiality agreement, or unauthorized disclosure of proprietary information, we may not have adequate legal remedies to protect our intellectual property. Litigation to determine the scope of our rights, even if successful, could be costly and a diversion of management's attention from other aspects of our business. In addition, trade secrets may otherwise become known or be independently developed by competitors. If we are unable adequately to protect our intellectual property rights, our business could be adversely affected. We have the right to use certain intellectual property licensed to us by third parties. In instances where third parties have licensed to us the right to use their intellectual property, we may be unable in the future to secure the necessary licenses to use such intellectual property on commercially reasonable terms.Anti-takeover provisions in our organizational documents and Delaware law, as well as regulatory requirements, could delay or prevent a change in control. Certain provisions of our Restated Certificate of Incorporation and Restated Bylaws may delay or prevent a merger or acquisition that stockholders may consider favorable. For example, our Restated Certificate of Incorporation and Restated Bylaws currently require advance notice for stockholder proposals and director nominations, and authorize our board of directors to issue one or more series of preferred stock. These provisions may discourage acquisition proposals or delay or prevent a change in control, which could reduce our stock price. Delaware law also imposes restrictions on mergers and other business combinations between any holder of 15% or more of our outstanding common stock and us. Our nuclear shipbuilding operations are considered vitally important to the U.S. Navy. As a result, our Navy contracts include provisions regarding notice and approval rights for the Navy in the event of a change of control of our nuclear shipbuilding operations and regarding the Navy's obligations to indemnify us for losses relating to our nuclear operations for the Navy. Such provisions require us to provide the U.S. Navy with notice of any potential change of control of our nuclear shipbuilding operations and obtain the Navy's consent for transferring certain related licenses to facilitate the Navy's ability to ensure that a potential buyer would continue to conduct our operations in a satisfactory manner. Provisions of our Restated Certificate of Incorporation and our Restated Bylaws and our existing contracts with the U.S. Navy may have the effect of discouraging, delaying, or preventing a change of control of our company that may be beneficial to our stockholders.General Risk FactorsOur insurance coverage may be inadequate to cover all of our significant risks or our insurers may deny coverage of material losses we incur, which could adversely affect our profitability and financial position. We seek to insure our significant risks and potential liabilities that are insurable, including, among others, property loss from natural disasters, product liability, and business interruption resulting from an insured property loss. In 23some circumstances, we may be indemnified for losses by the U.S. Government, subject to the availability of appropriated funds. Not every risk or liability can be protected by insurance, and, for insurable risks, the limits of coverage we can reasonably purchase may not be sufficient to cover the full amount of actual losses or liabilities incurred, including, for example, in the case of a catastrophic hurricane. In addition, the nature of our business can make it difficult to quantify the disruptive impact and loss resulting from such events. Limitations on the availability of insurance coverage may result in us incurring substantial costs for uninsured losses, which could have a material adverse effect on our financial position, results of operations, or cash flows. Even in cases for which we have insurance coverage, disputes with insurance carriers over coverage may affect the timing of cash flows, and, in the event of litigation with an insurance carrier, an outcome unfavorable to us may have a material adverse effect on our financial position, results of operations, or cash flows.Market volatility and adverse capital market conditions may affect our ability to access cost-effective sources of funding and may expose us to risks associated with the financial viability of suppliers and subcontractors.The financial markets can experience high levels of volatility and disruption, reducing the availability of credit for certain issuers. We access these markets from time to time to support certain business activities, including funding acquisitions and capital expansion projects and refinancing existing indebtedness. We may also access these markets to acquire credit support for our workers' compensation self-insurance program and letters of credit. A number of factors could cause us to incur higher borrowing costs and experience greater difficulty accessing public and private markets for debt, including disruptions or declines in the global capital markets and/or a decline in our financial performance, outlook, or credit ratings. The occurrence of any or all of these events may adversely affect our ability to fund our operations, meet contractual commitments, make future investments or desirable acquisitions, or respond to competitive challenges. Tightening capital markets could also adversely affect the ability of our suppliers and subcontractors to obtain financing. Delays in the ability of our suppliers or subcontractors to obtain financing, or the unavailability of financing, could negatively affect their ability to perform their contracts with us and, as a result, our ability to perform our contracts. The inability of our suppliers and subcontractors to obtain financing could also result in the need for us to transition to alternate suppliers and subcontractors, which could result in us incurring significant incremental costs and delays.Strategic acquisitions and investments involve risks and uncertainties.As part of our business strategy, we identify and evaluate potential acquisitions and investments. When evaluating such transactions, we make significant judgments regarding the values of business opportunities, technologies, and other assets, the risks and costs of potential liabilities, and the future prospects of strategic acquisitions. Acquisitions and investments also involve other risks and uncertainties, including the integration of acquired businesses, challenges achieving strategic objectives and other benefits anticipated from acquisitions or investments, the diversion of management attention and resources from our existing operations and other initiatives, the potential impairment of acquired assets, and the potential loss of key employees of acquired businesses. Our financial results, business, and future prospects could be adversely affected by unanticipated performance issues at acquired businesses, transaction-related charges, unexpected liabilities, amortization of expenses related to purchased intangible assets, and impairment charges on goodwill and purchased intangible assets.There can be no assurance we will continue to increase our dividends or to repurchase shares of our common stock at current levels.The payment of cash dividends and repurchases of our common stock are subject to limitations under applicable law and the discretion of our board of directors, considered in the context of then current conditions, including our earnings, other operating results, and capital requirements. Declines in asset values or increases in liabilities, including liabilities associated with benefit plans and assets and liabilities associated with taxes, can reduce stockholders’ equity. A deficit in stockholders’ equity could limit our ability under Delaware law to pay dividends and repurchase shares in the future. In addition, the timing and amount of share repurchases under board approved share repurchase programs are within the discretion of management and depend upon many factors, including our share price, results of operations, capital requirements, and general business conditions, as well as applicable law.24ITEM 1B. UNRESOLVED STAFF COMMENTSThere were no unresolved staff comments.ITEM 2. PROPERTIESOur principal properties are located in Huntsville, Alabama; Pascagoula, Mississippi; Fairfax, Hampton, Newport News, Suffolk, and Virginia Beach, Virginia; and Washington, D.C. Ingalls - The primary properties comprising our Ingalls operating segment are located in Pascagoula, Mississippi.Our Pascagoula shipyard is a primary builder of major surface warships for the U.S. Navy and has modernized dozens of other naval ships. It is the only U.S. shipyard in recent years to develop and build six different classes of ships for the U.S. Navy and U.S. Coast Guard. Our facilities in Pascagoula are located on approximately 800 acres on the banks of the Pascagoula River where it flows into the Mississippi Sound. We lease the west bank of our Pascagoula shipyard from the State of Mississippi pursuant to a 99-year lease, consisting of a 40-year base term plus six optional terms. We anticipate continued use of this facility for the remaining 46 years of the lease and beyond.Newport News - The primary properties comprising our Newport News operating segment are located in Newport News, Virginia. Our Newport News facilities are located on approximately 550 acres we own near the mouth of the James River, which adjoins the Chesapeake Bay, the premier deep-water harbor on the east coast of the United States. Our Newport News shipyard is one of the largest in the United States. It is the sole designer, builder, and refueler of nuclear-powered aircraft carriers and one of only two shipyards capable of designing and building nuclear-powered submarines for the U.S. Navy. The shipyard also provides services for naval and commercial vessels. Our Newport News shipyard includes seven graving docks, a floating dry dock, two outfitting berths, five outfitting piers, and various other shops. It also has a variety of other facilities, including an 18-acre all-weather steel fabrication shop, accessible by both rail and transporter, module outfitting facilities that enable us to assemble a ship's basic structural modules indoors and on land, machine shops totaling 300,000 square feet, and an apprentice school, which provides a four-year accredited apprenticeship program to train shipbuilders.Technical Solutions - The properties comprising our Technical Solutions operating segment are located throughout the United States. Our properties located in Fairfax and Virginia Beach, Virginia; Huntsville, Alabama; Orlando, Florida; San Antonio, Texas; Aberdeen and Annapolis Junction, Maryland; Bremerton, Washington; and Honolulu, Hawaii, primarily provide DFS services. Properties located in Pocasset, Massachusetts; Mayport and Panama City, Florida; and Hampton and Virginia Beach, Virginia, primarily provide unmanned systems. Properties located in Newport News, Virginia primarily provide nuclear and environmental services.We believe our physical facilities and equipment are generally well maintained, in good operating condition, and satisfactory for our current needs. We have undertaken substantial capital expenditure programs at our Ingalls and Newport News segments intended to increase our competitiveness and enable us to meet future obligations under our growing shipbuilding program backlog.ITEM 3. LEGAL PROCEEDINGSFor information regarding legal proceedings, see Note 15: Investigations, Claims and Litigation in
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+Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations—Key Business and Financial Metrics Used by Management" for additional information on these financial metrics. COVID-19 PandemicDuring the year ended December 31, 2020, the COVID-19 pandemic significantly impacted the global economy and strained the hospitality industry due to travel restrictions and stay-at-home directives in place at various times during the period, resulting in cancellations and significantly reduced travel around the world. The reduction in travel resulted in the complete and partial suspensions of hotel operations in many of the areas where our hotels are located. As such, it had a material adverse impact on our results for the year ended December 31, 2020. See "Part I—Item 1A. Risk Factors—Risks Related to the COVID-19 Pandemic" and "Part II—Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations" for additional information.Social MediaWe use our website at newsroom.hilton.com, our Facebook page at facebook.com/hiltonnewsroom and our corporate Twitter account at twitter.com/hiltonnewsroom as channels of distribution of company information. The information we post through these channels may be deemed material. Accordingly, investors should monitor these channels, in addition to following our press releases, our filings with the U.S. Securities and Exchange Commission (the "SEC") and our webcasts. The contents of our website and social media channels are not, however, part of this report.Item 1. BusinessOverviewHilton is one of the largest hospitality companies in the world, with 6,478 properties comprising 1,019,287 rooms in 119 countries and territories as of December 31, 2020. Founded in 1919, Hilton has been an innovator in the industry for more than 100 years, driven by the vision of our founder Conrad Hilton, "to fill the earth with the light and warmth of hospitality." Our premier brand portfolio includes: our luxury and lifestyle hotel brands, Waldorf Astoria Hotels & Resorts, LXR Hotels & Resorts, Conrad Hotels & Resorts, Canopy by Hilton, Tempo by Hilton and Motto by Hilton; our full service hotel brands, Signia by Hilton, Hilton Hotels & Resorts, Curio Collection by Hilton, DoubleTree by Hilton, Tapestry Collection by Hilton and Embassy Suites by Hilton; our focused service hotel brands, Hilton Garden Inn, Hampton by Hilton, Tru by Hilton, Homewood Suites by Hilton and Home2 Suites by Hilton; and our timeshare brand, Hilton Grand Vacations. As of December 31, 2020, we had more than 112 million members in our award-winning guest loyalty program, Hilton Honors.We operate our business through: (i) a management and franchise segment and (ii) an ownership segment, each of which is managed separately because of its distinct economic characteristics. The management and franchise segment includes all of the hotels we manage for third-party owners, as well as all franchised hotels that license our brands and where we provide other prescribed services to third-party owners, but the day-to-day services of the hotels are operated or managed by someone other than us. The management and franchise segment generates its revenue from: (i) management and franchise fees charged to 3third-party hotel owners; (ii) licensing fees from HGV's 56 resorts, consisting of 9,030 rooms, and strategic partnerships, including co-branded credit card arrangements, for the right to use certain Hilton marks and intellectual property ("IP"); and (iii) fees for managing our owned and leased hotels. As of December 31, 2020, this segment included 715 managed hotels and 5,646 franchised hotels consisting of 990,857 total rooms. As of December 31, 2020, the ownership segment included 61 hotels totaling 19,400 rooms, comprising 53 hotels that we wholly owned or leased, one hotel owned by a consolidated non-wholly owned entity, two hotels leased by consolidated variable interest entities ("VIEs") and five hotels owned or leased by unconsolidated affiliates. For more information regarding our segments, see "Part II—Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations—Segment Results" and Note 18: "Business Segments" in "Part II—
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+Item 7.Management's Discussion and Analysis of Financial Condition and Results of Operations:Results of operationsPages 4-5, 17-41, 48-49Liquidity Pages 4-5, 42-44, 48-49Capital resourcesPages 42-44Off balance sheet arrangements (a)Contractual obligationsPage 45Critical accounting estimates and policiesPages 52, 79-84Item 7A.Quantitative and Qualitative Disclosures About Market RiskPages 46-47
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+Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations:Refer to pages 18 through 64 of IBM’s 2020 Annual Report to Stockholders, which are incorporated herein by reference.​Item 7A. Quantitative and Qualitative Disclosures About Market Risk:Refer to the section titled “Market Risk” on pages 63 and 64 of IBM’s 2020 Annual Report to Stockholders, which is incorporated herein by reference.​12 Table of Contents
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+Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.Fiscal Year Ended December 31, 2020(DOLLARS IN THOUSANDS EXCEPT PER SHARE AMOUNTS)First QuarterSecond QuarterThird QuarterFourth QuarterTotal YearNet Sales$1,347,317 $1,198,773 $1,268,076 $1,270,073 $5,084,239 Gross Profit*565,867 481,842 524,427 513,730 2,085,866 Income before taxes153,508 103,065 105,500 79,298 441,371 Net income127,211 87,366 86,231 66,564 367,372 Net income attributable to IFF stockholders*124,607 86,204 84,828 67,589 363,228 Net income per share — basic*1.16 0.75 0.76 0.57 3.25 Net income per share — diluted*1.15 0.74 0.75 0.57 3.21 Fiscal Year Ended December 31, 2019(DOLLARS IN THOUSANDS EXCEPT PER SHARE AMOUNTS)First QuarterSecond QuarterThird QuarterFourth QuarterTotal YearNet Sales$1,297,402 $1,291,568 $1,267,345 $1,283,769 $5,140,084 Gross Profit*531,259 546,239 533,088 502,162 2,112,748 Income before taxes134,576 169,481 156,866 96,529 557,452 Net income111,214 138,869 129,807 80,378 460,268 Net income attributable to IFF stockholders*108,829 136,377 127,124 83,543 455,873 Net income per share — basic*0.97 1.21 1.15 0.71 4.05 Net income per share — diluted*0.96 1.20 1.13 0.70 4.00 _______________________*The key variances quarter-over-quarter relate to the volume of restructuring, acquisition and integration related charges which are included in the total of Non-GAAP adjustments. Refer to the Non-GAAP reconciliation in Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations for additional information. 35ITEM 7.MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.(UNLESS INDICATED OTHERWISE, DOLLARS IN MILLIONS EXCEPT PER SHARE AMOUNTS) OverviewCompany BackgroundWe are a leading innovator of sensory, food & beverage, pharmaceutical, health & wellness, home & personal care integrated solutions and ingredients that move the world. Our creative capabilities, global footprint, regulatory and technological know-how provide us a competitive advantage in meeting the demands of our global, regional and local customers around the world.Beginning in the first quarter of fiscal year 2020, we operated our business across two segments: Taste and Scent. Following the recent closing of the N&B Transaction, our business is organized in four business segments: Nourish, Scent, Health & Biosciences and Pharma Solutions.As a leading creator of flavor offerings, we help our customers deliver on the promise of delicious and healthy foods and drinks that appeal to consumers. While we are a global leader, our Taste business operates regionally in nature, with different formulas that reflect local taste preferences. Consequently, we manage our Taste business geographically, creating products in our regional creative centers which allows us to satisfy local taste preferences, while also helping to ensure regulatory compliance and production standards.Our global Scent business creates fragrance compounds and fragrance ingredients that are integral elements in the world’s finest perfumes and best-known household and personal care products. We believe our unique portfolio of natural and synthetic ingredients, global footprint, innovative technologies and know-how, deep consumer insight and customer intimacy make us a market leader in scent products.Impact of COVID-19 PandemicOn March 11, 2020, the World Health Organization designated COVID-19 as a global pandemic. Various policies and initiatives have been implemented around the world to reduce the global transmission of COVID-19, including the closure of non-essential businesses, reduced travel, the closure of retail establishments, the promotion of social distancing and remote working policies where appropriate. IFF has been designated an essential business in most locations given that both its Taste and Scent products are used in the manufacture of food products as well as the manufacture of a range of cleaning and hygiene products. Accordingly, although there continue to be minor disruptions, all of IFF’s manufacturing facilities remain open and continue to manufacture products.The COVID-19 pandemic remains a serious threat to the health of the world's population and certain countries and regions continue to suffer from outbreaks or have seen a recurrence of infections. Accordingly, the Company continues to take the threat from COVID-19 seriously even as the adverse financial impact of COVID-19 on the Company has lessened.For 2020, revenue was largely flat but this overall performance reflected strength in Consumer Fragrances, offset by declines in Fine Fragrances and most Taste categories, especially those in the food service area. The impact that COVID-19 will have on our consolidated results of operations in 2021 remains uncertain. Based on the length and severity of COVID-19, we experience continued volatility as a result of retail and travel, consumer shopping and consumption behavior. We will continue to evaluate the nature and extent of these potential impacts to our business, consolidated results of operations, segment results, liquidity and capital resources.Although IFF does not currently anticipate any impairment charges related to COVID-19, the continuing effects of a prolonged pandemic could result in increased risk of asset write-downs and impairments, including, but not limited to, equity investments, goodwill and intangibles. Any of these events could potentially result in a material adverse impact on IFF’s business and results of operations.Transaction with Nutrition & Biosciences, Inc.On February 1, 2021, pursuant to the Merger Agreement with DuPont, a wholly owned subsidiary of IFF merged with and into the N&B Business. The shares issued in the Merger represented approximately 55.4% of the common stock of IFF on a fully diluted basis, after giving effect to the Merger, as of February 1, 2021. The N&B Business is an innovation-driven and customer-focused business that provides solutions for the global food and beverage, dietary supplements, home and personal care, energy, animal nutrition and pharma markets. The transaction was made in order to strengthen IFF's customer base and market presence, with an enhanced position in the food & beverage, home & personal care and health & wellness markets. See Note 3 to the Consolidated Financial Statements for additional information relating to the N&B Transaction. 362020 Financial Performance OverviewFor a reconciliation between reported and adjusted figures, please refer to the "Non-GAAP Financial Measures" section.SalesSales in 2020 decreased 1% on a reported basis and were flat on a currency neutral basis (which excludes the effects of changes in currency by restating exchange ratios in effect for the current year based on the currency of the underlying transaction). Scent sales increased 2% on a reported basis and 3% on a currency neutral basis. Taste sales decreased 3% on a reported basis and 2% on a currency neutral basis. The change in consolidated reported and currency neutral sales was driven by strength in Consumer Fragrances and a slight increase in Fragrance Ingredients, offset by volume reductions in most Taste product categories and Fine Fragrances. The year-on-year declines in sales of many product categories was partially due to travel and shelter-in-place restrictions, in certain regions, as a result of COVID-19. The additional week of sales, or a 53rd week, in 2019 also contributed to the year-on-year decline in sales.Exchange rate variations had an unfavorable impact on net sales for 2020 of approximately 1%. The effect of exchange rates can vary by business and region, depending upon the mix of sales priced in U.S. dollars as compared to other currencies.Our 25 largest customers accounted for approximately 39% of total sales in 2020. In 2020, no customer accounted for more than 10% of sales. A key factor for commercial success is our inclusion on strategic customers’ core supplier lists, which provides opportunities to expand and win new business. We are on the core supplier lists of a large majority of our global and strategic customers within Taste and Scent.Gross MarginGross margin decreased to 41.0% in 2020 from 41.1% in 2019, principally driven by unfavorable price versus input costs and mix and sales volume reductions on existing business due, principally, to COVID-19, largely offset by the impact of productivity, integration and cross selling initiatives.Operating profitOperating profit decreased $98.8 million to $566.5 million (11.1% of sales) in 2020 compared to $665.3 million (12.9% of sales) in 2019. Foreign currency had a 2% unfavorable impact on operating profit in both the 2020 and 2019 periods. Adjusted operating profit was $729.7 million (14.4% of sales) for 2020, a decrease from $793.1 million (15.4% of sales) for 2019, principally driven by unfavorable price versus input costs and mix and sales volume reductions on existing business due, principally, to COVID-19, partially offset by the impact of productivity, integration and cross selling initiatives. 37Results of Operations Year Ended December 31,Change(DOLLARS IN THOUSANDS EXCEPT PER SHARE AMOUNTS)2020201920182020 vs. 20192019 vs. 2018Net sales$5,084,239 $5,140,084 $3,977,539 (1.1)%29.2 %Cost of goods sold2,998,373 3,027,336 2,294,832 (1.0)%31.9 %Gross profit2,085,866 2,112,748 1,682,707 Research and development (R&D) expenses356,863 346,128 311,583 3.1 %11.1 %Selling and administrative (S&A) expenses948,833 876,121 707,461 8.3 %23.8 %Restructuring and other charges, net17,295 29,765 5,079 (41.9)%NMFAmortization of acquisition-related intangibles192,607 193,097 75,879 (0.3)%154.5 %Losses (gains) on sale of fixed assets3,784 2,367 (1,177)59.9 %NMFOperating profit566,484 665,270 583,882 Interest expense131,802 138,221 132,558 (4.6)%4.3 %Loss on extinguishment of debt— — 38,810 — %(100.0)%Other income, net(6,689)(30,403)(35,243)(78.0)%(13.7)%Income before taxes441,371 557,452 447,757 Taxes on income73,999 97,184 107,976 (23.9)%(10.0)%Net income$367,372 $460,268 $339,781 Net income attributable to noncontrolling interest4,144 4,395 2,479 (5.7)%77.3 %Net income attributable to IFF stockholders363,228 455,873 337,302 Net income per share — diluted$3.21 $4.00 $3.79 (19.8)%5.5 %Gross margin41.0 %41.1 %42.3 %(10)bps(120)bpsR&D as a percentage of sales7.0 %6.7 %7.8 %30 bps(110)bpsS&A as a percentage of sales18.7 %17.0 %17.8 %170 bps(80)bpsOperating margin11.1 %12.9 %14.7 %(180)bps(180)bpsAdjusted operating margin 14.4 %15.4 %17.0 %(100)bps(160)bpsEffective tax rate16.8 %17.4 %24.1 %(60)bpsNMFSegment net salesTaste$3,109,781 $3,200,520 $2,091,635 (2.8)%53.0 %Scent1,974,458 1,939,564 1,885,904 1.8 %2.8 %Consolidated$5,084,239 $5,140,084 $3,977,539 _______________________NMF: Not meaningfulCost of goods sold includes the cost of materials and manufacturing expenses. R&D includes expenses related to the development of new and improved products and technical product support. S&A expenses include expenses necessary to support our commercial activities and administrative expenses supporting our overall operating activities including compliance with governmental regulations.2020 IN COMPARISON TO 2019 SalesSales for 2020 totaled $5.1 billion, which decreased 1% on a reported basis and flat on a currency neutral basis as compared to the prior year. Sales performance for the Scent segment reflected growth in Consumer Fragrances and a slight increase in Fragrance Ingredients, offset by declines in Fine Fragrances through the first nine months of 2020. In the fourth quarter of 2020, Fine Fragrances saw a slight increase in sales when compared to the comparable period of the prior year. Sales performance for the Taste segment reflected reduced sales in most Taste categories, especially those related to retail food services. 38Sales performance by segment was as follows: % Change in Sales - 2020 vs. 2019 ReportedCurrency Neutral(1)Taste-3 %-2 %Scent2 %3 %Total-1 %— %_______________________(1)Currency neutral sales growth is calculated by translating prior year sales at the exchange rates for the corresponding 2020 period.Taste SalesTaste sales in 2020 decreased 3% on a reported basis and 2% on a currency neutral basis versus the prior year period. Performance was primarily driven by sales declines in all regions, except North America, primarily from volume reductions due to reduced consumer demand, principally related to the COVID-19 pandemic, partially offset by new win performances (net of losses).Scent SalesScent sales in 2020 increased 2% on a reported basis and 3% on a currency neutral basis. Sales growth in the Scent business unit was led by Consumer Fragrances, primarily driven by new win performances (net of losses) and volume increases in most product offerings, such as fabric and home care items, to support consumer demand related to the COVID-19 pandemic. Fragrance Ingredients also contributed to a slight increase in the growth of the Scent business unit, primarily driven by volume increases, offset by price reductions. Performance in the Scent business unit was offset by Fine Fragrances through the first nine months of 2020, primarily driven by volume reductions caused by the disruption of consumer access to retail markets due to COVID-19. However, in the fourth quarter of 2020, Fine Fragrances sales grew slightly compared to the fourth quarter of 2019, primarily driven by new win performances (net of losses), offset by volume reductions.Cost of Goods SoldCost of goods sold, as a percentage of sales, increased to 59.0% in 2020 compared to 58.9% in 2019.Research and Development (R&D)Overall R&D expenses, as a percentage of sales, increased to 7.0% in 2020 compared to 6.7% in 2019.Selling and Administrative (S&A)S&A expenses increased $72.7 million to $948.8 million, or 18.7% as a percentage of sales, in 2020 compared to $876.1 million, or 17.0% as a percentage of sales, in 2019. Adjusted S&A expense increased by $19.8 million to $808.7 million (15.9% as a percentage of sales) in 2020 compared to $788.9 million (15.3% as a percentage of sales) in 2019. The increase in S&A expenses was due to higher employee related expenses (including bonuses to essential workers in 2020) and incentive compensation.Restructuring and Other ChargesRestructuring and other charges decreased to $17.3 million in 2020 compared to $29.8 million in 2019 primarily driven by the decrease in costs related to the 2019 Severance Plan (see Note 2 for additional information).Amortization of Acquisition-Related IntangiblesAmortization expenses decreased to $192.6 million in 2020 compared to $193.1 million in 2019. Operating Results by Business UnitWe evaluate the performance of business units based on segment profit which is defined as operating profit before Restructuring and other charges, net, Global expenses (as discussed in Note 15 to the Consolidated Financial Statements) and certain non-recurring items, net, Interest expense, Other (income) expense, net and Taxes on income. See Note 15 to the Consolidated Financial Statements for the reconciliation to Income before taxes. 39 For the Year EndedDecember 31,(DOLLARS IN THOUSANDS)20202019Segment profit:Taste$436,387 $482,394 Scent357,281 349,445 Global Expenses(63,982)(38,759)Operational Improvement Initiatives— (2,267)Frutarom Integration Related Costs(9,849)(55,160)Restructuring and Other Charges, net(17,295)(29,765)Losses on Sales of Assets(3,784)(2,367)Employee Separation Costs(2,813)— FDA Mandated Product Recall— (250)Frutarom Acquisition Related Costs(1,465)(5,940)Compliance Review & Legal Defense Costs(3,278)(11,314)N&B Transaction Related Costs(28,100)(20,747)N&B Integration Related Costs(96,618)— Operating Profit$566,484 $665,270 Profit marginTaste14.0 %15.1 %Scent18.1 %18.0 %Consolidated11.1 %12.9 %Taste Segment ProfitTaste segment profit decreased $46.0 million to $436.4 million (14.0% of segment sales) in 2020 from $482.4 million (15.1% of segment sales) in the comparable 2019 period. The decrease principally reflected volume reductions on existing business and unfavorable price versus input costs and mix, partially offset by new win performances (net of losses), integration, cross selling and productivity initiatives.Scent Segment ProfitScent segment profit increased $7.8 million to $357.3 million (18.1% of segment sales) in 2020, compared to $349.4 million (18.0% of segment sales) reported in 2019. The increase in segment profit principally reflected the impact of new win performances (net of losses) and productivity initiatives, partially offset by unfavorable price versus input costs and mix.Global ExpensesGlobal expenses represent corporate and headquarters-related expenses which include legal, finance, human resources and R&D and other administrative expenses that are not allocated to an individual business unit. In 2020, global expenses were $64.0 million compared to $38.8 million during 2019. The increase was principally driven by higher incentive compensation expense in 2020 and lower gains from our currency hedging program.Interest ExpenseIn 2020, interest expense decreased $6.4 million to $131.8 million, compared to $138.2 million in 2019. This decrease was primarily driven by repayments on the 2018 Term Loan Facility and TEUs. Average cost of debt was 3.0% for the 2020 and 2019 periods.Other Income, NetOther income, net, decreased approximately $23.7 million to $6.7 million of income in 2020 versus $30.4 million of income in 2019. The decrease was primarily driven by foreign exchange losses.Income TaxesThe effective tax rate was 16.8% in 2020 as compared to 17.4% in 2019. The year-over-year decrease was largely due to a more favorable mix of earnings and lower repatriation costs, partially offset by loss provisions and the cost of global intangible low-taxed income ("GILTI"). 40Excluding the $32.8 million tax benefit associated with the pre-tax Frutarom integration related costs, restructuring and other charges, net, losses on sale of assets, employee separation costs, a pension settlement, Frutarom acquisition related costs, compliance review & legal defense costs, N&B transaction related costs and N&B integration related costs, the adjusted effective tax rate for 2020 was 17.5%. For 2019, the adjusted effective tax rate was 18.1% excluding the $26.2 million tax benefit associated with the pre-tax operational improvement initiatives, Frutarom integration related costs, restructuring and other charges, net, losses on sale of assets, FDA mandated product recall, Frutarom acquisition related costs, compliance review & legal defense costs and N&B transaction related costs. The year-over-year decrease was largely due to a more favorable mix of earnings and lower repatriation costs, partially offset by loss provisions and the cost of GILTI.2019 IN COMPARISON TO 2018For a comparison of our results of operations for the fiscal years ended December 31, 2019 and December 31, 2018, see “Part II, Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations” of Exhibit 99.1 to our Form 8-K for the fiscal year ended December 31, 2019, filed with the SEC on June 18, 2020.Liquidity and Capital ResourcesCash and Cash EquivalentsWe had cash and cash equivalents of $649.5 million at December 31, 2020 compared to $606.8 million at December 31, 2019 and of this balance, a portion was held outside the United States. Cash balances held in foreign jurisdictions are, in most circumstances, available to be repatriated to the United States. Effective utilization of the cash generated by our international operations is a critical component of our strategy. We regularly repatriate cash from our non-U.S. subsidiaries to fund financial obligations in the U.S. As we repatriate these funds to the U.S. we will be required to pay income taxes in certain U.S. states and applicable foreign withholding taxes during the period when such repatriation occurs. Accordingly, as of December 31, 2020, we have a deferred tax liability of $47.1 million for the effect of repatriating the funds to the U.S.Restricted CashAs discussed in Note 1 to the Consolidated Financial Statements, restricted cash relates to amounts escrowed for various items including for payments to be made to former Frutarom option holders and for acquisition related payments. At December 31, 2020 we had a balance of $10.3 million (of which $7.3 million is included in Current Assets and $3.0 million is included in Other Assets) compared to $17.1 million at December 31, 2019.Cash Flows from Operating ActivitiesOperating cash flows in 2020 were $714.1 million compared to $699.0 million in 2019 and $437.6 million in 2018. The increase in operating cash flows from 2019 to 2020 was principally driven by changes primarily related to accounts receivable, inventories, incentive compensation and accrued expenses, largely offset by lower cash earnings in the current year. The increase in operating cash flows from 2018 to 2019 was principally driven by higher earnings from inclusion of our Frutarom acquisition and lower net working capital primarily related to accounts receivable.Working capital (current assets less current liabilities) totaled $1.2 billion at year-end 2020 compared to $1.4 billion at year-end 2019. We have various factoring agreements in the U.S. and The Netherlands under which we can factor up to approximately $100 million in receivables with a financial institution. Additionally, we maintain factoring programs that are sponsored by certain customers. Under all of the arrangements, we sell the receivables on a non-recourse basis to unrelated financial institutions and account for the transactions as a sale of receivables. The applicable receivables are removed from our Consolidated Balance Sheet when the cash proceeds are received. As of December 31, 2020, 2019 and 2018, we had sold receivables pursuant to these factoring programs of approximately $248.8 million, $205.7 million and $168.3 million, respectively. Participation in the various programs increased cash provided by operations by approximately $43.1 million, $37.7 million and $13.6 million in 2020, 2019 and 2018, respectively. The cost of participating in these programs was approximately $4.4 million, $7.1 million, and $3.4 million in 2020, 2019, and 2018, respectively (see Note 1 for additional information).Cash Flows Used in Investing ActivitiesNet investing activities in 2020 utilized $187.5 million compared to $225.9 million and $5.0 billion in 2019 and 2018, respectively. The decrease in cash paid for investing activities from 2019 to 2020 was primarily driven by lower payments for acquisitions and lower spending on property, plant and equipment, partially offset by lower proceeds from disposal of assets in 2020 and cash paid on settlement of derivative instruments in 2020 versus proceeds in 2019. The decrease in cash paid for investing activities from 2018 to 2019 was primarily driven by higher payments for acquisitions in 2018. In 2019, we acquired 41certain companies as described in Note 3 for approximately $49.1 million, net of cash acquired. In 2018, we acquired Frutarom for approximately $7.0 billion (net of cash acquired) of which $4.9 billion was paid in cash. Additions to property, plant and equipment were $191.8 million, $236.0 million and $170.1 million in 2020, 2019 and 2018, respectively (net of grants and other reimbursements from government authorities). These investments largely arise from our ongoing focus to align our manufacturing facilities with customer demand, primarily in emerging markets, and new technology consistent with our strategy. In light of the COVID-19 pandemic, we have evaluated and re-prioritized our capital projects. We expect that capital spending in 2021 will be approximately 4.5% of sales (net of potential grants and other reimbursements from government authorities).Frutarom Integration InitiativeWe expect to achieve $145 million of synergy targets, with total savings in line with our original expectations. See Note 2 for additional information related to the Frutarom Integration Initiative.Cash Flows Used in Financing ActivitiesNet cash used in financing activities in 2020 was $511.6 million, compared to $505.1 million in 2019 and cash provided by financing activities of $4.9 billion in 2018, respectively. The slight increase in 2020 versus 2019 was principally driven by higher repayments of debt and higher dividend payments, largely offset by cash proceeds from issuance of new long-term debt in the current year. The decrease in 2019 versus 2018 was principally driven by Frutarom related financing activities in 2018, partially offset by higher dividend payments in 2019.At December 31, 2020 and 2019, we had approximately $4.4 billion of debt outstanding.We paid dividends totaling $322.6 million, $313.5 million and $230.2 million in 2020, 2019 and 2018, respectively. The cash dividend declared per share in 2020, 2019 and 2018 was $3.04, $2.96 and $2.84, respectively. Our capital allocation strategy is primarily focused on debt repayment to maintain our investment grade rating. We will also prioritize capital investment in our businesses to support the strategic long term plans. We are also committed to maintaining our history of paying a dividend to investors determined by our Board of Directors at its discretion based on various factors.We currently have a board approved stock repurchase program with a total remaining value of $279.7 million. As of May 7, 2018, we have suspended our share repurchases.Capital Resources Operating cash flow provides the primary source of funds for capital investment needs, dividends paid to shareholders and debt service repayments. We anticipate that cash flows from operations and availability under our existing credit facilities will be sufficient to meet our investing and financing needs. We regularly assess our capital structure, including both current and long-term debt instruments, as compared to our cash generation and investment needs in order to provide ample flexibility and to optimize our leverage ratios. We believe our existing cash balances are sufficient to meet our debt service requirements.Transaction with Nutrition & Biosciences, Inc.On February 1, 2021 (the "Closing Date"), we completed the transaction with DuPont de Nemours, Inc. ("DuPont") to acquire its nutrition and biosciences business (the "N&B Business") which had been transferred to Nutrition & Biosciences, Inc., a Delaware corporation and wholly owned subsidiary of DuPont ("N&B") in a Reverse Morris Trust transaction. The N&B Business is an innovation-driven and customer-focused business that provides solutions for the global food and beverage, dietary supplements, home and personal care, energy, animal nutrition and pharma markets. We acquired 100% interest of N&B pursuant to definitive agreements, including an Agreement and Plan of Merger (the "Merger Agreement") entered into on December 15, 2019. The transaction was made in order to strengthen our customer base and market presence, with an enhanced position in the food & beverage, home & personal care and health & wellness markets.A wholly owned subsidiary of IFF merged with and into N&B in exchange for 141,740,461 shares of IFF common stock, par value $0.125 per share (“IFF Common Stock”) (collectively, the “N&B Transaction”), which had been approved in the special shareholder meeting that occurred on August 27, 2020 where IFF shareholders voted to approve the issuance of shares of IFF common stock in connection with the N&B Transaction pursuant to the Merger Agreement. In connection with the N&B Transaction, DuPont received a one-time $7.3 billion special cash payment (the “Special Cash Payment”). The shares issued in the Merger represented approximately 55.4% of the common stock of IFF on a fully diluted basis, after giving effect to the Merger, as of February 1, 2021 (see Note 3 for additional information). 42Revolving Credit Facility and Term Loan FacilitiesThe Credit Agreements contain various covenants, limitations and events of default customary for similar facilities for similarly rated borrowers, including the requirement for us to maintain, at the end of each fiscal quarter, a ratio of net debt for borrowed money to Consolidated EBITDA in respect of the previous 12-month period. Effective in the fourth quarter of 2020, the maximum permitted ratio of net debt to Consolidated EBITDA under the Credit Agreements is 4.0 to 1.0 through the end of 2020, with step-downs over time. On and after the Closing Date of the N&B Transaction, the Company’s maximum permitted ratio of net debt to Consolidated EBITDA under the Credit Agreements is 4.75 to 1.0, stepping down to 3.50 to 1.0 over time (with a step-up if the Company consummates certain qualified acquisitions).As of December 31, 2020, we had no outstanding borrowings under our Revolving Credit Facility, $240 million outstanding under the 2018 Term Loan Facility and $200 million outstanding in borrowings under the 2022 Term Loan Facility. The amount that we are able to draw down under the Revolving Credit Facility is limited by financial covenants as described below and in Note 9. As of December 31, 2020, our borrowing capacity was approximately $627 million under the Revolving Credit Facility.See Note 9 to the Consolidated Financial Statements for further information on our Credit Agreements.Debt CovenantsAt December 31, 2020 and 2019 we were in compliance with all financial and other covenants, including the net debt to adjusted EBITDA ratio. At December 31, 2020 our Net Debt/adjusted EBITDA(1) ratio was 3.43 to 1 as defined by our Credit Agreements, well below the maximum levels in the financial covenants in our existing outstanding credit facilities._______________________ (1)Adjusted EBITDA and Net Debt, which are non-GAAP measures used for these covenants, are calculated in accordance with the definition in the debt agreements. In this context, these measures are used solely to provide information on the extent to which we are in compliance with debt covenants and may not be comparable to adjusted EBITDA and Net Debt used by other companies. Reconciliations of adjusted EBITDA to net income and net debt to total debt are as follows:(DOLLARS IN MILLIONS)Year Ended December 31, 2020Net income$363.2 Interest expense131.8 Income taxes74.0 Depreciation and amortization325.4 Specified items(1)163.7 Non-cash items(2)39.6 Adjusted EBITDA$1,097.7 _______________________ (1)Specified items for the 12 months ended December 31, 2020 of $163.7 million consist of Frutarom integration related costs, restructuring and other charges, net, losses (gains) on sale of assets, employee separation costs, pension settlement, Frutarom acquisition related costs, compliance review & legal defense costs, N&B transaction related costs and N&B integration related costs.(2)Non-cash items represent all other adjustments to reconcile net income to net cash provided by operations as presented on the Statement of Cash Flows, including stock-based compensation and gain on sale of assets.(DOLLARS IN MILLIONS)December 31, 2020Total debt$4,413.5 Adjustments:Cash and cash equivalents(649.5)Net debt$3,764.0 Senior NotesAs of December 31, 2020, we had $3.97 billion aggregate principal amount outstanding in senior unsecured notes, with $1.97 billion principal amount denominated in EUR and $2.00 billion principal amount denominated in USD. The notes bear interest ranging from 0.50% per year to 5.00% per year, with maturities from September 2021 to September 2048. Of these notes, $300 million in aggregate principal amount of our 3.40% senior notes matured in September 2020, which the Company repaid during the third quarter of 2020. See Note 9 to the Consolidated Financial Statements for further information on our senior notes. 43As described above, in connection with the closing of the N&B Transaction, we guaranteed N&B’s obligations resulting from N&B’s issuance of $6.25 billion of senior unsecured notes. In lieu of IFF continuing to provide this guarantee, IFF intends to assume all of N&B obligations under the N&B Notes.Tangible Equity Units - Senior Unsecured Amortizing NotesOn September 17, 2018, in connection with the issuance of the TEUs, we issued $139.5 million aggregate principal amount of Amortizing Notes. There are no covenants or provisions in the indenture related to the TEUs that would afford the holders of the amortizing notes protection in the event of a highly leveraged transaction, reorganization, restructuring, merger or similar transaction involving us that may adversely affect such holders. If a fundamental change occurs, or if we elect to settle the SPCs early, then the holders of the Amortizing Notes will have the right to require us to repurchase the Amortizing Notes at a repurchase price equal to the principal amount of the Amortizing Notes as of the repurchase date plus accrued and unpaid interest. The indenture also contains customary events of default which would permit the holders of the Amortizing Notes to declare the notes to be immediately due and payable if not cured within applicable grace periods, including the failure to make timely installment payments on the notes or other material indebtedness, failure to give notice of a fundamental change and specified events of bankruptcy and insolvency. See Note 8 for further information on the TEUs.Other ContingenciesSee Note 20 to the Consolidated Financial Statements for information related to Other Contingencies.Other CommitmentsCompliance with existing governmental requirements regulating the discharge of materials into the environment has not materially affected our operations, earnings or competitive position. In 2020 and 2019, we spent approximately $7.4 million and $4.5 million on capital projects and approximately $29.2 million and $26.0 million, respectively, in operating expenses and governmental charges for the purpose of complying with such regulations. Expenditures for these purposes will continue for the foreseeable future. In addition, we are party to a number of proceedings brought under the Comprehensive Environmental Response, Compensation and Liability Act or similar state statutes. It is expected that the impact of any judgments in or voluntary settlements of such proceedings will not be material to our financial condition, results of operations or liquidity.Contractual ObligationsAt December 31, 2020, we had contractual payment obligations due within the time periods as specified in the following table: Payments Due by PeriodTotalLess than 1 Year1-3 Years3-5 YearsMore than5 Years(DOLLARS IN MILLIONS)20212022 - 20232024 - 20252026 and thereafter Borrowings(1)$4,444 $645 $500 $615 $2,684 Interest on borrowings(1)2,001 118 226 197 1,460 Leases(2)379 52 87 64 176 Pension funding obligations(3)721 68 138 143 372 Postretirement obligations(4)38 4 7 8 19 Purchase commitments(5)103 58 45 — — U.S. tax reform toll-charge(6)44 5 13 26 — Total$7,730 $950 $1,016 $1,053 $4,711 _______________________ (1)The rate assumed for the variable interest component of the contractual interest obligation was the rate in effect at December 31, 2020. See Note 9 to the Consolidated Financial Statements for a further discussion of our various borrowing facilities.(2)Leases include facility and other lease commitments executed in the normal course of the business included in Note 7 of the Notes to the Consolidated Financial Statements.(3)See Note 16 of the Notes to the Consolidated Financial Statements for a further discussion of our retirement plans. Anticipated funding obligations are based on current actuarial assumptions. The projected contributions beyond fiscal year 2023 are not currently determinable.(4)Amounts represent expected future benefit payments for our postretirement benefit plans. 44(5)Purchase commitments include agreements for raw material procurement and contractual capital expenditures. Amounts for purchase commitments represent only those items which are based on agreements that are enforceable and legally binding.(6)This amount represents the cash portion of the “toll charge” that is payable in installments over eight years beginning in 2018. This amount represents the five remaining installments.The table above does not include $96.6 million of the total unrecognized tax benefits for uncertain tax positions and approximately $17.4 million of associated accrued interest, and $47.1 million associated with the deferred tax liability on deemed repatriation. Due to the high degree of uncertainty regarding the timing of potential cash flows, we are unable to make a reasonable estimate of the amount and period in which the remaining liabilities might be paid.Critical Accounting Policies and Use of EstimatesOur significant accounting policies are more fully described in Note 1 to the Consolidated Financial Statements. As disclosed in Note 1, the preparation of financial statements in conformity with U.S. generally accepted accounting principles (“GAAP”) requires management to make estimates and assumptions that affect reported amounts and accompanying disclosures. These estimates are based on management’s best judgment of current events and actions that we may undertake in the future. Actual results may ultimately differ from these estimates.Those areas requiring the greatest degree of management judgment or deemed most critical to our financial reporting involve:Business Combinations. From time to time we enter into strategic acquisitions in an effort to better service existing customers and to attain new customers. When we acquire a controlling financial interest in an entity or group of assets that are determined to meet the definition of a business, we apply the acquisition method described in ASC Topic 805, Business Combinations. In accordance with GAAP, the results of the acquisitions we have completed are reflected in our financial statements from the date of acquisition forward.We allocate the purchase consideration paid to acquire the business to the assets acquired and liabilities assumed based on estimated fair values at the acquisition date, with the excess of purchase price over the estimated fair value of the net assets acquired recorded as goodwill. If during the measurement period (a period not to exceed twelve months from the acquisition date) we receive additional information that existed as of the acquisition date but at the time of the original allocation described above was unknown to us, we make the appropriate adjustments to the purchase price allocation in the reporting period in which the amounts are determined.Significant judgment is required to estimate the intangibles and fair value of fixed assets and in assigning their respective useful lives. Accordingly, we typically engage third-party valuation specialists, who work under the direction of management, to assist in valuing significant tangible and intangible assets acquired.The fair value estimates are based on available historical information, future expectations and assumptions deemed reasonable by management, but are inherently uncertain.We typically use an income method to estimate the fair value of intangible assets, which is based on forecasts of the expected future cash flows attributable to the respective assets. Significant estimates and assumptions inherent in the valuations reflect a consideration of other marketplace participants, and include the amount and timing of future cash flows (including expected growth rates, discount rate and profitability), royalty rates used in the relief of royalty method, customer attrition rates, product obsolescence factors, a brand’s relative market position and the discount rate applied to the cash flows. Unanticipated market or macroeconomic events and circumstances may occur, which could affect the accuracy or validity of the estimates and assumptions.Determining the useful life of an intangible asset also requires significant judgment. All of our acquired intangible assets (e.g., trademarks, product formulas, non-compete agreements and customer relationships) are expected to have finite useful lives. Our estimates of the useful lives of finite-lived intangible assets are based on a number of factors including competitive environment, market share, brand history, operating plans and the macroeconomic environment of the regions in which the brands are sold.The costs of finite-lived intangible assets are amortized through expense over their estimated lives. The value of residual goodwill is not amortized, but is tested at least annually for impairment as described in the following note. For acquired intangible assets, the remaining useful life of the trade names and trademarks, product formulas, and customer relationships was estimated at the point at which substantially all of the present value of cumulative cash flows have been earned. The periodic assessment of potential impairment of goodwill. We currently, as of December 31, 2020, have goodwill of $5.59 billion. We test goodwill for impairment at the reporting unit level as of November 30 every year or more frequently if 45events or changes in circumstances indicate the asset might be impaired. A reporting unit is an operating segment or one level below an operating segment (referred to as a component) to which goodwill is assigned when initially recorded.We identify our reporting units by assessing whether the components of our operating segments constitute businesses for which discrete financial information is available and management of each operating segment regularly reviews the operating results of those components. We have identified eight reporting units under the Taste and Scent Segments: (1) Flavor Compounds (which includes the Taste reporting unit that was previously included in the former Frutarom segment, as well as Legacy IFF Flavor Compounds), (2) Fragrance Compounds, (3) Fragrance Ingredients, (4) Cosmetic Active Ingredients, (5) Savory, (6) Natural Product Solutions, (7) Fine and Specialty Ingredients ("FSI") and (8) Inclusions.For the annual impairment test as of November 30, 2020, we utilized Step 0 of the guidance in ASC Topic 350, Intangibles – Goodwill and Other, which allows for the assessment of qualitative factors to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying value. If, based on a review of qualitative factors, it is more likely than not that the fair value of a reporting unit is less than its carrying value, a quantitative impairment test is performed by comparing the fair value of a reporting unit with its carrying amount. Based on a review of qualitative factors, we determined that for four of the reporting units, a quantitative (Step 1) impairment analysis was not necessary to determine if the carrying values of the reporting unit exceeded their fair values. For the other four reporting units (Savory, Natural Product Solutions, FSI, and Inclusions), we determined that a Step 1 test was necessary.We assessed the fair value of the reporting units primarily using an income approach. Under the income approach, we determined the fair value by using a discounted cash flow method at a rate of return that reflects the relative risk of the projected future cash flows of each reporting unit, as well as a terminal value. We use the most current actual and forecasted operating data available. Key estimates and assumptions used in these valuations include revenue growth rates and profit margins based on our internal forecasts and historical operating trends, and our specific weighted-average cost of capital used to discount future cash flows.In performing the quantitative test, we determined that the fair value of the four reporting units exceeded their carrying values and, taken together with the results of the qualitative test, we determined that there was no impairment of goodwill at any of our eight reporting units in 2020. Based on the quantitative impairment test performed at November 30, 2020, we determined that the excess of fair values over their respective carrying values ranged from 35% to 105% for two reporting units (FSI and Inclusions). The remaining two reporting units (Savory and Natural Product Solutions) had less than 10% excess fair value over carrying value.As of November 30, 2020, the Savory reporting unit had excess fair value over carrying value of approximately 5% and goodwill of $1.21 billion, and the Natural Product Solutions reporting unit had excess fair value over carrying value of approximately 1% and goodwill of $851.4 million. While management believes that the assumptions used in the impairment test were reasonable, changes in key assumptions, including, lower revenue growth, lower operating margin, lower terminal growth rates or increasing discount rates could result in a future impairment.If current long-term projections for these reporting units are not realized or materially decrease, we may be required to write-off all or a portion of the goodwill. Such charge could have a material effect on the Consolidated Statements of Operations and Balance Sheets.The periodic assessment of potential impairment of long-lived assets. We review long-lived assets for impairment when events or changes in business conditions indicate that their full carrying value may not be recovered. An estimate of undiscounted future cash flows produced by an asset or group of assets is compared to the carrying value to determine whether impairment exists. If assets are determined to be impaired, the loss is measured based on an estimate of fair value using various valuation techniques, including a discounted estimate of future cash flows.New Accounting Standards See Note 1 to the Consolidated Financial Statements for a discussion of recent accounting pronouncements.Non-GAAP Financial MeasuresWe use non-GAAP financial measures in this Form 10-K, including: (i) currency neutral metrics, (ii) adjusted gross margin, (iii) adjusted operating profit and adjusted operating margin, (iv) adjusted selling and administrative expenses, and (v) adjusted effective tax rate. We also provide the non-GAAP measures adjusted EBITDA and net debt solely for the purpose of providing information on the extent to which we are in compliance with debt covenants contained in its debt agreements. Our non-GAAP financial measures are defined below.These non-GAAP financial measures are intended to provide additional information regarding our underlying operating results and comparable year-over-year performance. Such information is supplemental to information presented in accordance 46with GAAP and is not intended to represent a presentation in accordance with GAAP. In discussing our historical and expected future results and financial condition, we believe it is meaningful for investors to be made aware of and to be assisted in a better understanding of, on a period-to-period comparable basis, financial amounts both including and excluding these identified items, as well as the impact of exchange rate fluctuations. These non-GAAP measures should not be considered in isolation or as substitutes for analysis of our results under GAAP and may not be comparable to other companies’ calculation of such metrics.Currency neutral metrics eliminate the effects that result from translating international currency to U.S. dollars. We calculate currency neutral numbers by comparing current year results to the prior year results restated at exchange rates in effect for the current year based on the currency of the underlying transaction. Adjusted gross margin excludes operational improvement initiatives, Frutarom integration related costs, FDA mandated product recall and Frutarom acquisition related costs.Adjusted operating profit and adjusted operating margin excludes operational improvement initiatives, Frutarom integration related costs, restructuring and other charges, net, losses (gains) on sale of assets, employee separation costs, FDA mandated product recall, Frutarom acquisition related costs, compliance review & legal defense costs, N&B transaction related costs and N&B integration related costs.Adjusted selling and administrative expenses excludes Frutarom integration related costs, employee separation costs, Frutarom acquisition related costs, compliance review & legal defense costs, N&B transaction related costs and N&B integration related costs.Adjusted effective tax rate excludes operational improvement initiatives, acquisition related costs, Frutarom integration related costs, restructuring and other charges, net, losses (gains) on sale of assets, employee separation costs, FDA mandated product recall, pension settlement, Frutarom acquisition related costs, compliance review & legal defense costs, N&B transaction related costs, N&B integration related costs and redemption value adjustment to EPS.Net Debt to Combined Adjusted EBITDA is the leverage ratio used in our credit agreements and defined as Net Debt (which is long-term debt less cash and cash equivalents) divided by Combined Adjusted EBITDA. However, as Adjusted EBITDA for these purposes was calculated in accordance with the provisions of the credit agreements, it may differ from the calculation used for other purposes.A. Reconciliation of Non-GAAP MetricsReconciliation of Gross ProfitYear Ended December 31,(DOLLARS IN THOUSANDS)20202019Reported (GAAP) $2,085,866 $2,112,748 Operational Improvement Initiatives (a)— 2,267 Frutarom Integration Related Costs (c)437 730 FDA Mandated Product Recall (f)— 250 Frutarom Acquisition Related Costs (h)759 4,247 Adjusted (Non-GAAP)$2,087,062 $2,120,242 Reconciliation of Selling and Administrative ExpensesYear Ended December 31,(DOLLARS IN THOUSANDS)20202019Reported (GAAP) $948,833 $876,121 Frutarom Integration Related Costs (c)(8,640)(53,481)Employee Separation Costs (e)(2,813)— Frutarom Acquisition Related Costs (h)(706)(1,693)Compliance Review & Legal Defense Costs (i)(3,278)(11,314)N&B Transaction Related Costs (j)(28,100)(20,747)N&B Integration Related Costs (k)(96,618)— Adjusted (Non-GAAP)$808,678 $788,886 47Reconciliation of Operating ProfitYear Ended December 31,(DOLLARS IN THOUSANDS)20202019Reported (GAAP) $566,484 $665,270 Operational Improvement Initiatives (a)— 2,267 Frutarom Integration Related Costs (c)9,849 55,160 Restructuring and Other Charges, net (d)17,295 29,765 Losses (Gains) on Sale of Assets 3,784 2,367 Employee Separation Costs (e)2,813 — FDA Mandated Product Recall (f)— 250 Frutarom Acquisition Related Costs (h)1,465 5,940 Compliance Review & Legal Defense Costs (i)3,278 11,314 N&B Transaction Related Costs (j)28,100 20,747 N&B Integration Related Costs (k)96,618 — Adjusted (Non-GAAP)$729,686 $793,080 Reconciliation of Net Income and EPSYear Ended December 31,20202019(DOLLARS IN THOUSANDS)Income before taxesTaxes on income (m)Net Income Attributable to IFF (n)Diluted EPS (o)Income before taxesTaxes on income (m)Net Income Attributable to IFF (n)Diluted EPS (o)Reported (GAAP) $441,371 $73,999 $363,228 $3.21 $557,452 $97,184 $455,873 $4.00 Operational Improvement Initiatives (a)— — — — 2,267 610 1,657 0.01 Acquisition Related Costs (b)— — — — (3,371)— (3,371)(0.03)Frutarom Integration Related Costs (c)9,849 1,459 8,390 0.07 55,160 12,461 42,699 0.38 Restructuring and Other Charges, net (d)17,295 3,991 13,304 0.12 29,765 6,797 22,968 0.20 Losses (Gains) on Sale of Assets 3,784 770 3,014 0.03 2,367 572 1,795 0.02 Employee Separation Costs (e)2,813 302 2,511 0.02 — — — — FDA Mandated Product Recall (f)— — — — 250 57 193 — Pension Settlement (g)4,441 844 3,597 0.03 — — — — Frutarom Acquisition Related Costs (h)1,465 448 1,017 0.01 5,940 794 5,146 0.05 Compliance Review & Legal Defense Costs (i)3,278 736 2,542 0.02 11,314 2,522 8,792 0.08 N&B Transaction Related Costs (j)28,100 1,579 26,521 0.23 20,747 2,354 18,393 0.16 N&B Integration Related Costs (k)96,618 22,695 73,923 0.65 — — — — Redemption value adjustment to EPS (l)— — — (0.02)— — — 0.02 Adjusted (Non-GAAP)$609,014 $106,823 $498,047 $4.38 $681,891 $123,351 $554,145 $4.88 (a)Represents accelerated depreciation related to plant relocations in India and China. (b)Represents adjustments to the fair value for an equity method investment in Canada which we began consolidating in the second quarter of 2019. (c)Represents costs related to the integration of the Frutarom acquisition. For 2020, costs primarily related to advisory services, retention bonuses and performance stock awards. For 2019, costs principally related to advisory services.(d)For 2020, represents costs primarily related to the Frutarom Integration Initiative. For 2019, represents costs primarily related to the Frutarom Integration Initiative and the 2019 Severance Program.(e)Represents costs related to severance liabilities for two executives who have announced their retirement. 48(f)Represents additional claims that management paid to co-packers. (g)Represents pension settlement charges incurred in one of the Company's UK pension plans.(h)Represents transaction-related costs and expenses related to the acquisition of Frutarom. For 2020, amount primarily includes earn-out payments, net of adjustments, amortization for inventory "step-up" costs and transaction costs principally related to the 2019 Acquisition Activity. For 2019, amount primarily includes amortization for inventory "step-up" costs and transaction costs.(i)Costs related to reviewing the nature of inappropriate payments and review of compliance in certain other countries. In addition, includes legal costs for related shareholder lawsuits.(j)Represents transaction costs and expenses related to the transaction with N&B, principally related to legal and professional fees for capital raising activities.(k)Represents costs primarily related to advisory services for the integration of the transaction with N&B, principally consulting fees.(l)Represents the adjustment to EPS related to the excess of the redemption value of certain redeemable noncontrolling interests over their existing carrying value.(m)The income tax expense (benefit) on non-GAAP adjustments is computed in accordance with ASC 740 using the same methodology as the GAAP provision of income taxes. Income tax effects of non-GAAP adjustments are calculated based on the applicable statutory tax rate for each jurisdiction in which such charges were incurred, except for those items which are non-taxable for which the tax expense (benefit) was calculated at 0%. Where non-GAAP adjustments are subject to foreign tax credits or valuation allowances, such factors are taken into consideration in calculating the tax expense (benefit). For amortization, the tax benefit has been calculated based on the statutory rate on a country by country basis.(n)For 2020 and 2019, net income is reduced by income attributable to noncontrolling interest of $4.1M and $4.4M, respectively.(o)The sum of these items does not foot due to rounding.B. Foreign Currency Reconciliation Operating ProfitYear Ended December 31,20202019% Change - Reported (GAAP)(15)%14%Items impacting comparability (1)7%3%% Change - Adjusted (Non-GAAP)(8)%17%Currency Impact2%2%% Change Year-over-Year - Currency Neutral Adjusted (Non-GAAP) (2)(3)(6)%20%_______________________ (1)Includes items impacting comparability of $163.2 million for the year ended December 31, 2020 and includes $127.8 million of items impacting comparability for the year ended December 31, 2019.(2)2019 item does not foot due to rounding.(3)Currency neutral amount is calculated by translating prior year amounts at the exchange rates used for the corresponding 2020 period. Currency neutral operating profit also eliminates the year-over-year impact of cash flow hedging.Cautionary Statement Under the Private Securities Litigation Reform Act of 1995Statements in this Form 10-K, which are not historical facts or information, are “forward-looking statements” within the meaning of The Private Securities Litigation Reform Act of 1995. Such forward-looking statements are based on management’s current assumptions, estimates and expectations and include statements concerning (i) the impacts of COVID-19 and our plans to respond to its implications; (ii) our combination with N&B, including the expected benefits and synergies of the N&B Transaction and future opportunities for the combined company; (iii) our ability to achieve the anticipated benefits of the Frutarom acquisition, including $145 million of expected synergies; (iv) our ability to achieve our Vision 2021 strategy of accelerated revenue and profitability growth, (v) the growth potential of the markets in which we operate, including the emerging markets, (vi) expected capital expenditures in 2021, (vii) expectations regarding the Frutarom Integration Initiative, (viii) the expected costs and benefits of our ongoing optimization of our manufacturing operations, including the expected number of closings, (ix) expected cash flow and availability of capital resources to fund our operations and meet our debt service requirements; (x) our ability to innovate and execute on specific consumer trends and demands; and (xi) our ability to continue to generate value for, and return cash to, our shareholders. These forward-looking statements should be evaluated with consideration given to the many risks and uncertainties inherent in our business that could cause actual results and events to 49differ materially from those in the forward-looking statements. Certain of such forward-looking information may be identified by such terms as “expect”, “anticipate”, “believe”, “intend”, “outlook”, “may”, “estimate”, “should”, “predict” and similar terms or variations thereof. Such forward-looking statements are based on a series of expectations, assumptions, estimates and projections about the Company, are not guarantees of future results or performance, and involve significant risks, uncertainties and other factors, including assumptions and projections, for all forward periods. Our actual results may differ materially from any future results expressed or implied by such forward-looking statements. Such risks, uncertainties and other factors include, among others, the following:•disruption in the development, manufacture, distribution or sale of our products from COVID-19 and other public health crises;•risks related to the integration of N&B and the Frutarom business, including whether we will realize the benefits anticipated from the acquisitions in the expected time frame; •unanticipated costs, liabilities, charges or expenses resulting from the Frutarom acquisition and the N&B Transaction;•risks related to the restrictions that we are required to abide by in connection with the N&B Transaction;•our ability to provide the same types and level of services to the N&B Business that historically have been provided by DuPont, and our ability to maintain relationships with third parties and pre-existing customers of N&B. •our ability to realize expected cost savings and increased efficiencies of the Frutarom integration and our ongoing optimization of our manufacturing facilities;•our ability to successfully establish and manage acquisitions, collaborations, joint ventures or partnership;•the increase in our leverage resulting from the additional debt incurred to pay a portion of the consideration for Frutarom and its impact on our liquidity and ability to return capital to its shareholders;•our ability to successfully market to our expanded and diverse Taste customer base;•our ability to effectively compete in our market and develop and introduce new products that meet customers’ needs;•our ability to retain key employees;•changes in demand from large multi-national customers due to increased competition and our ability to maintain “core list” status with customers;•our ability to successfully develop innovative and cost-effective products that allow customers to achieve their own profitability expectations;•disruption in the development, manufacture, distribution or sale of our products from natural disasters, public health crises, international conflicts, terrorist acts, labor strikes, political crisis, accidents and similar events;•the impact of a disruption in our supply chain, including the inability to obtain ingredients and raw materials from third parties;•volatility and increases in the price of raw materials, energy and transportation;•the impact of a significant data breach or other disruption in our information technology systems, and our ability to comply with data protection laws in the U.S. and abroad;•our ability to comply with, and the costs associated with compliance with, regulatory requirements and industry standards, including regarding product safety, quality, efficacy and environmental impact;•our ability to react in a timely and cost-effective manner to changes in consumer preferences and demands, including increased awareness of health and wellness;•our ability to meet consumer, customer and regulatory sustainability standards;•our ability to benefit from our investments and expansion in emerging markets; •the impact of currency fluctuations or devaluations in the principal foreign markets in which we operate; •economic, regulatory and political risks associated with our international operations;•the impact of global economic uncertainty on demand for consumer products;•our ability to comply with, and the costs associated with compliance with, U.S. and foreign environmental protection laws;•our ability to successfully manage our working capital and inventory balances; 50•the impact of the failure to comply with U.S. or foreign anti-corruption and anti-bribery laws and regulations, including the U.S. Foreign Corrupt Practices Act;•any impairment on our tangible or intangible long-lived assets, including goodwill associated with the acquisition of Frutarom;•our ability to protect our intellectual property rights;•the impact of the outcome of legal claims, regulatory investigations and litigation;•changes in market conditions or governmental regulations relating to our pension and postretirement obligations;•the impact of changes in federal, state, local and international tax legislation or policies, including the Tax Cuts and Jobs Act, with respect to transfer pricing and state aid, and adverse results of tax audits, assessments, or disputes;•the impact of the United Kingdom’s departure from the European Union; and•the impact of the phase out of the London Interbank Offered Rate (LIBOR) on interest expense.The foregoing list of important factors does not include all such factors, nor necessarily present them in order of importance. In addition, you should consult other disclosures made by the Company (such as in our other filings with the SEC or in company press releases) for other factors that may cause actual results to differ materially from those projected by the Company. Please refer to Part I. Item 1A., Risk Factors, of this Form 10-K for additional information regarding factors that could affect our results of operations, financial condition and liquidity.We intend our forward-looking statements to speak only as of the time of such statements and do not undertake or plan to update or revise them as more information becomes available or to reflect changes in expectations, assumptions or results. We can give no assurance that such expectations or forward-looking statements will prove to be correct. An occurrence of, or any material adverse change in, one or more of the risk factors or risks and uncertainties referred to in this report or included in our other periodic reports filed with the SEC could materially and adversely impact our operations and our future financial results.Any public statements or disclosures made by us following this report that modify or impact any of the forward-looking statements contained in or accompanying this report will be deemed to modify or supersede such outlook or other forward-looking statements in or accompanying this report.ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.We operate on a global basis and are exposed to currency fluctuation related to the manufacture and sale of our products in currencies other than the U.S. dollar. The major foreign currencies involve the markets in the European Union, Great Britain, Mexico, Brazil, China, India, Indonesia, Australia, Russia and Japan, although all regions are subject to foreign currency fluctuations versus the U.S. dollar. We actively monitor our foreign currency exposures in all major markets in which we operate, and employ a variety of techniques to mitigate the impact of exchange rate fluctuations, including foreign currency hedging activities.We have established a centralized reporting system to evaluate the effects of changes in interest rates, currency exchange rates and other relevant market risks. Our risk management procedures include the monitoring of interest rate and foreign exchange exposures and hedge positions utilizing statistical analyses of cash flows, market value and sensitivity analysis. However, the use of these techniques to quantify the market risk of such instruments should not be construed as an endorsement of their accuracy or the accuracy of the related assumptions. For the year ended December 31, 2020, our exposure to market risk was estimated using sensitivity analyses, which illustrate the change in the fair value of a derivative financial instrument assuming hypothetical changes in foreign exchange rates and interest rates.We enter into foreign currency forward contracts with the objective of reducing exposure to cash flow volatility associated with foreign currency receivables and payables, and with anticipated purchases of certain raw materials used in operations. These contracts, the counterparties to which are major international financial institutions, generally involve the exchange of one currency for a second currency at a future date, and have maturities not exceeding twelve months. The gain or loss on the hedging instrument and services is recorded in earnings at the same time as the transaction being hedged is recorded in earnings. At December 31, 2020, our foreign currency exposures pertaining to derivative contracts exist with the Euro, Japanese Yen, British Pound, Australian Dollar and Indonesian Rupiah. Based on a hypothetical decrease or increase of 10% in the applicable balance sheet exchange rates (primarily against the U.S. dollar), the estimated fair value of our foreign currency forward contracts would increase by approximately $7.0 million. However, any change in the value of the contracts, real or hypothetical, would be significantly offset by a corresponding change in the value of the underlying hedged items. 51We use derivative instruments as part of our interest rate risk management strategy. We have entered into certain cross currency swap agreements in order to mitigate a portion of our net European investments from foreign currency risk. As of December 31, 2020, these swaps were in a net liability position with an aggregate fair value of $23.4 million. Based on a hypothetical decrease or increase of 10% in the value of the U.S. dollar against the Euro, the estimated fair value of our cross currency swaps would change by approximately $34.7 million. At December 31, 2020, the fair value of our EUR fixed rate debt was €2.1 billion. Based on a hypothetical decrease or increase of 10% in foreign exchange rates, the estimated fair value of our EUR fixed rate debt would change by approximately $216.3 million.At December 31, 2020, the fair value of our USD fixed rate debt was $2.5 billion. Based on a hypothetical decrease or increase of 10% in interest rates, the estimated fair value of our US fixed rate debt would change by approximately $245.5 million.We purchase certain commodities, such as natural gas, electricity, petroleum based products and certain crop related items. We generally purchase these commodities based upon market prices that are established with the vendor as part of the purchase process. In general, we do not use commodity financial instruments to hedge commodity prices.
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+Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations. The Company’s equity interests in Ilim S.A. ("Ilim") and Graphic Packaging International Partners, LLC ("GPIP") are also separate reportable industry segments.On December 3, 2020, we announced a plan to pursue a spin-off of our Printing Papers segment into a standalone publicly-traded company ("SpinCo"). See discussion on page 27 of Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations and in Note 8 Divestitures and Impairments of Businesses on page 59 of
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+Item 7. Management Discussion and Analysis” for further details on the Joint Venture. In the remainder of our markets outside of the U.S. (“OUS”), we provide our products through distributors. During the years ended December 31, 2020, 2019, and 2018, domestic revenue accounted for 68%, 70%, and 71%, respectively, of total revenue, while revenue from our OUS markets accounted for 32%, 30%, and 29%, respectively, of total revenue. As of December 31, 2020, and 2019, 83% and 85% of all long-lived assets were in the U.S., respectively.Our direct sales organization is composed of a capital sales team, responsible for selling systems, and a clinical sales team, responsible for supporting system use in procedures performed at our hospital accounts. Our hospital accounts include both individual hospitals and healthcare facilities as well as hospitals and healthcare facilities that are part of an integrated delivery network (“IDN groups”). The initial system sale into an account is a major capital equipment purchase by our customers and typically has a lengthy sales cycle that can be affected by macroeconomic factors, capital spending prioritization, timing of budgeting cycles, and competitive bidding processes. Capital sales activities include educating surgeons or physicians and hospital staff across multiple specialties on the benefits of robotic-assisted surgery with a da Vinci Surgical System or robotic-assisted bronchoscopy with an Ion endoluminal system, total treatment costs, and the clinical applications that our technology enables. We also train our sales organization to educate hospital management on the potential benefits of adopting our technology, including the clinical benefits of robotic-assisted surgery with a da Vinci Surgical System or robotic-assisted bronchoscopy with an Ion endoluminal system, potential reductions in complications and length of stay, and the resulting potential for increased patient satisfaction, surgeon or physician recruitment, and procedure volume.10Table of ContentsOur clinical sales team works on site at hospitals, interacting with surgeons or physicians, operating room staff, and hospital administrators to develop and sustain successful robotic-assisted surgery or bronchoscopy programs. They assist the hospital in identifying surgeons or physicians who have an interest in robotic-assisted surgery or bronchoscopy and the potential benefits provided by the da Vinci Surgical System and the Ion endoluminal system. Our clinical sales team provides current clinical information on robotic-assisted surgery or bronchoscopy practices and new product applications to the hospital teams. Our clinical sales team has grown with the expanded installed bases of da Vinci Surgical Systems and Ion endoluminal systems as well as the total number of procedures performed. We expect this organization to continue to grow as our business expands.Our customers place orders to replenish their supplies of instruments and accessories on a regular basis. Orders received are typically shipped within one business day. New direct customers who purchase a new system typically place an initial stocking order of instruments and accessories soon after they receive their system.Our business is subject to seasonal fluctuations. Historically, our sales of da Vinci Surgical Systems have tended to be heavier in the fourth quarter and lighter in the first quarter, as hospital budgets are reset. In addition, we have historically experienced lower procedure volume in the first and third quarters and higher procedure volume in the second and fourth quarters. More than half of da Vinci procedures performed are for benign conditions. These benign procedures and other short-term elective procedures tend to be more seasonal than cancer procedures and surgeries for other life-threatening conditions. In the U.S., volumes for procedures associated with benign conditions are typically seasonally higher in the fourth quarter when more patients have met annual deductibles and lower in the first quarter when deductibles are reset. Seasonality outside the U.S. varies and is more pronounced around local holidays and vacation periods. The timing of procedures and changes in procedure volume impact the timing of instrument and accessory and capital purchases. As a result of factors outlined in "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations—COVID-19 Pandemic" below, including the past and potential future recommendations of authorities to defer elective procedures, historical procedure patterns have been and may continue to be disrupted.Customer Support and Training ProgramsWe have a network of field service engineers across the U.S., Europe, and Asia and maintain relationships with various distributors around the globe. This infrastructure of service and support specialists offers a full complement of services for our customers, including 24/7 support, installation, repair, and maintenance. We generate service revenue by providing these services to our customers through comprehensive service contracts and time and material programs.We provide basic system training that teaches the fundamental operating principles of the systems to surgeons, surgical assistants, and operating room nurses. We have established training centers where system training and ongoing surgical procedural training are provided, the latter led by expert surgeons. Training technologies include our Simulation program, which provides independent da Vinci skills development through interactive VR exercises, and our telementoring program, which provides real-time surgeon-to-surgeon learning and collaboration during robotic-assisted surgery.Research and DevelopmentWe focus our research and development efforts on innovation and improvement for products and services that align with our mission: We believe that minimally invasive care is life-enhancing care. Through ingenuity and intelligent technology, we believe that we can expand the potential of physicians to heal without constraints. We employ engineering and research and development staff to focus on delivering future innovations and sustaining improvements that advance our mission. In certain instances, we complement our research and development effort through collaborations with other companies, such as Trumpf Medical (a division of Hill-Rom Holdings, Inc.).ManufacturingWe manufacture our systems at our facilities in Sunnyvale, California and Durham, North Carolina. We manufacture our instruments at our facilities in Sunnyvale, California and Mexicali, Mexico. We also have manufacturing at multiple sites in Germany.We purchase both custom and off-the-shelf components from a large number of suppliers and subject them to stringent quality specifications and processes. Some of the components necessary for the assembly of our products are currently provided to us by sole-sourced suppliers (the only recognized supply source available to us) or single-sourced suppliers (the only approved supply source for us among other sources). We purchase the majority of our components and major assemblies through purchase orders rather than long-term supply agreements and generally do not maintain large volumes of finished goods relative to our anticipated demand.11Table of ContentsCompetitionWe face competition in the forms of existing open surgery, conventional MIS, drug therapies, radiation treatment, and emerging interventional surgical approaches. Our success depends on continued clinical and technical innovation, quality and reliability, as well as educating hospitals, surgeons, and patients on the demonstrated results associated with robotic-assisted surgery using da Vinci Surgical Systems and its value relative to other techniques. We also face competition from several companies that have introduced or are developing new approaches and products for the MIS market. We believe that the entrance or emergence of competition validates MIS and robotic-assisted surgery.Moreover, as we add new robotically controlled products (e.g., da Vinci Stapling and da Vinci Energy) that compete with product offerings traditionally within the domains of open surgery and/or conventional MIS, we face greater competition from larger and well established companies, such as Ethicon Endo-Surgery, Inc. and Medtronic plc.The companies that have introduced products in the field of robotic-assisted surgery or have made explicit statements about their efforts to enter the field, include, but are not limited to: avateramedical GmbH; CMR Surgical Ltd.; Johnson & Johnson (including their wholly owned subsidiaries Auris Health, Inc. and Verb Surgical Inc.); Medicaroid, Inc.; Medrobotics Corporation; Medtronic plc; meerecompany Inc.; MicroPort Scientific Corporation; Olympus Corporation; Samsung Group; Shandong Weigao Group Medical Polymer Company Ltd.; Smart Robot Technology Group Co. Ltd.; Titan Medical Inc.; and TransEnterix, Inc. Other companies with substantial experience in industrial robotics could potentially expand into the field of surgical robotics and become a competitor. In addition, research efforts utilizing computers and robotics in surgery are underway at various companies and research institutions. Our revenues may be adversely impacted as our competitors announce their intent to enter our markets and as our customers anticipate the availability of competing products.Intellectual PropertyWe place considerable importance on obtaining and maintaining patent, copyright, trademark, and trade secret protection for significant new technologies, products, and processes.We generally rely upon a combination of intellectual property laws, confidentiality procedures, and contractual provisions to protect our proprietary technology. For example, we have trademarks, both registered and unregistered, that provide distinctive identification of our products in the marketplace. We also have exclusive and non-exclusive patent licenses with various third parties to supplement our own robust patent portfolio.As of December 31, 2020, we held ownership or exclusive field-of-use licenses for more than 4,000 U.S. and foreign patents and have filed more than 2,000 U.S. and foreign patent applications. We intend to continue filing new patent applications in the U.S. and foreign jurisdictions to seek protection for our technology.Patents are granted for finite terms. Upon expiration, the inventions claimed in a patent enter the public domain.Government RegulationOur products and operations are subject to regulation by the FDA, the State of California, and countries or regions in which we market our products. In addition, our products must meet the requirements of a large and growing body of international standards, which govern the design, manufacture, materials content and sourcing, testing, certification, packaging, installation, use, and disposal of our products. We must continually keep abreast of these standards and requirements and integrate our compliance into the development and regulatory documentation for our products. Failure to meet these standards could limit our ability to market our products in those regions that require compliance to such standards. Examples of standards to which we are subject include electrical safety standards, such as those of the International Electrotechnical Commission (e.g., IEC 60601-ss series of standards), and composition standards, such as the Reduction of Hazardous Substances (“RoHS”) and the Waste Electrical and Electronic Equipment (“WEEE”) Directives.U.S. RegulationThe FDA regulates the development, testing, manufacturing, labeling, storage, recordkeeping, promotion, marketing, distribution, and service of medical devices in the U.S. to ensure that medical products distributed domestically are safe and effective for their intended uses. In addition, the FDA regulates the export of medical devices manufactured in the U.S. to markets outside of the U.S. and the importation of medical devices manufactured abroad.Under the Federal Food, Drug, and Cosmetic Act (“FFDCA”), medical devices are classified into one of three classes—Class I, Class II, or Class III—depending on the degree of risk associated with each medical device and the extent of control needed to ensure safety and effectiveness. Our current products are Class II medical devices.Class II medical devices are those which are subject to general controls, and most require premarket demonstration of adherence to certain performance standards or other special controls, as specified by the FDA, and clearance by the FDA. Premarket review and clearance by the FDA for these devices is accomplished through the 510(k) premarket notification 12Table of Contentsprocess. Unless a Class II medical device is exempt from a premarket review, the manufacturer must submit to the FDA a premarket notification submission demonstrating that the device is “substantially equivalent” in intended use and technology to a “predicate device” that is either:•a device that has grandfather marketing status, because it was legally marketed prior to May 28, 1976, the date upon which the Medical Device Amendments of 1976 were enacted; or•a device that has previously been cleared through the 510(k) process.If the FDA agrees that the device is substantially equivalent to a predicate device, it will grant clearance to commercially market the device in the U.S. The FDA has a statutory 90-day period to respond to a 510(k) submission, or a guidance-based 30-day period for “special” 510(k) submissions, which have a more restrictive scope and generally involve more specific or very limited changes to a legally marketed device. As a practical matter, clearance often takes longer. The FDA may require further information, including clinical data, to make a determination regarding substantial equivalence. If the FDA determines that the device, or its intended use, is not “substantially equivalent,” the FDA may deny the request for clearance. Although unlikely for the types of products marketed by us, the FDA may classify the device, or the particular use of the device, into Class III, and the device sponsor must then fulfill more rigorous pre-market approval (“PMA”) requirements. A PMA application, which is intended to demonstrate that a device is safe and effective, must be supported by data, typically including data from preclinical studies and human clinical trials. The FDA, by statute and regulation, has 180 days to review a PMA application, although the review more often occurs over a significantly longer period of time, and can take up to several years. In approving a PMA application or clearing a 510(k) submission, the FDA may also require some form of post-market surveillance when necessary to protect the public health or to provide additional safety and effectiveness data for the device. In such cases, the manufacturer might be required to follow certain patient groups for a number of years and make periodic reports to the FDA on the clinical status of those patients.After a device receives FDA 510(k) clearance, any modification that could significantly affect its safety or effectiveness, or that would constitute a major change in its intended use, requires a new 510(k) clearance or could require a PMA application approval. The FDA requires each manufacturer to make the determination of whether a modification requires a new 510(k) notification or PMA application in the first instance, but the FDA can review any such decision. If the FDA disagrees with a manufacturer’s decision not to seek a new 510(k) clearance or PMA approval for a particular change, the FDA may retroactively require the manufacturer to seek 510(k) clearance or PMA approval. The FDA also can require the manufacturer to cease U.S. marketing and/or recall the modified device until 510(k) clearance or PMA approval is obtained.Over the last several years, the FDA has proposed reforms to its 510(k) clearance process, and such proposals will include increased requirements for clinical data and a longer review period and make it more difficult for manufacturers to utilize the 510(k) clearance process for their products. For example, in November 2018, FDA officials announced forthcoming steps that the FDA intends to take to modernize the premarket notification pathway under Section 510(k) of the FFDCA. Among other things, the FDA announced that it planned to develop proposals to drive manufacturers utilizing the 510(k) pathway toward the use of newer predicates. These proposals included plans to potentially sunset certain older devices that were used as predicates under the 510(k) clearance pathway and to potentially publish a list of devices that have been cleared on the basis of demonstrated substantial equivalence to predicate devices that are more than 10 years old. In May 2019, the FDA solicited public feedback on these proposals. These proposals have not yet been finalized or adopted, and the FDA may work with Congress to implement such proposals through legislation.More recently, in September 2019, the FDA finalized guidance describing an optional “safety and performance based” premarket review pathway for manufacturers of “certain, well-understood device types” to demonstrate substantial equivalence under the 510(k) clearance pathway by showing that such device meets objective safety and performance criteria established by the FDA, thereby obviating the need for manufacturers to compare the safety and performance of their medical devices to specific predicate devices in the clearance process. The FDA maintains a list of device types appropriate for the “safety and performance based” pathway and will continue to develop product-specific guidance documents that identify the performance criteria for each such device type, as well as the testing methods recommended in the guidance documents, where feasible.In addition, after a device is placed on the market, numerous FDA and other regulatory requirements continue to apply. These requirements include establishment registration and device listing with the FDA, compliance with medical device reporting regulations, which require that manufacturers report to the FDA if their device may have caused or contributed to a death or serious injury or malfunctioned in a way that would likely cause or contribute to a death or serious injury if it were to recur, and compliance with corrections and removal reporting regulations, which require that manufacturers report to the FDA field corrections and product recalls or removals if undertaken to reduce a risk to health posed by the device or to remedy a violation of the FFDCA that may present a risk to health. The FDA and the Federal Trade Commission (“FTC”) also regulate the advertising and promotion of our products to ensure that the claims we make are consistent with our regulatory clearances, that there is scientific data to substantiate the claims, and that our advertising is neither false nor misleading. In general, we may not promote or advertise our products for uses not within the scope of our intended use statement in our clearances or make 13Table of Contentsunsupported safety and effectiveness claims. Many regulatory jurisdictions outside of the U.S. have similar regulations to which we are subject.Our manufacturing processes are required to comply with the FDA’s Good Manufacturing Practice (“GMP”) requirements contained in its Quality System Regulation (“QSR”) and associated regulations and guidance. The QSR covers, among other things, the methods used in, and the facilities and controls used for, the design, manufacture, packaging, labeling, storage, installation, and servicing of all medical devices intended for human use. The QSR also requires maintenance of extensive records, which demonstrate compliance with the FDA regulation, the manufacturer’s own procedures, specifications, and testing, as well as distribution and post-market experience. Compliance with the QSR is necessary to receive FDA clearance or approval to market new products and is necessary for a manufacturer to be able to continue to market cleared or approved product offerings in the U.S. A company’s facilities, records, and manufacturing processes are subject to periodic scheduled or unscheduled inspections by the FDA, which may issue reports known as Form FDA 483 or Notices of Inspectional Observations, which list instances where the FDA investigator believes the manufacturer has failed to comply with applicable regulations and/or procedures. If the observations are sufficiently serious or the manufacturer fails to respond appropriately, the FDA may issue Warning Letters, or Untitled Letters, which are notices of potential enforcement actions against the manufacturer. If a Warning Letter or Untitled Letter is not addressed to the satisfaction of the FDA or if the FDA becomes aware of any other serious issue with a manufacturer’s products or facilities, it could result in fines, injunctions, civil penalties, delays, suspension or withdrawal of clearances, seizures or recalls of products, operating restrictions, total shutdown of production facilities, prohibition on export or import, and criminal prosecution. Such actions may have further indirect consequences for the manufacturer outside of the U.S. and may adversely affect the reputation of the manufacturer and the product.To a greater or lesser extent, most other countries require some form of quality system and regulatory compliance, which may include periodic inspections, inspections by third-party auditors, and specialized documentation. Failure to meet all of the requirements of these countries could jeopardize our ability to import, market, support, and receive reimbursement for the use of our products in these countries.In addition to the above, we may seek to conduct clinical studies or trials in the U.S. or other countries on products that have not yet been cleared or approved for a particular indication. Additional regulations govern the approval, initiation, conduct, documentation, and reporting of clinical studies to regulatory agencies in the countries or regions in which they are conducted. Such investigational use is generally also regulated by local and institutional requirements and policies which usually include review by an ethics committee or institutional review board (“IRB”). Failure to comply with all regulations governing such studies could subject the Company to significant enforcement actions and sanctions, including halting of the study, seizure of investigational devices or data, sanctions against investigators, civil or criminal penalties, and other actions. Without the data from one or more clinical studies, it may not be possible for us to secure the data necessary to support certain regulatory submissions, secure reimbursement, or demonstrate other requirements. We cannot provide assurance that access to clinical investigators, sites, subjects, documentation, and data will be available on the terms and in the timeframes necessary.Products manufactured outside the U.S. by or for us are subject to U.S. Customs and FDA inspection upon entry into the U.S. We must demonstrate compliance of such products with U.S. regulations and carefully document the eventual distribution or re-exportation of such products. Failure to comply with all applicable regulations could prevent us from having access to products or components critical to the manufacture of finished products and lead to shortages and delays.California RegulationThe State of California requires that we obtain a license to manufacture medical devices and, until 2012, conducted periodic inspections of medical device manufacturers. Our facilities and manufacturing processes were last inspected in July 2011 and were found to be in compliance. In accordance with the State of California regulations, our license to manufacture is renewed annually with any updated manufacturing information. Although the State of California has announced the suspension of routine periodic inspections, there can be no assurance that the State of California will not resume such inspections or conduct such inspections under specific circumstances that are not yet known.Foreign RegulationIn order for us to market our products in countries outside the United States, we must obtain regulatory approvals and comply with extensive product and quality system regulations in other countries. These regulations, including the requirements for approvals or clearance and the time required for regulatory review, vary from country to country. Some countries have regulatory review processes that are substantially longer than U.S. processes. Failure to obtain regulatory approval in a timely manner and meet all of the local requirements including language and specific safety standards in any foreign country in which we plan to market our products could prevent us from marketing products in such countries or subject us to sanctions and fines.For example, most medical devices must undergo thorough safety examinations and demonstrate medical efficacy before they receive regulatory approval to be sold in Japan. We obtained approval from the Japanese Ministry of Health, Labor, and 14Table of ContentsWelfare (“MHLW”) for our da Vinci Si Surgical System in October 2012, for our da Vinci Xi Surgical System in March 2015, and for our da Vinci X Surgical System in April 2018. National reimbursement status in Japan was received for dVP procedures in April 2012 and for da Vinci partial nephrectomy procedures in April 2016. An additional 12 da Vinci procedures were granted reimbursement effective April 1, 2018, including gastrectomy, low anterior resection, lobectomy, and hysterectomy, for both malignant and benign conditions. An additional 7 procedures were granted reimbursement effective April 1, 2020. These additional 19 reimbursed procedures have varying levels of conventional laparoscopic penetration and will be reimbursed at rates equal to the conventional laparoscopic procedures. Given the reimbursement level and laparoscopic penetration for these 19 procedures, there can be no assurance that adoption will occur or that the adoption pace for these procedures will be similar to any other da Vinci procedures. If these procedures are not adopted and we are not successful in obtaining adequate procedure reimbursements for additional procedures, then the demand for our products in Japan could be limited. The process of reimbursement for new da Vinci surgical procedures in Japan is led by the surgical societies. The societies submit for reimbursement or incremental reimbursement to the MHLW for their evaluation. The decision to reimburse requires in-country clinical data and is fixed in April of even-numbered years.Commercialization of medical devices in Europe is regulated by the European Union (“EU”). The EU presently requires that all medical products bear the Conformité Européenne (“CE”) mark for compliance with the Medical Device Directive (93/42/EEC) as amended. The CE mark is an international symbol of adherence to certain essential principles of safety and performance mandated in applicable European medical device directives, which, once affixed, enables a product to be sold in member countries of the EU and those affiliated countries that accept the CE mark. The CE mark is also recognized in many countries outside of the EU, such as Australia, and can assist in the clearance process. In order to affix the CE mark on products, a recognized European Notified Body must certify a manufacturer’s quality system and design dossier for compliance with international and European requirements. We have received authorization from Presafe Denmark A/S (formerly DGM Denmark A/S), a recognized European Notified Body and part of Nemko Presafe A/S, to affix the CE mark to our da Vinci Surgical Systems and EndoWrist instruments and accessories. To maintain authorization to apply the CE mark, we are subject to annual surveillance audits and periodic re-certification audits. In September 2013, the European Commission adopted a recommendation indicating that all Notified Bodies, including Presafe, should carry out unannounced audits at least once every third year, of the manufacturers whose medical devices they have certified. These unannounced audits can also extend to the manufacturer’s critical suppliers or sub-contractors (those that supply a critical input or perform a critical function for the manufacturer).If we modify our existing products or develop new products in the future, we may need to apply for authorization to affix the CE mark to such products. We do not know whether we will be able to obtain authorization to affix the CE mark for new or modified products or whether we will continue to meet the safety and performance standards required to maintain the authorizations we have already received. If we are unable to maintain authorizations to affix the CE mark to our products, we will no longer be able to sell our products in member countries of the EU or those whose marketing authorizations are based on the CE mark.In May 2017, the Medical Device Regulation was implemented to replace the Medical Device Directive (93/42/EEC) as amended. The Medical Device Regulation ((EU) 2017/745) comes into force on May 26, 2021, and imposes stricter requirements for the marketing and sale of medical devices and grants Notified Bodies increased post-market surveillance authority. We may be subject to risks associated with additional testing, modification, certification, or amendment of our existing market authorizations, or we may be required to modify products already installed at our customers’ facilities to comply with the official interpretations of these revised regulations.Regulations in other countries, including the requirements for approvals or clearance and the time required for regulatory review, vary from country to country. Certain countries, such as China and South Korea, have their own regulatory agencies. These countries typically require regulatory approvals and compliance with extensive safety and quality system regulations. Failure to obtain regulatory approval in any foreign country in which we plan to market our products, or failure to comply with any regulation in any foreign country in which we market our products may negatively impact our ability to generate revenue and harm our business. Our system sales into China are also dependent on obtaining importation authorizations and provincial approvals, as well as hospitals completing a tender process under the authorization. In October 2018, the China National Health Commission published on its official website the quota for major medical equipment to be imported and sold in China through 2020. After an adjustment notice was published in the third quarter of 2020, the government will now allow for the total sale of 225 new surgical robots into China, which could include da Vinci Surgical Systems as well as surgical systems introduced by others. Sales of da Vinci Surgical Systems under the quota are uncertain, as they are dependent on hospitals completing a tender process and receiving associated approvals. In addition, local regulations may apply, which govern the use of our products and which could have an adverse effect on our product utilization if they are unfavorable. All such regulations are revised from time to time and, in general, are increasing in complexity, and in the scope and degree of documentation and testing required. There can be no assurance that the outcomes from such documentation and testing will be acceptable to any particular regulatory agency or will continue to be acceptable over time. There are further regulations governing the importation, marketing, sale, distribution, use, and service as well as the removal and disposal of medical devices in the regions in which we operate and 15Table of Contentsmarket our products. Failure to comply with any of these regulations could result in sanctions or fines and could prevent us from marketing our products in these regions.Other Healthcare LawsWe are also subject to federal and state healthcare laws and regulations pertaining to fraud and abuse, physician payment transparency, privacy, and security laws and regulations. These laws include:•the federal Anti-Kickback Statute, which prohibits, among other things, persons from knowingly and willfully soliciting, receiving, offering, or paying remuneration, directly or indirectly, in exchange for or to induce either the referral of an individual for, or the purchase, order, or recommendation of, any good or service for which payment may be made under federal healthcare programs, such as the Medicare and Medicaid programs. A person or entity does not need to have actual knowledge of the federal Anti-Kickback Statute or specific intent to violate it to have committed a violation. In addition, the government may assert that a claim including items or services resulting from a violation of the federal Anti-Kickback Statute constitutes a false or fraudulent claim for purposes of the False Claims Act;•federal false claims laws that prohibit, among other things, individuals or entities from knowingly presenting, or causing to be presented, claims for payment from Medicare, Medicaid, or other federal third-party payors that are false or fraudulent. Private individuals can bring False Claims Act “qui tam” actions on behalf of the government, and such individuals may share in amounts paid by the entity to the government in fines or settlement;•the federal Civil Monetary Penalties Law, which prohibits, among other things, offering or transferring remuneration to a federal healthcare beneficiary that a person knows or should know is likely to influence the beneficiary’s decision to order or receive items or services reimbursable by the government from a particular provider or supplier;•federal criminal laws that prohibit executing a scheme to defraud any federal healthcare benefit program or making false statements relating to healthcare matters;•the federal Health Insurance Portability and Accountability Act of 1996, as amended by the Health Information Technology for Economic and Clinical Health Act, which governs the conduct of certain electronic healthcare transactions and protects the security and privacy of protected health information;•the federal Physician Payment Sunshine Act, which requires (i) manufacturers of drugs, devices, biologics, and medical supplies for which payment is available under Medicare, Medicaid, or the Children’s Health Insurance Program (with certain exceptions) to report annually to the Centers for Medicare & Medicaid Services (“CMS”) information related to payments or other “transfers of value” made to physicians (defined to include doctors, dentists, optometrists, podiatrists, and chiropractors), certain other healthcare professionals (as described below), and teaching hospitals, and (ii) applicable manufacturers and group purchasing organizations to report annually to CMS ownership any investment interests held by the physicians described above and their immediate family members and payments or other “transfers of value” to such physician owners. Additionally, on October 25, 2018, President Trump signed into law the “Substance Use-Disorder Prevention that Promoted Opioid Recovery and Treatment for Patients and Communities Act,” which, in part (under a provision entitled “Fighting the Opioid Epidemic with Sunshine”), extends the reporting and transparency requirements for physicians in the Physician Payments Sunshine Act to physician assistants, nurse practitioners, clinical nurse specialists, certified registered nurse anesthetists, and certified nurse midwives (with reporting requirements going into effect in 2022 for payments made in 2021). Manufacturers are required to submit reports to CMS by the 90th day of each calendar year; and•analogous state and foreign law equivalents of each of the above federal laws, such as anti-kickback and false claims laws, which may apply to items or services reimbursed by any third-party payor, including commercial insurers, state laws that require device companies to comply with the industry’s voluntary compliance guidelines and the applicable compliance guidance promulgated by the federal government or otherwise restrict payments that may be made to healthcare providers and other potential referral sources, state laws that require device manufacturers to report information related to payments and other “transfers of value” to physicians and other healthcare providers or marketing expenditures and pricing information, and laws governing the privacy and security of health information in certain circumstances, including the E.U. General Data Protection Regulation (“GDPR”), many of which differ from each other in significant ways and may not have the same effect, thus complicating compliance efforts.16Table of ContentsIf our operations are found to violate any of the laws described above or any other laws and regulations that apply to us, we may be subject to penalties, including civil and criminal penalties, damages, fines, the curtailment or restructuring of our operations, the exclusion from our participation in federal and state healthcare programs, and imprisonment, any of which could adversely affect our ability to market our products and materially adversely affect our business, results of operations, and financial condition. Any action against us for violation of these laws, even if we successfully defend against it, could cause us to incur significant legal expenses and divert our management’s attention from the operation of our business.Third-Party Coverage and ReimbursementIn the U.S. and most markets OUS where we sell our products, the government and health insurance companies together are responsible for hospital and surgeon reimbursement for virtually all covered surgical procedures. Governments and insurance companies generally reimburse hospitals and physicians for surgery when the procedure is considered medically necessary. In the U.S., CMS administers the Medicare and Medicaid programs (the latter, along with applicable state governments). Many other third-party payors model their reimbursement methodologies after the Medicare program. As the single largest payor, this program has a significant impact on other payors’ payment systems.Generally, reimbursement for professional services performed at a facility by physicians is reported under billing codes issued by the American Medical Association (“AMA”), known as Current Procedural Terminology (“CPT”) codes. Physician reimbursement under Medicare generally is based on a fee schedule and determined by the relative value of the professional service rendered. In addition, CMS and the National Center for Health Statistics (“NCHS”) are jointly responsible for overseeing changes and modifications to billing codes used by hospitals to report inpatient procedures, ICD-10-PCS codes. For Medicare, CMS generally reimburses hospitals for services provided during an inpatient stay based on a prospective payment system that is determined by a classification system known as Medicare-Severity Diagnostic Related Groupings (“MS-DRGs”). MS-DRGs are assigned using a number of factors, including the principal diagnosis, major procedures, discharged status, patient age, and complicating secondary diagnoses, among other things. Hospital outpatient services, reported by CPT codes, are assigned to clinically relevant Ambulatory Payment Classifications (“APCs”) used to determine the payment amount for services provided.Since October 1, 2015, a new family of ICD-10-PCS codes can be used, in conjunction with other applicable procedure codes, to describe various robotic-assisted procedures. An inpatient surgical procedure, completed with or without robotic assistance, continues to be assigned to the clinically relevant MS-DRG.Governments and insurance companies carefully review and increasingly challenge the prices charged for medical products and surgical services. Reimbursement rates from private companies vary depending on the procedure performed, the third-party payor, contract terms, and other factors. Because both hospitals and physicians may receive the same reimbursement for their respective services, with or without robotics, regardless of actual costs incurred by the hospital or physician in furnishing the care, including for the specific products used in that procedure, hospitals and physicians may decide not to use our products if reimbursement amounts are insufficient to cover any additional costs incurred when purchasing our products.Domestic institutions typically bill various third-party payors, such as Medicare, Medicaid, and other government programs and private insurance plans for the primary surgical procedure that includes our products. Because our da Vinci Surgical Systems have been cleared for commercial distribution in the U.S. by the FDA, coverage and reimbursement by payors are generally determined by the medical necessity of the primary surgical procedure. Governmental and third-party payors may also consider additional factors when determining coverage and reimbursement, including the designation of the surgical procedure as a covered benefit, the appropriateness of the procedure for the specific patient, support by guidelines established by the relevant professional college or medical society, and a payor determination that the procedure is neither experimental nor investigational. We believe that the additional procedures we intend to pursue are established surgical procedures that are generally already reimbursable by government agencies and insurance companies for appropriately selected patients. If hospitals do not obtain sufficient reimbursement from third-party payors for procedures performed with our products, or if governmental and private payors’ policies do not cover surgical procedures performed using our products, we may not be able to generate the revenues necessary to support our business.In countries outside the U.S., reimbursement is obtained from various sources, including governmental authorities, private health insurance plans, and labor unions. In most foreign countries, private insurance systems may also offer payments for some therapies. In addition, health maintenance organizations are emerging in certain European countries. To effectively conduct our business, we may need to seek OUS reimbursement approvals, and we do not know if these required approvals will be obtained in a timely manner or at all. In some countries, patients may be permitted to pay directly for surgical services; however, such “co-pay” practices are not common in most countries.In the U.S., there have been, and continue to be, a number of legislative initiatives to contain healthcare costs. In March 2010, the Patient Protection and Affordable Care Act, as amended by the Health Care and Education Reconciliation Act (collectively, the “PPACA”), was enacted. The PPACA made changes that have significantly impacted healthcare providers, 17Table of Contentsinsurers, and pharmaceutical and medical device manufacturers. The PPACA contained a number of provisions designed to generate the revenues necessary to fund health insurance coverage expansion, including, but not limited to, fees or taxes on certain health-related industries, including medical device manufacturers.The PPACA also appropriated funding to research the comparative effectiveness of healthcare treatments and strategies. It remains unclear how this research will influence future Medicare coverage and reimbursement decisions as well as influence other third-party payor coverage and reimbursement policies. The PPACA, as well as other federal or state healthcare reform measures that may be adopted in the future, could have a material adverse effect on our business. The taxes imposed by PPACA and the expansion in the government’s role in the U.S. healthcare industry may result in decreased profits, lower reimbursement from payors for procedures that use our products, and/or reduced procedural volumes, all of which may adversely affect our business, financial condition, and results of operations.In addition, other legislative changes have been proposed and adopted since the PPACA was enacted. These changes included an aggregate reduction in Medicare payments to providers of up to 2% per fiscal year, which went into effect on April 1, 2013 and will remain in effect through 2030, unless additional Congressional action is taken, with the exception of a temporary suspension of the 2% cut in Medicare payments from May 1, 2020, through December 31, 2020. On January 2, 2013, the American Taxpayer Relief Act of 2012 was signed into law, which, among other things, further reduced Medicare payments to several types of providers, including hospitals, imaging centers, and cancer treatment centers. The Medicare Access and CHIP Reauthorization Act of 2015, enacted on April 16, 2015 (“MACRA”), repealed the formula by which Medicare made annual payment adjustments to physicians and replaced the former formula with fixed annual updates and a new system of incentive payments that began in 2019 and are based on various performance measures and physicians’ participation in alternative payment models, such as accountable care organizations. Individual states in the U.S. have also become increasingly aggressive in passing legislation and implementing regulations designed to control product pricing, including price or patient reimbursement constraints and discounts, and require marketing cost disclosure and transparency measures.There have also been judicial and congressional challenges to certain aspects of the PPACA, as well as efforts by the U.S. administration to modify, repeal, or otherwise invalidate all, or certain provisions of, the PPACA. Since January 2017, President Trump signed two Executive Orders designed to delay the implementation of certain provisions of the PPACA or otherwise circumvent some of the requirements for health insurance mandated by the PPACA. The Trump administration has also announced that it will discontinue the payment of cost-sharing reduction (“CSR”) payments to insurance companies until Congress approves the appropriation of funds for the CSR payments. The loss of the CSR payments is expected to increase premiums on certain policies issued by qualified health plans under the PPACA. Legislation to appropriate funds for CSR payments has been introduced in Congress, but the future of such legislation is uncertain. In addition, CMS finalized regulations that, effective beginning with the 2020 plan year, give states greater flexibility in setting benchmarks for insurers in the individual and small group marketplaces, which may have the effect of relaxing the essential health benefits required under the PPACA for plans sold through such marketplaces. As a result of the Tax Cuts and Jobs Act (“2017 Tax Act”) enacted on December 22, 2017, the PPACA’s individual mandate penalty for not having health insurance coverage was eliminated starting in 2019. Further, each chamber of Congress has put forth multiple bills designed to repeal or repeal and replace portions of the PPACA. On December 14, 2018, a U.S. District Court Judge in the Northern District of Texas, ruled that the individual mandate is a critical and inseverable feature of the ACA and, therefore, because it was repealed as part of the 2017 Tax Act, the remaining provisions of the ACA are invalid as well. The Fifth Court of Appeals affirmed the district court's ruling that the individual mandate was unconstitutional, but it remanded the case back to the district court for further analysis of whether the mandate could be severed from the Affordable Care Act. The Supreme Court of the United States granted certiorari on March 2, 2020 and held oral arguments on November 10, 2020. The case is expected to be decided by mid-2021. It is unclear how this decision, subsequent pending appeals, and other efforts to repeal and replace the ACA will impact the ACA and our business. Although the majority of these measures have not been enacted by Congress to date, Congress may continue to consider other legislation to repeal or repeal and replace elements of the PPACA. Any regulatory or legislative developments in domestic or foreign markets that eliminate or reduce reimbursement rates for procedures performed with our products could harm our ability to sell our products or cause downward pressure on the prices of our products, either of which would adversely affect our business, financial condition, and results of operations.18Table of ContentsHuman CapitalThe future success of our company depends on our ability to attract, retain, and further develop top talent. To facilitate talent attraction, retention, and development, we strive to make Intuitive an inclusive, diverse, and safe workplace with opportunities for our employees to grow and develop in their careers, supported by strong compensation, benefits, and health and wellness programs as well as by programs that build connections between our employees and the communities in which they live and work.At December 31, 2020, we had approximately 8,081 full-time employees, 1,111 of whom were engaged directly in research and development, 3,559 in manufacturing and service, and 3,411 in marketing, sales and administrative activities. During 2020, the number of employees increased by approximately 755. Our employees are based in 27 different countries around the world. Our global workforce consists of diverse, highly skilled talent at all levels. During 2020, our turnover rate was less than 6.5%.Inclusion and DiversityWe strive to foster a culture where mutual respect, inclusive behavior, and dignity are core to our individual expectations. Since our founding, we have remained committed to fostering an inclusive environment in which our differing backgrounds, life experiences, and perspectives join to positively impact the communities in which we live and serve.We continue to build a culture where the best idea wins and our doors and minds are always open. We do this by leading with inclusion and empowering everyone to do their best work as their most authentic selves—regardless of race, color, national origin, religion, sex, sexual orientation, gender identity and expression, age, disability, or military service status. We are united by our collective purpose and common set of organizational values that are core to our mission and culture.We support the growth and expansion of our employee resource groups (ERGs), which foster an inclusive culture and sense of belonging for our employees. Our ERGs provide a point of connection for employees who share common community attributes and want to engage, learn, communicate, and participate in advancing our inclusion and diversity objectives. Our ERGs include the Women Intuitive Network, Intuitive Pan-Asian Community, BLACK at Intuitive, Diverse Abilities, PRIDE, and VETS. In 2020, our ERGs grew from three to 10 companywide. These employee-volunteer-led groups focus on four key impact areas including recruitment, employee development, community building, and business development. ERGs also provided ideas and insight to senior management and various departments by serving as sources of employee feedback on important aspects of our business, such as talent acquisition and retention, accessibility accommodations, and operational challenge solutions. From a governance perspective, maintaining a mix of backgrounds and experience in our board composition is essential to understanding and reflecting the needs of our diverse stakeholders. Currently, three of our 10 board members are women, one of our board members identifies as Hispanic, and one of our board members identifies as Middle Eastern.Health, Safety, and WellnessThe health, safety, and wellness of our employees is a priority in which we have always invested, and will continue to do so. These investments and the prioritization of employee health, safety, and wellness took on particular significance in 2020 in light of COVID-19. We provide our employees and their families with access to a variety of innovative, flexible, and convenient health and wellness programs. Program benefits are intended to provide protection and security, so employees can have peace of mind concerning events that may require time away from work or that may impact their financial well-being. Additionally, we provide programs to help support employee physical and mental health by providing tools and resources to help them improve or maintain their health status, encourage engagement in healthy behaviors, and offer choices where possible so they are customized to meet their needs and the needs of their families.In response to the COVID-19 pandemic, we implemented significant changes that we determined were in the best interest of our employees, as well as the communities in which we operate, in compliance with government regulations. This includes having the vast majority of our employees work from home, while implementing additional safety measures for employees continuing critical on-site work. A number of employees critical to maintaining our essential engineering, manufacturing, repair, and logistics functions have continued to work from Intuitive locations globally. To protect and support our essential team members, we have implemented health and safety measures that included maximizing personal workspaces, changing shift schedules, providing personal protective equipment (PPE), and instituting mandatory screening before accessing buildings. We created subteam groups, keeping the same manufacturing teams working together to facilitate contact tracing and minimize potential staffing risk.19Table of ContentsCompensation and BenefitsWe provide compensation and benefits programs to help meet the needs of our employees. In addition to base compensation, these programs, which vary by country and region, include annual bonuses, stock awards, an Employee Stock Purchase Plan, 401(k) and pension plans, healthcare and insurance benefits, health savings and flexible spending accounts, paid time off, family leave, family care resources, and flexible work schedules, among many others. As a response to the COVID-19 pandemic, we implemented modifications to our compensation program, including paying a portion of 2020 bonuses mid-year to help staff cover unforeseen pandemic-related expenses. We also offered premium pay and a subsidized lunch program.Ensuring fair and equitable pay is integral to our commitment to our employees. Our executive team and Board of Directors strongly support this commitment. We conduct pay equity reviews annually to help us understand whether our compensation structure is appropriate and to identify what improvements can be made. In addition, we utilize a robust inspection process with an independent consulting firm for gender and ethnicity hiring, promotion, and wage equity to determine whether any statistically significant pay differences exist between women and men and between minorities and non-minorities. If pay disparities are identified, we conduct further evaluation to determine whether remedial adjustments are appropriate. In addition, employees can raise issues regarding pay equity with their manager, their human resources partner, or confidentially through our anonymous reporting helpline.Talent DevelopmentWe value our employees and the passion, commitment, and professional depth they provide. To enhance employee retention and job satisfaction, we offer ongoing learning and leadership training opportunities that support growth.With a commitment to achieving diverse representation within our leadership ranks that reflects the diversity that we see in our overall employee base, we increased our leadership development efforts in 2020 by reinforcing development around our People Leader Success Model. Leadership development focuses on people-leader effectiveness, cultural continuity, and organizational effectiveness, so that leaders at all levels have the capabilities and knowledge that they and their teams need to succeed.Our Global Talent Management team transitioned much of our leadership training from in-person sessions to remote learning with the emergence of COVID-19 in 2020. Our scaled learning platform of on-demand and virtual classroom learning eliminates travel and allows employees worldwide to access development at their convenience.We have robust annual global performance review processes for reviewing all employees’ performance and pay. To support our managers, we train them on conducting effective performance reviews and making compensation recommendations, which take into consideration market pay data and performance, as well as experience in an employee’s respective role.Community Programs and Our COVID-19 ResponseWe believe that building connections between our employees, their families, and our communities creates a more meaningful, fulfilling, and enjoyable workplace. Through our engagement programs, our employees can pursue their interests and hobbies, connect to volunteering and giving opportunities, and enjoy unique recreational experiences with family members.The Intuitive Foundation is a nonprofit organization established and funded by Intuitive in 2018. Since its founding, the Intuitive Foundation has been dedicated to promoting health, advancing education, and reducing human suffering. The Foundation supports outreach programs financially while we provide the volunteers and mentors from within our company. Since its inception, we have contributed $55 million to the Intuitive Foundation to fulfill its mission.The events of 2020 inspired Intuitive employees to further support the Foundation’s work on several key initiatives. The Foundation’s multifaceted response to the COVID-19 pandemic was a major focus in 2020. From the first days of the pandemic, Intuitive and the Intuitive Foundation engaged within the communities in which we live and work. We converted some of our manufacturing lines to produce PPE, donating more than a million face shields globally through the Intuitive Foundation. Employees and their families sewed facemasks and volunteered in their communities. Our engineers helped design and implement updates to ventilators that made them easier to produce. Some of our medically trained employees volunteered as healthcare workers on the front lines. Lastly, Intuitive and the Intuitive Foundation, along with many employees, contributed financially to support COVID-19 relief.We encourage you to review the "Talent and workplace experience" and "Creating stronger communities" section of our Sustainability Report 2020 (located on our website) for more detailed information regarding our Human Capital programs and initiatives. Nothing on our website, including our Sustainability Report 2020 or sections thereof, shall be deemed incorporated by reference into this Annual Report.20Table of ContentsGeneralWe make our periodic and current reports, including our Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and any amendments to those reports, available free of charge on our website as soon as practicable after such material is electronically filed or furnished with the Securities and Exchange Commission (the “SEC”). Our website address is www.intuitive.com, and the reports are filed under “SEC Filings” on the Company — Investor Relations portion of our website. Periodically, we webcast Company announcements, product launch events, and executive presentations, which can be viewed via our Investor Relations page on our website. In addition, we provide notifications of our material news, including SEC filings, investor events, and press releases as part of our Investor Relations page on our website. The contents of our website are not intended to be incorporated by reference into this report or in any other report or document we file, and any references to our website are intended to be inactive textual references only. The SEC maintains an internet site that contains reports, proxy and information statements, and other information regarding issuers that file electronically with the SEC at www.sec.gov. The contents of these websites are not incorporated into this filing. Further, references to the URLs for these websites are intended to be inactive textual references only.We operate our business as one segment, as defined by U.S. generally accepted accounting principles. Our financial results for the years ended December 31, 2020, 2019, and 2018 are discussed in “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations” and “
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+Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations You should read the following discussion and analysis of our financial condition and results of operations together with our consolidated financial statements and the related notes included elsewhere in this Annual Report on Form 10-K. Some of the information contained in this discussion and analysis or set forth elsewhere in this Annual Report, including information with respect to our plans and strategy for our business, includes forward-looking statements that involve risks and uncertainties. You should read the “Risk Factors” section of this Annual Report for a discussion of important factors that could cause actual results to differ materially from the results described in or implied by the forward-looking statements contained in the following discussion and analysis.Overview IQVIA is a leading global provider of advanced analytics, technology solutions, and clinical research services to the life sciences industry. IQVIA creates intelligent connections across all aspects of healthcare through its analytics, transformative technology, big data resources and extensive domain expertise. IQVIA Connected Intelligence™ delivers powerful insights with speed and agility — enabling customers to accelerate the clinical development and commercialization of innovative medical treatments that improve healthcare outcomes for patients. With approximately 70,000 employees, we conduct operations in more than 100 countries.We are a global leader in protecting individual patient privacy. We use a wide variety of privacy-enhancing technologies and safeguards to protect individual privacy while generating and analyzing information on a scale that helps healthcare stakeholders identify disease patterns and correlate with the precise treatment path and therapy needed for better outcomes. Our insights and execution capabilities help biotech, medical device and pharmaceutical companies, medical researchers, government agencies, payers and other healthcare stakeholders tap into a deeper understanding of diseases, human behaviors and scientific advances, in an effort to advance their path toward cures. We are managed through three reportable segments, Technology & Analytics Solutions, Research & Development Solutions and Contract Sales & Medical Solutions. Technology & Analytics Solutions provides critical information, technology solutions and real world insights and services to our life science clients. Research & Development Solutions, which primarily serves 45biopharmaceutical clients, is engaged in research and development and provides clinical research and clinical trial services. Contract Sales & Medical Solutions provides contract sales to both biopharmaceutical clients and the broader healthcare market. For a description of our service offerings within our segments, refer to Part I, Item 1, “Business”.Industry Outlook For information about the industry outlook and markets that we operate in, refer to Part I, Item I, “Our Market Outlook”.Overview of the Impact of COVID-19As a result of the global spread of COVID-19 beginning in early March, we began to experience general business disruptions that impeded normal business activity including our ability to perform on-site monitoring and deliver offerings that rely on face-to-face interaction or in-person gatherings.These disruptions have impacted all three of our reportable segments. The Research & Development Solutions business responded quickly to support our clients with the development of vaccines and therapies for COVID-19. We have been involved in clinical trials and studies for the virus, as well as patient recruitment for COVID-19 trials. The pandemic has accelerated the need for remote and risk-based monitoring in clinical research, which in turn has accelerated the adoption of our virtual trial technology. This technology was deployed to speed vaccine development and helped secure full-service COVID trials and new studies with top pharmaceutical clients. We continue to see gradual improvement in the accessibility of clinical research sites in the Research & Development Solutions business. We are seeing a return to on-site monitoring visits which exceeded the number of remote visits during the second half of the year. In instances where sites remain physically inaccessible for clinical monitoring, remote monitoring and virtual solutions continue to be effective alternatives. Site start-up activities continued to increase along with patient recruitment trends. In our Technology & Analytics Solutions segment, our Real-World business has been relatively well insulated from the impacts of the virus and it had strong growth for the year. The Real-World business is advanced in the use of secondary data, remote monitoring and virtual research approaches, which helped us pivot quickly to working in the new remote world at the onset of the pandemic. However, the portion of our Real-World business that requires site monitoring activity also experienced limitations on site accessibility, which led to a reduction in the associated revenue. Within our Technology & Analytics Solutions segment, we have had very little interruption in data supply and demand. Our analytics and consulting businesses have performed well despite business development being hampered by lack of in-person interactions. Our Technology & Analytics solutions offerings that rely on face-to-face interactions or are dependent on in-person gatherings, events or conferences continue to experience disruption, and where we were unable to execute on our commitments due to COVID-19, we were not able to recognize the associated revenue in the period. Activity within the Contract Sales and Medical Solutions business continues to be more challenging due to a decline in sales rep visits, and physician attention diverted to the COVID-19 crisis.We have accelerated and expanded a variety of cost containment actions to reduce the impact to profitability. We have activated business continuity plans, including remote delivery capabilities in technology and analytics, remote monitoring and virtual trials in Research & Development Solutions and virtual commercial activity with clients wherever possible. We anticipate an acceleration of business momentum when the crisis subsides as delayed trial activities will still need to be performed.The Company continues to maintain strong liquidity. As of December 31, 2020, cash and cash equivalents were $1,814 million and the Company had no amounts drawn under its $1.5 billion revolving credit facility. At December 31, 2020, the Company was in compliance with the financial covenants under its debt agreements in all material respects and does not have material uncertainty about ongoing ability to meet the covenants of our credit arrangements.To help ensure the safety and well-being of our employees, customers, partners and the broader community and continuity of our business operations, we continue to monitor health authority guidance on mitigating the spread of COVID-19 and managing positive cases. We manage our response to the pandemic through a combination of enterprise-wide and regional governance teams, with particular focus on the medical and scientific, information technology, human capital and financial impacts of the pandemic on our business. These teams met, and continue to meet, regularly as necessary based on the status of the pandemic. We closely monitor the impact of COVID-19 on our operations and report to our Board regularly on the progress of our response to the COVID-19 outbreak. We have established global workplace protocols that govern the return of our employees to our offices.46Business Combinations We have completed and will continue to consider strategic business combinations to enhance our capabilities and offerings in certain areas, including various individually immaterial acquisitions during the years ended December 31, 2020 and 2019. These transactions were accounted for as business combinations and the acquired results of operations are included in our consolidated financial information since the acquisition date. See Note 14 to our audited consolidated financial statements included elsewhere in this Annual Report on Form 10-K for additional information with respect to these business combinations.Sources of Revenue Total revenues are comprised of revenues from the provision of our services. We do not have any material product revenues.Costs and Expenses Our costs and expenses are comprised primarily of our costs of revenue, reimbursed expenses and selling, general and administrative expenses. Costs of revenue include compensation and benefits for billable employees and personnel involved in production, trial monitoring, data management and delivery, and the costs of acquiring and processing data for our information offerings; costs of staff directly involved with delivering technology-related services offerings and engagements, related accommodations and the costs of data purchased specifically for technology services engagements; and other expenses directly related to service contracts such as courier fees, laboratory supplies, professional services and travel expenses. As noted above, reimbursed expenses are comprised principally of payments to investigators who oversee clinical trials and travel expenses for our clinical monitors and sales representatives. Selling, general and administrative expenses include costs related to sales, marketing, and administrative functions (including human resources, legal, finance, quality assurance, compliance and general management) for compensation and benefits, travel, professional services, training and expenses for information technology, facilities and depreciation and amortization.Foreign Currency Translation In 2020, approximately 35% of our revenues were denominated in currencies other than the United States dollar, which represents approximately 60 currencies. Because a large portion of our revenues and expenses are denominated in foreign currencies and our financial statements are reported in United States dollars, changes in foreign currency exchange rates can significantly affect our results of operations. The revenue and expenses of our foreign operations are generally denominated in local currencies and translated into United States dollars for financial reporting purposes. Accordingly, exchange rate fluctuations will affect the translation of foreign results into United States dollars for purposes of reporting our condensed consolidated results. As a result, we believe that reporting results of operations that exclude the effects of foreign currency rate fluctuations on certain financial results can facilitate analysis of period to period comparisons. This constant currency information assumes the same foreign currency exchange rates that were in effect for the comparable prior-year period were used in translation of the current period results.Consolidated Results of Operations For information regarding our results of operations for Technology & Analytics Solutions, Research & Development Solutions and Contract Sales & Medical Solutions, refer to “Segment Results of Operations” later in this section. For a discussion of our results of operations comparison for 2019 and 2018, refer to our Annual Report on Form 10-K for the fiscal year ended December 31, 2019 filed on February 18, 2020. Our reportable segment results of operations comparison for 2018 included below within this Annual Report on Form 10-K reflects the change in segment presentation that occurred during the first quarter of 2019. RevenuesYear Ended December 31,Change2020 vs. 20192019 vs. 2018(dollars in millions)202020192018$%$%Revenues$11,359 $11,088 $10,412 $271 2.4 %$676 6.5 %47 2020 compared to 2019 In 2020, our revenues increased $271 million, or 2.4%, as compared to 2019. This increase was comprised of constant currency revenue growth of approximately $252 million, or 2.3%, reflecting a $365 million increase in Technology & Analytics Solutions, offset by a $38 million decrease in Research & Development Solutions and a $75 million decrease in Contract Sales & Medical Solutions.Costs of Revenue, exclusive of Depreciation and AmortizationYear Ended December 31,(dollars in millions)202020192018Costs of revenue, exclusive of depreciation and amortization$7,500 $7,300 $6,746 % of revenues66.0 %65.8 %64.8 % 2020 compared to 2019 When compared to 2019, costs of revenue, exclusive of depreciation and amortization, in 2020 increased $200 million, or 2.7%. This increase included a constant currency increase of approximately $223 million, or 3.1%, comprised of a $232 million increase in Technology & Analytics Solutions, a $67 million increase in Research & Development Solutions, offset by a $76 million decrease in Contract Sales & Medical Solutions. As a percent of revenues, costs of revenue remained flat compared to 2019.Selling, General and Administrative ExpensesYear Ended December 31,(dollars in millions)202020192018Selling, general and administrative expenses$1,789 $1,734 $1,716 % of revenues15.7 %15.6 %16.5 % 2020 compared to 2019 The $55 million increase in selling, general and administrative expenses in 2020 as compared to 2019 included a constant currency increase of approximately $62 million, or 3.6%, comprised of a $23 million increase in Technology & Analytics Solutions, a $31 million increase in Research & Development Solutions, and a $12 million increase in general corporate and unallocated expenses. These increases were partially offset by a $4 million decrease in Contract Sales & Medical Solutions. Depreciation and AmortizationYear Ended December 31,(dollars in millions)202020192018Depreciation and amortization$1,287 $1,202 $1,141 % of revenues11.3 %10.8 %11.0 % The $85 million increase in depreciation and amortization in 2020 as compared to 2019 was primarily due to higher intangible asset balances as a result of acquisitions occurring in 2019, increased amortization due to higher capitalized software balances, and accelerated depreciation on an internal-use software asset in the first quarter of 2020.Restructuring CostsYear Ended December 31,(in millions)202020192018Restructuring costs$52 $75 $68 48 The restructuring costs incurred were due to ongoing efforts to streamline our global operations. The remaining actions under these plans are expected to occur throughout 2021 and are expected to consist of consolidating functional activities, eliminating redundant positions, and aligning resources with customer requirements. Interest Income and Interest ExpenseYear Ended December 31,(in millions)202020192018Interest income$(6)$(9)$(8)Interest expense$416 $447 $414 Interest income included interest received primarily from bank balances and investments. Interest expense during 2020 was lower than 2019 due to lower interest rates attributed to lower LIBOR rates and the redemption of the $800 million of 4.875% senior notes due 2023, partially offset by an increase in the average debt outstanding. Loss on Extinguishment of DebtYear Ended December 31,(in millions)202020192018Loss on extinguishment of debt$13 $24 $2 During 2020, we recognized loss on extinguishment of debt of $13 million for fees and expenses related to the refinancing of our 3.500% senior notes due 2024 as discussed further in Note 10 to our audited consolidated financial statements included elsewhere in this Annual Report on Form 10-K. During 2019, we recognized loss on extinguishment of debt of $24 million for fees and expenses related to the redemption of our 4.875% senior notes due 2023 in aggregate principal amount of $800 million as discussed further in Note 10 to our audited consolidated financial statements included elsewhere in this Annual Report on Form 10-K. See “—Liquidity and Capital Resources” for more information on these transactions. Other Expense (Income), NetYear Ended December 31,(in millions)202020192018Other (income) expense, net$(65)$(37)$5 Other income, net for 2020 primarily consisted of a decrease in fair value of acquisition-related contingent consideration, mark-to-market gains on equity securities, a decrease in foreign currency losses, and a gain on investments in mutual funds. Other income, net for 2019 primarily consisted of a gain related to the remeasurement of a previously held equity interest of an equity method investment upon acquiring the remaining interest as a result of a business combination. Income Tax Expense (Benefit)Year Ended December 31,(dollars in millions)202020192018Income tax expense (benefit)$72 $116 $59 Effective income tax rate19.3 %33.0 %18.0 % In 2020, the U.S. Treasury Department issued final regulations regarding Foreign Derived Intangible Income (“FDII”) and Global Intangible Low-Taxed Income (“GILTI”). We have determined we will elect the GILTI high tax exception as allowed by the final regulations and we will amend our 2018 and 2019 US Federal consolidated income tax returns resulting in a favorable impact of $26 million, which we recorded in 2020.49In 2019 the U.S. Treasury Department issued final regulations on the transition tax and proposed regulations on Foreign Derived Intangible Income (“FDII") which we analyzed. While the final regulations related to the transition tax did not have a material impact on us, the proposed guidance for FDII had an unfavorable impact. Although the proposed guidance for FDII is not authoritative and subject to change in the regulatory review process, we reversed the tax benefit recorded in 2018 by recording a tax expense of $25 million for this impact. Equity in Earnings (Losses) of Unconsolidated AffiliatesYear Ended December 31,(in millions)202020192018Equity in (losses) earnings of unconsolidated affiliates$7 $(9)$15 Equity in earnings (losses) of unconsolidated affiliates increased in 2020 compared to 2019 primarily due to higher earnings from our investment in NovaQuest Pharma Opportunities Fund III. Net Income Attributable to Non-controlling InterestsYear Ended December 31,(in millions)202020192018Net income attributable to non-controlling interests$(29)$(36)$(25) Net income attributable to non-controlling interests primarily consists of Quest’s interest in Q2 Solutions.Segment Results of Operations Revenues and profit by segment are as follows:Segment RevenuesSegment Profit(in millions)202020192018202020192018Technology & Analytics Solutions$4,858 $4,486 $4,137 $1,216 $1,101 $1,041 Research & Development Solutions5,760 5,788 5,465 1,048 1,141 1,055 Contract Sales & Medical Solutions741 814 810 57 52 61 Total11,359 11,088 10,412 2,321 2,294 2,157 General corporate and unallocated(251)(240)(207)Depreciation and amortization(1,287)(1,202)(1,141)Restructuring costs(52)(75)(68)Consolidated$11,359 $11,088 $10,412 $731 $777 $741 Certain costs are not allocated to our segments and are reported as general corporate and unallocated expenses. These costs primarily consist of stock-based compensation and expenses to integration activities and acquisitions. We also do not allocate depreciation and amortization or impairment charges to our segments. Prior period segment results have been recast to conform to changes to management reporting in 2019. The recast impacts the allocation of selling, general and administrative expenses for 2018.50Technology & Analytics SolutionsYear Ended December 31,Change(dollars in millions)2020201920182020 vs. 20192019 vs. 2018Revenues$4,858 $4,486 $4,137 $372 8.3 %$349 8.4 %Cost of revenue, exclusive of depreciation and amortization 2,900 2,663 2,343 2378.932013.7Selling, general and administrative expenses742 722 753 202.8(31)-4.1Segment profit$1,216 $1,101 $1,041 $115 10.4 %$60 5.8 % Revenues 2020 compared to 2019 Technology & Analytics Solutions’ revenues were $4,858 million in 2020, an increase of $372 million, or 8.3%, over 2019. This increase was comprised of constant currency revenue growth of approximately $365 million, or 8.1%, reflecting revenue growth in the Europe and Africa region as well as the Americas region. The revenue growth in these regions was driven by higher real-world and analytical services. See Part II—Item 7—“Overview of the Impact of COVID-19" included elsewhere in this Annual Report on Form 10-K for a discussion of the impact from COVID-19 on Technology & Analytics Solutions business activity. Costs of Revenue, exclusive of Depreciation and Amortization 2020 compared to 2019 Technology & Analytics Solutions’ costs of revenue, exclusive of depreciation and amortization, were $2,900 million in 2020, an increase of $237 million over 2019. This increase was comprised of constant currency increase of approximately $232 million, or 8.7%, reflecting an increase in compensation and related expenses to support revenue growth.Selling, General and Administrative Expenses2020 compared to 2019 Technology & Analytics Solutions’ selling, general and administrative expenses increased $20 million in 2020 as compared to 2019. This increase was comprised of a constant currency increase of approximately $23 million, or 3.2%, reflecting an increase in compensation and related expenses.Research & Development SolutionsYear Ended December 31,Change(dollars in millions)2020201920182020 vs. 20192019 vs. 2018Revenues$5,760 $5,788 $5,465 $(28)(0.5)%$323 5.9 %Cost of revenue, exclusive of depreciation and amortization3,974 3,9363,721381.02155.8Selling, general and administrative expenses738 711689273.8223.2Segment profit$1,048 $1,141 $1,055 $(93)(8.2)%$86 8.2 % Backlog Research & Development Solutions contracted backlog increased from $19.0 billion at December 31, 2019 to $22.6 billion at December 31, 2020 and we expect approximately $5.9 billion of this backlog to convert to revenue in the next 12 months. Contracted backlog was $17.1 billion at December 31, 2018. 51 Backlog represents, at a particular point in time, future revenues from work not yet completed or performed under signed contracts. Once work begins on a project, revenues are recognized over the duration of the project. We believe that backlog is an indicator of future revenues but the timing of revenue will be affected by a number of factors, including the variable size and duration of projects, many of which are performed over several years, cancellations, and changes to the scope of work during the course of projects. Projects that have been delayed remain in backlog, but the timing of the revenue generated may differ from the timing originally expected. Additionally, projects may be terminated or delayed by the customer or delayed by regulatory authorities. In the event that a client cancels a contract, we typically would be entitled to receive payment for all services performed up to the cancellation date and subsequent client-authorized services related to winding down the canceled project. For more details regarding risks related to our backlog, see Part I, Item IA, “Risk Factors—Risks Related to our Business—The relationship of backlog to revenues varies over time.” Revenues 2020 compared to 2019 Research & Development Solutions’ revenues were $5,760 million in 2020, a decrease of $28 million, or 0.5%, over 2019. This decrease was comprised of constant currency revenue decline of approximately $38 million, or 0.7%, reflecting volume-related decreases in clinical services and lab testing impacted by COVID-19, largely offset by the incremental revenue from the clinical trials and studies to support the development of vaccines and therapies for COVID-19. See Part II—Item 7—“Overview of the Impact of COVID-19" included elsewhere in this Annual Report on Form 10-K for a discussion of the impact from COVID-19 on Research & Development Solutions business activity. Costs of Revenue, exclusive of Depreciation and Amortization 2020 compared to 2019 Research & Development Solutions’ costs of revenue, exclusive of depreciation and amortization, increased $38 million, or 1.0%, in 2020 as compared to 2019. This increase included a constant currency increase of approximately $67 million, or 1.7%, reflecting an increase in compensation and related expenses. Selling, General and Administrative Expenses 2020 compared to 2019 Research & Development Solutions’ selling, general and administrative expenses increased $27 million, or 3.8%, in 2020 as compared to 2019, which included a constant currency increase of approximately $31 million, or 4.4%, reflecting an increase in compensation and related expenses.Contract Sales & Medical SolutionsYear Ended December 31,Change(dollars in millions)2020201920182020 vs. 20192019 vs. 2018Revenues$741 $814 $810 $(73)(9.0)%$4 0.5 %Cost of revenue, exclusive of depreciation and amortization626 701 682 (75)(10.7)19 2.8Selling, general and administrative expenses58 61 67 (3)(4.9)(6)(9.0)Segment profit$57 $52 $61 $5 9.6 %$(9)(14.8)%52Revenues 2020 compared to 2019 Contract Sales & Medical Solutions’ revenues were $741 million in 2020, a decrease of $73 million, or 9.0%, over 2019. This decrease was comprised of a constant currency revenue decline of approximately $75 million, or 9.2%, reflecting a volume decrease in the Americas region. See Part II—Item 7—“Overview of the Impact of COVID-19" included elsewhere in this Annual Report on Form 10-K for a discussion of the impact from COVID-19 on Contract Sales & Medical Solutions business activity. Costs of Revenue, exclusive of Depreciation and Amortization 2020 compared to 2019 Contract Sales & Medical Solutions’ costs of revenue, exclusive of depreciation and amortization, decreased $75 million, or 10.7%, in 2020 as compared to 2019. This decrease included a constant currency decrease of approximately $76 million, or 10.8%, reflecting a decrease in compensation and related expenses as a result of reduced volume in the Americas region. Selling, General and Administrative Expenses 2020 compared to 2019 Contract Sales & Medical Solutions’ selling, general and administrative expenses decreased $3 million, or 4.9%, in 2020 as compared to 2019. This decrease included a constant currency decrease of approximately $4 million, or 6.6%, reflecting a decrease in compensation and related expenses.Liquidity and Capital Resources Overview We assess our liquidity in terms of our ability to generate cash to fund our operating, investing and financing activities. Our principal source of liquidity is operating cash flows. In addition to operating cash flows, other significant factors that affect our overall management of liquidity include: capital expenditures, acquisitions, investments, debt service requirements, dividends, equity repurchases, adequacy of our revolving credit and receivables financing facilities, and access to the capital markets. We manage our worldwide cash requirements by monitoring the funds available among our subsidiaries and determining the extent to which those funds can be accessed on a cost-effective basis. The repatriation of cash balances from certain of our subsidiaries could have adverse tax consequences; however, those balances are generally available without legal restrictions to fund ordinary business operations. We have and expect to transfer cash from those subsidiaries to the United States and to other international subsidiaries when it is cost effective to do so. We had a cash balance of $1,814 million at December 31, 2020 ($1,065 million of which was in the United States), an increase from $837 million at December 31, 2019. Based on our current operating plan, we believe that our available cash and cash equivalents, future cash flows from operations and our ability to access funds under our revolving credit and receivables financing facilities will enable us to fund our operating requirements, capital expenditures, contractual obligations, and meet debt obligations for at least the next 12 months. We regularly evaluate our debt arrangements, as well as market conditions, and from time to time we may explore opportunities to modify our existing debt arrangements or pursue additional financing arrangements that could result in the issuance of new debt securities by us or our affiliates. We may use our existing cash, cash generated from operations or dispositions of assets or businesses and/or proceeds from any new financing arrangements or issuances of debt or equity securities to repay or reduce some of our outstanding obligations, to repurchase shares from our stockholders or for other purposes. As part of our ongoing business strategy, we also continually evaluate new acquisition, expansion and investment possibilities or other strategic growth opportunities, as well as potential dispositions of assets or businesses, as appropriate, including dispositions that may cause us to recognize a loss on certain 53assets. Should we elect to pursue any such transaction, we may seek to obtain debt or equity financing to facilitate those activities. Our ability to enter into any such potential transactions and our use of cash or proceeds is limited to varying degrees by the terms and restrictions contained in our existing debt arrangements. We cannot provide assurances that we will be able to complete any such financing arrangements or other transactions on favorable terms or at all. Equity Repurchase Program On February 13, 2019, the Board increased the stock repurchase authorization under the “Repurchase Program by $2.0 billion, which increased the total amount that has been authorized under the Repurchase Program to $7.725 billion since the plan’s inception in October 2013. The Repurchase Program does not obligate the Company to repurchase any particular amount of common stock, and it may be modified, extended, suspended or discontinued at any time. As of December 31, 2020, the Company has remaining authorization to repurchase up to $0.9 billion of its common stock under the Repurchase Program. In addition, from time to time, the Company has repurchased and may continue to repurchase common stock through private or other transactions outside of the Repurchase Program. Additional information regarding the Repurchase Program is presented in Part II, Item 5 “Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities” and Note 13 to our audited consolidated financial statements included elsewhere in this Annual Report on Form 10-K. Debt As of December 31, 2020, we had $12.6 billion of total indebtedness, excluding $1.5 billion of available borrowings under our revolving credit facilities. See Note 10 to our audited consolidated financial statements included elsewhere in this Annual Report on Form 10-K for additional details regarding our credit arrangements. Our long-term debt arrangements contain customary restrictive covenants and, as of December 31, 2020, we believe we were in compliance with our restrictive covenants in all material respects.Senior Secured Credit Facilities and Senior NotesAt December 31, 2020, our Fourth Amended and Restated Credit Agreement, as amended (the “Credit Agreement”) provided financing through several senior secured credit facilities (collectively, the “senior secured credit facilities”) of up to approximately $7,692 million, which consisted of $6,192 million principal amounts of debt outstanding (as detailed in the table above), $4 million of issued standby letters of credit and $1,496 million of available borrowing capacity on the revolving credit facility. The revolving credit facility is comprised of a $675 million senior secured revolving facility available in U.S. dollars, a $600 million senior secured revolving facility available in U.S. dollars, Euros, Swiss Francs and other foreign currencies, and a $225 million senior secured revolving facility available in U.S. dollars and Yen. The term A loans and revolving credit facility under the Credit Agreement mature in June 2023, while the term B loans under the Credit Agreement mature in 2024 and 2025. We are required to make scheduled quarterly payments on the term A loans equal to 1.25% of the original principal amount, with the remaining balance paid at maturity. We are required to make scheduled quarterly payments on the term B loans equal to approximately 0.25% of the original principal amount, with the remaining balance paid at maturity. In addition, beginning with fiscal year ending December 31, 2017, we were required to apply 50% of excess cash flow (as defined in the Credit Agreement), subject to a reduction to 25% or 0% depending upon our senior secured first lien net leverage ratio, for prepayment of the term loans, with any such prepayment to be applied toward principal payments due in subsequent quarters. We are also required to pay an annual commitment fee that ranges from 0.20% to 0.35% in respect of any unused commitments under the revolving credit facility. The Senior Secured Credit Facilities are collateralized by substantially all of our assets and the assets of our material domestic subsidiaries including 100% of the equity interests of substantially all of our material domestic subsidiaries and 66% of the equity interests of substantially all of our first-tier material foreign subsidiaries and their domestic subsidiaries. For information regarding the Senior Secured Credit Facilities and senior notes, see Note 10 to our audited consolidated financial statements included elsewhere in this Annual Report on Form 10-K. 54Receivables Financing Facility For information regarding receivables financing facility, see Note 10 to our audited consolidated financial statements included elsewhere in this Annual Report on Form 10-K. As of December 31, 2020, there were $60 million of revolving loans available under the receivables financing facility.Years ended December 31, 2020, 2019 and 2018 Cash Flow from Operating ActivitiesYear Ended December 31,(in millions)202020192018Net cash provided by operating activities$1,959 $1,417 $1,254 2020 compared to 2019Cash provided by operating activities increased $542 million in 2020 as compared to 2019. The increase is primarily due to improved collections from clients resulting in a decrease in accounts receivable and unbilled services ($377 million), an increase in advanced billings ($182 million), an increase in cash-related net income ($102 million), and the timing of income tax and other payables ($78 million), partially offset by a decrease in customer prepayments ($54 million). Cash Flow from Investing ActivitiesYear Ended December 31,(in millions)202020192018Net cash used in investing activities$(796)$(1,190)$(810) 2020 compared to 2019 Cash used in investing activities decreased $394 million in 2020 as compared to 2019. The decrease was primarily driven by lower cash used for the acquisition of businesses, net of cash acquired ($411 million). Cash Flow from Financing ActivitiesYear Ended December 31,(in millions)202020192018Net cash used in financing activities$(217)$(276)$(452) 2020 compared to 2019 Cash used in financing activities decreased $59 million in 2020 as compared to 2019. The decrease in cash used in financing activities was primarily due to less cash used to repurchase common stock ($502 million), offset by a decrease in cash provided by proceeds from debt issuances ($309 million) and a decrease in cash proceeds from revolving credit facilities, net of repayments ($131 million).Contingencies We are exposed to certain known contingencies that are material to our investors. The facts and circumstances surrounding these contingencies and a discussion of their effect on us are in Note 12 to our audited consolidated financial statements included elsewhere in this Annual Report on Form 10-K. These contingencies may have a material effect on our liquidity, capital resources or results of operations. In addition, even where our reserves are adequate, the incurrence of any of these liabilities may have a material effect on our liquidity and the amount of cash available to us for other purposes. We believe that we have made appropriate arrangements in respect of the future effect on us of these known contingencies. We also believe that the amount of cash available to us from our operations, together with cash from financing, will be sufficient for us 55to pay any known contingencies as they become due without materially affecting our ability to conduct our operations and invest in the growth of our business.Off-Balance Sheet Arrangements We do not have any off-balance sheet arrangements except for operating leases entered into in the normal course of business.Contractual Obligations and Commitments Below is a summary of our future payment commitments by year under contractual obligations as of December 31, 2020:(in millions)20212022 - 20232024 - 2025ThereafterTotalLong-term debt, including interest(1)$498 $2,758 $6,875 $4,088 $14,219 Operating leases15923613152578Finance leases—1212159183Data acquisition344339822767Purchase obligations(2)1072221Commitments to unconsolidated affiliates(3)— — — — — Benefit obligations(4)32333490191Uncertain income tax positions(5)21379471Total$1,064 $3,422 $7,145 $4,397 $16,030 (1) Interest payments on our debt are based on the interest rates in effect on December 31, 2020.(2) Purchase obligations are defined as agreements to purchase goods or services that are enforceable and legally binding and that specify all significant terms, including fixed or minimum quantities to be purchased, fixed, minimum or variable pricing provisions and the approximate timing of the transactions.(3) We are currently committed to invest $130 million in private equity funds. As of December 31, 2020, we have funded approximately $80.2 million of these commitments and we have approximately $49.8 million remaining to be funded which has not been included in the above table as we are unable to predict when these commitments will be paid.(4) Amounts represent expected future benefit payments for our pension and postretirement benefit plans, as well as expected contributions for 2021 for our funded pension benefit plans. We made cash contributions totaling approximately $30 million to our defined benefit plans in 2020, and we estimate that we will make contributions totaling approximately $32 million to our defined benefit plans in 2021. Due to the potential impact of future plan investment performance, changes in interest rates, changes in other economic and demographic assumptions and changes in legislation in foreign jurisdictions, we are not able to reasonably estimate the timing and amount of contributions that may be required to fund our defined benefit plans for periods beyond 2021.(5) As of December 31, 2020, our liability related to uncertain income tax positions was approximately $129 million, $58 million of which has not been included in the above table as we are unable to predict when these liabilities will be paid due to the uncertainties in the timing of the settlement of the income tax positions.Application of Critical Accounting Policies Note 1 to the audited consolidated financial statements provided elsewhere in this Annual Report on Form 10-K describes the significant accounting policies used in the preparation of the consolidated financial statements. The preparation of our consolidated financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, and the disclosure of contingent assets and liabilities at the date of the financial statements, as well as the reported amounts of revenues and expenses during the period. Our estimates are based on historical experience and various other assumptions we believe are reasonable under the circumstances. We evaluate our estimates on an ongoing basis and make changes to the estimates and related disclosures as experience develops or new information becomes known. Actual results may differ from those estimates. We believe the following critical accounting policies affect our more significant judgments and estimates used in the preparation of our consolidated financial statements. Revenue Recognition The majority of the Company’s contracts within the Research & Development Solutions segment are service contracts for clinical research that represent a single performance obligation. The Company provides a significant integration service resulting in a 56combined output, which is clinical trial data that meets the relevant regulatory standards and can be used by the customer to progress to the next phase of a clinical trial or solicit approval of a treatment by the applicable regulatory body. The performance obligation is satisfied over time as the output is captured in data and documentation that is available for the customer to consume over the course of the arrangement and furthers progress of the clinical trial. The Company recognizes revenue over time using a cost-based input method since there is no single output measure that would fairly depict the transfer of control over the life of the performance obligation. Progress on the performance obligation is measured by the proportion of actual costs incurred to the total costs expected to complete the contract. Costs included in the measure of progress include direct labor and third-party costs (such as payments to investigators and other pass through expenses for the Company’s clinical monitors). This cost-based method of revenue recognition requires the Company to make estimates of costs to complete its projects on an ongoing basis. Significant judgment is required to evaluate assumptions related to these estimates. The effect of revisions to estimates related to the transaction price or costs to complete a project are recorded in the period in which the estimate is revised. Most contracts may be terminated upon 30 to 90 days notice by the customer; however, in the event of termination, most contracts require payment for services rendered through the date of termination, as well as for subsequent services rendered to close out the contract. Income Taxes Certain items of income and expense are not recognized on our income tax returns and financial statements in the same year, which creates timing differences. The income tax effect of these timing differences results in (1) deferred income tax assets that create a reduction in future income taxes and (2) deferred income tax liabilities that create an increase in future income taxes. Recognition of deferred income tax assets is based on management’s belief that it is more likely than not that the income tax benefit associated with certain temporary differences, income tax operating loss and capital loss carryforwards and income tax credits, would be realized. We recorded a valuation allowance to reduce our deferred income tax assets for those deferred income tax items for which it was more likely than not that realization would not occur. We determined the amount of the valuation allowance based, in part, on our assessment of future taxable income and in light of our ongoing income tax strategies. If our estimate of future taxable income or tax strategies changes at any time in the future, we would record an adjustment to our valuation allowance. Recording such an adjustment could have a material effect on our financial condition or results of operations. Income tax expense is based on the distribution of profit before income tax among the various taxing jurisdictions in which we operate, adjusted as required by the income tax laws of each taxing jurisdiction. Changes in the distribution of profits and losses among taxing jurisdictions may have a significant impact on our effective income tax rate. We do not consider the undistributed earnings of our foreign subsidiaries to be indefinitely reinvested outside of the United States. Business Combinations We use the acquisition method to account for business combinations, and accordingly, the identifiable assets acquired, the liabilities assumed and any non-controlling interest in the acquiree are recorded at their estimated fair values on the date of the acquisition. We use significant judgments, estimates and assumptions in determining the estimated fair value of assets acquired, liabilities assumed and non-controlling interest including expected future cash flows, discount rates that reflect the risk associated with the expected future cash flows and estimated useful lives. We have recorded and allocated to our reporting units the excess of the cost over the fair value of the net assets acquired, known as goodwill. The recoverability of the goodwill and indefinite-lived intangible assets are evaluated annually for impairment, or if and when events or circumstances indicate a possible impairment. We review the carrying values of other identifiable intangible assets if the facts and circumstances indicate a possible impairment. Any future impairment could have a material adverse effect on our financial condition or results of operations. Stock-based Compensation We measure compensation cost for stock-based payment awards (stock options and stock appreciation rights) granted to employees and non-employee directors at fair value using the Black-Scholes-Merton option-pricing model and for performance awards using the Monte Carlo simulation model. Stock-based compensation expense includes stock-based awards granted to employees and non-employee directors and has been reported in selling, general and administrative expenses in our consolidated statements of income based upon the classification of the individuals who were granted stock-based awards.57 The Black-Scholes-Merton option-pricing model requires the use of subjective assumptions, including share price volatility, the expected life of the award, risk-free interest rate and the fair value of the underlying common shares on the date of grant. In developing our assumptions, we take into account the following:•We calculate expected volatility based on reported data for selected reasonably similar publicly traded companies for which the historical information is available. We plan to continue to use the guideline peer group volatility information until the historical volatility of our common shares is relevant to measure expected volatility for future award grants;•We determine the risk-free interest rate by reference to implied yields available from United States Treasury securities with a remaining term equal to the expected life assumed at the date of grant;•We estimate the dividend yield to be zero as we do not currently anticipate paying any future dividends;•We estimate the average expected life of the award based on our historical experience; and•We estimate forfeitures based on our historical analysis of actual forfeitures. Pensions and Other Postretirement Benefits We provide retirement benefits to certain employees, including defined benefit pension plans and postretirement medical plans. The determination of benefit obligations and expense is based on actuarial models. In order to measure benefit costs and obligations using these models, critical assumptions are made with regard to the discount rate, expected return on plan assets, cash balance crediting rate, lump sum conversion rate and the assumed rate of compensation increases. In addition, retiree medical care cost trend rates are a key assumption used exclusively in determining costs for our postretirement health care and life insurance benefit plans.Recently Issued Accounting Standards Information relating to recently issued accounting standards is included in Note 1 to our audited consolidated financial statements included elsewhere in this Annual Report on Form 10-K.Item 7A. Quantitative and Qualitative Disclosures About Market Risk Market risk is the potential loss arising from adverse changes in market rates and prices. In the ordinary course of business, we are exposed to various market risks and we regularly evaluate our exposure to such changes. Our overall risk management strategy seeks to balance the magnitude of the exposure and the cost and availability of appropriate financial instruments. The following analyses present the sensitivity of our financial instruments to hypothetical changes that are reasonably possible over a one-year period. Foreign Currency Exchange Rates We transact business in more than 100 countries and approximately 60 currencies and are subject to risks associated with fluctuating foreign currency exchange rates. Our objective is to reduce earnings and cash flow volatility associated with foreign currency exchange rate movements. Accordingly, we enter into foreign currency forward contracts to hedge certain forecasted foreign currency cash flows related to service contracts and to hedge non-United States dollar anticipated intercompany reseller fees. It is our policy to enter into foreign currency transactions only to the extent necessary to meet our objectives as stated above. We do not enter into foreign currency transactions for investment or speculative purposes. The principal currencies hedged in 2020 were the British Pound and the Japanese Yen. The contractual value of our foreign exchange derivative instruments, all of which were foreign exchange forward contracts, was approximately $70 million at December 31, 2020. The fair value of these contracts is subject to change as a result of potential changes in foreign exchange rates. We assess our market risk based on changes in foreign exchange rates utilizing a sensitivity analysis. The sensitivity analysis measures the potential gain or loss in fair values based on a hypothetical 10% change in foreign currency exchange rates. The potential gain in fair value for foreign exchange forward contracts based on a hypothetical 10% decrease in the value of the United States dollar was $7 million at December 31, 2020. However, the change in the fair value of the foreign exchange forward contracts would likely be offset by a change in the value of the future service contract revenue or reseller fee being 58hedged caused by the currency exchange rate fluctuation. The estimated fair values of the foreign exchange forward contracts were determined based on quoted market prices. Exchange rate fluctuations affect the United States dollar value of foreign currency revenue and expenses and may have a significant effect on our results. Excluding the impacts from any outstanding or future hedging transactions, a hypothetical 10% change in average exchange rates used to translate all foreign currencies to the United States dollar would have impacted income before income taxes for 2020 by approximately $120 million. The actual impact of exchange rate movements in the future could differ materially from this hypothetical analysis, based on the mix of foreign currencies and the timing and magnitude of individual exchange rate movements. Additionally, commencing in 2016, we designated a portion of our foreign currency denominated debt as a hedge of our net investment in foreign subsidiaries to reduce the volatility in stockholders’ equity caused by changes in the Euro exchange rate with respect to the United States dollar. As of December 31, 2020, these borrowings (net of original issue discount) were €5,323 million ($6,529 million). A hypothetical 10% decrease in the value of the United States dollar would lead to a potential loss in fair value of $653 million. However, this change in fair value would be offset by the change in value of the hedged portion of our net investment in foreign subsidiaries caused by the currency exchange rate fluctuation. Interest Rates Because we have variable rate debt, fluctuations in interest rates affect our business. We attempt to minimize interest rate risk and lower our overall borrowing costs through the utilization of derivative financial instruments, primarily interest rate swaps. We have entered into interest rate swaps with financial institutions that have reset dates and critical terms that match the underlying debt. Accordingly, any change in market value associated with the interest rate swaps is offset by the opposite market impact on the related debt. As of December 31, 2020, we had approximately $6.4 billion of variable rate indebtedness and interest rate swaps with a notional value of $2.2 billion. Because we do not attempt to hedge all of our variable rate debt, we may incur higher interest costs for the portion of our variable rate debt that is not hedged. Excluding debt covered by hedges, each quarter-point increase or decrease in the interest rate on our variable rate debt would result in our interest expense changing by approximately $3.5 million per year. Marketable Securities At December 31, 2020, we held investments in marketable equity securities. These investments are classified as either trading securities or available-for-sale securities and are recorded at fair value. These securities are subject to price risk. As of December 31, 2020, the fair value of these investments was $88 million based on the quoted market value of the securities. The potential loss in fair value resulting from a hypothetical decrease of 10% in quoted market values was approximately $9 million at December 31, 2020.59
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+Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations” in this Annual Report.DESIGNED TO ACCELERATE EXECUTION OF STRATEGY AND CONTINUE GROWTHSimplifying Global Structure•Combining Records and Information ("RIM") operations under one global leader•Rebalancing resources to sharpen focus on higher growth areasCompelling Adjusted EBITDA Benefits~$375MExpected annual run-rate benefits realized exiting 2021$165MBenefits deliveredin 2020Streamlining Management Structure for the Future•Condensing number of layers and reporting levels•Reducing number of positions at Vice President level and above by ~45%•Reducing total managerial and administrative workforce by 700 positions•Realignment to create a more dynamic, agile organization better positioned to make faster decisions and execute strategy in key growth areasEnhancing Customer Experience•Aligning global and regional customer-facing resources across RIM product lines to provide customers with a more integrated experience•Leveraging technology to modernize processes for better alignment between new digital solutions and our core business•Providing customers with a consistent experience across global footprint and introducing new ways of engaging with customers2IRON MOUNTAIN 2020 FORM 10-KTable of ContentsPart IBUSINESS SEGMENTSThe amount of revenues derived from our business segments and other relevant data, including financial information about geographic areas and product and service lines, for the years ended December 31, 2020, 2019 and 2018, are set forth in Note 10 to Notes to Consolidated Financial Statements included in this Annual Report.GLOBAL RIM BUSINESSThe Global RIM Business segment includes five distinct offerings. Records Management, stores physical records and provides healthcare information services, vital records services, courier operations, and the collection, handling and disposal of sensitive documents (collectively, “Records Management”) for customers in 56 countries around the globe. As of December 31, 2020, we stored approximately 710 million cubic feet of hardcopy records.Data Management, provides storage and rotation of backup computer media as part of corporate disaster recovery plans, including service and courier operations (“Data Protection & Recovery”); server and computer backup services; and related services offerings, (collectively, “Data Management”).Global Digital Solutions (“GDS”), develops, implements and supports comprehensive storage and information management solutions for the complete lifecycle of our customers’ information, including the management of physical records, conversion of documents to digital formats and digital storage of information, primarily in the United States and Canada.Secure Shredding, includes the scheduled pick-up of office records that customers accumulate in specially designed secure containers we provide and is a natural extension of our hardcopy records management operations, completing the lifecycle of a record. Complementary to our shredding operations is the sale of the resultant waste paper to third-party recyclers. Through a combination of shredding facilities and mobile shredding units consisting of custom built trucks, we are able to offer secure shredding services to our customers throughout the United States, Canada and South Africa.Consumer Storage, provides on-demand, valet storage for consumers (“Consumer Storage”) across 31 markets in North America through a strategic partnership (the “MakeSpace JV”) with MakeSpace Labs, Inc., a consumer storage provider (“MakeSpace”), formed in March 2019. The MakeSpace JV utilizes data analytics and machine learning to provide effective customer acquisition and a convenient and seamless consumer storage experience.GLOBAL DATA CENTER BUSINESSThe Global Data Center Business segment provides enterprise-class data center facilities and hyperscale-ready capacity to protect mission-critical assets and ensure the continued operation of our customers’ IT infrastructure, with secure, reliable and flexible data center options. The world’s most heavily regulated organizations have trusted us with their data centers for over 15 years, and as of December 31, 2020, five of the top 10 global cloud providers were Iron Mountain Data Center customers.As of December 31, 2020, our Global Data Center Business footprint spans nine markets in the United States: Denver, Colorado; Kansas City, Missouri; Boston, Massachusetts; Boyers, Pennsylvania; Manassas, Virginia; Edison, New Jersey; Columbus, Ohio; and Phoenix and Scottsdale, Arizona and four international markets: Amsterdam, London, Singapore and, through an unconsolidated joint venture, Frankfurt.CORPORATE AND OTHER BUSINESSThe Corporate and Other Business segment consists primarily of Adjacent Businesses and other corporate items.Adjacent Businesses is comprised of (i) entertainment and media which helps industry clients store, safeguard and deliver physical media of all types, and provides digital content repository systems that house, distribute, and archive key media assets, throughout the United States, Canada, France, China - Hong Kong S.A.R., the Netherlands and the United Kingdom (“Entertainment Services”) and (ii) technical expertise in the handling, installation and storing of art in the United States, Canada and Europe (“Fine Arts”).Our Corporate and Other Business segment also includes costs related to executive and staff functions, including finance, human resources and IT, which benefit the enterprise as a whole.IRON MOUNTAIN 2020 FORM 10-K3Table of ContentsPart IBUSINESS ATTRIBUTESOur business has the following attributes: Large, Diversified,Global BusinessThe world’s most heavily regulated organizations trust us with the storage of their records. Our mission-critical storage offerings and related services generated approximately $4.1 billion in annual revenue in 2020. Our business has a highly diverse customer base of approximately 225,000 customers - with no single customer accounting for more than 1% of revenue during the year ended December 31, 2020 - and operates in 56 countries globally. This presents a significant cross-sell opportunity for our Global Data Center and Global Digital Solutions businesses.Recurring, Durable Revenue StreamWe generate a majority of our revenues from contracted storage rental fees, via agreements that generally range from one to five years in length. Historically, in our Records Management business, we have seen strong customer retention (of approximately 98%) and solid physical records retention; more than 50% of physical records that entered our facilities 15 years ago are still with us today. We have also seen strong customer retention in our Global Data Center Business, with low annual customer churn of approximately 4% - 8%.Comprehensive InformationManagement SolutionAs an S&P 500 REIT with approximately 1,450 locations globally and with offerings spanning physical storage, digitization solutions and digital storage, we are positioned to provide a holistic offering to our customers. We are able to cater to our customers’ physical and digital needs and to help guide their digital transformation journey. Significant Owner and Operatorof Real EstateWe operate approximately 93 million square feet of real estate worldwide. Our owned real estate footprint spans nearly 26 million square feet and is concentrated in major metropolitan statistical areas in North America, Western Europe and Latin America.Limited Revenue CyclicalityHistorically, economic downturns have not significantly affected our storage rental business. Due to the durability of our total global physical volumes, the success of our revenue management initiatives, and the growth of our Global Data Center Business, we believe we can continue to grow organic storage rental revenue over time.Shifting Revenue MixWe have identified a number of areas where we see opportunity for growth as we position ourselves to unlock greater value for our customers. These business lines, including Data Center, Fine Arts and Entertainment Services, Consumer Storage and Secure IT Asset Disposition, represent markets with strong secular growth.4IRON MOUNTAIN 2020 FORM 10-KTable of ContentsPart IIn addition, our Global Data Center business has the following attributes:Large Data CenterPlatform with SignificantExpansion OpportunityAs of December 31, 2020, we had 130 MW of leasable capacity with an additional 246 MW under construction or held for development.Differentiated Complianceand SecurityWe offer comprehensive compliance support and physical and cyber security. Our multi-layered approach to security includes a combination of technical and human security measures, and experienced senior military and public sector cyber security leaders oversee our security. As of December 31, 2020, our data centers comply with one of the most comprehensive compliance programs in the industry, including enterprise-wide certified ISO 14001 and 50001 environmental and energy management systems. We also report globally on service organizational controls, PCI-DSS compliance, and met FISMA HIGH and FedRAMP controls in the United States.Efficient Accessand FlexibilityWe have the ability to provide customers with a range of deployment options from one cabinet to an entire building, leveraging our global portfolio of hyperscale-ready and underground data centers. We also provide access to numerous carriers, cloud providers and peering exchanges with migration support and IT.100% Green PoweredData CentersAs of December 31, 2020, our Global Data Center platform was powered by 100% renewable energy, with carbon credit assistance and low power usage effectiveness (“PUE"). We are one of the top 25 buyers of renewable energy among the Fortune 1000 and now offer the Green Power Pass, which allows customers to include the power they consume at any Iron Mountain data center as green power in their CDP, RE100, GRI, or other sustainability reporting.COMPETITIONWe compete with thousands of storage and information management services providers around the world as well as storage and information management services managed and operated internally by organizations. We believe that competition for records and information customers is based on price, reputation and reliability, quality and security of storage, quality of service and scope and scale of technology. While the majority of our competitors operate in only one market or region, we believe we provide a differentiated global offering that competes effectively in these areas.We also compete with numerous data center developers, owners and operators, many of whom own properties similar to ours in some of the same metropolitan areas where our facilities are located. We believe that competition for data center customers is based on availability of power, security considerations, location, connectivity and rental rates, and we generally believe we compete effectively in each of these areas. Additionally, we believe our strong brand, global footprint and excellent commercial relationships enable us to compete successfully and provide significant cross-sell opportunities with our existing customer base.HUMAN CAPITAL MANAGEMENTEMPLOYEESAs of December 31, 2020, we employed approximately 9,000 employees in the United States and approximately 15,000 employees outside of the United States. As of December 31, 2020, approximately 500 employees in California and Georgia and three provinces in Canada were represented by unions in North America and approximately 1,100 employees were represented by unions in Latin America (in Argentina, Brazil, Chile, Colombia and Mexico). All union employees are currently under renewed labor agreements or operating under an extension agreement.BENEFIT PROGRAMSWhere applicable, employees are generally eligible to participate in our benefit programs, which may include health and welfare arrangements as well as pension schemes. Certain unionized employees in California receive these types of benefits through their unions and are not eligible to participate in our benefit programs. In addition to base compensation and other usual benefits, a significant portion of full-time employees participate in some form of incentive-based compensation program that provides payments based on revenues, profits or attainment of specified objectives for the unit in which they work. IRON MOUNTAIN 2020 FORM 10-K5Table of ContentsPart IINCLUSION AND DIVERSITYWe believe that an inclusive environment with diverse teams produces more creative solutions, results in better, more innovative products and services and is crucial to our efforts to attract and retain key talent. We have prioritized inclusion and diversity ("I&D") as part of our corporate-wide strategic goals. Strategies we have taken to create and sustain a more inclusive and diverse environment include: appointing senior leadership for I&D efforts; ensuring that our recruiting efforts reflect our diversity goals; and launching, expanding and supporting our Employee Resource Groups—groups of our employees that voluntarily join together based on shared characteristics, life experiences, or interest around particular activities.COMPANY CULTUREWe recognize that a great culture is foundational to how we deliver on our purpose and strategy and create sustained growth and value for our shareholders. We have committed significant resources to building a sustainable culture that enables innovation and creativity and facilitates trust, employee engagement, belonging and better performance. We understand the importance of listening to our employees, and, to that end, we regularly survey our employees to obtain their views and assess their experience. We use the views expressed in the surveys to adjust our approach on culture and driving employee engagement. We also use employee survey information, headcount data and cost analyses to gain insights into how and where we work.COMMUNITY INVOLVEMENTWe are committed to integrating responsible and sustainable practices throughout our organization to help our operations to have a positive impact on the environment and the communities in which we operate. We aim to give back to the communities where we live and work, and believe that this commitment helps in our efforts to attract and retain employees. We offer philanthropic support to our global community through our Living Legacy Initiative, which is our commitment to help preserve and make accessible cultural and historical information and artifacts. We encourage volunteerism in the communities in which we live and work through our Moving Mountains volunteer program, offering paid time off for employees to help community-based and civic-minded organizations.INSURANCEFor strategic risk transfer purposes, we maintain a comprehensive insurance program with insurers that we believe to be reputable and that have adequate capitalization in amounts that we believe to be appropriate. Property insurance is purchased on a comprehensive basis, including flood and earthquake (including excess coverage), subject to certain policy conditions, sublimits and deductibles. Property is insured based upon the replacement cost of real and personal property, including leasehold improvements, business income loss and extra expense. Other types of insurance that we carry, which are also subject to certain policy conditions, sublimits and deductibles, include medical, workers’ compensation, general liability, umbrella, automobile, professional, warehouse legal liability and directors’ and officers’ liability policies.GOVERNMENT REGULATIONWe are required to comply with numerous U.S. federal, state, and foreign laws and regulations covering a wide variety of subject matters which may have a material effect on our capital expenditures, earnings and competitive position.For example, some of our current and formerly owned or leased properties were previously used by entities other than us for industrial or other purposes, or were affected by waste generated from nearby properties, that involved the use, storage, generation and/or disposal of hazardous substances and wastes, including petroleum products. In some instances, this prior use involved the operation of underground storage tanks or the presence of asbestos-containing materials. Where we are aware of environmental conditions that require remediation, we undertake appropriate activity, in accordance with all legal requirements. Although we have from time to time conducted limited environmental investigations and remedial activities at some of our former and current facilities, we have not undertaken an environmental review of all of our properties, including those we have acquired. We therefore may be potentially liable for environmental cost and may be unable to sell, rent, mortgage or use contaminated real estate owned or leased by us. Under various federal, state and local environmental laws, we may be liable for environmental compliance and remediation costs to address contamination, if any, located at owned and leased properties as well as damages arising from such contamination, whether or not we know of, or were responsible for, the contamination, or the contamination occurred while we owned or leased the property. Environmental conditions for which we might be liable may also exist at properties that we may acquire in the future. In addition, future regulatory action and environmental laws may impose costs for environmental compliance that do not exist today.We transfer a portion of our risk of financial loss due to currently undetected environmental matters by purchasing an environmental impairment liability insurance policy, which covers all owned and leased locations. Coverage is provided for both liability and remediation costs.6IRON MOUNTAIN 2020 FORM 10-KTable of ContentsPart IIn addition, we are subject to numerous U.S. federal, state, local and foreign laws and regulations relating to data privacy and cybersecurity, which are complex, change frequently and have tended to become more stringent over time. We devote substantial resources, and may in the future have to devote significant additional resources, to facilitate compliance with these laws and regulations, and to investigate, defend or remedy actual or alleged violations or breaches. Any failure by us to comply with, or remedy any violations or breaches of, these laws and regulations could result in the curtailment of certain of our operations, the imposition of fines and penalties, liability resulting from litigation, restrictions on our ability to carry on or expand our operations, significant costs and expenses and reputational harm.For more information about laws and regulations that could affect our business, see “Item 1A. Risk Factors” included in this Annual Report.CORPORATE SOCIAL RESPONSIBILITYThrough our approach to Corporate Social Responsibility, we not only see ourselves as having our own responsibility to society, but also in helping our customers with their own environmental, social and governance (ESG) goals, and helping them gain value, make improvements and save costs. We are committed to responsible, sustainable growth and focus our environmental sustainability efforts on the concrete steps we can take to minimize the impact our operations have on the environment. To that end, we have publicly adopted long-term energy and emissions goals that establish aggressive reduction targets. We are committed to the safety and well-being of our employees and strive to cultivate a culture of inclusion that values diverse perspectives across our global workforce. Iron Mountain and its employees also make a social impact in the communities in which we operate through charitable giving and volunteerism.We have been recognized for our commitment to Corporate Social Responsibility. We were named one of America’s Most Responsible Companies by Newsweek magazine in 2020. We ranked 81st on Newsweek’s 2021 list of America’s Most Responsible Companies. We received a 100% on the Human Rights Campaign Corporate Equality Index for 2018, 2019, 2020 and 2021. We are committed to transparent reporting on sustainability and corporate responsibility efforts in accordance with the guidelines of the Global Reporting Initiative. Our corporate responsibility report highlights our progress against key measures of success for our efforts in the community, our environment, and for our people. We are a member of the FTSE4 Good Index, MSCI World ESG Index, MSCI ACWI ESG Index and MSCI USA IMI ESG Index, each of which include companies that meet globally recognized corporate responsibility standards. A copy of our corporate responsibility report is available on the “About Us” section of our website, www.ironmountain.com, under the heading “Corporate Social Responsibility." We are not including the information contained on or available through our website as part of, or incorporating such information by reference into, this Annual Report. In addition, we continue to work to further align our reporting with the recommendations of the Financial Stability Board’s Task Force on Climate-related Financial Disclosures to disclose climate-related financial risks and opportunities.STRONG SUSTAINABILITY FOCUS•Green Power Pass solution in Data Center market to help customers manage their carbon footprint.•Part of RE100 Initiative — commitment to using renewable energy sources for 100% of our worldwide electricity.•81% of our global electricity use — including 100% of the electricity used to power our Data Center business — was from renewable sources in 2020.•Recognized as a top 25 U.S. buyer of renewable energy and honored with the U.S. Department of Energy’s Better Buildings Goal Achiever Award.•Reduced GHG emissions by 52% (since 2016) and achieved a 25% reduction in non-IT energy intensity, surpassing an original goal of 20% by 2026.•Received a 100% on the Human Rights Campaign Corporate Equality Index for 2018, 2019, 2020 and 2021.INTERNET WEBSITEOur Internet address is www.ironmountain.com. Under the “Investors” section on our website, we make available, free of charge, our Annual Reports on Form 10-K, our Quarterly Reports on Form 10-Q, our Current Reports on Form 8-K and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934 (the “Exchange Act”) as soon as reasonably practicable after such forms are filed with or furnished to the SEC. We are not including the information contained on or available through our website as a part of, or incorporating such information by reference into, this Annual Report. Copies of our corporate governance guidelines, code of ethics and the charters of our audit, compensation, finance, nominating and governance, risk and safety, and technology committees are available on the “Investors” section of our website, www.ironmountain.com, under the heading “Corporate Governance."IRON MOUNTAIN 2020 FORM 10-K7Table of ContentsPart IITEM 1A. RISK FACTORS. We face many risks. If any of the events or circumstances described below actually occur, we and our businesses, financial condition or results of operations could suffer, and the trading price of our debt or equity securities could decline. Our current and potential investors should consider the following risks and the information contained under the heading “Cautionary Note Regarding Forward-Looking Statements” before deciding to invest in our securities.BUSINESS RISKSOur customers may shift from paper and tape storage to alternative technologies that require less physical space.We derive most of our revenues from rental fees for the storage of physical records and computer backup tapes and from storage related services. Storage volume and/or demand for our traditional storage related services may decline as our customers adopt alternative storage technologies, which require significantly less space than traditional physical records and tape storage. Our customers’ shift from paper and tape storage to alternative technologies may accelerate as a result of the COVID-19 pandemic. While volumes in our Global RIM Business segment were relatively steady in 2020 and we expect them to remain relatively consistent in the near term, we can provide no assurance that our customers will continue to store most or a portion of their records as paper documents or as tapes, or that the paper documents or tapes they do store with us will require our storage related services at the same levels as they have in the past. A significant shift by our customers to storage of data through non-paper or non-tape-based technologies, whether now existing or developed in the future, could adversely affect our businesses. In addition, the digitization of records may shift our revenue mix from the more predictable storage revenue to service revenue, which is inherently more volatile.The COVID-19 pandemic and its resulting economic impact may materially adversely affect our business, operations, financial results and liquidity.In March 2020, the World Health Organization declared a novel strain of coronavirus (“COVID-19”) a pandemic. This resulted in U.S. federal, state and local and foreign governments and private entities mandating various restrictions, including travel restrictions, restrictions on public gatherings and stay-at-home orders and advisories. In response, we temporarily closed certain of our offices and facilities across the world, implemented certain travel restrictions for our employees and transitioned many of our employees to remote working arrangements, with some of our operations being run with limited personnel on site. In addition, many of our customers have implemented stay-at-home measures and other restrictions that reduce the demand for our routine services. The preventative and protective actions that governments have ordered, or we or our customers have implemented, have resulted in a period of reduced service operations and business disruption for us, our customers and other third parties with which we do business. The COVID-19 pandemic has also had a substantial adverse impact on the global economy. While we do not currently believe that the implications of the COVID-19 pandemic have had a material adverse impact on our ability to collect our accounts receivable, global economic conditions related to the COVID-19 pandemic may have a material adverse effect on our customers, which could impact our future ability to collect our accounts receivable. In addition, if the COVID-19 pandemic and resulting recessionary conditions continue to disrupt the credit and financial markets or impact our credit ratings, our ability to access capital on favorable terms, if at all, could be adversely affected, which could have an adverse effect on our liquidity needs.Due to the unpredictable and rapidly changing nature of the COVID-19 pandemic and the resulting economic distress, the extent to which it continues to impact us will depend on numerous factors that we are currently unable to predict, including: the duration and severity of the COVID-19 pandemic; the development, distribution and efficacy of any COVID-19 vaccines; the duration or re-emergence of outbreaks; the continuation, resumption, and/or expansion of restrictions imposed by governments and businesses; the impact of the pandemic on economic activity and any resulting recessionary conditions, and the strength and duration of any economic recovery; the health of our workforce; our ability to meet staffing needs for critical functions; and the impact on our customers, suppliers, vendors, and other business partners, and their respective financial condition. Furthermore, when the COVID-19 pandemic has ended, our ability to resume normal business operations may be delayed, and actions we have taken to manage costs may make it more challenging to meet any increased customer demand following the pandemic.Failure to execute our strategic growth plan may adversely impact our financial condition and results of operations.As part of our strategic growth plan, we expect to invest in our existing businesses, including records and information management storage and services businesses in our higher-growth markets, data centers and adjacent businesses, and in new businesses, business strategies, products, services, technologies and geographies, and we may selectively divest certain businesses. These initiatives may involve significant risks and uncertainties, including:•our inability to execute on our plan to incorporate the digitization of our customers’ records and new digital information technologies into our offerings;•failure to achieve satisfactory returns on new product offerings, acquired companies, joint ventures, growth initiatives, or other investments, particularly in markets where we do not currently operate or have a substantial presence;•our inability to identify suitable companies to acquire, invest in or partner with;•our inability to complete acquisitions or investments on satisfactory terms;•our inability to structure acquisitions or investments in a manner that complies with our debt covenants and is consistent with our leverage ratio goals;8IRON MOUNTAIN 2020 FORM 10-KTable of ContentsPart I•increased demands on our management, operating systems, internal controls and financial and physical resources and, if necessary, our inability to successfully expand our infrastructure; •incurring additional debt necessary to acquire suitable companies or make other growth investments if we are unable to pay the purchase price or make the investment out of working capital or the issuance of our common stock or other equity securities;•our inability to manage the budgeting, forecasting and other process control issues presented by future growth, particularly with respect to operations in countries outside of the United States or in new lines of business;•insufficient revenues to offset expenses and liabilities associated with new investments; and•our inability to attract, develop and retain skilled employees to lead and support our strategic growth plan, particularly in new businesses, technologies, products or offerings outside our core competencies.Our data center expansion in particular requires significant capital commitments. Our data center expansion and other new ventures are inherently risky and we can provide no assurance that such strategies and offerings will be successful in achieving the desired returns within a reasonable timeframe, if at all, and that they will not adversely affect our business, reputation, financial condition, and operating results. We face competition from other companies, some of which possess substantial resources, in our efforts to grow our data center, international and complementary businesses. As a result, we may be unable to acquire or invest in, or we may pay a premium purchase price for, data centers, technology and higher-growth markets and adjacent businesses that support our strategic growth plan, which could have an adverse effect on our results of operations and financial condition. The foregoing risks may be exacerbated as a result of the COVID-19 pandemic. As stored records and tapes become less active our service revenue growth and profitability from related services may decline.Our Records Management and Data Management service revenue growth is being negatively impacted by declining activity rates as stored records and tapes are becoming less active and more archival, and these activity levels were further negatively impacted by the COVID-19 pandemic. The amount of information available to customers digitally or in their own information systems has been steadily increasing in recent years, and we believe this trend continues to accelerate. As a result, our customers are less likely than they have been in the past to retrieve records and rotate tapes, thereby reducing their activity levels. At the same time, many of our costs related to records and tape related services remain fixed. In addition, our reputation for providing secure information storage is critical to our success, and actions to manage cost structure, such as outsourcing certain transportation, security or other functions, could negatively impact our reputation and adversely affect our business. Ultimately, if we are unable to appropriately align our cost structure with decreased levels of service activity, our operating results could be adversely affected. Our program to simplify our global structure may not be successful.In October 2019, we announced Project Summit, a global program designed to better position us for future growth and achievement of our strategic objectives. Project Summit focuses on simplifying our global records and information management structure, streamlining our managerial structure and leveraging our global and regional customer facing resources. We also plan to implement systems and process changes designed to make our organization more agile and dynamic, streamline our organization and reallocate our resources to better align with our strategic goals. We expect the total program benefits associated with Project Summit, which we have expanded since our initial announcement, to be fully realized exiting 2021. However, we may not be able to realize the full amount of our expected improvements to Adjusted EBITDA in a timely manner, or at all, and the costs associated with Project Summit may exceed our expectations. In addition, this program may yield unintended consequences, such as attrition beyond our intended reduction in force, distraction of our employees and our anticipated systems and process changes may not work as expected and may create additional risks to our business. As a result, Project Summit could have a material adverse effect on our results of operations or financial condition.Our future growth depends in part upon our ability to continue to effectively manage and execute on revenue management.Over the past several years, our organic revenue growth has been positively impacted by our ability to effectively introduce, expand and monitor revenue management initially in our more established markets, and subsequently in our higher-growth markets. If we are not able to continue and effectively manage pricing, our results of operations could be adversely affected and we may not be able to execute on our strategic growth plan.Changes in customer behavior with respect to destruction of records stored with us could adversely affect our business, financial condition and results of operations.Over the past year, our destruction rates, as a percentage of records stored with us, have fluctuated. When destruction rates for records stored with us increase, it has a positive impact on our service revenues in the year of destruction but negatively impacts our longer term storage revenues, adversely affecting our financial condition and results of operations.IRON MOUNTAIN 2020 FORM 10-K9Table of ContentsPart IWe and our customers are subject to laws and governmental regulations relating to data privacy and cybersecurity and our customers’ demands in this area are increasing. This may cause us to incur significant expenses and non-compliance with such regulations and demands could harm our business.We are subject to numerous U.S. federal, state, local and foreign laws and regulations relating to data privacy and cybersecurity. These regulations are complex, change frequently and have tended to become more stringent over time. There are also a number of legislative proposals pending before the U.S. Congress, various state legislative bodies and foreign governments concerning data protection that could affect us. In addition, a growing number of U.S. and foreign legislative and regulatory bodies have adopted consumer notification and other requirements if consumer information is accessed by unauthorized persons and additional regulations regarding the use, access, accuracy and security of such information are possible. In the U.S., we are subject to various state laws which provide for disparate notification regimes. In addition, as a result of the continued emphasis on information security and instances in which personal information has been compromised, our customers are requesting that we take increasingly sophisticated measures to enhance security and comply with data privacy regulations, and that we assume higher liability under our contracts. We devote substantial resources, and may in the future have to devote significant additional resources, to facilitate compliance with laws and regulations, our customers’ data privacy and security demands, and to investigate, defend or remedy actual or alleged violations or breaches. Any failure by us to comply with, or remedy any violations or breaches of, laws and regulations or customer requirements could result in the curtailment of certain of our operations, the imposition of fines and penalties, liability resulting from litigation, restrictions on our ability to carry on or expand our operations, significant costs and expenses and reputational harm. For example, we have experienced incidents in which customers’ information has been lost, and we have been informed by customers that some of the incidents involved the loss of personal information, resulting in monetary costs to those customers for which we have provided reimbursement. It is difficult to predict the impact on our business if we were subject to allegations of having violated existing laws or regulations. Attacks on our internal IT systems could damage our reputation and adversely affect our business, financial condition and results of operations.Our reputation for providing secure information storage to customers is critical to the success of our business. Our reputation or brand, and specifically, the trust our customers place in us, could be negatively impacted in the event of perceived or actual failures by us to store information securely. Although we seek to prevent and detect attempts by unauthorized users to gain access to our IT systems, our IT and network infrastructure may be vulnerable to attacks by hackers or breaches due to employee error or other disruptions. Moreover, until we have migrated businesses we acquire onto our IT systems, we may face additional risks because of the continued use of predecessor IT systems. We have outsourced, and expect to continue to outsource, certain support services to third parties, which may subject our IT and other sensitive information to additional risk. In addition, the continuation of remote work arrangements or operating with limited personnel as a result of the COVID-19 pandemic could increase our cybersecurity risks. A successful breach of the security of our IT systems could lead to theft or misuse of our customers’ proprietary or confidential information and result in third party claims against us and reputational harm. Damage to our reputation could make us less competitive, which could negatively impact our business, financial condition and results of operations.Complying with fire and safety standards may result in significant expense.As of December 31, 2020, we operated approximately 1,450 facilities worldwide, including more than 600 in the United States. Many of these facilities were built and outfitted by third parties and added to our real estate portfolio as part of acquisitions. Some of these facilities contain fire suppression and safety features that are different from our current specifications and current standards for new facilities, although we believe all of our facilities were constructed, in all material respects, in compliance with applicable laws and regulations in effect at the time of their construction or outfitting. In some instances, local authorities may take the position that our fire suppression and safety features in a particular facility are insufficient and require additional measures that may involve considerable expense to us. In addition, where we determine that the fire suppression and safety features of a facility require improvement, we will develop and implement a plan to remediate the issue, although implementation may require an extended period to complete. A significant aspect of the integration of businesses we have acquired or may acquire is the process of making investments in the acquired facilities to conform such facilities to our standards of operations. This process is complex and time-consuming. If additional fire safety and suppression measures beyond our current operating plan were required at a large number of our facilities, the expense required for compliance could negatively impact our business, financial condition or results of operations.If we fail to meet our commitment to transition to more renewable and sustainable sources of energy, it may negatively impact our ability to attract and retain customers, employees and investors who focus on this commitment. Furthermore, changes to environmental laws and standards may increase the cost to operate some of our businesses. This could impact our results of operations and the trading of our stock.We have made a commitment to prioritize sustainable energy practices, reduce our carbon footprint and transition to more renewable and sustainable sources of energy, particularly in our data center business. We have made progress towards reducing our carbon footprint, but if we are not successful in continuing this reduction or if our customers, employees and investors are not satisfied with our sustainability efforts, it may negatively impact our ability to attract and retain customers, employees and investors who focus on this commitment. This could negatively impact our results of operations and the trading of our stock.10IRON MOUNTAIN 2020 FORM 10-KTable of ContentsPart IFurthermore, changes in environmental laws in any jurisdiction in which we operate could increase compliance costs or impose limitations on our operations. For example, our emergency generators at our data centers are subject to regulations and permit requirements governing air pollutants, and the heating, ventilation and air conditioning and fire suppression systems at some of our data centers and data management locations may include ozone-depleting substances that are subject to regulation. While environmental regulations do not normally impose material costs upon operations at our facilities, unexpected events, equipment malfunctions, human error and changes in law or regulations, among other factors, could result in unexpected costs, which could be material.Failure to successfully integrate acquired businesses could negatively impact our balance sheet and results of operations.Strategic acquisitions are an important element of our growth strategy and the success of any acquisition we make depends in part on our ability to integrate the acquired business and realize anticipated synergies. The process of integrating acquired businesses, particularly in new markets, may involve unforeseen difficulties and may require a disproportionate amount of our management’s attention and our financial and other resources.For example, the success of our significant acquisitions depends, in large part, on our ability to realize the anticipated benefits, including cost savings from combining the acquired businesses with ours. To realize these anticipated benefits, we must be able to successfully integrate our business and the acquired businesses, and this integration is complex and time-consuming. We may encounter challenges in the integration process including the following:•challenges and difficulties associated with managing our larger, more complex, company;•conforming standards, controls, procedures and policies, business cultures and compensation and benefits structures between the two businesses;•consolidating corporate and administrative infrastructures;•coordinating geographically dispersed organizations;•potential unknown liabilities and unforeseen expenses or delays associated with an acquisition; and•our ability to deliver on our strategy going forward.Further, our acquisitions subject us to liabilities (including tax liabilities) that may exist at an acquired company, some of which may be unknown. Although we and our advisors conduct due diligence on the operations of businesses we acquire, there can be no guarantee that we are aware of all liabilities of an acquired company. These liabilities, and any additional risks and uncertainties related to an acquired company not known to us or that we may deem immaterial or unlikely to occur at the time of the acquisition, could negatively impact our future business, financial condition and results of operations.We can give no assurance that we will ultimately be able to effectively integrate and manage the operations of any acquired business or realize anticipated synergies. The failure to successfully integrate the cultures, operating systems, procedures and information technologies of an acquired business could have a material adverse effect on our financial condition and results of operations.Our customer contracts may not always limit our liability and may sometimes contain terms that could lead to disputes in contract interpretation.Our customer contracts typically contain provisions limiting our liability regarding the loss or destruction of, or damage to, records, information, or other items stored with us. Our liability for physical storage is often limited to a nominal fixed amount per item or unit of storage (such as per cubic foot) and our liability for digital solutions, data center, destruction and other services unrelated to records, information and other items stored with us is often limited to a percentage of annual revenue under the contract; however, some of our contracts with large customers and some of the contracts assumed in our acquisitions contain no such limits or contain higher limits. We can provide no assurance that our limitation of liability provisions will be enforceable in all instances or, if enforceable, that they would otherwise protect us from liability. In addition to provisions limiting our liability, our customer contracts generally include a schedule setting forth the majority of the customer-specific terms, including storage rental and related service pricing and service delivery terms. Our customers may dispute the interpretation of various provisions in their contracts. In the past, we have had relatively few disputes with our customers regarding the terms of their customer contracts, and most disputes to date have not been material, but we can provide no assurance that we will not have material disputes in the future. Moreover, as we expand our operations in digital solutions and storage of fine arts and other valuable items and respond to customer demands for higher limitation of liability as a result of regulatory changes, our exposure to contracts with higher or no limitations of liability and disputes with customers over the interpretation of their contracts may increase. Although we maintain a comprehensive insurance program, we can provide no assurance that we will be able to maintain insurance policies on acceptable terms or with high enough coverage amounts to cover losses to us in connection with customer contract disputes.IRON MOUNTAIN 2020 FORM 10-K11Table of ContentsPart IInternational operations may pose unique risks.As of December 31, 2020, we operated in 55 countries outside the United States. Our international operations account for a significant portion of our overall operations, and as part of our growth strategy, we expect its share to increase as we continue to acquire or invest in businesses in select foreign markets, including countries where we do not currently operate. International operations are subject to numerous risks, including:•the impact of foreign government regulations and United States regulations that apply to us in foreign countries where we operate; in particular, we are subject to United States and foreign anti-corruption laws, such as the Foreign Corrupt Practices Act and the United Kingdom Bribery Act, and, although we have implemented internal controls, policies and procedures and training to deter prohibited practices, our employees, partners, contractors or agents may violate or circumvent such policies and the law;•the volatility of certain foreign economies in which we operate;•political uncertainties and changes in the global political climate or other global events, such as the recent trade wars involving the U.S. or global pandemics, which may impose restrictions on, or create additional risk in relation to, global operations, which risks may become more pronounced as we consolidate operations across countries and need to move records and data across borders; •unforeseen liabilities, particularly within acquired businesses;•costs and difficulties associated with managing international operations of varying sizes and scale, including operations involving cross-border service offerings;•our operations in the United Kingdom and the European Union may be adversely affected by the exit from the European Union (Brexit) by the United Kingdom, and the associated uncertainty;•the risk that business partners upon whom we depend for technical assistance or management and acquisition expertise in some markets outside of the United States will not perform as expected;•difficulties attracting and retaining local management and key employees to operate our business in certain countries; and•cultural differences and differences in business practices and operating standards, as well as risks and challenges in expanding into countries where we have no prior operational experience.Our use of joint ventures could expose us to additional risks and liabilities, including our reliance on joint venture partners that may have economic and business interests that are inconsistent with our business interests, our lack of sole decision-making authority, and disputes between us and our joint venture partners.As part of our growth strategy, particularly in connection with our international and data center expansion, we currently, and may in the future, co-invest with third parties using joint ventures. These joint ventures can result in our holding non-controlling interests in, or having shared responsibility for managing the affairs of, a property or portfolio of properties, business, partnership, joint venture or other entity. As a result, in connection with our pursuit or entrance into any such joint venture, we may be subject to additional risks, including:•our ability to sell our interests in the joint venture may be limited by the joint venture agreement; •our ability to grow our storage volume when we rely on non-controlling interests in joint ventures for this growth;•we may not have the right to exercise sole decision-making authority regarding the properties, business, partnership, joint venture or other entity;•if our partners become bankrupt or fail to fund their share of required capital contributions, we may choose or be required to contribute such capital;•our partners may have economic, tax or other interests or goals that are inconsistent with our interests or goals, and that could affect our ability to negotiate satisfactory joint venture terms, to operate the property or business or maintain our qualification for taxation as a REIT;•our partners may be subject to different laws or regulations than us, or may be structured differently than us for tax purposes, which could create conflicts of interest and/or affect our ability to maintain our qualification for taxation as a REIT;•our partners may take actions that are not within our control, which could require us to dispose of the joint venture asset, transfer it to a taxable REIT subsidiary (“TRS”) in order for us to maintain our qualification for taxation as a REIT, or purchase such partner’s interests or assets at an above-market price;•we may agree to restrictions on our ability to expand our business in certain geographies independently or with other partners;•disputes between us and our partners may result in litigation or arbitration that would increase our expenses and prevent our management from focusing their time and effort on our day-to-day business; and•we may in certain circumstances be liable for the actions of our third-party partners or guarantee all or a portion of the joint venture’s liabilities, which may require us to pay an amount greater than our investment in the joint venture.Each of these factors may result in returns on these investments being less than we expect or in losses, and our financial and operating results may be adversely affected.12IRON MOUNTAIN 2020 FORM 10-KTable of ContentsPart ISignificant costs or disruptions at our data centers could adversely affect our business, financial condition and results of operations.Since 2017, we have substantially expanded our Global Data Center Business and we expect to continue to grow our Global Data Center Business. For example, we paid an aggregate cash purchase price of over $1.7 billion for data center businesses we acquired in 2017 and 2018 and incurred other costs associated with the development of real estate to support this business. Our Global Data Center Business depends on providing customers with highly reliable facilities, power infrastructure and operations solutions, and we will need to retain and hire qualified personnel to manage our data centers. Service interruptions or significant equipment damage could result in difficulty maintaining service level commitment obligations that we owe to certain of our customers. Service interruptions or equipment damage may occur at one or more of our data centers because of numerous factors, including: human error; equipment failure; physical, electronic and cyber security breaches; fire, hurricane, flood, earthquake and other natural disasters; water damage; fiber cuts; extreme temperatures; power loss or telecommunications failure; war, terrorism and any related conflicts or similar events worldwide; and sabotage and vandalism. We also purchase significant amounts of electricity from generating facilities and utility companies that are subject to environmental laws, regulations and permit requirements. These environmental requirements are subject to material change, which could result in increases in our electricity suppliers’ compliance costs that may be passed through to us. In addition, climate change may increase the likelihood that our data centers are affected by some of these factors.While these risks could impact our overall business, they could have a more significant impact on our Global Data Center Business, where we have service level commitment obligations to certain of our customers. As a result, service interruptions or significant equipment damage at our data centers could result in difficulty maintaining service level commitments to these customers and potential claims related to such failures. Because our data centers are critical to many of our customers’ businesses, service interruptions or significant equipment damage at our data centers could also result in lost profits or other indirect or consequential damages to our customers.Our Global Data Center Business is susceptible to regional costs of power, power shortages, planned or unplanned power outages and limitations on the availability of adequate power resources. We rely on third parties to provide power to our data centers. We are therefore subject to an inherent risk that such third parties may fail to deliver such power in adequate quantities or on a consistent basis. If the power delivered to our data centers is insufficient or interrupted, we would be required to provide power through the operation of our on-site generators, generally at a significantly higher operating cost. Additionally, global fluctuations in the price of power can increase the cost of energy, and we may be limited in our ability to, or may not always choose to, pass these increased costs on to our customers. We also rely on third party telecommunications carriers to provide internet connectivity to our customers. These carriers may elect not to offer or to restrict their services within our data centers or may elect to discontinue such services. Furthermore, carriers may face business difficulties, which could affect their ability to provide telecommunications services or the quality of such services. If connectivity is interrupted or terminated, our financial condition and results of operations may be adversely affected. Events such as these may also impact our reputation as a data center provider which could adversely affect our results of operations.Our data center expansion requires a significant amount of capital and, if we are not able to raise that capital on advantageous terms, our ability to fund our data center expansion may be limited.Our data center expansion requires significant capital commitments. In addition, we may be required to commit significant operational and financial resources in connection with the organic growth of our Global Data Center Business, generally 12 to 18 months in advance of securing customer contracts, and we may not have enough customer demand to support these data centers when they are built. There can be no assurance we will have sufficient customer demand to support these data centers or data centers we have acquired or that we will not be adversely affected by the risks noted above, which could make it difficult for us to realize expected returns on our investments, if any. We have operations in numerous foreign countries and, as a result, are subject to foreign exchange translation risk, which could have an adverse effect on our financial results.We conduct business operations in numerous foreign countries through our foreign subsidiaries or affiliates, which primarily transact in their respective local currencies. Those local currencies are translated into United States dollars at the applicable exchange rates for inclusion in our consolidated financial statements. The results of operations of, and certain of our debt balances (including intercompany debt balances) associated with, our international businesses are exposed to foreign exchange rate fluctuations. Upon translation, operating results may differ materially from expectations, and significant shifts in foreign currencies can impact our short-term results, as well as our long-term forecasts and targets. Failure to comply with certain regulatory and contractual requirements under our United States Government contracts could adversely affect our revenues, operating results and financial position and reputation.Having the United States Government as a customer subjects us to certain regulatory and contractual requirements. Failure to comply with these requirements could subject us to investigations, price reductions, up to treble damages, and civil penalties. Noncompliance with certain regulatory and contractual requirements could also result in us being suspended or debarred from future United States Government contracting. We may also face private derivative securities claims because of adverse government actions. Any of these outcomes could have a material adverse effect on our revenues, operating results, financial position and reputation.IRON MOUNTAIN 2020 FORM 10-K13Table of ContentsPart IWe may be subject to certain costs and potential liabilities associated with the real estate required for our business.Because our business is heavily dependent on real estate, we face special risks attributable to the real estate we own or lease. Such risks include:•acquisition and occupancy costs that make it difficult to meet anticipated margins and difficulty locating suitable facilities due to a relatively small number of available buildings having the desired characteristics in some real estate markets;•uninsured losses or damage to our storage facilities due to an inability to obtain full coverage on a cost-effective basis for some casualties, such as fires, hurricanes and earthquakes, or any coverage for certain losses, such as losses from riots or terrorist activities;•inability to use our real estate holdings effectively and costs associated with vacating or consolidating facilities if the demand for physical storage were to diminish; and•liability under environmental laws for the costs of investigation and cleanup of contaminated real estate owned or leased by us, whether or not (i) we know of, or were responsible for, the contamination, or (ii) the contamination occurred while we owned or leased the property.Some of our current and formerly owned or leased properties were previously used by entities other than us for industrial or other purposes, or were affected by waste generated from nearby properties, that involved the use, storage, generation and/or disposal of hazardous substances and wastes, including petroleum products. In some instances this prior use involved the operation of underground storage tanks or the presence of asbestos-containing materials. Where we are aware of environmental conditions that require remediation, we undertake appropriate activity, in accordance with all legal requirements. Although we have from time to time conducted limited environmental investigations and remedial activities at some of our former and current facilities, we have not undertaken an environmental review of all of our properties, including those we have acquired. We therefore may be potentially liable for environmental costs like those discussed above and may be unable to sell, rent, mortgage or use contaminated real estate owned or leased by us. Environmental conditions for which we might be liable may also exist at properties that we may acquire in the future. In addition, future regulatory action and environmental laws may impose costs for environmental compliance that do not exist today.Unexpected events, including those resulting from climate change, could disrupt our operations and adversely affect our reputation and results of operations.Unexpected events, including fires or explosions at our facilities, war or terrorist activities, natural disasters such as earthquakes and wildfires, unplanned power outages, supply disruptions, failure of equipment or systems, and severe weather events, such as droughts, heat waves, hurricanes, and flooding, could adversely affect our reputation and results of operations through physical damage to our facilities and equipment and through physical damage to, or disruption of, local infrastructure. During the past several years we have seen an increase in the frequency and intensity of severe weather events and we expect this trend to continue due to climate change. Some of our key facilities worldwide are vulnerable to severe weather events, and global weather pattern changes may also pose long-term risks of physical impacts to our business. Our customers rely on us to securely store and timely retrieve their critical information, and, while we maintain disaster recovery and business continuity plans that would be implemented these situations, these unexpected events could result in customer service disruption, physical damage to one or more key operating facilities and the information stored in those facilities, the temporary closure of one or more key operating facilities or the temporary disruption of information systems, each of which could negatively impact our reputation and results of operations. In addition, these unexpected events could negatively impact our reputation if such events result in adverse publicity, governmental investigations or litigation or if customers do not otherwise perceive our response to be adequate. Fluctuations in commodity prices may affect our operating revenues and results of operations.Our operating revenues and results of operations are impacted by significant changes in commodity prices. In particular, our secure shredding operations generate revenue from the sale of shredded paper for recycling. Further, significant declines in the cost of paper may continue to negatively impact our revenues and results of operations, and increases in other commodity prices, including steel, may negatively impact our results of operations.Failure to manage and adequately implement our new IT systems could negatively affect our business.We rely on IT infrastructure, including hardware, networks, software, people and processes, to provide information to support assessments and conclusions about our operating performance. We are in the process of upgrading a number of our IT systems, including consolidating our existing billing systems, and we face risks relating to these transitions. For example, we may incur greater costs than we anticipate training our personnel on the new systems, we may experience service disruptions or errors in accurately capturing data or retaining our records, and we may be delayed in meeting our various reporting obligations. There can be no assurance that we will manage our IT systems and implement these new systems as planned or that we will do so without disruptions to our operations, which could have an adverse effect on our business, financial condition, results of operations and cash flows.14IRON MOUNTAIN 2020 FORM 10-KTable of ContentsPart IRISKS RELATED TO OUR INDEBTEDNESSOur substantial indebtedness could adversely affect our financial health and prevent us from fulfilling our obligations under our various debt instruments.We have a significant amount of indebtedness. As of December 31, 2020, our total long-term debt was approximately $8.7 billion, stockholders equity was approximately $1.1 billion and we had cash and cash equivalents (including restricted cash) of approximately $205.1 million. Our substantial indebtedness could have important consequences to our current and potential investors. These risks include:•inability to satisfy our obligations with respect to our various debt instruments;•inability to make borrowings to fund future working capital, capital expenditures and strategic opportunities, including acquisitions, further organic development of our Global Data Center Business and expansions into adjacent businesses, and other general corporate requirements, including possible required repurchases, redemptions or prepayments of our various indebtedness;•limits on our distributions to stockholders; in this regard if these limits prevented us from satisfying our REIT distribution requirements, we could fail to remain qualified for taxation as a REIT or, if these limits do not jeopardize our qualification for taxation as a REIT but do nevertheless prevent us from distributing 100% of our REIT taxable income, we will be subject to federal corporate income tax, and potentially a nondeductible excise tax, on the retained amounts;•limits on future borrowings under our existing or future credit arrangements, which could affect our ability to pay our indebtedness or to fund our other liquidity needs;•inability to generate sufficient funds to cover required interest payments;•restrictions on our ability to refinance our indebtedness on commercially reasonable terms;•limits on our flexibility in planning for, or reacting to, changes in our business and the information management services industry; and•inability to adjust to adverse economic conditions that could place us at a disadvantage to our competitors with less debt and who, therefore, may be able to take advantage of opportunities that our indebtedness prevents us from pursuing.We are subject to risks associated with debt financing, including the risk that our cash flow could be insufficient to meet required payments on our debt. In particular, if as a result of the COVID-19 pandemic our revenues, cash flows and/or Adjusted EBITDA continue to decline or we incur additional indebtedness, we may be unable to make required payments on our debt or to satisfy the financial and other covenants contained in our Credit Agreement (as defined in Note 6 to Notes to Consolidated Financial Statements included in this Annual Report) and our indentures. In addition, the expected elimination of the London Interbank Offered Rate (“LIBOR”) may adversely affect interest expense related to borrowings under certain of our credit arrangements and interest rate swaps, and could disrupt financial markets generally, which could potentially negatively impact our financial condition.Despite our current indebtedness levels, we may still be able to incur substantially more debt. The terms of our indentures generally do not cap the maximum amount of additional funds that may be borrowed under our Credit Agreement and possible future credit arrangements. Restrictive debt covenants may limit our ability to pursue our growth strategy.Our Credit Agreement and our indentures contain covenants restricting or limiting our ability to, among other things:•incur additional indebtedness;•pay dividends or make other restricted payments;•make asset dispositions;•create or permit liens;•sell, transfer or exchange assets;•guarantee certain indebtedness;•make acquisitions and other investments; and•enter into partnerships and joint ventures.These restrictions and our long-term commitment to reduce our leverage ratio may adversely affect our ability to pursue our acquisition and other growth strategies.IRON MOUNTAIN 2020 FORM 10-K15Table of ContentsPart IWe may not have the ability to raise the funds necessary to finance the repurchase of outstanding senior notes upon a change of control event as required by our indentures.Upon the occurrence of a “change of control,” as defined in our indentures, we will be required to offer to repurchase all of our outstanding senior notes. However, it is possible that we will not have sufficient funds at the time of a change of control to make the required repurchase of any outstanding notes or that restrictions in our Credit Agreement will not allow such repurchases. Certain important corporate events, however, such as leveraged recapitalizations that would increase the level of our indebtedness, would not constitute a “change of control” under our indentures.Iron Mountain Incorporated (“IMI”) is a holding company, and, therefore, its ability to make payments on its various debt obligations depends in large part on the operations of its subsidiaries.IMI is a holding company; substantially all of its assets consist of the equity in its subsidiaries, and substantially all of its operations are conducted by its direct and indirect consolidated subsidiaries. As a result, its ability to make payments on its debt obligations will be dependent upon the receipt of sufficient funds from its subsidiaries, whose ability to distribute funds may be limited by local capital requirements, joint venture structures and other applicable restrictions. However, our various debt obligations are guaranteed, on a joint and several and full and unconditional basis, by IMI’s U.S. subsidiaries that represent the substantial majority of its U.S. operations.RISKS RELATED TO OUR TAXATION AS A REITIf we fail to remain qualified for taxation as a REIT, we will be subject to tax at corporate income tax rates and will not be able to deduct distributions to stockholders when computing our taxable income.We have elected to be taxed as a REIT since our 2014 taxable year. We believe that our organization and method of operation comply with the rules and regulations promulgated under the Internal Revenue Code of 1986, as amended (the “Code”), such that we will continue to qualify for taxation as a REIT. However, we can provide no assurance that we will remain qualified for taxation as a REIT. If we fail to remain qualified for taxation as a REIT, we will be taxed at corporate income tax rates unless certain relief provisions apply.Qualification for taxation as a REIT involves the application of highly technical and complex provisions of the Code to our operations as well as various factual determinations concerning matters and circumstances not entirely within our control. There are limited judicial or administrative interpretations of applicable REIT provisions of the Code.If, in any taxable year, we fail to remain qualified for taxation as a REIT and are not entitled to relief under the Code:•we will not be allowed a deduction for distributions to stockholders in computing our taxable income;•we will be subject to federal and state income tax on our taxable income at regular corporate income tax rates; and•we would not be eligible to elect REIT status again until the fifth taxable year that begins after the first year for which we failed to qualify for taxation as a REIT.Any such corporate tax liability could be substantial and would reduce the amount of cash available for other purposes. If we fail to remain qualified for taxation as a REIT, we may need to borrow additional funds or liquidate some investments to pay any additional tax liability. Accordingly, funds available for investment and distributions to stockholders could be reduced.As a REIT, failure to make required distributions would subject us to federal corporate income tax.We expect to continue paying regular quarterly distributions; however, the amount, timing and form of our regular quarterly distributions will be determined, and will be subject to adjustment, by our board of directors. To remain qualified for taxation as a REIT, we are generally required to distribute at least 90% of our REIT taxable income (determined without regard to the dividends paid deduction and excluding net capital gain) each year, or in limited circumstances, the following year, to our stockholders. Generally, we expect to distribute all or substantially all of our REIT taxable income. If our cash available for distribution falls short of our estimates, we may be unable to maintain distributions that approximate our REIT taxable income and may fail to remain qualified for taxation as a REIT. In addition, our cash flows from operations may be insufficient to fund required distributions as a result of differences in timing between the actual receipt of income and the payment of expenses and the recognition of income and expenses for federal income tax purposes, or the effect of nondeductible expenditures.To the extent that we satisfy the 90% distribution requirement but distribute less than 100% of our REIT taxable income, we will be subject to federal corporate income tax on our undistributed taxable income. In addition, we will be subject to a 4% nondeductible excise tax on our undistributed taxable income if the actual amount that we distribute to our stockholders for a calendar year is less than the minimum amount specified under the Code.16IRON MOUNTAIN 2020 FORM 10-KTable of ContentsPart IWe may be required to borrow funds, sell assets or raise equity to satisfy our REIT distribution requirements, to comply with asset ownership tests or to fund capital expenditures, future growth and expansion initiatives.In order to satisfy our REIT distribution requirements and maintain our qualification and taxation as a REIT, or to fund capital expenditures, future growth and expansion initiatives, we may need to borrow funds, sell assets or raise equity, even if our financial condition or the then-prevailing market conditions are not favorable for these borrowings, sales or offerings. Furthermore, the REIT distribution requirements and our commitment to investors on dividend growth may result in increasing our financing needs to fund capital expenditures, future growth and expansion initiatives, which would increase our indebtedness. An increase in our outstanding debt could lead to a downgrade of our credit ratings, which could negatively impact our ability to access credit markets. Further, certain of our current debt instruments limit the amount of indebtedness we and our subsidiaries may incur. Additional financing, therefore, may be unavailable, more expensive or restricted by the terms of our outstanding indebtedness. For a discussion of risks related to our substantial level of indebtedness, see “Risks Related to Our Indebtedness.”Complying with REIT requirements may limit our flexibility, cause us to forgo otherwise attractive opportunities that we would otherwise pursue to execute our growth strategy, or otherwise reduce our income and amounts available for distribution to our stockholders.To remain qualified for taxation as a REIT, we must satisfy tests concerning, among other things, the sources of our income, the nature and diversification of our assets and the amounts we distribute to our stockholders. Thus, compliance with these tests may require us to refrain from certain activities and may hinder our ability to make certain attractive investments, including the purchase of non-REIT qualifying operations or assets, the expansion of non-real estate activities, and investments in the businesses to be conducted by our TRSs, and to that extent limit our opportunities and our flexibility to change our business strategy. This may restrict our ability to enter into joint ventures or acquire minority interests of companies. Furthermore, acquisition opportunities in domestic and international markets may be adversely affected if we need or require the target company to comply with some REIT requirements prior to closing.We conduct a significant portion of our business activities, including our information management services businesses and several of our international operations, through domestic and foreign TRSs. Under the Code, no more than 25% of the value of the assets of a REIT may be represented by securities of one or more TRSs and other nonqualifying assets. In addition, no more than 20% of the value of the assets of a REIT may be represented by securities of one or more TRSs within the overall 25% nonqualifying assets limitation. These limitations may affect our ability to make additional investments in non-REIT qualifying operations or assets or in international operations through TRSs.If we fail to comply with specified asset ownership tests applicable to REITs as measured at the end of any calendar quarter, we generally must correct such failure within 30 days after the end of the applicable calendar quarter or qualify for statutory relief provisions to avoid losing our qualification for taxation as a REIT. As a result, we may be required to liquidate assets or to forgo our pursuit of otherwise attractive investments. These actions may reduce our income and amounts available for distribution to our stockholders.As a REIT, we are limited in our ability to fund distribution payments using cash generated through our TRSs.Our ability to receive distributions from our TRSs is limited by the rules with which we must comply to maintain our qualification for taxation as a REIT. In particular, at least 75% of our gross income for each taxable year as a REIT must be derived from real estate, which generally includes gross income from providing customers with secure storage space or colocation or wholesale data center space. Consequently, no more than 25% of our gross income may consist of dividend income from our TRSs and other nonqualifying types of income. Thus, our ability to receive distributions from our TRSs may be limited, which may impact our ability to fund distributions to our stockholders using cash flows from our TRSs. Specifically, if our TRSs become highly profitable, we might become limited in our ability to receive net income from our TRSs in an amount required to fund distributions to our stockholders commensurate with that profitability.In addition, a significant amount of our income and cash flows from our TRSs is generated from our international operations. In many cases, there are local withholding taxes and currency controls that may impact our ability or willingness to repatriate funds to the United States to help satisfy REIT distribution requirements.Our extensive use of TRSs, including for certain of our international operations, may cause us to fail to remain qualified for taxation as a REIT.Our operations include an extensive use of TRSs. The net income of our TRSs is not required to be distributed to us, and income that is not distributed to us generally is not subject to the REIT income distribution requirement. However, there may be limitations on our ability to accumulate earnings in our TRSs and the accumulation or reinvestment of significant earnings in our TRSs could result in adverse tax treatment. In particular, if the accumulation of cash in our TRSs causes (1) the fair market value of our securities in our TRSs to exceed 20% of the fair market value of our assets or (2) the fair market value of our securities in our TRSs and other nonqualifying assets to exceed 25% of the fair market value of our assets, then we will fail to remain qualified for taxation as a REIT. Further, a substantial portion of our operations are conducted overseas, and a material change in foreign currency rates could also affect the value of our foreign holdings in our TRSs, negatively impacting our ability to remain qualified for taxation as a REIT.IRON MOUNTAIN 2020 FORM 10-K17Table of ContentsPart IEven if we remain qualified for taxation as a REIT, some of our business activities are subject to corporate level income tax and foreign taxes, which will continue to reduce our cash flows, and we will have potential deferred and contingent tax liabilities.Even if we remain qualified for taxation as a REIT, we may be subject to some federal, state, local and foreign taxes, including taxes on any undistributed income, and state, local or foreign income, franchise, property and transfer taxes. In addition, we could in certain circumstances be required to pay an excise or penalty tax, which could be significant in amount, in order to utilize one or more relief provisions under the Code to maintain our qualification for taxation as a REIT.A portion of our business is conducted through wholly-owned TRSs because certain of our business activities could generate nonqualifying REIT income as currently structured and operated. The income of our domestic TRSs will continue to be subject to federal and state corporate income taxes. In addition, our international assets and operations will continue to be subject to taxation in the foreign jurisdictions where those assets are held or those operations are conducted. Any of these taxes would decrease our earnings and our available cash.We will also be subject to a federal corporate level income tax at the highest regular corporate income tax rate (currently 21%) on gain recognized from a sale of a REIT asset where our basis in the asset is determined by reference to the basis of the asset in the hands of a C corporation (such as an asset that we hold in one of our qualified REIT subsidiaries (“QRSs”) following the liquidation or other conversion of a former TRS). This 21% tax is generally applicable to any disposition of such an asset during the five-year period after the date we first owned the asset as a REIT asset to the extent of the built-in-gain based on the fair market value of such asset on the date we first held the asset as a REIT asset. In addition, any depreciation recapture income that we recognize because of accounting method changes that we make in connection with our acquisition activities will be fully subject to this 21% tax.Complying with REIT requirements may limit our ability to hedge effectively and increase the cost of our hedging and may cause us to incur tax liabilities.The REIT provisions of the Code limit our ability to hedge assets, liabilities, revenues and expenses. Generally, income from hedging transactions that we enter into to manage risk of interest rate changes with respect to borrowings made or to be made by us to acquire or carry real estate assets and income from certain currency hedging transactions related to our non- United States operations, as well as income from qualifying counteracting hedges, do not constitute “gross income” for purposes of the REIT gross income tests. To the extent that we enter into other types of hedging transactions, the income from those transactions is likely to be treated as nonqualifying income for purposes of the REIT gross income tests. As a result of these rules, we may need to limit our use of advantageous hedging techniques or implement those hedges through our TRSs. This could increase the cost of our hedging activities because our TRSs would be subject to tax on income or gains resulting from hedges entered into by them and may expose us to greater risks associated with changes in interest rates or exchange rates than we would otherwise want to bear. In addition, hedging losses in any of our TRSs generally will not provide any tax benefit, except for being carried forward for possible use against future income or gain in the TRSs.Distributions payable by REITs generally do not qualify for preferential tax rates.Dividends payable by United States corporations to noncorporate stockholders, such as individuals, trusts and estates, are generally eligible for reduced United States federal income tax rates applicable to “qualified dividends.” Distributions paid by REITs generally are not treated as “qualified dividends” under the Code, and the reduced rates applicable to such dividends do not generally apply. However, for tax years beginning before 2026, REIT dividends paid to noncorporate stockholders are generally taxed at an effective tax rate lower than applicable ordinary income tax rates due to the availability of a deduction under the Code for specified forms of income from passthrough entities. More favorable rates will nevertheless continue to apply to regular corporate “qualified” dividends, which may cause some investors to perceive that an investment in a REIT is less attractive than an investment in a non-REIT entity that pays dividends, thereby reducing the demand and market price of our common stock.18IRON MOUNTAIN 2020 FORM 10-KTable of ContentsPart IThe ownership and transfer restrictions contained in our certificate of incorporation may not protect our qualification for taxation as a REIT, could have unintended antitakeover effects and may prevent our stockholders from receiving a takeover premium.In order for us to remain qualified for taxation as a REIT, no more than 50% of the value of outstanding shares of our capital stock may be owned, beneficially or constructively, by five or fewer individuals at any time during the last half of each taxable year. In addition, rents from “affiliated tenants” will not qualify as qualifying REIT income if we own 10% or more by vote or value of the customer, whether directly or after application of attribution rules under the Code. Subject to certain exceptions, our certificate of incorporation prohibits any stockholder from owning, beneficially or constructively, more than (i) 9.8% in value of the outstanding shares of all classes or series of our capital stock or (ii) 9.8% in value or number, whichever is more restrictive, of the outstanding shares of any class or series of our capital stock. We refer to these restrictions collectively as the “ownership limits” and we included them in our certificate of incorporation to facilitate our compliance with REIT tax rules. The constructive ownership rules under the Code are complex and may cause the outstanding stock owned by a group of related individuals or entities to be deemed to be constructively owned by one individual or entity. As a result, the acquisition of less than 9.8% of our outstanding common stock (or the outstanding shares of any class or series of our capital stock) by an individual or entity could cause that individual or entity or another individual or entity to own constructively in excess of the relevant ownership limits. Any attempt to own or transfer shares of our common stock or of any of our other capital stock in violation of these restrictions may result in the shares being automatically transferred to a charitable trust or may be void. Even though our certificate of incorporation contains the ownership limits, there can be no assurance that these provisions will be effective to prevent our qualification for taxation as a REIT from being jeopardized, including under the affiliated tenant rule. Furthermore, there can be no assurance that we will be able to monitor and enforce the ownership limits. If the restrictions in our certificate of incorporation are not effective and, as a result, we fail to satisfy the REIT tax rules described above, then absent an applicable relief provision, we will fail to remain qualified for taxation as a REIT.In addition, the ownership and transfer restrictions could delay, defer or prevent a transaction or a change in control that might involve a premium price for our stock or otherwise be in the best interest of our stockholders. As a result, the overall effect of the ownership and transfer restrictions may be to render more difficult or discourage any attempt to acquire us, even if such acquisition may be favorable to the interests of our stockholders. Legislative or other actions affecting REITs could have a negative effect on us or our stockholders. At any time, the federal or state income tax laws governing REITs, the administrative interpretations of those laws, or local laws impacting our REIT structure for our international operations may be amended. Federal, state and local tax laws are constantly under review by persons involved in the legislative process, the IRS, the United States Department of the Treasury (“Treasury”) and state and local taxing authorities. Changes to the tax laws, regulations and administrative interpretations or local laws governing our international operations, which may have retroactive application, could adversely affect us. In addition, some of these changes could have a more significant impact on us as compared to other REITs due to the nature of our business and our substantial use of TRSs, particularly non-United States TRSs or how we have structured our operations outside the United States to comply with our REIT structure. We cannot predict with certainty whether, when, in what forms, or with what effective dates, the tax laws, regulations, administrative interpretations or local laws applicable to us may be changed or if such laws would impact our ability to qualify for taxation as a REIT or the costs for doing so. GENERAL RISK FACTORSOur cash distributions are not guaranteed and may fluctuate.As a REIT, we are generally required to distribute at least 90% of our REIT taxable income to our stockholders. Furthermore, we are committed to growing our dividends, and have stated this publicly.Our board of directors, in its sole discretion, will determine, on a quarterly basis, the amount of cash to be distributed to our stockholders based on a number of factors including, but not limited to, our results of operations, cash flow and capital requirements, economic conditions, tax considerations, borrowing capacity and other factors, including debt covenant restrictions that may impose limitations on cash payments, future acquisitions and divestitures, any stock repurchase program and general market demand for our space and related services. Consequently, our distribution levels may fluctuate and we may not be able to meet our public commitments with respect to dividend growth.IRON MOUNTAIN 2020 FORM 10-K19Table of ContentsPart IOur business could be adversely impacted if there are deficiencies in our disclosure controls and procedures or internal control over financial reporting.The design and effectiveness of our disclosure controls and procedures and internal control over financial reporting may not prevent all errors, misstatements or misrepresentations. While management will continue to review the effectiveness of our disclosure controls and procedures and internal control over financial reporting, there can be no guarantee that our internal control over financial reporting will be effective in accomplishing all control objectives all of the time. Moreover, the continuation of remote work arrangements as a result of the COVID-19 pandemic could negatively impact our internal controls over financial reporting. Furthermore, our disclosure controls and procedures and internal control over financial reporting with respect to entities that we do not control or manage may be substantially more limited than those we maintain with respect to the subsidiaries that we have controlled or managed over the course of time. Deficiencies, including any material weakness, in our internal control over financial reporting which may occur in the future could result in misstatements of our results of operations, restatements of our financial statements, a decline in our stock price, or otherwise materially adversely affect our business, reputation, results of operations, financial condition or liquidity.We face competition for customers.We compete with multiple businesses in all geographic areas where we operate; our current or potential customers may choose to use those competitors instead of us. In addition, if we are successful in winning customers from competitors, the process of moving their stored records into our facilities is often costly and time consuming. We also compete, in some of our business lines, with our current and potential customers’ internal storage and information management services capabilities and their cloud-based alternatives. These organizations may not begin or continue to use us for their future storage and information management service needs.The performance of our businesses relies on our ability to attract, develop, and retain talented personnel, while controlling our labor costs.We are highly dependent on skilled and qualified personnel to operate our businesses. The failure to attract and retain qualified employees or to effectively control our labor costs could negatively affect our competitive position and operating results. Our ability to control labor costs and attract qualified personnel is subject to numerous external factors, including prevailing wages, labor shortages, the impact of legislation or regulations governing wages and hours, labor relations, immigration, healthcare and other benefits, other employment-related costs and the hiring practices of our competitors.ITEM 1B. UNRESOLVED STAFF COMMENTS.None.ITEM 2. PROPERTIES. As of December 31, 2020, we conducted operations through 1,167 leased facilities and 281 owned facilities. Our facilities are divided among our reportable operating segments as follows: Global RIM Business (1,374), Global Data Center Business (15) and Corporate and Other Business (59). These facilities contain a total of approximately 92.7 million square feet of space. A breakdown of owned and leased facilities by country (and by state within the United States) is listed below: 20IRON MOUNTAIN 2020 FORM 10-KTable of ContentsPart I LEASEDOWNEDTOTALCOUNTRY/STATENUMBERSQUARE FEETNUMBERSQUARE FEETNUMBERSQUARE FEETNorth AmericaUnited States (Including Puerto Rico)Alabama3 312,473 1 12,621 4 325,094 Arizona8 496,448 6 1,207,281 14 1,703,729 Arkansas2 63,604 — — 2 63,604 California66 5,606,499 10 958,856 76 6,565,355 Colorado10 499,546 4 484,490 14 984,036 Connecticut4 199,114 6 665,013 10 864,127 Delaware4 309,067 1 120,921 5 429,988 District of Columbia1 1,670 — — 1 1,670 Florida33 2,356,117 5 263,930 38 2,620,047 Georgia10 826,606 5 265,049 15 1,091,655 Idaho2 105,021 — — 2 105,021 Illinois15 1,213,808 7 1,309,975 22 2,523,783 Indiana6 344,516 — — 6 344,516 Iowa2 145,138 1 14,200 3 159,338 Kansas3 253,919 — — 3 253,919 Kentucky3 116,000 4 418,760 7 534,760 Louisiana4 388,475 — — 4 388,475 Maine— — 1 95,000 1 95,000 Maryland19 2,032,517 2 83,442 21 2,115,959 Massachusetts (including Corporate Headquarters)8 545,039 8 1,173,503 16 1,718,542 Michigan13 785,563 6 345,736 19 1,131,299 Minnesota12 908,474 — — 12 908,474 Mississippi3 201,300 — — 3 201,300 Missouri10 1,225,648 5 373,120 15 1,598,768 Montana3 35,990 — — 3 35,990 Nebraska1 34,560 3 316,970 4 351,530 Nevada7 276,520 1 107,041 8 383,561 New Hampshire— — 1 146,467 1 146,467 New Jersey34 3,091,948 8 2,476,635 42 5,568,583 New Mexico3 151,473 — — 3 151,473 New York20 921,775 13 1,186,266 33 2,108,041 North Carolina19 976,504 3 150,624 22 1,127,128 Ohio14 1,064,729 5 290,291 19 1,355,020 Oklahoma5 228,425 — — 5 228,425 Oregon11 384,296 1 55,621 12 439,917 Pennsylvania24 2,335,704 4 2,067,081 28 4,402,785 Puerto Rico4 237,969 1 54,352 5 292,321 Rhode Island1 70,159 1 12,748 2 82,907 South Carolina4 247,375 2 214,238 6 461,613 Tennessee5 256,743 4 63,909 9 320,652 Texas40 2,172,049 27 2,229,977 67 4,402,026 Utah2 78,148 1 90,553 3 168,701 Vermont2 55,200 — — 2 55,200 Virginia12 685,369 7 795,036 19 1,480,405 Washington7 719,991 5 196,028 12 916,019 West Virginia2 105,502 — — 2 105,502 Wisconsin6 389,857 1 10,655 7 400,512 Total United States467 33,456,848 160 18,256,389 627 51,713,237 Canada49 3,076,099 16 1,783,258 65 4,859,357 Total North America516 36,532,947 176 20,039,647 692 56,572,594 IRON MOUNTAIN 2020 FORM 10-K21Table of ContentsPart ILEASEDOWNEDTOTALCOUNTRY/STATENUMBERSQUARE FEETNUMBERSQUARE FEETNUMBERSQUARE FEETInternationalArgentina4 225,334 4 298,864 8 524,198 Armenia3 13,712 — — 3 13,712 Australia44 3,004,241 2 33,845 46 3,038,086 Austria3 92,296 1 30,000 4 122,296 Belarus4 18,472 — — 4 18,472 Belgium4 202,106 1 104,391 5 306,497 Brazil42 2,854,580 7 324,655 49 3,179,235 Bulgaria2 154,204 — — 2 154,204 Chile8 295,030 10 376,183 18 671,213 China Mainland (including China - Hong Kong S.A.R., China-Taiwan and China-Macau S.A.R.)45 1,878,851 1 20,518 46 1,899,369 Colombia24 938,325 — — 24 938,325 Croatia1 36,737 1 36,447 2 73,184 Cyprus2 51,118 2 46,246 4 97,364 Czech Republic7 152,889 — — 7 152,889 Denmark3 161,361 — — 3 161,361 England59 2,969,416 23 1,175,907 82 4,145,323 Estonia1 38,861 — — 1 38,861 Eswatini3 6,997 — — 3 6,997 Finland3 95,896 — — 3 95,896 France33 2,111,261 12 936,486 45 3,047,747 Germany14 690,283 2 93,226 16 783,509 Greece4 291,273 — — 4 291,273 Hungary7 350,898 — — 7 350,898 India75 3,211,253 — — 75 3,211,253 Indonesia3 85,423 1 37,674 4 123,097 Ireland5 133,153 3 158,558 8 291,711 Kazakhstan4 46,482 — — 4 46,482 Latvia2 58,710 — — 2 58,710 Lesotho2 4,736 — — 2 4,736 Lithuania2 60,543 — — 2 60,543 Malaysia8 443,149 — — 8 443,149 Mexico10 478,471 8 585,885 18 1,064,356 The Netherlands9 602,564 3 102,199 12 704,763 Northern Ireland3 129,083 — — 3 129,083 New Zealand6 413,959 — — 6 413,959 Norway5 194,321 — — 5 194,321 Peru4 63,949 10 433,770 14 497,719 Philippines9 338,040 — — 9 338,040 Poland19 796,561 — — 19 796,561 Romania7 412,214 — — 7 412,214 Russia44 1,743,914 — — 44 1,743,914 Scotland— — 4 375,294 4 375,294 Serbia3 98,876 — — 3 98,876 Singapore6 297,581 3 345,056 9 642,637 Slovakia5 173,792 — — 5 173,792 South Africa17 483,181 — — 17 483,181 South Korea8 257,233 — — 8 257,233 Spain31 766,667 5 170,707 36 937,374 Sweden6 759,793 — — 6 759,793 Switzerland11 283,104 — — 11 283,104 Thailand3 205,827 2 105,487 5 311,314 Turkey8 675,751 — — 8 675,751 Ukraine10 208,050 — — 10 208,050 United Arab Emirates6 314,628 — — 6 314,628 Total International651 30,375,149 105 5,791,398 756 36,166,547 Total1,167 66,908,096 281 25,831,045 1,448 92,739,141 22IRON MOUNTAIN 2020 FORM 10-KTable of ContentsPart IThe leased facilities typically have initial lease terms of five to 10 years with one or more renewal options. In addition, some of the leases contain either a purchase option or a right of first refusal upon the sale of the property. We believe that the space available in our facilities is adequate to meet our current needs, although future growth may require that we lease or purchase additional real property.Our total building utilization and total racking utilization by region as of December 31, 2020 in Records Management and Data Management are as follows: RECORDS MANAGEMENT(1)DATA MANAGEMENTREGIONBUILDINGUTILIZATIONRACKINGUTILIZATIONBUILDINGUTILIZATIONRACKINGUTILIZATIONNorth America83%90%85%97%Europe83%91%49%74%Latin America87%91%76%81%Asia86%93%66%72%Total84%91%75%90%(1)Total building utilization and total racking utilization for Records Management includes the utilization for GDS and Consumer Storage.See Note 2.i. to Notes to Consolidated Financial Statements included in this Annual Report for information regarding our minimum annual lease commitments as a lessee.See Schedule III—Schedule of Real Estate and Accumulated Depreciation in this Annual Report for information regarding the cost, accumulated depreciation and encumbrances associated with our owned real estate.The following table sets forth a summary of the lease expirations for leases in place related to our Global Data Center Business, for which we are the lessor, as of December 31, 2020. The information set forth in the table assumes that tenants exercise no renewal options and all early termination rights. YEARNUMBER OF LEASES EXPIRINGTOTAL MEGAWATTSEXPIRINGPERCENTAGEOF TOTAL MEGAWATTSEXPIRINGANNUALIZEDTOTAL CONTRACTRENT EXPIRING (IN THOUSANDS)PERCENTAGE OFTOTAL CONTRACT VALUE ANNUALIZEDRENT2021594 18.1 13.9 %$57,614 20.2 %2022320 17.6 13.5 %46,544 16.3 %2023261 18.7 14.4 %50,762 17.8 %202481 8.9 6.8 %22,497 7.9 %202548 11.6 8.9 %25,593 9.0 %202614 7.6 5.8 %15,683 5.5 %20273 6.8 5.2 %6,944 2.4 %Thereafter19 41.1 31.5 %59,851 20.9 %Total1,340 130.4 100.0 %$285,488 100.0 %ITEM 3. LEGAL PROCEEDINGS.We are involved in litigation from time to time in the ordinary course of business. A portion of the defense and/or settlement costs associated with such litigation is covered by various commercial liability insurance policies purchased by us and, in limited cases, indemnification from third parties. In the opinion of management, no material legal proceedings are pending to which we, or any of our properties, are subject. ITEM 4. MINE SAFETY DISCLOSURES.None.IRON MOUNTAIN 2020 FORM 10-K23Table of ContentsPART IIITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES.Our common stock is traded on the NYSE under the symbol “IRM". The closing price of our common stock on the NYSE on February 19, 2021 was $32.17. As of February 19, 2021, there were 8,071 holders of record of our common stock. See Note 8 to Notes to Consolidated Financial Statements included in this Annual Report for additional information on dividends declared on our common stock. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDSWe did not sell any unregistered equity securities during the three months ended December 31, 2020, nor did we repurchase any shares of our common stock during the three months ended December 31, 2020.ITEM 6. [RESERVED.]ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.The following discussion should be read in conjunction with the Consolidated Financial Statements and Notes thereto and the other financial and operating information included elsewhere in this Annual Report.This discussion contains “forward-looking statements” as that term is defined in the Private Securities Litigation Reform Act of 1995 and in other securities laws. See “Cautionary Note Regarding Forward-Looking Statements” on page iii of this Annual Report and “Item 1A. Risk Factors” beginning on page 8 of this Annual Report.IRON MOUNTAIN 2020 FORM 10-K25Table of ContentsPart IIOVERVIEWCOVID-19In March 2020, the World Health Organization declared COVID-19 a pandemic. This resulted in U.S. federal, state and local and foreign governments and private entities mandating various restrictions, including travel restrictions, restrictions on public gatherings and stay-at-home orders and advisories. In response, we temporarily closed certain of our offices and facilities across the world and implemented certain travel restrictions for our employees. The preventative and protective actions that governments have ordered, or we or our customers have implemented, have resulted in a period of reduced service operations and business disruption for us, our customers and other third parties with which we do business. While we have broad geographic and customer diversification with operations in 56 countries and no single customer accounting for more than 1% of our revenue during the year ended December 31, 2020, COVID-19 is a global pandemic impacting numerous industries and geographies. While we do not currently believe that the implications of the COVID-19 pandemic have had a material adverse impact on our ability to collect our accounts receivable, global economic conditions related to the COVID-19 pandemic may have a material adverse effect on our customers, which could impact our future ability to collect our accounts receivable. We continue to monitor the credit worthiness of our customers and customer payment trends, as well as the related impact on our liquidity.We have taken certain actions during the year ended December 31, 2020 to manage our costs and capital expenditures, including, but not limited to: (i) the termination of nearly all of our temporary and contract workers; (ii) reductions in our full-time and part-time work forces; (iii) temporary furloughs, reduced hours or other temporary reduction measures; (iv) the deferral of certain previously planned non-essential capital investments; and (v) the implementation of a temporary freeze on future acquisitions. We can provide no assurance that the cost savings measures we have taken, or may take in future periods, will be sufficient to offset any future service level declines, and we continue to evaluate the need for these cost saving measures and additional cost saving measures as additional information regarding the COVID-19 pandemic and the related economic downturn becomes known. We have incurred certain costs due to the COVID-19 pandemic which are direct, incremental and not expected to recur once the pandemic ends, which include the purchase of personal protective equipment for our employees and incremental cleaning costs of our facilities, among other direct costs. We have excluded these costs in calculating our various non-GAAP measures as described below.PROJECT SUMMITCompelling Adjusted EBITDA BenefitsImplementation Details~$375MExpected annual run-ratebenefits realized exiting 2021$165MBenefits delivered in 2020•Project Summit began in Q4 2019 and is expected to be substantially completed by the end of 2021•Cost to implement is estimated to be ~$450MIn October 2019, we announced Project Summit, our global program designed to better position us for future growth and achievement of our strategic objectives. We expanded Project Summit during the first quarter of 2020 to include additional opportunities to streamline our business and operations, as well as accelerated the timing of certain opportunities previously identified. Such opportunities include leveraging new technology solutions to enable us to modernize our service delivery model and more efficiently utilize our fleet, labor and real estate. As a result of the program, we expect to reduce the number of positions at vice president and above by approximately 45%. The total program is expected to reduce our total managerial and administrative workforce by approximately 700 positions by the end of 2021. We have also reduced our services and operations workforce. As of December 31, 2020, we have completed approximately 70% of our planned workforce reductions.26IRON MOUNTAIN 2020 FORM 10-KTable of ContentsPart IIThe activities associated with Project Summit began in the fourth quarter of 2019 and are expected to be substantially complete by the end of 2021. We expect the total program benefits associated with Project Summit to be fully realized exiting 2021. Including the expanded scope of Project Summit, we expect that Project Summit will improve annual Adjusted EBITDA (as defined below) by approximately $375.0 million exiting 2021. We will continue to evaluate our overall operating model, as well as various opportunities and initiatives, including those associated with real estate consolidation, system implementation and process changes, which could result in the identification and implementation of additional actions associated with Project Summit and incremental costs and benefits.2020$165 millionExiting 2021$375 million(expected)We estimate that the implementation of Project Summit will result in total operating expenditures ("Restructuring Charges") of approximately $450.0 million that primarily consist of: (1) employee severance costs; (2) internal costs associated with the development and implementation of Project Summit initiatives; (3) professional fees, primarily related to third party consultants who are assisting with the design and execution of various initiatives as well as project management activities and (4) system implementation and data conversion costs. The following table presents (in millions) total Restructuring Charges related to Project Summit primarily related to employee severance costs, internal costs associated with the development and implementation of Project Summit initiatives and professional fees from the inception of Project Summit through December 31, 2020, for the year ended December 31, 2020 and for the year ended December 31, 2019:From the Inception ofProject Summit throughDecember 31, 2020For the Year EndedDecember 31, 2020For the Year EndedDecember 31, 2019We have also incurred approximately $10.1 million in capital expenditures related to Project Summit from the inception of Project Summit through December 31, 2020. DIVESTMENTSIn March 2019, we contributed our customer contracts and certain intellectual property and other assets used by us to operate our consumer storage business in the United States and Canada (the “IM Consumer Storage Assets”) and approximately $20.0 million in cash (gross of certain transaction expenses) (the “Cash Contribution”) to the MakeSpace JV (the “Consumer Storage Transaction”), established by us and MakeSpace. Upon the closing of the Consumer Storage Transaction on March 19, 2019, the MakeSpace JV owned (i) the IM Consumer Storage Assets, (ii) the Cash Contribution and (iii) the customer contracts, intellectual property and certain other assets used by MakeSpace to operate its consumer storage business in the United States. As part of the Consumer Storage Transaction, we received an initial equity interest of approximately 34% in the MakeSpace JV (the “MakeSpace Investment”). In the second quarter of 2020, we committed to participate in a round of equity funding for the MakeSpace JV whereby we agreed to contribute $36.0 million of the $45.0 million being raised in installments beginning in May 2020 through October 2021. At December 31, 2020, we owned approximately 39% of the outstanding equity in the MakeSpace JV.As described in Note 4 to Notes to Consolidated Financial Statements included in this Annual Report, we have concluded that the divestment of the IM Consumer Storage Assets in the Consumer Storage Transaction does not meet the criteria to be reported as discontinued operations in our consolidated financial statements. In connection with the Consumer Storage Transaction and the MakeSpace Investment, we also entered into a storage and service agreement with the MakeSpace JV to provide certain storage and related services to the MakeSpace JV (the “MakeSpace Agreement”). Revenues and expenses associated with the MakeSpace Agreement are presented as a component of our Global RIM Business segment. During the years ended December 31, 2020 and 2019, we recognized revenue of approximately $33.6 million and $22.5 million, respectively, associated with the MakeSpace Agreement.As a result of the Consumer Storage Transaction, we recorded a gain on sale of approximately $4.2 million to Other expense (income), net, in the first quarter of 2019, representing the excess of the fair value of the consideration received over the sum of (i) the carrying value of our consumer storage operations and (ii) the Cash Contribution.IRON MOUNTAIN 2020 FORM 10-K27Table of ContentsPart IICHANGES IMPACTING COMPARABILITY WITH PRIOR YEARDuring the fourth quarter of 2020, we made changes to the definitions of the following non-GAAP measures: Adjusted EBITDA, Adjusted EPS, FFO (Nareit) and FFO (Normalized) (each as defined below). These changes were implemented to align our definitions more closely with our peers. These changes impacted the results reported for these non-GAAP measures for fiscal years 2019 and 2018. However, these changes did not materially impact the discussion to what was included in previous filings. All prior periods have been recast to conform to these changes. See “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations” in our Annual Report on Form 10-K for the year ended December 31, 2019 for a comparison of 2019 to 2018.GENERALRESULTS OF OPERATIONS - KEY TRENDS •In spite of the COVID-19 pandemic, we have experienced relatively steady volume in our Global RIM Business segment, with organic storage rental revenue growth driven primarily by revenue management. We expect organic storage rental revenue growth to benefit from revenue management and volume to be relatively stable in the near term. We expect our total organic storage rental revenue growth rate for 2021 to be approximately 2% to 4%.•Our organic service revenue during 2020 was significantly impacted by the COVID-19 pandemic, with declines primarily due to decreases in our service activity, particularly in regions where governments have imposed restrictions on our customers’ non-essential business operations. The severity of future service level declines is uncertain and is dependent, in part, on the duration and severity of the COVID-19 pandemic, the resulting governmental and business actions and the duration and strength of any ensuing economic recovery that may follow, particularly within the markets in which we operate and among our customers.Our revenues consist of storage rental revenues as well as service revenues and are reflected net of sales and value-added taxes. Storage rental revenues, which are considered a key driver of financial performance for the storage and information management services industry, consist primarily of recurring periodic rental charges related to the storage of materials or data (generally on a per unit basis) that are typically retained by customers for many years and revenues associated with our data center operations. Service revenues include charges for related service activities, the most significant of which include: (1) the handling of records, including the addition of new records, temporary removal of records from storage, refiling of removed records, customer termination and permanent withdrawal fees, project revenues, and courier operations, consisting primarily of the pickup and delivery of records upon customer request; (2) destruction services, consisting primarily of secure shredding of sensitive documents and the subsequent sale of shredded paper for recycling, the price of which can fluctuate from period to period; and (3) digital solutions, including the scanning, imaging and document conversion services of active and inactive records, and consulting services. Our service revenue growth has been negatively impacted by declining activity rates as stored records are becoming less active. While customers continue to store their records and tapes with us, they are less likely than they have been in the past to retrieve records for research and other purposes, thereby reducing service activity levels.BREAKDOWN OF REVENUES28IRON MOUNTAIN 2020 FORM 10-KTable of ContentsPart IICost of sales (excluding depreciation and amortization) consists primarily of labor, including wages and benefits for field personnel, facility occupancy costs (including rent and utilities), transportation expenses (including vehicle leases and fuel), other product cost of sales and other equipment costs and supplies. Of these, labor and facility occupancy costs are the most significant. Selling, general and administrative expenses consist primarily of wages and benefits for management, administrative, IT, sales, account management and marketing personnel, as well as expenses related to communications and data processing, travel, professional fees, bad debts, training, office equipment and supplies. Cost of sales (excluding depreciation and amortization) and Selling, general and administrative expenses for the year ended December 31, 2020 consists of the following:COST OF SALESSELLING, GENERAL AND ADMINISTRATIVE EXPENSESTrends in facility occupancy costs are impacted by:•the total number of facilities we occupy;•the mix of properties we own versus properties we lease;•fluctuations in per square foot occupancy costs; and•the levels of utilization of these properties.Trends in total wages and benefits in dollars and as a percentage of total consolidated revenue are influenced by:•changes in headcount and compensation levels;•achievement of incentive compensation targets;•workforce productivity; and•variability in costs associated with medical insurance and workers’ compensation.The expansion of our international businesses has impacted the major cost of sales components and selling, general and administrative expenses.•Our international operations are more labor intensive relative to revenue than our operations in North America and, therefore, labor costs are a higher percentage of international operational revenue.•The overhead structure of our expanding international operations has generally not achieved the same level of overhead leverage as our North American operations, which may result in an increase in selling, general and administrative expenses as a percentage of consolidated revenue as our international operations become a larger percentage of our consolidated results.Our depreciation and amortization charges result primarily from depreciation related to storage systems, which include racking structures, buildings, building and leasehold improvements and computer systems hardware and software. Amortization relates primarily to customer relationship intangible assets, contract fulfillment costs and data center lease-based intangible assets. Both depreciation and amortization are impacted by the timing of acquisitions. Our consolidated revenues and expenses are subject to the net effect of foreign currency translation related to our operations outside the United States. It is difficult to predict the future fluctuations of foreign currency exchange rates and how those fluctuations will impact our Consolidated Statements of Operations. As a result of the relative size of our international operations, these fluctuations may be material on individual balances. Our revenues and expenses from our international operations are generally denominated in the local currency of the country in which they are derived or incurred. Therefore, the impact of currency fluctuations on our operating income and operating margin is partially mitigated. In order to provide a framework for assessing how our underlying businesses performed excluding the effect of foreign currency fluctuations, we compare the percentage change in the results from one period to another period in this report using constant currency presentation. The constant currency growth rates are calculated by translating the 2019 results at the 2020 average exchange rates and the 2018 results at the 2019 average exchange rates. Constant currency growth rates are a non-GAAP measure.IRON MOUNTAIN 2020 FORM 10-K29Table of ContentsPart IIThe following table is a comparison of underlying average exchange rates of the foreign currencies that had the most significant impact on our United States dollar-reported revenues and expenses: PERCENTAGE OF UNITED STATES DOLLAR-REPORTED REVENUE FOR THEYEAR ENDED DECEMBER 31,AVERAGE EXCHANGE RATESFOR THE YEAR ENDEDDECEMBER 31,PERCENTAGESTRENGTHENING /(WEAKENING) OFFOREIGN CURRENCY 2020201920202019Australian dollar3.2 %3.4 %$0.690 $0.695 (0.7)%Brazilian real1.9 %2.6 %$0.196 $0.254 (22.8)%British pound sterling6.0 %6.4 %$1.283 $1.277 0.5 %Canadian dollar5.4 %5.7 %$0.746 $0.754 (1.1)%Euro7.5 %7.4 %$1.141 $1.120 1.9 % PERCENTAGE OF UNITED STATES DOLLAR-REPORTED REVENUE FOR THEYEAR ENDED DECEMBER 31,AVERAGE EXCHANGE RATESFOR THE YEAR ENDEDDECEMBER 31,PERCENTAGESTRENGTHENING /(WEAKENING) OFFOREIGN CURRENCY 2019201820192018Australian dollar3.4 %3.7 %$0.695 $0.748 (7.1)%Brazilian real2.6 %2.9 %$0.254 $0.276 (8.0)%British pound sterling6.4 %6.6 %$1.277 $1.335 (4.3)%Canadian dollar5.7 %5.9 %$0.754 $0.772 (2.3)%Euro7.4 %7.3 %$1.120 $1.182 (5.2)%The percentage of United States dollar-reported revenues for all other foreign currencies was 13.8%, 12.7% and 12.6% for the years ended December 31, 2020, 2019 and 2018, respectively.NON-GAAP MEASURESADJUSTED EBITDADuring the fourth quarter of 2020, we changed our definition of Adjusted EBITDA to (a) exclude stock-based compensation expense and (b) include our share of Adjusted EBITDA from our unconsolidated joint ventures. We now define Adjusted EBITDA as income (loss) from continuing operations before interest expense, net, provision (benefit) for income taxes, depreciation and amortization (inclusive of our share of Adjusted EBITDA from our unconsolidated joint ventures), and excluding certain items we do not believe to be indicative of our core operating results, specifically:EXCLUDED•Significant Acquisition Costs•Restructuring Charges•Intangible impairments•(Gain) loss on disposal/write-down of property, plant and equipment, net (including real estate)•Other expense (income), net•Stock-based compensation expense•COVID-19 Costs (as defined below)Adjusted EBITDA Margin is calculated by dividing Adjusted EBITDA by total revenues. We also show Adjusted EBITDA and Adjusted EBITDA Margin for each of our reportable operating segments under “Results of Operations – Segment Analysis” below.30IRON MOUNTAIN 2020 FORM 10-KTable of ContentsPart IIAdjusted EBITDA excludes both interest expense, net and the provision (benefit) for income taxes. These expenses are associated with our capitalization and tax structures, which we do not consider when evaluating the operating profitability of our core operations. Adjusted EBITDA also does not include depreciation and amortization expenses, in order to eliminate the impact of capital investments, which we evaluate by comparing capital expenditures to incremental revenue generated and as a percentage of total revenues. Adjusted EBITDA and Adjusted EBITDA Margin should be considered in addition to, but not as a substitute for, other measures of financial performance reported in accordance with accounting principles generally accepted in the United States of America (“GAAP”), such as operating income, income (loss) from continuing operations, net income (loss) or cash flows from operating activities from continuing operations (as determined in accordance with GAAP). RECONCILIATION OF INCOME (LOSS) FROM CONTINUING OPERATIONS TO ADJUSTED EBITDA (IN THOUSANDS): YEAR ENDED DECEMBER 31, 202020192018Income (Loss) from Continuing Operations$343,096 $268,211 $367,558 Add/(Deduct):Interest expense, net418,535 419,298 409,648 Provision (benefit) for income taxes29,609 59,931 42,753 Depreciation and amortization652,069 658,201 639,514 Significant Acquisition Costs— 13,293 50,665 Restructuring Charges194,396 48,597 — Intangible impairments23,000 — — (Gain) loss on disposal/write-down of property, plant and equipment, net (including real estate)(363,537)(63,824)(73,622)Other expense (income), net, excluding our share of losses (gains) from our unconsolidated joint ventures(1)133,611 25,720 (11,867)Stock-based compensation expense(2)34,272 36,194 31,014 COVID-19 Costs(3)9,285 — — Our share of Adjusted EBITDA reconciling items from our unconsolidated joint ventures1,385 3,388 3,261 Adjusted EBITDA$1,475,721 $1,469,009 $1,458,924 (1)Includes foreign currency transaction losses (gains), net, debt extinguishment expense and other, net. See Note 2.t. to Notes to Consolidated Financial Statements included in this Annual Report for additional information regarding the components of Other expense (income), net.(2)Stock-based compensation expense related to Project Summit is included within Restructuring Charges for the years ended December 31, 2020 and 2019.(3)Costs that are incremental and directly attributable to the COVID-19 pandemic which are not expected to recur once the pandemic ends (“COVID-19 Costs”). These costs include the purchase of personal protective equipment for our employees and incremental cleaning costs of our facilities, among other direct costs.ADJUSTED EPSDuring the fourth quarter of 2020, we changed our definition of Adjusted EPS to (a) exclude stock-based compensation expense and (b) include our share of adjusted losses (gains) from our unconsolidated joint ventures. We now define Adjusted EPS as reported earnings per share fully diluted from continuing operations (inclusive of our share of adjusted losses (gains) from our unconsolidated joint ventures) and excluding certain items, specifically:EXCLUDED•Significant Acquisition Costs•Restructuring Charges•Intangible impairments•(Gain) loss on disposal/write-down of property, plant and equipment, net (including real estate)•Other expense (income), net•Stock-based compensation expense•COVID-19 Costs•Tax impact of reconciling items and discrete tax itemsWe do not believe these excluded items to be indicative of our ongoing operating results, and they are not considered when we are forecasting our future results. We believe Adjusted EPS is of value to our current and potential investors when comparing our results from past, present and future periods.IRON MOUNTAIN 2020 FORM 10-K31Table of ContentsPart IIRECONCILIATION OF REPORTED EPS—FULLY DILUTED FROM CONTINUING OPERATIONS TO ADJUSTED EPS—FULLY DILUTED FROM CONTINUING OPERATIONS: YEAR ENDED DECEMBER 31, 202020192018Reported EPS—Fully Diluted from Continuing Operations$1.19 $0.93 $1.28 Add/(Deduct): Significant Acquisition Costs— 0.05 0.18 Restructuring Charges0.67 0.17 — Intangible impairments0.08 — — (Gain) loss on disposal/write-down of property, plant and equipment, net (including real estate)(1.26)(0.22)(0.25)Other expense (income), net, excluding our share of losses (gains) from our unconsolidated joint ventures0.46 0.09 (0.04)Stock-based compensation expense(1)0.12 0.13 0.11 COVID-19 Costs(2)0.03 — — Tax impact of reconciling items and discrete tax items(3)(0.11)(0.03)(0.10)Adjusted EPS—Fully Diluted from Continuing Operations(4)$1.19 $1.11 $1.16 (1)Stock-based compensation expense related to Project Summit is included within Restructuring Charges for the years ended December 31, 2020 and 2019.(2)These costs include the purchase of personal protective equipment for our employees and incremental cleaning costs of our facilities, among other direct costs.(3)The difference between our effective tax rate and our structural tax rate (or adjusted effective tax rate) for the years ended December 31, 2020, 2019, and 2018 is primarily due to (i) the reconciling items above, which impact our reported income (loss) from continuing operations before provision (benefit) for income taxes but have an insignificant impact on our reported provision (benefit) for income taxes and (ii) other discrete tax items. Our structural tax rate for purposes of the calculation of Adjusted EPS for the years ended December 31, 2020, 2019 and 2018 was 15.1%, 17.6%, and 17.9%, respectively.(4)Columns may not foot due to rounding.FFO (NAREIT) AND FFO (NORMALIZED)Funds from operations ("FFO") is defined by the National Association of Real Estate Investment Trusts (“Nareit”) as net income (loss) excluding depreciation on real estate assets, gains on sale of real estate, net of tax, and amortization of data center leased-based intangibles. Consistent with Nareit's definition of FFO, during the fourth quarter of 2020, we began adjusting for our share of reconciling items from our unconsolidated joint ventures from FFO ("FFO (Nareit)"). FFO (Nareit) does not give effect to real estate depreciation because these amounts are computed, under GAAP, to allocate the cost of a property over its useful life. Because values for well-maintained real estate assets have historically increased or decreased based upon prevailing market conditions, we believe that FFO (Nareit) provides investors with a clearer view of our operating performance. Our most directly comparable GAAP measure to FFO (Nareit) is net income (loss).Although Nareit has published a definition of FFO, we modify FFO (Nareit), as is common among REITs seeking to provide financial measures that most meaningfully reflect their particular business ("FFO (Normalized)"). During the fourth quarter of 2020, we changed our definition of FFO (Normalized) to exclude stock-based compensation expense and adjust for our share of FFO (Normalized) reconciling items from our unconsolidated joint ventures. Our definition of FFO (Normalized) excludes certain items included in FFO (Nareit) that we believe are not indicative of our core operating results, specifically:EXCLUDED•Significant Acquisition Costs•Restructuring Charges•Intangible impairments•Loss (gain) on disposal/write-down of property, plant and equipment, net (excluding real estate)•Other expense (income), net•Stock-based compensation expense•COVID-19 Costs•Real estate financing lease depreciation•Tax impact of reconciling items and discrete tax items•(Income) loss from discontinued operations, net of tax32IRON MOUNTAIN 2020 FORM 10-KTable of ContentsPart IIRECONCILIATION OF NET INCOME (LOSS) TO FFO (NAREIT) AND FFO (NORMALIZED) (IN THOUSANDS):YEAR ENDED DECEMBER 31,202020192018Net Income (Loss)$343,096 $268,315 $355,131 Add/(Deduct):Real estate depreciation(1)298,943 303,415 284,804 Gain on sale of real estate, net of tax(2)(365,709)(99,194)(55,328)Data center lease-based intangible assets amortization(3)42,637 46,696 43,061 Our share of FFO (Nareit) reconciling items from our unconsolidated joint ventures— 1,284 1,391 FFO (Nareit)318,967 520,516 629,059 Add/(Deduct):Significant Acquisition Costs— 13,293 50,665 Restructuring Charges194,396 48,597 — Intangible impairments23,000 — — Loss (gain) on disposal/write-down of property, plant and equipment, net (excluding real estate)2,523 40,763 (9,818)Other expense (income), net, excluding our share of losses (gains) from our unconsolidated joint ventures(4)133,611 25,720 (11,867)Stock-based compensation expense(5)34,272 36,194 31,014 COVID-19 Costs(6)9,285 — — Real estate financing lease depreciation13,801 13,364 13,650 Tax impact of reconciling items and discrete tax items(7)(31,825)(13,095)(38,365)(Income) loss from discontinued operations, net of tax(8)— (104)12,427 Our share of FFO (Normalized) reconciling items from our unconsolidated joint ventures(38)148 248 FFO (Normalized)$697,992 $685,396 $677,013 (1)Includes depreciation expense related to owned real estate assets (land improvements, buildings, building improvements, leasehold improvements and racking), excluding depreciation related to real estate financing leases.(2)Tax expense associated with the gain on sale of real estate for the years ended December 31, 2020, 2019, and 2018, was $0.4 million, $5.4 million, and $8.5 million, respectively.(3)Includes amortization expense for Data Center In-Place Lease Intangible Assets and Data Center Tenant Relationship Intangible Assets as defined in Note 2.l. to Notes to Consolidated Financial Statements included in this Annual Report.(4)Includes foreign currency transaction losses (gains), net, debt extinguishment expense and other, net. See Note 2.t. to Notes to Consolidated Financial Statements included in this Annual Report for additional information regarding the components of Other expense (income), net.(5)Stock-based compensation expense related to Project Summit is included within Restructuring Charges for the years ended December 31, 2020 and 2019.(6)These costs include the purchase of personal protective equipment for our employees and incremental cleaning costs of our facilities, among other direct costs.(7)Represents the tax impact of (i) the reconciling items above, which impacts our reported income (loss) from continuing operations before provision (benefit) for income taxes but has an insignificant impact on our reported provision (benefit) for income taxes and (ii) other discrete tax items. Discrete tax items resulted in a (benefit) provision for income taxes of $(16.8) million, $(1.5) million and $(27.7) million for the years ended December 31, 2020, 2019 and 2018, respectively.(8)Net of tax (benefit) provision of $0.0 million, $0.0 million and $(0.1) million for the years ended December 31, 2020, 2019 and 2018, respectively.CRITICAL ACCOUNTING ESTIMATESOur discussion and analysis of our financial condition and results of operations are based upon our Consolidated Financial Statements, which have been prepared in accordance with GAAP. The preparation of these financial statements requires us to make estimates, judgments and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities at the date of the financial statements and for the period then ended. On an ongoing basis, we evaluate the estimates used. We base our estimates on historical experience, actuarial estimates, current conditions and various other assumptions that we believe to be reasonable under the circumstances. These estimates form the basis for making judgments about the carrying values of assets and liabilities and are not readily apparent from other sources. Actual results may differ from these estimates. The following should be read in conjunction with Note 2 to Notes to Consolidated Financial Statements included in this Annual Report, which provides a summary of our significant accounting policies. Our critical accounting estimates include the following, which are listed in no particular order: IRON MOUNTAIN 2020 FORM 10-K33Table of ContentsPart IIREVENUE RECOGNITION Revenue is recognized when or as control of promised goods or services is transferred to the customer, in an amount that reflects the consideration we expect to be entitled to in exchange for those goods or services. See Note 2.r. to Notes to Consolidated Financial Statements included in this Annual Report for additional details on our revenue recognition policies. Revenue for all our lines of business, with the exception of storage revenues in our Global Data Center Business (which is subject to leasing guidance), is recognized under Accounting Standards Update No. 2014-09, Revenue from Contracts with Customers (Topic 606) (“ASU 2014-09”), the application of which requires that we make estimates and judgements that may affect the amount and timing of revenue we recognize. We have determined that the majority of our contracts contain series performance obligations which qualify to be recognized under a practical expedient available in ASU 2014-09 known as the “right to invoice.” This determination allows variable consideration in such contracts to be allocated to and recognized in the period to which the consideration relates, which is typically the period in which it is billed, rather than requiring estimation of variable consideration at the inception of the contract. From time to time, we make payments to entities that are also customers under a revenue contract. These payments are comprised of Customer Inducements (as defined in Note 2.l. to Notes to Consolidated Financial Statements included in this Annual Report). Consideration payable to a customer is reviewed as part of the transaction price. If the payment to the customer does not represent payment for a distinct service, revenue is recognized only up to the amount of consideration remaining after customer payment obligations are considered. Contract Fulfillment Costs are amortized over a three year term, which we have determined is consistent with the transfer of the underlying performance obligations to which the assets relate. Different determinations on term length would result in differences in the amount and timing of amortization expense recognized.ACCOUNTING FOR ACQUISITIONSPart of our growth strategy has been to acquire businesses. The purchase price of each acquisition has been determined after due diligence of the target business, market research, strategic planning and the forecasting of expected future results and synergies. Estimated future results and expected synergies are subject to revisions as we integrate each acquisition and attempt to leverage resources. Accounting for acquisitions of a business has resulted in the capitalization of the cost in excess of the estimated fair value of the net assets acquired in each of these acquisitions as goodwill. We estimate the fair values of the assets acquired in each acquisition as of the date of acquisition and these estimates are subject to adjustment based on the final assessments of the fair value of intangible assets (primarily customer relationship and data center lease-based intangible assets), property, plant and equipment (primarily building, building improvements, leasehold improvements, data center infrastructure and racking structures), operating leases, contingencies and income taxes (primarily deferred income taxes). See Note 3 to Notes to Consolidated Financial Statements included in this Annual Report for a description of recent acquisitions. Determining the fair values of the net assets acquired requires management’s judgment and often involves the use of assumptions with respect to future cash inflows and outflows, discount rates and market data, among other items. As it relates to our data center acquisitions, the fair values of the net assets acquired requires management’s judgment and often involves the use of assumptions with respect to (i) certain economic costs (as described more fully in Note 2.l. to Notes to Consolidated Financial Statements included in this Annual Report) avoided by acquiring a data center operation with active tenants that would have otherwise been incurred if the data center operation was purchased vacant, (ii) market rental rates and (iii) expectations of lease renewals and extensions. Due to the inherent uncertainty of future events, actual values of net assets acquired could be different from our estimated fair values and could have a material impact on our financial statements.Of the net assets acquired in our acquisitions, the fair value of owned buildings, including building improvements, customer relationship and data center lease-based intangible assets, racking structures and operating leases are generally the most common and most significant. For significant acquisitions or acquisitions involving new markets or new products, we generally use third parties to assist us in estimating the fair value of owned buildings, including building improvements, customer relationship and lease-based intangible assets and market rental rates for acquired operating leases. For acquisitions that are not significant or do not involve new markets or new products, we generally use third parties to assist us in estimating the fair value of acquired owned buildings, including building improvements, and market rental rates for acquired operating leases. When not using third party appraisals of the fair value of acquired net assets, the fair value of acquired customer relationship intangible assets, above and below market in-place operating leases, and racking structures is determined internally. The fair value of acquired racking structures is determined internally by taking current estimated replacement cost at the date of acquisition for the quantity of racking structures acquired, discounted to take into account the quality (e.g. age, material and type) of the racking structures. We use discounted cash flow models to determine the fair value of customer relationship assets, which requires a significant amount of judgment by management, including estimating expected lives of the relationships, expected future cash flows and discount rates. We determine the fair value of tangible data center assets using an estimated replacement cost at the date of acquisition, then discounting for age, economic and functional obsolescence.34IRON MOUNTAIN 2020 FORM 10-KTable of ContentsPart IIOur estimates of fair value are based upon assumptions believed to be reasonable at that time but which are inherently uncertain and unpredictable. Assumptions may be incomplete or inaccurate, and unanticipated events and circumstances may occur, which may affect the accuracy of such assumptions. Total property, plant and equipment and intangible assets acquired in our 2020 acquisitions were approximately $52.0 million and $79.1 million, respectively.IMPAIRMENT OF TANGIBLE AND INTANGIBLE ASSETS ASSETS SUBJECT TO DEPRECIATION OR AMORTIZATION We review long-lived assets and all finite-lived intangible assets for impairment whenever events or changes in circumstances indicate the carrying amount of such assets may not be recoverable. Examples of events or circumstances that may be indicative of impairment include, but are not limited to:•A significant decrease in the market price of an asset;•A significant change in the extent or manner in which a long-lived asset is being used or in its physical condition;•A significant adverse change in legal factors or in the business climate that could affect the value of the asset;•An accumulation of costs significantly greater than the amount originally expected for the acquisition or construction of an asset;•A current-period operating or cash flow loss combined with a history of operating or cash flow losses or a projection or forecast that demonstrates continuing losses associated with the use of a long-lived asset; and•A current expectation that, more likely than not, an asset will be sold or otherwise disposed of significantly before the end of its previously estimated useful life.If events indicate the carrying value of such assets may not be recoverable, recoverability of these assets is determined by comparing the sum of the forecasted undiscounted net cash flows of the operation to which the assets relate to their carrying amount. The operations are generally distinguished by the business segment and geographic region in which they operate. If it is determined that we are unable to recover the carrying amount of the assets, the long-lived assets are written down, on a pro rata basis, to fair value. Fair value is determined based on discounted cash flows or appraised values, depending upon the nature of the assets.GOODWILL AND OTHER INDEFINITE-LIVED INTANGIBLE ASSETS NOT SUBJECT TO AMORTIZATIONGoodwill and intangible assets with indefinite lives are not amortized but are reviewed annually for impairment, or more frequently if impairment indicators arise. Other than goodwill, we currently have no intangible assets that have indefinite lives and which are not amortized. See Note 2.k. to Notes to Consolidated Financial Statements included in this Annual Report for additional details on our goodwill and other indefinite-lived intangible assets policies. We have selected October 1 as our annual goodwill impairment review date. We have performed our annual goodwill impairment review as of October 1, 2020, 2019 and 2018. We concluded that as of October 1, 2020, 2019 and 2018, goodwill was not impaired. During the first quarter of 2020, we concluded that we had a triggering event related to our Fine Arts reporting unit, requiring us to perform an interim goodwill impairment test. The primary factor contributing to our conclusion was the expected impact of the COVID-19 pandemic to this particular business and its customers and revenue sources, which caused us to believe it was more likely than not that the carrying value of our Fine Arts reporting unit exceeded its fair value. Therefore, we performed an interim goodwill impairment test for our Fine Arts reporting unit utilizing a discounted cash flow model, with updated assumptions on future revenues, operating expenditures and capital expenditures. We concluded that the fair value of our Fine Arts reporting unit was less than its carrying value, and, therefore, we recorded a $23.0 million impairment charge on the goodwill associated with this reporting unit during the first quarter of 2020. Factors that may impact these assumptions include, but are not limited to: (i) our ability to maintain, or grow, storage rental and service revenues in line with current expectations and (ii) our ability to manage our fixed and variable costs in line with potential future revenue declines.Our reporting units at which level we performed our goodwill impairment analysis as of October 1, 2020 were as follows:•North American Records and Information Management reporting unit ("North America RIM")•Europe Records and Information Management reporting unit ("Europe RIM")•Latin America Records and Information Management reporting unit ("Latin America RIM")•Australia and New Zealand Records and Information Management reporting unit ("ANZ RIM")•Asia Records and Information Management reporting unit ("Asia RIM")•Global Data Center•Fine Arts•Entertainment Services•Technology Escrow ServicesIRON MOUNTAIN 2020 FORM 10-K35Table of ContentsPart IISee Note 2.k. to Notes to Consolidated Financial Statements included in this Annual Report for a description of our reporting units.Based on our goodwill impairment analysis as of October 1, 2020, our reporting units that had estimated fair values exceeding their carrying values by greater than 20% represented approximately $4,120.6 million, or 90.4%, of our consolidated goodwill balance at December 31, 2020. Our Global Data Center reporting unit had an estimated fair value that exceeded its carrying value by less than 20%. The reporting unit represented approximately $437.0 million, or 9.6%, of our consolidated goodwill balance at December 31, 2020. The following is a summary of the Global Data Center reporting unit including the goodwill balance (in thousands), percentage by which the fair value of the reporting unit exceeded its carrying value, and certain key assumptions used by us in determining the fair value of the reporting unit as of October 1, 2020:REPORTING UNITGOODWILLBALANCE ATOCTOBER 1,2020PERCENTAGE BYWHICH THE FAIR VALUEOF THE REPORTINGUNIT EXCEEDED THEREPORTING UNITCARRYING VALUE AS OFOCTOBER 1, 2020KEY ASSUMPTIONS IN THE FAIR VALUE OF REPORTING UNITMEASUREMENT AS OF OCTOBER 1, 2020DISCOUNTRATEAVERAGE ANNUALCONTRIBUTIONMARGIN USED INDISCOUNTEDCASH FLOWAVERAGEANNUAL CAPITALEXPENDITURES ASPERCENTAGE OFREVENUE(1)TERMINALGROWTHRATE(2)Global Data Center$430,594 8.5 %8.0 %43.7 %27.8 %3.0 %(1)For purposes of our goodwill impairment analysis, the term “capital expenditures” includes both growth investment and recurring capital expenditures. (2)Terminal growth rates are applied in year 10 of our discounted cash flow analysis.Reporting unit valuations have generally been determined using a combined approach based on the present value of future cash flows (the “Discounted Cash Flow Model”) and market multiples (the “Market Approach"). There are inherent uncertainties and judgments involved when determining the fair value of the reporting units for purposes of our annual goodwill impairment testing. The following includes supplemental information to the table above for the Global Data Center reporting unit where the estimated fair values exceeded its carrying value by less than 20% as of October 1, 2020. The success of this business and the achievement of certain key assumptions developed by management and used in the Discounted Cash Flow Model are contingent upon various factors including, but not limited to, (i) achieving growth from existing customers, (ii) sales to new customers, (iii) increased market penetration and (iv) accurately timing the capital investments related to expansions.Our Global Data Center Business footprint spans nine markets in the United States: Denver, Colorado; Kansas City, Missouri; Boston, Massachusetts; Boyers, Pennsylvania; Manassas, Virginia; Edison, New Jersey; Columbus, Ohio; and Phoenix and Scottsdale, Arizona and four international markets: Amsterdam, London, Singapore and, through an unconsolidated joint venture, Frankfurt. We provide mission-critical data centers that are designed and operated to protect and ensure the continued operation of IT infrastructure for our customers. Data centers are highly specialized and secure assets that serve as centralized repositories of server, storage and network equipment. They are capital intensive and designed to provide the space, power, cooling and network connectivity necessary to efficiently operate mission-critical IT equipment. The demand for data center infrastructure is being driven by many factors, but most importantly by significant growth in data as well as an increased demand for outsourcing. In order to attract and retain customers, as well as sustain growth in our existing and new markets, we must have the capability to tailor our facilities and invest capital to meet the customers’ needs. Our estimate of fair value reflects the expected growth in each of our data center markets along with the corresponding capital investments required to meet demand. The business is primarily comprised of acquisitions completed in 2018 and late 2017; therefore, we would expect that the fair value of this reporting unit will closely approximate its carrying value.Key factors that could reasonably be expected to have a negative impact on the estimated fair value of these reporting units and potentially result in impairment charges include, but are not limited to: (i) a deterioration in general economic conditions, (ii) significant adverse changes in regulatory factors or in the business climate, and (iii) adverse actions or assessment by regulators, all of which could result in adverse changes to the key assumptions used in valuing the reporting units. The inability to meet the assumptions used in the Discounted Cash Flow Model and Market Approach for each of the reporting units, or future adverse market conditions not currently known, could lead to a fair value that is less than the carrying value in any one of our reporting units. Reporting unit valuations have generally been determined using a combined approach based on the Discounted Cash Flow Model and Market Approach. The Discounted Cash Flow Model incorporates significant assumptions including future revenue growth rates, operating margins, discount rates and capital expenditures. The Market Approach requires us to make assumptions related to Adjusted EBITDA multiples. Changes in economic and operating conditions impacting these assumptions or changes in multiples could result in goodwill impairments in future periods. In conjunction with our annual goodwill impairment reviews, we reconcile the sum of the valuations of all of our reporting units to our market capitalization as of such dates.36IRON MOUNTAIN 2020 FORM 10-KTable of ContentsPart IIAlthough we believe we have sufficient historical and projected information available to us to test for goodwill impairment, it is possible that actual results could differ from the estimates used in our impairment tests. Of the key assumptions that impact the goodwill impairment test, the expected future cash flows and discount rate are among the most sensitive and are considered to be critical assumptions, as changes to these estimates could have an effect on the estimated fair value of each of our reporting units. We have assessed the sensitivity of these assumptions on each of our reporting units as of October 1, 2020. North America RIM, EuropeRIM, Latin America RIM, ANZRIM, Asia RIM, Fine Arts, EntertainmentServices and TechnologyEscrow ServicesWe noted that, based on the estimated fair value of these reporting units determined as of October 1, 2020:•a hypothetical decrease of 10% in the expected annual future cash flows of these reporting units, with all other assumptions unchanged, would have decreased the estimated fair value of these reporting units as of October 1, 2020 by a range of approximately 9.7% to 10.6% but would not, however, have resulted in the carrying value of any of these reporting units with goodwill exceeding their estimated fair value;•a hypothetical increase of 100 basis points in the discount rate, with all other assumptions unchanged, would have decreased the estimated fair value of these reporting units as of October 1, 2020 by a range of approximately 4.6% to 10.7% but would not, however, have resulted in the carrying value of any of these reporting units with goodwill exceeding their estimated fair value.Global Data CenterWe noted that, as of October 1, 2020, the estimated fair value of the reporting unit:•exceeds its carrying value by less than 20%.Accordingly, any significant negative change in either the expected annual future cash flows of the reporting unit or the discount rate may result in the carrying value of the reporting unit exceeding its estimated fair value.At December 31, 2020, no factors were identified that would alter the conclusions of our October 1, 2020 goodwill impairment analysis. In making this assessment, we considered a number of factors including operating results, business plans, anticipated future cash flows, transactions and marketplace data. There are inherent uncertainties related to these factors and our judgment in applying them to the analysis of goodwill impairment.INCOME TAXESAs a REIT, we are generally permitted to deduct from our federal taxable income the dividends we pay to our stockholders. The income represented by such dividends is not subject to federal taxation at the entity level but is taxed, if at all, at the stockholder level. The income of our domestic TRSs, which hold our domestic operations that may not be REIT-compliant as currently operated and structured, is subject, as applicable, to federal and state corporate income tax. In addition, we and our subsidiaries continue to be subject to foreign income taxes in other jurisdictions in which we have business operations or a taxable presence, regardless of whether assets are held or operations are conducted through subsidiaries disregarded for federal income tax purposes or TRSs. We will also be subject to a separate corporate income tax on any gains recognized on the sale or disposition of any asset previously owned by a C corporation during a five-year period after the date we first owned the asset as a REIT asset that are attributable to "built-in gains" with respect to that asset on that date. We will also be subject to a built-in gains tax on our depreciation recapture recognized into income as a result of accounting method changes in connection with our acquisition activities. If we fail to remain qualified for taxation as a REIT, we will be subject to federal income tax at regular corporate income tax rates. Even if we remain qualified for taxation as a REIT, we may be subject to some federal, state, local and foreign taxes on our income and property in addition to taxes owed with respect to our TRS operations. In particular, while state income tax regimes often parallel the federal income tax regime for REITs, many states do not completely follow federal rules and some do not follow them at all. See Note 9 to Notes to Consolidated Financial Statements included in this Annual Report for additional details on our tax policies.Accounting for income taxes requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of temporary differences between the tax and financial reporting bases of assets and liabilities and for loss and credit carryforwards. We measure deferred tax assets and liabilities using enacted tax rates expected to be applied to taxable income in the years in which those temporary differences and carryforwards are expected to be recovered or settled. The effect on deferred tax assets and liabilities as a result of a change in tax rates is recognized in income in the period that the change is enacted. Valuation allowances are provided when recovery of deferred tax assets does not meet the more likely than not standard as defined in GAAP. Valuation allowances would be reversed as a reduction to the provision for income taxes if related deferred tax assets are deemed realizable based on changes in facts and circumstances relevant to the recoverability of the asset.IRON MOUNTAIN 2020 FORM 10-K37Table of ContentsPart IIAt December 31, 2020, we have federal and state net operating loss carryforwards of which we are expecting an insignificant tax benefit to be realized. We have assets for foreign net operating losses of $92.1 million, with various expiration dates (and in some cases no expiration date), subject to a valuation allowance of approximately 43%. If actual results differ unfavorably from certain of our estimates used, we may not be able to realize all or part of our net deferred income tax assets and additional valuation allowances may be required. Although we believe our estimates are reasonable, no assurance can be given that our estimates reflected in the tax provisions and accruals will equal our actual results. These differences could have a material impact on our income tax provision and operating results in the period in which such determination is made.The evaluation of an uncertain tax position is a two-step process. The first step is a recognition process whereby we determine whether it is more likely than not that a tax position will be sustained upon examination, including resolution of any related appeals or litigation processes, based on the technical merits of the position. The second step is a measurement process whereby a tax position that meets the more likely than not recognition threshold is calculated to determine the amount of benefit to recognize in the financial statements. The tax position is measured as the largest amount of benefit that is greater than 50% likely of being realized upon ultimate settlement.We are subject to income taxes in the United States and numerous foreign jurisdictions. We are subject to examination by various tax authorities in jurisdictions in which we have business operations or a taxable presence. We regularly assess the likelihood of additional assessments by tax authorities and provide for these matters as appropriate. As of December 31, 2020 and 2019, we had approximately $26.0 million and $35.1 million, respectively, of reserves related to uncertain tax positions. The reversal of these reserves will be recorded as a reduction of our income tax provision if sustained. Although we believe our tax estimates are appropriate, the final determination of tax audits and any related litigation could result in changes in our estimates.Following our conversion to a REIT in 2014, we concluded that it was not our intent to reinvest our current and future undistributed earnings of our foreign subsidiaries indefinitely outside the United States. As of December 31, 2016, we concluded that it is our intent to indefinitely reinvest our current and future undistributed earnings of certain of our unconverted foreign TRSs outside the United States. With the exception of certain limited instances, we no longer provide incremental foreign withholding taxes on the retained book earnings of these unconverted foreign TRSs, which was approximately $262.4 million as of December 31, 2020. As a REIT, future repatriation of incremental undistributed earnings of our foreign subsidiaries will not be subject to federal or state income tax, with the exception of foreign withholding taxes in limited instances; however, such future repatriations will require distribution in accordance with REIT distribution rules, and any such distribution may then be taxable, as appropriate, at the stockholder level. We continue, however, to provide for incremental foreign withholding taxes on net book over outside basis differences related to the earnings of our foreign QRSs and certain other foreign TRSs (excluding unconverted foreign TRSs).RESULTS OF OPERATIONSCOMPARISON OF YEAR ENDED DECEMBER 31, 2020 TO YEAR ENDED DECEMBER 31, 2019 AND COMPARISON OF YEAR ENDED DECEMBER 31, 2019 TO YEAR ENDED DECEMBER 31, 2018 (IN THOUSANDS): YEAR ENDED DECEMBER 31,DOLLARCHANGEPERCENTAGECHANGE 20202019Revenues$4,147,270 $4,262,584 $(115,314)(2.7)%Operating Expenses3,212,485 3,481,246 (268,761)(7.7)%Operating Income934,785 781,338 153,447 19.6 %Other Expenses, Net591,689 513,127 78,562 15.3 %Income from Continuing Operations343,096 268,211 74,885 27.9 %Income (Loss) from Discontinued Operations, Net of Tax— 104 (104)(100.0)%Net Income343,096 268,315 74,781 27.9 %Net Income Attributable to Noncontrolling Interests403 938 (535)(57.0)%Net Income Attributable to Iron Mountain Incorporated$342,693 $267,377 $75,316 28.2 %Adjusted EBITDA(1)$1,475,721 $1,469,009 $6,712 0.5 %Adjusted EBITDA Margin(1)35.6 %34.5 % YEAR ENDED DECEMBER 31,DOLLARCHANGEPERCENTAGECHANGE 20192018Revenues$4,262,584 $4,225,761 $36,823 0.9 %Operating Expenses3,481,246 3,417,494 63,752 1.9 %Operating Income781,338 808,267 (26,929)(3.3)%Other Expenses, Net513,127 440,709 72,418 16.4 %Income from Continuing Operations268,211 367,558 (99,347)(27.0)%Income (Loss) from Discontinued Operations, Net of Tax104 (12,427)12,531 (100.8)%Net Income268,315 355,131 (86,816)(24.4)%Net Income Attributable to Noncontrolling Interests938 1,198 (260)(21.7)%Net Income Attributable to Iron Mountain Incorporated$267,377 $353,933 $(86,556)(24.5)%Adjusted EBITDA(1)$1,469,009 $1,458,924 $10,085 0.7 %Adjusted EBITDA Margin(1)34.5 %34.5 % (1)See “Non-GAAP Measures—Adjusted EBITDA” in this Annual Report for the definitions of Adjusted EBITDA and Adjusted EBITDA Margin, reconciliation of Adjusted EBITDA to Income (Loss) from Continuing Operations and a discussion of why we believe these non-GAAP measures provide relevant and useful information to our current and potential investors.IRON MOUNTAIN 2020 FORM 10-K38Table of ContentsPart IIREVENUESConsolidated revenues consist of the following (in thousands): YEAR ENDED DECEMBER 31, PERCENTAGE CHANGE 20202019DOLLARCHANGEACTUALCONSTANTCURRENCY(1)IMPACT OF ACQUISITIONSORGANICGROWTH(2)Storage Rental$2,754,091 $2,681,087 $73,004 2.7 %3.8 %1.4 %2.4 %Service1,393,179 1,581,497 (188,318)(11.9)%(11.0)%1.8 %(12.8)%Total Revenues$4,147,270 $4,262,584 $(115,314)(2.7)%(1.7)%1.6 %(3.3)% YEAR ENDED DECEMBER 31, PERCENTAGE CHANGE 20192018DOLLARCHANGEACTUALCONSTANTCURRENCY(1)IMPACT OF ACQUISITIONSORGANICGROWTH(2)Storage Rental$2,681,087 $2,622,455 $58,632 2.2 %4.3 %1.8 %2.5 %Service1,581,497 1,603,306 (21,809)(1.4)%0.9 %1.9 %(1.0)%Total Revenues$4,262,584 $4,225,761 $36,823 0.9 %3.0 %1.9 %1.1 %(1)Constant currency growth rates are calculated by translating the 2019 results at the 2020 average exchange rates and the 2018 results at the 2019 average exchange rates.(2)Our organic revenue growth rate, which is a non-GAAP measure, represents the year-over-year growth rate of our revenues excluding the impact of business acquisitions, divestitures and foreign currency exchange rate fluctuations, but including the impact of acquisitions of customer relationships.TOTAL REVENUESFor the year ended December 31, 2020, the decrease in reported consolidated revenue was driven by declines in reported service revenue partially offset by reported storage rental revenue growth. Foreign currency exchange rate fluctuations decreased our reported consolidated revenues by 1.0% in the year ended December 31, 2020 compared to the prior year period.STORAGE RENTAL REVENUES AND SERVICE REVENUESPrimary factors influencing the change in reported storage rental revenue and reported service revenue for the year ended December 31, 2020 compared to the year ended December 31, 2019 include the following: STORAGE RENTAL REVENUES•organic storage rental revenue growth driven by volume growth in faster growing markets and revenue management;•a 2.1% increase in global records management volume due to acquisitions (excluding acquisitions, global records management volume decreased 1.1%); and•a decrease of $29.1 million due to foreign currency exchange rate fluctuations.SERVICE REVENUES•a decrease in service activity as a result of the COVID-19 pandemic, particularly in regions where governments have imposed restrictions on our customers' non-essential business operations;•organic service revenue declines reflecting lower service activity levels; and•a decrease of $15.7 million due to foreign currency exchange rate fluctuations.39IRON MOUNTAIN 2020 FORM 10-KTable of ContentsPart IIOPERATING EXPENSESCOST OF SALESConsolidated Cost of sales (excluding depreciation and amortization) consists of the following expenses (in thousands): YEAR ENDED DECEMBER 31,PERCENTAGE CHANGE% OFCONSOLIDATEDREVENUESPERCENTAGECHANGE(FAVORABLE)/UNFAVORABLE 20202019DOLLAR CHANGEACTUALCONSTANTCURRENCY20202019Labor$738,038 $814,459 $(76,421)(9.4)%(7.9)%17.8 %19.1 %(1.3)%Facilities731,679 697,330 34,349 4.9 %6.0 %17.6 %16.4 %1.2 %Transportation125,591 162,905 (37,314)(22.9)%(22.6)%3.0 %3.8 %(0.8)%Product Cost of Sales and Other154,386 158,621 (4,235)(2.7)%(1.0)%3.7 %3.7 %— %COVID-19 Costs7,648 — 7,648 100.0 %100.0 %0.2 %— %0.2 %Total Cost of sales$1,757,342 $1,833,315 $(75,973)(4.1)%(2.9)%42.4 %43.0 %(0.6)% YEAR ENDED DECEMBER 31, PERCENTAGE CHANGE% OFCONSOLIDATEDREVENUESPERCENTAGECHANGE(FAVORABLE)/UNFAVORABLE 20192018DOLLARCHANGEACTUALCONSTANTCURRENCY20192018Labor$814,459 $818,729 $(4,270)(0.5)%2.2 %19.1 %19.4 %(0.3)%Facilities697,330 651,114 46,216 7.1 %9.5 %16.4 %15.4 %1.0 %Transportation162,905 158,528 4,377 2.8 %5.1 %3.8 %3.8 %— %Product Cost of Sales and Other158,621 165,583 (6,962)(4.2)%(1.4)%3.7 %3.9 %(0.2)%Total Cost of sales$1,833,315 $1,793,954 $39,361 2.2 %4.8 %43.0 %42.5 %0.5 %Primary factors influencing the change in reported consolidated Cost of sales for the year ended December 31, 2020 compared to the year ended December 31, 2019 include the following: •a decrease in labor costs driven by cost containment actions taken in response to lower service activity levels due to the COVID-19 pandemic, partially offset by incremental labor costs associated with recent acquisitions; •a decrease in transportation costs primarily driven by lower third party carrier cost and fuel cost reflecting cost containment actions taken in response to lower service activity levels;•an increase in facilities expenses driven by increases in rent expense, in part due to recent acquisitions and the impact from our recent sale-leaseback activity (which we expect to continue in 2021 as we continue to look for future opportunities to monetize a small portion of our owned industrial real estate assets as part of our ongoing capital recycling program); and•a decrease of $23.5 million due to foreign currency exchange rate fluctuations.IRON MOUNTAIN 2020 FORM 10-K40Table of ContentsPart IISELLING, GENERAL AND ADMINISTRATIVE EXPENSESConsolidated Selling, general and administrative expenses consists of the following expenses (in thousands): YEAR ENDED DECEMBER 31, PERCENTAGE CHANGE% OFCONSOLIDATEDREVENUESPERCENTAGECHANGE(FAVORABLE)/UNFAVORABLE DOLLARCHANGE 20202019ACTUALCONSTANTCURRENCY20202019General and Administrative$513,664 $563,965 $(50,301)(8.9)%(7.9)%12.4 %13.2 %(0.8)%Sales, Marketing and Account Management231,365 245,704 (14,339)(5.8)%(5.0)%5.6 %5.8 %(0.2)%Information Technology168,138 162,606 5,532 3.4 %4.2 %4.1 %3.8 %0.3 %Bad Debt Expense34,411 19,389 15,022 77.5 %78.9 %0.8 %0.5 %0.3 %COVID-19 Costs1,637 — 1,637 100.0 %100.0 %— %— %— %Total Selling, general and administrative expenses$949,215 $991,664 $(42,449)(4.3)%(3.4)%22.9 %23.3 %(0.4)% YEAR ENDED DECEMBER 31, PERCENTAGE CHANGE% OFCONSOLIDATEDREVENUESPERCENTAGECHANGE(FAVORABLE)/UNFAVORABLE 20192018DOLLARCHANGEACTUALCONSTANTCURRENCY20192018General and Administrative$563,965 $577,451 $(13,486)(2.3)%(0.5)%13.2 %13.7 %(0.5)%Sales, Marketing and Account Management245,704 257,306 (11,602)(4.5)%(2.8)%5.8 %6.1 %(0.3)%Information Technology162,606 153,601 9,005 5.9 %7.1 %3.8 %3.6 %0.2 %Bad Debt Expense19,389 18,625 764 4.1 %6.4 %0.5 %0.4 %0.1 %Total Selling, general and administrative expenses$991,664 $1,006,983 $(15,319)(1.5)%0.2 %23.3 %23.8 %(0.5)%Primary factors influencing the change in reported consolidated Selling, general and administrative expenses for the year ended December 31, 2020 compared to the year ended December 31, 2019 include the following: •a decrease in general and administrative expenses, driven by decreased wages and benefit expense and other employee related costs, as well as lower professional fees, reflecting benefits from Project Summit and ongoing cost containment measures, partially offset by higher bonus compensation accruals;•a decrease in sales, marketing and account management expenses, driven by decreased compensation expense and other employee related costs, reflecting benefits from Project Summit and ongoing cost containment measures;•higher bad debt expense, primarily driven by increased collectability risk resulting from the COVID-19 pandemic; and•foreign currency exchange rate fluctuations decreased reported consolidated Selling, general and administrative expenses by $9.4 million.DEPRECIATION AND AMORTIZATIONOur depreciation and amortization charges result primarily from depreciation related to storage systems, which include racking structures, buildings, building and leasehold improvements and computer systems hardware and software. Amortization relates primarily to customer relationship intangible assets, contract fulfillment costs and data center lease-based intangible assets. Both depreciation and amortization are impacted by the timing of acquisitions.Depreciation expense decreased $8.8 million, or 1.9%, on a reported dollar basis for the year ended December 31, 2020 compared to the year ended December 31, 2019. See Note 2.h. to Notes to Consolidated Financial Statements included in this Annual Report for additional information regarding the useful lives over which our property, plant and equipment is depreciated. Amortization expense increased $2.6 million, or 1.3%, on a reported dollar basis for the year ended December 31, 2020 compared to the year ended December 31, 2019. 41IRON MOUNTAIN 2020 FORM 10-KTable of ContentsPart IISIGNIFICANT ACQUISITION COSTSSignificant Acquisition Costs for the years ended December 31, 2020, 2019 and 2018 were approximately $0.0 million, $13.3 million and $50.7 million, respectively, and primarily consisted of operating expenditures associated with (1) our acquisition of Recall that we completed on May 2, 2016 (the “Recall Transaction"), including: (i) advisory and professional fees to complete the Recall Transaction; (ii) costs associated with the divestments required in connection with receipt of regulatory approvals (including transitional services); and (iii) costs to integrate Recall with our existing operations, including moving, severance, facility upgrade, REIT integration and system upgrade costs, as well as certain costs associated with our shared service center initiative for our finance, human resources and information technology functions; and (2) the advisory and professional fees to complete the IODC Transaction (collectively, “Significant Acquisition Costs”).RESTRUCTURING CHARGESRestructuring Charges for the years ended December 31, 2020 and 2019 were approximately $194.4 million and $48.6 million, respectively, and primarily consisted of employee severance costs and professional fees associated with Project Summit.INTANGIBLE IMPAIRMENTSThe intangible impairment charge for the year ended December 31, 2020 was $23.0 million and related to the write-down of goodwill associated with our Fine Arts reporting unit in the first quarter of 2020, as discussed above.GAIN ON DISPOSAL/WRITE-DOWN OF PROPERTY, PLANT ANDEQUIPMENT, NETYEAR ENDED DECEMBER 31,20202019Consolidated gain on disposal/write-down of property, plant and equipment, netApproximately $363.5 millionApproximately $63.8 millionThe gains primarily consisted of:•Gains associated with sale-leaseback transactions of approximately $342.1 million, of which (i) approximately $265.6 million relates to the sale-leaseback transactions of 14 facilities in the United States during the fourth quarter of 2020 and (ii) approximately $76.4 million relates to the sale-leaseback transactions of two facilities in the United States during the third quarter of 2020, each as part of our program to monetize a small portion of our industrial real estate assets•Gains of approximately $24.1 million associated with the Frankfurt JV Transaction (as defined below)•Gains associated with sale and sale-leaseback transactions of approximately $67.8 million in the United States•The sale of certain land and buildings of approximately $36.0 million in the United KingdomPartially offset by losses from:•The impairment charge on the assets associated with the select offerings within our Iron Mountain Iron Cloud ("Iron Cloud") portfolio and loss on the subsequent sale of certain IT infrastructure assets and rights to certain hardware and maintenance contracts used to deliver these Iron Cloud offerings of approximately $25.0 million•The write-down of certain property, plant and equipment of approximately $15.7 million in the United StatesOTHER EXPENSES, NETINTEREST EXPENSE, NETConsolidated Interest Expense, Net decreased $0.8 million, to $418.5 million for the year ended December 31, 2020 from $419.3 million for the year ended December 31, 2019. The decrease in Interest Expense, Net during the year ended December 31, 2020 compared to the year ended December 31, 2019 was mainly driven by a decrease in the weighted average interest rate on our outstanding debt, partially offset by higher average debt outstanding for the year ended December 31, 2020. Our weighted average interest rate, inclusive of the commitment fee on the unused portion of our Revolving Credit Facility (as defined below) and fees associated with the letters of credit, was 4.7% and 4.8% at December 31, 2020 and 2019, respectively. See Note 6 to Notes to Consolidated Financial Statements included in this Annual Report for additional information regarding our indebtedness.IRON MOUNTAIN 2020 FORM 10-K42Table of ContentsPart IIOTHER EXPENSE (INCOME), NET Consolidated other expense (income), net consists of the following (in thousands): YEAR ENDED DECEMBER 31,DOLLARCHANGEDESCRIPTION20202019Foreign currency transaction losses (gains), net$29,830 $24,852 $4,978 Debt extinguishment expense68,300 — 68,300 Other, net45,415 9,046 36,369 Other Expense (Income), Net$143,545 $33,898 $109,647 FOREIGN CURRENCY TRANSACTION LOSSES (GAINS), NET We recorded net foreign currency transaction losses of $29.8 million in the year ended December 31, 2020, based on period-end exchange rates. These losses resulted primarily from the impact of changes in the exchange rate of the British pound sterling against the United States dollar compared to December 31, 2019 on our intercompany balances with and between certain of our subsidiaries.DEBT EXTINGUISHMENT EXPENSEDebt extinguishment expense represents the call premiums and write-off of unamortized deferred financing costs associated with the early redemption of the 6% Notes, the 43/8% Notes, the 53/4% Notes, the CAD Notes, the Euro Notes and the 53/8% Notes (as defined below).OTHER, NETOther, net for the year ended December 31, 2020 consists primarily of changes in the estimated value of our mandatorily redeemable noncontrolling interests as well as losses on our equity method investments.PROVISION (BENEFIT) FOR INCOME TAXESOur effective tax rates for the years ended December 31, 2020 and 2019 were 7.9% and 18.3%, respectively. Our effective tax rate is subject to variability in the future due to, among other items: (1) changes in the mix of income between our QRSs and our TRSs, as well as among the jurisdictions in which we operate; (2) tax law changes; (3) volatility in foreign exchange gains and losses; (4) the timing of the establishment and reversal of tax reserves; and (5) our ability to utilize net operating losses that we generate.The primary reconciling items between the federal statutory tax rate of 21.0% and our overall effective tax rate were:YEAR ENDED DECEMBER 31,20202019The benefit derived from the dividends paid deduction of $60.4 million and the impact of differences in the tax rates at which our foreign earnings are subject to, resulting in a tax provision of $9.5 million.The benefit derived from the dividends paid deduction of $40.6 million and the impact of differences in the tax rates at which our foreign earnings are subject to, resulting in a tax provision of $8.6 million.As a REIT, we are entitled to a deduction for dividends paid, resulting in a substantial reduction of federal income tax expense. As a REIT, substantially all of our income tax expense will be incurred based on the earnings generated by our foreign subsidiaries and our domestic TRSs.We are subject to income taxes in the United States and numerous foreign jurisdictions. We are subject to examination by various tax authorities in jurisdictions in which we have business operations or a taxable presence. We regularly assess the likelihood of additional assessments by tax authorities and provide for these matters as appropriate. Although we believe our tax estimates are appropriate, the final determination of tax audits and any related litigation could result in changes in our estimates.43IRON MOUNTAIN 2020 FORM 10-KTable of ContentsPart IIINCOME (LOSS) FROM CONTINUING OPERATIONS AND ADJUSTED EBITDAThe following table reflects the effect of the foregoing factors on our consolidated income (loss) from continuing operations and Adjusted EBITDA (in thousands):YEAR ENDED DECEMBER 31,DOLLARCHANGEPERCENTAGECHANGE20202019Income (Loss) from Continuing Operations$343,096 $268,211 $74,885 27.9 %Income (Loss) from Continuing Operations as a percentage of Consolidated Revenue8.3 %6.3 %Adjusted EBITDA$1,475,721 $1,469,009 $6,712 0.5 %Adjusted EBITDA Margin35.6 %34.5 %YEAR ENDED DECEMBER 31,DOLLARCHANGEPERCENTAGECHANGE20192018Income (Loss) from Continuing Operations$268,211 $367,558 $(99,347)(27.0)%Income (Loss) from Continuing Operations as a percentage of Consolidated Revenue6.3 %8.7 %Adjusted EBITDA$1,469,009 $1,458,924 $10,085 0.7 %Adjusted EBITDA Margin34.5 %34.5 %Consolidated Adjusted EBITDA Margin for the year ended December 31, 2020 increased by 110 basis points compared to the prior year, reflecting benefits from Project Summit, revenue management, favorable revenue mix and ongoing cost containment measures, partially offset by fixed cost deleverage on lower service revenue and higher bonus compensation accruals.↑ INCREASED BY $6.7 MILLION OR 0.5%Consolidated Adjusted EBITDAIRON MOUNTAIN 2020 FORM 10-K44Table of ContentsPart IISEGMENT ANALYSIS See the discussion of Business Segments under Item I and Note 10 to Notes to Consolidated Financial Statements, both included in this Annual Report, for a description of our reportable operating segments.GLOBAL RIM BUSINESS (IN THOUSANDS) YEAR ENDED DECEMBER 31,PERCENTAGE CHANGE 20202019DOLLARCHANGEACTUALCONSTANTCURRENCYIMPACT OFACQUISITIONSORGANICGROWTHStorage Rental$2,373,783$2,320,076$53,707 2.3 %3.6 %1.7 %1.9 %Service1,325,4971,492,357(166,860)(11.2)%(10.2)%1.9 %(12.1)%Segment Revenue$3,699,280$3,812,433$(113,153)(3.0)%(1.8)%1.8 %(3.6)%Segment Adjusted EBITDA$1,574,069$1,566,065$8,004 Segment Adjusted EBITDA Margin42.6 %41.1 % YEAR ENDED DECEMBER 31,PERCENTAGE CHANGE 20192018DOLLARCHANGEACTUALCONSTANTCURRENCYIMPACT OFACQUISITIONSORGANICGROWTHStorage Rental$2,320,076$2,301,344$18,732 0.8 %3.0 %0.8 %2.2 %Service1,492,3571,541,256(48,899)(3.2)%(1.0)%0.3 %(1.3)%Segment Revenue$3,812,433$3,842,600$(30,167)(0.8)%1.4 %0.6 %0.8 %Segment Adjusted EBITDA$1,566,065$1,572,438$(6,373) Segment Adjusted EBITDA Margin41.1 %40.9 % 3-YEAR SEGMENT ANALYSIS: GLOBAL RIM BUSINESS (IN MILLIONS)Primary factors influencing the change in revenue and Adjusted EBITDA Margin in our Global RIM Business segment for the year ended December 31, 2020 compared to the year ended December 31, 2019 include the following:•a decline in organic service revenue mainly driven by reduced service activity levels, primarily due to the COVID-19 pandemic;•organic storage rental revenue growth driven by revenue management;•a decrease in revenue of $45.7 million due to foreign currency exchange rate fluctuations;•a 2.1% increase in global records management volume due to acquisitions (excluding acquisitions, global records management volume decreased 1.1%); and•a 150 basis point increase in Adjusted EBITDA Margin primarily driven by benefits from Project Summit, revenue management, favorable revenue mix and ongoing cost containment measures, partially offset by fixed cost deleverage on lower service revenues and higher bonus compensation accruals.45IRON MOUNTAIN 2020 FORM 10-KTable of ContentsPart IIGLOBAL DATA CENTER BUSINESS (IN THOUSANDS) YEAR ENDED DECEMBER 31,PERCENTAGE CHANGEIMPACT OF ACQUISITIONSORGANICGROWTH 20202019DOLLARCHANGEACTUALCONSTANTCURRENCYStorage Rental$263,695$246,925$16,770 6.8 %6.5 %— %6.5 %Service15,61710,2265,391 52.7 %51.5 %— %51.5 %Segment Revenue$279,312$257,151$22,161 8.6 %8.3 %— %8.3 %Segment Adjusted EBITDA$126,576$121,517$5,059 Segment Adjusted EBITDA Margin45.3 %47.3 % YEAR ENDED DECEMBER 31,PERCENTAGE CHANGEIMPACT OF ACQUISITIONSORGANICGROWTH 20192018DOLLARCHANGEACTUALCONSTANTCURRENCYStorage Rental$246,925$218,675$28,250 12.9 %13.4 %8.1 %5.3 %Service10,22610,308(82)(0.8)%(0.7)%4.1 %(4.8)%Segment Revenue$257,151$228,983$28,168 12.3 %12.8 %8.0 %4.8 %Segment Adjusted EBITDA$121,517$99,575$21,942 Segment Adjusted EBITDA Margin47.3 %43.5 % 3-YEAR SEGMENT ANALYSIS: GLOBAL DATA CENTER BUSINESS (IN MILLIONS)Primary factors influencing the change in revenue and Adjusted EBITDA Margin in our Global Data Center Business segment for the year ended December 31, 2020 compared to the year ended December 31, 2019 include the following:•organic revenue growth from leases signed in prior periods and service revenue growth, partially offset by churn of 680 basis points;•non-recurring revenue benefits in the prior year include a previously disclosed lease modification fee of $5.4 million, while non-recurring revenue benefits in the current year were $1.8 million; and•a 200 basis point decrease in Adjusted EBITDA Margin reflecting headwinds from flow through of non-recurring revenue benefits described above and a $4.0 million prior year contractual settlement, partially offset by ongoing cost containment measures.IRON MOUNTAIN 2020 FORM 10-K46Table of ContentsPart IICORPORATE AND OTHER BUSINESS (IN THOUSANDS) YEAR ENDED DECEMBER 31,PERCENTAGE CHANGEIMPACT OFACQUISITIONSORGANICGROWTH 20202019DOLLARCHANGEACTUALCONSTANTCURRENCYStorage Rental$116,613$114,086$2,527 2.2 %2.1 %(1.1)%3.2 %Service52,06578,914(26,849)(34.0)%(34.1)%0.3 %(34.4)%Segment Revenue$168,678$193,000$(24,322)(12.6)%(12.7)%(0.5)%(12.2)%Segment Adjusted EBITDA$(224,924)$(218,573)$(6,351) Segment Adjusted EBITDA as a Percentage of Consolidated Revenue(5.4)%(5.1)% YEAR ENDED DECEMBER 31,PERCENTAGE CHANGEIMPACT OFACQUISITIONSORGANICGROWTH 20192018DOLLARCHANGEACTUALCONSTANTCURRENCYStorage Rental$114,086$102,436$11,650 11.4 %11.9 %8.7 %3.2 %Service78,91451,74227,172 52.5 %55.0 %46.8 %8.2 %Segment Revenue$193,000$154,178$38,822 25.2 %26.3 %21.4 %4.9 %Segment Adjusted EBITDA$(218,573)$(213,089)$(5,484) Segment Adjusted EBITDA as a Percentage of Consolidated Revenue(5.1)%(5.0)% Primary factors influencing the change in revenue and Adjusted EBITDA in our Corporate and Other Business segment for the year ended December 31, 2020 compared to the year ended December 31, 2019 include the following:•a decline in organic service revenue due to lower service activity levels in our Fine Arts business, primarily related to the COVID-19 pandemic; and•a decrease in Adjusted EBITDA reflecting the impact of lower service activity in our Fine Arts business, increased information technology expenses and higher bonus compensation accruals, partially offset by benefits from Project Summit.47IRON MOUNTAIN 2020 FORM 10-KTable of ContentsPart IILIQUIDITY AND CAPITAL RESOURCESGENERALWe expect to meet our short-term and long-term cash flow requirements through cash generated from operations, cash on hand, borrowings under our Credit Agreement (as defined below) and proceeds from monetizing a small portion of our total industrial real estate assets in the future, as well as other potential financings (such as the issuance of debt or equity). Our cash flow requirements, both in the near and long term, include, but are not limited to, capital expenditures, the repayment of outstanding debt, shareholder dividends, Project Summit initiatives, potential and pending business acquisitions and normal business operation needs. PROJECT SUMMITAs disclosed above, in October 2019, we announced Project Summit. We estimate that the implementation of Project Summit will result in total Restructuring Charges of approximately $450.0 million. From the inception of Project Summit through December 31, 2020, we have incurred approximately $243.0 million of Restructuring Charges related to Project Summit, primarily related to employee severance costs, internal costs associated with the development and implementation of Project Summit initiatives and professional fees. From the inception of Project Summit through December 31, 2020, we have also incurred approximately $10.1 million of capital expenditures.CASH FLOWSThe following is a summary of our cash balances and cash flows (in thousands) as of and for the years ended December 31,202020192018Cash Flows from Operating Activities - Continuing Operations$987,657 $966,655 $936,544 Cash Flows from Investing Activities - Continuing Operations(85,440)(735,946)(2,230,128)Cash Flows from Financing Activities - Continuing Operations(886,699)(198,973)550,678 Cash and Cash Equivalents, including Restricted Cash, End of Year205,063 193,555 165,485 A. CASH FLOWS FROM OPERATING ACTIVITIESFor the year ended December 31, 2020, net cash flows provided by operating activities increased by $21.0 million compared to the prior year period primarily due to an increase in cash provided by working capital of $125.6 million, primarily related to the timing of payments associated with certain accrued expenses offset by a decrease in net income (including non-cash charges and realized foreign exchange losses) of $104.6 million.B. CASH FLOWS FROM INVESTING ACTIVITIESOur significant investing activities during the year ended December 31, 2020 are highlighted below:•We paid cash for capital expenditures of $438.3 million. Additional details of our capital spending are included in the “Capital Expenditures” section below.•We paid cash for acquisitions (net of cash acquired) of $118.6 million, primarily funded by borrowings under our Revolving Credit Facility.•We received $564.7 million in proceeds from sales of property, plant and equipment, primarily related to proceeds from sale-leaseback transactions of facilities during the third quarter and fourth quarter of 2020 and proceeds received in connection with the Frankfurt JV Transaction during the fourth quarter of 2020. C. CASH FLOWS FROM FINANCING ACTIVITIESOur significant financing activities for the year ended December 31, 2020 included:•Net proceeds of $2,376.0 million associated with the June 2020 Offerings (as defined below).•Net proceeds of $1,089.0 million associated with the issuance of the 41/2% Notes (as defined below).•Payments, including call premiums, of $2,942.6 million associated with the early redemption of the 43/8% Notes, the 6% Notes, the 53/4% Notes, the CAD Notes, the Euro Notes and the 53/8% Notes (each as defined below). •Net payments of $664.9 million primarily associated with the repayments on our Revolving Credit Facility and Accounts Receivable Securitization Program (as defined below).•Payment of dividends in the amount of $716.3 million on our common stock.IRON MOUNTAIN 2020 FORM 10-K48Table of ContentsPart IICAPITAL EXPENDITURESWe present two categories of capital expenditures: (1) Growth Investment Capital Expenditures and (2) Recurring Capital Expenditures with the following sub-categories: (i) Data Center; (ii) Real Estate; (iii) Innovation and Other (for Growth Investment Capital Expenditures only); and (iv) Non-Real Estate (for Recurring Capital Expenditures only). During 2020, a portion of what was previously categorized as Non-Real Estate Growth Capital Expenditures was recategorized as Real Estate Growth Capital Expenditures and the remaining portion was recategorized as Recurring Capital Expenditures. In addition, capital expenditures associated with restructuring (including Project Summit) and integration of acquisitions, which was previously categorized as recurring capital expenditures, have been recategorized as Innovation and Other. We have reclassified the categorization of our prior year capital expenditures to conform with our current presentation.GROWTH INVESTMENT CAPITAL EXPENDITURES:•Data Center: Expenditures primarily related to investments in new construction of data center facilities (including the acquisition of land and development of facilities) or capacity expansion in existing buildings.•Real Estate: Expenditures primarily related to investments in land, buildings, building improvements, leasehold improvements and racking structures to grow our revenues or achieve operational efficiencies.•Innovation and Other: Discretionary capital expenditures for significant new products and services, restructuring (including Project Summit), and integration of acquisitions.RECURRING CAPITAL EXPENDITURES:•Real Estate: Expenditures primarily related to the replacement of components of real estate assets such as buildings, building improvements, leasehold improvements and racking structures.•Non-Real Estate: Expenditures primarily related to the replacement of containers and shred bins, warehouse equipment, fixtures, computer hardware, or third-party or internally-developed software assets that support the maintenance of existing revenues or avoidance of an increase in costs. •Data Center: Expenditures related to the upgrade or re-configuration of existing data center assets.The following table presents our capital spend for 2020, 2019 and 2018 organized by the type of the spending as described above.NATURE OF CAPITAL SPEND (IN THOUSANDS)202020192018Growth Investment Capital Expenditures: Data Center$216,491 $401,902 $162,666 Real Estate67,217 133,093 138,307 Innovation and Other18,810 17,555 30,291 Total Growth Investment Capital Expenditures302,518 552,550 331,264 Recurring Capital Expenditures: Real Estate51,009 55,444 73,146 Non-Real Estate76,124 74,092 61,490 Data Center15,959 8,589 9,051 Total Recurring Capital Expenditures143,092 138,125 143,687 Total Capital Spend (on accrual basis)445,610 690,675 474,951 Net increase (decrease) in prepaid capital expenditures1,836 510 (1,844)Net (increase) decrease in accrued capital expenditures(9,183)1,798 (13,045)Total Capital Spend (on cash basis)$438,263 $692,983 $460,062 Excluding capital expenditures associated with potential future acquisitions, we expect total capital expenditures of approximately $550.0 million for the year ending December 31, 2021. Of this, we expect our capital expenditures for growth investment to be approximately $410.0 million, and our recurring capital expenditures to be approximately $140.0 million. Our capital expenditures for growth investment includes Global Data Center Business development spend of approximately $300.0 million.DIVIDENDSSee Note 8 to Notes to Consolidated Financial Statements included in this Annual Report for information on dividends.49IRON MOUNTAIN 2020 FORM 10-KTable of ContentsPart IIFINANCIAL INSTRUMENTS AND DEBTFinancial instruments that potentially subject us to credit risk consist principally of cash and cash equivalents (including money market funds) and accounts receivable. The only significant concentration of liquid investments as of December 31, 2020 is related to cash and cash equivalents. See Note 2.f. to Notes to the Consolidated Financial Statements included in this Annual Report for information on our money market funds.Long-term debt as of December 31, 2020 is as follows (in thousands): DECEMBER 31, 2020 DEBT (INCLUSIVEOF DISCOUNT)UNAMORTIZEDDEFERREDFINANCING COSTSCARRYINGAMOUNTRevolving Credit Facility$— $(8,620)$(8,620)Term Loan A215,625 — 215,625 Term Loan B679,621 (6,244)673,377 Australian Dollar Term Loan (the "AUD Term Loan")243,152 (1,624)241,528 UK Bilateral Revolving Credit Facility191,101 (1,307)189,794 37/8% GBP Senior Notes due 2025 (the "GBP Notes")546,003 (4,983)541,020 47/8% Senior Notes due 2027 (the "47/8% Notes due 2027")1,000,000 (9,598)990,402 51/4% Senior Notes due 2028 (the "51/4% Notes due 2028")825,000 (8,561)816,439 5% Senior Notes due 2028 (the "5% Notes")500,000 (5,486)494,514 47/8% Senior Notes due 2029 (the "47/8% Notes due 2029")1,000,000 (12,658)987,342 51/4% Senior Notes due 2030 (the "51/4% Notes due 2030")1,300,000 (14,416)1,285,584 41/2% Senior Notes due 2031 (the "41/2% Notes")1,100,000 (12,648)1,087,352 55/8% Senior Notes due 2032 (the "55/8% Notes")600,000 (6,727)593,273 Real Estate Mortgages, Financing Lease Liabilities and Other511,922 (1,086)510,836 Accounts Receivable Securitization Program85,000 (152)84,848 Total Long-term Debt8,797,424 (94,110)8,703,314 Less Current Portion(193,759)— (193,759)Long-term Debt, Net of Current Portion$8,603,665 $(94,110)$8,509,555 See Note 6 to Notes to Consolidated Financial Statements included in this Annual Report for additional information regarding our long-term debt. CREDIT AGREEMENTOur credit agreement (the "Credit Agreement") consists of a revolving credit facility (the “Revolving Credit Facility”) and a term loan (the “Term Loan A”). The Revolving Credit Facility enables IMI and certain of its United States and foreign subsidiaries to borrow in United States dollars and (subject to sublimits) a variety of other currencies (including Canadian dollars, British pounds sterling and Euros, among other currencies) in an aggregate outstanding amount not to exceed $1,750.0 million. Under the Credit Agreement, we have the option to request additional commitments of up to $1,260.0 million, in the form of term loans or through increased commitments under the Revolving Credit Facility, subject to the conditions specified in the Credit Agreement. The Credit Agreement is scheduled to mature on June 4, 2023, at which point all obligations become due. The original principal amount of the Term Loan A was $250.0 million and is to be paid in quarterly installments in an amount equal to $3.1 million per quarter, with the remaining balance due on June 4, 2023. IMI and the Guarantors guarantee all obligations under the Credit Agreement. The interest rate on borrowings under the Credit Agreement varies depending on our choice of interest rate and currency options, plus an applicable margin, which varies based on our consolidated leverage ratio. Additionally, the Credit Agreement requires the payment of a commitment fee on the unused portion of the Revolving Credit Facility, which fee ranges from between 0.25% to 0.4% based on our consolidated leverage ratio and fees associated with outstanding letters of credit. As of December 31, 2020, we had no outstanding borrowings under the Revolving Credit Facility and $215.6 million aggregate outstanding principal amount under the Term Loan A. At December 31, 2020, we had various outstanding letters of credit totaling $3.2 million under the Revolving Credit Facility. The amount available for borrowing under the Revolving Credit Facility as of December 31, 2020, which is based on IMI’s leverage ratio, the last 12 months' earnings before interest, taxes, depreciation and amortization and rent expense (“EBITDAR”), other adjustments as defined in the Credit Agreement and current external debt, was $1,746.8 million (which amount represents the maximum availability as of such date). Available borrowings under the Revolving Credit Facility are subject to compliance with our indenture covenants as discussed below. The average interest rate in effect for all outstanding borrowings under the Credit Agreement was 1.9% as of December 31, 2020. IRON MOUNTAIN 2020 FORM 10-K50Table of ContentsPart IIIMI’s wholly owned subsidiary, Iron Mountain Information Management, LLC (“IMIM”), has an incremental term loan B with a principal amount of $700.0 million (the “Term Loan B”). The Term Loan B, which matures on January 2, 2026, was issued at 99.75% of par. The Term Loan B holders benefit from the same security and guarantees as other borrowings under the Credit Agreement. The Term Loan B holders also benefit from the same affirmative and negative covenants as other borrowings under the Credit Agreement; however, the Term Loan B holders are not generally entitled to the benefits of the financial covenants under the Credit Agreement.Principal payments on the Term Loan B are to be paid in quarterly installments of $1.8 million per quarter during the period June 30, 2018 through December 31, 2025, with the balance due on January 2, 2026. The Term Loan B may be prepaid without penalty at any time. The Term Loan B bears interest at a rate of LIBOR plus 1.75%. As of December 31, 2020, we had $679.6 million aggregate outstanding principal amount under the Term Loan B. The interest rate in effect under Term Loan B as of December 31, 2020 was 1.9%.JUNE 2020 OFFERINGSOn June 22, 2020, IMI completed private offerings of (i) $500.0 million in aggregate principal amount of the 5% Notes, (ii) $1,300.0 million in aggregate principal amount of the 51/4% Notes due 2030 and (iii) $600.0 million in aggregate principal amount of the 55/8% Notes (collectively, the “June 2020 Offerings”). The 5% Notes, the 51/4% Notes due 2030 and the 55/8% Notes were issued at 100.000% of par. The total net proceeds of approximately $2,376.0 million from the June 2020 Offerings, after deducting the initial purchasers’ commissions, were used to redeem all of the 43/8% Senior Notes due 2021 (“the 43/8% Notes”), the 6% Senior Notes due 2023 (the “6% Notes”) and the 53/4% Senior Subordinated Notes due 2024 (the "53/4% Notes”) and to repay a portion of the outstanding borrowings under the Revolving Credit Facility.On June 29, 2020, we redeemed all of the $500.0 million in aggregate principal outstanding of the 43/8% Notes at 100.000% of par and all of the $600.0 million in aggregate principal outstanding of the 6% Notes at 102.000% of par, plus, in each case, accrued and unpaid interest to, but excluding, the redemption date. We recorded a charge of approximately $17.0 million to Other expense (income), net during the second quarter of 2020 related to the early extinguishment of this debt, representing the call premium associated with the early redemption of the 6% Notes, as well as a write-off of unamortized deferred financing costs associated with the early redemption of the 43/8% Notes and the 6% Notes.On July 2, 2020, we redeemed all of the $1,000.0 million in aggregate principal outstanding of the 53/4% Notes at 100.958% of par, plus accrued and unpaid interest to, but excluding, the redemption date. We recorded a charge of approximately $15.3 million to Other expense (income), net during the third quarter of 2020 related to the early extinguishment of this debt, representing the call premium and write-off of unamortized deferred financing fees.AUGUST 2020 OFFERINGOn August 18, 2020, IMI completed a private offering of $1,100.0 million in aggregate principal amount of the 41/2% Notes. The 41/2% Notes were issued at 100.000% of par. The total net proceeds of approximately $1,089.0 million from the issuance of the 41/2% Notes, after deducting the initial purchasers’ commissions, were used to redeem all of the 53/8% CAD Senior Notes due 2023 (the “CAD Notes”), the 3% Euro Senior Notes due 2025 (the “Euro Notes”) and the 53/8% Senior Notes due 2026 (the “53/8% Notes”) and to repay a portion of the outstanding borrowings under the Revolving Credit Facility.On August 21, 2020, we redeemed all of the 250.0 million CAD in aggregate principal outstanding of the CAD Notes at 104.031% of par, 300.0 million Euro in aggregate principal outstanding of the Euro Notes at 101.500% of par and $250.0 million in aggregate principal outstanding of the 53/8% Notes at 106.628% of par, plus, in each case accrued and unpaid interest to, but excluding, the redemption date. We recorded a charge of approximately $36.0 million to Other expense (income), net during the third quarter of 2020 related to the early extinguishment of the CAD Notes, the Euro Notes and the 53/8% Notes, representing the call premiums and write off unamortized deferred financing costs associated with the early redemption of these debt instruments.ACCOUNTS RECEIVABLE SECURITIZATION PROGRAMWe participate in an accounts receivable securitization program (the “Accounts Receivable Securitization Program”) involving several of our wholly owned subsidiaries and certain financial institutions. Under the Accounts Receivable Securitization Program, certain of our subsidiaries sell substantially all of their United States accounts receivable balances to our wholly owned special purpose entities, Iron Mountain Receivables QRS, LLC and Iron Mountain Receivables TRS, LLC (the “Accounts Receivable Securitization Special Purpose Subsidiaries”). The Accounts Receivable Securitization Special Purpose Subsidiaries use the accounts receivable balances to collateralize loans obtained from certain financial institutions. The Accounts Receivable Securitization Special Purpose Subsidiaries are consolidated subsidiaries of IMI. IMIM retains the responsibility of servicing the accounts receivable balances pledged as collateral for the Accounts Receivable Securitization Program and IMI provides a performance guaranty. The maximum availability allowed is limited by eligible accounts receivable, as defined under the terms of the Accounts Receivable Securitization Program. 51IRON MOUNTAIN 2020 FORM 10-KTable of ContentsPart IIOn March 31, 2020, we amended the Accounts Receivable Securitization Program to (i) increase the maximum amount available from $275.0 million to $300.0 million and (ii) extend the maturity date from July 30, 2020 to July 30, 2021, at which point all obligations become due. The full amount outstanding under the Accounts Receivable Securitization Program is classified within the current portion of long-term debt in our Consolidated Balance Sheet as of December 31, 2020. As of December 31, 2020, the maximum availability allowed and amount outstanding under the Accounts Receivable Securitization Program was $274.1 million and $85.0 million, respectively. The interest rate in effect under the Accounts Receivable Securitization Program was 1.1% as of December 31, 2020. Commitment fees at a rate of 40 basis points are charged on amounts made available but not borrowed under the Accounts Receivable Securitization Program. LETTERS OF CREDITAs of December 31, 2020, we had outstanding letters of credit totaling $36.2 million, of which $3.2 million reduce our borrowing capacity under the Revolving Credit Facility (as described above). The letters of credit expire at various dates between January 2021 and January 2033.DEBT COVENANTSThe Credit Agreement (as defined in Note 6 to Notes of Consolidated Financial Statements included in this Annual Report), our bond indentures and other agreements governing our indebtedness contain certain restrictive financial and operating covenants, including covenants that restrict our ability to complete acquisitions, pay cash dividends, incur indebtedness, make investments, sell assets and take certain other corporate actions. The covenants do not contain a rating trigger. Therefore, a change in our debt rating would not trigger a default under the Credit Agreement, our bond indentures or other agreements governing our indebtedness. The Credit Agreement requires that we satisfy a fixed charge coverage ratio, a net total lease adjusted leverage ratio and a net secured debt lease adjusted leverage ratio on a quarterly basis and our bond indentures require that, among other things, we satisfy a leverage ratio (not lease adjusted) or a fixed charge coverage ratio (not lease adjusted), as a condition to taking actions such as paying dividends and incurring indebtedness.The Credit Agreement uses EBITDAR-based calculations and the bond indentures use EBITDA-based calculations as the primary measures of financial performance for purposes of calculating leverage and fixed charge coverage ratios. The bond indenture EBITDA-based calculations include our consolidated subsidiaries, other than those we have designated as “Unrestricted Subsidiaries” as defined in the bond indentures. Generally, the Credit Agreement and the bond indentures use a trailing four fiscal quarter basis for purposes of the relevant calculations and require certain adjustments and exclusions for purposes of those calculations, which make the calculation of financial performance for purposes of those calculations under the Credit Agreement and bond indentures not directly comparable to Adjusted EBITDA as presented herein. These adjustments can be significant. For example, the calculation of financial performance under the Credit Agreement and certain of our bond indentures includes (subject to specified exceptions and caps) adjustments for non-cash charges and for expected benefits associated with (i) completed acquisitions, (ii) certain executed lease agreements associated with our data center business that have yet to commence, and (iii) restructuring and other strategic initiatives, such as Project Summit. The calculation of financial performance under our other bond indentures includes, for example, adjustments for non-cash charges and for expected benefits associated with (i) completed acquisitions, and (ii) events that are extraordinary, unusual or non-recurring, such as the COVID-19 pandemic.Our leverage and fixed charge coverage ratios under the Credit Agreement and our indentures as of December 31, 2020 are as follows: DECEMBER 31, 2020MAXIMUM/MINIMUM ALLOWABLENet total lease adjusted leverage ratio5.3Maximum allowable of 6.5Net secured debt lease adjusted leverage ratio1.9Maximum allowable of 4.0Fixed charge coverage ratio2.3Minimum allowable of 1.5Bond leverage ratio (not lease adjusted)5.9Maximum allowable of 7.0(1)Bond fixed charge coverage ratio (not lease adjusted)3.2Minimum allowable of 2.0(1)(1)The maximum allowable leverage ratio under our indentures for the GBP Notes due 2025, the 47/8% Notes due 2027, the 51/4% Notes due 2028 and the 47/8% Notes due 2029 is 7.0. As of December 31, 2020, we no longer have any indentures subject to a maximum leverage ratio of 6.5. The indentures for the 5% Notes, the 51/4% Notes due 2030, the 41/2% Notes and the 55/8% Notes do not include a maximum leverage ratio covenant; the indentures for these notes instead require us to maintain a minimum fixed charge coverage ratio of 2.0. In certain instances as provided in our indentures, we have the ability to incur additional indebtedness that would result in our bond leverage ratio or bond fixed charge coverage ratio exceeding or falling below the maximum or minimum permitted ratio under our indentures and still remain in compliance with the applicable covenant.Noncompliance with these leverage and fixed charge coverage ratios would have a material adverse effect on our financial condition and liquidity.___________________________________________________________________________________________________Our ability to pay interest on or to refinance our indebtedness depends on our future performance, working capital levels and capital structure, which are subject to general economic, financial, competitive, legislative, regulatory and other factors which may be beyond our control. There can be no assurance that we will generate sufficient cash flow from our operations or that future financings will be available on acceptable terms or in amounts sufficient to enable us to service or refinance our indebtedness or to make necessary capital expenditures.IRON MOUNTAIN 2020 FORM 10-K52Table of ContentsPart IIDERIVATIVE INSTRUMENTSINTEREST RATE SWAP AGREEMENTSIn March 2018, we entered into interest rate swap agreements to limit our exposure to changes in interest rates on a portion of our floating rate indebtedness. As of December 31, 2020, we had $350.0 million in notional value of interest rate swap agreements outstanding, which expire in March 2022. Under the interest rate swap agreements, we receive variable rate interest payments associated with the notional amount of each interest rate swap, based upon one-month LIBOR, in exchange for the payment of fixed interest rates as specified in the interest rate swap agreements. In July 2019, we entered into forward-starting interest rate swap agreements to limit our exposure to changes in interest rates on a portion of our floating rate indebtedness once our current interest rate swap agreements expire in March 2022. The forward-starting interest rate swap agreements have $350.0 million in notional value, commence in March 2022 and expire in March 2024. Under the swap agreements, we will receive variable rate interest payments based upon one-month LIBOR, in exchange for the payment of fixed interest rates as specified in the interest rate swap agreements. We have designated these interest rate swap agreements, including the forward-starting interest rate swap agreements, as cash flow hedges. CROSS-CURRENCY SWAP AGREEMENTSWe enter into cross-currency swap agreements to hedge the variability of exchange rate impacts between the United States dollar and the Euro. The cross-currency swap agreements are designated as a hedge of net investment against certain of our Euro denominated subsidiaries and require an exchange of the notional amounts at maturity.In August 2019, we entered into cross-currency swap agreements whereby we notionally exchanged approximately $110.0 million at an interest rate of 6.0% for approximately 99.1 million Euros at a weighted average interest rate of approximately 3.65%. These cross-currency swap agreements expire in August 2023.In September 2020, we entered into cross-currency swap agreements whereby we notionally exchanged approximately $359.2 million at an interest rate of 4.5% for approximately 300.0 million Euros at a weighted average interest rate of approximately 3.4%. These cross-currency swap agreements expire in February 2026.See Note 5 to Notes to Consolidated Financial Statements included in this Annual Report for additional information on our derivative instruments. EQUITY FINANCINGIn 2017, we entered into a Distribution Agreement with the Agents pursuant to which we may sell, from time to time, up to an aggregate sales price of $500.0 million of our common stock through the At The Market (ATM) Equity Program. Sales of our common stock made pursuant to the Distribution Agreement may be made in negotiated transactions or transactions that are deemed to be “at the market” offerings as defined in Rule 415 under the Securities Act, including sales made directly on the NYSE, or sales made to or through a market maker other than on an exchange, or as otherwise agreed between the applicable Agent and us. We intend to use the net proceeds from sales of our common stock pursuant to the At The Market (ATM) Equity Program for general corporate purposes, which may include acquisitions and investments, including acquisitions and investments in our Global Data Center Business, and repaying amounts outstanding from time to time under the Revolving Credit Facility.During the quarter and year ended December 31, 2020, there were no shares of common stock sold under the At The Market (ATM) Equity Program. As of December 31, 2020, the remaining aggregate sale price of shares of our common stock available for distribution under the At The Market (ATM) Equity Program was approximately $431.2 million.53IRON MOUNTAIN 2020 FORM 10-KTable of ContentsPart IIACQUISITIONS AND JOINT VENTURESSee Note 3 to Notes to Consolidated Financial Statements included in this Annual Report for information regarding our 2020 acquisitions and joint ventures.OSG ACQUISITIONOn January 9, 2020, we completed the acquisition of OSG Records Management (Europe) Limited ("OSG" and such acquisition, the "OSG Acquisition") for cash consideration of approximately $95.5 million. The OSG Acquisition enabled us to extend our Global RIM Business in Russia, Ukraine, Kazakhstan, Belarus, and Armenia. The results of OSG are fully consolidated within our consolidated financial statements from the closing date of the OSG Acquisition.GLENBEIGH ACQUISITIONOn February 17, 2020, in order to enhance our existing operations in the United Arab Emirates, we acquired Glenbeigh Records Management DWC-LLC, a storage and records management company, for total cash consideration of approximately $29.1 million.MAKESPACE JV CAPITAL CONTRIBUTIONIn March 2019, we formed the MakeSpace JV with MakeSpace Labs, Inc. In the second quarter of 2020, we committed to participate in a round of equity funding for the MakeSpace JV whereby we agreed to contribute $36.0 million of the $45.0 million being raised in installments beginning in May 2020 through October 2021. We account for our investment in the MakeSpace JV as an equity method investment, and the carrying value is presented as a component of Other within Other assets, net in our Consolidated Balance Sheet. At December 31, 2020, we owned approximately 39% of the outstanding equity in the MakeSpace JV and the carrying value of our investment in the MakeSpace JV at December 31, 2020 was approximately $16.9 million.FORMATION OF FRANKFURT JOINT VENTUREIn October 2020, we formed a joint venture (the "Frankfurt JV") with AGC Equity Partners ("AGC") to design and develop a 280,000 square foot, 27 megawatt, hyperscale data center currently under development in Frankfurt, Germany (the “Frankfurt JV Transaction”). AGC acquired an 80% equity interest in the Frankfurt JV, while we retained a 20% equity interest (the "Frankfurt JV Investment"). The total cash consideration for the 80% equity interest sold to AGC was approximately $105.0 million. We received approximately $93.3 million (gross of certain transaction expenses) upon the closing of the Frankfurt JV, and we are entitled to receive an additional approximately $11.7 million upon the completion of development of the data center, which we expect to occur in the second quarter of 2021. As a result of the Frankfurt JV Transaction, we recognized a gain of approximately $24.1 million, representing the excess of the fair value of the consideration received over the carrying value of the assets, which consisted primarily of land and land development assets which were previously included within our Global Data Center Business segment.We account for our Frankfurt JV Investment as an equity method investment. At the closing date of the Frankfurt JV Transaction, the fair value of the Frankfurt JV Investment was approximately $23.3 million. The carrying value of our Frankfurt JV Investment at December 31, 2020 was $26.5 million, which is presented as a component of Other within Other assets, net in our Consolidated Balance Sheet.NET OPERATING LOSSESAt December 31, 2020, we have federal and state net operating loss carryforwards of which we are expecting an insignificant tax benefit to be realized. We have assets for foreign net operating losses of $92.1 million, with various expiration dates (and in some cases no expiration date), subject to a valuation allowance of approximately 43%.IRON MOUNTAIN 2020 FORM 10-K54Table of ContentsPart IIITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.CREDIT RISKFinancial instruments that potentially subject us to credit risk consist principally of cash and cash equivalents (including money market funds and time deposits) and accounts receivable. The only significant concentrations of liquid investments as of December 31, 2020 relate to cash and cash equivalents held in money market funds with four “Triple A” rated money market funds and time deposits with one global bank. As per our risk management investment policy, we limit exposure to concentration of credit risk by limiting the amount invested in any one mutual fund to a maximum of 1% of the fund's total assets or in any one financial institution to a maximum of $75.0 million. As of December 31, 2020, our cash and cash equivalents balance, including restricted cash, was $205.1 million.INTEREST RATE RISKGiven the recurring nature of our revenues and the long-term nature of our asset base, we have the ability and the preference to use long-term, fixed interest rate debt to finance our business at attractive rates, thereby helping to preserve our long-term returns on invested capital. Occasionally, we may use interest rate swaps as a tool to maintain our targeted level of fixed rate debt.As of December 31, 2020, we had $1,108.1 million of variable rate debt outstanding with a weighted average variable interest rate of approximately 3.1%, and $7,689.3 million of fixed rate debt outstanding. As of December 31, 2020, approximately 87% of our total debt outstanding was fixed. If the weighted average variable interest rate on our variable rate debt had increased by 1%, our net income for the year ended December 31, 2020 would have been reduced by approximately $13.8 million. See Note 5 to Notes to Consolidated Financial Statements included in this Annual Report for a discussion on our interest rate swaps and Note 6 to Notes to Consolidated Financial Statements included in this Annual Report for a discussion of our long-term indebtedness, including the fair values of such indebtedness as of December 31, 2020.CURRENCY RISK Our international investments may be subject to risks and uncertainties related to fluctuations in currency valuation. Our reporting currency is the United States dollar. However, our international revenues and expenses are generated in the currencies of the countries in which we operate, primarily the British pound sterling, Euro, Canadian dollar, Brazilian real and the Australian dollar. Declines in the value of the local currencies in which we are paid relative to the United States dollar will cause revenues in United States dollar terms to decrease and dollar-denominated liabilities to increase in local currency.The impact of currency fluctuations on our earnings is mitigated by the fact that most operating and other expenses are also incurred and paid in the local currency. We also have several intercompany obligations between our foreign subsidiaries and IMI and our United States-based subsidiaries. In addition, our foreign subsidiaries and IME also have intercompany obligations between them. These intercompany obligations are primarily denominated in the local currency of the foreign subsidiary.We have adopted and implemented a number of strategies to mitigate the risks associated with fluctuations in foreign currency exchange rates. One strategy is to finance certain of our international subsidiaries with debt that is denominated in local currencies, thereby providing a natural hedge. In determining the amount of any such financing, we take into account local tax considerations, among other factors. Another strategy we utilize is for IMI or IMIM, a wholly-owned subsidiary of IMI, to borrow in foreign currencies to hedge our intercompany financing activities. In addition, on occasion, we enter into currency swaps to temporarily or permanently hedge an overseas investment, such as a major acquisition, to lock in certain transaction economics. We have implemented these strategies for our foreign investments in the United Kingdom, Canada, Australia, Latin America and continental Europe. IM UK has financed a portion of its capital needs through the issuance in British pounds sterling of the GBP Notes due 2025. Our Australian business has financed a portion of its capital needs through direct borrowings in Australian dollars under the AUD Term Loan. This creates a tax efficient natural currency hedge. Prior to their redemption in August 2020, we had designated a portion of our previously outstanding Euro Notes as a hedge of net investment of certain of our Euro denominated subsidiaries. As a result, we recorded $17.0 million ($17.0 million net of tax) of foreign exchange losses related to the “marking-to-market” of such debt to currency translation adjustments which is a component of Accumulated other comprehensive items, net included in our Consolidated Balance Sheet for the year ended December 31, 2020. As of December 31, 2020, cumulative net gains of $3.3 million, net of tax are recorded in Accumulated other comprehensive items, net associated with this net investment hedge.55IRON MOUNTAIN 2020 FORM 10-KTable of ContentsPart IIWe have entered into cross-currency swap agreements to hedge the variability of exchange rate impacts between the United States dollar and the Euro. These cross-currency swap agreements are designated as a hedge of net investment against certain of our Euro denominated subsidiaries and require an exchange of the notional amounts at maturity. These cross-currency swaps are marked to market at the end of each reporting period and any changes in fair value are recorded as a component of Accumulated other comprehensive items, net. Unrealized gains are recognized as assets, which are recorded as a component of Other within Other assets, net, while unrecognized losses are recognized as liabilities, which are recorded as a component of Other long-term liabilities in our Consolidated Balance Sheets. See Note 5 to Notes to Consolidated Financial Statements included in this Annual Report for a discussion on our cross-currency swap agreements.As of and during the year ending December 31, 2020, we had no outstanding forward contracts. At the maturity of any forward contract, we may enter into a new forward contract to hedge movements in the underlying currencies. At the time of settlement, we either pay or receive the net settlement amount from any forward contract and recognize this amount in Other expense (income), net in the accompanying statements of operations as a realized foreign exchange gain or loss. At the end of each month, we mark the outstanding forward contracts to market and record an unrealized foreign exchange gain or loss for the mark-to-market valuation. Historically, we have not designated any of the forward contracts we have entered as hedges.The impact of devaluation or depreciating currency on an entity depends on the residual effect on the local economy and the ability of an entity to raise prices and/or reduce expenses. Due to our constantly changing currency exposure and the potential substantial volatility of currency exchange rates, we cannot predict the effect of exchange fluctuations on our business. The effect of a change in foreign currency exchange rates on our net investment in foreign subsidiaries is reflected in the “Accumulated Other Comprehensive Items, net” component of equity. A 10% depreciation in year-end 2020 functional currencies, relative to the United States dollar, would result in a reduction in our equity of approximately $286.5 million.
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+Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our audited consolidated financial statements and related notes to our audited consolidated financial statements included elsewhere in this Form 10-K.(in millions, except per share amounts)For the Years Ended December 31,20202019201820172016Consolidated Statements of Operations:Revenues$4,910.2 $2,451.9 $2,689.8 $2,375.4 $1,939.4 Cost of sales3,296.8 1,540.2 1,677.3 1,477.5 1,222.7 Gross profit1,613.4 911.7 1,012.5 897.9 716.7 Selling and administrative expenses894.8 436.4 434.6 446.2 415.1 Amortization of intangible assets395.8 124.3 125.8 118.9 124.2 Impairment of goodwill— — — — — Impairment of other intangible assets19.9 — — 1.6 25.3 Other operating expense, net217.2 75.7 9.1 222.1 48.6 Operating income (loss)85.7 275.3 443.0 109.1 103.5 Interest expense111.1 88.9 99.6 140.7 170.3 Loss on extinguishment of debt2.0 0.2 1.1 84.5 — Other income, net(8.0)(4.7)(7.2)(3.4)(3.6)Income (loss) before income taxes(19.4)190.9 349.5 (112.7)(63.2)Provision (benefit) for income taxes13.0 31.8 80.1 (131.2)(31.9)Net income (loss)(32.4)159.1 269.4 18.5 (31.3)Less: Net income (loss) attributable to noncontrolling interest0.9 — — 0.1 5.3 Net income (loss) attributable to Ingersoll Rand Inc.$(33.3)$159.1 $269.4 $18.4 $(36.6)Earnings (loss) per share, basic$(0.09)$0.78 $1.34 $0.1 $(0.25)Earnings (loss) per share, diluted$(0.09)$0.76 $1.29 $0.1 $(0.25)Weighted average shares, basic382.8 203.5 201.6 182.2 149.2 Weighted average shares, diluted382.8 208.9 209.1 188.4 149.2 Statement of Cash Flow Data:Cash flows - operating activities$914.3 $343.3 $444.5 $200.5 $165.6 Cash flows - investing activities(37.9)(54.3)(235.0)(60.8)(82.1)Cash flows - financing activities328.7 (11.5)(373.0)(17.4)(43.0)Balance Sheet Data (at period end):Cash and cash equivalents$1,750.9 $505.5 $221.2 $393.3 $255.8 Total assets16,058.6 4,628.4 4,487.1 4,621.2 4,316.0 Total liabilities6,869.1 2,758.5 2,811.1 3,144.4 4,044.2 Total stockholders’ equity9,189.5 1,869.9 1,676.0 1,476.8 271.8 Other Financial Data (unaudited):Adjusted EBITDA(1)$1,017.6 $561.7 $683.4 $561.5 $400.7 Adjusted net income(1)599.0 329.3 396.3 249.3 133.6 Capital expenditures48.7 43.2 52.2 56.8 74.4 Free cash flow(1)865.6 300.1 392.3 143.7 91.2 28Table of Contents(1)We report our financial results in accordance with GAAP. To supplement this information, we also use the following measures in this Form 10-K: “Adjusted EBITDA,” “Adjusted Net Income” and “Free Cash Flow.” Management believes that Adjusted EBITDA and Adjusted Net Income are helpful supplemental measures to assist us and investors in evaluating our operating results as they exclude certain items whose fluctuation from period to period do not necessarily correspond to changes in the operations of our business. Adjusted EBITDA represents net income (loss) before interest, taxes, depreciation and amortization, as further adjusted to exclude certain non-cash, non-recurring and other adjustment items. We believe that the adjustments applied in presenting Adjusted EBITDA are appropriate to provide additional information to investors about certain material non-cash items and about non-recurring items that we do not expect to continue at the same level in the future. Adjusted Net Income is defined as net income (loss) including interest, depreciation and amortization of non-acquisition related intangible assets and excluding other items used to calculate Adjusted EBITDA and further adjusted for the tax effect of these exclusions.We use Free Cash Flow to review the liquidity of our operations. We measure Free Cash Flow as cash flows from operating activities less capital expenditures. We believe Free Cash Flow is a useful supplemental financial measure for us and investors in assessing our ability to pursue business opportunities and investments and to service our debt. Free Cash Flow is not a measure of our liquidity under GAAP and should not be considered as an alternative to cash flows from operating activities.As a result, we and our board of directors regularly use these measures as tools in evaluating our operating and financial performance and in establishing discretionary annual compensation. Such measures are provided in addition to, and should not be considered to be a substitute for, or superior to, the comparable measure under GAAP. In addition, we believe that Adjusted EBITDA, Adjusted Net Income and Free Cash Flow are frequently used by investors, analysts and other interested parties in the evaluation of issuers, many of which also present Adjusted EBITDA, Adjusted Net Income and Free Cash Flow when reporting their results in an effort to facilitate an understanding of their operating and financial results and liquidity.Adjusted EBITDA, Adjusted Net Income and Free Cash Flow should not be considered as alternatives to net income (loss) or other performance measures calculated in accordance with GAAP, or as alternatives to cash flow from operating activities as a measure of our liquidity. Adjusted EBITDA, Adjusted Net Income and Free Cash Flow have limitations as analytical tools, and you should not consider such measures either in isolation or as substitutes for analyzing our results as reported under GAAP.ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSThe following discussion contains management’s discussion and analysis of our financial condition and results of operations and should be read together with “Item 6. Selected Financial Data” and our audited consolidated financial statements and related notes to our consolidated financial statements included elsewhere in this Form 10-K. This discussion contains forward-looking statements and involves numerous risks and uncertainties. Our actual results may differ materially from those anticipated in any forward-looking statements as a result of many factors, including those set forth under the “Special Note Regarding Forward-Looking Statements,” “Item 1A. Risk Factors” and elsewhere in this Form 10-K.Executive OverviewOur CompanyIngersoll Rand is a global market leader with a broad range of innovative and mission-critical air, fluid, energy, specialty vehicle and medical technologies, providing services and solutions to increase industrial productivity and efficiency. We manufacture one of the broadest and most complete ranges of compressor, pump, vacuum and blower products in our markets, which, when combined with our global geographic footprint and application expertise, allows us to provide differentiated product and service offerings to our customers. Our products are sold under a collection of premier, market-leading brands, including Ingersoll Rand, Gardner Denver, Club Car, CompAir, Nash, Elmo Rietschle, Robuschi, Thomas, Milton Roy, ARO, Emco Wheaton and Runtech Systems, which we believe are globally recognized in their respective end-markets and known for product quality, reliability, efficiency and superior customer service.These attributes, along with over 160 years of engineering heritage, generate strong brand loyalty for our products and foster long-standing customer relationships, which we believe have resulted in leading market positions within each of our operating segments. We have sales in more than 175 countries and our diverse customer base utilizes our products across a wide array of end-markets that have favorable near- and long-term growth prospects, including industrial manufacturing, energy (with particular exposure to the North American upstream land-based market), transportation, medical and laboratory sciences, food and beverage packaging and chemical processing.Our products and services are critical to the processes and systems in which they are utilized, which are often complex and function in harsh conditions where the cost of failure or downtime is high. However, our products and services typically represent only a small portion of the costs of the overall systems or functions that they support. As a result, our customers place a high value on our application expertise, product reliability and the responsiveness of our service. To support our customers and 29Table of Contentsmarket presence, we maintain significant global scale with 65 key manufacturing facilities, approximately 50 complementary service and repair centers across six continents and approximately 15,900 employees worldwide as of December 31, 2020.The process-critical nature of our product applications, coupled with the standard wear and tear replacement cycles associated with the usage of our products, generates opportunities to support customers with our broad portfolio of aftermarket parts, consumables and services. Customers place a high value on minimizing any time their operations are offline. As a result, the availability of replacement parts, consumables and our repair and support services are key components of our value proposition. Our large installed base of products provides a recurring revenue stream through our aftermarket parts, consumables and services offerings. As a result, our aftermarket revenue is significant, representing 36.1% of total Company revenue and approximately 42.8% of our combined Industrial Technologies and Services and High Pressure Solutions segments’ revenue in 2020.Components of Our Revenue and ExpensesRevenuesWe generate revenue from sales of original equipment and associated aftermarket parts, consumables and services. We sell our products and deliver services directly to end-users and through independent distribution channels, depending on the product line and geography. Revenue derived from short duration contracts is recognized at a single point in time when control is transferred to the customer, generally at shipment or when delivery has occurred or as services are performed. Certain contracts are highly-engineered and unique to customer specifications. Depending on the contractual terms, revenue is recognized either over the duration of the contract or at contract completion when control is transferred to the customer. ExpensesCost of SalesCost of sales includes purchased materials, labor and overhead related to manufactured products and aftermarket parts sold during a period. Depreciation of manufacturing equipment and facilities is included in cost of sales. Purchased materials represent the majority of costs of sales, with steel, aluminum, copper and partially finished castings representing our most significant materials inputs. Stock-based compensation expense for employees associated with the manufacture of products or delivery of services to customers is included in cost of sales. We have instituted a global sourcing strategy to take advantage of coordinated purchasing opportunities of key materials across our manufacturing plant locations.Cost of sales for services includes direct labor, parts and other overhead costs including depreciation of equipment and facilities, to deliver repair, maintenance and other field services to our customers.Selling and Administrative ExpensesSelling and administrative expenses consist of (i) salaries and other employee-related expenses for our selling and administrative functions and other activities not associated with the manufacture of products or delivery of services to customers; (ii) facility operating expenses for selling and administrative activities, including office rent, maintenance, depreciation and insurance; (iii) marketing and direct costs of selling products and services to customers including internal and external sales commissions; (iv) research and development expenditures; (v) professional and consultant fees; (vi) employee related stock-based compensation for our selling and administrative functions and (vii) other miscellaneous expenses. Certain corporate expenses, including those related to our shared service centers in the United States and Europe that directly benefit our businesses are allocated to our business segments. Certain corporate administrative expenses, including corporate executive compensation, treasury, certain information technology, internal audit and tax compliance, are not allocated to the business segments.Amortization of Intangible AssetsAmortization of intangible assets represents the amortization of finite lived intangible assets recognized through accounting for acquisitions — including customer relationships, tradenames, and developed technology — as well as internal-use software.Impairment of Other Intangible AssetsImpairment of other intangible assets represents the recognition of non-cash charges to reduce the carrying value of intangible assets other than goodwill to their fair value.30Table of ContentsOther Operating Expense, NetOther operating expense, net includes foreign currency gains and losses, restructuring charges, acquisition and integration costs, certain litigation and contract settlement losses, environmental remediation and other miscellaneous operating expenses.Provision (Benefit) for Income TaxesThe provision or benefit for income taxes includes U.S. federal, state and local income taxes and all non-U.S. income taxes. We are subject to income tax in approximately 46 jurisdictions outside of the United States. Because we conduct operations on a global basis, our effective tax rate depends, and will continue to depend, on the geographic distribution of our pre-tax earnings among several different taxing jurisdictions. Our effective tax rate can also vary based on changes in the tax rates of the different jurisdictions, the availability of tax credits and non-deductible items.Items Affecting our Reported ResultsGeneral Economic Conditions and Capital Spending in the Industries We ServeOur financial results closely follow changes in the industries and end-markets we serve. Demand for most of our products depends on the level of new capital investment and planned and unplanned maintenance expenditures by our customers. The level of capital expenditures depends, in turn, on the general economic conditions as well as access to capital at reasonable cost. In particular, demand for our industrial products in our Industrial Technologies and Services and Precision and Science Technologies segment generally correlate with the rate of total industrial capacity utilization and the rate of change of industrial production. Capacity utilization rates above 80% have historically indicated a strong demand environment for industrial equipment. Demand for certain businesses in our Precision and Science Technologies segment are driven by favorable trends in healthcare spend due to an aging population requiring medical care and increased investment in health solutions and safety infrastructures in emerging economies. In our High Pressure Solutions segment, demand for our products that is influenced heavily by energy prices and the expectation as to future trends in those prices. Energy prices have historically been cyclical in nature and are affected by a wide range of factors. In addition to energy prices, demand for our upstream energy products are positively impacted by increasing global land rig count, drilled but uncompleted wells, the level of hydraulic fracturing intensity and activity measured by horsepower utilization and lateral lengths as well as drilling and completion capital expenditures. Over longer time periods, we believe that demand for all of our products also tends to follow economic growth patterns indicated by the rates of change in the GDP around the world, as augmented by secular trends in each segment. Our ability to grow and our financial performance will also be affected by our ability to address a variety of challenges and opportunities that are a consequence of our global operations, including efficiently utilizing our global sales, manufacturing and distribution capabilities and engineering innovative new product applications for end-users in a variety of geographic markets.Foreign Currency FluctuationsA significant portion of our revenues, approximately 49% for the year ended December 31, 2020, was recognized by subsidiaries with a functional currency other than the U.S. dollar. A significant portion of our costs are also denominated in currencies other than the U.S. dollar. Changes in foreign exchange rates can therefore impact our results of operations and are quantified when significant to our discussion.Factors Affecting the Comparability of our Results of OperationsAs a result of a number of factors, our historical results of operations are not comparable from period to period and may not be comparable to our financial results of operations in future periods. Key factors affecting the comparability of our results of operations are summarized below.Acquisition of Ingersoll Rand IndustrialOn February 29, 2020, we completed the acquisition of Ingersoll Rand Industrial. We reorganized our reportable segments in connection with this transaction and formed four new reportable segments.•Industrial Technologies and Services – Ingersoll Rand Industrial’s Compression Technologies and Services (“CTS”) and Power Tools and Lift (“PTL”) businesses joined the legacy Gardner Denver Industrial segment (excluding the Specialty Pump businesses) and the midstream and downstream portions of the Gardner Denver Energy segment to form the new “Industrial Technologies and Services” segment.31Table of Contents•Precision and Science Technologies – Ingersoll Rand Industrial’s Precision Flow Systems (“PFS”) and ARO businesses joined the legacy Gardner Denver Medical segment and Specialty Pump businesses from the legacy Gardner Denver Industrial segment to form the new “Precision and Science Technologies” segment.•Specialty Vehicle Technologies – Ingersoll Rand Industrial’s Club Car golf, utility and consumer low-speed vehicles business formed the new “Specialty Vehicle Technologies” segment.•High Pressure Solutions – The upstream energy portion of the legacy Gardner Denver Energy segment was disaggregated to form the new “High Pressure Solutions” segment.Ingersoll Rand Industrial is included in our results of operations beginning on the acquisition date (close of business February 29, 2020). Comparability between the years ended December 31, 2020 and 2019 will be affected by ten months of activity from Ingersoll Rand Industrial. Subsequent to the date of acquisition, in the year ended December 31, 2020, the Ingersoll Rand Industrial acquisition contributed $1,787.4 million, $406.1 million, and $741.4 million of revenue to the Industrial Technologies and Services, Precision and Science Technologies and Specialty Vehicle Technologies segments, respectively.See Note 3 “Business Combinations” to our audited consolidated financial statements included elsewhere in this Form 10-K for further discussion of the acquisition of Ingersoll Rand Industrial.Other acquisitionsPart of our strategy for growth is to acquire complementary flow control and compression equipment businesses, which provide access to new technologies or geographies or improve our aftermarket offerings. In addition to the Ingersoll Rand Industrial transaction discussed above, we have acquired several other businesses during the three year period ending December 31, 2020. While these acquisitions are not individually significant or significant in the aggregate, may be relevant when comparing our results from period to period.See Note 3 “Business Combinations” to our audited consolidated financial statements included elsewhere in this Form 10-K for further discussion of these acquisitions.Impact of Coronavirus (COVID-19)We continue to assess and actively manage the impact of the ongoing COVID-19 pandemic on our global operations and also the operations of our suppliers and customers. Overall demand for our products has decreased as a result of the pandemic, which impacted our operating results for the year ended December 31, 2020. We are adhering to all state and country mandates and guidelines wherever we operate. Although certain of our facilities were closed for a period of time during the COVID-19 pandemic, currently all our major manufacturing locations are operational, in accordance with country mandates and guidelines. We are taking certain actions to reduce costs and preserve cash given the rapidly changing environment. The length of time the pandemic will impact our operations, and the operations of our customers and suppliers remains uncertain. See “The COVID-19 pandemic has adversely affected our business and results of operations, and could have a material and adverse effect on our business, results of operations and financial condition in the future” in Part II Item 1A. “Risk Factors” included elsewhere in this Form 10-K.Variability within Upstream Energy MarketsWe sell products and services to customers in upstream energy markets, primarily in the United States. Within our High Pressure Solutions segment, we manufacture pumps and associated aftermarket products and services used in drilling, hydraulic fracturing and well service applications.Demand for upstream energy products has historically corresponded to the supply and demand dynamics related to oil and natural gas products, and has been influenced by oil and natural gas prices, the level and intensity of hydraulic fracturing activity rig count, drilling activity and other economic factors. These factors have caused the level of demand for certain of our High Pressure Solutions products to change at times (both positively and negatively) and we expect these trends to continue in the future.Restructuring and Other Business Transformation InitiativesWe continue to implement business transformation initiatives. A key element of those business transformation initiatives was restructuring programs within our Industrial Technologies and Services, Precision and Science Technologies, Specialty Vehicle 32Table of ContentsTechnologies and High Pressure Solutions segments as well as at the Corporate level. Restructuring charges, program related facility reorganization, relocation and other costs, and related capital expenditures were impacted most significantly.Subsequent to the acquisition of Ingersoll Rand Industrial, the Company announced a restructuring program (“2020 Plan”) to create efficiencies and synergies, reduce the number of facilities and optimize operating margin within the merged Company. For the year ended December 31, 2020, $92.9 million was charged to expense related to this restructuring program.We announced a restructuring program in the third quarter of 2018 that primarily involves workforce reductions and facility consolidations. For the year ended December 31, 2019, $17.1 million was charged to expense related to this restructuring program.Stock-Based Compensation ExpenseFor the year ended December 31, 2020, we incurred stock-based compensation expense of approximately $51.3 million which was decreased by $0.5 million due to costs associated with employer taxes. The increase from 2019 was primarily due to increased awards as a result of the Ingersoll Rand Industrial acquisition as well as the $150 million equity grant to nearly 16,000 employees worldwide announced in the third quarter of 2020. See Note 17 “Stock-Based Compensation” to our audited consolidated financial statements included elsewhere in this Form 10-K for further discussion around our stock-based compensation expense.For the year ended December 31, 2019, we incurred stock-based compensation expense of approximately $19.2 million which was increased by $1.5 million due to costs associated with employer taxes.OutlookIndustrial Technologies and ServicesThe mission-critical nature of our Industrial Technologies and Services segment products across manufacturing processes drives a demand environment and outlook that are correlated with global and regional industrial production, capacity utilization and long-term GDP growth. Due to the uncertainty of current economic conditions associated with COVID-19, and its impact on end markets, our near-term visibility is limited. In the fourth quarter of 2020, we had $996.8 million of orders in our Industrial Technologies and Services segment, an increase of 154.8% over the fourth quarter of 2019. Approximately $601.9 million of these orders relate to the acquisition of Ingersoll Rand Industrial.Precision and Science Technologies SegmentDuring the COVID-19 pandemic, the Precision and Science Technologies segment has seen increased demand for our vacuum pump and compressor solutions used in respirator and ventilator applications. Demand of other products and services have been curtailed as a result of the COVID-19 pandemic and near-term visibility is limited. In the fourth quarter of 2020 we booked $220.3 million of orders in our Precision and Science Technologies segment, an increase of 202.6% over the fourth quarter of 2019. Approximately $127.4 million of these orders relate to the acquisition of Ingersoll Rand Industrial.Specialty Vehicle Technologies SegmentDuring 2020, the Specialty Vehicle Technologies segment is seeing consistent demand in golf end markets along with record demand for consumer vehicle and aftermarket parts offerings. This has helped to offset demand pressure in the commercial end markets as the COVID-19 pandemic continues to impact the hospitality and resort industries. In the fourth quarter of 2020, we had $274.2 million of orders in our Specialty Vehicle Technologies segment.High Pressure Solutions SegmentThe demand and outlook for the majority of our High Pressure Solutions products and services are influenced heavily by the supply and demand dynamics related to oil and natural gas products, and have been influenced by oil and natural gas prices, the level and intensity of hydraulic fracturing activity, global land rig count, the number of drilled but uncompleted wells and other economic factors. The COVID-19 pandemic and related economic repercussions have negatively impacted the global demand for oil and natural gas. The ultimate duration of these conditions is unknown. In the fourth quarter of 2020, we booked $38.8 million of orders in our High Pressure Solutions segment, a decrease of 50.9% over the fourth quarter of 2019.33Table of ContentsHow We Assess the Performance of Our BusinessWe manage operations through the four business segments described above. In addition to our consolidated GAAP financial measures, we review various non-GAAP financial measures, including Adjusted EBITDA, Adjusted Net Income and Free Cash Flow.We believe Adjusted EBITDA and Adjusted Net Income are helpful supplemental measures to assist us and investors in evaluating our operating results as they exclude certain items whose fluctuation from period to period do not necessarily correspond to changes in the operations of our business. Adjusted EBITDA represents net income (loss) before interest, taxes, depreciation, amortization and certain non-cash, non-recurring and other adjustment items. We believe that the adjustments applied in presenting Adjusted EBITDA are appropriate to provide additional information to investors about certain material non-cash items and about non-recurring items that we do not expect to continue at the same level in the future. Adjusted Net Income is defined as net income (loss) including interest, depreciation and amortization of non-acquisition related intangible assets and excluding other items used to calculate Adjusted EBITDA and further adjusted for the tax effect of these exclusions.We use Free Cash Flow to review the liquidity of our operations. We measure Free Cash Flow as cash flows from operating activities less capital expenditures. We believe Free Cash Flow is a useful supplemental financial measure for us and investors in assessing our ability to pursue business opportunities and investments and to service our debt. Free Cash Flow is not a measure of our liquidity under GAAP and should not be considered as an alternative to cash flows from operating activities.Management and our board of directors regularly use these measures as tools in evaluating our operating and financial performance and in establishing discretionary annual compensation. Such measures are provided in addition to, and should not be considered to be a substitute for, or superior to, the comparable measures under GAAP. In addition, we believe that Adjusted EBITDA, Adjusted Net Income and Free Cash Flow are frequently used by investors and other interested parties in the evaluation of issuers, many of which also present Adjusted EBITDA, Adjusted Net Income and Free Cash Flow when reporting their results in an effort to facilitate an understanding of their operating and financial results and liquidity.Adjusted EBITDA, Adjusted Net Income and Free Cash Flow should not be considered as alternatives to net income (loss) or any other performance measure derived in accordance with GAAP, or as alternatives to cash flow from operating activities as a measure of our liquidity. Adjusted EBITDA, Adjusted Net Income and Free Cash Flow have limitations as analytical tools, and you should not consider such measures either in isolation or as substitutes for analyzing our results as reported under GAAP.Included in our discussion of our consolidated and segment results below are changes in revenues and Adjusted EBITDA on a Constant Currency basis. Constant Currency information compares results between periods as if exchange rates had remained constant period over period. We define Constant Currency revenues and Adjusted EBITDA as total revenues and Adjusted EBITDA excluding the impact of foreign exchange rate movements and use it to determine the Constant Currency revenue and Adjusted EBITDA growth on a year-over-year basis. Constant Currency revenues and Adjusted EBITDA are calculated by translating current period revenues and Adjusted EBITDA using corresponding prior period exchange rates. These results should be considered in addition to, not as a substitute for, results reported in accordance with GAAP. Results on a Constant Currency basis, as we present them, may not be comparable to similarly titled measures used by other companies and are not a measure of performance presented in accordance with GAAP.For further information regarding these measures, see “Item 6. Selected Financial Data” and “Non-GAAP Financial Measures” below.Results of OperationsConsolidated results should be read in conjunction with segment results and the Segment Information notes to our audited consolidated financial statements included elsewhere in this Form 10-K, which provide more detailed discussions concerning certain components of our consolidated statements of operations. All intercompany accounts and transactions have been eliminated within the consolidated results.This section discusses our results of operations for the year ended December 31, 2020 as compared to the year ended December 31, 2019. For a discussion and analysis of the year ended December 31, 2019, compared to the same in 2018, please refer to the “Management’s Discussion and Analysis of Financial Condition” and “Results of Operations” sections included in Item 7 in Exhibit 99.2 of our Current Report on Form 8-K, filed with the SEC on June 5, 2020.34Table of ContentsConsolidated Results of Operations for the Years Ended December 31, 2020 and 2019Year Ended December 31,20202019Consolidated Statements of OperationsRevenues$4,910.2 $2,451.9 Cost of sales3,296.8 1,540.2 Gross Profit1,613.4 911.7 Selling and administrative expenses894.8 436.4 Amortization of intangible assets395.8 124.3 Impairment of other intangible assets19.9 — Other operating expense, net217.2 75.7 Operating Income85.7 275.3 Interest expense111.1 88.9 Loss on extinguishment of debt2.0 0.2 Other income, net(8.0)(4.7)Income (Loss) Before Income Taxes(19.4)190.9 Provision for income taxes13.0 31.8 Net Income (Loss)(32.4)159.1 Less: Net income attributable to noncontrolling interests0.9 — Net Income (Loss) Attributable to Ingersoll Rand Inc.$(33.3)$159.1 Percentage of RevenuesGross profit32.9 %37.2 %Selling and administrative expenses18.2 %17.8 %Operating income1.7 %11.2 %Net income(0.7)%6.5 %Adjusted EBITDA(1)20.7 %22.9 %Other Financial DataAdjusted EBITDA(1)$1,017.6 $561.7 Adjusted net income(1)599.0 329.3 Cash flows - operating activities914.3 343.3 Cash flows - investing activities(37.9)(54.3)Cash flows - financing activities328.7 (11.5)Free cash flow(1)865.6 300.1 (1)See “Non-GAAP Financial Measures” below for a reconciliation to the most directly comparable GAAP measure.RevenuesRevenues for 2020 were $4,910.2 million, an increase of $2,458.3 million, or 100.3%, compared to $2,451.9 million in 2019. The increase in revenues was primarily due to acquisitions, including Ingersoll Rand Industrial of $2,934.9 million partially offset by lower volumes due to the effects of COVID-19 in our Industrial Technologies and Services segment of $260.5 million and in our High Pressure Solutions segment of $220.5 million. The percentage of consolidated revenues derived from aftermarket parts and services was 36.1% in 2020 compared to 37.8% in 2019.Gross ProfitGross profit in 2020 was $1,613.4 million, an increase of $701.7 million, or 77.0%, compared to $911.7 million in 2019, and as a percentage of revenues was 32.9% in 2020 and 37.2% in 2019. The increase in gross profit is primarily due to acquisitions, including Ingersoll Rand Industrial, partially offset by the runoff of the fair valuation adjustments related to purchase price allocation from inventory into cost of sales, lower volumes due to the effects of COVID-19 in our Industrial Technologies and 35Table of ContentsServices segment and our High Pressure Solutions segment. The decrease in gross profit as a percentage of revenues is primarily due to the runoff of the fair valuation adjustments related to purchase price allocation from inventory into cost of sales and changes in segment mix.Selling and Administrative ExpensesSelling and administrative expenses were $894.8 million in 2020, an increase of $458.4 million, or 105.0%, compared to $436.4 million in 2019. Selling and administrative expenses as a percentage of revenues increased to 18.2% in 2020 from 17.8% in 2019. This increase in selling and administrative expenses was primarily due to acquisitions, including Ingersoll Rand Industrial, increased professional and consultant fees and increased stock based compensation expense, partially offset by a decrease in advertising expenses and employee related expenses including salaries and wages, within our legacy business units.Amortization of Intangible AssetsAmortization of intangible assets was $395.8 million in 2020, an increase of $271.5 million compared to $124.3 million in 2019. The increase was primarily due to the amortization of intangible assets related to the acquisition of Ingersoll Rand Industrial.Impairment of Intangible AssetsImpairment of intangible assets was $19.9 million in 2020 due to the impairment of two tradenames in the Industrial Technologies and Services segment. See Note 8 “Goodwill and Other Intangible Assets” to our consolidated financial statements included elsewhere in this Form 10-K for further details.Other Operating Expense, NetOther operating expense, net was $217.2 million in 2020, an increase of $141.5 million compared to $75.7 million in 2019. The increase was primarily due to higher restructuring charges of $75.8 million, higher acquisition related expenses of $43.5 million, higher foreign currency transaction losses, net of $12.8 million and lower shareholder litigation recoveries of $6.0 million.Interest ExpenseInterest expense was $111.1 million in 2020, an increase of $22.2 million compared to $88.9 million in 2019. The increase was primarily due to the addition of a $1,900 million term loan entered into in conjunction with the acquisition of Ingersoll Rand Industrial and the addition of a $400 million term loan entered into in the second quarter of 2020, partially offset by a decrease in the weighted-average interest rate. The weighted-average interest rate was approximately 3.5% in 2020 and 5.4% in 2019.Loss on Extinguishment of DebtLoss on extinguishment of debt was $2.0 million in 2020, which was related to the refinancing of the senior secured term loan facility denominated in U.S. Dollars and the senior secured term loan facility denominated in Euros. See Note 10 “Debt” to our audited consolidated financial statements included elsewhere in this Form 10-K for further details.Other Income, NetOther income, net, was $8.0 million in 2020, an increase of $3.3 million compared to $4.7 million in 2019. The increase in other income, net was primarily due to increased gains on postretirement plan investments of $10.5 million due to the additional defined benefit plans from the acquisition of Ingersoll Rand Industrial, partially offset by increased costs in the other components of net periodic benefit cost of $6.1 million due to the additional defined benefit plans from the acquisition of Ingersoll Rand Industrial. Provision for Income TaxesThe provision for income taxes was $13.0 million resulting in a (67.0)% effective tax rate in 2020 compared to a provision of $31.8 million resulting in a 16.7% effective tax provision rate in 2019. The decrease in the tax provision and the change in the effective tax rate is primarily due to a reduction in the pre-tax book income in jurisdictions with lower effective tax rates combined with significant earnings in jurisdictions with higher tax rates. The reduction in pre-tax book income is mainly from the COVID-19 global pandemic, the transaction costs associated with the acquisition of Ingersoll Rand Industrial, and additional amortization and depreciation expense associated with the purchase price step up adjustments.36Table of ContentsNet Income (Loss)Net loss was $32.4 million in 2020 compared to net income of $159.1 million in 2019. The decrease in net income was primarily due to higher selling and administrative expenses, higher amortization, increased other operating expenses, net, and higher interest expense, partially offset by higher gross profit on increased revenues.Adjusted EBITDAAdjusted EBITDA increased $455.9 million to $1,017.6 million in 2020 compared to $561.7 million in 2019. Adjusted EBITDA as a percentage of revenues decreased 220 basis points to 20.7% in 2020 from 22.9% in 2019. The increase in Adjusted EBITDA was primarily due to acquisitions, including Ingersoll Rand Industrial of $691.1 million, partially offset by lower organic sales volume of $179.0 million and increased corporate costs associated with Ingersoll Rand Industrial. The decrease in Adjusted EBITDA as a percentage of revenues is primarily attributable to end market challenges in the upstream oil and gas market in our High Pressure Solutions segment.Adjusted Net IncomeAdjusted Net Income increased $269.7 million to $599.0 million in 2020 compared to $329.3 million in 2019. The increase was primarily due to increased Adjusted EBITDA, partially offset by an increased income tax provision, as adjusted and higher depreciation and interest expenses.37Table of ContentsNon-GAAP Financial MeasuresSet forth below are reconciliations of net income (loss) to Adjusted EBITDA and Adjusted Net Income and cash flows from operating activities to Free Cash Flow. For additional information regarding Adjusted EBITDA and Adjusted Net Income, see “How We Assess the Performance of Our Business” above.Year Ended December 31,20202019Net Income (Loss)$(32.4)$159.1 Plus:Interest expense111.1 88.9 Provision for income taxes13.0 31.8 Depreciation expense(a)97.1 53.8 Amortization expense(b)395.8 124.3 Impairment of other intangible assets19.9 — Restructuring and related business transformation costs(c)97.9 25.6 Acquisition related expenses and non-cash charges(d)233.2 54.6 Stock-based compensation(e)50.8 20.7 Foreign currency transaction losses (gains), net20.9 8.1 Loss on extinguishment of debt(f)2.0 0.2 Shareholder litigation settlement recoveries(g)— (6.0)Establish public company financial reporting compliance— 0.6 Other adjustments(h)8.3 — Adjusted EBITDA$1,017.6 $561.7 Minus:Interest expense$111.1 $88.9 Income tax provision, as adjusted(i)192.0 77.9 Depreciation expense97.1 53.8 Amortization of non-acquisition related intangible assets18.4 11.8 Adjusted Net Income$599.0 $329.3 Free Cash FlowCash flows - operating activities$914.3 $343.3 Minus:Capital expenditures48.7 43.2 Free Cash Flow$865.6 $300.1 (a)Depreciation expense excludes $8.0 million of depreciation of rental equipment for the year ended December 31, 2020.(b)Represents $377.4 million and $112.5 million of amortization of intangible assets arising from the acquisition of Ingersoll Rand Industrial and other acquisitions (customer relationships, technology, tradenames and backlog) and $18.4 million and $11.8 million of amortization of non-acquisition related intangible assets, in each case for the years ended December 31, 2020 and 2019, respectively.(c)Restructuring and related business transformation costs consisted of the following.Year Ended December 31,20202019Restructuring charges$92.9 $17.1 Facility reorganization, relocation and other costs2.1 2.4 Other, net2.9 6.1 Total restructuring and related business transformation costs$97.9 $25.6 (d)Represents costs associated with successful and/or abandoned acquisitions, including third-party expenses, post-closure integration costs (including certain incentive and non-incentive cash compensation costs), and non-cash charges and credits arising from fair value purchase accounting adjustments.38Table of Contents(e)Represents stock-based compensation expense recognized for the year ended December 31, 2020 of $51.3 million decreased by $0.5 million due to costs associated with employer taxes. Represents stock-based compensation expense recognized for stock options outstanding for the year ended December 31, 2019 of $19.2 million increased by $1.5 million due to costs associated with employer taxes.(f)Represents losses on the extinguishment of a portion of the U.S. term loan and the amendment of the revolving credit facility.(g)Represents insurance recoveries of our shareholder litigation settlement in 2014.(h)Includes (i) effects of the amortization of prior service costs and amortization of losses in pension and other postemployment (“OPEB”) expense, (ii) certain legal and compliance costs and (iii) other miscellaneous adjustments.(i)Represents our income tax provision adjusted for the tax effect of pre-tax items excluded from Adjusted Net Income and the removal of applicable discrete tax items. The tax effect of pre-tax items excluded from Adjusted Net Income is computed using the statutory tax rate related to the jurisdiction that was impacted by the adjustment after taking into account the impact of permanent differences and valuation allowances. Discrete tax items include changes in tax laws or rates, changes in uncertain tax positions relating to prior years and changes in valuation allowances. All impacts relating to the Tax Cuts and Jobs Act of 2017 have been included as an adjustment on the “Tax law change” line of the table below.The income tax provision, as adjusted for each of the periods presented below consists of the following.Year Ended December 31,20202019Provision (benefit) for income taxes$13.0 $31.8 Tax impact of pre-tax income adjustments184.0 45.6 Discrete tax items(5.0)0.5 Income tax provision, as adjusted$192.0 $77.9 Segment ResultsAs discussed above, we reorganized our segments during the three month period ended March 31, 2020 and no longer report under the three reportable segments of Industrial, Energy and Medical. Discussed below are the results of operations for the three reorganized reportable segments of Industrial Technologies and Services, Precision and Science Technologies and High Pressure Solutions as well as our new Specialty Vehicles Technologies reportable segment. Our Corporate operations (as described below) are not discussed separately as any results that had a significant impact on operating results are included in the consolidated results discussion above.We evaluate the performance of our segments based on Segment Revenues and Segment Adjusted EBITDA. Segment Adjusted EBITDA is indicative of operational performance and ongoing profitability. Our management closely monitors Segment Adjusted EBITDA to evaluate past performance and identify actions required to improve profitability.The segment measurements provided to, and evaluated by, the Chief Operating Decision Maker (“CODM”) are described in Note 22 “Segment Information” to our audited consolidated financial statements included elsewhere in this Form 10-K.Included in our discussion of our segment results below are changes in Segment Revenues and Segment Adjusted EBITDA on a Constant Currency basis. Constant Currency information compares results between periods as if exchange rates had remained constant period over period. We define Constant Currency as changes in Segment Revenues and Segment Adjusted EBITDA excluding the impact of foreign exchange rate movements. We use these measures to determine the Constant Currency Segment Revenues and Segment Adjusted EBITDA growth on a year-on-year basis. Constant Currency Segment Revenues and Segment Adjusted EBITDA are calculated by translating current period Segment Revenues and Segment Adjusted EBITDA using prior period exchange rates. These results should be considered in addition to, not as a substitute for, results reported in accordance with GAAP. Results on a constant currency basis, as we present them, may not be comparable to similarly titled measures used by other companies and are not a measure of performance presented in accordance with GAAP.Segment Results for Years Ended December 31, 2020 and 2019The following tables display Segment Revenues, Segment Adjusted EBITDA and Segment Adjusted EBITDA Margin (Segment Adjusted EBITDA as a percentage of Segment Revenues) for each of our Segments and illustrates, on a percentage basis, the impact of foreign currency fluctuations on Segment Revenues and Segment Adjusted EBITDA growth.39Table of ContentsIndustrial Technologies and Services Segment ResultsYears Ended December 31,Percent Change202020192020 vs. 2019Segment Revenues$3,248.2 $1,700.9 91.0 %Segment Adjusted EBITDA$759.8 $391.4 94.1 %Segment Margin23.4 %23.0 %40 bps2020 vs. 2019Segment Revenues for 2020 were $3,248.2 million, an increase of $1,547.3 million, or 91.0%, compared to $1,700.9 million in 2019. The increase in Segment Revenues was primarily due to acquisitions, including Ingersoll Rand Industrial, of $1,787.4 million or 105.1% and improved pricing of $21.2 million or 1.2%, partially offset by lower volume of $260.5 million or 15.3%. The percentage of Segment Revenues derived from aftermarket parts and service was 40.2% in 2020 compared to 32.3% in 2019.Segment Adjusted EBITDA in 2020 was $759.8 million, an increase of $368.4 million, or 94.1%, from $391.4 million in 2019. Segment Adjusted EBITDA Margin increased 40 bps to 23.4% from 23.0% in 2019. The increase in Segment Adjusted EBITDA was primarily due to acquisitions, including Ingersoll Rand Industrial, of $432.4 million or 110.5%, lower selling and administrative expenses of $35.4 million or 9.0%, and improved pricing of $21.2 million or 5.4%, partially offset by lower organic sales volumes of $104.0 million or 26.6% and unfavorable margin mix of $19.1 million or 4.9%.Precision and Science Technologies Segment ResultsYears Ended December 31,Percent Change202020192020 vs. 2019Segment Revenues$725.0 $316.6 129.0 %Segment Adjusted EBITDA$220.2 $95.8 129.9 %Segment Margin30.4 %30.3 %10 bps2020 vs. 2019Segment Revenues for 2020 were $725.0 million, an increase of $408.4 million, or 129.0%, compared to $316.6 million in 2019. The increase in Segment Revenues was primarily due to acquisitions, including Ingersoll Rand Industrial, of $406.1 million or 128.3% and improved pricing of $4.7 million or 1.5%, partially offset by lower volume of $4.6 million or 1.5%. The percentage of Segment Revenues derived from aftermarket parts and service was 14.6% in 2020 compared to 4.2% in 2019.Segment Adjusted EBITDA in 2020 was $220.2 million, an increase of $124.4 million, or 129.9%, from $95.8 million in 2019. Segment Adjusted EBITDA Margin increased 10 bps to 30.4% from 30.3% in 2019. The increase in Segment Adjusted EBITDA was due primarily to acquisitions, including Ingersoll Rand Industrial, of $120.1 million or 125.4%, improved pricing of $4.7 million or 4.9% and lower selling and administrative expenses of $2.1 million or 2.2%, partially offset by lower volume of $1.8 million or 1.9%.Specialty Vehicle Technologies Segment ResultsThe Specialty Vehicle Technologies segment is entirely composed of businesses acquired as part of the Ingersoll Rand Industrial transaction. Therefore, comparative prior period information was not part of our consolidated results.Segment Revenues for 2020 were $741.4 million. The percentage of Segment Revenues derived from aftermarket parts and service was 26.0% in 2020.Segment Adjusted EBITDA in 2020 was $138.6 million. Segment Adjusted EBITDA Margin was 18.7% in 2020.40Table of ContentsHigh Pressure Solutions Segment ResultsYears Ended December 31,Percent Change202020192020 vs. 2019Segment Revenues$195.6 $434.4 (55.0)%Segment Adjusted EBITDA$12.1 $117.0 (89.7)%Segment Margin6.2 %26.9 %(2,070) bps2020 vs. 2019Segment Revenues for 2020 were $195.6 million, a decrease of $238.8 million, or 55.0%, compared to $434.4 million in 2019. The decrease in Segment Revenues was primarily due to lower volume of $220.5 million or 50.8% and lower pricing $17.3 million or 4.0%. The percentage of Segment Revenues derived from aftermarket parts and service was 86.7% in 2020 compared to 83.9% in 2019.Segment Adjusted EBITDA in 2020 was $12.1 million, a decrease of $104.9 million, or 89.7%, from $117.0 million in 2019. Segment Adjusted EBITDA Margin decreased 2,070 bps to 6.2% from 26.9% in 2019. The decrease in Segment Adjusted EBITDA was due primarily to lower volume of $73.2 million or 62.6%, lower pricing of $17.3 million or 14.8%, unfavorable margin mix of $10.6 million or 9.1% and higher selling and administrative expenses of $5.0 million or 4.3%.Unaudited Quarterly Results of Operations(in millions, except per share amounts)Year Ended December 31, 2020(1)Year Ended December 31, 2019Q1Q2Q3Q4Q1Q2Q3Q4Revenues$799.9 $1,264.4 $1,335.2 $1,510.7 $620.3 $629.1 $596.7 $605.8 Gross profit$244.5 $360.0 $482.0 $526.9 $230.5 $234.4 $221.5 $225.3 Operating income (loss)$(66.8)$(52.2)$74.3 $130.4 $80.2 $74.6 $72.9 $47.6 Net income (loss)$(36.8)$(176.6)$29.9 $151.1 $47.1 $44.9 $41.3 $25.8 Net income (loss) attributable to Ingersoll Rand Inc.$(36.8)$(177.6)$29.5 $151.6 $47.1 $44.9 $41.3 $25.8 Weighted average shares, basic277.3 417.0 417.6 418.4 201.6 203.4 204.2 204.8 Weighted average shares, diluted277.3 417.0 422.0 424.5 207.7 208.9 209.0 209.4 Basic earnings (loss) per share$(0.13)$(0.43)$0.07 $0.36 $0.23 $0.22 $0.20 $0.13 Diluted earnings (loss) per share$(0.13)$(0.43)$0.07 $0.36 $0.23 $0.21 $0.20 $0.12 Adjusted EBITDA(2)$147.8 $241.2 $284.2 $344.4 $139.0 $146.3 $141.8 $134.6 (1)See “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations – Factors Affecting the Comparability of our Results of Operations.”41Table of Contents(2)Set forth below are the reconciliations of Net Income to Adjusted EBITDAYear Ended December 31, 2020Year Ended December 31, 2019Q1Q2Q3Q4Q1Q2Q3Q4Net Income (Loss)$(36.8)$(176.6)$29.9 $151.1 $47.1 $44.9 $41.3 $25.8 Plus:Interest expense27.1 30.8 28.8 24.4 22.4 22.4 23.2 20.9 Provision (benefit) for income taxes(58.9)95.9 18.2 (42.2)12.0 8.3 9.0 2.5 Depreciation expense15.9 28.4 25.9 26.9 14.1 13.5 12.7 13.5 Amortization expense55.2 114.6 114.2 111.8 31.4 30.9 30.4 31.6 Impairment of other intangible assets— — 19.9 — — — — — Restructuring and related business transformation costs (a)42.2 32.2 12.3 11.2 4.1 2.0 9.9 9.6 Acquisition related expenses and non-cash charges (b)96.1 96.0 15.3 25.8 1.6 17.1 15.9 20.0 Environmental remediation loss reserve (c)— — — — — — — 0.1 Establish public company financial reporting compliance(d)— — — — 0.6 — — — Stock-based compensation(e)3.0 12.7 12.8 22.3 8.7 6.2 — 5.8 Loss on extinguishment of debt(f)2.0 — — — — 0.2 — — Foreign currency transaction losses (gains), net2.6 5.2 6.2 6.9 3.1 0.6 (0.6)5.0 Shareholder litigation settlement recoveries(g)— — — — (6.0)— — — Other adjustments(h)(0.6)2.0 0.7 6.2 (0.1)0.2 — (0.2)Adjusted EBITDA$147.8 $241.2 $284.2 $344.4 $139.0 $146.3 $141.8 $134.6 (a)Restructuring and related business transformation costs consist of (i) restructuring charges, (ii) severance, sign-on, relocation and executive search costs, (iii) facility reorganization, relocation and other costs, (iv) information technology infrastructure transformation, (v) gains and losses on asset disposals, (vi) consultant and other advisor fees and (vii) other miscellaneous costs.(b)Represents costs associated with successful and/or abandoned acquisitions, including third-party expenses, post-closure integration costs (including certain incentive and non-incentive cash compensation costs) and non-cash charges and credits arising from fair value purchase accounting adjustments.(c)Represents estimated environmental remediation costs and losses related to a former production facility.(d)Represents third party expenses to comply with the requirements of Sarbanes-Oxley and the accelerated adoption of the new accounting standard (ASC 842 – Leases) in the first quarter of 2019, one year ahead of the required adoption dates for a private company.(e)Represents stock-based compensation expense recognized for stock options outstanding for the year ended December 31, 2020 of $51.3 million, decreased by $0.5 million due to costs associated with employer taxes.Represents stock-based compensation expense recognized for the year ended December 31, 2019 of $19.2 million, increased by $1.5 million due to costs associated with employer taxes.(f)Represents losses on extinguishment of portions of the U.S. Term Loan, the amendment of the revolving credit facility and losses reclassified from AOCI into income related to the amendment of the interest rate swaps in conjunction with the debt repayment.(g)Represents insurance recoveries of the Company’s shareholder litigation settlement in 2014.(h)Includes (i) non-cash impact of net LIFO reserve adjustments, (ii) effects of amortization of prior service costs and amortization of losses in pension and other postemployment (“OPEB”) expense, (iii) certain legal and compliance costs and (iv) other miscellaneous adjustments.Liquidity and Capital ResourcesOur investment resources include cash on hand, cash generated from operations and borrowings under our Revolving Credit Facility. We also have the ability to seek additional secured and unsecured borrowings, subject to Credit Agreement restrictions.For a description of our material indebtedness, see Note 10 “Debt” to our audited consolidated financial statements included elsewhere in this Form 10-K.42Table of ContentsAs of December 31, 2020, we had no outstanding borrowings, $101.9 million of outstanding letters of credit under the New Revolving Credit Facility and unused availability of $998.1 million.As of December 31, 2020 and 2019 we were in compliance with all of our debt covenants and no event of default had occurred or was ongoing.LiquidityA substantial portion of our liquidity needs arise from debt service requirements, and from the ongoing cost of operations, working capital and capital expenditures.Year Ended December 31,20202019Cash and cash equivalents$1,750.9 $505.5 Short-term borrowings and current maturities of long-term debt$40.4 $7.6 Long-term debt3,859.1 1,603.8 Total debt$3,899.5 $1,611.4 We can increase the borrowing availability under the Senior Secured Credit Facilities by up to $1,600.0 million in the form of additional commitments under the Revolving Credit Facility and/or incremental term loans plus an additional amount so long as we do not exceed a specified senior secured leverage ratio. We can incur additional secured indebtedness under the Senior Secured Credit Facilities if certain specified conditions are met under the credit agreement governing the Senior Secured Credit Facilities. Our liquidity requirements are significant primarily due to debt service requirements. See Note 10 “Debt” to our audited consolidated financial statements included elsewhere in this Form 10-K for further details.Our principal sources of liquidity have been existing cash and cash equivalents, cash generated from operations and borrowings under the Senior Secured Credit Facilities and, prior to its termination, the Receivables Financing Agreement. Our principal uses of cash will be to provide working capital, meet debt service requirements, fund capital expenditures and finance strategic plans, including possible acquisitions. We may also seek to finance capital expenditures under capital leases or other debt arrangements that provide liquidity or favorable borrowing terms. We continue to consider acquisition opportunities, but the size and timing of any future acquisitions and the related potential capital requirements cannot be predicted. In the event that suitable businesses are available for acquisition upon acceptable terms, we may obtain all or a portion of the necessary financing through the incurrence of additional long-term borrowings. We may from time to time, seek to repay loans that we have borrowed, including the borrowings under the Senior Secured Credit Facilities. Based on our current level of operations and available cash, we believe our cash flow from operations, together with availability under the Revolving Credit Facility, will provide sufficient liquidity to fund our current obligations, projected working capital requirements, debt service requirements and capital spending requirements for the foreseeable future. Our business may not generate sufficient cash flows from operations or future borrowings may not be available to us under our Revolving Credit Facility in an amount sufficient to enable us to pay our indebtedness, or to fund our other liquidity needs. Our ability to do so depends on, among other factors, prevailing economic conditions, many of which are beyond our control. In addition, upon the occurrence of certain events, such as a change in control, we could be required to repay or refinance our indebtedness. We may not be able to refinance any of our indebtedness, including the Senior Secured Credit Facilities, on commercially reasonable terms or at all. Any future acquisitions, joint ventures, or other similar transactions may require additional capital and there can be no assurance that any such capital will be available to us on acceptable terms or at all.A substantial portion of our cash is in jurisdictions outside the United States. We do not assert ASC 740-30 (formerly APB 23) indefinite reinvestment of our historical non-U.S. earnings or future non-U.S. earnings. The Company records a deferred foreign tax liability to cover all estimated withholding, state income tax and foreign income tax associated with repatriating all non-U.S. earnings back to the United States. Our deferred income tax liability as of December 31, 2020 is $32.5 million which consists mainly of withholding taxes.43Table of ContentsWorking CapitalFor the Years Ended December 31,20202019Net Working CapitalCurrent assets$3,862.1 $1,543.9 Less: Current liabilities1,498.6 574.6 Net working capital$2,363.5 $969.3 Operating Working CapitalAccounts receivable and contract assets$1,027.1 $488.1 Plus: Inventories (excluding LIFO)934.8 489.5 Less: Accounts payable671.1 322.9 Less: Contract liabilities172.8 51.7 Operating working capital$1,118.0 $603.0 Net working capital increased $1,394.2 million to $2,363.5 million as of December 31, 2020 from $969.3 million as of December 31, 2019. Operating working capital increased $515.0 million to $1,118.0 million as of December 31, 2020 from $603.0 million as of December 31, 2019. Operating working capital as of December 31, 2020 was 22.8% of 2020 revenues as compared to 24.6% as of December 31, 2019 as a percentage of 2019 revenues. The increase in operating working capital was primarily due to higher accounts receivable, higher inventories and higher contract assets, partially offset by higher accounts payable and higher contract liabilities. The increase in accounts receivable was primarily due to the acquisition of Ingersoll Rand Industrial, which accounts for $599.9 million of accounts receivable and $18.2 million of contract assets as of December 31, 2020. The increase in inventory was primarily attributable to the acquisition of Ingersoll Rand Industrial of which $447.4 million is included in the December 31, 2020 balance. The increase in accounts payable was primarily due to the acquisition of Ingersoll Rand Industrial of which $410.8 million is included in the December 31, 2020 balance and the timing of vendor cash disbursements. The increase in contract liabilities was due to the acquisition of Ingersoll Rand Industrial of which $113.9 million is included in the December 31, 2020 balance.Cash FlowsThe following table reflects the major categories of cash flows for the years ended December 31, 2020 and 2019, respectively.Year Ended December 31,20202019Cash flows - operating activities$914.3 $343.3 Cash flows - investing activities(37.9)(54.3)Cash flows - financing activities328.7 (11.5)Free cash flow (1)865.6 300.1 (1)See “Non-GAAP Financial Measures” for a reconciliation to the most directly comparable GAAP measure.Operating activitiesCash provided by operating activities increased $571.0 million to $914.3 million in 2020 from $343.3 million in 2019, due to higher net income adjusted for non-cash items and from cash generated from operating working capital.Operating working capital generated cash of $263.3 million in 2020 compared to generating cash of $38.7 million in 2019. Changes in account receivables generated cash of $100.3 million in 2020 compared to generating cash of $54.7 million in 2019. Changes in contract assets used cash of $12.6 million in 2020 compared to using cash of $9.1 million in 2019. Changes in inventory generated cash of $170.8 million in 2020 compared to generating cash of $18.7 million in 2019. Changes in accounts payable used cash of $13.3 million in 2020 compared to using cash of $9.2 million in 2019. Changes in contract liabilities generated cash of $18.1 million in 2020 compared to using cash of $16.4 million in 2019.44Table of ContentsInvesting activitiesCash flows used by investing activities included capital expenditures of $48.7 million (1.0% of consolidated revenues) and $43.2 million (1.8% of consolidated revenues) in 2020 and 2019, respectively. We expect capital expenditures will be in the range of 1.5% to 2.0% of consolidated revenues in 2021. Cash acquired (paid) in business combinations was $9.0 million in 2020 and $(12.0) million in 2019. Net proceeds from the disposal of property, plant and equipment were $1.8 million and $0.9 million in 2020 and 2019, respectively.Financing activitiesCash provided by financing activities of $328.7 million in 2020 is primarily due to proceeds from long-term debt of $1,980.1 million, offset by repayments of long term debt of $1,619.1 million and payments of debt issuance costs of $47.8 million. Also included are proceeds from stock option exercises of $22.7 million and a net usage of cash of $3.0 million related to the purchase and sale of noncontrolling interests of our India subsidiary. See Note 12 “Stockholders' Equity and Noncontrolling Interests” to our audited consolidated financial statements included elsewhere in this Form 10-K for further details.Cash used in financing activities of $11.5 million in 2019 reflects repayments of long-term debt of $32.8 million, purchases of treasury stock of $18.6 million, payments of $2.3 million for contingent consideration and payment of $0.5 million of debt issuance costs, partially offset by proceeds from stock option exercises of $42.7 million.Free cash flowFree cash flow increased $565.5 million to $865.6 million in 2020 from $300.1 million in 2019 primarily due to increased cash provided by operating activities, mainly driven by the acquisition of Ingersoll Rand Industrial.Off-Balance Sheet We have no off-balance sheet arrangements that have or are materially likely to have a current or future material effect on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources.Contractual ObligationsThe following table summarizes our future minimum payments as of December 31, 2020 for all contractual obligations for years subsequent to the year ended December 31, 2020.Payments Due by PeriodContractual ObligationsTotal20212022-20232024-2025More than 5 yearsDebt(1)$3,933.1 $39.6 $79.3 $79.2 $3,735.0 Estimated interest payments(2)586.1 80.4 169.6 206.1 130.0 Finance leases17.2 0.8 1.8 2.2 12.4 Operating leases159.2 57.4 66.2 23.5 12.1 Purchase obligations(3)394.4 343.9 46.6 3.7 0.2 Total$5,090.0 $522.1 $363.5 $314.7 $3,889.7 (1)As of February 28, 2020, we entered into an additional $1,900.0 million term loan in connection with the acquisition of Ingersoll Rand Industrial and as of June 29, 2020, we entered into a $400.0 million term loan. See Note 10 “Debt” to our audited consolidated financial statements included elsewhere in this Form 10-K for further details.(2)Estimated interest payments for long-term debt were calculated as follows: for fixed-rate debt and term debt, interest was calculated based on applicable rates and payment dates; for variable-rate debt and/or non-term debt, interest rates and payment dates were estimated based on management’s determination of the most likely scenarios for each relevant debt instrument. The increase of estimated interest payments since our previously disclosed contractual obligations on Form 10-K for the fiscal year ended December 31, 2019 was due to the $1,900.0 million term loan and $400.0 million term loan as discussed above, partially offset by lower interest rate.(3)Purchase obligations consist primarily of agreements to purchase inventory or services made in the normal course of business to meet operational requirements. The purchase obligation amounts do not represent the entire anticipated purchases in the future, but represent only those items for which we are contractually obligated as of December 31, 2020. For this reason, these amounts will not provide a complete and reliable indicator of our expected future cash outflows. The increase in purchase obligations since our 45Table of Contentspreviously disclosed contractual obligations on Form 10-K for the fiscal year ended December 31, 2019 was due to the acquisition of Ingersoll Rand Industrial.Total pension and other postretirement benefit liabilities recognized on our consolidated balance sheet as of December 31, 2020 were $287.0 million. The total pension and other postretirement benefit liabilities are included in our consolidated balance sheet line items “Accrued liabilities” and “Pensions and other postretirement benefits.” Because these liabilities are impacted by, among other items, plan funding levels, changes in plan demographics and assumptions and investment return on plan assets, these liabilities do not represent expected liquidity needs. Accordingly, we did not include these liabilities in the “Contractual Obligations” table above.We fund our U.S. qualified pension plans in accordance with the Employee Retirement Income Security Act of 1974 regulations for the minimum annual required contribution and Internal Revenue Service regulations for the maximum annual allowable tax deduction. We are committed to making the required minimum contributions and expect to contribute a total of approximately $0.1 million to our U.S. qualified pension plans during 2021. Furthermore, we expect to contribute a total of approximately $3.3 million to our postretirement life insurance benefit plans during 2021. Future contributions are dependent upon various factors including the performance of the plan assets, benefit payment experience and changes, if any, to current funding requirements. Therefore, no amounts were included in the “Contractual Obligations” table related to expected plan contributions. We generally expect to fund all future contributions to our plans with cash flows from operating activities.Our non-U.S. pension plans are funded in accordance with local laws and income tax regulations. We expect to contribute a total of approximately $8.2 million to our non-U.S. qualified pension plans during 2021. No amounts have been included in the “Contractual Obligations” table related to these plans due to the same reasons indicated above.Disclosure of amounts in the “Contractual Obligations” table regarding expected benefit payments in future years for our pension plans and other postretirement benefit plans cannot be properly reflected due to the ongoing nature of the obligations of these plans. We currently anticipate the annual benefit payments for the U.S. plans to be in the range of approximately $29.7 million to $42.1 million for the next several years, and the annual benefit payments for the non-U.S. plans to be in the range of approximately $13.1 million to $16.8 million for the next several years.ContingenciesWe are a party to various legal proceedings, lawsuits and administrative actions, which are of an ordinary or routine nature for a company of our size and in our sector. We believe that such proceedings, lawsuits and administrative actions will not materially adversely affect our operations, financial condition, liquidity or competitive position. We have accrued liabilities and other liabilities on our consolidated balance sheet, including a total litigation reserve of $131.4 million as of December 31, 2020 with respect to potential liability arising from our asbestos-related litigation. Other than our asbestos-related litigation reserves, we only have de minimis accrued liabilities and other liabilities on our consolidated balance sheet with respect to other legal proceedings, lawsuits and administrative actions. A more detailed discussion of certain of these proceedings, lawsuits and administrative actions is set forth in “Item 3. Legal Proceedings.”Critical Accounting PoliciesAccounting policies discussed in this section are those that we consider to be the most critical to an understanding of our financial statements because they involve significant judgments and uncertainties. Certain of these policies include estimates and assumptions. These estimates reflect our best judgment about current, and for some estimates, future economic and market conditions and their effect based on information available as of the date of these financial statements. If these conditions change from those expected, it is reasonably possible that the judgments and estimates described below could change, which may result in future impairments of goodwill, intangibles and long-lived assets, increases in reserves for contingencies, establishment of valuation allowances on deferred tax assets and increase in tax liabilities, among other effects. Also see Note 1 “Summary of Significant Accounting Policies” to our audited consolidated financial statements included elsewhere in this Form 10-K, which discusses the significant accounting policies that we have selected from acceptable alternatives.Business CombinationsWe apply the acquisition method of accounting with respect to the identifiable assets and liabilities of a business combination and record the assets acquired and liabilities assumed at their estimated fair values as of the acquisition date. The excess of the cost of the acquired business and the fair value of the assets acquired and liabilities assumed is recognized as goodwill. Estimates of fair value represent management’s best estimate of assumptions and about future events and uncertainties, including 46Table of Contentssignificant judgments related to future cash flows, discount rates, competitive trends, margin and revenue growth assumptions including royalty rates and customer attrition rates, market comparables and others. Inputs used are generally obtained from historical data supplemented by current and anticipated market conditions and growth rates.Significant judgment is required in estimating the fair value of identifiable intangible assets and in assigning their respective useful lives. The fair value estimates are based on historical information and on future expectations and assumptions deemed reasonable by management, but which are inherently uncertain. See Note 3 “Business Combinations” to our consolidated financial statements included elsewhere in this Form 10-K for further information regarding the fair value determination of each of the classes of identifiable intangible assets. Determining the useful life of an intangible asset also requires judgment. Certain intangibles are expected to have indefinite lives while certain other identifiable intangible assets have determinable lives. The useful lives of identifiable intangibles with determinable useful lives is based on a variety of factors, including but not limited to, the competitive environment, product cycles, order life cycles, historical customer attrition rates, market share, operating plans and the macroeconomic environment. The costs of determinable-lived intangible assets are amortized to expense over the estimated useful life.Impairment of Goodwill and Other Identified Intangible AssetsWe test goodwill for impairment annually in the fourth quarter of each year using data as of October 1 of that year and whenever events or changes in circumstances indicate that the carrying value may not be recoverable. Upon adoption of ASU 2019-04, the impairment test consists of comparing the fair value of the reporting unit to the carrying value of the reporting unit. An impairment charge is recognized for the amount by which the carrying amount exceeds the reporting unit’s fair value; provided, the loss recognized cannot exceed the total amount of goodwill allocated to the reporting unit. If applicable, we consider income tax effects from any tax deductible goodwill on the carrying amount of the reporting unit when measuring the goodwill impairment loss. We determined fair values for all of the reporting units using a combination of the income and market multiples approaches which are weighted 75% and 25%, respectively.Under the income approach, fair value is determined based on the present value of estimated future cash flows, discounted at an appropriate risk-adjusted rate. We use our internal forecasts to estimate future cash flows and include an estimate of long-term future growth rates based on our most recent views of the long-term outlook for each business. Actual results may differ from those assumed in our forecasts. We derive our discount rates using a capital asset pricing model and analyzing published rates for industries relevant to our reporting units to estimate the cost of equity financing. We use discount rates that are commensurate with the risks and uncertainty inherent in the respective businesses and in our internally developed forecasts. Discount rates used in our 2020 reporting unit valuations ranged from 8.5% to 9.5%. Additionally, we assumed 3.0% terminal growth rates for all reporting units, except a single reporting unit in which we determined it most appropriate to assume an 2.0% terminal growth rate due to it being closely aligned to the GDP percentage growth rate.Under the market multiples approach, fair value is determined based on multiples derived from the stock prices of publicly traded guideline companies to develop a business enterprise value (“BEV”) for our reporting units. The application of the market multiples method entails the development of book value multiples based on the market value of the guideline companies. The multiples are developed by first calculating the market value of equity of the guideline companies and then adjusting these multiples for cash and debt to arrive at a BEV multiple. Identifying appropriate guideline companies and computing appropriate market multiples is subjective. We considered various public companies that had reasonably similar qualitative factors as our reporting units while also considering quantitative factors such as revenue growth, profitability and total assets.The excess of the estimated fair value over carrying value (expressed as a percentage of carrying value) for two of our reporting units were between 4% and 6%, primarily due to the timing of the acquisition of Ingersoll Rand Industrial relative to our annual impairment test. For all other reporting units, this excess was a minimum of 25%. With each reporting unit’s fair value in excess of its carrying value, no goodwill impairment was recorded.We annually test intangible assets with indefinite lives for impairment utilizing a discounted cash flow valuation referred to as the relief from royalty method. We estimated forecasted revenues for a period of five years with discount rates ranging from 9.0% to 10.0%, terminal growth rates of 2.0 % to 3.0%, and royalty rates ranging from 1.0% to 4.0%. As a result of this test, the Company recognized an impairment in 2020 of $19.9 million to reduce the carrying value of two tradenames in the Industrial Technologies and Services segment.We review identified intangible assets with defined useful lives and subject to amortization for impairment whenever events or changes in circumstances indicate that the related carrying amounts may not be recoverable. Determining whether an impairment 47Table of Contentsloss occurred requires comparing the carrying amount to the sum of undiscounted cash flows expected to be generated by the asset.Also see Note 8 “Goodwill and Other Intangible Assets” to our audited consolidated financial statements included elsewhere in this Form 10-K.Income TaxesOur annual tax rate is based on our income, statutory tax rates and tax planning opportunities available to us in the various jurisdictions in which we operate. Tax laws are complex and subject to different interpretations by the taxpayer and respective governmental taxing authorities. Significant judgment is required in determining our tax expense and in evaluating our tax positions, including evaluating uncertainties. We review our tax positions quarterly and adjust the balances as new information becomes available.On December 22, 2017, the Tax Act was enacted into law and the new legislation contains several key tax provisions that affected the Company, including a one-time mandatory transition tax on accumulated foreign earnings and a reduction of the corporate income tax rate to 21% effective January 1, 2018, among others. The Company was required to recognize the effect of the Tax Act in the period of enactment. This included the determination of the transition tax, remeasurement of the Company’s U.S. deferred tax assets and liabilities as well as the reassessment of the net realizability of the Company’s deferred tax assets and liabilities. In December 2017, the SEC staff issued Staff Accounting Bulletin No. 118, Income Tax Accounting Implications of the Tax Cuts and Job Act (“SAB 118”), which allowed the Company to record provisional amounts during a measurement period not to extend more than one year subsequent to the enactment date. As a result, the Company previously provided a provisional estimate of the effect of the Tax Act in its financial statements for 2017 and through the first nine months of 2018. In the fourth quarter of 2018, the Company completed its accounting for all of the enactment-date income tax effects of the Tax Act and increased the total benefit taken in 2017 of $95.3 million to $96.5 million. Due to the Tax Act, the total U.S. deferred changed from a tax benefit of $89.6 million in 2017 to $74.5 million in 2018, with a 2018 measurement-period adjustment of $15.1 million. The ASC 740-30 (formally APB 23) liability reduction, relating to the permanently reinvested earnings in foreign subsidiaries assertion, changed from a tax benefit of $69.0 million in 2017 to $72.5 million in 2018, with a 2018 measurement-period adjustment of $3.5 million due to the policy change that occurred in 2018. The provisional one-time transition tax of $63.3 million in 2017 decreased to $50.5 million in 2018, with a 2018 measurement-period adjustment of $12.8 million. The total $1.2 million benefit had a (0.3)% impact to the overall rate in 2018.The Tax Act creates a new requirement that certain income (i.e., Global intangible low taxed income (“GILTI”)) earned by controlled foreign corporations (“CFC”) must be included currently in the gross income of the CFCs’ U.S. shareholder. GILTI is the excess of the shareholder’s “net CFC tested income” over the net deemed tangible income return, which is currently defined as the excess of (1) 10% of the aggregate of the U.S. shareholder’s pro rata share of the qualified business asset investment of each CFC with respect to which it is a U.S. shareholder over (2) the amount of certain interest expense taken into account in the determination of net CFC-tested income.Under U.S. GAAP, the Company is allowed to make an accounting policy choice of either (1) treating taxes due on future U.S. inclusions in taxable income related to GILTI as a current-period expense when incurred (the “period cost method”) or (2) factoring such amounts into a company’s measurement of its deferred taxes (the “deferred method”). The Company has determined that it will follow the period cost method (option 1 above) going forward. The tax provision for the year ended December 31, 2020 reflects this decision. All of the additional calculations and rule changes found in the Tax Act have been considered in the tax provision for the year ended December 31, 2020. The Company recorded a tax expense of $5.3 million in 2020 for the GILTI provisions of the Tax Act that were effective for the first time during 2018.Deferred income tax assets represent amounts available to reduce income taxes payable on taxable income in future years. Such assets arise because of temporary differences between the financial reporting and tax bases of assets and liabilities, as well as from net operating loss and tax credit carryforwards. We evaluate the recoverability of these future tax deductions and credits by assessing the adequacy of future expected taxable income from all sources, including reversal of taxable temporary differences, forecasted operating earnings and available tax planning strategies. These sources of income rely heavily on estimates. To the extent we do not consider it more likely than not that a deferred tax asset will be recovered, a valuation allowance is established. Amounts recorded for deferred tax assets related to tax attribute carryforwards, net of valuation allowances, were $40.7 million and $12.7 million as of December 31, 2020 and 2019, respectively, with the increase related to the Ingersoll Rand Industrial acquisition.48Table of ContentsLoss ContingenciesLoss contingencies are uncertain and unresolved matters that arise in the ordinary course of business and result from events or actions by others that have the potential to result in a future loss. Such contingencies include, but are not limited to, asbestos and silica related litigation, environmental obligations, litigation, regulatory proceedings, product quality and losses resulting from other events and developments.When a loss is considered probable and reasonably estimable, we record a liability in the amount of our best estimate for the ultimate loss. When there appears to be a range of possible costs with equal likelihood, liabilities are based on the low-end of such range. However, the likelihood of a loss with respect to a particular contingency is often difficult to predict and determining a meaningful estimate of the loss or a range of loss may not be practicable based on the information available and the potential effect of future events and decisions by third parties that will determine the ultimate resolution of the contingency. In particular, as it relates to estimating asbestos and silica contingencies, there are a number of key variables and assumptions including the number and type of new claims to be filed each year, the resolution or outcome of these claims, the average cost of resolution of each new claim, the amount of insurance available, allocation methodologies, the contractual terms with each insurer with whom we have reached settlements, the resolution of coverage issues with other excess insurance carriers with whom we have not yet achieved settlements and the solvency risk with respect to our insurance carriers. Moreover, it is not uncommon for such matters to be resolved over many years, during which time relevant developments and new information must be continuously evaluated to determine both the likelihood of potential loss and whether it is possible to reasonably estimate a range of possible loss. When a loss is probable but a reasonable estimate cannot be made, disclosure is provided.Disclosure also is provided when it is reasonably possible that a loss will be incurred or when it is reasonably possible that the amount of a loss will exceed the recorded provision. We regularly review all contingencies to determine whether the likelihood of loss has changed and to assess whether a reasonable estimate of the loss or range of loss can be made. As discussed above, development of a meaningful estimate of loss or a range of potential loss is complex when the outcome is directly dependent on negotiations with or decisions by third parties, such as regulatory agencies, the court system and other interested parties. Such factors bear directly on whether it is possible to reasonably estimate a range of potential loss and boundaries of high and low.Recent Accounting PronouncementsSee Note 2 “New Accounting Standards” to our audited consolidated financial statements included elsewhere in this Form 10-K for a discussion of recent accounting standards.ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKInterest Rate RiskWe are exposed to interest rate risk as a result of our variable-rate borrowings. We manage our exposure to interest rate risk by maintaining a mixture of fixed and variable debt, and from time to time, use pay-fixed interest rate swaps as cash flow hedges of our variable rate debt in order to adjust the relative fixed and variable portions.As of December 31, 2020, we had variable rate debt outstanding of $3,933.1 million at a current weighted average interest rate of approximately 2.0%, substantially all of which was incurred under our Senior Secured Credit Facility, under which an aggregate of $3,204.4 million was outstanding under the $1,900.0 million Dollar Term Loan B, $927.6 million Dollar Term Loan and $400.0 million Dollar Term Loan Series A, as well as €596.7 million outstanding under the €601.2 million Euro Term Loan Facility.The Dollar Term Loan Facility and the Euro Term Loan Facility bear interest primarily based on LIBOR and EURIBOR, respectively, plus a spread. The Dollar Term Loan Facility is subject to a 0% LIBOR base rate floor and the Euro Term Loan Facility is subject to a 0% EURIBOR base rate floor. Thus, the interest rate on the Dollar Term Loan Facility and the Euro Term Loan Facility will fluctuate when LIBOR or EURIBOR, respectively, exceeds that percentage. As of December 31, 2020, LIBOR was higher than the 0% floor and EURIBOR was lower than the 0% floor.We use interest rate swaps from time to time to offset our exposure to interest rate movements. These outstanding interest rate swaps qualify and are designated as cash flow hedges of forecasted LIBOR-based interest payments. As of December 31, 2020, we had no fixed-floating interest rate swaps. See Note 18 “Hedging Activities, Derivative Instruments and Credit Risk” to our audited consolidated financial statements included elsewhere in this Form 10-K.49Table of ContentsThe following table presents the impact of hypothetical changes in market interest rates across the yield curve by 100 basis points, including the effect of our interest rate swaps for the years ended December 31, 2020 and 2019 on our interest expense.Year Ended December 31,20202019Increase (decrease) in market interest rates100 basis points$35.1 $4.7 (100) basis points(1) (2)(4.7)(1.0)(1)A decrease in interest rates would not have impacted our interest expense in 2020 on EURIBOR debt which was lower than the 0% base rate floor under the Senior Secured Credit Facility for the entire fiscal year 2020, but would have impacted interest expense in 2020 on LIBOR debt which was higher than the 0% based rate floors under the Senior Secured Credit Facility for the year ended December 31, 2020.(2)A decrease in interest rates would not have impacted our interest expense in 2019 on EURIBOR debt which was lower than the 0% base rate floor under the Senior Secured Credit Facility for the entire fiscal year 2019, but would have impacted interest expense in 2019 on LIBOR debt which was higher than the 0% based rate floors under the Senior Secured Credit Facility for the year ended December 31, 2019.Foreign Currency RiskWe are exposed to foreign currency risks that arise from our global business operations. Changes in foreign currency exchange rates affect the translation of local currency balances of foreign subsidiaries, transaction gains and losses associated with intercompany loans with foreign subsidiaries and transactions denominated in currencies other than a subsidiary’s functional currency. In 2020, the relative strengthening of the U.S. dollar against foreign currencies had an unfavorable impact on our revenues and results of operations while in 2019, the relative weakening of the U.S. dollar against foreign currencies had a favorable impact on our revenues and results of operations. While future changes in foreign currency exchange rates are difficult to predict, our revenues and earnings may be adversely affected if the U.S. dollar strengthens against foreign currencies.We seek to minimize our exposure to foreign currency risks through a combination of normal operating activities, including by conducting our international business operations primarily in their functional currencies to match expenses with revenues and the use of foreign currency forward exchange contracts and net investment hedges. In addition, to mitigate the risk arising from entering into transactions in currencies other than our functional currencies, we typically settle intercompany trading balances at least quarterly.The table below presents the percentage of revenues and gross profit by functional currency for the years ended December 31, 2020 and 2019.U.S. DollarEuroBritish PoundChinese RenminbiOtherYears Ended December 31, 2020Revenues51 %24 %3 %12 %10 %Gross profit47 %27 %3 %15 %8 %Years Ended December 31, 2019Revenues44 %31 %5 %6 %14 %Gross profit42 %35 %6 %7 %10 %We utilize foreign currency denominated debt obligations supplemented from time to time with cross currency interest rate swaps designated as net investment hedges to selectively hedge portions of our investment in non-U.S. subsidiaries. The currency effects of the designated debt obligations and cross currency interest rate swaps are reflected in accumulated other comprehensive income within our stockholders’ equity, where they partially offset the currency translation effects of our investments in non-U.S. subsidiaries, which in turn partially offset gains and losses recorded on our net investments globally. These currency translation effects and offsetting impacts of our derivatives for the years ended December 31, 2020 and 2019 are summarized in Note 13 “Accumulated Other Comprehensive Income (Loss)” to our audited consolidated financial statements included elsewhere in this Form 10-K.We also enter into foreign currency forward contracts to manage the risk arising from transaction gains and losses associated with intercompany loans with foreign subsidiaries. Our foreign currency forward contracts are typically short-term and are rolled 50Table of Contentsforward as necessary upon settlement. As of December 31, 2020, we were party to ten foreign currency forward contracts, all of which are carried on our balance sheet at fair value. See Note 18 “Hedging Activities, Derivative Instruments and Credit Risk” to our audited consolidated financial statements included elsewhere in this Form 10-K.The table below presents, for the year ended December 31, 2020, the hypothetical effect of a 10% appreciation in the average exchange rate of the U.S. dollar relative to the principal foreign currencies in which our revenues and gross profit are denominated.Year Ended December 31, 2020EuroBritish PoundChinese RenminbiRevenues$(116.3)$(16.2)$(59.4)Gross profit(43.1)(5.7)(23.9)51Table of Contents
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+Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations in our 2019 Annual Report on Form 10-K, which was filed with the U.S. Securities and Exchange Commission on February 6, 2020. 47Overview We are a provider of marketplace infrastructure, data services and technology solutions to a broad range of customers including financial institutions, corporations and government entities. These products, which span major asset classes including futures, equities, fixed income and U.S. residential mortgages, provide our customers with access to mission critical workflow tools that are designed to increase asset class transparency and workflow efficiency. We report our results in three segments: Exchanges, Fixed Income and Data Services, and Mortgage Technology. The majority of our identifiable assets are located in the U.S. and U.K.•In our Exchanges segment, we operate regulated marketplaces for the listing, trading and clearing of a broad array of derivatives contracts and financial securities. Much of the revenue reported in the Exchanges segment was previously reported in our Trading & Clearing segment. However, data services revenues and listings revenues, which are now reported in the Exchanges segment, were previously reported in our Data & Listings segment.•In our Fixed Income and Data Services segment, we provide fixed income pricing, reference data, indices and execution services as well as global CDS clearing and multi-asset class data delivery solutions. Our CDS Clearing and ICE Bonds transaction revenue was previously reported in our Trading & Clearing segment, while all of our Fixed Income Data & Analytics and Other Data & Network Services revenues were reported in our Data & Listings segment.•In our Mortgage Technology segment, we provide an end-to-end technology platform that offers customers comprehensive, digital workflow tools that aim to address the inefficiencies that exist in the U.S. residential mortgage market. Prior to the re-alignment of our business, ICE Mortgage Technology was reported in our Trading & Clearing segment.Recent Developments COVID-19The coronavirus (COVID-19) pandemic has created economic and financial disruptions globally and has led governmental authorities to take unprecedented measures to mitigate the spread of the disease, including travel bans, border closings, business closures, quarantines and shelter-in-place orders, and to take actions designed to stabilize markets and promote economic growth. From an operational perspective, our businesses, including our exchanges, clearing houses, listing venues, data services businesses, and mortgage platforms, have remained open and we do not have any plans to close any of our business operations as a result of the COVID-19 pandemic. However, due to the COVID-19 pandemic, we have taken preventative measures and implemented contingency plans, and currently most of our employees are working remotely. In response to government mandates, we closed all of our office facilities between early March and late April 2020, with only our operationally essential employees working on-site at our facilities for business continuity purposes. As various governments began easing orders requiring office closures in late April, we began a phased re-opening of certain of our office facilities allowing a limited number of operationally non-essential workers to also work on-site. These measures are in compliance, as necessary, with local government directives and social distancing directives. We continue to monitor local government mandates in determining our office re-openings, re-closures and work-related travel.Global health concerns relating to COVID-19 and preventive measures taken to reduce its spread have created significant volatility in financial markets, which has resulted in higher trading volumes for some of our products and increased demand for our services. The extent of the impact of the pandemic on our business will depend largely on future developments, including the duration, spread and severity of the outbreak, the distribution, public acceptance and widespread use and effectiveness of vaccines against COVID-19 and the actions taken to contain the spread of the disease or mitigate its impact. We continue to monitor this dynamic situation, including guidance and regulations issued by U.S. and other governmental authorities. In light of the continually evolving nature of the COVID-19 outbreak, we are not able at this time to estimate the ultimate effect of the pandemic on our business, results of operations or financial condition in the future. Acquisition of Ellie MaeOn September 4, 2020, we acquired Ellie Mae for aggregate consideration of $11.4 billion from private equity firm Thoma Bravo. Ellie Mae is a cloud-based technology solution provider for the mortgage finance industry. Through its digital lending platform, Ellie Mae provides technology solutions to participants in the mortgage supply chain, including over 483,000 customers and thousands of partners and investors who participate on its open network. Originators rely on Ellie Mae to securely manage the exchange of data across the mortgage ecosystem to enable the origination of mortgages while adhering to various local, state and federal compliance requirements. Ellie Mae is a part of our ICE Mortgage Technology business and is included in our Mortgage Technology segment. From the acquisition date through December 31, 2020, Ellie Mae revenues of $351 million and operating expenses of $250 million were recorded for the year ended December 31, 2020, which are reflected in our mortgage technology revenues and operating expenses, respectively.The purchase price consisted of $9.5 billion in cash, as adjusted for $335 million of cash and cash equivalents held by Ellie Mae on the date of acquisition, and approximately $1.9 billion, or approximately 18.4 million shares of our common stock, based on our stock price on the acquisition date. ICE funded the cash portion of the purchase price with net proceeds from our offering of new senior notes in August 2020, together with the issuance of commercial paper and borrowings under a new senior unsecured term loan facility.Acquisition of Bridge2 SolutionsOn February 21, 2020, our Bakkt subsidiary acquired Bridge2 Solutions, a leading provider of loyalty solutions for merchants and consumers. Bridge2 Solutions enables some of the world’s leading brands to engage customers and drive loyalty. It powers incentive and employee perk programs for companies across a wide spectrum of industries.Bakkt TransactionAdditionally, on January 11, 2021, Bakkt, our majority-owned indirect subsidiary, entered into a definitive agreement and plan of merger, or the Merger Agreement, to combine with VPC Impact Acquisition Holdings, or VIH, a special purpose acquisition company sponsored by Victory Park Capital. Pursuant to the terms and subject to the conditions set forth in the Merger Agreement, VIH plans to domesticate and become a Delaware corporation (the “Domestication”) and be renamed “Bakkt Holdings, Inc.” (“Bakkt Pubco”) and, following the Domestication, a subsidiary of VIH plans to merge with and into Bakkt (the “Merger”), with Bakkt surviving the Merger. Upon the consummation of the Merger (the “Closing”), Bakkt Pubco plans to be organized in an “Up-C” structure in which substantially all of the assets and the business of Bakkt Pubco will be held by Bakkt and its subsidiaries, and Bakkt Pubco’s only direct assets will consist of its membership interests in Bakkt. Upon the Closing, Bakkt Pubco is expected to have a class of common stock listed on the New York Stock Exchange.Also on January 11, 2021, concurrently with the execution of the Merger Agreement, VIH entered into subscription agreements with certain investors (collectively, the “PIPE Investors”), pursuant to which, and on the terms and subject to the conditions of which, the PIPE Investors have collectively subscribed for additional equity in Bakkt Pubco for an aggregate purchase price equal to $325 million (the “PIPE Investment”). The PIPE Investors include ICE, and we committed to purchase additional equity in Bakkt Pubco that would comprise up to $50 million of the PIPE Investment. The PIPE Investment will be consummated immediately prior to the Closing.As part of the transaction, Bakkt’s existing equity holders and management will roll 100% of their equity into the combined company. Assuming no shareholders of VIH exercise their redemption rights, current Bakkt equity holders, including ICE, will own approximately 78% of the combined company, VIH’s public shareholders will own approximately 8%, VPC will own 2%, and PIPE investors (a group that will also include us) will own approximately 12% of the issued and outstanding common stock of the combined company at closing; ICE is expected to have a 65% economic interest in the combined company at the Closing, which is expected to occur in the second quarter of 2021. The proposed transaction is subject to customary closing conditions, including the approval of VIH’s shareholders and certain regulatory approvals. At the Closing, ICE, which is expected to own a majority of the common stock of the Bakkt Pubco immediately following the Merger, will enter into a voting agreement with Bakkt Pubco (the “Voting Agreement”). Pursuant to the Voting Agreement, for so long as we own at least 50% of the total voting power of Bakkt Pubco common stock, we will agree to vote on any matter submitted to a vote or consent of the stockholders of Bakkt Pubco any shares of common stock of Bakkt Pubco owned by us in excess of 30% of the outstanding voting power of Bakkt Pubco, in the same percentages, for and against the relevant matter, as votes are cast by all stockholders of Bakkt Pubco other than ICE. As a consequence of the Voting Agreement and Bakkt Pubco’s other governance arrangements, following the Closing, we expect to reclassify Bakkt Pubco as our equity method investment and Bakkt will therefore cease to be consolidated with our financial statements.Consolidated Financial HighlightsThe following summarizes our results and significant changes in our consolidated financial performance for the periods presented (dollars in millions, except per share amounts): 49Year Ended December 31,Year Ended December 31,20202019Change20192018ChangeRevenues, less transaction-based expenses $6,036 $5,202 16 %$5,202 $4,979 4 %Operating expenses $3,003 $2,529 19 %$2,529 $2,396 6 %Adjusted operating expenses(1)$2,495 $2,189 14 %$2,189 $2,071 6 %Operating income $3,033 $2,673 13 %$2,673 $2,583 3 %Adjusted operating income(1)$3,541 $3,013 18 %$3,013 $2,908 4 %Operating margin 50 %51 %(1 pt)51 %52 %(1 pt)Adjusted operating margin(1)59 %58 %1 pt58 %58 %— Other income (expense), net $(267)$(192)39 %$(192)$(63)203 %Income tax expense (benefit)$658 $521 26 %$521 $500 4 %Effective tax rate 24 %21 %3 pts21 %20 %1 ptNet income attributable to ICE$2,089 $1,933 8 %$1,933 $1,988 (3)%Adjusted net income attributable to ICE(1)$2,500 $2,194 14 %$2,194 $2,077 6 %Diluted earnings per share attributable to ICE common stockholders$3.77 $3.42 10 %$3.42 $3.43 — %Adjusted diluted earnings per share attributable to ICE common stockholders(1)$4.51 $3.88 16 %$3.88 $3.59 8 %Cash flows from operating activities$2,881 $2,659 8 %$2,659 $2,533 5 %(1) The adjusted figures exclude items that are not reflective of our ongoing core operations and business performance. Adjusted net income attributable to ICE and adjusted diluted earnings per share attributable to ICE common stockholders are presented net of taxes. These adjusted numbers are not calculated in accordance with U.S. Generally Accepted Accounting Principles, or GAAP. See “- Non-GAAP Financial Measures” below. 50•Revenues, less transaction-based expenses, increased $834 million in 2020 from 2019. The increase in revenues includes $7 million in favorable foreign exchange effects arising from the weaker U.S. dollar in 2020 from 2019.•Revenues, less transaction-based expenses, increased $223 million in 2019 from 2018. The increase in revenues includes $34 million in unfavorable foreign exchange effects arising from the stronger U.S. dollar in 2019 from 2018. •Operating expenses increased $474 million in 2020 from 2019. The increase in operating expenses includes $2 million in unfavorable foreign exchange effects arising from the weaker U.S. dollar in 2020 from 2019.•Operating expenses increased $133 million in 2019 from 2018. The increase in operating expenses includes $14 million in favorable foreign exchange effects arising from the stronger U.S. dollar in 2019 from 2018.•In connection with our acquisition of MERS, we recorded a $110 million gain in other income during 2018.•The effective tax rate in 2020 is higher than the effective tax rate in 2019 primarily due to U.K. tax law changes enacted in July 2020, partially offset by favorable state apportionment changes as a result of our acquisition of Ellie Mae, as well as favorable changes in certain international tax provisions as part of the U.S. Federal Tax Cuts and Jobs Act, or TCJA, in 2019.•The effective tax rate in 2019 was higher than the effective tax rate in 2018 primarily due to the 2018 discrete tax benefits from the acquisition of MERS and the divestiture of Trayport exceeding the net increased tax benefits recorded in 2019 from certain international tax provisions under the TCJA.Business Environment and Market TrendsOur business environment has been characterized by:•globalization of marketplaces, customers and competitors;•growing customer demand for workflow efficiency and automation; •commodity, interest rate and financial markets uncertainty;•growing demand for data to inform customers' risk management and investment decisions;•evolving, increasing and disparate regulation across multiple jurisdictions;•price volatility increasing customers' demand for risk management services;•increasing focus on capital and cost efficiencies;•customers' preference to manage risk in markets demonstrating the greatest depth of liquidity and product diversity;•the evolution of existing products and new product innovation to serve emerging customer needs and changing industry agreements;•rising demand for speed, data, data capacity and connectivity by market participants, necessitating increased investment in technology; and•consolidation and increasing competition among global markets for trading, clearing and listings.Recent changes with regard to global financial reform have emphasized the importance of transparent markets, centralized clearing and access to data, all of which are important aspects of our product offering. However, some of the proposed rules have yet to be implemented and some rules that have already been partially implemented are being reconsidered. In addition, some of the global regulations have not been fully harmonized and several non-U.S. regulations are inconsistent with U.S. rules. As the evolution continues, legislative and regulatory actions may change the way we conduct our business and may create uncertainty for market participants, which could affect trading volumes or demand for market data. As a result, it is difficult to predict all of the effects that the legislation and its implementing regulations will have on us. As discussed more fully in Item 1 “- Business - Regulation” included in this Annual Report, Brexit, the implementation of MiFID II and other regulations may result in operational, regulatory and/or business risk.We have diversified our business so that we are not dependent on volatility or transaction activity in any one asset class. In addition, we have increased our portion of non-transaction and clearing revenues from 34% in 2014 to 48% in 2020. This non-transaction revenue includes data services, listings and various mortgage technology solutions.Many of the data products we sell and services we provide are required for our clients’ business operations regardless of market volatility or shifts in business profitability levels. We anticipate that there will continue to be growth in the financial information services sector driven by a number of global trends, including the following: 51•increasing global regulatory demands; •greater use of fair value accounting standards and reliance on independent valuations; •greater emphasis on risk management; •market fragmentation driven by regulatory changes; •the move to passive investing and indexation; •ongoing growth in the size and diversity of financial markets; •increased automation of fixed income and other less automated markets; •the development of new data products; •the demand for greater data capacity and connectivity; •new entrants; and •increasing demand for outsourced services by financial institutions.We continue to focus on our strategy to grow each of our revenue streams, and prudently manage expenses, in order to mitigate these uncertainties and to build on our growth opportunities by leveraging our proprietary data, clearing, markets and technology solutions.Segment Results We previously operated as two reportable business segments, but effective October 1, 2020, we realigned our businesses as part of a review of, and changes in, our organizational structure following our acquisition of Ellie Mae. As a result, we changed our internal financial reporting and determined that a change in reportable segments had occurred. Prior periods have been adjusted to reflect this change. Our segments do not engage in intersegment transactions.As of December 31, 2020, our business is conducted through three reportable business segments, comprised of the following: •Our Exchanges segment includes our trade execution and clearing within our global futures network and NYSE businesses, various data and connectivity services that are directly related to those exchange platforms, administration fees and our NYSE listings business. Trade execution and clearing products include energy, agricultural and metals, financial futures and options, cash equities, equity options, OTC and other; •Our Fixed Income and Data Services segment includes trade execution and clearing within our ICE Bonds and CDS businesses, pricing and reference data, analytics, indices, consolidated feeds and our ICE Global Network businesses; and•Our Mortgage Technology segment includes our MERS, Simplifile and Ellie Mae mortgage services businesses. This segment includes origination technology, network and closing solutions, data and analytics, registrations and other.While revenues are recorded specifically in the segment in which they are earned or to which they relate, a significant portion of our operating expenses are not solely related to a specific segment because the expenses serve functions that are necessary for the operation of more than one segment. We directly allocate expenses when reasonably possible to do so. Otherwise, we use a pro-rata revenue approach as the allocation method for the expenses that do not relate solely to one segment and serve functions that are necessary for the operation of all segments. Our October 1, 2020 change in business segment presentation triggered a reallocation of our segment operating expenses. Prior periods have been adjusted to reflect this change.For details on trends in recent prior year periods, refer to our 2019 and 2018 Annual Reports on Form 10-K.52Exchanges SegmentThe following presents selected statements of income data for our Exchanges segment (dollars in millions):(1) The adjusted numbers in the charts above are calculated by excluding items that are not reflective of our cash operations and core business performance. As a result, these adjusted numbers are not calculated in accordance with U.S. GAAP. See “- Non-GAAP Financial Measures” below.53Year Ended December 31,Year Ended December 31,20202019Change20192018ChangeRevenues:Energy futures and options$1,120 $992 13 %$992 $965 3 %Agricultural and metals futures and options245 251 (2)251 251 — Financial futures and options357 332 8 332 354 (6)Futures and options1,722 1,575 9 1,575 1,570 — Cash equities and equity options2,585 1,643 57 1,643 1,624 1 OTC and other 296 233 27 233 227 2 Transaction and clearing, net 4,603 3,451 33 3,451 3,421 1 Data and connectivity services790 752 5 752 708 6 Listings446 449 (1)449 444 1 Revenues5,839 4,652 26 4,652 4,573 2 Transaction-based expenses(1) 2,208 1,345 64 1,345 1,297 4 Revenues, less transaction-based expenses3,631 3,307 10 3,307 3,276 1 Other operating expenses965 874 10 874 866 1 Depreciation and amortization 261 265 (2)265 246 8 Acquisition-related transaction and integration costs16 1 n/a1 2 (64)Operating expenses1,242 1,140 9 1,140 1,114 3 Operating income$2,389 $2,167 10 %$2,167 $2,162 — %(1)Transaction-based expenses are largely attributable to our cash equities and options business.Exchanges RevenuesOur Exchanges segment includes transaction and clearing revenues from our futures and NYSE exchanges as well as data and connectivity services and listings. Transaction and clearing revenues consist of fees collected from derivatives, cash equities and equity options trading and derivatives clearing, and are reported on a net basis, except for the NYSE transaction-based expenses discussed below. Rates per-contract, or RPC, are driven by the number of contracts or securities traded and the fees charged per contract, net of certain rebates. Our per-contract transaction and clearing revenues will depend upon many factors, including, but not limited to, market conditions, transaction and clearing volume, product mix, pricing, applicable revenue sharing and market making agreements, and new product introductions. Because transaction and clearing revenues are generally assessed on a per-contract basis, revenues and profitability fluctuate with changes in contract volume and product mix. Our data and connectivity services revenues are recurring subscription fees related to the various data and connectivity services that we provide which are directly attributable to our exchange venues. Our listings revenues are also recurring subscription fees that we earn for the provision of NYSE listings services for public companies and ETFs, and related corporate actions for listed companies.In both 2020 and 2019, 14% of our Exchanges segment revenues, less transaction-based expenses, were billed in pounds sterling or euros. Due to the fluctuations of the pound sterling and euro compared to the U.S. dollar, our Exchanges segment revenues, less transaction-based expenses, were higher by $4 million in 2020 from 2019.Our exchange transaction and clearing revenues are presented net of rebates. We recorded rebates of $962 million and $855 million in 2020 and 2019, respectively. We offer rebates in certain of our markets primarily to support market liquidity and trading volume by providing qualified participants in those markets a discount to the applicable commission rate. Such rebates are calculated based on volumes traded. The increase in the rebates is due primarily to increased volumes in products with higher rates per contract, an increase in the number of rebate programs offered and an increase in the number of participants within our energy futures and options programs. •Energy Futures and Options: Total energy volume increased 15% and revenues increased 13% in 2020 from 2019.–Total oil volume increased 13% in 2020 from 2019 due to increased risk management activity driven by shifting supply/demand dynamics related to various geopolitical events and the emergence of COVID-19.–Our global natural gas futures and options volume increased 22% in 2020 from 2019. The volume increase in our North American natural gas products was primarily driven by shifting supply/demand dynamics related to lower levels of U.S. shale production and increased demand for natural gas. In addition, the strength in our European TTF gas volumes was driven by the continued emergence of TTF as not only the European benchmark, but also the emerging global benchmark, for natural gas as the commodity continues to globalize.54•Agricultural and Metals Futures and Options: Total volume in our agricultural and metals futures and options markets decreased 3% and revenues decreased 2% in 2020 from 2019. The overall decrease in agricultural volumes was primarily driven by lower commodity price volatility than the prior year.–Sugar futures and options volumes increased 6% in 2020 from 2019, driven by shifting supply/demand dynamics coupled with increased price volatility. –Other agricultural and metal futures and options volume decreased 9% in 2020 from 2019, primarily due to lower cocoa volumes driven by geopolitical uncertainty. •Financial Futures and Options: Total volume decreased 2% and revenues increased 8% in our financial futures and options markets in 2020 from 2019. –Interest rate futures and options volume and revenue decreased 5% and 1% in 2020 from 2019, respectively, due to the impact of quantitative easing measures implemented by major central banks in response to COVID-19. Interest rate futures and options revenues were $193 million and $196 million in 2020 and 2019, respectively.–Other financial futures and options volume, which includes our MSCI®, FTSE® and NYSE FANG+ equity index products, increased 12% and revenue increased 20% in 2020 from 2019. Other financial futures and options volume increased due to increased equity market volatility driven by accelerating adoption of MSCI® index futures and options as well as uncertainty related to COVID-19. Other financial futures and options revenues were $164 million and $136 million in 2020 and 2019, respectively.•Cash Equities and Equity Options: Cash equities volume increased 42% in 2020 from 2019 due to heightened volatility driven by uncertainty related to COVID-19 and various geopolitical events. Cash equities revenues, net of transaction-based expenses, were $276 million and $203 million in 2020 and 2019, respectively. Equity options volume increased 61% in 2020 from 2019 primarily due to higher industry volumes and heightened volatility driven by uncertainty related to COVID-19 and various geopolitical events. Equity options revenues, net of transaction-based expenses, were $101 million and $95 million in 2020 and 2019, respectively. •OTC and Other: OTC and other transactions include revenues from our OTC energy business and other trade confirmation services, as well as interest income on certain clearing margin deposits, regulatory penalties and fines, fees for use of our facilities, regulatory fees charged to member organizations of our U.S. securities exchanges, designated market maker service fees, exchange membership fees and agricultural grading and certification fees. Our OTC and other transaction revenues increased 27% in 2020 from 2019 primarily due to increased income earned on certain clearing margin deposits reflecting higher balances and increased regulatory fees.•Data and Connectivity Services: Our data and connectivity services revenues increased 5% in 2020 from 2019. The increase in revenue was driven by the strong retention rate of existing customers, the addition of new customers and increased purchases by existing customers.•Listings Revenues: Through NYSE, NYSE American and NYSE Arca, we generate listings revenue related to the provision of listings services for public companies and ETFs, and related corporate actions for listed companies. Listings revenues decreased 1% in 2020 from 2019, driven by market volatility causing IPO delays as well as de-listings, partially offset by a rebound in IPO activity towards the end of 2020. Listings revenues in our securities markets arise from fees applicable to companies listed on our cash equities exchanges– original listing fees and annual listing fees. Original listing fees consist of two components: initial listing fees and fees related to corporate actions. Initial listing fees, subject to a minimum and maximum amount, are based on the number of shares that a company initially lists. All listings fees are billed upfront and the identified performance obligations are satisfied over time. Revenue related to the investor relations performance obligation is recognized ratably over the period these services are provided, with the remaining revenue recognized ratably over time as customers continue to list on our exchanges. In addition, we earn corporate actions-related listing fees in connection with actions involving the issuance of new shares, such as stock splits, rights issues and sales of additional securities, as well as mergers and acquisitions. Listings fees related to other corporate actions are considered contract modifications of our listing contracts and are recognized ratably over time as customers continue to list on our exchanges.In 2020, NYSE and NYSE American raised the most capital globally with approximately $185 billion raised in IPOs and follow-on offerings from over 435 transactions, an increase of 65% from $112 billion raised in 2019.55Selected Operating DataThe following charts and tables present trading activity in our futures and options markets by commodity type based on the total number of contracts traded, as well as futures and options rate per contract (in millions, except for percentages and rate per contract amounts):Volume and Rate per ContractYear Ended December 31,Year Ended December 31,20202019Change20192018ChangeNumber of contracts traded (in millions):Energy futures and options 773 669 15 %669 692 (3)% Agricultural and metals futures and options 108 111 (3)%111 107 4 %Financial futures and options 619 630 (2)%630 710 (11)%Total 1,500 1,410 6 %1,410 1,509 (7)%Year Ended December 31,Year Ended December 31,20202019Change20192018ChangeAverage Daily Volume of contracts traded (in thousands):Energy futures and options 3,054 2,655 15 %2,655 2,747 (3)% Agricultural and metals futures and options 428 442 (3)%442 427 4 %Financial futures and options 2,409 2,460 (2)%2,460 2,770 (11)%Total 5,891 5,557 6 %5,557 5,944 (7)%Year Ended December 31,Year Ended December 31,Rate per contract:20202019Change20192018ChangeEnergy futures and options$1.45 $1.48 (2)%$1.48 $1.39 6 %Agricultural and metals futures and options$2.27 $2.25 1 %$2.25 $2.34 (4)%Financial futures and options$0.57 $0.52 10 %$0.52 $0.49 6 %56Open interest is the aggregate number of contracts (long or short) that clearing members hold either for their own account or on behalf of their clients. Open interest refers to the total number of contracts that are currently “open,” – in other words, contracts that have been entered into but not yet liquidated by either an offsetting trade, exercise, expiration or assignment. Open interest is also a measure of the future activity remaining to be closed out in terms of the number of contracts that members and their clients continue to hold in the particular contract and by the number of contracts held for each contract month listed by the exchange. The following charts and table present our year-end open interest for our futures and options contracts (in thousands, except for percentages): As of December 31,As of December 31,20202019Change20192018ChangeOpen interest — in thousands of contracts:Energy futures and options 40,073 37,433 7 %37,433 35,019 7 %Agricultural and metals futures and options 3,608 3,836 (6)%3,836 3,643 5 %Financial futures and options 27,535 29,369 (6)%29,369 29,061 1 %Total 71,216 70,638 1 %70,638 67,723 4 %The following charts and tables present selected cash and equity options trading data. All trading volume below is presented as average net daily trading volume, or ADV, and is single counted:57Year Ended December 31,Year Ended December 31,20202019Change20192018ChangeNYSE cash equities (shares in millions):Total cash handled volume2,466 1,740 42 %1,740 1,735 — %Total cash market share matched22.1 %24.2 %(2.1) pts24.2 %23.2 %1.0 ptsNYSE equity options (contracts in thousands):NYSE equity options volume5,101 3,172 61 %3,172 3,386 (6)%Total equity options volume27,685 17,542 58 %17,542 18,217 (4)% NYSE share of total equity options18.4 %18.1 %0.3 pts18.1 %18.6 %(0.5) ptsRevenue capture or rate per contract:Cash equities rate per contract (per 100 shares)$0.044$0.046(4)%$0.046$0.050(8)%Equity options rate per contract$0.08$0.12(34)%$0.12$0.12(5)%Handled volume represents the total number of shares of equity securities, ETFs and crossing session activity internally matched on our exchanges or routed to and executed on an external market center. Matched volume represents the total number of shares of equity securities, ETFs and crossing session activity executed on our exchanges.Transaction-Based Expenses Our equities and equity options markets pay fees to the SEC pursuant to Section 31 of the Exchange Act. Section 31 fees are recorded on a gross basis as a component of transaction and clearing fee revenue. These Section 31 fees are assessed to recover the government’s costs of supervising and regulating the securities markets and professionals and are subject to change. We, in turn, collect corresponding activity assessment fees from member organizations clearing or settling trades on the equities and options exchanges, and recognize these amounts in our transaction and clearing revenues when invoiced. The activity assessment fees are designed to equal the Section 31 fees. As a result, activity assessment fees and the corresponding Section 31 fees do not have an impact on our net income, although the timing of 58payment by us will vary from collections. Section 31 fees were $622 million and $379 million in 2020 and 2019, respectively. The fees we collect are included in cash at the time of receipt and we remit the amounts to the SEC semi-annually as required. The total amount is included in accrued liabilities and was $207 million as of December 31, 2020.We make liquidity payments to cash and options trading customers, as well as routing charges made to other exchanges which are included in transaction-based expenses. We incur routing charges when we do not have the best bid or offer in the market for a security that a customer is trying to buy or sell on one of our securities exchanges. In that case, we route the customer’s order to the external market center that displays the best bid or offer. The external market center charges us a fee per share (denominated in tenths of a cent per share) for routing to its system. We record routing charges on a gross basis as a component of transaction and clearing fee revenue. Cash liquidity payments, routing and clearing fees were $1.6 billion and $966 million in 2020 and 2019, respectively.Operating Expenses, Operating Income and Operating MarginThe following chart summarizes our Exchanges segment's operating expenses, operating income and operating margin (dollars in millions). See “- Consolidated Operating Expenses” below for a discussion of the significant changes in our operating expenses.Exchanges Segment:Year Ended December 31,Year Ended December 31,20202019Change20192018ChangeOperating expenses $1,242 $1,140 9 %$1,140 $1,114 3 %Adjusted operating expenses(1)$1,145 $1,041 10 %$1,041 $1,035 1 %Operating income $2,389 $2,167 10 %$2,167 $2,162 — %Adjusted operating income(1)$2,486 $2,266 10 %$2,266 $2,241 1 %Operating margin 66 %66 %— 66 %66 %— Adjusted operating margin(1)68 %69 %(1 pt)69 %68 %1 pt(1) The adjusted figures exclude items that are not reflective of our ongoing core operations and business performance. These adjusted numbers are not calculated in accordance with GAAP. See “- Non-GAAP Financial Measures” below. 59Fixed Income and Data Services SegmentThe following charts and table present our selected statements of income data for our Fixed Income and Data Services segment (dollars in millions): (1) The adjusted numbers in the charts above are calculated by excluding items that are not reflective of our cash operations and core business performance. As a result, these adjusted numbers are not calculated in accordance with U.S. GAAP. See “- Non-GAAP Financial Measures” below.60Year Ended December 31,Year Ended December 31,20202019Change20192018ChangeRevenues:Fixed income execution$70 $83 (15)%$83 $63 30 %CDS clearing208 214 (2)214 211 2 Fixed income data and analytics1,018 969 5 969 931 4 Fixed income and credit1,296 1,266 3 1,266 1,205 5 Other data and network services514 490 5 490 476 3 Revenues1,810 1,756 3 1,756 1,681 4 Other operating expenses967 939 3 939 896 5 Acquisition-related transaction and integration costs— — (10)— 32 n/aDepreciation and amortization351 378 (7)378 337 12 Operating expenses1,318 1,317 — 1,317 1,265 4 Operating income$492 $439 12 %$439 $416 6 %Our Fixed Income and Data Services segment represents fixed income and credit trading and clearing as well as subscription-based, or recurring, revenues related to our fixed income data and analytics offerings as well as other multi-asset class data and network services. In 2020 and 2019, 14% and 13%, respectively, of our Fixed Income and Data Services segment revenues were billed in pounds sterling or euros. As the pound sterling or euro exchange rate changes, the U.S. equivalent of revenues denominated in foreign currencies changes accordingly. Due to the fluctuations of the pound sterling and euro compared to the U.S. dollar during 2020, our fixed income and data services revenues were higher by $3 million in 2020 than in 2019.Fixed Income and Data Services RevenuesOur fixed income and data services revenues increased 3% in 2020 from 2019 primarily due to growth in our fixed income data and analytics products, our other data and network services and strong cleared volumes within our CDS clearing business.•Fixed Income Execution: Fixed income execution includes revenues from ICE Bonds. Execution fees are reported net of rebates, which were nominal in 2020, 2019 and 2018. Our fixed income execution revenues decreased 15% in 2020 from 2019. The decrease in revenue was driven by decreased retail activity as a result of low interest rates, particularly municipal and corporate bond activity.•CDS Clearing: CDS clearing revenues decreased 2% in 2020 from 2019. The notional value of CDS cleared was $17.9 trillion and $14.7 trillion in 2020 and 2019, respectively. Despite record clearing activity in 2020 from both dealers and clients driven by heightened market volatility, revenue decreased as a result of lower interest earned on collateral balances held at the clearing house due to lower 2020 Fed Funds rates.•Fixed Income Data and Analytics: Our fixed income data and analytics revenues increased 5% in 2020 from 2019. The increase in revenue was due to strength in our index business and continued growth in our pricing and reference data business driven by the strong retention rate of existing customers, the addition of new customers, increased purchases by existing customers and increases in pricing of our products.•Other Data and Network Services: Our other data and network services revenues increased 5% in 2020 from 2019. The increase in revenues was driven primarily through growth in our ICE Global Network offering, coupled with strength in our consolidated feeds and stronger desktop revenues.Annual Subscription Value, or ASV, represents, at a point in time, the data services revenues, which includes Fixed Income Data and Analytics as well as Other Data and Network Services, subscribed for the succeeding 12 months. ASV does not include new sales, contract terminations or price changes that may occur during that 12-month period. However, while it is an indicative forward-looking metric, it does not provide a growth forecast of the next 12 months of data services revenues.61As of December 31, 2020, ASV was $1.569 billion, which increased 6.4% compared to the ASV as of December 31, 2019. ASV represents nearly 100% of total data services revenues for this segment. This does not adjust for year-over-year foreign exchange fluctuations or impacts of acquisitions.Operating Expenses, Operating Income and Operating MarginThe following chart summarizes our Fixed Income and Data Services segment's operating expenses, operating income and operating margin (dollars in millions). See “- Consolidated Operating Expenses” below for a discussion of the significant changes in our operating expenses.Fixed Income and Data Services Segment:Year Ended December 31,Year Ended December 31,20202019Change20192018ChangeOperating expenses $1,318 $1,317 — %$1,317 $1,265 4 %Adjusted operating expenses(1)$1,119 $1,092 3 %$1,092 $1,022 7 %Operating income $492 $439 12 %$439 $416 6 %Adjusted operating income(1)$691 $664 4 %$664 $659 1 %Operating margin 27 %25 %2 pts25 %25 %—Adjusted operating margin(1)38 %38 %—38 %39 %(1 pt)(1) The adjusted figures exclude items that are not reflective of our ongoing core operations and business performance. These adjusted numbers are not calculated in accordance with GAAP. See “- Non-GAAP Financial Measures” below.62Mortgage Technology SegmentThe following charts and table present our selected statements of income data for our Mortgage Technology segment (dollars in millions): (1) The adjusted numbers in the charts above are calculated by excluding items that are not reflective of our cash operations and core business performance. As a result, these adjusted numbers are not calculated in accordance with U.S. GAAP. See “- Non-GAAP Financial Measures” below.63Year Ended December 31,Year Ended December 31,20202019Change20192018ChangeRevenues:Origination technology253 — n/a— — — Network and closing solutions158 36 331 36 — n/aData and analytics22 — n/a— — — Registrations and other162 103 56 103 22 372 Revenues595 139 324 139 22 537 Other operating expenses215 52 310 52 14 301 Acquisition-related transaction and integration costs89 1 n/a1 — n/aDepreciation and amortization139 19 626 19 3 343 Operating expenses443 72 510 72 17 313 Operating income$152 $67 124 %$67 $5 1,427 %Mortgage Technology RevenuesOur mortgage technology revenues are derived from our comprehensive, end-to-end U.S. residential mortgage platform. Our mortgage technology business enables greater workflow efficiency for customers focused on originating U.S. residential mortgage loans. Mortgage technology revenues increased $456 million or 324% in 2020 from 2019. Revenues from Ellie Mae following our September 2020 acquisition were $351 million and revenues from Simplifile following our June 2019 acquisition were $95 million and $37 million in 2020 and 2019, respectively. •Origination technology: Our origination technology acts as a system of record for the mortgage transaction, automating the gathering, reviewing, and verifying of mortgage-related information and enabling automated enforcement of rules and business practices designed to help ensure that each completed loan transaction is of high quality and adheres to secondary market standards. Revenue from origination technology is based on recurring SaaS subscription fees, with an additive Success-Based Pricing fee as lenders exceed the number of loans closed that are included with their monthly base subscription. •Network and closing solutions: Our network and closing solutions provide customers connectivity to the mortgage supply chain and facilitates the secure exchange of information between our customers and a broad ecosystem of third-party service providers, as well as lenders and investors that are critical to consummating the millions of loan transactions that occur on our origination network each year. Our closing network uniquely connects key participants, such as lenders, title and settlement agents and individual county recorders, to digitize the traditionally manual and paper-based closing and recording process. Revenues from network and closing solutions are based largely on the number of applications and closed loans that utilize the various services.•Data and Analytics: Revenues include those related to ICE Mortgage Technology’s AIQ offering, which applies machine learning and artificial intelligence, or AI, to the entire loan origination process, offering customers greater efficiency by streamlining data collection and validation through our automated document recognition and data extraction capabilities. AIQ revenues can be both recurring and transaction-based in nature. In addition, our data offerings include real-time industry and peer benchmarking tools, which provide originators a granular view into the real-time trends of nearly half the U.S. residential mortgage market. We also provide a Data as a Service (DaaS) offering through private data clouds for lenders to access their own data and origination information. Revenues related to our data products are largely subscription-based and recurring in nature.•Registrations and other: Revenues are related to the MERS database, a leading system of record for recording and tracking changes in mortgage servicing rights and beneficial ownership interests in loans secured by U.S. residential real estate; these revenues are transaction-based. Other revenues include professional services fees, as well as revenues from ancillary products.The following chart summarizes our Mortgage Technology segment's operating expenses, operating income and operating margin (dollars in millions). See “- Consolidated Operating Expenses” below for a discussion of the significant changes in our operating expenses.64Mortgage Technology Segment:Year Ended December 31,Year Ended December 31,20202019Change20192018ChangeOperating expenses $443 $72 510 %$72 $17 313 %Adjusted operating expenses(1)$231 $56 306 %$56 $14 291 %Operating income $152 $67 124 %$67 $5 1,427 %Adjusted operating income(1)$364 $83 337 %$83 $8 1,024 %Operating margin 25 %48 %(23 pts)48 %20 %28 ptsAdjusted operating margin(1)61 %59 %2 pts59 %34 %25 pts(1) The adjusted figures exclude items that are not reflective of our ongoing core operations and business performance. These adjusted numbers are not calculated in accordance with GAAP. See “- Non-GAAP Financial Measures” 65Consolidated Operating Expenses The following presents our consolidated operating expenses (dollars in millions):Year Ended December 31,Year Ended December 31,20202019Change20192018ChangeCompensation and benefits $1,188 $1,042 14 %$1,042 $994 5 %Professional services 144 12515 125 131(5)Acquisition-related transaction and integration costs 105 2n/a2 34(94)Technology and communication 549 46917 469 4328 Rent and occupancy 81 6819 68 681 Selling, general and administrative 185 16115 161 1517 Depreciation and amortization 751 66213 662 58613 Total operating expenses $3,003 $2,529 19 %$2,529 $2,396 6 %The majority of our operating expenses do not vary directly with changes in our volume and revenues, except for certain technology and communication expenses, including data acquisition costs, licensing and other fee-related arrangements and a portion of our compensation expense that is tied directly to our data sales or overall financial performance.66We expect our operating expenses to increase in absolute terms in future periods in connection with the growth of our business, and to vary from year-to-year based on the type and level of our acquisitions, our integrations and other investments.In 2020 and 2019, 11% and 12%, respectively, of our operating expenses were incurred in pounds sterling or euros. Due to fluctuations in the U.S. dollar compared to the pound sterling and euro, our consolidated operating expenses were $2 million higher in 2020 than in 2019. See Item 7(A) “- Quantitative and Qualitative Disclosures About Market Risk - Foreign Currency Exchange Rate Risk” below for additional information.Compensation and Benefits Expenses Compensation and benefits expense is our most significant operating expense and includes non-capitalized employee wages, bonuses, non-cash or stock compensation, certain severance costs, benefits and employer taxes. The bonus component of our compensation and benefits expense is based on both our financial performance and individual employee performance. The performance-based restricted stock compensation expense is also based on our financial performance. Therefore, our compensation and benefits expense will vary year-to-year based on our financial performance and fluctuations in our number of employees. The below chart summarizes the significant drivers of our compensation and benefits expense results for the periods presented (dollars in millions, except employee headcount).Year Ended December 31,20202019ChangeEmployee headcount 8,890 5,989 48 %Stock-based compensation expenses$127 $139 (9)%Employee headcount increased in 2020 from 2019 primarily due to new employees at Ellie Mae and Bridge2 Solutions. These businesses, as well as additional expenses related to Simplifile and growth of our ICE India office, resulted in additional compensation and benefits expense of $113 million in 2020 from 2019. In addition, compensation and benefits expense increased $31 million in 2020 from 2019 as a result of other increases in employee headcount, 2020 merit pay and our 2020 adjustment of our employee cash bonus and non-cash performance-based restricted shares to above-target levels based on our 2020 financial performance metrics. Further, employee taxes and benefits expenses were higher in 2020 primarily due to increased employee insurance costs, partially offset by decreased employee severance expense in 2020 from 2019. The stock-based compensation expenses in the table above relate to employee stock option and restricted stock awards.Professional Services Expenses Professional services expense includes fees for consulting services received on strategic and technology initiatives, temporary labor, as well as regulatory, legal and accounting fees, and may fluctuate as a result of changes in our use of these services in our business. Professional services expenses increased in 2020 from 2019 primarily due to increased costs associated with regulatory and litigation matters and $13 million in additional consulting expenses related to our acquisitions of Ellie Mae and Bridge2 Solutions.Acquisition-Related Transaction and Integration CostsIn 2020, we incurred $105 million in acquisition-related transaction and integration costs, primarily related to our acquisitions of Ellie Mae and Bridge2 Solutions. The Bridge2 Solutions acquisition costs include $10 million of expenses resulting from a Bakkt incentive award market condition estimation adjustment that was directly related to the March 2020 capital call to fund the acquisition of Bridge2 Solutions. We expect to continue to explore and pursue various potential acquisitions and other strategic opportunities to strengthen our competitive position and support our growth. As a result, we may incur acquisition-related transaction costs in future periods.67Technology and Communication Expenses Technology support services consist of costs for running our wholly-owned data centers, hosting costs paid to third-party data centers, and maintenance of our computer hardware and software required to support our technology and cybersecurity. These costs are driven by system capacity, functionality and redundancy requirements. Communication expenses consist of costs for network connections for our electronic platforms and telecommunications costs.Technology and communications expense also includes fees paid for access to external market data, licensing and other fee agreement expenses. Technology and communications expenses may be impacted by growth in electronic contract volume, our capacity requirements, changes in the number of telecommunications hubs and connections with customers to access our electronic platforms directly. Beginning in the second quarter of 2019, we have reflected amounts owed under certain third-party revenue share arrangements as technology and communication operating expenses rather than as had been previously recorded net within transaction and clearing revenues, which resulted in an increase in technology and communications expense of $14 million in 2020 from 2019. Technology and communications expenses also increased by $21 million in 2020 from 2019, due to increased third-party revenue share fees. In addition, technology and communications expenses increased by $43 million in 2020 from 2019 due to our acquisitions of Ellie Mae and Bridge2 Solutions in 2020 and Simplifile in 2019, partially offset by lower data services costs.Rent and Occupancy ExpensesRent and occupancy expense relates to leased and owned property and includes rent, maintenance, real estate taxes, utilities and other related costs. We have significant operations located in and around Atlanta, New York, Pleasanton, London and Hyderabad with smaller offices located throughout the world. Rent and occupancy expenses increased in 2020 from 2019, primarily due to $6 million related to our acquisitions of Ellie Mae and Bridge2 Solutions, and $5 million combined costs for the early termination of our NYSE Chicago office lease and costs of our ICE India office. See Item 2 “- Properties” above for additional information regarding our leased and owned property.Selling, General and Administrative Expenses Selling, general and administrative expenses include marketing, advertising, public relations, insurance, bank service charges, dues and subscriptions, travel and entertainment, non-income taxes and other general and administrative costs. Selling, general and administrative expenses increased in 2020 from 2019, primarily due to a $10 million charitable contribution in support of COVID-19 relief efforts, $8 million in accruals for a regulatory settlement, $6 million in increased costs related to our acquisition of Ellie Mae and increased marketing and bad debt expenses, partially offset by lower travel expenses due to COVID-19. Depreciation and Amortization Expenses Depreciation and amortization expense results from depreciation of long-lived assets such as buildings, leasehold improvements, aircraft, hardware and networking equipment, software, furniture, fixtures and equipment over their estimated useful lives. This expense includes amortization of intangible assets obtained in our acquisitions of businesses, as well as on various licensing agreements, over their estimated useful lives. Intangible assets subject to amortization consist primarily of customer relationships, trading products with finite lives and technology. This expense also includes amortization of internally-developed and purchased software over its estimated useful life. We recorded amortization expenses on intangible assets acquired as part of our acquisitions, as well as on other intangible assets, of $388 million and $311 million in 2020 and 2019, respectively. In addition, 2019 amortization expense included a $31 million impairment loss on exchange registration intangible assets on ICE Futures Singapore. Amortization expense increased in 2020 from 2019, primarily due to $104 million in amortization expenses recorded on the Ellie Mae intangible assets following our acquisition, partially offset by certain Interactive Data intangible assets that became fully amortized in the fourth quarter of 2019.We recorded depreciation expenses on our fixed assets of $363 million and $320 million in 2020 and 2019, respectively. The increase in 2020 over 2019 was primarily due to depreciation resulting from increased software development and networking equipment and due to $8 million in additional expenses related to our September 2020 acquisition of Ellie Mae. In addition, our 2020 depreciation expense included a software impairment charge of $11 million related to a portion of customized software developed at Bakkt that is no longer useful.68Consolidated Non-Operating Income (Expense) Income and expenses incurred through activities outside of our core operations are considered non-operating. The following tables present our non-operating income (expenses) (dollars in millions): Year Ended December 31,Year Ended December 31,20202019Change20192018ChangeOther income (expense):Interest income$10 $35 (71)%$35 $22 55 %Interest expense (357)(285)25 (285)(244)17 Other income (expense), net 80 58 38 58 159 (63)Total other income (expense), net $(267)$(192)39 %$(192)$(63)203 %Net income attributable to non-controlling interest $(19)$(27)(27)%$(27)$(32)(17)%Interest IncomeInterest income decreased in 2020 from 2019 primarily due to a decrease in short-term interest rates on various investments.Interest ExpenseInterest expense increased in 2020 from 2019 primarily due to the issuance of new senior notes in the May 2020 refinancing and in August 2020 related to the Ellie Mae acquisition. Our fixed rate senior notes outstanding increased by $7.6 billion in 2020 from 2019. In 2020, interest expense included a $14 million extinguishment payment incurred related to the June 2020 early redemption of senior notes with an original maturity of December 1, 2020 and $5 million in pre-acquisition interest expense related to the Ellie Mae transaction. See “- Debt” below. Other income (expense), netWe have an equity method investment in the Options Clearing Corporation, or OCC, and we recognized $71 million and $62 million in equity income as other income related to this investment during 2020 and 2019, respectively. We own a 40% interest in the OCC, which is regulated by the SEC and the CFTC. Included within the amount recognized during 2019 is a positive earnings adjustment of $19 million to reflect higher reported OCC 2018 net income than originally estimated, due to the SEC's disapproval of the OCC capital plan that was established in 2015. Refer to Note 4 to our consolidated financial statements, included in this Annual Report for additional details on our OCC investment.In connection with our equity investment in Euroclear, we recognized dividend income of $19 million in 2019, which is included in other income. As a result of a 2020 European regulation limiting dividend payments, we did not receive a Euroclear dividend in 2020. In addition, in November 2020, we became aware of an observable price change in an orderly transaction of a similar Euroclear investment by a third party. The transaction resulted in a fair value adjustment of our Euroclear investment, and we recorded a gain of $35 million in other income, which includes the impact of foreign currency exchange.We historically held a 9% ownership interest in BIDS, a registered broker-dealer and the operator of the BIDS Alternative Trading System. In December 2020, we sold our investment in BIDS to Cboe and recorded a gain on the sale of $20 million, included in other income.In 2020, we recorded an accrual for potential legal settlements of $30 million.We incurred foreign currency transaction losses of $5 million in both 2020 and 2019. This was primarily attributable to the fluctuations of the pound sterling and euro relative to the U.S. dollar. Foreign currency transaction gains and losses are recorded in other income (expense), net, when the settlement of foreign currency assets, liabilities and payables occur in non-functional currencies and there is an increase or decrease in the period-end foreign currency exchange rates between periods. See Item 7A “- Quantitative and Qualitative Disclosures About Market Risk - Foreign Currency Exchange Rate Risk” included elsewhere in this Annual Report for more information on these items.In 2019, we recorded promissory note impairment charges of $16 million on work performed by the original plan processor on the CAT, and in 2020, we recorded an additional $2 million. Due to delays and failures in implementation and functionality by the original plan processor, as well as recently-published proposals by the SEC for an amended timeline 69and implementation structure, we believe the risk that execution venues are not reimbursed has increased, resulting in this impairment.In connection with our adoption of Accounting Standards Update, or ASU, 2017-07, Compensation Retirement Benefits: Improving the Presentation of Net Periodic Pension Cost and Net Periodic Postretirement Benefit Cost, or ASU 2017-07, we are recognizing the other components of net benefit cost of our defined benefit plans in the income statement as non-operating income on a full retrospective basis. The combined net periodic expense of these plans was $6 million and $4 million in 2020 and 2019, respectively.Non-controlling InterestFor consolidated subsidiaries in which our ownership is less than 100%, and for which we have control over the assets, liabilities and management of the entity, the outside stockholders’ interests are shown as non-controlling interests. As of December 31, 2020, our non-controlling interests include those related to the non-ICE limited partners' interest in our CDS clearing subsidiaries, non-controlling interest in ICE Futures Abu Dhabi and redeemable non-controlling interest of the non-ICE partners in Bakkt.The non-ICE limited partners of our CDS clearing subsidiaries hold a 26.7% ownership interest as of December 31, 2020. During 2020 we received a contribution from a group of minority investors for a non-controlling interest in ICE Futures Abu Dhabi.In December 2018, Bakkt was capitalized with $183 million in initial funding with ICE as the majority owner, along with a group of other minority investors, and in March 2020, an additional $300 million in funding occurred with ICE maintaining its majority ownership. We hold a call option over these interests subject to certain terms. Similarly, the non-ICE partners in Bakkt hold a put option to require us to repurchase their interests subject to certain terms. These minority interests are reflected as redeemable non-controlling interests in temporary equity within our consolidated balance sheet and are subject to remeasurement when repurchase is probable. Refer to Note 3 to our consolidated financial statements contained elsewhere in this Annual Report.Consolidated Income Tax Provision Consolidated income tax expense was $658 million and $521 million in 2020 and 2019, respectively. The change in consolidated income tax expense between years is primarily due to the tax impact of changes in our pre-tax income and the changes in our effective tax rate. Our effective tax rate was 24% and 21% in 2020 and 2019, respectively. The effective tax rate for 2020 is higher than the effective tax rate for 2019 primarily due to U.K. tax law changes enacted in July 2020, partially offset by favorable state apportionment changes as a result of our acquisition of Ellie Mae, as well as favorable changes in certain international tax provisions as part of the TCJA in 2019.In 2015 and 2016, the U.K. enacted corporate income tax rate reductions from 19% to 17% to be effective prospectively on April 1, 2020 and we recorded associated deferred tax benefits in those years. In July 2020, the U.K. enacted a reinstatement of the U.K. corporate income tax rate back to 19%, effective April 1, 2020. As a result, we revalued our U.K. deferred tax assets and liabilities back to the rate of 19%, and recorded a $65 million deferred tax expense during 2020.On March 27, 2020, the CARES Act was enacted and certain income tax related relief was provided under the CARES Act. There was no material impact of the CARES Act on our income tax provision for 2020.See Note 13 to our consolidated financial statements and related notes, which are included in this Annual Report, for additional information on these tax items.Quarterly Results of Operations The following quarterly unaudited condensed consolidated statements of income data has been prepared on substantially the same basis as our audited consolidated financial statements and includes all adjustments, consisting only of normal recurring adjustments, necessary for the fair presentation of our consolidated results of operations for the quarters presented. The historical results for any quarter do not necessarily indicate the results expected for any future period. This unaudited condensed consolidated quarterly data should be read together with our consolidated financial statements and related notes included in this Annual Report. The following table sets forth quarterly consolidated statements of income data (in millions): 70Three Months Ended,December 31,2020September 30, 2020June 30, 2020March 31, 2020December 31,2019September 30, 2019June 30, 2019March 31, 2019Revenues:Energy futures and options$262 $229 $276 $353 $243 $265 $255 $229 Agricultural and metals futures and options48 54 59 84 57 60 72 62 Financial futures and options82 76 76 123 80 91 78 83 Cash equities and equity options651 593 672 669 442 401 410 390 OTC and other77 73 75 71 60 59 57 57 Data and connectivity services201 201 195 193 190 185 190 187 Listings112 111 111 112 113 114 111 111 Total exchanges revenues1,433 1,337 1,464 1,605 1,185 1,175 1,173 1,119 Fixed income execution1415202119192124CDS Clearing4247477248574960Fixed income data and analytics262 259 252 245 244 244 242 239 Other data and network services132 129 127 126 125 124 121 120 Total fixed income and credit revenues450 450 446 464 436 444 433 443 Origination technology 20152——————Network and closing solutions7742221717163—Data and analytics175——————Registrations and other5544342929282521Total mortgage technology revenues350 143 56 46 46 44 28 21 Total revenues2,233 1,930 1,966 2,115 1,667 1,663 1,634 1,583 Transaction-based expenses562 519 571 556 369 327 336 313 Total revenues, less transaction-based expenses1,671 1,411 1,395 1,559 1,298 1,336 1,298 1,270 Compensation and benefits339 298 273 278 274 261 259 248 Professional services44 37 34 29 28 35 29 33 Acquisition-related transaction and integration costs15 76 2 12 1 — 1 — Technology and communication161 131 126 131 123 126 113 107 Rent and occupancy22 19 19 21 16 17 18 17 Selling, general and administrative53 43 40 49 45 33 41 42 Depreciation and amortization257 180 157 157 189 158 157 158 Total operating expenses891 784 651 677 676 630 618 605 Operating income780 627 744 882 622 706 680 665 Other income (expense), net (106)(44)(71)(46)(35)(66)(52)(39)Income tax expense146 189 145 178 134 103 150 134 Net income$528 $394 $528 $658 $453 $537 $478 $492 Net income attributable to non-controlling interest(2)(4)(5)(8)(5)(8)(6)(8)Net income attributable to Intercontinental Exchange, Inc.$526 $390 $523 $650 $448 $529 $472 $484 71Liquidity and Capital Resources Below are charts that reflect our outstanding debt and capital allocation. The acquisition and integration costs in the chart below includes cash paid for acquisitions, net of cash received for divestitures, cash paid for equity investments, cash paid for non-controlling interest and redeemable non-controlling interest, and acquisition-related transaction and integration costs, in each year.We have financed our operations, growth and cash needs primarily through income from operations and borrowings under our various debt facilities. Our principal capital requirements have been to fund capital expenditures, working capital, strategic acquisitions and investments, stock repurchases, dividends and the development of our technology platforms. We believe that our cash on hand and cash flows from operations will be sufficient to repay our outstanding debt, but we 72may also need to incur additional debt or issue additional equity securities in the future. See “- Future Capital Requirements” below. For a discussion of the COVID-19 pandemic and how the pandemic may impact our business, results of operations or financial condition in the future, including our liquidity and capital resources, see “– Recent Developments" and “– Risk Factors" in Part 1, Item 1(A), above.See “- Recent Developments” above for a discussion of the acquisitions that we made during 2020. These acquisitions were funded from borrowing under our Commercial Paper Program and term loan, the net proceeds from the issuance of the August 2020 Notes and cash flows from operations, as well as approximately $1.9 billion, or approximately 18.4 million shares of our common stock, based on our stock price, for the Ellie Mae acquisition.See “- Cash Flow” below for a discussion of our capital expenditures and capitalized software development costs.Consolidated cash and cash equivalents were $583 million and $841 million as of December 31, 2020 and 2019, respectively. We had $1.4 billion and $1.3 billion in short-term and long-term restricted cash and cash equivalents as of December 31, 2020 and 2019, respectively. As of December 31, 2020, the amount of unrestricted cash held by our non-U.S. subsidiaries was $292 million. Due to U.S. tax reform, the majority of our foreign earnings since January 1, 2018 have been subject to immediate U.S. income taxation, and the existing non-U.S. unrestricted cash balance can be distributed to the U.S. in the future with no material additional income tax consequences.Our cash and cash equivalents and financial investments are managed as a global treasury portfolio of non-speculative financial instruments that are readily convertible into cash, such as overnight deposits, term deposits, money market funds, mutual funds for treasury investments, short duration fixed income investments and other money market instruments, thus ensuring high liquidity of financial assets. We may invest a portion of our cash in excess of short-term operating needs in investment-grade marketable debt securities, including government or government-sponsored agencies and corporate debt securities. As of December 31, 2020, we held $27 million of unrestricted cash that was set aside for legal, regulatory and surveillance operations at NYSE.Cash Flow The following table presents the major components of net changes in cash, cash equivalents, and restricted cash and cash equivalents (in millions):Year Ended December 31,202020192018Net cash provided by (used in):Operating activities$2,881 $2,659 $2,533 Investing activities(9,830)(594)(1,755)Financing activities6,744 (1,753)(463)Effect of exchange rate changes 8 4 (11)Net (decrease) increase in cash, cash equivalents, and restricted cash and cash equivalents$(197)$316 $304 Operating Activities Net cash provided by operating activities primarily consists of net income adjusted for certain items, including depreciation and amortization, deferred taxes, stock based compensation, investment gains and losses and the effects of changes in working capital.The $222 million increase in net cash provided by operating activities in 2020 and 2019 was driven by a $148 million increase in net income and the non-cash impact of deferred taxes of $125 million, partially offset by the timing of NYSE collections on increased billings of $119 million and higher income taxes paid as a result of the U.K. government accelerating its required income tax installment payments in 2020. The remaining change is due to fluctuations in our working capital and the timing of various payments such as transaction-related expenses.Investing Activities Consolidated net cash used in investing activities in 2020 and 2019 relates to cash paid for acquisitions, net of cash acquired, a return of capital related to our investment in OCC, proceeds from investments related to MERS and changes in capital expenditures and capitalized software development costs. 73We paid cash for acquisitions, net of the cash of the companies acquired, of $9.4 billion and $352 million in 2020 and 2019, respectively, primarily relating to the Ellie Mae acquisition in 2020 and the Simplifile acquisition in 2019.In 2019, we had a $60 million return of capital related to our equity method investment in the OCC and $41 million proceeds from investments related to MERS. Refer to Note 4 to our consolidated financial statements, included in this Annual Report for additional details on these investments.We had capital expenditures of $207 million and $153 million in 2020 and 2019, respectively, and we had capitalized software development costs of $203 million and $152 million in 2020 and 2019, respectively. The capital expenditures primarily relate to hardware and software purchases to continue the development and expansion of our electronic platforms, data services and clearing houses and leasehold improvements. The software development expenditures primarily relate to the development and expansion of our electronic platforms, data services, mortgage services and clearing houses.Financing Activities Consolidated net cash provided by financing activities in 2020 primarily relates to $9.6 billion in net proceeds from the issuance of the May 2020 Notes and the August 2020 Notes, borrowings under a term loan facility and $1.1 billion in net issuances under our Commercial Paper Program. Cash provided by financing activities was partially offset by repayments of our $1.25 billion December 2020 Senior Notes, and the early payoff of the term loan mentioned above, $1.2 billion in repurchases of common stock, $669 million in dividend payments to our stockholders and $74 million in cash payments related to treasury shares received for restricted stock tax payments and stock options exercises.Consolidated net cash used in financing activities in 2019 primarily relates to $1.5 billion in repurchases of common stock, $360 million in net borrowings under our Commercial Paper Program, $621 million in dividend payments to stockholders and $65 million in cash payments related to treasury shares received for restricted stock tax payments and stock options exercises.See Note 10 to our consolidated financial statements, included in this Annual Report.Debt As of December 31, 2020, we had $16.5 billion in outstanding debt, consisting of $12.9 billion of fixed rate senior notes, $1.2 billion of floating rate senior notes, $2.4 billion under our U.S. dollar commercial paper program, or the Commercial Paper Program and $6 million under a line of credit at our ICE India subsidiary. The commercial paper notes had original maturities ranging from four to 266 days as of December 31, 2020, with a weighted average interest rate of 0.40% per annum, and a weighted average remaining maturity of 82 days. Commercial paper notes of $1.3 billion with original maturities ranging from two to 87 days were outstanding as of December 31, 2019, with a weighted average interest rate of 1.84% per annum, and a weighted average remaining maturity of 22 days. Our current fixed rate debt principal of $13.1 billion has a weighted average maturity of 16 years and a weighted average cost of 3.0% per annum. We have a $3.7 billion senior unsecured revolving credit facility, or the Credit Facility, pursuant to a credit agreement with Wells Fargo Bank, N.A., as primary administrative agent, issuing lender and swing-line lender, Bank of America, N.A., as syndication agent, backup administrative agent and swing-line lender, and the lenders party thereto. As of December 31, 2020, of the $3.7 billion that is currently available for borrowing under the Credit Facility, $2.4 billion is required to back-stop the amount outstanding under our Commercial Paper Program and $171 million is required to support certain broker-dealer and other subsidiary commitments. The amount required to backstop the amounts outstanding under the Commercial Paper Program will fluctuate as we increase or decrease our commercial paper borrowings. The remaining $1.1 billion is available for working capital and general corporate purposes, including, but not limited to, acting as a back-stop to future increases in the amounts outstanding under the Commercial Paper Program.On August 21, 2020, we entered into a $750 million 18-month senior unsecured delayed draw term loan facility with a maturity date of February 21, 2022. We borrowed in full under the facility on September 3, 2020 and the proceeds were used to fund a portion of the purchase price for the Ellie Mae acquisition. We had the option to prepay the facility in whole or in part at any time, and paid off the full balance of the loan on December 16, 2020. Interest on borrowings under this term loan facility were based on the principal amount outstanding at LIBOR plus an applicable margin, which was equal to 1.125%.On August 20, 2020, we issued $6.5 billion in aggregate principal amount of new senior notes, comprised of $1.25 billion in aggregate principal amount of floating rate senior notes due in 2023, $1.0 billion in aggregate principal amount of 0.70% senior notes due in 2023, $1.5 billion in aggregate principal amount of 1.85% senior notes due in 2032, $1.25 billion in aggregate principal amount of 2.65% senior notes due in 2040, and $1.5 billion in aggregate principal amount of 3.00% 74senior notes due in 2060. We used the net proceeds from the offering to fund a portion of the purchase price for the Ellie Mae acquisition.On May 26, 2020, we issued $2.5 billion in aggregate principal amount of new senior notes, comprised of $1.25 billion in aggregate principal amount of 2.10% senior notes due in 2030 and $1.25 billion in aggregate principal amount of 3.00% senior notes due in 2050. We used the net proceeds from the offering for general corporate purposes, including to fund the redemption of our $1.25 billion aggregate principal amount of 2.75% senior notes due in December 2020 and to pay down a portion of our commercial paper outstanding.Our Commercial Paper Program enables us to borrow efficiently at reasonable short-term interest rates and provides us with the flexibility to de-lever using our strong annual cash flows from operating activities whenever our leverage becomes elevated as a result of investment or acquisition activities. We had net issuances of $1.1 billion under our Commercial Paper Program during 2020.Upon maturity of our commercial paper and to the extent old issuances are not repaid by cash on hand, we are exposed to the rollover risk of not being able to issue new commercial paper. To mitigate this risk, we maintain an undrawn back-stop bank revolving credit facility for an aggregate amount which meets or exceeds the amount issued under our Commercial Paper Program at any time. If we were not able to issue new commercial paper, we have the option of drawing on the back-stop revolving facility. However, electing to do so would result in higher interest expense.For additional details of our debt instruments, refer to Note 10 to our consolidated financial statements, included in this Annual Report.Capital ReturnIn December 2019, our Board approved an aggregate of $2.4 billion for future repurchases of our common stock with no fixed expiration date that became effective January 1, 2020. The $2.4 billion replaced the previous amount approved by the Board.During 2020, we repurchased 13.6 million shares of our outstanding common stock at a cost of $1.2 billion, including 10.4 million shares at a cost of $948 million under our Rule 10b5-1 trading plan and 3.2 million shares at a cost of $299 million on the open market. In 2019, we repurchased 17.4 million shares of our outstanding common stock at a cost of $1.5 billion, including 16.1 million shares at a cost of $1.4 billion under our Rule 10b5-1 trading plan and 1.3 million shares at a cost of $100 million on the open market. Shares repurchased are held in treasury stock. We discontinued stock repurchases and terminated our Rule 10b5-1 trading plan in August 2020 in connection with our Ellie Mae acquisition. The remaining balance of Board approved funds for future repurchase is $1.2 billion. The approval of our Board for the share repurchases does not obligate us to acquire any particular amount of our common stock. In addition, our Board may increase or decrease the amount available for repurchases from time to time.From time to time, we enter into Rule 10b5-1 trading plans, as authorized by our Board, to govern some or all of the repurchases of our shares of common stock. The timing and extent of future repurchases that are not made pursuant to a Rule 10b5-1 trading plan will be at our discretion and will depend upon many conditions. In making a determination regarding any stock repurchases, management considers multiple factors, including overall stock market conditions, our common stock price performance, the remaining amount authorized for repurchases by our Board, the potential impact of a stock repurchase program on our corporate debt ratings, our expected free cash flow and working capital needs, our current and future planned strategic growth initiatives, and other potential uses of our cash and capital resources.During 2020, we paid cash dividends of $1.20 per share of our common stock in the aggregate, including quarterly dividends of $0.30 per share, for an aggregate payout of $669 million, which includes the payment of dividend equivalents on unvested employee restricted stock units. Refer to Note 12 to our consolidated financial statements included in this Annual Report, for details on the amounts of our quarterly dividend payouts for the last three years. Future Capital Requirements Our future capital requirements will depend on many factors, including the rate of growth across our segments, strategic plans and acquisitions, available sources for financing activities, required and discretionary technology and clearing initiatives, regulatory requirements, the timing and introduction of new products and enhancements to existing products, the geographic mix of our business and potential stock repurchases. We currently expect to incur capital expenditures (including operational and real estate capital expenditures) and to incur software development costs that are eligible for capitalization ranging in the aggregate between $400 million and 75$430 million in 2021, which we believe will support the enhancement of our technology, business integration and the continued growth of our businesses. In December 2019, our Board approved an aggregate of $2.4 billion for future repurchases of our common stock with no fixed expiration date that became effective on January 1, 2020. As of December 31, 2020, we had $1.2 billion authorized for future repurchases of our common stock. Refer to Note 12 to our consolidated financial statements included in this Annual Report for additional details on our stock repurchase program. Our Board has adopted a quarterly dividend policy providing that dividends will be approved quarterly by the Board or the Audit Committee taking into account factors such as our evolving business model, prevailing business conditions, our current and future planned strategic growth initiatives and our financial results and capital requirements, without a predetermined net income payout ratio. For the first quarter of 2021, we announced a $0.33 per share dividend payable on March 31, 2021 to stockholders of record as of March 17, 2021.Other than the facilities for the ICE Clearing Houses, our Credit Facility and our Commercial Paper Program are currently the only significant agreements or arrangements that we have for liquidity and capital resources with third parties. See Notes 10 and 14 to our consolidated financial statements for further discussion. In the event of any strategic acquisitions, mergers or investments, or if we are required to raise capital for any reason or desire to return capital to our stockholders, we may incur additional debt, issue additional equity to raise necessary funds, repurchase additional shares of our common stock or pay a dividend. However, we cannot provide assurance that such financing or transactions will be available or successful, or that the terms of such financing or transactions will be favorable to us. See “-Risk Factors" and Note 10 to our consolidated financial statements, included in this Annual Report.Non-GAAP Measures We use certain financial measures internally to evaluate our performance and make financial and operational decisions that are presented in a manner that adjusts from their equivalent GAAP measures or that supplement the information provided by our GAAP measures. We use these adjusted results because we believe they more clearly highlight trends in our business that may not otherwise be apparent when relying solely on GAAP financial measures, since these measures eliminate from our results specific financial items that have less bearing on our core operating performance. We use these measures in communicating certain aspects of our results and performance, including in this Annual Report, and believe that these measures, when viewed in conjunction with our GAAP results and the accompanying reconciliation, can provide investors with greater transparency and a greater understanding of factors affecting our financial condition and results of operations than GAAP measures alone. In addition, we believe the presentation of these measures is useful to investors for making period-to-period comparisons of results because the adjustments to GAAP are not reflective of our core business performance. These financial measures are not presented in accordance with, or as an alternative to, GAAP financial measures and may be different from non-GAAP measures used by other companies. We encourage investors to review the GAAP financial measures included in this Annual Report, including our consolidated financial statements, to aid in their analysis and understanding of our performance and in making comparisons.The table below outlines our adjusted operating expenses, adjusted operating income, adjusted operating margin, adjusted net income attributable to ICE common stockholders and adjusted earnings per share, which are non-GAAP measures that are calculated by making adjustments for items we view as not reflective of our cash operations and core business performance. These measures, including the adjustments and their related income tax effect and other tax adjustments (in millions, except for percentages and per share amounts), are as follows:76Exchanges SegmentFixed Income and Data Services SegmentMortgage Technology SegmentConsolidatedYear Ended December 31,Year Ended December 31,Year Ended December 31,Year Ended December 31,202020192018202020192018202020192018202020192018Total revenues, less transaction-based expenses$3,631 $3,307 $3,276 $1,810 $1,756 $1,681 $595 $139 $22 $6,036 $5,202 $4,979 Operating expenses1,242 1,140 1,114 1,318 1,317 1,265 443 72 17 3,003 2,529 2,396 Less: Amortization of acquisition-related intangibles74 68 71 191 225 213 123 16 3 388 309 287 Less: Transaction and integration costs and acquisition-related success fees 12 — — — — 30 89 — — 101 — 30 Less: Impairment of developed software11 — — — — — — — — 11 — — Less: Impairment of exchange registration intangible assets on ICE Futures Singapore— 31 — — — — — — — — 31 — Less: Accruals relating to a regulatory settlement— — — 8 — — — — — 8 — — Less: Impairment of exchange registration intangible assets on closure of ICE Futures Canada and ICE Clear Canada— — 4 — — — — — — — — 4 Less: Employee severance costs related to ICE Futures Canada and ICE Clear Canada operations— — 4 — — — — — — — — 4 Adjusted operating expenses$1,145 $1,041 $1,035 $1,119 $1,092 $1,022 $231 $56 $14 $2,495 $2,189 $2,071 Operating income$2,389 $2,167 $2,162 $492 $439 $416 $152 $67 $5 $3,033 $2,673 $2,583 Adjusted operating income$2,486 $2,266 $2,241 $691 $664 $659 $364 $83 $8 $3,541 $3,013 $2,908 Operating margin66 %66 %66 %27 %25 %25 %25 %48 %20 %50 %51 %52 %Adjusted operating margin68 %69 %68 %38 %38 %39 %61 %59 %34 %59 %58 %58 %Net income attributable to ICE common stockholders$2,089 $1,933 $1,988 Add: Amortization of acquisition-related intangibles388 309 287 Add: Transaction and integration costs and acquisition-related success fees 101 — 30 Less: Gain on equity investments(55)— — Add: Extinguishment of 2020 Senior Notes14 — — Add: Pre-acquisition interest expense on debt issued for Ellie Mae acquisition5 — — Add: Impairment of developed software11 — — Add: Impairment of CAT promissory notes2 16 — Add: Impairment of exchange registration intangible assets on ICE Futures Singapore— 31 — Less: Gain on acquisition of MERS — — (110)Add: Accrual for potential legal settlements30 — — Add: Accruals relating to a regulatory settlement8 — — Add: Impairment of exchange registration intangible assets on closure of ICE Futures Canada and ICE Clear Canada— — 4 Add: Employee severance costs related to ICE Futures Canada and ICE Clear Canada operations— — 4 Add: Adjustment to gain on divestiture of Trayport, net— — 1 Less: Income tax effect for the above items (129)(90)(98)Less: Deferred tax adjustments from U.S. tax rate reduction— — (11)Add/(Less): Deferred tax adjustments on acquisition-related intangibles36 (8)(5)Add/(Less): Other tax adjustments— 3 (13)Adjusted net income attributable to ICE common stockholders$2,500 $2,194 $2,077 Basic earnings per share attributable to ICE common stockholders$3.79 $3.44 $3.46 Diluted earnings per share attributable to ICE common stockholders$3.77 $3.42 $3.43 Adjusted basic earnings per share attributable to ICE common stockholders$4.53 $3.91 $3.61 Adjusted diluted earnings per share attributable to ICE common stockholders$4.51 $3.88 $3.59 Basic weighted average common shares outstanding552 561 575 Diluted weighted average common shares outstanding555 565 579 Amortization of acquisition-related intangibles are included in non-GAAP adjustments as excluding these non-cash expenses provides greater clarity regarding our financial strength and stability of cash operating results. Acquisition-related transaction costs are included as part of our core business expenses, except for those that are directly related to the announcement, closing, financing or termination of a transaction. However, we adjust for the acquisition-related transaction and integration costs relating to acquisitions such as Ellie Mae and Interactive Data given the 77magnitude of the $11.4 billion and $5.6 billion purchase prices, respectively, of these acquisitions. We also adjust for the acquisition-related transaction costs related to the expected merger between Bakkt and VIH due to the significance of the transaction. The integration of Interactive Data was completed by June 2018. In 2020, we also included a $10 million adjustment for Bridge2 Solutions acquisition costs resulting from a Bakkt incentive award market condition estimation adjustment as an acquisition-related success fee. This adjustment was directly related to the March 2020 capital call to fund the acquisition of Bridge2 Solutions and we believe is therefore appropriate since we exclude costs directly related to financing a transaction.The extinguishment payment on the 2020 Senior Notes is included as a non-GAAP adjustment as it relates to the June 2020 early redemption of senior notes with an original maturity of December 1, 2020 as a result of our new senior notes offering in May 2020. These costs include both a make-whole redemption payment and duplicative interest and are not considered part of our normal operations. We also adjust for pre-acquisition interest expense on the August 2020 debt issued to fund a portion of the purchase price of our Ellie Mae acquisition as we do not consider this to be reflective of our normal operations.We include the 2019 impairment of exchange registration intangible assets on ICE Futures Singapore as a non-GAAP adjustment. This impairment is not based on our core business operations, but rather was a result of the estimated fair value of an acquired intangible asset falling below its carrying value. See Note 8 to our consolidated financial statements, included in this Annual Report. We include the 2020 and 2019 promissory note impairment charges on work performed by the original plan processor on the CAT as non-GAAP adjustments. These are included as non-GAAP adjustments as these are not considered a part of our core business operations. See additional discussion on the CAT, above, in Item 1(A) "-Risk Factors" in this Annual Report.In addition, we also include the following items as non-GAAP adjustments, as each of these are not considered a part of our core business operations:•2020: Impairment of software developed at our Bakkt subsidiary since it relates to the build-out of a fundamental software design vs. a recurring upgrade;•2020: accrual for potential legal settlements;•2020: accruals relating to a regulatory settlement;•2020: the $35 million gain on the fair value adjustment of our Euroclear equity investment and the $20 million gain on the sale of our BIDS equity investment; •2018: the gain recognized on our initial majority investment in MERS in connection with our acquisition of 100% of the remaining MERS interests;•2018: the impairment loss on exchange registration intangible assets and employee severance costs related to the closure of ICE Futures Canada and ICE Clear Canada; and •2018: a subsequent adjustment to reduce the gain on the divestiture of Trayport.The tax items in non-GAAP adjustments are either the tax impacts of the pre-tax non-GAAP adjustments or tax items as described below that are not in the normal course of business and are not indicative of our core business performance. The following tax-related items are included as non-GAAP adjustments:•Deferred tax adjustments on acquisition-related intangibles, including the impact of U.K. and U.S. state tax law changes and apportionment updates, as well as foreign tax law changes which resulted in deferred tax expense/(benefit) of $36 million, ($8 million) and ($5 million) in 2020, 2019 and 2018, respectively;•Deferred tax benefits of $11 million in 2018 resulting from changes in estimates as a result of the enactment of the TCJA which reduced the corporate income tax rate from 35% to 21%; and•Other tax adjustments of $3 million in 2019 for audit settlement payments primarily related to pre-acquisition tax matters in connection with our acquisition of NYSE in 2013; and other tax adjustments in 2018 including a $17 million tax benefit on the sale of Trayport, partially offset by an audit settlement for a pre-acquisition period in connection with our acquisition of NYSE in 2013.For additional information on these items, refer to our consolidated financial statements included in this Annual Report and “- Recent Developments,” “- Consolidated Operating Expenses”, “- Consolidated Non-Operating Income (Expenses)” and “-Consolidated Income Tax Provision” above.78Off-Balance Sheet Arrangements As described in Notes 3 and 14 to our consolidated financial statements, which are included elsewhere in this Annual Report, certain clearing house collateral and Bakkt custodial assets are reported off-balance sheet. We do not have any relationships with unconsolidated entities or financial partnerships, often referred to as structured finance or special purpose entities. Contractual Obligations and Commercial Commitments The following presents our contractual obligations (which we intend to fund from existing cash as well as cash flow from operations) and commercial commitments as of December 31, 2020 (in millions): Payments Due by PeriodTotalLess Than 1 Year1-3 Years4-5 YearsAfter 5 YearsContractual Obligations:Short-term and long-term debt and interest $23,084 $2,799 $4,696 $1,866 $13,723 Operating lease obligations 426 79 152 112 83 Purchase obligations244 152 88 4 — Total contractual cash obligations $23,754 $3,030 $4,936 $1,982 $13,806 Purchase obligations include our estimate of the minimum outstanding obligations under agreements to purchase goods or services that we believe are enforceable and legally binding and that specify all significant terms, including: fixed or minimum quantities to be purchased; fixed, minimum or variable price provisions; and the approximate timing of the transaction. Purchase obligations exclude agreements that are cancellable at any time without penalty.We have excluded from the contractual obligations and commercial commitments listed above $84.1 billion in cash margin deposits, guaranty funds and delivery contracts payable. Clearing members of our clearing houses are required to deposit original margin and variation margin and to make deposits to a guaranty fund. The cash deposits made to these margin accounts and to the guaranty fund are recorded in the consolidated balance sheet as current assets with corresponding current liabilities to the clearing members that deposited them. ICE NGX administers the physical delivery of energy trading contracts. It has an equal and offsetting claim to and from its respective participants on opposite sides of the physically-settled contract, each of which is reflected as a delivery contract receivable with an offsetting delivery contract payable. See Note 14 to our consolidated financial statements included in this Annual Report for additional information on our clearing houses and the margin deposits, guaranty funds and delivery contracts payable. We have also excluded unrecognized tax benefits, or UTBs. As of December 31, 2020, our cumulative UTBs were $188 million, and interest and penalties related to UTBs were $39 million. We are under examination by various tax authorities. We are unable to make a reasonable estimate of the periods of cash settlement because it is not possible to reasonably predict the amount of tax, interest and penalties, if any, that might be assessed by a tax authority or the timing of an assessment or payment. It is also not possible to reasonably predict whether or not the applicable statutes of limitations might expire without us being examined by any particular tax authority. See Note 13 to our consolidated financial statements for additional information on our UTBs. As of December 31, 2020, we, through NYSE, have net obligations of $130 million related to our pension and other benefit programs. The date of payment under these net obligations cannot be determined and have been excluded from the table above. See Note 16 to our consolidated financial statements for additional information on our pension and other benefit programs. In addition, the future funding of the implementation and operation of the CAT is ultimately expected to be provided by both the SROs and broker-dealers. To date, however, funding has been provided solely by the SROs, and future funding is expected to be repaid if industry member fees are approved by the SEC and subsequently collected by industry members. See "- Non-GAAP Measures" above. New and Recently Adopted Accounting Pronouncements Refer to Note 2 to our consolidated financial statements included in this Annual Report for information on the new and recently adopted accounting pronouncements that are applicable to us.79Critical Accounting Policies We have identified the policies below as critical to our business operations and the understanding of our results of operations. The impact of, and any associated risks related to, these policies on our business operations is discussed throughout “- Management’s Discussion and Analysis of Financial Condition and Results of Operations.” For a detailed discussion on the application of these and other accounting policies, see Note 2 to our consolidated financial statements included in this Annual Report. Our discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with U.S. GAAP. The preparation of financial statements in conformity with these accounting principles requires us to make estimates and assumptions that affect the reported amount of assets and liabilities, and the disclosure of contingent assets and liabilities, at the date of our financial statements and the reported amounts of revenues and expenses during the reporting period. We base our estimates and judgments on our historical experience and other factors that we believe to be reasonable under the circumstances when we make these estimates and judgments and re-evaluate them on a periodic basis. Based on these factors, we make estimates and judgments about, among other things, the carrying values of assets and liabilities that are not readily apparent from market prices or other independent sources and about the recognition and characterization of our revenues and expenses. The values and results based on these estimates and judgments could differ significantly under different assumptions or conditions and could change materially in the future. We believe that the following critical accounting policies, among others, affect our more significant judgments and estimates used in the preparation of our consolidated financial statements and could materially increase or decrease our reported results, assets and liabilities. Goodwill and Other Identifiable Intangible Assets Assets acquired and liabilities assumed in connection with our acquisitions are recorded at their estimated fair values. Goodwill represents the excess of the purchase price of an acquired company over the fair value of its identifiable net assets, including identified intangible assets. We recognize specifically identifiable intangibles, such as customer relationships, trademarks, technology, trading products, data, exchange registrations, backlog, trade names and licenses when a specific right or contract is acquired. Our determination of the fair value of the intangible assets and whether or not these assets may be impaired following their acquisition requires us to apply significant judgments and make significant estimates and assumptions regarding future cash flows. If we change our strategy or if market conditions shift, our judgments and estimates may change, which may result in adjustments to recorded asset balances. Intangible assets with finite useful lives are amortized over their estimated useful lives whereas goodwill and intangible assets with indefinite useful lives are not. In performing the allocation of the acquisitions' purchase price to assets and liabilities, we consider, among other factors, the intended use of the acquired assets, analysis of past financial performance and estimates of future performance of the acquired business. At the acquisition date, a preliminary allocation of the purchase price is recorded based upon a preliminary valuation performed with the assistance of a third-party valuation specialist. We continue to review and assess our estimates, assumptions and valuation methodologies during the measurement period provided by GAAP, which ends as soon as we receive the information about facts and circumstances that existed as of the acquisition date or we learn that more information is not obtainable, which usually does not exceed one year from the date of acquisition. Accordingly, these estimates and assumptions are subject to change, which could have a material impact on our consolidated financial statements. Estimation uncertainty may exist due to the sensitivity of the respective fair value to underlying assumptions about the future performance of an acquired business in our discounted cash flow models. Significant assumptions typically include revenue growth rates and expense synergies that form the basis of the forecasted results and the discount rate.Our goodwill and other indefinite-lived intangible assets are evaluated for impairment annually in our fiscal fourth quarter or more frequently if conditions exist that indicate that the value may be impaired. We test our goodwill for impairment at the reporting unit level, and we have identified four reporting units, which have been updated in 2020 to reflect our new segment presentation. Our reporting units identified for our goodwill testing are the NYSE, Other Exchanges, Fixed Income and Data Services, and Mortgage Technology reporting units. These impairment evaluations are performed by comparing the carrying value of the goodwill or other indefinite-lived intangibles to its estimated fair value. In accordance with our adoption of Accounting Standards Update 2017-04, Simplifying the Test for Goodwill Impairment, or ASU-2017, for both goodwill and indefinite-lived intangible impairment testing, we have the option to first perform a qualitative assessment to determine whether it is more likely than not that the fair value of a reporting unit or indefinite-80lived intangible asset is less than its carrying amount. If the fair value of the goodwill or indefinite-lived intangible asset is less than its carrying value, an impairment loss is recognized in earnings in an amount equal to the difference. Alternatively, we may choose to bypass the qualitative option and perform quantitative testing to determine if the fair value is less than the carrying value. For our goodwill impairment testing, we have elected to bypass the qualitative assessment and apply the quantitative approach. For our testing of indefinite-lived intangible assets, we apply qualitative and quantitative approaches.Application of the impairment test requires judgment, including the identification of reporting units, assignment of assets and liabilities to reporting units, assignment of goodwill to reporting units, and determination of the fair value of each reporting unit. We have historically determined the fair value of our reporting units based on various valuation techniques, including discounted cash flow analysis and a multiple of earnings approach. In assessing whether goodwill and other intangible assets are impaired, we must make estimates and assumptions regarding future cash flows, long-term growth rates of our business, operating margins, discount rates, weighted average cost of capital and other factors to determine the fair value of our assets. These estimates and assumptions require management’s judgment, and changes to these estimates and assumptions, as a result of changing economic and competitive conditions, could materially affect the determination of fair value and/or impairment. During 2019, we recorded an impairment charge of $31 million on the remaining value of exchange registration intangible assets on ICE Futures Singapore as a result of a decrease in fair value determined during our annual impairment testing. We did not record any impairments in 2020 as a result of our goodwill or indefinite-lived impairment testing.We are also required to evaluate other finite-lived intangible assets for impairment by first determining whether events or changes in circumstances indicate that the carrying value of these assets to be held and used may not be recoverable. If impairment indicators are present, then an estimate of undiscounted future cash flows produced by these long-lived assets is compared to the carrying value of those assets to determine if the asset is recoverable. If an asset is not recoverable, the loss is measured as the difference between fair value and carrying value of the impaired asset. Fair value of these assets is based on various valuation techniques, including discounted cash flow analysis. Income Taxes We are subject to income taxes in the U.S., U.K. and other foreign jurisdictions where we operate. The determination of our provision for income taxes and related accruals, deferred tax assets and liabilities requires the use of significant judgment, estimates, and the interpretation and application of complex tax laws. We recognize a current tax liability or tax asset for the estimated taxes payable or refundable on tax returns for the current year. We recognize deferred tax assets and liabilities for the expected future tax consequences of temporary differences between the financial statement carrying amounts and the tax bases of our assets and liabilities. We establish valuation allowances if we believe that it is more likely than not that some or all of our deferred tax assets will not be realized. Deferred tax assets and liabilities are measured using current enacted tax rates in effect for the years in which those temporary differences and carryforwards are expected to reverse.SEC Staff Accounting Bulletin No. 118, or SAB 118, provided guidance for companies that had not completed their accounting for the income tax effects of the TCJA in the period of enactment, allowing for a measurement period of up to one year after the enactment date to finalize the recording of the related tax impacts. As of December 31, 2018, we had completed our accounting for the tax effects of the enactment of the TCJA. We reaffirmed our position that we were not subject to transition tax under the TCJA as of December 31, 2017. In addition, we concluded that the $764 million of deferred tax benefit recorded in the 2017 financial statements was a reasonable estimate of the TCJA’s impact on our deferred tax and no further adjustments are necessary. The FASB Staff also provided additional guidance to address the accounting for the effects of the provisions related to the taxation of Global Intangible Low-Taxed Income noting that companies should make an accounting policy election to recognize deferred taxes for temporary basis differences expected to reverse in future years or to include the tax expense in the year it is incurred. We have completed our analysis of the effects of these provisions and have made a policy election to recognize such taxes as current period expenses when incurred.We do not recognize a tax benefit unless we conclude that it is more likely than not that the benefit will be sustained on audit by the taxing authority based solely on the technical merits of the associated tax position. If the recognition threshold is met, we recognize a tax benefit measured at the largest amount of the tax benefit that, in our judgment, is greater than 50 percent likely to be realized. We recognize accrued interest and penalties related to uncertain income tax positions as income tax expense in the consolidated statements of income.We operate within multiple domestic and foreign taxing jurisdictions and are subject to audit in these jurisdictions by domestic and foreign tax authorities. These audits include questions regarding our tax filing positions, including the timing 81and amount of deductions taken and the allocation of income among various tax jurisdictions. We record accruals for the estimated outcomes of these audits, and the accruals may change in the future due to new developments in each matter. At any point in time, many tax years are subject to or in the process of being audited by various taxing authorities. To the extent our estimates of settlements change or the final tax outcome of these matters is different from the amounts recorded, such differences will impact the income tax provision in the period in which such determinations are made. Our income tax expense includes changes in our estimated liability for exposures associated with our various tax filing positions. Determining the income tax expense for these potential assessments requires management to make assumptions that are subject to factors such as proposed assessments by tax authorities, changes in facts and circumstances, issuance of new regulations, and resolution of tax audits. We believe the judgments and estimates discussed above are reasonable. However, if actual results are not consistent with our estimates or assumptions, we may be exposed to losses or gains that could be material. ITEM 7 (A). QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK As a result of our operating and financing activities, we are exposed to market risks such as interest rate risk, foreign currency exchange rate risk and credit risk. We have implemented policies and procedures designed to measure, manage, monitor and report risk exposures, which are regularly reviewed by the appropriate management and supervisory bodies. Interest Rate Risk We have exposure to market risk for changes in interest rates relating to our cash and cash equivalents, short-term and long-term restricted cash and cash equivalents, short-term and long-term investments and indebtedness. As of December 31, 2020 and 2019, our cash and cash equivalents, short-term and long-term restricted cash and cash equivalents and short-term and long-term investments were $2.0 billion and $2.2 billion, respectively, of which $245 million and $282 million, respectively, were denominated in pounds sterling, euros or Canadian dollars, and the remaining amounts are denominated in U.S. dollars. We do not use our investment portfolio for trading or other speculative purposes. A hypothetical 50% decrease in short-term interest rates would decrease annual pre-tax earnings by $5 million as of December 31, 2020, assuming no change in the amount or composition of our cash and cash equivalents and short-term and long-term restricted cash and cash equivalents. As of December 31, 2020, we had $16.5 billion in outstanding debt, of which $12.9 billion relates to our fixed rate senior notes. The remaining amount outstanding of $3.6 billion relates to $2.4 billion outstanding under our Commercial Paper Program and $1.2 billion of floating rate senior notes, each of which bear interest at fluctuating rates, and $6 million under a line of credit at our ICE India subsidiary. A hypothetical 100 basis point increase in short-term interest rates relating to the amounts of floating rate debt outstanding as of December 31, 2020 would decrease annual pre-tax earnings by $36 million, assuming no change in the volume or composition of our outstanding indebtedness and no hedging activity. See Note 10 to our consolidated financial statements included in this Annual Report. The interest rates on our Commercial Paper Program are currently evaluated based upon current maturities and market conditions. The weighted average interest rate on our Commercial Paper Program decreased from 1.84% as of December 31, 2019 to 0.40% as of December 31, 2020. The decrease in the Commercial Paper Program weighted average interest rate was primarily due to the decision by the U.S. Federal Reserve to decrease the federal funds short-term interest rate by 150 basis points in March 2020 due to the impact of COVID-19 on financial markets, which impacted the liquidity and pricing volatility for all commercial paper issuances. The effective interest rate of commercial paper issuances will continue to fluctuate based on the movement in short-term interest rates along with shifts in supply and demand within the commercial paper market. Foreign Currency Exchange Rate Risk As an international business, we are subject to foreign currency exchange rate risk. We may experience gains or losses from foreign currency transactions in the future given that a significant part of our assets and liabilities are recorded in pounds sterling, Canadian dollars or euros, and a significant portion of our revenues and expenses are recorded in pounds sterling or euros. Certain assets, liabilities, revenues and expenses of foreign subsidiaries are denominated in the local functional currency of such subsidiaries. Our exposure to foreign denominated earnings in 2020 and 2019 is presented by primary foreign currency in the following table (dollars in millions, except exchange rates): 82 Year Ended December 31, 2020Year Ended December 31, 2019 Pound Sterling EuroPound Sterling EuroAverage exchange rate to the U.S. dollar in the current year$1.2832 $1.1412 $1.2769 $1.1195 Average exchange rate to the U.S. dollar in the prior year$1.2769 $1.1195 $1.3356 $1.1813 Average exchange rate increase (decrease)— %2 %(4)%(5)%Foreign denominated percentage of: Revenues, less transaction-based expenses7 % 6 %8 %5 %Operating expenses9 % 2 %10 %2 %Operating income6 %9 %7 %8 %Impact of the currency fluctuations (1) on: Revenues, less transaction-based expenses$1 $6 $(19)$(15)Operating expenses$1 $1 $(11)$(3)Operating income$— $5 $(8)$(12)(1) Represents the impact of currency fluctuation for the year compared to the same period in the prior year.We have a significant part of our assets, liabilities, revenues and expenses recorded in pounds sterling or euros. In both 2020 and 2019, 13% of our consolidated revenues, less transaction-based expenses, were denominated in pounds sterling or euros, and in 2020 and 2019, 11% and 12%, respectively, of our consolidated operating expenses were denominated in pounds sterling or euros. As the pound sterling or euro exchange rate changes, the U.S. equivalent of revenues and expenses denominated in foreign currencies changes accordingly. Foreign currency transaction risk related to the settlement of foreign currency denominated assets, liabilities and payables occurs through our operations, which are received in or paid in pounds sterling, Canadian dollars, or euros, due to the increase or decrease in the foreign currency exchange rates between periods. We incurred foreign currency transaction losses of $5 million in both 2020 and 2019 inclusive of the impact of foreign currency hedging transactions. The foreign currency transaction gains/(losses) were primarily attributable to the fluctuations of the pound sterling and euro relative to the U.S. dollar. A 10% adverse change in the underlying foreign currency exchange rates as of December 31, 2020, assuming no change in the composition of the foreign currency denominated assets, liabilities and payables and assuming no hedging activity, would result in a foreign currency loss of $15 million.We entered into foreign currency hedging transactions during 2020 and 2019 as economic hedges to help mitigate a portion of our foreign exchange risk exposure and may enter into additional hedging transactions in the future to help mitigate our foreign exchange risk exposure. Although we may enter into additional hedging transactions in the future, these hedging arrangements may not be effective, particularly in the event of imprecise forecasts of the levels of our non-U.S. denominated assets and liabilities. We have foreign currency translation risk equal to our net investment in our foreign subsidiaries. The financial statements of these subsidiaries are translated into U.S. dollars using a current rate of exchange, with gains or losses included in the cumulative translation adjustment account, a component of equity. Our exposure to the net investment in foreign currencies is presented by primary foreign currencies in the table below (in millions): As of December 31, 2020 Position in pounds sterlingPosition in Canadian dollarsPosition in eurosAssets£761 C$1,359 €147 of which goodwill represents589 403 92 Liabilities86 960 46 Net currency position£675 C$399 €101 Net currency position, in $USD$922 $313 $123 Negative impact on consolidated equity of a 10% decrease in foreign currency exchange rates$92 $31 $12 Foreign currency translation adjustments are included as a component of accumulated other comprehensive income/(loss) within our balance sheet. See the table below for the portion of equity attributable to foreign currency translation adjustments as well as the activity by year included within our statement of other comprehensive income. The impact of 83the foreign currency exchange rate differences in the table below were primarily driven by fluctuations of the pound sterling as compared to the U.S. dollar which were 1.3665, 1.3260 and 1.2756 as of December 31, 2020, 2019, and 2018, respectively. Changes in Accumulated Other Comprehensive Income/ (Loss) from Foreign Currency Translation Adjustments (in millions)Balance, as of January 1, 2018$(136)Net current period other comprehensive income/(loss)(91)Balance, as of December 31, 2018(227)Net current period other comprehensive income/(loss)50 Balance, as of December 31, 2019(177)Net current period other comprehensive income/(loss)43 Balance, as of December 31, 2020$(134) The future impact on our business relating to the U.K. leaving the EU and the corresponding regulatory changes are uncertain at this time, including future impacts on currency exchange rates.Credit Risk We are exposed to credit risk in our operations in the event of a counterparty default. We limit our exposure to credit risk by rigorously selecting the counterparties with which we make our investments, monitoring them on an ongoing basis and executing agreements to protect our interests. Clearing House Cash Deposit RisksThe ICE Clearing Houses hold material amounts of clearing member cash and cash equivalent deposits which are held or invested primarily to provide security of capital while minimizing credit, market and liquidity risks. Refer to Note 14 to our consolidated financial statements for more information on the ICE Clearing Houses' cash and cash equivalent deposits, which were $84.1 billion as of December 31, 2020. While we seek to achieve a reasonable rate of return which may generate interest income for our clearing members, we are primarily concerned with preservation of capital and managing the risks associated with these deposits. As the ICE Clearing Houses may pass on interest revenues (minus costs) to the clearing members, this could include negative or reduced yield due to market conditions. The following is a summary of the risks associated with these deposits and how these risks are mitigated:•Credit Risk: When a clearing house has the ability to hold cash collateral at a central bank, the clearing house utilizes its access to the central bank system to minimize credit risk exposures. Credit risk is managed by using exposure limits depending on the credit profile of the counterparty as well as the nature and maturity of transactions. Our investment objective is to invest in securities that preserve principal while maximizing yields, without significantly increasing risk. We seek to substantially mitigate the credit risk associated with investments by placing them with governments, well-capitalized financial institutions and other creditworthy counterparties.An ongoing review is performed to evaluate changes in the financial status of counterparties. In addition to the intrinsic creditworthiness of counterparties, our policies require diversification of counterparties (banks, financial institutions, bond issuers and funds) so as to avoid a concentration of risk.•Liquidity Risk: Liquidity risk is the risk a clearing house may not be able to meet its payment obligations in the right currency, in the right place and at the right time. To mitigate this risk, the clearing houses monitor liquidity requirements closely and maintain funds and assets in a manner which minimizes the risk of loss or delay in the access by the clearing house to such funds and assets. For example, holding funds with a central bank where possible or making only short term investments such as overnight reverse repurchase agreements serves to reduce liquidity risks.•Interest Rate Risk: Interest rate risk is the risk that interest rates rise and cause the value of securities we hold or invest in to decline. If we were required to sell securities prior to maturity, and interest rates had risen, the sale might be made at a loss relative to the carrying value. Our clearing houses seek to manage this risk by making short term investments. For example, where possible and in accordance with regulatory requirements, the clearing houses invest 84cash pursuant to overnight reverse repurchase agreements or term reverse repurchase agreements with short dated maturities. In addition, the clearing house investment guidelines allow for direct purchases of high quality sovereign debt (for example, U.S. Treasury securities) and supranational debt instruments (Euro cash deposits only) with short dated maturities. •Security Issuer Risk: Security issuer risk is the risk that an issuer of a security defaults on the payment when the security matures or debt is serviced. This risk is mitigated by limiting allowable investments under the reverse repurchase agreements to high quality sovereign or government agency debt and limiting any direct investments to high quality sovereign debt instruments. •Investment Counterparty Risk: Investment counterparty risk is the risk that a reverse repurchase agreement counterparty might become insolvent and, thus, fail to meet its obligations to our clearing houses. We mitigate this risk by only engaging in transactions with high credit quality counterparties and by limiting the acceptable collateral to securities of high quality issuers. When engaging in reverse repurchase agreements, our clearing houses take delivery of the securities underlying the reverse repurchase arrangement in custody accounts under clearing house control. Additionally, the securities purchased subject to reverse repurchase have a market value greater than the reverse repurchase amount. The typical haircut for high quality sovereign debt is 2% of the reverse repurchase amount which provides additional excess collateral. Thus, in the event that a reverse repurchase counterparty defaults on its obligation to repurchase the underlying reverse repurchase securities, our clearing house will have possession of a security with a value potentially greater than the counterparty’s obligation.The ICE Clearing Houses may use third-party investment advisors who make investments subject to the guidelines provided by each clearing house. Such advisors do not hold clearing member cash or cash equivalent deposits or the underlying investments. Clearing house property is held in custody accounts under clearing house control with credit worthy custodians including JPMorgan Chase Bank N.A., Citibank N.A., BNY Mellon, BMO Harris N.A. and Euroclear Bank Brussels (for non-U.S. dollar deposits). The ICE Clearing Houses employ (or may employ) multiple investment advisors and custodians to ensure that in the event a single advisor or custodian is unable to fulfill its role, additional advisors or custodians are available as alternatives. •Cross-Currency Margin Deposit Risk: Each of the ICE Clearing Houses may permit posting of cross-currency collateral to satisfy margin requirements (for example, accepting margin deposits denominated in U.S. dollars to secure a Euro margin obligation). The ICE Clearing Houses mitigate the risk of a currency value exposure by applying a “haircut” to the currency posted as margin at a level viewed as sufficient to provide financial protection during periods of currency volatility. Cross-currency balances are marked-to-market on a daily basis. Should the currency posted to satisfy margin requirements decline in value, the clearing member is required to increase its margin deposit on a same-day basis.Impact of Inflation We have not been adversely affected by inflation as technological advances and competition have generally caused prices for the hardware and software that we use for our electronic platforms to remain constant. In the event of inflation, we believe that we will be able to pass on any price increases to our participants, as the prices that we charge are not governed by long-term contracts.85
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+Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operations — COVID-19.” As the COVID-19 pandemic continues to disrupt business activity, our board of directors plays a critical role by guiding and supporting management as they adapt our operations in response to the pandemic and ensuring that the Company positions itself to emerge from the crisis stronger and more resilient. Further, we seek to maximize revenue collections through our robust, standardized resident screening process (which includes credit checks, evaluations of household income, and criminal background checks), as well as by utilizing Automated Clearing House, which includes an auto-pay feature, to facilitate the collection of a majority of our rental payments. In addition, we track resident delinquency on a daily basis and assess any late fees promptly in accordance with the terms of our lease (typically between the third and fifth calendar day of the month).Our operations are also highly dependent upon information systems that support our business processes. Cyber intrusions could seriously compromise our networks and the information stored therein could be accessed, publicly disclosed, misused, lost, or stolen. In the face of ever-changing and increasing cyber threats, our board of directors is well-positioned to guide management in the development of an effective cybersecurity risk program for our Company. The board or its Audit Committee typically meets no less often than semi-annually with senior information technology personnel to discuss recent trends in cyber risks and reviews our strategy to defend our business systems and information against cyber attacks. 17InsuranceWe maintain property, casualty, and corporate-level insurance coverage related to our business, including general liability, business auto, umbrella, commercial crime, directors’ and officers’ liability, fiduciary liability, cyber liability, employment practices liability, and workers’ compensation insurance. We believe the policy specifications and insured limits under our insurance program are appropriate and adequate for our business and properties given the relative risk of loss, the cost of the coverage and industry practice. However, our insurance coverage is subject to deductibles and coverage exclusions, and we are self-insured up to the amount of such deductibles and exclusions. See Part I. Item 1A. “Risk Factors — Risks Related to Our Business and Industry — We may suffer losses that are not covered by insurance.” Systems and TechnologyEffective systems and technology are essential components of our business. We have made significant investments in our lease management, construction management, property and corporate accounting, and asset management systems. These systems have been designed to be scalable to accommodate continued growth in our portfolio of single-family homes for lease. Our website is fully integrated into our resident accounting and leasing system. From our website, which is accessible from mobile devices, prospective residents can browse homes available for lease, take virtual tours, request additional information, and apply to lease a specific home. Through online resident portals and native mobile applications, existing residents can set up automatic payments and request maintenance service. Our system is designed to handle the accounting requirements of residential property accounting, including accounting for security deposits and paying property-level expenses. The system also interfaces with our third party resident screening vendor partner to expedite evaluations of prospective residents’ rental applications. We have worked with a search engine optimization firm to ensure we place high in search engine results and will continue to monitor our placement on search engines. In addition, sponsored key words are generally purchased in selected markets as needed. CompetitionWe face competition from different sources in each of our two primary activities: acquiring properties and leasing our properties. We believe our competitors in acquiring properties for investment purposes are individual investors, small private investment partnerships looking for one-off acquisitions of investment properties that can either be leased or restored and sold, and larger investors, including private equity funds and other REITs, that are seeking to capitalize on the same market opportunity that we have identified. Our primary competitors in acquiring portfolios include large and small private equity investors, public and private REITs, and other sizable private institutional investors. These same competitors may also compete with us for residents. Competition may increase the prices for properties that we would like to purchase, reduce the amount of rent we may charge for our properties, reduce the occupancy of our portfolio, and adversely impact our ability to achieve attractive total returns. However, we believe that our acquisition platform, our extensive in-market property operations infrastructure, and local expertise in our markets provide us with competitive advantages.Seasonality Our business and related operating results have been, and we believe that they will continue to be, impacted by seasonal factors throughout the year. In particular, we have experienced higher levels of resident move-outs during the summer months, which impacts both our rental revenues and related turnover costs. Further, our property operating costs are seasonally impacted in certain markets by increases in expenses such as HVAC repairs and landscaping expenses during the summer season.RegulationGeneralOur business operations and properties are subject to various covenants, laws, ordinances, and rules. We believe that we are in material compliance with such covenants, laws, ordinances, and rules, and we also require that our residents agree to comply with such covenants, laws, ordinances, and rules in their leases with us. Fair Housing ActThe Fair Housing Act (“FHA”) and its state law counterparts, and the regulations promulgated by the United States Department of Housing and Urban Development and various state agencies, prohibit discrimination in housing on the basis of 18race or color, national origin, religion, sex, familial status (including children under the age of 18 living with parents or legal custodians, pregnant women, and people in the process of adopting a child or securing custody of children under the age of 18), disability or, in some states, financial capability. We train our associates on a regular basis regarding such laws and regulations and we believe that our properties are in compliance with the FHA and other such regulations. Municipal Regulations and Homeowners’ AssociationsOur properties are subject to various municipal regulations and orders, and county and city ordinances, including without limitation, use, operation and maintenance of our properties. Certain of our properties are subject to the rules of the various HOAs where such properties are located. HOA rules and regulations are commonly referred to as “covenants, conditions and restrictions,” or CC&Rs, and typically consist of various restrictions or guidelines regarding use and maintenance of the property, including, among others, noise restrictions or guidelines as to how many cars may be parked on the property. Broker LicensureWe own internal brokerages to serve each state in which we operate, and primarily utilize in-market leasing agents who work with us to lease our homes. Our internal brokerages are subject to numerous federal, state, and local laws and regulations that govern the licensure of real estate brokers and affiliate brokers and set forth standards for, and prohibitions on, the conduct of real estate brokers. Such standards and prohibitions include, among others, those relating to fiduciary and agency duties, administration of trust funds, collection of commissions, and advertising and consumer disclosures, as well as compliance with federal, state, and local laws and programs for providing housing to low-income families. Under applicable state law, we generally have a duty to supervise and are responsible for the conduct of our internal brokerages. Environmental MattersAs a current or prior owner of real estate, we are subject to various federal, state, and local environmental laws, regulations, and ordinances, and we could be liable to third parties as a result of environmental contamination or noncompliance at our properties, even if we no longer own such properties. We are not aware of any environmental matters that would have a material adverse effect on our financial position. See Part I. Item 1A. “Risk Factors — Risks Related to Our Business and Industry — Contingent or unknown liabilities could adversely affect our financial condition, cash flows, and operating results.”Laws and Regulations Regarding Privacy and Data ProtectionWe are subject to a variety of laws and regulations that involve matters such as privacy, data protection, content, consumer protection, and other matters. For example, the California Consumer Privacy Act and the Nevada Privacy Law, which took effect in January 2020, establish certain transparency rules and create new data privacy rights for users, including more ability to control how their data is shared with third parties. See Part I. Item 1A. “Risk Factors — Risks Related to Our Business and Industry — Our business is subject to laws and regulations regarding privacy, data protection, consumer protection, and other matters.” Many of these laws and regulations are subject to change and uncertain interpretation, and could result in claims, changes to our business practices, monetary penalties, or otherwise harm our business.Segment Reporting Operating segments are defined as components of an enterprise for which discrete financial information is available that is evaluated regularly by the chief operating decision maker (“CODM”) in deciding how to allocate resources and in assessing performance. Our CODM is the Chief Executive Officer. Under the provisions of ASC 280, Segment Reporting, we have determined that we have one reportable segment related to acquiring, renovating, leasing, and operating single-family homes as rental properties. The CODM evaluates operating performance and allocates resources on a total portfolio basis. The CODM utilizes NOI as the primary measure to evaluate performance of the total portfolio. The aggregation of individual homes constitutes the total portfolio. Decisions regarding acquisitions and dispositions of homes are made at the individual home level with a focus on growing accretively in high-growth locations where we have greater scale and density. 19REIT QualificationWe have elected to qualify as a REIT for United States federal income tax purposes. So long as we qualify as a REIT, we generally will not be subject to United States federal income tax on net taxable income that we distribute annually to our stockholders. In order to qualify as a REIT for United States federal income tax purposes, we must continually satisfy tests concerning, among other things, the real estate qualification of sources of our income, the composition and values of our assets, the amounts we distribute to our stockholders, and the diversity of ownership of our stock. In order to comply with REIT requirements, we may need to forego otherwise attractive opportunities and limit our expansion opportunities and the manner in which we conduct our operations.Website and Availability of SEC filingsWe file annual, quarterly, and current reports, proxy statements, and other information with the SEC. Our SEC filings are available to the public over the Internet at the SEC’s website at http://www.sec.gov. We maintain an internet site at IR.InvitationHomes.com, where we make our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Exchange Act available free of charge as soon as reasonably practicable after they are filed with or furnished to the SEC. Our website and the information contained on or through that site are not incorporated into this Annual Report on Form 10-K. We use our website IR.InvitationHomes.com as a channel of distribution of material company information. For example, financial and other material information regarding our company is routinely posted on and accessible at IR.InvitationHomes.com. Accordingly, investors should monitor the website, in addition to following our press releases, SEC filings, and public conference calls and webcasts. In addition, you may automatically receive email alerts and other information about Invitation Homes when you enroll your email address by visiting the Email Notification section at IR.InvitationHomes.com under the Investor Resources tab. The contents of our website and social media channels are not, however, a part of this Annual Report on Form 10-K and are not incorporated by reference herein. ITEM 1A. RISK FACTORSThe risk factors noted in this section and other factors noted throughout this Annual Report on Form 10-K, describe certain risks and uncertainties that could cause our actual results to differ materially from those contained in any forward-looking statement and should be considered carefully in evaluating our company and our business. Additional risks not presently known to us or that we currently deem immaterial may also impair our business operations. Moreover, many risk factors set forth in this Annual Report on Form 10-K have been heightened as a result of the impact of the COVID-19 pandemic.Risks Related to Our Business and IndustryOur business, results of operations, financial condition, and cash flows may be adversely affected by pandemics and outbreaks of infectious disease, particularly the ongoing COVID-19 pandemic.Pandemics, such as the current COVID-19 pandemic, and outbreaks of infectious disease may adversely impact our business, results of operations, financial condition, and cash flows. The ongoing COVID-19 outbreak in the United States has led entities directed by, or notionally affiliated with, the Federal government as well as certain states and cities, including those in which we own properties and where our principal places of business are located, to impose and continue to implement measures intended to control the spread of COVID-19, including instituting quarantines, restrictions on travel, “shelter in place” rules, and restrictions on types of business that may continue to operate. We depend on rental revenues and other property income from residents for substantially all of our revenues. The COVID-19 outbreak, as well as continuing measures taken by governmental authorities and private actors to limit the spread of this virus or mitigate its impact, are interfering with the ability of some of our residents to meet their lease obligations and make their rent payments on time or at all. 20In addition, entities directed by, or notionally affiliated with, the Federal government as well as some state and local jurisdictions across the United States, have imposed temporary eviction moratoriums if certain criteria are met by residents, are allowing residents to defer missed rent payments without incurring late fees, and are prohibiting rent increases. Jurisdictions and other local and national authorities may expand or extend measures imposing restrictions on our ability to enforce residents’ contractual rental obligations and limiting our ability to increase rents. While such measures are likely to enable residents to stay in their homes despite an inability to pay because of financial or other hardship stemming from the pandemic, they are likely to continue to result in loss of rental income and other property income. We cannot predict if states, municipalities, local, and/or national authorities will expand existing restrictions, if additional states or municipalities will implement similar restrictions, or when restrictions currently in place will expire.Additionally, COVID-19 and related containment measures may also continue to interfere with the ability of our associates, suppliers, and other business partners to carry out their assigned tasks or supply materials, services, or funding (in the case of our Revolving Facility (see definition in Part II, Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Liquidity and Capital Resources”)) at ordinary levels of performance relative to the conduct of our business.Business continuity and disaster recovery issues which may result from the current COVID-19 pandemic or any future pandemic could materially interrupt our business operations. In accordance with phased re-opening guidelines and the ongoing spread of COVID-19 cases in certain states where we operate, the majority of our associates based at our headquarters and local offices continue working remotely. An extended period of remote work arrangements could strain our business continuity plans, introduce operational risk, including, but not limited to cybersecurity risks, and impair our ability to manage our business.A significant outbreak of infectious disease in the human population or pandemic may result, and the COVID-19 pandemic has resulted, in a widespread health crisis adversely affecting the economies and financial markets of many countries, resulting in an economic downturn that could negatively affect our business, results of operations, and financial condition.The COVID-19 pandemic, or a future pandemic, could also have material and adverse effects on our ability to successfully operate our business and on our financial condition, results of operations and cash flows due to, among other factors:•demand for single-family rental properties decreasing substantially and/or occupancy decreasing materially;•inability of our residents to meet their lease obligations has reduced and may continue to reduce our cash flows, and the resulting impact on rental and other property income could impact our ability to make all required debt service payments and to continue paying dividends to our stockholders at expected levels or at all. For example, our securitized financings require that monthly cash collections from their respective property collateral pools be controlled by the servicer until monthly debt service payments and property management fees are paid and escrow reserves are funded. So long as we remain in compliance with certain covenants contained in the underlying loan agreements, after such monthly payments are made the servicer releases all residual net cash flow to us. This residual net cash flow represents a material portion of our cash flows. If the property collateral pools experience higher rates of resident defaults or delinquencies, these covenants may not be achieved. This would result in the servicer holding all residual net cash flow from any collateral pool that does not meet the covenant requirements, net of a monthly funding to us for budgeted operating expenses, in blocked collateral accounts for the benefit of the securitized lender rather than being made available to us. Our lack of access to the net cash flow from securitized collateral pools could have a material adverse effect on our business, results of operations and financial condition;•a general decline in business activity and demand for real estate transactions could adversely affect (1) our ability to acquire or dispose of single-family homes on terms that are attractive or at all and (2) the value of our homes and our business such that we may recognize impairment on the carrying value of our investments in single-family residential properties and other assets subject to impairment review, including, but not limited to, goodwill;•difficulty accessing debt and equity capital on attractive terms, or at all, impacts to our credit ratings, and a severe disruption of, and/or instability in, the global financial markets or deteriorations in credit and financing conditions may affect our access to capital necessary to fund business operations, including acquisitions, or address maturing liabilities on a timely basis;21•the financial impact of the COVID-19 pandemic could negatively impact our future compliance with financial covenants of our Credit Facility (see definition in Part II, Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Liquidity and Capital Resources”) and other debt agreements and result in a default and potentially an acceleration of indebtedness, which non-compliance could negatively impact our ability to make additional borrowings under our Revolving Facility or to exercise extension options on our mortgage loans and our Credit Facility;•a deterioration in our ability to operate in affected areas or delays in the supply of products or services by vendors that are needed for our efficient operations; and•the potential negative consequences for the health of our associates, particularly if a significant number of them are impacted, could result in a deterioration in our ability to ensure business continuity during this disruption.The extent to which the COVID-19 pandemic ultimately impacts our operations depends on ongoing developments, which remain highly uncertain and cannot be predicted with confidence, including the scope, severity, and duration of the pandemic, the extent and duration of actions taken to contain the pandemic or mitigate its impact, the availability of an effective vaccine and therapeutic drugs and the effectiveness of the distribution of any such vaccines and therapeutic drugs, and the direct and indirect economic effects of the pandemic, containment measures, monetary and/or fiscal policies implemented to provide support or relief to businesses and/or residents, and other government, regulatory, and/or legislative changes precipitated by the COVID-19 pandemic, among others.The ongoing development and fluidity of this situation precludes any prediction as to the full adverse impact of the COVID-19 pandemic. Nevertheless, the COVID-19 pandemic presents material uncertainty and risk with respect to our financial condition, results of operations, cash flows and performance. While we have taken steps to mitigate the impact of the pandemic on our results of operations, there can be no assurance that these efforts will be successful.Our operating results are subject to general economic conditions and risks associated with our real estate assets.Our operating results are subject to risks generally incident to the ownership and rental of residential real estate, in many cases heightened as a result of the impact of the COVID-19 pandemic (see “— Our business, results of operations, financial condition, and cash flows may be adversely affected by pandemics and outbreaks of infectious disease, particularly the ongoing COVID-19 pandemic”), many of which are beyond our control, including, without limitation:•changes in national, regional, or local economic, demographic, or real estate market conditions;•changes in job markets and employment levels on a national, regional, and local basis;•declines in the value of residential real estate;•overall conditions in the housing market, including:•macroeconomic shifts in demand for rental homes;•inability to lease or re-lease homes to residents on a timely basis, on attractive terms or at all;•failure of residents to pay rent when due or otherwise perform their lease obligations;•unanticipated repairs, capital expenditures, weather related damages, or other costs;•uninsured damages; and•increases in property taxes, HOA fees, and insurance costs;•level of competition for suitable rental homes;•terms and conditions of purchase contracts;•costs and time period required to convert acquisitions to rental homes;•changes in interest rates and availability of financing that may render the acquisition of any homes difficult or unattractive;22•the liquidity of real estate investments, generally;•the short-term nature of most residential leases and the costs and potential delays in re-leasing;•changes in laws, including those that increase operating expenses or limit our ability to increase rental rates. See “— Tenant relief laws, including laws regulating evictions, rent control laws, and other regulations that limit our ability to increase rental rates may negatively impact our rental income and profitability”;•the impact of potential reforms relating to government-sponsored enterprises involved in the home finance and mortgage markets;•rules, regulations and/or policy initiatives by government and private actors, including HOAs, to discourage or deter the purchase of single-family properties by entities owned or controlled by institutional investors;•disputes and potential negative publicity in connection with eviction proceedings;•construction of new supply;•costs resulting from the clean-up of, and liability to third parties for damages resulting from, environmental problems, such as indoor mold;•fraud by borrowers, originators, and/or sellers of mortgage loans;•undetected deficiencies and/or inaccuracies in underlying mortgage loan documentation and calculations;•casualty or condemnation losses;•the geographic mix of our properties;•the cost, quality, and condition of the properties we are able to acquire; and•our ability to provide adequate management, maintenance, and insurance.Any one or more of these factors could adversely affect our business, financial condition, and results of operations.We are employing a business model with a limited track record, which may make our business difficult to evaluate.Until recently, the single-family rental business consisted primarily of private and individual investors in local markets and was managed individually or by small, non-institutional owners and property managers. Our business strategy involves purchasing, renovating, maintaining, and managing a large number of residential properties and leasing them to qualified residents. Entry into this market by large, well-capitalized investors is a relatively recent trend, so few peer companies exist and none have yet established long-term track records that might assist us in predicting whether our business model and investment strategy can be implemented and sustained over an extended period of time. It may be difficult for you to evaluate our potential future performance without the benefit of established long-term track records from companies implementing a similar business model. We may encounter unanticipated problems as we continue to refine our business model, which may adversely affect our results of operations and ability to make distributions to our stockholders and cause our stock price to decline significantly.We have a limited operating history and may not be able to operate our business successfully or generate sufficient cash flows to make or sustain distributions to our stockholders.We have a limited operating history. As a result, an investment in our common stock may entail more risk than an investment in the common stock of a real estate company with a substantial operating history. If we are unable to operate our business successfully, we would not be able to generate sufficient cash flow to make or sustain distributions to our stockholders, and you could lose all or a portion of the value of your ownership in our common stock. Our ability to successfully operate our business and implement our operating policies and investment strategy depends on many factors, including:•our ability to effectively manage renovation, maintenance, marketing, and other operating costs for our properties;23•economic conditions in our markets, including changes in employment and household earnings and expenses, as well as the condition of the financial and real estate markets and the economy, in general;•our ability to maintain high occupancy rates and target rent levels;•the availability of, and our ability to identify, attractive acquisition opportunities consistent with our investment strategy;•our ability to compete with other investors entering the single-family rental industry;•costs that are beyond our control, including title litigation, litigation with residents or tenant organizations, legal compliance, property taxes, HOA fees, and insurance;•judicial and regulatory developments affecting landlord-tenant relations that may affect or delay our ability to dispossess or evict occupants or increase rental rates;•reversal of population, employment, or homeownership trends in our markets; and•interest rate levels and volatility, which may affect the accessibility of short-term and long-term financing on desirable terms.In addition, we face significant competition in acquiring attractive properties on advantageous terms, and the value of the properties that we acquire may decline substantially after we purchase them.We may not be able to effectively manage our growth, and any failure to do so may have an adverse effect on our business and operating results.Since commencing operations in 2012, we have grown rapidly, assembling a portfolio of over 80,000 homes as of December 31, 2020. Our future operating results may depend on our ability to effectively manage our growth, which is dependent, in part, upon our ability to:•stabilize and manage an increasing number of properties and resident relationships across our geographically dispersed portfolio while maintaining a high level of resident satisfaction and building and enhancing our brand;•identify and supervise a number of suitable third parties on which we rely to provide certain services outside of property management to our properties;•attract, integrate, and retain new management and operations personnel; and•continue to improve our operational and financial controls and reporting procedures and systems.We can provide no assurance that we will be able to manage our properties or grow our business efficiently or effectively, or without incurring significant additional expenses. Any failure to do so may have an adverse effect on our business and operating results.A significant portion of our costs and expenses are fixed and we may not be able to adapt our cost structure to offset declines in our revenue.Many of the expenses associated with our business, such as property taxes, HOA fees, insurance, utilities, acquisition, renovation and maintenance costs, and other general corporate expenses are relatively inflexible and will not necessarily decrease with a reduction in revenue from our business. Some components of our fixed assets depreciate more rapidly and require ongoing capital expenditures. Our expenses and ongoing capital expenditures are also affected by inflationary increases, and certain of our cost increases may exceed the rate of inflation in any given period or market. Our rental income is affected by many factors beyond our control, such as the availability of alternative rental housing and economic conditions in our markets. In addition, state and local regulations may require us to maintain properties that we own, even if the cost of maintenance is greater than the value of the property or any potential benefit from renting the property, or pass regulations that limit our ability to increase rental rates. As a result, we may not be able to fully offset rising costs and capital spending by increasing rental rates, which could have a material adverse effect on our results of operations and cash available for distribution.24Increasing property taxes, HOA fees, and insurance costs may negatively affect our financial results.As a result of our substantial real estate holdings, the cost of property taxes and insuring our properties is a significant component of our expenses. Our properties are subject to real and personal property taxes that may increase as tax rates change and as the real properties are assessed or reassessed by taxing authorities. As the owner of our properties, we are ultimately responsible for payment of the taxes to the applicable government authorities. If real property taxes increase, our expenses will increase. If we fail to pay any such taxes, the applicable taxing authority may place a lien on the real property and the real property may be subject to a tax sale.In addition, a significant portion of our properties are located within HOAs and we are subject to HOA rules and regulations. HOAs have the power to increase monthly charges and make assessments for capital improvements and common area repairs and maintenance. Property taxes, HOA fees, and insurance premiums are subject to significant increases, which can be outside of our control. If the costs associated with property taxes, HOA fees and assessments, or insurance rise significantly and we are unable to increase rental rates due to rent control laws or other regulations to offset such increases, our results of operations would be negatively affected.We recorded net losses in the past and we may experience net losses in the future.We recorded consolidated net losses for the year ended December 31, 2018. These net losses were inclusive in each period of significant non-cash charges, consisting primarily of depreciation and amortization expense. We expect such non-cash charges to continue to be significant in future periods and, as a result, we may record net losses in future periods.We are dependent on our executive officers and dedicated personnel, and the departure of any of our key personnel could materially and adversely affect us. We also face intense competition for the employment of highly skilled managerial, investment, financial, and operational personnel.We rely on a small number of persons to carry out our business and investment strategies, and the loss of the services of any of our key management personnel, or our inability to recruit and retain qualified personnel in the future, could have an adverse effect on our business and financial results.In addition, the implementation of our business plan may require that we employ additional qualified personnel. Competition for highly skilled managerial, investment, financial, and operational personnel is intense. As additional large real estate investors enter into and expand their scale within the single-family rental business, we have faced increased challenges in hiring and retaining personnel, and we cannot assure our stockholders that we will be successful in attracting and retaining such skilled personnel. If we are unable to hire and retain qualified personnel as required, our growth and operating results could be adversely affected.Our ability to meet our labor needs while controlling our labor costs is subject to numerous external factors, including unemployment levels, prevailing wage rates, changing demographics, and changes in employment legislation. If we are unable to retain qualified personnel or our labor costs increase significantly, our business operations and our financial performance could be adversely impacted.Our investments are and will continue to be concentrated in our markets and in the single-family properties sector of the real estate industry, which exposes us to seasonal fluctuations in rental demand and downturns in our markets or in the single-family properties sector.Our investments in real estate assets are and will continue to be concentrated in our markets and in the single-family properties sector of the real estate industry. A downturn or slowdown in the rental demand for single-family housing caused by adverse economic, regulatory, or environmental conditions, or other events, in our markets may have a greater impact on the value of our properties or our operating results than if we had more fully diversified our investments. We believe that there are seasonal fluctuations in rental demand with demand higher in the spring and summer than in the late fall and winter. Such seasonal fluctuations may impact our operating results. The COVID-19 pandemic, or a future pandemic, could also result in demand for single-family rental properties decreasing substantially and/or occupancy decreasing materially. See “— Our business, results of operations, financial condition, and cash flows may be adversely affected by pandemics and outbreaks of infectious disease, particularly the ongoing COVID-19 pandemic.”25In addition to general, regional, national, and international economic conditions, our operating performance will be impacted by the economic conditions in our markets. We base a substantial part of our business plan on our belief that property values and operating fundamentals for single-family properties in our markets will continue to improve over the near to intermediate term. However, these markets have experienced substantial economic downturns in recent years and could experience similar or worse economic downturns in the future. Additionally, a significant outbreak of infectious disease in the human population or pandemic may result, and the COVID-19 pandemic has resulted, in a widespread health crisis adversely affecting the economies and financial markets of many countries, resulting in an economic downturn that could negatively affect our business, results of operations, and financial condition. See “— Our business, results of operations, financial condition, and cash flows may be adversely affected by pandemics and outbreaks of infectious disease, particularly the ongoing COVID-19 pandemic.” We can provide no assurance as to the extent property values and operating fundamentals in these markets will improve, if at all. If the recent economic downturn in these markets returns or if we fail to accurately predict the timing of economic improvement in these markets, the value of our properties could decline and our ability to execute our business plan may be adversely affected to a greater extent than if we owned a real estate portfolio that was more geographically diversified, which could adversely affect our financial condition, operating results, and ability to make distributions to our stockholders and cause the value of our common stock to decline.We may not be able to effectively control the timing and costs relating to the renovation and maintenance of our properties, which may adversely affect our operating results and ability to make distributions to our stockholders.Nearly all of our properties require some level of renovation either immediately upon their acquisition or in the future following expiration of a lease or otherwise. We may acquire properties that we plan to extensively renovate. We may also acquire properties that we expect to be in good condition only to discover unforeseen defects and problems that require extensive renovation and capital expenditures. To the extent properties are leased to existing residents, renovations may be postponed until the resident vacates the premises, and we will pay the costs of renovating. In addition, from time to time, we may perform ongoing maintenance or make ongoing capital improvements and replacements and perform significant renovations and repairs that resident deposits and insurance may not cover. Because our portfolio consists of geographically dispersed properties, our ability to adequately monitor or manage any such renovations or maintenance may be more limited or subject to greater inefficiencies than if our properties were more geographically concentrated.Our properties have infrastructure and appliances of varying ages and conditions. Consequently, we routinely retain independent contractors and trade professionals to perform physical repair work and are exposed to all of the risks inherent in property renovation and maintenance, including potential cost overruns, increases in labor and materials costs, delays by contractors in completing work, delays in the timing of receiving necessary work permits, certificates of occupancy, and poor workmanship. Additionally, COVID-19 and related containment measures may also continue to interfere with the ability of our associates, suppliers, and other business partners to carry out their assigned tasks or supply materials, services, or funding at ordinary levels of performance relative to the conduct of our business. See “— Our business, results of operations, financial condition, and cash flows may be adversely affected by pandemics and outbreaks of infectious disease, particularly the ongoing COVID-19 pandemic.” If our assumptions regarding the costs or timing of renovation and maintenance across our properties prove to be materially inaccurate, our operating results and ability to make distributions to our stockholders may be adversely affected.We face significant competition in the leasing market for quality residents, which may limit our ability to lease our single-family homes on favorable terms.We depend on rental income from residents for substantially all of our revenues. As a result, our success depends in large part upon our ability to attract and retain qualified residents for our properties. We face competition for residents from other lessors of single-family properties, apartment buildings, and condominium units. Competing properties may be newer, better located, and more attractive to residents. Potential competitors may have lower rates of occupancy than we do or may have superior access to capital and other resources, which may result in competing owners more easily locating residents and leasing available housing at lower rental rates than we might offer at our homes. Many of these competitors may successfully attract residents with better incentives and amenities, which could adversely affect our ability to obtain quality residents and lease our single-family properties on favorable terms. Additionally, some competing housing options may qualify for 26government subsidies that may make such options more accessible and therefore more attractive than our properties. This competition may affect our ability to attract and retain residents and may reduce the rental rates we are able to charge.In addition, increases in unemployment levels and other adverse changes in economic conditions in our markets may adversely affect the creditworthiness of potential residents, which may decrease the overall number of qualified residents for our properties within such markets. We could also be adversely affected by overbuilding or high vacancy rates of homes in our markets, which could result in an excess supply of homes and reduce occupancy and rental rates. Continuing development of apartment buildings and condominium units in many of our markets will increase the supply of housing and exacerbate competition for residents.In addition, improving economic conditions, along with the availability of low residential mortgage interest rates and government sponsored programs to promote home ownership, have made home ownership more accessible for potential renters who have strong credit. These factors may encourage potential renters to purchase residences rather than lease them, thereby causing a decline in the number and quality of potential residents available to us.No assurance can be given that we will be able to attract and retain suitable residents. If we are unable to lease our homes to suitable residents, we would be adversely affected and the value of our common stock could decline.We intend to continue to acquire properties from time to time consistent with our investment strategy even if the rental and housing markets are not as favorable as they have been in the recent past, which could adversely impact anticipated yields.We intend to continue to acquire properties from time to time consistent with our investment strategy, even if the rental and housing markets are not as favorable as they have been in the recent past. Future acquisitions of properties may be more costly than those we have acquired previously. The following factors, among others, may make acquisitions more expensive:•improvements in the overall economy and employment levels;•greater availability of consumer credit;•improvements in the pricing and terms of mortgages;•the emergence of increased competition for single-family properties from private investors and entities with similar investment objectives to ours; and•tax or other government incentives that encourage homeownership.Additionally, a general decline in business activity and demand for real estate transactions, resulting from COVID-19 pandemic, could adversely affect our ability to acquire or dispose of single-family homes on terms that are attractive or at all. See “— Our business, results of operations, financial condition, and cash flows may be adversely affected by pandemics and outbreaks of infectious disease, particularly the ongoing COVID-19 pandemic.”We plan to continue acquiring properties as long as we believe such properties offer an attractive total return opportunity. Accordingly, future acquisitions may have lower yield characteristics than recent past and present opportunities and, if such future acquisitions are funded through equity issuances, the yield and distributable cash per share will be reduced, and the value of our common stock may decline.Competition in identifying and acquiring our properties could adversely affect our ability to implement our business and growth strategies, which could materially and adversely affect us.In acquiring our properties, we compete with a variety of institutional investors, including other REITs, specialty finance companies, public and private funds, savings and loan associations, banks, mortgage bankers, insurance companies, institutional investors, investment banking firms, financial institutions, governmental bodies, and other entities. We also compete with individual private home buyers and small scale investors.Certain of our competitors may be larger in certain of our markets and may have greater financial or other resources than we do. Some competitors may have a lower cost of funds and access to funding sources that may not be available to us. In addition, any potential competitor may have higher risk tolerances or different risk assessments and may not be subject to the operating constraints associated with qualification for taxation as a REIT, which could allow them to consider a wider variety 27of investments. Competition may result in fewer investments, higher prices, a broadly dispersed portfolio of properties that does not lend itself to efficiencies of concentration, acceptance of greater risk, lower yields and a narrower spread of yields over our financing costs. In addition, competition for desirable investments could delay the investment of our capital, which could adversely affect our results of operations and cash flows. As a result, there can be no assurance that we will be able to identify and finance investments that are consistent with our investment objectives or to achieve positive investment results, and our failure to accomplish any of the foregoing could have a material adverse effect on us and cause the value of our common stock to decline.Compliance with governmental laws, regulations, and covenants that are applicable to our properties or that may be passed in the future, including affordability covenants, permit, license, and zoning requirements, may adversely affect our ability to make future acquisitions, renovations, or dispositions, result in significant costs, delays, or losses, and adversely affect our growth strategy.Rental homes are subject to various covenants and local laws and regulatory requirements, including permitting, licensing, and zoning requirements. Local regulations, including municipal or local ordinances, restrictions, and restrictive covenants imposed by community developers may restrict our use of our properties and may require us to obtain approval from local officials or community standards organizations at any time with respect to our properties, including prior to acquiring any of our properties or when undertaking renovations of any of our existing properties. Among other things, these restrictions may relate to fire and safety, seismic, asbestos-cleanup, or hazardous material abatement requirements. Such local regulations may cause us to incur additional costs to renovate or maintain our properties in accordance with the particular rules and regulations. Additionally, state and local agencies may place affordability covenants on certain properties to ensure that they are used to provide affordable housing for persons or families of lower income. If any of our properties contain affordability covenants recorded in their chains of title, we will be forced to sell such properties at a maximum price limit as calculated per the applicable affordable housing covenant, which will likely result in us having to sell such properties below their market values. We cannot assure you that existing regulatory policies will not adversely affect us or the timing or cost of any future acquisitions, renovations, or dispositions, or that additional regulations will not be adopted that would increase such delays or result in additional costs or losses. Our business and growth strategies may be materially and adversely affected by our ability to obtain permits, licenses and approvals. Our failure to obtain such permits, licenses, and approvals could have a material adverse effect on us and cause the value of our common stock to decline.Tenant relief laws, including laws regulating evictions, rent control laws, and other regulations that limit our ability to increase rental rates may negatively impact our rental income and profitability.As the landlord of numerous properties, we are involved from time to time in evicting residents who are not paying their rent or who are otherwise in material violation of the terms of their lease. Eviction activities impose legal and managerial expenses that raise our costs and expose us to potential negative publicity. The eviction process is typically subject to legal barriers, mandatory “cure” policies, our internal policies and procedures, and other sources of expense and delay, each of which may delay our ability to gain possession and stabilize the property. Additionally, state and local landlord-tenant laws may impose legal duties to assist residents in relocating to new housing, or restrict the landlord’s ability to remove the resident on a timely basis or to recover certain costs or charge residents for damage residents cause to the landlord’s premises. Because such laws vary by state and locality, we must be familiar with and take all appropriate steps to comply with all applicable landlord-tenant laws, and need to incur supervisory and legal expenses to ensure such compliance. To the extent that we do not comply with state or local laws, we may be subjected to civil litigation filed by individuals, in class actions or actions by state or local law enforcement and our reputation and financial results may suffer. We may be required to pay our adversaries’ litigation fees and expenses if judgment is entered against us in such litigation or if we settle such litigation.Furthermore, state and local governmental agencies may introduce rent control laws or other regulations that limit our ability to increase rental rates, which may affect our rental income. Especially in times of recession and economic slowdown, rent control initiatives can acquire significant political support. If rent controls unexpectedly became applicable to certain of our properties, our revenue from and the value of such properties could be adversely affected.28For example, in 2019, the state of California passed the Tenant Protection Act of 2019, a rent control law which limits our ability to increase rental rates for existing residents and put into place protections for the terminations of tenancies. We believe this law negatively affects our rental income from certain of the 12,198 homes we own in California as of December 31, 2020.The COVID-19 pandemic in the United States has led entities directed by, or notionally affiliated with, the Federal government as well as certain states and cities, including those in which we own properties and where our principal places of business are located, to impose and continue to implement measures intended to control the spread of COVID-19, including instituting quarantines, restrictions on travel, “shelter in place” rules, and restrictions on types of business that may continue to operate. Entities directed by, or notionally affiliated with, the Federal government as well as some state and local jurisdictions across the United States, have imposed temporary eviction moratoriums if certain criteria are met by residents, are allowing residents to defer missed rent payments without incurring late fees, and are prohibiting rent increases. Jurisdictions and other local and national authorities may expand or extend measures imposing restrictions on our ability to enforce residents’ contractual rental obligations and limiting our ability to increase rents. While such measures are likely to enable residents to stay in their homes despite an inability to pay because of financial or other hardship stemming from the pandemic, they are likely to continue to result in loss of rental income and other property income. We cannot predict if states, municipalities, local, and/or national authorities will expand existing restrictions, if additional states or municipalities will implement similar restrictions, or when restrictions currently in place will expire. See “— Our business, results of operations, financial condition, and cash flows may be adversely affected by pandemics and outbreaks of infectious disease, particularly the ongoing COVID-19 pandemic.”We may become a target of legal demands, litigation (including class actions), and negative publicity by tenant and consumer rights organizations, which could directly limit and constrain our operations and may result in significant litigation expenses and reputational harm.Numerous tenant rights and consumer rights organizations exist throughout the country and operate in our markets, and we may attract attention from some of these organizations and become a target of legal demands, litigation, and negative publicity. Many such consumer organizations have become more active and better funded in connection with mortgage foreclosure-related issues; and with the increased market for homes arising from displaced homeownership, some of these organizations may shift their litigation, lobbying, fundraising, and grass roots organizing activities to focus on landlord-resident issues. While we intend to conduct our business lawfully and in compliance with applicable landlord-tenant and consumer laws, such organizations might work in conjunction with trial and pro bono lawyers in one or multiple states to attempt to bring claims against us on a class action basis for damages or injunctive relief and to seek to publicize our activities in a negative light. We cannot anticipate what form such legal actions might take or what remedies they may seek.Additionally, such organizations may lobby local county and municipal attorneys or state attorneys general to pursue enforcement or litigation against us, may lobby state and local legislatures to pass new laws and regulations to constrain or limit our business operations, adversely impact our business, or may generate negative publicity for our business and harm our reputation. If they are successful in any such endeavors, they could directly limit and constrain our operations and may impose on us significant litigation expenses, including settlements to avoid continued litigation or judgments for damages or injunctions.Our business is subject to laws and regulations regarding privacy, data protection, consumer protection, and other matters. Many of these laws and regulations are subject to change and uncertain interpretation, and could result in claims, changes to our business practices, monetary penalties, or otherwise harm our business.We are subject to a variety of laws and regulations that involve matters such as: privacy; data protection; personal information; rights of publicity; content; marketing; distribution; data security; data retention and deletion; electronic contracts and other communications; consumer protection; and online payment services. These laws and regulations are constantly evolving and can be subject to significant change. As a result, the application, interpretation, and enforcement of these laws and regulations are often uncertain and may be interpreted and applied inconsistently. Additionally, as we depend on third parties for key services (see “— Our dependence upon third parties for key services may have an adverse effect on our operating results or reputation if the third parties fail to perform”), we rely on such third party service providers’ 29compliance with laws and regulations regarding privacy, data protection, consumer protection, and other matters relating to our customers. There are a number of legislative proposals at both the federal and state level, as well as other jurisdictions that could impose new obligations in areas affecting our business. We are subject to numerous, complex, and frequently changing laws, regulations, and contractual obligations designed to protect personal information. Various federal and state privacy and data security laws, such as the California Consumer Privacy Act and Nevada Privacy Law, or other regulatory standards create data privacy rights for users, including more ability to control how their data is shared with third parties. These laws and regulations, as well as any associated inquiries or investigations or any other government actions, may be costly to comply with, result in negative publicity, require significant management time and attention, and subject us to remedies that may harm our business, including fines or demands or orders that we modify or cease existing business practices.Our evaluation of properties involves a number of assumptions that may prove inaccurate, which could result in us paying too much for properties we acquire and/or overvaluing our properties or our properties failing to perform as we expect.We are authorized to follow a broad investment policy established by our board of directors and subject to implementation by our management. Our board of directors periodically reviews and updates the investment policy and also reviews our portfolio of residential real estate, but it generally does not review or approve specific property acquisitions. Our success depends on our ability to acquire properties that can be quickly possessed, renovated, repaired, upgraded, and rented with minimal expense and maintained in quality condition. In determining whether a particular property meets our investment criteria, we also make a number of assumptions, including, among other things, assumptions related to estimated time of possession and estimated renovation costs and time frames, annual operating costs, market rental rates and potential rent amounts, time from purchase to leasing, and resident default rates. These assumptions may prove inaccurate, particularly since the properties that we acquire vary materially in terms of time to possession, renovation, quality and type of construction, geographic location, and hazards. As a result, we may pay too much for properties we acquire and/or overvalue our properties, or our properties may fail to perform as anticipated. Adjustments to the assumptions we make in evaluating potential purchases may result in fewer properties qualifying under our investment criteria, including assumptions related to our ability to lease properties we have purchased.Our dependence upon third parties for key services may have an adverse effect on our operating results or reputation if the third parties fail to perform.Though we are internally managed, we use local and national third party vendors and service providers to provide certain services for our properties. For example, we typically engage third party home improvement professionals with respect to certain maintenance and specialty services, such as HVAC, roofing, painting, and floor installations. Selecting, managing, and supervising these third party service providers requires significant resources and expertise, and because our portfolio consists of geographically dispersed properties, our ability to adequately select, manage, and supervise such third parties may be more limited or subject to greater inefficiencies than if our properties were more geographically concentrated.We have entered into a multi-year contract with a third party vendor to provide certain services for our properties. Because of the large volume of services under this contract, only a limited number of companies are capable of servicing our needs on this scale. Accordingly, the inability or unwillingness of this vendor to continue to provide these services on acceptable terms or at all could have a material adverse effect on our business.We generally do not have exclusive or long-term contractual relationships with third party providers and we can provide no assurance that we will have uninterrupted or unlimited access to their services. If we do not select, manage, and supervise appropriate third parties to provide these services, our reputation and financial results may suffer.We rely on the systems of our third party service providers, their ability to perform key operations on our behalf in a timely manner and in accordance with agreed levels of service, and their ability to attract and retain sufficient qualified personnel to perform our work. A failure in the systems of one of our third party service providers, or their inability to perform in accordance with the terms of our contracts or to retain sufficient qualified personnel, could have a material adverse effect on our business, results of operations, and financial condition.30Additionally, COVID-19 and related containment measures may also continue to interfere with the ability of our associates, suppliers, and other business partners to carry out their assigned tasks or supply materials, services, or funding at ordinary levels of performance relative to the conduct of our business. See “— Our business, results of operations, financial condition, and cash flows may be adversely affected by pandemics and outbreaks of infectious disease, particularly the ongoing COVID-19 pandemic.”Notwithstanding our efforts to implement and enforce strong policies and practices regarding service providers, we may not successfully detect and prevent fraud, misconduct, incompetence, or theft by our third party service providers. In addition, any removal or termination of third party service providers would require us to seek new vendors or providers, which would create delays and adversely affect our operations. Poor performance by such third party service providers may reflect poorly on us and could significantly damage our reputation among desirable residents. In the event of fraud or misconduct by a third party, we could also be exposed to material liability and be held responsible for damages, fines, or penalties and our reputation may suffer. In the event of failure by our general contractors to pay their subcontractors, our properties may be subject to filings of mechanics or materialmen liens, which we may need to resolve to remain in compliance with certain debt covenants, and for which indemnification from the general contractors may not be available.We have in the past and may from time to time in the future acquire some of our homes through the auction process, which could subject us to significant risks that could adversely affect us.We have in the past and may from time to time in the future acquire some of our homes through the auction process, including auctions of homes that have been foreclosed upon by third party lenders. Such auctions may occur simultaneously in a number of markets, including monthly auctions on the same day of the month in certain markets. As a result, we may only be able to visually inspect properties from the street and will purchase these homes without a contingency period and in “as is” condition with the risk that unknown defects in the property may exist. Upon acquiring a new home, we may have to evict residents who are in unlawful possession before we can secure possession and control of the home. The holdover occupants may be the former owners or residents of a property or others who are illegally in possession. Securing control and possession from these occupants can be both costly and time-consuming or generate negative publicity for our business and harm our reputation.Allegations of deficiencies in auction practices could result in claims challenging the validity of some auctions, potentially placing our claim of ownership to the properties at risk. Since we may not have obtained title insurance policies for properties we acquired through the auction process, such instances or such proceedings may result in a complete loss without compensation.Title defects could lead to material losses on our investments in our properties.Our title to a property may be challenged for a variety of reasons, and in such instances title insurance may not prove adequate. For example, while we do not lend to homeowners and accordingly do not foreclose on a home, our title to properties we acquire at foreclosure auctions may be subject to challenge based on allegations of defects in the foreclosure process undertaken by other parties. In addition, we have in the past, and may from time to time in the future, acquire a number of our properties on an “as is” basis, at auctions or otherwise. When acquiring properties on an “as is” basis, title commitments are often not available prior to purchase and title reports or title information may not reflect all senior liens, which may increase the possibility of acquiring houses outside predetermined acquisition and price parameters, purchasing residences with title defects and deed restrictions, HOA restrictions on leasing, or purchasing the wrong residence without the benefit of title insurance prior to closing. Although we use various policies, procedures, and practices to assess the state of title prior to purchase and obtain title insurance if an acquired property is placed into a securitization facility in connection with a mortgage loan financing, there can be no assurance that these policies and procedures will be effective, which could lead to a material if not complete loss on our investment in such properties.For properties we acquire at auction, we similarly may not obtain title insurance prior to purchase, and we are not able to perform the type of title review that is customary in acquisitions of real property. As a result, our knowledge of potential title issues will be limited, and title insurance protection may not be in place. This lack of title knowledge and insurance protection may result in third parties having claims against our title to such properties that may materially and adversely affect the values of the properties or call into question the validity of our title to such properties. Without title insurance, we 31are fully exposed to, and would have to defend ourselves against, such claims. Further, if any such claims are superior to our title to the property we acquired, we risk loss of the property purchased.Increased scrutiny of title matters could lead to legal challenges with respect to the validity of the sale. In the absence of title insurance, the sale may be rescinded, and we may be unable to recover our purchase price, resulting in a complete loss. Title insurance obtained subsequent to purchase offers little protection against discoverable defects because they are typically excluded from such policies. In addition, any title insurance on a property, even if acquired, may not cover all defects or the significant legal costs associated with obtaining clear title.Any of these risks could adversely affect our operating results, cash flows, and ability to make distributions to our stockholders.We are subject to certain risks associated with bulk portfolio acquisitions and dispositions.We have acquired and disposed of, and may continue to acquire and dispose of, properties we acquire or sell in bulk from or to other owners of single-family homes, banks, and loan servicers. When we purchase properties in this manner, we often do not have the opportunity to conduct interior inspections or conduct more than cursory exterior inspections on a portion of the properties. Such inspection processes may fail to reveal major defects associated with such properties, which may cause the amount of time and cost required to renovate and/or maintain such properties to substantially exceed our estimates. Bulk portfolio acquisitions are also more complex than single-family home acquisitions, and we may not be able to implement this strategy successfully. The costs involved in locating and performing due diligence (when feasible) on portfolios of homes as well as negotiating and entering into transactions with potential portfolio sellers could be significant, and there is a risk that either the seller may withdraw from the entire transaction for failure to come to an agreement or the seller may not be willing to sell us the bulk portfolio on terms that we view as favorable. In addition, a seller may require that a group of homes be purchased as a package even though we may not want to purchase certain individual assets in the bulk portfolio.Moreover, to the extent the management and leasing of such properties has not been consistent with our property management and leasing standards, we may be subject to a variety of risks, including risks relating to the condition of the properties, the credit quality and employment stability of the residents, and compliance with applicable laws, among others. In addition, financial and other information provided to us regarding such portfolios during our due diligence may be inaccurate, and we may not discover such inaccuracies until it is too late to seek remedies against such sellers. To the extent we pursue such remedies, we may not be able to successfully prevail against the seller in an action seeking damages for such inaccuracies. If we conclude that certain individual properties purchased in bulk portfolio sales do not fit our target investment criteria, we may decide to sell, rather than renovate and lease, such properties, which could take an extended period of time and may not result in a sale at an attractive price.From time to time we engage in bulk portfolio dispositions of properties consistent with our business and investment strategy. With respect to any such disposition, the purchaser may default on payment or otherwise breach the terms of the relevant purchase agreement, and it may be difficult for us to pursue remedies against such purchaser or retain or resume possession of the relevant properties. To the extent we pursue such remedies, we may not be able to successfully prevail against the purchaser.Contingent or unknown liabilities could adversely affect our financial condition, cash flows, and operating results. Assets and entities that we have acquired or may acquire in the future may be subject to unknown or contingent liabilities for which we may have limited or no recourse against the sellers. Unknown or contingent liabilities might include liabilities for, or with respect to, liens attached to properties, unpaid property tax, utilities, or HOA charges for which a subsequent owner remains liable, clean-up or remediation of environmental conditions or code violations, claims of customers, vendors, or other persons dealing with the acquired entities, and tax liabilities. Purchases of single-family properties acquired at auction, in short sales, from lenders, or in portfolio purchases typically involve few or no representations or warranties with respect to the properties and may allow us limited or no recourse against the sellers. Such properties also often have unpaid tax, utility, and HOA liabilities which we may be obligated to pay but fail to anticipate. As a result, the total amount of costs and expenses that we may incur with respect to liabilities associated with acquired properties and entities may exceed our expectations, which may adversely affect our operating results and financial condition. Additionally, such properties may be 32subject to covenants, conditions, or restrictions that restrict the use or ownership of such properties, including prohibitions on leasing. We may not discover such restrictions during the acquisition process and such restrictions may adversely affect our ability to operate such properties as we intend.In particular, under a Florida statutory framework implemented by certain Florida jurisdictions, a violation of the relevant building codes, zoning codes, or other similar regulations applicable to a property may result in a lien on that property and all other properties owned by the same violator and located in the same county as the property with the code violation, even though the other properties might not be in violation of any code. Until a municipal inspector verifies that the violation has been remedied and any applicable fines have been paid, additional fines accrue on the amount of the lien and the lien may not be released, in each case even at those properties that are not in violation. As a practical matter, it might be possible to obtain a release of these liens without remedying the property in violation through other methods, such as payment of an amount to the relevant county, although no assurance can be given that this option will necessarily be available or how long such a process would take.A significant number of our residential properties are part of HOAs and we and our residents are subject to the rules and regulations of such HOAs, which are subject to change and which may be arbitrary or restrictive, and violations of such rules may subject us to additional fees and penalties and litigation with such HOAs, which would be costly.A significant number of our properties are located within HOAs, which are private entities that regulate the activities of owners and occupants of, and levy assessments on, properties in a residential subdivision. The HOAs in which we own our properties may have enacted or may from time to time enact onerous or arbitrary rules that restrict our ability to restore, market, lease, or operate our properties in accordance with our investment strategy, or require us to restore or maintain such properties at standards or costs that are in excess of our planned budgets. Some HOAs impose limits on the number of property owners who may lease their homes, which, if met or exceeded, would cause us to incur additional costs to sell the property and opportunity costs from lost rental revenue. Furthermore, we may have residents who violate HOA rules and incur fines for which we may be liable as the property owner and for which we may not be able to obtain reimbursement from the resident. Additionally, the governing bodies of the HOAs in which we own property may not make important disclosures about the properties or may block our access to HOA records, initiate litigation, restrict our ability to sell our properties, impose assessments, or arbitrarily change the HOA rules. We may be unaware of or unable to review or comply with HOA rules before purchasing a property, and any such excessively restrictive or arbitrary regulations may cause us to sell such property at a loss, prevent us from leasing such property, or otherwise reduce our cash flow from such property, which would have an adverse effect on our returns on these properties. Several states have enacted laws that provide that a lien for unpaid monies owed to an HOA may be senior to or extinguish mortgage liens on properties. Such actions, if not cured, may give rise to events of default under certain of our indebtedness, which could have a material adverse impact on us.Environmentally hazardous conditions may adversely affect us.Under various federal, state, and local environmental laws, a current or previous owner or operator of real property may be liable for the cost of removing or remediating hazardous or toxic substances on such property. Such laws often impose liability whether or not the owner or operator knew of, or was responsible for, the presence of such hazardous or toxic substances. Even if more than one person may have been responsible for the contamination, each person covered by applicable environmental laws may be held responsible for all of the clean-up costs incurred. In addition, third parties may sue the owner or operator of a site for damages based on personal injury, natural resources, or property damage or other costs, including investigation and clean-up costs, resulting from the environmental contamination. The presence of hazardous or toxic substances on one of our properties, or the failure to properly remediate a contaminated property, could give rise to a lien in favor of the government for costs it may incur to address the contamination or otherwise adversely affect our ability to sell or lease the property or borrow using the property as collateral. Environmental laws also may impose restrictions on the manner in which property may be used or businesses may be operated. A property owner who violates environmental laws may be subject to sanctions which may be enforced by governmental agencies or, in certain circumstances, private parties. In connection with the acquisition and ownership of our properties, we may be exposed to such costs. The cost of defending against environmental claims, of compliance with environmental regulatory requirements, or of remediating any contaminated property could materially and adversely affect us.33Compliance with new or more stringent environmental laws or regulations or stricter interpretation of existing laws may require material expenditures by us. We are subject to environmental laws or regulations relating to our properties, such as those concerning lead-based paint, mold, asbestos, proximity to power lines, or other issues. We cannot assure you that future laws, ordinances, or regulations will not impose any material environmental liability or that the current environmental condition of our properties will not be affected by the activities of residents, existing conditions of the land, operations in the vicinity of the properties, or the activities of unrelated third parties. In addition, we may be required to comply with various local, state, and federal fire, health, life-safety, and similar regulations. Failure to comply with applicable laws and regulations could result in fines and/or damages, suspension of personnel, civil liability, or other sanctions.Vacant properties could be difficult to lease, which could adversely affect our revenues.The properties we acquire may often be vacant at the time of closing, and we may acquire multiple vacant properties in close geographic proximity to one another. We may not be successful in locating residents to lease the individual properties that we acquire as quickly as we had expected, or at all. Even if we are able to place residents as quickly as we had expected, we may incur vacancies in the future and may not be able to re-lease those properties without longer than assumed delays, which may result in increased renovation and maintenance costs and opportunity costs from lost revenues. The COVID-19 pandemic, or a future pandemic, could negatively affect the ability of our residents to meet their lease obligations resulting in an increased number of residents not renewing their leases. We may not be able to promptly re-lease properties that are vacant or become vacant because residents decide not to renew their leases or for other reasons, and the rental rates or other terms under new leases may be less favorable than the terms of the current leases. See “— Our business, results of operations, financial condition, and cash flows may be adversely affected by pandemics and outbreaks of infectious disease, particularly the ongoing COVID-19 pandemic.” Vacant homes may also be at risk for fraudulent activity which could impact our ability to lease a home. As a result, if vacancies continue for a longer period of time than we expect or indefinitely, we may suffer reduced revenues, incur additional operating expenses and capital expenditures, and our homes could be substantially impaired, all of which may have a material adverse effect on us.We rely on information supplied by prospective residents in managing our business. We evaluate prospective residents in a standardized manner through the use of a third party resident screening vendor partner. Our resident screening process includes obtaining appropriate identification, a thorough evaluation of credit history and household income, a review of the applicant’s rental history, and a background check for criminal activity. We make leasing decisions based on information in rental applications completed by a prospective resident and screened by our third party partner, and we cannot be certain that this information is accurate. Additionally, these applications are submitted to us at the time we evaluate a prospective resident, and we do not require residents to provide us with updated information during the terms of their leases, notwithstanding the fact that this information can, and frequently does, change over time. For example, increases in unemployment levels or adverse economic conditions in certain of our markets may adversely affect the creditworthiness of our residents in such markets. Even though this information is not updated, we will use it to evaluate the characteristics of our portfolio over time. If resident-supplied information is inaccurate or our residents’ creditworthiness declines over time, we may make poor or imperfect leasing decisions and our portfolio may contain more risk than we believe.We depend on our residents and their willingness to meet their lease obligations and renew their leases for substantially all of our revenues. Poor resident selection, defaults, and nonrenewals by our residents may adversely affect our reputation, financial performance, and ability to make distributions to our stockholders.We depend on rental income from residents for substantially all of our revenues. As a result, our success depends in large part upon our ability to attract and retain qualified residents for our properties. Our reputation, financial performance, and ability to make distributions to our stockholders would be adversely affected if a significant number of our residents fail to meet their lease obligations or fail to renew their leases. For example, residents may default on rent payments, make unreasonable and repeated demands for service or improvements, make unsupported or unjustified complaints to regulatory or political authorities, use our properties for illegal purposes, damage or make unauthorized structural changes to our 34properties that are not covered by security deposits, refuse to leave the property upon termination of the lease, engage in domestic violence or similar disturbances, disturb nearby residents with noise, trash, odors, or eyesores, fail to comply with HOA regulations, sublet to less desirable individuals in violation of our lease, or permit unauthorized persons to live with them. Additionally, the COVID-19 outbreak, as well as continuing measures taken by governmental authorities and private actors to limit the spread of this virus or mitigate its impact, are interfering with the ability of some of our residents to meet their lease obligations and make their rent payments on time or at all. Furthermore, entities directed by, or notionally affiliated with, the Federal government as well as some state and local jurisdictions across the United States, have imposed temporary eviction moratoriums if certain criteria are met by residents, are allowing residents to defer missed rent payments without incurring late fees, and are prohibiting rent increases. Jurisdictions and other local and national authorities may expand or extend measures imposing restrictions on our ability to enforce residents’ contractual rental obligations and limiting our ability to increase rents. See “— Our business, results of operations, financial condition, and cash flows may be adversely affected by pandemics and outbreaks of infectious disease, particularly the ongoing COVID-19 pandemic.”Damage to our properties may delay re-leasing after eviction, necessitate expensive repairs, or impair the rental income or value of the property resulting in a lower than expected rate of return. Increases in unemployment levels and other adverse changes in economic conditions in our markets could result in substantial resident defaults. In the event of a resident default or bankruptcy, we may experience delays in enforcing our rights as landlord at that property and will incur costs in protecting our investment and re-leasing the property.Our leases are relatively short-term, exposing us to the risk that we may have to re-lease our properties frequently, which we may be unable to do on attractive terms, on a timely basis, or at all.Substantially all of our new leases have a duration of one to two years. As such leases permit the residents to leave at the end of the lease term, we anticipate our rental revenues may be affected by declines in market rental rates more quickly than if our leases were for longer terms. Short-term leases may result in high turnover, which involves costs such as restoring the properties, marketing costs, and lower occupancy levels. Our resident turnover rate and related cost estimates may be less accurate than if we had more operating data upon which to base such estimates. If the rental rates for our properties decrease or our residents do not renew their leases, our operating results and ability to make distributions to our stockholders could be adversely affected. In addition, most of our potential residents are represented by leasing agents and we may need to pay all or a portion of any related agent commissions, which will reduce the revenue from a particular rental home. Alternatively, to the extent that a lease term exceeds one year, we may lose the opportunity to raise rents in an appreciating market and be locked into a lower rent until such lease expires.Many factors impact the single-family rental market, and if rents in our markets do not increase sufficiently to keep pace with rising costs of operations, our income and distributable cash could decline.The success of our business model depends, in part, on conditions in the single-family rental market in which we operate. A significant outbreak of infectious disease in the human population or pandemic may result, and the COVID-19 pandemic has resulted, in a widespread health crisis adversely affecting the economies and financial markets of many countries, resulting in an economic downturn that could negatively affect our business, results of operations, and financial condition. One of the direct impacts on our results of operations and key operating metrics is a decrease in gross rental revenues and other property income (before concessions and bad debt) due to the restrictions on rent increases imposed in certain jurisdictions in response to the COVID-19 pandemic. The COVID-19 pandemic, or a future pandemic, could also have material and adverse effect on demand for single-family rental properties and/or occupancy levels. See “— Our business, results of operations, financial condition, and cash flows may be adversely affected by pandemics and outbreaks of infectious disease, particularly the ongoing COVID-19 pandemic.” Our investment strategy is based on assumptions about occupancy levels, rental rates, interest rates, and other factors; and if those assumptions prove to be inaccurate, our cash flows and profitability may be reduced. Multiple economic and demographic factors may contribute to increases or decreases in homeownership rates resulting in fluctuating rental rates and average occupancy levels. In addition, we expect that as investors like us increasingly seek to capitalize on opportunities to purchase housing assets and convert them to productive uses, the supply of single-family rental properties will decrease, which may increase competition for residents, limit our strategic opportunities, and increase the cost to acquire those properties. A softening of the rental market in our core areas would reduce our rental revenue and profitability.35We may not have control over timing and costs arising from renovating our properties, and the cost of maintaining rental properties is generally higher than the cost of maintaining owner-occupied homes, which will affect our results of operations and may adversely impact our ability to make distributions to our stockholders.Renters impose additional risks to owning real property. Renters do not have the same interest as an owner in maintaining a property and its contents and generally do not participate in any appreciation of the property. Accordingly, renters may damage a property and its contents, and may not be forthright in reporting damages or amenable to repairing them completely, or at all. A rental property may need repairs and/or improvements after each resident vacates the premises, the costs of which may exceed any security deposit provided to us by the resident when the rental property was originally leased. Accordingly, the cost of maintaining rental properties can be higher than the cost of maintaining owner-occupied homes, which will affect our results of operations and may adversely impact our ability to make distributions to our stockholders.Declining real estate valuations and impairment charges could adversely affect our financial condition and operating results.We periodically review the value of our properties to determine whether their value, based on market factors, projected income, and generally accepted accounting principles in the United States (“GAAP”), has permanently decreased such that it is necessary or appropriate to take an impairment loss in the relevant accounting period. Such a loss would cause an immediate reduction of net income in the applicable accounting period and would be reflected in a decrease in our balance sheet assets. The reduction of net income from impairment losses could lead to a reduction in our dividends, both in the relevant accounting period and in future periods. Even if we do not determine that it is necessary or appropriate to record an impairment loss, a reduction in the intrinsic value of a property would become manifest over time through reduced income from the property and would therefore affect our earnings and financial condition.The COVID-19 pandemic, or a future pandemic, could also lead to a general decline in business activity and demand for real estate transactions could adversely affect the value of our homes and our business such that we may recognize impairment on the carrying value of our investments in single-family residential properties and other assets subject to impairment review, including, but not limited to, goodwill. See “— Our business, results of operations, financial condition, and cash flows may be adversely affected by pandemics and outbreaks of infectious disease, particularly the ongoing COVID-19 pandemic.”We are highly dependent on information systems, and systems failures could significantly disrupt our business, which may, in turn, negatively affect us and the value of our common stock.Our operations are dependent upon our information systems that support our business processes, including marketing, leasing, vendor communications, finance, intercompany communications, our resident portals, and property management service platforms, which include certain automated processes that require access to telecommunications or the Internet, each of which is subject to system security risks. Certain critical components of our platform are dependent upon third party service providers, and a significant portion of our business operations are conducted over the Internet. As a result, we could be severely impacted by a catastrophic occurrence, such as a natural disaster or a terrorist attack, or a circumstance that disrupted access to telecommunications, the Internet, or operations at our third party service providers, including viruses that could penetrate network security defenses and cause system failures and disruptions of operations. Even though we believe we utilize appropriate duplication and back-up procedures, a significant outage in telecommunications, the Internet, or at our third party service providers could negatively impact our operations.Security breaches and other disruptions could compromise our information systems and expose us to liability, which would cause our business and reputation to suffer.Information security risks have generally increased in recent years due to the rise in new technologies and the increased sophistication and activities of perpetrators of cyberattacks. In the ordinary course of our business, we acquire and store sensitive data, including intellectual property, our proprietary business information, and personally identifiable information of our prospective and current residents, employees, and third party service providers. The secure processing and maintenance of such information is critical to our operations and business strategy. Despite our security measures, our information 36technology and infrastructure are subject and may be vulnerable to attacks by malicious third parties or breached due to employee error, malfeasance, or other disruptions. Due to the nature of some of the attacks, there is a risk that they may remain undetected for a period of time. While we have invested in the protection of data and information technology and implemented processes, procedures, and internal controls that are designed to mitigate cybersecurity risks and cyber intrusions, there can be no assurance that our efforts will prevent cyber incidents or security breaches. Any such breach could compromise our networks and the information stored therein could be accessed, publicly disclosed, misused, lost, or stolen. Any such access, disclosure or other loss of information could result in legal claims or proceedings, misstated or unreliable financial data, liability under laws that protect the privacy of personal information, regulatory penalties, disruption to our operations and the services we provide to customers, or damage our reputation, any of which could adversely affect our results of operations, reputation, and competitive position. We maintain cyber liability insurance; however, this insurance may not be sufficient to cover the financial, legal, business, or reputational losses that may result from an interruption or breach of our systems. Business continuity and disaster recovery issues which may result from the current COVID-19 pandemic or any future pandemic could materially interrupt our business operations. In accordance with phased re-opening guidelines and the ongoing spread of COVID-19 cases in certain states where we operate, the majority of our associates based at our headquarters and local offices continue working remotely. An extended period of remote work arrangements could strain our business continuity plans, introduce operational risk, including, but not limited to cybersecurity risks, and impair our ability to manage our business. See “— Our business, results of operations, financial condition, and cash flows may be adversely affected by pandemics and outbreaks of infectious disease, particularly the ongoing COVID-19 pandemic.”Our participation in joint venture investments may limit our ability to invest in certain markets, and we may be adversely affected by our lack of sole decision-making authority, our reliance on joint venture partners’ financial condition, and disputes between us and our joint venture partners.We currently, and may in the future, co-invest with third parties through partnerships, joint ventures, or other entities, acquiring non-controlling interests in or sharing responsibility for managing the affairs of a property, partnership, joint venture, or other entity. These joint ventures may be subject to restrictions that prohibit us from making other investments in certain markets until all of the funds in such partnership, joint venture, or other entity are invested or committed. In addition, we may also not be in a position to exercise sole decision-making authority regarding the property, partnership, joint venture, or other entity, and our joint venture partners could take actions that are not within our control. Such actions could, among other things, impact our ability to maintain our status as a REIT. Further, investments in partnerships, joint ventures, or other entities may, under certain circumstances, involve risks not present were a third party not involved, including the possibility that joint venture partners might become bankrupt or fail to fund their share of required capital contributions. Joint venture partners may have economic or other business interests or goals that are inconsistent with our business interests or goals, and may be in a position to take actions contrary to our policies or objectives. Such investments also may have the potential risk of impasses on decisions, such as a sale, because neither we nor our partners would have full control over the partnership or joint venture. Disputes between us and our partners may result in litigation or arbitration that would increase our expenses and prevent our officers and/or directors from focusing their time and effort on our business. Consequently, actions by, or disputes with, any of our joint venture partners might result in subjecting properties owned by the partnership or joint venture to additional risk. In addition, we may in certain circumstances be liable for the actions of any of our third party partners or co-venturers.We are subject to litigation and regulatory proceedings.We are involved in a range of legal and regulatory proceedings, claims, actions, inquiries, and investigations in the ordinary course of business. These legal and regulatory proceedings may include, among others, eviction proceedings and other landlord-tenant disputes, challenges to title and ownership rights, disputes arising over potential violations of HOA rules and regulations, issues with local housing officials arising from the condition or maintenance of the property, outside vendor disputes, and trademark infringement and other intellectual property claims. These actions can be time-consuming and expensive, and may adversely affect our reputation. For example, eviction proceedings by owners and operators of single-family homes for lease have recently been the focus of negative media attention. Although we are not involved in any legal or regulatory proceedings that we expect would have a material adverse effect on our business, results of operations, or financial condition, such proceedings may arise in the future.37We may suffer losses that are not covered by insurance. We attempt to ensure that our properties are adequately insured to cover casualty losses. However, there are certain losses, including losses from floods, fires, earthquakes, wind, hail, pollution, acts of war, acts of terrorism or riots, certain environmental hazards, and security breaches for which we may self-insure or which may not always or generally be insured against because it may not be deemed economically feasible or prudent to do so. Changes in the cost or availability of insurance could expose us to uninsured casualty losses. In particular, a number of our properties are located in areas that are known to be subject to increased earthquake activity, fires, or wind and/or flood risk. While we have multi-year policies for earthquakes, hurricane, and/or flood risk, our properties may nonetheless incur casualty losses that are not fully covered by insurance. In such an event, the value of the affected properties would be reduced by the amount of any such uninsured loss, and we could experience a significant loss of capital invested and potential revenues in such properties and could potentially remain obligated under any recourse debt associated with such properties. Inflation, changes in building codes and ordinances, environmental considerations, and other factors might also keep us from using insurance proceeds to replace or renovate a particular property after it has been damaged or destroyed. Under those circumstances, the insurance proceeds we receive might be inadequate to restore our economic position in the damaged or destroyed property. Any such losses could adversely affect us and cause the value of our common stock to decline. In addition, we may have no source of funding to repair or reconstruct the damaged home, and we cannot assure that any such sources of funding will be available to us for such purposes in the future.We are subject to risks from natural disasters such as earthquakes and severe weather.Natural disasters and severe weather such as earthquakes, tornadoes, wind, or floods may result in significant damage to our properties. The extent of our casualty losses and loss of income in connection with such events is a function of the severity of the event and the total amount of exposure in the affected area.When we have geographic concentration of exposures, a single catastrophe (such as an earthquake, especially in California) or destructive weather event (such as a hurricane) affecting a region may have a significant negative effect on our financial condition and results of operations. As a result, our operating and financial results may vary significantly from one period to the next. We have in the past and may in the future incur losses arising from natural disasters or severe weather. For example, uninsured losses and damages related to Hurricanes Irma and Harvey totaled $8.0 million for the year ended December 31, 2018.Climate change may adversely affect our business.To the extent that significant changes in the climate occur in areas where our communities are located, we may experience extreme weather and/or changes in precipitation and temperature, all of which may result in physical damage to, or a decrease in demand for, properties located in these areas or affected by these conditions. Should the impact of climate change be material in nature, including significant property damage to or destruction of our properties, or occur for lengthy periods of time, our financial condition or results of operations may be adversely affected. In addition, changes in federal, state, and local legislation and regulation based on concerns about climate change could result in increased capital expenditures on our existing properties (for example, to improve their energy efficiency and/or resistance to inclement weather) without a corresponding increase in revenue, resulting in adverse impacts to our results of operations.Eminent domain could lead to material losses on our investments in our properties.Governmental authorities may exercise eminent domain to acquire the land on which our properties are built in order to build roads and other infrastructure. Any such exercise of eminent domain would allow us to recover only the fair value of the affected properties. In addition, “fair value” could be substantially less than the real market value of the property for a number of years, and we could effectively have no profit potential from properties acquired by the government through eminent domain.38We may have difficulty selling our real estate investments and our ability to distribute all or a portion of the net proceeds from any such sale to our stockholders may be limited.Real estate investments are relatively illiquid and, as a result, we may have a limited ability to sell our properties. When we sell any of our properties, we may recognize a loss on such sale. We may elect not to distribute any proceeds from the sale of properties to our stockholders. Instead, we may use such proceeds for other purposes, including:•purchasing additional properties;•repaying debt or buying back stock;•creating working capital reserves; or•making repairs, maintenance or other capital improvements or expenditures to our remaining properties.Our ability to sell our properties may also be limited by our need to avoid the 100% prohibited transactions tax that is imposed on gain recognized by a REIT from the sale of property characterized as dealer property. For example, we may be required to hold our properties for a minimum period of time and comply with certain other requirements in the Internal Revenue Code of 1986, as amended (the “Code”), or dispose of our properties through a taxable REIT subsidiary (“TRS”), in which case we will incur corporate level tax on any net gains from such dispositions. The COVID-19 pandemic, or a future pandemic, could also have material and adverse effects on our ability to sell our properties. See “— Our business, results of operations, financial condition, and cash flows may be adversely affected by pandemics and outbreaks of infectious disease, particularly the ongoing COVID-19 pandemic.”We are subject to increasing scrutiny from investors with respect to the social and environmental impact of our business, which may adversely impact our business and ability to raise capital from such investors.In recent years, certain investors have placed increasing importance on the implications of our business with respect to ESG matters. Investors’ increased focus and activism related to ESG and similar matters may constrain our business operations. In addition, investors may decide to refrain from investing in us as a result of their assessment of our approach to and consideration of the ESG factors.Risks Related to Our IndebtednessOur cash flows and operating results could be adversely affected by required payments of debt or related interest and other risks of our debt financing.We are generally subject to risks associated with debt financing. These risks include: (1) our cash flow may not be sufficient to satisfy required payments of principal and interest; (2) we may not be able to refinance existing indebtedness or the terms of any refinancing may be less favorable to us than the terms of existing debt; (3) required debt payments are not reduced if the economic performance of any property declines; (4) debt service obligations could reduce funds available for distribution to our stockholders and funds available for capital investment; (5) any default on our indebtedness could result in acceleration of those obligations and possible loss of property to foreclosure; (6) the risk that necessary capital expenditures cannot be financed on favorable terms; and (7) the value of the collateral securing our indebtedness may fluctuate and fall below the amount of indebtedness it secures. If the income from a property is pledged to secure payment of indebtedness and we cannot make the applicable debt payments, we may have to surrender the property to the lender with a consequent loss of any prospective income and equity value from such property. Any of these risks could place strains on our cash flows, reduce our ability to grow, and adversely affect our results of operations. The COVID-19 pandemic, or a future pandemic, could have material and adverse effect on our residents’ ability to meet their lease obligations thereby reducing our cash flows, and the resulting impact on rental and other property income could impact our ability to make all required debt service payments and to continue paying dividends to our stockholders at expected levels or at all. See “— Our business, results of operations, financial condition, and cash flows may be adversely affected by pandemics and outbreaks of infectious disease, particularly the ongoing COVID-19 pandemic.”39We utilize a significant amount of indebtedness in the operation of our business.As of December 31, 2020, we had approximately $8,080.5 million aggregate principal amount of indebtedness outstanding. Our leverage could have important consequences to us. For example, it could: (1) result in the acceleration of a significant amount of debt for non-compliance with the terms of such debt or, if such debt contains cross-default or cross-acceleration provisions, other debt; (2) result in the loss of assets, including individual properties or portfolios, due to foreclosure or sale on unfavorable terms, which could create taxable income without accompanying cash proceeds; (3) materially impair our ability to borrow unused amounts under existing financing arrangements or to obtain additional financing or refinancing on favorable terms, or at all; (4) require us to dedicate a substantial portion of our cash flow to paying principal and interest on our indebtedness, reducing the cash flow available to fund our business, to pay dividends, including those necessary to maintain our REIT qualification, or to use for other purposes; (5) increase our vulnerability to an economic downturn; (6) limit our ability to withstand competitive pressures; or (7) reduce our flexibility to respond to changing business and economic conditions. If any of the foregoing occurs, our business, financial condition, liquidity, results of operations, and prospects could be materially and adversely affected, and the trading price of our common stock could decline significantly.We may be unable to obtain financing through the debt and equity markets, which would have a material adverse effect on our growth strategy and our financial condition and results of operations.We cannot assure you that we will be able to access the capital and credit markets to obtain additional debt or equity financing or that we will be able to obtain financing on terms favorable to us. Our inability to obtain financing could have negative effects on our business. Among other things, we could have difficulty acquiring, re-developing or maintaining, our properties, which would materially and adversely affect our business strategy and portfolio, and may result in our: (1) liquidity being adversely affected; (2) inability to repay or refinance our indebtedness on or before its maturity; (3) making higher interest and principal payments or selling some of our assets on terms unfavorable to us to service our indebtedness; or (4) issuing additional capital stock, which could further dilute the ownership of our existing stockholders.Our access to additional third party sources of financing will depend, in part, on:•general market conditions;•the market’s perception of our growth potential;•with respect to acquisition financing, the market’s perception of the value of the homes to be acquired;•our current debt levels;•our current and expected future earnings;•our cash flow and cash distributions; and•the market price of our common stock.Potential lenders may be unwilling or unable to provide us with financing that is attractive to us or may charge us prohibitively high fees in order to obtain financing. Consequently, there is uncertainty regarding our ability to access the credit markets in order to attract financing on reasonable terms. Investment returns on our assets and our ability to make acquisitions could be adversely affected by our inability to secure financing on reasonable terms, if at all. The COVID-19 pandemic, or a future pandemic, could result in difficulty accessing debt and equity capital on attractive terms, or at all, have material and adverse impacts to our credit ratings, and lead to a severe disruption of, and/or instability in, the global financial markets or deteriorations in credit and financing conditions, which may affect our access to capital necessary to fund business operations, including acquisitions, or address maturing liabilities on a timely basis. See “— Our business, results of operations, financial condition, and cash flows may be adversely affected by pandemics and outbreaks of infectious disease, particularly the ongoing COVID-19 pandemic.”40Secured indebtedness exposes us to the possibility of foreclosure on our ownership interests in our rental homes.Incurring secured mortgage indebtedness increases our risk of loss of our ownership interests in our rental homes because defaults thereunder, and/or the inability to refinance such indebtedness, may result in foreclosure action initiated by lenders. For tax purposes, a foreclosure of any of our rental homes would be treated as a sale of the home for a purchase price equal to the outstanding balance of the indebtedness secured by such rental home. If the outstanding balance of the indebtedness secured by such rental home exceeds our tax basis in the rental home, we would recognize taxable income on foreclosure without receiving any cash proceeds.Covenants in our debt agreements may restrict our operating activities and adversely affect our financial condition.Our existing debt agreements contain, and future debt agreements may contain, financial and/or operating covenants including, among other things, certain coverage ratios, as well as limitations on the ability to incur additional secured and unsecured debt, and/or otherwise affect our distribution and operating policies. These covenants may limit our operational flexibility and acquisition and disposition activities. Moreover, if any of the covenants in these debt agreements are breached and not cured within the applicable cure period, we could be required to repay the debt immediately, even in the absence of a payment default. A default under one of our debt agreements could result in a cross-default under other debt agreements, and our lenders could elect to declare outstanding amounts due and payable, terminate their commitments, require the posting of additional collateral, and enforce their respective interests against existing collateral. As a result, a default under applicable debt covenants could have an adverse effect on our financial condition or results of operations. Additionally, borrowing base requirements associated with our financing arrangements may prevent us from drawing upon our total maximum capacity under these financing arrangements if sufficient collateral, in accordance with our facility agreements, is not available.For example, our mortgage loans and Secured Term Loan (see definition in Part II, Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Liquidity and Capital Resources”) require, among other things, that a cash management account controlled by the lender collect all rents and cash generated by the properties securing the portfolio. Upon the occurrence of an event of default or failure to satisfy the required minimum debt yield or debt service coverage ratio, the lender may apply any excess cash in such cash management account as the lender elects, including prepayment of principal and amounts due under the loans. The financial impact of the COVID-19 pandemic could negatively impact our future compliance with financial covenants of our Credit Facility and other debt agreements and result in a default and potentially an acceleration of indebtedness, which non-compliance could negatively impact our ability to make additional borrowings under our Revolving Facility or to exercise extension options on our mortgage loans and our Credit Facility. See “— Our business, results of operations, financial condition, and cash flows may be adversely affected by pandemics and outbreaks of infectious disease, particularly the ongoing COVID-19 pandemic.”These covenants may restrict our ability to engage in transactions that we believe would otherwise be in the best interests of our stockholders. Further, such restrictions could make it difficult for us to satisfy the requirements necessary to maintain our qualification as a REIT for United States federal income tax purposes.We have and expect to continue to utilize non-recourse long-term mortgage loans, and such structures may expose us to certain risks not prevalent in other debt financings, which could affect the availability and attractiveness of this financing option or otherwise result in losses to us.We have and expect to continue to utilize non-recourse long-term mortgage loans relating to pools of homes which we own, if and when they become available and to the extent consistent with the maintenance of our REIT qualification, in order to generate cash for funding new investments. Mortgage loans may expose us to certain risks not prevalent in other debt financings. For example, accounting rules for mortgage loans are complex and involve significant judgment and assumptions. These complexities and possible changes in accounting rules, interpretations or our assumptions could undermine our ability to prepare timely and accurate financial statements. Moreover, we cannot be assured that we will be able to access the securitization market in the future, or be able to do so at favorable rates. The global economy recently experienced a significant recession and recent events in the real estate and securitization markets, as well as the debt markets and the economy generally, have caused significant dislocations, illiquidity, and volatility in the market for asset-backed securities and mortgage-backed securities, as well as a severe, ongoing disruption in the wider global financial markets, including a 41significant reduction of investor demand for, and purchases of, asset-backed securities and structured financial products. Disruptions of the securitization market could preclude our ability to use mortgage loans as a financing source or could render it an inefficient source of financing, making us more dependent on alternative sourcing of financing that might not be as favorable as mortgage loans in otherwise favorable markets. In addition, in the United States and elsewhere, there is now increased political and regulatory scrutiny of the asset-backed securities industry. This has resulted in a raft of measures for increased regulation which are currently at various stages of implementation and which may have an adverse impact on the regulatory capital charge to certain investors in securitization exposures or the incentives for certain investors to hold asset-backed securities, and may thereby affect the liquidity of such securities. Any of these factors could limit our access to mortgage loans as a source of financing. The inability to consummate mortgage loans to finance our investments on a long-term basis could require us to seek other forms of potentially less attractive financing or to liquidate assets at an inopportune time or price, which could adversely affect our performance and our ability to grow our business.We may not have the ability to raise the funds necessary to settle conversions of the 2022 Convertible Notes or to repurchase the 2022 Convertible Notes upon a fundamental change; our future debt may contain limitations on our ability to pay cash upon conversion or repurchase of the 2022 Convertible Notes.Holders of the 2022 Convertible Notes (see definition in Part II, Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Liquidity and Capital Resources”) have the right to require us to repurchase their 2022 Convertible Notes upon the occurrence of a fundamental change, such as certain change in control transactions or recapitalization transactions as defined in the indentures governing the 2022 Convertible Notes, at a fundamental change repurchase price equal to 100% of the principal amount of the 2022 Convertible Notes to be repurchased, plus accrued and unpaid interest, if any. Upon conversion of the 2022 Convertible Notes, unless we elect to deliver solely common stock to settle such conversion (other than paying cash in lieu of delivering any fractional share of stock), we will be required to make cash payments in respect of the 2022 Convertible Notes being converted. However, we may not have enough available cash or be able to obtain financing at the time we are required to make repurchases of the 2022 Convertible Notes surrendered therefor or to pay the cash amounts due upon conversion of the 2022 Convertible Notes. In addition, our ability to repurchase the 2022 Convertible Notes or to pay cash upon conversion of the 2022 Convertible Notes may be limited by law, by regulatory authority, or by future agreements governing our indebtedness. The failure to repurchase the 2022 Convertible Notes at a time when the repurchase is required by the 2022 Convertible Notes indenture or to pay any cash due and payable on the 2022 Convertible Notes as required by the 2022 Convertible Notes indentures would constitute a default under the indenture. A default under the 2022 Convertible Notes indenture or the fundamental change itself could also lead to a default under agreements governing our existing and future indebtedness. If the repayment of the related indebtedness were to be accelerated after any applicable notice or grace periods, we may not have sufficient funds to repay the indebtedness and repurchase the 2022 Convertible Notes or make cash payments thereon.The conditional conversion feature of the 2022 Convertible Notes, if triggered, may adversely affect our financial condition and operating results.In the event the conditional conversion feature of the 2022 Convertible Notes is triggered, holders will be entitled to convert the 2022 Convertible Notes at any time during specified periods at their option. If one or more holders elect to convert their 2022 Convertible Notes, unless we elect to satisfy our conversion obligation by delivering solely common stock (other than paying cash in lieu of delivering any fractional share of stock), we would be required to settle a portion or all of our conversion obligation through the payment of cash, which could adversely affect our liquidity.The accounting method for convertible debt securities that may be settled in cash could have a material effect on our reported financial results.Under GAAP, an entity must separately account for the debt component and the embedded conversion option of convertible debt instruments that may be settled entirely or partially in cash upon conversion, such as the 2022 Convertible Notes, in a manner that reflects the issuer’s economic interest cost. The effect of the accounting treatment for such instruments is that the value of such embedded conversion option is recorded as a fair value adjustment to the debt component of the 2022 Convertible Notes. The adjustment is treated like a discount for accounting purposes and is amortized into interest expense over the term of the 2022 Convertible Notes using an effective interest method. As a result, we will initially be required to record a greater amount of non-cash interest expense because of the amortization of fair value 42adjustment to the 2022 Convertible Notes’ face amount over the term of the 2022 Convertible Notes. Accordingly, we will report lower net income in our financial results because of the recognition of both the current period’s amortization of the fair value adjustment and the 2022 Convertible Notes’ coupon interest, which could adversely affect our reported or future financial results, the trading price of our common stock, and the trading price of the 2022 Convertible Notes.Under certain circumstances, convertible debt instruments (such as the 2022 Convertible Notes) that may be settled entirely or partially in cash are evaluated for their impact on earnings per share utilizing the “if-converted” method, the effect of which is that the shares of common stock contingently issuable upon conversion of convertible debt instruments are included in the calculation of diluted earnings per share to the extent that the conversion value of convertible debt instruments exceeds their principal amount. Under the “if-converted” method, for diluted earnings per share purposes, convertible debt instruments are accounted for as if the number of shares of common stock that would be necessary to settle such excess, if we elected to settle such excess in stock, are issued if such calculation is dilutive to earnings per share for the relevant periods. This could adversely affect our reported financial results, including our diluted earnings per share.Offerings of additional debt securities or equity securities that rank senior to our common stock may adversely affect the market price of our common stock.If we decide to issue additional debt securities or equity securities that rank senior to our common stock in the future, it is likely that they will be governed by an indenture or other instrument containing covenants restricting our operating flexibility. Any additional debt or equity securities that we issue in the future may have rights, preferences, and privileges more favorable than those of our common stock and, if such securities are convertible or exchangeable, the issuance of such securities may result in dilution to owners of our common stock. We and, indirectly, our stockholders, will bear the cost of issuing and servicing such securities. Because our decision to issue debt or equity securities in any future offering will depend on market conditions and other factors beyond our control, we cannot predict or estimate the amount, timing, or nature of our future offerings. Thus, holders of our common stock will bear the risk of our future offerings reducing the market price of our common stock and diluting the value of their stockholdings in us.Failure to hedge effectively against interest rate changes may adversely affect our results of operations and our ability to make distributions to our stockholders.Borrowings under our debt instruments totaling $6,337.3 million as of December 31, 2020 bear interest at variable rates and expose us to interest rate risk. If interest rates were to increase, our debt service obligations on the variable rate indebtedness would increase even though the amount borrowed remained the same, and our earnings and cash flows will correspondingly decrease. After giving effect to our interest rate swap agreements (see Part II. Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Liquidity and Capital Resources” for more information), each 100 bps increase or decrease on our floating rate indebtedness would result in an estimated increase of $5.7 million or $15.8 million, respectively, in annual interest expense. A 100 bps decrease in the London Interbank Offered Rate (“LIBOR”) results in a negative LIBOR rate and additional interest expense for us. Our variable rate loan agreements contain LIBOR floors, and there is no reciprocal feature in our interest rate swap agreements.In connection with our debt instruments, we have obtained interest rate caps and swaps, and subject to complying with the requirements for REIT qualification, we may obtain in the future one or more additional forms of interest rate protection (in the form of swap agreements, interest rate cap contracts, or similar agreements) to hedge against the possible negative effects of interest rate fluctuations. However, we cannot assure you that any hedging will adequately relieve the adverse effects of interest rate increases or that counterparties under these agreements will honor their obligations thereunder. In addition, we may be subject to risks of default by hedging counterparties. Adverse economic conditions could also cause the terms on which we borrow to be unfavorable. We could be required to liquidate one or more of our investments at times which may not permit us to receive an attractive return on our investments in order to meet our debt service obligations.The REIT provisions of the Code may also limit our ability to hedge effectively. See “Risks Related to our REIT Status and Certain Other Tax Items — Complying with REIT requirements may limit our ability to hedge effectively and may cause us to incur tax liabilities.”43Expected phasing out of LIBOR may adversely affect the capital markets and our ability to raise capital. When LIBOR is discontinued, our variable rate debt agreements and financial instruments may be calculated using another base rate.On November 30, 2020, the Financial Conduct Authority of the United Kingdom (the “FCA”), which has statutory powers to require panel banks to contribute to LIBOR, announced that subject to confirmation following its consultation with the administrator of LIBOR, it would cease publication of the one-week and two-month USD LIBOR immediately after December 31, 2021 and cease publication of the remaining tenors immediately after June 30, 2023. As of December 31, 2020, we had $6,337.3 million of variable rate debt outstanding that references one month LIBOR as the benchmark rate to determine the applicable interest rate or payment amount and for which maturities extend past 2021 (assuming all extensions are exercised). If LIBOR is discontinued after 2021 as expected, there will be uncertainty or differences in the calculation of the applicable interest rate or payment amount, depending on the terms of the agreement, and significant management time and attention may be required to transition to using the new benchmark rates and to implement necessary changes to our financial models. This could result in different financial performance for previously recorded transactions and may impact our existing transaction data, operations, and pricing processes. The calculation of interest rates under the replacement benchmarks could also impact our net interest expense. LIBOR may perform differently during the phase-out period than in the past which could result in an adverse impact on the market for or value of any LIBOR-based securities, loans, derivatives, and other financial obligations or extensions of credit held by us and on our overall financial condition or results of operations. Additionally, debt holders or governing bodies may decide to transition to a successor rate prior to the expected LIBOR phase-out date.Risks Related to Our Organization, Structure, and Ownership of Our Common StockProvisions of Maryland law may limit the ability of a third party to acquire control of us by requiring our board of directors or stockholders to approve proposals to acquire our company or effect a change in control.Certain provisions of the Maryland General Corporation Law (the “MGCL”) may have the effect of inhibiting a third party from making a proposal to acquire us or of impeding a change in control under circumstances that otherwise could provide our stockholders with the opportunity to realize a premium over the then-prevailing market price of their shares of common stock, including:•“business combination” provisions that, subject to certain exceptions and limitations, prohibit certain business combinations between a Maryland corporation and an “interested stockholder” (defined generally as any person who beneficially owns 10% or more of the voting power of our outstanding voting stock or an affiliate or associate of ours who, at any time within the two-year period immediately prior to the date in question, was the beneficial owner of 10% or more of the voting power of our then outstanding shares of stock) or an affiliate of any interested stockholder for five years after the most recent date on which the stockholder becomes an interested stockholder, and thereafter imposes two super-majority stockholder voting requirements on these combinations, unless, among other conditions, our common stockholders receive a minimum price, as defined in the MGCL, for their shares of stock and the consideration is received in cash or in the same form as previously paid by the interested stockholder for its shares of stock; and•“control share” provisions that provide that, subject to certain exceptions, holders of “control shares” (defined as voting shares that, when aggregated with all other shares controlled by the stockholder, entitle the stockholder to exercise one of three increasing ranges of voting power in electing directors) acquired in a “control share acquisition” (defined as the direct or indirect acquisition of ownership or control of issued and outstanding “control shares”) have no voting rights except to the extent approved by our stockholders by the affirmative vote of at least two-thirds of all the votes entitled to be cast on the matter, excluding shares owned by the acquirer, by our officers, or by our employees who are also directors of our company.We have opted out of the business combination provisions of the MGCL and any business combination between us and any other person is exempt from the business combination provisions of the MGCL. In addition, pursuant to a provision in our bylaws, we opted out of the control share provisions of the MGCL. Provisions of our bylaws will prohibit our board of directors from revoking, altering, or amending its resolution exempting any business combination from the business combination provisions of the MGCL or amending our bylaws to opt in to the control share provisions of the MGCL, in each 44case, without the affirmative vote of a majority of the votes cast on the matter by our stockholders entitled to vote generally in the election of directors.In addition, the “unsolicited takeover” provisions of Title 3, Subtitle 8 of the MGCL permit our board of directors, without stockholder approval and regardless of what is provided in our charter or bylaws, to implement certain takeover defenses, including adopting a classified board or increasing the vote required to remove a director. Such takeover defenses may have the effect of inhibiting a third party from making an acquisition proposal for us or of delaying, deferring, or preventing a change in control of us under the circumstances that otherwise could provide our common stockholders with the opportunity to realize a premium over the then-current market price. Our charter provides that, without the affirmative vote of a majority of the votes cast on the matter by our stockholders entitled to vote generally in the election of directors, we may not elect to be subject to certain provisions of Subtitle 8, including the provisions relating to adopting a classified board or increasing the vote required to remove a director.Our board of directors may approve the issuance of stock, including preferred stock, with terms that may discourage a third party from acquiring us.Our charter permits our board of directors, without any action by our stockholders, to authorize the issuance of stock in one or more classes or series. Our board of directors may also classify or reclassify any unissued stock and set or change the preferences, conversion and other rights, voting powers, restrictions, limitations as to dividends and other distributions, qualifications, and terms and conditions of redemption of any such stock, which rights may be superior to those of our common stock. Thus, our board of directors could authorize the issuance of shares of a class or series of stock with terms and conditions which could have the effect of discouraging a takeover or other transaction in which holders of some or a majority of our outstanding common stock might receive a premium for their shares of stock over the then current market price of our common stock.Certain provisions in the indenture governing the 2022 Convertible Notes could delay or prevent an otherwise beneficial takeover or takeover attempt of us.Certain provisions in the 2022 Convertible Notes and the related indenture could make it more difficult or more expensive for a third party to acquire us. For example, if a takeover would constitute a fundamental change, holders of the 2022 Convertible Notes will have the right to require us to repurchase their 2022 Convertible Notes in cash. In addition, if a takeover constitutes a make-whole fundamental change, we may be required to increase the conversion rate for holders who convert their 2022 Convertible Notes in connection with such takeover. In either case, and in other cases, our obligations under the 2022 Convertible Notes and the indenture could increase the cost of acquiring us or otherwise discourage a third party from acquiring us or removing incumbent management.Our rights and the rights of our stockholders to take action against our directors and officers are limited.Our charter eliminates the liability of our directors and officers to us and our stockholders for money damages to the maximum extent permitted under Maryland law. Under current Maryland law and our charter, our directors and officers do not have any liability to us or our stockholders for money damages other than liability resulting from:•actual receipt of an improper benefit or profit in money, property, or services; or•active and deliberate dishonesty by the director or officer that was established by a final judgment and is material to the cause of action adjudicated.Our charter authorizes us and our bylaws obligate us to indemnify each of our directors or officers who is or is threatened to be made a party to or witness in a proceeding by reason of his or her service in those or certain other capacities, to the maximum extent permitted by Maryland law, from and against any claim or liability to which such person may become subject or which such person may incur by reason of his or her status as a present or former director or officer of us or serving in such other capacities. In addition, we may be obligated to pay or reimburse the expenses incurred by our present and former directors and officers without requiring a preliminary determination of their ultimate entitlement to indemnification. As a result, we and our stockholders may have more limited rights to recover money damages from our 45directors and officers than might otherwise exist absent these provisions in our charter and bylaws or that might exist with other companies, which could limit your recourse in the event of actions that are not in our best interests.Our charter contains a provision that expressly permits our non-employee directors, certain of our pre-IPO owners, and their affiliates to compete with us.Our charter provides that, to the maximum extent permitted from time to time by Maryland law, we renounce any interest or expectancy that we have in, or any right to be offered an opportunity to participate in, any business opportunities that are from time to time presented to or developed by our directors or their affiliates, other than to those directors who are employed by us or our subsidiaries, unless the business opportunity is expressly offered or made known to such person in his or her capacity as our director, and none of our pre-IPO owners, or any of their respective affiliates, or any director who is not employed by us or any of his or her affiliates, will have any duty to refrain from engaging, directly or indirectly, in the same business activities or similar business activities or lines of business in which we or our affiliates engage or propose to engage or to refrain from otherwise competing with us or our affiliates. Our charter provides that, to the maximum extent permitted from time to time by Maryland law, each of our non-employee directors, and any of their affiliates, may:•acquire, hold, and dispose of interests in us and/or our subsidiaries, including shares of our stock or common units of partnership interest in INVH LP for his, her or its own account or for the account of others, and exercise all of the rights of a stockholder of Invitation Homes Inc., or a limited partner of INVH LP, to the same extent and in the same manner as if he, she, or it were not our director or stockholder; and•in his, her, or its personal capacity or in his, her, or its capacity, as applicable, as a director, officer, trustee, stockholder, partner, member, equity owner, manager, advisor, or employee of any other person, have business interests and engage, directly or indirectly, in business activities that are similar to ours or compete with us, that involve a business opportunity that we could seize and develop or that include the acquisition, syndication, holding, management, development, operation, or disposition of interests in mortgages, real property or persons engaged in the real estate business.Our charter also provides that, to the maximum extent permitted from time to time by Maryland law, in the event that any of our non-employee directors, or any of their respective affiliates, acquires knowledge of a potential transaction or other business opportunity, such person will have no duty to communicate or offer such transaction or business opportunity to us or any of our affiliates and may take any such opportunity for itself, himself, or herself or offer it to another person or entity unless the business opportunity is expressly offered to such person in his or her capacity as our director. These provisions may limit our ability to pursue business or investment opportunities that we might otherwise have had the opportunity to pursue, which could have an adverse effect on our financial condition, our results of operations, our cash flow, the per share trading price of our common stock, and our ability to satisfy our debt service obligations and to pay dividends to our stockholders.The cash available for distribution to stockholders may not be sufficient to pay dividends at expected levels, nor can we assure you of our ability to make distributions in the future. We may use borrowed funds to make distributions.We have elected to qualify as a REIT for United States federal income tax purposes. The Code generally requires that a REIT annually distribute at least 90% of its REIT taxable income, determined without regard to the deduction for dividends paid and excluding any net capital gain, and imposes tax on any REIT taxable income retained by a REIT, including capital gains. We anticipate making quarterly distributions to our stockholders. We expect that the cash required to fund our dividends will be covered by cash generated by operations. However, our ability to make distributions to our stockholders will depend upon the performance of our asset portfolio. If our operations do not generate sufficient cash flow to allow us to satisfy the REIT distribution requirements, we may be required to fund distributions from working capital, borrow funds, raise additional equity capital, sell assets, or reduce such distributions. If such cash available for distribution decreases in future periods from expected levels, our inability to make the expected distributions could result in a decrease in the market price of our common stock. In addition, our charter allows us to issue preferred stock that could have a preference over our common stock as to distributions. All distributions will be made at the sole discretion of our board of directors and will depend upon a number of factors, including our actual and projected results of operations, financial condition, cash flows and liquidity, maintenance of our REIT qualification and other tax considerations, capital expenditure and other obligations, debt 46covenants, contractual prohibitions or other limitations, and applicable law and such other matters as our board of directors may deem relevant from time to time. We may not be able to make distributions in the future. In addition, some of our distributions may include a return of capital. To the extent that we decide to make distributions in excess of our current and accumulated earnings and profits, such distributions would generally be considered a return of capital for United States federal income tax purposes to the extent of the holder’s adjusted tax basis in their stock. A return of capital is not taxable, but it has the effect of reducing the holder’s adjusted tax basis in its investment. To the extent that distributions exceed the adjusted tax basis of a holder’s stock, they will be treated as gain from the sale or exchange of such stock. If we borrow to fund distributions, our future interest costs would increase, thereby reducing our earnings and cash available for distribution from what they otherwise would have been.Risks Related to our REIT Status and Certain Other Tax ItemsIf we do not maintain our qualification as a REIT, we will be subject to tax as a regular corporation and could face a substantial tax liability.We expect to continue to operate so as to qualify as a REIT under the Code. However, qualification as a REIT involves the application of highly technical and complex Code provisions for which only a limited number of judicial or administrative interpretations exist. Notwithstanding the availability of cure provisions in the Code, we could fail to meet various compliance requirements, which could jeopardize our REIT status. Furthermore, new tax legislation, administrative guidance, or court decisions, in each instance potentially with retroactive effect, could make it more difficult or impossible for us to qualify as a REIT. If we fail to qualify as a REIT in any tax year, then:•we would be taxed as a regular domestic corporation, which under current laws, among other things, means being unable to deduct distributions to stockholders in computing taxable income and being subject to United States federal income tax on our taxable income at regular corporate income tax rates;•any resulting tax liability could be substantial and could have a material adverse effect on our book value;•unless we were entitled to relief under applicable statutory provisions, we would be required to pay taxes, and thus, our cash available for distribution to stockholders would be reduced for each of the years during which we did not qualify as a REIT and for which we had taxable income; •we could be subject to increased state and local taxes; and•we generally would not be eligible to requalify as a REIT for the subsequent four full taxable years.REITs, in certain circumstances, may incur tax liabilities that would reduce our cash available for distribution to you.Even if we qualify and maintain our status as a REIT, we may become subject to United States federal income taxes and related state and local taxes. For example, net income from the sale of properties that are “dealer” properties sold by a REIT (a “prohibited transaction” under the Code) will be subject to a 100% tax. We may not make sufficient distributions to avoid excise taxes applicable to REITs. Similarly, if we were to fail an income test (and did not lose our REIT status because such failure was due to reasonable cause and not willful neglect), we would be subject to tax on the income that does not meet the income test requirements. We also may decide to retain net capital gain we earn from the sale or other disposition of our investments and pay income tax directly on such income. In that event, our stockholders would be treated as if they earned that income and paid the tax on it directly. However, stockholders that are tax-exempt, such as charities or qualified pension plans, would have no benefit from their deemed payment of such tax liability unless they file United States federal income tax returns and seek a refund of such tax. We also may be subject to state and local taxes on our income or property, including income, franchise, payroll, mortgage recording, and transfer taxes, either directly or at the level of the other companies through which we indirectly own our assets, such as our TRSs, which are subject to full United States federal, state, local, and foreign corporate-level income taxes. Any taxes we pay directly or indirectly will reduce our cash available for distribution to you.47Complying with REIT requirements may cause us to forgo otherwise attractive opportunities and limit our expansion opportunities.In order to qualify as a REIT for United States federal income tax purposes, we must continually satisfy tests concerning, among other things, our sources of income, the nature of our investments in commercial real estate and related assets, the amounts we distribute to our stockholders, and the ownership of our stock. We may also be required to make distributions to stockholders at disadvantageous times or when we do not have funds readily available for distribution. Thus, compliance with REIT requirements may hinder our ability to operate solely on the basis of maximizing profits.Complying with REIT requirements may force us to liquidate or restructure otherwise attractive investments.In order to qualify as a REIT, we must also ensure that at the end of each calendar quarter, at least 75% of the value of our assets consists of cash, cash items, government securities, and qualified REIT real estate assets. The remainder of our investments in securities (other than qualified real estate assets and government securities) generally cannot include more than 10% of the outstanding voting securities of any one issuer or 10% of the total value of the outstanding securities of any one issuer unless we and such issuer jointly elect for such issuer to be treated as a TRS under the Code. The total value of all of our investments in taxable REIT subsidiaries cannot exceed 20% of the value of our total assets. In addition, no more than 5% of the value of our assets (other than qualified real estate assets and government securities) can consist of the securities of any one issuer other than a TRS. If we fail to comply with these requirements, we must dispose of a portion of our assets within 30 days after the end of the calendar quarter in order to avoid losing our REIT status and suffering adverse tax consequences. In addition to the quarterly asset test requirements, we must annually satisfy two income test requirements (the “75% and 95% gross income tests”). As a result, we may be required to liquidate from our portfolio, or contribute to a taxable REIT subsidiary, otherwise attractive investments in order to maintain our qualification as a REIT. These actions could have the effect of reducing our income and amounts available for distribution to its stockholders. We may be unable to pursue investments that would otherwise be advantageous to it in order to satisfy the income or asset diversification requirements for qualifying as a REIT. Thus, compliance with REIT requirements may hinder our ability to operate solely on the basis of maximizing profits.Complying with REIT requirements may limit our ability to hedge effectively and may cause us to incur tax liabilities.The REIT provisions of the Code substantially limit our ability to hedge our liabilities. Any income from a hedging transaction we enter into to manage risk of interest rate changes with respect to borrowings made or to be made to acquire or carry real estate assets (each such hedge, a “Borrowings Hedge”) or to manage risk of foreign currency exchange rate fluctuations with respect to any item of qualifying income (each such hedge, a “Currency Hedge”), if clearly identified under applicable United States Treasury (“Treasury”) regulations, does not constitute “gross income” for purposes of the 75% or 95% gross income tests that we must satisfy to qualify and to maintain our qualification as a REIT. This exclusion from the 95% and 75% gross income tests also will apply if we previously entered into a Borrowings Hedge or a Currency Hedge, a portion of the hedged indebtedness or property is disposed of and in connection with such extinguishment or disposition, we enter into a new properly identified hedging transaction to offset the prior hedging position. To the extent that we enter into other types of hedging transactions, the income from those transactions is likely to be treated as non-qualifying income for purposes of both of the gross income tests. As a result of these rules, we intend to limit our use of advantageous hedging techniques or, subject to the limitations on the value of and income from our TRSs, implement those hedges through a domestic TRS. This could increase the cost of our hedging activities because our TRS would be subject to tax on gains or expose us to greater risks associated with changes in interest rates than we would otherwise want to bear. In addition, losses from hedges held in our TRS will generally not provide any tax benefit, except for being carried forward against future taxable income in the TRS, provided, however, losses in our TRS arising in taxable years beginning after December 31, 2017, may only be carried forward and may only be deducted against 80% of future taxable income in the TRS.48Complying with REIT requirements may force us to borrow to make distributions to stockholders.From time to time, our taxable income may be greater than our cash flow available for distribution to stockholders. If we do not have other funds available in these situations, we may be unable to distribute substantially all of our taxable income as required by the REIT provisions of the Code. Thus, we could be required to borrow funds, sell a portion of our assets at disadvantageous prices, or find another alternative. These options could increase our costs or reduce our equity.Even if we qualify to be subject to United States federal income tax as a REIT, we could be subject to tax on any unrealized net built-in gains in certain assets.As part of our pre-IPO reorganization transactions, we acquired certain appreciated assets that were held (directly or indirectly) in part by one or more C corporations in transactions in which the adjusted tax basis of the assets in our hands is determined by reference to the adjusted basis of such assets in the hands of such C corporations. If we dispose of any such appreciated assets during the five-year period following the date we acquired those assets, we will be subject to United States federal income tax on the portion of such gain attributable to such C corporations at the highest corporate tax rates to the extent of the excess of the fair market value of such assets on the date that we acquired those assets over the adjusted tax basis of such assets on such date, which are referred to as built-in gains. We would be subject to this tax liability even if we qualify and maintain our status as a REIT. Any recognized built-in gain will retain its character as ordinary income or capital gain and will be taken into account in determining REIT taxable income and our distribution requirement. Any tax on the recognized built-in gain will reduce REIT taxable income. We may choose not to sell in a taxable transaction appreciated assets we might otherwise sell during the five-year period in which the built-in gain tax applies to avoid the built-in gain tax. However, there can be no assurances that such a taxable transaction will not occur. If we sell such assets in a taxable transaction, the amount of corporate tax that we will pay will vary depending on the actual amount of net built-in gain or loss present in those assets as of the time we acquired those assets and the portion of such assets which were held by C corporations prior to their contribution to us.Our charter does not permit any person to own more than 9.8% of our outstanding common stock or of our outstanding stock of all classes or series, and attempts to acquire our common stock or our stock of all other classes or series in excess of these 9.8% limits would not be effective without an exemption from these limits by our board of directors.For us to qualify as a REIT under the Code, not more than 50% of the value of our outstanding stock may be owned directly or indirectly, by five or fewer individuals (including certain entities treated as individuals for this purpose) during the last half of a taxable year. For the purpose of assisting our qualification as a REIT for United States federal income tax purposes, among other purposes, our charter prohibits beneficial or constructive ownership by any person of more than a certain percentage, currently 9.8%, in value or by number of shares of stock, whichever is more restrictive, of the outstanding shares of our common stock or 9.8% in value of the outstanding shares of our stock, which we refer to as the “ownership limit.” The constructive ownership rules under the Code and our charter are complex and may cause shares of the outstanding common stock owned by a group of related persons to be deemed to be constructively owned by one person. As a result, the acquisition of less than 9.8% of our outstanding common stock or our stock by a person could cause a person to own constructively in excess of 9.8% of our outstanding common stock or our stock, respectively, and thus violate the ownership limit. There can be no assurance that our board of directors, as permitted in the charter, will not decrease this ownership limit in the future, and any decision to grant a waiver from the ownership limit in any particular instance is at the sole discretion of our board of directors. Any attempt to own or transfer shares of our common stock in excess of the ownership limit without the consent of our board of directors will result either in the shares of stock in excess of the limit being transferred by operation of the charter to a charitable trust, and the person who attempted to acquire such excess shares of stock will not have any rights in such excess shares of stock, or in the transfer being void. The ownership limit may have the effect of precluding a change in control of us by a third party, even if such change in control would be in the best interests of our stockholders or would result in receipt of a premium to the price of our common stock (and even if such change in control would not reasonably jeopardize our REIT status).49We may choose to make distributions in our own stock, in which case you may be required to pay income taxes without receiving any cash dividends.In connection with our qualification as a REIT, we are required to annually distribute to our stockholders at least 90% of our REIT taxable income (which does not equal net income, as calculated in accordance with GAAP), determined without regard to the deduction for dividends paid and excluding net capital gain. In order to satisfy this requirement, we may make distributions that are payable in cash and/or shares of our common stock (which could account for up to 90% of the aggregate amount of such distributions) at the election of each stockholder. Taxable stockholders receiving such distributions will be required to include the full amount of such distributions as ordinary dividend income to the extent of our current and accumulated earnings and profits, as determined for United States federal income tax purposes. As a result, United States stockholders may be required to pay income taxes with respect to such distributions in excess of the cash portion of the distribution received. Accordingly, United States holders receiving a distribution of our stock may be required to sell stocks received in such distribution or may be required to sell other stock or assets owned by them, at a time that may be disadvantageous, in order to satisfy any tax imposed on such distribution. If a United States stockholder sells the stock that it receives as part of the distribution in order to pay this tax, the sales proceeds may be less than the amount it must include in income with respect to the distribution, depending on the market price of our stock at the time of the sale. Furthermore, with respect to certain non-United States holders, we may be required to withhold United States tax with respect to such distribution, including in respect of all or a portion of such distribution that is payable in stock, by withholding or disposing of part of the stock included in such distribution and using the proceeds of such disposition to satisfy the withholding tax imposed. In addition, if a significant number of our stockholders determine to sell shares of our common stock in order to pay taxes owed on dividend income, such sale may put downward pressure on the market price of our common stock.No assurance can be given that the Internal Revenue Service (“IRS”) will not impose additional requirements in the future with respect to taxable cash/stock distributions, including on a retroactive basis, or assert that the requirements for such taxable cash/stock distributions have not been met.Dividends payable by REITs do not generally qualify for the reduced tax rates available for some dividends.The maximum tax rate applicable to qualified dividend income payable by non-REIT C corporations to certain non-corporate United States stockholders is currently 23.8% (taking into account the 3.8% Medicare tax applicable to net investment income). Dividends payable by REITs, however, generally are not eligible for the reduced rates. Effective for taxable years beginning after December 31, 2017, and before January 1, 2026, those non-corporate United States stockholders may deduct 20% of their dividends from REITs (excluding qualified dividend income and capital gains dividends). For those United States stockholders in the top marginal tax bracket of 37%, the deduction for REIT dividends yields an effective income tax rate of 29.6% on REIT dividends, which is higher than the 23.8% tax rate on qualified dividend income paid by non-REIT C corporations. Although the legislation benefits the taxation of REITs and dividends payable by REITs, the more favorable rates applicable to non-REIT corporate qualified dividends could cause certain non-corporate investors to perceive investments in REITs to be relatively less attractive than investments in the stocks of non-REIT corporations that pay dividends, which could adversely affect the value of the shares of REITs, including our common stock.We are dependent on external sources of capital to finance our growth.As with other REITs, but unlike corporations generally, our ability to finance our growth must largely be funded by external sources of capital because we generally have to distribute to our stockholders 90% of our REIT taxable income in order to qualify as a REIT, including taxable income where we do not receive corresponding cash. Our access to external capital depends upon a number of factors, including general market conditions, the market’s perception of our growth potential, our current and potential future earnings, cash distributions, and the market price of our common stock.We may be subject to adverse legislative or regulatory tax changes that could increase our tax liability, reduce our operating flexibility, and reduce the price of our common stock.In recent years, numerous legislative, judicial and administrative changes have been made in the provisions of United States federal income tax laws applicable to investments similar to an investment in shares of our common stock. For example, the recently enacted Tax Cuts and Jobs Act (“TCJA”) has resulted in fundamental changes to the Code. Among the 50numerous changes included in the TCJA is a deduction of 20% of ordinary REIT dividends for non-corporate taxpayers for tax years beginning on or after January 1, 2018 through 2025. We cannot assure you that the TCJA or any such changes in the future will not adversely affect the taxation of a stockholder. Any such changes could have an adverse effect on an investment in our stock or on the market value or the resale potential of our assets. You are urged to consult with your tax advisor with respect to the impact of the TCJA on your investment in our stock and the status of legislative, regulatory, or administrative developments and proposals and their potential effect on an investment in our stock. Although REITs generally receive certain tax advantages compared to entities taxed as regular corporations, it is possible that future legislation would result in a REIT having fewer tax advantages, and it could become more advantageous for a company that invests in real estate to elect to be treated for United States federal income tax purposes as a corporation. As a result, our charter provides our board of directors with the power, under certain circumstances, to revoke or otherwise terminate our REIT election and cause us to be taxed as a regular corporation, without the approval of our stockholders.Liquidation of assets may jeopardize our REIT qualification.To qualify as a REIT, we must comply with requirements regarding our assets and our sources of income. If we are compelled to liquidate our investments to repay obligations to our lenders, we may be unable to comply with these requirements, ultimately jeopardizing our qualification as a REIT, or we may be subject to a 100% tax on any resultant gain if we sell assets that are treated as dealer property or inventory.Our ownership of and relationship with any TRS will be restricted, and a failure to comply with the restrictions would jeopardize our REIT status and may result in the application of a 100% excise tax.A REIT may own up to 100% of the stock of one or more TRSs. A TRS may earn income that would not be qualifying income if earned directly by the parent REIT. Both the subsidiary and the REIT must jointly elect to treat the subsidiary as a TRS. A corporation of which a TRS directly or indirectly owns more than 35% of the voting power or value of the stock will automatically be treated as a TRS. Overall, no more than 20% of the value of a REIT’s assets may consist of stock or securities of one or more TRSs. The value of our interests in and thus the amount of assets held in a TRS may also be restricted by our need to qualify for an exclusion from regulation as an investment company under the Investment Company Act of 1940, as amended. A TRS will pay United States federal, state, and local income tax at regular corporate rates on any income that it earns. In addition, the TRS rules limit the deductibility of interest paid or accrued by a TRS to its parent REIT to assure that the TRS is subject to an appropriate level of corporate taxation. The rules also impose a 100% excise tax on certain transactions between a TRS and its parent REIT that are not conducted on an arm’s-length basis.Any TRS we own, as a domestic corporation, will pay United States federal, state, and local income tax on its taxable income, and its after-tax net income is available for distribution to us but is not required to be distributed to us. The aggregate value of the TRS stock and securities owned by us cannot exceed 20% of the value of our total assets (including the TRS stock and securities). Although we plan to monitor our investments in TRSs, there can be no assurance that we will be able to comply with the 20% limitation discussed above or to avoid application of the 100% excise tax discussed above.Re-characterization of leases as financing transactions may negatively affect us.While we generally intend to use reasonable commercial efforts to structure any lease transaction so that the lease will be characterized as a “true lease,” with us treated as the owner and lessor of the property for federal income tax purposes, the IRS could challenge such characterization. In the event that any lease transaction is challenged and re-characterized as a seller-financed conditional sale transaction for federal income tax purposes, deductions for depreciation and cost recovery relating to such property would be disallowed. In addition, if we enter such transactions at the REIT level, in the event of re-characterization, the REIT could be subject to prohibited transaction taxes. Finally, the amount of our REIT taxable income could be recalculated, which might cause us to fail to meet the distribution requirement for a taxable year and require us to pay deficiency dividends, interest, and penalty taxes in order to maintain REIT status.51ITEM 1B. UNRESOLVED STAFF COMMENTSNone.ITEM 2. PROPERTIESOur headquarters are located in Dallas, Texas at 1717 Main Street.The information required by this Item is included in a separate section in this Annual Report on Form 10-K. See Part II. Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Our Portfolio,” which is incorporated herein by reference.ITEM 3. LEGAL PROCEEDINGSThe Company currently is not subject to any material litigation nor, to management’s knowledge, is any material litigation currently threatened against the Company other than routine litigation and administrative proceedings arising in the ordinary course of business.ITEM 4. MINE SAFETY DISCLOSURESNot applicable.52PART IIITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS, AND ISSUER PURCHASES OF EQUITY SECURITIESMarket InformationOur common stock is listed on the New York Stock Exchange (“NYSE”) under the symbol “INVH.” HoldersAs of February 15, 2021, there were 54 holders of record of 567,220,432 shares of common stock outstanding. This does not include the number of stockholders who hold shares of our common stock through banks, brokers, and other financial institutions.DividendsWe have elected to qualify as a REIT for United States federal income tax purposes. The Code generally requires that a REIT annually distribute at least 90% of its REIT taxable income, determined without regard to the deduction for dividends paid and excluding any net capital gain, and imposes tax on any REIT taxable income retained by a REIT, including capital gains. To satisfy the requirements to qualify as a REIT and to avoid paying tax on our income, we intend to make quarterly distributions of all, or substantially all, of our REIT taxable income (excluding net capital gains) to our stockholders.For income tax purposes, dividends paid to holders of common stock primarily consist of ordinary income, capital gains, qualified dividends, unrecaptured Section 1250 gains, and return of capital, or a combination thereof. For the years ended December 31, 2020 and 2019, dividends per share held for the entire year were estimated to be taxable as follows:20202019Amount(1)PercentageAmount(1)PercentageOrdinary income$0.43 71.8 %$0.23 45.4 %Capital gains0.12 20.7 %0.22 42.7 %Qualified dividends0.01 0.9 %0.01 0.5 %Unrecaptured Section 1250 gain0.04 6.6 %0.06 11.4 %Return of capital— — %— — %Total$0.60 100.0 %$0.52 100.0 %(1)Amounts are displayed in actual dollars per share.53Stock Performance GraphThe following graph shows the total stockholder return of an investment of $100 cash on February 1, 2017 (the date our common stock began trading on the NYSE) for (1) our common stock, (2) the S&P 500 Total Return Index, and (3) the MSCI US REIT (RMS) Total Return Index. All values assume reinvestment of the full amount of all dividends. Stockholder returns over the indicated period are based on historical data and are not necessarily indicative of future stockholder returns.Cumulative Total Returns as ofFebruary 1, 2017December 31, 2017December 31, 2018December 31, 2019December 31, 2020Invitation Homes Inc.$100.00 $119.02 $103.43 $157.50 $159.38 S&P 500 Index100.00 119.50 114.26 150.24 177.88 MSCI US REIT Index100.00 106.43 101.56 127.80 118.12 Repurchases of Equity SecuritiesWe made no repurchases of our common stock during the three months ended December 31, 2020.ITEM 6. SELECTED FINANCIAL DATAThe selected financial data previously required by Item 301 of Regulation S-K has been omitted in reliance on SEC Release No. 33-10890, Management’s Discussion and Analysis, Selected Financial Data, and Supplementary Financial Information.54ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSThe following discussion and analysis of our financial condition and results of operations should be read together with Part I. Item 1. “Business” and the consolidated financial statements, including the notes thereto, that are included elsewhere in this Annual Report on Form 10-K. This discussion and analysis contains forward-looking statements based upon our current expectations that involve risks and uncertainties. Our actual results may differ materially from those anticipated in these forward-looking statements as a result of various factors, including those set forth under Part I. Item 1A. “Risk Factors,” “Forward-Looking Statements,” or in other parts of this reportFor similar operating and financial data and discussion of our year ended December 31, 2019 results compared to our year ended December 31, 2018 results, refer to Part II. Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operations” of our Annual Report on Form10 K which was filed with the SEC on February 19, 2020 (the “2019 10-K”). The sections entitled “Result of Operations — Year Ended December 31, 2019 Compared to Year Ended December 31, 2018” and “Cash Flows — Year Ended December 31, 2019 Compared to Year Ended December 31, 2018” in Part II. Item 7. “Management’s Discussion and Analysis of Financial Condition and Result of Operations” of our 2019 10-K are incorporated herein by reference.Capitalized terms used without definition have the meaning provided elsewhere in this Annual Report on Form 10-K.OverviewInvitation Homes is a leading owner and operator of single-family homes for lease, offering residents high-quality homes in sought-after neighborhoods across America. With over 80,000 homes for lease in 16 markets across the country as of December 31, 2020, Invitation Homes is meeting changing lifestyle demands by providing residents access to updated homes with features they value, such as close proximity to jobs and access to good schools. Our mission statement, “Together with you, we make a house a home,” reflects our commitment to high-touch service that continuously enhances residents’ living experiences and provides homes where individuals and families can thrive. We operate in markets with strong demand drivers, high barriers to entry, and high rent growth potential, primarily in the Western United States, Florida, and the Southeast United States. Through disciplined market and asset selection, as well as through strategic mergers and acquisitions, we designed our portfolio to capture the operating benefits of local density as well as economies of scale that we believe cannot be readily replicated. Since our founding in 2012, we have built a proven, vertically integrated operating platform that enables us to effectively and efficiently acquire, renovate, lease, maintain, and manage our homes. We invest in markets that we expect will exhibit lower new supply, stronger job and household formation growth, and superior NOI growth relative to the broader United States housing and rental markets. Within our 16 markets, we target attractive neighborhoods in in-fill locations with multiple demand drivers, such as proximity to major employment centers, desirable schools, and transportation corridors. Our homes average approximately 1,870 square feet with three bedrooms and two bathrooms, appealing to a resident base that we believe is less transitory than the typical multifamily resident. We invest in the upfront renovation of homes in our portfolio in order to address capital needs, reduce ongoing maintenance costs, and drive resident demand. The in-fill locations and high quality of our homes and service further differentiate our resident experience, which we continue to refine. COVID-19The ongoing COVID-19 pandemic has had a significant adverse impact on global and United States economic activity and has contributed to significant volatility and disruption in financial markets. The ultimate impacts remain unknown, but could include the potential worsening of global and United States economic conditions and the continued disruptions to, and volatility in, the credit and financial markets, consumer spending, and the market for acquisition and disposition of single-family homes, as well as other unanticipated consequences. As such, we are closely monitoring the impact of the ongoing COVID-19 pandemic on all aspects of our business, including operating, investment management, and capital markets activities.55With the safety and well-being of our residents and associates being our highest priority, we continue to follow protocols that enable teams to safely continue providing outstanding service to residents. The safety and service measures currently in place include: (1) creating and implementing a safety training program for all associates; (2) maintaining a three-month supply of masks, gloves, shoe covers, and hand sanitizer for field teams; (3) continuing to leverage self-show and virtual-tour technology as both safety measures and competitive advantages; (4) adhering to strict safety protocols for maintenance service trips; and (5) adapting to offer virtual options for resident move-in orientations and pre-move-out visits. Neither these procedural adjustments nor the overall impact of the COVID-19 pandemic created significant disruptions to our business model during the year ended December 31, 2020. However, the pandemic did impact our business, including operating, investment management, and capital markets activities as more fully described below. OperationsThe direct impacts on our results of operations and key operating metrics from the effects of the COVID-19 pandemic include, but are not limited to: (1) a decrease in gross rental revenues and other property income (before concessions and bad debt) due to jurisdictional restrictions on rent increases and late fees and/or forgiveness of late fees for residents who have requested leniency; (2) an increase in occupancy due to lower turnover partially driven by residents’ decisions not to relocate during the pandemic, strong demand for homes that become vacant, and the impact of eviction moratoriums; (3) an increase in uncollectible revenues (or decline in rent collections percentages) due to resident hardships and eviction moratoriums; and (4) a decrease in property operating and maintenance expenses for turnover costs (lower turnover rates) and property administrative fees (eviction moratoriums).In March 2020, to act on our core values of "Genuine Care" and "Standout Citizenship," we began to offer solutions for residents experiencing financial hardship when requested, including the ongoing creation of payment plans, without late fees, for residents requiring flexibility to meet rental obligations over time. Additionally, we continue to adhere to federal, state, and local restrictions on items such as evictions, collections, rent increases, and late fees as appropriate. The ongoing COVID-19 outbreak in the United States has led entities directed by, or notionally affiliated with, the Federal government as well as certain states and cities, including those in which we own properties and where our principal places of business are located, to impose and continue to implement measures intended to control the spread of COVID-19, including instituting quarantines, restrictions on travel, “shelter in place” rules, and restrictions on types of business that may continue to operate. We depend on rental revenues and other property income from residents for substantially all of our revenues. Overall revenue collections as a percentage of monthly billings was 96% for the period from April 2020 through December 2020, compared to a historical average of 99%. While collection of revenues has remained near historical levels thus far through the pandemic, the COVID-19 outbreak, as well as continuing measures taken by governmental authorities and private actors to limit the spread of this virus or mitigate its impact, are interfering with the ability of some of our residents to meet their lease obligations and make their rent payments on time or at all. In addition, entities directed by, or notionally affiliated with, the Federal government as well as some state and local jurisdictions across the United States, have imposed temporary eviction moratoriums if certain criteria are met by residents, are allowing residents to defer missed rent payments without incurring late fees, and are prohibiting rent increases. Jurisdictions and other local and national authorities may expand or extend measures imposing restrictions on our ability to enforce residents’ contractual rental obligations and limiting our ability to increase rents. We cannot predict if states, municipalities, local, and/or national authorities will expand existing restrictions, if additional states or municipalities will implement similar restrictions, or when restrictions currently in place will expire. Such measures are likely to enable residents to stay in their homes despite an inability to pay because of financial or other hardship stemming from the pandemic. Certain other restrictions imposed by jurisdictions across the United States are intended to limit operations by businesses not deemed “essential businesses.” While none of the current restrictions have materially impacted our ability to provide services to our residents or homes, future measures may negatively impact our ability to access our homes, complete service requests, or make our homes ready for new residents. Unless the residents report symptoms of or exposure to COVID-19, we are completing all service calls. In all cases, we work with the residents to ensure service requests are addressed in a timely and safe manner.While COVID-19 and related containment measures may interfere with the ability of our associates, suppliers, and other business partners to carry out their assigned tasks or to supply materials and services at ordinary levels of performance relative to the conduct of our business in the future, to date we have not experienced significant disruptions of these types. 56The majority of our office-based associates continue to work from home and will do so until we determine it is in our and their best interests to fully return to our offices. Additionally, changes to the working environment have not had a material effect on our internal controls over financial reporting since the pandemic began (see Part II. Item 9A. “Controls and Procedures” for additional information).Investment ManagementWe continue to successfully source and effectuate compelling acquisition and disposition opportunities. Since the pandemic began, we have continued to sell homes identified for disposition. We are also now acquiring new homes at a pre-COVID-19 pace after pausing activity from mid-March through May and entered into a joint venture partnership with Rockpoint Group, L.L.C. (“Rockpoint”). Despite this recent activity, our ability to acquire or dispose of properties could be impaired by local rules and ordinances that could be put in place to mitigate the impact of the COVID-19 pandemic, and a general decline in economic and business activity could adversely affect the single-family residential housing market and our ability to acquire and dispose of homes.Joint Venture with RockpointOn October 6, 2020, we entered into an agreement with Rockpoint to form a joint venture partnership to acquire single-family homes to operate as rental residences. The joint venture will be capitalized with a total equity commitment of $375.0 million, of which $75.0 million (20%) has been committed by us and $300.0 million (80%) has been committed by Rockpoint. A total of over $1.0 billion (including debt) is expected to be deployed by the joint venture to acquire and renovate single-family homes in attractive locations in markets within the Western United States, Southeast United States, Florida, and Texas, where we already own homes. The homes are expected to be of similarly high quality and similar characteristics to the homes in our existing portfolio. We will provide asset and property management services to the joint venture, for which we will earn asset management and property management fees, and we have the opportunity to earn a promoted interest subject to certain performance thresholds.The joint venture is anticipated to have a five to eight year term, with certain sale rights in favor of each member, but has the flexibility to continue owning homes for an unlimited period of time if neither member triggers a sale. Upon trigger of a sale by Rockpoint or us, the other member of the joint venture will have a right of first offer to acquire the homes proposed for sale.We also maintain the ability in all markets to continue deploying capital from our own balance sheet to acquire homes for our portfolio, concurrent with the joint venture’s deployment of capital. In markets where we and the joint venture are investing concurrently, our investment personnel will source acquisitions without knowledge of which entity will acquire the homes, and upon being approved for close, homes will be allocated on a rotational basis between us and the joint venture according to pre-determined ratios of investment between the two entities. In addition, we maintain the right to enter into portfolio acquisitions of ten or more homes outside of the joint venture.Capital Markets and FinancingTo date, our access to capital markets has not been significantly impacted by the COVID-19 pandemic. In June 2020, we successfully issued and sold 16.7 million shares of our common stock for net proceeds of $447.5 million to provide capital primarily for acquisition opportunities. We also entered into an amended and restated revolving credit and term loan agreement that provides $3,500.0 million of borrowing capacity and consists of a $1,000.0 million revolving facility and a $2,500.0 million term loan facility (see “ — Liquidity and Capital Resources” for additional information regarding the new credit facility, including significant changes in terms and provisions from our prior credit facility and a description of the use of proceeds). We continue to make scheduled debt service payments, including full repayment of the $270.0 million revolving credit facility balance that had been drawn in March and do not anticipate non-compliance with our key affirmative and negative debt covenants. As of December 31, 2020, we have $1,213.4 million in available liquidity through a combination of unrestricted cash and undrawn capacity on our revolving credit facility (see “ — Liquidity and Capital Resources” for additional information). That said, a severe disruption of, and/or instability in, the global financial markets or deteriorations in credit and financing conditions may affect our access to capital necessary to fund business operations, including acquisitions, or address maturing liabilities on a timely basis.57Ongoing ConsiderationsThe situation surrounding the ongoing COVID-19 pandemic remains fluid, and the ensuing impact of the COVID-19 pandemic on our rental revenues and other property income, in particular, cannot be fully be determined at present due to an inability to estimate actual collection rates, occupancy levels, and expiration of temporary restrictions on evictions, collections, rent increases, and late fees. We will continue to actively manage our response in collaboration with our residents and business partners and to assess potential impacts to our financial position and operating results, as well as potential adverse developments in our business. In addition to the foregoing uncertainties, we are unable to predict the impact that the COVID-19 pandemic will have on our future financial condition, results of operations, and cash flows due to numerous uncertainties regarding external factors. These uncertainties include the scope, severity, and duration of the pandemic, the extent and duration of actions taken to contain the pandemic or mitigate its impact, the availability of an effective vaccine and therapeutic drugs and the effectiveness of the distribution of any such vaccines and therapeutic drugs, and the direct and indirect economic effects of the pandemic, containment measures, monetary and/or fiscal policies implemented to provide support or relief to businesses and/or residents, and other government, regulatory, and/or legislative changes precipitated by the COVID-19 pandemic, among others. For further information regarding the impact of COVID-19 on our Company, see Part I. Item 1A. “Risk Factors.”58Our Portfolio The following table provides summary information regarding our total and Same Store portfolios as of and for the year ended December 31, 2020 as noted below: MarketNumber of Homes(1)Average Occupancy(2)Average MonthlyRent(3)Average MonthlyRent PSF(3)% ofRevenue(4)Western United States:Southern California7,95197.3%$2,524$1.4913.2 %Northern California4,24797.0%2,2031.426.4 %Seattle3,66995.5%2,2991.205.6 %Phoenix8,17295.8%1,4680.908.0 %Las Vegas3,00696.2%1,6970.853.5 %Denver2,34893.9%2,0981.163.3 %Western United States Subtotal29,39396.3%2,0451.1940.0 %Florida:South Florida8,32495.7%2,2271.1912.5 %Tampa8,19296.3%1,7160.929.5 %Orlando6,21795.6%1,7200.937.1 %Jacksonville1,86896.9%1,7270.872.2 %Florida Subtotal24,60196.0%1,8931.0131.3 %Southeast United States:Atlanta12,55596.5%1,5610.7613.1 %Carolinas4,93496.0%1,6290.765.2 %Southeast United States Subtotal17,48996.3%1,5790.7618.3 %Texas:Houston2,15595.1%1,5850.822.3 %Dallas2,76793.3%1,8350.883.0 %Texas Subtotal4,92294.2%1,7160.855.3 %Midwest United States:Chicago2,63095.9%2,0091.243.5 %Minneapolis1,12697.1%1,9400.991.5 %Midwest United States Subtotal3,75696.3%1,9891.155.0 %Announced Market-in-Exit:Nashville(5)1667.4%2,1350.810.1 %Total / Average80,17796.1%$1,875$1.01100.0 %Same Store Total / Average71,43397.5%$1,874$1.0091.1 %(1)As of December 31, 2020.(2)Represents average occupancy for the year ended December 31, 2020.(3)Represents average monthly rent for the year ended December 31, 2020.(4)Represents the percentage of rental revenues and other property income generated in each market for the year ended December 31, 2020.(5)In December 2019, we announced a plan to fully exit the Nashville market. As of December 31, 2020, we have 16 remaining homes in the market.59Factors That Affect Our Results of Operations and Financial Condition Our results of operations and financial condition are affected by numerous factors, many of which are beyond our control. See Part I. Item 1A. “Risk Factors” for more information regarding factors that could materially adversely affect our results of operations and financial condition. Key factors that impact our results of operations and financial condition include market fundamentals, rental rates and occupancy levels, turnover rates and days to re-resident homes, property improvements and maintenance, property acquisitions and renovations, and financing arrangements. Sensitivity to many of these factors has been heightened as a result of the ongoing and numerous adverse impacts of COVID-19.Market Fundamentals: Our results are impacted by housing market fundamentals and supply and demand conditions in our markets, particularly in the Western United States and Florida, which represented 71.3% of our rental revenues and other property income during the year ended December 31, 2020. We are actively monitoring the impact of the COVID-19 outbreak on market fundamentals and are quickly implementing changes in pricing as market fundamentals shift.Rental Rates and Occupancy Levels: Rental rates and occupancy levels are primary drivers of rental revenues and other property income. Our rental rates and occupancy levels are affected by macroeconomic factors and local and property-level factors, including market conditions, seasonality, resident defaults, and the amount of time it takes to prepare a home for its next resident and re-lease homes when residents vacate. An important driver of rental rate growth is our ability to increase monthly rents from expiring leases, which typically have a term of one to two years. The ongoing COVID-19 pandemic has negatively impacted our ability to increase rents and may impact our ability to maintain occupancy levels. Collection Rates: Our rental revenues and other property income is impacted by the rate at which we collect such revenues from our residents. We routinely work with residents facing financial hardships who need flexibility to fulfill their lease obligations, but the ongoing COVID-19 pandemic has increased the number of such residents. When requested, we work with these residents to create payment plans, without late fees, and then actively manage these receivables. However, a portion of these amounts may not ultimately be collected. Any amounts billed to residents that have been deemed uncollectible along with our estimate of amounts that may ultimately be uncollectible decrease our rental revenues and other property income. Turnover Rates and Days to Re-Resident: Other drivers of rental revenues and property operating and maintenance expense include the length of stay of our residents, resident turnover rates, and the number of days a home is unoccupied between residents. Our operating results are also impacted by the amount of time it takes to market and lease a property, which is a component of the number of days a home is unoccupied between residents. The period of time to market and lease a property can vary greatly and is impacted by local demand, our marketing techniques, the size of our available inventory, and both current economic conditions and future economic outlook, both of which are impacted by the ongoing COVID-19 pandemic. Days to re-resident may be negatively affected by homes potentially remaining vacant while prospective residents remain in their current housing. Our turnover rate may be affected by the current COVID-19 pandemic as a result of delayed eviction proceedings and/or move outs potentially being canceled by residents who have not secured their next housing plans. Increases in turnover rates and the average number of days to re-resident reduce rental revenues as the homes are not generating income during this period of vacancy.Property Improvements and Maintenance: Property improvements and maintenance impact capital expenditures, property operating and maintenance expense, and rental revenues. We actively manage our homes on a total portfolio basis to determine what capital and maintenance needs may be required, and what opportunities we may have to generate additional revenues or expense savings from such expenditures. Due to our size and scale both nationally and locally, we believe we are able to purchase goods and services at favorable prices. While the COVID-19 outbreak has required us to modify our property improvement and maintenance procedures to accommodate resident preferences, as a currently designated “essential business” we are completing all maintenance work orders unless a resident reports symptoms of or exposure to COVID-19. However, future potential governmental measures may restrict our ability to function as an “essential business.” Additionally, we have addressed a backlog of deferred work orders that resulted from our initial deferral of all non-emergency work orders at the onset of the pandemic.60Property Acquisitions and Renovations: Future growth in rental revenues and other property income may be impacted by our ability to identify and acquire homes, our pace of property acquisitions, and the time and cost required to renovate and lease a newly acquired home. Our ability to identify and acquire single-family homes that meet our investment criteria is impacted by home prices in targeted acquisition locations, the inventory of homes available for sale through our acquisition channels, and competition for our target assets. All of these factors may be negatively impacted by the COVID-19 outbreak, potentially reducing the number of homes we acquire. The acquisition of homes involves expenditures in addition to payment of the purchase price, including payments for acquisition fees, property inspections, closing costs, title insurance, transfer taxes, recording fees, broker commissions, property taxes, and HOA fees (when applicable). Additionally, we typically incur costs to renovate a home to prepare it for rental. The scope of renovation work varies, but may include paint, flooring, carpeting, cabinetry, appliances, plumbing hardware, roof replacement, HVAC replacement, and other items required to prepare the home for rental. The time and cost involved in accessing our homes and preparing them for rental can significantly impact our financial performance. The time to renovate a newly acquired property can vary significantly among homes for several reasons, including the property’s acquisition channel, the condition of the property, whether the property was vacant when acquired, and whether there are any state or local restrictions on our ability to complete renovations as an essential business function. Additionally, COVID-19 and related containment measures may interfere with the ability of our suppliers and other business partners to carry out their assigned tasks and/or source labor or supply materials at ordinary levels of performance relative to the conduct of our business. Due to our size and scale both nationally and locally, we believe we are able to purchase goods and services at favorable prices.Financing Arrangements: Financing arrangements directly impact our interest expense, mortgage loans, secured term loan, term loan facility, revolving facility, and convertible debt, as well as our ability to acquire and renovate homes. We have historically utilized indebtedness to fund the acquisition and renovation of new homes. Our current financing arrangements contain financial covenants, and certain financing arrangements contain variable interest rate terms. Interest rates are impacted by market conditions and the terms of the underlying financing arrangements. Inability by our residents to meet their lease obligations due to the COVID-19 pandemic could reduce our cash flows, which could impact our ability to make all required debt service payments. Furthermore, the COVID-19 pandemic has resulted in a widespread health crisis adversely affecting the economy and financial markets of many countries resulting in an economic downturn that could negatively affect our ability to access financial markets as well as our business, results of operations, and financial condition. See Part II. Item 7A. “Quantitative and Qualitative Disclosures about Market Risk” for further discussion regarding interest rate risk. Our future financing arrangements may not have similar terms with respect to amounts, interest rates, financial covenants, and durations. Components of Revenues and ExpensesThe following is a description of the components of our revenues and expenses. RevenuesRental Revenues and Other Property IncomeRental revenues, net of any concessions and bad debt (including write-offs, credit reserves, and uncollectible amounts), consist of rents collected under lease agreements related to our single-family homes for lease. We enter into leases directly with our residents, and the leases typically have a term of one to two years. Other property income is comprised of: (i) resident reimbursements for utilities, HOA fines, and other charge-backs; (ii) rent and non-refundable deposits associated with pets; (iii) revenues from ancillary services such as smart homes and HVAC replacement filters; and (iv) various other fees, including late fees, lease termination fees, among others. ExpensesProperty Operating and Maintenance Once a property is available for its initial lease, which we refer to as “rent-ready,” we incur ongoing property-related expenses, which consist primarily of property taxes, insurance, HOA fees (when applicable), market-level personnel 61expenses, utility expenses, repairs and maintenance, leasing costs, marketing expenses, and property administration. Prior to a property being “rent-ready,” certain of these expenses are capitalized as building and improvements. Once a property is “rent-ready,” expenditures for ordinary repairs and maintenance thereafter are expensed as incurred, and we capitalize expenditures that improve or extend the life of a home. Property Management ExpenseProperty management expense represents personnel and other costs associated with the oversight and management of our portfolio of homes, including those within our unconsolidated joint ventures. All of our homes are managed through our internal property manager. General and Administrative General and administrative expense represents personnel costs, professional fees, and other costs associated with our day-to-day activities. General and administrative expense also includes merger and transaction-related expenses, among other things, that are of a non-recurring nature.Share-Based Compensation Expense All share-based compensation expense is recognized in our consolidated statements of operations as components of general and administrative expense and property management expense. We issue share-based awards to align the interests of our associates with those of our investors.Interest Expense Interest expense includes interest payable on our debt instruments, payments and receipts related to our interest rate swap agreements, amortization of discounts and deferred financing costs, unrealized gains (losses) on non-designated hedging instruments, and non-cash interest expense related to our interest rate swap agreements.Depreciation and Amortization We recognize depreciation and amortization expense associated with our homes and other capital expenditures over their expected useful lives. Impairment and Other Impairment and other represents provisions for impairment when the carrying amount of our single-family residential properties is not recoverable and casualty (gains) losses, net of any insurance recoveries.Unrealized Gains on Investments in Equity SecuritiesUnrealized gains on investments in equity securities includes gains resulting from mark to market adjustments made for our equity securities.Other, net Other, net includes interest income, asset and property management fee income, income (loss) from investments in unconsolidated joint ventures, and other miscellaneous income and expenses.Gain on Sale of Property, net of tax Gain on sale of property, net of tax consists of net gains and losses resulting from sales of our homes. 62Results of OperationsYear Ended December 31, 2020 Compared to Year Ended December 31, 2019 The following table sets forth a comparison of the results of operations for the years ended December 31, 2020, and 2019:For the Years Ended December 31,($ in thousands)20202019$ Change% ChangeRental revenues and other property income$1,822,828 $1,764,685 $58,143 3.3 %Expenses:Property operating and maintenance680,543 669,987 10,556 1.6 %Property management expense58,613 61,614 (3,001)(4.9)%General and administrative63,305 74,274 (10,969)(14.8)%Interest expense353,923 367,173 (13,250)(3.6)%Depreciation and amortization552,530 533,719 18,811 3.5 %Impairment and other696 18,743 (18,047)(96.3)%Total expenses1,709,610 1,725,510 (15,900)(0.9)%Unrealized gains on investments in equity securities29,723 6,480 23,243 358.7 %Other, net(86)5,120 (5,206)(101.7)%Gain on sale of property, net of tax54,594 96,336 (41,742)(43.3)%Net income$197,449 $147,111 $50,338 34.2 %Portfolio InformationAs of December 31, 2020 and 2019, we owned 80,177 and 79,505 single-family rental homes, respectively, in our total portfolio. During the years ended December 31, 2020, and 2019, we acquired 2,252 and 2,153 homes, respectively, and sold 1,580 and 3,455 homes, respectively. During the years ended December 31, 2020, and 2019, we owned an average of 79,530 and 80,372 single-family rental homes, respectively.We believe presenting information about the portion of our total portfolio that has been fully operational for the entirety of both a given reporting period and its prior year comparison period provides investors with meaningful information about the performance of our comparable homes across periods, and about trends in our organic business. To do so, we provide information regarding the performance of our Same Store portfolio.As of December 31, 2020, our Same Store portfolio consisted of 71,433 single-family rental homes.Rental Revenues and Other Property IncomeFor the years ended December 31, 2020, and 2019, total portfolio rental revenues and other property income totaled $1,822.8 million and $1,764.7 million, respectively, an increase of 3.3%, driven by an increase in average occupancy, average monthly rent per occupied home, and utilities reimbursements, partially offset by an increase in bad debt, reduced fee income, and a 842 home decrease between periods in the average number of homes owned.Average occupancy for the years ended December 31, 2020, and 2019 for the total portfolio was 96.1% and 94.2%, respectively. Average monthly rent per occupied home for the total portfolio for the years ended December 31, 2020, and 2019 was $1,875 and $1,809, respectively, a 3.6% increase. For our Same Store portfolio, average occupancy was 97.5% and 96.2% for the years ended December 31, 2020, and 2019, respectively, and average monthly rent per occupied home for the years ended December 31, 2020, and 2019 was $1,874 and $1,810, respectively, a 3.5% increase.63The annual turnover rate for the Same Store portfolio for the years ended December 31, 2020, and 2019 was 26.1% and 29.7%, respectively. For the Same Store portfolio, an average home remained unoccupied for 36 and 46 days between residents for the years ended December 31, 2020, and 2019, respectively. The decreases in these two metrics contributed to our increase in occupancy on a year over year basis. Furthermore, we believe the decrease in turnover is partially attributable to the effects of the COVID-19 pandemic (e.g., eviction moratoriums and residents who are not inclined to relocate during this period). We cannot predict how long eviction moratoriums will remain in place nor when the general effects of the pandemic will subside and how those items may affect our turnover and occupancy rates.To monitor prospective changes in average monthly rent per occupied home, we compare the monthly rent from an expiring lease to the monthly rent from the next lease for the same home, in each case, net of any amortized non-service concessions, to calculate net effective rental rate growth. Leases are either renewal leases, where our current resident stays for a subsequent lease term, or new leases, where our previous resident moves out and a new resident signs a lease to occupy the same home.Renewal lease net effective rental rate growth for the total portfolio averaged 3.7% and 5.0% for the years ended December 31, 2020, and 2019, respectively, and new lease net effective rental rate growth for the total portfolio averaged 4.4% and 3.8% for the years ended December 31, 2020, and 2019, respectively. For our Same Store portfolio, renewal lease net effective rental rate growth averaged 3.7% and 5.0% for the years ended December 31, 2020, and 2019, respectively, and new lease net effective rental rate growth averaged 4.2% and 3.7% for the years ended December 31, 2020, and 2019, respectively.The COVID-19 pandemic has negatively impacted our rental revenues and other property income in three notable ways: (1) lower collection rates, which caused our bad debt to increase from 0.5% of gross rental income for the year ended December 31, 2019 to 1.7% of gross rental income for the year ended December 31, 2020; (2) voluntary non-enforcement of and jurisdictional restrictions on late fees during a portion of the year ended December 31, 2020, which was a primary driver of a decrease in fee income year over year; and (3) lower reimbursements of move out and other costs as a result of lower turnover and eviction moratoriums. The decreases in fee income and reimbursements were partially offset by continued increases in utilities reimbursements as more utilities remained in our name compared to the prior year. The COVID-19 pandemic is likely to continue to affect our collection rates and ability to raise rents and charge fees, and the impact of jurisdictional restrictions on rental rates, late fees, collections, and eviction moratoriums is likely to affect our ability to increase rental revenues and other operating income.Expenses For the years ended December 31, 2020, and 2019, total expenses were $1,709.6 million and $1,725.5 million, respectively. Set forth below is a discussion of changes in the individual components of total expenses.For the year ended December 31, 2020, property operating and maintenance expense increased to $680.5 million from $670.0 million for the year ended December 31, 2019. This 1.6% net increase resulted from increases in utilities, property taxes, and repairs and maintenance, partially offset by decreases in turnover, property administrative costs that declined due to lower turnover and eviction moratoriums, and savings in personnel and other costs. The 842 home decrease between periods in the average number of homes owned also offset the increases in certain expense categories. The COVID-19 pandemic is likely to continue to impact our turnover rates, and thus turnover costs, and other property operating and maintenance expense may continue to be affected by the ongoing impacts of the pandemic. Property management expense and general and administrative expense decreased to $121.9 million from $135.9 million for the years ended December 31, 2020, and 2019, respectively, due to decreases in severance expense of $7.9 million, merger and transaction-related expenses of $4.3 million, and share-based compensation expense of $1.1 million for the year ended December 31, 2020 as compared to the year ended December 31, 2019. To date, the COVID-19 pandemic has not had a material impact on our property management and general and administrative expenses.Interest expense was $353.9 million and $367.2 million for the years ended December 31, 2020, and 2019, respectively. The decrease in interest expense was primarily driven by a decrease in the average debt balance outstanding during the year ended December 31, 2020 as compared to the year ended December 31, 2019 due to various prepayments subsequent to December 31, 2019 and settlement of a portion of our convertible debt for common equity during the year ended 64December 31, 2019. Debt outstanding, net of deferred financing costs and discounts, decreased to $8,031.5 million as of December 31, 2020 from $8,467.5 million as of December 31, 2019.Depreciation and amortization expense increased to $552.5 million for the year ended December 31, 2020 from $533.7 million for the year ended December 31, 2019 due to an increase in cumulative capital expenditures. This was partially offset by a decrease in the average number of homes owned during the year ended December 31, 2020 compared to the year ended December 31, 2019. Impairment and other expenses were $0.7 million and $18.7 million for the years ended December 31, 2020, and 2019, respectively. During the year ended December 31, 2020, impairment and other expenses was comprised of impairment losses of $4.6 million on our single-family residential properties, partially offset by net gains on casualty losses of $3.9 million. During the year ended December 31, 2019, impairment and other expenses was comprised of impairment losses of $14.2 million on our single-family residential properties and casualty losses of $4.5 million. The impairment costs recognized during the year ended December 31, 2020 were not a direct result of the COVID-19 pandemic.Unrealized Gains on Investments in Equity SecuritiesUnrealized gains on investments in equity securities increased to $29.7 million for the year ended December 31, 2020 from $6.5 million for the year ended December 31, 2019 due to the merger of one of our investments with a special purpose acquisition company during the year ended December 31, 2020. Subsequent to this merger, the investment has a readily determinable fair value and has been marked to market.Other, netOther, net decreased to a $0.1 million loss for the year ended December 31, 2020 from $5.1 million of income for the year ended December 31, 2019, primarily due to changes in the components of our miscellaneous income and expenses and a $1.8 million ROU lease asset impairment during the year ended December 31, 2020.Gain on Sale of Property, net of taxGain on sale of property, net of tax was $54.6 million and $96.3 million for the years ended December 31, 2020, and 2019, respectively. The primary driver of the decrease was a decrease in the number of homes sold from 3,455 during the year ended December 31, 2019 to 1,580 during the year ended December 31, 2020.Year Ended December 31, 2019 Compared to Year Ended December 31, 2018For similar operating and financial data and discussion of our year ended December 31, 2019 results compared to our year ended December 31, 2018 results, refer to Part II. Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operations” of our 2019 10-K.65Liquidity and Capital ResourcesOur liquidity and capital resources as of December 31, 2020 and 2019 include unrestricted cash and cash equivalents of $213.4 million and $92.3 million, respectively, a 131.3% increase. The following significant activity occurred during the year ended December 31, 2020:•In December 2020, we entered into a sustainability-linked senior unsecured credit facility (the “Credit Facility”) that provides $3,500.0 million of borrowing capacity and consists of a $1,000.0 million revolving facility (the “Revolving Facility”) and a $2,500.0 million term loan facility (the “Term Loan Facility”), both of which mature on January 31, 2025, with two six month extension options available. The Credit Facility replaced a credit facility that consisted of a $1,000.0 million revolving facility (the “2017 Revolving Facility”) and a $1,500.0 million term loan facility (the “2017 Term Loan Facility” and together with the 2017 Revolving Facility, the “2017 Credit Facility”). Proceeds from the Term Loan Facility were used (1) to fully repay the $1,500.0 million 2017 Term Loan Facility due to mature in February 2022; (2) to fully repay the $731.0 million principal balance of the SWH 2017-1 securitization that was due to reach final maturity in January 2023; and (3) to voluntarily prepay higher-cost classes of certificates of various securitizations due to reach final maturity, provided all extensions were exercised, between March 2025 and January 2026. For both the Revolving Facility and the Term Loan Facility, spreads at closing, based on the Company's total leverage ratio, were 5 bps lower than the spreads most recently in effect for the 2017 Credit Facility.•In March 2020, we drew $250.0 million on the 2017 Revolving Facility due to uncertainties about the impact of the COVID-19 pandemic on our cash provided by operations and our near-term acquisition and disposition activity.•In May 2020, we used cash on hand to repay $120.0 million of the then-outstanding balance of the 2017 Revolving Facility. •In June 2020, we completed an underwritten public offering to sell 16,675,000 shares of our common stock and generated net proceeds of $447.5 million. Proceeds of $150.0 million were used to fully repay the then-outstanding balance on our 2017 Revolving Facility. The remaining proceeds were used primarily for acquisitions. As of December 31, 2020, our $1,000.0 million Revolving Facility remains undrawn, and there are no restrictions on our ability to draw additional funds thereunder provided we remain in compliance with all covenants. We have no debt reaching final maturity until December 2024, provided all extensions are exercised, with the exception of $345.0 million of convertible notes maturing in January 2022. Our ability to access capital as well as to use cash from operations to continue to meet our liquidity needs, all of which are highly uncertain and cannot be predicted, could be affected by various risks and uncertainties, including, but not limited to, the effects of the COVID-19 pandemic, as detailed in Part I. Item 1A. “Risk Factors.”Through December 31, 2020, disposition channels remained healthy in our markets, and we continued to sell homes that were designated for disposition. We have limited cash commitments outside of debt service as we do not engage in any development activity, and the pipeline of acquisitions to which we are committed is $30.9 million as of December 31, 2020. However, the ongoing impact of the COVID-19 pandemic may impact the acquisition and disposition of single-family homes in ways that we are unable to predict.Liquidity is a measure of our ability to meet potential cash requirements, maintain our assets, fund our operations, make dividend payments to our stockholders, and meet other general requirements of our business. Our liquidity, to a certain extent, is subject to general economic, financial, competitive, and other factors beyond our control. Our near-term liquidity requirements consist primarily of: (i) renovating newly-acquired homes; (ii) funding HOA fees (as applicable), property taxes, insurance premiums, and the ongoing maintenance of our homes; (iii) interest expense; (iv) payment of dividends to our equity investors; and (v) required contributions to the Rockpoint joint venture. We believe our rental income, net of total expenses, will generally provide cash flow sufficient to fund operations and dividend payments on a near-term basis. However, the COVID-19 pandemic may negatively impact our operating cash flow such that we are unable to make required debt service payments, which would result in an event of default for any such loan agreement under which payments were not made. Specifically, the collateral within individual borrower entities may underperform, resulting in cash flow shortfalls for debt service while consolidated cash flows are sufficient to fund our operations. If an event of default occurs for a specific mortgage loan or for our secured term loan, our loan agreements provide certain remedies, including our ability to 66fund shortfalls from consolidated cash flow; and such an event of default would not result in an immediate acceleration of the loan. Our real estate assets are illiquid in nature. A timely liquidation of assets may not be a viable source of short-term liquidity should a cash flow shortfall arise, and we may need to source liquidity from other financing sources, such as the Revolving Facility, which had an undrawn balance of $1,000.0 million as of December 31, 2020. Our long-term liquidity requirements consist primarily of funds necessary to pay for the acquisition of, and non-recurring capital expenditures for, our homes and principal payments on our indebtedness. We intend to satisfy our long-term liquidity needs through cash provided by operations, long-term secured and unsecured borrowings, the issuance of debt and equity securities, and property dispositions. As a REIT, we are required to distribute to our stockholders at least 90% of our taxable income, excluding net capital gain, on an annual basis. Therefore, as a general matter, it is unlikely that we will be able to retain substantial cash balances from our annual taxable income that could be used to meet our liquidity needs. Instead, we will need to meet these needs from external sources of capital and amounts, if any, by which our cash flow generated from operations exceeds taxable income. On August 22, 2019, we entered into distribution agreements with a syndicate of banks (the “Agents”), pursuant to which we may sell, from time to time, up to an aggregate sales price of $800.0 million of our common stock through the Agents (the “ATM Equity Program”). During the year ended December 31, 2020, we sold 8,413,224 shares of our common stock under our ATM Equity Program, generating net proceeds of $239.2 million after giving effect to Agent commissions and other costs totaling $3.9 million. As of December 31, 2020, $500.0 million remains available for future offerings under the ATM Equity Program. Certain Securitizations (defined below), the Secured Term Loan (defined below), the Term Loan Facility, and the Revolving Facility (collectively, the “LIBOR-Based Loans”) use LIBOR as a benchmark for establishing interest rates. Our derivative instruments are also indexed to LIBOR. On November 30, 2020, the FCA, which has statutory powers to require panel banks to contribute to LIBOR, announced that subject to confirmation following its consultation with the administrator of LIBOR, it would cease publication of the one week and two month USD LIBOR immediately after December 31, 2021 and cease publication of the remaining tenors immediately after June 30, 2023. Once LIBOR is phased out, the interest rates for our LIBOR-Based Loans will be based on a comparable or successor rate as provided for in our loan agreements. We will work with the counterparties to our swap and cap agreements to adjust each floating rate to a comparable or successor rate. While we do not expect that the transition from LIBOR and risks related thereto will have a material adverse effect on our financing costs, the ultimate outcome of this change is uncertain at this time, and significant management time and attention may be required to transition to using the new benchmark rates and to implement necessary changes to our financial models.The following describes the key terms of our current indebtedness.Mortgage Loans Our securitization transactions (the “Securitizations” or the “mortgage loans”) are collateralized by certain homes owned by wholly owned subsidiaries of INVH LP that were formed to facilitate certain of our financing arrangements (the “Borrower Entities”). We utilize the proceeds from our securitizations to fund: (i) repayments of then-outstanding indebtedness; (ii) initial deposits into Securitization reserve accounts; (iii) closing costs in connection with the mortgage loans; and (iv) general costs associated with our operations. 67The following table sets forth a summary of our mortgage loan indebtedness as of December 31, 2020 and 2019: Outstanding Principal Balance(5)($ in thousands)MaturityDate(1)Maturity Date ifFully Extended(2)InterestRate(3)Range of Spreads(4)December 31, 2020December 31, 2019IH 2017-1(6)June 9, 2027June 9, 20274.23%N/A$994,787 $995,520 SWH 2017-1(7)December 9, 2020N/A—%N/A— 744,092 IH 2017-2(7)December 9, 2021December 9, 20241.29%91-186 bps612,506 624,475 IH 2018-1(7)(8)March 9, 2021March 9, 20251.09%76-151 bps646,021 793,720 IH 2018-2(7)June 9, 2021June 9, 20251.23%95-150 bps693,988 957,135 IH 2018-3(7)July 9, 2021July 9, 20251.42%105-205 bps1,036,561 1,213,035 IH 2018-4(7)(9)January 9, 2021January 9, 20261.49%115-200 bps848,270 938,430 Total Securitizations4,832,133 6,266,407 Less: deferred financing costs, net (12,035)(27,946)Total $4,820,098 $6,238,461 (1)Maturity date represents repayment date for mortgage loans which have been repaid in full prior to December 31, 2020. For all other mortgage loans, the maturity dates above reflect all extension options that have been exercised. (2)Represents the maturity date if we exercise each of the remaining one year extension options available, which are subject to certain conditions being met.(3)Except for IH 2017-1, interest rates are based on a weighted average spread over LIBOR, plus applicable servicing fees; as of December 31, 2020, LIBOR was 0.14%. Our IH 2017-1 mortgage loan bears interest at a fixed rate of 4.23% per annum, equal to the market determined pass-through rate payable on the certificates including applicable servicing fees.(4)Range of spreads is based on outstanding principal balances as of December 31, 2020.(5)Outstanding principal balance is net of discounts and does not include deferred financing costs, net.(6)Net of unamortized discount of $2.3 million and $2.6 million as of December 31, 2020 and 2019, respectively. (7)The initial maturity term of each of these mortgage loans is two years, individually subject to three to five, one year extension options at the Borrower Entity’s discretion (provided that there is no continuing event of default under the mortgage loan agreement and the Borrower Entity obtains and delivers a replacement interest rate cap agreement from an approved counterparty within the required timeframe to the lender). Our IH 2018-1, IH 2018-2, and IH 2018-3 mortgage loans have exercised the first extension option, and our IH 2017-2 mortgage loan has exercised the second extension option. The maturity dates above reflect all extensions that have been exercised. (8)On December 1, 2020, we submitted a notification to request an extension of the maturity date of the IH 2018-1 mortgage loan from March 9, 2021 to March 9, 2022.(9)On January 9, 2021, the extension of the maturity date of the IH 2018-4 mortgage loan from January 9, 2021 to January 9, 2022 was approved by the lender. Securitization Transactions For each Securitization transaction, the Borrower Entity executed a loan agreement with a third party lender. Except for IH 2017-1, each outstanding mortgage loan originally consisted of six floating rate components. The two year initial terms are individually subject to three to five, one year extension options at the Borrower Entity’s discretion. Such extensions are available provided there is no continuing event of default under the respective mortgage loan agreement and the Borrower Entity obtains and delivers a replacement interest rate cap agreement from an approved counterparty within the required timeframe to the lender. IH 2017-1 is a 10 year, fixed rate mortgage loan comprised of two components. Certificates issued by the trust in connection with Component A of IH 2017-1 benefit from the Federal National Mortgage Association’s guaranty of timely payment of principal and interest.68Each mortgage loan is secured by a pledge of the equity in the assets of the respective Borrower Entities, as well as first-priority mortgages on the underlying properties and a grant of security interests in all of the related personal property. As of December 31, 2020 and 2019, a total of 31,316 and 37,040 homes, respectively, with a net book value of $5,761.6 million and $7,137.6 million, respectively, are pledged pursuant to the mortgage loans. Each Borrower Entity has the right, subject to certain requirements and limitations outlined in the respective loan agreements, to substitute properties. We are obligated to make monthly payments of interest for each mortgage loan. Transactions with Trusts Concurrent with the execution of each mortgage loan agreement, the respective third party lender sold each loan it originated to individual depositor entities (the “Depositor Entities”) who subsequently transferred each loan to Securitization-specific trust entities (the “Trusts”). The Depositor Entities for our currently outstanding Securitizations are wholly owned subsidiaries. As consideration for the transfer of each loan to the Trusts, the Trusts issued classes of certificates which mirror the components of the individual loans (collectively, the “Certificates”) to the Depositor Entities, except that Class R certificates do not have related loan components as they represent residual interests in the Trusts. The Certificates represent the entire beneficial interest in the Trusts. Following receipt of the Certificates, the Depositor Entities sold the Certificates to investors and used the proceeds as consideration for the loans sold to the Depositor Entities by the lenders. These transactions had no effect on our consolidated financial statements other than with respect to Certificates we retained in connection with Securitizations or purchased at a later date. The Trusts are structured as pass-through entities that receive interest payments from the Securitizations and distribute those payments to the holders of the Certificates. The assets held by the Trusts are restricted and can only be used to fulfill the obligations of those entities. The obligations of the Trusts do not have any recourse to the general credit of any entities in these consolidated financial statements. We have evaluated our interests in certain certificates of the Trusts held by us (discussed below) and determined that they do not create a more than insignificant variable interest in the Trusts. Additionally, the retained certificates do not provide us with any ability to direct activities that could impact the Trusts’ economic performance. Therefore, we do not consolidate the Trusts. Retained Certificates As the Trusts made Certificates available for sale to both domestic and foreign investors, sponsors of the mortgage loans are required to retain a portion of the risk that represents a material net economic interest in each loan pursuant to Regulation RR (the “Risk Retention Rules”) under the Securities Exchange Act of 1934, as amended. As such, loan sponsors are required to retain a portion of the credit risk that represents not less than 5% of the aggregate fair value of the loan as of the closing date.IH 2017-1 issued Class B certificates, which are restricted certificates that were made available exclusively to INVH LP in order to comply with the Risk Retention Rules. The Class B certificates bear a stated annual interest rate of 4.23%, including applicable servicing fees.For SWH 2017-1, IH 2017-2, IH 2018-1, IH 2018-2, IH 2018-3, and IH 2018-4, we retain 5% of each class of certificates to meet the Risk Retention Rules. These retained certificates accrue interest at a floating rate of LIBOR plus a spread ranging from 0.76% to 2.05%. The retained certificates total $245.2 million and $317.0 million as of December 31, 2020 and 2019, respectively, and are classified as held to maturity investments and recorded in other assets, net on the consolidated balance sheets. Loan CovenantsThe general terms that apply to all of the mortgage loans require each Borrower Entity to maintain compliance with certain affirmative and negative covenants. Affirmative covenants include each Borrower Entity’s, and certain of their respective affiliates’, compliance with (i) licensing, permitting and legal requirements specified in the mortgage loan agreements, (ii) organizational requirements of the jurisdictions in which they are organized, (iii) federal and state tax laws, and (iv) books and records requirements specified in the respective mortgage loan agreements. Negative covenants include each Borrower Entity’s, and certain of their affiliates’, compliance with limitations surrounding (i) the amount of each 69Borrower Entity’s indebtedness and the nature of their investments, (ii) the execution of transactions with affiliates, (iii) the Manager, (iv) the nature of each Borrower Entity’s business activities, and (v) the required maintenance of specified cash reserves. As of December 31, 2020, and through the date our consolidated financial statements were issued, we believe each Borrower Entity is in compliance with all affirmative and negative covenants. Prepayments For the mortgage loans, prepayments of amounts owed by us are generally not permitted under the terms of the respective mortgage loan agreements unless such prepayments are made pursuant to the voluntary election or mandatory provisions specified in such agreements. The specified mandatory provisions become effective to the extent that a property becomes characterized as a disqualified property, a property is sold, and/or upon the occurrence of a condemnation or casualty event associated with a property. To the extent either a voluntary election is made, or a mandatory prepayment condition exists, in addition to paying all interest and principal, we must also pay certain breakage costs as determined by the loan servicer and a spread maintenance premium if prepayment occurs before the month following the one or two year anniversary of the closing dates of each of the mortgage loans except for IH 2017-1. For IH 2017-1, prepayments on or before December 2026 will require a yield maintenance premium. For the years ended December 31, 2020, 2019, and 2018, we made voluntary and mandatory prepayments of $1,434.6 million, $997.4 million, and $4,579.6 million, respectively, under the terms of the mortgage loan agreements. During the year ended December 31, 2020 prepayments included the full repayment of the SWH 2017-1 mortgage loan. During the year ended December 31, 2019, prepayments included the full repayment of the CSH 2016-2 mortgage loan. During the year ended December 31, 2018, prepayments included full repayment of the CAH 2014-1, CAH 2014-2, CAH 2015-1, CSH 2016-1, IH 2015-1, IH 2015-2, and IH 2015-3 mortgage loans. Secured Term LoanOn June 7, 2019, 2019-1 IH Borrower LP, a consolidated subsidiary (“2019-1 IH Borrower” and one of our Borrower Entities), entered into a 12 year loan agreement with a life insurance company (the “Secured Term Loan”). The Secured Term Loan bears interest at a fixed rate of 3.59%, including applicable servicing fees, for the first 11 years and bears interest at a floating rate based on a spread of 147 bps, including applicable servicing fees, over one month LIBOR (subject to certain adjustments as outlined in the loan agreement) for the twelfth year. The Secured Term Loan is secured by first priority mortgages on a portfolio of single-family rental properties as well as a first priority pledge of the equity interests of 2019-1 IH Borrower. We utilized the proceeds from the Secured Term Loan to fund: (i) repayments of then-outstanding indebtedness; (ii) initial deposits into the Secured Term Loan’s reserve accounts; (iii) transaction costs related to the closing of the Secured Term Loan; and (iv) general corporate purposes.The following table sets forth a summary of our Secured Term Loan indebtedness as of December 31, 2020 and 2019:($ in thousands)MaturityDateInterestRate(1)December 31, 2020December 31, 2019Secured Term LoanJune 9, 20313.59%$403,363 $403,464 Deferred financing costs, net(2,268)(2,486)Secured Term Loan, net$401,095 $400,978 (1)The Secured Term Loan bears interest at a fixed rate of 3.59% per annum including applicable servicing fees for the first 11 years and for the twelfth year bears interest at a floating rate based on a spread of 147 bps over one month LIBOR (or a comparable or successor rate as provided for in our loan agreement), including applicable servicing fees, subject to certain adjustments as outlined in the loan agreement. Interest payments are made monthly. 70Collateral The Secured Term Loan’s collateral pool contains 3,332 and 3,333 homes, respectively, as of December 31, 2020 and 2019, with a net book value of $719.8 million and $734.8 million, respectively. 2019-1 IH Borrower has the right, subject to certain requirements and limitations outlined in the loan agreement, to substitute properties representing up to 20% of the collateral pool annually, and to substitute properties representing up to 100% of the collateral pool over the life of the Secured Term Loan. In addition, four times after the first anniversary of the closing date, 2019-1 IH Borrower has the right, subject to certain requirements and limitations outlined in the loan agreement, to execute a special release of collateral representing up to 15% of the then-outstanding principal balance of the Secured Term Loan in order to bring the loan-to-value ratio back in line with the Secured Term Loan’s loan-to-value ratio as of the closing date. Any such special release of collateral would not change the then-outstanding principal balance of the Secured Term Loan, but rather would reduce the number of single-family rental homes included in the collateral pool. Loan CovenantsThe Secured Term Loan requires 2019-1 IH Borrower to maintain compliance with certain affirmative and negative covenants. Affirmative covenants include 2019-1 IH Borrower’s, and certain of its affiliates’, compliance with (i) licensing, permitting and legal requirements specified in the loan agreement, (ii) organizational requirements of the jurisdictions in which they are organized, (iii) federal and state tax laws, and (iv) books and records requirements specified in the loan agreement. Negative covenants include 2019-1 IH Borrower’s, and certain of its affiliates’, compliance with limitations surrounding (i) the amount of 2019-1 IH Borrower’s indebtedness and the nature of its investments, (ii) the execution of transactions with affiliates, (iii) the Manager, (iv) the nature of 2019-1 IH Borrower’s business activities, and (v) the required maintenance of specified cash reserves. As of December 31, 2020, and through the date our consolidated financial statements were issued, we believe 2019-1 IH Borrower is in compliance with all affirmative and negative covenants. Prepayments Prepayments of the Secured Term Loan are generally not permitted unless such prepayments are made pursuant to the voluntary election or mandatory provisions specified in the loan agreement. The specified mandatory provisions become effective to the extent that a property becomes characterized as a disqualified property, a property is sold, and/or upon the occurrence of a condemnation or casualty event associated with a property. To the extent either a voluntary election is made, or a mandatory prepayment condition exists, in addition to paying all interest and principal, we must also pay certain breakage costs as determined by the loan servicer and a yield maintenance premium if prepayment occurs before June 9, 2030. For the year ended December 31, 2020, we made mandatory prepayments of $0.1 million. No prepayments were made for the year ended December 31, 2019.Term Loan Facility and Revolving FacilityOn December 8, 2020, we entered into an Amended and Restated Revolving Credit and Term Loan Agreement with a syndicate of banks, financial institutions, and institutional lenders for the Credit Facility. The Credit Facility provides $3,500.0 million of borrowing capacity and consists of the $1,000.0 million Revolving Facility and the $2,500.0 million Term Loan Facility, both of which mature on January 31, 2025, with two six month extension options available. The Revolving Facility also includes borrowing capacity for letters of credit. The Credit Facility provides us with the option to enter into additional incremental credit facilities (including an uncommitted incremental facility that provides us with the option to increase the size of the Revolving Facility and/or the Term Loan Facility such that the aggregate amount does not exceed at any time $4,000.0 million), subject to certain limitations. The Credit Facility replaced the 2017 Credit Facility that consisted of the $1,000.0 million 2017 Revolving Facility and the $1,500.0 million 2017 Term Loan Facility. The terms and conditions of the Credit Facility are consistent with those of the 2017 Credit Facility unless otherwise noted below. Proceeds from the Term Loan Facility were used to repay then-outstanding indebtedness, including the 2017 Term Loan Facility. Proceeds from the Revolving Facility are used for general corporate purposes. 71The following table sets forth a summary of the outstanding principal amounts under the Credit Facility and 2017 Credit Facility as of December 31, 2020 and 2019, respectively:($ in thousands)MaturityDateInterestRate(1)December 31, 2020December 31, 2019Term Loan Facility(2)January 31, 20251.79%$2,500,000 $1,500,000 Deferred financing costs, net(29,093)(6,253)Term Loan Facility, net$2,470,907 $1,493,747 Revolving Facility(2)January 31, 20251.84%$— $— (1)Interest rates for the Term Loan Facility and the Revolving Facility are based on LIBOR plus an applicable margin. As of December 31, 2020, the applicable margins were 1.65% and 1.70% respectively, and LIBOR was 0.14%.(2)If we exercise the two six month extension options, the maturity date will be January 31, 2026. Interest Rate and Fees Borrowings under the Credit Facility bear interest, at our option, at a rate equal to a margin over either (a) a LIBOR rate determined by reference to the Bloomberg LIBOR rate (or a comparable or successor rate as provided for in our loan agreement) for the interest period relevant to such borrowing, or (b) a base rate determined by reference to the highest of (1) the administrative agent’s prime lending rate, (2) the federal funds effective rate plus 0.50%, and (3) the LIBOR rate that would be payable on such day for a LIBOR rate loan with a one month interest period plus 1.00%. The margin is based on a total leverage based grid. The margins for the Term Loan Facility, Revolving Facility, 2017 Term Loan Facility, and 2017 Revolving Facility are as follows:Base Rate LoansLIBOR Rate LoansTerm Loan Facility0.45 %—1.15%1.45 %—2.15%Revolving Facility0.50 %—1.15%1.50 %—2.15%2017 Term Loan Facility0.70 %—1.30%1.70 %—2.30%2017 Revolving Facility0.75 %—1.30%1.75 %—2.30% In addition, the Credit Facility provides that, upon receiving an investment grade rating on its non-credit enhanced, senior unsecured long term debt of BBB- or better from Standard & Poor’s Rating Services, a division of The McGraw-Hill Companies, Inc., or Baa3 or better from Moody’s Investors Service, Inc., we may elect to convert to a credit rating based pricing grid. The margins for the Term Loan Facility and Revolving Facility under the credit rating based pricing grid are as follows: Base Rate LoansLIBOR Rate LoansTerm Loan Facility— %—0.65%0.80 %—1.65%Revolving Facility— %—0.45%0.75 %—1.45%The Credit Facility also includes a sustainability component whereby the Revolving Facility pricing can improve upon the Company’s achievement of certain sustainability ratings, determined via an independent third party evaluation. This sustainability feature was not included in the 2017 Revolving Facility.In addition to paying interest on outstanding principal under the Credit Facility, we are required to pay an unused facility fee to the lenders under the Revolving Facility in respect of the unused commitments thereunder. The unused facility fee rate is based on the daily unused amount of the Revolving Facility and is either 0.30% or 0.20% per annum based on the unused facility amount. The unused facility fee rate for the 2017 Revolving Facility was 0.35% or .20% per annum based on the unused facility amount. Upon conversion to a credit rating pricing based grid, the unused facility fee will no longer apply and we will be required to pay a facility fee ranging from 0.10% to 0.30%. We are also required to pay customary letter of credit fees. 72Prepayments and AmortizationNo principal reductions are required under the Credit Facility. We are permitted to voluntarily repay amounts outstanding under the Term Loan Facility at any time without premium or penalty, subject to certain minimum amounts and the payment of customary “breakage” costs with respect to LIBOR loans. Once repaid, no further borrowings will be permitted under the Term Loan Facility. Loan Covenants The Credit Facility contains certain customary affirmative and negative covenants and events of default. Such covenants will, among other things, restrict, subject to certain exceptions, our ability and that of the Subsidiary Guarantors (as defined below) and their respective subsidiaries to (i) engage in certain mergers, consolidations or liquidations, (ii) sell, lease or transfer all or substantially all of their respective assets, (iii) engage in certain transactions with affiliates, (iv) make changes to our fiscal year, (v) make changes in the nature of our business and our subsidiaries, and (vi) enter into certain burdensome agreements. The Credit Facility also requires us, on a consolidated basis with our subsidiaries, to maintain a (i) maximum total leverage ratio, (ii) maximum secured leverage ratio, (iii) maximum unencumbered leverage ratio, (iv) minimum fixed charge coverage ratio, (v) minimum unsecured interest coverage ratio, and (vi) maximum secured recourse leverage ratio. If an event of default occurs, the lenders under the Credit Facility are entitled to take various actions, including the acceleration of amounts due under the Credit Facility. As of December 31, 2020, and through the date our consolidated financial statements were issued, we believe we were in compliance with all affirmative and negative covenants. Guarantees and Security The obligations under the Credit Facility are guaranteed on a joint and several basis by each of our direct and indirect domestic wholly owned subsidiaries that directly own unencumbered assets (the “Subsidiary Guarantors”), subject to certain exceptions. These guarantees will be automatically released upon the occurrence of certain events, including if the applicable Subsidiary Guarantor is no longer a direct owner of an unencumbered asset. In addition, INVH and each subsidiary of INVH that owns equity in the Borrower may be required to provide a guarantee of the Credit Facility under certain circumstances, including if INVH does not maintain its qualification as a REIT. Although the 2017 Credit Facility was secured, such security interests have been released and the Credit Facility is unsecured. Convertible Senior NotesIn connection with the Mergers, we assumed SWH’s convertible senior notes. In July 2014, SWH issued $230.0 million in aggregate principal amount of 3.00% convertible senior notes due 2019 (the “2019 Convertible Notes”). Interest on the 2019 Convertible Notes was payable semiannually in arrears on January 1st and July 1st of each year. The notes matured on July 1, 2019, and we settled substantially all of the outstanding balance of the 2019 Convertible Notes through the issuance of 12,553,864 shares of our common stock.In January 2017, SWH issued $345.0 million in aggregate principal amount of 3.50% convertible senior notes due 2022 (the “2022 Convertible Notes” and together with the 2019 Convertible Notes, the “Convertible Senior Notes”). Interest on the 2022 Convertible Notes is payable semiannually in arrears on January 15th and July 15th of each year. The 2022 Convertible Notes will mature on January 15, 2022.73The following table summarizes the terms of the Convertible Senior Notes outstanding as of December 31, 2020 and 2019:Principal Amount($ in thousands)CouponRateEffectiveRate(1)ConversionRate(2)MaturityDateRemaining AmortizationPeriodDecember 31, 2020December 31, 20192022 Convertible Notes3.50%5.12%43.7694January 15, 20221.04 years$345,000 $345,000 Net unamortized fair value adjustment(5,596)(10,701)Total$339,404 $334,299 (1)Effective rate includes the effect of the adjustment to the fair value of the debt as of the Merger Date, the value of which reduced the initial liability recorded to $324.3 million for the 2022 Convertible Notes.(2)The conversion rate as of December 31, 2020 represents the number of shares of common stock issuable per $1,000 principal amount (actual $) of the 2022 Convertible Notes converted on such date, as adjusted in accordance with the indenture as a result of cash dividend payments and the effects of previous mergers. As of December 31, 2020, the 2022 Convertible Notes do not meet the criteria for conversion. We have the option to settle the 2022 Convertible Notes in cash, common stock, or a combination thereof. Terms of Conversion On July 1, 2019, we settled substantially all of the outstanding balance of the 2019 Convertible Notes with the issuance of 12,553,864 shares of our common stock. At the settlement date, the conversion rate applicable to the 2019 Convertible Notes was 54.5954 shares of our common stock per $1,000 principal amount (actual $) of the 2019 Convertible Notes (equivalent to a conversion price of approximately $18.32 per common share — actual $). For the years ended December 31, 2019 and 2018, interest expense for the 2019 Convertible Notes, including non-cash amortization of discounts, was $5.6 million and $11.1 million, respectively.As of December 31, 2020, the conversion rate applicable to the 2022 Convertible Notes is 43.7694 shares of our common stock per $1,000 principal amount (actual $) of the 2022 Convertible Notes (equivalent to a conversion price of approximately $22.85 per common share — actual $). The conversion rate for the 2022 Convertible Notes is subject to adjustment in some events, but will not be adjusted for any accrued and unpaid interest. In addition, following certain events that occur prior to the maturity date, we will adjust the conversion rate for a holder who elects to convert its 2022 Convertible Notes in connection with such an event in certain circumstances. At any time prior to July 15, 2021, holders may convert the 2022 Convertible Notes at their option only under specific circumstances as defined in the indenture agreement, dated as of January 10, 2017, between us and our trustee, Wilmington Trust National Association (the “Convertible Notes Trustee”). On or after July 15, 2021 and until maturity, holders may convert all or any portion of the 2022 Convertible Notes at any time. Upon conversion, we will pay or deliver, as the case may be, cash, common stock, or a combination of cash and common stock, at our election. The “if-converted” value of the 2022 Convertible Notes exceeds the principal amount by $103.5 million as of December 31, 2020 as the closing market price of our common stock of $29.70 per common share (actual $) exceeds the implicit conversion price. For the years ended December 31, 2020, 2019, and 2018, interest expense for the 2022 Convertible Notes, including non-cash amortization of discounts, was $17.2 million, $16.9 million, and $16.7 million respectively. General Terms We may not redeem the 2022 Convertible Notes prior to their maturity date except to the extent necessary to preserve our status as a REIT for United States federal income tax purposes, as further described in the indenture. If we undergo a fundamental change as defined in the indenture, holders may require us to repurchase for cash all or any portion of their 2022 Convertible Notes at a fundamental change repurchase price equal to 100% of the principal amount of the 2022 Convertible Notes to be repurchased, plus accrued and unpaid interest up to, but excluding, the fundamental change repurchase date.74The indenture contains customary terms and covenants and events of default. If an event of default occurs and is continuing, the Convertible Notes Trustee, by notice to us, or the holders of at least 25% in aggregate principal amount of the outstanding 2022 Convertible Notes, by notice to us and the Convertible Notes Trustee, may, and the Convertible Notes Trustee at the request of such holders shall, declare 100% of the principal of and accrued and unpaid interest on all the 2022 Convertible Notes to be due and payable. In the case of an event of default arising out of certain events of bankruptcy, insolvency or reorganization in respect to us (as set forth in the indenture), 100% of the principal of and accrued and unpaid interest on the 2022 Convertible Notes will automatically become due and payable. Certain Hedging ArrangementsFrom time to time, we enter into derivative instruments to manage the economic risk of changes in interest rates. We do not enter into derivative transactions for speculative or trading purposes. Designated hedges are derivatives that meet the criteria for hedge accounting and that we have elected to designate as hedges. Non-designated hedges are derivatives that do not meet the criteria for hedge accounting or that we did not elect to designate as hedges. Designated HedgesWe have entered into various interest rate swap agreements, which are used to hedge the variable cash flows associated with variable-rate interest payments. Currently, each of our swap agreements is indexed to LIBOR and is designated for hedge accounting purposes. LIBOR is set to expire at the end of 2021, and we will work with the counterparties to our swap agreements to adjust each floating rate to a comparable or successor rate. Changes in the fair value of these swaps are recorded in other comprehensive income and are subsequently reclassified into earnings in the period in which the hedged forecasted transactions affect earnings. The table below summarizes our interest rate swap instruments as of December 31, 2020 ($ in thousands):Agreement DateForwardEffective DateMaturityDateStrikeRateIndexNotionalAmountDecember 11, 2019February 28, 2017December 31, 20241.74%One month LIBOR$750,000 April 19, 2018January 31, 2019January 31, 20252.86%One month LIBOR400,000 February 15, 2019March 15, 2019March 15, 20222.23%One month LIBOR800,000 April 19, 2018March 15, 2019November 30, 20242.85%One month LIBOR400,000 April 19, 2018March 15, 2019February 28, 20252.86%One month LIBOR400,000 January 10, 2017January 15, 2020January 15, 20212.13%One month LIBOR550,000 May 8, 2018March 9, 2020June 9, 20252.99%One month LIBOR325,000 May 8, 2018June 9, 2020June 9, 20252.99%One month LIBOR595,000 June 3, 2016July 15, 2020July 15, 20211.47%One month LIBOR450,000 June 28, 2018August 7, 2020July 9, 20252.90%One month LIBOR1,100,000 January 10, 2017January 15, 2021July 15, 20212.23%One month LIBOR550,000 December 9, 2019July 15, 2021November 30, 20242.90%One month LIBOR400,000 November 7, 2018March 15, 2022July 31, 20253.14%One month LIBOR400,000 November 7, 2018March 15, 2022July 31, 20253.16%One month LIBOR400,000 During the year ended December 31, 2020, we terminated an interest rate swap and paid the counterparty $15.2 million in connection with this termination. During the year ended December 31, 2019, we modified the start date of an interest rate swap and paid the counterparty $8.2 million in connection with the modification.During the years ended December 31, 2020, 2019, and 2018, such derivatives were used to hedge the variable cash flows associated with existing variable-rate interest payments. Amounts reported in accumulated other comprehensive income related to derivatives will be reclassified to interest expense as interest payments are made on our variable-rate debt. During the next 12 months, we estimate that $147.0 million will be reclassified to earnings as an increase in interest expense.75During the year ended December 31, 2020, we accelerated the reclassification of certain amounts in other comprehensive income to earnings as a result of a portion of the hedged forecasted transactions becoming probable not to occur. The accelerated amounts represented a loss of $3.1 million and were recorded as interest expense in the accompanying consolidated statement of operations for the year ended December 31, 2020. We did not accelerate the reclassification of any amounts in other comprehensive income to earnings during the years ended December 31, 2019 and 2018.Non-Designated HedgesConcurrent with entering into certain of the mortgage loan agreements and in connection with previous mergers, we entered into or acquired and maintain interest rate cap agreements with terms and notional amounts equivalent to the terms and amounts of the mortgage loans made by the third party lenders. Currently, each of our cap agreements is indexed to LIBOR, which is set to expire at the end of 2021. We will work with the counterparties to our cap agreements to adjust each floating rate to a comparable or successor rate. To the extent that the maturity date of one or more of the mortgage loans is extended through an exercise of one or more extension options, replacement or extension interest rate cap agreements must be executed with terms similar to those associated with the initial interest rate cap agreements and strike prices equal to the greater of the interest rate cap strike price and the interest rate at which the debt service coverage ratio (as defined) is not less than 1.2 to 1.0. The interest rate cap agreements, including all of our rights to payments owed by the counterparties and all other rights, have been pledged as additional collateral for the mortgage loans. Additionally, in certain instances, in order to minimize the cash impact of purchasing required interest rate caps, we simultaneously sell interest rate caps (which have identical terms and notional amounts) such that the purchase price and sales proceeds of the related interest rate caps are intended to offset each other. The purchased and sold interest rate caps have strike prices ranging from approximately 3.75% to 6.32%.Purchase of Outstanding Debt Securities or Loans As market conditions warrant, we, our equity investors, our and their respective affiliates, and members of our management, may from time to time seek to purchase our outstanding debt, including borrowings under our credit facility and mortgage loans or debt securities that we may issue in the future, in privately negotiated or open market transactions, by tender offer or otherwise. Subject to any applicable limitations contained in the agreements governing our indebtedness, any purchases made by us may be funded by the use of cash on our consolidated balance sheet or the incurrence of new secured or unsecured debt, including borrowings under our credit facility and mortgage loans. The amounts involved in any such purchase transactions, individually or in the aggregate, may be material. Any such purchases may be with respect to a substantial amount of a particular class or series of debt, with the attendant reduction in the trading liquidity of such class or series. In addition, any such purchases made at prices below the “adjusted issue price” (as defined for United States federal income tax purposes) may result in taxable cancellation of indebtedness income to us, which amounts may be material, and in related adverse tax consequences to us.Cash FlowsYear Ended December 31, 2020 Compared to Year Ended December 31, 2019The following table summarizes our cash flows for the years ended December 31, 2020 and 2019: For the Years Ended December 31,($ in thousands)20202019$ Change% ChangeNet cash provided by operating activities$696,712 $662,130 $34,582 5.2 %Net cash provided by (used in) investing activities(425,156)102,226 (527,382)(515.9)%Net cash used in financing activities(146,033)(838,102)692,069 82.6 %Change in cash, cash equivalents, and restricted cash$125,523 $(73,746)$199,269 270.2 % 76Operating ActivitiesOur cash flows provided by operating activities depend on numerous factors, including the occupancy level of our homes, the rental rates achieved on our leases, the collection of rent from our residents, and the amount of our operating and other expenses. Net cash provided by operating activities was $696.7 million and $662.1 million for the years ended December 31, 2020, and 2019, respectively, an increase of 5.2%. The increase in cash provided by operating activities was driven by improved operational profitability, which was partially offset by changes in operating assets and liabilities.Investing Activities Net cash provided by (used in) investing activities consists primarily of the acquisition costs of homes, capital improvements, and proceeds from property sales. Net cash provided by (used in) investing activities was $(425.2) million and $102.2 million for the years ended December 31, 2020, and 2019, respectively, a decrease of $527.4 million. The decrease in net cash provided by (used in) investing activities primarily resulted from the combined effect of the following changes in cash flows during the year ended December 31, 2020 compared to the year ended December 31, 2019: (1) a decrease in proceeds from the sale of homes; (2) an increase in cash used for the initial renovation of homes; (3) an increase in cash used for the acquisition of homes; (4) an increase in cash used for investments in joint ventures; partially offset by (5) an increase in cash provided by repayment proceeds from retained debt securities. More specifically, proceeds from sales of homes decreased $440.7 million from the year ended December 31, 2019 to the year ended December 31, 2020 due to a significant decrease in the number of homes sold from 3,455 to 1,580, respectively, partially offset by an increase in proceeds per home. Initial renovation spend increased $41.3 million from the year ended December 31, 2019 compared to the year ended December 31, 2020 due to a significant increase in the number of homes undergoing their initial renovation and an increase in the cost per home. Acquisition spend increased $35.6 million due to an increase in the number of homes acquired from 2,153 homes during the year ended December 31, 2019 to 2,252 homes during the year ended December 31, 2020. Investments in joint ventures spend increased $16.3 million due to entering into a joint venture with Rockpoint during the year ended December 31, 2020. Proceeds from repayment of retained debt securities increased $22.1 million from the year ended December 31, 2019 to the year ended December 31, 2020 due to an increase in prepayments of mortgage loans, including the full repayment of SWH 2017-1 during the year ended December 31, 2020.Financing Activities Net cash used in financing activities was $146.0 million and $838.1 million for the years ended December 31, 2020, and 2019, respectively. During the year ended December 31, 2020, proceeds from our Term Loan Facility of $2,500.0 million, along with proceeds from issuances and sales of stock under our public offering and ATM Equity Program of $686.7 million, along with proceeds from home sales, were used (1) to repay $1,500.0 million of our 2017 Term Loan Facility; (2) to repay $1,434.6 million of our mortgage loans, including full repayment of SWH 2017-1 and partial repayments of IH 2018-1, IH 2018-2, IH 2018-3, and IH 2018-4; (3) to fund $334.3 million of dividend and distribution payments; and (4) to fund $41.4 million of deferred financing costs associated with the Credit Facility. For the year ended December 31, 2019, proceeds from our Secured Term Loan of $403.5 million, proceeds from our ATM Equity Program of $55.3 million, along with proceeds from home sales and operating cash flows, were used (1) to repay $997.4 million of our mortgage loans, including full repayment of CSH 2016-2 and partial repayments of IH 2017-2, IH 2018-1, IH 2018-2, and IH 2018-3; and (2) to fund $279.8 million of dividend and distribution payments. Year Ended December 31, 2019 Compared to Year Ended December 31, 2018For similar operating and financial data and discussion of our year ended December 31, 2019 results compared to our year ended December 31, 2018 results, refer to Part II. Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operations” of our 2019 10-K.77Contractual ObligationsOur contractual obligations as of December 31, 2020, consist of the following: ($ in thousands)Total20212022-20232024-2025ThereafterMortgage loans, net(1)(2)$5,337,454 $93,639 $187,277 $3,150,232 $1,906,306 Secured Term Loan(1)554,425 14,472 28,944 28,944 482,065 Term Loan Facility, net(1)2,730,835 45,372 90,743 90,867 2,503,853 Revolving Facility(1)(2)(3)18,054 3,549 7,097 7,107 301 2022 Convertible Notes(4)363,113 12,075 351,038 — — Derivative instruments(5)590,270 134,183 274,838 181,249 — Purchase commitments(6)30,894 30,894 — — — Operating leases17,144 5,108 7,384 4,269 383 Finance leases8,947 3,174 5,042 731 — Total$9,651,136 $342,466 $952,363 $3,463,399 $4,892,908 (1)Includes estimated interest payments on the respective debt based on amounts outstanding as of December 31, 2020 at rates in effect as of such date; as of December 31, 2020, LIBOR was 0.14%. (2)Represents the maturity date if we exercise each of the remaining one year extension options available, which are subject to certain conditions being met. See Part IV. Item 15. “Exhibits and Financial Statement Schedules — Note 7 of Notes to Consolidated Financial Statements” for a description of maturity dates without consideration of extension options.(3)Includes the related unused commitment fee.(4)Represents the principal amount and interest obligation of the 2022 Convertible Notes which is calculated using the notes’ coupon rate.(5)Includes interest rate swap and interest rate cap obligations calculated using LIBOR as of December 31, 2020, or 0.14%.(6)Represents commitments to acquire 99 single-family rental homes as of December 31, 2020.We have a commitment, which is not reflected in the table above, to make additional capital contributions to a joint venture. As of December 31, 2020, we are committed to fund an additional $59.4 million to the joint venture.Critical Accounting Policies and Estimates Our discussion and analysis of our historical financial condition and results of operations is based upon our consolidated financial statements, which have been prepared in accordance with GAAP and in conjunction with the rules and regulations of the SEC. The preparation of consolidated financial statements in conformity with GAAP requires management to make estimates and assumptions about the effect of matters that are inherently uncertain and that affect the amounts reported in the consolidated financial statements and accompanying notes. Actual results could ultimately differ from those estimates. For a discussion of recently-issued and adopted accounting standards, see Part IV. Item 15. “Exhibits and Financial Statement Schedules — Note 2 of Notes to Consolidated Financial Statements.”Investments in Single-Family Residential PropertiesThe following significant accounting policies affect the acquisition, disposition, recognition, classification, and fair value measurements (on a nonrecurring basis) related to our portfolio of over 80,000 single-family residential properties in 16 markets across the United States. For a complete discussion of our accounting policy and other factors related to each category below, see Part IV. Item 15. “Exhibits and Financial Statement Schedules — Note 2 of Notes to Consolidated Financial Statements.”•Acquisition of Real Estate Assets: Our purchases of homes are generally treated as asset acquisitions unless acquired in connection with a business combination. For asset acquisitions, homes are recorded at their purchase price, which is allocated between land, building and improvements, and in-place lease intangibles (when a resident is in place at the acquisition date) based upon their relative fair values at the date of acquisition. The purchase price for purposes 78of this allocation is inclusive of acquisition costs which typically include legal fees, bidding service and title fees, payments made to cure tax, utility, HOA, and other mechanic’s and miscellaneous liens, as well as other closing costs. If the percentage allocated to buildings and improvements versus land for the homes acquired during the year ended December 31, 2020 was increased or decreased by 500 bps, our annualized depreciation expense would have changed by approximately $1.1 million.•Cost Capitalization: We incur costs to acquire, stabilize, and prepare our single-family residential properties to be leased. We capitalize these costs as a component of our investment in each single-family residential property, using specific identification and relative allocation methodologies. The capitalization period associated with our stabilization activities begins at the time that such activities commence and concludes at the time that a single-family residential property is available to be leased.Once a property is ready for its intended use, expenditures for ordinary maintenance and repairs thereafter are expensed to operations as incurred, and we capitalize expenditures that improve or extend the life of a home and for certain furniture and fixtures additions.The capitalized costs are depreciated over their estimated useful lives on a straight-line basis. The weighted average useful lives range from 7 years to 28.5 years. If the useful lives for costs capitalized during the year ended December 31, 2020 were increased or decreased by 10%, our annualized depreciation expense would have changed by approximately $5.0 million.•Provisions for Impairment: We continuously evaluate, by property, whether there are any events or changes in circumstances indicating that the carrying amount of our single-family residential properties may not be recoverable. To the extent an event or change in circumstance is identified, a residential property is considered to be impaired only if its carrying value cannot be recovered through estimated future undiscounted cash flows from the use and eventual disposition of the property. To the extent an impairment has occurred, the carrying amount of our investment in a property is adjusted to its estimated fair value. The process whereby we assess our single-family residential properties for impairment requires significant judgment and assessment of factors that are, at times, subject to significant uncertainty. We evaluate multiple information sources and perform a number of internal analyses, each of which are important components of our process with no one information source or analysis being necessarily determinative. For those homes for which a change in an event or circumstance was identified in the most recent impairment analysis, a 5% change in the estimated fair value of those homes may have resulted in an increase in impairment expense of less than $0.1 million.•Single-Family Residential Properties Held for Sale: From time to time, we may identify single-family residential properties to be sold. Once we identify a property to be sold pursuant to GAAP requirements, we cease depreciating the property, measure the property at the lower of its carrying amount or its fair value less estimated costs to sell, and present the property separately within other assets, net on our consolidated balance sheets. If market values less disposal costs for our properties that were classified as held for sale as of December 31, 2020 were 10% lower, our impairment expense related to those properties would have increased by approximately $1.2 million. If the market values less disposal costs were 10% higher, our impairment expense would have been approximately $0.2 million lower.Segment Reporting Operating segments are defined as components of an enterprise for which discrete financial information is available that is evaluated regularly by the CODM in deciding how to allocate resources and in assessing performance. Our CODM is the Chief Executive Officer. Under the provisions of ASC 280, Segment Reporting, we have determined that we have one reportable segment related to acquiring, renovating, leasing, and operating single-family homes as rental properties. The CODM evaluates operating performance and allocates resources on a total portfolio basis. The CODM utilizes NOI as the primary measure to evaluate performance of the total portfolio. The aggregation of individual homes constitutes the total portfolio. Decisions regarding acquisitions and dispositions of homes are made at the individual home level with a focus on growing accretively in high-growth locations where we have greater scale and density. 79Non-GAAP Measures EBITDA, EBITDAre, and Adjusted EBITDAre EBITDA, EBITDAre, and Adjusted EBITDAre are supplemental, non-GAAP measures often utilized to evaluate the performance of real estate companies. We define EBITDA as net income or loss computed in accordance with GAAP before the following items: interest expense; income tax expense; and depreciation and amortization. The National Association of Real Estate Investment Trusts (“Nareit”) recommends as a best practice that REITs that report an EBITDA performance measure also report EBITDAre. We define EBITDAre, consistent with the Nareit definition, as EBITDA, further adjusted for gain on sale of property, net of tax and impairment on depreciated real estate investments. Adjusted EBITDAre is defined as EBITDAre before the following items: share-based compensation expense; merger and transaction-related expenses; severance; casualty (gains) losses, net; unrealized gains on investments in equity securities; and other income and expenses. EBITDA, EBITDAre, and Adjusted EBITDAre are used as supplemental financial performance measures by management and by external users of our financial statements, such as investors and commercial banks. Set forth below is additional detail on how management uses EBITDA, EBITDAre, and Adjusted EBITDAre as measures of performance. Our management uses EBITDA, EBITDAre, and Adjusted EBITDAre in a number of ways to assess our consolidated financial and operating performance, and we believe these measures are helpful to management and external users in identifying trends in our performance. EBITDA, EBITDAre, and Adjusted EBITDAre help management identify controllable expenses and make decisions designed to help us meet our current financial goals and optimize our financial performance, while neutralizing the impact of capital structure on results. Accordingly, we believe these metrics measure our financial performance based on operational factors that management can impact in the short-term, namely our cost structure and expenses.We believe that the presentation of EBITDA, EBITDAre, and Adjusted EBITDAre provides information useful to investors in assessing our financial condition and results of operations. The GAAP measure most directly comparable to EBITDA, EBITDAre, and Adjusted EBITDAre is net income or loss. EBITDA, EBITDAre, and Adjusted EBITDAre are not used as measures of our liquidity and should not be considered alternatives to net income or loss or any other measure of financial performance presented in accordance with GAAP. Our EBITDA, EBITDAre, and Adjusted EBITDAre may not be comparable to the EBITDA, EBITDAre, and Adjusted EBITDAre of other companies due to the fact that not all companies use the same definitions of EBITDA, EBITDAre, and Adjusted EBITDAre. Accordingly, there can be no assurance that our basis for computing these non-GAAP measures is comparable with that of other companies.80The following table presents a reconciliation of net income (loss) (as determined in accordance with GAAP) to EBITDA, EBITDAre, and Adjusted EBITDAre for each of the periods indicated: For the Years Ended December 31,($ in thousands)202020192018Net income (loss) available to common stockholders$195,764 $145,068 $(5,744)Net income available to participating securities448 395 817 Non-controlling interests1,237 1,648 (86)Interest expense353,923 367,173 383,595 Depreciation and amortization552,530 533,719 560,541 EBITDA1,103,902 1,048,003 939,123 Gain on sale of property, net of tax(54,594)(96,336)(49,682)Impairment on depreciated real estate investments4,578 14,210 6,709 EBITDAre1,053,886 965,877 896,150 Share-based compensation expense(1)17,090 18,158 29,499 Merger and transaction-related expenses(2)— 4,347 16,895 Severance601 8,465 8,238 Casualty (gains) losses, net(3)(3,882)4,533 14,110 Unrealized gains on investments in equity securities(29,723)(6,480)— Other, net(4)86 (5,120)(6,958)Adjusted EBITDAre$1,038,058 $989,780 $957,934 (1)For the years ended December 31, 2020, 2019, and 2018, $3,511, $3,075, and $5,500 was recorded in property management expense, respectively, and $13,579, $15,083, and $23,999 was recorded in general and administrative expense, respectively.(2)Includes merger and transaction-related expenses included within general and administrative.(3)Includes $8,013 for losses/damages related to Hurricanes Irma and Harvey for the year ended December 31, 2018. There were no such losses during the years ended December 31, 2020 and 2019.(4)Includes interest income and other miscellaneous income and expenses.Net Operating Income NOI is a non-GAAP measure often used to evaluate the performance of real estate companies. We define NOI for an identified population of homes as rental revenues and other property income less property operating and maintenance expense (which consists primarily of property taxes, insurance, HOA fees (when applicable), market-level personnel expenses, repairs and maintenance, leasing costs, and marketing expense). NOI excludes: interest expense; depreciation and amortization; property management expense; general and administrative expense; impairment and other; gain on sale of property, net of tax; unrealized gains on investments in equity securities; and other income and expenses. We consider NOI to be a meaningful supplemental financial measure of our performance when considered with the financial statements determined in accordance with GAAP. We believe NOI is helpful to investors in understanding the core performance of our real estate operations. The GAAP measure most directly comparable to NOI is net income or loss. NOI is not used as a measure of liquidity and should not be considered as an alternative to net income or loss or any other measure of financial performance presented in accordance with GAAP. Our NOI may not be comparable to the NOI of other companies due to the fact that not all companies use the same definition of NOI. Accordingly, there can be no assurance that our basis for computing this non-GAAP measure is comparable with that of other companies. We believe that Same Store NOI is also a meaningful supplemental measure of our operating performance for the same reasons as NOI and is further helpful to investors as it provides a more consistent measurement of our performance across reporting periods by reflecting NOI for homes in our Same Store portfolio. 81The following table presents a reconciliation of net income (loss) (as determined in accordance with GAAP) to NOI for our total portfolio and NOI for our Same Store portfolio for each of the periods indicated: For the Years Ended December 31,($ in thousands)202020192018Net income (loss) available to common stockholders$195,764 $145,068 $(5,744)Net income available to participating securities448 395 817 Non-controlling interests1,237 1,648 (86)Interest expense353,923 367,173 383,595 Depreciation and amortization552,530 533,719 560,541 Property management expense(1)58,613 61,614 65,485 General and administrative(2)63,305 74,274 98,764 Impairment and other(3)696 18,743 20,819 Gain on sale of property, net of tax(54,594)(96,336)(49,682)Unrealized gains on investments in equity securities(29,723)(6,480)— Other, net(4)86 (5,120)(6,958)NOI (total portfolio)1,142,285 1,094,698 $1,067,551 Non-Same Store NOI(98,821)(88,018)NOI (Same Store portfolio)(5)$1,043,464 $1,006,680 (1)Includes $3,511, $3,075, and $5,500 of share-based compensation expense for the years ended December 31, 2020, 2019, and 2018, respectively.(2)Includes $13,579, $15,083, and $23,999 of share-based compensation expense for the years ended December 31, 2020, 2019, and 2018, respectively.(3)Includes $8,013 for losses/damages related to Hurricanes Irma and Harvey for the year ended December 31, 2018. There were no such losses during the years ended December 31, 2020 and 2019.(4)Includes interest income and other miscellaneous income and expenses.(5)The Same Store portfolio totaled 71,433 homes for the years ended December 31, 2020 and 2019.82Funds from Operations, Core Funds from Operations, and Adjusted Funds from Operations Funds From Operations (“FFO”), Core FFO, and Adjusted FFO are supplemental, non-GAAP measures often utilized to evaluate the performance of real estate companies. FFO is defined by Nareit as net income or loss (computed in accordance with GAAP) excluding gains or losses from sales of previously depreciated real estate assets, plus depreciation, amortization and impairment of real estate assets, and adjustments for unconsolidated partnerships and joint ventures. We believe that FFO is a meaningful supplemental measure of the operating performance of our business because historical cost accounting for real estate assets in accordance with GAAP assumes that the value of real estate assets diminishes predictably over time, as reflected through depreciation and amortization. Because real estate values have historically risen or fallen with market conditions, management considers FFO an appropriate supplemental performance measure as it excludes historical cost depreciation and amortization, impairment on depreciated real estate investments, gains or losses related to sales of previously depreciated homes, as well non-controlling interests, from net income or loss (computed in accordance with GAAP). By excluding depreciation and amortization and gains or losses on sales of real estate, management uses FFO to measure returns on its investments in homes. However, because FFO excludes depreciation and amortization and captures neither the changes in the value of the homes that result from use or market conditions nor the level of capital expenditures to maintain the operating performance of the homes, all of which have real economic effect and could materially affect our results from operations, the utility of FFO as a measure of our performance is limited. Management also believes that FFO, combined with the required GAAP presentations, is useful to investors in providing more meaningful comparisons of the operating performance of a company’s real estate between periods or as compared to other companies. The GAAP measure most directly comparable to FFO is net income or loss. FFO is not used as a measure of our liquidity and should not be considered an alternative to net income or loss or any other measure of financial performance presented in accordance with GAAP. Our FFO may not be comparable to the FFO of other companies due to the fact that not all companies use the same definition of FFO. Accordingly, there can be no assurance that our basis for computing this non-GAAP measures is comparable with that of other companies. We believe that Core FFO and Adjusted FFO are also meaningful supplemental measures of our operating performance for the same reasons as FFO and are further helpful to investors as they provide a more consistent measurement of our performance across reporting periods by removing the impact of certain items that are not comparable from period to period. We define Core FFO as FFO adjusted for the following: non-cash interest expense related to amortization of deferred financing costs, loan discounts, and non-cash interest expense from derivatives; share-based compensation expense; offering related expenses; merger and transaction-related expenses; severance expense; unrealized gains on investments in equity securities; and casualty (gains) losses, net, as applicable. We define Adjusted FFO as Core FFO less recurring capital expenditures that are necessary to help preserve the value, and maintain the functionality, of our homes. The GAAP measure most directly comparable to Core FFO and Adjusted FFO is net income or loss. Core FFO and Adjusted FFO are not used as measures of our liquidity and should not be considered alternatives to net income or loss or any other measure of financial performance presented in accordance with GAAP. Our Core FFO and Adjusted FFO may not be comparable to the Core FFO and Adjusted FFO of other companies due to the fact that not all companies use the same definition of Core FFO and Adjusted FFO. No adjustments were made to the Core FFO and Adjusted FFO per common share — diluted computations for potential shares of common stock related to the Convertible Senior Notes. Accordingly, there can be no assurance that our basis for computing this non-GAAP measures is comparable with that of other companies. 83The following table presents a reconciliation of net income (loss) (as determined in accordance with GAAP) to FFO, Core FFO, and Adjusted FFO for each of the periods indicated: For the Years Ended December 31,(in thousands, except shares and per share data)202020192018Net income (loss) available to common stockholders$195,764 $145,068 $(5,744)Add (deduct) adjustments from net income (loss) to derive FFO:Net income available to participating securities448 395 817 Non-controlling interests1,237 1,648 (86)Depreciation and amortization on real estate assets546,419 529,205 549,505 Impairment on depreciated real estate investments4,578 14,210 6,709 Net gain on sale of previously depreciated investments in real estate(54,594)(96,336)(49,682)FFO693,852 594,190 501,519 Non-cash interest expense related to amortization of deferred financing costs, loan discounts, and non-cash interest expense from derivatives40,415 48,515 48,354 Share-based compensation expense(1)17,090 18,158 29,499 Offering related expenses(2)— 2,267 — Merger and transaction-related expenses(3)— 4,347 22,962 Severance expense601 8,465 8,238 Unrealized gains on investments in equity securities(29,723)(6,480)— Casualty (gains) losses, net(4)(3,882)4,533 14,110 Core FFO718,353 673,995 624,682 Recurring capital expenditures(115,951)(118,988)(122,733)Adjusted FFO$602,402 $555,007 $501,949 Net income (loss) available to common stockholdersWeighted average common shares outstanding — diluted(5)(6)(7)555,458,607 532,499,787 520,376,929 Net income (loss) per common share — diluted(5)(6)(7)$0.35 $0.27 $(0.01)FFONumerator for FFO per common share — diluted(5)$711,033 $599,776 $512,576 Weighted average common shares and OP Units outstanding — diluted(5)(6)(7)574,408,346 545,150,847 543,063,802 FFO per common share — diluted(5)(6)(7)$1.24 $1.10 $0.94 Core FFO and Adjusted FFOWeighted average common shares and OP Units outstanding — diluted(5)(6)(7)559,307,903 538,925,506 530,643,789 Core FFO per common share — diluted(5)(6)(7)$1.28 $1.25 $1.18 AFFO per common share — diluted(5)(6)(7)$1.08 $1.03 $0.95 (1)For the years ended December 31, 2020, 2019, and 2018, $3,511, $3,075, and $5,500 was recorded in property management expense, respectively, and $13,579, $15,083, and $23,999 was recorded in general and administrative expense, respectively.84(2)Includes expenses associated with secondary offerings of common stock completed during the year ended December 31, 2019 included within other, net.(3)Includes merger and transaction-related expenses included within general and administrative. Additionally, for the year ended December 31, 2018, includes accelerated depreciation and amortization of certain corporate assets included in depreciation and amortization.(4)Includes $8,013 for losses/damages related to Hurricanes Irma and Harvey for the year ended December 31, 2018. There were no such losses during the years ended December 31, 2020 and 2019.(5)On July 1, 2019, we settled the full outstanding balance of the 2019 Convertible Notes with the issuance of 12,553,864 shares of common stock, and these shares of common stock are included within all net income (loss), FFO, Core FFO, and AFFO per common share calculations subsequent to that date. Using the “if-converted” method, in the period prior to conversion for the year ended December 31, 2019, the 2019 Convertible Notes are excluded from net income (loss) per common share — diluted as they are anti-dilutive and are reflected in the FFO per common share — diluted computation above, consistent with Nareit’s guidance for calculating FFO per share. For the years ended December 31, 2019 and 2018, the numerator for FFO per common share — diluted is adjusted for $5,586 and $11,057, respectively, of interest expense on the 2019 Convertible Notes, including non-cash amortization of discounts. For the years ended December 31, 2019 and 2018, the denominator is adjusted for 6,225,341 and 12,420,013, respectively, potential shares of common stock for the 2019 Convertible Notes for the period prior to conversion. No such adjustments were made to Core FFO and AFFO per common share — diluted. With respect to the 2022 Convertible Notes, for the year ended December 31, 2020, the numerator for FFO per common share — diluted is adjusted for $17,181 of interest expense, including non-cash amortization of discounts, and the denominator is adjusted for 15,100,443 potential shares of common stock issuable upon the conversion of the 2022 Convertible Notes. Additionally, no such adjustments were made to Core FFO and AFFO per common share —diluted. For the years ended December 31, 2019 and 2018, 15,100,443 potential shares of common stock issuable upon the conversion of the 2022 Convertible Notes are excluded from the computation of net income or loss and FFO per common share — diluted as they are anti-dilutive, and are excluded from Core FFO and AFFO per common share — diluted.(6)Incremental shares attributed to non-vested share-based awards totaling 1,465,286 and 1,263,825 shares for the years ended December 31, 2020 and 2019, respectively. For the year ended December 31, 2018, we had a net loss, and inclusion of incremental shares attributed to non-vested share-based awards would be anti-dilutive to net loss per common share — diluted. For the computations of FFO, Core FFO, and AFFO per common share — diluted, common share equivalents of 1,851,297, 1,748,787, and 1,150,384 for the years ended December 31, 2020, 2019, and 2018, respectively, related to incremental shares attributed to non-vested share-based awards are included in the denominator.(7)Vested units of partnership interests in INVH LP (“OP Units”) have been excluded from the computation of net income (loss) per common share — diluted for the periods above because all net income (loss) attributable to the vested OP Units has been recorded as non-controlling interest and thus excluded from net income (loss) available to common stockholders. Weighted average vested OP Units of 3,463,285, 5,940,757, and 9,116,476 for the years ended December 31, 2020, 2019, and 2018, respectively, are included in the denominator for the computations of FFO, Core FFO, and AFFO per common share — diluted.ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKOur future income, cash flows, and fair values relevant to financial instruments are dependent upon prevalent market interest rates. Market risk refers to the risk of loss from adverse changes in interest rates, seasonality, market prices, commodity prices, and inflation. The primary market risks to which we are exposed are interest rate risk and seasonality. We may in the future use derivative financial instruments to manage, or hedge, interest rate risks related to any borrowings we may have. We may enter into such contracts only with major financial institutions based on their credit ratings and other factors. 85Interest Rate Risk A primary market risk to which we believe we are exposed is interest rate risk, which may result from many factors, including government monetary and tax policies, domestic and international economic and political considerations, and other factors that are beyond our control. We may incur additional variable rate debt in the future, including additional amounts that we may borrow under the Credit Facility. In addition, decreases in interest rates may lead to additional competition for the acquisition of single-family homes, which may lead to future acquisitions being more costly and resulting in lower yields on single-family homes targeted for acquisition. Significant increases in interest rates may also have an adverse impact on our earnings if we are unable to increase rents on expired leases or acquire single-family homes with rental rates high enough to offset the increase in interest rates on our borrowings. As of December 31, 2020, our outstanding variable-rate debt was comprised of borrowings on our mortgage loans of $3,837.3 million and Term Loan Facility of $2,500.0 million for a combined total of $6,337.3 million. We effectively converted 91.0% of these borrowings to a fixed rate through interest rate swap agreements. Additionally, all borrowings bear interest at LIBOR plus the applicable spread. Assuming no change in the outstanding balance of our existing debt, the projected effect of a 100 bps increase or decrease in LIBOR on our annual interest expense would be an estimated increase of $5.7 million or $15.8 million, respectively. This estimate considers the impact of our interest rate swap agreements, interest rate cap agreements, and any LIBOR floors or minimum interest rates stated in the agreements of the respective borrowings. A 100 bps decrease in LIBOR results in a negative LIBOR rate and additional interest expense for us. Our variable rate loan agreements contain LIBOR floors, and there is no reciprocal feature in our interest rate swap agreements.This analysis does not consider the effects of the reduced level of overall economic activity that could exist in such an environment. Further, in the event of a change of such magnitude, we may consider taking actions to further mitigate our exposure to the change. However, because of the uncertainty of the specific actions that would be taken and their possible effects, the sensitivity analysis assumes no changes in our capital structure. SeasonalityOur business and related operating results have been, and we believe that they will continue to be, impacted by seasonal factors throughout the year. In particular, we have experienced higher levels of resident move-outs during the summer months, which impacts both our rental revenues and related turnover costs. Further, our property operating costs are seasonally impacted in certain markets by increases in expenses such as HVAC repairs, costs to re-resident, and landscaping expenses during the summer season.
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+ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS IntroductionThis MD&A is intended to provide investors with an understanding of our recent performance, financial condition and prospects. This discussion and analysis compares 2020 results to 2019. For a discussion that compares our 2019 results to 2018, see Management's Discussion and Analysis of Financial Condition and Results of Operations in Part II, Item 7 of our 2019 Annual Report on Form 10-K. The reference to "N.M." indicates that the calculation is not meaningful. In addition, we provide commentary regarding organic sales growth, which describes the impact of changes in volume, product mix and net selling prices on net sales. Changes in foreign currency exchange rates and acquisitions also impact the year-over-year change in net sales. Dollar amounts are reported in millions, except per share dollar amounts, unless otherwise noted. The following will be discussed and analyzed:•Overview of Business•Overview of 2020 Results•Impact of COVID-19•Results of Operations and Related Information•Unaudited Quarterly Data•Liquidity and Capital Resources•Critical Accounting Policies and Use of Estimates•New Accounting Standards•Information Concerning Forward-Looking StatementsThroughout this MD&A, we refer to financial measures that have not been calculated in accordance with accounting principles generally accepted in the U.S., or GAAP, and are therefore referred to as non-GAAP financial measures. These measures include adjusted gross and operating profit, adjusted net income, adjusted earnings per share, adjusted other (income) and expense, net, and adjusted effective tax rate. We believe these measures provide our investors with additional information about our underlying results and trends, as well as insight to some of the financial measures used to evaluate management. Non-GAAP financial measures are not meant to be considered in isolation or as a substitute for the comparable GAAP measures, and they should be read only in conjunction with our consolidated financial statements prepared in accordance with GAAP. There are limitations to these non-GAAP financial measures because they are not prepared in accordance with GAAP and may not be comparable to similarly titled measures of other companies due to potential differences in methods of calculation and items being excluded. We compensate for these limitations by using these non-GAAP financial measures as a supplement to the GAAP measures and by providing reconciliations of the non-GAAP and comparable GAAP financial measures. The non-GAAP financial measures exclude the following items for the relevant time periods as indicated in the reconciliations included later in this MD&A:•2018 Global Restructuring Program - In 2018, we initiated a restructuring program to reduce our structural cost base by streamlining and simplifying our manufacturing supply chain and overhead organization. See Item 8, Note 2 to the consolidated financial statements for details.•Softex Indonesia Acquisition-Related Costs - Transaction and integration costs associated with the acquisition of Softex Indonesia. See Item 8, Note 3 to the consolidated financial statements for details.•Brazil Business Tax Credits - In the fourth quarter of 2020, we received a favorable legal ruling that resolved certain matters related to prior years' business taxes in Brazil. See Item 8, Note 1 to the consolidated financial statements for details.•Property Sale Gain - In the fourth quarter of 2019, we recognized a gain on the sale of property associated with a former manufacturing facility that was closed in 2012 as part of a past restructuring.12KIMBERLY-CLARK CORPORATION - 2020 Annual ReportOverview of BusinessWe are a global company focused on leading the world in essentials for a better life, with manufacturing facilities in 34 countries, including our equity affiliates, and products sold in more than 175 countries and territories. Our products are sold under well-known brands such as Kleenex, Scott, Huggies, Pull-Ups, Kotex and Depend. We have three reportable business segments: Personal Care, Consumer Tissue and K-C Professional. These business segments are described in greater detail in Item 8, Note 14 to the consolidated financial statements.In operating our business, we seek to:•grow our portfolio of brands through innovation, category development and commercial execution, •leverage our cost and financial discipline to fund growth and improve margins, and•allocate capital in value-creating ways. We describe our business outside North America in two groups – Developing and Emerging Markets ("D&E") and Developed Markets. D&E Markets comprise Eastern Europe, the Middle East and Africa, Latin America and Asia-Pacific, excluding Australia and South Korea. Developed Markets consist of Western and Central Europe, Australia and South Korea. On October 1, 2020, we acquired Softex Indonesia, a leader in the fast-growing Indonesian personal care market, in an all-cash transaction for approximately $1.2 billion. This transaction significantly expands our presence in an important D&E market and is a strong strategic fit with our core business. Softex Indonesia generated net sales of approximately $420 in 2019. We financed the transaction through a combination of short-term commercial paper, cash on hand and the issuance of a $600 bond. See Item 8, Note 3 to the consolidated financial statements for details.Overview of 2020 Results•Net sales of $19.1 billion increased 4 percent. Organic sales increased 6 percent. Changes in foreign currency exchange rates reduced sales by 2 percent.•In North America, organic sales increased 10 percent in consumer products and decreased 5 percent in K-C Professional.•Outside North America, organic sales increased 3 percent in D&E Markets and 6 percent in Developed Markets.•Operating Profit and Net Income Attributable to Kimberly-Clark were $3,244 and $2,352 in 2020, respectively.•Diluted earnings per share were $6.87 in 2020 compared to $6.24 in 2019. Results in 2020 and 2019 include net charges of $0.94 and $0.72, respectively, related to the 2018 Global Restructuring Program. Results in 2020 also include acquisition-related costs of $0.08 associated with the acquisition of Softex Indonesia and a benefit of $0.15 related to the resolution of certain business tax matters in Brazil. Results in 2019 also include a net gain of $0.07 related to the sale of property associated with a former manufacturing facility that was closed as part of a past restructuring.•We continue to focus on generating cash flow and allocating capital to shareholders. Cash provided by operations was $3.7 billion in 2020. We raised our dividend in 2020 by 4 percent, the 48th consecutive annual increase in our dividend. Altogether, share repurchases and dividends in 2020 amounted to $2.15 billion.In 2021, we plan to continue to execute our strategies for long-term success which include delivering balanced, sustainable growth by growing our brands in-line with or ahead of category growth, leveraging our cost and financial discipline to fund growth and improve margins, and allocating capital in value-creating ways. Our growth strategy is built on two pillars. Elevate our core business is our first pillar and is driven by delivering value-added innovations and driving category opportunities. Accelerating growth in D&E markets is our second pillar and emphasizes Personal Care and K-C Professional with Latin America, China, Eastern Europe and ASEAN as our priority markets. Both strategies are enabled by our focus on accelerating and investing in our commercial capabilities through digital marketing, revenue growth management, consumer-inspired innovation and strong in-market execution.Our strong legacy of financial discipline supports our growth strategy by driving ongoing supply chain productivity through our FORCE (Focused On Reducing Costs Everywhere) program, completing the execution of the 2018 Global Restructuring program, controlling discretionary spending, driving down working capital and maintaining the top-tier return on invested 13KIMBERLY-CLARK CORPORATION - 2020 Annual Reportcapital. Our capital allocation strategy is consistent with our historical approach of disciplined capital spending, payment of a top tier dividend, evaluation of acquisition opportunities and allocation of excess cash flow to share repurchases.We are subject to risks and uncertainties, which can affect our business operations and financial results. See Item 1A, "Risk Factors" in this Form 10-K for additional information.Impact of COVID-19We continue to actively address the COVID-19 situation and its impact globally. We believe that we will emerge from these events well positioned for long-term growth, though we cannot reasonably estimate the duration and severity of this global pandemic or its ultimate impact on the global economy and our business and results.We have experienced increased volatility in demand for some of our products as consumers adapt to the evolving environment. Beginning in the first quarter of 2020, particularly in March, demand increased in our Consumer Tissue and Personal Care business segments across all major geographies as consumers increased home inventory levels in response to COVID-19. The increase was followed by a period of demand softness as consumers used existing home inventories and demand returned to more normal levels. Demand for our consumer tissue products was elevated throughout 2020 as more people spent more time at home. Our K-C Professional business experienced volume declines throughout 2020 reflecting the reduction in away from home demand.During 2020, we experienced temporary closures of certain facilities, though we did not experience a material impact from a plant closure and our facilities were largely exempt or partially exempt from government closure orders. At many of our facilities, we have been experiencing increased employee absences, which may continue in the current situation.During 2020, we also experienced increased volatility in foreign currency exchange rates and commodity prices, as certain countries experienced increased macro-economic volatility from the COVID-19 situation.Results of Operations and Related InformationThis section presents a discussion and analysis of net sales, operating profit and other information relevant to an understanding of 2020 results of operations.14KIMBERLY-CLARK CORPORATION - 2020 Annual ReportConsolidatedSelected Financial ResultsYear Ended December 3120202019Change2020 vs. 2019Net Sales:North America$10,394 $9,735 +7 %Outside North America9,018 8,981 — Intergeographic sales(272)(266)+2 %Total Net Sales19,140 18,450 +4 %Operating Profit:North America2,689 2,441 +10 %Outside North America1,221 1,127 +8 %Corporate & Other(a)(720)(787)N.M.Other (income) and expense, net(a)(54)(210)-74 %Total Operating Profit3,244 2,991 +8 %Provision for income taxes(676)(576)+17 %Share of net income of equity companies142 123 +15 %Net Income Attributable to Kimberly-Clark Corporation2,352 2,157 +9 %Diluted Earnings per Share6.87 6.24 +10 %(a) Corporate & Other and Other (income) and expense, net includes income and expenses not associated with the business segments, including adjustments as indicated in the Non-GAAP Reconciliations.GAAP to Non-GAAP Reconciliations of Selected Financial ResultsTwelve Months Ended December 31, 2020AsReported2018 Global Restructuring ProgramSoftex Indonesia Acquisition-Related CostsBrazil Business Tax CreditsAsAdjustedNon-GAAPCost of products sold$12,318 $283 $— $— $12,035 Gross Profit6,822 (283)— — 7,105 Marketing, research and general expenses3,632 109 32 — 3,491 Other (income) and expense, net(54)(9)— (77)32 Operating Profit3,244 (383)(32)77 3,582 Nonoperating expense(70)(36)— — (34)Provision for income taxes(676)94 5 (26)(749)Effective tax rate23.1 %— — — 22.7 %Share of net income of equity companies142 (1)— — 143 Net income attributable to noncontrolling interests(44)3 — — (47)Net Income Attributable to Kimberly-Clark Corporation2,352 (323)(27)51 2,651 Diluted Earnings per Share(a)6.87 (0.94)(0.08)0.15 7.74 15KIMBERLY-CLARK CORPORATION - 2020 Annual ReportTwelve Months Ended December 31, 2019AsReported2018 Global Restructuring ProgramProperty Sale GainAsAdjustedNon-GAAPCost of products sold$12,415 $416 $— $11,999 Gross profit6,035 (416)— 6,451 Marketing, research and general expenses3,254 99 — 3,155 Other (income) and expense, net(210)(194)(31)15 Operating profit2,991 (321)31 3,281 Nonoperating expense(91)(45)— (46)Provision for income taxes(576)118 (7)(687)Effective tax rate21.7 %— — 23.0 %Share of net income of equity companies123 (2)— 125 Net income attributable to noncontrolling interests(40)2 — (42)Net income attributable to Kimberly-Clark Corporation2,157 (248)24 2,381 Diluted Earnings per Share(a)6.24 (0.72)0.07 6.89 (a) "As Adjusted Non-GAAP" may not equal "As Reported" plus "Adjustments" as a result of rounding.Analysis of Consolidated ResultsNet SalesPercent ChangeAdjusted Operating ProfitPercent Change2020 vs. 20192020 vs. 2019Volume4 Volume8 Net Price1 Net Price8 Mix/Other 1 Input Costs5 Currency(2)Cost Savings(c)17 Total(a)4 Currency Translation(1)Other(d)(28)Organic(b)6 Total9 (a) Total may not equal the sum of volume, net price, mix/other and currency due to rounding.(b) Combined impact of changes in volume, net price and mix/other.(c) Combined benefits of the FORCE program and 2018 Global Restructuring Program.(d) Includes impact of changes in product mix, marketing, research and general expenses, foreign currency transaction effects and other manufacturing costs.Net sales of $19.1 billion increased 4 percent compared to the year ago period. Operating profit was $3,244 in 2020 and $2,991 in 2019. Adjusted operating profit was $3,582 in 2020, up 9 percent compared to $3,281 in 2019. Results benefited from organic sales growth, $455 of FORCE cost savings and $120 of cost savings from the 2018 Global Restructuring Program. Input costs decreased $175, driven by pulp. The comparison was impacted by other manufacturing cost increases, unfavorable currency effects, increased advertising spending and higher general and administrative costs.Other (income) and expense, net of $54 in 2020 primarily reflected tax credits recognized related to a favorable legal ruling that resolved certain matters related to prior years' business taxes in Brazil. In 2019, Other (income) and expense, net of $210 primarily reflected gains on the sales of manufacturing facilities and associated real estate related to the 2018 Global Restructuring Program and property associated with a former manufacturing facility that was closed as part of a past restructuring. Adjusted other (income) and expense, net was $32 and $15 of expense in 2020 and 2019, respectively.16KIMBERLY-CLARK CORPORATION - 2020 Annual ReportThe effective tax rate of 23.1 percent in 2020 increased compared to the effective tax rate of 21.7 percent in 2019. The rate in 2019 included a net benefit of $47 related to a nonrecurring capital loss from a legal entity restructuring. See additional details in Item 8, Note 12 to the consolidated financial statements. The adjusted effective tax rate was 22.7 percent compared to 23.0 percent in 2019.Our share of net income of equity companies was $142 in 2020 and $123 in 2019. Kimberly-Clark de Mexico, S.A.B. de C.V. ("KCM") results in 2020 benefited from organic sales growth, lower input costs and cost savings but were negatively impacted by unfavorable currency effects.Diluted earnings per share were $6.87 in 2020 and $6.24 in 2019. Adjusted earnings per share of $7.74 in 2020 increased 12 percent compared to $6.89 in 2019. The increase was driven by growth in adjusted operating profit, along with higher net income from equity companies and declines in the share count and adjusted effective tax rate.Business SegmentsPersonal Care2020201920202019Net Sales$9,339 $9,108 Operating Profit$1,933 $1,904 Net SalesPercent ChangeOperating ProfitPercent Change2020 vs. 20192020 vs. 2019Volume4 Volume7 Net Price— Net Price2 Mix/Other 1 Input Costs2 Acquisition1 Cost Savings(c)15 Currency(4)Currency Translation(2)Total(a)3 Other(d)(22)Organic(b)5 Total2 (a) Total may not equal the sum of volume, net price, mix/other, acquisition and currency due to rounding.(b) Combined impact of changes in volume, net price and mix/other.(c) Combined benefits of the FORCE program and 2018 Global Restructuring Program.(d) Includes impact of changes in product mix, marketing, research and general expenses, foreign currency transaction effects and other manufacturing costs.Net sales in North America increased 6 percent. Volumes increased 4 percent, primarily driven by broad-based growth in baby and child care as well as increases in adult care. Changes in net selling prices and product mix each increased sales by 1 percent.Net sales in D&E Markets decreased 1 percent. Changes in foreign currency exchange rates decreased sales by 9 percent, primarily in Latin America. Volumes increased 4 percent led by growth in China, Eastern Europe, Brazil and India. Changes in product mix and the Softex Indonesia acquisition each increased sales by 2 percent. The improvements in product mix were primarily in China.Net sales in Developed Markets outside North America increased 1 percent. Changes in product mix increased sales by 2 percent, primarily in South Korea, and volumes increased 1 percent. Changes in foreign currency exchange rates and net selling prices each decreased sales by 1 percent.Operating profit of $1,933 increased 2 percent. The comparison was positively impacted by organic sales growth, cost savings and lower input costs, partially offset by unfavorable foreign currency effects, increases in other manufacturing costs and higher marketing and general and administrative costs.17KIMBERLY-CLARK CORPORATION - 2020 Annual ReportConsumer Tissue2020201920202019Net Sales$6,718 $5,993 Operating Profit$1,448 $1,007 Net SalesPercent ChangeOperating ProfitPercent Change2020 vs. 20192020 vs. 2019Volume12 Volume27 Net Price2 Net Price12 Mix/Other (1)Input Costs13 Currency(1)Cost Savings(c)20 Total(a)12 Currency Translation— Other(d)(28)Organic(b)13 Total44 (a) Total may not equal the sum of volume, net price, mix/other and currency due to rounding.(b) Combined impact of changes in volume, net price and mix/other.(c) Combined benefits of the FORCE program and 2018 Global Restructuring Program.(d) Includes impact of changes in product mix, marketing, research and general expenses, foreign currency transaction effects and other manufacturing costs.Net sales in North America increased by 17 percent. Volume increased 14 percent reflecting strong demand related to the COVID-19 and work from home environment, along with improved performance in Kleenex facial tissue. Volumes were up double-digits in all major product categories. Changes in net selling prices increased sales by 4 percent, driven by lower promotion spending. Changes in product mix decreased sales by 2 percent.Net sales in D&E Markets decreased 1 percent. Changes in foreign currency exchange rates decreased sales by approximately 6 percent, primarily in Latin America, and changes in net selling prices decreased sales by 2 percent. Volumes increased 4 percent, led by improvements in Latin America, and changes in product mix increased sales by 2 percent.Net sales in Developed Markets outside North America increased 14 percent. Volumes increased 12 percent. driven by strong growth in South Korea and Western and Central Europe and reflecting strong demand related to the COVID-19 and work from home environment. Changes in product mix increased sales by 1 percent.Operating profit of $1,448 increased 44 percent. Results benefited from higher volumes and net selling prices, cost savings and lower input costs, partially offset by increases in marketing and general and administrative costs, other manufacturing costs and unfavorable foreign currency effects.18KIMBERLY-CLARK CORPORATION - 2020 Annual ReportK-C Professional2020201920202019Net Sales$3,019 $3,292 Operating Profit$528 $657 Net SalesPercent ChangeOperating ProfitPercent Change2020 vs. 20192020 vs. 2019Volume(11)Volume(21)Net Price3 Net Price13 Mix/Other 2 Input Costs— Currency(1)Cost Savings(c)13 Total(a)(8)Currency Translation(1)Other(d)(24)Organic(b)(7)Total(20)(a) Total may not equal the sum of volume, net price, mix/other and currency due to rounding. (b) Combined impact of changes in volume, net price and mix/other.(c) Combined benefits of the FORCE program and 2018 Global Restructuring Program.(d) Includes impact of changes in product mix, marketing, research and general expenses, foreign currency transaction effects and other manufacturing costs.Net sales in North America decreased 5 percent. Volumes decreased 10 percent, reflecting lower away from home demand and challenging business conditions following the outbreak of COVID-19. Changes in product mix and net selling prices increased sales by 3 percent and 2 percent, respectively.Net sales in D&E Markets decreased 21 percent. Volumes decreased by 17 percent, reflecting lower away from home demand and challenging business conditions following the outbreak of COVID-19 with declines in all major markets. Changes in foreign currency exchange rates and product mix decreased sales by 5 percent and 2 percent, respectively, partially offset by changes in net selling prices which increased sales by 3 percent, all primarily related to Latin America.Net sales in Developed Markets outside North America decreased 4 percent. Volumes decreased 11 percent, reflecting lower away from home demand and challenging business conditions following the outbreak of COVID-19, primarily in Western and Central Europe. Changes in product mix and net selling prices increased sales by 4 percent and 3 percent, respectively, also primarily in Western and Central Europe.Operating profit of $528 decreased 20 percent. The comparison was impacted by lower volumes, other manufacturing cost increases, and increased general and administrative costs. Results benefited from favorable net selling prices and cost savings.2018 Global Restructuring ProgramAnnual pre-tax savings from the 2018 Global Restructuring Program are now expected to be $540 to $560 by the end of 2021. Savings for 2020 were $120, bringing cumulative savings to $420.To implement this program, we expect to incur incremental capital spending of approximately $600 to $700 by the end of 2021. See Item 8, Note 2 to the consolidated financial statements for additional information.19KIMBERLY-CLARK CORPORATION - 2020 Annual ReportUnaudited Quarterly Data2020(a)2019(a)FourthThirdSecondFirstFourthThirdSecondFirstNet Sales$4,836 $4,683 $4,612 $5,009 $4,583 $4,640 $4,594 $4,633 Gross Profit1,664 1,590 1,777 1,791 1,566 1,555 1,486 1,428 Operating Profit749 666 925 904 751 915 670 655 Net Income546 483 692 675 556 680 495 466 Net Income Attributable to Kimberly-Clark Corporation539 472 681 660 547 671 485 454 Per Share Basis-Diluted1.58 1.38 1.99 1.92 1.59 1.94 1.40 1.31 (a) Quarterly results in 2020 and 2019 were impacted by charges related to the 2018 Global Restructuring Program. See Item 8, Note 2 to the consolidated financial statements for details. Third and fourth quarter results in 2020 were impacted by acquisition-related costs associated with the acquisition of Softex Indonesia. See Item 8, Note 3 to the consolidated financial statements for details. Fourth quarter results in 2020 were also impacted by business tax credits related to the resolution of certain Brazil tax matters. See Item 8, Note 1 for details.Liquidity and Capital ResourcesCash Provided by OperationsCash provided by operations was $3.7 billion in 2020 compared to $2.7 billion in 2019. The increase was driven by improved working capital and higher earnings.ObligationsThe following table presents our total contractual obligations for which cash flows are fixed or determinable. Total202120222023202420252026+Long-term debt$8,156 $265 $314 $475 $618 $557 $5,927 Interest payments on long-term debt3,507 257 249 243 237 224 2,297 Operating lease liabilities603 148 126 100 76 63 90 Unconditional purchase obligations3,487 1,422 1,010 622 103 108 222 Open purchase orders2,626 2,514 101 10 1 — — Total contractual obligations$18,379 $4,606 $1,800 $1,450 $1,035 $952 $8,536 •The unconditional purchase obligations are for the purchase of raw materials, primarily superabsorbent materials, pulp and utilities. Although we are primarily liable for payments on the above operating leases and unconditional purchase obligations, based on historic operating performance and forecasted future cash flows, we believe exposure to losses, if any, under these arrangements is not material.•The open purchase orders displayed in the table represent amounts for goods and services we have negotiated for delivery.The table does not include amounts where payments are discretionary or the timing is uncertain. The following payments are not included in the table:•We will fund our defined benefit pension plans to meet or exceed statutory requirements and currently expect to contribute approximately $50 to these plans in 2021. •Other postretirement benefit payments are estimated using actuarial assumptions, including expected future service, to project the future obligations. Based upon those projections, we anticipate making annual payments for these obligations of approximately $50 through 2030.•Accrued income tax liabilities for uncertain tax positions, deferred taxes and noncontrolling interests.InvestingOur capital spending was $1.2 billion in 2020 and 2019, including incremental spending related to the 2018 Global Restructuring Program. Acquisition, net of cash acquired of $1.1 billion in 2020 reflected the purchase of Softex Indonesia. 20KIMBERLY-CLARK CORPORATION - 2020 Annual ReportProceeds from dispositions of property in 2019 of $242 primarily reflects the proceeds from the sales of manufacturing facilities and associated real estate related to the 2018 Global Restructuring Program and property associated with a former manufacturing facility that was closed as part of a past restructuring. We expect capital spending to be approximately $1.2 billion to $1.3 billion in 2021, including spending associated with the 2018 Global Restructuring Program and other growth initiatives. FinancingWe issue long-term debt in the public market periodically. Proceeds from the offerings are used for general corporate purposes, including repayment of maturing debt or outstanding commercial paper indebtedness. See Item 8, Note 5 to the consolidated financial statements for details.Our short-term debt, which consists of U.S. commercial paper with original maturities up to 90 days and/or other similar short-term debt issued by non-U.S. subsidiaries, was $223 as of December 31, 2020 (included in debt payable within one year on the consolidated balance sheet). The average month-end balance of short-term debt for the twelve months ended December 31, 2020 was $365. These short-term borrowings provide supplemental funding for supporting our operations. The level of short-term debt generally fluctuates depending upon the amount of operating cash flows and the timing of customer receipts and payments for items such as pension contributions, dividends and income taxes.At December 31, 2020, total debt was $8.4 billion compared to $7.7 billion at December 31, 2019.We maintain a $2.0 billion revolving credit facility which expires in June 2023 and a $750 revolving credit facility which expires in June 2021. These facilities, currently unused, support our commercial paper program, and would provide liquidity in the event our access to the commercial paper markets is unavailable for any reason.In July 2017, the United Kingdom's Financial Conduct Authority, which regulates the London Interbank Offered Rate (LIBOR), announced that it intends to phase out LIBOR by the end of 2021. We are currently evaluating the potential effect of the eventual replacement of the LIBOR, but we do not expect the effect to be material. Accounting guidance has been issued to ease the transition to alternative reference rates from a financial reporting perspective. See Item 8, Note 1 to the consolidated financial statements for details.We paid $1.5 billion in dividends in 2020. The Board of Directors approved a dividend increase of 6.5 percent for 2021. We repurchase shares of Kimberly-Clark common stock from time to time pursuant to publicly announced share repurchase programs. During 2020, we repurchased 4.9 million shares of our common stock at a cost of $700 through a broker in the open market. We are targeting full-year 2021 share repurchases between $650 and $750, subject to market conditions. On January 22, 2021, the Corporation’s Board of Directors authorized a new share repurchase program, pursuant to which the Corporation is authorized to repurchase up to 40 million shares of the Corporation’s common stock, subject to a limit of $5 billion in aggregate expenditures. The authorization is incremental to the remaining shares available to be repurchased under the current share repurchase program authorized on November 13, 2014.We believe that our ability to generate cash from operations and our capacity to issue short-term and long-term debt are adequate to fund working capital, payments for our 2018 Global Restructuring Program, capital spending, pension contributions, dividends and other needs for the foreseeable future. Further, we do not expect restrictions or taxes on repatriation of cash held outside of the U.S. to have a material effect on our overall business, liquidity, financial condition or results of operations for the foreseeable future.21KIMBERLY-CLARK CORPORATION - 2020 Annual ReportCritical Accounting Policies and Use of EstimatesThe preparation of financial statements in conformity with accounting principles generally accepted in the U.S. requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of net sales and expenses during the reporting period. The critical accounting policies we used in the preparation of the consolidated financial statements are those that are important both to the presentation of our financial condition and results of operations and require significant judgments by management with regard to estimates used. The critical judgments by management relate to accruals for sales incentives and trade promotion allowances, pension and other postretirement benefits, deferred income taxes and potential income tax assessments. These critical accounting policies have been reviewed with the Audit Committee of the Board of Directors.Sales Incentives and Trade Promotion AllowancesTrade promotion programs include introductory marketing funds such as slotting fees, cooperative marketing programs, temporary price reductions and other activities conducted by our customers to promote our products. Rebate and promotion accruals are based on estimates of the quantity of customer sales. Promotion accruals also consider estimates of the number of consumer coupons that will be redeemed and timing and costs of activities within the promotional programs. Generally, the estimated redemption value of consumer coupons and related expense are based on historical patterns of coupon redemption, influenced by judgments about current market conditions such as competitive activity in specific product categories, and the cost is recorded when the related revenue from customers is realized. Our related accounting policies are discussed in Item 8, Note 1 to the consolidated financial statements.Employee Postretirement BenefitsSubstantially all regular employees in the U.S. and the United Kingdom are covered by defined contribution retirement plans and certain U.S. and United Kingdom employees previously earned benefits covered by defined benefit pension plans that currently provide no future service benefit (the "Principal Plans"). Certain other subsidiaries have defined benefit pension plans or, in certain countries, termination pay plans covering substantially all regular employees. Our related accounting policies and account balances are discussed in Item 8, Note 7 to the consolidated financial statements.Changes in certain assumptions could affect pension expense and the benefit obligations, particularly the estimated long-term rate of return on plan assets and the discount rate used to calculate the obligations:•Long-term rate of return on plan assets. The expected long-term rate of return is evaluated on an annual basis. In setting these assumptions, we consider a number of factors including projected future returns by asset class relative to the target asset allocation. Actual asset allocations are regularly reviewed and they are periodically rebalanced to the targeted allocations when considered appropriate. As of December 31, 2020, the Principal Plans had cumulative unrecognized investment and actuarial losses of approximately $1.1 billion. These unrecognized net losses may increase future pension expense if not offset by (i) actual investment returns that exceed the assumed investment returns, (ii) other factors, including reduced pension liabilities arising from higher discount rates used to calculate pension obligations, or (iii) other actuarial gains, and whether such accumulated actuarial losses at each measurement date exceed the "corridor" as required. If the expected long-term rate of return on assets for the Principal Plans were lowered by 0.25 percent, the impact on annual pension expense would not be material in 2021.•Discount rate. The discount (or settlement) rate used to determine the present value of our future U.S. pension obligation at December 31, 2020 was based on a portfolio of high quality corporate debt securities with cash flows that largely match the expected benefit payments of the plan. For the United Kingdom plan, the discount rate was determined based on yield curves constructed from a portfolio of high quality corporate debt securities. Each year's expected future benefit payments were discounted to their present value at the appropriate yield curve rate to determine the pension obligations. If the discount rate assumptions for these same plans were reduced by 0.25 percent, the increase in annual pension expense would not be material in 2021, and the December 31, 2020 pension liability would increase by about $146.•Other assumptions. There are a number of other assumptions involved in the calculation of pension expense and benefit obligations, primarily related to participant demographics and benefit elections. 22KIMBERLY-CLARK CORPORATION - 2020 Annual ReportPension expense for defined benefit pension plans is estimated to approximate $85 in 2021, including incremental charges resulting from 2018 Global Restructuring Program actions. Pension expense beyond 2021 will depend on future investment performance, our contributions to the pension trusts, changes in discount rates and various other factors related to the covered participants in the plans.Substantially all U.S. retirees and employees have access to our unfunded health care and life insurance benefit plans. Changes in significant assumptions could affect the consolidated expense and benefit obligations, particularly the discount rate used to calculate the obligations and the health care cost trend rate:•Discount rate. The determination of the discount rates used to calculate the benefit obligations of the plans is discussed in the pension benefit section above, and the methodology for each country is the same as the methodology used to determine the discount rate for that country's pension obligation. If the discount rate assumptions for these plans were reduced by 0.25 percent, the impact to 2021 other postretirement benefit expense and the increase in the December 31, 2020 benefit liability would not be material. •Health care cost trend rate. The health care cost trend rate is based on a combination of inputs including our recent claims history and insights from external advisers regarding recent developments in the health care marketplace, as well as projections of future trends in the marketplace.Deferred Income Taxes and Potential AssessmentsAs a global organization, we are subject to income tax requirements in various jurisdictions in the U.S. and internationally. Changes in certain assumptions related to income taxes could significantly affect consolidated results, particularly with regard to valuation allowances on deferred tax assets, undistributed earnings of subsidiaries outside the U.S. and uncertain tax positions. Our income tax related accounting policies, account balances and matters affecting income taxes are discussed in Item 8, Note 12 to the consolidated financial statements. •Deferred tax assets and related valuation allowances. We have recorded deferred tax assets related to, among other matters, income tax loss carryforwards, income tax credit carryforwards and capital loss carryforwards and have established valuation allowances against these deferred tax assets. These carryforwards are primarily in non-U.S. taxing jurisdictions and in certain states in the U.S. Foreign tax credits earned in the U.S. in current and prior years, which cannot be used currently, also give rise to net deferred tax assets. In determining the valuation allowances to establish against these deferred tax assets, many factors are considered, including the specific taxing jurisdiction, the carryforward period, income tax strategies and forecasted earnings for the entities in each jurisdiction. A valuation allowance is recognized if, based on the weight of available evidence, it is more likely than not that some portion or all of the deferred tax asset will not be realized.•Undistributed earnings. As of December 31, 2020, we have accumulated undistributed earnings generated by our foreign subsidiaries of approximately $7.9 billion. Earnings of $5.2 billion were previously subject to tax, primarily due to the one-time transition tax on foreign earnings required by the Tax Cuts and Jobs Act. Any additional taxes due with respect to such previously-taxed earnings, if repatriated, would generally be limited to foreign and U.S. state income taxes. Deferred taxes have been recorded on $0.7 billion of earnings, most of which were previously taxed for U.S. federal income tax purposes, of foreign consolidated subsidiaries expected to be repatriated. We do not intend to distribute the remaining $4.5 billion of previously taxed foreign earnings and therefore have not recorded deferred taxes for foreign and U.S. state income taxes on such earnings. While the transition tax resulted in a reduction of the excess amount for financial reporting over the tax basis in our foreign subsidiaries, any remaining amount of financial reporting over tax basis after such reduction could be subject to additional taxes, if repatriated. However, we consider any excess to be indefinitely reinvested. The determination of deferred tax liabilities on the amount of financial reporting over tax basis or the $4.5 billion of previously taxed foreign earnings is not practicable.•Uncertain tax positions. We record our global tax provision based on the respective tax rules and regulations for the jurisdictions in which we operate. Where we believe that a tax position is supportable for income tax purposes, the item is included in our income tax returns. Where treatment of a position is uncertain, a liability is recorded based upon the expected most likely outcome taking into consideration the technical merits of the position based on specific tax regulations and facts of each matter. These liabilities may be affected by changing interpretations of laws, rulings by tax authorities or the expiration of the statute of limitations.23KIMBERLY-CLARK CORPORATION - 2020 Annual ReportGoodwill and Other Intangible AssetsGoodwill and other indefinite-lived intangible assets are not subject to amortization and are tested for impairment annually and whenever events or changes in circumstances indicate that impairment may have occurred. Intangible assets that are deemed to have finite lives are amortized over their useful lives, generally ranging from 10 to 20 years. We typically obtain the assistance of third-party valuation specialists to measure the acquisition date fair values of goodwill and other intangible assets acquired.Events and conditions that could result in impairment include a sustained drop in the market price of our common shares, increased competition or loss of market share, obsolescence, product claims that result in a significant loss of sales or profitability over the product life, deterioration in macroeconomic conditions, or declining financial performance in comparison to projected results.Our related accounting policies and our acquisition of Softex Indonesia are discussed in Item 8, Notes 1 and 3, respectively, to the consolidated financial statements.GoodwillIn our evaluation of goodwill impairment, we have the option to first assess qualitative factors such as macroeconomic, industry and competitive conditions, legal and regulatory environments, historical and projected financial performance, significant changes in the reporting unit and the magnitude of excess fair value over carrying amount from the previous quantitative impairment testing. If the result of a qualitative test indicates a potential for impairment, a quantitative test is performed. When a quantitative test is considered necessary, estimates of fair value for goodwill impairment testing are determined based on a discounted cash flow model and a market-based approach. We use inputs from our long-range planning process to determine growth rates for sales and earnings. The other key estimates and factors used in the discounted cash flow include, but are not limited to, discount rates, actual business trends experienced, commodity prices, foreign exchange rates, inflation and terminal growth rates.For 2020, we completed the required annual assessment of goodwill for impairment for all of our reporting units using a qualitative assessment as of the first day of the third quarter, and we determined that it is more likely than not that the fair value is more than the carrying amount for each of our reporting units.Other Intangible AssetsWe evaluate the useful lives of our other intangible assets, primarily brands, to determine if they are finite or indefinite-lived. Reaching a determination on useful life requires significant judgments and assumptions regarding the future effects of obsolescence, demand, competition, other economic factors (such as the stability of the industry, known technological advances and expected changes in distribution channels), the level of required maintenance expenditures, and the expected lives of other related groups of assets.Our estimate of the fair value of our brand assets is based on a discounted cash flow model and a market-based approach using inputs which include projected revenues from our long-range plan, assumed royalty rates that could be payable if we did not own the brands, and a discount rate. The cash flows used in the discounted cash flow model are consistent with those we use in our internal planning, which gives consideration to actual business trends experienced and the long-term business strategy.We performed our 2020 impairment assessment of our intangible assets as of the first day of the third quarter of 2020, and based upon a qualitative assessment, no impairment indicators were found to be present.New Accounting StandardsSee Item 8, Note 1 to the consolidated financial statements for a description of new accounting standards and their anticipated effects on our consolidated financial statements.Information Concerning Forward-Looking StatementsCertain matters contained in this report concerning the business outlook, including the anticipated cost savings from our FORCE program, costs and savings from the 2018 Global Restructuring Program, cash flow and uses of cash, growth initiatives, innovations, marketing and other spending, net sales, anticipated currency rates and exchange risks, including the impact in Argentina, raw material, energy and other input costs, effective tax rate, contingencies and anticipated transactions of Kimberly-Clark, including dividends, share repurchases and pension contributions, constitute "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995 and are based upon management's expectations and 24KIMBERLY-CLARK CORPORATION - 2020 Annual Reportbeliefs concerning future events impacting Kimberly-Clark. There can be no assurance that these future events will occur as anticipated or that our results will be as estimated. Forward-looking statements speak only as of the date they were made, and we undertake no obligation to publicly update them. The assumptions used as a basis for the forward-looking statements include many estimates that, among other things, depend on the achievement of future cost savings and projected volume increases. In addition, many factors outside our control, including pandemics (including the ongoing COVID-19 outbreak), epidemics, fluctuations in foreign currency exchange rates, the prices and availability of our raw materials, potential competitive pressures on selling prices for our products, energy costs, general economic and political conditions globally and in the markets in which we do business, as well as our ability to maintain key customer relationships and to realize the expected benefits and synergies of the Softex Indonesia acquisition, could affect the realization of these estimates.The factors described under Item 1A, "Risk Factors" in this Form 10-K, or in our other SEC filings, among others, could cause our future results to differ from those expressed in any forward-looking statements made by us or on our behalf. Other factors not presently known to us or that we presently consider immaterial could also affect our business operations and financial results.ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK As a multinational enterprise, we are exposed to risks such as changes in foreign currency exchange rates, interest rates and commodity prices. A variety of practices are employed to manage these risks, including operating and financing activities and, where deemed appropriate, the use of derivative instruments. Derivative instruments are used only for risk management purposes and not for speculation. Foreign currency derivative instruments are primarily entered into with major financial institutions. Our credit exposure under these arrangements is limited to agreements with a positive fair value at the reporting date. Credit risk with respect to the counterparties is actively monitored but is not considered significant since these transactions are executed with a diversified group of financial institutions.Presented below is a description of our risks (foreign currency risk and interest rate risk) together with a sensitivity analysis, performed annually, of each of these risks based on selected changes in market rates and prices. These analyses reflect management's view of changes which are reasonably possible to occur over a one-year period. Also included is a description of our commodity price risk.Foreign Currency Risk A portion of our foreign currency risk is managed through the systematic use of foreign currency forward contracts. The use of these instruments supports the management of transactional exposures to exchange rate fluctuations as the gains or losses incurred on the derivative instruments will offset, in whole or in part, gains or losses on the underlying foreign currency exposure. We also utilize cross currency swaps and foreign denominated debt to hedge certain investments in foreign subsidiaries. The gain or loss on these instruments is recognized in other comprehensive income to offset the change in value of the net investments being hedged.Foreign currency contracts and transactional exposures are sensitive to changes in foreign currency exchange rates. An annual test is performed to quantify the effects that possible changes in foreign currency exchange rates would have on annual operating profit based on our foreign currency contracts and transactional exposures at the current year-end. The balance sheet effect is calculated by multiplying each affiliate's net monetary asset or liability position by a 10 percent change in the foreign currency exchange rate versus the U.S. dollar.As of December 31, 2020, a 10 percent unfavorable change in the exchange rate of the U.S. dollar against the prevailing market rates of foreign currencies involving balance sheet transactional exposures would not be material to our consolidated financial position, results of operations or cash flows. This hypothetical loss on transactional exposures is based on the difference between the December 31, 2020 rates and the assumed rates. Our operations in Argentina are reported using highly inflationary accounting and their functional currency is the U.S. dollar. Changes in the value of an Argentine peso versus the U.S. dollar applied to our net peso monetary position are recorded in Other (income) and expense, net at the time of the change. As of December 31, 2020, K-C Argentina had a small net peso monetary position and a 10 percent unfavorable change in the exchange rate would not be material.25KIMBERLY-CLARK CORPORATION - 2020 Annual ReportThe translation of the balance sheets of non-U.S. operations from local currencies into U.S. dollars is also sensitive to changes in foreign currency exchange rates. Consequently, an annual test is performed to determine if changes in currency exchange rates would have a significant effect on the translation of the balance sheets of non-U.S. operations into U.S. dollars. These translation gains or losses are recorded as unrealized translation adjustments ("UTA") within stockholders' equity. The hypothetical change in UTA is calculated by multiplying the net assets of these non-U.S. operations by a 10 percent change in the currency exchange rates. As of December 31, 2020, a 10 percent unfavorable change in the exchange rate of the U.S. dollar against the prevailing market rates of our foreign currency translation exposures would have reduced stockholders' equity by approximately $750. In the view of management, the above potential UTA adjustments resulting from these assumed changes in foreign currency exchange rates are not material to our consolidated financial position because they would not affect our cash flow.Interest Rate RiskInterest rate risk is managed through the maintenance of a portfolio of variable and fixed-rate debt composed of short and long-term instruments. The objective is to maintain a cost-effective mix that management deems appropriate. At December 31, 2020, the long-term debt portfolio was comprised of primarily fixed-rate debt. From time to time, we also hedge the anticipated issuance of fixed-rate debt and those contracts are designated as cash flow hedges.In order to determine the impact of changes in interest rates on our financial position or future results of operations, we calculated the increase or decrease in the market value of fixed-rate debt using a 10 percent change in current market interest rates and the rates governing these instruments. At December 31, 2020, a 10 percent decrease in interest rates would have increased the fair value of fixed-rate debt by about $198, which would not have a significant impact on our financial statements as we do not record debt at fair value. Commodity Price RiskWe are subject to commodity price risk, the most significant of which relates to the price of pulp. Selling prices of tissue products are influenced, in part, by the market price for pulp. As previously discussed under Item 1A, "Risk Factors," increases in pulp prices could adversely affect earnings if selling prices are not adjusted or if such adjustments significantly trail the increases in pulp prices. In some instances, we utilize negotiated short-term contract structures, including fixed price contracts, to manage volatility for a portion of our commodity costs, but derivative instruments have not been used to manage these risks.Our energy, manufacturing and transportation costs are affected by various market factors including the availability of supplies of particular forms of energy, energy prices and local and national regulatory decisions. As previously discussed under Item 1A, "Risk Factors," there can be no assurance we will be fully protected against substantial changes in the price or availability of energy sources. In addition, we are subject to price risk for utilities and manufacturing inputs, used in our manufacturing operations. Derivative instruments are used in accordance with our risk management policy to hedge a limited portion of the price risk.26KIMBERLY-CLARK CORPORATION - 2020 Annual Report
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+Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.The following discussion and analysis should be read in conjunction with our consolidated financial statements and the notes thereto. We prepared our consolidated financial statements in accordance with GAAP. Additional sections in this report which should be helpful to the reading of our discussion and analysis include the following: (i) a description of our business strategy found in Items 1 and 2 “Business and Properties—Narrative Description of Business—Business Strategy;” (ii) a description of developments during 2020, found in Items 1 and 2 “Business and Properties—General Development of Business—Recent Developments;” (iii) a description of risk factors affecting us and our business, found in Item 1A “Risk Factors;” and (iv) a discussion of forward-looking statements, found in “Information Regarding Forward-Looking Statements” at the beginning of this report.35A comparative discussion of our 2019 to 2018 operating results can be found in Item 7 “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Results of Operations” included in our Annual Report on Form 10-K for the year ended December 31, 2019 filed with the SEC on February 7, 2020.GeneralAs an energy infrastructure owner and operator in multiple facets of the various U.S. energy industries and markets, we examine a number of variables and factors on a routine basis to evaluate our current performance and our prospects for the future. We have four business segments as further described below.Natural Gas PipelinesThis segment owns and operates (i) major interstate and intrastate natural gas pipeline and storage systems; (ii) natural gas gathering systems and processing and treating facilities; (iii) NGL fractionation facilities and transportation systems; and (iv) LNG regasification, liquefaction and storage facilities.With respect to our interstate natural gas pipelines, related storage facilities and LNG terminals, the revenues from these assets are primarily received under long-term fixed contracts. To the extent practicable and economically feasible in light of our strategic plans and other factors, we generally attempt to mitigate risk of reduced volumes and prices by negotiating contracts with longer terms, with higher per-unit pricing and for a greater percentage of our available capacity. These long-term contracts are typically structured with a fixed fee reserving the right to transport or store natural gas and specify that we receive the majority of our fee for making the capacity available, whether or not the customer actually chooses to utilize the capacity. Similarly, our Texas Intrastate natural gas pipeline operations, currently derives approximately 83% of its sales and transport margins from long-term transport and sales contracts. As contracts expire, we have additional exposure to the longer term trends in supply and demand for natural gas. As of December 31, 2020, the remaining weighted average contract life of our natural gas transportation contracts held by assets we own and have equity interests in (including intrastate pipelines’ sales portfolio) was approximately six years. Our LNG regasification and liquefaction and associated storage contracts are subscribed under long-term agreements with a weighted average remaining contract life of approximately 13 years.Our midstream assets provide natural gas gathering and processing services. These assets are mostly fee-based and the revenues and earnings we realize from gathering natural gas, processing natural gas in order to remove NGL from the natural gas stream, and fractionating NGL into its base components, are affected by the volumes of natural gas made available to our systems. Such volumes are impacted by producer rig count and drilling activity. In addition to fee-based arrangements, some of which may include minimum volume commitments, we also provide some services based on percent-of-proceeds, percent-of-index and keep-whole contracts. Our service contracts may rely solely on a single type of arrangement, but more often they combine elements of two or more of the above, which helps us and our counterparties manage the extent to which each shares in the potential risks and benefits of changing commodity prices.Products PipelinesThis segment owns and operates refined petroleum products, crude oil and condensate pipelines that primarily deliver, among other products, gasoline, diesel and jet fuel, crude oil and condensate to various markets. This segment also owns and/or operates associated product terminals and petroleum pipeline transmix facilities.The profitability of our refined petroleum products pipeline transportation business generally is driven by the volume of refined petroleum products that we transport and the prices we receive for our services. We also have 49 liquids terminals in this business segment that store fuels and offer blending services for ethanol and biodiesel. The transportation and storage volume levels are primarily driven by the demand for the refined petroleum products being shipped or stored. Demand for refined petroleum products tends to track in large measure demographic and economic growth, and, with the exception of periods of time with very high product prices or recessionary conditions, demand tends to be relatively stable. Because of that, we seek to own refined petroleum products pipelines and terminals located in, or that transport to, stable or growing markets and population centers. The prices for shipping are generally based on regulated tariffs that are adjusted annually based on changes in the U.S. Producer Price Index and a FERC index rate.Our crude, condensate and refined petroleum products transportation services are primarily provided pursuant to (i) either FERC or state tariffs and (ii) long-term contracts that normally contain minimum volume commitments. As a result of these contracts, our settlement volumes are generally not sensitive to changing market conditions in the shorter term; however, the revenues and earnings we realize from our pipelines and terminals are affected by the volumes of crude oil, refined petroleum 36products and condensate available to our pipeline systems, which are impacted by the level of oil and gas drilling activity and product demand in the respective regions that we serve. Our petroleum condensate processing facility splits condensate into its various components, such as light and heavy naphtha, under a long-term fee-based agreement with a major integrated oil company.TerminalsThis segment owns and operates (i) liquids and bulk terminal facilities located throughout the U.S. that store and handle various commodities including gasoline, diesel fuel, chemicals, ethanol, metals and petroleum coke; and (ii) Jones Act-qualified tankers.The factors impacting our Terminals business segment generally differ between liquid and bulk terminals, and in the case of a bulk terminal, the type of product being handled or stored. Our liquids terminals business generally has long-term contracts that require the customer to pay regardless of whether they use the capacity. Thus, similar to our natural gas pipelines business, our liquids terminals business is less sensitive to short-term changes in supply and demand. Therefore, the extent to which changes in these variables affect our terminals business in the near term is a function of the length of the underlying service contracts (which on average is approximately three years), the extent to which revenues under the contracts are a function of the amount of product stored or transported, and the extent to which such contracts expire during any given period of time. As with our refined petroleum products pipelines transportation business, the revenues from our bulk terminals business are generally driven by the volumes we handle and/or store, as well as the prices we receive for our services, which in turn are driven by the demand for the products being shipped or stored. While we handle and store a large variety of products in our bulk terminals, the primary products are petroleum coke, metals and ores. In addition, the majority of our contracts for this business contain minimum volume guarantees and/or service exclusivity arrangements under which customers are required to utilize our terminals for all or a specified percentage of their handling and storage needs. The profitability of our minimum volume contracts is generally unaffected by short-term variation in economic conditions; however, to the extent we expect volumes above the minimum and/or have contracts which are volume-based, we can be sensitive to changing market conditions. To the extent practicable and economically feasible in light of our strategic plans and other factors, we generally attempt to mitigate the risk of reduced volumes and pricing by negotiating contracts with longer terms, with higher per-unit pricing and for a greater percentage of our available capacity. In addition, weather-related events, including hurricanes, may impact our facilities and access to them and, thus, the profitability of certain terminals for limited periods of time or, in relatively rare cases of severe damage to facilities, for longer periods. In addition to liquid and bulk terminals, we also own Jones Act-qualified tankers in our Terminals business segment. As of December 31, 2020, we have sixteen Jones Act-qualified tankers that operate in the marine transportation of crude oil, condensate and refined products in the U.S. and are primarily operating pursuant to multi-year fixed price charters with major integrated oil companies, major refiners and the U.S. Military Sealift Command.CO2This segment (i) manages the production, transportation and marketing of CO2 to oil fields that use CO2 as a flooding medium to increase recovery and production of crude oil from mature oil fields; (ii) owns interests in and/or operates oil fields and gasoline processing plants in West Texas; and (iii) owns and operates a crude oil pipeline system in West Texas.The CO2 source and transportation business primarily has third-party contracts with minimum volume requirements, which as of December 31, 2020, had a remaining average contract life of approximately eight years. CO2 sales contracts vary from customer to customer and have evolved over time as supply and demand conditions have changed. Our recent contracts have generally provided for a delivered price tied to the price of crude oil, but with a floor price. On a volume-weighted basis, for third-party contracts making deliveries in 2020, and utilizing the average oil price per barrel contained in our 2021 budget, approximately 100% of our revenue is based on a fixed fee or floor price. Our success in this portion of the CO2 business segment can be impacted by the demand for CO2. In the CO2 business segment’s oil and gas producing activities, we monitor the amount of capital we expend in relation to the amount of production that we expect to add. The revenues we receive from our crude oil and NGL sales are affected by the prices we realize from the sale of these products. Over the long-term, we will tend to receive prices that are dictated by the demand and overall market price for these products. In the shorter term, however, market prices are likely not indicative of the revenues we will receive due to our risk management, or hedging, program, in which the prices to be realized for certain of our future sales quantities are fixed, capped or bracketed through the use of financial derivative contracts, particularly for crude oil. The realized weighted average crude oil price per barrel, with the hedges allocated to oil, was $53.78 per barrel in 2020 and $49.49 per barrel in 2019. Had we not used energy derivative 37contracts to transfer commodity price risk, our crude oil sales prices would have averaged $38.32 per barrel in 2020 and $55.12 per barrel in 2019.Also, see Note 15 “Revenue Recognition” to our consolidated financial statements for more information about the types of contracts and revenues recognized for each of our segments.Sale of U.S. Portion of Cochin Pipeline System and KMLOn December 16, 2019, we closed on two cross-conditional transactions resulting in the sale of the U.S. portion of the Cochin Pipeline system and all the outstanding equity of KML, including our 70% interest, to Pembina Pipeline Corporation (Pembina) (together, the “KML and U.S. Cochin Sale”). We received approximately 25 million shares of Pembina common equity for our interest in KML. On January 9, 2020, we sold our shares of Pembina and received proceeds of approximately $907 million ($764 million after tax) which were used to repay maturing debt. The assets sold were part of our Natural Gas Pipelines and Terminals business segments.COVID-19The COVID-19 pandemic-related reduction in energy demand and the dramatic decline in commodity prices that began to impact us in the first quarter of 2020 continued to cause disruptions and volatility. Sharp declines in crude oil and natural gas production along with reduced demand for refined products due to the economic shutdown in the wake of the pandemic affected our business and continues to do so. While we have seen some meaningful recovery during the second half of the year in demand for refined products that we move through our terminals, significant uncertainty remains regarding the duration and extent of the impact of the pandemic on the energy industry, including demand and prices for the products handled by our pipelines, terminals, shipping vessels and other facilities, although we expect to see further recovery as vaccines are distributed and more normal societal activity resumes. The events as described above resulted in decreases of current and estimated long-term crude oil and NGL sale prices and volumes we expect to realize and in significant reductions to the market capitalization of many midstream and oil and gas producing companies. These events triggered us to review the carrying value of our long-lived assets and recoverability of goodwill for interim periods in addition to our annual testing. Our evaluations resulted in the recognition during the first six months of 2020 of a $350 million impairment for long-lived assets in our CO2 business segment and goodwill impairments of $1,000 million and $600 million to our Natural Gas Pipelines Non-Regulated and CO2 reporting units, respectively. For a further discussion of these impairments and our risk for future impairments, see Note 3, “Impairments and Losses and Gains on Divestitures.”We have placed a priority on protecting our employees during this pandemic while continuing to provide essential services to our customers. We continue to follow the Centers for Disease Control guidelines for those employees that perform essential tasks in our operations and have taken a cautious enterprise-wide approach with a phased return to workplace process for our employees who are currently working remotely. During 2020, our incremental employee safety costs associated with COVID-19 mitigation were approximately $15 million, primarily for personal protective equipment, enhanced cleaning protocols, temperature screening and other measures we adopted to protect our employees. We continue to operate our assets safely and efficiently during this challenging period.2021 Dividends and Discretionary Capital We expect to declare dividends of $1.08 per share for 2021, a 3% increase from the 2020 declared dividends of $1.05 per share. We also expect to invest $0.8 billion in expansion projects and contributions to joint ventures during 2021.The expectations for 2021 discussed above involve risks, uncertainties and assumptions, and are not guarantees of performance. Many of the factors that will determine these expectations are beyond our ability to control or predict, and because of these uncertainties, it is advisable not to put undue reliance on any forward-looking statement. Please read our Item 1A “Risk Factors” below and “Information Regarding Forward-Looking Statements” at the beginning of this report for more information. Furthermore, we plan to provide updates to these 2021 expectations when we believe previously disclosed expectations no longer have a reasonable basis.Critical Accounting Policies and EstimatesAccounting standards require information in financial statements about the risks and uncertainties inherent in significant estimates, and the application of GAAP involves the exercise of varying degrees of judgment. Certain amounts included in or 38affecting our consolidated financial statements and related disclosures must be estimated, requiring us to make certain assumptions with respect to values or conditions that cannot be known with certainty at the time our financial statements are prepared. These estimates and assumptions affect the amounts we report for our assets and liabilities, our revenues and expenses during the reporting period, and our disclosure of contingent assets and liabilities at the date of our financial statements. We routinely evaluate these estimates, utilizing historical experience, consultation with experts and other methods we consider reasonable in the particular circumstances. Nevertheless, actual results may differ significantly from our estimates, and any effects on our business, financial position or results of operations resulting from revisions to these estimates are recorded in the period in which the facts that give rise to the revision become known.In preparing our consolidated financial statements and related disclosures, examples of certain areas that require more judgment relative to others include our use of estimates in determining: (i) revenue recognition; (ii) income taxes; (iii) the economic useful lives of our assets and related depletion rates; (iv) the fair values used in (a) calculations of possible asset and equity investment impairment charges, and (b) calculation for the annual goodwill impairment test (or interim tests if triggered); (v) reserves for environmental claims, legal fees, transportation rate cases and other litigation liabilities; (vi) provisions for credit losses; (vii) computation of the gain or loss, if any, on assets sold in whole or in part; and (viii) exposures under contractual indemnifications.For a summary of our significant accounting policies, see Note 2 “Summary of Significant Accounting Policies” to our consolidated financial statements. We believe that certain accounting policies are of more significance in our consolidated financial statement preparation process than others, which policies are discussed as follows.Environmental MattersWith respect to our environmental exposure, we utilize both internal staff and external experts to assist us in identifying environmental issues and in estimating the costs and timing of remediation efforts. We expense or capitalize, as appropriate, environmental expenditures that relate to current operations, and we record environmental liabilities when environmental assessments and/or remedial efforts are probable and we can reasonably estimate the costs. Generally, we do not discount environmental liabilities to a net present value, and we recognize receivables for anticipated associated insurance recoveries when such recoveries are deemed to be probable. We record at fair value, where appropriate, environmental liabilities assumed in a business combination.Our accrual of environmental liabilities often coincides either with our completion of a feasibility study or our commitment to a formal plan of action, but generally, we recognize and/or adjust our probable environmental liabilities, if necessary or appropriate, following quarterly reviews of potential environmental issues and claims that could impact our assets or operations. In recording and adjusting environmental liabilities, we consider the effect of environmental compliance, pending legal actions against us, and potential third party liability claims. For more information on environmental matters, see Part I, Items 1 and 2 “Business and Properties—Narrative Description of Business—Environmental Matters.” For more information on our environmental disclosures, see Note 18 “Litigation and Environmental” to our consolidated financial statements.Legal and Regulatory MattersMany of our operations are regulated by various U.S. regulatory bodies, and we are subject to legal and regulatory matters as a result of our business operations and transactions. We utilize both internal and external counsel in evaluating our potential exposure to adverse outcomes from orders, judgments or settlements. In general, we expense legal costs as incurred. When we identify contingent liabilities that are probable, we identify a range of possible costs expected to be required to resolve the matter. Generally, if no amount within this range is a better estimate than any other amount, we record a liability equal to the low end of the range. Any such liability recorded is revised as better information becomes available. Accordingly, to the extent that actual outcomes differ from our estimates, or additional facts and circumstances cause us to revise our estimates, our earnings will be affected. For more information on legal proceedings, see Note 18 “Litigation and Environmental” to our consolidated financial statements. Long-lived Asset and Equity Investment ImpairmentsWe evaluate long-lived assets including leases and investments for impairment whenever events or changes in circumstances indicate that our carrying amount of an asset or investment may not be recoverable. We recognize impairment losses when estimated future cash flows expected to result from our use of the asset and its eventual disposition is less than its carrying amount. Because the impairment test for long-lived assets held in use is based on undiscounted cash flows, there may be instances where an asset or asset group is not considered impaired, even when its fair value may be less than its carrying value, because the asset or asset group is recoverable based on the cash flows to be generated over the estimated life of the asset 39or asset group. If the carrying value of a long-lived asset or asset group is in excess of undiscounted cash flows, we typically use discounted cash flow analyses to determine if an impairment is required.For more information on our long-lived asset impairments and significant estimates and assumptions used in our evaluations, see Note 3 “Impairments and Losses and Gains on Divestitures.” Intangible AssetsIntangible assets are those assets which provide future economic benefit but have no physical substance. Identifiable intangible assets having indefinite useful economic lives, including goodwill, are not subject to regular periodic amortization, and such assets are not to be amortized until their lives are determined to be finite. Instead, the carrying amount of a recognized intangible asset with an indefinite useful life must be tested for impairment annually or on an interim basis if events or circumstances indicate that the fair value of the asset has decreased below its carrying value. We evaluate goodwill for impairment on May 31 of each year. At year end and during other interim periods we evaluate our reporting units for events and changes that could indicate that it is more likely than not that the fair value of a reporting unit could be less than its carrying amount.Excluding goodwill, our other intangible assets include customer contracts and relationships and agreements. These intangible assets have definite lives, are being amortized in a systematic and rational manner over their estimated useful lives, and are reported separately as “Other intangibles, net” in our accompanying consolidated balance sheets.For more information on our 2020 goodwill impairment evaluations and amortizable intangibles, see Note 3 “Impairments and Losses and Gains on Divestitures” and Note 8 “Goodwill” to our consolidated financial statements.Hedging ActivitiesWe engage in a hedging program that utilizes derivative contracts to mitigate (offset) our exposure to fluctuations in energy commodity prices, foreign currency exposure on Euro-denominated debt, and until our recent divestitures of our Canadian assets, net investments in foreign operations, and to balance our exposure to fixed and variable interest rates, and we believe that these derivative contracts are, or were in respect to our Canadian operations, generally effective in realizing these objectives. According to the provisions of GAAP, to be considered effective, changes in the value of a derivative contract or its resulting cash flows must substantially offset changes in the value or cash flows of the hedged risk, and any component excluded from the computation of the effectiveness of the derivative contract must be recognized in earnings over the life of the hedging instrument by using a systematic and rational method.All of our derivative contracts are recorded at estimated fair value. We utilize published prices, broker quotes, and estimates of market prices to estimate the fair value of these contracts; however, actual amounts could vary materially from estimated fair values as a result of changes in market prices. In addition, changes in the methods used to determine the fair value of these contracts could have a material effect on our results of operations. We do not anticipate future changes in the methods used to determine the fair value of these derivative contracts. For more information on our hedging activities, see Note 14 “Risk Management” to our consolidated financial statements.Employee Benefit PlansWe reflect an asset or liability for our pension and other postretirement benefit (OPEB) plans based on their overfunded or underfunded status. As of December 31, 2020, our pension plans were underfunded by $645 million, and our OPEB plans were overfunded by $62 million. Our pension and OPEB obligations and net benefit costs are primarily based on actuarial calculations. We use various assumptions in performing these calculations, including those related to the return that we expect to earn on our plan assets, the rate at which we expect the compensation of our employees to increase over the plan term, the estimated cost of health care when benefits are provided under our plan and other factors. A significant assumption we utilize is the discount rate used in calculating our benefit obligations. We utilize a full yield curve approach in the estimation of the service and interest cost components of net periodic benefit cost (credit) for our pension and OPEB plans which applies the specific spot rates along the yield curve used in the determination of the benefit obligation to their underlying projected cash flows. The selection of these assumptions is further discussed in Note 10 “Share-based Compensation and Employee Benefits” to our consolidated financial statements.Actual results may differ from the assumptions included in these calculations, and as a result, our estimates associated with our pension and OPEB can be, and have been revised in subsequent periods. The income statement impact of the changes in the assumptions on our related benefit obligations are deferred and amortized into income over either the period of expected 40future service of active participants, or over the expected future lives of inactive plan participants. As of December 31, 2020, we had deferred net losses of approximately $521 million in pre-tax accumulated other comprehensive loss related to our pension and OPEB plans.The following sensitivity analysis shows the estimated impact of a 1% change in the primary assumptions used in our actuarial calculations associated with our pension and OPEB plans for the year ended December 31, 2020: Pension BenefitsOPEBNet benefit cost (income)Change in funded status(a)Net benefit cost (income)Change in funded status(a)(In millions)One percent increase in:Discount rates$(11)$215 $— $21 Expected return on plan assets(20)— (3)— Rate of compensation increase3 (12)— — One percent decrease in:Discount rates12 (253)— (24)Expected return on plan assets20 — 3 — Rate of compensation increase(2)11 — — (a)Includes amounts deferred as either accumulated other comprehensive income (loss) or as a regulatory asset or liability for certain of our regulated operations.Income TaxesIncome tax expense is recorded based on an estimate of the effective tax rate in effect or to be in effect during the relevant periods. Changes in tax legislation are included in the relevant computations in the period in which such changes are enacted. We do business in a number of states with differing laws concerning how income subject to each state’s tax structure is measured and at what effective rate such income is taxed. Therefore, we must make estimates of how our income will be apportioned among the various states in order to arrive at an overall effective tax rate. Changes in our effective rate, including any effect on previously recorded deferred taxes, are recorded in the period in which the need for such change is identified.Deferred income tax assets and liabilities are recognized for temporary differences between the basis of assets and liabilities for financial reporting and tax purposes. Deferred tax assets are reduced by a valuation allowance for the amount that is more likely than not to not be realized. While we have considered estimated future taxable income and prudent and feasible tax planning strategies in determining the amount of our valuation allowance, any change in the amount that we expect to ultimately realize will be included in income in the period in which such a determination is reached.In determining the deferred income tax asset and liability balances attributable to our investments, we apply an accounting policy that looks through our investments. The application of this policy resulted in no deferred income taxes being provided on the difference between the book and tax basis on the non-tax-deductible goodwill portion of our investments, including KMI’s investment in its wholly-owned subsidiary, KMP.Results of OperationsOverviewAs described in further detail below, our management evaluates our performance primarily using the GAAP financial measures of Segment EBDA (as presented in Note 16, “Reportable Segments”), net income and net income attributable to Kinder Morgan, Inc., along with the non-GAAP financial measures of Adjusted Earnings and DCF, both in the aggregate and per share for each, Adjusted Segment EBDA, Adjusted EBITDA, Net Debt and Net Debt to Adjusted EBITDA.41GAAP Financial MeasuresThe Consolidated Earnings Results for the years ended December 31, 2020 and 2019 present Segment EBDA, net income and net income attributable to Kinder Morgan, Inc. which are prepared and presented in accordance with GAAP. Segment EBDA is a useful measure of our operating performance because it measures the operating results of our segments before DD&A and certain expenses that are generally not controllable by our business segment operating managers, such as general and administrative expenses and corporate charges, interest expense, net, and income taxes. Our general and administrative expenses and corporate charges include such items as unallocated employee benefits, insurance, rentals, unallocated litigation and environmental expenses, and shared corporate services including accounting, information technology, human resources and legal services.Non-GAAP Financial MeasuresOur non-GAAP financial measures described below should not be considered alternatives to GAAP net income or other GAAP measures and have important limitations as analytical tools. Our computations of these non-GAAP financial measures may differ from similarly titled measures used by others. You should not consider these non-GAAP financial measures in isolation or as substitutes for an analysis of our results as reported under GAAP. Management compensates for the limitations of these non-GAAP financial measures by reviewing our comparable GAAP measures, understanding the differences between the measures and taking this information into account in its analysis and its decision making processes.Certain ItemsCertain Items, as adjustments used to calculate our non-GAAP financial measures, are items that are required by GAAP to be reflected in net income, but typically either (i) do not have a cash impact (for example, asset impairments), or (ii) by their nature are separately identifiable from our normal business operations and in our view are likely to occur only sporadically (for example, certain legal settlements, enactment of new tax legislation and casualty losses). We also include adjustments related to joint ventures (see “Amounts from Joint Ventures” below and the tables included in “—Consolidated Earnings Results (GAAP)—Certain Items Affecting Consolidated Earnings Results,” “—Non-GAAP Financial Measures—Reconciliation of Net Income (GAAP) to Adjusted EBITDA” and “—Non-GAAP Financial Measures—Supplemental Information” below). In addition, Certain Items are described in more detail in the footnotes to tables included in “—Segment Earnings Results” and “—DD&A, General and Administrative and Corporate Charges, Interest, net and Noncontrolling Interests” below.Adjusted EarningsAdjusted Earnings is calculated by adjusting net income attributable to Kinder Morgan, Inc. for Certain Items. Adjusted Earnings is used by us and certain external users of our financial statements to assess the earnings of our business excluding Certain Items as another reflection of our ability to generate earnings. We believe the GAAP measure most directly comparable to Adjusted Earnings is net income attributable to Kinder Morgan, Inc. Adjusted Earnings per share uses Adjusted Earnings and applies the same two-class method used in arriving at basic earnings per common share. See “—Non-GAAP Financial Measures—Reconciliation of Net Income Attributable to Kinder Morgan, Inc. (GAAP) to Adjusted Earnings to DCF” below.DCFDCF is calculated by adjusting net income attributable to Kinder Morgan, Inc. for Certain Items (Adjusted Earnings), and further by DD&A and amortization of excess cost of equity investments, income tax expense, cash taxes, sustaining capital expenditures and other items. We also include amounts from joint ventures for income taxes, DD&A and sustaining capital expenditures (see “Amounts from Joint Ventures” below). DCF is a significant performance measure useful to management and external users of our financial statements in evaluating our performance and in measuring and estimating the ability of our assets to generate cash earnings after servicing our debt, paying cash taxes and expending sustaining capital, that could be used for discretionary purposes such as common stock dividends, stock repurchases, retirement of debt, or expansion capital expenditures. DCF should not be used as an alternative to net cash provided by operating activities computed under GAAP. We believe the GAAP measure most directly comparable to DCF is net income attributable to Kinder Morgan, Inc. DCF per common share is DCF divided by average outstanding common shares, including restricted stock awards that participate in common share dividends. See “—Non-GAAP Financial Measures—Reconciliation of Net Income Attributable to Kinder Morgan, Inc. (GAAP) to Adjusted Earnings to DCF” and “—Adjusted Segment EBDA to Adjusted EBITDA to DCF” below.42Adjusted Segment EBDAAdjusted Segment EBDA is calculated by adjusting Segment EBDA for Certain Items attributable to the segment. Adjusted Segment EBDA is used by management in its analysis of segment performance and management of our business. We believe Adjusted Segment EBDA is a useful performance metric because it provides management and external users of our financial statements additional insight into the ability of our segments to generate cash earnings on an ongoing basis. We believe it is useful to investors because it is a measure that management uses to allocate resources to our segments and assess each segment’s performance. We believe the GAAP measure most directly comparable to Adjusted Segment EBDA is Segment EBDA. See “—Consolidated Earnings Results (GAAP)—Certain Items Affecting Consolidated Earnings Results” for a reconciliation of Segment EBDA to Adjusted Segment EBDA by business segment. Adjusted EBITDAAdjusted EBITDA is calculated by adjusting EBITDA for Certain Items. We also include amounts from joint ventures for income taxes and DD&A (see “Amounts from Joint Ventures” below). Adjusted EBITDA is used by management and external users, in conjunction with our Net Debt (as described further below), to evaluate certain leverage metrics. Therefore, we believe Adjusted EBITDA is useful to investors. We believe the GAAP measure most directly comparable to Adjusted EBITDA is net income. See “—Adjusted Segment EBDA to Adjusted EBITDA to DCF” and “—Non-GAAP Financial Measures—Reconciliation of Net Income (GAAP) to Adjusted EBITDA” below.Amounts from Joint VenturesCertain Items, DCF and Adjusted EBITDA reflect amounts from unconsolidated joint ventures and consolidated joint ventures utilizing the same recognition and measurement methods used to record “Earnings from equity investments” and “Noncontrolling interests,” respectively. The calculations of DCF and Adjusted EBITDA related to our unconsolidated and consolidated joint ventures include the same adjustments (DD&A and income tax expense, and for DCF only, also cash taxes and sustaining capital expenditures) with respect to the joint ventures as those included in the calculations of DCF and Adjusted EBITDA for our wholly-owned consolidated subsidiaries. (See “—Non-GAAP Financial Measures—Supplemental Information” below.) Although these amounts related to our unconsolidated joint ventures are included in the calculations of DCF and Adjusted EBITDA, such inclusion should not be understood to imply that we have control over the operations and resulting revenues, expenses or cash flows of such unconsolidated joint ventures. DCF and Adjusted EBITDA are further adjusted for certain KML activities attributable to our noncontrolling interests in KML for the periods presented through KML’s sale on December 16, 2019, see “—Non-GAAP Financial Measures—Supplemental Information—KML Activities Prior to December 16, 2019” below.Net DebtNet Debt is calculated, based on amounts as of December 31, 2020, by subtracting the following amounts from our debt balance of $34,689 million: (i) cash and cash equivalents of $1,184 million; (ii) debt fair value adjustments of $1,293 million; and (iii) the foreign exchange impact on Euro-denominated bonds of $170 million for which we have entered into currency swaps. Net Debt is a non-GAAP financial measure that is useful to investors and other users of our financial information in evaluating our leverage. We believe the most comparable measure to Net Debt is debt net of cash and cash equivalents. Our Net Debt-to-Adjusted EBITDA ratio was 4.6 as of December 31, 2020.43Consolidated Earnings Results (GAAP)The following tables summarize the key components of our consolidated earnings results. Year Ended December 31,20202019Earningsincrease/(decrease) (In millions, except percentages)Segment EBDA(a) Natural Gas Pipelines$3,483 $4,661 $(1,178)(25)%Products Pipelines977 1,225 (248)(20)%Terminals1,045 1,506 (461)(31)%CO2(292)681 (973)(143)%Kinder Morgan Canada— (2)2 100 %Total segment EBDA5,213 8,071 (2,858)(35)%DD&A(2,164)(2,411)247 10 %Amortization of excess cost of equity investments(140)(83)(57)(69)%General and administrative and corporate charges(653)(611)(42)(7)%Interest, net(1,595)(1,801)206 11 %Income before income taxes661 3,165 (2,504)(79)%Income tax expense(481)(926)445 48 %Net income180 2,239 (2,059)(92)%Net income attributable to noncontrolling interests(61)(49)(12)(24)%Net income attributable to Kinder Morgan, Inc.$119 $2,190 $(2,071)(95)%(a)Includes revenues, earnings from equity investments, and other, net, less operating expenses, loss (gain) on impairments and divestitures, net, and other income, net. Operating expenses include costs of sales, operations and maintenance expenses, and taxes, other than income taxes. Year Ended December 31, 2020 vs. 2019Net income attributable to Kinder Morgan, Inc. decreased $2,071 million in 2020 compared to 2019. The decrease was due primarily to $1,950 million of non-cash impairments of goodwill associated with our Natural Gas Pipelines Non-Regulated and CO2 reporting units and non-cash impairments of certain oil and gas producing assets in our CO2 business segment. The decrease in results was further impacted by lower earnings from all of our business segments primarily attributable to COVID-19-related reduced energy demand and commodity price impacts and the impact of the KML and U.S. Cochin Sale in the fourth quarter of 2019 on our Natural Gas Pipelines and Terminals business segments, partially offset by the benefit of completed expansion projects in our Natural Gas Pipelines business segment, by lower interest expense and DD&A expense, and by lower income tax expense due to 2019 income taxes related to the KML and U.S. Cochin Sale.44Certain Items Affecting Consolidated Earnings ResultsYear Ended December 31,20202019GAAPCertain ItemsAdjustedGAAPCertain ItemsAdjustedAdjusted amountsincrease/(decrease) to earnings(In millions)Segment EBDANatural Gas Pipelines$3,483 $983 $4,466 $4,661 $(51)$4,610 $(144)Products Pipelines977 50 1,027 1,225 33 1,258 (231)Terminals1,045 (55)990 1,506 (332)1,174 (184)CO2(292)944 652 681 26 707 (55)Kinder Morgan Canada— — — (2)2 — — Total Segment EBDA(a)5,213 1,922 7,135 8,071 (322)7,749 (614)DD&A and amortization of excess cost of equity investments(2,304)— (2,304)(2,494)— (2,494)190 General and administrative and corporate charges(a)(653)92 (561)(611)13 (598)37 Interest, net(a)(1,595)(15)(1,610)(1,801)(15)(1,816)206 Income before income taxes661 1,999 2,660 3,165 (324)2,841 (181)Income tax expense(b)(481)(107)(588)(926)299 (627)39 Net income180 1,892 2,072 2,239 (25)2,214 (142)Net income attributable to noncontrolling interests(a)(61)— (61)(49)(4)(53)(8)Net income attributable to Kinder Morgan, Inc.$119 $1,892 $2,011 $2,190 $(29)$2,161 $(150)(a)For a more detailed discussion of these Certain Items, see the footnotes to the tables within “—Segment Earnings Results” and “—DD&A, General and Administrative and Corporate Charges, Interest, net and Noncontrolling Interests” below.(b)The combined net effect of the Certain Items represents the income tax provision on Certain Items plus discrete income tax items.Net income attributable to Kinder Morgan, Inc. adjusted for Certain Items (Adjusted Earnings) decreased by $150 million from the prior year and was primarily due to lower earnings from all of our business segments primarily attributable to COVID-19-related reduced energy demand and commodity price impacts and the impact of the KML and U.S. Cochin Sale in the fourth quarter of 2019 on our Natural Gas Pipelines and Terminals business segments, partially offset by the benefit of completed expansion projects in our Natural Gas Pipelines business segment and by lower interest expense and DD&A expense.45Non-GAAP Financial MeasuresReconciliation of Net Income Attributable to Kinder Morgan, Inc. (GAAP) to Adjusted Earnings to DCFYear Ended December 31,20202019(In millions)Net income attributable to Kinder Morgan Inc. (GAAP)$119 $2,190 Total Certain Items1,892 (29)Adjusted Earnings(a)2,011 2,161 DD&A and amortization of excess cost of equity investments for DCF(b)2,671 2,867 Income tax expense for DCF(a)(b)670 714 Cash taxes(c)(68)(90)Sustaining capital expenditures(c)(658)(688)Other items(d)(29)29 DCF$4,597 $4,993 Adjusted Segment EBDA to Adjusted EBITDA to DCFYear Ended December 31,20202019(In millions, except per share amounts)Natural Gas Pipelines$4,466 $4,610 Products Pipelines1,027 1,258 Terminals990 1,174 CO2652 707 Adjusted Segment EBDA(a)7,135 7,749 General and administrative and corporate charges(a)(561)(598)Joint venture DD&A and income tax expense(a)(e)449 487 Net income attributable to noncontrolling interests (net of KML noncontrolling interests and Certain Items)(a)(61)(20)Adjusted EBITDA6,962 7,618 Interest, net(a)(1,610)(1,816)Cash taxes(c)(68)(90)Sustaining capital expenditures(c)(658)(688)KML noncontrolling interests DCF adjustments(f)— (60)Other items(d)(29)29 DCF$4,597 $4,993 Adjusted Earnings per common share$0.88 $0.95 Weighted average common shares outstanding for dividends(g)2,276 2,276 DCF per common share$2.02 $2.19 Declared dividends per common share$1.05 $1.00 (a)Amounts are adjusted for Certain Items. See tables included in “—Reconciliation of Net Income (GAAP) to Adjusted EBITDA” and “—Supplemental Information” below.(b)Includes DD&A or income tax expense, as applicable, from joint ventures. 2019 amounts are also net of DD&A or income tax expense attributable to KML noncontrolling interests. See tables included in “—Supplemental Information” below.(c)Includes cash taxes or sustaining capital expenditures, as applicable, from joint ventures. See tables included in “—Supplemental Information” below.(d)Includes pension contributions and non-cash pension expense, and non-cash compensation associated with our restricted stock program.46(e)Represents joint venture DD&A and income tax expense. See tables included in “—Supplemental Information” below.(f)2019 amount represents the combined net income, DD&A and income tax expense adjusted for Certain Items, as applicable, attributable to KML noncontrolling interests. See table included in “—Supplemental Information” below.(g)Includes restricted stock awards that participate in common share dividends. Reconciliation of Net Income (GAAP) to Adjusted EBITDAYear Ended December 31,20202019(In millions)Net income (GAAP)$180 $2,239 Certain Items:Fair value amortization(21)(29)Legal, environmental and taxes other than income tax reserves26 46 Change in fair value of derivative contracts(a)(5)(24)Loss (gain) on impairments and divestitures, net(b)327 (280)Loss on impairment of goodwill(c)1,600 — Restricted stock accelerated vesting and severance52 — COVID-19 costs15 — Income tax Certain Items(107)299 Noncontrolling interests associated with Certain Items— (4)Other5 (37)Total Certain Items(d)1,892 (29)DD&A and amortization of excess cost of equity investments2,304 2,494 Income tax expense(e)588 627 Joint venture DD&A and income tax expense(e)(f)449 487 Interest, net(e)1,610 1,816 Net income attributable to noncontrolling interests (net of KML noncontrolling interests(e))(61)(16)Adjusted EBITDA$6,962 $7,618 (a)Gains or losses are reflected in our DCF when realized.(b)2020 amount includes: (i) a pre-tax non-cash impairment loss of $350 million related to oil and gas producing assets in our CO2 business segment driven by low oil prices and (ii) $21 million for asset impairments in our Products Pipelines business segment, which are reported within “Loss (gain) on impairments and divestitures, net” on the accompanying consolidated statement of income. 2019 amount primarily includes: (i) a $1,296 million pre-tax gain on the KML and U.S. Cochin Sale and a pre-tax loss of $364 million for asset impairments, related to gathering and processing assets in Oklahoma and northern Texas in our Natural Gas Pipelines business segment and oil and gas producing assets in our CO2 business segment, which are reported within “Loss (gain) on impairments and divestitures, net” on the accompanying consolidated statement of income and (ii) a pre-tax $650 million loss for an impairment of our investment in Ruby Pipeline which is reported within “Earnings from equity investments” on the accompanying consolidated statement of income. (c)2020 amount includes non-cash impairments of goodwill of $1,000 million and $600 million associated with our Natural Gas Pipelines Non-Regulated and our CO2 reporting units, respectively.(d)2020 and 2019 amounts include $(4) million and $634 million, respectively, reported within “Earnings from equity investments” on our accompanying consolidated statements of income.(e)Amounts are adjusted for Certain Items. See tables included in “—Supplemental Information” and “—DD&A, General and Administrative and Corporate Charges, Interest, net and Noncontrolling Interests” below.(f)Represents joint venture DD&A and income tax expense. See table included in “—Supplemental Information” below.47Supplemental InformationYear Ended December 31,20202019(In millions)DD&A (GAAP)$2,164 $2,411 Amortization of excess cost of equity investments (GAAP)140 83 DD&A and amortization of excess cost of equity investments2,304 2,494 Joint venture DD&A367 392 DD&A attributable to KML noncontrolling interests— (19)DD&A and amortization of excess cost of equity investments for DCF$2,671 $2,867 Income tax expense (GAAP)$481 $926 Certain Items107 (299)Income tax expense(a)588 627 Unconsolidated joint venture income tax expense(a)(b)82 95 Income tax expense attributable to KML noncontrolling interests(a)— (8)Income tax expense for DCF(a)$670 $714 KML activities prior to December 16, 2019Net income attributable to KML noncontrolling interests$— $29 KML noncontrolling interests associated with Certain Items— 4 KML noncontrolling interests(a)— 33 DD&A attributable to KML noncontrolling interests— 19 Income tax expense attributable to KML noncontrolling interests(a)— 8 KML noncontrolling interests DCF adjustments(a)$— $60 Net income attributable to noncontrolling interests (GAAP)$61 $49 Less: KML noncontrolling interests(a)— 33 Net income attributable to noncontrolling interests (net of KML noncontrolling interests(a))61 16 Noncontrolling interests associated with Certain Items— 4 Net income attributable to noncontrolling interests (net of KML noncontrolling interests and Certain Items)$61 $20 Additional joint venture informationUnconsolidated joint venture DD&A$407 $411 Less: Consolidated joint venture partners’ DD&A40 19 Joint venture DD&A367 392 Unconsolidated joint venture income tax expense(a)(b)82 95 Joint venture DD&A and income tax expense(a)$449 $487 Unconsolidated joint venture cash taxes(b)$(62)$(61)Unconsolidated joint venture sustaining capital expenditures$(120)$(114)Less: Consolidated joint venture partners’ sustaining capital expenditures(6)(6)Joint venture sustaining capital expenditures$(114)$(108)(a)Amounts are adjusted for Certain Items.(b)Amounts are associated with our Citrus, NGPL and PPL pipeline equity investments.48Segment Earnings ResultsNatural Gas Pipelines Year Ended December 31, 20202019 (In millions, except operating statistics)Revenues$7,259 $8,170 Operating expenses(3,457)(4,213)(Loss) gain on impairments and divestitures, net(1,010)677 Other income1 3 Earnings (losses) from equity investments679 (29)Other, net11 53 Segment EBDA3,483 4,661 Certain Items(a)983 (51)Adjusted Segment EBDA$4,466 $4,610 Change from prior periodIncrease/(Decrease)Adjusted Segment EBDA$(144)Volumetric data(b)Transport volumes (BBtu/d)37,487 36,793 Sales volumes (BBtu/d)2,353 2,420 Gathering volumes (BBtu/d)3,039 3,382 NGLs (MBbl/d)27 32 Certain Items affecting Segment EBDA(a)Includes Certain Item amounts of $983 million and $(51) million for 2020 and 2019, respectively. 2020 amount includes (i) a $1,000 million non-cash goodwill impairment on our Natural Gas Pipelines Non-Regulated reporting unit; (ii) an increase in revenues of $19 million resulting from amortization of regulatory liabilities including amounts recognized through earnings from equity investments; and (iii) a decrease in revenues of $15 million related to non-cash mark-to-market derivative contracts used to hedge forecasted natural gas and NGL sales. 2019 amount includes (i) a $957 million gain on the sale of Cochin Pipeline system; (ii) a $650 million non-cash impairment loss related to our investment in Ruby; (iii) $157 million and $133 million non-cash losses on impairments of certain gathering and processing assets in North Texas and Oklahoma, respectively; (iv) an increase in earnings of $23 million for a gain on an ownership rights contract with a joint venture partner; (v) a $16 million increase in earnings related to amortization of regulatory liabilities recognized through earnings of equity investments; and (vi) a $12 million decrease in revenues related to non-cash mark-to-market derivative contracts used to hedge forecasted natural gas and NGL sales. Other(b)Joint venture throughput is reported at our ownership share. Volumes for assets sold are excluded for all periods presented.Below are the changes in Adjusted Segment EBDA between 2020 and 2019:Year Ended December 31, 2020 versus Year Ended December 31, 2019 Adjusted Segment EBDA increase/(decrease) (In millions, except percentages)Midstream$(254)(18)%West Region (47)(4)%East Region157 7%Total Natural Gas Pipelines$(144)(3)%49The changes in Segment EBDA for our Natural Gas Pipelines business segment are further explained by the following discussion of the significant factors driving Adjusted Segment EBDA in the comparable years of 2020 and 2019:•Midstream’s decrease of $254 million (18%) was primarily due to (i) a decrease of $142 million related to the sale of the Cochin Pipeline system on December 16, 2019 to Pembina; (ii) lower commodity prices on, a decrease in volumes and two customer bankruptcies associated with our South Texas assets; (iii) lower volumes on KinderHawk; and (iv) lower contract rates on our North Texas assets. These decreases were partially offset by higher equity earnings due to the Gulf Coast Express Pipeline being placed in service in September 2019. Overall Midstream’s revenues decreased primarily due to lower commodity prices which was largely offset by corresponding decreases in costs of sales; •West Region’s decrease of $47 million (4%) was primarily due to decreases in earnings from (i) Ruby Pipeline Company, L.L.C. due principally to credit losses and lost revenues resulting from two of its customers’ bankruptcies; (ii) CPGPL as a result of the expiration of one shipper’s contract; and (iii) EPNG driven by higher operating expenses; and•East Region’s increase of $157 million (7%) was primarily due to increases in earnings from ELC and SLNG resulting from the liquefaction units of the Elba Liquefaction project gradually being placed into service in the later part of 2019 and through the first eight months of 2020, and increased equity earnings from NGPL primarily due to higher revenues. These increases were partially offset by reduced contributions from TGP due to the impact of the FERC 501-G rate settlement on its revenues.50Products Pipelines Year Ended December 31, 20202019 (In millions, except operating statistics)Revenues$1,721 $1,831 Operating expenses(779)(684)Loss on impairments and divestitures, net(21)— Earnings from equity investments55 72 Other, net1 6 Segment EBDA977 1,225 Certain Items(a)50 33 Adjusted Segment EBDA$1,027 $1,258 Change from prior periodIncrease/(Decrease)Adjusted Segment EBDA$(231)Volumetric data(b)Gasoline(c)897 1,041 Diesel fuel375 368 Jet fuel179 306 Total refined product volumes1,451 1,715 Crude and condensate552 651 Total delivery volumes (MBbl/d)2,003 2,366 Certain Items affecting Segment EBDA(a)Includes Certain Item amounts of $50 million and $33 million in the 2020 and 2019 periods, respectively. 2020 amount includes a $46 million unfavorable rate case reserve adjustment, a non-cash loss on impairment of our Belton Terminal of $21 million and a $17 million favorable adjustment for tax reserves, other than income taxes. 2019 amount primarily related to unfavorable adjustments of an environmental reserve and of tax reserves, other than income taxes.Other (b)Joint venture throughput is reported at our ownership share.(c)Volumes include ethanol pipeline volumes.Below are the changes in Adjusted Segment EBDA between 2020 and 2019:Year Ended December 31, 2020 versus Year Ended December 31, 2019Adjusted Segment EBDA increase/(decrease)(In millions, except percentages)Crude and Condensate$(119)(25)%West Coast Refined Products(63)(12)%Southeast Refined Products(49)(18)%Total Products Pipelines$(231)(18)%The changes in Segment EBDA for our Products Pipelines business segment are further explained by the following discussion of the significant factors driving Adjusted Segment EBDA in the comparable years of 2020 and 2019:•Crude and Condensate’s decrease of $119 million (25%) was primarily due to decreased earnings from Kinder Morgan Crude & Condensate Pipeline (KMCC) and the Bakken Crude assets. KMCC’s decreased earnings were primarily due to lower volumes. The Bakken Crude assets decreased earnings were primarily driven by lower volumes and reduced 51re-contracted rates on Double H pipeline. KMCC and Bakken Crude assets decreases were also impacted by unfavorable inventory valuation adjustments driven by declines in commodity prices during the first quarter 2020;•West Coast Refined Products’ decrease of $63 million (12%) was due to decreased earnings on Pacific (SFPP) operations, Calnev Pipe Line LLC and West Coast terminals driven by lower service revenues as a result of a reduction in volumes due to COVID-19; and•Southeast Refined Products’ decrease of $49 million (18%) was primarily due to decreased earnings from our South East Terminals and a decrease in equity earnings from PPL pipeline as a result of decreased services revenues driven by lower volumes and prices due to COVID-19, and lower earnings from our Transmix processing operations driven by unfavorable inventory adjustments resulting from commodity price declines during the first quarter 2020.Terminals Year Ended December 31, 20202019 (In millions, except operating statistics)Revenues$1,722 $2,034 Operating expenses(762)(888)Gain on divestitures and impairments, net49 342 Other income1 — Earnings from equity investments22 23 Other, net13 (5)Segment EBDA1,045 1,506 Certain Items(a)(55)(332)Adjusted Segment EBDA$990 $1,174 Change from prior periodIncrease/(Decrease)Adjusted Segment EBDA$(184)Volumetric data(b)Liquids leasable capacity (MMBbl)79.7 79.7 Liquids utilization %(c)95.3 %93.2 %Bulk transload tonnage (MMtons)48.0 55.3 Certain Items affecting Segment EBDA(a)Includes Certain Item amounts of $(55) million and $(332) million for 2020 and 2019, respectively. 2020 amount related to a gain on sale of our Staten Island terminal and 2019 amount primarily related to a gain of $339 million on the sale of KML.Other(b)Volumes for assets sold are excluded for all periods presented.(c)The ratio of our tankage capacity in service to tankage capacity available for service.52Below are the changes in Adjusted Segment EBDA between 2020 and 2019: Year Ended December 31, 2020 versus Year Ended December 31, 2019Adjusted Segment EBDAincrease/(decrease)(In millions, except percentages)Alberta Canada$(124)(100)%Gulf Liquids(23)(7)%West Coast(22)(100)%Mid Atlantic(10)(15)%Gulf Bulk(8)(12)%All others (including intrasegment eliminations)3 1%Total Terminals$(184)(16)%The changes in Segment EBDA for our Terminals business segment are further explained by the following discussion of the significant factors driving Adjusted Segment EBDA in the comparable years of 2020 and 2019:•the Sale of KML assets to Pembina on December 16, 2019, which accounted for the decreases on our Alberta Canada terminals and our West Coast terminals;•decrease of $23 million (7%) from our Gulf Liquids terminals primarily driven by lower volumes and associated ancillary fees related to demand reduction attributable to COVID-19 as well as tanks being temporarily off-lease as they are transitioned to new customers following the termination of a major customer contract; •decrease of $10 million (15%) from our Mid Atlantic terminals primarily due to lower coal volumes at our Pier IX facility driven by coal market weakness largely attributable to demand reduction associated with COVID-19; and•decrease of $8 million (12%) from our Gulf Bulk terminals primarily due to decreased coal volumes and the impact of an expired contract in January 2020.53CO2 Year Ended December 31, 20202019 (In millions, except operating statistics)Revenues$1,038 $1,219 Operating expenses(404)(496)Loss on impairments and divestitures, net(950)(76)Other expense— (1)Earnings from equity investments24 35 Segment EBDA(292)681 Certain Items(a)944 26 Adjusted Segment EBDA $652 $707 Change from prior periodIncrease/(Decrease)Adjusted Segment EBDA$(55)Volumetric dataSACROC oil production21.8 23.9 Yates oil production6.6 7.2 Katz and Goldsmith oil production2.8 3.8 Tall Cotton oil production1.7 2.3 Total oil production, net (MBbl/d)(b)32.9 37.2 NGL sales volumes, net (MBbl/d)(b)9.5 10.1 CO2 sales volumes, net (Bcf/d)0.4 0.6 Realized weighted average oil price ($ per Bbl)$53.78 $49.49 Realized weighted average NGL price ($ per Bbl)$17.95 $23.49 Certain Items affecting Segment EBDA(a)Includes Certain Item amounts of $944 million and $26 million for 2020 and 2019, respectively. 2020 amount includes (i) a $600 million goodwill impairment on our CO2 reporting unit and (ii) non-cash impairments of $350 million on our oil and gas producing assets. 2019 amount includes non-cash impairments of $75 million on our oil and gas producing assets and an increase in revenues of $49 million related to mark-to-market gains associated with derivative contracts used to hedge forecasted commodity sales.Other(b)Net of royalties and outside working interests.Below are the changes in Adjusted Segment EBDA between 2020 and 2019:Year Ended December 31, 2020 versus Year Ended December 31, 2019Adjusted Segment EBDA increase/(decrease)(In millions, except percentages)Source and Transportation activities$(82)(28)%Oil and Gas Producing activities27 6%Total CO2$(55)(8)%54The changes in Segment EBDA for our CO2 business segment are further explained by the following discussion of the significant factors driving Adjusted Segment EBDA in the comparable years of 2020 and 2019:•decrease of $82 million (28%) from our Source and Transportation activities primarily due to a decrease of $103 million related to lower CO2 sales volumes partially offset by lower operating expenses of $28 million; and•increase of $27 million (6%) from our Oil and Gas Producing activities primarily due to (i) lower operating expenses of $69 million; and (ii) higher realized crude oil prices which increased revenues by $62 million, offset by (i) lower volumes which decreased revenues by $92 million; and (ii) lower NGL prices which decreased revenues by $24 million.We believe that our existing hedge contracts in place within our CO2 business segment substantially mitigate commodity price sensitivities in the near-term and to lesser extent over the following few years from price exposure. Below is a summary of our CO2 business segment hedges outstanding as of December 31, 2020.2021202220232024Crude Oil(a)Price ($ per Bbl)$50.37 $50.98 $49.78 $43.50 Volume (MBbl/d)25.70 10.80 5.45 1.55 NGLsPrice ($ per Bbl)$29.26 Volume (MBbl/d)4.24 Midland-to-Cushing Basis SpreadPrice ($ per Bbl)$0.26 Volume (MBbl/d)24.55 (a)Includes West Texas Intermediate hedges.DD&A, General and Administrative and Corporate Charges, Interest, net and Noncontrolling Interests Year Ended December 31, 20202019 (In millions)DD&A (GAAP)$(2,164)$(2,411)General and administrative (GAAP)$(648)$(590)Corporate charges(5)(21)Certain Items(a)92 13 General and administrative and corporate charges(b)$(561)$(598)Interest, net (GAAP)$(1,595)$(1,801)Certain Items(c)(15)(15)Interest, net(b)$(1,610)$(1,816)Net income attributable to noncontrolling interests (GAAP)$(61)$(49)Certain Items— (4)Net income attributable to noncontrolling interests(b)$(61)$(53)Certain Items(a)2020 amount includes $52 million for restricted stock accelerated vesting and severance expense, $15 million related to costs incurred associated with COVID-19 mitigation and an increase in expense of $23 million associated with a non-cash fair value adjustment and the dividend on the Pembina common stock. 2019 amount includes: (i) an increase in asset sale related costs of $15 million; (ii) an increase in expense of $13 million related to a litigation matter; and (iii) a decrease in expense of $19 million associated with a non-cash fair value adjustment on the Pembina common stock. 55(b)Amounts are adjusted for Certain Items.(c)2020 and 2019 amounts include: (i) decreases in interest expense of $21 million and $29 million, respectively, related to non-cash debt fair value adjustments associated with acquisitions and (ii) increases of $8 million and $13 million, respectively, in interest expense related to non-cash mismatches between the change in fair value of interest rate swaps and change in fair value of hedged debt. DD&A expense decreased $247 million in 2020 when compared to 2019 primarily due to larger non-cash impairments taken in the first quarter 2020 compared to the fourth quarter 2019 on our oil and gas producing assets, lower CO2 business segment oil and gas production and the sale of KML partially offset by our Elba Liquefaction project gradually placed into service during 2019 and 2020. General and administrative expenses and corporate charges adjusted for Certain Items decreased $37 million in 2020 when compared to 2019 primarily due to lower non-cash pension expenses of $45 million, lower expenses of $31 million due to the KML and U.S. Cochin Sale and $20 million of cost savings associated with efficiency efforts and reduced activity during the pandemic, partially offset by lower capitalized costs of $57 million reflecting reduced capital projects primarily in our Natural Gas Pipelines, CO2 and Products Pipelines business segments.In the table above, we report our interest expense as “net,” meaning that we have subtracted interest income and capitalized interest from our total interest expense to arrive at one interest amount. Our consolidated interest expense, net adjusted for Certain Items decreased $206 million in 2020 when compared to 2019 primarily due to lower weighted average long-term debt balances and lower LIBOR rates partially offset by lower capitalized interest. We use interest rate swap agreements to convert a portion of the underlying cash flows related to our long-term fixed rate debt securities (senior notes) into variable rate debt in order to achieve our desired mix of fixed and variable rate debt. As of December 31, 2020 and 2019, approximately 16% and 27%, respectively, of the principal amount of our debt balances were subject to variable interest rates—either as short-term or long-term variable rate debt obligations or as fixed-rate debt converted to variable rates through the use of interest rate swaps. For more information on our interest rate swaps, see Note 14 “Risk Management—Interest Rate Risk Management” to our consolidated financial statements.Net income attributable to noncontrolling interests, represents the allocation of our consolidated net income attributable to all outstanding ownership interests in our consolidated subsidiaries that are not owned by us. Net income attributable to noncontrolling interests adjusted for Certain Items increased $8 million in 2020 compared to 2019. Income TaxesYear Ended December 31, 2020 versus Year Ended December 31, 2019 Our income tax expense for the year ended December 31, 2020 is approximately $481 million, as compared with income tax expense of $926 million for the same period of 2019. The $445 million decrease in income tax expense in 2020 as compared to 2019 is due primarily to (i) lower pretax income in 2020, (ii) lower foreign income taxes as a result of the KML and U.S. Cochin Sale in 2019, and (iii) the refund of alternative minimum tax sequestration credits in 2020. These decreases are partially offset by the lack of tax benefit on the higher impairment of non-tax deductible goodwill in 2020 and lower dividend-received deductions related to our investment in NGPL in 2020.Liquidity and Capital Resources GeneralAs of December 31, 2020, we had $1,184 million of “Cash and cash equivalents,” an increase of $999 million from December 31, 2019. Additionally, as of December 31, 2020, we had borrowing capacity of approximately $3.9 billion under our $4 billion revolving credit facility (discussed below in “—Short-term Liquidity”). As discussed further below, we believe our cash flows from operating activities, cash position and remaining borrowing capacity on our credit facility are more than adequate to allow us to manage our day-to-day cash requirements and anticipated obligations.We have consistently generated substantial cash flow from operations, providing a source of funds of $4,550 million and $4,748 million in 2020 and 2019, respectively. The year-to-year decrease is discussed below in “—Cash Flows—Operating Activities.” We primarily rely on cash provided from operations to fund our operations as well as our debt service, sustaining capital expenditures, dividend payments, and our growth capital expenditures. We believe our current cash on hand, our cash from operations and our borrowing capacity under our revolving credit facility are more than adequate to allow us to manage 56our cash requirements, including maturing debt, through 2021; however, we may access the debt capital markets from time to time to refinance our maturing long-term debt.Our board of directors declared a quarterly dividend of $0.2625 per share for the fourth quarter of 2020, consistent with previous quarters in 2020. The total of the dividends declared for 2020 of $1.05 represents a 5% increase over total dividends declared for 2019. We expect to fully fund our dividend payments as well as our discretionary spending for 2021 without funding from the capital markets with additional flexibility to engage in share repurchases on an opportunistic basis. Short-term LiquidityAs of December 31, 2020, our principal sources of short-term liquidity are (i) cash from operations; (ii) our $4.0 billion revolving credit facility and associated commercial paper program; and (iii) cash and cash equivalents. The loan commitments under our revolving credit facility can be used for working capital and other general corporate purposes, and as a backup to our commercial paper program. Letters of credit and commercial paper borrowings reduce borrowings allowed under our credit facility. We provide for liquidity by maintaining a sizable amount of excess borrowing capacity under our credit facility and, as previously discussed, have consistently generated strong cash flows from operations. We do not anticipate any significant limitations from the continuing impacts of COVID-19 with respect to our ability to access funding through our credit facility.As of December 31, 2020, our $2,558 million of short-term debt consisted primarily of senior notes that mature in the next twelve months. We intend to fund our debt, as it becomes due, primarily through credit facility borrowings, commercial paper borrowings, cash flows from operations, and/or issuing new long-term debt. Our short-term debt balance as of December 31, 2019 was $2,477 million. We had working capital (defined as current assets less current liabilities) deficits of $1,871 million and $1,862 million as of December 31, 2020 and 2019, respectively. From time to time, our current liabilities may include short-term borrowings used to finance our expansion capital expenditures, which we may periodically replace with long-term financing and/or pay down using retained cash from operations. The overall slight $9 million unfavorable change from year-end 2019 was primarily due to: (i) a decrease of $925 million related to the sale of Pembina common equity in January 2020; (ii) an increase of approximately $216 million in senior notes that mature in the next twelve months; and (iii) the $100 million repayment of the preferred interest in Kinder Morgan G.P. Inc.; substantially offset by (i) an increase in cash and cash equivalents of $999 million; and (ii) a favorable asset fair value adjustment of $101 million on derivative contracts in 2020. Generally, our working capital balance varies due to factors such as the timing of scheduled debt payments, timing differences in the collection and payment of receivables and payables, the change in fair value of our derivative contracts, and changes in our cash and cash equivalent balances as a result of excess cash from operations after payments for investing and financing activities (discussed below in “—Long-term Financing” and “—Capital Expenditures”).We employ a centralized cash management program for our U.S.-based bank accounts that concentrates the cash assets of our wholly owned subsidiaries in joint accounts for the purpose of providing financial flexibility and lowering the cost of borrowing. These programs provide that funds in excess of the daily needs of our wholly owned subsidiaries are concentrated, consolidated or otherwise made available for use by other entities within the consolidated group. We place no material restrictions on the ability to move cash between entities, payment of intercompany balances or the ability to upstream dividends to KMI other than restrictions that may be contained in agreements governing the indebtedness of those entities. Certain of our wholly owned subsidiaries are subject to FERC-enacted reporting requirements for oil and natural gas pipeline companies that participate in cash management programs. FERC-regulated entities subject to these rules must, among other things, place their cash management agreements in writing, maintain current copies of the documents authorizing and supporting their cash management agreements, and file documentation establishing the cash management program with the FERC.Credit Ratings and Capital Market LiquidityWe believe that our capital structure will continue to allow us to achieve our business objectives. We expect that our short-term liquidity needs will be met primarily through retained cash from operations or short-term borrowings. Generally, we anticipate re-financing maturing long-term debt obligations in the debt capital markets and are therefore subject to certain market conditions which could result in higher costs or negatively affect our and/or our subsidiaries’ credit ratings. A decrease in our credit ratings could negatively impact our borrowing costs and could limit our access to capital, including our ability to refinance maturities of existing indebtedness on similar terms, which could in turn reduce our cash flows and limit our ability to pursue acquisition or expansion opportunities.57As of December 31, 2020, our short-term corporate debt ratings were A-2, Prime-2 and F2 at Standard and Poor’s, Moody’s Investor Services and Fitch Ratings, Inc., respectively. The following table represents KMI’s and KMP’s senior unsecured debt ratings as of December 31, 2020.Rating agencySenior debt ratingOutlookStandard and Poor’sBBB StableMoody’s Investor ServicesBaa2StableFitch Ratings, Inc.BBBStableLong-term FinancingOur equity consists of Class P common stock with a par value of $0.01 per share. We do not expect to need to access the equity capital markets to fund our discretionary capital investments for the foreseeable future. See also “—Dividends and Stock Buy-back Program” below for additional discussion related to our dividends and stock buy-back program.From time to time, we issue long-term debt securities, often referred to as senior notes. All of our senior notes issued to date, other than those issued by certain of our subsidiaries, generally have very similar terms, except for interest rates, maturity dates and prepayment premiums. All of our fixed rate senior notes provide that the notes may be redeemed at any time at a price equal to 100% of the principal amount of the notes plus accrued interest to the redemption date, and, in most cases, plus a make-whole premium. In addition, from time to time, our subsidiaries issue long-term debt securities. Furthermore, we and almost all of our direct and indirect wholly owned domestic subsidiaries are parties to a cross guaranty wherein we each guarantee each other’s debt. See “—Summarized Combined Financial Information for Guarantee of Securities of Subsidiaries. As of December 31, 2020 and 2019, the aggregate principal amount outstanding of our various long-term debt obligations (excluding current maturities) was $30,838 million and $30,883 million, respectively.On August 5, 2020, we issued in a registered offering two series of senior notes consisting of $750 million aggregate principal amount of 2.00% senior notes due 2031 and $500 million aggregate principal amount of 3.25% senior notes due 2050 and received combined net proceeds of $1,226 million. We used the proceeds to repay maturing debt, including in early January 2021, our $750 million 3.50% senior notes that were scheduled to mature in March 2021.To refinance construction costs of its recent expansions, on February 24, 2020, TGP, a wholly owned subsidiary, issued in a private placement $1,000 million aggregate principal amount of its 2.90% senior notes due 2030 and received net proceeds of $991 million. We achieve our variable rate exposure primarily by issuing long-term fixed rate debt and then swapping the fixed rate interest payments for variable rate interest payments and through the issuance of commercial paper or credit facility borrowings.For additional information about our outstanding senior notes and debt-related transactions in 2020 , see Note 9 “Debt” to our consolidated financial statements. For information about our interest rate risk, see Item 7A “Quantitative and Qualitative Disclosures About Market Risk—Interest Rate Risk.”Counterparty CreditworthinessSome of our customers or other counterparties may experience severe financial problems that may have a significant impact on their creditworthiness. These financial problems may arise from our current global economic conditions, continued volatility of commodity prices or otherwise. In such situations, we utilize, to the extent allowable under applicable contracts, tariffs and regulations, prepayments and other security requirements, such as letters of credit, to enhance our credit position relating to amounts owed from these counterparties. While we believe we have taken reasonable measures to protect against counterparty credit risk, we cannot provide assurance that one or more of our customers or other counterparties will not become financially distressed and will not default on their obligations to us. The balance of our allowance for credit losses as of December 31, 2020 and December 31, 2019, was $26 million and $9 million, respectively, reflected in “Other current assets” on our consolidated balance sheets, which includes reserves for counterparty bankruptcies recorded during the year ended December 31, 2020. 58Capital ExpendituresWe account for our capital expenditures in accordance with GAAP. We also distinguish between capital expenditures that are maintenance/sustaining capital expenditures and those that are expansion capital expenditures (which we also refer to as discretionary capital expenditures). Expansion capital expenditures are those expenditures which increase throughput or capacity from that which existed immediately prior to the addition or improvement, and are not deducted in calculating DCF (see “—Results of Operations—Non-GAAP Financial Measures—Reconciliation of Net Income Attributable to Kinder Morgan, Inc. (GAAP) to Adjusted Earnings to DCF”). With respect to our oil and gas producing activities, we classify a capital expenditure as an expansion capital expenditure if it is expected to increase capacity or throughput (i.e., production capacity) from the capacity or throughput immediately prior to the making or acquisition of such additions or improvements. Maintenance capital expenditures are those which maintain throughput or capacity. The distinction between maintenance and expansion capital expenditures is a physical determination rather than an economic one, irrespective of the amount by which the throughput or capacity is increased.Budgeting of maintenance capital expenditures is done annually on a bottom-up basis. For each of our assets, we budget for and make those maintenance capital expenditures that are necessary to maintain safe and efficient operations, meet customer needs and comply with our operating policies and applicable law. We may budget for and make additional maintenance capital expenditures that we expect to produce economic benefits such as increasing efficiency and/or lowering future expenses. Budgeting and approval of expansion capital expenditures are generally made periodically throughout the year on a project-by-project basis in response to specific investment opportunities identified by our business segments from which we generally expect to receive sufficient returns to justify the expenditures. Generally, the determination of whether a capital expenditure is classified as maintenance/sustaining or as expansion capital expenditures is made on a project level. The classification of our capital expenditures as expansion capital expenditures or as maintenance capital expenditures is made consistent with our accounting policies and is generally a straightforward process, but in certain circumstances can be a matter of management judgment and discretion. The classification has an impact on DCF because capital expenditures that are classified as expansion capital expenditures are not deducted from DCF, while those classified as maintenance capital expenditures are. Our capital expenditures for the year ended December 31, 2020, and the amount we expect to spend for 2021 to sustain our assets and grow our business are as follows:2020Expected 2021(In millions)Sustaining capital expenditures(a)(b)$658 $792 Discretionary capital investments(b)(c)(d)1,692 794 (a)2020 and Expected 2021 amounts include $114 million and $119 million, respectively, for sustaining capital expenditures from unconsolidated joint ventures, reduced by consolidated joint venture partners’ sustaining capital expenditures. See table included in “Non-GAAP Financial Measures—Supplemental Information.” (b)2020 excludes $21 million due to decreases in accrued capital expenditures and contractor retainage and net changes in other.(c)2020 amount includes $550 million of our contributions to certain unconsolidated joint ventures for capital investments and small acquisitions.(d)Amounts include our actual or estimated contributions to certain unconsolidated joint ventures, net of actual or estimated contributions from certain partners in non-wholly owned consolidated subsidiaries for capital investments.Off Balance Sheet Arrangements We have invested in entities that are not consolidated in our financial statements. For information on our obligations with respect to these investments, as well as our obligations with respect to related letters of credit, see Note 13 “Commitments and Contingent Liabilities” to our consolidated financial statements. Additional information regarding the nature and business purpose of our investments is included in Note 7 “Investments” to our consolidated financial statements.59Contractual Obligations and Commercial Commitments Payments due by period TotalLess than 1year1-3 years3-5 yearsMore than 5 years (In millions)Contractual obligations: Debt borrowings-principal payments(a)$33,396 $2,558 $5,825 $3,491 $21,522 Interest payments(b) 21,693 1,684 3,077 2,631 14,301 Lease obligations(c)412 53 84 64 211 Pension and OPEB plans(d) 852 63 36 32 721 Transportation, volume and storage agreements(e)631 163 223 143 102 Other obligations(f) 435 91 132 68 144 Total$57,419 $4,612 $9,377 $6,429 $37,001 Other commercial commitments: Standby letters of credit(g)$147 $74 $73 $— $— Capital expenditures(h)$141 $141 $— $— $— (a)See Note 9 “Debt” to our consolidated financial statements.(b)Interest payment obligations exclude adjustments for interest rate swap agreements and assume no change in variable interest rates from those in effect at December 31,2020. (c)Represents commitments pursuant to the terms of operating lease agreements as of December 31, 2020.(d)Represents the amount by which the benefit obligations exceeded the fair value of plan assets at year-end for pension and OPEB plans whose accumulated postretirement benefit obligations exceeded the fair value of plan assets. The payments by period include expected contributions in 2021 and estimated benefit payments for underfunded plans in the other years. (e)Primarily represents transportation agreements of $279 million, NGL volume agreements of $208 million and storage agreements for capacity of $131 million.(f)Primarily includes (i) rights-of-way obligations; and (ii) environmental liabilities related to sites that we own or have a contractual or legal obligation with a regulatory agency or property owner upon which we will perform remediation activities. These environmental liabilities are included within “Other current liabilities” and “Other long-term liabilities and deferred credits” in our consolidated balance sheet as of December 31, 2020.(g)The $147 million in letters of credit outstanding as of December 31, 2020 consisted of the following (i) letters of credit totaling $46 million supporting our International Marine Terminals Partnership Plaquemines, Louisiana Port, Harbor, and Terminal Revenue Bonds; (ii) $46 million under seven letters of credit for insurance purposes; (iii) a $24 million letter of credit supporting our Kinder Morgan Operating LLC “B” tax-exempt bonds; and (iv) a combined $31 million in thirty letters of credit supporting environmental and other obligations of us and our subsidiaries.(h)Represents commitments for the purchase of plant, property and equipment as of December 31, 2020.Cash Flows Operating ActivitiesCash provided by operating activities decreased $198 million in 2020 compared to 2019 primarily due to:•a $409 million decrease in cash after adjusting the $2,059 million decrease in net income by $1,650 million for the combined effects of the period-to-period net changes in non-cash items including the following: (i) loss on impairments and divestitures, net (see discussion above in “—Results of Operations”); (ii) changes in fair market value of derivative contracts; (iii) DD&A expenses (including amortization of excess cost of equity investments); (iv) deferred income taxes; and (v) earnings from equity investments; partially offset by•a $145 million increase in cash primarily resulting from $227 million of net income tax payments in the 2020 period compared to $372 million of net income tax payments in the 2019 period, which in both periods were primarily for foreign income taxes associated with the sale of certain Canadian assets. The income tax payments for the 2020 period are net of a $20 million refund related to alternative minimum tax sequestration credits; and•a $66 million increase in cash associated with net changes in working capital items, other than income tax payments, and other non-current assets and liabilities. The increase was driven, among other things, primarily by a favorable change due to the timing of trade payables payments, and partially offset by higher pension plan contributions we made in the 2020 period compared to the 2019 period.60Investing ActivitiesCash used in investing activities decreased $803 million in 2020 compared to 2019 primarily due to:◦a $959 million increase in cash from the proceeds received from the sales of property, plant and equipment, investments, and other net assets, net of removal costs primarily due to $907 million of proceeds received from the sale of the Pembina shares in the 2020 period. See Note 4 “Divestitures” to our consolidated financial statements for further information regarding this transaction;◦a $913 million decrease in cash used for contributions to equity investments driven by lower contributions to Gulf Coast Express Pipeline LLC, MEP, Citrus, and FEP in the 2020 period compared with the 2019 period, partially offset by contributions made to SNG in the 2020 period; and◦a $563 million decrease in capital expenditures in the 2020 period over the comparative 2019 period primarily due to lower expenditures on the Elba Liquefaction expansion and also reflecting our reduction of expansion capital projects in the wake of COVID-19; partially offset by◦the $1,527 million decrease in cash resulting from proceeds received from the KML and U.S. Cochin Sale, net of cash disposed, in 2019. See Note 4 “Divestitures” to our consolidated financial statements for further information regarding this transaction; and◦a $179 million decrease in distributions received from equity investments in excess of cumulative earnings primarily from Ruby, FEP and SNG in the 2020 period over the comparative 2019 period.Financing ActivitiesCash used in financing activities decreased $3,547 million in 2020 compared to 2019 primarily due to:•a $3,065 million net increase in cash from net debt activity primarily driven by an increase in long-term debt issuances, and to a lesser extent, lower long-term debt repayments and lower utilization of our credit facility for short-term borrowings, which resulted in a substantial decrease in each our total debt issuances and total debt payments, in the 2020 period compared to the 2019 period. See Note 9 “Debt” to our consolidated financial statements for further information regarding our debt activity; and•an $879 million decrease in cash used resulting from the distribution of the TMPL sale proceeds to the owners of KML restricted voting shares in the 2019 period; partially offset by•a $199 million increase in dividend payments to our common shareholders; and•a $137 million decrease in contributions received from an investment partner and noncontrolling interests primarily driven by lower contributions received from EIG in the 2020 period compared to the 2019 period.Dividends and Stock Buy-back ProgramThe table below reflects the declaration of common stock dividends of $1.05 per common share for 2020:Three months endedTotal quarterly dividend per share for the periodDate of declarationDate of recordDate of dividendMarch 31, 2020$0.2625April 22, 2020May 4, 2020May 15, 2020June 30, 20200.2625July 22, 2020August 3, 2020August 17, 2020September 30, 20200.2625October 21, 2020November 2, 2020November 16, 2020December 31, 20200.2625January 20, 2021February 1, 2021February 16, 2021We expect to continue to return additional value to our shareholders in 2021 through our previously announced dividend increase. We plan to increase our dividend by 3% to $1.08 per common share in 2021. Based on our 2021 expectations, we also expect to have the capacity to engage in opportunistic share repurchases up to $450 million during the year under our $2 billion common share buy-back program approved by our board of directors in July 2017. Since December 2017, in total, we have repurchased approximately 32 million of our Class P shares under the program at an average price of approximately $17.71 per share for approximately $575 million. For information on our equity buy-back program and our equity distribution agreement, see Note 11 “Stockholders' Equity” to our consolidated financial statements.The actual amount of common stock dividends to be paid on our capital stock will depend on many factors, including our financial condition and results of operations, liquidity requirements, business prospects, capital requirements, legal, regulatory and contractual constraints, tax laws, Delaware laws and other factors. See Item 1A “Risk Factors—The guidance we provide 61for our anticipated dividends is based on estimates. Circumstances may arise that lead to conflicts between using funds to pay anticipated dividends or to invest in our business.” All of these matters will be taken into consideration by our board of directors in declaring dividends.Our common stock dividends are not cumulative. Consequently, if dividends on our common stock are not paid at the intended levels, our common stockholders are not entitled to receive those payments in the future. Our common stock dividends generally will be paid on or about the 15th day of each February, May, August and November. Summarized Combined Financial Information for Guarantee of Securities of SubsidiariesKMI and certain subsidiaries (Subsidiary Issuers) are issuers of certain debt securities. KMI and substantially all of KMI’s wholly owned domestic subsidiaries (Subsidiary Guarantors), are parties to a cross guarantee agreement whereby each party to the agreement unconditionally guarantees, jointly and severally, the payment of specified indebtedness of each other party to the agreement. Accordingly, with the exception of certain subsidiaries identified as Subsidiary Non-Guarantors, the parent issuer, subsidiary issuers and Subsidiary Guarantors (the “Obligated Group”) are all guarantors of each series of our guaranteed debt (Guaranteed Notes). As a result of the cross guarantee agreement, a holder of any of the Guaranteed Notes issued by KMI or subsidiary issuers are in the same position with respect to the net assets, and income of KMI and the Subsidiary Issuers and Guarantors. The only amounts that are not available to the holders of each of the Guaranteed Notes to satisfy the repayment of such securities are the net assets, and income of the Subsidiary Non-Guarantors.In lieu of providing separate financial statements for subsidiary issuers and guarantors, we have presented the accompanying supplemental summarized combined income statement and balance sheet information for the Obligated Group based on Rule 13-01 of the SEC’s Regulation S-X that we early adopted effective January 1, 2020. Also, see Exhibit 10.14 to this Report “Cross Guarantee Agreement, dated as of November 26, 2014, among KMI and certain of its subsidiaries, with schedules updated as of December 31, 2020.”All significant intercompany items among the Obligated Group have been eliminated in the supplemental summarized combined financial information. The Obligated Group’s investment balances in Subsidiary Non-guarantors have been excluded from the supplemental summarized combined financial information. Significant intercompany balances and activity for the Obligated Group with other related parties, including Subsidiary Non-Guarantors, (referred to as “affiliates”) are presented separately in the accompanying supplemental summarized combined financial information.Excluding fair value adjustments, as of December 31, 2020 and 2019, the Obligated Group had $32,563 million and $32,409 million, respectively, of Guaranteed Notes outstanding. Summarized combined balance sheet and income statement information for the Obligated Group follows:December 31,Summarized Combined Balance Sheet Information20202019(In millions)Current assets$2,957 $1,918 Current assets - affiliates1,151 1,146 Noncurrent assets61,783 63,298 Noncurrent assets - affiliates616 441 Total Assets$66,507 $66,803 Current liabilities$4,528 $4,569 Current liabilities - affiliates1,209 1,139 Noncurrent liabilities33,907 33,612 Noncurrent liabilities - affiliates1,078 1,325 Total Liabilities40,722 40,645 Redeemable noncontrolling interest728 803 Kinder Morgan, Inc.’s stockholders’ equity25,057 25,355 Total Liabilities, Redeemable Noncontrolling Interest and Stockholders’ Equity$66,507 $66,803 62Summarized Combined Income Statement InformationYear Ended December 31, 2020(In millions)Revenues$10,676 Operating income1,932 Net income654 Recent Accounting PronouncementsPlease refer to Note 19 “Recent Accounting Pronouncements” to our consolidated financial statements for information concerning recent accounting pronouncements.Item 7A. Quantitative and Qualitative Disclosures About Market Risk.Generally, our market risk sensitive instruments and positions have been determined to be “other than trading.” Our exposure to market risk as discussed below includes forward-looking statements and represents an estimate of possible changes in fair value or future earnings that would occur assuming hypothetical future movements in energy commodity prices or interest rates. Our views on market risk are not necessarily indicative of actual results that may occur and do not represent the maximum possible gains and losses that may occur, since actual gains and losses will differ from those estimated based on actual fluctuations in energy commodity prices or interest rates and the timing of transactions.Energy Commodity Market RiskWe are exposed to energy commodity market risk and other external risks in the ordinary course of business. However, we manage these risks by executing a hedging strategy that seeks to protect us financially against adverse price movements and serves to minimize potential losses. Our strategy involves the use of certain energy commodity derivative contracts to reduce and minimize the risks associated with unfavorable changes in the market price of crude oil, natural gas and NGL. The derivative contracts that we use include exchange-traded and OTC commodity financial instruments, including, but not limited to, futures and options contracts, fixed price swaps and basis swaps. We may categorize such use of energy commodity derivative contracts as cash flow hedges because the derivative contract is used to hedge the anticipated future cash flow of a transaction that is expected to occur but which value is uncertain.Our hedging strategy involves entering into a financial position intended to offset our physical position, or anticipated position, in order to minimize the risk of financial loss from an adverse price change. For example, as sellers of crude oil, natural gas and NGL, we often enter into fixed price swaps and/or futures contracts to guarantee or lock-in the sale price of our crude oil or the margin from the sale and purchase of our natural gas at the time of market delivery, thereby in whole or in part offsetting any change in prices, either positive or negative. Using derivative contracts for this purpose helps provide increased certainty with regard to operating cash flows which helps us to undertake further capital improvement projects, attain budget results and meet dividend targets.Our policies require that derivative contracts are only entered into with carefully selected major financial institutions or similar counterparties based upon their credit ratings and other factors, and we maintain strict dollar and term limits that correspond to our counterparties’ credit ratings. While it is our policy to enter into derivative transactions principally with investment grade counterparties and actively monitor their credit ratings, it is nevertheless possible that losses will result from counterparty credit risk in the future.The credit ratings of the primary parties from whom we transact in energy commodity derivative contracts (based on contract market values) are as follows (credit ratings per Standard & Poor’s Rating Service): Credit RatingINGA+CitibankA+JP MorganA+Bank of Nova ScotiaA+Bank of AmericaA-63We measure the risk of price changes in the derivative instrument portfolios utilizing a sensitivity analysis model. The sensitivity analysis applied to each portfolio measures the potential income or loss (i.e., the change in fair value of the derivative instrument portfolio) based upon a hypothetical 10% movement in the underlying quoted market prices. In addition to these variables, the fair value of each portfolio is influenced by fluctuations in the notional amounts of the instruments and the discount rates used to determine the present values. Because we enter into derivative contracts largely for the purpose of mitigating the risks that accompany certain of our business activities, both in the sensitivity analysis model and in reality, the change in the market value of the derivative contracts’ portfolio is offset largely by changes in the value of the underlying physical transactions. A hypothetical 10% movement in the underlying commodity prices would have the following effect on the associated derivative contracts’ estimated fair value:As of December 31,Commodity derivative20202019(In millions)Crude oil$81 $113 Natural gas12 8 NGL7 7 Total$100 $128 Our sensitivity analysis represents an estimate of the reasonably possible gains and losses that would be recognized on the crude oil, natural gas and NGL portfolios of derivative contracts assuming hypothetical movements in future market rates and is not necessarily indicative of actual results that may occur. It does not represent the maximum possible loss or any expected loss that may occur, since actual future gains and losses will differ from those estimated. Actual gains and losses may differ from estimates due to actual fluctuations in market rates, operating exposures and the timing thereof, as well as changes in our portfolio of derivatives during the year.Interest Rate RiskIn order to maintain a cost effective capital structure, it is our policy to borrow funds using a mix of fixed rate debt and variable rate debt. The market risk inherent in our debt instruments and positions is the potential change arising from increases or decreases in interest rates as discussed below.For fixed rate debt, changes in interest rates generally affect the fair value of the debt instrument, but not our earnings or cash flows. Conversely, for variable rate debt, changes in interest rates generally do not impact the fair value of the debt instrument, but may affect our future earnings and cash flows. Generally, there is not an obligation to prepay fixed rate debt prior to maturity and, as a result, changes in fair value should not have a significant impact on the fixed rate debt. We are generally subject to interest rate risk upon refinancing maturing debt. Below are our debt balances, including debt fair value adjustments and, as of December 31, 2019, the preferred interest in KMP held by KMGP that was redeemed on January 15, 2020, and sensitivity to interest rates: December 31, 2020December 31, 2019 CarryingvalueEstimatedfair value(e)CarryingvalueEstimatedfair value(e)(In millions)Fixed rate debt(a)$34,376 $39,306 $33,943 $37,588 Variable rate debt$313 $316 $449 $428 Notional principal amount of variable-to-fixed interest rate swap agreements(b)(2,750)(250)Notional principal amount of fixed-to-variable interest rate swap agreements(c)7,625 8,725 Debt balances subject to variable interest rates(d)$5,188 $8,924 (a)A hypothetical 10% change in the average interest rates applicable to such debt as of December 31, 2020 and 2019, would result in changes of approximately $1,541 million and $1,548 million, respectively, in the estimated fair values of these instruments.(b)December 31, 2020 amount includes $2.5 billion of variable-to-fixed interest rate swap agreements that expire during 2021.(c)December 31, 2020 amount includes $900 million of fixed-to-variable interest rate swap agreements that expire during 2021.64(d)A hypothetical 10% change in the weighted average interest rate on all of our borrowings (approximately 49 and 53 basis points, respectively, in 2020 and 2019) when applied to our outstanding balance of variable rate debt as of December 31, 2020 and 2019, including adjustments for the notional swap amounts described above, would result in changes of approximately $25 million and $47 million, respectively, in our 2020 and 2019 annual income before income taxes.(e)Fair values were determined using Level 2 inputs.Fixed-to-variable interest rate swap agreements are entered into for the purpose of converting a portion of the underlying cash flows related to long-term fixed rate debt securities into variable rate debt in order to achieve our desired mix of fixed and variable rate debt. Since the fair value of fixed rate debt varies with changes in the market rate of interest, swap agreements are entered into to receive a fixed and pay a variable rate of interest. Such swap agreements result in future cash flows that vary with the market rate of interest, and therefore hedge against changes in the fair value of the fixed rate debt due to market rate changes.As presented in the table above, we monitor the mix of fixed rate and variable rate debt obligations in light of changing market conditions and from time to time, may alter that mix by, for example, refinancing outstanding balances of variable rate debt with fixed rate debt (or vice versa) or by entering into interest rate swap agreements or other interest rate hedging agreements. As of December 31, 2020, including debt converted to variable rates through the use of interest rate swaps but excluding our debt fair value adjustments, approximately 16% of our debt balances were subject to variable interest rates.For more information on our interest rate risk management and on our interest rate swap agreements, see Note 14 “Risk Management” to our consolidated financial statements.LIBOR Phase OutAmounts drawn under our revolving credit facility may bear interest rates in relation to U.S. Dollar LIBOR (“USD LIBOR”), depending on our selection of repayment options, and certain of our outstanding interest rate swap agreements have a floating interest rate in relation to one-month LIBOR or three-month LIBOR. In July 2017, the Financial Conduct Authority in the U.K. announced a desire to phase out LIBOR as a benchmark by the end of 2021. The Alternative Reference Rates Committee, a steering committee consisting of large U.S. financial institutions convened by the U.S. Federal Reserve Board and the Federal Reserve Bank of New York, has recommended replacing LIBOR with the Secured Overnight Financing Rate (SOFR), an index supported by short-term Treasury repurchase agreements. On November 30, 2020, ICE Benchmark Administration (“IBA”), the administrator of USD LIBOR announced that it does not intend to cease publication of the remaining USD LIBOR tenors until June 30, 2023, providing additional time for existing contracts that are dependent on LIBOR to mature.The agreement governing our revolving credit facility includes provisions to determine a replacement rate for LIBOR if necessary during its term, which require that we and our administrative agent agree upon a replacement rate based on the then-prevailing market convention for similar agreements, which rate is not objected to by lenders holding a majority of the revolving commitments. The International Swaps and Derivatives Association has developed provisions for SOFR-based fall-back rates to apply upon permanent cessation of LIBOR and has published a protocol to enable market participants to include the new provisions in existing swap agreements.We currently do not expect the transition from LIBOR to have a material impact on us.Foreign Currency RiskAs of December 31, 2020, we had a notional principal amount of $1,358 million of cross-currency swap agreements that effectively convert all of our fixed-rate Euro denominated debt, including annual interest payments and the payment of principal at maturity, to U.S. dollar denominated debt at fixed rates. These swaps eliminate the foreign currency risk associated with our foreign currency denominated debt.
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+ITEM 7.MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.​The following discussion and analysis of financial condition and results of operations of The Kroger Co. should be read in conjunction with the “Forward-looking Statements” section set forth in Part I and the “Risk Factors” section set forth in Item 1A of Part I. MD&A is provided as a supplement to, and should be read in conjunction with, our Consolidated Financial Statements and the accompanying notes thereto contained in Item 8 of this report, as well as Part II, Item 7 “Management's Discussion and Analysis of Financial Condition and Results of Operations” of our Form 10-K for the year ended February 1, 2020, which provides additional information on comparisons of fiscal years 2019 and 2018.​EXECUTIVE SUMMARY – OUR PATH TO DELIVERING CONSISTENT AND ATTRACTIVE TOTAL SHAREHOLDER RETURN ​We are proud of our results in 2020 and the balance achieved in delivering for all our key stakeholders – our Associates, Customers, Communities and Investors. We gained market share and exceeded guidance that we gave in the second half of 2020. We committed more than $2.5 billion to safeguard the environment our associates and customers work and shop in and to reward associates, including a $1 billion commitment to a UFCW pension fund. Identical sales, without fuel, were 14.1% for 2020, as customers continued to consolidate trips and spend more per transaction. We grew digital sales triple digits in 2020, enabled by our team’s ability to pivot quickly and effectively in the first stage of the pandemic to ensure that we were meeting our customers’ demand for safe, low-touch or touchless shopping modalities. Our strong performance in digital is also a testament to the proactive investments we made over the last several years in our network, which positioned us to respond with agility during this critical time. We were disciplined in balancing investments in our customers and associates with cost savings. For the third year in a row, our operations and sourcing teams delivered over $1 billion in incremental cost savings. These savings continue to be focused in areas that take complexity out of the business and allow our associates to provide a better customer experience. Strong execution by our team and accelerated investments in our competitive moats – Fresh, Our Brands, Data & Personalization and Seamless, during the pandemic allowed us to create significant value for shareholders and strengthen our balance sheet, including accelerated growth in our alternative profit business. The momentum we see in our business, which started pre-pandemic and accelerated during the pandemic, places us in an even better position to grow sales and profitability in the future and deliver on our total shareholder return commitments.​Our financial model is underpinned by our leading position in food. We continue to invest in areas of the business that matter most to our customers and deepen our competitive moats, to drive sales growth in our retail supermarket business, including fuel and pharmacy. This in turn generates the data and traffic that enables our fast-growing alternative profit streams. Our financial strategy is to continue to use our free cash flow to invest in the business to drive long-term sustainable net earnings growth, through the identification of high-return projects that support our strategy. Capital allocation is a core element of our value creation model, and we will allocate capital towards driving profitable sales growth, accelerating digital, expanding margin as well as maintaining the business. We will continue to be disciplined in deploying capital towards projects that exceed our hurdle rate of return and prioritize the highest return opportunities to drive 3% to 5% net earnings growth. At the same time, we are committed to maintaining our net debt to adjusted EBITDA range of 2.30 to 2.50 in order to keep our current investment grade debt rating. Our resilient cash flow will allow us to continue to grow our dividend over time and continue to return excess cash to investors via share repurchases, resulting in consistently strong and sustainable total shareholder return of between 8% and 11%.​21 The following table provides highlights of our financial performance:​Financial Performance Data($ in millions, except per share amounts)​​​​​​​​​​​​​Fiscal Year​​​​ Percentage ​​​​2020​Change​2019​Sales​$ 132,498​ 8.4% $ 122,286​Sales without fuel​​ 123,012​ 13.7% ​ 108,234​Net earnings attributable to The Kroger Co.​​ 2,585​ 55.8% ​ 1,659​Adjusted net earnings attributable to The Kroger Co.​ 2,740​ 53.4% 1,786​Net earnings attributable to The Kroger Co. per diluted common share​ 3.27​ 60.3% 2.04​Adjusted net earnings attributable to The Kroger Co. per diluted common share​​ 3.47​ 58.4% 2.19​Operating profit​​ 2,780​ 23.5% ​ 2,251​Adjusted FIFO operating profit​​ 4,056​ 35.4% ​ 2,995​Dividends paid​​ 534​ 9.9% ​ 486​Dividends paid per common share​​ 0.68​ 13.3% ​ 0.60​Identical sales excluding fuel​​ 14.1% N/A​​ 2.0%FIFO gross margin rate, excluding fuel, bps increase (decrease)​​ 0.14​N/A​​ (0.23)​OG&A rate, excluding fuel and Adjusted Items, bps decrease​​ 0.06​N/A​​ 0.29​Reduction in total debt, including obligations under finance leases compared to prior fiscal year end​​ 663​N/A​​ 1,153​Share repurchases​​ 1,324​N/A​​ 465​​OVERVIEW Notable items for 2020 are: ​Shareholder Return​●Net earnings attributable to The Kroger Co. per diluted common share of $3.27.​●Adjusted net earnings attributable to The Kroger Co. per diluted common share of $3.47.​●Achieved operating profit of $2.8 billion.​●Achieved adjusted FIFO operating profit of $4.1 billion.​●Generated cash from operations of $6.8 billion.​●Increased cash and temporary cash investments by $1.3 billion, reflecting improved operating performance, significant improvements in working capital and the deferral of tax payments as a result of the Coronavirus Aid, Relief, and Economic Security Act (the “CARES Act”) which was enacted in the first quarter of 2020.​●Returned $1.9 billion to shareholders through share repurchases and dividend payments.​●Decreased total debt, including obligations under finance leases, by $663 million.​Other Financial Results​●Identical sales, excluding fuel, increased 14.1% in 2020. ​●Digital revenue grew 116% in 2020. Digital revenue primarily includes Pickup, Delivery, Ship and pharmacy e-commerce sales.​●Alternative profit streams contributed an incremental $150 million of operating profit in 2020 fueled by our retail media business – Kroger Precision Marketing.22 ●Cost savings for 2020 exceeded $1 billion.​Significant Events​●During the fourth quarter of 2020, certain of the Company’s associates ratified an agreement with certain UFCW local unions to withdraw from the UFCW International Union-Industry Pension Fund (“National Fund”). We incurred a withdrawal liability charge of $962 million, on a pre-tax basis, to fulfill obligations for past service for associates and retirees in the National Fund. We also made a $27 million commitment to a transition reserve in the new variable annuity pension plan. On an after-tax basis, the withdrawal liability and commitment to the transition reserve total $754 million (collectively, the “National Fund Commitment”). The withdrawal liability will be satisfied by payments to the National Fund over the next three years. ​●During 2020, we invested over $1.5 billion to support and safeguard associates, customers and communities during the COVID-19 pandemic. These investments primarily relate to items within OG&A such as associate appreciation awards, expanded sick and emergency leave pay and investments in associate and customer safety during the pandemic (collectively, the “COVID-19 Investments”). Supported by our strong performance and cash position, we committed more than $2.5 billion to safeguard the environment our associates and customers work and shop in and to reward associates, including the National Fund Commitment.​●During the first quarter of 2020, in addition to the recurring multi-employer pension contributions we make in the normal course of business, we contributed an incremental $236 million, $180 million net of tax, to multi-employer pension plans, helping stabilize future associate benefits (the “First Quarter 2020 Multi-Employer Pension Contribution”).​COVID-19​On March 11, 2020, the World Health Organization announced that infections of COVID-19 had become a pandemic, and on March 13, the U.S. President announced a National Emergency relating to the disease. The impact on our financial condition, results of operations, and cash flows was material in fiscal year 2020. We expect the ultimate significance will be dictated by the length of time that such circumstances continue, which will depend on the currently unknowable extent and duration of the COVID-19 pandemic and any governmental and public actions taken in response. ​Since the beginning of the pandemic, our most urgent priority has been to safeguard our associates and customers. We’ve implemented dozens of new safety and cleanliness processes and procedures in our stores and other facilities, including safety partitions and physical distancing floor decals, implementation of customer capacity limits, and providing personal protective equipment like masks for our associates. All of which are described in our Blueprint for Businesses – an open source guide we created to help other companies navigate the complexities of safely operating during a pandemic. ​As the pandemic has evolved, we have experienced unusually strong sales. We continue to see people eat and work more from home and prioritize health and cleanliness. The change in customer behavior caused by COVID-19 was a major factor in our 2020 results. The pandemic brought to the forefront the importance to the customer of fresh and digital. We continued to invest and grow our capabilities in these areas, leading to gains in both digital and total food at home market share. Identical sales, without fuel, were 14.1% for 2020, as customers continued to consolidate trips and spend more per transaction. Digital revenue grew 116% in 2020, enabled by our team’s ability to pivot quickly and effectively in the first stage of the pandemic to ensure that we were meeting our customers’ demand for safe, low-touch or touchless shopping modalities.​Our OG&A expenses include significant incremental costs related to investments in pay and benefits for our associates and measures to safeguard our associates and customers. Supported by our strong performance and cash position, in 2020 we committed more than $2.5 billion to safeguard the environment our associates and customers work and shop in and to reward associates, including committing nearly $1 billion to better secure pensions for over 30,000 associates. This was in addition to paid emergency leave, financial assistance through our Helping Hands program and more. As a percentage of sales, these incremental costs were partially offset by sales leverage resulting from strong sales growth due to the COVID-19 pandemic.​23 On March 18, 2020, we proactively borrowed $1 billion under the revolving credit facility. This was a precautionary measure in order to preserve financial flexibility, reduce reliance on the commercial paper market and maintain liquidity in response to the COVID-19 pandemic. Strong execution by our team and accelerated investments in our competitive moats during the pandemic allowed us to strengthen our balance sheet. During 2020, we fully repaid the $1 billion borrowed under the revolving credit facility and $1.2 billion in outstanding commercial paper obligations, as of year-end 2019, using cash generated by operations.​For additional information about our debt activity in 2020, including the drawdown and repayments under our revolving credit facility, forward-starting interest rate swap agreements and our senior note issuances, see Note 6 to the Consolidated Financial Statements. For additional information about our business results, including the impact of the COVID-19 pandemic, see our Results of Operations and Liquidity and Capital Resources sections within MD&A.​OUR BUSINESS​The Kroger Co. was founded in 1883 and incorporated in 1902. As of January 30, 2021, Kroger is one of the world’s largest retailers, as measured by revenue, operating 2,742 supermarkets under a variety of local banner names in 35 states and the District of Columbia. Of these stores, 2,255 have pharmacies and 1,596 have fuel centers. We offer Pickup (also referred to as ClickList®) and Harris Teeter ExpressLane™ — personalized, order online, pick up at the store services — at 2,223 of our supermarkets and provide home delivery service to substantially all of Kroger households. We also operate an online retailer.​We operate 35 food production plants, primarily bakeries and dairies, which supply approximately 29% of Our Brands units and 40% of the grocery category Our Brands units sold in our supermarkets; the remaining Our Brands items are produced to our strict specifications by outside manufacturers. ​Our revenues are predominately earned and cash is generated as consumer products are sold to customers in our stores, fuel centers and via our online platforms. We earn income predominately by selling products at price levels that produce revenues in excess of the costs we incur to make these products available to our customers. Such costs include procurement and distribution costs, facility occupancy and operational costs, and overhead expenses. Our retail operations, which represent 97% of our consolidated sales, is our only reportable segment.​On January 27, 2020, Lucky’s Market filed a voluntary petition in the Bankruptcy Court seeking relief under the Bankruptcy Code. Lucky’s Market is included in our Consolidated Statements of Operations in all periods in 2018 and through January 26, 2020. Refer to Note 17 to the Consolidated Financial Statements for additional information.​On April 26, 2019, we completed the sale of our Turkey Hill Dairy business for total proceeds of $225 million. Turkey Hill Dairy is included in our Consolidated Statements of Operations in all periods in 2018 and through April 25, 2019.​On March 13, 2019, we completed the sale of our You Technology business to Inmar for total consideration of $565 million, including $396 million of cash and $64 million of preferred equity received upon closing. We are also entitled to receive other cash payments of $105 million over five years. The transaction includes a long-term service agreement for Inmar to provide us digital coupon services. You Technology is included in our Consolidated Statements of Operations in all periods in 2018 and through March 12, 2019.​On June 22, 2018, we closed our merger with Home Chef by purchasing 100% of the ownership interest in Home Chef, for $197 million net of cash and cash equivalents of $30 million, in addition to future earnout payments of up to $500 million over five years that are contingent on achieving certain milestones. Home Chef is included in our ending Consolidated Balance Sheet for 2019 and 2020 and in our Consolidated Statements of Operations from June 22, 2018 through February 2, 2019 and all periods in 2019 and 2020. See Note 2 to the Consolidated Financial Statements for more information related to our merger with Home Chef.​On April 20, 2018, we completed the sale of our convenience store business unit for $2.2 billion. The convenience store business is included in our Consolidated Statements of Operations through April 19, 2018.​24 USE OF NON-GAAP FINANCIAL MEASURES The accompanying Consolidated Financial Statements, including the related notes, are presented in accordance with generally accepted accounting principles (“GAAP”). We provide non-GAAP measures, including First-In, First-Out (“FIFO”) gross margin, FIFO operating profit, adjusted net earnings and adjusted net earnings per diluted share because management believes these metrics are useful to investors and analysts. These non-GAAP financial measures should not be considered as an alternative to gross margin, operating profit, net earnings and net earnings per diluted share or any other GAAP measure of performance. These measures should not be reviewed in isolation or considered as a substitute for our financial results as reported in accordance with GAAP. ​We calculate FIFO gross margin as FIFO gross profit divided by sales. FIFO gross profit is calculated as sales less merchandise costs, including advertising, warehousing, and transportation expenses, but excluding the Last-In, First-Out (“LIFO”) charge. Merchandise costs exclude depreciation and rent expenses. FIFO gross margin is an important measure used by management as management believes FIFO gross margin is a useful metric to investors and analysts because it measures our day-to-day merchandising and operational effectiveness.​We calculate FIFO operating profit as operating profit excluding the LIFO charge. FIFO operating profit is an important measure used by management as management believes FIFO operating profit is a useful metric to investors and analysts because it measures our day-to-day operational effectiveness. The adjusted net earnings and adjusted net earnings per diluted share metrics are important measures used by management to compare the performance of core operating results between periods. We believe adjusted net earnings and adjusted net earnings per diluted share are useful metrics to investors and analysts because they present more accurate year-over-year comparisons for our net earnings and net earnings per diluted share because adjusted items are not the result of our normal operations. Net earnings for 2020 include the following, which we define as the “2020 Adjusted Items:”​●Charges to OG&A of $989 million, $754 million net of tax, for commitments to certain multi-employer pension funds, $189 million, $141 million net of tax, for the revaluation of Home Chef contingent consideration and $111 million, $81 million net of tax, for transformation costs (the “2020 OG&A Adjusted Items”).​●Gains in other income (expense) of $1.1 billion, $821 million net of tax, for the gain on investments (the “2020 Other Income (Expense) Adjusted Item”).​Net earnings for 2019 include the following, which we define as the “2019 Adjusted Items:”​●Charges to OG&A of $135 million, $104 million net of tax, for obligations related to withdrawal liabilities for certain multi-employer pension funds; $80 million, $61 million net of tax, for a severance charge and related benefits; $412 million including $305 million attributable to The Kroger Co., $225 million net of tax, for impairment of Lucky’s Market; $52 million, $37 million net of tax, for transformation costs, primarily including 35 planned store closures; and a reduction to OG&A of $69 million, $49 million net of tax, for the revaluation of Home Chef contingent consideration (the “2019 OG&A Adjusted Items”).​●Gains in other income (expense) of $106 million, $80 million net of tax, related to the sale of Turkey Hill Dairy; $70 million, $52 million net of tax, related to the sale of You Technology; and $157 million, $119 million net of tax, for the mark to market gain on Ocado Group plc (“Ocado”) securities (the “2019 Other Income (Expense) Adjusted Items”).​Net earnings for 2018 include the following, which we define as the “2018 Adjusted Items:”​●Charges to OG&A of $155 million, $121 million net of tax, for obligations related to withdrawal liabilities for certain local unions of the Central States multi-employer pension fund; $33 million, $26 million net of tax, for the revaluation of Home Chef contingent consideration; and $42 million, $33 million net of tax, for an impairment of financial instrument (the “2018 OG&A Adjusted Items”). We had initially received the financial instrument in 2016 with no cash outlay as part of the consideration for entering into agreements with a third party.25 ●A reduction to depreciation and amortization expenses of $14 million, $11 million net of tax, related to held for sale assets (the “2018 Depreciation Adjusted Item”).​●Gains in other income (expense) of $1.8 billion, $1.4 billion net of tax, related to the sale of our convenience store business unit and $228 million, $174 million net of tax, for the mark to market gain on Ocado securities.​The following table provides a reconciliation of net earnings attributable to The Kroger Co. to adjusted net earnings attributable to The Kroger Co. and a reconciliation of net earnings attributable to The Kroger Co. per diluted common share to adjusted net earnings attributable to The Kroger Co. per diluted common share, excluding the 2020, 2019 and 2018 Adjusted Items.​26 Net Earnings per Diluted Share excluding the Adjusted Items($ in millions, except per share amounts)​​​​​​​​​​​​​ 2020 2019 2018 Net earnings attributable to The Kroger Co.​$ 2,585​$ 1,659​$ 3,110​(Income) expense adjustments​​​​​​​​​​Adjustments for pension plan withdrawal liabilities(1)(2)​ 754​ 104​ 121​Adjustment for gain on sale of convenience store business(1)(3)​​ —​​ —​​ (1,360)​Adjustment for gain on sale of Turkey Hill Dairy(1)(4)​​ —​​ (80)​​ —​Adjustment for gain on sale of You Technology(1)(5)​​ —​​ (52)​​ —​Adjustment for gain on investments(1)(6)​​ (821)​​ (119)​​ (174)​Adjustment for depreciation related to held for sale assets(1)(7)​​ —​​ —​​ (11)​Adjustment for severance charge and related benefits(1)(8)​​ —​​ 61​​ —​Adjustment for deconsolidation and impairment of Lucky's Market attributable to The Kroger Co.(1)(9)​​ —​​ 225​​ —​Adjustment for Home Chef contingent consideration(1)(10)​​ 141​​ (49)​​ 26​Adjustment for impairment of financial instrument(1)(11)​​ —​​ —​​ 33​Adjustment for transformation costs(1)(12)​​ 81​​ 37​​ —​Total Adjusted Items​​ 155​​ 127​​ (1,365)​​​​​​​​​​​​Net earnings attributable to The Kroger Co. excluding the Adjusted Items​$ 2,740​$ 1,786​$ 1,745​​​​​​​​​​​​Net earnings attributable to The Kroger Co. per diluted common share​$ 3.27​$ 2.04​$ 3.76​(Income) expense adjustments​​​​​​​​​​Adjustments for pension plan withdrawal liabilities(13)​ 0.95​ 0.13​ 0.15​Adjustment for gain on sale of convenience store business(13)​​ —​​ —​​ (1.65)​Adjustment for gain on sale of Turkey Hill Dairy(13)​​ —​​ (0.10)​​ —​Adjustment for gain on sale of You Technology(13)​​ —​​ (0.06)​​ —​Adjustment for gain on investments(13)​​ (1.05)​​ (0.15)​​ (0.21)​Adjustment for depreciation related to held for sale assets(13)​​ —​​ —​​ (0.01)​Adjustment for severance charge and related benefits(13)​​ —​​ 0.08​​ —​Adjustment for deconsolidation and impairment of Lucky's Market attributable to The Kroger Co.(13)​​ —​​ 0.28​​ —​Adjustment for Home Chef contingent consideration(13)​​ 0.18​​ (0.07)​​ 0.03​Adjustment for impairment of financial instrument(13)​​ —​​ —​​ 0.04​Adjustment for transformation costs(13)​​ 0.12​​ 0.04​​ —​Total Adjusted Items​​ 0.20​​ 0.15​​ (1.65)​​​ ​​​​​​​​Net earnings attributable to The Kroger Co. per diluted common share excluding the Adjusted Items​$ 3.47​$ 2.19​$ 2.11​​​​​​​​​​​​Average numbers of common shares used in diluted calculation​ 781​ 805​ 818​(1)The amounts presented represent the after-tax effect of each adjustment, which was calculated using discrete tax rates. (2)The pre-tax adjustment for pension plan withdrawal liabilities was $989 in 2020, $135 in 2019 and $155 in 2018. (3)The pre-tax adjustment for gain on sale of convenience store business was ($1,782).(4)The pre-tax adjustment for gain on sale of Turkey Hill Dairy was ($106).(5)The pre-tax adjustment for gain on sale of You Technology was ($70).(6)The pre-tax adjustment for gain on investments was ($1,105) in 2020, ($157) in 2019 and ($228) in 2018.(7)The pre-tax adjustment for depreciation related to held for sale assets was ($14) in 2018.(8)The pre-tax adjustment for severance charge and related benefits was $80.(9)The pre-tax adjustment for deconsolidation and impairment of Lucky’s Market was $412 including $305 attributable to The Kroger Co.(10)The pre-tax adjustment for Home Chef contingent consideration was $189 in 2020, ($69) in 2019 and $33 in 2018.(11)The pre-tax adjustment for impairment of financial instrument was $42.(12)The pre-tax adjustment for transformation costs was $111 in 2020 and $52 in 2019. Transformation costs primarily include costs related to store and business closures and third-party professional consulting fees associated with business transformation and cost saving initiatives.(13)The amount presented represents the net earnings per diluted common share effect of each adjustment.​27 RESULTS OF OPERATIONS​Sales​Total Sales($ in millions)​​​​​​​​​​​​​​​​​​​​ ​ Percentage ​ Percentage ​​ ​​2020​Change(1)​2019​Change(2)​2018​Total sales to retail customers without fuel(3)​$ 122,134​ 13.6% $ 107,487​ 2.2% $ 105,123​Supermarket fuel sales​​ 9,486​ (32.5)% 14,052​ (5.7)% 14,903​Convenience stores(4)​ —​ —% —​ —% 944​Other sales(5)​ 878​ 17.5% 747​ (15.3)% 882​Total sales​$ 132,498​ 8.4% $ 122,286​ 0.4% $ 121,852​(1)This column represents the percentage change in 2020 compared to 2019.(2)This column represents the percentage change in 2019 compared to 2018.(3)Digital sales, primarily including Pickup, Delivery, Ship and pharmacy e-commerce sales, grew approximately 116% in 2020, 29% in 2019 and 58% in 2018. These sales are included in the “total sales to retail customers without fuel” line above. (4)We completed the sale of our convenience store business unit during the first quarter of 2018.(5)Other sales primarily relate to external sales at food production plants, data analytic services and third-party media revenue. The increase in 2020, compared to 2019, is primarily due to growth in third-party media revenue, partially offset by decreased sales due to the disposal of Turkey Hill Dairy and You Technology in the first quarter of 2019. The decrease in 2019, compared to 2018, is primarily due to the disposal of Turkey Hill Dairy and You Technology in the first quarter of 2019, partially offset by an increase in data analytic services and third-party media revenue.​Total sales increased in 2020, compared to 2019, by 8.4%. The increase was due to an increase in total sales to retail customers without fuel, partially offset by a reduction in supermarket fuel sales and decreased sales due to the disposal of Turkey Hill Dairy and You Technology in the first quarter of 2019. Total sales to retail customers without fuel increased 13.6% in 2020, compared to 2019. The increase was primarily due to our identical sales increase, excluding fuel, of 14.1%, partially offset by decreased sales due to the deconsolidation of Lucky’s Market in the fourth quarter of 2019. Total sales excluding fuel and dispositions increased 14.2% in 2020 compared to 2019. The significant increase in identical sales, excluding fuel, was caused by unprecedented demand due to the COVID-19 pandemic, digital sales growth and growth in market share. Market share growth contributed to our identical sales increase, excluding fuel, as our sales outpaced the general growth in the food retail industry during 2020. The increase in identical sales, excluding fuel, was broad based across all supermarket divisions and remained heightened throughout 2020. During the pandemic, customers reduced trips while significantly increasing basket value.​Total supermarket fuel sales decreased 32.5% in 2020, compared to 2019, primarily due to a decrease in fuel gallons sold of 17.5% and a decrease in the average retail fuel price of 18.2%. The decrease in fuel gallons sold was reflective of the national trend, which decreased due to the COVID-19 pandemic. The decrease in the average retail fuel price was caused by a decrease in the product cost of fuel.​Total sales increased in 2019, compared to 2018, by 0.4%. The increase was due to an increase in total sales to retail customers without fuel, partially offset by decreased supermarket fuel sales, a reduction in convenience store sales due to the sale of our convenience store business unit in the first quarter of 2018 and decreased sales due to the disposal of Turkey Hill Dairy and You Technology in the first quarter of 2019. Total sales, excluding fuel, dispositions and the merger with Home Chef increased 2.3% in 2019, compared to 2018. The increase in total sales to retail customers without fuel for 2019, compared to 2018, was primarily due to our merger with Home Chef and our identical sales increase, excluding fuel, of 2.0%. Identical sales, excluding fuel, for 2019, compared to 2018, increased primarily due to growth of loyal households, a higher customer basket value including retail inflation and Kroger Specialty Pharmacy sales growth, partially offset by continued investments in lower prices for our customers. ​Total supermarket fuel sales decreased 5.7% in 2019, compared to 2018, primarily due to a decrease in fuel gallons sold of 4.8% and a decrease in the average retail fuel price of 1.0%. The decrease in the average retail fuel price was caused by a decrease in the product cost of fuel.​28 We calculate identical sales, excluding fuel, as sales to retail customers, including sales from all departments at identical supermarket locations, Kroger Specialty Pharmacy businesses and ship-to-home solutions. We define a supermarket as identical when it has been in operation without expansion or relocation for five full quarters. Although identical sales is a relatively standard term, numerous methods exist for calculating identical sales growth. As a result, the method used by our management to calculate identical sales may differ from methods other companies use to calculate identical sales. We urge you to understand the methods used by other companies to calculate identical sales before comparing our identical sales to those of other such companies. Our identical sales, excluding fuel, results are summarized in the following table. We used the identical sales, excluding fuel, dollar figures presented below to calculate percentage changes for 2020 and 2019.​Identical Sales($ in millions)​​​​​​​​​​ 2020 2019 Excluding fuel​$ 120,762​$ 105,806​Excluding fuel​ 14.1% 2.0%​Gross Margin, LIFO and FIFO Gross Margin​We define gross margin as sales minus merchandise costs, including advertising, warehousing, and transportation. Rent expense, depreciation and amortization expense, and interest expense are not included in gross margin.​Our gross margin rates, as a percentage of sales, were 23.32% in 2020 and 22.07% in 2019. The increase in 2020, compared to 2019, resulted primarily from decreased fuel sales, which have a lower gross margin rate, an increase in our fuel gross margin, growth in our alternative profit stream portfolio, effective negotiations to achieve savings on the cost of products sold and decreased shrink, transportation and advertising costs, as a percentage of sales, reflecting the significant increase in sales volumes, partially offset by continued investments in lower prices for our customers and a change in our product sales mix, including lower relative sales in higher gross margin categories such as deli/bakery.​Our LIFO credit was $7 million in 2020 compared to a LIFO charge of $105 million in 2019. Our LIFO credit was primarily driven by fourth quarter 2020 working capital improvements in pharmacy inventory and dairy deflation. ​Our FIFO gross margin rate, which excludes the LIFO charge, was 23.32% in 2020, compared to 22.16% in 2019. Our fuel sales lower our FIFO gross margin rate due to the very low FIFO gross margin rate, as a percentage of sales, of fuel sales compared to non-fuel sales. Excluding the effect of fuel, our FIFO gross margin rate increased 14 basis points in 2020, compared to 2019. This increase resulted primarily from growth in our alternative profit stream portfolio, effective negotiations to achieve savings on the cost of products sold and decreased shrink, transportation and advertising costs, as a percentage of sales, reflecting the significant increase in sales volumes, partially offset by continued investments in lower prices for our customers and a change in our product sales mix, including lower relative sales in higher gross margin categories such as deli/bakery.​Operating, General and Administrative Expenses​OG&A expenses consist primarily of employee-related costs such as wages, healthcare benefit costs, retirement plan costs, utilities, and credit card fees. Rent expense, depreciation and amortization expense, and interest expense are not included in OG&A.​OG&A expenses, as a percentage of sales, were 18.49% in 2020 and 17.34% in 2019. The increase in 2020, compared to 2019, resulted primarily from the First Quarter 2020 Multi-Employer Pension Contribution, the 2020 OG&A Adjusted Items, the COVID-19 Investments, growth in our digital channel as a result of heightened demand during the pandemic, increased incentive plan costs and the effect of decreased fuel sales, which increases our OG&A rate, as a percentage of sales, partially offset by the effect of increased sales due to the pandemic which decreases our OG&A rate, as a percentage of sales, the 2019 OG&A Adjusted Items and broad based improvement from cost savings initiatives that drive administrative efficiencies, store productivity and sourcing cost reductions.​29 Our fuel sales lower our OG&A rate, as a percentage of sales, due to the very low OG&A rate, as a percentage of sales, of fuel sales compared to non-fuel sales. Excluding the effect of fuel, the 2020 OG&A Adjusted Items and the 2019 OG&A Adjusted Items, our OG&A rate decreased 6 basis points in 2020, compared to 2019. This decrease resulted primarily from the effect of increased sales due to the pandemic which decreases our OG&A rate, as a percentage of sales and broad based improvement from cost savings initiatives that drive administrative efficiencies, store productivity and sourcing cost reductions, partially offset by the First Quarter 2020 Multi-Employer Pension Contribution, the COVID-19 Investments, growth in our digital channel as a result of heightened demand during the pandemic and increased incentive plan costs. Excluding the $236 million First Quarter 2020 Multi-Employer Pension Contribution from the above calculation, which we proactively made to cover future funding requirements for certain multi-employer pension plans, our OG&A rate improved 25 basis points.​Rent Expense​Rent expense was $874 million, or 0.66% of sales, for 2020, compared to $884 million, or 0.72% of sales, for 2019. Rent expense, as a percentage of sales, decreased 6 basis points in 2020, compared to 2019, primarily due to the effect of increased sales due to the pandemic which decreases our rent expense, as a percentage of sales.​Depreciation and Amortization Expense​Depreciation and amortization expense was $2.7 billion, or 2.07% of sales, for 2020, compared to $2.6 billion, or 2.17% of sales, for 2019. Depreciation and amortization expense, as a percentage of sales, decreased 10 basis points in 2020, compared to 2019. This decrease resulted primarily from the effect of increased sales due to the pandemic which decreases our depreciation expense, as a percentage of sales, partially offset by decreased fuel sales, which increases our depreciation expense, as a percentage of sales, additional depreciation on capital investments, excluding mergers and lease buyouts, of $3.2 billion during 2020 and a decrease in the average useful life on these capital investments. Our strategy includes initiatives to enhance the customer experience in stores, improve our process efficiency and integrate our digital shopping experience through technology developments. As such, the percentage of capital investments related to digital and technology has grown compared to the prior year, which has caused a decrease in the average depreciable life of our capital portfolio.​Operating Profit and FIFO Operating Profit​Operating profit was $2.8 billion, or 2.10% of sales, for 2020, compared to $2.3 billion, or 1.84% of sales, for 2019. Operating profit, as a percentage of sales, increased 26 basis points in 2020, compared to 2019, due to improved sales to retail customers without fuel, a higher gross margin rate, decreased rent and depreciation and amortization expenses, as a percentage of sales, and increased fuel earnings, partially offset by increased OG&A expense with fuel, as a percentage of sales.​FIFO operating profit was $2.8 billion, or 2.09% of sales, for 2020, compared to $2.4 billion, or 1.93% of sales, for 2019. FIFO operating profit, excluding the 2020 and 2019 Adjusted Items, increased 64 basis points in 2020, compared to 2019, due to improved sales to retail customers without fuel, a higher gross margin rate, decreased rent and depreciation and amortization expenses, as a percentage of sales, and increased fuel earnings, partially offset by increased OG&A expense with fuel, as a percentage of sales.​Specific factors contributing to the trends driving operating profit and FIFO operating profit identified above are discussed earlier in this section.​30 The following table provides a reconciliation of operating profit to FIFO operating profit, excluding the 2020 and 2019 Adjusted Items.​Operating Profit excluding the Adjusted Items($ in millions)​​​​​​​​​​ 2020 2019​Operating profit​$ 2,780​$ 2,251​LIFO (credit) charge​​ (7)​​ 105​​​ ​​​​​FIFO Operating profit​ 2,773​ 2,356​​​​​​​​​Adjustment for pension plan withdrawal liabilities​​ 989​​ 135​Adjustment for Home Chef contingent consideration​​ 189​​ (69)​Adjustment for severance charge and related benefits​​ —​​ 80​Adjustment for transformation costs(1)​​ 111​​ 52​Adjustment for deconsolidation and impairment of Lucky's Market(2)​​ —​​ 412​Other​​ (6)​​ 29​​​​​​​​​2020 and 2019 Adjusted items​​ 1,283​​ 639​​​​​​​​​Adjusted FIFO operating profit excluding the adjustment items above​$ 4,056​$ 2,995​(1)Transformation costs primarily include costs related to store and business closures and third-party professional consulting fees associated with business transformation and cost saving initiatives.(2)The adjustment for impairment of Lucky’s Market includes a $107 million net loss attributable to the minority interest of Lucky’s Market.​Interest Expense​Interest expense totaled $544 million in 2020 and $603 million in 2019. The decrease in interest expense in 2020, compared to 2019, resulted primarily from decreased borrowings. Over the last 12 months, we decreased total debt, including obligations under finance leases, by $663 million. ​Income Taxes​Our effective income tax rate was 23.2% in 2020 and 23.7% in 2019. The 2020 tax rate differed from the federal statutory rate primarily due to the effect of state income taxes, partially offset by the utilization of tax credits and deductions. The 2019 tax rate differed from the federal statutory rate primarily due to the effect of state income taxes and Lucky’s Market losses attributable to the noncontrolling interest which reduced pre-tax income but did not impact tax expense.​Net Earnings and Net Earnings Per Diluted Share​Our net earnings are based on the factors discussed in the Results of Operations section.​Net earnings were $3.27 per diluted share for 2020 compared to net earnings of $2.04 per diluted share for 2019. Adjusted net earnings of $3.47 per diluted share for 2020 represented an increase of 58.4% compared to adjusted net earnings of $2.19 per diluted share for 2019. The increase in adjusted net earnings per diluted share resulted primarily from increased FIFO operating profit without fuel, the decrease in the LIFO charge, increased fuel earnings and lower weighted average common shares outstanding due to common share repurchases, partially offset by a higher income tax expense.​31 COMMON SHARE REPURCHASE PROGRAMS​We maintain share repurchase programs that comply with Rule 10b5-1 of the Securities Exchange Act of 1934 and allow for the orderly repurchase of our common shares, from time to time. The share repurchase programs do not have an expiration date but may be suspended or terminated by our Board of Directors at any time. We made open market purchases of our common shares totaling $1.2 billion in 2020 and $400 million in 2019. ​In addition to these repurchase programs, we also repurchase common shares to reduce dilution resulting from our employee stock option plans. This program is solely funded by proceeds from stock option exercises, and the tax benefit from these exercises. We repurchased approximately $128 million in 2020 and $65 million in 2019 of our common shares under the stock option program.​On November 5, 2019, our Board of Directors approved a $1.0 billion share repurchase program to reacquire shares via open market purchase or privately negotiated transactions, block trades, or pursuant to trades intending to comply with Rule 10b5-1 under the Securities Exchange Act of 1934, as amended (the “November 2019 Repurchase Program”). On September 11, 2020, our Board of Directors approved a $1.0 billion share repurchase program to reacquire shares via open market purchase or privately negotiated transactions, block trades, or pursuant to trades intending to comply with Rule 10b5-1 under the Securities Exchange Act of 1934, as amended (the “September 2020 Repurchase Program”). The September 2020 Repurchase Program authorization replaced the existing November 2019 Repurchase Program.​The shares repurchased in 2020 were reacquired under the following share repurchase programs: ​●The November 2019 Repurchase Program.​●The September 2020 Repurchase Program. ​●A program announced on December 6, 1999 to repurchase common shares to reduce dilution resulting from our employee stock option and long-term incentive plans, under which repurchases are limited to proceeds received from exercises of stock options and the tax benefits associated therewith (“1999 Repurchase Program”).​As of January 30, 2021, there was $400 million remaining under the September 2020 Repurchase Program.​During the first quarter through March 24, 2021, we repurchased an additional $36 million of our common shares under the stock option program and $191 million additional shares under the September 2020 Repurchase Program. As of March 24, 2021, we have $209 million remaining under the September 2020 Repurchase Program.​CAPITAL INVESTMENTS​Capital investments, including changes in construction-in-progress payables and excluding mergers and the purchase of leased facilities, totaled $3.2 billion in 2020 and $3.0 billion in 2019. Capital investments for the purchase of leased facilities totaled $58 million in 2020 and $82 million in 2019. The table below shows our supermarket storing activity and our total supermarket square footage:​32 Supermarket Storing Activity​​​​​​​​​​ 2020 2019 2018 Beginning of year 2,757 2,764 2,782​Opened 5 10 10​Opened (relocation) 6 9 4​Acquired — 6 10​Closed (operational) (20) (19) (38)​Closed (relocation) (6) (13) (4)​End of year 2,742 2,757 2,764​​​​​​​​​Total supermarket square footage (in millions) 179 180 179​​RETURN ON INVESTED CAPITAL​We calculate return on invested capital (“ROIC”) by dividing adjusted ROIC operating profit for the prior four quarters by the average invested capital. Adjusted operating profit for ROIC purposes is calculated by excluding certain items included in operating profit, and adding back our LIFO charge (credit), depreciation and amortization and rent to our U.S. GAAP operating profit of the prior four quarters. Average invested capital is calculated as the sum of (i) the average of our total assets, (ii) the average LIFO reserve, (iii) the average accumulated depreciation and amortization and (iv) for 2019, an adjustment due to the adoption of ASU 2016-02, “Leases,” at the beginning of 2019 as further described in Notes 10 and 18 to the Consolidated Financial Statements; minus (i) the average taxes receivable, (ii) the average trade accounts payable, (iii) the average accrued salaries and wages, (iv) the average other current liabilities, excluding accrued income taxes, (v) the average liabilities held for sale and (vi) certain other adjustments. Averages are calculated for ROIC by adding the beginning balance of the first quarter and the ending balance of the fourth quarter, of the last four quarters, and dividing by two. ROIC is a non-GAAP financial measure of performance. ROIC should not be reviewed in isolation or considered as a substitute for our financial results as reported in accordance with GAAP. ROIC is an important measure used by management to evaluate our investment returns on capital. Management believes ROIC is a useful metric to investors and analysts because it measures how effectively we are deploying our assets.​Although ROIC is a relatively standard financial term, numerous methods exist for calculating a company’s ROIC. As a result, the method used by our management to calculate ROIC may differ from methods other companies use to calculate their ROIC. We urge you to understand the methods used by other companies to calculate their ROIC before comparing our ROIC to that of such other companies.​33 The following table provides a calculation of ROIC for 2020 and 2019 on a 52 week basis ($ in millions). The 2019 calculation of ROIC excludes the financial position and results of operations of You Technology and Turkey Hill Dairy, due to the sales in 2019, and Lucky’s Market, due to the deconsolidation in 2019. ​​​​​​​​​​​Fiscal Year Ended​​​January 30,​February 1,​​ 2021​2020 Return on Invested Capital​​​​​​​Numerator​​​​​​​Operating profit​$ 2,780​$ 2,251​LIFO charge (credit)​ (7)​ 105​Depreciation and amortization​ 2,747​ 2,649​Rent​ 874​ 884​Adjustment for Home Chef contingent consideration​​ 189​​ (69)​Adjustment for pension plan withdrawal liabilities​​ 989​​ 135​Adjustment for severance charge and related benefits​​ —​​ 80​Adjustment for transformation costs ​​ 111​​ 52​Adjustment for deconsolidation and impairment of Lucky's Market​​ —​​ 412​Adjustment for operating losses of Lucky's Market​​ —​​ 75​Adjustment for disposal of You Technology​ —​ (49)​Adjusted ROIC operating profit​$ 7,683​$ 6,525​​​​​​​​​Denominator​​​​​​​Average total assets​$ 46,959​$ 41,687​Average taxes receivable(1)​ (74)​ (41)​Average LIFO reserve​ 1,377​ 1,329​Average accumulated depreciation and amortization​ 24,161​ 23,404​Average trade accounts payable​ (6,514)​ (6,204)​Average accrued salaries and wages​ (1,291)​ (1,198)​Average other current liabilities(2)​ (4,926)​ (3,942)​Average liabilities held for sale​ —​ (26)​Adjustment for disposal of Turkey Hill Dairy​​ —​​ (45)​Adjustment for disposal of You Technology​​ —​​ (13)​Adjustment for deconsolidation of Lucky's Market​​ —​​ (25)​Initial operating lease assets at adoption of ASU 2016-02, “Leases” (see Notes 10 and 18)​ —​ 3,406​Average invested capital​$ 59,692​$ 58,332​Return on Invested Capital​ 12.87% 11.19%(1)Taxes receivable were $66 as of January 30, 2021 and $82 as of February 1, 2020. We did not have any taxes receivable as of February 2, 2019.(2)Other current liabilities included accrued income taxes of $9 as of January 30, 2021 and $60 as of February 2, 2019. We did not have any accrued income taxes as of February 1, 2020. Accrued income taxes are removed from other current liabilities in the calculation of average invested capital.​34 CRITICAL ACCOUNTING POLICIES​We have chosen accounting policies that we believe are appropriate to report accurately and fairly our operating results and financial position, and we apply those accounting policies in a consistent manner. Our significant accounting policies are summarized in Note 1 to the Consolidated Financial Statements.​The preparation of financial statements in conformity with GAAP requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues, and expenses, and related disclosures of contingent assets and liabilities. We base our estimates on historical experience and other factors we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results could differ from those estimates.​We believe the following accounting policies are the most critical in the preparation of our financial statements because they involve the most difficult, subjective or complex judgments about the effect of matters that are inherently uncertain.​Impairments of Long-Lived Assets​We monitor the carrying value of long-lived assets for potential impairment each quarter based on whether certain triggering events have occurred. These events include current period losses combined with a history of losses or a projection of continuing losses or a significant decrease in the market value of an asset. When a triggering event occurs, we perform an impairment calculation, comparing projected undiscounted cash flows, utilizing current cash flow information and expected growth rates related to specific stores, to the carrying value for those stores. If we identify impairment for long-lived assets to be held and used, we compare the assets’ current carrying value to the assets’ fair value. Fair value is determined based on market values or discounted future cash flows. We record impairment when the carrying value exceeds fair market value. With respect to owned property and equipment held for disposal, we adjust the value of the property and equipment to reflect recoverable values based on our previous efforts to dispose of similar assets and current economic conditions. We recognize impairment for the excess of the carrying value over the estimated fair market value, reduced by estimated direct costs of disposal. ​We recorded asset impairments in the normal course of business totaling $70 million in 2020. In 2019, we recognized an impairment charge related to Lucky’s Market totaling $238 million. The Lucky’s Market impairment charge consisted of property, plant and equipment of $200 million; goodwill of $19 million; operating lease assets of $11 million; and other charges of $8 million. Additionally, we recorded asset impairments totaling $120 million in 2019, including $70 million of operating lease assets. This 2019 impairment charge included the 35 planned store closures across our footprint in 2020 related to our transformation efforts. We record costs to reduce the carrying value of long-lived assets in the Consolidated Statements of Operations as OG&A expense.​The factors that most significantly affect the impairment calculation are our estimates of future cash flows. Our cash flow projections look several years into the future and include assumptions on variables such as inflation, the economy and market competition. Application of alternative assumptions and definitions, such as reviewing long-lived assets for impairment at a different level, could produce significantly different results.​Business Combinations​We account for business combinations using the acquisition method of accounting. All the assets acquired, liabilities assumed and amounts attributable to noncontrolling interests are recorded at their respective fair values at the date of acquisition once we obtain control of an entity. The determination of fair values of identifiable assets and liabilities involves estimates and the use of valuation techniques when market value is not readily available. We use various techniques to determine fair value in such instances, including the income approach. Significant estimates used in determining fair value include, but are not limited to, the amount and timing of future cash flows, growth rates, discount rates and useful lives. The excess of the purchase price over fair values of identifiable assets and liabilities is recorded as goodwill. See Note 3 for further information about goodwill.​35 Goodwill​Our goodwill totaled $3.1 billion as of January 30, 2021. We review goodwill for impairment in the fourth quarter of each year, and also upon the occurrence of triggering events. We perform reviews of each of our operating divisions and other consolidated entities (collectively, “reporting units”) that have goodwill balances. Generally, fair value is determined using a multiple of earnings, or discounted projected future cash flows, and we compare fair value to the carrying value of a reporting unit for purposes of identifying potential impairment. We base projected future cash flows on management’s knowledge of the current operating environment and expectations for the future. We recognize goodwill impairment for any excess of a reporting unit's carrying value over its fair value, not to exceed the total amount of goodwill allocated to the reporting unit.​Our annual evaluation of goodwill is performed for our reporting units during the fourth quarter. The 2020 fair value of our Kroger Specialty Pharmacy reporting unit was estimated using multiple valuation techniques: a discounted cash flow model (income approach), a market multiple model and a comparable mergers and acquisition model (market approaches), with each method weighted in the calculation. The income approach relies on management’s projected future cash flows, estimates of revenue growth rates, margin assumptions and an appropriate discount rate. The market approaches require the determination of an appropriate peer group, which is utilized to derive estimated fair values based on selected market multiples. The annual evaluation of goodwill performed in 2020, 2019 and 2018 did not result in impairment for any of our reporting units. Based on current and future expected cash flows, we believe additional goodwill impairments are not reasonably likely. A 10% reduction in fair value of our reporting units would not indicate a potential for impairment of our goodwill balance. ​For additional information relating to our results of the goodwill impairment reviews performed during 2020, 2019 and 2018, see Note 3 to the Consolidated Financial Statements.​The impairment review requires the extensive use of management judgment and financial estimates. Application of alternative estimates and assumptions could produce significantly different results. The cash flow projections embedded in our goodwill impairment reviews can be affected by several factors such as inflation, business valuations in the market, the economy, market competition and our ability to successfully integrate recently acquired businesses.​Multi-Employer Pension Plans​We contribute to various multi-employer pension plans based on obligations arising from collective bargaining agreements. These multi-employer pension plans provide retirement benefits to participants based on their service to contributing employers. The benefits are paid from assets held in trust for that purpose. Trustees are appointed in equal number by employers and unions. The trustees typically are responsible for determining the level of benefits to be provided to participants as well as for such matters as the investment of the assets and the administration of the plans.​We recognize expense in connection with these plans as contributions are funded or when commitments are probable and reasonably estimable, in accordance with GAAP. We made cash contributions to these plans of $619 million in 2020, $461 million in 2019 and $358 million in 2018. The increase in 2020, compared to 2019 and 2018 is due to the First Quarter 2020 Multi-Employer Pension Contribution. ​We continue to evaluate and address our potential exposure to under-funded multi-employer pension plans as it relates to our associates who are beneficiaries of these plans. These under-fundings are not our liability. When an opportunity arises that is economically feasible and beneficial to us and our associates, we may negotiate the restructuring of under-funded multi-employer pension plan obligations to help stabilize associates’ future benefits and become the fiduciary of the restructured multi-employer pension plan. The commitments from these restructurings do not change our debt profile as it relates to our credit rating since these off-balance sheet commitments are typically considered in our investment grade debt rating. We are currently designated as the named fiduciary of the UFCW Consolidated Pension Plan and the International Brotherhood of Teamsters (“IBT”) Consolidated Pension Fund and have sole investment authority over these assets. Significant effects of these restructuring agreements recorded in our Consolidated Financial Statements are:​●In 2020, we incurred a $989 million charge, $754 million net of tax, for commitments to certain multi-employer pension funds.​36 ●In 2019, we incurred a $135 million charge, $104 million net of tax, for obligations related to withdrawal liabilities for certain multi-employer pension funds.​●In 2018, we incurred a $155 million charge, $121 million net of tax, for obligations related to withdrawal liabilities for certain local unions of the Central States multi-employer pension fund.​As we continue to work to find solutions to under-funded multi-employer pension plans, it is possible we could incur withdrawal liabilities for certain funds. ​Based on the most recent information available to us, we believe that the present value of actuarially accrued liabilities in most of the multi-employer plans to which we contribute substantially exceeds the value of the assets held in trust to pay benefits. We have attempted to estimate the amount by which these liabilities exceed the assets, (i.e., the amount of underfunding), as of December 31, 2020. Because we are only one of a number of employers contributing to these plans, we also have attempted to estimate the ratio of our contributions to the total of all contributions to these plans in a year as a way of assessing our “share” of the underfunding. Nonetheless, the underfunding is not a direct obligation or liability of ours or of any employer. ​As of December 31, 2020, we estimate our share of the underfunding of multi-employer pension plans to which we contribute was approximately $1.7 billion, $1.3 billion net of tax. This represents a decrease in the estimated amount of underfunding of approximately $600 million, $500 million net of tax, as of December 31, 2020, compared to December 31, 2019. The decrease in the amount of underfunding is primarily attributable to higher expected returns on assets in the funds during 2020, restructuring of the National Fund and the First Quarter 2020 Multi-Employer Pension Contribution. Our estimate is based on the most current information available to us including actuarial evaluations and other data (that include the estimates of others), and such information may be outdated or otherwise unreliable.​We have made and disclosed this estimate not because, except as noted above, this underfunding is a direct liability of ours. Rather, we believe the underfunding is likely to have important consequences. In the event we were to exit certain markets or otherwise cease making contributions to these plans, we could trigger a substantial withdrawal liability. Any adjustment for withdrawal liability will be recorded when it is probable that a liability exists and can be reasonably estimated, in accordance with GAAP. ​The amount of underfunding described above is an estimate and could change based on contract negotiations, returns on the assets held in the multi-employer pension plans, benefit payments or future restructuring agreements. The amount could decline, and our future expense would be favorably affected, if the values of the assets held in the trust significantly increase or if further changes occur through collective bargaining, trustee action or favorable legislation. On the other hand, our share of the underfunding could increase and our future expense could be adversely affected if the asset values decline, if employers currently contributing to these funds cease participation or if changes occur through collective bargaining, trustee action or adverse legislation. We continue to evaluate our potential exposure to under-funded multi-employer pension plans. Although these liabilities are not a direct obligation or liability of ours, any commitments to fund certain multi-employer pension plans will be expensed when our commitment is probable and an estimate can be made.​See Note 16 to the Consolidated Financial Statements for more information relating to our participation in these multi-employer pension plans.​NEW ACCOUNTING STANDARDS​Refer to Note 18 and Note 19 to the Consolidated Financial Statements for recently adopted accounting standards and recently issued accounting standards not yet adopted as of January 30, 2021.​37 LIQUIDITY AND CAPITAL RESOURCES​Cash Flow Information​Net cash provided by operating activities​We generated $6.8 billion of cash from operations in 2020 compared to $4.7 billion in 2019. Net earnings including noncontrolling interests, adjusted for non-cash items and other impacts, generated approximately $5.3 billion of operating cash flow in 2020 compared to $5.0 billion in 2019. Cash provided (used) by operating activities for changes in operating assets and liabilities, including working capital, net of effects from mergers and disposals of businesses was $1.5 billion in 2020 compared to ($312) million in 2019. The increase in cash provided by operating activities for changes in operating assets and liabilities, including working capital, net of effects from mergers and disposals of businesses, was primarily due to the following:​●A decrease in FIFO inventory at the end of 2020 due to accelerated timing of inventory sell-through resulting from elevated demand for our products during the pandemic;​●An increase in accrued expenses at the end of 2020 primarily due to the following:​oAn increase in the current portion of the deferral of the employer portion of social security tax payments as a result of the CARES Act;​oAn increase in accrued incentive plan costs at the end of 2020; and​oAn increase in the current portion of our commitments due to the National Fund; and​●An increase in long-term liabilities at the end of 2020, primarily due to the following:​oAn increase in the noncurrent portion of the deferral of the employer portion of social security tax payments as a result of the CARES Act; and​oAn increase in the noncurrent portion of our commitments due to the National Fund;​●Partially offset by an increase in prepaid and other current assets due to escrow deposits related to the restructuring of multi-employer pension plans; and​●Proceeds from a contract associated with the sale of a business that benefited 2019.​Cash paid for taxes decreased in 2020, compared to 2019, primarily due to the payment of taxes on the gain on sale of the You Technology and Turkey Hill Dairy businesses in 2019.​Cash paid for interest increased in 2020, compared to 2019, primarily due to the timing of certain semi-annual senior note interest payments that were paid during the first quarter of 2020 which were accrued as of the end of fiscal year 2019.​Net cash used by investing activities​Investing activities used cash of $2.8 billion in 2020 compared to $2.6 billion in 2019. The amount of cash used by investing activities increased in 2020, compared to 2019, primarily due to the following:​●Decreased proceeds from the sale of assets in 2020 compared to 2019; and​●Proceeds from the sale of businesses that benefited 2019, partially offset by​●Payments for property and equipment continued at a slower pace in 2020 due to disruptions from the pandemic. However, increased purchase activity near the end of the year resulted in an increase in construction-in-progress payables as of year-end 2020 compared to 2019.38 Net cash used by financing activities​We used $2.7 billion of cash for financing activities in 2020 compared to $2.1 billion during 2019. The amount of cash used for financing activities for 2020, compared to 2019, increased primarily due to increased payments on commercial paper and share repurchases, partially offset by increased proceeds from the issuance of long-term debt and decreased payments on long-term debt. ​Debt Management​Total debt, including both the current and long-term portions of obligations under finance leases, decreased $663 million to $13.4 billion as of year-end 2020 compared to 2019. The decrease in 2020, compared to 2019, resulted primarily from net payments on commercial paper borrowings of $1.2 billion and payment of $700 million of senior notes bearing an interest rate of 3.30%, partially offset by the issuance of $500 million of senior notes bearing an interest rate of 2.20%, the issuance of $500 million of senior notes bearing an interest rate of 1.70% and a net increase in obligations under finance leases of $183 million.​Dividends​The following table provides dividend information ($ in millions, except per share amounts):​​​​​​​​2020​2019Cash dividends paid$ 534​$ 486Cash dividends paid per common share$ 0.68​$ 0.60​Liquidity Needs​Based on current operating trends, we believe that cash flows from operating activities and other sources of liquidity, including borrowings under our commercial paper program and bank credit facility, will be adequate to meet our liquidity needs for the next twelve months and for the foreseeable future beyond the next twelve months. Our liquidity needs include anticipated requirements for working capital, capital investments, pension plan commitments, interest payments and scheduled principal payments of debt and commercial paper, offset by cash and temporary cash investments on hand at the end of 2020. We generally operate with a working capital deficit due to our efficient use of cash in funding operations and because we have consistent access to the capital markets. We have approximately $800 million of senior notes maturing in the next twelve months, $311 million of the employer portion of social security tax payments we have deferred under the CARES act that is required to be paid by December 31, 2021 and expect to pay approximately $307 million in the first half of 2021 to satisfy a portion of the National Fund commitment. We expect to satisfy these obligations using cash generated from operations, temporary cash investments on hand, or through the issuance of additional senior notes or commercial paper. We believe we have adequate coverage of our debt covenants to continue to maintain our current investment grade debt ratings and to respond effectively to competitive conditions.​We held cash and temporary cash investments of $1.7 billion as of the end of 2020 which reflects our elevated operating performance and significant improvements in working capital. We remain committed to our dividend and share repurchase program and we will evaluate the optimal use of any excess free cash flow, consistent with our previously stated capital allocation strategy. ​The CARES Act, which was enacted on March 27, 2020, includes measures to assist companies in response to the COVID-19 pandemic. These measures include deferring the due dates of tax payments and other changes to income and non-income-based tax laws. As permitted under the CARES Act, we are deferring the remittance of the employer portion of the social security tax. The social security tax provision requires that the deferred employment tax be paid over two years, with half of the amount required to be paid by December 31, 2021 and the other half by December 31, 2022. During 2020, we deferred the employer portion of social security tax of $622 million. Of the total, $311 million is included in “Other current liabilities” and $311 million is included in “Other long-term liabilities” in our Consolidated Balance Sheets. ​For additional information about our debt activity in 2020, including the drawdown and repayments under our revolving credit facility, forward-starting interest rate swap agreements and our senior notes issuances, see Note 6 to the Consolidated Financial Statements.39 Factors Affecting Liquidity​We can currently borrow on a daily basis approximately $2.75 billion under our commercial paper program. At January 30, 2021, we had no outstanding commercial paper. Commercial paper borrowings are backed by our credit facility and reduce the amount we can borrow under the credit facility. If our short-term credit ratings fall, the ability to borrow under our current commercial paper program could be adversely affected for a period of time and increase our interest cost on daily borrowings under our commercial paper program. This could require us to borrow additional funds under the credit facility, under which we believe we have sufficient capacity. However, in the event of a ratings decline, we do not anticipate that our borrowing capacity under our commercial paper program would be any lower than $500 million on a daily basis. Although our ability to borrow under the credit facility is not affected by our credit rating, the interest cost and applicable margin on borrowings under the credit facility could be affected by a downgrade in our Public Debt Rating. “Public Debt Rating” means, as of any date, the rating that has been most recently announced by either S&P or Moody’s, as the case may be, for any class of non-credit enhanced long-term senior unsecured debt issued by the Company. As of March 24, 2021, we had no commercial paper borrowings outstanding.​Our credit facility requires the maintenance of a Leverage Ratio and a Fixed Charge Coverage Ratio (our “financial covenants”). A failure to maintain our financial covenants would impair our ability to borrow under the credit facility. These financial covenants are described below:​●Our Leverage Ratio (the ratio of Net Debt to Adjusted EBITDA, as defined in the credit facility) was 1.63 to 1 as of January 30, 2021. If this ratio were to exceed 3.50 to 1, we would be in default of our credit facility and our ability to borrow under the facility would be impaired.​●Our Fixed Charge Coverage Ratio (the ratio of Adjusted EBITDA plus Consolidated Rental Expense to Consolidated Cash Interest Expense plus Consolidated Rental Expense, as defined in the credit facility) was 5.37 to 1 as of January 30, 2021. If this ratio fell below 1.70 to 1, we would be in default of our credit facility and our ability to borrow under the facility would be impaired.​Our credit facility is more fully described in Note 6 to the Consolidated Financial Statements. We were in compliance with our financial covenants at year-end 2020.​40 The tables below illustrate our significant contractual obligations and other commercial commitments, based on year of maturity or settlement, as of January 30, 2021 (in millions of dollars):​​​​​​​​​​​​​​​​​​​​​​​​​ 2021 2022 2023 2024 2025 Thereafter Total Contractual Obligations(1)(2)​​​​​​​​​​​​​​​​​​​​​​Long-term debt(3)​$ 844​$ 894​$ 617​$ 494​$ 575​$ 8,986​$ 12,410​Interest on long-term debt(4)​​ 491​​ 474​​ 439​​ 427​​ 407​​ 5,001​​ 7,239​Finance lease obligations​​ 109​​ 97​​ 95​​ 93​​ 92​​ 935​​ 1,421​Operating lease obligations​​ 947​​ 865​​ 790​​ 717​​ 653​​ 6,260​​ 10,232​Self-insurance liability(5)​​ 220​​ 156​​ 107​​ 70​​ 45​​ 133​​ 731​Construction commitments(6)​​ 1,030​​ —​​ —​​ —​​ —​​ —​​ 1,030​Purchase obligations(7)​​ 742​​ 378​​ 365​​ 257​​ 240​​ 1,950​​ 3,932​Total​$ 4,383​$ 2,864​$ 2,413​$ 2,058​$ 2,012​$ 23,265​$ 36,995​​​​​​​​​​​​​​​​​​​​​​​​Other Commercial Commitments​​​​​​​​​​​​​​​​​​​​​​Standby letters of credit​$ 368​$ —​$ —​$ —​$ —​$ —​$ 368​Surety bonds​​ 408​​ —​​ —​​ —​​ —​​ —​​ 408​Total​$ 776​$ —​$ —​$ —​$ —​$ —​$ 776​(1)The contractual obligations table excludes funding of pension and other postretirement benefit obligations, which totaled approximately $33 million in 2020. This table also excludes contributions under various multi-employer pension plans, which totaled $619 million in 2020.(2)The liability related to unrecognized tax benefits has been excluded from the contractual obligations table because a reasonable estimate of the timing of future tax settlements cannot be determined.(3)As of January 30, 2021, we had no outstanding commercial paper and no borrowings under our credit facility.(4)Amounts include contractual interest payments using the interest rate as of January 30, 2021 and stated fixed and swapped interest rates, if applicable, for all other debt instruments.(5)The amounts included in the contractual obligations table for self-insurance liability related to workers’ compensation claims have been stated on a present value basis.(6)Amounts include funds owed to third parties for projects currently under construction. These amounts are reflected in “Other current liabilities” in our Consolidated Balance Sheets.(7)Amounts include commitments, many of which are short-term in nature, to be utilized in the normal course of business, such as several contracts to purchase raw materials utilized in our food production plants and several contracts to purchase energy to be used in our stores and food production plants. Our obligations also include management fees for facilities operated by third parties and outside service contracts. Any upfront vendor allowances or incentives associated with outstanding purchase commitments are recorded as either current or long-term liabilities in our Consolidated Balance Sheets. We included our future commitments for customer fulfillment centers for which we have placed an order. We did not include our commitments associated with additional customer fulfillment centers that have not yet been ordered. We have provided a letter of credit which supports our commitment to build a certain number of fulfillment centers. The balance of the letter of credit reduces primarily upon the construction of each fulfillment center. If we do not reach our total purchase commitment, we will be responsible for the balance remaining on the letter of credit. This letter of credit balance is included in the “Standby letters of credit” line above.​As of January 30, 2021, we maintained a $2.75 billion (with the ability to increase by $1 billion), unsecured revolving credit facility that, unless extended, terminates on August 29, 2022. Outstanding borrowings under the credit facility, commercial paper borrowings, and some outstanding letters of credit reduce funds available under the credit facility. As of January 30, 2021, we had no outstanding commercial paper and no borrowings under our revolving credit facility. The outstanding letters of credit that reduce funds available under our credit facility totaled $2 million as of January 30, 2021.​In addition to the available credit mentioned above, as of January 30, 2021, we had authorized for issuance $3.3 billion of securities remaining under a shelf registration statement filed with the SEC and effective on May 24, 2019.​41 We also maintain surety bonds related primarily to our self-insured workers’ compensation claims. These bonds are required by most states in which we are self-insured for workers’ compensation and are placed with predominately third-party insurance providers to insure payment of our obligations in the event we are unable to meet our claim payment obligations up to our self-insured retention levels. These bonds do not represent liabilities of ours, as we already have reserves on our books for the claims costs. Market changes may make the surety bonds more costly and, in some instances, availability of these bonds may become more limited, which could affect our costs of, or access to, such bonds. Although we do not believe increased costs or decreased availability would significantly affect our ability to access these surety bonds, if this does become an issue, we would issue letters of credit, in states where allowed, against our credit facility to meet the state bonding requirements. This could increase our cost and decrease the funds available under our credit facility.​We also are contingently liable for leases that have been assigned to various third parties in connection with facility closings and dispositions. We could be required to satisfy obligations under the leases if any of the assignees are unable to fulfill their lease obligations. Due to the wide distribution of our assignments among third parties, and various other remedies available to us, we believe the likelihood that we will be required to assume a material amount of these obligations is remote. We have agreed to indemnify certain third-party logistics operators for certain expenses, including multi-employer pension plan obligations and withdrawal liabilities.​In addition to the above, we enter into various indemnification agreements and take on indemnification obligations in the ordinary course of business. Such arrangements include indemnities against third-party claims arising out of agreements to provide services to us; indemnities related to the sale of our securities; indemnities of directors, officers and employees in connection with the performance of their work; and indemnities of individuals serving as fiduciaries on benefit plans. While our aggregate indemnification obligation could result in a material liability, we are not aware of any current matter that could result in a material liability.​42 ITEM 7A.QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.​Financial Risk Management​We manage our exposure to interest rates and changes in the fair value of our debt instruments primarily through the strategic use of our commercial paper program, variable and fixed rate debt, and interest rate swaps. Our current program relative to interest rate protection contemplates hedging the exposure to changes in the fair value of fixed-rate debt attributable to changes in interest rates. To do this, we use the following guidelines: (i) use average daily outstanding borrowings to determine annual debt amounts subject to interest rate exposure, (ii) limit the average annual amount subject to interest rate reset and the amount of floating rate debt to a combined total amount that represents 25% of the carrying value of our debt portfolio or less, (iii) include no leveraged products, and (iv) hedge without regard to profit motive or sensitivity to current mark-to-market status.​When we use derivative financial instruments, it is primarily to manage our exposure to fluctuations in interest rates. We do not enter into derivative financial instruments for trading purposes. As a matter of policy, all of our derivative positions are intended to reduce risk by hedging an underlying economic exposure. Because of the high correlation between the hedging instrument and the underlying exposure, fluctuations in the value of the instruments generally are offset by reciprocal changes in the value of the underlying exposure. The interest rate derivatives we use are straightforward instruments with liquid markets. As of January 30, 2021, we had no forward-starting interest rate swap agreements outstanding. ​Annually, we review with the Financial Policy Committee of our Board of Directors compliance with the guidelines described above. The guidelines may change as our business needs dictate.​The tables below provide information about our underlying debt portfolio as of January 30, 2021 and February 1, 2020. The amounts shown for each year represent the contractual maturities of long-term debt, excluding finance leases, as of January 30, 2021 and February 1, 2020. Interest rates reflect the weighted average rate for the outstanding instruments. The variable rate debt is based on U.S. dollar LIBOR using the forward yield curve as of January 30, 2021 and February 1, 2020. The Fair Value column includes the fair value of our debt instruments as of January 30, 2021 and February 1, 2020. We have no outstanding interest rate derivatives classified as fair value hedges as of January 30, 2021 or February 1, 2020. See Notes 6, 7 and 8 to the Consolidated Financial Statements.​​​​​​​​​​​​​​​​​​​​​​​​​​​​​January 30, 2021 ​​Expected Year of Maturity ​ 2021 2022 2023 2024 2025 Thereafter Total Fair Value ​​(in millions) Debt​​​​​​​​​​​​​​​​​​​​​​​​​Fixed rate​$ (802)​$ (894)​$ (594)​$ (494)​$ (494)​$ (8,986)​$ (12,264)​$ (14,534)​Average interest rate​ 4.20% 4.29% 4.41% 4.55% 4.58% 4.40% ​​​​​​Variable rate​$ (42)​$ —​$ (23)​$ —​$ (81)​$ —​$ (146)​$ (146)​Average interest rate​ 1.87% —​ 2.62% —​ 0.08% —%​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​February 1, 2020 ​​Expected Year of Maturity ​ 2020 2021 2022 2023 2024 Thereafter Total Fair Value ​​(in millions) Debt​​​​​​​​​​​​​​​​​​​​​​​​​Fixed rate​$ (705)​$ (804)​$ (894)​$ (594)​$ (495)​$ (8,462)​$ (11,954)​$ (13,347)​Average interest rate​ 4.39% 4.56% 4.47% 4.69% 4.86% 4.65% ​​​​​​Variable rate​$ (1,221)​$ —​$ —​$ —​$ —​$ (81)​$ (1,302)​$ (1,302)​Average interest rate​ 1.88% —​ —​ —​ —​ 1.65%​​​​​​​Based on our year-end 2020 variable rate debt levels, a 10 percent change in interest rates would be immaterial. See Note 7 to the Consolidated Financial Statements for further discussion of derivatives and hedging policies.​43
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+ITEM 7. Management's Discussion and Analysis of Financial Condition and Results of Operations This section of this Annual Report on Form 10-K generally discusses the years ended December 31, 2020 and 2019 and year-over-year comparisons between the years ended December 31, 2020 and 2019. Discussions of the periods prior to the year ended December 31, 2019 that are not included in this Annual Report on Form 10-K are found in "Management's Discussion and Analysis of Financial Condition and Results of Operations" in Part II, Item 7 of our Annual Report on Form 10-K for the year ended December 31, 2019 and the discussion therein for the year ended December 31, 2019 compared to the year ended December 31, 2018 is incorporated by reference into this Annual Report. This Annual Report on Form 10-K contains the names of some of our owned or licensed trademarks, trade names and service marks, which we refer to as our brands. All of the product names included in this Annual Report on Form 10-K are either our registered trademarks or those of our licensors.OVERVIEWKDP is a leading beverage company in North America, with a diverse portfolio of flavored (non-cola) CSDs, NCBs, including water (enhanced and flavored), ready-to-drink tea and coffee, juice, juice drinks, mixers and specialty coffee, and is a leading producer of innovative single serve brewers. With a wide range of hot and cold beverages that meet virtually any consumer need, KDP key brands include Keurig, Dr Pepper, Canada Dry, Snapple, Bai, Mott's, Core, Green Mountain and The Original Donut Shop. KDP has some of the most recognized beverage brands in North America, with significant consumer awareness levels and long histories that evoke strong emotional connections with consumers. KDP offers more than 125 owned, licensed and partner brands, including the top ten best-selling coffee brands and Dr Pepper as a leading flavored CSD in the U.S. according to IRi, available nearly everywhere people shop and consume beverages. KDP operates as an integrated brand owner, manufacturer and distributor. We believe our integrated business model strengthens our route-to-market and provides opportunities for net sales and profit growth through the alignment of the economic interests of our brand ownership and our manufacturing and distribution businesses through both our DSD system and our WD delivery system. KDP markets and sells its products to retailers, including supermarkets, mass merchandisers, club stores, pure-play e-commerce retailers, and office superstores; to restaurants, hotel chains, office product and coffee distributors, and partner brand owners; and directly to consumers through its website. Our integrated business model enables us to be more flexible and responsive to the changing needs of our large retail customers and allows us to more fully leverage our scale and reduce costs by creating greater geographic manufacturing and distribution coverage.SEGMENTSAs of December 31, 2020, we report our business in four operating segments:•The Coffee Systems segment reflects sales in the U.S. and Canada of the manufacture and distribution of finished goods relating to the Company's single-serve brewers, K-Cup pods and other coffee products.•The Packaged Beverages segment reflects sales in the U.S. and Canada from the manufacture and distribution of finished beverages and other products, including sales of the Company's own brands and third-party brands, through our DSD and WD systems.•The Beverage Concentrates segment reflects sales of the Company's branded concentrates and syrup to third-party bottlers, primarily in the U.S. and Canada. Most of the brands in this segment are CSDs.•The Latin America Beverages segment reflects sales in Mexico, the Caribbean, and other international markets from the manufacture and distribution of concentrates, syrup and finished beverages.VOLUMEIn evaluating our performance, we consider different volume measures depending on whether we sell beverage concentrates, finished beverages, pods or brewers.Coffee Systems K-Cup Pod and Appliance Sales VolumeIn our Coffee Systems segments, we measure our sales volume as the number of appliances and the number of individual K-Cup pods sold to our customers.Packaged Beverages and Latin America Beverages Sales VolumeIn our Packaged Beverages and Latin America Beverages segments, we measure volume as case sales to customers. A case sale represents a unit of measurement equal to 288 fluid ounces of packaged beverage sold by us. Case sales include both our owned brands and certain brands licensed to and/or distributed by us.23Table of ContentsBeverage Concentrates Sales VolumeIn our Beverage Concentrates segment, we measure our sales volume as concentrate case sales for concentrates sold by us to our bottlers and distributors. A concentrate case is the amount of concentrate needed to make one case of 288 fluid ounces of finished beverage, the equivalent of 24 twelve ounce servings. It does not include any other component of the finished beverage other than concentrate. USE OF NON-GAAP FINANCIAL MEASURESNon-GAAP financial measures are provided in addition to U.S. GAAP measures, including adjusted income from operations, adjusted net income and adjusted diluted earnings per share. See Non-GAAP Financial Measures for more information, including reconciliations to the corresponding U.S. GAAP measures.UNCERTAINTIES AND TRENDS AFFECTING OUR BUSINESS We believe the North American beverage market is influenced by certain key trends and uncertainties. Some of these items, such as the ongoing outbreak of COVID-19, changes in consumer preferences and macroeconomic changes, have previously created and may continue to create category headwinds for a number of our products. Refer to Item 1A, "Risk Factors", combined with the Uncertainties and Trends Affecting Liquidity section below, for more information about the risks and uncertainties we face. COVID-19 Pandemic DisclosuresOur first priority, always, is to keep our employees safe and healthy. We have taken extraordinary precautions to do this and to provide the support our employees and their families may need during this unprecedented time.We continue to deliver for our customers and consumers, working hard to fulfill strong demand. We are finding innovative ways to quickly adapt to changes in shopping behaviors, with the vast majority of North America impacted by a mix of occupancy limitations, stay-at-home or shelter-in-place orders, and closures of non-essential businesses.We are also focused on providing for our communities by supporting frontline healthcare workers who are fighting this crisis day in and day out. We don’t make masks or medical equipment at our Company, but we do make beverages and, through our Fueling The Frontline program, we donated Keurig brewers, coffee and other beverages to hospitals in need, as our way to say thank you for the unwavering commitment and courage of the entire medical community.The COVID-19 pandemic has had divergent impacts within our business. For example, we experienced a significant increase in demand and consumption of our products in our at-home business caused in part by changing consumer habits in response to COVID-19, contributing to increases in net sales. At the same time, we experienced significant declines in net sales in our away-from-home business due to office closures and the slowdown of hospitality and fountain foodservice as a result of shelter-in-place guidelines and restaurant capacity limits. In the future, the economic effects of the COVID-19 pandemic, including higher levels of unemployment, lower wages or a recessionary environment, may result in reduced demand for our products. It could also lead to volatility in demand due to government actions, such as shelter-in-place notices, in response to increases in reported cases and hospitalizations in certain regions. These government actions could impact consumers' movements and access to our products. While we believe that there will continue to be strong long-term demand for our products, the timing and extent of economic recovery, and the uncertainties in short-term demand trends, make it difficult to predict the overall effects of the COVID-19 pandemic on our business. We expect that there will be heightened volatility in net sales during and subsequent to the duration of the pandemic that may impact interim periods. Our ability to continue to operate without any significant negative impacts will in part depend on our ability to protect our critical frontline employees and our supply chain. As food and agriculture is deemed part of the critical infrastructure by the Department of Homeland Security, our frontline employees have been identified as critical workers in maintaining the U.S. food and beverage supply. As a result, we have strived to follow recommended actions of government and health authorities to protect our employees, with particular measures in place for those working in our manufacturing and distribution facilities, which also included temporary incentive pay programs and benefits. We intend to continue to work with government authorities and implement our employee safety measures; however, disruptions to our supply chain, measures taken to protect employees, increased absenteeism or other local effects of the COVID-19 pandemic have impacted and could continue to impact our operations. For our corporate employees, we do not believe that the remote work environment has had any significant impact on our internal controls over financial reporting. With the health and safety of our employees remaining our top priority, we are diligently working on plans to safely bring our employees back to office locations with enhanced safety and health protocols. We do not believe these plans will impact our near-term liquidity needs. The COVID-19 pandemic has not materially impacted our liquidity position. We continue to generate operating cash flows to meet our short-term liquidity needs, and we expect to maintain access to the capital markets enabled by our debt ratings. Refer to Uncertainties and Trends Affecting Liquidity within the Liquidity and Capital Resources section below for more information.24Table of ContentsEXECUTIVE SUMMARY Impact of COVID-19 on our Financial StatementsThe impact of COVID-19 on our net sales performance presented both headwinds and tailwinds across the business and within the segments, requiring strong portfolio, package and channel mix management to optimize overall performance. The diversity of the Company’s broad portfolio and extensive route to market network enabled us to successfully navigate these mix impacts posed by the COVID-19 pandemic to drive overall performance. •Coffee Systems experienced growth in K-Cup coffee pods for at-home consumption and strong double-digit growth in brewers, which more than offset the significant decline in away-from-home consumption due to weaknesses in the office coffee channel, as many companies shifted to a work-from-home model during 2020. Sales in the e-commerce channel were very strong, as consumers shifted purchases to the online channel, including at the Keurig.com retail site. •Packaged Beverages experienced a net benefit from strong in-market execution, driven by net sales and market share growth in the majority of the segment's beverage portfolio. Performance in large-format channels continued to be strong across multi-pack and take-home packages, which was partially offset by softness in the convenience and gas channels due to decreased consumer mobility.•Beverage Concentrates experienced a significant decline in net sales due to the fountain foodservice component of the business, which services restaurants and hospitality, as a result of the impact of shutdowns and reductions in occupant capacity, which improved throughout the year, reflecting a modest reopening of quick-serve and other fast-casual restaurants. •Latin America Beverages experienced limited growth in sales volumes, driven by reduced consumer mobility and tourism in Mexico.The current environment has increased operating costs, requiring us to take deliberate action. In addition to strong portfolio, package and channel mix management to optimize overall net sales performance, we maintained our strong cost discipline, which included the following:•Reduced marketing expense, given the current COVID-19 landscape which has impacted the effectiveness and return on marketing investments; and•Reduced other discretionary costs, such as travel and entertainment expenses, within our business.As a result of these items, COVID-19 impacted our results, both positively and negatively, and should be taken into account when reviewing this Management's Discussion and Analysis. Refer to the section Uncertainties and Trends Affecting our Business - COVID-19 Pandemic Disclosures above for further information. The following table sets forth our reconciliation of significant COVID-19-related expenses. Employee compensation expense and employee protection costs, which impact our SG&A expenses and cost of sales, are included as the COVID-19 item affecting comparability and is excluded in our non-GAAP financial measures. In addition, reported amounts under U.S. GAAP also include additional costs, not included in the COVID-19 item affecting comparability, as presented in tables below.Items Affecting Comparability(1)(in millions)Employee Compensation Expense(2)Employee Protection Costs(3)Allowances for Expected Credit Losses(4)Inventory Write-Downs(5)TotalFor the year ended December 31, 2020Coffee Systems$15 $10 $2 $8 $35 Packaged Beverages76 25 8 — 109 Beverage Concentrates— — 4 — 4 Latin America Beverages— 2 — — 2 Total$91 $37 $14 $8 $150 (1)Employee compensation expense and employee protection costs are both included as the COVID-19 item affecting comparability in the reconciliation of our Adjusted Non-GAAP financial measures.(2)Primarily reflects temporary incremental frontline incentive pay and the associated taxes in order to maintain essential operations during the COVID-19 pandemic. Impacts both cost of sales and SG&A expenses. In mid-September 2020, we discontinued the incremental frontline incentive pay program.(3)Includes costs associated with personal protective equipment, temperature scans, cleaning and other sanitization services. Impacts both cost of sales and SG&A expenses.(4)Allowances reflect the expected impact of the economic uncertainty caused by COVID-19, leveraging estimates of credit worthiness, default and recovery rates for certain of our customers. Impacts SG&A expenses.(5)Inventory write-downs represent obsolescence charges, which impact cost of sales.25Table of ContentsFinancial OverviewThe following table details our net income and diluted EPS for the years ended December 31, 2020 and 2019: For the Year Ended December 31,DollarPercent(in millions, except per share data)20202019ChangeChangeNet income attributable to KDP$1,325 $1,254 $71 5.7 %Adjusted net income attributable to KDP1,988 1,727 261 15.1 %Diluted EPS0.93 0.88 0.05 5.7 %Adjusted diluted EPS1.40 1.22 0.18 14.8 %Net income attributable to KDP increased $71 million, or 5.7%, to $1,325 million for the year ended December 31, 2020, compared to $1,254 million in the prior year, reflecting strong growth in income from operations, driven primarily by the continued benefit of productivity and merger synergies, volume/mix growth and lower discretionary expenses, primarily marketing, partially offset by $150 million of additional pre-tax expenses associated with COVID-19 and a non-cash impairment on our Bai brand intangible asset. Other favorable drivers included lower interest expense due to continued deleveraging and the impact of a lower effective tax rate, partially offset by a non-cash impairment on equity investments and a related party note receivable.Adjusted net income attributable to KDP increased $261 million, or 15.1%, to $1,988 million, compared to $1,727 million in the prior year, reflecting the continued benefit of productivity and merger synergies, volume/mix growth and lower discretionary expenses, primarily marketing, which were partially offset by lower net price realization and higher operating and manufacturing costs associated with increased consumer retail demand for our products. Other drivers included lower Adjusted interest expense due to continued deleveraging and the impact of a lower Adjusted effective tax rate.During the year ended December 31, 2020, we made net repayments of $951 million related to our Notes, our 2019 KDP Term Loan, and our commercial paper notes. Additionally, we repaid $341 million and added $171 million of structured payables.In February 2021, our Board has approved an increase of 25% in our quarterly dividend, which will begin with the second quarter dividend announcement.26Table of ContentsRESULTS OF OPERATIONSWe eliminate from our financial results all intercompany transactions between entities included in our consolidated financial statements and the intercompany transactions with our equity method investees.References in the financial tables to percentage changes that are not meaningful are denoted by "NM".Consolidated OperationsThe following table sets forth our consolidated results of operations for the years ended December 31, 2020 and 2019: For the Year Ended December 31,DollarPercentage(in millions, except per share amounts)20202019ChangeChangeNet sales$11,618 $11,120 $498 4.5 %Cost of sales5,132 4,778 354 7.4 Gross profit6,486 6,342 144 2.3 Selling, general and administrative expenses3,978 3,962 16 0.4 Impairment of intangible assets67 — 67 NMOther operating (income) expense, net(39)2 (41)NMIncome from operations2,480 2,378 102 4.3 Interest expense604 654 (50)(7.6)Loss on early extinguishment of debt4 11 (7)(63.6)Impairment of investments and note receivable102 — 102 NMOther expense (income), net17 19 (2)(10.5)Income before provision for income taxes1,753 1,694 59 3.5 Provision for income taxes428 440 (12)(2.7)Net income1,325 1,254 71 5.7 Less: Net income attributable to non-controlling interest— — — NMNet income attributable to KDP$1,325 $1,254 $71 5.7 %Earnings per common share: Basic$0.94 $0.89 $0.05 5.6 %Diluted0.93 0.88 0.05 5.7 %Gross margin55.8 %57.0 %(120 bps)Operating margin21.3 %21.4 %(10 bps)Effective tax rate24.4 %26.0 %(160 bps)Sales Volume. The following table sets forth changes in sales volume for the year ended December 31, 2020 compared to the prior year:K-Cup pod volume6.3 %Brewer volume21.2 %CSD sales volume0.1 %NCB sales volume1.4 %Net Sales. Net sales for the year ended December 31, 2020 increased $498 million to $11,618 million compared with net sales of $11,120 million in the prior year. This performance reflected higher volume/mix of 5.6%, partially offset by lower net price realization of 0.6% and unfavorable foreign currency translation of 0.5%, primarily in our Latin America Beverages segment.Gross Profit. Gross profit for the year ended December 31, 2020 was $6,486 million, or 55.8% of net sales as compared to $6,342 million, or 57.0% of net sales in the prior year. This performance primarily reflected the impact of higher volume/mix and the benefit of productivity and merger synergies. These benefits were partially offset by unfavorable net price realization, unfavorable FX translation, $52 million in COVID-19 charges and an increase in other manufacturing costs, associated with the strong consumer demand. Gross margin decreased 120 bps from the prior year to 55.8%.27Table of ContentsSelling, General and Administrative Expenses. SG&A expenses for the year ended December 31, 2020 increased $16 million to $3,978 million, compared with $3,962 million in the prior year. The increase was driven by $98 million in COVID-19 charges, expenses associated with productivity projects, inflation in logistics, and higher operating costs associated with the strong consumer demand, such as logistics and labor. These increases were partially offset by the benefit of strong productivity and merger synergies and lower discretionary expenses, primarily marketing. Impairment of Intangible Assets. Impairment of intangible assets reflects a $67 million non-cash impairment charge recorded for the Bai brand as a result of our annual impairment analysis as of October 1, 2020. Refer to Note 4 of the Notes to our Consolidated Financial Statements for further information regarding the impairment analysis.Other Operating (Income) Expense, Net. Other operating (income) expense, net had a favorable change of $41 million for the year ended December 31, 2020 compared with the prior year, largely driven by the comparison to unfavorable fair value adjustments on real estate assets in the prior year. Additionally, we had an incremental gain from our network optimization program in the current year, with a gain of $42 million from the sale-leaseback of four facilities in the current year, compared to a gain of $30 million in the prior year from the sale-leaseback of three facilities.Income from Operations. Income from operations increased $102 million to $2,480 million for the year ended December 31, 2020, driven by the increase in gross profit and the favorable change in other operating (income) expense, net, partially offset by the non-cash impairment of the Bai brand intangible asset and the increase in SG&A expenses. Operating margin decreased 10 bps versus the prior year to 21.3%.Interest Expense. Interest expense decreased $50 million or 7.6%, to $604 million for the year ended December 31, 2020 compared to $654 million in the prior year. This change was primarily the result of the benefit of lower indebtedness due to continued deleveraging.Loss on Early Extinguishment of Debt. Loss on early extinguishment of debt decreased $7 million to $4 million for the year ended December 31, 2020 compared to $11 million for the prior year. This change was primarily the result of the Company's focus on repaying commercial paper during the current year, versus our focus on voluntary repayments on our term loan in the prior year.Impairment on Investments and Note Receivable. Impairment on investments and note receivable reflected a non-cash impairment charge of $102 million for the year ended December 31, 2020 associated with our Bedford investment and the related note receivable and our LifeFuels investment. Refer to Note 5 of the Notes to our Consolidated Financial Statements for additional information regarding the impairment charges.Effective Tax Rate. The effective tax rates for the years ended December 31, 2020 and 2019 were 24.4% and 26.0%, respectively. The decrease from prior year primarily related to the tax benefit received in the current year due to a decrease in our uncertain tax positions as a result of examination settlements and the reversal of a valuation allowance related to the carryforward of net operating losses in a wholly-owned subsidiary.Net Income Attributable to KDP. Net income attributable to KDP increased $71 million, or 5.7%, to $1,325 million for the year ended December 31, 2020 as compared to $1,254 million in the prior year, driven by improved income from operations, reduced interest expense and reduced losses on early extinguishment of debt, as well as the decrease in the effective tax rate, which were partially offset by the non-cash impairment on investments and note receivable during the year ended December 31, 2020.Diluted EPS. Diluted EPS increased 5.7% to $0.93 per diluted share as compared to $0.88 in the prior year.28Table of ContentsAdjusted Results of OperationsThe following table sets forth selected consolidated adjusted results of operations for the years ended December 31, 2020 and 2019: For the Year Ended December 31,DollarPercentage(in millions, except per share amounts)20202019ChangeChangeAdjusted income from operations$3,191 $2,890 $301 10.4 %Adjusted interest expense542 553 (11)(2.0)Adjusted provision for income taxes644 591 53 9.0 Adjusted net income attributable to KDP1,988 1,727 261 15.1 Adjusted diluted EPS1.40 1.22 0.18 14.8 Adjusted operating margin27.5 %26.0 %150 bpsAdjusted effective tax rate24.5 %25.5 %(100 bps)Adjusted Income from Operations. Adjusted income from operations increased $301 million, or 10.4%, to $3,191 million for the year ended December 31, 2020 compared to $2,890 million in the prior year. Driving this performance in the current year was the benefit of productivity and merger synergies, which impacted both SG&A and cost of sales, higher volume/mix, and lower discretionary expenses, primarily marketing. Partially offsetting these positive drivers were unfavorable net price realization, $22 million of COVID-19 charges and higher operating and manufacturing costs associated with the strong consumer demand. Adjusted operating margin grew 150 bps to 27.5%.Adjusted Interest Expense. Adjusted interest expense decreased $11 million, or 2.0%, to $542 million for the year ended December 31, 2020 compared to $553 million in the prior year. This benefit was primarily driven by lower indebtedness resulting from continued deleveraging, which was partially offset by the unfavorable comparison to realized gains in the prior year resulting from the termination of interest rate swaps and amortization of deferred financing costs incurred since the DPS Merger.Adjusted Effective Tax Rate. The Adjusted effective tax rate decreased 100 bps to 24.5% for the year ended December 31, 2020 compared to 25.5% in the prior year. The decrease from prior year primarily related to the tax benefit received in the current year due to a decrease in our uncertain tax positions as a result of examination settlements and the reversal of a valuation allowance related to the carryforward of net operating losses in a wholly-owned subsidiary.Adjusted Net Income Attributable to KDP. Adjusted net income increased 15.1% to $1,988 million for the year ended December 31, 2020 as compared to $1,727 million in the prior year. This performance was driven primarily by strong growth in Adjusted income from operations.Adjusted Diluted EPS. Adjusted diluted EPS increased 14.8% to $1.40 per diluted share as compared to $1.22 per diluted share in the prior year.29Table of ContentsResults of Operations by SegmentThe following tables set forth net sales and income from operations for our segments for the years ended December 31, 2020 and 2019, as well as the other amounts necessary to reconcile our total segment results to our consolidated results presented in accordance with U.S. GAAP:(in millions)For the Year Ended December 31,Segment Results — Net sales20202019Coffee Systems$4,433 $4,233 Packaged Beverages5,363 4,945 Beverage Concentrates1,325 1,414 Latin America Beverages497 528 Net sales$11,618 $11,120 For the Year Ended December 31,(in millions)20202019Segment Results — Income from Operations Coffee Systems$1,268 $1,219 Packaged Beverages822 757 Beverage Concentrates932 955 Latin America Beverages105 85 Unallocated corporate costs(647)(638)Income from operations$2,480 $2,378 COFFEE SYSTEMSThe following table provides selected information for our Coffee Systems segment for the years ended December 31, 2020 and 2019:For the Year Ended December 31,DollarPercentage(in millions)20202019ChangeChangeNet sales$4,433 $4,233 $200 4.7 %Income from operations1,268 1,219 49 4.0 %Operating margin28.6 %28.8 %(20 bps)Adjusted income from operations1,514 1,403 111 7.9 %Adjusted operating margin34.2 %33.1 %110 bpsSales Volume. Sales volume growth for the year ended December 31, 2020 compared to the prior year for the Coffee Systems segment included strong K-Cup pod volume growth of 6.3%, reflecting strength in at-home consumption which was significantly offset by softness in the away-from-home business due to the COVID-19 pandemic. Brewer volume increased 21.2% in the year ended December 31, 2020, as compared to 8.2% growth in the prior year, reflecting successful innovation introduced over the past two years and investments to drive household penetration.Net Sales. Net sales increased $200 million, or 4.7%, to $4,433 million for the year ended December 31, 2020, compared to $4,233 million in the prior year due to volume/mix growth of 7.2%, driven by strong sales volume growth in both pods and brewers. This growth was partially offset by lower net price realization of 2.4% and unfavorable foreign currency translation of 0.1%.Income from Operations. Income from operations increased $49 million, or 4.0%, to $1,268 million for the year ended December 31, 2020, compared to $1,219 million in the prior year, driven by the continued benefit of strong productivity and merger synergies, which impacted both cost of sales and SG&A, strong volume/mix growth and lower discretionary expenses, primarily marketing. These benefits were partially offset by strategic pricing, $35 million in COVID-19 charges, and expenses associated with productivity projects. Operating margin declined 20 bps to 28.6%. Adjusted Income from Operations. Adjusted income from operations increased $111 million, or 7.9%, to $1,514 million for the year ended December 31, 2020, compared to $1,403 million in the prior year, driven by the continued benefit of strong productivity and merger synergies, which impacted both cost of sales and SG&A, strong volume/mix, and lower discretionary expenses, primarily marketing. Partially offsetting these factors was strategic pricing and $10 million in COVID-19 charges. Adjusted operating margin grew 110 bps to 34.2%. 30Table of ContentsPACKAGED BEVERAGESThe following table provides selected information for our Packaged Beverages segment for the years ended December 31, 2020 and 2019:For the Year Ended December 31,DollarPercentage(in millions)20202019ChangeChangeNet sales$5,363 $4,945 $418 8.5 %Income from operations822 757 65 8.6 %Operating margin15.3 %15.3 %0 bpsAdjusted income from operations1,021 783 238 30.4 %Adjusted operating margin19.0 %15.8 %320 bpsSales Volume. Sales volume for the year ended December 31, 2020 increased 7.3% compared to the prior year, reflecting the impact of COVID-19 and our strong in-market execution, which displayed strength in CSDs, juice and juice drinks, premium water and apple sauce. These increases were partially offset by lower volume in enhanced flavored water, driven by Bai, due to continued softness in convenience and gas channels during the current year.Net Sales. Net sales increased $418 million, or 8.5%, to $5,363 million for the year ended December 31, 2020, compared to $4,945 million in the prior year, driven by higher volume/mix of 8.2% and favorable price realization of 0.3%. Income from Operations. Income from operations increased $65 million, or 8.6%, to $822 million for the year ended December 31, 2020, compared to $757 million in the prior year, driven primarily by strong volume/mix. Other favorable drivers included the benefit of continued productivity and merger synergies and lower discretionary expenses, primarily marketing. These growth drivers were partially offset by $109 million in COVID-19 charges, a non-cash impairment charge of $67 million related to the Bai brand, higher manufacturing and operating costs, such as logistics and labor, associated with the strong consumer demand, inflation in logistics, the unfavorable comparison to a $10 million net gain on a renegotiation of a manufacturing contract in the prior year and increased expenses associated with productivity projects. Operating margin was flat versus the prior year at 15.3%.Adjusted Income from Operations. Adjusted income from operations increased $238 million, or 30.4%, to $1,021 million for the year ended December 31, 2020 compared to $783 million in the prior year, largely driven by strong volume/mix. Other favorable drivers included the benefit of continued productivity and merger synergies and lower discretionary expenses, primarily marketing. These drivers were partially offset by higher manufacturing and operating costs, such as logistics and labor, associated with the strong consumer demand, inflation in logistics, and the unfavorable comparison to a $10 million net gain on a renegotiation of a manufacturing contract in the prior year. Adjusted operating margin grew 320 bps versus the prior year to 19.0%.BEVERAGE CONCENTRATESThe following table provides selected information for our Beverage Concentrates segment for the years ended December 31, 2020 and 2019:For the Year Ended December 31,DollarPercentage(in millions)20202019ChangeChangeNet sales$1,325 $1,414 $(89)(6.3)%Income from operations932 955 (23)(2.4)%Operating margin70.3 %67.5 %280 bpsAdjusted income from operations938 957 (19)(2.0)%Adjusted operating margin70.8 %67.7 %310 bpsSales Volume. Sales volume for the year ended December 31, 2020 declined 5.1% compared to the prior year, primarily reflecting the decline in our fountain foodservice component of the business, which services restaurants and hospitality, reflecting the impact of shutdowns and reductions in occupant capacity.Net Sales. Net sales decreased $89 million, or 6.3% to $1,325 million for the year ended December 31, 2020, compared to $1,414 million in the prior year, driven by unfavorable volume/mix of 5.8%, lower net price realization of 0.4% and unfavorable foreign currency translation of 0.1%.31Table of ContentsIncome from Operations. Income from operations decreased $23 million, or 2.4% to $932 million for the year ended December 31, 2020, compared to $955 million in the prior year, driven by the net sales decline and higher compensation costs, partially offset by lower discretionary expenses, primarily marketing. Operating margin increased 280 bps versus the prior year to 70.3%.Adjusted Income from Operations. Adjusted income from operations decreased $19 million, or 2.0%, to $938 million for the year ended December 31, 2020 compared to $957 million in the prior year, driven by the net sales decline, partially offset by lower discretionary expenses, primarily marketing. Adjusted operating margin grew 310 bps versus the prior year to 70.8%.LATIN AMERICA BEVERAGESThe following table provides selected information for our Latin America Beverages segment for the years ended December 31, 2020 and 2019:For the Year Ended December 31,DollarPercentage(in millions)20202019ChangeChangeNet sales$497 $528 $(31)(5.9)%Income from operations105 85 20 23.5 %Operating margin21.1 %16.1 %500 bpsAdjusted income from operations108 82 26 31.7 %Adjusted operating margin21.7 %15.5 %620 bpsSales Volume. Sales volume for the year ended December 31, 2020 increased 0.4% compared to the prior year, driven by Squirt.Net Sales. Net sales decreased $31 million, or 5.9% to $497 million for the year ended December 31, 2020, compared to $528 million in the prior year, driven primarily by unfavorable FX translation of 9.7%. Excluding the unfavorable impact of FX translation, net sales increased as a result of higher net price realization of 5.8%, partially offset by unfavorable volume/mix of 2.0%.Income from Operations. Income from operations increased $20 million, or 23.5%, to $105 million for the year ended December 31, 2020, compared to $85 million in the prior year, driven by higher net price realization, continued productivity and lower discretionary expenses, primarily marketing, partially offset by unfavorable FX effects (FX translation and transaction), unfavorable volume/mix, inflation in logistics and the comparison to a real estate gain in the prior year. Operating margin increased 500 bps versus the prior year to 21.1%.Adjusted Income from Operations. Adjusted income from operations increased $26 million, or 31.7%, to $108 million for the year ended December 31, 2020, compared to $82 million in the prior year. This performance reflected higher net price realization, continued productivity and lower marketing expense, partially offset by unfavorable FX effects (FX translation and transaction), unfavorable volume/mix and inflation in logistics. Adjusted operating margin grew 620 bps versus the prior year to 21.7%.LIQUIDITY AND CAPITAL RESOURCESOverview Our financial condition and liquidity remain strong. Net cash provided by operations was $2,456 million for the year ended December 31, 2020 compared to $2,474 million for the prior year. Although there is uncertainty related to the anticipated impact of the ongoing COVID-19 pandemic on our future results, we believe we are uniquely positioned, with our broad portfolio and unmatched distribution network, to successfully navigate through this pandemic, and the steps we have taken to strengthen our balance sheet leave us well positioned to manage our business as the crisis continues to unfold. We continue to manage all aspects of our business, including, but not limited to, monitoring the financial health of our customers, suppliers and other third-party relationships, implementing gross margin enhancement strategies and developing new opportunities for growth.Our principal sources of liquidity are our existing cash and cash equivalents, cash generated from operations and our $3.9 billion borrowing capacity currently available under our existing KDP Revolver and 2020 364-Day Credit Agreement. Additionally, we have an uncommitted commercial paper program where we can issue up to $2.4 billion of unsecured commercial paper notes on a private placement basis, which provides us significant flexibility and short-term liquidity. We believe this level of liquidity enables us to more than meet our commitments, even in a prolonged economic downturn, as we continue to exercise financial discipline to ensure our long-term financial health. Refer to Note 3 of the Notes to our Consolidated Financial Statements for management's discussion of these financing arrangements.As of December 31, 2020, we were in compliance with all debt covenants and we have no reason to believe that we will be unable to satisfy these covenants. 32Table of ContentsUncertainties and Trends Affecting LiquidityDisruptions in financial and credit markets, including those caused by the ongoing COVID-19 pandemic, may impact our ability to manage normal commercial relationships with our customers, suppliers and creditors. These disruptions could have a negative impact on the ability of our customers to timely pay their obligations to us, thus reducing our cash flow, or the ability of our vendors to timely supply materials.Customer and consumer demand for our products may additionally be impacted by all risk factors discussed in Item 1A, "Risk Factors" that could have a material effect on production, delivery and consumption of our products in the U.S., Mexico and the Caribbean or Canada, which could result in a reduction in our sales volume. Similarly, disruptions in financial and credit markets may impact our ability to manage normal commercial relationships with our customers, suppliers and creditors. These disruptions could have a negative impact on the ability of our customers to timely pay their obligations to us, thus reducing our cash flow, or the ability of our vendors to timely supply materials.We believe that the following events, trends and uncertainties may also impact liquidity:•Our intention to drive significant cash flow generation to enable rapid deleveraging within two to three years from the DPS Merger;•Our ability to issue unsecured commercial paper notes on a private placement basis up to a maximum aggregate amount outstanding at any time of $2,400 million;•Our ability to access our other financing arrangements, including the KDP Revolver and the 2020 364-Day Credit Agreement, which have availability of $3,900 million as of December 31, 2020;•A significant downgrade in our credit ratings could limit a financial institution's willingness to participate in our accounts payable program and reduce the attractiveness of the accounts payable program to participating suppliers who may sell payment obligations from us to financial institutions; •Our continued payment of dividends;•Our continued capital expenditures;•Future mergers or acquisitions of brand ownership companies, regional bottling companies, distributors and/or distribution rights to further extend our geographic coverage;•Future equity investments;•Seasonality of our operating cash flows, which could impact short-term liquidity; and•Fluctuations in our tax obligations.LIBOR ConsiderationsIn 2017, the U.K. Financial Conduct Authority announced that LIBOR will no longer be published after 2021. In the U.S., the Alternative Reference Rates Committee selected the Secured Overnight Financing Rate as the preferred alternative reference rate to LIBOR. In December 2020, it was announced that certain LIBOR rates will continue to be published through June 30, 2023.We have a number of financing arrangements which incorporate LIBOR as a benchmark rate and which extend past 2021, including the 2019 KDP Term Loan and the KDP Revolver. The agreements related to such financing arrangements contain provisions for alternative reference rates, and we do not expect a significant change to our cost of debt as a result of the transition from LIBOR to an alternative reference rate.LiquidityBased on our current and anticipated level of operations, we believe that our operating cash flows will be sufficient to meet our anticipated obligations for the next twelve months. To the extent that our operating cash flows are not sufficient to meet our liquidity needs, we may utilize cash on hand or amounts available under our financing arrangements, if necessary.The following table summarizes our cash activity:Year Ended December 31, (in millions)202020192018Net cash provided by operating activities$2,456 $2,474 $1,613 Net cash used in investing activities(316)(150)(19,131)Net cash (used in) provided by financing activities(1,990)(2,364)17,577 33Table of ContentsNET CASH PROVIDED BY OPERATING ACTIVITIESNet cash provided by operating activities decreased $18 million for the year ended December 31, 2020 as compared to year ended December 31, 2019, driven by the decline in working capital and an increase in income tax payments, partially offset by the increase in net income adjusted for non-cash items.As of December 31, 2020, we had no deferred estimated tax payments, as compared to deferred estimated tax payments as of December 31, 2019 of $59 million, which were paid in January 2020. Beginning in the second quarter of 2020 and continuing through the rest of the year, we deferred payments of employer-related payroll taxes as allowed under the U.S. Coronavirus Aid, Relief and Economic Security Act, commonly known as the CARES Act. Payment of at least 50% of the deferred amount is due on December 31, 2021 with the remainder due by December 31, 2022. As of December 31, 2020, we have deferred a total of $59 million in such payments.Cash Conversion CycleOur cash conversion cycle is defined as DIO and DSO less DPO. The calculation of each component of the cash conversion cycle is provided below:ComponentCalculation (on a trailing twelve month basis)DIO(Average inventory divided by cost of sales) * Number of days in the periodDSO(Accounts receivable divided by net sales) * Number of days in the periodDPO(Accounts payable * Number of days in the period) divided by cost of sales and SG&A expensesOur cash conversion cycle declined (17) days to approximately (63) days as of December 31, 2020 as compared to (46) days as of December 31, 2019. The following table summarizes our cash conversion cycle:December 31,20202019DIO54 52 DSO33 35 DPO150 133 Cash conversion cycle(63)(46)For the year ending December 31, 2021, DPO is expected to have a positive impact on our cash conversion cycle as a result of our supplier terms initiative, which has set our customary terms as we integrate our legacy businesses.Accounts Payable ProgramAs part of our ongoing efforts to improve our cash flow and related liquidity, we work with our suppliers to optimize our terms and conditions, which include the extension of payment terms. Excluding our suppliers who require cash at date of purchase or sale, our current payment terms with our suppliers generally range from 10 to 360 days. We also entered into an agreement with a third party administrator to allow participating suppliers to track payment obligations from us, and if voluntarily elected by the supplier, sell payment obligations from us to financial institutions. Suppliers can sell one or more of our payment obligations at their sole discretion and our rights and obligations to our suppliers are not impacted. We have no economic interest in a supplier’s decision to enter into these agreements and no direct financial relationship with the financial institutions. Our obligations to our suppliers, including amounts due and scheduled payment terms, are not impacted. We have been informed by the third party administrator that as of December 31, 2020 and December 31, 2019, $2,578 million and $2,097 million, respectively, of our outstanding payment obligations were voluntarily elected by the supplier and sold to financial institutions. The amounts settled through the program and paid to the financial institutions were $2,770 million and $1,745 million for the years ended December 31, 2020 and 2019, respectively.NET CASH USED IN INVESTING ACTIVITIESCash used in investing activities for the year ended December 31, 2020 was primarily driven by our purchases of property, plant and equipment of $461 million and purchases of intangible assets of $56 million, which was partially offset by proceeds of $203 million from sales of property, plant and equipment, primarily driven by our asset sale-leaseback transactions.Cash used in investing activities for the year ended December 31, 2019 was primarily driven by our purchases of property, plant and equipment of $330 million, partially offset by proceeds of $247 million from sales of property, plant and equipment, primarily driven by our asset sale-leaseback transactions. Other drivers of cash used investing activities included $35 million for purchases of intangible assets, primarily the reacquisition of distribution rights, and advances of $32 million to Bedford under its line of credit with us.34Table of ContentsNET CASH USED IN FINANCING ACTIVITIESCash used in financing activities for the year ended December 31, 2020 consisted primarily of the net repayment of $1,246 million for commercial paper notes. We made the decision to repay commercial paper notes with an equivalent amount of borrowings under our KDP Revolver, as the costs and ability to issue commercial paper became inefficient at the onset of the COVID-19 pandemic versus borrowings under our KDP Revolver. The KDP Revolver was subsequently repaid through the issuance of our 2030 Notes and 2050 Notes. Additionally, we made voluntary and mandatory repayments on the term loan facility of $955 million, dividend payments of $846 million, the repayment of the 2020 Notes of $250 million and net payments on structured payables of $170 million. We also received $29 million from controlling shareholder stock transactions, which related to the disgorgement of short-swing profits pursuant to Section 16(b) of the Exchange Act.Net cash used in financing activities for the year ended December 31, 2019 consisted primarily of the voluntary and mandatory repayments on the 2018 KDP Term Loan and 2019 KDP Term Loan of $1,203 million, dividend payments of $844 million, repayments of structured payables of $531 million and the repayment of the 2019 Notes of $250 million. These cash outflows from financing activities were partially offset by net issuance of commercial paper notes of $167 million and proceeds from structured payables of $330 million.Debt RatingsAs of December 31, 2020, our credit ratings were as follows:Rating AgencyLong-Term Debt RatingCommercial Paper RatingOutlookMoody'sBaa2P-2NegativeS&PBBBA-2StableThese debt and commercial paper ratings impact the interest we pay on our financing arrangements. A downgrade of one or both of our debt and commercial paper ratings could increase our interest expense and decrease the cash available to fund anticipated obligations. Capital ExpendituresPurchases of property, plant and equipment were $461 million and $330 million for the years ended December 31, 2020 and 2019, respectively. Capital expenditures, which includes purchases of property, plant and equipment and amounts reflected in accounts payable and accrued expenses, for the year ended December 31, 2020 primarily related to our continued investment in state-of-the-art manufacturing facilities and equipment through the build-out of our Spartanburg manufacturing facility, the purchase of real estate in Ireland and the associated build out of the manufacturing facility and the build-out of our Allentown manufacturing facility. Capital expenditures for the year ended December 31, 2019 primarily related to manufacturing equipment, our continued investment in the construction of our new Spartanburg facility in South Carolina and information technology infrastructure. Cash, Cash Equivalents, Restricted Cash and Restricted Cash EquivalentsCash, cash equivalents, restricted cash and restricted cash equivalents increased $144 million to $255 million as of December 31, 2020 compared to $111 million as of December 31, 2019.Our cash balances are used to fund working capital requirements, scheduled debt and interest payments, capital expenditures, income tax obligations, dividend payments and business combinations. Cash generated by our foreign operations is generally repatriated to the U.S. periodically as working capital funding requirements in those jurisdictions allow. Foreign cash balances were $165 million and $70 million as of December 31, 2020 and December 31, 2019, respectively. We accrue tax costs for repatriation, as applicable, as cash is generated in those foreign jurisdictions. 35Table of ContentsContractual Commitments and ObligationsWe enter into various contractual obligations that impact, or could impact, our liquidity. Based on our current and anticipated level of operations, we believe that our proceeds from operating cash flows will be sufficient to meet our anticipated obligations. To the extent that our operating cash flows are not sufficient to meet our liquidity needs, we may utilize cash on hand or amounts available under our financing arrangements, if necessary. Refer to Note 3 of the Notes to our Consolidated Financial Statements for obligations related to our senior unsecured notes and our KDP Credit Agreements. Refer to Note 9 of the Notes to our Consolidated Financial Statements for future minimum lease commitments.The following table summarizes our contractual obligations as of December 31, 2020: Payments Due in Year (in millions)Total20212022202320242025After 2025Interest payments$5,266 $504 $457 $406 $349 $326 $3,224 Purchase obligations(1)1,893 1,131 296 178 110 91 87 (1)Amounts represent payments under agreements to purchase goods or services that are legally binding and that specify all significant terms, including capital obligations and long-term contractual obligations.Amounts excluded from our tableAs of December 31, 2020, we had $11 million of non-current unrecognized tax benefits, related interest and penalties classified as a long-term liability. The table above does not reflect any payments related to these amounts as it is not possible to make a reasonable estimate of the amount or timing of the payment. Refer to Note 7 of the Notes to our Consolidated Financial Statements for further information. The total accrued benefit liability representing the underfunded position for pension recognized as of December 31, 2020 was approximately $25 million. This amount is impacted by, among other items, funding levels, plan amendments, changes in plan assumptions and the investment return on plan assets. We did not include estimated payments related to our total accrued benefit liability in the table above. The Pension Protection Act of 2006 was enacted in August 2006 and established, among other things, new standards for funding of U.S. defined benefit pension plans. We generally expect to fund all future contributions with cash flows from operating activities. Our international pension plans are generally funded in accordance with local laws and income tax regulations. We did not include our estimated contributions to our various single employer plans in the table above.We have a deferred compensation plan where the assets are maintained in a rabbi trust and the corresponding liability related to the plan is recorded in other non-current liabilities. We did not include estimated payments related to the deferred compensation liability as the timing and payment of these amounts are determined by the participants and outside our control. In general, we are covered under conventional insurance programs with high deductibles or are self-insured for large portions of many different types of claims. Our accrued liabilities for our losses related to these programs are estimated through actuarial procedures of the insurance industry and by using industry assumptions, adjusted for our specific expectations based on our claim history. As of December 31, 2020, our accrued liabilities for our losses related to these programs totaled approximately $107 million. CRITICAL ACCOUNTING ESTIMATES The process of preparing our consolidated financial statements in conformity with U.S. GAAP requires the use of estimates and judgments that affect the reported amounts of assets, liabilities, revenue and expenses. Critical accounting estimates are both fundamental to the portrayal of a company’s financial condition and results and require difficult, subjective or complex estimates and assessments. These estimates and judgments are based on historical experience, future expectations and other factors and assumptions we believe to be reasonable under the circumstances. The most significant estimates and judgments are reviewed on an ongoing basis and revised when necessary. We have not made any material changes in the accounting methodology we use to assess or measure our critical accounting estimates. We have identified the items described below as our critical accounting estimates. We do not believe there is a reasonable likelihood that there will be a material change in the future estimates or assumptions we use in our critical accounting estimates. However, if actual results are not consistent with our estimates or assumptions, we may be exposed to gains or losses that could be material to our consolidated financial statements. See Note 2 of the Notes to our Consolidated Financial Statements for a discussion of these and other accounting policies.36Table of ContentsGoodwill and Other Indefinite Lived Intangible AssetsWe conduct tests for impairment of our goodwill and our other indefinite lived intangible assets annually, as of October 1, or more frequently if events or circumstances indicate the carrying amount may not be recoverable. We use present value and other valuation techniques to make this assessment. If the carrying amount of goodwill or an intangible asset exceeds its fair value, an impairment loss is recognized in an amount equal to that excess. For purposes of impairment testing, we assign goodwill to the reporting unit that benefits from the synergies arising from each business combination, and we also assign indefinite lived intangible assets to our reporting units. We define our six reporting units as the following: SegmentsReporting UnitsPackaged BeveragesDSDWDCoffee SystemsCoffee Systems USCoffee Systems CanadaBeverage ConcentratesBeverage ConcentratesLatin America BeveragesLatin America BeveragesFor both goodwill and other indefinite lived intangible assets, we have the option to first assess qualitative factors to determine whether the fair value of either the reporting unit or indefinite lived intangible asset is not "more likely than not" less than its carrying value, also known as a Step 0 analysis. If a quantitative analysis is required, the following would be required:•The impairment test for indefinite lived intangible assets encompasses calculating a fair value of an indefinite lived intangible asset and comparing the fair value to its carrying value. If the carrying value exceeds the estimated fair value, impairment is recorded.•The impairment tests for goodwill include comparing fair value of the respective reporting unit with its carrying value, including goodwill and considering any indefinite lived intangible asset impairment charges.For the year ended December 31, 2020, we performed a quantitative analysis, whereby we used an income approach, or in some cases a combination of income and market based approaches, to determine the fair value of our assets, as well as an overall consideration of market capitalization and enterprise value. These types of analyses contain uncertainties because they require management to make assumptions and to apply judgment to estimate industry and economic factors and the profitability of future business strategies. These assumptions could be negatively impacted by various risks discussed in Item 1A, Risk Factors, in this Annual Report on Form 10-K.Critical assumptions for quantitative analyses include revenue growth and profit performance, including the achievability of productivity and synergies, over the next five year period, as well as an appropriate discount rate, long term growth rate and royalty rates, as applicable. Discount rates are based on a weighted average cost of equity and cost of debt, adjusted with various risk premiums. Long term growth rates are based on the long-term inflation forecast, industry growth and the long-term economic growth potential. Royalty rates are based on observable market participant information. The following table provides the range of rates used in the analysis as of October 1, 2020:RateMinimumMaximumDiscount rates6.0 %10.0 %Long-term growth rates— %3.5 %Royalty rates1.0 %10.0 %The carrying values of goodwill and indefinite lived intangible assets as of December 31, 2020, were $20,184 million and $22,534 million, respectively. During the year ended December 31, 2020, the Company recorded an impairment of $67 million for the indefinite lived brand asset of Bai. No other impairment of goodwill or indefinite lived intangible assets was identified during the year ended December 31, 2020, and no impairment was identified in each of the years ended December 31, 2019 and 2018.37Table of ContentsSensitivity Analysis - Discount RateFor goodwill, holding all other assumptions in the analysis constant, including the revenue and profit performance assumption, the effect of a 0.50% increase in the discount rate used to determine the fair value of the reporting units as of October 1, 2020, would not change our conclusion.For the indefinite-lived intangible assets, holding all other assumptions in the analysis constant, including the revenue and profit performance assumption, the effect of a 0.50% increase in the discount rate used to determine the fair value of our brands and trade names as of October 1, 2020, would impact the amount of headroom over the carrying value of our brands and trade names as follows (in millions):Selected Discount RateDiscount Rate Increase of 0.50%Headroom PercentageCarrying ValueFair ValueCarrying ValueFair ValueBrandsPotential impairment(1)$482 $415 $1,070 $948 0 - 10%588 625 3,575 3,693 11 - 25%4,464 5,150 2,986 3,492 26 - 50%2,261 2,993 10,916 15,867 In excess of 50%11,946 19,835 1,194 2,130 $19,741 $29,018 $19,741 $26,130 Trade NamesPotential impairment$— $— $— $— 0 - 10%1 1 1 1 11 - 25%— — — — 26 - 50%— — — — In excess of 50%2,479 6,990 2,479 6,420 $2,480 $6,991 $2,480 $6,421 (1)The amounts listed in the Selected Discount Rate columns represent the carrying value of Bai as of the October 1, 2020 measurement date, prior to the $67 million impairment recorded during the fourth quarter of 2020.Sensitivity Analysis - Long-Term Growth RateFor goodwill, holding all other assumptions in the analysis constant, including the discrete period revenue and profit performance assumptions as well as the discount rates, the effect of a 0.50% decrease in the long-term growth rate used to determine the fair value of the reporting units as of October 1, 2020, would not change our conclusion.For the indefinite-lived intangible assets, holding all other assumptions in the analysis constant, including the discrete period revenue and profit performance assumptions as well as the discount rates, the effect of a 0.50% decrease in the long-term revenue growth rate used to determine the fair value of our brands and trade names as of October 1, 2020, would impact the amount of headroom over the carrying value of our brands and trade names as follows (in millions):Selected Long-Term Growth RateLong-Term Growth Rate Decrease of 0.50%Headroom PercentageCarrying ValueFair ValueCarrying ValueFair ValueBrandsPotential impairment(1)$482 $415 $1,070 $968 0 - 10%588 625 3,603 3,805 11 - 25%4,464 5,150 2,644 3,142 26 - 50%2,261 2,993 3,060 4,269 In excess of 50%11,946 19,835 9,364 14,570 $19,741 $29,018 $19,741 $26,754 Trade NamesPotential impairment$— $— $— $— 0 - 10%1 1 1 1 11 - 25%— — — — 26 - 50%— — — — In excess of 50%2,479 6,990 2,479 6,540 $2,480 $6,991 $2,480 $6,541 (1)The amounts listed in the Selected Long-Term Growth Rate columns represent the carrying value of Bai as of the October 1, 2020 measurement date, prior to the $67 million impairment recorded during the fourth quarter of 2020.38Table of ContentsRevenue RecognitionWe recognize revenue when performance obligations under the terms of a contract with the customer are satisfied. Accruals for customer incentives, sales returns and marketing programs are established for the expected payout based on contractual terms, volume-based metrics and/or historical trends.Our customer incentives, sales returns and marketing accrual methodology contains uncertainties because it requires management to make assumptions and to apply judgment regarding our contractual terms in order to estimate our customer participation and volume performance levels which impact the expense recognition. Our estimates are based primarily on a combination of known or historical transaction experiences. Differences between estimated expenses and actual costs are normally insignificant and are recognized to earnings in the period differences are determined.Additionally, judgment is required to ensure the classification of the spend is correctly recorded as either a reduction from gross sales or advertising and marketing expense, which is a component of our SG&A expenses.A 10% change in the accrual for our customer incentives, sales returns and marketing programs would have affected our income from operations by $38 million for the year ended December 31, 2020.Income TaxesWe establish income tax liabilities to remove some or all of the income tax benefit of any of our income tax positions based upon one of the following: •the tax position is not “more likely than not” to be sustained, •the tax position is “more likely than not” to be sustained, but for a lesser amount, or•the tax position is “more likely than not” to be sustained, but not in the financial period in which the tax position was originally taken.Our liability for uncertain tax positions contains uncertainties because management is required to make assumptions and to apply judgment to estimate the exposures associated with our various tax positions.Our income tax returns, like those of most companies, are periodically audited by domestic and foreign tax authorities. These audits include questions regarding our tax positions, including the timing and amount of deductions and the allocation of income among various tax jurisdictions. As these audits progress, events may occur that cause us to change our liability for uncertain tax positions. To the extent we prevail in matters for which a liability for uncertain tax positions has been established, or are required to pay amounts in excess of our established liability, our effective tax rate in a given financial statement period could be materially affected. An unfavorable tax settlement generally would require use of our cash and may result in an increase in our effective tax rate in the period of resolution. A favorable tax settlement may be recognized as a reduction in our effective tax rate in the period of resolution.We also assess the likelihood of realizing our deferred tax assets. Valuation allowances reduce deferred tax assets to the amount more likely than not to be realized. We base our judgment of the recoverability of our deferred tax assets primarily on historical earnings, our estimate of current and expected future earnings and prudent and feasible tax planning strategies.If results differ from our assumptions, a valuation allowance against deferred tax assets may be increased or decreased which would impact our effective tax rate.Business CombinationsWe record acquisitions using the purchase method of accounting. All of the assets acquired and liabilities assumed are recorded at fair value as of the acquisition date. The excess of the purchase price over the estimated fair values of the net tangible and intangible assets acquired is recorded as goodwill. The application of the purchase method of accounting for business combinations requires management to make significant estimates and assumptions in the determination of the fair value of assets acquired and liabilities assumed, in order to properly allocate purchase price consideration between assets that are depreciated and amortized from goodwill. The fair value assigned to tangible and intangible assets acquired and liabilities assumed are based on management’s estimates and assumptions, as well as other information compiled by management, including valuations that utilize customary valuation procedures and techniques. Significant assumptions and estimates include, but are not limited to, the cash flows that an asset is expected to generate in the future, the appropriate weighted-average cost of capital, and the cost savings expected to be derived from acquiring an asset, if applicable.If the actual results differ from the estimates and judgments used in these estimates, the amounts recorded in the consolidated financial statements may be exposed to potential impairment of the intangible assets and goodwill, as discussed in the Goodwill and Other Indefinite Lived Intangible Assets critical accounting estimate section above. 39Table of ContentsOFF-BALANCE SHEET ARRANGEMENTSDistribution Rights Associated with Residual Value GuaranteeOn December 28, 2020, one of our third-party bottlers sold their manufacturing and distribution rights to Veyron SPE. Subsequently, we entered into a distribution arrangement with Veyron SPE, which provided us access to distribute certain CSD beverages, such as Canada Dry, 7UP and A&W in a number of counties in New York and New Jersey in exchange for a fixed service fee and a residual value guarantee. As a result of the residual value guarantee, Veyron SPE was determined to be a VIE; however, we did not consolidate the VIE as we were not the primary beneficiary. Since the agreement provided us immediate distribution access without reacquiring ownership of the distribution rights asset and includes a guarantee on the assets of Veyron SPE, we believe this is an off-balance sheet arrangement. Revenues and expenses related to the arrangement for the year ended December 31, 2020 were not significant. Refer to Note 16 of the Notes to our Consolidated Financial Statements for additional information.Multi-Employer Pension PlansWe currently participate, and have in the past participated, in multi-employer pension plans in the U.S. If, in the future, we choose to withdraw from participation in one of these plans, or we are deemed to have withdrawn from any of the multi-employer pension plans in which we currently participate or have participated in the past, the plan will assess us a withdrawal liability for exiting the plan, and U.S. GAAP would require us to record the withdrawal charge as an expense in our consolidated statements of income and as a liability on our consolidated balance sheets once the multi-employer pension withdrawal charge is probable and estimable. Refer to Note 10 of the Notes to our Consolidated Financial Statements for additional information regarding our multi-employer pension plans.There are no other off-balance sheet arrangements that have or are reasonably likely to have a current or future material effect on our results of operations, financial condition, liquidity, capital expenditures or capital resources other than letters of credit outstanding. Refer to Note 3 of the Notes to our Consolidated Financial Statements for additional information regarding outstanding letters of credit.EFFECT OF RECENT ACCOUNTING PRONOUNCEMENTSRefer to Note 2 of the Notes to our Consolidated Financial Statements for a discussion of recently issued accounting standards and recently adopted provisions of U.S. GAAP.40Table of ContentsSUPPLEMENTAL GUARANTOR FINANCIAL INFORMATIONThe Notes are fully and unconditionally guaranteed by certain of our direct and indirect subsidiaries (the "Guarantors"), as defined in the indentures governing the Notes. The Guarantors are 100% owned either directly or indirectly by us and jointly and severally guarantee, subject to the release provisions described below, our obligations under the Notes. None of our subsidiaries organized outside of the U.S., immaterial subsidiaries used for charitable purposes, any of the subsidiaries held by Maple Parent Holdings Corp. prior to the DPS Merger or any of the subsidiaries acquired after the DPS Merger (collectively, the "Non-Guarantors") guarantee the Notes. The subsidiary guarantees with respect to the Notes are subject to release upon the occurrence of certain events, including the sale of all or substantially all of a subsidiary's assets, the release of the subsidiary's guarantee of our other indebtedness, our exercise of the legal defeasance option with respect to the Notes and the discharge of our obligations under the applicable indenture. The following schedules present the summarized financial information for the Parent and the Guarantors on a combined basis after intercompany eliminations; the Parent and the Guarantors' amounts due from; amounts due to, and transactions with Non-Guarantors are disclosed separately. The consolidating schedules are provided in accordance with the reporting requirements of Rule 13-01 under SEC Regulation S-X for the issuer and guarantor subsidiaries. The summarized financial information for the Parent and Guarantors were as follows:(in millions)For the Year Ended December 31, 2020Net sales$6,636 Income from operations1,262 Net income attributable to KDP1,325 (in millions)December 31, 2020December 31, 2019Current assets(1)$1,810 $1,404 Non-current assets43,333 43,501 Current liabilities(2)$5,148 $3,942 Non-current liabilities16,164 17,707 (1)Includes $423 million and $241 million of current intercompany receivables due to the Parent and Guarantors from the Non-Guarantors as of December 31, 2020 and December 31, 2019, respectively. (2)Includes $30 million and $20 million of current intercompany payables due to the Non-Guarantors from the Parent and Guarantors as of December 31, 2020 and December 31, 2019, respectively.41Table of ContentsNon-GAAP Financial MeasuresTo supplement the consolidated financial statements presented in accordance with U.S. GAAP, we have presented for the years ended December 31, 2020 and 2019 (i) Adjusted income from operations, (ii) Adjusted interest expense, (iii) Adjusted provision for income taxes, (iv) Adjusted net income attributable to KDP and (v) Adjusted diluted EPS, which are considered non-GAAP financial measures. The non-GAAP financial measures provided should be viewed in addition to, and not as an alternative for, results prepared in accordance with U.S. GAAP. The non-GAAP financial measures presented may differ from similarly titled non-GAAP financial measures presented by other companies, and other companies may not define these non-GAAP financial measures in the same way. The adjusted measures are not substitutes for their comparable U.S. GAAP financial measures, such as income from operations, net income, diluted EPS, or other measures prescribed by U.S. GAAP, and there are limitations to using non-GAAP financial measures.For the years ended December 31, 2020 and 2019, we define our Adjusted non-GAAP financial measures as certain financial statement captions and metrics adjusted for certain items affecting comparability. The items affecting comparability are defined below.Items affecting comparability: Defined as certain items that are excluded for comparison to the prior year, adjusted for the tax impact as applicable. Tax impact is determined based upon an approximate rate for each item. For each year, management adjusts for (i) the unrealized mark-to-market impact of derivative instruments not designated as hedges in accordance with U.S. GAAP and do not have an offsetting risk reflected within the financial results; (ii) the amortization associated with definite-lived intangible assets; (iii) the amortization of the deferred financing costs associated with the DPS Merger and the Keurig Acquisition; (iv) the amortization of the fair value adjustment of the senior unsecured notes obtained as a result of the DPS Merger; (v) stock compensation expense attributable to the matching awards made to employees who made an initial investment in the EOP, the 2009 Incentive Plan or the 2019 Incentive Plan; and (vi) other certain items that are excluded for comparison purposes to the prior year. For the year ended December 31, 2020, the other certain items excluded for comparison purposes include (i) restructuring and integration expenses related to significant business combinations; (ii) productivity expenses; (iii) costs related to significant non-routine legal matters; (iv) the loss on early extinguishment of debt related to the redemption of debt; (v) incremental temporary costs to our operations related to risks associated with the COVID-19 pandemic; (vi) impairment recognized on the equity method investments with Bedford and LifeFuels; and (vii) impairment recognized on the Bai brand.Incremental costs to our operations related to risks associated with the COVID-19 pandemic include incremental expenses incurred to either maintain the health and safety of our front-line employees or temporarily increase compensation to such employees to ensure essential operations continue during the pandemic. We believe removing these costs reflects how management views our business results on a consistent basis. See Impact of COVID-19 on our Financial Statements for further information.For the year ended December 31, 2019, the other certain items excluded for comparison purposes include (i) restructuring and integration expenses related to significant business combinations; (ii) productivity expenses; (iii) transaction costs for significant business combinations (completed or abandoned) excluding the DPS Merger; (iv) costs related to significant non-routine legal matters; (v) the impact of the step-up of acquired inventory not associated with the DPS Merger; (vi) the loss on early extinguishment of debt related to the redemption of debt and (vii) the loss related to the February 2019 organized malware attack on our business operation networks in the Coffee Systems segment.For the years ended December 31, 2020 and 2019, the supplemental financial data set forth below includes reconciliations of Adjusted income from operations, Adjusted net income and Adjusted diluted EPS to the applicable financial measure presented in the consolidated financial statement for the same year. 42Table of ContentsKEURIG DR PEPPER INC.RECONCILIATION OF CERTAIN REPORTED ITEMS TO CERTAIN NON-GAAP ADJUSTED ITEMSFor the Year Ended December 31, 2020 (Unaudited, in millions, except per share data)Cost of salesGross profitGross marginSelling, general and administrative expensesImpairment of intangible assetsIncome from operationsOperating marginReported$5,132 $6,486 55.8 %$3,978 $67 $2,480 21.3 %Items Affecting Comparability:Mark to market33 (33)(5)— (28)Amortization of intangibles— — (133)— 133 Stock compensation— — (27)— 27 Restructuring and integration costs— — (199)— 199 Productivity(29)29 (99)— 128 Impairment of intangible assets— — — (67)67 Non-routine legal matters— — (57)— 57 COVID-19(44)44 (84)— 128 Adjusted$5,092 $6,526 56.2 %$3,374 $— $3,191 27.5 %Interest expenseImpairment on investments and note receivableLoss on early extinguishment of debtIncome before provision for income taxesProvision for income taxesEffective tax rateNet incomeWeighted Average Diluted sharesDiluted earnings per shareReported$604 $102 $4 $1,753 $428 24.4 %$1,325 1,422.1$0.93 Items Affecting Comparability:Mark to market(27)— — (1)(1)— — Amortization of intangibles— — — 133 35 98 0.07 Amortization of deferred financing costs(11)— — 11 3 8 0.01 Amortization of fair value debt adjustment(24)— — 24 6 18 0.01 Stock compensation— — — 27 5 22 0.02 Restructuring and integration costs— — — 199 49 150 0.11 Productivity— — — 128 33 95 0.07 Impairment on intangible asset— — 67 15 52 0.04 Loss on early extinguishment of debt— — (4)4 1 3 — Investment impairment— (102)— 102 25 77 0.05 Non-routine legal matters— — — 57 14 43 0.03 COVID-19— — — 128 31 97 0.07 Adjusted$542 $— $— $2,632 $644 24.5 %$1,988 1,422.1$1.40 Diluted EPS may not foot due to rounding.43Table of ContentsKEURIG DR PEPPER INC.RECONCILIATION OF CERTAIN REPORTED ITEMS TO CERTAIN NON-GAAP ADJUSTED ITEMSFor the Year Ended December 31, 2019 (Unaudited, in millions, except per share data)Cost of salesGross profitGross marginSelling, general and administrative expensesOther operating (income) expense, netIncome from operationsOperating marginReported$4,778 $6,342 57.0 %$3,962 $2 $2,378 21.4 %Items Affecting Comparability:Mark to market35 (35)10 — (45)Amortization of intangibles— — (126)— 126 Stock compensation— — (24)— 24 Restructuring and integration costs(1)1 (216)(25)242 Productivity(15)15 (60)(22)97 Transaction costs— — (9)— 9 Non-routine legal matters— — (48)— 48 Inventory step-up(3)3 — — 3 Malware incident(2)2 (6)— 8 Adjusted$4,792 $6,328 56.9 %$3,483 $(45)$2,890 26.0 %Interest expenseLoss on early extinguishment of debtIncome before provision for income taxesProvision for income taxesEffective tax rateNet incomeWeighted Average Diluted sharesDiluted earnings per shareReported$654 $11 $1,694 $440 26.0 %$1,254 1,419.1$0.88 Items Affecting Comparability:Mark to market(47)— 2 (1)3 — Amortization of intangibles— — 126 34 92 0.06 Amortization of deferred financing costs(13)— 13 4 9 0.01 Amortization of fair value debt adjustment(26)— 26 6 20 0.01 Stock compensation— — 24 6 18 0.01 Restructuring and integration costs1 — 241 55 186 0.13 Productivity— — 97 24 73 0.05 Transaction costs(16)— 25 7 18 0.01 Loss on early extinguishment of debt— (11)11 2 9 0.01 Non-routine legal matters— — 48 11 37 0.02Inventory step-up— — 3 1 2 — Malware incident— — 8 2 6 — Adjusted$553 $— $2,318 $591 25.5 %$1,727 1,419.1$1.22 Diluted EPS may not foot due to rounding.44Table of ContentsKEURIG DR PEPPER INC.RECONCILIATION OF SEGMENT ITEMS TO CERTAIN NON-GAAP ADJUSTED SEGMENT ITEMS(Unaudited)(in millions)ReportedItems Affecting ComparabilityAdjustedFor the Year Ended December 31, 2020Income from OperationsCoffee Systems$1,268 $246 $1,514 Packaged Beverages822 199 1,021 Beverage Concentrates932 6 938 Latin America Beverages105 3 108 Unallocated corporate costs(647)257 (390)Total income from operations$2,480 $711 $3,191 (in millions)ReportedItems Affecting ComparabilityAdjustedFor the Year Ended December 31, 2019Income from OperationsCoffee Systems$1,219 $184 $1,403 Packaged Beverages757 26 783 Beverage Concentrates955 2 957 Latin America Beverages85 (3)82 Unallocated corporate costs(638)303 (335)Total income from operations$2,378 $512 $2,890 45Table of ContentsITEM 7A. Quantitative and Qualitative Disclosures About Market RiskWe are exposed to market risks arising from changes in market rates and prices, including movements in foreign currency exchange rates, interest rates and commodity prices. From time to time, we may enter into derivatives or other financial instruments to hedge or mitigate commercial risks. We do not enter into derivative instruments for speculation, investing or trading. Refer to Note 8 of the Notes to our Consolidated Financial Statements for further information about our derivative instruments.FOREIGN EXCHANGE RISKThe majority of our net sales, expenses and capital purchases are transacted in U.S. dollars. However, we have exposure with respect to foreign exchange rate fluctuations. Our primary exposure to foreign exchange rates is the Canadian dollar, the Mexican peso and the Euro against the U.S. dollar. Exchange rate gains or losses related to foreign currency transactions are recognized as transaction gains or losses in our income statement as incurred. As of December 31, 2020, the impact to our income from operations of a 10% change (up or down) in exchange rates is estimated to be an increase or decrease of approximately $38 million on an annual basis.We use derivative instruments such as foreign exchange forward contracts to manage a portion of our exposure to changes in foreign exchange rates. As of December 31, 2020, we had derivative contracts outstanding with a notional value of $809 million maturing at various dates through September 25, 2024.INTEREST RATE RISKWe centrally manage our debt portfolio through the use of interest rate swaps and monitor our mix of fixed-rate and variable-rate debt. As of December 31, 2020, the carrying value of our fixed-rate debt, excluding lease obligations, was $13,065 million and our variable-rate debt was $423 million, inclusive of commercial paper. As of December 31, 2020, the total notional value of our receive-variable, pay-fixed interest rate swaps was $450 million. Based upon our variable rate debt and the fair value of the interest rate swaps that could result from hypothetical interest rate changes during the term of the financial instruments, there was no interest rate risk associated with our debt balances based on debt levels as of December 31, 2020.COMMODITY RISKWe are subject to market risks with respect to commodities because our ability to recover increased costs through higher pricing may be limited by the competitive environment in which we operate. Our principal commodities risks relate to our purchases of coffee beans, PET, aluminum, diesel fuel, corn (for high fructose corn syrup), apple juice concentrate, apples, sucrose and natural gas (for use in processing and packaging).We utilize commodities derivative instruments and supplier pricing agreements to hedge the risk of movements in commodity prices for limited time periods for certain commodities. As of December 31, 2020, we had derivative contracts outstanding with a notional value of $450 million maturing at various dates through January 1, 2024. The fair market value of these contracts as of December 31, 2020 was a net asset of $50 million.As of December 31, 2020, the impact of a 10% change (up or down) in market prices for these commodities where the risk of movements has not been hedged is estimated to have a $15 million impact to our income from operations for the year ended December 31, 2021.46Table of Contents
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+ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSThe following discussion of the company’s financial condition and results of operations should be read together with its consolidated financial statements and notes to the consolidated financial statements included in Item 8 of this Form 10-K. PageBusiness Overview19Executive Summary – Financial Results & Outlook20Consolidated Results and Other Information21Segment Discussion27Liquidity, Capital Resources and Other Financial Data33Off-Balance Sheet Arrangements37Critical Accounting Policies37New Accounting Standards39Fair Value Measurements40Non-GAAP Financial Measures40Supplemental Guarantee Information4418Table of ContentsBUSINESS OVERVIEWThe company's primary products in its industrial gases business are atmospheric gases (oxygen, nitrogen, argon, rare gases) and process gases (carbon dioxide, helium, hydrogen, electronic gases, specialty gases, acetylene). The company also designs, engineers, and builds equipment that produces industrial gases and offers its customers a wide range of gas production and processing services such as olefin plants, natural gas plants, air separation plants, hydrogen and synthesis gas plants and other types of plants. Linde’s industrial gas operations are managed on a geographical basis and in 2020 83% of sales were generated by Linde's three geographic segments (Americas, EMEA and APAC) and the remaining 17% are related primarily to the Engineering segment, and to a lesser extent Other (see Note 18 to the consolidated financial statements for operating segment details).Linde serves a diverse group of industries including healthcare, petroleum refining, manufacturing, food, beverage carbonation, fiber-optics, steel making, aerospace, chemicals and water treatment. The diversity of end-markets supports financial stability for Linde in varied business cycles.Linde generates most of its revenues and earnings in the following geographies where the company has its strongest market positions and where distribution and production operations allow the company to deliver the highest level of service to its customers at the lowest cost. North and South America ("Americas")Europe, Middle East and Africa (“EMEA”)Asia and Pacific (“APAC”)United StatesGermanyChina & TaiwanBrazilUnited KingdomAustraliaMexicoEastern EuropeSouth KoreaCanadaIndiaThe company manufactures and distributes its industrial gas products through networks of thousands of production plants, pipeline complexes, distribution centers and delivery vehicles. Major pipeline complexes are primarily located in the United States. These networks are a competitive advantage, providing the foundation of reliable product supply to the company’s customer base. The majority of Linde’s business is conducted through long-term contracts which provide stability in cash flow and the ability to pass through changes in energy and feedstock costs to customers. The company has growth opportunities in all major geographies and in diverse end-markets such as energy, electronics, chemicals, metals, healthcare, food and beverage, and aerospace. 19Table of ContentsEXECUTIVE SUMMARY – FINANCIAL RESULTS & OUTLOOK2020 Year in review•Sales of $27,243 million were 3% below 2019 sales of $28,228 million. Volumes decreased 2% as growth from project start-ups was more than offset by the global macroeconomic slowdown as a result of the COVID-19 pandemic. Higher pricing across all geographic segments contributed 2% to sales. Unfavorable currency translation, lower cost pass-through and the net impact of acquisitions and divestitures decreased sales by 3%. •Reported operating profit of $3,322 million was 13% above 2019. Adjusted operating profit of $5,797 million was 10% above 2019. The increase in both reported and adjusted operating profit was primarily driven by higher price and the benefit of cost reduction programs and other charges and productivity initiatives which more than offset the impact of lower volumes.*•Income from continuing operations of $2,497 million and diluted earnings per share from continuing operations of $4.70 increased from $2,183 million and $4.00, respectively in 2019. Adjusted income from continuing operations of $4,371 million and adjusted diluted earnings per share from continuing operations of $8.23 were 9% and 12%, respectively above 2019 adjusted amounts.*•Cash flow from operations was $7,429 million, or 27% of sales. Capital expenditures were $3,400 million; dividends paid were $2,028 million; net purchases of ordinary shares of $2,410 million; and debt borrowings, net were $1,313 million.*A reconciliation of the adjusted amounts can be found in the "Non-GAAP Financial Measures" section in this MD&A.2021 OutlookLinde provides quarterly updates on operating results, material trends that may affect financial performance, and financial guidance via earnings releases and investor teleconferences. These materials are available on the company’s website, www.linde.com, but are not incorporated herein.20Table of ContentsCONSOLIDATED RESULTS AND OTHER INFORMATIONThe discussion that follows includes a comparison of our results of operations and liquidity and capital resources for the years ended December 31, 2020 and 2019. For the discussion comparing the years ended December 31, 2019 and 2018, refer to Part II, Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations, of our Form 10-K for the year ended December 31, 2019. The following table provides summary information for 2020 and 2019. The reported amounts are GAAP amounts from the Consolidated Statements of Income. The adjusted amounts are intended to supplement investors' understanding of the company's financial information and are not a substitute for GAAP measures. (Millions of dollars, except per share data)Year Ended December 31,20202019VarianceReported AmountsSales$27,243 $28,228 (3)%Cost of sales, exclusive of depreciation and amortization$15,383 $16,644 (8)%As a percent of sales56.5 %59.0 %Selling, general and administrative$3,193 $3,457 (8)%As a percent of sales11.7 %12.2 %Depreciation and amortization$4,626 $4,675 (1)%Cost reduction programs and other charges (a)$506 $567 (11)%Net gain on sale of businesses (b)$— $164 Operating Profit$3,322 $2,933 13 %Operating margin12.2 %10.4 %Interest expense – net$115 $38 203 %Net pension and OPEB cost (benefit), excluding service cost$(177)$(32)453 %Effective tax rate25.0 %26.3 %Income from equity investments$85 $114 (25)%Noncontrolling interests from continuing operations$(125)$(89)40 %Income from continuing operations$2,497 $2,183 14 %Diluted earnings per share from continuing operations$4.70 $4.00 18 %Diluted shares outstanding531,157 545,170 (3)%Number of employees74,207 79,886 (7)%Adjusted Amounts (c)Operating profit$5,797 $5,272 10 %Operating margin21.3 %18.7 %Income from continuing operations$4,371 $4,003 9 %Diluted earnings per share from continuing operations$8.23 $7.34 12 %Other Financial Data (c)EBITDA from continuing operations$8,033 $7,722 4 %As percent of sales29.5 %27.4 %Adjusted EBITDA from continuing operations$8,645 $8,178 6 %As percent of sales31.7 %29.0 %________________________(a)See Note 3 to the consolidated financial statements.(b)See Note 2 to the consolidated financial statements.(c)Adjusted amounts and Other Financial Data are non-GAAP performance measures. A reconciliation of reported amounts to adjusted amounts can be found in the "Non-GAAP Financial Measures" section of this MD&A. Results of OperationsThe following table provides a summary of changes in consolidated sales:21Table of Contents2020 vs. 2019 % ChangeFactors Contributing to Changes - SalesVolume(2)%Price/Mix2 %Cost pass-through(1)%Currency(1)%Acquisitions/divestitures(1)%Engineering— %(3)%2020 Compared With 2019 SalesReported sales decreased $985 million, or 3%, for the 2020 year versus 2019. On an adjusted basis sales decreased $920 million in 2020 compared to 2019.On a reported and adjusted basis, sales decreased 3%. Volume decreased sales by 2% primarily driven by the impact of the macroeconomic slowdown, partially offset by new project start-ups. Higher pricing across all geographic segments contributed 2% to sales. Currency translation decreased sales by 1%, largely in the Americas, driven by the weakening of the Brazilian real against the U.S. dollar. Cost pass-through decreased sales by 1% with minimal impact on operating profit. The impact of merger-related divestitures decreased sales by $65 million in 2020. These sales have been excluded from the adjusted numbers.Cost of sales, exclusive of depreciation and amortization Cost of sales, exclusive of depreciation and amortization, decreased $1,261 million, or 8%, for the year primarily due to lower volumes and the impact of productivity initiatives. Cost of sales, exclusive of depreciation and amortization, was 56.5% and 59.0% of sales, respectively, in 2020 compared to 2019. The decrease as a percentage of sales was due primarily to the impact of cost reduction programs and productivity initiatives and the impact of lower cost pass-through.Selling, general and administrative expensesSelling, general and administrative expense ("SG&A") decreased $264 million, or 8%, in 2020 to $3,193 million. SG&A was 11.7% of sales in 2020 versus 12.2% in 2019. Currency impacts decreased SG&A by approximately $34 million in 2020. Excluding currency impacts, underlying SG&A decreased driven by the impact of cost reduction programs and productivity initiatives. Depreciation and amortizationReported depreciation and amortization expense decreased $49 million, or 1%, versus 2019. The decrease is primarily due to currency translation impacts.On an adjusted basis, depreciation and amortization expense decreased $29 million, or 1%, versus 2019. The decrease is primarily due to currency translation impacts which decreased depreciation and amortization by approximately $39 million in 2020 slightly offset by new project start ups primarily in APAC and the Americas. Cost reduction programs and other chargesLinde recorded cost reduction programs and other charges of $506 million and $567 million for 2020 and 2019, respectively, primarily associated with the company's cost reduction program, which represents charges for achieving synergies and cost efficiencies related to the merger. 2019 also included an asset impairment of approximately $73 million related to a joint venture in APAC resulting from an unfavorable arbitration ruling (see Note 3 to the consolidated financial statements).On an adjusted basis, these costs have been eliminated in both periods. Operating profitReported operating profit increased $389 million in 2020, or 13%. On an adjusted basis, operating profit increased $525 million, or 10%, for 2020 versus 2019.On a reported basis, operating profit increased $389 million, or 13% in 2020. The increase in the year was driven by higher price and the benefit of cost reduction programs and productivity initiatives. Cost reduction programs and other charges 22Table of Contentswere $506 million in 2020 and $567 million in 2019. 2019 also included a $164 million one time net gain on sale of business.On an adjusted basis, which excludes the impacts of purchase accounting, cost reduction programs and other charges and net gains from merger-related divestitures in 2019, operating profit increased $525 million, or 10%. Operating profit growth was driven by higher price and the benefit of cost reduction programs and productivity initiatives which were partially offset by lower volumes, unfavorable currency impacts and cost inflation. A discussion of operating profit by segment is included in the segment discussion that follows.Interest expense - netReported interest expense – net in 2020 increased $77 million, or 203%, versus 2019 and included a $16 million charge for the early redemption of bonds due in 2021 (see Note 11 to the consolidated financial statements). On an adjusted basis interest expense increased $50 million, or 37% in 2020 as compared to 2019.On both a reported and adjusted basis, the increase year over year included the impact of unfavorable foreign currency revaluation on unhedged intercompany loans and lower interest income, partially offset by a lower effective borrowing rate. Net pension and OPEB cost (benefit), excluding service costReported net pension and OPEB cost (benefit), excluding service cost was a benefit of $177 million in 2020 versus a benefit of $32 million in 2019. 2020 included pension settlement charges of $6 million while 2019 included pension settlement charges of $97 million and a net $8 million curtailment charge (see Note 16 to the consolidated financial statements). Excluding the impact of these charges, the net pension and OPEB benefit, excluding service cost increased $46 million in 2020, as the benefit of lower interest cost due to the low discount rate environment more than offset higher amortization of deferred losses. Effective tax rateThe reported effective tax rate ("ETR") for 2020 was 25.0% versus 26.3% in 2019. The decrease in the reported ETR is primarily due to higher tax benefits from share option exercises and higher tax expense in 2019 related to divestitures.On an adjusted basis, the ETR for 2020 was 23.8% versus 24.0% in 2019. The decrease in the adjusted ETR is primarily due to higher tax benefits from share option exercises.Income from equity investmentsReported income from equity investments for 2020 was $85 million as compared to $114 million in 2019. On an adjusted basis, income from equity investments for 2020 was $142 million versus $171 million in 2019. The decrease in the reported and adjusted income from equity investments was primarily driven by unfavorable foreign currency revaluation impacts on an unhedged loan of an investment in EMEA. Noncontrolling interests from continuing operationsAt December 31, 2020, noncontrolling interests from continuing operations consisted primarily of noncontrolling shareholders’ investments in APAC (primarily in China) and surface technologies. Reported noncontrolling interests from continuing operations increased $36 million to $125 million in 2020 from $89 million in 2019, primarily driven by the noncontrolling interest impact of $33 million for an asset impairment charge in the third quarter 2019 related to a joint venture in APAC.Adjusted noncontrolling interests from continuing operations increased $8 million in 2020 as compared to 2019.Income from continuing operationsReported income from continuing operations increased $314 million, or 14%, primarily due to higher overall operating profit and a lower effective tax rate. On an adjusted basis, which excludes the impacts of purchase accounting and other non-GAAP adjustments, income from continuing operations increased $368 million, or 9%, in 2020 versus 2019. The increase was primarily due to higher adjusted operating profit partially offset by higher interest expense and lower equity income.Diluted earnings per share from continuing operationsReported diluted earnings per share from continuing operations increased $0.70, or 18%, in 2020 as compared to 2019. 23Table of ContentsOn an adjusted basis, diluted EPS of $8.23 in 2020 increased 12% versus 2019, primarily due to higher income from continuing operations and lower diluted shares outstanding.EmployeesThe number of employees at December 31, 2020 was 74,207, a decrease of 5,679 employees from December 31, 2019 primarily driven by cost reduction actions and divestitures. Other Financial DataEBITDA increased to $8,033 million in 2020 from $7,722 million in 2019. Adjusted EBITDA from continuing operations increased to $8,645 million for 2020 as compared to $8,178 million in 2019 primarily due to higher income from continuing operations versus the prior year period. See the "Non-GAAP Financial Measures" section for definitions and reconciliations of these non-GAAP measures to reported GAAP amounts.Other Comprehensive Income (Loss)Other comprehensive income for the year ended December 31, 2020 of $157 million resulted primarily from currency translation adjustments of $595 million largely offset by a decrease in the funded status of the company's retirement obligations of $469 million driven by the low discount rate environment. The translation adjustments reflect the impact of translating local currency foreign subsidiary financial statements to U.S. dollars, and are largely driven by the movement of the U.S. dollar against major currencies including the Euro, the Chinese yuan and the British pound. See the "Currency" section of the MD&A for exchange rates used for translation purposes and Note 7 to the consolidated financial statements for a summary of the currency translation adjustment component of accumulated other comprehensive income by segment.Related Party TransactionsThe company’s related parties are primarily unconsolidated equity affiliates. The company did not engage in any material transactions involving related parties that included terms or other aspects that differ from those which would be negotiated with independent parties.Environmental MattersLinde’s principal operations relate to the production and distribution of atmospheric and other industrial gases, which historically have not had a significant impact on the environment. However, worldwide costs relating to environmental protection may continue to grow due to increasingly stringent laws and regulations, and Linde's ongoing commitment to rigorous internal standards. In addition, Linde may face physical risks from climate change and extreme weather. Climate ChangeLinde operates in jurisdictions that have, or are developing, laws and/or regulations to reduce or mitigate the perceived adverse effects of greenhouse gas ("GHG") emissions and faces a highly uncertain regulatory environment in this area. For example, the U.S. Environmental Protection Agency ("EPA") has promulgated rules requiring reporting of GHG emissions, and Linde and many of its suppliers and customers are subject to these rules. EPA has also promulgated regulations to restrict GHG emissions, including final rules regulating GHG emissions from light-duty vehicles and certain large manufacturing facilities, many of which are Linde suppliers or customers. In addition to these developments in the United States, several other countries worldwide have already implemented carbon taxation or trading systems which impact the company's customers and Linde operations, among those regulations in China, Singapore and the European Union. Among other impacts, such regulations are expected to raise the cost of energy, which is a significant cost for Linde. Nevertheless, Linde's long-term customer contracts routinely provide rights to recover increased electricity, natural gas, and other costs that are incurred by the company as a result of climate change regulation.Linde anticipates continued growth in its hydrogen business due to increased focus on air quality. Hydrogen production plants and a large number of other manufacturing and electricity-generating plants have been identified in California and the European Union as a source of carbon dioxide emissions and these plants are subject to cap-and-trade regulations in those jurisdictions. Linde believes it will be able to mitigate the costs of these regulations through the terms of its product supply contracts. However, legislation that limits GHG emissions may impact growth by increasing capital, compliance, operating and maintenance costs and/or decreasing demand.24Table of ContentsTo manage business risks from current and potential GHG emission regulation as well as physical consequences of climate change, Linde actively monitors current developments, evaluates the direct and indirect business risks, and takes appropriate actions. Among others, actions include: increasing relevant resources and training; maintaining contingency plans; obtaining advice and counsel from expert vendors, insurance providers and industry experts; incorporating GHG provisions in commercial agreements; and conducting regular reviews of the business risks with management. Although there are considerable uncertainties, Linde believes that the business risk from potential regulations can be effectively managed through its commercial contracts. Additionally, Linde does not anticipate any material effects regarding its plant operations or business arising from potential physical risks of climate change. Linde continuously seeks opportunities to optimize energy use and GHG footprint through research and development in customer applications and rigorous operational energy efficiency, investment in renewable energy, and purchasing hydrogen as a chemical byproduct where feasible. Linde maintains related performance improvement targets and reports progress against these targets regularly to business management and annually to Linde's Board of Directors. At the same time, Linde may benefit from business opportunities arising from governmental regulation of GHG and other emissions; uncertain costs of energy and certain natural resources; the development of renewable energy alternatives; and new technologies that help extract natural gas, improve air quality, increase energy efficiency and mitigate the impacts of climate change. Linde continues to develop new applications that can lower emissions, including GHG emissions, in Linde's processes and help customers lower energy consumption and increase product throughput. Stricter regulation of water quality in emerging economies such as China provide a growing market for a number of gases, e.g., oxygen for wastewater treatment. Increased concern about drought in areas such as California and Australia may create additional markets for carbon dioxide for desalination. Renewable fuel standards in the European Union and U.S. create a market for second-generation biofuels which use industrial gases such as oxygen, carbon dioxide, and hydrogen.Costs Relating to the Protection of the EnvironmentEnvironmental protection costs in 2020 were not significant. Linde anticipates that future annual environmental protection expenditures will be similar to 2020, subject to any significant changes in existing laws and regulations. Based on historical results and current estimates, management does not believe that environmental expenditures will have a material adverse effect on the consolidated financial position, the consolidated results of operations or cash flows in any given year.Legal ProceedingsSee Note 17 to the consolidated financial statements for information concerning legal proceedings.Retirement BenefitsPensionsThe net periodic benefit cost (benefit) for the U.S. and international pension plans was a benefit of $28 million in 2020 and costs of $107 million and $24 million in 2019 and 2018, respectively. 2019 net periodic pension cost included pension settlement charges of $97 million related to lump sum payments, which were triggered by either a change in control provision or merger-related divestitures, and a net curtailment charge of $8 million for termination benefits, primarily in connection with a defined benefit pension plan freeze. Settlement charges were $6 million and $14 million for 2020 and 2018, respectively.The funded status (pension benefit obligation ("PBO") less the fair value of plan assets) for the U.S. plans was a deficit of $436 million and $504 million at December 31, 2020 and 2019, respectively. The funded status for international plans was a deficit of $2,334 million and $1,801 million at December 31, 2020 and 2019, respectively. In the U.S., the benefit from the actual return on assets more than offset the impact of unfavorable liability experience, primarily resulting from the low discount rate environment. For the international plans, the unfavorable impact of lower discount rates outweighed favorable plan asset returns. Global pension contributions were $91 million in 2020, $94 million in 2019, and $87 million in 2018. At a minimum, Linde contributes to its pension plans to comply with local regulatory requirements (e.g., ERISA in the U.S.). Discretionary contributions in excess of the local minimum requirements are made based on many factors, including long-term projections of the plans' funded status, the economic environment, potential risk of overfunding, pension insurance costs and alternative uses of cash. Changes to these factors can impact the timing of discretionary contributions from year to year. Estimated required contributions for 2021 are currently expected to be in the range of $70 million to $80 million.25Table of ContentsLinde assumes expected returns on plan assets for 2021 of 7.00% and 5.27% for the U.S. and international plans, respectively, which are consistent with the long-term expected returns on its investment portfolios. Excluding the impact of any settlements, 2021 consolidated pension expense is expected to be a benefit of approximately $36 million. The benefit derived from the expected return on assets assumption for Linde's most significant plans is anticipated to more than offset the expense from service and interest cost accruals and the higher amortization of deferred losses. Refer to the Critical Accounting Policies section and Note 16 to the consolidated financial statements for a more detailed discussion of the company’s retirement benefits, including a description of the various retirement plans and the assumptions used in the calculation of net periodic benefit cost (benefit) and funded status.InsuranceLinde purchases insurance to limit a variety of property and casualty risks, including those related to property, business interruption, third-party liability and workers’ compensation. Currently, the company self retains up to $10 million per occurrence for vehicle liability in the United States, $5 million per occurrence for workers' compensation and general liability. In addition, the company self retains risk up to €5 million at its various properties worldwide for property damage resulting from fire, flood and other perils effecting its properties along with a separate €5 million deductible on all business interruption resulting from a major peril loss. To mitigate its aggregate loss potential above these retentions, the company purchases catastrophic insurance coverage from highly rated insurance companies. The company does not currently operate or participate in any captive insurance companies or other non-traditional risk transfer alternatives.At December 31, 2020 and 2019, the company had recorded a total of $71 million and $66 million, respectively, representing an estimate of the retained liability for the ultimate cost of claims incurred and unpaid as of the balance sheet dates. The estimated liability is established using statistical analysis and is based upon historical experience, actuarial assumptions and professional judgment. These estimates are subject to the effects of trends in loss severity and frequency and are subject to a significant degree of inherent variability. If actual claims differ from the company’s estimates, they will be adjusted at that time and financial results could be impacted.Linde recognizes estimated insurance proceeds relating to damages at the time of loss only to the extent of incurred losses. Any insurance recoveries for business interruption and for property damages in excess of the net book value of the property are recognized only when realized or pending payments confirmed by its insurance companies.26Table of ContentsSEGMENT DISCUSSIONLinde’s operations consist of two major product lines: industrial gases and engineering. As further described in the following paragraph, Linde’s industrial gases operations are managed on a geographic basis, which represents three of the company's reportable segments - Americas, EMEA (Europe/Middle East/Africa), and APAC (Asia/South Pacific); a fourth reportable segment which represents the company's Engineering business, designs and manufactures equipment for air separation and other industrial gas applications specifically for end customers and is managed on a worldwide basis operating in all geographic segments. Other consists of corporate costs and a few smaller businesses which individually do not meet the quantitative thresholds for separate presentation. The industrial gases product line centers on the manufacturing and distribution of atmospheric gases (oxygen, nitrogen, argon, rare gases) and process gases (carbon dioxide, helium, hydrogen, electronic gases, specialty gases, acetylene). Many of these products are co-products of the same manufacturing process. Linde manufactures and distributes nearly all of its products and manages its customer relationships on a regional basis. Linde’s industrial gases are distributed to various end-markets within a regional segment through one of three basic distribution methods: on-site or tonnage; merchant or bulk; and packaged or cylinder gases. The distribution methods are generally integrated in order to best meet the customer’s needs and very few of its products can be economically transported outside of a region. Therefore, the distribution economics are specific to the various geographies in which the company operates and are consistent with how management assesses performance.The company’s measure of profit/loss for segment reporting purposes is segment operating profit. Segment operating profit is defined as operating profit excluding purchase accounting impacts of the Linde AG merger, intercompany royalties, and items not indicative of ongoing business trends. This is the manner in which the company’s Chief Operating Decision Maker ("CODM") assesses performance and allocates resources. The table below presents sales and operating profit information about reportable segments and Other for the years ended December 31, 2020 and 2019.(Millions of dollars)Year Ended December 31,20202019VarianceSalesAmericas$10,459 $10,989 (5)%EMEA6,449 6,643 (3)%APAC5,687 5,779 (2)%Engineering2,851 2,799 2 %Other1,797 1,953 (8)%Total segment sales$27,243 $28,163 (3)%Merger-related divestitures— 65 Total Sales$27,243 $28,228 Operating ProfitAmericas$2,773 $2,577 8 %EMEA1,465 1,367 7 %APAC1,277 1,184 8 %Engineering435 390 12 %Other(153)(246)38 %Segment operating profit5,797 5,272 10 %Reconciliation to reported operating profit :Cost reduction programs and other charges (Note 3)(506)(567)Merger-related divestitures— 16 Net gain on sale of businesses— 164 Purchase accounting impacts - Linde AG(1,969)(1,952)Total operating profit$3,322 $2,933 27Table of ContentsAmericas(Dollar amounts in millions)VarianceYear Ended December 31,202020192020 vs. 2019Sales$10,459 $10,989 (5)%Operating profit$2,773 $2,577 8 %As a percent of sales26.5 %23.5 %2020 vs. 2019 % ChangeFactors Contributing to Changes - SalesVolume(2)%Price/Mix2 %Cost pass-through(1)%Currency(3)%Acquisitions/Divestitures(1)%(5)%The Americas segment includes Linde’s industrial gases operations in approximately 20 countries including the United States, Canada, Mexico and Brazil.SalesSales for the Americas segment decreased $530 million, or 5%, in 2020 versus 2019. Higher pricing contributed 2% to sales. Lower volumes, primarily related to the manufacturing and metals end markets, of 2%, were partially offset by new project start-ups and higher volumes related to the healthcare end market. Unfavorable currency translation decreased sales by 3%, primarily driven by the weakening of the Brazilian real, Mexican peso and Canadian dollar against the U.S. Dollar. Lower cost past-through, primarily natural gas, decreased sales by 1% with minimal impact on operating profit.Operating ProfitOperating profit in the Americas segment increased $196 million, or 8%, in 2020 versus 2019. Operating profit increased due primarily to higher pricing and cost reduction and productivity initiatives, partially offset by lower volumes and unfavorable currency translation impacts.EMEA (Dollar amounts in millions) VarianceYear Ended December 31,202020192020 vs. 2019Sales$6,449 $6,643 (3)%Operating profit$1,465 $1,367 7 %As a percent of sales22.7 %20.6 %28Table of Contents2020 vs. 2019 % ChangeFactors Contributing to Changes - SalesVolume(3)%Price/Mix2 %Cost pass-through(1)%Currency— %Acquisitions/Divestitures(1)%(3)%The EMEA segment includes Linde's industrial gases operations in approximately 45 European, Middle Eastern and African countries including Germany, France, Sweden, the Republic of South Africa, and the U.K. SalesEMEA segment sales decreased $194 million, or 3%, in 2020 versus 2019. Volumes decreased 3% driven by lower volumes to the manufacturing and metals end-markets. Higher price contributed 2% to sales and cost pass-through decreased sales by 1%. Sales decreased 1% related to the divestiture of a non-core business in Scandinavia.Operating ProfitOperating Profit for the EMEA segment increased $98 million, or 7%, in 2020 versus 2019 driven primarily by higher price and the impact of cost reduction programs, partially offset by lower volumes. APAC(Dollar amounts in millions) VarianceYear Ended December 31,202020192020 vs. 2019Sales$5,687 $5,779 (2)%Operating profit$1,277 $1,184 8 %As a percent of sales22.5 %20.5 %2020 vs. 2019 % ChangeFactors Contributing to Changes - SalesVolume/Equipment(2)%Price/Mix1 %Cost pass-through(1)%Currency— %Acquisitions/Divestitures— %(2)%The APAC segment includes Linde's industrial gases operations in approximately 20 Asian and South Pacific countries and regions including China, Australia, India, South Korea and Taiwan.SalesSales for the APAC segment decreased $92 million, or 2%, in 2020 versus 2019. Volumes decreased 2% as lower volumes to the manufacturing end-market and a prior year equipment sale more than offset the contribution of new project start-ups. Higher price increased sales by 1%. Cost pass-through decreased sales by 1% with minimal impact on operating profit.29Table of ContentsOperating ProfitOperating profit in the APAC segment increased $93 million, or 8%, in 2020 versus 2019, driven primarily by higher price and the impact of cost reduction programs, partially offset by lower volumes. Engineering(Dollar amounts in millions) VarianceYear Ended December 31,202020192020 vs. 2019Sales$2,851 $2,799 2 %Operating profit$435 $390 12 %As a percent of sales15.3 %13.9 %2020 vs. 2019 % ChangeFactors Contributing to Changes - SalesVolume/Price— %Currency2 %2 %Sales Engineering segment sales increased $52 million, or 2%, in 2020 versus 2019, driven by favorable currency impacts.Operating profit Engineering segment operating profit increased $45 million, or 12%, in 2020 versus 2019. The increase in operating profit for the year is due to project execution and the impact of productivity initiatives.Other (Dollar amounts in millions) VarianceYear Ended December 31,202020192020 vs. 2019Sales$1,797 $1,953 (8)%Operating profit$(153)$(246)38 %As a percent of sales(8.5)%(12.6)%2020 vs. 2019 % ChangeFactors Contributing to Changes - SalesVolume/Price(9)%Cost pass-through1 %Currency— %Acquisitions/Divestitures— %(8)%Other consists of corporate costs and a few smaller businesses including: Surface Technologies, GIST, global helium wholesale, and Electronic Materials; which individually do not meet the quantitative thresholds for separate presentation. 30Table of ContentsSales Sales for Other decreased $156 million, or 8%, in 2020 versus 2019, primarily due to lower volumes largely due to surface technologies and to a lesser extent helium, partially offset by higher price largely related to helium and cost pass through.Operating profit Operating profit in Other increased $93 million, or 38%, in 2020 versus 2019, due primarily to the impact of cost reduction and productivity initiatives. 31Table of ContentsCurrencyThe results of Linde’s non-U.S. operations are translated to the company’s reporting currency, the U.S. dollar, from the functional currencies used in the countries in which the company operates. For most foreign operations, Linde uses the local currency as its functional currency. There is inherent variability and unpredictability in the relationship of these functional currencies to the U.S. dollar and such currency movements may materially impact Linde’s results of operations in any given period.To help understand the reported results, the following is a summary of the significant currencies underlying Linde’s consolidated results and the exchange rates used to translate the financial statements (rates of exchange expressed in units of local currency per U.S. dollar): Percent of 2020Statements of IncomeBalance Sheets ConsolidatedAverage Year Ended December 31,December 31,CurrencySales2020201920202019Euro22 %0.88 0.89 0.82 0.89 Chinese yuan8 %6.90 6.90 6.53 6.96 British pound6 %0.78 0.78 0.73 0.75 Australian dollar4 %1.45 1.44 1.30 1.42 Brazilian real3 %5.11 3.94 5.20 4.03 Canadian dollar3 %1.34 1.33 1.27 1.30 Taiwan dollar3 %29.46 30.90 28.09 29.99 Mexican peso2 %21.35 19.24 19.91 18.93 Korean won2 %1,178 1,165 1,087 1,156 Indian rupee2 %74.08 70.40 73.07 71.38 Republic of South African rand1 %16.37 14.43 14.69 14.00 Swedish kroner1 %9.18 9.45 8.23 9.37 Thailand bhat1 %31.28 31.04 29.96 29.71 32Table of Contents LIQUIDITY, CAPITAL RESOURCES AND OTHER FINANCIAL DATA (Millions of dollars) Year Ended December 31,20202019Net Cash Provided by (Used for)Operating ActivitiesIncome from continuing operations (including noncontrolling interests)$2,622 $2,272 Non-cash charges (credits): Add: Cost reduction programs and other charges, net of payments (a)258 (236) Add: Amortization of merger-related inventory step-up— 12 Less: Net gain on sale of businesses, net of tax— (108) Add: Depreciation and amortization4,626 4,675 Add (Less): Deferred income taxes(369)(303) Add (Less): non-cash charges and other 285 (32) Income from continuing operations adjusted for non-cash charges and other7,422 6,280 Less: Pension contributions(91)(94)Add (Less): Working capital364 (160)Add (Less): Other(266)93 Net cash provided by operating activities$7,429 $6,119 Investing ActivitiesCapital expenditures$(3,400)$(3,682)Acquisitions, net of cash acquired(68)(225)Divestitures and asset sales, net of cash divested482 5,096 Net cash provided by (used for) investing activities$(2,986)$1,189 Financing ActivitiesDebt increases (decreases) – net$1,313 $(1,260)Issuances (purchases) of ordinary shares – net(2,410)(2,586)Cash dividends – Linde plc shareholders(2,028)(1,891)Noncontrolling interest transactions and other(220)(3,260)Net cash (used) for financing activities$(3,345)$(8,997)Effect of exchange rate changes on cash$(44)$(77)Cash and cash equivalents, end-of-period$3,754 $2,700 ____________________(a)See Note 3 to the consolidated financial statements.Cash increased $1,054 million in 2020 versus 2019. The primary sources of cash in 2020 were cash flows from operations of $7,429 million, net debt issuances of $1,313 million and proceeds from divestitures and asset sales of $482 million. The primary uses of cash included capital expenditures of $3,400 million, net purchases of ordinary shares of $2,410 million, and cash dividends to shareholders of $2,028 million. Noncontrolling interest transactions and other of $3,260 million in 2019 included a payment of approximately $3.2 billion related to the cash-merger squeeze-out of the 8% of Linde AG shares completed on April 8, 2019 (see Note 14 to the consolidated financial statements).33Table of ContentsCash Flows From Operations 2020 compared with 2019Cash flows from operations was $7,429 million, or 27% of sales, an increase of $1,310 million from $6,119 million, or 22% of sales in 2019. The increase was driven by higher net income adjusted for non-cash charges, better working capital management, and lower merger and synergy related cash outflows. Cost reduction programs and other charges of $506 million and $567 million for the years ended December 31, 2020 and 2019 were offset by related cash outflows of $248 million and $803 million, respectively. 34Table of ContentsInvesting2020 compared with 2019Net cash used for investing activities was $2,986 million in 2020 versus net cash provided by investing activities of $1,189 million in 2019. The decrease was primarily driven by lower proceeds from merger-related divestitures, partially offset by lower capital expenditures and acquisitions.Capital expenditures in 2020 were $3,400 million, a decrease of $282 million from 2019. Capital expenditures during 2020 related primarily to investments in new plant and production equipment for growth. Approximately 41% of the capital expenditures were in the Americas segment with 35% in the APAC segment and the rest primarily in the EMEA segment. At December 31, 2020, Linde's sale of gas backlog of large projects under construction was approximately $3.6 billion. This represents the total estimated capital cost of large plants under construction.Acquisition expenditures in 2020 were $68 million, a decrease of $157 million from 2019 and related primarily to acquisitions in the Americas and APAC. Divestitures and asset sales in 2020 totaled $482 million as compared to $5,096 million in 2019. The 2020 period includes net proceeds from merger-related divestitures of $98 million from the sale of selected assets of Linde China and proceeds of approximately $130 million related to the divestiture of a non-core business in Scandinavia. The 2019 period includes net proceeds from merger-related divestitures of $3.4 billion from the sale of Linde AG's Americas business, $1.2 billion from the sale of Linde South Korea and approximately $200 million each from the sale of the legacy Praxair and legacy Linde India selected assets (see Note 2 to the consolidated financial statements).FinancingLinde’s financing strategy is to secure long-term committed funding by issuing public notes and debentures and commercial paper backed by a long-term bank credit agreement. Linde’s international operations are funded through a combination of local borrowing and intercompany funding to minimize the total cost of funds and to manage and centralize currency exchange exposures. As deemed necessary, Linde manages its exposure to interest-rate changes through the use of financial derivatives (see Note 12 to the consolidated financial statements and Item 7A. Quantitative and Qualitative Disclosures About Market Risk).Cash used for financing activities was $3,345 million in 2020 compared to $8,997 million in 2019. Cash provided by debt was $1,313 million in 2020 versus cash used for debt of $1,260 million in 2019 primarily due to bond issuances in 2020 and increased commercial paper borrowings, net of bond repayments. Net purchases of ordinary shares were $2,410 million in 2020 versus $2,586 million in 2019. Cash dividends increased to $2,028 million in 2020 versus $1,891 million in 2019 driven primarily by a 10% increase in dividends per share from $3.50 per share to $3.85 per share. The 2019 period also includes an 35Table of Contentsoutflow of approximately $3.2 billion relating to the cash-merger squeeze-out of the 8% of Linde AG shares completed on April 8, 2019 (See Note 14 to the consolidated financial statements). The company believes that it has sufficient operating flexibility, cash reserves, and funding sources to maintain adequate amounts of liquidity to meet its business needs around the world. At December 31, 2020, Linde's credit ratings as reported by Standard & Poor’s and Moody’s were A-1 and P-1 for short-term debt, respectively, and A and A2 for long-term debt, respectively.Note 11 to the consolidated financial statements includes information with respect to the company’s debt activity in 2020, current debt position, debt covenants and the available credit facilities; and Note 12 includes information relating to derivative financial instruments. Linde's credit facilities are with major financial institutions and are non-cancelable until maturity. Therefore, the company believes the risk of the financial institutions being unable to make required loans under the credit facilities, if requested, to be low. Linde’s major bank credit and long-term debt agreements contain standard covenants. The company was in compliance with these covenants at December 31, 2020 and expects to remain in compliance for the foreseeable future.The company maintains a $5 billion unsecured and undrawn revolving credit agreement with no associated financial covenants. No borrowings were outstanding under the credit agreement as of December 31, 2020. The company does not anticipate any limitations on its ability to access the debt capital markets and/or other external funding sources and remains committed to its strong ratings from Moody’s and Standard & Poor’s.Linde’s total net debt outstanding at December 31, 2020 was $12,400 million, $1,144 million higher than $11,256 million at December 31, 2019. The December 31, 2020 net debt balance includes $15,048 million in public securities, $1,106 million representing primarily worldwide bank borrowings, net of $3,754 million of cash. Linde’s global effective borrowing rate was approximately 2% for 2020. In May 2020, Linde issued €750 million of 0.250% notes due 2027 and €750 million 0.550% notes due 2032. In August, 2020, Linde issued $700 million of 1.100% notes due 2030 and $300 million of 2.000% notes due 2050. In September 2020, the company repaid €1,000 million in 1.75% notes and $300 million of 2.25% notes that became due. In December 2020, the company repaid $500 million of 4.05% notes and $500 million of 3.00% notes that were due in 2021 resulting in a $16 million interest charge (see Note 11 to the consolidated financial statements). On January 25, 2021, the company’s board of directors approved the additional repurchase of $5.0 billion of its ordinary shares. For additional information related to the share repurchase programs, see Part II Item 5. Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.36Table of ContentsOFF-BALANCE SHEET ARRANGEMENTSAs discussed in Note 17 to the consolidated financial statements, at December 31, 2020, Linde had undrawn outstanding letters of credit, bank guarantees and surety bonds entered into in connection with normal business operations and they are not reasonably likely to have a material impact on Linde’s consolidated financial condition, results of operations, or liquidity.CRITICAL ACCOUNTING POLICIESThe policies discussed below are considered by management to be critical to understanding Linde’s financial statements and accompanying notes prepared in accordance with accounting principles generally accepted in the United States ("U.S. GAAP"). Their application places significant importance on management’s judgment as a result of the need to make estimates of matters that are inherently uncertain. Linde’s financial position, results of operations and cash flows could be materially affected if actual results differ from estimates made. These policies are determined by management and have been reviewed by Linde’s Audit Committee.Revenue RecognitionLong-Term Construction Contracts The company designs and manufactures equipment for air separation and other varied gas production and processing plants manufactured specifically for end customers. Revenue from sale of equipment is generally recognized over time as Linde has an enforceable right to payment for performance completed to date and performance does not create an asset with alternative use. For contracts recognized over time, revenue is recognized primarily using a cost incurred input method. Costs incurred to date relative to total estimated costs at completion are used to measure progress toward satisfying performance obligations. Costs incurred include material, labor, and overhead costs and represent work contributing and proportionate to the transfer of control to the customer. Contract modifications are typically accounted for as part of the existing contract and are recognized as a cumulative adjustment for the inception-to-date effect of such change. We assess performance as progress towards completion is achieved on specific projects, earnings will be impacted by changes to our forecast of revenues and costs on these projects.Pension BenefitsPension benefits represent financial obligations that will be ultimately settled in the future with employees who meet eligibility requirements. Because of the uncertainties involved in estimating the timing and amount of future payments, significant estimates are required to calculate pension expense and liabilities related to the company’s plans. The company utilizes the services of independent actuaries, whose models are used to facilitate these calculations. Several key assumptions are used in actuarial models to calculate pension expense and liability amounts recorded in the financial statements. Management believes the three most significant variables in the models are the expected long-term rate of return on plan assets, the discount rate, and the expected rate of compensation increase. The actuarial models also use assumptions for various other factors, including long-term inflation rates, employee turnover, retirement age, and mortality. Linde management believes the assumptions used in the actuarial calculations are reasonable, reflect the company’s experience and expectations for the future and are within accepted practices in each of the respective geographic locations in which it operates. Actual results in any given year will often differ from actuarial assumptions because of economic and other factors. The sensitivities to each of the key assumptions presented below exclude the impact of special items that occurred during the year.The weighted-average expected long-term rates of return on pension plan assets were 7.00% for U.S. plans and 5.31% for international plans for the year ended December 31, 2020 (7.27% and 5.15%, respectively at December 31, 2019). The expected long-term rate of return on the U.S. and international plan assets is estimated based on the plans' investment strategy and asset allocation, historical capital market performance and, to a lesser extent, historical plan performance. A 0.50% change in these expected long-term rates of return, with all other variables held constant, would change Linde’s pension expense by approximately $42 million.The company has consistently used a market-related value of assets rather than the fair value at the measurement date to determine annual pension expense. The market-related value recognizes investment gains or losses over a five-year period. As a result, changes in the fair value of assets from year to year are not immediately reflected in the company’s annual pension expense. Instead, annual pension expense in future periods will be impacted as deferred investment gains or losses 37Table of Contentsare recognized in the market-related value of assets over the five-year period. The consolidated market-related value of assets was $9,408 million, or $555 million lower than the fair value of assets of $9,963 million at December 31, 2020. These net deferred investment losses of $555 million will be recognized in the calculation of the market-related value of assets ratably over the next four years and will impact future pension expense. Future actual investment gains or losses will impact the market-related value of assets and, therefore, will impact future annual pension expense in a similar manner.Discount rates are used to calculate the present value of plan liabilities and pension costs and are determined annually by management. The company measures the service and interest cost components of pension and OPEB expense for significant U.S. and international plans using the spot rate approach. U.S. plans that do not use the spot rate approach continue to determine discount rates by using a cash flow matching model provided by the company's independent actuaries. The model includes a portfolio of corporate bonds graded Aa or better by at least half of the ratings agencies and matches the U.S. plans' projected cash flows to the calculated spot rates. Discount rates for the remaining international plans are based on market yields for high-quality fixed income investments representing the approximate duration of the pension liabilities on the measurement date. Refer to Note 16 to the consolidated financial statements for a summary of the discount rates used to calculate plan liabilities and benefit costs, and to the Retirement Benefits section of the Consolidated Results and Other Information section of this MD&A for a further discussion of 2020 benefit costs. A 0.50% reduction in discount rates, with all other variables held constant, would increase Linde’s pension expense by approximately $42 million whereas a 0.50% increase in discount rates would result in a decrease of $12 million. A 0.50% reduction in discount rates would increase the PBO by approximately $1,054 million whereas a 0.50% increase in discount rates would have a favorable impact to the PBO of approximately $932 million. The weighted-average expected rate of compensation increase was 3.25% for U.S. plans and 2.55% for international plans at December 31, 2020 (3.25% and 2.46%, respectively, at December 31, 2019). The estimated annual compensation increase is determined by management every year and is based on historical trends and market indices. A 0.50% change in the expected rate of compensation increase, with all other variables held constant, would change Linde’s pension expense by approximately $8 million and would impact the PBO by approximately $70 million.Asset ImpairmentsGoodwill and Other Indefinite-Lived Intangibles AssetsAt December 31, 2020, the company had goodwill of $28,201 million and $1,992 million of other indefinite-lived intangible assets. Goodwill represents the aggregate of the excess consideration paid for acquired businesses over the fair value of the net assets acquired. Indefinite-lived other intangibles relate to the Linde name. The company performs a goodwill impairment test annually or more frequently if events or circumstances indicate that an impairment loss may have been incurred. The impairment tests performed during the fourth quarter of 2020 indicated no impairment. At December 31, 2020, Linde’s enterprise value was approximately $150 billion (outstanding shares multiplied by the year-end stock price plus net debt, and without any control premium) while its total capital was approximately $62 billion.The impairment test allows an entity to first assess qualitative factors to determine if it is more likely than not that the fair value of a reporting unit is less than carrying value. If it is determined that it is more likely than not that the fair value of a reporting unit is less than carrying value then the company will estimate and compare the fair value of its reporting units to their carrying value, including goodwill. Reporting units are determined based on one level below the operating segment level. Management believes that the quantitative and qualitative factors used to perform its annual goodwill impairment assessment are appropriate and reasonable. Although the 2020 assessment indicated that it is more likely than not that the fair value of each reporting unit exceeded its carrying value, changes in circumstances or conditions affecting this analysis could have a significant impact on the fair value determination, which could then result in a material impairment charge to the company's results of operations. Reporting units with greater concentration of Linde AG assets fair valued during the 2018 Praxair, Inc. and Linde AG merger are at greater risk of impairment in future periods.Other indefinite-lived intangible assets from Linde AG recently fair valued are evaluated for impairment on an annual basis or more frequently if events and circumstances indicate that an impairment loss may have been incurred, and no impairments were indicated.See Notes 9 and 10 to the consolidated financial statements.38Table of ContentsLong-Lived AssetsLong-lived assets, including property, plant and equipment and finite-lived other intangible assets, are tested for impairment whenever events or changes in circumstances indicate that the carrying amount of an individual asset or asset group may not be recoverable. For purposes of this test, asset groups are determined based upon the lowest level for which there are independent and identifiable cash flows. Based upon Linde's business model an asset group may be a single plant and related assets used to support on-site, merchant and packaged gas customers. Alternatively, the asset group may a collection of distribution related assets (cylinders, distribution centers, and stores) or be a pipeline complex which includes multiple interdependent plants and related assets connected by pipelines within a geographic area used to support the same distribution methods. Income TaxesAt December 31, 2020, Linde had deferred tax assets of $2,270 million (net of valuation allowances of $243 million), and deferred tax liabilities of $8,706 million. At December 31, 2020, uncertain tax positions totaled $452 million (see Note 1 and Note 5 to the consolidated financial statements). Income tax expense was $847 million for the year ended December 31, 2020, or about 25.0% of pre-tax income (see Note 5 to the consolidated financial statements for additional information related to taxes).In the preparation of consolidated financial statements, Linde estimates income taxes based on diverse legislative and regulatory structures that exist in various jurisdictions where the company conducts business. Deferred income tax assets and liabilities represent tax benefits or obligations that arise from temporary differences due to differing treatment of certain items for accounting and income tax purposes. Linde evaluates deferred tax assets each period to ensure that estimated future taxable income will be sufficient in character (e.g. capital gain versus ordinary income treatment), amount and timing to result in their recovery. A valuation allowance is established when management determines that it is more likely than not that a deferred tax asset will not be realized to reduce the assets to their realizable value. Considerable judgments are required in establishing deferred tax valuation allowances and in assessing exposures related to tax matters. As events and circumstances change, related reserves and valuation allowances are adjusted to income at that time. Linde’s tax returns are subject to audit and local taxing authorities could challenge the company’s tax positions. The company’s practice is to review tax filing positions by jurisdiction and to record provisions for uncertain income tax positions, including interest and penalties when applicable. Linde believes it records and/or discloses such potential tax liabilities as appropriate and has reasonably estimated its income tax liabilities and recoverable tax assets. If new information becomes available, adjustments are charged or credited against income at that time. Management does not anticipate that such adjustments would have a material adverse effect on the company’s consolidated financial position or liquidity; however, it is possible that the final outcomes could have a material impact on the company’s reported results of operations.ContingenciesThe company accrues liabilities for non-income tax contingencies when management believes that a loss is probable and the amounts can be reasonably estimated, while contingent gains are recognized only when realized or realizable. If new information becomes available or losses are sustained in excess of recorded amounts, adjustments are charged against income at that time. Management does not anticipate that in the aggregate such losses would have a material adverse effect on the company’s consolidated financial position or liquidity; however, it is possible that the final outcomes could have a material impact on the company’s reported results of operations.Linde is subject to various claims, legal proceedings and government investigations that arise from time to time in the ordinary course of business. These actions are based upon alleged environmental, tax, antitrust and personal injury claims, among others (see Note 17 to the consolidated financial statements). Such contingencies are significant and the accounting requires considerable management judgments in analyzing each matter to assess the likely outcome and the need for establishing appropriate liabilities and providing adequate disclosures. Linde believes it records and/or discloses such contingencies as appropriate and has reasonably estimated its liabilities.NEW ACCOUNTING STANDARDSSee Note 1 to the consolidated financial statements for information concerning new accounting standards and the impact of the implementation of these standards on the company’s financial statements.39Table of ContentsFAIR VALUE MEASUREMENTSLinde does not expect changes in the aggregate fair value of its financial assets and liabilities to have a material impact on the consolidated financial statements. See Note 13 to the consolidated financial statements.NON-GAAP FINANCIAL MEASURESThe following non-GAAP measures are intended to supplement investors’ understanding of the company’s financial information by providing measures which investors, financial analysts and management use to help evaluate the company’s financial leverage and operating performance. Special items which the company does not believe to be indicative of on-going business performance are excluded from these calculations so that investors can better evaluate and analyze historical and future business trends on a consistent basis. Definitions of these non-GAAP measures may not be comparable to similar definitions used by other companies and are not a substitute for similar GAAP measures.The non-GAAP measures in the following reconciliations are presented in this MD&A.Adjusted Amounts(Dollar amounts in millions, except per share data)Year Ended December 31,20202019Adjusted SalesReported Sales$27,243 $28,228 Less: Merger-related divestitures (d)— (65)Adjusted Sales$27,243 $28,163 Adjusted Operating Profit and Operating MarginReported operating profit$3,322 $2,933 Less: Merger-related divestitures (d)— (16)Add: Cost reduction programs and other charges506 567 Less: Net gain on sale of businesses— (164)Add: Purchase accounting impacts - Linde AG (c)1,969 1,952 Total adjustments2,475 2,339 Adjusted operating profit$5,797 $5,272 Reported percentage change13 %Adjusted percentage change10 %Reported sales$27,243 $28,228 Adjusted sales$27,243 $28,163 Reported operating margin12.2 %10.4 %Adjusted operating margin21.3 %18.7 %Adjusted Depreciation and amortizationReported depreciation and amortization$4,626 $4,675 Less: Purchase accounting impacts - Linde AG (c)(1,920)(1,940)Adjusted depreciation and amortization$2,706 $2,735 Adjusted Other Income (Expense) - netReported Other Income (Expense) - net$(61)$68 40Table of ContentsAdd: Purchase accounting impacts - Linde AG (c)(49)— Adjusted Other Income (Expense) - net$(12)$68 Adjusted Net Pension and OPEB Cost (Benefit), Excluding Service CostReported net pension and OPEB cost (benefit), excluding service cost$(177)$(32)Add: Pension settlement charges(6)(107)Adjusted Net Pension and OPEB cost (benefit), excluding service costs$(183)$(139)Adjusted Interest Expense - NetReported interest expense - net$115 $38 Add: Purchase accounting impacts - Linde AG (c)85 96 Less: Bond Redemption(16)— Adjusted interest expense - net$184 $134 Adjusted Income Taxes (a)Reported income taxes$847 $769 Add: Purchase accounting impacts - Linde AG (c)399 450 Add: Pension settlement charges1 26 Add: Cost reduction programs and other charges130 83 Less: Merger-related divestitures (d)— (5)Less: Net gain on sale of businesses— (56)Less: Bond Redemption4 — Total adjustments 534 498 Adjusted income taxes $1,381 $1,267 Adjusted Effective Tax Rate (a)Reported income before income taxes and equity investments$3,384 $2,927 Less: Merger-related divestitures (d)— (16)Add: Pension settlement charge6 107 Add: Purchase accounting impacts - Linde AG (c)1,884 1,856 Add: Cost reduction programs and other charges506 567 Less: Bond Redemption16 — Less: Net gain on sale of businesses— (164)Total adjustments 2,412 2,350 Adjusted income before income taxes and equity investments$5,796 $5,277 Reported Income taxes $847 $769 Reported effective tax rate25.0 %26.3 %Adjusted income taxes $1,381 $1,267 Adjusted effective tax rate23.8 %24.0 %Income from Equity InvestmentsReported income from equity investments$85 $114 Add: Purchase accounting impacts - Linde AG (c)57 57 Adjusted income from equity investments $142 $171 41Table of ContentsAdjusted Noncontrolling Interests from Continuing OperationsReported noncontrolling interests from continuing operations$(125)$(89)Add: Cost reduction programs and other charges(4)(35)Add: Purchase accounting impacts - Linde AG (c)(57)(54)Total adjustments (61)(89)Adjusted noncontrolling interests from continuing operations$(186)$(178)Adjusted Income from Continuing Operations (b)Reported income from continuing operations$2,497 $2,183 Add: Pension settlement charge5 81 Less: Merger-related divestitures (d)— (12)Add: Cost reduction programs and other charges372 449 Less: Net gain on sale of business — (108)Add: Purchase accounting impacts - Linde AG (c)1,485 1,410 Less: Bond Redemption12 — Total adjustments1,874 1,820 Adjusted income from continuing operations$4,371 $4,003 Adjusted Diluted EPS from Continuing Operations (b)Reported diluted EPS from continuing operations$4.70 $4.00 Add: Pension settlement charge0.01 0.16 Add: Cost reduction programs and other charges0.70 0.83 Less: Merger-related divestitures (d)— (0.03)Less: Net gain on sale of business— (0.21)Less: Bond Redemption0.02 — Add: Purchase accounting impacts - Linde AG2.80 2.59 Total adjustments3.53 3.34 Adjusted diluted EPS from continuing operations$8.23 $7.34 Reported percentage change18 %Adjusted percentage change12 %Adjusted EBITDA and % of SalesIncome from continuing operations$2,497 $2,183 Add: Noncontrolling interests related to continuing operations125 89 Add: Net pension and OPEB cost (benefit), excluding service cost(177)(32)Add: Interest expense115 38 Add: Income taxes847 769 Add: Depreciation and amortization4,626 4,675 EBITDA from continuing operations8,033 7,722 Less: Merger-related divestitures (d)— (16)Less: Net gain on sale of business — (164)Add: Cost reduction programs and other charges506 567 Add: Purchase accounting impacts - Linde AG 106 69 42Table of ContentsTotal adjustments612 456 Adjusted EBITDA from continuing operations $8,645 $8,178 Reported sales $27,243 $28,228 Adjusted sales $27,243 $28,163 % of sales EBITDA from continuing operations 29.5 %27.4 %Adjusted EBITDA from continuing operations31.7 %29.0 %(a) The income tax expense (benefit) on the non-GAAP pre-tax adjustments was determined using the applicable tax rates for the jurisdictions that were utilized in calculating the GAAP income tax expense (benefit) and included both current and deferred income tax amounts.(b) Net of income taxes which are shown separately in “Adjusted Income Taxes and Effective Tax Rate”.(c) The company believes that its non-GAAP measures excluding Purchase accounting impacts - Linde AG are useful to investors because: (i) the business combination was a merger of equals in an all-stock merger transaction, with no cash consideration, (ii) the company is managed on a geographic basis and the results of certain geographies are more heavily impacted by purchase accounting than others, causing results that are not comparable at the reportable segment level, therefore, the impacts of purchasing accounting adjustments to each segment vary and are not comparable within the company and when compared to other companies in similar regions, (iii) business management is evaluated and variable compensation is determined based on results excluding purchase accounting impacts, and; (iv) it is important to investors and analysts to understand the purchase accounting impacts to the financial statements.A summary of each of the adjustments made for Purchase accounting impacts - Linde AG are as follows:Adjusted Operating Profit and Margin: The purchase accounting adjustments for the periods presented relate primarily to depreciation and amortization related to the fair value step up of fixed assets and intangible assets (primarily customer related) acquired in the merger and the allocation of fair value step-up for ongoing Linde AG asset disposals (reflected in Other Income/(Expense)). Adjusted Interest Expense - Net: Relates to the amortization of the fair value of debt acquired in the merger. Adjusted Income Taxes and Effective Tax Rate: Relates to the current and deferred income tax impact on the adjustments discussed above. The income tax expense (benefit) on the non-GAAP pre-tax adjustments was determined using the applicable tax rates for the jurisdictions that were utilized in calculating the GAAP income tax expense (benefit) and included both current and deferred income tax amounts.Adjusted Income from Equity Investments: Represents the amortization of increased fair value on equity investments related to depreciable and amortizable assets. Adjusted Noncontrolling Interests from Continuing Operations: Represents the noncontrolling interests’ ownership portion of the adjustments described above determined on an entity by entity basis.(d) To adjust for the results of Praxair's merger-related divestitures.Net Debt and Adjusted Net DebtNet debt is a financial liquidity measure used by investors, financial analysts and management to evaluate the ability of a company to repay its debt. Purchase accounting impacts have been excluded as they are non-cash and do not have an impact on liquidity.December 31,2020December 31,2019(Millions of dollars) Debt$16,154 $13,956 Less: cash and cash equivalents(3,754)(2,700)Net debt12,400 11,256 Less: purchase accounting impacts - Linde AG(121)(195)Adjusted net debt$12,279 $11,061 43Table of ContentsSUPPLEMENTAL GUARANTEE INFORMATIONOn June 6, 2020, the company filed a Form S-3 Registration Statement with the SEC (the "Registration Statement"). Linde plc may offer debt securities, preferred shares, depositary shares and ordinary shares under the Registration Statement, and debt securities exchangeable for or convertible into preferred shares, ordinary shares or other debt securities. Debt securities of Linde plc may be guaranteed by Linde Inc. (previously Praxair, Inc.) and/or Linde GmbH (previously Linde AG). Linde plc may provide guarantees of debt securities offered by its wholly owned subsidiaries Linde, Inc. or Linde Finance under the Registration Statement.Linde Inc. is a wholly owned subsidiary of Linde plc. Linde Inc. may offer debt securities under the Registration Statement. Debt securities of Linde Inc. will be guaranteed by Linde plc, and such guarantees by Linde plc may be guaranteed by Linde GmbH. Linde, Inc. may also provide (i) guarantees of debt securities offered by Linde plc under the Registration Statement and (ii) guarantees of the guarantees provided by Linde plc of debt securities of Linde Finance offered under the Registration Statement.Linde Finance B.V. is a wholly owned subsidiary of Linde plc. Linde Finance may offer debt securities under the Registration Statement. Linde plc will guarantee debt securities of Linde Finance offered under the Registration Statement. Linde GmbH and Linde, Inc. may guarantee Linde plc’s obligations under its downstream guarantee.Linde GmbH is a wholly owned subsidiary of Linde plc. Linde GmbH may provide (i) guarantees of debt securities offered by Linde plc under the Registration Statement and (ii) upstream guarantees of downstream guarantees provided by Linde plc of debt securities of Linde, Inc. or Linde Finance offered under the Registration Statement.In September 2019, Linde plc provided downstream guarantees of all of the pre-business combination Linde, Inc. and Linde Finance notes, and Linde GmbH and Linde, Inc., respectively, provided upstream guarantees of Linde plc’s downstream guarantees.For further information about the guarantees of the debt securities registered under the Registration Statement (including the ranking of such guarantees, limitations on enforceability of such guarantees and the circumstances under which such guarantees may be released), see “Description of Debt Securities – Guarantees” and “Description of Debt Securities – Ranking” in the Registration Statement, which subsections are incorporated herein by reference.The company has elected to comply with Rule 13-01 of SEC Regulation S-X in advance of the effective date of January 4, 2021, as permitted by the Adopting Release. The following tables present summarized financial information for Linde plc, Linde, Inc., Linde GmbH and Linde Finance on a combined basis, after eliminating intercompany transactions and balances between them and excluding investments in and equity in earnings from non-guarantor subsidiaries.44Table of Contents(Millions of dollars)Statement of Income DataTwelve Months Ended December 31, 2020Twelve Months Ended December 31, 2019Sales$6,772 $6,510 Operating profit760 592 Net income660 2,271 Transactions with non-guarantor subsidiaries2,082 3,533 Balance Sheet Data (at period end)Current assets (a)$3,117 $2,137 Long-term assets (b)17,892 20,421 Current liabilities (c)8,265 6,897 Long-term liabilities (d)38,188 35,338 (a) From current assets above, amount due from non-guarantor subsidiaries$937 $619 (b) From long-term assets above, amount due from non-guarantor subsidiaries4,553 7,725 (c) From current liabilities above, amount due to non-guarantor subsidiaries1,053 737 (d) From long-term liabilities above, amount due to non-guarantor subsidiaries22,419 21,242 45Table of ContentsITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKLinde is exposed to market risks relating to fluctuations in interest rates and currency exchange rates. The objective of financial risk management at Linde is to minimize the negative impact of interest rate and foreign exchange rate fluctuations on the company’s earnings, cash flows and equity.To manage these risks, Linde uses various derivative financial instruments, including interest-rate swaps, treasury rate locks, currency swaps, forward contracts, and commodity contracts. Linde only uses commonly traded and non-leveraged instruments. These contracts are entered into primarily with major banking institutions thereby minimizing the risk of credit loss. Also, see Note 1 and Note 12 to the consolidated financial statements for a more complete description of Linde’s accounting policies and use of such instruments.The following discussion presents the sensitivity of the market value, earnings and cash flows of Linde’s financial instruments to hypothetical changes in interest and exchange rates assuming these changes occurred at December 31, 2020. The range of changes chosen for these discussions reflects Linde’s view of changes which are reasonably possible over a one-year period. Market values represent the present values of projected future cash flows based on interest rate and exchange rate assumptions.Interest Rate RiskAt December 31, 2020, Linde had debt totaling $16,154 million ($13,956 million at December 31, 2019). For fixed-rate instruments, interest rate changes affect the fair market value but do not impact earnings or cash flows. Conversely, for floating-rate instruments, interest rate changes generally do not affect the fair market value of the instrument but impact future earnings and cash flows, assuming that other factors are held constant. At December 31, 2020, including the impact of derivatives, Linde had fixed-rate debt of $10,365 million and floating-rate debt of $5,789 million, representing 64% and 36%, respectively, of total debt. At December 31, 2019, Linde had fixed-rate debt of $10,799 million and floating-rate debt of $3,157 million, representing 77% and 23%, respectively, of total debt. Fixed Rate DebtIn order to mitigate interest rate risk, when considered appropriate, interest-rate swaps are entered into as hedges of underlying financial instruments to effectively change the characteristics of the interest rate without actually changing the underlying financial instrument. At December 31, 2020, Linde had fixed-to-floating interest rate swaps outstanding that were designated as hedging instruments of the underlying debt issuances - refer to Note 12 to the consolidated financial statements for additional information. This sensitivity analysis assumes that, holding all other variables constant (such as foreign exchange rates, swaps and debt levels), a one hundred basis point increase in interest rates would decrease the unrealized fair market value of the fixed-rate debt portfolio by approximately $674 million ($473 million in 2019). A one hundred basis point increase in interest rates would result in an approximate $61 million increase to derivative assets recorded.Variable Rate DebtAt December 31, 2020, the after-tax earnings and cash flows impact of a one hundred basis point increase in interest rates, including offsetting impact of derivatives, on the variable-rate debt portfolio would be approximately $44 million ($48 million in 2019).Foreign Currency RiskLinde’s exchange-rate exposures result primarily from its investments and ongoing operations in Latin America (primarily Brazil and Mexico), Europe (primarily Germany, Scandinavia, and the U.K.), Canada, Asia Pacific (primarily Australia and China) and other business transactions such as the procurement of equipment from foreign sources. Linde frequently utilizes currency contracts to hedge these exposures. At December 31, 2020, Linde had a notional amount outstanding of $7,553 million ($9,713 million at December 31, 2019) related to foreign exchange contracts. The majority of these were to hedge recorded balance sheet exposures, primarily intercompany loans denominated in non-functional currencies. See Note 12 to the consolidated financial statements.Holding all other variables constant, if there were a 10% increase in foreign-currency exchange rates for the portfolio, the fair market value of foreign-currency contracts outstanding at December 31, 2020 would decrease by approximately $99 million and at December 31, 2019 would increase by approximately $194 million, which would be largely offset by an offsetting loss or gain on the foreign-currency fluctuation of the underlying exposure being hedged.46Table of ContentsITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATAINDEX TO CONSOLIDATED FINANCIAL STATEMENTS PageManagement’s Statement of Responsibility for Financial Statements48Management’s Report on Internal Control Over Financial Reporting48Report of Independent Registered Public Accounting Firm49Audited Consolidated Financial StatementsConsolidated Statements of Income for the Years Ended December 31, 2020, 2019 and 201851Consolidated Statements of Comprehensive Income for the Years Ended December 31, 2020, 2019 and 201852Consolidated Balance Sheets as as of December 31, 2020 and 201953Consolidated Statements of Cash Flows for the Years Ended December 31, 2020, 2019 and 201854Consolidated Statements of Equity for the Years Ended December 31, 2020, 2019 and 201856Notes to Consolidated Financial StatementsNote 1. Summary of Significant Accounting Policies58Note 2. Business Combination and Divestitures61Note 3. Cost Reduction Programs and Other Charges64Note 4. Leases66Note 5. Income Taxes67Note 6. Earnings Per Share – Linde plc Shareholders73Note 7. Supplemental Information73Note 8. Property, Plant and Equipment – Net77Note 9. Goodwill77Note 10. Other Intangible Assets78Note 11. Debt80Note 12. Financial Instruments81Note 13. Fair Value Disclosures84Note 14. Equity and Noncontrolling Interests85Note 15. Share-Based Compensation87Note 16. Retirement Programs89Note 17. Commitments and Contingencies99Note 18. Segment Information100Note 19. Revenue Recognition102Note 20. Subsequent Events10547Table of ContentsMANAGEMENT’S STATEMENT OF RESPONSIBILITY FOR FINANCIAL STATEMENTSLinde’s consolidated financial statements are prepared by management, which is responsible for their fairness, integrity and objectivity. The accompanying financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America applied on a consistent basis, except for accounting changes as disclosed, and include amounts that are estimates and judgments. All historical financial information in this annual report is consistent with the accompanying financial statements.Linde maintains accounting systems, including internal accounting controls, monitored by a staff of internal auditors, that are designed to provide reasonable assurance of the reliability of financial records and the protection of assets. The concept of reasonable assurance is based on recognition that the cost of a system should not exceed the related benefits. The effectiveness of those systems depends primarily upon the careful selection of financial and other managers, clear delegation of authority and assignment of accountability, inculcation of high business ethics and conflict-of-interest standards, policies and procedures for coordinating the management of corporate resources, and the leadership and commitment of top management. In compliance with Section 404 of the Sarbanes-Oxley Act of 2002, Linde assessed its internal control over financial reporting and issued a report (see below).The Audit Committee of the Board of Directors, which consists solely of non-employee directors, is responsible for overseeing the functioning of the accounting system and related controls and the preparation of annual financial statements. The Audit Committee periodically meets with management, internal auditors and the independent accountants to review and evaluate their accounting, auditing and financial reporting activities and responsibilities, including management’s assessment of internal control over financial reporting. The independent registered public accounting firm and internal auditors have full and free access to the Audit Committee and meet with the committee, with and without management present.MANAGEMENT’S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTINGLinde’s management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Exchange Act Rule 13a-15(f). Under the supervision and with the participation of management, including the company’s principal executive officer and principal financial officer, the company conducted an evaluation of the effectiveness of its internal control over financial reporting based on the framework in Internal Control – Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (often referred to as COSO). Based on this evaluation, management concluded that the company’s internal control over financial reporting was effective as of December 31, 2020.PricewaterhouseCoopers LLP, an independent registered public accounting firm, has audited and issued their opinion on the effectiveness of the company’s internal control over financial reporting as of December 31, 2020 as stated in their report. /s/ STEPHEN F. ANGEL/s/ KELCEY E. HOYTStephen F. AngelChief Executive Officer Kelcey E. HoytChief Accounting Officer/s/ MATTHEW J. WHITEMatthew J. WhiteChief Financial Officer March 1, 202148Table of ContentsReport of Independent Registered Public Accounting Firm To the Board of Directors and Shareholders of Linde plcOpinions on the Financial Statements and Internal Control over Financial ReportingWe have audited the accompanying consolidated balance sheets of Linde plc and its subsidiaries (the “Company”) as of December 31, 2020 and 2019, and the related consolidated statements of income, of comprehensive income, of equity and of cash flows for each of the three years in the period ended December 31, 2020, including the related notes (collectively referred to as the “consolidated financial statements”). We also have audited the Company's internal control over financial reporting as of December 31, 2020, based on criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of the Company as of December 31, 2020 and 2019, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2020 in conformity with accounting principles generally accepted in the United States of America. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2020, based on criteria established in Internal Control - Integrated Framework (2013) issued by the COSO.Basis for OpinionsThe Company's management is responsible for these consolidated financial statements, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Report on Internal Control Over Financial Reporting. Our responsibility is to express opinions on the Company’s consolidated financial statements and on the Company's internal control over financial reporting based on our audits. We are a public accounting firm registered with the Public Company Accounting Oversight Board (United States) (PCAOB) and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement, whether due to error or fraud, and whether effective internal control over financial reporting was maintained in all material respects.Our audits of the consolidated financial statements included performing procedures to assess the risks of material misstatement of the consolidated financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the consolidated financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the consolidated financial statements. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.Definition and Limitations of Internal Control over Financial ReportingA company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.49Table of ContentsBecause of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.Critical Audit MattersThe critical audit matter communicated below is a matter arising from the current period audit of the consolidated financial statements that was communicated or required to be communicated to the audit committee and that (i) relates to accounts or disclosures that are material to the consolidated financial statements and (ii) involved our especially challenging, subjective, or complex judgments. The communication of critical audit matters does not alter in any way our opinion on the consolidated financial statements, taken as a whole, and we are not, by communicating the critical audit matter below, providing a separate opinion on the critical audit matter or on the accounts or disclosures to which it relates.Revenue Recognition - Estimated Costs at CompletionAs described in Note 19 to the consolidated financial statements, $2,851 million of the Company’s total revenues for the year ended December 31, 2020 was generated from the sale of equipment contracts. Sale of equipment contracts are generally comprised of a single performance obligation. Revenue from sale of equipment is generally recognized over time as the Company has an enforceable right to payment for performance completed to date and performance does not create an asset with alternative use. For contracts recognized over time, revenue is recognized primarily using a cost incurred input method. Costs incurred to date relative to total estimated costs at completion are used to measure progress toward satisfying performance obligations. Costs incurred include material, labor, and overhead costs and represent work contributing and proportionate to the transfer of control to the customer. The principal considerations for our determination that performing procedures relating to revenue recognition - estimated costs at completion is a critical audit matter are (i) the significant judgment by management when developing the estimated costs at completion for the sale of equipment contracts; (ii) a high degree of auditor judgment, subjectivity, and effort in performing procedures and evaluating audit evidence related to the estimated costs at completion and management’s significant assumptions related to the total estimated material and labor costs; and (iii) the audit effort involved the use of professionals with specialized skill and knowledge.Addressing the matter involved performing procedures and evaluating audit evidence in connection with forming our overall opinion on the consolidated financial statements. These procedures included testing the effectiveness of controls relating to the revenue recognition process, including controls over developing the estimated costs at completion for the sale of equipment contracts. These procedures also included, among others, evaluating and testing management’s process for developing the estimated costs at completion for the sale of equipment contracts, which included evaluating the reasonableness of management’s significant assumptions related to the total estimated material and labor costs. Evaluating the reasonableness of management’s significant assumptions involved evaluating management’s ability to reasonably estimate costs at completion for the sale of equipment contracts on a sample basis by (i) performing a comparison of the originally estimated and actual costs incurred on similar completed equipment contracts, and (ii) evaluating the timely identification of circumstances that may warrant a modification to estimated costs at completion, including actual costs in excess of estimates. Professionals with specialized skill and knowledge were used to assist in evaluating the reasonableness of management’s estimates and significant assumptions related to the total estimated material and labor costs. /s/ PricewaterhouseCoopers LLPStamford, ConnecticutMarch 1, 2021We have served as the Company’s or its predecessor’s auditor since 1992. 50Table of Contents CONSOLIDATED STATEMENTS OF INCOMELINDE PLC AND SUBSIDIARIES(Dollar amounts in millions, except per share data) Year Ended December 31,202020192018Sales$27,243 $28,228 $14,836 Cost of sales, exclusive of depreciation and amortization15,383 16,644 9,020 Selling, general and administrative3,193 3,457 1,629 Depreciation and amortization4,626 4,675 1,830 Research and development152 184 113 Cost reduction programs and other charges506 567 309 Net gain on sale of businesses— 164 3,294 Other income (expenses) – net(61)68 18 Operating Profit3,322 2,933 5,247 Interest expense – net115 38 202 Net pension and OPEB cost (benefit), excluding service cost(177)(32)(4)Income From Continuing Operations Before Income Taxes and Equity Investments3,384 2,927 5,049 Income taxes on continuing operations847 769 817 Income From Continuing Operations Before Equity Investments2,537 2,158 4,232 Income from equity investments85 114 56 Income From Continuing Operations (Including Noncontrolling Interests)2,622 2,272 4,288 Income from discontinued operations, net of tax4 109 117 Net Income (Including Noncontrolling Interests)2,626 2,381 4,405 Less: noncontrolling interests from continuing operations(125)(89)(15)Less: noncontrolling interests from discontinued operations— (7)(9)Net Income – Linde plc$2,501 $2,285 $4,381 Net Income – Linde plcIncome from continuing operations$2,497 $2,183 $4,273 Income from discontinued operations$4 $102 $108 Per Share Data – Linde plc ShareholdersBasic earnings per share from continuing operations$4.74 $4.03 $12.93 Basic earnings per share from discontinued operations0.01 0.19 0.33 Basic earnings per share$4.75 $4.22 $13.26 Diluted earnings per share from continuing operations$4.70 $4.00 $12.79 Diluted earnings per share from discontinued operations0.01 0.19 0.32 Diluted earnings per share$4.71 $4.19 $13.11 Weighted Average Shares Outstanding (000’s):Basic shares outstanding526,736 541,094 330,401 Diluted shares outstanding531,157 545,170 334,127 The accompanying Notes are an integral part of these financial statements.51Table of ContentsCONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOMELINDE PLC AND SUBSIDIARIES(Dollar amounts in millions) Year Ended December 31,202020192018 NET INCOME (INCLUDING NONCONTROLLING INTERESTS)$2,626 $2,381 $4,405 OTHER COMPREHENSIVE INCOME (LOSS)Translation adjustments:Foreign currency translation adjustments565 118 (401)Reclassifications to net income— 12 318 Income taxes30 3 7 Translation adjustments595 133 (76)Funded status - retirement obligations (Note 16):Retirement program remeasurements(675)(852)(260)Reclassifications to net income92 154 94 Income taxes114 154 (55)Funded status - retirement obligations(469)(544)(221)Derivative instruments (Note 12):Current year unrealized gain (loss)(3)(32)— Reclassifications to net income42 — (1)Income taxes(8)7 — Derivative instruments31 (25)(1)Securities:Current year unrealized gain (loss)— 1 (1)Reclassifications to net income— — — Income taxes— — — Securities— 1 (1)TOTAL OTHER COMPREHENSIVE INCOME (LOSS)157 (435)(299)COMPREHENSIVE INCOME (INCLUDING NONCONTROLLING INTERESTS)2,783 1,946 4,106 Less: noncontrolling interests(158)(19)(83)COMPREHENSIVE INCOME - LINDE PLC$2,625 $1,927 $4,023 The accompanying Notes are an integral part of these financial statements.52Table of ContentsCONSOLIDATED BALANCE SHEETSLINDE PLC AND SUBSIDIARIES(Dollar amounts in millions) December 31,20202019AssetsCash and cash equivalents$3,754 $2,700 Accounts receivable – net4,167 4,322 Contract assets162 368 Inventories1,729 1,697 Prepaid and other current assets1,112 1,265 Total Current Assets10,924 10,352 Property, plant and equipment – net28,711 29,064 Equity investments2,061 2,027 Goodwill28,201 27,019 Other intangible assets – net16,184 16,137 Other long-term assets2,148 2,013 Total Assets$88,229 $86,612 Liabilities and EquityAccounts payable$3,095 $3,266 Short-term debt3,251 1,732 Current portion of long-term debt751 1,531 Contract liabilities1,769 1,758 Accrued taxes542 370 Other current liabilities4,332 3,503 Total Current Liabilities13,740 12,160 Long-term debt12,152 10,693 Other long-term liabilities5,519 4,888 Deferred credits7,236 7,236 Total Liabilities38,647 34,977 Commitments and contingencies (Note 17)Redeemable noncontrolling interests13 113 Linde plc Shareholders’ Equity: Ordinary shares (€0.001 par value, authorized 1,750,000,000 shares, 2020 issued: 552,012,862 ordinary shares; 2019 issued: 552,012,862 ordinary shares) 1 1 Additional paid-in capital40,202 40,201 Retained earnings17,178 16,842 Accumulated other comprehensive income (loss)(4,690)(4,814)Less: Treasury stock, at cost (2020 – 28,718,333 shares and2019 – 17,632,318 shares)(5,374)(3,156)Total Linde plc Shareholders’ Equity47,317 49,074 Noncontrolling interests2,252 2,448 Total Equity49,569 51,522 Total Liabilities and Equity$88,229 $86,612 The accompanying Notes are an integral part of these financial statements.53Table of Contents CONSOLIDATED STATEMENTS OF CASH FLOWSLINDE PLC AND SUBSIDIARIES(Millions of dollars)Year Ended December 31,202020192018Increase (Decrease) in Cash and Cash EquivalentsOperationsNet income – Linde plc$2,501 $2,285 $4,381 Less: income from discontinued operations, net of tax and noncontrolling interests(4)(102)(108)Add: Noncontrolling interests from continuing operations125 89 15 Income from continuing operations (including noncontrolling interests)$2,622 $2,272 $4,288 Adjustments to reconcile net income to net cash provided by operating activities:Cost Reduction Programs and other charges, net of payments258 (236)40 Amortization of merger-related inventory step-up— 12 368 Tax Act income tax charge, net— — (61)Depreciation and amortization 4,626 4,675 1,830 Deferred income taxes, excluding Tax Act(369)(303)(187)Share-based compensation133 95 62 Net gain on sale of businesses, net of tax— (108)(2,923)Non-cash charges and other152 (127)175 Working capitalAccounts receivable19 80 (124)Contract assets and liabilities, net90 87 — Inventory18 (81)(4)Prepaid and other current assets128 (72)43 Payables and accruals109 (174)287 Pension contributions(91)(94)(87)Long-term assets, liabilities and other(266)93 (53)Net cash provided by operating activities7,429 6,119 3,654 InvestingCapital expenditures(3,400)(3,682)(1,883)Acquisitions, net of cash acquired(68)(225)(25)Divestitures and asset sales, net of cash divested482 5,096 5,908 Cash acquired in merger transaction—— 1,363 Net cash provided by (used for) investing activities(2,986)1,189 5,363 FinancingShort-term debt borrowings (repayments) – net1,198 224 208 Long-term debt borrowings2,796 99 8 Long-term debt repayments(2,681)(1,583)(3,124)Issuances of ordinary shares47 72 77 Purchases of ordinary shares(2,457)(2,658)(599)Cash dividends – Linde plc shareholders(2,028)(1,891)(1,166)Noncontrolling interest transactions and other(220)(3,260)(402)Net cash used for financing activities(3,345)(8,997)(4,998)Discontinued OperationsCash provided by operating activities$— $69 $48 Cash used for investing activities— (60)(23)Cash provided by financing activities— 5 2 Net cash provided by discontinued operations— 14 27 Effect of exchange rate changes on cash and cash equivalents(44)(77)(60)Change in cash and cash equivalents1,054 (1,752)3,986 Cash and cash equivalents, beginning-of-period2,700 4,466 617 Cash and cash equivalents, including discontinued operations$3,754 $2,714 $4,603 Cash and cash equivalents of discontinued operations— (14)(137)Cash and cash equivalents, end-of-period$3,754 $2,700 $4,466 54Table of ContentsSupplemental DataIncome taxes paid$1,066 $1,357 $757 Interest paid, net of capitalized interest (Note 7)$322 $275 $214 The accompanying Notes are an integral part of these financial statements.55Table of ContentsCONSOLIDATED STATEMENTS OF EQUITYLINDE PLC AND SUBSIDIARIES(Dollar amounts in millions, except per share data, shares in thousands) Linde plc Shareholders’ Equity Ordinary sharesAdditionalPaid-inCapitalRetainedEarningsAccumulated OtherComprehensiveIncome (Loss)(Note 7)Treasury StockLinde plcShareholders’EquityNoncontrollingInterestsTotal EquityActivitySharesAmountsSharesAmountsBalance, December 31, 2017383,231 $4 $4,084 $13,224 $(4,098)96,454 $(7,196)$6,018 $493 $6,511 Net Income available for Linde plc shareholders4,381 4,381 21 4,402 Other comprehensive income (loss)(265)(265)59 (206)Noncontrolling interests:Dividends and other capital reductions— (49)(49)Additions (Reductions) - (Note 14)(127)(127)(186)(313)Redemption value adjustments (Note 14)(3)(3)(3)Dividends ($3.30 per ordinary share)(1,166)(1,166)(1,166)Issuances of common stock:For the dividend reinvestment and stock purchase plan(31)5 5 5 For employee savings and incentive plans255 (46)(1,109)79 33 33 Purchases of common stock4,079 (630)(630)(630)Share-based compensation62 62 62 Impact of Tax Reform93 (93)— — Impact of Merger167,824 (3)36,178 (95,324)7,113 43,288 5,146 48,434 Balance, December 31, 2018551,310 $1 $40,151 $16,529 $(4,456)4,069 $(629)$51,596 $5,484 $57,080 Net Income available for Linde plc shareholders2,285 2,285 94 2,379 Other comprehensive income (loss)(358)(358)(77)(435)Noncontrolling interests:Dividends and other capital reductions— (132)(132)Additions (Reductions) - (Note 14)— (2,921)(2,921)Redemption value adjustments (Note 14)(8)(8)(8)Dividends ($3.50 per ordinary share)(1,891)(1,891)(1,891)56Table of Contents Linde plc Shareholders’ Equity Ordinary sharesAdditionalPaid-inCapitalRetainedEarningsAccumulated OtherComprehensiveIncome (Loss)(Note 7)Treasury StockLinde plcShareholders’EquityNoncontrollingInterestsTotal EquityActivitySharesAmountsSharesAmountsIssuances of common stock:For the dividend reinvestment and stock purchase plan— — For employee savings and incentive plans703 (45)(73)(770)127 9 9 Purchases of common stock14,333 (2,654)(2,654)(2,654)Share-based compensation9595 95 Balance, December 31, 2019552,013 1 40,201 16,842 (4,814)17,632 (3,156)49,074 2,448 51,522 Net Income available for Linde plc shareholders2,501 2,501 125 2,626 Other comprehensive income (loss)124 124 33 157 Noncontrolling interests:Dividends and other capital reductions— (161)(161)Additions (Reductions) - (Note 14)— (193)(193)Redemption value adjustments17 17 17 Dividends ($3.852 per ordinary share)(2,028)(2,028)(2,028)Issuances of ordinary shares:For employee savings and incentive plans(132)(154)(1,208)233 (53)(53)Purchases of ordinary shares12,294 (2,451)(2,451)(2,451)Share-based compensation133133133 Balance, December 31, 2020552,013 $1 $40,202 $17,178 $(4,690)28,718 $(5,374)$47,317 $2,252 $49,569 The accompanying Notes are an integral part of these financial statements57Table of ContentsNOTES TO CONSOLIDATED FINANCIAL STATEMENTSLINDE PLC AND SUBSIDIARIESNOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIESLinde plc ("Linde" or "the company") is an incorporated public limited company formed under the laws of Ireland. Linde’s registered office is located at Ten Earlsfort Terrace, Dublin 2, D02 T380 Ireland. Linde’s principal executive offices are located at The Priestley Centre, 10 Priestley Road, Surrey Research Park, Guildford, Surrey GU2 7XY, United Kingdom. Linde trades on the New York Stock Exchange and on the Frankfurt Stock Exchange under the symbol LIN.Principles of Consolidation – The consolidated financial statements were prepared in conformity with accounting principles generally accepted in the United States of America (" U.S. GAAP") and include the accounts of all significant subsidiaries where control exists and, in limited situations, variable-interest entities where the company is the primary beneficiary. Intercompany transactions and balances are eliminated in consolidation and any significant related-party transactions have been disclosed.Equity investments generally consist of 20% to 50% owned operations where the company exercises significant influence, but does not have control. Equity income from equity investments in corporations is reported on an after-tax basis. Pre-tax income from equity investments that are partnerships or limited-liability corporations is included in other income (expenses) – net with related taxes included in Income taxes. Equity investments are reviewed for impairment whenever events or circumstances reflect that an impairment loss may have been incurred. Changes in ownership interest that result either in consolidation or deconsolidation of an investment are recorded at fair value through earnings, including the retained ownership interest, while changes that do not result in either consolidation or deconsolidation of a subsidiary are treated as equity transactions.Use of Estimates – The preparation of financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. While actual results could differ, management believes such estimates to be reasonable.Operations – Linde is the largest industrial gases company globally. The company produces, sells and distributes atmospheric, process and specialty gases to a diverse group of industries including aerospace, chemicals, food and beverage, electronics, energy, healthcare, manufacturing, and metals. Linde’s Engineering business offers its customers an extensive range of gas production and processing services including supplying plant components and services directly to customers.Revenue Recognition – Revenue is recognized as control of goods or services are transferred to customers in an amount that reflects the consideration to which an entity expects to be entitled to receive in exchange for the goods or services. See Note 19 for additional details regarding Linde's revenue recognition policies. Cash Equivalents – Cash equivalents are considered to be highly liquid securities with original maturities of three months or less.Inventories – Inventories are stated at the lower of cost or net realizable value. Cost is determined using the average-cost method. Property, Plant and Equipment – Net – Property, plant and equipment are carried at cost, net of accumulated depreciation. The company capitalizes labor, applicable overhead and interest as part of the cost of constructing major facilities. Expenditures for additions and improvements that extend the lives or increase the capacity of plant assets are also capitalized. Depreciation is calculated on the straight-line method based on the estimated useful lives of the assets, which range from 3 years to 40 years (see Note 8). Linde uses accelerated depreciation methods for tax purposes where appropriate. Maintenance of property, plant and equipment is generally expensed as incurred.The company performs a test for impairment whenever events or changes in circumstances indicate that the carrying amount of an individual asset or asset group may not be recoverable. Should projected undiscounted future cash flows be less than the carrying amount of the asset or asset group, an impairment charge reducing the carrying amount to fair value is required. Fair value is determined based on the most appropriate valuation technique, including discounted cash flows.Asset-Retirement Obligations – An asset-retirement obligation is recognized in the period in which sufficient information exists to determine the fair value of the liability with a corresponding increase to the carrying amount of the related property, plant and equipment which is then depreciated over its useful life. The liability is initially measured at fair value and then accretion expense is recorded in each subsequent period. The company’s asset-retirement obligations are 58Table of Contentsprimarily associated with its on-site long-term supply arrangements where the company has built a facility on land leased from the customer and is obligated to remove the facility at the end of the contract term. The company's asset-retirement obligations are not material to its consolidated financial statements.Foreign Currency Translation – For most foreign operations, the local currency is the functional currency and translation gains and losses are reported as part of the accumulated other comprehensive income (loss) component of equity as a cumulative translation adjustment (see Note 7). Financial Instruments – Linde enters into various derivative financial instruments to manage its exposure to fluctuating interest rates, currency exchange rates, commodity pricing and energy costs. Such instruments primarily include interest-rate swap and treasury rate lock agreements; currency-swap agreements; forward contracts; currency options; and commodity-swap agreements. These instruments are not entered into for trading purposes. Linde only uses commonly traded and non-leveraged instruments.There are three types of derivatives the company enters into: (i) those relating to fair-value exposures, (ii) those relating to cash-flow exposures, and (iii) those relating to foreign currency net investment exposures. Fair-value exposures relate to recognized assets or liabilities, and firm commitments; cash-flow exposures relate to the variability of future cash flows associated with recognized assets or liabilities, or forecasted transactions; and net investment exposures relate to the impact of foreign currency exchange rate changes on the carrying value of net assets denominated in foreign currencies. When a derivative is executed and hedge accounting is appropriate, it is designated as either a fair-value hedge, cash-flow hedge, or a net investment hedge. Currently, Linde designates all interest-rate and treasury rate locks as hedges for accounting purposes; however, currency contracts are generally not designated as hedges for accounting purposes unless they are related to forecasted transactions. Whether designated as hedges for accounting purposes or not, all derivatives are linked to an appropriate underlying exposure. On an ongoing basis, the company assesses the hedge effectiveness of all derivatives designated as hedges for accounting purposes to determine if they continue to be highly effective in offsetting changes in fair values or cash flows of the underlying hedged items. If it is determined that the hedge is not highly effective, then hedge accounting will be discontinued prospectively.Changes in the fair value of derivatives designated as fair-value hedges are recognized in earnings as an offset to the change in the fair values of the underlying exposures being hedged. The changes in fair value of derivatives that are designated as cash-flow hedges are deferred in accumulated other comprehensive income (loss) and are reclassified to earnings as the underlying hedged transaction affects earnings. Provided the hedge remains highly effective, any ineffectiveness is deferred in accumulated other comprehensive income (loss) and are reclassified to earnings as the underlying hedged transaction affects earnings. Hedges of net investments in foreign subsidiaries are recognized in the cumulative translation adjustment component of accumulated other comprehensive income (loss) on the consolidated balance sheets to offset translation gains and losses associated with the hedged net investment. Derivatives that are entered into for risk-management purposes and are not designated as hedges (primarily related to anticipated net income and currency derivatives other than for firm commitments) are recorded at their fair market values and recognized in current earnings.See Note 12 for additional information relating to financial instruments.Goodwill – Acquisitions are accounted for using the acquisition method which requires allocation of the purchase price to assets acquired and liabilities assumed based on estimated fair values. Any excess of the purchase price over the fair value of the assets and liabilities acquired is recorded as goodwill. Allocations of the purchase price are based on preliminary estimates and assumptions at the date of acquisition and are subject to revision based on final information received, including appraisals and other analyses which support underlying estimates.The company performs a goodwill impairment test annually or more frequently if events or circumstances indicate that an impairment loss may have been incurred. During the fourth quarter of fiscal year 2019, the company changed the date of its annual goodwill impairment test from April 30 to October 1. The change was made to more closely align the impairment testing date with the company’s planning process. The impairment test allows an entity to first assess qualitative factors to determine if it is more likely than not that the fair value of a reporting unit is less than carrying value. If it is determined that it is more likely than not that the fair value of a reporting unit is less than carrying value then the company will estimate and compare the fair value of its reporting units to their carrying value, including goodwill. Reporting units are determined based on one level below the operating segment level. The qualitative analysis of goodwill for the year ending December 31, 2020 showed the fair value of the reporting units substantially exceeded the carrying value, as such further analysis was not performed. See Note 9 for additional information relating to goodwill.59Table of ContentsOther Intangible Assets – Other intangible assets, primarily customer relationships, are amortized over the estimated period of benefit. The determination of the estimated period of benefit will be dependent upon the use and underlying characteristics of the intangible asset. Linde evaluates the recoverability of its intangible assets subject to amortization when facts and circumstances indicate that the carrying value of the asset may not be recoverable. If the carrying value is not recoverable, impairment is measured as the amount by which the carrying value exceeds its estimated fair value. Fair value is generally estimated based on either appraised value or other valuation techniques. Indefinite lived intangible assets related to the Linde brand are evaluated for impairment on an annual basis or more frequently if events or circumstances indicate an impairment loss may have occurred. During the fourth quarter of fiscal year 2019, the company changed the date of its annual impairment test from April 30 to October 1. The change was made to more closely align the impairment testing date with the company’s planning process.See Note 10 for additional information relating to other intangible assets.Assets Held for Sale and Discontinued Operations – Assets held for sale, as well as liabilities directly related to these assets, are classified separately in the consolidated balance sheets as held for sale if the requirements of the FASB’s Accounting Standards Codification (“ASC”) 360, Property, Plant and Equipment, are satisfied. The main requirements of ASC 360 are: (i) management having the authority to approve the action has committed to a plan to sell the assets and an active program to locate a buyer has been initiated, (ii) the assets are available for sale in their present condition at a reasonable market price, and (iii) a sale within the next twelve months is probable. Assets classified as held for sale are measured at the lower of carrying amount and fair value less costs to sell. Amortization and depreciation has been discontinued. The process involved in determining the fair value less costs to sell involves estimates and assumptions that are subject to uncertainty.Discontinued operations are reported as soon as a business is classified as held for sale, or has already been disposed of, and when the business to be disposed of represents a strategic shift that has (or will have) a major effect on the company’s operations and financial results. Businesses acquired with the intent of divesting are also required to be reported as discontinued operations. The profit/loss from discontinued operations is reported separately from the expenses and income from continuing operations in the consolidated statements of income. In the consolidated statement of cash flows, the cash flows from discontinued operations are shown separately from the cash flows from continuing operations. The information provided in the Notes relates to continuing operations. If the information relates exclusively to discontinued operations, this is highlighted accordingly.Income Taxes – Deferred income taxes are recorded for the temporary differences between the financial statement and tax bases of assets and liabilities using currently enacted tax rates. Valuation allowances are established against deferred tax assets whenever circumstances indicate that it is more likely than not that such assets will not be realized in future periods.Under the guidance for accounting for uncertainty in income taxes, the company can recognize the benefit of an income tax position only if it is more likely than not (greater than 50%) that the tax position will be sustained upon tax examination, based solely on the technical merits of the tax position. Otherwise, no benefit can be recognized. The tax benefits recognized are measured based on the largest benefit that has a greater than 50% likelihood of being realized upon ultimate settlement. Additionally, the company accrues interest and related penalties, if applicable, on all tax exposures for which reserves have been established consistent with jurisdictional tax laws. Interest and penalties are classified as income tax expense in the financial statements. See Note 5 for additional information relating to income taxes.Retirement Benefits – Most Linde employees participate in a form of defined benefit or contribution retirement plan, and additionally certain employees are eligible to participate in various post-employment health care and life insurance benefit plans. The cost of contribution plans is recognized in the year earned while the cost of other plans is recognized over the employees’ expected service period to the company, all in accordance with the applicable accounting standards. The funded status of the plans is recorded as an asset or liability in the consolidated balance sheets. Funding of retirement benefits varies and is in accordance with local laws and practices. See Note 16 for additional information relating to retirement programs.Share-based Compensation– The company has historically granted share-based awards which consist of stock options, restricted stock and performance-based stock. Share-based compensation expense is generally recognized on a straight-line basis over the stated vesting period. For stock awards granted to full-retirement-eligible employees, compensation expense is recognized over the period from the grant date to the date retirement eligibility is achieved. For performance-based awards, compensation expense is recognized only if it is probable that the performance condition will be achieved. 60Table of ContentsSee Note 15 for additional disclosures relating to share-based compensation.Reclassifications – Certain prior years’ amounts have been reclassified to conform to the current year’s presentation.Recently Issued Accounting StandardsAccounting Standards Implemented in 2020 •Credit Losses on Financial Instruments –In June 2016, the FASB issued updated guidance on the measurement of credit losses. The guidance introduces a new accounting model for expected credit losses on financial instruments, including trade receivables, based on estimates of current expected credit losses. This guidance is effective for the company beginning in the first quarter 2020 and requires companies to apply the change in accounting on a modified retrospective basis. The adoption of the guidance had an immaterial impact on the consolidated financial statements.•Simplifying the Test for Goodwill Impairment – In January 2017, the FASB issued updated guidance on the measurement of goodwill. The new guidance eliminates the requirement to calculate the implied fair value of goodwill to measure a goodwill impairment charge. The guidance is effective for the company beginning in the first quarter 2020. The adoption of the guidance had no impact on the consolidated financial statements.•Fair Value Measurement Disclosures - In August 2018, the FASB issued guidance that modifies the disclosure requirements for fair value measurements. The guidance is effective in fiscal year 2020, with early adoption permitted. Certain amendments must be applied prospectively while other amendments must be applied retrospectively. The adoption of the guidance had an immaterial impact on the consolidated financial statements.•Retirement Benefit Disclosures - In August 2018, the FASB issued guidance that modifies the disclosure requirements for employers that sponsor defined benefit pension or other postretirement benefit plans. The guidance is effective in fiscal year 2020, with early adoption permitted, and must be applied on a retrospective basis. The adoption of the guidance had an immaterial impact on the consolidated financial statements impacting disclosure only.Accounting Standards to be Implemented•Income Taxes - Simplifying the Accounting for Income Taxes - In December 2019, the FASB issued guidance which simplifies the accounting for income taxes by removing several exceptions in the current standard and adds guidance to reduce complexity in certain areas, such as requiring that an entity reflect the effect of an enacted change in tax laws or rates in the annual effective tax rate computation in the interim period that includes the enactment date, evaluating whether a step-up in tax basis of goodwill relates to a business combination or a separate transaction and allocating taxes to members of a consolidated group. The new standard is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2020, with early adoption permitted. The company is currently assessing the impact that adopting this guidance will have on its consolidated financial statements and does not expect this guidance to have a material impact.•Reference Rate Reform - In March 2020, the FASB issued guidance related to reference rate reform which provides practical expedients and exceptions for applying GAAP to contract modifications, hedging relationships and other transactions that the reference London Interbank Offered Rate (“LIBOR”) and other interbank offered rates. This update is applicable to our contracts and hedging relationships that reference LIBOR and other interbank offered rates. The amendments may be applied to impacted contracts and hedges prospectively through December 31, 2022. We are currently evaluating the impact of this guidance on our consolidated financial statements.NOTE 2. Business Combination and DivestituresMerger of Praxair, Inc. and Linde AG61Table of ContentsOn October 31, 2018 Praxair and Linde AG combined their respective businesses through an all-stock transaction and became subsidiaries of the company.In connection with the business combination, each share of common stock of Praxair par value $0.01 per share, (excluding any shares held in treasury immediately prior to the effective time of the merger, which were automatically canceled and retired for no consideration) was converted into one ordinary share, par value €0.001 per share, of Linde plc. Additionally, each tendered share of common stock of Linde AG was converted into 1.54 ordinary shares of Linde plc.As provided in the business combination agreement, at the effective time of the business combination outstanding Praxair stock options and other equity awards were generally converted into stock options and equity awards on a 1:1 basis with respect to Linde shares. Outstanding Linde AG share-based compensation awards were either settled in cash (for the portion vested), or were converted into similar stock options and equity awards with respect to Linde shares (for the portion unvested), after giving effect to the 1.54 exchange ratio.Results of Linde AG Operations in 2018The results of operations of Linde AG have been included in the company’s consolidated statements of income since the merger. The following table provides Linde AG “Sales” and “Income (loss) from continuing operations” included in the company's results for the period November 1 through December 31, 2018.Millions of dollarsLinde AG Results of OperationsNovember 1, - December 31, 2018Sales$2,873 Income (loss) from continuing operations*$(385)*Includes net charges of $451 million related to the impacts of purchase accounting.Unaudited Pro Forma Information - 2018Linde's unaudited pro forma results presented below were prepared pursuant to the requirements of ASC 805 and give effect to the merger as if it had been consummated on January 1, 2017. The pro forma results have been prepared for comparative purposes only, and do not necessarily represent what the revenue or results of operations would have been had the merger been completed on January 1, 2017. In addition, these results are not intended to be a projection of future operating results and do not reflect synergies that might be achieved.The unaudited pro forma results include adjustments for the preliminary purchase accounting impact (including, but not limited to, depreciation and amortization associated with the acquired tangible and intangible assets, amortization of the fair value adjustment to investment in nonconsolidated affiliates, and reduction of interest expense related to the fair value adjustment to long-term debt along with the related tax and non-controlling interest impacts), the alignment of accounting policies, adjustments due to IFRS compliant reporting conversion to U.S. GAAP and the elimination of transactions between Praxair and Linde AG.The unaudited pro forma results exclude the results of operations of the Linde AG merger-related divestitures as these divestitures are reflected as discontinued operations. The Praxair merger-related divestitures are included in the results from continuing operations, including the results from Praxair's European business through the disposition date of December 3, 2018, in the unaudited pro forma results presented below, for all periods presented, as these divestitures do not qualify for discontinued operations.The unaudited pro forma results are summarized below:Millions of dollars2018Sales (a)$29,774 Income from continuing operations$4,739 (a) Includes sales from Praxair's merger-related divestitures of $1,625 million for the year ended December 31, 2018.Significant nonrecurring amounts reflected in the pro forma results are as follows:62Table of ContentsA $3,294 million gain ($2,923 million after tax) was recorded in the fourth quarter 2018 as a result of the divestiture of Praxair's European industrial gases business and is included in the December 31, 2018 pro forma income from continuing operations.From January 1, 2017 through December 31, 2018, Praxair, Inc. and Linde AG collectively incurred pre-tax costs of $736 million ($680 million after tax) to prepare for and close the merger. These merger costs were reflected within the results of operations in the pro forma results as if they were incurred on January 1, 2017. Any costs incurred related to merger-related divestitures and integration and to prepare for the intended business separations were reflected in the pro forma results in the period in which they were incurred.The company incurred pre-tax charges of $368 million ( $279 million after tax) and $10 million ($8 million after tax) in 2018 related to the fair value step‑up of inventories acquired and sold as well as a pension settlement due to the payout to certain participants as a result of change in control provisions within a U.S. nonqualified pension plan, respectively. The 2018 pro forma results were adjusted to exclude these charges. Merger-Related DivestituresPraxair Merger-Related Divestitures - Primarily European Industrial Gases BusinessAs a condition of the EC regulatory approval of the merger transaction, Praxair agreed to sell the majority of its industrial gases business in Europe. The below transactions were completed in 2018, and the company recognized a net pre-tax gain of $3,294 million ($2,923 million after tax) in the consolidated statements of income.•The Società Italiana Acetilene e Derivati S.p.A. ("SIAD") Sale and Purchase Agreement dated December 5, 2017 whereby Praxair agreed, inter alia, to sell its 34% non-controlling participation in its Italian joint venture SIAD to its joint venture partner Flow Fin in exchange for Flow Fin’s 40% non-controlling participation in Praxair’s majority-owned Italian joint venture, Rivoira S.p.A., and cash payment of a net purchase price of €90 million ($102 million as of October 31, 2018) by Praxair to Flow Fin. This transaction was completed on October 31, 2018, and;•The Praxair Europe Sale and Purchase Agreement dated July 5, 2018 pursuant to which Praxair sold the majority of its European businesses to Taiyo Nippon Sanso Corporation for €5,000 million in cash consideration ($5,700 million at December 3, 2018), reduced by estimated normal closing adjustments of €86 million ($96 million). These transactions were completed on December 3, 2018.Additionally, to satisfy regulatory requirements in other jurisdictions, Praxair agreed to sell certain operations in Chile, China, India and South Korea. The Chilean business was sold as part of the Linde AG Americas SPA (as defined below). The sale of the select Indian assets was completed on July 12, 2019 with a sale price of $218 million and resulted in a gain of $164 million recognized in "Net gain on sale of businesses" in the consolidated statements of income. The sale of select assets in South Korea and China were completed in 2019 and 2020, respectively. These businesses were evaluated for discontinued operations accounting treatment under U.S. GAAP and it was determined that they did not meet the definition of a discontinued operation as these transactions did not represent a strategic shift with a major effect, after considering the impact of the merger. Linde AG Merger-Related Divestitures - Primarily Americas Industrial Gases BusinessAs a condition of the U.S. regulatory approval of the merger, Linde AG agreed to sell the majority of its industrial gases business in the Americas, as described below:•The Linde AG Americas Sales and Purchase Agreement, dated July 16, 2018, as and further amended on September 22, 2018, October 19, 2018, and February 20, 2019 whereby Linde AG and Praxair, Inc. entered into an agreement with a consortium comprising companies of the German industrial gases manufacturer Messer Group and CVC Capital Partners Fund VII to sell the majority of Linde AG’s industrial gases business in North America and certain industrial gases business activities of Linde AG's in South America for $2.9 billion in cash consideration after purchase price adjustments for certain items relating to assets and liabilities of the sold 63Table of Contentsbusinesses. In addition, divestitures include $0.5 billion of proceeds for incremental plant sales within the Americas under other agreements. These transactions were completed on March 1, 2019.•On April 30, 2019, Linde completed the sale of select assets of Linde South Korea with the sale price of $1.2 billion to IMM Private Equity Inc., to satisfy requirements of the Korea Fair Trade Commission. The assets divested include bulk and on-site business in Giheung, Pohang and Seosansites as well as oxygen and nitrogen on-site generators.•On December 16, 2019, Linde completed the sale of select assets of Linde India with a sale price of $193 million. •In March 2020, Linde completed the sale of select assets of Linde China with a sale price of $98 million.Discontinued OperationsOnly the sales of the Linde AG merger-related divestitures meet the criteria for discontinued operations, Praxair merger-related divestitures do not qualify as discontinued operations. As such, operations related to the Linde AG merger-related divestitures are included within Income from discontinued operations, net of tax for periods subsequent to the merger, as summarized below:Millions of dollars20202019November 1, - December 31, 2018Net sales$7 $449 $388 Cost of sales3 251 173 Other operating costs1 43 90 Operating profit$3 $155 $125 Income from equity investments1 8 1 Income taxes— 54 9 Income from discontinued operations, net of tax$4 $109 $117 Noncontrolling interests— (7)(9)Income from continuing operations, net of tax and noncontrolling interests$4 $102 $108 For the years ended December 31, 2020, 2019 and 2018 there were no material amounts of capital expenditures or significant operating or investing non-cash items related to discontinued operations.Non-Merger Related AcquisitionsNon-merger related acquisitions of $68 million, $225 million and $25 million for the years ended December 31, 2020, 2019 and 2018, respectively, were primarily related to the Americas and are not material, individually or in the aggregate.NOTE 3. COST REDUCTION PROGRAMS AND OTHER CHARGESCost reduction programs and other charges were $506 million, $567 million, and $309 million for the 12 months ended December 31, 2020, 2019, and 2018, respectively. After tax and noncontrolling interests, charges were $372 million, $444 million, and $306 million for the same respective periods. The following tables provide a summary of the pre-tax charges by reportable segment for the years ended December 31, 2020 and December 31, 2019. 64Table of ContentsYear Ended December 31, 2020(millions of dollars)Severance costsOther cost reduction chargesTotal cost reduction program related chargesMerger related and other chargesTotalAmericas$35 $24 59 13 $72 EMEA131 21 152 3 155 APAC7 2 9 3 12 Engineering38 28 66 4 70 Other87 18 105 92 197 Total$298 $93 $391 $115 $506 Year Ended December 31, 2019(millions of dollars)Severance costsOther cost reduction chargesTotal cost reduction program related chargesMerger related and other chargesTotalAmericas$36 $20 56 34 $90 EMEA105 16 121 21 142 APAC40 10 50 72 122 Engineering1 12 13 (9)4 Other22 42 64 145 209 Total$204 $100 $304 $263 $567 Cost Reduction ProgramsIn 2019, Linde initiated a cost reduction program, which represents charges of achieving synergies and cost efficiencies expected from the merger of Praxair and Linde AG (see Note 2). Total charges related to the cost reduction programs were $391 million ($277 million, after tax and noncontrolling interests) and $304 million ($233 million, after tax) for the years ended December 31, 2020 and December 31, 2019, respectively. Severance costsDuring the year ended December 31, 2020, severance costs of $298 million were recorded for the elimination of approximately 3,100 positions. Severance costs of $204 million for the year ended December 31, 2019 were recorded for the elimination of approximately 2,400 positions. As of December 31, 2020, the majority of the actions have been taken, with the remaining actions anticipated to be completed within the next 12 months. Other cost reduction chargesOther cost reduction charges were $93 million and $100 million for the years ended December 31, 2020 and December 31, 2019, respectively. These amounts primarily represent charges related to the execution of the company's synergistic actions including location consolidations and business rationalization projects, software and process harmonization, and associated non-recurring costs.Merger-Related Costs and Other ChargesMerger-related costs and other charges were $115 million ($95 million, after tax), $263 million ($211 million, after tax and noncontrolling interests), and $309 million ($306 million, after tax and noncontrolling interests) for the years ended December 31, 2020, 2019, and 2018, respectively. 2019 includes other charges for an asset impairment related to a joint venture in APAC of approximately $73 million ($42 million, after tax and noncontrolling interests) resulting from an unfavorable arbitration ruling. 2018 includes other charges of $73 million comprised of the following; (i) a $40 million charge ($40 million, after-tax) related to an unfavorable development related to a supplier contract in China, (ii) restructuring charges of $21 million ($18 million, after-tax) and (iii) a $12 million charge ($12 million, after-tax) associated with the transition to hyper-inflationary accounting in Argentina.Cash RequirementsTotal cash requirements of the cost reduction program and other charges during the twelve months ended December 31, 2020 are estimated to be approximately $390 million, of which $221 million was paid through December 31, 2020. 65Table of ContentsRemaining cash requirements are expected to be paid through 2023. Total cost reduction programs and other charges, net of payments in the consolidated statements of cash flows for the twelve months ended December 31, 2020 and 2019 also reflect the impact of cash payments of liabilities, including merger-related tax liabilities, accrued as of December 31, 2019 and 2018, respectively.The following table summarizes the activities related to the company's cost reduction programs and other charges during 2019 and 2020:(millions of dollars)Severance costsOther cost reduction chargesTotal cost reduction program related chargesMerger related and other chargesTotal2019 Cost Reduction Programs and Other Charges$204 $100 304 $263 $567 Less: Cash payments(91)(57)(148)(112)(260)Less: Non-cash charges— (21)(21)(78)(99)Foreign currency translation and other4 (6)(2)(6)(8)Balance, December 31, 2019$117 $16 $133 $67 $200 2020 Cost Reduction Programs and Other Charges298 93 391 115 506 Less: Cash payments(156)(20)(176)(45)(221)Less: Non-cash charges— (68)(68)(82)(150)Foreign currency translation and other24 1 25 9 34 Balance, December 31, 2020$283 $22 $305 $64 $369 Classification in the consolidated financial statements The pre-tax charges for each year are shown within operating profit in a separate line item on the consolidated statements of income. In the consolidated balance sheets, reductions in assets are recorded against the carrying value of the related assets and unpaid amounts are recorded as other current or long-term liabilities (see Note 7). On the consolidated statements of cash flows, the pre-tax impact of these charges, net of cash payments, is shown as an adjustment to reconcile net income to net cash provided by operating activities. In Note 18 Segment Information, Linde excluded these charges from its management definition of segment operating profit; a reconciliation of segment operating profit to consolidated operating profit is shown within the segment operating profit table.NOTE 4. LEASESIn the normal course of its business, Linde enters into various leases as the lessee, primarily involving manufacturing and distribution equipment and office space. Linde determines whether a contract is or contains a lease at contract inception. Total lease and rental expenses related to operating lease right of use assets for the twelve months ended December 31, 2020 and 2019 was $341 million, and $364 million respectively. Operating leases costs are included in selling, general and administrative expenses and cost of sales, exclusive of depreciation and amortization. The related assets and obligations are included in other long term assets and other current liabilities and other long term liabilities, respectively. Total lease and rental expenses related to finance lease right of use assets for the twelve months ended December 31, 2020 and 2019 was $44 million and $31 million, respectively, and the costs are included in depreciation and amortization and interest. Related assets and obligations are included in other long term assets and other current liabilities and other long term liabilities, respectively. Linde includes renewal options that are reasonably certain to be exercised as part of the lease term. Operating and financing lease expenses above include short term and variable lease costs which are immaterial.As most leases do not provide an implicit rate, Linde uses the applicable incremental borrowing rate at lease commencement to measure lease liabilities and right-of-use assets. Linde determines incremental borrowing rates through market sources. The company has elected to apply the short-term lease exception for all underlying asset classes. Short-term leases are leases that, at the commencement date, have a lease term of twelve months or less and do not include a purchase option that the lessee is reasonably certain to exercise. Leases that meet the short-term lease definition are not recognized on the balance sheet, but rather expensed on a straight-line basis over the lease term.Some leasing arrangements require variable payments that are dependent on usage, output, or may vary for other reasons, such as insurance. The company does not have material variable lease payments.66Table of ContentsGains and losses on sale and leaseback transactions were immaterial. Operating cash flows used for operating leases for the twelve months ended December 31, 2020 and 2019 were $317 million and $341 million, respectively. Cash flows used for finance leases for the same period were immaterial. Supplemental balance sheet information related to leases is as follows: (Millions of dollars)December 31, 2020December 31, 2019Operating LeasesOperating lease right-of-use assets$935 $1,025 Other current liabilities237 260 Other long-term liabilities669 716 Total operating lease liabilities906 976 Finance LeasesFinance lease right-of-use assets*155 140 Other current liabilities*38 32 Other long-term liabilities*125 117 Total finance lease liabilities$163 $149 * Finance right of use assets at December 31, 2019 are recorded within property plant and equipment. Current and long-term finance lease liabilities at December 31, 2019 are recorded within current portion long-term debt and long-term debt, respectively.Supplemental operating lease information: December 31, 2020December 31, 2019Weighted average lease term (years)97Weighted average discount rate2.83 %2.97 %Future operating and finance lease payments as of December 31, 2020 are as follows (millions of dollars):PeriodOperating LeasesFinancing Leases2021$251 $41 2022187 37 2023131 27 202489 17 202562 12 Thereafter257 71 Total future undiscounted lease payments977 205 Less imputed interest(71)(42)Total reported lease liability$906 $163 NOTE 5. INCOME TAXESThe years ended December 31, 2020 and 2019 reflect a full year of Linde plc; the year ended December 31, 2018 reflects Praxair for the entire year and Linde AG for the period beginning October 31, 2018 (the merger date).Pre-tax income applicable to U.S. and foreign operations is as follows: 67Table of Contents(Millions of dollars)Year Ended December 31,202020192018United States$1,253 $1,161 $931 Foreign (a)2,131 1,766 4,118 Total income before income taxes$3,384 $2,927 $5,049 (a) 2019 includes a $164 million gain related to the Praxair India divestiture and 2018 includes a $3,294 million gain related to the Praxair Europe divestiture (See Note 2). Provision for Income TaxesThe following is an analysis of the provision for income taxes: (Millions of dollars)Year Ended December 31,20202019 (a)2018(b)Current tax expense (benefit)U.S. federal$185 $64 $390 State and local17 39 (7)Foreign1,013 969 620 1,215 1,072 1,003 Deferred tax expense (benefit)U.S. federal20 85 8 State and local7 — 15 Foreign(395)(388)(209)(368)(303)(186)Total income taxes$847 $769 $817 (a)2019 includes $70 million related to divestitures, foreign current tax expense of $48 million and foreign deferred tax expense of $22 million.(b)2018 includes a benefit of $61 million related to the Tax Act (See below) and a charge of $371 million ($252 million U.S., $4 million state, $114 million foreign current tax expense and $1 million of U.S. deferred income tax expense) related to divestitures (See Note 2).U.S. Tax Cuts and Jobs Act (Tax Act) 2018Following the enactment of the Tax Cuts and Jobs Act (“Tax Act”) in 2017, the company completed its accounting and updated its provisional estimates in accordance with SAB 118 in the fourth quarter of 2018, resulting in a net reduction to tax expense of $61 million, $41 million U.S. federal and $20 million of state income tax (net of federal tax benefit). As of December 31, 2020 and 2019, the tax payable related to the deemed repatriation tax is $230 million and $261 million, respectively, of which $204 million and $235 million is classified as other long-term liabilities on the consolidated balance sheet (See Note 7), respectively. The company is required to fund the balance in annual installments through 2025.Effective Tax Rate ReconciliationFor purposes of the effective tax rate reconciliation, the company utilizes the U.S. statutory income tax rate of 21%. An analysis of the difference between the provision for income taxes and the amount computed by applying the U.S. statutory income tax rate to pre-tax income follows: 68Table of Contents(Dollar amounts in millions)Year Ended December 31,202020192018U.S. statutory income tax$711 21.0 %$615 21.0 %$1,060 21.0 %State and local taxes – net of federal benefit21 0.6 %31 1.1 %30 0.6 %U.S. tax credits and deductions (a)(8)(0.2)%(31)(1.1)%(12)(0.2)%Foreign tax differentials (b)167 4.9 %113 3.9 %57 1.1 %Share-Based compensation(53)(1.6)%(41)(1.4)%(22)(0.4)%Tax Act— — %— — %(61)(1.2)%Divestitures (c)— — %36 1.2 %(321)(6.4)%Other – net (d)9 0.3 %46 1.6 %86 1.7 %Provision for income taxes$847 25.0 %$769 26.3 %$817 16.2 % ________________________(a)U.S. tax credits and deductions relate to foreign derived intangible income and the research and experimentation tax credit in 2020, 2019 and 2018.(b)Primarily related to differences between the U.S. tax rate and the statutory tax rate in the countries where the company operates. Other permanent items and tax rate changes were not significant.(c)Divestitures primarily relate to the sale of the company’s Indian business in 2019 and European business in 2018 (See Note 2).(d)Other - net includes $11 million, $26 million and $34 million of U.S tax related to Global Intangible Low-Taxed Income in 2020, 2019 and 2018, respectively and an increase in unrecognized tax benefits in Europe of $44 million in 2018.Net Deferred Tax LiabilitiesNet deferred tax liabilities included in the consolidated balance sheets are comprised of the following: 69Table of Contents(Millions of dollars)December 31,20202019Deferred tax liabilitiesFixed assets$3,430 $3,539 Goodwill173 145 Other intangible assets3,703 3,688 Subsidiary/equity investments609 664 Other (a)791 789 $8,706 $8,825 Deferred tax assetsCarryforwards$386 $441 Benefit plans and related (b)814 721 Inventory70 72 Accruals and other (c)1,243 1,167 $2,513 $2,401 Less: Valuation allowances (d)(243)(222)$2,270 $2,179 Net deferred tax liabilities$6,436 $6,646 Recorded in the consolidated balance sheets as (Note 7):Other long-term assets268 243 Deferred credits6,704 6,889 $6,436 $6,646 ________________________(a)Includes $255 million in 2020 and 2019 related to right-of-use lease assets.(b)Includes deferred taxes of $560 million and $446 million in 2020 and 2019, respectively, related to pension / OPEB funded status (See Notes 7 and 16).(c)Includes $255 million in 2020 and 2019 related to lease liabilities and $63 million and $81 million in 2020 and 2019, respectively, related to research and development costs.(d)Summary of valuation allowances relating to deferred tax assets follows (millions of dollars):202020192018Balance, January 1,$(222)$(237)$(76)Income tax (charge) benefit(21)(31)(51)Merger with Linde AG— 18 (121)Other, including write-offs (i)2 26 7 Translation adjustments(2)2 4 Balance, December 31,$(243)$(222)$(237)(i)2019 includes $26 million related to the squeeze out of Linde AG (See Note 14).The company evaluates deferred tax assets quarterly to ensure that estimated future taxable income will be sufficient in character (e.g., capital gain versus ordinary income treatment), amount and timing to result in their recovery. After considering the positive and negative evidence, a valuation allowance is established to reduce the assets to their realizable value when management determines that it is more likely than not (i.e., greater than 50% likelihood) that a deferred tax asset will not be realized. Considerable judgment is required in establishing deferred tax valuation allowances. As of December 31, 2020, the company had $386 million of deferred tax assets relating to net operating losses (“NOLs”) and tax credits and $243 million of valuation allowances. These deferred tax assets include $276 million relating to NOLs of which $34 million expire within 5 years, $110 million expire after 5 years and $132 million have no expiration. The 70Table of Contentsdeferred tax assets also include $110 million related to credits of which $9 million expire within 5 years, $93 million expire after 5 years, and $8 million have no expiration. The valuation allowances of $243 million primarily relate to NOLs and are required because management has determined, based on financial projections and available tax strategies, that it is unlikely that the NOLs will be utilized before they expire. If events or circumstances change, valuation allowances are adjusted at that time resulting in an income tax benefit or charge.The company has $609 million of foreign income taxes accrued related to its investments in subsidiaries and equity investments as of December 31, 2020. A provision has not been made for any additional foreign income tax at December 31, 2020 on approximately $32 billion related to its investments in subsidiaries because the company intends to remain indefinitely reinvested. While the $32 billion could become subject to additional foreign income tax if there is a sale of a subsidiary, or earnings are remitted as dividends, it is not practicable to estimate the unrecognized deferred tax liability.Uncertain Tax PositionsUnrecognized income tax benefits represent income tax positions taken on income tax returns but not yet recognized in the consolidated financial statements. The company has unrecognized income tax benefits totaling $452 million, $472 million and $319 million as of December 31, 2020, 2019 and 2018, respectively. If recognized, essentially all of the unrecognized tax benefits and related interest and penalties would be recorded as a benefit to income tax expense on the consolidated statements of income.A reconciliation of the beginning and ending amount of unrecognized tax benefits is as follows: (Millions of dollars)202020192018Unrecognized income tax benefits, January 1$472 $319 $54 Additions for tax positions of prior years (a)35 151 104 Reductions for tax positions of prior years(34)(3)(7)Additions for current year tax positions (b)11 33 179 Reductions for settlements with taxing authorities (c)(39)(26)(3)Foreign currency translation and other7 (2)(8)Unrecognized income tax benefits, December 31$452 $472 $319 ________________________(a)Increase primarily relates to tax positions in the United States and Europe, $66 million in 2019 related to the merger with Linde AG.(b)2018 includes $167 million related to the merger with Linde AG.(c)Settlements are uncertain tax positions that were effectively settled with the taxing authorities, including positions where the company has agreed to amend its tax returns to eliminate the uncertainty. The company classifies interest income and expense related to income taxes as tax expense in the consolidated statements of income. The company recognized net interest expense of $29 million, $1 million and $32 million for the years ended December 31, 2020, December 31, 2019 and December 31, 2018, respectively. The company had $99 million and $65 million of accrued interest and penalties as of December 31, 2020 and December 31, 2019, respectively which were recorded in other long-term liabilities in the consolidated balance sheets (See Note 7). 71Table of ContentsAs of December 31, 2020, the company remained subject to examination in the following major tax jurisdictions for the tax years as indicated below: Major tax jurisdictionsOpen YearsNorth and South AmericaUnited States2017 through 2020Canada2013 through 2020Mexico2014 through 2020Brazil2003 through 2020Europe and AfricaFrance2014 through 2020Germany2015 through 2020Netherlands2015 through 2020Republic of South Africa2017 through 2020Spain2006 through 2020United Kingdom2015 through 2020Asia and AustraliaAustralia2016 through 2020China2015 through 2020India2006 through 2020South Korea2015 through 2020Taiwan2015 through 2020The company is currently under audit in a number of jurisdictions. As a result, it is reasonably possible that some of these matters will conclude or reach the stage where a change in unrecognized income tax benefits may occur within the next twelve months. At the time new information becomes available, the company will record any adjustment to income tax expense as required. Final determinations, if any, are not expected to be material to the consolidated financial statements. The company is also subject to income taxes in many hundreds of state and local taxing jurisdictions that are open to tax examinations.72Table of ContentsNOTE 6. EARNINGS PER SHARE – LINDE PLC SHAREHOLDERSBasic and Diluted earnings per share - Linde plc shareholders is computed by dividing Income from continuing operations, Income from discontinued operations, net of tax, and Net income – Linde plc for the period by the weighted average number of either basic or diluted shares outstanding, as follows: 202020192018Numerator (Millions of dollars)Income from continuing operations $2,497 $2,183 $4,273 Income from discontinued operations, net of tax4 102 108 Net Income – Linde plc$2,501 $2,285 $4,381 Denominator (Thousands of shares)Weighted average shares outstanding526,404 540,859 330,088 Shares earned and issuable under compensation plans332 235 313 Weighted average shares used in basic earnings per share *526,736 541,094 330,401 Effect of dilutive securitiesStock options and awards4,421 4,076 3,726 Weighted average shares used in diluted earnings per share *531,157 545,170 334,127 Basic earnings per share from continuing operations$4.74 $4.03 $12.93 Basic earnings per share from discontinued operations0.01 0.19 0.33 Basic Earnings Per Share$4.75 $4.22 $13.26 Diluted earnings per share from continuing operations$4.70 $4.00 $12.79 Diluted earnings per share from discontinued operations0.01 0.19 0.32 Diluted Earnings Per Share$4.71 $4.19 $13.11 * As a result of the merger, share amounts for the year ended December 31, 2018 reflect a weighted average effect of Praxair shares outstanding prior to October 31, 2018 and Linde plc shares outstanding on and after October 31, 2018. There were no antidilutive shares for the years ended December 31, 2020, 2019 or 2018.NOTE 7. SUPPLEMENTAL INFORMATIONThe years ended December 31, 2020 and 2019 reflect the combined business. December 31, 2018 reflects Praxair for the entire year and the Linde AG for the period beginning after October 31, 2018 (the merger date), including the impacts of purchase accounting. Income Statement (Millions of dollars)Year Ended December 31,202020192018Selling, General and AdministrativeSelling$1,303 $1,600 $757 General and administrative1,890 1,857 872 $3,193 $3,457 $1,629 Year Ended December 31,202020192018Depreciation and Amortization (a)Depreciation$3,861 $3,940 $1,615 Amortization of intangibles (Note 10)765 735 215 Depreciation and Amortization$4,626 $4,675 $1,830 73Table of ContentsYear Ended December 31,202020192018Other Income (Expenses) – NetCurrency related net gains (losses)$(28)$(11)$4 Partnership income10 8 8 Severance expense(5)(7)(7)Asset divestiture gains (losses) – net(78)10 6 Other – net40 68 7 $(61)$68 $18 Year Ended December 31,202020192018Interest Expense – NetInterest incurred on debt and other$277 $284 $297 Interest income(55)(112)(80)Amortization on acquired debt(85)(96)(21)Interest capitalized(38)(38)(20)Bond redemption (b)16 — 26 $115 $38 $202 Year Ended December 31,202020192018Income Attributable to Noncontrolling InterestsNoncontrolling interests' operations (c)$125 $87 $12 Redeemable noncontrolling interests' operations (Note 14)— 2 3 Noncontrolling interests from continuing operations$125 $89 $15 Noncontrolling interests from discontinued operations— $7 $9 Balance Sheet(Millions of dollars)December 31,20202019Accounts ReceivableTrade and Other receivables$4,638 $4,628 Less: allowance for expected credit losses(471)(306)$4,167 $4,322 ReceivablesFor trade receivables an expected credit loss approach was adopted as of January 1, 2020. Linde applies loss rates that are lifetime expected credit losses at initial recognition of the receivables. These expected loss rates are based on an analysis of the actual historical default rates for each business, taking regional circumstances into account. If necessary, these historical default rates are adjusted to reflect the impact of current changes in the macroeconomic environment using forward-looking information. The loss rates are also evaluated based on the expectations of the responsible management team regarding the collectability of the receivables. Gross trade receivables aged less than one year were $4,169 million and $4,075 million at December 31, 2020 and December 31, 2019, respectively, and gross receivables aged greater than one year were $358 million and $249 million at December 31, 2020 and December 31, 2019, respectively. Gross other receivables were $111 million and $304 million at December 31, 2020 and December 31, 2019, respectively. Receivables aged greater than one year are generally fully reserved unless specific circumstances warrant exceptions, such as those backed by federal governments. Provisions for expected credit losses were $182 million, $170 million and $25 million for the twelve months ended December 31, 2020, 2019 and 2018, respectively. The allowance activity in the twelve months ended December 31, 2020 related to write-offs of uncollectible amounts, net of recoveries and currency movements is not material.74Table of ContentsDecember 31,20202019InventoriesRaw materials and supplies$411 $396 Work in process337 331 Finished goods981 970 $1,729 $1,697 December 31,20202019Prepaid and Other Current AssetsPrepaid and other deferred charges (d)$516 $516 VAT recoverable261 275 Unrealized gains on derivatives (Note 12)110 85 Assets held for sale (Note 2)4 125 Other221 264 $1,112 $1,265 December 31,20202019Other Long-term AssetsPension assets (Note 16)$55 $78 Insurance contracts (e)61 75 Long-term receivables, net (f)201 150 Lease assets (Note 4)1,090 1,025 Deposits47 56 Investments carried at cost23 40 Deferred charges96 90 Deferred income taxes (Note 5) 268 243 Unrealized gains on derivatives (Note 12)90 82 Other217 174 $2,148 $2,013 December 31,20202019Other Current LiabilitiesAccrued expenses$1,226 $1,079 Payroll653 619 VAT payable336 268 Pension and postretirement (Note 16)34 27 Interest payable135 127 Lease liability (Note 4)275 260 Insurance reserves38 38 Unrealized losses on derivatives (Note 12)70 54 Noncontrolling interest redemption and dividend (Note 14)231 — Synergy cost accruals (Note 3)199 140 Other1,135 891 $4,332 $3,503 75Table of ContentsDecember 31,20202019Other Long-term LiabilitiesPension and postretirement (Note 16)$2,963 $2,548 Tax liabilities for uncertain tax positions (Note 5)355 342 Tax Act liabilities for deemed repatriation (Note 5)204 235 Lease liability (Note 4)794 716 Interest and penalties for uncertain tax positions (Note 5)99 65 Insurance reserves33 28 Asset retirement obligation302 293 Unrealized losses on derivatives (Note 12)11 45 Synergy cost accruals (Note 3)170 60 Other 588 556 $5,519 $4,888 December 31,20202019Deferred CreditsDeferred income taxes (Note 5) $6,704 $6,889 Other532 347 $7,236 $7,236 December 31,20202019Accumulated Other Comprehensive Income (Loss)Cumulative translation adjustment - net of taxes:Americas (g)$(3,788)$(3,357)EMEA (g)1,020 (136)APAC (g)616 (140)Engineering354 (29)Other(1,020)282 (2,818)(3,380)Derivatives – net of taxes4 (27)Pension/OPEB funded status obligation (net of $560 million and $446 million tax benefit in 2020 and 2019) (Note 16)(1,876)(1,407)$(4,690)$(4,814)(a)Depreciation and amortization expense in 2020 include $1,267 million and $653 million, respectively, of Linde AG purchase accounting impacts. In 2019, depreciation and amortization expense include $1,298 million and $642 million, respectively, of Linde AG purchase accounting impacts.(b)In December 2018, Linde repaid $600 million of 4.50% notes due 2019 and €600 million of 1.50% notes due 2020 resulting in a $26 million interest charge. In December 2020, the company repaid $500 million of 4.05% notes and $500 million of 3.00% notes that were due in 2021 resulting in a $16 million interest charge.(c)Noncontrolling interests from continuing operations includes a $1 million benefit in 2019 and a $35 million charge in 2018 related to the 8% of Linde AG Shares which were not tendered in the Exchange Offer. Linde AG completed the cash merger squeeze-out of all its minority shares on April 8, 2019 (see Note 2).In addition, 2020, 2019 and 2018 noncontrolling interests from continuing operations includes $57 million, $54 million and $24 million, respectively, of Linde AG purchase accounting impacts.(d) Includes estimated income tax payments of $115 million in both 2020 and 2019. 76Table of Contents(e) Consists primarily of insurance contracts and other investments to be utilized for non-qualified pension and OPEB obligations.(f) The balances at December 31, 2020 and 2019 are net of reserves of $34 million and $44 million, respectively. The amounts in both years relate primarily to long-term notes receivable from customers in APAC and EMEA and government receivables in Brazil. (g) Americas consists of currency translation adjustments primarily in Canada, Mexico, and Brazil. EMEA relates primarily to Germany, the U.K. and Sweden. APAC relates primarily to China, South Korea, India and Australia. NOTE 8. PROPERTY, PLANT AND EQUIPMENT – NETSignificant classes of property, plant and equipment are as follows:(Millions of dollars)December 31,Depreciable Lives (Yrs)20202019Production plants (primarily 15-year life) (a)10-20$28,226 $25,493 Storage tanks15-204,461 4,295 Transportation equipment and other3-152,978 2,809 Cylinders 10-304,491 4,184 Buildings25-403,327 3,162 Land and improvements (b)0-201,259 1,229 Construction in progress3,257 3,146 47,999 44,318 Less: accumulated depreciation(19,288)(15,254)$28,711 $29,064 (a) - Depreciable lives of production plants related to long-term customer supply contracts are generally consistent with the contract lives.(b) - Land is not depreciated. NOTE 9. GOODWILLChanges in the carrying amount of goodwill for the years ended December 31, 2020 and 2019 were as follows:(Millions of dollars)AmericasEMEAAPACEngineeringOtherTotalBalance, December 31, 2018$9,174 $10,960 $5,295 $1,075 $370 $26,874 Acquisitions (Note 2)135 — — — 135 Measurement period adjustments (Note 2)(255)(636)(323)1,410 (42)154 Foreign currency translation and other(12)(81)(15)(15)(21)(144)Balance, December 31, 20199,042 10,243 4,957 2,470 307 27,019 Acquisitions (Note 2)13 — — — — 13 Foreign currency translation and other35 643 305 212 23 1,218 Disposals(7)(42)— — — (49)Balance, December 31, 2020$9,083 $10,844 $5,262 $2,682 $330 $28,201 Linde has performed its goodwill impairment tests annually during the fourth quarter of each year and has determined that the fair value of each of its reporting units was substantially in excess of its carrying value. For the 2020 test, the company applied the FASB's accounting guidance which allows the company to first assess qualitative factors to determine the extent of additional quantitative analysis, if any, that may be required to test goodwill for impairment. Based on the qualitative assessments performed, the company concluded that it was more likely than not that the fair value of each reporting unit substantially exceeded its carrying value and therefore, further quantitative analysis was not required. As a result, no impairment was recorded. There were no indicators of impairment through December 31, 2020. 77NOTE 10. OTHER INTANGIBLE ASSETSThe following is a summary of Linde’s other intangible assets at December 31, 2020 and 2019: (Millions of dollars) For the year ended December 31, 2020Customer RelationshipsBrands/TradenamesOther Intangible AssetsTotalCost:Balance, December 31, 2019$13,205 $2,764 $1,612 $17,581 Additions 5 — 56 61 Foreign currency translation632 134 47 813 Disposals(2)— (20)(22)Other *(64)(3)2 (65)Balance, December 31, 202013,776 2,895 1,697 18,368 Less: accumulated amortization:Balance, December 31, 2019(885)(69)(490)(1,444)Amortization expense (Note 7)(589)(45)(131)(765)Foreign currency translation(53)(3)1 (55)Disposals1 — 20 21 Other *56 (1)4 59 Balance, December 31, 2020(1,470)(118)(596)(2,184)Net intangible asset balance at December 31, 2020$12,306 $2,777 $1,101 $16,184 (Millions of dollars) For the year ended December 31, 2019Customer RelationshipsBrands/TradenamesOther Intangible AssetsTotalCost:Balance, December 31, 2018$13,288 $2,288 $1,366 $16,942 Additions 30 6 51 87 Foreign currency translation(59)(21)(11)(91)Measurement period adjustments(8)492 178 662 Other *(46)(1)28 (19)Balance, December 31, 201913,205 2,764 1,612 17,581 Less: accumulated amortization:Balance, December 31, 2018(317)(22)(380)(719)Amortization expense (Note 7)(584)(47)(104)(735)Foreign currency translation— — 2 2 Other *16 — (8)8 Balance, December 31, 2019(885)(69)(490)(1,444)Net balance at December 31, 2019$12,320 $2,695 $1,122 $16,137 *Other primarily relates to the write-off of fully amortized assets and reclassifications.There are no expected residual values related to these intangible assets. Amortization expense for the years ended December 31, 2020, 2019 and 2018 was $765 million, $735 million and $215 million, respectively. The remaining weighted-average amortization period for intangible assets is approximately 26 years.78Total estimated annual amortization expense related to finite-lived intangibles is as follows: (Millions of dollars) 2021$729 2022608 2023581 2024572 2025529 Thereafter11,173 Total amortization related to finite-lived intangible assets14,192 Indefinite-lived intangible assets at December 31, 20201,992 Net intangible assets at December 31, 2020$16,184 79Table of ContentsNOTE 11. DEBTThe following is a summary of Linde’s outstanding debt at December 31, 2020 and 2019:(Millions of dollars)20202019Short-termCommercial paper$2,527 $996 Other borrowings (primarily international)724 736 Total short-term debt3,251 1,732 Long-term (a)(U.S. dollar denominated unless otherwise noted)2.25% Notes due 2020 (b)— 300 1.75% Euro denominated notes due 2020 (b, c)— 1,137 0.634% Euro denominated notes due 2020— 56 4.05% Notes due 2021 (d)— 499 3.875% Euro denominated notes due 2021 (c)748 711 3.00% Notes due 2021 (d)— 499 0.250% Euro denominated notes due 2022 (c)1,226 1,129 2.45% Notes due 2022599 599 2.20% Notes due 2022499 499 2.70% Notes due 2023499 499 2.00% Euro denominated notes due 2023 (c)832 776 5.875% GBP denominated notes due 2023 (c)460 456 1.20% Euro denominated notes due 2024671 615 1.875% Euro denominated notes due 2024 (c)389 361 2.65% Notes due 2025398 398 1.625% Euro denominated notes due 2025607 556 3.20% Notes due 2026725 725 3.434% Notes due 2026196 196 1.652% Euro denominated notes due 2027100 93 0.250% Euro denominated notes due 2027 (e)914 — 1.00% Euro denominated notes due 2028 (c)966 872 1.10% Notes due 2030 (f)696 — 1.90% Euro denominated notes due 2030127 118 0.550% Euro denominated notes due 2032 (e)909 — 3.55% Notes due 2042664 662 2.00% Notes due 2050 (f)296 — International borrowings372 309 Other10 159 12,903 12,224 Less: current portion of long-term debt(751)(1,531)Total long-term debt12,152 10,693 Total debt$16,154 $13,956 ________________________(a)Amounts are net of unamortized discounts, premiums and/or debt issuance costs as applicable.(b)In September 2020, the company repaid €1,000 million of 1.75% notes and $300 million of 2.25% notes that became due.80Table of Contents(c)December 31, 2020 and 2019 included a cumulative $79 million and $38 million adjustment to carrying value, respectively, related to hedge accounting of interest rate swaps. (d)In December 2020, the company repaid $500 million of 4.05% notes and $500 million of 3.00% notes that were due in 2021 resulting in a $16 million interest charge.(e)In May 2020, Linde issued €750 million of 0.250% notes due 2027 and €750 million of 0.550% notes due 2032.(f)In August 2020, Linde issued $700 million of 1.100% notes due 2030 and $300 million of 2.000% notes due 2050.Credit FacilitiesOn March 26, 2019 the company and certain of its subsidiaries entered into an unsecured revolving credit agreement ("the Credit Agreement") with a syndicate of banking institutions, which became effective on March 29, 2019. The Credit Agreement provides for total commitments of $5.0 billion, which may be increased up to $6.5 billion, subject to receipt of additional commitments and satisfaction of customary conditions. There are no financial maintenance covenants contained within the Credit Agreement. The revolving credit facility expires on March 26, 2024 with the option to request two one-year extensions of the expiration date. In connection with the effectiveness of the Credit Agreement, Praxair and Linde AG terminated their major respective existing revolving credit facilities. No borrowings were outstanding under the Credit Agreement as of December 31, 2020.On September 3, 2019 Linde and the company’s subsidiaries Linde, Inc. and Linde GmbH entered into a series of parent and subsidiary guarantees related to currently outstanding notes as well as the $5 billion Credit Agreement.Other Debt InformationAs of December 31, 2020 and 2019, the weighted-average interest rate of short-term borrowings outstanding was 0.0% and 0.6%, respectively. Expected maturities of long-term debt are as follows:(Millions of dollars) 2021$751 20222,440 20231,853 20241,067 20251,083 Thereafter5,709 $12,903 As of December 31, 2020, the amount of Linde's assets pledged as collateral was immaterial.See Note 13 for the fair value information related to debt.NOTE 12. FINANCIAL INSTRUMENTSIn its normal operations, Linde is exposed to market risks relating to fluctuations in interest rates, foreign currency exchange rates and energy costs. The objective of financial risk management at Linde is to minimize the negative impact of such fluctuations on the company’s earnings and cash flows. To manage these risks, among other strategies, Linde routinely enters into various derivative financial instruments (“derivatives”) including interest-rate swap and treasury rate lock agreements, currency-swap agreements, forward contracts, currency options, and commodity-swap agreements. These instruments are not entered into for trading purposes and Linde only uses commonly traded and non-leveraged instruments.There are three types of derivatives that the company enters into: (i) those relating to fair-value exposures, (ii) those relating to cash-flow exposures, and (iii) those relating to foreign currency net investment exposures. Fair-value exposures relate to recognized assets or liabilities, and firm commitments; cash-flow exposures relate to the variability of future cash flows associated with recognized assets or liabilities, or forecasted transactions; and net investment exposures relate to the impact of foreign currency exchange rate changes on the carrying value of net assets denominated in foreign currencies.81Table of ContentsWhen a derivative is executed and hedge accounting is appropriate, it is designated as either a fair-value hedge, cash-flow hedge, or a net investment hedge. Currently, Linde designates all interest-rate and treasury-rate locks as hedges for accounting purposes; however, cross-currency interest rate contracts are generally not designated as hedges for accounting purposes. Certain currency contracts related to forecasted transactions are designated as hedges for accounting purposes. Whether designated as hedges for accounting purposes or not, all derivatives are linked to an appropriate underlying exposure. On an ongoing basis, the company assesses the hedge effectiveness of all derivatives designated as hedges for accounting purposes to determine if they continue to be highly effective in offsetting changes in fair values or cash flows of the underlying hedged items. If it is determined that the hedge is not highly effective, then hedge accounting will be discontinued prospectively.Counterparties to Linde’s derivatives are major banking institutions with credit ratings of investment grade or better. The company has Credit Support Annexes ("CSAs") in place for certain entities with their principal counterparties to minimize potential default risk and to mitigate counterparty risk. Under the CSAs, the fair values of derivatives for the purpose of interest rate and currency management are collateralized with cash on a regular basis. As of December 31, 2020, the impact of such collateral posting arrangements on the fair value of derivatives was insignificant. Management believes the risk of incurring losses on derivative contracts related to credit risk is remote and any losses would be immaterial.The following table is a summary of the notional amount and fair value of derivatives outstanding at December 31, 2020 and 2019 for consolidated subsidiaries: Fair Value(Millions of dollars)Notional AmountsAssets (a)Liabilities (a)December 31,202020192020201920202019Derivatives Not Designated as Hedging Instruments:Currency contracts:Balance sheet items $6,470 $7,936 $72 $62 $48 $37 Forecasted transactions823 748 16 14 12 15 Cross-currency swaps260 1,029 24 35 7 40 Commodity contracts N/AN/A1 — — — Total$7,553 $9,713 $113 $111 $67 $92 Derivatives Designated as Hedging Instruments:Currency contracts:Balance sheet items $— $27 $— $2 $— $3 Forecasted transactions355 464 20 9 14 3 Commodity contractsN/AN/A3 6 — 1 Interest rate swaps 1,923 1,908 64 39 — — Total Hedges$2,278 $2,399 $87 $56 $14 $7 Total Derivatives$9,831 $12,112 $200 $167 $81 $99 (a) Current assets of $110 million are recorded in prepaid and other current assets; long-term assets of $90 million are recorded in other long-term assets; current liabilities of $70 million are recorded in other current liabilities; and long-term liabilities of $11 million are recorded in other long-term liabilities. Balance Sheet ItemsForeign currency contracts related to balance sheet items consist of forward contracts entered into to manage the exposure to fluctuations in foreign-currency exchange rates on recorded balance sheet assets and liabilities denominated in currencies other than the functional currency of the related operating unit. Certain forward currency contracts are entered into to protect underlying monetary assets and liabilities denominated in foreign currencies from foreign exchange risk and are not designated as hedging instruments. For balance sheet items that are not designated as hedging instruments, the fair value adjustments on these contracts are offset by the fair value adjustments recorded on the underlying monetary assets and liabilities.82Table of ContentsForecasted TransactionsForeign currency contracts related to forecasted transactions consist of forward contracts entered into to manage the exposure to fluctuations in foreign-currency exchange rates on (1) forecasted purchases of capital-related equipment and services, (2) forecasted sales, or (3) other forecasted cash flows denominated in currencies other than the functional currency of the related operating units. For forecasted transactions that are designated as cash flow hedges, fair value adjustments are recorded to accumulated other comprehensive income ("AOCI") with deferred amounts reclassified to earnings over the same time period as the income statement impact of the associated purchase. For forecasted transactions that do not qualify for cash flow hedging relationships, fair value adjustments are recorded directly to earnings. Cross-Currency SwapsCross-currency swaps are entered into to limit the foreign currency risk of future principal and interest cash flows associated with intercompany loans, and to a more limited extent bonds, denominated in non-functional currencies. The fair value adjustments on the cross-currency swaps are recorded to earnings, where they are offset by fair value adjustments on the underlying intercompany loan or bond. Commodity Contracts Commodity contracts are entered into to manage the exposure to fluctuations in commodity prices, which arise in the normal course of business from its procurement transactions. To reduce the extent of this risk, Linde enters into a limited number of electricity, natural gas, and propane gas derivatives. The fair value adjustments for the majority of these contracts are recorded to AOCI and are eventually offset by the income statement impact of the underlying commodity purchase. For forecasted transactions that are designated as cash flow hedges, fair value adjustments are recorded to accumulated other comprehensive income ("AOCI") with deferred amounts reclassified to earnings over the same time period as the income statement impact of the associated purchase. Net investment hedgesAs of December 31, 2020, Linde has €1.7 billion ($2.1 billion) intercompany Euro-denominated credit facility loans and intercompany loans which are designated as hedges of the net investment positions in foreign operations. Since hedge inception, exchange rate movements have increased the credit facility loan and intercompany loans by $344 million, with the offsetting loss shown within the cumulative translation component of AOCI in the consolidated balance sheets and the consolidated statements of comprehensive income. Linde had previously designated Euro-denominated debt instruments as net investment hedges to reduce the company's exposure to changes in the currency exchange rate on investments in foreign subsidiaries with Euro functional currencies. Exchange rate movements of $206 million relating to the previously denominated Euro-denominated debt incurred in the financial periods prior to de-designation will remain in AOCI, until appropriate, such as upon sale or liquidation of the foreign operations at which time amounts will be reclassified to the consolidated statements of income. Exchange rate movements related to the Euro-denominated debt occurring after de-designation are shown in the consolidated statements of income.Interest Rate SwapsLinde uses interest rate swaps to hedge the exposure to changes in the fair value of financial assets and financial liabilities as a result of interest rate changes. These interest rate swaps effectively convert fixed-rate interest exposures to variable rates; fair value adjustments are recognized in earnings along with an equally offsetting charge/benefit to earnings for the changes in the fair value of the underlying financial asset or financial liability. The notional value of outstanding interest rate swaps of Linde with maturity dates from 2021 through 2028 was $1,923 million at December 31, 2020 and $1,908 million at December 31, 2019 (see Note 11 for further information).Terminated Treasury Rate LocksThe unrecognized aggregate losses related to terminated treasury rate lock contracts on the underlying $500 million 2.20% fixed-rate notes that mature in 2022 at December 31, 2020 and December 31, 2019 was immaterial in both periods. The unrecognized gains/(losses) for the treasury rate locks are shown in AOCI and are being recognized on a straight line basis to interest expense - net over the term of the underlying debt agreements. Impact of derivative instruments on earnings and AOCIThe following table summarizes the impact of the company's derivatives on the consolidated statements of income:83Table of Contents(Millions of dollars) Amount of Pre-Tax Gain (Loss) Recognized in Earnings *December 31,202020192018Derivatives Not Designated as Hedging InstrumentsCurrency contracts:Balance sheet items:Debt-related$(125)$253 $(118)Other balance sheet items(40)65 3 Total$(165)$318 $(115)* The gains (losses) on balance sheet items are offset by gains (losses) recorded on the underlying hedged assets and liabilities. Accordingly, the gains (losses) for the derivatives and the underlying hedged assets and liabilities related to debt items are recorded in the consolidated statements of income as interest expense-net. Other balance sheet items and anticipated net income gains (losses) are recorded in the consolidated statements of income as other income (expenses)-net.The amounts of gain or loss recognized in AOCI and reclassified to the consolidated statement of income was immaterial for the year ended December 31, 2020. Net losses expected to be reclassified to earnings during the next twelve months are also not material.The gains (losses) on net investment hedges are recorded as a component of AOCI within foreign currency translation adjustments in the consolidated balance sheets and the consolidated statements of comprehensive income. The gains (losses) on treasury rate locks are recorded as a component of AOCI within derivative instruments in the consolidated balance sheets and the consolidated statements of comprehensive income. The gains (losses) on net investment hedges are reclassified to earnings only when the related currency translation adjustments are required to be reclassified, usually upon sale or liquidation of the investment. The gains (losses) for interest rate contracts are reclassified to earnings as interest expense –net on a straight-line basis over the remaining maturity of the underlying debt.NOTE 13. FAIR VALUE DISCLOSURESThe fair value hierarchy prioritizes the inputs to valuation techniques used to measure fair value into three broad levels as follows:Level 1 – quoted prices in active markets for identical assets or liabilitiesLevel 2 – quoted prices for similar assets and liabilities in active markets or inputs that are observableLevel 3 – inputs that are unobservable (for example cash flow modeling inputs based on assumptions)Assets and Liabilities Measured at Fair Value on a Recurring BasisThe following table summarizes assets and liabilities measured at fair value on a recurring basis at December 31, 2020 and 2019: Fair Value Measurements Using(Millions of dollars)Level 1Level 2Level 3 202020192020201920202019AssetsDerivative assets$— $— $200 $167 $— $— Investments and securities *21 18 — — 47 28 Total$21 $18 $200 $167 $47 $28 LiabilitiesDerivative liabilities$— $— $81 $99 $— $— *Investments and securities are recorded in prepaid and other current assets and other long-term assets in the company's consolidated balance sheets.Level 1 investments and securities are marketable securities traded on an exchange. Level 2 investments are based on market prices obtained from independent brokers or determined using quantitative models that use as their basis readily observable market parameters that are actively quoted and can be validated through external sources, including third-party pricing services, brokers and market transactions. Level 3 investments and securities consist of a venture fund. For the valuation, Linde uses the net asset value received as part of the fund's quarterly reporting, which for the most part is not 84Table of Contentsbased on quoted prices in active markets. In order to reflect current market conditions, Linde proportionally adjusts these by observable market data (stock exchange prices) or current transaction prices.The level 3 investments and securities as of January 1, 2020 was $28 million. During the year ended December 31, 2020 there was approximately $3 million of foreign currency movement and $16 million in gains recognized in interest expense - net in the company's consolidated statements of income. The balance as of December 31, 2020 was $47 million.The fair value of cash and cash equivalents, short-term debt, accounts receivable-net, and accounts payable approximate carrying value because of the short-term maturities of these instruments. The fair value of long-term debt is estimated based on the quoted market prices for the same or similar issues. Long-term debt is categorized within either Level 1 or Level 2 of the fair value hierarchy depending on the trading volume of the issues and whether or not they are actively quoted in the market as opposed to traded through over-the-counter transactions. At December 31, 2020, the estimated fair value of Linde’s long-term debt portfolio was $13,611 million versus a carrying value of $12,903 million. At December 31, 2019 the estimated fair value of Linde’s long-term debt portfolio was $12,375 million versus a carrying value of $12,224 million. As Linde AG's assets and liabilities were measured at estimated fair value as of the merger date, differences between the carrying value and the fair value are not significant; remaining differences are attributable to interest rate increases subsequent to when the debt was issued and relative to stated coupon rates.NOTE 14. EQUITY AND NONCONTROLLING INTERESTSLinde plc Shareholders’ EquityAt December 31, 2020 and 2019, Linde has total authorized share capital of €1,825,000 divided into 1,750,000,000 ordinary shares of €0.001 each, 25,000 A ordinary shares of €1.00 each, 25,000 deferred shares of €1.00 each and 25,000,000 preferred shares of €0.001 each.At December 31, 2020 there were 552,012,862 and 523,294,529 of Linde plc ordinary shares issued and outstanding, respectively. At December 31, 2020 there were no shares of A ordinary shares, deferred shares or preferred shares issued or outstanding.At December 31, 2019 there were 552,012,862 and 534,380,544 of Linde plc ordinary shares issued and outstanding, respectively. At December 31, 2019, there were no shares of A ordinary shares, deferred shares or preferred shares issued or outstanding. Linde’s Board of Directors may from time to time authorize the issuance of one or more series of preferred stock and, in connection with the creation of such series, determine the characteristics of each such series including, without limitation, the preference and relative, participating, optional or other special rights, and the qualifications, limitations or restrictions of the series.Other Linde plc Ordinary Share and Treasury Stock TransactionsLinde may issue new ordinary shares for dividend reinvestment and stock purchase plans and employee savings and incentive plans. The number of new Linde ordinary shares issued from the merger date through December 31, 2019 was 958,293 shares. No new ordinary shares were issued in 2020.On December 10, 2018 the Linde board of directors approved the repurchase of $1.0 billion of its ordinary shares under which Linde had repurchased 6,385,887 shares through December 31, 2019 (4,068,642 shares were repurchased through December 31, 2018). Linde completed the repurchases under this program in the first quarter of 2019.On January 22, 2019 the company’s board of directors approved the additional repurchase of $6.0 billion of its ordinary shares under which Linde had repurchased 24,310,534 shares through December 31, 2020 (12,016,083 shares were repurchased through December 31, 2019). This program expired on February 1, 2021.On January 25, 2021 the Linde board of directors authorized a new share repurchase program for up to $5.0 billion of its ordinary shares expiring on July 31, 2023.Noncontrolling InterestsNoncontrolling interest ownership changes are presented within the consolidated statements of equity. The decrease during 2020 primarily relates to the initiated buyout of minority interests in the Republic of South Africa. As of December 31, 2020, the conditions of the buyout were met obligating the company to execute in January 2021. Therefore, the company 85Table of Contentsreclassified $196 million from non-controlling interest to other current liabilities reflecting the transaction price. An additional $35 million of dividends declared to the minority owners, reflected on the Dividends and other capital reductions line, was also reclassified to other current liabilities at December 31, 2020 and was paid in January 2021.The $2,921 million decrease during 2019 was primarily driven by completion of the cash merger squeeze-out of the 8% of Linde AG shares which were not tendered in the Exchange Offer related to the merger (See Note 2).The $186 million decrease during 2018 primarily relates to the sale of Praxair's industrial gases business in Europe (see Note 2). The "Impact of Merger" line item of the consolidated statements of equity includes the fair value of the noncontrolling interests acquired from Linde AG, including the 8% of Linde AG shares which were not tendered in the Exchange Offer that were the subject of a cash-merger squeeze-out completed in 2019 (See Note 2).Redeemable Noncontrolling InterestsNoncontrolling interests with redemption features, such as put/sell options, that are not solely within the company’s control (“redeemable noncontrolling interests”) are reported separately in the consolidated balance sheets at the greater of carrying value or redemption value. For redeemable noncontrolling interests that are not yet exercisable, Linde calculates the redemption value by accreting the carrying value to the redemption value over the period until exercisable. If the redemption value is greater than the carrying value, any increase is adjusted directly to retained earnings and does not impact net income. At December 31, 2020, the redeemable noncontrolling interest balance includes an industrial gas business in EMEA where the noncontrolling shareholders have put options. The decrease of $100 million during 2020 relates to the full redemption of the industrial gas business in the Americas and redemption of the majority of the redeemable noncontrolling interest in the industrial gas business in EMEA.86Table of ContentsNOTE 15. SHARE-BASED COMPENSATIONShare-based compensation expense was $133 million in 2020 ($95 million and $62 million in 2019 and 2018, respectively). The related income tax benefit recognized was $79 million in 2020 ($42 million and $30 million in 2019 and 2018, respectively). The expense was primarily recorded in selling, general and administrative expenses and no share-based compensation expense was capitalized.Summary of Plans The Amended and Restated 2009 Linde Long-Term Incentive Plan was initially adopted by the board of directors and shareholders of Praxair, Inc. on April 28, 2009 and has been amended since its initial adoption ("the 2009 Plan"). Upon completion of the business combination of Praxair, Inc. with Linde AG on October 31, 2018, the 2009 Plan was assumed by the company. The 2009 Plan permits awards of stock options, stock appreciation rights, restricted stock and restricted stock units, performance-based stock units and other equity awards to eligible officer and non-officer employees and non-employee directors of the company and its affiliates. As of December 31, 2020, 5,117,443 shares remained available for equity grants under the 2009 Plan, of which 1,406,647 shares may be granted as awards other than options or stock appreciation rights.Upon the completion of the business combination, all options outstanding under the 2009 Plan were converted into options to acquire the same number of shares of the company and at the same exercise price per share that applied prior to the business combination.Exercise prices for options granted under the 2009 Plan may not be less than the closing market price of the company’s ordinary shares on the date of grant and granted options may not be re-priced or exchanged without shareholder approval. Options granted under the 2009 Plan subject only to time vesting requirements may become partially exercisable after a minimum of one year after the date of grant but may not become fully exercisable until at least three years have elapsed from the date of grant, and all options have a maximum duration of ten years. In connection with the business combination, on October 31, 2018 the company's Board of Directors adopted the Long Term Incentive Plan 2018 of Linde plc (“the LTIP 2018”), the purpose of which was to replace certain outstanding Linde AG equity based awards that were terminated. Under the LTIP 2018, the aggregate number of shares available for replacement option rights and replacement restricted share units was set at 473,128. As of December 31, 2020, 277,553 shares remained available for grant, and since the company was obligated to make these replacement awards only in 2019, it does not anticipate any further grants under this plan.Exercise prices for the replacement option rights that were granted in 2019 under the LTIP 2018 were equal to EUR 1.67 ($1.92 as converted at an exchange rate from the time the exchange offer was completed as the option rights are exercisable in U.S. dollars on the NYSE) as prescribed in the business combination agreement. Each replacement option right granted under the LTIP 2018 is subject to vesting based on continued service until the end of the four-year waiting period applicable to the relevant Linde AG award that had been granted before the business combination. After vesting, each option right will be exercisable for one year.In order to satisfy option exercises and other equity grants, the company may issue authorized but previously unissued shares or it may issue treasury shares. Stock Option Fair ValueThe company utilizes the Black-Scholes Options-Pricing Model to determine the fair value of stock options consistent with that used in prior years. Management is required to make certain assumptions with respect to selected model inputs, including anticipated changes in the underlying stock price (i.e., expected volatility) and option exercise activity (i.e., expected life). Expected volatility is based on the historical volatility of the company’s stock over the most recent period commensurate with the estimated expected life of the company’s stock options and other factors. The expected life of options granted, which represents the period of time that the options are expected to be outstanding, is based primarily on historical exercise experience. The expected dividend yield is based on the company’s most recent history and expectation of dividend payouts. The risk-free rate is based on the U.S. Treasury yield curve in effect at the time of grant for a period commensurate with the estimated expected life. If factors change and result in different assumptions in future periods, the stock option expense that the company records for future grants may differ significantly from what the company has recorded in the current period.The weighted-average fair value of options granted during 2020 was $17.37 ($23.38 in 2019 and $19.29 in 2018) based on the Black-Scholes Options-Pricing model. The decrease in grant date fair value year-over-year is primarily attributable to 87Table of Contentsthe reduction in the risk-free interest rate. The weighted-average fair value of replacement option rights granted in 2019 was $160.08 based on intrinsic value method.The following weighted-average assumptions were used to value the grants in 2020, 2019 and 2018: Year Ended December 31,202020192018Dividend yield2.2 %2.0 %2.1 %Volatility15.8 %14.3 %14.4 %Risk-free interest rate0.60 %2.38 %2.67 %Expected term years665The following table summarizes option activity under the plans as of December 31, 2020 and changes during the period then ended (averages are calculated on a weighted basis; life in years; intrinsic value expressed in millions): ActivityNumber ofOptions(000’s)AverageExercisePriceAverageRemainingLifeAggregateIntrinsicValueOutstanding at January 1, 20209,297 $127.04 Granted1,155 173.16 Exercised(2,205)115.34 Cancelled or expired(180)162.97 Outstanding at December 31, 20208,067 $136.05 6.0$1,028 Exercisable at December 31, 20205,707 $123.93 5.0$797 The aggregate intrinsic value represents the difference between the company’s closing stock price of $263.51 as of December 31, 2020 and the exercise price multiplied by the number of in the money options outstanding as of that date. The total intrinsic value of stock options exercised during 2020 was $264 million ($219 million and $113 million in 2019 and 2018, respectively).Cash received from option exercises under all share-based payment arrangements for 2020 was $36 million ($64 million and $66 million in 2019 and 2018, respectively). The cash tax benefit realized from share-based compensation totaled $70 million for 2020 ($56 million and $30 million cash tax benefit in 2019 and 2018, respectively). As of December 31, 2020, $17 million of unrecognized compensation cost related to non-vested stock options is expected to be recognized over a weighted-average period of approximately 1 year.Performance-Based and Restricted Stock AwardsIn 2020, the company granted 224,045 performance-based stock awards under the 2009 Plan to senior management that vest, subject to the attainment of pre-established minimum performance criteria, principally on the third anniversary of their date of grant. These awards are tied to either after tax return on capital ("ROC") performance or relative total shareholder return ("TSR") performance versus that of the S&P 500 (weighted 67%) and Eurofirst 300 (weighted 33%). The actual number of shares issued in settlement of a vested award can range from zero to 200 percent of the target number of shares granted based upon the company’s attainment of specified performance targets at the end of a three-year period. Compensation expense related to these awards is recognized over the three-year performance period based on the fair value of the closing market price of the company’s ordinary shares on the date of the grant and the estimated performance that will be achieved. Compensation expense for ROC awards will be adjusted during the three-year performance period based upon the estimated performance levels that will be achieved. TSR awards are measured at their grant date fair value and not subsequently re-measured. The weighted-average fair value of ROC performance-based stock awards granted in 2020 was $161.56, and during 2019 was $168.47. These fair values are based on the closing market price of Linde's ordinary shares on the grant date adjusted for dividends that will not be paid during the vesting period. There were no ROC performance-based stock awards granted in 2018.The weighted-average fair value of performance-based stock tied to relative TSR performance granted in 2020 was $198.61, and during 2019 was $215.85, and was estimated using a Monte Carlo simulation performed as of the grant date. There were no performance-based stock tied to relative TSR performance granted in 2018.There were 185,973 restricted stock units granted to employees by Linde during 2020. The weighted-average fair value of restricted stock units granted during 2020 was $174.95 ($165.04 in 2019 and $144.86 in 2018). These fair values are based 88Table of Contentson the closing market price of Linde's ordinary shares on the grant date adjusted for dividends that will not be paid during the vesting period. Compensation expense related to the restricted stock units is recognized over the vesting period.The following table summarizes non-vested performance-based and restricted stock award activity as of December 31, 2020 and changes during the period then ended (shares based on target amounts, averages are calculated on a weighted basis): Performance-BasedRestricted StockNumber ofShares(000’s)AverageGrant DateFair ValueNumber ofShares(000’s)AverageGrant DateFair ValueNon-vested at January 1, 2020246 $184.29 884 $129.43 Granted224 174.70 186 174.95 Vested— — (355)117.62 Cancelled and Forfeited(33)178.27 (27)160.90 Non-vested at December 31, 2020437 $179.76 688 $148.56 There are approximately 10 thousand performance-based shares and 12 thousand restricted stock shares that are non-vested at December 31, 2020 which will be settled in cash due to foreign regulatory limitations. The liability related to these grants reflects the current estimate of performance that will be achieved and the current share price. As of December 31, 2020, $42 million of unrecognized compensation cost related to performance-based awards and $21 million of unrecognized compensation cost related to the restricted stock awards is expected to be recognized primarily through the first quarter of 2023.NOTE 16. RETIREMENT PROGRAMSDefined Benefit Pension Plans - U.S.Linde has two main U.S. retirement programs which are non-contributory defined benefit plans: the Linde U.S. Pension Plan and the CBI Pension Plan. The latter program benefits primarily former employees of CBI Industries, Inc. which Linde acquired in 1996. Effective July 1, 2002, the Linde U.S. Pension Plan was amended to give participating employees a one-time choice to remain covered by the old formula or to elect coverage under a new formula. The old formula is based predominantly on years of service, age and compensation levels prior to retirement, while the new formula provides for an annual contribution to an individual account which grows with interest each year at a predetermined rate. Also, this new formula applies to all new employees hired after April 30, 2002 into businesses adopting this plan. The U.S. and non-U.S. pension plan assets are comprised of a diversified mix of investments, including U.S. and non-U.S. corporate equities, government securities and corporate debt securities. Linde has several plans that provide supplementary retirement benefits primarily to higher level employees that are unfunded and are nonqualified for federal tax purposes. Pension coverage for employees of certain of Linde’s international subsidiaries generally is provided by those companies through separate plans. Obligations under such plans are primarily provided for through diversified investment portfolios, with some smaller plans provided for under insurance policies or by book reserves.Defined Benefit Pension Plans - InternationalLinde has international, defined benefit commitments primarily in Germany and the U.K. The defined benefit commitments in Germany relate to old age pensions, invalidity pensions and surviving dependents pensions. These commitments also take into account vested rights for periods of service prior to January 1, 2002 based on earlier final-salary pension plan rules. In addition, there are direct commitments in respect of the salary conversion scheme for the form of cash balance plans. The resulting pension payments are calculated on the basis of an interest guarantee and the performance of the corresponding investment. There are no minimum funding requirements. The pension obligations in Germany are partly funded by a Contractual Trust Agreement (CTA). Defined benefit commitments in the U.K. prior to July 1, 2003 are earnings-related and dependent on the period of service. Such commitments relate to old age pensions, invalidity pensions and surviving dependents pensions. Beginning in April 1, 2011, the amount of future increases in inflation-linked pensions and of increases in pensionable emoluments was restricted. Multi-employer Pension Plans89Table of ContentsIn the United States Linde participates in eight multi-employer defined benefit pension plans ("MEPs"), pursuant to the terms of collective bargaining agreements, that cover approximately 200 union-represented employees. The collective bargaining agreements expire on different dates through 2026. In connection with such agreements, the company is required to make periodic contributions to the MEPs in accordance with the terms of the respective collective bargaining agreements. Linde’s participation in these plans is not material either at the plan level or in the aggregate. Linde’s contributions to these plans were $2 million in 2020, 2019, and 2018 (these costs are not included in the tables that follow). For all MEPs, Linde’s contributions were significantly less than 1% of the total contributions to each plan for 2019 and 2018. Total 2020 contributions were not yet available from the MEPs.Linde has obtained the most recently available Pension Protection Act ("PPA") annual funding notices from the Trustees of the MEPs. The PPA classifies MEPs as either Red, Yellow or Green Zone plans. Among other factors, plans in the Red Zone are generally less than 65 percent funded with a projected insolvency date within the next twenty years; plans in the Yellow Zone are generally 65 to 80 percent funded; and plans in the Green Zone are generally at least 80 percent funded. Red Zone plans are considered to be in "critical" or "critical and declining" status, while Yellow Zone plans are considered to be in "endangered" status. Plans that are in neither "critical" nor "endangered" status are considered to have Green Zone status. According to the most recent data available, four of the MEPs that the company participates in are in a Red Zone status and four are in a Green Zone status. As of December 31, 2020, the four Red Zone plans have pending or have implemented financial improvement or rehabilitation plans. Linde does not currently anticipate significant future obligations due to the funding status of these plans. If Linde determined it was probable that it would withdraw from an MEP, the company would record a liability for its portion of the MEP’s unfunded pension obligations, as calculated at that time. Historically, such withdrawal payments have not been significant.Defined Contribution PlansLinde’s U.S. business employees are eligible to participate in the Linde defined contribution savings plan. Employees may contribute up to 40% of their compensation, subject to the maximum allowable by IRS regulations. For the U.S. packaged gases business, company contributions to this plan are calculated as a percentage of salary based on age plus service. U.S. employees other than those in the packaged gases business have company contributions to this plan calculated on a graduated scale based on employee contributions to the plan. The cost for these defined contribution plans was $46 million in 2020, $47 million in 2019 and $33 million in 2018 (these costs are not included in the tables that follow).The defined contribution plans include a non-leveraged employee stock ownership plan ("ESOP") which covers all employees participating in this plan. The collective number of shares of Linde ordinary shares in the ESOP totaled 1,872,450 at December 31, 2020.Certain international subsidiaries of the company also sponsor defined contribution plans where contributions are determined under various formulas. The expense for these plans was $106 million in 2020, $95 million in 2019 and $32 million in 2018 (these expenses are not included in the tables that follow). Postretirement Benefits Other Than Pensions (OPEB)Linde provides health care and life insurance benefits to certain eligible retired employees. These benefits are provided through various insurance companies and healthcare providers. The company does not currently fund its postretirement benefits obligations. Linde’s retiree plans may be changed or terminated by Linde at any time for any reason with no liability to current or future retirees.Linde uses a measurement date of December 31 for its pension and other post-retirement benefit plans.Pension and Postretirement Benefit CostsThe components of net pension and postretirement benefits other than pension ("OPEB") costs for 2020, 2019 and 2018 are shown in the table below (2018 reflects the impact of the Linde AG merger on October 31, 2018 and the divestiture of Praxair's European industrial gases business on December 3, 2018 (see Note 2)): 90Table of Contents(Millions of dollars)Year Ended December 31,PensionsOPEB202020192018202020192018Amount recognized in Operating Profit Service cost$150 $142 $74 $2 $2 $2 Amount recognized in Net pension and OPEB cost (benefit), excluding service cost Interest cost208 261 128 5 7 5 Expected return on plan assets(482)(462)(219)— — — Net amortization and deferral90 61 71 (4)(4)(3) Curtailment and termination benefits (a)— 8 — — — — Settlement charges (b)6 97 14 — — — $(178)$(35)$(6)$1 $3 $2 Amount recognized in Net gain on sale of businesses Settlement gains from divestitures (c)— — (44)— — — Net periodic benefit cost (benefit)$(28)$107 $24 $3 $5 $4 (a) In 2019, Linde recorded curtailment gains of $9 million and a charge of $17 million for termination benefits, primarily in connection with a defined benefit pension plan freeze. (b) In the third quarter of 2020, Linde recorded a pension settlement charge of $6 million triggered by lump sum benefit payments made from a U.S. non-qualified plan. In the first quarter of 2019, benefits of $91 million were paid related to the settlement of a U.S. non-qualified plan. Such benefits were triggered by a change in control provision and resulted in a settlement charge of $51 million. In the third and fourth quarters of 2019, Linde recorded pension settlement charges of $40 million and $6 million, respectively, related to lump sum payments made from a U.S. qualified plan. These payments were triggered by merger-related divestitures. 2018 includes the impact of a $4 million charge and a $10 million charge recorded in the third and fourth quarters, respectively. In the third quarter, a series of lump sum benefit payments made from the U.S. supplemental pension plan triggered a settlement of the related pension obligation. In the fourth quarter, a change in control provision triggered the settlement of a U.S. non-qualified plan. (c) In connection with Praxair merger-related divestitures, primarily the European industrial gases business, certain European pension plan obligations were settled. This resulted in the recognition of associated pension benefit obligations and deferred losses in accumulated other comprehensive income (loss) within operating profit in the "Net gain on sale of businesses" line item.Funded StatusChanges in the benefit obligation and plan assets for Linde’s pension and OPEB programs, including reconciliation of the funded status of the plans to amounts recorded in the consolidated balance sheet, as of December 31, 2020 and 2019 are shown below. 91Table of Contents(Millions of dollars)Year Ended December 31,Pensions 20202019OPEBU.S.International U.S.International20202019Change in Benefit Obligation ("PBO")Benefit obligation, January 1$2,552 $8,689 $2,508 $7,533 $192 $184 Service cost37 113 38 104 2 2 Interest cost68 140 81 180 5 7 Divestitures — — (1)— — — Participant contributions— 18 — 20 11 8 Plan amendment— 7 — 13 (13)— Actuarial loss (gain)250 893 266 1,045 (2)8 Benefits paid(152)(320)(105)(333)(22)(20)Plan settlement(9)(14)(235)— — — Plan curtailment— (1)— (9)— 2 Foreign currency translation and other changes— 462 — 136 (1)1 Benefit obligation, December 31$2,746 $9,987 $2,552 $8,689 $172 $192 Accumulated benefit obligation ("ABO")$2,646 $9,830 $2,464 $8,553 Change in Plan AssetsFair value of plan assets, January 1$2,048 $6,888 $1,952 $6,292 $— $— Actual return on plan assets386 641 341 598 — — Company contributions25 66 — 94 — — Participant contributions— 18 — 20 — — Benefits paid from plan assets(149)(267)(244)(268)— — Divestitures — — (1)— — — Foreign currency translation and other changes— 307 — 152 — — Fair value of plan assets, December 31$2,310 $7,653 $2,048 $6,888 $— $— Funded Status, End of Year$(436)$(2,334)$(504)$(1,801)$(172)$(192)Recorded in the Balance Sheet (Note 7)Other long-term assets$2 $53 $— $78 $— $— Other current liabilities(9)(13)(6)(10)(12)(11)Other long-term liabilities(429)(2,374)(498)(1,869)(160)(181)Net amount recognized, December 31$(436)$(2,334)$(504)$(1,801)$(172)$(192)Amounts recognized in accumulated other comprehensive income (loss) consist of:Net actuarial loss (gain)$687 $1,766 $753 $1,110 $(11)$(10)Prior service cost (credit)— 9 — 4 (15)(4)Deferred tax benefit (Note 7)(182)(383)(190)(251)5 (5)Amount recognized in accumulated other comprehensive income (loss) (Note 7)$505 $1,392 $563 $863 $(21)$(19)92Table of ContentsComparative funded status information as of December 31, 2020 and 2019 for select international pension plans is presented in the table below as the benefit obligations of these plans are considered to be significant relative to the total benefit obligation: United KingdomGermanyOther InternationalTotal International(Millions of dollars)2020202020202020Benefit obligation, December 31$6,012 $2,582 $1,393 $9,987 Fair value of plan assets, December 315,355 1,258 1,040 7,653 Funded Status, End of Year$(657)$(1,324)$(353)$(2,334) United KingdomGermanyOther InternationalTotal International(Millions of dollars)2019201920192019Benefit obligation, December 31$5,221 $2,180 $1,288 $8,689 Fair value of plan assets, December 314,777 1,119 992 6,888 Funded Status, End of Year$(444)$(1,061)$(296)$(1,801)The changes in plan assets and benefit obligations recognized in other comprehensive income in 2020 and 2019 are as follows: PensionsOPEB(Millions of dollars)2020201920202019Current year net actuarial losses (gains)*$598 $834 $(2)$8 Amortization of net actuarial gains (losses)(89)(59)2 3 Plan amendment7 (4)(13)— Amortization of prior service credits (costs)(1)(2)2 1 Pension settlements(6)(97)— — Curtailments(1)— — 2 Foreign currency translation and other changes87 12 (1)— Total recognized in other comprehensive income$595 $684 $(12)$14 ________________________ * Pension net actuarial losses in 2020 and 2019 are largely driven by lower discount rates across all significant pension plans. In the U.S., the benefit from the actual return on assets in both 2020 and 2019 largely offset the actuarial loss generated from a higher PBO, resulting from the low discount rate environment. For the international plans, the unfavorable impact of lower discount rates outweighed favorable plan asset experience in both years. OPEB net actuarial gains in 2020 relate to the favorable impact of liability experience and demographic assumptions, which more than outweighed the adverse impact of lower year-over-year discount rates. OPEB net actuarial losses in 2019 relate to the low interest rate environment, which was partially offset by favorable actual benefit payment experience. The following table provides information for pension plans where the accumulated benefit obligation exceeds the fair value of plan assets:(Millions of dollars)Year Ended December 31,Pensions20202019U.S.InternationalU.S.InternationalAccumulated benefit obligation ("ABO")$2,518 $8,694 $2,464 $7,664 Fair value of plan assets$2,180 $6,254 $2,048 $5,849 93Table of ContentsThe following table provides information for pension plans where the projected benefit obligation exceeds the fair value of plan assets:(Millions of dollars)Year Ended December 31,Pensions20202019U.S.InternationalU.S.InternationalProjected benefit obligation ("PBO")$2,618 $8,845 $2,552 $7,810 Fair value of plan assets$2,180 $6,282 $2,048 $5,872 AssumptionsThe assumptions used to determine benefit obligations are as of the respective balance sheet dates and the assumptions used to determine net benefit cost are as of the previous year-end, as shown below: Pensions U.S.InternationalOPEB 202020192020201920202019Weighted average assumptions used to determine benefit obligations at December 31,Discount rate2.40 %3.20 %1.36 %1.91 %2.39 %3.19 %Interest crediting rate1.57 %2.19 %1.01 %1.08 %N/AN/ARate of increase in compensation levels 3.25 %3.25 %2.55 %2.46 %N/AN/AWeighted average assumptions used to determine net periodic benefit cost for years ended December 31,Discount rate 3.20 %4.20 %1.91 %2.72 %3.19 %4.16 %Interest crediting rate2.19 %3.34 %1.08 %1.23 %N/AN/ARate of increase in compensation levels 3.25 %3.25 %2.46 %2.38 %N/AN/AExpected long-term rate of return on plan assets (1)7.00 %7.27 %5.31 %5.15 %N/AN/A________________________(1) The expected long term rate of return on the U.S. and international plan assets is estimated based on the plans' investment strategy and asset allocation, historical capital market performance and, to a lesser extent, historical plan performance. For the U.S. plans, the expected rate of return of 7.00% was derived based on the target asset allocation of 40%-60% equity securities (approximately 7.7% expected return), 30%-50% fixed income securities (approximately 5.4% expected return) and 5%-15% alternative investments (approximately 6.3% expected return). For the international plans, the expected rate of return was derived based on the weighted average target asset allocation of 15%-25% equity securities (approximately 6.4% expected return), 30%-50% fixed income securities (approximately 4.8% expected return), and 30%-50% alternative investments (approximately 5% expected return). For the U.S. plan assets, the actual annualized total return for the most recent 10-year period ended December 31, 2020 was approximately 9.5%. For the international plan assets, the actual annualized total return for the same period was approximately 7.9%. Changes to plan asset allocations and investment strategy over this time period limit the value of historical plan performance as factor in estimating the expected long term rate of return. For 2021, the expected long-term rate of return on plan assets will be 7.00% for the U.S. plans. For 2021, the expected weighted average long-term rate of return for international plans will be 5.27%.94Table of Contents OPEBAssumed healthcare cost trend rates20202019Historical Praxair, Inc. plansHealthcare cost trend assumed6.50 %7.00 %Rate to which the cost trend rate is assumed to decline (the ultimate trend rate)5.00 %5.00 %Year that the rate reaches the ultimate trend rate20272027Historical Linde AG plansHealthcare cost trend assumed 6.50 %5.49 %Rate to which the cost trend rate is assumed to decline (the ultimate trend rate)5.00 %4.50 %Year that the rate reaches the ultimate trend rate20272038Pension Plan AssetsThe investments of the U.S. pension plan are managed to meet the future expected benefit liabilities of the plan over the long term by investing in diversified portfolios consistent with prudent diversification and historical and expected capital market returns. Investment strategies are reviewed by management and investment performance is tracked against appropriate benchmarks. There are no concentrations of risk as it relates to the assets within the plans. The international pension plans are managed individually based on diversified investment portfolios, with different target asset allocations that vary for each plan. Weighted-average asset allocations at December 31, 2020 and 2019 for Linde’s U.S. and international pension plans, as well as respective asset allocation ranges by major asset category, are generally as follows: U.S.InternationalAsset CategoryTarget 2020Target 201920202019Target 2020Target 201920202019Equity securities40%-60%40%-60%66 %55 %15%-25%15%-25%27 %23 %Fixed income securities30%-50%30%-50%27 %30 %30%-50%30%-50%34 %41 %Other5%-15%5%-15%7 %15 %30%-50%30%-50%39 %36 %The following table summarizes pension assets measured at fair value by asset category at December 31, 2020 and 2019. For the twelve months ended December 31, 2020, transfers of assets of $15 million into Level 3 include insurance contract and real estate investments of $11 million and $4 million, respectively, which were reclassified as there is no active market quotation available. See Note 13 for the definition of levels within the fair value hierarchy: 95Table of Contents Fair Value Measurements Using Level 1Level 2Level 3 **Total(Millions of dollars)20202019202020192020201920202019Cash and cash equivalents$524 $436 $— $— $— $— $524 $436 Equity securities:Global equities1,974 1,395 — — — — 1,974 1,395 Mutual funds324 110 — 52 — — 324 162 Fixed income securities:Government bonds— — 1,545 1,642 — — 1,545 1,642 Emerging market debt— — 520 459 — — 520 459 Mutual funds123 225 12 14 — — 135 239 Corporate bonds— — 573 401 — — 573 401 Bank loans— — 242 210 — — 242 210 Alternative investments:Real estate funds— — — — 335 316 335 316 Private debt— — — — 1,120 1,003 1,120 1,003 Insurance contracts— — — — 11 — 11 — Liquid alternative— — 1,083 1,087 — — 1,083 1,087 Other investments— — 60 33 — — 60 33 Total plan assets at fair value,December 31,$2,945 $2,166 $4,035 $3,898 $1,466 $1,319 $8,446 $7,383 Pooled funds *1,517 1,553 Total fair value plan assetsDecember 31,$9,963 $8,936 * Pooled funds are measured using the net asset value ("NAV") as a practical expedient for fair value as permissible under the accounting standard for fair value measurements and have not been categorized in the fair value hierarchy. ** The following table summarizes changes in fair value of the pension plan assets classified as level 3 for the periods ended December 31, 2020 and 2019: (Millions of dollars)Insurance ContractsReal Estate FundsPrivate DebtTotalBalance, December 31, 2018$— $298 $671 $969 Gain/(Loss) for the period— 24 30 54 Acquisitions— — 14 14 Purchases— 26 304 330 Sales— (22)(33)(55)Transfer into/ (out of) Level 3— (10)— (10)Foreign currency translation— — 17 17 Balance, December 31, 2019$— $316 $1,003 $1,319 Gain/(Loss) for the period— (10)4 (6)Purchases— 21 137 158 Sales— (10)(69)(79)Transfer into / (out of) Level 311 4 — 15 Foreign currency translation— 14 45 59 Balance, December 31, 2020$11 $335 $1,120 $1,466 The descriptions and fair value methodologies for the company's pension plan assets are as follows:96Table of ContentsCash and Cash Equivalents – This category includes cash and short-term interest bearing investments with maturities of three months or less. Investments are valued at cost plus accrued interest. Cash and cash equivalents are classified within level 1 of the valuation hierarchy. Equity Securities – This category is comprised of shares of common stock in U.S. and international companies from a diverse set of industries and size. Common stock is valued at the closing market price reported on a U.S. or international exchange where the security is actively traded. Equity securities are classified within level 1 of the valuation hierarchy.Mutual Funds – These categories consist of publicly and privately managed funds that invest primarily in marketable equity and fixed income securities. The fair value of these investments is determined by reference to the net asset value of the underlying securities of the fund. Shares of publicly traded mutual funds are valued at the net asset value quoted on the exchange where the fund is traded and are primarily classified as level 1 within the valuation hierarchy. U.S. and International Government Bonds – This category includes U.S. treasuries, U.S. federal agency obligations and international government debt. The majority of these investments do not have quoted market prices available for a specific government security and so the fair value is determined using quoted prices of similar securities in active markets and is classified as level 2 within the valuation hierarchy.Corporate Bonds – This category is comprised of corporate bonds of U.S. and international companies from a diverse set of industries and size. The fair values for U.S. and international corporate bonds are determined using quoted prices of similar securities in active markets and observable data or broker or dealer quotations. The fair values for these investments are classified as level 2 within the valuation hierarchy.Pooled Funds - Pooled fund NAVs are provided by the trustee and are determined by reference to the fair value of the underlying securities of the trust, less its liabilities, which are valued primarily through the use of directly or indirectly observable inputs. Depending on the pooled fund, underlying securities may include marketable equity securities or fixed income securities. Bank Loans - This category is comprised of traded syndicated loans of larger corporate borrowers. Such loans are issued by sub-investment grade rated companies both in the U.S. and internationally and are syndicated by investment banks to institutional investors. They are regularly traded in an active dealer market comprised of large investment banks, which supply bid and offer quotes and are therefore classified within level 2 of the valuation hierarchy. Liquid Alternative Investments - This category is comprised of investments in alternative mutual funds whose holdings include liquid securities, cash, and derivatives. Such funds focus on diversification and employ a variety of investing strategies including long/short equity, multi-strategy, and global macro. The fair value of these investments is determined by reference to the net asset value of the underlying holdings of the fund, which can be determined using observable data (e.g., indices, yield curves, quoted prices of similar securities), and is classified within level 2 of the valuation hierarchy. Insurance Contracts – This category is comprised of purchased annuity insurance contracts (annuity contract buy-ins) and is intended to mitigate the Company's exposure to certain risks, such as longevity risk. The fair value is calculated based on the cash surrender value of the purchased annuity insurance contract, which is determined based on such factors as the fair value of the underlying assets and discounted cash flows. These contracts are with highly rated insurance companies. Insurance contracts are classified within level 3 of the valuation hierarchy.Real Estate Funds – This category includes real estate properties, partnership equities and investments in operating companies. The fair value of the assets is determined using discounted cash flows by estimating an income stream for the property plus a reversion into a present value at a risk adjusted rate. Yield rates and growth assumptions utilized are derived from market transactions as well as other financial and industry data. The fair value for these investments are classified within level 3 of the valuation hierarchy.Private Debt - This category includes non-traded, privately-arranged loans between one or a small group of private debt investment managers and corporate borrowers, which are typically too small to access the syndicated market and have no credit rating. This category also includes similar loans to real estate companies or individual properties. Loans included in this category are valued at par value, are held to maturity or to call, and are classified within level 3 of the valuation hierarchy. ContributionsAt a minimum, Linde contributes to its pension plans to comply with local regulatory requirements (e.g., ERISA in the United States). Discretionary contributions in excess of the local minimum requirements are made based on many factors, including long-term projections of the plans' funded status, the economic environment, potential risk of overfunding, 97Table of Contentspension insurance costs and alternative uses of the cash. Changes to these factors can impact the timing of discretionary contributions from year to year. Pension contributions were $91 million in 2020, $94 million in 2019 and $87 million in 2018. Estimated required contributions for 2021 are currently expected to be in the range of $70 million to $80 million. Estimated Future Benefit PaymentsThe following table presents estimated future benefit payments, net of participant contributions: (Millions of dollars)Pensions Year Ended December 31,U.S. InternationalOPEB 2021$175 $360 $13 2022146 360 12 2023148 371 12 2024151 380 11 2025155 389 10 2026-2030771 1,046 44 98Table of ContentsNOTE 17. COMMITMENTS AND CONTINGENCIESThe company accrues non income-tax liabilities for contingencies when management believes that a loss is probable and the amounts can be reasonably estimated, while contingent gains are recognized only when realized. In the event any losses are sustained in excess of accruals, they will be charged against income at that time. Attorney fees are recorded as incurred. Commitments represent obligations, such as those for future purchases of goods or services, that are not yet recorded on the company’s balance sheet as liabilities. The company records liabilities for commitments when incurred (i.e., when the goods or services are received).Contingent LiabilitiesLinde is subject to various lawsuits and government investigations that arise from time to time in the ordinary course of business. These actions are based upon alleged environmental, tax, antitrust and personal injury claims, among others. Linde has strong defenses in these cases and intends to defend itself vigorously. It is possible that the company may incur losses in connection with some of these actions in excess of accrued liabilities. Management does not anticipate that in the aggregate such losses would have a material adverse effect on the company’s consolidated financial position or liquidity; however, it is possible that the final outcomes could have a significant impact on the company’s reported results of operations in any given period.Significant matters are:•During 2009, the Brazilian government published Law 11941/2009 instituting a new voluntary amnesty program (“Refis Program”) which allowed Brazilian companies to settle certain federal tax disputes at reduced amounts. During 2009, the company decided that it was economically beneficial to settle many of its outstanding federal tax disputes and such disputes were enrolled in the Refis Program, subject to final calculation and review by the Brazilian federal government. The company recorded estimated liabilities based on the terms of the Refis Program. Since 2009, Linde has been unable to reach final agreement on the calculations and initiated litigation against the government in an attempt to resolve certain items. Open issues relate to the following matters: (i) application of cash deposits and net operating loss carryforwards to satisfy obligations and (ii) the amount of tax reductions available under the Refis Program. It is difficult to estimate the timing of resolution of legal matters in Brazil.•At December 31, 2020 the most significant non-income and income tax claims in Brazil, after enrollment in the Refis Program, relate to state VAT tax matters and a federal income tax matter where the taxing authorities are challenging the tax rate that should be applied to income generated by a subsidiary company. The total estimated exposure relating to such claims, including interest and penalties, as appropriate, is approximately $205 million. Linde has not recorded any liabilities related to such claims based on management judgments, after considering judgments and opinions of outside counsel. Because litigation in Brazil historically takes many years to resolve, it is very difficult to estimate the timing of resolution of these matters; however, it is possible that certain of these matters may be resolved within the near term. The company is vigorously defending against the proceedings. •On September 1, 2010, CADE (Brazilian Administrative Council for Economic Defense) announced alleged anticompetitive activity on the part of five industrial gas companies in Brazil and imposed fines. Originally, CADE imposed a civil fine of R$2.2 billion Brazilian reais ($423 million) on White Martins, the Brazil-based subsidiary of Praxair, Inc. The fine was reduced to R$1.7 billion Brazilian reais ($327 million) due to a calculation error made by CADE. The fine against White Martins was overturned by the Ninth Federal Court of Brasilia. CADE appealed this decision, and the Federal Court of Appeals rejected CADE's appeal and confirmed the decision of the Ninth Federal Court of Brasilia. CADE has filed an appeal with the Superior Court of Justice and a decision is pending.Similarly, on September 1, 2010, CADE imposed a civil fine of R$237 million Brazilian reais ($46 million) on Linde Gases Ltda., the former Brazil-based subsidiary of Linde AG, which was divested to MG Industries GmbH on March 1, 2019 and with respect to which Linde provided a contractual indemnity. The fine was reduced to R$188 million Brazilian reais ($36 million) due to a calculation error made by CADE. The fine against Linde Gases Ltda. was overturned by the Seventh Federal Court in Brasilia. CADE appealed this decision, and the Federal Court of Appeals rejected CADE's appeal and confirmed the decision of the Seventh Federal Court of Brasilia. CADE filed an appeal with the Superior Court of Justice, and a final decision is pending.Linde has strong defenses and is confident that it will prevail on appeal and have the fines overturned. Linde strongly believes that the allegations of anticompetitive activity against our current and former Brazilian 99Table of Contentssubsidiaries are not supported by valid and sufficient evidence. Linde believes that this decision will not stand up to judicial review and deems the possibility of cash outflows to be extremely unlikely. As a result, no reserves have been recorded as management does not believe that a loss from this case is probable. •On and after April 23, 2019 former shareholders of Linde AG filed appraisal proceedings at the District Court (Landgericht) Munich I (Germany), seeking an increase of the cash consideration paid in connection with the previously completed cash merger squeeze-out of all of Linde AG’s minority shareholders for €189.46 per share. Any such increase would apply to all 14,763,113 Linde AG shares that were outstanding on April 8, 2019, when the cash merger squeeze-out was completed. The period for plaintiffs to file claims expired on July 9, 2019. The company believes the consideration paid was fair and that the claims lack merit, and no reserve has been established. We cannot estimate the timing of resolution.CommitmentsAt December 31, 2020, Linde had undrawn outstanding letters of credit, bank guarantees and surety bonds valued at approximately $2,905 million from financial institutions. These relate primarily to customer contract performance guarantees (including plant construction in connection with certain on-site contracts), self-insurance claims and other commercial and governmental requirements, including non-U.S. litigation matters.Other commitments related to leases, tax liabilities for uncertain tax positions, long-term debt, other post retirement and pension obligations are summarized elsewhere in the financial statements (see Notes 4, 5, 11, and 16).NOTE 18. SEGMENT INFORMATIONLinde’s operations consist of two major product lines: industrial gases and engineering. As further described in the following paragraph, Linde’s industrial gases operations are managed on a geographic basis, which represent three of the company's reportable segments - Americas, EMEA (Europe/Middle East/Africa), and APAC (Asia/South Pacific); a fourth reportable segment which represents the company's Engineering business, designs and manufactures equipment for air separation and other industrial gas applications specifically for end customers and is managed on a worldwide basis operating in all three geographic segments. Other consists of corporate costs and a few smaller businesses which individually do not meet the quantitative thresholds for separate presentation. The industrial gases product line centers on the manufacturing and distribution of atmospheric gases (oxygen, nitrogen, argon, rare gases) and process gases (carbon dioxide, helium, hydrogen, electronic gases, specialty gases, acetylene). Many of these products are co-products of the same manufacturing process. Linde manufactures and distributes nearly all of its products and manages its customer relationships on a regional basis. Linde’s industrial gases are distributed to various end-markets within a regional segment through one of three basic distribution methods: on-site or tonnage; merchant or bulk; and packaged or cylinder gases. The distribution methods are generally integrated in order to best meet the customer’s needs and very few of its products can be economically transported outside of a region. Therefore, the distribution economics are specific to the various geographies in which the company operates and are consistent with how management assesses performance.The company’s measure of profit/loss for segment reporting is segment operating profit. Segment operating profit is defined as operating profit excluding purchase accounting impacts of the Linde AG merger, intercompany royalties, and items not indicative of ongoing business trends. This is the manner in which the company’s CODM assesses performance and allocates resources. Similarly, total assets have not been included as this is not provided to the CODM for their assessment. The table below presents information about reportable segments for the years ended December 31, 2020, 2019 and 2018. The years ended December 31, 2020 and 2019 reflect the results of the combined business for the entire year. The year ended December 31, 2018 reflects the results of Praxair for the entire year and the results of Linde AG for the period beginning after October 31, 2018 (the merger date).100Table of Contents(Millions of dollars)202020192018Sales (a)Americas$10,459 $10,989 $8,017 EMEA6,449 6,643 2,644 APAC5,687 5,779 2,446 Engineering2,851 2,799 459 Other1,797 1,953 1,270 Total Segment Sales27,243 28,163 14,836 Merger-related divestitures— 65 — Total Sales$27,243 $28,228 $14,836 202020192018Segment Operating ProfitAmericas$2,773 $2,577 $2,053 EMEA1,465 1,367 481 APAC1,277 1,184 465 Engineering435 390 14 Other(153)(246)(37)Reported Segment operating profit5,797 5,272 2,976 Cost reduction programs and other charges (Note 3)(506)(567)(309)Net gain on sale of business— 164 3,294 Purchase accounting impacts - Linde AG(1,969)(1,952)(714)Merger-related divestitures— 16 — Total operating profit$3,322 $2,933 $5,247 202020192018Depreciation and AmortizationAmericas$1,196 $1,195 $860 EMEA723 749 269 APAC619 613 271 Engineering36 35 5 Other132 143 79 Segment depreciation and amortization2,706 2,735 1,484 Purchase accounting impacts - Linde AG1,920 1,940 346 Total depreciation and amortization$4,626 $4,675 $1,830 202020192018Capital Expenditures and AcquisitionsAmericas$1,425 $1,814 $1,068 EMEA670 738 329 APAC1,214 1,231 372 Engineering13 79 27 Other146 45 112 Total Capital Expenditures and Acquisitions$3,468 $3,907 $1,908 101Table of Contents202020192018Sales by Major CountryUnited States$8,475 $8,604 $5,942 Germany3,740 3,630 868 China2,061 2,005 1,032 United Kingdom1,595 1,653 398 Australia1,071 1,127 183 Brazil822 994 1,003 Other – International9,479 10,215 5,410 Total sales$27,243 $28,228 $14,836 202020192018Long-lived Assets by Major Country (b)United States$7,777 $7,498 $7,189 Germany2,394 2,429 2,411 China2,413 2,254 2,237 United Kingdom1,313 1,479 1,582 Australia1,105 1,214 1,476 Brazil734 956 1,012 Other – International12,976 13,234 13,810 Total long-lived assets$28,711 $29,064 $29,717 ________________________(a)Sales reflect external sales only and include Linde AG sales from the merger date of October 31, 2018 forward. Intersegment sales, primarily from Engineering to the industrial gases segments, were not material.(b)Long-lived assets include property, plant and equipment - net. 19. REVENUE RECOGNITIONRevenue is accounted for in accordance with ASC 606. Revenue is recognized as control of goods or services are transferred to customers in an amount that reflects the consideration to which an entity expects to be entitled to receive in exchange for the goods or services.Contracts with CustomersApproximately 83% of Linde's consolidated sales are generated from industrial gases and related products in three geographic segments (Americas, EMEA, and APAC) and the remaining 17% is related primarily to the Engineering segment, and to a lesser extent Other (see Note 18 for operating segment details). Linde serves a diverse group of industries including healthcare, energy, manufacturing, food, beverage carbonation, fiber-optics, steel making, aerospace, chemicals and water treatment. Industrial GasesWithin each of the company’s geographic segments for industrial gases, there are three basic distribution methods: (i) on-site or tonnage; (ii) merchant or bulk liquid; and (iii) packaged or cylinder gases. The distribution method used by Linde to supply a customer is determined by many factors, including the customer’s volume requirements and location. The distribution method generally determines the contract terms with the customer and, accordingly, the revenue recognition accounting practices. Linde's primary products in its industrial gases business are atmospheric gases (oxygen, nitrogen, argon, rare gases) and process gases (carbon dioxide, helium, hydrogen, electronic gases, specialty gases, acetylene). These products are generally sold through one of the three distribution methods.Following is a description of each of the three industrial gases distribution methods and the respective revenue recognition policies: 102Table of ContentsOn-site. Customers that require the largest volumes of product and that have a relatively constant demand pattern are supplied by cryogenic and process gas on-site plants. Linde constructs plants on or adjacent to these customers’ sites and supplies the product directly to customers by pipeline. Where there are large concentrations of customers, a single pipeline may be connected to several plants and customers. On-site product supply contracts generally are total requirement contracts with terms typically ranging from 10-20 years and contain minimum purchase requirements and price escalation provisions. Many of the cryogenic on-site plants also produce liquid products for the merchant market. Therefore, plants are typically not dedicated to a single customer. Additionally, Linde is responsible for the design, construction, operations and maintenance of the plants and our customers typically have no involvement in these activities. Advanced air separation processes also allow on-site delivery to customers with smaller volume requirements. The company’s performance obligations related to on-site customers are satisfied over time as customers receive and obtain control of the product. Linde has elected to apply the practical expedient for measuring progress towards the completion of a performance obligation and recognizes revenue as the company has the right to invoice each customer, which generally corresponds with product delivery. Accordingly, revenue is recognized when product is delivered to the customer and the company has the right to invoice the customer in accordance with the contract terms. Consideration in these contracts is generally based on pricing which fluctuates with various price indices. Variable components of consideration exist within on-site contracts but are considered constrained.Merchant. Merchant deliveries generally are made from Linde's plants by tanker trucks to storage containers at the customer's site. Due to the relatively high distribution cost, merchant oxygen and nitrogen generally have a relatively small distribution radius from the plants at which they are produced. Merchant argon, hydrogen and helium can be shipped much longer distances. The customer agreements used in the merchant business are usually three to seven year supply agreements based on the requirements of the customer. These contracts generally do not contain minimum purchase requirements or volume commitments.The company’s performance obligations related to merchant customers are generally satisfied at a point in time as the customers receive and obtain control of the product. Revenue is recognized when product is delivered to the customer and the company has the right to invoice the customer in accordance with the contract terms. Any variable components of consideration within merchant contracts are constrained however this consideration is not significant.Packaged Gases. Customers requiring small volumes are supplied products in containers called cylinders, under medium to high pressure. Linde distributes merchant gases from its production plants to company-owned cylinder filling plants where cylinders are then filled for distribution to customers. Cylinders may be delivered to the customer’s site or picked up by the customer at a packaging facility or retail store. Linde invoices the customer for the industrial gases and the use of the cylinder container(s). The company also sells hardgoods and welding equipment purchased from independent manufacturers. Packaged gases are generally sold under one to three-year supply contracts and purchase orders and do not contain minimum purchase requirements or volume commitments.The company’s performance obligations related to packaged gases are satisfied at a point in time. Accordingly, revenue is recognized when product is delivered to the customer or when the customer picks up product from a packaged gas facility or retail store, and the company has the right to payment from the customer in accordance with the contract terms. Any variable consideration is constrained and will be recognized when the uncertainty related to the consideration is resolved. Linde Engineering The company designs and manufactures equipment for air separation and other industrial gas applications manufactured specifically for end customers. Sale of equipment contracts are generally comprised of a single performance obligation. Revenue from sale of equipment is generally recognized over time as Linde has an enforceable right to payment for performance completed to date and performance does not create an asset with alternative use. For contracts recognized over time, revenue is recognized primarily using a cost incurred input method. Costs incurred to date relative to total estimated costs at completion are used to measure progress toward satisfying performance obligations. Costs incurred include material, labor, and overhead costs and represent work contributing and proportionate to the transfer of control to the customer. Contract modifications are typically accounted for as part of the existing contract and are recognized as a cumulative adjustment for the inception-to-date effect of such change.Contract Assets and LiabilitiesContract assets and liabilities result from differences in timing of revenue recognition and customer invoicing. Contract assets primarily relate to sale of equipment contracts for which revenue is recognized over time. The balance represents unbilled revenue which occurs when revenue recognized under the measure of progress exceeds amounts invoiced to customers. Customer invoices may be based on the passage of time, the achievement of certain contractual milestones or a combination of both criteria. Contract liabilities include advance payments or right to consideration prior to performance 103Table of Contentsunder the contract. Contract liabilities are recognized as revenue as performance obligations are satisfied under contract terms. Linde has contract assets of $162 million at December 31, 2020 and $368 million at December 31, 2019. Total contract liabilities are $2,301 million at December 31, 2020 (current of $1,769 million and $532 million within other long-term liabilities in the consolidated balance sheets). Total contract liabilities were $2,106 million at December 31, 2019 (current contract liabilities of $1,758 million and $348 million within other long-term liabilities in the consolidated balance sheets). Revenue recognized for the twelve months ended December 31, 2020 that was included in the contract liability at December 31, 2019 was $1,283 million. Contract assets and liabilities primarily relate to the Linde Engineering business acquired in the merger. The industrial gases business does not typically have material contract assets or liabilities.Payment Terms and OtherLinde generally receives payment after performance obligations are satisfied, and customer prepayments are not typical for the industrial gases business. Payment terms vary based on the country where sales originate and local customary payment practices. Linde does not offer extended financing outside of customary payment terms. Amounts billed for sales and use taxes, value-added taxes, and certain excise and other specific transactional taxes imposed on revenue producing transactions are presented on a net basis and are not included in sales within the consolidated statement of income. Additionally, sales returns and allowances are not a normal practice in the industry and are not significant.Disaggregated Revenue InformationAs described above and in Note 18, the company manages its industrial gases business on a geographic basis, while the Engineering and Other businesses are generally managed on a global basis. Furthermore, the company believes that reporting sales by distribution method by reportable geographic segment best illustrates the nature, timing, type of customer, and contract terms for its revenues, including terms and pricing. The following tables show sales by distribution method at the consolidated level and for each reportable segment and Other for the years ended December 31, 2020, 2019 and 2018. The years ended December 31, 2020 and 2019 reflect the results of the combined business for the entire year. The year ended December 31, 2018 reflects the results of Praxair for the entire year and the results of Linde AG for the period beginning after October 31, 2018 (the merger date).(Millions of dollars)Year Ended December 31, 2020SalesAmericasEMEAAPACEngineeringOtherTotal%Merchant$2,839 $1,870 $2,005 $— $145 $6,859 25 %On-Site2,513 1,354 2,049 — — 5,916 22 %Packaged Gas5,034 3,175 1,559 — 22 9,790 36 %Other73 50 74 2,851 1,630 4,678 17 %$10,459 $6,449 $5,687 $2,851 $1,797 $27,243 100 %(Millions of dollars)Year Ended December 31, 2019SalesAmericasEMEAAPACEngineeringOther (a)Total%Merchant$2,945 $1,856 $2,080 $— $184 $7,065 25 %On-Site2,757 1,434 2,020 — — 6,211 22 %Packaged Gas5,183 3,347 1,542 — 19 10,091 36 %Other104 6 137 2,799 1,815 4,861 17 %$10,989 $6,643 $5,779 $2,799 $2,018 $28,228 100 %104Table of Contents(Millions of dollars)Year Ended December 31, 2018SalesAmericasEMEAAPACEngineeringOtherTotal%Merchant$2,775 $832 $826 $— $119 $4,552 31 %On-Site2,405 536 1,156 — — 4,097 28 %Packaged Gas2,800 1,271 443 — 3 4,517 30 %Other37 5 21 459 1,148 1,670 11 %$8,017 $2,644 $2,446 $459 $1,270 $14,836 100 % (a) Other/Other includes $65 million for the year ended December 31, 2019 of merger-related divestitures that have been excluded from segment sales.Remaining Performance ObligationsAs described above, Linde's contracts with on-site customers are under long-term supply arrangements which generally require the customer to purchase their requirements from Linde and also have minimum purchase requirements. The company estimates the consideration related to minimum purchase requirements is approximately $46 billion. This amount excludes all sales above minimum purchase requirements, which can be significant depending on customer needs. In the future, actual amounts will be different due to impacts from several factors, many of which are beyond the company’s control including, but not limited to, timing of newly signed, terminated and renewed contracts, inflationary price escalations, currency exchange rates, and pass-through costs related to natural gas and electricity. The actual duration of long-term supply contracts ranges up to twenty years. The company estimates that approximately half of the revenue related to minimum purchase requirements will be earned in the next five years and the remaining thereafter.NOTE 20. SUBSEQUENT EVENTSEffective January 1, 2021, Linde deconsolidated a joint venture with operations in Taiwan, due to the expiration of certain contractual rights that the parties mutually agreed not to renew. The joint venture contributed sales of approximately $600 million in 2020. From the effective date, the joint venture will be reflected as an equity investment on Linde's consolidated balance sheet with the corresponding results reflected in income from equity investments on the consolidated statement of income. The deconsolidation will not have an impact on earnings per share as the ownership percent remains the same.105Table of ContentsITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURENone.ITEM 9A. CONTROLS AND PROCEDURESConclusion Regarding the Effectiveness of Disclosure Controls and ProceduresBased on an evaluation of the effectiveness of Linde’s disclosure controls and procedures, which was made under the supervision and with the participation of management, including Linde’s principal executive officer and principal financial officer, the principal executive officer and principal financial officer have each concluded that, as of December 31, 2020, such disclosure controls and procedures are effective in ensuring that information required to be disclosed by Linde in reports that it files or submits under the Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms, and accumulated and communicated to management including Linde’s principal executive officer and principal financial officer, to allow timely decisions regarding required disclosure.Management’s Report on Internal Control Over Financial ReportingRefer to Item 8 for Management’s Report on Internal Control Over Financial Reporting as of December 31, 2020.Changes in Internal Control over Financial ReportingThere were no changes in Linde’s internal control over financial reporting that occurred during the quarter ended December 31, 2020 that have materially affected, or are reasonably likely to materially affect, Linde’s internal control over financial reporting.ITEM 9B. OTHER INFORMATIONNone.106Table of ContentsPART IIIITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCECertain information required by this item is incorporated herein by reference to the sections captioned “Corporate Governance and Board Matters - Director Nominees" and “Corporate Governance And Board Matters - "Delinquent Section 16 (a) Reports" in Linde’s Proxy Statement to be filed by April 30, 2021 for the Annual General Meeting. Identification of the Audit CommitteeLinde has a separately-designated standing Audit Committee established in accordance with Section 3(a)(58)(A) of the Securities Exchange Act of 1934 as amended (the “Exchange Act”). The members of that audit committee are Prof. Dr. Clemens Börsig (chairman), Dr. Nance K. Dicciani, Dr. Thomas Enders, Edward G. Galante, Larry D. McVay and Dr. Victoria Ossadnik, and each member is independent within the meaning of the independence standards adopted by the Board of Directors and those of the New York Stock Exchange.Audit Committee Financial ExpertThe Linde Board of Directors has determined that Prof. Dr. Clemens Börsig is an “audit committee financial expert” as defined by Item 407(d)(5)(ii) of Regulation S-K of the Exchange Act and is independent within the meaning of the independence standards adopted by the Board of Directors and those of the New York Stock Exchange.Code of EthicsLinde has adopted a code of ethics that applies to the company’s directors and all employees, including its Chief Executive Officer, Chief Financial Officer, and Chief Accounting Officer. This code of ethics, including specific standards for implementing certain provisions of the code, has been approved by the Linde Board of Directors and is named the “Code of Business Integrity”. This document is posted on the company’s public website, www.linde.com but is not incorporated herein.ITEM 11. EXECUTIVE COMPENSATIONInformation required by this item is incorporated herein by reference to the sections captioned “Executive Compensation Matters” and “Corporate Governance and Board Matters - Director Compensation” in Linde’s Proxy Statement to be filed by April 30, 2021 for the Annual General Meeting.107Table of ContentsITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERSEquity Compensation Plans Information - The table below provides information as of December 31, 2020 about company shares that may be issued upon the exercise of options, warrants and rights granted to employees or members of Linde’s Board of Directors under equity compensation plans that were assumed by Linde upon the completion of the business combination on October 31, 2018.EQUITY COMPENSATION PLANS TABLE Plan CategoryNumber of securities tobe issued upon exerciseof outstanding options,warrants and rights (a) Weighted-averageexercise price ofoutstanding options,warrants and rights (b)Number of securitiesremaining available forfuture issuance underequity compensation plans(excluding securitiesreflected in column (a)) (c)Equity compensation plans approved by shareholders9,192,326 (1)$136.05 5,394,996 (2)Equity compensation plans not approved by shareholders— — — Total9,192,326 $136.05 5,394,996 ________________________(1)This amount includes 688,170 restricted shares and 437,110 performance shares. (2)This amount includes 5,117,443 shares available for future issuance pursuant to the Amended and Restated 2009 Linde Long Term Incentive Plan assumed by Linde, and 277,553 shares available for future issuance pursuant to the Long Term Incentive Plan 2018 of Linde plc. Certain information required by this item regarding the beneficial ownership of the company’s ordinary shares is incorporated herein by reference to the section captioned “Information on Share Ownership” in Linde’s Proxy Statement to be filed by April 30, 2021 for the Annual General Meeting.ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS AND DIRECTOR INDEPENDENCEInformation required by this item is incorporated herein by reference to the sections captioned “Corporate Governance And Board Matters – Review, Approval or Ratification of Transactions with Related Persons,” “Corporate Governance And Board Matters – Certain Relationships and Transactions,” and “Corporate Governance And Board Matters – Director Independence” in Linde’s Proxy Statement to be filed by April 30, 2021 for the Annual General Meeting.ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICESInformation required by this item is incorporated herein by reference to the section captioned “Audit Matters” in Linde’s Proxy Statement to be filed by April 30, 2021 for the Annual General Meeting.108Table of Contents PART IVITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES(a)The following documents are filed as part of this report:(i)The company’s 2020 Consolidated Financial Statements and the Report of the Independent Registered Public Accounting Firm are included in Part II,
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+ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSThe following discussion of our financial condition and results of operations should be read in conjunction with our audited consolidated financial statements and notes thereto included in Part II, Item 8, "Financial Statements and Supplementary Data," of this Annual Report on Form 10-K. Discussion of 2018 items and the year-over-year comparison of changes in our financial condition and the results of operations as of and for the years ended December 31, 2019 and December 31, 2018 can be found in Part II, Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations," of our Annual Report on Form 10-K for the year ended December 31, 2019 filed with the SEC on February 27, 2020.OverviewWe are a global distributor of vehicle products, including replacement parts, components and systems used in the repair and maintenance of vehicles, and specialty products and accessories to improve the performance, functionality and appearance of vehicles.Buyers of vehicle replacement products have the option to purchase from primarily five sources: new products produced by OEMs; new products produced by companies other than the OEMs, which are referred to as aftermarket products; recycled products obtained from salvage and total loss vehicles; recycled products that have been refurbished; and recycled products that have been remanufactured. We distribute a variety of products to collision and mechanical repair shops, including aftermarket collision and mechanical products; recycled collision and mechanical products; refurbished collision products such as wheels, bumper covers and lights; and remanufactured engines and transmissions. Collectively, we refer to the four sources that are not new OEM products as alternative parts.We are a leading provider of alternative vehicle collision replacement products and alternative vehicle mechanical replacement products, with our sales, processing, and distribution facilities reaching most major markets in the United States and Canada. We are also a leading provider of alternative vehicle replacement and maintenance products in Germany, the United Kingdom, the Benelux region (Belgium, Netherlands, and Luxembourg), Italy, Czech Republic, Austria, Slovakia, Poland, and various other European countries. In addition to our wholesale operations, we operate self service retail facilities across the U.S. that sell recycled automotive products from end-of-life-vehicles. We are also a leading distributor of specialty vehicle aftermarket equipment and accessories reaching most major markets in the U.S. and Canada.We are organized into four operating segments: Wholesale – North America; Europe; Specialty and Self Service. We aggregate our Wholesale – North America and Self Service operating segments into one reportable segment, North America, resulting in three reportable segments: North America, Europe and Specialty.Our operating results have fluctuated on a quarterly and annual basis in the past and can be expected to continue to fluctuate in the future as a result of a number of factors, some of which are beyond our control. Please refer to the factors referred to in Forward-Looking Statements and Risk Factors above. Due to these factors and others, which may be unknown to us at this time, our operating results in future periods can be expected to fluctuate. Accordingly, our historical results of operations may not be indicative of future performance.Acquisitions and InvestmentsSince our inception in 1998, we have pursued a growth strategy through both organic growth and acquisitions. Through 2018, our acquisition strategy was focused on consolidation to build scale in fragmented markets across North America and Europe. We targeted companies that were market leaders, expanded our geographic presence and enhanced our ability to provide a wide array of vehicle products through our distribution network. In the last few years, we have shifted our focus from larger transactions to tuck-in acquisitions that target high synergies and/or add critical capabilities. Additionally, we have made investments in various businesses to advance our strategic objectives.On May 30, 2018, we acquired Stahlgruber, a leading European wholesale distributor of aftermarket spare parts for passenger cars, tools, capital equipment and accessories with operations in Germany, Austria, Italy, Slovenia, and Croatia with further sales to Switzerland. This acquisition expanded LKQ's geographic presence in continental Europe and serves as an additional strategic hub for our European operations. In addition, this acquisition should allow for continued improvement in procurement, logistics and infrastructure optimization. In addition to the acquisition mentioned above, during the years ended December 31, 2020, 2019 and 2018, we acquired various smaller businesses across our North America, Europe, and Specialty segments. See Note 2, "Business Combinations" and "Investments in Unconsolidated Subsidiaries" in Note 4, "Summary of Significant Accounting Policies," to the consolidated financial statements in Part II, Item 8 of this Annual Report on Form 10-K for additional information related to our acquisitions and investments.36Sources of RevenueWe report our revenue in two categories: (i) parts and services and (ii) other. Our parts revenue is generated from the sale of vehicle products, including replacement parts, components and systems used in the repair and maintenance of vehicles, and specialty products and accessories to improve the performance, functionality and appearance of vehicles. Our service revenue is generated primarily from the sale of service-type warranties, fees for admission to our self service yards, and diagnostic and repair services. During the year ended December 31, 2020, parts and services revenue represented approximately 94% of our consolidated revenue. Revenue from other sources includes scrap and other metals sales, bulk sales to mechanical manufacturers (including cores) and sales of aluminum ingots and sows from our furnace operations. Other revenue will vary from period to period based on fluctuations in commodity prices and the volume of materials sold. See Note 5, "Revenue Recognition" to the consolidated financial statements in Part II, Item 8 of this Annual Report on Form 10-K for additional information related to our sources of revenue.Critical Accounting Policies and EstimatesThe discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America ("GAAP"). The preparation of these financial statements requires us to make estimates, assumptions and judgments that affect the reported amounts of assets, liabilities, revenue and expenses, and related disclosure of contingent assets and liabilities. On an ongoing basis, we evaluate our estimates, assumptions, and judgments, including those related to revenue recognition, inventory valuation, lease accounting, business combinations and goodwill impairment. We base our estimates on historical experience and on various other assumptions that we believe are reasonable under the circumstances. The results of these estimates form the basis for our judgments about the carrying values of assets and liabilities and our recognition of revenue. Actual results may differ from these estimates. Revenue RecognitionFor information regarding our critical accounting policies related to revenue, refer to Note 5, "Revenue Recognition," to the consolidated financial statements in Part II, Item 8 of this Annual Report on Form 10-K.Inventory AccountingFor all inventory, carrying value is recorded at the lower of cost or net realizable value. Net realizable value can be influenced by current anticipated demand. If actual demand differs from our estimates, additional reductions to inventory carrying value would be necessary in the period such determination is made.For our aftermarket products, excluding our aftermarket automotive glass products, cost is established based on the average price we pay for parts; for our aftermarket automotive glass products inventory, cost is established using the first-in first-out method. Inventory cost for our aftermarket products includes expenses incurred for freight in and overhead costs; for items purchased from foreign companies, import fees and duties and transportation insurance are also included. Refurbished inventory cost is based upon the average price we pay for cores. The cost of our refurbished inventory also includes expenses incurred for freight in, labor and other overhead costs. Our salvage inventory cost is established based upon the price we pay for a vehicle, including auction, towing and storage fees, as well as expenditures for buying and dismantling vehicles. Inventory carrying value is determined using the average cost to sales percentage at each of our facilities and applying that percentage to the facility's inventory at expected selling prices, the assessment of which incorporates the sales probability based on a part's days in stock and historical demand. The average cost to sales percentage is derived from each facility's historical profitability for salvage vehicles. Remanufactured inventory cost is based upon the price paid for cores, and also includes expenses incurred for freight, direct manufacturing costs and overhead related to our remanufacturing operations. The cost of manufactured product inventory is established using the first-in first-out method.Lease AccountingFor information regarding our critical accounting policies related to leases, refer to Note 13, "Leases," to the consolidated financial statements in Part II, Item 8 of this Annual Report on Form 10-K.Business CombinationsWe record our acquisitions using the purchase method of accounting, under which the acquisition purchase price is allocated to the assets acquired and liabilities assumed based upon their respective fair values. We utilize management estimates and, in some instances, independent third party valuation firms to assist in determining the fair values of assets acquired, liabilities assumed and contingent consideration granted. There are inherent assumptions and estimates used in developing the future cash flows and fair values of tangible and intangible assets, such as projecting revenues and profits, discount rates, income tax rates, royalty rates, customer attrition rates and other various valuation assumptions. We use various valuation 37methods to value property, plant and equipment. When valuing real property, we typically use the sales comparison approach for land and the income approach for buildings and building improvements. When valuing personal property, we typically use either the income or cost approach. We used the relief-from-royalty method to value trade names, trademarks, software and other technology assets, and we used the multi-period excess earnings method to value customer relationships. The relief-from-royalty method assumes that the intangible asset has value to the extent that its owner is relieved of the obligation to pay royalties for the benefits received from the intangible asset. The multi-period excess earnings method is based on the present value of the incremental after-tax cash flows attributable only to the customer relationship after deducting contributory asset charges.Goodwill and Indefinite-Lived Intangibles ImpairmentWe are required to test goodwill and indefinite-lived intangible assets for impairment at least annually and between annual tests whenever events indicate that an impairment may exist. When testing goodwill for impairment, we are required to evaluate events and circumstances that may affect the performance of the reporting unit and the extent to which the events and circumstances may impact the future cash flows of the reporting unit to determine whether the fair value of the assets exceeds the carrying value. Developing the estimated future cash flows and fair value of the reporting unit requires management's judgment in projecting revenues and profits, allocation of shared corporate costs, tax rates, capital expenditures, working capital requirements, discount rates and market multiples. Many of the factors used in assessing fair value are outside the control of management, and it is reasonably likely that assumptions and estimates can change in future periods. If these assumptions or estimates change in the future, we may be required to record impairment charges for these assets. In response to changes in industry and market conditions, we may be required to strategically realign our resources and consider restructuring, disposing of, or otherwise exiting businesses, which could result in an impairment of goodwill.We perform goodwill impairment tests annually in the fourth quarter and between annual tests whenever events indicate that an impairment may exist. LKQ’s market capitalization declined by approximately 40% between February 20, 2020, when the Company released its 2019 financial results, and March 31, 2020. While we believed that the decrease was driven by market reaction to COVID-19, the magnitude of the market capitalization decrease was deemed to be a triggering event requiring an interim test of goodwill impairment in the first quarter, which did not result in a goodwill impairment. We did not perform an impairment test in the second or third quarters of 2020. Our goodwill impairment assessment is performed at the reporting unit level. A reporting unit is an operating segment, or a business one level below an operating segment (the "component" level), for which discrete financial information is prepared and regularly reviewed by segment management. However, components are aggregated as a single reporting unit if they have similar economic characteristics. For the purpose of aggregating our components into reporting units, we review the long-term performance of Segment EBITDA. Additionally, we review qualitative factors such as type or class of customers, nature of products, distribution methods, inventory procurement methods, level of integration, and interdependency of processes across components. Our assessment of the aggregation includes both qualitative and quantitative factors and is based on the facts and circumstances specific to the components.We have four operating segments: Wholesale – North America, Europe, Specialty and Self Service. Each of these operating segments consists of multiple components that have discrete financial information available that is reviewed by segment management on a regular basis. We have evaluated these components and concluded that the components that compose each of the Wholesale – North America, Europe, Specialty, and Self Service operating segments are economically similar and thus were aggregated into those four separate reporting units for our interim goodwill impairment test in the first quarter of 2020 and annual goodwill impairment test.Our goodwill would be considered impaired if the carrying value of a reporting unit exceeded its estimated fair value. The fair value estimates are established using weightings of the results of a discounted cash flow methodology and a comparative market multiples approach. We believe that using two methods to determine fair value limits the chances of an unrepresentative valuation. Discount rates, growth rates and cash flow projections are the assumptions that are most sensitive and susceptible to change as they require significant management judgment. Impairment may result from, among other things, deterioration in the performance of our reporting units' businesses, increases in our cost of capital, adverse market conditions, and adverse changes in applicable laws or regulations, including modifications that restrict the activities of our reporting units' businesses. To assess the reasonableness of the fair value estimates, we compare the sum of the reporting units’ fair values to the Company’s market capitalization and calculate an implied control premium, which is then evaluated against recent market transactions in our industry, or in the case of our interim test, against transactions during the 2008-2009 financial crisis. If we were required to recognize goodwill impairments, we would report those impairment losses as part of our operating results.We determined no impairments existed on any of our four reporting units when we performed our interim goodwill impairment testing in the first quarter of 2020, as each of those reporting units had a fair value estimate that exceeded the carrying value by at least 12%, the level at which our Europe reporting unit exceeded its carrying value. We did not identify a triggering event in the second or third quarter that necessitated an interim test of goodwill impairment. 38We determined no impairments existed when we performed our annual goodwill impairment testing in the fourth quarter of 2020 on all four reporting units as each of those reporting units had a fair value estimate that exceeded the carrying value by at least 30%. As of December 31, 2020, we had a total of $4.6 billion in goodwill subject to future impairment tests. We review indefinite-lived intangible assets for impairment annually or on an interim basis if events or changes in circumstances indicate that the carrying value may not be recoverable. In the first quarter of 2020, we determined that the effect of the uncertainty relating to the COVID-19 pandemic on our forecasted results represented a change in circumstances indicating that the carrying value of the Warn trademark, which is our only indefinite-lived intangible asset, might not be recoverable. As a result, we performed a quantitative impairment test as of March 31, 2020 using the relief-from-royalty method and determined no impairment existed, as the trademark had a fair value estimate which exceeded the carrying value by approximately 9%. We did not identify a triggering event in the second or third quarter that necessitated an interim test of impairment. We performed a quantitative impairment test in the fourth quarter as of October 31, 2020, using the relief-from-royalty method to value the Warn trademark; we determined no impairment existed at that time as the trademark had a fair value estimate which exceeded the carrying value by approximately 13%.Recently Issued Accounting PronouncementsSee "Recent Accounting Pronouncements" in Note 4, "Summary of Significant Accounting Policies" to the consolidated financial statements in Part II, Item 8 of this Annual Report on Form 10-K for information related to new accounting standards.Financial Information by Geographic AreaSee Note 16, "Segment and Geographic Information" to the consolidated financial statements in Part II, Item 8 of this Annual Report on Form 10-K for information related to our revenue and long-lived assets by geographic region.1 LKQ Europe ProgramWe have undertaken the 1 LKQ Europe program to create structural centralization and standardization of key functions to facilitate the operation of the Europe segment as a single business. Under this multi-year program, we expect to recognize the following:•Restructuring expenses — Non-recurring costs resulting directly from the implementation of the 1 LKQ Europe program from which the business will derive no ongoing benefit. See Note 6, “Restructuring and Acquisition Related Expenses” to the consolidated financial statements in Part II, Item 8 of this Annual Report on Form 10-K for further details.•Transformation expenses — Period costs incurred to execute the 1 LKQ Europe program that are expected to contribute to ongoing benefits to the business (e.g. non-capitalizable implementation costs related to a common ERP system). These expenses are recorded in Selling, general and administrative expenses.•Transformation capital expenditures — Capitalizable costs for long-lived assets, such as software and facilities, that directly relate to the execution of the 1 LKQ Europe program.Costs related to the 1 LKQ Europe program incurred to date are reflected in Selling, general and administrative expenses and Purchases of property, plant and equipment in our consolidated financial statements in Part II, Item 8 of this Annual Report on Form 10-K. Beginning in the second half of March 2020, management delayed certain projects under the 1 LKQ Europe program to reduce expenses and preserve capital in response to the COVID-19 pandemic. Based on our expectations in the second quarter of 2020 that the impacts on our business from COVID-19 had stabilized, we restarted the program in July 2020 with substantially the same initiatives and projects as prior to the pandemic. While certain projects were delayed as a result of the COVID-19 pandemic, such as our procurement initiatives and the new headquarters in Switzerland, we also accelerated certain projects, such as the integration of previously acquired networks and sharing resources across LKQ Europe. We have continued the project on schedule during the second wave of COVID-19. We are targeting to complete the organizational design and implementation projects by the middle of 2021, with the remaining projects scheduled to be completed by 2024. During the year ended December 31, 2020, we incurred $38 million in costs across all three categories noted above. We expect that costs of the program, reflecting all three categories noted above, will range between $60 million and $80 million in 2021 with an additional $80 million to $100 million between 2022 and the projected program completion date in 2024. In the future, we may also identify additional initiatives and projects under the 1 LKQ Europe program that may result in additional expenditures, although we are currently unable to estimate the range of charges for such potential future initiatives and projects. We expect the transformation and restructuring expenses will be entirely funded by the improved trade working capital initiatives across our Europe segment.39COVID-19 Impact on Our Operations In late February 2020, the Italian government began placing restrictions on activity as a result of the COVID-19 outbreak. Sales volumes fell as fewer cars were on the road and less maintenance activity was performed. While our Italian operation is an important part of our European business, it represented approximately 10% of the segment’s revenue in 2019, and thus the disruption did not have a material impact on the Company. By mid-March, the COVID-19 impact began spreading across the rest of the geographies where we operate at a very rapid pace. Governments adopted aggressive restrictions on the operation of non-essential businesses and personal movement, which reduced miles driven and collisions. While our businesses have been deemed essential in most jurisdictions in which we operate, the change in behavior driven by the COVID-19 restrictions negatively impacted our sales volume. Our organic parts and services revenue declined by 16.8%, 4.5%, and 5.2% in the second, third, and fourth quarters of 2020, respectively, relative to the comparable prior periods. We showed improvement in the third quarter of 2020 as governments gradually lifted restrictions for non-essential businesses and personal movement, however, in the fourth quarter of 2020 revenue declined as certain jurisdictions put restrictions back into place. As anticipated, April experienced the most negative revenue impact, with organic parts and services revenue (on a per day basis) down 30.3% compared to the prior year period. As movement restrictions lessened in May and June, we experienced organic parts and services revenue declines (on a per day basis) of 13.2% and 7.3%, respectively, compared to the prior year periods. However, the pace of improvement flattened into the third quarter as the increasing level of COVID-19 cases, especially in the United States, slowed the recovery. During the third quarter, organic parts and services revenue declined by 4.5% compared to the prior year period, a small improvement from the June decline of 7.3% (on a per day basis). During the fourth quarter, organic parts and services revenue declined by 6.1% (on a per day basis) and gradually worsened during the quarter with a decline of 7.2% (on a per day basis) in December. In the first quarter of 2021, we expect revenue to remain lower on a year over year basis as COVID-19 continues to impact economic activity in the U.S. and Europe, as the pandemic did not begin meaningfully impacting our results until March 2020. The level of the year over year decrease in revenue will depend on the extent of lockdown measures taken in response to an increase in the prevalence of the virus outbreak and the timing and effectiveness of the vaccination efforts. We expect revenue to increase in the second quarter of 2021 off of a low base and a gradual recovery in the second half of 2021.Recognizing the demand changes in the first quarter of 2020, we took action in all of our business units to reduce our cost structure. These actions included, but were not limited to, employee furloughs and reductions in force, decreases in hours and overtime, lowering compensation for salaried employees, a hiring freeze, elimination of temporary labor, route consolidation, deferral of projects, and temporary branch closures. In the second quarter, these cost actions contributed to a reduction of approximately 18% in quarterly selling, general and administrative expenses compared to our first quarter 2020 run rate. We estimate that the cost actions generated a $10 million benefit in cost of goods sold compared to our second quarter of 2019. Some of the savings from the cost actions were delayed as we paid out vacation balances in April and covered medical benefits for employees in the United States during their furlough period. During the third quarter and fourth quarters, we were able to sustain a portion of the cost benefits, with quarterly selling, general and administrative costs down approximately 10% for both periods compared to the first quarter 2020 run rate. We estimate that the cost actions generated an approximately $15 million benefit in cost of goods sold for the second half of 2020 compared to the same period of 2019. If revenue increases during 2021, we expect that some of the costs that were reduced as a result of COVID-19 will remain at a lower level; the management team has been implementing productivity initiatives to create lower cost structures going forward as seen in the third and fourth quarter results. We pursued certain financial assistance and relief programs that were available to us from governments in Europe and Canada, primarily in the form of grants to offset personnel expenses; through December 31, 2020, we qualified for $52 million of assistance, although that figure was heavily weighted to the second quarter. We currently do not anticipate qualifying for significant additional assistance in 2021, but we still will receive some government assistance in England. This view may change in the future based on developments with the resurgence of the virus outbreak.These cost actions lagged the revenue impact in the first and second quarters, which meant there was a negative timing impact of COVID-19 on our profitability in those periods in addition to the negative effect from reduced revenue. By the third quarter, the cost actions were aligned with the revenue changes, and we generated higher Segment EBITDA dollars and margins than in the third quarter of 2019. In the fourth quarter, selling, general and administrative ("SG&A") costs remained consistent with the third quarter and profitability remained higher than the prior year.We also emphasized the preservation of capital with a deferral of growth driven capital projects, reductions in inventory orders, more active monitoring of customer receivables and terms, income and value added tax payment deferrals (the majority of which were paid during the third quarter), and suspension of our share buyback program (which was reinstated during the fourth quarter). This focus was successful as we improved our liquidity position at year-end by approximately $1.0 billion relative to March 31, 2020 while managing through the disruption caused by the pandemic.In each quarter of 2020, we prepared forecasts of future revenues, profits and cash flows to use in multiple analyses, including the interim and annual goodwill impairment test, other impairment tests of long-lived assets, assessments of the 40recoverability of inventory, determination of customer and supplier rebate balances, calculation of the annual effective tax rate and evaluations of the realizability of deferred tax assets. Actual results have exceeded our initial forecast prepared in the first quarter of 2020 with a full year organic parts and service revenue decline of 8.2% on a per day basis, diluted earnings per share attributable to LKQ stockholders of $2.09 and operating cash flow of $1.4 billion. We expect to face continued pressure on revenue with COVID-19 infection rates remaining at heightened levels in a number of our geographies, but we believe that consolidated profit margins in 2021 will remain above those realized during 2020 due to margin and overhead cost initiatives implemented in 2019 and 2020. As the economic impact of the pandemic is dependent on variables that are difficult to project and in many cases are outside of our control, it is possible that the estimates underlying our analyses may change. This is particularly the case as it appears that the prevalence of the virus outbreak fluctuates depending on various factors, including the level of economic and social activity in a region and progress in vaccination efforts.One of our top priorities is the health and safety of our employees, customers and the communities in which we operate. We are using all reasonable efforts to follow governmental instructions and safety guidelines with respect to the operations of our facilities. We have implemented protocols across our business units to help ensure the health and safety of our employees, customers and communities including, but not limited to: restricting access to and enhancing cleaning and disinfecting protocols at our facilities; use of personal protective equipment; adhering to social distancing guidelines; instituting remote work arrangements for many of our employees; and restricting travel. See the Results of Operations and Liquidity sections for further detail on our year over year trends.Key Performance IndicatorsWe believe that organic revenue growth, Segment EBITDA and free cash flow are key performance indicators for our business. Segment EBITDA is our key measure of segment profit or loss reviewed by our chief operating decision maker. Free cash flow is a financial measure that is not prepared in accordance with U.S. generally accepted accounting principles (“non-GAAP”).•Organic revenue growth - We define organic revenue growth as total revenue growth from continuing operations excluding the effects of acquisitions and divestitures (i.e., revenue generated from the date of acquisition to the first anniversary of that acquisition, net of reduced revenue due to the disposal of businesses) and foreign currency movements (i.e., impact of translating revenue at prior period exchange rates). Organic revenue growth includes incremental sales from both existing and new (i.e., opened within the last twelve months) locations and is derived from expanding business with existing customers, securing new customers and offering additional products and services. We believe that organic revenue growth is a key performance indicator as this statistic measures our ability to serve and grow our customer base successfully.•Segment EBITDA - Refer to Note 16, "Segment and Geographic Information,” in Part II, Item 8 of this Form 10-K for a description of the calculation of Segment EBITDA. We believe that Segment EBITDA provides useful information to evaluate our segment profitability by focusing on the indicators of ongoing operational results.•Free Cash Flow - We calculate free cash flow as net cash provided by operating activities, less purchases of property, plant and equipment. Free cash flow provides insight into our liquidity and provides useful information to management and investors concerning cash flow available to meet our future debt service obligations and working capital requirements, to make strategic acquisitions and to repurchase our stock.These three key performance indicators are used as targets in determining incentive compensation at various levels of the organization, including senior management. By using these performance measures, we attempt to motivate a balanced approach to the business that rewards growth, profitability and cash flow generation in a manner that enhances our long-term prospects.41Results of Operations—ConsolidatedThe following table sets forth statements of income data as a percentage of total revenue for the periods indicated:Year Ended December 31, 20202019Revenue100.0 %100.0 %Cost of goods sold60.5 %61.2 %Gross margin39.5 %38.8 %Selling, general and administrative expenses28.1 %28.6 %Restructuring and acquisition related expenses0.6 %0.3 %Loss on disposal of businesses and impairment of net assets held for sale0.0 %0.4 %Depreciation and amortization2.3 %2.3 %Operating income8.5 %7.2 %Total other expense, net0.9 %0.8 %Income from continuing operations before provision for income taxes7.6 %6.3 %Provision for income taxes2.1 %1.7 %Equity in earnings (losses) of unconsolidated subsidiaries0.0 %(0.3)%Income from continuing operations5.5 %4.3 %Net (loss) income from discontinued operations(0.0)%0.0 %Net income5.5 %4.4 %Less: net income attributable to continuing noncontrolling interest0.0 %0.0 %Less: net income attributable to discontinued noncontrolling interest0.0 %0.0 %Net income attributable to LKQ stockholders5.5 %4.3 %Note: In the table above, the sum of the individual percentages may not equal the total due to rounding.Year Ended December 31, 2020 Compared to Year Ended December 31, 2019 Revenue. The following table summarizes the changes in revenue by category (in thousands):Year Ended December 31,Percentage Change in Revenue20202019OrganicAcquisition and DivestitureForeign ExchangeTotal ChangeParts & services revenue$10,963,713 $11,877,846 (7.6)%(0.5)%0.5 %(7.7)%Other revenue665,117 628,263 5.5 %0.4 %0.0 %5.9 %Total revenue$11,628,830 $12,506,109 (7.0)%(0.5)%0.4 %(7.0)%Note: In the table above, the sum of the individual percentages may not equal the total due to rounding.The decline in parts and services revenue of 7.7% represented decreases in segment revenue of 13.3% in North America and 6.0% in Europe, partially offset by an increase of 3.1% in Specialty segment revenue. Organic parts and services revenue declined by 7.6%, which included a 0.6% positive effect from approximately two additional selling days in the year ended December 31, 2020, resulting in a per day organic decline of 8.2%. The decline in 2020 is primarily related to the impact of COVID-19 from March 2020 through December 2020 (refer to the "COVID-19 Impact on Our Operations" section above for further details). The increase in other revenue of 5.9% was primarily driven by a $34 million organic increase, largely attributable to our North America segment. Refer to the discussion of our segment results of operations for factors contributing to the change in revenue by segment during the year ended December 31, 2020 compared to the year ended December 31, 2019. Cost of Goods Sold. Cost of goods sold decreased to 60.5% of revenue in the year ended December 31, 2020 from 61.2% of revenue in the year ended December 31, 2019. Cost of goods sold decreased 0.6% and 0.5% in our North America and Europe segments, respectively, partially offset by a 0.3% increase in cost of goods sold attributable to mix. The mix impact was a result of the decreased volumes in our North America segment primarily due to the COVID-19 pandemic, as the higher margin North America segment made up a smaller percentage of the consolidated results, causing an unfavorable effect on the gross margin percentage. For the year ended December 31, 2020, we recorded inventory write downs related to restructuring plans of $5 million and $3 million in our North America and Europe segments, respectively. For the year ended December 31, 2019, we recorded inventory write downs of $21 million, principally due to our Europe segment related to U.K. branch consolidation and brand rationalization initiated as part of our restructuring plans. The lower inventory write downs in the year 42ended December 31, 2020 compared to the prior year period resulted in a favorable impact on cost of goods sold of 0.1%. Our restructuring plans are described in Note 6, "Restructuring and Acquisition Related Expenses" to the consolidated financial statements in Part II, Item 8 of this Annual Report on Form 10-K. Refer to the discussion of our segment results of operations for factors contributing to the changes in cost of goods sold as a percentage of revenue by segment for the year ended December 31, 2020 compared to the year ended December 31, 2019.Selling, General and Administrative Expenses. Our SG&A expenses as a percentage of revenue decreased to 28.1% in the year ended December 31, 2020 compared to 28.6% in the year ended December 31, 2019. SG&A expenses decreased over the prior year period as a result of (i) a decrease of 0.5% in our North America segment and (ii) a 0.2% decrease in SG&A expenses attributable to mix, partially offset by (iii) an increase of 0.3% in our Europe segment. The mix impact was a result of the decreased volumes in our North America segment primarily due to the COVID-19 pandemic, as the higher SG&A expense percentage for the North America segment made up a smaller percentage of the consolidated results, which had a favorable effect on the SG&A expense percentage. Refer to the discussion of our segment results of operations for factors contributing to the changes in SG&A expenses as a percentage of revenue by segment for the year ended December 31, 2020 compared to the year ended December 31, 2019.Restructuring and Acquisition Related Expenses. The following table summarizes restructuring and acquisition related expenses for the periods indicated (in thousands):Year Ended December 31,20202019ChangeRestructuring expenses$58,204 (1)$34,832 (2)$23,372 Acquisition related expenses7,959 (3)2,147 (4)5,812 Total restructuring and acquisition related expenses$66,163 $36,979 $29,184 (1)Restructuring expenses for the year ended December 31, 2020 consisted of (i) $42 million related to our 2020 global restructuring program, (ii) $9 million related to integration costs from acquisitions, and (iii) $7 million related to our 2019 global restructuring program.(2) Restructuring expenses for the year ended December 31, 2019 primarily consisted of $20 million related to our 2019 global restructuring program and $14 million related to integration costs from acquisitions.(3) Acquisition related expenses for the year ended December 31, 2020 primarily consisted of an $8 million adjustment for the resolution of a purchase price matter related to the Stahlgruber transaction for an amount above our prior estimate.(4) Acquisition related expenses for the year ended December 31, 2019 included costs primarily related to the acquisition of an immaterial wholesale business in Europe. See Note 6, "Restructuring and Acquisition Related Expenses" to the consolidated financial statements in Part II, Item 8 of this Annual Report on Form 10-K for further information on our restructuring and integration plans. Loss on Disposal of Businesses and Impairment of Net Assets Held for Sale. For the year ended December 31, 2020, we recorded a net loss on the disposal of businesses and impairment charges on net assets held for sale totaling $3 million, compared to $47 million of net impairment charges on net assets held for sale for the year ended December 31, 2019 primarily attributable to our North America segment. See "Net Assets Held for Sale" in Note 4, "Summary of Significant Accounting Policies" to the consolidated financial statements in Part II, Item 8 of this Annual Report on Form 10-K for further information on the net loss on disposals and impairment charges.Depreciation and Amortization. The following table summarizes depreciation and amortization for the periods indicated (in thousands): Year Ended December 31,20202019ChangeDepreciation$153,027 $150,649 $2,378 (1)Amortization119,265 140,121 (20,856)(2)Total depreciation and amortization$272,292 $290,770 $(18,478)(1)Depreciation expense increased by $2 million, primarily due to capital expenditures in our North America segment.(2)The decrease in amortization expense primarily reflected decreases of $17 million and $6 million related to the customer relationship intangible assets recorded upon our acquisitions of Stahlgruber and Rhiag, respectively, as the 43accelerated amortization of the customer relationship intangible assets resulted in lower amortization expense during the year ended December 31, 2020 compared to the prior year period. Other Expense, Net. The following table summarizes the components of the change in other expense, net (in thousands):Other expense, net for the year ended December 31, 2019$105,621 (Decrease) increase due to:Interest expense(34,720)(1)Loss/gain on debt extinguishment12,879 (2)Interest income and other expense (income), net16,802 (3)Net decrease(5,039)Other expense, net for the year ended December 31, 2020$100,582 (1)The decrease in interest is primarily related to (i) a $32 million decrease resulting from lower outstanding debt during the year ended December 31, 2020 compared to the prior year period, and (ii) a $4 million decrease from lower interest rates on borrowings under our senior secured credit agreement compared to the prior year period, partially offset by (iii) a $2 million increase from foreign currency translation, primarily related to an increase in the euro exchange rate during the year ended December 31, 2020 compared to the prior year period.(2)In January 2020, we recorded a loss on debt extinguishment of $13 million related to the redemption of the U.S. Notes (2023) due to the early-redemption premium and the write-off of the unamortized debt issuance costs.(3)The decrease in interest income and other expense (income), net primarily consisted of (i) a $12 million non-recurring gain related to resolution of an acquisition related matter in the fourth quarter of 2019, (ii) pension settlement losses of $6 million related to our primary defined benefit plan in the U.S. (the "U.S. Plan") in 2020, and (iii) several individually immaterial factors that decreased interest income and other expense (income), net by $4 million in the aggregate in 2020, partially offset by (iv) a $6 million increase in insurance settlement proceeds compared to the prior year period, primarily due to our North America segment.Provision for Income Taxes. Our effective income tax rate for the year ended December 31, 2020 was 28.2%, compared to 27.2% for the comparable prior year period. Primary factors in the increase include valuation allowances on the tax benefit of net operating losses in certain jurisdictions where realization is uncertain and shifts in the geographic blend of international earnings. Net discrete items in both years were immaterial to the effective tax rate. See Note 15, "Income Taxes" to the consolidated financial statements in Part II, Item 8 of this Annual Report on Form 10-K for further information.Equity in Earnings (Losses) of Unconsolidated Subsidiaries. Equity in earnings (losses) of unconsolidated subsidiaries for the year ended December 31, 2020 primarily related to our investment in Mekonomen. During the first quarter of 2019, we recorded a $40 million other-than-temporary impairment related to our investment in Mekonomen. There were no impairment charges for Mekonomen in 2020. See "Investments in Unconsolidated Subsidiaries" in Note 4, "Summary of Significant Accounting Policies" to the consolidated financial statements in Part II, Item 8 of this Annual Report on Form 10-K for further information on the impairment charge. Foreign Currency Impact. We translate our statements of income at the average exchange rates in effect for the period. Relative to the rates used during the year ended December 31, 2019, the euro and pound sterling rates used to translate the 2020 statements of income increased by 2.0% and 0.6%, respectively, and the year to date average rates for the Canadian dollar and Czech koruna decreased by 1.0% and 0.9%, respectively. The unfavorable impact of realized and unrealized currency gains and losses for the year ended December 31, 2020 resulted in a $0.01 negative effect on diluted earnings per share relative to the prior year. Net Income Attributable to Continuing and Discontinued Noncontrolling Interest. Net income attributable to continuing noncontrolling interest for the year ended December 31, 2020 decreased $1 million compared to the year ended December 31, 2019 primarily due to the noncontrolling interest of subsidiaries acquired in connection with the Stahlgruber acquisition. Net income attributable to discontinued noncontrolling interest was immaterial and $1 million for the years ended December 31, 2020 and 2019, respectively, and related to the Stahlgruber Czech Republic wholesale business. See Note 3, "Discontinued Operations" to the consolidated financial statements in Part II, Item 8 of this Annual Report on Form 10-K for further information on this business. 44Results of Operations—Segment ReportingWe have four operating segments: Wholesale – North America, Europe, Specialty and Self Service. Our Wholesale – North America and Self Service operating segments are aggregated into one reportable segment, North America, because they possess similar economic characteristics and have common products and services, customers, and methods of distribution. Therefore, we present three reportable segments: North America, Europe and Specialty.We have presented the growth of our revenue and profitability in our operations on both an as reported and a constant currency basis. The constant currency presentation, which is a non-GAAP measure, excludes the impact of fluctuations in foreign currency exchange rates. We believe providing constant currency information provides valuable supplemental information regarding our growth and profitability, consistent with how we evaluate our performance, as this statistic removes the translation impact of exchange rate fluctuations, which are outside of our control and do not reflect our operational performance. Constant currency revenue and Segment EBITDA results are calculated by translating prior year revenue and Segment EBITDA in local currency using the current year's currency conversion rate. This non-GAAP financial measure has important limitations as an analytical tool and should not be considered in isolation or as a substitute for an analysis of our results as reported under GAAP. Our use of this term may vary from the use of similarly-titled measures by other issuers due to potential inconsistencies in the method of calculation and differences due to items subject to interpretation. In addition, not all companies that report revenue or profitability on a constant currency basis calculate such measures in the same manner as we do, and accordingly, our calculations are not necessarily comparable to similarly-named measures of other companies and may not be appropriate measures for performance relative to other companies. The following table presents our financial performance, including third party revenue, total revenue and Segment EBITDA, by reportable segment for the periods indicated (in thousands):Year Ended December 31, 2020% of Total Segment Revenue2019% of Total Segment RevenueThird Party RevenueNorth America$4,631,306 $5,208,589 Europe5,492,184 5,838,124 Specialty1,505,340 1,459,396 Total third party revenue$11,628,830 $12,506,109 Total RevenueNorth America$4,632,339 $5,209,294 Europe5,492,184 5,838,124 Specialty1,508,995 1,464,042 Eliminations(4,688)(5,351)Total revenue$11,628,830 $12,506,109 Segment EBITDANorth America$778,504 16.8 %$712,957 13.7 %Europe427,582 7.8 %454,220 7.8 %Specialty162,673 10.8 %161,184 11.0 %The key measure of segment profit or loss reviewed by our chief operating decision maker, our Chief Executive Officer, is Segment EBITDA. We use Segment EBITDA to compare profitability among our segments and evaluate business strategies. Segment EBITDA includes revenue and expenses that are controllable by the segment. Corporate general and administrative expenses are allocated to the segments based on usage, with shared expenses apportioned based on the segment's percentage of consolidated revenue. We calculate Segment EBITDA as EBITDA excluding restructuring and acquisition related expenses (which includes restructuring expenses recorded in Cost of goods sold); change in fair value of contingent consideration liabilities; other gains and losses related to acquisitions, equity method investments, or divestitures; equity in losses and earnings of unconsolidated subsidiaries; and impairment charges. EBITDA, which is the basis for Segment EBITDA, is calculated as net income attributable to LKQ stockholders excluding discontinued operations and discontinued noncontrolling interest, depreciation, amortization, interest (which includes gains and losses on debt extinguishment) and income tax expense. See Note 16, "Segment and Geographic Information" to the consolidated financial statements in Part II, Item 8 of this Annual Report on Form 10-K for a reconciliation of total Segment EBITDA to net income.45Year Ended December 31, 2020 Compared to Year Ended December 31, 2019 North AmericaThird Party Revenue. The following table summarizes the changes in third party revenue by category in our North America segment (in thousands):Year Ended December 31,Percentage Change in RevenueNorth America20202019Organic Acquisition and Divestiture (3)Foreign Exchange Total ChangeParts & services revenue$3,988,214 $4,600,903 (12.9)%(1)(0.3)%(0.1)%(13.3)%Other revenue643,092 607,686 5.5 %(2)0.4 %(0.0)%5.8 %Total third party revenue$4,631,306 $5,208,589 (10.8)%(0.2)%(0.1)%(11.1)%Note: In the table above, the sum of the individual percentages may not equal the total due to rounding.(1)Parts and services organic revenue declined despite one additional selling day in the year ended December 31, 2020 compared to the prior year period. On a per day basis, organic revenue declined 13.3%. The organic decline was impacted by collision and liability repairable auto claims, which, according to data from CCC, were 26.0% lower for the year ended December 31, 2020 compared to the prior year period. This decrease in claims activity was primarily due to the COVID-19 pandemic and had an adverse impact on sales volumes in our wholesale operations. The volume decline in collision parts was partially offset by an outperformance of the claims trend attributable to share gains, mechanical part sales and self service parts sales and admissions. Prior to the pandemic, parts and services organic revenue in North America was slightly less than the same period in the prior year, declining 1.1% through February 2020, principally due to (i) the termination in the fourth quarter of 2019 of an agreement signed in December 2017 for the distribution of batteries which had an unfavorable impact of 0.8% through February 2020 compared to the prior year period, and, (ii) to a lesser extent, milder winter weather conditions compared to the prior year period. During the period of March 2020 through December 2020, parts and services organic revenue declined 15.6% on a per day basis compared to the prior year period primarily due to volume effects caused by the COVID-19 pandemic (collision and liability repairable auto claims were down approximately 41.7%, 24.4%, and 27.2% in the second, third, and fourth quarters of 2020, respectively, according to data from CCC). Going into the first quarter of 2021, we anticipate downward pressures on aftermarket fill rates due to continued ocean freight delays, which in turn may adversely impact sales.(2)The $33 million year over year organic increase in other revenue is primarily related to a $106 million increase in revenue from precious metals (platinum, palladium and rhodium) primarily due to higher prices compared to the prior year, partially offset by (i) a $46 million decrease in revenue from other scrap metals (e.g. aluminum) and fluids due to lower volumes, (ii) an $18 million decrease in revenue from scrap steel due to lower prices and volumes, and (iii) a decrease in core revenue of $9 million due to lower volumes. The volume declines in other revenue were due to lower purchase volumes and throughput in our salvage and self service operations as a result of the COVID-19 pandemic. (3)Acquisition related growth for the year ended December 31, 2020 reflected revenue from our acquisition of three wholesale businesses and one self service business since the beginning of 2019 through the one-year anniversary of the acquisitions. Reduced revenue as a result of the disposal of our aviation business in the third quarter of 2019 more than offset the acquisition growth during this period.Segment EBITDA. Segment EBITDA increased $66 million, or 9.2%, in the year ended December 31, 2020, including the impact of one additional selling day compared to the prior year period. The adverse impact of the COVID-19 pandemic on sales volumes in our wholesale operations had a significant unfavorable impact on Segment EBITDA. This adverse impact was more than offset in part due to operational efficiency and rightsizing actions and higher revenue from precious metals. Net sequential increases in scrap steel prices in our salvage and self service operations had a $16 million favorable impact on North America Segment EBITDA during the year ended December 31, 2020, compared to a $23 million unfavorable impact during the year ended December 31, 2019 resulting from net sequential decreases in scrap steel prices. This favorable impact for the year ended December 31, 2020 resulted from the increase in scrap steel prices between the date we purchased a vehicle, which influences the price we pay for a vehicle, and the date we scrapped a vehicle, which influences the price we receive for scrapping a vehicle. 46The following table summarizes the changes in Segment EBITDA as a percentage of revenue in our North America segment:North AmericaPercentage of Total Segment RevenueSegment EBITDA for the year ended December 31, 201913.7 %Increase due to:Change in gross margin1.7 %(1)Change in segment operating expenses1.3 %(2)Segment EBITDA for the year ended December 31, 202016.8 %Note: In the table above, the sum of the individual percentages may not equal the total due to rounding.(1) The increase in gross margin primarily reflected favorable impacts of 1.2% from our wholesale operations and 0.4% from our self service operations. Despite the adverse impact of the COVID-19 pandemic on sales volumes in our wholesale operations, wholesale gross margin was favorable primarily due to the positive impact of cost reductions from operational efficiency and rightsizing actions, higher prices of precious metals and scrap steel, and improved return rates compared to the prior year period. The increase in self service gross margin was primarily attributable to higher prices of precious metals as well as sequential increases in scrap steel prices. We expect downward pressure on our salvage and self service margins going into 2021 as purchase costs increased in the second half of 2020 due to the reduced availability of cars for purchase reflecting the impact of the COVID-19 pandemic. We plan to continue to address this downward pressure through price adjustments and further operational efficiencies. We expect commodity prices to have a favorable impact on margin, at least in the short-term, as precious metals and scrap prices hold or improve from recent levels.(2) The decrease in segment operating expense as a percentage of revenue, despite the deleveraging impact of the organic revenue parts and services revenue decline of 13.3% compared to the prior year, on a per day basis, reflects (i) a favorable impact of 1.6% from personnel expenses related to permanent and temporary headcount reductions, reduced hours, limitations on travel and government grants in Canada and (ii) a 0.2% favorable impact from vehicle and fuel expenses due to fuel usage and prices. The impact was partially offset by a negative leverage effect of 0.5% from facility expenses, which are largely fixed. As the market recovers and volumes increase, we expect to bring back necessary resources to support our operations; however, we expect that permanent actions taken this year will provide a long-term favorable impact for the segment.EuropeThird Party Revenue. The following table summarizes the changes in third party revenue by category in our Europe segment (in thousands):Year Ended December 31,Percentage Change in RevenueEurope20202019Organic (1)Acquisition and Divestiture(2)Foreign Exchange (3)Total ChangeParts & services revenue$5,470,159 $5,817,547 (6.1)%(0.9)%1.1 %(6.0)%Other revenue22,025 20,577 5.4 %(0.0)%1.6 %7.0 %Total third party revenue$5,492,184 $5,838,124 (6.0)%(0.9)%1.1 %(5.9)%Note: In the table above, the sum of the individual percentages may not equal the total due to rounding.(1)The parts and services organic revenue decrease for the year ended December 31, 2020 was partially offset by having two additional selling days in 2020 compared to the year ended December 31, 2019. On a per day basis, organic parts and services revenue decreased 6.9%, mainly driven by the COVID-19 pandemic disruptions in all of our European operations. Prior to the pandemic, organic revenue in Europe had increased 0.3% through February, principally driven by the Central and Eastern European region, and to a lesser extent, Germany. During the period of March 2020 through December 2020, organic revenue declined 8.3% on a per day basis compared to the prior year period primarily due to volume effects caused by the COVID-19 pandemic. Germany and the Netherlands have been recovering at a faster rate, with the recovery in Italy and the U.K. lagging behind.(2)Acquisition related growth for the year ended December 31, 2020 reflected revenue from our acquisition of three immaterial wholesale businesses since the beginning of 2019 through the one-year anniversary of the acquisitions. Reduced revenue as a result of the disposals of a non-core telecommunications operation in Germany in the second 47quarter of 2020 and two smaller disposals during 2020 and a wholesale business in Bulgaria in the third quarter of 2019 more than offset the acquisition growth.(3)Compared to the prior year, exchange rates increased our revenue growth by $62 million, or 1.1%, primarily due to the weaker U.S. dollar against the euro and pound sterling during the year ended December 31, 2020 relative to the prior year period.Segment EBITDA. Segment EBITDA decreased $27 million, or 5.9%, for the year ended December 31, 2020 compared to the prior year period. Our Europe Segment EBITDA included a positive year over year impact of $6 million related to the translation of local currency results into U.S. dollars at higher exchange rates than those experienced during the year ended December 31, 2019. On a constant currency basis (i.e., excluding the translation impact), Segment EBITDA decreased by $32 million, or 7.1%, compared to the prior year. Refer to the Foreign Currency Impact discussion within the Results of Operations–Consolidated section above for further detail regarding foreign currency impact on our results for the year ended December 31, 2020.EuropePercentage of Total Segment RevenueSegment EBITDA for the year ended December 31, 20197.8 %Increase (decrease) due to:Change in gross margin0.5 %(1)Change in segment operating expenses(0.5)%(2)Change in other expense, net and net income attributable to continuing noncontrolling interest0.1 %Segment EBITDA for the year ended December 31, 20207.8 %Note: In the table above, the sum of the individual percentages may not equal the total due to rounding.(1) The increase in gross margin was primarily attributable to favorable impacts of (i) 0.2% across almost all our operations principally as a result of margin improvement initiatives supporting the pursuit of profitable revenue growth and (ii) 0.2% from the disposal of a non-core telecommunications operation in Germany in the second quarter of 2020.(2) The increase in segment operating expenses as a percentage of revenue reflects unfavorable impacts of (i) 0.2% from bad debt expense due to the downturn in economic conditions caused by the COVID-19 pandemic, (ii) 0.2% in transformation expenses related to the 1 LKQ Europe program, and (iii) several individually immaterial factors that had an unfavorable impact of 0.4% in the aggregate. These negative impacts were partially mitigated by actions to reduce personnel expense which generated a favorable impact of 0.3%. Despite the deleveraging impact from the third party parts and services organic revenue decline of 6.9% on a per day basis, management was able to utilize government assistance, permanent and temporary headcount reductions, and limited travel expenses to achieve this 0.3% reduction as a percentage of revenue. As the markets recovered from the second quarter low point, volumes increased and government programs ceased, we brought back necessary resources to support our operations; however, we expect that permanent actions taken this year will provide a long-term favorable impact for the segment. SpecialtyThird Party Revenue. The following table summarizes the changes in third party revenue by category in our Specialty segment (in thousands):Year Ended December 31,Percentage Change in RevenueSpecialty20202019Organic (1)Acquisition and DivestitureForeign ExchangeTotal ChangeParts & services revenue$1,505,340 $1,459,396 3.0 %0.3 %(0.1)%3.1 %Other revenue— — — %— %— %— %Total third party revenue$1,505,340 $1,459,396 3.0 %0.3 %(0.1)%3.1 %Note: In the table above, the sum of the individual percentages may not equal the total due to rounding.(1)Parts and services organic revenue increased 3.0% for the year ended December 31, 2020 compared to the prior year. On a per day basis, organic revenue increased 2.6%. The organic increase was primarily due to strong demand for recreational vehicle products and high drop ship fulfillment. We believe that organic growth was constrained by the 48impact of availability issues at certain suppliers that were not able to meet our demand due to the COVID-19 pandemic.Segment EBITDA. Segment EBITDA increased $1 million, or 0.9%, for the year ended December 31, 2020 compared to the prior year.The following table summarizes the changes in Segment EBITDA as a percentage of revenue in our Specialty segment:SpecialtyPercentage of Total Segment RevenueSegment EBITDA for the year ended December 31, 201911.0 %(Decrease) increase due to:Change in gross margin(0.6)%(1)Change in segment operating expenses0.5 %(2)Segment EBITDA for the year ended December 31, 202010.8 %Note: In the table above, the sum of the individual percentages may not equal the total due to rounding.(1) The decrease in gross margin primarily reflects unfavorable impacts of (i) 0.7% due to unfavorable product and channel mix for the year ended December 31, 2020 and (ii) 0.4% driven by higher product cost due to lower supplier discounts received in the current year compared to the prior year, partially offset by a favorable impact of (iii) 0.5% due to freight income, reflecting higher shipping and handling fees tied to increased usage of third party carriers (the offsetting delivery cost is a component of freight expense as mentioned below in the operating expenses discussion).(2) The decrease in segment operating expenses reflects a favorable impact of (i) 1.2% in personnel costs due to reduced headcount and reduced hours, partially offset by (ii) a 0.5% unfavorable impact in freight, vehicle and fuel expenses due to an increased use of third party freight, and (iii) several individually immaterial factors that had an unfavorable impact of 0.2% in the aggregate.Liquidity and Capital ResourcesThe following table summarizes liquidity data as of the dates indicated (in thousands):December 31, 2020December 31, 2019Cash and cash equivalents$312,154 $523,020 Total debt (1)2,896,676 4,072,026 Current maturities (2)58,810 326,648 Capacity under credit facilities (3)3,260,000 3,260,000 Availability under credit facilities (3)2,546,081 1,922,671 Total liquidity (cash and cash equivalents plus availability under credit facilities)2,858,235 2,445,691 (1) Debt amounts reflect the gross values to be repaid (excluding debt issuance costs of $26 million and $30 million as of December 31, 2020 and December 31, 2019, respectively).(2) Debt amounts reflect the gross values to be repaid (excluding debt issuance costs of immaterial amounts as of both December 31, 2020 and December 31, 2019).(3) Capacity under credit facilities includes our revolving credit facilities and our receivables securitization facility. Availability under credit facilities is reduced by our outstanding letters of credit.We assess our liquidity in terms of our ability to fund our operations and provide for expansion through both internal development and acquisitions. Our primary sources of liquidity are cash flows from operations and our credit facilities. We utilize our cash flows from operations to fund working capital and capital expenditures, with the excess amounts going towards funding acquisitions, paying down outstanding debt or repurchasing our common stock. As we have pursued acquisitions as part of our historical growth strategy, our cash flows from operations have not always been sufficient to cover our investing activities. To fund our acquisitions, we have accessed various forms of debt financing, including revolving credit facilities, senior notes and a receivables securitization facility.49As of December 31, 2020, we had debt outstanding and additional available sources of financing as follows:•Senior secured credit facilities maturing in January 2024, composed of term loans totaling $350 million ($324 million outstanding at December 31, 2020) and $3.15 billion in revolving credit ($643 million outstanding at December 31, 2020), bearing interest at variable rates (although a portion of the outstanding debt is hedged through interest rate swap contracts), with availability reduced by $71 million of amounts outstanding under letters of credit•Euro Notes (2024) totaling $611 million (€500 million), maturing in April 2024 and bearing interest at a 3.875% fixed rate•Euro Notes (2026/28) totaling $1.2 billion (€1.0 billion), consisting of (i) €750 million maturing in April 2026 and bearing interest at a 3.625% fixed rate, and (ii) €250 million maturing in April 2028 and bearing interest at a 4.125% fixed rate•Receivables securitization facility with availability up to $110 million (no outstanding balance as of December 31, 2020), maturing in November 2021 and bearing interest at variable commercial paper ratesAs of December 31, 2020, we had approximately $2.5 billion available under our credit facilities. Combined with $312 million of cash and cash equivalents at December 31, 2020, we had approximately $2.9 billion in available liquidity, an increase of $413 million from our available liquidity as of December 31, 2019.We believe that our current liquidity and cash expected to be generated by operating activities in future periods will be sufficient to meet our current operating and capital requirements. To support our liquidity position during the COVID-19 pandemic, we focused on preserving cash during the expected period of reduced demand. Our action plan to strengthen our liquidity position included a deferral of growth driven capital projects, reductions in inventory orders, more active monitoring of customer receivables and terms, income and value added tax deferrals, and suspension of our share buyback program, in addition to the cost saving measures discussed in the "COVID-19 Impact on Our Operations" section above. Given our success in strengthening our liquidity position as of September 30, 2020, we recommenced our share buyback program during the fourth quarter of 2020. However, due to the rapidly evolving global situation, it is not possible to predict whether unanticipated consequences of the COVID-19 pandemic are reasonably likely to materially affect our liquidity and capital resources negatively in the future.With $2.9 billion of total liquidity as of December 31, 2020 and $59 million of current maturities, we have access to funds to meet our near term commitments even if the pandemic effect extends longer than our current expectations. We have a surplus of current assets over current liabilities, which further reduces the risk of short term cash shortfalls.Our capital preservation plans delivered the desired results as we repaid approximately $327 million in borrowings from free cash flows generated in the fourth quarter as well as cash on hand and overall in 2020 repaid approximately $1.4 billion in borrowings. Our total liquidity has increased by $997 million since March 31, 2020, which we believe puts us in position to manage through the pandemic. Our total liquidity includes availability under our senior secured credit facility, which includes the two financial maintenance covenants presented below (our required debt covenants and our actual ratios with respect to those covenants as calculated per the credit agreement as of December 31, 2020):Covenant LevelRatio Achieved as of December 31, 2020Maximum net leverage ratio5.00:1.001.9Minimum interest coverage ratio3.00:1.0014.6The terms net leverage ratio and minimum interest coverage ratio used in the credit agreement are specifically calculated per the credit agreement and differ in specified ways from comparable GAAP or common usage terms.We amended our senior secured credit facility in June 2020 to increase the maximum net leverage ratio effective with our compliance certificate filed with respect to the second quarter of 2020; refer to "Senior Secured Credit Agreement" in Note 10, "Long-Term Obligations" to the consolidated financial statements in Part II, Item 8 of this Annual Report on Form 10-K for information on the June 2020 amendment. We entered into the amendment out of an abundance of caution to reduce the risk of breaching the net leverage covenant if the pandemic had a severe and extended effect on profitability. Our internal models from the first quarter of 2020 suggested that we would be able to meet our payment obligations during the pandemic, but there was a risk that we might exceed the maximum 4.0x net leverage ratio in the event a severe downside scenario developed. With the amendment and the better than forecasted performance since the pandemic began, we believe that we have significantly reduced 50the risk of a covenant breach, including by reducing our net leverage ratio further in the third and fourth quarters of 2020 relative to the second quarter. The indentures relating to our Euro Notes do not include financial maintenance covenants, and the indentures will not restrict our ability to draw funds on the credit facility. The indentures do not prohibit amendments to the financial covenants under the credit facility as needed.In the long term, while we believe that we have adequate capacity under our existing credit facilities, from time to time we may need to raise additional funds through public or private financing, strategic relationships or other arrangements. There can be no assurance that additional funding, or refinancing of our credit facilities, if needed, will be available on terms attractive to us, or at all. Furthermore, any additional equity financing may be dilutive to stockholders, and debt financing, if available, may involve restrictive covenants or higher interest costs. Our failure to raise capital if and when needed could have a material adverse impact on our business, operating results, and financial condition.From time to time, we may undertake financing transactions to increase our available liquidity, such as (i) our November 2018 amendment to our senior secured credit facility and (ii) the issuance of the Euro Notes (2026/28) in April 2018 related to the Stahlgruber acquisition. Given the long-term nature of our investment in Stahlgruber, combined with favorable interest rates, we decided to fund the acquisition primarily through long-term, fixed rate notes. We believe this approach provides financial flexibility to execute our long-term growth strategy while maintaining availability under our revolver. If we see an attractive acquisition opportunity, we have the ability to use our revolver to move quickly and have certainty of funding up to the amount of our then-available liquidity. In January 2020, we redeemed our U.S. Notes (2023) to eliminate higher cost debt with lower interest rate borrowings on our credit facilities and cash on hand. Beginning in 2019, a number of our European suppliers began participating in a supply chain financing initiative in select countries under which they may sell their accounts receivable to the participating financial institutions, allowing us to extend payment terms which in turn improves our operating cash flows. The initiative allows our suppliers to monetize the receivables prior to their payment date, subject to payment of a discount. We expect more suppliers will begin participating in our European supply chain financing initiative in 2021. Financial institutions participate in the supply chain financing initiative on an uncommitted basis and can cease purchasing receivables from our suppliers at any time. The initiative is at the sole discretion of both the supplier and the financial institution on terms that are negotiated between them. In the future, if the financial institutions did not continue to purchase receivables from our suppliers under the initiative, the participating vendors may have a need to renegotiate their payment terms with us, which in turn could cause our borrowings under our revolving credit facility to increase. All outstanding payments owed under the initiative to the participating financial institutions are recorded within Accounts payable in our Consolidated Balance Sheets.Borrowings under the credit agreement accrue interest at variable rates which are tied to LIBOR or the Canadian Dollar Offered Rate ("CDOR"), depending on the currency and the duration of the borrowing, plus an applicable margin rate that is subject to change quarterly based on our reported leverage ratio. We hold interest rate swaps to hedge the variable rates on a portion of our credit agreement borrowings, with the effect of fixing the interest rates on the respective notional amounts. In addition, we hold currency swaps that contain an interest rate swap component and a foreign currency forward contract component that, when combined with related intercompany financing arrangements, effectively convert variable rate U.S. dollar-denominated borrowings into fixed rate euro-denominated borrowings. These derivative transactions are described in Note 11, "Derivative Instruments and Hedging Activities" to the consolidated financial statements in Part II, Item 8 of this Annual Report on Form 10-K. After giving effect to these contracts, the weighted average interest rate on borrowings outstanding under our credit agreement at December 31, 2020 was 1.7%. Including our senior notes, our overall weighted average interest rate on borrowings was 3.1% at December 31, 2020. After 2021, it is unclear whether banks will continue to provide LIBOR submissions to the administrator of LIBOR. At this time, no consensus exists as to which reference rate or rates may become accepted alternatives to LIBOR, although the Alternative Reference Rates Committee, a group of market participants convened by the Federal Reserve Board and the Federal Reserve Bank of New York, has identified the Secured Overnight Financing Rate (“SOFR”) as the recommended alternative to LIBOR. On November 30, 2020, ICE Benchmark Administration, the administrator of LIBOR, with the support of the United States Federal Reserve and the United Kingdom’s Financial Conduct Authority, announced plans to consult on ceasing publication of USD LIBOR on December 31, 2021 for the one week and two month USD LIBOR tenors, and on June 30, 2023 for all other USD LIBOR tenors. While this announcement extends the transition period to June 2023, the United States Federal Reserve concurrently issued a statement advising banks to stop new USD LIBOR issuances by the end of 2021. We cannot currently predict the effect of the discontinuation of, or other changes to, LIBOR or any establishment of alternative reference rates in the United States, the European Union or elsewhere on the global capital markets. Outstanding debt under our Credit Agreement, which constitutes the most significant of our LIBOR-based debt obligations, contains provisions that address the potential discontinuation of LIBOR and facilitate the adoption of an alternative rate of interest. We do not believe that the discontinuation of LIBOR, or its replacement with an alternative reference rate or rates, such as the SOFR, will have a material impact on our results of operations, financial position or liquidity.51Cash interest payments were $107 million for the year ended December 31, 2020, including $64 million in semi-annual interest payments on our Euro Notes (2024) and Euro Notes (2026/2028). Interest payments on our Euro Notes (2024) and Euro Notes (2026/2028) are made in April and October.We had outstanding credit agreement borrowings of $967 million and $1.6 billion at December 31, 2020 and December 31, 2019, respectively. Of these amounts, $18 million was classified as current maturities at December 31, 2020 and 2019, respectively. The scheduled maturities of long-term obligations outstanding at December 31, 2020 are as follows (in thousands):Years ending December 31:2021 (1)$58,810 2022 32,757 202325,737 20241,532,638 2025 7,104 Thereafter1,239,630 Total debt (2)$2,896,676 (1) Maturities of long-term obligations due by December 31, 2021 includes $24 million of short-term debt that may be extended beyond the current due date.(2) The total debt amounts presented above reflect the gross values to be repaid (excluding debt issuance costs of $26 million as of December 31, 2020).Our credit agreement contains customary covenants that impose limitations and conditions on our ability to enter into certain transactions. The credit agreement also contains financial and affirmative covenants, including limitations on our net leverage ratio and a minimum interest coverage ratio. We were in compliance with all restrictive covenants under our credit agreement as of December 31, 2020. As of December 31, 2020, the Company had cash and cash equivalents of $312 million, of which $275 million was held by foreign subsidiaries. In general, it is our practice and intention to permanently reinvest the undistributed earnings of our foreign subsidiaries, and that position has not changed following the enactment of the Tax Act and the related imposition of the transition tax. Distributions of dividends from our foreign subsidiaries, if any, would be generally exempt from further U.S. taxation, either as a result of the 100% participation exemption under the Tax Act, or due to the previous taxation of foreign earnings under the transition tax and the GILTI regime. We believe that we have sufficient cash flow and liquidity to meet our financial obligations in the U.S. without repatriating our foreign earnings. We may, from time to time, choose to selectively repatriate foreign earnings if doing so supports our financing or liquidity objectives.The procurement of inventory is the largest operating use of our funds. We normally pay for aftermarket product purchases on standard payment terms or at the time of shipment, depending on the manufacturer and the negotiated payment terms. We normally pay for salvage vehicles acquired at salvage auctions and under direct procurement arrangements at the time that we take possession of the vehicles.The following table sets forth a summary of our aftermarket and manufactured inventory procurement for the years ended December 31, 2020 and 2019 (in thousands):Year Ended December 31,20202019Change (1)North America$1,033,500 $1,372,600 $(339,100)Europe3,503,300 3,966,000 (462,700)(2)Specialty1,056,200 1,107,200 (51,000)Total$5,593,000 $6,445,800 $(852,800)(1)Inventory purchases across all segments have decreased due to a slowdown in procurement beginning in March 2020 as a response to the COVID-19 pandemic.(2)The decrease in inventory purchases in our Europe segment was partially offset by an increase of $71 million attributable to the increase in the value of the euro, and to a lesser extent, the pound sterling, in the year ended December 31, 2020 compared to the prior year period.52The following table sets forth a summary of our global wholesale salvage and self service procurement of vehicles for the years ended December 31, 2020 and 2019 (in thousands):Year Ended December 31,20202019% ChangeNorth America wholesale salvage cars and trucks230 309 (25.6)%Europe wholesale salvage cars and trucks24 25 (4.0)%Self service and "crush only" cars574 591 (2.9)%Salvage purchases decreased relative to the prior year as we reduced buying to reflect lower demand during the COVID-19 pandemic. Purchasing began to increase as the second quarter progressed and revenue increased and continued to increase through the fourth quarter. Self service vehicle purchases declined due to supply constraints as certain outlets, such as city impound lots, were unavailable for a portion of the year and individuals held onto vehicles longer during the lockdown measures. Purchases increased towards the end of June 2020 and continued to increase through the end of the fourth quarter.We expect to continue to increase inventory purchases in the first quarter of 2021 to support the service and fill rate requirements of our businesses based on the revenue trend and expectations for 2021, including normal seasonality as we continue into winter. However, we expect to be able to operate effectively at a lower inventory balance than at the end of 2019.The following table summarizes the components of the year-over-year increase in cash provided by operating activities (in millions):Net cash provided by operating activities for the year ended December 31, 2019$1,064 Increase (decrease) due to:Operating income89 (1)Non-cash depreciation and amortization expense(15)Loss/gain on disposal of businesses and impairment of net assets held for sale(44)(2)Cash paid for taxes(67)(3)Cash paid for interest36 Working capital accounts: (4)Receivables, net67 Inventories418 Accounts payable(68)Other operating activities(36)(5)Net cash provided by operating activities for the year ended December 31, 2020$1,444 (1) Refer to the Results of Operations – Consolidated section for further information on the increase in operating income.(2) Refer to "Net Assets Held for Sale" in Note 4, "Summary of Significant Accounting Policies" to the consolidated financial statements in Part II, Item 8 of this Annual Report on Form 10-K for information on the net impairment activity recorded for the years ended December 31, 2020 and December 31, 2019.(3) Cash payments related to income taxes increased for U.S. federal and state income taxes due to (i) $94 million increase in income from continuing operations before income taxes, (ii) tax payment benefits from the loss on disposal of our aviation business in 2019, and (iii) 2018 overpayment credits carried forward into 2019.(4) Cash flows related to our primary working capital accounts can be volatile as the purchases, payments and collections can be timed differently from period to period. Receivables, net was a $67 million greater inflow in 2020 primarily due to greater cash conversion of accounts receivable balances in the year 2020 in the Europe segment (of $60 million) and the North America segment (of $38 million) and the lower revenues due to the COVID-19 pandemic. The inflows in North America and Europe were partially offset by outflows for the Specialty segment (of $31 million) as a result of increased revenues in the fourth quarter of 2020. 53 Inventories represented $418 million in incremental cash inflows in the year 2020 as a result of inventory decreases in the (i) Europe segment of $167 million, (ii) North America segment of $141 million, and (iii) Specialty segment of $110 million, due to a slowdown in inventory purchases starting in March 2020 due to the COVID-19 pandemic as we aligned our inventory balances to the projected demand. Accounts payable produced $68 million in higher cash outflows primarily due to lower accounts payable balances in the North America segment (of $259 million) and the Specialty segment (of $8 million) compared to the prior year period, as a result of a slowdown in inventory purchases due to the COVID-19 pandemic, partially offset by cash inflows for the Europe segment (of $199 million) primarily due to benefits from both improved payment terms and our supply chain financing initiative.(5) Cash flows from other operating activities decreased $18 million as a result of the timing of value added tax payables payments compared to the prior year. The remaining amount reflects a number of individually insignificant fluctuations in cash paid for other operating activities.Net cash used in investing activities totaled $166 million and $265 million for the years ended December 31, 2020 and 2019, respectively. Property, plant and equipment purchases were $173 million in 2020 compared to $266 million in the prior year. The period over period decrease in cash outflows for purchases of property, plant and equipment was due to decreased capital spending across our businesses as a result of the COVID-19 pandemic. We invested $7 million of cash, net of cash acquired, in business acquisitions during the year ended December 31, 2020 compared to $27 million during the year ended December 31, 2019. We received $22 million of net proceeds from divestitures of businesses held for sale and property, plant and equipment during the year ended December 31, 2020 compared to $35 million in the prior year period. The following table reconciles Net Cash Provided by Operating Activities to Free Cash Flow (in thousands):Year Ended December 31, 20202019Net cash provided by operating activities$1,443,870 $1,064,033 Less: purchases of property, plant and equipment172,695 265,730 Free cash flow$1,271,175 $798,303 Net cash used in financing activities totaled $1.5 billion and $601 million for the years ended December 31, 2020 and 2019, respectively. During the year ended December 31, 2020, net repayments of our borrowings totaled $1.4 billion compared to $301 million during the year ended December 31, 2019. The period over period increase in net repayments of our borrowings includes the $600 million repayment of our U.S. Notes (2023) in January 2020. We repurchased $117 million of our common stock in the year ended December 31, 2020, compared to $292 million in the year ended December 31, 2019.Although our efforts are currently scaled back due to the COVID-19 pandemic, we intend to continue to evaluate markets for potential growth through the internal development of distribution centers, processing and sales facilities, and warehouses, through further integration of our facilities, and through selected business acquisitions. Our future liquidity and capital requirements will depend upon numerous factors, including the costs and timing of our internal development efforts and the success of those efforts, the costs and timing of expansion of our sales and marketing activities, and the costs and timing of future business acquisitions. Off-Balance Sheet Arrangements and Future CommitmentsExcept as described below, we do not have any off-balance sheet arrangements or undisclosed borrowings or debt that would be required to be disclosed pursuant to Item 303 of Regulation S-K under the Securities Exchange Act of 1934. Additionally, we do not have any synthetic leases.As of December 31, 2020, there were letters of credit outstanding in the aggregate amount of $71 million. We guarantee the residual values for the majority of our leased vehicles. Had we terminated all of our operating leases subject to these guarantees at December 31, 2020, our portion of the guaranteed residual value would have totaled approximately $63 million. See Note 13, "Leases" to the consolidated financial statements in Part II, Item 8 of this Annual Report on Form 10-K for further information on leases.In December 2019, we modified the shares of a noncontrolling interest of a subsidiary acquired in connection with the Stahlgruber acquisition and issued new redeemable shares to the minority shareholder. The new redeemable shares contain a put option for all noncontrolling interest shares at a fixed price of $24 million (€21 million) for the minority shareholder exercisable in the fourth quarter of 2023. The put option is outside the control of the Company to exercise. See "Stockholders' 54Equity–Noncontrolling Interest" in Note 4, "Summary of Significant Accounting Policies" to the consolidated financial statements in Part II, Item 8 of this Annual Report on Form 10-K for further information. The following table represents our future commitments under contractual obligations as of December 31, 2020 (in millions):TotalLess than 1 Year1-3 Years3-5 YearsMore than 5 YearsContractual obligationsLong-term debt (1) $3,275.6 $140.5 $225.8 $1,628.5 $1,280.8 Finance lease obligations (2)69.0 13.1 19.3 12.2 24.4 Operating leases (3)1,877.5 298.1 473.4 328.8 777.2 Purchase obligations (4) 831.8 831.8 — — — Other long-term obligations (5)258.2 128.5 94.7 30.0 5.0 Total$6,312.1 $1,412.0 $813.2 $1,999.5 $2,087.4 (1) Our long-term debt under contractual obligations above includes interest of $436 million on the balances outstanding as of December 31, 2020. The long-term debt balance excludes debt issuance costs, as these expenses have already been paid. Interest on our senior notes, notes payable, and other long-term debt is calculated based on the respective stated rates. Interest on our variable rate credit facilities is calculated based on the weighted average rates, including the impact of interest rate swaps through their respective expiration dates, in effect for each tranche of borrowings as of December 31, 2020. Future estimated interest expense for the next year, one to three years, and three to five years is $94 million, $185 million and $100 million, respectively. Estimated interest expense beyond five years is $57 million. (2) Interest on finance lease obligations of $12 million is included based on incremental borrowing or implied rates. Future estimated interest expense for the next year, one to three years, and three to five years is $1 million, $1 million and $1 million, respectively. Estimated interest expense beyond five years is $9 million.(3) The operating lease payments above do not include certain tax, insurance and maintenance costs, which are also required contractual obligations under our operating leases but are generally not fixed and can fluctuate from year to year. Also, we have excluded future minimum lease payments for leases that have been signed but have not commenced as of December 31, 2020.(4) Our purchase obligations include open purchase orders for aftermarket inventory. (5) Our other long-term obligations consist of (i) estimated payments for our self-insurance reserves of $98 million, (ii) outstanding estimated payments of $32 million on the repatriation of earnings as a result of the Tax Act, (iii) $30 million of social security tax deferrals related to COVID-19 relief, (iv) a total of $5 million of guaranteed dividend payments to be made in quarterly installments through January 2024 to the minority shareholder of a subsidiary acquired in connection with the Stahlgruber acquisition, and (v) $93 million representing primarily other asset purchase commitments and payments for deferred compensation plans. The table above excludes amounts related to our defined benefit pension plans. As of December 31, 2020, the projected benefit obligation for our defined benefit pension plans was $212 million, and the fair value of the related plan assets was $59 million. Total expected contributions to our pension plans, including amounts that we expect to pay in benefits directly to participants, are $4 million for the year ended December 31, 2021. Benefit payments for our funded plans will be made from plan assets, whereas benefit payments for our unfunded plans are made from cash flows from operating activities. See Note 14, "Employee Benefit Plans" to the consolidated financial statements in Part II, Item 8 of this Annual Report on Form 10-K for further information related to our pension plans, including information related to expected benefit payments for the next 10 years and the plan assets available to satisfy those benefit payments. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKWe are exposed to market risks arising from adverse changes in:•foreign exchange rates;•interest rates; and•commodity prices.55Foreign Exchange RatesForeign currency fluctuations may impact the financial results we report for the portions of our business that operate in functional currencies other than the U.S. dollar. Our operations outside of the U.S. represented 50.5% and 50.3% of our revenue during the years ended December 31, 2020 and 2019, respectively. An increase or decrease in the strength of the U.S. dollar against these currencies by 10% would result in a 5.1% change in our consolidated revenue and a 2.6% change in our operating income for the year ended December 31, 2020. See our Results of Operations discussion in Part II, Item 7 of this Annual Report on Form 10-K for additional information regarding the impact of fluctuations in exchange rates on our year over year results.Additionally, we are exposed to foreign currency fluctuations with respect to the purchase of aftermarket products from foreign countries, primarily in Europe and Asia. To the extent that our inventory purchases are not denominated in the functional currency of the purchasing location, we are exposed to exchange rate fluctuations. In several of our operations, we purchase inventory from manufacturers in Taiwan in U.S. dollars, which exposes us to fluctuations in the relationship between the local functional currency and the U.S. dollar, as well as fluctuations between the U.S. dollar and the Taiwan dollar. We hedge our exposure to foreign currency fluctuations related to a portion of inventory purchases in our Europe operations, but the notional amount and fair value of these foreign currency forward contracts at December 31, 2020 were immaterial. We do not currently attempt to hedge foreign currency exposure related to our foreign currency denominated inventory purchases in our North America operations, and we may not be able to pass on any resulting price increases to our customers.To the extent that we are exposed to foreign currency fluctuations related to non-functional currency denominated financing transactions, we may hedge the exposure through the use of foreign currency forward contracts. As of December 31, 2020, we held short term foreign currency forward contracts with notional amounts of €142 million, £75 million and SEK 227 million. Only the SEK denominated foreign currency forward contract was designated as a cash flow hedge; the fair value was a liability of $1 million as of December 31, 2020. In February 2021, we entered into a short term foreign currency forward contract for $250 million to mitigate our exposure to non-functional currency borrowings in our European operations. We currently expect to enter into a similar instrument when this one matures in the first quarter of 2021. The values of these contracts are subject to changes in foreign currency exchange rates.Other than with respect to a portion of our foreign currency denominated inventory purchases and certain financing transactions, we do not hold derivative contracts to hedge foreign currency risk. Our net investment in foreign operations is partially hedged by the foreign currency denominated borrowings we use to fund foreign acquisitions; however, our ability to use foreign currency denominated borrowings to finance our foreign operations may be limited based on local tax laws. We have elected not to hedge the foreign currency risk related to the interest payments on foreign third party borrowings as we generate cash flows in the local currencies that can be used to fund debt payments. As of December 31, 2020, we had outstanding borrowings of €500 million under our Euro Notes (2024) and €1.0 billion under our Euro Notes (2026/28); we had no foreign borrowings under our revolving credit facilities. As of December 31, 2019, we had outstanding borrowings of €500 million under our Euro Notes (2024), €1.0 billion under our Euro Notes (2026/28), and £208 million, €229 million, CAD $130 million, and SEK 270 million under our revolving credit facilities.Interest RatesOur results of operations are exposed to changes in interest rates primarily with respect to borrowings under our credit facilities, where interest rates are tied to the prime rate, LIBOR or CDOR. Therefore, we implemented a policy to manage our exposure to variable interest rates on a portion of our outstanding variable rate debt instruments through the use of interest rate swap contracts. These contracts convert a portion of our variable rate debt to fixed rate debt, matching the currency, effective dates and maturity dates to specific debt instruments. We designate our interest rate swap contracts as cash flow hedges, and net interest payments or receipts from interest rate swap contracts are included as adjustments to interest expense. As of December 31, 2020, we held interest rate swap contracts with a total notional amount of $480 million, maturing in January 2021 and June 2021 ($150 million remains outstanding as of the filing date of this Annual Report on Form 10-K). All of our interest rate swap contracts have been executed with banks that we believe are creditworthy (Wells Fargo Bank, N.A.; Bank of America, N.A.; Citizens, N.A.; HSBC Bank USA, N.A.; and Banco Bilbao Vizcaya Argentaria, S.A.). As of December 31, 2020, the fair value of the interest rate swap contracts was a liability of $1 million. The values of such contracts are subject to changes in interest rates.In addition to these interest rate swaps, as of December 31, 2020, we held cross currency swap agreements for a total notional amount of €340 million with maturity dates in January 2021. These cross currency swaps contain an interest rate swap component and a foreign currency forward contract component that, combined with related intercompany financing arrangements, effectively convert variable rate U.S. dollar-denominated borrowings into fixed rate euro-denominated borrowings. The swaps are intended to reduce uncertainty in cash flows in U.S. dollars and euros in connection with intercompany financing arrangements. The cross currency swaps were also executed with banks we believe are creditworthy (Wells Fargo Bank, N.A.; Bank of America, N.A.; and MUFG Bank, Ltd. ("MUFG")). As of December 31, 2020, 56the fair value of our cross currency swaps was a liability of $56 million. The values of these contracts are subject to changes in interest rates and foreign currency exchange rates.In total, we had 87% (16% excluding the cash flow hedges that matured in January 2021) of our variable rate debt under our credit facilities at fixed rates at December 31, 2020 compared to 59% at December 31, 2019. See Note 10, "Long-Term Obligations" and Note 11, "Derivative Instruments and Hedging Activities" to the consolidated financial statements in Part II, Item 8 of this Annual Report on Form 10-K for additional information.At December 31, 2020, we had approximately $128 million of variable rate debt that was not hedged. Using sensitivity analysis, a 100 basis point movement in interest rates would change interest expense by $1 million over the next twelve months. Commodity PricesWe are exposed to market risk related to price fluctuations in scrap metal and other metals (including precious metals such as platinum, palladium and rhodium). Market prices of these metals affect the amount that we pay for our inventory and the revenue that we generate from sales of these metals. As both our revenue and costs are affected by the price fluctuations, we have a natural hedge against the changes. However, there is typically a lag between the effect on our revenue from metal price fluctuations and inventory cost changes, and there is no guarantee that the vehicle costs will decrease or increase at the same rate as the metals prices. Therefore, we can experience positive or negative gross margin effects in periods of rising or falling metals prices, particularly when such prices move rapidly. Additionally, if market prices were to change at a greater rate than our vehicle acquisition costs, we could experience a positive or negative effect on our operating margin. The average of scrap metal prices for 2020 was relatively flat compared to the average for 2019.57
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+Item 7. CNA is subject to extensive existing state, local, federal and foreign governmental regulations that restrict its ability to do business and generate revenues; additional regulation or significant modification to existing regulations or failure to comply with regulatory requirements may have a materially adverse effect on CNA’s business, results of operations and financial condition. The insurance industry is subject to comprehensive and detailed regulation and supervision. Most insurance regulations are designed to protect the interests of CNA’s policyholders and third-party claimants rather than its investors. Each jurisdiction in which CNA does business has established supervisory agencies that regulate the manner in which CNA conducts its business. Any changes in regulation could impose significant burdens on CNA. In addition, the Lloyd’s marketplace sets rules under which its members, including CNA’s Hardy syndicate, operate. These rules and regulations relate to, among other things, the standards of solvency (including risk-based capital measures), government-supported backstops for certain catastrophic events (including terrorism), investment restrictions, accounting and reporting methodology, establishment of reserves and potential assessments of funds to settle covered claims against impaired, insolvent or failed private or quasi-governmental insurers. Regulatory powers also extend to premium rate regulations which require that rates not be excessive, inadequate or unfairly discriminatory. State jurisdictions ensure compliance with such regulations through market conduct exams, which may result in losses to the extent non-compliance is ascertained, either as a result of failure to document transactions properly or failure to comply with internal guidelines, or otherwise. CNA may also be required by the jurisdictions in which it does business to provide coverage to persons who would not otherwise be considered eligible or restrict CNA from withdrawing from unprofitable lines of business or unprofitable market areas. Each jurisdiction dictates the types of insurance and the level of coverage that must be provided to such involuntary risks. CNA’s share of these involuntary risks is mandatory and generally a function of its respective share of the voluntary market by line of insurance in each jurisdiction. Risks Related to Us and Our Subsidiary, Boardwalk Pipelines Boardwalk Pipelines’ natural gas transportation and storage operations are subject to extensive regulation by the FERC, including rules and regulations related to the rates it can charge for its services and its ability to construct or abandon facilities. Boardwalk Pipelines may not be able to recover the full cost of operating its pipelines, including earning a reasonable return. Boardwalk Pipelines’ natural gas transportation and storage operations are subject to extensive regulation by the FERC, including the types, rates and terms of services Boardwalk Pipelines may offer to its customers, construction of new facilities, creation, modification or abandonment of services or facilities and recordkeeping and relationships with affiliated companies. An adverse FERC action in any of these areas could affect Boardwalk Pipelines’ ability to compete for business, construct new facilities, offer new services or recover the full cost of operating its pipelines. This regulatory oversight can result in longer lead times to develop and complete any future project than competitors that are not subject to the FERC’s regulations. The FERC can also deny Boardwalk Pipelines the right to abandon certain facilities from service. 24 Table of Contents The FERC also regulates the rates Boardwalk Pipelines can charge for its natural gas transportation and storage operations. For cost-based services, the FERC establishes both the maximum and minimum rates Boardwalk Pipelines can charge. The basic elements that the FERC considers are the costs of providing service, the volumes of gas being transported, the rate design, the allocation of costs between services, the capital structure and the rate of return a pipeline is permitted to earn. Boardwalk Pipelines may not be able to recover its costs, including certain costs associated with pipeline integrity, through existing or future rates. The FERC and/or Boardwalk Pipelines’ customers could challenge the maximum applicable rates that any of its regulated pipelines are allowed to charge in accordance with Section 5 of the NGA. Potential legislation that would amend Section 5 of the NGA to add refund provisions could increase the likelihood of such a challenge. If such a challenge is successful for any of Boardwalk Pipelines’ pipelines, the revenues associated with transportation and storage services the pipeline provides pursuant to cost-of-service rates could materially decrease in the future, which would adversely affect the revenues on that pipeline going forward. Legislative and regulatory initiatives relating to pipeline safety that require the use of new or more prescriptive compliance activities, substantial changes to existing integrity management programs or withdrawal of regulatory waivers could subject Boardwalk Pipelines to increased capital and operating costs and operational delays. Boardwalk Pipelines’ interstate pipelines are subject to regulation by PHMSA, which is part of the DOT. PHMSA regulates the design, installation, testing, construction, operation, and maintenance of existing interstate natural gas and NGLs pipeline facilities. PHMSA regulation currently requires pipeline operators to implement integrity management programs, including frequent inspections, correction of certain identified anomalies and other measures to promote pipeline safety in HCAs, MCAs, Class 3 and Class 4 areas, as well as in areas unusually sensitive to environmental damage and commercially navigable waterways. States have jurisdiction over certain of Boardwalk Pipelines’ intrastate pipelines and have adopted regulations similar to existing PHMSA regulations. State regulations may impose more stringent requirements than found under federal law that affect Boardwalk Pipelines’ intrastate operations. Compliance with these rules over time generally has resulted in an overall increase in maintenance costs. The imposition of new or more stringent pipeline safety rules applicable to natural gas or NGL pipelines, or any issuance or reinterpretation of guidance from PHMSA or any state agencies with respect thereto could cause Boardwalk Pipelines to install new or modified safety controls, pursue additional capital projects or conduct maintenance programs on an accelerated basis, any or all of which tasks could result in Boardwalk Pipelines incurring increased capital and operating costs, experiencing operational delays and suffering potential adverse impacts to its operations or ability to reliably serve its customers. Requirements that are imposed under the 2011 Act or the more recent 2016 Act may also increase Boardwalk Pipelines’ capital and operating costs or impact the operation of its pipelines. In the Fiscal Year 2021 Omnibus Appropriations Bill, Congress reauthorized PHMSA through fiscal year 2023 and directed the agency to move forward with several regulatory actions. Any new pipeline safety legislation or implementing regulations could impose more stringent or costly compliance obligations on Boardwalk Pipelines and could require it to pursue additional capital projects or conduct integrity or maintenance programs on an accelerated basis, any or all of which tasks could result in Boardwalk Pipelines incurring increased operating costs that could have a material adverse effect on its costs of providing transportation services. Boardwalk Pipelines has entered into certain firm transportation contracts with shippers on certain of its expansion projects that utilize the design capacity of certain of its pipeline assets, based upon the authority Boardwalk Pipelines received from PHMSA to operate those pipelines at higher than normal operating pressures of up to 0.80 of the pipeline’s SMYS under issued permits with specific conditions. PHMSA retains discretion to withdraw or modify this authority. If PHMSA were to withdraw or materially modify such authority, it could affect Boardwalk Pipelines’ ability to transport all of its contracted quantities of natural gas on these pipeline assets and it could incur significant additional costs to reinstate this authority or to develop alternate ways to meet its contractual obligations. Boardwalk Pipelines’ actual construction and development costs could exceed its forecasts, its anticipated cash flow from construction and development projects will not be immediate and its construction and development projects may not be completed on time or at all. Boardwalk Pipelines has been and is currently engaged in several construction projects involving its existing assets and the construction of new facilities for which it has expended or will expend significant capital. Boardwalk Pipelines expects to continue to engage in the construction of additional growth projects and modifications of its system. When Boardwalk Pipelines builds a new pipeline or expands or modifies an existing facility, the design, construction and 25 Table of Contents development occurs over an extended period of time, and it will not receive any revenue or cash flow from that project until after it is placed into commercial service. On Boardwalk Pipelines’ interstate pipelines there are several years between when the project is announced and when customers begin using the new facilities. During this period, Boardwalk Pipelines spends capital and incurs costs without receiving any of the financial benefits associated with the projects. The construction of new assets involves regulatory (federal, state and local), landowner opposition, environmental, activist, legal, political, materials and labor costs, as well as operational and other risks that are difficult to predict and some are beyond Boardwalk Pipelines’ control. A project may not be completed on time or at all due to a variety of factors, may be impacted by significant cost overruns or may be materially changed prior to completion as a result of developments or circumstances that Boardwalk Pipelines is not aware of when it commits to the project. Any of these events could result in material unexpected costs or have a material adverse effect on Boardwalk Pipelines’ ability to realize the anticipated benefits from its growth projects. Legislative and regulatory initiatives related to climate change make Boardwalk Pipelines’ operations as well as the operations of its fossil fuel producer customers subject to a series of regulatory, political, litigation and financial risks associated with the production and processing of fossil fuels and emission of greenhouse gases (“GHGs”). The threat of climate change continues to attract considerable attention in the U.S. and in foreign countries. Numerous proposals have been made and could continue to be made at the international, national, regional and state levels of government to monitor and limit existing emissions of GHGs as well as to restrict or eliminate such future emissions, which makes Boardwalk Pipelines operations as well as the operations of its fossil fuel producer customers subject to a series of regulatory, political, litigation and financial risks associated with the production and processing of fossil fuels and emission of GHGs. In the U.S., no comprehensive climate change legislation has been implemented at the federal level. With the U.S. Supreme Court finding that GHG emissions constitute a pollutant under the CAA, the Environmental Protection Agency (“EPA”) has adopted several rules that, among other things, establish construction and operating permit reviews for GHG emissions from certain large stationary sources, require the monitoring and annual reporting of GHG emissions from certain natural gas system sources in the U.S., implement New Source Performance Standards (“NSPS”) directing the reduction of methane from certain new, modified or reconstructed facilities in the natural gas sector, and together with the DOT, implement GHG emissions limits on vehicles manufactured for operation in the U.S. In recent years, there has been considerable uncertainty surrounding regulation of methane emissions, as the EPA under the Obama Administration published final regulations under the CAA establishing new performance standards for methane in 2016, but since that time the EPA under the Trump Administration has undertaken several measures, including publishing in September of 2020 final rule policy and technical amendments to the NSPS, for stationary sources of air emissions. The policy amendments, effective September 14, 2020, notably removed the transmission and storage sector from the regulated source category and rescinded methane and volatile organic compound (“VOC”) requirements for the remaining sources that were established by former President Obama’s Administration; whereas the technical amendments, effective November 16, 2020, included changes to fugitive emissions monitoring and repair schedules for gathering and boosting compressor stations and low-production wells, and recordkeeping and reporting requirements. Various states and industry and environmental groups are separately challenging both the original 2016 standards and the EPA's September 2020 final rules, and on January 20, 2021, President Biden issued an executive order, that directed the EPA to reconsider the technical amendments and issue a proposed rule suspending, revising or rescinding those amendments by no later than September of 2021. A reconsideration of the September 2020 policy amendments is expected to follow. The January 20, 2021, executive order also directed the establishment of new methane and VOC standards applicable to existing oil and gas operations, including the production, transmission, processing and storage segments. Various states and groups of states have adopted or are considering adopting legislation, regulations or other regulatory initiatives that are focused on such areas as GHG cap and trade programs, carbon taxes, reporting and tracking programs and restriction of emissions. At the international level, the non-binding Paris Agreement requests that nations limit their GHG emissions through individually-determined reduction goals every five years after 2020. Although the U.S. had withdrawn from the Paris Agreement, President Biden has issued executive orders recommitting the U.S. to the Paris Agreement and calling for the federal government to begin formulating the U.S.’ nationally determined emissions reduction goal under the agreement. With the U.S. recommitting to the Paris Agreement, additional executive orders may be issued or federal legislation or regulatory initiatives may be adopted to achieve the Paris Agreement’s goals. 26 Table of Contents Governmental, scientific and public concern over the threat of climate change arising from GHG emissions has resulted in increasing political risks in the U.S. On January 27, 2021, President Biden issued an executive order that commits to substantial action on climate change, calling for, among other things, suspending the issuance of new leases for oil and gas development on federal lands, pending completion of a review of leasing and permitting practices and expanding on the Acting Secretary of the U.S. Department of the Interior's January 20, 2020 order, effective immediately, that suspends new oil and gas leases and drilling permits on federal lands and waters for a period of 60 days. The executive order also called for the increased use of zero-emissions vehicles by the federal government, the elimination of subsidies provided to the fossil fuel industry, and an increased emphasis on climate-related risks across government agencies and economic sectors. Legal challenges to these suspensions are expected, with at least one industry group filing a lawsuit on January 27, 2021, in Wyoming federal district court and seeking to have the moratorium declared invalid. The new presidential administration could also pursue the imposition of more restrictive requirements for the establishment of pipeline infrastructure or the permitting of LNG export facilities, as well as more restrictive GHG emissions limitations for oil and gas facilities. Litigation risks are also increasing, as a number of cities and other local governments have sought to bring suit against fossil fuel producer companies in state or federal court, alleging that such companies created public nuisances by producing fuels that contributed to global warming effects, such as rising sea levels, and are responsible for roadway and infrastructure damages as a result, or alleging that the companies have been aware of the adverse effects of climate change for some time but defrauded their investors or customers by failing to adequately disclose those impacts. There are also increasing financial risks for fossil fuel energy companies as investors in fossil fuel energy companies become increasingly concerned about the potential effects of climate change and may elect in the future to shift some or all of their investments into non-energy related sectors. Institutional lenders who provide financing to fossil fuel energy companies also have become more attentive to sustainable lending practices and some of them may elect not to provide funding for fossil fuel energy companies. Additionally, there is the possibility that financial institutions will be required to adopt policies that limit funding for fossil fuel energy companies. Recently, the Federal Reserve announced that it has joined the Network for Greening the Financial System, a consortium of financial regulators focused on addressing climate-related risks in the financial sector. This could make it more difficult for Boardwalk Pipelines to secure funding for exploration and production or midstream energy business activities. The adoption and implementation of new or more stringent international, federal or state legislation, regulations or other regulatory initiatives that impose more stringent standards for GHG emissions from the oil and gas sector or otherwise restrict the areas in which this sector may produce fossil fuels or generate GHG emissions could result in increased costs of compliance or costs of consuming, and thereby reduce demand for fossil fuels, which could reduce demand for Boardwalk Pipelines’ transportation and storage services. Political, litigation and financial risks may result in its fossil fuel producer customers restricting or canceling production activities, incurring liability for infrastructure damages as a result of climatic changes or impairing their ability to continue to operate in an economic manner, which also could reduce demand for Boardwalk Pipelines’ services. Moreover, the increased competitiveness of alternative energy sources (such as wind, solar, geothermal, tidal and biofuels) could reduce demand for hydrocarbons, and for Boardwalk Pipelines’ services. Finally, increasing concentrations of GHG in the earth’s atmosphere may produce climate changes that have significant physical effects, such as increased frequency and severity of storms, droughts, floods, rising sea levels and other climatic events. The outbreak of COVID-19 and the measures to mitigate the spread of COVID-19 could materially adversely affect Boardwalk Pipelines’ business, financial condition and results of operations and those of its customers, suppliers and other business partners. The global outbreak of COVID-19 has materially negatively impacted worldwide economic and commercial activity and financial markets and has impacted global demand for oil and petrochemical products. COVID-19 has also resulted in significant business and operational disruptions, including business closures, supply chain disruptions, travel restrictions, stay-at-home orders and limitations on the availability of workforces. If significant portions of Boardwalk Pipelines’ workforce are unable to work effectively, including because of illness, quarantines, government actions, facility closures or other restrictions in connection with COVID-19, its business could be materially adversely affected. Boardwalk Pipelines may also be unable to perform fully on its contracts, and its costs may increase as a result of the COVID-19 outbreak. These cost increases may not be fully recoverable. It is possible that the continued spread of COVID-19 could also further cause disruption in Boardwalk Pipelines’ customers’ business; cause delay, or limit the ability of its customers to perform, including in making timely payments to it; and cause other 27 Table of Contents unpredictable events. The impact of COVID-19 has impacted capital markets, which may impact Boardwalk Pipelines’ customers’ financial position, and recoverability of its receivables from its customers may be at risk. The full impact of COVID-19 is unknown and continues to evolve. The extent to which COVID-19 negatively impacts Boardwalk Pipelines’ business and operations will depend on the severity, location and duration of the effects and spread of COVID-19, the continued actions undertaken by national, regional and local governments and health officials to contain the virus or treat its effects, and how quickly and to what extent economic conditions improve and normal business and operating conditions resume. It might also have the effect of increasing several of the other risk factors contained herein. Changes in energy prices, including natural gas, oil and NGLs, impact the supply of and demand for those commodities, which impact Boardwalk Pipelines’ business. Boardwalk Pipelines’ customers, especially producers and certain plant operators, are directly impacted by changes in commodity prices. The prices of natural gas, oil and NGLs fluctuate in response to changes in both domestic and worldwide supply and demand, market uncertainty and a variety of additional factors, including for natural gas the realization of potential LNG exports and demand growth within the power generation market. The recent volatility in the pricing levels of natural gas, oil and NGLs has adversely affected the businesses of certain of Boardwalk Pipelines’ producer customers and could result in defaults or the non-renewal of Boardwalk Pipelines’ contracted capacity when existing contracts expire. The current erosion in commodity prices could affect the operations of certain of Boardwalk Pipelines’ industrial customers, including the temporary closure or reduction of plant operations, resulting in decreased deliveries to those customers. Future increases in the price of natural gas and NGLs could make alternative energy and feedstock sources more competitive and decrease demand for natural gas and NGLs. A reduced level of demand for natural gas and NGLs could diminish the utilization of capacity on Boardwalk Pipelines’ systems and reduce the demand of its services. The price differentials between natural gas supplies and market demand for natural gas have reduced the transportation rates that Boardwalk Pipelines can charge on certain portions of its pipeline systems. Each year a portion of Boardwalk Pipelines firm natural gas transportation contracts expire and need to be replaced or renewed. Over the past several years, as a result of market conditions, Boardwalk Pipelines has renewed some expiring contracts at lower rates or for shorter terms than in the past. The transportation rates Boardwalk Pipelines is able to charge customers are heavily influenced by market trends (both short and longer term), including the available supply, geographical location of natural gas production, the competition between producing basins, competition with other pipelines for supply and markets, the demand for gas by end-users such as power plants, petrochemical facilities and LNG export facilities and the price differentials between the gas supplies and the market demand for the gas (basis differentials). Market conditions have resulted in a sustained narrowing of basis differentials on certain portions of Boardwalk Pipelines’ pipeline system, which has reduced transportation rates that can be charged in the affected areas and adversely affected the contract terms Boardwalk Pipelines can secure from its customers for available transportation capacity and for contracts being renewed or replaced. Boardwalk Pipelines expects these market conditions to continue. Boardwalk Pipelines is exposed to credit risk relating to default or bankruptcy by its customers. Credit risk relates to the risk of loss resulting from the default by a customer of its contractual obligations or the customer filing bankruptcy. Boardwalk Pipelines has credit risk with both its existing customers and those supporting its growth projects. Credit risk exists in relation to Boardwalk Pipelines’ growth projects, both because expansion customers make long term firm capacity commitments to Boardwalk Pipelines for such projects and certain of those expansion customers agree to provide credit support as construction for such projects progresses. If a customer fails to post the required credit support or defaults during the growth project process, overall returns on the project may be reduced to the extent an adjustment to the scope of the project occurs or Boardwalk Pipelines is unable to replace the defaulting customer with a customer willing to pay similar rates. In 2020 and 2019, two expansion customers declared bankruptcy for which Boardwalk Pipelines was able to use the credit support obtained during the growth project process to cover a portion of the customer’s remaining long term commitment. 28 Table of Contents Boardwalk Pipelines’ credit exposure also includes receivables for services provided, future performance under firm agreements and volumes of gas owed by customers for imbalances or gas loaned by Boardwalk Pipelines to them under certain NNS and parking and lending (“PAL”) services. Boardwalk Pipelines’ revolving credit facility contains operating and financial covenants that restrict its business and financing activities. Boardwalk Pipelines’ revolving credit facility contains operating and financial covenants that may restrict its ability to finance future operations or capital needs or to expand or pursue business activities. Its credit agreement limits its ability to make loans or investments, make material changes to the nature of its business, merge, consolidate or engage in asset sales, or grant liens or make negative pledges. This agreement also requires it to maintain a ratio of consolidated debt to consolidated EBITDA (as defined in the agreement) of not more than 5.0 to 1.0, or up to 5.5 to 1.0 for the three quarters following a qualified acquisition or series of acquisitions, where the purchase price exceeds $100.0 million over a rolling 12-month period, which limits the amount of additional indebtedness Boardwalk Pipelines can incur to grow its business, and could require it to reduce indebtedness if its earnings before interest, income taxes, depreciation and amortization (“EBITDA”) decreases to a level that would cause it to breach this covenant. Future financing agreements Boardwalk Pipelines may enter into could contain similar or more restrictive covenants or may not be as favorable as those under its existing indebtedness. Boardwalk Pipelines’ ability to comply with the covenants and restrictions contained in its credit agreement may be affected by events beyond its control, including economic, financial and market conditions. If market, economic conditions or its financial performance deteriorate, its ability to comply with these covenants may be impaired. If Boardwalk Pipelines is not able to incur additional indebtedness, it may be required to seek other sources of funding that may be on less favorable terms. If it defaults under its credit agreement or another financing agreement, significant additional restrictions may become applicable. In addition, a default could result in a significant portion of its indebtedness becoming immediately due and payable, and its lenders could terminate their commitment to make further loans to it. If such event occurs, Boardwalk Pipelines would not have, and may not be able to obtain, sufficient funds to make these accelerated payments. Boardwalk Pipelines’ substantial indebtedness could affect its ability to meet its obligations and may otherwise restrict its activities. As of December 31, 2020, Boardwalk Pipelines had $3.5 billion in principal amount of long-term debt outstanding, including amounts borrowed under its revolving credit facility. This level of debt requires significant interest payments. Boardwalk Pipelines’ inability to generate sufficient cash flow to satisfy its debt obligations, or to refinance its obligations on commercially reasonable terms, would have a material adverse effect on its business. Boardwalk Pipelines’ substantial indebtedness could have important consequences. For example, it could: • limit Boardwalk Pipelines’ ability to borrow money for its working capital, capital expenditures, debt service requirements or other general business activities; • impact the ratings received from credit rating agencies; • increase Boardwalk Pipelines’ vulnerability to general adverse economic and industry conditions; and • limit Boardwalk Pipelines’ ability to respond to business opportunities, including growing its business through acquisitions. Boardwalk Pipelines is permitted, under its revolving credit facility and the indentures governing its notes, to incur additional debt, subject to certain limitations under its revolving credit facility and, in the case of unsecured debt, under the indentures governing the notes. If Boardwalk Pipelines incurs additional debt, its increased leverage could also result in the consequences described above. 29 Table of Contents Limited access to the debt markets and increases in interest rates could adversely affect Boardwalk Pipelines’ business. Boardwalk Pipelines anticipates funding its capital spending requirements through its available financing options, including cash generated from operations and borrowings under its revolving credit facility. Changes in the debt markets, including market disruptions, limited liquidity, and an increase in interest rates, may increase the cost of financing as well as the risks of refinancing maturing debt. This may affect its ability to raise needed funding and reduce the amount of cash available to fund its operations or growth projects. If the debt markets were not available, it is not certain if other adequate financing options would be available to Boardwalk Pipelines on terms and conditions that it would find acceptable. Any disruption in the debt markets could require Boardwalk Pipelines to take additional measures to conserve cash until the markets stabilize or until it can arrange alternative credit arrangements or other funding for its business needs. Such measures could include reducing or delaying business activities, reducing its operations to lower expenses and reducing other discretionary uses of cash. Boardwalk Pipelines may be unable to execute its growth strategy or take advantage of certain business opportunities. Boardwalk Pipelines does not own all of the land on which its pipelines and facilities are located, which could result in disruptions to its operations. Substantial portions of Boardwalk Pipelines’ pipelines, storage and other facilities are constructed and maintained on property owned by others pursuant to rights-of-way, easements, permits, licenses or consents, and Boardwalk Pipelines is subject to the possibility of more onerous terms and/or increased costs to retain necessary land use rights if it does not have valid land use rights or if such land use rights lapse or terminate. Some of the rights to construct and operate Boardwalk Pipelines’ pipelines storage or other facilities on land owned by third parties and governmental agencies that it obtains are for specific periods of time. Boardwalk Pipelines cannot guarantee that it will always be able to renew, when necessary, existing land use rights or obtain new land use rights without experiencing significant costs or experiencing landowner opposition. Any loss of these land use rights with respect to the operation of Boardwalk Pipelines’ pipelines, storage and other facilities, through its inability to renew right-of-way or easement contracts or permits, licenses, consents or otherwise, could have a material adverse effect on its operations. Rising sea levels, subsidence and erosion could damage Boardwalk Pipelines’ pipelines and the facilities that serve its customers, particularly along coastal waters and offshore in the Gulf of Mexico. Boardwalk Pipelines’ pipeline operations along coastal waters and offshore in the Gulf of Mexico could be impacted by rising sea levels, subsidence and erosion. Subsidence issues are also a concern for Boardwalk Pipelines’ pipelines at major river crossings. Rising sea levels, subsidence and erosion could cause serious damage to its pipelines, which could affect its ability to provide transportation services or result in leakage, migration, releases or spills from its operations to surface or subsurface soils, surface water, groundwater or offshore waters, which could result in liability, remedial obligations and/or otherwise have a negative impact on continued operations. Such rising sea levels, subsidence and erosion processes could impact Boardwalk Pipelines’ customers who operate along coastal waters or offshore in the Gulf of Mexico, and they may be unable to utilize Boardwalk Pipelines services. Rising sea levels, subsidence and erosion could also expose Boardwalk Pipelines’ operations to increased risks associated with severe weather conditions and other adverse events and conditions, such as hurricanes and flooding. As a result, Boardwalk Pipelines may incur significant costs to repair and preserve its pipeline infrastructure. In recent years, local governments and landowners have filed lawsuits in Louisiana against energy companies, alleging that their operations contributed to increased coastal rising seas and erosion and seeking substantial damages. Boardwalk Pipelines may not be successful in executing its strategy to grow and diversify its business. Boardwalk Pipelines relies primarily on the revenues generated from its natural gas transportation and storage services. Negative developments in these services have significantly greater impact on Boardwalk Pipelines’ financial condition and results of operations than if it maintained more diverse assets. Boardwalk Pipelines’ ability to grow, diversify and increase cash flows will depend, in part, on its ability to expand its existing business lines and to close and execute on accretive acquisitions. Boardwalk Pipelines may not be successful in acquiring or developing such assets or may do so on terms that ultimately are not profitable. Any such transactions involve potential risks that may include, among other things: 30 Table of Contents • the diversion of management’s and employees’ attention from other business concerns; • inaccurate assumptions about volume, revenues and project costs, including potential synergies; • a decrease in Boardwalk Pipelines’ liquidity as a result of using available cash or borrowing capacity to finance the acquisition or project; • a significant increase in interest expense or financial leverage if it incurs additional debt to finance the acquisition or project or if Boardwalk Pipelines makes inaccurate assumptions about the overall costs of debt; • an inability to hire, train or retain qualified personnel to manage and operate the acquired business and assets or the developed assets; • unforeseen difficulties operating in new product areas or new geographic areas; and • changes in regulatory requirements or delays of regulatory approvals. Additionally, acquisitions also contain the following risks: • an inability to integrate successfully the businesses Boardwalk Pipelines acquires; • the assumption of unknown liabilities for which it is not indemnified, for which its indemnity is inadequate or for which its insurance policies may exclude from coverage; • limitations on rights to indemnity from the seller; and • customer or key employee losses of an acquired business. Boardwalk Pipelines’ ability to replace expiring gas storage contracts at attractive rates or on a long-term basis and to sell short-term services at attractive rates or at all are subject to market conditions. Boardwalk Pipelines owns and operates substantial natural gas storage facilities. The market for the storage and PAL services that it offers is impacted by the factors and market conditions discussed above for Boardwalk Pipelines’ transportation services, and is also impacted by natural gas price differentials between time periods, such as winter to summer (time period price spreads), and the volatility in time period price spreads. When market conditions cause a narrowing of time period price spreads and a decline in the price volatility of natural gas, these factors adversely impact the rates Boardwalk Pipelines can charge for its storage and PAL services. Boardwalk Pipelines’ operations are subject to catastrophic losses, operational hazards and unforeseen interruptions for which it may not be adequately insured. There are a variety of operating risks inherent in transporting and storing natural gas, ethylene and NGLs, such as leaks and other forms of releases, explosions, fires, cyber-attacks and mechanical problems, which could have catastrophic consequences. Additionally, the nature and location of Boardwalk Pipelines’ business may make it susceptible to catastrophic losses from hurricanes or other named storms, particularly with regard to its assets in the Gulf Coast region, windstorms, earthquakes, hail, and other severe weather. Any of these or other similar occurrences could result in the disruption of Boardwalk Pipelines’ operations, substantial repair costs, personal injury or loss of life, significant damage to property, environmental pollution, impairment of its operations and substantial financial losses. The location of pipelines in HCAs, which includes populated areas, residential areas, commercial business centers and industrial sites, could significantly increase the level of damages resulting from some of these risks. Boardwalk Pipelines currently possesses property, business interruption, cyber threat and general liability insurance, but proceeds from such insurance coverage may not be adequate for all liabilities or expenses incurred or revenues lost. Moreover, such insurance may not be available in the future at commercially reasonable costs and terms. The insurance coverage Boardwalk Pipelines does obtain may contain large deductibles or fail to cover certain events, hazards or all potential losses. 31 Table of Contents Risks Related to Us and Our Subsidiary, Loews Hotels & Co The COVID-19 pandemic and efforts to mitigate the spread of the virus have had, and are expected to continue to have, material adverse impacts on Loews Hotels & Co’s results of operations, financial condition and cash flows. In response to the spread of COVID-19, governments across the globe implemented measures to mitigate the spread of the virus, such as through city, regional or national lockdowns or stay-at-home orders, narrowly defined and widespread business closures, restrictions on travel, limitations on large group gatherings and quarantines, among others. Beyond the existence of governmental restrictions, the perception of health risks associated with COVID-19 has limited, and continues to further limit, business and leisure travel. Furthermore, theme parks in Orlando, Florida, which temporarily closed, now operate at reduced capacity levels. In addition, certain coastal beaches repeatedly have been ordered closed and professional sports leagues have suspended or modified their seasons with no or limited spectators permitted in attendance. The spread of the coronavirus and the containment efforts have had, and continue to have, macro-economic implications, including increased unemployment levels, declines in economic growth rates and possibly a global recession, the effects of which could be felt well beyond the time the spread of the virus is mitigated or contained. These developments have caused unprecedented disruptions to the global economy and normal business operations across sectors, including the hospitality industry that depends on active levels of business and leisure travel, very little of which is occurring in the current environment. Due to the COVID-19 pandemic and efforts to mitigate the spread of the virus, beginning in March of 2020, Loews Hotels & Co temporarily suspended operations at the majority of its owned and/or operated hotels. Since then, most hotels have resumed operations, but occupancy rates remain considerably lower than those from the prior year, or even occupancy rates prior to March of 2020. As such, revenues have been substantially lower and may be insufficient to offset certain fixed costs, such as insurance and property taxes. As of February 5, 2021, five hotels have suspended operations. These five hotels continue to be evaluated to determine when it will be prudent to resume operations. The potential for the suspension or resuspension of operations at operating hotels varies by hotel property and will depend on numerous factors, many of which are outside Loews Hotels & Co’s control. In addition, as a result of the COVID-19 crisis, Loews Hotels & Co has had to implement a number of new measures for the health and safety of its guests and employees. These new measures, which may need to remain in place for the foreseeable future, have resulted and will continue to result in increased costs. Given that Loews Hotels & Co owns and leases, relative to some of its competitors, a higher proportion of its hotel properties, compared to the number of properties that it manages for third-party owners, it may as a result of COVID-19 and mitigation measures face increased risks associated with mortgage debt, including the possibility of default, cash trap periods, the inability to draw further loan disbursements and reduced availability of replacement financing at reasonable terms or at all; difficulty reducing costs; declines in real estate values and potential additional impairments in the value of Loews Hotels & Co’s assets; and a limited ability to respond to market conditions. In addition, uncertain or fluctuating real estate valuations and the inability for third-party purchasers to obtain capital may prevent Loews Hotels & Co from selling properties on acceptable terms. The full extent and duration of the impacts caused by the COVID-19 outbreak on Loews Hotels & Co’s business, financial condition, operating results and cash flows remains largely uncertain and dependent on future developments that cannot be accurately predicted at this time, such as the continued severity, duration (including the extent of any resurgences in the future), transmission rate and geographic spread of COVID-19 in the United States, Canada and elsewhere, the extent and effectiveness of the containment measures taken, the timing of and manner in which containment efforts are reduced or lifted, the timing and ability of vaccinations and other treatments to combat COVID-19, and the response of the overall economy, financial markets and the population, particularly in areas in which Loews Hotels & Co operates, once the current containment measures are reduced or lifted. Accordingly, COVID-19 presents continuing material uncertainty and risk with respect to Loews Hotels & Co’s business, results of operations, financial condition and cash flows. Even following containment of COVID-19, continuing uncertainty exists around when and if Loews Hotels & Co will be able to resume normal, pre-COVID-19 level operations for business or leisure travel. Once the COVID-19 outbreak is mitigated or contained, whenever that may be, historical travel patterns, both domestic and international, may continue to be disrupted either on a temporary basis or with longer term effects. For example, certain travel is 32 Table of Contents dependent on commercial airlines restoring capacity, and their inability to restore full capacity could impact demand for Loews Hotels & Co’s services. Additionally, businesses now forced to rely on remote working and videoconferences may reduce the level of business travel both to save costs and to reduce the risk of exposure for their employees, and they may also seek alternatives to large public gatherings such as conferences and conventions. Leisure travelers may also be less inclined to travel or gather in large groups out of ongoing safety concerns, regardless of the lifting of mandated or recommended restrictions. In addition, with the expected adverse impact on jobs and the economy more broadly, at least in the short term, leisure travel will likely be further impacted due to economic reasons. Further, the demand for lodging, and consumer confidence in travel generally, may not recover as quickly as other industries. Any of these trends could have continuing material adverse effects on Loews Hotels & Co’s results of operations, financial condition and cash flow. As part of cost containment efforts, Loews Hotels & Co put a substantial number of its employees on unpaid leaves of absence or have severed them from the organization. When conditions warrant the resumption of operations that necessitate increased staffing levels, it may not be able to find or attract sufficient talent to fill the roles that have been furloughed or eliminated. Additionally, many of its service providers and suppliers have also put their employees on leaves of absence or have severed employees. Should they be unable to find or attract sufficient talent to fill the roles that they have furloughed or eliminated, Loews Hotels & Co may not have the requisite services or supplies available to resume operations at the time or in the manner of its choosing. Loews Hotels & Co continues to evaluate spending and manage operating expenses, including eliminating non-essential spending, reducing costs related to its management company, marketing, sales, and technology and deferring planned renovations, all of which could impair its ability to compete effectively and harm its business. Loews Hotels & Co has received and may receive additional demands or requests from labor unions that represent its employees, whether in the course of its periodic renegotiation of collective bargaining agreements or otherwise, for additional compensation, healthcare benefits, operational protocols or other terms that could increase costs, and could experience labor disputes or disruptions as it continues to implement mitigation or re-opening plans. Some actions Loews Hotels & Co has taken, or may take in the future, to reduce costs for it or its third-party owners may negatively impact guest loyalty, owner preference, and its ability to attract and retain employees, and its reputation and market share may suffer as a result. Further, once the effects of the pandemic subside, the recovery period could be extensive and certain operational changes, particularly with respect to enhanced health and safety measures, may continue to be necessary and could increase ongoing costs. Hotels are buildings designed to remain open every hour of every day. As Loews Hotels & Co has not previously suspended the operations of its hotels (other than in connection with planned renovations) for an extended period of time, there may be mechanical systems that require material repair and maintenance to restart for hotels that remain under a suspension of operations, or for facilities and outlets within operational hotels that continue to not be utilized. Loews Hotels & Co’s construction projects could be delayed as a result of COVID-19 and related containment efforts, including delays applicable to or affecting contractors, suppliers and inspectors required to review projects. As a manager of hotels owned by joint ventures that Loews Hotels & Co invests in and by third parties, Loews Hotels & Co earns fees based on the revenues that those managed hotels generate. As a result of reduced revenues described above due to COVID-19 and mitigating measures, Loews Hotels & Co’s fee-based revenues are also materially reduced. Certain of these properties also have contracts that require payments by Loews Hotels & Co to preserve its management of the hotel if the hotel’s operating results do not achieve certain performance levels. These payments may be uneconomical for Loews Hotels & Co and lead to Loews Hotels & Co no longer managing one or more of those properties. In properties in which Loews Hotels & Co has an ownership interest, Loews Hotels & Co leases space to third-party tenants and earns both fixed and variable amounts of rent, depending on each underlying lease arrangement. Some of these tenants informed Loews Hotels & Co that their operations are similarly impacted by COVID-19 business restrictions causing rent abatement periods in certain circumstances. In addition, variable rent, which is generally tied to the tenant’s sales, has been, and will continue to be, materially adversely affected by the effects of the pandemic. 33 Table of Contents Loews Hotels & Co’s business may be materially adversely affected by various operating risks common to the hospitality industry, including competition, excess supply and dependence on business travel and tourism. Loews Hotels & Co owns and operates hotels that have different economic characteristics than many other real estate assets. A typical office property, for example, has long-term leases with third-party tenants, which provide a relatively stable long-term stream of revenue. Hotels, on the other hand, generate revenue from guests that typically stay at the hotel for only a few nights, which causes the room rate and occupancy levels at each hotel to change every day, and results in earnings that can be highly volatile. In addition, Loews Hotels & Co’s properties are subject to various operating risks common to the hospitality industry, many of which are beyond Loews Hotels & Co’s control, including: • changes in general economic conditions, including the severity and duration of any downturn in the U.S. or global economy and financial markets, as well as more localized changes in the economy of each hotel’s geographic location; • war, political conditions or civil unrest, terrorist activities or threats and heightened travel security measures instituted in response to these events; • outbreaks of pandemic or contagious diseases, such as the recent coronavirus; • federal, state or local government-mandated travel restrictions and/or shut-down orders of hotels or other drivers that reduce demand for hotel businesses; • natural or man-made disasters or other catastrophes; • material reductions or prolonged interruptions of public utilities and services; • decreased corporate or government travel-related budgets and spending and cancellations, deferrals or renegotiations of group business due to self-imposed and/or government-mandated travel restrictions, adverse economic conditions or otherwise; • decreased need for business-related travel due to innovations in business-related technology; • competition from other hotels and alternative accommodations, such as Airbnb, in the markets in which Loews Hotels & Co operates; • requirements for periodic capital reinvestment to maintain and upgrade hotels; • increases in operating costs, including labor (such as from minimum wage increases), workers’ compensation, benefits, insurance, food and beverage, commodity costs, energy and unanticipated costs resulting from force majeure events, due to inflation, new or different federal, state or local governmental regulations, including tariffs, constrained supply, and other factors that may not be offset by increased revenues; • the costs and administrative burdens associated with compliance with applicable laws and regulations; • organized labor activities, which could cause a diversion of business from hotels involved in labor negotiations and loss of business for Loews Hotels & Co’s properties generally as a result of certain labor tactics; • changes in the desirability of particular locations or travel patterns of customers, including with respect to the underlying attractions supporting Loews Hotels & Co’s immersive destination properties, such as the Universal theme park for its Orlando, Florida properties, and stadiums, arenas and convention centers for properties in other markets; • geographic concentration of operations and customers; 34 Table of Contents • shortages of desirable locations for development; and • relationships with third-party property owners, developers and joint venture partners, including the risk that third-party property owners, developers and/or partners may encounter financial difficulties, may not fulfill material obligations and/or may terminate lease, management, joint venture or other agreements. In addition to materially affecting the business of Loews Hotels & Co generally, these factors, and the reputational repercussions of these factors, could materially adversely affect, and from time to time have materially adversely affected, individual hotels and hotels in particular regions. Loews Hotels & Co is exposed to the risks resulting from significant investments in owned and leased real estate, which could increase its costs, reduce its profits, limit its ability to respond to market conditions or restrict its growth strategy. Loews Hotels & Co’s proportion of owned and leased properties, compared to the number of properties that it manages for third-party owners, is larger than that of some of its competitors. Real estate ownership and leasing is subject to risks not applicable to managed or franchised properties, including: • real estate, insurance, zoning, tax, environmental and eminent domain laws; • the ongoing need for owner-funded capital improvements and expenditures to maintain or upgrade properties; • risks associated with mortgage debt, including the possibility of default, fluctuating interest rate levels and the availability of replacement financing; • risks associated with the possibility that cost increases will outpace revenue increases and that, in the event of an economic slowdown, a high proportion of fixed costs will make it difficult to reduce costs to the extent required to offset declining revenues; • risks associated with real estate leases, including the possibility of rent increases and the inability to renew or extend upon favorable terms; • risks associated with real estate condominiums, including the possibility of special assessments by condominiums that Loews Hotels & Co does not control; • fluctuations in real estate values and potential impairments in the value of Loews Hotels & Co’s assets; and • the relative illiquidity of real estate compared to some other assets. The hospitality industry is subject to seasonal and cyclical volatility. The hospitality industry is seasonal in nature. The periods during which Loews Hotels & Co’s properties experience higher revenues vary from property to property, depending principally upon location and the consumer base served. Historically, Loews Hotels & Co generally has experienced revenues and earnings that are lower in the third quarter of each year than in each of the other quarters. In addition, the hospitality industry is cyclical and demand generally follows the general economy on a lagged basis. The seasonality and cyclicality of its industry may contribute to fluctuation in Loews Hotels & Co’s results of operations and financial condition. 35 Table of Contents Loews Hotels & Co operates in a highly competitive industry, both for customers and for acquisitions and developments of new properties. The hospitality industry is highly competitive. Loews Hotels & Co’s properties compete with other hotels and alternative accommodations based on a number of factors, including room rates, quality of accommodations, service levels and amenities, location, brand affiliation, reputation and reservation systems. New hotels may be constructed and these additions to supply create new competitors, in some cases without corresponding increases in demand for hotel rooms. Some of its competitors also have greater financial and marketing resources than Loews Hotels & Co. In addition, travelers can book stays on websites that facilitate the short-term rental of homes and apartments from owners, thereby providing an alternative to hotel rooms. Loews Hotels & Co also competes for hotel acquisitions and development projects with entities that have similar investment objectives as it does. This competition could limit the number of suitable investment opportunities. It may also increase the bargaining power of Loews Hotels & Co’s counterparties, making it more difficult for Loews Hotels & Co to acquire or develop new properties on attractive terms or on the terms contemplated in its business plan. Any deterioration in the quality or reputation of Loews Hotels & Co’s brands could have a material adverse effect on its reputation and business. Loews Hotels & Co’s brands and reputation are among its most important assets. Its ability to attract and retain guests depends, in part, on the public recognition of its brands and their associated reputation. If its brands become obsolete or consumers view them as unfashionable or lacking in consistency and quality, or its brands or reputation are otherwise harmed, Loews Hotels & Co may be unable to attract guests to its properties, and may further be unable to attract or retain joint venture partners or hotel owners. Loews Hotels & Co’s reputation may also suffer as a result of negative publicity regarding its hotels, including as a result of social media reports, regardless of the accuracy of such publicity. The continued expansion of media and social media formats has compounded the potential scope of negative publicity and has made it more difficult to control and effectively manage negative publicity. Loews Hotels & Co’s efforts to develop new properties and renovate existing properties could be delayed or become more expensive. Loews Hotels & Co from time to time needs to renovate its properties and is currently expanding its portfolio through the ground-up construction of a new property in Coral Gables, Florida. Further it may in the future similarly develop additional new properties. Often these projects are undertaken with joint venture partners who may also serve as developer. These renovation and construction efforts are subject to a number of risks, including: • construction delays, changes to plans and specifications and cost overruns (including labor and materials or unforeseeable site conditions) that may increase project costs; cause new development projects to not be completed by lender imposed required completion dates or subject Loews Hotels & Co to cancellation penalties for reservations accepted; • obtaining zoning, occupancy and other required permits or authorizations; • changes in economic conditions that may result in weakened or lack of demand or negative project returns; • governmental restrictions on the size or kind of development; • projects financed with construction debt are subject to interest rate risk as uncertain timing and amount of draws make effective hedging difficult to obtain; • weather delays and force majeure events, including earthquakes, tornados, hurricanes or floods; and • design defects that could increase costs. 36 Table of Contents Additionally, developing new properties typically involves lengthy development periods during which significant amounts of capital must be funded before the properties begin to operate and generate revenue. If the cost of funding new development exceeds budgeted amounts, and/or the time period for development is longer than initially anticipated, Loews Hotels & Co’s operating results could be reduced. Further, due to the lengthy development cycle, intervening adverse economic conditions in general and as they apply to Loews Hotels & Co and its development partners may alter or impede the development plans, thereby resulting in incremental costs or potential impairment charges. In addition, using multiple sources of capital to develop new properties reduces or eliminates the ability of Loews Hotels & Co to cease commenced projects if the overall economic environment conditions change. Moreover, during the early stages of operations, charges related to interest expense and depreciation may substantially detract from, or even outweigh, the profitability of certain new property investments. Co-investing in hotel properties decreases Loews Hotels & Co’s ability to manage risk. Loews Hotels & Co has from time to time invested, and expects to continue to invest, in hotel properties or businesses as a co-investor. Co-investors often have shared control over the operation of the property or business. Therefore, the operation of such properties or businesses is subject to inherent risk due to the shared nature of the enterprise and the need to reach agreements on material matters. In addition, investments with other investors may involve risks such as the possibility that the co-investor might become bankrupt or not have the financial resources to meet its obligations, or have economic or business interests or goals that are inconsistent with Loews Hotels & Co’s business interests or goals. Further, Loews Hotels & Co may be unable to take action without the approval of its co-investors, or its co-investors could take actions binding on the property without the consent of Loews Hotels & Co. Additionally, should a co-investor become bankrupt, Loews Hotels & Co could become liable for its share of liabilities. Loews Hotels & Co’s properties are geographically concentrated, which exposes its business to the effects of regional events and occurrences. Loews Hotels & Co has a concentration of hotels in Florida. Specifically, as of December 31, 2020, eight hotels, representing 54% of rooms in its system, were located at Universal Orlando in Orlando, Florida and nine hotels, representing approximately 59% of rooms in its system, were located in Florida. The concentration of hotels in one region or a limited number of markets may expose Loews Hotels & Co to risks of adverse economic and other developments that are greater than if its portfolio were more geographically diverse. These developments include regional economic downturns, a decline in the popularity of or access to area tourist attractions, such as theme parks, significant increases in the number of Loews Hotels & Co’s competitors’ hotels in these markets and potentially higher local property, sales and income taxes, property insurance costs or other expenses in the geographic markets in which it is concentrated. In addition, Loews Hotels & Co’s properties in Florida are subject to the effects of adverse acts of nature, such as hurricanes, strong winds and flooding, which have in the past caused damage to its hotels in Florida, and which may in the future be intensified as a result of climate change, as well as outbreaks of pandemic or contagious diseases. Loews Hotels & Co’s business may be significantly affected by other risks common to the Florida tourism industry. For example, the cost and availability of air services and the impact of any events that disrupt or reduce air travel to and from Florida for any reason can adversely affect its business. The growth and use of alternative reservation channels adversely affects Loews Hotels & Co’s business. A significant percentage of hotel rooms for guests at Loews Hotels & Co’s properties is booked through internet travel and other intermediaries. In most cases, Loews Hotels & Co has agreements with such intermediaries and pays them commissions and/or fees for sales of its rooms through their systems. If such bookings increase, these intermediaries may be able to obtain higher commissions or fees, reduced room rates or other significant concessions from Loews Hotels & Co. There can be no assurance that Loews Hotels & Co will be able to negotiate such agreements in the future with terms as favorable as those that exist today. Moreover, these intermediaries generally employ aggressive marketing strategies, including expending significant resources for online and television advertising campaigns to drive consumers to their websites and other outlets. As a result, consumers may develop brand loyalties to the intermediaries’ offered brands, websites and reservations systems rather than to Loews Hotels & Co’s brands. 37 Table of Contents Loews Hotels & Co’s insurance coverage may not cover all possible losses, and it may not be able to renew its insurance policies on favorable terms, or at all. Although Loews Hotels & Co maintains various property, casualty and other insurance policies, proceeds from such insurance coverage may not be adequate for all liabilities or expenses incurred or revenues lost. Additionally, insurance policies that it maintains may not be available in the future at commercially reasonable costs and terms. The insurance coverage Loews Hotels & Co maintains may contain large deductibles or may not cover all risks to which its properties are potentially subject. Labor shortages could restrict Loews Hotels & Co’s ability to operate its properties or grow its business or result in increased labor costs that could reduce its results of operations. Loews Hotels & Co’s properties are staffed 24 hours a day, seven days a week by thousands of employees. If it is unable to attract, retain, train and engage skilled employees, its ability to manage and staff its properties adequately could be impaired, which could reduce customer satisfaction. Staffing shortages could also hinder its ability to grow and expand its business. Because payroll costs are a major component of the operating expenses at its properties, a shortage of skilled labor could also require higher wages that would increase its labor costs. A portion of Loews Hotels & Co’s labor force is covered by collective bargaining agreements. Work stoppages and other labor problems could negatively affect Loews Hotels & Co’s business and results of operations. A prolonged dispute with covered employees or any labor unrest, strikes or other business interruptions in connection with labor negotiations or otherwise could have an adverse impact on Loews Hotels & Co’s operations. Adverse publicity in the marketplace related to union messaging could further harm its reputation and reduce customer demand for its services. Also, wage and/or benefit increases resulting from new labor agreements may be significant and could have an adverse impact on its results of operations. To the extent that Loews Hotels & Co’s non-union employees join unions, Loews Hotels & Co would have greater exposure to risks associated with such labor problems. Furthermore, Loews Hotels & Co may have, or acquire in the future, multi-employer plans that are classified as “endangered,” “seriously endangered,” or “critical” status and a withdrawal in the future could result in the incurrence of a contingent liability that would be payable in an amount and at such time (or over a period of time) that would vary based on a number of factors at the time of (and after) withdrawal. Any such events or additional costs may have materially adverse effects. Risks Related to Us and Our Subsidiary, Altium Packaging The COVID-19 pandemic may have an adverse impact on Altium Packaging. Altium Packaging manufactures packaging that is used with products in critical sectors, such as the pharmaceutical, household and industrial cleaning and food and beverage markets, and is thus an essential business as contemplated by state and local orders. It therefore has operated, and continues to operate, nearly all of its manufacturing facilities at full capacity to support those sectors. However, certain of Altium Packaging’s end markets, such as its commercial food services, institutional food and automotive customers, have been negatively impacted and its sales to those customers have been adversely affected. In addition, if widespread infections were to affect any of its facilities or workers, including those supporting critical sectors, it may be required to temporarily shut down or otherwise modify the working conditions at such facilities to address the infections. Any such changes could cause Altium Packaging to be unable to meet demand from its customers if it cannot provide support from other facilities in its network. 38 Table of Contents Altium Packaging’s substantial indebtedness could affect its ability to meet its obligations and may otherwise restrict its activities. Altium Packaging has a significant amount of indebtedness, which requires significant interest payments. Its inability to generate sufficient cash flow to satisfy its debt obligations, or to refinance its obligations on commercially reasonable terms, would have a material adverse effect on its business. Altium Packaging’s substantial indebtedness could have important consequences. For example, it could: • limit its ability to borrow money for its working capital, capital expenditures, debt service requirements or other corporate purposes; • increase its vulnerability to general adverse economic and industry conditions; and • limit its ability to respond to business opportunities, including growing its business through acquisitions. In addition, the credit agreements governing its current indebtedness contain, and any future debt instruments would likely contain, financial and other restrictive covenants, which impose operating and financial restrictions on it. As a result of these covenants, Altium Packaging could be limited in the manner in which it conducts its business and may be unable to engage in favorable business activities or finance future operations or capital needs. Furthermore, a failure to comply with these covenants could result in an event of default which, if not cured or waived, could have a material adverse effect on Altium Packaging. Altium Packaging is exposed to changes in consumer preferences. Sales of Altium Packaging’s plastic containers depend heavily on the volume of sales made by its customers to consumers. Consequently, changes in consumer preferences for products in the industries that it serves or the packaging formats in which such products are delivered, whether as a result of changes in cost, convenience or health, environmental and social concerns or perceptions regarding plastics, may result in a decline in the demand for Altium Packaging’s plastic container products. Fluctuations in raw material prices and raw material availability may materially affect Altium Packaging’s results of operations. To produce its products, Altium Packaging uses large quantities of plastic resins and recycled plastic materials. It faces the risk that its access to these raw materials may be interrupted or that it may not be able to purchase these raw materials at prices that are acceptable to it. In general, Altium Packaging does not have long-term supply contracts with its suppliers, and its purchases of raw materials are subject to market price volatility. Although Altium Packaging generally is able to pass changes in the prices of raw materials through to its customers over a period of time, it may not always be able to do so or there may be a lag between when its costs increase and when it passes those costs through to its customers. It may not be able to pass through all future raw material price increases in a timely manner or at all due to competitive pressures. In addition, a sustained increase in resin and recycled plastic prices, relative to alternative packaging materials, would make plastic containers less economical for its customers and could result in reductions in the use of plastic containers. Any limitation on its ability to procure its primary raw materials or to pass through price increases in such materials on a timely basis could materially negatively affect Altium Packaging. Altium Packaging’s customers may increase their self-manufacturing. Increased self-manufacturing by Altium Packaging’s customers may have a material adverse impact on its sales volume and financial results. Altium Packaging believes that its customers may engage in self-manufacturing over time at locations where transportation costs are high, and where low complexity and available space to install blow molding equipment exist. Risks Related to Us and Our Subsidiaries Generally In addition to the specific risks and uncertainties faced by our subsidiaries, as discussed above, we and all of our subsidiaries face additional risks and uncertainties described below. 39 Table of Contents The COVID-19 pandemic is having widespread impacts on the way we and our subsidiaries operate. The spread of COVID-19 and mitigating measures has had, and continues to have, macroeconomic implications, including increased unemployment levels, declines in economic growth rates and possibly a global recession, the effects of which could be felt well beyond the time during which the spread of the virus is mitigated or contained. These developments have caused unprecedented disruptions to the global economy and normal business operations across sectors and countries, including the sectors and countries in which we and our subsidiaries operate. Because of the size and breadth of the pandemic, all of the direct and indirect consequences of COVID-19 are not yet known and may not emerge for some time. As a result of workplace restrictions, both voluntary and those imposed by governmental authorities, in response to the COVID-19 pandemic, large portions of our and our subsidiaries’ employees are working from home, which, among other things, may disrupt their productivity. Similar workplace restrictions are in place at many of our and our subsidiaries’ critical vendors, which may result in interruptions in service delivery or failure by vendors to properly perform required services. In addition, having shifted to remote working arrangements and being more dependent on internet and telecommunications access and capabilities, we and our subsidiaries also face a heightened risk of cybersecurity attacks or data security incidents. We and our subsidiaries also self-insure our health benefits and therefore may experience increased medical claims as a result of the pandemic. Acts of terrorism could harm us and our subsidiaries. Terrorist attacks and the continued threat of terrorism in the United States or abroad, the continuation or escalation of existing armed hostilities or the outbreak of additional hostilities, including military and other action by the United States and its allies, could have a significant impact on us and the assets and businesses of our subsidiaries. CNA issues coverages that are exposed to risk of loss from an act of terrorism. Terrorist acts or the threat of terrorism could also result in increased political, economic and financial market instability, a decline in energy consumption and volatility in the price of oil and gas, which could affect the market for Boardwalk Pipelines’ transportation and storage services. In addition, future terrorist attacks could lead to reductions in business travel and tourism which could harm Loews Hotels & Co. While our subsidiaries take steps that they believe are appropriate to secure their assets, there is no assurance that they can completely secure them against a terrorist attack or obtain adequate insurance coverage for terrorist acts at reasonable rates. Our subsidiaries face significant risks related to compliance with environmental laws. Our subsidiaries have extensive obligations and financial exposure related to compliance with federal, state, local, foreign and international environmental laws, including those relating to the discharge of substances into the environment, the disposal, removal or clean up of hazardous wastes and other activities relating to the protection of the environment. Many of such laws have become increasingly stringent in recent years and may in some cases impose strict liability, which could be substantial, rendering a person liable for environmental damage without regard to negligence or fault on the part of that person. For example, Boardwalk Pipelines is subject to environmental laws and regulations, including requiring the acquisition of permits or other approvals to conduct regulated activities, restricting the manner in which it disposes of waste, requiring remedial action to remove or mitigate contamination resulting from a spill or other release and requiring capital expenditures to comply with pollution control requirements. In addition, Altium Packaging may be adversely affected by laws or regulations concerning environmental matters that increase the cost of producing, or otherwise adversely affect the demand for, plastic products. Further, existing environmental laws or the interpretation or enforcement thereof may be amended and new laws may be adopted in the future. Failures or interruptions in or breaches to our or our subsidiaries’ computer systems could materially and adversely affect our or our subsidiaries’ operations. We and our subsidiaries are dependent upon information technologies, computer systems and networks, including those maintained by us and our subsidiaries and those maintained and provided to us and our subsidiaries by third parties (for example, “software-as-a-service” and cloud solutions), to conduct operations and are reliant on technology to help increase efficiency in our and their businesses. We and our subsidiaries are dependent upon operational and 40 Table of Contents financial computer systems to process the data necessary to conduct almost all aspects of our and their businesses. Any failure of our or our subsidiaries’ computer systems, or those of our or their customers, vendors or others with whom we and they do business, could materially disrupt business operations. Computer, telecommunications and other business facilities and systems could become unavailable or impaired from a variety of causes, including storms and other natural disasters, terrorist attacks, fires, utility outages, theft, design defects, human error or complications encountered as existing systems are replaced or upgraded. In addition, it has been reported that unknown entities or groups have mounted so-called “cyber attacks” on businesses and other organizations solely to disable or disrupt computer systems, disrupt operations and, in some cases, steal data. In particular, the U.S. government has issued public warnings that indicate energy assets may be specific targets of cyber attacks, which can have catastrophic consequences and hotel chains, among other consumer-facing businesses, have been subject to various cyber attacks targeting payment card and other sensitive consumer information. Breaches of our and our subsidiaries’ computer security infrastructure can result from actions by our employees, vendors, third party administrators or by unknown third parties, and may disrupt our or their operations, cause significant damage to our or their assets and surrounding areas, cause loss of life or serious bodily injury and impact our or their data framework or cause a failure to protect personal information of customers or employees. The foregoing risks relating to disruption of service, interruption of operations and data loss could impact our and our subsidiaries’ ability to timely perform critical business functions, resulting in disruption or deterioration in our and our subsidiaries’ operations and business and expose us and our subsidiaries to monetary and reputational damages. In addition, potential exposures include substantially increased compliance costs and required computer system upgrades and security related investments. The breach of confidential information also could give rise to legal liability and regulatory action under data protection and privacy laws and regulations, both in the U.S. and foreign jurisdictions. Loss of key vendor relationships or issues relating to the transitioning of vendor relationships could result in a materially adverse effect on our and our subsidiaries’ operations. We and our subsidiaries rely on products, equipment and services provided by many third-party suppliers, manufacturers and service providers in the United States and abroad, which exposes us and them to volatility in the quality, price and availability of such items. These include, for example, vendors of computer hardware, software and services, as well as other critical materials and services (including, in the case of CNA, claims administrators performing significant claims administration and adjudication functions). Certain products, equipment and services may be available from a limited number of sources. If one or more key vendors becomes unable to continue to provide products, equipment or services at the requisite level for any reason, or fails to protect our proprietary information, including in some cases personal information of employees, customers or hotel guests, we and our subsidiaries may experience a material adverse effect on our or their business, operations and reputation. We could incur impairment charges related to the carrying value of the long-lived assets and goodwill of our subsidiaries. Our subsidiaries regularly evaluate their long-lived assets and goodwill for impairment whenever events or changes in circumstances indicate the carrying value of these assets may not be recoverable. Most notably, we could incur impairment charges related to the carrying value of pipeline and storage assets at Boardwalk Pipelines and hotel investments owned by Loews Hotels & Co. We also test goodwill for impairment on an annual basis or when events or changes in circumstances indicate that a potential impairment exists. Asset impairment evaluations by us and our subsidiaries with respect to both long-lived assets and goodwill are, by nature, highly subjective. The use of different estimates and assumptions could result in materially different carrying values of our assets which could impact the need to record an impairment charge and the amount of any charge taken. We are a holding company and derive substantially all of our income and cash flow from our subsidiaries. We rely upon our invested cash balances and distributions from our subsidiaries to generate the funds necessary to meet our obligations and to declare and pay any dividends to holders of our common stock. Our subsidiaries are separate and independent legal entities and have no obligation, contingent or otherwise, to make funds available to us, whether in the form of loans, dividends or otherwise. The ability of our subsidiaries to pay dividends is subject to, 41 Table of Contents among other things, the availability of sufficient earnings and funds in such subsidiaries, applicable state laws, including in the case of the insurance subsidiaries of CNA, laws and rules governing the payment of dividends by regulated insurance companies, and their compliance with covenants in their respective loan agreements. Claims of creditors of our subsidiaries will generally have priority as to the assets of such subsidiaries over our claims and those of our creditors and shareholders. We and our subsidiaries face competition for senior executives and qualified specialized talent. We and our subsidiaries depend on the services of our key personnel, who possess skills critical to the operation of our and their businesses. Our and our subsidiaries’ executive management teams are highly experienced and possess extensive skills in their relevant industries. The ability to retain senior executives and to attract and retain highly skilled professionals and personnel with specialized industry and technical experience is important to our and our subsidiaries’ success and future growth. Competition for this talent can be intense, and we and our subsidiaries may not be successful in our efforts. The unexpected loss of the services of these individuals could have a detrimental effect on us and our subsidiaries and could hinder our and their ability to effectively compete in the various industries in which we and they operate. From time to time we and our subsidiaries are subject to litigation, for which we and they may be unable to accurately assess the level of exposure and which if adversely determined, may have a significant adverse effect on our or their financial condition or results of operations. We and our subsidiaries are or may become parties to legal proceedings and disputes. These matters may include, among others, contract disputes, claims disputes, reinsurance disputes, personal injury claims, environmental claims or proceedings, asbestos and other toxic tort claims, intellectual property disputes, disputes related to employment and tax matters and other litigation incidental to our or their businesses. It is difficult to predict the outcome or effect of any litigation matters and the outcome of any pending or future litigation could have a significant impact on our or our subsidiaries’ financial condition or results of operations. Item 1B. Unresolved Staff Comments. None. Item 2. Properties. Our corporate headquarters is located in leased office space in two buildings in New York City. Information relating to our subsidiaries’ properties is contained under Item 1. Item 3. Legal Proceedings. Information on our legal proceedings is included in Notes 18 and 19 of the Notes to Consolidated Financial Statements, included under Item 8. In addition, information regarding the bankruptcy of Diamond Offshore is included in the Overview section of MD&A in Item 7 and Note 2 of the Notes to Consolidated Financial Statements, included under
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+Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations; and Notes 2 and 17 to the Consolidated Financial Statements.We have made, and intend to continue to make, the expenditures necessary for compliance with applicable laws and regulations relating to environmental, health and safety matters. We incurred capital expenditures of $195 million in 2020 for health, safety and environmental compliance purposes and improvement programs, and estimate such expenditures to be approximately $260 million in 2021 and $250 million in 2022.While capital expenditures or operating costs for environmental compliance, including compliance with potential legislation and potential regulation related to climate change, cannot be predicted with certainty, we do not believe they will have a material effect on our competitive position.While there can be no assurance that physical risks to our facilities and supply chain due to climate change will not occur in the future, we do not believe these risks are material in the near term.Human CapitalOur success as a company is tied to the passion, knowledge and talent of our global team. We believe in integrity, diversity and fairness, and we focus on creating a work environment that is safe, respectful and inspires employees to strive for excellence. We recognize that individuals cannot succeed alone; we believe in the power of many and place a strong emphasis on teamwork. We reward performance based on personal, team and company results. We engage in open and ongoing dialogue with employees and their representatives to ensure a proper balance between the best interests of the Company and its employees. At a minimum, we provide all workers with fair wages and uphold all applicable fair wage laws, wherever we work. We never use child, forced, bonded or involuntary labor, and we do not knowingly work with subcontractors or suppliers who use child or forced labor or engage in human trafficking practices. In several of our locations, we partner with employee representatives on initiatives such as health and safety. We use the services of contractors, primarily to assist with non-core business functions, and we require that all contractors adhere to our operational excellence standards and GoalZERO, a comprehensive program to protect the health and safety of our employees and contractors. 14Table of ContentsOur Code of Conduct sets out our expectations on topics such as respecting fellow employees, anti-corruption, conflicts of interest, trade compliance, anti-trust and competition law, insider trading, sanctions, misconduct and political donations. It is available in 18 languages on our company website. New employees are trained on the Code and all employees complete annual refresher training. In 2020, we adopted a human rights policy that established our standards for workforce health and safety; prevention of discrimination, harassment and retaliation; diversity and inclusion; workplace security; working conditions and fair wages; freedom of association; freely chosen employment; and child labor protections.DemographicsAs of December 31, 2020, we employed approximately 19,200 full-time and part-time employees around the world. Of this total, approximately 8,600 were in the U.S. and Canada and another 8,100 were in Europe. The remainder of our employees are in other global locations. As of December 31, 2020, approximately 900 of our employees in the U.S. were represented by labor unions. Most of our employees in Europe and Latin America, and some of our employees in Asia Pacific, are subject to staff council or works council coverage or collective bargaining agreements.Some examples of key programs and initiatives that are focused to attract, develop and retain our diverse workforce include:Talent Development and EngagementWe believe in building an engaged, talented workforce by developing skill sets, supporting diversity and ensuring fair employment and work practices. In July 2020, we accelerated our efforts in the area of diversity, equity, and inclusion (“DEI”) with the appointment of a Chief Talent & Diversity Officer, the establishment of a DEI Leadership Council, the development of a multi-year DEI strategy, and the implementation of activities focused on listening to our employees and obtaining their perspectives on DEI.Employee growth and development are key elements supporting our vision of superior performance. We provide development opportunities for our employees through on-the-job experiences, learning from others, and in-class and online learning. In 2020, we offered more than 308,000 hours of training to our employees through both in-person classes and our online learning management system. We continue the investment in our leadership through Leadership Development programs, including accelerated development academies and robust development planning targeted at our high potential leaders. We encourage high performance and alignment with business goals through our performance management system which includes annual goal setting, continuous performance conversations throughout the year, and a year-end process to measure performance against goals. Employees are measured not only on results delivered, but how they are delivered based on established enterprise-wide competencies. SafetyWe are committed to providing a safe workplace, free from recognized hazards, and we comply with all applicable health and safety laws and recognized standards. Information on occupational health services is provided globally throughout the new hire on-boarding process and offered in various languages dependent on the site location. GoalZERO is our commitment to operating safely and with a goal of zero incidents, zero injuries and zero accidents. We cultivate a GoalZERO mindset with clear standards, regular communication, training, and targeted campaigns and events, including our annual Global Safety Day. 15Table of ContentsAs the COVID-19 pandemic spread around the globe, we continued to operate with three key objectives: protecting the health and safety of our people; ensuring the safety and security of our work locations; and maintaining business continuity with our customers and suppliers. We quickly mobilized to develop a globally coordinated, locally implemented plan to protect our workforce at the beginning of the pandemic, which we have regularly updated as new developments occurred. Among the numerous safety measures and protocols we developed were: strict social distancing and facial coverage, critical personal protective equipment, thoughtful procedures for return to workplaces, and several initiatives to support our employees’ mental health. Health, wellness, welfare and family resources Full-time employees at our major offices and manufacturing sites receive competitive benefits which may include, depending on location, the following: basic health and welfare benefits, which include medical coverage; life and accident insurance; business travel accident insurance; disability protection; retirement, savings and pension plans; share programs; and paid time off. Employees at our large sites have access to health services at an on-site clinic on paid work-time. We have defined benefit pension plans that cover employees in the U.S. and various non-U.S. countries. In addition, we provide other post-employment benefits such as early retirement and deferred compensation severance benefits to employees of certain non-U.S. countries.In 2020, we implemented family-friendly policies that expanded the availability of paid parental leave, provided financial reimbursement for certain adoption expenses, and ensured all employees globally have a minimum of ten paid vacation or personal leave days.16Table of ContentsINFORMATION ABOUT OUR EXECUTIVE OFFICERSOur executive officers as of February 25, 2021 were as follows:Name and AgeSignificant ExperienceBhavesh V. (“Bob”) Patel, 54Chief Executive Officer since January 2015 and member of the Board of Directors since June 2018. Executive Vice President, Olefins and Polyolefins–EAI and Technology, with responsibility for EAI Manufacturing, from October 2013 to January 2015. Senior Vice President, Olefins and Polyolefins–EAI and Technology from November 2010 to October 2013.Senior Vice President, Olefins and Polyolefins–Americas from March 2010 to June2011.Michael C. McMurray, 56Executive Vice President and Chief Financial Officer since November 2019.Senior Vice President and Chief Financial Officer at Owens Corning, a global manufacturer of insulation, roofing and fiberglass composites, from August 2012 to November 2019. James Guilfoyle, 50Executive Vice President, Advanced Polymer Solutions & Global Supply Chain since July 2018.Senior Vice President, Global Intermediates & Derivatives and Global Supply Chain from February 2017 to July 2018. Senior Vice President, Global Intermediates and Derivatives from June 2015 to February 2017. Vice President of Global Propylene Oxide and Co-Products from March 2015 to May 2015. Director of Polymer Sales Americas from January 2012 to February 2015.Jeffrey Kaplan, 52Executive Vice President and Chief Legal Officer since March 2015. Deputy General Counsel from December 2009 to March 2015.Kenneth (“Ken”) Lane, 52Executive Vice President, Global Olefins and Polyolefins since July 2019. President, Monomers Division at BASF, a German chemical company, from January 2019 to July 2019.President, Global Catalysts at BASF from June 2013 to December 2018. 17Table of ContentsName and AgeSignificant ExperienceTorkel Rhenman, 57Executive Vice President, Intermediates and Derivatives, and Refining since August 2020. Executive Vice President, Intermediates & Derivatives from July 2019 to July 2020. Chief Executive Officer and Director of Lhoist Group, a privately held minerals and mining company, from 2012 to 2017. Kim Foley, 54Senior Vice President, HSE, Global Engineering and Turnarounds since August 2020.Vice President, Health, Safety and Environment from October 2019 to July 2020.Site Manager at Channelview from May 2017 to October 2019.Senior Director, Global Supply Chain from January 2016 to May 2017. Director, Supply Chain, Americas from August 2010 to January 2016. Dale Friedrichs, 57Senior Vice President, Human Resources and Global Projects since August 2020.Vice President, Human Resources from October 2019 to July 2020.Vice President, Health, Safety, Environment and Security from February 2017 to October 2019. Site Manager of various facilities from January 1995 to February 2017.James Seward, 53Senior Vice President, Research & Development, Technology and Sustainability since August 2020.Senior Vice President, Technology Business, Sustainability, and Olefins & Polyolefins, Europe, Asia and International Joint Venture Management from September 2018 to July 2020.Vice President, Joint Ventures and International Marketing from May 2014 to August 2018.Anup Sharma, 46Senior Vice President, Global Business Services since February 2019. Vice President and GE corporate officer at GE Digital, a software company for industrial businesses, from May 2016 to February 2019.Global Chief Information Officer at GE Oil & Gas, a division of General Electric that owned investments in the petroleum industry, from 2011 to 2016.18Table of ContentsDescription of PropertiesOur principal manufacturing facilities as of December 31, 2020 are set forth below and are identified by the principal segment or segments using the facility. All of the facilities are wholly owned, except as otherwise noted. LocationSegmentAmericasBayport (Pasadena), TexasI&DBayport (Pasadena), Texas(1)I&DBayport (Pasadena), TexasO&P–AmericasChannelview, TexasO&P–AmericasChannelview, Texas(1)(2)I&DChocolate Bayou, Texas†O&P–AmericasClinton, IowaO&P–AmericasCorpus Christi, TexasO&P–AmericasEdison, New JerseyO&P–AmericasHouston, TexasRefiningLa Porte, Texas(3)O&P–AmericasLa Porte, Texas(3)I&DLake Charles, LouisianaO&P–AmericasLake Charles, Louisiana(4)O&P–AmericasMatagorda, TexasO&P–AmericasMorris, IllinoisO&P–AmericasTuscola, IllinoisO&P–AmericasVictoria, Texas†O&P–Americas19Table of ContentsLocationSegmentEuropeBerre l’Etang, FranceO&P–EAIBotlek, Rotterdam, The Netherlands†I&DBrindisi, ItalyO&P–EAICarrington, UK†O&P–EAIFerrara, ItalyO&P–EAITechnologyFos-sur-Mer, France†I&DFrankfurt, Germany†O&P–EAITechnologyKnapsack, Germany†O&P–EAIAPSKerpen, GermanyAPSLudwigshafen, Germany†TechnologyMaasvlakte, The Netherlands(5)†I&DMoerdijk, The Netherlands†APSMünchsmünster, GermanyO&P–EAITarragona, Spain(6)†O&P–EAIAPSWesseling, GermanyO&P–EAIAsia-PacificGeelong, Australia†O&P–EAIPanjin, China(7)†O&P–EAI† The facility is located on leased land.(1)The Bayport PO/TBA plants and the Channelview PO/SM I plant are held by the U.S. PO joint venture between Covestro and Lyondell Chemical Company. These plants are located on land leased by the U.S. PO joint venture.(2)Equistar Chemicals, LP operates a styrene maleic anhydride unit and a polybutadiene unit, which are owned by an unrelated party and are located within the Channelview facility on property leased from Equistar Chemicals, LP.(3)The La Porte facilities are on contiguous property.(4)The Lake Charles site is owned by the Louisiana joint venture and is located on land leased by the Louisiana joint venture. (5)The Maasvlakte plant is owned by the European PO joint venture and is located on land leased by the European PO joint venture.(6)The Tarragona PP facility is located on leased land; the compounds facility is located on co-owned land.(7)The Panjin facility is owned by the Bora LyondellBasell Petrochemical Co. Ltd joint venture and is located on land leased by the joint venture. Other Locations and PropertiesWe maintain executive offices in London, the United Kingdom; Rotterdam, The Netherlands; and Houston, Texas. We maintain research facilities in Lansing, Michigan; Channelview, Texas; Cincinnati, Ohio; Ferrara, Italy and Frankfurt, Germany. Our Asia-Pacific headquarters are in Hong Kong. We also have technical support centers in Bayreuth, Germany; Geelong, Australia and Tarragona, Spain. We have various sales facilities worldwide.20Table of ContentsWebsite Access to SEC ReportsOur Internet website address is http://www.LyondellBasell.com. Information contained on our Internet website is not part of this report on Form 10-K.Our Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and any amendments to these reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934 are available on our website, free of charge, as soon as reasonably practicable after such reports are filed with, or furnished to, the U.S. Securities and Exchange Commission (“SEC”). Alternatively, these reports may be accessed at the SEC’s website at http://www.sec.gov.Item 1A. Risk Factors.You should carefully consider the following risk factors in addition to the other information included in this Annual Report on Form 10-K. Each of these risk factors could adversely affect our business, operating results and financial condition, as well as adversely affect the value of an investment in our common stock.Risks Related to our Business and IndustryThe cyclicality and volatility of the industries in which we participate may cause significant fluctuations in our operating results.Our business operations are subject to the cyclical and volatile nature of the supply-demand balance in the chemical and refining industries. Our future operating results are expected to continue to be affected by this cyclicality and volatility. The chemical and refining industries historically have experienced alternating periods of capacity shortages, causing prices and profit margins to increase, followed by periods of excess capacity, resulting in oversupply, declining capacity utilization rates and declining prices and profit margins.In addition to changes in the supply and demand for products, changes in energy prices and other worldwide economic conditions can cause volatility. These factors result in significant fluctuations in profits and cash flow from period to period and over business cycles.New capacity additions around the world may lead to periods of oversupply and lower profitability. The timing and extent of any changes to currently prevailing market conditions are uncertain and supply and demand may be unbalanced at any time. As a consequence, we are unable to accurately predict the extent or duration of future industry cycles or their effect on our business, financial condition or results of operations.A sustained decrease in the price of crude oil may adversely impact the results of our operations, primarily in North America.Energy costs generally follow price trends of crude oil and natural gas. These price trends may be highly volatile and cyclical. In the past, raw material and energy costs have experienced significant fluctuations that adversely affected our business segments’ results of operations. For example, we have benefited from the favorable ratio of U.S. crude oil prices to natural gas prices in the past. If the price of crude oil remains lower relative to U.S. natural gas prices or if the demand for natural gas and NGLs increases, this may have a negative impact on our results of operations.Costs and limitations on supply of raw materials and energy may result in increased operating expenses.The costs of raw materials and energy represent a substantial portion of our operating expenses. Due to the significant competition we face and the commodity nature of many of our products we are not always able to pass on raw material and energy cost increases to our customers. When we do have the ability to pass on the cost increases, we are not always able to do so quickly enough to avoid adverse impacts on our results of operations.21Table of ContentsCost increases for raw materials also may increase working capital needs, which could reduce our liquidity and cash flow. Even if we increase our sales prices to reflect rising raw material and energy costs, demand for products may decrease as customers reduce their consumption or use substitute products, which may have an adverse impact on our results of operations. In addition, producers in natural gas cost-advantaged regions, such as the Middle East and North America, benefit from the lower prices of natural gas and NGLs. Competition from producers in these regions may cause us to reduce exports from Europe and elsewhere. Any such reductions may increase competition for product sales within Europe and other markets, which can result in lower margins in those regions.For some of our raw materials and utilities there are a limited number of suppliers and, in some cases, the supplies are specific to the particular geographic region in which a facility is located. It is also common in the chemical and refining industries for a facility to have a sole, dedicated source for its utilities, such as steam, electricity and gas. Having a sole or limited number of suppliers may limit our negotiating power, particularly in the case of rising raw material costs. Any new supply agreements we enter into may not have terms as favorable as those contained in our current supply agreements.Additionally, there is growing concern over the reliability of water sources, including around the U.S. Gulf Coast where several of our facilities are located. The decreased availability or less favorable pricing for water as a result of population growth, drought or regulation could negatively impact our operations, including by impacting our ability to produce or transport our products.If our raw material or utility supplies were disrupted, our businesses may incur increased costs to procure alternative supplies or incur excessive downtime, which would have a negative impact on plant operations. Disruptions of supplies may occur as a result of transportation issues resulting from natural disasters, water levels, and interruptions in marine water routes, among other causes, that can affect the operations of vessels, barges, rails, trucks and pipeline traffic. These risks are particularly prevalent in the U.S. Gulf Coast area. Additionally, increasing exports of NGLs and crude oil from the U.S. or greater restrictions on hydraulic fracturing could restrict the availability of our raw materials, thereby increasing our costs.With increased volatility in raw material costs, our suppliers could impose more onerous terms on us, resulting in shorter payment cycles and increasing our working capital requirements.Our ability to source raw materials may be adversely affected by political instability, civil disturbances or other governmental actions.We obtain a portion of our principal raw materials from sources in the Middle East and Central and South America that may be less politically stable than other areas in which we conduct business. Political instability, civil disturbances and actions by governments in these areas are more likely to substantially increase the price and decrease the supply of raw materials necessary for our operations, which could have a material adverse effect on our results of operations.Incidents of civil unrest, including terrorist attacks and demonstrations that have been marked by violence, have occurred in a number of countries in the Middle East and South America. Some political regimes in these countries are threatened or have changed as a result of such unrest. Political instability and civil unrest could continue to spread in the region and involve other areas. Such unrest, if it continues to spread or grow in intensity, could lead to civil wars, regional conflicts or regime changes resulting in governments that are hostile to countries in which we conduct substantial business, such as in the U.S., Europe or their respective trading partners.Our business is capital intensive and we rely on cash generated from operations and external financing to fund our growth and ongoing capital needs. Limitations on access to external financing could adversely affect our operating results.We require significant capital to operate our current business and fund our growth strategy. Moreover, interest payments, dividends and the expansion of our current business or other business opportunities may require significant amounts of capital. We believe that our cash from operations currently will be sufficient to meet these 22Table of Contentsneeds. However, if we need external financing, our access to credit markets and pricing of our capital is dependent upon maintaining sufficient credit ratings from credit rating agencies and the state of the capital markets generally. There can be no assurances that we would be able to incur indebtedness on terms we deem acceptable, and it is possible that the cost of any financings could increase significantly, thereby increasing our expenses and decreasing our net income. If we are unable to generate sufficient cash flow or raise adequate external financing, including as a result of significant disruptions in the global credit markets, we could be forced to restrict our operations and growth opportunities, which could adversely affect our operating results.We may use our $2.5 billion revolving credit facility, which backs our commercial paper program, to meet our cash needs, to the extent available. As of December 31, 2020, we had no borrowings or letters of credit outstanding under the facility and $500 million, net of discount, outstanding under our commercial paper program, leaving an unused and available credit capacity of $2,020 million. We may also meet our cash needs by selling receivables under our $900 million U.S. Receivables Facility. As of December 31, 2020, subject to a borrowing base of eligible receivables, we had availability of $757 million under this facility. In the event of a default under our credit facility or any of our senior notes, we could be required to immediately repay all outstanding borrowings and make cash deposits as collateral for all obligations the facility supports, which we may not be able to do. Any default under any of our credit arrangements could cause a default under many of our other credit agreements and debt instruments. Without waivers from lenders party to those agreements, any such default could have a material adverse effect on our ability to continue to operate.Risks Related to our OperationsOur operations are subject to risks inherent in chemical and refining businesses, and we could be subject to liabilities for which we are not fully insured or that are not otherwise mitigated.We maintain property, business interruption, product, general liability, casualty and other types of insurance that we believe are appropriate for our business and operations as well as in line with industry practices. However, we are not fully insured against all potential hazards incident to our business, including losses resulting from natural disasters, wars or terrorist acts. Changes in insurance market conditions have caused, and may in the future cause, premiums and deductibles for certain insurance policies to increase substantially and, in some instances, for certain insurance to become unavailable or available only for reduced amounts of coverage. If we were to incur a significant liability for which we were not fully insured, we might not be able to finance the amount of the uninsured liability on terms acceptable to us or at all, and might be obligated to divert a significant portion of our cash flow from normal business operations.Our business, including our results of operations and reputation, could be adversely affected by safety or product liability issues.Failure to appropriately manage safety, human health, product liability and environmental risks associated with our products, product life cycles and production processes could adversely impact employees, communities, stakeholders, our reputation and our results of operations. Public perception of the risks associated with our products and production processes could impact product acceptance and influence the regulatory environment in which we operate. While we have procedures and controls to manage safety risks, issues could be created by events outside of our control, including natural disasters, severe weather events and acts of sabotage.Further, because a part of our business involves licensing polyolefin process technology, our licensees are exposed to similar risks involved in the manufacture and marketing of polyolefins. Hazardous incidents involving our licensees, if they do result or are perceived to result from use of our technologies, may harm our reputation, threaten our relationships with other licensees and/or lead to customer attrition and financial losses. Our policy of covering these risks through contractual limitations of liability and indemnities and through insurance may not always be effective. As a result, our financial condition and results of operation would be adversely affected, and other companies with competing technologies may have the opportunity to secure a competitive advantage.23Table of ContentsInterruptions of operations at our facilities may result in increased liabilities or lower operating results.We own and operate large-scale facilities. Our operating results are dependent on the continued operation of our various production facilities and the ability to complete construction and maintenance projects on schedule. Interruptions at our facilities may materially reduce the productivity and profitability of a particular manufacturing facility, or our business as a whole, during and after the period of such operational difficulties. In recent years, we have had to shut down plants on the U.S. Gulf Coast, including the temporary shutdown of a portion of our Houston refinery, as a result of various hurricanes striking Texas and Louisiana. In addition, because the Houston refinery is our only refining operation, an outage at the refinery could have a particularly negative impact on our operating results as we do not have the ability to increase refining production elsewhere.Although we take precautions to enhance the safety of our operations and minimize the risk of disruptions, our operations are subject to hazards inherent in chemical manufacturing and refining and the related storage and transportation of raw materials, products and wastes. These potential hazards include:•pipeline leaks and ruptures;•explosions;•fires;•severe weather and natural disasters;•mechanical failure;•unscheduled downtimes;•supplier disruptions;•labor shortages or other labor difficulties;•transportation interruptions;•remediation complications;•increased restrictions on, or the unavailability of, water for use at our manufacturing sites or for the transport of our products or raw materials;•chemical and oil spills;•discharges or releases of toxic or hazardous substances or gases;•shipment of incorrect or off-specification product to customers;•storage tank leaks;•other environmental risks; and•terrorist acts.Some of these hazards may cause severe damage to or destruction of property and equipment or personal injury and loss of life and may result in suspension of operations or the shutdown of affected facilities.Large capital projects can take many years to complete, and market conditions could deteriorate significantly between the project approval date and the project startup date, negatively impacting project returns. If we are unable to complete capital projects at their expected costs and in a timely manner, or if the market conditions assumed in our project economics deteriorate, our business, financial condition, results of operations and cash flows could be materially and adversely affected.24Table of ContentsDelays or cost increases related to capital spending programs involving engineering, procurement and construction of facilities could materially adversely affect our ability to achieve forecasted internal rates of return and operating results. For example, higher costs arising from the delayed construction of our world-scale PO/TBA plant in Houston, due to COVID-19, more extensive civil construction, and unexpected tariffs on materials are expected to add approximately 40 to 50% to our original cost estimate for the project, impacting our projected rate of return on the project. Delays in making required changes or upgrades to our facilities could subject us to fines or penalties as well as affect our ability to contract with our customers and supply certain products we produce. Such delays or cost increases may arise as a result of unpredictable factors, many of which are beyond our control, including:•denial of or delay in receiving requisite regulatory approvals and/or permits; •unplanned increases in the cost of construction materials or labor;•disruptions in transportation of components or construction materials;•adverse weather conditions, natural disasters or other events (such as equipment malfunctions, explosions, fires or spills) affecting our facilities, or those of vendors or suppliers;•shortages of sufficiently skilled labor, or labor disagreements resulting in unplanned work stoppages; and•nonperformance by, or disputes with, vendors, suppliers, contractors or subcontractors.Any one or more of these factors could have a significant impact on our ongoing capital projects. If we were unable to make up the delays associated with such factors or to recover the related costs, or if market conditions change, it could materially and adversely affect our business, financial condition, results of operations and cash flows.Shared control or lack of control of joint ventures may delay decisions or actions regarding our joint ventures.A portion of our operations are conducted through joint ventures, where control may be exercised by or shared with unaffiliated third parties. We cannot control the actions of our joint venture partners, including any nonperformance, default or bankruptcy of joint venture partners. The joint ventures that we do not control may also lack financial reporting systems to provide adequate and timely information for our reporting purposes.Our joint venture partners may have different interests or goals than we do and may take actions contrary to our requests, policies or objectives. Differences in views among the joint venture participants also may result in delayed decisions or in failures to agree on major matters, potentially adversely affecting the business and operations of the joint ventures and in turn our business and operations. We may develop a dispute with any of our partners over decisions affecting the venture that may result in litigation, arbitration or some other form of dispute resolution. If a joint venture participant acts contrary to our interest, it could harm our brand, business, results of operations and financial condition.We may be required to record material charges against our earnings due to any number of events that could cause impairments to our assets.We may be required to reduce production or idle facilities for extended periods of time or exit certain businesses as a result of the cyclical nature of our industry. Specifically, oversupplies of or lack of demand for particular products or high raw material prices may cause us to reduce production. We may choose to reduce production at certain facilities because we have off-take arrangements at other facilities, which make any reductions or idling unavailable at those facilities. Any decision to permanently close facilities or exit a business would likely result in impairment and other charges to earnings. For example, in the third quarter of 2020, our Refining segment recognized a non-cash impairment charge of $582 million related to our Houston refinery driven by the expectation of a prolonged reduction in travel and associated transportation fuels consumption resulting from the pandemic which created an oversupply in global fuel markets that will pressure refining profitability for an extended period of time. 25Table of ContentsTemporary outages at our facilities can last for several quarters and sometimes longer. These outages could cause us to incur significant costs, including the expenses of maintaining and restarting these facilities. In addition, we have significant obligations under take-or-pay agreements. Even though we may reduce production at facilities, we may be required to continue to purchase or pay for utilities or raw materials under these arrangements.Integration of acquisitions could disrupt our business and harm our financial condition and stock price.We have made and may continue to make acquisitions in order to enhance our business. Acquisitions involve numerous risks, including meeting our standards for compliance, problems combining the purchased operations, technologies or products, unanticipated costs and liabilities, diversion of management’s attention from our core businesses, and potential loss of key employees.There can be no assurance that we will be able to integrate successfully any businesses, products, technologies, or personnel that we might acquire. The integration of businesses that we may acquire is likely to be a complex, time-consuming, and expensive process and we may not realize the anticipated revenues, synergies, or other benefits associated with our acquisitions if we do not manage and operate the acquired business up to our expectations. If we are unable to efficiently operate as a combined organization utilizing common information and communication systems, operating procedures, financial controls, and human resources practices, our business, financial condition, and results of operations may be adversely affected.Risks related to the Global Economy and Multinational OperationsEconomic disruptions and downturns in general, and particularly continued global economic uncertainty or economic turmoil in emerging markets, could have a material adverse effect on our business, prospects, operating results, financial condition and cash flows.Our results of operations can be materially affected by adverse conditions in the financial markets and depressed economic conditions generally. Economic downturns in the businesses and geographic areas in which we sell our products could substantially reduce demand for our products and result in decreased sales volumes and increased credit risk. Recessionary environments adversely affect our business because demand for our products is reduced, particularly from our customers in industrial markets generally and the automotive and housing industries specifically, and may result in higher costs of capital. A significant portion of our revenues and earnings are derived from our business in Europe. In addition, most of our European transactions and assets, including cash reserves and receivables, are denominated in euros.We also derive significant revenues from our business in emerging markets, particularly the emerging markets in Asia and South America. Any broad-based downturn in these emerging markets, or in a key market such as China, could require us to reduce export volumes into these markets and could also require us to divert product sales to less profitable markets. Any of these conditions could ultimately harm our overall business, prospects, operating results, financial condition and cash flows.We sell products in highly competitive global markets and face significant price pressures.We sell our products in highly competitive global markets. Due to the commodity nature of many of our products, competition in these markets is based primarily on price and, to a lesser extent, on product performance, product quality, product deliverability, reliability of supply and customer service. Often, we are not able to protect our market position for these products by product differentiation and may not be able to pass on cost increases to our customers due to the significant competition in our business.In addition, we face increased competition from companies that may have greater financial resources and different cost structures or strategic goals than us. These include large integrated oil companies (some of which also have chemical businesses), government-owned businesses, and companies that receive subsidies or other government incentives to produce certain products in a specified geographic region. Continuing competition from these companies, especially in our olefin and refining businesses, could limit our ability to increase product sales prices in 26Table of Contentsresponse to raw material and other cost increases, or could cause us to reduce product sales prices to compete effectively, which would reduce our profitability. Competitors with different cost structures or strategic goals than we have may be able to invest significant capital into their businesses, including expenditures for research and development. In addition, specialty products we produce may become commoditized over time. Increased competition could result in lower prices or lower sales volumes, which would have a negative impact on our results of operations.We operate internationally and are subject to exchange rate fluctuations, exchange controls, political risks and other risks relating to international operations.We operate internationally and are subject to the risks of doing business on a global level. These risks include fluctuations in currency exchange rates, economic instability and disruptions, restrictions on the transfer of funds and the imposition of trade restrictions or duties and tariffs, and complex regulations concerning privacy and data security. Additional risks from our multinational business include transportation delays and interruptions, war, terrorist activities, epidemics, pandemics, political instability, import and export controls, sanctions, changes in governmental policies, labor unrest and current and changing regulatory environments.We generate revenues from export sales and operations that may be denominated in currencies other than the relevant functional currency. Exchange rates between these currencies and functional currencies in recent years have fluctuated significantly and may do so in the future. It is possible that fluctuations in exchange rates will result in reduced operating results. Additionally, we operate with the objective of having our worldwide cash available in the locations where it is needed, including the United Kingdom for our parent company’s significant cash obligations as a result of dividend payments. It is possible that we may not always be able to provide cash to other jurisdictions when needed or that such transfers of cash could be subject to additional taxes, including withholding taxes.Our operating results could be negatively affected by the laws, rules and regulations, as well as political environments, in the jurisdictions in which we operate. There could be reduced demand for our products, decreases in the prices at which we can sell our products and disruptions of production or other operations. Trade protection measures such as quotas, duties, tariffs, safeguard measures or anti-dumping duties imposed in the countries in which we operate could negatively impact our business. Additionally, there may be substantial capital and other costs to comply with regulations and/or increased security costs or insurance premiums, any of which could reduce our operating results.We obtain a portion of our principal raw materials from international sources that are subject to these same risks. Our compliance with applicable customs, currency exchange control regulations, transfer pricing regulations or any other laws or regulations to which we may be subject could be challenged. Furthermore, these laws may be modified, the result of which may be to prevent or limit subsidiaries from transferring cash to us.Furthermore, we are subject to certain existing, and may be subject to possible future, laws that limit or may limit our activities while some of our competitors may not be subject to such laws, which may adversely affect our competitiveness.Changes in tax laws and regulations could affect our tax rate and our results of operations. We are a tax resident in the United Kingdom and are subject to the United Kingdom corporate income tax system. LyondellBasell Industries N.V. has little or no taxable income of its own because, as a holding company, it does not conduct any operations. Through our subsidiaries, we have substantial operations world-wide. Taxes are primarily paid on the earnings generated in various jurisdictions where our subsidiaries operate, including the U.S., The Netherlands, Germany, France and Italy.There continues to be increased attention to the tax practices of multinational companies, including the European Union’s state aid investigations, proposals by the Organization for Economic Cooperation and Development with respect to base erosion and profit shifting, and European Union tax directives and their implementation. Management does not believe that recent changes in income tax laws will have a material impact on our business, 27Table of Contentsfinancial condition, or results of operations, although new or proposed changes to tax laws could affect our tax liabilities in the future.Risks Related to Health, Safety, and the Environment We cannot predict with certainty the extent of future costs under environmental, health and safety and other laws and regulations, and cannot guarantee they will not be material. We may face liability arising out of the normal course of business, including alleged personal injury or property damage due to exposure to chemicals or other hazardous substances at our current or former facilities or chemicals that we manufacture, handle or own. In addition, because our products are components of a variety of other end-use products, we, along with other members of the chemical industry, are subject to potential claims related to those end-use products. Any substantial increase in the success of these types of claims could negatively affect our operating results. We are subject to extensive national, regional, state and local environmental laws, regulations, directives, rules and ordinances concerning: •emissions to the air; •discharges onto land or surface waters or into groundwater; and •the generation, handling, storage, transportation, treatment, disposal and remediation of hazardous substances and waste materials. Many of these laws and regulations provide for substantial fines and potential criminal sanctions for violations. Some of these laws and regulations are subject to varying and conflicting interpretations. In addition, some of these laws and regulations require us to meet specific financial responsibility requirements. Any substantial liability for environmental damage could have a material adverse effect on our financial condition, results of operations and cash flows. Although we have compliance programs and other processes intended to ensure compliance with all such regulations, we are subject to the risk that our compliance with such regulations could be challenged. Non-compliance with certain of these regulations could result in the incurrence of additional costs, penalties or assessments that could be material. Our industry is subject to extensive government regulation, and existing, or future regulations may restrict our operations, increase our costs of operations or require us to make additional capital expenditures. Compliance with regulatory requirements will result in higher operating costs, such as regulatory requirements relating to emissions, the security of our facilities, and the transportation, export or registration of our products. We generally expect that regulatory controls worldwide will become increasingly more demanding, but cannot accurately predict future developments. Increasingly strict environmental laws and inspection and enforcement policies, could affect the handling, manufacture, use, emission or disposal of products, other materials or hazardous and non-hazardous waste. Stricter environmental, safety and health laws, regulations and enforcement policies could result in increased operating costs or capital expenditures to comply with such laws and regulations. Additionally, we are required to have permits for our businesses and are subject to licensing regulations. These permits and licenses are subject to renewal, modification and in some circumstances, revocation. Further, the permits and licenses are often difficult, time consuming and costly to obtain and could contain conditions that limit our operations. 28Table of ContentsWe may incur substantial costs to comply with climate change legislation and related regulatory initiatives. There has been a broad range of proposed or promulgated international, national and state laws focusing on greenhouse gas (“GHG”) reduction. These proposed or promulgated laws apply or could apply in countries where we have interests or may have interests in the future. Laws and regulations in this field continue to evolve and, while they are likely to be increasingly widespread and stringent, at this stage it is not possible to accurately estimate either a timetable for implementation or our future compliance costs relating to implementation. Under the 2015 Paris Agreement, parties to the United Nations Framework Convention on Climate Change agreed to undertake ambitious efforts to reduce GHG emissions and strengthen adaptation to the effects of climate change. In February 2021, the U.S. recommitted to the Agreement after having withdrawn in August 2017. Other regions in which we operate, including, in particular, the European Union, are preparing national legislation and protection plans to implement their emission reduction commitments under the Agreement. In December 2020, European Union leadership agreed to cut GHG emissions by at least 55 percent by 2030, a step toward achieving the European Union’s goal of carbon neutrality by 2050. These actions could result in increased cost of purchased energy and increased costs of compliance for impacted locations. Our operations in Europe participate in the European Union Emissions Trading System (“ETS”) and we purchase annual emission allowances to meet our obligations. In light of changes resulting from the commencement of ETS Phase IV in 2021, we expect to incur additional costs in relation to future carbon or GHG emission trading schemes. In the U.S., the EPA promulgated federal GHG regulations under the Clean Air Act affecting certain sources. The EPA issued mandatory GHG reporting requirements, requirements to obtain GHG permits for certain industrial plants and GHG performance standards for some facilities. Although the EPA recently scaled back certain GHG requirements, addressing climate change is a stated priority of President Biden and as such additional regulations and legislation are likely to be forthcoming at the U.S. federal or state level that could result in increased operating costs for compliance, or required acquisition or trading of emission allowances. Additionally, demand for the products we produce may be reduced.Compliance with these regulations may result in increased permitting necessary for the operation of our business or for any of our growth plans. Difficulties in obtaining such permits could have an adverse effect on our future growth. Therefore, any future potential regulations and legislation could result in additional operating restrictions or delays in implementing growth projects or other capital investments, and could have a material adverse effect on our business and results of operations. Legislation and regulatory initiatives could lead to a decrease in demand for our products. New or revised governmental regulations and independent studies relating to the effect of our products on health, safety and the environment may affect demand for our products and the cost of producing our products. Initiatives by governments and private interest groups will potentially require increased toxicological testing and risk assessments of a wide variety of chemicals, including chemicals used or produced by us. For example, in the United States, the National Toxicology Program (“NTP”) is a federal interagency program that seeks to identify and select for study chemicals and other substances to evaluate potential human health hazards. In the European Union, the Regulation on Registration, Evaluation, Authorisation and Restriction of Chemicals (“REACH”) is regulation designed to identify the intrinsic properties of chemical substances, assess hazards and risks of the substances, and identify and implement the risk management measures to protect humans and the environment. Assessments under NTP, REACH or similar programs or regulations in other jurisdictions may result in heightened concerns about the chemicals we use or produce and may result in additional requirements being placed on the production, handling, labeling or use of those chemicals. Such concerns and additional requirements could also increase the cost incurred by our customers to use our chemical products and otherwise limit the use of these products, which could lead to a decrease in demand for these products. Such a decrease in demand could have an adverse impact on our business and results of operations. 29Table of ContentsThe physical impacts of climate change can negatively impact our facilities and operations. Potential physical impacts of climate change include increased frequency and severity of hurricanes and floods as well as drought conditions, and global sea level rise. Although we have preparedness plans in place designed to minimize impacts and enhance safety, should an event occur, it could have the potential to disrupt our supply chain and operations. A number of our facilities are located on the Gulf Coast, which has been impacted by hurricanes that have required us to temporarily shut down operations at those sites. In addition, our sites rely on rivers for transportation that may experience restrictions in times of drought or other unseasonal weather variation. Increased regulation or deselection of plastic could lead to a decrease in demand growth for some of our products. There is a growing concern with the accumulation of plastic, including microplastics, and other packaging waste in the environment. Additionally, plastics have recently faced increased public backlash and scrutiny. Policy measures to address this concern are being discussed or implemented by governments at all levels. In 2019, the international treaty governing transboundary shipments of waste, the Basel Convention, was amended to clarify its applicability to plastic waste. The European Commission has been undertaking a series of actions under its Strategy for Plastics in a Circular Economy, including adoption of the Single Use Plastics Directive in 2019, which introduced policy measures for single use plastics including bans, product design requirements, extended producer responsibility obligations, and labeling requirements. Member states are required to transpose these measures into national law by July 2021. In addition, a host of single-use plastic bans and taxes have been passed by countries around the world and counties and municipalities throughout the U.S. Increased regulation of, or prohibition on, the use of certain plastic products could increase the costs incurred by our customers to use such products or otherwise limit the use of these products, and could lead to a decrease in demand for PE, PP, and other products we make. Such a decrease in demand could adversely affect our business, operating results, and financial condition.General Risk FactorsThe novel coronavirus (COVID-19) pandemic could continue to materially adversely affect our financial condition and results of operations.In early 2020, the COVID-19 pandemic spread to countries worldwide and resulted in governments and other authorities implementing numerous measures to try to contain the disease, such as travel bans and restrictions, social distancing, quarantines, shelter-in-place orders and business shutdowns, among others. These measures caused significant economic disruption and adversely impacted the global economy, leading to reduced consumer spending and volatility in the global financial and commodities markets. Many of our facilities and employees are located in areas impacted by the virus. As a result of these measures and the general economic disruption, we experienced a decline in our financial results primarily in the second and third quarters of 2020, particularly in our Advanced Polymer Solutions and Refining segments. A return to more ordinary course of economic activity is dependent on the duration and severity of the COVID-19 pandemic, including the severity and transmission rate of the virus, the extent and effectiveness of containment efforts, including the spread of virus variants, the availability of vaccines, and future policy decisions made by governments across the globe as they react to evolving local and global conditions.We continue to work with our stakeholders (including customers, employees, suppliers, business partners, and local communities) to attempt to mitigate the impact of the global pandemic on our business, including by implementing policies and procedures to promote the safety of our employees, proactively reducing costs intended to allow us to protect against further risk, and investing in initiatives to support our long-term growth, while also focusing on maintaining liquidity. However, we cannot assure that these mitigation efforts will continue to be effective or successful. An extended period of global supply chain and economic disruption as a result of the COVID-19 pandemic could have a material negative impact on our business, results of operations, access to sources of liquidity and financial condition. To the extent that the COVID-19 pandemic adversely impacts our business, results of operations, liquidity or financial condition, it may also have the effect of increasing many of the other risks described in “Risk Factors” set forth in this Annual Report on Form 10-K.30Table of ContentsIncreased IT and cybersecurity threats and more sophisticated and targeted computer crime could pose a risk to our systems, networks, data, products, facilities and services.Increased global information cybersecurity threats and more sophisticated, targeted computer crime pose a risk to the confidentiality, availability and integrity of our data, operations and infrastructure. While we attempt to mitigate these risks by employing a number of measures, including security measures, employee training, comprehensive monitoring of our networks and systems, and maintenance of backup and protective systems, our employees, systems, networks, products, facilities and services remain potentially vulnerable to sophisticated espionage or cyber-assault. Depending on their nature and scope, such threats could potentially lead to the compromise of confidential information, improper use of our systems and networks, manipulation and destruction of data, defective products, production downtimes and operational disruptions, which in turn could adversely affect our reputation, competitiveness and results of operations.Many of our businesses depend on our intellectual property. Our future success will depend in part on our ability to protect our intellectual property rights, and our inability to do so could reduce our ability to maintain our competitiveness and margins.We have a significant worldwide patent portfolio of issued and pending patents. These patents and patent applications, together with proprietary technical know-how, are significant to our competitive position, particularly with regard to PO, intermediate chemicals, polyolefins, licensing and catalysts. We rely on the patent, copyright and trade secret laws of the countries in which we operate to protect our investment in research and development, manufacturing and marketing. We operate plants, sell catalysts and products, participate in joint ventures, and license our process technology in many foreign jurisdictions, including those having heightened risks for intellectual property. In some of these instances, we must disclose at least a portion of our technology to third parties or regulatory bodies. In these cases, we rely primarily on contracts and trade secret laws to protect the associated trade secrets. However, we may be unable to prevent third parties from using our intellectual property without authorization. Proceedings to protect these rights could be costly, and we may not prevail.The failure of our patents or confidentiality agreements to protect our processes, apparatuses, technology, trade secrets or proprietary know-how could result in significantly lower revenues, reduced profit margins and cash flows and/or loss of market share. We also may be subject to claims that our technology, patents or other intellectual property infringes on a third party’s intellectual property rights. Unfavorable resolution of these claims could result in restrictions on our ability to deliver the related service or in a settlement that could be material to us.Adverse results of legal proceedings could materially adversely affect us.We are subject to and may in the future be subject to a variety of legal proceedings and claims that arise out of the ordinary conduct of our business. Results of legal proceedings cannot be predicted with certainty. Irrespective of its merits, litigation may be both lengthy and disruptive to our operations and may cause significant expenditure and diversion of management attention. We may be faced with significant monetary damages or injunctive relief against us that could have an adverse impact on our business and results of operations should we fail to prevail in certain matters.Significant changes in pension fund investment performance or assumptions relating to pension costs may adversely affect the valuation of pension obligations, the funded status of pension plans, and our pension cost.Our pension cost is materially affected by the discount rates used to measure pension obligations, the level of plan assets available to fund those obligations at the measurement date and the expected long-term rates of return on plan assets. Significant changes in investment performance or a change in the portfolio mix of invested assets may result in corresponding increases and decreases in the value of plan assets, particularly equity securities, or in a change of the expected rate of return on plan assets. Any changes in key actuarial assumptions, such as the discount rate or mortality rate, would impact the valuation of pension obligations, affecting the reported funded status of our pension plans as well as the net periodic pension cost in the following fiscal years.31Table of ContentsNearly all of our current pension plans have projected benefit obligations that exceed the fair value of the plan assets. As of December 31, 2020, the aggregate deficit was $1,482 million. Any declines in the fair values of the pension plans’ assets could require additional payments by us in order to maintain specified funding levels. Our pension plans are subject to legislative and regulatory requirements of applicable jurisdictions, which could include, under certain circumstances, local governmental authority to terminate the plan.See Note 14 to the Consolidated Financial Statements for additional information regarding pensions and other postretirement benefits.Item 1B. Unresolved Staff Comments.None.Item 3. Legal Proceedings.Environmental MattersFrom time to time we and our joint ventures receive notices or inquiries from government entities regarding alleged violations of environmental laws and regulations pertaining to, among other things, the disposal, emission and storage of chemical and petroleum substances, including hazardous wastes. U.S. Securities and Exchange Commission rules require disclosure of certain environmental matters when a governmental authority is a party to the proceedings and the proceedings involve potential monetary sanctions that we reasonably believe could exceed $300,000. The matters below are disclosed solely pursuant to that requirement and we do not believe that any of these proceeding will have a material impact on the company’s Consolidated Financial Statements.In March 2018, the Cologne, Germany local court issued a regulatory fine notice of €1,800,000 arising from a pipeline leak near our Wesseling, Germany facility. We expect the Cologne prosecutor to issue a corresponding payment request, which will resolve the matter.The U.S. Environmental Protection Agency (EPA) has been conducting an enforcement initiative regarding flare emissions at petrochemical plants. In July 2014, we received a Clean Air Act section 114 information request regarding flares at four U.S. facilities, and entered into discussions with EPA and the Department of Justice (DOJ). In December 2020, we reached a settlement agreement with EPA and DOJ to resolve claims related to alleged improper operation and maintenance of flares at the four facilities. The Company has agreed to pay a penalty of $4,100,000, and make investments in equipment at the facilities. The complaint and consent decree are expected to be filed in the U.S. District Court for the Southern District of Texas.In February 2020, the State of Texas filed suit against Houston Refining, LP, a subsidiary of LyondellBasell, in Travis County District Court seeking civil penalties and injunctive relief for violations of the Texas Clean Air Act related to several emission events. In July 2020, Harris County, Texas petitioned to intervene in the lawsuit and the State added additional claims to its petition relating to self-reported deviations of Houston Refining's air operating permit. We reasonably believe resolution of this matter could result in payment of a penalty in excess of $300,000.Litigation and Other MattersInformation regarding our litigation and other legal proceedings can be found in Note 17 to the Consolidated Financial Statements.Item 4. Mine Safety Disclosures.Not applicable.32Table of ContentsPART II Item 5. Market for Registrant’s Common Equity, Related Shareholder Matters and Issuer Purchases of Equity Securities.Market and Dividend InformationOur shares were listed on the New York Stock Exchange (“NYSE”) on October 14, 2010 under the symbol “LYB.” The payment of dividends or distributions in the future will be subject to the requirements of Dutch law and the discretion of our Board of Directors. The declaration of any future cash dividends and, if declared, the amount of any such dividends, will depend upon general business conditions, our financial condition, our earnings and cash flow, our capital requirements, financial covenants and other contractual restrictions on the payment of dividends or distributions.There can be no assurance that any dividends or distributions will be declared or paid in the future.HoldersAs of February 23, 2021, there were approximately 5,400 record holders of our shares, including Cede & Co. as nominee of the Depository Trust Company.United Kingdom Tax ConsiderationsAs a result of its United Kingdom tax residency, dividend distributions by LyondellBasell Industries N.V. to its shareholders are not subject to withholding tax, as the United Kingdom currently does not levy a withholding tax on dividend distributions.33Table of ContentsPerformance GraphThe performance graph and the information contained in this section is not “soliciting material,” is being furnished, not filed, with the SEC and is not to be incorporated by reference into any of our filings under the Securities Act or the Exchange Act whether made before or after the date hereof and irrespective of any general incorporation language contained in such filing.The graph below shows the relative investment performance of LyondellBasell Industries N.V. shares, the S&P 500 Index and the S&P 500 Chemicals Index since December 31, 2015. The graph assumes that $100 was invested on December 31, 2015 and any dividends paid were reinvested at the date of payment. The graph is presented pursuant to SEC rules and is not meant to be an indication of our future performance. 12/31/201512/31/201612/31/201712/31/201812/31/201912/31/2020LyondellBasell Industries N.V.$100.00$102.90$137.61$107.75$128.67$132.07S&P 500 Index$100.00$111.96$136.40$130.42$171.49$203.04S&P 500 Chemicals Index$100.00$110.16$139.53$123.34$150.49$177.64Issuer Purchases of Equity SecuritiesOn May 29, 2020, we announced a share repurchase authorization of up to 34,004,563 of our ordinary shares through November 29, 2021, which superseded any prior repurchase authorizations and represents the maximum number of shares that may be purchased as of December 31, 2020. The maximum number of shares that may yet be purchased is not necessarily an indication of the number of shares that will ultimately be purchased.34Table of ContentsItem 6. Selected Financial Data.The following selected financial data was derived from our Consolidated Financial Statements, which were prepared from our books and records. In August 2018, we acquired all of the outstanding common stock of A. Schulman, Inc. (“A. Schulman”). As such, amounts below incorporate the businesses acquired from A. Schulman beginning August 2018. This data should be read in conjunction with the Consolidated Financial Statements and related notes thereto and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” below, which includes a discussion of factors that will enhance an understanding of this data. Year Ended December 31,In millions of dollars, except per share data20202019201820172016Results of operations data:Sales and other operating revenues$27,753 $34,727 $39,004 $34,484 $29,183 Operating income(a)1,559 4,116 5,231 5,460 5,060 Interest expense(b)(526)(347)(360)(491)(322)Income from equity investments256 225 289 321 367 Income from continuing operations(a)(b)(c)1,429 3,404 4,698 4,895 3,847 Earnings per share from continuing operations:Basic4.25 9.61 12.06 12.28 9.17 Diluted4.25 9.60 12.03 12.28 9.15 Loss from discontinued operations, net of tax(2)(7)(8)(18)(10)Loss per share from discontinued operations:Basic(0.01)(0.02)(0.02)(0.05)(0.02)Diluted(0.01)(0.02)(0.02)(0.05)(0.02)Balance sheet data:Total assets$35,403 $30,435 $28,278 $26,206 $23,442 Short-term debt663 445 885 68 594 Long-term debt(d)15,294 11,617 8,502 8,551 8,387 Cash and cash equivalents1,763 858 332 1,523 875 Short-term investments702 196 892 1,307 1,147 Accounts receivable3,441 3,102 3,503 3,539 2,842 Inventories4,344 4,588 4,515 4,217 3,809 Working capital(e)4,837 4,762 4,931 4,861 4,122 Cash flow data:Cash provided by (used in):Operating activities$3,404 $4,961 $5,471 $5,206 $5,606 Investing activities(4,906)(1,635)(3,559)(1,756)(2,301)Expenditures for property, plant and equipment(1,947)(2,694)(2,105)(1,547)(2,243)Financing activities2,271 (2,835)(3,008)(2,859)(3,349)Dividends - common stock declared per share$4.20 $4.15 $4.00 $3.55 $3.33 (a)Operating income and Income from continuing operations in 2020 include pre-tax charges of $37 million ($27 million, after tax) for integration costs associated with our acquisition of A. Schulman and a pre-tax non-cash charge of $582 million ( $446 million, after tax), related to impairment of long-lived assets at our Houston refinery. Integration activities related to our acquisition of A. Schulman were substantially completed by the third quarter of 2020. 35Table of ContentsIn 2019, we had pre-tax charges of $116 million ($89 million, after tax) for integration costs associated with our acquisition of A. Schulman. In 2018, we had pre-tax acquisition-related transaction and integration costs of $73 million ($57 million, after tax) associated with the acquisition of A. Schulman. In 2016, we had a pre-tax charge of $58 million ($37 million, after tax) for a pension settlement.(b)Interest expense and Income from continuing operations in 2020 include pre-tax charges of $69 million ($53 million, after tax) related to the redemption of $1,000 million aggregate principal amount of our then outstanding 6% senior notes due 2021 and €750 million aggregate principal amount of our then outstanding 1.875% guaranteed notes due 2022. In 2017, we had pre-tax charges of $113 million ($106 million, after tax) related to the redemption of $1,000 million aggregate principal amount of our then outstanding 5% senior notes due 2019.(c)Income from continuing operations in 2019 and 2018 includes a non-cash tax benefit of $113 million and $358 million, respectively, from the previously unrecognized tax benefits and the release of associated accrued interest.Also included in 2018 is a $34 million after tax gain on the sale of our carbon black subsidiary in France. Income from continuing operations in 2017 includes an $819 million non-cash tax benefit related to the lower federal income tax rate resulting from the enactment of the U.S. Tax Cuts and Jobs Act, an after tax gain $103 million on the sale of our 27% interest in Geosel, a joint venture in France and a $20 million after tax gain on the sale of property in Lake Charles, Louisiana.Income from continuing operations in 2016 includes $135 million of out-of-period adjustments related to taxes on our cross-currency swaps and deferred liabilities related to some of our consolidated subsidiaries. Also included in 2016, is an after tax gain of $78 million on the sale of our wholly owned Argentine subsidiary.(d)Includes Long-term debt and Current maturities of long-term debt.(e)We define working capital as the sum of Accounts receivable and Inventories less Accounts payable.36Table of ContentsItem 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.GENERALThis discussion should be read in conjunction with the information contained in our Consolidated Financial Statements, and the accompanying notes elsewhere in this report. Unless otherwise indicated, the “Company,” “we,” “us,” “our” or similar words are used to refer to LyondellBasell Industries N.V. together with its consolidated subsidiaries (“LyondellBasell N.V.”).The discussion summarizing the significant factors affecting the results of operations and financial condition for the year ended December 31, 2018, can be found in Part II, “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations” of our Annual Report on Form 10-K for the year ended December 31, 2019, which was filed with the Securities and Exchange Commission on February 20, 2020 , of which Item 7 is incorporated herein by reference.OVERVIEWDuring 2020, we demonstrated financial and operational resilience against the challenging backdrop of a global pandemic, the associated recession, volatile oil prices and significant capacity additions in our industry. Early in 2020, as the virus became more widespread, our leadership team established three principles to guide our actions in the short term. These were to (i) protect our employees, both from the virus in the workplace and also from widespread layoffs; (ii) prioritize cash flow and keep our commitments to our shareholders; and (iii) take action to strengthen the company for the future.Our manufacturing operations have been designated as an essential industry to support society’s needs during the pandemic in the majority of the regions in which we operate. Our performance was supported by consumer-driven demand for many of our products and the recovery in demand for durable goods during the second half of the year. Our Refining and Oxyfuels & Related Products businesses suffered from the unprecedented decline in demand for transportation fuels that began during March 2020 due to the pandemic. During the year, we advanced our growth agenda through the formation of joint ventures in China and on the U.S. Gulf Coast.Our strengths in operational excellence, cost management and capital discipline served us well as we quickly adapted to dynamic conditions by minimizing working capital and bolstering liquidity by rapidly accessing capital markets and efficiently generating cash. We honored commitments to maintain an investment grade credit rating and continued to fund dividends and capital investments with cash from operations.Significant items that affected results in 2020 relative to 2019 include:•Olefins and Polyolefins—Americas (“O&P—Americas”) and Olefins and Polyolefins—Europe, Asia, International (“O&P—EAI”) segment results declined primarily due to lower olefin and polyolefins margins;•Intermediates and Derivatives (“I&D”) segment results declined due to margin decreases primarily driven by our intermediate chemicals and oxyfuels and related products businesses; and•Refining segment results declined due to lower refining margins and a $582 million non-cash impairment charge which was recognized during the third quarter of 2020.37Table of ContentsOther noteworthy items include the following:•Launched production at our U.S. Gulf Coast high-density polyethylene plant using LyondellBasell's next-generation Hyperzone technology during the first quarter of 2020;•In April 2020, issued $2,000 million of Guaranteed Notes to bolster liquidity. Net proceeds from the sale of the notes totaled $1,974 million;•In April 2020, repaid $500 million outstanding under our Senior Revolving Credit Facility and $500 million outstanding under our U.S. Receivables Facility, which were borrowed in March 2020; •In August 2020, invested $472 million in our new 50 percent owned joint venture polyolefin complex in China with Liaoning Bora Enterprise Group using our polyolefin technologies;•In October 2020, issued $3,900 million of Guaranteed Notes to be used to repay certain outstanding borrowings and fund a portion of the Louisiana Integrated PolyEthylene JV LLC (“Louisiana Joint Venture”) purchase. Net proceeds from the sale of the notes totaled $3,848 million; •In the fourth quarter of 2020, repaid $500 million outstanding under our Term Loan due 2022 and all amounts outstanding on our Senior Notes due 2021 and Guaranteed Notes due 2022;•In December 2020, invested $2 billion to purchase a 50 percent interest in the newly formed Louisiana Joint Venture with Sasol Chemicals (USA) LLC;•In January 2021, signed an agreement to form a 50 percent owned joint venture with the China Petroleum & Chemical Corporation (“Sinopec”) which will construct a new PO and SM unit in China; and•In January 2021, repaid an additional $500 million outstanding under our Term Loan due 2022.Results of operations for the periods discussed are presented in the table below. Year Ended December 31,Millions of dollars20202019Sales and other operating revenues$27,753 $34,727 Cost of sales24,359 29,301 Impairment of long-lived assets582 — Selling, general and administrative expenses1,140 1,199 Research and development expenses113 111 Operating income1,559 4,116 Interest expense(526)(347)Interest income12 19 Other income, net85 39 Income from equity investments256 225 Income from continuing operations before income taxes1,386 4,052 (Benefit from) provision for income taxes(43)648 Income from continuing operations1,429 3,404 Loss from discontinued operations, net of tax(2)(7)Net income$1,427 $3,397 38Table of ContentsRESULTS OF OPERATIONSRevenues—Revenues decreased $6,974 million, or 20%, in 2020 compared to 2019. Average sales prices in 2020 were lower for most of our products as sales prices generally correlate with crude oil prices, which decreased relative to 2019. These lower prices led to a 19% decrease in revenue in 2020. Lower sales volumes resulted in a revenue decrease of 2% relative to 2019. Favorable foreign exchange impacts resulted in a revenue increase of 1% during 2020.Cost of Sales—Cost of sales decreased $4,942 million, or 17%, in 2020 compared to 2019. This decrease primarily related to lower feedstock and energy costs. Costs for crude oil, heavy liquid feedstocks and natural gas liquids (“NGLs”) and other feedstocks were lower in 2020 relative to 2019. This decrease corresponds with the decrease in revenues as discussed above.Fluctuations in our cost of sales are generally driven by changes in feedstock and energy costs. Feedstock and energy related costs generally represent approximately 70% to 80% of cost of sales, other variable costs account for approximately 10% of cost of sales on an annual basis and fixed operating costs, consisting primarily of expenses associated with employee compensation, depreciation and amortization, and maintenance, range from approximately 10% to 20% in each annual period.Impairment of Long-Lived Assets—In the third quarter of 2020, our Refining segment recognized a non-cash impairment charge of $582 million related to our Houston refinery driven by the expectation of a prolonged reduction of travel and associated transportation fuels consumption resulting from the pandemic which created an oversupply in global fuel markets that will pressure refining profitability for an extended period of time.SG&A Expense—Selling, general and administrative (“SG&A”) expense decreased $59 million, or 5% in 2020 compared to 2019 primarily due to lower integration costs related to the acquisition of A. Schulman. Integration activities related to our acquisition of A. Schulman were substantially completed by the third quarter of 2020. Operating Income—Operating income decreased by $2,557 million or 62% in 2020 compared to 2019. Operating income includes the effect of the non-cash long-lived asset impairment charge in our Refining segment as noted above.In 2020, Operating income declined across all of our segments by $784 million, $748 million, $607 million, $261 million, $87 million and $64 million for our Refining, I&D, O&P—Americas, O&P—EAI, Technology and APS segments, respectively, as compared to 2019.Interest Expense—Interest expense increased $179 million or 52% in 2020 compared to 2019 primarily due to an increase in long-term debt and the recognition of $69 million in charges related to the redemption of certain long-term notes in 2020. See Note 11 to the Consolidated Financial Statements for additional details.Income Taxes—Our effective income tax rates of -3.1% in 2020 and 16.0% in 2019 resulted in a tax benefit of $43 million and a tax provision of $648 million, respectively. Our effective income tax rate fluctuates based on, among other factors, changes in pre-tax income in countries with varying statutory tax rates, changes in valuation allowances, changes in foreign exchange gains/losses, the amount of exempt income, changes in unrecognized tax benefits associated with uncertain tax positions and changes in tax laws. We continue to maintain valuation allowances in various jurisdictions totaling $132 million as of 2020, which could impact our effective income tax rate in the future.On March 27, 2020, the U.S. enacted the Coronavirus Aid, Relief, and Economic Security Act, also known as the “CARES Act,” which contains numerous income tax provisions and other stimulus measures. In 2020 we recorded an overall tax benefit in relation to the CARES Act of approximately $300 million which reflects the impact of our expected 2020 U.S. tax losses which we intend to carryback to tax years with a higher tax rate and a cash refund of approximately $900 million. For additional information, see Note 16 to our Consolidated Financial Statements.39Table of ContentsThe 2020 effective income tax rate of -3.1%, which is lower than the U.S. statutory tax rate of 21%, was favorably impacted by tax law changes including the CARES Act (-21.5%) coupled with exempt income (-10.4%), partially offset by changes in unrecognized tax benefits associated with uncertain tax positions (7.0%).The 2019 effective income tax rate of 16%, which was lower than the U.S. statutory tax rate of 21%, was favorably impacted by exempt income (-4.5%), a tax benefit related to a patent box ruling (-1.6%), a loss on the liquidation of an entity (-1.3%), and changes in unrecognized tax benefits associated with uncertain tax positions (-1.0%). These favorable items were partially offset by the effects of earnings in various countries, notably in Europe, with higher statutory tax rates (1.6%) and U.S. state and local income taxes (0.7%).During 2019, we recognized a $113 million non-cash benefit to our effective tax rate primarily as a result of the expiration of certain statutes of limitations. This amount consists of the recognition of $100 million of previously unrecognized tax benefits and the release of $13 million of previously accrued interest.Comprehensive Income—We had comprehensive income of $1,268 million in 2020 and $2,976 million in 2019. Comprehensive income decreased by $1,708 million in 2020 compared to 2019, primarily due to lower net income and net unfavorable impacts of financial derivative instruments primarily driven by periodic changes in benchmark interest rates. These decreases were partially offset by net favorable impacts of unrealized changes in foreign currency translation adjustments and improved changes in defined pension and other postretirement benefits.The predominant functional currency for our operations outside of the U.S. is the euro. Relative to the U.S. dollar, the value of the euro increased during 2020 resulting in net gains as reflected in the Consolidated Statements of Comprehensive Income. The gains related to unrealized changes in foreign currency translation impacts were partially offset by pre-tax losses of $166 million in 2020, which represent the effective portion of our net investment hedges. In 2020, the cumulative after-tax effect of our derivatives designated as cash flow hedges was a net loss of $226 million. The strengthening of the euro against the U.S. dollar in 2020 and periodic changes in benchmark interest rates resulted in a pre-tax loss of $129 million related to our cross-currency swaps. A $170 million pre-tax gain related to our cross-currency swaps was reclassified to Other income, net in 2020. In 2020, a pre-tax loss of $347 million related to forward-starting interest rate swaps was driven by changes in benchmark interest rates. The remaining change relates to our commodity cash flow hedges.We recognized defined benefit pension and other post-retirement benefit plans pre-tax losses of $51 million and $361 million in 2020 and 2019, respectively, primarily due to the fluctuations in the discount rate assumption used in determining the net benefit liabilities for our pension and other post-retirement benefit plans. See Note 14 to the Consolidated Financial Statements for additional information regarding net actuarial losses.40Table of ContentsSegment AnalysisWe use earnings before interest, income taxes, and depreciation and amortization (“EBITDA”) as our measure of profitability for segment reporting purposes. This measure of segment operating results is used by our chief operating decision maker to assess the performance of, and allocate resources to, our operating segments. Intersegment eliminations and items that are not directly related or allocated to business operations, such as foreign exchange gains (losses) and components of pension and other postretirement benefit costs other than service cost, are included in “Other.” For additional information related to our operating segments, as well as a reconciliation of EBITDA to its nearest generally accepted accounting principles (“GAAP”) measure, Income from continuing operations before income taxes, see Note 20 to our Consolidated Financial Statements.Our continuing operations are managed through six reportable segments: O&P—Americas, O&P—EAI, I&D, APS, Refining and Technology. The following tables reflect selected financial information for our reportable segments.Year Ended December 31,Millions of dollars20202019Sales and other operating revenues:O&P–Americas$7,275 $8,435 O&P–EAI8,367 9,504 I&D6,269 7,834 APS3,913 4,850 Refining4,727 8,251 Technology659 663 Other, including segment eliminations(3,457)(4,810)Total$27,753 $34,727 Operating income (loss):O&P–Americas$1,170 $1,777 O&P–EAI412 673 I&D501 1,249 APS226 290 Refining(1,024)(240)Technology287 374 Other, including segment eliminations(13)(7)Total$1,559 $4,116 Depreciation and amortization:O&P–Americas$525 $470 O&P–EAI214 208 I&D305 295 APS152 133 Refining152 169 Technology37 37 Total$1,385 $1,312 Income (loss) from equity investments:O&P—Americas$45 $46 O&P—EAI186 172 I&D26 7 APS(1)— Total$256 $225 41Table of Contents Year Ended December 31,Millions of dollars20202019Other income (loss), net:O&P—Americas $70 $9 O&P—EAI14 9 I&D1 6 APS1 1 Refining1 6 Other, including intersegment eliminations(2)8 Total$85 $39 EBITDA:O&P—Americas$1,810 $2,302 O&P—EAI826 1,062 I&D833 1,557 APS378 424 Refining(871)(65)Technology324 411 Other, including intersegment eliminations(15)1 Total$3,285 $5,692 Olefins and Polyolefins–Americas SegmentOverview—EBITDA declined in 2020 relative to 2019 primarily due to lower margins in challenging market conditions arising from a low oil price environment and the impact of COVID-19.In calculating the impact of margin and volume on EBITDA, consistent with industry practice, management offsets revenues and volumes related to ethylene co-products against the cost to produce ethylene. Volume and price impacts of ethylene co-products are reported in margin.Ethylene Raw Materials—Ethylene and its co-products are produced from two major raw material groups:•NGLs, principally ethane and propane, the prices of which are generally affected by natural gas prices; and•crude oil-based liquids (“liquids” or “heavy liquids”), including naphtha, condensates and gas oils, the prices of which are generally related to crude oil prices.We have flexibility to vary the raw material mix and process conditions in our U.S. olefins plants in order to maximize profitability as market prices fluctuate for both feedstocks and products. Although prices of crude-based liquids and natural gas liquids are generally related to crude oil and natural gas prices, during specific periods the relationships among these materials and benchmarks may vary significantly. In 2020 and 2019, approximately 55-60% of the raw materials used in our North American crackers was ethane.42Table of ContentsThe following table sets forth selected financial information for the O&P—Americas segment including Income from equity investments, which is a component of EBITDA. Year Ended December 31,Millions of dollars20202019Sales and other operating revenues$7,275 $8,435 Income from equity investments45 46 EBITDA1,810 2,302 Revenues—Revenues decreased by $1,160 million, or 14%, in 2020 compared to 2019. Average sales prices were lower in 2020 compared to 2019 due to the lower oil price environment and other impacts of COVID-19. These lower sales prices were responsible for a revenue decrease of 18% in 2020. Volume increases resulted in a revenue increase of 4% in 2020, primarily due to high demand for polyethylene.EBITDA—EBITDA decreased by $492 million, or 21%, in 2020 compared to 2019. Lower olefin results led to a 10% decline in EBITDA in 2020, primarily due to lower co-product prices outpacing reduced feedstock costs. Polyethylene results declined resulting in a 5% decrease in EBITDA in 2020. This decrease was driven by a $77 per ton reduction in price spreads over ethylene in 2020. Polypropylene results led to a 4% decrease in EBITDA in 2020, largely due to a decline in margins attributed to lower price spreads over propylene of $84 per ton in 2020. Olefins and Polyolefins–Europe, Asia, International SegmentOverview—EBITDA decreased in 2020 compared to 2019 mainly as a result of lower olefin and polypropylene margins.In calculating the impact of margin and volume on EBITDA, consistent with industry practice, management offsets revenues and volumes related to ethylene co-products against the cost to produce ethylene. Volume and price impacts of ethylene co-products are reported in margin.Ethylene Raw Materials—In Europe, heavy liquids are the primary raw materials for our ethylene production. In 2020 and 2019, we continued to benefit from sourcing advantaged NGLs as market opportunities arose. The following table sets forth selected financial information for the O&P—EAI segment including Income from equity investments, which is a component of EBITDA. Year Ended December 31,Millions of dollars20202019Sales and other operating revenues$8,367 $9,504 Income from equity investments186 172 EBITDA826 1,062 Revenues—Revenues in 2020 decreased by $1,137 million, or 12%, compared to 2019. Average sales prices in 2020 were lower across most products as sales prices generally correlate with crude oil prices, which on average, decreased compared to 2019. These lower average sales prices were responsible for revenue decreases of 19% in 2020. Volume improvements resulted in revenue increases of 6% in 2020 driven by strong polymer demand in Europe and Asia. Foreign exchange impacts, which on average, were favorable resulted in a revenue increase of 1% in 2020.43Table of ContentsEBITDA—EBITDA decreased by $236 million, or 22%, in 2020 compared to 2019. Lower olefins results led to a 13% decrease in EBITDA in 2020, primarily driven by lower margins driven by a decline in ethylene prices outpacing lower feedstock costs. Polypropylene results led to a 10% decrease in EBITDA in 2020, largely due to a decline in margins attributed to a reduction in price spreads over propylene by $29 per ton in 2020. Favorable foreign exchange impacts resulted in an EBITDA benefit of 2%. Planned maintenance in 2021 is expected to reduce EBITDA by approximately $25 million.Intermediates and Derivatives SegmentOverview—EBITDA for our I&D segment was lower in 2020 compared to 2019, largely driven by margin erosion due to the impacts of COVID-19.The following table sets forth selected financial information for the I&D segment including Income from equity investments, which is a component of EBITDA. Year Ended December 31,Millions of dollars20202019Sales and other operating revenues$6,269 $7,834 Income from equity investments26 7 EBITDA833 1,557 Revenues—Revenues decreased by $1,565 million, or 20%, in 2020 compared to 2019. Lower average sales prices in 2020 for most products, which reflect the impacts of lower feedstock and energy costs, were responsible for a revenue decrease of 21%. Favorable foreign exchange impacts increased revenue by 1% in 2020.EBITDA—EBITDA decreased $724 million, or 46%, in 2020 compared to 2019 primarily driven by lower margins across most businesses. Oxyfuels and related products results declined, resulting in a 30% decrease in EBITDA in 2020. The decline was a result of a significant decrease in margins driven by lower gasoline prices and octane premiums. Declines in intermediate chemicals results led to an EBITDA decrease of 11% in 2020. This decrease was a result of lower margins as demand weakened due to the impacts of COVID-19 and additional market supply derived from competitors in 2020. Planned maintenance in 2021 is expected to reduce EBITDA by approximately $145 million.Advanced Polymer Solutions SegmentOverview—EBITDA for our APS segment decreased in 2020 compared to 2019, primarily due to lower compounding and solutions volumes.The following table sets forth selected financial information for the APS segment:Year Ended December 31,Millions of dollars20202019Sales and other operating revenues$3,913 $4,850 Loss from equity investments(1)— EBITDA378 424 44Table of ContentsRevenues—Revenues decreased in 2020 by $937 million, or 19%, compared to 2019. Sales volumes declined in 2020 stemming from lower market demand for compounding and solutions, including lower automotive and appliance demand, which led to a 15% decrease in revenue in 2020. Lower average sales prices resulted in a 6% decrease in revenue. Favorable foreign exchange impacts increased revenue by 2% in 2020.EBITDA—EBITDA decreased in 2020 by $46 million, or 11%, compared to 2019. Compounding and solutions results declined resulting in a 18% decrease of EBITDA. This decrease was attributable to lower volumes driven by reduced demand for our products utilized in the automotive and appliance sectors which were impacted by COVID-19. Advanced Polymers results reduced EBITDA by 8% largely due to lower margins driven by reduced construction market demand. This decrease was offset by an increase in EBITDA of approximately $80 million, or 19%, in 2020 due to lower integration costs related to the acquisition of A. Schulman. Integration activities related to our 2018 acquisition of A. Schulman Inc. were substantially completed by the third quarter of 2020. Refining SegmentOverview—EBITDA for our Refining segment decreased in 2020 relative to 2019 primarily due to lower margins and a non-cash impairment charge of $582 million recognized during the third quarter of 2020.The following table sets forth selected financial information and heavy crude oil processing rates for the Refining segment and the U.S. refining market margins for the applicable periods. “Brent” is a light sweet crude oil and is one of the main benchmark prices for purchases of oil worldwide. “Maya” is a heavy sour crude oil grade produced in Mexico that is a relevant benchmark for heavy sour crude oils in the U.S. Gulf Coast market. References to industry benchmarks for refining market margins are to industry prices reported by Platts, a division of S&P Global. Year Ended December 31,Millions of dollars20202019Sales and other operating revenues$4,727 $8,251 EBITDA(871)(65)Thousands of barrels per dayHeavy crude oil processing rates223 263 Market margins, dollars per barrel Brent - 2-1-1$5.74 $10.94 Brent - Maya differential6.89 6.58 Total Maya 2-1-1$12.63 $17.52 Revenues—Revenues decreased by $3,524 million, or 43%, in 2020 compared to 2019. Lower product prices led to a revenue decrease of 34% relative to 2019 due to an average crude oil price decrease of approximately $21 per barrel in 2020. Heavy crude oil processing rates decreased during 2020 due to reduced demand for refined products as a result of COVID-19, leading to a decrease in overall sales volumes of 9%. Rates on conversion units were lower due to an unplanned outage at our fluid catalytic cracking unit during the first two quarters of 2020, as well as crude selection and the optimization of refinery operations.45Table of ContentsEBITDA—EBITDA decreased by $806 million in 2020 compared to 2019. During the third quarter of 2020, we recognized a non-cash impairment charge of $582 million relating to our Houston refinery’s asset group as a result of an expected prolonged period of reduced demand and compressed margins that will decrease profitability for transportation fuels produced by our Houston refinery. The lower profitability is primarily a result of the impacts of COVID-19 and associated reductions in mobility affecting the global economy. In addition, the refinery is expected to continue to be adversely affected by lower discounts for the heavy crude oil feedstocks that we utilize. Of the remaining decrease, approximately two-thirds relates to a decline in margins, which reflect a 28% decrease in the Maya 2-1-1 market margin in 2020 relative to 2019, driven primarily by lower refined product cracks, and one-third relates to lower heavy crude oil processing rates driven by lower demand for refined products.In efforts to manage costs within the segment we deferred non-safety related discretionary activities and reduced the employee workforce by approximately 10% through early retirements and worker re-deployments to our other facilities. We plan to continue to operate the refinery at approximately 80% of nameplate capacity during the first quarter of 2021 and continue to evaluate options with regard to procuring crude oil and optimizing production from the asset.Technology SegmentOverview—The Technology segment recognizes revenues related to the sale of polyolefin catalysts and the licensing of chemical and polyolefin process technologies. These revenues are offset in part by the costs incurred in the production of catalysts, licensing and services activities and research and development (“R&D”) activities. In 2020 and 2019, our Technology segment incurred approximately half of all R&D costs. EBITDA for our Technology segment decreased in 2020 compared to 2019 largely due to lower licensing revenues.The following table sets forth selected financial information for the Technology segment. Year Ended December 31,Millions of dollars20202019Sales and other operating revenues$659 $663 EBITDA324 411 Revenues—Revenues decreased by $4 million, or 1%, in 2020 compared to 2019. Lower licensing revenues resulted in a revenue decrease of 9% in 2020 compared to 2019. Higher catalyst volumes resulted in a 2% increase in revenue in 2020 driven by increased orders as customers were likely securing inventory during the pandemic. Increases in average catalyst sales prices resulted in revenue increases of 4% in 2020 driven by the growth of high yield catalyst. Foreign exchange impacts, which on average, were favorable led to a revenue increase of 2% in 2020.EBITDA—EBITDA in 2020 decreased by $87 million, or 21%, compared to 2019. This decrease was primarily driven by lower licensing revenues due to lower average contract values in 2020 compared to 2019.46Table of ContentsFINANCIAL CONDITIONOperating, investing and financing activities of continuing operations, which are discussed below, are presented in the following table: Year Ended December 31,Millions of dollars20202019Source (use) of cash:Operating activities$3,404 $4,961 Investing activities(4,906)(1,635)Financing activities2,271 (2,835)Operating Activities—Cash of $3,404 million generated by operating activities in 2020 reflected earnings adjusted for non-cash items, payments for employee related expenses, income taxes, and cash provided by the main components of working capital–Accounts receivable, Inventories and Accounts payable. In 2020, the main components of working capital provided $311 million of cash driven by a decrease in Inventories and an increase in Accounts payable, partially offset by an increase in Accounts receivable. The decrease in Inventory was primarily driven by company-wide inventory reduction initiatives to maximize liquidity. The increase in Accounts payable was primarily driven by increased raw material purchases during the fourth quarter of 2020. The increase in Accounts receivable was driven by higher sales in the fourth quarter 2020 for our O&P—Americas, O&P—EAI, and I&D segments resulting from demand recovery.Other operating activities in 2020 includes the effects of changes in tax accruals, primarily driven by a tax refund of $900 million. For additional information see Note 16 to our Consolidated Financial Statements.Cash of $4,961 million generated by operating activities in 2019 reflected earnings adjusted for non-cash items, payments for employee bonuses, income taxes, and cash consumed by the main components of working capital. A$113 million non-cash reduction in unrecognized tax benefits is reflected in Other operating activities in 2019.In 2019, the main components of working capital consumed $13 million of cash driven by a decrease in Accounts payable and an increase in Inventories, partially offset by a decrease in Accounts receivable. The decrease in Accounts payable was primarily driven by weaker demand in our APS segment and a decrease in certain raw material costs in our I&D segment. The increase in Inventories was a result of inventory builds as a result of planned and unplanned maintenance in our O&P—EAI segment. The decrease in Accounts receivable was driven by decreases in our APS, I&D and O&P—Americas segments as a result of unfavorable market conditions.Investing ActivitiesAcquisition of Equity Method Investments—In 2020, we invested $2,440 million in cash for 50% equity interests in the Bora LyondellBasell Petrochemical Co. Ltd joint venture and the Louisiana Joint Venture. For additional information related to our Equity investments, see Note 8 to the Consolidated Financial Statements.Investments—We invest cash in investment-grade and other high-quality instruments that provide adequate flexibility to redeploy funds as needed to meet our cash flow requirements while maximizing yield.We received proceeds of $114 million and $511 million in 2020 and 2019, respectively, upon the sale and maturity of certain of our available-for-sale debt securities. Additionally, in 2020 and 2019, we received proceeds of $313 million and $332 million, respectively, on the sale of our investments in equity securities. In 2019, we received proceeds of $527 million upon the maturity of certain of our repurchase agreements. 47Table of ContentsIn 2020 and 2019 we invested $270 million and $108 million, respectively, in debt securities that are deemed available-for-sale. We also invested $608 million and $33 million in equity securities in 2020 and 2019, respectively. Our investments in available-for-sale debt securities and equity securities are classified as Short-term investments.Capital Expenditures—The following table summarizes capital expenditures for the periods presented: Year Ended December 31,Millions of dollars20202019Capital expenditures by segment:O&P—Americas$543 $1,099 O&P—EAI166 213 I&D880 1,064 APS63 59 Refining63 149 Technology111 94 Other121 16 Consolidated capital expenditures of continuing operations$1,947 $2,694 As a result of COVID-19 and current market conditions, during 2020 the Company postponed select growth projects and planned maintenance, including slowing certain construction activities, allowing us to prevent the spread of the virus at the construction site and conserve capital as we prepared for an uncertain economic environment caused by the pandemic. These actions resulted in a $500 million, or 20% reduction in our 2020 capital expenditures compared to what was forecasted at the beginning of year.Capital expenditures decreased by $747 million, or 28%, in 2020 compared to 2019. The decrease was primarily due to lower spending within our O&P—Americas segment which resulted in a decline of 21% primarily due to the completed construction of our Hyperzone polyethylene plant in La Porte, Texas and postponement of maintenance projects. Additionally, lower spending within our I&D segment resulted in a 7% decline primarily as a result of the slowed construction activities at our PO/TBA plant at our Houston, Texas facility. Financing Activities—In 2020 and 2019, we made payments of $4 million and $3,752 million to acquire approximately 0.1 million and 42.7 million, respectively, of our outstanding ordinary shares. We also made dividend payments totaling $1,405 million and $1,462 million in 2020 and 2019, respectively. For additional information related to our share repurchases and dividend payments, see Note 18 to the Consolidated Financial Statements.In January 2020, we amended the terms of certain forward-starting interest rate swaps to extend their maturities. Concurrently with the amendment of the swaps, we posted collateral of $238 million related to the liability position held with our counterparties as of the amendment date. In May 2020, we terminated and cash settled $2,000 million in notional value of our cross-currency interest rate swaps, designated as cash flows hedges, maturing in 2021 and 2024. Upon termination of the swaps, we received $346 million from our counterparties. In November 2020, we paid $882 million to our counterparties and received €750 million ($887 million at the expiry spot rate) from our counterparties upon expiration and settlement of the foreign currency contracts entered to economically hedge the redemption of €750 million aggregate principal amount of our 1.875% guaranteed notes originally due in 2022.For additional information related to our swaps and currency contracts, see Note 13 to the Consolidated Financial Statements.48Table of ContentsDuring 2019 and 2020 we entered into various financing transactions. See Note 11 to the Consolidated Financial Statements.In 2020 and 2019, we made payments of $30 million and $63 million related to the acquisition of additional non-controlling interests in our POSM II Limited Partnership joint venture and our subsidiary that holds our La Porte, Texas methanol facility, respectively.Liquidity and Capital ResourcesOverviewAs a result of COVID-19, we continue to take actions to manage our financial risk. In 2020, we increased our liquidity through the issuance of guaranteed notes and we continue to focus on cost savings while minimizing working capital. In April 2020, we announced that we reduced our budgeted 2020 capital expenditures by $500 million, to improve liquidity. We intend to continue to declare and pay quarterly dividends, with the goal of increasing the dividend over time, after giving consideration to our cash balances and expected results from operations. We remain committed to funding our dividends while maintaining a strong investment grade balance sheet. In the near term, we are prioritizing debt reduction on our balance sheet.We plan to fund our ongoing working capital, capital expenditures, debt service and other funding requirements with cash from operations, which could be affected by general economic, financial, competitive, legislative, regulatory, business and other factors, many of which are beyond our control. We believe that our current liquidity availability and cash from operating activities provide us with sufficient financial resources to meet our anticipated capital requirements and obligations as they come due. Further, we believe the current economic environment will not have an adverse effect on our ability to be in compliance with our debt covenants.Cash and Liquid InvestmentsAs of December 31, 2020, we had Cash and cash equivalents and marketable securities classified as Short-term investments totaling $2,465 million, which included $1,329 million of cash in jurisdictions outside of the U.S., principally in the United Kingdom. There are currently no legal or economic restrictions that would materially impede our transfers of cash.Credit ArrangementsAt December 31, 2020, we had total debt, including current maturities, of $15,957 million, and $205 million of outstanding letters of credit, bank guarantees and surety bonds issued under uncommitted credit facilities.We had total unused availability under our credit facilities of $2,777 million at December 31, 2020, which included the following:•$2,020 million under our $2,500 million Senior Revolving Credit Facility, which backs our $2,500 million commercial paper program. Availability under this facility is net of outstanding borrowings, outstanding letters of credit provided under the facility and notes issued under our commercial paper program. A small portion of our availability under this facility is impacted by changes in the euro/U.S. dollar exchange rate. At December 31, 2020, we had $500 million of outstanding commercial paper, net of discount, no borrowings or letters of credit outstanding under this facility; and•$757 million under our $900 million U.S. Receivables Facility. Availability under this facility is subject to a borrowing base of eligible receivables, which is reduced by outstanding borrowings and letters of credit, if any. At December 31, 2020 we had no borrowings or letters of credit outstanding under this facility.In October 2020, we amended some of our credit agreements. See Note 11 to the Consolidated Financial Statements.49Table of ContentsIn January 2021, we repaid $500 million outstanding under our Term Loan due 2022.We may repay or redeem our debt, including purchases of our outstanding bonds in the open market, using cash and cash equivalents, cash from our short-term investments, cash from operating activities, proceeds from the issuance of debt, proceeds from asset divestitures, or a combination thereof. In connection with any repayment or redemption of our debt, we may incur cash and non-cash charges, which could be material in the period in which they are incurred.In accordance with our current interest rate risk management strategy and subject to management’s evaluation of market conditions and the availability of favorable interest rates among other factors, we may from time to time enter into interest rate swap agreements to economically convert a portion of our fixed rate debt to variable rate debt or convert a portion of our variable rate debt to fixed rate debt.Share RepurchasesIn May 2020, our shareholders approved a proposal to authorize us to repurchase up to 34.0 million of our ordinary shares through November 29, 2021, which superseded our prior repurchase authorization. Our share repurchase authorization does not have a stated dollar amount, and purchases may be made through open market purchases, private market transactions or other structured transactions. Repurchased shares could be retired or used for general corporate purposes, including for various employee benefit and compensation plans. The maximum number of shares that may yet be purchased is not necessarily an indication of the number of shares that will ultimately be purchased. In 2020, we purchased approximately 0.1 million shares under our share repurchase authorizations for approximately $4 million. As of February 23, 2021, we had approximately 34.0 million shares remaining under the current authorization. The timing and amounts of additional shares repurchased, if any, will be determined based on our evaluation of market conditions and other factors, including any additional authorizations approved by our shareholders. In addition, cash and cash equivalents, cash from our short-term investments, cash from operating activities, proceeds from the issuance of debt, or a combination thereof, may be used to fund the purchase of shares under our share repurchase authorization. In the near term, we are prioritizing debt reduction over share repurchases. For additional information related to our share repurchase authorization, see Note 18 to the Consolidated Financial Statements.Capital Budget In 2021, we expect our capital budget spend to remain flat at approximately $2 billion, which includes approximately $63 million for investments in our U.S. and European PO joint ventures. Approximately half of the 2021 budget is planned for profit-generating growth projects, primarily our PO/TBA plant, with the remaining budget supporting sustaining maintenance. We expect a similar level of capital expenditures for 2022 followed by a modest reduction in 2023, after completion of the PO/TBA facility.Once completed, our world-scale PO/TBA plant in Houston, Texas will have the capacity to produce 470 thousand tons of PO and 1.0 million tons of tertiary butyl alcohol. Earlier in 2020, we slowed construction activities on our PO/TBA plant to ensure worksite safety and preserve liquidity during the pandemic. During the fourth quarter we resumed activity. The project is approximately 50% complete and expected to be completed in the fourth quarter of 2022, approximately one year later than originally estimated. The delayed timing of the startup should provide benefits from a more fully recovered global economy as well as another year of global demand growth for the products. Higher costs arising from the delayed project execution due to COVID-19, more extensive civil construction and unexpected tariffs on materials are expected to add approximately 40 to 50% to our original cost estimate of $2.4 billion.50Table of ContentsEquity InvestmentOn January 25, 2021 we signed an agreement with China Petroleum & Chemical Corporation to form Ningbo ZRCC LyondellBasell New Material Company Limited, a 50/50 joint venture. The joint venture will construct a new PO/SM unit in Zhenhai Ningbo, China. The unit will use LyondellBasell's leading PO/SM technology and will have the capacity to produce 275 thousand tons of PO and 600 thousand tons of SM per year. Products produced by the joint venture will be marketed equally by both partners, expanding our respective participation in the Chinese market. The formation of the joint venture is subject to approvals by relevant government authorities, including antitrust review by the State Administration for Market Regulation. We expect to make an equity contribution of approximately $100 million to the joint venture during the first half of 2021 and startup is expected at the end of 2021. The joint venture will be included within our I&D segment.Contractual and Other Obligations—The following table summarizes, as of December 31, 2020, our future minimum payments for long-term debt, including current maturities, short-term debt, and contractual and other obligations: TotalPayments Due By PeriodMillions of dollarsLess than 1 Year1-3 Years3-5 YearsMore than 5 YearsTotal debt$16,063 $671 $2,861 $2,009 $10,522 Interest on total debt9,712 538 1,041 866 7,267 Contract liabilities194 157 37 — — Other2,313 1,243 248 304 518 Deferred income taxes2,332 552 408 367 1,005 Purchase obligations:Take-or-pay contracts22,304 2,273 4,571 4,648 10,812 Other contracts 15,318 5,171 3,215 1,363 5,569 Operating leases2,506 534 599 429 944 Total$70,742 $11,139 $12,980 $9,986 $36,637 Total Debt—Our debt includes unsecured senior notes, guaranteed notes and various other U.S. and non-U.S. loans. See Note 11 to the Consolidated Financial Statements for a discussion of covenant requirements under our credit facilities and indentures and additional information regarding our debt facilities.Interest on Total Debt—Our debt and related party debt agreements contain provisions for the payment of monthly, quarterly, semi-annual, and annual interest at a stated or variable rate of interest over the term of the debt. Interest on variable rate debt is calculated based on the rate in effect as of December 31, 2020.Pension and other Postretirement Benefits—We maintain several defined benefit pension plans, as described in Note 14 to the Consolidated Financial Statements. Many of our U.S. and non-U.S. plans are subject to minimum funding requirements; however, the amounts of required future contributions for all our plans are not fixed and can vary significantly due to changes in economic assumptions, liability experience and investment return on plan assets. As a result, we have excluded pension and other postretirement benefit obligations from the Contractual and Other Obligations table above. Our annual contributions may include amounts in excess of minimum required funding levels. Contributions to our non-U.S. plans in years beyond 2021 are not expected to be materially different than the expected 2021 contributions disclosed in Note 14 to the Consolidated Financial Statements. At December 31, 2020, the projected benefit obligation for our pension plans exceeded the fair value of plan assets by $1,482 million. Subject to future actuarial gains and losses, as well as future asset earnings, we, together with our consolidated subsidiaries, will be required to fund the discounted obligation of $1,482 million in future years. We contributed $74 million and $97 million to our pension plans in 2020 and 2019, respectively. We provide other postretirement 51Table of Contentsbenefits, primarily medical benefits to eligible participants, as described in Note 14 to the Consolidated Financial Statements. We pay other unfunded postretirement benefits as incurred.Contract Liabilities—We are obligated to deliver products or services in connection with sales agreements under which customer payments were received before transfer of control to the customers occurs. These contract liabilities will be recognized in earnings when control of the product or service is transferred to the customer. The long-term portion of such advances totaled $37 million as of December 31, 2020.Other—Other primarily consists of accruals for taxes and employee-related expenses.Deferred Income Taxes—The scheduled settlement of the deferred tax liabilities shown in the table is based on the scheduled reversal of the underlying temporary differences. Actual cash tax payments will vary depending upon future taxable income. See Note 16 to the Consolidated Financial Statements for additional information related to our deferred tax liabilities.Purchase Obligations—We are party to various obligations to purchase products and services, principally for raw materials, utilities and industrial gases. These commitments are designed to ensure sources of supply and are not expected to be in excess of normal requirements. The commitments are segregated into take-or-pay contracts and other contracts. Under the take-or-pay contracts, we are obligated to make minimum payments whether or not we take the product or service. Other contracts include contracts that specify minimum quantities; however, in the event that we do not take the contractual minimum, we are only obligated for any resulting economic loss suffered by the vendor. The payments shown for the other contracts assume that minimum quantities are purchased. For contracts with variable pricing terms, the minimum payments reflect the contract price at December 31, 2020.Operating Leases—We lease various facilities and equipment under noncancelable lease arrangements for various periods. See Note 12 to the Consolidated Financial Statements for related lease disclosures.CURRENT BUSINESS OUTLOOKImproving trends seen in the closing weeks of December 2020 are continuing into the first quarter of 2021 and providing a bridge to the seasonal upticks typically seen in our businesses during the second and third quarters. Elevated export demand to China and Latin America combined with tight markets are supporting strong margins for our Olefins and Polyolefins businesses. In early 2021 we expect increased demand from automotive and construction markets to benefit our Advanced Polymer Solutions segment. With wider deployment of coronavirus vaccines, we anticipate that increasing mobility and transportation fuel demand could provide upside for our oxyfuels and refining businesses during the latter half of 2021. In February 2021, unusually cold temperatures and associated electrical power outages led to shutdowns of the majority of the petrochemical and refining capacity along the United States Gulf Coast, including LyondellBasell’s facilities in the region. The majority of our capacity in the region was down for at least one week. At this time, we are continuing to assess the impact of the weather event and develop timelines for the restart of each of our affected facilities.In the near term, we are prioritizing debt reduction on our balance sheet.RELATED PARTY TRANSACTIONSWe have related party transactions with our joint venture partners. We believe that such transactions are effected on terms substantially no more or less favorable than those that would have been agreed upon by unrelated parties on an arm’s length basis. See Note 4 to the Consolidated Financial Statements for additional related party disclosures.52Table of ContentsCRITICAL ACCOUNTING POLICIES AND ESTIMATESManagement applies those accounting policies that it believes best reflect the underlying business and economic events, consistent with accounting principles generally accepted in the U.S., see Note 2 to the Consolidated Financial Statements. Inherent in such policies are certain key assumptions and estimates made by management and updated periodically based on its latest assessment of the current and projected business and general economic environment.Management believes the following accounting policies and estimates, and the judgments and uncertainties affecting them, are critical in understanding our reported operating results and financial condition.Inventories—We account for our raw materials, work-in-progress and finished goods inventories using the last-in, first-out (“LIFO”) method of accounting.The cost of raw materials, which represents a substantial portion of our operating expenses, and energy costs generally follow price trends for crude oil and/or natural gas. Crude oil and natural gas prices are subject to many factors, including changes in economic conditions.Since our inventory consists of manufactured products derived from crude oil, natural gas, natural gas liquids and correlated materials, as well as the associated feedstocks and intermediate chemicals, our inventory market values are generally influenced by changes in the benchmark of crude oil and heavy liquid values and prices for manufactured finished goods. The degree of influence of a particular benchmark may vary from period to period, as the composition of the dollar value LIFO pools change. Due to natural inventory composition changes, variation in pricing from period to period does not necessarily result in a linear lower of cost or market (“LCM”) impact. Additionally, an LCM condition may arise due to a volumetric decline in a particular material that had previously provided a positive impact within a pool. As a result, market valuations and LCM conditions are dependent upon the composition and mix of materials on hand at the balance sheet date. In the measurement of an LCM adjustment, the numeric input value for determining the crude oil market price includes pricing that is weighted by volume of inventories held at a point in time, including WTI, Brent and Maya crude oils.As indicated above, fluctuation in the prices of crude oil, natural gas and correlated products from period to period may result in the recognition of charges to adjust the value of inventory to the lower of cost or market in periods of falling prices and the reversal of those charges in subsequent interim periods as market prices recover. Accordingly, our cost of sales and results of operations may be affected by such fluctuations.During 2020, commodity price volatility resulted in a large LCM inventory charge during the first quarter which was substantially reversed by the end of the year, resulting in an LCM inventory valuation charges of $16 million for the year. In the first quarter of 2020, we recognized LCM inventory valuation charges of $419 million which was driven by a decline in pricing for many of our raw material and finished goods inventories. During the second, third and fourth quarters of 2020, we recognized an LCM inventory valuation benefit of $96 million, $160 million and $147 million, respectively, as market prices began to recover subsequent to the first quarter of 2020.Market price volatility for crude oil, heavy liquids and ethylene were the primary contributors to the LCM inventory valuation charges, and representative prices used to determine the LCM inventory valuation charges recognized during the year ranged from $12.14 to $41.75 per barrel for crude oil, $13.50 to $51.07 per barrel for heavy liquids and $205 to $767 per ton for ethylene. 53Table of ContentsCurrently, four out of our eleven LIFO inventory pools are “at-risk” for further adjustment as each impacted LIFO pool has been reduced to, or close to, the calculated market value at the last balance sheet measurement date. “At-risk” inventory accounts for $1.5 billion of our total inventory carrying value as of December 31, 2020. Sustained price declines in our finished goods and raw materials could result in future LCM inventory valuation charges, the extent to which further adjustment may occur is dependent on the pool specific product prices and composition within each individual dollar value LIFO pool at the balance sheet date.Long-Lived Assets Impairment Assessment—The need to test for impairment can be based on several indicators, including a significant reduction in prices of or demand for products produced, a weakened outlook for profitability, a significant reduction in margins, other changes to contracts or changes in the regulatory environment. If the sum of the undiscounted estimated pre-tax cash flows for an asset group is less than the asset group’s carrying value, fair value is calculated for the asset group, and the carrying value is written down to the calculated fair value. For purposes of impairment evaluation, long-lived assets including finite-lived intangible assets must be grouped at the lowest level for which independent cash flows can be identified.Fair value calculated for the purpose of testing our long-lived assets for impairment is estimated using a discounted cash flow model and comparative market prices when appropriate. Significant judgment is involved in performing these fair value estimates since the results are based on forecasted financial information prepared using significant assumptions which may include, among other things, projected changes in supply and demand fundamentals (including industry-wide capacity, our planned utilization rate and end-user demand), new technological developments, capital expenditures, new competitors with significant raw material or other cost advantages, changes associated with world economies, the cyclical nature of the chemical and refining industries, uncertainties associated with governmental actions and other economic conditions. Such estimates are consistent with those used in our planning and capital investment and business performance reviews. The cash flows are discounted using a rate that is based on a variety of factors, including market and economic conditions, operational risk, regulatory risk and political risk. This discount rate is also compared to recent observable market transactions, if possible.Houston Refinery Impairment—During the third quarter of 2020, we identified impairment triggers relating to our Houston refinery’s asset group which resulted in a $582 million impairment charge recognized during the third quarter of 2020. Refer to Note 7 to our Consolidated Financial Statements.The estimates of the Houston refinery’s undiscounted pre-tax cash flows and estimated fair value utilized significant assumptions including management’s best estimates of the expected future cash flows, the estimated useful lives of the asset group, and the residual value of the refinery. These estimates required considerable judgment and are sensitive to changes in underlying assumptions such as future commodity prices, margins on refined products, operating rates and capital expenditures including repairs and maintenance. As a result, there can be no assurance that the estimates and assumptions made for purposes of our impairment determination will prove to be an accurate prediction of the future. Should our estimates and assumptions significantly change in future periods, it is possible that we may determine future impairment charges. In addition, assumptions about the effects of COVID-19 and the macroeconomic environment are inherently subjective and contingent upon the duration of the pandemic and its impact on the macroeconomic environment, which is difficult to forecast. We base our fair value estimates on projected financial information which we believe to be reasonable. However, actual results may differ from these projections.An estimate of the sensitivity to net income resulting from impairment calculations is not practicable, given the numerous assumptions, including pricing, volumes and discount rates, that can materially affect our estimates. That is, unfavorable adjustments to some of the above listed assumptions may be offset by favorable adjustments in other assumptions.Equity Method Investments Impairment—Investments in nonconsolidated entities accounted for under the equity method are assessed for impairment when there are indicators of a loss in value, such as a lack of sustained earnings capacity or a current fair value less than the investment’s carrying amount.54Table of ContentsWhen it is determined such a loss in value is other than temporary, an impairment charge is recognized for the difference between the investment’s carrying value and its estimated fair value. When determining whether a decline in value is other than temporary, management considers factors such as the length of time and extent of the decline, the investee’s financial condition and near-term prospects, and our ability and intention to retain our investment for a period that will be sufficient to allow for any anticipated recovery in the value of the investment. Management’s estimate of fair value of an investment is based on the income approach and/or market approach. For the income approach, the fair value is typically based on the present value of expected future cash flows using discount rates believed to be consistent with those used by principal market participants. For the market approach, since quoted market prices are usually not available, we utilize market multiples of revenue and earnings derived from comparable publicly-traded industrial gases companies.Goodwill—As of December 31, 2020, we have goodwill of $1,953 million. Of this amount, $1,357 million is related to the acquisition of A. Schulman in 2018, which is included in our APS segment, and is mainly attributed to acquired workforce and expected synergies. The remaining goodwill at December 31, 2020, primarily represents the tax effect of the differences between the tax and book basis of our assets and liabilities resulting from the revaluation of those assets and liabilities to fair value in connection with the Company’s emergence from bankruptcy and fresh-start accounting in 2010. Additional information on the amount of goodwill allocated to our reporting units appears in Note 7 and Note 20 to the Consolidated Financial Statements.We evaluate the recoverability of the carrying value of goodwill annually or more frequently if events or changes in circumstances indicate that the carrying amount of the goodwill of a reporting unit may not be fully recoverable. We have the option to first assess qualitative factors to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying value. Qualitative factors assessed for each of the reporting units include, but are not limited to, changes in long-term commodity prices, discount rates, competitive environments, planned capacity, cost factors such as raw material prices, and financial performance of the reporting units. If the qualitative assessment indicates that it is more likely than not that the carrying value of a reporting unit exceeds its estimated fair value, a quantitative test is required.We also have the option to proceed directly to the quantitative impairment test. Under the quantitative impairment test, the fair value of each reporting unit, calculated using a discounted cash flow model, is compared to its carrying value, including goodwill. The discounted cash flow model inherently utilizes a significant number of estimates and assumptions, including operating margins, tax rates, discount rates, capital expenditures and working capital changes. If the carrying value of the reporting unit including goodwill exceeds its fair value, an impairment charge equal to the excess would be recognized, up to a maximum amount of goodwill allocated to that reporting unit.For 2020 and 2019, management performed a qualitative impairment assessment of our reporting units, which indicated that the fair value of our reporting units was greater than their carrying value including goodwill. Accordingly, a quantitative goodwill impairment test was not required, and no goodwill impairment was recognized in 2020 or 2019.Long-Term Employee Benefit Costs—Our costs for long-term employee benefits, particularly pension and other postretirement medical and life insurance benefits, are incurred over long periods of time, and involve many uncertainties over those periods. The net periodic benefit cost attributable to current periods is based on several assumptions about such future uncertainties and is sensitive to changes in those assumptions. It is management’s responsibility, often with the assistance of independent experts, to select assumptions that in its judgment represent its best estimates of the future effects of those uncertainties and to review those assumptions periodically to reflect changes in economic or other factors.55Table of ContentsThe current benefit service costs, as well as the existing liabilities, for pensions and other postretirement benefits are measured on a discounted present value basis. The discount rate is a current rate, related to the rate at which the liabilities could be settled. Our assumed discount rate is based on yield information for high-quality corporate bonds with durations comparable to the expected cash settlement of our obligations. For the purpose of measuring the benefit obligations at December 31, 2020, we used a weighted average discount rate of 2.54% for the U.S. plans, which reflects the different terms of the related benefit obligations. The weighted average discount rate used to measure obligations for non-U.S. plans at December 31, 2020, was 0.99%, reflecting market interest rates. The discount rates in effect at December 31, 2020 will be used to measure net periodic benefit cost during 2021.The benefit obligation and the net periodic benefit cost of other postretirement medical benefits are also measured based on assumed rates of future increase in the per capita cost of covered health care benefits. As of December 31, 2020, the assumed rate of increase for our U.S. plans was 6.5%, decreasing to 4.5% in 2029 and thereafter.The net periodic benefit cost of pension benefits included in expense is affected by the expected long-term rate of return on plan assets assumption. Investment returns that are recognized currently in net income represent the expected long-term rate of return on plan assets applied to a market-related value of plan assets, which is defined as the market value of assets. The expected rate of return on plan assets is a longer-term rate and is expected to change less frequently than the current assumed discount rate, reflecting long-term market expectations, rather than current fluctuations in market conditions.The weighted average expected long-term rate of return on assets in our U.S. plans of 7.25% is based on the average level of earnings that our independent pension investment advisor advised could be expected to be earned over time. The weighted average expected long-term rate of return on assets in our non-U.S. plans of 1.79% is based on expectations and asset allocations that vary by region. The asset allocations are summarized in Note 14 to the Consolidated Financial Statements. The actual rate of return on plan assets may differ from the expected rate due to the volatility normally experienced in capital markets. Management’s goal is to manage the investments over the long term to achieve optimal returns with an acceptable level of risk and volatility.Net periodic pension cost recognized each year includes the expected asset earnings, rather than the actual earnings or loss. Along with other gains and losses, this unrecognized amount, to the extent it cumulatively exceeds 10% of the greater of the projected benefit obligation or the market related value of the plan assets for the respective plan, is recognized as additional net periodic benefit cost over the average remaining service period of the participants in each plan.The following table reflects the sensitivity of the benefit obligations and the net periodic benefit costs of our pension plans to changes in the actuarial assumptions: Effects onBenefit Obligationsin 2020Effects on NetPeriodic PensionCosts in 2021Millions of dollarsU.S.Non-U.S.U.S.Non-U.S.Projected benefit obligations at December 31, 2020$2,039 $2,159 $— $— Projected net periodic pension costs in 2021— — 29 68 Discount rate increases by 100 basis points(185)(292)(7)(5)Discount rate decreases by 100 basis points220 381 8 24 56Table of ContentsThe sensitivity of our postretirement benefit plans obligations and net periodic benefit costs to changes in actuarial assumptions are reflected in the following table: Effects onBenefit Obligationsin 2020Effects on NetPeriodic BenefitCosts in 2021Millions of dollarsU.S.Non-U.S.U.S.Non-U.S.Projected benefit obligations at December 31, 2020$211 $86 $— $— Projected net periodic benefit costs in 2021— — (1)5 Discount rate increases by 100 basis points(19)— (1)— Discount rate decreases by 100 basis points20 — 2 — Additional information on the key assumptions underlying these benefit costs appears in Note 14 to the Consolidated Financial Statements.Accruals for Taxes Based on Income—The determination of our provision for income taxes and the calculation of our tax benefits and liabilities is subject to management’s estimates and judgments due to the complexity of the tax laws and regulations in the tax jurisdictions in which we operate. Uncertainties exist with respect to interpretation of these complex laws and regulations.Deferred tax assets and liabilities are determined based on temporary differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax basis, and are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to reverse. We recognize future tax benefits to the extent that the realization of these benefits is more likely than not. Our current provision for income taxes is impacted by the recognition and release of valuation allowances related to net deferred tax assets in certain jurisdictions. Further changes to these valuation allowances may impact our future provision for income taxes, which will include no tax benefit with respect to losses incurred and no tax expense with respect to income generated in these countries until the respective valuation allowance is eliminated.We recognize the financial statement benefits with respect to an uncertain income tax position that we have taken or may take on an income tax return when we believe it is more likely than not that the position will be sustained with the tax authorities.ACCOUNTING AND REPORTING CHANGESFor a discussion of the potential impact of new accounting pronouncements on our Consolidated Financial Statements, see Note 2 to the Consolidated Financial Statements.57Table of ContentsItem 7A. Quantitative and Qualitative Disclosures About Market Risk.See Note 13 to the Consolidated Financial Statements for discussion of LyondellBasell Industries N.V.’s management of commodity price risk, foreign currency exposure and interest rate risk through its use of derivative instruments and hedging activities.Commodity Price RiskOur products and raw materials are subject to changes in market price as supply and demand fundamentals change. Natural gas, crude oil and refined products, along with feedstocks for ethylene and propylene production, constitute the main commodity exposures. We try to protect against such instability through various business strategies including provisions in sales contracts which allows us to pass on higher raw material costs to our customers through timely price increases and through the use of commodity swap and futures contracts.At December 31, 2020 and 2019, an instantaneous parallel shift up or down in the underlying commodity price of 10% and no corresponding change in the underlying implied volatilities of those prices, would have resulted in an additional impact to Other comprehensive loss of approximately $11 million and less than $1 million, respectively. Foreign Exchange RiskWe manufacture and market our products in many countries throughout the world and, as a result, are exposed to changes in foreign currency exchange rates. A significant portion of our reporting entities use the euro as their functional currency. Our reporting currency is the U.S. dollar. The translation gains or losses that result from the process of translating the euro denominated financial statements to U.S. dollars are deferred in Accumulated other comprehensive income until such time as those entities may be liquidated or sold. Changes in the value of the U.S. dollar relative to the euro can therefore have a significant impact on comprehensive income.We have entered into hedging arrangements designated as net investment hedges to reduce the volatility in shareholders’ equity resulting from foreign currency fluctuation associated with our net investments in foreign operations. The table below illustrates the impact on Other comprehensive loss of a 10% fluctuation in the foreign currency rate associated with each net investment hedge and the EURIBOR and LIBOR rates associated with the cross-currency basis swaps at December 31:2020201910% Variance onForeign Currency Rate20202019Net Investment HedgesNotional AmountImpact on OtherComprehensive LossCross Currency Basis Swaps€617 million€617 millioneuro/U.S. dollar rate$77 million$70 millionEURIBOR and LIBOR ratesLess than $1 millionLess than $1 millionCross Currency Swaps€750 million—euro/U.S. dollar rate$101 million—Forward Exchange Contracts€300 million—euro/U.S. dollar rate$37 million—Guaranteed Euro Notes due 2022—€750 millioneuro/U.S. dollar rate—$84 millionSome of our operations enter into transactions that are not denominated in their functional currency. This results in exposure to foreign currency risk for financial instruments, including, but not limited to, third party and intercompany receivables and payables and intercompany loans.58Table of ContentsOur policy is to maintain a balanced position in foreign currencies to minimize exchange gains and losses arising from changes in exchange rates. To minimize the effects of our net currency exchange exposures, we enter into foreign exchange contracts and cross-currency swaps. We also engage in short-term foreign exchange swaps in order to roll certain hedge positions and to make funds available for intercompany financing. Our net position in foreign currencies is monitored daily.We maintain risk management control practices to monitor the foreign currency risk attributable to our inter-company and third party outstanding foreign currency balances. These practices involve the centralization of our exposure to underlying currencies that are not subject to central bank and/or country specific restrictions. By centralizing most of our foreign currency exposure into one subsidiary, we are able to take advantage of any natural offsets thereby reducing the overall impact of changes in foreign currency rates on our earnings. At December 31, 2020 and 2019, a 10% fluctuation compared to the U.S. dollar in the underlying currencies that have no central bank or other currency restrictions related to non-hedged monetary net assets would have resulted in an additional impact to earnings of approximately $4 million and $2 million, respectively.At December 31, 2020, non-cancellable cross-currency swaps with an aggregated notional of $2,005 million, were designated as foreign currency cash flow hedges to reduce the variability in the functional currency equivalent cash flows of certain foreign currency denominated intercompany notes. These foreign currency contracts have maturity dates ranging from 2021 to 2027 and their fair value was a net liability of $259 million. A 10% fluctuation compared to the U.S. dollar would have resulted in an additional impact to Other comprehensive loss of approximately $250 million and $238 million in 2020 and 2019, respectively.Other income, net, in the Consolidated Statements of Income reflected net exchange rate foreign currency losses of $7 million, gains of $9 million and $24 million in 2020, 2019 and 2018, respectively. For forward contracts, including swap transactions, that economically hedge recognized monetary assets and liabilities in foreign currencies, no hedge accounting is applied. Changes in the fair value of foreign currency forward and swap contracts are reported in the Consolidated Statements of Income and offset the currency exchange results recognized on the assets and liabilities. At December 31, 2020, these foreign currency contracts, which will mature between January 2021 and June 2021, inclusively, had an aggregated notional amount of $225 million and the fair value was a net liability of $1 million. A 10% fluctuation compared to the U.S. dollar would have resulted in an additional impact to earnings of approximately $5 million and $31 million in 2020 and 2019, respectively.Interest Rate RiskInterest rate risk management is viewed as a trade-off between cost and risk. The cost of interest is generally lower for short-term debt and higher for long-term debt, and lower for floating rate debt and higher for fixed rate debt. However, the risk associated with interest rates is inversely related to the cost, with short-term debt carrying a higher refinancing risk and floating rate debt having higher interest rate volatility. Our interest rate risk management strategy attempts to optimize this cost/risk/reward trade-off.We are exposed to interest rate risk with respect to our fixed and variable rate debt. Fluctuations in interest rates impact the fair value of fixed-rate debt as well as pre-tax earnings stemming from interest expense on variable-rate debt. To minimize earnings at risk as part of our interest rate risk management strategy, we target to maintain floating rate debt, through the use of interest rate swaps and issuance of floating rate debt, equal to our cash and cash equivalents, marketable securities and tri-party repurchase agreements, as those assets are invested in floating rate instruments.59Table of ContentsPre-issuance interest rate—A pre-issuance interest rate strategy is utilized to mitigate the risk that benchmark interest rates (i.e. U.S. Treasury, mid-swaps, etc.) will increase between the time a decision has been made to issue debt and when the actual debt offering is issued. At December 31, 2020, the total notional amount of our interest rate contracts designated as cash flow hedges, which have maturity dates ranging from 2023 to 2024, was $1,000 million and the fair value was a net liability of $343 million. We estimate that a 10% change in market interest rates as of December 31, 2020 and 2019, would change the fair value of our forward-starting interest rate swaps outstanding and would have resulted in an impact on Other comprehensive loss of approximately $44 million and $66 million, respectively.Fixed-rate debt—We enter into interest rate swaps as part of our interest rate risk management strategy. At December 31, 2020, the total notional amount of an interest rate swap designated as a fair value hedge, which matures in 2026, was $122 million and their fair value was a net asset of $2 million.At December 31, 2020, after giving consideration to the $122 million of fixed-rate debt that we have effectively converted to floating through these fixed-for-floating interest rate swaps, approximately 83% of our debt portfolio, on a gross basis, incurred interest at a fixed-rate and the remaining 17% of the portfolio incurred interest at a variable-rate. We estimate that a 10% change in market interest rates as of December 31, 2020 and 2019, would change the fair value of our interest rate swaps outstanding and would have resulted in an impact on our pre-tax income of approximately less than $1 million and $15 million, respectively.Variable-rate debt—Our variable rate debt consists of our $2,500 million Senior Revolving Credit Facility, our $900 million U.S. Receivables Facility, our Term Loan due 2022, our Guaranteed Floating Rate Notes due 2023 and our Commercial Paper Program. At December 31, 2020, there were no outstanding borrowings under our Senior Revolving Credit Facility and our U.S. Receivables Facility. At December 31, 2020, our Term Loan due 2022, Guaranteed Floating Rate Notes due 2023 and Commercial Paper Program had carrying values of $1,448 million, $646 million and $500 million, respectively. Based on our average variable-rate debt outstanding per year, we estimate that a 10% change in market interest rates would have had $3 million and $1 million impact on earnings in 2020 and 2019, respectively.60Table of Contents
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+Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operations.” We believe our owned and leased properties are in generally good physical condition with the need for only routine repairs and maintenance and periodic capital improvements. Most of our regional offices, reservation centers, and sales offices, as well as our corporate headquarters, are in leased facilities, both domestically and internationally. As of December 31, 2020, we owned or leased the following hotel properties:PropertiesLocation RoomsU.S. & Canada Owned Hotels Courtyard Las Vegas Convention CenterLas Vegas, NV149 Las Vegas MarriottLas Vegas, NV278 Residence Inn Las Vegas Convention CenterLas Vegas, NV192 The Westin Peachtree Plaza, AtlantaAtlanta, GA1,073 W New York - Union SquareNew York, NY270 U.S. & Canada Leased HotelsAlbuquerque Airport CourtyardAlbuquerque, NM150 Anaheim MarriottAnaheim, CA1,030 Baltimore BWI Airport CourtyardLinthicum, MD149 Baton Rouge Acadian Centre/LSU Area CourtyardBaton Rouge, LA149 Chicago O'Hare CourtyardDes Plaines, IL180 Des Moines West/Clive CourtyardClive, IA108 Fort Worth University Drive CourtyardFort Worth, TX130 Greensboro CourtyardGreensboro, NC149 Indianapolis Airport CourtyardIndianapolis, IN151 Irvine John Wayne Airport/Orange County CourtyardIrvine, CA153 Louisville East CourtyardLouisville, KY151 Mt. Laurel CourtyardMt Laurel, NJ151 Newark Liberty International Airport CourtyardNewark, NJ146 Orlando Airport CourtyardOrlando, FL149 Orlando International Drive/Convention Center CourtyardOrlando, FL151 Renaissance New York Times Square HotelNew York, NY317 Sacramento Airport Natomas CourtyardSacramento, CA149 San Diego Sorrento Valley CourtyardSan Diego, CA149 Spokane Downtown at the Convention Center CourtyardSpokane, WA149 St. Louis Downtown West CourtyardSt. Louis, MO151 W New York – Times SquareNew York, NY509 International Owned HotelsCourtyard by Marriott Aberdeen AirportAberdeen, UK194 22Table of Contents PropertiesLocation RoomsCourtyard by Marriott Rio de Janeiro Barra da TijucaBarra da Tijuca, Brazil264 Courtyard by Marriott Toulouse AirportToulouse, France187 Colony Club, BarbadosBarbados96 Crystal Cove, BarbadosBarbados88 Marriott Puerto Vallarta Resort & SpaMexico433 Residence Inn Rio de Janeiro Barra da TijucaBarra da Tijuca, Brazil140 Sheraton Grand Rio Hotel & Resort Rio de Janeiro, Brazil 538 Sheraton Lima Hotel & Convention Center Lima, Peru 431 Sheraton Mexico City Maria Isabel Hotel Mexico City, Mexico 755 Tamarind, BarbadosBarbados104 The House, BarbadosBarbados34 Treasure Beach, BarbadosBarbados35 Turtle Beach, BarbadosBarbados161 Waves, BarbadosBarbados70 International Leased Hotels 15 on Orange Hotel, Autograph CollectionCape Town, South Africa129 African Pride Melrose Arch, Autograph CollectionJohannesburg, South Africa118 Berlin Marriott HotelBerlin, Germany379 Cape Town Marriott Hotel Crystal TowersCape Town, South Africa180 Courtyard by Marriott Paris Gare de LyonParis, France249 Frankfurt Marriott HotelFrankfurt, Germany593 Grosvenor House, A JW Marriott HotelLondon, UK496 Heidelberg Marriott HotelHeidelberg, Germany248 Hotel Alfonso XIII, a Luxury Collection Hotel, SevilleSeville, Spain148 Hotel Maria Cristina, San Sebastian San Sebastian, Spain 139 Leipzig Marriott HotelLeipzig, Germany231 Protea Hotel by Marriott Cape Town Sea PointCape Town, South Africa124 Protea Hotel by Marriott MidrandMidrand, South Africa177 Protea Hotel by Marriott O.R. Tambo AirportJohannesburg, South Africa213 Protea Hotel by Marriott RoodepoortRoodepoort, South Africa79 Protea Hotel Fire & Ice! by Marriott Cape TownCape Town, South Africa201 Protea Hotel Fire & Ice! by Marriott Johannesburg Melrose ArchJohannesburg, South Africa197 Renaissance Hamburg HotelHamburg, Germany205 Renaissance Santo Domingo Jaragua Hotel & CasinoSanto Domingo, Dominican Republic300 Sheraton Diana Majestic, Milan Milan, Italy 106 The Ritz-Carlton, BerlinBerlin, Germany303 The Ritz-Carlton, TokyoTokyo, Japan247 The St. Regis OsakaOsaka, Japan160 W Barcelona Barcelona, Spain 473 W London – Leicester Square London, UK 192 Item 3. Legal Proceedings. See the information under the “Litigation, Claims, and Government Investigations” caption in Note 8, which we incorporate here by reference. Within this section, we use a threshold of $1 million in disclosing material environmental proceedings involving a governmental authority.In May 2020, we received a notice from the District Attorneys of the Counties of Placer, Riverside, San Francisco and San Mateo in California asserting that nine properties in California have failed to comply with certain state statutes regulating hazardous and other waste handling and disposal. We are cooperating with the District Attorneys’ requests for information and have entered into a tolling agreement with the District Attorneys. We cannot predict the ultimate outcome of this matter; however, management does not believe that the outcome will have a material adverse effect on the Company.From time to time, we are also subject to other legal proceedings and claims in the ordinary course of business, including adjustments proposed during governmental examinations of the various tax returns we file. While management presently believes that the ultimate outcome of these other proceedings, individually and in aggregate, will not materially harm our 23Table of Contents financial position, cash flows, or overall trends in results of operations, legal proceedings are inherently uncertain, and unfavorable rulings could, individually or in aggregate, have a material adverse effect on our business, financial condition, or operating results.Item 4. Mine Safety Disclosures.Not applicable.Information about our Executive OfficersSee the information under “Information about our Executive Officers” in Part III, Item 10 of this report for information about our executive officers, which we incorporate here by reference.PART IIItem 5. Market for Registrant’s Common Equity, Related Stockholder Matters, and Issuer Purchases of Equity Securities.Market InformationAt February 10, 2021, 324,414,150 shares of our Class A Common Stock (our “common stock”) were outstanding and were held by 34,253 stockholders of record. Our common stock trades on the Nasdaq Global Select Market (“Nasdaq”) under the trading symbol MAR. Fourth Quarter 2020 Issuer Purchases of Equity Securities(in millions, except per share amounts) PeriodTotal Numberof SharesPurchasedAverage Priceper ShareTotal Number of Shares Purchased as Part of Publicly Announced Plans or Programs (1)Maximum Number of Shares That May Yet Be Purchased Under the Plans or Programs (1)October 1, 2020-October 31, 2020— $— — 17.4 November 1, 2020-November 30, 2020— $— — 17.4 December 1, 2020-December 31, 2020— $— — 17.4 (1)On February 15, 2019, we announced that our Board of Directors increased our common stock repurchase authorization by 25 million shares. At year-end 2020, 17.4 million shares remained available for repurchase under Board approved authorizations. We repurchase shares in the open market and in privately negotiated transactions. We do not anticipate repurchasing additional shares until business conditions improve, and are prohibited from doing so for the duration of the Covenant Waiver Period, as discussed in Note 10, under our Credit Facility, with certain exceptions.24Table of Contents Item 6. Selected Financial Data. The following table presents a summary of our selected historical financial data derived from our last five years of Financial Statements. Because this information is only a summary and does not provide all of the information contained in our Financial Statements, including the related notes, you should read “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our Financial Statements for each year for more detailed information. For 2016, we include Legacy-Starwood results from the Merger Date to year-end 2016. Fiscal Year ($ in millions, except per share data)20202019201820172016Income Statement Data:Revenues (2)$10,571 $20,972 $20,758 $20,452 $15,407 Operating income (loss) (2) (4)$84 $1,800 $2,366 $2,504 $1,424 Net (loss) income (2) (4)$(267)$1,273 $1,907 $1,459 $808 Per Share Data:Diluted (losses) earnings per share (2) (4)$(0.82)$3.80 $5.38 $3.84 $2.73 Cash dividends declared per share$0.48 $1.85 $1.56 $1.29 $1.15 Balance Sheet Data (at year-end):Total assets (2) (3) (4)$24,701 $25,051 $23,696 $23,846 $24,078 Long-term debt $9,203 $9,963 $8,514 $7,840 $8,197 Stockholders’ equity (2) (4)$430 $703 $2,225 $3,582 $6,265 Other Data:Base management fees$443 $1,180 $1,140 $1,102 $806 Franchise fees (1) (2)1,153 2,006 1,849 1,586 1,157 Incentive management fees87 637 649 607 425 Total fees (1) (2)$1,683 $3,823 $3,638 $3,295 $2,388 Gross Fee Revenue-Source:U.S. & Canada (1) (2)$1,345 $2,791 $2,641 $2,388 $1,845 Total Outside U.S. & Canada (1) (2)338 1,032 997 907 543 Total fees (1) (2)$1,683 $3,823 $3,638 $3,295 $2,388 (1)In 2017, we reclassified branding fees for third-party residential sales and credit card licensing to the “Franchise fees” caption from the “Owned, leased, and other revenue” caption on our Income Statements. We reclassified 2016 amounts to conform to our current presentation. (2)In 2018, we adopted ASU No. 2014-09, which impacted our recognition of revenues and certain expenses. (3)In 2019, we adopted ASU No. 2016-02, which brought substantially all leases onto the balance sheet. Years before 2019 have not been adjusted for this new accounting standard.(4)In 2020, we adopted ASU No. 2016-13, which impacted our provision for credit losses. Years before 2020 have not been adjusted for this new accounting standard.Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.A discussion regarding our financial condition and results of operations for year-end 2019 compared to year-end 2018 can be found in Part II, Item 7 “Management’s Discussion and Analysis of Financial Condition and Results of Operations” of our Annual Report on Form 10-K for the fiscal year ended December 31, 2019, as filed with the SEC on February 27, 2020.BUSINESS AND OVERVIEWOverviewWe are a worldwide operator, franchisor, and licensor of hotel, residential, and timeshare properties in 133 countries and territories under 30 brand names. Under our asset-light business model, we typically manage or franchise hotels, rather than own them. We discuss our operations in the following three reportable business segments: U.S. & Canada; Asia Pacific; and Europe, Middle East and Africa (“EMEA”). Our Caribbean and Latin America (“CALA”) operating segment does not meet the applicable accounting criteria for separate disclosure as a reportable business segment, and we include its results in “Unallocated corporate and other.” In January 2021, we modified our reportable segment structure as a result of a change in the way management intends to evaluate results and allocate resources within the Company. Beginning with the 2021 first quarter, we will report the following two operating segments: U.S. & Canada and International.25Table of Contents We earn base management fees and, under many agreements, incentive management fees from the properties that we manage, and we earn franchise fees on the properties that others operate under franchise agreements with us. In most markets, base management and franchise fees typically consist of a percentage of property-level revenue, or certain property-level revenue in the case of franchise fees, while incentive management fees typically consist of a percentage of net house profit after a specified owner return. For our hotels in the Middle East and Africa and in the Asia Pacific region, incentive management fees typically consist of a percentage of gross operating profit without adjustment for a specified owner return. Net house profit is calculated as gross operating profit (also referred to as “house profit”) less non-controllable expenses such as property insurance, real estate taxes, and capital spending reserves. Additionally, we earn franchise fees for use of our intellectual property, including fees from our co-brand credit card, timeshare, and residential programs.Starwood Data Security IncidentOn November 30, 2018, we announced a data security incident involving unauthorized access to the Starwood reservations database (the “Data Security Incident”). The Starwood reservations database is no longer used for business operations.In July 2019, the ICO issued a formal notice of intent under the U.K. Data Protection Act 2018 (the “U.K. DPA”) proposing a fine in the amount of £99 million against the Company in relation to the Data Security Incident. In October 2020, the ICO issued a final decision under the U.K. DPA, which includes a fine of £18.4 million. The Company did not appeal the ICO’s decision, but has made no admission of liability in relation to the decision or the underlying allegations. In 2019, we expensed $65 million for this loss contingency, in the “Restructuring and merger-related charges” caption of our Income Statements, based on the fine initially proposed by the ICO in July 2019 and the ongoing proceeding. In 2020, we recorded a $39 million reversal of expense, based on the ICO’s issuance of the final decision. We paid a portion of the ICO fine in the 2020 fourth quarter, and the remainder is payable over the next two years. Our accrual for this loss contingency, which we present in the “Accrued expenses and other” and “Other noncurrent liabilities” captions of our Balance Sheets, was $65 million at year-end 2019 and $17 million at year-end 2020. See Note 8 for additional information.We are currently unable to estimate the range of total possible financial impact to the Company from the Data Security Incident in excess of the expenses already incurred. However, we do not believe this incident will impact our long-term financial health. Although our insurance program includes coverage designed to limit our exposure to losses such as those related to the Data Security Incident, that insurance may not be sufficient or available to cover all of our expenses or other losses (including fines and penalties) related to the Data Security Incident. As we expected, the cost of such insurance again increased for our current policy period, and the cost of such insurance could continue to increase for future policy periods. We expect to incur significant expenses associated with the Data Security Incident in future periods, primarily related to legal proceedings and regulatory investigations (including possible additional fines and penalties), increased expenses and capital investments for information technology and information security and data privacy, and increased expenses for compliance activities and to meet increased legal and regulatory requirements. See Note 8 for additional information related to expenses incurred in 2020 and 2019, insurance recoveries, and legal proceedings and governmental investigations related to the Data Security Incident. Performance Measures We believe Revenue per Available Room (“RevPAR”), which we calculate by dividing room sales for comparable properties by room nights available for the period, is a meaningful indicator of our performance because it measures the period-over-period change in room revenues for comparable properties. RevPAR may not be comparable to similarly titled measures, such as revenues, and should not be viewed as necessarily correlating with our fee revenue. We also believe occupancy and average daily rate (“ADR”), which are components of calculating RevPAR, are meaningful indicators of our performance. Occupancy, which we calculate by dividing occupied rooms by total rooms available (including rooms in hotels temporarily closed due to issues related to COVID-19), measures the utilization of a property’s available capacity. ADR, which we calculate by dividing property room revenue by total rooms sold, measures average room price and is useful in assessing pricing levels. Comparisons to the prior year period are on a constant U.S. dollar basis. We calculate constant dollar statistics by applying exchange rates for the current period to the prior comparable period.We define our comparable properties as our properties that were open and operating under one of our brands since the beginning of the last full calendar year (since January 1, 2019 for the current period) and have not, in either the current or previous year: (1) undergone significant room or public space renovations or expansions, (2) been converted between company-operated and franchised, or (3) sustained substantial property damage or business interruption, with the exception of properties closed or otherwise experiencing interruptions related to COVID-19, which we continue to classify as comparable. For 2020 compared to 2019, we had 4,641 comparable U.S. & Canada properties and 1,340 comparable International properties. 26Table of Contents Impact of COVID-19COVID-19 continues to have a material impact on our business, our Company, and our industry. COVID-19 first impacted our business in Greater China beginning in January 2020, moved quickly into the rest of Asia Pacific and the European markets, and spread globally by March 2020. As the pandemic accelerated around the world, worldwide comparable systemwide constant dollar RevPAR fell sharply. Global occupancy levels and RevPAR have since improved compared to the extremely low levels reached in April 2020, but the pace of recovery generally slowed in most regions in the 2020 fourth quarter and into January 2021 due to the sharp rise in COVID-19 cases. As a result, our fee revenue and revenue from owned and leased properties declined significantly during 2020, and we expect that there will not be a significant rebound in travel and lodging demand until there is widespread distribution of effective vaccines. Worldwide comparable systemwide constant dollar RevPAR declined 23 percent in the 2020 first quarter, 84 percent in the 2020 second quarter, 66 percent in the 2020 third quarter, and 64 percent in the 2020 fourth quarter, compared to the same periods in 2019. Worldwide, approximately six percent of our hotels were closed as of February 15, 2021, compared to the peak of more than 25 percent closed on April 26, 2020. However, the progress of recovery is uneven. The spread of COVID-19 has constrained and continues to constrain the speed of recovery and will continue to have a dampening impact on demand. Demand is still being primarily driven by leisure travelers, and we have not seen meaningful demand return from business and group travelers.Of our geographic regions, Greater China experienced the greatest improvement in demand compared to the 2020 second quarter, driven initially by domestic leisure travel with business transient and group business improving through the year, while demand in the rest of Asia Pacific has generally improved at a much slower pace. In our Europe, Middle East, and Africa region, leisure demand drove RevPAR improvements in the 2020 third quarter compared to the 2020 second quarter, though increases in COVID-19 cases in Europe and resulting increases in government restrictions began anew in September 2020, which negatively impacted the recovery in the 2020 fourth quarter. In U.S. & Canada, demand improved during the remainder of 2020 from the lows seen in April 2020, primarily driven by leisure travel and by travelers within driving range of their destinations. We continue to take substantial measures to mitigate the negative financial and operational impacts for our hotel owners and our own business. Business contingency plans have been implemented around the world, and we continue to adjust these in response to the global situation. At the corporate level, our actions to date have substantially reduced the monthly run rate of corporate general and administrative costs compared to the monthly costs initially budgeted for 2020, excluding our provision for credit losses. We reduced spending on capital expenditures and other investments, and as previously announced, we suspended share repurchases and cash dividends.We have taken a number of steps to reorganize the Company in response to the decline in lodging demand caused by COVID-19. We implemented temporary furloughs and reduced work week schedules for both above-property and on-property associates, most of which ended in September 2020 for above-property associates. As part of the realignment of our organization, we implemented a voluntary transition program for certain associates, and we eliminated a significant number of positions. While we have substantially completed the programs related to our above-property organization, we are continuing to develop restructuring plans, which could result in additional on-property position eliminations, to achieve cost savings specific to each of our company-operated properties. See Note 3 for more information about our restructuring activities. At the property level, we continue to work with owners and franchisees to lower their cash outlays. The steps we have taken to date include deferring renovations, certain hotel initiatives and brand standard audits for hotel owners and franchisees; reducing the amount of certain charges for systemwide programs and services; offering a delay in payment terms for certain charges in the 2020 second quarter; supporting owners and franchisees who are working with their lenders to utilize furniture, fixtures, and equipment (FF&E) reserves to meet working capital needs; and waiving required FF&E funding through 2021. We have significantly lowered the reimbursed expenses we incur on behalf of our owners and franchisees to provide centralized programs and services such as the Loyalty Program, reservations, marketing and sales, which we generally collect through cost reimbursement revenue on the basis of hotel revenue or program usage. In 2020, we applied for Employee Retention Tax Credit refunds from the U.S. Treasury under the Coronavirus Aid, Relief, and Economic Security Act (“CARES Act”) totaling $164 million. In the 2020 fourth quarter, we received $119 million, $94 million of which we passed through to the related hotels that we manage on behalf of owners. We expect to receive the remaining refund in 2021, the majority of which we expect will inure to the benefit of our hotel owners. We continue to evaluate the availability of credits and benefits under the CARES Act and other legislation.The impact of COVID-19 on the Company remains fluid, as does our corporate and property-level response, and we expect to continue to assess and may implement additional measures to adapt our operations and plans as we continue to evaluate the implications of COVID-19 on our business. The overall operational and financial impact is highly dependent on 27Table of Contents the breadth and duration of COVID-19, including the availability and distribution of effective vaccines or treatments, and could be affected by other factors we are not currently able to predict.System Growth and PipelineIn 2020, our system grew from 7,349 properties (1,380,921 rooms) at year-end 2019 to 7,642 properties (1,423,044 rooms) at year-end 2020, reflecting the addition of 399 properties (62,776 rooms) and the exit of 106 properties (20,416 rooms). Approximately 45 percent of added rooms are located outside U.S. & Canada, and 13 percent are conversions from competitor brands. At year-end 2020, we had more than 498,000 rooms in our development pipeline, which includes hotel rooms under construction, hotel rooms under signed contracts, and roughly 20,000 hotel rooms approved for development but not yet under signed contracts. Over 229,000 rooms in our development pipeline were under construction at year-end 2020. Over half of the rooms in our development pipeline are outside U.S. & Canada. In 2020, we signed management and franchise agreements for 1,575 properties (248,660 rooms).In 2021, we expect gross rooms growth of approximately 6.0 percent (3.0 to 3.5 percent, net of deletions).Properties and RoomsAt year-end 2020, we operated, franchised, and licensed the following properties and rooms: ManagedFranchised/LicensedOwned/LeasedTotalPropertiesRoomsPropertiesRoomsPropertiesRoomsPropertiesRoomsU.S. & Canada788 240,487 4,720 677,120 26 6,483 5,534 924,090 Asia Pacific698 199,040 143 37,597 2 407 843 237,044 EMEA485 108,185 407 72,827 24 5,561 916 186,573 CALA112 21,520 132 27,613 14 3,449 258 52,582 Timeshare— — 91 22,755 — — 91 22,755 Total2,083 569,232 5,493 837,912 66 15,900 7,642 1,423,044 28Table of Contents Lodging StatisticsThe following tables present RevPAR, occupancy, and ADR statistics for comparable properties for 2020 and 2020 compared to 2019. Systemwide statistics include data from our franchised properties, in addition to our company-operated properties.RevPAROccupancyAverage Daily Rate2020vs. 20192020vs. 20192020vs. 2019Comparable Company-Operated PropertiesU.S. & Canada$50.73 (67.3)%28.6 %(47.2)%pts.$177.48 (13.4)%Asia Pacific$46.32 (53.7)%39.6 %(31.7)%pts.$116.90 (16.7)%CALA$52.55 (60.0)%26.7 %(37.8)%pts.$196.51 (3.6)%Europe$34.88 (76.8)%20.8 %(53.3)%pts.$167.70 (17.3)%Middle East & Africa$48.97 (52.1)%34.9 %(32.9)%pts.$140.34 (6.8)%EMEA (1)$41.11 (68.1)%27.0 %(44.3)%pts.$152.08 (15.9)%International - All (2)$44.77 (60.6)%33.8 %(37.0)%pts.$132.56 (17.4)%Worldwide (3)$47.53 (64.3)%31.4 %(41.7)%pts.$151.51 (16.7)%Comparable Systemwide PropertiesU.S. & Canada$48.28 (59.4)%37.2 %(36.5)%pts.$129.96 (19.4)%Asia Pacific$46.51 (54.2)%38.8 %(32.4)%pts.$119.89 (16.0)%CALA$38.81 (63.4)%24.4 %(37.4)%pts.$159.12 (7.1)%Europe$32.53 (75.1)%21.7 %(51.2)%pts.$149.58 (16.5)%Middle East & Africa$46.27 (52.5)%34.3 %(33.2)%pts.$134.87 (6.5)%EMEA (1) $36.91 (69.2)%25.8 %(45.4)%pts.$143.33 (14.9)%International - All (2)$41.51 (62.2)%31.5 %(38.5)%pts.$131.63 (16.1)%Worldwide (3)$46.28 (60.2)%35.5 %(37.1)%pts.$130.40 (18.5)%(1)Includes Europe and Middle East & Africa.(2)Includes Asia Pacific, CALA, and EMEA.(3)Includes U.S. & Canada and International - All.CONSOLIDATED RESULTSOur results declined in 2020 compared to 2019, primarily due to the impact of COVID-19. See the “Impact of COVID-19” section above for more information about the impact to our business during 2020, and the discussion below for additional analysis of our consolidated results of operations for 2020 and 2019. Fee Revenues($ in millions)20202019Change 2020 vs. 2019Base management fees$443 $1,180 $(737)(62)%Franchise fees1,153 2,006 (853)(43)%Incentive management fees87 637 (550)(86)%Gross fee revenues1,683 3,823 (2,140)(56)%Contract investment amortization(132)(62)70 113 %Net fee revenues$1,551 $3,761 $(2,210)(59)%The decrease in base management and franchise fees primarily reflected lower RevPAR and lower co-brand credit card fees of $84 million primarily due to COVID-19, as well as lower fees from properties that left the system of $32 million. The decrease in franchise fees was partially offset by unit growth ($37 million). The decrease in incentive management fees was primarily due to COVID-19. In 2020, we earned incentive management fees from 37 percent of our managed properties worldwide, compared to 72 percent in 2019. We earned incentive management fees from 3 percent of managed properties in U.S. & Canada and 56 percent of managed properties outside U.S. & Canada in 2020, compared to 57 percent in U.S. & Canada and 81 percent outside U.S. & Canada in 2019. In addition, 92 percent of our total incentive management fees in 2020 came from our managed properties outside U.S. & Canada, primarily in Asia Pacific, versus 65 percent in 2019.29Table of Contents Contract investment amortization increased primarily due to higher impairments of investments in management and franchise contracts, primarily due to COVID-19.Owned, Leased, and Other($ in millions)20202019Change 2020 vs. 2019Owned, leased, and other revenue$568 $1,612 $(1,044)(65)%Owned, leased, and other - direct expenses677 1,316 (639)(49)%Owned, leased, and other, net$(109)$296 $(405)(137)%Owned, leased, and other revenue, net of direct expenses decreased primarily due to lower demand at and the temporary closure of certain of our owned and leased hotels due to COVID-19, as well as net lower owned and leased profits attributable to hotels sold in the 2019 fourth and 2020 first quarters ($19 million).Cost Reimbursements($ in millions)20202019Change 2020 vs. 2019Cost reimbursement revenue$8,452 $15,599 $(7,147)(46)%Reimbursed expenses8,435 16,439 (8,004)(49)%Cost reimbursements, net$17 $(840)$857 102 %Cost reimbursements, net (cost reimbursement revenue, net of reimbursed expenses) varies due to timing differences between the costs we incur for centralized programs and services and the related reimbursements we receive from hotel owners and franchisees, primarily driven by our Loyalty Program. Over the long term, our centralized programs and services are not designed to impact our economics, either positively or negatively. See Note 2 for more information about the accounting for our Loyalty Program.The increase in cost reimbursements, net in 2020 primarily reflects the performance of the Loyalty Program, which had lower program expenses and redemptions.Other Operating Expenses($ in millions)20202019Change 2020 vs. 2019Depreciation, amortization, and other$346 $341 $5 1 %General, administrative, and other762 938 (176)(19)%Restructuring and merger-related charges267 138 129 93 %Depreciation, amortization, and other expenses increased, primarily due to higher operating lease impairment charges ($16 million). See Note 9 for more information about the operating lease impairment charges.General, administrative, and other expenses decreased primarily due to lower administrative costs due to our cost reduction measures and $20 million of lower legal expenses. The decrease was partially offset by a higher provision for credit losses and higher guarantee reserves primarily due to the negative current and expected economic impact of COVID-19 ($105 million).Restructuring and merger-related charges increased primarily due to the increased put option liability discussed in Note 8 ($243 million) and 2020 restructuring charges ($56 million), partially offset by the ICO Fine discussed in Note 8 ($104 million, representing the 2019 accrual and the 2020 reversal), the 2019 impairment charge of a Legacy-Starwood office building ($34 million), and lower integration costs ($19 million). Non-Operating Income (Expense)($ in millions)20202019Change 2020 vs. 2019Gains and other income, net$9 $154 $(145)(94)%Interest expense(445)(394)51 13 %Interest income27 26 1 4 %Equity in (losses) earnings(141)13 (154)(1,185)%30Table of Contents Gains and other income, net decreased primarily due to the 2019 gains on our property sales ($134 million).Interest expense increased primarily due to higher interest on Senior Note issuances, net of maturities ($93 million), partially offset by lower commercial paper and Credit Facility interest rates and aggregate average borrowings ($24 million) and net lower interest rates on floating rate debt ($22 million). Equity in (losses) earnings decreased due to losses recorded by the investees and impairment charges ($77 million), primarily as a result of COVID-19.Income Taxes($ in millions)20202019Change 2020 vs. 2019Benefit (provision) for income taxes$199 $(326)$(525)(161)%Our tax benefit in 2020, compared to our tax provision in 2019, primarily reflected the decrease in operating income ($336 million), the tax benefit from the release of tax reserves due to audit closures during 2020 ($100 million), the tax benefit from the Sheraton Grand Chicago put option reserve ($61 million), the year-over-year tax benefit from impairment charges ($39 million), and the prior year tax expense incurred for U.S. tax on Global Intangible Low-Taxed Income ($35 million). The decrease was partially offset by a shift in earnings to jurisdictions with higher tax rates ($36 million).BUSINESS SEGMENTSOur segment results declined in 2020 compared to 2019 primarily due to the impact of COVID-19. See the “Impact of COVID-19” section above for more information about the impact to our business during 2020 and the discussion below for additional analysis of the operating results of our reportable business segments. Segment revenues and profits for EMEA, a new reportable segment in 2020, did not change significantly in 2019 compared to 2018.($ in millions)20202019Change 2020 vs. 2019U.S. & CanadaSegment revenues$7,905 $16,833 $(8,928)(53)%Segment profits198 2,000 (1,802)(90)%Asia PacificSegment revenues612 1,189 (577)(49)%Segment profits1 369 (368)(100)%EMEASegment revenues758 1,932 (1,174)(61)%Segment (loss) profits(200)318 (518)(163)%PropertiesRoomsDecember 31, 2020December 31, 2019vs. December 31, 2019December 31, 2020December 31, 2019vs. December 31, 2019U.S. & Canada5,534 5,324 210 4 %924,090 899,805 24,285 3 %Asia Pacific843 782 61 8 %237,044 221,772 15,272 7 %EMEA916 893 23 3 %186,573 184,091 2,482 1 %U.S. & Canada U.S. & Canada segment profits decreased primarily due to the following:•$1,351 million of lower gross fee revenues (primarily reflecting lower comparable systemwide RevPAR and net house profits driven by decreases in both occupancy and ADR due to lower demand resulting from COVID-19, partially offset by unit growth of $32 million); •$60 million of higher contract investment amortization costs (primarily reflecting higher contract impairment charges);•$158 million of lower owned, leased, and other revenue, net of direct expenses (including $19 million from hotels sold in the 2019 fourth and 2020 first quarters);•$22 million of higher general, administrative, and other expenses (primarily reflecting $75 million of higher provision for credit losses and reserves for guarantee funding, partially offset by $48 million of lower administrative costs due to our cost reduction measures);31Table of Contents •$141 million of lower gains and other income, net (primarily reflecting a $134 million gain on the sale of two properties in 2019);•$101 million of lower equity in (losses) earnings due to impairment charges ($60 million) and losses recorded by investees, primarily as a result of COVID-19; and•$27 million of higher restructuring and merger-related charges; partially offset by: •$49 million of higher cost reimbursement revenue, net of reimbursed expenses.Asia Pacific Asia Pacific segment profits decreased primarily due to the following:•$294 million of lower gross fee revenues (primarily reflecting lower comparable systemwide RevPAR and net house profits driven by decreases in both occupancy and ADR due to lower demand resulting from COVID-19);•$39 million of lower owned, leased, and other revenue, net of direct expenses;•$9 million of lower cost reimbursement revenue, net of reimbursed expenses; and•$25 million of lower equity in (losses) earnings;partially offset by:•$13 million of lower general, administrative, and other expenses (primarily reflecting lower expenses due to COVID-19). EMEAEMEA segment loss, compared to prior year profits, primarily reflects the following:•$308 million of lower gross fee revenues (primarily reflecting lower comparable systemwide RevPAR and net house profits driven by decreases in both occupancy and ADR due to lower demand resulting from COVID-19);•$171 million of lower owned, leased, and other revenue, net of direct expenses;•$25 million of lower cost reimbursement revenue, net of reimbursed expenses; and•$11 million of lower equity in (losses) earnings; partially offset by:•$13 million of lower general, administrative, and other expenses (primarily reflecting lower expenses due to COVID-19, partially offset by a $24 million higher provision for credit losses).STOCK-BASED COMPENSATIONSee Note 6 for more information.NEW ACCOUNTING STANDARDSSee Note 2 for information on our adoption of new accounting standards. 32Table of Contents LIQUIDITY AND CAPITAL RESOURCES Our long-term financial objectives include diversifying our financing sources, optimizing the mix and maturity of our long-term debt, and reducing our working capital. At year-end 2020, our long-term debt had a weighted average interest rate of 3.7 percent and a weighted average maturity of approximately 6.0 years. Including the effect of interest rate swaps, the ratio of our fixed-rate long-term debt to our total long-term debt was 0.8 to 1.0 at year-end 2020.In response to the negative impact COVID-19 had on our cash from operations in 2020, which we expect to continue to be negatively impacted as discussed above, we have taken numerous actions to preserve our financial flexibility and manage our debt maturities, which include:•Substantially reducing our corporate general and administrative costs, reimbursed expenses we incur on behalf of our owners and franchisees, and our capital expenditures and other investment spending, and implementing restructuring plans, as we discuss under the “Impact of COVID-19” section above;•Suspending share repurchases and dividends until conditions improve and until permitted under our Credit Facility; •Drawing under the Credit Facility, as we discuss under the “Sources of Liquidity-Our Credit Facility” section below;•Amending the Credit Facility to, among other things, waive the quarterly-tested leverage covenant in the Credit Facility through and including the fourth quarter of 2021, as we discuss under the “Sources of Liquidity-Our Credit Facility” section below;•Issuing $3.6 billion aggregate principal amount of senior notes, and repurchasing and retiring approximately $853 million aggregate principal amount of the Company’s outstanding senior notes maturing in 2022, which we discuss under the “Sources of Liquidity - Senior Notes Issuances and Repurchases” section below; and•Raising $920 million of cash by entering into amendments to the existing agreements for our U.S.-issued co-brand credit cards, which we discuss under the “Co-brand Credit Card Agreements” section below.We monitor the status of the capital markets and regularly evaluate the effect that changes in capital market conditions may have on our ability to fund our liquidity needs. We currently believe the Credit Facility, our cash on hand, and our access to capital markets remain adequate to meet our liquidity requirements. Sources of LiquidityOur Credit FacilityOur Credit Facility provides for up to $4.5 billion of aggregate borrowings for general corporate needs, including to support our commercial paper program if and when we resume issuing commercial paper. Borrowings under the Credit Facility generally bear interest at LIBOR (the London Interbank Offered Rate) plus a spread, based on our public debt rating. We also pay quarterly fees on the Credit Facility at a rate based on our public debt rating. We classify outstanding borrowings under the Credit Facility and outstanding commercial paper borrowings as long-term based on our ability and intent to refinance the outstanding borrowings on a long-term basis. The Credit Facility expires on June 28, 2024. In 2020, we made borrowings of $4.5 billion and repayments of $3.6 billion, resulting in total outstanding borrowings under the Credit Facility of $0.9 billion as of December 31, 2020. The Credit Facility contains certain covenants, including a financial covenant that limits our maximum Leverage Ratio (as defined in the Credit Facility, and generally consisting of the ratio of Adjusted Total Debt to EBITDA, each as defined in the Credit Facility, and subject to additional adjustments as described therein). On April 13, 2020, we entered into an amendment to the Credit Facility (the “First Credit Facility Amendment”) under which the covenant governing the permitted Leverage Ratio is waived through and including the first quarter of 2021 (the “Covenant Waiver Period”), which waiver period may end sooner at our election, and the required leverage levels for such covenant are adjusted once re-imposed at the end of the Covenant Waiver Period (starting at 5.50 to 1.00 when the leverage test is first re-imposed and gradually stepping down to 4.00 to 1.00 over the succeeding seven fiscal quarters, as further described in the Credit Facility). The First Credit Facility Amendment also imposes a monthly-tested minimum liquidity covenant for the duration of the Covenant Waiver Period and makes certain other amendments to the terms of the Credit Facility, including increasing the interest and fees payable on the Credit Facility for the duration of the Covenant Waiver Period, tightening certain existing covenants and imposing additional covenants for the duration of the Covenant Waiver Period, including restricting dividends and share repurchases. On January 26, 2021, we entered into two more amendments to the Credit Facility (the “New Credit Facility Amendments,” and together with the First Credit Facility Amendment, the “Credit Facility Amendments”), which extend the 33Table of Contents Covenant Waiver Period through and including the fourth quarter of 2021 (which waiver period may end sooner at our election), revise the required leverage levels for such covenant when it is re-imposed at the end of the Covenant Waiver Period (starting at 5.50 to 1.00 when the leverage test is first re-imposed and gradually stepping down to 4.00 to 1.00 over the succeeding five fiscal quarters, as further described in the Credit Facility), and increase the minimum liquidity amount under the liquidity covenant that is tested monthly for the duration of the Covenant Waiver Period. The New Credit Facility Amendments also make certain other amendments to the terms of the Credit Facility, including reducing the rate floor for the LIBOR Daily Floating Rate and the Eurocurrency Rate.Our outstanding public debt does not contain a corresponding financial covenant or a requirement that we maintain certain financial ratios. We currently satisfy the covenants in our Credit Facility, including the liquidity covenant under the Credit Facility.Senior Notes Issuances and RepurchasesOn April 16, 2020, we issued $1.6 billion aggregate principal amount of 5.750 percent Series EE Notes due May 1, 2025 (the “Series EE Notes”). We pay interest on the Series EE Notes in May and November of each year, commencing in November 2020. We received net proceeds of approximately $1.581 billion from the offering of the Series EE Notes, after deducting the underwriting discount and estimated expenses, which were made available for general corporate purposes.On June 1, 2020, we issued $1.0 billion aggregate principal amount of 4.625 percent Series FF Notes due June 15, 2030 (the “Series FF Notes”). We pay interest on the Series FF Notes in June and December of each year, commencing in December 2020. We received net proceeds of approximately $985 million from the offering of the Series FF Notes, after deducting the underwriting discount and estimated expenses. We used the majority of these proceeds to repurchase Senior Notes with near term maturities, as discussed below and in Note 10.In June 2020, we completed a tender offer (the “Tender Offer”) and retired $853 million aggregate principal amount of our Senior Notes consisting of: •$351 million of our 2.3% Series Q Notes maturing January 15, 2022;•$176 million of our 3.3% Series L Notes maturing September 15, 2022; and •$326 million of our 2.1% Series DD Notes maturing October 3, 2022. We used proceeds from our Series FF Notes offering to complete the repurchase of such notes, including the payment of accrued interest and other costs incurred.On August 14, 2020, we issued $1.0 billion aggregate principal amount of 3.500 percent Series GG Notes due October 15, 2032 (the “Series GG Notes”). We will pay interest on the Series GG Notes in April and October of each year, commencing in April 2021. We received net proceeds of approximately $984 million from the offering of the Series GG Notes, after deducting the underwriting discount and estimated expenses, which were made available for general corporate purposes, including the repayment of a portion of our outstanding borrowings under the Credit Facility. Commercial PaperDue to changes to our credit ratings as a result of the impact of COVID-19 on our business, we currently are not issuing commercial paper. As a result, we have had to rely more on borrowings under the Credit Facility and issuance of senior notes, which carry higher interest costs than our commercial paper. Co-brand Credit Card Agreements In May 2020, we signed amendments to the existing agreements for our U.S.-issued co-brand credit cards associated with our Loyalty Program. These amendments provided the Company with $920 million of cash from the prepayment of certain future revenues, the early payment of a previously committed signing bonus, and the pre-purchase of Marriott Bonvoy points and other consideration. We recorded the amount of cash received primarily in the deferred revenue caption, and the remainder in the liability for guest loyalty program captions, on our Balance Sheet.Uses of CashCash, cash equivalents, and restricted cash totaled $894 million at December 31, 2020, an increase of $641 million from year-end 2019, primarily reflecting Senior Notes issuances, net of repayments ($1,797 million), Credit Facility borrowings, net of repayments ($900 million), net cash provided by operating activities ($1,639 million), and dispositions ($260 million). The following cash outflows partially offset these cash inflows: commercial paper repayments, net of borrowings ($3,190 million), 34Table of Contents dividend payments ($156 million), purchase of treasury stock ($150 million), capital and technology expenditures ($135 million), other debt repayments, net of borrowings ($123 million), and financing outflows for employee stock-based compensation withholding taxes ($103 million).Cash from OperationsNet cash provided by operating activities decreased by $46 million in 2020 compared to 2019, primarily due to the net loss that we recorded in 2020 (adjusted for non-cash items) due to COVID-19, partially offset by net cash inflows from our Loyalty Program, including the one-time cash payments as a result of the amendments to our co-brand credit card agreements discussed in Note 2, a cash benefit from working capital changes, and lower cash paid for income taxes. Working capital changes primarily reflect lower accounts receivable due to lower fee and cost reimbursement revenues and a higher allowance for credit losses, lower accounts payable due to lower purchasing activity, and lower bonus accruals.Our ratio of current assets to current liabilities was 0.5 to 1.0 at both year-end 2020 and year-end 2019. We have significant borrowing capacity under our Credit Facility should we need additional working capital.Investing Activities Cash FlowsCapital Expenditures and Other Investments. We made capital expenditures, including expenditures on technology, of $135 million in 2020 and $653 million in 2019. Capital expenditures in 2020 decreased by $518 million compared to 2019, primarily reflecting the net lower spending on owned and leased properties and our worldwide systems and the 2019 acquisitions of a U.S. & Canada property and Elegant Hotels Group plc (“Elegant”).We expect spending on capital expenditures and other investments will total approximately $575 million to $650 million for 2021, including contract acquisition costs, equity and other investments, loan advances, and various capital expenditures (including approximately $220 million for maintenance capital spending and our new headquarters). Over time, we have sold lodging properties, both completed and under development, subject to long-term management agreements. The ability of third-party purchasers to raise the debt and equity capital necessary to acquire such properties depends in part on the perceived risks in the lodging industry and other constraints inherent in the capital markets. We monitor the status of the capital markets and regularly evaluate the potential impact of changes in capital market conditions on our business operations. In the Starwood Combination, we acquired various hotels and equity interests in various hotels, many of which we have sold or are seeking to sell. We have made, and expect to continue making, selective and opportunistic investments to add units to our lodging business, which may include property acquisitions and renovations (such as our 2019 acquisitions of the W New York - Union Square and Elegant), new construction, loans, guarantees, and noncontrolling equity investments. Over time, we seek to minimize capital invested in our business through asset sales subject to long-term management or franchise agreements.Dispositions. Property and asset sales generated $260 million cash proceeds in 2020 and $395 million in 2019. See Note 4 for more information on dispositions.Loan Activity. From time to time, we make loans to owners of hotels that we operate or franchise. Loan advances, net of loan collections, amounted to $33 million in 2020, compared to net collections of $21 million in 2019. At year-end 2020, we had $163 million of senior, mezzanine, and other loans outstanding, compared to $126 million outstanding at year-end 2019. Financing Activities Cash FlowsDebt. Debt decreased by $564 million in 2020, to $10,376 million at year-end 2020 from $10,940 million at year-end 2019. See “Sources of Liquidity,” caption in this “Liquidity and Capital Resources” section and Note 10 for additional information on the Senior Note and Credit Facility transactions in 2020.Share Repurchases. We purchased 1.0 million shares of our common stock in 2020 (in the 2020 first quarter) at an average price of $145.42 per share and 17.3 million shares in 2019 at an average price of $130.79 per share. At year-end 2020, 17.4 million shares remained available for repurchase under Board approved authorizations. We do not anticipate repurchasing additional shares until business conditions improve, and are prohibited from doing so for the duration of the Covenant Waiver Period under our Credit Facility, with certain exceptions. For additional information, see “Fourth Quarter 2020 Issuer Purchases of Equity Securities” in Part II, Item 5. Dividends. On February 14, 2020, our Board of Directors declared a cash dividend of $0.48 per share payable to stockholders of record on February 28, 2020, which we paid on March 31, 2020. We do not anticipate declaring further cash dividends until business conditions improve and are prohibited from doing so for the duration of the Covenant Waiver Period under our Credit Facility.35Table of Contents Contractual Obligations and Off-Balance Sheet ArrangementsContractual ObligationsThe following table summarizes our contractual obligations at year-end 2020: Payments Due by Period($ in millions)TotalLess Than1 Year1-3 Years3-5 YearsAfter5 YearsDebt (1)$12,453 $1,542 $2,143 $4,281 $4,487 Finance lease obligations (1)206 13 27 28 138 Operating leases where we are the primary obligor1,890 184 349 284 1,073 Purchase obligations 437 186 185 66 — Other noncurrent liabilities178 — 97 28 53 Total contractual obligations$15,164 $1,925 $2,801 $4,687 $5,751 (1)Includes principal as well as interest.The preceding table does not reflect projected Deemed Repatriation Transition Tax payments totaling $395 million at year-end 2020 as a result of the U.S. tax legislation enacted on December 22, 2017, commonly referred to as the 2017 Tax Cuts and Jobs Act. In addition, the table does not reflect unrecognized tax benefits, including interest and penalties, at year-end 2020 of $508 million.In addition to the purchase obligations noted in the preceding table, in the normal course of business we enter into purchase commitments to manage the daily operating needs of the hotels that we manage. Since we are reimbursed from the cash flows of the hotels or by working capital calls to the hotel owners, these obligations have minimal impact on our net income and cash flow.Other CommitmentsThe following table summarizes our guarantee, investment, and loan commitments at year-end 2020:($ in millions)TotalAmountsCommittedLess Than1 Year1-3 Years3-5 YearsAfter5 YearsGuarantee commitments (expiration by period)$279 $35 $81 $40 $123 Investment and loan commitments (expected funding by period)22 12 7 3 — Total other commitments$301 $47 $88 $43 $123 In conjunction with financing obtained for specific projects or properties owned by entities in which we have an equity investment, we may provide industry standard indemnifications to the lender for loss, liability, or damage occurring as a result of our actions or the actions of the entity.Additionally, in 2017, we granted a hotel owner a one-time right, exercisable in 2022, to require us to purchase the leasehold interest in the land and hotel for $300 million in cash (the “put option”). If the owner exercises the put option, we have the option to purchase, at the same time the put transaction closes, the fee simple interest in the underlying land for an additional $200 million in cash (the “call option”). We also have the right to defer the closing on the put and call options, if exercised, to December 2024. We account for the put option as a guarantee and as of December 31, 2020, believe it is probable the hotel owner will exercise the put option and we will exercise the call option.For further information, including the nature of the commitments and their expirations, see the “Commitments” caption in Note 8.Letters of CreditAt year-end 2020, we had $156 million of letters of credit outstanding (all outside the Credit Facility, as defined in Note 10), most of which were for our self-insurance programs. Surety bonds issued as of year-end 2020 totaled $163 million, most of which state governments requested in connection with our self-insurance programs.36Table of Contents CRITICAL ACCOUNTING POLICIES AND ESTIMATES Our preparation of financial statements in accordance with GAAP requires management to make estimates and assumptions that affect reported amounts and related disclosures. Management considers an accounting policy and estimate to be critical if: (1) we must make assumptions that were uncertain when the estimate was made; and (2) changes in the estimate, or selection of a different estimate methodology could have a material effect on our consolidated results of operations or financial condition. Management has discussed the development and selection of its critical accounting policies and estimates with the Audit Committee of our Board of Directors.While we believe that our estimates, assumptions, and judgments are reasonable, they are based on information available when the estimate or assumption was made. Actual results may differ significantly. Additionally, changes in our assumptions, estimates or assessments due to unforeseen events or otherwise could have a material impact on our financial position or results of operations.See Note 2 for further information related to our critical accounting policies and estimates, which are as follows:Loyalty Program, including how we estimate the breakage of hotel points, credit card points, and free night certificates, the volume of points and free night certificates that will be issued under our co-brand credit card agreements, the amount of consideration to which we will be entitled under our co-brand credit card agreements, and the stand-alone selling prices of goods and services provided under our co-brand credit card agreements;Goodwill, including how we evaluate the fair value of reporting units and when we record an impairment loss on goodwill;Intangibles and Long-Lived Assets, including how we evaluate the fair value of intangibles and long-lived assets and when we record impairment losses on intangibles and long-lived assets;Investments, including information on how we evaluate the fair value of investments and when we record impairment losses on investments; andBusiness Combinations, including the assumptions that we make to estimate the fair values of assets acquired and liabilities assumed related to discount rates, royalty rates, and the amount and timing of future cash flows.Item 7A. Quantitative and Qualitative Disclosures About Market Risk.We are exposed to market risk from changes in interest rates, stock prices, currency exchange rates, and debt prices. We manage our exposure to these risks by monitoring available financing alternatives, through development and application of credit granting policies and by entering into derivative arrangements. We do not foresee any significant changes in either our exposure to fluctuations in interest rates or currency rates or how we manage such exposure in the future.We are exposed to interest rate risk on our floating-rate notes receivable and floating-rate debt. Changes in interest rates also impact the fair value of our fixed-rate notes receivable and the fair value of our fixed-rate long-term debt.We are also subject to risk from changes in debt prices from our investments in debt securities and fluctuations in stock price from our investments in publicly traded companies. Changes in the price of the underlying stock can impact the fair value of our investment. We use derivative instruments, including cash flow hedges, fair value hedges, net investment in non-U.S. operations hedges, and other derivative instruments, as part of our overall strategy to manage our exposure to market risks associated with fluctuations in interest rates and currency exchange rates. As a matter of policy, we only enter into transactions that we believe will be highly effective at offsetting the underlying risk, and we do not use derivatives for trading or speculative purposes. See Note 2 for more information on derivative instruments.37Table of Contents The following table sets forth the scheduled maturities and the total fair value as of year-end 2020 for our financial instruments that are impacted by market risks: Maturities by Period($ in millions)20212022202320242025There-afterTotalCarryingAmountTotalFairValueAssets - Maturities represent expected principal receipts, fair values represent assets.Fixed-rate notes receivable$2 $2 $1 $1 $1 $35 $42 $33 Average interest rate0.83 %Floating-rate notes receivable$2 $83 $1 $13 $1 $21 $121 $112 Average interest rate3.77 %Liabilities - Maturities represent expected principal payments, fair values represent liabilities.Fixed-rate debt$(849)$(572)$(674)$— $(2,293)$(3,804)$(8,192)$(9,100)Average interest rate4.06 %Floating-rate debt$(317)$(228)$— $(1,486)$— $— $(2,031)$(2,035)Average interest rate1.63 %38Table of Contents
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+Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations" of our Form 10-K for the fiscal year ended December 31, 2019.This MD&A contains forward-looking statements as that term is defined in the Private Securities Litigation Reform Act of 1995. See "Information Concerning Forward-Looking Statements" at the outset of this report.Business Update Related To COVID-19In March 2020, the World Health Organization declared the Coronavirus (COVID-19) a pandemic. The pandemic has impacted essentially every geography in which the Company operates. Governments implemented various restrictions around the world, including closure of non-essential businesses, travel, shelter-in-place requirements for citizens and other restrictions. The Company has taken a number of precautionary steps to safeguard its businesses and colleagues from COVID-19, including implementing travel restrictions, arranging work from home capabilities and flexible work policies. In the second and third quarters of 2020, the Company began re-opening offices in various locations around the world, while ensuring that it continued to adhere to guidelines and orders issued by national, state and local governments. The timing of additional office re-openings will vary based on the conditions and restrictions in each location. In the fourth quarter, there was a surge in COVID-19 infections in many parts of the world, leading to renewed lock-downs and increased government restrictions. The safety and well-being of our colleagues continues to be our first priority. Several vaccines have been or are in various stages of approval. However, the speed of distribution and the impact on colleagues' ability to return to the office remains uncertain. The vast majority of the Company’s colleagues have continued and will continue working in a remote work environment for most of 2021. The Company expects it will continue its ability to service clients effectively while colleagues remain in a remote work environment. 37For the year ended December 31, 2020, the COVID-19 pandemic had an adverse impact on the Company’s revenue growth, primarily in our businesses that are discretionary in nature, which was partly mitigated through disciplined expense management by implementing restrictions on travel and other cost containment measures. However, the ultimate extent of the COVID-19 impact to the Company will depend on numerous evolving factors and future developments that it is not able to predict. Factors that could adversely affect the Company’s financial statements related to the financial and operational impact of COVID-19 are outlined in the "Risk Factors” section of this report.Acquisition of JLTOn April 1, 2019, the Company completed the acquisition (the "Transaction") of all of the outstanding shares of Jardine Lloyd Thompson Group plc ("JLT"), a public company organized under the laws of England and Wales. In accordance with the terms of the Transaction, JLT shareholders received £19.15 in cash for each JLT share, which valued JLT’s existing share capital at approximately £4.3 billion (or approximately $5.6 billion based on the exchange rate of U.S. $1.31:£1) on the Transaction closing date. As of December 31, 2020, the Company has substantially integrated JLT into all of its business operations.After the acquisition of JLT, the Company assumed the legal liabilities of JLT’s litigation and regulatory exposures as of April 1, 2019. Please see the "Risk Factors" section of this Annual Report on Form 10-K for risks associated with the acquisition and Note 16 to the consolidated financial statements which discusses certain errors and omission matters related to the acquisition.JLT's results of operations for the period April 1, 2019 through December 31, 2019 are included in the Company’s results of operations for 2019. In accordance with applicable accounting guidance, JLT's results of operations for the period January 1 through March 31, 2019 and for the year ended 2018 are not included in the Company's results of operations and therefore, affect comparability. The Company’s results for the years ended December 31, 2020 and 2019 were impacted by JLT related acquisition, restructuring and integration costs as well as legacy MMC restructuring programs as discussed in Note 14 to the consolidated financial statements.Consolidated Results of OperationsFor the Years Ended December 31,(In millions, except per share figures)202020192018Revenue$17,224 $16,652 $14,950 ExpenseCompensation and benefits10,129 9,734 8,605 Other operating expenses4,029 4,241 3,584 Operating expenses14,158 13,975 12,189 Operating income$3,066 $2,677 $2,761 Income before income taxes$2,793 $2,439 $2,244 Net income before non-controlling interests$2,046 $1,773 $1,670 Net income attributable to the Company$2,016 $1,742 $1,650 Net income per share attributable to the Company– Basic$3.98 $3.44 $3.26 – Diluted$3.94 $3.41 $3.23 Average number of shares outstanding– Basic506 506 506 – Diluted512 511 511 Shares outstanding at December 31,508 504 504 Consolidated operating income was $3.1 billion in 2020 compared with $2.7 billion in 2019, reflecting the impact of a 3% increase in revenue and an increase in expenses of 1%. On an underlying basis, revenue increased 1%, reflecting an increase of 3% in Risk & Insurance Services offset by a decrease in Consulting of 2%. On an underlying basis, expenses decreased 2%, reflecting a decrease in JLT 38integration and restructuring and acquisition-related costs and savings realized from the completion of integration efforts to date. The expense decrease also reflects lower travel and entertainment, meeting costs and outside services resulting from the Company’s restrictions on travel and cost containment measures taken in light of COVID-19 and lower expenses recoverable from clients. These decreases were partly offset by higher incentive compensation, severance and a JLT legacy E&O provision of $161 million recorded in 2020, which is discussed in Note 16 of the consolidated financial statements.Income before income taxes increased 14% to $2.8 billion as compared to $2.4 billion in 2019, reflecting the change in operating income discussed in the preceding paragraph, partially offset by lower investment income.Diluted earnings per share increased 16% to $3.94 in 2020 compared with $3.41 in 2019. This increase is a result of the factors discussed above, and a lower effective tax rate in 2020.Risk and Insurance Services operating income increased $513 million, or 28%, in 2020 compared with 2019. Revenue increased 8%, reflecting increases of 3% on an underlying basis and 1% from acquisitions, partly offset by a 1% decrease from the impact of foreign currency translation. Expense increased 3% reflecting decreases of 2% on an underlying basis and 1% from the impact of foreign currency translation, partly offset by an increase of 2% from acquisitions. The decrease in underlying expenses is primarily due to lower JLT integration, restructuring and acquisition related costs and savings realized from the completion of integration efforts to date. The decrease also reflects lower travel and entertainment and meeting costs resulting from the Company’s restrictions on travel and cost containment measures taken in light of COVID-19, partly offset by higher severance.Consulting operating income decreased $216 million, or 18%, to $1.0 billion in 2020 compared with 2019, reflecting the impact of a decrease in revenue of 2% and an increase in expense of 1%. Revenue decreased 2% on an underlying basis and 1% from the impact of dispositions. On an underlying basis, expense increased 1% primarily due to a JLT legacy E&O provision of $161 million recorded in 2020, higher JLT integration and restructuring related costs as well as higher severance, partly offset by lower travel, entertainment and meeting costs resulting from the Company’s restrictions on travel and cost containment measures taken in light of COVID-19 and lower expenses recoverable from clients.The following chart summarizes the activity related to the restructuring and noteworthy items discussed in more detail below:For the Years Ended December 31,(In millions)202020192018Restructuring costs, excluding JLT$89 $112 $161 JLT integration and restructuring costs251 335 — JLT acquisition related costs54 150 12 JLT legacy E&O provision161 — — Impact on operating income555 597 173 Change in fair value of acquisition related derivative contracts— 8 441 Pension settlement charges3 7 42 Early extinguishment of JLT debt — 32 — JLT related interest income - pre-acquisition— (25)— JLT related interest expense - pre-acquisition— 53 30 Investment and impairment loss — — 83 Impact on income before taxes$558 $672 $769 39In 2020, 2019 and 2018, the Company’s results of operations and earnings per share were impacted by the following items:•Restructuring costs, excluding JLT: Includes severance, adjustments to restructuring liabilities for future rent under non-cancellable leases and other real estate exit costs, and restructuring costs related to the integration of recent acquisitions. These costs are discussed in more detail in Note 14 of the consolidated financial statements. •JLT integration and restructuring costs: Includes severance, lease related exit costs as well as consulting costs from the JLT Transaction. These costs are discussed in more detail in Note 14 of the consolidated financial statements. •JLT acquisition related costs: Includes advisor fees and stamp duty taxes related to the closing of the JLT Transaction and retention costs. Also includes the loss on the sale of JLT's aerospace business, which is included in revenue. •JLT legacy E&O provision: In 2020, reflects a provision for a legacy JLT E&O relating to suitability of financial advice provided to individuals for defined benefit pension transfers. This provision is discussed in more detail in Note 16 of the consolidated financial statements.•Change in fair value of acquisition related derivatives: In connection with the JLT Transaction, to hedge the risk of appreciation of the GBP-denominated purchase price relative to the U.S. dollar, in September 2018, the Company entered into a deal contingent foreign exchange contract (the "FX Contract") to, solely upon consummation of the JLT Transaction, purchase £5.2 billion and sell a corresponding amount of U.S. dollars at a contracted exchange rate. The FX Contract is discussed in Note 11 to the consolidated financial statements. An unrealized loss of $325 million related to the fair value changes to this derivative was recognized in the consolidated statement of income for the year ended December 31, 2018, largely due to the depreciation of the GBP from September 2018. In 2019, the Company recorded a gain of $31 million upon final settlement of the FX Contract. In addition, to hedge the economic risk of increases in interest rates prior to its issuance of senior notes in January 2019, in the fourth quarter of 2018, the Company entered into treasury lock contracts related to $2 billion of the expected debt issuance. These economic hedges were not designated as accounting hedges. The Company recorded an unrealized loss of $116 million related to the changes in the fair value of these derivatives in the consolidated statement of income for the year ended December 31, 2018. In January 2019, upon issuance of the $5 billion of senior notes, the Company settled the treasury lock contracts and made a payment to its counter party for $122 million.JLT also had a number of foreign exchange contracts to hedge the risk of foreign exchange movements between the U.S. dollar and the GBP, related to JLT’s U.S. dollar denominated revenue in the U.K. Prior to the acquisition, these derivative contracts were designated as cash flow hedges. Upon completion of the JLT Transaction, these derivative contracts were not re-designated as cash flow hedges by the Company. The contracts were settled in June 2019. The change in fair value between the acquisition date and the settlement date resulted in a charge of $26 million for the year ended December 31, 2019. The charge is recorded as a change in fair value of acquisition related derivative contracts in the consolidated statement of income.•JLT related interest income and expense: To secure funding for the Transaction, the Company entered into a bridge loan agreement with aggregate commitments of £5.2 billion in September 2018. The Company paid the customary upfront fees related to the bridge loan, which were amortized as interest expense based on the period of time the facility was expected to be in effect. The Company recorded interest expense of approximately $30 million for the year ended December 31, 2018 related to the amortization of the bridge loan fees and an additional $6 million in 2019 upon termination of the bridge loan agreement in connection with the closing of the JLT Transaction. The Company recorded approximately $47 million of interest expense related to the senior notes issued in the first quarter of 2019 and $25 million of interest income from the investment of the proceeds prior to the closing of the JLT Transaction.40•Investment loss-Alexander Forbes ("AF"): The Company recorded an impairment charge of $83 million in the 2018 consolidated statement of income for an other than temporary decline in the value of the investment. During 2020, the Company sold approximately 242 million shares of the common stock of AF. Upon completion of the sales of these shares, the investment in AF was accounted at fair value, with investment gains and losses recorded as investment income (loss) in the consolidated statement of income. •Pension settlement charge: The Defined Benefit Pension Plans in the U.K. and certain other countries allow participants an option for the payment of a lump sum distribution from plan assets before retirement in full satisfaction of the retirement benefits due to the participant as well as any survivor’s benefit. The Company’s policy in accordance with applicable U.S. GAAP is to treat these lump sum payments as a partial settlement of the plan liability if they exceed the sum of service cost plus interest cost components of net period pension cost of a plan for the year ("settlement thresholds"). The amount of lump sum payments in 2018 exceeded the settlement thresholds in two of the U.K. plans. The Company recorded non-cash settlement charges, primarily related to these plans of $42 million for the year ended December 31, 2018, of which approximately 90% impacted Risk and Insurance Services. In 2020 and 2019, the Company recorded $3 million and $7 million, respectively, of non-cash pension settlement charges related to certain of its non U.S. plans.JLT Integration and Restructuring CostsThe Company is completing its integration of JLT, which is discussed in more detail in Note 14 to the consolidated financial statements. The costs incurred in connection with the integration and restructuring of the combined businesses, primarily related to severance, real estate rationalization and technology, consulting fees related to the management of the integration processes and legal fees related to the rationalization of legal entity structures. The Company incurred costs of $251 million in 2020 and $335 million in 2019 and expects the remaining costs of $139 million to be incurred in 2021 of which $134 million will be cash expenditures. Through December 31, 2020, the Company has exceeded the initial estimated savings of $350 million. The Company now expects approximately $425 million of annualized savings when the integration is completed in 2021.41Consolidated Revenue and ExpenseRevenue - Components of ChangeThe Company conducts business in many countries. As a result, foreign exchange rate movements may impact period-to-period comparisons of revenue. Similarly, certain other items such as the revenue impact of acquisitions and dispositions, including transfers among businesses, may impact period-to-period comparisons of revenue. Underlying revenue measures the change in revenue from one period to another by isolating these impacts. The calculation of underlying revenue growth for the year ended December 31, 2020 as compared to 2019, is calculated as if MMC and JLT were a combined company as of January 1, 2019, but excludes the impact of currency and other acquisitions, dispositions, and transfers among businesses. Combined prior year revenue information for MMC and JLT for the year ended December 31, 2019 are presented below. The unaudited 2019 JLT revenue amounts in the "2019 including JLT" column reflect historical JLT revenue information following IFRS, adjusted to conform with U.S. GAAP and the Company's specific accounting policies, primarily related to development of constraints and subsequent release of those constraints related to the reinsurance business. The decrease in revenue due to the disposal of JLT's Aerospace business is reflected in the acquisitions/dispositions column beginning in June 2019, when the sale was completed. See the reconciliation of non-GAAP measures within MD&A. All other acquisitions/dispositions activity is included in the acquisitions/dispositions column. Underlying expense growth is calculated in a similar manner. The impact of foreign currency exchange fluctuations, acquisitions and dispositions, including transfers among businesses, on the Company’s operating revenues by segment are as follows:Year EndedDecember 31,2019 Including JLT% Change Including JLT in 2019Components of Revenue Change Including JLT*(In millions, except percentage figures)20202019% Change GAAPRevenueCurrency ImpactAcquisitions/Dispositions/ Other ImpactUnderlying RevenueRisk and Insurance ServicesMarsh$8,595 $8,014 7 %$8,246 4 %(1)%2 %3 %Guy Carpenter1,696 1,480 15 %1,598 6 %— — 6 %Subtotal10,291 9,494 8 %9,844 5 %(1)%1 %4 %Fiduciary Interest Income46 105 110 Total Risk and Insurance Services10,337 9,599 8 %9,954 4 %(1)%1 %3 %ConsultingMercer4,928 5,021 (2)%5,094 (3)%— (2)%(1)%Oliver Wyman Group2,048 2,122 (3)%2,122 (3)%— — (4)%Total Consulting6,976 7,143 (2)%7,216 (3)%— (1)%(2)%Corporate/Eliminations(89)(90)(90)Total Revenue$17,224 $16,652 3 %$17,080 1 %— — 1 %42The following table provides more detailed revenue information for certain of the components presented above:Year EndedDecember 31,2019 Including JLT% Change Including JLT in 2019Components of Revenue Change Including JLT*(In millions, except percentage figures)20202019% Change GAAPRevenueCurrency ImpactAcquisitions/ Dispositions/ OtherUnderlying RevenueMarsh:EMEA$2,575 $2,482 4 %$2,589 (1)%— — — Asia Pacific1,059 953 11 %1,019 4 %— — 4 %Latin America424 460 (8)%483 (12)%(10)%(5)%3 %Total International4,058 3,895 4 %4,091 (1)%(1)%(1)%1 %U.S./Canada4,537 4,119 10 %4,155 9 %— 4 %5 %Total Marsh$8,595 $8,014 7 %$8,246 4 %(1)%2 %3 %Mercer:Wealth2,348 2,369 (1)%2,422 (3)%— (2)%(1)%Health1,793 1,796 — 1,815 (1)%(1)%(2)%2 %Career787 856 (8)%857 (8)%— — (8)%Total Mercer$4,928 $5,021 (2)%$5,094 (3)%— (2)%(1)%* Components of revenue change may not add due to rounding.RevenueConsolidated revenue was $17 billion in 2020, an increase of 3%, or 1% on an underlying basis. Revenue in the Risk and Insurance Services segment increased 8% in 2020 compared with 2019, or 3% on an underlying basis. Revenue increased 3% and 6% on an underlying basis at Marsh and Guy Carpenter, respectively, as compared with 2019. The Consulting segment's revenue decreased 2% compared with 2019, as well as on an underlying basis. Revenue decreased 1% and 4% on an underlying basis at Mercer and Oliver Wyman Group, respectively, as compared with 2019.Operating ExpenseConsolidated operating expenses increased 1% in 2020 compared with 2019. Expenses decreased 2% on an underlying basis, reflecting a decrease in JLT integration and restructuring and acquisition-related costs, and savings realized from the completion of integration efforts to date. The decrease also reflects lower travel and entertainment, meeting costs and outside services resulting from the Company’s restrictions on travel and cost containment measures taken in light of COVID-19 and lower expenses recoverable from clients. These decreases were partly offset by a JLT legacy E&O provision of $161 million recorded in 2020, higher incentive compensation and severance.Risk and Insurance ServicesIn the Risk and Insurance Services segment, the Company’s subsidiaries and other affiliated entities act as brokers, agents or consultants for insureds, insurance underwriters and other brokers in the areas of risk management, insurance broking and insurance program management services, primarily under the name of Marsh; and engage in reinsurance broking, catastrophe and financial modeling services and related advisory functions, primarily under the name of Guy Carpenter.Marsh and Guy Carpenter are compensated for brokerage and consulting services primarily through fees paid by clients or commissions paid out of premiums charged by insurance and reinsurance companies. Commission rates vary in amount depending upon the type of insurance or reinsurance coverage provided, the particular insurer or reinsurer and the capacity in which the broker acts and negotiates with clients. Revenues can be affected by premium rate levels in the insurance/reinsurance markets, the amount of risk retained by insurance and reinsurance clients themselves and by the value of the risks that have been insured since commission-based compensation is frequently related to the premiums paid by insureds and reinsureds. In many cases, fee compensation may be negotiated in advance, based on the type of risk, coverage required and service provided by the Company and ultimately, the extent of the risk placed into the insurance market or retained by the client. The trends and comparisons of revenue from one period to the next can be affected by changes in premium rate levels, fluctuations in client risk 43retention and increases or decreases in the value of risks that have been insured, as well as new and lost business, and the volume of business from new and existing clients.Marsh also receives other compensation from insurance companies, separate from retail fees and commissions. This compensation includes, among other things, payment for consulting and analytics services provided to insurers; administrative and other services provided to or on behalf of insurers (including services relating to the administration and management of quota share, panels and other facilities in which insurers participate); and contingent commissions. Marsh and Guy Carpenter also receive interest income on certain funds (such as premiums and claims proceeds) held in a fiduciary capacity for others. The investment of fiduciary funds is regulated by state and other insurance authorities. These regulations typically require segregation of fiduciary funds and limit the types of investments that may be made with them. Interest income from these investments varies depending on the amount of funds invested and applicable interest rates, both of which vary from time to time. For presentation purposes, fiduciary interest is segregated from the other revenues of Marsh and Guy Carpenter and separately presented within the segment, as shown in the revenue by segments charts presented earlier in this MD&A.The results of operations for the Risk and Insurance Services segment are presented below: (In millions of dollars, except percentages)202020192018Revenue$10,337 $9,599 $8,228 Compensation and benefits5,690 5,370 4,485 Other operating expenses2,301 2,396 1,879 Operating expenses7,991 7,766 6,364 Operating income$2,346 $1,833 $1,864 Operating income margin22.7 %19.1 %22.7 %RevenueRevenue in the Risk and Insurance Services segment increased 8% in 2020 compared with 2019. Revenue grew 3% on an underlying basis and 1% from the impact of acquisitions, partly offset by a 1% decrease related to the impact of foreign currency translation.In Marsh, revenue increased 3% on an underlying basis and 2% from the impact of acquisitions, partly offset by a 1% decrease from the impact of foreign currency translation. U.S./Canada had underlying revenue growth of 5%. International operations increased 1% on an underlying basis, reflecting increases of 4% in Asia Pacific and 3% in Latin America, while EMEA was flat compared to prior year.Guy Carpenter’s revenue increased 15% to $1.7 billion in 2020 compared with 2019, or 6% on an underlying basis.Fiduciary interest income was $46 million in 2020 compared with $105 million in 2019. The decrease in 2020 compared to 2019 reflects the impact of lower interest rates partially offset by a higher level of average invested funds. The Risk and Insurance Services segment completed seven acquisitions during 2020. Information regarding those acquisitions is included in Note 5 to the consolidated financial statements.ExpenseExpense in the Risk and Insurance Services segment increased 3% in 2020 compared with 2019, reflecting decreases of 2% on an underlying basis and 1% from the impact of foreign currency, partly offset by a 2% increase from acquisitions. The decrease in underlying expense reflects lower JLT integration, restructuring and acquisition related costs and savings realized from the completion of integration efforts to date. The decrease also reflects lower travel and entertainment and meeting costs resulting from the Company’s restrictions on travel and cost containment measures taken in light of COVID-19 and lower base salaries. These decreases are partly offset by higher incentive compensation and severance.44ConsultingThe Company conducts business in its Consulting segment through two main business groups, Mercer and Oliver Wyman Group. Mercer provides consulting expertise, advice, services and solutions in the areas of health, wealth and career. Oliver Wyman Group provides specialized management, economic and brand consulting services.The major component of revenue in the Consulting business is fees paid by clients for advice and services. Mercer, principally through its health line of business, also earns revenue in the form of commissions received from insurance companies for the placement of group (and occasionally individual) insurance contracts, primarily life, health and accident coverages. Revenue for Mercer’s investment management business and certain of Mercer’s defined contribution administration services consists principally of fees based on assets under management or administration.Revenue in the Consulting segment is affected by, among other things, global economic conditions, including changes in clients’ particular industries and markets. Revenue is also affected by competition due to the introduction of new products and services, broad trends in employee demographics, including levels of employment, the effect of government policies and regulations, and fluctuations in interest and foreign exchange rates. Revenues from the provision of investment management services and retirement trust and administrative services are significantly affected by the level of assets under management or administration, which is impacted by securities market performance.For the investment management business, revenues from the majority of funds are included on a gross basis in accordance with U.S. GAAP and include reimbursable expenses incurred by professional staff and sub-advisory fees, and the related expenses are included in other operating expenses.The results of operations for the Consulting segment are presented below: (In millions of dollars, except percentages)202020192018Revenue$6,976 $7,143 $6,779 Compensation and benefits3,995 3,934 3,760 Other operating expenses1,987 1,999 1,920 Operating expenses5,982 5,933 5,680 Operating income$994 $1,210 $1,099 Operating income margin14.3 %16.9 %16.2 %RevenueConsulting revenue in 2020 decreased 2% compared with 2019, reflecting decreases of 2% on an underlying basis and 1% from the impact of dispositions.Mercer's revenue in 2020 decreased 1% on an underlying basis and 2% from the impact of dispositions. The decrease in underlying revenue reflects decreases in both Career of 8% and Wealth of 1% partly offset by an increase in Health of 2%. Oliver Wyman Group’s revenue decreased 3% in 2020 compared with 2019, or 4% on an underlying basis.ExpenseConsulting expense in 2020 increased 1% compared with 2019. This reflects an increase of 1% on an underlying basis and a decrease of 1% from the impact of dispositions. The increase in underlying expense reflects a JLT legacy E&O provision of $161 million recorded in 2020, higher JLT integration and restructuring costs as well as higher base salaries, incentive compensation and severance. These increases were partly offset by lower travel, entertainment and meeting costs resulting from the Company’s restrictions on travel and cost containment measures taken in light of COVID-19 and lower expenses recoverable from clients.Corporate and OtherCorporate expense in 2020 was $274 million compared with $366 million in 2019. Expenses decreased 17% on an underlying basis due to lower acquisition, integration and restructuring costs primarily related 45to the JLT Transaction and savings realized from the completion of integration efforts to date, partly offset by higher base salaries.Other Corporate ItemsInterestInterest income earned on corporate funds amounted to $7 million in 2020 compared with $39 million in 2019. During the first quarter of 2019, the Company issued approximately $6.5 billion of senior notes related to the JLT acquisition. The funds were held in escrow and released for payment in April 2019, when the acquisition was completed. The decrease in interest income from the prior year is primarily due to interest earned on these funds in 2019. Interest expense in 2020 was $515 million compared with $524 million in 2019. The decrease in interest expense was primarily due to the impact of lower average interest rates on borrowings. Investment (Loss) IncomeThe caption "Investment (loss) income" in the consolidated statements of income comprises realized and unrealized gains and losses from investments. It includes, when applicable, other than temporary declines in the value of securities, mark-to-market increases or decreases in equity investments with readily determinable fair values and equity method gains or losses on its investments in private equity funds. The Company's investments may include direct investments in insurance, consulting or other strategically linked companies and investments in private equity funds.The Company recorded a net investment loss of $22 million in 2020, primarily due to the loss from the sale of shares of AF during the second quarter of 2020. The Company recorded net investment income of $22 million in 2019 which included gains of $10 million related to mark-to-market changes to equity securities and gains of $12 million related to investments in private equity funds and other investments.Income TaxesThe Company completed the JLT Transaction on April 1, 2019. During 2020, the integration of this global organization required intercompany transfers of acquired entities into the Company's country structures and the combination of those entities within the equivalent Company businesses. The integration transactions were designed to be tax efficient. The Company's global effective tax rate on JLT's earnings was reduced compared to JLT's pre-acquisition tax rate by utilizing debt for the restructuring transactions to be capital efficient, and reducing the generation of post-acquisition tax losses by merging historically unprofitable JLT entities with profitable Company operations. Provisions for deferred taxes and uncertain tax positions were established as part of the purchase price allocation as of April 1, 2019.The broader JLT organization is now held under the Company's legal entity structure, which makes it part of a U.S.-based multinational company and subjects it to full U.S. taxation.The Company's consolidated effective tax rate was 26.7%, 27.3%, and 25.6% in 2020, 2019, and 2018, respectively. The rates in all periods reflect the effects of tax planning and the ongoing impact of the Tax Cuts and Jobs Act ("TCJA"), including regulatory and other guidance as it became available. The tax rate in 2020 includes a valuation allowance for certain tax credits, the impact of uncertain tax positions, and certain tax planning benefits. The 2019 rate reflects items related to the JLT acquisition, including non-deductible goodwill allocated to the sale of Aerospace and non-deductible expenses incurred in relation to the JLT acquisition. The 2018 rate includes the effect of a charge related to the Company’s investment in AF as discussed in Note 1. The tax rates in all periods reflect the impact of discrete tax matters, tax legislation, and nontaxable adjustments to contingent acquisition consideration.The effective tax rate may vary significantly from period to period for the foreseeable future. The effective tax rate is sensitive to the geographic mix and repatriation of the Company's earnings, which may result in higher or lower tax rates. A shift in the mix of profits among jurisdictions can also affect the effective tax rate. In 2020, pre-tax income in Barbados, Canada, Ireland, Australia, Japan and Germany accounted for approximately 60% of the Company's total non-U.S. pre-tax income, with effective rates in those countries of 1%, 27%, 15%, 23%, 33.7%, and 32% respectively.In addition, losses in certain jurisdictions cannot be offset by earnings from other operations, and may require valuation allowances that affect the rate, depending on estimates of the value of associated deferred tax assets which can be realized. A valuation allowance was recorded to reduce deferred tax 46assets to the amount that the Company believes is more likely than not to be realized. Details are provided in Note 7 of the consolidated financial statements. The effective tax rate is also sensitive to changes in unrecognized tax benefits, including the impact of settled tax audits and expired statutes of limitation. Changes in tax laws, rulings, policies or related legal and regulatory interpretations occur frequently and may also have significant favorable or adverse impacts on our effective tax rate. As a U.S. domiciled parent holding company, the Company is the issuer of essentially all of the Company's external indebtedness, and incurs the related interest expense in the U.S. The Company’s interest expense deductions are not currently limited. Further, most senior executive and oversight functions are conducted in the U.S. and the associated costs are incurred primarily in the U.S. Some of these expenses may not be deductible in the U.S., which may impact the effective tax rate.The quasi-territorial tax regime provides an opportunity for the Company to repatriate foreign earnings more tax efficiently and there is less incentive for permanent reinvestment of these earnings. However, permanent reinvestment continues to be a component of the Company’s global capital strategy. The Company continues to evaluate its global investment and repatriation strategy in light of our capital requirements and potential costs of repatriation.The Coronavirus Aid, Relief and Economic Security Act (the "CARES Act") was signed into law on March 27, 2020. The CARES Act provided over $2 trillion in economic relief to individuals, governmental agencies and companies, to deal with the public health and economic impacts of COVID-19. Pursuant to the CARES Act, payroll taxes due from March 27, 2020 through December 31, 2020 will be deferred until 2021 and 2022 (50% to be paid each year) without interest or penalties.Liquidity and Capital ResourcesThe Company is organized as a legal entity separate and distinct from its operating subsidiaries. As the Company does not have significant operations of its own, the Company is dependent upon dividends and other payments from its operating subsidiaries to pay principal and interest on its outstanding debt obligations, pay dividends to stockholders, repurchase its shares and pay corporate expenses. The Company can also provide financial support to its operating subsidiaries for acquisitions, investments and certain parts of their business that require liquidity, such as the capital markets business of Guy Carpenter. Other sources of liquidity include borrowing facilities in financing cash flows.The Company derives a significant portion of its revenue and operating profit from operating subsidiaries located outside of the U.S. Funds from those operating subsidiaries are regularly repatriated to the U.S. out of annual earnings. At December 31, 2020, the Company had approximately $789 million of cash and cash equivalents in its foreign operations, which includes $249 million of operating funds required to be maintained for regulatory requirements or as collateral under certain captive insurance arrangements. The Company expects to continue its practice of repatriating available funds from its non-U.S. operating subsidiaries out of current annual earnings. Where appropriate, a portion of the current year earnings will continue to be permanently reinvested. With respect to repatriating 2018 and prior earnings, the Company has evaluated such factors as its short- and long-term capital needs, acquisition and borrowing strategies, and the availability of cash for repatriation for each of its subsidiaries. In general, the Company has determined that its permanent reinvestment assertions, in light of the enactment of the TCJA, should allow the Company to repatriate previously taxed earnings from the deemed repatriations as cash becomes available.During 2020, the Company recorded foreign currency translation adjustments which increased net equity by $559 million. Continued weakening of the U.S. dollar against foreign currencies would further increase the translated U.S. dollar value of the Company’s net investments in its non-U.S. subsidiaries, as well as the translated U.S. dollar value of cash repatriations from those subsidiaries. Conversely, strengthening of the U.S. dollar against foreign currencies would decrease the translated U.S. dollar value of the Company’s net investments in its non-U.S. subsidiaries, as well as the translated U.S. dollar value of cash repatriations from those subsidiaries.Cash on our consolidated balance sheets includes funds available for general corporate purposes. Funds held on behalf of clients in a fiduciary capacity are segregated and shown separately in the consolidated 47balance sheets as an offset to fiduciary liabilities. Fiduciary funds cannot be used for general corporate purposes, and should not be considered as a source of liquidity for the Company.Operating Cash FlowsThe Company generated $3.4 billion of cash from operations in 2020 and $2.4 billion in 2019. These amounts reflect the net income of the Company during those periods, excluding gains or losses from investments, adjusted for non-cash charges and changes in working capital which relate primarily to the timing of payments of accrued liabilities or receipts of assets and pension contributions.Pension-Related ItemsContributionsDuring 2020, the Company contributed $65 million to its U.S. pension plans and $78 million to non-U.S. pension plans compared to contributions of $35 million to U.S. plans and $87 million to non-U.S. plans in 2019.In the U.S., contributions to the tax-qualified defined benefit plans are based on ERISA guidelines and the Company generally expects to maintain a funded status of 80% or more of the liability determined in accordance with the ERISA guidelines. In 2020, the Company made $30 million of contributions to non-qualified plans and $35 million to its qualified plans. The Company expects to contribute approximately $37 million to its U.S. pension plans in 2021, including $7 million to the U.S. qualified plans to meet ERISA funding requirements and $30 million to its non-qualified plans.The Company contributed $34 million to its U.K. plans in 2020, including an expense allowance of approximately $5 million. The Company's contributions to its U.K. plans in 2021 are expected to be approximately $47 million, including an expense allowance of $16 million.Outside the U.S., the Company has a large number of non-U.S. defined benefit pension plans, the largest of which are in the U.K., which comprise approximately 81% of non-U.S. plan assets at December 31, 2020. Contribution rates for non-U.S. plans are generally based on local funding practices and statutory requirements, which may differ significantly from measurements under U.S. GAAP. In the U.K., the assumptions used to determine pension contributions are the result of legally-prescribed negotiations between the Company and the plans' trustee that typically occur every three years in conjunction with the actuarial valuation of the plans. Currently, this results in a lower funded status compared to U.S. GAAP and may result in contributions irrespective of the U.S. GAAP funded status. For the MMC U.K. Pension Fund, a new agreement was reached with the trustee in the fourth quarter of 2019 based on the surplus funding position at December 31, 2018. In accordance with the agreement, no deficit funding is required until 2023. The funding level will be re-assessed during 2022 to determine if contributions are required in 2023. In order to have greater influence over asset allocation and overall investment decisions, in November 2019, the Company renewed its agreement to support annual deficit contributions by the U.K. operating companies under certain circumstances, up to GBP 450 million over a seven-year period. In addition, in the U.K., the Company assumed responsibility for JLT's Pension Scheme ("JLT U.K. plan"). We currently expect to pay $29 million of deficit funding in 2021, although we will also reach a new funding agreement with the trustee during 2021.In the aggregate, the Company expects to contribute approximately $87 million to its non-U.S. defined benefit plans in 2021, comprising approximately $40 million to plans outside of the U.K. and $47 million to the U.K. plans.Changes to Pension PlansAs part of the JLT Transaction, the Company assumed responsibility for a number of pension plans throughout the world, the most significant of which is the JLT U.K. plan. The JLT U.K. plan has a defined benefit section which was frozen to future accrual in 2006 and a defined contribution section. The assets of the scheme are held in a trustee administered fund separate from the Company.Changes in Funded Status and ExpenseThe year-over-year change in the funded status of the Company's pension plans is impacted by the 48difference between actual and assumed results, particularly with regard to return on assets, and changes in the discount rate, as well as the amount of Company contributions, if any. Unrecognized actuarial losses were approximately $2.4 billion and $3.5 billion at December 31, 2020 for the U.S. plans and non-U.S. plans, respectively, compared with losses of $2.1 billion and $3.1 billion at December 31, 2019. The increases in both the U.S. and non-U.S. plans was primarily due to a decrease in the discount rate used to measure plan liabilities partly offset by an increase in asset values. In the past several years, the amount of unamortized losses has been significantly impacted, both positively and negatively, by actual asset performance and changes in discount rates. The discount rate used to measure plan liabilities in 2020 and 2019 decreased in the U.S. and U.K. (the Company's largest plans) following increases in the U.S. and the U.K. in 2018. An increase in the discount rate decreases the measured plan benefit obligation, resulting in actuarial gains, while a decrease in the discount rate increases the measured plan obligation, resulting in actuarial losses. During 2020, the Company's defined benefit pension plan assets had gains of 13.1% and 12.0% in the U.S. and U.K., respectively, as compared to gains of 21.4% and 13.1% in the U.S. and U.K., respectively, in 2019. During 2018, the Company's defined benefit pension plan assets had losses of 7.4% in the U.S. and 1.0% in the U.K.Overall, based on the measurement at December 31, 2020, total benefit credits related to the Company’s defined benefit plans are expected to increase in 2021 by approximately $22 million compared to 2020, reflecting an increase in non-U.S. plans of approximately $31 million, offset by a decrease in U.S. plans of $9 million. The Company’s accounting policies for its defined benefit pension plans, including the selection of and sensitivity to assumptions, are discussed below under Management’s Discussion of Critical Accounting Policies. For additional information regarding the Company’s retirement plans, see Note 8 to the consolidated financial statements.Financing Cash FlowsNet cash used for financing activities was $1.9 billion in 2020 compared with $3.3 billion provided by financing activities in 2019.Credit FacilitiesThe Company and certain of its foreign subsidiaries have a multi-currency five-year unsecured revolving credit facility of $1.8 billion. The interest rate on this facility is based on LIBOR plus a fixed margin which varies with the Company's credit ratings. This facility expires in October 2023 and requires the Company to maintain certain coverage and leverage ratios which are tested quarterly. The Company borrowed $1 billion under this facility in the first quarter of 2020, which was repaid in full during the second quarter of 2020. There were no borrowings outstanding under this facility at December 31, 2020.In January 2020, the Company entered into two new term loan facilities: a $500 million one-year facility and a $500 million two-year facility. In the first quarter of 2020, the Company borrowed $1 billion against these facilities. During the third quarter of 2020, the Company repaid $500 million of borrowings from its one-year facility. In December 2020, the Company repaid $500 million of borrowings from the two year facility. These two facilities were terminated as of December 31, 2020 after repayment of the initial draw down.In April 2020, the Company entered into a new 364 day $1 billion unsecured revolving credit facility with a term out option after one year. The facility has similar coverage and leverage ratios as the multi-currency five-year unsecured revolving credit facility. The Company had no borrowings outstanding under this facility at December 31, 2020.The Company also maintains other credit facilities, guarantees and letters of credit with various banks, aggregating $573 million at December 31, 2020 and $598 million at December 31, 2019. There were no outstanding borrowings under these facilities as of December 31, 2020 or as of December 31, 2019.DebtThe Company has established a short-term debt financing program of up to $1.5 billion through the issuance of commercial paper. The proceeds from the issuance of commercial paper were used for general corporate purposes. The Company had no commercial paper outstanding at December 31, 2020.49In December 2020, the Company repaid $700 million of maturing Senior Notes and $300 million of floating rate notes with an original maturity of December 2021.In May 2020, the Company issued $750 million of 2.250% Senior Notes due 2030. The Company used the net proceeds from this offering to pay outstanding borrowings under the revolving credit facility.In March 2020, the Company repaid $500 million of maturing Senior Notes.In September 2019, the Company repaid $300 million of maturing Senior Notes.During 2019, the Company issued approximately $6.5 billion of Senior Notes to primarily fund the acquisition of JLT, including the payment of related fees and expenses, and to repay certain JLT indebtedness, as well as for general corporate purposes.In connection with the closing of the JLT Transaction, the Company assumed approximately $1 billion of historical JLT indebtedness, which it repaid during 2019. The Company incurred debt extinguishment costs of $32 million in regard to the repayment of this debt.The Company's senior debt is currently rated A- by Standard & Poor's and Baa1 by Moody's. The Company's short-term debt is currently rated A-2 by Standard & Poor's and P-2 by Moody's. The Company carries a Stable outlook with S&P and a Negative outlook with Moody's.Share RepurchasesThe Company did not repurchase any shares of its common stock during 2020. In November 2019, the Board of Directors authorized an increase in the Company’s share repurchase program, which supersedes any prior authorization, allowing management to buy back up to $2.5 billion of the Company’s common stock. As of December 31, 2020, the Company remained authorized to purchase shares of its common stock up to a value of approximately $2.4 billion. There is no time limit on this authorization.During 2019, the Company repurchased 4.8 million shares of its common stock for total consideration of $485 million at an average price per share of $100.48.DividendsThe Company paid total dividends of $943 million in 2020 ($1.84 per share), $890 million in 2019 ($1.74 per share) and $807 million in 2018 ($1.58 per share).Contingent Payments Related To AcquisitionsDuring 2020, the Company paid $102 million of contingent payments related to acquisitions made in prior years. These payments are split between financing and operating cash flows in the consolidated statements of cash flows. Payments of $54 million related to the contingent consideration liability that was recorded on the date of acquisition are reflected as financing cash flows. Payments related to increases in the contingent consideration liability subsequent to the date of acquisition of $48 million are reflected as operating cash flows. Remaining estimated future contingent consideration payments of $243 million for acquisitions completed in 2020 and in prior years are included in accounts payable and accrued liabilities or other liabilities in the consolidated balance sheet at December 31, 2020. The Company paid deferred purchase consideration related to prior years' acquisitions of $68 million and $43 million for the years ended December 31, 2020 and 2019, respectively, that is reflected as financing cash flows. Remaining deferred cash payments of approximately $241 million are included in accounts payable and accrued liabilities or other liabilities in the consolidated balance sheet at December 31, 2020.In 2019, the Company paid $63 million of contingent payments related to acquisitions made in prior periods, of which $22 million was reported as financing cash flows and $41 million as operating cash flows.DerivativesNet Investment HedgeThe Company has investments in various subsidiaries with Euro functional currencies. As a result, the Company is exposed to the risk of fluctuations between the Euro and U.S. dollar exchange rates. As part of its risk management program to fund the JLT acquisition, the Company issued €1.1 billion Senior Notes, and designated the debt instruments as a net investment hedge of its Euro denominated subsidiaries. The hedge is re-assessed each quarter to confirm that the designated equity balance at the 50beginning of each period continues to equal or exceed 80% of the outstanding balance of the Euro debt instrument and that all the critical terms of the hedging instrument and the hedged net investment continue to match. If the hedge is highly effective, the change in the debt balance related to foreign exchange fluctuations will be recorded in foreign currency translation gains (losses) in the consolidated balance sheet. The U.S. dollar value of the Euro notes increased by $124 million during 2020 related to the change in foreign exchange rates. The Company concluded that the hedge was highly effective and recorded an increase to accumulated other comprehensive loss for the year ended December 31, 2020.JLT Fair Value Debt Derivative ContractsPrior to the JLT Transaction closing, a significant portion of JLT's outstanding senior notes were denominated in U.S. dollars. In order to hedge its exposure against the risk of fluctuations between the British Pound ("GBP") and the U.S. dollar, JLT entered into foreign exchange and interest rate swaps, which were designated as fair value hedges. In June 2019, the Company redeemed these U.S. dollar denominated senior notes and settled the related derivative contracts. Both the change in fair value of the debt and the change in fair value of the derivative contracts were recorded in the consolidated statement of income in the second quarter of 2019. The Company received approximately $112 million upon settlement of these derivative contracts.JLT Cash Flow HedgesJLT also had a number of foreign exchange contracts to hedge the risk of foreign exchange movements between the U.S. dollar and the GBP, related to JLT’s U.S. dollar denominated revenue in the U.K. Prior to the acquisition, these derivative contracts were designated as cash flow hedges. Upon acquisition, the derivative contracts were not re-designated as cash flow hedges by the Company. The contracts were settled in June 2019. The change in fair value between the acquisition date and the settlement date resulted in a charge of $26 million in the second quarter of 2019. The charge is recorded as a change in fair value of acquisition related derivative contracts in the consolidated statement of income.Foreign Exchange Forward ContractIn connection with the JLT Transaction, to hedge the risk of appreciation of the GBP-denominated purchase price relative to the U.S. dollar, on September 20, 2018, the Company entered into the FX Contract to, solely upon consummation of the Transaction, purchase £5.2 billion and sell a corresponding amount of U.S. dollars at a contracted exchange rate. The FX Contract, which did not qualify for hedge accounting treatment under applicable accounting guidance, is discussed in Note 11 to the consolidated financial statements. The Company settled the FX Contract on April 1, 2019, recording a realized gain to the consolidated statement of income of approximately $31 million in 2019. The cash outflow related to the settlement of the FX Contract was approximately $294 million in 2019.Foreign Exchange Contract on Euro Debt IssuanceIn March 2019, the Company issued €1.1 billion of senior notes related to the JLT Transaction. See Note 13 for additional information related to the Euro senior note issuances. In connection with the senior note issuances of €1.1 billion, the Company entered into a forward exchange contract to hedge the economic risk of changes in foreign exchange rates from the issuance date to settlement date of the Euro senior notes. This forward exchange contract was settled in March 2019 and the Company recorded a charge of $7 million in the first quarter of 2019 related to the settlement of this contract.Treasury Locks on Senior NotesIn connection with the JLT Transaction and to hedge the risk of increases in future interest rates prior to its issuance of senior notes, the Company entered into treasury locks related to $2 billion of the expected debt in the fourth quarter of 2018. The fair value at December 31, 2018 was based on the published treasury rate plus forward premium as of December 31, 2018 compared to the all in rate at the inception of the contract. The contracts were not designated as an accounting hedge. The Company recorded an unrealized loss of $116 million related to the change in the fair value of these derivatives in the consolidated statement of income for the year ended December 31, 2018. In January 2019, upon issuance of the $5 billion of senior notes, the Company settled the treasury lock derivatives and made a payment to its counter party for $122 million.51Investing Cash FlowsNet cash used for investing activities amounted to $814 million in 2020 compared with $5.7 billion used for investing activities in 2019.The Company paid $668 million and $5.5 billion, net of cash acquired, for acquisitions it made during 2020 and 2019, respectively.During 2020, the Company sold certain businesses primarily in the U.S., U.K. and Canada for cash proceeds of approximately $98 million. At December 31, 2019, the Company owned approximately 443 million shares of the common stock of AF, a South African company listed on the Johannesburg Stock Exchange, which was accounted for under the equity method of accounting. In February 2020, the Company sold approximately 49 million shares, and in May 2020, sold an additional 193 million shares, leaving the Company with an investment of approximately 201 million shares of the common stock of AF at December 31, 2020. Upon completion of the sale of shares in May 2020, the investment in AF was accounted at fair value, with investment gains and losses recorded as investment income in the consolidated statement of income.During the first quarter of 2019, the Company disposed of its investment in Benefitfocus for total proceeds of approximately $132 million. The Company received $115 million in the first quarter of 2019 and $17 million in the second quarter of 2019 as final settlement on the sale.During the second quarter of 2019, the Company disposed of its investment in Payscale and received proceeds of approximately $47 million. In January 2019, the Company increased its equity ownership in Marsh India from 26% to 49% for approximately $88 million. Marsh India is carried under the equity method.The Company’s additions to fixed assets and capitalized software, which amounted to $348 million in 2020 and $421 million in 2019, primarily related to computer equipment purchases, the refurbishing and modernizing of office facilities and software development costs.The Company has commitments for potential future investments of approximately $46 million in four private equity funds that invest primarily in financial services companies.Commitments and ObligationsThe following sets forth the Company’s future contractual obligations by the types identified in the table below as of December 31, 2020:Payment due by PeriodContractual Obligations(In millions of dollars)TotalWithin1 Year1-3Years4-5YearsAfter 5YearsCurrent portion of long-term debt$517 $517 $— $— $— Long-term debt10,866 — 1,135 2,135 7,596 Interest on long-term debt5,454 461 821 674 3,498 Net operating leases2,570 410 711 544 905 Service agreements344 197 101 36 10 Other long-term obligations558 182 329 47 — Total$20,309 $1,767 $3,097 $3,436 $12,009 The above does not include the liability for unrecognized tax benefits of $98 million as the Company is unable to reasonably predict the timing of settlement of these liabilities, other than approximately $20 million that may become payable during 2021. The above does not include the remaining transitional tax payments related to the TCJA of $64.5 million. Management’s Discussion of Critical Accounting PoliciesThe preparation of financial statements in conformity with accounting principles generally accepted in the United States ("GAAP") requires management to make estimates and judgments that affect reported amounts of assets, liabilities, revenue and expenses, and disclosure of contingent assets and liabilities. Management considers the policies discussed below to be critical to understanding the Company’s 52financial statements because their application places the most significant demands on management’s judgment, and requires management to make estimates about the effect of matters that are inherently uncertain. Actual results may differ from those estimates.Revenue RecognitionIn the Risk and Insurance Services segment, judgments related to the amount of variable revenue consideration to ultimately be received on placement of quota share reinsurance treaties and contingent commission from insurers, which was previously recognized when the contingency was resolved, now requires significant judgments and estimates.The Company capitalizes the incremental costs to obtain contracts primarily related to commissions or sales bonus payments. These deferred costs are amortized over the expected life of the underlying customer relationships. The Company also capitalizes certain pre-placement costs that are considered fulfillment costs that are amortized at a point in time when the associated revenue is recognized.Management also makes significant judgments and estimates to measure the progress toward completing performance obligations and realization rates for consideration related to contracts as well as potential performance-based fees in the Consulting segment.See Note 2 to the consolidated financial statements for additional information.Legal and Other Loss ContingenciesThe Company and its subsidiaries are subject to numerous claims, lawsuits and proceedings including claims for errors and omissions ("E&O"). GAAP requires that a liability be recorded when a loss is both probable and reasonably estimable. Significant management judgment is required to apply this guidance. The Company utilizes case level reviews by inside and outside counsel, an internal actuarial analysis by Oliver Wyman, a subsidiary of the Company, and other methods to estimate potential losses. The liability is reviewed quarterly and adjusted as developments warrant. In many cases, the Company has not recorded a liability, other than for legal fees to defend the claim, because we are unable, at the present time, to make a determination that a loss is both probable and reasonably estimable. Given the unpredictability of E&O claims and of litigation that could flow from them, it is possible that an adverse outcome in a particular matter could have a material adverse effect on the Company’s businesses, results of operations, financial condition or cash flow in a given quarterly or annual period.In addition, to the extent that insurance coverage is available, significant management judgment is required to determine the amount of recoveries that are probable of collection under the Company’s various insurance programs.Retirement BenefitsThe Company maintains qualified and non-qualified defined benefit pension and defined contribution plans for its eligible U.S. employees and a variety of defined benefit and defined contribution plans for its eligible non-U.S. employees. The Company’s policy for funding its tax-qualified defined benefit retirement plans is to contribute amounts at least sufficient to meet the funding requirements set forth in U.S. and applicable foreign laws.The Company recognizes the funded status of its over-funded defined benefit pension and retiree medical plans as a net benefit plan asset and its unfunded and underfunded plans as a net benefit plan liability. The gains or losses and prior service costs or credits that have not been recognized as components of net periodic costs are recorded as a component of Accumulated Other Comprehensive Income ("AOCI"), net of tax, in the Company’s consolidated balance sheets. The gains and losses that exceed specified corridors, 10 percent of the greater of the projected benefit obligation or the market-related value of plan assets, are amortized prospectively out of AOCI over a period that approximates the remaining life expectancy of participants in plans where substantially all participants are inactive or the average remaining service period of active participants for plans with active participants. The vast majority of unrecognized losses relate to inactive plans and are amortized over the remaining life expectancy of the participants.The determination of net periodic pension cost is based on a number of assumptions, including an expected long-term rate of return on plan assets, the discount rate, mortality and assumed rate of salary increase. The assumptions used in the calculation of net periodic pension costs and pension liabilities are 53disclosed in Note 8 to the consolidated financial statements. The assumptions for expected rate of return on plan assets and the discount rate are discussed in more detail below.The long-term rate of return on plan assets assumption is determined for each plan based on the facts and circumstances that exist as of the measurement date, and the specific portfolio mix of each plan’s assets. The Company utilizes a model developed by Mercer, a subsidiary of the Company, to assist in the determination of this assumption. The model takes into account several factors, including: actual and target portfolio allocation; investment, administrative and trading expenses incurred directly by the plan trust; historical portfolio performance; relevant forward-looking economic analysis; and expected returns, variances and correlations for different asset classes. These measures are used to determine probabilities using standard statistical techniques to calculate a range of expected returns on the portfolio.The target asset allocation for the U.S. plans is 64% equities and equity alternatives and 36% fixed income. At the end of 2020, the actual allocation for the U.S. plans was 64% equities and equity alternatives and 36% fixed income. The target asset allocation for the U.K. plans, which comprise approximately 81% of non-U.S. plan assets, is 32% equities and equity alternatives and 68% fixed income. At the end of 2020, the actual allocation for the U.K. plans was 33% equities and equity alternatives and 67% fixed income. The discount rate selected for each U.S. plan is based on a model bond portfolio with coupons and redemptions that closely match the expected liability cash flows from the plan. Discount rates for non-U.S. plans are based on appropriate bond indices adjusted for duration; in the U.K., the plan duration is reflected using the Mercer yield curve.The table below shows the weighted average assumed rate of return and the discount rate at the December 31, 2020 measurement date (for measuring pension expense in 2021) for the total Company, the U.S. and the Rest of World ("ROW").Total CompanyU.S.ROWAssumed rate of return on plan assets4.72 %7.02 %3.89 %Discount rate1.92 %2.73 %1.49 %Holding all other assumptions constant, a half-percentage point change in the rate of return on plan assets and discount rate assumptions would affect net periodic pension cost for the U.S. and U.K. plans, which together comprise approximately 85% of total pension plan liabilities, as follows:0.5 PercentagePoint Increase0.5 PercentagePoint Decrease(In millions of dollars)U.S.U.K.U.S.U.K.Assumed rate of return on plan assets$(23)$(51)$23 $51 Discount Rate$3 $5 $(4)$(8)The impact of discount rate changes shown above relates to the increase or decrease in actuarial gains or losses being amortized through net periodic pension cost, as well as the increase or decrease in interest expense, with all other facts and assumptions held constant. It does not contemplate nor include potential future impacts a change in the interest rate environment and discount rates might cause, such as the impact on the market value of the plans’ assets. In addition, the assumed return on plan assets would likely be impacted by changes in the interest rate environment and other factors, including equity valuations, since these factors reflect the starting point used in the Company’s projection models. For example, a reduction in interest rates may result in a reduction in the assumed return on plan assets. Changing the discount rate and leaving the other assumptions constant also may not be representative of the impact on expense, because the long-term rates of inflation and salary increases are often correlated with the discount rate. Changes in these assumptions will not necessarily have a linear impact on the net periodic pension cost.The Company contributes to certain health care and life insurance benefits provided to its retired employees. The cost of these post-retirement benefits for employees in the U.S. is accrued during the period up to the date employees are eligible to retire but is funded by the Company as incurred. The key assumptions and sensitivity to changes in the assumed health care cost trend rate are discussed in Note 8 to the consolidated financial statements. 54Income TaxesSignificant judgment is required in determining the annual effective tax rate and in evaluating uncertain tax positions. The Company reports a liability for unrecognized tax benefits resulting from uncertain tax positions taken or expected to be taken in a tax return. The evaluation of a tax position is a two-step process:•First, the Company determines whether it is more likely than not that a tax position will be sustained upon tax examination, including resolution of any related appeals or litigation, based on only the technical merits of the position. If a tax position does not meet the more-likely-than-not recognition threshold, the benefit of that position is not recognized in the financial statements. •The second step is measurement. A tax position that meets the more-likely-than-not recognition threshold is measured to determine the amount of benefit to recognize in the financial statements. The tax position is measured as the largest amount of benefit that is greater than 50-percent likely of being realized upon ultimate resolution with a taxing authority. Uncertain tax positions are evaluated based upon the facts and circumstances that exist at each reporting period and involve significant management judgment. Subsequent changes in judgment based upon new information may lead to changes in recognition, de-recognition, and measurement. Adjustments may result, for example, upon resolution of an issue with the taxing authorities, or expiration of a statute of limitations barring an assessment for an issue. The Company recognizes interest and penalties, if any, related to unrecognized tax benefits in income tax expense. The Company’s accounting policy follows the portfolio approach that leaves stranded income tax effects in AOCI. Certain items are included in the Company's tax returns at different times than the items are reflected in the financial statements. As a result, the annual tax expense reflected in the consolidated statements of income is different than that reported in the tax returns. Some of these differences are permanent, such as non-deductible expenses, and some differences are temporary and reverse over time, such as depreciation expense. Temporary differences create deferred tax assets and liabilities, which are measured at existing tax rates. Deferred tax liabilities generally represent tax expense recognized in the financial statements for which payment has been deferred, or expense for which a deduction has been taken already in the tax return but the expense has not yet been recognized in the financial statements. Deferred tax assets generally represent items that can be used as a tax deduction or credit in tax returns in future years for which a benefit has already been recorded in the financial statements. The Company evaluates all significant available positive and negative evidence, including the existence of losses in recent years and its forecast of future taxable income by jurisdiction, in assessing the need for a valuation allowance. The Company also considers tax planning strategies that would result in realization of deferred tax assets, and the presence of taxable income in prior period tax filings in jurisdictions that allow for the carry back of tax attributes pursuant to the applicable tax law. The underlying assumptions the Company uses in forecasting future taxable income require significant judgment and take into account the Company's recent performance. The ultimate realization of deferred tax assets is dependent on the generation of future taxable income during the periods in which temporary differences or carry-forwards are deductible or creditable. Valuation allowances are established for deferred tax assets when it is estimated that it is more likely than not that future taxable income will be insufficient to fully use a deduction or credit in that jurisdiction.Fair Value DeterminationsGoodwill Impairment Testing – The Company is required to assess goodwill and any indefinite-lived intangible assets for impairment annually, or more frequently if circumstances indicate impairment may have occurred. The Company performs the annual impairment assessment for each of its reporting units during the third quarter of each year. In accordance with applicable accounting guidance, a company can assess qualitative factors to determine whether it is necessary to perform a quantitative goodwill impairment test. Alternatively, the Company may elect to proceed directly to the quantitative goodwill 55impairment test. In 2020, the Company elected to perform a qualitative impairment assessment. As part of its assessment, the Company considered numerous factors, including:•that the fair value of each reporting unit exceeds its carrying value by a substantial margin based on its most recent quantitative assessment in 2019; •whether significant acquisitions or dispositions occurred which might alter the fair value of its reporting units;•macroeconomic conditions and their potential impact on reporting unit fair values;•actual performance compared with budget and prior projections used in its estimation of reporting unit fair values;•industry and market conditions;•and the year-over-year change in the Company’s share price.The Company completed its qualitative assessment in the third quarter of 2020 and concluded that a quantitative goodwill impairment test was not required in 2020 and that goodwill was not impaired.Share-Based PaymentThe accounting guidance for share-based payments requires, among other things, that the estimated grant date fair value of stock options be charged to earnings. Significant management judgment is required to determine the appropriate assumptions for inputs such as volatility and expected term necessary to estimate option values. In addition, management judgment is required to analyze the terms of the plans and awards granted thereunder to determine if awards will be treated as equity awards or liability awards, as defined by the accounting guidance.As of December 31, 2020, there was $17.5 million of unrecognized compensation cost related to stock option awards. The weighted-average period over which the costs are expected to be recognized is 1.23 years. Also as of December 31, 2020, there was $347.7 million of unrecognized compensation cost related to the Company’s restricted stock, restricted stock unit and performance stock unit awards. The weighted-average period over which that cost is expected to be recognized is approximately 1 year.See Note 9 to the consolidated financial statements for additional information regarding accounting for share-based payments.Investments and DerivativesAlthough not directly recorded in the Company’s consolidated balance sheets, the Company's defined benefit pension plans hold investments of approximately $19.1 billion, which include private equity and other non-liquid investments. The fair value of the plan investments determines, in part, the over-or under-funded status of those plans, which is included in the Company’s consolidated balance sheets. The Company also has minority positions in certain equity securities (primarily Alexander Forbes), which are accounted for at fair value with gains or losses recorded as investment gains or losses in the consolidated statement of income. The Company also has approximately $111 million of investments in private equity funds accounted for using the equity method of accounting.The Company reviews the carrying value of its investments (both direct and held through its pension plans) to determine if any valuation adjustments are appropriate under the applicable accounting pronouncements. The Company bases its review on the facts and circumstances as they relate to each investment. In those instances where quoted market prices are not available, particularly for private equity funds, significant management judgment is required to determine the appropriate value of the Company’s investments. Fair value of investments in private equity funds is determined by the funds’ investment managers. Factors considered in determining the fair value of private equity investments include: implied valuation of recently completed financing rounds that included sophisticated outside investors; performance multiples of comparable public companies; restrictions on the sale or disposal of the investments; trading characteristics of the securities; and the relative size of the holdings in comparison to other private investors and the public market float. In connection with the JLT Transaction, the Company entered into several derivative contracts, described in Note 11 to the consolidated financial statements. These derivative contracts are recorded at fair value at the end of each period, with the change in fair value recorded in the consolidated statements of 56income. Prior to their settlement, determination of the fair value of these contracts, in particular the deal contingent foreign exchange contract, required significant management judgments or estimates about the potential closing dates of the transaction and remaining value of the deal contingency feature. All derivative contracts related to the JLT Transaction were settled during 2019.Purchase Price AllocationAssets acquired and liabilities assumed, including contingent consideration, as part of a business acquisition are generally recorded at their fair value at the date of acquisition. The excess of purchase price over the fair value of assets acquired and liabilities assumed is recorded as goodwill. Determining fair value of identifiable assets, particularly intangibles, and liabilities acquired also requires management to make estimates, which are based on all available information and in some cases assumptions with respect to the timing and amount of future revenues and expenses associated with an asset. These estimates directly impact the amount of identified intangible assets recognized and the related amortization expense in future periods.New Accounting PronouncementsNote 1 to the consolidated financial statements contains a summary of the Company’s significant accounting policies, including a discussion of recently issued accounting pronouncements and their impact or potential future impact on the Company’s financial results, if determinable, under the sub-heading "New Accounting Pronouncements".Reconciliation of Non-GAAP MeasuresOn April 1, 2019, the Company completed its acquisition of JLT. JLT's results of operations for the year ended December 31, 2020 are included in the Company’s results of operations. JLT's results of operations for the three months ending March 31, 2019 are not included in the Company's results of operations for the twelve month period ended December 31, 2019. Prior to being acquired by the Company, JLT operated in three segments, Specialty, Reinsurance and Employee Benefits. As of April 1, 2019, the historical JLT businesses were combined into MMC operations as follows: JLT Specialty is included by geography within Marsh, JLT Reinsurance is included within Guy Carpenter and the majority of the JLT Employee Benefits business is included in Mercer Health and Wealth.The JLT Transaction had a significant impact on the Company’s results of operations in 2020. The Company believes that in addition to the change in reported GAAP revenue, a comparison of 2020 GAAP reported revenue to the combined 2019 revenue of MMC and JLT, as if the companies were combined on January 1, 2019, provides investors with meaningful information as to the Company’s year-over-year underlying operating results. Investors should not consider the comparison of these non-GAAP measures in isolation from, or as a substitute for, the financial information that the Company reports in accordance with GAAP.The "2019 Including JLT" revenue information set forth in the table below presents revenue information as if the companies were combined on January 1, 2019 and is not necessarily indicative of what the results would have been had we operated the business since January 1, 2019. The MMC revenue amounts are as previously reported by the Company in its annual filing of Form 10-K for the year ended December 31, 2019. JLT 2019 revenue information is derived using the same policies and adjustments as the "JLT Supplemental Information - Revenue Analysis" furnished to the SEC on June 6, 2019 on Form 8-K, which is not incorporated by reference in this Form 10-K, and includes the revenue from JLT’s aerospace business.57(In millions)For the Year Ended December 31, 2019MMC As Previously ReportedRisk & Insurance ServicesMarsh$8,014 Guy Carpenter1,480 Subtotal9,494 Fiduciary interest income105 Total Risk & Insurance Services9,599 ConsultingMercer5,021 Oliver Wyman Group2,122 Total Consulting7,143 Corporate eliminations(90)Total revenue$16,652 JLT 2019Specialty (Marsh)$232 Reinsurance (Guy Carpenter)118 Employee Benefits (Mercer)73 Subtotal423 Fiduciary interest income5 Total Revenue$428 2019 including JLTMarsh$8,246 Guy Carpenter1,598 Subtotal9,844 Fiduciary interest income110 Total Risk & Insurance Services9,954 ConsultingMercer5,094 Oliver Wyman Group2,122 Total Consulting7,216 Corporate eliminations(90)Total revenue including JLT$17,080 58Item 7A. Quantitative and Qualitative Disclosures About Market RiskMarket Risk and Credit RiskCertain of the Company’s revenues, expenses, assets and liabilities are exposed to the impact of interest rate changes and fluctuations in foreign currency exchange rates and equity markets.Interest Rate Risk and Credit RiskInterest income generated from the Company’s cash investments as well as invested fiduciary funds will vary with the general level of interest rates.The Company had the following investments subject to variable interest rates: (In millions of dollars)December 31, 2020Cash and cash equivalents invested in money market funds, certificates of deposit and time deposits$2,089 Fiduciary cash and investments$8,585 Based on the above balances, if short-term interest rates increased or decreased by 10%, or 3 basis points, over the full year, annual interest income, including interest earned on fiduciary funds, would increase or decrease by approximately $2 million.In addition to interest rate risk, our cash investments and fiduciary fund investments are subject to potential loss of value due to counter-party credit risk. To minimize this risk, the Company and its subsidiaries invest pursuant to a Board approved investment policy. The policy mandates the preservation of principal and liquidity and requires broad diversification with counter-party limits assigned based primarily on credit rating and type of investment. The Company carefully monitors its cash and fiduciary fund investments and will further restrict the portfolio as appropriate to market conditions. The majority of cash and fiduciary fund investments are invested in short-term bank deposits and liquid money market funds.Foreign Currency RiskThe translated values of revenue and expense from the Company’s international operations are subject to fluctuations due to changes in currency exchange rates. The non-U.S. based revenue that is exposed to foreign exchange fluctuations is approximately 53% of total revenue. We periodically use forward contracts and options to limit foreign currency exchange rate exposure on net income and cash flows for specific, clearly defined transactions arising in the ordinary course of business. Although the Company has significant revenue generated in foreign locations which is subject to foreign exchange rate fluctuations, in most cases both the foreign currency revenue and expenses are in the functional currency of the foreign location. As such, under normal circumstances, the U.S. dollar translation of both the revenues and expenses, as well as the potentially offsetting movements of various currencies against the U.S. dollar, generally tends to mitigate the impact on net operating income of foreign currency risk. However, there have been periods where the impact was not mitigated due to external market factors, and external macroeconomic events may result in greater foreign exchange rate fluctuations in the future. If foreign exchange rates of major currencies (Euro, Sterling, Australian dollar and Canadian dollar) moved 10% in the same direction against the U.S. dollar compared with the foreign exchange rates in 2020, the Company estimates net operating income would increase or decrease by approximately $39 million. The Company has exposure to approximately 80 foreign currencies overall. In Continental Europe, the largest amount of revenue from renewals for the Risk & Insurance Services segment occurs in the first quarter. Equity Price RiskThe Company holds investments in both public and private companies as well as private equity funds, including investments of approximately $72 million that are valued using readily determinable fair values and approximately $33 million of investments without readily determinable fair values. The Company also has investments of approximately $280 million that are accounted for using the equity method. The investments are subject to risk of decline in market value, which, if determined to be other than temporary for assets without readily determinable fair values, could result in realized impairment losses. The 59Company periodically reviews the carrying value of such investments to determine if any valuation adjustments are appropriate under the applicable accounting pronouncements.At December 31, 2020, the Company owns approximately 14% of the common stock of AF, a South African company listed on the Johannesburg Stock Exchange. The investment in AF is accounted at fair value, with unrealized gains and losses recorded as investment income in the consolidated statement of income. The fair value of this investment at December 31, 2020 was approximately $54 million.OtherA number of lawsuits and regulatory proceedings are pending. See Note 16 ("Claims, Lawsuits and Other Contingencies") to the consolidated financial statements included in this report.60
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+Item 7.Management's Discussion and Analysis of Financial Condition and Results of Operations.The financial and business analysis below provides information which we believe is relevant to an assessment and understanding of our consolidated financial position, results of operations and cash flows. This financial and business analysis should be read in conjunction with the consolidated financial statements and related notes.The following discussion and certain other sections of this Report contain statements that reflect our views about our future performance and constitute "forward-looking statements" under the Private Securities Litigation Reform Act of 1995. Forward-looking statements can be identified by words such as "outlook," "believe," "anticipate," "appear," "may," "will," "should," "intend," "plan," "estimate," "expect," "assume," "seek," "forecast," and similar references to future periods. Our views about future performance involve risks and uncertainties that are difficult to predict and, accordingly, our actual results may differ materially from the results discussed in our forward-looking statements. We caution you against relying on any of these forward-looking statements.In addition to the various factors included in the "Executive Level Overview," "Critical Accounting Policies and Estimates" and "Outlook for the Company" sections, our future performance may be affected by the levels of residential repair and remodel activity, and to a lesser extent, new home construction, our ability to maintain our strong brands and reputation and to develop innovative products, our ability to maintain our competitive position in our industries, our reliance on key customers, the length and severity of the ongoing COVID-19 pandemic, including its impact on domestic and international economic activity, consumer confidence, our production capabilities, our employees and our supply chain, the cost and availability of materials and the imposition of tariffs, our dependence on third-party suppliers, risks associated with our international operations and global strategies, our ability to achieve the anticipated benefits of our strategic initiatives, our ability to successfully execute our acquisition strategy and integrate businesses that we have and may acquire, our ability to attract, develop and retain talented and diverse personnel, risks associated with our reliance on information systems and technology, and our ability to achieve the anticipated benefits from our investments in new technology. These and other factors are discussed in detail in Item 1A. "Risk Factors" of this Report. Any forward-looking statement made by us speaks only as of the date on which it was made. Factors or events that could cause our actual results to differ may emerge from time to time, and it is not possible for us to predict all of them. Unless required by law, we undertake no obligation to update publicly any forward-looking statements as a result of new information, future events or otherwise.Executive Level OverviewWe design, manufacture and distribute branded home improvement and building products. These products are sold primarily for repair and remodeling activity and, to a lesser extent, new home construction. We sell our products through home center retailers, online retailers, wholesalers and distributors, mass merchandisers, hardware stores, direct to the consumer and homebuilders.2020 ResultsNet sales were positively impacted by increased sales volume across our two segments. Such increases were partially offset by unfavorable net selling prices in our Decorative Architectural Products segment.Our Plumbing Products segment operating profit was positively impacted by cost saving initiatives, including actions taken to mitigate the COVID-19 pandemic impact, and higher sales volume. These positive impacts were partially offset by increased commodity costs, including tariffs, and an increase in other expenses (such as salaries and legal costs). Our Decorative Architectural Products segment operating profit benefited primarily from higher sales volume mostly due to paints and other coating products, as well as cost savings initiatives, including actions taken to mitigate the COVID-19 pandemic impact. Additionally, operating profit was positively impacted by the non-recurrence of a 2019 non-cash impairment charge related to an other indefinite-lived intangible asset for a trademark associated with lighting products. These positive impacts were partially offset by unfavorable net selling prices, higher fixed expenses in our lighting business, and an increase in other expenses (such as salaries, legal costs, and advertising).17COVID-19 Impact and ResponseDuring 2020, certain aspects of our businesses were adversely affected by the COVID-19 pandemic. Many, but not all, of our businesses remained operating in 2020 because the products we provide are critical to infrastructure sectors and the day-to-day operations of homes and businesses in our communities as defined by applicable local orders. However, some of our facilities experienced reduced capacity due to social distancing requirements and/or full closures ranging from a few days to 6-8 weeks, and if certain governmental orders are reimposed or if we are required to close a facility for employee safety reasons, we could experience new or extended closures which might adversely impact our ability to produce and distribute our products. Operational activity that was previously slowed at certain of our facilities, as a result of the pandemic and governmental orders, largely resumed operations at normal capacities by the third quarter of 2020 enabling them to progress on the fulfillment of production backlogs that developed in the first half of the year as well as to meet current consumer demand. Finally, we may experience supply chain disruptions, particularly disruptions related to our ability to source plumbing, lighting and builders’ hardware products.Given our portfolio of lower ticket, repair and remodel-oriented product and the increased demand for repair and remodel spending, we experienced strong consumer demand in 2020. These levels of demand may or may not continue and we may experience an adverse impact in our 2021 results due to economic contraction as a result of continued high unemployment levels and remaining or potential renewed shelter-in-place and social distancing orders. The COVID-19 pandemic and the mitigating measures taken by many countries have adversely impacted and could in the future materially adversely impact the Company’s business, results of operations and financial condition.During 2020, we implemented mitigating efforts to manage operating spend and preserve cash and liquidity including the temporary suspension of our share repurchase activity beginning in the second quarter of 2020, which we resumed in the fourth quarter of 2020. Currently, we have not identified, and will continue to monitor for, any substantive risk attributable to customer credit and have not experienced a significant impact from permanent store closures or retail bankruptcies.We continue to be committed to the safety and well-being of our employees during this time, and, led by our cross-functional Infectious Illness Response Team, we have employed best practices and followed guidance from the World Health Organization and the Centers for Disease Control and Prevention. We have implemented and are continuing to implement alternative work arrangements to support the health and safety of our employees, including working remotely and avoiding large gatherings. In addition, we have modified work areas and workstations to provide protective measures for employees, are staggering shifts, requiring the use of face coverings, practicing social distancing and increasing the cleaning of our facilities, and in the event that we learn of an employee testing positive for COVID-19, we are completing contact tracing and requiring impacted employees to self-quarantine.18Critical Accounting Policies and EstimatesOur discussion and analysis of our financial condition and results of operations is based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America ("GAAP"). The preparation of these financial statements requires us to make certain estimates and assumptions that affect or could have affected the reported amounts of assets and liabilities, disclosure of any contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting periods. We regularly review our estimates and assumptions, which are based upon historical experience, as well as current economic conditions and various other factors (including the anticipated impact of the COVID-19 pandemic) that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of certain assets and liabilities and related disclosures, and future revenues and expenses, that are not readily apparent from other sources. Actual results may differ from these estimates and assumptions.Note A to the consolidated financial statements includes our accounting policies, estimates and methods used in the preparation of our consolidated financial statements.We believe that the following critical accounting policies are affected by significant judgments and estimates used in the preparation of our consolidated financial statements.Revenue Recognition and ReceivablesWe recognize revenue as control of our products is transferred to our customers, which is generally at the time of shipment or upon delivery based on the contractual terms with our customers. We provide customer programs and incentive offerings, including special pricing and co-operative advertising arrangements, promotions and other volume-based incentives. These customer programs and incentives are considered variable consideration. We include in revenue variable consideration only to the extent that it is probable that a significant reversal in the amount of cumulative revenue recognized will not occur when the variable consideration is resolved. This determination is made based upon known customer program and incentive offerings at the time of sale, and expected sales volume forecasts as it relates to our volume-based incentives. This determination is updated each reporting period. We monitor our exposure for credit losses on customer receivable balances and the credit worthiness of customers on an on-going basis and maintain allowances for doubtful accounts receivable for estimated losses resulting from the inability of our customers to make required payments. Allowances are estimated based upon specific customer balances, where a risk of loss has been identified, and also include a provision for losses based upon historical collection and write-off activity as well as reasonable and supportable forecast information that considers macro-economic factors and industry-specific trends associated with our businesses, among others. A separate allowance is recorded for customer incentive rebates and is generally based upon sales activity.Goodwill and Other Intangible AssetsWe record the excess of purchase cost over the fair value of net tangible assets of acquired companies as goodwill or other identifiable intangible assets. In the fourth quarter of each year, or as events occur or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying amount, we complete the impairment testing of goodwill utilizing a discounted cash flow method. We selected the discounted cash flow methodology because we believe that it is comparable to what would be used by market participants. We have defined our reporting units and completed the impairment testing of goodwill at the operating segment level. 19Determining market values using a discounted cash flow method requires us to make significant estimates and assumptions, including long-term projections of cash flows, market conditions and appropriate discount rates. Our judgments are based upon historical experience, current market trends, consultations with external valuation specialists and other information. While we believe that the estimates and assumptions underlying the valuation methodology are reasonable, different estimates and assumptions could result in different outcomes. In estimating future cash flows, we rely on internally generated five-year forecasts for sales and operating profits, and, currently, a two percent to three percent long-term assumed annual growth rate of cash flows for periods after the five-year forecast. We generally develop these forecasts based upon, among other things, recent sales data for existing products, planned timing of new product launches, estimated repair and remodel activity and, to a lesser extent, estimated housing starts. Our assumptions included U.S. Gross Domestic Product growing at approximately 4.2 percent in 2021 and develop into a relatively stable 2.8 percent each year thereafter, and a eurozone Gross Domestic Product growing at approximately 5.2 percent in 2021 and developing into a relatively stable 2.2 percent per annum over the five-year forecast.We utilize our weighted average cost of capital of approximately 8.0 percent as the basis to determine the discount rate to apply to the estimated future cash flows. Our weighted average cost of capital in 2020 was consistent with 2019. In 2020, based upon our assessment of the risks impacting each of our businesses, we applied a risk premium to increase the discount rate to a range of 10.0 percent to 12.0 percent for our reporting units.If the carrying amount of a reporting unit exceeds its fair value, an impairment loss is recognized to the extent that a reporting unit's recorded carrying value exceeds its fair value, not to exceed the carrying amount of goodwill in that reporting unit.In the fourth quarter of 2020, we estimated that future discounted cash flows projected for all of our reporting units were greater than the carrying values. Accordingly, we did not recognize any impairment charges for goodwill. A 10 percent decrease in the estimated fair value of our reporting units would have resulted in a $6 million impairment to one of our reporting units.We review our other indefinite-lived intangible assets for impairment annually, in the fourth quarter, or as events occur or circumstances change that indicate the assets may be impaired without regard to the business unit. Potential impairment is identified by comparing the fair value of an other indefinite-lived intangible asset to its carrying value. We utilize a relief-from-royalty model to estimate the fair value of other indefinite-lived intangible assets. We consider the implications of both external (e.g., market growth, competition and local economic conditions) and internal (e.g., product sales and expected product growth) factors and their potential impact on cash flows related to the intangible asset in both the near- and long-term. We also consider the profitability of the business, among other factors, to determine the royalty rate for use in the impairment assessment.We utilize our weighted average cost of capital of approximately 8.0 percent as the basis to determine the discount rate to apply to the estimated future cash flows. In 2020, based upon our assessment of the risks impacting each of our businesses and the nature of the trade name, we applied a risk premium to increase the discount rate to a range of 11.0 percent to 12.5 percent for our other indefinite-lived intangible assets.In the fourth quarter of 2020, we estimated that future discounted cash flows projected for our other indefinite-lived intangible assets were greater than the carrying values. Accordingly, we did not recognize any impairment charges for other indefinite-lived intangible assets. A 10 percent decrease in the estimated fair value of our other indefinite-lived intangible assets would have resulted in a $3 million impairment for one of our trade names.Employee Retirement PlansAs of January 1, 2010, substantially all our domestic and foreign qualified and domestic non-qualified defined-benefit pension plans were frozen to future benefit accruals.Accounting for defined-benefit pension plans involves estimating the cost of benefits to be provided in the future, based upon vested years of service, and attributing those costs over the time period each employee works. We develop our pension costs and obligations from actuarial valuations. Inherent in these valuations are key assumptions regarding expected return on plan assets, mortality rates and discount rates for obligations and expenses. We consider current market conditions, including changes in interest rates, in selecting these assumptions. While we believe that the estimates and assumptions underlying the valuation methodology are reasonable, different estimates and assumptions could result in different reported pension costs and obligations within our consolidated financial statements.20In December 2019, our Board of Directors approved the termination of our qualified domestic defined-benefit pension plans. As a result of this decision, the projected benefit obligations for these plans were increased to reflect the incremental costs to terminate the plans. Upon termination in 2021, we expect to recognize from accumulated other comprehensive loss approximately $450 million of pre-tax actuarial losses and approximately $95 million of income tax benefit, which includes approximately $11 million of tax expense from the elimination of a disproportionate tax effect.In December 2020, our discount rate for obligations decreased to a weighted average of 1.7 percent from 2.5 percent. The discount rate for obligations is based primarily upon the expected duration of each defined-benefit pension plan's liabilities matched to the December 31, 2020 Willis Towers Watson Rate Link Curve. For our qualified domestic defined-benefit pension plans, the projected benefit obligations include the estimated incremental cost related to the termination. For these plans, the discount rate was then set equal to the discount rate that results in the same projected benefit obligation resulting from the normal projected benefit obligation calculation plus the estimated incremental cost to terminate. The discount rates we use for our defined-benefit pension plans ranged from 0.7 percent to 2.1 percent, with the most significant portion of the liabilities having a discount rate for obligations of 1.6 percent or higher. Due to the anticipated termination of our qualified domestic defined-benefit pension plans and the related plan assets comprised mostly of fixed income and cash, the assumed asset return for these assets was 2.0 percent.The net underfunded amount for our qualified defined-benefit pension plans, which is the difference between the projected benefit obligation and plan assets, increased to $255 million at December 31, 2020 from $254 million at December 31, 2019. Our projected benefit obligation for our unfunded, non-qualified, defined-benefit pension plans increased to $162 million at December 31, 2020 from $161 million at December 31, 2019. These unfunded plans are not subject to the funding requirements of the Pension Protection Act of 2006. In accordance with the Pension Protection Act, the Adjusted Funding Target Attainment Percentage for the various defined-benefit pension plans ranges from 113 percent to 117 percent.The increase in our qualified defined-benefit pension plan projected benefit obligation was primarily impacted by a decrease in the discount rate. During 2020, we contributed $57 million to our qualified defined-benefit pension plans, and our qualified defined-benefit pension plan assets had a positive return of 9.7 percent. Refer to Note N to the consolidated financial statements for additional information. We expect pension expense for our qualified defined-benefit pension plans to be $470 million in 2021 compared with $30 million in 2020. The expected increase in pension expense is due to the anticipated termination of our qualified domestic defined-benefit pension plans and the recognition of losses currently reported in accumulated other comprehensive loss. If we assumed that the future return on plan assets was 50 basis points lower than the assumed asset return and the discount rate decreased by 50 basis points, the 2021 pension expense would increase by $60 million. Assuming a 0 percent asset return for our qualified domestic defined-benefit pension plans, projected 2021 total qualified defined-benefit pension plan expenses are expected to be approximately $474 million. We expect pension expense for our non-qualified defined-benefit pension plans to be $6 million in 2021, compared to $8 million recognized in 2020.Consistent with our plan to terminate the qualified domestic defined-benefit pension plans, we currently anticipate contributing approximately $140 million in 2021. Refer to Note N to the consolidated financial statements for further information regarding the funding of our plans.Income TaxesDeferred taxes are recognized based on the future tax consequences of differences between the financial statement carrying value of assets and liabilities and their respective tax basis. The future realization of deferred tax assets depends on the existence of sufficient taxable income in future periods. Possible sources of taxable income include taxable income in carryback periods, the future reversal of existing taxable temporary differences recorded as a deferred tax liability, tax-planning strategies that generate future income or gains in excess of anticipated losses in the carryforward period and projected future taxable income.If, based upon all available evidence, both positive and negative, it is more likely than not (more than 50 percent likely) such deferred tax assets will not be realized, a valuation allowance is recorded. Significant weight is given to positive and negative evidence that is objectively verifiable. A company's three-year cumulative loss position is significant negative evidence in considering whether deferred tax assets are realizable, and the accounting guidance restricts the amount of reliance we can place on projected taxable income to support the recovery of the deferred tax assets. 21We maintain a valuation allowance on certain state and foreign deferred tax assets as of December 31, 2020. Should we determine that we would not be able to realize our remaining deferred tax assets in these jurisdictions in the future, an adjustment to the valuation allowance would be recorded in the period such determination is made. The need to maintain a valuation allowance against deferred tax assets may cause greater volatility in our effective tax rate.Corporate Development StrategyWe expect to maintain a balanced growth strategy pursuing organic growth by maximizing the full potential of our existing businesses and, as appropriate, complementing our existing business with strategic acquisitions. During 2020, we completed the acquisitions of Kraus, Work Tools and SmarTap and signed an agreement to acquire majority interest in ESS.In addition, we actively manage our portfolio of companies by divesting of those businesses that do not align with our long-term growth strategy. We will continue to review all of our businesses to determine which businesses, if any, may not align with our long-term growth strategy.Liquidity and Capital Resources Overview of Capital StructureHistorically, we have largely funded our growth through cash provided by our operations, the issuance of notes in the financial markets, bank borrowings and the issuance of our common stock, including issuances for certain mergers and acquisitions. Maintaining high levels of liquidity and focusing on cash generation are among our financial strategies. Our capital allocation strategy includes reinvesting in our business, balancing share repurchases with potential acquisitions and maintaining an appropriate dividend.We had cash and cash investments of approximately $1.3 billion at December 31, 2020. Our cash and cash investments consist of overnight interest bearing money market demand accounts, time deposit accounts, and money market mutual funds containing government securities and treasury obligations. While we attempt to diversify these investments in a prudent manner to minimize risk, it is possible that future changes in the financial markets could affect the security or availability of these investments. Of the $1.3 billion and $697 million of cash and cash investments we held at December 31, 2020 and 2019, respectively, $385 million and $297 million, respectively, was held in our foreign subsidiaries. If these funds were needed for our operations in the U.S., their repatriation into the U.S. would not result in significant additional U.S. income tax or foreign withholding tax, as we have recorded such taxes on substantially all undistributed foreign earnings, except for those that are legally restricted.Our current ratio was 1.8 to 1 at both December 31, 2020 and 2019.Our total debt as a percent of total capitalization was 87 percent and 102 percent at December 31, 2020 and 2019, respectively. Refer to Note L to the consolidated financial statements for additional information.Senior IndebtednessOn September 18, 2020, we issued $300 million of 2.0% Notes due October 1, 2030 (the "2030 Notes") and received proceeds of $300 million, net of discount, for the issuance of the 2030 Notes. Also on September 18, 2020, we issued an incremental $100 million on our existing 4.5% Notes due May 15, 2047 (the "2047 Notes") and received proceeds of $119 million, including a premium, for the issuance of the 2047 Notes. The incremental $100 million formed a single series with the existing $300 million of 4.5% Notes due May 15, 2047. The 2030 Notes and 2047 Notes are senior indebtedness and are redeemable at our option at the applicable redemption price. On September 29, 2020, proceeds from the debt issuances were used to repay and early retire $400 million of our 3.5% Notes due April 1, 2021. In connection with this early retirement, we incurred a loss on debt extinguishment of $6 million, which was recorded as interest expense in our consolidated statement of operations.On December 19, 2019, we redeemed and retired $201 million of our 7.125% Notes due March 15, 2020. In connection with this early retirement, we incurred a loss on debt extinguishment of $2 million, which was recorded as interest expense in our consolidated statement of operations.On April 16, 2018, we repaid and retired all of our $114 million, 6.625% Notes on the scheduled repayment date.22Credit Agreement On March 13, 2019, we entered into a credit agreement (the "Credit Agreement") with an aggregate commitment of $1.0 billion and a maturity date of March 13, 2024. Under the Credit Agreement, at our request and subject to certain conditions, we can increase the aggregate commitment up to an additional $500 million with the current lenders or new lenders. See Note L to the consolidated financial statements.The Credit Agreement contains financial covenants requiring us to maintain (A) a net leverage ratio, as adjusted for certain items, not exceeding 4.0 to 1.0, and (B) a minimum interest coverage ratio, as adjusted for certain items, not less than 2.5 to 1.0. We were in compliance with all covenants and no borrowings were outstanding under our Credit Agreement at December 31, 2020.Acquisitions During 2020, we acquired substantially all of the net assets of Kraus and Work Tools, and all of the share capital of SmarTap for a combined $175 million of cash and $5 million of debt.Additionally, we entered into an agreement to acquire a 75.1% equity interest in ESS for approximately €45 million ($55 million) subject to working capital and other adjustments. A cash payment was made to a third-party notary for $52 million on December 29, 2020 for the acquisition of this equity interest in advance of the transaction closing on January 4, 2021.On March 9, 2018, we acquired substantially all of the net assets of the L.D. Kichler Co. ("Kichler"). The purchase price, net of $2 million cash acquired, consisted of $549 million paid with cash on hand.Divestitures During 2020, we completed the divestiture of our Cabinetry business for proceeds of $853 million, net of cash disposed.During 2019, we completed the divestitures of our Milgard Windows and Doors business ("Milgard") and our UK Window Group business ("UKWG") for combined proceeds of $722 million.Share RepurchasesIn September 2019, our Board of Directors authorized the repurchase, for retirement, of up to $2.0 billion of shares of our common stock in open-market transactions or otherwise.During 2020, we repurchased and retired 18.8 million shares of our common stock (including 0.4 million shares to offset the dilutive impact of restricted stock units granted during the year), for approximately $727 million. At December 31, 2020, we had $774 million remaining under the 2019 authorization. Our Board of Directors authorized the repurchase, for retirement, of up to $2.0 billion shares of our common stock in open-market transactions or otherwise, effective February 10, 2021, replacing the 2019 authorization.During 2019, we repurchased and retired 20.1 million shares of our common stock (including 0.6 million shares to offset the dilutive impact of long-term stock awards granted in 2019), for approximately $896 million.During 2018, we repurchased and retired 18.6 million shares of our common stock (including 0.7 million shares to offset the dilutive impact of long-term stock awards granted in 2018) for approximately $654 million.Consistent with past practice and as part of our strategic initiative to drive shareholder value, we anticipate using approximately $800 million of cash for share repurchases (including shares which will be purchased to offset any dilution from restricted stock units granted as part of our compensation programs) in 2021.Dividend to holder of Common SharesIn the third quarter of 2020, we increased our quarterly dividend to $0.14 per common share from $0.135 per common share. As part of our capital allocation strategy and subject to declaration by our Board of Directors, we intend to increase the annual dividend to $0.94 per share, beginning in the second quarter of 2021.23Other Liquidity and Capital Resource Activities As part of our ongoing efforts to improve our cash flow and related liquidity, we work with suppliers to optimize our terms and conditions, including extending payment terms. We also facilitate a voluntary supply chain finance program (the "program") to provide certain of our suppliers with the opportunity to sell receivables due from us to participating financial institutions at the sole discretion of both the suppliers and the financial institutions. A third party administers the program; our responsibility is limited to making payment on the terms originally negotiated with our supplier, regardless of whether the supplier sells its receivable to a financial institution. We do not enter into agreements with any of the participating financial institutions in connection with the program. The range of payment terms we negotiate with our suppliers is consistent, irrespective of whether a supplier participates in the program. All outstanding payments owed under the program are recorded within accounts payable in our consolidated balance sheets. The amounts owed to participating financial institutions under the program and included in accounts payable for our continuing operations were $45 million and $29 million at December 31, 2020 and 2019, respectively. We account for all payments made under the program as a reduction to our cash flows from operations and reported within our increase (decrease) in accounts payable and accrued liabilities, net, line within our consolidated statements of cash flows. The amounts settled through the program and paid to participating financial institutions were $146 million, $164 million, and $117 million for our continuing operations during the years ended December 31, 2020, 2019, and 2018, respectively. A downgrade in our credit rating or changes in the financial markets could limit the financial institutions’ willingness to commit funds to, and participate in, the program. We do not believe such risk would have a material impact on our working capital or cash flows, as substantially all of our payments are made outside of the program.We utilize derivative and hedging instruments to manage our exposure to currency fluctuations, primarily related to the European euro, British pound, the Chinese renminbi and the U.S. dollar; occasionally, we have also used derivative and hedging instruments to manage our exposure to commodity cost fluctuations, primarily zinc and copper, and interest rate fluctuations, primarily related to debt issuances. We review our hedging program, derivative positions and overall risk management on a regular basis. We currently do not have any derivative instruments for which we have designated hedge accounting.24Cash FlowsSignificant sources and (uses) of cash in the past three years are summarized as follows, in millions: 202020192018Net cash from operating activities$953 $833 $1,032 Retirement of notes(400)(201)(114)Purchase of Company common stock(727)(896)(654)Cash dividends paid(145)(144)(134)Dividends paid to noncontrolling interest(23)(42)(89)Capital expenditures(114)(162)(219)Debt extinguishment costs(5)(2)— Acquisition of businesses, net of cash acquired(227)— (549)Issuance of notes, net of issuance costs415 — — Employee withholding taxes paid on stock-based compensation(25)(23)(42)Proceeds from disposition of: Businesses, net of cash disposed870 722 — Short-term bank deposits, net— — 108 Property and equipment1 34 14 Financial investments3 1 5 Payment of debt(2)(8)(1)Effect of exchange rate changes on cash and cash investments31 14 4 Other, net24 12 4 Cash increase (decrease) $629 $138 $(635)Our working capital days were as follows: At December 31, 20202019Receivable days54 54 Inventory days72 67 Accounts Payable days71 68 Working capital (receivables plus inventories, less accounts payable) as a percentage of net sales15.6 %15.7 %Net cash provided by operations of $953 million consisted primarily of net income adjusted for certain non-cash items, including depreciation and amortization expense of $133 million and stock-based compensation expense, as well as changes in working capital amounts and employee withholding taxes paid on stock-based compensation, which is classified as a financing activity. These amounts were partially offset by the net gain on the sale of Cabinetry as well as contributions to our defined-benefit pension plans.Net cash used for financing activities was $886 million, primarily due to $727 million for the repurchase and retirement of Company common stock (as part of our strategic initiative to drive shareholder value), $400 million for the early retirement of our 3.5% Notes due April 1, 2021, $145 million for the payment of cash dividends, $25 million for employee withholding taxes paid on stock-based compensation and $23 million for dividends paid to noncontrolling interests. These uses of cash were partially offset by the issuances of $300 million of 2.0% Notes due October 1, 2030 and an incremental $100 million on our existing 4.5% Notes due May 15, 2047 that was issued at a premium of $19 million, and $26 million of proceeds from the exercise of stock options.Net cash provided by investing activities was $531 million, primarily driven by $870 million of proceeds from the sale of Cabinetry, net of cash disposed. These proceeds were partially offset by $175 million for the 2020 acquisitions, net of cash acquired, $114 million for capital expenditures and the $52 million advance payment for the acquisition of ESS that closed on January 4, 2021.25We continue to invest in our manufacturing and distribution operations of those businesses that align with our long-term growth strategy to increase our productivity, improve customer service and support product innovation. Capital expenditures for 2020 were $114 million, compared with $162 million for 2019 and $219 million for 2018. For 2021, capital expenditures, excluding any potential 2021 acquisitions, are expected to be approximately $150 million. Depreciation and amortization expense for 2020 totaled $133 million, compared with $159 million for 2019 and $156 million for 2018. For 2021, depreciation and amortization expense, excluding any potential 2021 acquisitions, is expected to be approximately $155 million. Amortization expense totaled $28 million in 2020, compared with $27 million and $24 million in 2019 and 2018, respectively.Costs of environmental responsibilities and compliance with existing environmental laws and regulations have not had, nor do we expect them to have, a material effect on our capital expenditures, financial position or results of operations.We believe that our present cash balance and cash flows from operations, and borrowing availability under our Credit Agreement are sufficient to fund our near-term working capital and other investment needs. We believe that our longer-term working capital and other general corporate requirements will be satisfied through cash flows from operations and, to the extent necessary, from bank borrowings and future financial market activities. However, due to the highly uncertain nature, severity and duration or resurgence of the COVID-19 pandemic and its impact on our customer, suppliers and employees, we are unable to fully estimate the extent of the impact it may have on our future financial condition.Consolidated Results of OperationsWe report our financial results in accordance with GAAP in the United States. However, we believe that certain non-GAAP performance measures and ratios, used in managing the business, may provide users of this financial information with additional meaningful comparisons between current results and results in prior periods. Non-GAAP performance measures and ratios should be viewed in addition to, and not as an alternative for, our reported results under GAAP.The following discussion of consolidated results of operations compares 2020 and 2019. Descriptions of changes between 2019 and 2018 were excluded as there were no changes from what was disclosed in the "Management's Discussion and Analysis of Financial Condition and Results of Operations" section of the December 31, 2019 Form 10-K.Sales and OperationsNet sales for 2020 were $7.2 billion, which increased seven percent compared to 2019. Excluding the effect of currency translation, net sales increased seven percent. The following table reconciles reported net sales to net sales excluding the effect of currency translation, in millions: Year EndedDecember 31 20202019Net sales, as reported$7,188 $6,707 Currency translation(13)— Net sales, excluding the effect of currency translation$7,175 $6,707 Net sales for 2020 increased seven percent primarily due to higher sales volume of our paints and other coating products, plumbing products, and to a lesser extent, builders' hardware, which, in aggregate, increased sales by eight percent. This increase was slightly offset by unfavorable net selling prices of paints and other coating products, which decreased sales by one percent.Our gross profit margins were 36.0 percent, 35.4 percent and 35.0 percent in 2020, 2019 and 2018, respectively. The 2020 gross profit margin was positively impacted by increased sales volume and cost savings initiatives, including actions taken to mitigate the COVID-19 pandemic impact. Such increases were slightly offset by unfavorable net selling prices and increased commodity costs, partially attributed to tariffs. 26Selling, general and administrative expenses as a percent of sales were 18.0 percent in 2020 compared with 19.0 percent in 2019 and 18.8 percent in 2018. The decrease in selling, general, and administrative expenses as a percentage of sales in 2020 was primarily driven by cost containment activities including those actions taken to mitigate the COVID-19 pandemic impact and leverage of fixed expenses due primarily to increased sales volume. This improvement was partially offset by an increase in other expenses (such as salaries, legal costs and advertising).The following table reconciles reported operating profit to operating profit, as adjusted to exclude certain items, dollars in millions: 202020192018Operating profit, as reported$1,295 $1,088 $1,077 Rationalization charges11 13 9 Kichler inventory step up adjustment— — 40 Impairment charge for other intangible assets— 9 — Operating profit, as adjusted$1,306 $1,110 $1,126 Operating profit margins, as reported18.0 %16.2 %16.2 %Operating profit margins, as adjusted18.2 %16.5 %16.9 %Operating profit in 2020 was positively affected by increased sales volume and cost savings initiatives, including actions taken to mitigate the COVID-19 pandemic impact. These positive impacts were partially offset by unfavorable net selling prices, increased commodity costs, partially attributed to tariffs, higher fixed expenses in our lighting business, and an increase in other expenses (such as salaries, legal cost and advertising).Other Income (Expense), NetInterest expense was $144 million, $159 million and $156 million in 2020, 2019 and 2018, respectively.Other, net, for 2020 included $35 million of net periodic pension and post-retirement benefit cost and $10 million of realized foreign currency transaction losses, partially offset by $10 million of dividend income related to preferred stock of ACProducts Holding, Inc. and $9 million of income due from an escrow settlement.Income TaxesOur effective tax rate on income from continuing operations was 24 percent, 25 percent and 24 percent in 2020, 2019 and 2018, respectively. As a result of IRS guidance issued in the third quarter of 2020 that allows us to retroactively exclude certain high-taxed foreign income from the U.S. tax effects on Global Intangible Low-taxed Income ("GILTI") back to 2018, we lowered our normalized tax rate from 26 percent to 25 percent for 2020, 2019 and 2018.Our effective tax rate in 2020 was lower than our normalized tax rate of 25 percent due primarily to a $5 million income tax benefit from a change in judgment regarding the realizability of certain deferred tax assets in our foreign jurisdictions, an additional $4 million tax benefit from stock-based compensation payments and a $6 million tax benefit due to an anticipated refund claim from the retroactive application of the exclusion of certain high-taxed foreign income from the U.S. tax effects on GILTI back to 2018.Our effective tax rate in 2018 was lower than our normalized tax rate of 25 percent due primarily to an additional $14 million tax benefit from stock-based compensation payments, partially offset by a $6 million tax expense recognized on GILTI, prior to the retroactive exclusion of certain high-taxed foreign income as allowed under the recently issued IRS guidance in 2020.Refer to Note S to the consolidated financial statements for additional information. Income and Income Per Common Share from Continuing Operations (Attributable to Masco Corporation)Income and diluted income per common share from continuing operations for 2020 were $810 million and $3.04 per common share, respectively. Income and diluted income per common share from continuing operations for 2019 were $639 million and $2.20 per common share, respectively. Income and diluted income per common share from continuing operations for 2018 were $636 million and $2.05 per common share, respectively.27Outlook for the CompanyWe continue to execute our strategies of leveraging our strong brand portfolio, industry-leading positions and the Masco Operating System, our methodology to drive growth and productivity, to create long-term shareholder value. We believe that our strong financial position and cash flow generation, together with our investments in our industry-leading branded building products, our continued focus on innovation and disciplined capital allocation, will allow us to drive long-term growth and create value for our shareholders. While we continue to remain uncertain regarding the short-term impact that the COVID-19 pandemic may have on our businesses, we remain confident in the fundamentals of our businesses and long-term strategy.28Business Segment and Geographic Area ResultsThe following table sets forth our net sales and operating profit information for our continuing operations by business segment and geographic area, dollars in millions. PercentChange 2020201920182020 vs.20192019 vs.2018Net Sales: Plumbing Products$4,136 $3,984 $3,998 4 %— %Decorative Architectural Products3,052 2,723 2,656 12 %3 %Total$7,188 $6,707 $6,654 7 %1 %North America$5,805 $5,328 $5,208 9 %2 %International, principally Europe1,383 1,379 1,446 — %(5)%Total$7,188 $6,707 $6,654 7 %1 % 202020192018Operating Profit: (A) Plumbing Products$806 $708 $715 Decorative Architectural Products583 480 456 Total$1,389 $1,188 $1,171 North America$1,167 $987 $954 International, principally Europe222 201 217 Total1,389 1,188 1,171 General corporate expense, net(94)(100)(94)Total operating profit$1,295 $1,088 $1,077 (A)Before general corporate expense, net; refer to Note Q to the consolidated financial statements for additional information.29Business Segment Results DiscussionChanges in operating profit in the following Business Segment and Geographic Area Results discussion exclude general corporate expense, net, and compares each respective period to the same period of the immediately preceding year. Description of changes to sales and operating profit between 2019 and 2018 for the Plumbing Products and Decorative Architectural Products segments, as well as geographic areas, were excluded as there were no changes from what was disclosed in the "Management's Discussion and Analysis of Financial Condition and Results of Operations" section of the December 31, 2019 Form 10-K. Plumbing ProductsSalesNet sales in the Plumbing Products segment increased four percent in 2020 due primarily to higher sales volume of North American operations, which increased sales by three percent. Favorable foreign currency translation further increased sales by one percent.Operating ResultsOperating profit in the Plumbing Products segment in 2020 was positively impacted by cost savings initiatives, including actions taken to mitigate the COVID-19 pandemic impact, higher sales volume and favorable net selling prices. These positive impacts were partially offset by increased commodity costs, including tariffs, and an increase in other expenses (such as salaries and legal costs). Decorative Architectural ProductsSalesNet sales in the Decorative Architectural Products segment increased 12 percent in 2020, due mostly to higher sales volume of paints and other coating products, and to a lesser extent, builders' hardware products. Such increases were slightly offset by unfavorable net selling prices of paints and other coating products. Operating ResultsOperating profit in the Decorative Architectural Products segment in 2020 benefited primarily from higher sales volume, as well as cost savings initiatives, including actions taken to mitigate the COVID-19 pandemic impact, and decreased commodity costs. Additionally, operating profit was positively impacted by the non-recurrence of a 2019 non-cash impairment charge related to an other indefinite-lived intangible asset for a trademark associated with lighting products. These positive impacts were partially offset by unfavorable net selling prices, higher fixed expenses in our lighting business, and an increase in other expenses (such as salaries, legal costs and advertising). Business Rationalizations and Other InitiativesOver the last several years, we have taken several actions focused on the strategic rationalization of our businesses including business consolidations, plant closures, headcount reductions and other cost savings initiatives. In 2020, 2019 and 2018, we incurred net pre-tax costs and charges related to these initiatives of $11 million, $13 million, and $9 million, respectively.We continue to realize the benefits of our business rationalizations and continuous improvement initiatives across our enterprise and expect to identify additional opportunities to improve our business operations.During 2020, 2019 and 2018, our Plumbing Products segment incurred costs and charges of $7 million, $13 million and $9 million, respectively and our Decorative Architectural Products segment incurred costs and charges of $4 million in 2020. The 2020 costs primarily related to business and plant consolidation and severance costs in North America.30Geographic Area Results DiscussionNorth AmericaSalesNorth American net sales in 2020 increased nine percent. Higher sales volume of paints and other coating products, plumbing products, and to a lesser extent, builders' hardware, in aggregate, increased sales by 10 percent. Such increases were slightly offset by unfavorable net selling prices of paints and other coating products, which decreased sales by one percent.Operating ResultsOperating profit from North American operations in 2020 was positively affected by higher sales volume, cost savings initiatives, including actions taken to mitigate the COVID-19 pandemic impact and favorable sales mix of plumbing products. Additionally, operating profit was positively impacted by the non-recurrence of a 2019 non-cash impairment charge related to an other indefinite-lived intangible asset for a trademark associated with lighting products. These positive impacts were partially offset by unfavorable net selling prices and increased commodity costs, primarily attributable to tariffs. Additionally, operating profit was adversely impacted by higher fixed expenses in our lighting business, and an increase in other expenses (such as salaries, legal costs and advertising).International, Principally EuropeSalesNet sales from International operations in 2020 were flat. In local currencies (including sales in foreign currencies outside their respective functional currencies), net sales decreased one percent due to unfavorable sales mix of plumbing products that was partially offset by favorable net selling prices of plumbing products.Operating ResultsOperating profit from International operations in 2020 was positively impacted by cost savings initiatives, including actions taken to mitigate the COVID-19 pandemic impact, and favorable net selling prices. These positive impacts were partially offset by unfavorable sales mix.31Other MattersCommitments and ContingenciesLitigationInformation regarding our legal proceedings is set forth in Note U to the consolidated financial statements, which is incorporated herein by reference.Other CommitmentsWe enter into contracts, which include reasonable and customary indemnifications that are standard for the industries in which we operate. Such indemnifications include claims made against builders by homeowners for issues relating to our products and workmanship. In conjunction with divestitures and other transactions, we occasionally provide reasonable and customary indemnifications. We have never had to pay a material amount related to these indemnifications, and we evaluate the probability that amounts may be incurred and record an estimated liability when probable and reasonably estimable.Recently Adopted and Issued Accounting PronouncementsRefer to Note A to the consolidated financial statements for discussion of recently adopted and issued accounting pronouncements, which is incorporated herein by reference. 32Contractual ObligationsThe following table provides payment obligations related to current contracts at December 31, 2020, in millions: Payments Due by Period 20212022-20232024-2025Beyond2025OtherTotalDebt (A)$3 $337 $506 $1,948 $— $2,794 Interest (A)130 231 209 614 — 1,184 Operating leases46 64 36 89 — 235 Currently payable income taxes16 — — — — 16 Private equity funds (B)— — — — 4 4 Purchase commitments (C)307 — — — — 307 Uncertain tax positions, including interest and penalties (D)— — — — 84 84 Total$502 $632 $751 $2,651 $88 $4,624 ______________________________(A)We assume that all debt would be held to maturity. Amounts include finance lease obligations.(B)There is no schedule for the capital commitments to the private equity funds; accordingly, we are unable to make a reasonable estimate as to when capital commitments may be paid.(C)Excludes contracts that do not require volume commitments and open or pending purchase orders.(D)Due to the high degree of uncertainty regarding the timing of future cash outflows associated with uncertain tax positions, we are unable to make a reasonable estimate for the year in which cash settlements may occur with applicable tax authorities.Refer to Note N to the consolidated financial statements for defined-benefit pension plan obligations.33Item 7A. Quantitative and Qualitative Disclosures about Market Risk.We have considered the provisions of accounting guidance regarding disclosure of accounting policies for derivative financial instruments and disclosure of quantitative and qualitative information about market risk inherent in derivative financial instruments and other financial instruments.We are exposed to the impact of changes in interest rates and foreign currency exchange rates, particularly changes between the U.S. dollar and the European euro, British pound, Canadian dollar, and Chinese renminbi, and to market price fluctuations related to our financial investments. We have insignificant involvement with derivative financial instruments and use such instruments to the extent necessary to manage exposure to foreign currency fluctuations. At December 31, 2020, we performed sensitivity analyses to assess the potential loss in the fair values of market risk sensitive instruments resulting from a hypothetical change of 10 percent in foreign currency exchange rates, a 10 percent decline in the market value of our long-term investments, or a 100 basis point change in interest rates. Based upon the analyses performed, such changes would not be expected to materially affect our consolidated financial position, results of operations or cash flows.34Item 8.Financial Statements and Supplementary Data.Management's Report on Internal Control Over Financial ReportingOur management is responsible for establishing and maintaining adequate internal control over financial reporting. Our internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with accounting principles generally accepted in the United States of America.We assessed the effectiveness of our internal control over financial reporting as of December 31, 2020 using the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission ("COSO") in Internal Control – Integrated Framework (2013). Based on this assessment, we have determined that our internal control over financial reporting was effective as of December 31, 2020.PricewaterhouseCoopers LLP, an independent registered public accounting firm, has audited the effectiveness of our internal control over financial reporting as of December 31, 2020, as stated in their report, which is presented herein. Their report expressed an unqualified opinion on the effectiveness of our internal control over financial reporting as of December 31, 2020 and expressed an unqualified opinion on our 2020 consolidated financial statements. This report appears under '
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+ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSOverviewThe following Management’s Discussion and Analysis of Financial Condition and Results of Operations (MD&A) is intended to help the reader understand McCormick & Company, Incorporated, our operations and our present business environment. MD&A is provided as a supplement to, and should be read in conjunction with, our financial statements and the accompanying notes thereto contained in Item 8 of this report. We use certain non-GAAP information that we believe is important for purposes of comparison to prior periods and development of future projections and earnings growth prospects. This information is also used by management to measure the profitability of our ongoing operations and analyze our business performance and trends. The dollar and share information in the charts and tables in the MD&A are in millions, except per share data. On November 30, 2020, the Company effected a two-for-one stock split in the form of a stock dividend on all shares of the Company’s two classes of common stock. On November 30, one like share was issued to each share outstanding to shareholders of record as of November 20, 2020. All common stock and per share data has been retroactively adjusted to reflect the stock split.McCormick is a global leader in flavor. The company manufactures, markets and distributes spices, seasoning mixes, condiments and other flavorful products to the entire food industry–retailers, food manufacturers and foodservice businesses. We manage our business in two operating segments, consumer and flavor solutions, as described in Item 1 of this report.Our long-term annual growth objectives in constant currency are to increase sales 4% to 6%, increase adjusted operating income 7% to 9% and increase adjusted earnings per share 9% to 11%. Impact of Global COVID-19 Pandemic–During the year ended November 30, 2020, the effects of a new coronavirus (COVID-19) and related actions to attempt to control its spread significantly impacted not only our operating results but also the global economy.The impact of the global COVID-19 pandemic on our consolidated operating results in early fiscal 2020 was limited, in all material respects, to our operations in China where the Chinese government mandated numerous measures, including closures of businesses, limitations on movements of individuals and goods, and the imposition of other restrictive measures, in its efforts to mitigate the spread of COVID-19 within the country. In March 2020, as COVID-19 spread outside of China, significantly impacting the rest of the world, the World Health Organization designated the outbreak as a global pandemic. The pandemic spread outside of China in the balance of fiscal year 2020 to impact operations in our Americas and Europe, Middle East and Africa (EMEA) regions in addition to elsewhere in our Asia/Pacific region. The effects of COVID-19 and related actions to attempt to control its spread significantly impacted not only our operating results but also the global economy.In the U.S., many state and local governments, based on local conditions, either recommended or mandated actions to slow the transmission of COVID-19. These measures ranged from limitations on crowd size, together with closures of bars and dine-in restaurants, to mandatory orders for non-essential citizens to shelter in place. Governments in non-U.S. jurisdictions also implemented shelter-in-place orders, quarantines, significant restrictions on travel, as well as restrictions that prohibited many employees from going to work. Borders between countries have been closed to contain the spread of COVID-19 contagion. The extent and nature of government actions varied during fiscal year 2020 and in early fiscal year 2021 based upon the then-current extent and severity of the COVID-19 pandemic within their respective countries and localities. We identified three priorities while navigating through the period of volatility and uncertainty associated with various stages of the COVID-19 pandemic:▪First, to ensure the health and safety of our employees and the quality and integrity of our products.▪Second, to keep our brands and our customers' brands in supply and to maintain the financial strength of our business.19▪Third, to ensure McCormick emerges strong from this event. The pandemic will come to an end and we believe that we will come out a better company by driving our long-term strategies, responding to changing consumer behavior and capitalizing on opportunities from our relative strength. We implemented numerous measures over the course of fiscal 2020 to ensure that these priorities were achieved, including: (i) for our manufacturing and distribution employees, who played a critical role in maintaining the supply of our products to our customers and consumers, we instituted pre-shift temperature checks, temporarily increased pay and benefits, and provided time to enable social distancing and even greater sanitation procedures during shift changes; (ii) for our other employees, we instituted work-from-home arrangements; (iii) we maintained close communication with customers and suppliers to enable us to react to changing demand; and (iv) throughout the organization, we empowered global, regional and local crisis response teams that enabled us to react quickly to the challenging environment.Our sales increased by 4.7% for the year ended November 30, 2020 over the 2019 level. That increase was driven by an 10.0% increase in sales of our consumer segment, partially offset by a 3.5% decline in sales of our flavor solutions segment. Our operating results have and will continue to be impacted by COVID-19, including the related recovery and the shift in consumer demand resulting from the pandemic. We have partnered with our customers to monitor consumer demand changes and address the shift to at-home versus away-from-home consumption. We estimate that away-from-home consumption has historically represented approximately 20% of our consolidated sales. The effects of COVID-19 on consumer behavior have, on a net basis, favorably impacted the operating results of our consumer segment and unfavorably impacted the operating results of our flavor solutions segment during the year ended November 30, 2020. The impact of COVID-19 on our consumer segment during fiscal 2020 resulted in a significant increase in at-home consumption and related demand for our products. The unfavorable impact on our flavor solutions segment during the same periods was principally attributable to decreased demand from certain customers that were affected by government mandates related to COVID-19 in many of our markets. Those measures required closures of, or capacity limitations on, dine-in restaurants or restricted operations of those restaurants to carry-out or delivery only and also restricted operations of quick service restaurants to drive-through pick-up or delivery. The resulting negative demand impacts in our flavor solutions segment were partially offset by increased at-home consumption from certain customers in our flavor solutions segment that use our products to flavor their own brands for at-home consumption. The impact of COVID-19 on our consumer segment and flavor solutions segment moderated during our fourth quarter of fiscal 2020. During that quarter, our sales increased by 4.9% over the comparable period in 2019, driven by a 5.9% increase in sales of our consumer segment and a 3.1% increase in sales of our flavor solutions segment. The 5.9% fourth quarter growth in sales of our consumer segment was moderated by the lack of availability of certain of our consumer products in the U.S. following the sustained increase in demand earlier in 2020 that caused us to suspend or curtail production of some secondary products in the fourth quarter to protect the supply of our top selling holiday items. Upon worsening COVID-19 infection levels in certain localities in late fiscal 2020 and in early fiscal 2021, local governmental authorities have either re-imposed some or all of earlier restrictions or imposed other restrictions, all in an effort to check the spread of COVID-19. In early fiscal 2021, vaccines effective in combatting COVID-19 were approved by health agencies in certain countries/regions in which we operate (including the U.S., U.K., European Union, Canada and Mexico) and began to be administered. However, initial quantities of vaccines are limited and vaccine distributions, controlled by local authorities, are being allocated, generally first to front-line health care workers and other essential workers and next to those members of individual populations believed most susceptible to severe effects from COVID-19. Full administration of the COVID-19 vaccines is unlikely to occur in most jurisdictions until mid- to late-2021. The pace and shape of the COVID-19 recovery described above as well as the impact and extent of potential resurgences is not presently known. These and other uncertainties with respect to COVID-19 could result in changes to our current expectations in addition to a number of adverse impacts to our business, including but not limited to additional disruption to the economy and consumers’ willingness and ability to spend, temporary or permanent closures by businesses that consume our products, such as restaurants, additional work restrictions, and supply chains being interrupted, slowed, or rendered inoperable or, in the case of significant increased demand for our product, incapable of fulfilling that increased demand. As a result, it may be challenging to obtain and process raw materials to support our business needs, and individuals could become ill, quarantined, or otherwise unable to work and/or travel due to health reasons or governmental restrictions. Also, governments may impose other laws, regulations or taxes which could adversely impact our business, financial condition or results of operations. Further, if our customers’ businesses are similarly affected, they might delay or reduce purchases from us. The potential effects of COVID-19 also could impact us in a number of other ways including, but not limited to, variations in the level of our 20profitability, laws and regulations affecting our business, fluctuations in foreign currency markets, the availability of future borrowings, the cost of borrowings, valuation of our pension assets and obligations, credit risks of our customers and counterparties, and potential impairment of the carrying value of goodwill or other indefinite-lived intangible assets.Sales growth: Over time, we expect to grow sales with similar contributions from: 1) our base business – driven by brand marketing support, category management, and differentiated customer engagement; 2) new products; and 3) acquisitions. Base business – We expect to drive sales growth by optimizing our brand marketing investment through improved speed, quality and effectiveness. We measure the return on our brand marketing investment and have identified digital marketing as one of our highest return investments in brand marketing support. Through digital marketing, we are connecting with consumers in a personalized way to deliver recipes, provide cooking advice and discover new products.New Products – For our consumer segment, we believe that scalable and differentiated innovation continues to be one of the best ways to distinguish our brands from our competition, including private label. We are introducing products for every type of cooking occasion, from gourmet, premium items to convenient and value-priced flavors. For flavor solutions customers, we are developing seasonings for snacks and other food products, as well as flavors for new menu items. We have a solid pipeline of flavor solutions aligned with our customers’ new product launch plans, many of which include “better-for-you” innovation. With over 20 product innovation centers around the world, we are supporting the growth of our brands and those of our flavor solutions customers with products that appeal to local consumers.Acquisitions – Acquisitions are expected to approximate one-third of our sales growth over time. Since the beginning of 2015, we have completed nine acquisitions, which are driving sales in both our consumer and flavor solutions segments. We focus on acquisition opportunities that meet the growing demand for flavor and health. Geographically, our focus is on acquisitions that build scale where we currently have presence in both developed and emerging markets. Our acquisitions have included bolt-on opportunities as well as the following recent acquisitions: •On December 30, 2020, we acquired FONA International, LLC and certain of its affiliates (FONA), a privately owned company, for approximately $710 million, net of cash acquired, subject to certain customary purchase price adjustments. We financed this fiscal 2021 acquisition with cash and short-term borrowings. FONA is a leading manufacturer of clean and natural flavors providing solutions for a diverse customer base across various applications for the food, beverage and nutritional markets which expands the breadth of our flavor solutions segment into attractive categories, as well as extends our technology platform, strengthens our capabilities, and accelerates the strategic migration of our portfolio to more value-added and technically insulated products. •On November 30, 2020, we acquired the parent company of Cholula Hot Sauce® (Cholula) from L Catterton for approximately $803 million, net of cash acquired, subject to certain customary purchase price adjustments. Cholula is a strong addition to McCormick’s global branded flavor portfolio, which broadens the Company’s offering in the high growth hot sauce category to consumers and foodservice operators and accelerates our condiment growth opportunities with a complementary authentic Mexican flavor hot sauce in both our consumer and flavor solutions segments.•On August 17, 2017, we acquired Reckitt Benckiser's Food Division (RB Foods) for approximately $4.2 billion. The acquired market-leading brands of RB Foods included French’s®, Frank’s RedHot® and Cattlemen’s®, which are a natural strategic fit with our robust global branded flavor portfolio. We believe that these additions moved us to a leading position in the attractive U.S. condiments category and provide significant international growth opportunities for our consumer and flavor solutions segments.The FONA and Cholula acquisitions are expected to contribute more than one-third of our sales growth in 2021. The RB Foods acquisition contributed more than one-third of our sales growth in 2018 and 2017.Cost savings and business transformation: We are fueling our investment in growth with cost savings from our CCI program, an ongoing initiative to improve productivity and reduce costs throughout the organization, that also includes savings from the organization and streamlining actions described in note 3 of notes to our consolidated financial statements. In addition to funding brand marketing support, product innovation and other growth initiatives, our CCI program helps offset higher costs and is contributing to higher operating income and earnings per share.21We are making investments to build the McCormick of the future, including in our Global Enablement (GE) organization to transform McCormick through globally aligned, innovative services to enable growth. As more fully described in note 3 of notes to our consolidated financial statements, we expect to incur special charges of approximately $60 million to $65 million associated with our GE initiative of which approximately $39.9 million have been recognized through November 30, 2020. As technology provides the backbone for this greater process alignment, information sharing and scalability, we are also making investments in our information systems. From late 2018 through early 2020, we progressed in implementing our global enterprise resource planning (ERP) replacement program which will enable us to accelerate the transformation of our ways of working and provide a scalable platform for growth. In the second quarter of fiscal 2020, we elected to pause activity related to our ERP for the balance of fiscal 2020 due, in part, to COVID-19 restrictions that restricted necessary travel by internal and external ERP team members and made it difficult for local McCormick personnel to actively participate in the ERP development, data cleansing, and testing prior to then scheduled pilots later in fiscal 2020. In addition, the pause of this activity enabled all McCormick employees to focus their activities on the three priorities previously described under the heading “Impact of COVID-19 Pandemic” for navigating through the period of volatility and uncertainty associated with various stages of the COVID-19 pandemic.We expect that, in total over the course of the ERP replacement program from late 2018 through 2023, we will invest from approximately $350 million to $400 million, including expenses related to the go-live activities in our operations, to enable the anticipated completion of the global roll out of our new information technology platform in 2022. Of that projected, $350 million to $400 million, we expect capitalized software to account for approximately 50% and program expenses to account for approximately 50%. Of the approximately $175 million to $200 million of operating expenses included in our projected total spending related to our ERP replacement program, approximately $40 million have been recognized through November 30, 2020. Of the approximately $175 million to $200 million of capitalized software included in our projected total spending related to our ERP program, approximately $87 million has been recognized through November 30, 2020. The GE initiative is expected to generate annual savings, ranging from approximately $45 million to $55 million, once all actions are implemented, including those that are dependent on the replacement of our global ERP platform.Cash flow: We continue to generate strong cash flow. Net cash provided by operating activities reached $1,041.3 million in 2020, an increase of $94.5 million from the $946.8 million realized in 2019. In 2020, we continued to have a balanced use of cash for debt repayment, capital expenditures and the return of cash to shareholders through dividends and share repurchases. We are using our cash to fund shareholder dividends, with annual increases in each of the past 35 years, and to fund capital expenditures and acquisitions. In 2020, the return of cash to our shareholders through dividends and share repurchases was $377.4 million. Operating Results: On a long-term basis, we expect a combination of acquisitions and share repurchases to add about 2% to earnings per share growth. In 2020, we achieved further growth of our business with net sales rising 4.7% over the 2019 level due to the following factors:•We grew volume and product mix, which added 3.7% of sales growth. This growth was driven by sharply higher demand within our consumer segment, as the continuation of measures imposed to mitigate the spread of COVID-19 and the related change in consumer behavior, resulted in a shift in consumer behavior toward at-home meal preparation that more than offset lower demand within our flavor solutions segment principally associated with our branded food service customers.•Pricing actions contributed 1.6% of the increase in net sales. •Net sales growth was negatively impacted by fluctuations in currency rates that decreased sales growth by 0.6%. Excluding this impact, we grew sales by 5.3% over the prior year on a constant currency basis. Operating income was $999.5 million in 2020 and $957.7 million in 2019. We recorded $6.9 million and $20.8 million of special charges in 2020 and 2019, respectively, related to organization and streamlining actions. In 2020, we also recorded $12.4 million of transaction and integration expenses related to our acquisitions of Cholula and FONA that reduced operating income. In 2020, compared to the year-ago period, the favorable impact of higher sales and $113.0 million of cost savings from our CCI program, including organization and streamlining actions, more than offset the impact of increased conversion costs, COVID-19 related expenses, higher incentive compensation, and the unfavorable impact of foreign currency exchange rates. During 2020, COVID-19 related 22expenses included certain actions taken in response to the pandemic, including the impact of temporary arrangements that increased salaries and benefits paid to our manufacturing employees, measures to enable manufacturing and distribution staff to maintain social distancing and permit enhanced cleaning between shifts that reduced productivity, and impact of lower production volumes of flavor solutions inventories. Excluding special charges together with, for 2020, transaction and integration expenses related to our acquisitions of Cholula and FONA, adjusted operating income was $1,018.8 million in 2020, an increase of 4.1%, compared to $978.5 million in the year-ago period. In constant currency, adjusted operating income rose 4.8%. For further details and a reconciliation of non-GAAP to reported amounts, see the subsequent discussion under the heading "Non-GAAP Financial Measures".Diluted earnings per share was $2.78 in 2020 and $2.62 in 2019. The year-on-year increase in earnings per share was driven mainly by higher operating income and decreased interest expense. Those favorable impacts in 2020 were partially offset by the impact of a higher effective tax rate, a decrease in other income and the impact of higher shares outstanding. Special charges, and in 2020, transaction and integration expenses lowered earnings per share by $0.05 and $0.06 in 2020 and 2019, respectively. Excluding the effects of special charges, transaction and integration expenses, and the non-recurring benefit of the U.S. Tax Act, adjusted diluted earnings per share was $2.83 in 2020 and $2.68 in 2019, or an increase of 5.6%.2021 OutlookIn 2021, we expect to grow net sales over the 2020 level by 7% to 9%, including an estimated 2% favorable impact from currency rates, or 5 to 7% on a constant currency basis. That anticipated 2021 sales growth includes the incremental impact of the Cholula and FONA acquisitions, which we expect to comprise 3.5% to 4.0% of the expected 7% to 9% sales growth, and higher volume and product mix driven by our category management, brand marketing, new product, and differentiated customer engagement growth plans. We expect to have organic sales growth in both our consumer and flavor solutions segments. We expect our 2021 gross profit margin to range from a decline of 10 basis points to an increase of 15 basis points from our gross profit margin of 41.1% in 2020. The projected 2021 range of change in gross profit margin is principally due to (i) expected accretion from our acquisitions of Cholula and FONA, net of transaction and integration expenses of $6.9 million related to the amortization of the step-up of the acquired inventories of Cholula and FONA to fair value, (ii) anticipated unfavorable sales mix in 2021 between our consumer and flavor solutions segments as compared to 2020, (iii) an expected increase in COVID-19 expenses of approximately $10 million in 2021 over the 2020 level, and (iv) an anticipated low-single-digit level of inflation in 2021 compared to 2020. Excluding the $6.9 million of transaction and integration expenses related to our acquisitions of Cholula and FONA included in our projected range of gross profit margin anticipated in 2021, we expect our adjusted gross profit margin to range from comparable to 25 basis points higher than our 2020 gross profit margin of 41.1%.In 2021, we expect an increase in operating income of 4% to 6%, which includes an estimated 2% favorable impact from currency rates, over the 2020 level. The projected range of change in operating income in 2021 reflects an expected increase of approximately $30 million in expense related to our global ERP replacement program over the fiscal 2020 level. Our CCI-led cost savings target in 2021 is approximately $110 million and approximates the $113 million of CCI-led cost savings realized in 2020. We anticipate transaction and integration expenses related to the Cholula and FONA acquisitions of approximately $50 million to negatively impact operating income in 2021, as compared to $12.4 million of transaction and integration expenses in 2020. We also expect approximately $8 million of special charges in 2021 that relate to previously announced organization and streamlining actions; in 2020, special charges were $6.9 million. Excluding special charges and transaction and integration expenses, we expect 2021’s adjusted operating income to increase by 8% to 10%, which includes an estimated 2% favorable impact from currency rates, or to increase by 6% to 8% on a constant currency basis over the 2020 level. Our underlying effective tax rate is projected to be higher in 2021 than in 2020. We estimate our effective tax rate, including the net favorable impact of anticipated discrete tax items, to approximate 24% in 2021 as compared to 19.8% in 2020. Excluding projected taxes associated with special charges and transaction and integration expenses, including the unfavorable impact in 2021 of a discrete tax item related to our acquisition of FONA, we estimate that our adjusted effective tax rate will approximate 23% in fiscal 2021, as compared to an adjusted effective tax rate of 19.9% in 2020. Diluted earnings per share was $2.78 in 2020. Diluted earnings per share for 2021 is projected to range from $2.71 to $2.76. Excluding the per share impact of special charges and transaction and integration expenses of $0.01 and $0.04, respectively, adjusted diluted earnings per share was $2.83 in 2020. Adjusted diluted earnings per share 23(excluding an estimated per share impact from special charges of $0.02 and from transaction and integration expenses of $0.18, including the unfavorable impact of a discrete tax item of $0.04 related to our acquisition of FONA) is projected to range from $2.91 to $2.96 in 2021. We expect adjusted diluted earnings per share to grow by 3% to 5%, which includes a 2% favorable impact from currency rates, or to grow by 1% to 3% on a constant currency basis over adjusted diluted earnings per share of $2.83 in 2020. RESULTS OF OPERATIONS—2020 COMPARED TO 201920202019Net sales$5,601.3 $5,347.4 Percent growth4.7 %0.8 %Components of percent growth in net sales–increase (decrease):Volume and product mix3.7 %2.5 %Pricing actions1.6 %0.2 %Foreign exchange(0.6)%(1.9)%Sales for 2020 increased by 4.7% from 2019 and by 5.3% on a constant currency basis. That 4.7% sales increase was driven by higher sales in our consumer segment, which increased by 10.0% over the 2019 level, partially offset by lower sales in our flavor solutions segment, which declined by 3.5% from the prior year level. On a consolidated basis, higher volume and favorable product mix increased sales by 3.7% while pricing actions added 1.6% to sales. That net volume increase and favorable mix was driven by higher demand within our consumer segment, as measures imposed to mitigate the spread of COVID-19 and the related change in consumer behavior, resulted in a shift in consumer behavior toward at-home meal preparation that more than offset lower demand within our flavor solutions segment principally associated with our restaurant and branded food service customers. Sales were also impacted by unfavorable foreign currency rates that decreased net sales 0.6% compared to 2019 and is excluded from our measure of sales growth of 5.3% on a constant currency basis.20202019Gross profit$2,300.4 $2,145.3 Gross profit margin41.1 %40.1 %In 2020, our gross profit margin increased 100 basis points to 41.1% from 40.1% in 2019. This improvement was driven by the favorable impact of CCI-led cost savings, favorable pricing actions and the mix of consumer and flavor solutions sales, partially offset by unfavorable conversion costs and increased material costs. Higher conversion costs during 2020 reflected certain matters associated with COVID-19, including the impact of temporary arrangements that increased salaries and benefits paid to our manufacturing employees, measures to enable manufacturing and distribution staff to maintain social distancing and permit enhanced cleaning between shifts that reduced productivity, and the impact of lower production volumes of flavor solutions inventories.20202019Selling, general & administrative expense $1,281.6 $1,166.8 Percent of net sales22.9 %21.8 %Selling, general and administrative (SG&A) expense was $1,281.6 million in 2020 compared to $1,166.8 million in 2019, an increase of $114.8 million. That increase in SG&A expense was primarily a result of (i) higher performance-based employee incentive expense accruals, (ii) higher distribution expenses associated with the higher sales volume, (iii) increased brand marketing costs and (iv) a one-time fiscal 2019 expense reduction from the alignment of an employee benefit plan to our global standard that did not recur in 2020, all as compared to 2019. SG&A expense as a percent of net sales increased by 110 basis points from the prior year level, primarily as a result of the previously mentioned factors, partially offset by the impact of the leverage of fixed and semi-fixed expenses over a higher level of sales during the 2020 period.20202019Total special charges$6.9 $20.8 We regularly evaluate whether to implement changes to our organization structure to reduce fixed costs, simplify or improve processes, and improve our competitiveness, and we expect to continue to evaluate such actions in the future. From time to time, those changes are of such significance in terms of both up-front costs and organizational/ structural impact that we obtain advance approval from our Management Committee and classify expenses related to those changes as special charges in our financial statements. 24During 2020, we recorded $6.9 million of special charges, consisting of $5.3 million related to streamlining actions in our EMEA region and $1.6 million related to our GE initiative.During 2019, we recorded $20.8 million of special charges, consisting primarily of (i) $14.1 million of costs related to our multi-year GE business transformation initiative, including $10.6 million of third-party expenses, $2.1 million related to severance and related benefits, and $1.4 million related to other costs; (ii) $2.3 million of severance and related benefits associated with streamlining actions in the Americas; and (iii) $3.9 million related to streamlining actions in our EMEA region.20202019Transaction and integration expenses$12.4 $— Transaction and integration expenses related to our acquisitions of Cholula and FONA of $11.2 million and $1.2 million, respectively, were incurred late in fiscal 2020. We expect to incur additional transaction and integration expenses related to these acquisitions in fiscal 2021. 20202019Operating income$999.5 $957.7 Percent of net sales17.8 %17.9 %Operating income increased by $41.8 million, or 4.4%, from $957.7 million in 2019 to $999.5 million in 2020. Operating income as a percent of net sales declined by 10 basis points in 2020, to 17.8% in 2020 from 17.9% in 2019 as a result of the factors previously described. Excluding the effect of special charges and transaction and integration expenses previously described, adjusted operating income was $1,018.8 million in 2020 as compared to $978.5 million in 2019, an increase of $40.3 million or 4.1% over the 2019 level. Adjusted operating income as a percent of net sales declined by 10 basis points in 2020, to 18.2% in 2020 from 18.3% in 2019.20202019Interest expense$135.6 $165.2 Other income, net17.6 26.7 Interest expense was $29.6 million lower for 2020 as compared to the prior year primarily due to a decline in average total borrowings and a lower interest rate environment. Other income, net for 2020 decreased by $9.1 million from the 2019 level due principally to lower non-service cost income associated with our pension and postretirement benefit plans that declined by $7.6 million in 2020 from the prior year level. 20202019Income from consolidated operations before income taxes$881.5 $819.2 Income tax expense174.9 157.4 Effective tax rate19.8 %19.2 %The provision for income taxes is based on the current estimate of the annual effective tax rate adjusted to reflect the tax impact of items discrete to the fiscal period. We record tax expense or tax benefits that do not relate to ordinary income in the current fiscal year discretely in the period in which such items occur pursuant to the requirements of U.S. GAAP. Examples of such types of discrete items not related to ordinary income of the current fiscal year include, but are not limited to, excess tax benefits associated with share-based payments to employees, changes in estimates of the outcome of tax matters related to prior years, including reversals of reserves upon the lapsing of statutes of limitations, provision-to-return adjustments, the settlement of tax audits, changes in enacted tax rates, changes in the assessment of deferred tax valuation allowances and the tax effects of intra-entity asset transfers (other than inventory). The effective tax rate was 19.8% in 2020 as compared to 19.2% in 2019. The effective tax rate of 19.2% in 2019 includes a non-recurring net tax benefit of $1.5 million associated with the U.S. Tax Act, as more fully described in note 13 of notes to our consolidated financial statements. Net discrete tax benefits were $43.4 million in 2020, which is a decrease of $0.3 million from $43.7 million in 2019, including the $1.5 million non-recurring benefit of the U.S. Tax Act in 2019. Discrete tax benefits in both the 2020 and 2019 periods include excess tax benefits associated with share-based payments to employees ($14.2 million and $22.4 million in 2020 and 2019, respectively), the tax benefits associated with intra-entity asset transfers that occurred ($9.9 million and $15.2 million in 2020 and 2019, respectively), the reversal of reserves for unrecognized tax benefits for the expiration of the statues of limitations and other discrete items. In 2020, discrete tax benefits included $11.9 million associated with the release of valuation allowances due to a change in judgment about realizability of deferred tax assets. See note 13 of notes to 25our consolidated financial statements for a more detailed reconciliation of the U.S. federal tax rate with the effective tax rate.20202019Income from unconsolidated operations$40.8 $40.9 Income from unconsolidated operations, which is presented net of the elimination of earnings attributable to non-controlling interests, decreased $0.1 million in 2020 from the prior year. We own 50% of most of our unconsolidated joint ventures, including our largest joint venture, McCormick de Mexico, that comprised 75% and 72% of the income of our unconsolidated operations in 2020 and 2019, respectively.We reported diluted earnings per share of $2.78 in 2020, compared to $2.62 in 2019. The table below outlines the major components of the change in diluted earnings per share from 2019 to 2020. The increase in adjusted operating income in the table below includes the impact from unfavorable currency exchange rates in 2020. 2019 Earnings per share—diluted$2.62 Increase in operating income0.12 Decrease in special charges0.05 Increase in transaction and integration expenses (0.04)Decrease in interest expense0.09 Decrease in other income(0.03)Impact of income taxes(0.02)Impact of higher shares(0.01)2020 Earnings per share—diluted$2.78 Results of Operations—SegmentsWe measure the performance of our business segments based on operating income, excluding special charges and transaction and integration expenses related to our acquisitions. See note 16 of notes to our consolidated financial statements for additional information on our segment measures as well as for a reconciliation by segment of operating income, excluding special charges and transaction and integration expenses related to our acquisitions. In the following discussion, we refer to our previously described measure of segment profit as "Segment operating income". Consumer Segment 20202019Net sales$3,596.7 $3,269.8 Percent growth10.0 %0.7 %Components of percent growth in net sales–increase (decrease):Volume and product mix8.8 %2.4 %Pricing actions1.5 %0.1 %Foreign exchange(0.3)%(1.8)%Segment operating income$780.9 $676.3 Segment operating income margin21.7 %20.7 %Sales of our consumer segment in 2020 grew by 10.0% as compared to 2019 and grew by 10.3% on a constant currency basis. This increase was driven by sharply higher sales of our consumer business in the Americas and in EMEA, with a partial offset from a sales decline in the Asia/Pacific region. Asia/Pacific region sales declines were driven by lower sales in China, which includes the impact of away-from-home products included in its consumer portfolio. Higher volume and product mix added 8.8% to sales as measures imposed to mitigate the spread of COVID-19 resulted in a shift in consumer behavior toward at-home meal preparation. Pricing actions added 1.5% to sales as compared to the prior year period. The unfavorable impact of foreign currency exchange rates decreased consumer segment sales by 0.3% compared to 2019 and is excluded from our measure of sales growth of 10.3% on a constant currency basis.In the Americas, consumer sales rose 13.9% in 2020 as compared to 2019 and rose by 14.0% on a constant currency basis. Higher volume and product mix added 11.9% to sales driven by significant growth across the McCormick branded portfolio. In addition, pricing actions, taken in response to higher costs, increased sales by 262.1% as compared to the prior year period. The unfavorable impact of foreign currency exchange rates decreased sales by 0.1% compared to 2019 and is excluded from our measure of sales growth of 14.0% on a constant currency basis.In the EMEA region, consumer sales increased 14.5% in 2020 as compared to 2019 and rose by 14.3% on a constant currency basis. Volume and product mix increased sales by 13.9%. The increase was broad based across the region with particular strength in branded spices and seasonings and homemade dessert products in France. The impact of pricing actions increased sales by 0.4%. The favorable impact of foreign currency exchange rates increased sales by 0.2% compared to 2019 and is excluded from our measure of sales growth of 14.3% on a constant currency basis.In the Asia/Pacific region, consumer sales decreased 16.6% as compared to 2019 and decreased 15.1% on a constant currency basis. Lower volume and product mix reduced sales by 15.0%. The decrease was driven by products related to away-from-home consumption in China. Partially offsetting this decline was growth in cooking-at-home products, particularly in Australia. Pricing actions reduced sales by 0.1% as compared to 2019. The unfavorable impact from foreign currency exchange rates decreased sales by 1.5% compared to 2019 and is excluded from our measure of sales decline of 15.1% on a constant currency basis.We grew segment operating income for our consumer segment by $104.6 million, or 15.5%, in 2020 as compared to 2019. The increase in segment operating income was driven by the impact of higher sales, as previously described, and CCI-led cost savings, partially offset by higher conversion costs, increased material costs, increased brand marketing costs and higher performance-based employee incentive expense accruals. Higher conversion costs during 2020 reflected certain matters associated with COVID-19, including the impact of temporary arrangements that increased salaries and benefits paid to our manufacturing employees as well as measures to enable manufacturing and distribution staff to maintain social distancing and permit enhanced cleaning between shifts that reduced productivity. Segment operating margin for our consumer segment rose by 100 basis points in 2020 to 21.7%, driven by an increase in consumer gross profit margin that was partially offset by an increase in SG&A expense as a percentage of net sales as compared to the 2019 period. Segment operating margin in 2020 benefited from the leverage of fixed and semi-fixed expenses over a higher sales base than compared to the 2019 level. On a constant currency basis, segment operating income for our consumer segment rose by 15.7% in 2020 in comparison to the same period in 2019.Flavor Solutions Segment 20202019Net sales$2,004.6 $2,077.6 Percent (decline) growth (3.5)%1.1 %Components of percent change in net sales–increase (decrease):Volume and product mix(4.2)%2.9 %Pricing actions1.8 %0.3 %Foreign exchange(1.1)%(2.1)%Segment operating income$237.9 $302.2 Segment operating income margin11.9 %14.5 %Sales of our flavor solutions segment decreased 3.5% in 2020 as compared to 2019 and decreased by 2.4% on a constant currency basis. Driving that decrease in sales was lower demand due to the impact of the COVID-19 disruption on our restaurant and branded food service customers, particularly in the Americas and EMEA regions. Unfavorable volume and product mix decreased segment sales by 4.2% as compared to 2019, while pricing actions, taken in response to increased costs, during the period increased sales by 1.8%. The unfavorable impact of foreign currency rates decreased flavor solutions segment sales by 1.1% as compared to 2019 and is excluded from our measure of sales decline of 2.4% on a constant currency basis.In the Americas, flavor solutions sales decreased by 3.5% in 2020 as compared to the prior year level and decreased by 2.5% on a constant currency basis. Unfavorable volume and product mix decreased flavor solutions sales in the Americas by 4.4% during 2020, driven by lower sales to branded foodservice and quick service restaurant customers, but was partially offset by higher sales to packaged food companies. Pricing actions increased sales by 1.9% as compared to the prior year period. An unfavorable impact from foreign currency rates decreased sales by 1.0% compared to 2019 and is excluded from our measure of sales decline of 2.5% on a constant currency basis.27In the EMEA region, flavor solutions sales in 2020 decreased by 5.5% from the prior year level and decreased by 4.2% on a constant currency basis. Unfavorable volume and product mix decreased segment sales by 7.0% as compared to 2019. The decline was primarily attributable to lower sales to branded foodservice and quick service restaurant customers, partially offset by higher demand from packaged food companies. Pricing actions increased sales by 2.8% in 2020 as compared the prior year level. An unfavorable impact from foreign currency rates decreased sales by 1.3% compared to 2019 and is excluded from our measure of sales decline of 4.2% on a constant currency basis.In the Asia/Pacific region, flavor solutions sales increased 0.4% in 2020 from the prior year level and increased by 1.6% on a constant currency basis. Favorable volume and product mix increased sales by 2.2%, driven by higher sales to quick service restaurant customers. Pricing actions decreased sales by 0.6% as compared to the prior year period. An unfavorable impact from foreign currency rates decreased sales by 1.2% compared to 2019 and is excluded from our measure of sales growth of 1.6% on a constant currency basis.Segment operating income for our flavor solutions segment decreased by $64.3 million, or 21.3%, in 2020 as compared to 2019. The decrease in segment operating income was driven by lower sales, increased conversion costs, the impact of lower production volumes, increased material costs and higher performance-based employee incentive expense accruals that were partially offset by CCI-led cost savings. Higher conversion costs during 2020 reflected certain matters associated with COVID-19, including the impact of temporary arrangements that increased salaries and benefits paid to our manufacturing employees as well as measures to enable manufacturing and distribution staff to maintain social distancing and permit enhanced cleaning between shifts that reduced productivity, and the impact of lower production volumes of flavor solutions inventories. Segment operating margin for our flavor solutions segment decreased by 260 basis points from the prior year level to 11.9% in 2020, driven by lower flavor solutions segment gross profit margin and an increase in SG&A expense as a percent of net sales. Segment operating margin in 2020 also declined due to the deleveraging impact of fixed and semi-fixed expenses over a lower sales base as compared to the 2019 period. On a constant currency basis, segment operating income for our flavor solutions segment declined by 19.7% in 2020, as compared to the same period in 2019.RESULTS OF OPERATIONS—2019 COMPARED TO 201820192018Net sales$5,347.4 $5,302.8 Percent growth0.8 %12.1 %Components of percent growth in net sales–increase (decrease):Volume and product mix2.5 %2.2 %Pricing actions0.2 %0.5 %Acquisitions— %8.2 %Foreign exchange(1.9)%1.2 %Sales for 2019 increased by 0.8% from 2018 and by 2.7% on a constant currency basis. Both the consumer and flavor solutions segments drove higher volume and product mix that added 2.5% to sales. This was driven by product innovation as well as growth in the base business. Pricing actions added 0.2% to sales. These factors were partially offset by an unfavorable impact from foreign currency exchange rates that reduced sales by 1.9% compared to 2018 and is excluded from our measure of sales growth of 2.7% on a constant currency basis.20192018Gross profit$2,145.3 $2,093.3 Gross profit margin40.1 %39.5 %In 2019, our gross profit margin increased 60 basis points to 40.1% from 39.5% in 2018, driven by the favorable impact of CCI-led cost savings, partially offset by unfavorable conversion costs. 20192018Selling, general & administrative expense $1,166.8 $1,163.4 Percent of net sales21.8 %22.0 %SG&A expense was $1,166.8 million in 2019 compared to $1,163.4 million in 2018, an increase of $3.4 million. That increase in SG&A expense was driven by increased stock-based compensation expense and higher distribution costs, partially offset by CCI-led cost savings. SG&A expense in 2019 also reflected the impact of two significant, 28but largely offsetting items: (i) expenses associated with our investment in a global ERP platform in support of our GE business transformation initiative that increased SG&A expense over the prior year level; and (ii) a one-time fiscal 2019 expense reduction from the alignment of an employee benefit plan to our global standard that decreased SG&A expense from the prior year level. As a result of the above factors over an increased net sales base, SG&A expense as a percent of net sales was 21.8%, a 20-basis point improvement from 2018. 20192018Total special charges$20.8 $16.3 During 2019, we recorded $20.8 million of special charges, consisting primarily of (i) $14.1 million of costs related to our multi-year GE business transformation initiative, including $10.6 million of third-party expenses, $2.1 million related to severance and related benefits, and $1.4 million related to other costs; (ii) $2.3 million of severance and related benefits associated with streamlining actions in the Americas; and (iii) $3.9 million related to streamlining actions in our EMEA region.During 2018, we recorded $16.3 million of special charges, consisting primarily of: (i) $11.5 million related to our multi-year GE business transformation initiative, consisting of $7.5 million of third party expenses, $1.0 million of employee severance charges and a non-cash asset impairment charge of $3.0 million (that non-cash asset impairment charge was related to the write-off of certain software assets that are incompatible with our move to the new global ERP platform); (ii) a one-time payment, in the aggregate amount of $2.2 million, made to eligible U.S. hourly employees to distribute a portion of the non-recurring net income tax benefit recognized in connection with the enactment of the U.S. Tax Act; (iii) $1.0 million related to employee severance benefits and other costs directly associated with the relocation of one of our Chinese manufacturing facilities; and (iv) $1.6 million related to employee severance benefits and other costs related to the transfer of certain manufacturing operations in our Asia/Pacific region to a then newly constructed facility in Thailand.20192018Transaction and integration expenses$— $22.5 Transaction and integration expenses related to the RB Foods acquisition totaled $22.5 million for 2018. These costs primarily consisted of outside advisory, service and consulting costs; employee-related costs, and other costs related to the acquisition. 20192018Operating income$957.7 $891.1 Percent of net sales17.9 %16.8 %Operating income increased by $66.6 million, or 7.5%, from $891.1 million in 2018 to $957.7 million in 2019. An absence of transaction and integration expenses in 2019, compared to $22.5 million related to our acquisition of RB Foods in 2018, more than offset a $4.5 million increase in special charges in 2019 from $16.3 million in 2018 to $20.8 million in 2019. Operating income as a percent of net sales rose by 110 basis points in 2019, from 16.8% in 2018 to 17.9% in 2019 as a result of the factors previously described. Our operating income as a percent of net sales in 2019 was impacted by two large, but substantially offsetting items: (i) expenses associated with our investment in a global ERP platform in support of our GE business transformation initiative that decreased operating income as a percent of sales by approximately 35 basis points in 2019; and (ii) a one-time fiscal 2019 expense reduction from the alignment of an employee benefit plan to our global standard that increased operating income as a percent of sales by approximately 40 basis points in 2019. Excluding the effect of special charges and transaction and integration expenses previously described, adjusted operating income was $978.5 million in 2019 as compared to $929.9 million in 2018, an increase of $48.6 million or 5.2% over the 2018 level. Adjusted operating income as a percent of sales rose by 80 basis points in 2019, from 17.5% in 2018 to 18.3% in 2019. 20192018Interest expense$165.2 $174.6 Other income, net26.7 24.8 Interest expense was $9.4 million lower for 2019 as compared to the prior year primarily due to a decline in average total borrowings. Other income, net for 2019 increased by $1.9 million from the 2018 level due principally to higher non-service cost income associated with our pension and postretirement benefit plans and higher interest income, which was partially offset by a gain on the sale of a building, which was reflected in our 2018 results and did not recur in 2019. 2920192018Income from consolidated operations before income taxes$819.2 $741.3 Income tax (benefit) expense157.4 (157.3)Effective tax rate19.2 %(21.2)%As more fully described above and in note 13 of notes to our consolidated financial statements, the U.S. Tax Act was enacted in December 2017. The U.S. Tax Act significantly changed U.S. corporate income tax laws by, among other things, reducing the U.S. corporate income tax rate to 21% beginning on January 1, 2018 and creating a territorial tax system with a one-time transition tax on previously deferred post-1986 foreign earnings of U.S. subsidiaries. Under GAAP (specifically, ASC Topic 740, Income Taxes), the effects of changes in tax rates and laws on deferred tax balances are recognized in the period in which the new legislation is enacted. We recorded a net benefit of $301.5 million associated with the U.S. Tax Act during 2018. This amount includes a $380.0 million benefit from the revaluation of our net U.S. deferred tax liabilities as of January 1, 2018, based on the new lower corporate income tax rate offset, in part, by an estimated net transition tax impact of $78.5 million. That net transition tax impact is comprised of the mandated one-time transition tax on previously deferred post-1986 foreign earnings of U.S. subsidiaries estimated at $75.3 million, together with additional foreign withholding taxes of $7.9 million associated with previously unremitted prior year earnings of certain foreign subsidiaries that were no longer considered indefinitely reinvested as of the effective date of the U.S. Tax Act and that were subsequently repatriated in 2018, less a $4.7 million reduction in our fiscal 2018 income taxes directly resulting from the transition tax. In addition, in 2019, we recorded a benefit of $1.5 million relating to an adjustment to a prior year tax accrual associated with the U.S. Tax Act. The effective tax rate was an expense of 19.2% in 2019 as compared to a benefit of 21.2% in 2018. The effective tax rate benefit of 21.2% in 2018 includes the non-recurring net tax benefit of $301.5 million associated with the U.S. Tax Act, as more fully described above, that had a (40.7)% impact on 2018’s effective tax rate. Net discrete tax benefits were $43.7 million in 2019, which is an increase of $15.6 million from $28.1 million in 2018, excluding the non-recurring benefit of the U.S. Tax Act in 2018. For 2019, the effective tax rate was impacted by $15.2 million of tax benefits associated with an intra-entity asset transfer that occurred during 2019 under the provisions of ASU No. 2016-16, which we adopted on December 1, 2018. Discrete tax benefits in both periods include excess tax benefits associated with share-based payments to employees ($22.4 million and $21.7 million in 2019 and 2018, respectively), reversal of reserves for unrecognized tax benefits for the expiration of the statues of limitations and settlements with taxing authorities in several jurisdictions, the previously described non-recurring benefit of the U.S. Tax Act, and other discrete items. See note 13 of notes to our consolidated financial statements for a more detailed reconciliation of the U.S. federal tax rate with the effective tax rate.20192018Income from unconsolidated operations$40.9 $34.8 Income from unconsolidated operations increased $6.1 million in 2019 from the prior year. This increase was primarily attributable to the impact of higher earnings from our largest joint venture, McCormick de Mexico, as well as the impact of eliminating a lower level of earnings associated with our minority interests in 2019 as compared to 2018. We own 50% of most of our unconsolidated joint ventures, including McCormick de Mexico that comprised 72% of the income of our unconsolidated operations in 2019.We reported diluted earnings per share of $2.62 in 2019, compared to $3.50 in 2018. The table below outlines the major components of the change in diluted earnings per share from 2018 to 2019. The increase in adjusted operating income in the table below includes the impact from unfavorable currency exchange rates in 2019. 2018 Earnings per share—diluted$3.50 Increase in operating income0.15 Impact of non-recurring tax benefit recognized as a result of the U.S. Tax Act(1.13)Increase in special charges(0.01)Decrease in transaction and integration expenses 0.06 Decrease in interest expense0.03 Increase in other income0.01 Impact of income taxes0.01 Increase in unconsolidated income0.02 Impact of higher shares outstanding(0.02)2019 Earnings per share—diluted$2.62 Results of Operations—Segments30Consumer Segment 20192018Net sales$3,269.8 $3,247.0 Percent growth0.7 %11.9 %Components of percent growth in net sales–increase (decrease):Volume and product mix2.4 %1.7 %Pricing actions0.1 %0.6 %Acquisitions— %8.2 %Foreign exchange(1.8)%1.4 %Segment operating income$676.3 $637.1 Segment operating income margin20.7 %19.6 %Sales of our consumer segment in 2019 grew by 0.7% as compared to 2018 and grew by 2.5% on a constant currency basis. Higher volume and product mix added 2.4% to sales, and pricing actions added 0.1%. These factors offset an unfavorable impact from foreign currency exchange rates that reduced consumer segment sales by 1.8% compared to 2018 and is excluded from our measure of sales growth of 2.5% on a constant currency basis.In the Americas, consumer sales rose 2.4% in 2019 as compared to 2018 and rose by 2.7% on a constant currency basis. Higher volume and product mix added 2.7% to sales, driven by new product sales as well as base business growth. The unfavorable impact of foreign currency exchange rates decreased sales by 0.3% compared to 2018 and is excluded from our measure of sales growth of 2.7% on a constant currency basis.In the EMEA region, consumer sales decreased 5.5% in 2019 as compared to 2018 and decreased 0.2% on a constant currency basis. Volume and product mix increased sales by 1.0%, led by new products and promotions that were partially offset by declines in private label sales. The impact of pricing actions reduced sales by 1.2%. The unfavorable impact of foreign currency exchange rates decreased sales by 5.3% compared to 2018 and is excluded from our measure of sales decline of 0.2% on a constant currency basis.In the Asia/Pacific region, consumer sales increased 0.8% as compared to 2018 and increased 5.7% on a constant currency basis. Higher volume and product mix added 2.9% to sales, led by strong sales in India and Southeast Asia. Pricing actions, primarily in China, added 2.8% to sales as compared to 2018. These factors offset an unfavorable impact from foreign currency exchange rates that decreased sales by 4.9% compared to 2018 and is excluded from our measure of sales growth of 5.7% on a constant currency basis.We grew segment operating income for our consumer segment by $39.2 million, or 6.1%, in 2019 compared to 2018. The favorable impact of higher sales and CCI-led cost savings more than offset increased conversion costs. On a constant currency basis, segment operating income for our consumer segment rose 7.3%. Segment operating income margin for our consumer segment rose by 110 basis points to 20.7% in 2019 from 19.6% in 2018, driven by an improvement in gross margin.Flavor Solutions Segment20192018Net sales$2,077.6 $2,055.8 Percent growth 1.1 %12.4 %Components of percent growth in net sales–increase (decrease):Volume and product mix2.9 %3.1 %Pricing actions0.3 %0.3 %Acquisitions— %8.2 %Foreign exchange(2.1)%0.8 %Segment operating income$302.2 $292.8 Segment operating income margin14.5 %14.2 %Sales of our flavor solutions segment increased 1.1% in 2019 as compared to 2018 and increased by 3.2% on a constant currency basis. Higher volume and product mix added 2.9% to sales and pricing actions added 0.3%. These factors partially offset an unfavorable impact from foreign currency exchange rates that reduced flavor solutions segment sales by 2.1% compared to 2018 and is excluded from our measure of sales growth of 3.2% on a constant currency basis.31In the Americas, flavor solutions sales rose 2.2% in 2019 as compared to 2018 and rose 2.6% on a constant currency basis. Higher volume and product mix added 2.4% to sales and included growth in new products as well as in base business, led by sales to packaged food companies. Pricing actions added 0.2% to sales in 2019. These factors offset an unfavorable impact from foreign currency exchange rates that reduced sales by 0.4% in 2019 compared to 2018 and is excluded from our measure of sales growth of 2.6% on a constant currency basis.In the EMEA region, flavor solutions sales decreased 0.3% in 2019 as compared to 2018 and increased 6.7% on a constant currency basis. Higher volume and product mix added 5.4% to sales in 2019 with contributions from new products as well as base business growth. The increase was led by sales to quick service restaurants and packaged foods companies. Pricing actions added 1.3% to sales in 2019. These factors partially offset an unfavorable impact from foreign currency exchange rates that decreased sales by 7.0% in 2019 compared to 2018 and is excluded from our measure of sales growth of 6.7% on a constant currency basis.In the Asia/Pacific region, flavor solutions sales decreased 3.4% in 2019 as compared to 2018 and increased 0.6% on a constant currency basis. Higher volume and product mix added 0.9% to sales and included increased sales to quick service restaurants, partially offset by the exit of certain low margin business. Pricing actions reduced sales in 2019 by 0.3%. These factors partially offset an unfavorable impact from foreign currency exchange rates that reduced sales by 4.0% in 2019 compared to 2018 and is excluded from our measure of sales growth of 0.6% on a constant currency basis.We grew segment operating income for our flavor solutions segment by $9.4 million, or 3.2%, in 2019 compared to 2018. The increase in segment operating income was driven by higher sales as well as lower SG&A expense. On a constant currency basis, segment operating income for our flavor solutions segment rose 5.3%. Segment operating income margin for our flavor solutions segment rose by 30 basis points to 14.5% in 2019 from 14.2% in 2018 and reflected the impact of lower SG&A expense as a percentage of net sales.NON-GAAP FINANCIAL MEASURESThe following tables include financial measures of adjusted operating income, adjusted income tax expense, adjusted income tax rate, adjusted net income and adjusted diluted earnings per share. These represent non-GAAP financial measures which are prepared as a complement to our financial results prepared in accordance with United States generally accepted accounting principles. These financial measures exclude the impact, as applicable, of the following:•Special charges – Special charges consist of expenses associated with certain actions undertaken by the Company to reduce fixed costs, simplify or improve processes, and improve our competitiveness and are of such significance in terms of both up-front costs and organizational/structural impact to require advance approval by our Management Committee. Upon presentation of any such proposed action (including details with respect to estimated costs, which generally consist principally of employee severance and related benefits, together with ancillary costs associated with the action that may include a non-cash component or a component which relates to inventory adjustments that are included in cost of goods sold; impacted employees or operations; expected timing; and expected savings) to the Management Committee and the Committee’s advance approval, expenses associated with the approved action are classified as special charges upon recognition and monitored on an ongoing basis through completion. In 2018, we also included in special charges, as approved by our Management Committee, expense associated with a one-time payment, made to eligible U.S. hourly employees, to distribute a portion of the non-recurring net income tax benefit recognized in connection with the enactment of the U.S. Tax Act as that non-recurring income tax benefit is excluded from our computation of adjusted income taxes, adjusted net income and adjusted diluted earnings per share, each a non-GAAP measure.•Transaction and integration expenses associated with the Cholula, FONA and RB Foods acquisitions – We exclude certain costs associated with our acquisitions of Cholula and FONA in November and December 2020, respectively, and RB Foods in August 2017 and their subsequent integration into the Company. Such costs, which we refer to as “Transaction and integration expenses”, include transaction costs associated with each acquisition, as well as integration costs following the respective acquisition, including the impact of the acquisition date fair value adjustment for inventory, together with the impact of discrete tax items, if any, directly related to each acquisition. 32•Income taxes associated with the U.S. Tax Act – In connection with the enactment of the U.S. Tax Act in December 2017, we recorded a net non-recurring income tax benefit of $301.5 million during the year ended November 30, 2018, which included the estimated impact of the tax benefit from revaluation of net U.S. deferred tax liabilities based on the new lower corporate income tax rate and the tax expense associated with the one-time transition tax on previously unremitted earnings of non-U.S. subsidiaries. We recorded an additional net income tax benefit of $1.5 million during the year ended November 30, 2019 associated with a U.S. Tax Act related provision to return adjustment.Details with respect to the composition of transaction and integration expenses, special charges and non-recurring income tax benefits associated with the U.S. Tax Act recorded for the years and in the amounts set forth below are included in notes 2, 3 and 13, respectively, of notes to our consolidated financial statements. We believe that these non-GAAP financial measures are important. The exclusion of the items noted above provides additional information that enables enhanced comparisons to prior periods and, accordingly, facilitates the development of future projections and earnings growth prospects. This information is also used by management to measure the profitability of our ongoing operations and analyze our business performance and trends.These non-GAAP financial measures may be considered in addition to results prepared in accordance with GAAP, but they should not be considered a substitute for, or superior to, GAAP results. In addition, these non-GAAP financial measures may not be comparable to similarly titled measures of other companies because other companies may not calculate them in the same manner that we do. We intend to continue to provide these non-GAAP financial measures as part of our future earnings discussions and, therefore, the inclusion of these non-GAAP financial measures will provide consistency in our financial reporting. A reconciliation of these non-GAAP measures to GAAP financial results is provided below:202020192018Operating income$999.5 $957.7 $891.1 Impact of transaction and integration expenses 12.4 — 22.5 Impact of special charges 6.9 20.8 16.3 Adjusted operating income$1,018.8 $978.5 $929.9 % increase versus prior year4.1 %5.2 %18.7 %Adjusted operating income margin (1)18.2 %18.3 %17.5 %Income tax expense (benefit) $174.9 $157.4 $(157.3)Non-recurring benefit, net, of the U.S. Tax Act (2)— 1.5 301.5 Impact of transaction and integration expenses1.9 — 4.9 Impact of special charges2.1 4.7 3.8 Adjusted income tax expense$178.9 $163.6 $152.9 Adjusted income tax rate(3)19.9 %19.5 %19.6 %Net income$747.4 $702.7 $933.4 Impact of transaction and integration expenses 10.5 — 17.6 Impact of special charges4.8 16.1 12.5 Non-recurring benefit, net, of the U.S. Tax Act (2)— (1.5)(301.5)Adjusted net income$762.7 $717.3 $662.0 % increase versus prior year6.3 %8.4 %21.1 %Earnings per share—diluted$2.78 $2.62 $3.50 Impact of transaction and integration expenses 0.04 — 0.06 Impact of special charges 0.01 0.06 0.05 Non-recurring benefit, net, of the U.S. Tax Act (2)— — (1.13)Adjusted earnings per share—diluted$2.83 $2.68 $2.48 (1)Adjusted operating income margin is calculated as adjusted operating income as a percent of net sales for each period presented.(2)The non-recurring income tax benefit, net, associated with enactment of the U.S. Tax Act of $1.5 million and $301.5 million for the years ended November 30, 2019 and 2018, respectively, is more fully described in note 13 of notes to our consolidated financial statements. (3)Adjusted income tax rate is calculated as adjusted income tax expense as a percent of income from consolidated operations before income taxes, excluding transaction and integration expenses and special charges, or $900.8 million, $840.0 million, and $780.1 million for the years ended November 30, 2020, 2019, and 2018, respectively.33Estimate for the year ending November 30, 2021Earnings per share – diluted$2.71 to $2.76Impact of transaction and integration expenses (1)0.18Impact of special charges 0.02Adjusted earnings per share – diluted$2.91 to $2.96(1)Transaction and integration expenses include estimated transaction and integration expenses associated with our acquisitions of Cholula and FONA. These expenses include anticipated transaction expenses, integration expenses, including the effect of the fair value adjustment of acquired inventory on cost of goods sold and the unfavorable impact of a discrete item on income tax expenses directly related to our December 2020 acquisition of FONA, which we expect will approximate $0.04 per diluted share, and is included in the after-tax impact of transaction and integration expenses of $0.18 per diluted share estimated for the year ending November 30, 2021.Because we are a multi-national company, we are subject to variability of our reported U.S. dollar results due to changes in foreign currency exchange rates. Those changes have been volatile over the past several years. The exclusion of the effects of foreign currency exchange, or what we refer to as amounts expressed “on a constant currency basis,” is a non-GAAP measure. We believe that this non-GAAP measure provides additional information that enables enhanced comparison to prior periods excluding the translation effects of changes in rates of foreign currency exchange and provides additional insight into the underlying performance of our operations located outside of the U.S. It should be noted that our presentation herein of amounts and percentage changes on a constant currency basis does not exclude the impact of foreign currency transaction gains and losses (that is, the impact of transactions denominated in other than the local currency of any of our subsidiaries in their local currency reported results).Percentage changes in sales and adjusted operating income expressed on a constant currency basis are presented excluding the impact of foreign currency exchange. To present this information for historical periods, current year results for entities reporting in currencies other than the U.S. dollar are translated into U.S. dollars at the average exchange rates in effect during the prior fiscal year, rather than at the actual average exchange rates in effect during the current fiscal year. As a result, the foreign currency impact is equal to the current year results in local currencies multiplied by the change in the average foreign currency exchange rate between the current year and the prior fiscal year. The tables set forth below present our growth in net sales and adjusted operating income on a constant currency basis as follows: (1) to present our growth in net sales and adjusted operating income for 2020 on a constant currency basis, net sales and adjusted operating income for 2020 for entities reporting in currencies other than the U.S. dollar have been translated using the average foreign exchange rates in effect for 2019 and compared to the reported results for 2019; and (2) to present our growth in net sales and adjusted operating income for 2019 on a constant currency basis, net sales and operating income for 2019 for entities reporting in currencies other than the U.S. dollar have been translated using the average foreign exchange rates in effect for 2018 and compared to the reported results for 2018. 34For the year ended November 30, 2020Percentage change as reportedImpact of foreign currency exchangePercentage change on constant currency basisNet sales:Consumer segment:Americas13.9 %(0.1)%14.0 %EMEA14.5 %0.2 %14.3 %Asia/Pacific(16.6)%(1.5)%(15.1)%Total Consumer10.0 %(0.3)%10.3 %Flavor Solutions segment:Americas(3.5)%(1.0)%(2.5)%EMEA(5.5)%(1.3)%(4.2)%Asia/Pacific0.4 %(1.2)%1.6 %Total Flavor Solutions(3.5)%(1.1)%(2.4)%Total net sales4.7 %(0.6)%5.3 %Adjusted operating income:Consumer segment15.5 %(0.2)%15.7 %Flavor Solutions segment(21.3)%(1.6)%(19.7)%Total adjusted operating income4.1 %(0.7)%4.8 %For the year ended November 30, 2019Percentage changeas reportedImpact of foreign currency exchangePercentage change on constant currency basisNet sales:Consumer segment:Americas2.4 %(0.3)%2.7 %EMEA(5.5)%(5.3)%(0.2)%Asia/Pacific0.8 %(4.9)%5.7 %Total Consumer0.7 %(1.8)%2.5 %Flavor Solutions segment:Americas2.2 %(0.4)%2.6 %EMEA(0.3)%(7.0)%6.7 %Asia/Pacific(3.4)%(4.0)%0.6 %Total Flavor Solutions1.1 %(2.1)%3.2 %Total net sales0.8 %(1.9)%2.7 %Adjusted operating income:Consumer segment6.1 %(1.2)%7.3 %Flavor Solutions segment3.2 %(2.1)%5.3 %Total adjusted operating income5.2 %(1.5)%6.7 %To present the percentage change in projected 2021 net sales, adjusted operating income and adjusted earnings per share — diluted on a constant currency basis, 2021 projected local currency net sales, adjusted operating income, and adjusted net income for entities reporting in currencies other than the U.S. dollar are translated into U.S. dollars at currently prevailing exchange rates and are compared to those 2021 local currency projected results, translated into U.S. dollars at the average actual exchange rates in effect during the corresponding months in fiscal year 2020 to determine what the 2021 consolidated U.S. dollar net sales, adjusted operating income and adjusted earnings per share — diluted would have been if the relevant currency exchange rates had not changed from those of the comparable 2020 periods. 35Projections for the Year Ending November 30, 2021Percentage change in net sales7% to 9%Impact of favorable foreign currency exchange2 %Percentage change in net sales in constant currency5% to 7%Percentage change in adjusted operating income8% to 10%Impact of favorable foreign currency exchange2 %Percentage change in adjusted operating income in constant currency6% to 8%Percentage change in adjusted earnings per share— diluted3% to 5%Impact of favorable foreign currency exchange2 %Percentage change in adjusted earnings per share— diluted in constant currency1% to 3%In addition to the above non-GAAP financial measures, we use a leverage ratio which is determined using non-GAAP measures. A leverage ratio is a widely-used measure of ability to repay outstanding debt obligations and is a meaningful metric to investors in evaluating financial leverage. We believe that our leverage ratio is a meaningful metric to investors in evaluating our financial leverage, although our method to calculate our leverage ratio may be different than the method used by other companies to calculate such a leverage ratio. We determine our leverage ratio as net debt (which we define as total debt, net of cash in excess of $75.0 million) to adjusted earnings before interest, tax, depreciation and amortization (Adjusted EBITDA). We define Adjusted EBITDA as net income plus expenses for interest, income taxes, depreciation and amortization, less interest income and as further adjusted for cash and non-cash acquisition-related expenses (which may include the effect of the fair value adjustment of acquired inventory on cost of goods sold), special charges, stock-based compensation expenses, and certain gains or losses (which may include third party fees and expenses and integration costs). Adjusted EBITDA and our leverage ratio are both non-GAAP financial measures. Our determination of the leverage ratio is consistent with the terms of our revolving credit facilities, which require us to maintain our leverage ratio below certain levels. Under those agreements, the applicable leverage ratio is reduced periodically. As of November 30, 2020, our capacity under the revolving credit facilities was not affected by these covenants. In early fiscal 2021 following our acquisition of FONA, the levels specified in our revolving credit facilities under which we are required to maintain our leverage ratios were amended by the participating banks to increase the permitted maximum leverage ratios. We do not expect that these covenants would limit our access to our revolving credit facilities for the foreseeable future; however, the leverage ratio could restrict our ability to utilize these facilities. We expect to comply with this financial covenant for the foreseeable future.The following table reconciles our net income to Adjusted EBITDA for the years ended November 30:202020192018Net income$747.4 $702.7 $933.4 Depreciation and amortization165.0 158.8 150.7 Interest expense135.6 165.2 174.6 Income tax expense (benefit)174.9 157.4 (157.3)EBITDA1,222.9 1,184.1 1,101.4 Adjustments to EBITDA (1)57.5 47.9 57.3 Adjusted EBITDA$1,280.4 $1,232.0 $1,158.7 Net debt (2)$4,555.8 $4,243.8 $4,674.8 Leverage ratio (Net debt/Adjusted EBITDA) (3)3.6 3.4 4.0 36(1)Adjustments to EBITDA are determined under the leverage ratio covenant in our revolving credit facilities and include special charges, stock-based compensation expense, interest income and, for the years ended November 30, 2020 and 2018, transaction and integration expenses.(2)The leverage ratio covenant in our revolving credit facilities define net debt as the sum of short-term borrowings, current portion of long-term debt, and long-term debt, less the amount of cash and cash equivalents that exceed $75.0 million. (3)The leverage ratio covenant in our revolving credit facilities provide that Adjusted EBITDA also includes the pro forma impact of acquisitions. As of November 30, 2020, our leverage ratio under the terms of those agreements, including the pro forma impact of acquisitions was 3.5.Our long-term target for our leverage ratio is 1.5 to 2.0. Our leverage ratio can be temporarily impacted by our acquisition activity.LIQUIDITY AND FINANCIAL CONDITION202020192018Net cash provided by operating activities$1,041.3 $946.8 $821.2 Net cash used in investing activities(1,025.6)(171.0)(158.5)Net cash provided by (used in) financing activities220.9 (725.8)(751.1)We generate strong cash flow from operations which enables us to fund operating projects and investments that are designed to meet our growth objectives, service our debt, increase our dividend, fund capital projects and other investments, and make share repurchases when appropriate. Due to the cyclical nature of a portion of our business, our cash flow from operations has historically been the strongest during the fourth quarter. In the cash flow statement, the changes in operating assets and liabilities are presented excluding the effects of changes in foreign currency exchange rates, as these do not reflect actual cash flows. In addition, in the cash flow statement, the changes in operating assets and liabilities are presented excluding the effect of acquired operating assets and liabilities, as the cash flows associated with acquisition of businesses is presented as an investing activity. Accordingly, the amounts in the cash flow statement do not agree with changes in the operating assets and liabilities that are presented in the balance sheet.The reported values of our assets and liabilities held in our non-U.S. subsidiaries and affiliates can be significantly affected by fluctuations in foreign exchange rates between periods. At November 30, 2020, the exchange rates for the Euro, British pound sterling, Canadian dollar, Australian dollar, Chinese renminbi and Polish zloty were higher versus the U.S. dollar than at November 30, 2019. During 2020, we have seen greater-than-normal fluctuations in foreign exchanges rates as a result of increased market volatility driven by the global COVID-19 pandemic. Operating Cash Flow – Operating cash flow was $1,041.3 million in 2020, $946.8 million in 2019, and $821.2 million in 2018. The increases in cash flow from operations in both 2020 and 2019 were primarily due to higher net income, exclusive of the 2018 impact of the non-cash non-recurring net income tax benefit of $309.4 million related to the U.S. Tax Act. In addition, as more fully described below, our working capital management impacted operating cash flow. In 2020, the increases to operating cash flow were the result of a significantly lower use of cash associated with other assets and liabilities, including the timing of certain employee incentive and customer related payments, which was partially offset by the use of cash associated with working capital, driven by the increased level of inventory to meet demand. In 2019 and 2018, our working capital management favorably impacted operating cash flow. In 2019, those increases were partially offset by a use of cash associated with other assets and liabilities, totaling $81.5 million. In 2018, those increases were partially offset by a higher use of cash from other operating assets and liabilities partially related to the timing of our payment of transaction and integration expenses as well as of interest on indebtedness related to our acquisition of RB Foods. Our working capital management – principally related to inventory, trade accounts receivable, and accounts payable – impacts our operating cash flow. The change in inventory had a significant impact on the variability in cash flow from operations. It was a use of cash in 2020, 2019 and 2018. The change in trade accounts receivable was a source of cash in 2020, 2019 and 2018. The change in accounts payable was a significant source of cash in all three years. In addition to operating cash flow, we also use cash conversion cycle (CCC) to measure our working capital management. This metric is different than operating cash flow in that it uses average balances instead of specific point in time measures. CCC is a calculation of the number of days, on average, that it takes us to convert a cash outlay for resources, such as raw materials, to a cash inflow from collection of accounts receivable. Our goal is to lower our CCC over time. We calculate CCC as follows:37Days sales outstanding (average trade accounts receivable divided by average daily net sales) plus days in inventory (average inventory divided by average daily cost of goods sold) less days payable outstanding (average trade accounts payable divided by average daily cost of goods sold plus the average daily change in inventory).The following table outlines our cash conversion cycle (in days) over the last three years:202020192018Cash Conversion Cycle39 43 55 The decreases in CCC in 2020 from 2019 and in 2019 from 2018 were due, in both instances, to an increase in our days payable outstanding as a result of extending our payment terms to suppliers, as more fully described below, and to a lesser extent, by a decrease in our days sales outstanding. Our CCC is also impacted by days in inventory which increased in 2020 as compared to 2019 and also in 2019 as compared to 2018. Prior to fiscal 2018, in response to evolving market practices, we began a program to negotiate extended payment terms with our suppliers. We also initiated a Supply Chain Finance program (SCF) with several global financial institutions (SCF Banks). Under the SCF, qualifying suppliers may elect to sell their receivables from us to an SCF Bank. These participating suppliers negotiate their receivables sales arrangements directly with the respective SCF Bank. While we are not party to those agreements, the SCF Banks allow the participating suppliers to utilize our creditworthiness in establishing credit spreads and associated costs. This generally provides the suppliers with more favorable terms than they would be able to secure on their own. We have no economic interest in a supplier’s decision to sell a receivable. Once a qualifying supplier elects to participate in the SCF and reaches an agreement with a SCF Bank, the supplier elects which of our individual invoices they sell to the SCF bank. However, all of our payments to participating suppliers are paid to the SCF Bank on the invoice due date, regardless of whether the individual invoice is sold by the supplier to the SCF Bank. The SCF Bank pays the supplier on the invoice due date for any invoices that were not previously sold by the supplier to the SCF Bank.The terms of our payment obligation are not impacted by a supplier’s participation in the SCF. Our payment terms with our suppliers for similar materials within individual markets are consistent between those suppliers that elect to participate in the SCF and those suppliers that do not participate. Accordingly, our average days outstanding are not significantly impacted by the portion of suppliers or related input costs that are included in the SCF. For our participating suppliers, we believe substantially all of their receivables with us are sold to the SCF Banks. Accordingly, we would expect that at each balance sheet date, a similar proportion of amounts originally due to suppliers would instead be payable to SCF Banks. All outstanding amounts related to suppliers participating in the SCF are recorded within the line entitled "Trade accounts payable" in our consolidated balance sheets, and the associated payments are included in operating activities within our consolidated statements of cash flows. As of November 30, 2020 and 2019, the amount due to suppliers participating in the SCF and included in "Trade accounts payable" were approximately $273.6 million and $206.5 million, respectively.Future changes in our suppliers’ financing policies or economic developments, such as changes in interest rates, general market liquidity or our creditworthiness relative to participating suppliers could impact those suppliers’ participation in the SCF and/or our ability to negotiate extended payment terms with our suppliers. However, any such impacts are difficult to predict.Investing Cash Flow – Net cash used in investing activities was $1,025.6 million in 2020, $171.0 million in 2019, and $158.5 million in 2018. Our primary investing cash flows include the usage of cash associated with acquisition of businesses and capital expenditures. Cash usage related to our acquisitions of businesses were $803.0 million in 2020 and $4.2 million in 2018. Capital expenditures, including expenditures for capitalized software, were $225.3 million in 2020, $173.7 million in 2019, and $169.1 million in 2018. We expect 2021 capital expenditures to approximate $265 million to support our planned growth, including the multi-year program to replace our ERP system and other initiatives.Financing Cash Flow – Net cash associated with financing activities was a source of cash of $220.9 million in 2020. Net cash used in financing activities was $725.8 million in 2019 and $751.1 million in 2018. The variability between years is principally a result of changes in our net borrowings, share repurchase activity and dividends, all as described below. The following table outlines our net borrowing activities:38202020192018Net increase in short-term borrowings$286.5 $41.0 $305.5 Proceeds from issuance of long-term debt, net of debt issuance costs525.9 — 25.9 Repayments of long-term debt(257.7)(447.7)(797.9)Net cash provided from (used in) borrowing activities$554.7 $(406.7)$(466.5)In 2020, we borrowed $527.0 million under long-term borrowing arrangements, including net proceeds of $495.0 million of 2.5% notes due April 2030. We also repaid $257.7 million of long-term debt, including $250.0 million associated with our term loans due in August 2020.In 2019, we repaid $447.7 million of long-term debt, including $436.3 million of our $1,500.0 million term loans issued in August 2017. In 2018, we borrowed $25.9 million under long-term borrowing arrangements. In 2018, we repaid $797.9 million of long-term debt, including the $250 million 5.75% notes that matured on December 15, 2017 and $545.0 million of our $1,500.0 million term loans issued in August 2017.Through November 30, 2020, we have repaid in full the $1,500.0 million term loans issued in connection with our acquisition of RB Foods in August 2017, with a total of $1,275.0 million of those term loans repaid in advance of their scheduled maturities, which were in August 2020 and August 2022.The following table outlines the activity in our share repurchase programs:202020192018Number of shares of common stock0.5 1.3 1.1 Dollar amount$47.3 $95.1 $62.3 As of November 30, 2020, $585 million remained of a $600 million share repurchase program that was authorized by our Board of Directors in November 2019. The timing and amount of any shares repurchased is determined by our management based on its evaluation of market conditions and other factors. As a result of the increased level of indebtedness related to the acquisition of RB Foods in August 2017, we curtailed our share repurchase activity since that time. Although we have curtailed our share repurchase activity, we repurchased shares in 2020, 2019 and 2018 to mitigate the effect of shares issued upon the exercise of stock options. As a result of the additional indebtedness associated with our acquisitions of Cholula and FONA, we expect to continue the curtailment of share repurchase activity in fiscal 2021 while also continuing to mitigate the effect of shares issued upon the exercise of stock options.During 2020, 2019 and 2018, we received proceeds of $56.6 million, $90.9 million and $78.2 million, respectively, from exercised stock options. We repurchased $13.0 million, $12.7 million and $11.6 million of common stock during 2020, 2019 and 2018, respectively, in conjunction with employee tax withholding requirements associated with our stock compensation plans. Our dividend history over the past three years is as follows:202020192018Total dividends paid$330.1 $302.2 $273.4 Dividends paid per share1.24 1.14 1.04 Percentage increase per share8.8 %9.6 %10.6 %In November 2020, the Board of Directors approved an 9.7% increase in the quarterly dividend from $0.31 to $0.34 per share. The following table presents our leverage ratios for the years ended November 30, 2020, 2019 and 2018:202020192018Leverage ratio (1)3.6 3.4 4.0(1)The leverage ratio covenant in our revolving credit facilities provides that Adjusted EBITDA under that covenant also include the pro forma impact of acquisitions, as applicable. As of November 30, 2020, our leverage ratio under the terms of those revolving credit facilities, including the pro forma impact of acquisitions, was 3.5.Our leverage ratio was 3.6 as of November 30, 2020, as compared to the ratios of 3.4 and 4.0 as of November 30, 2019 and 2018, respectively. The increase in our leverage ratio from 3.4 as of November 30, 2019 to 3.6 as of November 30, 2020 is principally due to an increase in total debt associated with the funding of our acquisition of Cholula, which was partially offset by an increase in adjusted EBITDA. 39The decrease in the ratio from 4.0 as of November 30, 2018 to 3.4 as of November 30, 2019 is principally due to an increase in our adjusted EBITDA, which was driven by higher operating income in 2019 as compared to 2018. In addition, the ratio was favorably impacted by our lower level of net debt at November 30, 2019 as compared to the prior year-end. In early fiscal 2021 following our acquisition of FONA, the levels specified in our revolving credit facilities under which we are required to maintain our leverage ratios were amended by the participating banks to increase the permitted maximum leverage ratios. As amended, the maximum permitted leverage ratios under the terms of those revolving credit facilities, including the pro form impact of acquisitions, is 4.5 as of the measurement date at the end of each fiscal quarter in the year ending November 30, 2021. That maximum ratio drops to 4.25 on February 28, 2022, and drops to 3.75 for each fiscal quarter for the remaining term of the facility. At the same time in early fiscal 2021, a similar amendment was made to our synthetic lease agreement for a to-be-constructed distribution center, which contains covenants consistent with our revolving credit facilities.Most of our cash is in our subsidiaries outside of the U.S. We manage our worldwide cash requirements by considering available funds among the many subsidiaries through which we conduct our business and the cost effectiveness with which those funds can be accessed. Prior to the enactment of the U.S. Tax Act on December 22, 2017, the permanent repatriation of cash balances from certain of our non-U.S. subsidiaries could have had adverse tax consequences; however, those balances are generally available without legal restrictions to fund ordinary business operations, capital projects and future acquisitions. As of November 30, 2020, we have $1.3 billion of earnings from our non-U.S. subsidiaries and joint ventures that are considered indefinitely reinvested. While federal income tax expense has been recognized as a result of the U.S. Tax Act, we have not provided any additional deferred taxes with respect to items such as foreign withholding taxes, state income taxes, or foreign exchange gains or losses. It is not practicable for us to determine the amount of unrecognized tax expense on these indefinitely reinvested foreign earnings.At November 30, 2020, we temporarily used $100.0 million of cash from our non-U.S. subsidiaries to pay down short-term debt in the U.S. During the year, our short-term borrowings vary, but are lower at the end of a year or quarter. The average short-term borrowings outstanding for the years ended November 30, 2020 and 2019 were $518.1 million and $848.6 million, respectively. Those average short-term borrowings outstanding for the year ended November 30, 2020 included average commercial paper outstanding of $452.0 million. The total average debt outstanding for the years ended November 30, 2020 and 2019 was $4,327.4 million and $4,753.8 million, respectively.See notes 6 and 8 of notes to our consolidated financial statements for further details of these transactions.Credit and Capital Markets – The following summarizes the more significant impacts of credit and capital markets on our business:CREDIT FACILITIES – Cash flows from operating activities are our primary source of liquidity for funding growth, share repurchases, dividends and capital expenditures. We also rely on our revolving credit facilities, or borrowings backed by these facilities, to fund seasonal working capital needs and other general corporate requirements. 40In August 2017, we entered into a five-year $1.0 billion revolving credit facility, which will expire in August 2022. The current pricing for the credit facility, on a fully drawn basis, is LIBOR plus 1.25%. The pricing of the credit facility is based on a credit rating grid that contains a fully drawn maximum pricing of the credit facility equal to LIBOR plus 1.75%. In December 2020, we entered into a 364-day $1.0 billion revolving credit facility, which will expire in December 2021. The current pricing for that 364-day credit facility, on a fully drawn basis, is LIBOR plus 1.25%. The pricing of the 364-day credit facility is based on a credit rating grid that contains a fully drawn maximum pricing of the credit facility equal to LIBOR plus 1.75%. In early fiscal 2021, following our acquisition of FONA, the levels specified in our revolving credit facilities under which we are required to maintain our leverage ratios were amended by the participating banks to increase the permitted maximum leverage ratios. Our long-term target for our leverage ratio is 1.5 to 2.0. Our leverage ratio can be temporarily impacted by our acquisition activity.We generally use these revolving credit facilities to support our issuance of commercial paper. If the commercial paper market is not available or viable, we could borrow directly under our revolving credit facilities. These facilities are made available by a syndicate of banks, with various commitments per bank. If any of the banks in this syndicate are unable to perform on their commitments, our liquidity could be impacted, which could reduce our ability to grow through funding of seasonal working capital. We engage in regular communication with all banks participating in our credit facilities. During these communications, none of the banks have indicated that they may be unable to perform on their commitments. In addition, we periodically review our banking and financing relationships, considering the stability of the institutions and other aspects of the relationships. Based on these communications and our monitoring activities, we believe our banks will perform on their commitments. In addition to our committed revolving credit facilities, we have uncommitted facilities of $316.6 million as of November 30, 2020 that can be withdrawn based upon the lenders' discretion. See note 6 of notes to our consolidated financial statements for more details on our financing arrangements.We will continue to have cash requirements to support seasonal working capital needs and capital expenditures, to pay interest, to service debt, and to fund acquisitions. To meet those cash requirements, we intend to use our existing cash, cash equivalents and internally generated funds, to borrow under our existing credit facilities or under other short-term borrowing facilities, and depending on market conditions and upon the significance of the cost of a particular acquisition to our then-available sources of funds, to obtain additional short- and long-term financing. We believe that cash provided from these sources will be adequate to meet our cash requirements over the next twelve months. We recently funded the Cholula and FONA acquisitions with cash and short-term borrowings, principally under commercial paper. We will continue to monitor our liquidity and may seek to obtain additional long-term financing to further support our business.PENSION ASSETS AND OTHER INVESTMENTS – We hold investments in equity and debt securities in both our qualified defined benefit pension plans and through a rabbi trust for our nonqualified defined benefit pension plan. Cash contributions to pension plans, including unfunded plans, were $11.9 million in 2020, $11.4 million in 2019, and $13.5 million in 2018. It is expected that the 2021 total pension plan contributions will be approximately $10.0 million. Future increases or decreases in pension liabilities and required cash contributions are highly dependent on changes in interest rates and the actual return on plan assets. We base our investment of plan assets, in part, on the duration of each plan’s liabilities. Across all of our qualified defined benefit pension plans, approximately 59% of assets are invested in equities, 31% in fixed income investments and 10% in other investments. Assets associated with our nonqualified defined benefit pension plan are primarily invested in corporate-owned life insurance, the value of which approximates an investment mix of 60% in equities and 40% in fixed income investments. See note 11 of notes to our consolidated financial statements, which provides details on our pension funding.CUSTOMERS AND COUNTERPARTIES – See the subsequent section of this discussion under the heading "Market Risk Sensitivity–Credit Risk".ACQUISITIONSAcquisitions are part of our strategy to increase sales and profits.41In early fiscal 2021, we purchased FONA. The purchase price was approximately $710 million, net of cash acquired, subject to certain customary purchase price adjustments. FONA is a leading manufacturer of clean and natural flavors providing solutions for a diverse customer base across various applications for the food, beverage and nutritional markets. Our acquisition of FONA on December 30, 2020 expands the breadth of our flavor solutions segment into attractive categories, as well as extends our technology platform and strengthens our capabilities. The acquisition was funded with cash and short-term borrowings.On November 30, 2020, we purchased Cholula for approximately $803 million, net of cash acquired, subject to certain customary purchase price adjustments. The acquisition was funded with cash and short-term borrowings. Cholula, a premium Mexican hot sauce brand, is a strong addition to McCormick’s global branded flavor portfolio, which broadens the Company’s offering in the high growth hot sauce category to consumers and foodservice operators and accelerates our condiment growth opportunities with a complementary authentic Mexican flavor hot sauce. The results of Cholula’s operations have been included in our financial statements as a component of our consumer and flavor solutions segments from the date of acquisition.We did not have any acquisitions in fiscal 2019. In fiscal 2018, we purchased the remaining 10% minority ownership interest in our Shanghai subsidiary for a cash payment of $12.7 million.See notes 2 and 19 of notes to our consolidated financial statements for further details regarding these acquisitions.PERFORMANCE GRAPH — SHAREHOLDER RETURNThe following line graph compares the yearly change in McCormick’s cumulative total shareholder return (stock price appreciation plus reinvestment of dividends) on McCormick’s Non-Voting Common Stock with (1) the cumulative total return of the Standard & Poor’s 500 Stock Price Index, assuming reinvestment of dividends, and (2) the cumulative total return of the Standard & Poor’s Packaged Foods & Meats Index, assuming reinvestment of dividends.42MARKET RISK SENSITIVITYWe utilize derivative financial instruments to enhance our ability to manage risk, including foreign exchange and interest rate exposures, which exist as part of our ongoing business operations. We do not enter into contracts for trading purposes, nor are we a party to any leveraged derivative instrument. The use of derivative financial instruments is monitored through regular communication with senior management and the utilization of written guidelines. The information presented below should be read in conjunction with notes 6 and 8 of notes to our consolidated financial statements.Foreign Exchange Risk – We are exposed to fluctuations in foreign currency in the following main areas: cash flows related to raw material purchases; the translation of foreign currency earnings to U.S. dollars; the effects of foreign currency on loans between subsidiaries and unconsolidated affiliates and on cash flows related to repatriation of earnings of unconsolidated affiliates. Primary exposures include the U.S. dollar versus the Euro, British pound sterling, Canadian dollar, Polish zloty, Australian dollar, Mexican peso, Swiss franc, Chinese renminbi, Indian rupee and Thai baht, as well as the Euro versus the British pound sterling and Australian dollar, and finally the Canadian dollar versus British pound sterling. We routinely enter into foreign currency exchange contracts to manage certain of these foreign currency risks.During 2020, the foreign currency translation component in other comprehensive income was principally related to the impact of exchange rate fluctuations on our net investments in our subsidiaries with a functional currency of the British pound sterling, Euro, Polish zloty, Chinese yuan, Australian dollar, Canadian dollar and Mexican peso. 43We also utilize cross currency interest rate swap contracts, which are designated as net investment hedges, to manage the impact of exchange rate fluctuations on our net investments in subsidiaries with a functional currency of the British pound sterling and Euro. Gains and losses on these instruments are included in foreign currency translation adjustments in accumulated other comprehensive income (loss).The following table summarizes the foreign currency exchange contracts held at November 30, 2020. All contracts are valued in U.S. dollars using year-end 2020 exchange rates and have been designated as hedges of foreign currency transactional exposures, firm commitments or anticipated transactions.FOREIGN CURRENCY EXCHANGE CONTRACTS AT NOVEMBER 30, 2020Currency soldCurrency receivedNotionalvalueAveragecontractualexchangerateFair value British pound sterlingU.S. dollar$31.6 1.32 $(0.4)EuroU.S. dollar29.2 1.19 (0.3)Canadian dollarU.S. dollar96.4 0.76 (1.4)U.S. dollarAustralian dollar14.0 0.68 1.2 Polish zlotyU.S. dollar6.9 3.79 (0.1)Canadian dollarBritish pound sterling30.0 1.74 (0.1)British pound sterlingEuro36.4 0.90 (0.1)Australian dollarEuro45.1 1.67 (1.1)Swiss francU.S. dollar73.1 1.04 (4.6)We had a number of smaller contracts at November 30, 2020 with an aggregate notional value of $21.1 million to purchase or sell other currencies, such as the Romanian leu, Russian ruble, and Singapore dollar. The aggregate fair value of these contracts was $0.1 million at November 30, 2020.At November 30, 2019, we had foreign currency exchange contracts for the Euro, British pound sterling, Canadian dollar, Australian dollar, Polish zloty, Swiss franc and other currencies, with a notional value of $489.2 million. The aggregate fair value of these contracts was a loss of $0.3 million at November 30, 2019.We also utilized cross currency interest rate swap contracts that are considered net investment hedges. As of November 30, 2020, we had cross currency interest rate swap contracts of (i) $250 million notional value to receive $250 million at three-month U.S. LIBOR plus 0.685% and pay £194.1 million at three-month GBP LIBOR plus 0.740% and (ii) £194.1 million notional value to receive £194.1 million at three-month GBP LIBOR plus 0.740% and pay €221.8 million at three-month Euro EURIBOR plus 0.808%. We entered into these cross-currency interest rate swap contracts, which expire in August 2027, in early fiscal 2019. For more information, refer to note 8 of notes to our consolidated financial statements.Interest Rate Risk – Our policy is to manage interest rate risk by entering into both fixed and variable rate debt arrangements. We also use interest rate swaps to minimize worldwide financing costs and to achieve a desired mix of fixed and variable rate debt. The table that follows provides principal cash flows and related interest rates, excluding the effect of interest rate swaps and the amortization of any discounts or fees, by fiscal year of maturity at November 30, 2020. For foreign currency-denominated debt, the information is presented in U.S. dollar equivalents. Variable interest rates are based on the weighted-average rates of the portfolio at the end of the year presented.YEARS OF MATURITY AT NOVEMBER 30, 20202021202220232024ThereafterTotal Fair valueDebtFixed rate$257.2 $757.6 $257.8 $763.2 $1,902.1 $3,937.9 $4,294.1 Average interest rate3.89 %2.71 %3.50 %3.50 %2.68 %— — Variable rate$893.4 $7.4 $7.4 $28.7 $12.7 $949.6 $949.7 Average interest rate0.34 %1.38 %1.38 %1.73 %1.78 %— — The table above displays the debt, including capital leases, by the terms of the original debt instrument without consideration of fair value, interest rate swaps and any loan discounts or origination fees. Interest rate swaps have the following effects:•We issued $250 million of 3.90% notes due in 2021 in July 2011. Forward treasury lock agreements, settled upon the issuance of these notes in 2011, effectively set the interest rate on the $250 million notes at a weighted-average fixed rate of 4.01%.•We issued $250 million of 3.50% notes due in 2023 in August 2013. Forward treasury lock agreements settled upon issuance of these notes effectively set the interest rate on these notes at a weighted-average fixed rate of 3.30%. 44•We issued $250 million of 3.25% notes due in 2025 in November 2015. Forward treasury lock agreements settled upon issuance of these notes effectively set the interest rate on these notes at a weighted-average fixed rate of 3.45%. The fixed interest rate on $100 million of the 3.25% notes due in December 2025 was effectively converted to a variable rate by interest rate swaps through 2025. Net interest payments are based on 3-month LIBOR plus 1.22% during this period. •We issued an aggregate amount of $2.5 billion of senior unsecured notes in August 2017. These notes are due as follows: $750 million due August 15, 2022, $700 million due August 15, 2024, $750 million due August 15, 2027 and $300 million due August 15, 2047 with stated fixed interest rates of 2.70%, 3.15%, 3.40% and 4.20%, respectively. Forward treasury lock agreements settled upon issuance of the $750 million notes due August 15, 2027 effectively set the interest rate on these $750 million notes at a weighted-average fixed rate of 3.44%. The fixed interest rate on $250 million of the 3.40% notes due in 2027 was effectively converted to a variable rate by interest rate swaps through 2027. Net interest payments are based on 3-month LIBOR plus 0.685% during this period.Commodity Risk – We purchase certain raw materials which are subject to price volatility caused by weather, market conditions, growing and harvesting conditions, governmental actions and other factors beyond our control. In 2020, our most significant raw materials were dairy products, pepper, vanilla, capsicums (red peppers and paprika), garlic, onion, rice and wheat flour. While future movements of raw material costs are uncertain, we respond to this volatility in a number of ways, including strategic raw material purchases, purchases of raw material for future delivery and customer price adjustments. We generally have not used derivatives to manage the volatility related to this risk. To the extent that we have used derivatives for this purpose, it has not been material to our business.Credit Risk – The customers of our consumer segment are predominantly food retailers and food wholesalers. Consolidations in these industries have created larger customers. In addition, competition has increased with the growth in alternative channels including mass merchandisers, dollar stores, warehouse clubs, discount chains and e-commerce. This has caused some customers to be less profitable and increased our exposure to credit risk. Some of our customers and counterparties are highly leveraged. We continue to closely monitor the credit worthiness of our customers and counterparties. We feel that the allowance for doubtful accounts properly recognizes trade receivables at realizable value. We consider nonperformance credit risk for other financial instruments to be insignificant.CONTRACTUAL OBLIGATIONS AND COMMERCIAL COMMITMENTSThe following table reflects a summary of our contractual obligations and commercial commitments as of November 30, 2020:CONTRACTUAL CASH OBLIGATIONS DUE BY YEARTotalLess than1 year 1–3 years3–5 yearsMore than5 yearsShort-term borrowings$886.7 $886.7 $— $— $— Long-term debt, including finance leases4,000.8 263.9 1,030.2 1,063.3 1,643.4 Operating leases164.1 40.5 56.7 35.1 31.8 Interest payments(a)862.5 124.4 208.5 145.1 384.5 Raw material purchase obligations(b)505.5 505.5 — — — Pension and post-retirement benefit plans(c)184.3 14.9 23.6 23.5 122.3 Other purchase obligations(d)116.3 46.7 32.0 7.4 30.2 Total contractual cash obligations(e)$6,720.2 $1,882.6 $1,351.0 $1,274.4 $2,212.2 (a)Interest payments include interest payments on short-term borrowings and long-term debt. See notes 6 and 7 of notes to our consolidated financial statements for additional information.(b)Raw material purchase obligations outstanding as of year-end may not be indicative of outstanding obligations throughout the year due to our response to varying raw material cycles.(c)Represents the minimum pension contributions for our U.S. and international pension plans, which are generally determined for the next fiscal year, and our expected benefit payments under our post-retirement medical plan.(d)Other purchase obligations consist of information technology and other service agreements, advertising media commitments and utility contracts.(e)Contractual obligations do not include any potential future tax settlements. See note 13 of notes to our consolidated financial statements for additional information.Pension and postretirement funding can vary significantly each year due to changes in legislation, our significant assumptions and investment return on plan assets. As a result, we have not presented pension and postretirement funding in the table above.COMMERCIAL COMMITMENTS EXPIRATION BY YEAR45TotalLess than1 year 1–3 years3–5 yearsMore than5 yearsGuarantees(a)$0.7 $0.7 $— $— $— Standby letters of credit32.2 32.2 — — — Total commercial commitments$32.9 $32.9 $— $— $— (a)Guarantees do not include any amounts associated with a residual value guarantee that we provide under a lease arrangement, which is more fully described in note 7 of notes to our consolidated financial statements. OFF-BALANCE SHEET ARRANGEMENTSWe had no off-balance sheet arrangements as of November 30, 2020 and 2019.RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTSNew accounting pronouncements are issued periodically that affect our current and future operations. See note 1 of notes to our consolidated financial statements for further details of these impacts.CRITICAL ACCOUNTING ESTIMATES AND ASSUMPTIONSIn preparing the financial statements, we are required to make estimates and assumptions that have an impact on the assets, liabilities, revenue and expenses reported. These estimates can also affect supplemental information disclosed by us, including information about contingencies, risk and financial condition. We believe, given current facts and circumstances, our estimates and assumptions are reasonable, adhere to U.S. GAAP and are consistently applied. Inherent in the nature of an estimate or assumption is the fact that actual results may differ from estimates, and estimates may vary as new facts and circumstances arise. In preparing the financial statements, we make routine estimates and judgments in determining the net realizable value of accounts receivable, inventory, fixed assets and prepaid allowances. Our most critical accounting estimates and assumptions are in the following areas:Customer ContractsIn several of our major geographic markets, the consumer segment sells our products by entering into annual or multi-year customer arrangements. Known or expected pricing or revenue adjustments, such as trade discounts, rebates or returns, are estimated at the time of sale. Where applicable, future reimbursements are estimated based on a combination of historical patterns and future expectations regarding these programs. Key sales terms, such as pricing and quantities ordered, are established on a frequent basis such that most customer arrangements and related incentives have a one-year or shorter duration. Estimates that affect revenue, such as trade incentives and product returns, are monitored and adjusted each period until the incentives or product returns are realized.Goodwill and Intangible Asset ValuationWe review the carrying value of goodwill and non-amortizable intangible assets and conduct tests of impairment on an annual basis as described below. We also test for impairment if events or circumstances indicate it is more likely than not that the fair value of a reporting unit is below its carrying amount. We test indefinite-lived intangible assets for impairment if events or changes in circumstances indicate that the asset might be impaired.Determining the fair value of a reporting unit or an indefinite-lived purchased intangible asset is judgmental in nature and involves the use of significant estimates and assumptions. We base our fair value estimates on assumptions we believe to be reasonable but that are inherently uncertain. Actual future results may differ from those estimates.46Goodwill ImpairmentOur reporting units are the same as our operating segments. We estimate the fair value of a reporting unit by using a discounted cash flow model. Our discounted cash flow model calculates fair value by present valuing future expected cash flows of our reporting units using our internal cost of capital as the discount rate. We then compare this fair value to the carrying amount of the reporting unit, including intangible assets and goodwill. If the carrying amount of the reporting unit exceeds the estimated fair value, then we would determine the implied fair value of the reporting unit’s goodwill. An impairment charge would be recognized to the extent the carrying amount of goodwill exceeds the implied fair value. As of November 30, 2020, we had $4,986.3 million of goodwill recorded in our balance sheet ($3,711.2 million in the consumer segment and $1,275.1 million in the flavor solutions segment). Included in those amounts are $410.5 million ($273.7 million in the consumer segment and $136.8 million in the flavor solutions segment) of goodwill related to our acquisition of Cholula that, as of November 30, 2020, was determined on a preliminary basis. The final valuation of the acquired net assets of Cholula, and the related goodwill balance by segment, will be completed in 2021.Our fiscal year 2020 impairment testing indicated that the estimated fair values of our reporting units were significantly in excess of their carrying values. Accordingly, we believe that only significant changes in the cash flow assumptions would result in an impairment of goodwill.Indefinite-lived Intangible Asset ImpairmentOur indefinite-lived intangible assets consist of brand names and trademarks. We estimate fair values primarily through the use of the relief-from-royalty method and then compare those fair values to the related carrying amounts of the indefinite-lived intangible asset. In the event that the fair value of any of the brand names or trademarks are less than their related carrying amounts, a non-cash impairment loss would be recognized in an amount equal to the difference.The estimation of fair values of our brand names and trademarks requires us to make significant assumptions, including expectations with respect to sales and profits of the respective brands and trademarks, related royalty rates and appropriate discount rates, which are based, in part, upon current interest rates adjusted for our view of reasonable country- and brand-specific risks based upon the past and anticipated future performance of the related brand names and trademarks. As of November 30, 2020, we had $3,030.0 million of brand name assets and trademarks recorded in our balance sheet, and none of the balances exceeded their estimated fair values at that date. Of the $3,030.0 million of brand names assets and trademarks as of November 30, 2020: (i) $2,320.0 million relates to the French’s, Frank’s RedHot and Cattlemen’s brand names and trademarks, recognized as part of our acquisition of RB Foods in August 2017, that we group for purposes of our impairment analysis; (ii) $380.0 million relates to the Cholula brand names and trademarks, recognized as part of the preliminary purchase price allocation associated with the acquisition of Cholula in November 2020, and (iii) the remaining $330.0 million represents a number of other brand name assets and trademarks with individual carrying values ranging from $0.2 million to $106.4 million. The percentage excess of estimated fair value over respective book values for each of our brand names and trademarks, including the $2,320.0 million related to our French’s, Frank's RedHot and Cattlemen’s brands was 20% or more as of November 30, 2020, except for: (i) the Cholula brand, whose preliminary fair value of $380.0 million was determined as of its November 30, 2020 acquisition date; and (ii) one additional brand with a carrying value of $7.4 million whose fair value modestly exceeds its carrying value as of year-end 2020.The brand names and trademarks related to recent acquisitions, including our recent acquisitions of Cholula and, in early fiscal 2021, FONA, may be more susceptible to future impairment as their carrying values represent recently determined fair values. A change in assumptions with respect to recently acquired businesses, including those affected by rising interest rates or a deterioration in expectations of future sales, profitability or royalty rates as well as future economic and market conditions, or higher income tax rates, could result in non-cash impairment losses in the future.Income TaxesWe estimate income taxes and file tax returns in each of the taxing jurisdictions in which we operate and are required to file a tax return. At the end of each year, an estimate for income taxes is recorded in the financial statements. Tax returns are generally filed in the third or fourth quarter of the subsequent year. A reconciliation of the estimate to the final tax return is done at that time, which will result in changes to the original estimate. We believe that our tax return positions are appropriately supported, but tax authorities may challenge certain positions. We evaluate our uncertain tax positions in accordance with the GAAP guidance for uncertainty in income taxes. We believe that our reserve for uncertain tax positions, including related interest, is adequate. The amounts ultimately paid upon resolution of audits could be materially different from the amounts previously included in our income tax expense and, therefore, could have a material impact on our tax provision, net income and cash flows. We have 47recorded valuation allowances to reduce our deferred tax assets to the amount that is more likely than not to be realized. In doing so, we have considered future taxable income and tax planning strategies in assessing the need for a valuation allowance. Both future taxable income and tax planning strategies include a number of estimates.Pension and Postretirement BenefitsPension and other postretirement plans’ costs require the use of assumptions for discount rates, investment returns, projected salary increases, mortality rates and health care cost trend rates. The actuarial assumptions used in our pension and postretirement benefit reporting are reviewed annually and compared with external benchmarks to ensure that they appropriately account for our future pension and postretirement benefit obligations. While we believe that the assumptions used are appropriate, differences between assumed and actual experience may affect our operating results. A 1% increase or decrease in the actuarial assumption for the discount rate would impact 2021 pension and postretirement benefit expense by approximately $1 million. A 1% increase or decrease in the expected return on plan assets would impact 2021 pension expense by approximately $10 million. We will continue to evaluate the appropriateness of the assumptions used in the measurement of our pension and other postretirement benefit obligations. In addition, see note 11 of notes to our consolidated financial statements for a discussion of these assumptions and the effects on the financial statements.ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKThis information is set forth in the “Market Risk Sensitivity” section of “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and in note 8 of our notes to consolidated financial statements.48ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA49REPORT OF MANAGEMENTWe are responsible for the preparation and integrity of the consolidated financial statements appearing in our Annual Report. The consolidated financial statements were prepared in conformity with United States generally accepted accounting principles and include amounts based on our estimates and judgments. All other financial information in this report has been presented on a basis consistent with the information included in the financial statements.We are also responsible for establishing and maintaining adequate internal control over financial reporting. We maintain a system of internal control that is designed to provide reasonable assurance as to the fair and reliable preparation and presentation of the consolidated financial statements, as well as to safeguard assets from unauthorized use or disposition.Our control environment is the foundation for our system of internal control over financial reporting and is embodied in our Business Ethics Policy. It sets the tone of our organization and includes factors such as integrity and ethical values. Our internal control over financial reporting is supported by formal policies and procedures which are reviewed, modified and improved as changes occur in business conditions and operations.The Audit Committee of the Board of Directors, which is composed solely of independent directors, meets periodically with members of management, the internal auditors and the independent registered public accounting firm to review and discuss internal control over financial reporting and accounting and financial reporting matters. The independent registered public accounting firm and internal auditors report to the Audit Committee and accordingly have full and free access to the Audit Committee at any time.We conducted an assessment of the effectiveness of our internal control over financial reporting based on the framework in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework). This assessment included review of the documentation of controls, evaluation of the design effectiveness of controls, testing of the operating effectiveness of controls and a conclusion on this assessment. Although there are inherent limitations in the effectiveness of any system of internal control over financial reporting, based on our assessment, we have concluded with reasonable assurance that our internal control over financial reporting was effective as of November 30, 2020.Our internal control over financial reporting as of November 30, 2020 has been audited by Ernst & Young LLP.Lawrence E. KurziusChairman, President &Chief Executive OfficerMichael R. SmithExecutive Vice President &Chief Financial OfficerChristina M. McMullenVice President & ControllerChief Accounting Officer50REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRMTo the Shareholders and the Board of Directors of McCormick & Company, IncorporatedOpinion on Internal Control over Financial ReportingWe have audited McCormick & Company, Incorporated’s internal control over financial reporting as of November 30, 2020, based on criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework) (the COSO criteria). In our opinion, McCormick & Company, Incorporated (the Company) maintained, in all material respects, effective internal control over financial reporting as of November 30, 2020, based on the COSO criteria.We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (PCAOB), the consolidated balance sheets of the Company as of November 30, 2020 and 2019, the related consolidated income statements, statements of comprehensive income, cash flow statements and statements of shareholders’ equity for each of the three years in the period ended November 30, 2020, and the related notes and the financial statement schedule listed in the Index at item 15(2) and our report dated January 28, 2021 expressed an unqualified opinion thereon. Basis for Opinion The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Report of Management. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB. We conducted our audit in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.Definition and Limitations of Internal Control Over Financial Reporting A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.Baltimore, MarylandJanuary 28, 202151REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRMTo the Shareholders and the Board of Directors of McCormick & Company, IncorporatedOpinion on the Financial Statements We have audited the accompanying consolidated balance sheets of McCormick & Company, Incorporated (the Company) as of November 30, 2020 and 2019, the related consolidated income statements, statements of comprehensive income, cash flow statements and statements of shareholders’ equity for each of the three years in the period ended November 30, 2020, and the related notes and financial statement schedule listed in the Index at item 15(2) (collectively referred to as the “consolidated financial statements”). In our opinion, the consolidated financial statements present fairly, in all material respects, the financial position of the Company at November 30, 2020 and 2019, and the results of its operations and its cash flows for each of the three years in the period ended November 30, 2020, in conformity with U.S. generally accepted accounting principles.We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (PCAOB), the Company’s internal control over financial reporting as of November 30, 2020, based on criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework) and our report dated January 28, 2021 expressed an unqualified opinion thereon.Basis for OpinionThese financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on the Company’s financial statements based on our audits. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB. We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether due to error or fraud. Our audits included performing procedures to assess the risks of material misstatement of the financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements. We believe that our audits provide a reasonable basis for our opinion. Critical Audit MattersThe critical audit matters communicated below are matters arising from the current period audit of the financial statements that were communicated or required to be communicated to the audit committee and that: (1) relate to accounts or disclosures that are material to the financial statements and (2) involved our especially challenging, subjective or complex judgments. The communication of critical audit matters does not alter in any way our opinion on the consolidated financial statements, taken as a whole, and we are not, by communicating the critical audit matters below, providing separate opinions on the critical audit matters or on the accounts or disclosures to which they relate. 52Valuation of Indefinite-lived Intangible AssetsDescription of the MatterAt November 30, 2020, the Company's indefinite-lived intangible assets consist of brand names and trademarks with an aggregate carrying value of approximately $3.0 billion (of which $0.4 billion related to the Cholula brand name, which was acquired on November 30, 2020). As explained in Note 1 to the consolidated financial statements, these assets are assessed for impairment at least annually primarily using the relief-from-royalty methodology to determine their fair values. If the fair value of any of the brand names or trademarks is less than its carrying amount, an impairment loss is recognized in an amount equal to the difference.Auditing the Company's impairment assessments was complex due to the significant estimation required in determining the fair value of the brand names and trademarks. Significant management judgment is also involved in determining whether individual brand names and trademarks should be grouped for purposes of the fair value determination or must be evaluated individually. The Company's methodologies for estimating the fair value of these assets involve significant assumptions and inputs, including projected financial information for net sales and operating profit by brand, royalty rates, and discount rates, all of which are sensitive to and affected by economic, industry, and company-specific qualitative factors. These significant assumptions and inputs are forward-looking and could be affected by future economic and market conditions.How We Addressed the Matter in Our AuditWe obtained an understanding, evaluated the design and tested the operating effectiveness of the Company's controls over the Company’s indefinite-lived intangible asset review process, including controls over management’s review of its asset groupings and the significant assumptions described above. We tested controls over the review of methodologies used, significant assumptions and inputs, and completeness and accuracy of the data used in the measurements.To test the estimated fair value of the Company’s indefinite-lived intangible assets, we performed audit procedures that included, among others, evaluating the asset groupings used by the Company to perform its impairment assessment, assessing the methodologies and testing the significant assumptions discussed above and the underlying data used by the Company in its analyses. We compared the significant assumptions to current industry, market and economic trends, to the Company's historical results, to other guideline companies within the same industry, and to other relevant data. In addition, we evaluated management’s ability to estimate revenues by comparing the current year actual revenues for certain brand names or trademarks to the estimates made in the Company’s prior year impairment assessment. We also performed sensitivity analyses of the significant assumptions to evaluate the potential change in the fair values of the brand names and trademarks resulting from hypothetical changes in underlying assumptions. We involved an internal valuation specialist to assist in our evaluation of the methodologies used and significant assumptions and inputs used to determine the fair value of certain brand names and trademarks.Valuation of Acquired Intangible AssetsDescription of the MatterDuring 2020, the Company completed its acquisition of the parent company of Cholula Hot Sauce (“Cholula”) for net consideration of $803 million, and recognized identifiable intangible assets of $401 million, as disclosed in Note 2 to the consolidated financial statements. The transaction was accounted for as a business combination.Auditing the Company's purchase accounting for its acquisition of Cholula was complex due to the significant estimation required by management to determine the fair value of the acquired intangible assets, which principally consisted of brand names and trademarks. The estimation complexity was primarily due to the valuation models used to measure the fair value of the intangible assets and the sensitivity of the respective fair values to the significant underlying assumptions. The significant assumptions used to estimate the fair value of the intangible assets included discount rates, royalty rates and certain assumptions that form the basis of the forecasted results (e.g., revenue growth rates and operating profit margin). These significant assumptions are forward-looking and could be affected by future economic and market conditions.53How We Addressed the Matter in Our AuditWe obtained an understanding, evaluated the design and tested the operating effectiveness of the Company's controls over its accounting for acquisitions. For example, we tested controls over the recognition and measurement of intangible assets, including the valuation models and underlying assumptions used to develop such estimates. We also tested management’s controls over the completeness and accuracy of the data used in the models.To test the estimated fair value of the intangible assets, we performed audit procedures that included, among others, evaluating the Company's valuation models and testing the significant assumptions used in the models, as well as testing the completeness and accuracy of the underlying data. We compared the significant assumptions to current industry, market and economic trends, to the assumptions used to value similar assets in other acquisitions, and to the historical results of the acquired business. We also involved an internal valuation specialist to assist in our evaluation of the significant assumptions and those procedures included the completion of independent calculations of the fair value of the acquired intangible assets.We have served as the Company’s auditor since 1982.Baltimore, MarylandJanuary 28, 2021 54CONSOLIDATED INCOME STATEMENTSfor the year ended November 30 (millions except per share data)202020192018Net sales$5,601.3 $5,347.4 $5,302.8 Cost of goods sold3,300.9 3,202.1 3,209.5 Gross profit2,300.4 2,145.3 2,093.3 Selling, general and administrative expense1,281.6 1,166.8 1,163.4 Transaction and integration expenses12.4 — 22.5 Special charges6.9 20.8 16.3 Operating income999.5 957.7 891.1 Interest expense135.6 165.2 174.6 Other income, net17.6 26.7 24.8 Income from consolidated operations before income taxes881.5 819.2 741.3 Income tax expense (benefit) 174.9 157.4 (157.3)Net income from consolidated operations706.6 661.8 898.6 Income from unconsolidated operations40.8 40.9 34.8 Net income$747.4 $702.7 $933.4 Earnings per share–basic$2.80 $2.65 $3.55 Earnings per share–diluted$2.78 $2.62 $3.50 See Notes to Consolidated Financial Statements.55 CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOMEfor the year ended November 30 (millions)202020192018Net income$747.4 $702.7 $933.4 Net income attributable to non-controlling interest4.3 1.9 3.3 Other comprehensive income (loss):Unrealized components of pension and other postretirement plans (including curtailment gains of $18.0 for 2018)(80.4)(149.8)72.6 Currency translation adjustments89.7 (25.5)(119.8)Change in derivative financial instruments(0.9)1.1 2.3 Deferred taxes18.1 33.2 (17.2)Total other comprehensive income (loss)26.5 (141.0)(62.1)Comprehensive income$778.2 $563.6 $874.6 See Notes to Consolidated Financial Statements.56CONSOLIDATED BALANCE SHEETSat November 30 (millions)20202019AssetsCash and cash equivalents$423.6 $155.4 Trade accounts receivable, less allowances of $5.2 for 2020 and $5.6 for 2019528.5 502.9 Inventories1,032.6 801.2 Prepaid expenses and other current assets98.9 90.7 Total current assets2,083.6 1,550.2 Property, plant and equipment, net1,028.4 952.6 Goodwill4,986.3 4,505.2 Intangible assets, net3,239.4 2,847.0 Other long-term assets752.0 507.1 Total assets$12,089.7 $10,362.1 LiabilitiesShort-term borrowings$886.7 $600.7 Current portion of long-term debt263.9 97.7 Trade accounts payable1,032.3 846.9 Other accrued liabilities863.6 609.1 Total current liabilities3,046.5 2,154.4 Long-term debt3,753.8 3,625.8 Deferred taxes727.2 697.6 Other long-term liabilities622.2 427.6 Total liabilities8,149.7 6,905.4 Shareholders’ equityCommon stock, no par value; authorized 320.0 shares; issued and outstanding:2020–18.0 shares, 2019–18.6 shares484.0 447.6 Common stock non-voting, no par value; authorized 320.0 shares; issued and outstanding: 2020–248.9 shares, 2019–247.2 shares1,497.3 1,441.0 Retained earnings2,415.6 2,055.8 Accumulated other comprehensive loss(470.8)(500.2)Total McCormick shareholders’ equity3,926.1 3,444.2 Non-controlling interests13.9 12.5 Total shareholders’ equity3,940.0 3,456.7 Total liabilities and shareholders’ equity$12,089.7 $10,362.1 See Notes to Consolidated Financial Statements.57CONSOLIDATED CASH FLOW STATEMENTSfor the year ended November 30 (millions)202020192018Operating activitiesNet income$747.4 $702.7 $933.4 Adjustments to reconcile net income to net cash provided by operating activities:Depreciation and amortization165.0 158.8 150.7 Stock-based compensation46.0 37.2 25.6 Non-cash nonrecurring income tax benefit (related to enactment of the U.S. Tax Act)— — (309.4)Non-cash special charges— — 3.0 Loss (gain) on sale of assets3.0 (1.6)(5.4)Deferred income tax (benefit) expense(11.2)20.9 40.1 Income from unconsolidated operations(40.8)(40.9)(34.8)Changes in operating assets and liabilities (net of effect of businesses acquired):Trade accounts receivable4.8 12.2 19.8 Inventories(200.2)(20.9)(10.0)Trade accounts payable164.2 128.2 72.8 Other assets and liabilities133.8 (81.5)(91.8)Dividends received from unconsolidated affiliates29.3 31.7 27.2 Net cash provided by operating activities1,041.3 946.8 821.2 Investing activitiesAcquisitions of businesses (net of cash acquired)(803.0)— (4.2)Capital expenditures (including expenditures for capitalized software)(225.3)(173.7)(169.1)Other investing activities2.7 2.7 14.8 Net cash used in investing activities(1,025.6)(171.0)(158.5)Financing activitiesShort-term borrowings, net286.5 41.0 305.5 Long-term debt borrowings527.0 — 25.9 Payment of debt issuance costs(1.1)— — Long-term debt repayments(257.7)(447.7)(797.9)Proceeds from exercised stock options56.6 90.9 78.2 Taxes withheld and paid on employee stock awards(13.0)(12.7)(11.6)Payment of contingent consideration— — (2.5)Purchase of minority interest— — (13.0)Common stock acquired by purchase(47.3)(95.1)(62.3)Dividends paid(330.1)(302.2)(273.4)Net cash provided by (used in) financing activities220.9 (725.8)(751.1)Effect of exchange rate changes on cash and cash equivalents31.6 8.8 (1.8)Increase (decrease) in cash and cash equivalents268.2 58.8 (90.2)Cash and cash equivalents at beginning of year155.4 96.6 186.8 Cash and cash equivalents at end of year$423.6 $155.4 $96.6 See Notes to Consolidated Financial Statements.58 CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY(millions)Common Stock SharesCommon Stock Non-Voting SharesCommon Stock AmountRetained EarningsAccumulated Other Comprehensive (Loss) IncomeNon-controlling InterestsTotal Shareholders’ EquityBalance, November 30, 201720.0 242.0 $1,672.9 $1,166.5 $(279.5)$11.0 $2,570.9 Net income— 933.4 — — 933.4 Net income attributable to non-controlling interest— — — 3.3 3.3 Other comprehensive income (loss), net of tax— — (59.5)(2.6)(62.1)Dividends— (280.5)— — (280.5)Adoption of ASU 2018-02— 20.9 (20.9)— — Buyout of minority interest— (12.4)— (0.4)(12.8)Stock-based compensation25.6 — — — 25.6 Shares purchased and retired(0.6)(0.8)(16.8)(67.7)— — (84.5)Shares issued3.4 0.2 88.9 — — — 88.9 Equal exchange(3.7)3.7 — — — — — Balance, November 30, 201819.1 245.1 $1,770.6 $1,760.2 $(359.9)$11.3 $3,182.2 Net income— 702.7 — — 702.7 Net income attributable to non-controlling interest— — — 1.9 1.9 Other comprehensive loss, net of tax— — (140.3)(0.7)(141.0)Dividends— (309.3)— — (309.3)Stock-based compensation37.2 — — — 37.2 Shares purchased and retired(0.4)(1.2)(15.4)(97.8)— — (113.2)Shares issued3.0 0.2 96.2 — — — 96.2 Equal exchange(3.1)3.1 — — — — — Balance, November 30, 201918.6 247.2 $1,888.6 $2,055.8 $(500.2)$12.5 $3,456.7 Net income— 747.4 — — 747.4 Net income attributable to non-controlling interest— — — 4.3 4.3 Other comprehensive income (loss), net of tax— — 29.4 (2.9)26.5 Dividends— (338.5)— — (338.5)Stock-based compensation46.0 — — — 46.0 Shares purchased and retired(0.3)(0.2)(13.6)(49.1)— — (62.7)Shares issued1.6 — 60.3 — — — 60.3 Equal exchange(1.9)1.9 — — — — — Balance, November 30, 202018.0 248.9 $1,981.3 $2,415.6 $(470.8)$13.9 $3,940.0 See Notes to Consolidated Financial Statements.59NOTES TO CONSOLIDATED FINANCIAL STATEMENTS1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIESConsolidationThe financial statements include the accounts of our majority-owned or controlled subsidiaries and affiliates. Intercompany transactions have been eliminated. Investments in unconsolidated affiliates, over which we exercise significant influence, but not control, are accounted for by the equity method. Accordingly, our share of net income or loss of unconsolidated affiliates is included in net income.Foreign Currency Translation For majority-owned or controlled subsidiaries and affiliates, if located outside of the U.S., with functional currencies other than the U.S. dollar, asset and liability accounts are translated at the rates of exchange at the balance sheet date and the resultant translation adjustments are included in accumulated other comprehensive income (loss), a separate component of shareholders’ equity. Income and expense items are translated at average monthly rates of exchange. Gains and losses from foreign currency transactions of these majority-owned or controlled subsidiaries and affiliates — that is, transactions denominated in other than their functional currency — other than intercompany transactions designated as long-term investments, are included in net earnings.Our unconsolidated affiliates located outside the U.S. generally use their local currencies as their functional currencies. The asset and liability accounts of those unconsolidated affiliates are translated at the rates of exchange at the balance sheet date, with the resultant translation adjustments included in accumulated other comprehensive income (loss) of those affiliates. Income and expense items of those affiliates are translated at average monthly rates of exchange. We record our ownership share of the net assets and accumulated other comprehensive income (loss) of our unconsolidated affiliates in our consolidated balance sheet on the lines entitled “Other long-term assets” and “Accumulated other comprehensive loss,” respectively. We record our ownership share of the net income of our unconsolidated affiliates in our consolidated income statement on the line entitled “Income from unconsolidated operations.”Use of EstimatesPreparation of financial statements that follow accounting principles generally accepted in the U.S. requires us to make estimates and assumptions that affect the amounts reported in the financial statements and notes. Actual amounts could differ from these estimates.Cash and Cash EquivalentsAll highly liquid investments purchased with an original maturity of three months or less are classified as cash equivalents.InventoriesInventories are stated at the lower of cost or net realizable value. Cost is determined under the first-in, first-out costing method (FIFO), including the use of average costs which approximate FIFO.Property, Plant and EquipmentProperty, plant and equipment is stated at historical cost and depreciated over its estimated useful life using the straight-line method for financial reporting and both accelerated and straight-line methods for tax reporting. The estimated useful lives range from 20 to 50 years for buildings and 3 to 12 years for machinery, equipment and other assets. Assets leased under capital leases are depreciated over the shorter of the lease term or their useful lives unless it is reasonably certain that we will obtain ownership by the end of the lease term. Repairs and maintenance costs are expensed as incurred.Computer SoftwareWe capitalize costs of software developed or obtained for internal use. Capitalized software development costs include only (1) direct costs paid to others for materials and services to develop or buy the software, (2) payroll and payroll-related costs for employees who work directly on the software development project and (3) interest costs while developing the software. Capitalization of these costs stops when the project is substantially complete and ready for use. The net book value of capitalized software totaled $116.0 million and $76.4 million at November 30, 2020 and 2019, respectively. Such amounts are recorded within "Other long-term assets" in the consolidated balance sheet. Software is amortized using the straight-line method over a range of 3 to 13 years, but not exceeding the expected life of the product. The net book value of capitalized software includes $86.7 million and $44.9 million at November 6030, 2020 and 2019, respectively, which had not yet been placed into service and relates to our future implementation of a global enterprise resource planning (ERP) system. Goodwill and Other Intangible AssetsWe review the carrying value of goodwill and indefinite-lived intangible assets and conduct tests of impairment on an annual basis as described below. We also test goodwill for impairment if events or circumstances indicate it is more likely than not that the fair value of a reporting unit is below its carrying amount and test indefinite-lived intangible assets for impairment if events or changes in circumstances indicate that the asset might be impaired. Separable intangible assets that have finite useful lives are amortized over those lives.Determining the fair value of a reporting unit or an indefinite-lived purchased intangible asset is judgmental in nature and involves the use of significant estimates and assumptions. These estimates and assumptions include revenue growth rates and operating margins used to calculate projected future cash flows, risk-adjusted discount rates, assumed royalty rates, future economic and market conditions and determination of appropriate market comparables. We base our fair value estimates on assumptions we believe to be reasonable but that are unpredictable and inherently uncertain. Actual future results may differ from these estimates.Goodwill ImpairmentOur reporting units used to assess potential goodwill impairment are the same as our business segments. We calculate fair value of a reporting unit by using a discounted cash flow model and then compare that to the carrying amount of the reporting unit, including intangible assets and goodwill. If the carrying amount of the reporting unit exceeds the calculated fair value, we would determine the implied fair value of the reporting unit’s goodwill. An impairment charge would be recognized to the extent the carrying amount of goodwill exceeds the implied fair value.Indefinite-lived Intangible Asset ImpairmentOur indefinite-lived intangible assets consist of acquired brand names and trademarks. We primarily determine fair value by using a relief-from-royalty method and then compare that to the carrying amount of the indefinite-lived intangible asset. If the carrying amount of the indefinite-lived intangible asset exceeds its fair value, an impairment charge would be recorded to the extent the recorded indefinite-lived intangible asset exceeds the fair value.Long-lived Asset ImpairmentFixed assets and amortizable intangible assets are reviewed for impairment as events or changes in circumstances occur indicating that the carrying value of the asset may not be recoverable. Undiscounted cash flow analyses are used to determine if an impairment exists. If an impairment is determined to exist, the loss would be calculated based on the excess of the asset’s carrying value over its estimated fair value.Revenue RecognitionWe manufacture, market and distribute spices, seasoning mixes, condiments and other flavorful products to the entire food industry—retailers, food manufacturers and foodservice businesses. We recognize sales as performance obligations are fulfilled when control passes to the customer. Revenues are recorded net of trade and sales incentives and estimated product returns. Known or expected pricing or revenue adjustments, such as trade discounts, rebates and returns, are estimated at the time of sale. Any taxes collected on behalf of government authorities are excluded from net sales. We account for product shipping and handling as fulfillment activities with costs for these activities recorded within cost of goods sold. Amounts billed and due from our customers are classified as accounts receivable on the balance sheet and require payment on a short-term basis. Our allowance for doubtful accounts represents our estimate of probable non-payments and credit losses in our existing receivables, as determined based on a review of past due balances and other specific account data.The following table sets forth our net sales by the Americas, Europe, Middle East and Africa (EMEA) and Asia Pacific (APAC) geographic regions: (millions)AmericasEMEAAPACTotal2020Net sales$3,974.9 $1,046.7 $579.7 $5,601.3 2019Net sales$3,711.3 $986.1 $650.0 $5,347.4 2018Net sales$3,627.5 $1,021.1 $654.2 $5,302.8 61Performance ObligationsOur revenues primarily result from contracts or purchase orders with customers, which generally are both short-term in nature and have a single performance obligation—the delivery of our products to customers. We assess the goods and services promised in our customers’ contracts or purchase orders and identify a performance obligation for each promise to transfer a good or service (or bundle of goods or services) that is distinct. To identify the performance obligations, we consider all the goods or services promised, whether explicitly stated or implied based on customary business practices.Significant JudgmentsSales are recorded net of trade and sales incentives and estimated product returns. Known or expected pricing or revenue adjustments, such as trade discounts, rebates or returns, are estimated at the time of sale. Where applicable, future reimbursements are estimated based on a combination of historical patterns and future expectations regarding these programs. Key sales terms, such as pricing and quantities ordered, are established on a frequent basis such that most customer arrangements and related incentives have a one-year or shorter duration. Estimates that affect revenue, such as trade incentives and product returns, are monitored and adjusted each period until the incentives or product returns are realized. The adjustments recognized during the year ended November 30, 2020, 2019 and 2018 resulting from updated estimates of revenue for prior year product sales were not significant. The unsettled portion remaining in accrued liabilities for these activities was $183.3 million and $137.2 million at November 30, 2020 and 2019, respectively.Practical ExpedientsWe have elected the following policy elections and practical expedients with respect to revenue recognition:•Shipping and handling costs — We elected to account for shipping and handling activities that occur before the customer has obtained control of a good as fulfillment activities (i.e., an expense) rather than as a promised service.•Measurement of transaction price — We elected to exclude from the measurement of transaction price all taxes assessed by a governmental authority that are both imposed on and concurrent with a specific revenue-producing transaction and collected by us from a customer for sales, value added and other excise taxes.•Incremental cost of obtaining a contract — We elected to expense any incremental costs of obtaining a contract when the contract is for a period of one year or less.Shipping and Handling Shipping and handling costs on our products sold to customers related to activities that occur before the customer has obtained control of a good are included in cost of goods sold in the consolidated income statement.Brand Marketing SupportTotal brand marketing support costs, which are included in our consolidated income statement in the line entitled "Selling, general and administrative expense", were $230.3 million, $214.6 million and $218.7 million for 2020, 2019 and 2018, respectively. Brand marketing support costs include advertising and promotions but exclude trade funds paid to customers for such activities. All trade funds paid to customers are reflected in the consolidated income statement as a reduction of net sales. Promotion costs include public relations, shopper marketing, social marketing activities, general consumer promotion activities and depreciation of assets used in these promotional activities. Advertising costs include the development, production and communication of advertisements through television, digital, print and radio. Development and production costs are expensed in the period in which the advertisement is first run. All other costs of advertising are expensed as incurred. Advertising expense was $174.8 million, $150.8 million and $147.2 million for 2020, 2019 and 2018, respectively.Research and DevelopmentResearch and development costs are expensed as incurred and are included in our consolidated income statement in the line entitled "Selling, general and administrative expense". Research and development expense was $68.6 million, $67.3 million and $69.4 million for 2020, 2019 and 2018, respectively.Income Taxes62Income taxes are recognized in accordance with the liability method of accounting. Deferred taxes are recognized for the estimated taxes ultimately payable or recoverable based on enacted tax law. Changes in enacted tax rates are reflected in the tax provision as they occur. As more fully described in note 13, the U.S. Tax Act created a new requirement that certain income earned by foreign subsidiaries, referred to as Global Intangible Low-Taxed Income (GILTI), must be included in the gross income of the subsidiary’s U.S. shareholder; this provision of the U.S. Tax Act was effective for us beginning on December 1, 2018. Accounting principles generally accepted in the U.S. provide for an accounting policy election of either recognizing deferred taxes for temporary differences expected to reverse as GILTI in future years or recognizing such taxes as a current period expense when incurred. We have elected to treat GILTI as a current period expense when incurred.In accordance with ASC 740, Income Taxes, we recognize a tax position in our financial statements when it is more likely than not that the position will be sustained upon examination based on the technical merits of the position. That position is then measured at the largest amount of benefit that is greater than 50 percent likely of being realized upon ultimate settlement.Stock-Based Compensation Stock-based compensation expense is recognized in accordance with ASC 718, Compensation – Stock Compensation. We recognize stock-based compensation expense associated with options and restricted stock units (RSUs), which contain provisions that such awards fully vest upon an employee’s retirement, ratably over the shorter of the vesting period or the employees’ retirement eligibility date. Accordingly, we recognize stock-based compensation associated with options and RSUs subject to immediate retirement eligible vesting provisions on the date of grant.Compensation expense associated with our long-term performance plan (LTPP) is recorded in the income statement ratably over the three-year period of the program based on the number of shares ultimately expected to be awarded using our estimate of the most likely outcome of achieving the performance objectives. We estimate forfeitures at the time of grant based on historical experience and revises this estimate in subsequent periods if actual forfeitures differ.We recognize stock-based compensation expense associated with price-vested stock options ratably over the vesting period as such options do not contain provisions that fully vest these awards upon an employee’s retirement.Stock SplitOn September 28, 2020, our Board of Directors approved a 2-for-1 stock split in the form of a stock dividend on all shares of the Company’s two classes of common stock, Common Stock and Common Stock Non-Voting. On November 30, 2020, one like share was issued for each share outstanding to shareholders of record as of November 20, 2020. Trading of the Company’s common stock began on a split-adjusted basis on December 1, 2020. All common stock and per-share data have been retroactively adjusted for the impact of the stock split.Derivative InstrumentsWe record all derivatives on our balance sheet at fair value. The fair value of derivative instruments is recorded in our consolidated balance sheet on the lines entitled “Other current assets", "Other long-term assets", "Other accrued liabilities" or "Other long-term liabilities". Gains and losses representing either hedge ineffectiveness, hedge components excluded from the assessment of effectiveness, or hedges of translational exposure are recorded in our consolidated income statement in the lines entitled "Other income (expense), net" or "Interest expense". In our consolidated cash flow statement, settlements of cash flow and fair value hedges are classified as operating activities; settlements of all other derivative instruments, including instruments for which hedge accounting has been discontinued, are classified consistent with the nature of the instruments.Cash flow hedges. Qualifying derivatives are accounted for as cash flow hedges when the hedged item is a forecasted transaction. Gains and losses on these instruments are recorded in our consolidated balance sheet on the line entitled “Accumulated other comprehensive income (loss)" until the underlying transaction is recorded in earnings. When the hedged item is realized, gains or losses are reclassified from "Accumulated other comprehensive income (loss)" in our consolidated balance sheet to our consolidated income statement on the same line items as the underlying transactions.63Fair value hedges. Qualifying derivatives are accounted for as fair value hedges when the hedged item is a recognized asset, liability, or firm commitment. Gains and losses on these instruments are recorded in earnings, offsetting gains and losses on the hedged item.Net investment hedges. Qualifying derivative and nonderivative financial instruments are accounted for as net investment hedges when the hedged item is a nonfunctional currency investment in a subsidiary. Gains and losses on these instruments are included in foreign currency translation adjustments, a component of “Accumulated other comprehensive income (loss)" in our consolidated balance sheet.Employee Benefit and Retirement PlansWe sponsor defined benefit pension plans in the U.S. and certain foreign locations. In addition, we sponsor defined contribution plans in the U.S. We contribute to defined contribution plans in locations outside the U.S., including government-sponsored retirement plans. We also currently provide postretirement medical and life insurance benefits to certain U.S. employees and retirees. We recognize the overfunded or underfunded status of our defined benefit pension plans as an asset or a liability in our balance sheet, with changes in the funded status recorded through other comprehensive income in the year in which those changes occur.The expected return on plan assets is determined using the expected rate of return and a calculated value of plan assets referred to as the market-related value of plan assets. Differences between assumed and actual returns are amortized to the market-related value of assets on a straight-line basis over five years.We use the corridor approach in the valuation of defined benefit pension and postretirement benefit plans. The corridor approach defers all actuarial gains and losses resulting from variances between actual results and actuarial assumptions. Those unrecognized gains and losses are amortized when the net gains and losses exceed 10% of the greater of the market-related value of plan assets or the projected benefit obligation at the beginning of the year. The amount in excess of the corridor is amortized over the average remaining life expectancy of retired plan participants, for plans whose benefits have been frozen, or the average remaining service period to retirement date of active plan participants.Accounting Pronouncements Adopted in 2020We adopted the new accounting standard for leases, Accounting Standards Codification Topic 842 Leases (ASC 842), as of December 1, 2019 and we elected to do so using a modified retrospective transition method. That modified retrospective transition method allowed us to initially apply the standard at the adoption date and recognize a cumulative-effect adjustment to retained earnings in the opening balance sheet in the period of adoption without restating prior periods. ASC 842 revised prior practice related to accounting for leases under Accounting Standards Codification Topic 840 Leases (ASC 840) for both lessees and lessors and requires lessees to recognize most leases on their balance sheets as lease liabilities with corresponding right-of-use (ROU) assets. Under ASC 842, the lease liability is equal to the present value of lease payments, and the ROU asset is based on the lease liability, subject to adjustments, such as for deferred rent and initial direct costs. For income statement purposes, ASC 842 retains a dual model similar to ASC 840, requiring leases to be classified as either operating or finance. For lessees, operating leases result in straight-line expense (similar to prior accounting by lessees for operating leases under ASC 840) while finance leases result in a front-loaded expense pattern (similar to prior accounting by lessees for capital leases under ASC 840). We elected the package of practical expedients permitted under the transition guidance, which, among other things, allows us to carry forward the historical lease classification. In addition, we made accounting policy elections to combine the lease and non-lease components for all asset categories other than real estate. We also made elections to exclude from balance sheet reporting those leases with initial terms of 12 months or less (short-term leases). Adoption of the new standard resulted in the recording of operating lease ROU assets and lease liabilities of $136.5 million and $140.0 million, respectively, with the difference due to prepaid and deferred rents that were reclassified to the ROU asset value. No cumulative-effect adjustment to opening retained earnings was required as of December 1, 2019. The standard did not materially affect our consolidated net income or cash flows for our fiscal year ended November 30, 2020. See note 7 for further details.Recently Issued Accounting Pronouncements — Pending Adoption64In January 2017, the FASB issued ASU No. 2017-04 Intangibles—Goodwill and Other Topics (Topic 350)—Simplifying the Test for Goodwill Impairment. This guidance eliminates the requirement to calculate the implied fair value of goodwill of a reporting unit to measure a goodwill impairment charge. Instead, a company will record an impairment charge based on the excess of a reporting unit's carrying amount over its fair value. The new standard will be effective for the first quarter of our fiscal year ending November 30, 2021. We do not expect this guidance to have a material impact on our financial statements.In June 2016, the FASB issued ASU No. 2016-13 Financial Instruments—Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments, which institutes a new model for recognizing credit losses on financial instruments that are not measured at fair value. The new standard is effective for the first quarter of our fiscal year ending November 30, 2021, and it will primarily impact our credit losses recognized for trade accounts receivable. This guidance will not have a material impact on our consolidated financial statements. In December 2019, the FASB issued ASU No. 2019-12 Income Taxes (Topic 740): Simplifying the Accounting for Income Taxes, which simplifies the accounting for income taxes. The new guidance removes certain exceptions to the general principles for income taxes and also improves consistent application of accounting by clarifying or amending existing guidance. The new standard is effective for the first quarter of our fiscal year ending November 30, 2022, and interim periods within those years. We are currently evaluating the impact that the new guidance will have on our consolidated financial statements.In March 2020, the FASB issued ASU No. 2020-04 Reference Rate Reform (Topic 848): Facilitation of the Effects of Reference Rate Reform on Financial Reporting that provides optional expedients for a limited period of time for accounting for contracts, hedging relationship, and other transactions affected by the London Interbank Offered Rate (LIBOR) or other reference rate expected to be discontinued. These optional expedients can be applied from March 2020 through December 31, 2022. We are currently evaluating the impact that the new guidance will have on our consolidated financial statements.2. ACQUISITIONSAcquisitions are part of our strategy to increase sales and profits.Acquisition of Cholula Hot SauceOn November 30, 2020, we completed the acquisition of the parent company of Cholula Hot Sauce® (Cholula) from L Catterton. The purchase price was approximately $803.0 million, net of cash acquired, subject to certain customary purchase price adjustments. The acquisition was funded with cash and short-term borrowings. Cholula, a premium Mexican hot sauce brand, is a strong addition to McCormick’s global branded flavor portfolio, which we believe broadens our offering in the high growth hot sauce category to consumers and foodservice operators and accelerate our condiment growth opportunities with a complementary authentic Mexican flavor hot sauce. At the time of the acquisition, annual sales of Cholula were approximately $96 million. The results of Cholula’s operations have been included in our financial statements as a component of our consumer and flavor solutions segments from the date of acquisition.The purchase price of Cholula was preliminarily allocated to the underlying assets acquired and liabilities assumed based upon their estimated fair values at the date of acquisition. We estimated the fair values based on in-process independent valuations, discounted cash flow analyses, quoted market prices, and estimates made by management, a number of which are subject to finalization. The allocation of the purchase price will be finalized within the allowable measurement period. The preliminary allocation, net of cash acquired, of the fair value of the Cholula acquisition is summarized in the table below (in millions):65Trade accounts receivable$15.2 Inventories16.5 Goodwill410.5 Intangible assets401.0 Other assets12.5 Trade accounts payable(6.8)Other accrued liabilities (7.4)Deferred taxes(35.6)Other long-term liabilities(2.9)Total$803.0 The preliminary fair value of intangible assets was determined using income methodologies. We valued the acquired brand names and trademarks using the relief from royalty method, an income approach. For customer relationships, we used the distributor method, a variation of the excess earnings method that uses distributor-based inputs for margins and contributory asset charges. Some of the more significant assumptions inherent in developing the preliminary valuations included the estimated annual net cash flows for each indefinite-lived or definite-lived intangible asset (including net sales, operating profit margin, and working capital/contributory asset charges), royalty rates, the discount rate that appropriately reflects the risk inherent in each future cash flow stream, the assessment of each asset’s life cycle, and competitive trends, as well as other factors. We determined the assumptions used in the financial forecasts using historical data, supplemented by current and anticipated market conditions, estimated product category growth rates, management plans, and market comparables.We used carrying values to value trade receivables and payables, as well as certain other current and non-current assets and liabilities, as we determined that they represented the fair value of those items. We valued finished goods and work-in-process inventory using a net realizable value approach, which resulted in a step-up of $4.9 million that will be recognized in cost of goods sold in 2021 as the related inventory is sold. Raw materials and packaging inventory was valued using the replacement cost approach.Deferred income tax assets and liabilities represent the expected future tax consequences of temporary differences between the fair values of the assets acquired and liabilities assumed and their tax bases.The preliminary valuation of the acquired net assets of Cholula includes $380.0 million allocated to indefinite-lived brand assets and $21.0 million allocated to definite-lived intangible assets with a weighted-average life of 15 years. As a result of the acquisition, we recognized a total of $410.5 million of goodwill. That goodwill primarily represents the intangible assets that do not qualify for separate recognition, such as the value of leveraging our brand building expertise, our insights in demand from consumer and flavor solutions customers for value-added flavor solutions, and our supply chain capabilities, as well as expected synergies from the combined operations and assembled workforce. Our income tax basis in the acquired intangible assets and goodwill approximates $285 million. The final allocation of the fair value of the Cholula acquisition, including the allocation of goodwill to our reporting units, which are the consumer and flavor solutions segments, was not complete as of November 30, 2020, but will be finalized within the allowable measurement period. We expect transaction and integration expenses related to our acquisition of Cholula to total approximately $35 million, of which $11.2 million of transaction expenses were incurred in 2020. We anticipate incurring the balance of those transaction and integration expenses in fiscal 2021. We incurred an additional $1.2 million of transaction and integration expenses in 2020 related to our acquisition of FONA International, LLC and certain of its affiliates. See footnote 19 for additional details.The impact of Cholula on our 2020 consolidated income before taxes, was principally the effect of the previously noted transaction expenses, and an insignificant amount of interest expense.Acquisition of RB FoodsOn August 17, 2017, we completed the acquisition of Reckitt Benckiser's Food Division (RB Foods) from Reckitt Benckiser Group plc. The purchase price was approximately $4.21 billion. In December 2017, we paid $4.2 million associated with the final working capital adjustment. 66Total transaction and integration expenses related to the RB Foods acquisition totaled $22.5 million in 2018, of which $0.3 million and $22.2 million represented transaction expenses and integration expenses, respectively. Other AcquisitionsOn September 21, 2018, we purchased the remaining 10% ownership interest in our Shanghai subsidiary for a cash payment of $12.7 million. In conjunction with our purchase of this remaining 10% minority interest, we have eliminated the minority interest in that subsidiary and recorded an adjustment of $12.4 million to retained earnings in our consolidated balance sheet. The $12.7 million payment is reflected in the financing activities section of our consolidated cash flow statement for 2018.3. SPECIAL CHARGESIn our consolidated income statement, we include a separate line item captioned “Special charges” in arriving at our consolidated operating income. Special charges consist of expenses, including related impairment charges, associated with certain actions undertaken to reduce fixed costs, simplify or improve processes, and improve our competitiveness and are of such significance in terms of both up-front costs and organizational/structural impact to require advance approval by our Management Committee, comprised of our senior management, including our Chairman, President and Chief Executive Officer. Upon presentation of any such proposed action (generally including details with respect to estimated costs, which typically consist principally of employee severance and related benefits, together with ancillary costs associated with the action that may include a non-cash component, such as an asset impairment, or a component which relates to inventory adjustments that are included in cost of goods sold; impacted employees or operations; expected timing; and expected savings) to the Management Committee and the Committee’s advance approval, expenses associated with the approved action are classified as special charges upon recognition and monitored on an on-going basis through completion. Certain ancillary expenses related to these actions approved by our Management Committee do not qualify for accrual upon approval but are included as special charges as incurred during the course of the actions. In 2018, we also included in special charges, as approved by our Management Committee, expense associated with a one-time payment, made to eligible U.S. hourly employees, to distribute a portion of the non-recurring net income tax benefit recognized in connection with the enactment of the U.S. Tax Act and as more fully described in note 13.The following is a summary of special charges recognized for the years ended November 30 (in millions): 202020192018Employee severance and related benefits$4.1 $6.2 $2.0 Other costs (1)2.8 14.6 14.3 Total special charges$6.9 $20.8 $16.3 (1) Included in other costs for 2018 are non-cash fixed asset impairment charges of $3.0 million. The following is a summary of special charges by business segments for the years ended November 30 (in millions): 202020192018Consumer segment$5.5 $13.1 $10.0 Flavor solutions segment1.4 7.7 6.3 Total special charges$6.9 $20.8 $16.3 67We continue to evaluate changes to our organization structure to reduce fixed costs, simplify or improve processes, and improve our competitiveness.During 2020, we recorded $6.9 million of special charges, consisting of (i) $5.3 million related to streamlining actions in our EMEA region, including $3.8 million related to severance and related benefits and $1.0 million of third party expenses and $0.5 million related to other costs; and (ii) $1.6 million related to our GE initiative. Of the $6.9 million in special charges recorded during 2020, approximately $4.8 million were paid in cash, with the remaining accrual expected to be paid in 2021. As of November 30, 2020, reserves associated with special charges are included in the line entitled "Trade accounts payable" and "Other accrued liabilities" in our consolidated balance sheet. During 2019, we recorded $20.8 million of special charges, consisting primarily of (i) $14.1 million related to our GE initiative, including $10.6 million of third-party expenses, $2.1 million related to severance and related benefits, and $1.4 million related to other costs, (ii) $2.3 million of employee severance and related benefits associated with streamlining actions in the Americas and (iii) $3.9 million related to streamlining actions in our EMEA region. Of the $20.8 million in special charges recorded during 2019, approximately $16.8 million were paid in cash, with the remaining accrual paid in 2020.During 2018, we recorded $16.3 million of special charges, consisting primarily of: (i) $11.5 million related to our global enablement initiative, as more fully described below; (ii) a one-time payment, in the aggregate amount of $2.2 million made to certain U.S. hourly employees to distribute a portion of the non-recurring net income tax benefit recognized in connection with the enactment of the U.S. Tax Act; (iii) $1.0 million related to employee severance benefits and other costs directly associated with the relocation of one of our Chinese manufacturing facilities; and (iv) $1.6 million related to employee severance benefits and other costs related to the transfer of certain manufacturing operations in our Asia/Pacific region to a new facility then under construction in Thailand. Of the $11.5 million in special charges recognized in 2018 related to our GE initiative, $7.5 million related to third party expenses, $3.0 million represented a non-cash asset impairment charge, and $1.0 million related to employee severance benefits. That non-cash asset impairment charge was related to the write-off of certain software assets that are incompatible with our future move, approved in 2018, to a new global ERP platform to facilitate planned actions under our GE initiative to align and simplify our end-to-end processes to support our future growth.Of the $16.3 million in special charges recorded during 2018, approximately $12.3 million were paid in cash and $3.0 million represented a non-cash asset impairment, with the remaining accrual paid in 2019. During 2017, our Management Committee approved a multi-year initiative during which we have executed and expect to continue to execute significant changes to our global processes, capabilities and operating model to provide a scalable platform for future growth. We expect this initiative to enable us to accelerate our ability to work globally and cross-functionally by aligning and simplifying processes throughout McCormick, in part building upon our current shared services foundation and expanding the end-to-end processes presently under that foundation. We expect this initiative, which we refer to as Global Enablement (GE), to enable this scalable platform for future growth while reducing costs, enabling faster decision making, increasing agility and creating capacity within our organization.While we are continuing to fully develop the details of our GE operating model, we expect the cost of the GE initiative—to be recognized as “Special charges” in our consolidated income statement over its multi-year course—to range from approximately $60 million to $65 million. Of that $60 million to $65 million, we estimate that approximately sixty percent will be attributable to cash payments associated with related costs of GE implementation and transition, including outside consulting and other costs and approximately forty percent will be attributable to employee severance and related benefit payments both directly related to the initiative. Since its inception through November 30, 2020, we have recognized a total of $39.9 million of special charges associated with our GE initiative.4. GOODWILL AND INTANGIBLE ASSETSThe following table displays intangible assets as of November 30: 20202019(millions)GrosscarryingamountAccumulatedamortizationGrosscarryingamountAccumulatedamortizationDefinite-lived intangible assets$336.8 $127.4 $308.3 $104.3 Indefinite-lived intangible assets:Goodwill4,986.3 — 4,505.2 — Brand names and trademarks3,030.0 — 2,643.0 — 8,016.3 — 7,148.2 — Total goodwill and intangible assets$8,353.1 $127.4 $7,456.5 $104.3 We acquired Cholula in November 2020 (see note 2). A preliminary valuation of the acquired net assets of Cholula resulted in the allocation of $410.5 million to goodwill, $380.0 million to indefinite-lived intangible assets associated with the acquired brand names and trademarks, and $21.0 million to definite-lived intangible assets. We expect to finalize the valuation of the acquired net assets of Cholula, including the related goodwill and intangible assets, within the one-year measurement period from the date of acquisition.Intangible asset amortization expense was $20.2 million, $20.3 million and $20.6 million for 2020, 2019 and 2018, respectively. At November 30, 2020, definite-lived intangible assets had a weighted-average remaining life of approximately 10 years.The changes in the carrying amount of goodwill by segment for the years ended November 30 were as follows: 20202019(millions)ConsumerFlavor SolutionsConsumerFlavor SolutionsBeginning of year$3,377.6 $1,127.6 $3,398.9 $1,129.0 Increases from acquisitions273.7 136.8 — — Foreign currency fluctuations59.9 10.7 (21.3)(1.4)End of year$3,711.2 $1,275.1 $3,377.6 $1,127.6 A preliminary valuation of the acquired net assets of Cholula resulted in the allocation of $273.7 million and $136.8 million of goodwill to the consumer segment and flavor solutions segment, respectively. 5. INVESTMENTS IN AFFILIATESSummarized annual and year-end information from the financial statements of unconsolidated affiliates representing 100% of the businesses follows:(millions)202020192018Net sales$870.3 $863.0 $807.9 Gross profit318.0 316.2 290.5 Net income93.7 90.5 78.9 Current assets$421.7 $426.3 $342.1 Noncurrent assets126.2 134.0 129.9 Current liabilities192.3 223.8 172.1 Noncurrent liabilities12.2 9.2 10.0 Royalty income from unconsolidated affiliates was $19.5 million, $19.0 million and $18.5 million for 2020, 2019 and 2018, respectively.Our principal earnings from unconsolidated affiliates is from our 50% interest in McCormick de Mexico, S.A. de C.V. Profit from this joint venture represented 75% of income from unconsolidated operations in 2020, 72% in 2019 and 76% in 2018. 696. FINANCING ARRANGEMENTSOur outstanding debt, including capital leases, was as follows at November 30: (millions)20202019Short-term borrowings Commercial paper$845.8 $575.3 Other40.9 25.4 $886.7 $600.7 Weighted-average interest rate of short-term borrowings at year-end0.3 %2.5 %Long-term debt3.90% notes due 7/8/2021(1)$250.0 $250.0 2.70% notes due 8/15/2022750.0 750.0 Term loan due 8/17/2022(2)— 250.0 3.50% notes due 8/19/2023(3)250.0 250.0 3.15% notes due 8/15/2024700.0 700.0 3.25% notes due 11/15/2025(4)250.0 250.0 3.40% notes due 8/15/2027(5)750.0 750.0 2.50% notes due 4/15/2030500.0 — 4.20% notes due 8/15/2047300.0 300.0 7.63%–8.12% notes due 202455.0 55.0 Other, including capital leases195.8 171.6 Unamortized discounts, premiums, debt issuance costs and fair value adjustments(6)16.9 (3.1)4,017.7 3,723.5 Less current portion263.9 97.7 $3,753.8 $3,625.8 (1)Interest rate swaps, settled upon the issuance of these notes in 2011, effectively set the interest rate on the $250 million notes at a weighted-average fixed rate of 4.01%.(2)The term loan was prepayable in whole or in part. Also, the term loan due in 2022 required quarterly principal payments of 2.5% of the initial principal amount.(3)Interest rate swaps, settled upon the issuance of these notes in 2013, effectively set the interest rate on the $250 million notes at a weighted-average fixed rate of 3.30%.(4)Interest rate swaps, settled upon the issuance of these notes in 2015, effectively set the interest rate on the $250 million notes at a weighted-average fixed rate of 3.45%. The fixed interest rate on $100 million of the 3.25% notes due in 2025 is effectively converted to a variable rate by interest rate swaps through 2025. Net interest payments are based on 3-month LIBOR plus 1.22% during this period (our effective rate as of November 30, 2020 was 1.44%).(5)Interest rate swaps, settled upon the issuance of these notes in 2017, effectively set the interest rate on the $750 million notes at a weighted-average fixed rate of 3.44%. The fixed interest rate on $250 million of the 3.40% notes due in 2027 is effectively converted to a variable rate by interest rate swaps through 2027. Net interest payments are based on 3-month LIBOR plus 0.685% during this period (our effective rate as of November 30, 2020 was 0.91%).(6)Includes unamortized discounts, premiums and debt issuance costs of $(24.4) million and $(23.6) million as of November 30, 2020 and 2019, respectively. Includes fair value adjustment associated with interest rate swaps designated as fair value hedges of $41.3 million and $20.5 million as of November 30, 2020 and 2019, respectively.Maturities of long-term debt, including capital leases, during the fiscal years subsequent to November 30, 2020 are as follows (in millions):2021$263.9 2022765.0 2023265.2 2024791.9 2025271.4 Thereafter1,643.4 In April 2020, we issued $500.0 million of 2.50% notes due April 15, 2030, with cash proceeds received of $495.0 million, net of discounts and underwriters' fees. Interest is payable semiannually in arrears in April and October of each year. 70In August 2017, we issued an aggregate amount of $2.5 billion of senior unsecured notes. These notes are due as follows: $750.0 million due August 15, 2022, $700.0 million due August 15, 2024, $750.0 million due August 15, 2027 and $300.0 million due August 15, 2047 with stated fixed interest rates of 2.70%, 3.15%, 3.40% and 4.20%, respectively. Interest is payable semiannually in arrears in August and February of each year. The net proceeds received from the issuance of these notes were $2,479.3 million and were used to partially fund our acquisition of RB Foods. In connection with our acquisition of RB Foods, we entered into a Term Loan Agreement (Term Loan) in August 2017. The Term Loan provides for three-year and five-year senior unsecured term loans, each for $750 million. The net proceeds received from the issuance of the Term Loan was $1,498.3 million. The three-year loan was payable at maturity. The five-year loan was payable in equal quarterly installments in an amount of 2.5% of the initial principal amount, with the remaining unpaid balance due at maturity. The three-year and five-year loans were each prepayable in whole or in part. In 2019 and 2018, we repaid the three-year loan in the amounts of $130.0 million and $370.0 million, respectively. Prior to payoff, the three-year loan bore interest at LIBOR plus 1.125%. In 2020, 2019 and 2018, we repaid $250.0 million, $306.3 million and $175.0 million, respectively, of the five-year loan. Prior to payoff, the five-year loan bore interest at LIBOR plus 1.25%. The interest rates were based on our credit rating.We have available credit facilities with domestic and foreign banks for various purposes. Some of these lines are committed lines and others are uncommitted lines and could be withdrawn at various times. We have a five-year $1.0 billion revolving credit facility, which will expire in August 2022. The current pricing for the credit facility, on a fully drawn basis, is LIBOR plus 1.25%. The pricing of the credit facility is based on a credit rating grid that contains a fully drawn maximum pricing of the credit facility equal to LIBOR plus 1.75%. This credit facility supports our commercial paper program and, after $845.8 million was used to support issued commercial paper, we have $154.2 million of capacity at November 30, 2020. In December 2020, we entered into a 364-day $1.0 billion revolving credit facility which will expire in December 2021. The current pricing for that credit facility, on a fully drawn basis, is LIBOR plus 1.25%. The pricing of the credit facility is based on a credit rating grid that contains a fully drawn maximum pricing of the credit facility equal to LIBOR plus 1.75%. The provisions of our revolving credit facilities restrict subsidiary indebtedness and require us to maintain certain minimum and maximum financial ratios for interest expense coverage and our leverage ratio. The applicable leverage ratio is reduced periodically. As of November 30, 2020, our capacity under the five-year $1.0 billion revolving credit facility was not affected by these covenants. We do not expect that these covenants would limit our access to our revolving credit facilities for the foreseeable future; however, the leverage ratio could restrict our ability to utilize this facility.In addition, we have several uncommitted lines totaling $316.6 million, which have a total unused capacity at November 30, 2020 of $212.8 million. These lines, by their nature, can be withdrawn based on the lenders’ discretion. Committed credit facilities require a fee, and commitment fees were $1.3 million for both 2020 and 2019.In 2018, we consolidated our Corporate staff and certain non-manufacturing U.S. employees into our new headquarters building in Hunt Valley, Maryland. The 15-year lease for that building requires monthly lease payments of approximately $0.9 million which began in April 2019. The $0.9 million monthly lease payment is subject to adjustment after an initial 60-month period and thereafter on an annual basis as specified in the lease agreement. Upon commencement of fit-out in the second quarter of 2018, we obtained access to the building, which resulted in the lease commencement date for accounting purposes. We have recognized this lease as a capital lease, with the leased asset of $116.1 million and $124.7 million included in property, plant and equipment, net, as of November 30, 2020 and 2019, respectively. As of November 30, 2020, the total lease obligation was $130.9 million, of which $7.1 million was included in the current portion of long-term debt and $123.8 million was included in long-term debt. As of November 30, 2019, the total lease obligation was $137.7 million, of which $6.8 million was included in the current portion of long-term debt and $130.9 million was included in long-term debt. During 2020, 2019 and 2018, respectively, we recognized amortization expense of $8.7 million, $8.7 million and $5.2 million related to the leased asset.At November 30, 2020, we had guarantees outstanding of $0.7 million with terms of one year or less. As of both November 30, 2020 and 2019, we had outstanding letters of credit of $32.2 million. These letters of credit typically act as a guarantee of payment to certain third parties in accordance with specified terms and conditions. The unused portion of our letter of credit facility was $13.8 million at November 30, 2020.7. LEASESOur lease portfolio primarily consists of (i) certain real estate, including those related to a number of administrative, distribution and manufacturing locations; (ii) certain machinery and equipment, including forklifts; and (iii) automobiles, delivery trucks and other vehicles, including an airplane. When our real estate lease arrangements 71include lease and non-lease components (for example, common area maintenance), we account for each component separately, based on their relative standalone prices. For all other asset categories, we combine lease components and non-lease components into a single lease commitment. We determine if an agreement is a lease or contains a lease at inception. Leases with an initial term of 12 months or less (short-term leases) are not recorded on the balance sheet.ROU assets represent our right to use an underlying asset for the lease term, and lease liabilities represent our obligation to make lease payments arising from the lease. ROU assets and liabilities are based on the estimated present value of lease payments over the lease term and are recognized at the lease commencement date.As most of our leases do not provide an implicit borrowing rate, we use our estimated incremental borrowing rate in determining the present value of lease payments. The estimated incremental borrowing rate is derived from information available at the lease commencement date.Our lease terms may include options to extend or terminate the lease when it is reasonably certain that we will exercise that option. A limited number of our lease agreements include rental payments that are adjusted periodically based on a market rate or index. Our lease agreements generally do not contain residual value guarantees or material restrictive covenants, with the exception of the non-cancellable synthetic lease discussed below.The following presents the components of our lease expense for the year ended November 30, 2020 (in millions):Operating lease cost$41.2 Finance lease cost:Amortization of ROU assets9.0 Interest on lease liabilities4.5 Net lease cost$54.7 (1) Net lease cost does not include short-term leases, variable lease costs or sublease income, all of which are immaterial.Rental expense under operating leases (primarily buildings and equipment) was $48.1 million in 2019 and $58.5 million in 2018.Supplemental balance sheet information related to leases as of November 30, 2020 were as follows (in millions):LeasesClassificationAssets:Operating lease ROU assetsOther long-term assets$136.8 Finance lease ROU assetsProperty, plant and equipment, net120.7 Total leased assets$257.5 Liabilities:CurrentOperating Other accrued liabilities $37.3 FinanceCurrent portion of long-term debt7.3 Non-currentOperating Other long-term liabilities103.5 FinanceLong-term debt125.5 Total lease liabilities$273.6 Information regarding our lease terms and discount rates as of November 30, 2020 were as follows:72Weighted-average remaining lease term (years)Weighted-average discount rateOperating leases5.61.9 %Finance leases13.93.3 %The future maturity of our lease liabilities as of November 30, 2020 were as follows (in millions):Operating leasesFinance leasesTotal2021$39.4 $11.4 $50.8 202229.2 11.4 40.6 202322.3 11.4 33.7 202415.3 11.5 26.8 202512.6 11.7 24.3 Thereafter28.8 114.0 142.8 Total lease payments147.6 171.4 319.0 Less: Imputed interest6.8 38.6 45.4 Total lease liabilities$140.8 $132.8 $273.6 Supplemental cash flow and other information related to leases for the year ended November 30, 2020 were as follows (in millions):Cash paid for amounts included in the measurements of lease liabilities:Operating cash flows used for operating leases$41.5 Operating cash flows used for finance leases4.5 Financing cash flows used for finance leases6.9 ROU assets obtained in exchange for lease liabilities Operating leases$36.6 During October 2020, we entered into a non-cancellable synthetic lease for a distribution facility with an estimated construction cost of $315 million. The lease will commence upon completion of construction of the facility, for which we are the construction agent, which is expected to be in the later part of fiscal 2022. The term of the lease is five years after commencement. The lease contains options to negotiate a renewal of the lease or to purchase or sell the facility at the end of the lease term. Upon lease commencement, the ROU asset and lease liability will be determined and recorded. The lease arrangement also contains a residual value guarantee of approximately 75% of the total construction cost. The lease also contains covenants that are consistent with our revolving credit agreements as disclosed in Note 6.8. FINANCIAL INSTRUMENTSWe use derivative financial instruments to enhance our ability to manage risk, including foreign currency and interest rate exposures, which exist as part of our ongoing business operations. We do not enter into contracts for trading purposes, nor are we a party to any leveraged derivative instrument and all derivatives are designated as hedges. We are not a party to master netting arrangements, and we do not offset the fair value of derivative contracts with the same counterparty in our financial statement disclosures. The use of derivative financial instruments is monitored through regular communication with senior management and the use of written guidelines.73Foreign CurrencyWe are potentially exposed to foreign currency fluctuations affecting net investments in subsidiaries, transactions (both third-party and intercompany) and earnings denominated in foreign currencies. Management assesses foreign currency risk based on transactional cash flows and translational volatility and may enter into forward contract and currency swaps with highly-rated financial institutions to reduce fluctuations in the long or short currency positions. Forward contracts are generally less than 18 months duration. Currency swap agreements are established in conjunction with the terms of the underlying debt issues. At November 30, 2020, we had foreign currency exchange contracts to purchase or sell $383.8 million of foreign currencies as compared to $489.2 million at November 30, 2019. All of these contracts were designated as hedges of anticipated purchases denominated in a foreign currency or hedges of foreign currency denominated assets or liabilities. Hedge ineffectiveness was not material. All foreign currency exchange contracts outstanding at November 30, 2020 have durations of less than 18 months.Contracts which are designated as hedges of anticipated purchases denominated in a foreign currency (generally purchases of raw materials in U.S. dollars by operating units outside the U.S.) are considered cash flow hedges. The gains and losses on these contracts are deferred in accumulated other comprehensive income until the hedged item is recognized in cost of goods sold, at which time the net amount deferred in accumulated other comprehensive income is also recognized in cost of goods sold. Gains and losses from contracts that are designated as hedges of assets, liabilities or firm commitments are recognized through income, offsetting the change in fair value of the hedged item.We also enter into fair value foreign currency exchange contracts to manage exposure to currency fluctuations in certain intercompany loans between subsidiaries as well as currency exposure to third-party non-functional currency assets or liabilities. The notional value of these contracts was $212.3 million and $357.5 million at November 30, 2020 and 2019, respectively. Any gains or losses recorded based on both the change in fair value of these contracts and the change in the currency component of the underlying loans are recognized in our consolidated income statement as other income, net.Beginning in the first quarter of 2019, we also utilized cross currency interest rate swap contracts that are designated as net investment hedges. As of November 30, 2020, we had cross currency interest rate swap contracts of (i) $250 million notional value to receive $250 million at three-month U.S. LIBOR plus 0.685% and pay £194.1 million at three-month GBP LIBOR plus 0.740% and (ii) £194.1 million notional value to receive £194.1 million at three-month GBP LIBOR plus 0.740% and pay €221.8 million at three-month Euro EURIBOR plus 0.808%. These cross-currency interest rate swap contracts expire in August 2027. Interest RatesWe finance a portion of our operations with both fixed and variable rate debt instruments, primarily commercial paper, notes and bank loans. We utilize interest rate swap agreements to minimize worldwide financing costs and to achieve a desired mix of variable and fixed rate debt.As of November 30, 2020 and 2019, we have outstanding interest rate swap contracts for a notional amount of $350.0 million. Those interest rate swap contracts include a $100 million notional value of interest rate swap contracts where we receive interest at 3.25% and pay a variable rate of interest based on three-month LIBOR plus 1.22%. These swaps, which expire in November 2025, are designated as fair value hedges of the changes in fair value of $100 million of the $250 million 3.25% medium-term notes due 2025. We also have $250 million notional interest rate swap contracts where we receive interest at 3.40% and pay a variable rate of interest based on three-month LIBOR plus 0.685%, which expire in August 2027, and are designated as fair value hedges of the changes in fair value of $250 million of the $750 million 3.40% term notes due 2027. Any unrealized gain or loss on these swaps was offset by a corresponding increase or decrease in the value of the hedged debt. Hedge ineffectiveness was not material. All derivatives are recognized at fair value in our balance sheet and recorded in either other current assets, or other long-term assets, other accrued liabilities or other long-term liabilities depending upon their nature and maturity. 74The following tables disclose the notional amount and fair values of derivative instruments on our consolidated balance sheet:As ofNovember 30, 2020:(millions)Asset DerivativesLiability DerivativesDerivativesBalance sheetlocationNotional amountFair valueBalance sheetlocationNotional amountFair valueInterest rate contractsOther current assets/Other long-term assets$350.0 $43.1 Other accrued liabilities$— $— Foreign exchange contractsOther current assets27.5 1.4 Other accrued liabilities356.3 8.2 Cross currency contractsOther current assets/Other long-term assets— — Other long-term liabilities524.4 18.8 Total $44.5 $27.0 As ofNovember 30, 2019: (millions)Asset DerivativesLiability DerivativesDerivativesBalance sheetlocationNotional amountFair valueBalance sheetlocationNotional amountFair valueInterest rate contractsOther current assets/Other long-term assets$350.0 $20.9 Other accrued liabilities$— $— Foreign exchange contractsOther current assets293.1 3.3 Other accrued liabilities196.1 3.6 Cross currency contractsOther current assets/Other long-term assets495.5 3.2 Other accrued liabilities— — Total $27.4 $3.6 The following tables disclose the impact of derivative instruments on other comprehensive income (OCI), accumulated other comprehensive income (AOCI) and our consolidated income statement for the years ended November 30, 2020, 2019 and 2018:Fair value hedges (millions) Income statementlocationIncome (expense)Derivative202020192018Interest rate contractsInterest expense$5.2 $— $(0.1) Income statement locationGain (loss) recognized in incomeIncome statement locationGain (loss) recognized in incomeDerivative202020192018Hedged Item202020192018Foreign exchange contractsOther income, net$(4.0)$0.2 $(2.9)Intercompany loansOther income, net$3.0 $(0.9)$2.7 Cash flow hedges (millions) Gain (loss)recognized in OCIIncome statement location Gain (loss) reclassified from AOCI Derivative202020192018202020192018Interest rate contracts$— $— $— Interest expense$0.5 $0.5 $0.5 Foreign exchange contracts1.9 (0.2)2.6 Cost of goods sold 1.6 1.6 (3.3)Total$1.9 $(0.2)$2.6 $2.1 $2.1 $(2.8)The amount of gain or loss recognized in income on the ineffective portion of derivative instruments is not material. The net amount of accumulated other comprehensive income expected to be reclassified into income related to these contracts in the next twelve months is a $0.7 million increase to earnings.75Net investment hedges (millions) Gain (loss)recognized in OCIIncome statement location Gain (loss)excluded from the assessment of hedge effectivenessDerivative2020201920202019Cross currency contracts$(20.8)$1.1 Interest expense $3.1 $5.4 For all net investment hedges, no amounts have been reclassified out of other comprehensive income (loss). The amounts noted in the tables above for OCI do not include any adjustments for the impact of deferred income taxes. Fair Value of Financial InstrumentsThe carrying amount and fair value of financial instruments as of November 30 were as follows: 20202019(millions)CarryingamountFairvalueCarryingamountFairvalueLong-term investments$129.9 $129.9 $124.4 $124.4 Long-term debt (including current portion)4,017.7 4,357.1 3,723.5 3,859.0 Level 1 valuation techniques4,161.3 3,437.5 Level 2 valuation techniques195.8 421.5 Derivatives related to:Interest rates (assets)43.1 43.1 20.9 20.9 Foreign currency (assets)1.4 1.4 3.3 3.3 Foreign currency (liabilities)8.2 8.2 3.6 3.6 Cross currency (assets)— — 3.2 3.2 Cross currency (liabilities)18.8 18.8 — — Because of their short-term nature, the amounts reported in the balance sheet for cash and cash equivalents, receivables, short-term borrowings and trade accounts payable approximate fair value. The fair value for Level 2 long-term debt is determined by using quoted prices for similar debt instruments. Investments in affiliates are not readily marketable, and it is not practicable to estimate their fair value. Long-term investments are comprised of fixed income and equity securities held on behalf of employees in certain employee benefit plans and are stated at fair value on the balance sheet. Concentrations of Credit RiskWe are potentially exposed to concentrations of credit risk with trade accounts receivable and financial instruments. The customers of our consumer segment are predominantly food retailers and food wholesalers. Consolidations in these industries have created larger customers. In addition, competition has increased with the growth in alternative channels including mass merchandisers, dollar stores, warehouse clubs, discount chains and e-commerce. This has caused some customers to be less profitable and increased our exposure to credit risk. We generally have a large and diverse customer base which limits our concentration of credit risk. At November 30, 2020, we did not have amounts due from any single customer that exceed 10% of consolidated trade accounts receivable. Current credit markets are highly volatile and some of our customers and counterparties are highly leveraged. We continue to closely monitor the credit worthiness of our customers and counterparties and generally do not require collateral. We believe that the allowance for doubtful accounts properly recognized trade receivables at realizable value. We consider nonperformance credit risk for other financial instruments to be insignificant.9. FAIR VALUE MEASUREMENTSFair value can be measured using valuation techniques, such as the market approach (comparable market prices), the income approach (present value of future income or cash flow) and the cost approach (cost to replace the service capacity of an asset or replacement cost). Accounting standards utilize a fair value hierarchy that prioritizes the inputs to valuation techniques used to measure fair value into three broad levels. The following is a brief description of those three levels: •Level 1: Observable inputs such as quoted prices (unadjusted) in active markets for identical assets or liabilities.•Level 2: Inputs other than quoted prices that are observable for the asset or liability, either directly or indirectly. These include quoted prices for similar assets or liabilities in active markets and quoted prices for identical or similar assets or liabilities in markets that are not active.•Level 3: Unobservable inputs that reflect management’s own assumptions.76Our population of assets and liabilities subject to fair value measurements on a recurring basis are as follows: Fair value measurements using fairvalue hierarchy as of November 30, 2020(millions)Fair value Level 1Level 2Assets:Cash and cash equivalents$423.6 $423.6 $— Insurance contracts126.0 — 126.0 Bonds and other long-term investments3.9 3.9 — Interest rate derivatives43.1 — 43.1 Foreign currency derivatives1.4 — 1.4 Total$598.0 $427.5 $170.5 Liabilities:Foreign currency derivatives8.2 — 8.2 Cross currency contracts18.8 — 18.8 Total$27.0 $— $27.0 Fair value measurements using fairvalue hierarchy as of November 30, 2019(millions)Fair value Level 1Level 2Assets:Cash and cash equivalents$155.4 $155.4 $— Insurance contracts121.7 — 121.7 Bonds and other long-term investments2.7 2.7 — Interest rate derivatives20.9 — 20.9 Foreign currency derivatives3.3 — 3.3 Cross currency contracts3.2 — 3.2 Total$307.2 $158.1 $149.1 Liabilities:Foreign currency derivatives3.6 — 3.6 Total$3.6 $— $3.6 The fair values of insurance contracts are based upon the underlying values of the securities in which they are invested and are from quoted market prices from various stock and bond exchanges for similar type assets. The fair values of bonds and other long-term investments are based on quoted market prices from various stock and bond exchanges. The fair values for interest rate and foreign currency derivatives are based on values for similar instruments using models with market-based inputs. At November 30, 2020 and 2019, we had no financial assets or liabilities that were subject to a level 3 fair value measurement.10. ACCUMULATED OTHER COMPREHENSIVE LOSSThe following table sets forth the components of accumulated other comprehensive loss, net of tax where applicable, as of November 30 (in millions):20202019Accumulated other comprehensive loss, net of tax where applicableForeign currency translation adjustment (1)$(174.0)$(266.5)Unrealized loss on foreign currency exchange contracts(0.4)— Unamortized value of settled interest rate swaps(0.1)0.3 Pension and other postretirement costs(296.3)(234.0) $(470.8)$(500.2)(1)During the year ended November 30, 2020, the foreign currency translation adjustment of accumulated other comprehensive loss decreased by $92.5 million, including the impact of a $20.8 million increase associated with net investment hedges. During the year ended November 30, 2019, the foreign currency translation adjustment of accumulated other comprehensive loss increased by $24.9 million, of which $0.9 million was associated with net investment hedges. These net investment hedges are more fully described in Note 8.77The following table sets forth the amounts reclassified from accumulated other comprehensive income (loss) and into consolidated net income for the years ended November 30:(millions)Affected line items in the consolidated income statementAccumulated other comprehensive income (loss) components202020192018(Gains)/losses on cash flow hedges:Interest rate derivatives$(0.5)$(0.5)$(0.5)Interest expenseForeign exchange contracts(1.6)(1.6)3.3 Cost of goods soldTotal before taxes(2.1)(2.1)2.8 Tax effect0.5 0.4 (0.6)Income taxesNet, after tax$(1.6)$(1.7)$2.2 Amortization of pension and postretirement benefit adjustments:Amortization of prior service (credits) costs (1)$(4.0)$(8.0)$(8.5)Other income, netAmortization of net actuarial losses (1)11.0 2.6 12.6 Other income, netTotal before taxes7.0 (5.4)4.1 Tax effect(1.6)1.2 (1.0)Income taxesNet, after tax$5.4 $(4.2)$3.1 (1) This accumulated other comprehensive income (loss) component is included in the computation of total pension expense and total other postretirement expense (refer to note 11 for additional details).11. EMPLOYEE BENEFIT AND RETIREMENT PLANSWe sponsor defined benefit pension plans in the U.S. and certain foreign locations. In addition, we sponsor defined contribution plans in the U.S. We contribute to defined contribution plans in locations outside the U.S., including government-sponsored retirement plans. We also currently provide postretirement medical and life insurance benefits to certain U.S. employees and retirees.During fiscal year 2017, we made significant changes to certain of our employee benefit plans and retirements plans that froze the accrual of certain defined benefit pension plans in the U.S. and the United Kingdom. Also, on December 1, 2017, our Management Committee approved the freezing of benefits under our pension plans in Canada. The effective date of this freeze was November 30, 2019. Although those plans have been frozen, employees who are participants in the plans retained benefits accumulated up to the date of the freeze, based on credited service and eligible earnings, in accordance with the terms of the plans.As a result of the change to our pension plans in Canada, we remeasured pension assets and benefit obligations as of the date of the approval indicated above and, in fiscal year 2018, we reduced the Canadian plan benefit obligations by $17.5 million. These remeasurements resulted in a non-cash, pre-tax net actuarial gain of $17.5 million in fiscal year 2018. These net actuarial gains consist principally of a curtailment gain of $18.0 million, which is included in our consolidated statement of comprehensive income for 2018 as a component of "Other comprehensive income (loss)" on the line entitled "Unrealized components of pension plans". Deferred taxes associated with this actuarial gain, together with other unrealized components of pension plans recognized during 2018, are also included in that statement as a component of "Other comprehensive income (loss)".Included in our consolidated balance sheet as of November 30, 2020 on the line entitled "Accumulated other comprehensive loss" was $383.4 million ($296.3 million net of tax) related to net unrecognized actuarial losses that have not yet been recognized in net periodic pension or postretirement benefit cost. We expect to recognize $13.5 million ($9.7 million net of tax) in net periodic pension and postretirement benefit costs during 2021 related to the amortization of actuarial losses of $13.2 million and the amortization of prior service cost of $0.3 million.Defined Benefit Pension PlansThe significant assumptions used to determine benefit obligations are as follows as of November 30: United StatesInternational 2020201920202019Discount rate—funded plans2.8 %3.4 %1.9 %2.2 %Discount rate—unfunded plan2.7 %3.3 %— — Salary scale— — 2.9 %2.9 %78The significant assumptions used to determine pension expense for the years ended November 30 are as follows: United StatesInternational 202020192018202020192018Discount rate—funded plans3.4 %4.7 %4.0 %2.2 %3.3 %2.9 %Discount rate—unfunded plan3.3 %4.6 %3.9 %— — — Salary scale— %— %3.8 %2.9 %3.4 %3.5 %Expected return on plan assets6.8 %7.0 %7.3 %4.9 %5.5 %5.6 %Annually, we undertake a process, with the assistance of our external investment consultants, to evaluate the appropriate projected rates of return to use for our pension plans’ assumptions. We engage our investment consultants' research teams to develop capital market assumptions for each asset category in our plans to project investment returns into the future. The specific methods used to develop expected return assumptions vary by asset category. We adjust the outcomes for the fact that plan assets are invested with actively managed funds and subject to tactical asset reallocation.Our pension expense for the years ended November 30 was as follows: United StatesInternational(millions)202020192018202020192018Service cost$3.2 $2.1 $17.0 $1.3 $3.6 $4.3 Interest costs29.3 34.4 31.6 7.5 9.5 9.2 Expected return on plan assets(40.6)(42.5)(43.4)(15.3)(16.4)(16.6)Amortization of prior service costs0.5 0.5 — 0.1 0.2 0.1 Amortization of net actuarial loss7.8 2.3 9.9 2.0 1.2 2.8 Settlement/curtailment loss— — — 1.3 — 0.5 $0.2 $(3.2)$15.1 $(3.1)$(1.9)$0.3 A rollforward of the benefit obligation, fair value of plan assets and a reconciliation of the pension plans’ funded status as of November 30, the measurement date, follows: United StatesInternational(millions)2020201920202019Change in benefit obligation:Benefit obligation at beginning of year$884.8 $752.6 $345.6 $292.9 Service cost3.2 2.1 1.3 3.6 Interest costs29.3 34.4 7.5 9.5 Employee contributions— — — 0.6 Actuarial loss82.1 134.6 19.1 51.8 Benefits paid(41.4)(38.9)(14.1)(14.7)Expenses paid— — (0.2)(0.3)Foreign currency impact— — 12.5 2.2 Benefit obligation at end of year$958.0 $884.8 $371.7 $345.6 Change in fair value of plan assets:Fair value of plan assets at beginning of year$671.9 $640.4 $340.9 $306.5 Actual return on plan assets47.3 62.2 28.6 42.4 Employer contributions10.4 8.2 1.5 3.2 Employee contributions— — — 0.8 Benefits paid(41.4)(38.9)(14.1)(14.7)Foreign currency impact— — 11.8 2.7 Fair value of plan assets at end of year$688.2 $671.9 $368.7 $340.9 Funded status$(269.8)$(212.9)$(3.0)$(4.7)Pension plans in which accumulated benefit obligation exceeded plan assetsProjected benefit obligation$958.0 $884.8 $110.4 $103.9 Accumulated benefit obligation945.1 874.8 106.5 100.4 Fair value of plan assets688.2 671.9 87.7 83.6 Included in the U.S. in the preceding table is a benefit obligation of $110.5 million and $105.4 million for 2020 and 2019, respectively, related to our Supplemental Executive Retirement Plan (SERP). The assets related to this plan, 79which totaled $86.4 million and $85.5 million as of November 30, 2020 and 2019, respectively, are held in a rabbi trust and accordingly have not been included in the preceding table. Amounts recorded in the balance sheet for all defined benefit pension plans as of November 30 consist of the following: United StatesInternational (millions)2020201920202019Non-current pension asset$— $— $19.6 $15.6 Accrued pension liability269.8 212.9 22.6 20.3 Deferred income tax assets74.0 58.5 14.3 13.3 Accumulated other comprehensive loss235.5 183.9 63.7 60.1 The accumulated benefit obligation is the present value of pension benefits (whether vested or unvested) attributed to employee service rendered before the measurement date and based on employee service and compensation prior to that date. The accumulated benefit obligation differs from the projected benefit obligation in that it includes no assumption about future compensation or service levels. The accumulated benefit obligation for the U.S. pension plans was $945.1 million and $874.8 million as of November 30, 2020 and 2019, respectively. The accumulated benefit obligation for the international pension plans was $367.9 million and $342.2 million as of November 30, 2020 and 2019, respectively.The investment objectives of the defined benefit pension plans are to provide assets to meet the current and future obligations of the plans at a reasonable cost to us. The goal is to optimize the long-term return across the portfolio of investments at a moderate level of risk. Higher-returning assets include mutual, co-mingled and other funds comprised of equity securities, utilizing both active and passive investment styles. These more volatile assets are balanced with less volatile assets, primarily mutual, co-mingled and other funds comprised of fixed income securities. Professional investment firms are engaged to provide advice on the selection and monitoring of investment funds, and to provide advice on the allocation of plan assets across the various fund managers. This advice is based in part on the duration of each plan’s liability. The investment return performances are evaluated quarterly against specific benchmark indices and against a peer group of funds of the same asset classification.The allocations of U.S. pension plan assets as of November 30, by asset category, were as follows: Actual2020Asset Category20202019TargetEquity securities63.2 %63.3 %59.0 %Fixed income securities22.0 %21.5 %23.2 %Other14.8 %15.2 %17.8 %Total100.0 %100.0 %100.0 %The allocations of the international pension plans’ assets as of November 30, by asset category, were as follows: Actual2020Asset Category20202019Target Equity securities50.9 %50.4 %53.0 %Fixed income securities48.3 %48.9 %47.0 %Other0.8 %0.7 %— %Total100.0 %100.0 %100.0 %80The following tables set forth by level, within the fair value hierarchy as described in note 9, pension plan assets at their fair value as of November 30 for the United States and international plans:As of November 30, 2020United States(millions)TotalfairvalueLevel 1Level 2Cash and cash equivalents$28.1 $28.1 $— Equity securities:U.S. equity securities(a)271.1 138.2 132.9 International equity securities(b)159.2 147.6 11.6 Fixed income securities:U.S. government/corporate bonds(c)57.1 54.9 2.2 High yield bonds(d)37.3 — 37.3 International/government/corporate bonds(e)29.1 29.1 — Insurance contracts(f)1.1 — 1.1 Other types of investments:Real estate (g)24.5 20.6 3.9 Natural resources (h)9.7 — 9.7 Total $617.2 $418.5 $198.7 Investments measured at net asset value(i)Hedge funds(j)39.5 Private equity funds(k)4.8 Private debt funds(l)26.7 Total investments$688.2 As of November 30, 2020International(millions)TotalfairvalueLevel 1Level 2Cash and cash equivalents$3.1 $3.1 $— International equity securities(b)187.6 — 187.6 Fixed income securities: International/government/corporate bonds(e)155.4 — 155.4 Insurance contracts(f)22.6 — 22.6 Total investments$368.7 $3.1 $365.6 81As of November 30, 2019United States(millions)Total fair value Level 1Level 2Cash and cash equivalents$15.3 $15.3 $— Equity securities:U.S. equity securities(a)276.5 148.5 128.0 International equity securities(b)145.5 134.2 11.3 Fixed income securities:U.S./government/ corporate bonds(c)51.2 49.1 2.1 High yield bonds(d)40.1 — 40.1 International/government/ corporate bonds(e)26.8 26.8 — Insurance contracts(f)1.1 — 1.1 Other types of investments:Real estate (g)25.9 22.0 3.9 Natural resources (h)12.0 — 12.0 Total $594.4 $395.9 $198.5 Investments measured at net asset value(i)Hedge funds(j)49.3 Private equity funds(k)3.2 Private debt funds(l)25.0 Total investments$671.9 As of November 30, 2019International(millions)Total fair value Level 1Level 2Cash and cash equivalents$2.5 $2.5 $— International equity securities(b)171.6 — 171.6 Fixed income securities:International/government/corporate bonds(e)144.7 — 144.7 Insurance contracts(f)22.1 — 22.1 Total investments$340.9 $2.5 $338.4 (a)This category comprises equity funds and collective equity trust funds that most closely track the S&P index and other equity indices.(b)This category comprises international equity funds with varying benchmark indices.(c)This category comprises funds consisting of U.S. government and U.S. corporate bonds and other fixed income securities. An appropriate benchmark is the Barclays Capital Aggregate Bond Index.(d)This category comprises funds consisting of real estate related debt securities with an appropriate benchmark of the Barclays Investment Grade CMBS Index.(e)This category comprises funds consisting of international government/corporate bonds and other fixed income securities with varying benchmark indices.(f)This category comprises insurance contracts, the majority of which have a guaranteed investment return.(g)This category comprises funds investing in real estate investment trusts (REIT). An appropriate benchmark is the MSCI U.S. REIT Index.(h)This category comprises funds investing in natural resources. An appropriate benchmark is the Alerian master limited partnership (MLP) Index.(i)Certain investments that are valued using the net asset value per share (or its equivalent) as a practical expedient have not been classified in the fair value hierarchy. These are included to permit reconciliation of the fair value hierarchy to the aggregate pension plan assets. (j)This category comprises hedge funds investing in strategies represented in various HFRI Fund Indices. The net asset value is generally based on the valuation of the underlying investment. Limitations exist on the timing from notice by the plan of its intent to redeem and actual redemptions of these funds and generally range from a minimum of one month to several months.(k)This category comprises private equity, venture capital and limited partnerships. The net asset is based on valuation models of the underlying securities as determined by the general partner or general partner's designee. These valuation models include unobservable inputs that cannot be corroborated using verifiable observable market data. These funds typically have redemption periods of approximately 10 years. (l)This category comprises limited partnerships funds investing in senior loans, mezzanine and distressed debt. The net asset is based on valuation models of the underlying securities as determined by the general partner or general partner's designee. These valuation models include unobservable inputs that cannot be corroborated using verifiable observable market data. These funds typically have redemption periods of approximately 10 years. For the plans’ hedge funds, private equity funds and private debt funds, we engage an independent advisor to compare the funds’ returns to other funds with similar strategies. Each fund is required to have an annual audit by 82an independent accountant, which is provided to the independent advisor. This provides a basis of comparability relative to similar assets.Equity securities in the U.S. pension plans included McCormick stock with a fair value of $50.6 million (0.6 million shares and 7.4% of total U.S. pension plan assets) and $64.4 million (0.8 million shares and 9.6% of total U.S. pension plan assets) at November 30, 2020 and 2019, respectively. Dividends paid on these shares were $0.9 million in both 2020 and 2019.Pension benefit payments in our most significant plans are made from assets of the pension plans. It is anticipated that future benefit payments for the U.S. and international plans for the next 10 fiscal years will be as follows:(millions)United StatesInternational2021$43.7 $12.0 202243.7 11.7 202344.7 12.8 202447.5 12.4 202548.7 12.8 2026-2030252.8 66.0 U.S. Defined Contribution Retirement PlansEffective December 1, 2018 for the U.S. defined contribution retirement plan, we match 100% of a participant’s contribution up to the first 3% of the participant’s salary, and 66.7% of the next 3% of the participant’s salary. In addition, we make contributions of 3% of the participant's salary for all U.S. employees who are employed on December 31 of each year. Prior to December 1, 2018 for the U.S. defined contribution retirement plan, we matched 100% of a participant’s contribution up to the first 3% of the participant’s salary, and 50% of the next 2% of the participant’s salary. In addition, we made contributions of 3% of the participant's salary for U.S. employees not covered by the defined benefit plan. Some of our smaller U.S. subsidiaries sponsor separate 401(k) retirement plans. We also sponsor a non-qualified defined contribution retirement plan. Our contributions charged to expense under all U.S. defined contribution retirement plans were $30.8 million, $28.2 million and $15.5 million in 2020, 2019 and 2018, respectively.At the participant’s election, 401(k) retirement plans held 2.9 million shares of McCormick stock, with a fair value of $267.3 million, at November 30, 2020. Dividends paid on the shares held in the 401(k) retirement plans in 2020 and 2019 were $3.8 million and $3.9 million, respectively, in each year.Postretirement Benefits Other Than PensionsWe currently provide postretirement medical and life insurance benefits to certain U.S. employees who were covered under the active employees’ plan and retire after age 55 with at least five years of service. The subsidy provided under these plans is based primarily on age at date of retirement. These benefits are not pre-funded but paid as incurred. Employees hired after December 31, 2008 are not eligible for a company subsidy. They are eligible for coverage on an access-only basis.Our other postretirement benefit (income) expense for the years ended November 30 follows:(millions)202020192018Service cost$1.9 $1.8 $2.0 Interest costs2.0 2.7 2.4 Amortization of prior service credits(4.6)(8.7)(8.6)Amortization of actuarial gains(0.1)(0.9)(0.1)Postretirement benefit (income) expense$(0.8)$(5.1)$(4.3)83Rollforwards of the benefit obligation, fair value of plan assets and a reconciliation of the plans’ funded status at November 30, the measurement date, follow:(millions)20202019Change in benefit obligation:Benefit obligation at beginning of year$67.2 $62.9 Service cost1.9 1.8 Interest costs2.0 2.7 Participant contributions2.1 0.3 Plan amendments— (0.4)Actuarial loss3.9 4.1 Benefits paid(6.4)(4.2)Benefit obligation at end of year$70.7 $67.2 Change in fair value of plan assets:Fair value of plan assets at beginning of year$— $— Employer contributions4.3 3.9 Participant contributions2.1 0.3 Benefits paid(6.4)(4.2)Fair value of plan assets at end of year$— $— Other postretirement benefit liability$70.7 $67.2 Estimated future benefit payments (net of employee contributions) for the next 10 fiscal years are as follows:(millions)RetireemedicalRetiree lifeinsuranceTotal2021$3.6 $1.5 $5.1 20223.6 1.5 5.1 20233.7 1.4 5.1 20243.7 1.4 5.1 20253.7 1.4 5.1 2026-203017.5 6.5 24.0 The assumed discount rate in determining the benefit obligation was 2.3% and 3.1% for 2020 and 2019, respectively.For 2020, the assumed annual rate of increase in the cost of covered health care benefits is 6.8% (6.5% last year). It is assumed to decrease gradually to 4.5% in the year 2032 (4.5% in 2030 last year) and remain at that level thereafter. A one percentage point increase or decrease in the assumed health care cost trend rate would have had an immaterial effect on the benefit obligation and the total of service and interest cost components for 2020.12. STOCK-BASED COMPENSATIONWe have four types of stock-based compensation awards: restricted stock units (RSUs), stock options, company stock awarded as part of our long-term performance plan (LTPP), and beginning in 2020, price-vested stock options. Total stock-based compensation expense for 2020, 2019 and 2018 was $46.0 million, $37.2 million and $25.6 million, respectively. Total unrecognized stock-based compensation expense related to our RSUs and stock options at November 30, 2020 was $23.2 million and the weighted-average period over which this will be recognized is 1.3 years. Total unrecognized stock-based compensation expense related to our price-vested stock options at November 30, 2020 was $23.3 million and the weighted-average period over which this will be recognized is 3.0 years. Total unrecognized stock-based compensation expense related to our LTPP is variable in nature and is dependent on the company's execution against established performance metrics under performance cycles related to this plan. As of November 30, 2020, we have 6.6 million shares remaining available for future issuance under our RSUs, stock option and LTPP award programs.For all awards, forfeiture rates are considered in the calculation of compensation expense.The following summarizes the key terms and the methods of valuation and expense recognition for each of our stock-based compensation awards.RSUsRSUs are valued at the market price of the underlying stock, discounted by foregone dividends, on the date of grant. Substantially all of the RSUs granted vest over a three-year term or, if earlier, upon the retirement eligibilitydate of the holder. 84A summary of our RSU activity for the years ended November 30 follows:(shares in thousands)202020192018 SharesWeighted- average price SharesWeighted-averagepriceSharesWeighted-averagepriceBeginning of year762 $57.95 846 $51.53 534 $43.24 Granted296 67.03 258 71.62 556 56.36 Vested(325)57.56 (318)52.08 (226)44.08 Forfeited(19)62.96 (24)56.78 (18)48.27 Outstanding—end of year714 $61.74 762 $57.95 846 $51.53 Stock Options (Other than Price-Vested Stock Options)Stock options are granted with an exercise price equal to the market price of the stock on the date of grant. Substantially all of the options, with the exception of price-vested options detailed below, vest ratably over a three-year period or, if earlier, upon the retirement-eligibility dates of the holders and are exercisable over a 10-year period. Upon exercise of the option, shares are issued from our authorized and unissued shares.The fair value of the options is estimated with a lattice option pricing model which uses the assumptions in the following table. We believe the lattice model provides an appropriate estimate of fair value of our options as it allows for a range of possible outcomes over an option term and can be adjusted for changes in certain assumptions over time. Expected volatilities are based primarily on the historical performance of our stock. We also use historical data to estimate the timing and amount of option exercises and forfeitures within the valuation model. The expected term of the options is an output of the option pricing model and estimates the period of time that options are expected to remain unexercised. The risk-free interest rate is based on the U.S. Treasury yield curve in effect at the time of grant. Compensation expense is calculated based on the fair value of the options on the date of grant. The per share weighted-average fair value for all options granted was $13.27, $13.76 and $10.15 in 2020, 2019 and 2018, respectively. These fair values were computed using the following range of assumptions for the years ended November 30:202020192018Risk-free interest rates0.0 - 0.6%2.2 - 2.5%1.7 - 2.9%Dividend yield1.8 %1.5 %2.0 %Expected volatility22.8 %17.4%18.4%Expected lives7.9 years7.5 years7.6 yearsUnder our stock option plans, we may issue shares on a net basis at the request of the option holder. This occurs by netting the option cost in shares from the shares exercised.A summary of our stock option activity for the years ended November 30 follows:(shares in millions)202020192018 SharesWeighted- average exercise price SharesWeighted-averageexercisepriceSharesWeighted-averageexercisepriceBeginning of year5.2 $48.09 7.2 $41.30 9.6 $35.96 Granted0.7 69.31 0.6 73.70 0.8 52.98 Exercised(1.4)41.01 (2.6)35.54 (3.2)27.64 Outstanding—end of year4.5 53.56 5.2 48.09 7.2 41.30 Exercisable—end of year3.2 $47.76 3.8 $43.31 5.6 $38.27 As of November 30, 2020, the intrinsic value (the difference between the exercise price and the market price) for all options currently outstanding was $178.7 million and for options currently exercisable was $146.0 million. At November 30, 2020, the differences between options outstanding and options expected to vest and their related weighted-average exercise prices, aggregate intrinsic values and weighted-average remaining lives were not material. The total intrinsic value of all options exercised during the years ended November 30, 2020, 2019 and 2018 was $68.4 million, $111.0 million and $108.0 million, respectively. A summary of our stock options outstanding and exercisable at November 30, 2020 follows:85(shares in millions)Options outstandingOptions exercisableRange ofexercise priceSharesWeighted-averageremaininglife (yrs.)Weighted-averageexercisepriceSharesWeighted-averageremaininglife (yrs.)Weighted- average exercise price $23.00 - $37.500.5 2.8$33.99 0.5 2.8$33.99 $37.51 - $56.002.7 5.948.36 2.5 5.847.97 $56.01 - $74.501.3 8.971.27 0.2 8.373.64 4.5 6.5$53.56 3.2 5.6$47.76 Price-Vested Stock OptionsIn November 2020, we granted approximately 2,482,000 price-vested stock options to certain employees. The price-vested stock options were granted with an exercise price of $93.49 which was equal to the market price of our stock on the date of grant. The price-vested options are not exercisable until a three year service condition is achieved, and will become exercisable after that time period only if the average closing price of our stock price equals or exceeds thresholds of 60%, 80% or 100% appreciation from the exercise price for 30 consecutive trading days within a five-year period from the date of grant. If the options become exercisable, they are exercisable up to 10 years from the date of grant. The options granted were divided equally between the three appreciation thresholds. Employees who are retirement eligible vest on a pro-rata basis over a three-year period if the market condition is met in the five-year period from the date of grant. If the market conditions are not met in the five-year period from the date of grant, the options do not become exercisable and will be forfeited.The fair value of the price-vested options was estimated using a lattice model. The per share weighted-average fair value for the price-vested stock options granted was $11.88, $9.26, and $7.05, for the 60%, 80% and 100% appreciation thresholds, respectively. These fair values were computed using the following range of assumptions:Risk-free interest rates0.85 %Dividend yield1.5 %Expected volatility21.2 %Expected lives5.6 - 6.2 yearsLTPPOur LTPP grants in 2018 will deliver awards in a combination of cash and company stock. The stock compensation portion of the LTPP grants in 2018 awards shares of company stock if certain company performance objectives are met at the end of a three-year period. LTPP awards granted in 2020 and 2019 will be delivered entirely in company stock, with the target award calculated using a combination of a market-based total shareholder return and performance-based components. These awards are valued based on the fair value of the underlying stock on the date of grant. A summary of the LTPP award activity for the years ended November 30 follows:(shares in thousands)202020192018 SharesWeighted- average price SharesWeighted-averagepriceSharesWeighted-averagepriceBeginning of year392 $57.98 436 $41.78 440 $42.16 Granted130 86.14 136 75.26 172 50.95 Vested(88)44.98 (114)43.20 (120)37.01 Performance adjustment(44)50.95 (66)44.98 (52)43.20 Forfeited(8)65.68 — — (4)48.71 Outstanding—end of year382 $71.20 392 $57.98 436 $41.78 8613. INCOME TAXESThe provision for income taxes for the years ended November 30 consists of the following:(millions)202020192018Income taxesCurrentFederal$98.3 $52.3 $92.9 State14.8 10.7 11.0 International73.0 73.5 78.7 186.1 136.5 182.6 DeferredFederal4.6 26.4 (340.3)State0.5 3.6 1.5 International(16.3)(9.1)(1.1) (11.2)20.9 (339.9)Total income tax expense (benefit)$174.9 $157.4 $(157.3)In December 2017, President Trump signed into law Pub. L. 115-97, “An Act to provide for reconciliation pursuant to titles II and V of the concurrent resolution on the budget for fiscal year 2018” (this legislation is referred to herein as the U.S. Tax Act). The U.S. Tax Act provides for significant changes in the U.S. Internal Revenue Code of 1986, as amended. Certain provisions of the U.S. Tax Act were effective during our fiscal year ended November 30, 2018 with all provisions of the U.S. Tax Act effective as of the beginning of our fiscal year beginning December 1, 2018. The U.S. Tax Act contains provisions with separate effective dates but is generally effective for taxable years beginning after December 31, 2017. The U.S. Tax Act creates a new requirement that certain income earned by foreign subsidiaries, known as Global Intangible Low-Taxed Income (GILTI), must be included in the gross income of the subsidiary’s U.S. shareholder. This provision of the U.S. Tax Act was effective for us for our fiscal year beginning December 1, 2018. Beginning on January 1, 2018, the U.S. Tax Act lowered the U.S. corporate income tax rate from 35% to 21% on our U.S. earnings from that date and beyond. The revaluation of our U.S. deferred tax assets and liabilities to the 21% corporate tax rate has reduced our net U.S. deferred income tax liability by $380.0 million and is reflected as a reduction in our income tax expense in our results for the year ended November 30, 2018. The U.S. Tax Act imposed a one-time transition tax on post-1986 earnings of non-U.S. affiliates that have not been repatriated for purposes of U.S. federal income tax, with those earnings taxed at rates of 15.5% for earnings reflected by cash and cash equivalent items and 8% for other assets. This transition tax, based on our fiscal 2018 tax return filed in fiscal 2019, was $76.0 million (we estimated the transition tax to be $75.3 million in fiscal 2018). The cash tax effects of the transition tax, reduced by the utilization of $21.1 million of current and carried forward excess foreign tax credits, as well as other items of $7.7 million, resulted in a net tax liability of $47.2 million, which can be remitted in installments over an eight-year period as we are doing. As of November 30, 2020, our remaining unpaid transition tax is $39.7 million. In addition to the estimated transition tax of $75.3 million recognized in 2018, we incurred additional foreign withholding taxes, net of a U.S. foreign tax credit, of $7.9 million and a $4.7 million reduction in our fiscal 2018 income taxes as a consequence of the transition tax, both of which we recognized as a component of our income tax expense for the year ended November 30, 2018, for a net transition tax impact recognized in 2018 of $78.5 million. The components of income from consolidated operations before income taxes for the years ended November 30 follow:(millions)202020192018Pretax incomeUnited States$624.3 $569.0 $492.2 International257.2 250.2 249.1 $881.5 $819.2 $741.3 87A reconciliation of the U.S. federal statutory rate with the effective tax rate for the years ended November 30 follows:202020192018Federal statutory tax rate21.0 %21.0 %22.2 %State income taxes, net of federal benefits1.5 1.6 1.5 International tax at different effective rates1.3 1.6 0.4 U.S. tax on remitted and unremitted earnings0.8 0.5 0.6 Stock compensation expense(1.5)(2.8)(2.9)U.S. manufacturing deduction— — (0.8)Changes in prior year tax contingencies(0.3)(0.3)(0.8)Non-recurring benefit of U.S. Tax Act— (0.2)(40.7)Valuation allowance release(1.4)— — Intra-entity asset transfer(1.1)(1.8)— Other, net(0.5)(0.4)(0.7)Total19.8 %19.2 %(21.2)%Deferred tax assets and liabilities are comprised of the following as of November 30:(millions)20202019Deferred tax assetsEmployee benefit liabilities$121.9 $103.3 Other accrued liabilities40.3 32.3 Inventory10.6 7.5 Tax loss and credit carryforwards59.7 46.8 Operating lease liabilities33.0 — Other47.9 48.1 Valuation allowance(31.5)(32.4) 281.9 205.6 Deferred tax liabilitiesDepreciation89.1 82.6 Intangible assets815.1 770.5 Lease ROU assets32.2 — Other4.5 5.5 940.9 858.6 Net deferred tax liability$(659.0)$(653.0)At November 30, 2020, we have tax loss carryforwards of $214.4 million. Of these carryforwards, $0.1 million expire in 2021, $9.6 million from 2022 through 2023, $77.9 million from 2024 through 2037 and $126.8 million may be carried forward indefinitely. In addition, one of our non-U.S. subsidiaries has a capital loss carryforward of $5.0 million which may be carried forward indefinitely. At November 30, 2020, we also have U.S. foreign tax credit carryforwards of $7.3 million which expire in 2030.A valuation allowance has been provided to cover deferred tax assets that are not more likely than not realizable. The net decrease of $0.9 million in the valuation allowance from November 30, 2019 to November 30, 2020 resulted primarily from the net reversal of valuation allowances for net operating losses, capital losses and other tax attributes in certain non-US jurisdictions.Prior to the U.S. Tax Act, we asserted that substantially all of the undistributed earnings of our international subsidiaries and joint ventures were considered indefinitely invested and accordingly, no deferred taxes were provided. Pursuant to the provisions of the U.S. Tax Act, these earnings were subjected to a one-time transition tax in 2018. The transition tax was recognized in 2018 and was based on cumulative earnings prior to the U.S. Tax Act. Our intent is to continue to reinvest undistributed earnings of our international subsidiaries and joint ventures indefinitely. As of November 30, 2020, we have $1.3 billion of earnings that are considered indefinitely reinvested. While federal income tax expense has been recognized as a result of the U.S. Tax Act, we have not provided any additional deferred taxes with respect to items such as foreign withholding taxes, state income tax or foreign exchange gain or loss. It is not practicable for us to determine the amount of unrecognized tax expense on these reinvested international earnings. 88The following table summarizes the activity related to our gross unrecognized tax benefits for the years ended November 30:(millions)202020192018Balance at beginning of year$32.0 $27.9 $39.1 Additions for current year tax positions7.8 6.6 6.5 Additions for prior year tax positions2.5 0.6 0.3 Reductions for prior year tax positions— (0.3)(6.9)Settlements— — — Statute expirations(4.2)(2.5)(9.1)Foreign currency translation1.2 (0.3)(2.0)Balance at November 30$39.3 $32.0 $27.9 As of November 30, 2020, November 30, 2019, and November 30, 2018, if recognized, $39.3 million, $32.0 million and $27.5 million, respectively, of the unrecognized tax benefits would affect the effective rate.We record interest and penalties on income taxes in income tax expense. We recognized interest and penalty expense of $0.8 million, $2.1 million and $0.1 million in 2020, 2019 and 2018, respectively. As of November 30, 2020 and 2019, we had accrued $8.3 million and $7.1 million, respectively, of interest and penalties related to unrecognized tax benefits.Tax settlements or statute of limitation expirations could result in a change to our uncertain tax positions. We believe that the reasonably possible total amount of unrecognized tax benefits as of November 30, 2020 that could decrease in the next 12 months as a result of various statute expirations, audit closures and/or tax settlements would not be material.We file income tax returns in the U.S. federal jurisdiction and various state and non-U.S. jurisdictions. The open years subject to tax audits vary depending on the tax jurisdictions. In the U.S federal jurisdiction, we are no longer subject to income tax audits by taxing authorities for years before 2017. In other major jurisdictions, we are no longer subject to income tax audits by taxing authorities for years before 2014. We are under normal recurring tax audits in the U.S. and in several jurisdictions outside the U.S. While it is often difficult to predict the final outcome or the timing of resolution of any particular uncertain tax position, we believe that our reserves for uncertain tax positions are adequate to cover existing risks and exposures.14. CAPITAL STOCK AND EARNINGS PER SHAREHolders of Common Stock have full voting rights except that (1) the voting rights of persons who are deemed to own beneficially 10% or more of the outstanding shares of Common Stock are limited to 10% of the votes entitled to be cast by all holders of shares of Common Stock regardless of how many shares in excess of 10% are held by such person; (2) we have the right to redeem any or all shares of Common Stock owned by such person unless such person acquires more than 90% of the outstanding shares of each class of our common stock; and (3) at such time as such person controls more than 50% of the votes entitled to be cast by the holders of outstanding shares of Common Stock, automatically, on a share-for-share basis, all shares of Common Stock Non-Voting will convert into shares of Common Stock.Holders of Common Stock Non-Voting will vote as a separate class on all matters on which they are entitled to vote. Holders of Common Stock Non-Voting are entitled to vote on reverse mergers and statutory share exchanges where our capital stock is converted into other securities or property, dissolution of the company and the sale of substantially all of our assets, as well as forward mergers and consolidation of the company or any amendment to our charter repealing the right of the Common Stock Non-Voting to vote on any such matters.The reconciliation of shares outstanding used in the calculation of basic and diluted earnings per share for the years ended November 30 follows:(millions)202020192018Average shares outstanding—basic266.5 265.1 263.1 Effect of dilutive securities:Stock options/RSUs/LTPP2.6 3.0 3.4 Average shares outstanding—diluted269.1 268.1 266.5 The following table sets forth the stock options and RSUs for the years ended November 30 which were not considered in our earnings per share calculation since they were antidilutive:89(millions)202020192018Antidilutive securities0.1 0.2 0.4 15. COMMITMENTS AND CONTINGENCIESDuring the normal course of our business, we are occasionally involved with various claims and litigation. Reserves are established in connection with such matters when a loss is probable and the amount of such loss can be reasonably estimated. At November 30, 2020 and 2019, no material reserves were recorded. The determination of probability and the estimation of the actual amount of any such loss are inherently unpredictable, and it is therefore possible that the eventual outcome of such claims and litigation could exceed the estimated reserves, if any. However, we do not expect the outcome of the matters currently pending will have a material adverse effect on our financial statements.16. BUSINESS SEGMENTS AND GEOGRAPHIC AREASBusiness SegmentsWe operate in two business segments: consumer and flavor solutions. The consumer and flavor solutions segments manufacture, market and distribute spices, seasoning mixes, condiments and other flavorful products throughout the world. Our consumer segment sells to retail channels, including grocery, mass merchandise, warehouse clubs, discount and drug stores, and e-commerce under the “McCormick” brand and a variety of brands around the world, including “French's,” “Frank's RedHot,” “Lawry’s,” “Zatarain’s,” “Simply Asia,” “Thai Kitchen,” “Ducros,” “Vahiné,” "Cholula," “Schwartz,” “Club House,” “Kamis,” “Kohinoor,” "DaQiao," "Drogheria & Alimentari," "Stubb's," "OLD BAY" and "Gourmet Garden." Our flavor solutions segment sells to food manufacturers and the foodservice industry both directly and indirectly through distributors, with the exception of our businesses in China and India, where foodservice sales are managed by and reported in our consumer segment.In each of our segments, we produce and sell many individual products which are similar in composition and nature. With their primary attribute being flavor, the products within each of our segments are regarded as fairly homogenous. It is impracticable to segregate and identify sales and profits for each of these individual product lines.We measure segment performance based on operating income excluding special charges as this activity is managed separately from the business segments. We also excluded transaction and integration expenses related to our acquisitions of Cholula, FONA and RB Foods from our measure of segment performance as these expenses are similarly managed separately from the business segments. These transaction and integration expenses excluded from our segment performance measure include the amortization of the acquisition-date fair value adjustment of inventories that is included in cost of goods sold, costs directly associated with that acquisition and costs associated with integrating the businesses. Although the segments are managed separately due to their distinct distribution channels and marketing strategies, manufacturing and warehousing are often integrated to maximize cost efficiencies. We do not segregate jointly utilized assets by individual segment for purposes of internal reporting, performance evaluation, or capital allocation. We have a large number of customers for our products. Sales to one of our consumer segment customers, Wal-Mart Stores, Inc., accounted for approximately 12% of consolidated sales in 2020 and 11% of consolidated sales in 2019 and 2018. Sales to one of our flavor solutions segment customers, PepsiCo, Inc., accounted for approximately 11% of consolidated sales in 2020 and 10% of consolidated sales in both 2019 and 2018. Accounting policies for measuring segment operating income and assets are consistent with those described in note 1. Because of integrated manufacturing for certain products within the segments, products are not sold from one segment to another but rather inventory is transferred at cost. Inter-segment sales are not material. Corporate assets include cash, deferred taxes, investments and certain fixed assets.90Business Segment Results(millions)ConsumerFlavor SolutionsTotalsegmentsCorporate& otherTotal2020Net sales$3,596.7 $2,004.6 $5,601.3 $— $5,601.3 Operating income excluding special charges780.9 237.9 1,018.8 — 1,018.8 Income from unconsolidated operations34.1 6.7 40.8 — 40.8 Assets— — 11,339.2 750.5 12,089.7 Capital expenditures— — 150.1 75.2 225.3 Depreciation and amortization— — 123.9 41.1 165.0 2019Net sales$3,269.8 $2,077.6 $5,347.4 $— $5,347.4 Operating income excluding special charges and transaction and integration expenses676.3 302.2 978.5 — 978.5 Income from unconsolidated operations31.8 9.1 40.9 — 40.9 Assets— — 9,950.3 411.8 10,362.1 Capital expenditures— — 121.8 51.9 173.7 Depreciation and amortization— — 118.0 40.8 158.8 2018Net sales$3,247.0 $2,055.8 $5,302.8 $— $5,302.8 Operating income excluding special charges and transaction and integration expenses637.1 292.8 929.9 — 929.9 Income from unconsolidated operations29.5 5.3 34.8 — 34.8 Assets— — 10,015.8 240.6 10,256.4 Capital expenditures— — 126.3 42.8 169.1 Depreciation and amortization— — 115.0 35.7 150.7 A reconciliation of operating income excluding special charges and, for 2020 and 2018, transaction and integration expenses, to operating income for 2020, 2019 and 2018 is as follows:(millions)ConsumerFlavor SolutionsTotal2020Operating income excluding special charges and transaction and integration expenses$780.9 $237.9 $1,018.8 Less: Special charges5.5 1.4 6.9 Less: Transaction and integration expenses7.5 4.9 12.4 Operating income$767.9 $231.6 $999.5 2019Operating income excluding special charges$676.3 $302.2 $978.5 Less: Special charges13.1 7.7 20.8 Operating income$663.2 $294.5 $957.7 2018Operating income excluding special charges and transaction and integration expenses$637.1 $292.8 $929.9 Less: Special charges10.0 6.3 16.3 Less: Transaction and integration expenses15.0 7.5 22.5 Operating income$612.1 $279.0 $891.1 91Geographic AreasWe have net sales and long-lived assets in the following geographic areas:(millions)UnitedStatesEMEAOthercountriesTotal2020Net sales$3,445.9 $1,046.7 $1,108.7 $5,601.3 Long-lived assets7,202.0 1,135.6 916.5 9,254.1 2019Net sales$3,226.3 $986.1 $1,135.0 $5,347.4 Long-lived assets6,397.0 1,032.4 875.4 8,304.8 2018Net sales$3,145.0 $1,021.1 $1,136.7 $5,302.8 Long-lived assets6,411.0 1,057.1 874.6 8,342.7 Long-lived assets include property, plant and equipment, goodwill and intangible assets, net of accumulated depreciation and amortization.17. SUPPLEMENTAL FINANCIAL STATEMENT DATASupplemental consolidated information with respect to our income statement, balance sheet and cash flow follow:For the year ended November 30 (millions)202020192018Other income, netPension and other postretirement benefit income$10.0 17.7 12.2 Interest income7.8 10.1 7.1 Other(0.2)(1.1)5.5 $17.6 $26.7 $24.8 92At November 30 (millions)20202019InventoriesFinished products$499.3 $413.3 Raw materials and work-in-process533.3 387.9 $1,032.6 $801.2 Prepaid expenses$38.0 $36.0 Other current assets60.9 54.7 $98.9 $90.7 Property, plant and equipmentLand and improvements$87.2 $67.5 Buildings (including capital lease)698.2 658.5 Machinery, equipment and other1,102.9 1,007.8 Construction-in-progress125.5 85.8 Accumulated depreciation(985.4)(867.0) $1,028.4 $952.6 Other long-term assetsInvestments in affiliates$193.0 $186.0 Long-term investments129.9 124.4 Right of use asset136.8 — Software, net of accumulated amortization $281.8 for 2020 and $275.0 for 2019116.0 76.4 Other176.3 120.3 $752.0 $507.1 Other accrued liabilitiesPayroll and employee benefits$260.7 $184.9 Sales allowances183.3 137.2 Dividends payable90.7 82.4 Other328.9 204.6 $863.6 $609.1 Other long-term liabilitiesPension$286.1 $226.9 Postretirement benefits66.2 62.7 Operating lease liability103.5 — Unrecognized tax benefits46.0 37.6 Other120.4 100.4 $622.2 $427.6 For the year ended November 30 (millions)202020192018Depreciation$121.1 $113.6 $104.8 Software amortization12.4 13.7 14.0 Interest paid134.1 169.8 179.8 Income taxes paid183.3 137.2 154.6 Dividends paid per share were $1.24 in 2020, $1.14 in 2019 and $1.04 in 2018. Dividends declared per share were $1.27 in 2020, $1.17 in 2019, and $1.07 in 2018.9318. SELECTED QUARTERLY DATA (UNAUDITED)(millions except per share data)First SecondThirdFourth2020Net sales$1,212.0 $1,401.1 $1,430.3 $1,557.9 Gross profit469.9 579.5 590.3 660.7 Operating income194.2 257.4 273.0 274.9 Net income144.7 195.9 206.1 200.7 Basic earnings per share0.54 0.74 0.77 0.75 Diluted earnings per share0.54 0.73 0.76 0.74 Dividends paid per share—Common Stock and Common Stock Non-Voting0.31 0.31 0.31 0.31 Dividends declared per share—Common Stock and Common Stock Non-Voting— 0.31 0.31 0.65 2019Net sales$1,231.5 $1,301.9 $1,329.2 $1,484.8 Gross profit466.9 508.5 539.9 630.0 Operating income196.9 208.1 253.5 299.2 Net income148.0 149.4 191.9 213.4 Basic earnings per share0.56 0.56 0.72 0.80 Diluted earnings per share0.55 0.56 0.72 0.79 Dividends paid per share—Common Stock and Common Stock Non-Voting0.28 0.29 0.28 0.29 Dividends declared per share—Common Stock and Common Stock Non-Voting— 0.29 0.28 0.60 Operating income for the first quarter of 2020 included $1.0 million of special charges, with an after-tax impact of $0.7 million and no per share impact for both basic and diluted earnings per share. Operating income for the second quarter of 2020 included $2.9 million of special charges, with an after-tax impact of $2.0 million and a per share impact of $0.01 for both basic and diluted earnings per share. Operating income for the third quarter of 2020 included $0.1 million of special charges, with an after-tax impact of $0.1 million and no per share impact for both basic and diluted earnings per share. Operating income for the fourth quarter of 2020 included $2.9 million of special charges, with an after-tax impact of $2.0 million and a per share impact of $0.01 for both basic and diluted earnings per share. Operating income for the fourth quarter of 2020 included $12.4 million of transaction and integration expenses, with an after-tax impact of $10.5 million and a per share impact of $0.04 for both basic and diluted earnings per share. Operating income for the first quarter of 2019 included $2.1 million of special charges, with an after-tax impact of $1.6 million and a per share impact of $0.01 for both basic and diluted earnings per share. Operating income for the second quarter of 2019 included $7.1 million of special charges, with an after-tax impact of $5.4 million and a per share impact of $0.02 for both basic and diluted earnings per share. Operating income for the third quarter of 2019 included $7.7 million of special charges, with an after-tax impact of $6.1 million and a per share impact of $0.01 for both basic and diluted earnings per share. Net income for the third quarter of 2019 included $1.5 million of non-recurring income tax benefit related to enactment of the U.S. Tax Act, with no per share impact for both basic and diluted earnings per share. Operating income for the fourth quarter of 2019 included $3.9 million of special charges, with an after-tax impact of $3.0 million and a per share impact of $0.02 for both basic and diluted earnings per share. See note 3 for details with respect to actions undertaken in connection with these special charges. See note 13 for details regarding the non-recurring income tax benefits related to enactment of the U.S. Tax Act.Earnings per share are computed independently for each of the quarters presented. Therefore, the sum of the quarters may not be equal to the full year earnings per share.9419. SUBSEQUENT EVENT (UNAUDITED)On December 30, 2020, we purchased FONA International, LLC and certain of its affiliates (FONA), a privately held company, for a purchase price of approximately $710 million, net of cash acquired, subject to certain customary purchase price adjustments. FONA is a leading manufacturer of clean and natural flavors providing solutions for a diverse customer base across various applications for the food, beverage and nutritional markets. The acquisition of FONA in fiscal 2021 expands the breadth of our flavor solutions segment into attractive categories, as well as extends our technology platform and strengthens our capabilities. The acquisition was funded with cash and commercial paper.ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURENone.ITEM 9A. CONTROLS AND PROCEDURESDisclosure Controls and ProceduresOur management, with the participation of our Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of our disclosure controls and procedures, as defined in Rule 13a-15(e) of the Securities Exchange Act of 1934, as of the end of the period covered by this report. Based on that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that, as of the end of the period covered by this report, our disclosure controls and procedures were effective.Internal Control over Financial ReportingManagement’s report on our internal control over financial reporting and the report of our Independent Registered Public Accounting Firm on internal control over financial reporting are included in our 2020 financial statements in Item 8 of this Report under the captions entitled “Report of Management” and "Report of Independent Registered Public Accounting Firm.” No change occurred in our “internal control over financial reporting” (as defined in Rule 13a-15(f)) during our last fiscal quarter which has materially affected or is reasonably likely to materially affect, our internal control over financial reporting.ITEM 9B. OTHER INFORMATIONNone.PART III.ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCEInformation responsive to this item is set forth in the sections titled “Corporate Governance” and “Election of Directors” in our 2021 Proxy Statement, incorporated by reference herein, to be filed within 120 days after the end of our fiscal year.We have adopted a code of ethics that applies to all employees, including our principal executive officer, principal financial officer, principal accounting officer, and our Board of Directors. A copy of the code of ethics is available on our internet website at www.mccormickcorporation.com. We will satisfy the disclosure requirement under Item 5.05 of Form 8-K regarding any material amendment to our code of ethics, and any waiver from a provision of our code of ethics that applies to our principal executive officer, principal financial officer, principal accounting officer, or persons performing similar functions, by posting such information on our website at the internet website address set forth above.ITEM 11. EXECUTIVE COMPENSATION95Information responsive to this item is incorporated herein by reference to the sections titled “Compensation of Directors,” “Compensation Discussion and Analysis,” “Compensation Committee Report,” “Summary Compensation Table,” “Grants of Plan-Based Awards,” “Narrative to the Summary Compensation Table,” “Outstanding Equity Awards at Fiscal Year-End,” “Option Exercises and Stock Vested in Last Fiscal Year,” “Retirement Benefits,” “Non-Qualified Deferred Compensation,” “Potential Payments Upon Termination or Change in Control,” “Compensation Committee Interlocks and Insider Participation” and “Equity Compensation Plan Information” in the 2021 Proxy Statement.ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERSInformation responsive to this item is incorporated herein by reference to the sections titled “Principal Stockholders,” “Election of Directors” and “Equity Compensation Plan Information” in the 2021 Proxy Statement.ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCEInformation responsive to this item is incorporated herein by reference to the section entitled “Corporate Governance” in the 2021 Proxy Statement.ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICESInformation responsive to this item is incorporated herein by reference to the section titled “Report of Audit Committee and Fees of Independent Registered Public Accounting Firm” in the 2021 Proxy Statement.96PART IV. ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULESList of documents filed as part of this Report.1. Consolidated Financial StatementsThe Consolidated Financial Statements for McCormick & Company, Incorporated and related notes, together with the Report of Management, and the Reports of Ernst & Young LLP dated January 28, 2021, are included herein in Part II,
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+Item 7. Management’s Discussion and Analysis of Financial Condition and Results of OperationsIndex to Management’s Discussion and Analysis of Financial Condition and Results of OperationsPageForward-Looking Statements and Other Financial Information50Executive Summary50Industry Trends54Summary of Critical Accounting Estimates60Economic Capital67Acquisitions and Dispositions67Results of Operations69Effects of Inflation87Investments88Derivatives108Off-Balance Sheet Arrangements110Insolvency Assessments111Policyholder Liabilities111Liquidity and Capital Resources119Adoption of New Accounting Pronouncements 136Future Adoption of New Accounting Pronouncements 136Non-GAAP and Other Financial Disclosures13749Table of ContentsForward-Looking Statements and Other Financial InformationFor purposes of this discussion, “MetLife,” the “Company,” “we,” “our” and “us” refer to MetLife, Inc., a Delaware corporation incorporated in 1999, its subsidiaries and affiliates. This discussion should be read in conjunction with “Note Regarding Forward-Looking Statements,” “Risk Factors,” “Quantitative and Qualitative Disclosures About Market Risk” and the Company’s consolidated financial statements included elsewhere herein.This Management’s Discussion and Analysis of Financial Condition and Results of Operations may contain or incorporate by reference information that includes or is based upon forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. See “Note Regarding Forward-Looking Statements” for cautionary language regarding forward-looking statements.This Management’s Discussion and Analysis of Financial Condition and Results of Operations includes references to our performance measures, adjusted earnings and adjusted earnings available to common shareholders, that are not based on GAAP. See “— Non-GAAP and Other Financial Disclosures” for definitions and a discussion of these and other financial measures, and “— Results of Operations” for reconciliations of historical non-GAAP financial measures to the most directly comparable GAAP measures.For information relating to the Company’s financial condition and results of operations as of and for the year ended December 31, 2018, as well as for the year ended December 31, 2019 compared with the year ended December 31, 2018, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in MetLife, Inc.’s Annual Report on Form 10-K for the year ended December 31, 2019.Executive SummaryOverviewMetLife is one of the world’s leading financial services companies, providing insurance, annuities, employee benefits and asset management. MetLife is organized into five segments: U.S.; Asia; Latin America; EMEA; and MetLife Holdings. In addition, the Company reports certain of its results of operations in Corporate & Other. See “Business — Segments and Corporate & Other” and Note 2 of the Notes to the Consolidated Financial Statements for further information on the Company’s segments and Corporate & Other. See “— Consolidated Company Outlook” for a discussion of the impact of the COVID-19 Pandemic on the Company.Current Year HighlightsDuring 2020, adjusted premiums, fees and other revenues, net of foreign currency fluctuations, increased compared to 2019 in many of our segments, and most significantly in our U.S. segment, despite the negative impacts of the COVID-19 Pandemic and related restrictions. Positive net flows drove an increase in our investment portfolio; however, investment yields declined. Expenses, including interest credited expenses, also declined. Underwriting experience was favorable compared to 2019, and reflected impacts from the COVID-19 Pandemic and related restrictions. In addition, our annual actuarial assumption review resulted in a charge that was higher than the 2019 charge. A favorable change in net derivative gains (losses) over 2019 was primarily the result of a decline in long-term interest rates.50Table of ContentsThe following represents segment level results and percentage contributions to total segment level adjusted earnings available to common shareholders for the year ended December 31, 2020:_______________(1) Excludes Corporate & Other adjusted loss available to common shareholders of $749 million.(2) Consistent with GAAP guidance for segment reporting, adjusted earnings is our GAAP measure of segment performance. For additional information, see Note 2 of the Notes to the Consolidated Financial Statements. 51Table of ContentsYear Ended December 31, 2020 Compared with the Year Ended December 31, 2019Consolidated Results - HighlightsNet income (loss) available to MetLife, Inc.’s common shareholders down $530 million:•Unfavorable change in net investment gains (losses) of $554 million ($438 million, net of income tax)•Unfavorable change from annual actuarial assumption reviews of $177 million ($139 million, net of income tax) (2)•Favorable change in net derivative gains (losses) of $721 million ($570 million, net of income tax) (3)•Adjusted earnings available to common shareholders down $144 million(1) See “— Results of Operations — Consolidated Results” and “— Non-GAAP and Other Financial Disclosures” for reconciliations and definitions of non-GAAP financial measures.(2) Includes amounts recognized in net derivative gains (losses) and adjusted earnings available to common shareholders. See “— Results of Operations — Consolidated Results — Year Ended December 31, 2020 Compared with the Year Ended December 31, 2019 — Actuarial Assumption Review and Certain Other Insurance Adjustments” for additional information.(3) Includes amounts relating to investment hedge adjustments, which are also included in adjusted earnings available to common shareholders. See “— Investments — Investment Portfolio Results” for additional information.Consolidated Results - Adjusted Earnings HighlightsAdjusted earnings available to common shareholders down $144 million:•The primary drivers of the decrease in adjusted earnings were lower investment yields and a higher effective tax rate. These declines were partially offset by higher net investment income due to a larger asset base, and a decrease in expenses, including interest credited expenses.•Our results for 2020 included the unfavorable impact from our annual actuarial assumption review of$203 million, net of income tax.•Our results for 2019 included the following:•unfavorable impact from our annual actuarial assumption review of $143 million, net of income tax•a $17 million, net of income tax, charge due to an increase in our incurred but not reported (“IBNR”) long-term care reserves, reflecting enhancements to our methodology related to potential claims•expenses associated with our previously announced unit cost initiative of $332 million, net of income tax•a $317 million tax benefit related to the resolution of an uncertainty regarding the deemed repatriation transition tax enacted as a part of the Tax Cuts and Jobs Act of 2017 (“U.S. Tax Reform”)•a $222 million benefit from the IRS audit settlement related to the tax treatment of a wholly-owned U.K. investment subsidiary of MLIC, which was comprised of a $158 million tax benefit and a $64 million interest benefitFor a more in-depth discussion of our consolidated results, see “— Results of Operations — Consolidated Results,” “— Results of Operations — Consolidated Results — Adjusted Earnings” and “— Results of Operations — Segment Results and Corporate & Other.”52Table of ContentsConsolidated Company Outlook We continue to closely monitor developments relating to the COVID-19 Pandemic and assess its impact on our business. The COVID-19 Pandemic continues to impact the global economy and financial markets and has caused volatility in the global equity, credit and real estate markets. Governments and businesses have taken numerous measures to try to contain the virus, such as travel bans and restrictions, quarantines, social distancing, shelter in place or total lock down orders, and business limitations and shutdowns. Some governments and businesses have begun to ease some restrictions. Others have reinstated restrictions they previously lifted. Nevertheless, these measures have disrupted and will continue to disrupt business activity and have resulted in an economic slowdown and volatility in the financial markets, to which governments and central banks around the world have responded with unprecedented fiscal and monetary policies. Although vaccines have become available, distribution and access are expected to take time before a significant percentage of the population is vaccinated. See “— Industry Trends — Financial and Economic Environment.” In addition, a prolonged low or near zero interest rate environment remains possible. The economic projections of the Federal Reserve Board suggest that the current low interest rate environment will continue until 2023, and potentially longer. We believe that our investment portfolio is highly diversified and well positioned to withstand economic downturns; however, we expect that the market-related effects of the COVID-19 Pandemic, as well as the sustained low interest rate environment, will continue to have an impact across our investment portfolio. See “— Industry Trends — Impact of a Sustained Low Interest Rate Environment” for discussion of the mitigating actions the Company has taken to reduce interest rate sensitivity as market interest rates are a key driver of our results. Events related to the COVID-19 Pandemic may continue to adversely affect certain of our business operations, investment portfolio, derivatives, financial results or financial condition. See “Risk Factors.” We have implemented risk management and business continuity plans and taken preventive measures and other precautions, such as employee business travel restrictions and remote work arrangements which, to date, have enabled us to maintain our critical business processes, customer service levels, relationships with key vendors, financial reporting systems, internal controls over financial reporting and disclosure controls and procedures.We granted and continue to grant certain accommodations to our customers, borrowers and lessees, including (i) waiving exclusions, such as deferred rate increases, extending premium grace periods, waiving late payment fees, and relaxing claim documentation requirements, (ii) credits on auto and insured dental premiums, (iii) payment deferrals and other loan modifications on certain commercial, agricultural and residential mortgage loans, and (iv) certain operating and direct financing lease concessions. See Note 8 of the Notes to the Consolidated Financial Statements for further information regarding COVID-19 Pandemic-related mortgage loan and lease concessions. See also, “— Results of Operations — Segment Results and Corporate & Other — U.S.”As of December 31, 2020, we had $4.5 billion of cash and liquid assets at the holding companies which is above the high end of our $3.0 billion to $4.0 billion holding company cash target. In 2021, we expect to maintain this holding company cash target and expect to be within or above the high end of this range.Our capital stress testing and longstanding commitment to liquidity position us to withstand the current crisis. We have, and may continue to maintain, a higher than normal level of short-term liquidity, which may adversely affect net investment income if the reinvestment process occurs over an extended period of time. We do not expect any material liquidity deficiencies, and we expect to remain able to comply with the financial covenants of our credit agreements. See “— Liquidity and Capital Resources.” We will continue reviewing accounting estimates, asset valuations and various financial scenarios for capital and liquidity implications. See “— Investments — Current Environment” and “Risk Factors” for additional information.Assuming (i) interest rates following the observable forward yield curves as of December 31, 2020, including a 10-year U.S. Treasury rate of 0.91% at December 31, 2020, and 1.12% at December 31, 2021, and (ii) a mid-single digit S&P 500 equity index increase for the full year 2021, we expect the average annual ratio of free cash flow to adjusted earnings over the two-year period of 2020 and 2021 to be 65% to 75%. In addition, we remain on track to generate approximately $20.0 billion of free cash flow over the time period of 2020 through 2024. 53Table of ContentsWe continue to target an adjusted return on equity, excluding accumulated other comprehensive income (“AOCI”) other than foreign currency translation adjustments (“FCTA”) of 12% to 14% over the near-term assuming non-recessionary market conditions. However, (i) given the possible effects of the COVID-19 Pandemic and other events, (ii) given our exclusion of MetLife P&C from adjusted earnings because we expect to close its disposition in the second quarter 2021, and (iii) assuming (a) interest rates follow the observable forward yield curves as of December 31, 2020, including our updated assumptions for the 10-year U.S. Treasury rates noted in the paragraph above, (b) a mid-single digit S&P 500 equity index increase for the full year 2021, and (c) positive low double digit private equity returns in 2021, we could be below the low end of the target range in 2021.We are fully committed to achieving a direct expense ratio, excluding total notable items related to direct expenses and pension risk transfers below 12.3%. We expect pressure on this ratio in 2021 due to the pending disposition of MetLife P&C with its lower direct expense ratio, but we intend to continue to exercise expense discipline and be below 12.3% for 2022.Furthermore, we also remain fully committed to our Next Horizon Strategy, which was introduced at our December 2019 Investor Day.Our outlook relies on the accuracy of our assumptions about future economic and business conditions, which can be affected by known and unknown risks and other uncertainties, such as those posed by the COVID-19 Pandemic. Due to the evolving and highly uncertain nature of the COVID-19 Pandemic and other factors, we will continually review our assumptions, implementing mitigation plans, and taking precautions. We may revise our outlook as we obtain more information regarding the effects of the COVID-19 Pandemic, the effect and efficacy of efforts taken to respond to it, economic conditions, regulatory changes, and other events, and the impact of these events on our business operations, investment portfolio, derivatives, financial results and financial condition.Industry TrendsWe continue to be impacted by the changing global financial and economic environment that has been affecting the industry.Financial and Economic EnvironmentOur business and results of operations are materially affected by conditions in the global capital markets and the economy generally. Stressed conditions, volatility and disruptions in global capital markets, particular markets, or financial asset classes can have an adverse effect on us, in part because we have a large investment portfolio and our insurance liabilities and derivatives are sensitive to changing market factors. See “Risk Factors — Economic Environment and Capital Markets Risks — We May Face Difficult Economic Conditions.”We have market presence in numerous countries and, therefore, our business operations are exposed to risks posed by local and regional economic conditions. See “Risk Factors — Economic Environment and Capital Markets Risks — We May Face Difficult Economic Conditions — Currency Exchange Rate Risks.”We are closely monitoring political and economic conditions that might contribute to global market volatility and impact our business operations, investment portfolio and derivatives. For example, certain measures taken by governments and businesses as a result of the COVID-19 Pandemic to respond to the spread of the virus have disrupted business activity and have resulted in an economic slowdown and volatility in financial markets. Governmental and non-governmental organizations may not effectively respond to the spread and severity of the COVID-19 Pandemic, increasing the magnitude and longevity of the potential negative economic impacts. We cannot yet determine or estimate the actions that will be taken, including governmental laws, regulations or orders, and the extent to which these actions have affected or will affect our business operations, investment portfolio, financial results, or financial condition. See “— Executive Summary — Consolidated Company Outlook” and “— Investments — Current Environment.” We are also monitoring the imposition of tariffs or other barriers to international trade, changes to international trade agreements, and their potential impacts on our business, results of operations and financial condition, including the impact of the trade agreement reached by the U.K. and the EU in December 2020. See “Business — Regulation — Cross-Border Trade and Investments.” See also “Risk Factors — Business Risks — We May Face a Variety of Political, Legal, Operational, Economic and Other Risks Globally.” 54Table of ContentsGovernments and central banks around the world are responding to the COVID-19 Pandemic with unprecedented fiscal and monetary policies, which are expected to have significant and ongoing effects on financial markets and the global economy. In the United States, the Federal Reserve Board continues to expand its balance sheet and board members’ forecasts suggest the policy rate is likely to remain near zero through 2023. Separately, another COVID-related stimulus package has been passed. The European Central Bank has significantly increased the size of its asset purchase program, and extended its commitment to undertake purchases through 2021, reduced constraints on what and how much it can purchase, and launched new funding facilities for euro area banks, while the Bank of England significantly lowered interest rates and relaunched quantitative easing. Additionally, a number of European countries, including the U.K., have implemented large fiscal stimulus programs, as well as the provision of guarantees and loans for private sector companies. The EU approved a stimulus package comprised of grants and low interest financing to member states, which is expected to become operational in 2021.In Japan, the Bank of Japan has accelerated its purchases of interests in index-linked securities and real estate investments, increased the annual limit on purchases of commercial paper and bonds, and introduced new measures to facilitate corporate financing, including a new lending program for businesses impacted by the COVID-19 Pandemic. In addition, the Japanese government approved additional stimulus measures, including provisions for cash payouts to individuals and business owners, tax reform, and zero-interest loans. We cannot predict with certainty the actions that will be taken, effect of these actions or the impact on our business operations, investment portfolio, financial results, or financial condition. See “— Investments — Current Environment.”Impact of a Sustained Low Interest Rate EnvironmentMarket interest rates are a key driver of our results. Sustained periods of low U.S. interest rates may cause us to:•Reduce the difference between interest credited to policyholders and interest earned on supporting assets (“gross margin”); •Reinvest investment proceeds in lower yielding assets and experience higher frequency prepayment or redemption of assets in our portfolio;•Increase our reserves or trigger loss recognition events related to policy liabilities, accelerate amortization of DAC and VOBA, and potentially impair intangible assets;•Reduce interest expense, change pension and other post-retirement benefit calculations, and change derivative cash flows and market values;•Change our product offerings, design features, crediting rates and sales mix; and•Experience changing policyholder behavior, including surrender or withdrawal activity.For additional discussion on gross margin and interest rate assumptions, as well as the potential impact of low interest rates, see “— Results of Operations — Consolidated Results — Year Ended December 31, 2020 Compared with the Year Ended December 31, 2019 — Actuarial Assumption Review and Certain Other Insurance Adjustments.” See also “Risk Factors — Economic Environment and Capital Markets Risks — We May Face Difficult Economic Conditions — Interest Rate Risks;” “Risk Factors — Business Risks — We May Be Required to Accelerate the Amortization of or Impair DAC, DSI, VOBA or VOCRA;” “Risk Factors — Business Risks — We May Be Required to Recognize an Impairment of Our Goodwill or Other Long-Lived Assets or to Establish a Valuation Allowance Against Our Deferred Income Tax Assets;” and “Risk Factors — Business Risks — We May Face Volatility, Higher Risk Management Costs, and Increased Counterparty Risk Due to Guarantees Within Certain of Our Products.” Mitigating ActionsTo mitigate unfavorable impacts of a low U.S. interest rate environment, we maintain diversification across products, distribution channels, and geographies while proactively evaluating interest rate and product strategies. In addition, we apply disciplined asset/liability management (“ALM”) strategies, including the use of derivatives, and may take management actions such as:•Lowering interest crediting rates or adjusting the dividend scale on products; •Limiting or closing certain products to new sales to manage exposures; and•Shifting sales focus to less interest rate sensitive products. 55Table of ContentsOur ability to take such actions may be limited by competition, regulatory approval requirements, or minimum crediting rate guarantees and may not match the timing or magnitude of interest rate changes.In addition to proactive mitigation strategies, businesses within our Latin America, EMEA, and Asia (exclusive of our Japan business) segments help mitigate unfavorable impacts to our consolidated results given their limited U.S. interest rate sensitivity. For additional discussion on interest rate risk management and our ability to change interest crediting rates or dividend scales, see “Risk Factors — Economic Environment and Capital Markets Risks — We May Face Difficult Economic Conditions — Interest Rate Risks;” “— Policyholder Liabilities;” and “Quantitative and Qualitative Disclosures About Market Risk — Management of Market Risk Exposures.”Low Interest Rate Scenarios To illustrate our sensitivity to low U.S. interest rates, we compared the outcome of two hypothetical low interest rate environments (the “Flat Interest Rate Scenario” and “Declining Interest Rate Scenario”) relative to our baseline economic assumptions (the “Base Scenario”) through 2023. The impact of these scenarios are evaluated for certain of our segments, as well as Corporate & Other.The Flat Interest Rate Scenario assumes U.S. interest rates for all maturities remain at their December 31, 2020 levels and are unchanged through 2023. The Declining Interest Rate Scenario assumes (i) short-term U.S. interest rates remain through 2023 at their December 31, 2020 levels; and (ii) long-term U.S. interest rates decline immediately on January 1, 2021 with the 10-year interest rate remaining unchanged thereafter and interest rates beyond 10-years gradually falling through 2023. Other than changing U.S. interest rates through 2023, all other economic assumptions are equivalent in the Base Scenario, Flat Interest Rate Scenario and Declining Interest Rate Scenario.The following table compares the most relevant interest rate assumptions for the dates indicated: Years Ended December 31,202120222023Base ScenarioFlat Interest Rate ScenarioDeclining Interest Rate ScenarioBase ScenarioFlat Interest Rate ScenarioDeclining Interest Rate ScenarioBase ScenarioFlat Interest Rate ScenarioDeclining Interest Rate ScenarioThree-month LIBOR0.20%0.24%0.24%0.32%0.24%0.24%0.56%0.24%0.24%10-year U.S. Treasury1.12%0.91%0.50%1.31%0.91%0.50%1.49%0.91%0.50%30-year U.S. Treasury1.72%1.65%0.77%1.80%1.65%0.69%1.88%1.65%0.63%Hypothetical Impact to Net Derivative Gains (Losses) and Adjusted EarningsWe estimate a net favorable impact to net derivative gains (losses) from non-VA program derivatives through 2023 in both hypothetical low interest rate scenarios. We hold significant positions in long-duration receive-fixed U.S. interest rate swaps, which are most sensitive to the 10-year and 30-year swap rates, to hedge reinvestment risk. For purposes of the two hypothetical low interest rate scenarios, we have excluded all VA program derivatives. For information regarding our VA and non-VA program derivatives, see “— Results of Operations — Consolidated Results.”We estimate a net unfavorable impact to consolidated adjusted earnings through 2023 in both hypothetical low interest rate scenarios. The negative impact of reinvesting cash flows in lower yielding assets is partially offset by lowering interest crediting rates and dividend scales on products, and additional derivative income. This negative impact is more severe in the Declining Interest Rate Scenario given that reinvestment of cash flows would be at much lower rates relative to the Flat Interest Rate Scenario.56Table of ContentsThe following table summarizes the hypothetical impact on net derivative gains (losses) and adjusted earnings for certain of our segments, as well as Corporate & Other, for the Flat Interest Rate Scenario:Years Ended December 31,202120222023(In millions)Net Derivative Gains (Losses):Non-VA Program Derivatives$220 $390 $500 Adjusted Earnings:U.S. $(5)$(15)$— Group Benefits— (5)(5)RIS(5)(10)5 Asia (Japan only)— (5)(20)MetLife Holdings(5)(10)(15)Corporate & Other 5 5 5 Total Adjusted Earnings Impact$(5)$(25)$(30)The following table summarizes the hypothetical impact on net derivative gains (losses) and adjusted earnings for certain of our segments, as well as Corporate & Other, for the Declining Interest Rate Scenario:Years Ended December 31,202120222023(In millions)Net Derivative Gains (Losses):Non-VA Program Derivatives$1,510 $290 $285 Adjusted Earnings:U.S. $(20)$(35)$(40)Group Benefits(5)(15)(30)RIS(15)(20)(10)Asia (Japan only)(5)(15)(35)MetLife Holdings(10)(35)(55)Corporate & Other 30 10 (10)Total Adjusted Earnings Impact$(5)$(75)$(140)Segments and Corporate & OtherThe primary drivers impacting certain of our segments, as well as Corporate & Other, in the hypothetical low interest rate scenarios are summarized below. MetLife P&C is excluded due to the pending disposition. See Note 3 of the Notes to the Consolidated Financial Statements for further information. Our Latin America, EMEA, and Asia (exclusive of our Japan business) segments are excluded given their limited U.S. interest rate sensitivity. For additional information regarding account values subject to minimum crediting rate guarantees, the maturity profile of fixed maturity securities available-for-sale (“AFS”), and the yield on invested assets, see “— Investments;” “— Policyholder Liabilities — Policyholder Account Balances;” and Note 8 of the Notes to the Consolidated Financial Statements.57Table of ContentsU.S.Group BenefitsOur group life insurance products are primarily renewable term policies. This provides repricing flexibility to mitigate the negative impact of reinvesting in lower yielding assets. Our retained asset accounts experience gross margin compression due to minimum crediting rate guarantees. All of these accounts are at their minimum crediting rates. Additionally, we experience gross margin compression from our disability policy claim reserves for which crediting rates cannot be reduced. We use interest rate derivatives to mitigate gross margin compression for both products. Gross margin compression is limited for our group disability products, which are generally renewable term policies allowing for crediting rate adjustments at renewal based on the retrospective experience rating and the prevailing interest rate assumptions. Retirement and Income SolutionsThis business contains both short- and long-duration products consisting of capital market products, pension risk transfers, structured settlements, and other benefit funding products. Based on our investment portfolios and expected cash flows, only a small portion of invested assets are subject to reinvestment risk through 2023.A significant portion of short-duration products are managed on a floating rate basis, which mitigates gross margin compression. The two hypothetical low interest rate scenarios do not assume any additional ALM actions we may take in our capital markets business. Our long-duration products have very predictable cash flows and we use both interest rate derivatives and asset/liability duration matching to mitigate gross margin compression. These mitigating strategies partially offset the negative impact of reinvesting in lower yielding assets.AsiaOur Japan business offers traditional life insurance and accident & health products, many of which are U.S. dollar denominated. We experience gross margin compression to the extent our investment portfolios are U.S. interest rate sensitive and we are unable to offset the impact by lowering interest crediting rates. Additionally, we manage interest rate risk on our life products through a combination of product design features and ALM strategies.Our Japan business also offers U.S. dollar denominated annuities which are predominantly single premium products with crediting rates set upon issuance. This allows for tightly managing product ALM, cash flows and net spreads, which mitigates interest rate risk.MetLife HoldingsOur interest rate sensitive life products include traditional and universal life products. Since most of our traditional life insurance is participating, we can mitigate gross margin compression by adjusting the applicable dividend scale. For our universal life products, we manage interest rate risk through a combination of product design features and ALM strategies, including the use of interest rate derivatives. Although we are able to mitigate gross margin compression by lowering interest crediting rates on certain in-force universal life policies, these actions may be partially offset by increased liabilities for policies with secondary guarantees.Our annuity products experience gross margin compression primarily from deferred annuities with minimum crediting rate guarantees. Most of these contracts are at their minimum crediting rate, and, therefore we use interest rate derivatives to partially mitigate gross margin compression.Our long-term care business experiences gross margin compression as we cannot reduce interest crediting rates for established claim reserves. Long-term care policies are guaranteed renewable, and rates may be adjusted on a class basis with regulatory approval to reflect emerging experience. We review the discount rate assumptions and other assumptions associated with our long-term care claim reserves no less frequently than annually and, with respect to interest rates, set the discount rate based on the prevailing interest rate environment. Our retained asset accounts experience gross margin compression due to minimum crediting rate guarantees. Most of these accounts are at their minimum crediting rates and therefore we use interest rate derivatives to mitigate gross margin compression.58Table of ContentsBased on our investment portfolios and cash flow estimates, approximately 6% of our invested assets each year are subject to reinvestment risk through 2023. Corporate & OtherCorporate & Other contains the surplus investment portfolios used to fund capital and liquidity needs, certain reinsurance agreements, collateral financing arrangements, and our outstanding debt and preferred securities. For purposes of the two hypothetical low interest rate scenarios, the preferred stock dividend impact is excluded and the impact on pension and postretirement plan expenses is included within Corporate & Other and not allocated across segments. The negative impact of reinvesting in lower yielding assets is more than offset by the positive impact of lower interest expense on debt and lower pension expense. Although low interest rates result in pension and other postretirement benefit liabilities increasing, the impact is more than offset by the corresponding returns on fixed income investments and results in lower expenses. Competitive PressuresThe life insurance industry remains highly competitive. See “Business — Competition.” Product development is focused on differentiation leading to more intense competition with respect to product features and services. Certain of the industry’s products can be quite homogeneous and subject to intense price competition. Cost reduction efforts are a priority for industry players, with benefits resulting in price adjustments to favor customers and reinvestment capacity. Larger companies have the ability to invest in brand equity, product development, technology optimization, risk management, and innovation, which are among the fundamentals for sustained profitable growth in the life insurance industry. Insurers are focused on their core businesses, specifically in markets where they can achieve scale. Insurers are increasingly seeking alternative sources of revenue; there is a focus on monetization of assets, fee-based services, and opportunities to offer comprehensive solutions, which include providing value-added services along with traditional products. Financial strength and flexibility and technology modernization are prerequisites for sustainable growth in the life insurance industry. Larger market participants tend to have the capacity to invest in analytics, distribution, and information technology and have the ability to leverage the capabilities of new digital entrants. There is a shift in distribution from proprietary to third party models in mature markets, due to the lower cost structure. Evolving customer expectations are having a significant impact on the competitive environment as insurers strive to offer the superior customer service demanded by an increasingly sophisticated industry client base. Legislative and other changes affecting the regulatory environment can also affect the competitive environment within the life insurance industry and within the broader financial services industry. See “Business — Regulation.” We believe that the current low interest rate environment and increased volatility of the financial markets, as a result of the COVID-19 Pandemic, will continue to strain the life insurance industry, as well as the broader financial services industry. In addition to financial strength, technological efficiency and organizational agility, we believe that the ability to adapt to changes in the competitive environment as a result of the COVID-19 Pandemic is a significant differentiator to success in the life insurance industry and the broader financial services industry, and we are well positioned to compete in this environment.Regulatory DevelopmentsIn the United States, our life insurance companies are regulated primarily at the state level, with some products and services also subject to federal regulation. As life insurers introduce new and often more complex products, regulators refine capital requirements and introduce new reserving standards for the life insurance industry. Regulations recently adopted or currently under review can potentially impact the statutory reserve and capital requirements of the industry. See “Risk Factors — Regulatory and Legal Risks — Changes in Laws or Regulation, or in Supervisory and Enforcement Policies, May Reduce Our Profitability, Limit Our Growth, or Otherwise Adversely Affect Us.” Regulators have also undertaken market and sales practices reviews of several markets or products, including equity-indexed annuities, variable annuities and group products and, in some states, instituted a moratorium on new reserve financing transactions. See “Business — Regulation,” “Risk Factors — Economic Environment and Capital Markets Risks — Our Statutory Life Insurance Reserve Financings Costs May Increase, and We May Find Limited Market Capacity for New Financings,” “Risk Factors — Regulatory and Legal Risks — Changes in Laws or Regulation, or in Supervisory and Enforcement Policies, May Reduce Our Profitability, Limit Our Growth, or Otherwise Adversely Affect Us” and “— Liquidity and Capital Resources — The Company — Capital — Affiliated Captive Reinsurance Transactions.”59Table of ContentsSummary of Critical Accounting Estimates The preparation of financial statements in conformity with GAAP requires management to adopt accounting policies and make estimates and assumptions that affect amounts reported on the Consolidated Financial Statements. For a discussion of our significant accounting policies, see Note 1 of the Notes to the Consolidated Financial Statements. The most critical estimates include those used in determining:(i)liabilities for future policy benefits and the accounting for reinsurance;(ii)capitalization and amortization of DAC and the establishment and amortization of VOBA;(iii)estimated fair values of investments in the absence of quoted market values;(iv)investment allowance for credit loss (“ACL”) and impairments;(v)estimated fair values of freestanding derivatives and the recognition and estimated fair value of embedded derivatives requiring bifurcation; (vi)measurement of goodwill and related impairment;(vii)measurement of employee benefit plan liabilities;(viii)measurement of income taxes and the valuation of deferred tax assets; and(ix)liabilities for litigation and regulatory matters.In addition, the application of acquisition accounting requires the use of estimation techniques in determining the estimated fair values of assets acquired and liabilities assumed — the most significant of which relate to the aforementioned critical accounting estimates. In applying these policies and estimates, management makes subjective and complex judgments that frequently require assumptions about matters that are inherently uncertain. Many of these policies, estimates and related judgments are common in the insurance and financial services industries; others are specific to our business and operations. Actual results could differ from these estimates.Liability for Future Policy BenefitsGenerally, future policy benefits are payable over an extended period of time and related liabilities are calculated as the present value of future expected benefits to be paid, reduced by the present value of future expected premiums. Such liabilities are established based on methods and underlying assumptions in accordance with GAAP and applicable actuarial standards. Principal assumptions used in the establishment of liabilities for future policy benefits are mortality, morbidity, policy lapse, renewal, retirement, disability incidence, disability terminations, investment returns, inflation, expenses and other contingent events as appropriate to the respective product type and geographical area. These assumptions are established at the time the policy is issued and are intended to estimate the experience for the period the policy benefits are payable. Utilizing these assumptions, liabilities are established on a block of business basis. If experience is less favorable than assumed, additional liabilities may be established, resulting in a charge to policyholder benefits and claims.Future policy benefit liabilities for disabled lives are estimated using the present value of benefits method and experience assumptions as to claim terminations, expenses and interest.Liabilities for unpaid claims are estimated based upon our historical experience and other actuarial assumptions that consider the effects of current developments, anticipated trends and risk management programs, reduced for anticipated salvage and subrogation.Future policy benefit liabilities for minimum death and income benefit guarantees relating to certain annuity contracts are based on estimates of the expected value of benefits in excess of the projected account balance, recognizing the excess ratably over the accumulation period based on total expected assessments. Liabilities for ULSG and paid-up guarantees are determined by estimating the expected value of death benefits payable when the account balance is projected to be zero and recognizing those benefits ratably over the accumulation period based on total expected assessments. The assumptions used in estimating the secondary and paid-up guarantee liabilities are consistent with those used for amortizing DAC, and are thus subject to the same variability and risk. The assumptions of investment performance and volatility for variable products are consistent with historical experience of the appropriate underlying equity index, such as the S&P 500 Index.We regularly review our estimates of liabilities for future policy benefits and compare them with our actual experience. Differences between actual experience and the assumptions used in pricing these policies and guarantees, as well as in the establishment of the related liabilities, result in variances in profit and could result in losses.60Table of ContentsSee Note 4 of the Notes to the Consolidated Financial Statements for additional information on our liability for future policy benefits.ReinsuranceAccounting for reinsurance requires extensive use of assumptions and estimates, particularly related to the future performance of the underlying business and the potential impact of counterparty credit risks. We periodically review actual and anticipated experience compared to the aforementioned assumptions used to establish assets and liabilities relating to ceded and assumed reinsurance and evaluate the financial strength of counterparties to our reinsurance agreements using criteria similar to that evaluated in our security impairment process. See “— Investment Allowance for Credit Loss and Impairments.” Additionally, for each of our reinsurance agreements, we determine whether the agreement provides indemnification against loss or liability relating to insurance risk, in accordance with applicable accounting standards. We review all contractual features, including those that may limit the amount of insurance risk to which the reinsurer is subject or features that delay the timely reimbursement of claims. If we determine that a reinsurance agreement does not expose the reinsurer to a reasonable possibility of a significant loss from insurance risk, we record the agreement using the deposit method of accounting.See Note 6 of the Notes to the Consolidated Financial Statements for additional information on our reinsurance programs.Deferred Policy Acquisition Costs and Value of Business AcquiredWe incur significant costs in connection with acquiring new and renewal insurance business. Costs that relate directly to the successful acquisition or renewal of insurance contracts are capitalized as DAC. In addition to commissions, certain direct-response advertising expenses and other direct costs, deferrable costs include the portion of an employee’s total compensation and benefits related to time spent selling, underwriting or processing the issuance of new and renewal insurance business only with respect to actual policies acquired or renewed. We utilize various techniques to estimate the portion of an employee’s time spent on qualifying acquisition activities that result in actual sales, including surveys, interviews, representative time studies and other methods. These estimates include assumptions that are reviewed and updated on a periodic basis to reflect significant changes in processes or distribution methods.VOBA represents the excess of book value over the estimated fair value of acquired insurance, annuity, and investment-type contracts in force at the acquisition date. For certain acquired blocks of business, the estimated fair value of the in-force contract obligations exceeded the book value of assumed in-force insurance policy liabilities, resulting in negative VOBA, which is presented separately from VOBA as an additional insurance liability included in other policy-related balances. The estimated fair value of the acquired obligations is based on projections, by each block of business, of future policy and contract charges, premiums, mortality and morbidity, separate account performance, surrenders, expenses, investment returns, nonperformance risk adjustment and other factors. Actual experience on the purchased business may vary from these projections. The recovery of DAC and VOBA is dependent upon the future profitability of the related business.Separate account rates of return on variable universal life contracts and variable deferred annuity contracts affect in-force account balances on such contracts each reporting period, which can result in significant fluctuations in amortization of DAC and VOBA. Our practice to determine the impact of gross profits resulting from returns on separate accounts assumes that long-term appreciation in equity markets is not changed by short-term market fluctuations, but is only changed when sustained interim deviations are expected. We monitor these events and only change the assumption when our long-term expectation changes. The effect of an increase (decrease) by 100 basis points in the assumed future rate of return is reasonably likely to result in a decrease (increase) in the DAC and VOBA amortization with an offset to our unearned revenue liability which nets to approximately $30 million. We use a mean reversion approach to separate account returns where the mean reversion period is five years with a long-term separate account return after the five-year reversion period is over. The current long-term rate of return assumption for the variable universal life contracts and variable deferred annuity contracts is 6.0%.We periodically review long-term assumptions underlying the projections of estimated gross margins and profits. These assumptions primarily relate to investment returns, policyholder dividend scales, interest crediting rates, mortality, persistency, and expenses to administer business. Assumptions used in the calculation of estimated gross margins and profits which may have significantly changed are updated annually. If the update of assumptions causes expected future gross margins and profits to increase, DAC and VOBA amortization will decrease, resulting in a current period increase to earnings. The opposite result occurs when the assumption update causes expected future gross margins and profits to decrease.61Table of ContentsOur most significant assumption updates resulting in a change to expected future gross margins and profits and the amortization of DAC and VOBA are due to revisions to expected future investment returns, expenses, in-force or persistency assumptions and policyholder dividends on participating traditional life contracts, variable and universal life contracts and annuity contracts. We expect these assumptions to be the ones most reasonably likely to cause significant changes in the future. Changes in these assumptions can be offsetting and we are unable to predict their movement or offsetting impact over time. At December 31, 2020 and 2019, DAC and VOBA for the Company was $16.4 billion and $17.8 billion, respectively. The following illustrates the effect on DAC and VOBA of changing each of the respective assumptions, as well as updating estimated gross margins or profits with actual gross margins or profits during the years ended December 31, 2020 and 2019. Increases (decreases) in DAC and VOBA balances, as presented below, resulted in a corresponding decrease (increase) in amortization. Years Ended December 31, 20202019 (In millions)General account investment return$(285)$(116)Separate account investment return40 31 Net investment/Net derivative gains (losses) and GMIB(28)(106)In-force/Persistency(32)39 Policyholder dividends, expense and other(29)(81)Total$(334)$(233)Items contributing to the changes to DAC and VOBA amortization in 2020 consisted of the following:•Net increase in amortization of $285 million mostly due to the annual actuarial assumption review relating to the general account long-term investment rates of return.Items contributing to the changes to DAC and VOBA amortization in 2019 consisted of the following:•Net increase in amortization of $106 million associated with net investment/net derivative gains (losses) and GMIB, primarily driven by the following:◦An increase in amortization of $25 million from net derivative gains from freestanding derivatives hedging the variable annuity guarantees, partially offset by a decrease in amortization of approximately $10 million from net derivative losses resulting from the increases in variable annuity guarantee obligations.◦A decrease in amortization of approximately $10 million associated with gains from GMIB hedges and the decreases in GMIB obligations.◦Net increase in amortization of approximately $100 million from other investment activities.•Net increase in general account investment return mostly due to net investment income assumption unlocking and an update to the yield curve for market value adjustment.Our DAC and VOBA balance is also impacted by unrealized investment gains (losses) and the amount of amortization which would have been recognized if such gains and losses had been realized. The increase in unrealized investment gains (losses) decreased the DAC and VOBA balance by $1.3 billion and $1.5 billion in 2020 and 2019, respectively. See Notes 5 and 8 of the Notes to the Consolidated Financial Statements for information regarding the DAC and VOBA offset to unrealized investment gains (losses).Estimated Fair Value of InvestmentsIn determining the estimated fair value of our investments, fair values are based on unadjusted quoted prices for identical investments in active markets that are readily and regularly obtainable. When such unadjusted quoted prices are not available, estimated fair values are based on quoted prices in markets that are not active, quoted prices for similar but not identical investments, or other observable inputs. If these inputs are not available, or observable inputs are not determinable, unobservable inputs and/or adjustments to observable inputs requiring management judgment are used to determine the estimated fair value of investments.The methodologies, assumptions and inputs utilized are described in Note 10 of the Notes to the Consolidated Financial Statements.62Table of ContentsFinancial markets are susceptible to severe events evidenced by rapid depreciation in asset values accompanied by a reduction in asset liquidity. Our ability to sell investments, or the price ultimately realized for investments, depends upon the demand and liquidity in the market and increases the use of judgment in determining the estimated fair value of certain investments.Investment Allowance for Credit Loss and ImpairmentsThe significant estimates related to our evaluation of credit loss and impairments on our investment portfolio are summarized below. In addition, information about the evaluation processes and measurement methodologies and changes thereto from the implementation of new credit loss guidance on January 1, 2020, is contained in Notes 1 and 8 of the Notes to the Consolidated Financial Statements.Fixed Maturity SecuritiesThe assessment of whether a credit loss has occurred is based on our case-by-case evaluation of whether the net amount expected to be collected is less than the amortized cost basis. We consider a wide range of factors about the security issuer and use our best judgment in evaluating the cause of the decline in the estimated fair value of the security and in assessing the prospects for near-term recovery. In accordance with new credit loss guidance adopted January 1, 2020, we evaluate credit loss by considering information about past events, current and forecasted economic conditions, and we measure credit loss by estimating recovery value using a discounted cash flow analysis. In accordance with this new credit loss guidance, we record an ACL for the amount of the credit loss instead of recording a reduction of the amortized cost as an impairment. We revise these evaluations as conditions change and new information becomes available.Prior to adopting the new credit loss guidance, we used the incurred loss model. The credit loss evaluation process and the measurement of credit loss are generally similar under the new credit loss guidance and the incurred loss model. Mortgage LoansThe ACL is established both for pools of loans with similar risk characteristics and for loans with dissimilar risk characteristics, collateral dependent loans and reasonably expected troubled debt restructurings, individually on a loan specific basis. We record an allowance for expected lifetime credit loss in an amount that represents the portion of the amortized cost basis of mortgage loans that we do not expect to collect, resulting in mortgage loans being presented at the net amount expected to be collected. In accordance with new credit loss guidance adopted January 1, 2020, to determine the mortgage loan ACL, we estimate expected lifetime credit loss over the contractual term of our mortgage loans adjusted for expected prepayments and any extensions; and we consider past events and current and forecasted economic conditions. Our estimates are revised as conditions change and new information becomes available.Prior to adopting the new credit loss guidance, we used the incurred loss model. The credit loss evaluation process and the measurement of credit loss are generally similar under the new credit loss guidance and the incurred loss model, except that the new credit loss guidance requires recording an ACL for expected lifetime credit loss.Real Estate, Leases and Other Asset ClassesThe determination of the amount of ACL and impairments on real estate, leases and the remaining invested asset classes is highly subjective and is based upon our quarterly evaluation and assessment of known and inherent risks associated with the respective asset class. Such evaluations and assessments are revised as conditions change and new information becomes available.DerivativesThe determination of the estimated fair value of freestanding derivatives, when quoted market values are not available, is based on market standard valuation methodologies and inputs that management believes are consistent with what other market participants would use when pricing the instruments. Derivative valuations can be affected by changes in interest rates, foreign currency exchange rates, financial indices, credit spreads, default risk, nonperformance risk, volatility, liquidity and changes in estimates and assumptions used in the pricing models. See Note 10 of the Notes to the Consolidated Financial Statements for additional details on significant inputs into the OTC derivative pricing models and credit risk adjustment.63Table of ContentsWe issue variable annuity products with guaranteed minimum benefits, some of which are embedded derivatives measured at estimated fair value separately from the host variable annuity product, with changes in estimated fair value reported in net derivative gains (losses). The estimated fair values of these embedded derivatives are determined based on the present value of projected future benefits minus the present value of projected future fees. The projections of future benefits and future fees require capital market and actuarial assumptions, including expectations concerning policyholder behavior. A risk neutral valuation methodology is used under which the cash flows from the guarantees are projected under multiple capital market scenarios using observable risk-free rates. The valuation of these embedded derivatives also includes an adjustment for our nonperformance risk and risk margins for non-capital market inputs. The nonperformance risk adjustment, which is captured as a spread over the risk-free rate in determining the discount rate to discount the cash flows of the liability, is determined by taking into consideration publicly available information relating to spreads in the secondary market for MetLife, Inc.’s debt, including related credit default swaps. These observable spreads are then adjusted, as necessary, to reflect the priority of these liabilities and the claims paying ability of the issuing insurance subsidiaries compared to MetLife, Inc. Risk margins are established to capture the non-capital market risks of the instrument which represent the additional compensation a market participant would require to assume the risks related to the uncertainties in certain actuarial assumptions. The establishment of risk margins requires the use of significant management judgment, including assumptions of the amount and cost of capital needed to cover the guarantees.The table below illustrates the impact that a range of reasonably likely variances in credit spreads would have on our consolidated balance sheet, excluding the effect of income tax, related to the embedded derivative valuation on certain variable annuity products measured at estimated fair value. In determining the ranges, we have considered current market conditions, as well as the market level of spreads that can reasonably be anticipated over the near term. The ranges do not reflect extreme market conditions such as those experienced during the 2008-2009 financial crisis, as we do not consider those to be reasonably likely events in the near future.The impact of the range of reasonably likely variances in credit spreads decreased as compared to prior periods. However, these estimated effects do not take into account potential changes in other variables, such as equity price levels and market volatility, which can also contribute significantly to changes in carrying values. Therefore, the table does not necessarily reflect the ultimate impact on the consolidated financial statements under the credit spread variance scenarios presented below. Changes in Balance Sheet Carrying Value At December 31, 2020 Policyholder Account BalancesDAC and VOBA (In millions)100% increase in our credit spread$800 $74 As reported$934 $105 50% decrease in our credit spread $1,009 $121 The accounting for derivatives is complex and interpretations of accounting standards continue to evolve in practice. If it is determined that hedge accounting designations were not appropriately applied, reported net income could be materially affected. Assessments of the effectiveness of hedging relationships are also subject to interpretations and estimations and different interpretations or estimates may have a material effect on the amount reported in net income.Variable annuities with guaranteed minimum benefits may be more costly than expected in volatile or declining equity markets. Market conditions including, but not limited to, changes in interest rates, equity indices, market volatility and foreign currency exchange rates, changes in our nonperformance risk, variations in actuarial assumptions regarding policyholder behavior, mortality and risk margins related to non-capital market inputs, may result in significant fluctuations in the estimated fair value of the guarantees that could materially affect net income. If interpretations change, there is a risk that features previously not bifurcated may require bifurcation and reporting at estimated fair value on the consolidated financial statements and respective changes in estimated fair value could materially affect net income.64Table of ContentsAdditionally, we ceded the risk associated with certain of the variable annuities with guaranteed minimum benefits described in the preceding paragraphs. The value of the embedded derivatives on the ceded risk is determined using a methodology consistent with that described previously for the guarantees directly written by us with the exception of the input for nonperformance risk that reflects the credit of the reinsurer. Because certain of the direct guarantees do not meet the definition of an embedded derivative and, thus are not accounted for at fair value, significant fluctuations in net income may occur since the change in fair value of the embedded derivative on the ceded risk is being recorded in net income without a corresponding and offsetting change in fair value of the direct guarantee.See Note 9 of the Notes to the Consolidated Financial Statements for additional information on our derivatives and hedging programs.Goodwill Goodwill is tested for impairment at least annually or more frequently if events or circumstances that management deems a triggering event indicate that there may be justification for conducting an interim test. Examples of such events or circumstances are changes in business climate, including disruptions in global capital markets. Effective January 1, 2020, the Company adopted a new accounting pronouncement related to simplifying the test for goodwill impairment, as described in Note 1 of the Notes to the Consolidated Financial Statements.For purposes of goodwill impairment testing, if the carrying value of a reporting unit exceeds its estimated fair value, an impairment charge would be recognized for the amount by which the carrying value exceeds the reporting unit’s fair value; however, the loss recognized would not exceed the total amount of goodwill allocated to that reporting unit. Additionally, the Company will consider income tax effects from any tax deductible goodwill on the carrying value of the reporting unit when measuring the goodwill impairment loss, if applicable. The key inputs, judgments and assumptions necessary in determining estimated fair value of the reporting units include projected adjusted earnings, current book value, the level of economic capital required to support the mix of business, long-term growth rates, comparative market multiples, the account value of in-force business, projections of new and renewed business, as well as margins on such business, interest rate levels, credit spreads, equity market levels, and the discount rate that we believe is appropriate for the respective reporting unit. In the third quarter of 2020, the Company performed its annual goodwill impairment tests on all of its reporting units using quantitative assessments under the market multiple, embedded value and discounted cash flow valuation approaches based on best available data as of June 30, 2020. The Company concluded that the estimated fair values of all its reporting units were substantially in excess of their carrying values and, therefore, goodwill was not impaired.We apply significant judgment when determining the estimated fair value of our reporting units and when assessing the relationship of market capitalization to the aggregate estimated fair value of our reporting units. The valuation methodologies utilized are subject to key judgments and assumptions that are sensitive to change. Estimates of fair value are inherently uncertain and represent only management’s reasonable expectation regarding future developments. These estimates and the judgments and assumptions upon which the estimates are based will, in all likelihood differ in some respects from actual future results. Declines in the estimated fair value of our reporting units could result in goodwill impairments in future periods which could materially adversely affect our results of operations or financial position.See Note 12 of the Notes to the Consolidated Financial Statements for additional information on our goodwill.Employee Benefit PlansCertain subsidiaries of MetLife, Inc. sponsor defined benefit pension plans and other postretirement benefit plans covering eligible employees. See Note 18 of the Notes to the Consolidated Financial Statements for information on amendments to our U.S. benefit plans. The calculation of the obligations and expenses associated with these plans requires an extensive use of assumptions such as the discount rate, expected rate of return on plan assets, rate of future compensation increases and healthcare cost trend rates, as well as assumptions regarding participant demographics such as rate and age of retirement, withdrawal rates and mortality. In consultation with external actuarial firms, we determine these assumptions based upon a variety of factors such as historical experience of the plan and its assets, currently available market and industry data, and expected benefit payout streams.65Table of ContentsWe determine the expected rate of return on plan assets based upon an approach that considers inflation, real return, term premium, credit spreads, equity risk premium and capital appreciation, as well as expenses, expected asset manager performance, asset weights and the effect of rebalancing. Given the amount of plan assets as of December 31, 2019, the beginning of the measurement year, if we had assumed an expected rate of return for both our pension and other postretirement benefit plans that was 100 basis points higher or 100 basis points lower than the rates we assumed, the change in our net periodic benefit costs would have been a decrease of $114 million and an increase of $114 million, respectively, in 2020. This considers only changes in our assumed long-term rate of return given the level and mix of invested assets at the beginning of the year, without consideration of possible changes in any of the other assumptions described above that could ultimately accompany any changes in our assumed long-term rate of return.We determine the discount rates used to value the Company’s pension and postretirement obligations, based upon rates commensurate with current yields on high quality corporate bonds. Given our pension and postretirement obligations as of December 31, 2019, the beginning of the measurement year, if we had assumed a discount rate for both our pension and postretirement benefit plans that was 100 basis points higher or 100 basis points lower than the rates we assumed, the change in our net periodic benefit costs would have been a decrease of $93 million and an increase of $88 million, respectively, in 2020. This considers only changes in our assumed discount rates without consideration of possible changes in any of the other assumptions described above that could ultimately accompany any changes in our assumed discount rate. The assumptions used may differ materially from actual results due to, among other factors, changing market and economic conditions and changes in participant demographics. These differences may have a significant impact on the Company’s consolidated financial statements and liquidity.See Note 18 of the Notes to the Consolidated Financial Statements for additional discussion of assumptions used in measuring liabilities relating to our employee benefit plans.Income TaxesWe provide for federal, state and foreign income taxes currently payable, as well as those deferred due to temporary differences between the financial reporting and tax bases of assets and liabilities. Our accounting for income taxes represents our best estimate of various events and transactions. Tax laws are often complex and may be subject to differing interpretations by the taxpayer and the relevant governmental taxing authorities. In establishing a provision for income tax expense, we must make judgments and interpretations about the application of inherently complex tax laws. We must also make estimates about when in the future certain items will affect taxable income in the various tax jurisdictions in which we conduct business.In establishing a liability for unrecognized tax benefits, assumptions may be made in determining whether, and to what extent, a tax position may be sustained. Once established, unrecognized tax benefits are adjusted when there is more information available or when events occur requiring a change. Valuation allowances are established against deferred tax assets when management determines, based on available information, that it is more likely than not that deferred income tax assets will not be realized. Significant judgment is required in determining whether valuation allowances should be established, as well as the amount of such allowances. See Note 1 of the Notes to the Consolidated Financial Statements for additional information relating to our determination of such valuation allowances.We may be required to change our provision for income taxes when estimates used in determining valuation allowances on deferred tax assets significantly change, or when receipt of new information indicates the need for adjustment in valuation allowances. Additionally, future events, such as changes in tax laws, tax regulations, or interpretations of such laws or regulations, could have an impact on the provision for income tax and the effective tax rate. Any such changes could significantly affect the amounts reported on the consolidated financial statements in the year these changes occur. See also Notes 1 and 19 of the Notes to the Consolidated Financial Statements for additional information on our income taxes.66Table of ContentsLitigation ContingenciesWe are a defendant in a large number of litigation matters and are involved in a number of regulatory investigations. Given the large and/or indeterminate amounts sought in certain of these matters and the inherent unpredictability of litigation, it is possible that an adverse outcome in certain matters could, from time to time, have a material effect on the Company’s consolidated net income or cash flows in particular quarterly or annual periods. Liabilities are established when it is probable that a loss has been incurred and the amount of the loss can be reasonably estimated. Liabilities related to certain lawsuits, including our asbestos-related liability, are especially difficult to estimate due to the limitation of reliable data and uncertainty regarding numerous variables that can affect liability estimates. On a quarterly and annual basis, we review relevant information with respect to liabilities for litigation, regulatory investigations and litigation-related contingencies to be reflected in our consolidated financial statements. It is possible that an adverse outcome in certain of our litigation and regulatory investigations, including asbestos-related cases, or the use of different assumptions in the determination of amounts recorded could have a material effect upon our consolidated net income or cash flows in particular quarterly or annual periods.See Note 21 of the Notes to the Consolidated Financial Statements for additional information regarding our assessment of litigation contingencies.Economic CapitalEconomic capital is an internally developed risk capital model, the purpose of which is to measure the risk in the business and to provide a basis upon which capital is deployed. The economic capital model accounts for the unique and specific nature of the risks inherent in our business. Our economic capital model, coupled with considerations of local capital requirements, aligns segment allocated equity with emerging standards and consistent risk principles. Economic capital-based risk estimation is an evolving science and industry best practices have emerged and continue to evolve. Areas of evolving industry best practices include stochastic liability valuation techniques, alternative methodologies for the calculation of diversification benefits, and the quantification of appropriate shock levels. MetLife’s management is responsible for the ongoing production and enhancement of the economic capital model and reviews its approach periodically to ensure that it remains consistent with emerging industry practice standards. For further information, see “Financial Measures and Segment Accounting Policies” in Note 2 of the Notes to the Consolidated Financial Statements.Acquisitions and DispositionsAcquisitionsAcquisition of Versant Health For information regarding the Company's acquisition of Versant Health, see Note 3 of the Notes to the Consolidated Financial Statements.Acquisition of PetFirstIn January 2020, the Company completed the acquisition of PetFirst Healthcare, LLC (“PetFirst”), a fast-growing pet health insurance administrator. Acquisition of WillingIn November 2019, the Company completed the acquisition of Bequest, Inc. (“Willing”), a leading digital estate planning service. This transaction brings new digital capabilities to the Company and reinforces its commitment to providing simple and easy-to-use benefits that respond to consumer needs.DispositionsPending Disposition of MetLife P&CFor information regarding the Company's pending disposition of MetLife P&C, reported as held-for-sale, see Notes 1 and 3 of the Notes to the Consolidated Financial Statements.Disposition of MetLife RussiaFor information regarding the Company's disposition of MetLife Russia, see Note 3 of the Notes to the Consolidated Financial Statements.67Table of ContentsDisposition of MetLife Seguros de RetiroFor information regarding the Company's disposition of MetLife Seguros de Retiro, see Note 3 of the Notes to the Consolidated Financial Statements.Disposition of MetLife Hong KongFor information regarding the Company’s disposition of MetLife Hong Kong, see Note 3 of the Notes to the Consolidated Financial Statements.68Table of ContentsResults of OperationsConsolidated Results Years Ended December 31, 20202019 (In millions)RevenuesPremiums$42,034 $42,235 Universal life and investment-type product policy fees5,603 5,603 Net investment income17,117 18,868 Other revenues1,849 1,842 Net investment gains (losses)(110)444 Net derivative gains (losses)1,349 628 Total revenues67,842 69,620 ExpensesPolicyholder benefits and claims and policyholder dividends42,551 42,672 Interest credited to policyholder account balances5,214 6,464 Capitalization of DAC(3,013)(3,358)Amortization of DAC and VOBA3,160 2,896 Amortization of negative VOBA(45)(33)Interest expense on debt913 955 Other expenses12,135 13,229 Total expenses60,915 62,825 Income (loss) before provision for income tax6,927 6,795 Provision for income tax expense (benefit)1,509 886 Net income (loss)5,418 5,909 Less: Net income (loss) attributable to noncontrolling interests11 10 Net income (loss) attributable to MetLife, Inc.5,407 5,899 Less: Preferred stock dividends202 178 Preferred stock redemption premium14 — Net income (loss) available to MetLife, Inc.’s common shareholders$5,191 $5,721 Year Ended December 31, 2020 Compared with the Year Ended December 31, 2019During 2020, net income (loss) decreased $491 million from 2019, primarily driven by unfavorable changes in net investment gains (losses) and adjusted earnings, as well as the impact of our actuarial assumption review, largely offset by a favorable change in net derivative gains (losses), net of investment hedge adjustments.Management of Investment Portfolio and Hedging Market Risks with Derivatives. We manage our investment portfolio using disciplined ALM principles, focusing on cash flow and duration to support our current and future liabilities. Our intent is to match the timing and amount of liability cash outflows with invested assets that have cash inflows of comparable timing and amount, while optimizing risk-adjusted investment income and risk-adjusted total return. Our investment portfolio is heavily weighted toward fixed income investments, with over 80% of our portfolio invested in fixed maturity securities AFS and mortgage loans. These securities and loans have varying maturities and other characteristics which cause them to be generally well suited for matching the cash flow and duration of insurance liabilities. In addition, our general account investment portfolio includes, within contractholder-directed equity securities and fair value option securities (“FVO Securities”) (collectively, “Unit-linked and FVO Securities”), contractholder-directed equity securities supporting unit-linked variable annuity type liabilities (“Unit-linked investments”), which do not qualify as separate account assets. Returns on these Unit-linked investments, which can vary significantly from period to period, include changes in estimated fair value subsequent to purchase, inure to contractholders and are offset in earnings by a corresponding change in policyholder account balances through interest credited to policyholder account balances.69Table of ContentsWe purchase investments to support our insurance liabilities and not to generate net investment gains and losses. However, net investment gains and losses are incurred and can change significantly from period to period due to changes in external influences, including changes in market factors such as interest rates, foreign currency exchange rates, credit spreads and equity markets; counterparty specific factors such as financial performance, credit rating and collateral valuation; and internal factors such as portfolio rebalancing. Changes in these factors from period to period can significantly impact the levels of provision for credit loss and impairments on our investment portfolio, as well as realized gains and losses on investments sold.We also use derivatives as an integral part of our management of the investment portfolio and insurance liabilities to hedge certain risks, including changes in interest rates, foreign currency exchange rates, credit spreads and equity market levels. We use freestanding interest rate, equity, credit and currency derivatives to hedge certain invested assets and insurance liabilities. A portion of these hedges are designated and qualify as accounting hedges, which reduce volatility in earnings. For those hedges not designated as accounting hedges, changes in market factors lead to the recognition of fair value changes in net derivative gains (losses) generally without an offsetting gain or loss recognized in earnings for the item being hedged, which creates volatility in earnings. We actively evaluate market risk hedging needs and strategies to ensure our free cash flow and capital objectives are met under a range of market conditions. Certain variable annuity products with guaranteed minimum benefits contain embedded derivatives that are measured at estimated fair value separately from the host variable annuity contract, with changes in estimated fair value recorded in net derivative gains (losses). We use freestanding derivatives to hedge the market risks inherent in these variable annuity guarantees. We continuously review and refine our strategy and ongoing refinement of the strategy may be required to take advantage of the NAIC rules related to a statutory accounting election for derivatives that mitigate interest rate sensitivity related to variable annuity guarantees. Our macro hedge program, included in the non-VA program derivatives section of the table below, protects our overall statutory capital from significant adverse economic conditions. The valuation of these embedded derivatives includes a nonperformance risk adjustment, which is unhedged, and can be a significant driver of net derivative gains (losses) and volatility in earnings, but does not have an economic impact on us.Net Derivative Gains (Losses). The variable annuity embedded derivatives and associated freestanding derivative hedges are collectively referred to as “VA program derivatives.” All other derivatives that are economic hedges of certain invested assets and insurance liabilities are referred to as “non-VA program derivatives.” The table below presents the impact on net derivative gains (losses) from non-VA program derivatives and VA program derivatives: Years Ended December 31, 20202019 (In millions)Non-VA program derivativesInterest rate$2,880 $1,384 Foreign currency exchange rate(148)(67)Credit(76)282 Equity(1,005)(403)Non-VA embedded derivatives(80)(162)Total non-VA program derivatives1,571 1,034 VA program derivativesMarket risks in embedded derivatives139 851 Nonperformance risk adjustment on embedded derivatives(10)(116)Other risks in embedded derivatives(159)(301)Total embedded derivatives(30)434 Freestanding derivatives hedging embedded derivatives(192)(840)Total VA program derivatives(222)(406)Net derivative gains (losses)$1,349 $628 70Table of ContentsThe favorable change in net derivative gains (losses) on non-VA program derivatives was $537 million ($424 million, net of income tax). This was primarily due to the impact of certain derivative transactions after long-term rates declined during 2020, favorably impacting interest rate options and receive-fixed interest rate swaps acquired primarily as part of our macro hedge program. These favorable impacts were partially offset by key equity index increases in 2020 unfavorably impacting equity TRRs acquired in 2020 primarily as part of our macro hedge program. Also, certain credit spreads widened in 2020 and narrowed in 2019, unfavorably impacting written credit default swaps used in replications. Because certain of these hedging strategies are not designated or do not qualify as accounting hedges, the changes in the estimated fair value of these freestanding derivatives are recognized in net derivative gains (losses) without an offsetting gain or loss recognized in earnings for the items being hedged.The favorable change in net derivative gains (losses) on VA program derivatives was $184 million ($145 million, net of income tax). This was due to a favorable change of $106 million ($84 million, net of income tax) in the nonperformance risk adjustment on embedded derivatives and a favorable change of $142 million ($112 million, net of income tax) in other risks in embedded derivatives. These favorable changes were partially offset by an unfavorable change of $64 million ($51 million, net of income tax) in market risks in embedded derivatives net of freestanding derivatives hedging market risks in embedded derivatives. Other risks relate primarily to the impact of policyholder behavior and other non-market risks that generally cannot be hedged.The aforementioned $106 million ($84 million, net of income tax) favorable change in the nonperformance risk adjustment on embedded derivatives resulted from a favorable change of $58 million, before income tax, related to changes in our own credit spread and a favorable change of $48 million, before income tax, related to model changes and changes in capital market inputs, such as long-term interest rates and key equity index levels, on variable annuity guarantees. The aforementioned $142 million ($112 million, net of income tax) favorable change in other risks in embedded derivatives reflects actuarial assumption updates and a combination of factors, which include fees deducted from accounts, changes in the benefit base, premiums, lapses, withdrawals and deaths, in addition to changes in cross-effect, basis mismatch, risk margin and fund allocation.The aforementioned $64 million ($51 million, net of income tax) unfavorable change reflects a $712 million ($563 million, net of income tax) unfavorable change in market risks in embedded derivatives, partially offset by a $648 million ($512 million, net of income tax) favorable change in freestanding derivatives hedging market risks in embedded derivatives. The primary change in market factors affecting VA program derivatives is summarized as follows:•Key equity index levels either increased less or decreased in 2020 compared to 2019, contributing to an unfavorable change in our embedded derivatives and a favorable change in our freestanding derivatives. For example, the S&P 500 equity index increased 16% in 2020 and increased 29% in 2019.When equity index levels decrease in isolation, the variable annuity guarantees become more valuable to policyholders, which results in an increase in the undiscounted embedded derivative liability. Discounting this unfavorable change by the risk adjusted rate yields a smaller loss than by discounting at the risk-free rate, thus creating a gain from including an adjustment for nonperformance risk.When the risk-free interest rate decreases in isolation, discounting the embedded derivative liability produces a higher valuation of the liability than if the risk-free interest rate had remained constant. Discounting this unfavorable change by the risk adjusted rate yields a smaller loss than by discounting at the risk-free interest rate, thus creating a gain from including an adjustment for nonperformance risk.When our own credit spread increases in isolation, discounting the embedded derivative liability produces a lower valuation of the liability than if our own credit spread had remained constant. As a result, a gain is created from including an adjustment for nonperformance risk. For each of these primary market drivers, the opposite effect occurs when the driver moves in the opposite direction.Net Investment Gains (Losses). The unfavorable change in net investment gains (losses) of $554 million ($438 million, net of income tax) primarily reflects 2019 gains on sales of real estate joint ventures, mark-to-market losses in 2020 on equity securities, which are measured at estimated fair value through net income (loss), higher provisions for credit loss on mortgage loans in 2020, losses incurred in connection with the dispositions of MetLife Seguros de Retiro and MetLife Russia and a 2019 gain on a renewable energy partnership. These unfavorable changes were partially offset by higher foreign currency transaction gains in 2020, a 2020 recovery on a leveraged lease that was previously impaired, a 2019 tax credit partnership impairment and a loss in 2019 as a result of the disposition of MetLife Hong Kong.71Table of ContentsDivested Businesses. Income (loss) before provision for income tax related to the divested businesses, excluding net investment gains (losses) and net derivative gains (losses), increased $74 million ($61 million, net of income tax) to a loss of $30 million ($23 million, net of income tax) in 2020 from a loss of $104 million ($84 million, net of income tax) in 2019. Included in this increase was a decrease in total revenues of $22 million, before income tax, and a decrease in total expenses of $96 million, before income tax. Divested businesses primarily include activity related to the separation of Brighthouse Financial, Inc. and its subsidiaries, as well as the dispositions of MetLife Hong Kong and MetLife Seguros de Retiro.Taxes. Our 2020 effective tax rate on income (loss) before provision for income tax was 22%. Our effective tax rate differed from the U.S. statutory rate of 21% primarily due to tax charges from foreign earnings taxed at different rates than the U.S. statutory rate and the dispositions of MetLife Seguros de Retiro and MetLife Russia, partially offset by tax benefits related to non-taxable investment income, tax credits, the finalization of bankruptcy proceedings for a leveraged lease investment and the impact from an IRS audit matter. Our 2019 effective tax rate on income (loss) before provision for income tax was 13%. Our effective tax rate differed from the U.S. statutory rate of 21% primarily due to tax benefits related to non-taxable investment income, tax credits, tax benefits related to the resolution of an uncertainty regarding the deemed repatriation transition tax enacted as a part of U.S. Tax Reform and the settlement of certain tax audits, partially offset by tax charges from foreign earnings taxed at different rates than the U.S. statutory rate and the disposition of MetLife Hong Kong. Actuarial Assumption Review and Certain Other Insurance Adjustments. Results for 2020 include a $378 million ($301 million, net of income tax) charge associated with our annual review of actuarial assumptions related to reserves and DAC, of which a $44 million gain ($34 million, net of income tax) was recognized in net derivative gains (losses).Of the $378 million charge, $120 million ($94 million, net of income tax) was related to DAC and $258 million ($207 million, net of income tax) was associated with reserves. The portion of the $378 million charge that is included in adjusted earnings is $255 million ($203 million, net of income tax).The $44 million gain ($34 million, net of income tax) recognized in net derivative gains (losses) associated with our annual review of actuarial assumptions is included within the other risks in embedded derivatives line in the table above.As a result of our annual review of actuarial assumptions, changes were made to economic, biometric, policyholder behavior, and operational assumptions. The most significant impacts were in the MetLife Holdings segment, driven by economic assumption updates, including changes to interest rate projections. The breakdown of total 2020 results is summarized as follows:•Economic assumption updates resulted in unfavorable impacts to reserves and DAC for a net charge of $352 million ($278 million, net of income tax).•Changes in biometric assumptions resulted in favorable impacts to reserves and DAC for a net gain of $45 million ($31 million, net of income tax).•Changes in policyholder behavior assumptions resulted in unfavorable impacts to reserves and DAC for a net charge of $30 million ($28 million, net of income tax).•Changes in operational assumptions resulted in slightly favorable impacts to reserves and unfavorable impacts to DAC for a net charge of $41 million ($26 million, net of income tax).Results for 2019 include a $201 million ($162 million, net of income tax) charge associated with our annual review of actuarial assumptions related to reserves and DAC, of which a $31 million ($27 million, net of income tax) loss was recognized in net derivative gains (losses). Of the $201 million charge, $49 million ($37 million, net of income tax) was related to DAC and $152 million ($125 million, net of income tax) was associated with reserves. The portion of the $201 million charge that is included in adjusted earnings is $179 million ($143 million, net of income tax). Certain other insurance adjustments recorded in 2019 include a $22 million ($17 million, net of income tax) charge due to a 2019 increase in our IBNR long-term care reserves reflecting enhancements to our methodology related to potential claims in our MetLife Holdings segment. This adjustment is included in adjusted earnings.72Table of ContentsAdjusted Earnings. As more fully described in “— Non-GAAP and Other Financial Disclosures,” we use adjusted earnings, which does not equate to net income (loss), as determined in accordance with GAAP, to analyze our performance, evaluate segment performance, and allocate resources. We believe that the presentation of adjusted earnings and other financial measures based on adjusted earnings, as we measure it for management purposes, enhances the understanding of our performance by highlighting the results of operations and the underlying profitability drivers of the business. Adjusted earnings and other financial measures based on adjusted earnings allow analysis of our performance relative to our business plan and facilitate comparisons to industry results. Adjusted earnings should not be viewed as a substitute for net income (loss). Adjusted earnings available to common shareholders and adjusted earnings available to common shareholders on a constant currency basis should not be viewed as substitutes for net income (loss) available to MetLife, Inc.’s common shareholders. Adjusted earnings available to common shareholders decreased $144 million, net of income tax, to $5.6 billion, net of income tax, for 2020 from $5.8 billion, net of income tax, for 2019.73Table of ContentsReconciliation of net income (loss) to adjusted earnings available to common shareholders and premiums, fees and other revenues to adjusted premiums, fees and other revenuesYear Ended December 31, 2020U.S.AsiaLatin AmericaEMEAMetLife HoldingsCorporate & OtherTotal(In millions)Net income (loss) available to MetLife, Inc.'s common shareholders$3,136 $1,684 $27 $280 $1,277 $(1,213)$5,191 Add: Preferred stock dividends— — — — — 202 202 Add: Net income (loss) attributable to noncontrolling interests— 1 4 5 — 1 11 Add: Preferred stock redemption premium— — — — — 14 14 Net income (loss)3,136 1,685 31 285 1,277 (996)5,418 Less: adjustments from net income (loss) to adjusted earnings available to common shareholders:Revenues:Net investment gains (losses)61 261 (103)(159)(9)(161)(110)Net derivative gains (losses)202 226 75 30 1,149 (333)1,349 Premiums— 52 — — — — 52 Universal life and investment-type product policy fees— 39 (2)17 84 — 138 Net investment income(340)(7)(1)428 (284)(7)(211)Other revenues— — — — — 159 159 Expenses:Policyholder benefits and claims and policyholder dividends(44)(109)(170)75 (444)— (692)Interest credited to policyholder account balances9 (107)(43)(400)— — (541)Capitalization of DAC— 5 — — — — 5 Amortization of DAC and VOBA— (53)— 2 (115)— (166)Amortization of negative VOBA— — — — — — — Interest expense on debt— — — — — — — Other expenses— (24)(9)(7)— (223)(263)Goodwill impairment— — — — — — — Provision for income tax (expense) benefit24 (163)4 (28)(80)116 (127)Adjusted earnings$3,224 $1,565 $280 $327 $976 (547)5,825 Less: Preferred stock dividends202 202 Adjusted earnings available to common shareholders$(749)$5,623 Premiums, fees and other revenues$29,292 $8,615 $3,295 $2,761 $4,995 $528 $49,486 Less: adjustments to premiums, fees and other revenues— 91 (2)17 84 159 349 Adjusted premiums, fees and other revenues$29,292 $8,524 $3,297 $2,744 $4,911 $369 $49,137 74Table of ContentsYear Ended December 31, 2019 U.S.AsiaLatin AmericaEMEAMetLife HoldingsCorporate& OtherTotal(In millions)Net income (loss) available to MetLife, Inc.'s common shareholders$3,148 $1,755 $403 $272 $780 $(637)$5,721 Add: Preferred stock dividends— — — — — 178 178 Add: Net income (loss) attributable to noncontrolling interests— — 8 3 — (1)10 Add: Preferred stock redemption premium— — — — — — — Net income (loss)3,148 1,755 411 275 780 (460)5,909 Less: adjustments from net income (loss) to adjusted earnings available to common shareholders:Revenues:Net investment gains (losses)44 232 (22)(1)294 (103)444 Net derivative gains (losses)566 467 (11)(24)(273)(97)628 Premiums— 71 — — — — 71 Universal life and investment-type product policy fees— 105 — 15 88 — 208 Net investment income(200)229 (9)1,151 (141)8 1,038 Other revenues— 11 — — — 246 257 Expenses:Policyholder benefits and claims and policyholder dividends(37)(83)(202)15 (177)4 (480)Interest credited to policyholder account balances19 (293)(53)(1,108)— — (1,435)Capitalization of DAC— 20 — — — — 20 Amortization of DAC and VOBA— (92)— 8 (25)— (109)Amortization of negative VOBA— — — — — — — Interest expense on debt— — — — — — — Other expenses— (54)11 (29)(87)(292)(451)Goodwill impairment— — — — — — — Provision for income tax (expense) benefit(82)(263)88 (34)67 (3)(227)Adjusted earnings$2,838 $1,405 $609 $282 $1,034 (223)5,945 Less: Preferred stock dividends178 178 Adjusted earnings available to common shareholders$(401)$5,767 Adjusted earnings available to common shareholders on a constant currency basis (1)$2,838 $1,404 $535 $271 $1,034 $(401)$5,681 Premiums, fees and other revenues$28,766 $8,549 $3,861 $2,669 $5,213 $622 $49,680 Less: adjustments to premiums, fees and other revenues— 187 — 15 88 246 536 Adjusted premiums, fees and other revenues$28,766 $8,362 $3,861 $2,654 $5,125 $376 $49,144 Adjusted premiums, fees and other revenues on a constant currency basis (1)$28,766 $8,473 $3,428 $2,629 $5,125 $376 $48,797 __________________(1)Amounts for U.S., MetLife Holdings and Corporate & Other are shown on a reported basis, as constant currency impact is not significant.75Table of ContentsConsolidated Results — Adjusted EarningsBusiness Overview. Adjusted premiums, fees and other revenues for 2020 decreased $7 million, or less than 1%, compared to 2019. Adjusted premiums, fees and other revenues, net of foreign currency fluctuations, increased $340 million, or 1%, compared to 2019, primarily due to an increase in our U.S. segment, despite negative impacts from the COVID-19 Pandemic and related restrictions. Growth in core and voluntary products in our Group Benefits business was partially offset by a decline in our RIS business and a decrease in exposures in our Property & Casualty (“P&C”) business. The decrease in RIS was mainly driven by decreases in our structured settlement and institutional income annuity businesses, due to market conditions, partially offset by an increase in our pension risk transfer business. An increase in our EMEA segment was due to business growth across the region. In addition, an increase in our Asia segment reflects the impact in both years of our annual actuarial assumption review, which resulted in higher fees from foreign currency-denominated life products in 2020, partially offset by lower premiums from yen-denominated life products in Japan and the disposition of MetLife Hong Kong in 2019. A decrease in our Latin America segment was mainly driven by lower annuitizations in Chile due to the COVID-19 Pandemic. Our MetLife Holdings segment consists of operations relating to products and businesses, previously included in our former retail business, that we no longer actively market in the United States. We anticipate an average decline in adjusted premiums, fees and other revenues of approximately 5% to 7% per year in our MetLife Holdings segment from expected business run-off. Year Ended December 31, 2020 Compared with the Year Ended December 31, 2019Unless otherwise stated, all amounts discussed below are net of income tax.Overview. The primary drivers of the decrease in adjusted earnings were lower investment yields and a higher effective tax rate. These declines were partially offset by higher net investment income due to a larger asset base, and a decrease in expenses, including interest credited expenses.Foreign Currency. Changes in foreign currency exchange rates had an $86 million negative impact on adjusted earnings for 2020 compared to 2019. Unless otherwise stated, all amounts discussed below are net of foreign currency fluctuations. Foreign currency fluctuations can result in significant variances in the financial statement line items.Business Growth. We benefited from positive net flows from many of our businesses, which increased our invested asset base. Growth in the investment portfolios of all of our segments and Corporate & Other resulted in higher net investment income. However, consistent with the growth in average invested assets, interest credited expenses on certain insurance-related liabilities increased. Also, an increase in expenses was primarily due to the 2020 reinstatement of the annual health insurer fee under the Patient Protection and Affordable Care Act (“PPACA”) and was more than offset by a corresponding increase in adjusted premiums, fees and other revenues. In addition, lower fee income in our MetLife Holdings segment was partially offset by increases in our other segments. The combined impact of the items affecting our business growth, in addition to lower DAC amortization, resulted in a $451 million increase in adjusted earnings.Market Factors. Market factors, including interest rate levels, variability in equity market returns, and foreign currency fluctuations, continued to impact our results; however, certain impacts were mitigated by derivatives used to hedge these risks. Excluding the impact of changes in foreign currency exchange rates on net investment income in our non-U.S. segments and changes in inflation rates on our inflation-indexed investments, investment yields decreased. Investment yields were negatively affected by lower yields on fixed income securities and mortgage loans, and lower returns on FVO Securities and real estate investments. These decreases in net investment income were partially offset by higher net investment income on derivatives. The impact of interest rate fluctuations resulted in a decline in our average interest credited rates on deposit-type and long-duration liabilities, which drove a decrease in interest credited expenses. The changes in market factors discussed above resulted in a $349 million decrease in adjusted earnings.Underwriting, Actuarial Assumption Review and Other Insurance Adjustments. Favorable underwriting experience resulted in an $82 million increase in adjusted earnings and reflected impacts from the COVID-19 Pandemic and related restrictions. Favorable morbidity in our U.S., MetLife Holdings and EMEA segments, as well as a decrease in non-catastrophe claims in our P&C business were partially offset by unfavorable mortality in our U.S., Latin America and MetLife Holdings segments, as well as higher catastrophe-related claims in our Property & Casualty business. The impact in both years of our annual actuarial assumption review resulted in a net decrease of $60 million in adjusted earnings, primarily due to changes in economic assumptions. Refinements to DAC and certain insurance-related liabilities in both years resulted in an $88 million decrease in adjusted earnings, which included the impact of favorable insurance adjustments in 2019 resulting from enhancements to our claim-related processes, as well as a 2019 charge due to an increase in our IBNR long-term care reserves reflecting enhancements to our methodology related to potential claims.76Table of ContentsExpenses. Expenses decreased compared to 2019, primarily due to declines in costs associated with corporate initiatives and projects, certain corporate-related expenses and employee-related costs. The decrease in expenses resulted in a $567 million increase in adjusted earnings.Taxes. Our 2020 effective tax rate on adjusted earnings was 19%. Our effective tax rate differed from the U.S. statutory rate of 21% primarily due to tax benefits from non-taxable investment income, tax credits and the finalization of bankruptcy proceedings for a leveraged lease investment, partially offset by tax charges from foreign earnings taxed at different rates than the U.S. statutory rate. Our 2019 effective tax rate on adjusted earnings was 10%. Our effective tax rate differed from the U.S. statutory rate of 21% primarily due to tax benefits from non-taxable investment income and tax credits, the resolution of an uncertainty regarding the deemed repatriation transition tax enacted as a part of U.S. Tax Reform and the settlement of certain tax audits, partially offset by tax charges from foreign earnings taxed at different rates than the U.S. statutory rate.77Table of ContentsSegment Results and Corporate & OtherU.S.Business Overview. Adjusted premiums, fees and other revenues for 2020 increased $526 million, or 2%, compared to 2019, attributable to higher premiums in our Group Benefits business, partially offset by decreases in our RIS and P&C businesses. The increase in Group Benefits was primarily due to growth in core and voluntary products despite negative pressures from the economic impact of the COVID-19 Pandemic. Growth in our core products was driven by increases in our group life and vision businesses. In our dental business, higher premiums due to business growth were more than offset by premium credits granted to customers due to COVID-19 Pandemic restrictions. Growth in our voluntary products increased across the segment, driven by the impact of new sales and growth in membership in our accident & health and legal plans businesses. The decrease in RIS was mainly driven by decreases in our structured settlement and institutional income annuity businesses, due to market conditions, partially offset by an increase in our pension risk transfer business. Changes in RIS premiums are mostly offset by a corresponding change in policyholder benefits. The decrease in P&C was primarily driven by a decrease in exposures in both the auto and homeowners businesses, as well as the impact of premium credits granted to customers as a result of COVID-19 Pandemic restrictions, partially offset by the impact of pricing actions, mainly in the homeowners business. Growth in RIS’s capital market investments and stable value businesses resulted in higher fees and interest margins.For information regarding the Company's pending disposition of MetLife P&C and the acquisition of Versant Health, see Note 3 of the Notes to the Consolidated Financial Statements. Years Ended December 31, 20202019 (In millions)Adjusted revenuesPremiums$27,265 $26,801 Universal life and investment-type product policy fees1,070 1,078 Net investment income6,903 7,021 Other revenues957 887 Total adjusted revenues36,195 35,787 Adjusted expensesPolicyholder benefits and claims and policyholder dividends26,309 26,165 Interest credited to policyholder account balances1,622 1,984 Capitalization of DAC(453)(484)Amortization of DAC and VOBA471 475 Interest expense on debt7 10 Other expenses4,162 4,075 Total adjusted expenses32,118 32,225 Provision for income tax expense (benefit)853 724 Adjusted earnings$3,224 $2,838 Adjusted premiums, fees and other revenues$29,292 $28,766 78Table of ContentsYear Ended December 31, 2020 Compared with the Year Ended December 31, 2019 Unless otherwise stated, all amounts discussed below are net of income tax.Business Growth. The impact of positive flows from pension risk transfer transactions in 2019, funding agreement issuances and structured settlements resulted in higher average invested assets, improving net investment income. However, consistent with the growth in average invested assets, interest credited expenses on long-duration and deposit-type liabilities increased. Higher volume-related, premium tax and direct expenses, driven by business growth, coupled with the increase due to the 2020 reinstatement of the annual health insurer fee under the PPACA, were more than offset by a corresponding increase in adjusted premiums, fees and other revenues and lower pension and post-retirement expenses. The combined impact of the items affecting our business growth increased adjusted earnings by $156 million. Market Factors. Market factors, including interest rate levels, variability in equity market returns and foreign currency fluctuations, continued to impact our results; however, certain impacts were mitigated by derivatives used to hedge these risks. Investment yields decreased primarily driven by lower yields on fixed income securities and mortgage loans, as well as lower returns on real estate investments. These decreases were partially offset by increases in net investment income on derivatives and securities lending income. The impact of interest rate fluctuations resulted in a decrease in our average interest credited rates on deposit-type and long-duration liabilities, which drove a decrease in interest credited expenses. The changes in market factors discussed above resulted in a $116 million increase in adjusted earnings. Underwriting and Other Insurance Adjustments. Favorable claims experience, coupled with the impact of growth in our Group Benefits business, resulted in a $363 million increase in adjusted earnings. This increase was primarily driven by: (i) favorable dental results, driven by the impact of COVID-19 Pandemic restrictions which limited availability of services and reduced utilization in the current period; (ii) the impact of business growth and favorable claims experience in our accident & health business; and (iii) favorable claims experience in our group disability business, partially offset by less favorable individual disability results. Favorable mortality in our RIS business resulted in an increase in adjusted earnings of $154 million, driven by our pension risk transfer, institutional income annuity and structured settlement businesses. Unfavorable mortality in our Group Benefits business resulted in a decrease in adjusted earnings of $407 million. This was primarily driven by the impact of COVID-19 claims experience across our life businesses, as well as the impact of lower incidence in 2019 in our term life business, partially offset by favorable results in our accidental death & dismemberment business due to lower incidence as a result of COVID-19 Pandemic restrictions. In our P&C business, adjusted earnings increased $62 million due to a decrease in non-catastrophe claims costs of $197 million, partially offset by a $108 million increase in catastrophe-related claims costs, primarily driven by Northeast and Midwest storms, and the impact of adverse prior year development of $27 million. The decrease in non-catastrophe claims costs was the result of lower frequencies, primarily in our auto business, driven by the impact of lower mileage driven due to the impact of COVID-19 Pandemic restrictions, partially offset by higher severity. Refinements to certain insurance and other liabilities in both years resulted in a $59 million decrease in adjusted earnings, which included the impact of favorable insurance adjustments in 2019 resulting from enhancements to our claim-related processes. 79Table of ContentsAsiaBusiness Overview. Adjusted premiums, fees and other revenues for 2020 increased $162 million, or 2%, compared to 2019. Adjusted premiums, fees and other revenues, net of foreign currency fluctuations, increased $51 million, or 1%, compared to 2019, mainly due to the impact in both periods of our annual actuarial assumption review, which resulted in higher fees from foreign currency-denominated life products in 2020, partially offset by lower premiums from yen-denominated life products in Japan and the disposition of MetLife Hong Kong in 2019. Years Ended December 31, 20202019 (In millions)Adjusted revenuesPremiums$6,571 $6,632 Universal life and investment-type product policy fees1,892 1,674 Net investment income3,938 3,691 Other revenues61 56 Total adjusted revenues12,462 12,053 Adjusted expensesPolicyholder benefits and claims and policyholder dividends5,213 5,185 Interest credited to policyholder account balances1,834 1,710 Capitalization of DAC(1,652)(1,913)Amortization of DAC and VOBA1,415 1,288 Amortization of negative VOBA(37)(25)Other expenses3,481 3,818 Total adjusted expenses10,254 10,063 Provision for income tax expense (benefit)643 585 Adjusted earnings$1,565 $1,405 Adjusted earnings on a constant currency basis$1,565 $1,404 Adjusted premiums, fees and other revenues$8,524 $8,362 Adjusted premiums, fees and other revenues on a constant currency basis$8,524 $8,473 Year Ended December 31, 2020 Compared with the Year Ended December 31, 2019Unless otherwise stated, all amounts discussed below are net of income tax.Foreign Currency. Changes in foreign currency exchange rates decreased adjusted earnings slightly for 2020 compared to 2019, primarily due to the weakening of the Australian dollar and Korean won, essentially offset by the strengthening of the Japanese Yen against the U.S. dollar. Unless otherwise stated, all amounts discussed below are net of foreign currency fluctuations. Foreign currency fluctuations can result in significant variances in the financial statement line items.Business Growth. Positive net flows in Japan and Korea resulted in higher average invested assets, which improved net investment income. The increase in net investment income was partially offset by a corresponding increase in interest credited expenses on certain insurance liabilities. The decrease in Asia’s adjusted premiums, fees and other revenues from yen-denominated life products in Japan and the disposition of MetLife Hong Kong in 2019 was partially offset by a related decline in policyholder benefits. Lower commissions and other variable expenses, net of DAC capitalization, resulted in an increase to adjusted earnings. The combined impact of the items affecting our business growth improved adjusted earnings by $132 million.80Table of ContentsMarket Factors. Market factors, including interest rate levels and variability in equity market returns, continued to impact our results; however, certain impacts were mitigated by derivatives used to hedge these risks. Investment yields were unfavorably impacted by lower yields on fixed income securities supporting products sold in Japan denominated in Australian dollar, U.S. dollar and, to a lesser extent, Japanese yen. These unfavorable impacts were partially offset by increased net investment income on derivatives and higher returns on private equity funds. The changes in market factors discussed above increased adjusted earnings by $20 million.Underwriting, Actuarial Assumption Review and Other Insurance Adjustments. Lower claims, primarily in Japan and Korea, increased adjusted earnings by $16 million. The impact in both years of our annual actuarial assumption review resulted in a net decrease of $9 million in adjusted earnings. Refinements to certain insurance liabilities and other liabilities in both years resulted in a $10 million decrease in adjusted earnings. Expenses and Taxes. Lower expenses in Japan, including advertising, printing, consulting and travel costs, partially offset by higher corporate overhead, resulted in a $14 million increase in adjusted earnings. Tax-related impacts in both periods resulted in a net decrease in adjusted earnings of $2 million.Latin AmericaBusiness Overview. Adjusted premiums, fees and other revenues for 2020 decreased $564 million, or 15%, compared to 2019. Adjusted premiums, fees and other revenues, net of foreign currency fluctuations, decreased $131 million, or 4%, compared to 2019, mainly driven by lower annuitizations in Chile due to the COVID-19 Pandemic. Years Ended December 31, 20202019 (In millions)Adjusted revenuesPremiums$2,265 $2,723 Universal life and investment-type product policy fees994 1,094 Net investment income992 1,271 Other revenues38 44 Total adjusted revenues4,289 5,132 Adjusted expensesPolicyholder benefits and claims and policyholder dividends2,406 2,623 Interest credited to policyholder account balances240 332 Capitalization of DAC(362)(396)Amortization of DAC and VOBA276 291 Interest expense on debt4 3 Other expenses1,318 1,443 Total adjusted expenses3,882 4,296 Provision for income tax expense (benefit)127 227 Adjusted earnings$280 $609 Adjusted earnings on a constant currency basis$280 $535 Adjusted premiums, fees and other revenues$3,297 $3,861 Adjusted premiums, fees and other revenues on a constant currency basis$3,297 $3,428 Year Ended December 31, 2020 Compared with the Year Ended December 31, 2019Unless otherwise stated, all amounts discussed below are net of income tax.Foreign Currency. Changes in foreign currency exchange rates decreased adjusted earnings by $74 million for 2020 compared to 2019, mainly due to the weakening of foreign currencies against the U.S. dollar, primarily the Mexican and Chilean pesos. Unless otherwise stated, all amounts discussed below are net of foreign currency fluctuations. Foreign currency fluctuations can result in significant variances in the financial statement line items.81Table of ContentsBusiness Growth. Despite the aforementioned decrease in annuity premiums in Chile driven by the COVID-19 Pandemic, Latin America experienced growth in Mexico. The decrease in premiums in Chile was offset by related changes in policyholder benefits. An increase in average invested assets, primarily in Chile, generated higher net investment income. In addition, interest credited expenses on certain insurance liabilities decreased and policy fee income increased in our universal life business in Mexico. Business growth also drove an increase in commissions and other variable expenses, net of DAC capitalization. The combined impact of the items affecting business growth increased adjusted earnings by $55 million.Market Factors. Market factors, including interest rate levels and variability in equity market returns, continued to impact our results; however, certain impacts were mitigated by derivatives used to hedge these risks. Investment yields decreased driven by lower yields on fixed income securities and mortgage loans, the unfavorable impact of equity market returns on our Chilean encaje within FVO Securities, as well as lower returns on private equity funds and lower net investment income on derivatives. The changes in market factors discussed above, partially offset by a decrease in interest credited expenses, decreased adjusted earnings by $94 million.Underwriting, Actuarial Assumption Review and Other Insurance Adjustments. Unfavorable underwriting drove a $197 million decrease in adjusted earnings which includes impacts from COVID-19-related life claims, primarily in Mexico. The impact in both years of our annual actuarial assumption review resulted in a net decrease of $19 million in adjusted earnings. Refinements to certain insurance liabilities and other liabilities in both years resulted in a $9 million increase in adjusted earnings.Expenses and Taxes. Adjusted earnings increased by $16 million, primarily driven by lower expenses due to COVID-19 Pandemic restrictions. Adjusted earnings decreased by $17 million primarily driven by reduced tax charges in 2019 as a result of tax regulations related to U.S. Tax Reform. Other tax-related adjustments in both years resulted in a net decrease in adjusted earnings of $7 million.82Table of ContentsEMEABusiness Overview. Adjusted premiums, fees and other revenues for 2020 increased $90 million, or 3%, compared to 2019. Adjusted premiums, fees and other revenues, net of foreign currency fluctuations, increased $115 million, or 4%, compared to 2019 due to growth across the region, mainly in our accident & health business, our credit life business in Turkey and Europe and our corporate solutions business in Egypt and the U.K. These improvements were partially offset by a decrease in our retirement business in the U.K., as well as the impact in both years of our annual actuarial assumption review. Years Ended December 31, 20202019 (In millions)Adjusted revenuesPremiums$2,259 $2,177 Universal life and investment-type product policy fees433 423 Net investment income269 291 Other revenues52 54 Total adjusted revenues3,013 2,945 Adjusted expensesPolicyholder benefits and claims and policyholder dividends1,196 1,176 Interest credited to policyholder account balances109 98 Capitalization of DAC(491)(505)Amortization of DAC and VOBA454 428 Amortization of negative VOBA(8)(8)Interest expense on debt1 — Other expenses1,344 1,399 Total adjusted expenses2,605 2,588 Provision for income tax expense (benefit)81 75 Adjusted earnings$327 $282 Adjusted earnings on a constant currency basis$327 $271 Adjusted premiums, fees and other revenues$2,744 $2,654 Adjusted premiums, fees and other revenues on a constant currency basis$2,744 $2,629 Year Ended December 31, 2020 Compared with the Year Ended December 31, 2019Unless otherwise stated, all amounts discussed below are net of income tax.Foreign Currency. Changes in foreign currency exchange rates decreased adjusted earnings by $11 million for 2020 as compared to 2019, primarily driven by the strengthening of the U.S. dollar against the Turkish lira. Unless otherwise stated, all amounts discussed below are net of foreign currency fluctuations. Foreign currency fluctuations can result in significant variances in the financial statement line items.Business Growth. Growth across the region, mainly in our credit life business in Turkey, our accident & health business in Europe and our pension business in Romania increased adjusted earnings by $19 million.Market Factors. Market factors, including interest rate levels and variability in equity market returns, continued to impact our results. DAC amortization increased in our variable life business. In addition, investment yields were lower across the region. The changes in market factors discussed above resulted in a $25 million decrease in adjusted earnings.83Table of ContentsUnderwriting, Actuarial Assumption Review and Other Insurance Adjustments. Adjusted earnings increased by $22 million as a result of favorable underwriting experience in our corporate solutions business across the majority of the region, partially offset by unfavorable underwriting in our accident & health business in Greece and in our ordinary life business in France. Underwriting results reflect impacts of the COVID-19 Pandemic and related restrictions. The impact in both years of our annual actuarial assumption review resulted in a net decrease of $18 million in adjusted earnings. Refinements to certain insurance-related assets and liabilities in both years resulted in an $8 million decrease in adjusted earnings.Expenses and Taxes. Adjusted earnings increased by $64 million, mainly driven by lower compensation-related expenses, lower costs associated with enterprise-wide initiatives, and various other expense decreases. Tax-related adjustments in both years slightly increased adjusted earnings.MetLife HoldingsBusiness Overview. Our MetLife Holdings segment consists of operations relating to products and businesses, previously included in our former retail business, that we no longer actively market in the United States. We anticipate an average decline in adjusted premiums, fees and other revenues of approximately 5% to 7% per year from expected business run-off. A significant portion of our adjusted earnings is driven by separate account balances. Most directly, these balances determine asset-based fee income but they also impact DAC amortization and asset-based commissions. Separate account balances are driven by movements in the market, surrenders, deposits, withdrawals, benefit payments, transfers and policy charges. Although we have discontinued selling our long-term care product, we continue to collect premiums and administer the existing block of business, which contributed to asset growth in the segment, and we expect the related reserves to grow as this block matures. Our future policyholder benefit liability for our long-term care business was $14.3 billion and $12.5 billion as of December 31, 2020 and 2019, respectively. Years Ended December 31, 20202019 (In millions)Adjusted revenuesPremiums$3,600 $3,748 Universal life and investment-type product policy fees1,073 1,124 Net investment income5,184 5,281 Other revenues238 253 Total adjusted revenues10,095 10,406 Adjusted expensesPolicyholder benefits and claims and policyholder dividends6,738 6,970 Interest credited to policyholder account balances868 905 Capitalization of DAC(39)(28)Amortization of DAC and VOBA370 299 Interest expense on debt6 8 Other expenses942 969 Total adjusted expenses8,885 9,123 Provision for income tax expense (benefit)234 249 Adjusted earnings$976 $1,034 Adjusted premiums, fees and other revenues$4,911 $5,125 84Table of ContentsYear Ended December 31, 2020 Compared with the Year Ended December 31, 2019Unless otherwise stated, all amounts discussed below are net of income tax.Business Growth. Negative net flows from our deferred annuities business and a decrease in universal life deposits resulted in lower fee income. Also, in our deferred annuity business, higher costs associated with our variable annuity GMDBs resulted in a decrease in adjusted earnings. These decreases were partially offset by higher net investment income, resulting from a higher invested asset base, as well as lower DAC amortization. The higher invested asset base was primarily the result of positive net flows in our long-term care business. The combined impact of the items affecting our business growth resulted in a $34 million decrease in adjusted earnings.Market Factors. Market factors, including interest rate levels, variability in equity market returns, and foreign currency fluctuations, continued to impact our results; however, certain impacts were mitigated by derivatives used to hedge these risks. Investment yields decreased primarily due to lower yields on fixed income securities and mortgage loans, as well as lower returns on real estate investments. These decreases were partially offset by higher net investment income on derivatives. In our deferred annuity business, higher costs associated with our variable annuity GMDBs resulted in a decrease in adjusted earnings. These unfavorable earnings impacts were partially offset by an increase in asset-based fee income and lower DAC amortization. The changes in market factors discussed above resulted in a $76 million decrease in adjusted earnings.Underwriting, Actuarial Assumption Review, and Other Insurance Adjustments. Favorable underwriting, mainly in our long-term care and universal life businesses, partially offset by unfavorable underwriting in our traditional life business resulted in a $63 million increase in adjusted earnings, which reflects the impact of the COVID-19 Pandemic. The impact in both years of our annual actuarial assumption review resulted in a net decrease of $14 million in adjusted earnings. Changes mainly in economic assumptions, including interest rate projections, and updates to the closed block projections, were slightly more unfavorable in 2020 when compared to 2019. Refinements to DAC and certain insurance-related liabilities in both years resulted in a $20 million decrease in adjusted earnings. This includes a 2019 charge due to an increase in our IBNR long-term care reserves reflecting enhancements to our methodology related to potential claims. A reduction in our dividend scale as a result of the sustained low interest rate environment, as well as run-off in MLIC’s closed block, contributed to lower dividend expense and resulted in an increase of $106 million in adjusted earnings. The impact of this dividend action was more than offset by lower net investment income, as well as a $97 million increase in DAC amortization.Expenses. Adjusted earnings increased by $16 million mainly due to lower operational costs, as well as lower pension and post-retirement benefits.85Table of ContentsCorporate & Other Years Ended December 31, 20202019 (In millions)Adjusted revenuesPremiums$22 $83 Universal life and investment-type product policy fees3 2 Net investment income42 275 Other revenues344 291 Total adjusted revenues411 651 Adjusted expensesPolicyholder benefits and claims and policyholder dividends(3)73 Capitalization of DAC(11)(12)Amortization of DAC and VOBA8 6 Interest expense on debt895 934 Other expenses625 1,074 Total adjusted expenses1,514 2,075 Provision for income tax expense (benefit)(556)(1,201)Adjusted earnings(547)(223)Less: Preferred stock dividends202 178 Adjusted earnings available to common shareholders$(749)$(401)Adjusted premiums, fees and other revenues$369 $376 The table below presents adjusted earnings available to common shareholders by source: Years Ended December 31,20202019(In millions)Business activities$96 $70 Net investment income54 290 Interest expense on debt(943)(978)Corporate initiatives and projects(159)(563)Other(151)(330)Provision for income tax (expense) benefit and other tax-related items556 1,288 Preferred stock dividends(202)(178)Adjusted earnings available to common shareholders$(749)$(401)Year Ended December 31, 2020 Compared with the Year Ended December 31, 2019Unless otherwise stated, all amounts discussed below are net of income tax.Business Activities. Adjusted earnings from business activities increased $21 million. This was primarily related to improved results from certain of our businesses.Net Investment Income. Net investment income declined $186 million, primarily due to decreased returns on our equity market sensitive investments, including private equity funds, as well as lower yields on our fixed income securities. Interest Expense on Debt. Interest expense on debt decreased by $28 million, primarily due to the excess premium associated with redeemed debt in 2019, as well as the impact of a decrease in three-month LIBOR on our surplus notes, partially offset by the issuance of senior notes at lower interest rates in March 2020 and May 2019.86Table of ContentsCorporate Initiatives and Projects. Adjusted earnings increased $319 million due to lower expenses associated with corporate initiatives and projects, primarily due to 2019 costs related to our unit cost initiative.Provision for Income Tax (Expense) Benefit and Other Tax-Related Items. An unfavorable change in Corporate & Other’s taxes was primarily due to 2019 tax benefits related to the resolution of an uncertainty regarding the deemed repatriation transition tax enacted as a part of U.S. Tax Reform and the settlement of certain tax audits related to the tax treatment of a wholly-owned U.K. investment subsidiary of MLIC. In addition, lower utilization of tax preferenced items, which include non-taxable investment income, tax credits, foreign earnings taxed at different rates than the U.S. statutory rate and taxes on stock compensation, was partially offset by the finalization of bankruptcy proceedings for a leveraged lease investment.Other. Adjusted earnings increased $141 million, primarily as a result of decreases in certain corporate-related expenses, lower employee-related costs, and a 2019 loss related to the sale of a run-off business that was previously reinsured, partially offset by higher interest expenses on tax positions due to 2019 audit settlements and higher legal expenses.Preferred Stock Dividends. Adjusted earnings available to common shareholders decreased $24 million as a result of dividends paid on the 4.75% Non-Cumulative Preferred Stock, Series F we issued in January 2020, partially offset by changes in dividend payments on and the partial redemption of the Series C preferred stock.Effects of InflationManagement believes that inflation has not had a material effect on the Company’s consolidated results of operations, except insofar as inflation may affect interest rates.An increase in inflation could affect our business in several ways. During inflationary periods, the value of fixed income investments falls which could increase realized and unrealized losses. Inflation also increases expenses for labor and other costs, potentially putting pressure on profitability if such costs cannot be passed through in our product prices. Inflation could also lead to increased costs for losses and loss adjustment expenses in certain of our businesses, which could require us to adjust our pricing to reflect our expectations for future inflation. Prolonged and elevated inflation could adversely affect the financial markets and the economy generally, and dispelling it may require governments to pursue a restrictive fiscal and monetary policy, which could constrain overall economic activity, inhibit revenue growth and reduce the number of attractive investment opportunities.87Table of ContentsInvestmentsInvestment RisksOur primary investment objective is to optimize, net of income tax, risk-adjusted investment income and risk-adjusted total return while ensuring that assets and liabilities are managed on a cash flow and duration basis. The Investments Department, led by the Chief Investment Officer, manages investment risks using a risk control framework comprised of policies, procedures and limits, as discussed further below. The Investment Risk Committee and Asset-Liability Steering Committee review and monitor investment risk limits and tolerances. We are exposed to the following primary sources of investment risks:•credit risk, relating to the uncertainty associated with the continued ability of a given obligor to make timely payments of principal and interest;•interest rate risk, relating to the market price and cash flow variability associated with changes in market interest rates. Changes in market interest rates will impact the net unrealized gain (loss) position of our fixed income investment portfolio and the rates of return we receive on both new funds invested and reinvestment of existing funds;•liquidity risk, relating to the diminished ability to sell certain investments, in times of strained market conditions;•market valuation risk, relating to the variability in the estimated fair value of investments associated with changes in market factors such as credit spreads and equity market levels. A widening of credit spreads will adversely impact the net unrealized gain (loss) position of the fixed income investment portfolio, will increase losses associated with credit-based non-qualifying derivatives where we assume credit exposure, and, if credit spreads widen significantly or for an extended period of time, will likely result in higher credit losses. Credit spread tightening will reduce net investment income associated with purchases of fixed income investments and will favorably impact the net unrealized gain (loss) position of the fixed income investment portfolio;•currency risk, relating to the variability in currency exchange rates for foreign denominated investments including as a result of the U.K.’s withdrawal from the EU. This risk relates to potential decreases in estimated fair value and net investment income resulting from changes in currency exchange rates versus the U.S. dollar. In general, the weakening of foreign currencies versus the U.S. dollar will adversely affect the estimated fair value of our foreign denominated investments; and•real estate risk, relating to commercial, agricultural and residential real estate, and stemming from factors, which include, but are not limited to, market conditions, including the supply and demand of leasable commercial space, creditworthiness of borrowers, tenants and our joint venture partners, capital markets volatility, changes in market interest rates, commodity prices, farm incomes and U.S. housing market conditions.We manage investment risk through in-house fundamental credit analysis of the underlying obligors, issuers, transaction structures and real estate properties. We also manage credit, market and liquidity risk through industry and issuer diversification and asset allocation. These risk limits, approved annually by the Investment Risk Committee, promote diversification by asset sector, avoid concentrations in any single issuer and limit overall aggregate credit and equity risk exposure, as measured by our economic capital framework. For real estate assets, we manage credit and market risk through asset allocation and by diversifying by geography, property and product type. We manage interest rate risk as part of our ALM strategies which are reviewed and approved by the Asset-Liability Steering Committee. These strategies include maintaining an investment portfolio with diversified maturities that has a weighted average duration that reflects the duration of our estimated liability cash flow profile, and utilizing product design, such as the use of market value adjustment features and surrender charges, to manage interest rate risk. We also manage interest rate risk through proactive monitoring and management of certain NGEs of our products, such as the resetting of credited interest and dividend rates for policies that permit such adjustments. In addition to hedging with foreign currency derivatives, we manage currency risk by matching much of our foreign currency liabilities in our foreign subsidiaries with their respective foreign currency assets, thereby reducing our risk to foreign currency exchange rate fluctuation. We also use certain derivatives in the management of credit, interest rate, and market valuation risk.88Table of ContentsWe enter into market standard purchased and written credit default swap contracts. Payout under such contracts is triggered by certain credit events experienced by the referenced entities. For credit default swaps covering North American corporate issuers, credit events typically include bankruptcy and failure to pay on borrowed money. For European corporate issuers, credit events typically also include involuntary restructuring. With respect to credit default contracts on sovereign debt, credit events typically include failure to pay debt obligations, repudiation, moratorium, or involuntary restructuring. In each case, payout on a credit default swap is triggered only after the Credit Derivatives Determinations Committee of the International Swaps and Derivatives Association determines that a credit event has occurred.We use purchased credit default swaps to mitigate credit risk in our investment portfolio. Generally, we purchase credit protection by entering into credit default swaps referencing the issuers of specific assets we own. In certain cases, basis risk exists between these credit default swaps and the specific assets we own. For example, we may purchase credit protection on a macro basis to reduce exposure to specific industries or other portfolio concentrations. In such instances, the referenced entities and obligations under the credit default swaps may not be identical to the individual obligors or securities in our investment portfolio. In addition, our purchased credit default swaps may have shorter tenors than the underlying investments they are hedging, which gives us more flexibility in managing our credit exposures. We believe that our purchased credit default swaps serve as effective economic hedges of our credit exposure.Current EnvironmentAs a global insurance company, we continue to be impacted by the changing global financial and economic environment, the fiscal and monetary policy of governments and central banks around the world and other governmental measures. The COVID-19 Pandemic continues to impact the global economy and financial markets and has caused volatility in the global equity, credit and real estate markets. See “— Industry Trends — Financial and Economic Environment.”Governments and central banks around the world are responding to the COVID-19 Pandemic with unprecedented fiscal and monetary policies, which are expected to have significant and ongoing effects on financial markets and the global economy. These policy responses include fiscal and monetary stimulus measures, including, but not limited to, financial assistance, liquidity programs, new financing facilities and reductions in the level of interest rates. As time progresses, we will know more about the efficacy of these policies and what they may mean for the outlook for the global economy and financial markets, but currently the number of factors makes reliably estimating the duration and severity of the impact of the COVID-19 Pandemic on our business operations, investment portfolio and derivatives difficult.As a result of the impact of the COVID-19 Pandemic, during the year ended December 31, 2020, there was an economic slowdown and volatility in the financial markets, including liquidity driven price dislocation and credit spread widening. As a result, during the year ended December 31, 2020, the value of certain investments within our portfolio decreased; however, some of those effects were mitigated by an increase in the value of certain freestanding derivatives that hedge such market risks. These conditions may persist for some time and may continue to impact pricing levels of risk-bearing investments, as well as our business operations, investment portfolio and derivatives.89Table of ContentsSelected Country and Sector InvestmentsSelected Country: We have a market presence in numerous countries and, therefore, our investment portfolio, which supports our insurance operations and related policyholder liabilities, as well as our global portfolio diversification objectives, is exposed to risks posed by local political and economic conditions, as well as those resulting from the COVID-19 Pandemic. Our investment portfolios in the countries in the table below are currently the most affected by these conditions. The following table presents a summary of selected country fixed maturity securities AFS, at estimated fair value. The information below is presented on a “country of risk basis” (e.g. where the issuer primarily conducts business).In the second quarter of 2020, Argentina defaulted on its foreign currency denominated sovereign fixed maturity securities. In the third quarter of 2020, Argentina exchanged new sovereign fixed maturity securities for substantially all of its defaulted foreign currency denominated sovereign fixed maturity securities. As a result of the economic conditions prior to the default, the Company impaired its holdings of such securities initially in the fourth quarter of 2019 and then, in the first quarter of 2020, recorded an ACL. Through June 30, 2020, the prior impairment and ACL on the defaulted securities totaled $155 million. In the third quarter of 2020, the Company exchanged securities with a par value and amortized cost net of ACL of $361 million and $146 million, respectively, plus accrued investment income of $11 million, for new securities with an estimated fair value of $182 million which resulted in a net gain of $25 million recorded in net investment gain (loss). In connection with the disposition of MetLife Seguros de Retiro in October 2020, the Company reduced its exposure to Argentina sovereign fixed maturity securities, as the assets disposed included $132 million of such securities at amortized cost. See Note 3 of the Notes to the Consolidated Financial Statements. Selected Country Fixed Maturity Securities AFS at December 31, 2020CountrySovereign (1)FinancialServicesNon-FinancialServicesStructuredTotal (2) (Dollars in millions)United Kingdom$333 $6,714 $13,069 $105 $20,221 Mexico2,729 933 2,335 41 6,038 China278 2 569 — 849 Italy45 85 658 — 788 Turkey149 2 16 — 167 Hong Kong SAR44 34 57 — 135 Argentina (3)72 1 20 — 93 Lebanon (3)3 — — — 3 Total$3,653 $7,771 $16,724 $146 $28,294 Investment grade %89.8 %99.2 %93.1 %81.9 %94.3 %__________________(1)Sovereign includes government and agency.(2)The par value and amortized cost net of ACL of these selected country fixed maturity securities AFS were $24.4 billion and $25.0 billion, respectively, at December 31, 2020. (3)The sovereign securities amounts for Argentina and Lebanon were net of ACL of $19 million and $2 million, respectively, at December 31, 2020. See “— Investment Allowance for Credit Loss and Impairments - Overview.”90Table of ContentsSelected Sector: As a result of current economic conditions, including the effects on the global economy and financial markets from the COVID-19 Pandemic, certain sectors of our investment portfolio experienced stress during the year ended December 31, 2020. Our fixed maturity securities AFS exposure to stressed sectors is summarized below: Selected Sectors at December 31, 2020SectorsBook Value (1) InvestmentGrade % % of TotalInvestments(Dollars in millions)Energy $7,936 86 %1.5 %Airports 3,219 83 %0.6 %Cruise Lines / Leisure680 95 %0.1 %Airlines 424 70 %0.1 %Restaurants 418 95 %0.1 %Lodging247 60 %— %Fixed Maturity Securities AFS Exposure to Stressed Sectors (2)$12,924 2.4 %Total Investments (3)$528,314 __________________(1)Fixed maturity securities AFS at amortized cost, net of ACL. (2)The estimated fair value of these fixed maturity securities AFS was $14.6 billion at December 31, 2020. (3)Represents total cash, cash equivalents and invested assets. We maintain a portfolio of energy sector fixed maturity securities AFS that is diversified across sub-sectors and issuers. This portfolio is primarily invested in higher quality, highly rated investment grade securities and is defensively positioned in sub-sectors which are less impacted by lower oil prices. During the year ended December 31, 2020, we reduced our exposure to such securities by 13%. Through our energy sector securities, we have exposure to the volatility in oil prices. During 2020, largely as a result of the COVID-19 Pandemic, there were wide fluctuations in oil prices. As a result of recovering oil prices and credit spread tightening in the fourth quarter of 2020, this securities portfolio increased in value during the year ended December 31, 2020, from an unrealized gain at December 31, 2019 of $849 million to an unrealized gain of $1.1 billion at December 31, 2020. Additional asset types within our investment portfolio may be impacted by the COVID-19 Pandemic, including fixed maturity securities AFS (including below investment grade securities and structured products), equity securities, Unit-linked investments, FVO Securities, mortgage loans, real estate and real estate joint ventures, private equity funds, hedge funds and lease investments. See “— Executive Summary — Consolidated Company Outlook.”We manage direct and indirect investment exposure in the selected countries, sectors and asset types through fundamental analysis and we continually monitor and adjust our level of investment exposure. Investment Allowance for Credit Loss and Impairments - OverviewOn January 1, 2020, we adopted the new credit loss guidance. See “— Summary of Critical Accounting Estimates — Investment Allowance for Credit Loss and Impairments.” For our mortgage loans and leveraged and direct financing leases, this new credit loss guidance requires that we incorporate the impact of both current and forecasted economic conditions and estimate expected lifetime credit loss in determining the ACL. Upon adoption of this new credit loss guidance, our ACL reflected the then current and forecasted economic conditions and our estimate of expected lifetime credit loss. Subsequently, we incorporated the effects of the COVID-19 Pandemic into our economic forecast, using available information, to reflect our best estimate, in determining the level of our ACL for mortgage loans and leveraged and direct financing leases.Upon adoption of the new credit loss guidance, we increased our mortgage loan and lease ACL and liability for unfunded mortgage loan commitments by $141 million, or 40%. During the year ended December 31, 2020, we increased our mortgage loan and lease ACL and liability for unfunded mortgage loan commitments by another $150 million, or 42%. Our mortgage loan and lease ACL and liability for unfunded mortgage loan commitments totaled $643 million at December 31, 2020, an increase of 82% from December 31, 2019. 91Table of ContentsIn accordance with this new credit loss guidance, an ACL is recorded for fixed maturity securities AFS for the amount of the credit loss instead of recording a reduction of the amortized cost as an impairment. During the year ended December 31, 2020, we recorded an ACL for our fixed maturity securities AFS of $81 million. As a result, our total investments-related ACL and liability for unfunded mortgage loan commitments totaled $724 million at December 31, 2020. During the year ended December 31, 2020, we recorded a charge for provisions for credit loss and impairments of $488 million, prior to the release of the ACL for securities subsequently sold or exchanged of $133 million. In addition, there was an additional $11 million decrease in the ACL during the year ended December 31, 2020, in connection with the disposition of MetLife Seguros de Retiro.The determination of the amount of our ACL and impairments on our investment portfolio is highly subjective. Our ACL is revised as conditions change and new information becomes available. Provisions for credit loss and impairments recognized in future quarters on our investment portfolio will depend primarily on future economic fundamentals, including the evolving impact of the COVID-19 Pandemic, performance of our issuers, borrowers, tenants and lessees, changes in credit ratings, collateral valuation and changes in estimated fair value. In upcoming periods, if there are changes in the above factors, provisions for credit loss and impairments may be recorded, as well as changes in the ACL for which a provision for credit loss was previously recorded.Investment Portfolio ResultsThe reconciliation of net investment income under GAAP to adjusted net investment income is presented below. For the Years Ended December 31, 20202019 (In millions)Net investment income — GAAP basis$17,117 $18,868 Investment hedge adjustments815 469 Unit-linked investment income(568)(1,475)Other(36)(32)Adjusted net investment income (1)$17,328 $17,830 __________________(1)See “Financial Measures and Segment Accounting Policies” in Note 2 of the Notes to the Consolidated Financial Statements for a discussion of the adjustments made to net investment income under GAAP in calculating adjusted net investment income.The following yield table presentation is consistent with how we measure our investment performance for management purposes, and we believe it enhances understanding of our investment portfolio results. For the Years Ended December 31, 20202019Asset ClassYield% (1)AmountYield% (1)Amount (Dollars in millions)Fixed maturity securities (2), (3)3.88 %$11,356 4.22 %$11,743 Mortgage loans (3)4.27 3,518 4.82 3,782 Real estate and real estate joint ventures (4)1.56 178 3.20 327 Policy loans5.18 498 5.29 512 Equity securities4.83 50 5.25 61 Other limited partnership interests (4)12.17 1,010 11.81 840 Cash and short-term investments1.35 140 2.47 256 Other invested assets1,162 901 Investment income4.22 %$17,912 4.56 %$18,422 Investment fees and expenses(0.13)(538)(0.14)(545)Net investment income including divested businesses (5)4.09 %$17,374 4.42 %$17,877 Less: net investment income from divested businesses (5)46 47 Adjusted net investment income$17,328 $17,830 __________________92Table of Contents(1)We calculate yields using adjusted net investment income as a percent of average quarterly asset carrying values. Adjusted net investment income excludes recognized gains (losses) and includes the impact of changes in foreign currency exchange rates. Average quarterly asset carrying values exclude unrealized gains (losses), collateral received in connection with our securities lending program, annuities funding structured settlement claims, freestanding derivative assets, collateral received from derivative counterparties, the effects of consolidating under GAAP certain variable interest entities that are treated as consolidated securitization entities (“CSEs”) and contractholder-directed equity securities. In addition, average quarterly asset carrying values include invested assets reclassified to held-for-sale. A yield is not presented for other invested assets, as it is not considered a meaningful measure of performance for this asset class.(2)Investment income from fixed maturity securities includes amounts from FVO Securities of $140 million and $184 million for the years ended December 31, 2020 and 2019, respectively.(3)Investment income from fixed maturity securities AFS and mortgage loans includes prepayment fees.(4)See “— Real Estate and Real Estate Joint Ventures” and “— Other Limited Partnership Interests” for discussion of results for the year ended December 31, 2020.(5)See “Financial Measures and Segment Accounting Policies” in Note 2 of the Notes to the Consolidated Financial Statements for discussion of divested businesses.See “— Results of Operations — Consolidated Results — Adjusted Earnings” for an analysis of the period over period changes in investment portfolio results.Fixed Maturity Securities AFS and Equity SecuritiesThe COVID-19 Pandemic contributed to financial market volatility, credit spread widening and equity market volatility during the year ended December 31, 2020. Governments and central banks around the world have responded with unprecedented fiscal and monetary policies, including reductions in the level of interest rates. See “— Current Environment.” As a result of the interest rate reductions, partially offset by credit spread widening, during the year ended December 31, 2020, the net unrealized gain on our fixed maturity securities AFS increased $13.9 billion, from $30.2 billion at December 31, 2019 to $44.1 billion at December 31, 2020. As a result of the equity market volatility during the year ended December 31, 2020, the value of our equity securities decreased, resulting in a mark-to-market loss of $153 million in net investment gains (losses), as the change in estimated fair value is recorded in net income.The following table presents fixed maturity securities AFS and equity securities by type (public or private) and information about perpetual and redeemable securities held at:December 31, 2020December 31, 2019Estimated FairValue% ofTotalEstimated FairValue% ofTotal(Dollars in millions)Fixed maturity securities AFS:Publicly-traded$284,083 80.1 %$267,617 81.6 %Privately-placed70,726 19.9 60,203 18.4 Total fixed maturity securities AFS$354,809 100.0 %$327,820 100.0 %Percentage of cash and invested assets67.2 %66.8 %Equity securities:Publicly-traded$851 78.9 %$1,156 86.1 %Privately-held228 21.1 186 13.9 Total equity securities$1,079 100.0 %$1,342 100.0 %Percentage of cash and invested assets0.2 %0.3 %Perpetual and redeemable securities:Perpetual securities included within fixed maturity securities AFS and equity securities$344 $363 Redeemable preferred stock with a stated maturity included within fixed maturity securities AFS$912 $960 See Note 8 of the Notes to the Consolidated Financial Statements for information about fixed maturity securities AFS by sector, contractual maturities and continuous gross unrealized losses.93Table of ContentsIncluded within fixed maturity securities AFS are structured securities, including residential mortgage-backed securities (“RMBS”), ABS and commercial mortgage-backed securities (“CMBS”) (collectively, “Structured Products”).Perpetual securities are included within fixed maturity securities AFS and equity securities. Upon acquisition, we classify perpetual securities that have attributes of both debt and equity as fixed maturity securities AFS if the securities have an interest rate step-up feature which, when combined with other qualitative factors, indicates that the securities have more debt-like characteristics; while those with more equity-like characteristics are classified as equity securities. Many of such securities, commonly referred to as “perpetual hybrid securities,” have been issued by non-U.S. financial institutions that are accorded the highest two capital treatment categories by their respective regulatory bodies (i.e. core capital, or “Tier 1 capital” and perpetual deferrable securities, or “Upper Tier 2 capital”).Redeemable preferred stock with a stated maturity is included within fixed maturity securities AFS. These securities, which are commonly referred to as “capital securities,” primarily have cumulative interest deferral features and are primarily issued by U.S. financial institutions.Valuation of Securities. We are responsible for the determination of the estimated fair value of our investments. We determine the estimated fair value of publicly-traded securities after considering one of three primary sources of information: quoted market prices in active markets, independent pricing services, or independent broker quotations. We determine the estimated fair value of privately-placed securities after considering one of three primary sources of information: market standard internal matrix pricing, market standard internal discounted cash flow techniques, or independent pricing services (after we determine the independent pricing services’ use of available observable market data). For publicly-traded securities, the number of quotations obtained varies by instrument and depends on the liquidity of the particular instrument. Generally, we obtain prices from multiple pricing services to cover all asset classes and obtain multiple prices for certain securities, but ultimately utilize the price with the highest placement in the fair value hierarchy. Independent pricing services that value these instruments use market standard valuation methodologies based on data about market transactions and inputs from multiple pricing sources that are market observable or can be derived principally from or corroborated by observable market data. See Note 10 of the Notes to the Consolidated Financial Statements for a discussion of the types of market standard valuation methodologies utilized and key assumptions and observable inputs used in applying these standard valuation methodologies. When a price is not available in the active market or through an independent pricing service, management values the security primarily using market standard internal matrix pricing or discounted cash flow techniques, and non-binding quotations from independent brokers who are knowledgeable about these securities. Independent non-binding broker quotations utilize inputs that may be difficult to corroborate with observable market data. As shown in the following section, less than 1% of our fixed maturity securities AFS were valued using non-binding quotations from independent brokers at December 31, 2020.Senior management, independent of the trading and investing functions, is responsible for the oversight of control systems and valuation policies for securities, mortgage loans and derivatives. On a quarterly basis, new transaction types and markets are reviewed and approved to ensure that observable market prices and market-based parameters are used for valuation, wherever possible, and for determining that valuation adjustments, when applied, are based upon established policies and are applied consistently over time. Senior management oversees the selection of independent third-party pricing providers and the controls and procedures to evaluate third-party pricing. We review our valuation methodologies on an ongoing basis and revise those methodologies when necessary based on changing market conditions. Assurance is gained on the overall reasonableness and consistent application of input assumptions, valuation methodologies and compliance with fair value accounting standards through controls designed to ensure valuations represent an exit price. Several controls are utilized, including certain monthly controls, which include, but are not limited to, analysis of portfolio returns to corresponding benchmark returns, comparing a sample of executed prices of securities sold to the fair value estimates, comparing fair value estimates to management’s knowledge of the current market, reviewing the bid/ask spreads to assess activity, comparing prices from multiple independent pricing services and ongoing due diligence to confirm that independent pricing services use market-based parameters. The process includes a determination of the observability of inputs used in estimated fair values received from independent pricing services or brokers by assessing whether these inputs can be corroborated by observable market data. We ensure that prices received from independent brokers, also referred to herein as “consensus pricing,” are representative of estimated fair value by considering such pricing relative to our knowledge of the current market dynamics and current pricing for similar financial instruments. While independent non-binding broker quotations are utilized, they are not used for a significant portion of the portfolio.94Table of ContentsWe also apply a formal process to challenge any prices received from independent pricing services that are not considered representative of estimated fair value. If prices received from independent pricing services are not considered reflective of market activity or representative of estimated fair value, independent non-binding broker quotations are obtained, or an internally developed valuation is prepared. Internally developed valuations of current estimated fair value, compared with pricing received from the independent pricing services, did not produce material differences in the estimated fair values for the majority of the portfolio; accordingly, overrides were not material. This is, in part, because internal estimates are generally based on available market evidence and estimates used by other market participants. In the absence of such market-based evidence, management’s best estimate is used.We have reviewed the significance and observability of inputs used in the valuation methodologies to determine the appropriate fair value hierarchy level for each of our securities. Based on the results of this review and investment class analysis, each instrument is categorized as Level 1, 2 or 3 based on the lowest level significant input to its valuation. See Note 10 of the Notes to the Consolidated Financial Statements for valuation approaches and key inputs by major category of assets or liabilities that are classified within Level 2 and Level 3 of the fair value hierarchy.Fair Value of Fixed Maturity Securities AFS and Equity SecuritiesFixed maturity securities AFS and equity securities measured at estimated fair value on a recurring basis and their corresponding fair value pricing sources are as follows: December 31, 2020LevelFixed MaturitySecurities AFSEquitySecurities (Dollars in millions)Level 1Quoted prices in active markets for identical assets$23,180 6.5 %$636 58.9 %Level 2Independent pricing sources300,989 84.9 213 19.8 Internal matrix pricing or discounted cash flow techniques1,133 0.3 80 7.4 Significant other observable inputs302,122 85.2 293 27.2 Level 3Independent pricing sources23,745 6.7 11 1.0 Internal matrix pricing or discounted cash flow techniques5,110 1.4 139 12.9 Independent broker quotations652 0.2 — — Significant unobservable inputs29,507 8.3 150 13.9 Total estimated fair value$354,809 100.0 %$1,079 100.0 %See Note 10 of the Notes to the Consolidated Financial Statements for the fixed maturity securities AFS and equity securities fair value hierarchy.The majority of the Level 3 fixed maturity securities AFS and equity securities were concentrated in three sectors at December 31, 2020: foreign corporate securities, U.S. corporate securities and RMBS. During the year ended December 31, 2020, Level 3 fixed maturity securities AFS increased by $10.7 billion, or 57%. The increase was driven by transfers into Level 3 in excess of transfers out of Level 3, purchases in excess of sales and by an increase in estimated fair value recognized in other comprehensive income (loss). The increase in transfers into Level 3 for the year ended December 31, 2020, in part, was from market conditions including decreased liquidity, decreased transparency of valuations and an increased use of unobservable inputs, principally for U.S. and foreign corporate securities.See Note 10 of the Notes to the Consolidated Financial Statements for a rollforward of the fair value measurements for securities measured at estimated fair value on a recurring basis using significant unobservable (Level 3) inputs; transfers into and/or out of Level 3; and further information about the valuation approaches and inputs by level by major classes of invested assets that affect the amounts reported above. Fixed Maturity Securities AFS See Notes 1 and 8 of the Notes to the Consolidated Financial Statements for information about fixed maturity securities AFS by sector, contractual maturities and continuous gross unrealized losses.95Table of ContentsFixed Maturity Securities AFS Credit Quality — Ratings The Securities Valuation Office of the NAIC evaluates the fixed maturity security investments of insurers for regulatory reporting and capital assessment purposes. Historically, the NAIC assigned securities to one of six credit quality categories called “NAIC designations.” If no designation is available from the NAIC, then, as permitted by the NAIC, an internally developed designation is used. NAIC designations are generally similar to the credit quality ratings of the NRSRO for fixed maturity securities, except for certain non-agency RMBS and CMBS as described below. Effective with year-end 2020 NAIC reporting, the NAIC implemented an expansion of the fixed maturity security rating classification from six to 20 categories. The NAIC retained the six NAIC designations and expanded with 20 “NAIC designation categories.” The NAIC designation categories correspond more closely to the NRSROs alpha-numeric credit quality ratings. The NAIC’s goal is to better align RBC charges on fixed maturity securities with the instruments’ actual credit risk. Effective with year-end 2020 regulatory reporting, insurers are required to report both the NAIC designation and NAIC designation category for each fixed maturity security. The NAIC maintained the current RBC factors for NAIC designations 1-6 until the NAIC completes an impact analysis to confirm or refine the NAIC’s proposed new RBC factors for the 20 NAIC designation categories.Rating agency ratings are based on availability of applicable ratings from rating agencies on the NAIC credit rating provider list, including Moody’s Investor Service (“Moody’s”), S&P, Fitch Ratings (“Fitch”), Dominion Bond Rating Service, A.M. Best Company (“A.M. Best”), Kroll Bond Rating Agency, Egan Jones Ratings Company and Morningstar Credit Ratings, LLC (“Morningstar”). If no rating is available from a rating agency, then an internally developed rating is used.The NAIC has adopted revised methodologies for non-agency RMBS and CMBS. The NAIC’s objective with the revised methodologies for non-agency RMBS and CMBS was to increase the accuracy in assessing expected losses, and to use the improved assessment to determine a more appropriate capital requirement for non-agency RMBS and CMBS. The revised methodologies reduce regulatory reliance on rating agencies and allow for greater regulatory input into the assumptions used to estimate expected losses from non-agency RMBS and CMBS. We apply the revised NAIC methodologies to non-agency RMBS and CMBS held by MetLife, Inc.’s insurance subsidiaries that maintain the NAIC statutory basis of accounting. The NAIC’s present methodology is to evaluate non-agency RMBS and CMBS held by insurers using the revised NAIC methodologies on an annual basis. If MetLife, Inc.’s insurance subsidiaries acquire non-agency RMBS and CMBS that have not been previously evaluated by the NAIC, but are expected to be evaluated by the NAIC in the upcoming annual review, an internally developed designation is used until a NAIC designation becomes available. NAIC designations may not correspond to NRSRO ratings.96Table of ContentsThe following table presents total fixed maturity securities AFS by NRSRO rating and the applicable NAIC designation from the NAIC published comparison of NRSRO ratings to NAIC designations, except for non-agency RMBS and CMBS, held by MetLife, Inc.'s insurance subsidiaries that maintain the NAIC statutory basis of accounting, which are presented using revised NAIC methodologies. NRSRO ratings are as of the dates shown below. Over time, credit ratings can migrate, up or down, through the NRSRO continuous monitoring process. As of December 31, 2020, securities are presented net of ACL, reflecting the adoption of new credit loss guidance on January 1, 2020. As of December 31, 2019, securities are presented at amortized cost in accordance with prior guidance. See Notes 1 and 8 of the Notes to the Consolidated Financial Statements for further information. December 31, 20202019NAICDesignationNRSRO RatingAmortizedCost net of ACLUnrealizedGains (Losses) (1)EstimatedFairValue% of TotalAmortizedCostUnrealizedGains (Losses)EstimatedFairValue% ofTotal (Dollars in millions)1Aaa/Aa/A$218,252 $31,761 $250,013 70.5 %$207,742 $22,966 $230,708 70.4 %2Baa76,342 11,360 87,702 24.7 74,568 6,857 81,425 24.8 Subtotal investment grade294,594 43,121 337,715 95.2 282,310 29,823 312,133 95.2 3Ba11,840 972 12,812 3.6 11,210 442 11,652 3.6 4B3,688 14 3,702 1.1 3,297 40 3,337 1.0 5Caa and lower536 (33)503 0.1 832 (139)693 0.2 6In or near default72 5 77 — 6 (1)5 — Subtotal below investment grade16,136 958 17,094 4.8 15,345 342 15,687 4.8 Total fixed maturity securities AFS$310,730 $44,079 $354,809 100.0 %$297,655 $30,165 $327,820 100.0 %(1) Excludes gross unrealized gains (losses) related to assets held-for-sale. See Note 3 of the Notes to the Consolidated Financial Statements for information on the pending disposition of MetLife P&C.As a result of current economic conditions, including the effects of the COVID-19 Pandemic which caused increased concerns over more highly leveraged issuers and downgrade risk, our below investment grade securities initially decreased in value but, as a result of credit spread tightening in the fourth quarter of 2020, these securities increased in value from an unrealized gain position at December 31, 2019 of $342 million to an unrealized gain position of $958 million at December 31, 2020. Foreign government securities, acquired to support our local insurance operations and related policyholder liabilities, represented $3.7 billion, or 22% of our $17.1 billion below investment grade securities, at estimated fair value, at December 31, 2020. U.S. corporate and foreign corporate securities comprise the vast majority of the remaining below investment grade securities. We have been actively repositioning our corporate below investment grade portfolios, including our syndicated bank loan portfolio, into higher quality, higher rated securities and with an increased allocation to privately-placed securities that include covenant protections.97Table of ContentsThe following tables present total fixed maturity securities AFS, based on estimated fair value, by sector and by NRSRO rating and the applicable NAIC designations from the NAIC published comparison of NRSRO ratings to NAIC designations, except for non-agency RMBS and CMBS, which are presented using the revised NAIC methodologies: Fixed Maturity Securities AFS — by Sector & Credit Quality RatingNAIC Designation123456TotalEstimatedFair ValueNRSRO RatingAaa/Aa/ABaaBaBCaa and LowerIn or Near Default (Dollars in millions)December 31, 2020U.S. corporate$46,847 $39,552 $4,649 $2,018 $326 $24 $93,416 Foreign government61,322 6,678 3,161 456 77 5 71,699 Foreign corporate26,812 37,884 3,984 648 74 6 69,408 U.S. government and agency46,543 557 — — — — 47,100 RMBS29,347 706 197 153 14 18 30,435 ABS15,328 1,496 197 96 1 1 17,119 Municipals13,240 460 22 — — — 13,722 CMBS10,574 369 602 331 11 23 11,910 Total fixed maturity securities AFS$250,013 $87,702 $12,812 $3,702 $503 $77 $354,809 Percentage of total70.5 %24.7 %3.6 %1.1 %0.1 %— %100.0 %December 31, 2019U.S. corporate$41,504 $37,915$5,760 $2,199 $374 $1 $87,753 Foreign government58,325 5,8662,383 392 263 — 67,229 Foreign corporate26,078 34,6742,810 556 47 — 64,165 U.S. government and agency41,577 507— — — — 42,084 RMBS27,957 403102 75 7 3 28,547 ABS12,727 1,339448 25 2 1 14,542 Municipals12,397 62432 — — — 13,053 CMBS10,143 97117 90 — — 10,447 Total fixed maturity securities AFS$230,708 $81,425$11,652 $3,337 $693 $5 $327,820 Percentage of total70.4 %24.8 %3.6 %1.0 %0.2 %— %100.0 %98Table of ContentsU.S. and Foreign Corporate Fixed Maturity Securities AFSWe maintain a diversified portfolio of corporate fixed maturity securities AFS across industries and issuers. This portfolio did not have any exposure to any single issuer in excess of 1% of total investments at December 31, 2020. The top 10 holdings comprised 2% of total investments at both December 31, 2020 and 2019. The table below presents our U.S. and foreign corporate securities holdings by industry at: December 31, 20202019IndustryEstimated Fair Value% ofTotalEstimated Fair Value% of Total (Dollars in millions)Industrial$47,472 29.2 %$46,018 30.3 %Finance37,645 23.1 34,776 22.9 Consumer33,384 20.5 31,952 21.0 Utility29,984 18.4 25,763 17.0 Communications12,107 7.4 11,471 7.5 Other2,232 1.4 1,938 1.3 Total$162,824 100.0 %$151,918 100.0 %As a result of current economic conditions, including the effects of the COVID-19 Pandemic, we have experienced stress within certain sub-sectors of our industrial and consumer corporate securities portfolios, principally in Energy, Airports, Cruise Lines / Leisure, Airlines, Restaurants and Lodging. See “— Current Environment — Selected Country and Sector Investments.”Structured ProductsWe held $59.5 billion and $53.5 billion of Structured Products, at estimated fair value, at December 31, 2020 and 2019, respectively, as presented in the RMBS, ABS and CMBS sections below.RMBS Our RMBS portfolio is diversified by security type and risk profile. The following table presents our RMBS portfolio by security type, risk profile and ratings profile at: December 31, 20202019 EstimatedFairValue% ofTotalNet Unrealized Gains (Losses) (1)EstimatedFairValue% ofTotalNetUnrealizedGains (Losses) (Dollars in millions)Security typeCollateralized mortgage obligations$17,342 57.0 %$1,468 $16,315 57.2 %$1,185 Pass-through mortgage-backed securities13,093 43.0 552 12,232 42.8 311 Total RMBS$30,435 100.0 %$2,020 $28,547 100.0 %$1,496 Risk profileAgency$20,408 67.1 %$1,314 $19,563 68.5 %$797 Prime1,637 5.4 38 1,142 4.0 48 Alt-A3,809 12.5 306 3,323 11.7 347 Sub-prime4,581 15.0 362 4,519 15.8 304 Total RMBS$30,435 100.0 %$2,020 $28,547 100.0 %$1,496 Ratings profileRated Aaa/AAA$22,555 74.1 %$21,122 74.0 %Designated NAIC 1$29,347 96.4 %$27,957 97.9 %99Table of Contents(1) Excludes gross unrealized gains (losses) related to assets held-for-sale. See Note 3 of the Notes to the Consolidated Financial Statements for information on the pending disposition of MetLife P&C.Collateralized mortgage obligations are structured by dividing the cash flows of mortgage loans into separate pools or tranches of risk that create multiple classes of bonds with varying maturities and priority of payments. Pass-through mortgage-backed securities are secured by a mortgage loan or collection of mortgage loans. The monthly mortgage loan payments from homeowners pass from the originating bank through an intermediary, such as a government agency or investment bank, which collects the payments and, for a fee, remits or passes these payments through to the holders of the pass-through securities.The majority of our RMBS holdings were rated Aaa/AAA and were designated NAIC 1 at December 31, 2020 and 2019. Agency RMBS were guaranteed or otherwise supported by Federal National Mortgage Association, Federal Home Loan Mortgage Corporation or Government National Mortgage Association. Non-agency RMBS include prime, alternative residential mortgage loans (“Alt-A”) and sub-prime RMBS. Prime residential mortgage lending includes the origination of residential mortgage loans to the most creditworthy borrowers with high quality credit profiles. Alt-A is a classification of mortgage loans where the risk profile of the borrower is between prime and sub-prime. Sub-prime mortgage lending is the origination of residential mortgage loans to borrowers with weak credit profiles. Historically, we have managed our exposure to sub-prime RMBS holdings by focusing primarily on senior tranche securities, stress testing the portfolio with severe loss assumptions and closely monitoring the performance of the portfolio. Our sub-prime RMBS portfolio consists predominantly of securities that were purchased after 2012 at significant discounts to par value and discounts to the expected principal recovery value of these securities. The vast majority of these securities are investment grade under the NAIC designations (e.g., NAIC 1 and NAIC 2).Our RMBS holdings were comprised of 67% Agency securities that were all designated NAIC 1 and 33% of non-agency securities, of which 93% were designated NAIC 1, at December 31, 2020. As result of current economic conditions, including increased unemployment levels as result of the COVID-19 Pandemic, the unrealized gain on our non-agency RMBS holdings initially decreased but, as a result of credit spread tightening in the fourth quarter of 2020, these securities increased in value from an unrealized gain of $699 million at December 31, 2019 to an unrealized gain of $706 million at December 31, 2020. Our non-agency RMBS portfolio is defensively positioned with most of the portfolio concentrated in senior tranches with strong structural protections including credit enhancement in the form of capital structure subordination that is available to absorb losses before they impact the securities we own.ABS Our ABS portfolio is diversified by collateral type and issuer. The following table presents our ABS portfolio by collateral type and ratings profile at: December 31, 20202019 EstimatedFairValue% ofTotalNet UnrealizedGains (Losses) (1)EstimatedFairValue% ofTotalNetUnrealizedGains (Losses) (Dollars in millions)Collateral typeCollateralized obligations (2)$8,946 52.2 %$(16)$7,974 54.8 %$(54)Consumer loans1,535 9.0 46 1,181 8.1 9 Student loans1,174 6.9 7 1,350 9.3 (5)Credit card loans1,006 5.9 13 454 3.1 4 Automobile loans976 5.7 20 813 5.6 7 Foreign residential loans956 5.5 15 1,088 7.5 14 Other loans2,526 14.8 71 1,682 11.6 20 Total$17,119 100.0 %$156 $14,542 100.0 %$(5)Ratings profileRated Aaa/AAA$9,164 53.5 %$7,711 53.0 %Designated NAIC 1$15,328 89.5 %$12,727 87.5 %(1) Excludes gross unrealized gains (losses) related to assets held-for-sale. See Note 3 of the Notes to the Consolidated Financial Statements for information on the pending disposition of MetLife P&C.100Table of Contents(2) Includes primarily collateralized loan obligations.As a result of current economic conditions, including the effects of the COVID-19 Pandemic, causing increased concerns over leveraged lending, our $8.9 billion collateralized obligations securities portfolio, at estimated fair value, initially decreased in value but, as a result of credit spread tightening in the fourth quarter of 2020, these securities increased in value from an unrealized loss position of $54 million at December 31, 2019 to an unrealized loss position of $16 million at December 31, 2020. We have been actively repositioning this portfolio into higher quality, higher rated securities primarily collateralized by first lien senior secured loans. As a result, this portfolio includes strong structural protections, primarily credit enhancement in the form of capital structure subordination that is available to absorb losses before they impact the securities we own. We do not own equity tranches of such securities or combination notes in this portfolio. As we invest primarily in securities rated AAA, AA or A, 98% of this portfolio was investment grade rated at December 31, 2020. CMBS Our CMBS portfolio is comprised primarily of securities collateralized by multiple commercial mortgage loans and is diversified by property type, borrower, geography and vintage year. The following tables present our CMBS portfolio by NRSRO rating and vintage year. As of December 31, 2020, securities are presented net of ACL, reflecting the adoption of new credit loss guidance on January 1, 2020. As of December 31, 2019, securities are presented at amortized cost in accordance with the prior guidance. See Notes 1 and 8 of the Notes to the Consolidated Financial Statements for further information. December 31, 2020 AaaAaABaaBelowInvestmentGradeTotalVintage YearAmortizedCost net of ACLEstimatedFairValueAmortizedCost net of ACLEstimatedFairValueAmortizedCost net of ACLEstimatedFairValueAmortizedCost net of ACLEstimatedFairValueAmortizedCost net of ACLEstimatedFairValueAmortizedCost net of ACLEstimatedFairValue (Dollars in millions)2003 - 2013$958 $1,011 $898 $917 $373 $355 $105 $96 $114 $98 $2,448 $2,477 2014451 480 429 449 169 171 10 9 — — 1,059 1,109 2015462 492 65 69 38 40 7 6 — — 572 607 2016282 310 56 60 54 53 — — — — 392 423 2017757 807 432 463 150 150 — — — — 1,339 1,420 20181,704 1,891 592 647 205 214 9 9 — — 2,510 2,761 20191,048 1,100 138 141 596 610 — — — — 1,782 1,851 2020734 748 280 293 186 191 29 30 — — 1,229 1,262 Total$6,396 $6,839 $2,890 $3,039 $1,771 $1,784 $160 $150 $114 $98 $11,331 $11,910 Ratings Distribution57.4 %25.5 %15.0 %1.3 %0.8 %100.0 % December 31, 2019 AaaAaABaaBelowInvestmentGradeTotalVintage YearAmortizedCostEstimatedFairValueAmortizedCostEstimatedFairValueAmortizedCostEstimatedFairValueAmortizedCostEstimatedFairValueAmortizedCostEstimatedFairValueAmortizedCostEstimatedFairValue (Dollars in millions)2003 - 2013$1,109 $1,169 $973 $1,007 $368 $376 $37 $36 $52 $41 $2,539 $2,629 2014372 389 486 502 114 119 — — — — 972 1,010 2015419 436 65 67 31 33 — — — — 515 536 2016285 298 71 73 55 56 — — — — 411 427 2017668 689 589 608 181 182 — — — — 1,438 1,479 20181,713 1,804 704 739 240 249 22 22 — — 2,679 2,814 2019744 754 143 143 652 655 — — — — 1,539 1,552 Total$5,310 $5,539 $3,031 $3,139 $1,641 $1,670 $59 $58 $52 $41 $10,093 $10,447 Ratings Distribution53.0 %30.0 %16.0 %0.6 %0.4 %100.0 %The tables above reflect NRSRO ratings including Moody’s, S&P, Fitch and Morningstar, Inc. CMBS designated NAIC 1 were 88.8% and 97.1% of total CMBS at December 31, 2020 and 2019, respectively.101Table of ContentsEvaluation of Fixed Maturity Securities AFS for Credit Loss, Rollforward of Allowance for Credit Loss and Credit Loss on Fixed Maturity Securities AFS Recognized in EarningsSee Note 8 of the Notes to the Consolidated Financial Statements for information about the evaluation of fixed maturity securities AFS for credit loss, rollforward of the ACL, net provision (release) for credit loss, as well as gross gains and gross losses on fixed maturity securities AFS sold at and for the years ended December 31, 2020 and 2019.Overview of Credit Loss on Fixed Maturity Securities AFS Excluding the impact of securities with an ACL that were subsequently sold or exchanged and the related release of the ACL, the provision for credit loss on fixed maturity securities AFS was $225 million for the year ended December 31, 2020, as compared to $129 million for the year ended December 31, 2019. The provision for credit loss on foreign government securities was $134 million for the year ended December 31, 2020, which was concentrated in Argentine foreign currency denominated sovereign securities, as a result of their default in 2020. The provision for credit loss on U.S. corporate securities and foreign corporate securities was $91 million for the year ended December 31, 2020, which were concentrated in industrial and consumer securities, as a result of market driven and issuer specific factors, primarily in the communications, energy and transportation sectors in 2020. See “— Current Environment — Selected Country and Sector Investments.”The release of the ACL for securities that were subsequently sold or exchanged was $133 million for the year ended December 31, 2020. Including the impact of these releases and impact of intent-to-sell impairments of $62 million, the net provision for credit loss on fixed maturity securities AFS was $154 million for the year ended December 31, 2020. In addition, there was an additional $11 million decrease in the ACL during the year ended December 31, 2020 in connection with the disposition of MetLife Seguros de Retiro.See Notes 1 and 8 of the Notes to the Consolidated Financial Statements for information on new credit loss guidance adopted on January 1, 2020 affecting the credit loss evaluation process and the measurement of credit loss; and a summary of the similarities and the differences of this new credit loss guidance with the previous guidance. Future Credit LossesProvisions for credit loss recognized in future quarters on fixed maturity securities AFS will depend primarily on future economic fundamentals, issuer performance (including changes in the present value of future cash flows expected to be collected), changes in credit ratings and collateral valuation. In upcoming periods, if there are changes in the above factors, provisions for credit loss may be recorded, as well as changes in the ACL on securities for which a provision for credit loss was previously recorded. Contractholder-Directed Equity Securities and Fair Value Option SecuritiesThe estimated fair value of these investments, which are primarily comprised of Unit-linked investments, was $13.3 billion and $13.1 billion, or 2.5% and 2.7% of cash and invested assets, at December 31, 2020 and 2019, respectively. See Notes 1 and 10 of the Notes to the Consolidated Financial Statements for a description of this portfolio, its fair value hierarchy and a rollforward of the fair value measurements for these investments measured at estimated fair value on a recurring basis using significant unobservable (Level 3) inputs.The COVID-19 Pandemic initially caused volatility in the equity markets and widening of credit spreads decreasing the estimated fair value of our Unit-linked investments and FVO Securities. However, during the fourth quarter of 2020, equity markets increased and credit spreads tightened. As a result, the estimated fair value of these securities still held at year end increased, resulting in a mark-to-market gain of $489 million in net investment income, as the change in estimated fair value on these securities is recorded in net investment income.Securities Lending, Repurchase Agreements and FHLB of Boston Advance AgreementsWe participate in a securities lending program whereby securities are loaned to third parties, primarily brokerage firms and commercial banks. We also participate in short-term repurchase agreement transactions with unaffiliated financial institutions. In addition, a subsidiary of the Company has entered into short-term advance agreements with the FHLB of Boston. See “— Liquidity and Capital Resources — The Company — Liquidity and Capital Uses — Securities Lending and Repurchase Agreements” and Notes 1 and 8 of the Notes to the Consolidated Financial Statements for further information.102Table of ContentsMortgage LoansOur mortgage loans held-for-investment are principally collateralized by commercial, agricultural and residential properties. Mortgage loans held-for-investment are carried at amortized cost and the related ACL are summarized as follows at: December 31, 20202019Portfolio SegmentAmortized Cost% ofTotalACLACL as % ofAmortized CostAmortized Cost% ofTotalACLACL as % ofAmortized Cost (Dollars in millions)Commercial$52,434 62.2 %$252 0.5 %$49,624 61.5 %$246 0.5 %Agricultural18,128 21.5 106 0.6 %16,695 20.7 52 0.3 %Residential13,782 16.3 232 1.7 %14,316 17.8 55 0.4 %Total$84,344 100.0 %$590 0.7 %$80,635 100.0 %$353 0.4 %The carrying value of all mortgage loans, net of ACL, was 15.9% and 16.4% of cash and invested assets at December 31, 2020 and 2019, respectively.Our commercial, agricultural and residential mortgage loan portfolios are subject to uncertain market conditions, including the effects of the COVID-19 Pandemic. As a result of the COVID-19 Pandemic, during the year ended December 31, 2020, we granted concessions (e.g., payment deferrals and other loan modifications) to certain of our commercial mortgage loan borrowers (principally in the hotel and retail sectors) and residential mortgage loan borrowers and, to a much lesser extent, some of our agricultural mortgage loan borrowers. See Note 8 of the Notes to the Consolidated Financial Statements for further information regarding COVID-19 Pandemic-related mortgage loan concessions. See also “— Commercial Mortgage Loans by Geographic Region and Property Type.”We diversify our mortgage loan portfolio by both geographic region and property type to reduce the risk of concentration. Of our commercial and agricultural mortgage loan held-for-investment portfolios, 83% are collateralized by properties located in the United States, with the remaining 17% collateralized by properties located outside the United States, which includes 4% of properties located in the U.K. and 4% of properties located in Mexico, at December 31, 2020. The carrying values of our commercial and agricultural mortgage loans held-for-investment located in California, New York and Texas were 17%, 10% and 7%, respectively, of total commercial and agricultural mortgage loans held-for-investment at December 31, 2020. Additionally, we manage risk when originating commercial and agricultural mortgage loans by generally lending up to 75% of the estimated fair value of the underlying real estate collateral.We manage our residential mortgage loan held-for-investment portfolio in a similar manner to reduce risk of concentration, with 92% collateralized by properties located in the United States, and the remaining 8% collateralized by properties located outside the United States, principally in Chile, at December 31, 2020. The carrying values of our residential mortgage loans located in California, Florida, and New York were 33%, 9%, and 7%, respectively, of total residential mortgage loans at December 31, 2020.103Table of ContentsCommercial Mortgage Loans by Geographic Region and Property Type. Commercial mortgage loans are the largest component of the mortgage loan invested asset class. The tables below present the diversification across geographic regions and property types of commercial mortgage loans held-for-investment at: December 31, 20202019 Amount% ofTotalAmount% ofTotal (Dollars in millions)RegionNon-U.S.$10,581 20.2 %$10,093 20.3 %Pacific10,235 19.5 10,169 20.5 Middle Atlantic8,233 15.7 8,302 16.7 South Atlantic7,217 13.8 6,487 13.1 West South Central3,887 7.4 4,255 8.6 East North Central2,494 4.8 3,066 6.2 New England2,126 4.0 1,433 2.9 Mountain1,777 3.4 1,602 3.2 East South Central700 1.3 502 1.0 West North Central609 1.2 607 1.2 Multi-Region and Other4,575 8.7 3,108 6.3 Total amortized cost52,434 100.0 %49,624 100.0 %Less: ACL252 246 Carrying value, net of ACL$52,182 $49,378 Property TypeOffice$23,928 45.6 %$22,925 46.2 %Retail8,911 17.0 9,052 18.2 Apartment8,764 16.7 8,212 16.6 Industrial5,365 10.2 3,985 8.0 Hotel3,377 6.5 3,471 7.0 Other2,089 4.0 1,979 4.0 Total amortized cost52,434 100.0 %49,624 100.0 %Less: ACL252 246 Carrying value, net of ACL$52,182 $49,378 __________________ Our commercial mortgage loan portfolio is well positioned with exposures concentrated in high quality underlying properties located in primary markets typically with institutional investors who are better positioned to manage their assets during periods of market volatility. Our portfolio is comprised primarily of lower risk loans with higher debt-service coverage ratios (“DSCR”) and lower loan-to-value (“LTV”) ratios. See “— Mortgage Loan Credit Quality — Monitoring Process” for further information and Note 8 of the Notes to the Consolidated Financial Statements for a distribution of our commercial mortgage loans by DSCR and LTV ratios. Excluding loans with a COVID-19 Pandemic-related payment deferral, over 99% of our commercial mortgage loan portfolio was current and 100% of our hotel and retail commercial mortgage loan portfolio was current at December 31, 2020. See Note 8 of the Notes to the Consolidated Financial Statements for further information regarding COVID-19 Pandemic-related mortgage loan concessions.Mortgage Loan Credit Quality — Monitoring Process. We monitor our mortgage loan investments on an ongoing basis, including a review of loans by credit quality indicator and loans that are current, past due, restructured and under foreclosure. See Note 8 of the Notes to the Consolidated Financial Statements for further information regarding mortgage loans by credit quality indicator, past due and nonaccrual mortgage loans.104Table of ContentsWe review our commercial mortgage loans on an ongoing basis. These reviews may include an analysis of the property financial statements and rent roll, lease rollover analysis, property inspections, market analysis, estimated valuations of the underlying collateral, LTV ratios, DSCR and tenant creditworthiness. The monitoring process focuses on higher risk loans, which include those that are classified as restructured, delinquent or in foreclosure, as well as loans with higher LTV ratios and lower DSCR and loans with a COVID-19 Pandemic-related payment deferral. The monitoring process for agricultural mortgage loans is generally similar, with a focus on higher risk loans, such as loans with higher LTV ratios. Agricultural mortgage loans are reviewed on an ongoing basis which include, but are not limited to, property inspections, market analysis, estimated valuations of the underlying collateral, LTV ratios and borrower creditworthiness, including reviews on a geographic and property-type basis. We review our residential mortgage loans on an ongoing basis, with a focus on higher risk loans, such as nonperforming loans. See Note 8 of the Notes to the Consolidated Financial Statements for information on our evaluation of residential mortgage loans and related ACL methodology.LTV ratios and DSCR are common measures in the assessment of the quality of commercial mortgage loans. LTV ratios are a common measure in the assessment of the quality of agricultural mortgage loans. LTV ratios compare the amount of the loan to the estimated fair value of the underlying collateral. A LTV ratio greater than 100% indicates that the loan amount is greater than the collateral value. A LTV ratio of less than 100% indicates an excess of collateral value over the loan amount. Generally, the higher the LTV ratio, the higher the risk of experiencing a credit loss. The DSCR compares a property’s net operating income to amounts needed to service the principal and interest due under the loan. Generally, the lower the DSCR, the higher the risk of experiencing a credit loss. For our commercial mortgage loans, our average LTV ratio was 58% and 55% at December 31, 2020 and 2019 respectively, and our average DSCR was 2.5x and 2.4x at December 31, 2020 and 2019, respectively. The DSCR and the values utilized in calculating the ratio are updated routinely. In addition, the LTV ratio is routinely updated for all but the lowest risk loans as part of our ongoing review of our commercial mortgage loan portfolio. For our agricultural mortgage loans, our average LTV ratio was 48% and 47% at December 31, 2020 and 2019, respectively. The values utilized in calculating our agricultural mortgage loan LTV ratio are developed in connection with the ongoing review of our agricultural loan portfolio and are routinely updated.Mortgage Loan Allowance for Credit Loss. Our ACL is established for both pools of loans with similar risk characteristics and for mortgage loans with dissimilar risk characteristics, collateral dependent loans and reasonably expected troubled debt restructurings, individually on a loan specific basis. We record an allowance for expected lifetime credit loss in an amount that represents the portion of the amortized cost basis of mortgage loans that the Company does not expect to collect, resulting in mortgage loans being presented at the net amount expected to be collected. In determining our ACL, management (i) pools mortgage loans that share similar risk characteristics, (ii) considers expected lifetime credit loss over the contractual term of our mortgage loans, as adjusted for expected prepayments and any extensions, and (iii) considers past events and current and forecasted economic conditions. Actual credit loss realized could be different from the amount of the ACL recorded. These evaluations and assessments are revised as conditions change and new information becomes available, which can cause the ACL to increase or decrease over time as such evaluations are revised. Negative credit migration, including an actual or expected increase in the level of problem loans, will result in an increase in the ACL. Positive credit migration, including an actual or expected decrease in the level of problem loans, will result in a decrease in the ACL. See Notes 1 and 8 of the Notes to the Consolidated Financial Statements for information on how the ACL is established and monitored, and activity in and balances of the ACL, as of and for the years ended December 31, 2020 and 2019.See Notes 1 and 8 of the Notes to the Consolidated Financial Statements for information on the new credit loss guidance adopted in 2020 affecting the credit loss evaluation process and the measurement of credit loss effective January 1, 2020, as well as a summary of the similarities and the differences of this new credit loss guidance with the previous guidance. Real Estate and Real Estate Joint VenturesReal estate and real estate joint ventures is comprised of wholly-owned real estate and joint ventures with interests in single property income-producing real estate and, to a lesser extent, joint ventures with interests in multi-property projects with varying strategies ranging from the development of properties to the operation of income-producing properties, as well as a runoff portfolio. The carrying value of real estate and real estate joint ventures was $11.9 billion and $10.7 billion, or 2.3% and 2.2% of cash and invested assets, at December 31, 2020 and 2019, respectively.105Table of ContentsAs a result of the COVID-19 Pandemic, certain of our real estate investments, principally hotel properties, experienced a reduction in income during the year ended December 31, 2020 as compared to the year ended December 31, 2019. We lease investment real estate, principally commercial real estate, for office and retail use, through a variety of operating lease arrangements. In response to the COVID-19 Pandemic, during the year ended December 31, 2020, we granted lease concessions (e.g., rent payment deferrals) to some of our lessees. In addition, we have interests in certain unconsolidated real estate joint ventures which have granted COVID-19 Pandemic-related lease concessions. See Note 8 of the Notes to the Consolidated Financial Statements for further information regarding COVID-19 Pandemic-related lease concessions. Our real estate investments are typically stabilized properties that we intend to hold for the longer-term for portfolio diversification and long-term appreciation. Our real estate investment portfolio has significantly appreciated since acquisition to a $6.3 billion unrealized gain position at December 31, 2020 that is available to absorb valuation declines from the current economic conditions. We continuously monitor expected future cash flows of our real estate investments and incorporate them into our periodic impairment analyses. As a result of the COVID-19 Pandemic, we performed impairment analyses during the year ended December 31, 2020, which included updated estimates of expected future cash flows. As a result of our impairment analyses, we recorded one impairment during the year ended December 31, 2020 for $13 million. This impairment was recorded in net investment income as the investment is in a real estate fund that is accounted for under the equity method. There were no impairments recognized in net investment gains (losses) on real estate and real estate joint ventures for the year ended December 31, 2020. There were $10 million in impairments recognized for the year ended December 31, 2019.We diversify our real estate investments by both geographic region and property type to reduce risk of concentration. See Note 8 of the Notes to the Consolidated Financial Statements for a summary of real estate investments, by income type, as well as income earned.Geographical diversification: Of our real estate investments, excluding funds, 60% were located in the United States, with the remaining 40% located outside the United States, at December 31, 2020. The carrying value of our real estate investments, excluding funds, located in Japan, California and Washington, D.C. were 35%, 10% and 9%, respectively, of total real estate investments, excluding funds, at December 31, 2020. Real estate funds were 25% of our real estate investments at December 31, 2020. The majority of these funds hold underlying real estate investments that are well diversified across the United States.Property type diversification: Real estate and real estate joint venture investments are categorized by property type as follows at: December 31, 20202019Property TypeCarryingValue% ofTotalCarryingValue% ofTotal (Dollars in millions)Office$4,082 34.2 %$3,678 34.2 %Real estate funds2,966 24.9 2,539 23.6 Retail1,273 10.7 1,260 11.7 Apartment1,260 10.6 1,211 11.3 Land 910 7.6 669 6.2 Hotel 610 5.0 599 5.6 Industrial 448 3.8 393 3.7 Agriculture20 0.2 21 0.2 Other 364 3.0 371 3.5 Total real estate and real estate joint ventures$11,933 100.0 %$10,741 100.0 % 106Table of ContentsOther Limited Partnership InterestsOther limited partnership interests are comprised of investments in private funds, including private equity funds and hedge funds. At December 31, 2020 and 2019, the carrying value of other limited partnership interests was $9.5 billion and $7.7 billion, which included $643 million and $575 million of hedge funds, respectively. Other limited partnership interests were 1.79% and 1.57% of cash and invested assets at December 31, 2020 and 2019, respectively. Cash distributions on these investments are generated from investment gains, operating income from the underlying investments of the funds and liquidation of the underlying investments of the funds.We use the equity method of accounting for most of our private equity funds. We generally recognize our share of a private equity fund’s earnings in net investment income on a three-month lag when the information is reported to us. Accordingly, declines in the equity markets, which can impact the underlying results of these private equity funds, are recorded in our net investment income on a three-month lag. As a result of declines in the equity market in the first quarter of 2020, which were reported to us in the second quarter of 2020 by our investees, we recorded negative net investment income of $607 million on our private equity and hedge fund investments during the three months ended June 30, 2020. As a result of increases in the equity market in the second quarter of 2020, which were reported to us in the third quarter of 2020 by our investees, we recorded net investment income of $578 million on our private equity and hedge fund investments during the three months ended September 30, 2020. As a result of increases in the equity market in the third quarter of 2020, which were reported to us in the fourth quarter of 2020 by our investees, we recorded net investment income of $709 million on our private equity and hedge fund investments during the three months ended December 31, 2020. For a discussion of our expected private equity returns in 2021, see “— Executive Summary — Consolidated Company Outlook.” Other Invested AssetsThe following table presents the carrying value of our other invested assets by type at: December 31, 20202019Asset TypeCarrying Value% of TotalCarrying Value% of Total(Dollars in millions)Freestanding derivatives with positive estimated fair values$11,866 57.6 %$10,084 53.0 %Tax credit and renewable energy partnerships1,751 8.5 1,993 10.5 Direct financing leases1,340 6.5 1,247 6.6 Annuities funding structured settlement claims1,263 6.1 1,271 6.7 Leveraged leases816 4.0 1,052 5.4 FHLB common stock 814 4.1 809 4.3 Operating joint ventures733 3.6 838 4.4 Funds withheld508 2.5 470 2.5 Other1,502 7.2 1,251 6.6 Total$20,593 100 %$19,015 100 %Percentage of cash and invested assets3.9 %3.9 %Our direct financing and leveraged lease portfolios are subject to uncertain market conditions, including the effects of the COVID-19 Pandemic and related economic slowdown. In response to the COVID-19 Pandemic, during the year ended December 31, 2020, we granted lease concessions, primarily in the form of rent deferrals, to some of our lessees. See Note 8 of the Notes to the Consolidated Financial Statements for further information regarding COVID-19 Pandemic-related direct financing lease concessions. See Note 8 of the Notes to the Consolidated Financial Statements for information on the new credit loss guidance adopted in 2020 affecting the credit loss evaluation process and the measurement of credit loss, including direct financing and leveraged leases effective January 1, 2020.See Notes 1, 8 and 9 of the Notes to the Consolidated Financial Statements for information regarding freestanding derivatives with positive estimated fair values, tax credit and renewable energy partnerships, direct financing and leveraged leases, annuities funding structured settlement claims, FHLB common stock, operating joint ventures and funds withheld, as well as, gains (losses) on disposals of, and impairments of, tax credit and renewable energy partnerships, and leveraged lease impairment losses.107Table of ContentsDerivatives Derivative RisksWe are exposed to various risks relating to our ongoing business operations, including interest rate, foreign currency exchange rate, credit and equity market. We use a variety of strategies to manage these risks, including the use of derivatives. See Note 9 of the Notes to the Consolidated Financial Statements for: •A comprehensive description of the nature of our derivatives, including the strategies for which derivatives are used in managing various risks.•Information about the primary underlying risk exposure, gross notional amount, and estimated fair value of our derivatives by type of hedge designation, excluding embedded derivatives held at December 31, 2020 and 2019.•The statement of operations effects of derivatives in net investments in foreign operations, cash flow, fair value, or nonqualifying hedge relationships for the years ended December 31, 2020, 2019 and 2018.See “Quantitative and Qualitative Disclosures About Market Risk — Management of Market Risk Exposures — Hedging Activities” for more information about our use of derivatives by major hedge program.Fair Value HierarchySee Note 10 of the Notes to the Consolidated Financial Statements for derivatives measured at estimated fair value on a recurring basis and their corresponding fair value hierarchy.The valuation of Level 3 derivatives involves the use of significant unobservable inputs and generally requires a higher degree of management judgment or estimation than the valuations of Level 1 and Level 2 derivatives. Although Level 3 inputs are unobservable, management believes they are consistent with what other market participants would use when pricing such instruments and are considered appropriate given the circumstances. The use of different inputs or methodologies could have a material effect on the estimated fair value of Level 3 derivatives and could materially affect net income.Derivatives categorized as Level 3 at December 31, 2020 include: interest rate forwards with maturities which extend beyond the observable portion of the yield curve; interest rate total return swaps with unobservable repurchase rates; foreign currency swaps and forwards with certain unobservable inputs, including the unobservable portion of the yield curve; credit default swaps priced using unobservable credit spreads, or that are priced through independent broker quotations; equity variance swaps with unobservable volatility inputs; and equity index options with unobservable correlation inputs. At December 31, 2020, less than 1% of the estimated fair value of our derivatives was priced through independent broker quotations.See Note 10 of the Notes to the Consolidated Financial Statements for a rollforward of the fair value measurements for derivatives measured at estimated fair value on a recurring basis using significant unobservable (Level 3) inputs.The gain (loss) on Level 3 derivatives primarily relates to foreign currency derivatives and interest rate forwards that are valued using an unobservable portion of the swap yield curves and unobservable interest rates, respectively. Other significant inputs, which are observable, include equity volatility and observable interest rates. We validate the reasonableness of these inputs by valuing the positions using internal models and comparing the results to broker quotations.The gain (loss) on Level 3 derivatives, percentage of gain (loss) attributable to observable and unobservable inputs, and the primary drivers of observable gain (loss) are summarized as follows: Year Ended December 31, 2020Gain (loss) recognized in net income (loss) $279Approximate percentage of gain (loss) attributable to observable inputs48%Primary drivers of observable gain (loss)Decreases in interest rates on interest rate total return swaps.Approximate percentage of gain (loss) attributable to unobservable inputs52%See “— Summary of Critical Accounting Estimates — Derivatives” for further information on the estimates and assumptions that affect derivatives.108Table of ContentsCredit RiskSee Note 9 of the Notes to the Consolidated Financial Statements for information about how we manage credit risk related to derivatives and for the estimated fair value of our net derivative assets and net derivative liabilities after the application of master netting agreements and collateral.Our policy is not to offset the fair value amounts recognized for derivatives executed with the same counterparty under the same master netting agreement. This policy applies to the recognition of derivatives on the consolidated balance sheets and does not affect our legal right of offset.Credit DerivativesThe following table presents the gross notional amount and estimated fair value of credit default swaps at:December 31,20202019Credit Default SwapsGrossNotionalAmountEstimated Fair ValueGrossNotionalAmountEstimated Fair Value(In millions)Purchased$2,978 $(112)$2,944 $(98)Written9,609 196 11,520 271 Total$12,587 $84 $14,464 $173 The following table presents the gross gains, gross losses and net gains (losses) recognized in net derivative gains (losses) for credit default swaps as follows: Years Ended December 31,20202019Credit Default SwapsGrossGains GrossLosses NetGains(Losses)GrossGains GrossLosses NetGains(Losses)(In millions)Purchased (1)$36 $(64)$(28)$2 $(40)$(38)Written (1)65 (171)(106)257 (9)248 Total$101 $(235)$(134)$259 $(49)$210 __________________(1)Gains (losses) do not include earned income (expense) on credit default swaps.The unfavorable change in net gains (losses) on written credit default swaps was $354 million for the year ended December 31, 2020 as compared to the year ended December 31, 2019 due to certain credit spreads on certain credit default swaps used as replications widening in the current period and narrowing in the prior period.The maximum amount at risk related to our written credit default swaps is equal to the corresponding gross notional amount. In a replication transaction, we pair an asset on our balance sheet with a written credit default swap to synthetically replicate a corporate bond, a core asset holding of life insurance companies. Replications are entered into in accordance with the guidelines approved by state insurance regulators and the NAIC and are an important tool in managing the overall corporate credit risk within the Company. In order to match our long-dated insurance liabilities, we seek to buy long-dated corporate bonds. In some instances, these may not be readily available in the market, or they may be issued by corporations to which we already have significant corporate credit exposure. For example, by purchasing Treasury bonds (or other high quality assets) and associating them with written credit default swaps on the desired corporate credit name, we can replicate the desired bond exposures and meet our ALM needs. In addition, given the shorter tenor of the credit default swaps (generally five-year tenors) versus a long-dated corporate bond, we have more flexibility in managing our credit exposures. Embedded DerivativesSee Note 10 of the Notes to the Consolidated Financial Statements for information about embedded derivatives measured at estimated fair value on a recurring basis and their corresponding fair value hierarchy and a rollforward of the fair value measurements for embedded derivatives measured at estimated fair value on a recurring basis using significant unobservable (Level 3) inputs.109Table of ContentsSee Note 9 of the Notes to the Consolidated Financial Statements for information about the nonperformance risk adjustment included in the valuation of guaranteed minimum benefits accounted for as embedded derivatives.See “— Summary of Critical Accounting Estimates — Derivatives” for further information on the estimates and assumptions that affect embedded derivatives.Off-Balance Sheet ArrangementsCredit and Committed FacilitiesWe maintain an unsecured revolving credit facility, as well as certain committed facilities (“Committed Facilities”), with various financial institutions. See Note 13 of the Notes to the Consolidated Financial Statements for descriptions of such arrangements, the classification of expenses on such credit and committed facilities and the nature of the associated liability for letters of credit issued and drawdowns on these credit and committed facilities. See also “— Liquidity and Capital Resources — The Company — Liquidity and Capital Sources — Global Funding Sources — Credit and Committed Facilities.” Collateral for Securities Lending, Repurchase Agreements, Third-Party Custodian Administered Repurchase Programs and DerivativesWe participate in securities lending transactions, repurchase agreements and third-party custodian administered repurchase programs in the normal course of business for the purpose of enhancing the total return on our investment portfolio. See Notes 1 and 8 of the Notes to the Consolidated Financial Statements for further discussion of our securities lending transactions and repurchase agreements, the classification of revenues and expenses, and the nature of the secured financing arrangements and associated liabilities.Securities lending and repurchase agreements: Periodically we receive non-cash collateral for securities lending and repurchase agreements from counterparties, which is not reflected on our consolidated financial statements. The amount of this non-cash collateral was $1 million and $0 at estimated fair value at December 31, 2020 and 2019, respectively. Third-party custodian administered repurchase programs: We loan certain of our fixed maturity securities AFS to unaffiliated financial institutions and, in exchange, non-cash collateral is put on deposit by the unaffiliated financial institutions on our behalf with third-party custodians. The estimated fair value of securities loaned in connection with these transactions was $19 million and $85 million at December 31, 2020 and 2019, respectively. Non-cash collateral on deposit with third-party custodians on our behalf was $20 million and $90 million, at estimated fair value, at December 31, 2020 and 2019, respectively, which cannot be sold or re-pledged, and which is not reflected on our consolidated financial statements.Derivatives: We enter into derivatives to manage various risks relating to our ongoing business operations. We receive non-cash collateral from counterparties for derivatives, which can be sold or re-pledged subject to certain constraints, and which is not reflected on our consolidated balance sheets. The amount of this non-cash collateral was $1.7 billion at estimated fair value, at both December 31, 2020 and 2019. See “— Liquidity and Capital Resources — The Company — Liquidity and Capital Uses — Pledged Collateral” and Note 9 of the Notes to the Consolidated Financial Statements for information regarding the earned income on and the gross notional amount, estimated fair value of assets and liabilities and primary underlying risk exposure of our derivatives.Investment CommitmentsWe enter into the following commitments in the normal course of business for the purpose of enhancing the total return on our investment portfolio: mortgage loan commitments and commitments to fund partnerships, bank credit facilities, bridge loans and private corporate bond investments. See Note 21 of the Notes to the Consolidated Financial Statements for further information about these investment commitments. See “Net Investment Income” and “Net Investment Gains (Losses)” in Note 8 of the Notes to the Consolidated Financial Statements for information on the investment income, investment expense, gains and losses from such investments and the liability for credit loss for unfunded mortgage loan commitments. See also “— Investments — Fixed Maturity Securities AFS and Equity Securities,” “— Investments — Mortgage Loans,” “— Investments — Real Estate and Real Estate Joint Ventures” and “— Investments — Other Limited Partnership Interests.” Lease CommitmentsAs lessee, we have entered into various lease and sublease agreements for office space and equipment. Our commitments under such lease agreements are included within the contractual obligations table. See “— Liquidity and Capital Resources — The Company — Contractual Obligations” and Note 11 of the Notes to the Consolidated Financial Statements.110Table of ContentsGuaranteesSee “Guarantees” in Note 21 of the Notes to the Consolidated Financial Statements.Insolvency AssessmentsSee Note 21 of the Notes to the Consolidated Financial Statements.Policyholder Liabilities We establish, and carry as liabilities, actuarially determined amounts that are calculated to meet policy obligations or to provide for future annuity payments. Amounts for actuarial liabilities are computed and reported on the consolidated financial statements in conformity with GAAP. For more details on Policyholder Liabilities, see “— Summary of Critical Accounting Estimates.” Due to the nature of the underlying risks and the uncertainty associated with the determination of actuarial liabilities, we cannot precisely determine the amounts that will ultimately be paid with respect to these actuarial liabilities, and the ultimate amounts may vary from the estimated amounts, particularly when payments may not occur until well into the future.We periodically review our estimates of actuarial liabilities for future benefits and compare them with our actual experience. We revise estimates, to the extent permitted or required under GAAP, if we determine that future expected experience differs from assumptions used in the development of actuarial liabilities. We charge or credit changes in our liabilities to expenses in the period the liabilities are established or re-estimated. If the liabilities originally established for future benefit payments prove inadequate, we must increase them. Such an increase could adversely affect our earnings and have a material adverse effect on our business, results of operations and financial condition.We have experienced, and will likely in the future experience, catastrophe losses and possibly acts of terrorism, as well as turbulent financial markets that may have an adverse impact on our business, results of operations and financial condition. Due to their nature, we cannot predict the incidence, timing, severity or amount of losses from catastrophes and acts of terrorism, but we make broad use of catastrophic and non-catastrophic reinsurance to manage risk from these perils. We also use hedging, reinsurance and other risk management activities to mitigate financial market volatility.See “Business — Regulation — Insurance Regulation — Policy and Contract Reserve Adequacy Analysis” for further information regarding required analyses of the adequacy of statutory reserves of our insurance operations.Future Policy BenefitsWe establish liabilities for amounts payable under insurance policies. See Notes 1 and 4 of the Notes to the Consolidated Financial Statements for additional information. See also “— Industry Trends — Impact of a Sustained Low Interest Rate Environment — Low Interest Rate Scenarios” and “— Variable Annuity Guarantees.” A discussion of future policy benefits by segment (as well as Corporate & Other) follows.U.S.Amounts payable under insurance policies for this segment are comprised of group insurance and annuities. For group insurance, future policyholder benefits are comprised mainly of liabilities for disabled lives under disability waiver of premium policy provisions, liabilities for survivor income benefit insurance, active life policies and premium stabilization and other contingency liabilities held under life insurance contracts. For group annuity contracts, future policyholder benefits are primarily related to payout annuities, including pension risk transfers, structured settlement annuities and institutional income annuities. There is no interest rate crediting flexibility on these liabilities. As a result, a sustained low interest rate environment could negatively impact earnings; however, we mitigate our risks by applying various ALM strategies, including the use of various interest rate derivative positions.AsiaFuture policy benefits for this segment are held primarily for traditional life, endowment, annuity and accident & health contracts. They are also held for total return pass-through provisions included in certain universal life and savings products. They include certain liabilities for variable annuity and variable life guarantees of minimum death benefits, and longevity guarantees. Factors impacting these liabilities include sustained periods of lower than expected yields, lower than expected asset reinvestment rates, market volatility, actual lapses resulting in lower than expected income, and actual mortality or morbidity resulting in higher than expected benefit payments. We mitigate our risks by applying various ALM strategies and by the use of reinsurance.111Table of ContentsLatin AmericaFuture policy benefit liabilities for this segment are held primarily for immediate annuities, traditional life contracts and total return pass-through provisions included in certain universal life and savings products. There is limited interest rate crediting flexibility on the immediate annuity and traditional life liabilities. As a result, sustained periods of lower than expected yields could negatively impact earnings; however, we mitigate our risks by applying various ALM strategies. Other factors impacting these liabilities are actual mortality resulting in higher than expected benefit payments and actual lapses resulting in lower than expected income.EMEAFuture policy benefits for this segment include unearned premium reserves for group life and medical and credit insurance contracts. Future policy benefits are also held for traditional life, endowment and annuity contracts with significant mortality risk and accident & health contracts. Factors impacting these liabilities include lower than expected asset reinvestment rates, market volatility, actual lapses resulting in lower than expected income, and actual mortality or morbidity resulting in higher than expected benefit payments. We mitigate our risks by having premiums which are adjustable or cancellable in some cases, applying various ALM strategies and by the use of reinsurance.MetLife Holdings Future policy benefits for the life insurance business are comprised mainly of liabilities for traditional life insurance contracts. In order to manage risk, we have often reinsured a portion of the mortality risk on life insurance policies. We routinely evaluate our reinsurance programs, which may result in increases or decreases to existing coverage. We have entered into various interest rate derivative positions to mitigate the risk that investment of premiums received and reinvestment of maturing assets over the life of the policy will be at rates below those assumed in the original pricing of these contracts. For the annuities business, future policy benefits are comprised mainly of liabilities for life-contingent income annuities and liabilities for the variable annuity guaranteed minimum benefits that are accounted for as insurance. For the long-term care business, future policyholder benefits are comprised mainly of liabilities for disabled lives under disability waiver of premium policy provisions, and active life policies. In addition, for our other products, future policyholder benefits related to the reinsurance of our former Japan joint venture are comprised of liabilities for the variable annuity guaranteed minimum benefits that are accounted for as insurance.Corporate & OtherFuture policy benefits primarily include liabilities for other reinsurance business.Policyholder Account Balances Policyholder account balances are generally equal to the account value, which includes accrued interest credited, but excludes the impact of any applicable charge that may be incurred upon surrender. See “— Industry Trends — Impact of a Sustained Low Interest Rate Environment — Low Interest Rate Scenarios” and “— Variable Annuity Guarantees.” See also Notes 1 and 4 of the Notes to the Consolidated Financial Statements for additional information. A discussion of policyholder account balances by segment follows.U.S.Policyholder account balances in this segment are comprised of funding agreements, retained asset accounts, universal life policies, the fixed account of variable life insurance policies and specialized life insurance products for benefit programs.Group BenefitsPolicyholder account balances in this business are held for retained asset accounts, universal life policies, the fixed account of variable life insurance policies and specialized life insurance products for benefit programs. Policyholder account balances are credited interest at a rate we determine, which is influenced by current market rates. A sustained low interest rate environment could adversely impact liabilities and earnings as a result of the minimum credited rate guarantees present in most of these policyholder account balances. We have various interest rate derivative positions to partially mitigate the risks associated with such a scenario.112Table of ContentsThe table below presents the breakdown of account value subject to minimum guaranteed crediting rates for Group Benefits: December 31, 2020Guaranteed Minimum Crediting RateAccountValue Account Value at Guarantee (In millions)Greater than 0% but less than 2%$5,029 $4,903 Equal to or greater than 2% but less than 4%$1,629 $1,593 Equal to or greater than 4%$780 $752 Retirement and Income SolutionsPolicyholder account balances in this business are held largely for investment-type products, mainly funding agreements, as well as postretirement benefits and corporate-owned life insurance to fund non-qualified benefit programs for executives. Interest crediting rates vary by type of contract and can be fixed or variable. Variable interest crediting rates are generally tied to an external index, most commonly (1-month or 3-month) LIBOR or Secured Overnight Financing Rate. We are exposed to interest rate risks, as well as foreign currency exchange rate risk, when guaranteeing payment of interest and return of principal at the contractual maturity date. We may invest in floating rate assets or enter into receive-floating interest rate swaps, also tied to external indices, as well as interest rate caps, to mitigate the impact of changes in market interest rates. We also mitigate our risks by applying various ALM strategies and seek to hedge all foreign currency exchange rate risk through the use of foreign currency hedges, including cross currency swaps.The table below presents the breakdown of account value subject to minimum guaranteed crediting rates for RIS: December 31, 2020Guaranteed Minimum Crediting RateAccountValue Account Value at Guarantee (In millions)Greater than 0% but less than 2%$145 $— Equal to or greater than 2% but less than 4%$1,053 $108 Equal to or greater than 4%$4,598 $4,379 AsiaPolicyholder account balances in this segment are held largely for fixed income retirement and savings plans, fixed deferred annuities, interest sensitive whole life products, universal life and, to a lesser degree, liability amounts for Unit-linked investments that do not meet the GAAP definition of separate accounts. Also included are certain liabilities for retirement and savings products sold in certain countries in Asia that generally are sold with minimum credited rate guarantees. Liabilities for guarantees on certain variable annuities in Asia are accounted for as embedded derivatives and recorded at estimated fair value and are also included within policyholder account balances. A sustained low interest rate environment could adversely impact liabilities and earnings as a result of the minimum credited rate guarantees present in most of these policyholder account balances. We mitigate our risks by applying various ALM strategies and with reinsurance. Liabilities for Unit-linked investments are impacted by changes in the fair value of the associated underlying investments, as the return on assets is generally passed directly to the policyholder.113Table of ContentsThe table below presents the breakdown of account value subject to minimum guaranteed crediting rates for Asia: December 31, 2020Guaranteed Minimum Crediting Rate AccountValue Account Value at Guarantee (In millions)AnnuitiesGreater than 0% but less than 2%$31,552 $1,920 Equal to or greater than 2% but less than 4%$1,083 $420 Equal to or greater than 4%$1 $1 Life & OtherGreater than 0% but less than 2%$13,186 $12,687 Equal to or greater than 2% but less than 4%$31,304 $9,829 Equal to or greater than 4%$280 $280 Latin AmericaPolicyholder account balances in this segment are held largely for investment-type products, universal life products, deferred annuities and Unit-linked investments that do not meet the GAAP definition of separate accounts. Liabilities for Unit-linked investments are impacted by changes in the fair value of the associated investments, as the return on assets is generally passed directly to the policyholder. Many of the other liabilities have minimum credited rate guarantees, which could adversely impact liabilities and earnings in a sustained low interest rate environment. We mitigate our risk by applying various ALM strategies.EMEAPolicyholder account balances in this segment are held mostly for universal life, deferred annuities, pension products, and Unit-linked investments that do not meet the GAAP definition of separate accounts. They are also held for endowment products without significant mortality risk. A sustained low interest rate environment could adversely impact liabilities and earnings as a result of the minimum credited rate guarantees present in many of these policyholder account balances. We mitigate our risks by applying various ALM strategies. Liabilities for Unit-linked investments are impacted by changes in the fair value of the associated investments, as the return on assets is generally passed directly to the policyholder.MetLife Holdings Life policyholder account balances in this segment are held for retained asset accounts, universal life policies, the fixed account of variable life insurance policies, and funding agreements. For annuities, policyholder account balances are held for fixed deferred annuities, the fixed account portion of variable annuities, non-life contingent income annuities, and embedded derivatives related to variable annuity guarantees. Interest is credited to the policyholder’s account at interest rates we determine which are influenced by current market rates, subject to specified minimums. A sustained low interest rate environment could adversely impact liabilities and earnings as a result of the minimum credited rate guarantees present in most of these policyholder account balances. We have various interest rate derivative positions to partially mitigate the risks associated with such a scenario. Additionally, for our other products, policyholder account balances are held for variable annuity guarantees assumed from a former operating joint venture in Japan that are accounted for as embedded derivatives.The table below presents the breakdown of account value subject to minimum guaranteed crediting rates for the MetLife Holdings segment: December 31, 2020Guaranteed Minimum Crediting Rate AccountValue AccountValue atGuarantee (In millions)Greater than 0% but less than 2%$1,280 $1,238 Equal to or greater than 2% but less than 4%$17,806 $16,074 Equal to or greater than 4%$7,619 $6,789 114Table of ContentsVariable Annuity GuaranteesWe issue, directly and through assumed business, certain variable annuity products with guaranteed minimum benefits that provide the policyholder a minimum return based on their initial deposit (i.e., the benefit base) less withdrawals. In some cases, the benefit base may be increased by additional deposits, bonus amounts, accruals or optional market value resets. See Notes 1 and 4 of the Notes to the Consolidated Financial Statements for additional information.Certain guarantees, including portions thereof, have insurance liabilities established that are included in future policy benefits. Guarantees accounted for in this manner include GMDBs, the life-contingent portion of GMWBs, elective GMIB annuitizations, and the life contingent portion of GMIBs that require annuitization when the account balance goes to zero. These liabilities are accrued over the life of the contract in proportion to actual and future expected policy assessments based on the level of guaranteed minimum benefits generated using multiple scenarios of separate account returns. The scenarios are based on best estimate assumptions consistent with those used to amortize DAC. When current estimates of future benefits exceed those previously projected or when current estimates of future assessments are lower than those previously projected, liabilities will increase, resulting in a current period charge to net income. The opposite result occurs when the current estimates of future benefits are lower than those previously projected or when current estimates of future assessments exceed those previously projected. At the end of each reporting period, we update the actual amount of business remaining in-force, which impacts expected future assessments and the projection of estimated future benefits resulting in a current period charge or increase to earnings.Certain guarantees, including portions thereof, accounted for as embedded derivatives, are recorded at estimated fair value and included in policyholder account balances. Guarantees accounted for as embedded derivatives include GMABs, the non-life contingent portion of GMWBs and certain non-life contingent portions of GMIBs. The estimated fair values of guarantees accounted for as embedded derivatives are determined based on the present value of projected future benefits minus the present value of projected future fees. The projections of future benefits and future fees require capital market and actuarial assumptions, including expectations concerning policyholder behavior. A risk-neutral valuation methodology is used to project the cash flows from the guarantees under multiple capital market scenarios to determine an economic liability. The reported estimated fair value is then determined by taking the present value of these risk-free generated cash flows using a discount rate that incorporates a spread over the risk-free rate to reflect our nonperformance risk and adding a risk margin. For more information on the determination of estimated fair value, see Note 10 of the Notes to the Consolidated Financial Statements.The table below presents the carrying value for guarantees at: Future PolicyBenefitsPolicyholderAccount Balances December 31,December 31, 2020201920202019 (In millions)AsiaGMDB$6 $3 $— $— GMAB— — 26 34 GMWB35 34 134 143 EMEAGMDB6 3 — — GMAB— — 31 25 GMWB31 15 (23)(62)MetLife HoldingsGMDB450 335 — — GMIB954 756 323 110 GMAB— — — (1)GMWB179 125 443 375 Total $1,661 $1,271 $934 $624 115Table of ContentsThe carrying amounts for guarantees included in policyholder account balances above include nonperformance risk adjustments of $137 million and $147 million at December 31, 2020 and 2019, respectively. These nonperformance risk adjustments represent the impact of including a credit spread when discounting the underlying risk neutral cash flows to determine the estimated fair values. The nonperformance risk adjustment does not have an economic impact on us as it cannot be monetized given the nature of these policyholder liabilities. The change in valuation arising from the nonperformance risk adjustment is not hedged.The carrying values of these guarantees can change significantly during periods of sizable and sustained shifts in equity market performance, equity volatility, interest rates or foreign currency exchange rates. Carrying values are also impacted by our assumptions around mortality, separate account returns and policyholder behavior, including lapse rates.As discussed below, we use a combination of product design, hedging strategies, reinsurance, and other risk management actions to mitigate the risks related to these benefits. Within each type of guarantee, there is a range of product offerings reflecting the changing nature of these products over time. Changes in product features and terms are in part driven by customer demand but, more importantly, reflect our risk management practices of continuously evaluating the guaranteed benefits and their associated asset-liability matching. We continue to diversify the concentration of income benefits in our portfolio by focusing on withdrawal benefits, variable annuities without living benefits and index-linked annuities.The sections below provide further detail by total account value for certain of our most popular guarantees. Total account values include amounts not reported on the consolidated balance sheets from assumed business, Unit-linked investments that do not qualify for presentation as separate account assets, and amounts included in our general account. The total account values and the net amounts at risk include direct and assumed business, but exclude offsets from hedging or ceded reinsurance, if any.GMDBsWe offer a range of GMDBs to our contractholders. The table below presents GMDBs, by benefit type, at December 31, 2020:Total Account Value (1)Asia & EMEAMetLife Holdings (In millions)Return of premium or five to seven year step-up$8,075 $48,037 Annual step-up— 3,209 Roll-up and step-up combination— 5,617 Total$8,075 $56,863 __________________(1)Total account value excludes $603 million for contracts with no GMDBs. The Company’s annuity contracts with guarantees may offer more than one type of guarantee in each contract. Therefore, the amounts listed for GMDBs and for living benefit guarantees are not mutually exclusive.Based on total account value, less than 18% of our GMDBs included enhanced death benefits such as the annual step-up or roll-up and step-up combination products at December 31, 2020.116Table of ContentsLiving Benefit Guarantees The table below presents our living benefit guarantees based on total account values at December 31, 2020: Total Account Value (1)Asia & EMEAMetLife Holdings (In millions)GMIB$— $21,229 GMWB - non-life contingent (2)1,153 2,397 GMWB - life-contingent3,494 9,235 GMAB1,879 186 Total$6,526 $33,047 __________________(1)Total account value excludes $26.0 billion for contracts with no living benefit guarantees. The Company’s annuity contracts with guarantees may offer more than one type of guarantee in each contract. Therefore, the amounts listed for GMDBs and for living benefit guarantee amounts are not mutually exclusive.(2)The Asia and EMEA segments include the non-life contingent portion of the GMWB total account value of $1.2 billion with a guarantee at annuitization.In terms of total account value, GMIBs are our most significant living benefit guarantee. Our primary risk management strategy for our GMIB products is our derivatives hedging program as discussed below. Additionally, we have engaged in certain reinsurance agreements covering some of our GMIB business. As part of our overall risk management approach for living benefit guarantees, we continually monitor the reinsurance markets for the right opportunity to purchase additional coverage for our GMIB business. We stopped selling GMIBs in February 2016.The table below presents our GMIB associated total account values, by their guaranteed payout basis, at December 31, 2020: Total Account Value (In millions)7-year setback, 2.5% interest rate$6,249 7-year setback, 1.5% interest rate1,008 10-year setback, 1.5% interest rate4,282 10-year mortality projection, 10-year setback, 1.0% interest rate8,234 10-year mortality projection, 10-year setback, 0.5% interest rate1,456 $21,229 The annuitization interest rates on GMIBs have been decreased from 2.5% to 0.5% over time, partially in response to the low interest rate environment, accompanied by an increase in the setback period from seven years to 10 years and the introduction of a 10-year mortality projection.Additionally, 40% of the $21.2 billion of GMIB total account value has been invested in managed volatility funds as of December 31, 2020. These funds seek to manage volatility by adjusting the fund holdings within certain guidelines based on capital market movements. Such activity reduces the overall risk of the underlying funds while maintaining their growth opportunities. These risk mitigation techniques reduce or eliminate the need for us to manage the funds’ volatility through hedging or reinsurance.Our GMIB products typically have a waiting period of 10 years to be eligible for annuitization. As of December 31, 2020, only 26% of our contracts with GMIBs were eligible for annuitization. The remaining contracts are not eligible for annuitization for an average of three years.117Table of ContentsOnce eligible for annuitization, contractholders would be expected to annuitize only if their contracts were in-the-money. We calculate in-the-moneyness with respect to GMIBs consistent with net amount at risk as discussed in Note 4 of the Notes to the Consolidated Financial Statements, by comparing the contractholders’ income benefits based on total account values and current annuity rates versus the guaranteed income benefits. The net amount at risk was $614 million at December 31, 2020, of which $552 million was related to GMIBs. For those contracts with GMIB, the table below presents details of contracts that are in-the-money and out-of-the-money at December 31, 2020:In-the-MoneynessTotal Account Value% of Total (In millions) In-the-money30% or greater$549 3 %20% to less than 30%340 2 %10% to less than 20% 538 2 %0% to less than 10%1,162 5 %2,589 Out-of-the-money-10% to 0%2,319 11 %-20% to less than -10%4,154 20 %Greater than -20%12,167 57 %18,640 Total GMIBs$21,229 Derivatives Hedging Variable Annuity GuaranteesOur risk mitigating hedging strategy uses various OTC and exchange traded derivatives. The table below presents the gross notional amount, estimated fair value and primary underlying risk exposure of the derivatives hedging our variable annuity guarantees: December 31, 20202019Primary Underlying Risk Exposure Gross NotionalEstimated Fair ValueGross NotionalEstimated Fair ValueInstrument TypeAmountAssetsLiabilitiesAmountAssetsLiabilities (In millions)Interest rateInterest rate swaps$14,188 $85 $21 $8,639 $73 $16 Interest rate futures1,442 — 2 1,678 3 3 Interest rate options637 134 — 838 209 — Foreign currency exchange rateForeign currency forwards1,834 27 13 1,644 16 24 Currency options— — — 1 — — Equity marketEquity futures4,891 12 38 4,127 5 8 Equity index options5,360 558 408 8,775 473 667 Equity variance swaps716 15 12 1,115 23 19 Equity total return swaps1,533 3 124 761 — 70 Total$30,601 $834 $618 $27,578 $802 $807 The change in estimated fair values of our derivatives is recorded in policyholder benefits and claims if such derivatives are hedging guarantees included in future policy benefits, and in net derivative gains (losses) if such derivatives are hedging guarantees included in policyholder account balances.Our hedging strategy involves the significant use of static longer-term derivative instruments to avoid the need to execute transactions during periods of market disruption or higher volatility. We continually monitor the capital markets for opportunities to adjust our liability coverage, as appropriate. Futures are also used to dynamically adjust the daily coverage levels as markets and liability exposures fluctuate.118Table of ContentsWe remain liable for the guaranteed benefits in the event that reinsurers or derivative counterparties are unable or unwilling to pay. Certain of our reinsurance agreements and all derivative positions are collateralized and derivatives positions are subject to master netting agreements, both of which significantly reduce the exposure to counterparty risk. In addition, we are subject to the risk that hedging and other risk management actions prove ineffective or that unanticipated policyholder behavior or mortality, combined with adverse market events, produces economic losses beyond the scope of the risk management techniques employed.Liquidity and Capital ResourcesOverviewOur business and results of operations are materially affected by conditions in the global capital markets and the economy generally. Stressed conditions, volatility and disruptions in global capital markets, particular markets, or financial asset classes can have an adverse effect on us, in part because we have a large investment portfolio and our insurance liabilities and derivatives are sensitive to changing market factors. Changing conditions in the global capital markets and the economy may affect our financing costs and market interest for our debt or equity securities. For further information regarding market factors that could affect our ability to meet liquidity and capital needs, see “— Industry Trends” and “— Investments — Current Environment.”Liquidity ManagementBased upon the strength of our franchise, diversification of our businesses, strong financial fundamentals and the substantial funding sources available to us as described herein, we continue to believe we have access to ample liquidity to meet business requirements under current market conditions and reasonably possible stress scenarios. We continuously monitor and adjust our liquidity and capital plans for MetLife, Inc. and its subsidiaries in light of market conditions, as well as changing needs and opportunities.Short-term LiquidityWe maintain a substantial short-term liquidity position, which was $9.4 billion and $9.8 billion at December 31, 2020 and 2019, respectively. Short-term liquidity includes cash and cash equivalents and short-term investments, excluding assets that are pledged or otherwise committed, including amounts received in connection with securities lending, repurchase agreements, derivatives, and secured borrowings, as well as amounts held in the closed block. Liquid AssetsAn integral part of our liquidity management includes managing our level of liquid assets, which was $235.1 billion and $221.4 billion at December 31, 2020 and 2019, respectively. Liquid assets include cash and cash equivalents, short-term investments and publicly-traded securities, excluding assets that are pledged or otherwise committed. Assets pledged or otherwise committed include amounts received in connection with securities lending, repurchase agreements, derivatives, regulatory deposits, the collateral financing arrangement, funding agreements and secured borrowings, as well as amounts held in the closed block.Capital ManagementWe have established several senior management committees as part of our capital management process. These committees, including the Capital Management Committee and the Enterprise Risk Committee (“ERC”), regularly review actual and projected capital levels (under a variety of scenarios including stress scenarios) and our annual capital plan in accordance with our capital policy. The Capital Management Committee is comprised of members of senior management, including MetLife, Inc.’s Chief Financial Officer (“CFO”), Treasurer, and Chief Risk Officer (“CRO”). The ERC is also comprised of members of senior management, including MetLife, Inc.’s CFO, CRO and Chief Investment Officer.Our Board of Directors and senior management are directly involved in the development and maintenance of our capital policy. The capital policy sets forth, among other things, minimum and target capital levels and the governance of the capital management process. All capital actions, including proposed changes to the annual capital plan, capital targets or capital policy, are reviewed by the Finance and Risk Committee of the Board of Directors prior to obtaining full Board of Directors approval. The Board of Directors approves the capital policy and the annual capital plan and authorizes capital actions, as required.See “Risk Factors — Capital Risks — We May not be Able to Pay Dividends or Repurchase Our Stock Due to Legal and Regulatory Restrictions or Cash Buffer Needs” for information regarding restrictions on payment of dividends and stock repurchases. See also Note 16 of the Notes to the Consolidated Financial Statements for information regarding MetLife, Inc.’s common stock repurchase authorizations.119Table of ContentsThe CompanyLiquidityLiquidity refers to the ability to generate adequate amounts of cash to meet our needs. We determine our liquidity needs based on a rolling 12-month forecast by portfolio of invested assets which we monitor daily. We adjust the asset mix and asset maturities based on this rolling 12-month forecast. To support this forecast, we conduct cash flow and stress testing, which include various scenarios of the potential risk of early contractholder and policyholder withdrawal. We include provisions limiting withdrawal rights on many of our products, including general account pension products sold to employee benefit plan sponsors. Certain of these provisions prevent the customer from making withdrawals prior to the maturity date of the product. In the event of significant cash requirements beyond anticipated liquidity needs, we have various alternatives available depending on market conditions and the amount and timing of the liquidity need. These available alternatives include cash flows from operations, sales of liquid assets, global funding sources including commercial paper and various credit and committed facilities.Under certain stressful market and economic conditions, our access to liquidity may deteriorate, or the cost to access liquidity may increase. A downgrade in our credit or financial strength ratings could also negatively affect our liquidity. See “— Rating Agencies.” If we require significant amounts of cash on short notice in excess of anticipated cash requirements or if we are required to post or return cash collateral in connection with derivatives or our securities lending program, we may have difficulty selling investments in a timely manner, be forced to sell them for less than we otherwise would have been able to realize, or both. In addition, in the event of such forced sale, for securities in an unrealized loss position, realized losses would be incurred on securities sold and impairments would be incurred, if there is a need to sell securities prior to recovery, which may negatively impact our financial condition. See “Risk Factors — Investment Risks — We May Have Difficulty Selling Holdings in Our Investment Portfolio or in Our Securities Lending Program in a Timely Manner to Realize Their Full Value.”All general account assets within a particular legal entity — other than those which may have been pledged to a specific purpose — are generally available to fund obligations of the general account of that legal entity.CapitalWe manage our capital position to maintain our financial strength and credit ratings. See “— Rating Agencies” for information regarding such ratings. Our capital position is supported by our ability to generate strong cash flows within our operating companies and borrow funds at competitive rates, as well as by our demonstrated ability to raise additional capital to meet operating and growth needs despite adverse market and economic conditions.Statutory Capital and DividendsOur U.S. insurance subsidiaries have statutory surplus well above levels to meet current regulatory requirements.RBC requirements are used as minimum capital requirements by the NAIC and the state insurance departments to identify companies that merit regulatory action. RBC is based on a formula calculated by applying factors to various asset, premium, claim, expense and statutory reserve items. The formula takes into account the risk characteristics of the insurer, including asset risk, insurance risk, interest rate risk, market risk and business risk and is calculated on an annual basis. The formula is used as an early warning regulatory tool to identify possible inadequately capitalized insurers for purposes of initiating regulatory action, and not as a means to rank insurers generally. These rules apply to most of our U.S. insurance subsidiaries. State insurance laws provide insurance regulators the authority to require various actions by, or take various actions against, insurers whose total adjusted capital does not meet or exceed certain RBC levels. As of the date of the most recent annual statutory financial statements filed with insurance regulators, the total adjusted capital of each of these subsidiaries subject to these requirements was in excess of each of those RBC levels.As a Delaware corporation, American Life is subject to Delaware law; however, because it does not conduct insurance business in Delaware or any other U.S. state, it is exempt from RBC requirements under Delaware law. American Life’s operations are also regulated by applicable authorities of the jurisdictions in which it operates and is subject to capital and solvency requirements in those jurisdictions.120Table of ContentsThe amount of dividends that our insurance subsidiaries can pay to MetLife, Inc. or to other parent entities is constrained by the amount of surplus we hold to maintain our ratings, which provides an additional margin for risk protection and investment in our businesses. We proactively take actions to maintain capital consistent with these ratings objectives, which may include adjusting dividend amounts and deploying financial resources from internal or external sources of capital. Certain of these activities may require regulatory approval. Furthermore, the payment of dividends and other distributions to MetLife, Inc. and other parent entities by their respective insurance subsidiaries is governed by insurance laws and regulations. See “Business — Regulation — Insurance Regulation,” “— MetLife, Inc. — Liquidity and Capital Sources — Dividends from Subsidiaries” and Note 16 of the Notes to the Consolidated Financial Statements. Affiliated Captive Reinsurance TransactionsMLIC cedes specific policy classes, including term and universal life insurance, participating whole life insurance, LTD insurance, group life insurance and other business to various wholly-owned captive reinsurers. The reinsurance activities among these affiliated companies are eliminated within our consolidated results of operations. The statutory reserves of such affiliated captive reinsurers are supported by a combination of funds withheld assets, investment assets and letters of credit issued by unaffiliated financial institutions. MetLife, Inc. has entered into various support agreements in connection with the activities of these captive reinsurers. See Note 5 of the Notes to the MetLife, Inc. (Parent Company Only) Condensed Financial Information included in Schedule II of the Financial Statement Schedules for further details on certain of these support arrangements. MLIC has entered into reinsurance agreements with affiliated captive reinsurers for risk and capital management purposes, as well as to manage statutory reserve requirements related to universal life and term life insurance policies and other business. The NYDFS continues to have a moratorium on new reserve financing transactions involving captive insurers. We are not aware of any states other than New York and California implementing such a moratorium. While such a moratorium would not impact our existing reinsurance agreements with captive reinsurers, a moratorium placed on the use of captives for new reserve financing transactions could impact our ability to write certain products and/or impact our RBC ratios and ability to deploy excess capital in the future. This could result in our need to increase prices, modify product features or limit the availability of those products to our customers. While this affects insurers across the industry, it could adversely impact our competitive position and our results of operations in the future. We continue to evaluate product modifications, pricing structure and alternative means of managing risks, capital and statutory reserves and we expect the discontinued use of captive reinsurance on new reserve financing transactions would not have a material impact on our future consolidated financial results. See Note 6 of the Notes to the Consolidated Financial Statements for further information on our reinsurance activities.Rating AgenciesRating agencies assign insurer financial strength ratings to MetLife, Inc.’s U.S. life insurance subsidiaries and credit ratings to MetLife, Inc. and certain of its subsidiaries. Financial strength ratings represent the opinion of rating agencies regarding the ability of an insurance company to pay obligations under insurance policies and contracts in accordance with their terms and are not evaluations directed toward the protection of investors in MetLife, Inc.’s securities. Insurer financial strength ratings are not statements of fact nor are they recommendations to purchase, hold or sell any security, contract or policy. Each rating should be evaluated independently of any other rating.Rating agencies use an “outlook statement” of “positive,” “stable,” ‘‘negative’’ or “developing” to indicate a medium- or long-term trend in credit fundamentals which, if continued, may lead to a rating change. A rating may have a “stable” outlook to indicate that the rating is not expected to change; however, a “stable” rating does not preclude a rating agency from changing a rating at any time, without notice. Certain rating agencies assign rating modifiers such as “CreditWatch” or “under review” to indicate their opinion regarding the potential direction of a rating. These ratings modifiers are generally assigned in connection with certain events such as potential mergers, acquisitions, dispositions or material changes in a company’s results, in order for the rating agency to perform its analysis to fully determine the rating implications of the event.121Table of ContentsOur insurer financial strength ratings at the date of this filing are indicated in the following table. Outlook is stable unless otherwise indicated. Additional information about financial strength ratings can be found on the websites of the respective rating agencies.A.M. BestFitchMoody’sS&PRatings Structure“A++ (superior)”to “S (suspended)”“AAA(exceptionallystrong)” to “C(distressed)”“Aaa (highestquality)” to “C(lowest rated)”“AAA (extremelystrong)” to “SD(SelectiveDefault)” or “D(Default)”American Life Insurance Company NRNRA1AA-5th of 214th of 22Metropolitan Life Insurance Company A+AA-Aa3AA-2nd of 164th of 194th of 214th of 22MetLife Insurance K.K. (MetLife Japan)NRNRNRAA-4th of 22Metropolitan Tower Life Insurance Company A+AA-Aa3AA-2nd of 164th of 194th of 214th of 22 __________________ NR = Not ratedCredit ratings indicate the rating agency’s opinion regarding a debt issuer’s ability to meet the terms of debt obligations in a timely manner. They are important factors in our overall funding profile and ability to access certain types of liquidity. The level and composition of regulatory capital at the subsidiary level and our equity capital are among the many factors considered in determining our insurer financial strength ratings and credit ratings. Each agency has its own capital adequacy evaluation methodology, and assessments are generally based on a combination of factors. In addition to heightening the level of scrutiny that they apply to insurance companies, rating agencies have increased and may continue to increase the frequency and scope of their credit reviews, may request additional information from the companies that they rate and may adjust upward the capital and other requirements employed in the rating agency models for maintenance of certain ratings levels.A downgrade in the credit ratings or insurer financial strength ratings of MetLife, Inc. or its subsidiaries would likely impact us in the following ways, including:•impact our ability to generate cash flows from the sale of funding agreements and other capital market products offered by our RIS business;•impact the cost and availability of financing for MetLife, Inc. and its subsidiaries; and•result in additional collateral requirements or other required payments under certain agreements, which are eligible to be satisfied in cash or by posting investments held by the subsidiaries subject to the agreements. See “— Liquidity and Capital Uses — Pledged Collateral.”See also “Risk Factors — Economic Environment and Capital Markets Risks — We May Lose Business Due to a Downgrade or a Potential Downgrade in Our Financial Strength or Credit Ratings.”122Table of ContentsSummary of the Company’s Primary Sources and Uses of Liquidity and CapitalOur primary sources and uses of liquidity and capital are summarized as follows:Years Ended December 31,20202019(In millions)Sources:Operating activities, net$11,639 $13,786 Net change in policyholder account balances8,246 6,524 Net change in payables for collateral under securities loaned and other transactions3,538 2,019 Cash received for other transactions with tenors greater than three months150 125 Long-term debt issued1,124 1,382 Preferred stock issued, net of issuance costs1,961 — Other, net191 — Effect of change in foreign currency exchange rates on cash and cash equivalents163 9 Total sources27,012 23,845 Uses:Investing activities, net18,569 17,586 Cash paid for other transactions with tenors greater than three months175 200 Long-term debt repaid99 906 Collateral financing arrangement repaid148 67 Financing element on certain derivative instruments and other derivative related transactions, net46 126 Treasury stock acquired in connection with share repurchases1,151 2,285 Redemption of preferred stock989 — Preferred stock redemption premium14 — Dividends on preferred stock202 178 Dividends on common stock1,657 1,643 Other, net— 77 Total uses23,050 23,068 Net increase (decrease) in cash and cash equivalents$3,962 $777 Cash Flows from OperationsThe principal cash inflows from our insurance activities come from insurance premiums, net investment income, annuity considerations and deposit funds. The principal cash outflows are the result of various life insurance, property and casualty, annuity and pension products, operating expenses and income tax, as well as interest expense. A primary liquidity concern with respect to these cash flows is the risk of early contractholder and policyholder withdrawal.Cash Flows from InvestmentsThe principal cash inflows from our investment activities come from repayments of principal, proceeds from maturities and sales of investments and settlements of freestanding derivatives. The principal cash outflows relate to purchases of investments, issuances of policy loans and settlements of freestanding derivatives. Additional cash outflows relate to purchases of businesses. We typically have a net cash outflow from investing activities because cash inflows from insurance operations are reinvested in accordance with our ALM discipline to fund insurance liabilities. We closely monitor and manage these risks through our comprehensive investment risk management process. The primary liquidity concerns with respect to these cash flows are the risk of default by debtors and market disruption.123Table of ContentsCash Flows from FinancingThe principal cash inflows from our financing activities come from issuances of debt and other securities, deposits of funds associated with policyholder account balances and lending of securities. The principal cash outflows come from repayments of debt and the collateral financing arrangement, payments of dividends on and repurchases or redemptions of MetLife, Inc.’s securities, withdrawals associated with policyholder account balances and the return of securities on loan. The primary liquidity concerns with respect to these cash flows are market disruption and the risk of early contractholder and policyholder withdrawal.Liquidity and Capital SourcesIn addition to the general description of liquidity and capital sources in “— Summary of the Company’s Primary Sources and Uses of Liquidity and Capital,” the Company’s primary sources of liquidity and capital are set forth below.Global Funding SourcesLiquidity is provided by a variety of global funding sources, including funding agreements, credit and committed facilities and commercial paper. Capital is provided by a variety of global funding sources, including short-term and long-term debt, the collateral financing arrangement, junior subordinated debt securities, preferred securities, equity securities and equity-linked securities. MetLife, Inc. maintains a shelf registration statement with the SEC that permits the issuance of public debt, equity and hybrid securities. As a “Well-Known Seasoned Issuer” under SEC rules, MetLife, Inc.’s shelf registration statement provides for automatic effectiveness upon filing and has no stated issuance capacity. The diversity of our global funding sources enhances our funding flexibility, limits dependence on any one market or source of funds and generally lowers the cost of funds. Our primary global funding sources include:Preferred StockSee Note 16 of the Notes to the Consolidated Financial Statements for information on preferred stock issuances.Common StockSee Note 16 of the Notes to the Consolidated Financial Statements.Commercial Paper, Reported in Short-term DebtMetLife, Inc. and MetLife Funding each have a commercial paper program that is supported by our unsecured revolving credit facility (see “— Credit and Committed Facilities”). MetLife Funding raises cash from its commercial paper program and uses the proceeds to extend loans through MetLife Credit Corp., another subsidiary of MLIC, to affiliates in order to enhance the financial flexibility and liquidity of these companies.FHLB Funding Agreements, Reported in Policyholder Account BalancesCertain of our U.S. insurance subsidiaries are members of a regional FHLB. For the years ended December 31, 2020 and 2019, we issued $35.4 billion and $33.0 billion, respectively, and repaid $34.5 billion and $32.8 billion, respectively, of funding agreements with certain regional FHLBs. At December 31, 2020 and 2019, total obligations outstanding under these funding agreements were $16.3 billion and $15.3 billion, respectively. See Note 4 of the Notes to the Consolidated Financial Statements.FHLB Advance Agreements, Reported in Payables for Collateral Under Securities Loaned and Other TransactionsFor the years ended December 31, 2020 and 2019, we borrowed $2.8 billion and $3.0 billion, respectively, and repaid $2.9 billion and $3.0 billion, respectively, under advance agreements with the FHLB of Boston. At December 31, 2020, total obligations outstanding under these advance agreements were $700 million and reported in liabilities held-for-sale. At December 31, 2019, total obligations outstanding under these advance agreements were $800 million and reported in payables for collateral under securities loaned and other transactions. See Note 3 of the Notes to the Consolidated Financial Statements for information on the pending disposition of MetLife P&C.124Table of ContentsSpecial Purpose Entity Funding Agreements, Reported in Policyholder Account BalancesWe issue fixed and floating rate funding agreements which are denominated in either U.S. dollars or foreign currencies, to certain unconsolidated special purpose entities that have issued either debt securities or commercial paper for which payment of interest and principal is secured by such funding agreements. For the years ended December 31, 2020 and 2019, we issued $40.4 billion and $37.3 billion, respectively, and repaid $36.7 billion and $36.4 billion, respectively, under such funding agreements. At December 31, 2020 and 2019, total obligations outstanding under these funding agreements were $39.9 billion and $34.6 billion, respectively. See Note 4 of the Notes to the Consolidated Financial Statements.Federal Agricultural Mortgage Corporation Funding Agreements, Reported in Policyholder Account BalancesWe have issued funding agreements to a subsidiary of Farmer Mac which are secured by a pledge of certain eligible agricultural mortgage loans. For the years ended December 31, 2020 and 2019, we issued $250 million and $700 million, respectively, and repaid $425 million and $700 million, respectively, under such funding agreements. At December 31, 2020 and 2019, total obligations outstanding under these funding agreements were $2.4 billion and $2.6 billion, respectively. See Note 4 of the Notes to the Consolidated Financial Statements.Debt IssuancesSee “— Liquidity and Capital Uses — Debt Repurchases, Redemptions and Exchanges” and Note 13 of the Notes to the Consolidated Financial Statements for information on senior note redemptions and issuances.Credit and Committed FacilitiesSee Note 13 of the Notes to the Consolidated Financial Statements for information on credit and committed facilities.We have no reason to believe that our lending counterparties will be unable to fulfill their respective contractual obligations under these facilities. As commitments under our credit and committed facilities may expire unused, these amounts do not necessarily reflect our actual future cash funding requirements.Outstanding Debt Under Global Funding SourcesThe following table summarizes our outstanding debt excluding long-term debt relating to CSEs at: December 31, 20202019 (In millions)Short-term debt (1)$393 $235 Long-term debt (2)$14,598 $13,461 Collateral financing arrangement$845 $993 Junior subordinated debt securities$3,153 $3,150 __________________(1)Includes $293 million and $136 million of debt that is non-recourse to MetLife, Inc. and MLIC, subject to customary exceptions, at December 31, 2020 and 2019, respectively. Certain subsidiaries have pledged assets to secure this debt.(2)Includes $474 million and $403 million of debt that is non-recourse to MetLife, Inc. and MLIC, subject to customary exceptions, at December 31, 2020 and 2019, respectively. Certain investment subsidiaries have pledged assets to secure this debt.Debt and Facility CovenantsCertain of our debt instruments and committed facilities, as well as our unsecured revolving credit facility, contain various administrative, reporting, legal and financial covenants. We believe we were in compliance with all applicable financial covenants at December 31, 2020.DispositionsFor information regarding pending and other dispositions, see Note 3 of the Notes to the Consolidated Financial Statements.125Table of ContentsLiquidity and Capital UsesIn addition to the general description of liquidity and capital uses in “— Summary of the Company’s Primary Sources and Uses of Liquidity and Capital” and “— Contractual Obligations,” the Company’s primary uses of liquidity and capital are set forth below.Preferred Stock RedemptionSee Note 16 of the Notes to the Consolidated Financial Statements for information about the partial redemption of Series C preferred stock.Common Stock RepurchasesSee Note 16 of the Notes to the Consolidated Financial Statements for information relating to authorizations by the Board of Directors to repurchase MetLife, Inc. common stock, amounts of common stock repurchased pursuant to such authorizations for the years ended December 31, 2020 and 2019, and the amount remaining under such authorizations at December 31, 2020. Common stock repurchases are subject to the discretion of our Board of Directors and will depend upon our capital position, liquidity, financial strength and credit ratings, general market conditions, the market price of MetLife, Inc.’s common stock compared to management’s assessment of the stock’s underlying value, applicable regulatory approvals, and other legal and accounting factors. Restrictions on the payment of dividends that may arise under so-called “Dividend Stopper” provisions would also restrict MetLife, Inc.’s ability to repurchase common stock. See “— Dividends” for information about these restrictions. See also “Risk Factors — Capital Risks — We May not be Able to Pay Dividends or Repurchase Our Stock Due to Legal and Regulatory Restrictions or Cash Buffer Needs.”DividendsFor the years ended December 31, 2020 and 2019, MetLife, Inc. paid dividends on its preferred stock of $202 million and $178 million, respectively. For the years ended December 31, 2020 and 2019, MetLife, Inc. paid dividends on its common stock of $1.7 billion and $1.6 billion, respectively. See Note 16 of the Notes to the Consolidated Financial Statements for information regarding the calculation and timing of these dividend payments.The declaration and payment of common stock dividends are subject to the discretion of our Board of Directors, and will depend on MetLife, Inc.’s financial condition, results of operations, cash requirements, future prospects, regulatory restrictions on the payment of dividends by MetLife, Inc.’s insurance subsidiaries and other factors deemed relevant by the Board. “Dividend Stopper” Provisions in MetLife’s Preferred Stock and Junior Subordinated DebenturesMetLife, Inc.’s preferred stock and junior subordinated debentures contain “dividend stopper” provisions under which MetLife, Inc. may not pay dividends on instruments junior to those instruments if payments have not been made on those instruments. Moreover, MetLife, Inc.’s Series A preferred stock and its junior subordinated debentures contain provisions that would limit the payment of dividends or interest on those instruments if MetLife, Inc. fails to meet certain tests (“Trigger Events”), to an amount not greater than the net proceeds from sales of common stock and other specified instruments during a period preceding the dividend declaration date or the interest payment date, as applicable. If such proceeds were under the circumstances insufficient to make such payments on those instruments, the dividend stopper provisions affecting common stock (and preferred stock, as applicable) would come into effect.A “Trigger Event” would occur if:•the RBC ratio of MetLife’s largest U.S. insurance subsidiaries in the aggregate (as defined in the applicable instrument) were to be less than 175% of the company action level based on the subsidiaries’ prior year annual financial statements filed (generally around March 1) with state insurance commissioners; or•at the end of a quarter (“Final Quarter End Test Date”), consolidated GAAP net income for the four-quarter period ending two quarters before such quarter-end (the “Preliminary Quarter End Test Date”) is zero or a negative amount and the consolidated GAAP stockholders’ equity, minus AOCI (the “adjusted stockholders’ equity amount”), as of the Final Quarter End Test Date and the Preliminary Quarter End Test Date, declined by 10% or more from its level 10 quarters before the Final Quarter End Test Date (the “Benchmark Quarter End Test Date”). 126Table of ContentsOnce a Trigger Event occurs for a Final Quarter End Test Date, the suspension of payments of dividends and interest (in the absence of sufficient net proceeds from the issuance of certain securities during specified periods) would continue until there is no Trigger Event at a subsequent Final Quarter End Test Date, and, if the test in the second paragraph above caused the Trigger Event, the adjusted stockholders’ equity amount is no longer 10% or more below its level at the Benchmark Quarter End Test Date that is associated with the Trigger Event. In the case of successive Trigger Events, the suspension would continue until MetLife satisfies these conditions for each of the Trigger Events.The junior subordinated debentures further provide that MetLife, Inc. may, at its option and provided that certain conditions are met, elect to defer payment of interest. See Note 15 of the Notes to the Consolidated Financial Statements. Any such elective deferral would trigger the dividend stopper provisions.Further, MetLife, Inc. is a party to certain replacement capital covenants which limit its ability to eliminate these restrictions through the repayment, redemption or purchase of the junior subordinated debentures by requiring MetLife, Inc., with some limitations, to receive cash proceeds during a specified period from the sale of specified replacement securities prior to any repayment, redemption or purchase. See Note 15 of the Notes to the Consolidated Financial Statements for a description of such covenants.Debt RepaymentsFor the years ended December 31, 2020 and 2019, following regulatory approval, MetLife Reinsurance Company of Charleston, a wholly-owned subsidiary of MetLife, Inc., repurchased and canceled $148 million and $67 million, respectively, in aggregate principal amount of its surplus notes, which were reported in collateral financing arrangement on the consolidated balance sheets. See Notes 13 and 14 of the Notes to the Consolidated Financial Statements for further information on long-term and short-term debt and the collateral financing arrangement, respectively.Debt Repurchases, Redemptions and ExchangesWe may from time to time seek to retire or purchase our outstanding debt through cash purchases, redemptions and/or exchanges for other securities, in open market purchases, privately negotiated transactions or otherwise. Any such repurchases, redemptions, or exchanges will be dependent upon several factors, including our liquidity requirements, contractual restrictions, general market conditions, and applicable regulatory, legal and accounting factors. Whether or not to repurchase or redeem any debt and the size and timing of any such repurchases or redemptions will be determined at our discretion.See Note 13 of the Notes to the Consolidated Financial Statements for further information on the redemption and cancellation of senior notes.Support AgreementsMetLife, Inc. and several of its subsidiaries (each, an “Obligor”) are parties to various capital support commitments and guarantees with subsidiaries. Under these arrangements, each Obligor has agreed to cause the applicable entity to meet specified capital and surplus levels or has guaranteed certain contractual obligations. We anticipate that in the event these arrangements place demands upon us, there will be sufficient liquidity and capital to enable us to meet such demands. See Note 5 of the Notes to the MetLife, Inc. (Parent Company Only) Condensed Financial Information included in Schedule II of the Financial Statement Schedules.Insurance LiabilitiesLiabilities arising from our insurance activities primarily relate to benefit payments under various life insurance, property and casualty, annuity and group pension products, as well as payments for policy surrenders, withdrawals and loans. For annuity or deposit type products, surrender or lapse behavior differs somewhat by segment. In the MetLife Holdings segment, which includes individual annuities, lapses and surrenders tend to occur in the normal course of business. For the years ended December 31, 2020 and 2019, general account surrenders and withdrawals from annuity products were $1.3 billion and $1.8 billion, respectively. In the RIS business within the U.S. segment, which includes pension risk transfers, bank-owned life insurance and other fixed annuity contracts, as well as funding agreements and other capital market products, most of the products offered have fixed maturities or fairly predictable surrenders or withdrawals. With regard to the RIS business products that provide customers with limited rights to accelerate payments, at December 31, 2020, there were funding agreements totaling $132 million that could be put back to the Company.127Table of ContentsPledged CollateralWe pledge collateral to, and have collateral pledged to us by, counterparties in connection with our derivatives. At December 31, 2020 and 2019, we had received pledged cash collateral from counterparties of $7.6 billion and $6.3 billion, respectively. At December 31, 2020 and 2019, we had pledged cash collateral to counterparties of $266 million and $275 million, respectively. See Note 9 of the Notes to the Consolidated Financial Statements for additional information about collateral pledged to us, collateral we pledge and derivatives subject to credit contingent provisions. We pledge collateral and have had collateral pledged to us, and may be required from time to time to pledge additional collateral or be entitled to have additional collateral pledged to us, in connection with the collateral financing arrangement related to the reinsurance of closed block liabilities. See Note 14 of the Notes to the Consolidated Financial Statements.We pledge collateral from time to time in connection with funding agreements and advance agreements. See Note 4 of the Notes to the Consolidated Financial Statements.Securities Lending and Repurchase AgreementsWe participate in a securities lending program and in short-term repurchase agreements whereby securities are loaned to unaffiliated financial institutions. We obtain collateral, usually cash, from the borrower, which must be returned to the borrower when the loaned securities are returned to us. Through these arrangements, we were liable for cash collateral under our control of $21.8 billion and $19.7 billion at December 31, 2020 and 2019, respectively, including a portion that may require the immediate return of cash collateral we hold. See Note 8 of the Notes to the Consolidated Financial Statements.LitigationWe establish liabilities for litigation and regulatory loss contingencies when it is probable that a loss has been incurred and the amount of the loss can be reasonably estimated. For material matters where a loss is believed to be reasonably possible but not probable, no accrual is made but we disclose the nature of the contingency and an aggregate estimate of the reasonably possible range of loss in excess of amounts accrued, when such an estimate can be made. It is not possible to predict the ultimate outcome of all pending investigations and legal proceedings. In some of the matters referred to herein, very large and/or indeterminate amounts, including punitive and treble damages, are sought. Given the large and/or indeterminate amounts sought in certain of these matters and the inherent unpredictability of litigation, it is possible that an adverse outcome in certain matters could, from time to time, have a material adverse effect on our consolidated net income or cash flows in particular quarterly or annual periods. See Note 21 of the Notes to the Consolidated Financial Statements.AcquisitionsSee Note 3 of the Notes to the Consolidated Financial Statements for information regarding the acquisition of Versant Health.Contractual ObligationsThe following table summarizes our major contractual obligations at December 31, 2020:TotalOne Yearor LessMore thanOne Year toThree YearsMore thanThree Yearsto Five YearsMore than Five Years (In millions)Insurance liabilities$354,749 $22,197 $12,088 $13,046 $307,418 Policyholder account balances250,482 32,419 30,454 16,703 170,906 Payables for collateral under securities loaned and other transactions29,475 29,475 — — — Debt32,052 1,423 3,428 4,986 22,215 Investment commitments11,735 11,408 308 17 2 Operating leases1,675 283 457 382 553 Other18,222 17,848 — — 374 Total$698,390 $115,053 $46,735 $35,134 $501,468 128Table of ContentsInsurance LiabilitiesInsurance liabilities include future policy benefits, other policy-related balances, policyholder dividends payable and the policyholder dividend obligation, which are all reported on the consolidated balance sheet and are more fully described in Notes 1 and 4 of the Notes to the Consolidated Financial Statements. The amounts presented reflect future estimated cash payments and (i) are based on mortality, morbidity, lapse and other assumptions comparable with our experience and expectations of future payment patterns; and (ii) consider future premium receipts on current policies in-force. All estimated cash payments presented are undiscounted as to interest, net of estimated future premiums on in-force policies and gross of any reinsurance recoverable. Payment of amounts related to policyholder dividends left on deposit are projected based on assumptions of policyholder withdrawal activity. Because the exact timing and amount of the ultimate policyholder dividend obligation is subject to significant uncertainty and the amount of the policyholder dividend obligation is based upon a long-term projection of the performance of the closed block, we have reflected the obligation at the amount of the liability, if any, presented on the consolidated balance sheet in the more than five years category. Additionally, the more than five years category includes estimated payments due for periods extending for more than 100 years.The sum of the estimated cash flows of $354.7 billion exceeds the liability amounts of $227.3 billion included on the consolidated balance sheet principally due to (i) the time value of money, which accounts for a substantial portion of the difference; (ii) differences in assumptions, most significantly mortality, between the date the liabilities were initially established and the current date; and (iii) liabilities related to accounting conventions, or which are not contractually due, which are excluded.Actual cash payments may differ significantly from the liabilities as presented on the consolidated balance sheet and the estimated cash payments as presented due to differences between actual experience and the assumptions used in the establishment of these liabilities and the estimation of these cash payments.For the majority of our insurance operations, estimated contractual obligations for future policy benefits and policyholder account balances, as presented, are derived from the annual asset adequacy analysis used to develop actuarial opinions of statutory reserve adequacy for state regulatory purposes. These cash flows are materially representative of the cash flows under GAAP. See “— Policyholder Account Balances.”Policyholder Account BalancesSee Notes 1 and 4 of the Notes to the Consolidated Financial Statements for a description of the components of policyholder account balances. See “— Insurance Liabilities” regarding the source and uncertainties associated with the estimation of the contractual obligations related to future policy benefits and policyholder account balances.Amounts presented represent the estimated cash payments undiscounted as to interest and including assumptions related to the receipt of future premiums and deposits; withdrawals, including unscheduled or partial withdrawals; policy lapses; surrender charges; annuitization; mortality; future interest credited; policy loans and other contingent events as appropriate for the respective product type. Such estimated cash payments are also presented net of estimated future premiums on policies currently in-force and gross of any reinsurance recoverable. For obligations denominated in foreign currencies, cash payments have been estimated using current spot foreign currency rates.The sum of the estimated cash flows of $250.5 billion exceeds the liability amount of $205.2 billion included on the consolidated balance sheet principally due to (i) the time value of money, which accounts for a substantial portion of the difference; (ii) differences in assumptions, between the date the liabilities were initially established and the current date; and (iii) liabilities related to accounting conventions, or which are not contractually due, which are excluded.Payables for Collateral Under Securities Loaned and Other TransactionsWe have accepted cash collateral in connection with securities lending, repurchase agreements, FHLB of Boston short-term advance agreements and derivatives. As these transactions expire within the next year and the timing of the return of the derivatives collateral is uncertain, the return of the collateral has been included in the one year or less category in the table above. We also held non-cash collateral, which is not reflected as a liability on the consolidated balance sheet, of $1.7 billion at December 31, 2020.129Table of ContentsDebtAmounts presented for debt include short-term debt, long-term debt, the collateral financing arrangement and junior subordinated debt securities, the total of which differs from the total of the corresponding amounts presented on the consolidated balance sheet as the amounts presented herein (i) do not include premiums or discounts upon issuance or purchase accounting fair value adjustments; (ii) include future interest on such obligations for the period from January 1, 2021 through maturity; and (iii) do not include long-term debt relating to CSEs at December 31, 2020 as such debt does not represent our contractual obligation. Future interest on variable rate debt was computed using prevailing rates at December 31, 2020 and, as such, does not consider the impact of future rate movements. Future interest on fixed rate debt was computed using the stated rate on the obligations for the period from January 1, 2021 through maturity, except with respect to junior subordinated debt which was computed using the stated rates through the scheduled redemption dates as it is our expectation that such obligations will be redeemed as scheduled. Inclusion of interest payments on junior subordinated debt securities through the final maturity dates would increase the contractual obligation by $7.7 billion. Pursuant to the collateral financing arrangement, MetLife, Inc. may be required to deliver cash or pledge collateral to the unaffiliated financial institution. See Note 14 of the Notes to the Consolidated Financial Statements.Investment CommitmentsTo enhance the return on our investment portfolio, we commit to lend funds under mortgage loans, bank credit facilities, bridge loans and private corporate bond investments and we commit to fund partnership investments. In the table above, the timing of the funding of mortgage loans and private corporate bond investments is based on the expiration dates of the corresponding commitments. As it relates to commitments to fund partnerships and bank credit facilities, we anticipate that these amounts could be invested any time over the next five years; however, as the timing of the fulfillment of the obligation cannot be predicted, such obligations are generally presented in the one year or less category. Commitments to fund bridge loans are short-term obligations and, as a result, are presented in the one year or less category. See Note 21 of the Notes to the Consolidated Financial Statements and “— Off-Balance Sheet Arrangements.”Operating LeasesAs a lessee, we have various operating leases, primarily for office space. Contractual provisions exist that could increase or accelerate those lease obligations presented, including various leases with early buyouts and/or escalation clauses. However, the impact of any such transactions would not be material to our financial position or results of operations. See Note 11 of the Notes to the Consolidated Financial Statements.OtherOther obligations presented are principally comprised of amounts due under reinsurance agreements, payables related to securities purchased but not yet settled, securities sold short, accrued interest on debt obligations, estimated fair value of derivative obligations, deferred compensation arrangements, guaranty liabilities, and accruals and accounts payable due under contractual obligations, which are all reported in other liabilities on the consolidated balance sheet. If the timing of any of these other obligations is sufficiently uncertain, the amounts are included within the one year or less category. Items reported in other liabilities on the consolidated balance sheet that were excluded from the table represent accounting conventions or are not liabilities due under contractual obligations. Unrecognized tax benefits and related accrued interest totaling $323 million were excluded as the timing of payment could not be reliably determined at December 31, 2020.Separate account liabilities are excluded as they are fully funded by cash flows from the corresponding separate account assets and are set equal to the estimated fair value of separate account assets.We also enter into agreements to purchase goods and services in the normal course of business; however, such amounts are excluded as these purchase obligations were not material to our consolidated results of operations or financial position at December 31, 2020.Additionally, we have agreements in place for services we conduct, generally at cost, between subsidiaries relating to insurance, reinsurance, loans and capitalization. Intercompany transactions have been eliminated in consolidation. Intercompany transactions among insurance subsidiaries and affiliates have been approved by the appropriate insurance regulators as required.130Table of ContentsMetLife, Inc.Liquidity and Capital ManagementLiquidity and capital are managed to preserve stable, reliable and cost-effective sources of cash to meet all current and future financial obligations and are provided by a variety of sources, including a portfolio of liquid assets, a diversified mix of short- and long-term funding sources from the wholesale financial markets and the ability to borrow through credit and committed facilities. Liquidity is monitored through the use of internal liquidity risk metrics, including the composition and level of the liquid asset portfolio, timing differences in short-term cash flow obligations, access to the financial markets for capital and debt transactions and exposure to contingent draws on MetLife, Inc.’s liquidity. MetLife, Inc. is an active participant in the global financial markets through which it obtains a significant amount of funding. These markets, which serve as cost-effective sources of funds, are critical components of MetLife, Inc.’s liquidity and capital management. Decisions to access these markets are based upon relative costs, prospective views of balance sheet growth and a targeted liquidity profile and capital structure. A disruption in the financial markets could limit MetLife, Inc.’s access to liquidity.MetLife, Inc.’s ability to maintain regular access to competitively priced wholesale funds is fostered by its current credit ratings from the major credit rating agencies. We view our capital ratios, credit quality, stable and diverse earnings streams, diversity of liquidity sources and our liquidity monitoring procedures as critical to retaining such credit ratings. See “— The Company — Rating Agencies.”LiquidityFor a summary of MetLife, Inc.’s liquidity, see “— The Company — Liquidity.”CapitalFor a summary of MetLife, Inc.’s capital, see “— The Company — Capital.” See also “— The Company — Liquidity and Capital Uses — Common Stock Repurchases” for information regarding MetLife, Inc.’s common stock repurchases.Liquid AssetsAt December 31, 2020 and 2019, MetLife, Inc. and other MetLife holding companies had $4.5 billion and $4.2 billion, respectively, in liquid assets. Of these amounts, $3.6 billion and $3.0 billion were held by MetLife, Inc. and $873 million and $1.2 billion were held by other MetLife holding companies at December 31, 2020 and 2019, respectively. Liquid assets include cash and cash equivalents, short-term investments and publicly-traded securities, excluding assets that are pledged or otherwise committed. Assets pledged or otherwise committed include amounts received in connection with derivatives and a collateral financing arrangement.Liquid assets held in non-U.S. holding companies are generated in part through dividends from non-U.S. insurance operations. Such dividends are subject to local insurance regulatory requirements, as discussed in “— Liquidity and Capital Sources — Dividends from Subsidiaries.” As a result of U.S. Tax Reform, we expect to repatriate future foreign earnings back to the U.S. with minimal or no additional U.S. tax. See Note 19 of the Notes to the Consolidated Financial Statements and “— Risk Factors — Regulatory and Legal Risks — Changes in Laws or Regulation, or in Supervisory and Enforcement Policies, May Reduce Our Profitability, Limit Our Growth, or Otherwise Adversely Affect Us.”See “— Executive Summary — Consolidated Company Outlook,” for the targeted level of liquid assets at the holding companies.131Table of ContentsMetLife, Inc. and Other MetLife Holding Companies Sources and Uses of Liquid Assets and Sources and Uses of Liquid Assets included in Free Cash FlowMetLife, Inc.’s sources and uses of liquid assets, as well as sources and uses of liquid assets included in free cash flow are summarized as follows. Year Ended December 31, 2020Year Ended December 31, 2019Sources and Uses of Liquid AssetsSources and Uses of Liquid Assets Included in Free Cash FlowSources and Uses of Liquid AssetsSources and Uses of Liquid Assets Included in Free Cash Flow(In millions)MetLife, Inc. (Parent Company Only)Sources:Dividends and returns of capital from subsidiaries (1)$4,327 $4,327 $4,800 $4,800 Long-term debt issued (2)990 990 1,373 494 Repayments on and (issuances of) loans to subsidiaries and related interest, net (3)50 50 — — Preferred stock issuance, net of redemption of preferred stock and preferred stock redemption premium (2)958 458 — — Other, net (4)— — 320 196 Total sources6,325 5,825 6,493 5,490 Uses:Capital contributions to subsidiaries422 422 75 75 Long-term debt repaid — unaffiliated— — 877 — Interest paid on debt and financing arrangements — unaffiliated763 763 817 817 Dividends on common stock1,657 — 1,643 — Treasury stock acquired in connection with share repurchases1,151 — 2,285 — Dividends on preferred stock202 202 178 178 Issuances of and (repayments on) loans to subsidiaries and related interest, net (3) — — 44 44 Other, net (4), (5)1,539 (249)— — Total uses5,734 1,138 5,919 1,114 Net increase (decrease) in liquid assets, MetLife, Inc. (Parent Company Only)591 574 Liquid assets, beginning of year3,004 2,430 Liquid assets, end of year$3,595 $3,004 Free Cash Flow, MetLife, Inc. (Parent Company Only) 4,687 4,376 Net cash provided by operating activities, MetLife, Inc. (Parent Company Only) $3,479 $4,177 Other MetLife Holding CompaniesSources:Dividends and returns of capital from subsidiaries$1,301 $1,301 $2,199 $2,199 Capital contributions from MetLife, Inc.— — — — Total sources1,301 1,301 2,199 2,199 Uses:Capital contributions to subsidiaries55 55 67 67 Repayments on and (issuance of) loans to subsidiaries and affiliates and related interest, net111 111 16 16 Dividends and returns of capital to MetLife, Inc.1,200 1,200 1,100 1,100 Other, net247 612 444 444 Total uses1,613 1,978 1,627 1,627 Net increase (decrease) in liquid assets, Other MetLife Holding Companies(312)572 Liquid assets, beginning of year1,185 613 Liquid assets, end of year$873 $1,185 Free Cash Flow, Other MetLife Holding Companies (677)572 Net increase (decrease) in liquid assets, All Holding Companies$279 $1,146 Free Cash Flow, All Holding Companies (6)$4,010 $4,948 132Table of Contents__________________(1)Dividends and returns of capital to MetLife, Inc. included $3.1 billion and $3.7 billion from operating subsidiaries and $1.2 billion and $1.1 billion from other MetLife holding companies for the years ended December 31, 2020 and 2019, respectively.(2)Included in free cash flow is the portion of long-term debt issued and preferred stock issuance, net of redemption of preferred stock and preferred stock redemption premium that represents incremental debt to be at or below target leverage ratios.(3)See MetLife, Inc. (Parent Company Only) Condensed Statements of Cash Flows included in Schedule II of the Financial Statement Schedules for information regarding the source of liquid assets from receipts on loans to subsidiaries (excluding interest) and the use of liquid assets related to the issuances of loans to subsidiaries (excluding interest).(4)Other, net includes $296 million and $155 million of net receipts (payments) by MetLife, Inc. to and from subsidiaries under a tax sharing agreement and tax payments to tax agencies for the years ended December 31, 2020 and 2019, respectively. (5)Amounts to fund business acquisitions were $1.9 billion (included in other, net) and $0 for the years ended December 31, 2020 and 2019, respectively.(6)See “— Non-GAAP and Other Financial Disclosures” for the reconciliation of net cash provided by operating activities of MetLife, Inc. to free cash flow of all holding companies.Sources and Uses of Liquid Assets of MetLife, Inc.The primary sources of MetLife, Inc.’s liquid assets are dividends and returns of capital from subsidiaries, issuances of long-term debt, issuances of common and preferred stock, and net receipts from subsidiaries under a tax sharing agreement. MetLife, Inc.’s insurance subsidiaries are subject to regulatory restrictions on the payment of dividends imposed by the regulators of their respective domiciles. See “— Liquidity and Capital Sources — Dividends from Subsidiaries.”The primary uses of MetLife, Inc.’s liquid assets are principal and interest payments on long-term debt, dividends on and repurchases of common and preferred stock, capital contributions to subsidiaries, funding of business acquisitions, income taxes and operating expenses. MetLife, Inc. is party to various capital support commitments and guarantees with certain of its subsidiaries. See “— Liquidity and Capital Uses — Support Agreements.”In addition, MetLife, Inc. issues loans to subsidiaries or subsidiaries issue loans to MetLife, Inc. Accordingly, changes in MetLife, Inc. liquid assets include issuances of loans to subsidiaries, proceeds of loans from subsidiaries and the related repayment of principal and payment of interest on such loans. See “— Liquidity and Capital Sources — Affiliated Long-term Debt” and “— Liquidity and Capital Uses — Affiliated Capital and Debt Transactions.”Sources and Uses of Liquid Assets of Other MetLife Holding CompaniesThe primary sources of liquid assets of other MetLife holding companies are dividends, returns of capital and remittances from their subsidiaries and branches, principally non-U.S. insurance companies; capital contributions received; receipts of principal and interest on loans to subsidiaries and affiliates and borrowings from subsidiaries and affiliates. MetLife, Inc.’s non-U.S. operations are subject to regulatory restrictions on the payment of dividends imposed by local regulators. See “— Liquidity and Capital Sources — Dividends from Subsidiaries.” The primary uses of liquid assets of other MetLife holding companies are capital contributions paid to their subsidiaries and branches, principally non-U.S. insurance companies; loans to subsidiaries and affiliates; principal and interest paid on loans from subsidiaries and affiliates; dividends and returns of capital to MetLife, Inc. and the following items, which are reported within other, net: business acquisitions; and operating expenses. There were no uses of liquid assets of other MetLife holding companies to fund business acquisitions during the years ended December 31, 2020 or 2019.Liquidity and Capital SourcesIn addition to the description of liquidity and capital sources in “— The Company — Summary of the Company’s Primary Sources and Uses of Liquidity and Capital” and “— The Company — Liquidity and Capital Sources,” MetLife, Inc.’s primary sources of liquidity and capital are set forth below.133Table of ContentsDividends from SubsidiariesMetLife, Inc. relies, in part, on dividends from its subsidiaries to meet its cash requirements. MetLife, Inc.’s insurance subsidiaries are subject to regulatory restrictions on the payment of dividends imposed by the regulators of their respective domiciles. See Note 16 of the Notes to the Consolidated Financial Statements. The dividend limitation for U.S. insurance subsidiaries is generally based on the surplus to policyholders at the end of the immediately preceding calendar year and statutory net gain from operations for the immediately preceding calendar year. Statutory accounting practices, as prescribed by insurance regulators of various states in which we conduct business, differ in certain respects from accounting principles used in financial statements prepared in conformity with GAAP. The significant differences relate to the treatment of DAC, certain deferred income tax, required investment liabilities, statutory reserve calculation assumptions, goodwill and surplus notes.The table below sets forth the dividends permitted to be paid by MetLife, Inc.’s primary U.S. insurance subsidiaries without insurance regulatory approval and the actual dividends paid: 202120202019CompanyPermitted Without Approval (1)Paid (2) Permitted Without Approval (1)Paid (2)Permitted Without Approval (1) (In millions)Metropolitan Life Insurance Company$3,392 $2,832 $3,272 $3,065 $3,065 American Life Insurance Company$800 $1,200 (3)$— $1,100 $— Metropolitan Property and Casualty Insurance Company (4)$222 $250 $114 $430 $171 Metropolitan Tower Life Insurance Company$82 $— $149 $— $154 __________________(1)Reflects dividend amounts that may be paid during the relevant year without prior regulatory approval. However, because dividend tests may be based on dividends previously paid over rolling 12-month periods, if paid before a specified date during such year, some or all of such dividends may require regulatory approval. (2)Reflects all amounts paid, including those where regulatory approval was obtained as required.(3)Includes a $341 million non-cash dividend.(4)See Note 3 for information regarding the pending disposition of MetLife P&C which may impact the ability of MetLife P&C to pay a dividend to MetLife, Inc. in 2021.In addition to the amounts presented in the table above, for the years ended December 31, 2020 and 2019, MetLife, Inc. also received cash payments of $29 million and $195 million, respectively, representing dividends from certain other subsidiaries. Additionally, for the years ended December 31, 2020 and 2019, MetLife, Inc. received cash returns of capital of $16 million and $10 million, respectively.The dividend capacity of our non-U.S. operations is subject to similar restrictions established by the local regulators. The non-U.S. regulatory regimes also commonly limit dividend payments to the parent company to a portion of the subsidiary’s prior year statutory income, as determined by the local accounting principles. The regulators of our non-U.S. operations, including the FSA, may also limit or not permit profit repatriations or other transfers of funds to the U.S. if such transfers are deemed to be detrimental to the solvency or financial strength of the non-U.S. operations, or for other reasons. Most of our non-U.S. subsidiaries are second tier subsidiaries which are owned by various non-U.S. holding companies. The capital and rating considerations applicable to our first tier subsidiaries may also impact the dividend flow into MetLife, Inc.We proactively manage target and excess capital levels and dividend flows and forecast local capital positions as part of the financial planning cycle. The dividend capacity of certain U.S. and non-U.S. subsidiaries is also subject to business targets in excess of the minimum capital necessary to maintain the desired rating or level of financial strength in the relevant market. See “Risk Factors — Capital Risks — Our Subsidiaries May be Unable to Pay Dividends, a Major Component of Holding Company Free Cash Flow” and Note 16 of the Notes to the Consolidated Financial Statements.Affiliated Long-term Debt See “Senior Notes — Affiliated” in Note 4 of the Notes to the MetLife, Inc. (Parent Company Only) Condensed Financial Information included in Schedule II of the Financial Statement Schedules for information on affiliated long-term debt.134Table of ContentsCollateral Financing Arrangement and Junior Subordinated Debt SecuritiesFor information on MetLife, Inc.’s collateral financing arrangement and junior subordinated debt securities, see Notes 14 and 15 of the Notes to the Consolidated Financial Statements, respectively. Credit and Committed FacilitiesSee Note 13 of the Notes to the Consolidated Financial Statements for further information regarding the Company’s unsecured revolving credit facility and certain committed facilities.Long-term Debt OutstandingThe following table summarizes the outstanding long-term debt of MetLife, Inc. at: December 31, 20202019 (In millions)Long-term debt — unaffiliated$13,463 $12,379 Long-term debt — affiliated$2,073 $1,976 Junior subordinated debt securities$2,461 $2,458 Debt and Facility CovenantsCertain of MetLife, Inc.’s debt instruments and committed facilities, as well as its unsecured revolving credit facility, contain various administrative, reporting, legal and financial covenants. MetLife, Inc. believes it was in compliance with all applicable financial covenants at December 31, 2020.DispositionsFor information regarding the pending disposition of MetLife P&C, see Note 3 of the Notes to the Consolidated Financial Statements.Liquidity and Capital UsesThe primary uses of liquidity of MetLife, Inc. include debt service, cash dividends on common and preferred stock, capital contributions to subsidiaries, common stock, preferred stock and debt repurchases, payment of general operating expenses and acquisitions. Based on our analysis and comparison of our current and future cash inflows from the dividends we receive from subsidiaries that are permitted to be paid without prior insurance regulatory approval, our investment portfolio and other cash flows and anticipated access to the capital markets, we believe there will be sufficient liquidity and capital to enable MetLife, Inc. to make payments on debt, pay cash dividends on its common and preferred stock, contribute capital to its subsidiaries, repurchase its common stock and certain of its other securities, pay all general operating expenses and meet its cash needs under current market conditions and reasonably possible stress scenarios.In addition to the description of liquidity and capital uses in “— The Company — Liquidity and Capital Uses” and “— The Company — Contractual Obligations,” MetLife, Inc.’s primary uses of liquidity and capital are set forth below.Affiliated Capital and Debt TransactionsFor the years ended December 31, 2020 and 2019, excluding acquisitions, MetLife, Inc. invested a net amount of $425 million and $89 million, respectively, in various subsidiaries.MetLife, Inc. lends funds, as necessary, through credit agreements or otherwise to its subsidiaries and affiliates, some of which are regulated, to meet their capital requirements or to provide liquidity. MetLife, Inc. had loans to subsidiaries outstanding of $0 and $100 million at December 31, 2020 and 2019, respectively. In June 2020, the $100 million loan was repaid at maturity.Debt RepaymentsFor information on MetLife, Inc.’s debt repayments, see “— The Company — Liquidity and Capital Uses — Debt Repayments.” MetLife, Inc. intends to repay or refinance, in whole or in part, all the debt that is due in 2021. 135Table of ContentsMaturities of Senior NotesThe following table summarizes MetLife, Inc.’s outstanding senior notes by year of maturity, excluding any premium or discount and unamortized issuance costs, at December 31, 2020:Year of MaturityPrincipalInterest Rate (In millions) Unaffiliated:2022$500 3.05%2023$1,000 4.37%2024$1,000 3.60%2024$478 5.38%2025$500 3.00%2025$500 3.60%2026 - 2046$9,570 Ranging from 0.50% - 6.50%Affiliated:2021$520 2.97%2021$529 3.14%2023$362 1.60%2025$250 2.05%2026-2029$412 Ranging from 1.64% - 1.81%Support AgreementsMetLife, Inc. is party to various capital support commitments and guarantees with certain of its subsidiaries. See Note 5 of the Notes to the MetLife, Inc. (Parent Company Only) Condensed Financial Information included in Schedule II of the Financial Statement Schedules.AcquisitionsSee Note 3 of the Notes to the Consolidated Financial Statements for information regarding the acquisition of Versant Health.Adoption of New Accounting PronouncementsSee Note 1 of the Notes to the Consolidated Financial Statements.Future Adoption of New Accounting PronouncementsSee Note 1 of the Notes to the Consolidated Financial Statements.136Table of ContentsNon-GAAP and Other Financial DisclosuresIn this report, the Company presents certain measures of its performance on a consolidated and segment basis that are not calculated in accordance with GAAP. We believe that these non-GAAP financial measures enhance the understanding for the Company and our investors of our performance by highlighting the results of operations and the underlying profitability drivers of our business. Segment-specific financial measures are calculated using only the portion of consolidated results attributable to that specific segment.The following non-GAAP financial measures should not be viewed as substitutes for the most directly comparable financial measures calculated in accordance with GAAP:Non-GAAP financial measures:Comparable GAAP financial measures:(i)adjusted premiums, fees and other revenues (i)premiums, fees and other revenues (ii)adjusted earnings(ii)net income (loss) (iii)adjusted earnings available to commonshareholders(iii)net income (loss) available to MetLife, Inc.’s common shareholders(iv)free cash flow of all holding companies(iv)MetLife, Inc. (parent company only) net cash providedby (used in) operating activities(v) adjusted net investment income(v) net investment incomeAny of these financial measures shown on a constant currency basis reflect the impact of changes in foreign currency exchange rates and are calculated using the average foreign currency exchange rates for the most recent period and applied to the comparable prior period (“constant currency basis”). Reconciliations of these non-GAAP financial measures to the most directly comparable historical GAAP financial measures are included in “— Results of Operations” and “— Investments.” Reconciliations of these non-GAAP measures to the most directly comparable GAAP measures are not accessible on a forward-looking basis because we believe it is not possible without unreasonable effort to provide other than a range of net investment gains and losses and net derivative gains and losses, which can fluctuate significantly within or outside the range and from period to period and may have a material impact on net income. Our definitions of non-GAAP and other financial measures discussed in this report may differ from those used by other companies.Adjusted earnings and related measures:•adjusted earnings; •adjusted earnings available to common shareholders; and•adjusted earnings available to common shareholders on a constant currency basis. These measures are used by management to evaluate performance and allocate resources. Consistent with GAAP guidance for segment reporting, adjusted earnings and components of, or other financial measures based on, adjusted earnings are also our GAAP measures of segment performance. Adjusted earnings and other financial measures based on adjusted earnings are also the measures by which senior management’s and many other employees’ performance is evaluated for the purposes of determining their compensation under applicable compensation plans. Adjusted earnings and other financial measures based on adjusted earnings allow analysis of our performance relative to our business plan and facilitate comparisons to industry results. Adjusted earnings is defined as adjusted revenues less adjusted expenses, net of income tax. Adjusted loss is defined as negative adjusted earnings. Adjusted earnings available to common shareholders is defined as adjusted earnings less preferred stock dividends. For information relating to adjusted revenues and adjusted expenses, see “Financial Measures and Segment Accounting Policies” in Note 2 of the Notes to the Consolidated Financial Statements.In addition, adjusted earnings available to common shareholders excludes the impact of preferred stock redemption premium, which is reported as a reduction to net income (loss) available to MetLife, Inc.’s common shareholders.Return on equity, allocated equity and related measures:•Total MetLife, Inc.’s common stockholders’ equity, excluding AOCI other than FCTA, is defined as total MetLife, Inc.’s common stockholders’ equity, excluding the net unrealized investment gains (losses) and defined benefit plans adjustment components of AOCI, net of income tax.137Table of Contents•Adjusted return on MetLife, Inc.’s common stockholders’ equity is defined as adjusted earnings available to common shareholders divided by MetLife, Inc.’s average common stockholders’ equity.•Adjusted return on MetLife, Inc.’s common stockholders’ equity, excluding AOCI other than FCTA, is defined as adjusted earnings available to common shareholders divided by MetLife, Inc.’s average common stockholders’ equity, excluding AOCI other than FCTA.•Allocated equity is the portion of MetLife, Inc.’s common stockholders’ equity that management allocates to each of its segments and sub-segments based on local capital requirements and economic capital. See “— Economic Capital.” Allocated equity excludes the impact of AOCI other than FCTA. The above measures represent a level of equity consistent with the view that, in the ordinary course of business, we do not plan to sell most investments for the sole purpose of realizing gains or losses. Also, refer to the utilization of adjusted earnings and components of, or other financial measures based on, adjusted earnings mentioned above. Expense ratio and direct expense ratio:•Expense ratio: other expenses, net of capitalization of DAC, divided by premiums, fees and other revenues.•Direct expense ratio: adjusted direct expenses divided by adjusted premiums, fees and other revenues. Direct expenses are comprised of employee-related costs, third party staffing costs, and general and administrative expenses.•Direct expense ratio, excluding total notable items related to direct expenses and pension risk transfers: adjusted direct expenses excluding total notable items related to direct expenses, divided by adjusted premiums, fees and other revenues, excluding pension risk transfers.The following additional information is relevant to an understanding of our performance results and outlook:•We sometimes refer to sales activity for various products. These sales statistics do not correspond to revenues under GAAP, but are used as relevant measures of business activity. Further, sales statistics for our Latin America, Asia and EMEA segments are on a constant currency basis.•Near-term represents one to three years.•We refer to observable forward yield curves as of a particular date in connection with making our estimates for future results. The observable forward yield curves at a given time are based on implied future interest rates along a range of interest rate durations. This includes the 10-year U.S. Treasury rate which we use as a benchmark rate to describe longer-term interest rates used in our estimates for future results.•Asymmetrical and non-economic accounting refers to: (i) the portion of net derivative gains (losses) on embedded derivatives attributable to the inclusion of our credit spreads in the liability valuations, (ii) hedging activity that generates net derivative gains (losses) and creates fluctuations in net income because hedge accounting cannot be achieved and the item being hedged does not a have an offsetting gain or loss recognized in earnings, (iii) inflation-indexed benefit adjustments associated with contracts backed by inflation-indexed investments and amounts associated with periodic crediting rate adjustments based on the total return of a contractually referenced pool of assets and other pass through adjustments, and (iv) impact of changes in foreign currency exchange rates on the re-measurement of foreign denominated unhedged funding agreements and financing transactions to the U.S. dollar and the re-measurement of certain liabilities from non-functional currencies to functional currencies. We believe that excluding the impact of asymmetrical and non-economic accounting from total GAAP results enhances investor understanding of our performance by disclosing how these accounting practices affect reported GAAP results.•Notable items represent a positive (negative) impact to adjusted earnings available to common shareholders. Notable items reflect the unexpected impact of events that affect MetLife’s results, but that were unknown and that MetLife could not anticipate when it devised its business plan. Notable items also include certain items regardless of the extent anticipated in the business plan, to help investors have a better understanding of MetLife’s results and to evaluate and forecast those results. 138Table of Contents•The Company uses a measure of free cash flow to facilitate an understanding of its ability to generate cash for reinvestment into its businesses or use in non-mandatory capital actions. The Company defines free cash flow as the sum of cash available at MetLife’s holding companies from dividends from operating subsidiaries, expenses and other net flows of the holding companies (including capital contributions to subsidiaries), and net contributions from debt to be at or below target leverage ratios. This measure of free cash flow is prior to capital actions, such as common stock dividends and repurchases, debt reduction and mergers and acquisitions. Free cash flow should not be viewed as a substitute for net cash provided by (used in) operating activities calculated in accordance with GAAP. The free cash flow ratio is typically expressed as a percentage of annual adjusted earnings available to common shareholders. A reconciliation of net cash provided by operating activities of MetLife, Inc. (parent company only) to free cash flow of all holding companies for the years ended December 31, 2020 and 2019 is provided below.Reconciliation of Net Cash Provided by Operating Activities of MetLife, Inc. to Free Cash Flow of All Holding CompaniesYears Ended December 31,20202019 (In millions, except ratios)MetLife, Inc. (parent company only) net cash provided by operating activities $3,479 $4,177 Adjustments from net cash provided by operating activities to free cash flow:Add: Incremental debt to be at or below target leverage ratios1,448 494 Add: Capital contributions to subsidiaries(422)(75)Add: Returns of capital from subsidiaries16 10 Add: Repayments on and (issuances of) loans to subsidiaries, net100 — Add: Investment portfolio and derivatives changes and other, net66 (230)MetLife, Inc. (parent company only) free cash flow4,687 4,376 Other MetLife, Inc. holding companies:Add: Dividends and returns of capital from subsidiaries1,301 2,199 Add: Capital contributions to subsidiaries(55)(67)Add: Repayments on and (issuances of) loans to subsidiaries, net(111)(16)Add: Other expenses(644)(720)Add: Dividends and returns of capital to MetLife, Inc.(1,200)(1,100)Add: Investment portfolio and derivative changes and other, net32 276 Total other MetLife, Inc. holding companies free cash flow(677)572 Free cash flow of all holding companies$4,010 $4,948 Ratio of net cash provided by operating activities to consolidated net income (loss) available to MetLife, Inc.’s common shareholders:MetLife, Inc. (parent company only) net cash provided by operating activities $3,479 $4,177 Consolidated net income (loss) available to MetLife, Inc.’s common shareholders$5,191 $5,721 Ratio of net cash provided by operating activities (parent company only) to consolidated net income (loss) available to MetLife, Inc.'s common shareholders (1)67 %73 %Ratio of free cash flow to adjusted earnings available to common shareholders:Free cash flow of all holding companies (2)$4,010 $4,948 Consolidated adjusted earnings available to common shareholders (2)$5,623 $5,767 Ratio of free cash flow of all holding companies to consolidated adjusted earnings available to common shareholders (2)71 %86 %__________________(1)Including the free cash flow of other MetLife, Inc. holding companies of ($677) million and $572 million for the years ended December 31, 2020 and 2019, respectively, in the numerator of the ratio, this ratio, as adjusted, would be 54% and 83%, respectively. (2)i) Consolidated adjusted earnings available to common shareholders for the year ended December 31, 2020 was negatively impacted by a notable item related to actuarial assumption review and other insurance adjustments of $203 million, net of income tax. Excluding this notable item from the denominator of the ratio, the adjusted free cash flow ratio for 2020 would be 69%.139Table of Contentsii) Consolidated adjusted earnings available to common shareholders for the year ended December 31, 2019 was positively impacted by notable items, primarily related to tax related adjustments, of $539 million, net of income tax, partially offset by expense initiative costs of $332 million, net of income tax. Excluding such notable items from the denominator of the ratio, the adjusted free cash flow ratio for the year ended December 31, 2019 would be 87%.140Table of ContentsItem 7A. Quantitative and Qualitative Disclosures About Market RiskRisk ManagementWe have an integrated process for managing risk, which we conduct through multiple Board and senior management committees (financial and non-financial) across the Global Risk Management, ALM, Finance, Treasury, Investments and business segment departments. The risk committee structure is designed to provide a consolidated enterprise-wide assessment and management of risk. The ERC is responsible for reviewing all material risks to the enterprise and deciding on actions, if necessary, in the event risks exceed desired tolerances, taking into consideration industry best practices and the current environment to resolve or mitigate those risks. Additional committees at the MetLife, Inc. and subsidiary company level manage capital and risk positions and establish corporate business standards. Global Risk ManagementIndependent from the lines of business, the centralized Global Risk Management department, led by the CRO, coordinates across all committees to ensure that all material risks are properly identified, measured, aggregated, managed and reported across the Company. The CRO reports to the Chief Executive Officer (“CEO”) and is primarily responsible for maintaining and communicating the Company’s enterprise risk policies and for monitoring and analyzing all material risks.Global Risk Management considers and monitors a full range of risks against the Company’s solvency, liquidity, earnings, business operations and reputation. Global Risk Management’s primary responsibilities consist of:•implementing an enterprise risk framework, which outlines our enterprise approach for managing risk;•developing policies and procedures for identifying, managing, measuring, monitoring and controlling those risks identified in the enterprise risk framework;•coordinating ORSAs for Board, senior management and regulator use;•establishing appropriate enterprise risk tolerance levels;•recommending risk appetite statements and investment general authorizations to the Board;•measuring capital on an economic basis; and•reporting to (i) the Finance and Risk Committee of MetLife, Inc.’s Board of Directors; (ii) the Investment Committee of MetLife, Inc.’s Board of Directors; (iii) the Compensation Committee of MetLife, Inc.’s Board of Directors; and (iv) the financial and non-financial senior management committees on various aspects of risk.Asset/Liability ManagementWe actively manage our assets using an approach that is liability driven and balances quality, diversification, asset/liability matching, liquidity, concentration and investment return. The goals of the investment process are to optimize, net of income tax, risk-adjusted investment income and risk-adjusted total return while ensuring that the assets and liabilities are reasonably aligned on a cash flow and duration basis. The ALM process is the shared responsibility of the ALM, Global Risk Management, and Investments departments, with the engagement of senior members of the business segments and Finance, and is governed by the ALM Committees. The ALM Committees’ duties include reviewing and approving investment guidelines and limits, approving significant portfolio and ALM strategies and providing oversight of the ALM process. The directives of the ALM Committees are carried out and monitored through ALM Working Groups which are set up to manage risk by geography, product or portfolio type. The ALM Steering Committee oversees the activities of the underlying ALM Committees and Working Groups. The ALM Steering Committee reports to the ERC.We establish portfolio guidelines that define ranges and limits related to asset allocation, interest rate risk, liquidity, concentration and other risks for each major business segment, legal entity or insurance product group. These guidelines support implementation of investment strategies used to adequately fund our liabilities within acceptable levels of risk. We also establish hedging programs and associated investment portfolios for different blocks of business. The ALM Working Groups monitor these strategies and programs through regular review of portfolio metrics, such as effective duration, yield curve sensitivity, convexity, value at risk, market sensitivities (to interest rates, equity market levels, equity volatility, and foreign currency exchange rates), stress scenario payoffs, liquidity, asset sector concentration and credit quality.141Table of ContentsMarket Risk ExposuresWe regularly analyze our exposure to interest rate, foreign currency exchange rate and equity market price risk. As a result of that analysis, we have determined that the estimated fair values of certain assets and liabilities are materially exposed to changes in interest rates, foreign currency exchange rates and equity markets. We have exposure to market risk through our insurance operations and investment activities. For purposes of this disclosure, “market risk” is defined as the risk of loss resulting from changes in interest rates, foreign currency exchange rates and equity markets.Interest RatesOur exposure to interest rate changes results most significantly from our holdings of fixed maturity securities and derivatives, as well as our interest rate sensitive liabilities. The fixed maturity securities AFS include U.S. and foreign government bonds, securities issued by government agencies, corporate bonds, mortgage-backed securities and ABS, all of which are mainly exposed to changes in medium- and long-term interest rates. The interest rate sensitive liabilities for purposes of this disclosure include debt, policyholder account balances related to certain investment type contracts, and embedded derivatives on variable annuities with guaranteed minimum benefits which have the same type of interest rate exposure (medium- and long-term interest rates) as fixed maturity securities AFS. The interest rate sensitive liabilities for purposes of this disclosure exclude a significant portion of the liabilities relating to insurance contracts. See “Risk Factors — Economic Environment and Capital Markets Risks — We May Face Difficult Economic Conditions.”Foreign Currency Exchange RatesOur exposure to fluctuations in foreign currency exchange rates against the U.S. dollar results from our holdings in non-U.S. dollar denominated fixed maturity and equity securities, mortgage loans, and certain liabilities, as well as through our investments in foreign subsidiaries. The foreign currency exchange rate liabilities for purposes of this disclosure exclude a significant portion of the liabilities relating to insurance contracts. The principal currencies that create foreign currency exchange rate risk in our investment portfolios and liabilities are the Euro, the Japanese yen and the British pound. Selectively, we use U.S. dollar assets to support certain long-duration foreign currency liabilities. Through our investments in foreign subsidiaries and joint ventures, we are primarily exposed to the Japanese yen, the Euro, the Australian dollar, the British pound, the Mexican peso, the Chilean peso and the Korean won. In addition to hedging with foreign currency swaps, forwards and options, local surplus in some countries may be held entirely or in part in U.S. dollar assets, which further minimize exposure to foreign currency exchange rate fluctuation risk. We have matched much of our foreign currency liabilities in our foreign subsidiaries with their respective foreign currency assets, thereby reducing our risk to foreign currency exchange rate fluctuation. See “Risk Factors — Economic Environment and Capital Markets Risks — We May Face Difficult Economic Conditions.”Equity MarketAlong with investments in equity securities, we have exposure to equity market risk through certain liabilities that involve long-term guarantees on equity performance such as embedded derivatives on variable annuities with guaranteed minimum benefits and certain policyholder account balances. Equity exposures associated with limited partnership interests are excluded from this discussion as they are not considered financial instruments under GAAP.142Table of ContentsManagement of Market Risk ExposuresWe use a variety of strategies to manage interest rate, foreign currency exchange rate and equity market risk, including the use of derivatives.Interest Rate Risk ManagementTo manage interest rate risk, we analyze interest rate risk using various models, including multi-scenario cash flow projection models that forecast cash flows of the liabilities and their supporting investments, including derivatives. These projections involve evaluating the potential gain or loss on most of our in-force business under various increasing and decreasing interest rate environments. The NYDFS regulations require that we perform some of these analyses annually as part of our review of the sufficiency of our regulatory reserves. For several of our legal entities, we maintain segmented operating and surplus asset portfolios for the purpose of ALM and the allocation of investment income to product lines. In the U.S., for each segment, invested assets greater than or equal to the GAAP liabilities net of certain non-invested assets allocated to the segment are maintained, with any excess allocated to Corporate & Other. The business segments may reflect differences in legal entity, statutory line of business and any product market characteristic which may drive a distinct investment strategy with respect to duration, liquidity or credit quality of the invested assets. Certain smaller entities make use of unsegmented general accounts for which the investment strategy reflects the aggregate characteristics of liabilities in those entities. We measure relative sensitivities of the value of our assets and liabilities to changes in key assumptions utilizing internal models. These models reflect specific product characteristics and include assumptions based on current and anticipated experience regarding lapse, mortality, morbidity and interest crediting rates. In addition, these models include asset cash flow projections reflecting interest payments, sinking fund payments, principal payments, bond calls, mortgage loan prepayments and defaults.We employ product design, pricing and ALM strategies to reduce the potential effects of interest rate movements. Product design and pricing strategies include the use of surrender charges or restrictions on withdrawals in some products and the ability to reset crediting rates for certain products. ALM strategies include the use of derivatives. We also use reinsurance to mitigate interest rate risk.We also use common industry metrics, such as duration and convexity, to measure the relative sensitivity of assets and liability values to changes in interest rates. In computing the duration of liabilities, we consider all policyholder guarantees and how we intend to set indeterminate policy elements such as interest credits or dividends. Each asset portfolio or portfolio group has a duration target based on the liability duration and the investment objectives of that portfolio. Where a liability cash flow may exceed the maturity of available assets, we may support such liabilities with equity investments, derivatives or interest rate curve mismatch strategies.Foreign Currency Exchange Rate Risk ManagementMetLife has a well-established policy to manage foreign currency exchange rate exposures within its risk tolerance. In general, investments backing specific liabilities are currency matched. This is achieved through direct investments in matching currency or through the use of foreign currency exchange derivatives. Enterprise foreign currency exchange rate risk limits are established by the ERC. Management of each of our segments, with oversight from our FX Working Group and the ALM committee for the respective segment, is responsible for managing any foreign currency exchange rate exposure.We use foreign currency swaps, forwards and options to mitigate the liability exposure, risk of loss and financial statement volatility associated with our investments in foreign subsidiaries, foreign currency denominated fixed income investments and the sale of certain insurance products.Equity Market Risk ManagementWe manage equity market risk on an integrated basis with other risks through our ALM strategies, including the dynamic hedging of certain variable annuity guarantee benefits, as well as reinsurance, in order to limit losses, minimize exposure to large risks, and provide additional capacity for future growth. We also manage equity market risk exposure in our investment portfolio through the use of derivatives. These derivatives include exchange-traded equity futures, equity index options contracts, TRRs and equity variance swaps. This risk is managed by our ALM Department in partnership with the Investments Department. 143Table of ContentsHedging ActivitiesWe use derivative contracts primarily to hedge a wide range of risks including interest rate risk, foreign currency exchange rate risk, and equity market risk. Derivative hedges are designed to reduce risk on an economic basis while considering their impact on financial results under different accounting regimes, including U.S. GAAP and local statutory accounting. Our derivative hedge programs vary depending on the type of risk being hedged. Some hedge programs are asset or liability specific while others are portfolio hedges that reduce risk related to a group of liabilities or assets. Our use of derivatives by major hedge programs is as follows:•Risks Related to Guarantee Benefits — We use a wide range of derivative contracts to mitigate the risk associated with living guarantee benefits. These derivatives include equity and interest rate futures, interest rate swaps, currency futures/forwards, equity indexed options, TRRs, interest rate option contracts and equity variance swaps.•Minimum Interest Rate Guarantees — For certain liability contracts, we provide the contractholder a guaranteed minimum interest rate. These contracts include certain fixed annuities and other insurance liabilities. We purchase interest rate caps and floors to reduce risk associated with these liability guarantees.•Reinvestment Risk in Long-Duration Liability Contracts — Derivatives are used to hedge interest rate risk related to certain long-duration liability contracts. Hedges include interest rate swaps, swaptions and Treasury bond forwards.•Foreign Currency Exchange Rate Risk — We use foreign currency swaps, forwards and options to hedge foreign currency exchange rate risk. These hedges are generally used to swap foreign currency denominated bonds, investments in foreign subsidiaries or equity market exposures to U.S. dollars. Our foreign subsidiaries also use these hedges to swap non-local currency assets to local currency, to match liabilities.•General ALM Hedging Strategies — In the ordinary course of managing our asset/liability risks, we use interest rate futures, interest rate swaps, interest rate caps, interest rate floors, and inflation swaps. These hedges are designed to reduce interest rate risk or inflation risk related to the existing assets or liabilities or related to expected future cash flows.•Macro Hedge Program — We use equity options, equity TRRs, interest rate swaptions and interest rate swaps to mitigate the potential loss of legal entity statutory capital under stress scenarios.Risk Measurement: Sensitivity AnalysisWe measure market risk related to our market sensitive assets and liabilities based on changes in interest rates, foreign currency exchange rates and equity market prices utilizing a sensitivity analysis. For purposes of this disclosure, a significant portion of the liabilities relating to insurance contracts is excluded, as discussed further below. This analysis estimates the potential changes in estimated fair value based on a hypothetical 10% change (increase or decrease) in interest rates, foreign currency exchange rates and equity market prices. We believe that a 10% change (increase or decrease) in these market rates and prices is reasonably possible in the near term. In performing the analysis summarized below, we used market rates at December 31, 2020. The sensitivity analysis separately calculates each of our market risk exposures (interest rate, foreign currency exchange rate and equity market) relating to our assets and liabilities. We modeled the impact of changes (increases and decreases) in market rates and prices on the estimated fair values of our market sensitive assets and liabilities and present the results with the most adverse level of market risk impact to the Company for each of these market risk exposures as follows:•the net present values of our interest rate sensitive exposures resulting from a 10% change (increase or decrease) in interest rates;•estimated fair values of our foreign currency exchange rate sensitive exposures due to a 10% change (appreciation or depreciation) in the value of the U.S. dollar compared to all other currencies; and•the estimated fair value of our equity market sensitive exposures due to a 10% change (increase or decrease) in equity market prices.144Table of ContentsThe sensitivity analysis is an estimate and should not be viewed as predictive of our future financial performance. We cannot ensure that our actual losses in any particular period will not exceed the amounts indicated in the table below. Limitations related to this sensitivity analysis include:•interest sensitive and foreign currency exchange rate sensitive liabilities do not include $223.8 billion, at carrying value, of insurance contracts. Management believes that the changes in the economic value of those contracts under changing interest rates and changing foreign currency exchange rates would offset a significant portion of the fair value changes of interest sensitive and foreign currency exchange rate sensitive assets;•the market risk information is limited by the assumptions and parameters established in creating the related sensitivity analysis, including the impact of prepayment rates on mortgage loans;•sensitivities do not include the impact on asset or liability valuation of changes in market liquidity or changes in market credit spreads;•foreign currency exchange rate risk is not isolated for certain embedded derivatives within host asset and liability contracts, as the risk on these instruments is reflected as equity;•for the derivatives that qualify as hedges, and for certain other assets such as mortgage loans, the impact on reported earnings may be materially different from the change in market values;•the analysis excludes liabilities pursuant to insurance contracts, as well as real estate holdings, private equity and hedge fund holdings; and•the model assumes that the composition of assets and liabilities remains unchanged throughout the period.Accordingly, we use such models as tools and not as substitutes for the experience and judgment of our management. Based on our analysis of the impact of a 10% change (increase or decrease) in market rates and prices, we have determined that such a change could have a material adverse effect on the estimated fair value of certain assets and liabilities from interest rate, foreign currency exchange rate and equity market exposures.The table below illustrates the potential loss in estimated fair value for each market risk exposure based on market sensitive assets and liabilities at: December 31, 2020 (In millions)Interest rate risk $4,012 Foreign currency exchange rate risk$8,389 Equity market risk $370 __________________The risk sensitivities derived used a 10% increase to interest rates, a 10% strengthening of the U.S. dollar against foreign currencies, and a 10% increase in equity prices. The potential losses in estimated fair value presented are for non-trading securities.145Table of ContentsThe table below provides additional detail regarding the potential loss in estimated fair value of our interest sensitive financial instruments due to a 10% increase in interest rates at:December 31, 2020NotionalAmount EstimatedFairValue (1) Assuming a10% Increasein Interest Rates(In millions)AssetsFixed maturity securities AFS$354,809 $(3,446)Equity securities$1,079 — FVO securities$1,611 (6)Mortgage loans$88,675 (200)Policy loans$11,598 (46)Short-term investments$3,904 (1)Other invested assets$2,073 (2)Cash and cash equivalents$19,795 — Accrued investment income$3,388 — Premiums, reinsurance and other receivables$2,978 (15)Other assets$301 (2)Embedded derivatives within asset host contracts (2)$55 — Total assets$(3,718)Liabilities (3)Policyholder account balances$129,637 $320 Payables for collateral under securities loaned and other transactions$29,475 — Short-term debt$393 — Long-term debt$18,332 196 Collateral financing arrangement$710 — Junior subordinated debt securities$4,604 49 Other liabilities$3,133 40 Embedded derivatives within liability host contracts (2)$1,196 83 Total liabilities$688 Derivative InstrumentsInterest rate swaps$57,497 $6,909 $(547)Interest rate floors$12,701 $350 (5)Interest rate caps$40,730 $13 1 Interest rate futures$1,498 $(2)3 Interest rate options$17,746 $497 (27)Interest rate forwards$7,728 $383 (169)Interest rate total return swaps$1,048 $(59)(33)Synthetic GICs$38,646 $— — Foreign currency swaps$52,975 $(628)(178)Foreign currency forwards$17,743 $(80)(20)Currency futures$914 $3 (4)Currency options$4,950 $70 (2)Credit default swaps$12,587 $84 — Equity futures$5,427 $(24)— Equity index options$22,954 $397 (1)Equity variance swaps$716 $3 — Equity total return swaps$3,294 $(279)— Total derivative instruments$(982)Net Change$(4,012)__________________(1)Separate account assets and liabilities and Unit-linked investments and associated policyholder account balances, which are interest rate sensitive, are not included herein as any interest rate risk is borne by the contractholder, notwithstanding any general account guarantees which are included within embedded derivatives (see footnote (2) below) or included within future policy benefits and other policy-related balances (see footnote (3) below). Long-term debt excludes $5 million related to CSEs. 146Table of Contents(2)Embedded derivatives are recognized on the consolidated balance sheet in the same caption as the host contract.(3)Excludes $223.8 billion of liabilities, at carrying value, pursuant to insurance contracts reported within future policy benefits and other policy-related balances. These liabilities would economically offset a significant portion of the net change in fair value of our financial instruments resulting from a 10% increase in interest rates.Sensitivity to interest rates decreased $1.2 billion to $4.0 billion at December 31, 2020 from $5.2 billion at December 31, 2019. The table below provides additional detail regarding the potential loss in estimated fair value of our portfolio due to a 10% appreciation in the U.S. dollar compared to all other currencies at:December 31, 2020NotionalAmountEstimatedFairValue (1)Assuming a 10% Appreciation in the U.S. Dollar(In millions)AssetsFixed maturity securities AFS$354,809 $(11,381)Equity securities$1,079 (49)FVO securities$1,611 (76)Mortgage loans$88,675 (990)Policy loans$11,598 (158)Short-term investments$3,904 (182)Other invested assets$2,073 (49)Cash and cash equivalents$19,795 (444)Accrued investment income$3,388 (83)Premiums, reinsurance and other receivables$2,978 (44)Other assets$301 (18)Embedded derivatives within asset host contracts (2)$55 (8)Total assets$(13,482)Liabilities (3)Policyholder account balances$129,637 $3,733 Payables for collateral under securities loaned and other transactions$29,475 176 Long-term debt$18,332 207 Other liabilities$3,133 20 Embedded derivatives within liability host contracts (2)$1,196 53 Total liabilities$4,189 Derivative InstrumentsInterest rate swaps$57,497 $6,909 $(132)Interest rate floors$12,701 $350 — Interest rate caps$40,730 $13 — Interest rate futures$1,498 $(2)— Interest rate options$17,746 $497 (27)Interest rate forwards$7,728 $383 8 Interest rate total return swaps$1,048 $(59)— Synthetic GICs$38,646 $— — Foreign currency swaps$52,975 $(628)1,843 Foreign currency forwards$17,743 $(80)(824)Currency futures$914 $3 (92)Currency options$4,950 $70 126 Credit default swaps$12,587 $84 (9)Equity futures$5,427 $(24)— Equity index options$22,954 $397 11 Equity variance swaps$716 $3 — Equity total return swaps$3,294 $(279)— Total derivative instruments$904 Net Change$(8,389)__________________147Table of Contents(1)Does not necessarily represent those financial instruments solely subject to foreign currency exchange rate risk. Separate account assets and liabilities and Unit-linked investments and associated policyholder account balances, which are foreign currency exchange rate sensitive, are not included herein as any foreign currency exchange rate risk is borne by the contractholder, notwithstanding any general account guarantees which are included within embedded derivatives (see footnote (2) below) or included within future policy benefits and other policy-related balances (see footnote (3) below). Long-term debt excludes $5 million related to CSEs. (2)Embedded derivatives are recognized on the consolidated balance sheet in the same caption as the host contract.(3)Excludes $223.8 billion of liabilities, at carrying value, pursuant to insurance contracts reported within future policy benefits and other policy-related balances. These liabilities would economically offset a significant portion of the net change in fair value of our financial instruments resulting from a 10% appreciation in the U.S. dollar compared to all other currencies.Sensitivity to foreign currency exchange rates increased $0.1 billion to $8.4 billion at December 31, 2020 from $8.3 billion at December 31, 2019. These sensitivities exclude those liabilities, at carrying value, pursuant to insurance contracts reported within future policy benefits and other policy-related balances. These liabilities would economically offset a significant portion of the net change in fair value of our financial instruments resulting from a 10% appreciation in the U.S. dollar compared to all other currencies.148Table of ContentsThe table below provides additional detail regarding the potential loss in estimated fair value of our portfolio due to a 10% increase in equity prices at: December 31, 2020 NotionalAmountEstimatedFairValue (1)Assuming a10% Increasein EquityPrices (In millions)AssetsEquity securities$1,079 $85 FVO securities$1,611 74 Other invested assets$2,073 $51 Embedded derivatives within asset host contracts (2)$55 (5)Total assets$205 Liabilities (3)Policyholder account balances$129,637 $— Embedded derivatives within liability host contracts (2)$1,196 225 Total liabilities$225 Derivative InstrumentsInterest rate swaps$57,497 $6,909 $— Interest rate floors$12,701 $350 — Interest rate caps$40,730 $13 — Interest rate futures$1,498 $(2)— Interest rate options$17,746 $497 — Interest rate forwards$7,728 $383 — Interest rate total return swaps$1,048 $(59)— Synthetic GICs$38,646 $— — Foreign currency swaps$52,975 $(628)— Foreign currency forwards$17,743 $(80)— Currency futures$914 $3 — Currency options$4,950 $70 — Credit default swaps$12,587 $84 — Equity futures$5,427 $(24)(493)Equity index options$22,954 $397 49 Equity variance swaps$716 $3 — Equity total return swaps$3,294 $(279)(356)Total derivative instruments$(800)Net Change$(370)__________________(1)Does not necessarily represent those financial instruments solely subject to equity price risk. Additionally, separate account assets and liabilities and Unit-linked investments and associated policyholder account balances, which are equity market sensitive, are not included herein as any equity market risk is borne by the contractholder, notwithstanding any general account guarantees which are included within embedded derivatives (see footnote (2) below) or included within future policy benefits and other policy-related balances (see footnote (3) below).(2)Embedded derivatives are recognized on the consolidated balance sheet in the same caption as the host contract.(3)Excludes $223.8 billion of liabilities, at carrying value, pursuant to insurance contracts reported within future policy benefits and other policy-related balances.Sensitivity to equity market prices increased $337 million to $370 million at December 31, 2020 from $33 million at December 31, 2019.149Table of Contents
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+Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations under “Results of Operations by Reportable Segment” for detailed results by segment and geographic region.We manufacture a wide variety of precision instruments and provide value-added services to our customers. Our principal products and services are described below. We also describe our customers and distribution, sales and service, research and development, manufacturing, and certain other matters. These descriptions apply to substantially all of our products and related reportable segments.Laboratory InstrumentsWe make a wide variety of precision laboratory instruments for sample preparation, synthesis, analytical bench top, material characterization, and in-line measurement. Our portfolio includes laboratory balances, liquid pipetting solutions, automated laboratory reactors including real-time analytics, titrators, pH meters, process analytics sensors and analyzer technology, physical value analyzers including density and refractometry instruments, thermal analysis systems, and other analytical instruments such as UV/VIS spectrophotometers and moisture analyzers. Our laboratory instruments have leading-edge embedded software and we also offer LabX, our laboratory software platform to manage and analyze data generated from our instruments. The laboratory instruments and related service business accounted for approximately 54% of our net sales in 2020, 52% in 2019, and 51% in 2018.Laboratory BalancesOur laboratory balances have weighing ranges from one ten-millionth of a gram up to 64 kilograms. To respond to a wide range of customer needs and value/price points, we market our balances in a range of product tiers offering different levels of functionality. We also provide filter weighing and powder and liquid dosing automated systems. Based on the same weighing technology platform, we manufacture mass comparators, which are used by weights and measures officials as well as National Measurement Institute laboratories to ensure the accuracy of reference weights. Laboratory balances are primarily used in the pharmaceutical, biotechnology, testing labs, food, chemical, cosmetics, academia, and other industries.4Table of ContentsPipettesPipettes are used in life science research laboratories for dispensing small volumes of liquids. We develop, manufacture, and distribute advanced pipettes, including single- and multi-channel manual and electronic pipettes. We also develop and produce high-value consumables such as pipette tips and tubes. We maintain service centers in the key markets where customers periodically send their pipettes for certified recalibrations. These service centers, combined with our advanced asset management solutions, provide our customers with innovative solutions to maintain their instruments and meet regulatory compliance. Our principal end-markets are pharmaceutical, biotech, and academia.Analytical InstrumentsTitrators measure the chemical composition of samples and are used in environmental and research laboratories as well as in quality control labs in the pharmaceutical, testing labs, food and beverage, and other industries. Our high-end titrators are multi-tasking models, which can perform two determinations simultaneously on multiple vessels. Our offering includes robotics to automate routine work in quality control applications.Thermal analysis systems measure material properties as a function of temperature, such as weight, dimension, energy flow, and viscoelastic properties. Thermal analysis systems are used in nearly every industry, but primarily in the plastics and polymer industries, academia, and increasingly in the pharmaceutical industry.pH meters measure acidity in laboratory samples. We also manufacture and sell density and refractometry instruments, which measure chemical concentrations in solutions. In addition, we manufacture and sell moisture analyzers, which precisely determine the moisture content of a sample by utilizing the loss on drying method, and UV/VIS spectrophotometers that optimize spectroscopic workflows.Laboratory SoftwareLabX, our laboratory software platform, manages and analyzes data generated by our balances, titrators, pH meters, physical value analyzers, and other analytical instruments like UV/VIS spectrophotometers. LabX provides full network capability; assists with workflow automation; has efficient, intuitive protocols; and enables customers to collect and archive data in compliance with the U.S. Food and Drug Administration’s traceability and data integrity requirements for electronically stored data (also known as 21 CFR Part 11). Automated Chemistry SolutionsOur automated chemistry solutions focus on selected applications in the chemical and drug discovery process. Our automated lab reactors and in situ analysis systems are considered integral to the process development and scale-up activities of our customers. Our on-line measurement technologies, based on infrared and laser light scattering, enable customers to monitor chemical reactions and crystallization processes in real time in the lab and plant. In situ samples allow overnight sampling and testing. Additionally, we provide industry-leading embedded software solutions that enable our customers to manage, optimize, and improve experiments as well as production scale-up. We believe that our portfolio of integrated technologies can bring significant efficiencies to the development process, enabling our customers to bring new chemicals and drugs to market faster.Process AnalyticsOur process analytics business provides instruments for the in-line measurement of liquid and gas parameters used primarily in the production process of pharmaceutical, biotech, beverage, microelectronics, chemical, and refining companies, as well as power plants. More than half of our 5Table of Contentsprocess analytics sales are to the pharmaceutical and biotech markets, where our customers need fast and secure scale-up and production that meet the validation processes required for GMP (Good Manufacturing Processes) and other regulatory standards like the USP (US Pharmacopoeia) regulations for ultrapure water quality. We are a leading solution provider for liquid analytical measurement to control and optimize production processes. Our solutions include sensor and analyzer technology for measuring pH, dissolved oxygen, carbon dioxide, conductivity, turbidity, ozone, total organic carbons, bioburden, sodium, and silica, as well as laser analyzers for gas measurement. Intelligent sensor diagnostics capabilities enable improved asset management solutions for our customers to reduce process downtime and maintenance costs. Our instruments offer leading multi-parameter capabilities and plant-wide control system integration, which are key for integrated measurement of multiple parameters to secure production quality and efficiency. With a worldwide network of specialists, we support customers in critical process applications, compliance, and systems integration questions.Industrial InstrumentsWe manufacture numerous industrial weighing instruments and related terminals and offer dedicated software solutions for the pharmaceutical, chemical, food, discrete manufacturing, and other industries. In addition, we manufacture metal detection, x-ray, checkweighing, and other end-of-line product inspection systems used in production and packaging. We supply automatic identification and data capture solutions, which integrate in-motion weighing, dimensioning, and identification technologies for transport, shipping, and logistics customers. We also offer heavy industrial scales and related software. The industrial instruments and related service business accounted for approximately 40% of our net sales in 2020 and 41% in 2019 and 2018.Industrial Weighing InstrumentsWe offer a comprehensive line of industrial scales and weighing devices, such as bench scales, floor scales, and weigh modules for weighing loads from a few grams to several thousand kilograms in applications ranging from measuring materials in chemical production to quality completeness control in discrete manufacturing to weighing packages at the end of the line. Our products are used in a wide range of industrial applications, such as counting, formulating and mixing ingredients, and quality control.Industrial TerminalsOur industrial scale terminals collect data and integrate it into manufacturing processes, helping to automate them. Our terminals allow users to remotely download formulation recipes or access setup data and can minimize downtime through predictive rather than reactive maintenance.Transportation and LogisticsWe supply automatic dimensional measurement and data capture solutions, which integrate in-motion weighing, dimensioning, and identification technologies. With these solutions, customers can measure the weight and cubic volume of packages for appropriate billing, load management, and quality control. Our solutions also integrate into customers’ information systems.Vehicle Scale SystemsOur primary heavy industrial products are scales for weighing trucks or railcars (i.e., weighing bulk goods as they enter or leave a factory or at a toll station). Heavy industrial scales are capable of measuring weights up to 500 tons and permit accurate weighing under extreme environmental conditions. We also offer advanced computer software that can be used with our heavy industrial scales to facilitate a broad range of customer solutions and provides a complete system for managing vehicle transaction processing.6Table of ContentsIndustrial SoftwareWe offer software that can be used with our industrial instruments. Examples include FreeWeigh.Net, statistical quality control software; FormWeigh.Net, formulation/batching software; and DataBridge, which supports the operation of vehicle scales. FreeWeigh.Net and FormWeigh.Net provide full network capability and enable customers to collect and archive data in compliance with U.S. Food and Drug Administration requirements, 21 CFR Part 11.Product InspectionIncreasing safety and consumer protection requirements are driving the need for more sophisticated end-of-line product inspection systems (e.g., for use in food processing and packaging, pharmaceutical, packaged consumer goods, and other industries). We are a leading global provider of metal detectors, x-ray systems, checkweighers, camera-based imaging equipment, and track-and-trace solutions that are used in these industries. Metal detectors are most commonly used to detect fine particles of metal that may be contained in raw materials or may be generated by the manufacturing process itself. X-ray inspection is used to detect metallic contamination in applications unsuited to metal detectors and many types of non-metallic contamination, such as glass, calcified bone, stones, and pits. Our x-ray systems are also used for mass control and for determining and controlling the fat content in meat. Checkweighers are used to control the filled weight of packaged goods such as food, pharmaceuticals, and cosmetics. Our camera-based vision inspection solutions provide in-line inspection of package quality, labels, and content, which are needs for food and beverage, consumer goods, and pharmaceutical companies. Vision inspection systems with associated specialist software enable our pharmaceutical customers to implement traceability and serialization tracking, as required by regulation. All of our technologies are integrated with material handling systems to ensure the correct presentation of the customer’s product to the device and the secure rejection of non-conforming product, and are frequently designed to comply with stringent hygiene standards. Our technologies may also be used together as components of integrated packaging lines. ProdX Inspect is our quality and productivity control software for helping customers comply with regulations and optimize process efficiency, either as a stand-alone solution or through integration with the customer’s manufacturing and enterprise systems.Retail Weighing SolutionsSupermarkets, hypermarkets, and other food retail businesses make use of multiple weighing and food labeling solutions for handling fresh goods (such as meats, vegetables, fruits, or cheeses). We offer networked scales and software, which can integrate backroom, counter, self-service, and checkout functions and can incorporate fresh goods item data into a supermarket’s overall food item and inventory management system. The scale screen display allows for in-store marketing and can help encourage consumers in the store to make more purchase decisions at the point of sale. In addition, we offer stand-alone scales for basic counter weighing and pricing, price finding, and printing. The customer benefits of our retail solutions are in the areas of enterprise-wide article and price management, merchandising, and regulatory compliance. In North America and select other markets, our offering also includes automated packaging and labeling solutions for the meat backroom, which are fully integrated with the scales in the store. The retail business accounted for approximately 6% of our net sales in 2020, 7% in 2019, and 8% in 2018.Customers and DistributionOur principal customers include companies in the following key end-markets: the life science industry (pharmaceutical and biotech companies, as well as independent research organizations and testing labs); food and beverage manufacturers; chemical, specialty chemicals, and cosmetics companies; food 7Table of Contentsretailers; the transportation and logistics industry; the metals industry; the electronics industry; and the academic community.Our products are sold through a variety of distribution channels. Generally, more technically sophisticated products are sold through our direct sales force, while less complicated products are sold through indirect channels. Our sales through direct channels exceed our sales through indirect channels. A significant portion of our sales in the Americas is generated through indirect channels, including sales of our Ohaus-branded products. Ohaus-branded products target markets, such as the educational market, in which customers are interested in lower cost, a more limited set of features, and less comprehensive support and service.We have a diversified customer base, with no single end-customer accounting for more than 1% of 2020 net sales.Sales and ServiceMarket OrganizationsWe maintain geographically focused market organizations around the world that are responsible for all aspects of our sales and service. The market organizations are customer-focused, with an emphasis on building and maintaining value-added relationships with customers in our target market segments. Each market organization has the ability to leverage best practices from other units while maintaining the flexibility to adapt its marketing and service efforts to account for different cultural and economic conditions. Market organizations also work closely with our producing organizations (described below) by providing feedback on manufacturing and product development initiatives, new product and application ideas, and information about key market segments.We have one of the largest and broadest global sales and service organizations among precision instrument manufacturers we compete against. At December 31, 2020, our sales and service group consisted of approximately 8,150 employees in sales, marketing and customer service (including related administration), and post-sales technical service, located in approximately 40 countries. This field organization has the capability to provide service and support to our customers and distributors in major markets across the globe. This is important because our customers increasingly seek to do business with a consistent global approach.ServiceOur service business continues to be successful with a focus on providing uptime and calibration services, as well as further expanding our offerings to provide value-added services for a range of market needs, including regulatory compliance, performance enhancements, application expertise and training, and remote services. We have a unique offering to our pharmaceutical customers in promoting the use of our instruments in compliance with FDA and other international regulations, and we can provide these services to most customers’ locations around the world. Our global service network is also an important factor in our ability to expand in emerging markets. We estimate that we have the largest installed base of weighing instruments in the world. Service (representing service contracts, on demand services, and replacement parts) accounted for approximately 22% of our net sales in 2020, 2019, and 2018. Beyond revenue opportunities, we believe service is a key part of our solution offering and helps significantly in customer retention. The close relationships and frequent contact with our large customer base allow us to be the trusted advisor of our customers, which provides us with high-quality sales opportunities as well as innovative product and application ideas.8Table of ContentsResearch and Development and ManufacturingProducing OrganizationsOur research, product development, and manufacturing efforts are organized into a number of producing organizations. Our focused producing organizations help reduce product development time and costs, improve customer focus, and maintain technological leadership. The producing organizations work together to share ideas and best practices, and there is a close interface and coordinated customer interaction among marketing organizations and producing organizations. We also have regional logistics hubs to satisfy customer delivery requirements while optimizing our logistic processes.Research and DevelopmentWe continue to invest in product innovation to provide technologically advanced products to our customers for existing and new applications. Over the last three years, we have invested $425 million in research and development ($140 million in 2020, $144 million in 2019, and $141 million in 2018), which is approximately 5% of net sales for each year. Our research and development efforts fall into two categories:•technology advancements, which generate new products or features and increase the value of our products. These advancements may be in the form of enhanced or new functionality, new applications for our technologies, more accurate or reliable measurement, additional software capability, or automation through robotics or other means.•cost reductions, which reduce the manufacturing cost of our products through better overall design and/or improve the ease of serviceability.We devote a substantial proportion of our research and development budget to software development. This includes software to process the signals captured by the sensors of our instruments, application-specific software, and software that connects our solutions into customers’ existing IT systems. We closely integrate research and development with marketing, manufacturing, and product engineering. We have approximately 1,400 employees in research and development and product engineering in countries around the globe.ManufacturingWe are a worldwide manufacturer, with facilities principally located in China, Switzerland, the United States, Germany, the United Kingdom, and Mexico. We emphasize product quality in our manufacturing operations, and most of our products require very strict tolerances and exact specifications. We use an extensive quality control system that is integrated into each step of the manufacturing process. All major manufacturing facilities have achieved ISO 9001 certification. We believe that our manufacturing capacity is sufficient to meet our present and currently anticipated demand. We expect to make net investments in new or expanded manufacturing facilities of approximately $10 million to $15 million in 2021.We generally manufacture critical components, which are components that contain proprietary technology. When outside manufacturing is more efficient, we contract with other manufacturers for certain nonproprietary components. We use a wide range of suppliers. We believe our supply arrangements are adequate and that there are no material constraints on the sources and availability of materials. From time to time, we may rely on a single supplier for all of our requirements of a particular component. Supply arrangements for electronic components are generally made globally.9Table of ContentsBacklog; SeasonalityOur manufacturing turnaround time is generally short, which permits us to manufacture orders to fill for most of our products. Backlog is generally a function of requested customer delivery dates and is typically no longer than one to two months.Our business has historically experienced a slight amount of seasonal variation, particularly the high-end laboratory instruments business. Traditionally, sales in the first quarter are slightly lower than, and sales in the fourth quarter are slightly higher than, sales in the second and third quarters. Fourth quarter sales have historically generated approximately 28% to 30% of our net sales. This trend has a somewhat greater effect on income from operations than on net sales because fixed costs are generally incurred evenly across all quarters.EmployeesOur total global workforce was 16,500, including 14,900 employees and 1,600 temporary personnel, as of December 31, 2020, and includes approximately 6,000 in Europe, 4,900 in North and South America, and 5,600 in Asia and other countries. We are proud of our corporate culture and our talented employees. We endeavor to continue to provide an attractive work environment and keep our employees fully engaged. We know that our future success depends on attracting, developing, and retaining the best employees. We promote equal opportunity worldwide and value diversity in our global workforce, which reflects the diversity in the many communities in which we operate internationally. We employ people of more than 85 nationalities. We wish to further promote all forms of diversity, and we encourage all employees, inclusive of all our demographics, to take on more responsibilities and management positions. As of December 31, 2020, approximately 35% of our global employee headcount was female, with approximately 27% holding management positions. We place great emphasis on performance management, training, and developing our employees across all levels and regions. During 2020, approximately 14,500 employees completed one or more training courses. Lastly, we have local safety programs in place in all relevant units, and select locations have implemented a certified work safety management system. Severe workplace accidents are rare and we have had no fatalities from occupational incidents in the past five years.We believe our employee relations are good, and we have not suffered any material employee work stoppage or strike during the last five years. Approximately 7,400 employees are represented by collective bargaining or another arrangement organized to represent employee interests.SustainabilitySustainability touches all aspects of our business, from designing, sourcing, and producing our products, to selling and delivering them to our customers, to handling them at the end of their lifecycle. A sustainable mindset helps guide us to make the right decisions for our customers, employees, suppliers, shareholders, and the communities in which we operate our business. We want to manage our business sustainably to position the Company for long-term growth. More than 10 years ago, we launched our GreenMT program to pursue environmental, social, and governance priorities where we can have a significant impact. We do this in five key areas: (1) keeping our operations sustainable over the long term by ensuring we use resources efficiently, (2) helping our customers to be sustainable in their businesses by offering green products and services, (3) promoting responsible practices within our supply chain, (4) ensuring an engaged workforce through fair, attractive, safe, and development-minded workplaces, and (5) following corporate governance best practices. We have set a number of goals relating to our GreenMT sustainability program, including reducing our carbon footprint and other environmental, social, and governance goals. As of 2020, we achieved carbon neutrality with respect to Scope 1 and Scope 2 CO2 emissions. We also broadened our goals 10Table of Contentsrelating to waste, including reducing our waste intensity by 20% and achieving zero waste to landfill, in each case by 2025. We report annually on our progress in our Corporate Responsibility Report, available on www.mt.com/sustainability. Blue Ocean Program“Blue Ocean” refers to our program to establish a global operating model with standardized, automated, and integrated processes and high levels of global data transparency. It encompasses an enterprise architecture, with a global, single-instance ERP system. Within our IT systems, we continue to move toward integrated, homogeneous applications and common data structures. We are also largely standardizing our key business processes. The implementation of the systems and processes has been proceeding on a staggered basis over a multi-year period. We have implemented the Blue Ocean program in our Swiss, Chinese, U.K., Benelux, German, U.S., and Southeast Asia operations. We estimate that we have more than 80% of our users on the program, and we will continue to implement additional locations and functionality over the coming years.Intellectual PropertyWe hold over 5,000 patents and trademarks (including pending applications), primarily in the United States, Switzerland, China, the European Union, Germany, the United Kingdom, Italy, France, Japan, South Korea, Brazil, and India. Our products generally incorporate a wide variety of technological innovations, some of which are protected by patents of various durations. Products are generally not protected as a whole by individual patents, and as a result, no one patent or group of related patents is material to our business. We have numerous trademarks, including the Mettler-Toledo name and logo, which are material to our business. We regularly protect against infringement of our intellectual property.RegulationOur products are subject to various regulatory standards and approvals by weights and measures regulatory authorities. All of our electrical components are subject to electrical safety standards. We believe that we are in compliance in all material respects with applicable regulations.Approvals are required to ensure our instruments do not impermissibly influence other instruments and are themselves not affected by other instruments. In addition, some of our products are used in “legal for trade” applications, in which prices based on weight are calculated and for which specific weights and measures approvals are required. Although there are a large number of regulatory agencies across our markets, there is an increasing trend toward harmonization of standards, and weights and measures regulation is harmonized across the European Union.Our products may also be subject to special requirements depending on the end-user and market. For example, laboratory customers are typically subject to Good Laboratory Practices (GLP), industrial customers to Good Manufacturing Practices (GMP), pharmaceutical customers to U.S. Food and Drug Administration (FDA) regulations, and customers in food processing industries may be subject to Hazard Analysis and Critical Control Point (HACCP) regulations. Products used in hazardous environments may also be subject to special requirements.Environmental MattersWe are subject to environmental laws and regulations in the jurisdictions in which we operate. We own or lease a number of properties and manufacturing facilities around the world. Like many of our competitors, we have incurred, and will continue to incur, capital and operating expenditures and other costs in complying with such laws and regulations.We are currently involved in, or have potential liability with respect to, the remediation of past contamination in certain of our facilities. A former subsidiary of Mettler-Toledo, LLC known as Hi-Speed 11Table of ContentsCheckweigher Co., Inc. was one of two private parties ordered by the New Jersey Department of Environmental Protection, in an administrative consent order signed on June 13, 1988, to investigate and remediate certain ground water contamination at a property in Landing, New Jersey. After the other party under this order failed to fulfill its obligations, Hi-Speed became solely responsible for compliance with the order. Residual ground water contamination at this site is now within a Classification Exception Area which the Department of Environmental Protection has approved and within which the Company oversees monitoring of the decay of contaminants of concern. A concurrent Well Restriction Area also exists for the site. The Department of Environmental Protection does not view these vehicles as remedial measures, but rather as “institutional controls” that must be adequately maintained and periodically evaluated. We estimate that the costs of compliance associated with the site over the next several years will be approximately a total of $0.4 million.In addition, certain of our present and former facilities have or had been in operation for many decades and, over such time, some of these facilities may have used substances or generated and disposed of wastes that are or may be considered hazardous. It is possible that these sites, as well as disposal sites owned by third parties to which we have sent wastes, may in the future be identified and become the subject of remediation. Although we believe that we are in substantial compliance with applicable environmental requirements and, to date, we have not incurred material expenditures in connection with environmental matters, it is possible that we could become subject to additional environmental liabilities in the future that could have a material adverse effect on our financial condition, results of operations, or cash flows.CompetitionOur markets are highly competitive. Many of the markets in which we compete are fragmented both geographically and by application, particularly the industrial and food retailing markets. As a result, we face numerous regional or specialized competitors, many of which are well established in their markets. For example, some of our competitors are divisions of larger companies with potentially greater financial and other resources than our own. In addition, some of our competitors are domiciled in emerging markets and may have a lower cost structure than ours. We are confronted with new competitors in emerging markets which, although relatively small in size today, could become larger companies in their home markets. Given the sometimes significant growth rates of these emerging markets, and in light of their cost advantage over developed markets, emerging market competitors could become more significant global competitors. Taken together, the competitive forces present in our markets can impair our operating margins in certain product lines and geographic markets.We expect our competitors to continue to improve the design and performance of their products and to introduce new products with competitive prices. Although we believe that we have technological and other competitive advantages over many of our competitors, we may not be able to realize and maintain these advantages. These advantages include our worldwide market leadership positions; our global brand and reputation; our track record of technological innovation; our comprehensive, high-quality solution offering; our global sales and service offering; our large installed base of instruments; and the diversification of our revenue base by geographic region, product range, application, and customer. To remain competitive, we must continue to invest in research and development, sales and marketing, and customer service and support. We cannot be sure that we will have sufficient resources to continue to make these investments or that we will be successful in identifying, developing, and maintaining any competitive advantages.We believe the principal competitive factors in developed markets for purchasing decisions are the product itself, application support, service support, and price. In emerging markets, where there is greater demand for less sophisticated products, price is a more important factor than in developed markets. 12Table of ContentsCompetition in the U.S. laboratory market is also influenced by the presence of large distributors that sell not only our products but those of our competitors as well.Company Website and InformationYou can find our website on the internet at www.mt.com. The website contains information about us and our operations. The information contained on our website is not included in, or incorporated by reference into, this annual report on Form 10-K. You can view and download free of charge copies of each of our filings with the SEC on Form 10-K, Form 10-Q, Form 8-K, and Schedule 14A and all amendments to those reports by accessing www.mt.com, clicking on About Us, Investor Relations, and then clicking on SEC Filings. The SEC maintains a website at https://www.sec.gov that contains reports, proxy and information statements, and other information regarding issuers that file electronically with the SEC.Our website also contains copies of the following documents that you can download free of charge:•Corporate Governance Guidelines•Audit Committee Charter•Compensation Committee Charter•Nominating and Corporate Governance Committee Charter•Code of Conduct•Equal Employment Opportunity Policy•Business Partner Code of Conduct•Ethical, Social, and Quality Standards•Corporate Responsibility Report•Environmental Policy•Political Participation Policy•Conflict Mineral Report•Statement on Slavery, Human Trafficking, and Transparency in the Supply ChainYou can also obtain in print, free of charge, any of the above documents and any of our reports on Form 10-K, Form 10-Q, Form 8-K, and Schedule 14A and all amendments to those reports by sending a written request to our Investor Relations Department:Investor RelationsMettler-Toledo International Inc.1900 Polaris ParkwayColumbus, OH 43240 U.S.A.Phone: +1 614 438 4748E-mail: mary.finnegan@mt.com13Table of ContentsItem 1A.Risk FactorsFactors Affecting Our Future Operating ResultsOperational RisksThe COVID-19 pandemic has negatively affected, and will likely continue to negatively affect, various aspects of our business, including our workforce and supply chain, and make it more difficult and expensive to meet our obligations to our customers, and has resulted in, and will likely continue to result in, reduced demand from our customers as their businesses may also be negatively affected.Our global operations are susceptible to global events that could have an adverse effect on our business results and financial condition. For instance, we are susceptible to a widespread outbreak of an illness or other health issue, such as the ongoing coronavirus pandemic ("COVID-19"), which has spread globally, resulting in millions of confirmed cases throughout the world and in all countries where we conduct business. The pandemic has caused many governments to implement stay-at-home orders, quarantines, and significant restrictions on travel. Several governments have also implemented work restrictions that prohibit many employees from going to their customary work locations and that require these employees to work remotely if possible. Quarantines, travel bans, work and other restrictions were initially put in place on a national level in China in January 2020, and with the global spread of the virus, subsequently adopted in many other countries and regions with many restrictions in Asia Pacific, Europe, North America, and South America. These restrictions continue to change as COVID-19 evolves in each country and region.As a result of pandemic outbreaks, including COVID-19, businesses can be shut down; supply chains can be interrupted, slowed, or rendered inoperable; and individuals can become ill, quarantined, or otherwise unable to work and/or travel due to health reasons or governmental restrictions. COVID-19 interferes with general commercial activity related to our supply chain and customer base. In addition, COVID-19 may negatively affect the global economy and our customers’ businesses, which may result in delayed or reduced purchases from us. Some customers may also have difficulty meeting their payment obligations to us, resulting in late payments or an inability of some customers to make payments at all. During the year ended December 31, 2020, COVID-19 had a negative impact on our business, primarily related to reduced global customer demand. We remain cautious as uncertainties related to COVID-19 and the resulting impact to the economy continue in all regions of the world and market conditions may also change quickly. With the global spread of the virus and related negative impact to the global economy, we may experience reduced global sales volume from lower customer demand. Our operations could be negatively affected further if our employees who are currently not subject to stay-at-home or work restriction orders are quarantined or become ill as a result of exposure to COVID-19, or if they become subject to governmental COVID-19 curfews or stay-at-home orders. The longer-term effects on our business will be impacted by the global economy and any recession implications in different regions of the world. While it is extremely difficult to estimate the extent and duration of any COVID-19 implications, the effects on our business, results of operations, and financial condition could be material.14Table of ContentsWe sell primarily to companies in developed countries. An economic downturn in these countries could hurt our operating results.Most of our business is derived from companies in developed countries. Economic uncertainty in many parts of the world, including international trade disputes and sovereign debt levels in the European Union and the United States, are situations that we monitor closely. If developed countries were to experience slow growth or recession, we could see the following effects:•a drop in demand for our products; •companies being unable to finance their businesses; •difficulty in obtaining materials and supplies; •potential devaluation and/or impairment of assets;•difficulty in collecting accounts receivables; •an increase in accounts receivable write-offs; and•greater foreign exchange rate volatility affecting our profitability and cash flow.Economic downturns or recessions adversely affect our operating results because our customers often decrease or delay capital expenditures. Customers may also purchase lower-cost products made by competitors and not resume purchasing our products even after economic conditions improve. These conditions would reduce our revenues and profitability.In addition, a potential financial crisis on financial institutions globally would likely have an adverse effect on the global capital markets and our business.We are subject to certain risks associated with our international operations and have a significant concentration of business in China.We conduct business in many countries, including emerging markets in Asia, Latin America, and Eastern Europe, and these operations represent a significant portion of our sales and earnings. For example, our Chinese operations accounted for 19% of sales to external customers, approximately 32% of our global production, and 32% of total segment profit during 2020. In addition to the currency risks discussed below, international operations pose other substantial risks and problems for us, including the following:•local tariffs and trade barriers;•additions or revisions to a country's legal and regulatory requirements;•difficulties in staffing and managing local operations and/or mandatory salary increases;•credit risks arising from financial difficulties facing local customers and distributors;•difficulties in protecting intellectual property;•nationalization of private enterprises which may result in the confiscation of assets, as we hold significant assets around the world in the form of property, plant, and equipment, inventory, and accounts receivable, as well as $43.2 million of cash at December 31, 2020 in our Chinese subsidiaries;•restrictions on investments and/or limitations regarding foreign ownership;•adverse tax consequences, including tax disputes and imposition or increase of withholding and other taxes on remittances and other payments by subsidiaries;•the adoption of new or expansion of current travel restrictions or the intensification of trade wars;•other uncertain local economic, political, and social conditions, including hyper-inflationary conditions or periods of low or no productivity growth; and•credit tightening or reduction in credit availability for local customers.We must also comply with regulations regarding the conversion and repatriation of funds earned in local currencies. For example, we need government approval to convert earnings from our operations in 15Table of ContentsChina into other currencies and to repatriate these funds. If we cannot comply with these or other applicable regulations, we may face increased difficulties in using cash generated in China.We are required to comply with various import, export control, and economic sanctions laws, which may affect our transactions with certain customers, business partners, and other persons, including in certain cases dealings with or between our employees and subsidiaries. In certain circumstances, export control and economic sanctions regulations may prohibit the export of certain products, services, and technologies, and in other circumstances, we may be required to obtain an export license before exporting a controlled item. We follow all relevant laws and continue to do business in Russia. Sanctions imposed on business in Russia may affect the economy and our business in Russia. In addition, failure to comply with any of these regulations could result in civil and criminal, monetary and non-monetary penalties, disruptions to our business, limitations on our ability to import and export products and services, and damage to our reputation.Growth in emerging markets, especially China, can be volatile and change quickly. Our business and financial performance may be adversely affected by a cybersecurity attack.We rely on our technology infrastructure to interact with suppliers, sell our products and services, fulfill orders, support our customers, and bill, collect, and make payments. Our system and processes may be susceptible to damage or interruption from cybersecurity incidents, such as terrorist or hacker attacks, the introduction of malicious computer viruses, ransomware, falsification of banking and other information, insider risk, or other security breaches. If there is a cybersecurity incident, we may suffer interruptions in service, loss of assets or data, or reduced functionality. Many of our systems are not redundant, and our disaster recovery planning is not sufficient for every eventuality a cybersecurity incident could cause. Security breaches of our systems which allow inappropriate access to or inadvertent transfer of information and misappropriation or unauthorized disclosure of confidential information belonging to us or to our employees, customers, or suppliers could result in our suffering significant financial and reputational damage.Customers may use our products and/or software to generate or manage critical information. Though we take steps to ensure our products and/or software are secure, it is possible that a cyber attack could result in the loss or compromise of critical information. If a customer alleges that a cyber attack causes or contributes to a loss or compromise of critical information, we could face harm to our reputation and financial condition.While we attempt to mitigate cybersecurity risks by employing a number of proactive measures, including employee training and awareness, technical security controls, enhanced data protection, and maintenance of backup and protective systems, our systems remain potentially vulnerable to cybersecurity threats, any of which could have a material adverse effect on our business. We believe our mitigation measures reduce, but cannot eliminate, the risk of a cybersecurity incident. Despite any precautions we may take, a cybersecurity incident could harm our reputation and financial condition and cause us to incur legal liability and increased costs to respond to such events. Our cyber liability insurance may not be sufficient to compensate us for losses that may result from interruptions in our services or asset or data loss as a result of cybersecurity incidents. In addition, regulatory or legislative action related to cybersecurity, privacy, and data protection worldwide, such as the European General Data Protection Regulation which went into effect in May 2018, may increase the costs to develop, implement, or secure our products or services. We expect cybersecurity regulations to continue to evolve and be costly to implement. If we violate or fail to comply with such regulatory or legislative requirements, we could be fined or otherwise sanctioned, and such fines or penalties could have a material adverse effect on our business and operations.16Table of ContentsWe are vulnerable to system failures and data loss risks, which could harm our business.We rely on our technology infrastructure to interact with suppliers, sell our products and services, support our customers, fulfill orders, and bill, collect, and make payments. Our systems are vulnerable to damage or interruption from natural disasters, power loss, telecommunication failures, malicious employees or employee negligence, computer viruses, and other events. When we upgrade or change systems, we may suffer interruptions in service, loss of data, or reduced functionality. A significant number of our systems are not redundant, and our disaster recovery planning is not sufficient for every eventuality. Despite any precautions we may take, such problems could result in interruptions in our services, fraudulent or negligent loss of assets, or unauthorized disclosure of confidential information, which could harm our reputation and financial condition. Our business interruption insurance may not be sufficient to compensate us for losses that may result from interruptions in our services or data loss as a result of system failures.Customers may use our products and/or software to generate or manage confidential information. Though we take steps to ensure our products and/or software are secure, it is possible customers could lose confidential information stored on our products. If a customer alleges system failures in our products and/or software cause or contribute to a loss, we could face harm to our reputation and financial condition and legal liability.We have also been implementing a program to globalize our business processes and information technology systems that includes the implementation of a Company-wide enterprise resource planning system. This has been proceeding on a staggered basis over a multi-year period. We have implemented the program in our Swiss, Chinese, U.K., Benelux, German, U.S., and Southeast Asia operations. We estimate that we have more than 80% of our users on the program and will continue to implement additional locations and functionality over the coming years. If our implementation is flawed, we could suffer interruptions in operations and customer-facing activities that could harm our reputation and financial condition or cause us to lose data, experience reduced functionality, or have delays in reporting financial information. It may take us longer to implement the program than we have planned, and the project may cost us more than we have estimated, either of which would negatively impact our ability to generate cost savings or other efficiencies. In addition, the program has increased our reliance on a single information technology system, which would have greater consequences should we experience a system disruption.Our ability to manufacture and deliver products and services may be disrupted.We have key manufacturing facilities located in China, Europe, and the United States. Many of our products are developed and manufactured at single locations, with limited alternate facilities. In addition, a large portion of our products and spare parts are distributed through regional logistics centers, in which certain logistics activities are outsourced to third parties. If we experience any significant disruption in these facilities for any reason, such as the COVID-19 pandemic described on page 14, strikes or other labor unrest, power interruptions, cybersecurity attacks, fire, earthquakes, hurricanes, floods, rising water levels, or other events beyond our control, we may be unable to satisfy customer demand for our products or services resulting in lost sales. It may be expensive to resolve these issues, even though some of these risks are covered by insurance policies. More importantly, customers may switch to competitors and may not return to us even if we resolve the interruption.Our business would suffer if we were unable to obtain supplies of material.We purchase most of our raw materials, components, and supplies from multiple suppliers. Some items are purchased from a limited or single source of supply, and disruption of these sources could affect our ability to manufacture products. Even where multiple sources of materials and components are available, the quality of the alternative materials, regulatory and contractual requirements to qualify 17Table of Contentsmaterials for use in manufacturing, and the time required to establish new relationships with reliable suppliers could result in manufacturing delays and possible loss of sales. If we are unable to obtain materials or components for an extended time, this could damage our customer relationships and harm our financial condition or results of operations.Our product development efforts may not produce commercially viable products in a timely manner.If we do not introduce new products and enhancements, our products could become technologically obsolete over time, which would harm our operating results. To remain competitive, we must continue to make significant investments in research and development, sales and marketing, and customer service and support. We cannot be sure that we will have sufficient resources to continue to make these investments. In developing new products, we may be required to make substantial investments before we can determine their commercial viability. As a result, we may not be successful in developing new products and we may never realize the benefits of our research and development activities.We face risks related to sales through distributors and other third parties that we do not control, which could harm our business.We sell some products through third parties, including distributors and value-added resellers. This exposes us to various risks, including competitive pressure, concentration of sales volumes, credit risks, and compliance risks. We may rely on one or a few key distributors for a product or market, and the loss of these distributors could reduce our revenue and net earnings. Distributors may also face financial difficulties, including bankruptcy, which could harm our collection of accounts receivables. Violations of the FCPA or similar anti-bribery laws by distributors or other third-party intermediaries could materially impact our business. In addition to financial risk, actions of some of our distributors could cause reputational harm, especially if our products are involved. Risks related to our use of distributors may reduce sales, increase expenses, and weaken our competitive position.Departures of key employees could impair our operations.Key employees could leave the Company. If any key employees stopped working for us, our operations could be harmed. Important R&D personnel may leave and join competitors, which could substantially delay or hinder ongoing development projects. We have no key man life insurance policies with respect to any of our senior executives.Our business involves certain operating risks, and our insurance may not be adequate to cover all insured losses of liabilities we might incur in our operations. We have procured various insurance policies for certain types of insurance coverage and in varying coverage amounts. Our insurance may not be adequate to cover all losses or liabilities that we might incur in our operations. Furthermore, our insurance may not adequately protect us against liability from all of the hazards of our business. As a result of market conditions, premiums and deductibles for certain of our insurance policies may substantially increase. In some instances, certain insurance could become unavailable or available only for reduced amounts of coverage. We also are subject to the risk that we may be unable to maintain or obtain insurance of the type and amount we desire at a reasonable cost. If we were to incur a significant liability for which we were uninsured or for which we were not fully insured, it could have a material adverse effect on our financial position, results of operations, and cash flows.18Table of ContentsStrategic RisksA prolonged downturn or additional consolidation in the pharmaceutical, food and beverage, and chemical industries could adversely affect our operating results. A reduction in the capital resources or government funding of our customers could reduce our sales.Our products are used extensively in the pharmaceutical, food and beverage, and chemical industries. Consolidation in these industries hurt our sales in prior years. In recent years, there has been an increase in consolidation within these industries. A prolonged global economic downturn, a downturn affecting one or more of these industries, or additional consolidation in any of these industries could adversely affect our operating results. In addition, the capital spending policies of our customers in these and other industries are based on a variety of factors we cannot control, including the resources available for purchasing equipment, the spending priorities among various types of equipment, and policies regarding capital expenditures. Any decrease or delay in capital spending by our customers would cause our revenues to decline and could harm our profitability. A decline in government funding of research or education could reduce some customers’ ability to purchase our products.We operate in highly competitive markets, and it may be difficult for us to preserve operating margins, gain market share, and maintain a technological advantage.Our markets are highly competitive. Many are fragmented both geographically and by application, particularly the industrial and food retailing markets. As a result, we face numerous regional or specialized competitors, many of which are well established in their markets. In addition, some of our competitors are divisions of larger companies with potentially greater financial and other resources than our own. There has also been an increase in the consolidation of precision instrument companies in recent years. Any consolidation within our market could result in competitors becoming larger and having greater financial and other resources than our own. Some of our competitors are domiciled or operate in emerging markets and may have a lower cost structure than ours. We are confronted with new competitors in emerging markets which, although relatively small in size today, could become larger companies in their home markets. Given the sometimes significant growth rates of these emerging markets, and in light of their cost advantage over developed markets, emerging market competitors could become more significant global competitors. Taken together, the competitive forces present in our markets could harm our operating margins. We expect our competitors to continue to improve the design and performance of their products and to introduce new products with competitive prices. Although we believe that our products and services have advantages over our competitors, we may not be able to realize and maintain these advantages. We may face risks associated with future acquisitions.We may pursue acquisitions of complementary product lines, technologies, or businesses. Acquisitions involve numerous risks, including difficulties in integrating the acquired operations, technologies, and products; diversion of management’s attention from other business concerns; and potential departures of key employees of the acquired company. If we successfully identify acquisitions in the future, completing such acquisitions may result in new issuances of our stock that may be dilutive to current owners, increases in our debt and contingent liabilities, and additional amortization expense related to intangible assets. Any of these acquisition-related risks could have a material adverse effect on our profitability.Larger companies have identified life sciences and instruments as businesses they will consider entering or expanding their presence, which could change the competitive dynamics of these markets. In addition, we may not be able to identify, successfully complete, or integrate potential acquisitions in the future. Even if we can do so, we cannot be sure that these acquisitions will have a positive impact on our business or operating results. We are also required to estimate the fair value of certain assets acquired or 19Table of Contentsliabilities assumed. Such fair values may be based on valuation models which are subject to inherent uncertainties and our judgments regarding certain assumptions.Financial RisksCurrency fluctuations affect our operating profits.Our earnings are affected by changing exchange rates. We are particularly sensitive to changes in the exchange rates between the Swiss franc, euro, Chinese renminbi, and U.S. dollar. We have more Swiss franc expenses than we do Swiss franc sales because we develop and manufacture products in Switzerland that we sell globally and have a number of corporate functions located in Switzerland. When the Swiss franc strengthens against our other trading currencies, particularly the U.S. dollar and euro, our earnings go down. We also have significantly more sales in the euro than we do expenses. When the euro weakens against the U.S. dollar and Swiss franc, our earnings also go down. We estimate a 1% strengthening of the Swiss franc against the euro would reduce our earnings before tax by approximately $1.6 million to $1.8 million annually.We also conduct business throughout the world, including Asia Pacific, the United Kingdom, Eastern Europe, Latin America, and Canada. Fluctuations in these currency exchange rates against the U.S. dollar can also affect our operating results. The most significant of these currency exposures is the Chinese renminbi. The impact on our earnings before tax of the Chinese renminbi weakening 1% against the U.S. dollar is a reduction of approximately $2.0 million to $2.2 million annually. In addition to the effects of exchange rate movements on operating profits, our debt levels can fluctuate due to changes in exchange rates, particularly between the U.S. dollar, the Swiss franc, and euro. Based on our outstanding debt at December 31, 2020, we estimate that a 5% weakening of the U.S. dollar against the currencies in which our debt is denominated would result in an increase of $25.2 million in the reported U.S. dollar value of our debt.We may experience impairments of goodwill or other intangible assets.As of December 31, 2020, our consolidated balance sheet included goodwill of $550.3 million and other intangible assets of $196.8 million.Our business acquisitions typically result in goodwill and other intangible assets, which affect the amount of future period amortization expense and possible impairment expense. We make estimates and assumptions in valuing such intangible assets that affect our consolidated financial statements.In accordance with U.S. GAAP, our goodwill and indefinite-lived intangible assets are not amortized, but are evaluated for impairment annually in the fourth quarter, or more frequently if events or changes in circumstances indicate that an asset might be impaired. The evaluation may be based on valuation models that estimate fair value. In preparing the valuation models, we consider a number of factors, including operating results, business plans, economic conditions, future cash flows, and transactions and market data. There are inherent uncertainties related to these factors and our judgment in applying them to the impairment analyses. The significant estimates and assumptions within our fair value models include sales growth, controllable cost growth, perpetual growth, effective tax rates, and discount rates. Our assessments to date have indicated that there has been no impairment of these assets.Should any of these estimates or assumptions change, or should we incur lower-than-expected operating performance or cash flows, including from a prolonged economic slowdown, we may experience a triggering event that requires a new fair value assessment for our reporting units, possibly prior to the required annual assessment. These types of events and resulting analysis could result in 20Table of Contentsimpairment charges for goodwill and other indefinite-lived intangible assets if the fair value estimate declines below the carrying value.Our amortization expense related to intangible assets with finite lives may materially change should our estimates of their useful lives change.Concerns regarding the Eurozone debt levels and market perception related to the instability of the euro could affect our operating profits.We conduct business in many countries that use the euro as their currency (the Eurozone). Concerns persist regarding the debt burden of certain Eurozone countries and their ability to meet future financial obligations. In addition, concerns in recent years have existed regarding the overall stability of the euro and the suitability of the euro as a single currency given the diverse economic and political circumstances in individual Eurozone countries. These concerns could lead to the re-introduction of individual currencies in one or more Eurozone countries or, in more extreme circumstances, the possible dissolution of the euro currency entirely. Should the euro dissolve entirely, the legal and contractual consequences for holders of euro-denominated obligations would be determined by laws in effect at such time. These potential developments, or market perceptions concerning these and related issues, could adversely affect the value of our euro-denominated assets and obligations. In addition, concerns over the effect of this type of financial crisis on financial institutions in Europe and globally could have an adverse effect on the global capital markets and, more specifically, on the ability of our Company, our customers, suppliers, and lenders to finance their respective businesses and to access liquidity at acceptable financing costs, if at all, on the availability of supplies and materials, and on the demand for our products.Legal, Tax, Regulatory, and Other RisksUnanticipated changes in our tax rates or additional income tax liabilities could impact our profitability.We are subject to income taxes in the United States and various other jurisdictions, and our domestic and international tax liabilities are subject to allocation of expenses among different jurisdictions. Our effective tax rates and tax obligations could be adversely affected by changes in tax laws or rates, changes in the mix of earnings by jurisdiction, changes in the valuation of deferred tax assets and liabilities, and material adjustments from tax audits.In particular, the carrying value of deferred tax assets, which are predominantly in the U.S., is dependent upon our ability to generate future taxable income in the U.S. In addition, the amount of income taxes we pay is subject to ongoing audits in various jurisdictions, and a material assessment by a governing tax authority could affect our profitability.Our tax expense and tax obligations could increase as a result of changing application of tax law.Governments are facing greater pressure on public finances, which could lead to their more aggressively applying existing tax laws and regulations. Governments also periodically change tax laws and regulations. The Organization for Economic Co-Operation and Development ("OECD") is also performing an economic impact study that is expected to develop a solution to the digital economy, and also propose a supplement to the current transfer pricing arm’s length standard for allocating profit. While the OECD’s current focus appears to be related to the digital economy and consumer businesses, there is a possibility that the OECD also proposes changes to business-to-business transfer pricing regulations. Any changes in corporate income tax rates or regulations, on repatriation of dividends, earnings, or capital, or on transfer pricing, as well as changes in the interpretation of existing tax laws and regulations in the 21Table of Contentsjurisdictions in which we operate, could adversely affect our cash flow and increase our overall tax burden, which would negatively affect our profitability. Potential OECD changes impacting consumer businesses could also have an unfavorable effect on some of our key customer segments such as pharmaceutical and food and beverage, which could result in a decline or delay in capital spending by our customers and a resulting decline in our revenues and lower profitability. We may be adversely affected by failure to comply with regulations of governmental agencies or by the adoption of new regulations. United States trade policy, including the imposition of tariffs and the resulting consequences, as well as other political policies in the United States, China, the U.K., and certain European countries, may also impact global trade or create uncertainty impacting our business.Our products are subject to regulation by governmental agencies. These regulations govern a wide variety of activities relating to our products, including design and development, product safety, labeling, manufacturing, promotion, sales, and distribution. We also operate a global business and are subject to various laws and regulations in the many markets where we do business, including those relating to competition, employment and labor practices, international trade, and corruption. If we fail to comply with these regulations, or if new regulations are adopted that substantially change existing practice or impose new burdens, we may have to recall products and cease their manufacture and distribution. In addition, we could be subject to investigation costs, reputational harm, fines, criminal prosecution, and other damages that could impact our profitability. Political policy in the United States, China, the U.K., and certain European countries may impact global trade or create uncertainty. The United States government has recently adopted a new approach to trade policy and in certain cases to renegotiate, or possibly terminate, certain existing trade agreements. The United States government has also initiated tariffs on certain foreign goods, particularly those produced in China. As a result, certain foreign governments, including the Chinese government, have imposed retaliatory tariffs on goods that their countries import from the United States.These various trade policy and regulatory actions described above may restrict our access to lower-cost countries in certain circumstances or otherwise create uncertainty, negatively impact global markets, and make it more difficult or costly for us to import our products into certain countries. The adoption and expansion of trade restrictions or other governmental action related to tariffs or trade agreements or policies could also lead to an economic downturn and/or could create unfavorable fluctuations in currency exchange rates (see above description "currency fluctuations affect our operating profits"). In times of uncertainty, some customers delay investments or defer normal replacement cycles, which could have an adverse impact on our sales. The adoption and expansion of trade restrictions or other governmental action related to tariffs or trade agreements or policies have the potential to adversely impact our business and financial performance. The United Kingdom’s withdrawal from the European Union could adversely impact our results of operations.In June 2016, voters in the United Kingdom ("U.K.") approved an advisory referendum to withdraw from the European Union ("E.U."), commonly referred to as "Brexit." On October 17, 2019, the U.K. Prime Minister and the E.U. agreed to new terms for the country’s exit from the E.U., which received all necessary parliamentary approvals. On January 31, 2020, the U.K. formally left the E.U. and immediately entered into an 11-month transition period during which all E.U. rules and trading agreements remained as they were. On December 24, 2020, the U.K. and E.U. agreed to a trade deal (the “Trade and Cooperation Agreement”) which was ratified by the U.K. on December 30, 2020. The Trade and Cooperation Agreement is subject to formal approval by the European Parliament and the Council of the European Union before it comes into effect and has been applied provisionally since January 1, 2021. The Trade and 22Table of ContentsCooperation Agreement allows the U.K. and E.U. to continue trading without tariffs or quotas; however, the movement of goods between the U.K. and the remaining member states of the E.U. may be subject to additional inspections and documentation checks, leading to possible delays at ports of entry and departure. In addition, there are still a number of areas of uncertainty in connection with the future of the U.K. and its relationship with the E.U. and the application and interpretation of the Trade and Cooperation Agreement, and Brexit-related matters may take several years to be clarified and resolved. In particular, the Trade and Cooperation Agreement only covers the trade of goods and, therefore, uncertainty remains over the U.K.'s long-term trading of services relationship with the E.U. At this time, we cannot predict the potential impact of Brexit on our business. However, Brexit could adversely affect our operating results and financial condition.If we cannot protect our intellectual property rights, or if we infringe or misappropriate the proprietary rights of others, our operating results could be harmed.Our success depends on our ability to obtain, maintain, and enforce patents on our technology, maintain our trademarks, and protect our trade secrets. Our patents may not provide complete protection or may expire, and competitors may develop similar products that are not covered by our patents. Our patents may also be challenged by third parties and invalidated or narrowed. We may experience a decline in sales and/or profitability if any of these things occur. Competitors sometimes seek to take advantage of our trademarks or brands in ways that may create customer confusion or weaken our brand. Improper use or disclosure of our trade secrets may still occur.We may be sued for infringing on the intellectual property rights of others. The cost of any litigation could affect our profitability regardless of the outcome, and management attention could be diverted. If we are unsuccessful in such litigation, we may have to pay damages, stop the infringing activity, and/or obtain a license. If we fail to obtain a required license, we may be unable to sell some of our products, which could result in a decline in our revenues.We may be adversely affected by environmental laws and regulations.We are subject to various environmental laws and regulations and incur expenditures in complying with environmental laws and regulations. We are currently involved in, or have potential liability with respect to, the remediation of past contamination in various facilities. In addition, some of our facilities are or have been in operation for many decades and may have used substances or generated and disposed of wastes that are hazardous or may be considered hazardous in the future. These sites and disposal sites owned by others to which we sent waste may in the future be identified as contaminated and require remediation. Accordingly, it is possible that we could become subject to additional environmental liabilities in the future that may harm our results of operations or financial condition.We may be adversely affected by regulations and market expectations related to sourcing and our supply chain, including conflict minerals.The SEC has adopted disclosures and reporting requirements for companies whose products contain certain minerals and their derivatives, namely tin, tantalum, tungsten, or gold, known as conflict minerals. Companies must report annually whether or not such minerals originate from the Democratic Republic of Congo (DRC) and adjoining countries. These requirements could adversely affect the sourcing, availability, and pricing of materials used in the manufacturing of our products. In addition, we have incurred additional costs to comply with the disclosure requirements, including cost related to determining the source of any of the relevant minerals used in our products. Since our supply chain is complex, due diligence procedures we have implemented to understand the origins of the minerals we use in our operations may not enable us to ascertain with sufficient certainty the origins for these minerals or determine that these minerals are DRC conflict free, which may harm our reputation. We may also face 23Table of Contentsdifficulties in satisfying customers who may require that our products be certified as DRC conflict free, which could harm our relationships with these customers and/or lead to a loss of revenue. These requirements also could have the effect of limiting the pool of suppliers from which we source these minerals, and we may be unable to obtain conflict-free minerals at prices similar to the past, which could increase our costs and adversely affect our manufacturing operations and our profitability.Future laws, regulations, or customers may make additional demands on supply chain transparency. These demands can include more transparency into the activities of our suppliers with regard to human rights and sustainable sourcing. We have significant protections in place to ensure we partner with responsible suppliers, but increased demands may cause us to incur increased supply chain costs. If we cannot satisfy customers’ demands, we may lose business, and if we cannot meet new regulatory requirements, we may have to alter our sourcing at increased expense.Our ability to generate and repatriate cash depends in part on factors beyond our control.Our ability to make payments on our debt and to fund our share repurchase program, planned capital expenditures, and research and development efforts depends on our ability to generate and repatriate cash in the future. This is subject to factors beyond our control, including general economic, financial, competitive, legislative, regulatory, governmental, and other factors described in this section.We cannot ensure that our business will generate sufficient cash flows from operations or that future borrowings will be available to us under our credit facility in an amount sufficient to enable us to pay our debt or to fund our other liquidity needs. We may need to refinance all or a portion of our indebtedness on or before maturity. We cannot ensure that we will be able to refinance any of our debt, including our credit facility and the senior notes, on commercially reasonable terms or at all.Our ability to fund our share repurchase program is also dependent on our ability to repatriate our international cash flows. Changes in governmental cash repatriation policies, restrictions, or tax laws could impair our ability to continue our share repurchase program.Risks Related to Our DebtWe have debt and we may incur substantially more debt, which could affect our ability to meet our debt obligations and may otherwise restrict our activities.We have debt and we may incur substantial additional debt in the future. As of December 31, 2020, we had total indebtedness of approximately $1.2 billion, net of cash of $94.3 million. Our debt instruments allow us to incur substantial additional indebtedness.The existence and magnitude of our debt could have important consequences. For example, it could make it more difficult for us to satisfy our obligations under our debt instruments; require us to dedicate a substantial portion of our cash flow to payments on our indebtedness, which would reduce the amount of cash flow available to fund working capital, capital expenditures, product development, and other corporate requirements; increase our vulnerability to general adverse economic and industry conditions, including changes in raw material costs; limit our ability to respond to business opportunities; limit our ability to borrow additional funds, which may be necessary; and subject us to financial and other restrictive covenants, which, if we fail to comply with these covenants and our failure is not waived or cured, could result in an event of default under our debt instruments.The agreements governing our debt impose restrictions on our business.The note purchase agreements governing our notes and the agreements governing our credit facility contain covenants imposing various restrictions on our business. These restrictions may affect our ability to operate our business and may limit our ability to take advantage of potential business opportunities. The 24Table of Contentsrestrictions these covenants place on us include limitations on our ability to incur liens and consolidate, merge, sell, or lease all or substantially all of our assets. Our credit facility and the note purchase agreements governing our senior notes also require us to meet certain financial ratios.Our ability to comply with these agreements may be affected by events beyond our control, including economic, financial, and industry conditions. The breach of any covenants or restrictions could result in a default under the note purchase agreements governing the senior notes and/or under our credit facility. An event of default under the agreements governing our debt would permit holders of our debt to declare all amounts owed to them under such agreements to be immediately due and payable. Acceleration of our other indebtedness may cause us to be unable to make interest payments on the senior notes and repay the principal amount of the senior notes.The lenders under our credit agreement may be unable to meet their funding commitments, reducing the amount of our borrowing capacity.We have a revolving credit facility outstanding under which the Company and certain of its subsidiaries may borrow up to $1.1 billion. Our credit facility is provided by a group of 15 financial institutions, which individually have between 1% and 11% of the total funding commitment. At December 31, 2020, we had borrowings of $497.5 million outstanding under our credit facility. Our ability to borrow further funds under our credit facility is subject to the various lenders’ financial condition and ability to make funds available. Even though the financial institutions are contractually obligated to lend funds, if one or more of the lenders encounters financial difficulties or goes bankrupt, such lenders may be unable to meet their obligations. This could result in us being unable to borrow the full $1.1 billion amount available.We are subject to risks associated with the discontinuation of LIBOR.The U.K. Financial Conduct Authority announced in 2017 that it intends to phase out the London Interbank Offered Rate ("LIBOR") by the end of 2021. Changes in the method of calculating LIBOR, or the replacement of LIBOR with an alternative rate or benchmark, may adversely affect interest rates and could result in higher borrowing costs. In addition, if changes are made to the method of calculating LIBOR or LIBOR ceases to exist, we may need to amend certain contracts, including our credit facility and swap arrangements, and we cannot predict what alternative rate or benchmark would be negotiated. This may also result in an increase in our interest expense.General Risk FactorsWe make forward-looking statements, and actual events or results may differ materially from these statements because assumptions we have made prove incorrect due to market conditions in our industries or other factors.We provide forward-looking statements both in our filings with the SEC and orally in connection with our quarterly earnings calls, including guidance on anticipated sales growth and earnings per share. You should not rely on forward-looking statements to predict our actual results. Our actual results or performance may be materially different than reflected in forward-looking statements because of various risks and uncertainties.Our forward-looking statements may not be accurate or complete, and we do not intend to update or revise them in light of actual results. New risks also periodically arise. Please consider the risks and factors that could cause our results to differ materially from what is described in our forward-looking statements. See in particular “Factors Affecting Our Future Operating Results” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”25Table of ContentsIn providing guidance on our future earnings, we evaluate our budgets, strategic plans, and other factors relating to our business. We make assumptions about external factors, including the following:•the outlook for our end-markets and the global economy;•the impact of external factors on our competition;•the financial position of our customers and their willingness to pay for our products and services;•the estimated costs of purchasing materials;•developments in personnel costs; •our estimated income tax expense; and•rates for currency exchange, particularly between the Swiss franc and the euro and between the Chinese renminbi and the U.S. dollar.Some of these assumptions may prove to be incorrect over time. For example, although no single end-customer accounts for more than 1% of our revenues, if a number of our customers experienced significant deteriorations in their financial positions concurrently, it could have an impact on our results of operations.Some of our key internal assumptions include the following:•our ability to implement our business strategy;•our ability to implement price increases as forecasted;•the effectiveness of our sales and marketing programs such as our Spinnaker, market penetration, and Field Turbo initiatives;•the effectiveness of our programs to improve our service business, including growth, globalization, and productivity initiatives;•our ability to develop and deliver innovative products and services;•the continued growth of our sales in emerging markets; and•the effectiveness of productivity and cost saving initiatives.These internal assumptions may also prove to be incorrect over time. For example, with respect to our ability to realize our planned price increases without disturbing our customer base in core markets, in certain markets, such as emerging markets, price tends to be a more significant factor in customers’ decisions to purchase our products and services. Furthermore, we can have no assurance that our cost reduction programs will generate adequate cost savings. Additionally, it may become necessary to take additional restructuring actions resulting in additional restructuring costs.We believe our current assumptions are reasonable and prudent for planning purposes. However, should any of these assumptions prove to be incorrect, or should we incur lower-than-expected operating performance or cash flows, we may experience results different than our projections.Item 1B.Unresolved Staff CommentsNone.26Table of ContentsItem 2.PropertiesOur principal executive offices are located in Columbus, Ohio and Greifensee, Switzerland. The following table lists our principal facilities, indicating the location and whether the facility is owned or leased. The properties listed below serve primarily as manufacturing facilities or shared service centers and also typically have a certain amount of space for service, sales and marketing, and administrative activities. The facilities in Giessen, Germany, Viroflay, France, and Salford, United Kingdom are used primarily for sales and marketing. We believe our facilities are adequate for our current and reasonably anticipated future needs.Location Owned/Leased Business Segment Europe: Greifensee/Nänikon, Switzerland Owned Swiss OperationsUrdorf, Switzerland Owned Swiss OperationsManchester, EnglandLeasedWestern European OperationsRoyston, United Kingdom Owned Western European OperationsSalford, United Kingdom Leased Western European OperationsViroflay, France (two facilities) Owned Western European OperationsAlbstadt, Germany Owned Western European OperationsGiessen, (Hesse) GermanyOwnedWestern European OperationsGiesen, (Lower Saxony) Germany Owned Western European Operations Warsaw, PolandLeasedOther OperationsAmericas: Columbus, Ohio Leased U.S. OperationsWorthington, Ohio (two facilities) Owned U.S. OperationsOakland, California Owned U.S. OperationsBillerica, Massachusetts Owned U.S. OperationsTampa, Florida Owned U.S. OperationsTijuana, MexicoLeasedU.S. OperationsThorofare, New JerseyOwnedU.S. OperationsOther: Shanghai, China (two facilities) Buildings Owned; Chinese Operations Land Leased Changzhou, China (two facilities) Buildings Owned; Chinese Operations Land Leased ChengDu, China Building Owned; Chinese OperationsLand LeasedMumbai, India (four facilities) Building, Land Owned (1); Leased (3) Other OperationsItem 3.Legal ProceedingsWe are not currently involved in any legal proceeding that we believe could have a material adverse effect upon our financial condition, results of operations, or cash flows. See the disclosure in Item 1 above under “Environmental Matters.”Executive Officers of the RegistrantSee Part III, Item 10 of this annual report for information about our executive officers.27Table of ContentsPART IIItem 5.Market for Registrant’s Common Equity, Related Stockholder Matters, and Issuer Purchases of Equity SecuritiesMarket Information for Common StockOur common stock is traded on the New York Stock Exchange under the symbol “MTD.” HoldersAt January 25, 2021, there were 39 holders of record of common stock and 23,408,050 shares of common stock outstanding. We estimate we have approximately 116,897 beneficial owners of common stock.Dividend PolicyHistorically, we have not paid dividends on our common stock. However, we will evaluate this policy on a periodic basis taking into account our results of operations, financial condition, capital requirements including potential acquisitions, our share repurchase program, the taxation of dividends to our shareholders, and other factors deemed relevant by our Board of Directors.Share Performance GraphThe following graph compares the cumulative total returns (assuming reinvestment of dividends) on $100 invested on December 31, 2015 through December 31, 2020 in our common stock, the Standard & Poor’s 500 Composite Stock Index (S&P 500 Index), and the SIC Code 3826 Index — Laboratory Analytical Instruments.28Table of ContentsComparison of Cumulative Total Return Among Mettler-Toledo International Inc., the S&P 500 Index, and SIC Code 3826 Index — Laboratory Analytical Instruments(a)12/31/1512/31/1612/31/1712/31/1812/31/1912/31/20Mettler-Toledo$100$123$183$167$234$336S&P 500 Index$100$112$136$130$171$203SIC Code 3826 Index$100$101$139$155$212$294(a) The Performance Graph will not be deemed to be incorporated by reference into any filing under the Securities Act of 1933 or the Securities Exchange Act of 1934, except to the extent that the Company specifically incorporates it by reference. In addition, the Performance Graph will not be deemed to be "soliciting material" or to be "filed" with the SEC or subject to Regulation 14A or 14C, other than as provided in Regulation S-K, or to the liabilities of Section 18 of the Securities Exchange Act of 1934, except to the extent that the Company specifically requests that such information be treated as soliciting material or specifically incorporates it by reference into a filing under the Securities Act or the Exchange Act.Purchases of Equity Securities by the Issuer and Affiliated PurchasersIssuer Purchases of Equity SecuritiesTotal Number ofShares PurchasedAverage Price Paidper ShareTotal Number ofShares Purchased asPart of PubliclyAnnouncedProgramApproximate DollarValue (in thousands) ofShares that may yet bePurchased under theProgramPeriodOctober 1 to October 31, 202097,777 $1,022.61 97,777 $833,435 November 1 to November 30, 2020114,527 1,131.02 114,527 3,203,901 December 1 to December 31, 2020127,818 1,138.12 127,818 3,058,426 Total340,122 $1,102.52 340,122 $3,058,426 In November 2020, the Company’s Board of Directors authorized an additional $2.5 billion to the share repurchase program which has $3.1 billion of remaining availability as of December 31, 2020. The share repurchases are expected to be funded from cash generated from operating activities, borrowings, and cash balances. Repurchases will be made through open market transactions, and the amount and timing of purchases will depend on business and market conditions, the stock price, trading restrictions, the level of acquisition activity, and other factors. We have purchased 29.4 million common shares since the inception of the program in 2004 through December 31, 2020, at a total cost of $5.9 billion. During the years ended December 31, 2020 and 2019, we spent $775 million in both years on the repurchase of 815,652 shares and 1,094,648 shares at an average price per share of $950.14 and $707.97, respectively. We reissued 162,176 shares and 298,002 shares held in treasury for the exercise of stock options and restricted stock units during 2020 and 2019, respectively. 29Table of ContentsItem 6.Selected Financial DataThe selected historical financial information set forth below as of and for the years then ended December 31 is derived from our consolidated financial statements. The financial information presented below, in thousands except share data, was prepared in accordance with accounting principles generally accepted in the United States of America (“U.S. GAAP”).20202019201820172016Statement of Operations Data: Net sales$3,085,177 $3,008,652 $2,935,586 $2,725,053 $2,508,257 Cost of sales1,284,146 1,267,441 1,251,208 1,149,302 1,070,525 Gross profit1,801,031 1,741,211 1,684,378 1,575,751 1,437,732 Research and development140,102 143,950 141,071 128,308 119,196 Selling, general, and administrative820,221 819,183 812,802 794,861 745,358 Amortization56,665 49,690 47,524 42,671 36,052 Interest expense38,616 37,411 34,511 32,785 28,026 Restructuring charges(a)10,516 15,760 18,420 12,772 6,235 Other income, net(b)(13,832)(6,177)(21,808)(9,868)(1,328)Earnings before taxes748,743 681,394 651,858 574,222 504,193 Provision for taxes(c)146,004 120,285 139,247 198,250 119,823 Net earnings$602,739 $561,109 $512,611 $375,972 $384,370 Basic earnings per common share:Net earnings$25.24 $22.84 $20.33 $14.62 $14.49 Weighted average number of common shares23,882,648 24,567,609 25,215,674 25,713,575 26,517,768 Diluted earnings per common share:Net earnings$24.91 $22.47 $19.88 $14.24 $14.22 Weighted average number of common and common equivalent shares24,199,230 24,974,457 25,781,324 26,393,783 27,023,905 Balance Sheet Data:Cash and cash equivalents$94,254 $207,785 $178,110 $148,687 $158,674 Working capital(d)201,857 230,271 182,987 188,040 169,569 Total assets(e)2,814,549 2,789,321 2,618,847 2,549,805 2,166,777 Long-term debt(d)1,284,174 1,235,350 985,021 960,170 875,056 Other non-current liabilities(e)(f)372,925 333,412 260,511 301,452 204,957 Shareholders’ equity(g)282,675 420,780 590,063 547,280 434,943 _________________________(a)Restructuring charges primarily relate to our global cost reduction programs. See Note 15 and Note 19 to the consolidated financial statements.(b)Other charges (income), net includes non-service pension costs (benefits), losses (gains) from foreign currency transactions and related hedging activities, interest income, and other items. Other charges (income), net for 2018 includes a one-time gain of $18.7 million associated with the settlement of the Biotix acquisition contingent consideration, as well as a one-time legal charge of $3 million. Other charges (income), net includes $1.7 million and $1.1 million of acquisition costs for 2017 and 2016, respectively. Other charges (income), net for 2017 also includes a one-time gain of $3.4 million relating to the sale of a facility in Switzerland in connection with our initiative to consolidate certain Swiss operations into a new facility, while 2016 includes a one-time non-cash pension settlement charge of $8.2 million related to a lump sum offering to former employees of our U.S. pension plan.(c)Provision for taxes for 2019 includes a non-cash net benefit of $15.8 million related to the enactment of Swiss tax reform. Provision for taxes for 2018 and 2017 includes charges of $3.6 million and $72 million, respectively, for the enactment of the Tax Cuts and Jobs Act. Of this aggregate amount, $62 million is expected to be paid over a period of up to eight years beginning in 2018. See Note 14 to the consolidated financial statements.30Table of Contents(d)Working capital represents total current assets net of cash, less total current liabilities net of short-term borrowings and current maturities of long-term debt and short-term lease liabilities.(e)Includes a lease right-of-use asset of $98.6 million and $87.3 million, a short-term lease liability of $29.2 million and $27.6 million, and a long-term lease liability of $69.8 million and $60.9 million as of December 31, 2020 and 2019, respectively, in accordance with ASC 842 - Leases that went into effect on January 1, 2019.(f)Other non-current liabilities consist of pension and other post-retirement liabilities, long-term taxes payable of $37 million, $41 million, $45 million, and $48 million as of December 31, 2020, 2019, 2018, and 2017 related to the Tax Cuts and Jobs Act, plus certain other non-current liabilities. See Note 13 to the consolidated financial statements for pension and other post-retirement disclosures.(g)No dividends were paid during the five-year period ended December 31, 2020.Item 7.Management’s Discussion and Analysis of Financial Condition and Results of OperationsThe following discussion and analysis of our financial condition and results of operations should be read together with our consolidated financial statements.Changes in local currencies exclude the effect of currency exchange rate fluctuations. Local currency amounts are determined by translating current and previous year consolidated financial information at an index utilizing historical currency exchange rates. We believe local currency information provides a helpful assessment of business performance and a useful measure of results between periods. We do not, nor do we suggest that investors should, consider such non-GAAP financial measures in isolation from, or as a substitute for, financial information prepared in accordance with GAAP. We present non-GAAP financial measures in reporting our financial results to provide investors with an additional analytical tool to evaluate our operating results.We also include in the discussion below disclosures of immaterial qualitative factors that are not quantified. Although the impact of such factors is not considered material, we believe these disclosures can be useful in evaluating our operating results.OverviewWe operate a global business with sales that are diversified by geographic region, product range, and customer. We hold leading positions worldwide in many of our markets and attribute this leadership to several factors, including the strength of our brand name and reputation, our comprehensive offering of innovative instruments and solutions, our Spinnaker sales and marketing program, and the breadth and quality of our global sales and service network.Net sales in U.S. dollars increased 3% in 2020 and 2% in 2019. Excluding the effect of currency exchange rate fluctuations, or in local currencies, net sales increased 2% in 2020 and 5% in 2019. Net sales in 2020 were negatively impacted by the COVID-19 pandemic, which reduced global customer demand as further described below. However, we continue to benefit from our strong global leadership positions, diversified customer base, innovative product offering, investment in emerging markets, significant installed base, and the impact of our sophisticated global sales and marketing programs. Examples of these programs include identifying and investing in growth and market penetration opportunities, more effectively pricing our products and services, increasing our sales force effectiveness through improved guidance and redirecting resources to our most promising growth opportunities, increasing digitalization tools, and continuing to optimize our lead generation and lead nurturing processes. During 2020, we accelerated our ability to use advanced analytics to identify and pursue growth opportunities, while increasing the effectiveness of our digital tools to support our global sales organization. We also successfully adapted to a remote work environment and increased overall engagement with our customers with our Go-to-Market and digital approaches. We remain cautious as 31Table of Contentsuncertainties relating to COVID-19 and the global economy continue and market conditions may change quickly. Net sales in local currencies may be adversely affected in future quarters by the COVID-19 pandemic related to unfavorable economic conditions and reduced customer demand.Our laboratory sales experienced solid growth in 2020, particularly from life sciences and biotech customers. We also benefited from COVID-19 testing and vaccine development and production preparation activities in biopharma. We expect to continue to benefit from favorable biopharma market trends including the continued need for COVID-19 testing, treatment, and vaccine production activities. We should also benefit from increased customer demand for automation, digitalization, and safety; new facility investments; and continued focus on regulatory compliance including data integrity requirements. However, other segments such as academia and certain segments of chemical were negatively impacted in 2020 and may continue to be challenging.Our industrial sales experienced a slight decline in 2020 as our product inspection business was particularly impacted in 2020 by reduced customer demand during COVID-19. Core industrial experienced growth, which included strong growth in China. We continue to benefit from our focus on the more attractive, faster-growing segments of the market and strong execution of our growth initiatives in each region. Emerging market economies, especially China, have historically been an important source of growth based upon the expansion of their domestic economies, and we expect this to be a continued source of future growth. Our core industrial-related products are also especially sensitive to changes in economic growth. We expect our industrial markets to also benefit from our customers’ focus on brand protection, food safety, and productivity within our product inspection end-market. Our food retailing sales decreased during 2020 primarily due to a lack of key account activity, weak market conditions, and minimal customer investments during COVID-19. Traditionally, the spending levels in this sector have experienced more volatility than our other end-markets due to the timing of customer project activity and new regulations. In 2021, we expect to continue to pursue the overall business growth strategies which we have followed in recent years:Gaining Market Share. Our global sales and marketing initiative, “Spinnaker,” continues to be an important growth strategy. We aim to gain market share by implementing sophisticated sales and marketing programs, leveraging our extensive customer databases, and leveraging our product offering to larger customers through key account management. While this initiative is broad-based, efforts to improve these processes include utilizing advanced data analytics to identify, prioritize, and pursue growth opportunities, the implementation of more effective pricing and value-based selling strategies and processes, improved sales force guidance, training and effectiveness, cross-selling, increased segment marketing, and leads generation and nurturing activities. Over the past few years, we have also added field sales and service resources to pursue under-penetrated market opportunities and will consider additional investments to front-end resources as market conditions improve. We also continue to adapt our Go-to-Market approaches with additional inside and telesales resources, while also increasing digital customer interaction. In 2020, we also benefited from digitalization tools to gain efficiencies and increase the effectiveness of our field sales force. In addition, our comprehensive service offerings, and our initiatives to globalize and harmonize these offerings, help us further penetrate developed markets. We estimate that we have the largest installed base of weighing instruments in the world, and we continue to leverage advanced data analytics and invest in sales and marketing activities to increase the proportion of our installed base that is under service contract, or sell new products that replace old products in our installed base. In addition to traditional repair and maintenance, our service offerings continue to expand into value-added services for a range of market needs, including regulatory compliance. In 2020, we also made 32Table of Contentsadjustments to our service model to incorporate remote service, depot drop-off/pickup, and other approaches to ensure the safety of our technicians and customers.Expanding Emerging Markets. Emerging markets, comprising Asia (excluding Japan), Eastern Europe, Latin America, the Middle East, and Africa, account for approximately 35% of our total net sales. We have a two-pronged strategy in emerging markets: first, to capitalize on long-term growth opportunities in these markets, and second, to leverage our low-cost manufacturing operations in China. We have more than a 30-year track record in China, and our sales in Asia have grown more than 12% on a compound annual growth basis in local currencies since 1999. Over the years, we have also broadened our product offering to the Asian markets. India has also been a source of emerging market sales growth in past years due to increased life science research activities. Overall, we experienced a 3% increase in emerging market local currency sales by destination during 2020 versus the prior year, which included 7% local currency sales growth in China. Within China, we continue to redeploy resources and sales and marketing efforts to the faster-growing segments of pharma, food manufacturing, chemical, and environment. We believe the long-term growth of these segments will be favorably impacted by the Chinese government’s emphasis on science, high-value industries, product quality, and food safety. We expect our laboratory and product inspection businesses will particularly benefit from our focus on these segments. We also continue to invest and add sales and marketing resources to pursue growth in under-penetrated emerging markets. However, emerging market sales can be volatile. In particular, China has historically been volatile and market conditions may change unfavorably due to various factors. Extending Our Technology Lead. We continue to focus on product innovation. In the last three years, we spent approximately 5% of net sales on research and development. We seek to accelerate product replacement cycles, as well as improve our product offerings and their capabilities with additional integrated technologies and software which also support our pricing differentiation. In addition, we aim to create value for our customers by having an intimate knowledge of their processes via our significant installed product base.Expanding Our Margins. We continue to strive to improve our margins by more effectively pricing our products and services and optimizing our cost structure. For example, sophisticated data analytic tools provide us new insights to further refine our price strategies and processes. We also focus on reallocating resources and better aligning our cost structure to support our investments in market penetration initiatives, higher-growth areas, and opportunities for margin improvement. We have also initiated various cost reduction programs over the past few years, including temporary cost containment measures during 2020 in response to COVID-19. We have also implemented global procurement and supply chain management programs over the last several years aimed at lowering supply costs, and have increased our focus on these programs with our SternDrive initiative. SternDrive is our global operational excellence program for continuous improvement efforts within our supply chain, manufacturing, and back-office operations. Blue Ocean is also an important enabler of our various margin expansion initiatives. Our move to standardized business processes, systems, and data structures throughout our global organization provides greater data transparency and faster access to real-time data. Our cost leadership and productivity initiatives are also focused on continuously improving our invested capital efficiency, such as reducing our working capital levels, increasing our order to cash cycle, and ensuring appropriate returns on our expenditures. Pursuing Strategic Acquisitions. We seek to pursue "bolt-on" acquisitions that may leverage our global sales and service network, respected brand, extensive distribution channels, and technological leadership. We have identified life sciences, process analytics, and product inspection as three key areas for acquisitions. For example, during 2017, we acquired Biotix, Inc., a U.S.-based manufacturer and distributor of plastic consumables associated with pipettes, including tips, tubes, and reagent reservoirs 33Table of Contentsused in the life sciences market, for an initial cash payment of $105 million plus additional cash consideration of $10 million that was paid in the first quarter of 2019. COVID-19The COVID-19 pandemic has resulted in millions of confirmed cases throughout the world and in all countries where we conduct business. The outbreak has caused many governments to implement stay-at-home orders, quarantines, and significant restrictions on travel. Several governments have also implemented work restrictions that prohibit many employees from going to their customary work locations and that require these employees to work remotely if possible. Quarantines, travel bans, work and other restrictions were initially put in place on a national level in China in January 2020, and with the global spread of the virus, subsequently adopted in other countries and regions with many restrictions in Asia Pacific, Europe, North America, and South America. These restrictions continue to change as COVID-19 evolves in each country and region.The health and safety of our employees and business partners have been our highest priority throughout the COVID-19 pandemic, and we have implemented several preventative and protective measures relating to social distancing, hygiene, health monitoring, personal protective equipment, split shifts, and remote work. We have also implemented business continuity plans and have been able to continue to support our customers with their essential businesses such as life sciences, food manufacturing, chemicals (e.g., sanitizers, disinfectants, soaps, etc.), food retail, and transportation and logistics. Our production and logistics facilities are currently operational, and our office-based employees have been able to work remotely in adherence to applicable jurisdictional stay-at-home orders. Our supply chain is currently continuing with minimal interruption, and we generally maintain adequate product inventory levels and safety stock for certain components. We quickly adapted to leverage our digital and remote sales and service capabilities, while also meeting delivery requirements with our global supply chain. Our service organization also continues to provide on-site and remote customer support to facilitate uptime, productivity, and regulatory compliance.We have also implemented various temporary cost containment measures related to workforce management and discretionary spending. Our workforce management measures primarily included reduced work hours, salary freezes, and voluntary senior leadership salary reductions. We maintain adequate liquidity consisting of approximately $602.5 million of additional borrowings available under our Credit Agreement and $94.3 million of cash and cash equivalents as of December 31, 2020. COVID-19 presents several risks to our business as further described on page 14 in the Risk Factors section of this Form 10-K. During the year ended December 31, 2020, COVID-19 had a negative impact on our business, primarily related to reduced customer demand. We remain cautious as uncertainties related to COVID-19 and the resulting impact to the global economy continue in most regions of the world and market conditions can change quickly. With the global spread of the virus and related negative impact to the global economy, we may experience reduced global sales volume due to lower customer demand. The longer-term effects on our business will be impacted by the global economy and any recession implications in different regions of the world. While it is extremely difficult to estimate the extent and duration of any COVID-19 implications, the effects on our business, results of operations, and financial condition could be material.34Table of ContentsResults of Operations — ConsolidatedNet salesNet sales were $3.1 billion for the year ended December 31, 2020, compared to $3.0 billion in 2019 and $2.9 billion in 2018. This represents an increase of 3% in 2020 and 2% in 2019 in U.S. dollars and an increase of 2% in 2020 and 5% in 2019 in local currencies. Net sales were negatively impacted by the COVID-19 pandemic and related reduction in global customer demand on our operations. However, our competitive position increased due to our sophisticated sales and marketing program that was highly effective in the enhanced digital environment, and we strengthened our brand with our ability to serve customers throughout the crisis. Our heightened focus on the most attractive market segments and differentiated resource allocation helped capture growth by pinpointing which customers would be most COVID-19 resilient and which would recover faster. Net sales during the second half of 2020 reflected improved customer demand in most businesses and regions with particularly strong growth in China and our laboratory-related products. We continue to benefit from the execution of our global sales and marketing programs, our innovative product portfolio, and investments in our field organization, particularly surrounding digital tools and techniques. However, we remain cautious as uncertainties relating to COVID-19 and the global economy continue and market conditions may change quickly. Net sales in local currencies may be adversely affected in future quarters by the COVID-19 pandemic related to unfavorable economic conditions and reduced customer demand.In 2020, our net sales by geographic destination increased in U.S. dollars compared to 2019 by 1% in the Americas and 3% both in Europe and in Asia/Rest of World. In local currencies, our net sales by geographic destination increased in 2020 by 2% in the Americas, 1% in Europe, and 3% in Asia/Rest of World, with 7% growth in China. A discussion of sales by operating segment is included below. As described in Note 3 to our consolidated financial statements, our net sales comprise product sales of precision instruments and related services. Service revenues are primarily derived from repair and other services, including regulatory compliance qualification, calibration, certification, preventative maintenance, and spare parts.Net sales of products increased 2% both in U.S. dollars and in local currencies during 2020 and increased 2% in U.S. dollars and 4% in local currencies in 2019. Service revenue (including spare parts) increased 3% in U.S. dollars and 2% in local currencies in 2020 and increased 4% in U.S. dollars and 7% in local currencies in 2019.Net sales of our laboratory products and services, which represented approximately 54% of our total net sales in 2020, increased 6% in U.S. dollars and 5% in local currencies during 2020. The local currency increase in net sales of our laboratory-related products during 2020 includes very strong growth in pipettes, as well as good results in automated chemistry and process analytics. As previously mentioned, our laboratory-related products in 2020 benefited from COVID-19 testing and vaccine development and production preparation activities. Net sales of our industrial products and services, which represented approximately 40% of our total net sales in 2020, decreased 1% both in U.S. dollars and in local currencies during 2020. The local currency decrease in net sales of our industrial-related products during 2020 includes a decline in product inspection due to challenging market conditions, offset in part by growth in core industrial products. Net sales of our food retailing products and services, which represented approximately 6% of our total net sales in 2020, decreased 3% in U.S. dollars and 4% in local currencies during 2020. The decline in food retailing is primarily due to challenging market conditions.35Table of ContentsGross profitGross profit as a percentage of net sales was 58.4% for 2020, compared to 57.9% for 2019 and 57.4% for 2018.Gross profit as a percentage of net sales for products was 60.3% for 2020, compared to 60.4% for 2019 and 60.3% for 2018. Gross profit as a percentage of net sales for services (including spare parts) was 51.6% for 2020, compared to 49.0% for 2019 and 47.0% for 2018.The increase in gross profit as a percentage of net sales for 2020 primarily reflects favorable price realization, benefits from temporary cost savings measures, and material cost reductions, offset in part by higher transportation costs and unfavorable business mix.Research and development and selling, general, and administrative expensesResearch and development expenses as a percentage of net sales were 4.5% for 2020 and 4.8% for both 2019 and 2018. Research and development expenses in U.S. dollars decreased 3% in 2020 and increased 2% in 2019, and in local currencies decreased 5% in 2020 and increased 5% in 2019. The decrease during 2020 relates to the timing of project activity and was impacted by our temporary cost savings measures.Selling, general, and administrative expenses as a percentage of net sales were 26.6% for 2020, compared to 27.2% for 2019 and 27.7% for 2018. Selling, general, and administrative expenses were flat in U.S. dollars and decreased 1% in local currencies in 2020 and increased 1% and 3% in U.S. dollars and local currencies in 2019, respectively. The decrease during 2020 includes benefits from our temporary and ongoing cost savings initiatives.Amortization expenseAmortization expense was $56.7 million in 2020, compared to $49.7 million and $47.5 million in 2019 and 2018, respectively. The increase in amortization expense is primarily related to our investments in information technology, including our Blue Ocean program. Restructuring chargesDuring the past few years, we initiated various cost reduction measures. For the year ended December 31, 2020, we have incurred $10.5 million of restructuring expenses which primarily comprise employee-related costs. See Note 15 and Note 19 to our consolidated financial statements for a summary of restructuring activity during 2020.Other charges (income), netOther charges (income), net consisted of net income of $13.8 million, $6.2 million, and $21.8 million in 2020, 2019, and 2018, respectively. Other charges (income), net includes non-service pension costs (benefits), net (gains) losses from foreign currency transactions and hedging activities, interest income, and other items. Non-service pension benefits were $12.2 million, $4.8 million, and $6.2 million in 2020, 2019, and 2018, respectively. Other charges (income), net in 2018 also includes a one-time gain of $18.7 million associated with the settlement of the Biotix acquisition contingent consideration, as well as a one-time legal charge of $3.0 million. 36Table of ContentsInterest expense and taxesInterest expense was $38.6 million for 2020, compared to $37.4 million for 2019 and $34.5 million for 2018. Our reported tax rate was 19.5% during 2020, compared to 17.7% and 21.4% during 2019 and 2018, respectively. The 2019 reported tax rate includes a net benefit of $15.8 million associated with Swiss tax reform described below. The 2018 reported tax rate includes a charge of $3.6 million associated with the Tax Cuts and Jobs Act.In May 2019, a public referendum was held in Switzerland that approved Swiss federal tax reform proposals previously approved by the Swiss Parliament. Additional changes in Swiss cantonal law were enacted in October 2019. The changes in Swiss federal tax had an immaterial effect on our financial statements. We recognized a discrete non-cash net deferred tax benefit of $15.8 million as a result of the enactment of the cantonal law in the fourth quarter of 2019. A further description of Swiss tax reform is in Note 14 to our consolidated financial statements.Results of Operations — by Operating SegmentThe following is a discussion of the financial results of our operating segments. We currently have five reportable segments: U.S. Operations, Swiss Operations, Western European Operations, Chinese Operations, and Other. A more detailed description of these segments is outlined in Note 19 to our consolidated financial statements.U.S. Operations (amounts in thousands)202020192018Increase(Decrease) in %2020 vs. 2019Increase(Decrease) in %2019 vs. 2018Net sales$1,194,169 $1,171,909 $1,112,256 2%5%Net sales to external customers$1,072,319 $1,057,115 $1,007,798 1%5%Segment profit$244,940 $210,133 $161,615 17%30%Total net sales increased 2% in 2020 and 5% in 2019 and net sales to external customers increased 1% in 2020 and 5% in 2019. The increase during 2020 is driven by very strong growth in pipettes, as well as transportation and logistics and good growth in process analytics. These results were offset in part by declines in product inspection and food retailing. Segment profit increased $34.8 million in our U.S. Operations segment during 2020, compared to an increase of $48.5 million during 2019. The segment profit increase in 2020 includes benefits from our temporary cost savings measures, margin expansion initiatives, and favorable business mix.Swiss Operations (amounts in thousands)202020192018Increase(Decrease) in % (1)2020 vs. 2019Increase(Decrease) in % (1)2019 vs. 2018Net sales$823,760 $797,177 $762,593 3%5%Net sales to external customers$143,923 $139,499 $134,064 3%4%Segment profit$245,465 $233,292 $202,027 5%15%(1)Represents U.S. dollar growth.Total net sales in U.S. dollars increased 3% in 2020 and 5% in 2019, and in local currencies decreased 2% in 2020 and increased 6% in 2019. Net sales to external customers increased 3% in U.S. dollars and decreased 1% in local currencies in 2020, while net sales to external customers increased 4% in U.S. dollars and 5% in local currencies in 2019. Local currency net sales to external customers 37Table of Contentsduring 2020 include declines in most products related to lower customer demand as a result of COVID-19, offset in part by strong growth in automated chemistry, pipettes, and product inspection.Segment profit increased $12.2 million in our Swiss Operations segment during 2020, compared to an increase of $31.3 million during 2019. The segment profit increase in 2020 includes benefits from our temporary cost savings measures and the timing of research and development activity, offset in part by unfavorable currency translation.Western European Operations (amounts in thousands)202020192018Increase(Decrease) in % (1)2020 vs. 2019Increase(Decrease) in % (1)2019 vs. 2018Net sales$889,891 $876,500 $895,783 2%(2)%Net sales to external customers$716,715 $700,741 $718,788 2%(3)%Segment profit$147,562 $123,845 $122,574 19%1%(1)Represents U.S. dollar growth.Total net sales in U.S. dollars increased 2% in 2020 and decreased 2% in 2019, and in local currencies decreased 1% in 2020 and increased 3% in 2019. Net sales to external customers in U.S. dollars increased 2% in 2020 and decreased 3% in 2019, and in local currencies were flat in 2020 and increased 3% in 2019. Local currency net sales to external customers during 2020 include strong growth in pipettes, offset by declines in industrial-related products related to lower customer demand as a result of COVID-19.Segment profit increased $23.7 million in our Western European Operations segment during 2020, compared to an increase of $1.3 million in 2019. The segment profit increase in 2020 includes benefits from our temporary cost savings measures and margin expansion initiatives, timing of research and development activity, and favorable foreign currency translation.Chinese Operations (amounts in thousands)202020192018Increase(Decrease) in % (1)2020 vs. 2019Increase(Decrease) in % (1)2019 vs. 2018Net sales$792,345 $769,233 $767,561 3%0%Net sales to external customers$578,610 $544,716 $525,109 6%4%Segment profit$270,497 $266,522 $270,668 1%(2)%(1)Represents U.S. dollar growth.Total net sales in U.S. dollars increased 3% in 2020 and were flat in 2019, and in local currencies increased 3% in 2020 and 4% in 2019. Net sales by origin to external customers in U.S. dollars increased 6% in 2020 and 4% in 2019, and in local currencies increased 6% in 2020 and 8% in 2019. The increase in net sales to external customers during 2020 reflects strong growth in laboratory and industrial-related products during the second half of 2020 after experiencing a significant decline in customer demand during the first quarter of 2020 related to COVID-19. However, uncertainty remains and market conditions may change quickly.Segment profit increased $4.0 million in our Chinese Operations segment during 2020, compared to a decrease of $4.1 million in 2019. The increase in segment profit during 2020 primarily includes increased sales volume and benefits from our temporary cost savings measures. 38Table of Contents Other (amounts in thousands)202020192018Increase(Decrease) in % (1)2020 vs. 2019Increase(Decrease) in % (1)2019 vs. 2018Net sales$578,210 $572,471 $556,370 1%3%Net sales to external customers$573,610 $566,581 $549,827 1%3%Segment profit$77,910 $71,483 $78,317 9%(9)%(1)Represents U.S. dollar growth.Other includes reporting units in Southeast Asia, Latin America, Eastern Europe, and other countries. Both net sales and net sales to external customers in U.S. dollars increased 1% in 2020 and 3% in 2019, and in local currencies increased 2% in 2020 and 5% in 2019. The increase in local currency growth in net sales to external customers during 2020 includes growth in laboratory-related products, especially pipettes and automated chemistry, offset in part by a decline in industrial-related products due to reduced customer demand related to COVID-19.Segment profit increased $6.4 million in our Other segment during 2020, compared to a decrease of $6.8 million during 2019. The increase in segment profit during 2020 primarily includes increased sales volume and benefits from our temporary cost savings measures.Liquidity and Capital ResourcesLiquidity is our ability to generate sufficient cash to meet our obligations and commitments. Sources of liquidity include cash flows from operating activities, available borrowings under our Credit Agreement, the ability to obtain appropriate financing, and our cash and cash equivalent balances. Currently, our financing requirements are primarily driven by working capital requirements, capital expenditures, share repurchases, and acquisitions. Global market conditions can be uncertain, and our ability to generate cash flows could be reduced by a deterioration in global markets.Cash provided by operating activities totaled $724.7 million in 2020, compared to $603.5 million in 2019 and $565.0 million in 2018. The increase in 2020 includes benefits from favorable working capital including strong cash collections and higher net earnings compared to the prior year.Capital expenditures are made primarily for investments in information systems and technology, machinery, equipment, and the purchase and expansion of facilities. Our capital expenditures totaled $92.5 million in 2020, $97.3 million in 2019, and $142.7 million in 2018. We expect to make net investments in new or expanded manufacturing facilities of approximately $10 million to $15 million in 2021.Cash flows used in financing activities during 2020 primarily comprised share repurchases. As further described below, in accordance with our share repurchase plan, we repurchased 815,652 shares and 1,094,648 shares in the amount of $775 million during both 2020 and 2019, respectively. We continue to explore potential acquisitions. In connection with any acquisition, we may incur additional indebtedness. As further described in Note 4 of our consolidated financial statements, in the third quarter of 2017, we acquired all of the shares of Biotix, Inc., a U.S.-based manufacturer and distributor of plastic consumables associated with pipettes, including tips, tubes, and reagent reservoirs used in the life sciences market, for an initial cash payment of $105 million plus additional cash consideration of $10 million that was paid in the first quarter of 2019. We also recorded a one-time gain of $18.7 million during 2018 related to the settlement of the Biotix acquisition contingent consideration. In 2020, 2019, and 2018, we also incurred additional acquisition payments totaling $6.2 million, $2.0 million, and $5.5 million, respectively.39Table of ContentsWe plan to continue to repatriate earnings from China, Switzerland, Germany, the United Kingdom, and certain other countries in future years and expect the only additional cost associated with the repatriation of such foreign earnings will be withholding taxes. All other undistributed earnings are considered to be permanently reinvested. We believe the ongoing tax impact associated with repatriating our undistributed foreign earnings will not have a material effect on our liquidity.Senior Notes and Credit Facility AgreementOur short-term borrowings and long-term debt consisted of the following at December 31, 2020:U.S. DollarOther PrincipalTrading CurrenciesTotal3.67% $50 million 10-year Senior Notes due December 17, 2022$50,000 $— $50,000 4.10% $50 million 10-year Senior Notes due September 19, 202350,000 — 50,000 3.84% $125 million 10-year Senior Notes due September 19, 2024125,000 — 125,000 4.24% $125 million 10-year Senior Notes due June 25, 2025125,000 — 125,000 3.91% $75 million 10-year Senior Notes due June 25, 202975,000 — 75,000 3.19% $50 million 15-year Senior Notes due January 24, 203550,000 — 50,000 1.47% EUR 125 million 15-year Senior Notes due June 17, 2030— 153,299 153,299 1.30% EUR 135 million 15-year Senior Notes due November 6, 2034— 165,563 165,563 Senior Notes debt issuance costs, net(1,132)(1,628)(2,760)Total Senior Notes473,868 317,234 791,102 $1.1 billion Credit Agreement, interest at LIBOR plus 87.5 basis points(1)382,162 109,257 491,419 Other local arrangements1,665 50,305 51,970 Total debt857,695 476,796 1,334,491 Less: current portion(169)(50,148)(50,317)Total long-term debt$857,526 $426,648 $1,284,174 (1) See Note 6 and Note 7 for additional disclosures on the financial instruments associated with the Credit Agreement.As of December 31, 2020, approximately $602.5 million of additional borrowings were available under our Credit Agreement, and we maintained $94.3 million of cash and cash equivalents. Changes in exchange rates between the currencies in which we generate cash flow and the currencies in which our borrowings are denominated affect our liquidity. In addition, because we borrow in a variety of currencies, our debt balances fluctuate due to changes in exchange rates. Further, we do not have any downgrade triggers from rating agencies that would accelerate the maturity dates of our debt. We were in compliance with our debt covenants at December 31, 2020.We currently believe that cash flows from operating activities, together with liquidity available under our Credit Agreement, local working capital facilities, and cash balances, will be sufficient to fund currently anticipated working capital needs and capital spending requirements for at least the foreseeable future. Senior NotesThe Senior Notes listed above are senior unsecured obligations and interest is payable semi-annually. The Senior Notes each contain customary affirmative and negative covenants as further described in Note 10 of our consolidated financial statements.In December 2020, we entered into an agreement to issue and sell EUR 125 million of 15-year 1.06% Euro Senior Notes ("1.06% Euro Senior Notes"). The terms of the Euro Senior Notes are consistent with the previous Euro Senior Notes as described in Note 10 to the consolidated financial statements. The Company also entered into a forward contract to receive $152.1 million at the time of issuing the 1.06% 40Table of ContentsEuro Senior Notes in March 2021. The proceeds will be used to repay outstanding amounts on the Company’s credit facility and fund operational expenses.Credit AgreementWe have a $1.1 billion Credit Agreement (the “Credit Agreement”), which has $602.5 million of availability remaining as of December 31, 2020. The Credit Agreement is provided by a group of financial institutions and has a maturity date of June 15, 2023. It is a revolving credit facility and is not subject to any scheduled principal payments prior to maturity. The obligations under the Credit Agreement are unsecured.Borrowings under the Credit Agreement bear interest at current market rates plus a margin based on our consolidated leverage ratio, which was set at LIBOR plus 87.5 basis points as of June 15, 2018. We must also pay facility fees that are tied to our leverage ratio. The Credit Agreement contains covenants as further described in Note 10 of our consolidated financial statements, with which we were in compliance as of December 31, 2020. Other Local ArrangementsIn April 2018, two of our non-U.S. pension plans issued loans totaling $39.6 million (Swiss franc 38 million) to a wholly owned subsidiary of the Company. The loans have the same terms and conditions which include an interest rate of Swiss franc LIBOR plus 87.5 basis points. The loans were renewed for one year in April 2020.Contractual ObligationsThe following summarizes certain of our contractual obligations at December 31, 2020 and the effect such obligations are expected to have on our liquidity and cash flows in future periods. We do not have significant outstanding letters of credit or other financial commitments. Payments Due by Period TotalLess than 1 Year1-3 Years3-5 YearsAfter 5 YearsShort- and long-term debt$1,488,735 $50,127 $591,419 $250,000 $597,189 Interest on debt191,635 31,666 56,169 32,653 71,147 Non-cancelable operating leases88,756 31,155 35,780 11,469 10,352 Pension and post-retirement funding(1)28,215 28,215 — — — Purchase obligations117,139 87,272 23,907 5,960 — Total(1)$1,914,480 $228,435 $707,275 $300,082 $678,688 (1)In addition to the above table, we also have liabilities for pension and post-retirement funding and income taxes (and transition tax liabilities of $43 million related to the Tax Cuts and Jobs Act). However, we cannot determine the timing or the amounts for income taxes or the timing and amounts beyond 2021 for pension and post-retirement funding. We have purchase commitments for materials, supplies, services, and fixed assets in the normal course of business. Due to the proprietary nature of many of our materials and processes, certain supply contracts contain penalty provisions. We do not expect potential payments under these provisions to materially affect our results of operations or financial condition. This conclusion is based upon reasonably likely outcomes derived by reference to historical experience and current business plans.41Table of ContentsShare Repurchase ProgramIn November 2020, the Company’s Board of Directors authorized an additional $2.5 billion to the share repurchase program which has $3.1 billion of remaining availability as of December 31, 2020. The share repurchases are expected to be funded from cash generated from operating activities, borrowings, and cash balances. Repurchases will be made through open market transactions, and the amount and timing of purchases will depend on business and market conditions, the stock price, trading restrictions, the level of acquisition activity, and other factors. We have purchased 29.4 million common shares since the inception of the program in 2004 through December 31, 2020, at a total cost of $5.9 billion. During the years ended December 31, 2020 and 2019, we spent $775 million in both years on the repurchase of 815,652 shares and 1,094,648 shares at an average price per share of $950.14 and $707.97, respectively. We reissued 162,176 shares and 298,002 shares held in treasury for the exercise of stock options and restricted stock units during 2020 and 2019, respectively. Off-Balance Sheet ArrangementsCurrently, we have no off-balance sheet arrangements that have or are reasonably likely to have a current or future material effect on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures, or capital resources.Effect of Currency on Results of OperationsOur earnings are affected by changing exchange rates. We are particularly sensitive to changes in the exchange rates between the Swiss franc, euro, Chinese renminbi, and U.S. dollar. We have more Swiss franc expenses than we do Swiss franc sales because we develop and manufacture products in Switzerland that we sell globally and have a number of corporate functions located in Switzerland. When the Swiss franc strengthens against our other trading currencies, particularly the U.S. dollar and euro, our earnings go down. We also have significantly more sales in the euro than we do expenses. When the euro weakens against the U.S. dollar and Swiss franc, our earnings also go down. We estimate a 1% strengthening of the Swiss franc against the euro would reduce our earnings before tax by approximately $1.6 million to $1.8 million annually.We also conduct business throughout the world, including Asia Pacific, the United Kingdom, Eastern Europe, Latin America, and Canada. Fluctuations in these currency exchange rates against the U.S. dollar can also affect our operating results. The most significant of these currency exposures is the Chinese renminbi. The impact on our earnings before tax of the Chinese renminbi weakening 1% against the U.S. dollar is a reduction of approximately $2.0 million to $2.2 million annually. In addition to the effects of exchange rate movements on operating profits, our debt levels can fluctuate due to changes in exchange rates, particularly between the U.S. dollar, the Swiss franc, and euro. Based on our outstanding debt at December 31, 2020, we estimate that a 5% weakening of the U.S. dollar against the currencies in which our debt is denominated would result in an increase of $25.2 million in the reported U.S. dollar value of our debt.TaxesWe are subject to taxation in many jurisdictions throughout the world. Our effective tax rate and tax liability will be affected by a number of factors, such as changes in law, the amount of taxable income in particular jurisdictions, the tax rates in such jurisdictions, tax treaties between jurisdictions, the extent to which we transfer funds between jurisdictions, and earnings repatriations between jurisdictions. Generally, the tax liability for each taxpayer within the group is determined either (i) on a non-consolidated/non-42Table of Contentscombined basis or (ii) on a consolidated/combined basis only with other eligible entities subject to tax in the same jurisdiction, in either case without regard to the taxable losses of non-consolidated/non-combined affiliated legal entities.Environmental MattersWe are subject to environmental laws and regulations in the jurisdictions in which we operate. We own or lease a number of properties and manufacturing facilities around the world. Like many of our competitors, we have incurred, and will continue to incur, capital and operating expenditures and other costs in complying with such laws and regulations.We are currently involved in, or have potential liability with respect to, the remediation of past contamination in certain of our facilities. A former subsidiary of Mettler-Toledo, LLC known as Hi-Speed Checkweigher Co., Inc. was one of two private parties ordered by the New Jersey Department of Environmental Protection, in an administrative consent order signed on June 13, 1988, to investigate and remediate certain ground water contamination at a property in Landing, New Jersey. After the other party under this order failed to fulfill its obligations, Hi-Speed became solely responsible for compliance with the order. Residual ground water contamination at this site is now within a Classification Exception Area which the Department of Environmental Protection has approved and within which the Company oversees monitoring of the decay of contaminants of concern. A concurrent Well Restriction Area also exists for the site. The Department of Environmental Protection does not view these vehicles as remedial measures, but rather as “institutional controls” that must be adequately maintained and periodically evaluated. We estimate that the costs of compliance associated with the site over the next several years will approximate a total of $0.4 million.In addition, certain of our present and former facilities have or had been in operation for many decades and, over such time, some of these facilities may have used substances or generated and disposed of wastes which are or may be considered hazardous. It is possible that these sites, as well as disposal sites owned by third parties to which we have sent wastes, may in the future be identified and become the subject of remediation. Although we believe that we are in substantial compliance with applicable environmental requirements and, to date, we have not incurred material expenditures in connection with environmental matters, it is possible that we could become subject to additional environmental liabilities in the future that could have a material adverse effect on our financial condition, results of operations, or cash flows.InflationInflation can affect the costs of goods and services that we use, including raw materials to manufacture our products. The competitive environment in which we operate limits somewhat our ability to recover higher costs through increased selling prices.Moreover, there may be differences in inflation rates between countries in which we incur the major portion of our costs and other countries in which we sell products, which may limit our ability to recover increased costs. We remain committed to operations in China, Eastern Europe, India, and Brazil, which have experienced inflationary conditions. To date, inflationary conditions have not had a material effect on our operating results. However, as our presence in China, Eastern Europe, India, and Brazil increases, these inflationary conditions could have a greater impact on our operating results.Quantitative and Qualitative Disclosures about Market RiskWe have only limited involvement with derivative financial instruments and do not use them for trading purposes. 43Table of ContentsWe have entered into certain interest rate swap agreements. These contracts are more fully described in Note 6 to our consolidated financial statements. The fair value of these contracts was a net liability of $2.5 million at December 31, 2020. Based on our agreements outstanding at December 31, 2020, a 100-basis-point change in interest rates would result in a change in the net aggregate market value of these instruments of approximately $1.2 million. Any change in fair value would not affect our consolidated statement of operations unless such agreements and the debt they hedge were prematurely settled.We have entered into certain cross currency swap agreements. The fair value of these contracts was a net liability of $19.4 million at December 31, 2020. Based on our agreements outstanding at December 31, 2020, a 100-basis-point change in interest rates and foreign currency exchange rates would result in a change in the net aggregate market value of these instruments by approximately $3.4 million. Any change in fair value would not affect our consolidated statement of operations unless such agreements and the debt they hedge were prematurely settled.Critical Accounting PoliciesManagement’s discussion and analysis of our financial condition and results of operations is based upon our consolidated financial statements, which have been prepared in accordance with U.S. GAAP. The preparation of these consolidated financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues, expenses, and related disclosure of contingent assets and liabilities. On an ongoing basis, we evaluate our estimates, including those related to revenue, income taxes, inventories, goodwill and intangibles, leases, and pensions and other post-retirement benefits. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances. The results form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.We believe the following critical accounting policies affect our more significant judgments and estimates used in the preparation of our consolidated financial statements. For a detailed discussion on the application of these and other accounting policies, see Note 2 to our consolidated financial statements.Revenue recognitionProduct revenue is recognized from contracts with customers when a customer has obtained control of a product. We consider control to have transferred based upon shipping terms. To the extent that our contracts have a separate performance obligation, revenue related to any post-shipment performance obligation is deferred until completed. Shipping and handling costs charged to customers are included in total net sales and the associated expense is a component of cost of sales. Certain products are also sold through indirect distribution channels whereby the distributor assumes any further obligations to the end-customer. Revenue is recognized on these distributor arrangements upon transfer of control to the distributor. Contracts do not contain variable pricing arrangements that are retrospective, except for rebate programs. Rebates are estimated based on expected sales volumes and offset against revenue at the time such revenue is recognized. We generally maintain the right to accept or reject a product return in our terms and conditions and also maintain appropriate accruals for outstanding credits. The provisions for estimated returns and rebates are immaterial to the consolidated financial statements. Certain of our product arrangements include separate performance obligations, primarily related to installation. Such performance obligations are accounted for separately when the deliverables have stand-alone value and the satisfaction of the undelivered performance obligations is probable and within our control. The allocation of revenue between the performance obligations is based on the observable stand-alone selling prices at the time of the sale in accordance with a number of factors including service technician billing rates, time to install, and geographic location. 44Table of ContentsSoftware is generally not considered a distinct performance obligation with the exception of a limited number of software applications. We generally sell software products with the related hardware instrument as the software is usually embedded in the product. Our products typically require no significant production, modification, or customization of the hardware or software that is essential to the functionality of the products. Service revenue not under contract is recognized upon the completion of the service performed. Revenue from spare parts sold on a stand-alone basis is recognized when control is transferred to the customer, which is generally at the time of shipment or delivery. Revenue from service contracts is recognized ratably over the contract period using a time-based method. These contracts represent an obligation to perform repair and other services including regulatory compliance qualification, calibration, certification, and preventative maintenance on a customer’s pre-defined equipment over the contract period.Income taxesIncome tax expense, deferred tax assets and liabilities, and reserves for unrecognized tax benefits reflect management’s assessment of estimated future taxes to be paid on items in the consolidated financial statements. We record a valuation allowance to reduce our deferred tax assets to the amount that is more likely than not to be realized. The valuation allowance is based on management’s estimates of future taxable income and application of relevant income tax law. In the event we were to determine that we would be able to realize our deferred tax assets in the future in excess of the net recorded amount, an adjustment to the valuation allowance would increase income or equity in the period such determination was made. Likewise, should we determine that we would not be able to realize all or part of the valuation allowance in the future, an adjustment to the net deferred tax asset would be charged to income in the period such determination was made.We plan to repatriate earnings from China, Switzerland, Germany, the United Kingdom, and certain other countries in future years and expect the additional tax costs associated with the repatriation of such earnings will be non-U.S. withholding taxes, certain state taxes, and U.S. taxes on currency gains, if any. All other undistributed earnings are considered permanently reinvested. The significant assumptions and estimates described in the preceding paragraphs are important contributors to our ultimate effective tax rate for each year in addition to our income mix from geographical regions. If any of our assumptions or estimates were to change, or should our income mix from our geographical regions change, our effective tax rate could be materially affected. Based on earnings before taxes of $748.7 million for the year ended December 31, 2020, each increase of $7.5 million in tax expense would increase our effective tax rate by 1%.InventoriesAs of December 31, 2020, inventories were $297.6 million.We record our inventory at the lower of cost or net realizable value. Cost, which includes direct materials, labor, and overhead, is generally determined using the first in, first out (FIFO) method. The estimated net realizable value is based on assumptions for future demand and related pricing. Adjustments to the cost basis of our inventory are made for excess and obsolete items based on usage, orders, and technological obsolescence. If actual market conditions are less favorable than those projected by management, reductions in the value of inventory may be required.Goodwill and other intangible assetsAs of December 31, 2020, our consolidated balance sheet included goodwill of $550.3 million and other intangible assets of $196.8 million.45Table of ContentsOur business acquisitions typically result in goodwill and other intangible assets, which affect the amount of future period amortization expense and possible impairment expense. The determination of the value of such intangible assets requires management to make estimates and assumptions that affect our consolidated financial statements.In accordance with U.S. GAAP, our goodwill and indefinite-lived intangible assets are not amortized, but are evaluated for impairment annually in the fourth quarter, or more frequently if events or changes in circumstances indicate that an asset might be impaired. The annual evaluations of goodwill and indefinite-lived intangible assets are generally based on an assessment of qualitative factors to determine whether it is more likely than not that the fair value of the asset is less than its carrying amount. If we are unable to conclude whether the goodwill or indefinite-lived intangible asset is not impaired after considering the totality of events and circumstances during our qualitative assessment, we perform a quantitative impairment test by estimating the fair value of the respective reporting unit or indefinite-lived intangible asset and comparing the fair value to the carrying amount of the goodwill asset. If the carrying amount of the reporting unit or indefinite-lived intangible asset exceeds its fair value, an impairment charge equal to the difference is recognized. Both the qualitative and quantitative evaluations consider operating results, business plans, economic conditions, and market data, among other factors. There are inherent uncertainties related to these factors and our judgment in applying them to the impairment analyses. Our assessments to date have indicated that there has been no impairment of these assets.Should any of these estimates or assumptions change, or should we incur lower than expected operating performance or cash flows, including from a prolonged economic slowdown, we may experience a triggering event that requires a new fair value assessment for our reporting units, possibly prior to the required annual assessment. These types of events and resulting analysis could result in impairment charges for goodwill and other indefinite-lived intangible assets if the fair value estimate declines below the carrying value.Our amortization expense related to intangible assets with finite lives may materially change should our estimates of their useful lives change.LeasesWe consider an arrangement a lease if the arrangement transfers the right to control the use of an identified asset in exchange for consideration. We have operating leases, but do not have material financing leases. As of December 31, 2020, our balance sheet included a right-of-use asset of $98.6 million, a short-term lease liability of $29.2 million, and a long-term lease liability of $69.8 million.Operating lease right-of-use assets represent the right to use an underlying asset for the lease term, and lease liabilities represent the obligation to make payments arising from the lease agreement. These assets and liabilities are recognized at the commencement of the lease based upon the present value of the lease payments over the lease term. The lease term reflects the non-cancellable period of the lease together with periods covered by an option to extend or terminate the lease when management is reasonably certain that it will exercise such option. Changes in the lease term assumption could impact the right-of-use assets and lease liabilities recognized on the balance sheet. We apply our incremental borrowing rate assumption at the lease commencement date in determining the present value of lease payments as the information necessary to determine the rate implicit in the lease is not readily available. The incremental borrowing rate reflects similar terms by geographic location to the underlying leases. A change in the incremental borrowing rate assumption of 1% would impact the lease liability by approximately $3.1 million.46Table of ContentsEmployee benefit plansThe net periodic pension cost for 2020 and projected benefit obligation as of December 31, 2020 were $1.3 million and $149.9 million, respectively, for our U.S. pension plan. The net periodic cost for 2020 and projected benefit obligation as of December 31, 2020 were $6.2 million and $1.1 billion, respectively, for our international pension plans. The net periodic post-retirement benefit for 2020 and expected post-retirement benefit obligation as of December 31, 2020 for our U.S. post-retirement medical benefit plan were $0.1 million and $1.0 million, respectively.Pension and post-retirement benefit plan expense and obligations are developed from assumptions utilized in actuarial valuations. The most significant of these assumptions include the discount rate and expected return on plan assets. In accordance with U.S. GAAP, actual results that differ from the assumptions are accumulated and deferred over future periods. While management believes the assumptions used are appropriate, differences in actual experience or changes in assumptions may affect our plan obligations and future expense.The expected rates of return on the various defined benefit pension plans’ assets are based on the asset allocation of each plan and the long-term projected return of those assets, which represent a diversified mix of U.S. and international corporate equities and government and corporate debt securities. In 2002, we froze our U.S. defined benefit pension plan and discontinued our retiree medical program for certain current and all future employees. Consequently, no significant future service costs will be incurred on these plans. For 2020, the weighted average return on assets assumption was 6.25% for the U.S. plan and 3.73% for the international plans. A change in the rate of return of 1% would impact annual benefit plan expense by approximately $8.7 million after tax.The discount rates for defined benefit and post-retirement plans are set by benchmarking against high-quality corporate bonds. For 2020, the weighted average discount rate assumption was 2.2% for the U.S. plan and 0.3% for the international plans, representing a weighted average of local rates in countries where such plans exist. A change in the discount rate of 1% would impact annual benefit plan expense by approximately $10.7 million after tax.New Accounting PronouncementsSee Note 2 to the consolidated financial statements.Item 7A.Quantitative and Qualitative Disclosures about Market RiskDiscussion of this item is included in Management’s Discussion and Analysis of Financial Condition and Results of Operations.
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+ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS This management’s discussion and analysis of financial condition and results of operations includes discussion as of and for the year ended December 31, 2020 compared to December 31, 2019. Discussion of our financial condition and results of operations as of and for the year ended December 31, 2019 compared to December 31, 2018 can be found in our Annual Report on Form 10-K for the fiscal year ended December 31, 2019, filed with the Securities and Exchange Commission (“SEC”) on February 27, 2020. Description of our business and key performance indicators Our primary business is the ownership and operation of casino resorts, which offer gaming, hotel, convention, dining, entertainment, retail and other resort amenities. We own or invest in several of the finest casino resorts in the world and we continually reinvest in our resorts to maintain our competitive advantage. Most of our revenue is cash-based, through customers wagering with cash or paying for non-gaming services with cash or credit cards. We rely heavily on the ability of our resorts to generate operating cash flow to fund capital expenditures, provide excess cash flow for future development and repay debt financings. We make significant investments in our resorts through newly remodeled hotel rooms, restaurants, entertainment and nightlife offerings, as well as other new features and amenities. Our results of operations are affected by decisions we make related to our capital allocation, our access to capital and our cost of capital. While we continue to be focused on improving our financial position and returning capital to shareholders, we are also dedicated to capitalizing on strategic development or initiatives. Our results of operations do not tend to be seasonal in nature, though a variety of factors may affect the results of any interim period, including the timing of major conventions, Far East baccarat volumes, the amount and timing of marketing and special events for our high-end gaming customers, and the level of play during major holidays, including New Year and Lunar New Year. While our results do not depend on key individual customers, a significant portion of our operating income is generated from high-end gaming customers, which can cause variability in our results. In addition, our success in marketing to customer groups such as convention customers and the financial health of customer segments such as business travelers or high-end gaming customers from a specific country or region can affect our results. Financial Impact of COVID-19 The spread of COVID-19 and developments surrounding the global pandemic have had, and we expect will continue to have, a significant impact on our business, financial condition, results of operations and cash flows in 2021. In March 2020, all of our domestic properties were temporarily closed pursuant to state and local government restrictions imposed as a result of COVID-19. Throughout the second and third quarters of 2020 all of our properties that were temporarily closed re-opened to the public but continue to operate without certain amenities and subject to certain occupancy limitations, with restrictions varying by jurisdiction and with further temporary re-closures and re-openings occurring for our properties or portions of our properties into the first quarter of 2021. In response to reduced demand, we temporarily closed the hotel tower operations at Mandalay Bay and Park MGM midweek and temporarily closed The Mirage midweek, which are expected to resume full week operations on March 3, 2021. Accordingly, our properties continued to generate revenues that are significantly lower than historical results. In addition, as a result of the continued impact of the COVID-19 pandemic and the emergence of variant strains, our properties may be subject to temporary, complete, or partial shutdowns in the future. At this time, we cannot predict whether the jurisdictions in which our properties are located, states or the federal government will continue to impose operating restrictions on us or adopt similar or more restrictive measures in the future, including stay-at-home orders or ordering the temporary closures of all or a portion of our properties. We have implemented certain measures to mitigate the spread of COVID-19, including limitations on the number of gaming tables allowed to operate and on the number of seats at each table game, as well as slot machine spacing, temperature checks, mask protection, limitations on restaurant capacity, entertainment events and conventions as well as other measures to enforce social distancing. In addition, following a temporary closure of our properties in Macau on February 5, 2020, operations resumed on February 20, 2020, subject to certain health safeguards, such as limiting the number of gaming tables allowed to operate and the number of seats available at each table game, slot machine spacing, reduced operating hours at a number of restaurants and bars, temperature checks, mask protection and the need to present negative COVID-19 test results and health declarations submitted through the Macau Health Code system which remain in effect. Effective July 15, 2020, all guests entering our casinos were required to provide a negative nucleic acid test result with a valid ‘green’ Macau Health Code. Although the issuance of tourist visas (including the IVS) for residents of Zhuhai, Guangdong Province and all other provinces in mainland China to travel to Macau resumed on August 12, 2020, August 26, 2020 and September 23, 2020, respectively, several travel and entry restrictions in Macau, Hong Kong and mainland China remain in place (including the temporary suspension of ferry services from Hong Kong to Macau, the nucleic acid test result certificate and mandatory quarantine requirements 36 for visitors from Hong Kong and Taiwan, and bans on entry or enhanced quarantine requirements on other visitors into Macau), which have significantly impacted visitation to our Macau properties. During 2020, we engaged in aggressive cost reduction efforts to minimize cash outflows while our properties were initially closed and have continued to engage in such efforts as the properties have re-opened, we still face significant fixed and variable expenses. Our efforts included: • reducing or deferring at least 50% of planned domestic capital expenditures in 2020; • reducing employee costs, including through hiring freezes, headcount reductions and substantial furloughs of employees (which have resulted in a number of employees being separated from us) and cancellation of merit pay increases; • midweek closures of certain hotel towers and properties in response to reduced demand; • initiating a program where certain senior executives and directors voluntarily elected to receive all or a portion of their remaining base salary during 2020 in the form of restricted stock units in lieu of cash; and • starting with our dividend for the second quarter of 2020, our Board approved a nominal annual dividend of $0.01 per share. On March 27, 2020, the Coronavirus Aid, Relief, and Economic Security Act (the “CARES Act”) was signed into law. The CARES Act provides opportunities for additional liquidity, loan guarantees, and other government programs to support companies affected by the COVID-19 pandemic and their employees. Based on a preliminary analysis of the CARES Act, the benefits we expect to recognize include: • refund of federal income taxes due to a five-year carryback of net operating loss incurred in 2020 that we estimate will result in a $205 million to $215 million refund; • relaxation of interest expense deduction limitation for income tax purposes, which is included in the estimate above; • reduction of employer Federal Insurance Contributions Act (“FICA”) taxes equal to 50% of wages paid and health care coverage provided to furloughed employees during 2020, which resulted in permanent savings of approximately $121 million that was recorded in the year ended December 31, 2020, including our share of the savings recorded by CityCenter; and • deferral of all employer FICA taxes from the date of enactment through December 31, 2020, 50% payable by December 2021 and the remainder payable by December 2022, which resulted in a deferral of approximately $51 million. In addition, we have seen and continue to expect to see weakened demand at our properties as a result of continued domestic and international travel restrictions or warnings, restrictions on amenity use, such as gaming, restaurant and pool capacity limitations, consumer fears and reduced consumer discretionary spending, general economic uncertainty, and increased rates of unemployment. In light of the foregoing, we are unable to determine when our properties will return to pre-pandemic demand or pricing, or if our properties will remain re-opened. The COVID-19 pandemic has had a material impact on our consolidated results of operations during 2020 and we expect that it will continue to have a material impact on our consolidated results of operations during 2021 and potentially thereafter. The Las Vegas Strip segment results of operations are heavily impacted by visitor volume and trends. During the year ended December 31, 2020, Las Vegas visitor volume decreased 55% compared to the prior year period according to information published by the Las Vegas Convention and Visitors Authority. Although the Las Vegas market has had the addition of new sporting events and venues, the expansion of convention centers, as well as music and entertainment events, the COVID-19 pandemic has drastically impacted visitation. The MGM China segment results of operations also are heavily impacted by visitor volume and trends. During the year ended December 31, 2020 Macau visitor arrivals decreased 85% compared to the prior year period according to statistics published by the Statistics and Census Service of the Macau Government, as a result of the disruption caused by the COVID-19 pandemic. 37 Other Developments As of December 31, 2020, pursuant to a master lease agreement with MGP, we lease the real estate assets of The Mirage, Luxor, New York-New York, Park MGM, Excalibur, The Park, Gold Strike Tunica, MGM Grand Detroit, Beau Rivage, Borgata, Empire City, MGM National Harbor, and MGM Northfield Park. See Note 1 in the accompanying consolidated financial statements for information regarding MGP and the Operating Partnership, which we consolidate in our financial statements. All intercompany transactions, including transactions under the master lease with MGP, have been eliminated in consolidation. As further discussed below, pursuant to a lease agreement with the Bellagio BREIT Venture, we lease the real estate assets of Bellagio, and pursuant to a lease agreement with the MGP BREIT Venture, we lease the real estate assets of Mandalay Bay and MGM Grand Las Vegas. In July 2018, MGP completed its Northfield Acquisition for approximately $1.1 billion. In April 2019, we acquired the membership interests of Northfield from MGP and MGP retained the real estate assets. We then rebranded the property to MGM Northfield Park, and added it to the master lease between us and MGP. See Note 4 and Note 18 in the accompanying financial statements for information regarding this acquisition. In July 2018, we and Entain formed BetMGM, a venture that is owned 50% by each party. In connection with its formation, we provided BetMGM with exclusive access to all of our domestic land-based and online sports betting, major tournament poker, and online gaming operations and Entain provided BetMGM with exclusive access to its technology in the United States. Also, in January 2019, we acquired the real property and operations associated with Empire City in Yonkers, New York for consideration of approximately $865 million. Subsequently, MGP acquired the developed real property associated with Empire City from us and Empire City was added to the master lease between us and MGP. In addition, pursuant to the master lease amendment, we agreed to provide MGP a right of first offer with respect to certain undeveloped land adjacent to the property to the extent that we develop additional gaming facilities and choose to sell or transfer such property in the future. See Note 4 and Note 18 in the accompanying consolidated financial statements for information regarding this acquisition. In March 2019, we entered into an amendment to the master lease between us and MGP with respect to improvements made by us related to rebranding of the Park MGM and NoMad Las Vegas. See Note 18 in the accompanying financial statements for information regarding this transaction with MGP, which is eliminated in consolidation. In November 2019, we completed the Bellagio transaction, pursuant to which the Bellagio BREIT Venture was formed, which acquired the Bellagio real estate assets from us and entered into a lease agreement to lease the real estate assets back to us. The Bellagio lease provides for a term of 30 years with two ten-year renewal options and has initial annual base rent of $245 million with a fixed 2% escalator for the first ten years and, thereafter, an escalator equal to the greater of 2% and the CPI increase during the prior year, subject to a cap of 3% during the 11th through 20th years and 4% thereafter. In exchange for the contribution of the real estate assets, we received total consideration of $4.25 billion, which consisted of a 5% equity interest in the venture and approximately $4.2 billion in cash. We also provide a shortfall guarantee of the principal amount of indebtedness of the Bellagio BREIT Venture (and any interest accrued and unpaid thereon). As a result of the sale, we recorded a gain of approximately $2.7 billion. See Note 1, Note 11, and Note 12 in the accompanying consolidated financial statements for information regarding this transaction, lease agreement, and shortfall guarantee. In December 2019, we sold Circus Circus Las Vegas and adjacent land for $825 million, which consisted of $662.5 million paid in cash and a secured note due 2024 with a face value of $162.5 million and fair value of $133.7 million. In connection with our review of the carrying value of assets to be sold due to the offer for sale received during the third quarter of 2019, we recorded a non-cash impairment charge of $219 million. Upon completion of the sale in the fourth quarter, we recorded a loss of $2 million. See Note 1 and Note 16 in the accompanying consolidated financial statements for information regarding this transaction. On February 14, 2020, we completed the MGP BREIT Venture Transaction pursuant to which the real estate assets of MGM Grand Las Vegas and Mandalay Bay (including Mandalay Place) were contributed to MGP BREIT Venture, owned 50.1% by the Operating Partnership and 49.9% by a subsidiary of BREIT. In exchange for the contribution of the real estate assets, MGM and MGP received total consideration of $4.6 billion, which was comprised of $2.5 billion of cash, $1.3 billion of the Operating Partnership’s secured indebtedness assumed by the MGP BREIT Venture, and the Operating Partnership’s 50.1% equity interest in the MGP BREIT Venture. In addition, the Operating Partnership issued approximately 3 million Operating Partnership units to us representing 5% of the equity value of the MGP BREIT Venture. We also provide a shortfall guarantee of the principal amount of indebtedness of the MGP BREIT Venture (and any interest accrued and unpaid thereon). On the closing date, BREIT also purchased approximately 5 million MGP Class A shares for $150 million. See Note 1, Note 11, and Note 12 in the accompanying consolidated financial statements for information regarding this transaction, lease agreement, and shortfall guarantee. 38 In connection with the MGP BREIT Venture Transaction, MGP BREIT Venture entered into a lease with us for the real estate assets of Mandalay Bay and MGM Grand Las Vegas. The lease provides for a term of thirty years with two ten-year renewal options and has an initial annual base rent of $292 million, escalating annually at a rate of 2% per annum for the first fifteen years and thereafter equal to the greater of 2% and the CPI increase during the prior year subject to a cap of 3%. In addition, the lease obligates us to spend a specified percentage of net revenues at the properties on capital expenditures and that we comply with certain financial covenants, which, if not met, would require us to maintain cash security or provide one or more letters of credit in favor of the landlord in an amount equal to the rent for the succeeding one-year period. See Note 11 in the accompanying financial statements for information regarding this lease agreement. In connection with the MGP BREIT Venture Transaction, the master lease with MGP was modified to remove the Mandalay Bay property and the annual cash rent under the MGP master lease was reduced by $133 million. Also, on January 14, 2020, we, the Operating Partnership, and MGP entered into an agreement for the Operating Partnership to waive its right to issue MGP Class A shares, in lieu of cash, to us in connection with us exercising our right to require the Operating Partnership to redeem the Operating Partnership units we hold, at a price per unit equal to a 3% discount to the applicable cash amount as calculated in accordance with the operating agreement. The waiver was scheduled to terminate on the earlier of 24 months following the closing of the MGP BREIT Venture Transaction or upon our receipt of cash proceeds of $1.4 billion as consideration for the redemption of our Operating Partnership units. On May 18, 2020 the Operating Partnership redeemed approximately 30 million Operating Partnership units that we held for $700 million, or $23.10 per unit, and on December 2, 2020, the Operating Partnership redeemed approximately 24 million Operating Partnership units that we held for the remaining $700 million, or $29.78 per unit. As a result, the waiver terminated in accordance with its terms. In January 2019, we announced the implementation of a company-wide business optimization initiative (the “MGM 2020 Plan”) to further reduce costs, improve efficiencies and position us for growth. With the impact of COVID-19, we further addressed our strategy and cost approach with the aggressive reduction in operating costs, as further discussed earlier. Key Performance Indicators Key performance indicators related to gaming and hotel revenue are: • Gaming revenue indicators: table games drop and slots handle (volume indicators); “win” or “hold” percentage, which is not fully controllable by us. Our normal table games hold percentage at our Las Vegas Strip Resorts is in the range of 25.0% to 35.0% of table games drop for Baccarat and 19.0% to 23.0% for non-Baccarat; however, reduced gaming volumes as a result of the COVID-19 pandemic could cause volatility in our hold percentages; and • Hotel revenue indicators: hotel occupancy (a volume indicator); average daily rate (“ADR,” a price indicator); and revenue per available room (“REVPAR,” a summary measure of hotel results, combining ADR and occupancy rate). Our calculation of ADR, which is the average price of occupied rooms per day, includes the impact of complimentary rooms. Complimentary room rates are determined based on standalone selling price. Because the mix of rooms provided on a complimentary basis, particularly to casino customers, includes a disproportionate suite component, the composite ADR including complimentary rooms is slightly higher than the ADR for cash rooms, reflecting the higher retail value of suites. Rooms that were out of service during the year ended December 31, 2020 as a result of property closures due to the COVID-19 pandemic were excluded from the available room count when calculating hotel occupancy and REVPAR. Additional key performance indicators at MGM China are: • Gaming revenue indicators: MGM China utilizes “turnover,” which is the sum of nonnegotiable chip wagers won by MGM China calculated as nonnegotiable chips purchased plus nonnegotiable chips exchanged less nonnegotiable chips returned. Turnover provides a basis for measuring VIP casino win percentage. Win for VIP gaming operations at MGM China is typically in the range of 2.6% to 3.3% of turnover; however, reduced gaming volumes as a result of the COVID-19 pandemic could cause volatility in MGM China’s hold percentages. 39 Results of Operations The following discussion is based on our consolidated financial statements for the years ended December 31, 2020, 2019 and 2018. Summary Financial Results The following table summarizes our operating results: Year Ended December 31, 2020 2019 2018 (In thousands) Net revenues $ 5,162,082 $ 12,899,672 $ 11,763,096 Operating income (loss) (642,434 ) 3,940,215 1,469,486 Net income (loss) (1,319,907 ) 2,214,380 583,894 Net income (loss) attributable to MGM Resorts International (1,032,724 ) 2,049,146 466,772 Summary Operating Results Our domestic properties were temporarily closed due to COVID-19 on the dates shown below: Las Vegas Strip Resorts Closure Date Initial Re-opening Date Bellagio March 17, 2020 June 4, 2020 MGM Grand Las Vegas March 17, 2020 June 4, 2020 New York-New York March 17, 2020 June 4, 2020 Excalibur March 17, 2020 June 11, 2020 Luxor March 17, 2020 June 25, 2020 Mandalay Bay(1) March 17, 2020 July 1, 2020 The Mirage(2) March 17, 2020 August 27, 2020 Park MGM(1) March 17, 2020 September 30, 2020 Regional Operations Gold Strike March 17, 2020 May 25, 2020 Beau Rivage March 17, 2020 June 1, 2020 MGM Northfield Park March 14, 2020 June 20, 2020 MGM National Harbor March 15, 2020 June 29, 2020 MGM Springfield(3) March 15, 2020 July 13, 2020 Borgata March 16, 2020 July 26, 2020 MGM Grand Detroit(4) March 16, 2020 August 7, 2020 Empire City March 14, 2020 September 21, 2020 (1) Park MGM and Mandalay Bay’s hotel tower operations were closed midweek starting November 9, 2020 and November 30, 2020, respectively, with full week hotel tower operations expected to resume on March 3, 2021. (2) The Mirage’s hotel tower operations were closed midweek beginning November 30, 2020. The entire property was closed midweek starting January 4, 2021, with re-opening expected to occur on March 3, 2021. (3) MGM Springfield’s hotel was closed beginning November 2, 2020, with re-opening expected to occur on March 5, 2021. (4) MGM Grand Detroit re-closed on November 17, 2020 and re-opened on December 23, 2020, with the hotel tower operations remaining closed through February 8, 2021. Consolidated net revenues in 2020 decreased 60% compared to 2019 due primarily to the impact of COVID-19, which included a partial year of operations due to temporary closures at our properties, midweek hotel closures at certain domestic properties subsequent to re-opening, travel restrictions to Macau, including the suspension of the IVS for part of the year, restrictions on the number of table games allowed to operate in certain jurisdictions, and restrictions on the number of seats available at each table at both our domestic resorts and Macau properties, and other social distancing restrictions in place at our properties, including the number of slot machines available for use, property capacity restrictions, and venue/amenity limitations, as discussed above, as well as a decrease in travel and business volume. These factors resulted in a 77% decrease in net revenues at MGM China, a 61% decrease in net revenues at our Las Vegas Strip Resorts, and a 45% decrease in net revenues at our Regional Operations. Consolidated operating loss was $642 million for the year ended December 31, 2020 compared to operating income of $3.9 billion in 2019, due primarily to the impact of COVID-19 which included a decrease in net revenues discussed above, a $1.2 billion decrease in the gain related to our REIT transactions, and a $21 million increase in general and administrative expense, as discussed 40 below, partially offset by a decrease in operating expenses as a result of cost reduction efforts during property closures, a $66 million decrease in restructuring costs of which a portion was recorded to corporate expense, discussed below, a $182 million decrease in property transactions, net, and a $94 million decrease in depreciation and amortization. General and administrative expense increased in the current year period compared to the prior year period due primarily to $678 million of rent expense in the current year period associated with the Bellagio lease and the Mandalay Bay and MGM Grand Las Vegas lease compared to $42 million associated with the Bellagio lease in the prior year period, largely offset by aggressive efforts to reduce expenses at our domestic properties during the temporary closures, which primarily related to decreases in payroll expense, utilities, and advertising expense. In addition, general and administrative expense in the current year included $10 million of restructuring costs related to severance and accelerated stock compensation expense compared to $76 million in the prior year period. Corporate expense in the current year period included $49 million of October 1 litigation settlement expense, $44 million of CEO transition expense, and $11 million of restructuring costs. Included in the CEO transition expense is $20 million of stock compensation expense, of which approximately $13 million related to the modification and accelerated vesting of outstanding stock compensation awards. Corporate expense in the prior year period included $20 million of Empire City acquisition costs, primarily related to transfer taxes and advisory fees, $29 million in costs incurred to implement the MGM 2020 Plan, and $11 million in finance modernization initiative costs. Property transactions, net in the current year period included a $64 million other-than-temporary non-cash impairment charge on an equity method investment and $17 million related to a loss on production show costs, and the prior year period included a $220 million loss related to the sale of Circus Circus Las Vegas and the adjacent land. Depreciation and amortization and the gain related to our REIT transactions decreased compared to the prior year period due primarily to the sale of the MGM Grand Las Vegas and Mandalay Bay real estate assets in February 2020 and the sale of the Bellagio real estate assets in November 2019. 41 Net Revenues by Segment The following table presents a detail by segment of net revenues: Year Ended December 31, 2020 2019 2018 (In thousands) Las Vegas Strip Resorts Table games win $ 470,432 $ 789,330 $ 949,055 Slots win 649,229 1,193,607 1,140,269 Other 31,014 64,834 62,249 Less: Incentives (422,421 ) (751,601 ) (743,840 ) Casino revenue 728,254 1,296,170 1,407,733 Rooms 662,813 1,863,521 1,776,029 Food and beverage 471,529 1,517,745 1,402,378 Entertainment, retail and other 383,189 1,153,615 1,130,532 Non-casino revenue 1,517,531 4,534,881 4,308,939 2,245,785 5,831,051 5,716,672 Regional Operations Table games win 487,942 827,155 793,754 Slots win 1,404,567 2,362,638 1,947,325 Other 177,086 313,710 108,690 Less: Incentives (500,402 ) (965,723 ) (822,844 ) Casino revenue 1,569,193 2,537,780 2,026,925 Rooms 130,945 316,753 318,017 Food and beverage 184,153 494,243 428,934 Entertainment, retail and other 82,880 201,008 160,645 Non-casino revenue 397,978 1,012,004 907,596 1,967,171 3,549,784 2,934,521 MGM China VIP table games win 212,560 1,237,297 1,235,387 Main floor table games win 467,209 1,906,600 1,391,454 Slots win 72,298 286,939 284,919 Less: Commissions and incentives (186,396 ) (821,030 ) (716,616 ) Casino revenue 565,671 2,609,806 2,195,144 Rooms 36,624 142,306 118,527 Food and beverage 40,284 127,152 114,862 Entertainment, retail and other 14,124 26,158 21,424 Non-casino revenue 91,032 295,616 254,813 656,703 2,905,422 2,449,957 Reportable segment net revenues 4,869,659 12,286,257 11,101,150 Corporate and other 292,423 613,415 661,946 $ 5,162,082 $ 12,899,672 $ 11,763,096 Las Vegas Strip Resorts Las Vegas Strip Resorts casino revenue decreased 44% in 2020 compared to 2019 due primarily to the impact of COVID-19, which included a partial year of operations due to the temporary closure of properties, operational restrictions related to the pandemic, as discussed above, as well as a decrease in travel and business volume, which resulted in decreases in table games win and slots win of 40% and 46%, respectively. 42 The following table shows key gaming statistics for our Las Vegas Strip Resorts: Year Ended December 31, 2020 2019 2018 (Dollars in millions) Table Games Drop $2,001 $3,526 $3,857 Table Games Win % 23.5% 22.4% 24.6% Slots Handle $6,904 $12,874 $12,569 Slots Hold % 9.4% 9.3% 9.1% Las Vegas Strip Resorts rooms revenue decreased 64% in 2020 compared to 2019 due primarily to the impacts of COVID-19, which included a partial year of operations due to the temporary closure of the properties, midweek hotel closures at certain properties, and a decrease in REVPAR due primarily to a decrease in occupancy as a result of operational restrictions and a decrease in travel and business volume related to the pandemic, as discussed above. The following table shows key hotel statistics for our Las Vegas Strip Resorts: Year Ended December 31, 2020 2019 2018 Occupancy 55% 91% 91% Average Daily Rate (ADR)(1) $161 $167 $161 Revenue per Available Room (REVPAR)(1) 88 153 147 (1) Rooms that were out of service during the year ended December 31, 2020 as a result of property and hotel tower closures due to the COVID-19 pandemic were excluded from the available room count when calculating hotel occupancy and REVPAR. Las Vegas Strip Resorts food and beverage revenue decreased 69% in 2020 compared to 2019 due primarily to the impact of COVID-19, which included a partial year of operations due to the temporary closure of properties, operational restrictions related to the pandemic, as well as a decrease in travel and business volume, as discussed above. Las Vegas Strip Resorts entertainment, retail and other revenue decreased 67% in 2020 compared to 2019 due primarily to the impact of COVID-19, which included a partial year of operations due to the temporary closure of properties, operational restrictions related to the pandemic, as well as a decrease in travel and business volume, as discussed above, including the temporary closure of entertainment venues, such as theaters and nightclubs. Regional Operations Regional Operations casino revenue decreased 38% in 2020 compared to 2019 due primarily to the impact of COVID-19, which included a partial year of operations due to the temporary closure of properties, operational restrictions related to the pandemic, as well as a decrease in business volume, as discussed above, which resulted in decreases in each of table games win and slots win of 41%. The following table shows key gaming statistics for our Regional Operations: Year Ended December 31, 2020 2019 2018 (Dollars in millions) Table Games Drop $2,422 $4,226 $4,038 Table Games Win % 20.1% 19.6% 19.7% Slots Handle $14,527 $25,031 $21,468 Slots Hold % 9.7% 9.4% 9.1% Regional Operations rooms revenue decreased 59% in 2020 compared to 2019 due primarily to the impacts of COVID-19, which included a partial year of operations due to the temporary closure of the properties, the temporary closure of the hotel at MGM Grand Detroit, and a decrease in REVPAR due primarily to a decrease in occupancy as a result of operational restrictions and a decrease in business volume related to the pandemic, as discussed above. 43 Regional Operations food and beverage revenue decreased 63% in 2020 compared to 2019 due primarily to the impact of COVID-19, which included a partial year of operations due to the temporary closure of properties, operational restrictions related to the pandemic, as well as a decrease in business volume, as discussed above. Regional Operations entertainment, retail and other revenue decreased 59% in 2020 compared to 2019 due primarily to the impact of COVID-19, which included a partial year of operations due to the temporary closure of properties, operational restrictions related to the pandemic, as well as a decrease in business volume, as discussed above, including the temporary closure of certain entertainment venues such as theaters. MGM China The following table shows key gaming statistics for MGM China: Year Ended December 31, 2020 2019 2018 (Dollars in millions) VIP Table Games Turnover $7,015 $38,071 $40,599 VIP Table Games Win % 3.0% 3.2% 3.0% Main Floor Table Games Drop $2,037 $8,252 $7,566 Main Floor Table Games Win % 22.9% 23.1% 18.4% MGM China net revenue decreased 77% in 2020 compared to 2019 due primarily to the suspension of operations for a 15-day period in February, travel restrictions to Macau, including the suspension of the IVS for the majority of the current year period, as well as other operational restrictions and a decrease in travel and business volume related to the pandemic, as discussed above. VIP table games win decreased 83% and main floor table games win decreased 75% compared to the prior year period. Corporate and other Corporate and other revenue includes revenues from other corporate operations, management services and reimbursed costs revenue primarily related to our CityCenter management agreement. Corporate and other revenue in 2019 included $68 million in net revenues from MGP’s Northfield casino, which represents revenues prior to our acquisition of MGM Northfield Park’s operations from MGP on April 1, 2019. Reimbursed costs revenue represents reimbursement of costs, primarily payroll-related, incurred by us in connection with the provision of management services and was $245 million, $437 million and $425 million for 2020, 2019 and 2018, respectively. Reimbursed costs revenue for the year ended December 31, 2020 decreased compared to the prior year due primarily to property closures and other operational restrictions caused by the COVID-19 pandemic. See below for additional discussion of our share of operating results from unconsolidated affiliates. Adjusted Property EBITDAR and Adjusted EBITDAR The following table presents Adjusted Property EBITDAR and Adjusted EBITDAR. Adjusted Property EBITDAR is our reportable segment generally accepted accounting principles (“GAAP”) measure, which we utilize as the primary profit measure for our reportable segments. See Note 17 – Segment Information in the accompanying consolidated financial statements and “Reportable Segment GAAP measure” below for additional information. Year Ended December 31, 2020 2019 2018 (In thousands) Las Vegas Strip Resorts $ 232,188 $ 1,643,122 $ 1,706,315 Regional Operations 343,990 969,866 781,854 MGM China (193,832 ) 734,729 574,333 Corporate and other (530,843 ) (331,621 ) (224,800 ) Adjusted EBITDAR $ (148,497 ) 44 Las Vegas Strip Resorts Adjusted Property EBITDAR at our Las Vegas Strip Resorts decreased 86% and Adjusted Property EBITDAR margin decreased to 10.3% in 2020 from 28.2% in 2019. Adjusted Property EBITDAR decreased compared to the prior year period due primarily to a decrease in casino and non-casino revenues resulting from the temporary closure of our properties, operational restrictions related to the pandemic, and a decrease in travel and business volume, partially offset by a decrease in operating expenses as a result of cost reduction efforts. Regional Operations Adjusted Property EBITDAR at our Regional Operations decreased 65% in 2020 and Adjusted Property EBITDAR margin decreased to 17.5% in 2020 from 27.3% in 2019. Adjusted Property EBITDAR decreased compared to the prior year period due primarily to a decrease in casino and non-casino revenues resulting from the temporary closure of our properties, operational restrictions related to the pandemic, and a decrease in business volume, partially offset by a decrease in operating expenses as a result of cost reduction efforts. MGM China MGM China’s Adjusted Property EBITDAR loss was $194 million in 2020 compared to Adjusted Property EBITDAR of $735 million in 2019 due primarily to a decrease in casino revenues resulting from the temporary suspension of casino operations, travel restrictions to Macau, including the suspension of the IVS for majority of the current year period, operational restrictions related to the pandemic, and a decrease in travel and business volumes. The current period included $11 million of license fee expense compared to $51 million in the prior year period. Operating Results – Details of Certain Charges Property transactions, net consisted of the following: Year Ended December 31, 2020 2019 2018 (In thousands) Loss related to sale of Circus Circus Las Vegas and adjacent land $ — $ 220,294 $ — Gain on sale of Grand Victoria — — (44,703 ) Other property transactions, net 93,567 55,508 53,850 $ 93,567 $ 275,802 $ 9,147 See Note 16 to the accompanying consolidated financial statements for further discussion of property transactions, net. Operating Results – Income from Unconsolidated Affiliates The following table summarizes information related to our share of operating income from unconsolidated affiliates: Year Ended December 31, 2020 2019 2018 (In thousands) CityCenter $ (29,753 ) $ 128,421 $ 138,383 MGP BREIT Venture 136,755 — — Other (64,064 ) (8,900 ) 9,307 $ 42,938 $ 119,521 $ 147,690 On March 17, 2020, CityCenter temporarily closed to the public as a result of the unprecedented public health crisis from the COVID-19 pandemic described above. Aria re-opened on July 1, 2020 and Vdara re-opened on July 16, 2020. In 2020, our share of CityCenter’s operating loss, including certain basis difference adjustments, was $30 million compared to operating income of $128 million in 2019, primarily driven by the decrease in CityCenter’s casino and non-casino revenue as a result of the operational restrictions related to the COVID-19 pandemic, including the temporary closure, as well as a decrease in travel and business volume. 45 Non-operating Results Interest expense. The following table summarizes information related to interest expense, net: Year Ended December 31, 2020 2019 2018 (In thousands) Total interest incurred $ 679,251 $ 853,007 $ 821,229 Interest capitalized (2,871 ) (5,075 ) (51,716 ) $ 676,380 $ 847,932 $ 769,513 Gross interest expense was $679 million in 2020 compared to $853 million in 2019. The decrease in gross interest expense was due primarily to a decrease in the average debt outstanding under the credit facilities and senior notes due to the early retirement of debt discussed below, partially offset by the May 2020 issuance of the $750 million 6.75% senior notes due 2025, the June 2020 issuance of the Operating Partnership’s $800 million 4.625% senior notes due 2025, the June 2020 issuance of MGM China’s $500 million 5.25% senior notes due 2025, the October 2020 issuance of the $750 million 4.75% senior notes due 2028, and the November 2020 issuance of the Operating Partnership’s $750 million 3.875% senior notes due 2029. See Note 9 to the accompanying consolidated financial statements for additional discussion on long-term debt and see “Liquidity and Capital Resources” for additional discussion on issuances and repayments of long-term debt and other sources and uses of cash. Other, net. Other expenses, net in 2020 decreased $94 million compared to 2019. The current year period included a $109 million loss incurred on the early retirement of debt related to our senior notes and the termination of our revolving facility, as well as an $18 million loss incurred on the early retirement of debt related to the Operating Partnership’s repayment of its term loan A facility and its term loan B facility, partially offset by a $7 million remeasurement gain on MGM China’s U.S. dollar-denominated senior notes, and a $18 million increase in interest income resulting from an increase in cash and cash equivalents. The prior year period included a $198 million loss incurred on the early retirement of debt related to our senior notes and senior credit facility, the Operating Partnership’s prepayments on its senior credit facility, and the early retirement of debt related to MGM China’s senior secured credit facility, partially offset by a $11 million remeasurement gain on MGM China’s U.S. dollar-denominated senior notes. Refer to Note 9 for further discussion on long-term debt. Income taxes. The following table summarizes information related to our income taxes: Year Ended December 31, 2020 2019 2018 (In thousands) Income (loss) before income taxes $ (1,511,479 ) $ 2,846,725 $ 634,006 Benefit (provision) for income taxes 191,572 (632,345 ) (50,112 ) Effective income tax rate 12.7 % 22.2 % 7.9 % Federal, state and foreign income taxes paid, net of refunds $ 8,543 $ 28,493 $ (10,100 ) Our effective rate for 2020 was unfavorably impacted by losses incurred on our Macau operations for which we could not provide tax benefit and increases to valuation allowances for Macau deferred tax assets and foreign tax credits, partially offset by tax benefit resulting from carrying back net operating losses to tax years with a higher tax rate than is currently in effect. Our effective tax rate for 2019 was driven primarily by the $2.7 billion gain recorded on the Bellagio transaction. Income tax expense recorded on this gain results in our effective tax rate approximating our federal and state combined statutory rate and minimizes the impact of other items. Cash taxes paid decreased in 2020 compared to 2019 due to the impact of COVID-19 on business operations. In addition, 2019 cash taxes paid included federal taxes paid on the liquidation of MGP OH, Inc., a consolidated subsidiary directly owned by MGM Growth Properties Operating Partnership LP. Reportable Segment GAAP measure “Adjusted Property EBITDAR” is our reportable segment GAAP measure, which we utilize as the primary profit measure for our reportable segments and underlying operating segments. Adjusted Property EBITDAR is a measure defined as earnings before interest and other non-operating income (expense), taxes, depreciation and amortization, preopening and start-up expenses, gain on REIT transactions, net, restructuring costs (which represents costs related to severance, accelerated stock compensation expense, and consulting fees directly related to the operating model component of the MGM 2020 Plan), rent expense associated with triple-net 46 operating and ground leases, income from unconsolidated affiliates related to investments in real estate ventures, property transactions, net, and also excludes corporate expense and stock compensation expense, which are not allocated to each operating segment, and rent expense related to the master lease with MGP that eliminates in consolidation. We manage capital allocation, tax planning, stock compensation, and financing decisions at the corporate level. “Adjusted Property EBITDAR margin” is Adjusted Property EBITDAR divided by related segment net revenues. Non-GAAP Measure “Adjusted EBITDAR” is earnings before interest and other non-operating income (expense), taxes, depreciation and amortization, preopening and start-up expenses, gain on REIT transactions, net, CEO transition expense, October 1 litigation settlement, restructuring costs (which represents costs related to severance, accelerated stock compensation expense, and consulting fees directly related to the operating model component of the MGM 2020 Plan), rent expense associated with triple-net operating and ground leases, income from unconsolidated affiliates related to investments in real estate ventures, and property transactions, net. Adjusted EBITDAR information is a valuation metric, should not be used as an operating metric, and is presented solely as a supplemental disclosure to reported GAAP measures because we believe this measure is widely used by analysts, lenders, financial institutions, and investors as a principal basis for the valuation of gaming companies. We believe that while items excluded from Adjusted EBITDAR may be recurring in nature and should not be disregarded in evaluation of our earnings performance, it is useful to exclude such items when analyzing current results and trends. Also, we believe excluded items may not relate specifically to current trends or be indicative of future results. For example, preopening and start-up expenses will be significantly different in periods when we are developing and constructing a major expansion project and will depend on where the current period lies within the development cycle, as well as the size and scope of the project(s). Property transactions, net includes normal recurring disposals, gains and losses on sales of assets related to specific assets within our resorts, but also includes gains or losses on sales of an entire operating resort or a group of resorts and impairment charges on entire asset groups or investments in unconsolidated affiliates, which may not be comparable period over period. However, as discussed herein, Adjusted EBITDAR should not be viewed as a measure of overall operating performance, considered in isolation, or as an alternative to net income, because this measure is not presented on a GAAP basis and exclude certain expenses, including the rent expense associated with our triple-net operating and ground leases, and are provided for the limited purposes discussed herein. Adjusted EBITDAR should not be construed as an alternative to operating income or net income, as an indicator of our performance; or as an alternative to cash flows from operating activities, as a measure of liquidity; or as any other measure determined in accordance with GAAP. We have significant uses of cash flows, including capital expenditures, interest payments, taxes, real estate triple-net lease and ground lease payments, and debt principal repayments, which are not reflected in Adjusted EBITDAR. Also, other companies in the gaming and hospitality industries that report Adjusted EBITDAR information may calculate Adjusted EBITDAR in a different manner and such differences may be material. 47 The following table presents a reconciliation of net income attributable to MGM Resorts International to Adjusted EBITDAR: Year Ended December 31, 2020 2019 2018 (In thousands) Net income (loss) attributable to MGM Resorts International $ (1,032,724 ) $ 2,049,146 $ 466,772 Plus: Net income (loss) attributable to noncontrolling interests (287,183 ) 165,234 117,122 Net income (loss) (1,319,907 ) 2,214,380 583,894 Provision (benefit) for income taxes (191,572 ) 632,345 50,112 Income (loss) before income taxes (1,511,479 ) 2,846,725 634,006 Non-operating expense Interest expense, net of amounts capitalized 676,380 847,932 769,513 Non-operating items from unconsolidated affiliates 103,304 62,296 47,827 Other, net 89,361 183,262 18,140 869,045 1,093,490 835,480 Operating income (loss) (642,434 ) 3,940,215 1,469,486 Preopening and start-up expenses 84 7,175 151,392 Property transactions, net 93,567 275,802 9,147 Gain on REIT transactions, net (1,491,945 ) (2,677,996 ) — Depreciation and amortization 1,210,556 1,304,649 1,178,044 CEO transition expense 44,401 — — October 1 litigation settlement 49,000 — — Restructuring 26,025 92,139 — Triple-net operating lease and ground lease rent expense 710,683 74,656 29,633 Income from unconsolidated affiliates related to real estate ventures (148,434 ) (544 ) — Adjusted EBITDAR $ (148,497 ) Guarantor Financial Information As of December 31, 2020, all of our principal debt arrangements are guaranteed by each of our wholly owned material domestic subsidiaries that guarantee our senior credit facility. Our principal debt arrangements are not guaranteed by MGP, the Operating Partnership, MGM Grand Detroit, MGM National Harbor, Blue Tarp reDevelopment, LLC (the entity that owns and operates MGM Springfield), and each of their respective subsidiaries. Our foreign subsidiaries, including MGM China and its subsidiaries, are also not guarantors of our principal debt arrangements. In the event that any subsidiary is no longer a guarantor of our credit facility or any of our future capital markets indebtedness, that subsidiary will be released and relieved of its obligations to guarantee our existing senior notes. The indentures governing the senior notes further provide that in the event of a sale of all or substantially all of the assets of, or capital stock in a subsidiary guarantor then such subsidiary guarantor will be released and relieved of any obligations under its subsidiary guarantee. The guarantees provided by the subsidiary guarantors rank senior in right of payment to any future subordinated debt of ours or such subsidiary guarantors, junior to any secured indebtedness to the extent of the value of the assets securing such debt and effectively subordinated to any indebtedness and other obligations of our subsidiaries that do not guarantee the senior notes. In addition, the obligations of each subsidiary guarantor under its guarantee is limited so as not to constitute a fraudulent conveyance under applicable law, which may eliminate the subsidiary guarantor’s obligations or reduce such obligations to an amount that effectively makes the subsidiary guarantee lack value. 48 The summarized financial information of us and our guarantor subsidiaries, on a combined basis, is presented below. Certain of our guarantor subsidiaries collectively own Operating Partnership units and each subsidiary accounts for its respective investment under the equity method within the summarized financial information presented below. These subsidiaries have also accounted for the MGP master lease as an operating lease, recording operating lease liabilities and operating ROU assets with the related rent expense of guarantor subsidiaries reflected within the summarized financial information. December 31, 2020 Balance Sheet (In thousand) Current assets $ 4,749,542 Investment in the MGP Operating Partnership 1,617,055 Intercompany accounts due from non-guarantor subsidiaries 16,622 MGP master lease right-of-use asset, net 6,714,101 Other long-term assets 12,318,912 MGP master lease operating lease liabilities – current 153,415 Other current liabilities 1,123,814 MGP master lease operating lease liabilities – noncurrent 7,191,450 Other long-term liabilities 15,827,794 Year Ended December 31, 2020 Income Statement (In thousand) Net revenues $ 3,586,846 MGP master lease rent expense (641,841 ) Operating loss (222,009 ) Loss from continuing operations (520,152 ) Net loss (310,705 ) Net loss attributable to MGM Resorts International (310,705 ) Liquidity and Capital Resources Cash Flows – Summary Our cash flows consisted of the following: Year Ended December 31, 2020 2019 2018 (In thousands) Net cash provided by (used in) operating activities $ (1,493,043 ) $ 1,810,401 $ 1,722,539 Net cash provided by (used in) investing activities 2,159,304 3,519,434 (2,083,021 ) Net cash provided by (used in) financing activities 2,103,427 (4,529,594 ) 389,234 Cash Flows Operating activities. Trends in our operating cash flows tend to follow trends in operating income, excluding non-cash charges, but can be affected by changes in working capital, the timing of significant interest payments, tax payments or refunds, and distributions from unconsolidated affiliates. Cash used in operating activities was $1.5 billion in 2020 compared to cash provided by operating activities of $1.8 billion in 2019. Operating cash flows were significantly negatively impacted by the temporary closures at our properties and hotels, travel restrictions to Macau, and other operational restrictions resulting from the COVID-19 pandemic, as discussed above, and triple-net operating lease rent payments, partially offset by an increase in distributions from unconsolidated affiliates primarily received from the MGP BREIT Venture and a decrease in cash paid for interest, as discussed in “Non-operating Results.” In addition to the decrease in our operating results across all properties, the current year period was negatively affected by a change in working capital primarily related to a decrease in accrued expenses, partially offset by a decrease in accounts receivable, each of which were impacted by the COVID-19 pandemic, discussed above, and the settlement of the October 1 litigation. The prior year period was negatively affected by a change in working capital, primarily related to gaming deposits. 49 Investing activities. Our investing cash flows can fluctuate significantly from year to year depending on our decisions with respect to strategic capital investments in new or existing resorts, business acquisitions or dispositions, and the timing of maintenance capital expenditures to maintain the quality of our resorts. Capital expenditures related to regular investments in our existing resorts can also vary depending on timing of larger remodel projects related to our public spaces and hotel rooms. Cash provided by investing activities decreased to $2.2 billion in 2020 from $3.5 billion in 2019. The change was due primarily to $2.5 billion in net cash proceeds from the sale of the real estate of Mandalay Bay and MGM Grand Las Vegas in the current year compared to $4.2 billion of proceeds received related to the sale of Bellagio and $652 million of proceeds received related to the sale of Circus Circus Las Vegas and adjacent land that was partially offset by a $536 million outflow for the acquisition of Empire City in the prior year, and a decrease of $468 million in capital expenditures, partially offset by a $37 million decrease in distributions from unconsolidated affiliates. In the current year period, distributions from unconsolidated affiliates included $51 million related to our share of a distribution received from CityCenter. In the prior year period, distributions from unconsolidated affiliates included $90 million related to our share of a distribution received from CityCenter. The decrease in capital expenditures primarily reflects our efforts to reduce or defer planned domestic capital expenditures as we mitigate the impact of the COVID-19 pandemic on our liquidity, and the substantial completion of our MGM Springfield development project, the rebranding at Park MGM, and the expansion of the convention center at MGM Grand Las Vegas in the prior year, as discussed in further detail below. Capital Expenditures In 2020, we made capital expenditures of $271 million, of which $108 million related to MGM China. Capital expenditures at MGM China included $95 million primarily related to construction close-out and projects at MGM Cotai and $13 million related to projects at MGM Macau. Capital expenditures at our Las Vegas Strip Resorts, Regional Operations and corporate entities of $162 million included expenditures relating to information technology, health and safety initiatives, and various room, restaurant, and entertainment venue remodels. In 2019, we made capital expenditures of $739 million, of which $146 million related to MGM China. Capital expenditures at MGM China included $118 million related to projects at MGM Cotai and $28 million related to projects at MGM Macau. Capital expenditures at our Las Vegas Strip Resorts, Regional Operations and corporate entities of $593 million included $49 million related to the construction of MGM Springfield, $52 million related to the Park MGM rebranding project, as well as expenditures relating to information technology, the expansion of the convention center at MGM Grand Las Vegas and various room, restaurant, and entertainment venue remodels. Financing activities. Cash provided by financing activities was $2.1 billion in 2020 compared to cash used in financing activities of $4.5 billion in 2019. In 2020, we received net proceeds from the incurrence of the bridge loan facility in connection with the MGP BREIT Venture Transaction of $1.3 billion, net proceeds of $525 million from MGP’s Class A share issuances, net debt borrowings of $1.1 billion, as further discussed below, repurchased $354 million of our common stock, distributed $286 million to noncontrolling interest owners, and paid $78 million in dividends to our shareholders. In comparison, in the prior year period, we repaid net debt of $4.1 billion, had net proceeds from MGP’s issuance of Class A shares of $1.3 billion, repurchased $1.0 billion of our common stock, distributed $223 million to noncontrolling interest owners, and paid $271 million in dividends to our shareholders. Borrowings and Repayments of Long-term Debt In 2020, we had net proceeds from the incurrence of the bridge loan facility in connection with the MGP BREIT Venture Transaction of $1.3 billion and net debt borrowings of $1.1 billion, which consisted of net borrowings on MGM China’s credit facility of $103 million, our issuance of $750 million of 4.75% senior notes and $750 million of 6.75% senior notes, the Operating Partnership’s issuance of $750 million of 3.875% senior notes and $800 million of 4.625% senior notes, and MGM China’s issuance of $500 million of 5.25% senior notes, partially offset by the tender of $750 million of our senior notes and the corresponding $97 million of tender offer costs, and the net repayment of $1.7 billion on the Operating Partnership's senior credit facility consisting of the repayment of $1.3 billion of its term loan B facility in full using the proceeds of the $1.3 billion bridge loan facility, which was then assumed by the MGP BREIT Venture, the repayment of its $399 million term loan A facility in full using the net proceeds from MGP’s settlement of forward equity agreements, partially offset by a net draw of $10 million on its revolving credit facility. In March 2020, with certain of the proceeds from the MGP BREIT Venture Transaction, we completed cash tender offers for an aggregate amount of $750 million of our senior notes, comprised of $325 million principal amount of our outstanding 5.75% senior notes due 2025, $100 million principal amount of our outstanding 4.625% senior notes due 2026, and $325 million principal amount of our outstanding 5.5% senior notes due 2027. In May 2020, we issued $750 million in aggregate principal amount of 6.750% senior notes due 2025. The proceeds were used to further increase our liquidity position. 50 In June 2020, the Operating Partnership issued $800 million in aggregate principal amount of 4.625% senior notes due 2025. The proceeds were used to repay borrowings on the Operating Partnership’s senior credit facility, which were used to fund the May 2020 redemption of $700 million of Operating Partnership units held by us. In June 2020, MGM China issued $500 million in aggregate principal amount of 5.25% senior notes due 2025. The proceeds were used to partially repay amounts outstanding under the MGM China credit facility and for general corporate purposes. In October 2020, we issued $750 million in aggregate principal amount of 4.75% senior notes due 2028. The proceeds were used for general corporate purposes. In November 2020, the Operating Partnership issued $750 million in aggregate principal amount of 3.875% senior notes due 2029. The proceeds were used for general corporate purposes, which included the December 2020 redemption of $700 million of the Operating Partnership units held by us. In 2019, we repaid net debt of $4.1 billion which consisted of the repayment of our $850 million 8.625% notes due 2019, the repayment of an aggregate $2.8 billion of our senior notes, as described below, $750 million of net repayments on our senior credit facility, $1.1 billion of net repayments on the Operating Partnership’s senior credit facility, and $1.8 billion of net repayments on the current and previous MGM China senior secured credit facilities, partially offset by our issuance of $1.0 billion of our senior notes, the Operating Partnership’s issuance of $750 million of senior notes, and MGM China’s issuance of $1.5 billion of senior notes. In April 2019, we issued $1.0 billion in aggregate principal amount of 5.5% senior notes due 2027. We used the net proceeds from the offering to fund the purchase of $639 million in aggregate principal amount of our outstanding 6.75% senior notes due 2020 and $233 million in aggregate principal amount of our outstanding 5.25% senior notes due 2020 through our cash tender offers. In December 2019, we used a portion of the net proceeds from the Bellagio transaction to redeem for cash the remaining $267 million principal amount of its outstanding 5.25% senior notes due 2020, the remaining $361 million principal amount of its outstanding 6.75% senior notes due 2020, all $1.25 billion principal amount of its outstanding 6.625% senior notes due 2021, permanently repay the $750 million outstanding on our term loan A facility, and fully repay amounts outstanding under our revolving credit facility. In May 2019, MGM China issued $750 million in aggregate principal amount of 5.375% senior notes due 2024 and $750 million in aggregate principal amount of 5.875% senior notes due 2026 and used the proceeds to permanently repay approximately $1.0 billion on its term loan facility with the remainder used to pay down its revolving credit facility. In August 2019, MGM China entered into a new $1.25 billion senior unsecured revolving credit facility, on which it drew $776 million and used the proceeds to fully repay the borrowings outstanding under its previous senior secured credit facility. In November 2019, the Operating Partnership used the proceeds from its November 2019 Class A share issuance to prepay $65 million on the term loan A facility and $476 million on the term loan B facility, which reflects all scheduled amortization plus additional principal, and fully repaid the outstanding balance on its revolving credit facility. The proceeds from the Operating Partnership’s issuance of $750 million 5.75% senior notes due 2027 in January 2019 along with the proceeds from MGP’s January 2019 Class A share issuance were primarily used to finance MGP’s acquisition of the real property associated with Empire City and finance the Park MGM Transaction. Dividends, Distributions to Noncontrolling Interest Owners and Share Repurchases In May 2018, our Board of Directors authorized a $2.0 billion stock repurchase program and completed the previously announced $1.0 billion stock repurchase program. In 2020, we repurchased and retired $354 million of our common stock pursuant to our current $2.0 billion stock repurchase plan. In 2019, we repurchased and retired $1.0 billion of our common stock pursuant to our current $2.0 billion stock repurchase plan. The remaining availability under our $2.0 billion stock repurchase program was approximately $4 million as of December 31, 2020, and the remaining availability under the $3.0 billion stock repurchase program was $3.0 billion as of December 31, 2020. In March 2020, we paid a dividend of $0.15 per share, and in June 2020, September 2020 and December 2020, we paid dividends of $0.0025 per share, totaling $78 million for 2020. In March 2019, June 2019, September 2019 and December 2019, we paid dividends of $0.13 per share, totaling $271 million for 2019. In 2020, MGM China paid the final dividend for 2019 of $41 million, of which we received $23 million and noncontrolling interests received $18 million. In 2019, MGM China paid dividends of $62 million, of which we received $35 million and noncontrolling interests received $27 million. 51 The Operating Partnership paid the following distributions to its partnership unit holders during 2020 and 2019: • $602 million of distributions paid in 2020, of which we received $358 million and MGP received $244 million, which MGP concurrently paid as a dividend to its Class A shareholders; and • $534 million of distributions paid in 2019, of which we received $372 million and MGP received $162 million, which MGP concurrently paid as a dividend to its Class A shareholders. Other Factors Affecting Liquidity and Anticipated Uses of Cash We require a certain amount of cash on hand to operate our resorts. In addition to required cash on hand for operations, we utilize corporate cash management procedures to minimize the amount of cash held on hand or in banks. Funds are swept from the accounts at most of our domestic resorts daily into central bank accounts, and excess funds are invested overnight or are used to repay amounts drawn under our revolving credit facility. In addition, from time to time we may use excess funds to repurchase our outstanding debt and equity securities subject to limitations in our revolving credit facility and Delaware law, as applicable. We have significant outstanding debt, interest payments, rent payments, and contractual obligations in addition to planned capital expenditures and investments. As previously discussed, the spread of COVID-19 and developments surrounding the global pandemic have had, and we expect will continue to have, a significant impact on our business, financial condition, results of operations, and cash flows. During this time, we have remained committed to managing our expenses to strengthen our liquidity position. As of December 31, 2020, we had cash and cash equivalents of $5.1 billion, of which MGM China held $344 million and the Operating Partnership held $626 million. In addition to our cash and cash equivalent balance, we have significant real estate assets and other holdings: we own MGM Springfield, a 50% interest in CityCenter in Las Vegas, an approximate 56% interest in MGM China, and a 53% economic interest in MGP. At December 31, 2020, we had $12.5 billion in principal amount of indebtedness, including $10 million outstanding under the $1.35 billion Operating Partnership revolving credit facility, and $770 million outstanding under the $1.25 billion MGM China revolving credit facility. No amounts were drawn on our $1.5 billion revolving credit facility or the $400 million MGM China second revolving credit facility. We have no debt maturing prior to 2022. We have planned capital expenditures in 2021 of approximately $425 million to $450 million domestically and approximately $100 million to $125 million at MGM China. We also plan to invest approximately $220 million in BetMGM during 2021. As of December 31, 2020, our expected cash interest payments excluding MGP and MGM China for each of 2021, 2022, and 2023 was approximately $340 million, and our expected cash interest payments on a consolidated basis for 2021, 2022, and 2023 were approximately $720 million, $715 million, and $705 million, respectively. We are also required as of December 31, 2020 to make annual rent payments of $828 million under the master lease with MGP, annual rent payments of $250 million under the lease with Bellagio BREIT Venture, and annual rent payments of $292 million under the lease with MGP BREIT Venture, which leases are also subject to annual escalators. In April 2020, we amended our credit facility to provide us with certain relief from the effects of the COVID-19 pandemic. The amendment provides us a waiver of the financial maintenance covenants for the period beginning with the quarter ending June 30, 2020 through the earlier of (x) the date we deliver to the administrative agent a compliance certificate with respect to the quarter ending June 30, 2021 and (y) the date we deliver to the administrative agent an irrevocable notice terminating the covenant relief period (such period, the “covenant relief period”). In connection with the amendment, we pledged the Operating Partnership units held by loan parties to the lenders as collateral. We also agreed to certain limitations including, among other things, further restricting our ability to incur debt and liens, make restricted payments, make investments and prepay subordinated debt. In addition, in connection with the amendment, we agreed to a liquidity test that requires our borrower group (as defined in the credit agreement) to maintain a minimum liquidity level of not less than $600 million (including unrestricted cash, cash equivalents and availability under the revolving credit facility), tested at the end of each month during the covenant relief period. In February 2021, we further amended our credit facility to extend the covenant relief period through (but excluding) the second quarter of 2022 and adjust the required leverage and interest coverage levels for the covenant when it is reimposed at the end of the waiver period. Pursuant to that amendment, we agreed to increase our total required minimum liquidity level to $1.0 billion. Additionally, due to the continued impact of the COVID-19 pandemic, in April 2020, MGM China entered into an amendment to its credit agreement, which provided for a waiver of its maximum leverage ratio through the second quarter of 2021, and a waiver of its minimum interest coverage ratio beginning in the second quarter of 2020 through the second quarter of 2021. In October 2020, MGM China further amended its credit agreement to provide for a waiver of its maximum leverage ratio and its minimum interest coverage ratio through the fourth quarter of 2021. In October 2020, MGM China entered into an amendment of its second credit facility which provided for a waiver of its maximum leverage ratio and its minimum interest coverage ratio through the fourth quarter 52 of 2021. In February 2021, MGM China further amended each of its revolving credit facility and its second revolving credit facility to provide for waivers of the maximum leverage ratio and minimum interest coverage ratio through the fourth quarter of 2022. In January 2021, the Operating Partnership paid $136 million of distributions to its partnership unit holders, of which we received $72 million and MGP received $64 million, which MGP concurrently paid as a dividend to its Class A shareholders. On February 10, 2021, our Board of Directors approved a quarterly dividend of $0.0025 per share. The dividend will be payable on March 15, 2021 to holders of record on March 10, 2021. Future determinations regarding the declaration and payment of dividends, if any, will be at the discretion of our board of directors and will depend on then-existing conditions, including our results of operations, financial condition, and other factors that our Board of Directors may deem relevant. As previously discussed, the COVID-19 pandemic has caused, and is continuing to cause, significant economic disruption both globally and in the United States, and will continue to impact our business, financial condition, results of operations and cash flows. We cannot predict the degree, or duration, to which our operations will be affected by the COVID-19 outbreak, and the effects could be material. While we believe our strong liquidity position, valuable real estate assets and aggressive cost reduction initiatives will enable us to fund our current obligations for the foreseeable future, COVID-19 has resulted in significant disruption of global financial markets, which could have a negative impact on our ability to access capital in the future. We continue to monitor the rapidly evolving situation and guidance from international and domestic authorities, including federal, state and local public health authorities and may take additional actions based on their recommendations. In these circumstances, there may be developments outside our control requiring us to further adjust our operating plan, including the implementation or extension of new or existing restrictions, which may include the reinstatement of stay-at-home orders in the jurisdictions in which we operate or additional restrictions on travel and/or our business operations. Because the situation is ongoing, and because the duration and severity remain unclear, it is difficult to forecast any impacts on our future results. For additional information related to our long-term obligations, refer to the maturities of long-term debt table in Note 9 and the lease liability maturity table in Note 11. Principal Debt Arrangements See Note 9 to the accompanying consolidated financial statements for information regarding our debt agreements as of December 31, 2020. Critical Accounting Policies and Estimates Management’s discussion and analysis of our results of operations and liquidity and capital resources are based on our consolidated financial statements. To prepare our consolidated financial statements in accordance with accounting principles generally accepted in the United States of America, we must make estimates and assumptions that affect the amounts reported in the consolidated financial statements. We regularly evaluate these estimates and assumptions, particularly in areas we consider to be critical accounting estimates, where the estimates and assumptions involve a significant level of estimation uncertainty and have had or are reasonably likely to have a material effect on our financial condition or results of operations. However, by their nature, judgments are subject to an inherent degree of uncertainty and therefore actual results can differ from our estimates. Loss Reserve for Casino Accounts Receivable Marker play represents a significant portion of the table games volume at certain of our Las Vegas resorts. Our other casinos do not emphasize marker play to the same extent, although we offer markers to customers at those casinos as well. MGM China extends credit to certain in-house VIP gaming customers and gaming promoters. We maintain strict controls over the issuance of markers and aggressively pursue collection from our customers who fail to pay their marker balances timely. These collection efforts are similar to those used by most large corporations when dealing with overdue customer accounts, including the mailing of statements and delinquency notices, personal contacts, the use of outside collection agencies and civil litigation. Markers are generally legally enforceable instruments in the United States and Macau. Markers are not legally enforceable instruments in some foreign countries, but the United States assets of foreign customers may be reached to satisfy judgments entered in the United States. We consider the likelihood and difficulty of enforceability, among other factors, when we issue credit to customers at our domestic resorts who are not residents of the United States. MGM China performs background checks and investigates the credit worthiness of gaming promoters and casino customers prior to issuing credit. Refer to Note 2 for further discussion of our casino receivables and those due from customers residing in foreign countries. We maintain a loss reserve for casino accounts at all of our operating casino resorts. The provision for doubtful accounts, an operating expense, increases the loss reserve. We regularly evaluate the loss reserve for casino accounts. At domestic resorts where marker play is not significant, the loss reserve is generally established by applying standard reserve percentages to aged account 53 balances, which is supported by relevant historical analysis and any other known information such as the current economic conditions that could drive losses. At domestic resorts where marker play is significant, we apply standard reserve percentages to aged account balances under a specified dollar amount and specifically analyze the collectability of each account with a balance over the specified dollar amount, based on the age of the account, the customer’s current and expected future financial condition, collection history and current and expected future economic conditions. MGM China specifically analyzes the collectability of casino receivables on an individual basis taking into account the age of the account, the financial condition and the collection history of the gaming promoter or casino customer. In addition to enforceability issues, the collectability of unpaid markers given by foreign customers at our domestic resorts is affected by a number of factors, including changes in currency exchange rates and economic conditions in the customers’ home countries. Because individual customer account balances can be significant, the loss reserve and the provision can change significantly between periods, as information about a certain customer becomes known or as changes in a region’s economy occur. The following table shows key statistics related to our casino receivables, net of discounts: December 31, 2020 2019 (In thousands) Casino receivables $ 260,998 $ 394,163 Loss reserve for casino accounts receivable 107,723 88,338 Loss reserve as a percentage of casino accounts receivable 41 % 22 % Approximately $54 million and $77 million of casino receivables and $18 million and $16 million of the loss reserve for casino accounts receivable relate to MGM China at December 31, 2020 and 2019, respectively. The loss reserve as a percentage of casino accounts receivable increased in the current year due to an increase in the age of outstanding account balances at our domestic resorts and MGM China primarily due to the COVID-19 pandemic. At December 31, 2020, a 100 basis-point change in the loss reserve as a percentage of casino accounts receivable would change income before income taxes by $3 million. Fixed Asset Capitalization and Depreciation Policies Property and equipment are stated at cost. A significant amount of our property and equipment was acquired through business combinations and was therefore recognized at fair value at the acquisition date. Maintenance and repairs that neither materially add to the value of the property nor appreciably prolong its life are charged to expense as incurred. Depreciation and amortization are provided on a straight-line basis over the estimated useful lives of the assets. When we construct assets, we capitalize direct costs of the project, including fees paid to architects and contractors, property taxes, and certain costs of our design and construction subsidiaries. In addition, interest cost associated with major development and construction projects is capitalized as part of the cost of the project. Interest is typically capitalized on amounts expended on the project using the weighted average cost of our outstanding borrowings. Capitalization of interest starts when construction activities begin and ceases when construction is substantially complete, or development activity is suspended for more than a brief period. We must make estimates and assumptions when accounting for capital expenditures. Whether an expenditure is considered a maintenance expense, or a capital asset is a matter of judgment. When constructing or purchasing assets, we must determine whether existing assets are being replaced or otherwise impaired, which also may be a matter of judgment. In addition, our depreciation expense is highly dependent on the assumptions we make about our assets’ estimated useful lives. We determine the estimated useful lives based on our experience with similar assets, engineering studies, and our estimate of the usage of the asset. Whenever events or circumstances occur which change the estimated useful life of an asset, we account for the change prospectively. Impairment of Long-lived Assets, Goodwill and Indefinite-lived Intangible Assets We evaluate our property and equipment and other long-lived assets for impairment based on our classification as held for sale or to be held and used. Several criteria must be met before an asset is classified as held for sale, including that management with the appropriate authority commits to a plan to sell the asset at a reasonable price in relation to its fair value and is actively seeking a buyer. For assets classified as held for sale, we recognize the asset at the lower of carrying value or fair market value less costs of disposal, as estimated based on comparable asset sales, offers received, or a discounted cash flow model. For assets to be held and used, we review for impairment whenever indicators of impairment exist. We then compare the estimated future cash flows of the asset, on an undiscounted basis, to the carrying value of the asset. If the undiscounted cash flows exceed the carrying value, no impairment is indicated. If the undiscounted cash flows do not exceed the carrying value, then an impairment is recorded based on the fair value of the asset. For operating assets, fair value is typically measured using a discounted cash flow model whereby future cash flows are discounted using a weighted average cost of capital, developed using a standard capital asset pricing model, based on guideline 54 companies in our industry. If an asset is still under development, future cash flows include remaining construction costs. All recognized impairment losses, whether for assets to be held for sale or assets to be held and used, are recorded as operating expenses. There are several estimates, assumptions and decisions in measuring impairments of long-lived assets. First, management must determine the usage of the asset. To the extent management decides that an asset will be sold, it is more likely that an impairment may be recognized. Assets must be tested at the lowest level for which identifiable cash flows exist. This means that some assets must be grouped, and management has some discretion in the grouping of assets. Future cash flow estimates are, by their nature, subjective and actual results may differ materially from our estimates. On a quarterly basis, we review our major long-lived assets to determine if events have occurred or circumstances exist that indicate a potential impairment. Potential factors which could trigger an impairment include underperformance compared to historical or projected operating results, negative industry or economic factors, significant changes to our operating environment, or changes in intended use of the asset group. We estimate future cash flows using our internal budgets and probability weight cash flows in certain circumstances to consider alternative outcomes associated with recoverability of the asset group, including potential sale. Historically, undiscounted cash flows of our significant operating asset groups have exceeded their carrying values by a substantial margin. During 2019, we recorded a non-cash impairment charge relating to the carrying value of Circus Circus Las Vegas and adjacent land. Refer to Note 16 for further discussion. We review indefinite-lived intangible assets at least annually and between annual test dates in certain circumstances. We perform our annual impairment test for indefinite-lived intangible assets in the fourth quarter of each fiscal year. Indefinite-lived intangible assets consist primarily of license rights and trademarks. For our 2020 annual impairment tests, we utilized the option to perform a qualitative (“step zero”) analysis for certain of our indefinite-lived intangibles and concluded it was more likely than not that the fair values of such intangibles exceeded their carrying values by a substantial margin. We elected to perform a quantitative analysis for the Northfield gaming license in 2020 primarily using the discounted cash flow approach, for which the fair value exceeded its carrying value by 14%. As discussed below, management makes significant judgments and estimates as part of these analyses. If certain future operating results do not meet current expectations it could cause carrying values of the intangibles to exceed their fair values in future periods, potentially resulting in an impairment charge. We review goodwill at least annually and between annual test dates in certain circumstances. None of our reporting units incurred any goodwill impairment charges in 2020. For our 2020 annual impairment tests, we utilized the option to perform a step zero analysis for certain of our reporting units and concluded it was more likely than not that the fair values of such reporting units exceeded their carrying values by a substantial margin. For reporting units for which we elected to perform a quantitative analysis, the fair value of such reporting units exceeded their carrying value by a substantial margin. As discussed below, management makes significant judgments and estimates as part of these analyses. If future operating results of our reporting units do not meet current expectations it could cause carrying values of our reporting units to exceed their fair values in future periods, potentially resulting in a goodwill impairment charge. There are several estimates inherent in evaluating these assets for impairment. In particular, future cash flow estimates are, by their nature, subjective and actual results may differ materially from our estimates. In addition, the determination of multiples, capitalization rates and the discount rates used in the impairment tests are highly judgmental and dependent in large part on expectations of future market conditions. See Note 2 and Note 7 to the accompanying consolidated financial statements for further discussion of goodwill and other intangible assets. Impairment of Investments in Unconsolidated Affiliates See Note 2 to the accompanying consolidated financial statements for discussion of our evaluation of other-than-temporary impairment of investments in unconsolidated affiliates. During 2020, we recorded $64 million in other-than-temporary impairment charges on an equity method investment. Refer to Note 6 for further discussion. Our investments in unconsolidated affiliates had no material impairments in 2019 or 2018. Income Taxes We are subject to income taxes in the U.S. federal jurisdiction, various state and local jurisdictions, and foreign jurisdictions, although the income taxes paid in foreign jurisdictions are not material. We recognize deferred tax assets and liabilities related to net operating losses, tax credit carryforwards and temporary differences with future tax consequences. We reduce the carrying amount of deferred tax assets by a valuation allowance if it is more likely than not such assets will not be realized. Accordingly, the need to establish valuation allowances for deferred tax assets is assessed at each reporting period based on such "more-likely-than-not" realization threshold. This assessment considers, among other 55 matters, the nature, frequency and severity of current and cumulative losses, forecasts of future profitability, the scheduled reversal of deferred tax liabilities, the duration of statutory carryforward periods, and tax planning strategies. We recorded a valuation allowance on the net deferred tax assets of our domestic jurisdictions of $2.7 billion and $2.5 billion as of December 31, 2020 and 2019, respectively, and a valuation allowance on certain net deferred tax assets of foreign jurisdictions of $156 million and $104 million as of December 31, 2020 and 2019, respectively. We reassess the realization of deferred tax assets each reporting period. In the event we were to determine that it is more likely than not that we will be unable to realize all or part of our deferred tax assets in the future, we would increase the valuation allowance and recognize a corresponding charge to earnings or other comprehensive income in the period in which we make such a determination. Likewise, if we later determine that we are more likely than not to realize the deferred tax assets, we would reverse the applicable portion of the previously recognized valuation allowance. In order for us to realize our deferred tax assets, we must be able to generate sufficient taxable income in the jurisdictions in which the deferred tax assets are located. Furthermore, we are subject to routine corporate income tax audits in many of these jurisdictions. We believe that positions taken on our tax returns are fully supported, but tax authorities may challenge these positions, which may not be fully sustained on examination by the relevant tax authorities. Accordingly, our income tax provision includes amounts intended to satisfy assessments that may result from these challenges. Determining the income tax provision for these potential assessments and recording the related effects requires management judgments and estimates. The amounts ultimately paid on resolution of an audit could be materially different from the amounts previously included in our income tax provision and, therefore, could have a material impact on our income tax provision, net income and cash flows. Refer to Note 10 in the accompanying consolidated financial statements for further discussion relating to income taxes. 56 ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Market Risk In addition to the inherent risks associated with our normal operations, we are also exposed to additional market risks. Market risk is the risk of loss arising from adverse changes in market rates and prices, such as interest rates and foreign currency exchange rates. Our primary exposure to market risk is interest rate risk associated with our variable rate long-term debt. We attempt to limit our exposure to interest rate risk by managing the mix of our long-term fixed rate borrowings and short-term borrowings under our bank credit facilities and by utilizing interest rate swap agreements that provide for a fixed interest payment on the Operating Partnership’s credit facility. A change in interest rates generally does not have an impact upon our future earnings and cash flow for fixed-rate debt instruments. As fixed-rate debt matures, however, and if additional debt is acquired to fund the debt repayment, future earnings and cash flow may be affected by changes in interest rates. This effect would be realized in the periods subsequent to the periods when the debt matures. We do not hold or issue financial instruments for trading purposes and do not enter into derivative transactions that would be considered speculative positions. As of December 31, 2020, variable rate borrowings represented approximately 6% of our total borrowings after giving effect on the Operating Partnership’s borrowings for the currently effective interest rate swap agreements on which the Operating Partnership pays a weighted average of 1.821% on a total notional amount of $1.9 billion. Additionally, the Operating Partnership has $900 million of notional amount of forward starting swaps that are not currently effective. The following table provides additional information about our gross long-term debt subject to changes in interest rates excluding the effect of the Operating Partnership interest rate swaps discussed above: Fair Value Debt maturing in December 31, 2021 2022 2023 2024 2025 Thereafter Total 2020 (In millions except interest rates) Fixed-rate $ — $ 1,000 $ 1,250 $ 1,800 $ 2,725 $ 4,926 $ 11,701 $ 12,425 Average interest rate N/A 7.8 % 6.0 % 5.5 % 5.6 % 5.0 % 5.6 % Variable rate $ — $ — $ 10 $ 770 $ — $ — $ 780 $ 780 Average interest rate N/A N/A 1.9 % 3.0 % N/A N/A 3.0 % In addition to the risk associated with our variable interest rate debt, we are also exposed to risks related to changes in foreign currency exchange rates, mainly related to MGM China and to our operations at MGM Macau and MGM Cotai. While recent fluctuations in exchange rates have not been significant, potential changes in policy by governments or fluctuations in the economies of the United States, China, Macau or Hong Kong could cause variability in these exchange rates. We cannot assure you that the Hong Kong dollar will continue to be pegged to the U.S. dollar or the current peg rate for the Hong Kong dollar will remain at the same level. The possible changes to the peg of the Hong Kong dollar may result in severe fluctuations in the exchange rate thereof. For U.S. dollar denominated debt incurred by MGM China, fluctuations in the exchange rates of the Hong Kong dollar in relation to the U.S. dollar could have adverse effects on our financial position and results of operations. As of December 31, 2020, a 1% weakening of the Hong Kong dollar (the functional currency of MGM China) to the U.S. dollar would result in a foreign currency transaction loss of $20 million. 57
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+Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations and Item 7A. Quantitative and Qualitative Disclosures about Market Risk, includes forward-looking statements that are subject to risks, contingencies or uncertainties. You can identify forward-looking statements by words such as “anticipate,” “believe,” “commitment,” “could,” “design,” “estimate,” “expect,” “forecast,” “goal,” “guidance,” “imply,” “intend,” “may,” “objective,” “opportunity,” “outlook,” “plan,” “policy,” “position,” “potential,” “predict,” “priority,” “project,” “proposition,” “prospective,” “pursue,” “seek,” “should,” “strategy,” “target,” “will,” “would” or other similar expressions that convey the uncertainty of future events or outcomes. Forward-looking statements include, among other things, statements regarding: •future financial and operating results; •future levels of capital, environmental or maintenance expenditures, general and administrative and other expenses; •expected savings from the restructuring or reorganization of business components;•the success or timing of completion of ongoing or anticipated capital or maintenance projects; •business strategies, growth opportunities and expected investment; •consumer demand for refined products, natural gas and NGLs; •the timing and amount of any future common stock repurchases or dividends; and•the anticipated effects of actions of third parties such as competitors, activist investors or federal, foreign, state or local regulatory authorities or plaintiffs in litigation. Our forward-looking statements are not guarantees of future performance, and you should not rely unduly on them, as they involve risks, uncertainties and assumptions that we cannot predict. Material differences between actual results and any future performance suggested in our forward-looking statements could result from a variety of factors, including the following:•general economic, political or regulatory developments, including changes in governmental policies relating to refined petroleum products, crude oil, natural gas or NGLs, regulation or taxation and other economic and political developments;•the magnitude and duration of the COVID-19 pandemic and its effects, including travel restrictions, business and school closures, increased remote work, stay-at-home orders and other actions taken by individuals, government and the private sector to stem the spread of the virus;•our ability to successfully complete the planned Speedway sale and realize the expected benefits within the expected timeframe or at all;•further impairments;•the regional, national and worldwide availability and pricing of refined products, crude oil, natural gas, NGLs and other feedstocks;•our ability to manage disruptions in credit markets or changes to credit ratings;•the reliability of processing units and other equipment;•the adequacy of capital resources and liquidity, including availability, timing and amounts of free cash flow necessary to execute business plans and to effect any share repurchases or to maintain or increase the dividend;•the potential effects of judicial or other proceedings on the business, financial condition, results of operations and cash flows;•continued or further volatility in and degradation of general economic, market, industry or business conditions as a result of the COVID-19 pandemic (including any related government policies and actions), other infectious disease outbreaks, natural hazards, extreme weather events or otherwise;•compliance with federal and state environmental, economic, health and safety, energy and other policies and regulations and enforcement actions initiated thereunder;•adverse market conditions or other similar risks affecting MPLX;2Table of Contents•refining industry overcapacity or under capacity;•changes in producer customers’ drilling plans or in volumes of throughput of crude oil, natural gas, NGLs, refined products or other hydrocarbon-based products;•non-payment or non-performance by our customers;•changes in the cost or availability of third-party vessels, pipelines, railcars and other means of transportation for crude oil, natural gas, NGLs, feedstocks and refined products;•the price, availability and acceptance of alternative fuels and alternative-fuel vehicles and laws mandating such fuels or vehicles;•political and economic conditions in nations that consume refined products, natural gas and NGLs, including the United States and Mexico, and in crude oil producing regions, including the Middle East, Africa, Canada and South America;•actions taken by our competitors, including pricing adjustments, expansion of retail activities, the expansion and retirement of refining capacity and the expansion and retirement of pipeline capacity, processing, fractionation and treating facilities in response to market conditions;•completion of pipeline projects within the United States;•changes in fuel and utility costs for our facilities;•accidents or other unscheduled shutdowns affecting our refineries, machinery, pipelines, processing, fractionation and treating facilities or equipment, or those of our suppliers or customers;•acts of war, terrorism or civil unrest that could impair our ability to produce refined products, receive feedstocks or to gather, process, fractionate or transport crude oil, natural gas, NGLs or refined products;•adverse changes in laws including with respect to tax and regulatory matters;•political pressure and influence of environmental groups and other stakeholders upon policies and decisions related to the production, gathering, refining, processing, fractionation, transportation and marketing of crude oil or other feedstocks, refined products, natural gas, NGLs or other hydrocarbon-based products;•labor and material shortages; •the costs, disruption and diversion of management’s attention associated with campaigns commenced by activist investors; •personnel changes; and•the other factors described in Item 1A. Risk Factors.We undertake no obligation to update any forward-looking statements except to the extent required by applicable law.3Table of ContentsPART IITEM 1. BUSINESSOVERVIEWMarathon Petroleum Corporation (“MPC”) has over 130 years of experience in the energy business, and is the largest independent petroleum product refining, marketing, retail and midstream business in the United States. We operate the nation's largest refining system with approximately 2.9 million barrels per day of crude oil refining capacity and believe we are one of the largest wholesale suppliers of gasoline and distillates to resellers in the United States. We also operate Speedway, the second largest chain of company-owned and operated retail gasoline and convenience stores in the United States, which we have agreed to sell to 7-Eleven, Inc. (“7-Eleven”) for $21 billion in cash, subject to certain adjustments based on the levels of cash, debt and working capital at closing and certain other items. We distribute our refined products through one of the largest terminal operations in the United States and one of the largest private domestic fleets of inland petroleum product barges. In addition, our integrated midstream energy asset network links producers of natural gas and NGLs from some of the largest supply basins in the United States to domestic and international markets. Our operations consist of two reportable operating segments: Refining & Marketing and Midstream. Each of these segments is organized and managed based upon the nature of the products and services it offers.•Refining & Marketing – refines crude oil and other feedstocks at our refineries in the Gulf Coast, Mid-Continent and West Coast regions of the United States, purchases refined products and ethanol for resale and distributes refined products through transportation, storage, distribution and marketing services provided largely by our Midstream segment. We sell refined products to wholesale marketing customers domestically and internationally, to buyers on the spot market, to independent entrepreneurs who operate primarily Marathon® branded outlets, through long-term supply contracts with direct dealers who operate locations mainly under the ARCO® brand and to approximately 3,800 Speedway locations. •Midstream – transports, stores, distributes and markets crude oil and refined products principally for the Refining & Marketing segment via refining logistics assets, pipelines, terminals, towboats and barges; gathers, processes and transports natural gas; and gathers, transports, fractionates, stores and markets NGLs. The Midstream segment primarily reflects the results of MPLX LP (“MPLX”). MPLX is a diversified, large-cap master limited partnership (“MLP”) formed in 2012 that owns and operates midstream energy infrastructure and logistics assets and provides fuels distribution services. As of December 31, 2020, we owned the general partner of MPLX and approximately 62 percent of the outstanding MPLX common units.Corporate History and StructureMPC was incorporated in Delaware on November 9, 2009 in connection with an internal restructuring of Marathon Oil Corporation (“Marathon Oil”). On May 25, 2011, the Marathon Oil board of directors approved the spinoff of its Refining, Marketing & Transportation Business into an independent, publicly traded company, MPC, through the distribution of MPC common stock to the stockholders of Marathon Oil on June 30, 2011. Our common stock trades on the NYSE under the ticker symbol “MPC.” On October 1, 2018, we acquired Andeavor. Andeavor shareholders received in the aggregate approximately 239.8 million shares of MPC common stock valued at $19.8 billion and $3.5 billion in cash. Andeavor was a highly integrated marketing, logistics and refining company operating primarily in the Western and Mid-Continent United States. Our acquisition of Andeavor in 2018 substantially increased our geographic diversification and the scale of our assets, which provides increased opportunities to optimize our system.Recent DevelopmentsStrategic Actions to Enhance Shareholder ValueSpeedway SaleOn August 2, 2020, we entered into a definitive agreement to sell Speedway, our company-owned and operated retail transportation fuel and convenience store business, to 7-Eleven for $21 billion in cash, 4Table of Contentssubject to certain adjustments based on the levels of cash, debt and working capital at closing and certain other items. The taxable transaction is targeted to close by the end of the first quarter of 2021, subject to customary closing conditions and the receipt of regulatory approvals. This transaction is expected to result in after-tax cash proceeds of approximately $16.5 billion. We expect to use the proceeds from the sale to strengthen the balance sheet and return capital to shareholders. In connection with the agreement to sell Speedway, we have agreed to enter into certain ancillary agreements, including a 15-year fuel supply agreement associated with 7-Eleven or its subsidiaries, depending on the fuel demand of Speedway and other factors to be set forth in the fuel supply agreement. Further, we expect incremental opportunities over time to supply 7-Eleven's remaining business as 7-Eleven's existing arrangements mature and as new locations are added in connection with its announced U.S. and Canada growth strategy. As a result of the agreement to sell Speedway, its results are reported separately as discontinued operations in our consolidated statements of income for all periods presented and its assets and liabilities have been reclassified in our consolidated balance sheets to assets and liabilities held for sale. Prior to presentation of Speedway as discontinued operations, Speedway and our retained direct dealer business were the two reporting units within our Retail segment. Beginning with the third quarter of 2020, the direct dealer business is managed as part of the Refining & Marketing segment. The results of the Refining & Marketing segment have been retrospectively adjusted to include the results of the direct dealer business in all periods presented.As a result of our agreement to sell Speedway, the following changes in our basis of presentation have occurred:•In accordance with ASC 205, Discontinued Operations, intersegment sales from our Refining & Marketing segment to Speedway are no longer eliminated as intercompany transactions and are now presented within sales and other operating revenue, since we will continue to supply fuel to Speedway subsequent to the sale to 7-Eleven. All periods presented have been retrospectively adjusted to reflect this change.•Beginning August 2, 2020, in accordance with ASC 360, Property, Plant, and Equipment, we ceased recording depreciation and amortization for Speedway’s property, plant and equipment, finite-lived intangible assets and right of use lease assets.Midstream ReviewOn March 18, 2020, we announced that MPC’s board of directors unanimously decided to maintain MPC’s current midstream structure, with MPC remaining, through a wholly owned subsidiary, the general partner of MPLX. This decision concluded a comprehensive evaluation, led by a special committee of the board, that included extensive input from multiple external advisors and significant feedback from investors.OUR OPERATIONSOur operations consist of two reportable operating segments: Refining & Marketing and Midstream.REFINING & MARKETINGRefineriesWe currently own and operate refineries in the Gulf Coast, Mid-Continent and West Coast regions of the United States with an aggregate crude oil refining capacity of 2,874 mbpcd. During 2020, our refineries processed 2,418 mbpd of crude oil and 165 mbpd of other charge and blendstocks. During 2019, our refineries processed 2,902 mbpd of crude oil and 210 mbpd of other charge and blendstocks. Our refineries include crude oil atmospheric and vacuum distillation, fluid catalytic cracking, hydrocracking, catalytic reforming, coking, desulfurization and sulfur recovery units. The refineries process a wide variety of condensate and light and heavy crude oils purchased from various domestic and foreign suppliers. We produce numerous refined products, ranging from transportation fuels, such as reformulated gasolines, blend-grade gasolines intended for blending with ethanol and ULSD fuel, to heavy fuel oil and asphalt. Additionally, we manufacture aromatics, propane, propylene and sulfur. See the Refined Product Marketing section for further information about the products we produce. 5Table of ContentsOur refineries are integrated with each other via pipelines, terminals and barges to maximize operating efficiency. The transportation links that connect our refineries allow the movement of intermediate products between refineries to optimize operations, produce higher margin products and efficiently utilize our processing capacity. Also, shipping intermediate products between facilities during partial refinery shutdowns allows us to utilize processing capacity that is not directly affected by the shutdown work.Following is a description of each of our refineries and their capacity by region.Gulf Coast Region (1,171 mbpcd)Galveston Bay, Texas City, Texas Refinery (593 mbpcd) Our Galveston Bay refinery is a world-class refining complex resulting from the combination of our former Texas City refinery and Galveston Bay refinery. The refinery is located on the Texas Gulf Coast approximately 30 miles southeast of Houston, Texas and can process a wide variety of crude oils into gasoline, distillates, feedstocks, petrochemicals, propane and heavy fuel oil. The refinery has access to the export market and multiple options to sell refined products. Our cogeneration facility, which supplies the Galveston Bay refinery, currently has 1,055 megawatts of electrical production capacity and can produce 4.3 million pounds of steam per hour. Approximately 49 percent of the power generated in 2020 was used at the refinery, with the remaining electricity being sold into the electricity grid.Garyville, Louisiana Refinery (578 mbpcd) Our Garyville refinery, which is one of the largest refineries in the U.S., is located along the Mississippi River in southeastern Louisiana between New Orleans, Louisiana and Baton Rouge, Louisiana. The Garyville refinery is configured to process a wide variety of crude oils into gasoline, distillates, petrochemicals, feedstocks, asphalt, propane and heavy fuel oil. The refinery has access to the export market and multiple options to sell refined products. Our Garyville refinery has earned designation as an OSHA VPP Star site.Mid-Continent Region (1,153 mbpcd)Catlettsburg, Kentucky Refinery (291 mbpcd)Our Catlettsburg refinery is located in northeastern Kentucky on the western bank of the Big Sandy River, near the confluence with the Ohio River. The Catlettsburg refinery processes sweet and sour crude oils, including production from the nearby Utica Shale, into gasoline, distillates, asphalt, petrochemicals, heavy fuel oil, propane and feedstocks. Our Catlettsburg refinery has earned designation as an OSHA VPP Star site. Robinson, Illinois Refinery (253 mbpcd) Our Robinson refinery is located in southeastern Illinois. The Robinson refinery processes sweet and sour crude oils into gasoline, distillates, feedstocks, propane, petrochemicals and heavy fuel oil. The Robinson refinery has earned designation as an OSHA VPP Star site.Detroit, Michigan Refinery (140 mbpcd) Our Detroit refinery is located in southwest Detroit. It is the only petroleum refinery currently operating in Michigan. The Detroit refinery processes sweet and heavy sour crude oils into gasoline, distillates, asphalt, feedstocks, petrochemicals, propane and heavy fuel oil. Our Detroit refinery has earned designation as an OSHA VPP Star site. El Paso, Texas Refinery (131 mbpcd) Our El Paso refinery is located approximately three miles east of downtown El Paso, Texas. The El Paso refinery processes sweet and sour crudes into gasoline, distillates, asphalt, heavy fuel oil, propane and petrochemicals. St. Paul Park, Minnesota Refinery (104 mbpcd) Our St. Paul Park refinery is located along the Mississippi River southeast of St. Paul Park, Minnesota. The St. Paul Park refinery processes sweet and heavy sour crude and manufactures gasoline, distillates, asphalt, petrochemicals, propane, heavy fuel oil and feedstocks.Canton, Ohio Refinery (97 mbpcd) Our Canton refinery is located approximately 60 miles south of Cleveland, Ohio. The Canton refinery processes sweet and sour crude oils, including production from the nearby Utica Shale, into gasoline, 6Table of Contentsdistillates, asphalt, propane, petrochemicals, heavy fuel oil and feedstocks. The Canton refinery has earned designation as an OSHA VPP Star site.Mandan, North Dakota Refinery (71 mbpcd) The Mandan refinery processes primarily sweet domestic crude oil from North Dakota and manufactures gasoline, distillates, propane, heavy fuel oil and petrochemicals.Salt Lake City, Utah Refinery (66 mbpcd) Our Salt Lake City refinery is now the largest in Utah. The Salt Lake City refinery processes crude oil from Utah, Colorado, Wyoming and Canada to manufacture gasoline, distillates, propane, heavy fuel oil, feedstocks and petrochemicals.West Coast Region (550 mbpcd)Los Angeles, California Refinery (363 mbpcd) Our Los Angeles refinery is located in Los Angeles County, near the Los Angeles Harbor. The Los Angeles refinery is the largest refinery on the West Coast and is a major producer of clean fuels. The Los Angeles refinery processes heavy crude from California’s San Joaquin Valley and Los Angeles Basin as well as crudes from the Alaska North Slope, South America, West Africa and other international sources and manufactures cleaner-burning CARB gasoline and CARB diesel fuel, as well as conventional gasoline, distillates, feedstocks, petrochemicals, heavy fuel oil and propane.Anacortes, Washington Refinery (119 mbpcd) Our Anacortes refinery is located about 70 miles north of Seattle on Puget Sound. The Anacortes refinery processes Canadian crude, domestic crude from North Dakota and Alaska North Slope and international crudes to manufacture gasoline, distillates, heavy fuel oil, feedstocks, propane and petrochemicals.Kenai, Alaska Refinery (68 mbpcd)Our Kenai refinery is located on the Cook Inlet, 60 miles southwest of Anchorage. The Kenai refinery processes mainly Alaska domestic crude, domestic crude from North Dakota, along with limited international crude and manufactures distillates, gasoline, heavy fuel oil, feedstocks, asphalt, propane and petrochemicals.Planned maintenance activities, or turnarounds, requiring temporary shutdown of certain refinery operating units, are periodically performed at each refinery. See Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations for additional detail. Refined Product YieldsThe following table sets forth our refinery production by product group for each of the last three years including production from the refineries acquired in the Andeavor acquisition from October 1, 2018 forward.(mbpd)202020192018Gasoline1,314 1,560 1,107 Distillates905 1,087 773 Feedstocks and petrochemicals244 315 288 Asphalt81 87 69 Propane51 55 41 Heavy fuel oil28 49 38 Total2,623 3,153 2,316 7Table of ContentsCrude Oil SupplyWe obtain the crude oil we refine through negotiated term contracts and purchases or exchanges on the spot market. Our term contracts generally have market-related pricing provisions. The following table provides information on our sources of crude oil for each of the last three years. It includes crude sourced for the refineries acquired in the Andeavor acquisition from October 1, 2018 forward. The crude oil sourced outside of North America was acquired from various foreign national oil companies, production companies and trading companies.(mbpd)202020192018United States1,650 1,962 1,319 Canada442 541 465 Middle East and other international326 399 297 Total2,418 2,902 2,081 Our refineries receive crude oil and other feedstocks and distribute our refined products through a variety of channels, including pipelines, trucks, railcars, ships and barges. Renewable Fuels During 2020, we completed the conversion of our Dickinson, North Dakota refinery into an approximately 184 million gallons per year renewable diesel facility.We also progressed activities associated with the conversion of the Martinez refinery to a renewable diesel facility, including applying for permits, advancing discussions with feedstock suppliers, and beginning detailed engineering activities. As envisioned, the Martinez facility would start producing approximately 260 million gallons per year of renewable diesel by the second half of 2022, with a potential to build to full capacity of approximately 730 million gallons per year by the end of 2023. On February 24, 2021, MPC’s board of directors approved these plans.We own a biofuel production facility in Cincinnati, Ohio that produces biodiesel, glycerin and other by-products. The capacity of the plant is approximately 91 million gallons per year. Our wholly owned subsidiary, Virent, is an advanced biofuels facility in Madison, Wisconsin that is working to commercialize a process for converting biobased feedstocks into renewable fuels and chemicals.We hold an ownership interest in ethanol production facilities in Albion, Michigan; Logansport, Indiana; Greenville, Ohio and Denison, Iowa. These plants have a combined ethanol production capacity of approximately 475 million gallons per year and are managed by our joint venture partner, The Andersons.Refined Product MarketingOur refined products are sold to independent retailers, wholesale customers, our brand jobbers and direct dealers. In addition, we sell refined products for export to international customers. As of December 31, 2020, there were 7,090 branded outlets in 35 states, the District of Columbia and Mexico where independent entrepreneurs primarily maintain Marathon-branded outlets. We also have long-term supply contracts for 1,093 direct dealer locations primarily in Southern California, largely under the ARCO® brand. We believe we are one of the largest wholesale suppliers of gasoline and distillates to resellers and consumers within our 41-state market area.8Table of ContentsThe following table sets forth our refined product sales volumes by product group for each of the last three years including sales from the refineries acquired in the Andeavor acquisition from October 1, 2018 forward.(mbpd)202020192018Gasoline1,669 1,967 1,416 Distillates1,040 1,205 847 Feedstocks and petrochemicals323 345 289 Asphalt86 93 70 Propane69 72 44 Heavy fuel oil35 53 37 Total3,222 3,735 2,703 Refined Product Sales Destined for ExportWe sell gasoline, distillates and asphalt for export, primarily out of our Garyville, Galveston Bay, Anacortes, Los Angeles and Kenai refineries. The following table sets forth our refined product sales destined for export by product group for the past three years including sales from the refineries acquired in the Andeavor acquisition from October 1, 2018 forward.(mbpd)202020192018Gasoline110 131 117 Distillates187 215 193 Other43 51 24 Total340 397 334 Gasoline and Distillates We sell gasoline, gasoline blendstocks and distillates (including No. 1 and No. 2 fuel oils, jet fuel, kerosene and diesel fuel) to wholesale customers, Marathon-branded jobbers, direct dealers and in the spot market. In addition, we sell diesel fuel and gasoline for export to international customers. The demand for gasoline and distillates is seasonal in many of our markets, with demand typically at its highest levels during the summer months.Feedstocks and PetrochemicalsWe are a producer and marketer of feedstocks and petrochemicals. Product availability varies by refinery and includes, among others, propylene, naphtha, butane, xylene, benzene, alkylate, cumene, raffinate, toluene and platformate. We market these products domestically to customers in the chemical, agricultural and fuel-blending industries. In addition, we produce fuel-grade coke at our Garyville, Detroit, Galveston Bay and Los Angeles refineries, which is used for power generation and in miscellaneous industrial applications, and anode-grade coke at our Los Angeles and Robinson refineries, in addition to calcined coke at our Los Angeles refinery, which are both used to make carbon anodes for the aluminum smelting industry.AsphaltWe have refinery-based asphalt production capacity of up to 139 mbpcd, which includes asphalt cements, polymer-modified asphalt, emulsified asphalt, industrial asphalts and roofing flux. We have a broad customer base, including asphalt-paving contractors, resellers, government entities (states, counties, cities and townships) and asphalt roofing shingle manufacturers. We sell asphalt in the domestic and export wholesale markets via rail, barge and vessel.PropaneWe produce propane at all of our refineries. Propane is primarily used for home heating and cooking, as a feedstock within the petrochemical industry, for grain drying and as a fuel for trucks and other vehicles. Our propane sales are split approximately 80 percent and 20 percent between the home heating market and petrochemical consumers, respectively.9Table of ContentsHeavy Fuel OilWe produce and market heavy residual fuel oil or related components, including slurry, at all of our refineries. Heavy residual fuel oil is primarily used in the utility and ship bunkering (fuel) industries, though there are other more specialized uses of the product.Terminals and TransportationWe transport, store and distribute crude oil, feedstocks and refined products through pipelines, terminals and marine fleets owned by MPLX and third parties in our market areas. We own a fleet of transport trucks and trailers for the movement of refined products and crude oil. In addition, we maintain a fleet of leased and owned railcars for the movement and storage of refined products.The locations and detailed information about our Refining & Marketing assets are included under Item 2. Properties and are incorporated herein by reference. Competition, Market Conditions and SeasonalityThe downstream petroleum business is highly competitive, particularly with regard to accessing crude oil and other feedstock supply and the marketing of refined products. We compete with a number of other companies to acquire crude oil for refinery processing and in the distribution and marketing of a full array of refined products. Based upon company data as reported in the “The Oil & Gas Journal 2020 Worldwide Refinery Survey,” we ranked first among U.S. petroleum companies on the basis of U.S. crude oil refining capacity.We compete in four distinct markets for the sale of refined products—wholesale, including exports, spot, branded and retail distribution. Our marketing operations compete with numerous other independent marketers, integrated oil companies and high-volume retailers. We compete with companies in the sale of refined products to wholesale marketing customers, including private-brand marketers and large commercial and industrial consumers; companies in the sale of refined products in the spot market; and refiners or marketers in the supply of refined products to refiner-branded independent entrepreneurs. In addition, we compete with producers and marketers in other industries that supply alternative forms of energy and fuels to satisfy the requirements of our industrial, commercial and retail consumers.Market conditions in the oil and gas industry are cyclical and subject to global economic and political events and new and changing governmental regulations. Our operating results are affected by price changes in crude oil, natural gas and refined products, as well as changes in competitive conditions in the markets we serve. Price differentials between sweet and sour crude oils, ANS, WTI and LLS crude oils and other market structure impacts also affect our operating results. Demand for gasoline, diesel fuel and asphalt is higher during the spring and summer months than during the winter months in most of our markets, primarily due to seasonal increases in highway traffic and construction. As a result, the operating results for our Refining & Marketing segment for the first and fourth quarters may be lower than for those in the second and third quarters of each calendar year.MIDSTREAM The Midstream segment primarily includes the operations of MPLX, our sponsored MLP, and certain related operations retained by MPC.MPLXMPLX owns and operates a network of crude oil, natural gas and refined product pipelines and has joint ownership interests in other crude oil and refined products pipelines. MPLX also owns and operates light products terminals, storage assets and maintains a fleet of owned and leased towboats and barges. MPLX’s assets also include natural gas gathering systems and natural gas processing and NGL fractionation complexes. 10Table of ContentsMPC-Retained Midstream Assets and Investments We have ownership interests in several crude oil and refined products pipeline systems and pipeline companies and have indirect ownership interests in two ocean vessel joint ventures through our investment in Crowley Coastal Partners. The locations and detailed information about our Midstream assets are included under Item 2. Properties and are incorporated herein by reference. Competition, Market Conditions and SeasonalityOur Midstream operations face competition for natural gas gathering, crude oil transportation and in obtaining natural gas supplies for our processing and related services; in obtaining unprocessed NGLs for gathering, transportation and fractionation; and in marketing our products and services. Competition for natural gas supplies is based primarily on the location of gas gathering facilities and gas processing plants, operating efficiency and reliability, residue gas and NGL market connectivity, the ability to obtain a satisfactory price for products recovered and the fees charged for the services supplied to the customer. Competition for oil supplies is based primarily on the price and scope of services, location of gathering/transportation and storage facilities and connectivity to the best priced markets. Competitive factors affecting our fractionation services include availability of fractionation capacity, proximity to supply and industry marketing centers, the fees charged for fractionation services and operating efficiency and reliability of service. Competition for customers to purchase our natural gas and NGLs is based primarily on price, credit and market connectivity. In addition, certain of our Midstream operations are subject to rate regulation, which affects the rates that our common carrier pipelines can charge for transportation services and the return we obtain from such pipelines.Our Midstream segment can be affected by seasonal fluctuations in the demand for natural gas and NGLs and the related fluctuations in commodity prices caused by various factors such as changes in transportation and travel patterns and variations in weather patterns from year to year. REGULATORY MATTERSOur operations are subject to numerous laws and regulations, including those relating to the protection of the environment. Such laws and regulations include, among others, the Clean Air Act (“CAA”) with respect to air emissions, the Clean Water Act (“CWA”) with respect to water discharges, the Resource Conservation and Recovery Act (“RCRA”) with respect to solid and hazardous waste treatment, storage and disposal, the Comprehensive Environmental Response, Compensation, and Liability Act (“CERCLA”) with respect to releases and remediation of hazardous substances and the Oil Pollution Act of 1990 (“OPA-90”) with respect to oil pollution and response. In addition, many states where we operate have similar laws. New laws are being enacted and regulations are being adopted on a continuing basis, and the costs of compliance with such new laws and regulations are very difficult to estimate until finalized.For a discussion of environmental capital expenditures and costs of compliance, see Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations-Environmental Matters and Compliance Costs. For additional information regarding regulatory risks, see Item 1A. Risk Factors.AirGreenhouse Gas EmissionsWe believe it is likely that the scientific and political attention to greenhouse gas emissions, climate change, and climate adaptation will continue, with the potential for further regulations that could affect our operations. Currently, legislative and regulatory measures to address greenhouse gas emissions are in various phases of review, discussion or implementation. Reductions in greenhouse gas emissions could result in increased costs to (i) operate and maintain our facilities, (ii) install new emission controls at our facilities, (iii) capture the emissions from our facilities and (iv) administer and manage any greenhouse gas emissions programs, including acquiring emission credits or allotments.In January 2021, President Biden announced that the United States was rejoining the 2015 Paris UN Climate Change Conference Agreement, effective February 19, 2021. President Biden also issued an Executive Order on climate change in which he announced putting the U.S. on a path to achieve net-zero carbon emissions, economy-wide, by 2050. The Executive Order also calls for the federal government to pause oil and gas leasing on federal lands, reduce methane emissions from the oil and gas sector as quickly as possible, and requires federal permitting decisions to consider the effects of greenhouse gas emissions 11Table of Contentsand climate change. In a second Executive Order, President Biden reestablished a working group to develop the social cost of carbon and the social cost of methane. The social cost of carbon and social cost of methane can be used to weigh the costs and benefits of proposed regulations. A higher social cost of carbon could support more stringent greenhouse gas emission regulation.States are becoming active in regulating greenhouse gas emissions. These measures may include state actions to develop statewide or regional programs to impose emission reductions. These measures may also include low-carbon fuel standards, such as the California program, or a state carbon tax. These measures could result in increased costs to operate and maintain our facilities, capital expenditures to install new emission controls and costs to administer any carbon trading or tax programs implemented. For example, the California state legislature enacted AB 398, which provides direction and parameters on utilizing cap and trade after 2020 to meet the 40 percent reduction target from 1990 levels by 2030 specified in SB 32. Compliance with the cap and trade program is demonstrated through a market-based credit system. Much of the compliance costs associated with these California regulations are ultimately passed on to the consumer in the form of higher fuel costs. States are increasingly announcing aspirational goals to be net-zero carbon emissions by a certain date through both legislation and executive orders. To date, these states have not provided significant details as to achievement of these goals; however, meeting these aspirations will require a reduction in fossil fuel combustion and/or a mechanism to capture greenhouse gases from the atmosphere. As a result, we cannot currently predict the impact of these potential regulations on our liquidity, financial position, or results of operations.Other Air EmissionsIn 2015, United States Environmental Protection Agency (“EPA”) finalized a revision to the National Ambient Air Quality Standards (“NAAQS”) for ozone. The EPA lowered the primary ozone NAAQS from 75 ppb to 70 ppb. In December 2020, the EPA published a rule maintaining this standard. Designation as a nonattainment area could result in increased costs associated with, or result in cancellation or delay of, capital projects at our facilities, or could require nitrogen oxide (“NOx”) and/or volatile organic compound (“VOC”) reductions that could result in increased costs to our facilities.In California, the Board for the South Coast Air Quality Management District (“SCAQMD”) passed amendments to the Regional Clean Air Incentives Market (“RECLAIM”) that became effective in 2016, requiring a staged reduction of nitrogen oxide emissions through 2022. In 2017, the State of California passed AB 617, which requires implementation of best available retrofit control technology (“BARCT”) on specific facilities, including facilities subject to RECLAIM. In response to AB 617, the SCAQMD is currently working to identify BARCT and determine whether to “sunset” the existing RECLAIM program. A “sunset” of the RECLAIM program and application of BARCT is expected to result in increased costs to operate and maintain our Los Angeles refinery.WaterWe maintain numerous discharge permits as required under the National Pollutant Discharge Elimination System program of the CWA and have implemented systems to oversee our compliance with these permits. In addition, we are regulated under OPA-90, which, among other things, requires the owner or operator of a tank vessel or a facility to maintain an emergency plan to respond to releases of oil or hazardous substances. OPA-90 also requires the responsible company to pay resulting removal costs and damages and provides for civil penalties and criminal sanctions for violations of its provisions. We operate tank vessels and facilities from which spills of oil and hazardous substances could occur. We have implemented emergency oil response plans for all of our components and facilities covered by OPA-90 and we have established Spill Prevention, Control and Countermeasures plans for all facilities subject to such requirements. Some coastal states in which we operate have passed state laws similar to OPA-90, but with expanded liability provisions, that include provisions for cargo owner responsibility as well as ship owner and operator responsibility.On October 22, 2019, the EPA and the United States Army Corps of Engineers (“Army Corps”) published a final rule to repeal the 2015 “Clean Water Rule: Definition of Waters of the United States” (“2015 Rule”), which amended portions of the Code of Federal Regulations (“CFR”) to restore the regulatory text that existed prior to the 2015 Rule, effective December 23, 2019. The rule repealing the 2015 Clean Water Rule has been challenged in multiple federal courts. On April 21, 2020, the EPA and the Army Corps promulgated the Navigable Waters Protection Rule (“2020 Rule”) to define “waters of the United States.” The 2020 Rule has been challenged in court. The Biden administration has signaled its intent to revisit the definition of “waters of the United States,” and replace it with a definition consistent with the 2015 Rule. A 12Table of Contentsbroader definition could result in increased cost of compliance or increased capital costs for construction of new facilities or expansion of existing facilities. In April 2020, the U.S. District Court in Montana vacated Nationwide Permit 12 (“NWP 12”), which authorizes the placement of fill material in “waters of the United States” for utility line activities as long as certain best management practices are implemented. The decision was ultimately appealed to the United States Supreme Court, which partially reversed the district court’s decision, temporarily reinstating NWP 12 for all projects except the Keystone XL oil pipeline. The United States Army Corps of Engineers subsequently reissued its nationwide permit authorizations on January 13, 2021, by dividing the NWP that authorizes utility line activities (NWP 12) into three separate NWPs that address the differences in how different utility line projects are constructed, the substances they convey, and the different standards and best management practices that help ensure those NWPs authorize only those activities that have no more than minimal adverse environmental effects. The 2021 authorization may be challenged in court or the Biden Administration may repeal or replace the 2021 authorization in a subsequent rulemaking. Repeal or replacement of the rule could impact pipeline maintenance activities. As part of our emergency response activities, we have used aqueous film forming foam (“AFFF”) containing per- and polyfluoroalkyl substances (“PFAS”) chemicals as a fire suppressant. At this time, AFFFs containing PFAS are the only proven foams that can prevent and control most flammable petroleum-based liquid fires. In May 2016, the EPA issued lifetime health advisories (“HAs”) and health effects support documents for two PFAS substances - Perfluorooctanoic Acid (“PFOA”) and Perfluorooctane Sulfonate (“PFOS”). Then, in February 2019, EPA issued a PFAS Action Plan identifying actions the EPA is planning to take to study and regulate various PFAS chemicals. The EPA identified that it would evaluate, among other actions, (1) proposing national drinking water standards for PFOA and PFOS, (2) develop cleanup recommendations for PFOA and PFOS, (3) evaluate listing PFOA and PFOS as hazardous substances under CERCLA, and (4) conduct toxicity assessments for other PFAS chemicals. To date EPA has not issued any further regulations for PFAS under the Trump administration; however, the Biden Administration has indicated its intent to issue proposed rules to regulate PFAS, which could include the designation of variants of PFAS as CERCLA hazardous substances and/or establish national drinking water standards. Congress may also take further action to regulate PFAS. We cannot currently predict the impact of potential statutes or regulations on our operations or remediation costs.In addition, many states are actively proposing and adopting legislation and regulations relating to the use of AFFF. Additionally, some states are adopting and proposing state-specific drinking water and cleanup standards for various PFAS. We cannot currently predict the impact of these regulations on our liquidity, financial position, or results of operations.Solid WasteWe continue to seek methods to minimize the generation of hazardous wastes in our operations. RCRA establishes standards for the management of solid and hazardous wastes. Besides affecting waste disposal practices, RCRA also addresses the environmental effects of certain past waste disposal operations, the recycling of wastes and the regulation of USTs containing regulated substances.RemediationWe own or operate, or have owned or operated, certain convenience stores and other locations where, during the normal course of operations, releases of refined products from USTs have occurred. Federal and state laws require that contamination caused by such releases at these sites be assessed and remediated to meet applicable standards. Penalties or other sanctions may be imposed for noncompliance. The enforcement of the UST regulations under RCRA has been delegated to the states, which administer their own UST programs. Our obligation to remediate such contamination varies, depending on the extent of the releases and the applicable state laws and regulations. A portion of these remediation costs may be recoverable from the appropriate state UST reimbursement funds once the applicable deductibles have been satisfied. We also have ongoing remediation projects at a number of our current and former refinery, terminal and pipeline locations.Claims under CERCLA and similar state acts have been raised with respect to the clean-up of various waste disposal and other sites. CERCLA is intended to facilitate the clean-up of hazardous substances without regard to fault. Potentially responsible parties for each site include present and former owners and operators of, transporters to and generators of the hazardous substances at the site. Liability is strict and can be joint 13Table of Contentsand several. Because of various factors including the difficulty of identifying the responsible parties for any particular site, the complexity of determining the relative liability among them, the uncertainty as to the most desirable remediation techniques and the amount of damages and clean-up costs and the time period during which such costs may be incurred, we are unable to reasonably estimate our ultimate cost of compliance with CERCLA; however, we do not believe such costs will be material to our business, financial condition, results of operations or cash flows.Renewable Fuels and Other Fuels RequirementsThe U.S. Congress passed the Energy Independence and Security Act of 2007 (“EISA”), which, among other things, set a target of 35 miles per gallon for the combined fleet of cars and light trucks in the United States by model year 2020. In March 2020, the EPA and the National Highway Traffic Safety Administration (“NHTSA”) released the final Safer Affordable Fuel-Efficient (“SAFE”) Vehicles Rule setting corporate average fuel economy (“CAFE”) and carbon dioxide (“CO2”) standards for model years 2021-2026 passenger cars and light trucks. The final rule increases the stringency of CAFE and CO2 emission standards by 1.5 percent each year from model years 2021 through 2026. The rule has been challenged in court and could be revised by the Biden Administration through notice and comment rulemaking. Higher CAFE standards for cars and light trucks have the potential to reduce demand for our transportation fuels. In addition, the NHTSA and the EPA issued rules providing that the Energy Policy and Conservation Act (“EPCA”) preempts state regulations of tailpipe carbon dioxide emissions, withdrew the waiver granted to California for its Advanced Clean Car program and determined that the Clean Air Act permits other states to adopt only those California standards that are designed to control traditional “criteria pollutants.” California may establish per its Clean Air Act waiver authority different standards that could apply in multiple states. California’s governor issued an executive order requiring sales of all new passenger vehicles in the state be zero-emission by 2035. Other states have issued, or may issue, zero emission vehicle mandates. The Biden Administration could reinstate the California waiver and may take federal action to incentivize or mandate zero emission vehicle production.Pursuant to the Energy Policy Act of 2005 and the EISA, the EPA has promulgated a Renewable Fuel Standard (“RFS”) program that requires certain volumes of renewable fuel be blended with our products. By November 30 of each year, the EPA is required to promulgate the annual renewable fuel standards for the following compliance year. In a legal challenge to the 2014-2016 volumes, the D.C. Circuit Court of Appeals vacated the total renewable volume for 2016 and remanded to the EPA for reconsideration consistent with the court’s opinion. A rule that increases the total renewable volume for any compliance year to make up for the 2016 shortfall could increase our cost of compliance with the RFS program, require us to use carryover RINs and be detrimental to the RIN market. The EPA has finalized the annual renewable fuel standards for the year 2020. For the first time, the EPA has proposed to reallocate to non-exempt obligated parties the renewable volume obligations of the refiners that were granted a small refinery exemption. Also, the Tenth Circuit Court of Appeals held that a small refinery is eligible for an exemption from the RFS only if it is applying for an extension of its original exemption. According to the EPA’s data, seven refineries were granted the small refinery exemption in 2015. The United States Supreme Court has granted certiorari in the 10th Circuit case. If the 10th Circuit decision is upheld, EPA’s reallocation of volumes could be greater than the actual volumes exempted in 2020. The reallocation of volumes under the 2020 rule or the invalidation of past small refinery exemptions granted to us or other refiners could result in a decrease in the RIN bank, an increase in the price of RINs or an increase in the amount of renewable fuel we are required to blend, any of which could increase MPC’s RFS cost of compliance. Further, the EPA has failed to promulgate timely the annual renewable fuel standards for 2021.The RFS is satisfied primarily with ethanol blended into gasoline. Vehicle, regulatory and infrastructure constraints limit the blending of significantly more than 10 percent ethanol into gasoline (“E10”). Since 2016, the volume requirements have resulted in the ethanol content of gasoline exceeding the E10 blendwall, which will require obligated parties to either sell E15 or ethanol flex fuel at levels that exceed historical levels or retire carryover RINs.There is currently no regulatory method for verifying the validity of the RINs sold on the open market. We have developed a RIN integrity program to vet the RINs that we purchase, and we incur costs to audit RIN generators. Nevertheless, if any of the RINs that we purchase and use for compliance are found to be invalid, we could incur costs and penalties for replacing the invalid RINs.14Table of ContentsIn addition to the federal Renewable Fuel Standards, certain states have, or are considering, promulgation of state renewable or low carbon fuel standards. For example, California began implementing its Low Carbon Fuel Standard (“LCFS”) in January 2011. In September 2015, the CARB approved the re-adoption of the LCFS, which became effective on January 1, 2016, to address procedural deficiencies in the way the original regulation was adopted. The LCFS was amended again in 2018 with the current version targeting a 20 percent reduction in fuel carbon intensity from a 2010 baseline by 2030. We incur costs to comply with the California LCFS, and these costs may increase if the cost of LCFS credits increases.In sum, the RFS has required, and may in the future continue to require, additional capital expenditures or expenses by us to accommodate increased renewable fuels use. We may experience a decrease in demand for refined products due to an increase in combined fleet mileage or due to refined products being replaced by renewable fuels. Demand for our refined products also may decrease as a result of low carbon fuel standard programs or electric vehicle mandates.Safety MattersWe are subject to oversight pursuant to the federal Occupational Safety and Health Act, as amended (“OSHA”), as well as comparable state statutes that regulate the protection of the health and safety of workers. We believe that we have conducted our operations in substantial compliance with OSHA requirements, including general industry standards, record-keeping requirements and monitoring of occupational exposure to regulated substances.We are also subject at regulated facilities to the OSHA’s Process Safety Management (“PSM”) and EPA’s Risk Management Program requirements, which are intended to prevent or minimize the consequences of catastrophic releases of toxic, reactive, flammable or explosive chemicals. The application of these regulations can result in increased compliance expenditures.In general, we expect industry and regulatory safety standards to become stricter over time, resulting in increased compliance expenditures. While these expenditures cannot be accurately estimated at this time, we do not expect such expenditures will have a material adverse effect on our results of operations.The DOT has adopted safety regulations with respect to the design, construction, operation, maintenance, inspection and management of our pipeline assets. These regulations contain requirements for the development and implementation of pipeline integrity management programs, which include the inspection and testing of pipelines and the correction of anomalies. These regulations also require that pipeline operation and maintenance personnel meet certain qualifications and that pipeline operators develop comprehensive spill response plans. Tribal LandsVarious federal agencies, including the EPA and the Department of the Interior, along with certain Native American tribes, promulgate and enforce regulations pertaining to oil and gas operations on Native American tribal lands where we operate. These regulations include such matters as lease provisions, drilling and production requirements, and standards to protect environmental quality and cultural resources. In addition, each Native American tribe is a sovereign nation having the right to enforce certain laws and regulations and to grant approvals independent from federal, state and local statutes and regulations. These laws and regulations may increase our costs of doing business on Native American tribal lands and impact the viability of, or prevent or delay our ability to conduct, our operations on such lands.TRADEMARKS, PATENTS AND LICENSES Our Marathon and ARCO trademarks are material to the conduct of our refining and marketing operations, and our Speedway trademark is material to the conduct of our retail operations. We currently hold a number of U.S. and foreign patents and have various pending patent applications. Although in the aggregate our patents and licenses are important to us, we do not regard any single patent or license or group of related patents or licenses as critical or essential to our business as a whole. In general, we depend on our technological capabilities and the application of know-how rather than patents and licenses in the conduct of our operations.HUMAN CAPITALWe believe our employees are our greatest source of strength, and our culture reflects the quality of individuals across our workforce. Our collaborative efforts to foster an inclusive environment, provide 15Table of Contentsbroad-based development and mentorship opportunities, recognize and reward accomplishments, and offer benefits that support the well-being of our employees and their families contribute to increased engagement and fulfilling careers. Empowering our people and prioritizing accountability also are key components for developing MPC’s high-performing culture, which is critical to achieving our strategic vision. Employee ProfileAs of December 31, 2020, we employed approximately 57,900 people in full-time and part-time roles. Excluding employees of Speedway, which is targeted to be sold in the first quarter of 2021, we employ approximately 18,600 people in full-time and part-time roles. Many of these employees provide services to MPLX, for which we are reimbursed in accordance with employee service agreements. Approximately 3,770 of the 18,600 employees are covered by collective bargaining agreements.Talent ManagementExecuting our strategic vision requires that we attract and retain the best talent. Recruiting and retention success requires that we effectively nurture new employees, providing opportunities for long-term engagement and career advancement. We also appropriately reward high-performers and offer competitive benefits. Our Talent Acquisition team consists of three segments: Executive Recruiting, Experienced Recruiting and University Recruiting. The specialization within each group allows us to specifically address MPC’s broad range of current and future talent needs, as well as devote time and attention to candidates during the hiring process. We value diverse perspectives in the workforce, and accordingly we seek candidates with a variety of backgrounds and experience. Our primary source of full-time, entry-level new hires is our intern/co-op program. Through our university recruiters, we offer college students who have completed their freshman year the opportunity to participate in our hands-on programs focused in areas of finance and accounting, marketing, engineering and IT.We provide a broad range of leadership training opportunities to support the development of leaders at all levels. Our programs, which are offered across the organization are a blended approach of business and leadership content, with many featuring external faculty. We utilize various learning modalities, such as visual, audio, print, tactile, interactive, kinesthetic, experiential and leader-teaching-leader to address and engage different learning styles. We believe networking and access to our executive team are a key leadership success factor, and we incorporate these opportunities into all of our programs.Compensation and BenefitsTo ensure we are offering competitive pay packages in our recruitment and retention efforts, we annually benchmark compensation, including base salaries, bonus levels and equity targets. Our annual bonus program is a critical component of our compensation, as it provides individual reward for MPC’s achievement against preset financial and sustainability goals, encouraging a sense of employee ownership. Employees in our officer-level pay grades, as well as senior leaders and most mid-level leaders, are eligible to receive long-term equity incentive awards as part of their compensation.We offer comprehensive benefits, including medical, dental and vision insurance for our employees, their spouses or domestic partners, and their dependents. We also provide retirement programs, life insurance, education assistance, family assistance, short-term disability and paid vacation and sick time. Following our acquisition of Andeavor, we enhanced several of our benefits programs to reflect our larger, coast-to-coast organization. We increased the maximum accrual cap for vacation banks and doubled the number of college and trade school scholarships offered to the high school senior children of our employees through the Marathon Petroleum Scholars Program. In addition, we increased our paid parental leave benefit to eight weeks for birth mothers and four weeks for nonbirth parents, including adoptive and foster parents. Both full-time and part-time employees are eligible for this benefit. Parents who both work for the company are each eligible for a parental pay benefit.InclusionOur company-wide Diversity and Inclusion (“D&I”) program is managed by a dedicated D&I Office team and supported by leadership. Our program is based on our three-pillar D&I strategy, of building awareness, increasing representation and ensuring success. The strategy focuses on understanding the benefits of diverse perspectives, increasing diversity across the organization and recognizing that cultural inclusion is an ongoing process. We have employee networks focusing on six populations: Asian, Black, Hispanic, Veterans, Women and LGBTQ+. Our employee networks have approximately 60 chapters across the company and all networks encourage ally membership. This broad support extends also to our leaders throughout MPC, with each employee network represented by two active executive sponsors. The sponsors 16Table of Contentsform several counsels that meet regularly to share updates, gain alignment, build deeper connections across networks and pursue collaboration ideas. Our employee networks not only provide opportunities for our employees to make meaningful and supportive connections, but they also serve a significant role in our D&I strategy.Safety We are committed to safe operations to protect the health and safety of our employees, contractors and communities. Our commitment to safe operations is reflected in our safety systems design, our well-maintained equipment and by learning from our incidents. Part of our effort to promote safety includes a management system based on the principles of RC14001®, the Plan-Do-Check-Act continual improvement cycle, and our Operational Excellence Management System. Together, these components of our safety management system provide us with a comprehensive approach to managing risks and preventing incidents, illnesses and fatalities. Additionally, our annual cash bonus program metrics includes several employee, process and environmental safety metrics.The COVID-19 pandemic has underscored for us the importance of keeping our employees safe and healthy. In March 2020, MPC activated its Corporate Emergency Response Team to ensure a consistent and aggressive response across all facets of our company. The safety and health of our employees, including our essential personnel, were our top priorities. As part of our existing pandemic plan, we had a central inventory of N95 respirators, surgical masks, and nitrile gloves to supply to our employees and contractors when the pandemic began. We implemented a number of protective measures to ensure employee and contractor safety as they continued to keep our critical operations running safely. We continue to monitor the situation and adapt our practices as appropriate. Information about our Executive and Corporate OfficersThe executive and corporate officers of MPC are as follows:NameAge as of February 1, 2021Position with MPCMichael J. Hennigan61President, Chief Executive Officer and DirectorMaryann T. Mannen58Executive Vice President and Chief Financial OfficerTimothy T. Griffith51President, Speedway LLCRaymond L. Brooks60Executive Vice President, RefiningBrian C. Davis55Executive Vice President and Chief Commercial OfficerSuzanne Gagle55General Counsel and Senior Vice President, Government AffairsFiona C. Laird*59Chief Human Resources Officer and Senior Vice President, CommunicationsEhren D. Powell*41Chief Digital Officer and Senior Vice PresidentC. Tracy Case*60Senior Vice President, Western Refining OperationsDavid R. Heppner*54Senior Vice President, Strategy and Business DevelopmentRichard A. Hernandez*61Senior Vice President, Eastern Refining OperationsRick D. Hessling*54Senior Vice President, Global FeedstocksThomas Kaczynski59Senior Vice President, Finance, and TreasurerBrian K. Partee*47Senior Vice President, Global Clean ProductsJohn J. Quaid49Senior Vice President and ControllerJames R. Wilkins*54Senior Vice President, Health, Environment, Safety and SecurityMolly R. Benson*54Vice President, Chief Securities, Governance & Compliance Officer and Corporate SecretaryKristina A. Kazarian*38Vice President, Investor RelationsD. Rick Linhardt*62Vice President, TaxGlenn M. Plumby*61Executive Vice President and Chief Operating Officer, Speedway LLC* Corporate officer.17Table of ContentsMr. Hennigan was appointed President and Chief Executive Officer effective March 2020, and as a member of the Board of Directors effective April 2020. He also has served as Chief Executive Officer of MPLX since November 2019 and as President since June 2017. Before joining MPLX, Mr. Hennigan was President, Crude, NGL and Refined Products, of the general partner of Energy Transfer Partners L.P., an energy service provider. He was President and Chief Executive Officer of Sunoco Logistics Partners L.P., an oil and gas transportation, terminalling and storage company, from 2012 to 2017, President and Chief Operating Officer beginning in 2010, and Vice President, Business Development, beginning in 2009. Ms. Mannen was appointed Executive Vice President and Chief Financial Officer effective January 25, 2021. Before joining MPC, she served as Executive Vice President and Chief Financial Officer of TechnipFMC (a successor to FMC Technologies, Inc.), a global leader in subsea, onshore/offshore, and surface projects for the energy industry, since 2017, having previously served as Executive Vice President and Chief Financial Officer of FMC Technologies, Inc. since 2014, Senior Vice President and Chief Financial Officer since 2011, and in various positions of increasing responsibility with FMC Technologies, Inc. since 1986. Mr. Griffith was appointed President, Speedway LLC, effective July 2019. Prior to this appointment, he served as Senior Vice President and Chief Financial Officer beginning in 2015, Vice President, Finance and Investor Relations, and Treasurer beginning in 2014, and Vice President of Finance and Treasurer beginning in 2011.Mr. Brooks was appointed Executive Vice President, Refining, effective October 2018. Prior to this appointment, he served as Senior Vice President, Refining, beginning in March 2016, General Manager of the Galveston Bay refinery beginning in 2013, General Manager of the Robinson refinery beginning in 2010, and General Manager of the St. Paul Park, Minnesota refinery beginning in 2006.Mr. Davis was appointed Executive Vice President and Chief Commercial Officer effective February 1, 2021. Before joining MPC, he spent 32 years with Royal Dutch Shell, a multinational oil and gas company, in roles spanning the full oil and gas value chain, including most recently as Global Vice President, Energy Solutions, from 2016 to 2020. Previous positions with Royal Dutch Shell include service as Group Vice President, Corporate Strategy, from 2014 to 2016, Global Vice President, Base Chemicals, from 2011 to 2014, Global Vice President, Downstream Strategy, from 2009 to 2011 and General Manager, Refining and Supply Strategy, from 2005 to 2009. Ms. Gagle was appointed General Counsel and Senior Vice President, Government Affairs, effective February 24, 2021. Prior to this appointment, she served as General Counsel beginning in March 2016, Assistant General Counsel, Litigation and Human Resources, beginning in 2011, Senior Group Counsel, Downstream Operations, beginning in 2010, and Group Counsel, Litigation, beginning in 2003.Ms. Laird was appointed Chief Human Resources Officer and Senior Vice President, Communications, effective February 24, 2021. Prior to this appointment, she served as Chief Human Resources Officer beginning in October 2018, having previously served as Chief Human Resources Officer at Andeavor beginning in February 2018. Before joining Andeavor, Ms. Laird was Chief Human Resources and Communications Officer for Newell Brands, a global consumer goods company, beginning in May 2016 and Executive Vice President, Human Resources, for Unilever, a global consumer goods company, beginning in 2011.Mr. Powell was appointed Chief Digital Officer and Senior Vice President effective July 20, 2020. Before joining MPC, he served as Vice President and Chief Information Officer (“CIO”) at GE Healthcare, a segment of General Electric Company (“GE”) that provides medical technologies and services, beginning in April 2018, having previously served as Senior Vice President and CIO, Services, of GE, a multinational conglomerate, since January 2017 and CIO, Power Services, with GE Power since 2014, and in various positions of increasing responsibility with GE and its subsidiaries since 2000.Mr. Case was appointed Senior Vice President, Western Refining Operations, effective October 2018. Prior to this appointment, he served as General Manager of the Garyville refinery beginning in 2014, and General Manager of the Detroit refinery beginning in 2010.Mr. Heppner was appointed Senior Vice President, Strategy and Business Development, effective February 24, 2021. Prior to this appointment, he served as Vice President, Commercial and Business Development, beginning in October 2018, Senior Vice President of Engineering Services and Corporate Support of Speedway LLC beginning in 2014, and Director, Wholesale Marketing, beginning in 2010.18Table of ContentsMr. Hernandez was appointed Senior Vice President, Eastern Refining Operations, effective October 2018. Prior to this appointment, he served as General Manager of the Galveston Bay refinery beginning in February 2016, and General Manager of the Catlettsburg refinery beginning in 2013.Mr. Hessling was appointed Senior Vice President, Global Feedstocks, effective February 24, 2021. Prior to this appointment, he served as Senior Vice President, Crude Oil Supply and Logistics, beginning in October 2018, Manager, Crude Oil & Natural Gas Supply and Trading, beginning in 2014, and Crude Oil Logistics & Analysis Manager beginning in 2011.Mr. Kaczynski was appointed Senior Vice President, Finance, and Treasurer effective February 24, 2021. Prior to this appointment, he served as Vice President, Finance, and Treasurer since 2015. Before joining MPC, Mr. Kaczynski was Vice President and Treasurer of Goodyear Tire and Rubber Company, one of the world’s largest tire manufacturers, beginning in 2014, and Vice President, Investor Relations, beginning in 2013. Mr. Partee was appointed Senior Vice President, Global Clean Products, effective February 24, 2021. Prior to this appointment, he served as Senior Vice President, Marketing, beginning in October 2018, Vice President, Business Development, beginning in February 2018, Director of Business Development beginning in January 2017, Manager of Crude Oil Logistics beginning in 2014, and Vice President, Business Development and Franchise, at Speedway beginning in 2012. Mr. Quaid was appointed Senior Vice President and Controller effective April 1, 2020. Prior to this appointment, he served as Vice President and Controller beginning in 2014. Before joining MPC, Mr. Quaid was Vice President of Iron Ore at United States Steel Corporation, an integrated steel producer, beginning in 2014, and Vice President and Treasurer beginning in 2011.Mr. Wilkins was appointed Senior Vice President, Health, Environment, Safety and Security, effective February 24, 2021. Prior to this appointment, he served as Vice President, Environment, Safety and Security, beginning in October 2018, Director, Environment, Safety, Security and Product Quality, beginning in February 2016, and Director, Refining Environmental, Safety, Security and Process Safety Management, beginning in 2013.Ms. Benson was appointed Vice President, Chief Securities, Governance & Compliance Officer and Corporate Secretary effective June 2018, having previously served as Vice President, Chief Compliance Officer and Corporate Secretary since March 2016. Prior to her 2016 appointment, she served as Assistant General Counsel, Corporate and Finance, beginning in 2012, and Group Counsel, Corporate and Finance, beginning in 2011. Ms. Kazarian was appointed Vice President, Investor Relations, effective April 2018. Before joining MPC, she was Managing Director and head of the MLP, Midstream and Refining Equity Research teams at Credit Suisse, a global investment bank and financial services company, beginning in September 2017. Previously, Ms. Kazarian was Managing Director of MLP, Midstream and Natural Gas Equity Research at Deutsche Bank, a global investment bank and financial services company, beginning in 2014, and an analyst specializing on various energy industry subsectors with Fidelity Management & Research Company, a privately held investment manager, beginning in 2005. Mr. Linhardt was appointed Vice President, Tax, effective February 2018. Prior to this appointment, he served as Director of Tax beginning in June 2017, and Manager of Tax Compliance beginning in 2013.Mr. Plumby was appointed Executive Vice President and Chief Operating Officer, Speedway LLC, effective August 2019. Prior to this appointment, he served as Senior Vice President and Chief Operating Officer, Speedway LLC, beginning in January 2018, Senior Vice President of Operations, Speedway LLC, beginning in 2013, and Vice President of Operations, Speedway LLC, beginning in 2010.19Table of ContentsAvailable InformationGeneral information about MPC, including our Corporate Governance Principles, our Code of Business Conduct and our Code of Ethics for Senior Financial Officers, can be found at www.marathonpetroleum.com under the “Investors” tab by selecting “Corporate Governance.” In addition, our Code of Business Conduct and Code of Ethics for Senior Financial Officers are also available in this same location. We will post on our website any amendments to, or waivers from, either of our codes requiring disclosure under applicable rules within four business days of the amendment or waiver. Charters for the Audit Committee, Compensation and Organization Development Committee, Corporate Governance and Nominating Committee and Sustainability Committee are also available at this site under the “About” tab by selecting “Board of Directors.”MPC uses its website, www.marathonpetroleum.com, as a channel for routine distribution of important information, including news releases, analyst presentations, financial information and market data. Our Annual Report on Form 10-K, Quarterly Reports on Form 10-Q and Current Reports on Form 8-K, as well as any amendments and exhibits to those reports, are available free of charge through our website as soon as reasonably practicable after the reports are filed or furnished with the SEC. These documents are also available in hard copy, free of charge, by contacting our Investor Relations office. In addition, our website allows investors and other interested persons to sign up to automatically receive email alerts when we post news releases and financial information on our website. Information contained on our website is not incorporated into this Annual Report on Form 10-K or other securities filings.ITEM 1A. RISK FACTORS You should carefully consider each of the following risks and all the other information contained in this Annual Report on Form 10-K in evaluating us and our common stock. Although the risks are organized by headings, and each risk is discussed separately, many are interrelated. Our business, financial condition, results of operations and cash flows could be materially and adversely affected by these risks, and, as a result, the trading price of our common stock could decline.Business and Operational RisksThe COVID-19 pandemic resulted in a significant decrease in demand for the petroleum products that we manufacture, sell, transport and store, which has had, and may continue to have, a material and adverse effect on our business and on general economic, financial and business conditions.The COVID-19 pandemic continues to negatively impact worldwide economic and commercial activity. Travel restrictions, business and school closures, increased remote work, stay-at-home orders and other actions taken by individuals, governments and the private sector to stem the spread of the virus have significantly reduced global economic activity, significantly reduced demand for the petroleum products that we manufacture, sell, transport and store, and contributed to increased market and oil price volatility. Our refinery utilization and operating margins and other aspects of our business have been adversely impacted by these developments.During 2020, there were significant variations in the market prices of products held in our inventories. In each quarter of 2020, these variations required us to record either inventory valuation charges or benefits to reflect the valuation of our inventories at the lower of cost or market. Depending on future movements of refined product prices, future inventory valuation adjustments could have a negative or positive effect on our financial performance. In addition, a sustained period of low crude oil prices may also result in significant financial constraints on certain producers from which we acquire our crude oil, which could result in long term crude oil supply constraints for our business. Such conditions could also result in an increased risk that our customers and other counterparties may be unable to fully fulfill their obligations in a timely manner, or at all. Resurgences in COVID-19 infections could result in the imposition of new stay-at-home orders or other restrictions to slow the spread of the virus, which could further weaken demand for the petroleum products we manufacture, sell, transport and store, and could contribute to increased market and oil price volatility.A prolonged period of economic slowdown or recession, or a protracted period of depressed prices for crude oil or refined petroleum products, could continue to have significant and adverse consequences for our financial condition and the financial condition of our customers, suppliers and other counterparties, and 20Table of Contentscould diminish our liquidity, trigger additional impairments and negatively affect our ability to obtain adequate crude oil volumes and to market certain of our products at favorable prices, or at all.The ultimate extent to which COVID-19 will continue to negatively affect us and our customers, suppliers and other counterparties will depend largely on the length and severity of the pandemic; actions taken by individuals, governments and the private sector to stem the spread of the virus; general economic conditions; and the availability and widespread distribution and use of safe and effective vaccines, all of which cannot be predicted with certainty.Our financial results are affected by volatile refining margins, which are dependent on factors beyond our control.Our operating results, cash flows, future rate of growth, the carrying value of our assets and our ability to execute share repurchases and continue the payment of our base dividend are highly dependent on the margins we realize on our refined products. Historically, refining and marketing margins have been volatile, and we believe they will continue to be volatile. Our margins from the sale of gasoline and other refined products are influenced by a number of conditions, including the price of crude oil. The price of crude oil and the price at which we can sell our refined products may fluctuate independently due to a variety of regional and global market factors that are beyond our control, including:•worldwide and domestic supplies of and demand for crude oil and refined products; •transportation infrastructure availability, local market conditions and operation levels of other refineries in our markets;•natural gas and electricity supply costs incurred by refineries; •political instability, threatened or actual terrorist incidents, armed conflict or other global political conditions; •local weather conditions; •seasonality of demand in our marketing areas due to increased highway traffic in the spring and summer months; •natural disasters such as hurricanes and tornadoes; •domestic and foreign governmental regulations and taxes; and •local, regional, national and worldwide economic conditions. Some of these factors can vary by region and may change quickly, adding to market volatility, while others may have longer-term effects. The longer-term effects of these and other factors on refining and marketing margins are uncertain. We purchase our crude oil and other refinery feedstocks weeks before we refine them and sell the refined products. Price level changes during the period between purchasing feedstocks and selling the refined products from these feedstocks can have a significant effect on our financial results. We also purchase refined products manufactured by others for resale to our customers. Price changes during the periods between purchasing and reselling those refined products can have a material and adverse effect on our business, financial condition, results of operations and cash flows.Lower refining and marketing margins have in the past, and may in the future, lead us to reduce the amount of refined products we produce, which may reduce our revenues, income from operations and cash flows. Significant reductions in refining and marketing margins could require us to reduce our capital expenditures, impair the carrying value of our assets (such as property, plant and equipment, inventory or goodwill), and require us to re-evaluate practices regarding our repurchase activity and dividends.Legal, technological, political and scientific developments regarding emissions and fuel efficiency may decrease demand for transportation fuels.Developments aimed at reducing greenhouse gas emissions or increasing vehicle efficiency may decrease the demand or increase the cost for our transportation fuels. In March 2020, the U.S. Environmental Protection Agency (the “EPA”) and the U.S. Department of Transportation’s National Highway Traffic Safety Administration (“NHTSA”) released the final Safer Affordable Fuel-Efficient (“SAFE”) Vehicles Rule setting corporate average fuel economy (“CAFE”) and carbon dioxide (“CO2”) standards for model years 2021 through 2026 passenger cars and light trucks. The final rule increases the stringency of CAFE and CO2 emission standards by 1.5 percent each year from model years 2021 through 2026. The rule has been challenged in court and could be revised by the Biden Administration through notice and comment rulemaking. In addition, California’s governor issued an executive order requiring sales of all new passenger vehicles in the state be zero-emission by 2035. Other states have, or may issue, zero-emission 21Table of Contentsvehicle mandates. Future developments involving climate change and environmental laws and regulations may require heightened fuel efficiency standards. Government efforts to steer the public toward non-petroleum-based fuel dependent modes of transportation may foster a negative perception toward transportation fuels or increase costs for our products. New technologies that increase fuel efficiency or offer alternative vehicle power sources and the proliferation of alternative-fuel vehicles (i.e., vehicles that do not use petroleum-based transportation fuels or that are powered by hybrid engines) may result in decreased demand for petroleum-based transportation fuel. These developments could have a material and adverse effect on our business, financial condition, results of operations and cash flows.Our operations are subject to business interruptions and casualty losses, which could materially and adversely affect our operations, financial condition, results of operations and cash flows.Our operations are subject to business interruptions, such as scheduled and unscheduled refinery turnarounds, unplanned maintenance, explosions, fires, refinery or pipeline releases, power outages, severe weather, labor disputes, acts of terrorism, or other natural or man-made disasters. The inability to operate one or more of our facilities due to any of these events could significantly impair our ability to manufacture our products. Explosions, fires, refinery or pipeline releases, product quality or other incidents may result in serious personal injury or loss of human life, significant damage to property and equipment, environmental pollution, impairment of operations and substantial losses to us. We have experienced certain of these incidents in the past. For assets located near populated areas, the level of damage resulting from these risks could be greater.In addition, we operate in and adjacent to environmentally sensitive waters where tanker, pipeline, rail car and refined product transportation and storage operations are closely regulated by federal, state and local agencies and monitored by environmental interest groups. Certain of our refineries receive crude oil and other feedstocks by tanker or barge. MPLX operates a fleet of boats and barges to transport light products, heavy oils, crude oil, renewable fuels, chemicals and feedstocks to and from refineries and terminals owned by MPC. Transportation and storage of crude oil, other feedstocks and refined products over and adjacent to water involves inherent risk and subjects us to the provisions of the OPA-90 and state laws in U.S. coastal and Great Lakes states and states bordering inland waterways on which we operate, as well as international laws in the jurisdictions in which we operate. If we are unable to promptly and adequately contain any accident or discharge involving tankers, pipelines, rail cars or above ground storage tanks transporting or storing crude oil, other feedstocks or refined products, we may be subject to substantial liability. In addition, the service providers contracted to aid us in a discharge response may be unavailable due to weather conditions, governmental regulations or other local or global events. Damages resulting from an incident involving any of our assets or operations may result in our being named as a defendant in one or more lawsuits asserting potentially substantial claims or in our being assessed potentially substantial fines by governmental authorities.We rely on the performance of our information technology systems, and the interruption or failure of any information technology system, including an interruption or failure due to a cybersecurity breach, could have an adverse effect on our business, financial condition, results of operations and cash flows.We are heavily dependent on our information technology systems (and those of our third-party business partners, whether cloud-based or hosted on proprietary servers), including our network infrastructure and cloud applications, for the safe and effective operation of our business. We rely on such systems to process, transmit and store electronic information, including financial records and personally identifiable information such as employee, customer, investor and payroll data, and to manage or support a variety of business processes, including our supply chain, pipeline operations, gathering and processing operations, retail sales, credit card payments and authorizations at our retail outlets, financial transactions, banking and numerous other processes and transactions. Our systems and infrastructure are subject to damage or interruption from a number of potential sources including natural disasters, malware, power failures, cyber-attacks and other events. We also face various other cybersecurity threats from criminal hackers and employee malfeasance, including threats to gain unauthorized access to our computer network and systems or render data or systems unusable. 22Table of ContentsOur cybersecurity protections, infrastructure protection technologies, disaster recovery plans and employee training may not be sufficient to defend us against all unauthorized attempts to access our information. We have been and may in the future be subject to attempts to gain unauthorized access to our computer network and systems. To date, the impacts of prior events have not had a material adverse effect on us.Any cybersecurity incident involving our information technology systems or those of our third-party business partners could result in theft, destruction, loss, misappropriation or release of confidential financial and other data, intellectual property, customer awards or loyalty points; give rise to remediation or other expenses; expose us to liability under federal and state laws; reduce our customers’ willingness to do business with us; disrupt the services we provide to customers; and subject us to litigation and legal liability under federal and state laws. Any of such results could have a material and adverse effect on our reputation, business, financial condition, results of operations and cash flows.Competition in our industry is intense, and very aggressive competition could adversely impact our business.We compete with a broad range of refining and marketing companies, including certain multinational oil companies. Competitors with integrated operations with exploration and production resources and broader access to resources may be better able to withstand volatile market conditions and to bear the risks inherent in the refining industry. For example, competitors that engage in exploration and production of crude oil may be better positioned to withstand periods of depressed refining margins or feedstock shortages.We have agreed to sell Speedway to 7-Eleven. Nevertheless, pending closing of the Speedway sale, which remains subject to customary closing conditions and the receipt of regulatory approvals, we still face strong competition in the market for the retail sale of transportation fuels and merchandise. Our competitors include outlets owned or operated by fully integrated major oil companies or their dealers or jobbers, and other well-recognized national or regional retail outlets, often selling transportation fuels and merchandise at very competitive prices. Non-traditional transportation fuel retailers, such as supermarkets, club stores and mass merchants, may be better able to withstand volatile market conditions or levels of low or no profitability in the retail segment of the market. These retailers may use promotional pricing or discounts, both at the pump and in the store, to encourage in-store merchandise sales, which could in turn pressure us to offer similar discounts. Additionally, the loss of market share by our convenience stores to these and other retailers relating to either transportation fuels or merchandise could have a material adverse effect on our business, financial condition, results of operations and cash flows.We are subject to interruptions of supply and increased costs as a result of our reliance on third-party transportation of crude oil and refined products.We utilize the services of third parties to transport crude oil and refined products to and from our refineries. In addition to our own operational risks, we could experience interruptions of supply or increases in costs to deliver refined products to market if the ability of the pipelines, railways or vessels to transport crude oil or refined products is disrupted because of weather events, accidents, governmental regulations or third-party actions. In particular, pipelines or railroads provide a nearly exclusive form of transportation of crude oil to, or refined products from, some of our refineries. A prolonged interruption, material reduction or cessation of service of such a pipeline or railway, whether due to private party or governmental action or other reason, or any other prolonged disruption of the ability of the trucks, pipelines, railways or vessels to transport crude oil or refined products to or from one or more of our refineries, could have a material adverse effect on our business, financial condition, results of operations and cash flows.A significant decrease in oil and natural gas production in MPLX’s areas of operation may adversely affect MPLX’s business, financial condition, results of operations and cash available for distribution to its unitholders, including MPC.A significant portion of MPLX’s operations is dependent on the continued availability of natural gas and crude oil production. The production from oil and natural gas reserves and wells owned by its producer customers will naturally decline over time, which means that MPLX’s cash flows associated with these wells will also decline over time. To maintain or increase throughput levels and the utilization rate of MPLX’s facilities, MPLX must continually obtain new oil, natural gas, NGL and refined product supplies, which depend in part on the level of successful drilling activity near its facilities, its ability to compete for volumes from successful new wells and its ability to expand its system capacity as needed.23Table of ContentsWe have no control over the level of drilling activity in the areas of MPLX’s operations, the amount of reserves associated with the wells or the rate at which production from a well will decline. In addition, we have no control over producers or their production decisions, which are affected by demand, prevailing and projected energy prices, drilling costs, operational challenges, access to downstream markets, the level of reserves, geological considerations, governmental regulations and the availability and cost of capital. Reductions in exploration or production activity in MPLX’s areas of operations could lead to reduced throughput on its pipelines and utilization rates of its facilities.Decreases in energy prices can decrease drilling activity, production rates and investments by third parties in the development of new oil and natural gas reserves. The prices for oil, natural gas and NGLs depend upon factors beyond our control, including global and local demand, production levels, changes in interstate pipeline gas quality specifications, imports and exports, seasonality and weather conditions, economic and political conditions domestically and internationally and governmental regulations. Sustained periods of low prices could result in producers deciding to limit their oil and gas drilling operations, which could substantially delay the production and delivery of volumes of oil, natural gas and NGLs to MPLX’s facilities and adversely affect their revenues and cash available for distribution to us. This impact may also be exacerbated due to the extent of MPLX’s commodity-based contracts, which are more directly impacted by changes in natural gas and NGL prices than its fee-based contracts due to frac spread exposure and may result in operating losses when natural gas becomes more expensive on a Btu equivalent basis than NGL products. In addition, the purchase and resale of natural gas and NGLs in the ordinary course exposes our Midstream operations to volatility in natural gas or NGL prices due to the potential difference in the time of the purchases and sales and the potential difference in the price associated with each transaction, and direct exposure may also occur naturally as a result of production processes. Also, the significant volatility in natural gas, NGL and oil prices could adversely impact MPLX’s unit price, thereby increasing its distribution yield and cost of capital. Such impacts could adversely impact MPLX’s ability to execute its long‑term organic growth projects, satisfy obligations to its customers and make distributions to unitholders at intended levels, and may also result in non-cash impairments of long-lived assets or goodwill or other-than-temporary non-cash impairments of our equity method investments.Severe weather events and other climate conditions may adversely affect our facilities and ongoing operations.Our facilities are subject to potential acute physical risks, such as floods, hurricane-force winds, wildfires and snowstorms, and potential chronic physical risks, such as sea-level rise or water shortages. If any such events were to occur, they could have an adverse effect on our assets and operations. We have incurred and will continue to incur additional costs to protect our assets and operations from such physical risks and employ the evolving technologies and processes available to mitigate such risks. To the extent such severe weather events or other climate conditions increase in frequency and severity, we may be required to modify operations and incur costs that could materially and adversely affect our business, financial condition, results of operations and cash flows.We are subject to risks arising from our operations outside the United States and generally to worldwide political and economic developments.We operate and sell some of our products outside the United States, particularly in Mexico, South America and Asia. Our business, financial condition, results of operations and cash flows could be negatively impacted by disruptions in any of these markets, including economic instability, restrictions on the transfer of funds, duties and tariffs, transportation delays, difficulty in enforcing contractual provisions, import and export controls, changes in governmental policies, labor unrest, security issues involving key personnel and changing regulatory and political environments. Global outbreaks of infectious diseases, such as the current COVID-19 pandemic, could affect demand for refined products and economic conditions generally. In addition, if trade relationships deteriorate with these countries, if existing trade agreements are modified or terminated, if new economic sanctions relevant to such jurisdictions are passed or if taxes, border adjustments or tariffs make trading with these countries more costly, it could have a material adverse effect on our business, financial condition, results of operations and cash flows.We are required to comply with U.S. and international laws and regulations, including those involving anti-bribery, anti-corruption and anti-money laundering. For example, the Foreign Corrupt Practices Act and similar laws and regulations prohibit improper payments to foreign officials for the purpose of obtaining or retaining business or gaining any business advantage. Our compliance policies and programs mandate 24Table of Contentscompliance with all applicable anti-corruption laws but may not be completely effective in ensuring our compliance. Our training and compliance program and our internal control policies and procedures may not always protect us from violations committed by our employees or agents. Actual or alleged violations of these laws could disrupt our business and cause us to incur significant legal expenses, and could result in a material adverse effect on our reputation, business, financial condition, results of operations and cash flows.More broadly, political and economic factors in global markets could impact crude oil and other feedstock supplies and could have a material adverse effect on us in other ways. Hostilities in the Middle East or the occurrence or threat of future terrorist attacks could adversely affect the economies of the U.S. and other developed countries. A lower level of economic activity could result in a decline in energy consumption, which could cause our revenues and margins to decline and limit our future growth prospects. These risks could lead to increased volatility in prices for refined products, NGLs and natural gas. Additionally, these risks could increase instability in the financial and insurance markets and make it more difficult or costly for us to access capital and to obtain the insurance coverage that we consider adequate. Additionally, tax policy, legislative or regulatory action and commercial restrictions could reduce our operating profitability. For example, the U.S. government could prevent or restrict exports of refined products, NGLs, natural gas or the conduct of business in or with certain foreign countries. In addition, foreign countries could restrict imports, investments or commercial transactions.Our investments in joint ventures could be adversely affected by our reliance on our joint venture partners and their financial condition, and our joint venture partners may have interests or goals that are inconsistent with ours.We conduct some of our operations through joint ventures in which we share control over certain economic and business interests with our joint venture partners. Our joint venture partners may have economic, business or legal interests or goals that are inconsistent with our goals and interests or may be unable to meet their obligations. Failure by us, or an entity in which we have an interest, to adequately manage the risks associated with any acquisitions or joint ventures could have a material adverse effect on the financial condition or results of operations of our joint ventures and adversely affect our reputation, business, financial condition, results of operations and cash flows.Terrorist attacks aimed at our facilities or that impact our customers or the markets we serve could adversely affect our business.Refining, gathering and processing, pipeline and terminal infrastructure, and other energy assets, may be future targets of terrorist organizations. Any terrorist attack on our facilities, those of our customers and, in some cases, those of other energy assets, could have a material adverse effect on our business. Similarly, any future terrorist attacks that severely disrupt the markets we serve could materially and adversely affect our results of operations, financial position and cash flows.Financial RisksWe have significant debt obligations; therefore, our business, financial condition, results of operations and cash flows could be harmed by a deterioration of our credit profile or downgrade of our credit ratings, a decrease in debt capacity or unsecured commercial credit available to us, or by factors adversely affecting credit markets generally.At December 31, 2020, our total debt obligations for borrowed money and finance lease obligations were $32.17 billion, including $20.54 billion of obligations of MPLX and its subsidiaries and $130 million of obligations of Speedway. We may incur substantial additional debt obligations in the future.Our indebtedness may impose various restrictions and covenants on us that could have material adverse consequences, including:•increasing our vulnerability to changing economic, regulatory and industry conditions; •limiting our ability to compete and our flexibility in planning for, or reacting to, changes in our business and the industry; •limiting our ability to pay dividends to our stockholders; •limiting our ability to borrow additional funds; and •requiring us to dedicate a substantial portion of our cash flow from operations to payments on our debt, thereby reducing funds available for working capital, capital expenditures, acquisitions, share repurchases, dividends and other purposes. 25Table of ContentsA decrease in our debt or commercial credit capacity, including unsecured credit extended by third-party suppliers, or a deterioration in our credit profile could increase our costs of borrowing money and limit our access to the capital markets and commercial credit. Our credit rating is determined by independent credit rating agencies. We cannot provide assurance that any of our credit ratings will remain in effect for any given period of time or that a rating will not be lowered or withdrawn entirely by a rating agency if, in its judgment, circumstances so warrant. The planned Speedway sale could be a factor causing or contributing to a future determination by one or more of the rating agencies to lower our credit rating. Any changes in our credit capacity or credit profile could materially and adversely affect our business, financial condition, results of operations and cash flows.We have a trade receivables securitization facility that provides liquidity of up to $750 million depending on the amount of eligible domestic trade accounts receivables outstanding. In periods of lower prices, we may not have sufficient eligible accounts receivables to support full availability of this facility.Our working capital, cash flows and liquidity can be significantly affected by decreases in commodity prices.Payment terms for our crude oil purchases are generally longer than the terms we extend to our customers for refined product sales. As a result, the payables for our crude oil purchases are proportionally larger than the receivables for our refined product sales. Due to this net payables position, a decrease in commodity prices generally results in a use of working capital, and given the significant volume of crude oil that we purchase the impact can materially affect our working capital, cash flows and liquidity. The expected phase out of LIBOR could impact the interest rates paid on our variable rate indebtedness and could cause our interest expense to increase. A portion of our borrowing capacity and outstanding indebtedness bears interest at a variable rate based on LIBOR. The ICE Benchmark Administration Limited (“ICE”) announced that it will cease calculating and publishing all USD LIBOR tenors on June 30, 2023 and cease calculating and publishing certain USD LIBOR tenors on December 31, 2021. Further, U.K. and U.S. regulatory authorities have recently issued statements encouraging banks to cease entering into new USD LIBOR based loans as soon as possible and by no later than December 31, 2021 and to continue to transition away from USD LIBOR based loans in preparation of ICE ceasing to calculate and public LIBOR based rates on June 30, 2023. These developments may cause fluctuations in LIBOR rates and pricing of USD LIBOR based loans that are not transitioned to a new benchmark rate. The agreements that govern our variable rate indebtedness contain customary transition and fallback provisions in contemplation of the cessation of LIBOR. Nevertheless, at this time, it is not possible to predict the effect that these developments, any discontinuance, modification or other reforms to LIBOR or any other reference rate, or the establishment of alternative reference rates may have on LIBOR, other benchmarks or floating rate indebtedness. Uncertainty as to the nature of such potential discontinuance, modification, alternative reference rates or other reforms may materially adversely affect the trading market for securities linked to such benchmarks. Furthermore, the use of alternative reference rates or other reforms could cause the market value of, the applicable interest rate on and the amount of interest paid on our floating rate indebtedness to be materially different than expected and could materially adversely impact our ability to refinance such floating rate indebtedness or raise future indebtedness on a cost effective basis.We may incur losses and additional costs as a result of our forward-contract activities and derivative transactions.We currently use commodity derivative instruments, and we expect to continue their use in the future. If the instruments we use to hedge our exposure to various types of risk are not effective, we may incur losses. Derivative transactions involve the risk that counterparties may be unable to satisfy their obligations to us. The risk of counterparty default is heightened in a poor economic environment. In addition, we may be required to incur additional costs in connection with future regulation of derivative instruments to the extent it is applicable to us.We do not insure against all potential losses, and, therefore, our business, financial condition, results of operations and cash flows could be adversely affected by unexpected liabilities and increased costs.We maintain insurance coverage in amounts we believe to be prudent against many, but not all, potential liabilities arising from operating hazards. Uninsured liabilities arising from operating hazards such as explosions, fires, refinery or pipeline releases, cybersecurity breaches or other incidents involving our 26Table of Contentsassets or operations, could reduce the funds available to us for capital and investment spending and could have a material adverse effect on our business, financial condition, results of operations and cash flows. Historically, we also have maintained insurance coverage for physical damage and resulting business interruption to our major facilities, with significant self-insured retentions. In the future, we may not be able to maintain insurance of the types and amounts we desire at reasonable rates.We have recorded goodwill and other intangible assets that could become further impaired and result in material non-cash charges to our results of operations.We accounted for the Andeavor and other acquisitions using the acquisition method of accounting, which requires that the assets and liabilities of the acquired business be recorded to our balance sheet at their respective fair values as of the acquisition date. Any excess of the purchase consideration over the fair value of the acquired net assets is recognized as goodwill.As of December 31, 2020, our balance sheet reflected $8.3 billion and $2.4 billion of goodwill and other intangible assets, respectively. In 2020, we recorded approximately $7.4 billion and $177 million in goodwill and other intangible asset impairment expense, respectively. To the extent the value of goodwill or intangible assets becomes further impaired, we may be required to incur additional material non-cash charges relating to such impairment. Our operating results may be significantly impacted from both the impairment and the underlying trends in the business that triggered the impairment.Large capital projects can take years to complete, and market conditions could deteriorate significantly between the project approval date and the project startup date, negatively impacting project returns. We have several large capital projects underway, including the activities associated with the conversion of the Martinez refinery to a renewable diesel facility. Delays in completing capital projects or making required changes or upgrades to our facilities could subject us to fines or penalties as well as affect our ability to supply certain products we produce. Such delays or cost increases may arise as a result of unpredictable factors, many of which are beyond our control, including:•denials of, delays in receiving, or revocations of requisite regulatory approvals or permits;•unplanned increases in the cost of construction materials or labor;•disruptions in transportation of components or construction materials;•adverse weather conditions, natural disasters or other events (such as equipment malfunctions, explosions, fires or spills) affecting our facilities, or those of vendors or suppliers;•shortages of sufficiently skilled labor, or labor disagreements resulting in unplanned work stoppages;•market-related increases in a project’s debt or equity financing costs; •nonperformance by, or disputes with, vendors, suppliers, contractors or subcontractors; and•delays due to citizen, state or local political or activist pressure.Any one or more of these factors could have a significant impact on our ongoing capital projects. If we were unable to make up the delays associated with such factors or to recover the related costs, or if market conditions change, it could materially and adversely affect our business, financial condition, results of operations and cash flows.Legal and Regulatory RisksWe expect to continue to incur substantial capital expenditures and operating costs to meet the requirements of evolving environmental or other laws or regulations. Future environmental laws and regulations may impact our current business plans and reduce demand for our products.Our business is subject to numerous environmental laws and regulations. These laws and regulations continue to increase in both number and complexity and affect our business. Laws and regulations expected to become more stringent relate to the following:•the emission or discharge of materials into the environment,•solid and hazardous waste management,•the regulatory classification of materials currently or formerly used in our business,•pollution prevention,•greenhouse gas emissions,•climate change,27Table of Contents•characteristics and composition of transportation fuels, including the quantity of renewable fuels that must be blended into transportation fuels,•public and employee safety and health, •permitting,•inherently safer technology, and•facility security.The specific impact of laws and regulations, and their enforcement, on us and our competitors may vary depending on a number of factors, including the age and location of operating facilities, marketing areas, crude oil and feedstock sources, production processes and subsequent judicial interpretation of such laws and regulations. We have incurred and will continue to incur substantial capital, operating and maintenance, and remediation expenditures to modify operations, install pollution control equipment, perform site cleanups or curtail operations. We may also face liability for personal injury, property damage, natural resource damage or clean-up costs due to alleged contamination and/or exposure to chemicals or other regulated materials, such as various perfluorinated compounds, including perfluorooctanoate, perfluorooctane sulfonate, perfluorohexane sulfonate, or other per-and polyfluoroalkyl substances, benzene, MTBE and petroleum hydrocarbons, at or from our facilities. Such expenditures could materially and adversely affect our business, financial condition, results of operations and cash flows.Increased regulation of hydraulic fracturing and other oil and gas production activities could result in reductions or delays in U.S. production of crude oil and natural gas, which could adversely affect our results of operations and financial condition.While we do not conduct hydraulic fracturing operations, we do provide gathering, processing and fractionation services with respect to natural gas and natural gas liquids produced by our customers as a result of such operations. Our refineries are also supplied in part with crude oil produced from unconventional oil shale reservoirs. A range of federal, state and local laws and regulations currently govern or, in some cases, prohibit, hydraulic fracturing in some jurisdictions. Stricter laws, regulations and permitting processes may be enacted in the future. For example, President Biden has suspended new oil and gas permitting on public lands and properties, and has proposed modifying royalties to account for climate costs. If these or other federal, state and local legislation and regulatory initiatives relating to hydraulic fracturing or other oil and gas production activities are enacted or expanded, such efforts could impede oil and gas production, increase producers’ cost of compliance, and result in reduced volumes available for our midstream assets to gather, process and fractionate.Climate change and greenhouse gas emission regulation could affect our operations, energy consumption patterns and regulatory obligations, any of which could affect our results of operations and financial condition.Currently, multiple legislative and regulatory measures to address greenhouse gas (including carbon dioxide, methane and nitrous oxides) and other emissions are in various phases of consideration, promulgation or implementation. These include actions to develop international, federal, regional or statewide programs, which could require reductions in our greenhouse gas or other emissions, establish a carbon tax and decrease the demand for refined products. Requiring reductions in these emissions could result in increased costs to (i) operate and maintain our facilities, (ii) install new emission controls at our facilities and (iii) administer and manage any emissions programs, including acquiring emission credits or allotments.For example, in 2017, the California state legislature adopted AB 398, which provides direction and parameters on utilizing cap and trade after 2020 to meet the 40 percent reduction target from 1990 levels by 2030 specified in SB 32. Compliance with the cap and trade program is demonstrated through a market-based credit system. Additionally, the CARB is now exploring the potential for additional greenhouse gas reductions by 2045 via a yet undefined carbon neutrality standard. Other states are proposing, or have already promulgated, low carbon fuel standards or similar initiatives to reduce emissions from the transportation sector. If we are unable to pass the costs of compliance on to our customers, sufficient credits are unavailable for purchase, we have to pay a significantly higher price for credits, or if we are otherwise unable to meet our compliance obligation, our financial condition and results of operations could be adversely affected.Regional and state climate change and air emissions goals and regulatory programs are complex, subject to change and considerable uncertainty due to a number of factors including technological feasibility, legal challenges and potential changes in federal policy. Increasing concerns about climate change and carbon 28Table of Contentsintensity have also resulted in societal concerns and a number of international and national measures to limit greenhouse gas emissions. Additional stricter measures and investor pressure can be expected in the future and any of these changes may have a material adverse impact on our business or financial condition.International climate change-related efforts, such as the 2015 United Nations Conference on Climate Change, which led to the creation of the Paris Agreement, may impact the regulatory framework of states whose policies directly influence our present and future operations. Though the United States had withdrawn from the Paris Agreement, President Biden issued an executive order recommitting the United States to the Paris Agreement on January 20, 2021. President Biden also issued an Executive Order on climate change in which he announced putting the U.S. on a path to achieve net-zero carbon emissions, economy-wide, by 2050. The Executive Order also calls for the federal government to pause oil and gas leasing on federal lands, reduce methane emissions from the oil and gas sector as quickly as possible, and requires federal permitting decisions to consider the effects of greenhouse gas emissions and climate change. In a second Executive Order, President Biden reestablished a working group to develop the social cost of carbon and the social cost of methane. The social cost of carbon and social cost of methane can be used to weigh the costs and benefits of proposed regulations. A higher social cost of carbon could support more stringent greenhouse gas emission regulation.The scope and magnitude of the changes to U.S. climate change strategy under the Biden administration and future administrations, however, remain subject to the passage of legislation and interpretation and action of federal and state regulatory bodies; therefore, the impact to our industry and operations due to greenhouse gas regulation is unknown at this time.Energy assets and companies are subject to increasing environmental and climate-related litigation. Governmental and other entities in various U.S. states have filed lawsuits against coal, gas, oil and petroleum companies, including us. The lawsuits allege damages as a result of climate change and the plaintiffs are seeking unspecified damages and abatement under various tort theories. Similar lawsuits may be filed in other jurisdictions. Additionally, private plaintiffs and government parties have undertaken efforts to shut down energy assets by challenging operating permits, the validity of easements or the compliance with easement conditions. For example, the Dakota Access Pipeline, in which MPLX has a minority interest, has been subject to litigation in which plaintiffs have challenged the validity of an easement necessary for the operation of the pipeline and demanded a permanent shutdown of the pipeline. There remains a high degree of uncertainty regarding the ultimate outcome of these types of proceedings, as well as their potential effect on our business, financial condition, results of operation and cash flows.We are subject to risks associated with societal and political pressures and other forms of opposition to the development, transportation and use of carbon-based fuels. Such risks could adversely impact our business and ability to realize certain growth strategies.We operate and develop our business with the expectation that regulations and societal sentiment will continue to enable the development, transportation and use of carbon-based fuels. However, policy decisions relating to the production, refining, transportation, storage and marketing of carbon-based fuels are subject to political pressures and the influence and protests of environmental and other special interest groups. The approval process for storage and transportation projects has become increasingly challenging, due in part to state and local concerns related to pipelines, negative public perception regarding the oil and gas industry, and concerns regarding greenhouse gas emissions downstream of pipeline operations. In addition, government disruptions may delay or halt the granting and renewal of permits, licenses and other items required by us and our customers to conduct our business. Our expansion or construction projects may not be completed on schedule (or at all), or at the budgeted cost. We also may be required to incur additional costs and expenses in connection with the design and installation of our facilities due to their location and the surrounding terrain. We may be required to install additional facilities, incur additional capital and operating expenditures, or experience interruptions in or impairments of our operations to the extent that the facilities are not designed or installed correctly. Moreover, our revenues may not increase immediately upon the expenditure of funds on a particular project. For instance, if we build a new pipeline, the construction will occur over an extended period of time and we may not receive any material increases in revenues until after completion of the project, if at all. Delays or cost increases related to capital spending programs involving engineering, procurement and construction of facilities (including improvements and repairs to our existing facilities) could adversely 29Table of Contentsaffect our ability to achieve forecasted internal rates of return and operating results, thereby limiting our ability to grow and generate cash flows.Regulatory and other requirements concerning the transportation of crude oil and other commodities by rail may cause increases in transportation costs or limit the amount of crude oil that we can transport by rail.We rely on a variety of systems to transport crude oil, including rail. Rail transportation is regulated by federal, state and local authorities. New regulations or changes in existing regulations could result in increased compliance expenditures. For example, in 2015, the U.S. Department of Transportation issued new standards and regulations applicable to crude-by-rail transportation (Enhanced Tank Car Standards and Operational Controls for High-Hazard Flammable Trains). These or other regulations that require the reduction of volatile or flammable constituents in crude oil that is transported by rail, change the design or standards for rail cars used to transport the crude oil we purchase, change the routing or scheduling of trains carrying crude oil, or require any other changes that detrimentally affect the economics of delivering North American crude oil by rail could increase the time required to move crude oil from production areas to our refineries, increase the cost of rail transportation and decrease the efficiency of shipments of crude oil by rail within our operations. Any of these outcomes could have a material adverse effect on our business and results of operations.Historic or current operations could subject us to significant legal liability or restrict our ability to operate.We currently are defending litigation and anticipate we will be required to defend new litigation in the future. Our operations, including those of MPLX, and those of our predecessors could expose us to litigation and civil claims by private plaintiffs for alleged damages related to contamination of the environment or personal injuries caused by releases of hazardous substances from our facilities, products liability, consumer credit or privacy laws, product pricing or antitrust laws or any other laws or regulations that apply to our operations. While an adverse outcome in most litigation matters would not be expected to be material to us, in class-action litigation, large classes of plaintiffs may allege damages relating to extended periods of time or other alleged facts and circumstances that could increase the amount of potential damages. Attorneys general and other government officials have in the past and may in the future pursue litigation in which they seek to recover civil damages from companies on behalf of a state or its citizens for a variety of claims, including violation of consumer protection and product pricing laws or natural resources damages. We are defending litigation of that type and anticipate that we will be required to defend new litigation of that type in the future. If we are not able to successfully defend such litigation, it may result in liability to our company that could materially and adversely affect our business, financial condition, results of operations and cash flows. In addition to substantial liability, plaintiffs in litigation may also seek injunctive relief which, if imposed, could have a material adverse effect on our future business, financial condition, results of operations and cash flows.A portion of our workforce is unionized, and we may face labor disruptions that could materially and adversely affect our business, financial condition, results of operations and cash flows.Approximately 3,771 of our employees are covered by collective bargaining agreements. Of these employees, approximately 192 employees at our St. Paul Park refinery are covered by a collective bargaining agreement which expired on December 31, 2020. Approximately 231 employees at our El Paso refinery are covered by a collective bargaining agreement scheduled to expire in April 2021. Approximately 2,390 employees at our Anacortes, Canton, Catlettsburg, Galveston Bay, Los Angeles, Mandan, Martinez and Salt Lake City refineries are covered by collective bargaining agreements that are due to expire on February 1, 2022. The remaining 958 hourly represented employees are covered by collective bargaining agreements with expiration dates ranging from 2021 to 2024. These agreements may be renewed at an increased cost to us. In addition, we have experienced in the past, and may experience in the future, work stoppages as a result of labor disagreements. For example, approximately 192 workers at our St. Paul Park refinery have been on strike since January 21, 2021. Any prolonged work stoppages disrupting operations could have a material adverse effect on our business, financial condition, results of operations and cash flows.In addition, California requires refinery owners to pay prevailing wages to contract craft workers and restricts refiners’ ability to hire qualified employees to a limited pool of applicants. Legislation or changes in regulations could result in labor shortages, higher labor costs, and an increased risk that contract workers become joint employees, which could trigger bargaining issues, and wage and benefit consequences, especially during critical maintenance and construction periods.30Table of ContentsOne of our subsidiaries acts as the general partner of a master limited partnership, which may expose us to certain legal liabilities.One of our subsidiaries acts as the general partner of MPLX, a master limited partnership. Our control of the general partner of MPLX may increase the possibility of claims of breach of fiduciary duties, including claims of conflicts of interest. Any liability resulting from such claims could have a material adverse effect on our future business, financial condition, results of operations and cash flows.If foreign investment in us or MPLX exceeds certain levels, MPLX could be prohibited from operating inland river vessels, which could adversely affect MPLX’s business, financial condition, results of operations and cash available for distribution to its unitholders, including MPC.The Shipping Act of 1916 and Merchant Marine Act of 1920 (collectively, the “Maritime Laws”), generally require that vessels engaged in U.S. coastwise trade be owned by U.S. citizens. Among other requirements to establish citizenship, entities that own such vessels must be owned at least 75 percent by U.S. citizens. If we fail to maintain compliance with the Maritime Laws, MPLX would be prohibited from operating vessels in the U.S. inland waters. Such a prohibition could materially and adversely affect our business, financial condition, results of operations and cash flows.Our operations could be disrupted if we are unable to maintain or obtain real property rights required for our business.We do not own all of the land on which certain of our assets are located, particularly our midstream assets, but rather obtain the rights to construct and operate such assets on land owned by third parties and governmental agencies for a specific period of time. Therefore, we are subject to the possibility of more burdensome terms and increased costs to retain necessary land use if our leases, rights-of-way or other property rights lapse, terminate or are reduced or it is determined that we do not have valid leases, rights-of-way or other property rights. Any loss of or reduction in these rights, including loss or reduction due to legal, governmental or other actions or difficulty renewing leases, right-of-way agreements or permits on satisfactory terms or at all, could have a material adverse effect on our business, financial condition, results of operations and cash flows.Certain of our facilities are located on Native American tribal lands and are subject to various federal and tribal approvals and regulations, which may increase our costs and delay or prevent our efforts to conduct planned operations.Various federal agencies within the U.S. Department of the Interior, particularly the Bureau of Indian Affairs, Bureau of Land Management, and the Office of Natural Resources Revenue, along with each Native American tribe, regulate natural gas and oil operations on Native American tribal lands, including drilling and production requirements and environmental standards. In addition, each Native American tribe is a sovereign nation having the right to enforce laws and regulations and to grant approvals independent from federal, state and local statutes and regulations. These tribal laws and regulations include various taxes, fees, requirements to employ Native American tribal members and other conditions that apply to operators and contractors conducting operations on Native American tribal lands. Persons conducting operations on tribal lands are generally subject to the Native American tribal court system. In addition, if our relationships with any of the relevant Native American tribes were to deteriorate, we could face significant risks to our ability to continue operations on Native American tribal lands. One or more of these factors may increase our cost of doing business on Native American tribal lands and impact the viability of, or prevent or delay our ability to conduct operations on such lands.The Court of Chancery of the State of Delaware will be, to the extent permitted by law, the sole and exclusive forum for substantially all disputes between us and our shareholders. Our Restated Certificate of Incorporation provides that the Court of Chancery of the State of Delaware will be the sole and exclusive forum for:•any derivative action or proceeding brought on behalf of MPC;•any action asserting a claim of breach of a fiduciary duty owed by any director or officer of MPC to MPC or its stockholders•any action asserting a claim against MPC arising pursuant to any provision of the General Corporation Law of the State of Delaware, MPC’s Restated Certificate of Incorporation, any Preferred Stock Designation or the Bylaws of MPC; or•any other action asserting a claim against MPC or any Director or officer of MPC that is governed by or subject to the internal affairs doctrine for choice of law purposes.31Table of ContentsThe forum selection provision may restrict a stockholder’s ability to bring a claim against us or directors or officers of MPC in a forum that it finds favorable, which may discourage stockholders from bringing such claims at all. Alternatively, if a court were to find the forum selection provision contained in our Restated Certificate of Incorporation to be inapplicable or unenforceable in an action, we may incur additional costs associated with resolving such action in another forum, which could materially adversely affect our business, financial condition and results of operations. However, the forum selection provision does not apply to any claims, actions or proceedings arising under the Securities Act or the Exchange Act.Provisions in our corporate governance documents could operate to delay or prevent a change in control of our company, dilute the voting power or reduce the value of our capital stock or affect its liquidity.The existence of some provisions within our restated certificate of incorporation and amended and restated bylaws could discourage, delay or prevent a change in control of us that a stockholder may consider favorable. These include provisions:•providing that our board of directors fixes the number of members of the board; •providing for the division of our board of directors into three classes with staggered terms; •providing that only our board of directors may fill board vacancies; •limiting who may call special meetings of stockholders; •prohibiting stockholder action by written consent, thereby requiring stockholder action to be taken at a meeting of the stockholders; •establishing advance notice requirements for nominations of candidates for election to our board of directors or for proposing matters that can be acted on by stockholders at stockholder meetings; •establishing supermajority vote requirements for certain amendments to our restated certificate of incorporation; •providing that our directors may only be removed for cause; •authorizing a large number of shares of common stock that are not yet issued, which would allow our board of directors to issue shares to persons friendly to current management, thereby protecting the continuity of our management, or which could be used to dilute the stock ownership of persons seeking to obtain control of us; and •authorizing the issuance of “blank check” preferred stock, which could be issued by our board of directors to increase the number of outstanding shares and thwart a takeover attempt. Our restated certificate of incorporation also authorizes us to issue, without the approval of our stockholders, one or more classes or series of preferred stock having such designation, powers, preferences and relative, participating, optional and other special rights, including preferences over our common stock respecting dividends and distributions, as our board of directors generally may determine. The terms of one or more classes or series of preferred stock could dilute the voting power or reduce the value of our common stock. For example, we could grant holders of preferred stock the right to elect some number of our board of directors in all events or on the happening of specified events or the right to veto specified transactions. Similarly, the repurchase or redemption rights or liquidation preferences we could assign to holders of preferred stock could affect the residual value of our common stock.Finally, to facilitate compliance with the Maritime Laws, our restated certificate of incorporation limits the aggregate percentage ownership by non-U.S. citizens of our common stock or any other class of our capital stock to 23 percent of the outstanding shares. We may prohibit transfers that would cause ownership of our common stock or any other class of our capital stock by non-U.S. citizens to exceed 23 percent. Our restated certificate of incorporation also authorizes us to effect any and all measures necessary or desirable to monitor and limit foreign ownership of our common stock or any other class of our capital stock. These limitations could have an adverse impact on the liquidity of the market for our common stock if holders are unable to transfer shares to non-U.S. citizens due to the limitations on ownership by non-U.S. citizens. Any such limitation on the liquidity of the market for our common stock could adversely impact the market price of our common stock.32Table of ContentsStrategic Transaction Risks Our pending sale of Speedway to 7-Eleven is subject to conditions, including certain conditions that may not be satisfied or completed on a timely basis, if at all. Failure to complete the Speedway sale could have a material and adverse effect on us. Even if completed, the Speedway sale may not achieve the intended benefits.We have announced our agreement to sell Speedway, our company-owned and operated retail transportation fuel and convenience store business, to 7-Eleven. The sale, which is targeted for completion in the first quarter of 2021, is subject to customary conditions. We and 7-Eleven may be unable to satisfy such conditions to the closing of the sale in a timely manner or at all and, accordingly, the Speedway sale may be delayed or may not be completed. Failure to complete the Speedway sale could have a material and adverse effect on us, including by delaying our strategic and other objectives relating to the separation of Speedway and adversely affecting our plans to use the proceeds from the sale to strengthen our balance sheet and return capital to our shareholders. Even if the sale is completed, we may not realize some or all the expected benefits. For example, we may be unable to utilize the proceeds from the sale as anticipated or capture the value we expect from our plans to strengthen our balance sheet and return capital to our shareholders. Executing the Speedway sale will require significant time and attention from management, which could divert attention from the management of our operations and the pursuit of our business strategies. If the proposed Speedway sale is completed, our diversification of revenue sources will diminish, and it is possible that our business, financial condition, results of operations and cash flows may be subject to increased volatility as a result.General Risk FactorsSignificant stockholders may attempt to effect changes at our company or acquire control over our company, which could impact the pursuit of business strategies and adversely affect our results of operations and financial condition.Our stockholders may from time to time engage in proxy solicitations, advance stockholder proposals or otherwise attempt to effect changes or acquire control over our company. Campaigns by stockholders to effect changes at publicly traded companies are sometimes led by investors seeking to increase short-term stockholder value through actions such as financial restructuring, increased debt, special dividends, stock repurchases or sales of assets or the entire company. Responding to proxy contests and other actions by activist stockholders can be costly and time-consuming and could divert the attention of our board of directors and senior management from the management of our operations and the pursuit of our business strategies. As a result, stockholder campaigns could adversely affect our results of operations and financial condition.Future acquisitions will involve the integration of new assets or businesses and may present substantial risks that could adversely affect our business, financial conditions, results of operations and cash flows.Future transactions involving the addition of new assets or businesses will present potential risks, which may include, among others:•inaccurate assumptions about future synergies, revenues, capital expenditures and operating costs;•an inability to successfully integrate, or a delay in the successful integration of, assets or businesses we acquire;•a decrease in our liquidity resulting from using a portion of our available cash or borrowing capacity under our revolving credit agreement to finance transactions;•a significant increase in our interest expense or financial leverage if we incur additional debt to finance transactions;•the assumption of unknown environmental and other liabilities, losses or costs for which we are not indemnified or for which our indemnity is inadequate;•the diversion of management’s attention from other business concerns; •the loss of customers or key employees from the acquired business; and•the incurrence of other significant charges, such as impairment of goodwill or other intangible assets, asset devaluation or restructuring charges.33Table of ContentsCompliance with and changes in tax laws could materially and adversely impact our financial condition, results of operations and cash flows.We are subject to extensive tax liabilities, including federal and state income taxes and transactional taxes such as excise, sales and use, payroll, franchise, withholding and property taxes. New tax laws and regulations and changes in existing tax laws and regulations could result in increased expenditures by us for tax liabilities in the future and could materially and adversely impact our financial condition, results of operations and cash flows.Additionally, many tax liabilities are subject to periodic audits by taxing authorities, and such audits could subject us to interest and penalties.ITEM 1B. UNRESOLVED STAFF COMMENTSNone.ITEM 2. PROPERTIES We believe that our properties and facilities are adequate for our operations and that our facilities are adequately maintained. See the following sections for details of our assets by segment.REFINING & MARKETINGThe table below sets forth the location and crude oil refining capacity for each of our refineries as of December 31, 2020. Refining throughput can exceed crude oil refining capacity due to the processing of other charge and blendstocks in addition to crude oil and the timing of planned turnaround and major maintenance activity.RefineryCrude Oil Refining Capacity (mbpcd)Gulf Coast RegionGalveston Bay, Texas City, Texas593 Garyville, Louisiana578 Subtotal Gulf Coast region1,171 Mid-Continent RegionCatlettsburg, Kentucky291 Robinson, Illinois253 Detroit, Michigan140 El Paso, Texas131 St. Paul Park, Minnesota104 Canton, Ohio97 Mandan, North Dakota71 Salt Lake City, Utah66 Subtotal Mid-Continent region1,153 West Coast RegionLos Angeles, California363 Anacortes, Washington119 Kenai, Alaska68 Subtotal West Coast region550 2,874 34Table of ContentsThe following table sets forth the location and capacity of our renewable fuel production facilities as of December 31, 2020.LocationCapacity (gallons per year)Dickinson, North Dakota184 millionCincinnati, Ohio91 millionThe company also progressed activities associated with the conversion of the Martinez refinery to a renewable diesel facility. The full capacity of the Martinez facility would be approximately 730 million gallons per year. 35Table of ContentsThe following table sets forth the approximate number of locations where jobbers maintain branded outlets, marketing fuels under the Marathon, Shell, ARCO, Mobil, Tesoro and other brands, as of December 31, 2020.LocationNumber ofBranded OutletsAlabama392 Alaska44 Arizona95 California98 Colorado12 District of Columbia2 Florida668 Georgia365 Idaho100 Illinois201 Indiana642 Iowa4 Kentucky515 Louisiana37 Maryland53 Mexico261 Michigan779 Minnesota295 Mississippi105 Nevada13 New Mexico36 New York49 North Carolina203 North Dakota113 Ohio819 Oregon45 Pennsylvania88 South Carolina116 South Dakota30 Tennessee409 Texas3 Utah96 Virginia160 Washington67 West Virginia107 Wisconsin63 Wyoming5 Total7,090 36Table of ContentsThe Refining & Marketing segment sells transportation fuels through long-term fuel supply contracts to direct dealer locations, primarily under the ARCO brand. The following table sets forth the number of direct dealer locations by state as of December 31, 2020.LocationNumber ofLocationsArizona72 California944 Nevada63 New Mexico12 Texas1 Washington1 Total1,093 The following table sets forth details about our Refining & Marketing owned and operated terminals as of December 31, 2020. See the Midstream - MPLX section for information with respect to MPLX owned and operated terminals. Owned and Operated TerminalsNumber ofTerminalsTank StorageCapacity(thousand barrels)Light Products Terminals:Alaska1 206 New York1 328 Ohio1 125 Subtotal light products terminals3 659 Asphalt Terminals:Florida1 263 Indiana1 120 Kentucky4 548 Louisiana1 54 Michigan1 12 New York1 417 Ohio4 1,006 Pennsylvania1 355 Tennessee2 483 Subtotal asphalt terminals16 3,258 Total owned and operated terminals19 3,917 37Table of ContentsMIDSTREAM - MPLXThe following tables set forth certain information relating to MPLX’s crude oil, refined products and water pipeline and gathering systems and storage assets as of December 31, 2020.Pipeline System or Storage AssetDiameter(inches)Length(miles)Capacity(a)Total crude oil pipeline systems(b)(c)(d)2” - 48”8,125 VariousTotal refined products pipeline systems(b)(e)(f)4” - 36”5,655 VariousWater pipeline systems:Belfield water system3”- 6”106 VariousGreen River water system4” - 8”11 VariousTotal117 Barge Docks (thousand barrels)2,490 Storage assets (thousand barrels):Refinery Logistics - tank storage(g)96,357 Mt. Airy Terminal5,307 Tank Farms32,911 Caverns4,375 (a)All capacities reflect 100 percent of the pipeline systems’ and barge docks’ average capacity in thousands of barrels per day and 100 percent of the available storage capacity of our caverns and tank farms in thousands of barrels.(b)Includes pipelines leased from third parties.(c)Includes approximately 1,916 miles of pipeline in which MPLX has a 9.2 percent ownership interest, 168 miles of pipeline in which MPLX has a 35.0 percent ownership interest, 48 miles of pipeline in which MPLX has a 40.7 percent ownership interest, 57 miles of pipeline in which MPLX has a 58.5 percent ownership interest, 107 miles of pipeline in which MPLX has a 67.0 percent ownership interest and 975 miles of pipeline in which MPLX has a 17.0 percent ownership interest. (d)Includes approximately 696 miles of inactive pipeline.(e)Includes approximately 1,830 miles of pipeline in which MPLX has a 24.5 percent ownership interest, 87 miles of pipeline in which MPLX has a 65.16 percent ownership interest and 43 miles of refined product pipeline in which MPLX has a 25 percent interest.(f)Includes approximately 247 miles of inactive pipeline.(g)Refining logistics assets also include rail racks, truck racks and docks.38Table of ContentsThe following table sets forth details about MPLX owned and operated terminals as of December 31, 2020. Additionally, MPLX operates one leased terminal and has partial ownership interest in one terminal.Owned and Operated TerminalsNumber ofTerminalsTank StorageCapacity(thousand barrels)Refined Products Terminals:Alabama2 443 Alaska3 1,510 California8 3,421 Florida4 3,407 Georgia4 982 Idaho3 998 Illinois4 1,221 Indiana6 3,229 Kentucky6 2,587 Louisiana1 97 Michigan8 2,440 Minnesota1 13 New Mexico3 711 North Carolina3 1,508 North Dakota1 1 Ohio12 3,218 Pennsylvania1 390 South Carolina1 371 Tennessee4 1,149 Texas1 72 Utah1 47 Washington4 908 West Virginia2 1,587 Subtotal light products terminals83 30,310 Asphalt TerminalsArizona3 538 California3 701 Minnesota1 529 Nevada(a)1 273 New Mexico1 38 Texas1 193 Subtotal asphalt terminals10 2,272 Total owned and operated terminals93 32,582 (a) MPLX accounts for as an equity method investment.The following table sets forth details about MPLX barges and towboats as of December 31, 2020.Class of EquipmentNumberin ClassCapacity(thousand barrels)Inland tank barges(a)300 7,931 Inland towboats23 N/A(a) All of our barges are double-hulled.39Table of ContentsThe following tables set forth certain information relating to MPLX’s consolidated and operated joint venture gas processing facilities, fractionation facilities, natural gas gathering systems, NGL pipelines and natural gas pipelines as of December 31, 2020. All throughputs and utilizations included are weighted-averages for days in operation.Gas Processing ComplexesDesignThroughputCapacity (MMcf/d)Natural GasThroughput (MMcf/d)(a)Utilizationof DesignCapacity(a)Marcellus Shale6,172 5,629 91 %Utica Shale1,325 578 44 %Southern Appalachia620 231 37 %Southwest(b)2,067 1,361 68 %Bakken190 136 72 %Rockies1,472 502 34 %Total 11,846 8,437 72 %(a) Natural gas throughput is a weighted average for days in operation. The utilization of design capacity has been calculated using the weighted average design throughput capacity.(b) Centrahoma Processing LLC’s processing capacity of 550 MMcf/d and actual throughput of 176 MMcf/d are not included in this table as MPLX owns a non-operating 40 percent interest in this joint venture.Fractionation & Condensate Stabilization ComplexesDesignThroughputCapacity (mbpd)NGL Throughput (mbpd)(a)Utilizationof DesignCapacity(a)Marcellus Shale427 310 82 %Utica Shale23 12 52 %Southern Appalachia24 12 50 %Southwest11 7 64 %Bakken34 25 74 %Rockies61 4 7 %Total 580 370 69 %(a) NGL throughput is a weighted average for days in operation. The utilization of design capacity has been calculated using the weighted average design throughput capacity.De-ethanization ComplexesDesignThroughputCapacity (mbpd)NGL Throughput (mbpd)(a)Utilizationof DesignCapacity(a)Marcellus Shale273 187 68 %Utica Shale40 6 15 %Southwest18 11 61 %Total331 204 62 %(a) NGL throughput is a weighted average for days in operation. The utilization of design capacity has been calculated using the weighted average design throughput capacity.40Table of ContentsNatural Gas Gathering SystemsDesignThroughputCapacity (MMcf/d)Natural GasThroughput (MMcf/d)(a)Utilizationof DesignCapacity(a)Marcellus Shale1,547 1,349 87 %Utica Shale3,183 1,818 57 %Southwest2,770 1,483 54 %Bakken194 137 71 %Rockies1,486 544 37 %Total9,180 5,331 58 %(a) Natural gas throughput is a weighted average for days in operation. The utilization of design capacity has been calculated using the weighted average design throughput capacity.The following tables set forth certain information relating to MPLX’s NGL pipelines as of December 31, 2020.NGL PipelinesDiameter (inches)Length(miles)DesignThroughputCapacity (mbpd)Marcellus Shale4” - 20”442VariousUtica Shale4”- 12”119VariousSouthern Appalachia6” - 8”13835Southwest(a)6”5039Bakken8” - 12”8480Rockies8”1015(a) Includes 38 miles of inactive pipeline.MIDSTREAM - MPC-RETAINED ASSETS AND INVESTMENTSThe following tables set forth certain information related to our crude oil and refined products pipeline systems not owned by MPLX. As of December 31, 2020, we had partial ownership interests in the following pipeline companies.Pipeline CompanyDiameter(inches)Length(miles)OwnershipInterestOperatedby MPLCrude oil pipeline companies:Capline Pipeline Company LLC40”644 33 %YesGray Oak Pipeline, LLC8”-30”850 25 %NoLOOP(a)48”48 10 %NoTotal1,494 Refined products pipeline companies:Ascension Pipeline Company LLC12”32 50 %NoCentennial Pipeline LLC(b)24”-26”796 50 %YesMuskegon Pipeline LLC10”-12”170 60 %YesWolverine Pipe Line Company6”-18”798 6 %NoTotal1,796 (a)Represents interest retained by MPC and excludes MPLX’s 40.7 percent ownership interest in LOOP. Pipeline mileage is excluded from total as it is included with MPLX assets.(b)All system pipeline miles are inactive.41Table of ContentsAs of December 31, 2020, we had a partial ownership interest in the following crude oil terminal.TerminalOwnershipInterestTank StorageCapacity(million barrels)South Texas Gateway Terminal LLC(a)25%8.6(a)The tank storage capacity represents the capacity when the terminal is fully operational.The following table sets forth details about the assets held by two ocean vessel joint ventures in which we hold a 50% interest as of December 31, 2020.Class of EquipmentNumberin ClassCapacity(thousand barrels)Jones Act product tankers(a)4 1,320 750 Series ATB vessels(b)3 990 (a)Represents ownership through our indirect noncontrolling interest in Crowley Ocean Partners.(b)Represents ownership through our indirect noncontrolling interest in Crowley Blue Water Partners.42Table of ContentsDISCONTINUED OPERATIONSSpeedway sells transportation fuels and merchandise through convenience stores it owns and operates, primarily under the Speedway brand. The following table sets forth the number of company-owned convenience stores by state as of December 31, 2020.LocationNumber ofConvenience StoresAlabama5 Alaska31 Arizona92 California489 Colorado12 Connecticut1 Delaware4 Florida197 Georgia9 Idaho5 Illinois129 Indiana307 Kentucky147 Massachusetts108 Michigan306 Minnesota193 Nevada9 New Hampshire12 New Jersey64 New Mexico118 New York328 North Carolina264 Ohio488 Oregon12 Pennsylvania110 Rhode Island19 South Carolina47 South Dakota1 Tennessee53 Texas31 Utah30 Virginia59 Washington30 West Virginia57 Wisconsin69 Wyoming3 Total3,839 43Table of ContentsITEM 3. LEGAL PROCEEDINGSWe are the subject of, or a party to, a number of pending or threatened legal actions, contingencies and commitments involving a variety of matters, including laws and regulations relating to the environment. While it is possible that an adverse result in one or more of the lawsuits or proceedings in which we are a defendant could be material to us, based upon current information and our experience as a defendant in other matters, we believe that these lawsuits and proceedings, individually or in the aggregate, will not have a material adverse effect on our consolidated results of operations, financial position or cash flows.LitigationClimate ChangeGovernmental and other entities in various states have filed lawsuits against energy companies, including MPC. The lawsuits allege damages as a result of climate change and the plaintiffs are seeking unspecified damages and abatement under various tort theories. Similar lawsuits may be filed in other jurisdictions. The names of the courts in which the proceedings are pending and the dates instituted are as follows:PlaintiffDate InstitutedName of Court(s) where pendingCounty of San Mateo, CaliforniaJuly 17, 2017U.S. District Court (Northern District of California); U.S. Court of Appeals for the Ninth Circuit; U.S. Supreme CourtCounty of Marin, CaliforniaJuly 17, 2017U.S. District Court (Northern District of California); U.S. Court of Appeals for the Ninth Circuit; U.S. Supreme CourtCity of Imperial Beach, CaliforniaJuly 17, 2017U.S. District Court (Northern District of California); U.S. Court of Appeals for the Ninth Circuit; U.S. Supreme CourtCounty of Santa Cruz, CaliforniaDecember 20, 2017U.S. District Court (Northern District of California); U.S. Court of Appeals for the Ninth Circuit; U.S. Supreme CourtCity of Santa Cruz, CaliforniaDecember 20, 2017U.S. District Court (Northern District of California); U.S. Court of Appeals for the Ninth Circuit; U.S. Supreme CourtCity of Richmond, CaliforniaJanuary 22, 2018U.S. District Court (Northern District of California); U.S. Court of Appeals for the Ninth Circuit; U.S. Supreme CourtState of Rhode IslandJuly 2, 2018Superior Court of Providence County; U.S. Supreme CourtMayor and City Council of Baltimore, MarylandJuly 20, 2018Circuit Court of Baltimore City; U.S. Supreme CourtPacific Coast Federation of Fishermen’s Associations, Inc.November 14, 2018U.S. District Court (Northern District of California)City and County of Honolulu, HawaiiMarch 9, 2020U.S. District Court (District of Hawaii)City of Charleston, South CarolinaSeptember 9, 2020U.S. District Court (District of South Carolina)State of DelawareSeptember 10, 2020U.S. District Court (District of Delaware)County of Maui, HawaiiOctober 12, 2020U.S. District Court (District of Hawaii)City of Annapolis, MarylandFebruary 22, 2021Circuit Court for Anne Arundel County, MarylandDakota Access PipelineIn connection with MPLX’s 9.19 percent indirect interest in a joint venture (“Dakota Access”) that owns and operates the Dakota Access Pipeline and Energy Transfer Crude Oil Pipeline projects, (collectively the “Bakken Pipeline system” or “DAPL”), MPLX has entered into a Contingent Equity Contribution Agreement whereby MPLX LP, along with the other joint venture owners in the Bakken Pipeline system, has agreed to make equity contributions to the joint venture upon certain events occurring to allow the entities that own and operate the Bakken Pipeline system to satisfy their senior note payment obligations. The senior notes were issued to repay amounts owed by the pipeline companies to fund the cost of construction of the Bakken Pipeline system.44Table of ContentsIn March 2020, the U.S. District Court for the District of Columbia (the “D.D.C.”) ordered the U.S. Army Corps of Engineers (“Army Corps”), which granted permits and an easement for the Bakken Pipeline system, to conduct a full environmental impact statement (“EIS”), and further requested briefing on whether an easement necessary for the operation of the Bakken Pipeline system should be vacated while the EIS is being prepared.On July 6, 2020, the D.D.C. ordered vacatur of the easement to cross Lake Oahe during the pendency of an EIS and further ordered a shut down of the pipeline by August 5, 2020. The D.D.C. denied a motion to stay that order. Dakota Access and the Army Corps appealed the D.D.C.’s order to the U.S. Court of Appeals for the District of Columbia Circuit (the “Court of Appeals”). On July 14, 2020, the Court of Appeals issued an administrative stay while the court considered Dakota Access and the Army Corps’ emergency motion for stay pending appeal. On August 5, 2020, the Court of Appeals stayed the D.D.C.’s injunction that required the pipeline be shutdown and emptied of oil by August 5, 2020. The Court of Appeals denied a stay of the D.D.C.’s March order, which required the EIS, and further denied a stay of the D.D.C.’s July order, which vacated the easement. On January 26, 2021, the Court of Appeals upheld the D.D.C.’s order vacating the easement while the Army Corps prepares the EIS. The Court of Appeals reversed the D.D.C.’s order to the extent it directed that the pipeline be shutdown and emptied of oil. In the D.D.C., briefing has been completed for a renewed request for an injunction. The pipeline remains operational.If the pipeline is temporarily shut down pending completion of the EIS, MPLX would have to contribute its 9.19 percent pro rata share of funds required to pay interest accruing on the notes and any portion of the principal that matures while the pipeline is shutdown. It is also expected that MPLX would contribute its 9.19 percent pro rata share of any costs to remediate any deficiencies to reinstate the permit and/or return the pipeline into operation. If the vacatur of the easement permit results in a permanent shutdown of the pipeline, MPLX would have to contribute its 9.19 percent pro rata share of the cost to redeem the bonds (including the one percent redemption premium required pursuant to the indenture governing the notes) and any accrued and unpaid interest. As of December 31, 2020, our maximum potential undiscounted payments under the Contingent Equity Contribution Agreement were approximately $230 million and we had an investment of $465 million in MarEn Bakken Company LLC, which includes our 9.19 percent direct interest in Dakota Access.Tesoro High Plains PipelineIn early July 2020, MPLX received a Notification of Trespass Determination from the Bureau of Indian Affairs (“BIA”) relating to a portion of the Tesoro High Plains Pipeline that crosses the Fort Berthold Reservation in North Dakota. The notification covered the rights of way for 23 tracts of land and demanded the immediate cessation of pipeline operations. The notification also assessed trespass damages of approximately $187 million. MPLX appealed this determination, which triggered an automatic stay of the requested pipeline shutdown and payment. On October 29, the Assistant Secretary - Indian Affairs issued an order vacating the BIA’s trespass order and requiring the Regional Director for the BIA Great Plains Region to issue a new decision on or before December 15 covering all 34 tracts at issue. On December 15, the Regional Director of the BIA issued a new trespass notice to THPP consistent with the Assistant Secretary of Indian Affairs order vacating the prior trespass order. The new order found that THPP was in trespass and assessed trespass damages of approximately $4MM (including interest). The order also required THPP to immediately cease and desist use of the portion of the pipeline that crosses the property at issue. The new order was appealed, and was upheld by the Assistant Secretary - Indian Affairs. THPP has complied with the Regional Director’s December 15, 2020 notice. On February 12, 2021, landowners filed suit in the U.S. District Court for the District of North Dakota, requesting, among other things, that decisions by the Assistant Secretary - Indian Affairs and the Interior Board of Indian Appeals be vacated as to the award of damages to plaintiffs.MPLX continues to work towards a settlement of this matter with holders of the property rights at issue. Environmental ProceedingsItem 103 of Regulation S-K promulgated by the SEC requires disclosure of certain environmental matters when a governmental authority is a party to the proceedings and such proceedings involve potential monetary sanctions, unless we reasonably believe that the matter will result in no monetary sanctions, or in monetary sanctions, exclusive of interest and costs, of less than $300,000. The following matters are disclosed in accordance with that requirement. We do not currently believe that the eventual outcome of any such matters, individually or in the aggregate, could have a material adverse effect on our business, financial condition, results of operations or cash flows.45Table of ContentsMartinez RefineryWe are currently negotiating the settlement of 141 NOVs received from the Bay Area Air Quality Management District (“BAAQMD”). The NOVs were issued from 2011 to 2019 and allege violations of air quality regulations and the idled Martinez refinery’s air permit. While we are negotiating a settlement of the allegations with the BAAQMD through two separate enforcement actions, we cannot currently estimate the timing of the resolution of these matters.On July 18, 2016, the U.S. Department of Justice (“DOJ”) lodged a complaint on behalf of the EPA and a Consent Decree in the U.S. Court for the Western District of Texas. Among other things, the Consent Decree required that the Martinez refinery meet certain annual emission limits for NOx by July 1, 2018. In February 2018, TRMC informed the EPA that it would need additional time to satisfy requirements of the Consent Decree. In the fourth quarter of 2019, TRMC and the United States entered into an agreement to amend the Consent Decree to resolve these issues. In light of the actions to strategically reposition the Martinez refinery to a renewable diesel facility, we are renegotiating the Consent Decree modification. Subject to final approval by the court, we expect that the renegotiated Consent Decree modification will no longer require the installation of a Selective Catalytic Reduction system to control NOx emissions from the now-idled fluid catalytic cracking unit, but will result in an increased civil penalty. Gathering and ProcessingIn November 2020, we received an offer from the EPA to settle multiple alleged violations of the National Emission Standards for Hazardous Air Pollutants by the Chapita, Coyote Wash, Island, River Bend and Wonsits Valley Compressor Stations in Utah. The proposed settlement consists of an injunctive relief package, mitigation project and proposed penalty in excess of $300,000. We continue to negotiate a settlement of the allegations and cannot currently estimate the timing of the resolution of this matter.ITEM 4. MINE SAFETY DISCLOSURESNot applicable.46Table of ContentsPART IIITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES Our common stock is listed on the NYSE and traded under the symbol “MPC.” As of February 12, 2021, there were 30,210 registered holders of our common stock.Issuer Purchases of Equity SecuritiesThe following table sets forth a summary of our purchases during the quarter ended December 31, 2020, of equity securities that are registered by MPC pursuant to Section 12 of the Securities Exchange Act of 1934, as amended:PeriodTotal Numberof SharesPurchased(a)AveragePrice Paidper Share(b)Total Number ofShares Purchased asPart of PubliclyAnnounced Plansor ProgramsMaximum DollarValue of Shares thatMay Yet Be PurchasedUnder the Plansor Programs(c)10/01/2020-10/31/20205,973 $28.19 — $2,954,604,016 11/01/2020-11/30/2020256 30.18 — 2,954,604,016 12/01/2020-12/31/202035,811 40.76 — 2,954,604,016 Total42,040 38.91 — (a)The amounts in this column include 5,973, 256 and 35,811 shares of our common stock delivered by employees to MPC, upon vesting of restricted stock, to satisfy tax withholding requirements in October, November and December, respectively.(b)Amounts in this column reflect the weighted average price paid for shares tendered to us in satisfaction of employee tax withholding obligations upon the vesting of restricted stock granted under our stock plans. (c)On April 30, 2018, we announced that our board of directors had approved a $5 billion share repurchase authorization in addition to the remaining authorization pursuant to the May 31, 2017 announcement. These share purchase authorizations have no expiration date. The share repurchase authorization announced on April 30, 2018, together with prior authorizations, results in a total of $18 billion of share repurchase authorizations since January 1, 2012. 47Table of ContentsITEM 6. SELECTED FINANCIAL DATAThe following table should be read in conjunction with Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations and
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+Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations” of this Form 10-K for a discussion regarding the impact of the COVID-19 pandemic on our financial results, and “Part I. Item 1A. Risk Factors” of this Form 10-K for a discussion of the risks and uncertainties associated with the COVID-19 pandemic.Other InformationBacklogOur backlog includes orders that have been received and are believed to be firm. As of December 31, 2020 and December 31, 2019, our backlog was as follows: December 31(In millions)20202019Products and Systems Integration$3,120 $3,158 Software and Services8,314 8,101 $11,434 $11,259 Approximately 47% of the Products and Systems Integration segment backlog and 24% of the Software and Services segment backlog is expected to be recognized as revenue during 2021. The firmness of such orders is subject to future events that may cause the amount recognized to change.7Recent AcquisitionsTechnologySegmentAcquisitionDescriptionPurchase PriceDate of AcquisitionCommand Center SoftwareSoftware and ServicesCallyoProvider of cloud-based mobile applications for law enforcement in North America, including critical mobile technological capabilities that enable information to flow seamlessly from the field to the command center. $63 million, inclusive of share-based compensation of $3 millionAugust 28, 2020Video Security and AnalyticsProducts and Systems IntegrationSoftware and ServicesPelco, Inc.Global provider of video security solutions, adding a broad range of products for a variety of commercial and industrial environments and use cases. $110 millionJuly 31, 2020Video Security and AnalyticsProducts and Systems IntegrationSoftware and Services IndigoVision Group plcProvider of video security solutions to enhance geographical reach across a wider customer base.$37 millionJune 16, 2020LMRSoftware and ServicesUnnamed cybersecurity services businessProvider of vulnerability assessments, cybersecurity consulting, and managed services, including security monitoring of network operations.$32 million April 30, 2020LMRSoftware and ServicesUnnamed cybersecurity services businessProvider of vulnerability assessments, cybersecurity consulting, managed services, and remediation and response capabilities. $40 million, inclusive of share-based compensation of $6 millionMarch 3, 2020Video Security and AnalyticsSoftware and ServicesUnnamed data solutions business for vehicle location informationProvider of additional data to our existing license plate recognition database.$85 millionOctober 16, 2019Video Security and AnalyticsProducts and Systems IntegrationSoftware and ServicesWatchGuard, Inc.Provider of in-car and body-worn video solutions.$271 million, inclusive of share-based compensation of $16 million July 11, 2019LMRProducts and Systems IntegrationSoftware and ServicesAvtec, Inc.Provider of dispatch communications for U.S. public safety and commercial customers to communicate, coordinate resources, and secure their facilities. $136 millionMarch 11, 2019Video Security and AnalyticsProducts and Systems IntegrationSoftware and ServicesVaaS International HoldingsGlobal provider of data and image analytics for vehicle location.$445 million, inclusive of share-based compensation of $38 millionJanuary 7, 2019Video Security and AnalyticsProducts and Systems IntegrationSoftware and ServicesAvigilon CorporationProvider of advanced security and video solutions including video analytics, network video management hardware and software, video cameras, and access control solutions.$974 millionMarch 28, 2018Command Center SoftwareSoftware and ServicesPlant Holdings, Inc.Provider of next generation 911 solutions.$237 millionMarch 7, 20188Research and DevelopmentWe prioritize investments in R&D to expand and improve our products through both new product introductions and continuous enhancements to our core products. Our R&D programs are focused on the development of: (i) LMR Mission Critical Communications, (ii) Command Center Software and (iii) Video Security and Analytics.R&D expenditures were $686 million in 2020, $687 million in 2019, and $637 million in 2018. As of December 31, 2020, we had approximately 6,000 employees engaged in R&D activities. In addition, we engage in R&D activities with joint development and manufacturing partners and outsource certain activities to engineering firms to further supplement our internal spend. Intellectual Property MattersPatent protection is an important aspect of our operations. We have a portfolio of U.S. and foreign utility and design patents relating to our products, systems, and technologies, including developments in radio frequency technology and circuits, wireless network technologies, over-the-air protocols, mission critical communications, software and services, video security and analytics and next-generation public safety. We also file new patent applications with the U.S. Patent and Trademark Office and foreign patent offices.We license some of our patents to third-parties, but licensing is not a significant source of revenue for our business. We are also licensed to use certain patents owned by others. Royalty and licensing fees vary from year-to-year and are subject to the terms of the agreements and sales volumes of the products subject to the license. Motorola Solutions has a royalty-free license under all of the patents and patent applications assigned to Motorola Mobility at the time of the separation of the two businesses in 2011.We actively participate in the development of standards for interoperable, mission critical digital two-way radio systems. Our patents are used in standards in which our products and services are based. We offer standards-based licenses to those patents on fair, reasonable, and non-discriminatory terms.We believe that our patent portfolio will continue to provide us with a competitive advantage in our core product areas as well as provide leverage in the development of future technologies. While we are not dependent upon a single patent or even a few patents, we do have patents that protect features and functionality of our products and services. While these patents are important, our success also depends upon our extensive know-how, innovative culture, technological leadership, and distribution channels. We do not rely solely on patents or other intellectual property rights to protect or establish our market position; however, we will enforce our intellectual property rights when it is necessary to protect our innovation, or in some cases where attempts to negotiate mutually-agreeable licenses are not successful.We seek to obtain patents, copyright registrations, and trademark registrations to protect our proprietary positions whenever possible and wherever practical. As of December 31, 2020, we owned approximately 6,100 granted patents in the U.S. and foreign countries. As of December 31, 2020, we had approximately 1,300 U.S. and foreign patent applications pending. Foreign patents and patent applications are mostly counterparts of our U.S. patents. During 2020, we were granted approximately 500 patents in the U.S. and in foreign countries.We no longer own certain logos and other trademarks, trade names and service marks, including MOTOROLA, MOTO, MOTOROLA SOLUTIONS and the Stylized M logo and all derivatives thereof (“Motorola Marks”) and, since 2010, we have licensed the Motorola Marks from Motorola Mobility Holdings, Inc. which is currently owned by Lenovo Group Limited. For a description of the risks we face related to intellectual property, refer to “Part 1. Item 1A. Risk Factors” in this Form 10-K.Inventory and Raw MaterialsOur practice is to carry reasonable amounts of inventory to meet customers' delivery requirements. We provide custom products that require the stocking of inventories and a large variety of piece parts and replacement parts in order to meet delivery and warranty requirements. To the extent supplier product life cycles are shorter than ours, stocking of lifetime buy inventories is required to meet long-term warranty and contractual requirements. In addition, replacement parts are stocked for delivery on customer demand within a short delivery cycle.Availability of required materials and components is generally dependable; however, fluctuations in supply and market demand could cause selective shortages and affect our results of operations. We currently procure certain materials and components from single-source vendors. In addition, we import materials and components that are subject to import duties, including tariffs in connection with products procured in China. The duties and tariffs we are subject to do not have a significant impact on our financial results. A material disruption from a single-source vendor may have a material adverse impact on our results of operations. If certain single-source suppliers were to become capacity constrained or insolvent, it could result in a reduction or interruption in supplies, or an increase in the price of supplies, and adversely impact our financial results.Natural gas, electricity and, to a lesser extent, oil are the primary sources of energy for our manufacturing operations. Each of these resources is currently in adequate supply for our operations. The cost to operate our facilities and freight costs are dependent on world oil prices and external third-party logistics rates for inbound and outbound air lanes. Labor is generally available in reasonable proximity to our manufacturing facilities and the manufacturing facilities of our largest outsourced manufacturing suppliers. Difficulties in obtaining any of the aforementioned resources, or significant cost increases, could affect our financial results. For a description of risks related to our supply chain, refer to “Part 1. Item 1A. Risk Factors” in this Form 10-K.9Government RegulationsSome of our operations use substances regulated under various federal, state, local, and international laws governing the environment and worker health and safety, including those governing the discharge of pollutants into the ground, air, and water, the management and disposal of hazardous substances and wastes, and the cleanup of contaminated sites, as well as relating to the protection of the environment. Certain products of ours are subject to various federal, state, local, and international laws governing chemical substances in electronic products. Compliance with these U.S. federal, state and local, and international laws did not have a material effect on our capital expenditures or competitive position in 2018 through 2020; however, we recorded a $57 million charge in 2018 once to address additional remediation requirements for a designated Superfund site under the Comprehensive Environmental Response, Compensation and Liability Act (commonly known as the “Superfund Act”) incurred by a legacy business. Radio spectrum is required to provide wireless voice, data, and video communications service. The allocation of spectrum is regulated in the U.S. and other countries and limited spectrum is allocated to wireless services and specifically to public safety users. We manufacture and market products in spectrum bands already allocated by regulatory bodies. These include voice and data infrastructure, mobile radios, and portable or hand-held devices. Consequently, our results could be positively or negatively affected by the rules and regulations adopted by regulatory agencies. Our products operate both on licensed and unlicensed spectrum. The availability of additional radio spectrum may provide new business opportunities. Conversely, the loss of available radio spectrum may result in the loss of business opportunities. Regulatory changes in current spectrum bands (e.g., the sharing of previously dedicated or other spectrum) may also provide opportunities or may require modifications to some of our products so they can continue to be manufactured and marketed. The U.S. federal government and many state and local governments have adopted or are considering laws or regulations governing the use of artificial intelligence, biometrics, facial recognition and license plate recognition technology, primarily based on concerns about privacy or bias. (References to privacy-related legislation or laws in this document encompass all of these technologies.) Similar laws and regulations are being considered in some jurisdictions outside the U.S., including the European Union. Based on growing demands for broadband, regulators continue to consider repurposing narrowband spectrum to broadband. There are calls for more stringent health and safety requirements for occupational equipment for public safety and commercial users. Attention in the U.S. on supply chain vulnerabilities related to country of origin and national security continues. Our entrance into new service offerings could present new or additional regulatory burdens and compliance issues. For a description of the risks we face related to regulatory matters, refer to “Part 1. Item 1A. Risk Factors” of this Form 10-K.Human Capital ManagementWe have a "people first" philosophy. Our high-performing employees are our driving force, drawn from all segments of our global society to make a difference for our customers. As of December 31, 2020, we employed approximately 18,000 people globally with 52% in the North America region and 48% in the International region. Of our total global employees, 42% were employed in engineering. We believe a diverse, equitable and inclusive workplace is one where our employees feel that their unique opinions, cultures and abilities contribute to their personal success, as well as our company’s success.We believe our management team has the experience necessary to effectively execute our strategy and advance our product and technology leadership. Our Chief Executive Officer and senior management leaders have extensive industry experience. They are supported by an experienced and talented management team that is dedicated to maintaining and expanding our position as a global leader for government, public safety and enterprise mission critical communications and analytics. For discussion of the risks relating to the attraction and retention of senior management and key technical employees, see “Part 1. Item 1A. Risk Factors" in this Form 10-K.We believe the next big idea can come from anyone, anywhere, at any time. We invest in our employees’ development and training at all levels, challenging them to develop and grow skills to imagine new opportunities that will keep making a difference to public and enterprise safety. Employees have access to a wide variety of technical, functional and professional skills learning resources, including virtual, self-directed courses and on-the-job learning opportunities. We strive for business growth by creating a supportive, fair and equitable environment where employees feel they belong and are engaged, connected to our business and invested in the collective success of our customers and communities. Our human resources team works with leaders within each business function to perform annual talent reviews to assess the performance of every team member and identify the best development opportunities. This extensive process fosters growth across our company through focus on our high performing and high potential talent and the rigor of succession plan development for our most critical roles. As part of our compensation philosophy, we strive to offer and maintain market competitive wages, incentives, and benefits for our employees in order to attract and retain superior talent.We are focused on recruiting diverse candidates into our company by incorporating best practices into our hiring and creating partnerships with diversity organizations. In 2020, we appointed our first chief diversity officer, invested in development programs for high-potential female leaders, added an unconscious bias curriculum to our global workforce, and surveyed more than 4,000 employees to help leaders better understand the employee experience, particularly as it relates to diversity, equity and inclusion. In 2019, more than 170 leaders from all parts of the Company participated in a variety of blended learning programs that included in-person training, self-paced learning and practice activities, all geared toward building their leadership skills. In 2018, over 100 human resources professionals and hiring managers received several hours of specialized training on how to remove unconscious bias from the hiring process.10Our company-sponsored employee business councils support and promote mutual objectives of both the employees and the Company, including driving inclusion and diversity, enhancing company culture and impacting business results. As of December 31, 2020, we had six business councils: Women’s Business Council, Multicultural Business Council, LGBTA Business Council, People with Disabilities and Allies Council, Veterans Business Council and Global Young Professionals Group.In 2020 we established a cross-collaborative advisory committee, the Motorola Solutions Technology Advisory Committee (“MTAC”), to ensure our technological advancements remain aligned with our purpose and ethics, and are informed by the broader implications to our customers, the communities we serve and society at large.Additional information regarding how our purpose and ethics informs our approach to corporate responsibility can be found in our 2019 Corporate Responsibility Report, which is available on our website at www.motorolasolutions.com/en_us/about/company-overview/corporate-responsibility.html. The information contained on or accessible through our corporate website is not incorporated by reference into and is not a part of this Form 10-K.Material DispositionsNone.Available InformationWe make available free of charge through the Investor Relations section of our website, www.motorolasolutions.com/investors, our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, proxy statements, other reports filed under the Securities Exchange Act of 1934 (“Exchange Act”), and all amendments to those reports simultaneously or as soon as reasonably practicable after such material is electronically filed with, or furnished to, the SEC. Our reports are also available free of charge on the SEC’s website, www.sec.gov. Also available free of charge on our website are the following corporate governance documents:•Motorola Solutions, Inc. Restated Certificate of Incorporation with Amendments•Conformed Restated Certificate of Incorporation of Motorola Solutions, Inc. (amended Jan. 4, 2011)•Certificate of Amendment to the Restated Certificate of Incorporation of Motorola, Inc. (effective Jan. 4, 2011)•Certificate of Ownership and Merger of Motorola Name Change Corporation into Motorola, Inc. (effective Jan. 4, 2011)•Motorola Solutions, Inc. Amended and Restated Bylaws•Board Governance Guidelines•Director Independence Guidelines•Principles of Conduct for Members of the Motorola Solutions, Inc. Board of Directors•Motorola Solutions Code of Business Conduct, which is applicable to all Motorola Solutions employees, including the principal executive officers, the principal financial officer and the controller (principal accounting officer)•Audit Committee Charter•Compensation and Leadership Committee Charter•Governance and Nominating Committee CharterAll of our reports and corporate governance documents may also be obtained without charge by contacting Investor Relations, Motorola Solutions, Inc., Corporate Offices, 500 W. Monroe Street, Chicago, IL 60661, E-mail: investors@motorolasolutions.com. Our internet website and the information contained therein or incorporated therein are not intended to be incorporated into this Form 10-K.11Item 1A: Risk FactorsYou should carefully consider the risks described below in addition to our other filings with the SEC and the other information set forth in this Form 10-K, including the “Management’s Discussion and Analysis of Financial Conditions and Results of Operations” section in Part II. Item 7 and our consolidated financial statements in Part II.
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+Item 7.Management’s Discussion and Analysis of Financial Condition and Results of OperationsThis section of this Form 10-K generally discusses 2020 and 2019 items and year-to-year comparisons between 2020 and 2019. Discussions of 2018 items and year-to-year comparisons between 2019 and 2018 that are not included in this Form 10-K can be found in "Management's Discussion and Analysis of Financial Condition and Results of Operations" in Part II, Item 7 of the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 2019.Results of OperationsThe following represents our consolidated performance highlights:As of/ Year Ended December 31,Change 2020201920182020 vs. 2019 (in thousands, except revenue per membership and percentages)Financial Results:Streaming revenues$24,756,675 $19,859,230 $15,428,752 25 %DVD revenues239,381 297,217 365,589 (19)%Total revenues$24,996,056 $20,156,447 $15,794,341 24 %Global Streaming Memberships:Paid net membership additions36,573 27,831 28,615 31 %Paid memberships at end of period203,663 167,090 139,259 22 %Average paying memberships189,083 152,984 124,658 24 %Average monthly revenue per paying membership$10.91 $10.82 $10.31 1 %Operating income$4,585,289 $2,604,254 $1,605,226 76 %Operating margin18 %13 %10 %38 %Consolidated revenues for the year ended December 31, 2020 increased 24% as compared to the year ended December 31, 2019. The increase in our consolidated revenues was due to the 24% growth in average paying memberships and a 1% increase in average monthly revenue per paying membership. The increase in average monthly revenue per paying membership resulted from our price changes and plan mix, partially offset by unfavorable fluctuations in foreign exchange rates. Paid net membership additions for the year ended December 31, 2020 increased 31% as compared to the year ended December 31, 2019, as a result of the long term trend toward streaming on demand entertainment and due to the COVID-19 pandemic and resulting social restrictions and local government mandates of home confinement in certain jurisdictions. The increase in operating margin is due primarily to increased revenues and decreased marketing costs, coupled with cost of revenues, technology and development, and general and administrative costs growing at a slower rate as compared to the 24% increase in revenues.The full extent of the impact of the COVID-19 pandemic on our business, operations and financial results will depend on numerous evolving factors that we may not be able to accurately predict. See Item 1A: "Risk Factors" section set forth in this Annual Report on Form 10-K for additional details. In an effort to protect the health and safety of our employees, our workforce has had and continues in most instances to spend a significant amount of time working from home, international travel has been severely curtailed and many of our productions continue to experience disruption, as are the productions of our third-party content suppliers. Our other partners have similarly had their operations disrupted, including those partners that we use for our operations as well as development, production, and post-production of content. While we and our partners have resumed productions and related operations in many parts of the world, our ability to produce content remains affected by the pandemic. In an effort to contain COVID-19 or slow its spread, governments around the world have also enacted various measures, some of which have been subsequently rescinded, modified or reinstated, including orders to close all businesses not deemed “essential,” isolate residents to their homes or places of residence, and practice social distancing. We anticipate that these actions and the global health crisis caused by COVID-19, including any resurgences, will continue to negatively impact business activity across the globe. We will continue to actively monitor the situation and may take further actions that alter our business operations as may be required by federal, state, local or foreign authorities, or that we determine are in the best interests of our employees, customers, 22Table of Contentspartners and stockholders. It is not clear what the potential effects any such alterations or modifications may have on our business, including the effects on our customers, suppliers or vendors, or on our financial results.Streaming Revenues We derive revenues from monthly membership fees for services related to streaming content to our members. We offer a variety of streaming membership plans, the price of which varies by country and the features of the plan. As of December 31, 2020, pricing on our plans ranged from the U.S. dollar equivalent of $2 to $24 per month. We expect that from time to time the prices of our membership plans in each country may change and we may test other plan and price variations.The following tables summarize streaming revenue and other streaming membership information by region for the years ended December 31, 2020, 2019 and 2018.United States and Canada (UCAN)As of/ Year Ended December 31,Change 2020201920182020 vs. 2019 (in thousands, except revenue per membership and percentages)Revenues$11,455,396 $10,051,208 $8,281,532 $1,404,188 14 %Paid net membership additions6,274 2,905 6,335 3,369 116 %Paid memberships at end of period (1)73,936 67,662 64,757 6,274 9 %Average paying memberships71,689 66,615 61,845 5,074 8 %Average monthly revenue per paying membership$13.32 $12.57 $11.16 $0.75 6 %Constant currency change (2)6 %Europe, Middle East, and Africa (EMEA)As of/ Year Ended December 31,Change 2020201920182020 vs. 2019 (in thousands, except revenue per membership and percentages)Revenues$7,772,252 $5,543,067 $3,963,707 $2,229,185 40 %Paid net membership additions14,920 13,960 11,814 960 7 %Paid memberships at end of period (1)66,698 51,778 37,818 14,920 29 %Average paying memberships60,425 44,731 31,601 15,694 35 %Average monthly revenue per paying membership$10.72 $10.33 $10.45 $0.39 4 %Constant currency change (2)3 %Latin America (LATAM)As of/ Year Ended December 31,Change 2020201920182020 vs. 2019 (in thousands, except revenue per membership and percentages)Revenues$3,156,727 $2,795,434 $2,237,697 $361,293 13 %Paid net membership additions6,120 5,340 6,360 780 15 %Paid memberships at end of period (1)37,537 31,417 26,077 6,120 19 %Average paying memberships35,297 28,391 22,767 6,906 24 %Average monthly revenue per paying membership$7.45 $8.21 $8.19 $(0.76)(9)%Constant currency change (2)8 %23Table of ContentsAsia-Pacific (APAC)As of/ Year Ended December 31,Change 2020201920182020 vs. 2019 (in thousands, except revenue per membership and percentages)Revenues$2,372,300 $1,469,521 $945,816 $902,779 61 %Paid net membership additions9,259 5,626 4,106 3,633 65 %Paid memberships at end of period (1)25,492 16,233 10,607 9,259 57 %Average paying memberships21,674 13,247 8,446 8,427 64 %Average monthly revenue per paying membership$9.12 $9.24 $9.33 $(0.12)(1)%Constant currency change (2)(1)%(1) A paid membership (also referred to as a paid subscription) is defined as a membership that has the right to receive Netflix service following sign-up and a method of payment being provided, and that is not part of a free trial or certain other promotions that may be offered by the Company to new or rejoining members. A membership is canceled and ceases to be reflected in the above metrics as of the effective cancellation date. Voluntary cancellations generally become effective at the end of the prepaid membership period. Involuntary cancellations, as a result of a failed method of payment, become effective immediately. Memberships are assigned to territories based on the geographic location used at time of sign-up as determined by the Company’s internal systems, which utilize industry standard geo-location technology.(2) We believe constant currency information is useful in analyzing the underlying trends in average monthly revenue per paying membership. In order to exclude the effect of foreign currency rate fluctuations on average monthly revenue per paying membership, we estimate current period revenue assuming foreign exchange rates had remained constant with foreign exchange rates from each of the corresponding months of the prior-year period. For the year ended December 31, 2020, our revenues would have been approximately $596 million higher had foreign currency exchange rates remained constant with those for the year ended December 31, 2019.Cost of RevenuesAmortization of content assets makes up the majority of cost of revenues. Expenses associated with the acquisition, licensing and production of content (such as payroll and related personnel expenses, costs associated with obtaining rights to music included in our content, overall deals with talent, miscellaneous production related costs and participations and residuals), streaming delivery costs and other operations costs make up the remainder of cost of revenues. We have built our own global content delivery network (“Open Connect”) to help us efficiently stream a high volume of content to our members over the internet. Delivery expenses, therefore, include equipment costs related to Open Connect, payroll and related personnel expenses and all third-party costs, such as cloud computing costs, associated with delivering content over the internet. Other operations costs include customer service and payment processing fees, including those we pay to our integrated payment partners, as well as other costs incurred in making our content available to members. Year Ended December 31,Change 2020201920182020 vs. 2019 (in thousands, except percentages)Cost of revenues$15,276,319 $12,440,213 $9,967,538 $2,836,106 23 %As a percentage of revenues61 %62 %63 %The increase in cost of revenues for the year ended December 31, 2020 as compared to the year ended December 31, 2019 was primarily due to a $1,591 million increase in content amortization relating to our existing and new content, including more exclusive and original programming. Expenses associated with the acquisition, licensing and production of content increased $1,101 million, primarily due to expenses related to the COVID-19 pandemic and continued growth in our content production activities. Streaming delivery costs and other operations costs increased driven by our growing member base.MarketingMarketing expenses consist primarily of advertising expenses and certain payments made to our marketing partners, including consumer electronics ("CE") manufacturers, MVPDs, mobile operators and ISPs. Advertising expenses include 24Table of Contentspromotional activities such as digital and television advertising. Marketing expenses also include payroll and related expenses for personnel that support marketing activities. Year Ended December 31,Change 2020201920182020 vs. 2019 (in thousands, except percentages)Marketing$2,228,362 $2,652,462 $2,369,469 $(424,100)(16)%As a percentage of revenues9 %13 %15 %The decrease in marketing expenses for the year ended December 31, 2020 as compared to the year ended December 31, 2019 was primarily due to a $432 million decrease in advertising expenses, partially offset by increased payments to our marketing partners.Technology and DevelopmentTechnology and development expenses consist of payroll and related expenses for all technology personnel, as well as other costs incurred in making improvements to our service offerings, including testing, maintaining and modifying our user interface, our recommendations, merchandising and streaming delivery technology and infrastructure. Technology and development expenses also include costs associated with computer hardware and software. Year Ended December 31,Change 2020201920182020 vs. 2019 (in thousands, except percentages)Technology and development$1,829,600 $1,545,149 $1,221,814 $284,451 18 %As a percentage of revenues7 %8 %8 %The increase in technology and development expenses for the year ended December 31, 2020 as compared to the year ended December 31, 2019 was primarily due to a $254 million increase in personnel-related costs, including increases in compensation for existing employees and growth in average headcount to support the increase in our production activity and continued improvements in our streaming service. General and AdministrativeGeneral and administrative expenses consist of payroll and related expenses for corporate personnel. General and administrative expenses also include professional fees and other general corporate expenses. Year Ended December 31,Change 2020201920182020 vs. 2019 (in thousands, except percentages)General and administrative$1,076,486 $914,369 $630,294 $162,117 18 %As a percentage of revenues4 %5 %4 %The increase in general and administrative expenses for the year ended December 31, 2020 as compared to the year ended December 31, 2019 was primarily due to a $128 million increase in personnel-related costs, including increases in compensation for existing employees and growth in average headcount to support the increase in our production activity and continued improvements in our streaming service. Interest ExpenseInterest expense consists primarily of the interest associated with our outstanding debt obligations, including the amortization of debt issuance costs. See Note 6 Debt in the accompanying notes to our consolidated financial statements included in Part II, Item 8, "Financial Statements and Supplementary Data" of this Annual Report on Form 10-K for further detail on our debt obligations. 25Table of Contents Year Ended December 31,Change 2020201920182020 vs. 2019 (in thousands, except percentages)Interest expense$767,499 $626,023 $420,493 $141,476 23 %As a percentage of revenues3 %3 %3 %Interest expense for the year ended December 31, 2020 consisted primarily of $749 million of interest on our Notes. The increase in interest expense for the year ended December 31, 2020 as compared to the year ended December 31, 2019 is due to the increase in debt.Interest and Other Income (Expense)Interest and other income (expense) consists primarily of foreign exchange gains and losses on foreign currency denominated balances and interest earned on cash and cash equivalents. Year Ended December 31,Change 2020201920182020 vs. 2019 (in thousands, except percentages)Interest and other income (expense)$(618,441)$84,000 $41,725 $(702,441)(836)%As a percentage of revenues(2)%— %— %Interest and other income (expense) decreased primarily due to foreign exchange losses of $660 million for the year ended December 31, 2020 as compared to a gain of $7 million for the year ended December 31, 2019. The foreign exchange loss in the year ended December 31, 2020 was primarily driven by the non-cash $533 million loss from the remeasurement of our Senior Notes denominated in euros, coupled with the remeasurement of cash and content liability positions in currencies other than the functional currencies.Provision for Income Taxes Year Ended December 31,Change 2020201920182020 vs. 2019 (in thousands, except percentages)Provision for income taxes$(437,954)$(195,315)$(15,216)$(242,639)(124)%Effective tax rate14 %9 %1 % As of December 31, 2020, we had a California research and development ("R&D") credit carryforward of $250 million, which can be carried forward indefinitely. On June 29, 2020, California enacted legislative changes that impose an annual cap of $5 million on the amount of business incentive tax credits we can utilize in California effective for tax years 2020 through 2022. As a result, we evaluated our ability to realize the California R&D credit, and considered all available positive and negative evidence, including operating results, ongoing tax planning, and forecasts of future taxable income and determined it is more likely than not that the pre-2020 credits and a portion of the current year R&D credit would not be realized. In the twelve months ended December 31, 2020 we recorded a valuation allowance of $250 million. We will monitor our business strategies, weighing positive and negative evidence in assessing the realization of this asset in the future and in the event there is a need to release the valuation allowance, a tax benefit will be recorded.The increase in our effective tax rate for the year ended December 31, 2020 as compared to the year ended December 31, 2019 is primarily due to the establishment of a valuation allowance on the California R&D credit, partially offset by the recognition of excess tax benefits of stock-based compensation. In 2020, the difference between our 14% effective tax rate and the Federal statutory rate of 21% was primarily due to the recognition of excess tax benefits of stock-based compensation and Federal and California R&D credits, partially offset by the establishment of a valuation allowance on the California R&D credit. 26Table of ContentsLiquidity and Capital Resources Year Ended December 31,Change202020192020 vs. 2019(in thousands)Cash, cash equivalents and restricted cash$8,238,870 $5,043,786 $3,195,084 63 %Short-term and long-term debt16,308,973 14,759,260 1,549,713 10 %Cash, cash equivalents and restricted cash increased $3,195 million in the year ended December 31, 2020 primarily due to cash provided by operations coupled with the issuance of debt. Debt, net of debt issuance costs, increased $1,550 million primarily due to the issuance of debt in April 2020 coupled with the remeasurement of our euro-denominated notes. The amount of principal and interest due in the next twelve months is $1,264 million. As of December 31, 2020, no amounts had been borrowed under our $750 million Revolving Credit Agreement. See Note 6 Debt in the accompanying notes to our consolidated financial statements. As our cash provided by operating activities improved in 2020, we anticipate that our future capital needs from the debt market will be more limited compared to prior years. Our ability to obtain this or any additional financing that we may choose to, or need to, obtain will depend on, among other things, our development efforts, business plans, operating performance and the condition of the capital markets at the time we seek financing. We may not be able to obtain such financing on terms acceptable to us or at all. If we raise additional funds through the issuance of equity or debt securities, those securities may have rights, preferences or privileges senior to the rights of our common stock, and our stockholders may experience dilution. As our cash provided by operating activities grows and exceeds our minimum cash needs, our future capital allocation may include stock repurchase programs. The timing and magnitude of such programs will depend on, among other things, our development efforts, business plans and operating performance.Our primary uses of cash include the acquisition, licensing and production of content, streaming delivery, marketing programs and personnel-related costs. Cash payment terms for non-original content have historically been in line with the amortization period. Investments in original content, and in particular content that we produce and own, require more cash upfront relative to licensed content. For example, production costs are paid as the content is created, well in advance of when the content is available on the service and amortized. We expect to continue to significantly increase our investments in global content, particularly in original content, which will impact our liquidity. We currently anticipate that cash flows from operations, available funds and access to financing sources, including our revolving credit facility, will continue to be sufficient to meet our cash needs for at least the next twelve months. Free Cash FlowWe define free cash flow as cash provided by (used in) operating activities less purchases of property and equipment and change in other assets. We believe free cash flow is an important liquidity metric because it measures, during a given period, the amount of cash generated that is available to repay debt obligations, make strategic acquisitions and investments and for certain other activities like share repurchases. Free cash flow is considered a non-GAAP financial measure and should not be considered in isolation of, or as a substitute for, net income, operating income, cash flow provided by (used in) operating activities, or any other measure of financial performance or liquidity presented in accordance with GAAP.In assessing liquidity in relation to our results of operations, we compare free cash flow to net income, noting that the major recurring differences are excess content payments over amortization, non-cash stock-based compensation expense, non-cash remeasurement gain/loss on our euro-denominated debt, and other working capital differences. Working capital differences include deferred revenue, excess property and equipment purchases over depreciation, taxes and semi-annual interest payments on our outstanding debt. Our receivables from members generally settle quickly.27Table of Contents Year Ended December 31,Change 2020201920182020 vs. 2019(in thousands)Net cash provided by (used in) operating activities$2,427,077 $(2,887,322)$(2,680,479)$5,314,399 184 %Net cash used in investing activities(505,354)(387,064)(339,120)(118,290)(31)%Net cash provided by financing activities1,237,311 4,505,662 4,048,527 (3,268,351)(73)%Non-GAAP reconciliation of free cash flow:Net cash provided by (used in) operating activities2,427,077 (2,887,322)(2,680,479)5,314,399 184 %Purchases of property and equipment(497,923)(253,035)(173,946)(244,888)(97)%Change in other assets(7,431)(134,029)(165,174)126,598 94 %Free cash flow$1,921,723 $(3,274,386)$(3,019,599)$5,196,109 159 %While we and our partners have resumed productions and related operations in many parts of the world, our ability to produce content remains affected by the pandemic. As a result, the timing of certain production payments has been and will continue to be delayed until productions can resume and may be shifted to future years. Net cash provided by operating activities increased $5,314 million from the year ended December 31, 2019 to $2,427 million for the year ended December 31, 2020 primarily driven by a $4,840 million or 24% increase in revenues coupled with a decrease in cash payments for content assets. The payments for content assets decreased $2,074 million, from $14,611 million to $12,537 million, or 14%, as compared to the increase in the amortization of content assets of $1,591 million, from $9,216 million to $10,807 million, or 17%. In addition, we had increased payments associated with higher operating expenses, primarily related to increased headcount to support our continued improvements in our streaming service and our international expansion.Net cash used in investing activities increased $118 million, primarily due to an increase in purchases of property and equipment.Net cash provided by financing activities decreased $3,268 million primarily due to a decrease in the proceeds from the issuance of debt of $3,431 million from $4,433 million in the year ended December 31, 2019 to $1,002 million in the year ended December 31, 2020, partially offset by an increase in the proceeds from the issuance of common stock of $163 million.Free cash flow was $840 million lower than net income for the year ended December 31, 2020 primarily due to $1,730 million of cash payments for content assets over amortization expense and $308 million in other non-favorable working capital differences, partially offset by $533 million of non-cash remeasurement loss on our euro-denominated debt, $415 million of non-cash stock-based compensation expenses, and a $250 million non-cash valuation allowance for deferred taxes due to recent legislation which imposed an annual cap on research and development credits.Free cash flow was $5,141 million lower than net income for the year ended December 31, 2019 primarily due to $5,394 million of cash payments for streaming content assets over streaming amortization expense, $46 million non-cash remeasurement gain on our euro-denominated debt, and $106 million in other non-favorable working capital differences, partially offset by $405 million of non-cash stock-based compensation expense.Contractual ObligationsFor the purpose of this table, contractual obligations for purchases of goods or services are defined as agreements that are enforceable and legally binding and that specify all significant terms, including: fixed or minimum quantities to be purchased; fixed, minimum or variable price provisions; and the approximate timing of the transaction. The expected timing of the payment of the obligations discussed below is estimated based on information available to us as of December 31, 2020. Timing of payments and actual amounts paid may be different depending on the time of receipt of goods or services or changes to agreed-upon amounts for some obligations. The following table summarizes our contractual obligations at December 31, 2020: 28Table of Contents Payments due by PeriodContractual obligations (in thousands):TotalLess than1 year1-3 years3-5 yearsMore than5 yearsContent obligations (1)$19,218,830 $8,980,868 $7,819,563 $1,973,091 $445,308 Debt (2)21,857,087 1,264,020 2,136,997 3,614,906 14,841,164 Operating lease obligations (3)2,838,985 345,442 651,801 577,253 1,264,489 Other purchase obligations (4)809,383 562,970 241,194 5,219 — Total$44,724,285 $11,153,300 $10,849,555 $6,170,469 $16,550,961 (1)As of December 31, 2020, content obligations were comprised of $4.4 billion included in "Current content liabilities" and $2.6 billion of "Non-current content liabilities" on the Consolidated Balance Sheets and $12.2 billion of obligations that are not reflected on the Consolidated Balance Sheets as they did not then meet the criteria for recognition.Content obligations include amounts related to the acquisition, licensing and production of content. An obligation for the production of content includes non-cancelable commitments under creative talent and employment agreements and other production related commitments. An obligation for the acquisition and licensing of content is incurred at the time we enter into an agreement to obtain future titles. Once a title becomes available, a content liability is recorded on the Consolidated Balance Sheets. Certain agreements include the obligation to license rights for unknown future titles, the ultimate quantity and/or fees for which are not yet determinable as of the reporting date. Traditional film output deals, or certain TV series license agreements where the number of seasons to be aired is unknown, are examples of these types of agreements. The contractual obligations table above does not include any estimated obligation for the unknown future titles, payment for which could range from less than one year to more than five years. However, these unknown obligations are expected to be significant and we believe could include approximately $1 billion to $4 billion over the next three years, with the payments for the vast majority of such amounts expected to occur after the next twelve months. The foregoing range is based on considerable management judgments and the actual amounts may differ. Once we know the title that we will receive and the license fees, we include the amount in the contractual obligations table above.(2)Debt obligations include our Notes consisting of principal and interest payments. See Note 6 Debt in the accompanying notes to our consolidated financial statements included in Part II, Item 8, "Financial Statements and Supplementary Data" of this Annual Report on Form 10-K for further details. (3)See Note 5 Balance Sheet Components in the accompanying notes to our consolidated financial statements for further details regarding leases. As of December 31, 2020, the Company has additional operating leases for real estate that have not yet commenced of $256 million which has been included above. Total lease obligations as of December 31, 2020 increased $82 million from $2,757 million as of December 31, 2019 to $2,839 million as of December 31, 2020 due to growth in facilities to support our growing headcount and growing number of original productions.(4)Other purchase obligations include all other non-cancelable contractual obligations. These contracts are primarily related to streaming delivery and cloud computing costs, as well as other miscellaneous open purchase orders for which we have not received the related services or goods.As of December 31, 2020, we had gross unrecognized tax benefits of $140 million, of which $38 million was classified in “Other non-current liabilities” and $54 million as a reduction to deferred tax assets which was classified as "Other non-current assets" in the Consolidated Balance Sheets. At this time, an estimate of the range of reasonably possible adjustments to the balance of unrecognized tax benefits cannot be made.Off-Balance Sheet Arrangements We do not have transactions with unconsolidated entities, such as entities often referred to as structured finance or special purpose entities, whereby we have financial guarantees, subordinated retained interests, derivative instruments, or other contingent arrangements that expose us to material continuing risks, contingent liabilities, or any other obligation under a variable interest in an unconsolidated entity that provides financing, liquidity, market risk, or credit risk support to us. 29Table of ContentsIndemnificationsThe information set forth under Note 8 Guarantees - Indemnification Obligations in the accompanying notes to our consolidated financial statements included in Part II, Item 8, "Financial Statements and Supplementary Data" of this Annual Report on Form 10-K is incorporated herein by reference.Critical Accounting Policies and EstimatesThe preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosures of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reported periods. The Securities and Exchange Commission ("SEC") has defined a company’s critical accounting policies as the ones that are most important to the portrayal of a company’s financial condition and results of operations, and which require a company to make its most difficult and subjective judgments. Based on this definition, we have identified the critical accounting policies and judgments addressed below. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances. Actual results may differ from these estimates.Content We acquire, license and produce content, including original programming, in order to offer our members unlimited viewing of video entertainment. The content licenses are for a fixed fee and specific windows of availability. Payment terms for certain content licenses and the production of content require more upfront cash payments relative to the amortization expense. Payments for content, including additions to content assets and the changes in related liabilities, are classified within "Net cash provided by (used in) operating activities" on the Consolidated Statements of Cash Flows.We recognize content assets (licensed and produced) as "Content assets, net" on the Consolidated Balance Sheets. For licensed content, we capitalize the fee per title and record a corresponding liability at the gross amount of the liability when the license period begins, the cost of the title is known and the title is accepted and available for streaming. For produced content, we capitalize costs associated with the production, including development cost, direct costs and production overhead. Participations and residuals are expensed in line with the amortization of production costs. Based on factors including historical and estimated viewing patterns, we amortize the content assets (licensed and produced) in “Cost of revenues” on the Consolidated Statements of Operations over the shorter of each title's contractual window of availability or estimated period of use or ten years, beginning with the month of first availability. The amortization is on an accelerated basis, as we typically expect more upfront viewing, for instance due to additional merchandising and marketing efforts, and film amortization is more accelerated than TV series amortization. On average, over 90% of a licensed or produced content asset is expected to be amortized within four years after its month of first availability. We review factors that impact the amortization of the content assets on a regular basis. Our estimates related to these factors require considerable management judgment.Our business model is subscription based as opposed to a model generating revenues at a specific title level. Content assets (licensed and produced) are predominantly monetized as a group and therefore are reviewed at a group level when an event or change in circumstances indicates a change in the expected usefulness of the content or that the fair value may be less than unamortized cost. To date, we have not identified any such event or changes in circumstances. If such changes are identified in the future, these aggregated content assets will be stated at the lower of unamortized cost or fair value. In addition, unamortized costs for assets that have been, or are expected to be, abandoned are written off. Income TaxesWe record a provision for income taxes for the anticipated tax consequences of our reported results of operations using the asset and liability method. Deferred income taxes are recognized by applying enacted statutory tax rates applicable to future years to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases as well as net operating loss and tax credit carryforwards. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. The measurement of deferred tax assets is reduced, if necessary, by a valuation allowance for any tax benefits for which future realization is uncertain. Although we believe our assumptions, judgments and estimates are reasonable, changes in tax laws or our interpretation of tax laws and the resolution of any tax audits could significantly impact the amounts provided for income taxes in our consolidated financial statements.In evaluating our ability to recover our deferred tax assets, in full or in part, we consider all available positive and negative evidence, including our past operating results, and our forecast of future earnings, future taxable income and prudent 30Table of Contentsand feasible tax planning strategies. The assumptions utilized in determining future taxable income require significant judgment and are consistent with the plans and estimates we are using to manage the underlying businesses. Actual operating results in future years could differ from our current assumptions, judgments and estimates. However, we believe that it is more likely than not that most of the deferred tax assets recorded on our Consolidated Balance Sheets will ultimately be realized. We record a valuation allowance to reduce our deferred tax assets to the net amount that we believe is more likely than not to be realized. As of December 31, 2020 the valuation allowance of $250 million was related to the California research and development credits that we do not expect to realize. We did not recognize certain tax benefits from uncertain tax positions within the provision for income taxes. We may recognize a tax benefit only if it is more likely than not the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the position. The tax benefits recognized in the financial statements from such positions are then measured based on the largest benefit that has a greater than 50% likelihood of being realized upon settlement. At December 31, 2020, our estimated gross unrecognized tax benefits were $140 million of which $86 million, if recognized, would favorably impact our future earnings. Due to uncertainties in any tax audit outcome, our estimates of the ultimate settlement of our unrecognized tax positions may change and the actual tax benefits may differ significantly from the estimates. See Note 10 to the consolidated financial statements for further information regarding income taxes.Recent Accounting PronouncementsThe information set forth under Note 1 to the consolidated financial statements under the caption “Basis of Presentation and Summary of Significant Accounting Policies” is incorporated herein by reference. Item 7A.Quantitative and Qualitative Disclosures about Market RiskWe are exposed to market risks related to interest rate changes and the corresponding changes in the market values of our debt and foreign currency fluctuations. Interest Rate RiskAt December 31, 2020, our cash equivalents were generally invested in money market funds. Interest paid on such funds fluctuates with the prevailing interest rate. As of December 31, 2020, we had $16.4 billion of debt, consisting of fixed rate unsecured debt in sixteen tranches due between 2021 and 2030. Refer to Note 6 to the consolidated financial statements for details about all issuances. The fair value of our debt will fluctuate with movements of interest rates, increasing in periods of declining rates of interest and declining in periods of increasing rates of interest. The fair value of our debt will also fluctuate based on changes in foreign currency rates, as discussed below. Foreign Currency RiskRevenues denominated in currencies other than the U.S. dollar account for 54% of the consolidated amount for the year ended December 31, 2020. We therefore have foreign currency risk related to these currencies, which are primarily the euro, the British pound, the Brazilian real, the Canadian dollar, the Mexican peso, the Australian dollar, and the Japanese yen.Accordingly, changes in exchange rates, and in particular a weakening of foreign currencies relative to the U.S. dollar may negatively affect our revenue and operating income as expressed in U.S. dollars. For the year ended December 31, 2020, our revenues would have been approximately $596 million higher had foreign currency exchange rates remained constant with those for the year ended December 31, 2019.We have also experienced and will continue to experience fluctuations in our net income as a result of gains (losses) on the settlement and the remeasurement of monetary assets and liabilities denominated in currencies that are not the functional currency. In the year ended December 31, 2020, we recognized a $660 million foreign exchange loss primarily due to the non-cash remeasurement of our Senior Notes denominated in euros, coupled with the remeasurement of cash and content liability positions denominated in currencies other than functional currencies.In addition, the effect of exchange rate changes on cash and cash equivalents in the year ended December 31, 2020 was an increase of $36 million. We do not use foreign exchange contracts or derivatives to hedge any foreign currency exposures. The volatility of exchange rates depends on many factors that we cannot forecast with reliable accuracy. Our continued international expansion increases our exposure to exchange rate fluctuations and as a result such fluctuations could have a significant impact on our future results of operations.31Table of Contents
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+Item 7.Management's Discussion and Analysis of Financial Condition and Results of Operations34Item 7A.Quantitative and Qualitative Disclosures About Market Risk54Item 8.Financial Statements and Supplementary Data55Item 9.Changes in and Disagreements With Accountants on Accounting and Financial Disclosure114Item 9A.Controls and Procedures114Item 9B.Other Information114PART IIIItem 10.Directors, Executive Officers and Corporate Governance115Item 11.Executive Compensation115Item 12.Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters115Item 13.Certain Relationships and Related Transactions, and Director Independence115Item 14.Principal Accounting Fees and Services116PART IVItem 15.Exhibits, Financial Statement Schedules117Item 16.Form 10-K Summary124Signatures125FORWARD-LOOKING STATEMENTSThis report includes forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Any statements that express, or involve discussions as to, expectations, beliefs, plans, objectives, assumptions, strategies, future events or performance (often, but not always, through the use of words or phrases such as may result, are expected to, will continue, is anticipated, believe, will, could, should, would, estimated, may, plan, potential, future, projection, goals, target, outlook, predict and intend or words of similar meaning) are not statements of historical facts and may be forward looking. Forward-looking statements involve estimates, assumptions and uncertainties. Accordingly, any such statements are qualified in their entirety by reference to, and are accompanied by, important factors included in Part I, Item 1A. Risk Factors (in addition to any assumptions and other factors referred to specifically in connection with such forward-looking statements) that could have a significant impact on NEE's and/or FPL's operations and financial results, and could cause NEE's and/or FPL's actual results to differ materially from those contained or implied in forward-looking statements made by or on behalf of NEE and/or FPL in this combined Form 10-K, in presentations, on their respective websites, in response to questions or otherwise.Any forward-looking statement speaks only as of the date on which such statement is made, and NEE and FPL undertake no obligation to update any forward-looking statement to reflect events or circumstances, including, but not limited to, unanticipated events, after the date on which such statement is made, unless otherwise required by law. New factors emerge from time to time and it is not possible for management to predict all of such factors, nor can it assess the impact of each such factor on the business or the extent to which any factor, or combination of factors, may cause actual results to differ materially from those contained or implied in any forward-looking statement.3Table of ContentsPART IItem 1. BusinessOVERVIEWNEE is one of the largest electric power and energy infrastructure companies in North America and a leader in the renewable energy industry. NEE has two principal businesses, FPL, including Gulf Power, and NEER. FPL is the largest electric utility in the state of Florida and one of the largest electric utilities in the U.S. FPL’s strategic focus is centered on investing in generation, transmission and distribution facilities to deliver on its value proposition of low customer bills, high reliability, outstanding customer service and clean energy solutions for the benefit of its more than 5.6 million customers. NEER is the world's largest generator of renewable energy from the wind and sun, as well as a world leader in battery storage. NEER’s strategic focus is centered on the development, construction and operation of long-term contracted assets throughout the U.S. and Canada, primarily consisting of clean energy solutions such as renewable generation facilities and battery storage projects, and electric transmission facilities.In January 2019, NEE acquired Gulf Power, a rate-regulated electric utility engaged in the generation, transmission, distribution and sale of electric energy in northwest Florida. On January 1, 2021, FPL and Gulf Power merged, with FPL as the surviving entity. However, FPL will continue to be regulated as two separate ratemaking entities in the former service areas of FPL and Gulf Power until the FPSC approves consolidation of the FPL and Gulf Power rates and tariffs. FPL has notified the FPSC of its intent to submit such a request as part of its upcoming base rate proceeding to be initiated in March 2021 (see FPL - FPL Regulation - FPL Electric Rate Regulation - Base Rates - FPL 2021 Base Rate Proceeding). FPL and Gulf Power will continue to be separate operating segments of NEE as well as FPL, through 2021. For purposes of discussion herein, prior to the merger, the use of the term "FPL" represents FPL the legal entity, which excludes Gulf Power, and "Gulf Power" represents Gulf Power Company the legal entity; post-merger "FPL" represents the legal entity, including Gulf Power, "FPL segment" represents FPL, excluding Gulf Power, and "Gulf Power" represents an operating division of FPL.As described in more detail in the following sections, NEE seeks to create value in its two principal businesses by meeting its customers' needs more economically and more reliably than its competitors. NEE's strategy has resulted in profitable growth over sustained periods at both FPL and NEER. Management seeks to grow each business in a manner consistent with the varying opportunities available to it; however, management believes that the diversification and balance represented by FPL and NEER is a valuable characteristic of the enterprise and recognizes that each business contributes to NEE's financial strength in different ways. FPL and NEER share a common platform with the objective of lowering costs and creating efficiencies for their businesses. NEE and its subsidiaries, with employees totaling approximately 14,900 as of December 31, 2020, continue to develop and implement enterprise-wide initiatives focused on improving productivity, process effectiveness and quality. NEE's segments for financial reporting purposes are the FPL segment, Gulf Power and NEER. NEECH, a wholly owned subsidiary of NEE, owns and provides funding for NEE's operating subsidiaries, other than FPL and its subsidiaries. NEP, an affiliate of NextEra Energy Resources, acquires, manages and owns contracted clean energy projects with stable, long-term cash flows. See NEER section below for further discussion of NEP. The following diagram depicts NEE's simplified ownership structure:4Table of ContentsFPLFPL is a rate-regulated electric utility engaged primarily in the generation, transmission, distribution and sale of electric energy in Florida. FPL is the largest electric utility in the state of Florida and one of the largest electric utilities in the U.S. At December 31, 2020, FPL had approximately 28,400 MW of net generating capacity, approximately 76,200 circuit miles of transmission and distribution lines and 673 substations. FPL provides service to its electric customers through integrated transmission and distribution systems that link its generation facilities to its customers. In 2018, FPL acquired a retail gas business (see Note 6 - Other). On January 1, 2021, FPL and Gulf Power merged, with FPL as the surviving entity. However, FPL will continue to be regulated as two separate ratemaking entities in the former service areas of FPL and Gulf Power until the FPSC approves consolidation of the FPL and Gulf Power rates and tariffs. FPL and Gulf Power will continue to be separate operating segments of NEE as well as FPL, through 2021. See FPL - FPL Regulation - FPL Electric Rate Regulation - Base Rates - FPL 2021 Base Rate Proceeding and Gulf Power below. Following the merger, FPL now serves more than 11 million people through more than 5.6 million customer accounts. The following map shows FPL's service areas and plant locations, which cover most of the east and lower west coasts of Florida and are in eight counties throughout northwest Florida (see FPL Sources of Generation below).5Table of ContentsCUSTOMERS AND REVENUEFPL's primary source of operating revenues is from its retail customer base; it also serves a limited number of wholesale customers within Florida. The percentage of FPL's operating revenues and customer accounts by customer class were as follows: For both retail and wholesale customers, the prices (or rates) that FPL may charge are approved by regulatory bodies, by the FPSC in the case of retail customers and by the FERC in the case of wholesale customers. In general, under U.S. and Florida law, regulated rates are intended to cover the cost of providing service, including a reasonable rate of return on invested capital. Since the regulatory bodies have authority to determine the relevant cost of providing service and the appropriate rate of return on capital employed, there can be no guarantee that FPL will be able to earn any particular rate of return or recover all of its costs through regulated rates. See FPL Regulation below.FPL seeks to maintain attractive rates for its customers. Since rates are largely cost-based, maintaining low rates requires a strategy focused on developing and maintaining a low-cost position, including the implementation of ideas generated from cost savings initiatives. A common benchmark used in the electric power industry for comparing rates across companies is the price of 1,000 kWh of consumption per month for a residential customer. FPL's 2020 average bill for 1,000 kWh of monthly residential usage was well below both the average of reporting electric utilities within Florida and the July 2020 national average (the latest date for which this data is available) as indicated below:6Table of ContentsFRANCHISE AGREEMENTS AND COMPETITIONFPL's service to its electric retail customers is provided primarily under franchise agreements negotiated with municipalities or counties. During the term of a franchise agreement, which is typically 30 years, the municipality or county agrees not to form its own utility, and FPL has the right to offer electric service to residents. At December 31, 2020, FPL held 192 franchise agreements with various municipalities and counties in Florida with varying expiration dates through 2050. These franchise agreements covered approximately 88% of FPL's retail customer base in Florida. At December 31, 2020, FPL also provided service to customers in 11 other municipalities and to 23 unincorporated areas within its service area without franchise agreements pursuant to the general obligation to serve as a public utility. FPL relies upon Florida law for access to public rights of way. Because any customer may elect to provide his/her own electric services, FPL effectively must compete for an individual customer's business. As a practical matter, few customers provide their own service at the present time since FPL's cost of service is lower than the cost of self-generation for the vast majority of customers. Changing technology, economic conditions and other factors could alter the favorable relative cost position that FPL currently enjoys; however, FPL seeks as a matter of strategy to ensure that it delivers superior value, in the form of low customer bills, high reliability, outstanding customer service and clean energy solutions.In addition to self-generation by residential, commercial and industrial customers, FPL also faces competition from other suppliers of electrical energy to wholesale customers and from alternative energy sources. In each of 2020, 2019 and 2018, operating revenues from wholesale and industrial electric customers combined represented approximately five percent of FPL's total operating revenues.For the building of new steam and solar generating capacity of 75 MW or greater, the FPSC requires investor-owned electric utilities, including FPL, to issue a request for proposal (RFP) except when the FPSC determines that an exception from the RFP process is in the public interest. The RFP process allows independent power producers and others to bid to supply the new generating capacity. If a bidder has the most cost-effective alternative, meets other criteria such as financial viability and demonstrates adequate expertise and experience in building and/or operating generating capacity of the type proposed, the investor-owned electric utility would seek to negotiate a purchased power agreement with the selected bidder and request that the FPSC approve the terms of the purchased power agreement and, if appropriate, provide the required authorization for the construction of the bidder's generating capacity.FPL SOURCES OF GENERATIONAt December 31, 2020, FPL's resources for serving load consisted of approximately 28,528 MW, of which 28,414 MW were from FPL-owned facilities and 114 MW were available through purchased power agreements. FPL owned and operated 30 units that used fossil fuels, primarily natural gas, with generating capacity of 22,008 MW and had a joint ownership interest in Scherer Unit No. 4, a coal unit located in Georgia which it does not operate, with net generating capacity of 634 MW. During 2020, FPL announced plans to retire Scherer Unit No. 4 in early 2022 (see Note 7 - Jointly-Owned Electric Plants). In addition, FPL owned, or had undivided interests in, and operated 4 nuclear units with net generating capacity totaling 3,502 MW (see Nuclear Operations below) and owned and operated 32 solar generation facilities with generating capacity totaling 2,270 MW. FPL customer usage and operating revenues are typically higher during the summer months, largely due to the prevalent use of air conditioning in its service area. Occasionally, unusually cold temperatures during the winter months result in significant increases in electricity usage for short periods of time.FPL is in the process of modernizing two generating units at its Lauderdale facility to a high-efficiency, clean-burning natural gas unit (Dania Beach Clean Energy Center). The Dania Beach Clean Energy Center is expected to provide approximately 1,200 MW of generating capacity and to be in service in 2022. FPL is also in the process of completing the construction of the final nine of twenty planned 74.5 MW solar power plants dedicated to its SolarTogether program, a voluntary community solar program approved by the FPSC that gives certain FPL electric customers an opportunity to participate directly in the expansion of solar energy and receive credits on their related monthly customer bill. The final nine plants are expected to be placed in service by mid-2021. 7Table of ContentsFuel SourcesFPL relies upon a mix of fuel sources for its generation facilities, the ability of some of its generation facilities to operate on both natural gas and oil, and on purchased power to maintain the flexibility to achieve a more economical fuel mix in order to respond to market and industry developments.*approximately 71% has dual fuel capabilitySignificant Fuel and Transportation Contracts. At December 31, 2020, FPL had the following significant fuel and transportation contracts in place:•firm transportation contracts with seven different transportation suppliers for natural gas pipeline capacity for an aggregate maximum quantity of 3,169,000 MMBtu/day with expiration dates ranging from 2021 to 2042 (see Note 15 - Contracts); •several contracts for the supply of uranium and the conversion, enrichment and fabrication of nuclear fuel with expiration dates ranging from March 2021 through 2032; and•short- and medium-term natural gas supply contracts to provide a portion of FPL's anticipated needs for natural gas. The remainder of FPL's natural gas requirements is purchased in the spot market.Nuclear OperationsAt December 31, 2020, FPL owned, or had undivided interests in, and operated the four nuclear units in Florida discussed below. FPL's nuclear units are periodically removed from service to accommodate planned refueling and maintenance outages, including inspections, repairs and certain other modifications. Scheduled nuclear refueling outages require the unit to be removed from service for variable lengths of time.FacilityFPL's Ownership(MW)Beginning of NextScheduled Refueling OutageOperating LicenseExpiration DateSt. Lucie Unit No. 1981April 20212036St. Lucie Unit No. 2 840(a)August 20212043Turkey Point Unit No. 3837October 20212052Turkey Point Unit No. 4844March 20222053______________________(a) Excludes 147 MW operated by FPL but owned by non-affiliates.NRC regulations require FPL to submit a plan for decontamination and decommissioning five years before the projected end of plant operation. FPL's current plans, under the existing operating licenses, provide for St. Lucie Unit No. 1 to be shut down in 2036 with decommissioning activities to be integrated with the dismantlement of St. Lucie Unit No. 2 commencing in 2043. Current plans provide for the dismantlement of Turkey Point Units Nos. 3 and 4 with decommissioning activities commencing in 2052 and 2053, respectively. 8Table of ContentsFPL's nuclear facilities use both on-site storage pools and dry storage casks to store spent nuclear fuel generated by these facilities, which are expected to provide sufficient storage of spent nuclear fuel that is generated at these facilities through license expiration.FPL ENERGY MARKETING AND TRADINGFPL's Energy Marketing & Trading division (EMT) buys and sells wholesale energy commodities, such as natural gas, oil and electricity. EMT procures natural gas and oil for FPL's use in power generation and sells excess natural gas, oil and electricity. EMT also uses derivative instruments (primarily swaps, options and forwards) to manage the physical and financial risks inherent in the purchase and sale of fuel and electricity. Substantially all of the results of EMT's activities are passed through to customers in the fuel or capacity clauses. See Management's Discussion - Energy Marketing and Trading and Market Risk Sensitivity and Note 3.FPL REGULATIONFPL's operations are subject to regulation by a number of federal, state and other organizations, including, but not limited to, the following:•the FPSC, which has jurisdiction over retail rates, service area, issuances of securities, planning, siting and construction of facilities, among other things;•the FERC, which oversees the acquisition and disposition of generation, transmission and other facilities, transmission of electricity and natural gas in interstate commerce, proposals to build and operate interstate natural gas pipelines and storage facilities, and wholesale purchases and sales of electric energy, among other things;•the NERC, which, through its regional entities, establishes and enforces mandatory reliability standards, subject to approval by the FERC, to ensure the reliability of the U.S. electric transmission and generation system and to prevent major system blackouts;•the NRC, which has jurisdiction over the operation of nuclear power plants through the issuance of operating licenses, rules, regulations and orders; and•the EPA, which has the responsibility to maintain and enforce national standards under a variety of environmental laws, in some cases delegating authority to state agencies. The EPA also works with industries and all levels of government, including federal and state governments, in a wide variety of voluntary pollution prevention programs and energy conservation efforts.FPL Electric Rate RegulationThe FPSC sets rates at a level that is intended to allow the utility the opportunity to collect from retail customers total revenues (revenue requirements) equal to its cost of providing service, including a reasonable rate of return on invested capital. To accomplish this, the FPSC uses various ratemaking mechanisms, including, among other things, base rates and cost recovery clauses. Although FPL and Gulf Power merged effective January 1, 2021, FPL will continue to be regulated as two separate rate making entities until the FPSC approves consolidation of the FPL and Gulf Power rates and tariffs (see FPL 2021 Base Rate Proceeding below).Base Rates. In general, the basic costs of providing electric service, other than fuel and certain other costs, are recovered through base rates, which are designed to recover the costs of constructing, operating and maintaining the utility system. These basic costs include O&M expenses, depreciation and taxes, as well as a return on investment in assets used and useful in providing electric service (rate base). At the time base rates are established, the allowed rate of return on rate base approximates the FPSC's determination of the utility's estimated weighted-average cost of capital, which includes its costs for outstanding debt and an allowed return on common equity. The FPSC monitors the utility's actual regulatory ROE through a surveillance report that is filed monthly with the FPSC. The FPSC does not provide assurance that any regulatory ROE will be achieved. Base rates are determined in rate proceedings or through negotiated settlements of those proceedings. Proceedings can occur at the initiative of the utility or upon action by the FPSC. Existing base rates remain in effect until new base rates are approved by the FPSC.FPL Base Rates Effective January 2017 - In December 2016, the FPSC issued a final order approving a stipulation and settlement between FPL and several intervenors in FPL's base rate proceeding (2016 rate agreement). Key elements of the 2016 rate agreement, which became effective in January 2017, include, among other things, the following: •New retail base rates and charges were established resulting in the following increases in annualized retail base revenues:◦$400 million beginning January 1, 2017;◦$211 million beginning January 1, 2018; and◦$200 million beginning April 1, 2019 for a new approximately 1,720 MW natural gas-fired combined-cycle unit in Okeechobee County, Florida (Okeechobee Clean Energy Center) that achieved commercial operation on March 31, 2019.9Table of Contents•In addition, FPL received base rate increases in 2018 through 2020 associated with the addition of approximately 1,200 MW of new solar generating capacity that became operational during that timeframe.•FPL's allowed regulatory ROE is 10.55%, with a range of 9.60% to 11.60%. If FPL's earned regulatory ROE falls below 9.60%, FPL may seek retail base rate relief. If the earned regulatory ROE rises above 11.60%, any party with standing, other than FPL, may seek a review of FPL's retail base rates.•Subject to certain conditions, FPL may amortize, over the term of the 2016 rate agreement, up to $1.0 billion of depreciation reserve surplus plus the reserve amount that remained under FPL's previous rate agreement (approximately $250 million), provided that in any year of the 2016 rate agreement FPL must amortize at least enough reserve to maintain a 9.60% earned regulatory ROE but may not amortize any reserve that would result in an earned regulatory ROE in excess of 11.60%.•Future storm restoration costs would be recoverable on an interim basis beginning 60 days from the filing of a cost recovery petition, but capped at an amount that could produce a surcharge of no more than $4 for every 1,000 kWh of usage on residential bills during the first 12 months of cost recovery. Any additional costs would be eligible for recovery in subsequent years. If storm restoration costs exceed $800 million in any given calendar year, FPL may request an increase to the $4 surcharge to recover amounts above $400 million. See Note 1 - Storm Funds, Storm Reserves and Storm Cost Recovery. FPL 2021 Base Rate Proceeding - On January 11, 2021, FPL filed a formal notification with the FPSC indicating its intent to initiate a base rate proceeding by submitting a four-year rate plan that would begin in January 2022 replacing the 2016 rate agreement. As Gulf Power legally merged with FPL on January 1, 2021, the notification indicates that the plan will include the total revenue requirements of the combined utility system, reflecting the legal and operational consolidation of Gulf Power into FPL. The notification also states that, based on preliminary estimates, FPL expects to request a general base annual revenue requirement increase of approximately $1.1 billion effective January 2022 and a subsequent annual increase of approximately $615 million effective January 2023. The plan is also expected to request authority for a Solar Base Rate Adjustment (SoBRA) mechanism to recover, subject to FPSC review, the revenue requirements of up to 900 MW of solar projects in 2024 and up to 900 MW in 2025. If the full amount of new solar capacity allowed under the proposed SoBRA mechanism were constructed, FPL’s preliminary estimate is that it would result in base rate adjustments of approximately $140 million in 2024 and $140 million in 2025. The proposed SoBRA mechanism adjustments would be offset, in part, by a reduction in FPL’s fuel costs. Under the filing, FPL does not expect to request further adjustments to general base annual revenue requirements to be effective before January 2026. In addition, FPL expects to propose an allowed regulatory ROE midpoint of 11.50%, which includes a 50 basis point incentive for superior performance. FPL expects to file its formal request to initiate a base rate proceeding in March 2021.Cost Recovery Clauses. Cost recovery clauses are designed to permit full recovery of certain costs and provide a return on certain assets allowed to be recovered through various clauses. Cost recovery clause costs are recovered through levelized monthly charges per kWh or kW, depending on the customer's rate class. These cost recovery clause charges are calculated annually based on estimated costs and estimated customer usage for the following year, plus or minus true-up adjustments to reflect the estimated over or under recovery of costs for the current and prior periods. An adjustment to the levelized charges may be approved during the course of a year to reflect revised estimates. FPL recovers costs from customers through the following clauses:•Fuel - primarily fuel costs, the most significant of the cost recovery clauses in terms of operating revenues (see Note 1 - Rate Regulation);•Storm Protection Plan - costs associated with an FPSC-approved transmission and distribution storm protection plan, which includes costs for hardening of overhead transmission and distribution lines, undergrounding of certain distribution lines and vegetation management;•Capacity - primarily certain costs associated with the acquisition of several electric generation facilities (see Note 1 - Rate Regulation); •Energy Conservation - costs associated with implementing energy conservation programs; and•Environmental - certain costs of complying with federal, state and local environmental regulations enacted after April 1993 and costs associated with three of FPL's solar facilities placed in service prior to 2016.The FPSC has the authority to disallow recovery of costs that it considers excessive or imprudently incurred. These costs may include, among others, fuel and O&M expenses, the cost of replacing power lost when fossil and nuclear units are unavailable, storm restoration costs and costs associated with the construction or acquisition of new facilities.FERCThe Federal Power Act grants the FERC exclusive ratemaking jurisdiction over wholesale sales of electricity and the transmission of electricity and natural gas in interstate commerce. Pursuant to the Federal Power Act, electric utilities must maintain tariffs and rate schedules on file with the FERC which govern the rates, terms and conditions for the provision of FERC-jurisdictional wholesale power and transmission services. The Federal Power Act also gives the FERC authority to certify and oversee an electric reliability organization with authority to establish and independently enforce mandatory reliability standards applicable to all users, owners and operators of the bulk-power system. See NERC below. Electric utilities are subject to accounting, record-keeping and reporting requirements administered by the FERC. The FERC also places certain limitations on transactions between electric utilities and their affiliates.10Table of ContentsNERCThe NERC has been certified by the FERC as an electric reliability organization. The NERC's mandate is to ensure the reliability and security of the North American bulk-power system through the establishment and enforcement of reliability standards approved by FERC. The NERC's regional entities also enforce reliability standards approved by the FERC. FPL is subject to these reliability standards and incurs costs to ensure compliance with continually heightened requirements, and can incur significant penalties for failing to comply with them.FPL Environmental RegulationFPL is subject to environmental laws and regulations as described in the NEE Environmental Matters section below. FPL expects to seek recovery through FPL's and Gulf Power's respective environmental clauses for compliance costs associated with any new environmental laws and regulations.FPL HUMAN CAPITALFPL had approximately 9,100 employees at December 31, 2020, with approximately 31% of these employees represented by the International Brotherhood of Electrical Workers (IBEW), substantially all of which are under a collective bargaining agreement with FPL that expires January 31, 2022.GULF POWERGulf Power, a part of FPL's rate-regulated electric utility system beginning January 1, 2021, is engaged in the generation, transmission, distribution and sale of electric energy in northwest Florida, and is subject to similar regulations described in FPL - FPL Regulation above. Gulf Power operates under a separate base rate settlement agreement, which took effect July 1, 2017, that provides for an allowed regulatory ROE of 10.25%, with a range of 9.25% to 11.25%. As of December 31, 2020, Gulf Power served approximately 474,000 customers in eight counties throughout northwest Florida and had approximately 2,400 MW of primarily fossil-fueled electric net generating capacity and 9,500 miles of transmission and distribution lines located primarily in Florida. See FPL - FPL Regulation - FPL Electric Rate Regulation - Base Rates - FPL 2021 Base Rate Proceeding.On January 1, 2019, NEE completed the acquisition of all of the outstanding common shares of Gulf Power under a stock purchase agreement with The Southern Company dated May 20, 2018, as amended, for approximately $4.44 billion in cash consideration and the assumption of approximately $1.3 billion of Gulf Power debt. On January 1, 2021, Gulf Power merged with FPL, with FPL as the surviving entity. FPL and Gulf Power will continue to be separate operating segments of NEE as well as FPL, through 2021. See Note 6 - Gulf Power Company and - Merger of FPL and Gulf Power for further discussion. NEERNEER, comprised of NEE's competitive energy and rate-regulated transmission businesses, is a diversified clean energy business with a strategy that emphasizes the development, construction and operation of long-term contracted assets with a focus on renewable projects. NEE reports NextEra Energy Resources and NEET, a rate-regulated transmission business, on a combined basis for segment reporting purposes, and the combined segment is referred to as NEER. The NEER segment currently owns, develops, constructs, manages and operates electric generation facilities in wholesale energy markets in the U.S. and Canada. NEER, with approximately 23,900 MW of total net generating capacity at December 31, 2020, is one of the largest wholesale generators of electric power in the U.S., including approximately 23,370 MW of net generating capacity across 38 states and 520 MW of net generating capacity in 4 Canadian provinces. At December 31, 2020, NEER operates facilities, in which it has ownership interests, with a total generating capacity of 27,300 MW. NEER produces the majority of its electricity from clean and renewable sources as described more fully below. In addition, NEER develops and constructs battery storage projects, which when combined with its renewable projects, serve to enhance its ability to meet customer needs for a nearly firm generation source. NEER is the world's largest generator of renewable energy from the wind and sun based on 2020 MWh produced on a net generation basis, as well as a world leader in battery storage. NEER also owns and operates rate-regulated transmission facilities, primarily in Texas and California, and transmission lines that connect its electric generation facilities to the electric grid, which are comprised of approximately 215 substations and 1,910 circuit miles of transmission lines at December 31, 2020.NEER also engages in energy-related commodity marketing and trading activities, including entering into financial and physical contracts. These contracts primarily include power and fuel commodities and their related products for the purpose of providing full energy and capacity requirements services, primarily to distribution utilities in certain markets, and offering customized power and fuel and related risk management services to wholesale customers, as well as to hedge the production from NEER's generation assets that is not sold under long-term power supply agreements. In addition, NEER participates in natural gas, natural gas liquids and oil production through operating and non-operating ownership interests, and in pipeline infrastructure construction, management and operations, through either wholly owned subsidiaries or noncontrolling or joint venture interests, hereafter referred to as the gas infrastructure business. NEER also hedges the expected output from its gas infrastructure production assets to protect against price movements. 11Table of ContentsNEP - NEP acquires, manages and owns contracted clean energy projects with stable long-term cash flows through a limited partner interest in NEP OpCo. NEP's projects include energy projects contributed by or acquired from NextEra Energy Resources, as well as ownership interests in contracted natural gas pipelines acquired from third parties. NextEra Energy Resources' indirect limited partnership interest in NEP OpCo based on the number of outstanding NEP OpCo common units was approximately 57.2% at December 31, 2020. NextEra Energy Resources accounts for its ownership interest in NEP as an equity method investment with its earnings/losses from NEP as equity in earnings (losses) of equity method investees and accounts for its asset sales to NEP as third-party sales in its consolidated financial statements. See Note 1 - Basis of Presentation. At December 31, 2020, NEP owned, or had an ownership interest in, a portfolio of 38 wind and solar projects with generating capacity totaling approximately 5,730 MW and in contracted natural gas pipelines, all located in the U.S. as further discussed in Generation and Other Operations. NextEra Energy Resources operates all of the energy projects in NEP's portfolio and its ownership interest in the portfolio's generating capacity was approximately 3,379 MW at December 31, 2020. GENERATION AND OTHER OPERATIONSNEER sells products associated with its generation facilities (energy, capacity, renewable energy credits (RECs) and ancillary services) in competitive markets in regions where those facilities are located. Customer transactions may be supplied from NEER generation facilities or from purchases in the wholesale markets, or from a combination thereof. See Markets and Competition below.At December 31, 2020, NEER managed or participated in the management of essentially all of the following generation projects, natural gas pipelines and transmission facilities that it wholly owned or in which it had an ownership interest. 12Table of ContentsGeneration Assets and Other Operations*Primarily natural gasGeneration Assets.NEER's portfolio of generation assets primarily consist of generation facilities with long-term power sales agreements for substantially all of their capacity and/or energy output. Information related to contracted generation assets at December 31, 2020 was as follows:•represented approximately 21,983 MW of total net generating capacity; •weighted-average remaining contract term of the power sales agreements and the remaining life of the PTCs associated with repowered wind facilities of approximately 16 years, based on forecasted contributions to earnings and forecasted amounts of electricity produced by the repowered wind facilities; and•contracts for the supply of uranium and the conversion, enrichment and fabrication of nuclear fuel have expiration dates ranging from March 2021 through 2033 (see Note 15 - Contracts).NEER's merchant generation assets primarily consist of generation facilities that do not have long-term power sales agreements to sell their capacity and/or energy output and therefore require active marketing and hedging. Merchant generation assets at December 31, 2020 represented approximately 1,913 MW of total net generating capacity, including 1,102 MW from nuclear generation and 805 MW from other peak generation facilities, and are primarily located in the Northeast region of the U.S. NEER utilizes swaps, options, futures and forwards to lock in pricing and manage the commodity price risk inherent in power sales and fuel purchases.13Table of ContentsOther Operations.Gas Infrastructure Business - At December 31, 2020, NextEra Energy Resources had ownership interests in natural gas pipelines, the most significant of which are discussed below, and in oil and gas shale formations located primarily in the Midwest and South regions of the U.S.MilesofPipelinePipelineLocation/RouteOwnershipTotal Net Capacity (per day)Actual/ExpectedIn-ServiceDatesOperational:Texas Pipelines(a)542South Texas53.8%(b)2.19 Bcf1950s - 2015Sabal Trail(c)517Southwestern Alabama to Central Florida42.5%0.43 BcfJune 2017 - May 2020Florida Southeast Connection(c)169Central Florida to South Florida100%0.64 BcfJune 2017Central Penn Line(d)185Northeastern Pennsylvania to SoutheasternPennsylvania22.3%(b)0.29 Bcf - 0.40 BcfOctober 2018 - Mid-2022Under Construction:Mountain Valley Pipeline(e)303Northwestern West Virginia to SouthernVirginia 31.5%0.63 Bcf2022______________________(a) A NEP portfolio of seven natural gas pipelines, of which a third party owns a 10% interest in a 120-mile pipeline with a daily capacity of approximately 2.3 Bcf. Approximately 1.71 Bcf per day of net capacity is contracted with firm ship-or-pay contracts that have expiration dates ranging from 2021 to 2035. (b) Ownership percentage based on NextEra Energy Resources limited partnership interest in NEP OpCo common units. (c) See Note 15 - Contracts for a discussion of transportation contracts with FPL. (d) NEP has an indirect equity method investment in the Central Penn Line (CPL) which represents an approximately 39% aggregate ownership interest in the CPL.(e) Completion of construction of the natural gas pipeline is subject to certain conditions, including applicable regulatory approvals and the resolution of legal challenges. Also, see Note 4 - Nonrecurring Fair Value Measurements for a discussion of an impairment charge and Note 15 - Contracts for a discussion of a transportation contract with a NextEra Energy Resources subsidiary.Rate-Regulated Transmission - At December 31, 2020, certain entities within the NEER segment had ownership interests in rate-regulated transmission facilities, the most significant of which are discussed below, which facilities are located primarily in ERCOT, CAISO and Independent Electricity System Operator (IESO) jurisdictions.MilesSubstationsKilovoltLocationRate RegulatorOwnershipActual/ExpectedIn-ServiceDatesOperational:Lone Star3306345Central TexasPUCT100%2013Trans Bay Cable532200 DC(a)Northern CaliforniaFERC100%2010Under Construction:NextBridge Infrastructure280-230Ontario, CanadaOEB50%First Quarter of 2022______________________(a) Direct currentIn September 2020, a wholly owned subsidiary of NEET entered into agreements to acquire GridLiance Holdco, LP and GridLiance GP, LLC, which owns and operates three FERC-regulated transmission utilities with approximately 700 miles of high-voltage transmission lines across six states. The acquisition is expected to close in the first half of 2021, and is subject to, among other things, certain regulatory approvals. See Note 6 - GridLiance.Customer Supply and Proprietary Power and Gas Trading - NEER provides commodities-related products to customers, engages in energy-related commodity marketing and trading activities and includes the operations of a retail electricity provider. Through NextEra Energy Resources subsidiary PMI, NEER:•manages risk associated with fluctuating commodity prices and optimizes the value of NEER's power generation and gas infrastructure production assets through the use of swaps, options, futures and forwards;•sells output from NEER's plants that is not sold under long-term contracts and procures fossil fuel for use by NEER's generation fleet;•provides full energy and capacity requirements to customers; and•markets and trades energy-related commodity products and provides a wide range of electricity and fuel commodity products as well as marketing and trading services to customers.14Table of ContentsNEER Generation Assets Fuel/Technology MixNextEra Energy Resources utilized the following mix of fuel sources for generation facilities in which it has an ownership interest: *Primarily natural gasWind Facilities•located in 20 states in the U.S. and 4 provinces in Canada;•operated a total generating capacity of 18,551 MW at December 31, 2020;•ownership interests in a total net generating capacity of 16,073 MW at December 31, 2020; ◦all MW are from contracted wind assets located primarily throughout Texas and the Midwest and West regions of the U.S. and Canada; ◦added approximately 2,299 MW of new generating capacity and repowered wind generating capacity totaling 1,412 MW in the U.S. in 2020 and sold assets to NEP (see Note 1 - Disposal of Businesses/Assets and - Sale of Noncontrolling Ownership Interests).Solar Facilities•located in 27 states in the U.S.;•operated PV and solar thermal facilities with a total generating capacity of 3,629 MW at December 31, 2020;•ownership interests in PV and solar thermal facilities with a total net generating capacity of 3,160 MW at December 31, 2020;◦essentially all MW are from contracted solar facilities located primarily throughout the West and South regions of the U.S.;◦added approximately 625 MW of generating capacity in the U.S. in 2020 (see Note 1 - Disposal of Businesses/Assets and - Sale of Noncontrolling Ownership Interests for asset sales, including sales to NEP).Nuclear FacilitiesAt December 31, 2020, NextEra Energy Resources owned, or had undivided interests in, and operated the three nuclear units discussed below. NEER's nuclear units are periodically removed from service to accommodate planned refueling and maintenance outages, including inspections, repairs and certain other modifications. Scheduled nuclear refueling outages require the unit to be removed from service for variable lengths of time.FacilityLocationOwnership(MW)PortfolioCategoryNext ScheduledRefueling OutageOperating LicenseExpiration DateSeabrookNew Hampshire1,102(a)MerchantOctober 20212050Point Beach Unit No. 1Wisconsin595Contracted(b)March 20222030(c)Point Beach Unit No. 2Wisconsin595Contracted(b)October 20212033(c)______________________(a) Excludes 147 MW operated by NEER but owned by non-affiliates.(b) NEER sells all of the output of Point Beach Units Nos. 1 and 2 under long-term contracts through their current operating license expiration dates.(c) In 2020, NEER filed an application with the NRC to renew both Point Beach operating licenses for an additional 20 years. License renewal is pending.15Table of ContentsNEER is responsible for all nuclear unit operations and the ultimate decommissioning of the nuclear units, the cost of which is shared on a pro-rata basis by the joint owners for the jointly-owned units. NRC regulations require plant owners to submit a plan for decontamination and decommissioning five years before the projected end of plant operation. NEER's nuclear facilities use both on-site storage pools and dry storage casks to store spent nuclear fuel generated by these facilities, which are expected to provide sufficient storage of spent nuclear fuel that is generated at these facilities through current license expiration.NEER also owns an approximately 70% interest in Duane Arnold Energy Center (Duane Arnold), a nuclear facility located in Iowa that ceased operations in August 2020. NEER submitted a site-specific cost estimate and plan for decontamination and decommissioning to the NRC. All spent nuclear fuel housed onsite is expected to be in long-term dry storage within three years of plant shutdown and until the DOE is able to take possession. NEER estimates that the cost of decommissioning Duane Arnold is fully funded and expects completion by approximately 2080.Policy Incentives for Renewable Energy ProjectsU.S. federal, state and local governments have established various incentives to support the development of renewable energy projects. These incentives include accelerated tax depreciation, PTCs, ITCs, cash grants, tax abatements and RPS programs. Pursuant to the U.S. federal Modified Accelerated Cost Recovery System, wind and solar projects are fully depreciated for tax purposes over a five-year period even though the useful life of such projects is generally much longer than five years.Owners of utility-scale wind facilities are eligible to claim an income tax credit (the PTC, or an ITC in lieu of the PTC) upon initially achieving commercial operation. The PTC is determined based on the amount of electricity produced by the wind facility during the first ten years of commercial operation. This incentive was created under the Energy Policy Act of 1992 and has been extended several times. Alternatively, an ITC equal to 30% of the cost of a wind facility may be claimed in lieu of the PTC. Owners of solar facilities are eligible to claim a 30% ITC for new solar facilities. Previously, owners of solar facilities could have elected to receive an equivalent cash payment from the U.S. Department of Treasury for the value of the 30% ITC (convertible ITC) for qualifying solar facilities where construction began before the end of 2011 and the facilities were placed in service before 2017. In order to qualify for the PTC (or an ITC in lieu of the PTC) for wind or ITC for solar, construction of a facility must begin before a specified date and the taxpayer must maintain a continuous program of construction or continuous efforts to advance the project to completion. The Internal Revenue Service (IRS) issued guidance stating that the safe harbor for continuous efforts and continuous construction requirements will generally be satisfied if the facility is placed in service no more than four years after the year in which construction of the facility began (extended to five years for a facility that began construction in 2016 or 2017). The IRS also confirmed that retrofitted wind facilities may re-qualify for PTCs or ITCs pursuant to the 5% safe harbor for the begin construction requirement, as long as the cost basis of the new investment is at least 80% of the facility’s total fair value. Tax credits for qualifying wind and solar projects are subject to the following schedule. Year construction of project begins(a)201620172018201920202021202220232024 and beyondPTC(b)100 %80 %60 %40 %60 %60 %---Wind ITC(c)30 %24 %18 %12 %18 %18 %---Solar ITC(d)30 %30 %30 %30 %26 %26 %26 %22 %10 %_________________________(a) A project must be placed in service no more than four years after the year in which construction of the project began (extended to five years for a facility that began construction in 2016 or 2017) to qualify for the PTC or ITC.(b) Percentage of the full PTC available for wind projects that begin construction during the applicable year.(c) Percentage of eligible project costs that can be claimed as ITC by wind projects that begin construction during the applicable year.(d) Percentage of eligible project costs that can be claimed as ITC by solar projects that begin construction during the applicable year. ITC is limited to 10% for solar projects not placed in service before January 1, 2026.Other countries, including Canada, provide for incentives like feed-in-tariffs for renewable energy projects. The feed-in-tariffs promote renewable energy investments by offering long-term contracts to renewable energy producers, typically based on the cost of generation of each technology.MARKETS AND COMPETITIONElectricity markets in the U.S. and Canada are regional and diverse in character. All are extensively regulated, and competition in these markets is shaped and constrained by regulation. The nature of the products offered varies based on the specifics of regulation in each region. Generally, in addition to the natural constraints on pricing freedom presented by competition, NEER may also face specific constraints in the form of price caps, or maximum allowed prices, for certain products. NEER's ability to sell the output of its generation facilities may also be constrained by available transmission capacity, which can vary from time to time and can have a significant impact on pricing.The degree and nature of competition is different in wholesale markets than in retail markets. During 2020, 2019 and 2018, approximately 85% of NEER's revenue was derived from wholesale electricity markets.Wholesale power generation is a capital-intensive, commodity-driven business with numerous industry participants. NEER primarily competes on the basis of price, but believes the green attributes of NEER's generation assets, its creditworthiness and 16Table of Contentsits ability to offer and manage reliable customized risk solutions to wholesale customers are competitive advantages. Wholesale power generation is a regional business that is highly fragmented relative to many other commodity industries and diverse in terms of industry structure. As such, there is a wide variation in terms of the capabilities, resources, nature and identity of the companies NEER competes with depending on the market. In wholesale markets, customers' needs are met through a variety of means, including long-term bilateral contracts, standardized bilateral products such as full requirements service and customized supply and risk management services.In general, U.S. and Canadian electricity markets encompass three classes of services: energy, capacity and ancillary services. Energy services relate to the physical delivery of power; capacity services relate to the availability of MW capacity of a power generation asset; and ancillary services are other services that relate to power generation assets, such as load regulation and spinning and non-spinning reserves. The exact nature of these classes of services is defined in part by regional tariffs. Not all regions have a capacity services class, and the specific definitions of ancillary services vary from region to region.RTOs and ISOs exist throughout much of North America to coordinate generation and transmission across wide geographic areas and to run markets. NEER operates in all RTO and ISO jurisdictions. At December 31, 2020, NEER also had generation facilities with ownership interests in a total net generating capacity of approximately 5,913 MW that fall within reliability regions that are not under the jurisdiction of an established RTO or ISO, including 3,641 MW within the Western Electricity Coordinating Council and 1,303 MW within the SERC Reliability Corporation. Although each RTO and ISO may have differing objectives and structures, some benefits of these entities include regional planning, managing transmission congestion, developing larger wholesale markets for energy and capacity, maintaining reliability and facilitating competition among wholesale electricity providers. NEER has operations that fall within the following RTOs and ISOs:NEER competes in different regions to differing degrees, but in general it seeks to enter into long-term bilateral contracts for the full output of its generation facilities. At December 31, 2020, approximately 92% of NEER's net generating capacity was committed under long-term contracts. Where long-term contracts are not in effect, NEER sells the output of its facilities into daily spot markets. In such cases, NEER will frequently enter into shorter term bilateral contracts, typically of less than three years duration, to hedge the price risk associated with selling into a daily spot market. Such bilateral contracts, which may be hedges 17Table of Contentseither for physical delivery or for financial (pricing) offset, serve to protect a portion of the revenue that NEER expects to derive from the associated generation facility. Contracts that serve the economic purpose of hedging some portion of the expected revenue of a generation facility but are not recorded as hedges under GAAP are referred to as “non-qualifying hedges” for adjusted earnings purposes. See Management's Discussion - Overview - Adjusted Earnings.Certain facilities within the NEER wind and solar generation portfolio produce RECs and other environmental attributes which are typically sold along with the energy from the plants under long-term contracts, or may be sold separately from wind and solar generation not sold under long-term contracts. The purchasing party is solely entitled to the reporting rights and ownership of the environmental attributes.While the majority of NEER's revenue is derived from the output of its generation facilities, NEER is also an active competitor in several regions in the wholesale full requirements business and in providing structured and customized power and fuel products and services to a variety of customers. In the full requirements service, typically, the supplier agrees to meet the customer's needs for a full range of products for every hour of the day, at a fixed price, for a predetermined period of time, thereby assuming the risk of fluctuations in the customer's volume requirements.Expanded competition in a frequently changing regulatory environment presents both opportunities and risks for NEER. Opportunities exist for the selective acquisition of generation assets and for the construction and operation of efficient facilities that can sell power in competitive markets. NEER seeks to reduce its market risk by having a diversified portfolio by fuel type and location, as well as by contracting for the future sale of a significant amount of the electricity output of its facilities.NEER REGULATIONThe energy markets in which NEER operates are subject to domestic and foreign regulation, as the case may be, including local, state and federal regulation, and other specific rules.At December 31, 2020, essentially all of NEER's operating independent power projects located in the U.S. have received exempt wholesale generator status as defined under the Public Utility Holding Company Act of 2005. Exempt wholesale generators own or operate a facility exclusively to sell electricity to wholesale customers. They are barred from selling electricity directly to retail customers. While projects with exempt wholesale generator status are exempt from various restrictions, each project must still comply with other federal, state and local laws, including, but not limited to, those regarding siting, construction, operation, licensing, pollution abatement and other environmental laws.Additionally, most of the NEER facilities located in the U.S. are subject to FERC regulations and market rules and the NERC's mandatory reliability standards, all of its facilities are subject to environmental laws and the EPA's environmental regulations, and its nuclear facilities are also subject to the jurisdiction of the NRC. See FPL - FPL Regulation for additional discussion of FERC, NERC, NRC and EPA regulations. Rates of NEER's rate-regulated transmission businesses are set by regulatory bodies as noted in Generation and Other Operations - Generation Assets and Other Operations - Other Operations - Rate-Regulated Transmission. With the exception of facilities located in ERCOT, the FERC has jurisdiction over various aspects of NEER's business in the U.S., including the oversight and investigation of competitive wholesale energy markets, regulation of the transmission and sale of natural gas, and oversight of environmental matters related to natural gas projects and major electricity policy initiatives. The PUCT has jurisdiction, including the regulation of rates and services, oversight of competitive markets, and enforcement of statutes and rules, over NEER facilities located in ERCOT.Certain entities within the NEER segment and their affiliates are also subject to federal and provincial or regional regulations in Canada related to energy operations, energy markets and environmental standards. In Canada, activities related to owning and operating wind and solar projects and participating in wholesale and retail energy markets are regulated at the provincial level. In Ontario, for example, electricity generation facilities must be licensed by the OEB and may also be required to complete registrations and maintain market participant status with the IESO, in which case they must agree to be bound by and comply with the provisions of the market rules for the Ontario electricity market as well as the mandatory reliability standards of the NERC. In addition, NEER is subject to environmental laws and regulations as described in the NEE Environmental Matters section below. In order to better anticipate potential regulatory changes, NEER continues to actively evaluate and participate in regional market redesigns of existing operating rules for the integration of renewable energy resources and for the purchase and sale of energy commodities.NEER HUMAN CAPITALNEER had approximately 4,900 employees at December 31, 2020. NEER has collective bargaining agreements with the IBEW, the Utility Workers Union of America and the Security Police and Fire Professionals of America, which collectively represent approximately 13% of NEER's employees. The collective bargaining agreements have approximately two- to five-year terms and expire between June 2021 and September 2022.18Table of ContentsNEE ENVIRONMENTAL MATTERSNEE and its subsidiaries, including FPL, are subject to environmental laws and regulations, including extensive federal, state and local environmental statutes, rules and regulations relating to, among others, air quality, water quality and usage, waste management, wildlife protection and historical resources, for the siting, construction and ongoing operations of their facilities. The U.S. government and certain states and regions, as well as the Government of Canada and its provinces, have taken and continue to take certain actions, such as proposing and finalizing regulations or setting targets or goals, regarding the regulation and reduction of GHG emissions and the increase of renewable energy generation. The environmental laws in the U.S., including, among others, the Endangered Species Act, the Migratory Bird Treaty Act, and the Bald and Golden Eagle Protection Act, provide for the protection of numerous species, including endangered species and/or their habitats, migratory birds and eagles. The environmental laws in Canada, including, among others, the Species at Risk Act, provide for the recovery of wildlife species that are endangered or threatened and the management of species of special concern. Complying with these environmental laws and regulations could result in, among other things, changes in the design and operation of existing facilities and changes or delays in the location, design, construction and operation of new facilities. Failure to comply could result in fines, penalties, criminal sanctions or injunctions. NEE's rate-regulated subsidiaries expect to seek recovery for compliance costs associated with any new environmental laws and regulations, which recovery for FPL, including Gulf Power, would be through their respective environmental clause.WEBSITE ACCESS TO SEC FILINGSNEE and FPL make their SEC filings, including the annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and any amendments to those reports, available free of charge on NEE's internet website, www.nexteraenergy.com, as soon as reasonably practicable after those documents are electronically filed with or furnished to the SEC. The information and materials available on NEE's website (or any of its subsidiaries' or affiliates' websites) are not incorporated by reference into this combined Form 10-K. INFORMATION ABOUT OUR EXECUTIVE OFFICERS(a)NameAgePositionEffective DateMiguel Arechabala59Executive Vice President, Power Generation Division of NEEExecutive Vice President, Power Generation Division of FPLJanuary 1, 2014Deborah H. Caplan58Executive Vice President, Human Resources and Corporate Services of NEEExecutive Vice President, Human Resources and Corporate Services of FPLApril 15, 2013Paul I. Cutler61Treasurer of NEETreasurer of FPLAssistant Secretary of NEEFebruary 19, 2003February 18, 2003December 10, 1997John W. Ketchum50President and Chief Executive Officer of NextEra Energy ResourcesMarch 1, 2019Rebecca J. Kujawa45Executive Vice President, Finance and Chief Financial Officer of NEEExecutive Vice President, Finance and Chief Financial Officer of FPLMarch 1, 2019James M. May44Vice President, Controller and Chief Accounting Officer of NEEMarch 1, 2019Donald A. Moul55Executive Vice President, Nuclear Division and Chief Nuclear Officer of NEEVice President and Chief Nuclear Officer of FPLJanuary 1, 2020May 17, 2019Ronald R. Reagan52Executive Vice President, Engineering, Construction and Integrated Supply Chain of NEE Vice President, Engineering and Construction of FPLJanuary 1, 2020March 1, 2019James L. Robo58Chairman, President and Chief Executive Officer of NEEChairman of FPLDecember 13, 2013May 2, 2012Charles E. Sieving48Executive Vice President & General Counsel of NEEExecutive Vice President of FPLDecember 1, 2008January 1, 2009Eric E. Silagy55President and Chief Executive Officer of FPLMay 30, 2014______________________(a)Information is as of February 12, 2021. Executive officers are elected annually by, and serve at the pleasure of, their respective boards of directors. Except as noted below, each officer has held his/her present position for five years or more and his/her employment history is continuous. Mr. Ketchum served as Executive Vice President, Finance and Chief Financial Officer of NEE and FPL from March 2016 to February 2019 and NEE’s Senior Vice President, Finance from February 2015 to March 2016. Ms. Kujawa served as Vice President, Business Management of NextEra Energy Resources from March 2012 to February 2019. Mr. May served as Controller of NextEra Energy Resources from April 2015 to February 2019. Mr. Moul served as Vice President and Chief Nuclear Officer of NEE from May 2019 to December 2019. He previously held various roles at several subsidiaries of FirstEnergy Corp., which are energy suppliers involved in the generation, transmission and distribution of electricity. Mr. Moul was Executive on Special Assignment of FirstEnergy Solutions Corp. from March 2019 to May 2019, President and Chief Nuclear Officer of FirstEnergy Generation Companies from March 2018 to March 2019, President of FirstEnergy Generation LLC from April 2017 to March 2018 and Senior Vice President, Fossil Operations and Environmental of FirstEnergy Solutions from August 2015 to April 2017. Mr. Reagan served as Vice President, Engineering and Construction of NEE from November 2018 to December 2019 and Vice President, Integrated Supply Chain of NEE from October 2012 to November 2018.19Table of ContentsItem 1A. Risk FactorsRisks Relating to NEE's and FPL's BusinessThe business, financial condition, results of operations and prospects of NEE and FPL are subject to a variety of risks, many of which are beyond the control of NEE and FPL. These risks, as well as additional risks and uncertainties either not presently known or that are currently believed to not be material to the business, may materially adversely affect the business, financial condition, results of operations and prospects of NEE and FPL and may cause actual results of NEE and FPL to differ substantially from those that NEE or FPL currently expects or seeks. In that event, the market price for the securities of NEE or FPL could decline. Accordingly, the risks described below should be carefully considered together with the other information set forth in this report and in future reports that NEE and FPL file with the SEC. Regulatory, Legislative and Legal RisksNEE's and FPL's business, financial condition, results of operations and prospects may be materially adversely affected by the extensive regulation of their business.The operations of NEE and FPL are subject to complex and comprehensive federal, state and other regulation. This extensive regulatory framework, portions of which are more specifically identified in the following risk factors, regulates, among other things and to varying degrees, NEE's and FPL's industry, businesses, rates and cost structures, operation and licensing of nuclear power facilities, construction and operation of electricity generation, transmission and distribution facilities and natural gas and oil production, natural gas, oil and other fuel transportation, processing and storage facilities, acquisition, disposal, depreciation and amortization of facilities and other assets, decommissioning costs and funding, service reliability, wholesale and retail competition, and commodities trading and derivatives transactions. In their business planning and in the management of their operations, NEE and FPL must address the effects of regulation on their business and any inability or failure to do so adequately could have a material adverse effect on their business, financial condition, results of operations and prospects.NEE's and FPL's business, financial condition, results of operations and prospects could be materially adversely affected if they are unable to recover in a timely manner any significant amount of costs, a return on certain assets or a reasonable return on invested capital through base rates, cost recovery clauses, other regulatory mechanisms or otherwise.FPL operates as an electric utility and is subject to the jurisdiction of the FPSC over a wide range of business activities, including, among other items, the retail rates charged to its customers through base rates and cost recovery clauses, the terms and conditions of its services, procurement of electricity for its customers and fuel for its plant operations, issuances of securities, and aspects of the siting, construction and operation of its generation plants and transmission and distribution systems for the sale of electric energy. The FPSC has the authority to disallow recovery by FPL of costs that it considers excessive or imprudently incurred and to determine the level of return that FPL is permitted to earn on invested capital. The regulatory process, which may be adversely affected by the political, regulatory and economic environment in Florida and elsewhere, limits or could otherwise adversely impact FPL's earnings. The regulatory process also does not provide any assurance as to achievement of authorized or other earnings levels, or that FPL will be permitted to earn an acceptable return on capital investments it wishes to make. NEE's and FPL's business, financial condition, results of operations and prospects could be materially adversely affected if any material amount of costs, a return on certain assets or a reasonable return on invested capital cannot be recovered through base rates, cost recovery clauses, other regulatory mechanisms or otherwise. Certain other subsidiaries of NEE are utilities subject to the jurisdiction of their regulators and are subject to similar risks.Regulatory decisions that are important to NEE and FPL may be materially adversely affected by political, regulatory and economic factors.The local and national political, regulatory and economic environment has had, and may in the future have, an adverse effect on FPSC decisions with negative consequences for FPL. These decisions may require, for example, FPL to cancel or delay planned development activities, to reduce or delay other planned capital expenditures or to pay for investments or otherwise incur costs that it may not be able to recover through rates, each of which could have a material adverse effect on the business, financial condition, results of operations and prospects of NEE and FPL. Certain other subsidiaries of NEE are subject to similar risks.FPL's use of derivative instruments could be subject to prudence challenges and, if found imprudent, could result in disallowances of cost recovery for such use by the FPSC.The FPSC engages in an annual prudence review of FPL's use of derivative instruments in its risk management fuel procurement program and should it find any such use to be imprudent, the FPSC could deny cost recovery for such use by FPL. Such an outcome could have a material adverse effect on FPL's business, financial condition, results of operations and prospects.Any reductions or modifications to, or the elimination of, governmental incentives or policies that support utility scale renewable energy, including, but not limited to, tax laws, policies and incentives, RPS or feed-in-tariffs, or the 20Table of Contentsimposition of additional taxes or other assessments on renewable energy, could result in, among other items, the lack of a satisfactory market for the development and/or financing of new renewable energy projects, NEER abandoning the development of renewable energy projects, a loss of NEER's investments in renewable energy projects and reduced project returns, any of which could have a material adverse effect on NEE's business, financial condition, results of operations and prospects.NEER depends heavily on government policies that support utility scale renewable energy and enhance the economic feasibility of developing and operating wind and solar energy projects in regions in which NEER operates or plans to develop and operate renewable energy facilities. The federal government, a majority of state governments in the U.S. and portions of Canada provide incentives, such as tax incentives, RPS or feed-in-tariffs, that support or are designed to support the sale of energy from utility scale renewable energy facilities, such as wind and solar energy facilities. As a result of budgetary constraints, political factors or otherwise, governments from time to time may review their laws and policies that support renewable energy and consider actions that would make the laws and policies less conducive to the development and operation of renewable energy facilities. Any reductions or modifications to, or the elimination of, governmental incentives or policies that support renewable energy or the imposition of additional taxes or other assessments on renewable energy, could result in, among other items, the lack of a satisfactory market for the development and/or financing of new renewable energy projects, NEER abandoning the development of renewable energy projects, a loss of NEER's investments in the projects and reduced project returns, any of which could have a material adverse effect on NEE's business, financial condition, results of operations and prospects.NEE's and FPL's business, financial condition, results of operations and prospects could be materially adversely affected as a result of new or revised laws, regulations, interpretations or ballot or regulatory initiatives.NEE's and FPL's business is influenced by various legislative and regulatory initiatives, including, but not limited to, new or revised laws, including international trade laws, regulations, interpretations or ballot or regulatory initiatives regarding deregulation or restructuring of the energy industry, regulation of the commodities trading and derivatives markets, and regulation of environmental matters, such as regulation of air emissions, regulation of water consumption and water discharges, and regulation of gas and oil infrastructure operations, as well as associated environmental permitting. Changes in the nature of the regulation of NEE's and FPL's business could have a material adverse effect on NEE's and FPL's business, financial condition, results of operations and prospects. NEE and FPL are unable to predict future legislative or regulatory changes, initiatives or interpretations, although any such changes, initiatives or interpretations may increase costs and competitive pressures on NEE and FPL, which could have a material adverse effect on NEE's and FPL's business, financial condition, results of operations and prospects.FPL has limited competition in the Florida market for retail electricity customers. Any changes in Florida law or regulation which introduce competition in the Florida retail electricity market, such as government incentives that facilitate the installation of solar generation facilities on residential or other rooftops at below cost or that are otherwise subsidized by non-participants, or would permit third-party sales of electricity, could have a material adverse effect on FPL's business, financial condition, results of operations and prospects. There can be no assurance that FPL will be able to respond adequately to such regulatory changes, which could have a material adverse effect on FPL's business, financial condition, results of operations and prospects.NEER is subject to FERC rules related to transmission that are designed to facilitate competition in the wholesale market on practically a nationwide basis by providing greater certainty, flexibility and more choices to wholesale power customers. NEE cannot predict the impact of changing FERC rules or the effect of changes in levels of wholesale supply and demand, which are typically driven by factors beyond NEE's control. There can be no assurance that NEER will be able to respond adequately or sufficiently quickly to such rules and developments, or to any changes that reverse or restrict the competitive restructuring of the energy industry in those jurisdictions in which such restructuring has occurred. Any of these events could have a material adverse effect on NEE's business, financial condition, results of operations and prospects.NEE’s and FPL’s OTC financial derivatives are subject to rules implementing certain provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act and similar international regulations. NEE and FPL cannot predict the impact any proposed or not fully implemented final rules will have on their ability to hedge their commodity and interest rate risks or on OTC derivatives markets as a whole, but such rules and regulations could have a material adverse effect on NEE's and FPL's risk exposure, as well as reduce market liquidity and further increase the cost of hedging activities. NEE and FPL are subject to numerous environmental laws, regulations and other standards that may result in capital expenditures, increased operating costs and various liabilities, and may require NEE and FPL to limit or eliminate certain operations.NEE and FPL are subject to domestic environmental laws, regulations and other standards, including, but not limited to, extensive federal, state and local environmental statutes, rules and regulations relating to air quality, water quality and usage, soil quality, climate change, emissions of greenhouse gases, including, but not limited to, carbon dioxide, waste management, hazardous wastes, marine, avian and other wildlife mortality and habitat protection, historical artifact preservation, natural resources, health (including, but not limited to, electric and magnetic fields from power lines and substations), safety and RPS, that could, among other things, prevent or delay the development of power generation, power or natural gas transmission, or other infrastructure projects, restrict or enjoin the output of some existing facilities, limit the availability and use of some fuels 21Table of Contentsrequired for the production of electricity, require additional pollution control equipment, and otherwise increase costs, increase capital expenditures and limit or eliminate certain operations. Certain subsidiaries of NEE are also subject to foreign environmental laws, regulations and other standards and, as such, are subject to similar risks.There are significant capital, operating and other costs associated with compliance with these environmental statutes, rules and regulations, and those costs could be even more significant in the future as a result of new requirements and stricter or more expansive application of existing environmental laws and regulations. Violations of current or future laws, rules, regulations or other standards could expose NEE and FPL to regulatory and legal proceedings, disputes with, and legal challenges by, governmental entities and third parties, and potentially significant civil fines, criminal penalties and other sanctions, such as restrictions on how NEER develops, sites and operates wind facilities. Proceedings could include, without limitation, litigation regarding property damage, personal injury, common law nuisance and enforcement by citizens or governmental authorities of environmental requirements. For example, NEER’s wind facilities operate without take permits under the Bald and Golden Eagle Protection Act (BGEPA) and the federal government could seek to prosecute NEER or its wind facility subsidiaries for the accidental eagle collisions with wind turbines or other structures that occur or may occur at those facilities for criminal violations of BGEPA if the federal government ultimately disagrees with NEER’s position that BGEPA’s criminal liability provisions relate only to hunting and other intentional activities, and do not apply to accidental collisions with wind turbines or other structures, such as airplanes and buildings.NEE's and FPL's business could be negatively affected by federal or state laws or regulations mandating new or additional limits on the production of greenhouse gas emissions.Federal or state laws or regulations may be adopted that would impose new or additional limits on the emissions of greenhouse gases, including, but not limited to, carbon dioxide and methane, from electric generation units using fossil fuels like coal and natural gas. The potential effects of greenhouse gas emission limits on NEE's and FPL's electric generation units are subject to significant uncertainties based on, among other things, the timing of the implementation of any new requirements, the required levels of emission reductions, the nature of any market-based or tax-based mechanisms adopted to facilitate reductions, the relative availability of greenhouse gas emission reduction offsets, the development of cost-effective, commercial-scale carbon capture and storage technology and supporting regulations and liability mitigation measures, and the range of available compliance alternatives.While NEE's and FPL's electric generation portfolio emits greenhouse gases at a lower rate of emissions than most of the U.S. electric generation sector, the results of operations of NEE and FPL could be materially adversely affected to the extent that new federal or state laws or regulations impose any new greenhouse gas emission limits. Any future limits on greenhouse gas emissions could:•create substantial additional costs in the form of taxes or emissions allowances;•make some of NEE's and FPL's electric generation units uneconomical to operate in the long term;•require significant capital investment in carbon capture and storage technology, fuel switching, or the replacement of high-emitting generation facilities with lower-emitting generation facilities; or•affect the availability or cost of fossil fuels.There can be no assurance that NEE or FPL would be able to completely recover any such costs or investments, which could have a material adverse effect on their business, financial condition, results of operations and prospects.Extensive federal regulation of the operations and businesses of NEE and FPL exposes NEE and FPL to significant and increasing compliance costs and may also expose them to substantial monetary penalties and other sanctions for compliance failures.NEE's and FPL's operations and businesses are subject to extensive federal regulation, which generally imposes significant and increasing compliance costs on their operations and businesses. Additionally, any actual or alleged compliance failures could result in significant costs and other potentially adverse effects of regulatory investigations, proceedings, settlements, decisions and claims, including, among other items, potentially significant monetary penalties. As an example, under the Energy Policy Act of 2005, NEE and FPL, as owners and operators of bulk-power transmission systems and/or electric generation facilities, are subject to mandatory reliability standards. Compliance with these mandatory reliability standards may subject NEE and FPL to higher operating costs and may result in increased capital expenditures. If FPL or NEE is found not to be in compliance with these standards, they may incur substantial monetary penalties and other sanctions. Both the costs of regulatory compliance and the costs that may be imposed as a result of any actual or alleged compliance failures could have a material adverse effect on NEE's and FPL's business, financial condition, results of operations and prospects.Changes in tax laws, guidance or policies, including but not limited to changes in corporate income tax rates, as well as judgments and estimates used in the determination of tax-related asset and liability amounts, could materially adversely affect NEE's and FPL's business, financial condition, results of operations and prospects.22Table of ContentsNEE's and FPL's provision for income taxes and reporting of tax-related assets and liabilities require significant judgments and the use of estimates. Amounts of tax-related assets and liabilities involve judgments and estimates of the timing and probability of recognition of income, deductions and tax credits, including, but not limited to, estimates for potential adverse outcomes regarding tax positions that have been taken and the ability to utilize tax benefit carryforwards, such as net operating loss and tax credit carryforwards. Actual income taxes could vary significantly from estimated amounts due to the future impacts of, among other things, changes in tax laws, guidance or policies, including changes in corporate income tax rates, the financial condition and results of operations of NEE and FPL, and the resolution of audit issues raised by taxing authorities. These factors, including the ultimate resolution of income tax matters, may result in material adjustments to tax-related assets and liabilities, which could materially adversely affect NEE's and FPL's business, financial condition, results of operations and prospects.NEE's and FPL's business, financial condition, results of operations and prospects may be materially adversely affected due to adverse results of litigation.NEE's and FPL's business, financial condition, results of operations and prospects may be materially affected by adverse results of litigation. Unfavorable resolution of legal or administrative proceedings in which NEE or FPL is involved or other future legal or administrative proceedings may have a material adverse effect on the business, financial condition, results of operations and prospects of NEE and FPL.Development and Operational RisksNEE's and FPL's business, financial condition, results of operations and prospects could suffer if NEE and FPL do not proceed with projects under development or are unable to complete the construction of, or capital improvements to, electric generation, transmission and distribution facilities, gas infrastructure facilities or other facilities on schedule or within budget.NEE's and FPL's ability to proceed with projects under development and to complete construction of, and capital improvement projects for, their electric generation, transmission and distribution facilities, gas infrastructure facilities and other facilities on schedule and within budget may be adversely affected by escalating costs for materials and labor and regulatory compliance, inability to obtain or renew necessary licenses, rights-of-way, permits or other approvals on acceptable terms or on schedule, disputes involving contractors, labor organizations, land owners, governmental entities, environmental groups, Native American and aboriginal groups, lessors, joint venture partners and other third parties, negative publicity, transmission interconnection issues and other factors. If any development project or construction or capital improvement project is not completed, is delayed or is subject to cost overruns, certain associated costs may not be approved for recovery or otherwise be recoverable through regulatory mechanisms that may be available, and NEE and FPL could become obligated to make delay or termination payments or become obligated for other damages under contracts, could experience the loss of tax credits or tax incentives, or delayed or diminished returns, and could be required to write off all or a portion of their investment in the project. Any of these events could have a material adverse effect on NEE's and FPL's business, financial condition, results of operations and prospects.NEE and FPL face risks related to project siting, financing, construction, permitting, governmental approvals and the negotiation of project development agreements that may impede their development and operating activities.NEE and FPL own, develop, construct, manage and operate electric-generation and transmission facilities and natural gas transmission facilities. A key component of NEE's and FPL's growth is their ability to construct and operate generation and transmission facilities to meet customer needs. As part of these operations, NEE and FPL must periodically apply for licenses and permits from various local, state, federal and other regulatory authorities and abide by their respective conditions. Should NEE or FPL be unsuccessful in obtaining necessary licenses or permits on acceptable terms or resolving third-party challenges to such licenses or permits, should there be a delay in obtaining or renewing necessary licenses or permits or should regulatory authorities initiate any associated investigations or enforcement actions or impose related penalties or disallowances on NEE or FPL, NEE's and FPL's business, financial condition, results of operations and prospects could be materially adversely affected. Any failure to negotiate successful project development agreements for new facilities with third parties could have similar results.The operation and maintenance of NEE's and FPL's electric generation, transmission and distribution facilities, gas infrastructure facilities, retail gas distribution system in Florida and other facilities are subject to many operational risks, the consequences of which could have a material adverse effect on NEE's and FPL's business, financial condition, results of operations and prospects.NEE's and FPL's electric generation, transmission and distribution facilities, gas infrastructure facilities, retail gas distribution system in Florida and other facilities are subject to many operational risks. Operational risks could result in, among other things, lost revenues due to prolonged outages, increased expenses due to monetary penalties or fines for compliance failures or legal claims, liability to third parties for property and personal injury damage or loss of life, a failure to perform under applicable power sales agreements or other agreements and associated loss of revenues from terminated agreements or liability for liquidated damages under continuing agreements, and replacement equipment costs or an obligation to purchase or generate replacement power at higher prices.23Table of ContentsUncertainties and risks inherent in operating and maintaining NEE's and FPL's facilities include, but are not limited to:•risks associated with facility start-up operations, such as whether the facility will achieve projected operating performance on schedule and otherwise as planned;•failures in the availability, acquisition or transportation of fuel or other necessary supplies;•the impact of unusual or adverse weather conditions and natural disasters, including, but not limited to, hurricanes, tornadoes, icing events, floods, earthquakes and droughts;•performance below expected or contracted levels of output or efficiency;•breakdown or failure, including, but not limited to, explosions, fires, leaks or other major events, of equipment, transmission or distribution systems or pipelines;•availability of replacement equipment;•risks of property damage, human injury or loss of life from energized equipment, hazardous substances or explosions, fires, leaks or other events, especially where facilities are located near populated areas;•potential environmental impacts of gas infrastructure operations; •availability of adequate water resources and ability to satisfy water intake and discharge requirements;•inability to identify, manage properly or mitigate equipment defects in NEE's and FPL's facilities;•use of new or unproven technology;•risks associated with dependence on a specific type of fuel or fuel source, such as commodity price risk, availability of adequate fuel supply and transportation, and lack of available alternative fuel sources; •increased competition due to, among other factors, new facilities, excess supply, shifting demand and regulatory changes; and•insufficient insurance, warranties or performance guarantees to cover any or all lost revenues or increased expenses from the foregoing.NEE's and FPL's business, financial condition, results of operations and prospects may be negatively affected by a lack of growth or slower growth in the number of customers or in customer usage.Growth in customer accounts and growth of customer usage each directly influence the demand for electricity and the need for additional power generation and power delivery facilities, as well as the need for energy-related commodities such as natural gas. Customer growth and customer usage are affected by a number of factors outside the control of NEE and FPL, such as mandated energy efficiency measures, demand side management requirements, and economic and demographic conditions, such as population changes, job and income growth, housing starts, new business formation and the overall level of economic activity. A lack of growth, or a decline, in the number of customers or in customer demand for electricity or natural gas and other fuels may cause NEE and FPL to fail to fully realize the anticipated benefits from significant investments and expenditures and could have a material adverse effect on NEE's and FPL's growth, business, financial condition, results of operations and prospects.NEE's and FPL's business, financial condition, results of operations and prospects can be materially adversely affected by weather conditions, including, but not limited to, the impact of severe weather.Weather conditions directly influence the demand for electricity and natural gas and other fuels and affect the price of energy and energy-related commodities. In addition, severe weather and natural disasters, such as hurricanes, floods, tornadoes, icing events and earthquakes, can be destructive and cause power outages and property damage, reduce revenue, affect the availability of fuel and water, and require NEE and FPL to incur additional costs, for example, to restore service and repair damaged facilities, to obtain replacement power and to access available financing sources. Furthermore, NEE's and FPL's physical plants could be placed at greater risk of damage should changes in the global climate produce unusual variations in temperature and weather patterns, resulting in more intense, frequent and extreme weather events, abnormal levels of precipitation and, particularly relevant to FPL, a change in sea level. FPL operates in the east and lower west coasts of Florida and in northwest Florida, areas that historically have been prone to severe weather events, such as hurricanes. A disruption or failure of electric generation, transmission or distribution systems or natural gas production, transmission, storage or distribution systems in the event of a hurricane, tornado or other severe weather event, or otherwise, could prevent NEE and FPL from operating their business in the normal course and could result in any of the adverse consequences described above. Any of the foregoing could have a material adverse effect on NEE's and FPL's business, financial condition, results of operations and prospects.At FPL and other businesses of NEE where cost recovery is available, recovery of costs to restore service and repair damaged facilities is or may be subject to regulatory approval, and any determination by the regulator not to permit timely and full recovery of the costs incurred could have a material adverse effect on NEE's and FPL's business, financial condition, results of operations and prospects.Changes in weather can also affect the production of electricity at power generation facilities, including, but not limited to, NEER's wind and solar facilities. For example, the level of wind resource affects the revenue produced by wind generation facilities. Because the levels of wind and solar resources are variable and difficult to predict, NEER's results of operations for individual wind and solar facilities specifically, and NEE's results of operations generally, may vary significantly from period to 24Table of Contentsperiod, depending on the level of available resources. To the extent that resources are not available at planned levels, the financial results from these facilities may be less than expected.Threats of terrorism and catastrophic events that could result from terrorism, cyberattacks, or individuals and/or groups attempting to disrupt NEE's and FPL's business, or the businesses of third parties, may materially adversely affect NEE's and FPL's business, financial condition, results of operations and prospects.NEE and FPL are subject to the potentially adverse operating and financial effects of terrorist acts and threats, as well as cyberattacks and other disruptive activities of individuals or groups. There have been cyberattacks within the energy industry on energy infrastructure such as substations, gas pipelines and related assets in the past and there may be such attacks in the future. NEE's and FPL's generation, transmission and distribution facilities, fuel storage facilities, information technology systems and other infrastructure facilities and systems could be direct targets of, or otherwise be materially adversely affected by, such activities.Terrorist acts, cyberattacks or other similar events affecting NEE's and FPL's systems and facilities, or those of third parties on which NEE and FPL rely, could harm NEE's and FPL's business, for example, by limiting their ability to generate, purchase or transmit power, natural gas or other energy-related commodities, by limiting their ability to bill customers and collect and process payments, and by delaying their development and construction of new generation, distribution or transmission facilities or capital improvements to existing facilities. These events, and governmental actions in response, could result in a material decrease in revenues, significant additional costs (for example, to repair assets, implement additional security requirements or maintain or acquire insurance), significant fines and penalties, and reputational damage, could materially adversely affect NEE's and FPL's operations (for example, by contributing to disruption of supplies and markets for natural gas, oil and other fuels), and could impair NEE's and FPL's ability to raise capital (for example, by contributing to financial instability and lower economic activity). In addition, the implementation of security guidelines and measures has resulted in and is expected to continue to result in increased costs. Such events or actions may materially adversely affect NEE's and FPL's business, financial condition, results of operations and prospects.The ability of NEE and FPL to obtain insurance and the terms of any available insurance coverage could be materially adversely affected by international, national, state or local events and company-specific events, as well as the financial condition of insurers. NEE's and FPL's insurance coverage does not provide protection against all significant losses.Insurance coverage may not continue to be available or may not be available at rates or on terms similar to those presently available to NEE and FPL. The ability of NEE and FPL to obtain insurance and the terms of any available insurance coverage could be materially adversely affected by international, national, state or local events and company-specific events, as well as the financial condition of insurers. If insurance coverage is not available or obtainable on acceptable terms, NEE or FPL may be required to pay costs associated with adverse future events. NEE and FPL generally are not fully insured against all significant losses. For example, FPL is not fully insured against hurricane-related losses, but could instead seek recovery of such uninsured losses from customers subject to approval by the FPSC, to the extent losses exceed restricted funds set aside to cover the cost of storm damage. A loss for which NEE or FPL is not fully insured could have a material adverse effect on NEE's and FPL's business, financial condition, results of operations and prospects.NEE invests in gas and oil producing and transmission assets through NEER’s gas infrastructure business. The gas infrastructure business is exposed to fluctuating market prices of natural gas, natural gas liquids, oil and other energy commodities. A prolonged period of low gas and oil prices could impact NEER’s gas infrastructure business and cause NEER to delay or cancel certain gas infrastructure projects and could result in certain projects becoming impaired, which could materially adversely affect NEE's results of operations.Natural gas and oil prices are affected by supply and demand, both globally and regionally. Factors that influence supply and demand include operational issues, natural disasters, weather, political instability, conflicts, new discoveries, technological advances, economic conditions and actions by major oil-producing countries. There can be significant volatility in market prices for gas and oil, and price fluctuations could have a material effect on the financial performance of gas and oil producing and transmission assets. For example, in a low gas and oil price environment, NEER would generate less revenue from its gas infrastructure investments in gas and oil producing properties, and as a result certain investments might become less profitable or incur losses. Prolonged periods of low oil and gas prices could also result in the delay or cancellation of oil and gas production and transmission projects, could cause projects to experience lower returns, and could result in certain projects becoming impaired, which could materially adversely affect NEE's results of operations.If supply costs necessary to provide NEER's full energy and capacity requirement services are not favorable, operating costs could increase and materially adversely affect NEE's business, financial condition, results of operations and prospects.NEER provides full energy and capacity requirements services primarily to distribution utilities, which include load-following services and various ancillary services, to satisfy all or a portion of such utilities' power supply obligations to their customers. The supply costs for these transactions may be affected by a number of factors, including, but not limited to, events that may occur after such utilities have committed to supply power, such as weather conditions, fluctuating prices for energy and ancillary 25Table of Contentsservices, and the ability of the distribution utilities' customers to elect to receive service from competing suppliers. NEER may not be able to recover all of its increased supply costs, which could have a material adverse effect on NEE's business, financial condition, results of operations and prospects.Due to the potential for significant volatility in market prices for fuel, electricity and renewable and other energy commodities, NEER's inability or failure to manage properly or hedge effectively the commodity risks within its portfolios could materially adversely affect NEE's business, financial condition, results of operations and prospects.There can be significant volatility in market prices for fuel, electricity and renewable and other energy commodities. NEE's inability or failure to manage properly or hedge effectively its assets or positions against changes in commodity prices, volumes, interest rates, counterparty credit risk or other risk measures, based on factors that are either within, or wholly or partially outside of, NEE's control, may materially adversely affect NEE's business, financial condition, results of operations and prospects.Reductions in the liquidity of energy markets may restrict the ability of NEE to manage its operational risks, which, in turn, could negatively affect NEE's results of operations.NEE is an active participant in energy markets. The liquidity of regional energy markets is an important factor in NEE's ability to manage risks in these operations. Market liquidity is driven in part by the number of active market participants. Liquidity in the energy markets can be adversely affected by price volatility, restrictions on the availability of credit and other factors, and any reduction in the liquidity of energy markets could have a material adverse effect on NEE's business, financial condition, results of operations and prospects.NEE's and FPL's hedging and trading procedures and associated risk management tools may not protect against significant losses.NEE and FPL have hedging and trading procedures and associated risk management tools, such as separate but complementary financial, credit, operational, compliance and legal reporting systems, internal controls, management review processes and other mechanisms. NEE and FPL are unable to assure that such procedures and tools will be effective against all potential risks, including, without limitation, employee misconduct. If such procedures and tools are not effective, this could have a material adverse effect on NEE's business, financial condition, results of operations and prospects.If price movements significantly or persistently deviate from historical behavior, NEE's and FPL's risk management tools associated with their hedging and trading procedures may not protect against significant losses.NEE's and FPL's risk management tools and metrics associated with their hedging and trading procedures, such as daily value at risk, earnings at risk, stop loss limits and liquidity guidelines, are based on historical price movements. Due to the inherent uncertainty involved in price movements and potential deviation from historical pricing behavior, NEE and FPL are unable to assure that their risk management tools and metrics will be effective to protect against material adverse effects on their business, financial condition, results of operations and prospects. If power transmission or natural gas, nuclear fuel or other commodity transportation facilities are unavailable or disrupted, the ability for subsidiaries of NEE, including FPL, to sell and deliver power or natural gas may be limited.Subsidiaries of NEE, including FPL, depend upon power transmission and natural gas, nuclear fuel and other commodity transportation facilities, many of which they do not own. Occurrences affecting the operation of these facilities that may or may not be beyond the control of subsidiaries of NEE, including FPL, (such as severe weather or a generation or transmission facility outage, pipeline rupture, or sudden and significant increase or decrease in wind generation) may limit or halt their ability to sell and deliver power and natural gas, or to purchase necessary fuels and other commodities, which could materially adversely impact NEE's and FPL's business, financial condition, results of operations and prospects.NEE and FPL are subject to credit and performance risk from customers, hedging counterparties and vendors.NEE and FPL are exposed to risks associated with the creditworthiness and performance of their customers, hedging counterparties and vendors under contracts for the supply of equipment, materials, fuel and other goods and services required for their business operations and for the construction and operation of, and for capital improvements to, their facilities. Adverse conditions in the energy industry or the general economy, as well as circumstances of individual customers, hedging counterparties and vendors, may adversely affect the ability of some customers, hedging counterparties and vendors to perform as required under their contracts with NEE and FPL. If any hedging, vending or other counterparty fails to fulfill its contractual obligations, NEE and FPL may need to make arrangements with other counterparties or vendors, which could result in material financial losses, higher costs, untimely completion of power generation facilities and other projects, and/or a disruption of their operations. If a defaulting counterparty is in poor financial condition, NEE and FPL may not be able to recover damages for any contract breach.26Table of ContentsNEE and FPL could recognize financial losses or a reduction in operating cash flows if a counterparty fails to perform or make payments in accordance with the terms of derivative contracts or if NEE or FPL is required to post margin cash collateral under derivative contracts.NEE and FPL use derivative instruments, such as swaps, options, futures and forwards, some of which are traded in the OTC markets or on exchanges, to manage their commodity and financial market risks, and for NEE to engage in trading and marketing activities. Any failures by their counterparties to perform or make payments in accordance with the terms of those transactions could have a material adverse effect on NEE's or FPL's business, financial condition, results of operations and prospects. Similarly, any requirement for FPL or NEE to post margin cash collateral under its derivative contracts could have a material adverse effect on its business, financial condition, results of operations and prospects. These risks may be increased during periods of adverse market or economic conditions affecting the industry in which NEE and FPL participate.NEE and FPL are highly dependent on sensitive and complex information technology systems, and any failure or breach of those systems could have a material adverse effect on their business, financial condition, results of operations and prospects.NEE and FPL operate in a highly regulated industry that requires the continuous functioning of sophisticated information technology systems and network infrastructure. Despite NEE's and FPL's implementation of security measures, all of their technology systems are vulnerable to disability, failures or unauthorized access due to such activities. If NEE's or FPL's information technology systems were to fail or be breached, sensitive confidential and other data could be compromised and NEE and FPL could be unable to fulfill critical business functions.NEE's and FPL's business is highly dependent on their ability to process and monitor, on a daily basis, a very large number of transactions, many of which are highly complex and cross numerous and diverse markets. Due to the size, scope, complexity and geographical reach of NEE's and FPL's business, the development and maintenance of information technology systems to keep track of and process information is critical and challenging. NEE's and FPL's operating systems and facilities may fail to operate properly or become disabled as a result of events that are either within, or wholly or partially outside of, their control, such as operator error, severe weather, terrorist activities or cyber incidents. Any such failure or disabling event could materially adversely affect NEE's and FPL's ability to process transactions and provide services, and their business, financial condition, results of operations and prospects.NEE and FPL add, modify and replace information systems on a regular basis. Modifying existing information systems or implementing new or replacement information systems is costly and involves risks, including, but not limited to, integrating the modified, new or replacement system with existing systems and processes, implementing associated changes in accounting procedures and controls, and ensuring that data conversion is accurate and consistent. Any disruptions or deficiencies in existing information systems, or disruptions, delays or deficiencies in the modification or implementation of new information systems, could result in increased costs, the inability to track or collect revenues and the diversion of management's and employees' attention and resources, and could negatively impact the effectiveness of the companies' control environment, and/or the companies' ability to timely file required regulatory reports.NEE and FPL also face the risks of operational failure or capacity constraints of third parties, including, but not limited to, those who provide power transmission and natural gas transportation services.NEE's and FPL's retail businesses are subject to the risk that sensitive customer data may be compromised, which could result in a material adverse impact to their reputation and/or have a material adverse effect on the business, financial condition, results of operations and prospects of NEE and FPL.NEE's and FPL's retail businesses require access to sensitive customer data in the ordinary course of business. NEE's and FPL's retail businesses may also need to provide sensitive customer data to vendors and service providers who require access to this information in order to provide services, such as call center services, to the retail businesses. If a significant breach occurred, the reputation of NEE and FPL could be materially adversely affected, customer confidence could be diminished, or customer information could be subject to identity theft. NEE and FPL would be subject to costs associated with the breach and/or NEE and FPL could be subject to fines and legal claims, any of which may have a material adverse effect on the business, financial condition, results of operations and prospects of NEE and FPL.NEE and FPL could recognize financial losses as a result of volatility in the market values of derivative instruments and limited liquidity in OTC markets.NEE and FPL execute transactions in derivative instruments on either recognized exchanges or via the OTC markets, depending on management's assessment of the most favorable credit and market execution factors. Transactions executed in OTC markets have the potential for greater volatility and less liquidity than transactions on recognized exchanges. As a result, NEE and FPL may not be able to execute desired OTC transactions due to such heightened volatility and limited liquidity.In the absence of actively quoted market prices and pricing information from external sources, the valuation of derivative instruments involves management's judgment and use of estimates. As a result, changes in the underlying assumptions or use of 27Table of Contentsalternative valuation methods could affect the reported fair value of these derivative instruments and have a material adverse effect on NEE's and FPL's business, financial condition, results of operations and prospects.NEE and FPL may be materially adversely affected by negative publicity.From time to time, political and public sentiment may result in a significant amount of adverse press coverage and other adverse public statements affecting NEE and FPL. Adverse press coverage and other adverse statements, whether or not driven by political or public sentiment, may also result in investigations by regulators, legislators and law enforcement officials or in legal claims. Responding to these investigations and lawsuits, regardless of the ultimate outcome of the proceeding, can divert the time and effort of senior management from NEE's and FPL's business.Addressing any adverse publicity, governmental scrutiny or enforcement or other legal proceedings is time consuming and expensive and, regardless of the factual basis for the assertions being made, can have a negative impact on the reputation of NEE and FPL, on the morale and performance of their employees and on their relationships with regulators. It may also have a negative impact on their ability to take timely advantage of various business and market opportunities. The direct and indirect effects of negative publicity, and the demands of responding to and addressing it, may have a material adverse effect on NEE's and FPL's business, financial condition, results of operations and prospects.NEE's and FPL's business, financial condition, results of operations and prospects may be adversely affected if FPL is unable to maintain, negotiate or renegotiate franchise agreements on acceptable terms with municipalities and counties in Florida.FPL may negotiate franchise agreements with municipalities and counties in Florida to provide electric services within such municipalities and counties, and electricity sales generated pursuant to these agreements represent a very substantial portion of FPL's revenues. If FPL is unable to maintain, negotiate or renegotiate such franchise agreements on acceptable terms, it could contribute to lower earnings and FPL may not fully realize the anticipated benefits from significant investments and expenditures, which could adversely affect NEE's and FPL's business, financial condition, results of operations and prospects.NEE's and FPL's business, financial condition, results of operations and prospects could be materially adversely affected by work strikes or stoppages and increasing personnel costs.Employee strikes or work stoppages could disrupt operations and lead to a loss of revenue and customers. Personnel costs may also increase due to inflationary or competitive pressures on payroll and benefits costs and revised terms of collective bargaining agreements with union employees. These consequences could have a material adverse effect on NEE's and FPL's business, financial condition, results of operations and prospects.NEE's ability to successfully identify, complete and integrate acquisitions is subject to significant risks, including, but not limited to, the effect of increased competition for acquisitions resulting from the consolidation of the energy industry.NEE is likely to encounter significant competition for acquisition opportunities that may become available as a result of the consolidation of the energy industry in general. In addition, NEE may be unable to identify attractive acquisition opportunities at favorable prices and to complete and integrate them successfully and in a timely manner. Nuclear Generation RisksThe operation and maintenance of NEE's and FPL's nuclear generation facilities involve environmental, health and financial risks that could result in fines or the closure of the facilities and in increased costs and capital expenditures.NEE's and FPL's nuclear generation facilities are subject to environmental, health and financial risks, including, but not limited to, those relating to site storage of spent nuclear fuel, the disposition of spent nuclear fuel, leakage and emissions of tritium and other radioactive elements in the event of a nuclear accident or otherwise, the threat of a terrorist attack or cyber incident and other potential liabilities arising out of the ownership or operation of the facilities. NEE and FPL maintain decommissioning funds and external insurance coverage which are intended to reduce the financial exposure to some of these risks; however, the cost of decommissioning nuclear generation facilities could exceed the amount available in NEE's and FPL's decommissioning funds, and the exposure to liability and property damages could exceed the amount of insurance coverage. If NEE or FPL is unable to recover the additional costs incurred through insurance or, in the case of FPL, through regulatory mechanisms, their business, financial condition, results of operations and prospects could be materially adversely affected.In the event of an incident at any nuclear generation facility in the U.S. or at certain nuclear generation facilities in Europe, NEE and FPL could be assessed significant retrospective assessments and/or retrospective insurance premiums as a result of their participation in a secondary financial protection system and nuclear insurance mutual companies.28Table of ContentsLiability for accidents at nuclear power plants is governed by the Price-Anderson Act, which limits the liability of nuclear reactor owners to the amount of insurance available from both private sources and an industry retrospective payment plan. In accordance with this Act, NEE maintains the maximum amount of private liability insurance obtainable, and participates in a secondary financial protection system, which provides liability insurance coverage for an incident at any nuclear reactor in the U.S. Under the secondary financial protection system, NEE is subject to retrospective assessments and/or retrospective insurance premiums, plus any applicable taxes, for an incident at any nuclear reactor in the U.S. or at certain nuclear generation facilities in Europe, regardless of fault or proximity to the incident. Such assessments, if levied, could materially adversely affect NEE's and FPL's business, financial condition, results of operations and prospects.NRC orders or new regulations related to increased security measures and any future safety requirements promulgated by the NRC could require NEE and FPL to incur substantial operating and capital expenditures at their nuclear generation facilities and/or result in reduced revenues.The NRC has broad authority to impose licensing and safety-related requirements for the operation and maintenance of nuclear generation facilities, the addition of capacity at existing nuclear generation facilities and the construction of new nuclear generation facilities, and these requirements are subject to change. In the event of non-compliance, the NRC has the authority to impose fines and/or shut down a nuclear generation facility, depending upon the NRC's assessment of the severity of the situation, until compliance is achieved. Any of the foregoing events could require NEE and FPL to incur increased costs and capital expenditures, and could reduce revenues.Any serious nuclear incident occurring at a NEE or FPL plant could result in substantial remediation costs and other expenses. A major incident at a nuclear facility anywhere in the world could cause the NRC to limit or prohibit the operation or licensing of any domestic nuclear generation facility. An incident at a nuclear facility anywhere in the world also could cause the NRC to impose additional conditions or other requirements on the industry, or on certain types of nuclear generation units, which could increase costs, reduce revenues and result in additional capital expenditures.The inability to operate any of NEE's or FPL's nuclear generation units through the end of their respective operating licenses could have a material adverse effect on NEE's and FPL's business, financial condition, results of operations and prospects.If any of NEE's or FPL's nuclear generation facilities are not operated for any reason through the life of their respective operating licenses, NEE or FPL may be required to increase depreciation rates, incur impairment charges and accelerate future decommissioning expenditures, any of which could materially adversely affect their business, financial condition, results of operations and prospects.NEE's and FPL's nuclear units are periodically removed from service to accommodate planned refueling and maintenance outages, and for other purposes. If planned outages last longer than anticipated or if there are unplanned outages, NEE's and FPL's results of operations and financial condition could be materially adversely affected.NEE's and FPL's nuclear units are periodically removed from service to accommodate planned refueling and maintenance outages, including, but not limited to, inspections, repairs and certain other modifications as well as to replace equipment. In the event that a scheduled outage lasts longer than anticipated or in the event of an unplanned outage due to, for example, equipment failure, such outages could materially adversely affect NEE's or FPL's business, financial condition, results of operations and prospects.Liquidity, Capital Requirements and Common Stock RisksDisruptions, uncertainty or volatility in the credit and capital markets, among other factors, may negatively affect NEE's and FPL's ability to fund their liquidity and capital needs and to meet their growth objectives, and can also materially adversely affect the results of operations and financial condition of NEE and FPL.NEE and FPL rely on access to capital and credit markets as significant sources of liquidity for capital requirements and other operations requirements that are not satisfied by operating cash flows. Disruptions, uncertainty or volatility in those capital and credit markets could increase NEE's and FPL's cost of capital and affect their ability to fund their liquidity and capital needs and to meet their growth objectives. If NEE or FPL is unable to access regularly the capital and credit markets on terms that are reasonable, it may have to delay raising capital, issue shorter-term securities and incur an unfavorable cost of capital, which, in turn, could adversely affect its ability to grow its business, could contribute to lower earnings and reduced financial flexibility, and could have a material adverse effect on its business, financial condition, results of operations and prospects.Although NEE's competitive energy and certain other subsidiaries have used non-recourse or limited-recourse, project-specific or other financing in the past, market conditions and other factors could adversely affect the future availability of such financing. The inability of NEE's subsidiaries, including, without limitation, NEECH and its subsidiaries, to access the capital and credit markets to provide project-specific or other financing for electric generation or other facilities or acquisitions on favorable terms, whether because of disruptions or volatility in those markets or otherwise, could necessitate additional capital raising or borrowings by NEE and/or NEECH in the future.29Table of ContentsThe inability of subsidiaries that have existing project-specific or other financing arrangements to meet the requirements of various agreements relating to those financings, as well as actions by third parties or lenders, could give rise to a project-specific financing default which, if not cured or waived, might result in the specific project, and potentially in some limited instances its parent companies, being required to repay the associated debt or other borrowings earlier than otherwise anticipated, and if such repayment were not made, the lenders or security holders would generally have rights to foreclose against the project assets and related collateral. Such an occurrence also could result in NEE expending additional funds or incurring additional obligations over the shorter term to ensure continuing compliance with project-specific financing arrangements based upon the expectation of improvement in the project's performance or financial returns over the longer term. Any of these actions could materially adversely affect NEE's business, financial condition, results of operations and prospects, as well as the availability or terms of future financings for NEE or its subsidiaries.NEE's, NEECH's and FPL's inability to maintain their current credit ratings may materially adversely affect NEE's and FPL's liquidity and results of operations, limit the ability of NEE and FPL to grow their business, and increase interest costs.The inability of NEE, NEECH and FPL to maintain their current credit ratings could materially adversely affect their ability to raise capital or obtain credit on favorable terms, which, in turn, could impact NEE's and FPL's ability to grow their business and service indebtedness and repay borrowings, and would likely increase their interest costs. In addition, certain agreements and guarantee arrangements would require posting of additional collateral in the event of a ratings downgrade. Some of the factors that can affect credit ratings are cash flows, liquidity, the amount of debt as a component of total capitalization, NEE's overall business mix and political, legislative and regulatory actions. There can be no assurance that one or more of the ratings of NEE, NEECH and FPL will not be lowered or withdrawn entirely by a rating agency.NEE's and FPL's liquidity may be impaired if their credit providers are unable to fund their credit commitments to the companies or to maintain their current credit ratings.The inability of NEE's, NEECH's and FPL's credit providers to fund their credit commitments or to maintain their current credit ratings could require NEE, NEECH or FPL, among other things, to renegotiate requirements in agreements, find an alternative credit provider with acceptable credit ratings to meet funding requirements, or post cash collateral and could have a material adverse effect on NEE's and FPL's liquidity.Poor market performance and other economic factors could affect NEE's defined benefit pension plan's funded status, which may materially adversely affect NEE's and FPL's business, financial condition, liquidity and results of operations and prospects.NEE sponsors a qualified noncontributory defined benefit pension plan for substantially all employees of NEE and its subsidiaries. A decline in the market value of the assets held in the defined benefit pension plan due to poor investment performance or other factors may increase the funding requirements for this obligation.NEE's defined benefit pension plan is sensitive to changes in interest rates, since as interest rates decrease, the funding liabilities increase, potentially increasing benefits costs and funding requirements. Any increase in benefits costs or funding requirements may have a material adverse effect on NEE's and FPL's business, financial condition, liquidity, results of operations and prospects.Poor market performance and other economic factors could adversely affect the asset values of NEE's and FPL's nuclear decommissioning funds, which may materially adversely affect NEE's and FPL's liquidity, financial condition and results of operations.NEE and FPL are required to maintain decommissioning funds to satisfy their future obligations to decommission their nuclear power plants. A decline in the market value of the assets held in the decommissioning funds due to poor investment performance or other factors may increase the funding requirements for these obligations. Any increase in funding requirements may have a material adverse effect on NEE's and FPL's liquidity, financial condition and results of operations.Certain of NEE's investments are subject to changes in market value and other risks, which may materially adversely affect NEE's liquidity, financial condition and results of operations.NEE holds certain investments where changes in the fair value affect NEE's financial results. In some cases there may be no observable market values for these investments, requiring fair value estimates to be based on other valuation techniques. This type of analysis requires significant judgment and the actual values realized in a sale of these investments could differ materially from those estimated. A sale of an investment below previously estimated value, or other decline in the fair value of an investment, could result in losses or the write-off of such investment, and may have a material adverse effect on NEE's liquidity, financial condition and results of operations.NEE may be unable to meet its ongoing and future financial obligations and to pay dividends on its common stock if its subsidiaries are unable to pay upstream dividends or repay funds to NEE.30Table of ContentsNEE is a holding company and, as such, has no material operations of its own. Substantially all of NEE's consolidated assets are held by its subsidiaries. NEE's ability to meet its financial obligations, including, but not limited to, its guarantees, and to pay dividends on its common stock is primarily dependent on its subsidiaries' net income and cash flows, which are subject to the risks of their respective businesses, and their ability to pay upstream dividends or to repay funds to NEE.NEE's subsidiaries are separate legal entities and have no independent obligation to provide NEE with funds for its payment obligations. The subsidiaries have financial obligations, including, but not limited to, payment of debt service, which they must satisfy before they can provide NEE with funds. In addition, in the event of a subsidiary's liquidation or reorganization, NEE's right to participate in a distribution of assets is subject to the prior claims of the subsidiary's creditors.The dividend-paying ability of some of the subsidiaries is limited by contractual restrictions which are contained in outstanding financing agreements and which may be included in future financing agreements. The future enactment of laws or regulations also may prohibit or restrict the ability of NEE's subsidiaries to pay upstream dividends or to repay funds.NEE may be unable to meet its ongoing and future financial obligations and to pay dividends on its common stock if NEE is required to perform under guarantees of obligations of its subsidiaries.NEE guarantees many of the obligations of its consolidated subsidiaries, other than FPL, through guarantee agreements with NEECH. These guarantees may require NEE to provide substantial funds to its subsidiaries or their creditors or counterparties at a time when NEE is in need of liquidity to meet its own financial obligations. Funding such guarantees may materially adversely affect NEE's ability to meet its financial obligations or to pay dividends.NEP may not be able to access sources of capital on commercially reasonable terms, which would have a material adverse effect on its ability to consummate future acquisitions and on the value of NEE’s limited partner interest in NEP OpCo.Through an indirect wholly owned subsidiary, NEE owns a limited partner interest in NEP OpCo. NEP's inability to access capital on commercially reasonable terms and effectively consummate future acquisitions could have a material adverse effect on NEP's ability to grow its cash distributions to its common unitholders, including NEE, and on the value of NEE’s limited partnership interest in NEP OpCo. In addition, NEP's issuance of additional common units, securities convertible into NEP common units or other securities in connection with acquisitions could cause significant common unitholder dilution and reduce cash distributions to its common unitholders, including NEE, if the acquisitions are not sufficiently accretive.Disruptions, uncertainty or volatility in the credit and capital markets may exert downward pressure on the market price of NEE's common stock.The market price and trading volume of NEE's common stock are subject to fluctuations as a result of, among other factors, general credit and capital market conditions and changes in market sentiment regarding the operations, business and financing strategies of NEE and its subsidiaries. As a result, disruptions, uncertainty or volatility in the credit and capital markets may, for example, have a material adverse effect on the market price of NEE's common stock.Widespread public health crises and epidemics or pandemics, including the novel coronavirus (COVID-19), may have material adverse impacts on NEE’s and FPL's business, financial condition, liquidity and results of operations.NEE and FPL are subject to the impacts of widespread public health crises, epidemics and pandemics, including, but not limited to, impacts on the global, national or local economy, capital and credit markets, NEE's and FPL's workforce, customers and suppliers. There is no assurance that NEE's and FPL's businesses will be able to operate without material adverse impacts depending on the nature of the public health crisis, epidemic or pandemic. Actions taken in response to such crises by federal, state and local government or regulatory agencies may have a material adverse impact on NEE's and FPL's business, financial condition, liquidity and results of operations.The ultimate severity, duration and impact of public health crises, epidemics and pandemics cannot be predicted. Additionally, there is no assurance that vaccines or other treatments will be widely available or effective, or that the public will be willing to participate, in an effort to contain the spread of disease.NEE and FPL are closely monitoring the global outbreak of COVID-19. At this time, NEE and FPL are unable to determine the ultimate severity or duration of the outbreak or its effects on, among other things, the global, national or local economy, the capital and credit markets, or NEE’s and FPL’s workforce, customers and suppliers. To date, COVID-19 has not had a material adverse impact on NEE's and FPL's business, financial condition, liquidity and results of operations.Item 1B. Unresolved Staff CommentsNone31Table of ContentsItem 2. PropertiesSee Item 1. Business - FPL and Item 1. Business - NEER for a description of principal properties.Character of OwnershipSubstantially all of FPL's properties are subject to the lien of FPL's mortgage, which secures most debt securities issued by FPL. The majority of FPL's real property is held in fee and is free from other encumbrances, subject to minor exceptions which are not of a nature as to substantially impair the usefulness to FPL of such properties. Some of FPL's electric lines are located on parcels of land which are not owned in fee by FPL but are covered by necessary consents of governmental authorities or rights obtained from owners of private property. Subsidiaries within the NEER segment have ownership interests in entities that own generation facilities, pipeline facilities and transmission assets and a number of those facilities and assets are encumbered by liens securing various financings. Additionally, the majority of NEER's generation facilities, pipeline facilities and transmission lines are located on land under easement or leased from owners of private property. See Note 7 - FPL and - NEER.Item 3. Legal ProceedingsNone. With regard to environmental proceedings to which a governmental authority is a party, NEE's and FPL's policy is to disclose any such proceeding if it is reasonably expected to result in monetary sanctions of greater than or equal to $1 million.Item 4. Mine Safety DisclosuresNot applicable32Table of ContentsPART IIItem 5. Market for Registrants' Common Equity, Related Stockholder Matters and Issuer Purchases of Equity SecuritiesCommon Stock Data. All of FPL's common stock is owned by NEE. NEE's common stock is traded on the New York Stock Exchange under the symbol "NEE." As of January 31, 2021, there were 16,080 holders of record of NEE's common stock. The amount and timing of dividends payable on NEE's common stock are within the sole discretion of NEE's Board of Directors. The Board of Directors reviews the dividend rate at least annually (generally in February) to determine its appropriateness in light of NEE's financial position and results of operations, legislative and regulatory developments affecting the electric utility industry in general and FPL in particular, competitive conditions, change in business mix and any other factors the Board of Directors deems relevant. In February 2021, NEE announced that it would increase its quarterly dividend on its common stock from $0.35 per share to $0.385 per share.Issuer Purchases of Equity Securities. Information regarding purchases made by NEE of its common stock during the three months ended December 31, 2020 is as follows:PeriodTotalNumberof SharesPurchased(a)AveragePrice PaidPer ShareTotal Number of SharesPurchased as Part of aPublicly Announced ProgramMaximum Number ofShares that May Yet bePurchased Under theProgram(b)10/1/20 - 10/31/20— — —180,000,00011/1/20 - 11/30/201,456$77.19 —180,000,00012/1/20 - 12/31/201,420$74.43 —180,000,000Total2,876$75.83 — ______________________(a)Includes: (1) in November 2020, shares of common stock withheld from employees to pay certain withholding taxes upon the vesting of stock awards granted to such employees under the NextEra Energy, Inc. Amended and Restated 2011 Long Term Incentive Plan; and (2) in December 2020, shares of common stock purchased as a reinvestment of dividends by the trustee of a grantor trust in connection with NEE's obligation under a February 2006 grant under the NextEra Energy, Inc. Amended and Restated Long-Term Incentive Plan (former LTIP) to an executive officer of deferred retirement share awards.(b)In May 2017, NEE's Board of Directors authorized repurchases of up to 45 million shares of common stock (180 million shares after giving effect to the four-for-one stock split of NEE common stock effective October 26, 2020 (2020 stock split)) over an unspecified period.Item 6. Selected Financial DataOmitted/Not Applicable33Table of ContentsItem 7. Management’s Discussion and Analysis of Financial Condition and Results of OperationsOVERVIEWNEE’s operating performance is driven primarily by the operations of its two principal businesses, FPL, which serves more than 5.6 million customer accounts in Florida and is one of the largest electric utilities in the U.S., and NEER, which together with affiliated entities is the world's largest generator of renewable energy from the wind and sun based on 2020 MWh produced on a net generation basis. The table below presents net income (loss) attributable to NEE and earnings (loss) per share attributable to NEE, assuming dilution, by reportable segment, FPL and NEER, as well as Gulf Power, acquired by NEE in January 2019 (see Note 6 - Gulf Power Company), and Corporate and Other, which is primarily comprised of the operating results of other business activities, as well as other income and expense items, including interest expense, and eliminating entries. Prior years' share-based data included in Management's Discussion has been retrospectively adjusted to reflect the 2020 stock split. See Note 14 - Earnings Per Share. The following discussion should be read in conjunction with the Notes to Consolidated Financial Statements contained herein and all comparisons are with the corresponding items in the prior year. Net Income (Loss) Attributableto NEEEarnings (Loss) Per Share Attributable to NEE, Assuming DilutionYears Ended December 31,Years Ended December 31,202020192018202020192018(millions)FPL$2,650 $2,334 $2,171 $1.35 $1.20 $1.14 Gulf Power(a)238 180 — 0.12 0.09 — NEER(b)(c)531 1,807 4,704 0.27 0.93 2.46 Corporate and Other(500)(552)(237)(0.26)(0.28)(0.13)NEE(c)$2,919 $3,769 $6,638 $1.48 $1.94 $3.47 ______________________(a) Gulf Power was acquired by NEE in January 2019. See Note 6 - Gulf Power Company.(b) NEER’s results reflect an allocation of interest expense from NEECH based on a deemed capital structure of 70% debt and differential membership interests sold by NextEra Energy Resources' subsidiaries.(c) NEP was deconsolidated from NEER in January 2018. See Note 1 - Basis of Presentation.For the five years ended December 31, 2020, NEE delivered a total shareholder return of approximately 237.6%, above the S&P 500’s 103.0% return, the S&P 500 Utilities' 72.3% return and the Dow Jones U.S. Electricity's 72.6% return. The historical stock performance of NEE's common stock shown in the performance graph below is not necessarily indicative of future stock price performance.34Table of ContentsAdjusted EarningsNEE prepares its financial statements under GAAP. However, management uses earnings adjusted for certain items (adjusted earnings), a non-GAAP financial measure, internally for financial planning, analysis of performance, reporting of results to the Board of Directors and as an input in determining performance-based compensation under NEE’s employee incentive compensation plans. NEE also uses adjusted earnings when communicating its financial results and earnings outlook to analysts and investors. NEE’s management believes that adjusted earnings provide a more meaningful representation of NEE's fundamental earnings power. Although these amounts are properly included in the determination of net income under GAAP, management believes that the amount and/or nature of such items make period to period comparisons of operations difficult and potentially confusing. Adjusted earnings do not represent a substitute for net income, as prepared under GAAP.The following table provides details of the after-tax adjustments to net income considered in computing NEE's adjusted earnings discussed above.Years Ended December 31,202020192018(millions)Net losses associated with non-qualifying hedge activity(a)$(650)$(404)$(186)Tax reform-related, including the impact of tax rate change on differential membership interests(b)$(87)$(89)$436 NEP investment gains, net(c)$(94)$96 $2,863 Gain on disposal of a business - NEER(d)$274 $— $— Change in unrealized gains (losses) on NEER's nuclear decommissioning funds and OTTI, net(e)$131 $176 $(125)Acquisition-related(f)$— $(70)$(14)Operating results of solar projects in Spain - NEER$1 $(2)$(9)Impairment charge related to investment in Mountain Valley Pipeline - NEER(g)$(1,208)$— $— ______________________(a)For 2020, 2019 and 2018, approximately $439 million of losses, $63 million of losses, and $41 million of gains, respectively, are included in NEER's net income; the balance is included in Corporate and Other. The change in non-qualifying hedge activity is primarily attributable to changes in forward power and natural gas prices, interest rates and foreign currency exchange rates, as well as the reversal of previously recognized unrealized mark-to-market gains or losses as the underlying transactions were realized. (b)For 2020 and 2019, the balances relate to NEER. For 2018, approximately $421 million of favorable tax reform-related impacts, including the impact of tax rate change on differential membership interests, relates to NEER and the balance relates to Corporate and Other. (c)For 2020 and 2019, the balances relate to NEER. For 2018, approximately $2,885 million relates to NEER and the balance relates to Corporate and Other. See Note 1 - Basis of Presentation and - Disposal of Businesses/Assets.(d)See Note 1 - Disposal of Businesses/Assets for a discussion of the sale of two solar generation facilities in Spain (Spain projects).(e)For 2020, 2019 and 2018, approximately $131 million of gains, $176 million of gains and $127 million of losses, respectively, are included in NEER's net income; the balance for 2018 is included in Corporate and Other.(f)For 2019, approximately $44 million, $20 million and $6 million of costs are included in Corporate and Other's, Gulf Power's and NEER's net income, respectively. For 2018, $9 million of costs are included in Corporate and Other's net income; the balance is included in NEER.(g)See Note 4 - Nonrecurring Fair Value Measurements for a discussion of the impairment charge related to the investment in Mountain Valley Pipeline.NEE segregates into two categories unrealized mark-to-market gains and losses and timing impacts related to derivative transactions. The first category, referred to as non-qualifying hedges, represents certain energy derivative, interest rate derivative and foreign currency transactions entered into as economic hedges, which do not meet the requirements for hedge accounting, or for which hedge accounting treatment is not elected or has been discontinued. Changes in the fair value of those transactions are marked to market and reported in the consolidated statements of income, resulting in earnings volatility because the economic offset to certain of the positions are generally not marked to market. As a consequence, NEE's net income reflects only the movement in one part of economically-linked transactions. For example, a gain (loss) in the non-qualifying hedge category for certain energy derivatives is offset by decreases (increases) in the fair value of related physical asset positions in the portfolio or contracts, which are not marked to market under GAAP. For this reason, NEE's management views results expressed excluding the impact of the non-qualifying hedges as a meaningful measure of current period performance. The second category, referred to as trading activities, which is included in adjusted earnings, represents the net unrealized effect of actively traded positions entered into to take advantage of expected market price movements and all other commodity hedging activities. At FPL, substantially all changes in the fair value of energy derivative transactions are deferred as a regulatory asset or liability until the contracts are settled, and, upon settlement, any gains or losses are passed through the fuel clause. See Note 3.2020 SummaryNet income attributable to NEE for 2020 was lower than 2019 by $850 million, or $0.46 per share, assuming dilution, due to lower results at NEER, partly offset by higher results at FPL, Gulf Power and Corporate and Other.FPL's increase in net income in 2020 was primarily driven by continued investments in plant in service and other property.35Table of ContentsNEER's results decreased in 2020 primarily driven by an impairment charge related to its investment in Mountain Valley Pipeline, unfavorable non-qualifying hedge activity, the absence of NEP investment gains recorded upon the sale of ownership interests to NEP in June 2019 and unfavorable changes in the fair value of equity securities in NEER's nuclear decommissioning funds compared to 2019, partly offset by the gain recognized on the sale of the Spain projects and higher earnings on new investments and existing generation assets. In 2020, NEER added approximately 2,299 MW of new wind generating capacity, 1,412 MW of wind repowering generating capacity and 625 MW of solar generating capacity in the U.S. and increased its backlog of contracted renewable development projects. Gulf Power's increase in net income in 2020 is primarily related to lower operating expenses - net. Corporate and Other's results in 2020 increased primarily due to lower net losses associated with non-qualifying hedge activity.NEE and its subsidiaries require funds to support and grow their businesses. These funds are primarily provided by cash flows from operations, borrowings or issuances of short- and long-term debt, proceeds from differential membership investors, sales of assets to NEP or third parties and, from time to time, issuances of equity securities. See Liquidity and Capital Resources - Liquidity.RESULTS OF OPERATIONSNet income attributable to NEE for 2020 was $2.92 billion compared to $3.77 billion in 2019. In 2020, net income attributable to NEE decreased primarily due to lower results at NEER, partly offset by higher results at FPL, Gulf Power and Corporate and Other. The comparison of the results of operations for the years ended December 31, 2019 and 2018 are included in Management's Discussion in NEE's and FPL's Annual Report on Form 10-K for the year ended December 31, 2019.In 2019, subsidiaries of NextEra Energy Resources sold ownership interests in three wind generation facilities and three solar generation facilities with a total net generating capacity of approximately 611 MW to a NEP subsidiary. In February 2020, a subsidiary of NextEra Energy Resources sold its ownership interest in two solar generation facilities located in Spain with a total generating capacity of 99.8 MW. In December 2020, a subsidiary of NextEra Energy Resources sold a 90% noncontrolling ownership interest in a portfolio of three wind generation facilities and four solar generation facilities representing a total net generating capacity of 900 MW. In addition, a subsidiary of NextEra Energy Resources sold its 100% ownership interest in a 100 MW solar generation facility and a 30 MW battery storage facility under construction with an expected in service date in early 2021 to a NEP subsidiary. See Note 1 - Disposal of Businesses/Assets and – Sale of Noncontrolling Ownership Interest.In July 2019, a wholly owned subsidiary of NEET acquired the outstanding membership interests of an entity that indirectly owns Trans Bay Cable, LLC (Trans Bay), which owns and operates a 53-mile, high-voltage direct current underwater transmission cable system in California. See Note 6 - Trans Bay Cable, LLC. In September 2020, a wholly owned subsidiary of NEET entered into agreements to acquire GridLiance, which owns and operates three FERC-regulated transmission utilities across six states, five in the Midwest and Nevada. See Note 6 - GridLiance.NEE's effective income tax rates for the years ended December 31, 2020 and 2019 were approximately 2% and 12%, respectively. The rates for both years reflect the impact of PTCs and ITCs and, in 2020, also reflect the impact of lower pretax income and the gain on sale of the Spain solar projects which was not taxable for federal nor state income tax purposes. See Note 5.On January 1, 2021, FPL and Gulf Power merged, with FPL as the surviving entity. However, FPL will continue to be regulated as two separate ratemaking entities in the former service areas of FPL and Gulf Power until the FPSC approves consolidation of the FPL and Gulf Power rates and tariffs. FPL and Gulf Power will continue to be separate operating segments of NEE as well as FPL, through 2021. See Note 6 - Merger of FPL and Gulf Power. NEE and FPL are closely monitoring the global outbreak of COVID-19 and are taking steps intended to mitigate the potential risks to NEE and FPL posed by COVID-19. See Note 15 - Coronavirus Pandemic.FPL: Results of OperationsFPL obtains its operating revenues primarily from the sale of electricity to retail customers at rates established by the FPSC through base rates and cost recovery clause mechanisms. FPL’s net income for 2020 and 2019 was $2,650 million and $2,334 million, respectively, representing an increase of $316 million. The increase was primarily driven by higher earnings from investments in plant in service and other property. Such investments grew FPL's average retail rate base by approximately $3.9 billion in 2020 and reflect, among other things, solar generation additions and ongoing transmission and distribution additions.36Table of ContentsFPL’s service area was impacted by Hurricane Dorian in 2019 and by Hurricane Isaias and Tropical Storm Eta in 2020. FPL determined that it would not seek recovery of the Hurricane Dorian, Hurricane Isaias and Tropical Storm Eta storm restoration costs through a storm surcharge from customers and instead recorded costs as storm restoration costs in NEE’s and FPL’s consolidated statements of income. FPL used available reserve amortization to offset all such storm restoration costs that were expensed for Hurricane Dorian, Hurricane Isaias and Tropical Storm Eta. See Note 1 - Storm Funds, Storm Reserves and Storm Cost Recovery. The use of reserve amortization is permitted by the 2016 rate agreement. See Item 1. Business - FPL - FPL Regulation - FPL Electric Rate Regulation - Base Rates - FPL Base Rates Effective January 2017 for additional information on the 2016 rate agreement. In order to earn a targeted regulatory ROE, subject to limitations associated with the 2016 rate agreement, reserve amortization is calculated using a trailing thirteen-month average of retail rate base and capital structure in conjunction with the trailing twelve months regulatory retail base net operating income, which primarily includes the retail base portion of base and other revenues, net of O&M, depreciation and amortization, interest and tax expenses. In general, the net impact of these income statement line items must be adjusted, in part, by reserve amortization to earn the targeted regulatory ROE. In certain periods, reserve amortization is reversed so as not to exceed the targeted regulatory ROE. The drivers of FPL's net income not reflected in the reserve amortization calculation typically include wholesale and transmission service revenues and expenses, cost recovery clause revenues and expenses, AFUDC - equity and revenue and costs not recoverable from retail customers. In 2020 and 2019, FPL recorded the reversal of reserve amortization of approximately $1 million and $357 million, respectively. FPL's regulatory ROE for both 2020 and 2019 was approximately 11.60%. During 2020, FPL's operating revenues decreased $530 million primarily related to lower fuel cost recovery revenues of $637 million and $66 million in lower storm-related revenues, partly offset by $244 million in higher retail base revenues. Retail BaseFPL’s retail base revenues for 2020 and 2019 reflect the 2016 rate agreement. In December 2016, the FPSC issued a final order approving the 2016 rate agreement which became effective January 2017 and will remain in effect until new base rates are approved by the FPSC. The 2016 rate agreement establishes FPL's allowed regulatory ROE at 10.55%, with a range of 9.60% to 11.60%, and allowed for retail rate base increases in 2017, 2018, and upon commencement of commercial operations at the Okeechobee Clean Energy Center and certain solar projects. In January 2021, FPL filed a formal notification with the FPSC indicating its intent to initiate a base rate proceeding. See Item 1. Business - FPL - FPL Regulation - FPL Electric Rate Regulation - Base Rates for additional information on the 2016 rate agreement and details of FPL's formal notification.The increase in retail base revenues in 2020 primarily reflects additional revenues of approximately $64 million related to retail base rate adjustments associated with the addition of new solar generation and the Okeechobee Clean Energy Center which achieved commercial operation at the end of the first quarter of 2019. In 2020, retail base revenues were also impacted by an increase of 1.5% in the average number of customer accounts. Although the weather in 2020 was favorable when compared to 2019, usage per retail customer remained flat. See Note 1 - Rate Regulation. Cost Recovery ClausesRevenues from fuel and other cost recovery clauses and pass-through costs, such as franchise fees, revenue taxes and storm-related surcharges, are largely a pass-through of costs. Such revenues also include a return on investment allowed to be recovered through the cost recovery clauses on certain assets, primarily related to certain solar and environmental projects and the unamortized balance of the regulatory asset associated with FPL's acquisition of certain generation facilities. See Item 1. Business - FPL - FPL Regulation - FPL Electric Rate Regulation - Cost Recovery Clauses. Underrecovery or overrecovery of cost recovery clause and other pass-through costs (deferred clause and franchise expenses and revenues) can significantly affect NEE's and FPL's operating cash flows. The 2020 net underrecovery impacting NEE's and FPL's operating cash flows was approximately $110 million.Fuel cost recovery revenues decreased in 2020 primarily as a result of lower fuel and energy prices, including the flow back of lower expected fuel costs to retail customers. Storm-related revenues decreased in 2020 primarily as a result of the conclusion of the storm-recovery bond surcharge in the third quarter of 2019.In 2020 and 2019, cost recovery clauses contributed approximately $111 million and $117 million, respectively, to FPL’s net income. Other Items Impacting FPL's Consolidated Statements of IncomeFuel, Purchase Power and Interchange ExpenseFuel, purchased power and interchange expense decreased $640 million in 2020 primarily related to lower fuel and energy prices.37Table of ContentsDepreciation and Amortization ExpenseThe major components of FPL’s depreciation and amortization expense are as follows:Years Ended December 31,20202019(millions)Reserve reversal recorded under the 2016 rate agreement$1 $357 Other depreciation and amortization recovered under base rates (excluding reserve amortization) and other2,017 1,876 Depreciation and amortization primarily recovered under cost recovery clauses and securitized storm-recovery cost amortization228 291 Total$2,246 $2,524 Depreciation expense decreased $278 million during 2020 primarily reflecting a lower reversal of reserve amortization in 2020 compared to 2019 and lower storm-recovery cost amortization primarily as a result of the final payment of the storm-recovery bonds in the third quarter of 2019. The decreases in depreciation and amortization expense during 2020 were partly offset by increased depreciation related to higher plant in service balances. Reserve amortization, or reversal of such amortization, reflects adjustments to accrued asset removal costs provided under the 2016 rate agreement in order to achieve the targeted regulatory ROE. Reserve amortization is recorded as a reduction to (or when reversed as an increase to) accrued asset removal costs which is reflected in noncurrent regulatory liabilities on the consolidated balance sheets. At December 31, 2020, approximately $894 million remains in accrued asset removal costs related to reserve amortization. Income TaxesDuring 2020, income taxes increased $169 million, primarily related to the absence of a 2019 income tax adjustment recorded pursuant to the FPSC's order in connection with its review of impacts associated with tax reform, as well as higher income before income taxes in 2020. See Note 5.NEER: Results of OperationsNEER owns, develops, constructs, manages and operates electric generation facilities in wholesale energy markets primarily in the U.S., as well as in Canada. NEER also provides full energy and capacity requirements services, engages in power and fuel marketing and trading activities, owns and operates rate-regulated transmission facilities and transmission lines and invests in natural gas, natural gas liquids and oil production and pipeline infrastructure assets. NEER’s net income less net loss attributable to noncontrolling interests for 2020 and 2019 was $531 million and $1,807 million, respectively, resulting in a decrease in 2020 of $1,276 million. The primary drivers, on an after-tax basis, of the change are in the following table. Increase (Decrease) From Prior PeriodYear Ended December 31, 2020(millions)New investments(a)$143 Existing generation assets(a)65 Gas infrastructure(a)(6)Customer supply and proprietary power and gas trading(b)3 NEET(b)47 Asset sales/abandonment37 Interest and other general and administrative expenses(c)(34)Other, including other investment income and income taxes8 Change in non-qualifying hedge activity(d)(376)Change in unrealized gains/losses on equity securities held in nuclear decommissioning funds and OTTI, net(d)(45)NEP investment gains, net(d)(190)Disposal of a business(d)274 Acquisition-related(d)6 Impairment charge related to investment in Mountain Valley Pipeline(d)(1,208)Decrease in net income less net loss attributable to noncontrolling interests$(1,276)______________________(a) Reflects after-tax project contributions, including the net effect of deferred income taxes and other benefits associated with PTCs and ITCs for wind and solar projects, as applicable (see Note 1 - Income Taxes and - Sales of Differential Membership Interests and Note 5), but excludes allocation of interest expense or corporate general and administrative expenses. Results from projects and pipelines are included in new investments during the first twelve months of operation or ownership. Project results are included in existing assets and pipeline results are included in gas infrastructure beginning with the thirteenth month of operation or ownership. (b) Excludes allocation of interest expense and corporate general and administrative expenses.(c) Includes differential membership interest costs. Excludes unrealized mark-to-market gains and losses related to interest rate derivative contracts, which are included in change in non-qualifying hedge activity.(d) See Overview - Adjusted Earnings for additional information.38Table of ContentsThe discussion below describes changes in certain line items set forth in NEE's consolidated statements of income as they relate to NEER.Operating RevenuesOperating revenues for 2020 decreased $593 million primarily due to:•the impact of non-qualifying commodity hedges (approximately $244 million of losses during 2020 compared to $342 million of gains for 2019), and •lower revenues from existing generation assets of $260 million primarily related to lower nuclear revenues, due primarily to the closure of Duane Arnold in August 2020 and a refueling outage at the Seabrook nuclear facility, as well as the sale of the Spain projects, partly offset by,•revenues from new investments of $145 million, and•higher revenues of $129 million from NEET primarily related to the acquisition of Trans Bay in 2019.Operating Expenses - netOperating expenses - net for 2020 increased $88 million primarily due to increases of $156 million in O&M expenses primarily associated with new investments and acquisitions, partly offset by lower fuel costs of $89 million.Gains on Disposal of Businesses/Assets - netIn 2020, gains on disposal of businesses/assets - net primarily related to the sale of the Spain projects in the first quarter of 2020; in 2019, the amount was primarily related to the sale of ownership interests in wind and solar projects to NEP. See Note 1 - Disposal of Businesses/Assets.Interest ExpenseNEER's interest expense for 2020 decreased $214 million primarily reflecting lower losses of approximately $99 million related to changes in the fair value of interest rate derivative instruments as compared to 2019, as well as lower interest rates in 2020, partly offset by higher average debt balances. Equity in Earnings (Losses) of Equity Method InvesteesNEER recognized $1.4 billion of equity in losses of equity method investees in 2020 compared to $67 million of equity in earnings of equity method investees for the prior year period. The change for 2020 primarily reflects an impairment charge related to the investment in Mountain Valley Pipeline of approximately $1.5 billion. See Note 4 - Nonrecurring Fair Value Measurements. Tax Credits, Benefits and ExpensesPTCs from wind projects and ITCs from solar and certain wind projects are reflected in NEER’s earnings. A portion of the PTCs and ITCs have been allocated to investors in connection with sales of differential membership interests. PTCs are recognized as wind energy is generated and sold based on a per kWh rate prescribed in applicable federal and state statutes. Reflected in income taxes in NEE's consolidated statements of income are PTCs totaling approximately $150 million and $75 million and ITCs totaling approximately $133 million and $199 million in 2020 and 2019, respectively. See Note 1 - Income Taxes for a discussion of PTCs and ITCs and Note 5. Gulf Power: Results of OperationsGulf Power's net income increased $58 million in 2020. During 2020, operating revenues decreased $89 million primarily related to lower fuel revenues. Operating expenses - net decreased $135 million in 2020 primarily related to decreases in fuel, purchased power and interchange expense and O&M expenses, as well as the absence of 2019 acquisition-related costs, partly offset by higher depreciation and amortization as a result of increased investments in plant in service and other property.In September 2020, Gulf Power's service area was impacted by Hurricane Sally and Gulf Power recorded estimated recoverable storm restoration costs of approximately $206 million. See Note 1 - Storm Funds, Storm Reserves and Storm Cost Recovery.Corporate and Other: Results of OperationsCorporate and Other is primarily comprised of the operating results of other business activities, as well as corporate interest income and expenses. Corporate and Other allocates a portion of NEECH's corporate interest expense to NEER. Interest expense is allocated based on a deemed capital structure of 70% debt and differential membership interests sold by NextEra Energy Resources' subsidiaries. Corporate and Other's results increased $52 million during 2020 primarily due to lower net losses of approximately $130 million associated with non-qualifying hedge activity as a result of changes in the fair value of interest rate derivative instruments and the absence of acquisition and integration costs incurred in 2019, partly offset by higher corporate interest and operating expenses.39Table of ContentsLIQUIDITY AND CAPITAL RESOURCESNEE and its subsidiaries require funds to support and grow their businesses. These funds are used for, among other things, working capital, capital expenditures (see Note 15 - Commitments), investments in or acquisitions of assets and businesses (see Note 6), payment of maturing debt and related derivative obligations (see Note 13 and Note 3) and, from time to time, redemption or repurchase of outstanding debt or equity securities. It is anticipated that these requirements will be satisfied through a combination of cash flows from operations, short- and long-term borrowings, the issuance of short- and long-term debt and, from time to time, equity securities, proceeds from differential membership investors and sales of assets to NEP or third parties, consistent with NEE’s and FPL’s objective of maintaining, on a long-term basis, a capital structure that will support a strong investment grade credit rating. NEE, FPL and NEECH rely on access to credit and capital markets as significant sources of liquidity for capital requirements and other operations that are not satisfied by operating cash flows. The inability of NEE, FPL and NEECH to maintain their current credit ratings could affect their ability to raise short- and long-term capital, their cost of capital and the execution of their respective financing strategies, and could require the posting of additional collateral under certain agreements.In October 2015, NEE authorized a program to purchase, from time to time, up to $150 million of common units representing limited partner interests in NEP. Under the program, purchases may be made in amounts, at prices and at such times as NEE or its subsidiaries deem appropriate, all subject to market conditions and other considerations. The purchases may be made in the open market or in privately negotiated transactions. Any purchases will be made in such quantities, at such prices, in such manner and on such terms and conditions as determined by NEE or its subsidiaries in their discretion, based on factors such as market and business conditions, applicable legal requirements and other factors. The common unit purchase program does not require NEE to acquire any specific number of common units and may be modified or terminated by NEE at any time. The purpose of the program is not to cause NEP’s common units to be delisted from the New York Stock Exchange or to cause the common units to be deregistered with the SEC. As of December 31, 2020, NEE had purchased approximately $36 million of NEP common units under this program. At December 31, 2020, NEE owned a noncontrolling general partner interest in NEP and beneficially owned approximately 58.0% of NEP’s voting power.40Table of ContentsCash FlowsNEE's sources and uses of cash for 2020, 2019 and 2018 were as follows:Years Ended December 31,202020192018(millions)Sources of cash:Cash flows from operating activities$7,983 $8,155 $6,593 Issuances of long-term debt, including premiums and discounts12,404 13,905 4,391 Proceeds from differential membership investors3,522 1,604 1,841 Sale of independent power and other investments of NEER1,012 1,316 1,693 Issuances of common stock/equity units - net— 1,494 718 Net increase in commercial paper and other short-term debt(a)— — 6,272 Non-operating distributions from equity method investees— — 637 Proceeds from sale of noncontrolling interests501 99 — Other sources - net83 121 47 Total sources of cash25,505 26,694 22,192 Uses of cash:Capital expenditures, acquisitions, independent power and other investments and nuclear fuel purchases(14,610)(17,462)(13,004)Retirements of long-term debt(6,103)(5,492)(3,102)Net decrease in commercial paper and other short-term debt(a)(907)(4,799)— Payments to related parties under a cash sweep and credit support agreement – net(2)(54)(21)Issuances of common stock/equity units - net(92)— — Dividends(2,743)(2,408)(2,101)Other uses - net(590)(628)(687)Total uses of cash(25,047)(30,843)(18,915)Effects of currency translation on cash, cash equivalents and restricted cash(20)4 (7)Net increase (decrease) in cash, cash equivalents and restricted cash$438 $(4,145)$3,270 ______________________(a) 2019 and 2018 amounts primarily relate to the acquisition of Gulf Power. See Note 6 - Gulf Power Company.NEE's primary capital requirements are for expanding and enhancing FPL's and Gulf Power's electric system and generation facilities to continue to provide reliable service to meet customer electricity demands and for funding NEER's investments in independent power and other projects. See Note 15 - Commitments for estimated capital expenditures in 2021 through 2025. The following table provides a summary of capital investments for 2020, 2019 and 2018. Years Ended December 31,202020192018(millions)FPL:Generation:New$1,464 $1,242 $976 Existing1,063 1,215 1,142 Transmission and distribution3,150 2,893 2,456 Nuclear fuel203 195 123 General and other651 550 334 Other, primarily change in accrued property additions and exclusion of AFUDC - equity149 (340)104 Total6,680 5,755 5,135 Gulf Power1,012 729 — NEER:Wind3,359 1,974 4,093 Solar1,920 1,741 698 Battery storage168 29 37 Nuclear, including nuclear fuel125 179 233 Natural gas pipelines269 687 873 Other gas infrastructure572 969 893 Other (2019 primarily related to acquisitions, see Note 6)480 926 362 Total6,893 6,505 7,189 Corporate and Other (2019 primarily related to acquisitions, see Note 6)25 4,473 680 Total capital expenditures, independent power and other investments and nuclear fuel purchases$14,610 $17,462 $13,004 .41Table of ContentsLiquidityAt December 31, 2020, NEE's total net available liquidity was approximately $10.9 billion. The table below provides the components of FPL's, Gulf Power's and NEECH's net available liquidity at December 31, 2020.GulfMaturity DateFPL(a)Power(a)NEECHTotalFPLGulf PowerNEECH(millions)Syndicated revolving credit facilities(b)$2,913 $900 $5,282 $9,095 2021 - 202520252021 - 2025Issued letters of credit(3)— (484)(487)2,910 900 4,798 8,608 Bilateral revolving credit facilities(c)680 100 2,400 3,180 2021 - 202220212021 - 2023Borrowings— — — — 680 100 2,400 3,180 Letter of credit facilities(d)— — 950 950 2022 - 2023Issued letters of credit— — (885)(885)— — 65 65 Subtotal3,590 1,000 7,263 11,853 Cash and cash equivalents20 5 1,077 1,102 Commercial paper and other short-term borrowingsoutstanding(1,526)(225)(258)(2,009)Net available liquidity$2,084 $780 $8,082 $10,946 `______________________(a) See Note 6 - Merger of FPL and Gulf Power regarding FPL's assumption of Gulf Power's revolving credit facilities and debt on January 1, 2021.(b) Provide for the funding of loans up to the amount of the credit facility and the issuance of letters of credit up to $2,525 million ($575 million for FPL, $75 million for Gulf Power and $1,875 million for NEECH). The entire amount of the credit facilities is available for general corporate purposes and to provide additional liquidity in the event of a loss to the companies’ or their subsidiaries’ operating facilities (including, in the case of FPL, a transmission and distribution property loss). FPL’s syndicated revolving credit facilities are also available to support the purchase of $948 million of pollution control, solid waste disposal and industrial development revenue bonds (tax exempt bonds) in the event they are tendered by individual bondholders and not remarketed prior to maturity, as well as, the repayment of approximately $556 million of floating rate notes in the event an individual noteholder requires repayment prior to maturity. Gulf Power's syndicated revolving credit facilities are also available to support the purchase of approximately $426 million of its tax exempt bonds in the event they are tendered by individual bondholders and not remarketed prior to maturity. Approximately $2,314 million of FPL's and $4,062 million of NEECH's syndicated revolving credit facilities expire in 2025.(c) Approximately $300 million of NEECH's bilateral revolving credit facilities is available for costs incurred in connection with the development, construction and operations of wind and solar power generation facilities. (d) Only available for the issuance of letters of credit.At December 31, 2020, 73 banks participate in FPL’s, Gulf Power's and NEECH’s revolving credit facilities, with no one bank providing more than 7% of the combined revolving credit facilities. European banks provide approximately 24% of the combined revolving credit facilities. Pursuant to a 1998 guarantee agreement, NEE guarantees the payment of NEECH’s debt obligations under its revolving credit facilities. In order for FPL, Gulf Power or NEECH to borrow or to have letters of credit issued under the terms of their respective revolving credit facilities and, also for NEECH, its letter of credit facilities, FPL, in the case of FPL, Gulf Power in the case of Gulf Power, and NEE, in the case of NEECH, are required, among other things, to maintain a ratio of funded debt to total capitalization that does not exceed a stated ratio. The FPL, Gulf Power and NEECH revolving credit facilities also contain default and related acceleration provisions relating to, among other things, failure of FPL, Gulf Power and NEE, as the case may be, to maintain the respective ratio of funded debt to total capitalization at or below the specified ratio. At December 31, 2020, each of NEE, Gulf Power and FPL was in compliance with its required ratio.Capital SupportGuarantees, Letters of Credit, Surety Bonds and Indemnifications (Guarantee Arrangements) Certain subsidiaries of NEE issue guarantees and obtain letters of credit and surety bonds, as well as provide indemnities, to facilitate commercial transactions with third parties and financings. Substantially all of the guarantee arrangements are on behalf of NEE’s consolidated subsidiaries, as discussed in more detail below. NEE is not required to recognize liabilities associated with guarantee arrangements issued on behalf of its consolidated subsidiaries unless it becomes probable that they will be required to perform. At December 31, 2020, NEE believes that there is no material exposure related to these guarantee arrangements.NEE subsidiaries issue guarantees related to equity contribution agreements associated with the development, construction and financing of certain power generation facilities, engineering, procurement and construction agreements and equity contributions associated with natural gas pipeline projects under development and construction and a related natural gas transportation agreement. Commitments associated with these activities are included in the contracts table in Note 15. 42Table of ContentsIn addition, at December 31, 2020, NEE subsidiaries had approximately $4.3 billion in guarantees related to obligations under purchased power agreements, nuclear-related activities, payment obligations related to PTCs, as well as other types of contractual obligations (see Note 6 - GridLiance and Note 15 - Commitments). In some instances, subsidiaries of NEE elect to issue guarantees instead of posting other forms of collateral required under certain financing arrangements, as well as for other project-level cash management activities. At December 31, 2020, these guarantees totaled approximately $390 million and support, among other things, cash management activities, including those related to debt service and O&M service agreements, as well as other specific project financing requirements.Subsidiaries of NEE also issue guarantees to support customer supply and proprietary power and gas trading activities, including the buying and selling of wholesale and retail energy commodities. At December 31, 2020, the estimated mark-to-market exposure (the total amount that these subsidiaries of NEE could be required to fund based on energy commodity market prices at December 31, 2020) plus contract settlement net payables, net of collateral posted for obligations under these guarantees totaled approximately $616 million.At December 31, 2020, subsidiaries of NEE also had approximately $1.8 billion of standby letters of credit and approximately $621 million of surety bonds to support certain of the commercial activities discussed above. FPL's and NEECH's credit facilities are available to support the amount of the standby letters of credit.In addition, as part of contract negotiations in the normal course of business, certain subsidiaries of NEE have agreed and in the future may agree to make payments to compensate or indemnify other parties, including those associated with asset divestitures, for possible unfavorable financial consequences resulting from specified events. The specified events may include, but are not limited to, an adverse judgment in a lawsuit, or the imposition of additional taxes due to a change in tax law or interpretations of the tax law, or the triggering of cash grant recapture provisions under the Recovery Act. NEE is unable to estimate the maximum potential amount of future payments under some of these contracts because events that would obligate them to make payments have not yet occurred or, if any such event has occurred, they have not been notified of its occurrence.NEECH, a 100% owned subsidiary of NEE, provides funding for, and holds ownership interests in, NEE's operating subsidiaries other than FPL. NEE has fully and unconditionally guaranteed certain payment obligations of NEECH, including most of its debt and all of its debentures registered pursuant to the Securities Act of 1933 and commercial paper issuances, as well as most of its payment guarantees and indemnifications, and NEECH has guaranteed certain debt and other obligations of subsidiaries within the NEER segment. Certain guarantee arrangements described above contain requirements for NEECH and FPL to maintain a specified credit rating. For a discussion of credit rating downgrade triggers, see Credit Ratings below.NEE fully and unconditionally guarantees NEECH debentures pursuant to a guarantee agreement, dated as of June 1, 1999 (1999 guarantee) and NEECH junior subordinated debentures pursuant to an indenture, dated as of September 1, 2006 (2006 guarantee). The 1999 guarantee is an unsecured obligation of NEE and ranks equally and ratably with all other unsecured and unsubordinated indebtedness of NEE. The 2006 guarantee is unsecured and subordinate and junior in right of payment to NEE senior indebtedness (as defined therein). No payment on those junior subordinated debentures may be made under the 2006 guarantee until all NEE senior indebtedness has been paid in full in certain circumstances. NEE’s and NEECH’s ability to meet their financial obligations are primarily dependent on their subsidiaries’ net income, cash flows and their ability to pay upstream dividends or to repay funds to NEE and NEECH. The dividend-paying ability of some of the subsidiaries is limited by contractual restrictions which are contained in outstanding financing agreements.43Table of ContentsSummarized financial information of NEE and NEECH is as follows:Year Ended December 31, 2020Issuer/Guarantor Combined(a)NEECH Consolidated(b)NEE Consolidated(b)(millions)Operating revenues$(1)$5,093 $17,997 Operating income (loss)$(269)$1,221 $5,116 Net income (loss)$(500)$(551)$2,369 Net income (loss) attributable to NEE/NEECH$(500)$— $2,919 December 31, 2020Issuer/Guarantor Combined(a)NEECH Consolidated(b)NEE Consolidated(b)(millions)Total current assets $620 $4,571 $7,382 Total noncurrent assets $2,069 $52,565 $120,302 Total current liabilities$4,317 $9,991 $15,558 Total noncurrent liabilities$22,854 $31,439 $67,197 Noncontrolling interests$— $8,416 $8,416 ————————————(a)Excludes intercompany transactions, and investments in, and equity in earnings of, subsidiaries. (b)Information has been prepared on the same basis of accounting as NEE's consolidated financial statements.Shelf RegistrationIn July 2018, NEE, NEECH and FPL filed a shelf registration statement with the SEC for an unspecified amount of securities, which became effective upon filing. The amount of securities issuable by the companies is established from time to time by their respective boards of directors. Securities that may be issued under the registration statement include, depending on the registrant, senior debt securities, subordinated debt securities, junior subordinated debentures, first mortgage bonds, common stock, preferred stock, stock purchase contracts, stock purchase units, warrants and guarantees related to certain of those securities. 44Table of ContentsCredit RatingsNEE’s liquidity, ability to access credit and capital markets, cost of borrowings and collateral posting requirements under certain agreements is dependent on its and its subsidiaries credit ratings. At February 12, 2021, Moody’s Investors Service, Inc. (Moody’s), S&P Global Ratings (S&P) and Fitch Ratings, Inc. (Fitch) had assigned the following credit ratings to NEE, FPL and NEECH:Moody's(a)S&P(a)Fitch(a)NEE:(b)Corporate credit ratingBaa1A-A-FPL:(b)Corporate credit ratingA1AAFirst mortgage bonds Aa2A+AA-Senior unsecured notesA1AA+Pollution control, solid waste disposal and industrial development revenue bonds(c)VMIG-1/P-1A-1F1Commercial paperP-1A-1F1NEECH:(b)Corporate credit ratingBaa1A-A-DebenturesBaa1BBB+A-Junior subordinated debenturesBaa2BBBBBBCommercial paperP-2A-2F2_________________________(a) A security rating is not a recommendation to buy, sell or hold securities and should be evaluated independently of any other rating. The rating is subject to revision or withdrawal at any time by the assigning rating organization.(b) The outlook indicated by each of Moody's, S&P and Fitch is stable.(c) Short-term ratings are presented as all bonds outstanding are currently paying a short-term interest rate. At FPL's election, a portion or all of the bonds may be adjusted to a long-term interest rate.NEE and its subsidiaries have no credit rating downgrade triggers that would accelerate the maturity dates of outstanding debt. A change in ratings is not an event of default under applicable debt instruments, and while there are conditions to drawing on the credit facilities noted above, the maintenance of a specific minimum credit rating is not a condition to drawing on these credit facilities.Commitment fees and interest rates on loans under these credit facilities’ agreements are tied to credit ratings. A ratings downgrade also could reduce the accessibility and increase the cost of commercial paper and other short-term debt issuances and borrowings and additional or replacement credit facilities. In addition, a ratings downgrade could result in, among other things, the requirement that NEE subsidiaries post collateral under certain agreements and guarantee arrangements, including, but not limited to, those related to fuel procurement, power sales and purchases, nuclear decommissioning funding, debt-related reserves and trading activities. FPL’s, Gulf Power's and NEECH’s credit facilities are available to support these potential requirements.CovenantsNEE's charter does not limit the dividends that may be paid on its common stock. As a practical matter, the ability of NEE to pay dividends on its common stock is dependent upon, among other things, dividends paid to it by its subsidiaries. For example, FPL pays dividends to NEE in a manner consistent with FPL's long-term targeted capital structure. However, the mortgage securing FPL's first mortgage bonds contains provisions which, under certain conditions, restrict the payment of dividends to NEE and the issuance of additional first mortgage bonds. Additionally, in some circumstances, the mortgage restricts the amount of retained earnings that FPL can use to pay cash dividends on its common stock. The restricted amount may change based on factors set out in the mortgage. Other than this restriction on the payment of common stock dividends, the mortgage does not restrict FPL's use of retained earnings. At December 31, 2020, no retained earnings were restricted by these provisions of the mortgage and, in light of FPL's current financial condition and level of earnings, management does not expect that planned financing activities or dividends would be affected by these limitations.FPL may issue first mortgage bonds under its mortgage subject to its meeting an adjusted net earnings test set forth in the mortgage, which generally requires adjusted net earnings to be at least twice the annual interest requirements on, or at least 10% of the aggregate principal amount of, FPL’s first mortgage bonds including those to be issued and any other non-junior FPL indebtedness. At December 31, 2020, coverage for the 12 months ended December 31, 2020 would have been approximately 8.2 times the annual interest requirements and approximately 3.6 times the aggregate principal requirements. New first mortgage bonds are also limited to an amount equal to the sum of 60% of unfunded property additions after adjustments to offset property retirements, the amount of retired first mortgage bonds or qualified lien bonds and the amount of cash on deposit with the mortgage trustee. At December 31, 2020, FPL could have issued in excess of $25 billion of additional first mortgage bonds based on the unfunded property additions and retired first mortgage bonds. At December 31, 2020, no cash was deposited with the mortgage trustee for these purposes.45Table of ContentsIn September 2006, NEE and NEECH executed a Replacement Capital Covenant (as amended, September 2006 RCC) in connection with NEECH's offering of $350 million principal amount of Series B Enhanced Junior Subordinated Debentures due 2066 (Series B junior subordinated debentures). The September 2006 RCC is for the benefit of persons that buy, hold or sell a specified series of long-term indebtedness (covered debt) of NEECH (other than the Series B junior subordinated debentures) or, in certain cases, of NEE. NEECH's 3.625% Debentures, Series due June 15, 2023 have been designated as the covered debt under the September 2006 RCC. The September 2006 RCC provides that NEECH may redeem, and NEE or NEECH may purchase, any Series B junior subordinated debentures on or before October 1, 2036, only to the extent that the redemption or purchase price does not exceed a specified amount of proceeds from the sale of qualifying securities, subject to certain limitations described in the September 2006 RCC. Qualifying securities are securities that have equity-like characteristics that are the same as, or more equity-like than, the Series B junior subordinated debentures at the time of redemption or purchase, which are sold within 365 days prior to the date of the redemption or repurchase of the Series B junior subordinated debentures.In June 2007, NEE and NEECH executed a Replacement Capital Covenant (as amended, June 2007 RCC) in connection with NEECH's offering of $400 million principal amount of its Series C Junior Subordinated Debentures due 2067 (Series C junior subordinated debentures). The June 2007 RCC is for the benefit of persons that buy, hold or sell a specified series of covered debt of NEECH (other than the Series C junior subordinated debentures) or, in certain cases, of NEE. NEECH's 3.625% Debentures, Series due June 15, 2023 have been designated as the covered debt under the June 2007 RCC. The June 2007 RCC provides that NEECH may redeem or purchase, or satisfy, discharge or defease (collectively, defease), and NEE and any majority-owned subsidiary of NEE or NEECH may purchase, any Series C junior subordinated debentures on or before June 15, 2037, only to the extent that the principal amount defeased or the applicable redemption or purchase price does not exceed a specified amount raised from the issuance, during the 365 days prior to the date of that redemption, purchase or defeasance, of qualifying securities that have equity-like characteristics that are the same as, or more equity-like than, the applicable characteristics of the Series C junior subordinated debentures at the time of redemption, purchase or defeasance, subject to certain limitations described in the June 2007 RCC.New Accounting Rules and InterpretationsReference Rate Reform - In March 2020, the FASB issued an accounting standards update which provides certain options to apply GAAP guidance on contract modifications and hedge accounting as companies transition from the London Inter-Bank Offered Rate and other interbank offered rates to alternative reference rates. See Note 1 - Reference Rate Reform.CRITICAL ACCOUNTING POLICIES AND ESTIMATESNEE’s significant accounting policies are described in Note 1 to the consolidated financial statements, which were prepared under GAAP. Critical accounting policies are those that NEE believes are both most important to the portrayal of its financial condition and results of operations, and require complex, subjective judgments, often as a result of the need to make estimates and assumptions about the effect of matters that are inherently uncertain. Judgments and uncertainties affecting the application of those policies may result in materially different amounts being reported under different conditions or using different assumptions.NEE considers the following policies to be the most critical in understanding the judgments that are involved in preparing its consolidated financial statements:Accounting for Derivatives and Hedging ActivitiesNEE uses derivative instruments (primarily swaps, options, futures and forwards) to manage the physical and financial risks inherent in the purchase and sale of fuel and electricity, as well as interest rate and foreign currency exchange rate risk associated primarily with outstanding and expected future debt issuances and borrowings. In addition, NEE, through NEER, uses derivatives to optimize the value of its power generation and gas infrastructure assets and engages in power and fuel marketing and trading activities to take advantage of expected future favorable price movements.Nature of Accounting EstimatesAccounting pronouncements require the use of fair value accounting if certain conditions are met, which may require significant judgment to measure the fair value of assets and liabilities. This applies not only to traditional financial derivative instruments, but to any contract having the accounting characteristics of a derivative. As a result, significant judgment must be used in applying derivatives accounting guidance to contracts. In the event changes in interpretation occur, it is possible that contracts that currently are excluded from derivatives accounting rules would have to be recorded on the balance sheet at fair value, with changes in the fair value recorded in the statement of income.Assumptions and Accounting ApproachDerivative instruments, when required to be marked to market, are recorded on the balance sheet at fair value using a combination of market and income approaches. Fair values for some of the longer-term contracts where liquid markets are not available are derived through the use of industry-standard valuation techniques, such as internally developed models which 46Table of Contentsestimate the fair value of a contract by calculating the present value of the difference between the contract price and the forward prices. Forward prices represent the price at which a buyer or seller could contract today to purchase or sell a commodity at a future date. The near-term forward market for electricity is generally liquid and therefore the prices in the early years of the forward curves reflect observable market quotes. However, in the later years, the market is much less liquid and forward price curves must be developed using factors including the forward prices for the commodities used as fuel to generate electricity, the expected system heat rate (which measures the efficiency of power plants in converting fuel to electricity) in the region where the purchase or sale takes place, and a fundamental forecast of expected spot prices based on modeled supply and demand in the region. NEE estimates the fair value of interest rate and foreign currency derivatives using an income approach based on a discounted cash flows valuation technique utilizing the net amount of estimated future cash inflows and outflows related to the derivative agreements. The assumptions in these models are critical since any changes therein could have a significant impact on the fair value of the derivative.At FPL, substantially all changes in the fair value of energy derivative transactions are deferred as a regulatory asset or liability until the contracts are settled, and, upon settlement, any gains or losses are passed through the fuel clause. See Note 3.In NEE’s non-rate regulated operations, predominantly NextEra Energy Resources, essentially all changes in the derivatives’ fair value for power purchases and sales, fuel sales and trading activities are recognized on a net basis in operating revenues; fuel purchases used in the production of electricity are recognized in fuel, purchased power and interchange expense; and the equity method investees’ related activity is recognized in equity in earnings of equity method investees in NEE’s consolidated statements of income. For interest rate and foreign currency derivative instruments, all changes in the derivatives' fair value are recognized in interest expense and the equity method investees' related activity is recognized in equity in earnings of equity method investees in NEE's consolidated statements of income. NEE estimates the fair value of these derivatives using an income approach based on a discounted cash flows valuation technique utilizing observable inputs. Certain derivative transactions at NEER are entered into as economic hedges but the transactions do not meet the requirements for hedge accounting, hedge accounting treatment is not elected or hedge accounting has been discontinued. Changes in the fair value of those transactions are marked to market and reported in the consolidated statements of income, resulting in earnings volatility. These changes in fair value are reflected in the non-qualifying hedge category in computing adjusted earnings and could be significant to NEER’s results because the economic offset to the positions are not marked to market. As a consequence, NEE's net income reflects only the movement in one part of economically-linked transactions. For example, a gain (loss) in the non-qualifying hedge category for certain energy derivatives is offset by decreases (increases) in the fair value of related physical asset positions in the portfolio or contracts, which are not marked to market under GAAP. For this reason, NEE’s management views results expressed excluding the unrealized mark-to-market impact of the non-qualifying hedges as a meaningful measure of current period performance. For additional information regarding derivative instruments, see Note 3, Overview and Energy Marketing and Trading and Market Risk Sensitivity.Accounting for Pension BenefitsNEE sponsors a qualified noncontributory defined benefit pension plan for substantially all employees of NEE and its subsidiaries. Management believes that, based on actuarial assumptions and the well-funded status of the pension plan, NEE will not be required to make any cash contributions to the qualified pension plan in the near future. The qualified pension plan has a fully funded trust dedicated to providing benefits under the plan. NEE allocates net periodic income associated with the pension plan to its subsidiaries annually using specific criteria.Nature of Accounting EstimatesFor the pension plan, the benefit obligation is the actuarial present value, as of the December 31 measurement date, of all benefits attributed by the pension benefit formula to employee service rendered to that date. The amount of benefit to be paid depends on a number of future events incorporated into the pension benefit formula, including an estimate of the average remaining life of employees/survivors as well as the average years of service rendered. The projected benefit obligation is measured based on assumptions concerning future interest rates and future employee compensation levels. NEE derives pension income from actuarial calculations based on the plan’s provisions and various management assumptions including discount rate, rate of increase in compensation levels and expected long-term rate of return on plan assets.Assumptions and Accounting ApproachAccounting guidance requires recognition of the funded status of the pension plan in the balance sheet, with changes in the funded status recognized in other comprehensive income within shareholders’ equity in the year in which the changes occur. Since NEE is the plan sponsor, and its subsidiaries do not have separate rights to the plan assets or direct obligations to their employees, this accounting guidance is reflected at NEE and not allocated to the subsidiaries. The portion of previously unrecognized actuarial gains and losses and prior service costs or credits that are estimated to be allocable to FPL as net periodic (income) cost in future periods and that otherwise would be recorded in accumulated other comprehensive income are classified as regulatory assets and liabilities at NEE in accordance with regulatory treatment.47Table of ContentsNet periodic pension income is calculated using a number of actuarial assumptions. Those assumptions for the years ended December 31, 2020, 2019 and 2018 include: 202020192018Discount rate3.22 %4.26 %3.59 %Salary increase4.40 %4.40 %4.10 %Expected long-term rate of return, net of investment management fees7.35 %7.35 %7.35 %Weighted-average interest crediting rate3.83 %3.88 %3.94 %In developing these assumptions, NEE evaluated input, including other qualitative and quantitative factors, from its actuaries and consultants, as well as information available in the marketplace. In addition, for the expected long-term rate of return on pension plan assets, NEE considered different models, capital market return assumptions and historical returns for a portfolio with an equity/bond asset mix similar to its pension fund, as well as its pension fund's historical compounded returns. NEE believes that 7.35% is a reasonable long-term rate of return, net of investment management fees, on its pension plan assets. NEE will continue to evaluate all of its actuarial assumptions, including its expected rate of return, at least annually, and will adjust them as appropriate.NEE utilizes in its determination of pension income a market-related valuation of plan assets. This market-related valuation reduces year-to-year volatility and recognizes investment gains or losses over a five-year period following the year in which they occur. Investment gains or losses for this purpose are the difference between the expected return calculated using the market-related value of plan assets and the actual return realized on those plan assets. Since the market-related value of plan assets recognizes gains or losses over a five-year period, the future value of plan assets will be affected as previously deferred gains or losses are recognized. Such gains and losses together with other differences between actual results and the estimates used in the actuarial valuations are deferred and recognized in determining pension income only to the extent they exceed 10% of the greater of projected benefit obligations or the market-related value of plan assets.The following table illustrates the effect on net periodic pension income of changing the critical actuarial assumptions discussed above, while holding all other assumptions constant:Increase (Decrease) in 2020Net Periodic Pension IncomeChange inAssumptionNEEFPL(millions)Expected long-term rate of return(0.5)%$(22)$(13)Discount rate0.5%$13 $8 Salary increase0.5%$(4)$(3)NEE also utilizes actuarial assumptions about mortality to help estimate obligations of the pension plan. NEE has adopted the latest revised mortality tables and mortality improvement scales released by the Society of Actuaries, which did not have a material impact on the pension plan's obligation.See Note 12.Carrying Value of Long-Lived AssetsNEE evaluates long-lived assets for impairment when events or changes in circumstances indicate that the carrying amount may not be recoverable.Nature of Accounting EstimatesThe amount of future net cash flows, the timing of the cash flows and the determination of an appropriate interest rate all involve estimates and judgments about future events. In particular, the aggregate amount of cash flows determines whether an impairment exists, and the timing of the cash flows is critical in determining fair value. Because each assessment is based on the facts and circumstances associated with each long-lived asset, the effects of changes in assumptions cannot be generalized.Assumptions and Accounting ApproachAn impairment loss is required to be recognized if the carrying value of the asset exceeds the undiscounted future net cash flows associated with that asset. The impairment loss to be recognized is the amount by which the carrying value of the long-lived asset exceeds the asset’s fair value. In most instances, the fair value is determined by discounting estimated future cash flows using an appropriate interest rate. 48Table of ContentsCarrying Value of Equity Method InvestmentsNEE evaluates its equity method investments for impairment when events or changes in circumstances indicate that the fair value of the investment is less than the carrying value and the investment may be other-than-temporarily impaired. Nature of Accounting EstimatesIndicators of a potential impairment include, but are not limited to, a series of operating losses of an investee, the absence of an ability to recover the carrying amount of the investment, the inability of the investee to sustain an earnings capacity and a current fair value of an investment that may be less than its carrying value. If indicators of impairment exist, an estimate of the investment’s fair value will be calculated. Approaches for estimating fair value include, among others, an income approach using a probability-weighted discounted cash flows model and a market approach using an earnings before interest, taxes, depreciation and amortization (EBITDA) multiple model. The probability assigned to each scenario as well as the cash flows and EBITDA multiple identified are critical in determining fair value. Assumptions and Accounting ApproachAn impairment loss is required to be recognized if the impairment is deemed to be other than temporary. Assessment of whether an investment is other-than-temporarily impaired involves, among other factors, consideration of the length of time that the fair value is below the carrying value, current expected performance relative to the expected performance when the investment was initially made, performance relative to peers, industry performance relative to the economy, credit rating, regulatory actions and legal and permitting challenges. If management is unable to reasonably assert that an impairment is temporary or believes that there will not be full recovery of the carrying value of its investment, then the impairment is considered to be other than temporary. Investments that are other-than-temporarily impaired are written down to their estimated fair value and cannot subsequently be written back up for increases in estimated fair value. Impairment losses are recorded in equity in earnings (losses) of equity method investees in NEE’s consolidated statements of income. See Note 4 - Nonrecurring Fair Value Measurements.Decommissioning and DismantlementNEE accounts for asset retirement obligations and conditional asset retirement obligations (collectively, AROs) under accounting guidance that requires a liability for the fair value of an ARO to be recognized in the period in which it is incurred if it can be reasonably estimated, with the offsetting associated asset retirement costs capitalized as part of the carrying amount of the long-lived assets. NEE's AROs relate primarily to decommissioning obligations of FPL's and NEER's nuclear units and to obligations for the dismantlement of certain of NEER's wind and solar facilities.Nature of Accounting EstimatesThe calculation of the future cost of retiring long-lived assets, including nuclear decommissioning and plant dismantlement costs, involves estimating the amount and timing of future expenditures and making judgments concerning whether or not such costs are considered a legal obligation. Estimating the amount and timing of future expenditures includes, among other things, making projections of when assets will be retired and ultimately decommissioned and how costs will escalate with inflation. In addition, NEE also makes interest rate and rate of return projections on its investments in determining recommended funding requirements for nuclear decommissioning costs. Periodically, NEE is required to update these estimates and projections which can affect the annual expense amounts recognized, the liabilities recorded and the annual funding requirements for nuclear decommissioning costs. For example, an increase of 0.25% in the assumed escalation rates for nuclear decommissioning costs would increase NEE’s AROs at December 31, 2020 by approximately $128 million.Assumptions and Accounting ApproachFPL - For ratemaking purposes, FPL accrues and funds for nuclear plant decommissioning costs over the expected service life of each unit based on studies that are approved by the FPSC. The most recent studies, filed in 2020, reflect, among other things, the expiration dates of the operating licenses for FPL’s nuclear units at the time of the studies. FPL’s portion of the future cost of decommissioning its four nuclear units, including spent fuel storage above what is expected to be refunded by the DOE under a spent fuel settlement agreement, is estimated to be approximately $7.0 billion, or $2.5 billion expressed in 2020 dollars.FPL accrues the cost of dismantling its fossil and solar plants over the expected service life of each unit based on studies filed with the FPSC. Unlike nuclear decommissioning, dismantlement costs are not funded. The most recent studies became effective January 1, 2017. At December 31, 2020, FPL’s portion of the ultimate cost to dismantle its fossil and solar units is approximately $1.2 billion, or $541 million expressed in 2020 dollars. The majority of the dismantlement costs are not reported as AROs. FPL accrues for interim removal costs over the life of the related assets based on depreciation studies approved by the FPSC. Any differences between the amount of the ARO and the amount recorded for ratemaking purposes are reported as a regulatory liability in accordance with regulatory accounting.49Table of ContentsThe components of FPL’s decommissioning of nuclear plants, dismantlement of plants and other accrued asset removal costs are as follows:NuclearDecommissioningFossil/SolarDismantlementInterim RemovalCosts and OtherTotalDecember 31,December 31,December 31,December 31,20202019202020192020201920202019(millions)AROs(a)$1,604 $2,076 $194 $186 $6 $6 $1,804 $2,268 Less capitalized ARO asset net of accumulated depreciation— 225 26 48 1 1 27 274 Accrued asset removal costs(b)408 368145144462 645 1,015 1,157 Asset retirement obligation regulatory expense difference(b)3,690 2,904 (102)(72)(5)(4)3,583 2,828 Accrued decommissioning, dismantlement and other accrued asset removal costs(c)$5,702 $5,123 $211 $210 $462 $646 $6,375 $5,979 ______________________(a) See Note 11 - Asset Retirement Obligations.(b) Included in noncurrent regulatory liabilities on NEE’s and FPL’s consolidated balance sheets. See Note 1 - Rate Regulation.(c) Represents total amount accrued for ratemaking purposes.NEER - NEER records liabilities for the present value of its expected nuclear plant decommissioning costs which are determined using various internal and external data and applying a probability percentage to a variety of scenarios regarding the life of the plant and timing of decommissioning. The liabilities are being accreted using the interest method through the date decommissioning activities are expected to be complete. At December 31, 2020 and 2019, the AROs for decommissioning of NEER’s nuclear plants approximated $637 million and $623 million, respectively. NEER’s portion of the ultimate cost of decommissioning its nuclear plants, including costs associated with spent fuel storage above what is expected to be refunded by the DOE under a spent fuel settlement agreement, is estimated to be approximately $9.5 billion, or $2.1 billion expressed in 2020 dollars.See Note 1 - Asset Retirement Obligations and - Decommissioning of Nuclear Plants, Dismantlement of Plants and Other Accrued Asset Removal Costs and Note 11.Regulatory AccountingCertain of NEE's businesses are subject to rate regulation which results in the recording of regulatory assets and liabilities. See Note 1 - Rate Regulation for details regarding NEE’s regulatory assets and liabilities. Nature of Accounting EstimatesRegulatory assets and liabilities represent probable future revenues that will be recovered from or refunded to customers through the ratemaking process. Regulatory assets and liabilities are included in rate base or otherwise earn (pay) a return on investment during the recovery period.Assumptions and Accounting ApproachAccounting guidance allows regulators to create assets and impose liabilities that would not be recorded by non-rate regulated entities. If NEE's rate-regulated entities, primarily FPL, were no longer subject to cost-based rate regulation, the existing regulatory assets and liabilities would be written off unless regulators specify an alternative means of recovery or refund. In addition, the regulators, including the FPSC for FPL, have the authority to disallow recovery of costs that they consider excessive or imprudently incurred. Such costs may include, among others, fuel and O&M expenses, the cost of replacing power lost when fossil and nuclear units are unavailable, storm restoration costs and costs associated with the construction or acquisition of new facilities. The continued applicability of regulatory accounting is assessed at each reporting period.ENERGY MARKETING AND TRADING AND MARKET RISK SENSITIVITYNEE and FPL are exposed to risks associated with adverse changes in commodity prices, interest rates and equity prices. Financial instruments and positions affecting the financial statements of NEE and FPL described below are held primarily for purposes other than trading. Market risk is measured as the potential loss in fair value resulting from hypothetical reasonably possible changes in commodity prices, interest rates or equity prices over the next year. Management has established risk management policies to monitor and manage such market risks, as well as credit risks.50Table of ContentsCommodity Price RiskNEE and FPL use derivative instruments (primarily swaps, options, futures and forwards) to manage the physical and financial risks inherent in the purchase and sale of fuel and electricity. In addition, NEE, through NEER, uses derivatives to optimize the value of its power generation and gas infrastructure assets and engages in power and fuel marketing and trading activities to take advantage of expected future favorable price movements. See Critical Accounting Policies and Estimates - Accounting for Derivatives and Hedging Activities and Note 3.During 2019 and 2020, the changes in the fair value of NEE’s consolidated subsidiaries’ energy contract derivative instruments were as follows:Hedges on Owned AssetsTradingNon-QualifyingFPL CostRecoveryClausesGulf Power Cost Recovery ClausesNEE Total(millions)Fair value of contracts outstanding at December 31, 2018$593 $794 $(41)$— $1,346 Reclassification to realized at settlement of contracts(215)(154)30 7 (332)Value of contracts acquired28 9 — (6)31 Net option premium purchases (issuances)43 5 — — 48 Changes in fair value excluding reclassification to realized202 555 1 (2)756 Fair value of contracts outstanding at December 31, 2019651 1,209 (10)(1)1,849 Reclassification to realized at settlement of contracts(329)(253)11 1 (570)Value of contracts acquired91 (36)— — 55 Net option premium purchases (issuances)10 4 — — 14 Changes in fair value excluding reclassification to realized283 72 (1)— 354 Fair value of contracts outstanding at December 31, 2020706 996 — — 1,702 Net margin cash collateral paid (received)(48)Total mark-to-market energy contract net assets (liabilities) at December 31, 2020$706 $996 $— $— $1,654 NEE’s total mark-to-market energy contract net assets (liabilities) at December 31, 2020 shown above are included on the consolidated balance sheets as follows:December 31, 2020(millions)Current derivative assets$567 Noncurrent derivative assets1,587 Current derivative liabilities(240)Noncurrent derivative liabilities(260)NEE's total mark-to-market energy contract net assets$1,654 51Table of ContentsThe sources of fair value estimates and maturity of energy contract derivative instruments at December 31, 2020 were as follows: Maturity20212022202320242025ThereafterTotal(millions)Trading:Quoted prices in active markets for identical assets$(195)$10 $29 $42 $— $— $(114)Significant other observable inputs11 18 (7)(27)18 (68)(55)Significant unobservable inputs202 62 67 62 62 420 875 Total18 90 89 77 80 352 706 Owned Assets - Non-Qualifying: Quoted prices in active markets for identical assets10 3 10 6 — — 29 Significant other observable inputs64 79 66 33 41 184 467 Significant unobservable inputs44 45 36 37 37 301 500 Total118 127 112 76 78 485 996 Owned Assets - FPL Cost Recovery Clauses: Quoted prices in active markets for identical assets— — — — — — — Significant other observable inputs1 — — — — — 1 Significant unobservable inputs— (1)— — — — (1)Total1 (1)— — — — — Total sources of fair value$137 $216 $201 $153 $158 $837 $1,702 With respect to commodities, NEE’s Exposure Management Committee (EMC), which is comprised of certain members of senior management, and NEE's chief executive officer are responsible for the overall approval of market risk management policies and the delegation of approval and authorization levels. The EMC and NEE's chief executive officer receive periodic updates on market positions and related exposures, credit exposures and overall risk management activities.NEE uses a value-at-risk (VaR) model to measure commodity price market risk in its trading and mark-to-market portfolios. The VaR is the estimated loss of market value based on a one-day holding period at a 95% confidence level using historical simulation methodology. The VaR figures are as follows:TradingNon-Qualifying Hedgesand Hedges in FPL Cost Recovery Clauses(a)TotalFPLNEERNEEFPLNEERNEEFPLNEERNEE(millions)December 31, 2019$— $2 $2 $— $25 $25 $— $26 $26 December 31, 2020$— $3 $3 $1 $77 $78 $1 $84 $85 Average for the year ended December 31, 2020$— $3 $3 $1 $51 $51 $1 $52 $52 ______________________(a) Non-qualifying hedges are employed to reduce the market risk exposure to physical assets or contracts which are not marked to market. The VaR figures for the non-qualifying hedges and hedges in FPL cost recovery clauses category do not represent the economic exposure to commodity price movements.Interest Rate RiskNEE's and FPL's financial results are exposed to risk resulting from changes in interest rates as a result of their respective outstanding and expected future issuances of debt, investments in special use funds and other investments. NEE and FPL manage their respective interest rate exposure by monitoring current interest rates, entering into interest rate contracts and using a combination of fixed rate and variable rate debt. Interest rate contracts are used to mitigate and adjust interest rate exposure when deemed appropriate based upon market conditions or when required by financing agreements.52Table of ContentsThe following are estimates of the fair value of NEE's and FPL's financial instruments that are exposed to interest rate risk: December 31, 2020 December 31, 2019 CarryingAmountEstimatedFair Value(a) CarryingAmountEstimatedFair Value(a) (millions)NEE: Fixed income securities: Special use funds$2,134 $2,134 $2,099 $2,099 Other investments, primarily debt securities$247 $247 $181 $181 Long-term debt, including current portion$46,082 $51,525 $39,667 $42,928 Interest rate contracts - net unrealized losses$(961)$(961)$(716)$(716)FPL: Fixed income securities - special use funds$1,617 $1,617 $1,574 $1,574 Long-term debt, including current portion$15,676 $19,470 $14,161 $16,448 ______________________(a) See Notes 3 and 4.The special use funds of NEE and FPL consist of restricted funds set aside to cover the cost of storm damage for FPL and for the decommissioning of NEE's and FPL's nuclear power plants. See Note 1 - Storm Funds, Storm Reserves and Storm Cost Recovery. A portion of these funds is invested in fixed income debt securities primarily carried at estimated fair value. At FPL, changes in fair value, including any credit losses, result in a corresponding adjustment to the related regulatory asset or liability accounts based on current regulatory treatment. The changes in fair value for NEE's non-rate regulated operations result in a corresponding adjustment to other comprehensive income, except for credit losses and unrealized losses on available for sale securities intended or required to be sold prior to recovery of the amortized cost basis, which are reported in current period earnings. Because the funds set aside by FPL for storm damage could be needed at any time, the related investments are generally more liquid and, therefore, are less sensitive to changes in interest rates. The nuclear decommissioning funds, in contrast, are generally invested in longer-term securities.At December 31, 2020, NEE had interest rate contracts with a net notional amount of approximately $10.5 billion related to expected future and outstanding debt issuances and borrowings. The net notional amount consists of approximately $10.9 billion to manage exposure to the variability of cash flows associated with expected future and outstanding debt issuances at NEECH and NEER. This is offset by approximately $400 million that effectively convert fixed-rate debt to variable-rate debt instruments at NEECH. See Note 3.Based upon a hypothetical 10% decrease in interest rates, which is a reasonable near-term market change, the fair value of NEE’s net liabilities would increase by approximately $1,278 million ($541 million for FPL) at December 31, 2020.Equity Price RiskNEE and FPL are exposed to risk resulting from changes in prices for equity securities. For example, NEE’s nuclear decommissioning reserve funds include marketable equity securities carried at their market value of approximately $4,726 million and $3,963 million ($3,012 million and $2,491 million for FPL) at December 31, 2020 and 2019, respectively. NEE's and FPL’s investment strategy for equity securities in their nuclear decommissioning reserve funds emphasizes marketable securities which are broadly diversified. At December 31, 2020, a hypothetical 10% decrease in the prices quoted on stock exchanges, which is a reasonable near-term market change, would result in a $434 million ($277 million for FPL) reduction in fair value. For FPL, a corresponding adjustment would be made to the related regulatory asset or liability accounts based on current regulatory treatment, and for NEE’s non-rate regulated operations, a corresponding amount would be recorded in change in unrealized gains (losses) on equity securities held in NEER's nuclear decommissioning funds - net in NEE's consolidated statements of income. Credit RiskNEE and its subsidiaries, including FPL, are also exposed to credit risk through their energy marketing and trading operations. Credit risk is the risk that a financial loss will be incurred if a counterparty to a transaction does not fulfill its financial obligation. NEE manages counterparty credit risk for its subsidiaries with energy marketing and trading operations through established policies, including counterparty credit limits, and in some cases credit enhancements, such as cash prepayments, letters of credit, cash and other collateral and guarantees.Credit risk is also managed through the use of master netting agreements. NEE’s credit department monitors current and forward credit exposure to counterparties and their affiliates, both on an individual and an aggregate basis. For all derivative and contractual transactions, NEE’s energy marketing and trading operations, which include FPL's energy marketing and trading 53Table of Contentsdivision, are exposed to losses in the event of nonperformance by counterparties to these transactions. Some relevant considerations when assessing NEE’s energy marketing and trading operations’ credit risk exposure include the following:•Operations are primarily concentrated in the energy industry.•Trade receivables and other financial instruments are predominately with energy, utility and financial services related companies, as well as municipalities, cooperatives and other trading companies in the U.S.•Overall credit risk is managed through established credit policies and is overseen by the EMC.•Prospective and existing customers are reviewed for creditworthiness based upon established standards, with customers not meeting minimum standards providing various credit enhancements or secured payment terms, such as letters of credit or the posting of margin cash collateral.•Master netting agreements are used to offset cash and noncash gains and losses arising from derivative instruments with the same counterparty. NEE’s policy is to have master netting agreements in place with significant counterparties.Based on NEE’s policies and risk exposures related to credit, NEE and FPL do not anticipate a material adverse effect on their financial statements as a result of counterparty nonperformance. At December 31, 2020, approximately 83% of NEE’s and 100% of FPL's energy marketing and trading counterparty credit risk exposure is associated with companies that have investment grade credit ratings.Item 7A. Quantitative and Qualitative Disclosures About Market RiskSee Management’s Discussion – Energy Marketing and Trading and Market Risk Sensitivity.54Table of Contents
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+Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations Norfolk Southern Corporation and Subsidiaries The following discussion and analysis should be read in conjunction with the Consolidated Financial Statements and Notes. OVERVIEW We are one of the nation’s premier transportation companies. Our Norfolk Southern Railway Company subsidiary operates approximately 19,300 route miles in 22 states and the District of Columbia, serves every major container port in the eastern U.S., and provides efficient connections to other rail carriers. We are a major transporter of industrial products, including agriculture, forest and consumer products, chemicals, and metals and construction materials. In addition, we operate the most extensive intermodal network in the East and are a principal carrier of coal, automobiles, and automotive parts. In 2020, we continued the implementation of our strategic plan, including tactical changes to our operating plan, to generate operational efficiencies, improve customer service, and deliver strong financial results. The COVID-19 pandemic caused significant economic disruption and, along with softening energy markets, reduced the demand for our services. Nevertheless, we executed on operational initiatives to generate efficiencies and lower our cost structure. In the face of economic headwinds that resulted in a year-over-year volume decline of 12%, we improved productivity by driving year-over-year average headcount down by 18%, and we increased asset utilization through rationalization of our locomotive fleet. These sustainable cost structure improvements will provide greater benefits as the economy recovers. However, there is still substantial uncertainty as to the pace of economic recovery and the continued effects of the pandemic on our results of operations. We continue to monitor the impact of the pandemic on our employees’ availability and remain committed to protecting our employees and providing excellent transportation service products for our customers. SUMMARIZED RESULTS OF OPERATIONS20202019202020192018vs. 2019vs. 2018 ($ in millions, except per share amounts)(% change)Income from railway operations$3,002 $3,989 $3,959 (25 %)1 %Net income$2,013 $2,722 $2,666 (26 %)2 %Diluted earnings per share$7.84 $10.25 $9.51 (24 %)8 %Railway operating ratio (percent)69.3 64.7 65.4 7 %(1 %)Income from railway operations declined in 2020 compared to 2019 as railway operating revenues fell 13% which exceeded a 7% reduction in operating expenses. Railway operating revenues declined as lower customer demand resulted in volume reductions. Additionally, negative mix and lower fuel surcharge revenue, partially offset by increased pricing, led to lower revenue per unit. Railway operating expenses decreased due to declines in fuel price and consumption, reduced employment levels, lower volumes and operational efficiency improvements. Additionally, 2020 results were adversely impacted by a loss on asset disposal of $385 million related to locomotives sold, and by a $99 million impairment charge related to an equity method investment. For more information on the impact of these charges, see Notes 7 and 6, respectively. Income from railway operations rose in 2019 compared to 2018 as a 3% reduction in railway operating expenses more than offset the impact of a 1% decline in railway operating revenues. In addition to higher income from railway operations, net income and diluted earnings per share growth in 2019 also benefited from a lower effective K19tax rate. Our continuing share repurchase program contributed to diluted earnings per share growth that exceeded that of net income.The following tables adjust our 2020 U.S. Generally Accepted Accounting Principles (“GAAP”) financial results to exclude the effects of the aforementioned charges. The income tax effects on the non-GAAP adjustments were calculated based on the applicable tax rates to which the non-GAAP adjustments relate. We use these non-GAAP financial measures internally and believe this information provides useful supplemental information to investors to facilitate making period-to-period comparisons by excluding the 2020 charges. While we believe that these non-GAAP financial measures are useful in evaluating our business, this information should be considered as supplemental in nature and is not meant to be considered in isolation from, or as a substitute for, the related financial information prepared in accordance with GAAP. In addition, these non-GAAP financial measures may not be the same as similar measures presented by other companies. Non-GAAP Reconciliation for 2020Reported 2020 (GAAP)Loss on Asset DisposalInvestment ImpairmentAdjusted 2020(non-GAAP)($ in millions, except per share amounts)Railway operating expenses$6,787 $(385)$(99)$6,303 Income from railway operations$3,002 $385 $99 $3,486 Income before income taxes$2,530 $385 $99 $3,014 Income taxes$517 $97 $25 $639 Net income$2,013 $288 $74 $2,375 Diluted earnings per share$7.84 $1.12 $0.29 $9.25 Railway operating ratio (percent)69.3 (3.9)(1.0)64.4 In the table below, references to 2020 results and related comparisons use the adjusted, non-GAAP results from the table above. AdjustedAdjusted20202020(non-GAAP)2019(non-GAAP)20192018vs. 2019vs. 2018 ($ in millions, except per share amounts)(% change)Railway operating expenses$6,303 $7,307 $7,499 (14 %)(3 %)Income from railway operations$3,486 $3,989 $3,959 (13 %)1 %Income before income taxes$3,014 $3,491 $3,469 (14 %)1 %Income taxes$639 $769 $803 (17 %)(4 %)Net income$2,375 $2,722 $2,666 (13 %)2 %Diluted earnings per share$9.25 $10.25 $9.51 (10 %)8 %Railway operating ratio (percent)64.4 64.7 65.4 — %(1 %)K20DETAILED RESULTS OF OPERATIONSRailway Operating RevenuesThe following tables present a three-year comparison of revenues, volumes (units), and average revenue per unit by major commodity group. Revenues20202019202020192018vs. 2019vs. 2018($ in millions)(% change)Merchandise:Agriculture, forest and consumer products$2,116 $2,256 $2,188 (6 %)3 %Chemicals1,809 2,092 2,083 (14 %)— %Metals and construction1,333 1,461 1,482 (9 %)(1 %)Automotive830 994 991 (16 %)— % Merchandise6,088 6,803 6,744 (11 %)1 %Intermodal2,654 2,824 2,893 (6 %)(2 %)Coal1,047 1,669 1,821 (37 %)(8 %) Total$9,789 $11,296 $11,458 (13 %)(1 %)Units20202019202020192018vs. 2019vs. 2018(in thousands)(% change)Merchandise:Agriculture, forest and consumer products704.4 763.7 790.7 (8 %)(3 %)Chemicals482.0 588.9 604.7 (18 %)(3 %)Metals and construction601.2 685.1 719.8 (12 %)(5 %)Automotive329.7 394.7 403.9 (16 %)(2 %) Merchandise2,117.3 2,432.4 2,519.1 (13 %)(3 %)Intermodal3,992.1 4,207.2 4,375.7 (5 %)(4 %)Coal574.1 914.0 1,033.5 (37 %)(12 %)Total6,683.5 7,553.6 7,928.3 (12 %)(5 %)Revenue per Unit20202019202020192018vs. 2019vs. 2018($ per unit)(% change)Merchandise:Agriculture, forest and consumer products$3,004 $2,953 $2,767 2 %7 %Chemicals3,753 3,553 3,444 6 %3 %Metals and construction2,216 2,133 2,059 4 %4 %Automotive2,518 2,517 2,453 — %3 % Merchandise2,875 2,797 2,677 3 %4 %Intermodal665 671 661 (1 %)2 %Coal1,824 1,826 1,762 — %4 % Total1,465 1,495 1,445 (2 %)3 %K21At the beginning of 2020, we combined the agriculture products and forest and consumer commodity groups. In addition, we also made changes in the categorization of certain other commodity groups within Merchandise. Prior period railway operating revenues, units, and revenue per unit have been reclassified to conform to the current presentation (see Note 2).Revenues decreased $1.5 billion in 2020 and $162 million in 2019 compared to the prior years. As reflected in the table below, lower revenues for both years were the result of decreased volumes and lower fuel surcharge revenue, partially offset by pricing gains.The table below reflects the components of the revenue change by major commodity group. 2020 vs. 20192019 vs. 2018Increase (Decrease)Increase (Decrease)($ in millions)MerchandiseIntermodalCoalMerchandiseIntermodalCoalVolume $(881)$(144)$(621)$(232)$(111)$(210)Fuel surchargerevenue(92)(124)(13)(14)(30)(35)Rate, mix andother258 98 12 305 72 93 Total$(715)$(170)$(622)$59 $(69)$(152) Approximately 90% of our revenue base is covered by contracts that include negotiated fuel surcharges. These revenues totaled $349 million, $578 million, and $657 million in 2020, 2019, and 2018, respectively.MERCHANDISE revenues decreased in 2020 but increased in 2019 compared with the prior years. In 2020, revenues decreased due to volume declines in all commodity groups which were partially offset by higher average revenue per unit, driven by pricing gains. In 2019, revenues grew due to higher average revenue per unit, driven by pricing gains, which were partially offset by volume declines in all commodity groups. For 2021, merchandise revenues are expected to increase, the result of higher volume as the market continues to recover from the impact of the COVID-19 pandemic and increased revenue per unit driven by pricing gains.Agriculture, forest and consumer products revenues decreased in 2020 but increased in 2019 compared with the prior years. In 2020, the decline was the result of reduced volume partially offset by higher average revenue per unit, driven by pricing gains partially offset by lower fuel surcharge revenue. Volume declined due to the impact of COVID-19 on the demand for ethanol, corn, food service products, and building, industrial and commercial products. Revenue growth in 2019 was due to higher average revenue per unit, a result of pricing gains, which more than offset volume declines. Volume was down due to decreased shipments of ethanol, pulpboard, lumber, soybeans, pulp, woodchips, canned goods, and fertilizer, partially offset by increased corn shipments. In 2021, agriculture, forest and consumer products revenues are expected to rise, a result of increased volume as the economic recovery continues, and revenue per unit increases resulting from pricing gains. We expect volumes to increase in most markets led by ethanol, corn, pulpboard, and food services.Chemicals revenues fell in 2020 but rose slightly in 2019 compared with the prior years. In 2020, the decrease was the result of volume declines partially offset by higher average revenue per unit, due to pricing gains. Volume declined due to the impact from COVID-19 and ongoing disruptions in the energy market. The pandemic created an overabundance of products in the market as companies reduced stockpiles before requiring more products. Oil and petroleum shipments were negatively impacted due to reductions in gasoline/jet fuel demand and travel. In K222019, the rise was the result of higher average revenue per unit, due to pricing gains, which were partially offset by volume declines. Volume declines in natural gas, sand, petroleum products, organic and inorganic chemicals, and plastics were partially offset by gains in crude oil and municipal waste. For 2021, chemicals revenues are anticipated to increase, as a result of increased volume and revenue per unit driven by pricing gains. We expect carloads to increase due to growth in plastics, organic chemicals, petroleum products, and solid waste which is projected to be partially offset by reduced volumes of sand, crude oil and natural gas liquids. Metals and construction revenues declined in both periods. In 2020, volume declines were partially offset by higher average revenue per unit, the result of pricing gains. Volume declines were largely the result of weakened demand due to reductions in metal and domestic vehicle production. The pandemic caused industries to suspend production which heavily impacted customers’ needs for materials and shipping of finished and semi-finished goods. These declines were partially offset by increased demand for cement. In 2019, volume declines were largely offset by higher average revenue per unit, the result of pricing gains. Volume declines in iron and steel, coil, scrap metal, and kaolin were partially offset by increases in aggregates shipments due to improved service and market strength. For 2021, metals and construction revenues are expected to rise, a result of increased volume and revenue per unit driven by pricing gains. As the economic recovery continues, volume growth is expected in almost all markets led by scrap metal, coil, iron and steel, and construction.Automotive revenues declined in 2020 but were flat in 2019 compared with the prior years. In 2020, revenue declines were driven by lower volume and fuel surcharge revenue, partially offset by pricing gains. The volume decline was mostly the result of unplanned automotive plant shutdowns in the first half of the year, primarily due to the COVID-19 pandemic, which was partially offset by increased demand in the second half of the year. In 2019, higher average revenue per unit, driven by price increases, offset volume declines that were primarily the result of decreases in U.S. light vehicle production and the United Automobile Workers strike in the fourth quarter. In 2021, automotive revenues are expected to increase as a result of higher volume as inventories continue to rebuild. INTERMODAL revenues decreased in both periods. The decline in 2020 was driven by lower volume and fuel surcharge revenue, which were partially offset by pricing gains and favorable mix. The decline in 2019 was driven by lower volume, which was partially offset by higher average revenue per unit, a result of pricing gains. For 2021, we expect intermodal revenues to rise, the result of increased demand, expected highway conversions, and higher fuel surcharge revenue.Intermodal units by market were as follows:20202019202020192018vs. 2019vs. 2018 (units in thousands)(% change)Domestic2,568.7 2,593.5 2,801.1 (1 %)(7 %)International1,423.4 1,613.7 1,574.6 (12 %)2 %Total3,992.1 4,207.2 4,375.7 (5 %)(4 %)Domestic volume fell in both periods. While volume rebounded in the second half of 2020 due to inventory replenishment and a strong peak season, volume for the year was challenged by supply chain disruptions related to K23COVID-19 and strong over-the-road competition in the first half of the year. Volume was challenged in 2019 by stronger over-the-road competition.For 2021, we expect higher domestic volume driven by growth from new and existing customers and continued highway conversions.International volume fell in 2020, but rose in 2019. The decline in 2020 resulted from supply chain disruptions due to COVID-19. The rise in 2019 was due to increased demand from new and existing customers partially offset by lower shipments due to tariff concerns. For 2021, we expect international volume growth as demand and trade continue to recover. COAL revenues decreased in both periods. The decrease in 2020 was a result of significant volume declines. The decrease in 2019 was a result of lower volume, which was partially offset by higher average revenue per unit, driven by pricing gains. For 2021, we expect coal revenues to decline. We anticipate overall coal volume to be down as continued declines in utility are projected to more than offset domestic metallurgical and export gains. As shown in the following table, total tonnage decreased in both periods. 20202019202020192018vs. 2019vs. 2018 (tons in thousands)(% change)Utility32,479 60,278 65,688 (46 %)(8 %)Export18,900 23,324 28,046 (19 %)(17 %)Domestic metallurgical9,441 13,562 15,500 (30 %)(13 %)Industrial3,566 4,655 5,410 (23 %)(14 %)Total64,386 101,819 114,644 (37 %)(11 %)Utility coal tonnage decreased in both periods. The decline in 2020 was due to low natural gas prices, diminished industrial and commercial electricity demand, and high stockpiles. The decline in 2019 was due to continued headwinds from low natural gas prices and additional natural gas and renewable energy generating capacity, which were slightly offset by customer inventory rebuilding. For 2021, utility coal tonnage is expected to decrease as a result of high stockpiles and continued pressure from natural gas and renewable energy.Export coal tonnage decreased in both periods. The decline in 2020 was a result of weak seaborne pricing, COVID-19-related global disruptions, and import restrictions. The decline in 2019 was a result of weak thermal seaborne pricing and coal supply disruptions at certain mines. For 2021, export coal tonnage is expected to increase due to the global recovery from COVID-19. Domestic metallurgical coal tonnage was down in both years. The decline in 2020 was a reflection of continued reduced domestic steel demand which led to idled customer facilities and lower production. The decline in 2019 was a reflection of challenging overall market conditions including softening domestic steel demand, customer sourcing changes, and plant outages. For 2021, domestic metallurgical coal tonnage is expected to increase due to the recovery from COVID-19.K24Industrial coal tonnage decreased in both years driven by pressure from natural gas conversions and customer sourcing changes. For 2021, industrial coal tonnage is expected to decrease as a result of continued pressure from natural gas conversions and customer sourcing changes.Railway Operating ExpensesRailway operating expenses summarized by major classifications were as follows:20202019202020192018vs. 2019vs. 2018 ($ in millions)(% change)Compensation and benefits$2,373 $2,751 $2,925 (14 %)(6 %)Purchased services and rents1,687 1,725 1,730 (2 %)— %Fuel535 953 1,087 (44 %)(12 %)Depreciation1,154 1,138 1,102 1 %3 %Materials and other653 740 655 (12 %)13 %Loss on asset disposal385 — — Total$6,787 $7,307 $7,499 (7 %)(3 %)In 2020, expenses fell as our strategic initiatives to improve productivity and asset utilization resulted in lower compensation and benefits expense, declines in fuel consumption, reduced purchased services, and lower materials expense. Fuel expense also declined due to lower prices. These expense reductions were partially offset by a loss on asset disposal of $385 million related to locomotives sold, and a $99 million impairment charge included in purchased services and rents related to an equity method investment. In 2019, expenses fell as our strategic initiatives to improve productivity resulted in lower compensation, equipment rents, and materials expense. These decreases along with lower fuel prices and consumption were partially offset by lower gains on operating property sales, increased depreciation, and a write-off of a $32 million receivable as a result of a legal dispute.Compensation and benefits decreased in 2020, reflecting changes in:•employment levels (down $309 million),•health and welfare benefits for craft employees (down $77 million),•overtime and recrews (down $54 million),•incentive and stock-based compensation (down $38 million),•increased pay rates (up $50 million),•lower capitalized labor (additional expense of $51 million), and•other (down $1 million).K25In 2019, compensation and benefits decreased, a result of changes in:•employment levels (down $117 million),•incentive and stock-based compensation (down $83 million),•overtime and recrews (down $45 million),•higher capitalized labor (reduced expense of $9 million), •2018 employment tax refund ($31 million unfavorable in 2019),•pay rates (up $76 million), and•other (down $27 million).Our employment averaged 20,200 in 2020, compared with 24,600 in 2019, and 26,700 in 2018. Purchased services and rents includes the costs of services purchased from external vendors and contractors, including the net costs of operating joint (or leased) facilities with other railroads and the net cost of equipment rentals. 20202019 202020192018vs. 2019vs. 2018 ($ in millions)(% change)Purchased services$1,387 $1,434 $1,367 (3 %)5 %Equipment rents300 291 363 3 %(20 %)Total$1,687 $1,725 $1,730 (2 %)— %The decrease in purchased services in 2020 resulted from volume-related declines and strategic initiatives to improve productivity and asset utilization, partially offset by the $99 million impairment related to an equity method investment. The increase in purchased services in 2019 was the result of increased technology-related costs, expenses associated with our headquarters relocation, and increased intermodal-related costs partially offset by decreased transportation activities. Equipment rents, which includes our cost of using equipment (mostly freight cars) owned by other railroads or private owners less the rent paid to us for the use of our equipment, increased in 2020, but decreased in 2019. In 2020, the increase was primarily the result of lower equity in TTX earnings and increased automotive equipment expenses partially offset by decreased intermodal equipment expenses. In 2019, the decrease was largely due to improved network velocity and the absence of short-term locomotive resource costs incurred in the prior year. Fuel expense, which includes the cost of locomotive fuel as well as other fuel used in railway operations, decreased in both periods. The change in both years was due to lower locomotive fuel prices (down 32% in 2020 and 8% in 2019) which decreased expenses by $235 million in 2020 and $82 million in 2019. Additionally, locomotive fuel consumption decreased 18% in 2020 and 4% in 2019. We consumed approximately 368 million gallons of diesel fuel in 2020, compared with 451 million gallons in 2019 and 472 million gallons in 2018. Depreciation expense increased in both periods, a reflection of reinvestment in our infrastructure, rolling stock, and technology.K26Materials and other expenses decreased in 2020 but increased in 2019 as shown in the following table.20202019 202020192018vs. 2019vs. 2018 ($ in millions)(% change)Materials$274 $327 $362 (16 %)(10 %)Claims179 193 176 (7 %)10 %Other200 220 117 (9 %)88 %Total$653 $740 $655 (12 %)13 % Materials expense decreased in 2020 and 2019 due primarily to lower maintenance requirements as a result of fewer locomotives and freight cars in service. Claims expense includes costs related to personal injury, property damage, and environmental matters. The 2020 expense declined, primarily the result of lower costs related to environmental remediation matters partially offset by increased derailment costs. The 2019 expense increased, primarily due to higher costs related to environmental remediation matters and personal injury claims. Other expense decreased in 2020, largely due to the absence of the 2019 write-off of a $32 million receivable as a result of a legal dispute. Additionally, 2020 benefited from reduced travel expenses resulting from the COVID-19 pandemic. These reductions were partially offset by lower gains from sales of operating property. Other expense increased in 2019, primarily due to lower gains from sales of operating property and the $32 million write-off. Gains from operating property sales amounted to $26 million, $64 million, and $158 million in 2020, 2019, and 2018, respectively. Loss on asset disposalDuring 2020, we recorded a $385 million charge related to the disposal of 703 locomotives, the sales of which were completed during the fourth quarter. For more information on the impact of the charge, see Note 7. Other income – netOther income – net increased in 2020 and 2019. The increase in 2020 was driven by the absence of the prior year $49 million impairment loss related to natural resource assets that were sold in 2020, lower pension and postretirement benefit expenses, and higher returns on corporate-owned life insurance (“COLI”) investments, which more than offset the absence of coal royalties and lower gains on sales of non-operating property. The increase in 2019 was driven by higher COLI returns and increased gains on sales of non-operating property, which more than offset the aforementioned $49 million impairment loss. Income taxes The effective income tax rate was 20.4% in 2020, compared with 22.0% in 2019 and 23.1% in 2018. The current year benefited from a reduction of taxes upon the resolution of our 2012 amended return (see Note 4). All three years benefited from favorable tax benefits associated with stock-based compensation and COLI returns. For 2021, we expect an effective income tax rate between 23% and 24%. K27FINANCIAL CONDITION, LIQUIDITY, AND CAPITAL RESOURCES Cash provided by operating activities, our principal source of liquidity, was $3.6 billion in 2020, $3.9 billion in 2019, and $3.7 billion in 2018. The decline in 2020 reflects a decrease in income from railway operations offset in part by lower income tax payments. The increase in 2019 was primarily the result of improved operating results. We had working capital of $158 million and negative working capital of $219 million at December 31, 2020, and 2019, respectively. Cash and cash equivalents totaled $1.1 billion and $580 million at December 31, 2020, and 2019, respectively. We expect cash on hand combined with cash provided by operating activities will be sufficient to meet our ongoing obligations. In addition, we believe our currently-available borrowing capacity, access to additional financing, and ability to reduce property additions and shareholder distributions, including share repurchases, provide additional flexibility to meet our ongoing obligations. Nonetheless, we continue to monitor the ongoing impacts of the COVID-19 pandemic, which could lead to a reduction in cash flows from operations.Contractual obligations at December 31, 2020, include long-term debt (Note 9), interest on fixed-rate long-term debt, unconditional purchase obligations (Note 17), long-term advances from Conrail (Note 6), operating leases (Note 10), agreements with Consolidated Rail Corporation (CRC) (Note 6), and unrecognized tax benefits (Note 4).Total20212022 -20232024 -20252026 andSubsequentOther ($ in millions)Long-term debt principal$13,693 $579 $1,156 $958 $11,000 — Interest on fixed-rate long-term debt13,515 568 1,062 997 10,888 — Unconditional purchase obligations1,120 600 329 76 115 — Long-term advances from Conrail534 — — — 534 — Operating leases504 101 143 115 145 — Agreements with CRC140 41 82 17 — — Unrecognized tax benefits*22 — — — — 22 Total$29,528 $1,889 $2,772 $2,163 $22,682 $22 * This amount is shown in the Other column because the year of settlement cannot be reasonably estimated. Off balance sheet arrangements consist primarily of unrecognized obligations, including unconditional purchase obligations and future interest payments on fixed-rate long-term debt, which are included in the table above. In addition, we entered into a synthetic lease during 2019 which is discussed further in Note 10. Cash used in investing activities was $1.2 billion in 2020, compared with $1.8 billion in 2019, and $1.7 billion in 2018. The decrease in 2020 was primarily driven by lower property additions. In 2019, increased COLI activity and higher property additions were partially offset by increased proceeds from property sales. We had the ability to borrow up to $750 million against our COLI policies at December 31, 2020. Capital spending and track and equipment statistics can be found within the “Railway Property” section of Part I of this report on Form 10-K. For 2021, we expect capital spending will approximate $1.6 billion.Cash used in financing activities was $1.9 billion in 2020, compared with $2.0 billion in 2019, and $2.3 billion in 2018. The change in 2020 reflects lower repurchases of Common Stock and debt repayments, partially offset byreduced proceeds from borrowings. In 2019, the decrease was impacted by fewer repurchases of Common Stock, higher debt repayments, and increased dividends.Share repurchases of $1.4 billion in 2020, $2.1 billion in 2019, and $2.8 billion in 2018 resulted in the retirement of 7.4 million, 11.3 million, and 17.1 million shares, respectively. As of December 31, 2020, 20.7 million shares K28remain authorized by our Board of Directors for repurchase. The timing and volume of future share repurchases will be guided by our assessment of market conditions and other pertinent factors. Any near-term purchases under the program are expected to be made with internally generated cash, cash on hand, or proceeds from borrowings.In May 2020, we issued $800 million of 3.05% senior notes due 2050, resulting in $790 million in net proceeds.In May 2020, we also issued $800 million of 3.155% senior notes due 2055 in exchange for $554 million of previously issued notes ($450 million at 5.1% due 2118, $42 million at 6% due 2111, $29 million at 7.9% due 2097, $26 million at 6% due 2105, and $7 million at 7.05% due 2037). As part of the debt exchange, a $4 million loss on extinguishment was recognized in “Other income – net.” In May 2020, we also renewed and amended our accounts receivable securitization program, reducing our maximum borrowing capacity from $450 million to $400 million. The term expires in May 2021. We had no amounts outstanding at December 31, 2020 or December 31, 2019, and our available borrowing capacity was $400 million and $429 million, respectively. In March 2020, we renewed and amended our five-year credit agreement. We increased the program’s borrowing capacity from $750 million to $800 million. The amended agreement expires in 2025 and provides for borrowings at prevailing rates and includes covenants. We had no amounts outstanding under this facility at December 31, 2020 or December 31, 2019. We discuss our credit agreement and our accounts receivable securitization program in Note 9, and we have authority from our Board of Directors to issue an additional $1.6 billion of debt or equity securities through public or private sale, all of which provide for access to additional liquidity should the need arise. Our debt-to-total capitalization ratio was 46.2% at December 31, 2020, compared with 44.5% at December 31, 2019. Upcoming annual debt maturities are disclosed in Note 9. Overall, our goal is to maintain a capital structure with appropriate leverage to support our business strategy and provide flexibility through business cycles.APPLICATION OF CRITICAL ACCOUNTING POLICIES The preparation of financial statements in accordance with GAAP requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. These estimates and assumptions may require judgment about matters that are inherently uncertain, and future events are likely to occur that may require us to make changes to these estimates and assumptions. Accordingly, we regularly review these estimates and assumptions based on historical experience, changes in the business environment, and other factors we believe to be reasonable under the circumstances. The following critical accounting policies are a subset of our significant accounting policies described in Note 1. Pensions and Other Postretirement Benefits Accounting for pensions and other postretirement benefit plans requires us to make several estimates and assumptions (Note 12). These include the expected rate of return from investment of the plans’ assets and the expected retirement age of employees as well as their projected earnings and mortality. In addition, the amounts recorded are affected by changes in the interest rate environment because the associated liabilities are discounted to their present value. We make these estimates based on our historical experience and other information we deem pertinent under the circumstances (for example, expectations of future stock market performance). We utilize an independent actuarial consulting firm’s studies to assist us in selecting appropriate actuarial assumptions and valuing related liabilities. For 2020, we assumed a long-term investment rate of return of 8.25%, which was supported by our long-term total rate of return on plan assets since inception, as well as our expectation of future returns. A one-percentage point change to this rate of return assumption would result in a $24 million change in annual pension expense. We review K29assumptions related to our defined benefit plans annually, and while changes are likely to occur in assumptions concerning retirement age, projected earnings, and mortality, they are not expected to have a material effect on our net pension expense or net pension liability in the future. The net pension liability is recorded at net present value using discount rates that are based on the current interest rate environment in light of the timing of expected benefit payments. We utilize analyses in which the projected annual cash flows from the pension and postretirement benefit plans are matched with yield curves based on an appropriate universe of high-quality corporate bonds. We use the results of the yield curve analyses to select the discount rates that match the payment streams of the benefits in these plans. A one-percentage point change to this discount rate assumption would result in a $17 million change in annual pension expense. Properties and Depreciation Most of our assets are long-lived railway properties (Note 7). “Properties” are stated principally at cost and are depreciated using the group method whereby assets with similar characteristics, use, and expected lives are grouped together in asset classes and depreciated using a composite depreciation rate. See Note 1 for a more detailed discussion of assumptions and estimates.Expenditures, including those on leased assets, that extend an asset’s useful life or increase its utility are capitalized. Expenditures capitalized include those that are directly related to a capital project and may include materials, labor, and other direct costs, in addition to an allocable portion of indirect costs that relate to a capital project. A significant portion of our annual capital spending relates to self-constructed assets. Costs related to repairs and maintenance activities that, in our judgment, do not extend an asset’s useful life or increase its utility are expensed when such repairs are performed. Depreciation expense for 2020 totaled $1.2 billion. Our composite depreciation rates for 2020 are disclosed in Note 7; a one-year increase (or decrease) in the estimated average useful lives of depreciable assets would have resulted in an approximate $40 million decrease (or increase) to annual depreciation expense. Personal Injury Claims expense, included in “Materials and other” in the Consolidated Statements of Income, includes our estimate of costs for personal injuries. To aid in valuing our personal injury liability and determining the amount to accrue with respect to such claims during the year, we utilize studies prepared by an independent consulting actuarial firm. The actuarial firm studies our historical patterns of reserving for claims and subsequent settlements, taking into account relevant outside influences. We adjust the liability quarterly based upon our assessment and the results of the study. The accuracy of our estimate of the liability is subject to inherent limitation given the difficulty of predicting future events and, as such, the ultimate loss sustained may vary from the estimated liability recorded. See Note 17 for a more detailed discussion of the assumptions and estimates we use for personal injury.Income Taxes Our net deferred tax liability totaled $6.9 billion at December 31, 2020 (Note 4). This liability is estimated based on the expected future tax consequences of items recognized in the financial statements. After application of the federal statutory tax rate to book income, judgment is required with respect to the timing and deductibility of expenses in our income tax returns. For state income and other taxes, judgment is also required with respect to the apportionment among the various jurisdictions. A valuation allowance is recorded if we expect that it is more likely than not that deferred tax assets will not be realized. We have a $57 million valuation allowance on $509 million of deferred tax assets as of December 31, 2020, reflecting the expectation that almost all of these assets will be realized.K30OTHER MATTERS Labor AgreementsApproximately 80% of our railroad employees are covered by collective bargaining agreements with various labor unions. Pursuant to the Railway Labor Act, these agreements remain in effect until new agreements are reached, or until the bargaining procedures mandated by the Railway Labor Act are completed. We largely bargain nationally in concert with other major railroads, represented by the National Carriers Conference Committee. Moratorium provisions in the labor agreements govern when the railroads and unions may propose changes to the agreements. The current round of bargaining commenced on November 1, 2019 with both management and the unions serving their formal proposals for changes to the collective bargaining agreements and direct negotiations are ongoing.Market Risks At December 31, 2020, we had no outstanding debt subject to interest rate fluctuations. Market risk for fixed-rate debt is estimated as the potential increase in fair value resulting from a one-percentage point decrease in interest rates as of December 31, 2020 and amounts to an increase of approximately $2.0 billion to the fair value of our debt at December 31, 2020. We consider it unlikely that interest rate fluctuations applicable to these instruments will result in a material adverse effect on our financial position, results of operations, or liquidity. New Accounting PronouncementsFor a detailed discussion of new accounting pronouncements, see Note 1.Inflation In preparing financial statements, GAAP requires the use of historical cost that disregards the effects of inflation on the replacement cost of property. As a capital-intensive company, we have most of our capital invested in long-lived assets. The replacement cost of these assets, as well as the related depreciation expense, would be substantially greater than the amounts reported on the basis of historical cost.FORWARD-LOOKING STATEMENTS Certain statements in Management’s Discussion and Analysis of Financial Condition and Results of Operations are “forward-looking statements” within the meaning of the “safe harbor” provisions of the Private Securities Litigation Reform Act of 1995, as amended. These statements relate to future events or our future financial performance and involve known and unknown risks, uncertainties, and other factors that may cause our actual results, levels of activity, performance, or our achievements or those of our industry to be materially different from those expressed or implied by any forward-looking statements. In some cases, forward-looking statements can be identified by terminology such as “may,” “will,” “could,” “would,” “should,” “expect,” “plan,” “anticipate,” “intend,” “believe,” “estimate,” “project,” “consider,” “predict,” “potential,” “feel,” or other comparable terminology. We have based these forward-looking statements on our current expectations, assumptions, estimates, beliefs, and projections. While we believe these expectations, assumptions, estimates, beliefs, and projections are reasonable, such forward-looking statements are only predictions and involve known and unknown risks and uncertainties, many of which involve factors or circumstances that are beyond our control. These and other important factors, including those discussed in Item 1A “Risk Factors,” may cause actual results, performance, or achievements to differ materially from those expressed or implied by these forward-looking statements. The forward-looking statements herein are made only as of the date they were first issued, and unless otherwise required by applicable securities laws, we disclaim any intention or obligation to update or revise any forward-looking statements, whether as a result of new information, future events, or otherwise. K31 Item 7A. Quantitative and Qualitative Disclosures About Market Risk The information required by this item is included in Item 7 “Management’s Discussion and Analysis of Financial Condition and Results of Operations” under the heading “Market Risks.” K32
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+Item 7. Management’s Discussion and Analysis of Financial Condition and Results of OperationsOVERVIEWThe following discussion should be read along with the financial statements included in this Form 10-K, as well as Part II, “Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations” of our Form 10-K for the year ended December 31, 2019 (“2019 Annual Report on Form 10-K”), as well as Exhibit 99.3 of our Form 8-K that we filed with the SEC on April 29, 2020, which recasts the disclosures in certain portions of the 2019 Annual Report on Form 10-K to reflect changes in the company’s reportable segments, both of which provide additional information on comparisons of years 2019 and 2018. Acquisition of Orbital ATKOn June 6, 2018 (the “Merger Date”), the company completed its previously announced acquisition of Orbital ATK, Inc. (“Orbital ATK”) (the “Merger”). On the Merger date, Orbital ATK became a wholly-owned subsidiary of the company and its name was changed to Northrop Grumman Innovation Systems, Inc. We established Innovation Systems as a new, fourth business sector. The operating results of legacy Innovation Systems subsequent to the Merger Date have been included in the company’s consolidated results of operations and, upon our January 1, 2020 sector realignment, are reflected in the Space Systems, Defense Systems and Aeronautics Systems sectors. See Note 2 to the consolidated financial statements for further information regarding the acquisition of Orbital ATK.In June 2018, the U.S. Federal Trade Commission (FTC) issued a Decision and Order enabling the acquisition to proceed and providing for solid rocket motors to be available on a non-discriminatory basis under certain circumstances and processes. The company has taken and continues to take robust actions to help ensure compliance with the terms of the Order. Similarly, the Compliance Officer, appointed under the Order, and the FTC have taken and continue to take various actions to oversee compliance. In October 2019, the company received a civil investigative demand from the FTC requesting certain information relating to a potential issue of the company’s compliance with the Order in connection with a then pending strategic missile competition. The company has provided information in response to the request. We believe the company has been and continues to be in full compliance with the Order, but we cannot predict the ultimate outcome of this matter.Disposition of IT and Mission Support Services BusinessOn December 7, 2020, we entered into a definitive agreement to sell our IT and mission support services business for $3.4 billion in cash. The IT and mission support services business is comprised of the majority of the Information Solutions and Services (IS&S) division of Defense Systems (excluding our Vinnell Arabia business); select cyber, intelligence and missions support programs, which are part of the Cyber and Intelligence Mission Solutions (CIMS) division of Mission Systems; and the Space Technical Services business unit of Space Systems. The assets and liabilities of the IT and mission support services business were classified as held for sale in the consolidated statement of financial position as of December 31, 2020 and no impairment losses were recognized in the consolidated statement of earnings and comprehensive income for the year ended December 31, 2020. We expect to complete the sale of the IT and mission support services business in the first quarter of 2021, subject to regulatory approvals and customary closing conditions. See Note 2 to the consolidated financial statements for further information regarding the disposition.COVID-19Coronavirus disease 2019 (“COVID-19”) was first reported in late 2019 and has since dramatically impacted the global health and economic environment, including millions of confirmed cases, business slowdowns or shutdowns, government challenges and market volatility. In March 2020, the World Health Organization characterized COVID-19 as a global pandemic, and the President declared a national emergency concerning the COVID-19 outbreak. The company’s leadership, our crisis management and business resumption teams, and local site leadership continue closely to monitor and address the developments, including the impact on our company, our employees, our customers, our suppliers and our communities. The company has considered and continues to consider guidance from the Centers for Disease Control (CDC), other health organizations, federal, state and local governmental authorities, and our customers, among others. We have taken, and continue to take, robust actions to help protect the health, safety and well-being of our employees, to support our suppliers and local communities, and to continue to serve our customers. Our goals have been to lessen the immediate potential adverse impacts, both health and economic, and to continue to position the company for long-term success. Like the communities in which we serve, our actions have varied depending on the spread of COVID-19 and local health requirements, the needs of our employees and the needs of our business. Among other actions, we have required or enabled employees to work from home or remotely where practicable, and expanded IT and communication support to enhance their productivity; adjusted work spaces and shift schedules to facilitate social distancing for those who continue to work in our facilities; enhanced cleaning and disinfecting procedures at our facilities; required face coverings and worked -27-NORTHROP GRUMMAN CORPORATION to procure and distribute personal protective equipment (PPE); implemented health checks and visitor protocols; restricted travel; provided additional benefits to our employees, including for those most at risk; and contributed financial and manufacturing resources to supporting critical national requirements, such as for PPE. Along with the Northrop Grumman Foundation, we have provided grants for global, national and local organizations that support frontline healthcare workers, address food insecurity, advance efforts for vaccines, increase student access to technology and provide support to vulnerable populations; donated PPE items to emergency response teams and healthcare professionals, including N95 masks and Tyvek suits; and established a COVID-19 relief matching gift program for employees. More recently, we have sought to assist state and local governments as they start to distribute and deliver vaccines.Earlier in the COVID-19 pandemic and at times of higher transmission, many state and local jurisdictions implemented mandatory stay-at-home or shelter-in-place orders. Most of those orders exempted some or all of the defense industrial base, including Northrop Grumman and many of our suppliers, as part of the essential or critical infrastructure. Our facilities have largely remained open and many of our employees who cannot work remotely are continuing to come to work and support our customers’ national security and mission-essential operations. Towards the end of the second quarter of 2020, some state and local jurisdictions started to lift mandatory stay-at-home or shelter-in-place orders and started gradually to ease restrictions. We started to implement, or prepared to implement certain return to office plans to allow some employees who had been working remotely gradually to return to the workplace. Later in 2020, as the number of cases began to rise again, and particularly in the fourth quarter of 2020, we paused or reversed many of our efforts to bring more employees back to the work place. In the fourth quarter of 2020 and the first quarter of 2021, after FDA approval, we began to explore how the company could best facilitate the provision of vaccinations to our personnel in accordance with federal guidance and state and local vaccination plans. Absenteeism rates (including because of employees in quarantine or those suffering from COVID-19) and the impacts on productivity have fluctuated significantly, especially as local cases and transmission rates have changed. Throughout, we have worked to adapt and to take robust actions to protect the health, safety and well-being of our employees and to serve our customers, considering, among other things, local circumstances, state and local requirements and guidance from the CDC. We have also taken various steps in efforts to support our suppliers, with a particular focus on critical small and midsized business partners, including passing through increased progress payments from DoD to our suppliers and accelerating payments to certain suppliers. We have experienced and expect to continue to experience various increased costs to maintain our operations, including as a result of actions taken to protect the health, safety and well-being of our employees; because of illness, quarantines, and absenteeism; as a result of government actions; and because of disruption and stress among our suppliers and customers. We have also experienced certain lower costs, including those related to employee travel, some health benefits and personal time off. We continue to monitor this situation closely and cannot predict how it will change, including the extent of any increase in the number of COVID-19 cases and the costs and impacts to us. Our customers have generally continued to make timely payments, and we are working with them to consider the possibility of additional cost recoveries. Again, however, our customers are facing tremendous demands and budget pressures, and we cannot predict how this may change and how they will continue to allocate limited resources.The company’s overall 2020 revenue and operating income were not significantly impacted by COVID-19. However, our employees, suppliers and customers, the company and our global community are facing tremendous challenges and we cannot predict how this dynamic situation will evolve or the impact it will have on the company. For further information on the potential impact to the company of COVID-19, see “Risk Factors.”Global Security and Economic EnvironmentThe U.S. and its allies continue to face a global security environment of heightened tensions and instability, threats from state and non-state actors as well as terrorist organizations, emerging nuclear tensions, diverse regional security concerns and political instability. Global threats persist across all domains, from undersea to space to cyber. The market for defense products, services and solutions globally is driven by these complex and evolving security challenges, considered in the broader context of political and socioeconomic priorities.The global geopolitical and economic environments also continue to be impacted by uncertainty. Geopolitical relationships are changing and global economic growth is expected to remain in the low single digits in 2021 reflecting the impact of and uncertainty surrounding geopolitical tensions globally and financial market volatility and the COVID-19 pandemic. The global economy may also be affected by Britain’s exit from the European Union, the full impact of which is not known at this time. Additionally, economic tensions and changes in international trade policies, including higher tariffs on imported goods and materials and renegotiation of free trade agreements, could impact the global market for defense products, services and solutions. -28-NORTHROP GRUMMAN CORPORATION U.S. Political and Economic EnvironmentThe U.S. continues to face an uncertain and changing political environment and substantial fiscal and economic challenges, which affect funding for discretionary and non-discretionary budgets. The Budget Control Act of 2011 (BCA) mandated spending caps for all federal discretionary spending across a ten-year period (FY 2012 through FY 2021), including specific limits for defense and non-defense spending. In prior years, these spending caps have been revised by separate bills for specific fiscal years.In August 2019, the Bipartisan Budget Act of 2019 was enacted, increasing spending caps under the Budget Control Act (BCA) for FY 2020 and FY 2021, the final two fiscal years covered by the BCA, and suspending the debt ceiling through July 31, 2021. In February 2020, the then President proposed a budget request for FY 2021, which addressed various capabilities highlighted in the U.S. National Security Strategy, the National Defense Strategy and the Missile Defense Review. On December 27, 2020, FY 2021 appropriations were enacted under the Consolidated Appropriations Act of 2021. In 2020, Congress also passed several emergency COVID-19 relief bills addressing certain impacts of the pandemic. It is continuing to consider other responses to the COVID-19 crisis, with broader implications for the defense industry and the overall economic environment, including the national debt. With a new President and Administration, a new Congress and pressing debt and needs, it is difficult to predict the specific course of future defense budgets. However, the threat remains very substantial and we believe that our capabilities, particularly in space, missiles, missile defense, hypersonics, counter-hypersonics, survivable aircraft and mission systems should help our customers to meet the threats and, as a result, continue to allow for long-term profitable growth in our business. The political environment, federal budget and debt ceiling are expected to continue to be the subject of considerable debate, which could have material impacts on defense spending broadly and the company’s programs in particular. For further information on the risks we face from the current political and economic environment, see “Risk Factors.”Operating Performance Assessment and ReportingWe manage and assess our business based on our performance on contracts and programs (typically larger contracts or two or more closely-related contracts). We recognize sales from our portfolio of long-term contracts as control is transferred to the customer, primarily over time on a cost-to-cost basis (cost incurred relative to costs estimated at completion). As a result, sales tend to fluctuate in concert with costs incurred across our large portfolio of contracts. Due to Federal Acquisition Regulation (FAR) rules that govern our U.S. government business and related Cost Accounting Standards (CAS), most types of costs are allocable to U.S. government contracts. As such, we do not focus on individual cost groupings (such as manufacturing, engineering and design labor, subcontractor, material, overhead and general and administrative (G&A) costs), as much as we do on total contract cost, which is the key driver of our sales and operating income.In evaluating our operating performance, we look primarily at changes in sales and operating income. Where applicable, significant fluctuations in operating performance attributable to individual contracts or programs, or changes in a specific cost element across multiple contracts, are described in our analysis. Based on this approach and the nature of our operations, the discussion of results of operations below first focuses on our four segments before distinguishing between products and services. Changes in sales are generally described in terms of volume, while changes in margin rates are generally described in terms of performance and/or contract mix. For purposes of this discussion, volume generally refers to increases or decreases in sales or cost from production/service activity levels and performance generally refers to non-volume related changes in profitability. Contract mix generally refers to changes in the ratio of contract type and/or life cycle (e.g., cost-type, fixed-price, development, production, and/or sustainment).CONSOLIDATED OPERATING RESULTSFor purposes of the operating results discussion below, we assess our performance using certain financial measures that are not calculated in accordance with GAAP. These non-GAAP financial measures exclude Mark-to-market pension and OPB (“MTM”) expense and related tax impacts, and are described as MTM-adjusted net earnings and MTM-adjusted diluted earnings per share. These non-GAAP measures may be useful to investors and other users of our financial statements as supplemental measures in evaluating the company’s underlying financial performance by presenting the company’s operating results before the non-operational impact of pension and OPB actuarial gains and losses. These measures are also consistent with how management views the underlying performance of the business as the impact of MTM accounting is not considered in management’s assessment of the company’s operating performance or in its determination of incentive compensation awards. We reconcile these non-GAAP -29-NORTHROP GRUMMAN CORPORATION financial measures to their most directly comparable GAAP financial measures below. These non-GAAP measures may not be defined and calculated by other companies in the same manner and should not be considered in isolation or as an alternative to operating results presented in accordance with GAAP.Selected financial highlights are presented in the table below: Year Ended December 31% Change in$ in millions, except per share amounts20202019201820202019Sales$36,799 $33,841 $30,095 9 %12 %Operating costs and expenses32,734 29,872 26,315 10 %14 %Operating costs and expenses as a % of sales89.0 %88.3 %87.4 %Operating income4,065 3,969 3,780 2 %5 %Operating margin rate11.0 %11.7 %12.6 %Mark-to-market pension and OPB expense(1,034)(1,800)(655)(43)%175 %Federal and foreign income tax expense539 300 513 80 %(42)%Effective income tax rate14.5 %11.8 %13.7 %Net earnings3,189 2,248 3,229 42 %(30)%Diluted earnings per share19.03 13.22 18.49 44 %(29)%Sales2020 sales increased $3.0 billion, or 9 percent, due to higher sales at all four sectors.See “Segment Operating Results” below for further information by segment and “Product and Service Analysis” for product and service detail. See Note 16 to the consolidated financial statements for information regarding the company’s sales by customer type, contract type and geographic region for each of our segments. Operating Income and Margin Rate2020 operating income increased $96 million, or 2 percent, primarily due to an increase in segment operating income, partially offset by higher unallocated corporate expense and a lower net FAS (service)/CAS pension adjustment. 2020 operating margin rate declined to 11.0 percent from 11.7 percent principally due to a lower segment operating margin rate, higher unallocated corporate expense and lower net FAS (service)/CAS pension adjustment.2020 G&A costs as a percentage of sales decreased to 9.3 percent from 9.7 percent, primarily due to higher sales volume, partially offset by higher independent research and development costs.For further information regarding product and service operating costs and expenses, see “Product and Service Analysis” below.Mark-to-Market Pension and OPB ExpenseThe primary components of pre-tax MTM expense are presented in the table below: Year Ended December 31$ in millions202020192018Actuarial (losses) gains on projected benefit obligation$(3,570)$(4,866)$2,772 Actuarial gains (losses) on plan assets 2,536 3,066 (3,426)Other— — (1)MTM expense$(1,034)$(1,800)$(655)2020 MTM expense of $1.0 billion was primarily driven by a 71 basis point decrease in the discount rate from year end 2019, partially offset by actual net plan asset returns of approximately 16.2 percent compared to our 8.0 percent asset return assumption.Federal and Foreign Income TaxesThe 2020 effective tax rate increased to 14.5 percent from 11.8 percent in 2019. MTM expense reduced the 2020 effective tax rate by 1.3 percentage points and the 2019 effective tax rate by 3.7 percentage points. See Note 7 to the consolidated financial statements for additional information.-30-NORTHROP GRUMMAN CORPORATION Net EarningsThe table below reconciles net earnings to MTM-adjusted net earnings: Year Ended December 31% Change in$ in millions20202019201820202019Net earnings$3,189 $2,248 $3,229 42 %(30)%MTM expense1,034 1,800 655 (43)%175 %MTM-related deferred state tax benefit(1)(54)(81)(29)(33)%179 %Federal tax benefit of items above(2)(206)(361)(131)(43)%176 %MTM expense, net of tax774 1,358 495 (43)%174 %MTM-adjusted net earnings$3,963 $3,606 $3,724 10 %(3)%(1)MTM expense is expected to be deductible on our future state tax returns. The deferred state tax benefit was calculated using the company’s blended state tax rate of 5.25 percent in 2020 and 4.50 percent in 2019 and 2018 and included in Unallocated corporate expense within operating income. (2)MTM expense is expected to be deductible on our future federal tax returns. The federal tax benefit in each period was calculated by subtracting the deferred state tax benefit from MTM expense and applying the 21 percent federal statutory rate. Net earnings increased $941 million, or 42 percent, in 2020 principally due to a $584 million decrease in our MTM expense, net of tax. Excluding this impact, MTM-adjusted net earnings increased by $357 million, or 10 percent, primarily due to increases in our FAS (non-service) benefit and operating income, partially offset by higher income tax and interest expense.Diluted Earnings Per ShareThe table below reconciles diluted earnings per share to MTM-adjusted diluted earnings per share: Year Ended December 31% Change in20202019201820202019Diluted earnings per share$19.03 $13.22 $18.49 44 %(29)%MTM expense per share6.17 10.59 3.76 (42)%182 %MTM-related deferred state tax benefit per share(1)(0.32)(0.48)(0.17)(33)%182 %Federal tax benefit of items above per share(2)(1.23)(2.12)(0.75)(42)%183 %MTM expense per share, net of tax4.62 7.99 2.84 (42)%181 %MTM-adjusted diluted earnings per share$23.65 $21.21 $21.33 12 %(1)%(1)MTM expense is expected to be deductible on our future state tax returns. The deferred state tax benefit was calculated using the company’s blended state tax rate of 5.25 percent in 2020 and 4.50 percent in 2019 and 2018 and included in Unallocated corporate expense within operating income. (2)MTM expense is expected to be deductible on our future federal tax returns. The federal tax benefit in each period was calculated by subtracting the deferred state tax benefit from MTM expense and applying the 21 percent federal statutory rate.Diluted earnings per share increased $5.81, or 44 percent, principally due to a $3.37 increase associated with lower MTM expense, net of tax. Excluding this impact, MTM-adjusted diluted earnings per share increased $2.44, or 12 percent, reflecting a 10 percent increase in MTM-adjusted net earnings and a 1 percent decrease in weighted-average diluted shares outstanding.SEGMENT OPERATING RESULTSBasis of PresentationEffective January 1, 2020, the company reorganized its sectors to better align the company’s broad portfolio to serve its customers’ needs. At December 31, 2020, the company was aligned in four operating sectors, which also comprise our reportable segments: Aeronautics Systems, Defense Systems, Mission Systems and Space Systems. The segment operating results below include sales and operating income for legacy Innovation Systems subsequent to the Merger date. For a more complete description of each segment’s products and services, see “Business.”Beginning in the second quarter of 2020, the company no longer considers certain unallowable costs as part of management’s evaluation of segment operating performance. As a result, certain unallowable costs, which were previously included in segment operating results, are now reported in Unallocated corporate expense within -31-NORTHROP GRUMMAN CORPORATION operating income. This change has been applied retrospectively in the accompanying financial information. See Part II, Item 5 in the Quarterly Report on Form 10-Q for the quarter ended June 30, 2020 for further information regarding the impact of this change on the company’s prior period segment information.We present our sectors in the following business areas, which are reported in a manner reflecting core capabilities:Aeronautics SystemsDefense SystemsMission SystemsSpace SystemsAutonomous SystemsBattle Management & Missile SystemsAirborne Sensors & NetworksLaunch & Strategic MissilesManned AircraftMission ReadinessCyber & Intelligence Mission SolutionsSpaceMaritime/Land Systems & SensorsNavigation, Targeting & SurvivabilityThis section discusses segment sales, operating income and operating margin rates. A reconciliation of segment operating income to total operating income is provided below. Segment Operating Income and Margin RateSegment operating income, as reconciled in the table below, and segment operating margin rate (segment operating income divided by sales) are non-GAAP (accounting principles generally accepted in the United States of America) measures that reflect total earnings from our four segments, including allocated pension expense we have recognized under FAR and CAS, and excluding FAS pension expense and unallocated corporate items (certain corporate-level expenses, which are not considered allowable or allocable under applicable CAS or FAR, and costs not considered part of management’s evaluation of segment operating performance). These non-GAAP measures may be useful to investors and other users of our financial statements as supplemental measures in evaluating the financial performance and operational trends of our sectors. These measures may not be defined and calculated by other companies in the same manner and should not be considered in isolation or as alternatives to operating results presented in accordance with GAAP. Year Ended December 31% Change in$ in millions20202019201820202019Segment operating income$4,188 $3,978 $3,514 5 %13 %Segment operating margin rate11.4 %11.8 %11.7 %CAS pension expense827 832 1,017 (1)%(18)%Less: FAS (service) pension expense(409)(367)(404)11 %(9)%Net FAS (service)/CAS pension adjustment418 465 613 (10)%(24)%Intangible asset amortization and PP&E step-up depreciation(322)(390)(220)(17)%NMMTM-related deferred state tax benefit(1)54 81 29 (33)%179 %Other unallocated corporate expense(273)(165)(156)65 %6 %Unallocated corporate expense(541)(474)(347)14 %37 %Total operating income$4,065 $3,969 $3,780 2 %5 %(1)Represents the deferred state tax benefit associated with MTM expense, which is recorded in Unallocated corporate expense consistent with other changes in deferred state taxes.Segment Operating Income and Margin Rate2020 segment operating income increased $210 million, or 5 percent, and reflects higher operating income at all four sectors. Segment operating margin rate decreased to 11.4 percent from 11.8 percent principally due to a lower operating margin rate at Aeronautics Systems.Net FAS (service)/CAS Pension AdjustmentThe decrease in our 2020 net FAS (service)/CAS pension adjustment is primarily due to higher FAS (service) pension expense largely as a result of changes in actuarial assumptions as of December 31, 2019.-32-NORTHROP GRUMMAN CORPORATION Unallocated Corporate ExpenseThe increase in 2020 unallocated corporate expense is primarily due to the absence in 2020 of an $89 million benefit related to the favorable resolution of a cost accounting litigation matter and $60 million of higher state tax expense in the current year. State tax expense increased principally due to changes in deferred state income taxes, including a lower MTM-related deferred state tax benefit, and an increase in reserves, in part, for potential unallowable costs associated with state apportionment. These increases were partially offset by $68 million of lower intangible asset amortization and PP&E step-up depreciation.Net Estimate-At-Completion (EAC) Adjustments - We record changes in estimated contract earnings at completion (net EAC adjustments) using the cumulative catch-up method of accounting. Net EAC adjustments can have a significant effect on reported sales and operating income and the aggregate amounts are presented in the table below:Year Ended December 31$ in millions202020192018Favorable EAC adjustments$1,082 $1,040 $1,019 Unfavorable EAC adjustments(616)(560)(442)Net EAC adjustments$466 $ 480 $ 577 Net EAC adjustments by segment are presented in the table below:Year Ended December 31$ in millions202020192018Aeronautics Systems(1)$77 $143 $271 Defense Systems(1)148 99 75 Mission Systems216 189 172 Space Systems(1)33 63 73 Eliminations(8)(14)(14)Net EAC adjustments$466 $480 $577 (1)Amounts reflect EAC adjustments after the percent complete on legacy Innovation Systems contracts was reset to zero as of the Merger date.For purposes of the discussion in the remainder of this Segment Operating Results section, references to operating income and operating margin rate reflect segment operating income and segment operating margin rate, respectively.AERONAUTICS SYSTEMS Year Ended December 31% Change in$ in millions20202019201820202019Sales$12,169 $11,116 $10,293 9 %8 %Operating income1,206 1,188 1,128 2 %5 %Operating margin rate9.9 %10.7 %11.0 %Sales2020 sales increased $1.1 billion, or 9 percent, due to higher sales in both Manned Aircraft and Autonomous Systems. Higher volume on restricted programs, including a $444 million sale of equipment to a restricted customer, E-2D and Triton were partially offset by lower volume on the B-2 Defensive Management System Modernization program as it nears completion. See Note 1 to the consolidated financial statements for further detail on the sale of equipment described above.Operating Income2020 operating income increased $18 million, or 2 percent, due to higher sales partially offset by a lower operating margin rate. 2020 operating margin rate decreased to 9.9 percent from 10.7 percent principally due to lower net EAC adjustments as well as the sale of equipment to a restricted customer, which was dilutive to the overall sector margin rate.-33-NORTHROP GRUMMAN CORPORATION DEFENSE SYSTEMS Year Ended December 31% Change in$ in millions20202019201820202019Sales$7,543 $7,495 $6,612 1 %13 %Operating income846 793 697 7 %14 %Operating margin rate11.2 %10.6 %10.5 %Sales2020 sales increased $48 million, or 1 percent, due to higher volume in both business areas. Battle Management & Missile Systems sales increased primarily due to higher volume on the Guided Missile Launch Rocket System (GMLRS), the Advanced Anti-Radiation Guided Missile (AARGM), the Counter-Rocket, Artillery and Mortar program and other missile products, partially offset by lower volume on programs nearing completion, including an international weapons program and the close-out of our contract at the Army’s Lake City ammunition plant. Mission Readiness sales increased principally due to higher volume on restricted and international programs, partially offset by lower volume on the Hunter sustainment program as it nears completion.Operating Income2020 operating income increased $53 million, or 7 percent, primarily due to a higher operating margin rate. Operating margin increased to 11.2 percent from 10.6 percent principally due to improved performance at Battle Management & Missile Systems and Mission Readiness.MISSION SYSTEMS Year Ended December 31% Change in$ in millions20202019201820202019Sales$10,080 $9,410 $8,949 7 %5 %Operating income1,459 1,408 1,245 4 %13 %Operating margin rate14.5 %15.0 %13.9 %Sales2020 sales increased $670 million, or 7 percent, due to higher volume across all four business areas. Airborne Sensors & Networks sales increased principally due to higher airborne radar volume, including the F-35, Multi-role Electronically Scanned Array (MESA) and Scalable Agile Beam Radar (SABR) programs, and higher restricted volume. Navigation, Targeting & Survivability sales increased primarily due to higher volume on self-protection, avionics and targeting programs, including LITENING, partially offset by lower volume on infrared countermeasures programs. Maritime/Land Systems & Sensors sales increased primarily due to higher volume on marine systems and restricted programs, partially offset by lower international commercial volume due, in part, to COVID-19-related impacts. Cyber & Intelligence Mission Solutions sales increased principally due to higher restricted volume, partially offset by lower volume on an intelligence program as it nears completion.Operating Income2020 operating income increased $51 million, or 4 percent, due to higher sales, partially offset by a lower operating margin rate. Operating margin rate decreased to 14.5 percent from 15.0 percent primarily due to lower margin rates at Maritime/Land Systems & Sensors, including COVID-19-related impacts on certain international commercial businesses.SPACE SYSTEMS Year Ended December 31% Change in$ in millions20202019201820202019Sales$8,744 $7,425 $5,845 18 %27 %Operating income893 794 644 12 %23 %Operating margin rate10.2 %10.7 %11.0 %Sales2020 sales increased $1.3 billion, or 18 percent, due to higher sales in both Space and Launch & Strategic Missiles. Space sales were driven by higher volume on restricted programs and the Next Generation Overhead Persistent Infrared and NASA Artemis programs. Launch & Strategic Missiles sales increased due to ramp-up on the Ground -34-NORTHROP GRUMMAN CORPORATION Based Strategic Deterrent program and higher volume on launch vehicles and hypersonics programs, partially offset by lower volume on the Ground-based Midcourse Defense program.Operating Income2020 operating income increased $99 million, or 12 percent, due to higher sales, partially offset by a lower operating margin rate. Operating margin rate decreased to 10.2 percent from 10.7 percent principally due to lower net EAC adjustments and changes in contract mix.PRODUCT AND SERVICE ANALYSISThe following table presents product and service sales and operating costs and expenses by segment: Year Ended December 31$ in millions202020192018Segment Information:SalesOperating Costs and ExpensesSalesOperating Costs and ExpensesSalesOperating Costs and ExpensesAeronautics SystemsProduct$ 10,437 $ 9,435 $ 9,387 $ 8,428 $ 8,665 $ 7,731 Service1,610 1,417 1,626 1,407 1,555 1,369 Intersegment eliminations122 111 103 93 73 65 Total Aeronautics Systems12,169 10,963 11,116 9,928 10,293 9,165 Defense SystemsProduct3,024 2,740 2,784 2,572 1,703 1,521 Service3,791 3,305 4,020 3,513 4,159 3,718 Intersegment eliminations728 652 691 617 750 676 Total Defense Systems7,543 6,697 7,495 6,702 6,612 5,915 Mission SystemsProduct6,744 5,757 6,022 5,073 5,790 4,992 Service2,557 2,201 2,660 2,314 2,441 2,109 Intersegment eliminations779 663 728 615 718 603 Total Mission Systems10,080 8,621 9,410 8,002 8,949 7,704 Space SystemsProduct6,810 6,084 5,659 5,021 4,311 3,798 Service1,826 1,672 1,683 1,535 1,471 1,343 Intersegment eliminations108 95 83 75 63 60 Total Space Systems8,744 7,851 7,425 6,631 5,845 5,201 Segment TotalsTotal Product$27,015 $24,016 $23,852 $21,094 $20,469 $18,042 Total Service9,784 8,595 9,989 8,769 9,626 8,539 Total Segment(1)$36,799 $32,611 $33,841 $29,863 $30,095 $26,581 (1)A reconciliation of segment operating income to total operating income is included in “Segment Operating Results.”Product Sales and Costs2020 product sales increased $3.2 billion, or 13 percent, due to higher product sales at all four sectors, including restricted programs and E-2D at Aeronautics Systems; restricted programs, Next Gen OPIR and GBSD at Space Systems; restricted, F-35 and airborne radar programs at Mission Systems; and AARGM, GMLRS and other missile products at Defense Systems.2020 product costs increased $2.9 billion, or 14 percent, consistent with the higher product sales described above and reflects lower product margins at Mission Systems and Aeronautics Systems.Service Sales and Costs2020 service sales decreased $205 million, or 2 percent, primarily due to lower service sales at Defense Systems principally due to lower volume on the Hunter sustainment program and a shift toward more product content in the lifecycle of certain programs.2020 service costs decreased $174 million, or 2 percent, consistent with the lower service sales described above.-35-NORTHROP GRUMMAN CORPORATION BACKLOGBacklog represents the future sales we expect to recognize on firm orders received by the company and is equivalent to the company’s remaining performance obligations at the end of each period. It comprises both funded backlog (firm orders for which funding is authorized and appropriated) and unfunded backlog. Unexercised contract options and indefinite delivery indefinite quantity (IDIQ) contracts are not included in backlog until the time the option or IDIQ task order is exercised or awarded. Backlog is converted into sales as costs are incurred or deliveries are made.Backlog consisted of the following at December 31, 2020 and 2019: 20202019$ in millionsFundedUnfundedTotalBacklogTotalBacklog% Change in 2020Aeronautics Systems$10,587 $13,415 $24,002 $26,021 (8)%Defense Systems6,942 1,189 8,131 8,481 (4)%Mission Systems9,444 4,361 13,805 14,226 (3)%Space Systems5,569 29,462 35,031 16,112 117 %Total backlog$32,542 $48,427 $80,969 $64,840 25 %2020 net awards totaled $52.9 billion. Significant 2020 new awards include $17.4 billion for restricted programs ($9.0 billion at Space Systems, $6.0 billion at Aeronautics Systems and $2.2 billion at Mission Systems), $13.3 billion for the Ground Based Strategic Deterrent EMD program, $1.9 billion for Next Gen OPIR, $1.7 billion for F-35, $0.9 billion for Triton, $0.9 billion for E-2D and $0.8 billion for Global Hawk.LIQUIDITY AND CAPITAL RESOURCESWe endeavor to ensure the most efficient conversion of operating income into cash for deployment in our business and to maximize shareholder value through cash deployment activities. In addition to our cash position, we use various financial measures to assist in capital deployment decision-making, including cash provided by operating activities and adjusted free cash flow, a non-GAAP measure described in more detail below.As of December 31, 2020, we had cash and cash equivalents of $4.9 billion; approximately $276 million was held outside of the U.S. by foreign subsidiaries. In March 2020, we issued $2.25 billion of unsecured senior notes for general corporate purposes, including debt repayment and working capital, to help preserve financial flexibility in light of uncertainty resulting from the COVID-19 pandemic. In April 2020, we entered into a one-year $500 million uncommitted credit facility to provide an additional source of potential financing. On October 15, 2020, the company repaid $1.0 billion of unsecured senior notes upon maturity.The Coronavirus Aid, Relief, and Economic Security Act (the “CARES Act”) established a program with provisions to allow U.S. companies to defer the employer’s portion of social security taxes between March 27, 2020 and December 31, 2020 and pay such taxes in two installments in 2021 and 2022. Under Section 3610, the CARES Act also authorized the government to reimburse qualifying contractors for certain costs of providing paid leave to employees as a result of COVID-19. The company has begun to seek, and anticipates continuing to seek, recovery for certain COVID-19-related costs under Section 3610 of the CARES Act and through our contract provisions. In addition, the U.S. Department of Defense (DoD) has taken steps to increase the rate for certain progress payments from 80 percent to 90 percent for costs incurred and work performed on relevant contracts. While it is unclear how much we will be able to recover, in particular under Section 3610, we believe these actions should continue to mitigate some potential COVID-19-related negative impacts to our operating cash flows in 2021.Cash and cash equivalents and cash generated from operating activities, supplemented by borrowings under credit facilities, commercial paper and/or in the capital markets, if needed, are expected to be sufficient to fund our operations for at least the next 12 months. Capital expenditure commitments were $1.3 billion at December 31, 2020, and are expected to be paid with cash on hand.-36-NORTHROP GRUMMAN CORPORATION Operating Cash FlowThe table below summarizes key components of cash flow provided by operating activities: Year Ended December 31$ in millions202020192018Net earnings$3,189 $2,248 $3,229 Non-cash items(1)2,601 2,683 1,775 Changes in assets and liabilities:Trade working capital227 128 (65)Retiree benefits, excluding MTM expense(1,678)(703)(1,083)Other, net(34)(59)(29)Net cash provided by operating activities$4,305 $4,297 $3,827 (1)Includes depreciation and amortization, MTM expense, stock based compensation expense and deferred income taxes.2020 cash provided by operating activities was comparable to the prior period and reflects higher net earnings and improved trade working capital as well as a $750 million discretionary pre-tax pension contribution ($593 million after-tax) as compared to a $120 million discretionary pre-tax pension contribution ($95 million after-tax) in the prior year period.Adjusted Free Cash FlowAdjusted free cash flow, as reconciled in the table below, is a non-GAAP measure defined as net cash provided by operating activities, less capital expenditures, plus proceeds from sale of equipment to a customer (not otherwise included in net cash provided by operating activities) and the after-tax impact of discretionary pension contributions. Adjusted free cash flow includes proceeds from the sale of equipment to a customer as such proceeds were generated in a customer sales transaction. It also includes the after-tax impact of discretionary pension contributions for consistency and comparability of financial performance. This measure may not be defined and calculated by other companies in the same manner. We use adjusted free cash flow as a key factor in our planning for, and consideration of, acquisitions, the payment of dividends and share repurchases. This non-GAAP measure may be useful to investors and other users of our financial statements as a supplemental measure of our cash performance, but should not be considered in isolation, as a measure of residual cash flow available for discretionary purposes, or as an alternative to operating cash flows presented in accordance with GAAP.The table below reconciles net cash provided by operating activities to adjusted free cash flow:Year Ended December 31% Change in$ in millions20202019201820202019Net cash provided by operating activities$4,305 $4,297 $3,827 — %12 %Capital expenditures(1,420)(1,264)(1,249)12 %1 %Proceeds from sale of equipment to a customer205 — — NMNMAfter-tax discretionary pension contributions593 95 186 524 %(49)%Adjusted free cash flow$3,683 $3,128 $2,764 18 %13 %2020 adjusted free cash flow increased $555 million, principally driven by higher net earnings and improved trade working capital as well as $205 million in proceeds from the sale of equipment to a customer, partially offset by higher capital expenditures.Investing Cash Flow2020 net cash used in investing activities was comparable to the prior period and reflects higher capital expenditures, as well as $205 million in proceeds from the sale of equipment to a customer.Financing Cash Flow2020 net cash used in financing activities decreased to $432 million from $2.4 billion principally due to $2.2 billion of net proceeds from the issuance of long-term debt in the first quarter of 2020.Share Repurchases – See Note 3 to the consolidated financial statements for further information on our share repurchase programs.-37-NORTHROP GRUMMAN CORPORATION Commercial Paper, Credit Facilities and Unsecured Senior Notes – See Note 10 to the consolidated financial statements for further information on our commercial paper, credit facilities and unsecured senior notes. Financial Arrangements – See Note 12 to the consolidated financial statements for further information on our use of standby letters of credit and guarantees.Other Sources of Capital – We believe we can obtain additional capital, if necessary for long-term liquidity, from such sources as the public or private capital markets, the sale of assets, sale and leaseback of operating assets, and leasing rather than purchasing new assets. We have an effective shelf registration statement on file with the SEC, which allows us to access capital in a timely manner.Contractual ObligationsAt December 31, 2020, we had contractual commitments to repay debt with interest, make payments under operating leases, settle obligations related to agreements to purchase goods and services and make payments on various other liabilities. Payments due under these obligations and commitments, and the estimated timing of those payments, are as follows:$ in millionsTotal20212022- 20232024- 20252026 and beyondLong-term debt$15,091 $742 $2,558 $1,506 $10,285 Interest payments on long-term debt8,473 596 1,126 996 5,755 Operating leases2,022 298 495 327 902 Purchase obligations(1)17,761 8,279 4,065 2,941 2,476 Other long-term liabilities(2)1,619 370 579 157 513 Total contractual obligations$44,966 $10,285 $8,823 $5,927 $19,931 (1)A “purchase obligation” is defined as an agreement to purchase goods or services that is enforceable and legally binding on us and that specifies all significant terms, including: fixed or minimum quantities to be purchased; fixed, minimum, or variable price provisions; and the approximate timing of the transaction. These amounts are primarily comprised of open purchase order commitments to suppliers and subcontractors pertaining to funded contracts.(2)Other long-term liabilities, including their current portions, primarily consist of total accrued environmental reserves, deferred compensation, and other miscellaneous liabilities. It excludes obligations for uncertain tax positions of $1.5 billion as we are not able to reasonably estimate the timing of future cash flows related to such positions.The table above excludes estimated minimum funding requirements for the company’s pension and OPB plans, as set forth by the Employee Retirement Income Security Act, as amended. For further information about future minimum contributions for these plans, see Note 13 to the consolidated financial statements. Further details regarding long-term debt and operating leases can be found in Notes 10 and 15, respectively, to the consolidated financial statements.CRITICAL ACCOUNTING POLICIES, ESTIMATES AND JUDGMENTSOur consolidated financial statements are based on GAAP, which requires us to make estimates and assumptions about future events that affect the amounts reported in our consolidated financial statements. We employ judgment in making our estimates in consideration of historical experience, currently available information and various other assumptions that we believe to be reasonable under the circumstances. Actual results could differ from our estimates and assumptions, and any such differences could be material to our consolidated financial statements. We believe the following accounting policies are critical to the understanding of our consolidated financial statements and require the use of significant management judgment in their application. For a summary of our significant accounting policies, see Note 1 to the consolidated financial statements.Revenue RecognitionDue to the long-term nature of our contracts, we generally recognize revenue over time using the cost-to-cost method, which requires us to make reasonably dependable estimates regarding the revenue and cost associated with the design, manufacture and delivery of our products and services. Contract sales may include estimates of variable consideration, including cost or performance incentives (such as award and incentive fees), contract claims and requests for equitable adjustment (REAs). Variable consideration is included in total estimated sales to the extent it is probable that a significant reversal in the amount of cumulative revenue recognized will not occur when the uncertainty associated with the variable consideration is subsequently resolved. We estimate variable consideration as the most likely amount to which we expect to be entitled. -38-NORTHROP GRUMMAN CORPORATION Our cost estimation process is based on the professional knowledge of our engineering, program management and financial professionals, and draws on their significant experience and judgment. We prepare EACs for our contracts and calculate an estimated contract profit based on total estimated contract sales and cost. Since our contracts typically span a period of several years, estimation of revenue, cost, and progress toward completion requires the use of judgment. Factors considered in these estimates include our historical performance, the availability, productivity and cost of labor, the nature and complexity of work to be performed, the effect of change orders, availability and cost of materials, components and subcontracts, the effect of any delays in performance and the level of indirect cost allocations.We generally review and reassess our sales, cost and profit estimates for each significant contract at least annually or more frequently as determined by the occurrence of events, changes in circumstances and evaluations of contract performance to reflect the latest reliable information available. The company performs on a broad portfolio of long-term contracts, including the development of complex and customized military platforms and systems, as well as advanced electronic equipment and software, that often include technology at the forefront of science. Cost estimates on fixed-price development contracts are inherently more uncertain as to future events than production contracts, and, as a result, there is typically more variability in those estimates, as well as financial risk associated with unanticipated cost growth. Changes in estimates occur for a variety of reasons, including changes in contract scope, the resolution of risk at lower or higher cost than anticipated, unanticipated performance and other risks affecting contract costs, performance issues with subcontractors or suppliers, changes in indirect cost allocations, such as overhead and G&A costs, and changes in estimated award and incentive fees. Identified risks typically include technical, schedule and/or performance risk based on our evaluation of the contract effort. Similarly, the changes in estimates may include changes in, or resolution of, identified opportunities for operating margin improvement.For the impacts of changes in estimates on our consolidated statements of earnings and comprehensive income, see “Segment Operating Results” and Note 1 to the consolidated financial statements.Retirement BenefitsOverview – The determination of projected benefit obligations, the fair value of plan assets, and pension and OPB expense for our retirement benefit plans requires the use of estimates and actuarial assumptions. We perform an annual review of our actuarial assumptions in consultation with our actuaries. As we determine changes in the assumptions are warranted, or as a result of plan amendments, future pension and OPB expense and our projected benefit obligation could increase or decrease. The principal estimates and assumptions that have a significant effect on our consolidated financial position and annual results of operations are the discount rate, cash balance crediting rate, expected long-term rate of return on plan assets, estimated fair market value of plan assets, and the mortality rate of those covered by our pension and OPB plans. The effects of actual results differing from our assumptions and the effects of changing assumptions (i.e. actuarial gains or losses) are recognized immediately through earnings upon annual remeasurement in the fourth quarter, or on an interim basis as triggering events warrant remeasurement. Discount Rate – The discount rate represents the interest rate used to determine the present value of future cash flows currently expected to be required to settle our pension and OPB obligations. The discount rate is generally based on the yield of high-quality corporate fixed-income investments. At the end of each year, we determine the discount rate using a theoretical bond portfolio model of bonds rated AA or better to match the notional cash outflows related to projected benefit payments for each of our significant benefit plans. Taking into consideration the factors noted above, our weighted-average composite pension discount rate was 2.68 percent at December 31, 2020, and 3.39 percent at December 31, 2019.The effects of a hypothetical change in the discount rate may be nonlinear and asymmetrical for future years as the discount rate changes. Holding all other assumptions constant, an increase or decrease of 25 basis points in the December 31, 2020 discount rate assumption would have the following estimated effects on 2020 pension and OPB obligations, which would be reflected in the 2020 MTM expense (benefit), and 2021 expected pension and OPB expense:$ in millions25 Basis Point Decrease in Rate25 Basis Point Increase in Rate2021 pension and OPB (benefit) expense$(45)$42 2020 pension and OPB obligation and MTM expense (benefit)1,471 (1,385)-39-NORTHROP GRUMMAN CORPORATION Cash Balance Crediting Rate – A portion of the company’s pension obligation and resulting pension expense is based on a cash balance formula, where participants’ hypothetical account balances are accumulated over time with pay-based credits and interest. Interest is credited monthly using the current 30-Year Treasury bond rate. The interest crediting rate is part of the cash balance formula and independent of actual pension investment earnings. The cash balance crediting rate used for FAS purposes tends to move in concert with the discount rate but has an offsetting effect on pension benefit obligations and the related MTM expense (benefit). The minimum cash balance crediting rate allowed under the plan is 2.25 percent. The cash balance crediting rate assumption has been set to the minimum threshold of 2.25 percent as of December 31, 2020, and will remain at 2.25 percent through 2026. Holding all other assumptions constant, an increase or decrease of 25 basis points in the December 31, 2020 cash balance crediting rate assumption would have the following estimated effects on the 2020 pension benefit obligation, which would be reflected in the 2020 MTM expense (benefit), and 2021 expected pension expense:$ in millions25 Basis Point Decrease in Rate25 Basis Point Increase in Rate2021 pension (benefit) expense$— $11 2020 pension obligation and MTM expense (benefit)— 169 Expected Long-Term Rate of Return on Plan Assets – The expected long-term rate of return on plan assets (EROA) assumption reflects the average rate of net earnings we expect on current and future benefit plan investments. EROA is a long-term assumption, which we review annually and adjust to reflect changes in our long-term view of expected market returns and/or significant changes in our plan asset investment policy. Due to the inherent uncertainty of this assumption, we consider multiple data points at the measurement date including the plan’s target asset allocation, historical asset returns and third party projection models of expected long-term returns for each of the plans’ strategic asset classes. In addition to the data points themselves, we consider trends in the data points, including changes from the prior measurement date. The EROA assumptions we use for pension benefits are consistent with those used for OPB plans; however, we reduce the EROA for OPB plans to allow for the impact of tax on investment earnings, as certain Voluntary Employee Beneficiary Association trusts are taxable.During 2020, the Investment Committee of the company’s benefit plans reviewed and approved the plans’ major asset class allocations. The current asset allocation is approximately 40% public equities, 35% fixed-income, 20% alternatives and 5% cash. At this time, the Investment Committee is not contemplating any significant changes to that mix. For further information on plan asset investments, see Note 13 to the consolidated financial statements.While historical market returns are not necessarily predictive of future market returns, given our long history of plan performance supported by the stability in our investment mix, investment managers, and active asset management, we believe our actual historical performance is a reasonable metric to consider when developing our EROA. Our average annual rate of return from 1976 to 2020 was approximately 11.2 percent and our 20-year and 30-year rolling average rates of return were approximately 8.0 percent and 10.2 percent, respectively, each determined on an arithmetic basis and net of expenses. Our 2020 actual net plan asset returns were approximately 16.2 percent.Consistent with our past practice, we obtained long-term capital market forecasting models from several third parties and, using our target asset allocation, developed an expected rate of return on plan assets from each model. We considered not only the specific returns projected by those third party models, but also changes in the models year-to-year when developing our EROA.For determining 2020 FAS expense, we assumed an expected long-term rate of return on pension plan assets of 8.0 percent and an expected long-term rate of return on OPB plan assets of 7.66 percent. For 2021 FAS expense, we have assumed an expected long-term rate of return on pension plan assets of 7.5 percent and 7.22 percent on OPB plans. We decreased the EROA assumption following an assessment of the historical and anticipated long-term returns of various asset classes, including consideration of recent Federal Reserve policy changes that are expected to extend the duration of the current low interest rate environment. Holding all other assumptions constant, an increase or decrease of 25 basis points in our December 31, 2020 EROA assumption would have the following estimated effects on 2021 expected pension and OPB expense:$ in millions25 Basis Point Decrease25 Basis Point Increase2021 pension and OPB expense (benefit)$88 $(88)-40-NORTHROP GRUMMAN CORPORATION In addition, holding all other assumptions constant, an increase or decrease of 100 basis points in actual versus expected return on plan assets would have the following estimated effects on our 2021 MTM expense (benefit):$ in millions100 Basis Point Decrease100 Basis Point Increase 2021 MTM expense (benefit)$351 $(351)Estimated Fair Market Value of Plan Assets – For certain plan assets where the fair market value is not readily determinable, such as real estate, private equity, hedge funds and opportunistic investments, we develop estimates of fair value using the best information available. Estimated fair values on these plan assets are based on redemption values and net asset values, as well as valuation methodologies that include third party appraisals, comparable transactions, discounted cash flow valuation models and public market data.Mortality Rate – Mortality assumptions are used to estimate life expectancies of plan participants. In October 2014, the Society of Actuaries Retirement Plans Experience Committee (RPEC) issued updated mortality tables and a mortality improvement scale, which reflected longer life expectancies than previously projected. In October 2019, the RPEC issued an updated mortality base table (the Private Retirement Plans Mortality table for 2012 (Pri-2012)), which we adopted after reviewing our own historical mortality experience. In October 2020, the RPEC released a new projection scale (MP-2020) that included a reshaping of the long-term mortality improvement assumption. The MP-2020 projection scale includes long-term mortality improvement assumptions greater than 1.0% at earlier ages, but trends down more rapidly than the prior projection scales. After considering the information released by the RPEC in October 2020, we adopted the full MP-2020 projection scale while continuing to use the Pri-2012 White Collar table. Accordingly, we updated the mortality assumptions used in calculating our pension and OPB obligations recognized at December 31, 2020, and the amounts estimated for our 2021 pension and OPB expense.For further information regarding our pension and OPB plans, see “Risk Factors” and Notes 1 and 13 to the consolidated financial statements.Litigation, Commitments and ContingenciesWe are subject to a range of claims, disputes, enforcement actions, investigations, lawsuits, overhead cost claims, environmental matters, income tax matters and administrative proceedings that arise in the ordinary course of business. Estimating liabilities and costs associated with these matters requires judgment based upon the professional knowledge and experience of management. We determine whether to record a reserve and, if so, what amount based on consideration of the facts and circumstances of each matter as then known to us. Determinations regarding whether to record a reserve and, if so, of what amount, reflect management’s assessment regarding what is likely to occur; they do not necessarily reflect what management believes should occur. The ultimate resolution of any such exposure to us may vary materially from earlier estimates as further facts and circumstances develop or become known to us.Environmental Matters – We are subject to environmental laws and regulations in the jurisdictions in which we do or have done business. Factors that could result in changes to the assessment of probability, range of reasonably estimated costs and environmental accruals include: modification of planned remedial actions; changes in the estimated time required to conduct remedial actions; discovery of more or less extensive (or different) contamination than anticipated; information regarding the potential causes and effects of contamination; results of efforts to involve other responsible parties; financial capabilities of other responsible parties; changes in laws and regulations, their interpretation or application; contractual obligations affecting remediation or responsibilities; and improvements in remediation technology. As we expect to be able to recover a portion of environmental remediation liabilities through overhead charges on government contracts, such amounts are deferred in prepaid expenses and other current assets (current portion) and other non-current assets until charged to contracts. We use judgment to evaluate the recoverability of our environmental remediation costs, assessing, among other things, U.S. government regulations, our U.S. government contract mix and past practices. Portions of the company’s environmental liabilities we do not expect to be recoverable have been expensed. Income Tax Matters – The evaluation of tax positions taken in a filed tax return, or planned to be taken in a future tax return or claim, requires the use of judgment. We establish reserves for uncertain tax positions when, despite the belief that our tax positions are supportable, there remains uncertainty in a tax position taken in our filed tax returns or planned to be taken in a future tax return or claim. The company follows a recognition and measurement approach, considering the facts, circumstances, and information available at the reporting date. Judgment is exercised by the company in determining the level of evidence necessary and appropriate to support its assessment using all available information. The technical merits of a given tax position are derived from sources of authority in -41-NORTHROP GRUMMAN CORPORATION the tax law and their applicability to the facts and circumstances of the position. In measuring the tax position, the company considers the amounts and probabilities of the outcomes that could be realized upon settlement. When it is more likely than not that a tax position will be sustained, we record the largest amount of tax benefit with a greater than 50 percent likelihood of being realized upon ultimate settlement with a taxing authority. To the extent we prevail in matters for which reserves have been established or are required to pay amounts in excess of reserves, there could be a significant impact on our consolidated financial position and annual results of operations. During 2020, we increased our gross unrecognized tax benefits by approximately $346 million, primarily related to state apportionment, our methods of accounting associated with the timing of revenue recognition and related costs, and the 2017 Tax Act.For further information on litigation, commitments and contingencies, see “Risk Factors” and Note 1, Note 7, Note 11 and Note 12 to the consolidated financial statements.Goodwill and Other Purchased Intangible AssetsOverview – We allocate the purchase price of acquired businesses to the underlying tangible and intangible assets acquired and liabilities assumed based upon their respective fair values, with the excess recorded as goodwill. Such fair value assessments require judgments and estimates that can be affected by contract performance and other factors over time, which may cause final amounts to differ materially from original estimates. Adjustments to the fair value of purchased assets and liabilities after the initial measurement period are recognized in net earnings.We recognize purchased intangible assets in connection with our business acquisitions at fair value on the acquisition date. The most significant purchased intangible assets recognized from our acquisitions are generally customer-related intangible assets, including customer contracts and commercial customer relationships. We determine the fair value of those customer-related intangible assets based on estimates and judgments, including the amount and timing of expected future cash flows, long-term growth rates and discount rates. In some cases, we use discounted cash flow analyses, which are based on estimates of future sales, earnings and cash flows after considering such factors as general market conditions, customer budgets, existing firm and future orders, changes in working capital, long term business plans and recent operating performance. Impairment Testing – We test for impairment of goodwill annually at each of our reporting units, which comprise our operating segments. The results of our annual goodwill impairment tests as of December 31, 2020 and 2019, respectively, indicated that the estimated fair value of each reporting unit exceeded its respective carrying value. There were no impairment charges recorded in the years ended December 31, 2020, 2019 and 2018.In addition to performing an annual goodwill impairment test, we may perform an interim impairment test if events occur or circumstances change that suggest goodwill in any of our reporting units may be impaired. Such indicators may include, but are not limited to, the loss of significant business, significant reductions in federal government appropriations or other significant adverse changes in industry or market conditions. During 2020, we considered COVID-19-related impacts on our business and determined there were no impairment indicators requiring us to perform an interim goodwill impairment test.When testing goodwill for impairment, we compare the fair values of each of our reporting units to their respective carrying values. To determine the fair value of our reporting units, we primarily use the income approach based on the cash flows we expect the reporting units to generate in the future, consistent with our operating plans. This income valuation method requires management to project sales, operating expenses, working capital, capital spending and cash flows for the reporting units over a multi-year period, as well as to determine the weighted-average cost of capital (WACC) used as a discount rate and terminal value assumptions. The WACC takes into account the relative weights of each component of our consolidated capital structure (equity and debt) and represents the expected cost of new capital adjusted as appropriate to consider lower risk profiles associated with longer-term contracts and barriers to market entry. The terminal value assumptions are applied to the final year of the discounted cash flow model. We use industry multiples (including relevant control premiums) of operating earnings to corroborate the fair values of our reporting units determined under the market valuation method of the income approach.We test for impairment of our purchased intangible assets when events or changes in circumstances indicate that the carrying amount of these assets may not be recoverable. Our assessment is based on our projection of the undiscounted future operating cash flows of the related asset group. If such projections indicate that future undiscounted cash flows are not sufficient to recover the carrying amount, we recognize a non-cash impairment charge to reduce the carrying amount to fair value. There were no impairment charges recorded in the years ended December 31, 2020, 2019 and 2018.-42-NORTHROP GRUMMAN CORPORATION Impairment assessment inherently involves management judgments as to assumptions about expected future cash flows and the impact of market conditions on those assumptions. Due to the many variables inherent in the estimation of a business’ fair value and the relative size of our recorded goodwill and other purchased intangible assets, differences in assumptions may have a material effect on the results of our impairment analysis.OTHER MATTERSOff-Balance Sheet ArrangementsAs of December 31, 2020, we had no significant off-balance sheet arrangements.-43-NORTHROP GRUMMAN CORPORATION Item 7A. Quantitative and Qualitative Disclosures About Market RiskEQUITY RISKWe are exposed to market risk with respect to our portfolio of marketable securities with a fair value of $396 million at December 31, 2020. These securities are exposed to market volatilities, changes in price and interest rates.INTEREST RATE RISKWe are exposed to interest rate risk on variable-rate short-term credit facilities for which there were no borrowings outstanding at December 31, 2020. At December 31, 2020, we have $15.0 billion of long-term debt, primarily consisting of fixed-rate debt, with a fair value of approximately $18.2 billion. The terms of our fixed-rate debt obligations do not generally allow investors to demand payment of these obligations prior to maturity. Therefore, we do not have significant exposure to interest rate risk for our fixed-rate debt; however, we do have exposure to fair value risk if we repurchase or exchange long-term debt prior to maturity.FOREIGN CURRENCY RISKIn certain circumstances, we are exposed to foreign currency risk. We enter into foreign currency forward contracts to manage a portion of the exchange rate risk related to receipts from customers and payments to suppliers denominated in foreign currencies. We do not hold or issue derivative financial instruments for trading purposes. At December 31, 2020, foreign currency forward contracts with a notional amount of $133 million were outstanding. At December 31, 2020, a 10 percent unfavorable foreign exchange rate movement would not have a material impact on our consolidated financial position, annual results of operations and/or cash flows. INFLATION RISKWe have generally been able to anticipate increases in costs when pricing our contracts. Bids for longer-term firm fixed-price contracts typically include assumptions for labor and other cost escalations in amounts that historically have been sufficient to cover cost increases over the period of performance.-44-
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+Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations The following Management’s Discussion and Analysis of Financial Condition and Results of Operations of Nucor Corporation should be read in conjunction with the consolidated financial statements of the Company and the accompanying notes to the consolidated financial statements. Management’s Discussion and Analysis of Financial Condition and Results of Operations included in this report discusses our financial condition and results of operations as of and for the years ended December 31, 2020 and 2019. Information concerning the year ended December 31, 2019 and a comparison of the years ended December 31, 2019 and December 31, 2018 may be found under “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations” in the Company’s Annual Report on Form 10-K for the year ended December 31, 2019, filed with the SEC on February 28, 2020. Overview The COVID-19 pandemic began to impact Nucor’s operations in the final weeks of the first quarter of 2020. It would rapidly become the most significant event of 2020, impacting almost all aspects of our business through the remainder of the year and into the present. Our most important value is the health and safety of our teammates, their families and the communities where we operate. We formed several internal task forces to closely monitor developments related to the pandemic. Our facilities around the country have taken steps to respond to COVID-19 based on the nature of their operations and the actions being taken by their state and local governments. We have restricted travel, upgraded the cleaning practices at our facilities and offices, implemented remote work for teammates wherever possible, and instituted social distancing measures throughout the Company. In addition to these measures, which are still in effect to varying degrees, we also took significant action to further strengthen our liquidity resources and financial position. These financial measures are further explained in the “Liquidity and Capital Resources” section of this “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.” Across Nucor, we remain committed to protecting our teammates while minimizing disruptions to our customers and supply chain. Due to the impact of the pandemic, the U.S. economy shrank by 3.5% in 2020, compared to a growth rate of 2.2% in 2019. Despite this, demand in several key end-use markets was surprisingly resilient in 2020, most notably in nonresidential construction and automotive, which together account for nearly two-thirds of steel consumption. Operating rates at our steel mills for the full year 2020 decreased to 82% as compared to 84% for the full year 2019. Industry-wide, the U.S. capacity utilization rate was 68% for 2020, down from 80% in 2019. Economic conditions improved in the second half of 2020 and we are optimistic about market conditions heading into 2021. We expect the nonresidential construction and automotive markets to remain strong. We hope to see improvement in markets like heavy duty trucks, heavy equipment and agriculture that were down in 2020. We anticipate the recovery in oil and gas markets to be slow, but Nucor has seen increased sales into the renewable energy market. The Section 232 steel tariffs continued to be effective in keeping unfairly traded imports out of the U.S. market. For the full year 2020, finished steel imports were down approximately 23% from the previous year and accounted for approximately 18% of U.S. market share. Our Challenges and Risks Sales of many of our products are largely dependent upon capital spending in the nonresidential construction markets in the United States, including in the industrial and commercial sectors, as well as capital spending on infrastructure that is publicly funded, such as bridges, schools, prisons and hospitals. While there has been no federal infrastructure bill in recent years, many states have passed bills funding infrastructure improvements. 26 Table of Contents While the Section 232 tariffs are having their intended impact by keeping unfairly traded imports out of the U.S. market, global steel production overcapacity continues to be a long-term challenge. Steel production in China rose in 2020, going from approximately 1.10 billion tons in 2019 to approximately 1.16 billion tons in 2020 – an increase of 5.5%. As a result, China’s share of global crude steel production rose from 53.3% in 2019 to 56.6% in 2020. The OECD projects that global excess steel production capacity was approximately 776 million tons in 2020, up from 624 million tons at the end of 2019, which was itself up significantly from the prior year. A major uncertainty we continue to face in our business is the price of our principal raw material, ferrous scrap, which is volatile and often increases or decreases rapidly in response to changes in domestic demand, unanticipated events that affect the flow of scrap into scrap yards, the availability of scrap substitutes, currency fluctuations and changes in foreign demand for scrap. In periods of rapidly increasing raw material prices in the industry, which are often also associated with periods of strong or rapidly improving steel market conditions, being able to increase our prices for the products we sell quickly enough to offset increases in the prices we pay for ferrous scrap is challenging but critical to maintaining our profitability. We attempt to mitigate the scrap price risk by managing scrap inventory levels at the steel mills to match the anticipated demand over the next several weeks. Certain scrap substitutes, including pig iron, have longer lead times for delivery than scrap, which can make this inventory management strategy difficult to achieve. Continued successful implementation of our raw material strategy, including key investments in DRI production, coupled with the scrap brokerage and processing services performed by our team at DJJ, give us greater control over our metallic inputs and thus also helps us to mitigate this risk. During periods of stronger or improving steel market conditions, we are more likely to be able to pass through to our customers, relatively quickly, the increased costs of ferrous scrap and scrap substitutes, protecting our gross margins from significant erosion. During weaker or rapidly deteriorating steel market conditions, weak steel demand, low industry utilization rates and the impact of imports create an even more intensified competitive environment and increased pricing pressure. All of those factors, to some degree, impact pricing, which increases the likelihood that Nucor will experience lower gross margins. Although the majority of our steel sales are to spot market customers in North America who place their orders each month based on their business needs and our pricing competitiveness compared to both domestic and global producers and trading companies, we also sell contract tons, most notably in our sheet operations. Approximately 70% of our sheet sales were to contract customers in 2020 (75% in 2019), with the balance being sold in the spot market at the prevailing prices at the time of sale. Steel contract sales outside of our sheet operations are not significant. The amount of tons sold to contract customers at any given time depends on the overall market conditions at the time, how the end-use customers see the market moving forward and the strategy that Nucor management believes is appropriate to the upcoming period. Nucor management considerations include maintaining an appropriate balance of spot and contract tons based on market projections and appropriately supporting our diversified customer base. The percentage of tons that is placed under contract also depends on the overall market dynamics and customer negotiations. In years of strengthening demand, we typically see an increase in the percentage of sheet sales sold under contract as our customers have an expectation that transaction prices will rapidly rise, and available capacity will quickly be sold out. To mitigate this risk, customers prefer to enter into contracts in order to obtain committed volumes of supply from the mills. The vast majority of our contracts include a method of adjusting prices on a periodic basis to reflect changes in the market pricing for steel and/or scrap. Market indices for steel generally trend with scrap pricing changes, but, during periods of steel market weakness, the more intensified competitive steel market environment can cause the sales price indices to decrease resulting in reduced gross margins and profitability. Furthermore, since the selling price adjustments are not immediate, there will always be a timing difference between changes in the prices we pay for raw materials and the adjustments we make to our contract selling prices. Generally, in periods of increasing scrap prices, we experience a short-term margin contraction on 27 Table of Contents contract tons. Conversely, in periods of decreasing scrap prices, we typically experience a short-term margin expansion. Contract sales typically have terms ranging from six to 12 months. Our Strengths and Opportunities We are North America’s most diversified steel producer. As a result, our short-term performance is not tied to any one market. We have numerous, large, strategic capital projects at various stages of progress that we believe will help us further diversify our product offerings and expand the markets that we serve. We expect these investments to grow our long-term earnings power by increasing our channels to market, expanding our product portfolio into higher value-added offerings that are less vulnerable to imports, improving our cost structure and further building upon our market leadership positions. We believe that Nucor’s raw material supply chain is another important strength. Our investment in DRI production facilities and scrap brokerage and processing businesses provides Nucor with significant flexibility in optimizing our raw materials costs. Additionally, having a significant portion of our raw materials supply under our control reduces risk associated with the global sourcing of raw materials, particularly since a considerable portion of scrap substitutes comes from regions of the world that historically have experienced greater political turmoil. Our highly variable, low-cost structure, combined with our financial strength and liquidity, has allowed us to successfully navigate cyclical, severely depressed steel industry market conditions in the past. In such times, our incentive-based pay system reduces our payroll costs, both hourly and salary, which helps to offset lower selling prices. Our pay-for-performance system that is closely tied to our levels of production also allows us to keep our highly experienced workforce intact and to continue operating our facilities when some of our competitors with greater fixed costs are forced to shut down some of their facilities. Because we use EAFs to produce our steel, we can easily vary our production levels to match short-term changes in demand, unlike our blast furnace-based integrated competitors. We believe these strengths also provide us further opportunities to gain market share during such times. Evaluating Our Operating Performance We report our results of operations in three segments: steel mills, steel products and raw materials. Most of the steel we produce in our mills is sold to outside customers (80% in both 2020 and 2019), but a significant percentage is used internally by many of the facilities in our steel products segment (20% in both 2020 and 2019). We begin measuring our performance by comparing our net sales, both in total and by individual segment, during a reporting period with our net sales in the corresponding period in the prior year. In doing so, we focus on changes in and the reasons for such changes in the two key variables that have the greatest influence on our net sales: average sales price per ton during the period and total tons shipped to outside customers. We also focus on both dollar and percentage changes in gross margins, which are key drivers of our profitability, and the reasons for such changes. There are many factors from period to period that can affect our gross margins. One consistent area of focus for us is changes in “metal margins,” which is the difference between the selling price of steel and the cost of scrap and scrap substitutes. Increases or decreases in the cost of scrap and scrap substitutes that are not offset by changes in the selling price of steel can quickly compress or expand our margins and reduce or increase our profitability. Changes in marketing, administrative and other expenses, particularly profit sharing and other variable incentive-based payment costs, can have a material effect on our results of operations for a reporting period as well. These costs vary significantly from period to period as they are based upon changes in our pre-tax earnings and other profitability metrics that are a reflection of our pay-for-performance system that is closely tied to our levels of production. 28 Table of Contents Evaluating Our Financial Condition We evaluate our financial condition each reporting period by focusing primarily on the amounts of and reasons for changes in cash provided by operating activities, our current ratio, the turnover rate of our accounts receivable and inventories, the amounts of and reasons for changes in cash used in or provided by investing activities (including projected capital expenditures) and financing activities and our cash and cash equivalents and short-term investments position at period end. We believe that our conservative financial practices have served us well in the past and are serving us well today. As a result, our financial position remains strong. Comparison of 2020 to 2019 Results of Operations Nucor reported consolidated net earnings of $2.36 per diluted share in 2020 and $4.14 per diluted share in 2019. The COVID-19 pandemic and the impacts it had on the domestic economy were the primary factor driving the decrease in earnings in 2020 as compared to 2019. In 2019, the steel mills segment’s profitability peaked in the first quarter and experienced a downward trend for the remainder of the year primarily due to inventory destocking. The first quarter of 2020 was off to a promising start for the steel mills segment, building off of the momentum of price increases announced in the fourth quarter of 2019 and a strong quarterly utilization rate of 89%. The first quarter of 2020 ended with the rapidly intensifying impact of the COVID-19 pandemic beginning to impact our business late in the quarter. We also determined a triggering event occurred related to our equity method investment located in Italy, Duferdofin Nucor S.r.l. (“Duferdofin Nucor”), that would result in us reserving a note receivable and a significant impairment charge in the first quarter of 2020. We ultimately exited our investment in Duferdofin Nucor prior to the end of the year. Total losses and impairments of assets related to Duferdofin Nucor that were included in the steel mills segment earnings were approximately $483.5 million in 2020. We also recorded additional impairment charges in the fourth quarter of 2020 related to certain inventory and long-lived assets of $103.2 million that were primarily related to our Castrip sheet operations. The steel mills segment performance bottomed in the second quarter of 2020 but had an upward trajectory for the remainder of the year. Our steel mills segment is expected to have a very strong first quarter of 2021 due to increases in steel selling prices and strengthening market conditions at the end of 2020. Nonresidential construction market conditions were strong in 2019 and 2020.The resiliency of nonresidential construction markets during the COVID-19 pandemic paved the way for our steel products segment to have record profitability in 2020, surpassing the previous record set in 2019. Many of our business units in this segment performed at record or near-record levels, with our rebar fabrication and tubular products businesses driving the year-over-year increase for the segment. In addition to the strength of nonresidential construction markets over the last two years, the steel products segment continues to benefit from the lasting effects of changes in business strategy and efficiency initiatives that have significantly improved the performance of our rebar fabrication operations and metal buildings business. The raw materials segment’s profitability in 2020 increased from 2019 primarily due to the improved performance of our DRI facilities. Our DRI facility in Louisiana experienced a planned 70-day outage in 2019 to enhance operational reliability, and the facility set new records for production, shipping and operating hours in 2020. Low average selling prices and higher iron ore costs have caused the DRI facilities to have combined operating losses in 2020 and 2019. However, selling prices for raw materials increased dramatically in the fourth quarter of 2020 and we expect strong performance for the raw materials segment in the first quarter of 2021. The raw materials segment incurred non-cash impairment charges of $27.0 million and $35.0 million in 2020 and 2019, respectively. The 2020 charges related to our leasehold interest in unproved oil and gas properties and the 2019 charges related to our proved oil and gas properties. Refer to “Critical Accounting Policies and Estimates” for further discussion of these charges. 29 Table of Contents Nucor’s income tax provision in 2020 benefited from several notable items that are not included in segment reporting. Of note, the 2020 tax provision benefited from $201.9 million related to certain tax deductions claimed related to our now exited investment in Duferdofin Nucor, $39.7 million related to certain state tax credits and $48.2 million related to the anticipated carryback of a 2020 tax net operating loss under the Coronavirus Aid, Relief, and Economic Security Act (the “CARES Act”). The following discussion will provide greater quantitative and qualitative analysis of Nucor’s performance in 2020 as compared to 2019.Net Sales Net sales to external customers by segment for 2020 and 2019 were as follows (in thousands): Year Ended December 31, 2020 2019 % Change Steel mills $12,109,307 $13,933,950 -13% Steel products 6,623,068 6,990,064 -5% Raw materials 1,407,283 1,664,844 -15% Total net sales to external customers $20,139,658 $22,588,858 -11% Net sales for 2020 decreased 11% from the prior year. Average sales price per ton decreased 7% from $851 in 2019 to $789 in 2020. Total tons shipped to outside customers decreased 4% from 26,532,000 tons in 2019 to 25,519,000 in 2020. In the steel mills segment, sales tons were as follows (in thousands): Year Ended December 31, 2020 2019 % Change Outside steel shipments 18,049 18,585 -3% Inside steel shipments 4,637 4,771 -3% Total steel shipments 22,686 23,356 -3% Net sales for the steel mills segment decreased 13% in 2020 from the prior year due to a 10% decrease in the average sales price per ton, from $748 in 2019 to $671 in 2020, as well as a 3% decrease in total tons shipped to outside customers. Outside sales tonnage for the steel products segment was as follows (in thousands): Year Ended December 31, 2020 2019 % Change Joist sales 557 499 12% Deck sales 496 495 — Cold finished sales 406 498 -18% Rebar fabrication sales 1,232 1,223 1% Piling products sales 649 638 2% Tubular products sales 1,080 1,053 3% Other steel products sales 374 408 -8% Total steel products sales 4,794 4,814 — Net sales for the steel products segment decreased 5% in 2020 from the prior year due to a 5% decrease in average sales price per ton. Net sales for the raw materials segment decreased 15% in 2020 from the prior year primarily due to decreased average selling prices at DJJ’s brokerage operations and decreased volumes at DJJ’s scrap processing operations and brokerage operations. In 2020, approximately 88% of outside sales for the raw 30 Table of Contents materials segment were from the brokerage operations of DJJ, and approximately 9% of outside sales were from the scrap processing operations of DJJ (90% and 9%, respectively, in 2019). Gross Margins In 2020, Nucor recorded gross margins of $2.23 billion (11%) which was a decrease from $2.68 billion (12%) in 2019: • The primary driver for the decrease in gross margin in 2020 as compared to 2019 was decreased metal margins in the steel mills segment. Metal margin is the difference between the selling price of steel and the cost of scrap and scrap substitutes. The average scrap and scrap substitute cost per gross ton used decreased 8% from $314 in 2019 to $290 in 2019. Despite the decrease in average scrap and scrap substitute cost per gross ton used, metal margin in the steel mills segment decreased due to lower average selling prices across all steel mill businesses. Scrap prices are driven by the global supply and demand for scrap and other iron-based raw materials used to make steel. Scrap prices decreased during most of 2020 but began to rapidly increase late in the year. As we enter 2021, we see downward pressure on scrap prices in the near term that we believe is likely to stabilize and follow a more typical seasonal pattern during the remainder of the year. • Pre-operating and start-up costs of new facilities decreased to approximately $101 million in 2020 as compared to approximately $103 million in 2019. Pre-operating and start-up costs in 2020 primarily related to the bar mills being built in Missouri and Florida, the plate mill being built in Kentucky, the sheet mill expansion in Kentucky and the merchant bar quality mill expansion at our bar mill in Illinois. In 2019, pre-operating and start-up costs primarily related to the bar mills being built in Missouri and Florida, the expansion at our sheet mill in Kentucky and the upgrades at our Louisiana DRI facility. Nucor defines pre-operating and start-up costs, all of which are expensed, as the losses attributable to facilities or major projects that are either under construction or in the early stages of operation. Once these facilities or projects have attained a utilization rate that is consistent with our similar operating facilities, they are no longer considered by Nucor to be in start-up. • Gross margins in the steel products segment for 2020 increased as compared to 2019 primarily due to the increased profitability of our rebar fabrication and tubular products businesses which were partially offset by the decreased profitability of our building systems and cold finish operations. • Gross margins in the raw materials segment for 2020 increased as compared to 2019 primarily due to the improved performance of our DRI facilities that resulted in lower losses. Gross margins related to DJJ’s brokerage operations decreased in 2020 as compared to 2019 due to margin compression and decreased volumes. Gross margins for DJJ’s scrap processing operations slightly increased in 2020. Marketing, Administrative and Other Expenses A major component of marketing, administrative and other expenses is profit sharing and other incentive compensation costs. These costs, which are based upon and fluctuate with Nucor’s financial performance, decreased from 2019 to 2020 due to our decreased profitability in 2020. In 2020, profit sharing costs consisted of $86.6 million of contributions, including the Company’s matching contribution, made to the Company’s Profit Sharing and Retirement Savings Plan for qualified employees ($181.4 million in 2019). Other employee bonus costs also fluctuate based on Nucor’s achievement of certain financial performance goals, including achieving record earnings, and comparisons of Nucor’s financial performance to peers in the steel industry and other companies. Stock-based compensation included in marketing, administrative and other expenses decreased by 21% to $29.2 million in 2020 compared with $36.9 million in 2019 and includes costs associated with vesting of stock awards granted in prior years. Included in marketing, administrative and other expenses in 2020 was $18.2 million of restructuring charges related to the realignment of Nucor’s metal buildings business in the steel products segment. 31 Table of Contents Included in marketing, administrative and other expenses in 2019 was a benefit of $33.7 million related to the gain on the sale of an equity method investment in the raw materials segment. Equity in Losses (Earnings) of Unconsolidated Affiliates Equity method investment losses and (earnings) were $10.5 million in 2020 and $(3.3) million in 2019. The decrease in equity method investment earnings from 2019 to 2020 was primarily due to the decreased results of Nucor-JFE and NuMit.Losses and Impairments of Assets During the fourth quarter of 2019, Nucor performed an impairment analysis of its three fields of proved producing natural gas well assets and determined that the carrying amount of one of the fields of wells exceeded its fair value and the impairment condition was considered to be other than temporary. This field of wells was not impaired as a result of the analysis performed in 2018. Nucor recorded a $35.0 million non-cash impairment charge against this field of wells, driven primarily by estimated lease operating costs that were higher than the estimates used in the 2018 analysis. These charges were included in the raw materials segment. See Note 7 to the Company’s consolidated financial statements for additional information. Nucor recorded additional impairment charges in 2019 of $20.0 million related to certain property, plant and equipment in the steel mills segment, and $11.9 million related to the write-down of certain intangible assets in the steel products segment. In 2020, Nucor recorded losses on assets of $483.5 million related to our equity method investment in Duferdofin Nucor. Nucor also recorded impairment charges in 2020 of $103.2 million related to certain inventory and long-lived assets in the steel mills segment, and $27.0 million related to the write-down of our unproved natural gas well assets included in the raw materials segment. Interest Expense (Income) Net interest expense is detailed below (in thousands): Year Ended December 31, 2020 2019 Interest expense $ 166,613 $ 157,358 Interest income (13,415 ) (35,933 ) Interest expense, net $ 153,198 $ 121,425 Interest expense increased in 2020 compared to 2019 due to a higher average outstanding debt balance. Interest income decreased in 2020 compared to 2019 due to significantly lower average interest rates on investments. Earnings (Loss) Before Income Taxes and Noncontrolling Interests The following table presents earnings (loss) before income taxes and noncontrolling interests by segment for the years ended December 31, 2020 and 2019 (in thousands). The change between periods were driven by the quantitative and qualitative factors previously discussed. Year Ended December 31, 2020 2019 Steel mills $ 720,151 $ 1,790,694 Steel products 690,547 511,145 Raw materials 23,621 (28,244 ) Corporate/eliminations (598,781 ) (490,788 ) Earnings before income taxes and noncontrolling interests $ 835,538 $ 1,782,807 32 Table of Contents Noncontrolling Interests Noncontrolling interests represent the income attributable to the noncontrolling partners of Nucor’s joint ventures, primarily Nucor–Yamato, of which Nucor owns 51%. The 15% increase in earnings attributable to noncontrolling interests in 2020 as compared to 2019 was primarily due to the increased earnings of Nucor–Yamato. Under the Nucor–Yamato limited partnership agreement, the minimum amount of cash to be distributed each year to the partners is the amount needed by each partner to pay applicable U.S. federal and state income taxes. In 2020, the amount of cash distributed to noncontrolling interest holders exceeded the earnings attributable to noncontrolling interests based on mutual agreement of the general partners; however, the cumulative amount of cash distributed to partners was less than the cumulative net earnings of the partnership. Provision for Income Taxes The Company’s effective tax rate in 2020 was -0.06% compared with 23.1% in 2019. The decrease in the effective tax rate was primarily due to a net tax benefit of $201.9 million (-24.16%) for a tax loss on our investment in Duferdofin Nucor, a net tax benefit of $45.2 million (-5.41%) for state tax credits, and a federal tax benefit of $48.2 million (-5.77%) for the carryback of a federal tax net operating loss (an “NOL”) under the CARES Act. These benefits were all recognized in 2020 and were somewhat offset by the rate impact (11.2%) of financial statement impairments of $445.6 million which did not affect the provision for income taxes. The CARES Act allows for an NOL generated in 2020 to be carried back to taxable years where the federal income tax rate was 35%. The difference in the tax rate in 2020 and tax years before the enactment of the Tax Cuts and Jobs Act of 2017 is the main driver of the federal tax NOL benefit in 2020, but this is somewhat offset by the partial loss of the domestic manufacturing deduction in the carryback year. Nucor has concluded U.S. federal income tax matters for tax years through 2014 and for tax year 2016. The tax years 2015 and 2017 through 2019 remain open to examination by the Internal Revenue Service. The 2015 Canadian income tax returns for Harris Steel Group Inc. and certain related affiliates are currently under examination by the Canada Revenue Agency. The tax years 2014 through 2019 remain open to examination by other major taxing jurisdictions to which Nucor is subject (primarily Canada and other state and local jurisdictions). Net Earnings and Return on Equity Nucor reported net earnings of $721.5 million, or $2.36 per diluted share, in 2020, compared to net earnings of $1.27 billion, or $4.14 per diluted share, in 2019. Net earnings attributable to Nucor stockholders as a percentage of net sales were 3.6% and 5.6% in 2020 and 2019, respectively. Return on average stockholders’ equity was 6.8% and 12.6% in 2020 and 2019, respectively. Liquidity and Capital Resources As a result of the COVID-19 pandemic and the significant uncertainty it had on Nucor and our stakeholders, we instituted enterprise-wide efforts to enhance our liquidity and support our teammates, which include, among other things: • Capital Expenditures – We began the year with a capital expenditures budget of $2.00 billion. We reviewed our capital expenditures budget and decided to delay certain capital projects that had not begun, briefly paused a few of our larger projects and continued with certain projects that were either close to completion or where work had been scheduled. As a result, our total capital expenditures in 2020 was $1.54 billion. Our 2021 capital expenditures estimate is approximately $2.00 billion. • Working Capital – Our net working capital position has contracted to provide a source of incremental liquidity while business activity has slowed. In addition, we are maintaining reduced raw material inventory levels in line with our anticipated near-term production requirements, a change we believe is sustainable and intend to maintain throughout 2021. 33 Table of Contents • Pay & Benefits – Almost all of our compensation plans are heavily weighted toward incentive compensation which rewards productivity and profitability. We implemented a temporary compensation floor for production and non-production hourly teammates and committed to offering at least their normal benefits during the crisis. Nucor’s executive compensation program intentionally sets base salaries below the market median for similar size industrial and materials companies. With lower profitability in 2020 as compared to the prior year, our executive leadership incurred a reduction in earned incentive compensation on an absolute dollar and percentage basis compared to compensation attributable to 2019 performance. Nucor’s cash and cash equivalents, short-term investments and restricted cash and cash equivalents position remained strong at $3.16 billion at December 31, 2020, compared with $1.83 billion as of December 31, 2019. Approximately $316.0 million and $354.4 million of the cash and cash equivalents position at December 31, 2020 and 2019, respectively, was held by our majority-owned joint ventures. Cash flows provided by operating activities provide us with a significant source of liquidity. When needed, we have external short-term financing sources available, including the issuance of commercial paper and borrowings under our bank credit facilities. We also issue long-term debt securities from time to time. To further enhance our liquidity, Nucor took advantage of attractive market conditions during the second quarter of 2020 to issue low coupon debt in the form of long-term notes. In May, Nucor issued $500.0 million of 2.000% Notes due 2025 and $500.0 million of 2.700% Notes due 2030. Additionally, in July, Nucor became an obligor with respect to $162.6 million in 40-year variable-rate Green Bonds to partially fund the capital costs associated with the construction of our plate mill located in Brandenburg, Kentucky. Proceeds of the Green Bonds are held on Nucor’s balance sheet as restricted cash and cash equivalents until they are utilized in connection with the construction of the plate mill in Brandenburg, Kentucky. In December 2020, Nucor exchanged $106.7 million of its 6.400% Notes due 2037, $161.9 million of its 5.200% Notes due 2043 and $170.8 million of its 4.400% Notes due 2048 with holders of the existing notes for $439.3 million of its 2.979% Notes due 2055 and a cash component of $180.3 million. This exchange transaction has been accounted for as a modification and, as such, the cash component of $180.3 million has been capitalized as a reduction of long-term debt and is being amortized into interest expense over the life of the new notes. Nucor’s $1.50 billion revolving credit facility is undrawn and was amended and restated in April 2018 to extend the maturity date to April 2023. We believe our financial strength is a key strategic advantage among domestic steel producers, particularly during recessionary business cycles. We carry the highest credit ratings of any steel producer headquartered in North America, with an A- long-term rating from Standard and Poor’s and a Baa1 long-term rating from Moody’s. Our credit ratings are dependent, however, upon a number of factors, both qualitative and quantitative, and are subject to change at any time. The disclosure of our credit ratings is made in order to enhance investors’ understanding of our sources of liquidity and the impact of our credit ratings on our cost of funds. Based upon the preceding factors, we expect to continue to have adequate access to the capital markets at a reasonable cost of funds for liquidity purposes when needed. Selected Measures of Liquidity and Capital Resources (Dollars in thousands) December 31, 2020 2019 Cash and cash equivalents $ 2,639,671 $ 1,534,605 Short-term investments 408,004 300,040 Restriced cash and cash equivalents 115,258 — Working capital 6,860,802 5,762,596 Current ratio 3.6 3.3 The current ratio, which is calculated by dividing current assets by current liabilities, was 3.6 at year-end 2020 compared with 3.3 at year-end 2019. The current ratio was positively impacted by the 66% increase in cash and cash equivalents and short-term investments. The increase in cash and cash equivalents and short-term investments was a result of the issuance of $500.0 million of 2.000% Notes 34 Table of Contents due 2025 and $500.0 million of 2.700% Notes due 2030 and robust cash provided by operations during 2020. In 2020, total accounts receivable turned approximately every six weeks and inventories turned approximately every 11 weeks. These ratios compare with accounts receivable turnover of approximately every five weeks and inventory turnover of approximately every 11 weeks in 2019. Funds provided by operations, cash and cash equivalents, short-term investments, restricted cash and cash equivalents and new borrowings under existing credit facilities are expected to be adequate to meet future capital expenditure and working capital requirements for existing operations for at least the next 24 months. Additionally, Nucor has no significant debt maturities until September 2022. Off-Balance Sheet Arrangements We have a simple capital structure with no off-balance sheet arrangements or relationships with unconsolidated special purpose entities that we believe could have a material impact on our financial condition or liquidity. Capital Allocation Strategy We believe that our conservative financial practices have served us well in the past and are serving us well today. Nucor’s financial strength allows for a consistent, balanced approach to capital allocation throughout the business cycle. Nucor’s highest capital allocation priority is to reinvest in our business to ensure our continued profitable growth over the long term. We have historically done this by investing to optimize our existing operations, initiate greenfield expansions and make acquisitions. Our second priority is to return capital to our stockholders through cash dividends and share repurchases. We intend to return a minimum of 40% of our net earnings to our stockholders, while maintaining a debt-to-capital ratio that supports a strong investment grade credit rating. The Company repurchased $39.5 million of shares of its common stock in 2020 ($298.5 million in 2019 and $854.0 million in 2018). Operating Activities Cash provided by operating activities was $2.70 billion in 2020 as compared to $2.81 billion in 2019. Net earnings declined by $534.9 million over the prior year, which included $613.6 million of non-cash losses and impairments of assets related to our equity method investment in Duferdofin Nucor, impairment of certain inventory and long-lived assets in the steel mills segment and a write-down of our unproved natural gas well assets in the raw materials segment ($66.9 million of non-cash losses and impairments of assets in 2019). Additionally, the decrease in cash provided by operating activities was driven by the $209.3 million reduction of cash provided by operating assets and operating liabilities. Changes in operating assets and operating liabilities (exclusive of acquisitions and dispositions) provided cash of $204.0 million in 2020 as compared to $413.3 million in 2019. The funding of working capital increased in 2020 over the prior year mainly due to increases in accounts receivable and a more moderate decrease in inventory from year-end 2019 to the end of 2020 as compared to the same prior year period, offset by an increase in accounts payable and a more moderate cash outflow related to salaries, wages and related accruals. Accounts receivable at the end of 2020 increased from prior year-end due to a 2.5% increase in composite sales price. From year-end 2019 to year-end 2020, inventories decreased by $273.0 million due to a 13% decrease in inventory tons, as compared to inventories decreasing by $711.4 million due to a 22% decline in average scrap and scrap substitutes cost per ton in inventory and a 9% decline in total inventory tons on hand in the prior year period. Inventory tons reduction, especially scrap, was a particular focus due to uncertainty from the COVID-19 pandemic beginning in the second quarter of 2020, and our investment in inventory at the end of 2020 continued to decline from prior quarter-end levels. Accounts payable increased due to the increase in average scrap and scrap substitute cost per ton mentioned previously. Finally, the decrease in cash used to fund salaries, wages and related accruals in 2020 as compared to 2019 was due to the timing of incentive compensation payments and lower current year profit sharing accruals due to the decreased profitability of the Company. The 2019 payments were based on Nucor’s financial performance in 2018, which was a record earnings year. 35 Table of Contents Investing Activities Our business is capital intensive; therefore, cash used in investing activities primarily represents capital expenditures for new facilities, the expansion and upgrading of existing facilities and the acquisition of other companies. Cash used in investing activities in 2020 was $1.76 billion as compared to $1.79 billion in 2019. Cash used for capital expenditures was relatively flat from the prior year, $1.54 billion in 2020 as opposed to $1.48 billion in 2019. The primary drivers of capital expenditures were related to the sheet mill expansion at Nucor Steel Gallatin, the flex galvanizing line at Nucor Steel Arkansas, the new micro mill greenfield expansion in Frostproof, Florida, and the new plate mill in Brandenburg, Kentucky. Also impacting cash used in investing activities in 2020 was the purchase of $488.5 million of investments, as opposed to $367.7 million in the prior year. These purchases were partially offset by proceeds from the sale of investments of $392.2 million in 2020 and $67.7 million in 2019. Additionally, 2019 benefited from cash provided by the divestiture of an affiliate of $67.6 million related to the sale of an equity method investment. Financing Activities Cash provided by financing activities during 2020 was $285.9 million as compared to cash used in financing activities of $880.4 million in 2019. The majority of this change related to the debt issuance discussed previously, as well as Nucor becoming an obligor with respect to $162.6 million in 40-year variable rate Green Bonds to partially fund the capital costs associated with the construction of our plate mill located in Brandenburg, Kentucky. There were also approximately $39.5 million of stock repurchases in 2020, all in the first quarter, as compared to $298.5 million in 2019. In addition, in the fourth quarter of 2020, $180.4 million of cash was used for payment of premiums on the debt exchange where Nucor issued $439.2 million of its new 2.979% Notes due 2055 in exchange for certain of its existing notes. Finally, in the first quarter of 2020, one of the remarketing agents for Nucor’s industrial development revenue bonds (“IDRBs”) put a portion of two bonds to us, resulting in repayment of $32.0 million in long-term debt. We subsequently remarketed the bonds and received $32.0 million in proceeds. Nucor’s IDRBs are variable-rate, tax-exempt bonds which have interest rates that reset on a weekly basis through an ongoing remarketing process. We expect our bonds to be successfully placed with investors at the market driven rates in the future. However, there have been times in severe economic downturns, as was the case during the first quarter of 2020 as a result of the economic impacts of COVID-19, that a remarketing agent is unable to remarket Nucor’s bonds successfully and is unwilling to temporarily hold the bonds. In that situation, which has been rare in our experience, it is possible that the bonds could be put back to us in the future. In this instance during the first quarter of 2020, the IDRBs were remarketed successfully in a short period of time. However, in the event of a prolonged failed remarketing, we have, among other options, availability under our $1.50 billion revolving credit facility to repurchase the IDRBs until they are remarketed successfully. In general, Nucor has the ability and intent to refinance the IDRB debt on a long-term basis, therefore we classify the IDRBs as a long-term liability. The remaining $65.2 million of debt that was repaid during 2020 was related to a different tranche of Nucor’s IDRBs that was repurchased as part of our investment strategy and the payoff of a series of IDRBs that matured during the third quarter. Our undrawn revolving credit facility includes only one financial covenant, which is a limit of 60% on the ratio of funded debt to total capitalization. In addition, the undrawn revolving credit facility contains customary non-financial covenants, including a limit on Nucor’s ability to pledge the Company’s assets and a limit on consolidations, mergers and sales of assets. Our funded debt to total capital ratio was 32% at the end of 2020 and 29% at the end of 2019, and we were in compliance with all other covenants under our undrawn revolving credit facility at the end of 2020. Market Risk Nucor’s largest exposure to market risk is in our steel mills and steel products segments. Our utilization rates for the steel mills and steel products facilities for the fourth quarter of 2020 were 87% and 71%, respectively. A significant portion of our steel mills and steel products segments’ sales are into the commercial, industrial and municipal construction markets. Our largest single customer in 2020 represented less than 5% of sales and consistently pays within terms. In the raw materials segment, we are exposed to price fluctuations related to the purchase of scrap steel, pig iron and iron ore. Our exposure to market risk is mitigated by the fact that our steel mills use a significant portion of the products of this segment. 36 Table of Contents Nucor’s tax-exempt IDRBs have variable interest rates that are adjusted weekly. These IDRBs represented 22% of Nucor’s long-term debt outstanding at December 31, 2020. The remaining 78% of Nucor’s long-term debt is at fixed rates. Future changes in interest rates are not expected to significantly impact earnings. From time to time, Nucor makes use of interest rate swaps to manage interest rate risk. As of December 31, 2020, there were no such contracts outstanding. Nucor’s investment practice is to invest in securities that are highly liquid with short maturities. As a result, we do not expect changes in interest rates to have a significant impact on the value of our investment securities recorded as short-term investments. Nucor also uses derivative financial instruments from time to time to partially manage its exposure to price risk related to purchases of natural gas used in the production process, as well as scrap, copper and aluminum purchased for resale to its customers. In addition, Nucor uses forward foreign exchange contracts from time to time to hedge cash flows associated with certain assets and liabilities, firm commitments and anticipated transactions. Nucor generally does not enter into derivative instruments for any purpose other than hedging the cash flows associated with specific volumes of commodities that will be purchased and processed or sold in future periods and hedging the exposures related to changes in the fair value of outstanding fixed-rate debt instruments and foreign currency transactions. Nucor recognizes all derivative instruments in the consolidated balance sheets at fair value. The Company is exposed to foreign currency risk primarily through its operations in Canada and Mexico. We periodically use derivative contracts to mitigate the risk of currency fluctuations. Dividends Nucor has increased its base cash dividend every year since it began paying dividends in 1973. Nucor paid dividends of $1.61 per share in 2020, compared with $1.60 per share in 2019. In December 2019, the Board of Directors increased the regular quarterly cash dividend on Nucor’s common stock to $0.405 per share. Over the past 10 years, Nucor has returned approximately $6.00 billion in capital to its stockholders in the form of base dividends and share repurchases. In February 2021, the Board of Directors declared Nucor’s 192nd consecutive quarterly cash dividend of $0.405 per share payable on May 11, 2021 to stockholders of record on March 31, 2021. Contractual Obligations and Other Commercial Commitments The following table sets forth our contractual obligations and other commercial commitments as of December 31, 2020 for the periods presented (in thousands): Payments Due By Period Contractual Obligations Total 2021 2022-2023 2024-2025 2026 and thereafter Long-term debt $ 5,403,240 $ — $ 1,101,000 $ 500,000 $ 3,802,240 Estimated interest on long-term debt (1) 2,288,503 169,935 299,534 244,559 1,574,475 Finance leases 162,006 20,676 38,274 24,525 78,531 Operating leases 117,221 23,134 36,361 23,545 34,181 Raw material purchase commitments (2) 2,997,021 1,248,172 1,017,162 312,453 419,234 Utility purchase commitments (2) 803,562 274,186 206,959 120,594 201,823 Other unconditional purchase obligations (3) 1,058,932 1,041,822 9,463 3,159 4,488 Other long-term obligations (4) 488,618 322,553 34,052 2,283 129,730 Total contractual obligations $ 13,319,103 $ 3,100,478 $ 2,742,805 $ 1,231,118 $ 6,244,702 (1) Interest is estimated using applicable rates at December 31, 2020 for Nucor’s outstanding fixed-rate and variable-rate debt. (2) Nucor enters into contracts for the purchase of scrap and scrap substitutes, iron ore, electricity, natural gas, and other raw materials and related services. These contracts include multi-year commitments and minimum annual purchase requirements and are valued at prices in effect on December 31, 2020, or according to the contract 37 Table of Contents language. These contracts are part of normal operations and are reflected in historical operating cash flow trends. We do not believe such commitments will adversely affect our liquidity position. (3) Purchase obligations include commitments for capital expenditures on operating machinery and equipment. (4) Other long-term obligations include amounts associated with Nucor’s early-retiree medical benefits, management compensation and guarantees. Note: In addition to the amounts shown in the table above, $48.0 million of unrecognized tax benefits have been recorded as liabilities, and we are uncertain as to if or when such amounts may be settled. Related to these unrecognized tax benefits, we have also recorded a liability for potential penalties and interest of $12.0 million at December 31, 2020. Outlook In 2021, we will continue to take advantage of our position of strength to grow Nucor’s long-term earnings power and stockholder value by continuing to successfully focus on profitable growth strategies. We have invested significant capital over a broad range of strategic acquisitions and investments that we believe will further enhance our ability to: grow Nucor’s long-term earnings power by increasing our channels to market; expand our product portfolios into higher value-added offerings that are less vulnerable to imports; improve our highly variable low-cost structure; build upon our market leadership positions; and achieve commercial excellence. We are utilizing Nucor’s financial strength to execute on investment opportunities to further grow our long-term earnings capacity. We expect Nucor’s earnings in the first quarter of 2021 to increase significantly as compared to the fourth quarter of 2020. We expect a very significant increase in earnings in the steel mills segment in the first quarter of 2021 as compared to the fourth quarter of 2020 (excluding the fourth quarter of 2020 impairment charges), due to price increases that were announced in the fourth quarter of 2020 and expected higher volumes. We expect the profitability of the steel products segment in the first quarter of 2021 to be similar to the fourth quarter of 2020. We expect the performance of the raw materials segment to significantly increase in the first quarter of 2021 as compared to the fourth quarter of 2020, due to an improvement in pricing for raw materials and the absence of the impairment charge related to our unproved natural gas assets taken in 2020. As we begin 2021, we see key economic indicators rebounding and stable or improving market conditions in 23 of the 24 steel intensive end-use markets that we monitor. We believe that full year domestic steel demand will experience modest growth in 2021 as compared to 2020. Backlog volumes in both the steel mills and steel products segments were significantly higher at the end of 2020 compared to the end of 2019. We are ever mindful of the threat of increases in imported steel stemming from the still significant excess foreign steel capacity. The Section 232 tariffs are having their intended impact by taking artificially low-cost foreign imports out of the U.S. market. Over the past decade, the steel industry has won several important trade cases that addressed unfairly traded imports prior to the imposition of the Section 232 tariffs. The cumulative impact of those trade case victories also took a sizeable amount of unfairly traded imports out of the market, and those duties will remain in the event the Section 232 tariffs are lifted. We are committed to executing on the opportunities we see ahead to reward Nucor stockholders with very attractive long-term returns on their valuable capital invested in our company. Our industry-leading financial strength allows us to support investments in our facilities that we believe will enable us to generate increased profitability. In 2021, as we have in our past, we will allocate capital to investments that we believe will build our long-term earnings power. Capital expenditures are currently projected to be approximately $2.00 billion in 2021 and we will be very focused on ensuring that these investments generate appropriate returns. 38 Table of Contents Critical Accounting Policies and Estimates Our discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in conformity with generally accepted accounting principles in the United States of America. The preparation of these consolidated financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at year end and the reported amount of revenues and expenses during the year. On an ongoing basis, we evaluate our estimates, including those related to the valuation allowances for receivables, the carrying value of non-current assets and reserves for environmental obligations and income taxes. Our estimates are based on historical experience and various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Accordingly, actual costs could differ materially from these estimates under different assumptions or conditions. We believe the following critical accounting policies affect our significant judgments and estimates used in the preparation of our consolidated financial statements. Allowances for Doubtful Accounts We maintain allowances for doubtful accounts for estimated losses resulting from the inability of our customers to make required payments. If the financial condition of our customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required. Inventories Inventories are stated at the lower of cost or market. The Company records any amount required to reduce the carrying value of inventory to net realizable value as a charge to cost of products sold. Scrap and scrap substitute costs are a very significant component of the raw material, semi-finished and finished product inventory balances. The vast majority of the Company’s inventory is recorded on the first-in, first-out method. Production costs are applied to semi-finished and finished product inventory from the approximate period in which they are produced. If steel selling prices were to decline in future quarters, write-downs of inventory could result. Specifically, the valuation of raw material inventories purchased during periods of peak market pricing would most likely be impacted. Low utilization rates at our steel mills or raw materials facilities could hinder our ability to work through high-priced scrap and scrap substitutes (particularly pig iron and iron ore), leading to period-end exposure when comparing carrying value to net realizable value. Long-Lived Asset Impairments We evaluate our property, plant and equipment and finite-lived intangible assets for potential impairment on an individual asset basis or at the lowest level asset grouping for which cash flows can be independently identified. Asset impairments are assessed whenever circumstances indicate that the carrying amounts of those productive assets could exceed their projected undiscounted cash flows. In developing estimated values for assets that we currently use in our operations, we utilize judgments and assumptions of future undiscounted cash flows that the assets will produce. When it is determined that an impairment exists, the related assets are written down to estimated fair market value. Certain long-lived asset groupings were tested for impairment during the fourth quarter of 2020. Undiscounted cash flows for each asset grouping were estimated using management’s long-range estimates of market conditions associated with each asset grouping over the estimated useful life of the principal asset within the group. Our undiscounted cash flow analysis indicated that, other than the groupings discussed below, the tested long-lived asset groupings were recoverable as of December 31, 2020; however, if our projected cash flows are not realized, either because of an extended recessionary period or other unforeseen events, impairment charges may be required in future periods. A 13% decrease in the projected cash flows of each of our asset groupings would not result in an impairment. 39 Table of Contents Steel Mills Segment Asset Impairments In 2019, Nucor recorded a non-cash impairment charge of $20.0 million related to certain property, plant and equipment at our plate mill in Texas. This charge is included in losses and impairments of assets in the consolidated statement of earnings for the year ended December 31, 2019. In 2020, Nucor recorded non-cash impairment charges totaling $103.2 million related to certain inventory and long-lived assets, which primarily related to our Castrip sheet mill operations. Due to the advancements in the capabilities at our new cold mill and galvanizing line we have under construction at Nucor Steel Arkansas, we believe the value of the technology and process has diminished for Nucor. As such, the existing Castrip assets are not expected to be materially utilized going forward. These charges are included in losses and impairments of assets in the consolidated statement of earnings for the year ended December 31, 2020. Raw Materials Segment Asset Impairments In the third quarter of 2018, due to the deteriorating natural gas pricing environment at our sales point in the Piceance Basin, Nucor determined a triggering event had occurred and performed an impairment analysis that resulted in $110.0 million of non-cash impairment charges relating to two of its three groups (“fields”) of wells. In the fourth quarter of 2019, due to the deteriorating natural gas pricing environment at our sales point in the Piceance Basin as well as the decreased performance of the natural gas well assets, Nucor determined a triggering event had occurred and performed an impairment analysis on all three fields of wells. As a result of the fourth quarter of 2019 analysis, a $35.0 million non-cash impairment charge was recorded on the field of wells that was not previously impaired in the third quarter of 2018. An increase in the estimated lease operating cost projections was the primary factor in causing this field of wells to be impaired. The non-cash impairment charges are included in losses and impairments of assets in the consolidated statements of earnings for the years ended December 31, 2019 and 2018. One of the main assumptions that most significantly affects the undiscounted cash flows determination is management’s estimate of future pricing of natural gas and natural gas liquids. The pricing used in the impairment assessments was developed by management based on projected natural gas market supply and demand dynamics, in conjunction with a review of projections by market analysts. Management also makes key estimates on the expected reserve levels and on the expected lease operating costs. The impairment assessments were performed on each of Nucor’s three fields of wells, with each field defined by common geographic location. The combined carrying value of the three fields of wells was $71.7 million at December 31, 2020 ($78.9 million at December 31, 2019). Changes in the natural gas industry or a prolonged low-price environment beyond what had already been assumed in the assessments could cause management to revise the natural gas and natural gas liquids price assumptions, the estimated reserves or the estimated lease operating costs. Unfavorable revisions to these assumptions or estimates could possibly result in further impairment of some or all of the fields of proved well assets. In 2020, regulatory authorities in Colorado adopted new rules that became effective January 2021. One of these rules increases drilling setback distances. In the fourth quarter of 2020, Nucor determined a triggering event had occurred, as we do not expect to be able to access the full extent of the resources in the ground, and performed an impairment analysis. As a result, Nucor recorded a $27.0 million non-cash impairment charge related to the write-down of our leasehold interest in unproved oil and gas properties. This charge is included in losses and impairments of assets in the consolidated statement of earnings for the year ended December 31, 2020. Goodwill and Intangibles Goodwill is tested annually for impairment and whenever events or circumstances change that would make it more likely than not that an impairment may have occurred. We perform our annual 40 Table of Contents impairment analysis as of the first day of the fourth quarter each year. The evaluation of impairment involves comparing the current estimated fair value of each reporting unit to the recorded value, including goodwill. When appropriate, Nucor performs a qualitative assessment to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount. For certain reporting units, it is necessary to perform a quantitative analysis. In these instances, a discounted cash flow model is used to determine the current estimated fair value of these reporting units. Significant assumptions used to determine the fair value of each reporting unit as part of our annual testing (and any required interim testing) include: (i) expected cash flow for the five-year period following the testing date (including market share, sales volumes and prices, raw materials and other costs to produce and estimated capital needs); (ii) an estimated terminal value using a terminal year growth rate determined based on the growth prospects of the reporting unit; (iii) a discount rate based on management’s best estimate of the after-tax weighted-average cost of capital; and (iv) a probability-weighted scenario approach by which varying cash flows are assigned to certain scenarios based on the likelihood of occurrence. Management considers historical and anticipated future results, general economic and market conditions, the impact of planned business and operational strategies and all available information at the time the fair values of its reporting units are estimated. Those estimates and judgments may or may not ultimately prove appropriate. Our fourth quarter 2020 annual goodwill impairment analysis did not result in an impairment charge. Management does not believe that future impairment of these reporting units is probable. However, the performance of certain businesses that comprise our reporting units requires continued improvement. An increase of approximately 50 basis points in the discount rate, a critical assumption in which a minor change can have a significant impact on the estimated fair value, would not result in an impairment charge. See Note 8 to the Company’s consolidated financial statements for further discussion of the results of the Company’s 2020 annual goodwill impairment analysis. Nucor will continue to monitor operating results within all reporting units throughout 2021 in an effort to determine if events and circumstances warrant further interim impairment testing. Otherwise, all reporting units will again be subject to the required annual qualitative and/or quantitative impairment test during our fourth quarter of 2021. Changes in the judgments and estimates underlying our analysis of goodwill for possible impairment, including expected future operating cash flows and discount rate, could decrease the estimated fair value of our reporting units in the future and could result in an impairment of goodwill. Equity Method Investments Investments in joint ventures in which Nucor shares control over the financial and operating decisions but in which Nucor is not the primary beneficiary are accounted for under the equity method. Each of the Company’s equity method investments is subject to a review for impairment if, and when, circumstances indicate that a decline in value below its carrying amount may have occurred. Examples of such circumstances include, but are not limited to, a significant deterioration in the earnings performance or business prospects of the investee; missed financial projections; a significant adverse change in the regulatory, tax, economic or technological environment of the investee; a significant adverse change in the general market condition of either the geographic area or the industry in which the investee operates; and recurring negative cash flows from operations. When management considers the decline to be other than temporary, the Company would write down the related investment to its estimated fair market value. An other-than-temporary decline in carrying value is determined to have occurred when, in management’s judgment, a decline in fair value below carrying value is of such length of time and/or severity that it is considered long-term. In the event that an impairment review is necessary, we calculate the estimated fair value of our equity method investments using a probability-weighted multiple-scenario income approach. Management’s analysis includes three discounted cash flow scenarios (best case, base case and recessionary case), which contain forecasted near-term cash flows under each scenario. Generally, (i) the best case scenario contains estimates of future results ranging from slightly higher than recent operating performance to levels that are consistent with historical operating and financial performance; (ii) the base case scenario contains estimates of future results ranging from generally in line with recent operating performance to levels that are more conservative than historical operating and financial performance; and (iii) the recessionary case scenario contains estimates of future results which include limited growth resulting only from operational cost improvements and limited benefits of new higher-value product offerings. Management determines the probability that each cash flow scenario will come to fruition based 41 Table of Contents on the specific facts and circumstances of each of the preceding scenarios, with the base case typically receiving the majority of the weighting. Key assumptions used to determine the fair value of our equity method investments include: (i) expected cash flow for the six-year period following the testing date (including market share, sales volumes and prices, costs to produce and estimated capital needs); (ii) an estimated terminal value using a terminal year growth rate determined based on the growth prospects of the investment; (iii) a discount rate based on management’s best estimate of the after-tax weighted-average cost of capital; and (iv) a probability-weighted scenario approach by which varying cash flows are assigned to certain scenarios based on the likelihood of occurrence. While the assumptions that most significantly affect the fair value determination include projected revenues, metal margins and discount rate, the assumptions are often interdependent, and no single factor predominates in determining the estimated fair value. Management considers historical and anticipated future results, general economic and market conditions, the impact of planned business and operational strategies and all available information at the time the fair values of its investments are estimated. Those estimates and judgments may or may not ultimately prove appropriate. Nucor determined that a triggering event occurred in the first quarter of 2020 with respect to its equity method investment in Duferdofin Nucor due to adverse developments in the joint venture’s commercial outlook, which were exacerbated by the COVID-19 pandemic, all of which negatively impacted the joint venture’s strategic direction. After completing its impairment assessment, Nucor determined that the carrying amount exceeded its estimated fair value and the impairment condition was considered to be other than temporary. Therefore, Nucor recorded a $250.0 million impairment charge in the first quarter of 2020. The assumptions that most significantly affected the fair value determination included projected cash flows and the discount rate. The Company-specific inputs for measuring fair value are considered “Level 3” or unobservable inputs that are not corroborated by market data under applicable fair value authoritative guidance, as quoted market prices are not available. Throughout 2020, additional capital contributions were made by the Company to Duferdofin Nucor that were immediately impaired. These additional capital contributions resulted in $5.0 million, $6.6 million and $25.4 million impairment charges against our investment in Duferdofin Nucor in the second, third and fourth quarters of 2020, respectively. Also, in the fourth quarter of 2020, Nucor reclassified into earnings, $158.6 million of cumulative foreign currency translation losses on our investment in Duferdofin Nucor. In 2020, total impairment charges, including the aforementioned note receivable, related to our investment in Duferdofin Nucor were approximately $483.5 million. These non-cash impairment charges are included in the steel mills segment and in losses and impairments of assets in the consolidated statement of earnings for the year ended December 31, 2020. Environmental Remediation We are subject to environmental laws and regulations established by federal, state and local authorities, and we make provisions for the estimated costs related to compliance. Undiscounted remediation liabilities are accrued based on estimates of known environmental exposures. The accruals are reviewed periodically and, as investigations and remediation proceed, adjustments are made as we believe are necessary. Our measurement of environmental liabilities is based on currently available facts, present laws and regulations and current technology. Income Taxes We utilize the liability method of accounting for income taxes. Under the liability method, deferred taxes are determined based on the temporary differences between the financial statement and tax basis of assets and liabilities using tax rates expected to be in effect during the years in which the basis differences reverse. A valuation allowance is recorded when it is more likely than not that some of the deferred tax assets will not be realized. We recognize the effect of income tax positions only if those positions are more likely than not of being sustained. Potential accrued interest and penalties related to unrecognized tax benefits within operations are recognized as a component of interest expense and other expenses. 42 Table of Contents Note Regarding Forward-Looking Statements Certain statements made in this report, or in other public filings, press releases, or other written or oral communications made by Nucor, which are not historical facts are forward-looking statements subject to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. These forward-looking statements involve risks and uncertainties which we expect will or may occur in the future and may impact our business, financial condition and results of operations. The words “anticipate,” “believe,” “expect,” “intend,” “project,” “may,” “will,” “should,” “could” and similar expressions are intended to identify those forward-looking statements. These forward-looking statements reflect the Company’s best judgment based on current information, and, although we base these statements on circumstances that we believe to be reasonable when made, there can be no assurance that future events will not affect the accuracy of such forward-looking information. As such, the forward-looking statements are not guarantees of future performance, and actual results may vary materially from the projected results and expectations discussed in this report. Factors that might cause the Company’s actual results to differ materially from those anticipated in forward-looking statements include, but are not limited to: (1) competitive pressure on sales and pricing, including pressure from imports and substitute materials; (2) U.S. and foreign trade policies affecting steel imports or exports; (3) the sensitivity of the results of our operations to prevailing market steel prices and changes in the supply and cost of raw materials, including pig iron, iron ore and scrap steel; (4) the availability and cost of electricity and natural gas which could negatively affect our cost of steel production or result in a delay or cancellation of existing or future drilling within our natural gas drilling programs; (5) critical equipment failures and business interruptions; (6) market demand for steel products, which, in the case of many of our products, is driven by the level of nonresidential construction activity in the United States; (7) impairment in the recorded value of inventory, equity investments, fixed assets, goodwill or other long-lived assets; (8) uncertainties surrounding the global economy, including excess world capacity for steel production; (9) fluctuations in currency conversion rates; (10) significant changes in laws or government regulations affecting environmental compliance, including legislation and regulations that result in greater regulation of GHG emissions that could increase our energy costs and our capital expenditures and operating costs or cause one or more of our permits to be revoked or make it more difficult to obtain permit modifications; (11) the cyclical nature of the steel industry; (12) capital investments and their impact on our performance; (13) our safety performance; (14) the impact of the COVID-19 pandemic; and (15) the risks discussed in Part I, “Item 1A. Risk Factors” of this report. Caution should be taken not to place undue reliance on the forward-looking statements included in this report. We assume no obligation to update any forward-looking statements except as may be required by law. In evaluating forward-looking statements, these risks and uncertainties should be considered, together with the other risks described from time to time in our reports and other filings with the SEC. 43 Table of Contents Item 7A. Quantitative and Qualitative Disclosures About Market Risk In the ordinary course of business, Nucor is exposed to a variety of market risks. We continually monitor these risks and develop strategies to manage them. Interest Rate Risk – Nucor manages interest rate risk by using a combination of variable-rate and fixed-rate debt. At December 31, 2020, approximately 22% of Nucor’s long-term debt was in industrial revenue bonds that have variable interest rates that are adjusted weekly. The remaining 78% of Nucor’s long-term debt was at fixed rates. Future changes in interest rates are not expected to significantly impact earnings. Nucor also occasionally makes use of interest rate swaps to manage net exposure to interest rate changes. As of December 31, 2020, there were no such contracts outstanding. Nucor’s investment practice is to invest in securities that are highly liquid with short maturities. As a result, we do not expect changes in interest rates to have a significant impact on the value of our investment securities recorded as short-term investments. Commodity Price Risk – In the ordinary course of business, Nucor is exposed to market risk for price fluctuations of raw materials and energy, principally scrap steel, other ferrous and nonferrous metals, alloys and natural gas. We attempt to negotiate the best prices for our raw materials and energy requirements and to obtain prices for our steel products that match market price movements in response to supply and demand. In periods of strong or stable demand for our products, we are more likely to be able to effectively reduce the normal time lag in passing through higher raw material costs so that we can maintain our gross margins. When demand for our products is weaker, this becomes more challenging. Our DRI facilities in Trinidad and Louisiana provide us with flexibility in managing our input costs. DRI is particularly important for operational flexibility when demand for prime scrap increases due to increased domestic steel production. Natural gas produced by Nucor’s drilling operations is being sold to third parties to offset our exposure to changes in the price of natural gas consumed by our Louisiana DRI facility and our steel mills in the United States. Nucor also periodically uses derivative financial instruments to hedge a portion of our exposure to price risk related to natural gas purchases used in the production process and to hedge a portion of our scrap, aluminum and copper purchases and sales. Gains and losses from derivatives designated as hedges are deferred in accumulated other comprehensive loss, net of income taxes on the consolidated balance sheets and recognized in net earnings in the same period as the underlying physical transaction. At December 31, 2020, accumulated other comprehensive loss, net of income taxes included $4.7 million in unrealized net-of-tax losses for the fair value of these derivative instruments. Changes in the fair values of derivatives not designated as hedges are recognized in earnings each period. The following table presents the negative effect on pre-tax earnings of a hypothetical change in the fair value of the derivative instruments outstanding at December 31, 2020, due to an assumed 10% and 25% change in the market price of each of the indicated commodities (in thousands): Commodity Derivative 10% Change 25% Change Natural gas $ 5,854 $ 14,635 Aluminum 5,413 13,542 Copper 3,487 8,719 Any resulting changes in fair value would be recorded as adjustments to accumulated other comprehensive loss, net of income taxes, or recognized in net earnings, as appropriate. These hypothetical losses would be partially offset by the benefit of lower prices paid or higher prices received for the physical commodities. Foreign Currency Risk – Nucor is exposed to foreign currency risk primarily through its operations in Canada, Europe and Mexico. We periodically use derivative contracts to mitigate the risk of currency fluctuations. Open foreign currency derivative contracts at December 31, 2020 and 2019 were insignificant. 44 Table of Contents
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+ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion and analysis of our financial condition and results of operations should be read in conjunction with “Item 1A. Risk Factors”, our Consolidated Financial Statements and related Notes thereto, as well as other cautionary statements and risks described elsewhere in this Annual Report on Form 10-K, before deciding to purchase, hold or sell shares of our common stock. OverviewOur Company and Our BusinessesNVIDIA pioneered accelerated computing to help solve the most challenging computational problems. Starting with a focus on PC graphics, we extended our focus in recent years to the revolutionary field of AI. Fueled by the sustained demand for exceptional 3D graphics and the scale of the gaming market, NVIDIA leveraged its GPU architecture to create platforms for virtual reality, HPC, and AI. Through fiscal year 2020, our reportable segments were GPU and Tegra Processor. We changed our reportable segments to "Graphics" and "Compute & Networking" starting with the first quarter of fiscal year 2021. Our Graphics segment includes GeForce GPUs for gaming and PCs, the GeForce NOW game streaming service and related infrastructure, and solutions for gaming platforms; Quadro/NVIDIA RTX GPUs for enterprise workstation graphics; vGPU software for cloud-based visual and virtual computing; and automotive platforms for infotainment systems.Our Compute & Networking segment includes Data Center platforms and systems for AI, HPC, and accelerated computing; Mellanox networking and interconnect solutions; automotive AI Cockpit, autonomous driving development agreements, and autonomous vehicle solutions; and Jetson for robotics and other embedded platforms.All prior period comparisons presented reflect our new reportable segments. Our market platforms – Gaming, Professional Visualization, Data Center, Automotive, OEM and Other – remain unchanged.Headquartered in Santa Clara, California, NVIDIA was incorporated in California in April 1993 and reincorporated in Delaware in April 1998. Recent Developments, Future Objectives and ChallengesPending Acquisition of Arm LimitedOn September 13, 2020, we entered into a Purchase Agreement with Arm and SoftBank for us to acquire, from SoftBank, all allotted and issued ordinary shares of Arm in a transaction valued at $40 billion. We paid $2 billion in cash at signing, or the Signing Consideration, and will pay upon closing of the acquisition $10 billion in cash and issue to SoftBank 44.3 million shares of our common stock with an aggregate value of $21.5 billion. The transaction includes a potential earn out, which is contingent on the achievement of certain financial performance targets by Arm during the fiscal year ending March 31, 2022. If the financial performance targets are achieved, Softbank can elect to receive either up to an additional $5 billion in cash or up to an additional 10.3 million shares of our common stock. We will issue up to $1.5 billion in restricted stock units to Arm employees after closing. The $2 billion paid upon signing was allocated between advanced consideration for the acquisition of $1.36 billion and the prepayment of intellectual property licenses from Arm of $0.17 billion and royalties of $0.47 billion, both with a 20-year term. The closing of the acquisition is subject to customary closing conditions, including receipt of specified governmental and regulatory consents and approvals and expiration of any related mandatory waiting period, and Arm's implementation of the reorganization and distribution of Arm’s IoT Services Group and certain other assets and liabilities. We are engaged with regulators in the United States, the United Kingdom, the European Union, China and other jurisdictions. If the Purchase Agreement is terminated under certain circumstances, we will be refunded $1.25 billion of the Signing Consideration. The $2 billion payment upon signing was allocated on a fair value basis and any refund of the Signing Consideration will use stated values in the Purchase Agreement. We believe the closing of the acquisition will likely occur in the first quarter of calendar year 2022.DemandOur products are manufactured based on estimates of customers’ future demand and our manufacturing lead times are very long. This could lead to a significant mismatch between supply and demand, giving rise to product shortages or excess inventory, and make our demand forecast more uncertain. We sell many of our products through a channel model, and our channel customers sell to retailers, distributors, and/or end customers. As a result, the decisions made 29Table of Contentsby our channel partners, retailers, and distributors in response to changing market conditions and the changing demand for our products could impact our financial results. In order to have shorter shipment lead times and quicker delivery schedules for our customers, we may build inventory for anticipated periods of growth which do not occur, may build inventory anticipating demand that does not materialize, or may build inventory to serve what we believe is pent-up demand. In periods with limited availability of capacity and components in our supply chain, we may place non-cancellable inventory orders significantly in advance of our normal lead times, pay premiums or provide deposits to secure normal and incremental future supply, which could negatively impact our financial results. Demand for our products is based on many factors, including our product introductions and transitions, competitor announcements, and competing technologies, all of which can impact the timing and amount of our revenue. For example, our GPUs for gaming are capable of digital currency mining. Demand and use of GPUs for cryptocurrency has fluctuated in the past and is likely to continue to change quickly. Volatility in the cryptocurrency market, including changes in the prices of cryptocurrencies, can impact demand for our products and our ability to estimate demand for our products. Changes to cryptocurrency standards and processes including, but not limited to, the pending Ethereum 2.0 standard may also create increased aftermarket resales of our GPUs and may reduce demand for our new GPUs. Additionally, consumer behavior during the COVID-19 pandemic, such as increased demand for our Gaming, Data Center and mobile workstation and laptop products and suppressed corporate demand for desktop workstations, has made it more difficult for us to estimate future demand, and these challenges may be more pronounced in the future if and when the effects of the pandemic subside. In estimating demand and evaluating trends, we make multiple assumptions, any of which may prove to be incorrect. COVID-19The worldwide COVID-19 pandemic is prompting governments and businesses to take unprecedented measures including restrictions on travel, temporary business closures, quarantines and shelter-in-place orders. It has significantly impacted global economic activity and caused volatility and disruption in global financial markets. Since March 2020, most of our employees have been working remotely and we have temporarily prohibited most business travel.Our Gaming and Data Center market platforms have benefited from stronger demand as people continue to work, learn, and play from home. In Professional Visualization, mobile workstations continue to benefit from work-from-home trends, and desktop workstation demand has started to recover, although not back to pre-COVID levels. In Automotive, COVID is no longer having a significant impact on demand. Throughout our supply chain, stronger demand globally has limited the availability of capacity and components, particularly in Gaming.As the COVID-19 pandemic continues, the timing and overall demand from customers and the availability of supply chain, logistical services and component supply may have a material net negative impact on our business and financial results. Refer to Part I, Item 1A of this Annual Report on Form 10-K for additional information under the heading “Risk Factors”.We believe our existing balances of cash, cash equivalents and marketable securities, along with commercial paper and other short-term liquidity arrangements, will be sufficient to satisfy its working capital needs, capital asset purchases, dividends, debt repayments and other liquidity requirements associated with its existing operations.Fiscal Year 2021 Summary Year Ended January 31,2021January 26,2020Change($ in millions, except per share data)Revenue$16,675 $10,918 Up 53%Gross margin62.3 %62.0 %Up 30 bpsOperating expenses$5,864 $3,922 Up 50%Income from operations$4,532 $2,846 Up 59%Net income$4,332 $2,796 Up 55%Net income per diluted share$6.90 $4.52 Up 53%Revenue for fiscal year 2021 was $16.68 billion, up 53% from a year earlier.30Table of ContentsFrom a market-platform perspective, Gaming revenue was up 41% from a year ago, reflecting higher sales across desktop and laptop GPUs for gaming, and game-console SOCs. GPUs for gaming benefited from the ramp of our GeForce RTX 30 Series based on the NVIDIA Ampere architecture.Professional Visualization revenue was down 13% from a year ago due to lower sales of GPUs for desktop workstations as enterprise demand was impacted by COVID. Data Center revenue was up 124% from a year ago. Revenue growth was driven by our Mellanox acquisition and the ramp of the NVIDIA Ampere GPU architecture. In fiscal year 2021, Mellanox revenue contributed 10% of total company revenue. Automotive revenue was down 23% from a year earlier, reflecting lower revenue from the expected ramp down of legacy infotainment modules and autonomous driving development agreements, partially offset by increases in AI cockpit and autonomous vehicle solutions.OEM and Other revenue was up 25% from a year ago, primarily due to higher volume of entry-level laptop GPUs.Gross margin for fiscal year 2021 was up 30 basis points from a year ago, primarily driven by product mix with higher Data Center and lower Automotive revenue, partially offset by Mellanox acquisition-related charges.Operating expenses for fiscal year 2021 were $5.86 billion, up 50% from a year ago. The growth was influenced by the inclusion of Mellanox in the second quarter of fiscal year 2021, employee additions and increases in employee compensation and related expenses. Additionally, acquisition-related and other costs of $411 million primarily include $190 million in non-recurring intangible amortization of Mellanox order backlog, $123 million in recurring amortization of Mellanox intangible assets, and $40 million related to the pending acquisition of Arm.Income from operations for fiscal year 2021 was $4.53 billion, up 59% from a year earlier. Net income and net income per diluted share for fiscal year 2021 were $4.33 billion and $6.90, up 55% and 53%, respectively, from a year earlier.Cash, cash equivalents and marketable securities were $11.56 billion as of January 31, 2021, compared with $10.90 billion as of January 26, 2020. The increase primarily reflects the issuance of the $5 billion of notes in March 2020 and cash-flow generation, partially offset by acquisitions.We paid $395 million in quarterly cash dividends in fiscal year 2021.Market Platform Highlights During fiscal year 2021, in our Gaming platform, we announced the launch of new laptop models powered by NVIDIA GeForce GPUs; unveiled GeForce RTX 30 Series GPUs including our second generation NVIDIA RTX; expanded NVIDIA GeForce NOW; announced that a range of games now support NVIDIA RTX ray tracing and DLSS AI super resolution; unveiled NVIDIA Reflex and NVIDIA Broadcast; expanded the RTX Studio lineup powered by new GeForce RTX SUPER GPUs; and released DLSS 2.0.In our Professional Visualization platform, we launched mobile workstations with Acer, Dell, HP, Lenovo and Microsoft based on NVIDIA Quadro graphics for professional creators; released NVIDIA Quadro View; collaborated with Adobe to bring GPU-accelerated neural filters to Adobe Photoshop AI-powered tools; powered Autodesk’s latest 3D visualization software with NVIDIA Quadro RTX; and collaborated with many other independent software vendors to help incorporate NVIDIA RTX and AI technology in their applications.In our Data Center platform, we announced the NVIDIA A100 Tensor Core GPU and DGX A100, the first products based on the NVIDIA Ampere architecture; announced more than 50 NVIDIA A100-powered systems with OEM partners and released NVIDIA-Certified Systems with NVIDIA A100 GPUs to OEMs; shared news that major cloud providers, including Google Cloud Platform, AWS, Microsoft Azure and Oracle Cloud Infrastructure, reached general availability of cloud computing instances based on the NVIDIA A100 GPU; announced the NVIDIA DGX SuperPOD Solution for Enterprise; introduced the new family of NVIDIA BlueField-2 DPUs; introduced new products for the EGX Edge AI platform; announced a broad partnership with VMware to create an end-to-end enterprise platform for AI and a new architecture for data center, cloud and edge; powered eight of the top 10, and two-thirds of the total systems, on the latest TOP500 list of the world’s fastest supercomputers; announced that five supercomputers backed by EuroHPC will use NVIDIA’s data center accelerators or networking; and set 16 AI performance records on the latest MLPerf benchmarks.In our Automotive platform, we announced with Mercedes-Benz that the automaker will launch software-defined, intelligent vehicles using end-to-end NVIDIA technology starting in 2024; announced that NVIDIA DRIVE autonomous 31Table of Contentsdriving technology is powering a range of electric vehicles from carmakers SAIC, Nio, Li Auto, Xpeng, robotaxi-maker Zoox, and cabless truck-maker Einride; announced that NVIDIA is powering the new Mercedes-Benz AI cockpit in the first half of 2021; announced that Hyundai Motor Group’s entire lineup of Hyundai, Kia and Genesis models will come standard with NVIDIA DRIVE in-vehicle infotainment systems starting in 2022; and expanded the NVIDIA DRIVE sensor ecosystem with new solutions.Critical Accounting Policies and EstimatesManagement’s discussion and analysis of financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States, or U.S. GAAP. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue, cost of revenue, expenses and related disclosure of contingencies. On an on-going basis, we evaluate our estimates, including those related to business combinations, inventories, revenue recognition, income taxes, and goodwill. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities. We believe the following critical accounting policies affect our significant judgments and estimates used in the preparation of our consolidated financial statements. Our management has discussed the development and selection of these critical accounting policies and estimates with the Audit Committee of our Board of Directors. The Audit Committee has reviewed our disclosures relating to our critical accounting policies and estimates in this Annual Report on Form 10-K.Business CombinationsThe application of acquisition accounting to a business acquisition requires that we identify the individual assets acquired and liabilities assumed and estimate the fair value of each. The fair value of assets acquired and liabilities assumed in a business acquisition are recognized at the acquisition date, with the purchase price exceeding the fair values being recognized as goodwill. Determining fair value of identifiable assets, particularly intangibles, liabilities acquired and contingent obligations assumed requires management to make estimates. In certain circumstances, the allocations of the purchase price are based upon preliminary estimates and assumptions and subject to revision when we receive final information, including appraisals and other analyses. Accordingly, the measurement period for such purchase price allocations will end when the information, or the facts and circumstances, becomes available, but will not exceed twelve months. We will recognize measurement-period adjustments during the period of resolution, including the effect on earnings of any amounts that would have been recorded in previous periods if the accounting had been completed at the acquisition date.Goodwill and intangible assets often represent a significant portion of the assets acquired in a business combination. We recognize the fair value of an acquired intangible apart from goodwill whenever the intangible arises from contractual or other legal rights, or when it can be separated or divided from the acquired entity and sold, transferred, licensed, rented or exchanged, either individually or in combination with a related contract, asset or liability. Intangible assets consist primarily of technology, customer relationships, order backlog and trade name acquired in a business combination and in-process research and development, or IPR&D. We generally assess the estimated fair values of acquired intangibles using a combination of valuation techniques. To estimate fair value, we are required to make certain estimates and assumptions, including future economic and market conditions, revenue growth, technology migration curve, and risk-adjusted discount rates. Our estimates require significant judgment and are based on historical data, various internal estimates, and external sources. Our assessment of IPR&D also includes consideration of the risk of the projects not achieving technological feasibility.InventoriesInventory cost is computed on an adjusted standard basis, which approximates actual cost on an average or first-in, first-out basis. We charge cost of sales for inventory provisions to write-down our inventory to the lower of cost or net realizable value or for obsolete or excess inventory. Most of our inventory provisions relate to excess quantities of products or components, based on our inventory levels and future product purchase commitments compared to assumptions about future demand and market conditions.Situations that may result in excess or obsolete inventory include changes in business and economic conditions, changes in market conditions, sudden and significant decreases in demand for our products, inventory obsolescence because of changing technology and customer requirements, failure to estimate customer demand properly, or 32Table of Contentsunexpected competitive pricing actions by our competition. In addition, cancellation or deferral of customer purchase orders could result in our holding excess inventory.The overall net effect on our gross margin from inventory provisions and sales of items previously written down was insignificant in fiscal years 2021 and 2020. As a fabless semiconductor company, we must make commitments to purchase inventory based on forecasts of future customer demand. In doing so, we must account for our third-party manufacturers' lead times and constraints. We also adjust to other market factors, such as product offerings and pricing actions by our competitors, new product transitions, and macroeconomic conditions - all of which may impact demand for our products.Refer to the Gross Profit and Gross Margin discussion below in this Management's Discussion and Analysis for further discussion.Revenue RecognitionWe derive our revenue from product sales, including hardware and systems, license and development arrangements, and software licensing. We determine revenue recognition through the following steps: (1) identification of the contract with a customer; (2) identification of the performance obligations in the contract; (3) determination of the transaction price; (4) allocation of the transaction price to the performance obligations in the contract (where revenue is allocated on a relative standalone selling price basis by maximizing the use of observable inputs to determine the standalone selling price for each performance obligation); and (5) recognition of revenue when, or as, we satisfy a performance obligation.Product Sales RevenueRevenue from product sales is recognized upon transfer of control of promised products to customers in an amount that reflects the consideration we expect to receive in exchange for those products. Certain products are sold along with support or extended warranty. Support and extended warranty revenue is recognized ratably over the service period, or as services are performed. Revenue is recognized net of allowances for returns, customer programs and any taxes collected from customers.For products sold with a right of return, we record a reduction to revenue by establishing a sales return allowance for estimated product returns at the time revenue is recognized, based primarily on historical return rates. However, if product returns for a fiscal period are anticipated to exceed historical return rates, we may determine that additional sales return allowances are required to properly reflect our estimated exposure for product returns.Our customer programs involve rebates, which are designed to serve as sales incentives to resellers of our products in various target markets, and marketing development funds, or MDFs, which represent monies paid to our partners that are earmarked for market segment development and are designed to support our partners’ activities while also promoting NVIDIA products. We account for customer programs as a reduction to revenue and accrue for potential rebates and MDFs based on the amount we expect to be claimed by customers.License and Development ArrangementsOur license and development arrangements with customers typically require significant customization of our intellectual property components. As a result, we recognize the revenue from the license and the revenue from the development services as a single performance obligation over the period in which the development services are performed. We measure progress to completion based on actual cost incurred to date as a percentage of the estimated total cost required to complete each project. If a loss on an arrangement becomes probable during a period, we record a provision for such loss in that period.Refer to Note 1 of the Notes to the Consolidated Financial Statements in Part IV, Item 15 of this Annual Report on Form 10-K for additional information.Income TaxesWe recognize federal, state and foreign current tax liabilities or assets based on our estimate of taxes payable or refundable in the current fiscal year by tax jurisdiction. We recognize federal, state and foreign deferred tax assets or liabilities, as appropriate, for our estimate of future tax effects attributable to temporary differences and carryforwards; and we record a valuation allowance to reduce any deferred tax assets by the amount of any tax benefits that, based on available evidence and judgment, are not expected to be realized.Our calculation of deferred tax assets and liabilities is based on certain estimates and judgments and involves dealing with uncertainties in the application of complex tax laws. Our estimates of deferred tax assets and liabilities may change 33Table of Contentsbased, in part, on added certainty or finality to an anticipated outcome, changes in accounting standards or tax laws in the United States, or foreign jurisdictions where we operate, or changes in other facts or circumstances. In addition, we recognize liabilities for potential United States and foreign income tax contingencies based on our estimate of whether, and the extent to which, additional taxes may be due. If we determine that payment of these amounts is unnecessary or if the recorded tax liability is less than our current assessment, we may be required to recognize an income tax benefit or additional income tax expense in our financial statements accordingly.As of January 31, 2021, we had a valuation allowance of $728 million related to state and certain foreign deferred tax assets that management determined are not likely to be realized due to jurisdictional projections of future taxable income, tax attributes usage limitation by certain jurisdictions, and potential utilization limitations of tax attributes acquired as a result of stock ownership changes. To the extent realization of the deferred tax assets becomes more-likely-than-not, we would recognize such deferred tax assets as an income tax benefit during the period.We recognize the benefit from a tax position only if it is more-likely-than-not that the position would be sustained upon audit based solely on the technical merits of the tax position. Our policy is to include interest and penalties related to unrecognized tax benefits as a component of income tax expense.Refer to Note 14 of the Notes to the Consolidated Financial Statements in Part IV, Item 15 of this Annual Report on Form 10-K for additional information.GoodwillGoodwill is subject to our annual impairment test during the fourth quarter of our fiscal year, or earlier, if indicators of potential impairment exist, using either a qualitative or a quantitative assessment. Our impairment review process compares the fair value of the reporting unit in which the goodwill resides to its carrying value. We changed our reportable segments to "Graphics" and "Compute & Networking" starting with the first quarter of fiscal year 2021. As a result, our reporting units also changed, and we reassigned the goodwill balance to the new reporting units based on their relative fair values. We determined there was no goodwill impairment immediately prior to the reorganization. As of January 31, 2021, the total carrying amount of goodwill was $4.19 billion and the amount of goodwill allocated to our Graphics and Compute & Networking reporting units was $347 million and $3.85 billion, respectively. Determining the fair value of a reporting unit requires us to make judgments and involves the use of significant estimates and assumptions. We also make judgments and assumptions in allocating assets and liabilities to each of our reporting units. We base our fair value estimates on assumptions we believe to be reasonable but that are unpredictable and inherently uncertain.We performed our annual goodwill assessment during the fourth quarter of fiscal year 2021 using a qualitative assessment and concluded there was no goodwill impairment.Refer to Note 6 of the Notes to the Consolidated Financial Statements in Part IV, Item 15 of this Annual Report on Form 10-K for additional information.Results of OperationsA discussion regarding our financial condition and results of operations for fiscal year 2021 compared to fiscal year 2020 is presented below. A discussion regarding our financial condition and results of operations for fiscal year 2020 compared to fiscal year 2019 can be found under Item 7 in our Annual Report on Form 10-K for the fiscal year ended January 26, 2020, filed with the SEC on February 20, 2020, which is available free of charge on the SEC’s website at http://www.sec.gov and at our investor relations website, http://investor.nvidia.com.34Table of ContentsThe following table sets forth, for the periods indicated, certain items in our Consolidated Statements of Income expressed as a percentage of revenue. Year Ended January 31,2021January 26,2020Revenue100.0 %100.0 %Cost of revenue37.7 38.0 Gross profit62.3 62.0 Operating expenses: Research and development23.5 25.9 Sales, general and administrative11.6 10.0 Total operating expenses35.1 35.9 Income from operations27.2 26.1 Interest income0.3 1.6 Interest expense(1.1)(0.5)Other, net0.1 — Other income (expense), net(0.7)1.1 Income before income tax expense26.5 27.2 Income tax expense0.5 1.6 Net income26.0 %25.6 %RevenueRevenue by Reportable SegmentsYear EndedJanuary 31,2021January 26,2020$Change%Change($ in millions)Graphics$9,834 $7,639 $2,195 29 %Compute & Networking6,841 3,279 3,562 109 %Total$16,675 $10,918 $5,757 53 %Graphics - Graphics segment revenue increased by 29% in fiscal year 2021 compared to fiscal year 2020, reflecting growth in GeForce GPUs and game console SOCs, partially offset by lower sales of Quadro/NVIDIA RTX workstations.Compute & Networking - Compute & Networking segment revenue increased by 109% in fiscal year 2021 compared to fiscal year 2020, reflecting the addition of Mellanox acquired on April 27, 2020 and the continued ramp of NVIDIA Ampere GPU architecture systems and new products.Concentration of RevenueRevenue from sales to customers outside of the United States accounted for 81% and 92% of total revenue for fiscal years 2021 and 2020, respectively. Revenue by geographic region is allocated to individual countries based on the location to which the products are initially billed even if the revenue is attributable to end customers in a different location.No customer represented 10% or more of total revenue for fiscal year 2021. Dell represented approximately 11% of our total revenue for fiscal year 2020, and was attributable primarily to the Graphics segment.Gross Profit and Gross MarginGross profit consists of total revenue, net of allowances, less cost of revenue. Cost of revenue consists primarily of the cost of semiconductors purchased from subcontractors, including wafer fabrication, assembly, testing and packaging, board and device costs, manufacturing support costs, including labor and overhead associated with such purchases, final test yield fallout, inventory and warranty provisions, memory and component costs, and shipping costs. Cost of 35Table of Contentsrevenue also includes acquisition-related costs, development costs for license and service arrangements, IP-related costs, and stock-based compensation related to personnel associated with manufacturing. Our overall gross margin was 62.3% and 62.0% for fiscal years 2021 and 2020, respectively. The increase in fiscal year 2021 was driven by product mix with higher Data Center and lower Automotive revenue, partially offset by Mellanox acquisition-related charges, including a non-recurring inventory step-up charge of $161 million and ongoing intangible asset amortization of $263 million. Inventory provisions totaled $116 million and $161 million for fiscal years 2021 and 2020, respectively. Sales of inventory that was previously written-off or written-down totaled $145 million for both fiscal years 2021 and 2020. As a result, the overall net effect on our gross margin was insignificant in both fiscal years 2021 and 2020.A discussion of our gross margin results for each of our reportable segments is as follows: Graphics - The gross margin of our Graphics segment increased during fiscal year 2021 when compared to fiscal year 2020, primarily driven by product mix with lower legacy automotive infotainment revenue and higher margin mix within Quadro/Nvidia RTX.Compute & Networking - The gross margin of our Compute & Networking segment increased during fiscal year 2021 when compared to fiscal year 2020, primarily driven by the addition of Mellanox products, higher margins in Data Center compute systems, and lower product mix of certain Automotive solutions.Operating Expenses Year Ended January 31,2021January 26,2020$Change%Change ($ in millions)Research and development expenses$3,924 $2,829 $1,095 39 %% of net revenue23.5 %25.9 % Sales, general and administrative expenses1,940 1,093 847 77 %% of net revenue11.6 %10.0 % Total operating expenses$5,864 $3,922 $1,942 50 %Research and DevelopmentResearch and development expenses increased by 39% in fiscal year 2021 compared to fiscal year 2020, driven primarily by the acquisition of Mellanox. In addition, the increases reflect employee compensation and related costs, including stock-based compensation, and infrastructure costs.Sales, General and AdministrativeSales, general and administrative expenses increased by 77% in fiscal year 2021 compared to fiscal year 2020, driven primarily by the Mellanox acquisition. In addition, the increases reflect employee compensation and related costs, including stock-based compensation.Other Income (Expense), NetInterest income consists of interest earned on cash, cash equivalents and marketable securities. Interest income was $57 million and $178 million in fiscal years 2021 and 2020, respectively. The decrease in interest income was primarily due to lower interest rates earned on our investments.Interest expense is primarily comprised of coupon interest and debt discount amortization related to our September 2016 Notes and March 2020 Notes. Interest expense was $184 million and $52 million in fiscal years 2021 and 2020, respectively.Income TaxesWe recognized income tax expense of $77 million and $174 million for fiscal years 2021 and 2020, respectively. Our annual effective tax rate was 1.7% and 5.9% for fiscal years 2021 and 2020, respectively. 36Table of ContentsThe decrease in our effective tax rate in fiscal year 2021 as compared to fiscal year 2020 was primarily due to a decrease in the proportional amount of earnings subject to United States tax and an increase of tax benefits from stock-based compensation.Our effective tax rate for fiscal years 2021 and 2020 was lower than the U.S. federal statutory rate of 21% due primarily to income earned in jurisdictions, including the British Virgin Islands, Israel, and Hong Kong, where the tax rate was lower than the U.S. federal statutory tax rate, recognition of U.S. federal research tax credits, and excess tax benefits related to stock-based compensation.Refer to Note 14 of the Notes to the Consolidated Financial Statements in Part IV, Item 15 of this Annual Report on Form 10-K for additional information.Liquidity and Capital Resources January 31,2021January 26,2020 (In millions)Cash and cash equivalents$847 $10,896 Marketable securities10,714 1 Cash, cash equivalents, and marketable securities$11,561 $10,897 Year EndedJanuary 31,2021January 26,2020 (In millions)Net cash provided by operating activities$5,822 $4,761 Net cash provided by (used in) investing activities$(19,675)$6,145 Net cash provided by (used in) financing activities$3,804 $(792)As of January 31, 2021, we had $11.56 billion in cash, cash equivalents and marketable securities, an increase of $664 million from the end of fiscal year 2020. Our investment policy requires the purchase of highly rated fixed income securities, the diversification of investment types and credit exposures, and certain maturity limits on our portfolio.In the third quarter of fiscal year 2021, we paid $2 billion as part of the proposed acquisition of Arm, which was allocated between advanced consideration for the acquisition of $1.36 billion, the prepayment of intellectual property licenses from Arm of $0.17 billion and royalties of $0.47 billion. The cash flow allocation of the payment resulted in $1.36 billion of advanced consideration included in acquisitions, net of cash acquired, $0.17 billion for the intellectual property license included in purchases related to property and equipment and intangible assets and $0.47 billion in prepayment of royalties included in changes in prepaid expenses and other assets.Cash provided by operating activities increased in fiscal year 2021 compared to fiscal year 2020, due to higher net income, higher non-cash adjustments, partially offset by changes in working capital. Changes in working capital include increases in purchases of inventory and outstanding trade receivables, both due to higher fiscal year 2021 revenue, and a prepayment of royalties to Arm.Cash used in investing activities increased in fiscal year 2021 compared to cash provided in fiscal year 2020, which primarily reflects cash used for the acquisition of Mellanox and the advanced consideration for the proposed acquisition of Arm, higher purchases of marketable securities, higher purchases of property and equipment and intangible assets, and lower sales of marketable securities, offset by higher maturities of marketable securities.Cash provided by financing activities increased in fiscal year 2021 compared to cash used in fiscal year 2020, which primarily reflects the debt issued in the first quarter of fiscal year 2021, offset by payments related to tax on restricted stock units.37Table of ContentsLiquidityOur primary sources of liquidity are our cash and cash equivalents, our marketable securities, and the cash generated by our operations. As of January 31, 2021, we had $11.56 billion in cash, cash equivalents and marketable securities. We believe that we have sufficient liquidity to meet our operating requirements for at least the next twelve months, including our proposed acquisition of Arm. We continuously evaluate our liquidity and capital resources, including our access to external capital, to ensure we can adequately and efficiently finance our capital requirements beyond twelve months. Refer to Note 2 of the Notes to the Consolidated Financial Statements in Part IV, Item 15 of this Annual Report on Form 10-K for additional information.Our marketable securities consist of debt securities issued by the U.S. government and its agencies, highly rated corporations and financial institutions, and foreign government entities, and certificates of deposits. These marketable securities are primarily denominated in U.S. dollars. Refer to Note 8 of the Notes to the Consolidated Financial Statements in Part IV, Item 15 of this Annual Report on Form 10-K for additional information.During fiscal year 2022, we expect to use our existing cash and cash equivalents, our marketable securities, and the cash generated by our operations to fund our capital investments of approximately $1.0 billion to $1.2 billion related to property and equipment, including construction of a new building at our Santa Clara campus.We have approximately $1.38 billion of cash, cash equivalents, and marketable securities held outside the U.S. for which we have not accrued any related foreign or state taxes if we repatriate these amounts to the U.S. Other than that, substantially all of our cash, cash equivalents and marketable securities held outside of the U.S. as of January 31, 2021 are available for use in the U.S. without incurring additional U.S. federal income taxes. Refer to Note 14 of the Notes to the Consolidated Financial Statements in Part IV, Item 15 of this Annual Report on Form 10-K for additional information.Capital Return to ShareholdersIn fiscal year 2021, we paid $395 million in quarterly cash dividends. Our cash dividend program and the payment of future cash dividends under that program are subject to our Board's continuing determination that the dividend program and the declaration of dividends thereunder are in the best interests of our shareholders. As of January 31, 2021, we were authorized, subject to certain specifications, to repurchase additional shares of our common stock up to $7.24 billion through December 2022. We did not repurchase any shares during fiscal year 2021.Outstanding Indebtedness and Credit FacilitiesWe have outstanding $1.50 billion of Notes Due 2030, $1.00 billion of Notes Due 2040, $2.00 billion of Notes Due 2050, and $500 million of Notes due 2060, or collectively, the March 2020 Notes.We have outstanding $1.00 billion of Notes due 2021 and $1.00 billion of Notes due 2026, or collectively, the September 2016 Notes.We have a Credit Agreement under which we may borrow up to $575 million for general corporate purposes and can obtain revolving loan commitments up to $425 million. As of January 31, 2021, we had not borrowed any amounts under this agreement.We have a $575 million commercial paper program to support general corporate purposes. As of January 31, 2021, we had not issued any commercial paper.Refer to Note 12 of the Notes to the Consolidated Financial Statements in Part IV, Item 15 of this Annual Report on Form 10-K for further discussion.Contractual ObligationsWe have $157 million of long-term tax liabilities related to tax basis differences in Mellanox and unrecognized tax benefits of $395 million, which includes related interest and penalties of $43 million recorded in non-current income tax payable as of January 31, 2021. We are unable to reasonably estimate the timing of any potential tax liability, interest payments, or penalties in individual years due to uncertainties in the underlying income tax positions and the timing of the effective settlement of such tax positions. We are currently under examination by the Internal Revenue Service for our fiscal years 2018 and 2019. Refer to Note 14 of the Notes to the Consolidated Financial Statements in Part IV, Item 15 of this Annual Report on Form 10-K for further information.38Table of ContentsFor a description of our long-term debt, purchase obligations, and operating lease obligations, refer to Note 12, Note 13, and Note 3 of the Notes to the Consolidated Financial Statements in Part IV, Item 15 of this Annual Report on Form 10-K, respectively.Adoption of New and Recently Issued Accounting PronouncementsRefer to Note 1 of the Notes to the Consolidated Financial Statements in Part IV, Item 15 of this Annual Report on Form 10-K for a discussion of adoption of new and recently issued accounting pronouncements.ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKInvestment and Interest Rate RiskWe are exposed to interest rate risk related to our fixed-rate investment portfolio and outstanding debt. The investment portfolio is managed consistent with our overall liquidity strategy in support of both working capital needs and strategic growth of our businesses.As of January 31, 2021, we performed a sensitivity analysis on our investment portfolio. According to our analysis, parallel shifts in the yield curve of both plus or minus 0.5%, taking into account a yield floor of 0%, would result in a decrease in fair value for these investments of $24 million, or an increase in fair value for these investments of $8 million, respectively.In September 2016, we issued $1.00 billion of the Notes Due 2021 and $1.00 billion of the Notes Due 2026. In March 2020, we issued $1.50 billion of Notes Due 2030, $1.00 billion of Notes Due 2040, $2.00 billion of Notes Due 2050, and $500 million of Notes due 2060. We carry the Notes at face value less unamortized discount on our Consolidated Balance Sheets. As the Notes bear interest at a fixed rate, we have no financial statement risk associated with changes in interest rates. Refer to Note 12 of the Notes to the Consolidated Financial Statements in Part IV, Item 15 of this Annual Report on Form 10-K for additional information. Foreign Exchange Rate RiskWe consider our direct exposure to foreign exchange rate fluctuations to be minimal. Gains or losses from foreign currency remeasurement are included in other income or expense and to date have not been significant. The impact of foreign currency transaction gain or loss included in determining net income was not significant for fiscal years 2021 and 2020.Sales and arrangements with third-party manufacturers provide for pricing and payment in United States dollars, and, therefore, are not subject to exchange rate fluctuations. Increases in the value of the United States’ dollar relative to other currencies would make our products more expensive, which could negatively impact our ability to compete. Conversely, decreases in the value of the United States’ dollar relative to other currencies could result in our suppliers raising their prices in order to continue doing business with us. Additionally, we have international operations and incur expenditures in currencies other than U.S. dollars. Our operating expenses benefit from a stronger dollar and are adversely affected by a weaker dollar. We use foreign currency forward contracts to mitigate the impact of foreign currency exchange rate movements on our operating expenses. We designate these contracts as cash flow hedges and assess the effectiveness of the hedge relationships on a spot to spot basis. Gains or losses on the contracts are recorded in accumulated other comprehensive income or loss, and then reclassified to operating expense when the related operating expenses are recognized in earnings or ineffectiveness should occur.We also use foreign currency forward contracts to mitigate the impact of foreign currency movements on monetary assets and liabilities that are denominated in currencies other than U.S. dollar. These forward contracts were not designated for hedge accounting treatment. Therefore, the change in fair value of these contracts is recorded in other income or expense and offsets the change in fair value of the hedged foreign currency denominated monetary assets and liabilities, which is also recorded in other income or expense.If the U.S. dollar strengthened by 10% as of January 31, 2021 and January 26, 2020, the amount recorded in accumulated other comprehensive income (loss) related to our foreign exchange contracts before tax effect would have been approximately $84 million and $43 million lower as of January 31, 2021 and January 26, 2020, respectively. Change in value recorded in accumulated other comprehensive income (loss) would be expected to offset a corresponding change in hedged forecasted foreign currency expenses when recognized.39Table of ContentsIf an adverse 10% foreign exchange rate change was applied to our balance sheet hedging contracts, it would have resulted in an adverse impact on income before taxes of approximately $44 million and $29 million as of January 31, 2021 and January 26, 2020, respectively. These changes in fair values would be offset in other income (expense), net by corresponding change in fair values of the foreign currency denominated monetary assets and liabilities, assuming the hedge contracts fully cover the foreign currency denominated monetary assets and liabilities balances.Refer to Note 11 of the Notes to the Consolidated Financial Statements in Part IV, Item 15 of this Annual Report on Form 10-K for additional information.
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+Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations—Liquidity and Capital Resources.”NCLH’s principal executive offices are located in Miami, Florida where we lease approximately 335,900 square feet of facilities. We lease a number of domestic and international offices throughout Europe, Asia, South America and Australia to administer our brand operations globally. Norwegian owns a private island in the Bahamas, Great Stirrup Cay, which we utilize as a port-of-call on some of our itineraries. We operate a private cruise destination in Belize, Harvest Caye.We believe that our facilities are adequate for our current needs, and that we are capable of obtaining additional facilities as necessary.​Item 3. Legal ProceedingsSee “Item 8—Financial Statements and Supplementary Data—Notes to Consolidated Financial Statements—Note 13 Commitments and Contingencies” in Part II of this annual report for information about legal proceedings.​​46 Table of ContentsItem 4. Mine Safety DisclosuresNone.​47 Table of ContentsPART II​Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity SecuritiesMarket InformationNCLH’s ordinary shares are listed on the NYSE under the symbol “NCLH.”HoldersAs of February 16, 2021, there were 276 record holders of NCLH’s ordinary shares. Since certain of NCLH’s ordinary shares are held by brokers and other institutions on behalf of shareholders, the foregoing number is not representative of the number of beneficial owners.DividendsNCLH does not currently pay dividends to its shareholders. Any determination to pay dividends in the future will be at the discretion of our Board of Directors and will depend upon our results of operations, financial condition, restrictions imposed by applicable law and our financing agreements and other factors that our Board of Directors deems relevant.Stock Performance GraphThis performance graph shall not be deemed “soliciting material” or to be “filed” with the SEC for purposes of Section 18 of the Exchange Act, or otherwise subject to the liabilities under that Section, and shall not be deemed to be incorporated by reference into any filing of NCLH under the Securities Act of 1933, as amended, or the Exchange Act.The following graph shows a comparison of the cumulative total return for our ordinary shares, the Standard & Poor’s 500 Composite Stock Index and the Dow Jones United States Travel and Leisure index. The Stock Performance Graph assumes that $100 was invested at the closing price of our ordinary shares on the Nasdaq and in each index on the last 48 Table of Contentstrading day of fiscal 2015. Past performance is not necessarily an indicator of future results. The stock prices used were as of the close of business on the respective dates.​​​​​​​​​​​​​49 Table of ContentsItem 6. Selected Financial DataThe following selected financial data should be read in conjunction with the consolidated financial statements and notes thereto and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” appearing elsewhere in this annual report.Our financial results have been negatively impacted by the COVID-19 pandemic, which has significantly affected and will continue to affect the comparability of the selected financial data. See Note 2 – “Summary of Significant Accounting Policies” to the Notes to the Consolidated Financial Statements included herein for additional information about COVID-19. Additionally, the consolidated financial statements as of December 31, 2019 include the impact of a change in accounting policy related the adoption of Accounting Standards Codification 842 – Leases on January 1, 2019. See Note 5 – “Leases” to the Notes to the Consolidated Financial Statements included herein for additional information about our leases.​​​​​​​​​​​​​​​​​​​As of or for the Year Ended December 31, (in thousands, except share data, per ​​ ​​ ​​ ​​ ​​​share data and operating data)​2020​2019​2018​2017​2016​Statement of operations data:​​​​​​​​​​​​​​​​Total revenue​$ 1,279,908​$ 6,462,376​$ 6,055,126​$ 5,396,175​$ 4,874,340​Operating income (loss)​$ (3,484,135)​$ 1,178,077​$ 1,219,061​$ 1,048,819​$ 925,464​Net income (loss)​$ (4,012,514)​$ 930,228​$ 954,843​$ 759,872​$ 633,085​EPS:​ ​ ​ ​ ​ ​Basic​$ (15.75)​$ 4.33​$ 4.28​$ 3.33​$ 2.79​Diluted​$ (15.75)​$ 4.30​$ 4.25​$ 3.31​$ 2.78​Weighted-average shares outstanding:​ ​ ​ ​ ​ ​Basic​ 254,728,932​ 214,929,977​ 223,001,739​ 228,040,825​ 227,121,875​Diluted​ 254,728,932​ 216,475,076​ 224,419,205​ 229,418,326​ 227,850,286​Balance sheet data:​ ​ ​ ​ ​ ​Total assets​$ 18,399,317​$ 16,684,599​$ 15,205,970​$ 14,094,869​$ 12,973,911​Property and equipment, net​$ 13,411,226​$ 13,135,337​$ 12,119,253​$ 11,040,488​$ 10,117,689​Long-term debt, including current portion​$ 11,806,119​$ 6,801,693​$ 6,492,091​$ 6,307,765​$ 6,398,687​Total shareholders’ equity​$ 4,354,105​$ 6,515,579​$ 5,963,001​$ 5,749,766​$ 4,537,726​Operating data:​ ​​ ​​ ​ ​ ​Passengers carried​ 499,729​ 2,695,718​ 2,795,101​ 2,519,324​ 2,337,311​Passenger Cruise Days​ 4,278,602​ 20,637,949​ 20,276,568​ 18,523,030​ 17,588,707​Capacity Days​ 4,123,858​ 19,233,459​ 18,841,678​ 17,363,422​ 16,376,063​Occupancy Percentage​ 103.8% 107.3% 107.6% 106.7% 107.4% ​​50 Table of ContentsItem 7. Management’s Discussion and Analysis of Financial Condition and Results of OperationsFinancial PresentationThe following discussion and analysis contains forward-looking statements within the meaning of the federal securities laws, and should be read in conjunction with the disclosures we make concerning risks and other factors that may affect our business and operating results. You should read this information in conjunction with the consolidated financial statements and the notes thereto included in this annual report. See also “Cautionary Statement Concerning Forward-Looking Statements” immediately prior to Part I, Item 1 in this annual report.We categorize revenue from our cruise and cruise-related activities as either “passenger ticket” revenue or “onboard and other” revenue. Passenger ticket revenue and onboard and other revenue vary according to product offering, the size of the ship in operation, the length of cruises operated and the markets in which the ship operates. Our revenue is seasonal based on demand for cruises, which has historically been strongest during the Northern Hemisphere’s summer months; however, our cruise voyages were completely suspended during the last nine months of 2020 due to the COVID-19 pandemic and such suspension has been extended through May 31, 2021. Passenger ticket revenue primarily consists of revenue for accommodations, meals in certain restaurants on the ship, certain onboard entertainment, port fees and taxes and includes revenue for service charges and air and land transportation to and from the ship to the extent guests purchase these items from us. Onboard and other revenue primarily consists of revenue from casino, beverage sales, shore excursions, specialty dining, retail sales, spa services and photo services. Our onboard revenue is derived from onboard activities we perform directly or that are performed by independent concessionaires, from which we receive a share of their revenue.Our cruise operating expense is classified as follows:●Commissions, transportation and other primarily consists of direct costs associated with passenger ticket revenue. These costs include travel advisor commissions, air and land transportation expenses, related credit card fees, certain port fees and taxes and the costs associated with shore excursions and hotel accommodations included as part of the overall cruise purchase price.●Onboard and other primarily consists of direct costs incurred in connection with onboard and other revenue, including casino, beverage sales and shore excursions.●Payroll and related consists of the cost of wages and benefits for shipboard employees and costs of certain inventory items, including food, for a third party that provides crew and other hotel services for certain ships. The cost of crew repatriation, including charters, housing, testing and other costs related to COVID-19 are also included.●Fuel includes fuel costs, the impact of certain fuel hedges and fuel delivery costs.●Food consists of food costs for passengers and crew on certain ships.●Other consists of repairs and maintenance (including Dry-dock costs), ship insurance and other ship expenses.Critical Accounting PoliciesOur consolidated financial statements have been prepared in accordance with U.S. GAAP. The preparation of these consolidated financial statements requires us to make estimates, judgments and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of our consolidated financial statements and the reported amounts of revenue and expenses during the periods presented. We rely on historical experience and on various other assumptions that we believe to be reasonable under the circumstances to make these estimates and judgments. Actual results could differ materially from these estimates. We believe that the following critical accounting policies reflect the significant estimates and assumptions used in the preparation of our consolidated 51 Table of Contentsfinancial statements. These critical accounting policies, which are presented in detail in our notes to our audited consolidated financial statements, relate to liquidity, ship accounting and asset impairment.LiquidityWe make several critical accounting estimates with respect to our liquidity. Significant events affecting travel, including COVID-19, typically have an impact on demand for cruise vacations, with the full extent of the impact generally determined by the length of time the event influences travel decisions. We believe the ongoing effects of COVID-19 on our operations and global bookings have had, and will continue to have, a significant impact on our financial results and liquidity, and such negative impact may continue beyond the containment of the pandemic. The estimation of our future cash flow projections includes numerous assumptions that are subject to various risks and uncertainties. Upon the relaunch of cruise voyages, our principal assumptions for future cash flow projections include:●Expected gradual phased relaunch at reduced occupancy levels;●Forecasted cash collections primarily upon completion of future voyages and the payment of cash refunds for any further cancellations, in accordance with the terms of our credit card processing agreements (see Note 13 - “Commitments and Contingencies”); and●Expected incremental expenses for resumption of cruise voyages, including the maintenance of and compliance with additional health and safety protocols.Due to the unknown duration and extent of the COVID-19 pandemic, travel restrictions, bans and advisories, uncertainties around our ability to comply with governmental regulations, the potential unavailability of ports and/or destinations, voyage cancellations and timing of redeployments, and a general impact on consumer sentiment regarding cruise travel, we cannot predict when we will relaunch voyages or when our full fleet will be back in service at historical occupancy levels. Until we are able to begin our phased relaunch, our projected liquidity requirements reflect our principal assumptions surrounding ongoing operating costs during the suspension of cruise voyages, as well as liquidity requirements for financing costs and necessary capital expenditures, and our ability to implement further cash conservation strategies, including, but not limited to:●Moving our ships to minimum manning levels, which we expect would result in further reductions in crew payroll costs, fuel consumption, and maintenance costs;●Further reductions in general operating expenses; and●Further reductions in discretionary capital expenditures including cancellation or reduction in scope of certain Dry-docks.We cannot make assurances that our assumptions used to estimate our liquidity requirements may not change because we have never experienced a complete cessation of our cruise voyages. Accordingly, the full effect of our suspension of cruise voyages on our financial performance and financial condition cannot be quantified at this time. We have made reasonable estimates and judgments of the impact of COVID-19 within our financial statements and there may be material changes to those estimates in future periods. The Company has taken and will continue to take proactive cost reduction and cash conservation measures to mitigate the financial and operational impacts of COVID-19, through the reduction of capital expenditures and operating expenses, deferral of ship milestone payments, amendments of debt agreements and capital market transactions. ​52 Table of ContentsShip AccountingShips represent our most significant assets, and we record them at cost less accumulated depreciation. Depreciation of ships is computed on a straight-line basis over the weighted average useful lives of primarily 30 years after a 15% reduction for the estimated residual value of the ship. Ship improvement costs that we believe add value to our ships are capitalized to the ship and depreciated over the shorter of the improvements’ estimated useful lives or the remaining useful life of the ship. When we record the retirement of a ship component included within the ship’s cost basis, we estimate the net book value of the component being retired and remove it from the ship’s cost basis. Repairs and maintenance activities are charged to expense as incurred. We account for Dry-dock costs under the direct expense method which requires us to expense all Dry-dock costs as incurred.We determine the weighted average useful lives of our ships based primarily on our estimates of the useful lives of the ships’ major component systems on the date of acquisition, such as cabins, main diesels, main electric, superstructure and hull. The useful lives of ship improvements are estimated based on the economic lives of the new components. In addition, to determine the useful lives of the ship or ship components, we consider the impact of the historical useful lives of similar assets, manufacturer recommended lives and anticipated changes in technological conditions. Given the large and complex nature of our ships, our accounting estimates related to ships and determinations of ship improvement costs to be capitalized require judgment and are uncertain. Should certain factors or circumstances cause us to revise our estimate of ship service lives or projected residual values, depreciation expense could be materially lower or higher. In 2020, one ship had significant improvements that extended the remaining weighted average useful life of the vessel. Accordingly, we have updated our estimate of both its useful life and residual value based on the new weighted average useful life of its current components. The impact of the change in estimate is accounted on a prospective basis and is not material.If circumstances cause us to change our assumptions in making determinations as to whether ship improvements should be capitalized, the amounts we expense each year as repairs and maintenance costs could increase, partially offset by a decrease in depreciation expense. If we reduced our estimated weighted average 30-year ship service life by one year, depreciation expense for the year ended December 31, 2020 would have increased by $19.8 million. In addition, if our ships were estimated to have no residual value, depreciation expense for the same period would have increased by $99.6 million. We believe our estimates for ship accounting are reasonable and our methods are consistently applied. We believe that depreciation expense is based on a rational and systematic method to allocate our ships’ costs to the periods that benefit from the ships’ usage.Asset ImpairmentWe review our long-lived assets, principally ships, for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Assets are grouped and evaluated at the lowest level for which there are identifiable cash flows that are largely independent of the cash flows of other groups of assets. For ship impairment analyses, the lowest level for which identifiable cash flows are largely independent of other assets and liabilities is each individual ship. We consider historical performance and future estimated results in our evaluation of potential impairment and then compare the carrying amount of the asset to the estimated future cash flows expected to result from the use of the asset. If the carrying amount of the asset exceeds the estimated expected undiscounted future cash flows, we measure the amount of the impairment by comparing the carrying amount of the asset to its estimated fair value. We estimate fair value based on the best information available utilizing estimates, judgments and projections as necessary. Our estimate of fair value is generally measured by discounting expected future cash flows at discount rates commensurate with the associated risk.We evaluate goodwill and trade names for impairment on December 31 or more frequently when an event occurs or circumstances change that indicates the carrying value of a reporting unit may not be recoverable. For our evaluation of goodwill, we use the Step 0 Test which allows us to first assess qualitative factors to determine whether it is more likely than not (i.e., more than 50%) that the estimated fair value of a reporting unit is less than its carrying value. For trade names we also provide a qualitative assessment to determine if there is any indication of impairment.53 Table of ContentsIn order to make this evaluation, we consider whether any of the following factors or conditions exist:●Changes in general macroeconomic conditions such as a deterioration in general economic conditions; limitations on accessing capital; fluctuations in foreign exchange rates; or other developments in equity and credit markets;●Changes in industry and market conditions such as a deterioration in the environment in which an entity operates; an increased competitive environment; a decline in market-dependent multiples or metrics (in both absolute terms and relative to peers); a change in the market for an entity’s products or services; or a regulatory or political development;●Changes in cost factors that have a negative effect on earnings and cash flows;●Decline in overall financial performance (for both actual and expected performance);●Entity and reporting unit specific negative events such as changes in management, key personnel, strategy, or customers; litigation; or a change in the composition or carrying amount of net assets; and●Decline in share price (in both absolute terms and relative to peers).We also may conduct a quantitative assessment comparing the estimated fair value of each reporting unit to its carrying value, including goodwill. This is called the Step 1 Test which uses discounted future cash flows and other market data to determine the estimated fair value of the reporting units. Our discounted cash flow valuation reflects our principal assumptions of 1) forecasted future operating results and growth rates, which have been prepared under multiple scenarios and are probability weighted, 2) forecasted capital expenditures for fleet growth and ship improvements and 3) a weighted average cost of capital of market participants. Historically, our Step 1 Test consisted of a combined approach using discounted future cash flows and market multiples to determine the estimated fair value of the reporting units. However, beginning with the Step 1 Test performed as of March 31, 2020 as a result of triggering events, the market multiples were used solely as a corroboratory approach given the impact of COVID-19 on the current year’s results, as of the valuation date, as well as prospective results including the lack of any guidance provided, which were not available for our peers. We concluded that this approach is the most representative method to estimate fair value as it utilizes expectations of long-term growth as well as current market conditions. For the trade names, we use the relief from royalty method, which uses the same forecasts and discount rates from the discounted cash flow valuation in the goodwill assessment along with a trade name royalty rate assumption.​We have concluded that our business has three reporting units. Each brand, Oceania Cruises, Regent Seven Seas and Norwegian, constitutes a business for which discrete financial information is available and management regularly reviews the operating results and, therefore, each brand is considered an operating segment. During the year ended December 31, 2020, we recognized a goodwill impairment loss of $1.3 billion based on the impairment test performed as of March 31, 2020. See Note 4 – “Goodwill and Intangible Assets” for additional information. As of December 31, 2020, there was $98.1 million of goodwill remaining for the Regent Seven Seas reporting unit. We also recognized an impairment loss for our Oceania Cruises and Regent Seven Seas Cruises trade names in an aggregate amount of $317.0 million based on the March 31, 2020 impairment test, with $500.5 million remaining as of December 31, 2020. For our 2020 annual goodwill and trade name impairment evaluations, we elected to perform quantitative testing. Based on the results of the Step 1 Tests at December 31, 2020, we determined there was no further impairment of goodwill because the estimated fair value of the Regent Seven Seas reporting unit substantially exceeded the carrying value. We also determined there was no impairment to our trade names. We believe that we have made reasonable estimates and judgments. However, a change in our estimated future operating cash flows may result in a decline in estimated fair value in future periods, which may result in a need to recognize additional impairment charges.54 Table of ContentsNon-GAAP Financial MeasuresWe use certain non-GAAP financial measures, such as Net Cruise Cost, Adjusted Net Cruise Cost Excluding Fuel, Adjusted EBITDA, Adjusted Net Income and Adjusted EPS, to enable us to analyze our performance. See “Terms Used in this Annual Report” for the definitions of these and other non-GAAP financial measures. We utilize Net Cruise Cost and Adjusted Net Cruise Cost Excluding Fuel to manage our business on a day-to-day basis. In measuring our ability to control costs in a manner that positively impacts net income, we believe changes in Net Cruise Cost and Adjusted Net Cruise Cost Excluding Fuel to be the most relevant indicators of our performance. As a result of our voluntary suspension of sailings during the last nine months of 2020, we did not have any Capacity Days in those periods. Accordingly, we have not presented herein per Capacity Day data for the year ended December 31, 2020.As our business includes the sourcing of passengers and deployment of vessels outside of the U.S., a portion of our revenue and expenses are denominated in foreign currencies, particularly British pound, Canadian dollar, euro and Australian dollar which are subject to fluctuations in currency exchange rates versus our reporting currency, the U.S. dollar. In order to monitor results excluding these fluctuations, we calculate certain non-GAAP measures on a Constant Currency basis, whereby current period revenue and expenses denominated in foreign currencies are converted to U.S. dollars using currency exchange rates of the comparable period. We believe that presenting these non-GAAP measures on both a reported and Constant Currency basis is useful in providing a more comprehensive view of trends in our business.We believe that Adjusted EBITDA is appropriate as a supplemental financial measure as it is used by management to assess operating performance. We also believe that Adjusted EBITDA is a useful measure in determining our performance as it reflects certain operating drivers of our business, such as sales growth, operating costs, marketing, general and administrative expense and other operating income and expense. Adjusted EBITDA is not a defined term under GAAP nor is it intended to be a measure of liquidity or cash flows from operations or a measure comparable to net income, as it does not take into account certain requirements such as capital expenditures and related depreciation, principal and interest payments and tax payments and it includes other supplemental adjustments.In addition, Adjusted Net Income and Adjusted EPS are non-GAAP financial measures that exclude certain amounts and are used to supplement GAAP net income and EPS. We use Adjusted Net Income and Adjusted EPS as key performance measures of our earnings performance. We believe that both management and investors benefit from referring to these non-GAAP financial measures in assessing our performance and when planning, forecasting and analyzing future periods. These non-GAAP financial measures also facilitate management’s internal comparison to our historical performance. In addition, management uses Adjusted EPS as a performance measure for our incentive compensation. The amounts excluded in the presentation of these non-GAAP financial measures may vary from period to period; accordingly, our presentation of Adjusted Net Income and Adjusted EPS may not be indicative of future adjustments or results. For example, for the year ended December 31, 2019, we incurred $30.6 million related to the redeployment of Norwegian Joy from Asia to the U.S. We included this as an adjustment in the reconciliation of Adjusted Net Income since the expenses are not representative of our day-to-day operations; however, this adjustment did not occur and is not included in the comparative period presented within this Form 10-K.You are encouraged to evaluate each adjustment used in calculating our non-GAAP financial measures and the reasons we consider our non-GAAP financial measures appropriate for supplemental analysis. In evaluating our non-GAAP financial measures, you should be aware that in the future we may incur expenses similar to the adjustments in our presentation. Our non-GAAP financial measures have limitations as analytical tools, and you should not consider these measures in isolation or as a substitute for analysis of our results as reported under GAAP. Our presentation of our non-GAAP financial measures should not be construed as an inference that our future results will be unaffected by unusual or non-recurring items. Our non-GAAP financial measures may not be comparable to other companies. Please see a historical reconciliation of these measures to the most comparable GAAP measure presented in our consolidated financial statements below in the “Results of Operations” section.​​55 Table of ContentsUpdate Regarding COVID-19 Pandemic ​Suspension of Cruise Voyages​Due to the continued spread of COVID-19, evolving travel restrictions and limited access to ports around the world, in March 2020, we implemented a voluntary suspension of all cruise voyages across our three brands, which has subsequently been extended through May 31, 2021. This is the first time we have completely suspended our cruise voyages, and as a result of these unprecedented circumstances, we are not able to predict the full impact of such a suspension on our Company. The duration of any voluntary suspensions we have implemented and the resumption of operations both inside and outside of the United States will be dependent, in part, on our ability to comply with the Conditional Order, the severity and duration of the COVID-19 global pandemic, including further resurgences and new variants of COVID-19, the availability, distribution and efficacy of vaccines and therapeutics for COVID-19, the lifting of various travel restrictions and travel bans issued by various countries and communities around the world, as well as the availability of ports. For more information on the impact of COVID-19 on our business, see “Impact of COVID-19” and “Strategy for COVID-19” in Part I Item 1-Business in this annual report on Form 10-K.​Modified Policies​Our brands have launched new cancellation policies for certain sailings booked during certain time periods to permit our guests to cancel cruises which were not part of our temporary suspension of voyages up to 15 days prior to embarkation and receive a refund in the form of a credit to be applied toward a future cruise. The future cruise credits issued under these programs are valid for any sailing through December 31, 2022, and we may extend the length of time these future cruise credits may be redeemed. The use of such credits may prevent us from garnering certain future cash collections as staterooms booked by guests with such credits will not be available for sale, resulting in less cash collected from bookings to new guests. We may incur incremental commission expense for the use of these future cruise credits. In addition, to provide more flexibility to our guests, we have also extended our modified final payment schedule for all voyages on Regent Seven Seas Cruises through July 31, 2021 and for voyages on Oceania Cruises and for the majority of bookings for voyages on Norwegian Cruise Line through October 31, 2021 which now requires payment 60 days prior to embarkation versus the standard 120 days. Our brands currently expect to provide cash refunds for cash bookings for future sailings we may cancel.​Update on Bookings ​While overall booking volumes since the emergence of the COVID-19 global pandemic remain below historical levels, there continues to be demand for future cruise vacations. Despite reduced sales and marketing investments, and a travel agency industry that has not been at full strength for months, bookings have been strong for future periods resulting in an elongated booking window as guests book further into the future. The Company’s overall cumulative booked position for the second half of 2021 remains below historical levels, driven by continued uncertainty around timing of the resumption of cruising and the shift of limited marketing investments to 2022 sailings. Pricing for the second half of 2021 is in line with pre-pandemic levels, even after including the dilutive impact of future cruise credits. While still early in the booking cycle, 2022 booking trends are very positive driven by strong pent up demand. The overall cumulative booked position for the first half of 2022 is significantly ahead of 2019’s record levels with pricing in line when excluding the dilutive impact of future cruise credits and down including the dilutive future cruise credits. Our operations may be suspended beyond our announced suspensions and as a result, current booking data may not be informative. In addition, because of our updated cancellation policies, bookings may not be representative of actual cruise revenues.​The ongoing effects of the COVID-19 pandemic on our operations and global bookings have had, and we believe they will continue to have, a significant impact on our financial results and liquidity, and such negative impact may continue well beyond the containment of the pandemic. Significant events affecting travel, including COVID-19, typically have an impact on the demand for cruise vacations, with the full extent of the impact generally determined by the length of time the event influences travel decisions. Due to the unknown duration and extent of the COVID-19 pandemic, uncertainty surrounding the availability of COVID-19 vaccines and therapeutics, travel restrictions and advisories, uncertainties around our ability to comply with the Conditional Order, the potential unavailability of ports and/or 56 Table of Contentsdestinations, unknown cancellations and timing of redeployments and a general impact on consumer sentiment regarding cruise travel, there are remaining uncertainties about when our full fleet will be back in service at historical occupancy levels and, accordingly, we cannot estimate the impact on our business, financial condition or near- or longer-term financial or operational results with certainty; however, we will report a net loss for the quarter ending March 31, 2021 and expect to report a net loss until we are able to resume voyages. ​Financing Transactions and Cost Containment MeasuresIn March 2020, NCLC borrowed the full amount of $1.55 billion under its existing $875 million Revolving Loan Facility and its then existing $675 million Epic Credit Facility. Since March 2020, we have taken several actions to bolster our financial position while our global cruise voyages are currently suspended, including a series of debt and equity financing transactions completed in May, July, November and December 2020. In May 2020, NCLH and NCLC launched a series of capital markets transactions and raised approximately $2.4 billion, including the full exercise of options to purchase additional ordinary shares and exchangeable notes. In July 2020, NCLH and NCLC launched a series of capital markets transactions and raised approximately $1.5 billion, including the full exercise of the option to purchase additional ordinary shares and partial exercise of the option to purchase additional exchangeable notes. From the proceeds, approximately $675 million was used to repay the Epic Credit Facility, which was terminated in July 2020. In November 2020, NCLH launched an offering of ordinary shares and raised $824 million. In December 2020, NCLC launched an offering of its 5.875% Senior Notes due 2026 (the “2026 Senior Unsecured Notes”) and raised approximately $850 million.We have also undertaken several proactive cost reduction and cash conservation measures to mitigate the financial and operational impacts of the COVID-19 pandemic, through the reduction of capital expenditures as well as a reduction in operating expenses, including ship operating expenses and selling, general and administrative expenses. Cost savings initiatives to reduce selling, general and administrative expenses already implemented include the significant reduction or deferral of marketing expenditures, the implementation of hiring freezes, a 20% salary or hours reduction for certain shoreside team members, a pause in our 401(k) matching contributions and corporate travel freezes for shoreside employees. We have returned certain shoreside team members to full salary and hours and expect to continue to do so over time as we prepare to resume cruise voyages. Further, as part of our ongoing strategy to improve our ability to sustain the long-term health of the business and to preserve financial flexibility during the COVID-19 crisis, we have furloughed certain shoreside employees, subject to change based on business needs. While on furlough, employees will not receive salary or hourly wages, but will continue to receive health benefit coverage if they currently participate in a Company-sponsored plan. See “—Liquidity and Capital Resources” below for more information. ​Executive OverviewThe ongoing effects of COVID-19 on our operations and global bookings have had a significant adverse effect on our results of operations for the year ended December 31, 2020 compared to the year ended December 31, 2019.Total revenue decreased 80.2% to $1.3 billion for the year ended December 31, 2020 compared to $6.5 billion for the year ended December 31, 2019. Capacity Days decreased by 78.6%.For the year ended December 31, 2020, we had net loss and diluted EPS of $(4.0) billion and $(15.75), respectively. For the year ended December 31, 2019, we had net income and diluted EPS of $930.2 million and $4.30, respectively. Operating income (loss) decreased 395.7% to $(3.5) billion for the year ended December 31, 2020 from $1.2 billion for the year ended December 31, 2019.We had Adjusted Net Loss and Adjusted EPS of $(2.2) billion and $(8.64), respectively, for the year ended December 31, 2020, including $1.8 billion of adjustments primarily consisting of expenses related to non-cash share-based compensation, losses on the extinguishment and modification of debt and impairment losses, compared to Adjusted Net Income and Adjusted EPS of $1.1 billion and $5.09, respectively, for the year ended December 31, 2019. 57 Table of ContentsA 154.0% decrease in Adjusted EBITDA was incurred for the same period. We refer you to our “Results of Operations” below for a calculation of Adjusted Net Income (Loss), Adjusted EPS and Adjusted EBITDA.Results of OperationsThe discussion below compares the results of operations for the year ended December 31, 2020 to the year ended December 31, 2019. For a comparison of the Company’s results of operations for the fiscal years ended December 31, 2019 to the year ended December 31, 2018, see “Item 7—Management’s Discussion and Analysis of Financial Condition and Results of Operations” in the Company’s Annual Report on Form 10-K for the year ended December 31, 2019, which was filed with the U.S. Securities and Exchange Commission on February 27, 2020.​We reported total revenue, total cruise operating expense, operating income and net income as follows (in thousands, except per share data):​​​​​​​​​​Year Ended December 31, ​ 2020 2019Total revenue​$ 1,279,908​$ 6,462,376Total cruise operating expense​$ 1,693,061​$ 3,663,261Operating income (loss)​$ (3,484,135)​$ 1,178,077Net income (loss)​$ (4,012,514)​$ 930,228EPS:​ ​ Basic​$ (15.75)​$ 4.33Diluted​$ (15.75)​$ 4.30​58 Table of ContentsThe following table sets forth operating data as a percentage of total revenue:​​​​​​​​​Year Ended December 31, ​​ 2020 2019 Revenue​​​​​Passenger ticket 67.7% 69.9%Onboard and other 32.3% 30.1%Total revenue 100.0% 100.0%Cruise operating expense Commissions, transportation and other 29.7% 17.4%Onboard and other 6.7% 6.1%Payroll and related 40.7% 14.3%Fuel 20.7% 6.3%Food 5.1% 3.4%Other 29.4% 9.2%Total cruise operating expense 132.3% 56.7%Other operating expense Marketing, general and administrative 58.2% 15.1%Depreciation and amortization 56.1% 10.0%Impairment loss​ 125.6% —%Total other operating expense 239.9% 25.1%Operating income (loss) (272.2)% 18.2%Non-operating income (expense) Interest expense, net (37.7)% (4.2)%Other income (expense), net (2.6)% 0.1%Total non-operating income (expense) (40.3)% (4.1)%Net income (loss) before income taxes (312.5)% 14.1%Income tax benefit (expense) (1.0)% 0.3%Net income (loss) (313.5)% 14.4%​59 Table of ContentsThe following table sets forth selected statistical information:​​​​​​​Year Ended December 31, ​​2020 2019​Passengers carried 499,729 2,695,718​Passenger Cruise Days 4,278,602 20,637,949​Capacity Days 4,123,858 19,233,459​Occupancy Percentage 103.8% 107.3%​Gross Cruise Cost, Net Cruise Cost, Net Cruise Cost Excluding Fuel and Adjusted Net Cruise Cost Excluding Fuel were calculated as follows (in thousands, except Capacity Days and per Capacity Day data):​​​​​​​​​​​​​Year Ended December 31, ​​​​ 2020​​​​ ​​ Constant ​​​​2020 Currency​2019Total cruise operating expense​$ 1,693,061​$ 1,696,364​$ 3,663,261Marketing, general and administrative expense​ 745,345​ 744,999​ 974,850Gross Cruise Cost​ 2,438,406​ 2,441,363​ 4,638,111Less:​ ​ ​ Commissions, transportation and other expense​ 380,710​ 382,132​ 1,120,886Onboard and other expense​ 85,678​ 85,678​ 394,673Net Cruise Cost​ 1,972,018​ 1,973,553​ 3,122,552Less: Fuel expense​ 264,712​ 264,712​ 409,602Net Cruise Cost Excluding Fuel​ 1,707,306​ 1,708,841​ 2,712,950Less Non-GAAP Adjustments:​ ​ ​ Non-cash deferred compensation (1)​ 2,665​ 2,665​ 2,135Non-cash share-based compensation (2)​ 111,297​ 111,297​ 95,055Severance payments and other fees (3)​​ —​​ —​​ 6,514Redeployment of Norwegian Joy (4)​​ —​​ —​​ 7,051Adjusted Net Cruise Cost Excluding Fuel​$ 1,593,344​$ 1,594,879​$ 2,602,195Capacity Days​ 4,123,858​​ 4,123,858​ 19,233,459Gross Cruise Cost per Capacity Day​​​​​​​$ 241.15Net Cruise Cost per Capacity Day​​​​​​​$ 162.35Net Cruise Cost Excluding Fuel per Capacity Day​​​​​​​$ 141.05Adjusted Net Cruise Cost Excluding Fuel per Capacity Day​​​​​​​$ 135.30(1)Non-cash deferred compensation expenses related to the crew pension plan and other crew expenses, which are included in payroll and related expense.(2)Non-cash share-based compensation expense related to equity awards, which are included in marketing, general and administrative expense and payroll and related expense.(3)Severance payments related to restructuring costs are included in marketing, general and administrative expense.(4)Expenses related to the redeployment of Norwegian Joy from Asia to the U.S. and the closing of the Shanghai office, which are included in other cruise operating expense and marketing, general and administrative expense.60 Table of ContentsAdjusted Net Income (Loss) and Adjusted EPS were calculated as follows (in thousands, except share and per share data):​​​​​​​​​​Year Ended December 31, ​ 2020 2019Net income (loss)​$ (4,012,514)​$ 930,228Non-GAAP Adjustments:​ ​ Non-cash deferred compensation (1)​ 3,967​ 3,514Non-cash share-based compensation (2)​ 111,297​ 95,055Severance payments and other fees (3)​ —​ 6,514Extinguishment and modification of debt (4)​ 27,795​ 16,676Amortization of intangible assets (5)​ 9,831​ 18,414Redeployment of Norwegian Joy (6)​​ —​​ 30,629Impairment loss (7)​ 1,633,337​ —Non-cash interest on beneficial conversion feature and payment-in-kind premium (8)​ 26,082​ —Adjusted Net Income (Loss)​$ (2,200,205)​$ 1,101,030Diluted weighted-average shares outstanding - Net income (loss) and Adjusted Net Income (Loss)​ 254,728,932​ 216,475,076Diluted earnings (loss) per share​$ (15.75)​$ 4.30Adjusted EPS​$ (8.64)​$ 5.09(1)Non-cash deferred compensation expenses related to the crew pension plan and other crew expenses are included in payroll and related expense and other income (expense), net.(2)Non-cash share-based compensation expenses related to equity awards are included in marketing, general and administrative expense and payroll and related expense.(3)Severance payments related to restructuring costs are included in marketing, general and administrative expense.(4)Losses on extinguishments and modifications of debt are included in interest expense, net.(5)Amortization of intangible assets related to the Acquisition of Prestige are included in depreciation and amortization expense.(6) Expenses related to the redeployment of Norwegian Joy from Asia to the U.S. and the closing of the Shanghai office, which are included in other cruise operating expense, marketing, general and administrative expense and depreciation and amortization expense. (7) Impairment loss consists of goodwill, trade name and property and equipment impairments. The impairments of goodwill and trade names are included in impairment loss and the impairment of property and equipment is included in depreciation and amortization expense.(8)Non-cash interest expense related to a beneficial conversion feature recognized on our exchangeable notes and additional payment-in-kind interest recognized upon transfer to the debt principal, which is recognized in interest expense, net. 61 Table of ContentsEBITDA and Adjusted EBITDA were calculated as follows (in thousands):​​​​​​​​​Year Ended December 31, ​ 2020 2019Net income (loss)​$ (4,012,514)​$ 930,228Interest expense, net​ 482,313​ 272,867Income tax (benefit) expense​ 12,467​ (18,863)Depreciation and amortization expense​ 717,840​ 646,188EBITDA​ (2,799,894)​ 1,830,420Other (income) expense, net (1)​ 33,599​ (6,155)Non-GAAP Adjustments:​ ​ Non-cash deferred compensation (2)​ 2,665​ 2,135Non-cash share-based compensation (3)​ 111,297​ 95,055Severance payments and other fees (4)​​ —​​ 6,514Redeployment of Norwegian Joy (5)​​ —​​ 7,051Impairment loss (6)​ 1,607,797​ —Adjusted EBITDA​$ (1,044,536)​$ 1,935,020(1)In 2020, primarily consists of gains and losses, net for forward currency exchanges and derivatives no longer designated as hedges. In 2019, primarily consists of gains and losses, net for forward currency exchanges and proceeds from insurance and litigation settlements.(2)Non-cash deferred compensation expenses related to the crew pension plan and other crew expenses are included in payroll and related expense.(3)Non-cash share-based compensation expense related to equity awards are included in marketing, general and administrative expense and payroll and related expense.(4)Severance payments related to restructuring costs are included in marketing, general and administrative expense.(5)Expenses related to the redeployment of Norwegian Joy from Asia to the U.S. and the closing of the Shanghai office, which are included in other cruise operating expense and marketing, general and administrative expense.(6)Impairment loss consists of goodwill and trade name impairments.Year Ended December 31, 2020 (“2020”) Compared to Year Ended December 31, 2019 (“2019”)RevenueTotal revenue decreased 80.2% to $1.3 billion in 2020 compared to $6.5 billion in 2019. The adverse impact on revenue was due to the cancellation of the vast majority of sailings in 2020 as a result of the COVID-19 pandemic, which resulted in a 78.6% decrease in Capacity Days. ExpenseTotal cruise operating expense decreased 53.8% in 2020 compared to 2019. In 2020, our expenses subsequent to the suspension of voyages primarily included the cost of protected commissions and crew costs, including salaries, food and other repatriation costs; fuel; and other ongoing costs such as insurance and ship maintenance. To repatriate crew as fast as possible, the Company leveraged certain ships in its fleet to assist with the repatriation efforts along with utilizing scheduled chartered flights. Additionally, during the first quarter of 2020, there was a notable increase from 2019 in fuel expense associated with the International Maritime Organization’s 2020 regulations, and cruise operating expense increased due to the addition of Norwegian Encore and Seven Seas Splendor to the fleet. Gross Cruise Cost decreased 47.4% in 2020 compared to 2019, due to a decrease in total cruise operating expense described above in addition to a 23.5% decrease in marketing, general and administrative expenses primarily due to cost savings initiatives in connection with the COVID-19 pandemic as described under “Update Regarding COVID-19 Pandemic—Financing Transactions and Cost Containment Measures.” Total other operating expense increased 89.4% in 2020 compared to 2019 primarily due to the impairment of goodwill and trade names triggered by the COVID-19 pandemic. Depreciation and amortization expense also increased primarily due to the delivery of Norwegian Encore in the fourth quarter of 2019 and Seven Seas Splendor in the first quarter of 2020 as well as ship improvement projects. 62 Table of ContentsInterest expense, net was $482.3 million in 2020 compared to $272.9 million in 2019. The increase in 2020 is driven by additional debt outstanding at higher interest rates, partially offset by lower LIBOR. In 2020, interest expense also reflects losses on extinguishment of debt and debt modification costs of $27.8 million. 2019 included losses on extinguishment of debt and debt modification costs of $16.7 million.Other income (expense), net was expense of $33.6 million in 2020 compared to income of $6.2 million in 2019. Other expense in 2020 was primarily due to losses from foreign currency exchange and fuel hedges recognized in earnings as a result of the forecasted transactions no longer being probable or no longer designated as hedges. Other income in 2019 was primarily due to gains from insurance proceeds and a litigation settlement partially offset by losses on foreign currency exchange.Income tax benefit (expense) was an expense of $12.5 million in 2020 compared to a benefit of $18.9 million in 2019. In 2020, the tax expense is primarily due to a valuation allowance of $39.6 million recognized in the fourth quarter on certain net operating loss carryforwards partially offset by operating losses. During 2018, we implemented certain tax restructuring strategies that created our ability to utilize the net operating loss carryforwards of Prestige, for which we had previously provided a full valuation allowance. As a result, we recorded a tax benefit of $35.7 million in connection with the reversal of substantially all of the valuation allowance in 2019.Liquidity and Capital ResourcesGeneralAs of December 31, 2020, our liquidity was $3.3 billion, consisting of cash and cash equivalents, and our working capital was $1.6 billion. The increase in working capital is a result of the actions described below and is expected to decrease as advance ticket sales increase leading up to when we are able to resume voyages.Since March 2020, we have taken several actions to bolster our financial condition while our global cruise voyages are suspended. In March 2020, NCLC borrowed the full amount of $1.55 billion under its $875 million Revolving Loan Facility and its then existing $675 million Epic Credit Facility. The Epic Credit Facility was repaid in July 2020. Through December 31, 2020, the Company received additional financing through various debt financings and equity offerings totaling $5.6 billion in gross proceeds. See Note 8 – “Long-Term Debt” for further information on the debt financings. The NCLH equity offerings in May, July and November 2020 resulted in 100,984,848 ordinary shares being issued, which does not include any ordinary shares that may be issued pursuant to our exchangeable notes. We have taken additional measures to improve our liquidity through deferring certain ship milestone payments, deferring certain debt amortization payments and extending certain maturities under other agreements, including under our agreements with export credit agencies and related governments. See Note 8 – “Long-Term Debt” for further information. In January 2021, we amended our Senior Secured Credit Facility to further defer certain amortization payments prior to June 30, 2022 and to waive certain financial and other covenants through December 31, 2022. In connection with such amendment, our minimum liquidity requirement was increased to $200 million and such requirement applies through December 31, 2022. Although the Pride of America Credit Facility and Jewel Credit Facility amortization was not deferred, we have entered into an amendment to each facility to waive certain financial and other covenants through the maturity dates of such facilities. The amendments to the Pride of America Credit Facility and Jewel Credit Facility also require us to maintain at least $200 million in free liquidity for the duration of the covenant waiver period. In connection with the foregoing amendments, NCLC and its restricted subsidiaries’ ability to make certain investments, restricted payments, prepayments of certain indebtedness and certain asset sales has also been further restricted. The Company intends to refinance the Pride of America Credit Facility and Jewel Credit Facility as soon as practicable.In addition, in February 2021, we amended certain of our export-credit backed facilities to defer amortization payments aggregating approximately $680 million through March 31, 2022. We also amended all of our export-credit backed facilities to provide that, from the effective date of the amendments to and including December 31, 2022, certain of the financial covenants under such facilities will be suspended and the free liquidity test will be replaced by a covenant to maintain at least $200 million in free liquidity. The amendments also made certain other changes to the facilities, including imposing further restrictions on NCLC’s ability to incur debt, create security, issue equity and make dividends 63 Table of Contentsand other distributions. See Note 8 – “Long-Term Debt” for further information on amendments completed subsequent to December 31, 2020.The Company has also undertaken several proactive cost reduction and cash conservation measures to mitigate the financial and operational impacts of the COVID-19 pandemic, through the reduction of capital expenditures and operating expenses, including food, fuel, insurance, port charges and reduced crew manning of vessels during the suspension, resulting in lower crew payroll expense. See “Update Regarding COVID-19 Pandemic—Financing Transactions and Cost Containment Measures” above for further information.The Company's monthly average cash burn for the fourth quarter 2020 was approximately $190 million and included approximately $15 million per month of additional relaunch-related expenses as the Company began preparing vessels for a potential return to service in early 2021, in connection with the CDC Conditional Order, which did not materialize. The incremental relaunch costs were associated with crew re-staffing, re-positioning and provisioning of vessels, implementation of new health and safety protocols and a ramp-up of demand-generating marketing investments which helped further stimulate the strong future demand the Company is experiencing.For the first quarter of 2021, the Company expects the average cash burn rate to temporarily remain elevated at approximately $190 million per month, or approximately $170 million per month excluding non-recurring debt modification costs, as it ramps down relaunch-related expenses and repatriates crew. The Company has incurred approximately $60 million of one-time debt deferral and modification costs and fees in the first quarter of 2021 as a result of successful debt deferrals and covenant waivers and suspensions, which combined with newbuild payment extensions, have resulted in approximately $1 billion of additional liquidity over the next 12 months. Once the ramp down of relaunch-related expenses are complete, the Company expects its average cash burn rate to decrease and remain at reduced levels until return to service preparations resume. Cash burn rates include ongoing ship operating expenses, administrative operating expenses, interest expense, taxes and expected non-newbuild capital expenditures and excludes cash refunds of customer deposits as well as cash inflows from new and existing bookings, newbuild related capital expenditures and other working capital changes. Future cash burn rate estimates also exclude unforeseen expenses. The fourth quarter 2020 cash burn rate and first quarter 2021 estimate also reflect the deferral of debt amortization and newbuild related payments.We continue to expect a gradual phased relaunch of our ships after the voyage suspension period, with our ships initially operating at reduced occupancy levels. The timing for bringing our ships back to service and the percentage of our fleet in service will depend on a number of factors including, but not limited to, the duration and extent of the COVID-19 pandemic, further resurgences and new variants of COVID-19, the availability, distribution, and efficacy of vaccines and therapeutics for COVID-19, our ability to comply with governmental regulations, port availability, travel restrictions, bans and advisories, and our ability to re-staff our ships and implement new health and safety protocols. The estimation of our future cash flow projections includes numerous assumptions that are subject to various risks and uncertainties. Until we are able to begin our phased relaunch, our projected liquidity requirements reflect our principal assumptions surrounding ongoing operating costs during the suspension of cruise voyages, as well as liquidity requirements for financing costs and necessary capital expenditures, and our ability to implement further cash conservation strategies. Refer to Note 2 – “Summary of Significant Accounting Policies” for further information on liquidity and management’s plan.There can be no assurance that the accuracy of the assumptions used to estimate our liquidity requirements will be correct, and our ability to be predictive is uncertain due to the unknown magnitude and duration of the COVID-19 global pandemic. Based on the liquidity estimates and our current resources, we have concluded we have sufficient liquidity to satisfy our obligations for at least the next twelve months even in the event we do not resume cruise voyages during that period. Nonetheless, we anticipate that we will need additional equity and/or debt financing to fund our operations in the future, especially if our suspension of cruise voyages is prolonged. At December 31, 2020, we were in compliance with all of our debt covenants. Subsequent to December 31, 2020, we have received certain financial and other debt covenant waivers through December 31, 2022 and added new free liquidity requirements. If we do not continue to remain in compliance with our covenants, we would have to seek to amend the covenants. However, no assurances can be made that such amendments would be approved by our lenders. 64 Table of ContentsGenerally, if an event of default under any debt agreement occurs, then pursuant to cross default and/or cross acceleration clauses, substantially all of our outstanding debt and derivative contract payables could become due, and all debt and derivative contracts could be terminated, which could have a material adverse impact to our operations and liquidity.Since March 2020, Moody’s has downgraded our long-term issuer rating to B2, our senior secured rating to B1 and our senior unsecured rating to Caa1. Since April 2020, S&P Global has downgraded our issuer credit rating to B+, lowered our issue-level rating on our $875 million Revolving Loan Facility and $1.5 billion Term Loan A Facility to BB, our issue-level rating on our $675 million 2024 Senior Secured Notes and $750 million 2026 Senior Secured Notes to BB- and our senior unsecured rating to B. If our credit ratings were to be further downgraded, or general market conditions were to ascribe higher risk to our rating levels, our industry, or us, our access to capital and the cost of any debt or equity financing will be further negatively impacted. There is no guarantee that debt or equity financings will be available in the future to fund our obligations, or that they will be available on terms consistent with our expectations. As of December 31, 2020, we had advance ticket sales of $1.2 billion, including the long-term portion, which included approximately $0.85 billion of future cruise credits. We also have agreements with our credit card processors that, as of December 31, 2020, governed approximately $1.0 billion in advance ticket sales that had been received by the Company relating to future voyages. These agreements allow the credit card processors to require under certain circumstances, including the existence of a material adverse change, excessive chargebacks and other triggering events, that the Company maintain a reserve which would be satisfied by posting collateral. Although the agreements vary, these requirements may generally be satisfied either through a percentage of customer payments withheld or providing cash funds directly to the card processor. Any cash reserve or collateral requested could be increased or decreased. As of December 31, 2020, we had a reserve of approximately $200 million with a credit card processor recognized in other long-term assets, and in January 2021, we provided additional cash collateral of $250 million. Additionally, we are required to fund all refunds until further notice and 100% of incoming advance ticket sales deposits with this credit card processor will be withheld and are not expected to the released until the credit card processor’s exposure is fully collateralized. As of December 31, 2020, the exposure was approximately $780 million. The reserve shortfall of approximately $330 million, after taking into effect the January additional collateral provided, will decrease as refunds are funded, cruises are provided and amounts withheld by the credit card processor are allocated to the reserve rather than remitted to the Company. We may be required to find new credit card processors, pledge additional collateral and/or post cash reserves or take other actions that may further reduce our liquidity.Sources and Uses of CashIn this section, references to 2020 refer to the year ended December 31, 2020 and references to 2019 refer to the year ended December 31, 2019.Net cash used in operating activities was $2.6 billion in 2020 compared to net cash provided by operating activities of $1.8 billion in 2019. This decrease was due to the suspension of global cruise voyages during 2020. The net cash used in operating activities in 2020 included net loss of $(4.0) billion, a decrease in advance ticket sales of $811.8 million and timing differences in cash receipts and payments relating to various operating assets and liabilities, which was offset primarily by a $1.6 billion impairment loss. The change in net cash provided by operating activities in 2019 includes net income of $930.2 million as well as timing differences in cash receipts and payments relating to various operating assets and liabilities, including an increase in advance ticket sales of $347.4 million.Net cash used in investing activities was $1.0 billion in 2020, primarily related to payments for the delivery of Seven Seas Splendor, ships under construction, ship improvement projects and shoreside projects. Net cash used in investing activities was $1.7 billion in 2019, primarily related to payments for the delivery of Norwegian Encore, ships under construction, ship improvements and shoreside projects. Net cash provided by financing activities was $6.6 billion in 2020, primarily due to $6.1 billion in proceeds from the issuance of debt and $1.5 billion in proceeds from issuance of NCLH’s ordinary shares. Net cash used in financing activities was $53.4 million in 2019, primarily due to the repurchase of $349.9 million of NCLH’s ordinary shares, net 65 Table of Contentsrepayments of our Revolving Loan Facility and the net refinancing of term loans partially offset by the issuance of new debt. For the Company’s cash flow activities for the fiscal year ended December 31, 2018, see “Item 7—Management’s Discussion and Analysis of Financial Condition and Results of Operations” in the Company’s Annual Report on Form 10-K for the year ended December 31, 2019, which was filed with the U.S. Securities and Exchange Commission on February 27, 2020.Future Capital CommitmentsFuture capital commitments consist of contracted commitments, including ship construction contracts. After recent deferrals, anticipated expenditures related to ship construction contracts were $0.4 billion, $1.6 billion and $2.5 billion for the years ending December 31, 2021, 2022 and 2023, respectively. The Company has export credit financing in place for the anticipated expenditures related to ship construction contracts of $0.2 billion, $0.8 billion and $1.8 billion for the years ending December 31, 2021, 2022 and 2023, respectively. Subsequent to December 31, 2020, we also have a memorandum of agreement in place to finance another $35.2 million. Future expected capital expenditures will significantly increase our depreciation and amortization expense.For the Norwegian brand, Project Leonardo will introduce six additional ships, each ranging from approximately 140,000 to 156,300 Gross Tons with approximately 3,300 to 3,550 Berths, with expected delivery dates from 2022 through 2027. For the Regent brand, we have one Explorer Class Ship on order to be delivered in 2023, which will be approximately 55,000 Gross Tons and 750 Berths. For the Oceania Cruises brand, we have orders for two Allura Class Ships to be delivered in 2023 and 2025. Each of the Allura Class Ships will be approximately 67,000 Gross Tons and 1,200 Berths.The combined contract prices of the nine ships on order for delivery was approximately €7.1 billion, or $8.7 billion based on the euro/U.S. dollar exchange rate as of December 31, 2020. We have obtained export credit financing which is expected to fund approximately 80% of the contract price of each ship, subject to certain conditions. We do not anticipate any contractual breaches or cancellations to occur. However, if any such events were to occur, it could result in, among other things, the forfeiture of prior deposits or payments made by us and potential claims and impairment losses which may materially impact our business, financial condition and results of operations.Capitalized interest for the years ended December 31, 2020 and 2019 was $25.2 million and $32.9 million, respectively, primarily associated with the construction of our newbuild ships.Off-Balance Sheet TransactionsNone.​​​​​​66 Table of ContentsContractual ObligationsAs of December 31, 2020, our contractual obligations with initial or remaining terms in excess of one year, including interest payments on long-term debt obligations, were as follows (in thousands):​​​​​​​​​​​​​​​​​​ ​​ Less than ​​ ​​ More than​​Total 1 year​1-3 years​3-5 years 5 yearsLong-term debt (1)​$ 12,152,083​$ 795,895​$ 1,909,485​$ 5,780,791​$ 3,665,912Operating leases (2)​ 236,185​ 27,371​​ 63,971​​ 63,892​​ 80,951Ship construction contracts (3)​ 8,471,993​ 463,549​​ 3,286,557​​ 2,851,080​​ 1,870,807Port facilities (4)​ 2,067,777​ 71,691​ 142,756​ 145,954​ 1,707,376Interest (5)​ 2,308,176​ 498,851​ 935,898​ 596,396​ 277,031Other (6)​ 1,157,261​ 287,680​ 457,893​ 408,991​ 2,697Total​$ 26,393,475​$ 2,145,037​$ 6,796,560​$ 9,847,104​$ 7,604,774(1)Long-term debt excludes discounts, premiums, deferred financing fees and a beneficial conversion feature, which are a direct addition or deduction from the carrying value of the related debt liability in the consolidated balance sheets. After giving effect to the debt deferrals discussed more fully in Note 8 – “Long-Term Debt”, which were finalized after December 31, 2020, our obligations for the payment of long-term debt are as follows (in thousands): ​​​​​​​​​​​​​​​​​​ ​​ Less than ​​ ​​ More than​​Total 1 year​1-3 years​3-5 years 5 yearsLong-term debt​$ 12,152,083​$ 124,829​$ 2,110,816​$ 6,097,640​$ 3,818,798​(2)Operating leases are primarily for port facilities and offices.(3)Ship construction contracts are for our newbuild ships based on the euro/U.S. dollar exchange rate as of December 31, 2020. Export credit financing is in place from syndicates of banks for $212.0 million. Subsequent to December 31, 2020, $194.1 million of payments due within one year have been deferred and we have a memorandum of agreement to finance another $35.2 million.(4)Port facilities represent our usage of certain port facilities. Our port facilities agreements generally include force majeure provisions that may alleviate an unspecified amount of obligations under minimum guarantees during the COVID-19 pandemic. In 2020, the Company provided the required notice that such provisions were being enacted. Customary practice is to prorate these obligations for the annual period impacted. A portion of our port fees may be waived as a result of these provisions, including those ports that are presented within operating leases in the table above.(5)Interest includes fixed and variable rates with LIBOR held constant as of December 31, 2020. Due to the subsequent deferrals of scheduled amortization and amendments to interest rates as more fully discussed in Note 8 – “Long-Term Debt”, interest obligations for debt outstanding as of December 31, 2020 are as follows (in thousands):​​​​​​​​​​​​​​​​​​ ​​ Less than ​​ ​​ More than​​Total 1 year​1-3 years​3-5 years 5 yearsInterest​$ 2,352,474​$ 504,197​$ 968,782​$ 600,479​$ 279,016​(6)Other includes future commitments for service, maintenance and other business enhancement capital expenditure contracts. Certain contracts to provide many of our hotel and restaurant services, including both food and labor costs, contain provisions which provide for reduced obligations in the case of a ship(s) removed from operations. As a result, we may only be required to cover reasonable costs during the time period whereby our operations have temporarily been suspended. These reasonable costs are subject to ongoing negotiations.​OtherCertain service providers may require collateral in the normal course of our business. The amount of collateral may change based on certain terms and conditions.67 Table of ContentsAs a routine part of our business, depending on market conditions, exchange rates, pricing and our strategy for growth, we regularly consider opportunities to enter into contracts for the building of additional ships. We may also consider the sale of ships, potential acquisitions and strategic alliances. If any of these transactions were to occur, they may be financed through the incurrence of additional permitted indebtedness, through cash flows from operations, or through the issuance of debt, equity or equity-related securities.We refer you to “—Liquidity and Capital Resources” for information regarding collateral provided to our credit card processors.Funding SourcesCertain of our debt agreements contain covenants that, among other things, require us to maintain a minimum level of liquidity, as well as limit our net funded debt-to-capital ratio, and maintain certain other ratios. Substantially all of our ships and other property and equipment are pledged as collateral for certain of our debt. We believe we were in compliance with these covenants as of December 31, 2020.In addition, our existing debt agreements restrict, and any of our future debt arrangements may restrict, among other things, the ability of our subsidiaries, including NCLC, to make distributions and/or pay dividends to NCLH and NCLH’s ability to pay cash dividends to its shareholders. NCLH is a holding company and depends upon its subsidiaries for their ability to pay distributions to it to finance any dividend or pay any other obligations of NCLH. However, we do not believe that these restrictions have had or are expected to have a significant impact on our ability to meet our cash obligations.In light of the measures described under "Update Regarding COVID-19—Financing Transactions and Cost Containment Measures", we believe our cash on hand, expected future operating cash inflows and our ability to issue debt securities or additional equity securities, will be sufficient to fund operations, debt payment requirements, capital expenditures and maintain compliance with covenants under our debt agreements over the next 12-month period. Certain debt covenant waivers were received in 2021 to enable the Company to maintain this compliance. Refer to “—Liquidity and Capital Resources” for further information regarding the debt covenant waivers. There is no assurance that cash flows from operations and additional financings will be available in the future to fund our future obligations. Furthermore, we anticipate that we will need additional equity and/or debt financing to fund our operations in the future, especially if our suspension of cruise voyages is prolonged.​Item 7A. Quantitative and Qualitative Disclosures about Market RiskGeneralWe are exposed to market risk attributable to changes in interest rates, foreign currency exchange rates and fuel prices. We attempt to minimize these risks through a combination of our normal operating and financing activities and through the use of derivatives. The financial impacts of these derivative instruments are primarily offset by corresponding changes in the underlying exposures being hedged. We achieve this by closely matching the notional, term and conditions of the derivatives with the underlying risk being hedged. We do not hold or issue derivatives for trading or other speculative purposes. Derivative positions are monitored using techniques including market valuations and sensitivity analyses.Interest Rate RiskAs of December 31, 2020, we had interest rate swap and collar agreements to hedge our exposure to interest rate movements and to manage our interest expense. As of December 31, 2020, 74% of our debt was fixed and 26% was variable, which includes the effects of the interest rate swaps and collars. The notional amount of outstanding debt associated with the interest rate derivative agreements was $0.7 billion as of December 31, 2020. As of December 31, 2019, 78% of our debt was fixed and 22% was variable, which includes the effects of the interest rate swaps and collars. The notional amount of outstanding debt associated with the interest rate derivative agreements was $1.7 billion as of 68 Table of ContentsDecember 31, 2019. The change in our fixed rate percentage from December 31, 2019 to December 31, 2020 was primarily due to the maturity of interest rate swaps.Based on our December 31, 2020 outstanding variable rate debt balance, a one percentage point increase in annual LIBOR interest rates would increase our annual interest expense by approximately $31.9 million excluding the effects of capitalization of interest.Foreign Currency Exchange Rate RiskAs of December 31, 2020, we had foreign currency derivatives to hedge the exposure to volatility in foreign currency exchange rates related to our ship construction contracts denominated in euros. These derivatives hedge the foreign currency exchange rate risk on a portion of the payments on our ship construction contracts. The payments not hedged aggregate €5.0 billion, or $6.1 billion based on the euro/U.S. dollar exchange rate as of December 31, 2020. As of December 31, 2019, the payments not hedged aggregated €3.0 billion, or $3.4 billion, based on the euro/U.S. dollar exchange rate as of December 31, 2019. The change from December 31, 2019 to December 31, 2020 was due to the delivery of Seven Seas Splendor. We estimate that a 10% change in the euro as of December 31, 2020 would result in a $0.6 billion change in the U.S. dollar value of the foreign currency denominated remaining payments.Fuel Price RiskOur exposure to market risk for changes in fuel prices relates to the forecasted purchases of fuel on our ships. Fuel expense, as a percentage of our total cruise operating expense, was 15.6% for the year ended December 31, 2020 and 11.2% for the year ended December 31, 2019. We use fuel derivative agreements to mitigate the financial impact of fluctuations in fuel prices and as of December 31, 2020, excluding fuel swaps for transactions that are no longer probable of occurrence, we had hedged approximately 59%, 37% and 15% of our 2021, 2022 and 2023 projected metric tons of fuel purchases, respectively. As of December 31, 2019, we had hedged approximately 50% and 18% of our 2021 and 2022 projected metric tons of fuel purchases, respectively. Additional hedges were executed between December 31, 2019 to December 31, 2020 to lower our fuel price risk.We estimate that a 10% increase in our weighted-average fuel price would increase our anticipated 2021 fuel expense by $29.5 million. This increase would be partially offset by an increase in the fair value of our fuel swap agreements of $17.5 million. Fair value of our derivative contracts is derived using valuation models that utilize the income valuation approach. These valuation models take into account the contract terms such as maturity, as well as other inputs such as fuel types, fuel curves, creditworthiness of the counterparty and the Company, as well as other data points.​
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+ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (MD&A)The following discussion should be read together with the Consolidated Financial Statements and the Notes to Consolidated Financial Statements, which are included in this Form 10-K in Item 8 and the information set forth in Risk Factors under Part 1, Item 1A.INDEXPAGECurrent Business Outlook and Strategy20Oil and Gas Segment23Chemical Segment32Midstream and Marketing Segment33Segment Results of Operations and Items Affecting Comparability35Income Taxes38Consolidated Results of Operations39Liquidity and Capital Resources42Off-Balance Sheet Arrangements43Commitments and Obligations43Lawsuits, Claims, Commitments and Contingencies44Environmental Liabilities and Expenditures46Global Investments48Critical Accounting Policies and Estimates48Significant Accounting and Disclosure Changes52Safe Harbor Discussion Regarding Outlook and Other Forward-Looking Data52OXY 2020 FORM 10-K19MANAGEMENT’S DISCUSSION AND ANALYSISCURRENT BUSINESS OUTLOOK AND STRATEGYGENERALOccidental’s operations, financial condition, cash flows and levels of expenditures are highly dependent on oil prices and, to a lesser extent, NGL and natural gas prices, the Midland-to-Gulf-Coast oil spreads and the prices it receives for its chemical products. The worldwide economy has been severely impacted by the ongoing effects of the COVID-19 pandemic, which began during the first quarter of 2020. In the first quarter, travel restrictions and stay-at-home orders were implemented for much of the world to limit the spread of COVID-19. Though certain restrictions have been lifted, some areas have recently reinstated stay at home orders and oil and gas demand remains below pre-pandemic levels. On April 12, 2020, certain members of the OPEC and 10 non-OPEC partner countries (OPEC+) agreed to production cuts intended to mitigate the oil supply and demand imbalance to stabilize prices. On January 5, 2021, OPEC+ agreed to extend the cuts through March 2021. These production cuts coupled with declining U.S. production helped mitigate the supply and demand imbalance. While the spot WTI oil price has recovered to above $60.00/Bbl as of the date of this filing, the average daily WTI oil price fell from $57.03/Bbl in 2019 to $39.40/Bbl in 2020 or 31 percent. We expect that the oil supply and demand balance and consequently oil prices in the near-term will continue to be influenced by the duration and severity of the COVID-19 pandemic; the effectiveness and pace of the distribution of the recently approved vaccines; and OPEC+ and U.S. production levels. LIQUIDITYIn response to the dramatic drop in oil prices and the current macroeconomic environment, Occidental has taken significant measures to increase its near and mid-term liquidity and address near-term debt maturities. Specifically, during 2020 Occidental:■Reduced its 2020 capital budget to $2.6 billion from a range of $5.2 billion to $5.4 billion, a midpoint reduction of approximately 50%;■Made significant cuts to its 2020 operating and corporate costs. On an annualized basis, Occidental has realized $1.5 billion of overhead savings and over $900 million in operating cost savings, of which a majority is expected to remain permanent in future years;■Reduced the quarterly common stock dividend to $0.01 per share from $0.79 per share, effective July 2020, which on an annualized basis, will reduce its common stock dividend outlay by approximately $2.9 billion;■Elected to pay the preferred stock dividend paid in the second and third quarters of 2020 in the form of shares of common stock, in lieu of cash, preserving $400 million of liquidity. Occidental elected to pay the dividend paid in the fourth quarter in cash. The Board of Directors will continue to assess market conditions and Occidental's financial condition on a quarterly basis to determine whether the preferred stock dividend will be paid in shares of stock, in cash or a combination of shares of common stock and cash;■Entered into a new receivable securitization facility that provides additional liquidity of up to $400 million;■Issued $7.0 billion in senior unsecured notes (the Senior Notes Offerings) during 2020 to extend certain debt maturities in 2021-2023 to 2025-2031;■Since the Acquisition, completed significant asset divestitures for net proceeds of approximately $8.2 billion;■Used the net proceeds from asset sales, cash on hand and Senior Notes Offerings to retire or tender $6.0 billion of 2021, $2.7 billion of 2022 and $264 million of 2023 maturities; and■Exchanged approximately 27.9 million WES common units to retire a $260 million note payable to WES due 2038.In 2019, Occidental entered into three-way oil collar and call derivative instruments to reduce its exposure to commodity price risk and increase the predictability of near-term cash flows. The majority of the collars settled in 2020 with the receipt of cash of $960 million. The remaining $52 million settled in 2021. See Note 9 - Derivatives in the Notes to Consolidated Financial Statements in Part II, Item 8 of this Form 10-K. Occidental believes the actions outlined above enhance its liquidity position to fund its operations. Occidental will continue to evaluate the economic environment, as well as the commodity price environment, and may make further adjustments to its future levels of expenditures and operating and corporate costs. However, the ultimate impact of the COVID-19 pandemic on Occidental's results of operations, cash flows and financial position are unknown, and those impacts could be material. Additionally, actions taken in response to the current macro-environment may result in the long-term reduction of its capital expenditure and production profile. DEBT AND INTEREST RATE SWAPSWith the completion of the liquidity measures above, as of the date of this filing, Occidental has debt maturities of approximately $371 million in 2021, $2.1 billion in 2022 and $0.9 billion in 2023. Occidental’s $2.3 billion Zero Coupon senior notes due 2036 (Zero Coupons) can be put to Occidental in October of each year, in whole or in part, for the then accreted value of the outstanding Zero Coupons. An immaterial amount was put 20OXY 2020 FORM 10-KMANAGEMENT’S DISCUSSION AND ANALYSISto Occidental in 2020. The Zero Coupons can next be put to Occidental in October 2021, which, if put in whole, would require a payment of approximately $1.0 billion at such date. Occidental currently has the intent and ability to meet this obligation, including, if necessary, using amounts available under the revolving credit facility (RCF) should the put right be exercised. Interest rate swaps with a notional value of $750 million and fair value of $894 million, as of December 31, 2020, have mandatory termination dates in September 2021. Interest rate swaps with a notional value of $725 million and fair value of $876 million, as of December 31, 2020, have mandatory termination dates in September 2022 and 2023. The interest rate swaps fair value, and cash required to settle them on their termination dates, will continue to fluctuate with changes in interest rates through the mandatory termination dates. As of December 31, 2020, Occidental had approximately $2.0 billion of cash and cash equivalents on hand. As of the date of this filing, $5.0 billion of borrowing capacity under its existing RCF, which matures in 2023. Occidental continues to pursue divestitures of certain assets and intends to use the net proceeds from asset sales and excess free cash flow to repay its nearer-term debt maturities, but the expected timing and final proceeds from such asset sales are uncertain. Occidental currently expects its cash on hand and funds available under its RCF to be sufficient to meet its debt maturities, operating expenditures and other obligations for the next 12 months from the date of this filing. However, given the inherent uncertainty associated with the duration and severity of the COVID-19 pandemic and its resulting impact on oil demand, Occidental may need to raise capital to fund its operations and refinance debt maturities.DEBT RATINGSIn connection with the Senior Notes Offerings, Occidental's long-term debt credit ratings were reviewed by the three major rating agencies. As of December 31, 2020, Occidental’s long-term debt was rated BB by Fitch Ratings, Ba2 by Moody’s Investors Service and BB- by Standard and Poor’s. Any additional downgrade in credit ratings could impact Occidental's ability to access capital markets and increase its cost of capital. In addition, given that Occidental’s current debt ratings are non-investment grade, Occidental may be requested, and in some cases required, to provide collateral in the form of cash, letters of credit, surety bonds or other acceptable support as financial assurance of its performance and payment obligations under certain contractual arrangements such as pipeline transportation contracts, environmental remediation obligations, oil and gas purchase contracts and certain derivative instruments.As of the date of this filing, Occidental has provided required financial assurances through a combination of cash, letters of credit and surety bonds and has not issued any letters of credit under the RCF or other committed facilities. For additional information, see Risk Factors in Part I, Item 1A of this Form 10-K.IMPACT OF COVID-19 PANDEMIC TO GLOBAL OPERATIONSOccidental is focused on protecting the health and safety of its employees and contractors during the COVID-19 pandemic. Occidental has implemented workplace restrictions in our offices and work sites for health and safety reasons. Occidental has not incurred material costs as a result of new protocols and procedures. Occidental continues to monitor national, state and local government directives where Occidental has operations and/or offices. While Occidental has not incurred any significant disruptions to its day-to-day operations as a result of any workplace restrictions related to the COVID-19 pandemic to date, the extent to which the COVID-19 pandemic adversely affects our business, results of operations and financial condition will depend on future developments, which are highly uncertain.RECENT GOVERNMENTAL RULE MAKING AND EXECUTIVE ORDERSIn January 2021, the COGCC adopted new regulations that impose siting requirements or “setbacks” on certain oil and gas drilling locations based on the distance of a proposed well pad to occupied structures. Pursuant to the regulations, well pads cannot be located within 500 feet of an occupied structure without the consent of the property owner. As part of the permitting process, the COGCC will consider a series of siting requirements for all drilling locations located between 500 feet and 2,000 feet of an occupied structure. Alternatively, the operator may seek a waiver from each owner and tenant within the designated distance. While Occidental is currently evaluating the impact of these regulations on its business, at this time, Occidental does not anticipate significant near-term changes to our development program in the DJ Basin based on these regulations. However, as a result certain of Occidental’s PUD reserves have been derecognized as they no longer meet the regulatory certainty criteria to be considered proved reserves. Occidental’s ability to reestablish previously derecognized PUD reserves, as well as establishing new PUD locations will depend upon Occidental establishing a history of obtaining drilling permits under the new regulations and thus meeting the SEC’s “reasonably certain” threshold for adding PUD reserves. Occidental currently believes it will be able to successfully navigate the new setback guidelines.An executive order was issued in January 2021, Tackling the Climate Crisis at Home and Abroad, that mandated an indefinite pause on new oil and gas leasing on federal lands, onshore and offshore, while a comprehensive review of oil and gas permitting and leasing is conducted by the U.S. Department of the Interior. In conducting this review, the Secretary of the Interior shall consider whether to adjust royalties associated with oil and gas resources extracted from public lands and offshore waters to account for corresponding climate costs.In addition, effective January 20, 2021, the Department of the Interior issued an order temporarily elevating the decision-making approval previously delegated to the Department of the Interior’s agencies and bureaus, including the BOEM and the BLM, to issue any onshore and offshore fossil fuel authorization for, including but not limited to a lease, OXY 2020 FORM 10-K21MANAGEMENT’S DISCUSSION AND ANALYSISamendment to a lease, affirmative extension of a lease, contract or other agreement or permit to drill to the leadership of the Department of the Interior.Neither of these orders impact existing operations or permits for ongoing operations under valid leases and does not preclude the issuances of leases, permits and other authorizations. Both of these orders align with the new governmental administration’s commitment to addressing climate change, specifically both orders allow for the Department of the Interior to consider potential climate and other impacts associated with oil and gas activities on public lands or in offshore waters.Approximately 9% of Occidental’s onshore net acres are on federal lands while all of its Gulf of Mexico leases are in federal waters. Occidental is continuing to evaluate the overall impact of these new regulatory issuances on its oil and gas operations on federal leases and will reallocate capital to non-federal leases to the extent there are delays in obtaining permits and other authorizations that would alter the timing of development and exploration programs on federal leases. STRATEGYOccidental is focused on delivering a unique shareholder value proposition with its combined integrated asset portfolio, continual enhancements to its organizational capability and commitment to implement innovative carbon management and storage solutions for the reduction of greenhouse gas emissions. Occidental conducts its operations with a focus on sustainability, health, safety and environmental and social responsibility. Capital is employed to operate all assets in a safe and environmentally sound manner. Occidental aims to maximize shareholder returns through a combination of:■Maximizing capital efficiency to sustain fourth quarter 2020 production levels in order to maximize free cash flow;■Prioritizing projects to decrease its carbon footprint and create a business model to help other companies lower theirs;■Reducing financial leverage; and■Maintaining a robust liquidity position.KEY PERFORMANCE INDICATORSOccidental seeks to meet its strategic goals by continually measuring its success against key performance indicators that drive total stockholder return. In addition to efficient capital allocation and deployment discussed below in “Oil and Gas Segment - Business Strategy”, Occidental believes the following are its most significant performance indicators:SAFETY ■Injury Incidence Rate (IIR) and Days Away Restricted Transfer rate (DART) - Occidental’s combined employee and contractor IIR is determined by multiplying the total number of Occupational Safety and Health Administration (OSHA) recordable injuries and illnesses by 200,000 and dividing that result by the total number of hours worked by all employees and contractors. The DART rate is calculated in the same manner as IIR, but uses the number of incidents that resulted in days away from work, job transfer, or restricted job duties instead of the number of recordable injuries or illnesses.OPERATIONAL■Annual cost synergies - Post Acquisition, Occidental has focused on an annualized reduction in overhead and operating expense strategies from the historical amounts of Occidental and Anadarko, and exceeded its initial goal of at least $1.1 billion by realizing $2.3 billion in total synergies and additional cost savings on an annualized basis in 2020.■Total spend per barrel - In 2021, Occidental will focus on controlling total costs from a per-barrel perspective. Total spend per barrel is the sum of capital spending, general and administrative expenses, other operating and non-operating expenses and oil and gas lease operating costs divided by global oil, NGL and natural gas sales volumes.FINANCIAL■Cash returns on capital employed (CROCE) - CROCE is calculated as (i) the cash flows from operating activities, before changes in working capital, plus distributions from WES, divided by (ii) the average of the opening and closing balances of total equity plus total debt.■Reduce financial leverage.SUSTAINABILITY AND ENVIRONMENTAL■Advancing specific Carbon Capture, Use and Sequestration projects;■Net-zero operational and energy use emissions before 2040, with an ambition to achieve before 2035;■Net-zero total emissions inventory including product use with an ambition to achieve before 2050; and■Total carbon impact through carbon removal and storage technology and development past 2050.22OXY 2020 FORM 10-KMANAGEMENT’S DISCUSSION AND ANALYSISOIL AND GAS SEGMENTBUSINESS STRATEGYOccidental’s oil and gas segment focuses on long-term value creation and leadership in sustainability, health, safety and the environment. In each core operating area, Occidental’s operations benefit from scale, technical expertise, decades of high-margin inventory, environmental and safety leadership and commercial and governmental collaboration. These attributes allow Occidental to bring additional production quickly to market, extend the life of older fields at lower costs and provide low-cost returns-driven growth opportunities with advanced technology.With the completion of the Acquisition, Occidental became one of the largest U.S. producers of liquids, which includes oil, condensate and NGL, allowing Occidental to maximize cash margins on a Boe basis. Since the Acquisition, Occidental has focused on its divestiture program to divest of non-core assets to pay down near-term debt maturities, however, the advantages that Occidental’s portfolio provides, coupled with unmatched subsurface characterization ability and the proven ability to execute, ensures that Occidental is positioned for full-cycle success in the years ahead. The oil and gas segment has realized synergies to deliver lower breakeven costs and generate excess free cash flow. Since the Acquisition, Occidental completed the sale of significant non-core assets for net proceeds of approximately $8.2 billion.Despite the pandemic impacts on commodity prices and the overall economy as discussed above, Occidental’s assets are strategically positioned to provide a future portfolio of projects that are flexible and have short-cycle investment paybacks. Together with Occidental’s technical capabilities, the oil and gas segment strives to achieve low development and operating costs to maximize full-cycle value of the assets.The oil and gas business implements Occidental’s strategy primarily by:■Operating and developing areas where reserves are known to exist and optimizing capital intensity in core areas, primarily in the Permian Basin, DJ Basin, Gulf of Mexico, UAE, Oman and Algeria;■Maintaining a disciplined and prudent approach to capital expenditures with a focus on high-return, short-cycle, cash-flow-generating opportunities and an emphasis on creating value and further enhancing Occidental’s existing positions;■Focusing Occidental’s subsurface characterization and technical activities on unconventional opportunities, primarily in the Permian Basin;■Using EOR techniques, such as CO2, water and steam floods in mature fields; and■Focusing on cost-reduction efficiencies and innovative technologies to reduce carbon emissions.In 2020, oil and gas capital expenditures were approximately $2.2 billion and primarily focused on Occidental’s assets in the Permian Basin, DJ Basin, Gulf of Mexico and Oman.OIL AND GAS PRICE ENVIRONMENTOil and gas prices are the major variables that drive the industry’s financial performance. The following table presents the average daily West Texas Intermediate (WTI) and Brent prices for oil in dollars per barrel ($/Bbl) and New York Mercantile Exchange (NYMEX) natural gas prices for 2020 and 2019:20202019% ChangeWTI Oil ($/Bbl)$39.40 $57.03 (31)%Brent Oil ($/Bbl)$43.21 $64.18 (33)%NYMEX Natural Gas ($/Mcf)$2.11 $2.67 (21)%The following table presents Occidental’s average realized prices for continuing operations as a percentage of WTI, Brent and NYMEX for 2020 and 2019:20202019Worldwide oil as a percentage of average WTI95 %99 %Worldwide oil as a percentage of average Brent (a)87 %88 %Worldwide NGL as a percentage of average WTI32 %30 %Worldwide NGL as a percentage of average Brent (a)29 %27 %Domestic natural gas as a percentage of NYMEX56 %49 %(a)Prior period percentages have been adjusted to reflect the Algeria operations as continuing operations.OXY 2020 FORM 10-K23MANAGEMENT’S DISCUSSION AND ANALYSISPrices and differentials can vary significantly, even on a short-term basis, making it difficult to predict realized prices with a reliable degree of certainty.As a result of the expected prolonged period of lower commodity prices brought on by the COVID-19 pandemic’s impact on oil demand, Occidental tested substantially all of its oil and gas assets for impairment during the second quarter of 2020. Occidental recognized pre-tax impairment charges of $6.4 billion related to continuing operations and $2.2 billion related to discontinued operations for the three months ended June 30, 2020. While oil prices have modestly improved since the second quarter of 2020, if there was a worsening of the macroeconomic conditions caused by the impacts of COVID-19 and if such worsened condition was expected to be prolonged, Occidental’s oil and gas properties may be subject to further testing for impairment, which could result in additional non-cash asset impairments, and such impairments could be material to our financial statements. DOMESTIC INTERESTSBUSINESS REVIEWOccidental conducts its domestic operations through land leases, subsurface mineral rights it owns, or a combination of both. Occidental’s domestic oil and gas leases have a primary term ranging from one to 10 years, which is extended through the end of production once it commences. Occidental has leasehold and mineral interests in 9.5 million net acres, of which approximately 52% is leased, 24% is owned subsurface mineral rights and 24% is owned land with mineral rights. The following chart shows Occidental’s domestic production volumes for the previous three years in thousand barrels of oil equivalent (Mboe) per day: 24OXY 2020 FORM 10-KMANAGEMENT’S DISCUSSION AND ANALYSISDOMESTIC ASSETS (a)1. Powder River Basin2. DJ Basin3. Permian Basin4. Gulf of Mexico(a)Map represents geographic outlines of the respective basins.The Permian Basin The Permian Basin extends throughout West Texas and southeast New Mexico and is one of the largest and most active oil basins in the United States, accounting for more than 36% of total United States oil production in 2020. Occidental manages its Permian Basin operations through two business units: Permian Resources, which includes unconventional opportunities, and Permian EOR, which utilizes EOR techniques such as CO2 floods and waterfloods. Occidental has a leading position in the Permian Basin, producing approximately 13% of total oil in the basin. By exploiting the natural synergies between Permian Resources and Permian EOR, Occidental is able to deliver unique short- and long-term advantages, efficiencies and expertise across its Permian Basin operations. Permian Resources unconventional oil development projects provide very short-cycle investment payback, averaging less than two years, and generate some of the highest margin and returns of any oil and gas projects in the world. These investments contribute cash flow, while increasing long-term value and sustainability through higher return on capital employed. Occidental’s oil and gas operations in Permian Resources include approximately 1.6 million net acres. In 2020, new well design and flowback methods were implemented, which helped lower the overall well cost while improving recovery. Overall in 2020, Permian Resources produced approximately 435 Mboe/d from approximately 6,000 gross wells. Additionally in 2020, Permian Resources added 122 million barrels of oil equivalent (MMboe) to Occidental’s proved reserves for improved recovery additions. The Permian Basin’s concentration of large conventional reservoirs, favorable CO2 flooding performance and the expansive CO2 transportation and processing infrastructure has resulted in decades of high-value enhanced oil production. With 34 active CO2 floods and over 40 years of experience, Occidental is the industry leader in Permian Basin CO2 flooding, which can increase ultimate oil recovery by 10% to 25%. Technology improvements, such as the recent trend toward vertical expansion of the CO2 flooded interval into residual oil zone targets, continue to yield more recovery from existing projects. Occidental’s share of production from Permian EOR was approximately 140 Mboe/d in 2020.Significant opportunities also remain to gain additional recovery by expanding Occidental’s existing CO2 projects into new portions of reservoirs that have only been water-flooded. Permian EOR has a large inventory of future CO2 projects, which could be developed over the next 20 years or accelerated, depending on market conditions. In addition, OLCV continues making progress towards supplying anthropogenic, or man-made, CO2 for the purpose of carbon capture, utilization and storage in Occidental’s Permian EOR operations.In 2020, Occidental spent approximately $1.1 billion of capital in the Permian Basin, of which over 87% was spent on Permian Resources assets. Also in 2020, Occidental divested of certain non-core, largely non-operated acreage in the Permian Basin. In 2021, Occidental expects to allocate approximately 38% of its worldwide capital budget to the Permian Basin.OXY 2020 FORM 10-K25MANAGEMENT’S DISCUSSION AND ANALYSISDJ BasinOccidental remains Colorado’s top oil and gas producer with interest in approximately 0.7 million net acres in Colorado. Production is derived from 2,500 operated vertical wells and 2,100 operated horizontal wells primarily focused in 460,000 net acres in the Niobrara and Codell formations. The DJ Basin provides competitive economics, low breakeven costs and free cash flow generation.Occidental produced approximately 293 Mboe/d in the DJ Basin in 2020. Horizontal drilling results in the field continue to be strong, with improved operational efficiencies in drilling and completions. In 2020, Occidental drilled 65 operated horizontal wells and completed 117 operated horizontal wells.Occidental is currently fully permitted for all planned 2021 completions activity and has received drilling permits for all planned drilling activity through the first half of 2021. New statewide regulations were adopted in the fourth quarter of 2020 and became effective in mid-January 2021. Occidental’s focus for 2021 is continuing to build operational inventory while implementing the new regulations and maintaining social licenses to operate. Occidental additionally continues to have development optionality by flexing resources between the DJ Basin and another emerging high rate-of-return program in the Powder River Basin.As discussed above, in January 2021, the COGCC adopted new regulations that impose siting requirements or “setbacks” on certain oil and gas drilling locations based on the distance of a proposed well pad to occupied structures. While Occidental is currently evaluating the impact of these regulations on its business; at this time, Occidental does not anticipate significant near-term changes to our development program in the DJ Basin based on these regulations. However, if Occidental is unable to obtain new drilling permits to develop a significant portion of the company’s undeveloped acreage in the DJ Basin, the company’s DJ Basin assets may be subject to testing for impairment, and if deemed to be impaired, such impairment could be material to our financial statements.Other DomesticOccidental holds approximately 5.0 million net acres in other domestic locations, which is primarily comprised of the Powder River Basin, North DJ Basin and Wyoming. Occidental's share of production in other domestic locations was approximately 39 Mboe/d in 2020.OFFSHORE DOMESTIC ASSETSGulf of MexicoOccidental owns a working interest in 182 blocks in the Gulf of Mexico, operates 10 active floating platforms and holds interests in 17 active fields. The Gulf of Mexico produced approximately 130 Mboe/d during 2020. In 2021, Occidental will continue to take advantage of its extensive infrastructure across the Gulf of Mexico to execute its long-term plan for development and exploration. Occidental will operate one floating drillship and one platform rig together with two multi-service vessels to cost effectively develop known resources. Occidental continues to work with the BSEE and the BOEM to address the additional regulatory requirements to ensure a minimal disruption of activities in the Gulf of Mexico. The following table shows areas of continuing development in the Gulf of Mexico along with the corresponding working interest in those areas.Working InterestHorn Mountain100 %Holstein100 %Marlin100 %Lucius64 %K2 Complex42 %Caesar Tonga34 %Constellation33 %INTERNATIONAL INTERESTSBUSINESS REVIEWOccidental conducts its ongoing international operations in two sub-regions: the Middle East and Africa. Its activities include oil, NGL and natural gas production through direct working-interests and production sharing contracts (PSC).Production Sharing ContractsOccidental’s interest in Oman and Qatar are subject to PSCs. Under such contracts, Occidental records a share of production and reserves to recover certain development and production costs and an additional share for profit. These contracts do not transfer any right of ownership to Occidental and reserves reported from these arrangements are based on 26OXY 2020 FORM 10-KMANAGEMENT’S DISCUSSION AND ANALYSISOccidental’s economic interest as defined in the contracts. Occidental’s share of production and reserves from these contracts decreases when product prices rise and increases when prices decline. Overall, Occidental’s net economic benefit from these contracts is greater when product prices are higher.The following chart shows Occidental’s international production volumes for the previous three years:Note: Operations sold, exited or held for sale include the Ghana assets (held for sale at December 31, 2020 and 2019), the Colombia onshore assets (sold in December 2020) and the Qatar Idd El Shargi Fields (exited in 2019).MIDDLE EAST / NORTH AFRICA ASSETS1.Algeria2.Oman3.Qatar4.United Arab EmiratesAlgeriaIn April 2020, subsequent to communications with Algerian government officials, Occidental determined that the sale of the Algeria operations to Total would not be consummated and the decision was made to continue to operate within Algeria. As a result, Occidental reclassified 2019 results to reflect the Algeria operations as continuing operations. Operations in Algeria involve production and development activities in 18 fields within Blocks 404A and 208, which are located in the Berkine Basin in Algeria’s Sahara Desert and are governed by a Production Sharing Agreement (PSA) between Occidental, Sonatrach and other partners. Under this PSA, Occidental is responsible for 24.5% of the development and production costs. The El Merk Central Processing Facility (CPF) in Block 208 processed produced oil and NGL, while the Hassi Berkine OXY 2020 FORM 10-K27MANAGEMENT’S DISCUSSION AND ANALYSISSouth and Ourhoud CPFs in Block 404A processed produced oil. In 2020, Occidental drilled two development wells and plans to continue drilling operations throughout 2021. Net production in Algeria was 44 Mboe/d in 2020.OmanIn Oman, Occidental is the operator of Block 9 with a 50% working interest, Block 27 with a 65% working interest, Block 53 with a 47% working interest and Block 62 with a 100% working interest. Occidental additionally has exploration and production sharing agreements for Blocks 30, 51, 65 and 72. Occidental holds 6.0 million gross acres and has 10,000 potential well inventory locations. In 2020, Occidental’s share of production was 85 Mboe/d.The Block 9 contract expires in 2030 and the Block 27 contract expires in 2035. Occidental’s share of production for Blocks 9 and 27 was 30 Mboe/d and six Mboe/d in 2020, respectively. The Block 53 (Mukhaizna Field) contract expires in 2035 and is a major world-class pattern steam flood project for EOR that utilizes some of the largest mechanical vapor compressors ever built. Since assuming operations in Mukhaizna in 2005, Occidental has drilled over 3,550 new wells and has increased gross production by over 15 fold. Occidental’s share of production for Block 53 was 30 Mboe/d in 2020. Subject to a declaration of commerciality, Occidental’s permit for Block 62 will expire in 2028. Occidental’s share of production for Block 62 was 19 Mboe/d in 2020.QatarIn Qatar, Occidental partners in the Dolphin Energy Project, an investment that is comprised of two separate economic interests. Occidental has a 24.5% interest in the upstream operations (Dolphin) to develop and produce NGL, natural gas and condensate from Qatar’s North Field through mid-2032. Occidental also has a 24.5% interest in Dolphin Energy Limited, which operates a pipeline and is discussed further in the Midstream and Marketing Segment section in this Form 10-K under Pipeline. Occidental’s net share of production from the Dolphin upstream operations was 44 Mboe/d in 2020.United Arab EmiratesIn 2011, Occidental acquired a 40% participating interest in the Shah gas field (Al Hosn Gas), joining with the Abu Dhabi National Oil Company (ADNOC) in a 30-year joint venture agreement. In 2020, Occidental’s share of production from Al Hosn Gas was 238 MMcf/d of natural gas and 38 Mboe/d of NGL and condensate. Al Hosn Gas includes gas processing facilities which are discussed further in the Midstream and Marketing Segment section in this Form 10-K under Gas Processing, Gathering and CO2.In 2019 and 2020, Occidental acquired 9-year exploration concessions and, subject to a declaration of commerciality, 35-year production concessions adjacent to Al Hosn Gas for onshore Block 3 and Block 5, which cover an area of approximately 1.5 million acres and 1.0 million acres, respectively. Occidental conducts a majority of its Middle East business development activities through its office in Abu Dhabi, which also provides various support functions for Occidental’s Middle East oil and gas operations.Ghana - Discontinued OperationsIn May 2020, Occidental and Total mutually agreed to execute a waiver of the obligation to purchase and sell the Ghana assets, so that Occidental could begin marketing the sale of the Ghana assets to other third parties. Occidental is currently marketing the Ghana assets. The assets and liabilities for Ghana remain presented as held for sale in discontinued operations at December 31, 2020. Ghana operations include production and development activities located offshore in the West Cape Three Point Block and the Deepwater Tano Block. Occidental’s share of production in 2020 was 30 Mboe/d.LATIN AMERICA ASSETSColombiaIn December 2020, Occidental completed the sale of its Colombia onshore assets, specifically the operations and working interests in the Llanos Norte, Middle Magdalena and Putumayo Basins. Occidental has retained a presence with exploration blocks offshore Colombia. PROVED RESERVESProved oil, NGL and natural gas reserves were estimated using the unweighted arithmetic average of the first-day-of-the-month price for each month within the year, unless prices were defined by contractual arrangements. Oil, NGL and natural gas prices used for this purpose were based on posted benchmark prices and adjusted for price differentials including gravity, quality and transportation costs. 28OXY 2020 FORM 10-KMANAGEMENT’S DISCUSSION AND ANALYSISThe following table shows the 2020, 2019 and 2018 calculated first-day-of-the-month average prices for both WTI and Brent oil prices, as well as the Henry Hub gas prices measured in million British thermal units (MMbtu):202020192018WTI Oil ($/Bbl)$39.57 $55.69 $65.56 Brent Oil ($/Bbl)$43.41 $63.03 $72.20 Henry Hub Natural Gas ($/MMbtu)$1.98 $2.58 $3.10 Mt. Belvieu NGL ($/Bbl) (a)$18.74 N/AN/A(a)Mt. Belvieu pricing was added as an NGL benchmark beginning in 2020. Prior to 2020, WTI oil was used as a benchmark for NGL.Occidental had proved reserves from continuing operations at year-end 2020 of 2,911 MMboe, compared to the year-end 2019 amount of 3,904 MMboe. Proved developed (PD) reserves represented approximately 78% and 77% of Occidental’s total proved reserves at year-end 2020 and 2019, respectively. The following table shows the breakout of Occidental’s proved reserves from continuing operations by commodity as a percentage of total proved reserves:20202019Oil51 %52 %Natural gas29 %29 %NGL20 %19 %Occidental does not have any reserves from non-traditional sources. For further information regarding Occidental’s proved reserves, see the Supplemental Oil and Gas Information section in Item 8 of this Form 10-K.CHANGES IN PROVED RESERVESOccidental’s total proved reserves from continuing operations decreased 993 MMboe in 2020, which was primarily driven by price and other revisions of 484 MMboe and asset divestitures of 241 MMboe. These decreases were partially offset by increases from Occidental’s development program of 212 MMboe. Changes in reserves were as follows:MMboe2020Revisions of previous estimates(484)Improved recovery190 Extensions and discoveries22 Purchases4 Sales(241)Production(484)Total (993)Occidental’s ability to add reserves, other than through purchases, depends on the success of improved recovery, extension and discovery projects, each of which depends on reservoir characteristics, technology improvements and oil and natural gas prices, as well as capital and operating costs. Many of these factors are outside management’s control and may negatively or positively affect Occidental’s reserves.Revisions of Previous EstimatesRevisions can include upward or downward changes to previous proved reserve estimates for existing fields due to the evaluation or interpretation of geologic, production decline or operating performance data. In addition, product price changes affect proved reserves recorded by Occidental. For example, lower prices may decrease the economically recoverable reserves, particularly for domestic properties, because the reduced margin limits the expected life of the operations. Offsetting this effect, lower prices increase Occidental’s share of proved reserves under PSCs because more oil is required to recover costs. Conversely, when prices rise, Occidental’s share of proved reserves decreases for PSCs and economically recoverable reserves may increase for other operations. Reserve estimation rules require that estimated ultimate recoveries be much more likely to increase or remain constant than to decrease, as changes are made due to increased availability of technical data.In 2020, Occidental’s revisions of previous estimates of proved reserves were negative 484 MMboe, of which approximately 342 MMboe were negative price revisions. The negative price revisions were primarily associated with the OXY 2020 FORM 10-K29MANAGEMENT’S DISCUSSION AND ANALYSISPermian Basin (283 MMboe) and the DJ Basin (74 MMboe), which were partially offset by positive price revisions of 36 MMboe on international production sharing contracts.An additional 197 MMboe of negative revisions were related to management changes in development plans due to lower average commodity prices compared to the prior year and the reallocation of capital to higher return projects. These changes were primarily associated with the Permian Basin (143 MMboe).Further positive revisions of 57 MMboe, net, were associated with updates based on reservoir performance. The remaining revisions were associated with various other cost related revisions.Improved RecoveryIn 2020, Occidental added proved reserves of 190 MMboe related to improved recovery primarily due to additional development drilling, mainly in the Permian Basin which accounted for approximately two-thirds of the reserve additions. These properties comprise both unconventional projects and conventional projects, which are characterized by the deployment of EOR development methods, largely employing application of CO2 flood, waterflood or steam flood and unconventional projects. These types of conventional EOR development methods can be applied through existing wells, though additional drilling is frequently required to fully optimize the development configuration. Waterflooding is the technique of injecting water into the formation to displace the oil to the offsetting oil production wells. The use of either CO2 or steam flooding depends on the geology of the formation, the evaluation of engineering data, availability and cost of either CO2 or steam and other economic factors. Both techniques work similarly to lower viscosity causing the oil to move more easily to the producing wells. Many of Occidental’s projects, including unconventional projects, rely on improving permeability to increase flow in the wells. In addition, some improved recovery comes from drilling infill wells that allow recovery of reserves that would not be recoverable from existing wells. Further positive additions of 32 MMboe in the UAE, 13 MMboe in Oman, 9 MMboe in the DJ Basin and 9 MMboe in the Gulf of Mexico were similarly the result of development drilling.Extensions and DiscoveriesOccidental also added proved reserves from extensions and discoveries, which are dependent on successful exploration and exploitation programs. In 2020, extensions and discoveries added 22 MMboe primarily related to the recognition of proved reserves in the DJ Basin, Wyoming and Oman.Purchases of Proved ReservesIn 2020, Occidental purchased proved reserves of 4 MMboe primarily consisting of proved reserves in the Permian Basin.Sales of Proved ReservesIn 2020, Occidental sold 241 MMboe in proved reserves, primarily related to the divestitures of the Colombia onshore assets, the mineral acres and fee surface acres located in Wyoming, Colorado and Utah and the non-core, largely non-operated acreage in the Permian Basin. Proved Undeveloped ReservesOccidental had proved undeveloped reserves at year-end 2020 of 645 MMboe, compared to the year-end 2019 amount of 905 MMboe.Changes in proved undeveloped reserves were as follows:MMboe2020Revisions of previous estimates(253)Improved recovery132 Extensions and discoveries6 Purchases3 Sales(44)Transfer to proved developed reserves(104)Total(260)Total improved recovery additions of 132 MMboe were primarily the result of additional development drilling in the Permian Basin (80 MMboe), international assets (41 MMboe) and the DJ Basin (7 MMboe). The 2020 additions to proved undeveloped reserves were offset by transfers to proved developed reserves and negative revisions of previous estimates. Transfers to proved developed reserves were a total of 104 MMboe. The transfers were primarily associated with the DJ Basin (53 MMboe) and the Permian Basin (48 MMboe). Revisions of previous estimates were a negative 253 MMboe. Approximately 123 MMboe of the negative revisions were related to management changes in development plans, primarily associated with the Permian Basin (111 MMboe). Additionally, the revisions include preliminary impacts related to the 30OXY 2020 FORM 10-KMANAGEMENT’S DISCUSSION AND ANALYSISJanuary 2021 COGCC regulation in the DJ Basin. Further, 77 MMboe of negative revisions were associated with updates based on reservoir performance and 55 MMboe of negative revisions were associated with price revisions.Proved undeveloped reserves are supported by a five-year detailed field-level development plan, which includes the timing, location and capital commitment of the wells to be drilled. Only proved undeveloped reserves which are reasonably certain to be drilled within five years of booking and are supported by a final investment decision to drill them are included in the development plan. A portion of the proved undeveloped reserves associated with international operations are expected to be developed beyond the five years and are tied to approved long-term development projects.In 2020, Occidental incurred approximately $0.5 billion to convert proved undeveloped reserves to proved developed reserves. Given the impact of the COVID-19 pandemic on demand and cash flows, Occidental reduced its 2020 capital expenditures from $5.2 billion to $2.6 billion and; accordingly, converted a lower than expected amount of reserves from proved undeveloped reserves to proved developed reserves. In 2020 Occidental converted approximately 17% of its PUDs to proved developed, when adjusted for revisions and sales. As of December 31, 2020, Occidental had 645 MMboe of PUDs of which 49% were associated with domestic onshore, 8% with Gulf of Mexico and 43% with international assets.Occidental’s most active development areas are located in the Permian Basin, which represented 36% of the proved undeveloped reserves as of December 31, 2020. Approximately 40% of Occidental’s 2021 capital program of $2.9 billion is allocated to the development program in the Permian Basin. Overall, Occidental plans to spend approximately $1.5 billion over the next five years to develop its proved undeveloped reserves in the Permian Basin.At December 31, 2020, Occidental had 207 MMboe of pre-2016 proved undeveloped reserves that remained undeveloped. These proved undeveloped reserves relate to approved long-term development plans, 187 MMboe of which are associated with international development projects with physical limitations in existing gas processing capacity and 20 MMboe associated with certain Permian EOR projects. Occidental remains committed to these projects and continues to actively progress the development of these volumes. In addition to the above, Occidental has 89 MMboe of proved undeveloped reserves that are scheduled to be developed more than five years from their initial date of booking. These proved undeveloped reserves are primarily related to approved long-term development plans with physical limitations in existing gas processing capacity, 51 MMboe of which are associated with other Permian EOR projects and 31 MMboe associated with international development projects. RESERVES EVALUATION AND REVIEW PROCESSOccidental’s estimates of proved reserves and associated future net cash flows as of December 31, 2020, were made by Occidental’s technical personnel and are the responsibility of management. The estimation of proved reserves is based on the requirement of reasonable certainty of economic producibility and funding commitments by Occidental to develop the reserves. This process involves reservoir engineers, geoscientists, planning engineers and financial analysts. As part of the proved reserves estimation process, all reserve volumes are estimated by a forecast of production rates, operating costs and capital expenditures. Price differentials between benchmark prices (the unweighted arithmetic average of the first-day-of-the-month price for each month within the year) and realized prices and specifics of each operating agreement are then used to estimate the net reserves. Production rate forecasts are derived by a number of methods, including estimates from decline curve analysis, type curve analysis, material balance calculations that take into account the volumes of substances replacing the volumes produced and associated reservoir pressure changes, seismic analysis and computer simulation of the reservoir performance. These reliable field-tested technologies have demonstrated reasonably certain results with consistency and repeatability in the formation being evaluated or in an analogous formation. Operating and capital costs are forecast using the current cost environment applied to expectations of future operating and development activities.Net proved developed reserves are those volumes that are expected to be recovered through existing wells with existing equipment and operating methods for which the incremental cost of any additional required investment is relatively minor.Net proved undeveloped reserves are those volumes that are expected to be recovered from new wells on undrilled acreage, or from existing wells where a relatively major expenditure is required for recompletion. Proved undeveloped reserves are supported by a five-year, detailed, field-level development plan, which includes the timing, location and capital commitment of the wells to be drilled. The development plan is reviewed and approved annually by senior management and technical personnel. Annually, a detailed review is performed by Occidental’s Worldwide Reserves Group and its technical personnel on a lease-by-lease basis to assess whether proved undeveloped reserves are being converted on a timely basis within five years from the initial disclosure date. Any leases not showing timely transfers from proved undeveloped reserves to proved developed reserves are reviewed by senior management to determine if the remaining reserves will be developed in a timely manner and have sufficient capital committed in the development plan. Only proved undeveloped reserves that are reasonably certain to be drilled within five years of booking and are supported by a final investment decision to drill them are included in the development plan. A portion of the proved undeveloped reserves associated with international operations are expected to be developed beyond the five years and are tied to approved long-term development plans.The current Senior Vice President, Reserves for Oxy Oil and Gas is responsible for overseeing the preparation of reserve estimates, in compliance with U.S. SEC rules and regulations, including the internal audit and review of Occidental’s oil and gas reserves data. He has over 40 years of experience in the upstream sector of the exploration and production business and has held various assignments in North America, Asia and Europe. He is a three-time past Chair of the Society of Petroleum Engineers Oil and Gas Reserves Committee. He is an American Association of Petroleum Geologists (AAPG) Certified Petroleum Geologist and currently serves on the AAPG Committee on Resource Evaluation. He is a member of the OXY 2020 FORM 10-K31MANAGEMENT’S DISCUSSION AND ANALYSISSociety of Petroleum Evaluation Engineers, the Colorado School of Mines Potential Gas Committee and the United Nations Economic Commission for Europe Expert Group on Resource Management. He has Bachelor of Science and Master of Science degrees in geology from Emory University in Atlanta.Occidental has a Corporate Reserves Review Committee (Reserves Committee), consisting of senior corporate officers, to review and approve Occidental’s oil and gas reserves. The Reserves Committee reports to the Audit Committee of Occidental’s Board of Directors during the year. Since 2003, Occidental has retained Ryder Scott Company, L.P. (Ryder Scott), independent petroleum engineering consultants, to review its annual oil and gas reserve estimation processes. For additional reserves information, see Supplemental Oil and Gas Information under Item 8 of this Form 10-K. In 2020, Ryder Scott conducted a process review of the methods and analytical procedures utilized by Occidental’s engineering and geological staff for estimating the proved reserves volumes, preparing the economic evaluations and determining the reserves classifications as of December 31, 2020, in accordance with SEC regulatory standards. Ryder Scott reviewed the specific application of such methods and procedures for selected oil and gas properties considered to be a valid representation of Occidental’s 2020 year-end total proved reserves portfolio. In 2020, Ryder Scott reviewed approximately 30% of Occidental’s proved oil and gas reserves. Since being engaged in 2003, Ryder Scott has reviewed the specific application of Occidental’s reserve estimation methods and procedures for approximately 87% of Occidental’s existing proved oil and gas reserves.Management retained Ryder Scott to provide objective third-party input on its methods and procedures and to gather industry information applicable to Occidental’s reserve estimation and reporting process. Ryder Scott has not been engaged to render an opinion as to the reasonableness of reserves quantities reported by Occidental. Occidental has filed Ryder Scott’s independent report as an exhibit to this Form 10-K.Based on its reviews, including the data, technical processes and interpretations presented by Occidental, Ryder Scott has concluded that the overall procedures and methodologies Occidental utilized in estimating the proved reserves volumes, documenting the changes in reserves from prior estimates, preparing the economic evaluations and determining the reserves classifications for the reviewed properties are appropriate for the purpose thereof and comply with current SEC regulations.CHEMICAL SEGMENTBUSINESS STRATEGYOxyChem seeks to be a low-cost producer in order to generate cash flow in excess of its normal capital expenditure requirements and achieve above-cost-of-capital returns. OxyChem concentrates on the chlorovinyls chain, beginning with the co-production of caustic soda and chlorine. Caustic soda and chlorine are marketed to external customers. In addition, chlorine, together with ethylene, is converted through a series of intermediate products into PVC. OxyChem’s focus on chlorovinyls allows it to maximize the benefits of integration and take advantage of economies of scale. Capital is employed to sustain production capacity and to focus on projects and developments designed to improve the competitiveness of segment assets. Acquisitions and plant development opportunities may be pursued when they are expected to enhance the existing core chlor-alkali and PVC businesses or take advantage of other specific opportunities. In 2020, capital expenditures for OxyChem totaled $255 million.BUSINESS ENVIRONMENTIn 2020, the United States economic contraction, estimated to be 3.5%, was significantly lower than the 2.2% growth experienced in 2019, which resulted in lower demand for caustic soda and PVC. Pricing for PVC rebounded in the second half of 2020 and finished higher than the 2019 average due to increased domestic demand and lower supply. Caustic soda prices were lower in 2020, partially offset by lower ethylene and energy costs.BUSINESS REVIEWBASIC CHEMICALS The U.S. economic contraction due to the COVID-19 pandemic resulted in lower domestic demand as the industry chlor-alkali operating rates decreased by 8% compared to 2019. Liquid caustic soda prices were lower both domestically and globally in 2020 due to weaker demand in the pulp and paper and industrial market segments, which was partially offset by lower energy prices than in 2019. Stronger chlorine derivative demand in relation to caustic soda resulted in persistent downward pressure on caustic soda pricing.VINYLSDue to the impact of the COVID-19 pandemic and supply interruptions during a very active hurricane season, industry demand for PVC in 2020 decreased year-over-year by 4%, resulting in 6% lower operating rates. Domestic demand was up 5.4% while export demand was down 22% from 2019. Second half 2020 housing starts, construction and home improvement markets were the main contributors for the strong rebound in domestic demand. US domestic producers grappled with extended production outages resulting in lower PVC availability for export markets. Export volume 32OXY 2020 FORM 10-KMANAGEMENT’S DISCUSSION AND ANALYSISrepresented 28% of total North American production. Industry PVC margins increased in 2020 due to a strong price environment driven by higher than expected demand and limited supply.INDUSTRY OUTLOOKIndustry performance will depend on the health of the global economy and the effectiveness of the vaccine rollouts. Continued recovery from 2020 should result in improvement in the housing, construction, automotive and durable goods markets. The housing and construction as well as automotive markets are expected to strengthen over the next year. Margins also depend on market supply and demand balances and feedstock and energy prices. Recovery in the petroleum industry should strengthen the demand and pricing of a number of Occidental’s products that are consumed by industry participants. U.S. commodity export markets will continue to be impacted by the relative strength of the U.S. dollar.BASIC CHEMICALSDemand for basic chemicals is expected to improve in 2021 over 2020 levels. Improvement in most market segments is expected with improvement in the overall economy. Demand for chlorine and derivatives will improve with continued growth in the housing, general construction and automotive markets. Demand for alkali products, particularly caustic soda, will improve with growth in the pulp and paper, industrial and alumina markets. Chlor-alkali operating rates should improve moderately with higher demand and continued competitive energy and raw material pricing as compared to global feedstock costs.VINYLSDomestic PVC demand is expected to improve in 2021 over 2020 levels. Growth in residential construction spending and expected new infrastructure projects is forecast to drive domestic growth in 2021. Although overall PVC demand is expected to remain strong in North America, operating rates are anticipated to remain relatively flat in 2021 as new PVC capacity is expected to enter the market in the second half of the year.MIDSTREAM AND MARKETING SEGMENTBUSINESS STRATEGYThe midstream and marketing segment strives to maximize realized value by optimizing the use of its gathering, processing, transportation, storage and terminal commitments and by providing access to domestic and international markets. To generate returns, the segment evaluates opportunities across the value chain and uses its assets to provide services to Occidental’s subsidiaries, as well as third parties. The midstream and marketing segment operates or contracts for services on gathering systems, gas plants, co-generation facilities and storage facilities and invests in entities that conduct similar activities. As of December 31, 2019, Occidental began accounting for its ownership investment in WES under the equity method of accounting. See Note 16 - Investments and Related-Party Transactions in the Notes to Consolidated Financial Statements in Part II Item 8 of this Form 10-K for more information.The midstream and marketing segment has equity investments in WES and Dolphin Energy Limited. WES owns gathering systems, plants and pipelines and earns revenue from fee-based and service-based contracts with Occidental and third parties. Dolphin Energy Limited owns and operates a pipeline which connects its gas processing and compression plant in Qatar and its receiving facilities in UAE, and uses its network of Dolphin Energy Limited-owned and other existing leased pipelines to supply natural gas across the UAE and to Oman. Also included in the midstream and marketing segment is OLCV. OLCV seeks to leverage Occidental’s carbon management expertise that is derived from its EOR operations to develop carbon capture, utilization and storage facilities that are expected to source anthropogenic CO2 and promote innovative technologies that drive cost efficiencies and economically grow Occidental’s business while reducing emissions.This segment also seeks to minimize the costs of gas and power used in Occidental’s various businesses. Capital is employed to sustain or expand assets to improve the competitiveness of Occidental’s businesses. In 2020, capital expenditures related to the midstream and marketing segment totaled $50 million.BUSINESS ENVIRONMENTMidstream and marketing segment earnings are affected by the performance of its various businesses, including its marketing, gathering and transportation, gas processing and power-generation assets. The marketing business aggregates, markets and stores Occidental and third-party volumes. Marketing performance is affected primarily by commodity price changes and margins in oil and gas transportation and storage programs. The marketing business results can experience significant volatility depending on commodity price changes and the Midland-to-Gulf-Coast oil spreads. The Midland-to-Gulf-Coast oil spreads have decreased from an average of $6.58 per barrel in 2019 to $1.43 per barrel for the year ended December 31, 2020 and averaging $0.59 per barrel in the fourth quarter of 2020. A $0.25 change in the Midland-to-Gulf- Coast oil spreads impacts total year operating cash flows by $65 million. In 2020, Permian to Gulf Coast transportation capacity increased as new third-party pipelines were completed. This along with reduction in Permian Basin production, reduced the Midland-to-Gulf-Coast oil spreads. Gas gathering, processing and transportation results are affected by fluctuations in commodity prices and the volumes that are processed and transported through the segment’s plants, as well OXY 2020 FORM 10-K33MANAGEMENT’S DISCUSSION AND ANALYSISas the margins obtained on related services from investments in which Occidental has an equity interest. The 2020 declines in NGL prices and sulfur prices negatively impacted the gas processing business.BUSINESS REVIEWMARKETINGThe marketing group markets substantially all of Occidental’s oil, NGL and natural gas production, as well as trades around its assets, including contracted transportation and storage capacity. Occidental’s third-party marketing activities focus on purchasing oil, NGL and gas for resale from parties whose oil and gas supply is located near its transportation and storage assets. These purchases allow Occidental to aggregate volumes to better utilize and optimize its assets. In 2020, compared to the prior year, marketing results were negatively impacted by the decline in the Midland-to-Gulf-Coast oil spreads. PIPELINEOccidental’s pipeline business mainly consists of its 24.5% ownership interest in Dolphin Energy Limited. Dolphin Energy Limited owns and operates a 230-mile-long, 48-inch-diameter natural gas pipeline (Dolphin Pipeline), which transports dry natural gas from Qatar to the UAE and Oman. The Dolphin Pipeline has capacity to transport up to 3.2 Bcf/d and currently transports approximately 2.2 Bcf/d and up to 2.5 Bcf/d in the summer months.GAS PROCESSING, GATHERING AND CO2Occidental processes its and third-party domestic wet gas to extract NGL and other gas byproducts, including CO2 and delivers dry gas to pipelines. Margins primarily result from the difference between inlet costs of wet gas and market prices for NGL.As of December 31, 2020, Occidental has a 2% non-voting general partner interest and a 51.8% limited partner interest in WES and a 2% non-voting limited partner interest in WES Operating, a subsidiary of WES. As of December 31, 2020, on a combined basis, Occidental's total effective economic interest in WES and its subsidiaries is 53.5%. Occidental intends to reduce its limited partner ownership interest in WES to below 50%. See Note 1 - Summary of Significant Accounting Policies in the Notes to Consolidated Financial Statements in Part II Item 8 of this Form 10-K for more information regarding Occidental’s equity method investment in WES. WES owns gathering systems, plants and pipelines and earns revenue from fee-based and service-based contracts with Occidental and third parties.Occidental’s 40% participating interest in Al Hosn Gas also includes sour gas processing facilities that are designed to process 1.3 Bcf/d of natural gas and separate it into salable gas, condensate, NGL and sulfur. In 2020, the facilities produced 11,300 tons per day of sulfur, of which approximately 4,500 tons per day was Occidental’s net share. In 2020, compared to the prior year, gas processing, gathering and CO2 results decreased primarily due to lower NGL prices and sulfur prices, which negatively impacted the gas processing business.POWER GENERATION FACILITIESEarnings from power and steam generation facilities are derived from sales to affiliates and third parties.LOW CARBON VENTURESOLCV was formed to execute on Occidental’s vision to reduce global emissions and provide a more sustainable future through low carbon energy and products. OLCV capitalizes on Occidental’s extensive experience in utilizing CO2 for EOR by investing in technologies, developing projects and providing services to facilitate and accelerate the implementation of carbon capture, utilization and storage projects and opportunities for zero-carbon power. Moreover, OLCV is fostering new technologies and business models with the potential to position Occidental as a leader in the production of low-carbon oil and products.Occidental has developed standards and protocols recognized by the EPA for monitoring, reporting and verifying the amount, safety and permanence of CO2 stored through secure geologic sequestration. The company holds the nation’s first two EPA-approved monitoring, reporting and verification plans for geologic sequestration through EOR production.INDUSTRY OUTLOOKMidstream and marketing segment results can experience volatility depending on the Midland-to-Gulf-Coast oil spreads and commodity price changes. To a lesser extent, declines in commodity prices, including NGL and sulfur prices, reduce the results for the gas processing business.34OXY 2020 FORM 10-KMANAGEMENT’S DISCUSSION AND ANALYSISSEGMENT RESULTS OF OPERATIONS AND ITEMS AFFECTING COMPARABILITYSEGMENT RESULTS OF OPERATIONSSegment earnings exclude income taxes, interest income, interest expense, environmental remediation expenses, unallocated corporate expenses and discontinued operations, but include gains and losses from divestitures of segment assets and income from the segments’ equity investments. Seasonality is not a primary driver of changes in Occidental’s consolidated quarterly earnings during the year.The following table sets forth the sales and earnings of each operating segment and corporate items for the years ended December 31:millions, except per share amounts202020192018NET SALES (a)Oil and gas$13,066 $13,941 $10,441 Chemical3,733 4,102 4,657 Midstream and marketing1,768 4,132 3,656 Eliminations (758)(1,264)(930)Total$17,809 $20,911 $17,824 SEGMENT RESULTS AND EARNINGSDomestic$(8,758)$838 $621 International(742)1,851 1,896 Exploration(132)(169)(75)Oil and gas (9,632)2,520 2,442 Chemical 664 799 1,159 Midstream and marketing(4,175)241 2,802 Total$(13,143)$3,560 $6,403 Unallocated corporate itemsInterest expense, net(1,424)(1,002)(356)Income tax benefit (expense)2,172 (861)(1,477)Other(1,138)(2,204)(439)Income (loss) from continuing operations$(13,533)$(507)$4,131 Discontinued operations, net (1,298)(15)— Net income (loss)(14,831)(522)4,131 Less: Net loss attributable to noncontrolling interests— (145)— Less: Preferred stock dividends(844)(318)— Net income (loss) attributable to common stockholders$(15,675)$(985)$4,131 Net income (loss) attributable to common stockholders—basic$(17.06)$(1.22)$5.40 Net income (loss) attributable to common stockholders—diluted$(17.06)$(1.22)$5.39 (a)Intersegment sales eliminate upon consolidation and are generally made at prices approximating those that the selling entity would be able to obtain in third-party transactions.OXY 2020 FORM 10-K35MANAGEMENT’S DISCUSSION AND ANALYSISITEMS AFFECTING COMPARABILITYOIL AND GAS SEGMENTResults of Operationsmillions202020192018Segment Sales$13,066 $13,941 $10,441 Segment Results (a)Domestic$(8,758)$838 $621 International(742)1,851 1,896 Exploration(132)(169)(75)Total$(9,632)$2,520 $2,442 Items affecting comparabilityAsset impairments and related items - domestic (b)$(5,904)$(288)$— Asset impairments and related items - international (c)$(1,195)$(39)$(416)Asset sale gains (losses), net - domestic (d)$(1,275)$475 $— Asset sale losses, net - international (e)$(353)$— $— Oil and natural gas collars mark-to-market gains (losses)$1,064 $(107)$— Rig terminations and other - domestic$(59)$— $— Rig terminations and other - international$(13)$— $— (a)Results included significant items affecting comparability discussed in the footnotes below.(b)The 2020 amount included pre-tax impairments of $4.5 billion primarily related to domestic onshore unproved acreage as well as $1.3 billion primarily related to other domestic onshore assets and the Gulf of Mexico. The 2019 amount included $285 million of impairment and related charges associated with domestic undeveloped leases that were set to expire in the near-term, where Occidental had no plans to pursue exploration activities.(c)The 2020 amount included $1.2 billion of impairment and related charges associated with Occidental’s proved properties in Algeria and Oman. The 2019 amount related to Occidental’s mutually agreed early termination of certain Qatar concessions. The 2018 amount consisted of impairment and related charges associated with certain Qatar concessions.(d)The 2020 amount included a $440 million loss on the sale of Occidental’s mineral and fee surface acres in Wyoming, Colorado and Utah and losses of $820 million related to the sale of non-core, largely non-operated acreage in the Permian Basin. The 2019 amount included gain on the sale of a portion of Occidental’s joint venture with ECOPETROL S.A. (Ecopetrol) and a loss on sale of real estate assets.(e)The 2020 amount included a loss on the sale of Occidental’s Colombia assets of $353 million.The following table sets forth the average realized prices for oil, NGL and natural gas from ongoing operations for each of the three years in the period ended December 31, 2020, and includes a year-over-year change calculation:2020Year over Year Change2019Year over Year Change2018Average Realized Prices Oil ($/Bbl) United States$36.39 (33)%$54.31 (4)%$56.30 Latin America $38.80 (32)%$57.26 (11)%$64.32 Middle East/Africa$41.52 (33)%$62.03 (8)%$67.69 Total worldwide$37.41 (34)%$56.32 (7)%$60.64 NGL ($/Bbl)United States$11.98 (25)%$16.03 (42)%$27.64 Middle East/Africa$16.22 (26)%$21.85 (6)%$23.20 Total worldwide$12.58 (27)%$17.20 (34)%$26.25 Natural Gas ($/Mcf)United States$1.18 (10)%$1.31 (18)%$1.59 Latin America$5.41 (23)%$7.01 9 %$6.43 Total worldwide $1.31 (10)%$1.45 (10)%$1.62 36OXY 2020 FORM 10-KMANAGEMENT’S DISCUSSION AND ANALYSISDomestic oil and gas results, excluding significant items affecting comparability, decreased in 2020 compared to 2019 primarily due to lower realized oil, NGL and natural gas prices, partially offset by higher crude oil, NGL and natural gas sales volumes mostly due to additional production from the Acquisition.International oil and gas results, excluding significant items affecting comparability, decreased in 2020 compared to 2019 primarily due to a decrease in realized commodity prices as well as lower volumes as a result of exiting Qatar in 2019.ProductionThe following table sets forth the production volumes of oil, NGL and natural gas per day from ongoing operations for each of the three years in the period ended December 31, 2020 and includes a year-over-year change calculation:Production per Day, Ongoing Operations (Mboe/d)2020Year over Year Change2019Year over Year Change2018United States Permian Resources435 23 %355 66 %214 Permian EOR140 (9)%154 — %154 DJ Basin293 144 %120 N/A— Gulf of Mexico130 124 %58 N/A— Other Domestic39 44 %27 575 %4 Total1,037 45 %714 92 %372 Latin America32 (6)%34 6 %32 Middle East / AfricaAlgeria44 83 %24 N/A— Al Hosn Gas78 (5)%82 12 %73 Dolphin44 5 %42 5 %40 Oman85 (4)%89 3 %86 Total251 6 %237 19 %199 Total Production from Ongoing Operations1,320 34 %985 63 %603 Operations exited or exiting30 (32)%44 (20)%55 Total Production (Mboe/d) (a)1,350 31 %1,029 56 %658 (a)Natural gas volumes have been converted to Boe based on energy content of six Mcf of gas to one barrel of oil. Boe equivalent does not necessarily result in price equivalency. Please refer to the Supplemental Oil and Gas Information (unaudited) section of this Form 10-K for additional information on oil and gas production and sales.Average daily production volumes from ongoing operations increased in 2020 compared to 2019 primarily due to a full year of production associated with the assets acquired from the Acquisition.Lease Operating ExpenseThe following table sets forth the average lease operating expense per Boe from ongoing operations for each of the three years in the period ended December 31, 2020:202020192018Average lease operating expense per Boe$6.38$9.07$11.52Average lease operating expense per Boe decreased in 2020 compared to 2019 primarily due to operational efficiencies related to downhole maintenance and supports. OXY 2020 FORM 10-K37MANAGEMENT’S DISCUSSION AND ANALYSISCHEMICAL SEGMENTmillions202020192018Segment Sales$3,733 $4,102 $4,657 Segment Results$664 $799 $1,159 Chemical segment results decreased in 2020 compared to 2019 due to lower realized caustic soda prices and overall lower sales volumes as a result of the COVID-19 pandemic, partially offset by lower natural gas costs and lower plant spending. MIDSTREAM AND MARKETING SEGMENTmillions202020192018Segment Sales$1,768 $4,132 $3,656 Segment Results (a)$(4,175)$241 $2,802 Items affecting comparabilityAsset and equity investment sale gains (losses) (b)$(46)$114 $907 Asset impairments and other charges (c)$(4,194)$(1,002)$— Interest rate swaps mark-to-market, net (d)$— $30 $— (a)Results included items affecting comparability listed below.(b)The 2020 amount represented a loss on the exchange of WES common units to retire a $260 million note. The 2019 amount represented a $114 million gain on the sale of an equity investment in Plains All American Pipeline, L.P. and Plains GP Holdings, L.P. (together, Plains). The 2018 amount represented a gain on sale of non-core domestic midstream assets.(c)The 2020 amount included a $2.7 billion other-than-temporary impairment of the equity investment in WES and $1.4 billion of impairments related to the write-off of goodwill and a loss from an equity investment related to WES’ write-off of its goodwill. The 2019 amount included a $1 billion charge as a result of recording Occidental’s investment in WES at fair value as of December 31, 2019 upon the loss of control.(d)The 2019 amount represented a $30 million mark-to-market gain on an interest rate swap for WES.Midstream and marketing segment results, excluding items affecting comparability, decreased in 2020 compared to 2019, primarily due to lower marketing margins from the tightening of the average Midland-to-Gulf-Coast oil spreads by $5.15 per barrel, and to a lesser extent lower pipeline income following the sale of the Plains equity investment in the third quarter of 2019 and lower sulfur prices impacting Al Hosn Gas.CORPORATESignificant corporate items include the following:millions202020192018Items Affecting ComparabilityAnadarko Acquisition-related costs$(339)$(1,647)$— Bridge loan financing fees$— $(122)$— Acquisition-related pension and termination benefits$114 $37 $— Interest rate swaps mark-to-market, net$(428)$122 $— Other charges and asset impairments$— $(22)$— Warrant gains mark-to-market$5 $81 $— INCOME TAXES Total deferred tax assets, after valuation allowance, were $4.3 billion and $3.7 billion at December 31, 2020, and 2019, respectively. Occidental expects to realize the recorded deferred tax assets, net of any allowances, through future operating income and reversal of temporary differences. The total deferred tax liabilities were $11.4 billion and $13.4 billion as of December 31, 2020, and 2019, respectively. The decrease in net deferred tax liability in 2020 over 2019 is primarily driven by domestic asset impairments for which Occidental does not receive an immediate tax benefit as well as an increase in net operating loss carryforwards.38OXY 2020 FORM 10-KMANAGEMENT’S DISCUSSION AND ANALYSISWORLDWIDE EFFECTIVE TAX RATEThe following table sets forth the calculation of the worldwide effective tax rate for income from continuing operations:millions202020192018SEGMENT RESULTS Oil and gas$(9,632)$2,520 $2,442 Chemical664 799 1,159 Midstream and marketing(4,175)241 2,802 Unallocated corporate items(2,562)(3,206)(795)Income (loss) from continuing operations before taxes(15,705)354 5,608 Income tax benefit (expense) Federal and state2,607 34 (463)Foreign(435)(895)(1,014)Total income tax benefit (expense)2,172 (861)(1,477)Income (loss) from continuing operations(13,533)(507)4,131 Worldwide effective tax rate14%243%26%In 2020, Occidental’s worldwide effective tax rate was 14%, which was largely a result of the impairment of the WES goodwill and certain international assets, for which Occidental receives no tax benefit and higher-taxed foreign operations which generally caused Occidental’s tax rate to vary significantly from the U.S. corporate tax rate. Occidental’s effective tax rate is impacted each year by the relative pre-tax income (loss) earned by its domestic and international operations.CONSOLIDATED RESULTS OF OPERATIONSREVENUE AND OTHER INCOME ITEMSmillions202020192018Net sales$17,809 $20,911 $17,824 Interest, dividends and other income$118 $217 $136 Gains (losses) on sale of assets, net$(1,666)$622 $974 Price and volume changes generally represent the majority of the change in the oil and gas and chemical segments sales. Midstream and marketing sales are mainly impacted by the lower marketing margins from the decrease in the Midland-to-Gulf-Coast oil spreads and, to a lesser extent, the change in NGL and sulfur prices for the gas processing business.The decrease in net sales in 2020 compared to 2019 was primarily due to lower realized oil prices in the oil and gas segment despite higher volumes as a result of a full year of production from properties added in the Acquisition and net gains on the three-way oil collars. Midstream and marketing sales declined due to tightening of the Midland-to-Gulf-Coast oil spreads. Chemical sales declined primarily due to lower sales volumes across all products and lower realized caustic soda prices.The 2020 losses on sales of assets, net, is primarily comprised of $820 million related to the sale of certain non-core, largely non-operated acreage in the Permian Basin, $440 million related to the sale of 4.5 million mineral acres and 1 million fee surface acres located in Wyoming, Colorado and Utah, $353 million related to the sale of the Colombia onshore assets and a loss of $46 million related to the WES note exchange.OXY 2020 FORM 10-K39MANAGEMENT’S DISCUSSION AND ANALYSISEXPENSE ITEMSmillions202020192018Oil and gas operating expense$3,065 $3,282 $2,761 Transportation and gathering expense$1,600 $635 $152 Chemical and midstream cost of sales$2,408 $2,791 $2,833 Purchased commodities$1,395 $1,679 $822 Selling, general and administrative$864 $893 $585 Other operating and non-operating expense$884 $1,421 $1,028 Depreciation, depletion and amortization$8,097 $6,140 $3,977 Asset impairments and other charges$11,083 $1,361 $561 Taxes other than on income$622 $840 $439 Anadarko Acquisition-related costs$339 $1,647 $— Exploration expense$132 $247 $110 Interest and debt expense, net$1,424 $1,066 $389 OIL AND GAS OPERATING EXPENSEOil and gas operating expense decreased in 2020 from the prior year, primarily due to operational efficiencies that decreased downhole maintenance and workover and support costs and lower energy and purchased injectant costs. TRANSPORTATION AND GATHERING EXPENSETransportation and gathering expense increased in 2020 from the prior year, primarily due to a full year of increased sales volumes related to the Acquisition as well as transportation costs to WES which was previously a consolidated entity in 2019. CHEMICAL AND MIDSTREAM COST OF SALESChemical and midstream cost of sales decreased in 2020 from the prior year, primarily due to favorable raw material costs in the chemical segment and lower midstream operation costs due to the loss of control of WES in 2019. PURCHASED COMMODITIESPurchased commodities decreased in 2020 largely as a result of lower crude oil prices on third-party crude purchases related to the midstream and marketing segment. OTHER OPERATING AND NON-OPERATING EXPENSEOther operating and non-operating expense decreased in 2020 from the prior year, primarily due to the realization of overhead savings and a net gain related to the settlement, curtailment and special termination benefits on pension plans acquired in the Acquisition. DEPRECIATION, DEPLETION AND AMORTIZATION (DD&A)DD&A expense increased in 2020 from the prior year, primarily due to having a full year of production in 2020 associated with assets acquired through the Acquisition. ASSET IMPAIRMENTS AND OTHER CHARGESIn 2020, asset impairments and other charges included pre-tax impairments of $4.5 billion primarily related to domestic onshore unproved acreage as well as $1.3 billion primarily related to other domestic onshore assets and the Gulf of Mexico. In addition there were $931 million of impairment and related charges associated with Occidental’s proved properties in Algeria to remeasure the Algeria oil and gas properties to their fair value. In addition, for the midstream and marketing segment, there were pre-tax impairment charges of $2.7 billion other-than-temporary impairment of the equity investment in WES and $1.2 billion of impairments related to the write-off of goodwill.TAXES OTHER THAN ON INCOMETaxes other than on income in 2020 decreased from the prior year, due to lower production taxes which are directly tied to prices on oil, NGL and natural gas volumes.40OXY 2020 FORM 10-KMANAGEMENT’S DISCUSSION AND ANALYSISACQUISITION RELATED EXPENSESAcquisition related expenses in 2020 are associated with employee severance and related employee costs primarily related to one-time severance costs and the accelerated vesting of certain Anadarko share-based awards for former Anadarko employees based on the terms of the Acquisition and existing change of control provisions within the former Anadarko employment agreements. INTEREST AND DEBT EXPENSE, NETInterest and debt expense, net, increased in 2020 from the prior year due to an increase in debt issued to partially fund the Acquisition, as well as the debt assumed through the Acquisition. OTHER ITEMSIncome/(expense) millions202020192018Gains (losses) on interest rate swaps and warrants$(423)$233 $— Income from equity investments$370 $373 $331 Income tax benefit (expense)$2,172 $(861)$(1,477)GAINS (LOSSES) ON INTEREST RATE SWAPS AND WARRANTS Gains (losses) on interest rate swaps and warrants are primarily due to a decline in the reference rate on the interest rate swaps throughout 2020, as fixed interest rates exceed the floating interest rates during the reference period. INCOME TAX BENEFIT (EXPENSE)Occidental realized an income tax benefit for the year ended December 31, 2020 as compared to an income tax expense for the year ended December 31, 2019, primarily due to lower pre-tax income, partially offset by the impairment of certain international assets as well as the equity method goodwill associated with the WES investment, for which Occidental received no tax benefit.DISCONTINUED OPERATIONS, NETDiscontinued operations, net in 2020 is associated with the operations of Ghana for which Occidental continues to present as held for sale. The decrease in income in 2020 is primarily associated with an after-tax impairment of $1.4 billion in the second quarter of 2020 to reflect the held for sale assets at their fair value less costs to sell based on the income approach.OXY 2020 FORM 10-K41MANAGEMENT’S DISCUSSION AND ANALYSISLIQUIDITY AND CAPITAL RESOURCESCASH ON HANDAt December 31, 2020, Occidental had approximately $2.0 billion in cash and cash equivalents. A substantial majority of this cash is held and available for use in the United States.Occidental’s $5 billion RCF, available cash, continued access to capital markets and positive operating cash flows will allow Occidental to meet its short- and long-term purchase obligations, near-term debt maturities and other liabilities.At December 31, 2020, Occidental had $0.4 billion in current maturities of long-term debt through December 31, 2021 and an additional $2.1 billion in long-term obligations due in 2022. Other near-term obligations include interest rate swaps with mandatory termination dates in September 2021 with a notional value of $750 million and accounts payable incurred in the course of Occidental’s business activities. Occidental continues to pursue divestitures of certain assets and intends to use the net proceeds from asset sales and free cash flow to repay its nearer-term debt maturities, but the expected timing and final proceeds from such asset sales are uncertain. Occidental currently expects its cash on hand to be sufficient to meet its debt maturities, operating expenditures and other obligations for the next 12 months from the date of this filing. However, given the inherent uncertainty associated with the duration and severity of the COVID-19 pandemic and its resulting impact on oil demand, Occidental may need to raise capital to fund its operations and refinance debt maturities.At December 31, 2020, Occidental had $170 million in restricted cash and restricted cash equivalents, which was primarily associated with an international joint venture, a benefits trust for former Anadarko employees that was funded as part of the Acquisition and a judicially controlled account related to a Brazilian tax dispute. Restricted cash within the benefits trust will be made available to Occidental as benefits are paid to former Anadarko employees.DEBT ACTIVITYOn March 23, 2020, Occidental amended the sole financial covenant in its RCF by revising the definition of "Total Capitalization" to exclude any non-cash write-downs, impairments and related charges occurring after September 30, 2019. The amendments provide Occidental with additional flexibility in the event of any such write-downs, impairments or other changes under the ratio of Total Debt to Total Capitalization covenant.In July, August, and December, 2020, Occidental issued several series of notes with maturities from five to ten years. The proceeds from these issuances were used to tender and repay nearer-term notes and the Term Loan. Occidental used proceeds from the sale of mineral and surface acres located in Wyoming, Colorado and Utah, the Colombian asset sale and proceeds from other divestitures to repay debt. Occidental used the net proceeds from asset sales, cash on hand and Senior Notes Offerings to retire or tender $6.0 billion of 2021, $2.7 billion of 2022 and $264 million of 2023 maturities. In August 2020, Occidental exchanged approximately 27.9 million WES common units to retire a $260 million note payable to WES.See Note 7 - Long-Term Debt in the Notes to Consolidated Financial Statements in Part II Item 8 of this Form 10-K for more information related to Occidental’s debt issuance and repayments.As of December 31, 2020, under the most restrictive covenants of its financing agreements, Occidental had substantial capacity for additional unsecured borrowings, the payment of cash dividends and other distributions on, or acquisitions of, Occidental stock.CASH FLOW ANALYSISCASH PROVIDED BY OPERATING ACTIVITIESmillions202020192018Operating cash flow from continuing operations$3,842 $7,336 $7,669 Operating cash flow from discontinued operations, net of taxes113 39 — Net cash provided by operating activities$3,955 $7,375 $7,669 Cash provided by operating activities decreased $3.4 billion in 2020 compared to 2019, primarily due to lower oil prices as average WTI and Brent prices decreased by 31% and 33%, respectively. Operating cash flows also decreased due to the decrease in the average Midland-to-Gulf-Coast oil spreads, which decreased by $5.15 per barrel in 2020 compared to 2019. To a lesser extent, the reduction in realized NGL and natural gas prices also impacted the lower operating cash flows in 2020. These decreases were partially offset by higher oil and gas sale volumes as 2020 had a full year of production from assets associated with the Acquisition along with settlement of the three-way oil collars of $0.9 billion. 42OXY 2020 FORM 10-KMANAGEMENT’S DISCUSSION AND ANALYSISCASH USED BY INVESTING ACTIVITIESmillions202020192018Capital expenditures Oil and gas$(2,208)$(5,512)$(4,413)Chemical(255)(267)(271)Midstream and marketing(50)(461)(216)Corporate(22)(127)(75)Total$(2,535)$(6,367)$(4,975)Changes in capital accrual(519)(249)55 Purchase of businesses and assets, net(114)(28,088)(928)Proceeds from sale of assets and equity investments, net2,281 6,143 2,824 Other investing activities, net109 (291)(182)Investing cash flows from continuing operations$(778)$(28,852)$(3,206)Investing cash flows from discontinued operations(41)(175)— Net cash used by investing activities$(819)$(29,027)$(3,206)Cash flows used by investing activities decreased by $28.2 billion in 2020 compared to 2019 primarily due to the 2019 Acquisition. Additionally, Occidental reduced capital spending in 2020 in response to the COVID-19 pandemic. See Note 4 - Divestitures and Other Transactions in the Notes to Consolidated Financial Statements in Part II Item 8 of this Form 10-K for a listing of assets and equity investments sold in 2020, 2019 and 2018.CASH PROVIDED (USED) BY FINANCING ACTIVITIESmillions202020192018Financing cash flows from continuing operations$(4,508)$22,196 $(3,102)Financing cash flows from discontinued operations$(8)$(3)$— Net cash provided (used) by financing activities$(4,516)$22,193 $(3,102)Cash provided by financing activities decreased by $26.7 billion compared to 2019 primarily due to the 2019 increase in debt used to fund the Acquisition. Additionally, common dividends paid in 2020 were lower than 2019 due to the Board of Directors’ decision to reduce the quarterly dividend rate effective as of July 2020 from $0.79 to $0.01 per share. See Note 7 - Long-Term Debt in the Notes to Consolidated Financial Statements in Part II Item 8 of this Form 10-K for more information related to Occidental’s debt issuance and repayments. OFF-BALANCE SHEET ARRANGEMENTSGUARANTEESOccidental has guaranteed its portion of the debt of Dolphin Energy Limited, an equity method investment, and has entered into various other guarantees, including performance bonds, letters of credit, indemnities and commitments provided by Occidental to third parties, mainly to provide assurance that Occidental or its subsidiaries and affiliates will meet their various obligations. See “Midstream and Marketing Segment — Business Review — Pipeline” and “Segment Results of Operations” for further information regarding the Dolphin Energy Project. As of December 31, 2020, and 2019, Occidental had provided limited recourse guarantees of approximately $242 million, primarily related to Dolphin Energy Limited’s debt, which are limited to certain political and other events.COMMITMENTS AND OBLIGATIONSDELIVERY COMMITMENTSOccidental has made long-term commitments to certain refineries and other buyers to deliver oil, NGL and natural gas. The total amount contracted to be delivered is approximately 111 MMbbl of oil through 2025, 862 MMbbl of NGL through 2029 and 1,025 Bcf of gas through 2029. The price for these deliveries is set at the time of delivery of the product. Occidental has significantly more production capacity than the amounts committed and has the ability to secure additional volumes in case of a shortfall.OXY 2020 FORM 10-K43MANAGEMENT’S DISCUSSION AND ANALYSISCONTRACTUAL OBLIGATIONSThe following table summarizes and cross-references Occidental’s contractual obligations and indicates on- and off-balance sheet obligations as of December 31, 2020. Commitments related to held for sale assets are excluded.millions Payments Due by YearTotal20212022 and 20232024 and 20252026 and thereafterOn-Balance Sheet Current portion of long-term debt (Note 7) (a)$398 $398 $— $— $— Long-term debt (Note 7) (a)34,837 — 3,007 6,798 25,032 Leases (Note 8) (b)1,724 500 374 234 616 Asset retirement obligations (Note 1)4,130 153 845 631 2,501 Other long-term liabilities (c)2,386 321 336 187 1,542 Off-Balance SheetPurchase obligations (d)13,184 2,826 4,344 2,986 3,028 Total$56,659 $4,198 $8,906 $10,836 $32,719 (a)Excluded unamortized debt discount and interest on the debt. As of December 31, 2020, interest on long-term debt totaling $19.9 billion is payable in the following years: 2021 - $1.6 billion, 2022 and 2023 - $3.2 billion, 2024 and 2025 - $2.9 billion, 2026 and thereafter - $12.2 billion.(b)Occidental is the lessee under various agreements for real estate, equipment, plants and facilities. See Note 2 - Accounting and Disclosure Changes in the Notes to Consolidated Financial Statements in Part II Item 8 of this Form 10-K regarding the impact of rules effective January 1, 2019 which required Occidental to recognize most leases, including operating leases, on the balance sheet.(c)Includes long term obligations and current portions of long term obligations under postretirement benefit, accrued transportation commitments, ad valorem taxes and other accrued liabilities.(d)Amounts include payments which will become due under long-term agreements to purchase goods and services used in the normal course of business to secure terminal, pipeline and processing capacity, CO2, electrical power, steam and certain chemical raw materials. Amounts exclude certain product purchase obligations related to marketing activities for which there are no minimum purchase requirements or the amounts are not fixed or determinable. Long-term purchase contracts are discounted at a 4.41% discount rate. LAWSUITS, CLAIMS, COMMITMENTS AND CONTINGENCIESLEGAL MATTERSOccidental or certain of its subsidiaries are involved, in the normal course of business, in lawsuits, claims and other legal proceedings that seek, among other things, compensation for alleged personal injury, breach of contract, property damage or other losses, punitive damages, civil penalties, or injunctive or declaratory relief. Occidental or certain of its subsidiaries also are involved in proceedings under Comprehensive Environmental Response, Compensation and Liability Act (CERCLA) and similar federal, state, local and foreign environmental laws. These environmental proceedings seek funding or performance of remediation and, in some cases, compensation for alleged property damage, punitive damages, civil penalties and injunctive relief. Usually Occidental or such subsidiaries are among many companies in these environmental proceedings and have to date been successful in sharing response costs with other financially sound companies. Further, some lawsuits, claims and legal proceedings involve acquired or disposed assets with respect to which a third party or Occidental retains liability or indemnifies the other party for conditions that existed prior to the transaction.In accordance with applicable accounting guidance, Occidental accrues reserves for outstanding lawsuits, claims and proceedings when it is probable that a liability has been incurred and the liability can be reasonably estimated. Reserves for matters, other than for environmental remediation, that satisfy this criteria as of December 31, 2020 and 2019, were not material to Occidental’s Consolidated Balance Sheets.In 2016, Occidental received payments from the Republic of Ecuador of approximately $1.0 billion pursuant to a November 2015 arbitration award for Ecuador’s 2006 expropriation of Occidental's Participation Contract for Block 15. The awarded amount represented a recovery of 60% of the value of Block 15. In 2017, Andes Petroleum Ecuador Ltd. (Andes) filed a demand for arbitration, claiming it is entitled to a 40% share of the judgment amount obtained by Occidental. Occidental contends that Andes is not entitled to any of the amounts paid under the 2015 arbitration award because Occidental’s recovery was limited to Occidental’s own 60% economic interest in the block. The merits hearing occurred in September 2020 and an arbitration decision is expected within the next six months.In August 2019, Sanchez Energy Corporation and certain of its affiliates (Sanchez) filed voluntary petitions for reorganization under Chapter 11 of the United States Bankruptcy Code. Sanchez is a party to agreements with Anadarko as 44OXY 2020 FORM 10-KMANAGEMENT’S DISCUSSION AND ANALYSISa result of its 2017 purchase of Anadarko's Eagle Ford Shale assets. Sanchez is attempting to reject some of the agreements related to the purchase of Anadarko’s Eagle Ford Shale assets. If Sanchez is permitted to reject certain of those agreements, then Anadarko may owe deficiency payments to various third parties. Occidental intends to defend vigorously any attempt by Sanchez to reject the agreements. Occidental expects a ruling on Sanchez's purported contract rejection in the first half of 2021.On May 26, 2020, a putative securities class action captioned City of Sterling Heights General Employees’ Retirement System, et al. v. Occidental Petroleum Corporation, et al., No. 651994/2020 (City of Sterling), was filed in the Supreme Court of the State of New York. The complaint asserts claims under Sections 11, 12 and 15 of the Securities Act of 1933, as amended (the Securities Act), based on alleged misstatements in the Securities Act filings, including the registration statement filed in connection with the Anadarko Acquisition and Occidental’s related issuance of common stock and debt securities offerings that took place in August 2019. The lawsuit was filed against Occidental, certain current and former officers and directors and certain underwriters of the debt securities offerings, and seeks damages in an unspecified amount, plus attorneys’ fees and expenses. Two additional putative class actions were filed in the same court (together with City of Sterling, the State Cases) and the State Cases were consolidated into In re Occidental Petroleum Corporation Securities Litigation, No. 651830/2020. Occidental intends to vigorously defend itself in all respects in regard to the State Cases.The ultimate outcome and impact of outstanding lawsuits, claims and proceedings on Occidental cannot be predicted. Management believes that the resolution of these matters will not, individually or in the aggregate, have a material adverse effect on Occidental's Consolidated Balance Sheets. If unfavorable outcomes of these matters were to occur, future results of operations or cash flows for any particular quarterly or annual period could be materially adversely affected. Occidental’s estimates are based on information known about the legal matters and its experience in contesting, litigating and settling similar matters. Occidental reassesses the probability and estimability of contingent losses as new information becomes available.TAX MATTERSDuring the course of its operations, Occidental is subject to audit by tax authorities for varying periods in various federal, state, local and foreign tax jurisdictions. Taxable years through 2017 for U.S. federal income tax purposes have been audited by the U.S. Internal Revenue Service (IRS) pursuant to its Compliance Assurance Program and subsequent taxable years are currently under review. Taxable years through 2009 have been audited for state income tax purposes. All other significant audit matters in foreign jurisdictions have been resolved through 2010. During the course of tax audits, disputes have arisen and other disputes may arise as to facts and matters of law. Occidental believes that the resolution of outstanding tax matters would not have a material adverse effect on its consolidated financial position or results of operations.For Anadarko, its taxable years through 2014 and tax year 2016 for U.S. federal and state income tax purposes have been audited by the IRS and respective state taxing authorities. There are outstanding significant audit matters in one foreign jurisdiction. As stated above, during the course of tax audits, disputes have arisen and other disputes may arise as to facts and matters of law. Other than the matter discussed below, Occidental believes that the resolution of these outstanding tax matters would not have a material adverse effect on its consolidated financial position or results of operations. Anadarko received an $881 million tentative refund in 2016 related to its $5.2 billion Tronox Adversary Proceeding settlement payment in 2015. In September 2018, Anadarko received a statutory notice of deficiency from the IRS disallowing the net operating loss carryback and rejecting Anadarko’s refund claim. As a result, Anadarko filed a petition with the U.S. Tax Court to dispute the disallowances in November 2018. The case was in the IRS appeals process until the second quarter of 2020, however it has since been returned to the U.S. Tax Court where Occidental expects to continue pursuing resolution.In accordance with ASC 740’s guidance on the accounting for uncertain tax positions, Occidental has recorded no tax benefit on the tentative cash tax refund of $881 million. As a result, should Occidental not ultimately prevail on the issue, there would be no additional tax expense recorded relative to this position for financial statement purposes other than future interest. However, in that event Occidental would be required to repay approximately $925 million ($898 million federal and $27 million in state taxes) plus accrued interest of approximately $255 million. A liability for this amount plus interest is included in deferred credits and other liabilities-other.INDEMNITIES TO THIRD PARTIESOccidental, its subsidiaries, or both, have indemnified various parties against specified liabilities those parties might incur in the future in connection with purchases and other transactions that they have entered into with Occidental. These indemnities usually are contingent upon the other party incurring liabilities that reach specified thresholds. As of December 31, 2020, Occidental is not aware of circumstances that it believes would reasonably be expected to lead to indemnity claims that would result in payments materially in excess of reserves.OXY 2020 FORM 10-K45MANAGEMENT’S DISCUSSION AND ANALYSISENVIRONMENTAL LIABILITIES AND EXPENDITURESOccidental’s operations are subject to stringent federal, state, local and international laws and regulations related to improving or maintaining environmental quality. The laws that require or address environmental remediation, including CERCLA and similar federal, state, local and international laws, may apply retroactively and regardless of fault, the legality of the original activities or the current ownership or control of sites. Occidental or certain of its subsidiaries participate in or actively monitor a range of remedial activities and government or private proceedings under these laws with respect to alleged past practices at operating, closed and third-party sites. Remedial activities may include one or more of the following: investigation involving sampling, modeling, risk assessment or monitoring; cleanup measures including removal, treatment or disposal; or operation and maintenance of remedial systems. The environmental proceedings seek funding or performance of remediation and, in some cases, compensation for alleged property damage, punitive damages, civil penalties, injunctive relief and government oversight costs.ENVIRONMENTAL REMEDIATIONAs of December 31, 2020, Occidental participated in or monitored remedial activities or proceedings at 170 sites. The following table presents Occidental’s current and non-current environmental remediation liabilities as of December 31, 2020 and 2019, the current portion of which is included in accrued liabilities ($123 million in 2020 and $162 million in 2019) and the remainder in deferred credits and other liabilities - environmental remediation liabilities ($1.03 billion in 2020 and $1.04 billion in 2019).Occidental’s environmental remediation sites are grouped into four categories: National Priorities List (NPL) sites listed or proposed for listing by the EPA on the CERCLA NPL and three categories of non-NPL sites — third-party sites, Occidental-operated sites and closed or non-operated Occidental sites.20202019millions, except number of sitesNumber of SitesRemediation BalanceNumber of SitesRemediation BalanceNPL sites35 $447 36 $463 Third-party sites69 293 74 311 Occidental-operated sites17 144 17 154 Closed or non-operated Occidental sites49 267 50 269 Total170 $1,151 177 $1,197 As of December 31, 2020, Occidental’s environmental liabilities exceeded $10 million each at 19 of the 170 sites described above, and 96 of the sites had liabilities from $0 to $1 million each. As of December 31, 2020, two sites — the Diamond Alkali Superfund Site and a former chemical plant in Ohio (both of which are indemnified by Maxus Energy Corporation, as discussed further below) — accounted for 92% of its liabilities associated with NPL sites. 17 of the 35 NPL sites are indemnified by Maxus.Five of the 69 third-party sites — a Maxus-indemnified chrome site in New Jersey, a former copper mining and smelting operation in Tennessee, a former oil field and a landfill in California, and an active refinery in Louisiana where Occidental reimburses the current owner for certain remediation activities — accounted for 76% of Occidental’s liabilities associated with these sites. 9 of the 69 third-party sites are indemnified by Maxus.Five sites — oil and gas operations in Colorado and chemical plants in Kansas, Louisiana, New York and Texas — accounted for 70% of the liabilities associated with the Occidental-operated sites. Seven other sites — a landfill in Western New York, a former refinery in Oklahoma, former chemical plants in California, Michigan, Tennessee and Washington, and a closed coal mine in Pennsylvania — accounted for 70% of the liabilities associated with closed or non-operated Occidental sites.Environmental remediation liabilities vary over time depending on factors such as acquisitions or divestitures, identification of additional sites and remedy selection and implementation. Occidental recorded environmental remediation expenses of $36 million, $112 million and $47 million for the years ended December 31, 2020, 2019, and 2018, respectively. Environmental remediation expenses primarily relate to changes to existing conditions from past operations. Based on current estimates, Occidental expects to expend funds corresponding to approximately 45% of the year-end remediation balance over the next three to four years with the remainder over the subsequent 10 or more years. Occidental believes its range of reasonably possible additional losses beyond those amounts currently recorded for environmental remediation for all of its environmental sites could be up to $1.1 billion.46OXY 2020 FORM 10-KMANAGEMENT’S DISCUSSION AND ANALYSISMAXUS ENVIRONMENTAL SITESWhen Occidental acquired Diamond Shamrock Chemicals Company (DSCC) in 1986, Maxus agreed to indemnify Occidental for a number of environmental sites, including the Diamond Alkali Superfund Site (Site) along a portion of the Passaic River. On June 17, 2016, Maxus and several affiliated companies filed for Chapter 11 bankruptcy in Federal District Court in the State of Delaware. Prior to filing for bankruptcy, Maxus defended and indemnified Occidental in connection with clean-up and other costs associated with the sites subject to the indemnity, including the Site.In March 2016, the EPA issued a Record of Decision (ROD) specifying remedial actions required for the lower 8.3 miles of the Lower Passaic River. The ROD does not address any potential remedial action for the upper nine miles of the Lower Passaic River or Newark Bay. During the third quarter of 2016, and following Maxus’s bankruptcy filing, Occidental and the EPA entered into an Administrative Order on Consent (AOC) to complete the design of the proposed clean-up plan outlined in the ROD at an estimated cost of $165 million. The EPA announced that it will pursue similar agreements with other potentially responsible parties.Occidental has accrued a reserve relating to its estimated allocable share of the costs to perform the design and remediation called for in the AOC and the ROD, as well as for certain other Maxus-indemnified sites. Occidental's accrued estimated environmental reserve does not consider any recoveries for indemnified costs. Occidental’s ultimate share of this liability may be higher or lower than the reserved amount, and is subject to final design plans and the resolution of Occidental's allocable share with other potentially responsible parties. Occidental continues to evaluate the costs to be incurred to comply with the AOC, the ROD and to perform remediation at other Maxus-indemnified sites in light of the Maxus bankruptcy and the share of ultimate liability of other potentially responsible parties. In June 2018, Occidental filed a complaint under CERCLA in Federal District Court in the State of New Jersey against numerous potentially responsible parties for reimbursement of amounts incurred or to be incurred to comply with the AOC, the ROD, or to perform other remediation activities at the Site.In June 2017, the court overseeing the Maxus bankruptcy approved a Plan of Liquidation (Plan) to liquidate Maxus and create a trust to pursue claims against current and former parents YPF and each of its respective subsidiaries and affiliates (YPF) and Repsol, S.A. and each of its respective subsidiaries and affiliates (Repsol), as well as others to satisfy claims by Occidental and other creditors for past and future cleanup and other costs. In July 2017, the court-approved Plan became final and the trust became effective. The trust is pursuing claims against YPF, Repsol and others and is expected to distribute assets to Maxus' creditors in accordance with the trust agreement and Plan. In June 2018, the trust filed its complaint against YPF and Repsol in Delaware bankruptcy court asserting claims based upon, among other things, fraudulent transfer and alter ego. During 2019, the bankruptcy court denied Repsol's and YPF's motions to dismiss the complaint as well as their motions to move the case away from the bankruptcy court. Discovery remains ongoing at the time of this report.ENVIRONMENTAL COSTSOccidental’s environmental costs, some of which include estimates, are presented below for each segment for each of the years ended December 31:millions202020192018Operating Expenses Oil and gas$176 $174 $91 Chemical73 80 80 Midstream and marketing4 12 10 Total$253 $266 $181 Capital ExpendituresOil and gas$74 $109 $71 Chemical40 34 23 Midstream and marketing1 4 2 Total$115 $147 $96 Remediation ExpensesCorporate$36 $112 $47 Operating expenses are incurred on a continual basis. Capital expenditures relate to longer-lived improvements in properties currently operated by Occidental. Remediation expenses relate to existing conditions from past operations.OXY 2020 FORM 10-K47MANAGEMENT’S DISCUSSION AND ANALYSISGLOBAL INVESTMENTSA portion of Occidental’s assets are located outside North America. The following table shows the geographic distribution of Occidental’s assets at December 31, 2020 at both the segment and consolidated level related to Occidental’s ongoing operations:millionsOil and gasChemicalMidstream and marketingCorporate and otherTotal ConsolidatedNorth AmericaUnited States$57,026 $4,140 $6,260 $2,951 $70,377 Canada— 123 22 — 145 Middle East3,500 — 3,547 — 7,047 Latin America33 57 — — 90 Africa and Other2,372 6 27 — 2,405 Consolidated$62,931 $4,326 $9,856 $2,951 $80,064 For the year ended December 31, 2020, net sales outside North America totaled $3.4 billion, or approximately 19% of total net sales.CRITICAL ACCOUNTING POLICIES AND ESTIMATESThe process of preparing financial statements in accordance with generally accepted accounting principles requires Occidental’s management to make informed estimates and judgments regarding certain items and transactions. Changes in facts and circumstances or discovery of new information may result in revised estimates and judgments and actual results may differ from these estimates upon settlement but generally not by material amounts. The selection and development of these policies and estimates have been discussed with the Audit Committee of the Board of Directors. Occidental considers the following to be its most critical accounting policies and estimates that involve management’s judgment.OIL AND GAS PROPERTIESThe carrying value of Occidental’s property, plant and equipment (PP&E) represents the cost incurred to acquire or develop the asset, including any asset retirement obligations (AROs) and capitalized interest, net of DD&A and any impairment charges. For assets acquired in a business combination, PP&E cost is based on fair values at the acquisition date. Asset retirement obligations and interest costs incurred in connection with qualifying capital expenditures are capitalized and amortized over the useful lives of the related assets.Occidental uses the successful efforts method to account for its oil and gas properties. Under this method, Occidental capitalizes costs of acquiring properties, costs of drilling successful exploration wells and development costs. The costs of exploratory wells are initially capitalized pending a determination of whether proved reserves have been found. If proved reserves have been found, the costs of exploratory wells remain capitalized. For exploratory wells that find reserves that cannot be classified as proved when drilling is completed, costs continue to be capitalized as suspended exploratory drilling costs if there have been sufficient reserves found to justify completion as a producing well and sufficient progress is being made in assessing the economic and operating viability of the project. At the end of each quarter, management reviews the status of all suspended exploratory drilling costs in light of ongoing exploration activities, in particular, whether Occidental is making sufficient progress in its ongoing exploration and appraisal efforts or, in the case of discoveries requiring government sanctioning, analyzing whether development negotiations are underway and proceeding as planned. If management determines that future appraisal drilling or development activities are unlikely to occur, associated suspended exploratory well costs are expensed.Occidental expenses annual lease rentals, the costs of injectants used in production and geological and geophysical costs as incurred for exploration activities.Occidental determines depreciation and depletion of oil and gas producing properties by the unit-of-production method. It amortizes leasehold acquisition costs over total proved reserves and capitalized development and successful exploration costs over proved developed reserves.Proved oil and gas reserves are those quantities of oil and gas which, by analysis of geoscience and engineering data, can be estimated with reasonable certainty to be economically producible—from a given date forward, from known reservoirs, and under existing economic conditions, operating methods, and government regulations—prior to the time at which contracts providing the right to operate expire, unless evidence indicates that renewal is reasonably certain, 48OXY 2020 FORM 10-KMANAGEMENT’S DISCUSSION AND ANALYSISregardless of whether deterministic or probabilistic methods are used for the estimation. Occidental has no proved oil and gas reserves for which the determination of economic producibility is subject to the completion of major additional capital expenditures.Several factors could change Occidental’s proved oil and gas reserves. For example, Occidental receives a share of production from PSCs to recover its costs and generally an additional share for profit. Occidental’s share of production and reserves from these contracts decreases when product prices rise and increases when prices decline. Generally, Occidental’s net economic benefit from these contracts is greater at higher product prices. In other cases, particularly with long-lived properties, lower product prices may lead to a situation where production of a portion of proved reserves becomes uneconomical. For such properties, higher product prices typically result in additional reserves becoming economical. Estimation of future production and development costs is also subject to change partially due to factors beyond Occidental’s control, such as energy costs and inflation or deflation of oil field service costs. These factors, in turn, could lead to changes in the quantity of proved reserves. Additional factors that could result in a change of proved reserves include production decline rates and operating performance differing from those estimated when the proved reserves were initially recorded. Changes in the political and regulatory climate could lead to decreases in proved reserves as development horizons may be extended into the future. Occidental performs impairment tests with respect to its proved properties whenever events or circumstances indicate that the carrying value of property may not be recoverable. If there is an indication the carrying amount of the asset may not be recovered due to significant and prolonged declines in current and forward prices, significant changes in reserve estimates, changes in management’s plans, or other significant events, management will evaluate the property for impairment. Under the successful efforts method, if the sum of the undiscounted cash flows is less than the carrying value of the proved property, the carrying value is reduced to estimated fair value and reported as an impairment charge in the period. Individual proved properties are grouped for impairment purposes at the lowest level for which there are identifiable cash flows. The fair value of impaired assets is typically determined based on the present value of expected future cash flows using discount rates believed to be consistent with those used by market participants. The impairment test incorporates a number of assumptions involving expectations of future cash flows which can change significantly over time. These assumptions include estimates of future production, product prices, contractual prices, estimates of risk-adjusted oil and gas proved and unproved reserves and estimates of future operating and development costs. It is reasonably possible that prolonged declines in commodity prices, reduced capital spending in response to lower prices or increases in operating costs could result in additional impairments.For impairment testing, unless prices are contractually fixed, Occidental uses observable forward strip prices for oil and natural gas prices when projecting future cash flows. Future operating and development costs are estimated using the current cost environment applied to expectations of future operating and development activities to develop and produce oil and gas reserves. Market prices for oil, NGL and natural gas have been volatile and may continue to be volatile in the future. Changes in global supply and demand, transportation capacity, currency exchange rates, applicable laws and regulations and the effect of changes in these variables on market perceptions could impact current forecasts. Future fluctuations in commodity prices could result in estimates of future cash flows to vary significantly. Net capitalized costs attributable to unproved properties were $18.6 billion at December 31, 2020, and $29.5 billion at December 31, 2019. The unproved amounts are not subject to DD&A until they are classified as proved properties. Individually insignificant unproved properties are combined and amortized on a group basis based on factors such as lease terms, success rates and other factors to provide for full amortization upon lease expiration or abandonment. Significant unproved properties, primarily as a result of the Acquisition, are assessed individually for impairment and when events or circumstances indicate that the carrying value of property may not be recovered a valuation allowance is provided if an impairment is indicated. Occidental periodically reviews significant unproved properties for impairments; numerous factors are considered, including but not limited to, availability of funds for future exploration and development activities, current exploration and development plans, favorable or unfavorable exploration activity on the property or the adjacent property, geologists’ evaluation of the property, the current and projected political and regulatory climate, contractual conditions and the remaining lease term for the properties. If an impairment is indicated, Occidental will first determine whether a comparable transaction for similar properties or implied acreage valuation derived from domestic onshore market participants is available and will adjust the carrying amount of the unproved property to its fair value using the market approach. In situations where the market approach is not observable and unproved reserves are available, undiscounted future net cash flows used in the impairment analysis are determined based on managements’ risk adjusted estimates of unproved reserves, future commodity prices and future costs to produce the reserves. If undiscounted future net cash flows are less than the carrying value of the property, the future net cash flows are discounted and compared to the carrying value for determining the amount of the impairment loss to record. Occidental utilizes the same assumptions and methodology discussed above for cash flows associated with proved properties. OXY 2020 FORM 10-K49MANAGEMENT’S DISCUSSION AND ANALYSISPROVED RESERVESOccidental estimates its proved oil and gas reserves according to the definition of proved reserves provided by the SEC and Financial Accounting Standards Board. This definition includes oil, NGL and natural gas that geological and engineering data demonstrate with reasonable certainty to be economically producible in future periods from known reservoirs under existing economic conditions, operating methods, government regulations, etc. (at prices and costs as of the date the estimates are made). Prices include consideration of price changes provided only by contractual arrangements and do not include adjustments based on expected future conditions. For reserves information, see the Supplemental Information on Oil and Gas Exploration and Production Activities under Item 8 of this Form 10-K.Engineering estimates of the quantities of proved reserves are inherently imprecise and represent only approximate amounts because of the judgments involved in developing such information. Occidental’s estimates of proved reserves are made using available geological and reservoir data as well as production performance data. The reliability of these estimates at any point in time depends on both the quality and quantity of the technical and economic data and the efficiency of extracting and processing the hydrocarbons. These estimates are reviewed annually by internal reservoir engineers and revised, either upward or downward, as warranted by additional data. Revisions are necessary due to changes in, among other things, development plans, reservoir performance, prices, economic conditions and governmental restrictions as well as changes in the expected recovery associated with infill drilling. Decreases in prices, for example, may cause a reduction in some proved reserves due to reaching economic limits at an earlier projected date. A material adverse change in the estimated volume of proved reserves could have a negative impact on DD&A and could result in property impairments.The most significant ongoing financial statement effect from a change in Occidental’s oil and gas reserves or impairment of its proved properties would be to the DD&A rate. For example, a 5% increase or decrease in the amount of oil and gas reserves would change the DD&A rate by approximately $0.80/Bbl, which would increase or decrease pre-tax income by approximately $330 million annually at current production rates. FAIR VALUESOccidental estimates fair-value of long-lived assets for impairment testing, assets and liabilities acquired in a business combination or exchanged in non-monetary transactions, pension plan assets and initial measurements of AROs.Accounting for the acquisition of a business requires the allocation of the purchase price to the various assets and liabilities of the acquired business and recording deferred taxes for any differences between the allocated values and tax basis of assets and liabilities. Any excess of the purchase price over the amounts assigned to assets and liabilities is recorded as goodwill. The purchase price allocation is accomplished by recording each asset and liability at its estimated fair value.Occidental primarily applies the market approach for recurring fair value measurements, maximizes its use of observable inputs and minimizes its use of unobservable inputs. When estimating the fair values of assets acquired and liabilities assumed, Occidental must apply various assumptions.FINANCIAL ASSETS AND LIABILITIESOccidental utilizes the mid-point between bid and ask prices for valuing the majority of its financial assets and liabilities measured and reported at fair value. In addition to using market data, Occidental makes assumptions in valuing its assets and liabilities, including assumptions about the risks inherent in the inputs to the valuation technique. For financial assets and liabilities carried at fair value, Occidental measures fair value using the following methods:■Occidental values exchange-cleared commodity derivatives using closing prices provided by the exchange as of the balance sheet date. These derivatives are classified as using quoted prices in active markets for the assets or liabilities (Level 1).■Over-the-Counter (OTC) bilateral financial commodity contracts, international exchange contracts, options and physical commodity forward purchase and sale contracts are generally classified as using observable inputs other than quoted prices for the assets or liabilities (Level 2) and are generally valued using quotations provided by brokers or industry-standard models that consider various inputs, including quoted forward prices for commodities, time value, volatility factors, credit risk and current market and contractual prices for the underlying instruments, as well as other relevant economic measures. Substantially all of these inputs are observable in the marketplace throughout the full term of the instrument and can be derived from observable data or are supported by observable prices at which transactions are executed in the marketplace.■Occidental values commodity derivatives based on a market approach that considers various assumptions, including quoted forward commodity prices and market yield curves. The assumptions used include inputs that are generally unobservable in the marketplace or are observable but have been adjusted based upon various assumptions and the fair value is designated as using unobservable inputs (Level 3) within the valuation hierarchy.■Occidental values debt using market-observable information for debt instruments that are traded on secondary markets. For debt instruments that are not traded, the fair value is determined by interpolating the value based on debt with similar terms and credit risk.50OXY 2020 FORM 10-KMANAGEMENT’S DISCUSSION AND ANALYSISNON-FINANCIAL ASSETSOccidental uses market-observable prices for assets when comparable transactions can be identified that are similar to the asset being valued. When Occidental is required to measure fair value and there is not a market-observable price for the asset or for a similar asset then the cost or income approach is used depending on the quality of information available to support management’s assumptions. The cost approach is based on management’s best estimate of the current asset replacement cost. The income approach is based on management’s best assumptions regarding expectations of future net cash flows and the expected cash flows are discounted using a commensurate risk-adjusted discount rate. Such evaluations involve significant judgment. The results are based on expected future events or conditions such as sales prices, estimates of future oil and gas production or throughput, development and operating costs and the timing thereof, economic and regulatory climates and other factors, most of which are often outside of management’s control. However, assumptions used reflect a market participant’s view of long-term prices, costs and other factors and are consistent with assumptions used in Occidental’s business plans and investment decisions. ENVIRONMENTAL LIABILITIES AND EXPENDITURESEnvironmental expenditures that relate to current operations are expensed or capitalized as appropriate. Occidental records environmental liabilities and related charges and expenses for estimated remediation costs that relate to existing conditions from past operations when environmental remediation efforts are probable and the costs can be reasonably estimated. In determining the environmental remediation liability and the range of reasonably possible additional losses, Occidental refers to currently available information, including relevant past experience, remedial objectives, available technologies, applicable laws and regulations and cost-sharing arrangements. Occidental bases its environmental remediation liabilities on management’s estimate of the most likely cost to be incurred, using the most cost-effective technology reasonably expected to achieve the remedial objective. Occidental periodically reviews its environmental remediation liabilities and adjusts them as new information becomes available. Occidental records environmental remediation liabilities on a discounted basis when it deems the aggregate amount and timing of cash payments to be reliably determinable at the time the reserves are established. The reserve methodology with respect to discounting for a specific site is not modified once it is established. Presently none of its environmental remediation liabilities are recorded on a discounted basis. Occidental generally records reimbursements or recoveries of environmental remediation costs in income when received, or when receipt of recovery is highly probable.Many factors could affect Occidental’s future remediation costs and result in adjustments to its environmental remediation liabilities and the range of reasonably possible additional losses. The most significant are: (1) cost estimates for remedial activities may vary from the initial estimate; (2) the length of time, type or amount of remediation necessary to achieve the remedial objective may change due to factors such as site conditions, the ability to identify and control contaminant sources or the discovery of additional contamination; (3) a regulatory agency may ultimately reject or modify Occidental’s proposed remedial plan; (4) improved or alternative remediation technologies may change remediation costs; (5) laws and regulations may change remediation requirements or affect cost sharing or allocation of liability; and (6) changes in allocation or cost-sharing arrangements may occur.Certain sites involve multiple parties with various cost-sharing arrangements, which fall into the following three categories: (1) environmental proceedings that result in a negotiated or prescribed allocation of remediation costs among Occidental and other alleged potentially responsible parties; (2) oil and gas ventures in which each participant pays its proportionate share of remediation costs reflecting its working interest; or (3) contractual arrangements, typically relating to purchases and sales of properties, in which the parties to the transaction agree to methods of allocating remediation costs. In these circumstances, Occidental evaluates the financial viability of other parties with whom it is alleged to be jointly liable, the degree of their commitment to participate and the consequences to Occidental of their failure to participate when estimating Occidental’s ultimate share of liability. Occidental records its environmental remediation liabilities at its expected net cost of remedial activities and, based on these factors, believes that it will not be required to assume a share of liability of such other potentially responsible parties in an amount materially above amounts reserved.In addition to the costs of investigations and cleanup measures, which often take in excess of 10 years at CERCLA NPL sites, Occidental’s environmental remediation liabilities include management’s estimates of the costs to operate and maintain remedial systems. If remedial systems are modified over time in response to significant changes in site-specific data, laws, regulations, technologies or engineering estimates, Occidental reviews and adjusts its environmental remediation liabilities accordingly.If Occidental were to adjust the balance of its environmental remediation liabilities based on the factors described above, the amount of the increase or decrease would be recognized in earnings. For example, if the balance were reduced by 10%, Occidental would record a pre-tax gain of $115 million. If the balance were increased by 10%, Occidental would record an additional remediation expense of $115 million.INCOME TAXESOccidental files various U.S. federal, state and foreign income tax returns. The impact of changes in tax regulations are reflected when enacted. In general, deferred federal, state and foreign income taxes are provided on temporary differences between the financial statement carrying amounts of assets and liabilities and their respective tax basis. Occidental routinely assesses the realizability of its deferred tax assets. If Occidental concludes that it is more likely than not that some of the OXY 2020 FORM 10-K51MANAGEMENT’S DISCUSSION AND ANALYSISdeferred tax assets will not be realized, the tax asset is reduced by a valuation allowance. Occidental recognizes a tax benefit from an uncertain tax position when it is more likely than not that the position will be sustained upon examination, based on the technical merits of the position. The tax benefit recorded is equal to the largest amount that is greater than 50% likely to be realized through final settlement with a taxing authority. Interest and penalties related to unrecognized tax benefits are recognized in income tax expense (benefit). Occidental uses the flow-through method to account for its investment tax credits. See Note 12 - Income Taxes in the Notes to Consolidated Financial Statements in Part II Item 8 of this Form 10-K.LOSS CONTINGENCIESOccidental is involved, in the normal course of business, in lawsuits, claims and other legal proceedings and audits. Occidental accrues reserves for these matters when it is probable that a liability has been incurred and the liability can be reasonably estimated. In addition, Occidental discloses, in aggregate, its exposure to loss in excess of the amount recorded on the balance sheet for these matters if it is reasonably possible that an additional material loss may be incurred. Occidental reviews its loss contingencies on an ongoing basis.Loss contingencies are based on judgments made by management with respect to the likely outcome of these matters and are adjusted as appropriate. Management’s judgments could change based on new information, changes in, or interpretations of, laws or regulations, changes in management’s plans or intentions, opinions regarding the outcome of legal proceedings, or other factors. See Note 11 - Lawsuits, Claims, Commitments and Contingencies in the Notes to Consolidated Financial Statements in Part II Item 8 of this Form 10-K for additional information.SIGNIFICANT ACCOUNTING AND DISCLOSURE CHANGESSee Note 2 - Accounting and Disclosure Changes in the Notes to Consolidated Financial Statements in Part II Item 8 of this Form 10-K for further information on significant accounting and disclosure changes.SAFE HARBOR DISCUSSION REGARDING OUTLOOK AND OTHER FORWARD-LOOKING DATAPortions of this report contain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. All statements other than statements of historical fact are “forward-looking statements” for purposes of federal and state securities laws, and they include, but are not limited to: any projections of earnings, revenue or other financial items or future financial position or sources of financing; any statements of the plans, strategies and objectives of management for future operations or business strategy; any statements regarding future economic conditions or performance; any statements of belief; and any statements of assumptions underlying any of the foregoing. Words such as “estimate,” “project,” “predict,” “will,” “would,” “should,” “could,” “may,” “might,” “anticipate,” “plan,” “intend,” “believe,” “expect,” “aim,” “goal,” “target,” “objective,” “likely” or similar expressions that convey the prospective nature of events or outcomes are generally indicative of forward-looking statements. You should not place undue reliance on these forward-looking statements, which speak only as of the date of this report. Unless legally required, Occidental does not undertake any obligation to update, modify or withdraw any forward-looking statements as a result of new information, future events or otherwise.Although Occidental believes that the expectations reflected in any of its forward-looking statements are reasonable, actual results may differ from anticipated results, sometimes materially. Factors that could cause results to differ from those projected or assumed in any forward-looking statement include, but are not limited to: the scope and duration of the COVID-19 pandemic and actions taken by governmental authorities and other third parties in response to the pandemic; Occidental’s indebtedness and other payment obligations, including the need to generate sufficient cash flows to fund operations; Occidental’s ability to successfully monetize select assets, repay or refinance debt and the impact of changes in Occidental’s credit ratings; assumptions about energy markets; global and local commodity and commodity-futures pricing fluctuations, such as the sharp decline in crude oil prices that occurred in the first half of 2020; supply and demand considerations for, and the prices of, Occidental’s products and services; actions by OPEC and non-OPEC oil producing countries; results from operations and competitive conditions; future impairments of our proved and unproved oil and gas properties or equity investments, or write-downs of productive assets, causing charges to earnings; unexpected changes in costs; availability of capital resources, levels of capital expenditures and contractual obligations; the regulatory approval environment, including Occidental's ability to timely obtain or maintain permits or other governmental approvals, including those necessary for drilling and/or development projects; Occidental's ability to successfully complete, or any material delay of, field developments, expansion projects, capital expenditures, efficiency projects, acquisitions or dispositions; risks associated with acquisitions, mergers and joint ventures, such as difficulties integrating businesses, uncertainty associated with financial projections, projected synergies, restructuring, increased costs and adverse tax consequences; uncertainties and liabilities associated with acquired and divested properties and businesses; uncertainties about the estimated quantities of oil, NGL and natural gas reserves; lower-than-expected production from development projects or acquisitions; 52OXY 2020 FORM 10-KMANAGEMENT’S DISCUSSION AND ANALYSISOccidental’s ability to realize the anticipated benefits from prior or future streamlining actions to reduce fixed costs, simplify or improve processes and improve Occidental’s competitiveness; exploration, drilling and other operational risks; disruptions to, capacity constraints in, or other limitations on the pipeline systems that deliver Occidental’s oil and natural gas and other processing and transportation considerations; general economic conditions, including slowdowns, domestically or internationally, and volatility in the securities, capital or credit markets; uncertainty from the expected discontinuance of LIBOR and transition to any other interest rate benchmark; governmental actions and political conditions and events; legislative or regulatory changes, including changes relating to hydraulic fracturing or other oil and natural gas operations, retroactive royalty or production tax regimes, deepwater and onshore drilling and permitting regulations and environmental regulation (including regulations related to climate change); environmental risks and liability under international, provincial, federal, regional, state, tribal, local and foreign environmental laws and regulations (including remedial actions); potential liability resulting from pending or future litigation; disruption or interruption of production or manufacturing or facility damage due to accidents, chemical releases, labor unrest, weather, natural disasters, cyber attacks or insurgent activity; the creditworthiness and performance of Occidental's counterparties, including financial institutions, operating partners and other parties; failure of risk management; Occidental’s ability to retain and hire key personnel; reorganization or restructuring of Occidental’s operations; changes in state, federal or foreign tax rates; and actions by third parties that are beyond Occidental's control. The unprecedented nature of the COVID-19 pandemic and recent market decline may make it more difficult to identify potential risks, give rise to risks that are currently unknown or amplify the impact of known risks.Additional information concerning these and other factors that may cause Occidental’s results of operations and financial position to differ from expectations can be found in Item 1A, “Risk Factors” and elsewhere in this Form 10-K, as well as in Occidental’s other filings with the U.S. Securities and Exchange Commission, including Occidental’s Quarterly Reports on Form 10-Q and Current Reports on Form 8-K.ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKCOMMODITY PRICE RISKGENERALOccidental’s results are sensitive to fluctuations in oil, NGL and natural gas prices. Price changes at current global prices and levels of production affect Occidental’s pre-tax annual income by approximately $200 million for a $1 per barrel change in oil prices and $85 million for a $1 per barrel change in NGL prices. If domestic natural gas prices varied by $0.10 per Mcf, it would have an estimated annual effect on Occidental’s pre-tax income of approximately $35 million. These price-change sensitivities include the impact of PSC and similar contract volume changes on income. If production levels change in the future, the sensitivity of Occidental’s results to prices also will change. Marketing results are sensitive to price changes of oil, natural gas and, to a lesser degree, other commodities. A $0.25 change in the Midland-to-Gulf-Coast oil spreads impacts total year operating cash flows by $65 million.Occidental’s results are also sensitive to fluctuations in chemical prices. A variation in chlorine and caustic soda prices of $10 per ton would have a pre-tax annual effect on income of approximately $10 million and $30 million, respectively. A variation in PVC prices of $0.01 per lb. would have a pre-tax annual effect on income of approximately $30 million. Historically, over time, product price changes have tracked raw material and feedstock product price changes, somewhat mitigating the effect of price changes on margins.Occidental uses derivative instruments, including a combination of short-term futures, forwards, options and swaps, to obtain the average prices for the relevant production month and to improve realized prices for oil and gas.RISK MANAGEMENTOccidental conducts its risk management activities for marketing and trading under the controls and governance of its risk control policies. The controls under these policies are implemented and enforced by a risk management group which monitors risk by providing an independent and separate evaluation and check. Members of the risk management group report to the Corporate Vice President and Treasurer. Controls for these activities include limits on value at risk, limits on credit, limits on total notional trade value, segregation of duties, delegation of authority, daily price verifications, reporting to senior management on various risk measures and a number of other policy and procedural controls.FAIR VALUE OF MARKETING DERIVATIVE CONTRACTSOccidental carries derivative contracts it enters into in connection with its marketing activities at fair value. Fair values for these contracts are derived from Level 1 and Level 2 sources. The fair values in future maturity periods are insignificant. OXY 2020 FORM 10-K53QUANTITATIVE AND QUALITATIVE DISCLOSURESThe following table shows the fair value of Occidental’s derivatives (excluding collateral), segregated by maturity periods and by methodology of fair value estimation:Maturity Periods Source of Fair Value Assets/(Liabilities)millions20212022 and 20232024 and 20252026 and thereafterTotalPrices actively quoted$(97)$— $— $— $(97)Prices provided by other external sources(1)2 — — 1 Total$(98)$2 $— $— $(96)QUANTITATIVE INFORMATIONOccidental uses value at risk to estimate the potential effects of changes in fair values of commodity contracts used in trading activities. This measure determines the maximum potential negative one day change in fair value with a 95% level of confidence. Additionally, Occidental uses complementary trading limits including position and tenor limits and maintains liquid positions as a result of which market risk typically can be neutralized or mitigated on short notice. As a result of these controls, Occidental believes that the market risk of its trading activities is not reasonably likely to have a material adverse effect on its performance.INTEREST RATE RISKGENERALOccidental acquired interest rate swap contracts in the Acquisition. Occidental pays a fixed interest rate and receives a floating interest rate indexed to three-month LIBOR. The swaps have an initial term of 30 years with mandatory termination dates in September 2021 through 2023 and a total notional amount of approximately $1.5 billion as of December 31, 2020. As of December 31, 2020, Occidental had a net liability of approximately $1.4 billion based on the fair value of the swaps of negative $1.8 billion netted against $374 million in posted cash collateral. A 25-basis point decrease in implied LIBOR rates over the term of the swaps would result in an additional liability of approximately $173 million on these swaps.As of December 31, 2020, Occidental had variable rate debt with a notional value of $1.1 billion outstanding. A 25-basis point increase in LIBOR interest rates would increase gross interest expense approximately $3 million per year.As of December 31, 2020, Occidental had fixed rate debt with a fair value of $32.7 billion outstanding. A 25-basis point change in Treasury rates would change the fair value of the fixed rate debt approximately $600 million.TABULAR PRESENTATION OF INTEREST RATE RISKThe table below provides information about Occidental’s long-term debt obligations. Debt amounts represent principal payments by maturity date.millions except percentagesU.S. DollarFixed-Rate DebtU.S. DollarVariable-Rate DebtTotal (a)2021$371 $27 $398 20221,006 1,052 2,058 2023949 — 949 20243,898 — 3,898 20252,900 — 2,900 Thereafter24,964 68 25,032 Total$34,088 $1,147 $35,235 Weighted-average interest rate4.78%1.73%4.68%Fair Value$32,678 $1,128 $33,806 (a)Excluded net unamortized debt premiums of $748 million and debt issuance cost of $156 million.FOREIGN CURRENCY RISKOccidental’s international operations have limited currency risk. Occidental manages its exposure primarily by balancing monetary assets and liabilities and limiting cash positions in foreign currencies to levels necessary for operating purposes. A vast majority of international oil sales are denominated in United States dollars. Additionally, all of Occidental’s consolidated 54OXY 2020 FORM 10-KQUANTITATIVE AND QUALITATIVE DISCLOSURESinternational oil and gas subsidiaries have the United States dollar as the functional currency. As of December 31, 2020, the fair value of foreign currency derivatives used in the marketing operations was immaterial. The effect of exchange rates on transactions in foreign currencies is included in periodic income.CREDIT RISKThe majority of Occidental’s counterparty credit risk is related to the physical delivery of energy commodities to its customers and any inability of these customers to meet their settlement commitments. Occidental manages credit risk by selecting counterparties that it believes to be financially strong, by entering into netting arrangements with counterparties and by requiring collateral or other credit risk mitigants, as appropriate. Occidental actively evaluates the creditworthiness of its counterparties, assigns appropriate credit limits and monitors credit exposures against those assigned limits. Occidental also enters into futures contracts through regulated exchanges with select clearinghouses and brokers, which are subject to minimal credit risk as a significant portion of these transactions settle on a daily margin basis.Certain OTC derivative instruments contain credit-risk-contingent features, primarily tied to credit ratings for Occidental or its counterparties, which may affect the amount of collateral that each party would need to post. The fair value of derivative instruments with credit-risk-contingent features, that were net liabilities at December 31, 2020 was $104 million (net of $374 million collateral) and $787 million (net of $169 million collateral) at December 31, 2019. Credit-risk-contingent features are primarily related to interest rate swaps.As of December 31, 2020, the substantial majority of the credit exposures were with investment grade counterparties. Occidental believes its exposure to credit-related losses at December 31, 2020, was not material and losses associated with credit risk have been insignificant for all years presented.DERIVATIVE INSTRUMENTS HELD FOR NON-TRADING PURPOSESAs of December 31, 2020, Occidental had derivative instruments in place to reduce the price risk associated with future oil production of 350Mbbl/d. As of December 31, 2020, these derivative instruments were at a $42 million net derivative liability position.The following table shows a sensitivity analysis based on both a 5% and 10% change in commodity prices and their effect on the net derivative liability position of $42 million at December 31, 2020:millions except percentagesPercent change in commodity pricesResulting net fair value position-asset (liability)Change to fair value from December 31, 2020 position+ 5%$(67)$(25)- 5%$(26)$16 + 10%$(102)$(60)-10%$(15)$27 As of December 31, 2020, Occidental had derivative instruments in place to reduce the price risk associated with future gas production of 530 thousand MMbtu/d. As of December 31, 2020, these derivative instruments were at a $25 million net derivative asset position.The following table shows a sensitivity analysis based on both a 5% and 10% change in commodity prices and their effect on the net derivative asset position of $25 million at December 31, 2020:millions except percentagesPercent change in commodity pricesResulting net fair value position-asset (liability)Change to fair value from December 31, 2020 position+ 5%$13 $(12)- 5%$37 $12 + 10%$1 $(24)-10%$51 $26 OXY 2020 FORM 10-K55FINANCIAL STATEMENTSINDEX
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+Item 7. Management’s Discussion and Analysis of Financial Condition and Results of OperationsYou should read the following discussion in conjunction with our audited historical consolidated financial statements, including the notes thereto, which are included elsewhere in this Form 10-K. Management's Discussion and Analysis of Financial Condition and Results of Operations contains statements that are forward-looking. These statements are based on current expectations and assumptions that are subject to risk, uncertainties, and other factors. Actual results could differ materially because of the factors discussed in "Risk Factors" included elsewhere in this Form 10-K. Executive OverviewThis executive overview presents summarized information regarding our business and operating trends only. For further information relating to the information summarized herein, see "Management's Discussion and Analysis of Financial Condition and Results of Operations" in its entirety.Recent ON Semiconductor ResultsOur revenue for the year ended December 31, 2020 was $5,255.0 million, a decrease of 4.8% from $5,517.9 million for the year ended December 31, 2019. The decrease was attributable to reduced demand for our products across PSG, ASG and ISG primarily due to the negative impact from the COVID-19 pandemic. During 2020, while we reported net income attributable to ON Semiconductor of $234.2 million compared to $211.7 million in 2019, our operating income during 2020 was $348.7 million compared to $432.7 million during 2019. While the decrease in operating income was primarily due to the pervasive macroeconomic impacts of the COVID-19 pandemic, the increase in net income attributable to ON Semiconductor was due to the income tax benefit recorded during the year. Our gross margin decreased by approximately 310 basis points to 32.7% in 2020 from 35.8% in 2019. See discussion under "Results of Operations" for further discussion on the reasons for the fluctuations year over year.Business and Macroeconomic EnvironmentThe COVID-19 pandemic has had, and is expected to continue to have, a significant adverse impact on global economic activity, including creating supply chain and market disruption. While certain measures enacted in 2020 to contain the spread of the COVID-19 pandemic have since been relaxed in many jurisdictions, the extent to which the pandemic will impact demand for our products depends on future developments, which are highly uncertain and difficult to predict, including new information that may emerge concerning the severity and longevity of the pandemic, and actions to contain and treat its impact. We historically have pursued, and expect to continue to pursue, cost-saving initiatives to align our overall cost structure, capital investments and other expenditures with our expected revenue, spending and capacity levels based on our current sales and manufacturing projections. We have taken, and continue to take, significant cost containment efforts, including, but not limited to, workforce reductions, reducing discretionary spending, furloughs, and mandatory vacations. While all our global 39manufacturing sites are currently operational, our facilities could be required to temporarily curtail production levels or temporarily cease operations based on government mandates. There can be no assurances that we will adequately forecast the impact of adverse economic conditions on our business or that we will effectively align our cost structure, capital investments and other expenditures with our revenue, spending and capacity levels in the future.See Note 7: ''Restructuring, Asset Impairments and Other Charges, net'' in the notes to our audited consolidated financial statements included elsewhere in this Form 10-K for information relating to our most recent cost-saving initiatives. The Impact of the COVID-19 Pandemic on our BusinessIn an effort to protect the health and safety of our employees, we have taken proactive, aggressive actions to adopt social distancing policies at our locations around the world, including reducing the number of people in our sites at any one time, encouraging our employees to work from home where possible, limiting the number of employees attending meetings and significantly reducing employee travel. In our role as responsible corporate citizens, we have taken actions to support our global communities by providing personal protective equipment to hospitals and health workers. We will continue to actively monitor implications of the COVID-19 pandemic on our business and may take further actions to adjust our business operations if deemed necessary, or as required by federal, state, or local law.During the majority of 2020, our results of operations were adversely impacted due to the reduced demand from our customers, government-mandated temporary shutdowns of certain of our facilities, supply shortages and other logistical constraints arising from the COVID-19 pandemic. However, towards the end of 2020, we experienced a meaningful improvement in the demand for most of our products, specifically products in the automotive sector that had been significantly impacted by the pandemic. However, current demand levels have yet to reach levels achieved before the pandemic. While we believe that our business has stabilized from the impact of the pandemic, a possible resurgence or another wave of the pandemic could alter the business and economic landscape again. We expect volatility in demand to continue in varying duration and severity until such time as the COVID-19 pandemic is effectively contained globally. Our long-term fundamentals remain strong as we believe that we are well-positioned for growth as business conditions continue to improve. We believe that secular trends in the automotive, industrial, and cloud-power end-markets, which are our primary areas of focus, will continue to drive long-term growth in the semiconductor industry.Results of OperationsOur results of operations for the year ended December 31, 2020 includes the full year results, and our results of operations for the year ended December 31, 2019 includes partial year results of Quantenna, which we acquired on June 19, 2019. For a discussion and comparison of the results of our operations for the year ended December 31, 2019 with the year ended December 31, 2018, refer to "Management's Discussion and Analysis of Financial Conditions and Results of Operations" in our Form 10-K for the year ended December 31, 2019 filed with the SEC on February 19, 2020.Operating Results40The following table summarizes certain information relating to our operating results that has been derived from our audited consolidated financial statements (in millions): Year ended December 31, 20202019ChangeRevenue$5,255.0 $5,517.9 $(262.9)Cost of revenue (exclusive of amortization shown below)3,539.2 3,544.3 (5.1)Gross profit1,715.8 1,973.6 (257.8)Operating expenses:Research and development642.9 640.9 2.0 Selling and marketing278.7 301.0 (22.3)General and administrative258.7 284.0 (25.3)Litigation settlement— 169.5 (169.5)Amortization of acquisition-related intangible assets120.3 115.2 5.1 Restructuring, asset impairments and other charges, net65.2 28.7 36.5 Intangible asset impairment1.3 1.6 (0.3)Total operating expenses1,367.1 1,540.9 (173.8)Operating income348.7 432.7 (84.0)Other income (expense), net:Interest expense(168.4)(148.3)(20.1)Interest income4.9 10.2 (5.3)Loss on debt refinancing and prepayment— (6.2)6.2 Other expense(8.6)(11.8)3.2 Other income (expense), net(172.1)(156.1)(16.0)Income before income taxes176.6 276.6 (100.0)Income tax (provision) benefit59.8 (62.7)122.5 Net income236.4 213.9 22.5 Less: Net income attributable to non-controlling interest(2.2)(2.2)— Net income attributable to ON Semiconductor Corporation$234.2 $211.7 $22.5 RevenueRevenue was $5,255.0 million and $5,517.9 million for 2020 and 2019, respectively. The decrease from 2019 to 2020 of $262.9 million, or 4.8%, was primarily attributable to a 6.5%, 3.1% and 2.5% decrease in revenue in PSG, ASG and ISG, respectively, which is further explained below. We had one customer, a distributor, whose revenue accounted for approximately 11% of the total revenue for the year ended December 31, 2020. Revenue by operating and reportable segments was as follows (dollars in millions):2020As a % ofRevenue (1)2019As a % ofRevenue (1)PSG$2,606.1 49.6 %$2,788.3 50.5 %ASG1,910.4 36.4 %1,972.3 35.7 %ISG738.5 14.1 %757.3 13.7 %Total revenue$5,255.0 $5,517.9 _______________________(1) Certain of the amounts may not total due to rounding of individual amounts.Revenue from PSG41Revenue from PSG decreased by $182.2 million, or approximately 7%, during 2020 compared to 2019. The revenue from our Advanced Power Division and Protection and Signal Division decreased by $116.8 million and $49.1 million, respectively. The decreases were due to a combination of a general decline in demand for these products due to economic conditions caused by the COVID-19 pandemic, and was exacerbated by internal delays in fulfilling certain customer orders due to our factories in China, the Philippines and Malaysia, which operated at significantly reduced capacity levels during portions of the first half of 2020 as a result of the COVID-19 pandemic. Revenue from ASG Revenue from ASG decreased by $61.9 million, or approximately 3%, during 2020 compared to 2019. The revenue from our Automotive Division and Mobile, Computing and Cloud Division decreased by $47.4 million and $39.6 million, respectively, and was partially offset by an increase in revenue of $34.1 million in our Wireless Connectivity Solutions Division, which included the acquired Quantenna business. The decreases in demand for the products in these divisions was primarily due to the economic conditions as a result of the COVID-19 pandemic, and specifically the automotive industry during the first half of the year, which has started to experience a meaningful recovery during the fourth quarter. Similar to PSG, this decrease was exacerbated by delays in fulfilling certain customer orders due to our factories in China, the Philippines and Malaysia, which operated at a significantly reduced capacity levels during portions of the first half of 2020 as a result of the COVID-19 pandemic.Revenue from ISG Revenue from ISG decreased by $18.8 million, or 2.5%, during 2020 compared 2019, which was primarily due to the decrease in revenue from our Automotive Sensing Division of $20.0 million, which was due to decreased demand and delays in fulfilling certain customer orders due to supply chain constraints during the first half of 2020 as a result of the COVID-19 pandemic.Revenue by Geographic LocationRevenue by geographic location, based on sales billed from the respective country or regions, are as follows (dollars in millions): 2020As a % ofRevenue (1)2019As a % ofRevenue (1)Singapore$1,799.5 34.2 %$1,713.1 31.0 %Hong Kong1,311.6 25.0 %1,417.3 25.7 %United Kingdom805.9 15.3 %921.6 16.7 %United States728.6 13.9 %810.3 14.7 %Other609.4 11.6 %655.6 11.9 %Total$5,255.0 $5,517.9 _______________________(1) Certain of the amounts may not total due to rounding of individual amounts. Gross Profit and Gross Margin (exclusive of amortization of acquisition-related intangible assets)Our gross profit by operating and reportable segment was as follows (dollars in millions):2020As a % ofSegment Revenue (1)2019As a % of Segment Revenue (1)PSG$801.7 30.8 %$976.0 35.0 %ASG730.5 38.2 %794.8 40.3 %ISG237.7 32.2 %275.4 36.4 %Gross profit for all segments$1,769.9 $2,046.2 Unallocated manufacturing costs (2)(54.1)(1.0)%(72.6)(1.3)%Total gross profit$1,715.8 32.7 %$1,973.6 35.8 %___________________42(1) Certain of the amounts may not total due to rounding of individual amounts.(2) Unallocated manufacturing costs are presented as a percentage of total revenue (2019 includes expensing of the fair market value step-up of inventory of $19.6 million acquired from Quantenna). Our gross profit was $1,715.8 million during 2020 compared to $1,973.6 million during 2019 representing a decrease of $257.8 million, or approximately 13%. Our gross margin decreased to 32.7% during 2020 compared to 35.8% during 2019. The decrease in gross profit and gross margin were attributable to a significant decline in sales volume due to the COVID-19 pandemic and a decline in average selling prices.While the improving business conditions during the second half of 2020 positively impacted our gross margins, we incurred additional expenses for freight, transportation and cleaning costs to operate our facilities in compliance with local government regulations that had an adverse impact on our gross margin.Operating Expenses Research and DevelopmentResearch and development expenses were $642.9 million and $640.9 million, or approximately 12% of revenue during each of 2020 and 2019, representing an increase of $2.0 million, or approximately 0.3% year-over-year. While there was a decrease in the cost of external consultants and travel-related expenses due to the cost-saving measures and travel restrictions implemented in response to the COVID-19 pandemic, these decreases were offset due to the payroll expenses for Quantenna employees for the entire year in 2020.Selling and MarketingSelling and marketing expenses were $278.7 million and $301.0 million, or approximately 5% of revenue during each of 2020 and 2019, representing a decrease of $22.3 million, or approximately 7.4% year-over-year. The decrease was primarily related to a significant decrease in travel-related expenses due to the cost-saving measures and travel restrictions implemented in response to the COVID-19 pandemic and nominal decreases in payroll expenses as a result of furloughs and the VSP and Involuntary Separation Program ("ISP") offered during 2020. Please see Note 7: ''Restructuring, Asset Impairments and Other Charges, net'' in the notes to our audited consolidated financial statements included elsewhere in this Form 10-K for a more detailed description of the VSP and the ISP.General and AdministrativeGeneral and administrative expenses were $258.7 million and $284.0 million, or approximately 5% of revenue during each of 2020 and 2019, representing a decrease of $25.3 million, or approximately 9% year-over-year. This decrease was primarily attributable to a decrease in stock compensation expense, travel-related expenses due to the cost-saving measures and travel restrictions implemented in response to the COVID-19 pandemic and certain other categories due to the general cost-saving measures.Litigation SettlementDuring 2019, we reached a litigation settlement with Power Integrations, Inc. ("PI"). In connection with the settlement, we incurred an expense of $169.5 million, and ultimately paid $175.0 million in cash, pursuant to which all outstanding legal and administrative disputes were withdrawn by both the parties. No such expenses were incurred during 2020. See Note 13: ''Commitments and Contingencies'' in the notes to our audited consolidated financial statements included elsewhere in this Form 10-K for additional information with respect to the litigation settlement with PI.Amortization of Acquisition—Related Intangible AssetsAmortization of acquisition-related intangible assets was $120.3 million and $115.2 million for 2020 and 2019, respectively. The increase of $5.1 million, or approximately 4.4%, was primarily due to the amortization of intangible assets acquired from Quantenna.See Note 5: ''Acquisitions, Divestiture and Licensing Transactions'' and Note 6: ''Goodwill and Intangible Assets'' in the notes to our audited consolidated financial statements included elsewhere in this Form 10-K for additional information with respect to the acquired intangible assets.43 Restructuring, Asset Impairments and Other Charges, netRestructuring, asset impairments and other charges, net was $65.2 million and $28.7 million for 2020 and 2019, respectively. Amounts incurred during 2020 related to the VSP, ISP and other restructuring programs, primarily through workforce reductions. Included in 2020 were also asset impairment charges amounting to $17.5 million. Amounts incurred during 2019 related to the post-Quantenna acquisition related restructuring program as well as certain restructuring actions undertaken by us aimed at cost savings, primarily through workforce reductions.For additional information, see Note 7: ''Restructuring, Asset Impairments and Other Charges, net'' in the notes to our audited consolidated financial statements included elsewhere in this Form 10-K.Intangible Asset Impairment Intangible asset impairment charges were $1.3 million and $1.6 million for 2020 and 2019, respectively, related to the cancellation and abandonment of certain IPRD projects during the year.See Note 6: ''Goodwill and Intangible Assets'' in the notes to our audited consolidated financial statements included elsewhere in this Form 10-K for additional information. Other Income and ExpensesInterest Expense Interest expense increased by $20.1 million, or approximately 14%, to $168.4 million during 2020 compared to $148.3 million in 2019, primarily due to an increase in the outstanding balances of long-term debt as a result of the borrowings under the Revolving Credit Facility (which was subsequently repaid) and our issuance of the 3.875% Notes, offset partially by the repayment of our 1.00% Notes. We recorded amortization of debt discount to interest expense of $38.2 million and $37.8 million for 2020 and 2019, respectively. Our average gross amount of long-term debt balance (including current maturities) during 2020 and 2019 was $3,669.4 million and $3,344.1 million, respectively. Our weighted average interest rate on our gross amount of long-term debt (including current maturities) was 4.6% and 4.4% per annum in 2020 and 2019, respectively. See "Liquidity and Capital Resources—Key Financing and Capital Events" below and Note 9: ''Long-Term Debt'' in the notes to our audited consolidated financial statements included elsewhere in this Form 10-K for a description of our indebtedness and our refinancing activities.Loss on Debt Refinancing and PrepaymentWe recorded loss on debt refinancing and prepayment of $6.2 million during 2019 related to the activity under the Amended Credit Agreement. No such expenses were incurred during 2020.Other Income (Expense)Other expense decreased by $3.2 million, or approximately 27%, from 2019 to 2020. The decrease was primarily attributable to a decrease of $11.6 million in actuarial losses on our pension obligations during 2020 compared to 2019, offset by the recognition of an indemnification gain of $7.8 million primarily attributable to the resolution of a foreign tax dispute and other IP related claims during 2019.Income Tax ProvisionWe recorded an income tax benefit of $59.8 million and a provision of $62.7 million in 2020 and 2019, respectively.The income tax benefit for the year ended December 31, 2020 consisted of discrete benefits of $63.0 million primarily due to the recognition of certain deferred tax assets, net of deferred tax liabilities, related to the domestication of certain foreign subsidiaries and a benefit of $49.4 million related to the release of valuation allowance against certain state deferred tax assets. These benefits were partially offset by a provision of $43.9 million for income and withholding taxes of certain of our foreign and domestic operations, a $2.3 million discrete provision relating to prior year uncertain tax positions, a discrete provision of $5.5 million relating to additional foreign valuation allowance, and $0.9 million of other discrete items.44The income tax provision for the year ended December 31, 2019 consisted primarily of $66.4 million for income and withholding taxes of certain of our foreign and domestic operations, $6.0 million relating to the resolution of a foreign tax dispute and $3.3 million of new reserves and interest on existing reserves for uncertain tax positions in foreign jurisdictions and $2.1 million of prior year adjustments. These amounts were offset by discrete benefits of $9.2 million relating to the release of reserves and interest for uncertain tax positions in foreign jurisdictions related to prior years and $5.9 million relating to equity award excess tax benefits.For additional information, see Note 16: ''Income Taxes'' in the notes to the audited consolidated financial statements included elsewhere in this Form 10-K.Liquidity and Capital ResourcesThis section includes a discussion and analysis of our cash requirements, off-balance sheet arrangements, contingencies, sources and uses of cash, operations, working capital and long-term assets and liabilities.Contractual ObligationsOur principal outstanding contractual obligations relate to our long-term debt, operating lease liabilities and purchase obligations. The following table summarizes our contractual obligations at December 31, 2020 and the effect such obligations are expected to have on our liquidity and cash flow in the future (in millions): Payments Due by PeriodContractual obligations (1)Total20212022202320242025ThereafterLong-term debt (2)$4,110.8 $699.0 $107.9 $104.7 $785.8 $77.3 $2,336.1 Operating lease liabilities174.6 36.5 30.1 23.1 20.8 14.2 49.9 Purchase obligations for (3):Capital expenditures58.1 52.0 4.8 1.3 — — — Inventory and external manufacturing1,256.9 418.6 339.5 245.9 246.0 3.4 3.5 Information technology and support services16.1 8.8 4.8 2.2 0.3 — — Other (4)307.2 45.5 249.8 10.1 1.7 0.1 — Total contractual obligations$5,923.7 $1,260.4 $736.9 $387.3 $1,054.6 $95.0 $2,389.5 _______________________(1)The table above excludes approximately $45.1 million of liabilities related to unrecognized tax benefits because we are unable to reasonably estimate the timing of the settlement of such liabilities.(2)Includes interest payments at applicable rates as of December 31, 2020.(3)These represent our off-balance sheet arrangements (See "Liquidity and Capital Resources - Off-Balance Sheet Arrangements" for further information).(4)During 2019, we incurred additional commitments relating to the pending acquisition of a manufacturing facility, of which, $170.0 million has been deposited with the seller already. The remaining commitment of $230.0 million will be owed on or around December 31, 2022. See Note 5: ''Acquisitions, Divestiture and Licensing Transactions'' in the notes to our audited consolidated financial statements included elsewhere in this Form 10-K for additional information.The table also excludes our pension obligations. We expect to make cash contributions to comply with local funding requirements and required benefit payments of approximately $22.1 million and $7.0 million, respectively, in 2021. This future payment estimate assumes we continue to meet our statutory funding requirements. The timing and amount of contributions may be impacted by a number of factors, including the funded status of the plans. Beyond 2021, the actual amounts required to be contributed are dependent upon, among other things, interest rates, underlying asset returns and the impact of legislative or regulatory actions related to pension funding obligations. See Note 12: ''Employee Benefit Plans'' in the notes to our audited consolidated financial statements included elsewhere in this Form 10-K for more information on our pension obligations.Our balance of cash and cash equivalents was $1,080.7 million as of December 31, 2020. We believe that our cash flows from operations, coupled with our existing cash and cash equivalents, and cash available from our Revolving Credit Facility, will be adequate to fund our operating, debt repayment and capital needs for at least the next 12 months. Total cash and cash equivalents at December 31, 2020 include approximately $489.1 million available in the United States. We require a substantial 45amount of cash in the United States for operating requirements, debt service, debt repayments and acquisitions. While we hold a significant amount of cash and cash equivalents outside the United States in various foreign subsidiaries, we have the ability to obtain cash in the United States in order to cover our domestic needs, through distributions from our foreign subsidiaries, by utilizing existing credit facilities or through new bank loans or debt obligations.See Note 9: ''Long-Term Debt,'' in the notes to our audited consolidated financial statements included elsewhere in this Form 10-K for a discussion of our long-term debt. See "Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities" included elsewhere in this Form 10-K for a discussion of restrictions on our ability to pay dividends and our stock repurchase activities.Off-Balance Sheet ArrangementsIn the ordinary course of business, we provide standby letters of credit or other guarantee instruments to certain parties in connection with certain transactions including, but not limited to: material purchase commitments, agreements to mitigate collection risk, leases, utilities or customs guarantees. As of December 31, 2020, our Revolving Credit Facility included $15.0 million available for the issuance of letters of credit. There were $0.9 million letters of credit outstanding under our Revolving Credit Facility as of December 31, 2020, which reduced our borrowing capacity dollar-for-dollar. As of December 31, 2020, we also had outstanding guarantees and letters of credit outside of our Revolving Credit Facility in the amount of $9.7 million.As part of securing financing in the ordinary course of business, we have issued guarantees related to certain of our subsidiaries', which totaled $0.9 million as of December 31, 2020. Based on historical experience and information currently available, we believe that we will not be required to make payments under the standby letters of credit or guarantee arrangements for the foreseeable future.We have not recorded any liability in connection with these letters of credit and guarantee arrangements. See Note 9: ''Long-Term Debt,'' and Note 13: ''Commitments and Contingencies'' in the notes to our audited consolidated financial statements found elsewhere in this Form 10-K for additional information.ContingenciesWe are a party to a variety of agreements entered into in the ordinary course of business pursuant to which we may be obligated to indemnify other parties for certain liabilities that arise out of or relate to the subject matter of the agreements. Some of the agreements entered into by us require us to indemnify the other party against losses, including, but not limited to, losses due to IP infringement, environmental contamination and other property damage, personal injury, our failure to comply with applicable laws, our negligence or willful misconduct or our breach of representations, warranties or covenants related to such matters as title to sold assets.We face risk of exposure to warranty and product liability claims in the event that our products fail to perform as expected or such failure of our products results, or is alleged to result, in economic damage, bodily injury or property damage. In addition, if any of our designed products are alleged to be defective, we may be required to participate in their recall. Depending on the significance of any particular customer and other relevant factors, we may agree to provide more favorable rights to such customer for valid defective product claims.We maintain directors’ and officers’ insurance policies that indemnify our directors and officers against various liabilities, including certain liabilities under the Exchange Act that might be incurred by any director or officer in his or her capacity as such.The agreement and plan of merger relating to the acquisition of Fairchild Semiconductor International Inc. (the "Fairchild Agreement") provides for indemnification and insurance rights in favor of Fairchild’s then current and former directors, officers and employees. Specifically, we have agreed that, for no fewer than six years following the Fairchild acquisition, we will: (a) indemnify and hold harmless each such indemnitee against losses and expenses (including advancement of attorneys’ fees and expenses) in connection with any proceeding asserted against the indemnified party in connection with such person’s servings as a director, officer, employee or other fiduciary of Fairchild or its subsidiaries prior to the effective time of the acquisition; (b) maintain in effect all provisions of the certificate of incorporation or bylaws of Fairchild or any of its subsidiaries or any other agreements of Fairchild or any of its subsidiaries with any indemnified party regarding elimination of liability, indemnification of officers, directors and employees and advancement of expenses in existence on the date of the Fairchild Agreement for acts or omissions occurring prior to the effective time of the acquisition and; (c) subject to certain qualifications, provide to Fairchild’s then current directors and officers an insurance and indemnification policy that provides 46coverage for events occurring prior to the effective time of the acquisition that is no less favorable than Fairchild’s then-existing policy, or, if insurance coverage that is no less favorable is unavailable, the best available coverage. Similarly, the agreement and plan of merger relating to the acquisition of Quantenna (the "Quantenna Agreement") provides for indemnification and insurance rights in favor of Quantenna’s then current and former directors, officers, employees and agents. Specifically, we have agreed that, for no fewer than six years following the Quantenna acquisition, we will: (a) indemnify and hold harmless each such indemnified party to the fullest extent permitted by Delaware law in the event of any threatened or actual claim suit, action, proceeding or investigation against the indemnified party based in whole or in part on, or pertaining to, such person’s serving as a director, officer, employee or agent of Quantenna or its subsidiaries or predecessors prior to the effective time of the acquisition or in connection with the Quantenna Agreement; (b) maintain in effect provisions of the certificate of incorporation and bylaws of Quantenna and each of its subsidiaries regarding the elimination of liability of directors and indemnification of officers, directors and employees that are no less advantageous to the intended beneficiaries than the corresponding provisions in the certificate of incorporation and bylaws of Quantenna and each of its subsidiaries in existence on the date of the Quantenna Agreement; and (c) obtain and fully pay the premium for a non-cancelable extension of directors’ and officers’ liability coverage of Quantenna’s directors’ and officers’ policies and Quantenna’s fiduciary liability insurance policies in effect as of the date of the Quantenna Agreement.While our future obligations under certain agreements may contain limitations on liability for indemnification, other agreements do not contain such limitations and under such agreements it is not possible to predict the maximum potential amount of future payments due to the conditional nature of our obligations and the unique facts and circumstances involved in each particular agreement. Historically, payments made by us under any of these indemnities have not had a material effect on our business, financial condition, results of operations or cash flows, and we do not believe that any amounts that we may be required to pay under these indemnities in the future will be material to our business, financial condition, results of operations or cash flows.See Note 13: ''Commitments and Contingencies'' in the notes to our audited consolidated financial statements included elsewhere in this Form 10-K for possible contingencies related to legal matters. See also "Business—Government Regulation" for information on certain environmental matters.Sources and Uses of CashOur balance of cash and cash equivalents was $1,080.7 million as of December 31, 2020. We require cash to fund our operating expenses, working capital requirements, outlays for strategic acquisitions and investments, for debt service including principal and interest, for research and development, for capital expenditures, and to repurchase our common stock. As part of our business strategy, we review acquisition and divestiture opportunities on a regular basis. During 2019, we entered into an agreement on the pending acquisition of a manufacturing facility and completed the acquisition of Quantenna. We believe that the key factors that could affect our internal and external sources of cash include:•Geopolitical and macroeconomic factors caused by the COVID-19 pandemic which has had, and is expected to continue to have, negative impacts on the economies of the majority of countries and industries. While there has been a nominal recovery during the second half of 2020, the ultimate effect of the COVID-19 pandemic and the responses of various governmental entities and industries thereto, the duration and severity and the possibility of the re-emergence of the pandemic in future months and the anticipated recovery period is uncertain.•Factors that affect our results of operations and cash flows, including the impact on our business and operations as a result of changes in demand for our products, including as a result of the COVID-19 pandemic, competitive pricing pressures, effective management of our manufacturing capacity, our ability to achieve further reductions in operating expenses, the impact of our restructuring programs on our production and cost efficiency and our ability to make the research and development expenditures required to remain competitive in our business; and•Factors that affect our access to bank financing and the debt and equity capital markets that could impair our ability to obtain needed financing on acceptable terms or to respond to business opportunities and developments as they arise, including interest rate fluctuations, macroeconomic conditions, including as a result of the COVID-19 pandemic, sudden reductions in the general availability of lending from banks or the related increase in cost to obtain bank financing and our ability to maintain compliance with covenants under our debt agreements in effect from time to time.The following are some of the significant sources and uses of cash during 2020 outside of our operating activities and regular capital expenditures:•Borrowing of $1,165.0 million under the Revolving Credit Facility on March 24, 2020 and repayment of $1,200.0 million of such borrowings using the net proceeds from the issuance of the 3.875% Notes and cash on hand on August 21, 2020.•Issuance of $700.0 million of 3.875% Notes on August 21, 2020, the net proceeds of which were used to repay a portion of the outstanding borrowings under the Revolving Credit Facility.47•Additional deposit of $100.0 million for the pending acquisition of GFUS’s East Fishkill, New York site and fabrication facilities and certain other assets and liabilities on October 5, 2020.•Repayment upon maturity of the principal portion of the 1.00% Notes amounting to $690.0 million on December 1, 2020.•Repayment of $65.0 million of the outstanding borrowings under the Revolving Credit Facility on December 31, 2020.•Repurchase of 3.6 million shares of common stock for an aggregate purchase price of approximately $65.3 million under the 2018 Share Repurchase ProgramOur ability to service our long-term debt, including our 3.875% Notes, 1.625% Notes, Revolving Credit Facility and Term Loan "B" Facility, to remain in compliance with the various covenants contained in our debt agreements and to fund working capital, capital expenditures and business development efforts will depend on our ability to generate cash from operating activities, which is subject to, among other things, our future operating performance, timing of the full economic recovery from the COVID-19 pandemic, as well as to financial, competitive, legislative, regulatory and other conditions, some of which may be beyond our control.If we fail to generate sufficient cash from operations, we may need to raise additional equity or borrow additional funds to achieve our longer-term objectives. There can be no assurance that such equity or borrowings will be available or, if available, will be at rates or prices acceptable to us. We believe that cash flow from operating activities coupled with existing cash and cash equivalents and existing credit facilities will be adequate to fund our operating, debt repayment and capital needs, as well as enable us to maintain compliance with our various debt agreements, through at least the next 12 months. To the extent that results or events differ from our financial projections or business plans, our liquidity may be adversely impacted.During the ordinary course of business, we evaluate our cash requirements and, if necessary, adjust our expenditures for inventory, operating expenditures and capital expenditures to reflect the current market conditions and our projected sales and demand. Our capital expenditures are primarily directed towards manufacturing equipment. Our capital expenditure levels can materially influence our available cash for other initiatives. For example, during 2020, we paid approximately $383.6 million for capital expenditures, while in 2019 we paid approximately $534.6 million. While our capital expenditures have historically been approximately 6% to 7% of annual revenue, we incurred capital expenditures of approximately 7% and 10% of annual revenue in 2020 and 2019, respectively. We expect to incur capital expenditures in the range of 7% to 8% of revenue in 2021 to further improve our manufacturing cost structure. Future capital expenditures are expected to be lower, however, may be impacted by events and transactions that are not currently forecasted.As of December 31, 2020, there was $1,614.5 million outstanding under the Term Loan "B" Facility and $700.0 million outstanding under the Revolving Credit Facility, in addition to the 3.875% Notes for $700.0 million and 1.625% Notes for $575.0 million, of which the 1.625% Notes net of unamortized discount and issuance costs has been reclassified as a current portion of long-term debt. The associated interest expense related to this indebtedness will continue to have a significant impact on our results of operations.See Note 5: ''Acquisitions, Divestiture and Licensing Transactions'' and Note 9: ''Long-Term Debt'' in the notes to our audited consolidated financial statements included elsewhere in this Form 10-K for additional information. Cash ManagementOur ability to manage cash is limited, as our primary cash inflows and outflows are dictated by the terms of our sales and supply agreements, contractual obligations, debt instruments and legal and regulatory requirements. While we have some flexibility with respect to the timing of capital equipment purchases, we must invest in capital equipment on a timely basis to allow us to maintain our manufacturing efficiency and support our platforms for new products.Primary Cash Flow SourcesOur long-term cash generation is dependent on the ability of our operations to generate cash. Our cash flows from operating activities were $884.3 million, $694.7 million, and $1,274.2 million for the years ended December 31, 2020, 2019 and 2018, respectively. Our operating cash flows for the year ended December 31, 2020 increased by $189.6 million, or 27.3%, compared to the year ended December 31, 2019, which was primarily due to the payment of $175.0 million in 2019 to PI relating to a litigation settlement, which decreased our cash flows during 2019. Although, there was a significant decrease in operating income and income before income taxes in 2020 due to decreased demand for our products as a result of the COVID-19 pandemic, the negative impact on the cash flows provided from operating activities were offset by effective working capital management. Our ability to maintain positive operating cash flows is dependent on, among other factors, our success in achieving our 48revenue goals and manufacturing and operating cost targets. Our management of our assets and liabilities, including both working capital and long-term assets and liabilities, also influences our operating cash flows, and each of these components is discussed below.Working CapitalWorking capital, calculated as total current assets less total current liabilities, fluctuates depending on end-market demand and our effective management of certain items such as receivables, inventory and payables. In times of escalating demand, our working capital requirements may be affected as we purchase additional manufacturing materials and increase production. Our working capital may also be affected by restructuring programs, which may require us to use cash for severance payments, asset transfers and contract termination costs. In addition, our working capital may be affected by acquisitions and transactions involving our convertible notes and other debt instruments. Although investments made to fund working capital will reduce our cash balances, these investments are necessary to support business and operating initiatives. Our working capital, excluding cash and cash equivalents and the current portion of long-term debt, was $960.5 million as of December 31, 2020 and has fluctuated between $879.3 million and $1,057.1 million at the end of each of our last eight fiscal quarters. Our working capital, including cash and cash equivalents and the current portion of long-term debt, was $1,509.6 million as of December 31, 2020 and has fluctuated between $1,071.4 million and $2,379.8 million at the end of each of our last eight fiscal quarters. The significant fluctuation was due to the additional borrowings under the Revolving Credit Facility during 2020 in light of the COVID-19 pandemic. For the year ended December 31, 2020, there was not a significant impact to our working capital as we tried to manage our business conservatively in light of the negative impact from the COVID-19 pandemic. Long-Term Assets and LiabilitiesOur long-term assets consist primarily of property, plant and equipment, intangible assets, deferred taxes and goodwill. Our manufacturing rationalization plans have included efforts to utilize our existing manufacturing assets and supply arrangements more efficiently. We believe that near-term access to additional manufacturing capacity, should it be required, could be readily obtained on reasonable terms through manufacturing agreements with third parties. We will continue to look for opportunities to make strategic purchases in the future for additional capacity.Our long-term liabilities, excluding long-term debt and deferred taxes, consist of liabilities under our foreign defined benefit pension plans, operating lease liabilities and contingent tax reserves. In regard to our foreign defined benefit pension plans, our annual funding of these obligations is equal to the minimum amount legally required in each jurisdiction in which the plans operate. This annual amount is dependent upon numerous actuarial assumptions. For additional information, see Note 12: ''Employee Benefit Plans'', "Note 8: ''Balance Sheet Information'' and Note 16: ''Income Taxes'' in the notes to our audited consolidated financial statements included elsewhere in this Form 10-K.Key Financing and Capital Events OverviewFor the past several years, we have undertaken various measures to secure liquidity to pursue acquisitions, repurchase shares of our common stock, reduce interest costs, amend existing key financing arrangements and, in some cases, extend a portion of our debt maturities to continue to provide us additional operating flexibility. Certain of these measures continued in 2020. Set forth below is a summary of certain key financing events affecting our capital structure during the last three years. For further discussion of our debt instruments, see Note 9: ''Long-Term Debt'' and for further discussion on the 2018 Share Repurchase Program and the 2014 Share Repurchase Program (as defined below), see Note 10: ''Earnings Per Share and Equity'' in the notes to our audited consolidated financial statements included elsewhere in this Form 10-K.2020 Financing EventsMaturity and Settlement of 1.00% Notes due 2020The 1.00% Notes matured on December 1, 2020. The maturity of the notes resulted in us paying $690.0 million in cash, representing the principal portion of the 1.00% Notes, to holders of the 1.00% Notes using our available cash and cash equivalents. The excess over the principal amount was settled by issuing shares of common stock held in treasury. At the time of issuance of 49the 1.00% Notes, we concurrently entered into hedge transactions with certain of the initial purchasers of the 1.00% Notes, and accordingly, repurchased an equivalent number of shares of our common stock at fair market value, to effectively offset the issuance of shares.Also at the time of issuance of the 1.00% Notes, we sold warrants to certain bank counterparties whereby the holders of the warrants have the option to purchase from us, the equivalent number of shares of our common stock at a price of $25.96 per share. These warrants can be exercised by the holders beginning in March 2021 and expire no later than April 2021. We currently anticipate the holders to exercise the warrants to purchase up to 37.3 million shares of common stock from us, which will be settled on a net-share basis depending on the average stock price on the day of exercise. Issuance of 3.875% NotesOn August 21, 2020, we completed a private offering of $700.0 million aggregate principal amount of the 3.875% Notes. The 3.875% Notes were offered in the United States to qualified institutional buyers pursuant to Rule 144A under the Securities Act and outside the United States pursuant to Regulation S under the Securities Act. The 3.875% Notes are fully and unconditionally guaranteed, on a joint and several basis, by each of our subsidiaries that is a borrower or guarantor under the Amended Credit Agreement and will also be fully and unconditionally guaranteed by any our subsidiaries that becomes a borrower or guarantees any indebtedness under the Amended Credit Agreement in the future.The 3.875% Notes and the guarantees thereof are ours' and the guarantors' general unsecured obligations, respectively, and (i) rank equally in right of payment with all of ours' and the guarantors’ existing and future senior indebtedness (including the 1.625% Notes); (ii) rank senior to any subordinated indebtedness that we or the guarantors may incur; (iii) are effectively subordinated to all of ours' or the guarantors’ existing and future secured indebtedness (including indebtedness under the Amended Credit Agreement), in each case, to the extent of the value of the assets securing such indebtedness; and (iv) are structurally subordinated in right of payment to all existing and future obligations of our subsidiaries that are not guarantors of the 3.875% Notes.The 3.875% Notes bear interest at a rate of 3.875% per year, payable semi-annually on March 1 and September 1 of each year, beginning on March 1, 2021, and will mature on September 1, 2028, unless earlier redeemed or repurchased by us. In connection with the issuance, we incurred original issue discount and debt issuance costs amounting to $9.4 million, which has been capitalized and will be amortized to interest expense through the maturity date of September 1, 2028. The net proceeds from the issuance of the 3.875% Notes were used entirely to repay borrowings under the Revolving Credit Facility.Borrowing and repayment under the Revolving Credit FacilityOn March 24, 2020, we borrowed $1,165.0 million under the Revolving Credit Facility as a precautionary measure in order to increase the Company’s cash position and provide financial flexibility in light of the uncertainty resulting from the impact of the COVID-19 pandemic. Due to better macroeconomic and business conditions, on August 21, 2020, we used the net proceeds from the issuance of the 3.875% Notes along with cash on hand to repay $1,200.0 million of outstanding borrowings. Additionally, on December 31, 2020, we repaid $65.0 million of outstanding borrowings under the Revolving Credit Facility. As of December 31, 2020, approximately $1,269.0 million was available for future borrowings under the Revolving Credit Facility.Amendments to the Amended Credit AgreementOn June 23, 2020, we entered into the Eighth Amendment ("Eighth Amendment") to the Amended Credit Agreement with the subsidiary guarantors party thereto, Deutsche Bank AG New York Branch, as administrative agent and collateral agent, and certain Lenders party thereto constituting the Required Lenders (as defined in the Amended Credit Agreement). The Eighth Amendment provided for, among other things, (i) replacing the defined term "Capital Lease Obligations" with a new defined term "Finance Lease Obligations," providing that such obligations only include property classified as finance leases under U.S. GAAP and (ii) making certain amendments in connection with the proposed domestication of ON Management Ltd. and Quantenna Ltd., each of which is our subsidiary that is not a Loan Party (as defined in the Amended Credit Agreement) and both of which hold economic rights in certain intellectual property, from Bermuda entities to Delaware entities, including, among other things, (a) permitting Investments (as defined in the Amended Credit Agreement) by any Loan Party in any Foreign Subsidiary (as defined in the Amended Credit Agreement) if the proceeds of such Investments are used for Capital Expenditures (as defined in the Amended Credit Agreement) ("Capital Expenditure Investments") and (b) increasing the amount of certain permitted intercompany Investments by any Loan Party in any subsidiary that is not a Loan Party by an amount (which shall not be less than zero) equal to (A) Net Royalties (as defined in the Amended Credit Agreement) minus (B) the aggregate amount of Capital Expenditure Investments.2018 Share Repurchase Program50During 2020, we repurchased 3.6 million shares of our common stock for an aggregate purchase price of $65.3 million pursuant to the 2018 Share Repurchase Program. 2019 Financing EventsAmendments to the Amended Credit AgreementOn June 12, 2019, we entered into the Fifth Amendment to the Amended Credit Agreement (the "Fifth Amendment"), with the subsidiary guarantors party thereto, Deutsche Bank AG New York Branch, as administrative agent, collateral agent and issuing lender, the "2019 Incremental Revolving Lenders" (as defined in the Fifth Amendment) party thereto, and the "New Required Lenders" (as defined in the Fifth Amendment) party thereto. The Fifth Amendment provided for, among other things, modifications to the Amended Credit Agreement to: (i) increase the amount that may be borrowed pursuant to the Revolving Credit Facility by $900.0 million to $1.9 billion; (ii) extend the maturity date of borrowings under the Revolving Credit Facility to the later of (x) December 30, 2022 or (y) June 12, 2024, so long as the borrowings under the Term Loan "B" Facility have been fully repaid or otherwise redeemed, discharged or defeased on or prior to December 30, 2022, or if the maturity date of borrowings under the Term Loan "B" Facility has been extended prior to December 30, 2022, to a date no earlier than June 12, 2024; and (iii) amend certain financial covenants, including deleting the minimum Interest Coverage Ratio and increasing the maximum Consolidated Total Net Leverage Ratio (as such terms are defined in the Amended Credit Agreement) from 4.00 to 1.00 to 4.50 to 1.00 during any period of four consecutive fiscal quarters commencing after a Permitted Acquisition (as defined in the Amended Credit Agreement) with consideration in excess of $250.0 million. On June 19, 2019, we drew $900.0 million of the Revolving Credit Facility to partially fund the acquisition of Quantenna.On August 15, 2019, we entered into the Sixth Amendment to the Amended Credit Agreement (the "Sixth Amendment"), which increased amounts that may be borrowed under the Revolving Credit Facility by $70.0 million to $1.97 billion. On September 19, 2019, we entered into the Seventh Amendment to the Amended Credit Agreement (the "Seventh Amendment"). The Seventh Amendment provided for, among other things, modifications to the Amended Credit Agreement to (i) increase the amount that may be borrowed pursuant to the Term Loan "B" Facility by approximately $500.5 million, up to an aggregate principal amount of $1.635 billion; (ii) extend the maturity date of borrowings under the Term Loan "B" Facility to September 19, 2026; (iii) for any interest period ending after the date of the Seventh Amendment, increase the interest rate for borrowings under the Term Loan "B" Facility to (a) with respect to eurocurrency loans, a base rate per annum equal to the Adjusted LIBO Rate (as defined in the Amended Credit Agreement) plus an applicable margin of 2.00% and (b) with respect to alternate base rate loans, a base rate per annum equal to the Alternate Base Rate (as defined in the Amended Credit Agreement) plus an applicable margin equal to 1.00%; and (iv) make certain amendments providing for the determination of an alternate interest rate to the Adjusted LIBO Rate and/or the LIBO Rate (as defined in the Amended Credit Agreement) in the event of certain circumstances that result in the inability to adequately and reasonably determine such rates or such rates no longer adequately and fairly reflecting the cost of the applicable loans. In addition, pursuant to the Fifth Amendment (defined above), as a result of the extension described in (ii) above, the maturity date of borrowings under the Revolving Credit Facility was extended to June 12, 2024. We utilized the additional borrowings pursuant to the Seventh Amendment to repay $500.0 million of the outstanding balance under the Revolving Credit Facility. 2018 Share Repurchase ProgramDuring 2019, we repurchased 7.8 million shares of our common stock for an aggregate purchase price of $138.9 million pursuant to the 2018 Share Repurchase Program.2018 Financing EventsAmendments to the Amended Credit AgreementOn May 31, 2018, we, the Guarantors (as defined in the Amended Credit Agreement), the several lenders party thereto and the Agent (as defined in the Amended Credit Agreement) entered into the Fourth Amendment to the Amended Credit Agreement (the “Fourth Amendment”). Pursuant to the Fourth Amendment, for any interest period ending after the date of the Fourth Amendment, Eurocurrency Loans (as defined in the Amended Credit Agreement) will accrue interest at (i) a base rate per annum equal to the Adjusted LIBO Rate (as defined in the Amended Credit Agreement) plus (ii) an applicable margin equal to (x) 1.25% with respect to borrowings under the Revolving Credit Facility (with step-downs and step-ups as set forth in the Amended Credit Agreement) or (y) 1.75% with respect to borrowings under the Term Loan “B” Facility.51Pursuant to the Fourth Amendment, ABR Loans (as defined in the Amended Credit Agreement) will accrue interest at (i) a base rate per annum equal to the highest of (x) the federal funds rate plus 0.50%, (y) the prime commercial lending rate announced by the Agent from time to time as its prime lending rate and (z) the Adjusted LIBO Rate (as defined in the Amended Credit Agreement) for a one month interest period (or if such day is not a business day, the immediately preceding business day) (determined after giving effect to any applicable “floor”) plus 1.00%; provided that, the Adjusted LIBO Rate for any day shall be based on the LIBO Rate (as defined in the Amended Credit Agreement), subject to the interest rate floors set forth in the Amended Credit Agreement, plus (ii) an applicable margin equal to (x) 0.25% with respect to borrowings under the Revolving Credit Facility (with step-ups as set forth in the Amended Credit Agreement) or (y) 0.75% with respect to borrowings under the Term Loan "B" Facility.During the year ended December 31, 2018, we prepaid $70.0 million of borrowings under the Term Loan "B" Facility.2014 Share Repurchase ProgramDuring 2018, we repurchased 16.8 million shares of our common stock for an aggregate purchase price of $315.0 million under the 2014 Share Repurchase Program (as defined below).Debt Guarantees and Related CovenantsAs of December 31, 2020, we were in compliance with the indentures relating to our 3.875% Notes and 1.625% Notes and with covenants relating to our Term Loan "B" Facility and Revolving Credit Facility. Our 3.875% Notes and 1.625% Notes are senior to the existing and future subordinated indebtedness of ON Semiconductor and our guarantor subsidiaries and rank equally in right of payment to all of our existing and future senior debt and as unsecured obligations and are subordinated to all of our existing and future secured debt to the extent of the assets securing such debt. See Note 9: ''Long-Term Debt'' in the notes to our audited consolidated financial statements included elsewhere in this Form 10-K for additional information.Critical Accounting Policies and EstimatesThe accompanying discussion and analysis of our financial condition and results of operations is based upon our audited consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. We believe certain of our accounting policies are critical to understanding our financial position and results of operations. We utilize the following critical accounting policies in the preparation of our financial statements.Use of Estimates. The preparation of financial statements in accordance with GAAP requires us to make estimates and assumptions that affect the reported amount of assets and liabilities at the date of the financial statements and the reported amount of revenue and expenses during the reporting period. We evaluate these estimates and judgments on an ongoing basis and base our estimates on experience, current and expected future conditions, third-party evaluations and various other assumptions that we believe are reasonable under the circumstances. Significant estimates have been used by management in conjunction with the following: (i) future payouts for customer incentives and amounts subject to allowances and returns; (ii) valuation and obsolescence relating to inventories; (iii) variable and share-based compensation; and (iv) measurement of valuation allowances against deferred tax assets, and evaluations of uncertain tax positions. Additionally, during periods where it becomes applicable, significant estimates will be used by management in determining the future cash flows used to assess and test for impairment of indefinite-lived intangible assets, long-lived assets and goodwill and in assumptions used in connection with business combinations. Actual results may differ from the estimates and assumptions used in the consolidated financial statements.Revenue. We generate revenue from sales of our semiconductor products to OEMs, electronic manufacturing service providers and distributors. We also generate revenue, to a much lesser extent, from product development agreements and manufacturing services provided to customers. We recognize revenue when we satisfy a performance obligation in an amount reflecting the consideration to which we expect to be entitled. For sales agreements, we have identified the promise to transfer products, each of which is distinct, to be the performance obligation. For product development agreements, we have identified the completion of a service defined in the agreement to be the performance obligation. We apply a five-step approach in determining the amount and timing of revenue to be recognized: (1) identifying the contract with a customer; (2) identifying the performance obligations in the contract; (3) determining the transaction price; (4) allocating the transaction price to the performance obligations in the contract; and (5) recognizing revenue when the performance obligation is satisfied. We allocate the transaction price to each distinct product based on its relative stand-alone selling price. In determining the transaction price, we evaluate whether the price is subject to refund or adjustment to determine the net consideration to which we expect to be entitled. Substantially all of our revenue is recognized at the time control of the products transfers to the customer.52Sales to certain distributors, primarily those with ship and credit rights, can be subject to price adjustment on certain products. We develop an estimate of their expected claims under the ship and credit program based on the historical claims data submitted by product and customer and expected future claims, which requires the use of estimates and assumptions related to the amount of each claim as well as the historical period used to develop the estimate. Our OEM customers do not have the right to return products, other than pursuant to the provisions of our standard warranty. Sales to distributors, however, are typically made pursuant to agreements that provide return rights and stock rotation provisions permitting limited levels of product returns. Provisions for discounts and rebates to customers, estimated returns and allowances, ship and credit claims and other adjustments are provided for in the same period the related revenue are recognized, and are netted against revenue. For non-quality related returns, we recognize a related asset for the right to recover returned products with a corresponding reduction to cost of goods sold. We record a reserve for cash discounts as a reduction to accounts receivable and a reduction to revenue, based on the experience with each customer. Inventories. We carry our inventories at the lower of standard cost (which approximates actual cost on a first-in, first-out basis) or net realizable value and record provisions for potential excess and obsolete inventories based upon a regular analysis of inventory on hand compared to historical and projected end-user demand. The determination of projected end-user demand requires the use of estimates and assumptions related to projected unit sales for each product. These provisions can influence our results from operations. For example, when demand falls for a given part, all or a portion of the related inventory that is considered to be in excess of anticipated demand is reserved, impacting our cost of revenue and gross profit. The majority of product inventory that has been previously reserved is ultimately discarded. However, we do sell some products that have previously been written down, such sales have historically been consistently insignificant and the related impact on our margins has also been insignificant.Variable and Share-Based Compensation. We record compensation expense for all share-based payment awards, including RSUs and shares issued under the ESPP, and measure them at the grant date, based on the estimated fair value of the award, and we recognize each such award as an expense over the performance measurement period and/or employee's requisite service period. We have outstanding awards with service, performance, and market-based vesting conditions. Determining the amount of share-based compensation requires us to develop estimates and use valuation models in calculating the grant-date fair value of the award. Additionally, employees are compensated on a variable basis during periods when we are profitable and certain performance goals are achieved. Determining the amount of variable compensation expense requires us to estimate future profitability and achievement of performance goals, which involves judgment.Income Taxes. Income taxes are accounted for using the asset and liability method. Under this method, deferred income tax assets and liabilities are recognized for the future tax consequences attributable to temporary differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred income tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which these temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. A valuation allowance is provided for those deferred tax assets for which we cannot conclude that it is more likely than not that such deferred tax assets will be realized.In determining the amount of the valuation allowance, estimated future taxable income, feasible tax planning strategies, future reversals of existing temporary differences and taxable income in prior carryback years, if a carryback is permitted are considered. If we determine it is more likely than not that all or a portion of the remaining deferred tax assets will not be realized, the valuation allowance will be increased with a charge to income tax expense. Conversely, if we determine it is more likely than not to be able to utilize all or a portion of the deferred tax assets for which a valuation allowance has been provided, the related portion of the valuation allowance will be recorded as a reduction to income tax expense. We recognize and measure benefits for uncertain tax positions using a two-step approach. The first step is to evaluate the tax position taken or expected to be taken in a tax return by determining if the weight of available evidence indicates that is it more likely than not that the tax positions will be sustained upon audit, including resolution of any related appeals or litigation processes. For tax positions that are more likely than not to be sustained upon audit, the second step is to measure the tax benefit as the largest amount that is more than 50% likely to be realized upon settlement. No tax benefit is recognized for tax positions that are not more likely than not to be sustained. Our practice is to recognize interest and/or penalties related to income tax matters in income tax expense. Significant judgment is required to evaluate uncertain tax positions. Evaluations are based upon a number of factors, including changes in facts or circumstances, changes in tax law, correspondence with tax authorities during the course of tax audits and effective settlement of audit issues. Changes in the recognition or measurement of uncertain tax positions could result in material increases or decreases in income tax expense in the period in which the change is made, which could have a material impact to our effective tax rate. 53Business Combination. We use significant estimates and assumptions in allocating the purchase price of acquired business by utilizing established valuation techniques appropriate for the technology industry to record the acquired assets and liabilities at fair value. We utilize the income approach, cost approach or market approach, depending upon which approach is the most appropriate based on the nature and reliability of available data. If the income approach is used, the fair value determination is predicated upon the value of the future cash flows that an asset is expected to generate over its economic life and involves significant assumptions as to cash flows, associated expenses, long-term growth rates and discount rates. The cost approach takes into account the cost to replace (or reproduce) the asset and involves assumptions relating to the asset's value of physical, functional and/or economic obsolescence that has occurred with respect to the asset. The market approach is used to estimate value from an analysis of actual transactions or offerings for economically comparable assets available as of the valuation date. Determining the fair value of acquired technology assets is judgmental in nature and requires the use of significant estimates and assumptions, including the discount rate, revenue growth rates, projected gross margins, and estimated research and development expenses. Impairment of Goodwill, Indefinite-lived Intangible Assets and Long-Lived Assets. We evaluate our goodwill for potential impairment annually during the fourth quarter and whenever events or changes in circumstances indicate the carrying value of goodwill may not be recoverable. Our impairment evaluation consists of a qualitative assessment, and if deemed necessary, a quantitative test is performed which compares the fair value of a reporting unit with its carrying amount, including goodwill. Determining the fair value of our reporting units is subjective in nature and involves the use of significant estimates and assumptions, including projected net cash flows, discount and long-term growth rates. We determine the fair value of our reporting units based on an income approach, whereby the fair value of the reporting unit is derived from the present value of estimated future cash flows. The assumptions about estimated cash flows include factors such as future revenue, gross profit, operating expenses, and industry trends. We consider historical rates and current market conditions when determining the discount and long-term growth rates to use in its analysis. We consider other valuation methods, such as the cost approach or market approach, if it is determined that these methods provide a more representative approximation of fair value. We are required to test our IPRD assets for impairment annually using the guidance for indefinite-lived intangible assets. Our impairment evaluation consists of first assessing qualitative factors, and if deemed necessary, we calculate the fair value of the IPRD asset and record an impairment charge if the carrying amount exceeds fair value. We determine the fair value based on an income approach, which is calculated as the present value of the estimated future cash flows of the IPRD asset. The assumptions about estimated cash flows include factors such as future revenue, gross profit, operating expenses, and industry trends. We evaluate the recoverability of the carrying amount of our property, plant and equipment and intangible assets (excluding IPRD), whenever events or changes in circumstances indicate that the carrying amount of an asset group may not be fully recoverable. Impairment is first assessed when the undiscounted expected cash flows derived for an asset group are less than its carrying amount. Impairment losses, if applicable, are measured as the amount by which the carrying value of an asset group exceeds its fair value and are recognized in operating results. We continually apply our best judgment when applying these impairment rules to determine the timing of the impairment test, the undiscounted cash flows used to assess impairments and the fair value of an impaired asset group. The dynamic economic environment in which we operate and the resulting assumptions used to estimate future cash flows impact the outcome of our impairment tests.Contingencies. We are involved in a variety of legal matters that arise in the normal course of business. Based on the available information, we evaluate the relevant range and likelihood of potential outcomes and we record the appropriate liability when the amount is deemed probable and reasonably estimable.For a further listing and discussion of our accounting policies, see Note 2: ''Significant Accounting Policies'' in the notes to our audited consolidated financial statements included elsewhere in this Form 10-K.Recent Accounting PronouncementsFor a discussion of recent accounting pronouncements, see Note 4: ''Recent Accounting Pronouncements'' in the notes to our audited consolidated financial statements included elsewhere in this Form 10-K.Item 7A. Quantitative and Qualitative Disclosures About Market RiskWe are exposed to financial market risks, including changes in interest rates and foreign currency exchange rates. To mitigate these risks, we utilize derivative financial instruments. We do not use derivative financial instruments for speculative or trading 54purposes.As of December 31, 2020, our gross long-term debt (including current maturities) totaled $3,589.5 million. We have no interest rate exposure to rate changes on our fixed rate debt, which totaled $2,775.0 million. We do have interest rate exposure with respect to the $814.5 million balance of our variable interest rate debt outstanding as of December 31, 2020. A 50 basis point increase in interest rates would impact our expected annual interest expense for the next 12 months by approximately $4.1 million. However, some of this impact would be offset by additional interest earned on our cash and cash equivalents should rates on deposits and investments also increase. Our interest rate swaps hedge the majority of the risk of variability in cash flows resulting from future interest payments on our variable interest rate debt.While we have recently begun to observe stabilization in the capital markets impacted by the COVID-19 pandemic, there can be no assurance that equity or borrowings will be available when we access the capital markets again or, if available, will be at rates or prices acceptable to us.To ensure the adequacy and effectiveness of our foreign exchange hedge positions, we continually monitor our foreign exchange forward positions, both on a stand-alone basis and in conjunction with their underlying foreign currency exposures, from an accounting and economic perspective. However, given the inherent limitations of forecasting and the anticipatory nature of exposures intended to be hedged, we cannot provide any assurances that such programs will offset more than a portion of the adverse financial impact resulting from unfavorable movements in foreign exchange rates.We are subject to risks associated with transactions that are denominated in currencies other than our functional currencies, as well as the effects of translating amounts denominated in a foreign currency to the U.S. Dollar as a normal part of the reporting process. Some of our Japanese operations utilize Japanese Yen as the functional currency, which results in a translation adjustment that is included as a component of accumulated other comprehensive income.We enter into forward foreign currency contracts that economically hedge the gains and losses generated by the re-measurement of certain recorded assets and liabilities in a non-functional currency. Changes in the fair value of these undesignated hedges are recognized in other income and expense immediately as an offset to the changes in the fair value of the assets or liabilities being hedged. The notional amount of foreign exchange contracts at December 31, 2020 and 2019 was $263.4 million and $183.3 million, respectively. Our policies prohibit speculation on financial instruments, trading in currencies for which there are no underlying exposures, or entering into trades for any currency to intentionally increase the underlying exposure. Substantially all of our revenue is transacted in U.S. Dollars. However, a significant amount of our operating expenditures and capital purchases are transacted in local currencies, including Chinese Renminbi, Czech Koruna, Euros, Japanese Yen, Korean Won, Malaysian Ringgit, Philippine Peso and Vietnamese Dong. Due to the materiality of our transactions in these local currencies, our results are impacted by changes in currency exchange rates measured against the U.S. Dollar. For example, we determined that based on a hypothetical weighted-average change of 10% in currency exchange rates, our results would have impacted our income before taxes by approximately $129.7 million for the year ended December 31, 2020, assuming no offsetting hedge position or correlated activities. See Note 15: ''Financial Instruments'' in the notes to the audited consolidated financial statements included elsewhere in this Form 10-K for further information with respect to our hedging activity.
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+ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSThe following discussion and analysis should be read in conjunction with Part I, Item 1, Business, our audited Consolidated Financial Statements and the Notes to Consolidated Financial Statements in this Annual Report.RECENT DEVELOPMENTSPlease refer to the “Financial Results and Operating Information” and “Liquidity and Capital Resources” sections of Management’s Discussion and Analysis of Financial Condition and Results of Operations in this Annual Report for additional information.COVID-19 - While we are still experiencing global and regional economic disruption due primarily to COVID-19, our producers have reversed curtailments that were put in place during the second quarter 2020, bringing volumes back to pre-COVID-19 levels as prices significantly improved from second quarter 2020 lows. The full impact of the continued global and regional economic disruption will depend on the unknown duration and severity of COVID-19, and, among other things, the impact of governmental actions imposed in response to COVID-19, the pace and scale of economic recovery and corresponding demand for crude oil, and the impacts to commodity prices. We continue to monitor producers’ drilling, completion and production plans, which are increasingly positive as commodity prices have stabilized and improved, and our expectations for 2021 include the potential for an improving pace of drilling and completion activity.In this challenging market environment, we expect to maintain sufficient liquidity and financial stability into 2021 due to cash on hand from our June 2020 equity issuance, cash flows from operations and access to our undrawn $2.5 Billion Credit Agreement. We have no debt maturities prior to 2022, and our investment-grade credit ratings have remained stable.Sustainability - In 2020, we were included in the Dow Jones Sustainability North America Index for the second consecutive year and added to the Dow Jones Sustainability World Index (DJSI World), which recognize companies for industry-leading 35environmental, social and governance performance. We are currently the only North American energy company included in the DJSI World group of global sustainability leaders. We continue to look for ways to reduce our environmental impact and utilize more efficient technologies. We are preparing for the future energy transition and our role in meeting the world’s energy needs in an environmentally responsible way.Growth Projects - We operate an integrated, reliable and diversified network of NGL and natural gas gathering, processing, fractionation, storage and transportation assets connecting supply in the Rocky Mountain, Mid-Continent and Permian regions with key market centers. We have completed significant capital-growth projects that include NGL pipelines, NGL fractionators, natural gas processing plants and related natural gas and NGL infrastructure. These projects provide us the capacity to benefit from future supply growth without significant capital investment. In the first quarter 2020, due to the decline in commodity prices and economic demand disruption caused by COVID-19, we suspended our announced plans to construct the Demicks Lake III natural gas processing plant, the fourth expansion of the ONEOK West Texas NGL pipeline system, and reduced the scope of the expansion of our Elk Creek pipeline and various other paused projects. These projects can be restarted quickly when producer activity warrants additional infrastructure. Our announced capital-growth projects are outlined in the table below:36Project (b)ScopeApproximateCosts (a)CompletionNatural Gas Gathering and Processing(In millions)Demicks Lake I plant and related infrastructure200 MMcf/d processing plant and related gathering infrastructure in the core of the Williston Basin$400CompletedOctober 2019Supported by acreage dedications with long-term primarily fee-based contracts Demicks Lake II plant and related infrastructure200 MMcf/d processing plant and related gathering infrastructure in the core of the Williston Basin$410CompletedJanuary 2020Supported by acreage dedications with long-term primarily fee-based contracts Bear Creek plant expansion and related infrastructure200 MMcf/d processing plant expansion and related gathering infrastructure in the Williston Basin$405Paused (c)Supported by acreage dedications with long-term primarily fee-based contractsNatural Gas LiquidsElk Creek pipeline and related infrastructure900-mile NGL pipeline from the Williston Basin to the Mid-Continent region, with capacity of up to 240 MBbl/d, and related infrastructure$1,400CompletedDecember 2019Anchored by long-term contracts Expansion capability up to 400 MBbl/d with additional pump facilitiesArbuckle II pipeline and related infrastructure530-mile NGL pipeline from the STACK area to Mont Belvieu, Texas, and related infrastructure$1,360CompletedMarch 2020Supported by long-term contractsExpansion capability up to 1 MMBbl/d MB-4 fractionator and related infrastructure125 MBbl/d NGL fractionator in Mont Belvieu, Texas, and related infrastructure, which includes additional NGL storage in Mont Belvieu$575CompletedMarch 2020 (d)Fully contracted with long-term contractsONEOK West Texas NGL pipeline expansion and Arbuckle II connectionIncreasing mainline capacity by 80 MBbl/d with additional pump facilities and pipeline looping$295CompletedJune 2020 (e)Connecting ONEOK West Texas NGL pipeline system to the Arbuckle II pipelineSupported by long-term dedicated production from six third-party processing plants expected to produce up to 60 MBbl/dBakken NGL pipeline extension75-mile NGL pipeline in the Williston Basin connecting to a third-party processing plant$100CompletedAugust 2020Supported by a long-term contract with a minimum volume commitmentArbuckle II extension project and additional gathering infrastructureProvide additional takeaway capacity in the STACK area$240CompletedAllow increasing volumes on the Elk Creek pipeline access to fractionation capacity at Mont Belvieu, TexasAugust 2020Arbuckle II pipeline expansionIncreasing mainline capacity with additional pump facilities$60Paused (c)Increases capacity to 500 MBbl/dMB-5 fractionator and related infrastructure125 MBbl/d NGL fractionator in Mont Belvieu, Texas, and related infrastructure, which includes additional NGL storage in Mont Belvieu$750Paused (c)Fully contracted with long-term contractsONEOK West Texas NGL pipeline expansionIncreasing mainline capacity by 40 MBbl/d$145Paused (c)Supported by long-term dedicated production from third-party processing plants expected to produce up to 45 MBbl/dMid-Continent fractionation facility expansions65 MBbl/d of expansions at our Mid-Continent NGL facilities$150Paused (c)(a) - Excludes capitalized interest/AFUDC.(b) - Projects listed exclude our suspended capital-growth projects, which include the Demicks Lake III natural gas processing plant, the fourth expansion of the ONEOK West Texas NGL pipeline system and a reduction in the scope of the expansion of the Elk Creek pipeline.(c) - Given the current environment, we paused the majority of construction activities on these projects and do not expect to complete construction by the original target completion date.(d) - We completed 75 MBbl/d in December 2019 and completed the remaining 50 MBbl/d in March 2020.(e) - We completed expansions to increase mainline capacity by approximately 45 MBbl/d in the first quarter 2020 and completed the remaining portion of this project in the second quarter 2020, which was delayed due to weather.37Ethane Production - Ethane production fluctuates over short-term periods driven by ethane economics, and as a result, volumes can also fluctuate period to period. Ethane volumes under long-term contracts delivered to our NGL system averaged 375 MBbl/d in 2020, compared with 385 MBbl/d in 2019, but increased by approximately 30 MBbl/d in the second half of 2020, compared with the second quarter 2020, due primarily to improved ethane economics. We expect ethane production to continue to fluctuate throughout 2021.Debt Issuances and Repayments - In May 2020, we completed an underwritten public offering of $1.5 billion senior unsecured notes consisting of $600 million, 5.85% senior notes due 2026; $600 million, 6.35% senior notes due 2031; and $300 million, 7.15% senior notes due 2051. The net proceeds, after deducting underwriting discounts, commissions and offering expenses, were $1.48 billion. A portion of the proceeds was used to repay the outstanding borrowings under our $1.5 Billion Term Loan Agreement. The remainder was used for general corporate purposes.In March 2020, we completed an underwritten public offering of $1.75 billion senior unsecured notes consisting of $400 million, 2.2% senior notes due 2025; $850 million, 3.1% senior notes due 2030; and $500 million, 4.5% senior notes due 2050. The net proceeds, after deducting underwriting discounts, commissions and offering expenses, were $1.73 billion. A portion of the proceeds was used to pay all outstanding amounts under our commercial paper program. The remainder was used for general corporate purposes, which included repayment of other existing indebtedness and funding capital expenditures. In 2020, we repurchased in the open market outstanding principal of certain of our senior notes in the amount of $224.4 million for an aggregate repurchase price of $199.6 million with cash on hand. In connection with these open market repurchases, we recognized $22.3 million of net gains on extinguishment of debt.Equity Issuances - In June 2020, we completed an underwritten public offering of 29.9 million shares of our common stock at a public offering price of $32.00 per share, generating net proceeds, after deducting underwriting discounts, commissions and offering expenses, of $937.0 million. A portion of the proceeds was, and we anticipate the remainder will be, used for general corporate purposes, including repayment of existing indebtedness and funding capital expenditures.Dividends - During 2020, we paid dividends totaling $3.74 per share, an increase of 6% from the $3.53 per share paid in 2019. In February 2021, we maintained and paid a quarterly dividend of $0.935 per share ($3.74 per share on an annualized basis), which is consistent with the same quarter in the prior year. Impairments - Due to historic events as a result of COVID-19 impacting supply, demand and commodity prices, in 2020 we evaluated our goodwill, certain long-lived asset groups and equity investments for impairment. Based on the results, we recorded the following impairment charges:Natural Gas Gathering and Processing - In 2020, we recorded $382.2 million of noncash impairment charges related primarily to certain long-lived asset groups that were not recoverable, $153.4 million of noncash impairment charges related to goodwill and $30.5 million of noncash impairment charges related to our 10.2% investment in Venice Energy Services Company.Natural Gas Liquids - In 2020, we recorded $71.6 million of noncash impairment charges related primarily to certain inactive assets as our expectation for future use of the assets changed and $7.2 million of noncash impairment charges related to our 50% investment in Chisholm Pipeline Company.For additional information on our impairment charges, see Notes A, D, E and M of the Notes to Consolidated Financial Statements in this Annual Report.FINANCIAL RESULTS AND OPERATING INFORMATIONHow We Evaluate Our OperationsManagement uses a variety of financial and operating metrics to analyze our performance. Our consolidated financial metrics include: (1) operating income; (2) net income; (3) diluted EPS; and (4) the following non-GAAP financial measures: adjusted EBITDA and distributable cash flow. We evaluate segment operating results using adjusted EBITDA and our operating metrics, which include various volume and rate statistics that are relevant for the respective segment. These operating metrics allow investors to analyze the various components of segment financial results in terms of volumes and rate/price. Management uses these metrics to analyze historical segment financial results and as the key inputs for forecasting and budgeting segment financial results. For additional information on our operating metrics, see the respective segment subsections of this “Financial Results and Operating Information” section.38Non-GAAP Financial Measures - Adjusted EBITDA, distributable cash flow and dividend coverage ratio are non-GAAP measures of our financial performance. Adjusted EBITDA is defined as net income adjusted for interest expense, depreciation and amortization, noncash impairment charges, income taxes, allowance for equity funds used during construction, noncash compensation expense and certain other noncash items. Distributable cash flow is defined as adjusted EBITDA, computed as described above, less interest expense, maintenance capital expenditures and equity earnings from investments, excluding noncash impairment charges, adjusted for net cash distributions received from unconsolidated affiliates and certain other items. Dividend coverage ratio is defined as distributable cash flow to common shareholders divided by the dividends paid in the period. We believe these non-GAAP financial measures are useful to investors because they and similar measures are used by many companies in our industry as a measurement of financial performance and are commonly employed by financial analysts and others to evaluate our financial performance and to compare financial performance among companies in our industry. Adjusted EBITDA, distributable cash flow and dividend coverage ratio should not be considered alternatives to net income, EPS or any other measure of financial performance presented in accordance with GAAP. Additionally, these calculations may not be comparable with similarly titled measures of other companies.Consolidated OperationsSelected Financial Results - The following table sets forth certain selected consolidated financial results for the periods indicated: Years Ended December 31,2020 vs. 20192019 vs. 2018Financial Results202020192018$ Increase (Decrease) (Millions of dollars, except per share amounts)RevenuesCommodity sales$7,255.2 $8,916.1 $11,395.6 (1,660.9)(2,479.5)Services1,287.0 1,248.3 1,197.6 38.7 50.7 Total revenues8,542.2 10,164.4 12,593.2 (1,622.2)(2,428.8)Cost of sales and fuel (exclusive of items shown separately below)5,110.1 6,788.0 9,422.7 (1,677.9)(2,634.7)Operating costs886.1 982.9 907.0 (96.8)75.9 Depreciation and amortization578.7 476.5 428.6 102.2 47.9 Impairment charges607.2 — — 607.2 — (Gain) loss on sale of assets(1.3)2.6 (0.6)3.9 (3.2)Operating income$1,361.4 $1,914.4 $1,835.5 (553.0)78.9 Equity in net earnings from investments$143.2 $154.5 $158.4 (11.3)(3.9)Impairment of equity investments$(37.7)$— $— 37.7 — Interest expense, net of capitalized interest$(712.9)$(491.8)$(469.6)221.1 22.2 Net income$612.8 $1,278.6 $1,155.0 (665.8)123.6 Diluted EPS$1.42 $3.07 $2.78 (1.65)0.29 Adjusted EBITDA$2,723.7 $2,580.2 $2,447.5 143.5 132.7 Distributable cash flow$1,881.6 $2,016.1 $1,822.4 (134.5)193.7 Capital expenditures$2,195.4 $3,848.3 $2,141.5 (1,652.9)1,706.8 See reconciliation of net income to adjusted EBITDA and distributable cash flow in the “Non-GAAP Measures” section.Changes in commodity prices and sales volumes affect both revenues and cost of sales and fuel in our Consolidated Statements of Income, and, therefore, the impact is largely offset between these line items. 2020 vs. 2019 - Operating income decreased $553.0 million primarily as a result of the following:•a decrease of $607.2 million due to noncash impairment charges in our Natural Gas Gathering and Processing and Natural Gas Liquids segments;•an increase of $102.2 million in depreciation expense due to capital projects placed in service;•Natural Gas Gathering and Processing - a decrease of $47.6 million due primarily to lower realized prices and a decrease of $42.6 million due primarily to natural production declines in the Mid-Continent region; offset partially by•Natural Gas Liquids - an increase of $270.6 million in exchange services due primarily to higher volumes in the Rocky Mountain region and Permian Basin and lower rail and pipeline transportation costs, offset partially by a decrease of $123.5 million in optimization and marketing due primarily to narrower location price differentials, lower optimization volumes and lower marketing earnings; 39•a decrease of $96.8 million in operating costs due primarily to reduced outside services, lower materials and supplies expenses, lower employee-related costs and the noncash mark-to-market impact of our share-based deferred compensation plan; and•Natural Gas Pipelines - an increase of $6.7 million in transportation services due primarily to higher firm transportation revenue and a $13.5 million contract settlement, offset partially by lower interruptible revenue.Net income and diluted EPS decreased due primarily to the items discussed above and higher interest expense related to an increase in our debt balance and lower capitalized interest and noncash impairment charges related to equity investments in our Natural Gas Gathering and Processing and Natural Gas Liquids segments, offset partially by net gains on extinguishment of debt related to open market repurchases. Diluted EPS was also impacted by our equity issuance in June 2020.Capital expenditures decreased due primarily to our previously completed capital-growth projects as well as our paused and suspended capital-growth projects related to weakened commodity prices and economic disruption caused by COVID-19.Additional information regarding our financial results and operating information is provided in the discussions for each of our segments and in Non-GAAP Measures. Selected Financial Results and Operating Information for the Year Ended December 31, 2019 vs. 2018 - The consolidated and segment financial results and operating information for the year ended December 31, 2019, compared with the year ended December 31, 2018, are included in Part II, Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations of our 2019 Annual Report on Form 10-K, which is available via the SEC’s website at www.sec.gov and our website at www.oneok.com.Natural Gas Gathering and ProcessingGrowth Projects - Our Natural Gas Gathering and Processing segment has invested in growth projects in NGL-rich areas in the Williston Basin. See “Growth Projects” in the “Recent Developments” section for discussion of our capital-growth projects.See “Capital Expenditures” in “Liquidity and Capital Resources” for additional detail of our projected capital expenditures.Selected Financial Results and Operating Information - The following tables set forth certain selected financial results and operating information for our Natural Gas Gathering and Processing segment for the periods indicated: Years Ended December 31,2020 vs. 20192019 vs. 2018Financial Results202020192018$ Increase (Decrease) (Millions of dollars)NGL sales$775.9 $1,024.3 $1,567.2 (248.4)(542.9)Condensate sales113.5 200.1 208.8 (86.6)(8.7)Residue natural gas sales771.5 966.1 1,084.2 (194.6)(118.1)Gathering, compression, dehydration and processing fees and other revenue159.2 178.1 174.4 (18.9)3.7 Cost of sales and fuel (exclusive of depreciation and operating costs)(844.0)(1,302.3)(2,041.4)(458.3)(739.1)Operating costs, excluding noncash compensation adjustments(320.0)(352.8)(357.7)(32.8)(4.9)Equity in net earnings (loss) from investments(1.1)(6.3)0.4 5.2 (6.7)Other(5.0)(4.5)(4.3)(0.5)(0.2)Adjusted EBITDA$650.0 $702.7 $631.6 (52.7)71.1 Impairment charges$566.1 $— $— 566.1 — Capital expenditures$446.1 $926.5 $694.6 (480.4)231.9 See reconciliation of net income to adjusted EBITDA in the “Non-GAAP Measures” section.Changes in commodity prices and sales volumes affect both revenue and cost of sales and fuel, and, therefore, the impact is largely offset between these line items. 2020 vs. 2019 - Adjusted EBITDA decreased $52.7 million, primarily as a result of the following:•a decrease of $47.6 million due primarily to lower realized prices impacting our fee with POP contracts; and40•a decrease of $42.6 million due primarily to natural production declines in the Mid-Continent region; offset partially by•a decrease of $32.8 million in operating costs due primarily to lower materials and supplies expenses due to reduced asset utilization, lower employee-related costs and outside services.The year ended December 31, 2020, includes $382.2 million of noncash impairment charges related primarily to certain long-lived asset groups in the Powder River Basin, western Oklahoma and Kansas that were not recoverable, a $153.4 million noncash impairment charge related to goodwill and a $30.5 million noncash impairment charge related to our 10.2% investment in Venice Energy Services Company. For additional information on our impairment charges, see Notes A, D, E and M of the Notes to Consolidated Financial Statements in this Annual Report.Capital expenditures decreased due primarily to capital-growth projects completed in 2019 and early 2020, as well as several paused capital-growth projects in 2020. Years Ended December 31,Operating Information (a)202020192018Natural gas gathered (BBtu/d)2,553 2,753 2,546 Natural gas processed (BBtu/d) (b)2,364 2,555 2,382 Average fee rate ($/MMBtu)$0.89 $0.92 $0.90 (a) - Includes volumes for consolidated entities only.(b) - Includes volumes at company-owned and third-party facilities.2020 vs. 2019 - Our natural gas gathered and natural gas processed volumes decreased due primarily to natural production declines in the Mid-Continent region. In the Williston Basin, we saw significant declines in volumes in the second quarter 2020 due to production curtailments from some of our crude oil and natural gas producers. By the end of the third quarter 2020, curtailed volumes returned.Our average fee rate decreased due primarily to production curtailments in the second quarter 2020 on producer contracts with higher fees and lower POP components in the Williston Basin. As these curtailed volumes returned to our system, the Williston Basin’s contribution to our average fee rate increased in the second half of 2020.Commodity Price Risk - See discussion regarding our commodity price risk under “Commodity Price Risk” in Item 7A, Quantitative and Qualitative Disclosures about Market Risk.Natural Gas LiquidsGrowth Projects - Our Natural Gas Liquids segment invests in projects to transport, fractionate, store and deliver to market centers NGL supply from shale and other resource development areas. Our growth strategy is focused around connecting diversified supply basins from the Rocky Mountain region through the Mid-Continent region and the Permian Basin with NGL product demand from the petrochemical and refining industries and NGL export demand in the Gulf Coast. See “Growth Projects” in the “Recent Developments” section for discussion of our capital-growth projects.In 2020, we connected two third-party natural gas processing plants in the Permian Basin and two third-party natural gas processing plants in the Rocky Mountain region to our NGL system. In addition, one affiliate and two third-party natural gas processing plants in the Rocky Mountain region and one third-party natural gas processing plant in the Mid-Continent region connected to our system were expanded.For a discussion of our capital expenditure financing, see “Capital Expenditures” in the “Liquidity and Capital Resources” section.41Selected Financial Results and Operating Information - The following tables set forth certain selected financial results and operating information for our Natural Gas Liquids segment for the periods indicated: Years Ended December 31,2020 vs. 20192019 vs. 2018Financial Results202020192018$ Increase (Decrease) (Millions of dollars)NGL and condensate sales$6,409.3 $7,910.8 $10,319.9 (1,501.5)(2,409.1)Exchange service revenues and other497.8 424.2 415.7 73.6 8.5 Transportation and storage revenues182.9 197.5 199.0 (14.6)(1.5)Cost of sales and fuel (exclusive of depreciation and operating costs)(5,108.6)(6,690.9)(9,176.8)(1,582.3)(2,485.9)Operating costs, excluding noncash compensation adjustments(396.4)(434.4)(378.3)(38.0)56.1 Equity in net earnings from investments39.9 65.1 67.1 (25.2)(2.0)Other(7.7)(6.5)(6.0)(1.2)(0.5)Adjusted EBITDA$1,617.2 $1,465.8 $1,440.6 151.4 25.2 Impairment charges$78.8 $— $— 78.8 — Capital expenditures$1,655.8 $2,796.6 $1,306.3 (1,140.8)1,490.3 See reconciliation of net income to adjusted EBITDA in the “Non-GAAP Measures” section.Changes in commodity prices and sales volumes affect both revenues and cost of sales and fuel, and, therefore, the impact is largely offset between these line items. 2020 vs. 2019 - Adjusted EBITDA increased $151.4 million, primarily as a result of the following:•an increase of $270.6 million in exchange services due primarily to $137.8 million in higher volumes in the Rocky Mountain region and Permian Basin, $128.4 million in lower costs due primarily to lower rail and pipeline transportation costs, $18.8 million in higher fees charged to customers with minimum volume obligations primarily in the Rocky Mountain region, $17.2 million in higher average fee rates primarily in the Permian Basin and $13.7 million related to lower unfractionated NGLs held in inventory, offset partially by $34.2 million in lower volumes in the Mid-Continent region; and•a decrease of $38.0 million in operating costs due primarily to lower outside services and employee-related costs; offset partially by•a decrease of $123.5 million in optimization and marketing due primarily to a decrease of $78.2 million related to narrower location price differentials and lower optimization volumes, lower marketing earnings of $53.0 million due to lower earnings from purity NGL inventory sales and changes in the value of NGLs held in inventory; and•a decrease of $25.2 million from lower equity in net earnings from investments due primarily to lower volumes on Overland Pass Pipeline.The year ended December 31, 2020, includes $71.6 million of noncash impairment charges related primarily to certain inactive assets and a $7.2 million noncash impairment charge related to our 50% investment in Chisholm Pipeline Company. For additional information on our impairment charges, see Notes A, D and M of the Notes to Consolidated Financial Statements in this Annual Report.Capital expenditures decreased due primarily to completed and paused capital-growth projects. Years Ended December 31,Operating Information202020192018Raw feed throughput (MBbl/d) (a)1,084 1,079 1,010 Average Conway-to-Mont Belvieu OPIS price differential - ethane in ethane/propane mix ($/gallon)$0.01 $0.07 $0.15 (a) - Represents physical raw feed volumes on which we charge a fee for transportation and/or fractionation services.2020 vs. 2019 - Volumes increased due primarily to increased production at new and existing processing plants in the Rocky Mountain region and Permian Basin, offset partially by lower volumes in the Mid-Continent region and the unfavorable impact from producer curtailments primarily in the second quarter 2020.42Natural Gas PipelinesSelected Financial Results and Operating Information - The following tables set forth certain selected financial results and operating information for our Natural Gas Pipelines segment for the periods indicated: Years Ended December 31,2020 vs. 20192019 vs. 2018Financial Results202020192018$ Increase (Decrease) (Millions of dollars)Transportation revenues$401.7 $393.7 $343.0 8.0 50.7 Storage revenues68.4 72.6 72.0 (4.2)0.6 Residue natural gas sales and other revenues9.9 5.7 16.7 4.2 (11.0)Cost of sales and fuel (exclusive of depreciation and operating costs)(6.8)(4.6)(16.0)2.2 (11.4)Operating costs, excluding noncash compensation adjustments(137.2)(150.8)(139.2)(13.6)11.6 Equity in net earnings from investments104.4 95.7 90.8 8.7 4.9 Other(3.0)(3.5)(1.0)0.5 (2.5)Adjusted EBITDA$437.4 $408.8 $366.3 28.6 42.5 Capital expenditures$71.9 $99.2 $119.2 (27.3)(20.0)See reconciliation of net income to adjusted EBITDA in the “Non-GAAP Measures” section.2020 vs. 2019 - Adjusted EBITDA increased $28.6 million primarily as a result of the following:•a decrease of $13.6 million in operating costs due primarily to lower employee-related costs and materials and supplies expenses;•an increase of $8.7 million from higher equity in net earnings from investments due primarily to additional firm transportation capacity contracted on Northern Border; •an increase of $6.7 million in transportation services due primarily to higher firm transportation revenue and a $13.5 million contract settlement, offset partially by lower interruptible revenue; and•an increase of $4.0 million from higher net retained fuel and timing of equity gas sales; offset partially by•a decrease of $3.9 million from storage services due primarily to lower park-and-loan activity.Capital expenditures decreased due primarily to the completion of our expansion projects in 2019. Years Ended December 31,Operating Information (a)202020192018Natural gas transportation capacity contracted (MDth/d)7,461 7,618 6,846 Transportation capacity contracted96 %98 %96 %(a) - Includes volumes for consolidated entities only.2020 vs. 2019 - Natural gas transportation capacity contracted decreased due to a contract settlement and the impact of market conditions.Roadrunner, in which we have a 50% ownership interest, has contracted all of its westbound capacity through 2041.Northern Border Pipeline, in which we have a 50% ownership interest, has contracted substantially all of its long-haul transportation capacity through the fourth quarter 2021.In June 2019, our subsidiary, Viking Gas Transmission Company (Viking), filed a proposed change in rates pursuant to Section 4 of the Natural Gas Act with the FERC. In February 2020, Viking filed a Stipulation and Offer of Settlement (Settlement) with the FERC for approval. The FERC accepted the Settlement in July 2020, which did not impact materially our results of operations.43NON-GAAP MEASURESThe following table sets forth a reconciliation of net income, the nearest comparable GAAP financial performance measure, to adjusted EBITDA, distributable cash flow and dividend coverage for the periods indicated:Years Ended December 31,(Unaudited)202020192018Reconciliation of net income to adjusted EBITDA, distributable cash flow and dividend coverage(Thousands of dollars, except per share amounts and coverage ratios)Net income$612,809 $1,278,577 $1,155,032 Add:Interest expense, net of capitalized interest712,886 491,773 469,620 Depreciation and amortization578,662 476,535 428,557 Income tax expense189,507 372,414 362,903 Impairment charges644,930 — — Noncash compensation expense (a)8,540 26,699 37,954 Equity AFUDC and other noncash items(23,661)(65,811)(6,545)Adjusted EBITDA (b)2,723,673 2,580,187 2,447,521 Interest expense, net of capitalized interest(712,886)(491,773)(469,620)Maintenance capital(136,920)(195,631)(188,420)Equity in net earnings from investments(143,241)(154,541)(158,383)Distributions received from unconsolidated affiliates176,160 257,644 197,285 Other (b)(25,195)20,227 (5,994)Distributable cash flow1,881,591 2,016,113 1,822,389 Dividends paid to preferred shareholders(1,100)(1,100)(1,100)Distributable cash flow to shareholders1,880,491 2,015,013 1,821,289 Dividends paid(1,604,266)(1,456,528)(1,333,958)Distributable cash flow in excess of dividends paid$276,225 $558,485 $487,331 Dividends paid per share$3.74 $3.53 $3.245 Dividend coverage ratio1.17 1.38 1.37 Number of shares used in computation (thousands)428,948 412,614 411,081 (a) - Year ended December 31, 2020, includes a benefit of $11.2 million related to the mark-to-market of our share-based deferred compensation plan.(b) - Year ended December 31, 2020, includes net gains of $22.3 million on extinguishment of debt related to open market repurchases.Years Ended December 31,(Unaudited)202020192018Reconciliation of segment adjusted EBITDA to adjusted EBITDA(Thousands of dollars)Segment adjusted EBITDA:Natural Gas Gathering and Processing$650,036 $702,650 $631,607 Natural Gas Liquids1,617,241 1,465,765 1,440,605 Natural Gas Pipelines437,426 408,816 366,251 Other (a)18,970 2,956 9,058 Adjusted EBITDA$2,723,673 $2,580,187 $2,447,521 (a) - Year ended December 31, 2020, includes corporate net gains of $22.3 million on extinguishment of debt related to open market repurchases.CONTINGENCIESSee Note N of the Notes to Consolidated Financial Statements in this Annual Report for a discussion of regulatory matters.Other Legal Proceedings - We are a party to various litigation matters and claims that have arisen in the normal course of our operations. While the results of these litigation matters and claims cannot be predicted with certainty, we believe the reasonably possible losses from such matters, individually and in the aggregate, are not material. Additionally, we believe the probable final outcome of such matters will not have a material adverse effect on our consolidated results of operations, financial position or cash flows. 44LIQUIDITY AND CAPITAL RESOURCESGeneral - Our primary sources of cash inflows are operating cash flows, proceeds from our commercial paper program and our $2.5 Billion Credit Agreement, debt issuances and the issuance of common stock for our liquidity and capital resources requirements. In addition, we expect cash outflows in 2021 to be primarily related to dividends paid to shareholders and capital expenditures.We expect our sources of cash inflows to provide sufficient resources to finance our operations and quarterly cash dividends. We believe we have sufficient liquidity due to our $2.5 Billion Credit Agreement, which expires in June 2024, cash on hand from our June 2020 equity issuance and access to $1.0 billion available through our “at-the-market” equity program.We manage interest-rate risk through the use of fixed-rate debt, floating-rate debt and interest-rate swaps. For additional information on our interest-rate swaps, see Note C of the Notes to Consolidated Financial Statements in this Annual Report.Guarantees and Cash Management - In March 2020, the SEC amended Rule 3-10 of Regulation S-X and created Rule 13-01 to simplify disclosure requirements related to certain registered securities. We and ONEOK Partners are issuers of certain public debt securities. We guarantee certain indebtedness of ONEOK Partners, and ONEOK Partners and the Intermediate Partnership guarantee certain of our indebtedness. The guarantees in place for our and ONEOK Partners’ indebtedness are full, irrevocable, unconditional and absolute joint and several guarantees to the holders of each series of outstanding securities. Liabilities under the guarantees rank equally in right of payment with all existing and future senior unsecured indebtedness. As ONEOK Partners and the Intermediate Partnership are consolidated subsidiaries of ONEOK, separate financial statements for the guarantors are not required, as long as the alternative disclosure required by Rule 13-01 is provided, which includes narrative disclosure and summarized financial information. The Intermediate Partnership holds all of ONEOK Partners’ interests and equity in its subsidiaries, which are non-guarantors, and substantially all the assets and operations reside with non-guarantor operating subsidiaries. Therefore, as allowed under Rule 13-01, we have excluded the summarized financial information for each issuer and guarantor as the combined financial information of the subsidiary issuer and parent guarantor, excluding our ownership of all the interests in ONEOK Partners, reflect no material assets, liabilities or results of operations, apart from the guaranteed indebtedness. For additional information on our and ONEOK Partners’ indebtedness, see Note F of the Notes to Consolidated Financial Statements in this Annual Report.We use a centralized cash management program that concentrates the cash assets of our non-guarantor operating subsidiaries in joint accounts for the purposes of providing financial flexibility and lowering the cost of borrowing, transaction costs and bank fees. Our centralized cash management program provides that funds in excess of the daily needs of our operating subsidiaries are concentrated, consolidated or otherwise made available for use by other entities within our consolidated group. Our operating subsidiaries participate in this program to the extent they are permitted pursuant to FERC regulations or their operating agreements. Under the cash management program, depending on whether a participating subsidiary has short-term cash surpluses or cash requirements, we provide cash to the subsidiary or the subsidiary provides cash to us.Short-term Liquidity - Our principal sources of short-term liquidity consist of cash generated from operating activities, distributions received from our equity-method investments, proceeds from our commercial paper program and our $2.5 Billion Credit Agreement. As of December 31, 2020, we are in compliance with all covenants of our $2.5 Billion Credit Agreement.At December 31, 2020, we had no borrowings under our $2.5 Billion Credit Agreement and $524.5 million of cash and cash equivalents.We had a working capital (defined as current assets less current liabilities) surplus of $525.2 million and a working capital deficit of $550.0 million as of December 31, 2020, and December 31, 2019, respectively. Although working capital is influenced by several factors, including, among other things: (i) the timing of (a) debt and equity issuances, (b) the funding of capital expenditures, (c) scheduled debt payments, and (d) accounts receivable and payable; and (ii) the volume and cost of inventory and commodity imbalances; our working capital surplus at December 31, 2020, was driven primarily by cash on hand and our working capital deficit at December 31, 2019, was driven primarily by short-term borrowings and accrued interest. We may have working capital deficits in future periods as we continue to repay long-term debt and finance our capital-growth projects, often initially with short-term borrowings.For additional information on our $2.5 Billion Credit Agreement, see Note F of the Notes to Consolidated Financial Statements in this Annual Report. Long-term Financing - In addition to our principal sources of short-term liquidity discussed above, we expect to fund our longer-term financing requirements by issuing long-term notes. Other options to obtain financing include, but are not limited 45to, issuing common stock, loans from financial institutions, issuance of convertible debt securities or preferred equity securities, asset securitization and the sale and lease-back of facilities.Debt Issuances - In May 2020, we completed an underwritten public offering of $1.5 billion senior unsecured notes consisting of $600 million, 5.85% senior notes due 2026; $600 million, 6.35% senior notes due 2031; and $300 million, 7.15% senior notes due 2051. The net proceeds, after deducting underwriting discounts, commissions and offering expenses, were $1.48 billion. A portion of the proceeds was used to repay the outstanding borrowings under our $1.5 Billion Term Loan Agreement. The remainder was used for general corporate purposes.In March 2020, we completed an underwritten public offering of $1.75 billion senior unsecured notes consisting of $400 million, 2.2% senior notes due 2025; $850 million, 3.1% senior notes due 2030; and $500 million, 4.5% senior notes due 2050. The net proceeds, after deducting underwriting discounts, commissions and offering expenses, were $1.73 billion. A portion of the proceeds was used to pay all outstanding amounts under our commercial paper program. The remainder was used for general corporate purposes, which included repayment of other existing indebtedness and funding capital expenditures. Debt Repayments - In May 2020, we repaid the remaining $1.25 billion of our $1.5 Billion Term Loan Agreement with cash on hand from our May 2020 public offering of $1.5 billion senior unsecured notes. In 2020, we repurchased in the open market outstanding principal of certain of our senior notes in the amount of $224.4 million for an aggregate repurchase price of $199.6 million with cash on hand. In connection with these open market repurchases, we recognized $22.3 million of net gains on extinguishment of debt.For additional information on our long-term debt, see Note F of the Notes to Consolidated Financial Statements in this Annual Report.Equity Issuances - In July 2020, we established an “at-the-market” equity program for the offer and sale from time to time of our common stock up to an aggregate offering price of $1.0 billion. The program allows us to offer and sell common stock at prices we deem appropriate through a sales agent, in forward sales transactions through a forward seller or directly to one or more of the program’s managers acting as principals. Sales of our common stock may be made by means of ordinary brokers’ transactions on the NYSE, in block transactions or as otherwise agreed to between us and the sales agent. We are under no obligation to offer and sell common stock under the program. No shares have been sold through our “at-the-market” program as of the date of this report.In June 2020, we completed an underwritten public offering of 29.9 million shares of our common stock at a public offering price of $32.00 per share, generating net proceeds, after deducting underwriting discounts, commissions and offering expenses, of $937.0 million. A portion of the proceeds was, and we anticipate the remainder will be, used for general corporate purposes, including repayment of existing indebtedness and funding capital expenditures.Capital Expenditures - We classify expenditures that are expected to generate additional revenue, return on investment or significant operating efficiencies as capital-growth expenditures. Maintenance capital expenditures are those capital expenditures required to maintain our existing assets and operations and do not generate additional revenues. Maintenance capital expenditures are made to replace partially or fully depreciated assets, to maintain the existing operating capacity of our assets and to extend their useful lives. Our capital expenditures are financed typically through operating cash flows and short- and long-term debt.The following table sets forth our growth and maintenance capital expenditures, excluding AFUDC and capitalized interest, for the periods indicated:Capital Expenditures202020192018 (Millions of dollars)Natural Gas Gathering and Processing$446.1 $926.5 $694.6 Natural Gas Liquids1,655.8 2,796.6 1,306.3 Natural Gas Pipelines71.9 99.2 119.2 Other21.6 26.0 21.4 Total capital expenditures$2,195.4 $3,848.3 $2,141.5 Capital expenditures decreased in 2020, compared with 2019, due primarily to our previously completed capital-growth projects, as well as our paused and suspended capital-growth projects. We expect our 2021 capital expenditures to decrease 46relative to 2020 due to our previously completed capital-growth projects and paused and suspended capital-growth projects, unless producer activity levels warrant additional infrastructure. See discussion of our announced capital-growth projects in the “Recent Developments” section. We expect total capital expenditures, excluding AFUDC and capitalized interest, of $525-$675 million in 2021.Credit Ratings - Our long-term debt credit ratings as of February 16, 2021, are shown in the table below:Rating AgencyLong-Term RatingShort-Term RatingOutlookMoody’sBaa3Prime-3StableS&PBBBA-2StableFitch (a)BBBF2Stable(a) - Fitch assigned first-time ratings to ONEOK in November 2020.Our credit ratings, which are investment grade, may be affected by a material change in our financial ratios or a material event affecting our business and industry. Although we are in the midst of a challenging market environment, our credit ratings have remained stable. The most common criteria for assessment of our credit ratings are the debt-to-EBITDA ratio, interest coverage, business risk profile and liquidity. If our credit ratings were downgraded, our cost to borrow funds under our $2.5 Billion Credit Agreement could increase and a potential loss of access to the commercial paper market could occur. In the event that we are unable to borrow funds under our commercial paper program and there has not been a material adverse change in our business, we would continue to have access to our $2.5 Billion Credit Agreement, which expires in 2024. An adverse credit rating change alone is not a default under our $2.5 Billion Credit Agreement.In the normal course of business, our counterparties provide us with secured and unsecured credit. In the event of a downgrade in our credit ratings or a significant change in our counterparties’ evaluation of our creditworthiness, we could be required to provide additional collateral in the form of cash, letters of credit or other negotiable instruments as a condition of continuing to conduct business with such counterparties. We may be required to fund margin requirements with our counterparties with cash, letters of credit or other negotiable instruments.Dividends - Holders of our common stock share equally in any common stock dividends declared by our Board of Directors, subject to the rights of the holders of outstanding preferred stock. In 2020, we paid dividends of $3.74 per share, an increase of 6% compared with the prior year. In February 2021, we maintained and paid a quarterly dividend of $0.935 per share ($3.74 per share on an annualized basis), which is consistent with the same quarter in the prior year. Our Series E Preferred Stock pays quarterly dividends on each share of Series E Preferred Stock, when, as and if declared by our Board of Directors, at a rate of 5.5% per year. In 2020, we paid dividends of $1.1 million for the Series E Preferred Stock. In February 2021, we paid quarterly dividends totaling $0.3 million for the Series E Preferred Stock.For the year ended December 31, 2020, our cash flows from operations exceeded dividends paid by $293.7 million. We expect our cash flows from operations to continue to sufficiently fund our cash dividends. To the extent operating cash flows are not sufficient to fund our dividends, we may utilize cash on hand from other sources of short- and long-term liquidity to fund a portion of our dividends.CASH FLOW ANALYSISWe use the indirect method to prepare our Consolidated Statements of Cash Flows. Under this method, we reconcile net income to cash flows provided by operating activities by adjusting net income for those items that affect net income but do not result in actual cash receipts or payments during the period and for operating cash items that do not impact net income. These reconciling items can include depreciation and amortization, impairment charges, allowance for equity funds used during construction, gain or loss on sale of assets, deferred income taxes, net undistributed earnings from equity-method investments, share-based compensation expense, other amounts and changes in our assets and liabilities not classified as investing or financing activities.47The following table sets forth the changes in cash flows by operating, investing and financing activities for the periods indicated: Years Ended December 31, 202020192018 (Millions of dollars)Total cash provided by (used in): Operating activities$1,899.0 $1,946.8 $2,186.7 Investing activities(2,270.5)(3,768.8)(2,114.9)Financing activities875.0 1,831.0 (97.0)Change in cash and cash equivalents503.5 9.0 (25.2)Cash and cash equivalents at beginning of period21.0 12.0 37.2 Cash and cash equivalents at end of period$524.5 $21.0 $12.0 Operating Cash Flows - Operating cash flows are affected by earnings from our business activities and changes in our operating assets and liabilities. Changes in commodity prices and demand for our services or products, whether because of general economic conditions, changes in supply, changes in demand for the end products that are made with our products or increased competition from other service providers, could affect our earnings and operating cash flows. Our operating cash flows can also be impacted by changes in our NGLs and natural gas inventory balances, which are driven primarily by commodity prices, supply, demand and the operation of our assets.2020 vs. 2019 - Cash flows from operating activities, before changes in operating assets and liabilities, decreased $51.1 million due primarily to higher interest expense, lower realized prices in our Natural Gas Gathering and Processing segment and lower optimization and marketing earnings in our Natural Gas Liquids segment. These decreases were offset partially by an increase in exchange services due to higher volumes and lower rail and pipeline transportation costs in our Natural Gas Liquids segment and lower operating costs across our segments, as discussed in “Financial Results and Operating Information.”The impact of changes in operating assets and liabilities for 2020 was relatively unchanged compared with 2019, due primarily to net decreases from changes in risk-management assets and liabilities, which include a loss on the settlement of $750 million of our forward-starting interest-rate swaps related to our March 2020 issuance of senior unsecured notes and changes in the fair value of risk-management assets and liabilities, which vary from period to period and with changes in commodity prices and interest rates; and changes in other accruals and deferrals. These decreases were offset partially by the changes in commodity imbalances and NGLs and natural gas in storage, which also vary from period to period and with changes in commodity prices.Investing Cash Flows2020 vs. 2019 - Cash used in investing activities decreased $1.5 billion due primarily to reduced capital expenditures related to our completed and paused capital-growth projects.Financing Cash Flows2020 vs. 2019 - Cash from financing activities decreased $956.0 million due primarily to the issuance of $3.2 billion in long-term debt in 2020, compared with $4.2 billion in long-term debt issuances in 2019, and the repayment of long-term debt and short-term borrowings, offset partially by the issuance of common stock in June 2020.Cash Flow Analysis for the Year Ended December 31, 2019 vs. 2018 - The cash flow analysis for the year ended December 31, 2019, compared with the year ended December 31, 2018, is included in Part II, Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations of our 2019 Annual Report on Form 10-K, which is available via the SEC’s website at www.sec.gov and our website at www.oneok.com.IMPACT OF NEW ACCOUNTING STANDARDSInformation about the impact of new accounting standards is included in Note A of the Notes to Consolidated Financial Statements in this Annual Report.CRITICAL ACCOUNTING POLICIES AND ESTIMATESThe preparation of our Consolidated Financial Statements and related disclosures in accordance with GAAP requires us to make estimates and assumptions with respect to values or conditions that cannot be known with certainty that affect the 48reported amounts of assets and liabilities, and the disclosure of contingent assets and liabilities at the date of the Consolidated Financial Statements. These estimates and assumptions also affect the reported amounts of revenue and expenses during the reporting period. Although we believe these estimates and assumptions are reasonable, actual results could differ from our estimates.The following is a summary of our most critical accounting policies and estimates, which are defined as those estimates and policies most important to the portrayal of our financial condition and results of operations and requiring management’s most difficult, subjective or complex judgment, particularly because of the need to make estimates concerning the impact of inherently uncertain matters. We have discussed the development and selection of our estimates and critical accounting policies with the Audit Committee of our Board of Directors. See Note A of the Notes to Consolidated Financial Statements in this Annual Report for the description of our accounting policies and additional information about our critical accounting policies and estimates.Derivatives and Risk-management Activities - We utilize derivatives to reduce our market-risk exposure to commodity price and interest-rate fluctuations and to achieve more predictable cash flows. Our commodity price risk includes basis risk, which is the difference in price between various locations where commodities are purchased and sold. We record all derivative instruments at fair value, except for normal purchases and normal sales transactions that are expected to result in physical delivery. Many of the contracts in our derivative portfolio are executed in liquid markets where price transparency exists.Our fair value measurements classified as Level 3 are composed predominantly of exchange-cleared and over-the-counter derivatives to hedge NGL price risk and natural gas basis risk between various transaction locations and the NYMEX Henry Hub. These measurements are based on inputs that may include one or more unobservable inputs, including internally developed commodity price curves, that incorporate market data from broker quotes and third-party pricing services. Our commodity derivatives are generally valued using forward quotes provided by third-party pricing services that are validated with other market data. We believe any measurement uncertainty at December 31, 2020, is immaterial as our Level 3 fair value measurements are based on unadjusted pricing information from broker quotes and third-party pricing services.The accounting for changes in the fair value of a derivative instrument depends on whether it qualifies and has been designated as part of a hedging relationship. When possible, we implement effective hedging strategies using derivative financial instruments that qualify as hedges for accounting purposes. We have not used derivative instruments for trading purposes. For a derivative designated as a cash flow hedge, the gain or loss from a change in fair value of the derivative instrument is deferred in accumulated other comprehensive income (loss) until the forecasted transaction affects earnings, at which time the fair value of the derivative instrument is reclassified into earnings. We assess hedging relationships at the inception of the hedge and on an ongoing basis to determine whether the hedging relationship is, and is expected to remain, highly effective. We do not believe that changes in our fair value estimates of our derivative instruments have a material impact on our results of operations, as the majority of our derivatives are accounted for as effective cash flow hedges. However, if a derivative instrument is ineligible for cash flow hedge accounting or if we fail to appropriately designate it as a cash flow hedge, changes in fair value of the derivative instrument would be recorded currently in earnings. Additionally, if a cash flow hedge ceases to qualify for hedge accounting treatment because it is no longer probable that the forecasted transaction will occur, the change in fair value of the derivative instrument would be recognized in earnings. For more information on commodity price sensitivity and a discussion of the market risk of pricing changes, see Item 7A, Quantitative and Qualitative Disclosures about Market Risk.See Notes A, B and C of the Notes to Consolidated Financial Statements in this Annual Report for additional discussion of fair value measurements and derivatives and risk-management activities.Impairment of Goodwill and Long-Lived Assets, Including Intangible Assets - We assess our goodwill for impairment at least annually as of July 1, unless events or changes in circumstances indicate an impairment may have occurred before that time. Due to historic events as a result of COVID-19 impacting supply, demand and commodity prices, we performed a Step 1 analysis in the first quarter 2020 to test our goodwill for impairment and evaluated certain long-lived asset groups and equity investments for impairment.Goodwill - In the Step 1 analysis, an assessment is made by comparing the fair value of a reporting unit with its carrying amount, including goodwill. If the carrying value of a reporting unit exceeds its fair value, an impairment loss is recognized in an amount equal to that excess, limited to the total amount of goodwill allocated to that reporting unit. In January 2020, we adopted ASU 2017-04 in which the requirement to calculate the implied fair value of goodwill under the two-step impairment test was eliminated.49To estimate the fair value of our reporting units, we use two generally accepted valuation approaches, an income approach and a market approach, using assumptions consistent with a market participant’s perspective. Under the income approach, we use anticipated cash flows over a period of years plus a terminal value and discount these amounts to their present value using appropriate discount rates. Under the market approach, we apply EBITDA multiples to forecasted EBITDA. The multiples used are consistent with historical asset transactions. The forecasted cash flows are based on average forecasted cash flows for a reporting unit over a period of years.Based on the results of our impairment test, we concluded that the carrying value of the Natural Gas Gathering and Processing reporting unit exceeded its estimated fair value, resulting in a noncash impairment charge of $153.4 million. The estimated fair value of our Natural Gas Liquids and Natural Gas Pipelines reporting units substantially exceeded their respective carrying values.We assess our goodwill for impairment at least annually as of July 1, unless events or changes in circumstances indicate an impairment may have occurred before that time. At July 1, 2020, we assessed qualitative factors subsequent to our first quarter 2020 impairment charges discussed below, to determine whether it was more likely than not that the fair value of our Natural Gas Liquids and Natural Gas Pipelines reporting units were less than their carrying amount. After assessing qualitative factors (including macroeconomic conditions, industry and market considerations, cost factors and overall financial performance), we determined that it was more likely than not that the fair value of our Natural Gas Liquids and Natural Gas Pipelines reporting units were not less than their respective carrying value, no further testing was necessary and goodwill was not considered impaired. At July 1, 2020, there was no remaining goodwill associated with our Natural Gas Gathering and Processing reporting unit.Long-lived assets - We assess our long-lived assets for impairment whenever events or changes in circumstances indicate that an asset’s carrying amount may not be recoverable. An impairment is indicated if the carrying amount of a long-lived asset exceeds the sum of the undiscounted future cash flows expected to result from the use and eventual disposition of the asset. If an impairment is indicated, we record an impairment loss equal to the difference between the carrying value and the fair value of the long-lived asset. In 2020, we evaluated our Natural Gas Gathering and Processing segment asset groups and determined that the carrying value of certain long-lived asset groups in the Powder River Basin, western Oklahoma and Kansas were not recoverable and exceeded their estimated fair value. We recorded noncash impairment charges of $382.2 million, which includes a natural gas processing plant and infrastructure in the Powder River Basin and its related supply contracts and natural gas processing plants and infrastructure in western Oklahoma and Kansas. In our Natural Gas Liquids segment, we recorded noncash impairment charges of $71.6 million related primarily to certain inactive assets, as our expectation for future use of the assets changed.Investments in unconsolidated affiliates - The impairment test for equity-method investments considers whether the fair value of the equity investment as a whole, not the underlying net assets, has declined and whether that decline is other than temporary. Therefore, we periodically evaluate the amount at which we carry our equity-method investments to determine whether current events or circumstances warrant adjustments to our carrying values.In 2020, we evaluated our investments in unconsolidated affiliates and concluded that the carrying value of our 10.2% investment in Venice Energy Services Company in our Natural Gas Gathering and Processing segment exceeded its estimated fair value, resulting in a noncash impairment charge of $30.5 million, which includes an impairment to our equity-method goodwill of $22.3 million. We also concluded that the carrying value of our 50% investment in Chisholm Pipeline Company in our Natural Gas Liquids segment exceeded its estimated fair value, resulting in a noncash impairment charge of $7.2 million. Our impairment tests required the use of assumptions and estimates, such as industry economic factors and the profitability of future business strategies. To estimate the fair value of these assets and investments, we used two generally accepted valuation approaches, an income approach and a market approach. Under the income approach, our discounted cash flow analysis included the following inputs that are not readily available: a discount rate reflective of industry cost of capital, our estimated contract rates, volumes, operating margins, operating and maintenance costs and capital expenditures. Under the market approach, our inputs included EBITDA multiples, which were estimated from recent peer acquisition transactions, and forecasted EBITDA, which incorporates inputs similar to those used under the income approach. If actual results are not consistent with our assumptions and estimates or our assumptions and estimates change due to new information, we may be exposed to future impairment charges.See Notes A, D, E and M of the Notes to Consolidated Financial Statements in this Annual Report for additional discussion of goodwill, long-lived assets and investments in unconsolidated affiliates.50Depreciation Methods and Estimated Useful Lives of Property, Plant and Equipment - Our property, plant and equipment are depreciated using the straight-line method that incorporates management assumptions regarding useful economic lives and residual values. As we place additional assets in service, our estimates related to depreciation expense have become more significant and changes in estimated useful lives of our assets could have a material effect on our results of operations. At the time we place our assets in service, we believe such assumptions are reasonable; however, circumstances may develop that would cause us to change these assumptions, which would change our depreciation expense prospectively. Examples of such circumstances include changes in (i) competition, (ii) laws and regulations that limit the estimated economic life of an asset, (iii) technology that render an asset obsolete, (iv) expected salvage values and (v) forecasts of the remaining economic life for the resource basins where our assets are located, if any. For the fiscal years presented in this Form 10-K, no changes were made to the determinations of useful lives that would have a material effect on the timing of depreciation expense in future periods.See Note D of the Notes to Consolidated Financial Statements in this Annual Report for additional discussion of property, plant and equipment.CONTRACTUAL OBLIGATIONS AND COMMERCIAL COMMITMENTSThe following table sets forth our contractual obligations related to debt, leases and other long-term obligations as of December 31, 2020. For additional discussion of the debt and lease agreements, see Notes F and O, respectively, of the Notes to Consolidated Financial Statements in this Annual Report. Payments Due by PeriodContractual ObligationsTotal20212022202320242025Thereafter(Millions of dollars)Senior notes$14,347.9 $— $1,437.7 $925.0 $500.0 $887.0 $10,598.2 Guardian Pipeline senior notes13.7 7.7 6.0 — — — — Interest payments on debt9,710.4 704.2 675.0 631.4 586.8 555.7 6,557.3 Operating leases116.1 16.5 15.1 13.8 12.5 11.1 47.1 Finance lease35.1 4.5 4.5 4.5 4.5 4.5 12.6 Firm transportation and storage contracts516.7 70.9 60.9 55.8 53.4 47.9 227.8 Financial and physical derivatives393.4 377.9 15.5 — — — — Employee benefit plans57.0 11.2 11.8 12.9 10.3 10.8 — Purchase commitments and other369.6 83.8 83.4 81.6 41.1 40.7 39.0 Total$25,559.9 $1,276.7 $2,309.9 $1,725.0 $1,208.6 $1,557.7 $17,482.0 Senior notes - Represents the amount of principal due in each period. Interest payments on debt - Interest payments are calculated by multiplying long-term debt principal amount by the respective coupon rates.Operating leases - Our operating leases primarily include leases for pipeline capacity, certain buildings, warehouses, office space, land and equipment, including pipeline equipment, rail cars and information technology equipment. Finance lease - We lease certain compression facilities under a finance lease that has a fixed-price purchase option in 2028.Firm transportation and storage contracts - Our Natural Gas Gathering and Processing and Natural Gas Liquids segments are party to fixed-rate contracts for firm transportation and storage capacity.Financial and physical derivatives - These are obligations arising from our fixed- and variable-price purchase commitments for physical and financial commodity derivatives. Estimated future variable-price purchase commitments are based on market information at December 31, 2020. Actual future variable-price purchase obligations may vary depending on market prices at the time of delivery. Sales of the related physical volumes and net positive settlements of financial derivatives are not reflected in the table above.Employee benefit plans - Represents projected minimum required cash contributions. We contributed $11.2 million to our defined benefit pension plan in January 2021 and do not expect to make any contributions to our other postretirement plans in 51the remainder of 2021. See Note K of the Notes to Consolidated Financial Statements in this Annual Report for discussion of our employee benefit plans.Purchase commitments and other - Purchase commitments include payments for NGL fractionation capacity and other contractual commitments. Purchase commitments exclude commodity purchase contracts, which are included in the “Financial and physical derivatives” amounts.FORWARD-LOOKING STATEMENTSSome of the statements contained and incorporated in this Annual Report are forward-looking statements as defined under federal securities laws. The forward-looking statements relate to our anticipated financial performance (including projected operating income, net income, capital expenditures, cash flows and projected levels of dividends), liquidity, management’s plans and objectives for our future capital-growth projects and other future operations (including plans to construct additional natural gas and NGL pipelines, processing and fractionation facilities and related cost estimates), our business prospects, the outcome of regulatory and legal proceedings, market conditions and other matters. We make these forward-looking statements in reliance on the safe harbor protections provided under federal securities legislation and other applicable laws. The following discussion is intended to identify important factors that could cause future outcomes to differ materially from those set forth in the forward-looking statements.Forward-looking statements include the items identified in the preceding paragraph, the information concerning possible or assumed future results of our operations and other statements contained or incorporated in this Annual Report identified by words such as “anticipate,” “believe,” “continue,” “could,” “estimate,” “expect,” “forecast,” “goal,” “guidance,” “intend,” “may,” “might,” “outlook,” “plan,” “potential,” “project,” “scheduled,” “should,” “will,” “would,” and other words and terms of similar meaning.One should not place undue reliance on forward-looking statements. Known and unknown risks, uncertainties and other factors may cause our actual results, performance or achievements to be materially different from any future results, performance or achievements expressed or implied by forward-looking statements. Those factors may affect our operations, markets, products, services and prices. In addition to any assumptions and other factors referred to specifically in connection with the forward-looking statements, factors that could cause our actual results to differ materially from those contemplated in any forward-looking statement include, among others, the following:•the length, severity and reemergence of a pandemic or other health crisis, such as the recent outbreak of COVID-19 and the measures that international, federal, state and local governments, agencies, law enforcement and/or health authorities implement to address it, which may (as with COVID-19) precipitate or exacerbate one or more of the factors herein, reduce the demand for natural gas, NGLs and crude oil and significantly disrupt or prevent us and our customers and counterparties from operating in the ordinary course for an extended period and increase the cost of operating our business;•operational challenges relating to the COVID-19 pandemic and efforts to mitigate the spread of the virus, including logistical challenges, protecting the health and well-being of our employees, remote work arrangements, performance of contracts and supply chain disruption;•the impact on drilling and production by factors beyond our control, including the demand for natural gas and crude oil; producers’ desire and ability to drill and obtain necessary permits; regulatory compliance; reserve performance; and capacity constraints and/or shut downs on the pipelines that transport crude oil, natural gas and NGLs from producing areas and our facilities;•risks associated with adequate supply to our gathering, processing, fractionation and pipeline facilities, including production declines that outpace new drilling, the shutting-in of production by producers, actions taken by federal, state or local governments to require producers to prorate or to cut their production levels as a way to address any excess market supply situations or extended periods of ethane rejection;•demand for our services and products in the proximity of our facilities;•economic climate and growth in the geographic areas in which we operate;•the risk of a slowdown in growth or decline in the United States or international economies, including liquidity risks in United States or foreign credit markets;•performance of contractual obligations by our customers, service providers, contractors and shippers;•the effects of changes in governmental policies and regulatory actions, including changes with respect to income and other taxes, pipeline safety, environmental compliance, climate change initiatives, production limits and authorized rates of recovery of natural gas and natural gas transportation costs;•changes in demand for the use of natural gas, NGLs and crude oil because of the development of new technologies or other market conditions caused by concerns about climate change;52•the effects of weather and other natural phenomena, including climate change, on our operations, demand for our services and energy prices;•acts of nature, sabotage, terrorism or other similar acts that cause damage to our facilities or our suppliers’, customers’ or shippers’ facilities;•the possibility of future terrorist attacks or the possibility or occurrence of an outbreak of, or changes in, hostilities or changes in the political conditions throughout the world;•the risk of increased costs for insurance premiums, security or other items as a consequence of terrorist attacks;•the timing and extent of changes in energy commodity prices, including changes due to production decisions by other countries, such as the failure of countries to abide by recent agreements to reduce production volumes;•competition from other United States and foreign energy suppliers and transporters, as well as alternative forms of energy, including, but not limited to, solar power, wind power, geothermal energy and biofuels such as ethanol and biodiesel;•the ability to market pipeline capacity on favorable terms, including the effects of:– future demand for and prices of natural gas, NGLs and crude oil;– competitive conditions in the overall energy market;– availability of supplies of United States natural gas and crude oil; and– availability of additional storage capacity;•the efficiency of our plants in processing natural gas and extracting and fractionating NGLs;•the composition and quality of the natural gas and NGLs we gather and process in our plants and transport on our pipelines;•risks of marketing, trading and hedging activities, including the risks of changes in energy prices or the financial condition of our counterparties;•our ability to control operating costs and make cost-saving changes;•the risk inherent in the use of information systems in our respective businesses and those of our counterparties and service providers, including cyber-attacks, which, according to experts, have increased in volume and sophistication since the beginning of the COVID-19 pandemic; implementation of new software and hardware; and the impact on the timeliness of information for financial reporting;•the timely receipt of approval by applicable governmental entities for construction and operation of our pipeline and other projects and required regulatory clearances;•the ability to recover operating costs and amounts equivalent to income taxes, costs of property, plant and equipment and regulatory assets in our state and FERC-regulated rates;•the results of administrative proceedings and litigation, regulatory actions, executive orders, rule changes and receipt of expected clearances involving any local, state or federal regulatory body, including the FERC, the National Transportation Safety Board, the PHMSA, the EPA and the CFTC;•the mechanical integrity of facilities and pipelines operated;•the capital-intensive nature of our businesses;•the impact of unforeseen changes in interest rates, debt and equity markets, inflation rates, economic recession and other external factors over which we have no control, including the effect on pension and postretirement expense and funding resulting from changes in equity and bond market returns;•actions by rating agencies concerning our credit;•our indebtedness and guarantee obligations could make us vulnerable to general adverse economic and industry conditions, limit our ability to borrow additional funds and/or place us at competitive disadvantages compared with our competitors that have less debt or have other adverse consequences;•our ability to access capital at competitive rates or on terms acceptable to us;•our ability to acquire all necessary permits, consents or other approvals in a timely manner, to promptly obtain all necessary materials and supplies required for construction, and to construct gathering, processing, storage, fractionation and transportation facilities without labor or contractor problems;•our ability to control construction costs and completion schedules of our pipelines and other projects;•difficulties or delays experienced by trucks, railroads or pipelines in delivering products to or from our terminals or pipelines;•the uncertainty of estimates, including accruals and costs of environmental remediation;•the impact of uncontracted capacity in our assets being greater or less than expected;•the impact of potential impairment charges;•the profitability of assets or businesses acquired or constructed by us;•risks associated with pending or possible acquisitions and dispositions, including our ability to finance or integrate any such acquisitions and any regulatory delay or conditions imposed by regulatory bodies in connection with any such acquisitions and dispositions;•the risk that material weaknesses or significant deficiencies in our internal controls over financial reporting could emerge or that minor problems could become significant;53•the impact and outcome of pending and future litigation;•the impact of recently issued and future accounting updates and other changes in accounting policies; and•the risk factors listed in the reports we have filed and may file with the SEC, which are incorporated by reference.These factors are not necessarily all of the important factors that could cause actual results to differ materially from those expressed in any of our forward-looking statements. Other factors could also affect adversely our future results. These and other risks are described in greater detail in Part I, Item 1A, Risk Factors, in this Annual Report and in our other filings that we make with the SEC, which are available via the SEC’s website at www.sec.gov and our website at www.oneok.com. All forward-looking statements attributable to us or persons acting on our behalf are expressly qualified in their entirety by these factors. Any such forward-looking statement speaks only as of the date on which such statement is made, and other than as required under securities laws, we undertake no obligation to update publicly any forward-looking statement whether as a result of new information, subsequent events or change in circumstances, expectations or otherwise.ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKOur exposure to market risk discussed below includes forward-looking statements and represents an estimate of possible changes in future earnings that could occur assuming hypothetical future movements in interest rates or commodity prices. Our views on market risk are not necessarily indicative of actual results that may occur and do not represent the maximum possible gains and losses that may occur since actual gains and losses will differ from those estimated based on actual fluctuations in interest rates or commodity prices and the timing of transactions.We are exposed to market risk due to commodity price and interest-rate volatility. Market risk is the risk of loss arising from adverse changes in market rates and prices. We may use financial instruments, including forward sales, swaps, options and futures, to manage the risks of certain identifiable or anticipated transactions and achieve more predictable cash flows. Our risk-management function follows policies and procedures established by our Risk Oversight and Strategy Committee to monitor our natural gas, condensate and NGL marketing activities and interest rates to ensure our hedging activities mitigate market risks and comply with approved thresholds or limits. We do not use financial instruments for trading purposes.We utilize a sensitivity analysis model to assess the risk associated with our derivative portfolio. The sensitivity analysis measures the potential change in fair value of our derivative instruments based upon a hypothetical 10% movement in the underlying commodity prices or interest rates. In addition to these variables, the fair value of our derivative portfolio is influenced by fluctuations in the notional amounts of the instruments and the discount rates used to determine the present values. Because we enter into these derivative instruments for the purpose of mitigating the risks that accompany certain of our business activities, as described below, the change in the market value of our derivative portfolio would typically be offset largely by a corresponding gain or loss on the hedged item. See Note A of the Notes to Consolidated Financial Statements in this Annual Report for discussion on our accounting policies for our derivative instruments and the impact on our Consolidated Financial Statements.COMMODITY PRICE RISKAs part of our hedging strategy, we use commodity derivative financial instruments and physical-forward contracts described in Note C of the Notes to Consolidated Financial Statements in this Annual Report to reduce the impact of near-term price fluctuations of natural gas, NGLs and condensate. Although our businesses are primarily fee-based, in our Natural Gas Gathering and Processing segment, we are exposed to commodity price risk as a result of retaining a portion of the commodity sales proceeds associated with our fee with POP contracts. Under certain fee with POP contracts, our contractual fees and POP percentage may increase or decrease if production volumes, delivery pressures or commodity prices change relative to specified thresholds. We are exposed to basis risk between the various production and market locations where we buy and sell commodities.The following table presents the effect a hypothetical 10% change in the underlying commodity prices would have on the estimated fair value of our commodity derivative instruments for the periods indicated:54Commodity ContractsDecember 31,2020December 31,2019 (Millions of dollars)Crude oil and NGLs$20.0 $26.1 Natural gas10.6 12.7 Total change in estimated fair value of commodity contracts$30.6 $38.8 Our sensitivity analysis represents an estimate of the reasonably possible gains and losses that would be recognized on our commodity derivative contracts assuming hypothetical movements in future market prices and is not necessarily indicative of actual results that may occur. Actual gains and losses may differ from estimates due to actual fluctuations in market prices, as well as changes in our commodity derivative portfolio during the year.The following tables set forth hedging information for our Natural Gas Gathering and Processing segment’s forecasted equity volumes for the periods indicated: Year Ending December 31, 2021 VolumesHedgedAverage PricePercentageHedgedNGLs - excluding ethane (MBbl/d) - Conway/Mont Belvieu10.4 $0.51 / gallon60%Condensate (MBbl/d) - WTI-NYMEX2.9 $42.87 / Bbl74%Natural gas (BBtu/d) - NYMEX and basis118.6 $2.64 / MMBtu75%Our Natural Gas Gathering and Processing segment’s commodity price sensitivity is estimated as a hypothetical change in the price of NGLs, crude oil and natural gas at December 31, 2020. Condensate sales are typically based on the price of crude oil. Assuming normal operating conditions, we estimate the following for our forecasted equity volumes:•a $0.01 per gallon change in the composite price of NGLs, excluding ethane, would change adjusted EBITDA for the year ending December 31, 2021, by $2.7 million;•a $1.00 per barrel change in the price of crude oil would change adjusted EBITDA for the year ending December 31, 2021, by $1.4 million; and•a $0.10 per MMBtu change in the price of residue natural gas would change adjusted EBITDA for the year ending December 31, 2021, by $5.8 million.These estimates do not include any effects of hedging or effects on demand for our services or natural gas processing plant operations that might be caused by, or arise in conjunction with, commodity price fluctuations. For example, a change in the gross processing spread may cause a change in the amount of ethane extracted from the natural gas stream, impacting gathering and processing financial results for certain contracts.INTEREST-RATE RISKWe are exposed to interest-rate risk through borrowings under our $2.5 Billion Credit Agreement, commercial paper program and long-term debt issuances. Future increases in commercial paper rates or bond rates could expose us to increased interest costs on future borrowings. We manage interest-rate risk through the use of fixed-rate debt, floating-rate debt and interest-rate swaps. Interest-rate swaps are agreements to exchange interest payments at some future point based on specified notional amounts. In 2020, we settled $750 million of our forward-starting interest-rate swaps related to our underwritten public offerings of $1.75 billion senior unsecured notes and the remaining $1.3 billion of our interest-rate swaps used to hedge our LIBOR-based interest payments upon repayment of the remaining balance of our $1.5 Billion Term Loan Agreement. At December 31, 2020 and 2019, we had forward-starting interest-rate swaps with notional amounts totaling $1.1 billion and $1.8 billion, respectively, to hedge the variability of interest payments on a portion of our forecasted debt issuances. At December 31, 2019, we had interest-rate swaps with notional amounts totaling $1.3 billion to hedge the variability of our LIBOR-based interest payments, all of which have settled as of December 31, 2020. All of our interest-rate swaps are designated as cash flow hedges. At December 31, 2020, we had derivative liabilities of $203.4 million related to these interest-rate swaps. At December 31, 2019, we had derivative assets of $0.6 million and derivative liabilities of $201.9 million related to these interest-rate swaps.55The following table presents the effect of a 10% hypothetical change in interest rates on the estimated fair value of our interest- rate derivative instruments for the periods indicated:December 31,2020December 31,2019 (Millions of dollars)Forward-starting interest-rate swaps$12.9 $40.5 Our sensitivity analysis represents an estimate of the reasonably possible gains and losses that would be recognized on our interest-rate derivative contracts assuming hypothetical movements in future interest rates and is not necessarily indicative of actual results that may occur. Actual gains and losses may differ from estimates due to actual fluctuations in interest rates, as well as changes in our interest-rate derivative portfolio during the year.See Note C of the Notes to Consolidated Financial Statements in this Annual Report for more information on our hedging activities.COUNTERPARTY CREDIT RISKWe assess the creditworthiness of our counterparties on an ongoing basis and require security, including prepayments and other forms of collateral, when appropriate. Certain of our counterparties may be impacted by a relatively low commodity price environment and could experience financial problems, which could result in nonpayment and/or nonperformance, which could impact adversely our results of operations.Natural Gas Gathering and Processing - Our Natural Gas Gathering and Processing segment derives services revenue primarily from major and independent crude oil and natural gas producers, which include both large integrated and independent exploration and production companies. In this segment, our downstream commodity sales customers are primarily utilities, large industrial companies, marketing companies and our NGL affiliate. We are not typically exposed to material credit risk with producers under fee with POP contracts as we sell the commodities and remit a portion of the sales proceeds back to the producer less our contractual fees. In 2020 and 2019, approximately 90% of the downstream commodity sales in our Natural Gas Gathering and Processing segment were made to customers rated investment-grade by S&P, approved through comparable internal counterparty analysis, or were secured by letters of credit or other collateral. Natural Gas Liquids - Our Natural Gas Liquids segment’s counterparties are primarily NGL and natural gas gathering and processing companies; major and independent crude oil and natural gas production companies; utilities; large industrial companies; natural gasoline distributors; propane distributors; municipalities; and petrochemical, refining and marketing companies. We charge fees to NGL and natural gas gathering and processing counterparties and NGL pipeline transportation customers. We are not typically exposed to material credit risk on the majority of our exchange services fees, as we purchase NGLs from our gathering and processing counterparties and deduct our fee from the amounts we remit. We also earn sales revenue on the downstream sales of NGL products. In 2020 and 2019, approximately 75% and 80%, respectively, of this segment’s commodity sales were made to customers rated investment-grade by S&P, approved through comparable internal counterparty analysis, or were secured by letters of credit or other collateral. In addition, the majority of our Natural Gas Liquids segment’s pipeline tariffs provide us the ability to require security from shippers. Natural Gas Pipelines - Our Natural Gas Pipelines segment’s customers are primarily local natural gas distribution companies, electric-generation facilities, large industrial companies, municipalities, producers, processors and marketing companies. In 2020 and 2019, approximately 85% of our revenues in this segment were from customers rated investment-grade by S&P, approved through comparable internal counterparty analysis, or were secured by letters of credit or other collateral. In addition, the majority of our Natural Gas Pipelines segment’s pipeline tariffs provide us the ability to require security from shippers. 56
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+ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. OVERVIEW: PACCAR is a global technology company whose Truck segment includes the design and manufacture of high-quality light-, medium- and heavy-duty commercial trucks. In North America, trucks are sold under the Kenworth and Peterbilt nameplates, in Europe, under the DAF nameplate and in Australia and South America, under the Kenworth and DAF nameplates. The Parts segment includes the distribution of aftermarket parts for trucks and related commercial vehicles. The Company’s Financial Services segment derives its earnings primarily from financing or leasing PACCAR products in North America, Europe and Australia. The Company’s Other business includes the manufacturing and marketing of industrial winches. PACCAR’s financial results for year ended December 31, 2020 were impacted by the COVID-19 pandemic, with the most significant impact in the quarter ended June 30, 2020. The Company’s truck and engine production was suspended at its factories worldwide starting March 24, 2020. Truck and engine production restarted in Europe and Australia on April 20, 2020, and factories gradually resumed operations in North America and Brasil in early May. In the third quarter the Company resumed production at rates sufficient to accommodate demand while maintaining appropriate health and safety protocols. Effects of the pandemic included reduced truck deliveries, increased costs associated with the suspension of production, lower aftermarket parts sales and higher provision for losses on Financial Services receivables. Increased costs related to the suspension and subsequent resumption of production primarily included reduced labor efficiency, costs to prepare factories for safe re-opening and reduced factory utilization. The Company implemented cost saving measures to partially offset the increased costs. During the pandemic, the Company’s Parts segment continues to provide aftermarket support through its parts distribution centers, and the Financial Services segment continues to provide financing, leasing services and related support to customers. 2020 Financial Highlights • Worldwide net sales and revenues were $18.73 billion in 2020 compared to $25.60 billion in 2019 due to lower truck revenues. • Truck sales were $13.16 billion in 2020 compared to $19.99 billion in 2019 primarily due to lower truck deliveries in the U.S. and Canada and Europe. • Parts sales were $3.91 billion in 2020 compared to $4.02 billion in 2019 primarily due to lower demand in the U.S. and Canada. • Financial Services revenues were $1.57 billion in 2020 compared to $1.48 billion in 2019. The increase was primarily the result of higher used truck sales in Europe. • In 2020, PACCAR earned net income for the 82nd consecutive year. Net income was $1.30 billion ($3.74 per diluted share) in 2020 compared to $2.39 billion ($6.87 per diluted share) in 2019 primarily reflecting lower Truck operating results. • Capital investments were $569.5 million in 2020 compared to $743.9 million in 2019 reflecting continued investments in the Company’s manufacturing facilities, new product development and enhanced aftermarket support. • After-tax return on beginning equity (ROE) was 13.4% in 2020 compared to 27.8% in 2019. • Research and development (R&D) expenses were $273.9 million in 2020 compared to $326.6 million in 2019. PACCAR signed a global strategic agreement with Aurora, a leader in autonomous driving technologies, to develop autonomous Peterbilt 579 and Kenworth T680 trucks. The partnership will integrate PACCAR’s autonomous vehicle platform with the Aurora self-driving technologies to deliver enhanced safety and operational efficiency to customers. Kenworth T680 and Peterbilt 579 trucks utilizing the Aurora Driver are expected to be delivered in the next several years. A Kenworth T680 fuel cell electric vehicle and a battery electric Peterbilt 579EV became the first Class 8 zero emissions vehicles to drive to the 14,115 foot summit of Pikes Peak in Colorado, demonstrating superb power and excellent drivability. More than 60 hybrid and zero emissions vehicles are currently in customer testing, which have traveled nearly 500,000 miles. Kenworth K270E and T680E, Peterbilt 579EV, 220EV and 520EV, and DAF CF Electric zero emissions trucks became available for customers to order in the third quarter of 2020. The Company anticipates electric vehicle production may be a few hundred units in 2021. Kenworth and Toyota Motor North America are collaborating on a project to develop Kenworth T680 zero emissions trucks powered by hydrogen fuel cell electric powertrains. PACCAR Parts continues to add global parts distribution capacity to further enhance parts availability to its customers. A new 260,000 square-foot distribution center will open in Louisville, Kentucky next year. 16 PACCAR has been honored as a global leader in environmental practices by reporting firm CDP, earning a score of “A-” in 2020, which places PACCAR in the top 15% of over 9,500 reporting companies which disclose data about their environmental programs to CDP for independent assessment. Environmental leadership is one of PACCAR’s core values, and the Company has earned an “A” or “A-” rating for six consecutive years. PACCAR Inc, Kenworth, Peterbilt, PACCAR Parts and Dynacraft were each honored by the Women in Trucking Association (WIT) as a 2020 “Top Company for Women to Work for in Transportation”. The recognition was for fostering gender diversity, flexible hours, competitive compensation and benefits, training, professional development and career advancement opportunities. PACCAR Financial Services (PFS) recently opened used truck centers in Lyon, France, Denton, Texas, and Prague, Czech Republic, and plans to open a used truck facility in Madrid, Spain in 2021. The PFS group of companies has operations covering four continents and 26 countries. The global breadth of PFS and its rigorous credit application process support a portfolio of loans and leases with total assets of $15.80 billion. PFS issued $1.99 billion in medium-term notes during 2020 to support portfolio growth and repay maturing debt. Truck Outlook The Company suspended truck production worldwide on March 24, 2020, due to the COVID-19 pandemic, with production resuming at all facilities by early May. The Company adjusted its manufacturing facilities for social distancing and implemented deep cleaning procedures. Initial truck production rates at all facilities were lower than those in effect at the time of the worldwide closure. In the fourth quarter, production rates had returned to pre-pandemic levels. Future production volumes will depend on market demand for trucks, parts availability from the Company’s suppliers and further government directives related to the COVID-19 pandemic. Assuming no significant impacts from a resurgence of the COVID-19 pandemic, truck industry retail sales in the U.S. and Canada in 2021 are expected to be 250,000 to 280,000 units compared to 216,500 in 2020. In Europe, the 2021 truck industry registrations for over 16-tonne vehicles are expected to be 250,000 to 280,000 units compared to 230,400 in 2020. In South America, heavy-duty truck industry registrations in 2021 are projected to be 100,000 to 110,000 units as compared to 93,000 in 2020. Parts Outlook The Company continues to provide strong aftermarket support to enable the shipment of essential goods and services to communities around the world while following social distancing and hygiene protocols. Strengthening economies and higher truck traffic in the second half of the year resulted in increased demand for aftermarket parts as compared to the first half of the year. In 2021, PACCAR Parts sales are expected to increase 7-9% from 2020 levels. If economic conditions were to worsen, lower freight volumes could reduce the demand for replacement parts, resulting in lower parts revenues and operating results. Financial Services Outlook Based on the truck market outlook, average earning assets in 2021 are expected to increase 4-6% compared to 2020. Current high levels of freight tonnage, freight rates and fleet utilization are contributing to customers’ profitability and cash flow. If current freight transportation conditions decline due to weaker economic conditions, then past due accounts, truck repossessions and credit losses would likely increase from the current low levels and new business volume would likely decline. Capital Spending and R&D Outlook Capital investments in 2021 are expected to be $575 to $625 million, and R&D is expected to be $350 to $375 million. The Company is investing for medium- and long-term growth in aerodynamic truck models, integrated powertrains including diesel, electric, hybrid, and hydrogen fuel cell technologies, as well as advanced driver assistance and autonomous systems, connected vehicle services and next-generation manufacturing and distribution capabilities. See the Forward-Looking Statements section of Management’s Discussion and Analysis for factors that may affect these outlooks. 17 RESULTS OF OPERATIONS: The Company’s results of operations for the years ended December 31, 2020 and 2019 are presented below. For information on the year ended December 31, 2018, refer to Part II, Item 7 in the 2019 Annual Report on Form 10-K. ($ in millions, except per share amounts) Year Ended December 31, 2020 2019 Net sales and revenues: Truck $ 13,164.8 $ 19,989.5 Parts 3,912.9 4,024.9 Other 76.6 105.3 Truck, Parts and Other 17,154.3 24,119.7 Financial Services 1,574.2 1,480.0 $ 18,728.5 $ 25,599.7 Income (loss) before income taxes: Truck $ 581.4 $ 1,904.9 Parts 799.3 830.8 Other 18.2 (17.7 ) Truck, Parts and Other 1,398.9 2,718.0 Financial Services 223.1 298.9 Investment income 35.9 82.3 Income taxes (359.5 ) (711.3 ) Net Income $ 1,298.4 $ 2,387.9 Diluted earnings per share $ 3.74 $ 6.87 After-tax return on revenues 6.9 % 9.3 % The following provides an analysis of the results of operations for the Company’s three reportable segments - Truck, Parts and Financial Services. Where possible, the Company has quantified the impact of factors identified in the following discussion and analysis. In cases where it is not possible to quantify the impact of factors, the Company lists them in estimated order of importance. Factors for which the Company is unable to specifically quantify the impact include market demand, fuel prices, freight tonnage and economic conditions affecting the Company’s results of operations. 2020 Compared to 2019: Truck The Company’s Truck segment accounted for 70% of revenues in 2020 compared to 78% in 2019. The Company’s new truck deliveries are summarized below: Year Ended December 31, 2020 2019 % CHANGE U.S. and Canada 73,300 117,200 (37 ) Europe 42,900 59,900 (28 ) Mexico, South America, Australia and other 17,100 21,700 (21 ) Total units 133,300 198,800 (33 ) The decrease in new truck deliveries worldwide in 2020 compared to 2019 was driven primarily by lower build rates caused by lower demand partially as a result of the COVID-19 pandemic. Market share data discussed below is provided by third party sources and is measured by either registrations or retail sales for the Company’s dealer network as a percentage of total registrations or retail sales depending on the geographic market. In the U.S. and Canada, market share is based on retail sales. In Europe, market share is based primarily on registrations. In 2020, industry retail sales in the heavy-duty market in the U.S. and Canada decreased to 216,500 units from 308,800 units in 2019. The Company’s heavy-duty truck retail market share was 30.1% in 2020 compared to 30.0% in 2019. The medium-duty market was 74,500 units in 2020 compared to 114,200 units in 2019. The Company’s medium-duty market share was 22.6% in 2020 compared to 17.2% in 2019. 18 The over 16‑tonne truck market in Europe in 2020 decreased to 230,400 units from 320,200 units in 2019, and DAF’s market share was 16.3% in 2020 compared to 16.2% in 2019. The 6 to 16‑tonne market in 2020 decreased to 41,400 units from 53,600 units in 2019. DAF’s market share in the 6 to 16-tonne market in 2020 was 9.5% compared to 9.7% in 2019. The Company’s worldwide truck net sales and revenues are summarized below: ($ in millions) Year Ended December 31, 2020 2019 % CHANGE Truck net sales and revenues: U.S. and Canada $ 8,062.0 $ 13,106.5 (38 ) Europe 3,419.3 4,797.6 (29 ) Mexico, South America, Australia and other 1,683.5 2,085.4 (19 ) $ 13,164.8 $ 19,989.5 (34 ) Truck income before income taxes $ 581.4 $ 1,904.9 (69 ) Pre-tax return on revenues 4.4 % 9.5 % The Company’s worldwide truck net sales and revenues decreased to $13.16 billion in 2020 from $19.99 billion in 2019 due to lower truck deliveries in all markets, though primarily the U.S. and Canada and Europe. Truck segment income before income taxes and pretax return on revenues reflect the impact of lower truck unit deliveries and lower margins, driven primarily by reduced demand and the worldwide truck plant closures as a result of the COVID-19 pandemic. The major factors for the Truck segment changes in net sales and revenues, cost of sales and revenues and gross margin between 2020 and 2019 are as follows: NET COST OF SALES AND SALES AND GROSS ($ in millions) REVENUES REVENUES MARGIN 2019 $ 19,989.5 $ 17,562.6 $ 2,426.9 (Decrease) increase Truck sales volume (6,738.2 ) (5,504.2 ) (1,234.0 ) Average truck sales prices (44.5 ) (44.5 ) Average per truck material, labor and other direct costs 271.5 (271.5 ) Factory overhead and other indirect costs (200.8 ) 200.8 Extended warranties, operating leases and other (78.3 ) 8.2 (86.5 ) Currency translation 36.3 34.4 1.9 Total decrease (6,824.7 ) (5,390.9 ) (1,433.8 ) 2020 $ 13,164.8 $ 12,171.7 $ 993.1 • Truck sales volume primarily reflects lower unit deliveries in the U.S. and Canada ($5.01 billion sales and $4.05 billion cost of sales), Europe ($1.42 billion sales and $1.19 billion cost of sales) and Mexico ($254.1 million sales and $211.0 million cost of sales), due to reduced retail demand and the impact of the worldwide production suspension due to the COVID-19 pandemic. • Average truck sales prices decreased sales by $44.5 million, primarily due to lower price realization in North America and Europe. • Average cost per truck increased cost of sales by $271.5 million, primarily reflecting higher accruals for product support costs and increased labor costs from lower volumes and inefficiencies related to the COVID-19 pandemic. • Factory overhead and other indirect costs decreased $200.8 million, primarily due to lower costs for labor, repair and maintenance and depreciation, partially offset by increased costs associated with the COVID-19 pandemic. • Extended warranties, operating leases and other revenues decreased by $78.3 million primarily due to lower revenues from operating leases as a result of a decreasing portfolio and lower revenues from dealer support services, partially offset by higher revenues from extended warranty contracts. Cost of sales and revenues increased by $8.2 million primarily due to higher costs on extended warranty contracts and higher impairments and losses on used trucks in Europe, partially offset by lower costs from operating leases and dealer support services. • The currency translation effect on sales and cost of sales primarily reflects an increase in the value of the euro relative to the U.S. dollar, partially offset by a decline in the value of the Brazilian real and the Canadian dollar. • Truck gross margins decreased to 7.5% in 2020 from 12.1% in 2019, primarily due to the factors noted above. 19 Truck selling, general and administrative expenses (SG&A) for 2020 decreased to $210.9 million from $269.7 million in 2019. The decrease was primarily due to lower sales and marketing costs ($30.1 million), salaries and related expenses ($22.7 million) and travel expenses ($17.3 million). As a percentage of sales, Truck SG&A increased to 1.6% in 2020 from 1.3% in 2019 due to lower net sales, partially offset by lower spending. Parts The Company’s Parts segment accounted for 21% of revenues in 2020 compared to 16% in 2019. ($ in millions) Year Ended December 31, 2020 2019 % CHANGE Parts net sales and revenues: U.S. and Canada $ 2,664.9 $ 2,731.7 (2 ) Europe 896.1 908.5 (1 ) Mexico, South America, Australia and other 351.9 384.7 (9 ) $ 3,912.9 $ 4,024.9 (3 ) Parts income before income taxes $ 799.3 $ 830.8 (4 ) Pre-tax return on revenues 20.4 % 20.6 % The Company’s worldwide parts net sales and revenues decreased to $3.91 billion in 2020 from $4.02 billion in 2019 due to lower sales volume, partially offset by higher prices. The decrease in Parts segment income before income taxes and pre-tax return on revenues in 2020 was primarily due to lower volume and margins. Parts income before income taxes in 2020 included a $10.2 million gain on the sale of the prior Las Vegas parts distribution facility which was replaced by a new larger facility. The gain was recorded in the second quarter in Interest and other (income), net on the Consolidated Statement of Income. The major factors for the Parts segment changes in net sales and revenues, cost of sales and revenues and gross margin between 2020 and 2019 are as follows: NET SALES AND COST OF SALES AND GROSS ($ in millions) REVENUES REVENUES MARGIN 2019 $ 4,024.9 $ 2,906.8 $ 1,118.1 (Decrease) increase Aftermarket parts volume (220.1 ) (149.1 ) (71.0 ) Average aftermarket parts sales prices 96.8 96.8 Average aftermarket parts direct costs 60.8 (60.8 ) Warehouse and other indirect costs 17.8 (17.8 ) Currency translation 11.3 6.5 4.8 Total decrease (112.0 ) (64.0 ) (48.0 ) 2020 $ 3,912.9 $ 2,842.8 $ 1,070.1 • Aftermarket parts sales volume decreased by $220.1 million and related cost of sales decreased by $149.1 million primarily due to lower demand in the U.S. and Canada. • Average aftermarket parts sales prices increased sales by $96.8 million primarily due to higher price realization in North America. • Average aftermarket parts direct costs increased $60.8 million due to higher material costs. • Warehouse and other indirect costs increased $17.8 million, primarily due to higher salaries and related expenses. • The currency translation effect on sales and cost of sales primarily reflects an increase in the value of the euro relative to the U.S. dollar, partially offset by a decrease in the value of the Brazilian real. • Parts gross margins in 2020 decreased to 27.3% from 27.8% in 2019 due to the factors noted above. Parts SG&A expense for 2020 decreased to $192.7 million compared to $207.8 million in 2019 primarily due to lower salaries and related expenses, lower travel expenses and lower sales and marketing costs. As a percentage of sales, Parts SG&A decreased to 4.9% in 2020 from 5.2% in 2019, primarily due to lower spending, partially offset by lower net sales. 20 Financial Services The Company’s Financial Services segment accounted for 8% of revenues in 2020 compared to 6% in 2019. ($ in millions) Year Ended December 31, 2020 2019 % CHANGE New loan and lease volume: U.S. and Canada $ 3,027.0 $ 3,425.8 (12 ) Europe 1,204.1 1,349.5 (11 ) Mexico, Australia and other 787.6 857.7 (8 ) $ 5,018.7 $ 5,633.0 (11 ) New loan and lease volume by product: Loans and finance leases $ 3,975.0 $ 4,277.1 (7 ) Equipment on operating lease 1,043.7 1,355.9 (23 ) $ 5,018.7 $ 5,633.0 (11 ) New loan and lease unit volume: Loans and finance leases 36,100 38,000 (5 ) Equipment on operating lease 10,700 13,700 (22 ) 46,800 51,700 (9 ) Average earning assets: U.S. and Canada $ 9,011.3 $ 8,837.7 2 Europe 3,560.2 3,547.6 Mexico, Australia and other 1,782.4 1,895.5 (6 ) $ 14,353.9 $ 14,280.8 1 Average earning assets by product: Loans and finance leases $ 9,123.8 $ 8,758.8 4 Dealer wholesale financing 2,101.4 2,428.8 (13 ) Equipment on lease and other 3,128.7 3,093.2 1 $ 14,353.9 $ 14,280.8 1 Revenues: U.S. and Canada $ 785.0 $ 810.1 (3 ) Europe 562.2 409.3 37 Mexico, Australia and other 227.0 260.6 (13 ) $ 1,574.2 $ 1,480.0 6 Revenues by product: Loans and finance leases $ 457.8 $ 470.2 (3 ) Dealer wholesale financing 69.6 112.8 (38 ) Equipment on lease and other 1,046.8 897.0 17 $ 1,574.2 $ 1,480.0 6 Income before income taxes $ 223.1 $ 298.9 (25 ) New loan and lease volume was $5.02 billion in 2020 compared to $5.63 billion in 2019, primarily reflecting lower truck deliveries worldwide, partially offset by higher finance market share. PFS finance market share of new PACCAR truck sales was 28.3% in 2020 compared to 24.5% in 2019. PFS revenues increased to $1.57 billion in 2020 from $1.48 billion in 2019. The increase was primarily due to higher used truck sales in Europe, partially offset by lower portfolio yields reflecting lower U.S. market interest rates. The effects of currency translation decreased PFS revenues by $7.3 million in 2020, primarily due to a weaker Mexican peso and Brazilian real, partially offset by a stronger euro. PFS income before income taxes decreased to $223.1 million in 2020 from $298.9 million in 2019, primarily due to lower used truck results, lower yields and a higher provision for credit losses, partially offset by lower SG&A expenses. The effects of translating weaker foreign currencies to the U.S. dollar decreased PFS income before taxes by $9.3 million in 2020. 21 Included in Financial Services “Other Assets” on the Company’s Consolidated Balance Sheets are used trucks held for sale, net of impairments, of $375.8 million at December 31, 2020 and $391.4 million at December 31, 2019. These trucks are primarily units returned from matured operating leases in the ordinary course of business, and also include trucks acquired from repossessions, through acquisitions of used trucks in trades related to new truck sales and trucks returned from residual value guarantees (RVGs). The Company recognized losses on used trucks, excluding repossessions, of $88.2 million in 2020 compared to $57.5 million in 2019, including losses on multiple unit transactions of $38.6 million in 2020 compared to $19.1 million in 2019. Used truck losses related to repossessions, which are recognized as credit losses, were insignificant for 2020 and 2019. The major factors for the changes in interest and fees, interest and other borrowing expenses and finance margin between 2020 and 2019 are outlined below: ($ in millions) INTEREST AND FEES INTEREST AND OTHER BORROWING EXPENSES FINANCE MARGIN 2019 $ 583.0 $ 230.5 $ 352.5 Increase (decrease) Average finance receivables 3.0 3.0 Average debt balances 1.2 (1.2 ) Yields (47.1 ) (47.1 ) Borrowing rates (35.8 ) 35.8 Currency translation and other (11.5 ) (3.8 ) (7.7 ) Total decrease (55.6 ) (38.4 ) (17.2 ) 2020 $ 527.4 $ 192.1 $ 335.3 • Average finance receivables increased $51.4 million (excluding foreign exchange effects) in 2020 as a result of retail portfolio new business volume exceeding collections, partially offset by lower dealer wholesale balances. • Average debt balances increased $12.4 million (excluding foreign exchange effects) in 2020. The higher average debt balances reflect funding for a higher average earning assets portfolio. • Lower portfolio yields (4.7% in 2020 compared to 5.2% in 2019) decreased interest and fees by $47.1 million. The lower portfolio yields were primarily due to lower market rates in North America. • Lower borrowing rates (1.8% in 2020 compared to 2.2% in 2019) were primarily due to lower debt market rates in North America. • The currency translation effects reflect a decrease in the value of foreign currencies relative to the U.S. dollar, primarily the Mexican peso and the Brazilian real. The following table summarizes operating lease, rental and other revenues and depreciation and other expenses: ($ in millions) Year Ended December 31, 2020 2019 Operating lease and rental revenues $ 832.0 $ 831.0 Used truck sales 194.8 43.9 Insurance, franchise and other revenues 20.0 22.1 Operating lease, rental and other revenues $ 1,046.8 $ 897.0 Depreciation of operating lease equipment $ 651.9 $ 605.4 Vehicle operating expenses 152.4 143.8 Cost of used truck sales 200.1 45.9 Insurance, franchise and other expenses 3.6 3.1 Depreciation and other expenses $ 1,008.0 $ 798.2 22 The major factors for the changes in operating lease, rental and other revenues, depreciation and other expenses and lease margin between 2020 and 2019 are outlined below: ($ in millions) OPERATING LEASE, RENTAL AND OTHER REVENUES DEPRECIATION AND OTHER EXPENSES LEASE MARGIN 2019 $ 897.0 $ 798.2 $ 98.8 Increase (decrease) Used truck sales 151.0 154.2 (3.2 ) Results on returned lease assets 28.7 (28.7 ) Average operating lease assets (1.4 ) .9 (2.3 ) Revenue and cost per asset (2.0 ) 17.5 (19.5 ) Currency translation and other 2.2 8.5 (6.3 ) Total increase (decrease) 149.8 209.8 (60.0 ) 2020 $ 1,046.8 $ 1,008.0 $ 38.8 • A higher sales volume of used trucks received on trade and upon RVG contract expiration increased operating lease, rental and other revenues by $151.0 million and increased depreciation and other expenses by $154.2 million. • Results on returned lease assets increased depreciation and other expenses by $28.7 million primarily due to higher impairments in the U.S. and Europe and higher losses on sales of returned lease units in the U.S. • Average operating lease assets increased $9.8 million (excluding foreign exchange effects), which increased related depreciation and other expenses by $.9 million. Revenues decreased by $1.4 million due to lower rental income per unit in Europe. • Revenue per asset decreased $2.0 million primarily due to lower fleet utilization. Cost per asset increased $17.5 million due to higher operating lease impairments in Europe, higher depreciation expense and higher vehicle operating expenses. • The currency translation effects reflect an increase in the value of foreign currencies relative to the U.S. dollar, primarily the euro, partially offset by the Mexican peso. Financial Services SG&A expense decreased to $122.2 million in 2020 from $137.0 million in 2019. The decrease was due to lower salaries and related expenses as a result of cost controls and lower travel expenses. As a percentage of revenues, Financial Services SG&A decreased to 7.8% in 2020 from 9.3% in 2019. The following table summarizes the provision for losses on receivables and net charge-offs: 2020 2019 ($ in millions) PROVISION FOR LOSSES ON RECEIVABLES NET CHARGE-OFFS PROVISION FOR LOSSES ON RECEIVABLES NET CHARGE-OFFS U.S. and Canada $ 16.2 $ 13.8 $ 13.5 $ 14.0 Europe 5.1 3.2 (3.2 ) (.8 ) Mexico, Australia and other 7.5 5.3 5.1 4.2 $ 28.8 $ 22.3 $ 15.4 $ 17.4 The provision for losses on receivables increased to $28.8 million in 2020 from $15.4 million in 2019, primarily driven by growth in the loans and finance leases portfolio and challenging economic conditions related to the COVID-19 pandemic. In addition, the provision for losses in 2019 also included recoveries on charged-off accounts in Europe. The Company modifies loans and finance leases as a normal part of its Financial Services operations. The Company may modify loans and finance leases for commercial reasons or for credit reasons. Modifications for commercial reasons are changes to contract terms for customers that are not considered to be in financial difficulty. Insignificant delays are modifications extending terms up to three months for customers experiencing some short-term financial stress, but not considered to be in financial difficulty. Modifications for credit reasons are changes to contract terms for customers considered to be in financial difficulty. The Company’s modifications typically result in granting more time to pay the contractual amounts owed and charging a fee and interest for the term of the modification. When considering whether to modify customer accounts for credit reasons, the Company evaluates the creditworthiness of the customers and modifies those accounts that the Company considers likely to perform under the modified terms. When the 23 Company modifies a loan or finance lease for credit reasons and grants a concession, the modification is classified as a troubled debt restructuring (TDR). The post-modification balances of accounts modified during the years ended December 31, 2020 and 2019 are summarized below: 2020 2019 ($ in millions) AMORTIZED COST BASIS % OF TOTAL PORTFOLIO* AMORTIZED COST BASIS % OF TOTAL PORTFOLIO* Commercial $ 244.4 2.5 % $ 316.4 3.5 % Insignificant delay 2,545.3 26.0 % 83.2 .9 % Credit - no concession 120.2 1.2 % 23.3 .3 % Credit - TDR 74.7 .8 % 2.5 $ 2,984.6 30.5 % $ 425.4 4.7 % * Amortized cost basis immediately after modification as a percentage of the year-end retail portfolio balance. In 2020, total modification activity significantly increased compared to 2019. The decrease in modifications for Commercial reasons primarily reflects lower volumes of refinancing. The increase in modifications for Insignificant delay reflects fleet customers requesting payment relief for up to three months related to the COVID-19 pandemic. The increase in modifications for Credit - no concession is primarily due to higher volumes of refinancing and requests for payment relief in Europe, the U.S. and Mexico. Credit - TDR modifications increased to $74.7 million in 2020 from $2.5 million in 2019 primarily due to two fleet customers in the U.S. and four fleet customers in Mexico. The following table summarizes the Company’s 30+ days past due accounts: At December 31, 2020 2019 Percentage of retail loan and lease accounts 30+ days past due: U.S. and Canada .1 % .4 % Europe .9 % .7 % Mexico, Australia and other 1.7 % 2.0 % Worldwide .5 % .7 % Accounts 30+ days past due decreased to .5% at December 31, 2020 from .7% at December 31, 2019. The Company continues to focus on maintaining low past due balances. When the Company modifies a 30+ days past due account, the customer is then generally considered current under the revised contractual terms. The Company modified $18.6 million and $1.7 million of accounts worldwide during the fourth quarter of 2020 and the fourth quarter of 2019, respectively, which were 30+ days past due and became current at the time of modification. Had these accounts not been modified and continued to not make payments, the pro forma percentage of retail loan and lease accounts 30+ days past due would have been as follows: At December 31, 2020 2019 Pro forma percentage of retail loan and lease accounts 30+ days past due: U.S. and Canada .1 % .4 % Europe 1.5 % .7 % Mexico, Australia and other 1.9 % 2.1 % Worldwide .6 % .7 % Modifications of accounts in prior quarters that were more than 30 days past due at the time of modification are included in past dues if they were not performing under the modified terms at December 31, 2020 and 2019. The effect on the allowance for credit losses from such modifications was not significant at December 31, 2020 and 2019. The Company’s 2020 and 2019 annualized pre-tax return on average assets for Financial Services was 1.4% and 2.0%, respectively. 24 Other Other includes the winch business as well as sales, income and expenses not attributable to a reportable segment. Other also includes non-service cost components of pension expense and a portion of corporate expense. Other sales represent less than 1% of consolidated net sales and revenues for 2020 and 2019. Other SG&A decreased to $55.6 million in 2020 from $84.0 million in 2019 primarily due to lower compensation costs reflecting stringent cost controls and lower travel expenses. Other income (loss) before tax was $18.2 million in 2020 compared to $(17.7) million in 2019. The income in 2020 compared to loss in 2019 was primarily due to lower salaries and related expenses, lower expected costs to resolve certain environmental matters and lower travel expenses, partially offset by lower results from the winch business. Investment income decreased to $35.9 million in 2020 from $82.3 million in 2019, primarily due to lower yields on U.S. investments due to lower market interest rates. Income Taxes In 2020, the effective tax rate was 21.7% compared to 23.0% in 2019. The lower effective tax rate in 2020 was primarily due to the change in mix of income generated in jurisdictions with lower tax rates in 2020 as compared to 2019. ($ in millions) Year Ended December 31, 2020 2019 Domestic income before taxes $ 1,122.9 $ 2,201.1 Foreign income before taxes 535.0 898.1 Total income before taxes $ 1,657.9 $ 3,099.2 Domestic pre-tax return on revenues 10.8 % 14.5 % Foreign pre-tax return on revenues 6.4 % 8.6 % Total pre-tax return on revenues 8.9 % 12.1 % In 2020, both domestic and foreign income before income taxes and pre-tax return on revenues decreased primarily due to lower revenues and lower margins from truck operations. LIQUIDITY AND CAPITAL RESOURCES: ($ in millions) At December 31, 2020 2019 Cash and cash equivalents $ 3,539.6 $ 4,175.1 Marketable debt securities 1,429.0 1,162.1 $ 4,968.6 $ 5,337.2 The Company’s total cash and marketable debt securities at December 31, 2020 decreased $368.6 million from the balances at December 31, 2019 due to a decrease in cash and cash equivalents, primarily reflecting $1,239.8 million of dividends paid during 2020, partially offset by other cash flows as described below. 25 The change in cash and cash equivalents is summarized below: ($ in millions) Year Ended December 31, 2020 2019 Operating activities: Net income $ 1,298.4 $ 2,387.9 Net income items not affecting cash 1,097.7 1,190.1 Pension contributions (184.9 ) (35.7 ) Changes in operating assets and liabilities, net 776.0 (682.0 ) Net cash provided by operating activities 2,987.2 2,860.3 Net cash used in investing activities (1,875.8 ) (2,207.4 ) Net cash (used in) provided by financing activities (1,808.5 ) 83.4 Effect of exchange rate changes on cash 61.6 2.9 Net (decrease) increase in cash and cash equivalents (635.5 ) 739.2 Cash and cash equivalents at beginning of the year 4,175.1 3,435.9 Cash and cash equivalents at end of the year $ 3,539.6 $ 4,175.1 Operating activities: Cash provided by operations increased by $126.9 million to $2.99 billion in 2020 from $2.86 billion in 2019. The increase reflects $1,391.4 million from wholesale receivables on new trucks as there was a cash inflow of $871.2 million in 2020 versus a cash outflow of $520.2 million in 2019. Higher operating cash flows reflect an increase of $144.2 million from used truck inventories as there was a cash inflow in 2020 ($65.1 million) compared to a cash outflow in 2019 ($79.1 million) and $194.1 million from accounts receivable as collections exceeded sales in 2020 ($121.8 million) compared to sales exceeding collections in 2019 ($72.3 million). The higher operating cash inflows were partially offset by lower net income of $1,089.5 million and a higher outflow for product support liabilities of $255.7 million as payments exceeded accruals by $89.1 million in 2020 and accruals exceeded payments by $166.6 million in 2019. Additionally, there were higher cash outflows for pension contributions of $149.2 million and higher net purchases of inventories of $72.8 million as there were $48.2 million in net purchases in 2020 and $24.6 million in net inventory reductions in 2019. Investing activities: Cash used in investing activities decreased by $331.6 million to $1,875.8 million in 2020 from $2,207.4 million in 2019. Lower net cash used in investing activities reflects lower cash used in the acquisition of equipment for operating leases of $308.8 million. In addition, there was $101.0 million of higher proceeds from dealer wholesale receivables on used trucks as cash receipts exceeded cash outflows in 2020 ($53.3 million) compared to originations exceeding cash receipts in 2019 ($47.7 million). The lower cash usage was partially offset by higher net purchases of marketable securities of $109.5 million in 2020 compared to 2019. Financing activities: Cash used in financing activities increased $1,891.9 million to $1,808.5 million in 2020 compared to cash provided by financing activities of $83.4 million in 2019. In 2020, the Company issued $2,150.1 million of term debt, repaid term debt of $1,898.5 million and decreased its outstanding commercial paper and short-term bank loans by $831.9 million. In 2019, the Company issued $2,504.3 million of term debt, repaid term debt of $1,790.0 million and increased its outstanding commercial paper and short-term bank loans by $557.1 million. This resulted in cash used by borrowing activities of $580.3 million in 2020, $1,851.7 million lower than the cash provided by borrowing activities of $1,271.4 million in 2019. The Company paid $1,239.8 million in dividends in 2020 compared to $1,138.6 million in 2019 due to a higher extra dividend paid in January 2020. In addition, the Company repurchased .7 million shares of common stock for $42.1 million in 2020 compared to the purchase of 1.7 million shares for $110.2 million in 2019. Credit Lines and Other: The Company has line of credit arrangements of $3.52 billion, of which $3.29 billion were unused at December 31, 2020. Included in these arrangements are $3.00 billion of committed bank facilities, of which $1.00 billion expires in June 2021, $1.00 billion expires in June 2023 and $1.00 billion expires in June 2024. The Company intends to extend or replace these credit facilities on or before expiration to maintain facilities of similar amounts and duration. These credit facilities are maintained primarily to provide backup liquidity for commercial paper borrowings and maturing medium-term notes. There were no borrowings under the committed bank facilities for the year ended December 31, 2020. On December 4, 2018, PACCAR’s Board of Directors approved the repurchase of up to $500.0 million of the Company’s outstanding common stock. As of December 31, 2020, the Company has repurchased $110.0 million of shares under the December 4, 2018 authorization. The Company has temporarily suspended its repurchases as a result of the economic uncertainty related to the COVID-19 pandemic. 26 Truck, Parts and Other The Company provides funding for working capital, capital expenditures, R&D, dividends, stock repurchases and other business initiatives and commitments primarily from cash provided by operations. Management expects this method of funding to continue in the future. Investments for manufacturing property, plant and equipment in 2020 were $558.8 million compared to $734.0 million in 2019. Over the past decade, the Company’s combined investments in worldwide capital projects and R&D totaled $7.20 billion and have significantly increased the operating capacity and efficiency of its facilities and enhanced the quality and operating efficiency of the Company’s premium products. Capital investments in 2021 are expected to be $575 to $625 million, and R&D is expected to be $350 to $375 million. The Company is investing for medium- and long-term growth in aerodynamic truck models, integrated powertrains including diesel, electric, hybrid, and hydrogen fuel cell technologies, as well as advanced driver assistance and autonomous systems, connected vehicle services and next-generation manufacturing and distribution capabilities. Financial Services The Company funds its financial services activities primarily from collections on existing finance receivables and borrowings in the capital markets. The primary sources of borrowings in the capital markets are commercial paper and medium-term notes issued in the public markets and, to a lesser extent, bank loans. In November 2018, the Company’s U.S. finance subsidiary, PACCAR Financial Corp. (PFC), filed a shelf registration under the Securities Act of 1933. The total amount of medium-term notes outstanding for PFC as of December 31, 2020 was $6.00 billion. In February 2021, PFC issued $400.0 million of medium-term notes under this registration. The registration expires in November 2021 and does not limit the principal amount of debt securities that may be issued during that period. As of December 31, 2020, the Company’s European finance subsidiary, PACCAR Financial Europe, had €1.60 billion available for issuance under a €2.50 billion medium-term note program listed on the Euro MTF Market of the Luxembourg Stock Exchange. This program replaced an expiring program in the second quarter of 2020 and is renewable annually through the filing of a new listing. In April 2016, PACCAR Financial Mexico registered a 10.00 billion peso medium-term note and commercial paper program with the Comision Nacional Bancaria y de Valores. The registration expires in April 2021 and limits the amount of commercial paper (up to one year) to 5.00 billion pesos. At December 31, 2020, 6.84 billion pesos were available for issuance. In August 2018, the Company’s Australian subsidiary, PACCAR Financial Pty. Ltd. (PFPL), registered a medium-term note program. The program does not limit the principal amount of debt securities that may be issued under the program. The total amount of medium-term notes outstanding for PFPL as of December 31, 2020 was 450.0 million Australian dollars. The Company believes its cash balances and investments, collections on existing finance receivables, committed bank facilities, and current investment-grade credit ratings of A+/A1 will continue to provide it with sufficient resources and access to capital markets at competitive interest rates and therefore contribute to the Company maintaining its liquidity and financial stability. In the event of a decrease in the Company’s credit ratings or a disruption in the financial markets, the Company may not be able to refinance its maturing debt in the financial markets. In such circumstances, the Company would be exposed to liquidity risk to the degree that the timing of debt maturities differs from the timing of receivable collections from customers. The Company believes its various sources of liquidity, including committed bank facilities, would continue to provide it with sufficient funding resources to service its maturing debt obligations. 27 Commitments The following summarizes the Company’s contractual cash commitments at December 31, 2020: MATURITY ($ in millions) WITHIN 1 YEAR 1-3 YEARS 3-5 YEARS MORE THAN 5 YEARS TOTAL Borrowings* $ 5,396.0 $ 4,604.4 $ 865.6 $ 10,866.0 Purchase obligations 91.6 75.4 .4 167.4 Interest on debt** 114.6 103.6 15.4 233.6 Lease liabilities 14.3 16.8 5.7 $ 6.0 42.8 Other obligations 37.6 5.5 1.1 44.2 $ 5,654.1 $ 4,805.7 $ 888.2 $ 6.0 $ 11,354.0 * Commercial paper included in borrowings is at par value. ** Interest on floating-rate debt is based on the applicable market rates at December 31, 2020. Total cash commitments for borrowings and interest on term debt were $11.10 billion and were related to the Financial Services segment. As described in Note J of the consolidated financial statements, borrowings consist primarily of term notes and commercial paper issued by the Financial Services segment. The Company expects to fund its maturing Financial Services debt obligations principally from funds provided by collections from customers on loans and lease contracts, as well as from the proceeds of commercial paper and medium-term note borrowings. Purchase obligations are the Company’s contractual commitments to acquire future production inventory and capital equipment. Other obligations primarily include commitments to purchase energy. The Company’s other commitments include the following at December 31, 2020: COMMITMENT EXPIRATION ($ in millions) WITHIN 1 YEAR 1-3 YEARS 3-5 YEARS MORE THAN 5 YEARS TOTAL Loan and lease commitments $ 823.4 $ 823.4 Residual value guarantees 633.0 $ 709.2 $ 158.7 $ 42.2 1,543.1 Letters of credit 9.3 .1 .2 .7 10.3 $ 1,465.7 $ 709.3 $ 158.9 $ 42.9 $ 2,376.8 Loan and lease commitments are for funding new retail loan and lease contracts. Residual value guarantees represent the Company’s commitment to acquire trucks at a guaranteed value if the customer decides to return the truck at a specified date in the future. IMPACT OF ENVIRONMENTAL MATTERS: The Company, its competitors and industry in general are subject to various domestic and foreign requirements relating to the environment. The Company believes its policies, practices and procedures are designed to prevent unreasonable risk of environmental damage and that its handling, use and disposal of hazardous or toxic substances have been in accordance with environmental laws and regulations in effect at the time such use and disposal occurred. The Company is involved in various stages of investigations and cleanup actions in different countries related to environmental matters. In certain of these matters, the Company has been designated as a “potentially responsible party” by domestic and foreign environmental agencies. The Company has accrued the estimated costs to investigate and complete cleanup actions where it is probable that the Company will incur such costs in the future. Expenditures related to environmental activities in the years ended December 31, 2020 and 2019 were $1.9 million and $1.3 million, respectively. While the timing and amount of the ultimate costs associated with future environmental cleanup cannot be determined, management expects that these matters will not have a significant effect on the Company’s consolidated cash flow, liquidity or financial condition. 28 CRITICAL ACCOUNTING POLICIES: The Company’s significant accounting policies are disclosed in Note A of the consolidated financial statements. In the preparation of the Company’s financial statements, in accordance with U.S. generally accepted accounting principles, management uses estimates and makes judgments and assumptions that affect asset and liability values and the amounts reported as income and expense during the periods presented. The following are accounting policies which, in the opinion of management, are particularly sensitive and which, if actual results are different from estimates used by management, may have a material impact on the financial statements. Operating Leases Trucks sold pursuant to agreements accounted for as operating leases are disclosed in Note F of the consolidated financial statements. In determining its estimate of the residual value of such vehicles, the Company considers the length of the lease term, the truck model, the expected usage of the truck and anticipated market demand. Operating lease terms generally range from three to five years. The resulting residual values on operating leases generally range between 30% and 70% of the original equipment cost. If the sales price of a truck at the end of the term of the agreement differs from the Company’s estimated residual value, a gain or loss will result. Future market conditions, changes in government regulations and other factors outside the Company’s control could impact the ultimate sales price of trucks returned under these contracts. Residual values are reviewed regularly and adjusted if market conditions warrant. A decrease in the estimated equipment residual values would increase annual depreciation expense over the remaining lease term. During 2020 and 2019, market values on equipment returning upon operating lease maturity were generally lower than the residual values on the equipment, resulting in an increase in depreciation expense of $99.9 million and $65.8 million, respectively. At December 31, 2020, the aggregate residual value of equipment on operating leases in the Financial Services segment and residual value guarantee on trucks accounted for as operating leases in the Truck segment was $2.42 billion. A 10% decrease in used truck values worldwide, if expected to persist over the remaining maturities of the Company’s operating leases, would reduce residual value estimates and result in the Company recording additional depreciation expense of approximately $80.7 million in 2021, $70.6 in 2022, $55.6 in 2023, $22.6 in 2024 and $12.9 in 2025 and thereafter. Allowance for Credit Losses The allowance for credit losses related to the Company’s loans and finance leases is disclosed in Note E of the consolidated financial statements. The Company has developed a systematic methodology for determining the allowance for credit losses for its two portfolio segments, retail and wholesale. The retail segment consists of retail loans and finance leases, net of unearned interest. The wholesale segment consists of truck inventory financing loans to dealers that are collateralized by trucks and other collateral. The wholesale segment generally has less risk than the retail segment. Wholesale receivables generally are shorter in duration than retail receivables, and the Company requires periodic reporting of the wholesale dealer’s financial condition, conducts periodic audits of the trucks being financed and in many cases obtains guarantees or other security such as dealership assets. In determining the allowance for credit losses, retail loans and finance leases are evaluated together since they relate to a similar customer base, their contractual terms require regular payment of principal and interest, generally over three to five years, and they are secured by the same type of collateral. The allowance for credit losses consists of both specific and general reserves. The Company individually evaluates certain finance receivables for impairment. Finance receivables that are evaluated individually for impairment consist of all wholesale accounts and certain large retail accounts with past due balances or otherwise determined to be at a higher risk of loss. A finance receivable is impaired if it is considered probable the Company will be unable to collect all contractual interest and principal payments as scheduled. In addition, all retail loans and leases which have been classified as TDRs and all customer accounts over 90 days past due are considered impaired. Generally, impaired accounts are on non-accrual status. Impaired accounts classified as TDRs which have been performing for 90 consecutive days are placed on accrual status if it is deemed probable that the Company will collect all principal and interest payments. Impaired receivables are generally considered collateral dependent. Large balance retail and all wholesale impaired receivables are individually evaluated to determine the appropriate reserve for losses. The determination of reserves for large balance impaired receivables considers the fair value of the associated collateral. When the underlying collateral fair value exceeds the Company’s amortized cost basis, no reserve is recorded. Small balance impaired receivables with similar risk characteristics are evaluated as a separate pool to determine the appropriate reserve for losses using the historical loss and economic forecasts information discussed below. 29 The Company evaluates finance receivables that are not individually impaired and share similar risk characteristics on a collective basis and determines the general allowance for credit losses for both retail and wholesale receivables based on historical loss information, using past due account data, current market conditions, and expected changes in future macroeconomic conditions that affect collectability. Historical credit loss information provides relevant information of expected credit losses. The historical information used includes assumptions regarding the likelihood of collecting current and past due accounts, repossession rates, and the recovery rate on the underlying collateral based on used truck values and other pledged collateral or recourse. The Company has developed a range of loss estimates for each of its country portfolios based on historical experience, taking into account loss frequency and severity in both strong and weak truck market conditions. A projection is made of the range of estimated credit losses inherent in the portfolio from which an amount is determined based on current market conditions and other factors impacting the creditworthiness of the Company’s borrowers and their ability to repay. Adjustments to historical loss information are made for changes in forecasted economic conditions that are specific to the industry and markets in which the Company conducts business. The Company utilizes economic forecasts from third party sources and determines expected losses based on historical experience under similar market conditions. After determining the appropriate level of the allowance for credit losses, a provision for losses on finance receivables is charged to income as necessary to reflect management’s estimate of expected credit losses, net of recoveries, inherent in the portfolio. The adequacy of the allowance is evaluated quarterly based on the most recent past due account information and current and future market conditions. As accounts become past due, the likelihood that they will not be fully collected increases. The Company’s experience indicates the probability of not fully collecting past due accounts ranges between 30% and 70%. Over the past two years, the Company’s year-end 30+ days past due accounts have ranged between .5% and .7% of loan and lease receivables. Historically, a 100 basis point increase in the 30+ days past due percentage has resulted in an increase in credit losses of 2 to 37 basis points of receivables. At December 31, 2020, 30+ days past dues were .5%. If past dues were 100 basis points higher or 1.5% as of December 31, 2020, the Company’s estimate of credit losses would likely have increased by a range of $2 to $36 million depending on the extent of the past dues, the estimated value of the collateral as compared to amounts owed and general economic factors. Product Warranty Product warranty is disclosed in Note I of the consolidated financial statements. The expenses related to product warranty are estimated and recorded at the time products are sold based on historical and current data and reasonable expectations for the future regarding the frequency and cost of warranty claims, net of recoveries. Management takes actions to minimize warranty costs through quality-improvement programs; however, actual claim costs incurred could materially differ from the estimated amounts and require adjustments to the reserve. Historically those adjustments have not been material. Over the past two years, warranty expense as a percentage of Truck, Parts and Other net sales and revenues has ranged between 1.7% and 2.2%. If the 2020 warranty expense had been .2% higher as a percentage of net sales and revenues in 2020, warranty expense would have increased by approximately $34 million. FORWARD-LOOKING STATEMENTS: This report contains “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements include statements relating to future results of operations or financial position and any other statement that does not relate to any historical or current fact. Such statements are based on currently available operating, financial and other information and are subject to risks and uncertainties that may affect actual results. Risks and uncertainties include, but are not limited to: a significant decline in industry sales; competitive pressures; reduced market share; reduced availability of or higher prices for fuel; increased safety, emissions, or other regulations or tariffs resulting in higher costs and/or sales restrictions; currency or commodity price fluctuations; lower used truck prices; insufficient or under-utilization of manufacturing capacity; supplier interruptions; insufficient liquidity in the capital markets; fluctuations in interest rates; changes in the levels of the Financial Services segment new business volume due to unit fluctuations in new PACCAR truck sales or reduced market shares; changes affecting the profitability of truck owners and operators; price changes impacting truck sales prices and residual values; insufficient supplier capacity or access to raw materials; labor disruptions; shortages of commercial truck drivers; increased warranty costs; pandemics; litigation, including EC settlement-related claims; or legislative and governmental regulations. A more detailed description of these and other risks is included under the heading Part I, Item 1A, “Risk Factors” and in Note L in the Notes to Consolidated Financial Statements of this Annual Report on Form 10-K. 30 ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK. Currencies are presented in millions for the market risks and derivative instruments sections below. Interest-Rate Risks - See Note P for a description of the Company’s hedging programs and exposure to interest rate fluctuations. The Company measures its interest-rate risk by estimating the amount by which the fair value of interest-rate sensitive assets and liabilities, including derivative financial instruments, would change assuming an immediate 100 basis point increase across the yield curve as shown in the following table: Fair Value (Losses) Gains 2020 2019 CONSOLIDATED: Assets Cash equivalents and marketable debt securities $ (26.9 ) $ (19.5 ) FINANCIAL SERVICES: Assets Fixed rate loans (105.7 ) (94.4 ) Liabilities Fixed rate term debt 124.3 113.3 Interest-rate swaps 14.2 13.9 Total $ 5.9 $ 13.3 Currency Risks - The Company enters into foreign currency exchange contracts to hedge its exposure to exchange rate fluctuations of foreign currencies, particularly the Canadian dollar, the euro, the British pound, the Australian dollar, the Brazilian real and the Mexican peso (see Note P for additional information concerning these hedges). Based on the Company’s sensitivity analysis, the potential loss in fair value for such financial instruments from a 10% unfavorable change in quoted foreign currency exchange rates would be a loss of $155.2 related to contracts outstanding at December 31, 2020, compared to a loss of $128.0 at December 31, 2019. These amounts would be largely offset by changes in the values of the underlying hedged exposures. 31
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+Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations” of this Form 10-K. Executive Officers of the Registrant Brief statements setting forth the age at February 24, 2021, the principal occupation, employment during the past five years, the year in which such person first became an officer of PCA, and other information concerning each of our executive officers appears below. Mark W. Kowlzan, 65, Chairman and Chief Executive Officer - Mr. Kowlzan has served as PCA's Chairman since January 2016 and as Chief Executive Officer and a director since July 2010. From 1998 through June 2010, Mr. Kowlzan led the company’s containerboard mill system, first as Vice President and General Manager and then as Senior Vice President - Containerboard. From 1996 through 1998, Mr. Kowlzan served in various senior mill-related operating positions with PCA and Tenneco Packaging, including as manager of the Counce linerboard mill. Prior to joining Tenneco Packaging, Mr. Kowlzan spent 15 years at International Paper Company, a global paper and packaging company, where he held a series of operational and managerial positions within its mill organization. Mr. Kowlzan is a member of the board of American Forest and Paper Association. Thomas A. Hassfurther, 65, Executive Vice President - Corrugated Products - Mr. Hassfurther has served as Executive Vice President - Corrugated Products of PCA since September 2009. From February 2005 to September 2009, Mr. Hassfurther served as Senior Vice President - Sales and Marketing, Corrugated Products. Prior to this he held various senior-level management and sales positions at PCA and Tenneco Packaging. Mr. Hassfurther joined the company in 1977. Robert P. Mundy, 59, Executive Vice President and Chief Financial Officer - Mr. Mundy has served as Executive Vice President and Chief Financial Officer since May 2019. Mr. Mundy previously served as PCA’s Senior Vice President and Chief Financial Officer from 2015 to 2019. He previously served as Senior Vice President and Chief Financial Officer of Verso Corporation, a leading North American supplier of coated papers to catalog and magazine publishers, from 2006 to June 2015. Verso Corporation filed for Chapter 11 bankruptcy in January 2016. Prior to that, he worked at International Paper Company, from 1983 to 2006, where he was Director of Finance of the Coated and Supercalendered Papers division from 2002 to 2006, Director of Finance Projects from 2001 to 2002, Controller of Masonite Corporation from 1999 to 2001, and Controller of the Petroleum and Minerals business from 1996 to 1999. He served in various business positions at International Paper from 1983 to 1996. Pamela A. Barnes, 56, Senior Vice President – Finance and Controller - Ms. Barnes has served as Senior Vice President – Finance and Controller since May 2019. Ms. Barnes previously served as a Vice President in PCA’s finance organization from 2012 to 2019. After joining the company in 1992, she has held various positions of increasing responsibility, including serving as PCA’s Treasurer since 1999. Before joining PCA, Ms. Barnes worked for Deloitte & Touche. Charles J. Carter, 61, Senior Vice President - Containerboard Mill Operations - Mr. Carter has served as Senior Vice President - Containerboard Mill Operations since July 2013. Prior to this, he served as Vice President – Containerboard Mill Operations since January 2011. From March 2010 to January 2011, Mr. Carter served as PCA’s Director of Papermaking Technology. Prior to joining PCA in 2010, Mr. Carter spent 28 years with various pulp and paper companies in managerial and technical positions of increasing responsibility, most recently as Vice President and General Manager of the Calhoun, Tennessee mill of Abitibi Bowater from 2007 to 2010 and as manager of SP Newsprint’s Dublin, Georgia mill from 1999 to 2007. Jeff S. Kaser, 55, Senior Vice President – Corrugated Products - Mr. Kaser has served as Senior Vice President — Corrugated Products since May 2020. Prior to this, he served as Vice President and Area General Manager of PCA’s Midwest Area, Mid-Atlantic Area and Pennsylvania Region. Mr. Kaser joined PCA in 1987 and has also held plant positions in sales, sales management and general management. 8 Kent A. Pflederer, 50, Senior Vice President, General Counsel and Secretary - Mr. Pflederer has served as Senior Vice President, General Counsel and Corporate Secretary since January 2013 and has led our legal department since June 2007. Prior to joining PCA, Mr. Pflederer served as Senior Counsel, Corporate and Securities, at Hospira, Inc. from 2004 to 2007 and served in the corporate and securities practice at Mayer Brown, LLP from 1996 to 2004. Bruce A. Ridley, 65, Senior Vice President – Environmental Health and Safety and Operational Services - Mr. Ridley has served as Senior Vice President – Environmental Health and Safety and Operational Services since May 2019. Mr. Ridley previously served as Vice President of Operations from 2012 to 2019 and at PCA’s Tomahawk, Wisconsin containerboard mill as the Operations Manager and Mill Manager from 1999 to 2011. Before joining PCA, he held several positions of increasing responsibility at multiple locations during his 19 years with International Paper Co. and two years with Champion International. Robert A. Schneider, 55, Senior Vice President and Chief Information Officer - Mr. Schneider has served as Senior Vice President and Chief Information Officer since May 2019. He previously served as Vice President and Chief Information Officer from 2000 to 2019. Mr. Schneider joined the company in 1989 and has held various management and other positions of increasing responsibility in information systems for PCA. D. Ray Shirley, 49, Senior Vice President – Corporate Engineering and Process Technology - Mr. Shirley has served as PCA’s Senior Vice President – Corporate Engineering and Process Technology since May 2019. Mr. Shirley previously served as PCA’s Vice President – Containerboard Mills Engineering and Process Technology from 2012 to 2019 and as Mill Manager at PCA’s Counce, Tennessee containerboard mill from 2010 to 2012. He has served in various management roles within the company, including the Operations Manager at the Filer City, Michigan containerboard mill. Before joining PCA in 1996, Mr. Shirley worked for Georgia-Pacific Corporation. Thomas W.H. Walton, 61, Senior Vice President - Sales and Marketing, Corrugated Products - Mr. Walton has served as Senior Vice President - Sales and Marketing, Corrugated Products since October 2009. Prior to this, he served as a Vice President and Area General Manager within the Corrugated Products Group since 1998. Mr. Walton joined the company in 1981 and has also held positions in production, sales, and general management. Available Information PCA’s internet website address is www.packagingcorp.com. Our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 are available free of charge through our website as soon as reasonably practicable after they are electronically filed with, or furnished to, the Securities and Exchange Commission. In addition, our Code of Ethics may be accessed in the Investor Relations section of PCA’s website. PCA’s website and the information contained or incorporated therein are not intended to be incorporated into this report. Item 1A. RISK FACTORS Some of the statements in this report and, in particular, statements found in Management’s Discussion and Analysis of Financial Condition and Results of Operations, that are not historical in nature are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements include statements about our expectations regarding our future liquidity, earnings, expenditures, and financial condition. These statements are often identified by the words “will,” “should,” “anticipate,” “believe,” “expect,” “intend,” “estimate,” “hope,” or similar expressions. These statements reflect management’s current views with respect to future events and are subject to risks and uncertainties. There are important factors that could cause actual results to differ materially from those in forward-looking statements, many of which are beyond our control. These factors, risks and uncertainties include, but are not limited to, the factors described below. Our actual results, performance, or achievement could differ materially from those expressed in, or implied by, these forward-looking statements, and accordingly, we can give no assurances that any of the events anticipated by the forward-looking statements will transpire or occur, or if any of them do so, what impact they will have on our results of operations or financial condition. In view of these uncertainties, investors are cautioned not to place undue reliance on these forward-looking statements. We expressly disclaim any obligation to publicly revise or otherwise update any forward-looking statements that have been made to reflect the occurrence of events after the date hereof. In addition to the risks and uncertainties we discuss elsewhere in this Form 10-K (particularly in “Part II, Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations”) or in our other filings with the 9 Securities and Exchange Commission (SEC), the following are important factors that could cause our actual results to differ materially from those we project in any forward-looking statement. Risks Related to the COVID-19 Pandemic The future effect of the COVID-19 pandemic on our operations is uncertain. On March 11, 2020, the World Health Organization declared the COVID-19 outbreak a pandemic. Since that time, federal, state and local authorities have taken measures to control the outbreak of COVID-19 in the United States, where we primarily operate. These measures have included travel bans and restrictions, quarantines and shelter in place orders. Due to the importance of our products to the continued distribution of food, beverage and other necessities, our operating facilities have been permitted to remain in operation and we have not experienced material disruptions in operations to date. Despite the spread of the virus in the United States, we have maintained sufficient workforce availability as well as adequate supply of raw materials and necessary services to continue operating without material disruption. However, the impact of the further spread of the virus and the measures to control the spread of the virus are uncertain and may materially restrict or hinder our ability to operate our facilities due to measures we may need to take to assure the health and safety of our employees, lack of available workforce, disruptions in the supply of key materials and services or restrictions due to governmental actions. We cannot assure you as to the timing and effectiveness of vaccination efforts on the control of spread of the virus. If our operations are hindered or restricted, we may not be able to serve our customers, which could have a material adverse effect on our business, financial condition and results of operations. The pandemic resulting from the COVID-19 outbreak, and measures to control the outbreak, are having a negative impact on domestic economic activity, which could adversely affect demand for our products and our business, financial condition and results of operations. Many businesses in the United States have been required to cease or curtail operations and workers have been laid off or furloughed, and have slowed down economic activity. The severity and duration of the impact on the economy will depend on the future spread of the outbreak, future measures by governmental authorities to control the outbreak, the timing and effectiveness of vaccination efforts, the timing and manner in which normal social and business activities are permitted to resume and the effectiveness of governmental efforts to mitigate the economic effect of the outbreak, all of which are highly uncertain. We have experienced significantly lower demand for our uncoated freesheet paper products, due to economic conditions, office closings and school shutdowns associated with the COVID-19 pandemic, which harmed the performance of our Paper segment. Our Jackson, Alabama mill was idled for the majority of the second and third quarters of 2020 and began to produce containerboard for the Packaging segment on a trial basis during the fourth quarter. While we have not experienced lower demand for our containerboard and corrugated packaging products to date, the effect of the pandemic on economic conditions affecting our business and future demand is uncertain. It is uncertain whether, to what extent and for what period of time current favorable demand conditions in the Packaging segment will continue. With the uncertainty of economic conditions, we are unable to determine the impact on our future operating and financial performance. A prolonged period of lower earnings and reduced cash flow could adversely affect our ability to fund operations, capital requirements, and common stock dividend payments and access capital markets. Risks Related to our Operations, Business and Industry Industry Cyclicality - Changes in the prices of our products could materially affect our financial condition, results of operations, and liquidity. Macroeconomic conditions and fluctuations in industry capacity can create changes in prices, sales volumes, and margins for most of our products, particularly commodity grades of packaging and paper products. Prices for all of our products are driven by many factors, including demand for our products, industry capacity and decisions made by other producers with respect to capacity and production, and other competitive conditions in our industry. These factors are affected by general global and domestic economic conditions. We have little influence over the timing and extent of price changes of our products, which may be unpredictable and volatile. In addition, as many of our customer contracts include price adjustment provisions based upon published index prices for containerboard or certain grades of UFS papers, our selling prices are influenced by index levels published by trade publications. Changes in how these index levels are determined or maintained may affect our sales prices. If supply exceeds demand, industry operating conditions deteriorate or other factors result in lower prices for our products, our earnings and operating cash flows would be harmed. Competition - The intensity of competition in the industries in which we operate could result in downward pressure on pricing and volume, which could lower earnings and operating cash flows. Our industries are highly competitive, with no single containerboard, corrugated packaging, or UFS paper producer having a dominant position. Containerboard and commodity UFS paper products cannot generally be differentiated by producer, which tends to intensify price competition. The corrugated packaging industry is also sensitive to changes in economic conditions, as well as other factors including innovation, 10 design, quality, and service. To the extent that one or more competitors are more successful than we are with respect to any key competitive factor, our business could be adversely affected. Our packaging products also compete, to some extent, with various other packaging materials, including products made of paper, plastics, wood, and various types of metal. If we are unable to successfully compete, we may lose market share or may be required to charge lower sales prices for our products, both of which would reduce our earnings and operating cash flows. UFS paper products compete with electronic data transmission and document storage alternatives. Increasing shifts to electronic alternatives have had and will continue to have an adverse effect on usage of these products. As a result of such competition, the industry is experiencing decreasing demand for existing UFS paper products. As the use of these alternatives grows, demand for UFS paper products is likely to further decline. Declines in demand for our paper products may adversely affect our earnings and operating cash flows. Some of our competitors are larger than we are and may have greater financial and other resources, greater manufacturing economies of scale, greater energy self-sufficiency, or lower operating costs, compared to our company. We may be unable to compete effectively with these companies particularly during economic downturns. Some of the factors that may adversely affect our ability to compete in the markets in which we participate include the entry of new competitors into the markets we serve, increased competition from overseas producers, our competitors' pricing strategies, changes in customer preferences, and the cost-efficiency of our facilities. Cost of Fiber - An increase in the cost of fiber could increase our manufacturing costs and lower our earnings. The market price of wood fiber varies based upon availability, source, and the costs of fuels used in the harvesting and transportation of wood fiber. The cost and availability of wood fiber can also be impacted by weather, general logging conditions, geography, and regulatory activity. The availability and cost of recycled fiber depends heavily on recycling rates and the domestic and global demand for recycled products. We purchase recycled fiber for use at five of our six containerboard mills and both paper mills. In 2020, we purchased approximately 725,000 tons of recycled fiber, net of the recycled fiber generated by our corrugated box plants. The amount of recycled fiber purchased each year varies based upon production and the prices of both recycled fiber and wood fiber. Periods of supply and demand imbalance have created significant price volatility. Periods of higher recycled fiber costs and unusual price volatility have occurred in the past, including during 2020 as demand for domestic recycled fiber from Chinese producers continued to remain low. Prices for recycled fiber may continue to fluctuate significantly in the future, which could result in higher costs and lower earnings. A $10 per ton price increase in recycled fiber for our containerboard mills would result in approximately $7 million of additional expense based on 2020 consumption. Cost of Purchased Fuels and Chemicals - An increase in the cost of purchased fuels and chemicals could lead to higher manufacturing costs, resulting in reduced earnings. We have the ability to use various types of purchased fuels in our manufacturing operations, including natural gas, bark, and other purchased fuels. Fuel prices, in particular prices for oil and natural gas, have fluctuated in the past. New and more stringent environmental regulations may discourage, reduce the availability of, or make more expensive, the use of certain fuels, particularly coal and fossil fuels. In addition, costs for key chemicals used in our manufacturing operations also fluctuate. These fluctuations impact our manufacturing costs and result in earnings volatility. If fuel and chemical prices rise, our production costs and transportation costs will increase and cause higher manufacturing costs and reduced earnings if we are unable to recover such increases through higher prices of our products. A $0.10 per million MMBTU increase in natural gas prices would result in approximately $3 million of additional expense, based on 2020 usage. Customer Concentration - We rely on certain large customers. Our packaging and paper segments each have large customers, the loss of which could adversely affect the segment’s sales and profitability. In particular, because our businesses operate in highly competitive industry segments, we regularly bid for new business or for renewal of existing business. The loss of business from our larger customers, or the renewal of business on less favorable terms, may adversely impact our financial results. Office Depot, Inc. is our largest customer in the Paper segment. Effective January 1, 2020, we have a revised agreement with Office Depot in which we will continue to supply commodity and non-commodity office papers to Office Depot through December 31, 2022. Office Depot is not subject to a minimum volume commitment and is entitled to receive rebates for achieving certain volume thresholds. If the agreement is not renewed by the parties, Office Depot’s obligation to purchase paper would phase down over a two-year period beginning on January 1, 2023. 11 In 2020, sales to Office Depot represented 45% of our Paper segment sales and 5% of our consolidated sales. If these sales are reduced, including if we are unable to renew the agreement at historical volume levels, we would need to find new customers. We may not be able to fully replace any lost sales, and any new sales may be at lower prices or higher costs. Any significant deterioration in the financial condition of Office Depot affecting its ability to pay or any other change that makes Office Depot less willing to purchase our products will harm our business and results of operations. Transportation Costs - Reduced truck and rail availability could lead to higher costs or poorer service, resulting in lower earnings, and harm our ability to distribute our products. We ship our products primarily by truck and rail. We have experienced lower availability of third-party trucking services and service issues, interruptions, and delays in rail services. We have also experienced higher costs for transportation services in general. If these factors persist, we could experience even higher transportation costs in the future and difficulties shipping our products in a timely manner. We may not be able to recover higher transportation costs through higher prices or otherwise, which would result in lower earnings. Material Disruption of Manufacturing - A material disruption at one of our manufacturing facilities could prevent us from meeting customer demand, reduce our sales, and/or negatively affect our results of operations and financial condition. Our business depends on continuous operation of our facilities, particularly at our mills. Any of our manufacturing facilities, or any of our machines within such facilities, could cease operations unexpectedly for a significant period of time due to a number of events, including: • Unscheduled maintenance outages. • Prolonged power failures. • Equipment or information system breakdowns or failures. • Explosion of a boiler or other major facilities. • Disruption in the supply of raw materials, such as wood fiber, energy, or chemicals. • A spill or release of pollutants or hazardous substances. • Closure or curtailment related to environmental concerns. • Labor difficulties. • Disruptions in the transportation infrastructure, including roads, bridges, railroad tracks, and tunnels. • Fires, floods, earthquakes, hurricanes, or other catastrophic events. • Terrorism or threats of terrorism. • Other operational problems. These events could harm our ability to produce our products and serve our customers and may lead to higher costs and reduced earnings. Reliance on Personnel - We may fail to attract and retain qualified personnel, including key management personnel. Our ability to operate and grow our business depends on our ability to attract and retain employees with the skills necessary to operate and maintain our facilities, produce our products and serve our customers. The increasing demand for qualified personnel may make it more difficult for us to attract and retain qualified employees. Changing demographics and labor work force trends may make it difficult for us to replace retiring employees at our manufacturing and other facilities. If we fail to attract and retain qualified personnel, or if we experience labor shortages, we may experience higher costs and other difficulties, and our business may be adversely impacted. In addition, we rely on key executive and management personnel to manage our business efficiently and effectively. As our business has grown in size and geographic scope, we have relied on these individuals to manage increasingly complex operations. The loss of any of our key personnel could adversely affect our business. Cyber Security - Risks related to security breaches of company, customer, employee, and vendor information, as well as the technology that manages our operations and other business processes, could adversely affect our business. We rely on various information technology systems to capture, process, store, and report data and interact with customers, vendors, and employees. Despite careful security and controls design, implementation, updating, and internal and independent third-party assessments, our information technology systems, and those of our third party providers, could become subject to cyber-attacks or security breaches. Network, system, and data breaches could result in misappropriation of sensitive data or operational 12 disruptions including interruption to systems availability and denial of access to and misuse of applications required by our customers to conduct business with us. Misuse of internal applications; theft of intellectual property, trade secrets, or other corporate assets; and inappropriate disclosure of confidential information could stem from such incidents. Delayed sales, slowed production, or other issues resulting from these disruptions could result in lost sales, business delays, and negative publicity and could have a material adverse effect on our operations, financial condition, or operating cash flows. Environmental Matters - PCA may incur significant environmental liabilities with respect to both past and future operations. We are subject to, and must comply with, a variety of federal, state and local environmental laws, particularly those relating to air and water quality, waste disposal and the cleanup of contaminated soil and groundwater. Failure to comply with these regulations could result in fines, which may be significant, or other adverse regulatory action. Because environmental regulations are constantly evolving, we have incurred, and will continue to incur, costs to maintain compliance with those laws. See Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Environmental Matters” for estimates of expenditures we expect to make for environmental compliance in the next few years. New and more stringent environmental regulations may be adopted and may require us to incur additional operating expenses and/or significant additional capital expenditures to modify or replace certain of our boilers and other equipment. In addition, environmental regulations may increase the cost of our raw materials and purchased energy. Although we have established reserves to provide for known environmental liabilities, these reserves may change over time due to the enactment of new environmental laws or regulations or changes in existing laws or regulations, which might require additional significant environmental expenditures. Labor Relations- If we experience strikes or other work stoppages, our business will be harmed. Our workforce is highly unionized and operates under various collective bargaining agreements. We must negotiate to renew or extend any union contracts that have recently expired or are expiring in the near future. While we believe that we have satisfactory labor relations, we may not be able to successfully negotiate new agreements without work stoppages or labor difficulties in the future or renegotiate them on favorable terms. If we are unable to successfully renegotiate the terms of any of these agreements, or if we experience any extended interruption of operations at any of our facilities as a result of strikes or other work stoppages, our business, results of operations and financial condition may be harmed. Financial Risks General Economic Conditions - If business, political, and economic conditions change in an adverse manner, our business, results of operations, liquidity, and financial position may be harmed. General global and domestic economic conditions directly affect the levels of demand and production of consumer goods, levels of employment, the availability and cost of credit, and ultimately, the profitability of our business. If economic conditions deteriorate and result in higher unemployment rates, lower disposable income, unfavorable currency exchange rates, lower corporate earnings, lower business investment, and lower consumer spending, we may experience lower demand for our products, which is largely driven by demand for products of our customers which utilize our products. If economic conditions result in higher inflation, we may experience higher production and transportation costs, which we may not be able to recover through higher prices or otherwise. In addition, changes in trade policy, including renegotiating or potentially terminating existing bilateral or multilateral agreements as well as the imposition of tariffs, could impact global markets and demand for our and our customers’ products and the costs associated with certain of our capital investments. Further changes in tax laws or tax rates may have a material impact on our future cash taxes, effective tax rate or deferred tax assets and liabilities. These conditions are beyond our control and may have a material impact on our business, results of operations, liquidity, and financial position. Inflation and Other General Cost Increases - We may not be able to offset higher costs. We are subject to both contractual, inflationary, and other general cost increases, including with regard to our labor costs and purchases of raw materials and transportation services. General economic conditions may result in higher inflation, which may increase our exposure to higher costs. If we are unable to offset these cost increases by price increases, growth, and/or cost reductions in our operations, these inflationary and other general cost increases could have a material adverse effect on our operating cash flows, profitability, and liquidity. In 2020, our total company costs including cost of sales (COS) and selling, general, and administrative expenses (SG&A) was $5.8 billion, and excluding non-cash costs (depreciation, depletion and amortization, pension and postretirement expense, and share-based compensation expense) was $5.4 billion. A 1% increase in COS and SG&A costs would increase costs by $58 million and cash costs by $54 million. 13 Debt obligations - Our debt service obligations may reduce our operating flexibility. At December 31, 2020, we had $2.5 billion of debt outstanding and a $326.3 million undrawn revolving credit facility, after deducting letters of credit. All debt is comprised of fixed-rate senior notes. We and our subsidiaries are not restricted from incurring, and may incur, additional indebtedness in the future. Our current borrowings, plus any future borrowings, may affect our ability to operate our business, including, without limitation: • Result in significant cash requirements to make interest and maturity payments on our outstanding indebtedness; • Increase our vulnerability to adverse changes in our business or industry conditions; • Increase our vulnerability to increases in interest rates; • Limit our ability to obtain additional financing for working capital, capital expenditures, general corporate, and other purposes; • Limit our flexibility in planning for, or reacting to, changes in our business and our industry; and • Limit our flexibility to make acquisitions. Further, if we cannot service our indebtedness, we may have to take actions to secure additional cash by selling assets, seeking additional equity or reducing investments, which may not be achievable on acceptable terms or at all. Pension Plans – Our pension plans may require additional funding. We record a liability associated with our pensions equal to the excess of the benefit obligations over the fair value of the assets funding the plans. The actual required amounts and timing of future cash contributions will be sensitive to changes in the applicable discount rates and returns on plan assets, and could also be impacted by future changes in the laws and regulations applicable to plan funding. Fluctuations in the market performance of our plan assets will affect our pension plan costs in future periods. Changes in assumptions regarding expected long-term rate of return on plan assets, our discount rate, expected compensation levels, or mortality will also increase or decrease pension costs. Market Price of our Common Stock - The market price of our common stock may be volatile, which could cause the value of the stock to decline. Securities markets worldwide periodically experience significant price declines and volume fluctuations due to macroeconomic factors and other factors beyond our control. This market volatility, as well as general economic, market, or political conditions, could reduce the market price of our common stock with little regard to our operating performance. In addition, our operating results could be below the expectations of public market analysts and investors, and in response, the market price of our common stock could decrease significantly. Item 1B. UNRESOLVED STAFF COMMENTS None. Item 2. PROPERTIES We own and lease properties in our business. Primarily all of our leases are non-cancelable and are accounted for as operating leases. These leases are not subject to early termination except for standard nonperformance clauses. Information regarding our principal operating facilities, the segments that use those facilities, and a map of geographical locations is presented in “Part I, Item 1. Business” of this Form 10-K. We assess the condition and capacity of our manufacturing, distribution, and other facilities needed to meet our operating requirements. Our properties have been generally well maintained and are in good operating condition. In general, our facilities have sufficient capacity and are adequate for our production and distribution requirements. We currently own buildings and land for six containerboard mills and two paper mills. Additionally, we have 90 corrugated manufacturing operations, of which the buildings and land for 52 are owned, including 44 combining operations, or corrugated plants, one corrugated sheet-only manufacturer, and seven sheet plants. We lease the buildings for 14 corrugated plants and 24 sheet plants. We own warehouses and miscellaneous other properties, including sales offices and woodlands management offices. We lease space for regional design centers and numerous other distribution centers, warehouses, and facilities. The equipment in these leased facilities is, in virtually all cases, owned by us, except for forklifts and other rolling stock, which are generally leased. 14 We lease the cutting rights to approximately 71,000 acres of timberland located near our Valdosta mill (64,000 acres) and our Counce mill (7,000 acres). On average, these cutting rights agreements have terms with approximately 17 years remaining. We own our corporate headquarters building, which is located in Lake Forest, Illinois. Item 3. LEGAL PROCEEDINGS Information concerning legal proceedings can be found in Note 20, Commitments, Guarantees, Indemnifications, and Legal Proceedings, of the Notes to Consolidated Financial Statements in “Part II,
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+ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF=OPERATIONSForward-looking statementsThis report contains statements that we believe to be “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. All statements, other than statements of historical fact are forward-looking statements. Without limitation, any statements preceded or followed by or that include the words “targets,” “plans,” “believes,” “expects,” “intends,” “will,” “likely,” “may,” “anticipates,” “estimates,” “projects,” “should,” “would,” “could,” “positioned,” “strategy,” “future” or words, phrases or terms of similar substance or the negative thereof, are forward-looking statements. These forward-looking statements are not guarantees of future performance and are subject to risks, uncertainties, assumptions and other factors, some of which are beyond our control, which could cause actual results to differ materially from those expressed or implied by such forward-looking statements. These factors include the overall impact of the COVID-19 pandemic on our business; the duration and severity of the COVID-19 pandemic; actions that may be taken by us, other businesses and governments to address or otherwise mitigate the impact of the COVID-19 pandemic, including those that may impact our ability to operate our facilities, meet production demands, and deliver products to our customers; the negative impacts of the COVID-19 pandemic on the global economy, our customers and suppliers, and customer demand; overall global economic and business conditions impacting our business, including the strength of housing and related markets; demand, competition and pricing pressures in the markets we serve; volatility in currency exchange rates; failure of markets to accept new product introductions and enhancements; the ability to successfully identify, finance, complete and integrate acquisitions; the ability to achieve the benefits of our restructuring plans and cost reduction initiatives; risks associated with operating foreign businesses; the impact of material cost and other inflation; the impact of seasonality of sales and weather conditions; our ability to comply with laws and regulations; the impact of changes in laws, regulations and administrative policy, including those that limit U.S. tax benefits or impact trade agreements and tariffs; the outcome of litigation and governmental proceedings; and the ability to achieve our long-term strategic operating goals. Additional information concerning these and other factors is contained in our filings with the U.S. Securities and Exchange Commission (the “SEC”), including this Annual Report on Form 10-K. All forward-looking statements speak only as of the date of this report. Pentair assumes no obligation, and disclaims any obligation, to update the information contained in this report.OverviewPentair plc and its consolidated subsidiaries (“we,” “us,” “our,” “Pentair” or the “Company”) is a pure play water industrial manufacturing company comprised of two reporting segments: Consumer Solutions and Industrial & Flow Technologies. We classify our operations into business segments based primarily on types of products offered and markets served. For the year ended December 31, 2020, the Consumer Solutions and Industrial & Flow Technologies segments represented approximately 58% and 42% of total revenues, respectively.Although our jurisdiction of organization is Ireland, we manage our affairs so that we are centrally managed and controlled in the United Kingdom (the “U.K.”) and therefore have our tax residency in the U.K. On April 30, 2018, we completed the separation of our Electrical business from the rest of Pentair (the “Separation”) by means of a dividend in specie of the Electrical business, which was effected by the transfer of the Electrical business from Pentair to nVent and the issuance by nVent of nVent ordinary shares directly to Pentair shareholders (the “Distribution”). We did not retain an equity interest in nVent. The results of the Electrical business have been presented as discontinued operations for all periods presented. The Electrical business was previously disclosed as a stand-alone reporting segment.In February 2019, as part of Consumer Solutions, we completed the acquisitions of Aquion, Inc. (“Aquion”) and Pelican Water Systems (“Pelican”) for $163.4 million and $121.1 million, respectively, in cash, net of cash acquired and final working capital true-ups. Aquion offers a diverse line of water conditioners, water filters, drinking-water purifiers, ozone and ultraviolet disinfection systems, reverse osmosis systems and acid neutralizers for the residential and commercial water treatment industry. Pelican provides residential whole home water treatment systems.COVID-19 PandemicIn March 2020, the World Health Organization declared the COVID-19 outbreak a pandemic. The COVID-19 pandemic continues to spread throughout the United States (“U.S.”) and the world, with the continued potential for significant impact. The COVID-19 pandemic has resulted in governments around the world implementing increasingly stringent measures to help control the spread of the virus, including quarantines, “shelter-in-place” and “stay-at-home” orders, travel restrictions, business curtailments, limits on gatherings, and other measures. In addition, governments and central banks in several parts of the world have enacted fiscal and monetary stimulus measures to counteract the economic impacts of the COVID-19 pandemic. The effects of the COVID-19 pandemic have had and may continue to have an unfavorable impact on certain parts of our business.22Health and safetyFrom the earliest signs of the outbreak, we have taken proactive action to protect the health and safety of our employees, customers, and suppliers. We have enacted rigorous safety measures in our sites, including implementing social distancing protocols, implementing working from home arrangements for those employees who do not need to be physically present on the manufacturing floor and do not provide manufacturing-support activities, suspending travel, extensively and frequently disinfecting our workspaces, conducting temperature monitoring at our facilities, and providing or accommodating the wearing of facial coverings to those employees who must be physically present in their workplace and where facial coverings are required by local government orders. We expect to continue to implement these measures until we determine that the COVID-19 pandemic is adequately contained for purposes of our business, and we may take further actions as government authorities require or recommend or as we determine to be in the best interests of our employees, customers, and suppliers. For the year ended December 31, 2020, we incurred $10.4 million of costs related to providing for the health and safety of our employees specific to the COVID-19 pandemic. OperationsWe have important manufacturing operations in the U.S. and around the world that have been affected by the COVID-19 pandemic, and we have taken certain actions to help curb its spread. Government-mandated measures providing for business curtailments or shutdowns generally exclude certain essential businesses and services, including businesses that manufacture and sell products that are considered essential to daily lives or otherwise operate in essential or critical sectors. While substantially all of our manufacturing facilities are considered essential and have remained operational, we have experienced intermittent partial or full factory closures at certain facilities as a result of these measures or the need to sanitize the facilities and address employee well-being. We also experienced brief interruptions in operations due to government-mandated shutdowns at our sites in India, Italy, and New Zealand during the year ended December 31, 2020. While sanitation-related closures or governmental shutdowns may occur again in the future, all of our manufacturing facilities currently remain operational. In addition, we have experienced disruptions at some of our facilities with higher absenteeism due to the COVID-19 pandemic. SupplyThe COVID-19 pandemic has impacted our factory productivity and supply chain. Certain of our suppliers, particularly in our pool and flow businesses, faced difficulties maintaining operations in light of manufacturing shutdowns and interruptions due to the COVID-19 pandemic, which negatively impacted our production and contributed to an increase in backlog. During the third quarter of 2020, we identified second source suppliers and increased supply for key items in our pool business to reduce the production and capacity challenges we encountered in the second quarter of 2020 as a result of supply chain issues and increased demand. These supply chain and capacity challenges have led to higher transportation and labor costs in order to timely deliver finished goods to our customers. Restrictions or disruptions of transportation, such as reduced availability of air transport, port closures and increased border controls or closures, have in certain cases resulted, and may continue to result, in higher costs and delays, both for obtaining raw materials and components and shipping finished goods to customers, which could harm our profitability, make our products less competitive, or cause our customers to seek alternative suppliers. Although we regularly monitor the financial health and operations of companies in our supply chain, and use alternative suppliers when necessary and available, financial hardship or government restrictions on our suppliers or sub-suppliers caused by the COVID-19 pandemic could cause a disruption in our ability to obtain raw materials or components required to manufacture our products and adversely affect our operations. DemandThe COVID-19 pandemic has significantly increased economic and demand uncertainty. We have experienced and expect to continue to experience reductions in customer demand in several of our end-markets. Within our Consumer Solutions segment, the COVID-19 pandemic has impacted demand in each of our businesses. Our pool business has experienced high demand as consumers sheltered-in-place and have spent more time at home. While shelter-in-place orders impacted our ability to reach our customers in our residential water treatment business at the beginning of the second quarter of 2020, we started to see stabilization in demand in this business towards the end of the second quarter and then saw demand rebound in the second half of 2020 as consumers became more comfortable allowing dealers back into their homes to test their water and install new systems. Our commercial filtration business was negatively impacted by restaurant and hospitality industry closures or operations at limited capacity across North America and Europe in the second quarter and to a lesser extent in the second half of 2020. New or extended government-mandated shutdowns could impact demand for our Consumer Solutions products in the future. 23Within our Industrial & Flow Technologies segment, demand for our residential flow products was initially negatively impacted due to store closures as a result of state-wide orders in the U.S. However, sell through improved throughout the year driven by pent up demand from the earlier closures. Demand continued to remain soft in our commercial and infrastructure flow businesses, but stabilized in the third quarter of 2020. In our industrial filtration business, demand is mostly driven by customer capital spending, which was reduced and/or delayed beginning in the second quarter of 2020 across most industries served. In addition, lower asset utilization drove down demand in industrial filtration aftermarket sales. Furthermore, many of our commercial customers have been negatively impacted due to worldwide lockdowns as a result of the COVID-19 pandemic. While we are preparing for this business to remain under pressure in the near term, we expect long-term demand drivers for this business not to be significantly changed. The current COVID-19 pandemic or continued spread of COVID-19 has caused a global economic slowdown, and a possibility of a global recession. In the event of a recession, demand for our products would decline and our business and results of operations would be adversely affected.Cost mitigation actionsWith the continuing uncertainty in light of the COVID-19 pandemic, we have taken steps across our organization to align costs with lower sales volumes. These steps include renegotiation with suppliers to reduce input costs, driving manufacturing direct labor reductions in line with volume drop, delaying, reducing or eliminating purchased services and travel and, where appropriate, temporary furloughs and hiring freezes. Additionally, we are proactively managing our working capital and reviewing our capital spending plan, but have not deferred strategic ongoing initiatives. We also continue to monitor government economic stabilization efforts and have participated in certain legislative provisions, such as deferring estimated tax payments, and may apply for job retention credits.We continue to monitor the rapidly evolving situation including the development of vaccines and their distribution to address the COVID-19 virus and guidance from international and domestic authorities, including federal, state and local public health authorities, and may take additional actions based on their requirements and recommendations. In these circumstances, there may be developments outside our control requiring us to adjust our operating plan. As such, given the dynamic nature of this situation, we cannot reasonably estimate the impacts of the COVID-19 pandemic on our financial condition, results of operations or cash flows in the future. In addition, see Part I—ITEM 1A, “Risk Factors,” included herein for our risk factors regarding risks associated with the COVID-19 pandemic.Key Trends and Uncertainties Regarding Our Existing BusinessThe following trends and uncertainties affected our financial performance in 2020, and will likely impact our results in the future:•There are many uncertainties regarding the COVID-19 pandemic, including the anticipated duration and severity of the pandemic, the extent of worldwide social, political and economic disruption it may continue to cause and the development and distribution of vaccines to address the COVID-19 virus. The broader implications of the COVID-19 pandemic on our business, financial condition, results of operations and cash flows cannot be determined at this time, and ultimately will be affected by a number of evolving factors including the length of time that the pandemic continues and the impact of vaccines on it, its effect on the demand for our products and services, our supply chain, and our manufacturing capacity, as well as the impact of governmental regulations imposed in response to the pandemic. See further discussion above under “COVID-19 Pandemic” for key trends and uncertainties with regard to the COVID-19 pandemic. •During 2020, we executed certain business restructuring initiatives unrelated to the COVID-19 pandemic aimed at reducing our fixed cost structure and realigning our business. We expect these actions to continue into 2021 and to drive margin growth.•We have identified specific product and geographic market opportunities that we find attractive and continue to pursue, both within and outside the U.S. We are reinforcing that our businesses more effectively address these opportunities through research and development and additional sales and marketing resources. Unless we successfully penetrate these markets, our core sales growth will likely be limited or may decline.•We have experienced material and other cost inflation. We strive for productivity improvements, and we implement increases in selling prices to help mitigate this inflation. We expect the current economic environment will result in continuing price volatility for many of our raw materials, and we are uncertain as to the timing and impact of these market changes.24In 2021, our operating objectives remain to focus on delivering our core while continuing to build out our future. We expect to execute these objectives by:•Delivering revenue growth in our core businesses; •Delivering income and cash by managing price/cost inflation, prioritization of growth investments and addressing the cost structures as necessary;•Continued focus on capital allocation through:◦Commitment to maintain our investment grade rating;◦Return cash to shareholders through dividends and buybacks; and◦Supplement our business with strategically-aligned mergers and acquisitions.•Focused growth initiatives that accelerate our investments in digital, technology and services expansion; and•Building a high performance growth culture and delivering on our commitments while living our Win Right values.CONSOLIDATED RESULTS OF OPERATIONSThe consolidated results of operations were as follows:Years ended December 31% / point changeIn millions2020201920182020 vs 20192019 vs 2018Net sales$3,017.8 $2,957.2 $2,965.1 2.0 %(0.3)%Cost of goods sold1,960.2 1,905.7 1,917.4 2.9 %(0.6)%Gross profit1,057.6 1,051.5 1,047.7 0.6 %0.4 %% of net sales35.0 %35.6 %35.3 %(0.6) pts0.3 ptsSelling, general and administrative520.5 540.1 534.3 (3.6)%1.1 %% of net sales17.2 %18.3 %18.0 %(1.1) pts0.3 ptsResearch and development75.7 78.9 76.7 (4.1)%2.9 %% of net sales2.5 %2.7 %2.6 %(0.2) pts0.1 ptsOperating income461.4 432.5 436.7 6.7 %(1.0)%% of net sales15.3 %14.6 %14.7 %0.7 pts(0.1) ptsLoss (gain) on sale of businesses0.1 (2.2)7.3 N.M.N.M.Loss on early extinguishment of debt— — 17.1 N.M.N.M.Net interest expense23.9 30.1 32.6 (20.6)%(7.7)%Other expense (income)5.3 (2.9)(0.1)N.M.N.M.Income from continuing operations before income taxes432.1 407.5 379.8 6.0 %7.3 %Provision for income taxes75.0 45.8 58.1 63.8 %(21.2) % Effective tax rate17.4 %11.2 %15.3 %6.2 pts(4.1) ptsN.M. Not Meaningful25Net salesThe components of the consolidated net sales change were as follows:2020 vs 20192019 vs 2018Volume0.4 %(3.9)%Price0.9 2.6 Core growth1.3 (1.3)Acquisition0.5 2.5 Currency0.2 (1.5)Total2.0 %(0.3)%The 2.0 percent increase in consolidated net sales in 2020 from 2019 was primarily the result of:•selective increases in selling prices to mitigate inflationary cost increases;•increased sales due to the Aquion and Pelican acquisitions in February 2019 and other small acquisitions in our Consumer Solutions segment in the fourth quarter of 2019 and first half of 2020; •volume increase in our Consumer Solutions segment mainly driven by our pool business;•volume increase in our residential and irrigation flow businesses in our Industrial & Flow Technologies segment; and •favorable foreign currency effects in 2020 compared to the prior year.This increase was partially offset by:•sales volume declines in certain businesses within our Industrial & Flow Technologies segment due to the impacts of the COVID-19 pandemic.Gross profit The 0.6 percentage point decrease in gross profit as a percentage of net sales in 2020 from 2019 was primarily the result of:•unfavorable mix within the pool and commercial and infrastructure flow businesses;•lower volumes within our commercial water supply, water disposal, industrial filtration and food and beverage businesses;•higher transportation and labor costs due to increased demand in our pool business; •costs related to providing for the health and safety of our employees specific to the COVID-19 pandemic of $8.6 million for the year ended December 31, 2020; and •inflationary increases related to certain raw materials.This decrease was partially offset by:•increased productivity due to higher volumes in our pool business; •selective increases in selling prices to mitigate impacts of inflation; and•increased productivity due to cost actions such as temporary furloughs and hiring freezes in response to the COVID-19 pandemic driving manufacturing efficiencies and lower operating expenses.Selling, general and administrative (“SG&A”) The 1.1 percentage point decrease in SG&A expense as a percentage of net sales in 2020 from 2019 was driven by:•asset impairment charges of $21.2 million in 2019;•reduction in travel and entertainment, trade show and advertising expenses due to the COVID-19 pandemic; and•restructuring and other costs of $15.4 million in 2020, compared to $21.0 million in 2019.26This decrease was partially offset by:•higher employee compensation incentive expense compared to the prior year. Net interest expenseThe 20.6 percent decrease in net interest expense in 2020 from 2019 was the result of:•cross currency swaps entered into in June 2019 and December 2019 resulting in more interest income in 2020 than in the prior period; •lower interest rate revolving credit facilities replacing higher interest rate fixed rate debt that matured during the second half of 2019; and•strong cash flows in 2020 leading to lower overall debt levels.Provision for income taxesThe 6.2 percentage point increase in the effective tax rate in 2020 from 2019 was primarily due to:•the unfavorable impact of discrete items, including items related to the CARES Act, and items related to final regulations as part of the Tax Cuts and Jobs Act of 2017 that place limitations on the deductibility of certain interest expense for U.S. tax purposes.2019 Comparison with 2018A discussion of changes in our consolidated results of operations and liquidity and capital resources from the year ended December 31, 2019 to December 31, 2018 can be found in Part II, ITEM 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations of our Annual Report on Form 10-K for the year ended December 31, 2019, which was filed with the SEC on February 25, 2020. However, such discussion is not incorporated by reference into, and does not constitute a part of, this Annual Report on Form 10-K.SEGMENT RESULTS OF OPERATIONSThe summary that follows provides a discussion of the results of operations of our two reportable segments (Consumer Solutions and Industrial & Flow Technologies). Each of these segments is comprised of various product offerings that serve multiple end users.We evaluate performance based on net sales and segment income and use a variety of ratios to measure performance of our reporting segments. Segment income represents equity income of unconsolidated subsidiaries and operating income exclusive of intangible amortization, certain acquisition related expenses, costs of restructuring activities, impairments and other unusual non-operating items.Consumer SolutionsThe net sales and segment income for Consumer Solutions were as follows:Years ended December 31% / point changeIn millions2020201920182020 vs 20192019 vs 2018Net sales$1,742.9 $1,611.7 $1,578.4 8.1 %2.1 %Segment income419.1 379.6 392.9 10.4 %(3.4)%% of net sales24.0 %23.6 %24.9 %0.4 pts(1.3) pts27Net salesThe components of the change in Consumer Solutions net sales were as follows:2020 vs 20192019 vs 2018Volume6.3 %(6.2)%Price0.8 3.3 Core growth7.1 (2.9)Acquisition1.0 5.8 Currency— (0.8)Total8.1 %2.1 %The 8.1 percent increase in net sales for Consumer Solutions in 2020 from 2019 was primarily the result of:•increased sales volume across several of the product lines in our pool business due to consumers’ desire to invest in their pools and backyards while sheltering-in-place due to the COVID-19 pandemic;•higher sales volumes in our residential filtration product lines in North America and China during the second half of 2020;•selective increases in selling prices to mitigate impacts of inflation; and•increased sales due to the Aquion and Pelican acquisitions that occurred in February 2019 and other small acquisitions in the fourth quarter of 2019 and during 2020. This increase was partially offset by:•sales decreases for 2020 due to lower demand in the water treatment business as government-mandated shutdown and shelter-in-place orders and commercial closures due to the COVID-19 pandemic impacting the ability to reach customers; and•higher-than-usual rebate activity that lowered price due to sales growth in our pool business.The 2.1 percent increase in net sales for Consumer Solutions in 2019 from 2018 was primarily the result of:•increased sales due to the acquisitions of Aquion and Pelican in the first quarter of 2019; and•selective increases in selling prices to mitigate inflationary cost increases.This increase was partially offset by:•sales volume declines in our pool business due to cold, wet weather during the first half of 2019 in key markets; •higher than anticipated inventory levels in some of our key distribution channels impacting our pool business during the first nine months of 2019; •sales volume declines in our residential and commercial components business; and•unfavorable foreign currency effects compared to the same period of the prior year.28Segment income The components of the change in Consumer Solutions segment income from the prior period were as follows:20202019Growth1.1 pts(1.4) ptsAcquisition (divestiture)0.4 (0.4)Inflation(1.3)(2.9)Productivity/Price0.2 3.4 Total0.4 pts(1.3) ptsThe 0.4 percentage point increase in segment income for Consumer Solutions as a percentage of net sales in 2020 from 2019 was primarily the result of:•increased sales volume in our pool business;•reduction in travel and entertainment, trade show and advertising expenses due to the COVID-19 pandemic and other cost reduction initiatives; •impact of Aquion and Pelican acquisitions; and•selective increases in selling prices to mitigate the impacts of inflation.This increase was partially offset by:•lower sales volume in the higher margin commercial filtration business; •higher sales rebates and employee incentive compensation expense in line with increased sales in our pool business;•higher transportation and labor costs due to increased demand in our pool business; and•inflationary increases related to certain raw materials.The 1.3 percentage point decrease in segment income for Consumer Solutions as a percentage of net sales in 2019 from 2018 was primarily the result of:•declines in core sales volume in our pool business resulting in unfavorable sales mix; •increased investment in both research and development and sales and marketing to drive growth; and•inflationary increases related to raw material and labor costs.This decrease was partially offset by:•selective increases in selling prices to mitigate inflationary cost increases; and•productivity and cost savings generated from PIMS initiatives, including lean and supply management practices.Industrial & Flow TechnologiesThe net sales and segment income for Industrial & Flow Technologies were as follows:Years ended December 31% / point changeIn millions2020201920182020 vs 20192019 vs 2018Net sales$1,273.6 $1,344.1 $1,385.4 (5.2)%(3.0)%Segment income164.6 199.0 198.8 (17.3)%0.1 %% of net sales12.9 %14.8 %14.3 %(1.9) pts0.5 pts29Net salesThe components of the change in Industrial & Flow Technologies net sales were as follows:2020 vs 20192019 vs 2018Volume(6.5)%(1.4)%Price0.9 1.9 Core growth(5.6)0.5 Acquisition (divestiture)— (1.3)Currency0.4 (2.2)Total(5.2)%(3.0)%The 5.2 percent decrease in net sales for Industrial & Flow Technologies in 2020 from 2019 was primarily the result of:•decreased sales volume in our commercial water supply and water disposal, industrial filtration and food and beverage businesses due to less project sales as a result of customers deferring their capital spending and less service and aftermarket revenue driven by reduced consumption and travel restrictions from government-mandated shutdowns and “shelter-in-place” orders due to the COVID-19 pandemic; •decreased sales volume in our residential and irrigation flow businesses in the first half of 2020 due to market conditions resulting from the COVID-19 pandemic.This decrease was partially offset by:•increased sales volume in our residential and irrigation flow businesses in the second half of 2020 due to strong demand in the residential water supply, water disposal and specialty spray product lines;•sales growth in our infrastructure business as a result of strong backlog entering 2020; •selective increases in selling prices to mitigate inflationary cost increases; and•favorable foreign currency effects compared to the same period of the prior year.The 3.0 percent decrease in net sales for Industrial & Flow Technologies in 2019 from 2018 was primarily the result of:•decreased sales volume in our agriculture-related business due to cold, wet weather in the first half of 2019;•unfavorable foreign currency effects compared to the same period of the prior year; and•the impact of divestitures in our agriculture-related business in Brazil and commercial flow business in Australia.This decrease was partially offset by:•increased sales volume in our industrial filtration and food and beverage businesses; and •selective increases in selling prices to mitigate inflationary cost increases.Segment income The components of the change in Industrial & Flow Technologies segment income from the prior period were as follows:20202019Growth(2.5) pts0.4 ptsInflation(1.0)(2.5)Productivity/Price1.6 2.6 Total(1.9) pts0.5 ptsThe 1.9 percentage point decrease in segment income for Industrial & Flow Technologies as a percentage of net sales in 2020 from 2019 was primarily the result of:•decreased sales volumes in our residential and irrigation flow business in the first half of 2020 due to the COVID-19 pandemic, which resulted in decreased leverage on fixed operating expenses; 30•decreased sales volume in our commercial water supply and water disposal, industrial filtration and food and beverage businesses due to the COVID-19 pandemic along with unfavorable mix within our commercial and infrastructure flow and industrial filtration businesses; and•inflationary increases related to raw material and labor costs.This decrease was partially offset by:•selective increases in selling prices to mitigate inflationary cost increases; •lower sales incentive expense in line with decreased sales; and•increased productivity due to cost actions driving manufacturing efficiencies and lower operating expenses.The 0.5 percentage point increase in segment income for Industrial & Flow Technologies as a percentage of net sales in 2019 from 2018 was primarily the result of:•selective increases in selling prices to mitigate inflationary cost increases; •increased productivity; and•increased volume and favorable mix in our industrial filtration and food and beverage businesses.This increase was partially offset by:•inflationary increases related to raw material and labor costs.BACKLOG OF ORDERS BY SEGMENT December 31In millions20202019$ change% changeConsumer Solutions$459.1 $138.2 $320.9 232.2 %Industrial & Flow Technologies288.7 251.2 37.5 14.9 %Total$747.8 $389.4 $358.4 92.0 %A substantial portion of our revenues result from orders received and products delivered in the same month. Our backlog typically has a short manufacturing cycle and products generally ship within 90 days of the date on which a customer places an order. However, a portion of our backlog, particularly from orders for major capital projects, can take more than one year depending on the size and type of order. We record, as part of our backlog, all orders from external customers, which represent firm commitments, and are supported by a purchase order or other legitimate contract. The increase in our backlog at December 31, 2020 compared to 2019 was mainly a result of increased demand in our pool business. We expect the majority of our backlog at December 31, 2020 will be shipped in 2021.LIQUIDITY AND CAPITAL RESOURCESWe generally fund cash requirements for working capital, capital expenditures, equity investments, acquisitions, debt repayments, dividend payments and share repurchases from cash generated from operations, availability under existing committed revolving credit facilities and in certain instances, public and private debt and equity offerings. Our primary revolving credit facility has generally been adequate for these purposes, although we have negotiated additional credit facilities or completed debt and equity offerings as needed to allow us to complete acquisitions. We experience seasonal cash flows primarily due to seasonal demand in a number of markets. Consistent with historical trends, we experienced seasonal cash usage in the first quarter of 2020 and drew on our revolving credit facility to repay commercial paper and to fund our operations. This cash usage reversed in the second quarter of 2020 as the seasonality of our businesses peaked. Consistent with historical seasonal patterns, the second quarter of 2020 generated significant cash to fund our operations and we used this cash to significantly reduce the draw on our revolving credit facility. We continued to experience strong cash flow in the second half of 2020, causing our revolving credit facility balance to remain low at December 31, 2020 compared to the prior year end. End-user demand for pool and certain pumping equipment follows warm weather trends and is at seasonal highs from April to August. The magnitude of the sales spike is partially mitigated by employing some advance sale “early buy” programs 31(generally including extended payment terms and/or additional discounts). Demand for residential and agricultural water systems is also impacted by weather patterns, particularly by temperature, heavy flooding and droughts. We expect to continue to have sufficient cash and borrowing capacity to support working capital needs and capital expenditures, to pay interest and service debt and to pay dividends to shareholders quarterly. We believe our existing liquidity position, coupled with our currently anticipated operating cash flows, will be sufficient to meet our cash needs arising in the ordinary course of business for the next twelve months. Although the impact of the COVID-19 pandemic on our future results is uncertain, we believe we are well-positioned to manage our business and have the ability and sufficient capacity to meet these cash requirements by using available cash, internally generated funds and borrowing under our committed and uncommitted credit facilities. We are committed to maintaining investment grade credit ratings and a solid liquidity position.Summary of Cash FlowsCash flows from continuing operations were as follows:Years ended December 31In millions202020192018Cash provided by (used for): Operating activities$574.2$345.2$458.1 Investing activities(117.9)(331.9)(61.7) Financing activities(435.9)(17.1)(407.9)Operating activitiesIn 2020, net cash provided by operating activities of continuing operations primarily reflects net income from continuing operations of $432.2 million, net of non-cash depreciation and amortization. Additionally, the Company had a cash inflow of $109.5 million as a result of changes in net working capital, primarily the result of accounts receivables collections and reduced accounts receivables due to the pool business early buy program shipments with extended payment terms moving from the fourth quarter of 2020 into 2021 due to continued strong demand.In 2019, net cash provided by operating activities of continuing operations primarily reflects net income from continuing operations of $462.9 million, net of non-cash depreciation, amortization and asset impairment, partially offset by a cash outflow of $105.4 million as a result of changes in net working capital and $20.9 million of pension and other post-retirement plan contributions, including $11.1 million of contributions made in conjunction with the termination of the Pentair Salaried Plan during 2019.Investing activitiesNet cash used for investing activities of continuing operations in 2020 primarily reflects capital expenditures of $62.2 million and cash paid for acquisitions of $58.0 million in our Consumer Solutions reporting segment, net of cash acquired.Net cash used for investing activities of continuing operations in 2019 primarily reflects capital expenditures of $58.5 million and cash paid for the Aquion and Pelican acquisitions, partially offset by $15.3 million of proceeds received from divestitures primarily related to our former aquaculture business.Financing activitiesIn 2020, net cash used for financing activities primarily relates to repayment of commercial paper and revolving long-term debt of $117.5 million, repayment of the 3.625% Senior Notes due in 2020 of $74.0 million, $150.2 million of share repurchases and dividend payments of $127.1 million. In 2019, net cash used for financing activities primarily relates to repayment of senior notes due in 2019 totaling $401.5 million, $150.0 million of share repurchases and payment of dividends of $122.7 million, partially offset by proceeds from long-term debt of $600.0 million and net receipts of commercial paper and revolving long-term debt of $51.5 million. 32Free Cash FlowIn addition to measuring our cash flow generation or usage based upon operating, investing and financing classifications included in the Consolidated Statements of Cash Flows, we also measure our free cash flow. We have a long-term goal to consistently generate free cash flow that equals or exceeds 100 percent conversion of net income. Free cash flow is a non-GAAP financial measure that we use to assess our cash flow performance. We believe free cash flow is an important measure of liquidity because it provides us and our investors a measurement of cash generated from operations that is available to pay dividends, repurchase shares and repay debt. In addition, free cash flow is used as a criterion to measure and pay compensation-based incentives. Our measure of free cash flow may not be comparable to similarly titled measures reported by other companies. The following table is a reconciliation of free cash flow: Years ended December 31In millions202020192018Net cash provided by operating activities of continuing operations$574.2 $345.2 $458.1 Capital expenditures of continuing operations(62.2)(58.5)(48.2)Proceeds from sale of property and equipment of continuing operations0.1 0.6 0.2 Free cash flow from continuing operations$512.1 $287.3 $410.1 Net cash (used for) provided by operating activities of discontinued operations(0.6)7.8 (19.0)Capital expenditures of discontinued operations— — (7.4)Proceeds from sale of property and equipment of discontinued operations— — 2.3 Free cash flow$511.5 $295.1 $386.0 Debt and CapitalIn April 2018, Pentair, Pentair Investments Switzerland GmbH (“PISG”), Pentair Finance S.à r.l (“PFSA“) and Pentair, Inc. entered into a credit agreement, providing for an $800.0 million senior unsecured revolving credit facility with a term of five years (the “Senior Credit Facility”), with Pentair and PISG as guarantors and PFSA and Pentair, Inc. as borrowers. In June 2020, Pentair assumed the PISG guarantee. The Senior Credit Facility has a maturity date of April 25, 2023. Borrowings under the Senior Credit Facility bear interest at a rate equal to an adjusted base rate or the London Interbank Offered Rate, plus, in each case, an applicable margin. The applicable margin is based on, at PFSA’s election, Pentair’s leverage level or PFSA’s public credit rating. In May 2019, PFSA executed an increase of the Senior Credit Facility by $100.0 million for a total commitment up to $900.0 million in the aggregate.In December 2019, the Senior Credit Facility was amended to provide for the extension of term loans in an aggregate amount of $200.0 million (the “Term Loans”). The Term Loans are in addition to the Senior Credit Facility commitment. In addition, PFSA has the option to further increase the Senior Credit Facility in an aggregate amount of up to $300.0 million, through a combination of increases to the total commitment amount of the Senior Credit Facility and/or one or more tranches of term loans in addition to the Term Loans, subject to customary conditions, including the commitment of the participating lenders.PFSA is authorized to sell short-term commercial paper notes to the extent availability exists under the Senior Credit Facility. PFSA uses the Senior Credit Facility as back-up liquidity to support 100% of commercial paper outstanding. PFSA had no commercial paper outstanding as of December 31, 2020 and $117.8 million as of December 31, 2019, all of which was classified as long-term debt as we have the intent and the ability to refinance such obligations on a long-term basis under the Senior Credit Facility.In March 2020, the commercial paper market began to experience high levels of volatility due to uncertainty related to the COVID-19 pandemic. The volatility impacted both market access to and pricing of commercial paper. As a cost mitigation action, we withdrew our credit ratings to access the commercial paper market in the second quarter of 2020 and continued to use the revolving credit facility, along with cash generated from operations, to fund our general operations. As of December 31, 2020, total availability under the Senior Credit Facility was $863.9 million. 33Our debt agreements contain various financial covenants, but the most restrictive covenants are contained in the Senior Credit Facility. The Senior Credit Facility contains covenants requiring us not to permit (i) the ratio of our consolidated debt (net of our consolidated unrestricted cash in excess of $5.0 million but not to exceed $250.0 million) to our consolidated net income (excluding, among other things, non-cash gains and losses) before interest, taxes, depreciation, amortization and non-cash share-based compensation expense (“EBITDA”) on the last day of any period of four consecutive fiscal quarters to exceed 3.75 to 1.00 (the “Leverage Ratio”) and (ii) the ratio of our EBITDA to our consolidated interest expense, for the same period to be less than 3.00 to 1.00 as of the end of each fiscal quarter. For purposes of the Leverage Ratio, the Senior Credit Facility provides for the calculation of EBITDA giving pro forma effect to certain acquisitions, divestitures and liquidations during the period to which such calculation relates. Our debt agreements contain various financial covenants. As of December 31, 2020, we were in compliance with all financial covenants in our debt agreements. In addition to the Senior Credit Facility, we have various other credit facilities with an aggregate availability of $21.4 million, of which there were no outstanding borrowings at December 31, 2020. Borrowings under these credit facilities bear interest at variable rates.We have $103.8 million aggregate principal amount of fixed rate senior notes maturing in the next twelve months. We classified this debt as long-term as of December 31, 2020 as we have the intent and ability to refinance such obligation on a long-term basis under the Senior Credit Facility.As of December 31, 2020, we had $56.9 million of cash held in certain countries in which the ability to repatriate is limited due to local regulations or significant potential tax consequences.We expect to continue to have sufficient cash and borrowing capacity to support working capital needs and capital expenditures, to pay interest and service debt and to pay dividends to shareholders quarterly. We believe we have the ability and sufficient capacity to meet these cash requirements by using available cash and internally generated funds and to borrow under our committed and uncommitted credit facilities.Authorized sharesOur authorized share capital consists of 426.0 million ordinary shares with a par value of $0.01 per share. Share RepurchasesIn May 2018, the Board of Directors authorized the repurchase of our ordinary shares up to a maximum dollar limit of $750.0 million (the “2018 Authorization”). The 2018 Authorization expires on May 31, 2021. On December 8, 2020, the Board of Directors authorized the repurchase of our ordinary shares up to a maximum dollar limit of $750.0 million (the “2020 Authorization”). The 2020 Authorization expires on December 31, 2025. The 2020 Authorization supplements the 2018 Authorization. During the year ended December 31, 2019, we repurchased 4.0 million of our ordinary shares for $150.0 million under the 2018 Authorization. During the year ended December 31, 2020, we repurchased 3.7 million of our ordinary shares for $150.2 million under the 2018 Authorization. As of December 31, 2020, we had $99.7 million and $750.0 million available for share repurchases under the 2018 Authorization and 2020 Authorization, respectively. DividendsOn December 8, 2020, the Board of Directors approved a 5 percent increase in the Company’s regular quarterly dividend rate (from $0.19 per share to $0.20 per share) that was paid on February 5, 2021 to shareholders of record at the close of business on January 22, 2021. The balance of dividends payable included in Other current liabilities on our Consolidated Balance Sheets was $33.2 million at December 31, 2020. Dividends paid per ordinary share were $0.76, $0.72 and $1.05 for the years ended December 31, 2020, 2019 and 2018, respectively.Under Irish law, the payment of future cash dividends and repurchases of shares may be paid only out of Pentair plc’s “distributable reserves” on its statutory balance sheet. Pentair plc is not permitted to pay dividends out of share capital, which includes share premiums. Distributable reserves may be created through the earnings of the Irish parent company and through a reduction in share capital approved by the Irish High Court. Distributable reserves are not linked to a GAAP reported amount (e.g., retained earnings). Our distributable reserve balance was $8.8 billion and $6.6 billion as of December 31, 2020 and 2019, respectively.34Supplemental guarantor informationPentair plc (the “Parent Company Guarantor”), fully and unconditionally, guarantees the senior notes of PFSA (the “Subsidiary Issuer”). The Subsidiary Issuer is a Luxembourg private limited liability company and 100 percent-owned subsidiary of the Parent Company Guarantor. The Parent Company Guarantor is a holding company established to own directly and indirectly substantially all of its operating and other subsidiaries. The Subsidiary Issuer is a holding company formed to own directly and indirectly substantially all of its operating and other subsidiaries and to issue debt securities, including the senior notes. The Parent Company Guarantor’s principal source of cash flow, including cash flow to make payments on the senior notes pursuant to the guarantees, is dividends from its subsidiaries. The Subsidiary Issuer’s principal source of cash flow is interest income from its subsidiaries. None of the subsidiaries of the Parent Company Guarantor or the Subsidiary Issuer is under any direct obligation to pay or otherwise fund amounts due on the senior notes or the guarantees, whether in the form of dividends, distributions, loans or other payments. In addition, there may be statutory and regulatory limitations on the payment of dividends from certain subsidiaries of the Parent Company Guarantor or the Subsidiary Issuer. If such subsidiaries are unable to transfer funds to the Parent Company Guarantor or the Subsidiary Issuer and sufficient cash or liquidity is not otherwise available, the Parent Company Guarantor or the Subsidiary Issuer may not be able to make principal and interest payments on their outstanding debt, including the senior notes or the guarantees.The following table presents summarized financial information as of December 31, 2020 for the Parent Company Guarantor and Subsidiary Issuer on a combined basis after elimination of (i) intercompany transactions and balances among the guarantors and issuer and (ii) equity in earnings from and investments in any subsidiary that is a non-Guarantor or issuer.In millionsDecember 31,2020Current assets (1)$8.2 Noncurrent assets (2)1,040.9 Current liabilities (3)608.3 Noncurrent liabilities (4)1,283.0 (1) Includes assets due from non-guarantor subsidiaries of $2.8 million.(2) Includes assets due from non-guarantor subsidiaries of $1,028.5 million. (3) Includes liabilities due to non-guarantor subsidiaries of $556.6 million.(4) Includes liabilities due to non-guarantor subsidiaries of $495.2 million.The Parent Company Guarantor and Subsidiary Issuer do not have material results of operations on a combined basis.Contractual obligationsThe following summarizes our significant contractual obligations that impact our liquidity: Years ended December 31In millions20212022202320242025ThereafterTotalDebt obligations$103.8 $88.3 $236.1 $— $19.3 $400.0 $847.5 Interest obligations on fixed-rate debt24.3 21.7 18.9 18.9 18.9 72.0 174.7 Operating lease obligations, net of sublease rentals26.2 22.9 19.5 14.8 6.0 9.5 98.9 Purchase and marketing obligations26.9 8.5 4.6 3.8 3.8 6.2 53.8 Pension and other post-retirement plan contributions8.5 8.6 8.7 8.8 8.6 40.3 83.5 Total contractual obligations, net$189.7 $150.0 $287.8 $46.3 $56.6 $528.0 $1,258.4 The majority of the purchase obligations represent commitments for raw materials to be utilized in the normal course of business. For purposes of the above table, arrangements are considered purchase obligations if a contract specifies all significant terms, including fixed or minimum quantities to be purchased, a pricing structure and approximate timing of the transaction.In addition to the summary of significant contractual obligations, we will incur annual interest expense on outstanding variable rate debt. As of December 31, 2020, variable interest rate debt was $236.1 million at a weighted average interest rate of 1.23%.35The total gross liability for uncertain tax positions at December 31, 2020 was estimated to be $46.3 million. We record penalties and interest related to unrecognized tax benefits in Provision for income taxes and Net interest expense, respectively, which is consistent with our past practices. As of December 31, 2020, we had recorded $0.2 million for the possible payment of penalties and $4.6 million related to the possible payment of interest.Off-balance sheet arrangementsAt December 31, 2020, we had no off-balance sheet financing arrangements.COMMITMENTS AND CONTINGENCIESWe have been, and in the future may be, made parties to a number of actions filed or have been, and in the future may be, given notice of potential claims relating to the conduct of our business, including those relating to commercial or contractual disputes with suppliers, customers or parties to acquisitions and divestitures, intellectual property matters, environmental, asbestos, safety and health matters, product liability, the use or installation of our products, consumer matters, and employment and labor matters.While we believe that a material impact on our consolidated financial position, results of operations or cash flows from any such future claims or potential claims is unlikely, given the inherent uncertainty of litigation, a remote possibility exists that a future adverse ruling or unfavorable development could result in future charges that could have a material impact. We do and will continue to periodically reexamine our estimates of probable liabilities and any associated expenses and receivables and make appropriate adjustments to such estimates based on experience and developments in litigation. As a result, the current estimates of the potential impact on our consolidated financial position, results of operations and cash flows for the proceedings and claims described in ITEM 8, Note 15 of the Notes to Consolidated Financial Statements could change in the future.Product liability claimsWe are subject to various product liability lawsuits and personal injury claims. A substantial number of these lawsuits and claims are insured and accrued for by Penwald, our captive insurance subsidiary. See discussion in ITEM 1 and ITEM 8, Note 1 of the Notes to Consolidated Financial Statements — Insurance subsidiary. Penwald records a liability for these claims based on actuarial projections of ultimate losses. For all other claims, accruals covering the claims are recorded, on an undiscounted basis, when it is probable that a liability has been incurred and the amount of the liability can be reasonably estimated based on existing information. The accruals are adjusted periodically as additional information becomes available. We have not experienced significant unfavorable trends in either the severity or frequency of product liability lawsuits or personal injury claims.Stand-by letters of credit, bank guarantees and bondsIn certain situations, Tyco International Ltd., Pentair Ltd.’s former parent company (“Tyco”), guaranteed performance by the flow control business of Pentair Ltd. (“Flow Control”) to third parties or provided financial guarantees for financial commitments of Flow Control. In situations where Flow Control and Tyco were unable to obtain a release from these guarantees in connection with the spin-off of Flow Control from Tyco, we will indemnify Tyco for any losses it suffers as a result of such guarantees.In the ordinary course of business, we are required to commit to bonds, letters of credit and bank guarantees that require payments to our customers for any non-performance. The outstanding face value of these instruments fluctuates with the value of our projects in process and in our backlog. In addition, we issue financial stand-by letters of credit primarily to secure our performance to third parties under self-insurance programs.As of December 31, 2020 and 2019, the outstanding value of bonds, letters of credit and bank guarantees totaled $99.1 million and $91.3 million, respectively. NEW ACCOUNTING STANDARDSSee ITEM 8, Note 1 of the Notes to Consolidated Financial Statements, included in this Form 10-K, for information pertaining to recently adopted accounting standards or accounting standards to be adopted in the future.36CRITICAL ACCOUNTING POLICIESWe have adopted various accounting policies to prepare the consolidated financial statements in accordance with GAAP. Our significant accounting policies are more fully described in ITEM 8, Note 1 of the Notes to Consolidated Financial Statements. Certain accounting policies require the application of significant judgment by management in selecting the appropriate assumptions for calculating financial estimates. By their nature, these judgments are subject to an inherent degree of uncertainty. These judgments are based on our historical experience, terms of existing contracts, our observance of trends in the industry and information available from other outside sources, as appropriate. We consider an accounting estimate to be critical if:•it requires us to make assumptions about matters that were uncertain at the time we were making the estimate; and•changes in the estimate or different estimates that we could have selected would have had a material impact on our financial condition or results of operations.Our critical accounting estimates include the following:Impairment of goodwill and indefinite-lived intangiblesGoodwillGoodwill represents the excess of the cost of acquired businesses over the net of the fair value of identifiable tangible net assets and identifiable intangible assets purchased and liabilities assumed.We test our goodwill for impairment at least annually during the fourth quarter or more frequently if events or changes in circumstances indicate that the asset might be impaired. We perform our annual or interim goodwill impairment test by comparing the fair value of the relevant reporting unit with its carrying amount. We would recognize an impairment charge for the amount by which the carrying amount exceeds the reporting unit’s fair value; however, the loss recognized would not exceed the total amount of goodwill allocated to that reporting unit. We have the option to perform a qualitative assessment to determine whether it is necessary to perform the quantitative goodwill impairment test. However, we may elect to perform the quantitative goodwill impairment test even if no indications of a potential impairment exist.During 2020, a quantitative assessment was performed. The fair value of each reporting unit was determined using a discounted cash flow analysis and market approach. Projecting discounted future cash flows requires us to make significant estimates regarding future revenues and expenses, projected capital expenditures, changes in working capital and the appropriate discount rate. Use of the market approach consists of comparisons to comparable publicly-traded companies that are similar in size and industry. The non-recurring fair value measurement is a “Level 3” measurement under the fair value hierarchy. For the 2020 annual impairment test, the estimated fair value exceeded the carrying value in each of our reporting units, therefore, no impairment charge was required. During 2019, a qualitative assessment was performed. We determined that it was more likely than not that the fair value of the reporting units exceeded their respective carrying values. Factors considered in the analysis included the last discounted cash flow fair value assessment of reporting units and the calculated excess fair value over carrying amount, financial performance, forecasts and trends, market capitalization, regulatory and environmental issues, macro-economic conditions, industry and market considerations, raw material costs and management stability. We also consider the extent to which each of the adverse events and circumstances identified affect the comparison of the respective reporting unit’s fair value with its carrying amount. We place more weight on the events and circumstances that most affect the respective reporting unit’s fair value or the carrying amount of its net assets. We consider positive and mitigating events and circumstances that may affect its determination of whether it is more likely than not that the fair value exceeds the carrying amount. Identifiable intangible assetsOur primary identifiable intangible assets include: customer relationships, trade names, proprietary technology and patents. Identifiable intangibles with finite lives are amortized and those identifiable intangibles with indefinite lives are not amortized. Identifiable intangible assets that are subject to amortization are evaluated for impairment whenever events or changes in circumstances indicate that the carrying amount may not be recoverable. Identifiable intangible assets not subject to amortization are tested for impairment annually or more frequently if events warrant. We complete our annual impairment test the first day of the fourth quarter each year for those identifiable assets not subject to amortization.37The impairment test for trade names consists of a comparison of the fair value of the trade name with its carrying value. Fair value is measured using the relief-from-royalty method. This method assumes the trade name has value to the extent that the owner is relieved of the obligation to pay royalties for the benefits received from them. This method requires us to estimate the future revenue for the related brands, the appropriate royalty rate and the weighted average cost of capital. The non-recurring fair value measurement is a “Level 3” measurement under the fair value hierarchy.There was no impairment charge recorded in any of the years presented for identifiable intangible assets. Pension and other post-retirement plansWe sponsor U.S. and non-U.S. defined-benefit pension and other post-retirement plans. The amounts recognized in our consolidated financial statements related to our defined-benefit pension and other post-retirement plans are determined from actuarial valuations. Inherent in these valuations are assumptions, including: expected return on plan assets, discount rates, rate of increase in future compensation levels and health care cost trend rates. These assumptions are updated annually and are disclosed in ITEM 8, Note 11 to the Notes to Consolidated Financial Statements. Differences in actual experience or changes in assumptions may affect our pension and other post-retirement obligations and future expense. We recognize changes in the fair value of plan assets and net actuarial gains or losses for pension and other post-retirement benefits annually in the fourth quarter each year (“mark-to-market adjustment”) and, if applicable, in any quarter in which an interim re-measurement is triggered. Net actuarial gains and losses occur when the actual experience differs from any of the various assumptions used to value our pension and other post-retirement plans or when assumptions change as they may each year. The primary factors contributing to actuarial gains and losses each year are (1) changes in the discount rate used to value pension and other post-retirement benefit obligations as of the measurement date and (2) differences between the expected and the actual return on plan assets. This accounting method also results in the potential for volatile and difficult to forecast mark-to-market adjustments. Mark-to-market adjustments resulted in a pre-tax loss of $6.7 million in 2020, a pre-tax gain of $3.4 million in 2019 and a pre-tax loss of $3.6 million in 2018. The remaining components of pension expense, including service and interest costs and the expected return on plan assets, are recorded on a quarterly basis as ongoing pension expense.Discount ratesThe discount rate reflects the current rate at which the pension liabilities could be effectively settled at the end of the year based on our December 31 measurement date. The discount rate was determined by matching our expected benefit payments to payments from a stream of bonds rated AA or higher available in the marketplace. There are no known or anticipated changes in our discount rate assumptions that will impact our pension expense in 2021.Expected rate of returnThe expected rate of return is designed to be a long-term assumption that may be subject to considerable year-to-year variance from actual returns. In developing the expected long-term rate of return, we considered our historical returns, with consideration given to forecasted economic conditions, our asset allocations, input from external consultants and broader long-term market indices.Loss contingenciesAccruals are recorded for various contingencies including legal proceedings, self-insurance and other claims that arise in the normal course of business. The accruals are based on judgment, the probability of losses and, where applicable, the consideration of opinions of internal and/or external legal counsel and actuarial determined estimates. Additionally, we record receivables from third party insurers when recovery has been determined to be probable.Income taxesIn determining taxable income for financial statement purposes, we must make certain estimates and judgments. These estimates and judgments affect the calculation of certain tax liabilities and the determination of the recoverability of certain of the deferred tax assets, which arise from temporary differences between the tax and financial statement recognition of revenue and expense. In evaluating our ability to recover our deferred tax assets we consider all available positive and negative evidence including our past operating results, the existence of cumulative losses in the most recent years and our forecast of future taxable income. In estimating future taxable income, we develop assumptions including the amount of future pre-tax operating income, the reversal of temporary differences and the implementation of feasible and prudent tax planning strategies. These assumptions require significant judgment about the forecasts of future taxable income and are consistent with the plans and estimates we are using to manage the underlying businesses.38We currently have recorded valuation allowances that we will maintain until when, in the opinion of management, it is more likely than not that some portion or all of the deferred tax assets will be realized. Our income tax expense recorded in the future may be reduced to the extent of decreases in our valuation allowances. The realization of our remaining deferred tax assets is primarily dependent on future taxable income in the appropriate jurisdiction. Any reduction in future taxable income including but not limited to any future restructuring activities may require that we record an additional valuation allowance against our deferred tax assets. An increase in the valuation allowance could result in additional income tax expense in such period and could have a significant impact on our future earnings.Changes in tax laws and rates could also affect recorded deferred tax assets and liabilities in the future. Management records the effect of a tax rate or law change on the Company’s deferred tax assets and liabilities in the period of enactment. Future tax rate or law changes could have a material effect on the Company’s financial condition, results of operations or cash flows.In addition, the calculation of our tax liabilities involves dealing with uncertainties in the application of complex tax regulations in a multitude of jurisdictions across our global operations. We perform reviews of our income tax positions on a quarterly basis and accrue for uncertain tax positions. We recognize potential liabilities and record tax liabilities for anticipated tax audit issues in the tax jurisdictions in which we operate based on our estimate of whether, and the extent to which, additional taxes will be due. These tax liabilities are reflected net of related tax loss carryforwards. As events change or resolution occurs, these liabilities are adjusted, such as in the case of audit settlements with taxing authorities. The ultimate resolution may result in a payment that is materially different from our current estimate of the tax liabilities. If our estimate of tax liabilities proves to be less than the ultimate assessment, an additional charge to expense would result. If payment of these amounts ultimately proves to be less than the recorded amounts, the reversal of the liabilities would result in tax benefits being recognized in the period when we determine the liabilities are no longer necessary.ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKMarket risk is the potential economic loss that may result from adverse changes in the fair value of financial instruments. We are exposed to various market risks, including changes in interest rates and foreign currency rates. Periodically, we use derivative financial instruments to manage or reduce the impact of changes in interest rates and foreign currency rates. Counterparties to all derivative contracts are major financial institutions. All instruments are entered into for other than trading purposes. The major accounting policies and utilization of these instruments is described more fully in ITEM 8, Note 1 of the Notes to Consolidated Financial Statements.Interest rate riskOur debt portfolio as of December 31, 2020, was comprised of debt predominantly denominated in U.S. dollars. This debt portfolio is comprised of 72% fixed-rate debt and 28% variable-rate debt. Changes in interest rates have different impacts on the fixed and variable-rate portions of our debt portfolio. A change in interest rates on the fixed portion of the debt portfolio impacts the fair value, but has no impact on interest incurred or cash flows. A change in interest rates on the variable portion of the debt portfolio impacts the interest incurred and cash flows but does not impact the net financial instrument position.Based on the fixed-rate debt included in our debt portfolio, as of December 31, 2020, a 100 basis point increase or decrease in interest rates would result in a $37.6 million decrease or $40.9 million increase in fair value, respectively.Based on the variable-rate debt included in our debt portfolio as of December 31, 2020, a 100 basis point increase or decrease in interest rates would result in a $2.4 million increase or decrease in interest incurred.Foreign currency riskWe conduct business in various locations throughout the world and are subject to market risk due to changes in the value of foreign currencies in relation to our reporting currency, the U.S. dollar. Periodically, we use derivative financial instruments to manage these risks. The functional currencies of our foreign operating locations are generally the local currency in the country of domicile. We manage these operating activities at the local level and revenues, costs, assets and liabilities are generally denominated in local currencies, thereby mitigating the risk associated with changes in foreign exchange. However, our results of operations and assets and liabilities are reported in U.S. dollars and thus will fluctuate with changes in exchange rates between such local currencies and the U.S. dollar.39From time to time, we may enter into short duration foreign currency contracts to hedge foreign currency risks. As the majority of our foreign currency contracts have an original maturity date of less than one year, there is no material foreign currency risk. At December 31, 2020, we had outstanding foreign currency derivative contracts with gross notional U.S. dollar equivalent amounts of $12.4 million. Changes in the fair value of all derivatives are recognized immediately in income unless the derivative qualifies as a hedge of future cash flows. Gains and losses related to a hedge are deferred and recorded in the Consolidated Balance Sheets as a component of Accumulated other comprehensive loss and subsequently recognized in the Consolidated Statements of Operations and Comprehensive Income when the hedged item affects earnings.At December 31, 2020, we had outstanding cross currency swap agreements with a combined notional amount of $855.1 million. The cross currency swap agreements are accounted for as either cash flow hedges to hedge foreign currency fluctuations on certain intercompany debt, or as net investment hedges to manage our exposure to fluctuations in the Euro-U.S. Dollar exchange rate. The currency risk related to the cross currency swap agreements is measured by estimating the potential impact of a 10% change in the value of the U.S. dollar relative to the Euro. A 10% appreciation of the U.S. dollar relative to the Euro would result in a $63.7 million net increase in accumulated other comprehensive income. Conversely, a 10% depreciation of the U.S. dollar relative to the Euro would result in an $57.0 million net decrease in accumulated other comprehensive income. However, these increases and decreases in other comprehensive income would be offset by decreases or increases in the hedged items on our balance sheet.40
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+Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations – Our Business – Our Business Risks.” Investors are cautioned not to place undue reliance on any such forward-looking statements, which speak only as of the date they are made. We undertake no obligation to update any forward-looking statement, whether as a result of new information, future events or otherwise. The discussion of risks in this report is by no means all-inclusive but is designed to highlight what we believe are important factors to consider when evaluating our future performance.PART IItem 1. Business.When used in this report, the terms “we,” “us,” “our,” “PepsiCo” and the “Company” mean PepsiCo, Inc. and its consolidated subsidiaries, collectively. Certain terms used in this Annual Report on Form 10-K are defined in the Glossary included in Item 7. of this report.Company OverviewWe were incorporated in Delaware in 1919 and reincorporated in North Carolina in 1986. We are a leading global food and beverage company with a complementary portfolio of brands, including Frito-Lay, Gatorade, Pepsi-Cola, Quaker and Tropicana. Through our operations, authorized bottlers, contract manufacturers and other third parties, we make, market, distribute and sell a wide variety of convenient beverages, foods and snacks, serving customers and consumers in more than 200 countries and territories.Our OperationsWe are organized into seven reportable segments (also referred to as divisions), as follows:1)Frito-Lay North America (FLNA), which includes our branded food and snack businesses in the United States and Canada;2)Quaker Foods North America (QFNA), which includes our cereal, rice, pasta and other branded food businesses in the United States and Canada;3)PepsiCo Beverages North America (PBNA), which includes our beverage businesses in the United States and Canada;4)Latin America (LatAm), which includes all of our beverage, food and snack businesses in Latin America;5)Europe, which includes all of our beverage, food and snack businesses in Europe;6)Africa, Middle East and South Asia (AMESA), which includes all of our beverage, food and snack businesses in Africa, the Middle East and South Asia; and2Table of Contents7)Asia Pacific, Australia and New Zealand and China Region (APAC), which includes all of our beverage, food and snack businesses in Asia Pacific, Australia and New Zealand, and China region.Frito-Lay North AmericaEither independently or in conjunction with third parties, FLNA makes, markets, distributes and sells branded snack foods. These foods include branded dips, Cheetos cheese-flavored snacks, Doritos tortilla chips, Fritos corn chips, Lay’s potato chips, Ruffles potato chips and Tostitos tortilla chips. FLNA’s branded products are sold to independent distributors and retailers. In addition, FLNA’s joint venture with Strauss Group makes, markets, distributes and sells Sabra refrigerated dips and spreads.Quaker Foods North AmericaEither independently or in conjunction with third parties, QFNA makes, markets, distributes and sells cereals, rice, pasta and other branded products. QFNA’s products include Aunt Jemima mixes and syrups, Cap’n Crunch cereal, Life cereal, Quaker Chewy granola bars, Quaker grits, Quaker oatmeal, Quaker rice cakes, Quaker simply granola and Rice-A-Roni side dishes. QFNA’s branded products are sold to independent distributors and retailers.PepsiCo Beverages North AmericaEither independently or in conjunction with third parties, PBNA makes, markets and sells beverage concentrates, fountain syrups and finished goods under various beverage brands including Aquafina, Diet Mountain Dew, Diet Pepsi, Gatorade, Mountain Dew, Pepsi, Propel and Tropicana. PBNA operates its own bottling plants and distribution facilities and sells branded finished goods directly to independent distributors and retailers. PBNA also sells concentrate and finished goods for our brands to authorized and independent bottlers, who in turn sell our branded finished goods to independent distributors and retailers in certain markets. PBNA also, either independently or in conjunction with third parties, makes, markets, distributes and sells ready-to-drink tea and coffee products through joint ventures with Unilever (under the Lipton brand name) and Starbucks, respectively. Further, PBNA manufactures and distributes certain brands licensed from Keurig Dr Pepper Inc., including Crush, Dr Pepper and Schweppes, and certain juice brands licensed from Dole Food Company, Inc. (Dole) and Ocean Spray Cranberries, Inc. (Ocean Spray). In 2020, we acquired Rockstar Energy Beverages (Rockstar), an energy drink maker with whom we had a distribution agreement prior to the acquisition. See Note 14 to our consolidated financial statements for further information about our acquisition of Rockstar.Latin America Either independently or in conjunction with third parties, LatAm makes, markets, distributes and sells a number of snack food brands including Cheetos, Doritos, Emperador, Lay’s, Marias Gamesa, Rosquinhas Mabel, Ruffles, Sabritas, Saladitas and Tostitos, as well as many Quaker-branded cereals and snacks. LatAm also, either independently or in conjunction with third parties, makes, markets, distributes and sells beverage concentrates, fountain syrups and finished goods under various beverage brands including 7UP, Gatorade, H2oh!, Manzanita Sol, Mirinda, Pepsi, Pepsi Black, San Carlos and Toddy. These branded products are sold to authorized and independent bottlers, independent distributors and retailers. LatAm also, either independently or in conjunction with third parties, makes, markets, distributes and sells ready-to-drink tea products through an international joint venture with Unilever (under the Lipton brand name).3Table of ContentsEuropeEither independently or in conjunction with third parties, Europe makes, markets, distributes and sells a number of snack food brands including Cheetos, Chipita, Doritos, Lay’s, Ruffles and Walkers, as well as many Quaker-branded cereals and snacks, through consolidated businesses, as well as through noncontrolled affiliates. Europe also, either independently or in conjunction with third parties, makes, markets, distributes and sells beverage concentrates, fountain syrups and finished goods under various beverage brands including 7UP, Diet Pepsi, Lubimy Sad, Mirinda, Pepsi, Pepsi Max and Tropicana. These branded products are sold to authorized and independent bottlers, independent distributors and retailers. In certain markets, however, Europe operates its own bottling plants and distribution facilities. Europe also, as part of its beverage business, manufactures and distributes SodaStream sparkling water makers and related products. Further, Europe makes, markets, distributes and sells a number of dairy products including Agusha, Chudo and Domik v Derevne. Europe also, either independently or in conjunction with third parties, makes, markets, distributes and sells ready-to-drink tea products through an international joint venture with Unilever (under the Lipton brand name).Africa, Middle East and South AsiaEither independently or in conjunction with third parties, AMESA makes, markets, distributes and sells a number of snack food brands including Chipsy, Doritos, Kurkure, Lay’s, Sasko, Spekko and White Star, as well as many Quaker-branded cereals and snacks, through consolidated businesses, as well as through noncontrolled affiliates. AMESA also makes, markets, distributes and sells beverage concentrates, fountain syrups and finished goods under various beverage brands including 7UP, Aquafina, Mirinda, Mountain Dew and Pepsi. These branded products are sold to authorized and independent bottlers, independent distributors and retailers. In certain markets, however, AMESA operates its own bottling plants and distribution facilities. AMESA also, either independently or in conjunction with third parties, makes, markets, distributes and sells ready-to-drink tea products through an international joint venture with Unilever (under the Lipton brand name). In 2020, we acquired Pioneer Food Group Ltd. (Pioneer Foods), a food and beverage company in South Africa with exports to countries across the globe. See Note 14 to our consolidated financial statements for further information about our acquisition of Pioneer Foods.Asia Pacific, Australia and New Zealand and China RegionEither independently or in conjunction with third parties, APAC makes, markets, distributes and sells a number of snack food brands including BaiCaoWei, Cheetos, Doritos, Lay’s and Smith’s, as well as many Quaker-branded cereals and snacks, through consolidated businesses, as well as through noncontrolled affiliates. APAC also makes, markets, distributes and sells beverage concentrates, fountain syrups and finished goods under various beverage brands including 7UP, Aquafina, Mirinda, Mountain Dew and Pepsi. These branded products are sold to authorized and independent bottlers, independent distributors and retailers. APAC also, either independently or in conjunction with third parties, makes, markets, distributes and sells ready-to-drink tea products through an international joint venture with Unilever (under the Lipton brand name). Further, APAC licenses the Tropicana brand for use in China on co-branded juice products in connection with a strategic alliance with Tingyi (Cayman Islands) Holding Corp. (Tingyi). In 2020, we acquired all of the outstanding shares of Hangzhou Haomusi Food Co., Ltd. (Be & Cheery), one of the largest online snacks companies in China. See Note 14 to our consolidated financial statements for further information about our acquisition of Be & Cheery.COVID-19The novel coronavirus (COVID-19) pandemic in 2020 resulted in challenging operating environments and affected almost all of the more than 200 countries and territories in which our products are made, manufactured, distributed or sold, including as a result of travel bans and restrictions, quarantines, curfews, restrictions on public gatherings, shelter in place and safer-at-home orders, business shutdowns 4Table of Contentsand closures. We expect that the COVID-19 pandemic will continue to impact our business operations, including our employees, customers, consumers, bottlers, contract manufacturers, distributors, joint venture partners, suppliers and other third parties with which we do business. The extent to which the COVID-19 pandemic will impact our future business operations and financial results remains uncertain and will continue to depend on numerous evolving factors outside our control.See “Item 1A. Risk Factors” for discussion of the risks and uncertainties associated with the COVID-19 pandemic. Also, see “Our Business Risks” in Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations and Note 1 to our consolidated financial statements for further information related to the impact of COVID-19 on our 2020 financial results. Our Distribution NetworkOur products are primarily brought to market through direct-store-delivery (DSD), customer warehouse and distributor networks and are also sold directly to consumers through e-commerce platforms and retailers. The distribution system used depends on customer needs, product characteristics and local trade practices.Direct-Store-DeliveryWe, our independent bottlers and our distributors operate DSD systems that deliver beverages, foods and snacks directly to retail stores where the products are merchandised by our employees or our independent bottlers. DSD enables us to merchandise with maximum visibility and appeal. DSD is especially well-suited to products that are restocked often and respond to in-store promotion and merchandising.Customer WarehouseSome of our products are delivered from our manufacturing plants and distribution centers, both company and third-party operated, to customer warehouses. These less costly systems generally work best for products that are less fragile and perishable, and have lower turnover.Distributor NetworksWe distribute many of our products through third-party distributors. Third-party distributors are particularly effective when greater distribution reach can be achieved by including a wide range of products on the delivery vehicles. For example, our foodservice and vending business distributes beverages, foods and snacks to restaurants, businesses, schools and stadiums through third-party foodservice and vending distributors and operators.E-commerceOur products are also available and sold directly to consumers on a growing number of company-owned and third-party e-commerce websites and mobile commerce applications.Ingredients and Other SuppliesThe principal ingredients we use in our beverage, food and snack products are apple, orange and pineapple juice and other juice concentrates, aspartame, corn, corn sweeteners, flavorings, flour, grapefruit, oranges and other fruits, oats, potatoes, raw milk, rice, seasonings, sucralose, sugar, vegetable and essential oils, and wheat. We also use water in the manufacturing of our products. Our key packaging materials include plastic resins, including polyethylene terephthalate (PET) and polypropylene resins used for plastic beverage bottles and film packaging used for snack foods, aluminum, glass, closures, cardboard and paperboard cartons. In addition, we continue to integrate recyclability into our product development process and support the increased use of recycled content, including recycled PET, in our packaging. Fuel, electricity and natural gas are also important commodities for our businesses due to their use in our and our business partners’ facilities and the vehicles delivering our products. We employ specialists to secure 5Table of Contentsadequate supplies of many of these items and have not experienced any significant continuous shortages that would prevent us from meeting our requirements. Many of these ingredients, raw materials and commodities are purchased in the open market. The prices we pay for such items are subject to fluctuation, and we manage this risk through the use of fixed-price contracts and purchase orders, pricing agreements and derivative instruments, including swaps and futures. In addition, risk to our supply of certain raw materials is mitigated through purchases from multiple geographies and suppliers. When prices increase, we may or may not pass on such increases to our customers. In addition, we continue to make investments to improve the sustainability and resources of our agricultural supply chain, including the development of our initiative to advance sustainable farming practices by our suppliers and expanding it further globally. See Note 9 to our consolidated financial statements for further information on how we manage our exposure to commodity prices. We also maintain voluntary supply chain finance agreements with several participating global financial institutions, pursuant to which our suppliers, at their sole discretion, may elect to sell their accounts receivable with PepsiCo to such global financial institutions. These agreements have not had a material impact on our business or financial results. See “Our Financial Results – Our Liquidity and Capital Resources” in Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations for further information.Our Brands and Intellectual Property RightsWe own numerous valuable trademarks which are essential to our worldwide businesses, including Agusha, Amp Energy, Aquafina, Aquafina Flavorsplash, Arto Lifewtr, Aunt Jemima, BaiCaoWei, Bare, Bokomo, Bolt24, bubly, Cap’n Crunch, Ceres, Cheetos, Chester’s, Chipita, Chipsy, Chokis, Chudo, Cracker Jack, Crunchy, Diet Mountain Dew, Diet Mug, Diet Pepsi, Diet 7UP (outside the United States), Domik v Derevne, Doritos, Driftwell, Duyvis, Elma Chips, Emperador, Evolve, Frito-Lay, Fritos, Fruktovy Sad, G2, Gamesa, Gatorade, Grandma’s, H2oh!, Health Warrior, Imunele, Izze, J-7 Tonus, Kas, KeVita, Kurkure, Lay’s, Life, Lifewtr, Liquifruit, Lubimy, Manzanita Sol, Marias Gamesa, Matutano, Mirinda, Miss Vickie’s, Moirs, Mother’s, Mountain Dew, Mountain Dew Code Red, Mountain Dew Game Fuel, Mountain Dew Ice, Mountain Dew Kickstart, Mountain Dew Zero Sugar, Mug, Munchies, Muscle Milk, Naked, Near East, Off the Eaten Path, O.N.E., Paso de los Toros, Pasta Roni, Pearl Milling Company, Pepsi, Pepsi Black, Pepsi Max, Pepsi Zero Sugar, PopCorners, Pronutro, Propel, Quaker, Quaker Chewy, Rice-A-Roni, Rockstar Energy, Rold Gold, Rosquinhas Mabel, Ruffles, Sabritas, Safari, Sakata, Saladitas, San Carlos, Sandora, Santitas, Sasko, 7UP (outside the United States), 7UP Free (outside the United States), Sierra Mist, Sierra Mist Zero Sugar, Simba, Smartfood, Smith’s, Snack a Jacks, SoBe, SodaStream, Sonric’s, Spekko, Stacy’s, Sting, Stubborn Soda, SunChips, Toddy, Toddynho, Tostitos, Trop 50, Tropicana, Tropicana Pure Premium, Tropicana Twister, V Water, Vesely Molochnik, Walkers, Weetbix, White Star, Ya and Yachak. We also hold long-term licenses to use valuable trademarks in connection with our products in certain markets, including Dole and Ocean Spray. We also distribute Bang Energy drinks and various Keurig Dr Pepper Inc. brands, including Dr Pepper in certain markets, Crush and Schweppes. Joint ventures in which we have an ownership interest either own or have the right to use certain trademarks, such as Lipton, Sabra and Starbucks. Trademarks remain valid so long as they are used properly for identification purposes, and we emphasize correct use of our trademarks. We have authorized, through licensing arrangements, the use of many of our trademarks in such contexts as snack food joint ventures and beverage bottling appointments. In addition, we license the use of our trademarks on merchandise that is sold at retail, which enhances brand awareness.We either own or have licenses to use a number of patents which relate to certain of our products, their packaging, the processes for their production and the design and operation of various equipment used in our businesses. Some of these patents are licensed to others.6Table of ContentsSeasonalityOur businesses are affected by seasonal variations. Our beverage, food and snack sales are generally highest in the third quarter due to seasonal and holiday-related patterns and generally lowest in the first quarter. However, taken as a whole, seasonality has not had a material impact on our consolidated financial results.Our CustomersOur customers include wholesale and other distributors, foodservice customers, grocery stores, drug stores, convenience stores, discount/dollar stores, mass merchandisers, membership stores, hard discounters, e-commerce retailers and authorized independent bottlers, among others. We normally grant our independent bottlers exclusive contracts to sell and manufacture certain beverage products bearing our trademarks within a specific geographic area. These arrangements provide us with the right to charge our independent bottlers for concentrate, finished goods and Aquafina royalties and specify the manufacturing process required for product quality. We also grant distribution rights to our independent bottlers for certain beverage products bearing our trademarks for specified geographic areas.We rely on and provide financial incentives to our customers to assist in the distribution and promotion of our products to the consumer. For our independent distributors and retailers, these incentives include volume-based rebates, product placement fees, promotions and displays. For our independent bottlers, these incentives are referred to as bottler funding and are negotiated annually with each bottler to support a variety of trade and consumer programs, such as consumer incentives, advertising support, new product support, and vending and cooler equipment placement. Consumer incentives include pricing discounts and promotions, and other promotional offers. Advertising support is directed at advertising programs and supporting independent bottler media. New product support includes targeted consumer and retailer incentives and direct marketplace support, such as point-of-purchase materials, product placement fees, media and advertising. Vending and cooler equipment placement programs support the acquisition and placement of vending machines and cooler equipment. The nature and type of programs vary annually.Changes to the retail landscape, including increased consolidation of retail ownership, the rapid growth of sales through e-commerce websites and mobile commerce applications, including through subscription services and other direct-to-consumer businesses, the integration of physical and digital operations among retailers, as well as the international expansion of hard discounters, and the current economic environment, including in light of the COVID-19 pandemic, continue to increase the importance of major customers. In 2020, sales to Walmart Inc. (Walmart) and its affiliates, including Sam’s Club (Sam’s), represented approximately 14% of our consolidated net revenue, with sales reported across all of our divisions, including concentrate sales to our independent bottlers, which were used in finished goods sold by them to Walmart. The loss of this customer would have a material adverse effect on our FLNA, QFNA and PBNA divisions. See “Off-Balance-Sheet Arrangements” in “Our Financial Results – Our Liquidity and Capital Resources” in Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations for further information on our independent bottlers.Our CompetitionOur beverage, food and snack products are in highly competitive categories and markets and compete against products of international beverage, food and snack companies that, like us, operate in multiple geographies, as well as regional, local and private label manufacturers and economy brands and other competitors, including smaller companies developing and selling micro brands directly to consumers through e-commerce platforms or through retailers focused on locally-sourced products. In many countries in which our products are sold, including the United States, The Coca-Cola Company is our primary beverage competitor. Other beverage, food and snack competitors include, but are not limited to, 7Table of ContentsCampbell Soup Company, Conagra Brands, Inc., Kellogg Company, Keurig Dr Pepper Inc., The Kraft Heinz Company, Link Snacks, Inc., Mondelēz International, Inc., Monster Beverage Corporation, Nestlé S.A., Red Bull GmbH and Utz Brands, Inc.Many of our food and snack products hold significant leadership positions in the food and snack industry in the United States and worldwide. In 2020, we and The Coca-Cola Company represented approximately 22% and 20%, respectively, of the U.S. liquid refreshment beverage category by estimated retail sales in measured channels, according to Information Resources, Inc. However, The Coca-Cola Company has significant carbonated soft drink (CSD) share advantage in many markets outside the United States.Our beverage, food and snack products compete primarily on the basis of brand recognition and loyalty, taste, price, value, quality, product variety, innovation, distribution, advertising, marketing and promotional activity (including digital), packaging, convenience, service and the ability to anticipate and effectively respond to consumer preferences and trends, including increased consumer focus on health and wellness and the continued acceleration of e-commerce and other methods of distributing and purchasing products. Success in this competitive environment is dependent on effective promotion of existing products, effective introduction of new products and reformulations of existing products, increased efficiency in production techniques, effective incorporation of technology and digital tools across all areas of our business, the effectiveness of our advertising campaigns, marketing programs, product packaging and pricing, new vending and dispensing equipment and brand and trademark development and protection. We believe that the strength of our brands, innovation and marketing, coupled with the quality of our products and flexibility of our distribution network, allows us to compete effectively.Research and DevelopmentWe engage in a variety of research and development activities and invest in innovation globally with the goal of meeting the needs of our customers and consumers and accelerating growth. These activities principally involve: innovations focused on creating consumer preferred products to grow and transform our portfolio through development of new technologies, ingredients, flavors and substrates; development and improvement of our manufacturing processes including reductions in cost and environmental footprint; implementing product improvements to our global portfolio that reduce added sugars, sodium or saturated fat; offering more products with functional ingredients and positive nutrition including whole grains, fruit, vegetables, dairy, protein, fiber, micronutrients and hydration; development of packaging technology and new package designs, including reducing the amount of plastic in our packaging and developing recyclable and sustainable packaging; development of marketing, merchandising and dispensing equipment; further expanding our beyond the bottle portfolio including innovation for our SodaStream business; investments in technology and digitalization including data analytics to enhance our consumer insights and research; continuing to strengthen our omnichannel capabilities, particularly in e-commerce; and efforts focused on reducing our impact on the environment including reducing water use in our operations and our agricultural practices.Our research centers are located around the world, including in Brazil, China, India, Ireland, Mexico, Russia, South Africa, the United Kingdom and the United States, and leverage consumer insights, food science and engineering to meet our strategy to continually innovate our portfolio of convenient foods and beverages.Regulatory Matters The conduct of our businesses, including the production, storage, distribution, sale, display, advertising, marketing, labeling, content, quality, safety, transportation, packaging, disposal, recycling and use of our products, as well as our employment and occupational health and safety practices and protection of personal information, are subject to various laws and regulations administered by federal, state and local governmental agencies in the United States, as well as to laws and regulations administered by 8Table of Contentsgovernment entities and agencies in the more than 200 other countries and territories in which our products are made, manufactured, distributed or sold. It is our policy to abide by the laws and regulations around the world that apply to our businesses.The U.S. laws and regulations that we are subject to include, but are not limited to: the Federal Food, Drug and Cosmetic Act and various state laws governing food safety; the Food Safety Modernization Act; the Occupational Safety and Health Act and various state laws and regulations governing workplace health and safety; various federal, state and local environmental protection laws, as discussed below; the Federal Motor Carrier Safety Act; the Federal Trade Commission Act; the Lanham Act; various federal and state laws and regulations governing competition and trade practices; various federal and state laws and regulations governing our employment practices, including those related to equal employment opportunity, such as the Equal Employment Opportunity Act and the National Labor Relations Act and those related to overtime compensation, such as the Fair Labor Standards Act; data privacy and personal data protection laws and regulations, including the California Consumer Privacy Act of 2018; customs and foreign trade laws and regulations, including laws regarding the import or export of our products or ingredients used in our products and tariffs; laws regulating the sale of certain of our products in schools; laws regulating our supply chain, including the 2010 California Transparency in Supply Chains Act and laws relating to the payment of taxes. We are also required to comply with the Foreign Corrupt Practices Act and the Trade Sanctions Reform and Export Enhancement Act. We are also subject to various state and local statutes and regulations, including state consumer protection laws such as Proposition 65 in California, which requires that a specific warning appear on any product that contains a substance listed by the State of California as having been found to cause cancer or birth defects, unless the amount of such substance in the product is below a safe harbor level. We are subject to numerous similar and other laws and regulations outside the United States, including but not limited to laws and regulations governing food safety, international trade and tariffs, supply chain, including the U.K. Modern Slavery Act, occupational health and safety, competition, anti-corruption and data privacy, including the European Union General Data Protection Regulation. In many jurisdictions, compliance with competition laws is of special importance to us due to our competitive position in those jurisdictions, as is compliance with anti-corruption laws, including the U.K. Bribery Act. We rely on legal and operational compliance programs, as well as in-house and outside counsel and other experts, to guide our businesses in complying with the laws and regulations around the world that apply to our businesses.In addition, certain jurisdictions have either imposed, or are considering imposing, new or increased taxes on the manufacture, distribution or sale of our products, ingredients or substances contained in, or attributes of, our products or commodities used in the production of our products. These taxes vary in scope and form: some apply to all beverages, including non-caloric beverages, while others apply only to beverages with a caloric sweetener (e.g., sugar). Similarly, some measures apply a single tax rate per ounce/liter on beverages containing over a certain level of added sugar (or other sweetener) while others apply a graduated tax rate depending upon the amount of added sugar (or other sweetener) in the beverage and some apply a flat tax rate on beverages containing a particular substance or ingredient, regardless of the level of such substance or ingredient.In addition, certain jurisdictions have either imposed, or are considering imposing, product labeling or warning requirements or other limitations on the marketing or sale of certain of our products as a result of ingredients or substances contained in such products or the audience to whom products are marketed. These types of provisions have required that we highlight perceived concerns about a product, warn consumers to avoid consumption of certain ingredients or substances present in our products, restrict the age of consumers to whom products are marketed or sold or limit the location in which our products may be available. It is possible that similar or more restrictive requirements may be proposed or enacted in the future. 9Table of ContentsIn addition, certain jurisdictions have either imposed or are considering imposing regulations designed to increase recycling rates or encourage waste reduction. These regulations vary in scope and form from deposit return systems designed to incentivize the return of beverage containers, to extended producer responsibility policies and even bans on the use of some types of single-use plastics. It is possible that similar or more restrictive requirements may be proposed or enacted in the future.We are also subject to national and local environmental laws in the United States and in foreign countries in which we do business, including laws related to water consumption and treatment, wastewater discharge and air emissions. In the United States, our facilities must comply with the Clean Air Act, the Clean Water Act, the Comprehensive Environmental Response, Compensation and Liability Act, the Resource Conservation and Recovery Act and other federal and state laws regarding handling, storage, release and disposal of wastes generated onsite and sent to third-party owned and operated offsite licensed facilities and our facilities outside the United States must comply with similar laws and regulations. In addition, continuing concern over climate change may result in new or increased legal and regulatory requirements (in or outside of the United States) to reduce or mitigate the potential effects of greenhouse gases, or to limit or impose additional costs on commercial water use due to local water scarcity concerns. Our policy is to abide by all applicable environmental laws and regulations, and we have internal programs in place with respect to our global environmental compliance. We have made, and plan to continue making, necessary expenditures for compliance with applicable environmental laws and regulations. While these expenditures have not had a material impact on our business, financial condition or results of operations to date, changes in environmental compliance requirements, and any expenditures necessary to comply with such requirements, could adversely affect our financial performance. In addition, we and our subsidiaries are subject to environmental remediation obligations arising in the normal course of business, as well as remediation and related indemnification obligations in connection with certain historical activities and contractual obligations, including those of businesses acquired by us or our subsidiaries. While these environmental remediation and indemnification obligations cannot be predicted with certainty, such obligations have not had, and are not expected to have, a material impact on our capital expenditures, earnings or competitive position.In addition to the discussion in this section, see also “Item 1A. Risk Factors.”Human CapitalPepsiCo believes that human capital management, including attracting, developing and retaining a high quality workforce, is critical to our long-term success. Our Board and its Committees provide oversight on a broad range of human capital management topics, including corporate culture, diversity and inclusion, pay equity, health and safety, training and development and compensation and benefits. We employed approximately 291,000 people worldwide as of December 26, 2020, including approximately 120,000 people within the United States. We are party to numerous collective bargaining agreements and believe that relations with our employees are generally good. Protecting the safety, health, and well-being of our associates around the world is PepsiCo’s top priority. We strive to achieve an injury-free work environment. We also continue to invest in emerging technologies to protect our employees from injuries, including leveraging fleet telematics and distracted driving technology, resulting in reductions in road traffic accidents, and deploying wearable ergonomic risk reduction devices. In addition, throughout the COVID-19 pandemic, we have remained focused on the health and safety of our associates, especially our frontline associates who continue to make, move and sell our products during this critical time, including by implementing new safety protocols in our facilities, providing personal protective equipment and enabling testing. We believe that our culture of diversity and inclusion is a competitive advantage that fuels innovation, enhances our ability to attract and retain talent and strengthens our reputation. We continually strive to 10Table of Contentsimprove the attraction, retention, and advancement of diverse associates to ensure we sustain a high-caliber pipeline of talent that also represents the communities we serve. As of December 26, 2020, our global workforce was approximately 25% female, while management roles were approximately 41% female. As of December 26, 2020, approximately 43% of our U.S. workforce was comprised of racially/ethnically diverse individuals, of which approximately 30% of our U.S. associates in managerial roles were racially/ethnically diverse individuals. Direct reports of our Chief Executive Officer include 7 executives globally who are racially/ethnically diverse and/or female. We are also committed to the continued growth and development of our associates. PepsiCo supports and develops its associates through a variety of global training and development programs that build and strengthen employees' leadership and professional skills, including career development plans, mentoring programs and in-house learning opportunities, such as PEP U Degreed, our internal global online learning resource. In 2020, PepsiCo employees completed over 875,000 hours of training.Available InformationWe are required to file annual, quarterly and current reports, proxy statements and other information with the U.S. Securities and Exchange Commission (SEC). The SEC maintains an Internet site that contains reports, proxy and information statements, and other information regarding issuers that file electronically with the SEC at http://www.sec.gov.Our Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, proxy statements and amendments to those documents filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended (Exchange Act), are also available free of charge on our Internet site at http://www.pepsico.com as soon as reasonably practicable after such reports are electronically filed with or furnished to the SEC.Investors should note that we currently announce material information to our investors and others using filings with the SEC, press releases, public conference calls, webcasts or our corporate website (www.pepsico.com), including news and announcements regarding our financial performance, key personnel, our brands and our business strategy. Information that we post on our corporate website could be deemed material to investors. We encourage investors, the media, our customers, consumers, business partners and others interested in us to review the information we post on these channels. We may from time to time update the list of channels we will use to communicate information that could be deemed material and will post information about any such change on www.pepsico.com. The information on our website is not, and shall not be deemed to be, a part hereof or incorporated into this or any of our other filings with the SEC.Item 1A. Risk Factors. The following risks, some of which have occurred and any of which may occur in the future, can have a material adverse effect on our business or financial performance, which in turn can affect the price of our publicly traded securities. These are not the only risks we face. There may be other risks we are not currently aware of or that we currently deem not to be material but may become material in the future. COVID-19 Risks The impact of COVID-19 continues to create considerable uncertainty for our business.Our global operations continue to expose us to risks associated with the COVID-19 pandemic. Authorities around the world have implemented numerous measures to try to reduce the spread of the virus and such measures have impacted and continue to impact us, our business partners and consumers. While some of these measures have been lifted or eased in certain jurisdictions, other jurisdictions have seen a resurgence of COVID-19 cases resulting in reinstitution or expansion of such measures. 11Table of ContentsWe have seen and could continue to see changes in consumer demand as a result of COVID-19, including the inability of consumers to purchase our products due to illness, quarantine or other restrictions, store closures, or financial hardship. We also continue to see shifts in product and channel preferences, particularly an increase in demand in the e-commerce channel, which has impacted and could continue to impact our sales and profitability. Reduced demand for our products or changes in consumer purchasing patterns, as well as continued economic uncertainty, can adversely affect our customers’ financial condition, which can result in bankruptcy filings and/or an inability to pay for our products. In addition, we may also continue to experience business disruptions as a result of COVID-19, resulting from temporary closures of our facilities or facilities of our business partners or the inability of a significant portion of our or our business partners’ workforce to work because of illness, quarantine, or travel or other governmental restrictions. Any sustained interruption in our or our business partners’ operations, distribution network or supply chain or any significant continuous shortage of raw materials or other supplies, including personal protective equipment or sanitization products, can negatively impact our business. We have also incurred, and expect to continue to incur, increased employee and operating costs as a result of COVID-19, such as costs related to expanded benefits and frontline incentives, the provision of personal protective equipment and increased sanitation, allowances for credit losses, upfront payment reserves and inventory write-offs, which have negatively impacted and may continue to negatively impact our profitability. In addition, the increase in certain of our employees working remotely has resulted in increased demand on our information technology infrastructure, which can be subject to failure, disruption or unavailability, and increased vulnerability to cyberattacks and other cyber incidents. Also, continued economic uncertainty associated with the COVID-19 pandemic has resulted in volatility in the global capital and credit markets which can impair our ability to access these markets on terms commercially acceptable to us, or at all. The impact of COVID-19 has heightened, or in some cases manifested, certain of the other risks discussed herein. The extent of the impact of the COVID-19 pandemic on our business remains uncertain and will continue to depend on numerous evolving factors that we are not able to accurately predict and which will vary by jurisdiction and market, including the duration and scope of the pandemic, the development and availability of effective treatments and vaccines, global economic conditions during and after the pandemic, governmental actions that have been taken, or may be taken in the future, in response to the pandemic, and changes in consumer behavior in response to the pandemic, some of which may be more than just temporary. Business Risks Reduction in future demand for our products would adversely affect our business. Demand for our products depends in part on our ability to anticipate and effectively respond to shifts in consumer trends and preferences, including the types of products our consumers want and how they browse for, purchase and consume them. Consumer preferences continuously evolve due to a variety of factors, including: changes in consumer demographics, consumption patterns and channel preferences (including continued rapid increases in the e-commerce and online-to-offline channels); pricing; product quality; concerns or perceptions regarding packaging and its environmental impact (such as single-use and other plastic packaging); and concerns or perceptions regarding the nutrition profile and health effects of, or location of origin of, ingredients or substances in our products. Concerns with any of the foregoing could lead consumers to reduce or publicly boycott the purchase or consumption of our products. Consumer preferences are also influenced by perception of our brand image or the brand images of our products, the success of our advertising and marketing campaigns, our ability to engage with our consumers in the manner they prefer, including through the use of digital media, and the perception of our use, and the use of social media. These and other factors have reduced in the past and could continue to reduce consumers’ willingness to purchase certain of our products. Any inability on our part to anticipate 12Table of Contentsor react to changes in consumer preferences and trends, or make the right strategic investments to do so, including investments in data analytics to understand consumer trends, can lead to reduced demand for our products, lead to inventory write-offs or erode our competitive and financial position, thereby adversely affecting our business. In addition, our business operations are subject to disruption by natural disasters or other events beyond our control that could negatively impact product availability and decrease demand for our products if our crisis management plans do not effectively resolve these issues.Damage to our reputation or brand image can adversely affect our business.Maintaining a positive reputation globally is critical to selling our products. Our reputation or brand image has in the past been, and could in the future be, adversely impacted by a variety of factors, including: any failure by us or our business partners to maintain high ethical, social, business and environmental practices, including with respect to human rights, child labor laws and workplace conditions and employee health and safety; any failure to achieve our sustainability goals, including with respect to the nutrition profile of our products, packaging, water use and our impact on the environment; any failure to address health concerns about our products or particular ingredients in our products, including concerns regarding whether certain of our products contribute to obesity; our research and development efforts; any product quality or safety issues, including the recall of any of our products; any failure to comply with laws and regulations; consumer perception of our advertising campaigns, sponsorship arrangements, marketing programs and use of social media; or any failure to effectively respond to negative or inaccurate comments about us on social media or otherwise regarding any of the foregoing. Damage to our reputation or brand image has in the past and could in the future decrease demand for our products, thereby adversely affecting our business.Issues or concerns with respect to product quality and safety can adversely affect our business.Product quality or safety issues, including alleged mislabeling, misbranding, spoilage, undeclared allergens, adulteration or contamination, whether as a result of failure to comply with food safety laws or otherwise, have in the past and could in the future reduce consumer confidence and demand for our products, cause production and delivery disruptions, require product recalls and result in increased costs (including payment of fines and/or judgments) and damage our reputation, all of which can adversely affect our business. Failure to maintain adequate oversight over product quality or safety can result in product recalls, litigation, government investigations or inquiries or civil or criminal proceedings, all of which may result in fines, penalties, damages or criminal liability. Our business can also be adversely affected if consumers lose confidence in product quality, safety and integrity generally, even if such loss of confidence is unrelated to products in our portfolio.Any inability to compete effectively can adversely affect our business.Our products compete against products of international beverage, food and snack companies that, like us, operate in multiple geographies, as well as regional, local and private label and economy brand manufacturers and other competitors, including smaller companies developing and selling micro brands directly to consumers through e-commerce platforms or through retailers focused on locally sourced products. In many countries in which our products are sold, including the United States, The Coca-Cola Company is our primary beverage competitor. Our products compete primarily on the basis of brand recognition and loyalty, taste, price, value, quality, product variety, innovation, distribution, advertising, marketing and promotional activity, packaging, convenience, service and the ability to anticipate and effectively respond to consumer preferences and trends. Our business can be adversely affected if we are unable to effectively promote or develop our existing products or introduce new products, if our competitors spend more aggressively than we do or if we are otherwise unable to effectively respond to pricing pressure or compete effectively, and we may be unable to grow or maintain sales or category share or we may need to increase capital, marketing or other expenditures.13Table of ContentsFailure to attract, develop and maintain a highly skilled and diverse workforce can have an adverse effect on our business. Our business requires that we attract, develop and maintain a highly skilled and diverse workforce. Our employees are highly sought after by our competitors and other companies and our continued ability to compete effectively depends on our ability to attract, retain, develop and motivate highly skilled personnel for all areas of our organization. Any unplanned turnover or unsuccessful implementation of our succession plans to backfill current leadership positions, including the Chief Executive Officer, or failure to attract, develop and maintain a highly skilled and diverse workforce, including with key capabilities such as e-commerce and digital marketing and data analytic skills, can deplete our institutional knowledge base, erode our competitive advantage or result in increased costs due to increased competition for employees, higher employee turnover or increased employee benefit costs. In addition, failure to attract, retain and develop associates from underrepresented communities can damage our business results and our reputation. Any of the foregoing can adversely affect our business.Water scarcity can adversely affect our business.We and our business partners use water in the manufacturing and sourcing of our products. Lack of available water of acceptable quality, increasing focus by governmental and non-governmental organizations, investors, customers and consumers on water scarcity and increasing pressure to conserve and replenish water in areas of scarcity and stress may lead to: supply chain disruption; adverse effects on our operations or the operations of our business partners; higher compliance costs; capital expenditures (including investments in the development of technologies to enhance water efficiency and reduce consumption); higher production costs, including less favorable pricing for water; the interruption or cessation of operations at, or relocation of, our facilities or the facilities of our business partners; failure to achieve our sustainability goals relating to water use; perception of our failure to act responsibly with respect to water use or to effectively respond to legal or regulatory requirements concerning water scarcity; or damage to our reputation, any of which can adversely affect our business.Changes in the retail landscape or in sales to any key customer can adversely affect our business.The retail landscape continues to evolve, including rapid growth in e-commerce channels and hard discounters. Our business will be adversely affected if we are unable to maintain and develop successful relationships with e-commerce retailers and hard discounters, while also maintaining relationships with our key customers operating in traditional retail channels (many of whom are also focused on increasing their e-commerce sales). Our business can be adversely affected if e-commerce channels and hard discounters take significant additional market share away from traditional retailers or we fail to find ways to create more powerful digital tools and capabilities for our retail customers to enable them to grow their businesses. In addition, our business can be adversely affected if we are unable to profitably expand our own direct-to-consumer e-commerce capabilities. The retail industry is also impacted by increased consolidation of ownership and purchasing power, particularly in North America, Europe and Latin America, resulting in large retailers or buying groups with increased purchasing power, impacting our ability to compete in these areas. Consolidation also adversely impacts our smaller customers’ ability to compete effectively, resulting in an inability on their part to pay for our products or reduced or canceled orders of our products. Further, we must maintain mutually beneficial relationships with our key customers, including Walmart, to compete effectively. Any inability to resolve a significant dispute with any of our key customers, a change in the business condition (financial or otherwise) of any of our key customers, even if unrelated to us, a significant reduction in sales to any key customer, or the loss of any of our key customers can adversely affect our business. 14Table of ContentsDisruption of our supply chain may adversely affect our business.Many of the raw materials and supplies used in the production of our products are sourced from countries experiencing civil unrest, political instability or unfavorable economic conditions. Some raw materials and supplies, including packaging materials such as recycled PET, are available only from a limited number of suppliers or from a sole supplier or are in short supply when seasonal demand is at its peak. There can be no assurance that we will be able to maintain favorable arrangements and relationships with suppliers or that our contingency plans will be effective to prevent disruptions that may arise from shortages or discontinuation of any raw materials and other supplies that we use in the manufacture, production and distribution of our products. The raw materials and other supplies, including agricultural commodities and fuel, that we use for the manufacturing, production and distribution of our products are subject to price volatility and fluctuations in availability caused by many factors, including changes in supply and demand, weather conditions (including potential effects of climate change), fire, natural disasters, disease or pests (including the impact of greening disease on the citrus industry), agricultural uncertainty, health epidemics or pandemics or other contagious outbreaks, governmental incentives and controls (including import/export restrictions, such as new or increased tariffs, sanctions, quotas or trade barriers), political uncertainties, acts of terrorism, governmental instability or currency exchange rates. Many of our raw materials and supplies are purchased in the open market. The prices we pay for such items are subject to fluctuation. If price changes result in unexpected or significant increases in the costs of any raw materials or other supplies, we may be unwilling or unable to increase our product prices or unable to effectively hedge against price increases to offset these increased costs without suffering reduced volume, revenue, margins and operating results.Political and social conditions can adversely affect our business.Political and social conditions in the markets in which our products are sold have been and could continue to be difficult to predict, resulting in adverse effects on our business. The results of elections, referendums or other political conditions (including government shutdowns) in these markets, including the United Kingdom’s withdrawal from the European Union, have in the past and could continue to impact how existing laws, regulations and government programs or policies are implemented or result in uncertainty as to how such laws, regulations, programs or policies may change, including with respect to tariffs, sanctions, environmental and climate change regulations, taxes, benefit programs, the movement of goods, services and people between countries, relationships between countries, customer or consumer perception of a particular country or its government and other matters, and has resulted in and could continue to result in exchange rate fluctuation, volatility in global stock markets and global economic uncertainty or adversely affect demand for our products, any of which can adversely affect our business. In addition, political and social conditions in certain cities throughout the U.S. as well as globally have resulted in demonstrations and protests, including in connection with political elections and civil rights and liberties. Our operations, including the distribution of our products and the ingredients or other raw materials used in the production of our products, may be disrupted if such events persist for a prolonged period of time, including due to actions taken by governmental authorities in affected cities and regions, which can adversely affect our business. Our business can be adversely affected if we are unable to grow in developing and emerging markets.Our success depends in part on our ability to grow our business in developing and emerging markets, including Mexico, Russia, the Middle East, Brazil, China, South Africa and India. There can be no assurance that our products will be accepted or be successful in any particular developing or emerging market, due to competition, price, cultural differences, consumer preferences, method of distribution or otherwise. Our business in these markets has been and could continue in the future to be impacted by economic, political and social conditions; acts of war, terrorist acts, and civil unrest, including demonstrations and protests; competition; tariffs, sanctions or other regulations restricting contact with 15Table of Contentscertain countries in these markets; foreign ownership restrictions; nationalization of our assets or the assets of our business partners; government-mandated closure, or threatened closure, of our operations or the operations of our business partners; restrictions on the import or export of our products or ingredients or substances used in our products; highly inflationary economies; devaluation or fluctuation or demonetization of currency; regulations on the transfer of funds to and from foreign countries, currency controls or other currency exchange restrictions, which result in significant cash balances in foreign countries, from time to time, or can significantly affect our ability to effectively manage our operations in certain of these markets and can result in the deconsolidation of such businesses; the lack of well-established or reliable legal systems; increased costs of doing business due to compliance with complex foreign and U.S. laws and regulations that apply to our international operations, including the Foreign Corrupt Practices Act, the U.K. Bribery Act and the Trade Sanctions Reform and Export Enhancement Act; and adverse consequences, such as the assessment of fines or penalties, for any failure to comply with laws and regulations. Our business can be adversely affected if we are unable to expand our business in developing and emerging markets, effectively operate, or manage the risks associated with operating, in these markets, or achieve the return on capital we expect from our investments in these markets. Changes in economic conditions can adversely impact our business.Many of the jurisdictions in which our products are sold have experienced and could continue to experience uncertain or unfavorable economic conditions, such as recessions or economic slowdowns, which have and could continue to result in adverse changes in interest rates, tax laws or tax rates; volatile commodity markets; highly inflationary economies, devaluation, fluctuation or demonetization; contraction in the availability of credit; demonetization, austerity or stimulus measures; the effects of any default by or deterioration in the creditworthiness of the countries in which our products are sold; or a decrease in the fair value of pension or post-retirement assets that could increase future employee benefit costs and/or funding requirements of our pension or post-retirement plans. In addition, we cannot predict how current or future economic conditions will affect our business partners, including financial institutions with whom we do business, and any negative impact on any of the foregoing may also have an adverse impact on our business.Future cyber incidents and other disruptions to our information systems can adversely affect our business.We depend on information systems and technology, including public websites and cloud-based services, for many activities important to our business, including communications within our company, interfacing with customers and consumers; ordering and managing inventory; managing and operating our facilities; protecting confidential information; maintaining accurate financial records and complying with regulatory, financial reporting, legal and tax requirements. Our business has in the past and could in the future be negatively affected by system shutdowns, degraded systems performance, systems disruptions or security incidents. These disruptions or incidents may be caused by cyberattacks and other cyber incidents, network or power outages, software, equipment or telecommunications failures, the unintentional or malicious actions of employees or contractors, natural disasters, fires or other catastrophic events. Cyberattacks and other cyber incidents are occurring more frequently, are constantly evolving in nature, are becoming more sophisticated and are being carried out by groups and individuals with a wide range of expertise and motives. Cyberattacks and cyber incidents take many forms including cyber extortion, denial of service, social engineering, introduction of viruses or malware, exploiting vulnerabilities in hardware, software or other infrastructure, hacking, website defacement or theft of passwords and other credentials, unauthorized use of computing resources for digital currency mining and business email compromise. As with other global companies, we are regularly subject to cyberattacks and other cyber incidents, including many of the types of attacks and incidents described above. If we do not allocate and effectively manage the resources necessary to continue to build and maintain our information technology infrastructure, or if 16Table of Contentswe fail to timely identify or appropriately respond to cyberattacks or other cyber incidents, our business can be adversely affected, resulting in transaction errors, processing inefficiencies, data loss, legal claims or proceedings, regulatory penalties, and the loss of sales and customers. Similar risks exist with respect to third-party providers, including cloud-based service providers, that we rely upon for aspects of our information technology support services and administrative functions, including payroll processing, health and benefit plan administration and certain finance and accounting functions, and the systems managed, hosted, provided and/or used by such third parties and their vendors. The need to coordinate with various third-party service providers, including with respect to timely notification and access to personnel and information concerning an incident, may complicate our efforts to resolve issues that arise. As a result, we are subject to the risk that the activities associated with our third-party service providers can adversely affect our business even if the attack or breach does not directly impact our systems or information. Although the cyber incidents and other systems disruptions that we have experienced to date have not had a material effect on our business, such incidents or disruptions could have a material adverse effect on us in the future. While we devote significant resources to network security, disaster recovery, employee training and other security measures to protect our systems and data, there are no assurances that such measures will protect us against all cyber incidents or systems disruptions. In addition, while we currently maintain insurance coverage that, subject to its terms and conditions, is intended to address costs associated with certain aspects of cyber incidents and information systems failures, this insurance coverage may not, depending on the specific facts and circumstances surrounding an incident, cover all losses or all types of claims that arise from an incident, or the damage to our reputation or brands that may result from an incident. Failure to successfully complete or manage strategic transactions can adversely affect our business.We regularly review our portfolio of businesses and evaluate potential acquisitions, joint ventures, distribution agreements, divestitures, refranchisings and other strategic transactions. The success of these transactions is dependent upon, among other things, our ability to realize the full extent of the expected returns, benefits, cost savings or synergies as a result of a transaction, within the anticipated time frame, or at all; receipt of necessary consents, clearances and approvals; and diversion of management’s attention from day-to-day operations. Risks associated with strategic transactions include integrating manufacturing, distribution, sales, accounting, financial reporting and administrative support activities and information technology systems with our company; operating through new business models or in new categories or territories; motivating, recruiting and retaining executives and key employees; conforming controls (including internal control over financial reporting and disclosure controls and procedures) and policies (including with respect to environmental compliance, health and safety compliance and compliance with anti-bribery laws); retaining existing customers and consumers and attracting new customers and consumers; managing tax costs or inefficiencies; maintaining good relations with divested or refranchised businesses in our supply or sales chain; managing the impact of business decisions or other actions or omissions of our joint venture partners that may have different interests than we do; and other unanticipated problems or liabilities, such as contingent liabilities and litigation. Strategic transactions that are not successfully completed or managed effectively, or our failure to effectively manage the risks associated with such transactions, have in the past and could continue to result in adverse effects on our business.Our reliance on third-party service providers can have an adverse effect on our business.We rely on third-party service providers, including cloud data service providers, for certain areas of our business, including payroll processing, health and benefit plan administration and certain finance and accounting functions. Failure by these third parties to meet their contractual, regulatory and other obligations to us, or our failure to adequately monitor their performance, has in the past and could 17Table of Contentscontinue to result in our inability to achieve the expected cost savings or efficiencies and result in additional costs to correct errors made by such service providers. Depending on the function involved, such errors can also lead to business disruption, systems performance degradation, processing inefficiencies or other systems disruptions, the loss of or damage to intellectual property or sensitive data through security breaches or otherwise, incorrect or adverse effects on financial reporting, litigation or remediation costs, damage to our reputation or have a negative impact on employee morale, all of which can adversely affect our business. In addition, we continue on our multi-year business transformation initiative to migrate certain of our systems, including our financial processing systems, to enterprise-wide systems solutions. If we do not allocate and effectively manage the resources necessary to build and sustain the proper information technology infrastructure, or if we fail to achieve the expected benefits from this initiative, our business could be adversely affected.Climate change or measures to address climate change can negatively affect our business or damage our reputation.Climate change may have a negative effect on agricultural productivity which may result in decreased availability or less favorable pricing for certain commodities that are necessary for our products, such as potatoes, sugar cane, corn, wheat, rice, oats, oranges and other fruits (and fruit-derived oils). In addition, climate change may also increase the frequency or severity of natural disasters and other extreme weather conditions, which could impair our production capabilities, disrupt our supply chain or impact demand for our products. Also, concern over climate change may result in new or increased legal and regulatory requirements to reduce or mitigate the effects of climate change, which could result in significant increased costs and require additional investments in facilities and equipment. As a result, the effects of climate change can negatively affect our business and operations. In addition, any failure to achieve our goals with respect to reducing our impact on the environment or perception of a failure to act responsibly with respect to the environment or to effectively respond to regulatory requirements concerning climate change can lead to adverse publicity, resulting in an adverse effect on our business or damage to our reputation.Strikes or work stoppages can cause our business to suffer.Many of our employees are covered by collective bargaining agreements, and other employees may seek to be covered by collective bargaining agreements. Strikes or work stoppages or other business interruptions can occur if we are unable to renew, or enter into new, collective bargaining agreements on satisfactory terms and can impair manufacturing and distribution of our products, lead to a loss of sales, increase our costs or otherwise affect our ability to fully implement future operational changes to enhance our efficiency or to adapt to changing business needs or strategy, all of which can adversely affect our business.Financial RisksFailure to realize benefits from our productivity initiatives can adversely affect our financial performance.Our future growth depends, in part, on our ability to continue to reduce costs and improve efficiencies, including implementing shared business service organizational models. We continue to identify and implement productivity initiatives that we believe will position our business for long-term sustainable growth by allowing us to achieve a lower cost structure, improve decision-making and operate more efficiently. Some of these measures result in unintended consequences, such as business disruptions, distraction of management and employees, reduced morale and productivity, unexpected employee attrition, an inability to attract or retain key personnel and negative publicity. If we are unable to successfully implement our productivity initiatives as planned or do not achieve expected savings as a 18Table of Contentsresult of these initiatives, we may not realize all or any of the anticipated benefits, resulting in adverse effects on our financial performance.A deterioration in our estimates and underlying assumptions regarding the future performance of our business can result in an impairment charge that can adversely affect our results of operations. We conduct impairment tests on our goodwill and other indefinite-lived intangible assets annually or more frequently if circumstances indicate that impairment may have occurred. In addition, amortizable intangible assets, property, plant and equipment and other long-lived assets are evaluated for impairment upon a significant change in the operating or macroeconomic environment. A deterioration in our underlying assumptions regarding the impact of competitive operating conditions, macroeconomic conditions or other factors used to estimate the future performance of any of our reporting units or assets, including any deterioration in the weighted-average cost of capital based on market data available at the time, can result in an impairment, which can adversely affect our results of operations.Fluctuations in exchange rates impact our financial performance. Because our consolidated financial statements are presented in U.S. dollars, the financial statements of our subsidiaries outside the United States, where the functional currency is other than the U.S. dollar, are translated into U.S. dollars. Given our global operations, we also pay for the ingredients, raw materials and commodities used in our business in numerous currencies. Fluctuations in exchange rates, including as a result of currency controls or other currency exchange restrictions have had, and could continue to have, an adverse impact on our financial performance.Our borrowing costs and access to capital and credit markets can be adversely affected by a downgrade or potential downgrade of our credit ratings.Rating agencies routinely evaluate us and their ratings are based on a number of factors, including our cash generating capability, levels of indebtedness, policies with respect to shareholder distributions and our financial strength generally, as well as factors beyond our control, such as the state of the economy and our industry. We expect to maintain Tier 1 commercial paper access, which we believe will facilitate appropriate financial flexibility and ready access to global credit markets at favorable interest rates. Any downgrade or announcement that we are under review for a potential downgrade of our credit ratings, especially any downgrade to below investment grade, can increase our future borrowing costs, impair our ability to access capital and credit markets on terms commercially acceptable to us or at all, result in a reduction in our liquidity, or impair our ability to access the commercial paper market with the same flexibility that we have experienced historically (and therefore require us to rely more heavily on more expensive types of debt financing), all of which can adversely affect our financial performance. Legal, Tax and Regulatory Risks Taxes aimed at our products can adversely affect our business or financial performance.Certain jurisdictions in which our products are sold have either imposed, or are considering imposing, new or increased taxes on the manufacture, distribution or sale of certain of our products, particularly our beverages, as a result of the ingredients or substances contained in our products. These taxes vary in scope and form: some apply to all beverages, including non-caloric beverages, while others apply only to beverages with a caloric sweetener (e.g., sugar). Similarly, some measures apply a single tax rate per ounce/liter on beverages containing over a certain amount of added sugar (or other sweetener), some apply a graduated tax rate depending upon the amount of added sugar (or other sweetener) in the beverage and others apply a flat tax rate on beverages containing any amount of added sugar (or other sweetener). For example, Poland enacted a graduated tax on all sweetened beverages, effective January 1, 2021, at a rate of PLN 0.5 (USD 0.12) per liter for drinks with a sugar (or other sweetener) content of up to 5g per 100ml and an additional PLN 0.05 (USD 0.01) for each gram of sugar (or other sweetener) over 5g. These tax measures, whatever their scope or form, have in the past and could continue to increase the cost of certain 19Table of Contentsof our products, reduce overall consumption of our products or lead to negative publicity, resulting in an adverse effect on our business and financial performance.Limitations on the marketing or sale of our products can adversely affect our business and financial performance.Certain jurisdictions in which our products are sold have either imposed, or are considering imposing, limitations on the marketing or sale of our products as a result of ingredients or substances in our products. These limitations require that we highlight perceived concerns about a product, warn consumers to avoid consumption of certain ingredients or substances present in our products, restrict the age of consumers to whom products are marketed or sold or limit the location in which our products may be available. For example, Mexico has imposed a stop-sign labeling scheme to signal the presence of non-caloric sweeteners and caffeine in pre-packaged foods and non-alcoholic beverages. Certain jurisdictions have imposed or are considering imposing color-coded labeling requirements where colors such as red, yellow and green are used to indicate various levels of a particular ingredient, such as sugar, sodium or saturated fat, in products. The imposition or proposed imposition of additional limitations on the marketing or sale of our products has in the past and could continue to reduce overall consumption of our products, lead to negative publicity or leave consumers with the perception that our products do not meet their health and wellness needs, resulting in an adverse effect on our business and financial performance.Laws and regulations related to the use or disposal of plastics or other packaging can adversely affect our business and financial performance.Certain of our products are sold in plastic or other packaging designed to be recyclable. However, not all packaging is recycled, whether due to lack of infrastructure or otherwise, and certain of our packaging is not currently recyclable. Packaging waste that displays one or more of our brands has in the past resulted in and could continue to result in negative publicity or reduced consumer demand for our products, adversely affecting our financial performance. Many jurisdictions in which our products are sold have imposed or are considering imposing regulations or policies intended to encourage the use of sustainable packaging, waste reduction or increased recycling rates or to restrict the sale of products utilizing certain packaging. These regulations vary in form and scope and include taxes to incentivize behavior, restrictions on certain products and materials, requirements for bottle caps to be tethered to bottles, bans on the use of single-use plastics, extended producer responsibility policies and requirements to charge deposit fees. For example, the European Union has imposed a minimum recycled content requirement for beverage bottles packaging and similar legislation is under consideration in several states in the United States. These laws and regulations have in the past and could continue to increase the cost of our products, impact demand for our products, result in negative publicity and require us and our business partners, including our independent bottlers, to increase our capital expenditures to invest in minimizing the amount of plastic or other materials used in our packaging or to develop alternative packaging, all of which can adversely affect our business and financial performance.Failure to comply with personal data protection and privacy laws can adversely affect our business.We are subject to a variety of continuously evolving and developing laws and regulations in numerous jurisdictions regarding personal data protection and privacy laws. These laws and regulations may be interpreted and applied differently from country to country or, within the United States, from state to state, and can create inconsistent or conflicting requirements. Our efforts to comply with these laws and regulations, including with respect to data from residents of the European Union who are covered by the General Data Protection Regulation or residents of the state of California who are covered by the California Consumer Privacy Act, impose significant costs and challenges that are likely to continue to increase over time. Failure to comply with these laws and regulations can result in litigation, claims, legal or regulatory proceedings, inquiries or investigations or damage to our reputation, all of which can adversely affect our business.20Table of ContentsIncreases in income tax rates, changes in income tax laws or disagreements with tax authorities can adversely affect our financial performance.Increases in income tax rates or other changes in tax laws, including changes in how existing tax laws are interpreted or enforced, can adversely affect our financial performance. For example, economic and political conditions in countries where we are subject to taxes, including the United States, have in the past and could continue to result in significant changes in tax legislation or regulation, including as a result of any changes enacted during the new U.S. presidential administration. The increasingly complex global tax environment has in the past and could continue to increase tax uncertainty, resulting in higher compliance costs and adverse effects on our financial performance. We are also subject to regular reviews, examinations and audits by numerous taxing authorities with respect to income and non-income based taxes. Economic and political pressures to increase tax revenues in jurisdictions in which we operate, or the adoption of new or reformed tax legislation or regulation, may make resolving tax disputes more difficult and the final resolution of tax audits and any related litigation can differ from our historical provisions and accruals, resulting in an adverse effect on our financial performance.If we are unable to adequately protect our intellectual property rights, or if we are found to infringe on the intellectual property rights of others, our business can be adversely affected.We possess intellectual property rights that are important to our business, including ingredient formulas, trademarks, copyrights, patents, business processes and other trade secrets. The laws of various jurisdictions in which we operate have differing levels of protection of intellectual property. Our competitive position and the value of our products and brands can be reduced and our business adversely affected if we fail to obtain or adequately protect our intellectual property, including our ingredient formulas, or if there is a change in law that limits or removes the current legal protections afforded our intellectual property. Also, if, in the course of developing new products or improving the quality of existing products, we are found to have infringed on the intellectual property rights of others, directly or indirectly, such finding can damage our reputation and limit our ability to introduce new products or improve the quality of existing products, resulting in an adverse effect on our business.Failure to comply with laws and regulations applicable to our business can adversely affect our business. The conduct of our business is subject to numerous laws and regulations relating to the production, storage, distribution, sale, display, advertising, marketing, labeling, content (including whether a product contains genetically engineered ingredients), quality, safety, transportation, traceability, packaging, disposal, recycling and use of our products, employment and occupational health and safety, environmental matters (including pesticide use) and data privacy and protection. In addition, in many jurisdictions, compliance with competition laws is of special importance to us due to our competitive position, as is compliance with anti-corruption laws. The imposition of new laws, changes in laws or regulatory requirements or changing interpretations thereof, and differing or competing regulations and standards across the markets where our products are made, manufactured, distributed or sold, have in the past and could continue to result in higher compliance costs, capital expenditures and higher production costs, resulting in adverse effects on our business. In addition, if one jurisdiction imposes or proposes to impose new laws or regulations that impact the manufacture, distribution or sale of our products, other jurisdictions can often follow. Failure to comply with such laws or regulations can subject us to criminal or civil enforcement actions, including fines, injunctions, product recalls, penalties, disgorgement of profits or activity restrictions, all of which can adversely affect our business.21Table of ContentsPotential liabilities and costs from litigation, claims, legal or regulatory proceedings, inquiries or investigations can have an adverse impact on our business.We and our subsidiaries are party to a variety of litigation, claims, legal or regulatory proceedings, inquiries and investigations, including but not limited to matters related to our advertising, marketing or commercial practices, product labels, claims and ingredients, intellectual property rights, environmental, privacy, employment, tax and insurance matters and matters relating to our compliance with applicable laws and regulations. These matters are inherently uncertain and there is no guarantee that we will be successful in defending ourselves or that our assessment of the materiality of these matters and the likely outcome or potential losses and established reserves will be consistent with the ultimate outcome of such matters. Responding to these matters, even those that are ultimately non-meritorious, requires us to incur significant expense and devote significant resources, and may generate adverse publicity that damages our reputation or brand image. Any of the foregoing can adversely affect our business.Item 1B. Unresolved Staff Comments.We have received no written comments regarding our periodic or current reports from the staff of the SEC that were issued 180 days or more preceding the end of our 2020 year and that remain unresolved.22Table of ContentsItem 2. Properties.Our principal executive office located in Purchase, New York and our facilities located in Plano, Texas, all of which we own, are our most significant corporate properties.In connection with making, marketing, distributing and selling our products, each division utilizes manufacturing, processing, bottling and production plants, warehouses, distribution centers, storage facilities, offices, including division headquarters, research and development facilities and other facilities, all of which are either owned or leased. Significant properties by division are as follows: Property TypeLocationOwned/ LeasedFLNAResearch and development facilityPlano, TexasOwnedQFNAFood plantCedar Rapids, IowaOwnedPBNAResearch and development facilityValhalla, New YorkOwnedPBNAConcentrate plantArlington, TexasOwnedPBNATropicana plantBradenton, FloridaOwnedLatAmSnack plantCelaya, MexicoOwnedLatAmTwo snack plantsVallejo, MexicoOwnedEuropeSnack plantKashira, RussiaOwnedEuropeManufacturing plantLehavim, IsraelOwnedEuropeDairy plantMoscow, RussiaOwned (a)AMESASnack plantRiyadh, Saudi ArabiaOwned (a)APACSnack plantWuhan, ChinaOwned (a)FLNA, QFNA, PBNAShared service centerWinston Salem, North CarolinaLeasedPBNA, LatAmConcentrate plantColonia, UruguayOwned (a)PBNA, Europe, AMESATwo concentrate plantsCork, IrelandOwnedPBNA, AMESA, APACConcentrate plantSingaporeOwned (a)All divisionsShared service centerHyderabad, IndiaLeased(a)The land on which these plants are located is leased.Most of our plants are owned or leased on a long-term basis. In addition to company-owned or leased properties described above, we also utilize a highly distributed network of plants, warehouses and distribution centers that are owned or leased by our contract manufacturers, co-packers, strategic alliances or joint ventures in which we have an equity interest. We believe that our properties generally are in good operating condition and, taken as a whole, are suitable, adequate and of sufficient capacity for our current operations.Item 3. Legal Proceedings.We and our subsidiaries are party to a variety of litigation, claims, legal or regulatory proceedings, inquiries and investigations. While the results of such litigation, claims, legal or regulatory proceedings, inquiries and investigations cannot be predicted with certainty, management believes that the final outcome of the foregoing will not have a material adverse effect on our financial condition, results of operations or cash flows. See also “Item 1. Business – Regulatory Matters” and “Item 1A. Risk Factors.”Item 4. Mine Safety Disclosures.Not applicable. __________________________________________________23Table of ContentsInformation About Our Executive OfficersThe following is a list of names, ages and backgrounds of our current executive officers:Name Age Title Marie T. Gallagher61Senior Vice President and Controller, PepsiCoHugh F. Johnston59Vice Chairman, PepsiCo; Executive Vice President and Chief Financial Officer, PepsiCoRamon L. Laguarta57Chairman of the Board of Directors and Chief Executive Officer, PepsiCoSilviu Popovici53Chief Executive Officer, EuropePaula Santilli56Chief Executive Officer, Latin AmericaRonald Schellekens56Executive Vice President and Chief Human Resources Officer, PepsiCoKirk Tanner52Chief Executive Officer, PepsiCo Beverages North AmericaEugene Willemsen53Chief Executive Officer, Africa, Middle East, South AsiaSteven Williams55Chief Executive Officer, PepsiCo Foods North AmericaDavid Yawman52Executive Vice President, General Counsel and Corporate Secretary, PepsiCoMarie T. Gallagher was appointed PepsiCo’s Senior Vice President and Controller in 2011. Ms. Gallagher joined PepsiCo in 2005 as Vice President and Assistant Controller. Prior to joining PepsiCo, Ms. Gallagher was Assistant Controller at Altria Corporate Services from 1992 to 2005 and, prior to that, a senior manager at Coopers & Lybrand.Hugh F. Johnston was appointed Vice Chairman, PepsiCo in 2015 and Executive Vice President and Chief Financial Officer, PepsiCo in 2010. In addition to providing strategic financial leadership for PepsiCo, Mr. Johnston’s portfolio has included a variety of responsibilities, including leadership of the Company’s information technology function since 2015, the Company’s global e-commerce business from 2015 to 2019, and the Quaker Foods North America division from 2014 to 2016. He has also held a number of leadership roles throughout his PepsiCo career, serving as Executive Vice President, Global Operations from 2009 to 2010, President of Pepsi-Cola North America from 2007 to 2009, Executive Vice President, Operations from 2006 to 2007, and Senior Vice President, Transformation from 2005 to 2006. Prior to that, he served as Senior Vice President and Chief Financial Officer of PepsiCo Beverages and Foods from 2002 through 2005, and as PepsiCo’s Senior Vice President of Mergers and Acquisitions in 2002. Mr. Johnston joined PepsiCo in 1987 as a Business Planner and held various finance positions until 1999 when he left to join Merck & Co., Inc. as Vice President, Retail, a position which he held until he rejoined PepsiCo in 2002. Prior to joining PepsiCo in 1987, Mr. Johnston was with General Electric Company in a variety of finance positions.Ramon L. Laguarta has served as PepsiCo’s Chief Executive Officer and a director on the Board since 2018, and assumed the role of Chairman of the Board in 2019. Mr. Laguarta previously served as President of PepsiCo from 2017 to 2018. Prior to serving as President, Mr. Laguarta held a variety of positions of increasing responsibility in Europe, including as Commercial Vice President of PepsiCo Europe from 2006 to 2008, PepsiCo Eastern Europe Region from 2008 to 2012, President, Developing & Emerging Markets, PepsiCo Europe from 2012 to 2015, Chief Executive Officer, PepsiCo Europe in 2015, and Chief Executive Officer, Europe Sub-Saharan Africa from 2015 until 2017. From 2002 to 2006, he was General Manager for Iberia Snacks and Juices, and from 1999 to 2001 a General Manager for Greece Snacks. Prior to joining PepsiCo in 1996 as a marketing vice president for Spain Snacks, Mr. Laguarta worked for Chupa Chups, S.A., where he worked in several international assignments in Asia, Europe, the Middle East and the United States. Mr. Laguarta has served as a director of Visa Inc. since 2019.24Table of ContentsSilviu Popovici was appointed Chief Executive Officer, Europe, effective 2019. Prior to this role, he served as Chief Executive Officer, Europe Sub-Saharan Africa in 2019 and as President, Europe Sub-Saharan Africa from 2017 to early 2019. Mr. Popovici previously served as President, Russia, Ukraine and CIS (The Commonwealth of Independent States) from 2015 to 2017, and as President, PepsiCo Russia from 2013 to 2015. Mr. Popovici joined PepsiCo in 2011 following PepsiCo’s acquisition of Wimm-Bill-Dann Foods OJSC (WBD) and served as General Manager, WBD Foods Division from 2011 until 2012. Prior to the acquisition, Mr. Popovici held senior leadership roles at WBD, running its dairy business from 2008 to 2011 and its beverages business from 2006 to 2008.Paula Santilli was appointed Chief Executive Officer, Latin America, effective 2019. Previously, she served in various leadership positions at PepsiCo Mexico Foods, as President from 2017 to 2019, as Chief Operating Officer from 2016 to 2017 and as Vice President and General Manager from 2011 to 2016. Prior to joining PepsiCo Mexico Foods, she held a variety of roles, including leadership positions in Beverages in Mexico, as well as in Foods and Snacks in the Latin America Southern Cone region comprising Argentina, Uruguay and Paraguay. Ms. Santilli joined PepsiCo in 2001 following PepsiCo’s acquisition of the Quaker Oats Company. At Quaker, she held various roles of increasing responsibility from 1992 to 2001, including running the regional Quaker Foods and Gatorade businesses in Argentina, Chile and Uruguay. Ronald Schellekens was appointed Executive Vice President and Chief Human Resources Officer, PepsiCo, in 2018. Prior to that, Mr. Schellekens served as Group HR Director of Vodafone Group Services Limited from 2009 to 2018, where he was responsible for the Vodafone Human Resource Management function, as well as health and safety, and property and real estate functions. Prior to joining Vodafone, Mr. Schellekens was executive vice president, human resources for the global downstream division of Royal Dutch Shell Plc. Prior to that, he worked for PepsiCo for nine years from 1994 to 2003 in various international, senior human resources roles, including assignments in Switzerland, Spain, South Africa, the United Kingdom and Poland, where he was most recently responsible for the Europe, Middle East & Africa region for PepsiCo Foods International. Prior to that, he served for nine years at AT&T Inc. in Human Resources. Kirk Tanner was appointed Chief Executive Officer, PepsiCo Beverages North America, effective 2019. Prior to that, Mr. Tanner served as President and Chief Operating Officer, North America Beverages from 2016 to 2018, Chief Operating Officer, North America Beverages and President, Global Foodservice from 2015 to 2016, and President, Global Foodservice from 2014 to 2015. Mr. Tanner joined PepsiCo in 1992, where he has worked in numerous domestic and international locations and in a variety of roles, including Senior Vice President of Frito-Lay North America’s West region from 2009 to 2013, Vice President, Sales of PepsiCo U.K. and Ireland from 2008 to 2009, Region Vice President of Frito-Lay North America’s Mountain region from 2005 to 2008, Region Vice President of Frito-Lay North America’s Mid-America region from 2002 to 2005 and Region Vice President of Frito-Lay North America’s California region from 2000 to 2002. Eugene Willemsen was appointed Chief Executive Officer, Africa, Middle East, South Asia, effective 2019. Previously he served as Chief Executive Officer, Sub-Saharan Africa in 2019 and as Executive Vice President, Global Categories and Franchise Management from 2015 to 2019. Before that, he led the global Pepsi-Lipton Joint Venture as President from 2014 to 2015. Prior to such role, Mr. Willemsen served as PepsiCo’s Senior Vice President and General Manager, South East Europe from 2011 to 2013, as Senior Vice President and General Manager, Commercial, Europe from 2008 to 2011, as Senior Vice President and General Manager, Northern Europe from 2006 to 2008, as Vice President, General Manager, Benelux from 2000 to 2005 and as Commercial Director, Benelux for the snacks business from 1998 to 2000. Mr. Willemsen joined PepsiCo in 1995 as a business development manager.25Table of ContentsSteven Williams was appointed Chief Executive Officer, PepsiCo Foods North America, effective 2019. Prior to this role, Mr. Williams served in leadership positions for Frito-Lay’s U.S. operations, as Senior Vice President, Commercial Sales and Chief Commercial Officer from 2017 to 2019 and as General Manager and Senior Vice President, East Division from 2016 to 2017. Prior to that, he served as General Manager and Senior Vice President, Customer Management for PepsiCo’s global Walmart business from 2013 to 2016, as Sales Senior Vice President, North American Nutrition from 2011 to 2013 and as Vice President, Sales, Central Division from 2009 to 2011. Mr. Williams joined PepsiCo in 2001 as a part of PepsiCo’s acquisition of the Quaker Oats Company, which he joined in 1997 and has held leadership positions of increasing responsibility in sales and customer management. David Yawman has served as Executive Vice President, General Counsel and Corporate Secretary, PepsiCo since 2017 and will continue in that role until March 1, 2021. From 2017 through 2020, Mr. Yawman also oversaw PepsiCo’s Public Policy and Government Affairs department. He previously served as Senior Vice President and Deputy General Counsel for PepsiCo and General Counsel for North America and Corporate in 2017, as Senior Vice President, PepsiCo Deputy General Counsel, General Counsel, North America Beverages and Quaker Foods North America from 2015 to 2017, as Senior Vice President, PepsiCo Deputy General Counsel, General Counsel, PepsiCo America Beverages from 2014 to 2015, as Senior Vice President, PepsiCo Chief Compliance and Ethics Officer from 2012 to 2014, and as Senior Vice President, General Counsel, Pepsi Beverages Company from 2010 to 2012. Prior to that, he served five years in the law department of The Pepsi Bottling Group, Inc. (PBG) and, prior to that, was a member of PepsiCo’s corporate law department from the time he joined PepsiCo in 1998 until 2003.Executive officers are elected by our Board of Directors, and their terms of office continue until the next annual meeting of the Board or until their successors are elected and have qualified. There are no family relationships among our executive officers.26Table of ContentsPART IIItem 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.Stock Trading Symbol – PEPStock Exchange Listings – The Nasdaq Global Select Market is the principal market for our common stock, which is also listed on the SIX Swiss Exchange.Shareholders – As of February 4, 2021, there were approximately 105,807 shareholders of record of our common stock. Dividends – We have paid consecutive quarterly cash dividends since 1965. The declaration and payment of future dividends are at the discretion of the Board of Directors. Dividends are usually declared in February, May, July and November and paid at the end of March, June and September and the beginning of January. On February 4, 2021, the Board of Directors declared a quarterly dividend of $1.0225 payable March 31, 2021, to shareholders of record on March 5, 2021. For the remainder of 2021, the record dates for these dividend payments are expected to be June 4, September 3 and December 3, 2021, subject to approval of the Board of Directors. On February 11, 2021, we announced a 5% increase in our annualized dividend to $4.30 per share from $4.09 per share, effective with the dividend expected to be paid in June 2021. We expect to return a total of approximately $5.9 billion to shareholders in 2021, comprised of dividends of approximately $5.8 billion and share repurchases of approximately $100 million. We have recently completed our share repurchase activity and do not expect to repurchase any additional shares for the balance of 2021.For information on securities authorized for issuance under our equity compensation plans, see “Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters.”A summary of our common stock repurchases (in millions, except average price per share) during the fourth quarter of 2020 is set forth in the table below. Issuer Purchases of Common StockPeriodTotalNumber ofSharesRepurchased(a)AveragePrice PaidPer ShareTotal Number of Shares Purchased as Part of Publicly Announced Plans or ProgramsMaximum Number (or Approximate Dollar Value) of Shares that May Yet Be Purchased Under the Plans or Programs9/5/2020$9,525 9/6/2020 - 10/3/20201.0 $134.59 1.0 (137)9,388 10/4/2020 - 10/31/20200.9 $138.83 0.9 (125)9,263 11/1/2020 - 11/28/20200.9 $141.82 0.9 (120)9,143 11/29/2020 - 12/26/20200.4 $144.83 0.4 (59)Total3.2 $139.04 3.2 $9,084 (a)All shares were repurchased in open market transactions pursuant to the $15 billion repurchase program authorized by our Board of Directors and publicly announced on February 13, 2018, which commenced on July 1, 2018 and will expire on June 30, 2021. Shares repurchased under this program may be repurchased in open market transactions, in privately negotiated transactions, in accelerated stock repurchase transactions or otherwise.27Table of ContentsItem 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.OUR BUSINESSExecutive Overview29Our Operations30Other Relationships30Our Business Risks30OUR FINANCIAL RESULTSResults of Operations – Consolidated Review35Results of Operations – Division Review37FLNA39QFNA39PBNA39LatAm40Europe40AMESA41APAC41Results of Operations – Other Consolidated Results42Non-GAAP Measures42Items Affecting Comparability44Our Liquidity and Capital Resources47Return on Invested Capital51OUR CRITICAL ACCOUNTING POLICIESRevenue Recognition52Goodwill and Other Intangible Assets53Income Tax Expense and Accruals54Pension and Retiree Medical Plans55Consolidated Statement of Income58Consolidated Statement of Comprehensive Income59Consolidated Statement of Cash Flows60Consolidated Balance Sheet62Consolidated Statement of Equity63Notes to Consolidated Financial StatementsNote 1 – Basis of Presentation and Our Divisions64Note 2 – Our Significant Accounting Policies68Note 3 – Restructuring and Impairment Charges72Note 4 – Intangible Assets76Note 5 – Income Taxes78Note 6 – Share-Based Compensation82Note 7 – Pension, Retiree Medical and Savings Plans86Note 8 – Debt Obligations92Note 9 – Financial Instruments94Note 10 – Net Income Attributable to PepsiCo per Common Share99Note 11 – Preferred Stock99Note 12 – Accumulated Other Comprehensive Loss Attributable to PepsiCo100Note 13 – Leases101Note 14 – Acquisitions and Divestitures 103Note 15 – Supplemental Financial Information 105Report of Independent Registered Public Accounting Firm 107GLOSSARY11128Our discussion and analysis is intended to help the reader understand our results of operations and financial condition and is provided as an addition to, and should be read in connection with, our consolidated financial statements and the accompanying notes. Definitions of key terms can be found in the glossary. Unless otherwise noted, tabular dollars are presented in millions, except per share amounts. All per share amounts reflect common stock per share amounts, assume dilution unless otherwise noted, and are based on unrounded amounts. Percentage changes are based on unrounded amounts. Discussion in this Form 10-K includes results of operations and financial condition for 2020 and 2019 and year-over-year comparisons between 2020 and 2019. For discussion on results of operations and financial condition pertaining to 2018 and year-over-year comparisons between 2019 and 2018, please refer to “Management's Discussion and Analysis of Financial Condition and Results of Operations” in Part II, Item 7 of our Annual Report on Form 10-K for the year ended December 28, 2019.OUR BUSINESSExecutive Overview PepsiCo is a leading global food and beverage company with a complementary portfolio of brands, including Frito-Lay, Gatorade, Pepsi-Cola, Quaker and Tropicana. Through our operations, authorized bottlers, contract manufacturers and other third parties, we make, market, distribute and sell a wide variety of convenient beverages, foods and snacks, serving customers and consumers in more than 200 countries and territoriesEverything we do is driven by an approach we call Winning with Purpose. Winning with Purpose is our guide for achieving accelerated, sustainable growth that includes our mission, to Create More Smiles with Every Sip and Every Bite; our vision, to Be the Global Leader in Convenient Foods and Beverages by Winning with Purpose; and The PepsiCo Way, seven behaviors that define our shared culture.This approach proved prescient and powerful in 2020 as we faced a worsening climate crisis, renewed calls for racial equality, and the first global pandemic in a century. Life in communities around the world was transformed, and our business was tested like never before. First and foremost, we had to protect the health of our associates, so that we could continue to serve our consumers, customers and communities. At the same time, we had to secure our supply chain; ensure continuity in manufacturing, distribution and sales; further strengthen our e-commerce and digital capabilities; reimagine our marketing; deliver positive outcomes for people, our shareholders and the planet; and much more. These challenges were in addition to the structural issues facing our Company, including: shifting consumer preferences and behaviors; a highly competitive operating environment; a rapidly changing retail landscape, including the growth in e-commerce; continued macroeconomic and political volatility; and an evolving regulatory landscape.To meet this once in a generation moment and ensure our Company’s long-term success, we will continue to focus on becoming Faster, Stronger, and Better:•We will become Faster by sustaining or improving growth and market share in our high return foods and snacks businesses in North America; improving the profitability of our PBNA business and capturing our fair share of category growth; accelerating our growth and presence in international snacks and food while investing wisely in beverages to balance between growth and returns; and making the necessary investments in our manufacturing capacity, go-to-market systems and digital initiatives, such as improving our presence and scale in our e-commerce business.29Table of Contents•We will become Stronger by renewing our focus on driving holistic cost management throughout our organization to support our investments in advantaged capabilities, such as a highly agile and flexible end-to-end value chain; more precision around revenue management; and investing in data analytics that can provide more granularity around consumer insights. We also plan to continue investing to further expand global business services into new capabilities, which will enable better insight and support for our businesses at a lower cost. And we will remain focused on diversifying our workforce and reinforcing The PepsiCo Way, where we emphasize that employees act like owners to get things done quickly.•We will become Better by further integrating purpose into our business strategy and brands by becoming planet positive, strengthening our roots in our communities, and advancing social justice. This includes supporting practices and technologies that improve farmer livelihoods and agricultural resiliency; using precious resources such as water more efficiently; accelerating our efforts to reduce greenhouse gas emissions throughout our value chain; driving progress toward a world where plastics need never become waste; advancing respect for human rights; and investing to promote shared prosperity in local communities where we live and work.We believe these priorities will position our Company for long-term sustainable growth.See also “Item 1A. Risk Factors” for further information about risks and uncertainties that the Company faces.Our OperationsSee “Item 1. Business” for information on our divisions and a description of our distribution network, ingredients and other supplies, brands and intellectual property rights, seasonality, customers, competition and human capital. In addition, see Note 1 to our consolidated financial statements for financial information about our divisions and geographic areas. Other RelationshipsCertain members of our Board of Directors also serve on the boards of certain vendors and customers. These Board members do not participate in our vendor selection and negotiations nor in our customer negotiations. Our transactions with these vendors and customers are in the normal course of business and are consistent with terms negotiated with other vendors and customers. In addition, certain of our employees serve on the boards of Pepsi Bottling Ventures LLC and other affiliated companies of PepsiCo and do not receive incremental compensation for such services.Our Business RisksCOVID-19Our global operations continue to expose us to risks associated with the COVID-19 pandemic, which continues to result in challenging operating environments and has affected almost all of the more than 200 countries and territories in which our products are made, manufactured, distributed or sold. Travel bans and restrictions, quarantines, curfews, restrictions on public gatherings, shelter in place and safer-at-home orders, business shutdowns and closures continue in many of these markets. These measures have impacted and will continue to impact us, our customers (including foodservice customers), consumers, employees, bottlers, contract manufacturers, distributors, joint venture partners, suppliers and other third parties with whom we do business, which may result in changes in demand for our products, increases in operating costs (whether as a result of changes to our supply chain or increases in employee costs, including expanded benefits and frontline incentives, costs associated with the provision of personal protective equipment and increased sanitation, or otherwise), or adverse impacts to our supply chain through reduced availability of air or other commercial transport, port closures or border restrictions, any 30Table of Contentsof which can impact our ability to make, manufacture, distribute and sell our products. In addition, measures that impact our ability to access our offices (several of which remain closed), plants, warehouses, distribution centers or other facilities, or that impact the ability of our customers (including our foodservice customers), consumers, bottlers, contract manufacturers, distributors, joint venture partners, suppliers and other third parties to do the same, may continue to impact the availability or productivity of our and their employees, many of whom are not able to perform their job functions remotely.Public concern regarding the risk of contracting COVID-19 has impacted and may continue to impact demand from consumers, including due to consumers not leaving their homes or leaving their homes less often than they did prior to the start of the pandemic or otherwise shopping for and consuming food and beverage products in a different manner than they historically have or because some of our consumers have lower discretionary income due to unemployment or reduced or limited work as a result of measures taken in response to the pandemic. Even as governmental restrictions are relaxed and economies gradually, partially, or fully reopen in certain of these jurisdictions and markets, the ongoing economic impacts and health concerns associated with the pandemic may continue to affect consumer behavior, spending levels and shopping and consumption preferences. In addition, as a result of COVID-19, certain jurisdictions, such as certain states in Mexico, have enacted or are considering enacting new or expanded product labeling or warning requirements or limitations on the marketing or sale of certain of our products as a result of ingredients or substances contained in such products. Changes in consumer purchasing and consumption patterns may increase demand for our products in one quarter, resulting in decreased demand for our products in subsequent quarters, or in a lower-margin sales channel resulting in potentially reduced profit from sales of our products. We continue to see shifts in product and channel preferences as markets move through varying stages of restrictions and re-opening at different times, including changes in at-home consumption, in immediate consumption and away-from-home channels, such as convenience and gas and foodservice. In addition, we continue to see a rapid increase in demand in the e-commerce and online-to-offline channels and any failure to capitalize on this demand could adversely affect our ability to maintain and grow sales or category share and erode our competitive position. Any reduced demand for our products or change in consumer purchasing and consumption patterns, as well as continued economic uncertainty, can adversely affect our customers’ and business partners’ financial condition, which can result in bankruptcy filings and/or an inability to pay for our products, reduced or canceled orders of our products, continued or additional closing of restaurants, stores, entertainment or sports complexes, schools or other venues in which our products are sold, or reduced capacity at any of the foregoing, or our business partners’ inability to supply us with ingredients or other items necessary for us to make, manufacture, distribute or sell our products. Such adverse changes in our customers’ or business partners’ financial condition have also resulted and may continue to result in our recording additional charges for our inability to recover or collect any accounts receivable, owned or leased assets, including certain foodservice and vending and other equipment, or prepaid expenses. In addition, continued economic uncertainty associated with the COVID-19 pandemic has resulted in volatility in the global capital and credit markets which can impair our ability to access these markets on terms commercially acceptable to us, or at all.While we have developed and implemented and continue to develop and implement health and safety protocols, business continuity plans and crisis management protocols in an effort to mitigate the negative impact of COVID-19 to our employees and our business, the extent of the impact of the pandemic on our business and financial results will continue to depend on numerous evolving factors that we are not able to accurately predict and which will vary by jurisdiction and market, including the duration and scope of the pandemic, the development and availability of effective treatments and vaccines, global economic conditions during and after the pandemic, governmental actions that have been taken, or may be taken in 31Table of Contentsthe future, in response to the pandemic and changes in consumer behavior in response to the pandemic, some of which may be more than just temporary.Coronavirus Aid, Relief, and Economic Security Act (CARES Act)The CARES Act was enacted on March 27, 2020 in the United States. The CARES Act and related notices include several significant provisions, such as delaying certain payroll tax payments, mandatory transition tax payments under the Tax Cuts and Jobs Act (TCJ Act) and estimated income tax payments. The CARES Act did not have a material impact on our financial results in 2020, including on our annual estimated effective tax rate or on our liquidity. We will continue to monitor and assess the impact similar legislation in other countries may have on our business and financial results.Refer to the COVID-19 discussion above and Note 5 to our consolidated financial statements for further information.Risks Associated with International OperationsWe are subject to risks in the normal course of business. During the periods presented in this report, certain jurisdictions in which our products are made, manufactured, distributed or sold operated in a challenging environment, experiencing unstable economic, political and social conditions, civil unrest, natural disasters, debt and credit issues and currency controls or fluctuations. We continue to monitor the economic, operating and political environment in these markets closely and to identify actions to potentially mitigate any unfavorable impacts on our future results.Imposition of Taxes and Regulations on our ProductsCertain jurisdictions in which our products are made, manufactured, distributed or sold have either imposed, or are considering imposing, new or increased taxes or regulations on the manufacture, distribution or sale of our products or their packaging, ingredients or substances contained in, or attributes of, our products or their packaging, commodities used in the production of our products or their packaging or the recyclability or recoverability of our packaging. These taxes and regulations vary in scope and form. For example, some taxes apply to all beverages, including non-caloric beverages, while others apply only to beverages with a caloric sweetener (e.g., sugar). In addition, some regulations apply to all products using certain types of packaging (e.g., plastic), while others are designed to increase the sustainability of packaging, encourage waste reduction and increased recycling rates or facilitate the waste management process or restrict the sale of products in certain packaging. We sell a wide variety of beverages, foods and snacks in more than 200 countries and territories and the profile of the products we sell, the amount of revenue attributable to such products and the type of packaging used vary by jurisdiction. Because of this, we cannot predict the scope or form potential taxes, regulations or other limitations on our products or their packaging may take, and therefore cannot predict the impact of such taxes, regulations or limitations on our financial results. In addition, taxes, regulations and limitations may impact us and our competitors differently. We continue to monitor existing and proposed taxes and regulations in the jurisdictions in which our products are made, manufactured, distributed and sold and to consider actions we may take to potentially mitigate the unfavorable impact, if any, of such taxes, regulations or limitations, including advocating alternative measures with respect to the imposition, form and scope of any such taxes, regulations or limitations.Tax Cuts and Jobs Act During the fourth quarter of 2017, the TCJ Act was enacted in the United States. The related provisional measurement period allowed by the SEC ended in the fourth quarter of 2018. While our accounting for the recorded impact of the TCJ Act was deemed to be complete, additional guidance issued by the IRS impacted our recorded amounts after December 29, 2018. For further information, see “Our Liquidity and 32Table of ContentsCapital Resources,” “Our Critical Accounting Policies” and Note 5 to our consolidated financial statements.Other Tax Matters On May 19, 2019, a public referendum held in Switzerland passed the Federal Act on Tax Reform and AHV Financing (TRAF), effective January 1, 2020. The enactment of certain provisions of the TRAF resulted in adjustments to our deferred taxes. During 2020, we recorded a net tax benefit of $72 million related to the adoption of the TRAF in the Swiss Canton of Bern. During 2019, we recorded net tax expense of $24 million related to the impact of the TRAF. See “Our Critical Accounting Policies” and Note 5 to our consolidated financial statements for further information.Retail LandscapeOur industry continues to be affected by disruption of the retail landscape, including the rapid growth in sales through e-commerce websites and mobile commerce applications, including through subscription services, the integration of physical and digital operations among retailers and the international expansion of hard discounters. We have seen and expect to continue to see a further shift to e-commerce, online-to-offline, and other online purchasing by consumers, including as a result of the COVID-19 pandemic. We continue to monitor changes in the retail landscape and seek to identify actions we may take to build our global e-commerce and digital capabilities, such as expanding our direct-to-consumer business, and distribute our products effectively through all existing and emerging channels of trade and potentially mitigate any unfavorable impacts on our future results.See also “Item 1A. Risk Factors,” “Executive Overview” above and “Market Risks” below for more information about these risks and the actions we have taken to address key challenges.Risk Management Framework The achievement of our strategic and operating objectives involves taking risks and that those risks may evolve over time. To identify, assess, prioritize, address, manage, monitor and communicate these risks across the Company’s operations, we leverage an integrated risk management framework. This framework includes the following:•PepsiCo’s Board of Directors has oversight responsibility for PepsiCo’s integrated risk management framework. One of the Board’s primary responsibilities is overseeing and interacting with senior management with respect to key aspects of the Company’s business, including risk assessment and risk mitigation of the Company’s top risks. The Board receives updates on key risks throughout the year, including risks related to cybersecurity. During 2020, in addition to COVID-19 discussions as part of risk updates to the Board and the relevant Committees, the Board was provided with updates on COVID-19’s impact to our business, financial condition and operations through memos, teleconferences or other appropriate means of communication. In addition, the Board has tasked designated Committees of the Board with oversight of certain categories of risk management, and the Committees report to the Board regularly on these matters.◦The Audit Committee of the Board reviews and assesses the guidelines and policies governing PepsiCo’s risk management and oversight processes, and assists the Board’s oversight of financial, compliance and employee safety risks facing PepsiCo; ◦The Compensation Committee of the Board reviews PepsiCo’s employee compensation policies and practices to assess whether such policies and practices could lead to unnecessary risk-taking behavior; 33Table of Contents◦The Nominating and Corporate Governance Committee assists the Board in its oversight of the Company’s governance structure and other corporate governance matters, including succession planning; and◦The Sustainability, Diversity and Public Policy Committee of the Board assists the Board in its oversight of PepsiCo’s policies, programs and related risks that concern key sustainability, diversity and inclusion, and public policy matters. •The PepsiCo Risk Committee (PRC), which is comprised of a cross-functional, geographically diverse, senior management group, including PepsiCo’s Chairman of the Board and Chief Executive Officer, meets regularly to identify, assess, prioritize and address top strategic, financial, operating, compliance, safety, reputational and other risks. The PRC is also responsible for reporting progress on our risk mitigation efforts to the Board;•Division and key country risk committees, comprised of cross-functional senior management teams, meet regularly to identify, assess, prioritize and address division and country-specific business risks;•PepsiCo’s Risk Management Office, which manages the overall risk management process, provides ongoing guidance, tools and analytical support to the PRC and the division and key country risk committees, identifies and assesses potential risks and facilitates ongoing communication between the parties, as well as with PepsiCo’s Board of Directors, the Audit Committee of the Board and other Committees of the Board;•PepsiCo’s Corporate Audit Department evaluates the ongoing effectiveness of our key internal controls through periodic audit and review procedures; and•PepsiCo’s Compliance & Ethics and Law Departments lead and coordinate our compliance policies and practices.Market RisksWe are exposed to market risks arising from adverse changes in:•commodity prices, affecting the cost of our raw materials and energy;•foreign exchange rates and currency restrictions; and•interest rates.In the normal course of business, we manage commodity price, foreign exchange and interest rate risks through a variety of strategies, including productivity initiatives, global purchasing programs and hedging. Ongoing productivity initiatives involve the identification and effective implementation of meaningful cost-saving opportunities or efficiencies, including the use of derivatives. Our global purchasing programs include fixed-price contracts and purchase orders and pricing agreements. See “Item 1A. Risk Factors” for further discussion of our market risks, and see “Our Liquidity and Capital Resources” for further information on our non-cancelable purchasing commitments. The fair value of our derivatives fluctuates based on market rates and prices. The sensitivity of our derivatives to these market fluctuations is discussed below. See Note 9 to our consolidated financial statements for further discussion of these derivatives and our hedging policies. See “Our Critical Accounting Policies” for a discussion of the exposure of our pension and retiree medical plan assets and liabilities to risks related to market fluctuations.Inflationary, deflationary and recessionary conditions impacting these market risks also impact the demand for and pricing of our products. See “Item 1A. Risk Factors” for further discussion.34Table of ContentsCommodity PricesOur commodity derivatives had a total notional value of $1.1 billion as of December 26, 2020 and December 28, 2019. At the end of 2020, the potential change in fair value of commodity derivative instruments, assuming a 10% decrease in the underlying commodity price, would have decreased our net unrealized gains in 2020 by $121 million, which would generally be offset by a reduction in the cost of the underlying commodity purchases.Foreign ExchangeOur operations outside of the United States generated 42% of our consolidated net revenue in 2020, with Mexico, Russia, Canada, the United Kingdom, China and South Africa, collectively, comprising approximately 21% of our consolidated net revenue in 2020. As a result, we are exposed to foreign exchange risks in the international markets in which our products are made, manufactured, distributed or sold. Additionally, we are exposed to foreign exchange risk from net investments in foreign subsidiaries, foreign currency purchases, foreign currency assets and liabilities created in the normal course of business. During 2020, unfavorable foreign exchange reduced net revenue growth by 2 percentage points, primarily due to declines in the Mexican peso, Russian ruble and Brazilian real. Currency declines against the U.S. dollar which are not offset could adversely impact our future financial results.In addition, volatile economic, political and social conditions and civil unrest in certain markets in which our products are made, manufactured, distributed or sold, including in Argentina, Brazil, China, Mexico, the Middle East, Russia and Turkey, and currency controls or fluctuations in certain of these international markets, continue to, and the threat or imposition of new or increased tariffs or sanctions or other impositions in or related to these international markets may, result in challenging operating environments. We also continue to monitor the economic and political developments related to the United Kingdom’s withdrawal from the European Union (Brexit), including the effects of the post-Brexit trade deal entered into between the United Kingdom and the European Union in December 2020, as well as the economic, operating and political environment in Russia and the potential impact for the Europe segment and our other businesses.Our foreign currency derivatives had a total notional value of $1.9 billion as of December 26, 2020 and December 28, 2019. At the end of 2020, we estimate that an unfavorable 10% change in the underlying exchange rates would have increased our net unrealized losses in 2020 by $175 million, which would be significantly offset by an inverse change in the fair value of the underlying exposure.The total notional amount of our debt instruments designated as net investment hedges was $2.7 billion as of December 26, 2020 and $2.5 billion as of December 28, 2019. Interest RatesOur interest rate derivatives had a total notional value of $3.0 billion as of December 26, 2020 and $5.0 billion as of December 28, 2019. Assuming year-end 2020 investment levels and variable rate debt, a 1-percentage-point increase in interest rates would have decreased our net interest expense in 2020 by $80 million due to higher cash and cash equivalents and short-term investments levels, as compared with our variable rate debt.OUR FINANCIAL RESULTSResults of Operations — Consolidated ReviewVolume Physical or unit volume is one of the key metrics management uses internally to make operating and strategic decisions, including the preparation of our annual operating plan and the evaluation of our business performance. We believe volume provides additional information to facilitate the comparison of 35Table of Contentsour historical operating performance and underlying trends, and provides additional transparency on how we evaluate our business because it measures demand for our products at the consumer level.Beverage volume includes volume of concentrate sold to independent bottlers and volume of finished products bearing company-owned or licensed trademarks and allied brand products and joint venture trademarks sold by company-owned bottling operations, including by our noncontrolled affiliates. Concentrate volume sold to independent bottlers is reported in concentrate shipments and equivalents (CSE), whereas finished beverage product volume is reported in bottler case sales (BCS). Both CSE and BCS convert all beverage volume to an 8-ounce-case metric. Typically, CSE and BCS are not equal in any given period due to seasonality, timing of product launches, product mix, bottler inventory practices and other factors. While our net revenue is not entirely based on BCS volume due to the independent bottlers in our supply chain, we believe that BCS is a better measure of the consumption of our beverage products. PBNA, LatAm, Europe, AMESA and APAC, either independently or in conjunction with third parties, make, market, distribute and sell ready-to-drink tea products through a joint venture with Unilever (under the Lipton brand name), and PBNA, either independently or in conjunction with third parties, makes, markets, distributes and sells ready-to-drink coffee products through a joint venture with Starbucks. In addition, APAC licenses the Tropicana brand for use in China on co-branded juice products in connection with a strategic alliance with Tingyi.Food and snack volume includes volume sold by our subsidiaries and noncontrolled affiliates of snack products bearing company-owned or licensed trademarks. Internationally, we measure food and snack product volume in kilograms, while in North America we measure food and snack product volume in pounds. FLNA makes, markets, distributes and sells Sabra refrigerated dips and spreads through a joint venture with Strauss Group. Consolidated Net Revenue and Operating Profit 20202019ChangeNet revenue$70,372 $67,161 5 %Operating profit$10,080 $10,291 (2)%Operating profit margin14.3 %15.3 %(1.0)See “Results of Operations – Division Review” for a tabular presentation and discussion of key drivers of net revenue. Operating profit decreased 2% and operating profit margin declined 1.0 percentage point. Operating profit performance was primarily driven by certain operating cost increases, partially offset by net revenue growth and productivity savings.The charges taken as a result of the COVID-19 pandemic negatively impacted operating profit performance by 7 percentage points. See Note 1 to our consolidated financial statements for further information. Additionally, higher inventory fair value adjustments and merger and integration charges included in “Items Affecting Comparability” and unfavorable foreign exchange each negatively impacted operating profit performance by 2 percentage points.36Table of ContentsResults of Operations — Division ReviewSee “Non-GAAP Measures” and “Items Affecting Comparability” for a discussion of items to consider when evaluating our results and related information regarding measures not in accordance with U.S. Generally Accepted Accounting Principles (GAAP). In the discussions of net revenue and operating profit below, “effective net pricing” reflects the year-over-year impact of discrete pricing actions, sales incentive activities and mix resulting from selling varying products in different package sizes and in different countries, and “net pricing” reflects the year-over-year combined impact of list price changes, weight changes per package, discounts and allowances. Additionally, “acquisitions and divestitures” reflect all mergers and acquisitions activity, including the impact of acquisitions, divestitures and changes in ownership or control in consolidated subsidiaries and nonconsolidated equity investees.Net Revenue and Organic Revenue GrowthOrganic revenue growth is a non-GAAP financial measure. For further information on this measure, see “Non-GAAP Measures.”2020Impact ofImpact ofReported % Change, GAAP MeasureForeign exchange translationAcquisitions and divestituresOrganic % Change, Non-GAAP Measure(a)Organic Volume(b)Effective net pricingFLNA7 %— (1)6 %3 3 QFNA10 %— — 11 %10 — PBNA4 %— (2)2 %(1)3 LatAm(8)%11 — 3 %— 3 Europe2 %4 — 6 %6 — AMESA25 %1 (25)1 %1 — APAC18 %— (10)8 %5 3 Total5 %2 (3)4 %2 2 (a)Amounts may not sum due to rounding.(b)Excludes the impact of acquisitions and divestitures. In certain instances, the impact of organic volume growth on net revenue growth differs from the unit volume growth disclosed in the following divisional discussions due to product mix, nonconsolidated joint venture volume, and, for our beverage businesses, temporary timing differences between BCS and CSE. Our net revenue excludes nonconsolidated joint venture volume, and, for our franchise-owned beverage businesses, is based on CSE.37Table of ContentsOperating Profit, Operating Profit Adjusted for Items Affecting Comparability and Operating Profit Growth Adjusted for Items Affecting Comparability on a Constant Currency BasisOperating profit adjusted for items affecting comparability and operating profit growth adjusted for items affecting comparability on a constant currency basis are both non-GAAP financial measures. For further information on these measures see “Non-GAAP Measures” and “Items Affecting Comparability.”Operating Profit and Operating Profit Adjusted for Items Affecting Comparability2020Items Affecting Comparability(a)Reported, GAAP Measure(b)Mark-to-market net impactRestructuring and impairment chargesInventory fair value adjustments and merger and integration chargesCore, Non-GAAP Measure(b)FLNA$5,340 $— $83 $29 $5,452 QFNA669 — 5 — 674 PBNA1,937 — 47 66 2,050 LatAm1,033 — 31 — 1,064 Europe1,353 — 48 — 1,401 AMESA600 — 14 173 787 APAC590 — 5 7 602 Corporate unallocated expenses(1,442)(73)36 (20)(1,499)Total$10,080 $(73)$269 $255 $10,531 2019Items Affecting Comparability(a)Reported, GAAP MeasureMark-to-market net impactRestructuring and impairment chargesInventory fair value adjustments and merger and integration chargesCore, Non-GAAP MeasureFLNA$5,258 $— $22 $— $5,280 QFNA544 — 2 — 546 PBNA2,179 — 51 — 2,230 LatAm1,141 — 62 — 1,203 Europe1,327 — 99 46 1,472 AMESA671 — 38 7 716 APAC477 — 47 — 524 Corporate unallocated expenses(1,306)(112)47 2 (1,369)Total$10,291 $(112)$368 $55 $10,602 (a)See “Items Affecting Comparability.”(b)Operating profit for 2020 includes the charges taken as a result of the COVID-19 pandemic. See Note 1 to our consolidated financial statements for further information.38Table of ContentsOperating Profit Growth and Operating Profit Growth Adjusted for Items Affecting Comparability on a Constant Currency Basis2020 Impact of Items Affecting Comparability(a)Impact ofReported % Change, GAAP MeasureMark-to-market net impactRestructuring and impairment chargesInventory fair value adjustments and merger and integration chargesCore % Change, Non-GAAP Measure(b)Foreign exchange translationCore Constant Currency % Change, Non-GAAP Measure(b)FLNA2 %— 1 1 3 %— 3 %QFNA23 %— — — 24 %— 24 %PBNA(11)%— — 3 (8)%— (8)%LatAm(10)%— (2)— (12)%11 — %Europe2 %— (4)(3)(5)%4 (0.5)%AMESA(11)%— (3.5)24 10 %— 10 %APAC24 %— (10)2 15 %1 16 %Corporate unallocated expenses10 %(6)2 3.5 10 %— 10 %Total(2)%— (1)2 (1)%2 1 %(a)See “Items Affecting Comparability” for further information.(b)Amounts may not sum due to rounding.FLNANet revenue grew 7% and unit volume grew 3%. The net revenue growth was driven by effective net pricing and organic volume growth. The unit volume growth primarily reflects double-digit growth in variety packs and dips, and high-single-digit growth in trademark Tostitos and Ruffles, partially offset by a double-digit decline in nuts and seeds. Operating profit increased 2%, primarily reflecting the net revenue growth and productivity savings, partially offset by certain operating cost increases. Additionally, the charges taken as a result of the COVID-19 pandemic reduced operating profit growth by 4 percentage points.QFNANet revenue and unit volume each increased 10%. The net revenue growth reflects organic volume growth and favorable pricing, partially offset by unfavorable mix. The unit volume growth was driven by double-digit growth in oatmeal and pancake syrup and mix and high-single-digit growth in ready-to-eat cereals. The COVID-19 pandemic drove an increase in consumer demand, which had a positive impact on both net revenue and unit volume growth.Operating profit grew 23%, reflecting the net revenue growth and productivity savings, partially offset by certain operating cost increases. Additionally, the charges taken as a result of the COVID-19 pandemic reduced operating profit growth by 3 percentage points.PBNANet revenue increased 4%, primarily driven by effective net pricing, partially offset by a decrease in organic volume. Unit volume decreased 1%, driven by a 5% decrease in CSD volume, largely offset by a 4% increase in non-carbonated beverage (NCB) volume. The NCB volume increase primarily reflected a high-single-digit increase in Gatorade sports drinks, a double-digit increase in our energy portfolio, primarily due to acquisitions, and a low-single-digit increase in our overall water portfolio, partially offset by a mid-single-digit decrease in our juice and juice drinks portfolio. In addition, acquisitions contributed 2 percentage points to net revenue growth.39Table of ContentsOperating profit decreased 11%, reflecting certain operating cost increases, including incremental information technology costs, a 14-percentage-point impact of the charges taken as a result of the COVID-19 pandemic and the organic volume decrease. These impacts were partially offset by the effective net pricing, productivity savings, lower advertising and marketing expenses, and a 4-percentage-point impact of lower commodity costs. Prior-year gains associated with sales of assets negatively impacted operating profit performance by 2 percentage points. Additionally, impairment charges associated with a coconut water brand negatively impacted operating profit performance by 2 percentage points. Acquisitions positively contributed 4 percentage points to operating profit performance.In the fourth quarter of 2020, we received notice of termination without cause from Vital Pharmaceuticals, Inc., which would end our distribution rights of Bang Energy drinks, effective October 24, 2023.LatAmNet revenue decreased 8%, primarily reflecting an 11-percentage-point impact of unfavorable foreign exchange, partially offset by effective net pricing.Snacks unit volume grew slightly, primarily reflecting low-single-digit growth in Brazil, partially offset by a slight decline in Mexico.Beverage unit volume declined 1%, primarily reflecting a high-single-digit decline in Argentina, a mid-single-digit decline in Honduras and a low-single-digit decline in Guatemala, partially offset by double-digit growth in Brazil, low-single-digit growth in Mexico and mid-single-digit growth in Chile. The COVID-19 pandemic contributed to a decrease in consumer demand, which had a negative impact on beverage unit volume performance.Operating profit decreased 10%, primarily reflecting certain operating cost increases and a 9-percentage-point impact of higher commodity costs due to transaction-related foreign exchange. These impacts were partially offset by productivity savings and the effective net pricing. Additionally, unfavorable foreign exchange and certain charges taken as a result of the COVID-19 pandemic negatively impacted operating profit performance by 11 percentage points and 8 percentage points, respectively.EuropeNet revenue increased 2%, reflecting organic volume growth, partially offset by a 4-percentage-point impact of unfavorable foreign exchange.Snacks unit volume grew 4%, primarily reflecting double-digit growth in Turkey, high-single-digit growth in the United Kingdom and France and mid-single-digit growth in the Netherlands, partially offset by a low-single-digit decline in Spain. Additionally, Russia and Poland each experienced low-single-digit growth.Beverage unit volume grew 11%, primarily reflecting double-digit growth in Germany and France, partially offset by a mid-single-digit decline in Poland and a low-single-digit decline in Turkey. Additionally, Russia experienced low-single-digit growth and the United Kingdom experienced mid-single-digit growth.Operating profit increased 2%, primarily reflecting the organic volume growth, productivity savings, a 4-percentage-point impact of lower restructuring and impairment charges, a 3-percentage-point impact of the prior-year inventory fair value adjustments and merger and integration charges primarily associated with our acquisition of SodaStream International Ltd. (SodaStream) and a 2-percentage-point impact of a gain on an asset sale. These impacts were partially offset by certain operating cost increases and a 2-percentage-point impact of higher commodity costs due to transaction-related foreign exchange. Additionally, the charges taken as a result of the COVID-19 pandemic and unfavorable foreign exchange reduced operating profit growth by 6 percentage points and 4 percentage points, respectively. 40Table of ContentsAMESANet revenue increased 25%, primarily reflecting a 28-percentage-point impact of the Pioneer Foods acquisition, partially offset by a 3-percentage-point impact of the prior-year refranchising of a portion of our beverage business in India. Net revenue was also negatively impacted by the COVID-19 pandemic.Snacks unit volume grew 199%, primarily reflecting a 195-percentage-point impact of the Pioneer Foods acquisition, double-digit growth in Pakistan and mid-single-digit growth in the Middle East. Additionally, India and South Africa (excluding our Pioneer Foods acquisition) each experienced low-single-digit growth.Beverage unit volume declined 5%, primarily reflecting a double-digit decline in India and a high-single-digit decline in Pakistan, partially offset by slight growth in the Middle East and low-single-digit growth in Nigeria. Our Pioneer Foods acquisition positively contributed 2 percentage points to beverage unit volume performance. The COVID-19 pandemic contributed to a decrease in consumer demand, which had a negative impact on beverage unit volume performance.Operating profit decreased 11%, primarily reflecting certain operating cost increases, partially offset by productivity savings, lower advertising and marketing expenses and a 3-percentage-point impact of lower commodity costs. The inventory fair value adjustments and merger and integration charges associated with our Pioneer Foods acquisition negatively impacted operating profit performance by 24 percentage points and were partially offset by Pioneer Foods’ 9-percentage-point positive contribution to operating profit performance. Additionally, the charges taken as a result of the COVID-19 pandemic negatively impacted operating profit performance by 5 percentage points.APACNet revenue increased 18%, primarily reflecting a 10-percentage-point impact of our Be & Cheery acquisition, organic volume growth and effective net pricing.Snacks unit volume grew 17%, primarily reflecting a 10-percentage-point impact of our Be & Cheery acquisition and double-digit growth in Indonesia, partially offset by a low-single-digit decline in Thailand. Additionally, China (excluding our Be & Cheery acquisition) and Australia each experienced mid-single-digit growth and Taiwan experienced low-single-digit growth.Beverage unit volume grew 1%, primarily reflecting high-single-digit growth in China, partially offset by a double-digit decline in the Philippines, a mid-single-digit decline in Vietnam and a low-single-digit decline in Thailand. The COVID-19 pandemic contributed to a decrease in consumer demand, which had a negative impact on beverage unit volume growth.Operating profit increased 24%, primarily reflecting the net revenue growth, productivity savings and a 10-percentage-point impact of lower restructuring and impairment charges, partially offset by certain operating cost increases and higher advertising and marketing expenses.41Table of ContentsOther Consolidated Results 20202019ChangeOther pension and retiree medical benefits income/(expense)$117 $(44)$161 Net interest expense and other$(1,128)$(935)$(193)Annual tax rate20.9 %21.0 %Net income attributable to PepsiCo (a)$7,120 $7,314 (3)%Net income attributable to PepsiCo per common share – diluted (a)$5.12 $5.20 (2)%(a)The charges taken as a result of the COVID-19 pandemic negatively impacted both net income attributable to PepsiCo performance and net income attributable to PepsiCo per common share performance by 8 percentage points. See Note 1 to our consolidated financial statements for further information.Other pension and retiree medical benefits income increased $161 million, primarily reflecting the recognition of fixed income gains on plan assets, the impact of discretionary plan contributions and higher prior-year settlement losses, partially offset by the decrease in discount rates.Net interest expense and other increased $193 million, primarily due to higher average debt balances, lower interest rates on cash, as well as lower gains on the market value of investments used to economically hedge a portion of our deferred compensation liability. These impacts were partially offset by lower interest rates on debt and higher average cash balances.The reported tax rate decreased 0.1 percentage points, primarily reflecting the net tax benefits related to the TRAF, partially offset by an increase in reserves for uncertain tax positions in foreign jurisdictions.Non-GAAP MeasuresCertain financial measures contained in this Form 10-K adjust for the impact of specified items and are not in accordance with U.S. GAAP. We use non-GAAP financial measures internally to make operating and strategic decisions, including the preparation of our annual operating plan, evaluation of our overall business performance and as a factor in determining compensation for certain employees. We believe presenting non-GAAP financial measures in this Form 10-K provides additional information to facilitate comparison of our historical operating results and trends in our underlying operating results and provides additional transparency on how we evaluate our business. We also believe presenting these measures in this Form 10-K allows investors to view our performance using the same measures that we use in evaluating our financial and business performance and trends. We consider quantitative and qualitative factors in assessing whether to adjust for the impact of items that may be significant or that could affect an understanding of our ongoing financial and business performance or trends. Examples of items for which we may make adjustments include: amounts related to mark-to-market gains or losses (non-cash); charges related to restructuring plans; amounts associated with mergers, acquisitions, divestitures and other structural changes; pension and retiree medical related items; charges or adjustments related to the enactment of new laws, rules or regulations, such as significant tax law changes; amounts related to the resolution of tax positions; tax benefits related to reorganizations of our operations; debt redemptions, cash tender or exchange offers; asset impairments (non-cash); and remeasurements of net monetary assets. See below and “Items Affecting Comparability” for a description of adjustments to our U.S. GAAP financial measures in this Form 10-K. Non-GAAP information should be considered as supplemental in nature and is not meant to be considered in isolation or as a substitute for the related financial information prepared in accordance with U.S. GAAP. In addition, our non-GAAP financial measures may not be the same as or comparable to similar non-GAAP measures presented by other companies.42Table of ContentsThe following non-GAAP financial measures contained in this Form 10-K are discussed below:Cost of sales, gross profit, selling, general and administrative expenses, other pension and retiree medical benefits income/expense, provision for income taxes, net income attributable to noncontrolling interests and net income attributable to PepsiCo, each adjusted for items affecting comparability, operating profit and net income attributable to PepsiCo per common share – diluted, each adjusted for items affecting comparability, and the corresponding constant currency growth ratesThese measures exclude the net impact of mark-to-market gains and losses on centrally managed commodity derivatives that do not qualify for hedge accounting, restructuring and impairment charges related to our 2019 Multi-Year Productivity Plan (2019 Productivity Plan) and our 2014 Multi-Year Productivity Plan (2014 Productivity Plan), inventory fair value adjustments and merger and integration charges associated with our acquisitions, pension-related settlement charges and net tax related to the TCJ Act (see “Items Affecting Comparability” for a detailed description of each of these items). We also evaluate performance on operating profit, adjusted for items affecting comparability, and net income attributable to PepsiCo per common share – diluted, adjusted for items affecting comparability, each on a constant currency basis, which measure our financial results assuming constant foreign currency exchange rates used for translation based on the rates in effect for the comparable prior-year period. In order to compute our constant currency results, we multiply or divide, as appropriate, our current-year U.S. dollar results by the current-year average foreign exchange rates and then multiply or divide, as appropriate, those amounts by the prior-year average foreign exchange rates. We believe these measures provide useful information in evaluating the results of our business because they exclude items that we believe are not indicative of our ongoing performance.Organic revenue growthWe define organic revenue growth as net revenue growth adjusted for the impact of foreign exchange translation, as well as the impact from acquisitions, divestitures and other structural changes. We believe organic revenue growth provides useful information in evaluating the results of our business because it excludes items that we believe are not indicative of ongoing performance or that we believe impact comparability with the prior year.See “Net Revenue and Organic Revenue Growth” in “Results of Operations – Division Review” for further information.Free cash flowWe define free cash flow as net cash provided by operating activities less capital spending, plus sales of property, plant and equipment. Since net capital spending is essential to our product innovation initiatives and maintaining our operational capabilities, we believe that it is a recurring and necessary use of cash. As such, we believe investors should also consider net capital spending when evaluating our cash from operating activities. Free cash flow is used by us primarily for acquisitions and financing activities, including debt repayments, dividends and share repurchases. Free cash flow is not a measure of cash available for discretionary expenditures since we have certain non-discretionary obligations such as debt service that are not deducted from the measure.See “Free Cash Flow” in “Our Liquidity and Capital Resources” for further information.43Table of ContentsReturn on invested capital (ROIC) and net ROIC, excluding items affecting comparabilityWe define ROIC as net income attributable to PepsiCo plus interest expense after-tax divided by the sum of quarterly average debt obligations and quarterly average common shareholders’ equity. Although ROIC is a common financial metric, numerous methods exist for calculating ROIC. Accordingly, the method used by management to calculate ROIC may differ from the methods other companies use to calculate their ROIC. We believe this metric serves as a measure of how well we use our capital to generate returns. In addition, we use net ROIC, excluding items affecting comparability, to compare our performance over various reporting periods on a consistent basis because it removes from our operating results the impact of items that we believe are not indicative of our ongoing performance and reflects how management evaluates our operating results and trends. We define net ROIC, excluding items affecting comparability, as ROIC, adjusted for quarterly average cash, cash equivalents and short-term investments, after-tax interest income and items affecting comparability. We believe the calculation of ROIC and net ROIC, excluding items affecting comparability, provides useful information to investors and is an additional relevant comparison of our performance to consider when evaluating our capital allocation efficiency. See “Return on Invested Capital” in “Our Liquidity and Capital Resources” for further information.Items Affecting ComparabilityOur reported financial results in this Form 10-K are impacted by the following items in each of the following years: 2020Cost of salesGross profitSelling, general and administrative expensesOperating profitOther pension and retiree medical benefits incomeProvision for income taxes(a)Net income attributable to PepsiCoReported, GAAP Measure$31,797 $38,575 $28,495 $10,080 $117 $1,894 $7,120 Items Affecting ComparabilityMark-to-market net impact64 (64)9 (73)— (15)(58)Restructuring and impairment charges(30)30 (239)269 20 58 231 Inventory fair value adjustments and merger and integration charges(32)32 (223)255 — 18 237 Pension-related settlement charge— — — — 205 47 158 Core, Non-GAAP Measure$31,799 $38,573 $28,042 $10,531 $342 $2,002 $7,688 2019Cost of salesGross profitSelling, general and administrative expensesOperating profitOther pension and retiree medical benefits (expense)/incomeProvision for income taxes(a)Net income attributable to noncontrolling interestsNet income attributable to PepsiCoReported, GAAP Measure$30,132 $37,029 $26,738 $10,291 $(44)$1,959 $39 $7,314 Items Affecting ComparabilityMark-to-market net impact57 (57)55 (112)— (25)— (87)Restructuring and impairment charges(115)115 (253)368 2 67 5 298 Inventory fair value adjustments and merger and integration charges(34)34 (21)55 — 8 — 47 Pension-related settlement charges— — — — 273 62 — 211 Net tax related to the TCJ Act— — — — — 8 — (8)Core, Non-GAAP Measure$30,040 $37,121 $26,519 $10,602 $231 $2,079 $44 $7,775 44Table of Contents(a)Provision for income taxes is the expected tax charge/benefit on the underlying item based on the tax laws and income tax rates applicable to the underlying item in its corresponding tax jurisdiction. 20202019ChangeNet income attributable to PepsiCo per common share – diluted, GAAP measure$5.12 $5.20 (2)%Mark-to-market net impact(0.04)(0.06)Restructuring and impairment charges0.17 0.21 Inventory fair value adjustments and merger and integration charges0.17 0.03 Pension-related settlement charges0.11 0.15 Net tax related to the TCJ Act— (0.01)Core net income attributable to PepsiCo per common share – diluted, non-GAAP measure$5.52 (a)$5.53 (a)— %Impact of foreign exchange translation2 Growth in core net income attributable to PepsiCo per common share – diluted, on a constant currency basis, non-GAAP measure2 %(a)Does not sum due to rounding.Mark-to-Market Net ImpactWe centrally manage commodity derivatives on behalf of our divisions. These commodity derivatives include agricultural products, energy and metals. Commodity derivatives that do not qualify for hedge accounting treatment are marked to market each period with the resulting gains and losses recorded in corporate unallocated expenses as either cost of sales or selling, general and administrative expenses, depending on the underlying commodity. These gains and losses are subsequently reflected in division results when the divisions recognize the cost of the underlying commodity in operating profit. Therefore, the divisions realize the economic effects of the derivative without experiencing any resulting mark-to-market volatility, which remains in corporate unallocated expenses.Restructuring and Impairment Charges2019 Multi-Year Productivity PlanThe 2019 Productivity Plan, publicly announced on February 15, 2019, will leverage new technology and business models to further simplify, harmonize and automate processes; re-engineer our go-to-market and information systems, including deploying the right automation for each market; and simplify our organization and optimize our manufacturing and supply chain footprint. In connection with this plan, we expect to incur pre-tax charges of approximately $2.5 billion, including cash expenditures of approximately $1.6 billion. Plan to date through December 26, 2020, we have incurred pre-tax charges of $797 million, including cash expenditures of $518 million. In our 2021 financial results, we expect to incur pre-tax charges of approximately $500 million, including cash expenditures of approximately $400 million, with the balance to be reflected in our 2022 and 2023 financial results. These charges will be funded primarily through cash from operations. We expect to incur the majority of the remaining pre-tax charges and cash expenditures in our 2021 and 2022 results. 2014 Multi-Year Productivity PlanThe 2014 Productivity Plan was completed in 2019. The total plan pre-tax charges and cash expenditures approximated the previously disclosed plan estimates of $1.3 billion and $960 million, respectively. See Note 3 to our consolidated financial statements for further information related to our 2019 and 2014 Productivity Plans. We regularly evaluate productivity initiatives beyond the productivity plans and other initiatives discussed above and in Note 3 to our consolidated financial statements.Inventory Fair Value Adjustments and Merger and Integration ChargesIn 2020, we recorded inventory fair value adjustments and merger and integration charges related to our acquisitions of BFY Brands, Inc. (BFY Brands), Rockstar, Pioneer Foods and Be & Cheery. Inventory fair value adjustments and merger and integration charges include fair value adjustments to the acquired 45Table of Contentsinventory included in the acquisition-date balance sheets and closing costs, employee-related costs, contract termination costs, changes in the fair value of contingent consideration and other integration costs. Merger and integration charges also include liabilities to support socioeconomic programs in South Africa, which are irrevocable conditions of our acquisition of Pioneer Foods. In 2019, we recorded inventory fair value adjustments and merger and integration charges primarily related to SodaStream’s acquired inventory included in acquisition-date balance sheet, as well as merger and integration charges, including employee-related costs.See Note 14 to our consolidated financial statements for further information.Pension-Related Settlement ChargesIn 2020, we recorded a pension settlement charge related to lump sum distributions exceeding the total of annual service and interest cost.In 2019, we recorded pension settlement charges related to the purchase of a group annuity contract and one-time lump sum payments to certain former employees who had vested benefits.See Note 7 to our consolidated financial statements for further information.Net Tax Related to the TCJ ActDuring the fourth quarter of 2017, the TCJ Act was enacted in the United States. We recognized net tax benefits in 2019 related to the TCJ Act. See Note 5 to our consolidated financial statements for further information.46Table of ContentsOur Liquidity and Capital Resources We believe that our cash generating capability and financial condition, together with our revolving credit facilities, working capital lines and other available methods of debt financing, such as commercial paper borrowings and long-term debt financing, will be adequate to meet our operating, investing and financing needs, including with respect to our net capital spending plans. Our primary sources of cash available to fund cash outflows, such as our anticipated dividend payments, debt repayments, payments for acquisitions, including the contingent consideration related to Rockstar, and the transition tax liability under the TCJ Act, include cash from operations, proceeds obtained from issuances of commercial paper and long-term debt and cash and cash equivalents. See “Item 1A. Risk Factors,” “Our Business Risks” and Note 8 to our consolidated financial statements for further information.Our sources and uses of cash were not materially adversely impacted by COVID-19 in 2020 and, to date, we have not identified any material liquidity deficiencies as a result of the COVID-19 pandemic. Based on the information currently available to us, we do not expect the impact of COVID-19 to have a material impact on our liquidity. We will continue to monitor and assess the impact COVID-19 may have on our business and financial results. See Note 1 to our consolidated financial statements for further information. The CARES Act and related notices include several significant provisions, such as delaying certain payroll tax payments, mandatory transition tax payments under the TCJ Act and estimated income tax payments. The CARES Act did not have a material impact on our financial results in 2020, including on our annual estimated effective tax rate or on our liquidity. We will continue to monitor and assess the impact similar legislation in other countries may have on our business and financial results. See “Item 1A. Risk Factors” and “Our Business Risks” for further information related to the COVID-19 pandemic.As of December 26, 2020, cash, cash equivalents and short-term investments in our consolidated subsidiaries subject to currency controls or currency exchange restrictions were not material.The TCJ Act imposed a mandatory one-time transition tax on undistributed international earnings, including $18.9 billion held in our consolidated subsidiaries outside the United States as of December 30, 2017. As of December 26, 2020, our mandatory transition tax liability was $3.2 billion, which must be paid through 2026 under the provisions of the TCJ Act; we currently expect to pay approximately $309 million of this liability in 2021. See “Credit Facilities and Long-Term Contractual Commitments.” Any additional guidance issued by the IRS may impact our recorded amounts for this transition tax liability. See Note 5 to our consolidated financial statements for further discussion of the TCJ Act.As part of our evolving market practices, we work with our suppliers to optimize our terms and conditions, which include the extension of payment terms. Our current payment terms with a majority of our suppliers generally range from 60 to 90 days, which we deem to be commercially reasonable. We will continue to monitor economic conditions and market practice working with our suppliers to adjust as necessary. We also maintain voluntary supply chain finance agreements with several participating global financial institutions. Under these agreements, our suppliers, at their sole discretion, may elect to sell their accounts receivable with PepsiCo to these participating global financial institutions. Supplier participation in these financing arrangements is voluntary. Our suppliers negotiate their financing agreements directly with the respective global financial institutions and we are not a party to these agreements. These financing arrangements allow participating suppliers to leverage PepsiCo’s creditworthiness in establishing credit spreads and associated costs, which generally provides our suppliers with more favorable terms than they would be able to secure on their own. Neither PepsiCo nor any of its subsidiaries provide any guarantees to any third party in connection with these financing arrangements. We have no economic interest in our suppliers’ decision to participate in these agreements. Our obligations to our suppliers, including amounts due and scheduled payment terms, are not impacted. All outstanding amounts related to suppliers participating in such financing arrangements are recorded within 47Table of Contentsaccounts payable and other current liabilities in our consolidated balance sheet. We have been informed by the participating financial institutions that as of December 26, 2020 and December 28, 2019, $1.2 billion and $1.1 billion, respectively, of our accounts payable to suppliers who participate in these financing arrangements are outstanding. These supply chain finance arrangements did not have a material impact on our liquidity or capital resources in the periods presented and we do not expect such arrangements to have a material impact on our liquidity or capital resources for the foreseeable future. Furthermore, our cash provided from operating activities is somewhat impacted by seasonality. Working capital needs are impacted by weekly sales, which are generally highest in the third quarter due to seasonal and holiday-related sales patterns and generally lowest in the first quarter. On a continuing basis, we consider various transactions to increase shareholder value and enhance our business results, including acquisitions, divestitures, joint ventures, dividends, share repurchases, productivity and other efficiency initiatives and other structural changes. These transactions may result in future cash proceeds or payments.The table below summarizes our cash activity: 20202019Net cash provided by operating activities$10,613 $9,649 Net cash used for investing activities$(11,619)$(6,437)Net cash provided by/(used for) financing activities$3,819 $(8,489)Operating ActivitiesIn 2020, net cash provided by operating activities was $10.6 billion, compared to $9.6 billion in the prior year. The increase in operating cash flow primarily reflects lower net cash tax payments and lower pre-tax pension and retiree medical plan contributions in the current year.Investing ActivitiesIn 2020, net cash used for investing activities was $11.6 billion, primarily reflecting net cash paid in connection with our acquisitions of Rockstar of $3.85 billion, Pioneer Foods of $1.2 billion and Be & Cheery of $0.7 billion, net capital spending of $4.2 billion, as well as purchases of short-term investments with maturities greater than three months of $1.1 billion.In 2019, net cash used for investing activities was $6.4 billion, primarily reflecting $4.1 billion of net capital spending, as well as $1.9 billion of the remaining cash paid in connection with our acquisition of SodaStream.See Note 1 to our consolidated financial statements for further discussion of capital spending by division; see Note 9 to our consolidated financial statements for further discussion of our investments in debt securities; and see Note 14 to our consolidated financial statements for further discussion of our acquisitions.We regularly review our plans with respect to net capital spending, including in light of the ongoing uncertainty caused by the COVID-19 pandemic on our business, and believe that we have sufficient liquidity to meet our net capital spending needs.Financing ActivitiesIn 2020, net cash provided by financing activities was $3.8 billion, primarily reflecting proceeds from issuances of long-term debt of $13.8 billion, partially offset by the return of operating cash flow to our shareholders through dividend payments and share repurchases of $7.5 billion, payments of long-term debt borrowings of $1.8 billion and debt redemptions of $1.1 billion.48Table of ContentsIn 2019, net cash used for financing activities was $8.5 billion, primarily reflecting the return of operating cash flow to our shareholders through dividend payments and share repurchases of $8.3 billion, payments of long-term debt borrowings of $4.0 billion and debt redemptions of $1.0 billion, partially offset by proceeds from issuances of long-term debt of $4.6 billion.See Note 8 to our consolidated financial statements for further discussion of debt obligations.We annually review our capital structure with our Board of Directors, including our dividend policy and share repurchase activity. On February 13, 2018, we announced the 2018 share repurchase program providing for the repurchase of up to $15.0 billion of PepsiCo common stock which commenced on July 1, 2018 and will expire on June 30, 2021. In addition, on February 11, 2021, we announced a 5% increase in our annualized dividend to $4.30 per share from $4.09 per share, effective with the dividend expected to be paid in June 2021. We expect to return a total of approximately $5.9 billion to shareholders in 2021, comprised of dividends of approximately $5.8 billion and share repurchases of approximately $100 million. We have recently completed our share repurchase activity and do not expect to repurchase any additional shares for the balance of 2021.Free Cash FlowThe table below reconciles net cash provided by operating activities, as reflected in our cash flow statement, to our free cash flow. Free cash flow is a non-GAAP financial measure. For further information on free cash flow see “Non-GAAP Measures.”20202019ChangeNet cash provided by operating activities, GAAP measure$10,613 $9,649 10 %Capital spending(4,240)(4,232)Sales of property, plant and equipment55 170 Free cash flow, non-GAAP measure$6,428 $5,587 15 %We use free cash flow primarily for acquisitions and financing activities, including debt repayments, dividends and share repurchases. We expect to continue to return free cash flow to our shareholders through dividends and share repurchases while maintaining Tier 1 commercial paper access, which we believe will facilitate appropriate financial flexibility and ready access to global capital and credit markets at favorable interest rates. However, see “Item 1A. Risk Factors” and “Our Business Risks” for certain factors that may impact our credit ratings or our operating cash flows.Any downgrade of our credit ratings by a credit rating agency, especially any downgrade to below investment grade, whether or not as a result of our actions or factors which are beyond our control, could increase our future borrowing costs and impair our ability to access capital and credit markets on terms commercially acceptable to us, or at all. In addition, any downgrade of our current short-term credit ratings could impair our ability to access the commercial paper market with the same flexibility that we have experienced historically, and therefore require us to rely more heavily on more expensive types of debt financing. See “Item 1A. Risk Factors,” “Our Business Risks” and Note 8 to our consolidated financial statements for further discussion.49Table of ContentsCredit Facilities and Long-Term Contractual CommitmentsSee Note 8 to our consolidated financial statements for a description of our credit facilities.The following table summarizes our long-term contractual commitments by period:Payments Due by Period(a) Total20212022 –20232024 –20252026 andbeyondRecorded Liabilities:Long-term debt obligations (b)$40,330 $— $6,895 $6,298 $27,137 Operating leases (c)1,895 486 663 333 413 One-time mandatory transition tax - TCJ Act (d)3,239 309 617 1,351 962 Other long-term liabilities (e)1,277 159 135 140 843 Other:Interest on debt obligations (f)15,988 1,160 2,043 1,771 11,014 Purchasing commitments (g)2,295 894 1,034 246 121 Marketing commitments (h)950 355 366 161 68 Other long-term contractual commitments (i)347 85 167 95 — Total contractual commitments$66,321 $3,448 $11,920 $10,395 $40,558 (a)Based on year-end foreign exchange rates.(b)Excludes $3,358 million related to current maturities of debt, $40 million related to the fair value adjustments for debt acquired in acquisitions and interest rate swaps and payments of $260 million related to unamortized net discounts.(c)Primarily reflects building leases. See Note 13 to our consolidated financial statements for further information on operating leases.(d)Reflects our transition tax liability as of December 26, 2020, which must be paid through 2026 under the provisions of the TCJ Act.(e)Reflects contingent consideration related to estimated future tax benefits associated with our acquisition of Rockstar. Also reflects commitments to support socioeconomic programs in South Africa, which are irrevocable conditions of our acquisition of Pioneer Foods. See Note 9 and Note 14 to our consolidated financial statements for further information.(f)Interest payments on floating-rate debt are estimated using interest rates effective as of December 26, 2020. Includes accrued interest of $352 million as of December 26, 2020.(g)Reflects non-cancelable commitments, primarily for the purchase of commodities and outsourcing services in the normal course of business and does not include purchases that we are likely to make based on our plans but are not obligated to incur.(h)Reflects non-cancelable commitments, primarily for sports marketing in the normal course of business. (i)Reflects our commitment to incur capital expenditures and/or business-related costs associated with our acquisition of Pioneer Foods. See Note 14 to our consolidated financial statements for further information.Reserves for uncertain tax positions are excluded from the table above as we are unable to reasonably predict the ultimate amount or timing of any such settlements. Bottler funding to independent bottlers is not reflected in the table above as it is negotiated on an annual basis. Accrued liabilities for pension and retiree medical plans are not reflected in the table above. See Note 7 to our consolidated financial statements for further information regarding our pension and retiree medical obligations.Off-Balance-Sheet ArrangementsWe do not have guarantees or other off-balance-sheet financing arrangements, including variable interest entities, that we believe could have a material impact on our financial condition or liquidity.We coordinate, on an aggregate basis, the contract negotiations of raw material requirements, including sweeteners, aluminum cans and plastic bottles and closures for us and certain of our independent bottlers. Once we have negotiated the contracts, the bottlers order and take delivery directly from the supplier and pay the suppliers directly. Consequently, transactions between our independent bottlers and suppliers are not reflected in our consolidated financial statements. As the contracting party, we could be liable to these suppliers in the event of any nonpayment by our independent bottlers, but we consider this exposure to be remote.50Table of ContentsReturn on Invested CapitalROIC is a non-GAAP financial measure. For further information on ROIC, see “Non-GAAP Measures.” 20202019Net income attributable to PepsiCo$7,120 $7,314 Interest expense1,252 1,135 Tax on interest expense(278)(252)$8,094 $8,197 Average debt obligations (a)$41,402 $31,975 Average common shareholders’ equity (b)13,536 14,317 Average invested capital$54,938 $46,292 ROIC, non-GAAP measure14.7 %17.7 %(a)Includes a quarterly average of short-term and long-term debt obligations.(b)Includes a quarterly average of common stock, capital in excess of par value, retained earnings, accumulated other comprehensive loss and repurchased common stock.The table below reconciles ROIC as calculated above to net ROIC, excluding items affecting comparability. 20202019ROIC14.7 %17.7 %Impact of:Average cash, cash equivalents and short-term investments3.4 3.0 Interest income (0.2)(0.5)Tax on interest income0.1 0.1 Mark-to-market net impact(0.1)(0.2)Restructuring and impairment charges0.3 0.5 Inventory fair value adjustments and merger and integration charges0.4 0.1 Pension-related settlement charges0.2 0.5 Net tax related to the TCJ Act0.1 (1.0)Other net tax benefits1.0 2.2 Charges related to cash tender and exchange offers— (0.1)Net ROIC, excluding items affecting comparability19.9 %22.3 %OUR CRITICAL ACCOUNTING POLICIESAn appreciation of our critical accounting policies is necessary to understand our financial results. These policies may require management to make difficult and subjective judgments regarding uncertainties, including those related to the COVID-19 pandemic, and as a result, such estimates may significantly impact our financial results. The precision of these estimates and the likelihood of future changes depend on a number of underlying variables and a range of possible outcomes. We applied our critical accounting policies and estimation methods consistently in all material respects and for all periods presented. We have discussed our critical accounting policies with our Audit Committee.Our critical accounting policies are:•revenue recognition;•goodwill and other intangible assets;•income tax expense and accruals; and•pension and retiree medical plans.51Table of ContentsRevenue RecognitionWe recognize revenue when our performance obligation is satisfied. Our primary performance obligation (the distribution and sales of beverage products and food and snack products) is satisfied upon the shipment or delivery of products to our customers, which is also when control is transferred. The transfer of control of products to our customers is typically based on written sales terms that do not allow for a right of return. However, our policy for DSD, including certain chilled products, is to remove and replace damaged and out-of-date products from store shelves to ensure that consumers receive the product quality and freshness they expect. Similarly, our policy for certain warehouse-distributed products is to replace damaged and out-of-date products. As a result, we record reserves, based on estimates, for anticipated damaged and out-of-date products. We recorded $20 million of reserves for product returns in 2020 as a result of the COVID-19 pandemic. See Note 1 to our consolidated financial statements for further information.Our products are sold for cash or on credit terms. Our credit terms, which are established in accordance with local and industry practices, typically require payment within 30 days of delivery in the United States, and generally within 30 to 90 days internationally, and may allow discounts for early payment. There were no material changes in credit terms as a result of the COVID-19 pandemic.We estimate and reserve for our expected credit loss exposure based on our experience with past due accounts and collectibility, write-off history, the aging of accounts receivable, our analysis of customer data, and forward-looking information (including the expected impact of the global economic uncertainty related to the COVID-19 pandemic), leveraging estimates of creditworthiness and projections of default and recovery rates for certain of our customers (including foodservice and vending businesses). We recorded an allowance for expected credit losses of $56 million in 2020 as a result of the COVID-19 pandemic. See Note 1 to our consolidated financial statements for further information.Our policy is to provide customers with product when needed. In fact, our commitment to freshness and product dating serves to regulate the quantity of product shipped or delivered. In addition, DSD products are placed on the shelf by our employees with customer shelf space and storerooms limiting the quantity of product. For product delivered through other distribution networks, we monitor customer inventory levels.As discussed in “Our Customers” in “Item 1. Business,” we offer sales incentives and discounts through various programs to customers and consumers. Total marketplace spending includes sales incentives, discounts, advertising and other marketing activities. Sales incentives and discounts are primarily accounted for as a reduction of revenue and include payments to customers for performing activities on our behalf, such as payments for in-store displays, payments to gain distribution of new products, payments for shelf space and discounts to promote lower retail prices. Sales incentives and discounts also include support provided to our independent bottlers through funding of advertising and other marketing activities.A number of our sales incentives, such as bottler funding to independent bottlers and customer volume rebates, are based on annual targets, and accruals are established during the year, as products are delivered, for the expected payout, which may occur after year end once reconciled and settled. These accruals are based on contract terms and our historical experience with similar programs and require management judgment with respect to estimating customer and consumer participation and performance levels. Differences between estimated expense and actual incentive costs are normally insignificant and are recognized in earnings in the period such differences are determined. In addition, certain advertising and marketing costs are also based on annual targets and recognized during the year as incurred.See Note 2 to our consolidated financial statements for further information on our revenue recognition and related policies, including total marketplace spending.52Table of ContentsGoodwill and Other Intangible AssetsWe sell products under a number of brand names, many of which were developed by us. Brand development costs are expensed as incurred. We also purchase brands and other intangible assets in acquisitions. In a business combination, the consideration is first assigned to identifiable assets and liabilities, including brands and other intangible assets, based on estimated fair values, with any excess recorded as goodwill. Determining fair value requires significant estimates and assumptions, including those related to the COVID-19 pandemic, based on an evaluation of a number of factors, such as marketplace participants, product life cycles, market share, consumer awareness, brand history and future expansion expectations, amount and timing of future cash flows and the discount rate applied to the cash flows.We believe that a brand has an indefinite life if it has a history of strong revenue and cash flow performance and we have the intent and ability to support the brand with marketplace spending for the foreseeable future. If these indefinite-lived brand criteria are not met, brands are amortized over their expected useful lives, which generally range from 20 to 40 years. Determining the expected life of a brand requires management judgment and is based on an evaluation of a number of factors, including market share, consumer awareness, brand history, future expansion expectations and regulatory restrictions, as well as the macroeconomic environment of the countries in which the brand is sold.In connection with previous acquisitions, we reacquired certain franchise rights which provided the exclusive and perpetual rights to manufacture and/or distribute beverages for sale in specified territories. In determining the useful life of these franchise rights, many factors were considered, including the pre-existing perpetual bottling arrangements, the indefinite period expected for these franchise rights to contribute to our future cash flows, as well as the lack of any factors that would limit the useful life of these franchise rights to us, including legal, regulatory, contractual, competitive, economic or other factors. Therefore, certain of these franchise rights are considered as indefinite-lived. Franchise rights that are not considered indefinite-lived are amortized over the remaining contractual period of the contract in which the right was granted.Indefinite-lived intangible assets and goodwill are not amortized and, as a result, are assessed for impairment at least annually, using either a qualitative or quantitative approach. We perform this annual assessment during our third quarter, or more frequently if circumstances indicate that the carrying value may not be recoverable. Where we use the qualitative assessment, first we determine if, based on qualitative factors, it is more likely than not that an impairment exists. Factors considered include macroeconomic (including those related to the COVID-19 pandemic), industry and competitive conditions, legal and regulatory environment, historical financial performance and significant changes in the brand or reporting unit. If the qualitative assessment indicates that it is more likely than not that an impairment exists, then a quantitative assessment is performed.In the quantitative assessment for indefinite-lived intangible assets and goodwill, estimated fair value is determined using discounted cash flows and requires an analysis of several estimates including future cash flows or income consistent with management’s strategic business plans, annual sales growth rates, perpetuity growth assumptions and the selection of assumptions underlying a discount rate (weighted-average cost of capital) based on market data available at the time. Significant management judgment is necessary to estimate the impact of competitive operating, macroeconomic and other factors (including those related to the COVID-19 pandemic) to estimate future levels of sales, operating profit or cash flows. All assumptions used in our impairment evaluations for indefinite-lived intangible assets and goodwill, such as forecasted growth rates (including perpetuity growth assumptions) and weighted-average cost of capital, are based on the best available market information and are consistent with our internal forecasts and operating plans. A deterioration in these assumptions could adversely impact our results. These 53Table of Contentsassumptions could be adversely impacted by certain of the risks described in “Item 1A. Risk Factors” and “Our Business Risks.” Amortizable intangible assets are only evaluated for impairment upon a significant change in the operating or macroeconomic environment. If an evaluation of the undiscounted future cash flows indicates impairment, the asset is written down to its estimated fair value, which is based on its discounted future cash flows. See Note 2 and Note 4 to our consolidated financial statements for further information. Income Tax Expense and AccrualsOur annual tax rate is based on our income, statutory tax rates and tax structure and transactions, including transfer pricing arrangements, available to us in the various jurisdictions in which we operate. Significant judgment is required in determining our annual tax rate and in evaluating our tax positions. We establish reserves when, despite our belief that our tax return positions are fully supportable, we believe that certain positions are subject to challenge and that we likely will not succeed. We adjust these reserves, as well as the related interest, in light of changing facts and circumstances, such as the progress of a tax audit, new tax laws, relevant court cases or tax authority settlements. See “Item 1A. Risk Factors” for further discussion.An estimated annual effective tax rate is applied to our quarterly operating results. In the event there is a significant or unusual item recognized in our quarterly operating results, the tax attributable to that item is separately calculated and recorded at the same time as that item. We consider the tax adjustments from the resolution of prior-year tax matters to be among such items.Tax law requires items to be included in our tax returns at different times than the items are reflected in our consolidated financial statements. As a result, our annual tax rate reflected in our consolidated financial statements is different than that reported in our tax returns (our cash tax rate). Some of these differences are permanent, such as expenses that are not deductible in our tax return, and some differences reverse over time, such as depreciation expense. These temporary differences create deferred tax assets and liabilities. Deferred tax assets generally represent items that can be used as a tax deduction or credit in our tax returns in future years for which we have already recorded the tax benefit on our consolidated financial statements. We establish valuation allowances for our deferred tax assets if, based on the available evidence, it is more likely than not that some portion or all of the deferred tax assets will not be realized. Deferred tax liabilities generally represent tax expense recognized in our consolidated financial statements for which payment has been deferred, or expense for which we have already taken a deduction in our tax return but have not yet recognized as expense in our consolidated financial statements.During the fourth quarter of 2017, the TCJ Act was enacted in the United States. Among its many provisions, the TCJ Act imposed a mandatory one-time transition tax on undistributed international earnings and reduced the U.S. corporate income tax rate from 35% to 21%, effective January 1, 2018. We recorded a net tax benefit of $28 million ($0.02 per share) in 2018 related to the TCJ Act. The related provisional measurement period allowed by the SEC ended in the fourth quarter of 2018. While our accounting for the recorded impact of the TCJ Act was deemed to be complete, additional guidance issued by the IRS impacted our recorded amounts after December 29, 2018. In 2019, we recognized a net tax benefit totaling $8 million ($0.01 per share) related to the TCJ Act. See further information in “Items Affecting Comparability.”On May 19, 2019, a public referendum held in Switzerland passed the TRAF, effective January 1, 2020. The enactment of certain provisions of the TRAF resulted in adjustments to our deferred taxes. During 2020, we recorded a net tax benefit of $72 million related to the adoption of the TRAF in the 54Table of ContentsSwiss Canton of Bern. During 2019, we recorded net tax expense of $24 million related to the impact of the TRAF. In 2020, our annual tax rate was 20.9% compared to 21.0% in 2019. See “Other Consolidated Results” for further information.See Note 5 to our consolidated financial statements for further information. Pension and Retiree Medical PlansOur pension plans cover certain employees in the United States and certain international employees. Benefits are determined based on either years of service or a combination of years of service and earnings. Certain U.S. and Canada retirees are also eligible for medical and life insurance benefits (retiree medical) if they meet age and service requirements. Generally, our share of retiree medical costs is capped at specified dollar amounts, which vary based upon years of service, with retirees contributing the remainder of the cost. In addition, we have been phasing out certain subsidies of retiree medical benefits.In 2020, lump sum distributions exceeded the total of annual service and interest cost and triggered a pre-tax settlement charge in the PepsiCo Employees Retirement Plan A (Plan A) of $205 million ($158 million after-tax or $0.11 per share).In 2020, we adopted an amendment to the U.S. defined benefit pension plans to freeze benefit accruals for salaried participants, effective December 31, 2025. Since 2011, salaried new hires are not eligible to participate in the defined benefit plan. After the effective date, all salaried participants will receive an employer contribution to the 401(k) savings plan based on age and years of service regardless of employee contribution and will have the opportunity to receive employer contributions to match employee contributions up to defined limits. As a result of this amendment, pension benefits pre-tax expense is expected to decrease by approximately $70 million in 2021, primarily impacting corporate unallocated expenses.In 2020, we approved an amendment to reorganize the U.S. qualified defined benefit pension plans that resulted in the transfer of certain participants from Plan A to the PepsiCo Employees Retirement Plan I (Plan I) and to a newly created plan, the PepsiCo Employees Retirement Hourly Plan (Plan H), effective January 1, 2021. The benefits offered to the plans’ participants were unchanged. The reorganization will facilitate a more targeted investment strategy and provide additional flexibility in evaluating opportunities to reduce risk and volatility. No material impact to pension benefit pre-tax expense is expected from this reorganization.In 2020, we adopted an amendment, effective January 1, 2021, to enhance the pay credit benefits of certain participants in Plan H. As a result of this amendment, pension benefits pre-tax expense is expected to increase approximately $45 million in 2021, primarily impacting service cost expense. In 2019, Plan A purchased a group annuity contract whereby a third-party insurance company assumed the obligation to pay and administer future annuity payments for certain retirees. This transaction triggered a pre-tax settlement charge in 2019 of $220 million ($170 million after-tax or $0.12 per share). Also in 2019, certain former employees who had vested benefits in our U.S. defined benefit pension plans were offered the option of receiving a one-time lump sum payment equal to the present value of the participant’s pension benefit. This transaction triggered a pre-tax settlement charge in 2019 of $53 million ($41 million after-tax or $0.03 per share). Collectively, the group annuity contract and one-time lump sum payments to certain former employees who had vested benefits resulted in settlement charges in 2019 of $273 million ($211 million after-tax or $0.15 per share). See “Items Affecting Comparability” and Note 7 to our consolidated financial statements.55Table of ContentsOur AssumptionsThe determination of pension and retiree medical expenses and obligations requires the use of assumptions to estimate the amount of benefits that employees earn while working, as well as the present value of those benefits. Annual pension and retiree medical expense amounts are principally based on four components: (1) the value of benefits earned by employees for working during the year (service cost), (2) the increase in the projected benefit obligation due to the passage of time (interest cost), and (3) other gains and losses as discussed in Note 7 to our consolidated financial statements, reduced by (4) the expected return on assets for our funded plans.Significant assumptions used to measure our annual pension and retiree medical expenses include:•certain employee-related demographic factors, such as turnover, retirement age and mortality;•the expected return on assets in our funded plans;•for pension expense, the rate of salary increases for plans where benefits are based on earnings; •for retiree medical expense, health care cost trend rates; and•for pension and retiree medical expense, the spot rates along the yield curve used to determine service and interest costs and the present value of liabilities.Certain assumptions reflect our historical experience and management’s best judgment regarding future expectations. All actuarial assumptions are reviewed annually, except in the case of an interim remeasurement due to a significant event such as a curtailment or settlement. Due to the significant management judgment involved, these assumptions could have a material impact on the measurement of our pension and retiree medical expenses and obligations.At each measurement date, the discount rates are based on interest rates for high-quality, long-term corporate debt securities with maturities comparable to those of our liabilities. Our U.S. obligation and pension and retiree medical expense is based on the discount rates determined using the Mercer Above Mean Curve. This curve includes bonds that closely match the timing and amount of our expected benefit payments and reflects the portfolio of investments we would consider to settle our liabilities.See Note 7 to our consolidated financial statements for information about the expected rate of return on plan assets and our plans’ investment strategy. Although we review our expected long-term rates of return on an annual basis, our asset returns in a given year do not significantly influence our evaluation of long-term rates of return.The health care trend rate used to determine our retiree medical plans’ obligation and expense is reviewed annually. Our review is based on our claims experience, information provided by our health plans and actuaries, and our knowledge of the health care industry. Our review of the trend rate considers factors such as demographics, plan design, new medical technologies and changes in medical carriers.56Table of ContentsWeighted-average assumptions for pension and retiree medical expense are as follows: 202120202019PensionService cost discount rate 2.6 %3.4 %4.4 %Interest cost discount rate 1.9 %2.8 %3.9 %Expected rate of return on plan assets 6.2 %6.6 %6.8 %Expected rate of salary increases3.1 %3.2 %3.2 %Retiree medicalService cost discount rate 2.3 %3.2 %4.3 %Interest cost discount rate 1.6 %2.6 %3.8 %Expected rate of return on plan assets 5.4 %5.8 %6.6 %Current health care cost trend rate5.5 %5.6 %5.7 %In 2020, lump sum distributions exceeded the total of annual service and interest cost and triggered a pre-tax settlement charge in Plan A. In addition, based on our assumptions, we expect our total pension and retiree medical expense to decrease in 2021 primarily reflecting the recognition of fixed income gains on plan assets, the impact of discretionary plan contributions and plan changes, partially offset by lower discount rates and lower rate of expected returns on U.S. plan assets.Sensitivity of AssumptionsA decrease in each of the collective discount rates or in the expected rate of return assumptions would increase expense for our benefit plans. A 25-basis-point decrease in each of the above discount rates and expected rate of return assumptions would individually increase 2021 pre-tax pension and retiree medical expense as follows:AssumptionAmountDiscount rates used in the calculation of expense$55 Expected rate of return$50 FundingWe make contributions to pension trusts that provide plan benefits for certain pension plans. These contributions are made in accordance with applicable tax regulations that provide for current tax deductions for our contributions and taxation to the employee only upon receipt of plan benefits. Generally, we do not fund our pension plans when our contributions would not be currently tax deductible. As our retiree medical plans are not subject to regulatory funding requirements, we generally fund these plans on a pay-as-you-go basis, although we periodically review available options to make additional contributions toward these benefits.In November 2020, we received approval from our Board of Directors to make discretionary contributions of $500 million to our U.S. qualified defined benefit plans. We contributed $300 million of the approved amount in January 2021; we expect to contribute the remaining $200 million in the third quarter of 2021. We made discretionary contributions to our U.S. qualified defined benefit plans of $325 million in 2020 and $400 million in 2019.Our pension and retiree medical contributions are subject to change as a result of many factors, such as changes in interest rates, deviations between actual and expected asset returns and changes in tax or other benefit laws. We continue to monitor the impact of the COVID-19 pandemic and related global economic conditions and uncertainty on the net unfunded status of our pension and retiree medical plans. We regularly evaluate different opportunities to reduce risk and volatility associated with our pension and retiree medical plans. See Note 7 to our consolidated financial statements for our past and expected contributions and estimated future benefit payments.57Table of ContentsConsolidated Statement of IncomePepsiCo, Inc. and SubsidiariesFiscal years ended December 26, 2020, December 28, 2019 and December 29, 2018 (in millions except per share amounts) 202020192018Net Revenue$70,372 $67,161 $64,661 Cost of sales31,797 30,132 29,381 Gross profit38,575 37,029 35,280 Selling, general and administrative expenses28,495 26,738 25,170 Operating Profit10,080 10,291 10,110 Other pension and retiree medical benefits income/(expense)117 (44)298 Net interest expense and other(1,128)(935)(1,219)Income before income taxes9,069 9,312 9,189 Provision for/(benefit from) income taxes (See Note 5)1,894 1,959 (3,370)Net income7,175 7,353 12,559 Less: Net income attributable to noncontrolling interests55 39 44 Net Income Attributable to PepsiCo$7,120 $7,314 $12,515 Net Income Attributable to PepsiCo per Common ShareBasic$5.14 $5.23 $8.84 Diluted$5.12 $5.20 $8.78 Weighted-average common shares outstandingBasic1,385 1,399 1,415 Diluted1,392 1,407 1,425 See accompanying notes to the consolidated financial statements.58Table of ContentsConsolidated Statement of Comprehensive IncomePepsiCo, Inc. and SubsidiariesFiscal years ended December 26, 2020, December 28, 2019 and December 29, 2018 (in millions)202020192018Net income$7,175 $7,353 $12,559 Other comprehensive (loss)/income, net of taxes:Net currency translation adjustment(650)628 (1,641)Net change on cash flow hedges7 (90)40 Net pension and retiree medical adjustments(532)283 (467)Other(1)(2)6 (1,176)819 (2,062)Comprehensive income5,999 8,172 10,497 Less: Comprehensive income attributable to noncontrolling interests55 39 44 Comprehensive Income Attributable to PepsiCo$5,944 $8,133 $10,453 See accompanying notes to the consolidated financial statements.59Table of ContentsConsolidated Statement of Cash FlowsPepsiCo, Inc. and SubsidiariesFiscal years ended December 26, 2020, December 28, 2019 and December 29, 2018 (in millions)202020192018Operating ActivitiesNet income$7,175 $7,353 $12,559 Depreciation and amortization2,548 2,432 2,399 Share-based compensation expense264 237 256 Restructuring and impairment charges289 370 308 Cash payments for restructuring charges(255)(350)(255)Inventory fair value adjustments and merger and integration charges255 55 75 Cash payments for merger and integration charges(131)(10)(73)Pension and retiree medical plan expenses408 519 221 Pension and retiree medical plan contributions(562)(716)(1,708)Deferred income taxes and other tax charges and credits361 453 (531)Net tax related to the TCJ Act— (8)(28)Tax payments related to the TCJ Act(78)(423)(115)Other net tax benefits related to international reorganizations— (2)(4,347)Change in assets and liabilities:Accounts and notes receivable(420)(650)(253)Inventories(516)(190)(174)Prepaid expenses and other current assets26 (87)9 Accounts payable and other current liabilities766 735 882 Income taxes payable(159)(287)448 Other, net642 218 (258)Net Cash Provided by Operating Activities10,613 9,649 9,415 Investing ActivitiesCapital spending(4,240)(4,232)(3,282)Sales of property, plant and equipment55 170 134 Acquisitions, net of cash acquired, and investments in noncontrolled affiliates(6,372)(2,717)(1,496)Divestitures4 253 505 Short-term investments, by original maturity:More than three months - purchases(1,135)— (5,637)More than three months - maturities— 16 12,824 More than three months - sales— 62 1,498 Three months or less, net27 19 16 Other investing, net42 (8)2 Net Cash (Used for)/Provided by Investing Activities(11,619)(6,437)4,564 (Continued on following page)60Table of ContentsConsolidated Statement of Cash Flows (continued)PepsiCo, Inc. and SubsidiariesFiscal years ended December 26, 2020, December 28, 2019 and December 29, 2018 (in millions)202020192018Financing ActivitiesProceeds from issuances of long-term debt$13,809 $4,621 $— Payments of long-term debt(1,830)(3,970)(4,007)Debt redemption/cash tender and exchange offers(1,100)(1,007)(1,589)Short-term borrowings, by original maturity:More than three months - proceeds4,077 6 3 More than three months - payments(3,554)(2)(17)Three months or less, net(109)(3)(1,352)Cash dividends paid(5,509)(5,304)(4,930)Share repurchases - common(2,000)(3,000)(2,000)Proceeds from exercises of stock options179 329 281 Withholding tax payments on restricted stock units (RSUs), performance stock units (PSUs) and PepsiCo equity performance units (PEPunits) converted(96)(114)(103)Other financing(48)(45)(55)Net Cash Provided by/(Used for) Financing Activities3,819 (8,489)(13,769)Effect of exchange rate changes on cash and cash equivalents and restricted cash(129)78 (98)Net Increase/(Decrease) in Cash and Cash Equivalents and Restricted Cash2,684 (5,199)112 Cash and Cash Equivalents and Restricted Cash, Beginning of Year5,570 10,769 10,657 Cash and Cash Equivalents and Restricted Cash, End of Year$8,254 $5,570 $10,769 See accompanying notes to the consolidated financial statements.61Table of ContentsConsolidated Balance SheetPepsiCo, Inc. and SubsidiariesDecember 26, 2020 and December 28, 2019 (in millions except per share amounts)20202019ASSETSCurrent AssetsCash and cash equivalents $8,185 $5,509 Short-term investments1,366 229 Accounts and notes receivable, net8,404 7,822 Inventories4,172 3,338 Prepaid expenses and other current assets874 747 Total Current Assets23,001 17,645 Property, Plant and Equipment, net21,369 19,305 Amortizable Intangible Assets, net1,703 1,433 Goodwill18,757 15,501 Other Indefinite-Lived Intangible Assets17,612 14,610 Investments in Noncontrolled Affiliates2,792 2,683 Deferred Income Taxes4,372 4,359 Other Assets3,312 3,011 Total Assets$92,918 $78,547 LIABILITIES AND EQUITYCurrent LiabilitiesShort-term debt obligations$3,780 $2,920 Accounts payable and other current liabilities19,592 17,541 Total Current Liabilities23,372 20,461 Long-Term Debt Obligations40,370 29,148 Deferred Income Taxes4,284 4,091 Other Liabilities11,340 9,979 Total Liabilities79,366 63,679 Commitments and contingenciesPepsiCo Common Shareholders’ EquityCommon stock, par value 12/3¢ per share (authorized 3,600 shares; issued, net of repurchased common stock at par value: 1,380 and 1,391 shares, respectively)23 23 Capital in excess of par value3,910 3,886 Retained earnings63,443 61,946 Accumulated other comprehensive loss(15,476)(14,300)Repurchased common stock, in excess of par value (487 and 476 shares, respectively)(38,446)(36,769)Total PepsiCo Common Shareholders’ Equity13,454 14,786 Noncontrolling interests98 82 Total Equity13,552 14,868 Total Liabilities and Equity$92,918 $78,547 See accompanying notes to the consolidated financial statements.62Table of ContentsConsolidated Statement of EquityPepsiCo, Inc. and SubsidiariesFiscal years ended December 26, 2020, December 28, 2019 and December 29, 2018(in millions except per share amounts) 202020192018 SharesAmountSharesAmountSharesAmountPreferred StockBalance, beginning of year— $— — $— 0.8 $41 Conversion to common stock— — — — (0.1)(6)Retirement of preferred stock— — — — (0.7)(35)Balance, end of year— — — — — — Repurchased Preferred StockBalance, beginning of year— — — — (0.7)(197)Redemptions— — — — — (2)Retirement of preferred stock— — — — 0.7 199 Balance, end of year— — — — — — Common StockBalance, beginning of year1,391 23 1,409 23 1,420 24 Shares issued in connection with preferred stock conversion to common stock— — — — 1 — Change in repurchased common stock(11)— (18)— (12)(1)Balance, end of year1,380 23 1,391 23 1,409 23 Capital in Excess of Par ValueBalance, beginning of year3,886 3,953 3,996 Share-based compensation expense263 235 250 Equity issued in connection with preferred stock conversion to common stock— — 6 Stock option exercises, RSUs, PSUs and PEPunits converted(143)(188)(193)Withholding tax on RSUs, PSUs and PEPunits converted(96)(114)(103)Other— — (3)Balance, end of year3,910 3,886 3,953 Retained EarningsBalance, beginning of year61,946 59,947 52,839 Cumulative effect of accounting changes(34)8 (145)Net income attributable to PepsiCo7,120 7,314 12,515 Cash dividends declared - common (a)(5,589)(5,323)(5,098)Retirement of preferred stock— — (164)Balance, end of year63,443 61,946 59,947 Accumulated Other Comprehensive LossBalance, beginning of year(14,300)(15,119)(13,057)Other comprehensive (loss)/income attributable to PepsiCo(1,176)819 (2,062)Balance, end of year(15,476)(14,300)(15,119)Repurchased Common StockBalance, beginning of year(476)(36,769)(458)(34,286)(446)(32,757)Share repurchases(15)(2,000)(24)(3,000)(18)(2,000)Stock option exercises, RSUs, PSUs and PEPunits converted4 322 6 516 6 469 Other— 1 — 1 — 2 Balance, end of year(487)(38,446)(476)(36,769)(458)(34,286)Total PepsiCo Common Shareholders’ Equity13,454 14,786 14,518 Noncontrolling InterestsBalance, beginning of year82 84 92 Net income attributable to noncontrolling interests55 39 44 Distributions to noncontrolling interests(44)(42)(49)Acquisitions5 — — Other, net— 1 (3)Balance, end of year98 82 84 Total Equity$13,552 $14,868 $14,602 (a) Cash dividends declared per common share were $4.0225, $3.7925 and $3.5875 for 2020, 2019 and 2018, respectively.See accompanying notes to the consolidated financial statements.63Table of ContentsNotes to Consolidated Financial StatementsNote 1 — Basis of Presentation and Our DivisionsBasis of PresentationThe accompanying consolidated financial statements have been prepared in accordance with U.S. GAAP and include the consolidated accounts of PepsiCo, Inc. and the affiliates that we control. In addition, we include our share of the results of certain other affiliates using the equity method based on our economic ownership interest, our ability to exercise significant influence over the operating or financial decisions of these affiliates or our ability to direct their economic resources. We do not control these other affiliates, as our ownership in these other affiliates is generally 50% or less. Intercompany balances and transactions are eliminated. As a result of exchange restrictions and other operating restrictions, we do not have control over our Venezuelan subsidiaries. As such, our Venezuelan subsidiaries are not included within our consolidated financial results for any period presented.Raw materials, direct labor and plant overhead, as well as purchasing and receiving costs, costs directly related to production planning, inspection costs and raw materials handling facilities, are included in cost of sales. The costs of moving, storing and delivering finished product, including merchandising activities, are included in selling, general and administrative expenses.The preparation of our consolidated financial statements requires us to make estimates and assumptions that affect reported amounts of assets, liabilities, revenues, expenses and disclosure of contingent assets and liabilities. Estimates are used in determining, among other items, sales incentives accruals, tax reserves, share-based compensation, pension and retiree medical accruals, amounts and useful lives for intangible assets and future cash flows associated with impairment testing for indefinite-lived brands, goodwill and other long-lived assets. We evaluate our estimates on an ongoing basis using our historical experience, as well as other factors we believe appropriate under the circumstances, such as current economic conditions, and adjust or revise our estimates as circumstances change. The business and economic uncertainty resulting from the COVID-19 pandemic has made such estimates and assumptions more difficult to calculate. As future events and their effect cannot be determined with precision, actual results could differ significantly from those estimates.Our fiscal year ends on the last Saturday of each December, resulting in an additional week of results every five or six years. While our North America results are reported on a weekly calendar basis, substantially all of our international operations report on a monthly calendar basis. Certain operations in our Europe segment report on a weekly calendar basis. The following chart details our quarterly reporting schedule for the three years presented:QuarterUnited States and CanadaInternationalFirst Quarter12 weeksJanuary, FebruarySecond Quarter12 weeksMarch, April and MayThird Quarter12 weeksJune, July and AugustFourth Quarter16 weeksSeptember, October, November and DecemberUnless otherwise noted, tabular dollars are in millions, except per share amounts. All per share amounts reflect common per share amounts, assume dilution unless otherwise noted, and are based on unrounded amounts. Certain reclassifications were made to the prior year’s consolidated financial statements to conform to the current year presentation.64Table of ContentsOur DivisionsWe are organized into seven reportable segments (also referred to as divisions), as follows:1)FLNA, which includes our branded food and snack businesses in the United States and Canada;2)QFNA, which includes our cereal, rice, pasta and other branded food businesses in the United States and Canada;3)PBNA, which includes our beverage businesses in the United States and Canada;4)LatAm, which includes all of our beverage, food and snack businesses in Latin America;5)Europe, which includes all of our beverage, food and snack businesses in Europe;6)AMESA, which includes all of our beverage, food and snack businesses in Africa, the Middle East and South Asia; and7)APAC, which includes all of our beverage, food and snack businesses in Asia Pacific, Australia and New Zealand and China region.Through our operations, authorized bottlers, contract manufacturers and other third parties, we make, market, distribute and sell a wide variety of convenient beverages, foods and snacks, serving customers and consumers in more than 200 countries and territories with our largest operations in the United States, Mexico, Russia, Canada, the United Kingdom, China and South Africa.The accounting policies for the divisions are the same as those described in Note 2, except for the following allocation methodologies:•share-based compensation expense;•pension and retiree medical expense; and•derivatives.Share-Based Compensation ExpenseOur divisions are held accountable for share-based compensation expense and, therefore, this expense is allocated to our divisions as an incremental employee compensation cost. The allocation of share-based compensation expense of each division is as follows:202020192018FLNA13 %13 %13 %QFNA1 %1 %1 %PBNA18 %17 %18 %LatAm6 %7 %8 %Europe16 %17 %9 %AMESA6 %3 %4 %APAC2 %5 %4 %Corporate unallocated expenses38 %37 %43 %The expense allocated to our divisions excludes any impact of changes in our assumptions during the year which reflect market conditions over which division management has no control. Therefore, any variances between allocated expense and our actual expense are recognized in corporate unallocated expenses.Pension and Retiree Medical ExpensePension and retiree medical service costs measured at fixed discount rates are reflected in division results. The variance between the fixed discount rate used to determine the service cost reflected in division results and the discount rate as disclosed in Note 7 is reflected in corporate unallocated expenses. 65Table of ContentsDerivativesWe centrally manage commodity derivatives on behalf of our divisions. These commodity derivatives include agricultural products, energy and metals. Commodity derivatives that do not qualify for hedge accounting treatment are marked to market each period with the resulting gains and losses recorded in corporate unallocated expenses as either cost of sales or selling, general and administrative expenses, depending on the underlying commodity. These gains and losses are subsequently reflected in division results when the divisions recognize the cost of the underlying commodity in operating profit. Therefore, the divisions realize the economic effects of the derivative without experiencing any resulting mark-to-market volatility, which remains in corporate unallocated expenses. These derivatives hedge underlying commodity price risk and were not entered into for trading or speculative purposes.Net Revenue and Operating ProfitNet revenue and operating profit of each division are as follows: Net RevenueOperating Profit 202020192018202020192018FLNA$18,189 $17,078 $16,346 $5,340 $5,258 $5,008 QFNA2,742 2,482 2,465 669 544 637 PBNA22,559 21,730 21,072 1,937 2,179 2,276 LatAm6,942 7,573 7,354 1,033 1,141 1,049 Europe11,922 11,728 10,973 1,353 1,327 1,256 AMESA (a)4,573 3,651 3,657 600 671 661 APAC (b)3,445 2,919 2,794 590 477 619 Total division70,372 67,161 64,661 11,522 11,597 11,506 Corporate unallocated expenses— — — (1,442)(1,306)(1,396)Total$70,372 $67,161 $64,661 $10,080 $10,291 $10,110 (a)In 2020, the increase in net revenue primarily reflects our acquisition of Pioneer Foods. See Note 14 for further information.(b)In 2020, the increase in net revenue primarily reflects our acquisition of Be & Cheery. See Note 14 for further information.Our primary performance obligation is the distribution and sales of beverage and food and snack products to our customers. The following tables reflect the approximate percentage of net revenue generated between our beverage business and our food and snack business for each of our international divisions, as well as our consolidated net revenue:202020192018Beverage(a)Food/SnackBeverage(a)Food/SnackBeverage(a)Food/SnackLatAm10 %90 %10 %90 %10 %90 %Europe55 %45 %55 %45 %50 %50 %AMESA (b)30 %70 %40 %60 %45 %55 %APAC25 %75 %25 %75 %25 %75 %PepsiCo45 %55 %45 %55 %45 %55 %(a)Beverage revenue from company-owned bottlers, which primarily includes our consolidated bottling operations in our PBNA and Europe segments, is approximately 40% of our consolidated net revenue in 2020, 2019 and 2018. Generally, our finished goods beverage operations produce higher net revenue, but lower operating margins as compared to concentrate sold to authorized bottling partners for the manufacture of finished goods beverages.(b)The increase in the approximate percentage of net revenue generated by our food and snack business primarily reflects our acquisition of Pioneer Foods. See Note 14 for further information.66Table of ContentsOperating profit in 2020 includes certain pre-tax charges taken as a result of the COVID-19 pandemic. These pre-tax charges by division are as follows: 2020Allowances for Expected Credit Losses(a)Upfront Payments to Customers(b)Inventory Write-Downs and Product Returns(c)Employee Compensation Expense(d)Employee Protection Costs(e)Other(f)TotalFLNA$17 $— $8 $145 $59 $— $229 QFNA2 — — 9 3 1 15 PBNA29 56 28 115 50 26 304 LatAm1 — 19 56 18 8 102 Europe5 3 11 23 22 24 88 AMESA2 — 3 9 7 12 33 APAC (g)— — 3 (7)2 5 3 Total$56 $59 $72 $350 $161 $76 $774 (a)Reflects the expected impact of the global economic uncertainty caused by COVID-19, leveraging estimates of creditworthiness, projections of default and recovery rates for certain of our customers, including foodservice and vending businesses.(b)Relates to promotional spending for which benefit is not expected to be received.(c)Includes a reserve for product returns of $20 million.(d)Includes incremental frontline incentive pay, crisis child care and other leave benefits and labor costs.(e)Includes costs associated with personal protective equipment, temperature scans, cleaning and other sanitization services.(f)Includes reserves for property, plant and equipment, donations of cash and product and other costs.(g)Income amount includes a social welfare relief credit of $11 million.Corporate Unallocated Expenses Corporate unallocated expenses include costs of our corporate headquarters, centrally managed initiatives such as commodity derivative gains and losses, foreign exchange transaction gains and losses, our ongoing business transformation initiatives, unallocated research and development costs, unallocated insurance and benefit programs, tax-related contingent consideration and certain other items.Other Division Information Total assets and capital spending of each division are as follows: Total AssetsCapital Spending 20202019202020192018FLNA$8,730 $7,519 $1,189 $1,227 $840 QFNA1,021 941 85 104 53 PBNA (a)37,079 31,449 1,245 1,053 945 LatAm6,977 7,007 390 557 492 Europe17,917 17,814 730 613 466 AMESA (b)5,942 3,672 252 267 198 APAC (c)5,770 4,113 230 195 138 Total division83,436 72,515 4,121 4,016 3,132 Corporate (d)9,482 6,032 119 216 150 Total$92,918 $78,547 $4,240 $4,232 $3,282 (a)In 2020, the increase in assets was primarily related to our acquisition of Rockstar. See Note 14 for further information.(b)In 2020, the increase in assets was primarily related to our acquisition of Pioneer Foods. See Note 14 for further information. (c)In 2020, the increase in assets was primarily related to our acquisition of Be & Cheery. See Note 14 for further information. (d)Corporate assets consist principally of certain cash and cash equivalents, restricted cash, short-term investments, derivative instruments, property, plant and equipment and tax assets. In 2020, the change in assets was primarily due to an increase in cash and cash equivalents and short-term investments. Refer to the cash flow statement for further information.67Table of ContentsAmortization of intangible assets and depreciation and other amortization of each division are as follows: Amortization of Intangible Assets Depreciation andOther Amortization 202020192018202020192018FLNA$10 $7 $7 $550 $492 $457 QFNA— — — 41 44 45 PBNA28 29 31 899 857 821 LatAm4 5 5 251 270 253 Europe40 37 23 350 341 319 AMESA3 2 2 149 116 169 APAC5 1 1 91 76 80 Total division90 81 69 2,331 2,196 2,144 Corporate— — — 127 155 186 Total$90 $81 $69 $2,458 $2,351 $2,330 Net revenue and long-lived assets by country are as follows: Net RevenueLong-Lived Assets(a) 20202019201820202019United States (b)$40,800 $38,644 $37,148 $36,657 $30,601 Mexico3,924 4,190 3,878 1,708 1,666 Russia3,009 3,263 3,191 3,644 4,314 Canada2,989 2,831 2,736 2,794 2,695 United Kingdom1,882 1,723 1,743 874 827 China (c)1,732 1,300 1,164 1,649 705 South Africa (d)1,282 405 432 1,484 137 All other countries14,754 14,805 14,369 13,423 12,587 Total$70,372 $67,161 $64,661 $62,233 $53,532 (a)Long-lived assets represent property, plant and equipment, indefinite-lived intangible assets, amortizable intangible assets and investments in noncontrolled affiliates. See Note 2 and Note 15 for further information on property, plant and equipment. See Note 2 and Note 4 for further information on goodwill and other intangible assets. Investments in noncontrolled affiliates are evaluated for impairment upon a significant change in the operating or macroeconomic environment. These assets are reported in the country where they are primarily used.(b)In 2020, the increase in long-lived assets was primarily related to our acquisition of Rockstar. See Note 14 for further information. (c)In 2020, the increase in net revenue and long-lived assets was primarily related to our acquisition of Be & Cheery. See Note 14 for further information. (d)In 2020, the increase in net revenue and long-lived assets was primarily related to our acquisition of Pioneer Foods. See Note 14 for further information. Note 2 — Our Significant Accounting PoliciesRevenue RecognitionWe recognize revenue when our performance obligation is satisfied. Our primary performance obligation (the distribution and sales of beverage products and food and snack products) is satisfied upon the shipment or delivery of products to our customers, which is also when control is transferred. Merchandising activities are performed after a customer obtains control of the product, are accounted for as fulfillment of our performance obligation to ship or deliver product to our customers and are recorded in selling, general and administrative expenses. Merchandising activities are immaterial in the context of our contracts. In addition, we exclude from net revenue all sales, use, value-added and certain excise taxes assessed by government authorities on revenue producing transactions.The transfer of control of products to our customers is typically based on written sales terms that do not allow for a right of return. However, our policy for DSD, including certain chilled products, is to remove 68Table of Contentsand replace damaged and out-of-date products from store shelves to ensure that consumers receive the product quality and freshness they expect. Similarly, our policy for certain warehouse-distributed products is to replace damaged and out-of-date products. As a result, we record reserves, based on estimates, for anticipated damaged and out-of-date products. We recorded $20 million of reserves for product returns in 2020 as a result of the COVID-19 pandemic. See Note 1 for further information.As a result of the implementation of the revenue recognition guidance adopted in the first quarter of 2018, which did not have a material impact on our accounting policies, we recorded an adjustment in the first quarter of 2018 of $137 million to beginning retained earnings to reflect marketplace spending that our customers and independent bottlers expected to be entitled to in line with revenue recognition.Our products are sold for cash or on credit terms. Our credit terms, which are established in accordance with local and industry practices, typically require payment within 30 days of delivery in the United States, and generally within 30 to 90 days internationally, and may allow discounts for early payment. There were no material changes in credit terms as a result of the COVID-19 pandemic.We estimate and reserve for our expected credit loss exposure based on our experience with past due accounts and collectibility, write-off history, the aging of accounts receivable, our analysis of customer data, and forward-looking information (including the expected impact of the global economic uncertainty related to the COVID-19 pandemic), leveraging estimates of creditworthiness and projections of default and recovery rates for certain of our customers (including foodservice and vending businesses). We recorded an allowance for expected credit losses of $56 million in 2020 as a result of the COVID-19 pandemic. See Note 1 for further information. Expected credit loss expense is classified within selling, general and administrative expenses on our income statement.We are exposed to concentration of credit risk from our major customers, including Walmart. In 2020, sales to Walmart and its affiliates (including Sam’s) represented approximately 14% of our consolidated net revenue, including concentrate sales to our independent bottlers, which were used in finished goods sold by them to Walmart. We have not experienced credit issues with these customers.Total Marketplace SpendingWe offer sales incentives and discounts through various programs to customers and consumers. Total marketplace spending includes sales incentives, discounts, advertising and other marketing activities. Sales incentives and discounts are primarily accounted for as a reduction of revenue and include payments to customers for performing activities on our behalf, such as payments for in-store displays, payments to gain distribution of new products, payments for shelf space and discounts to promote lower retail prices. Sales incentives and discounts also include support provided to our independent bottlers through funding of advertising and other marketing activities.A number of our sales incentives, such as bottler funding to independent bottlers and customer volume rebates, are based on annual targets, and accruals are established during the year, as products are delivered, for the expected payout, which may occur after year end once reconciled and settled. These accruals are based on contract terms and our historical experience with similar programs and require management judgment with respect to estimating customer and consumer participation and performance levels. Differences between estimated expense and actual incentive costs are normally insignificant and are recognized in earnings in the period such differences are determined. In addition, certain advertising and marketing costs are also based on annual targets and recognized during the year as incurred.The terms of most of our incentive arrangements do not exceed a year, and, therefore, do not require highly uncertain long-term estimates. Certain arrangements, such as fountain pouring rights, may extend beyond one year. Upfront payments to customers under these arrangements are recognized over the 69Table of Contentsshorter of the economic or contractual life, primarily as a reduction of revenue, and the remaining balances of $299 million as of December 26, 2020 and $272 million as of December 28, 2019 are included in prepaid expenses and other current assets and other assets on our balance sheet. We recorded reserves of $59 million for upfront payments to customers in 2020 as a result of the COVID-19 pandemic. See Note 1 for further information.For interim reporting, our policy is to allocate our forecasted full-year sales incentives for most of our programs to each of our interim reporting periods in the same year that benefits from the programs. The allocation methodology is based on our forecasted sales incentives for the full year and the proportion of each interim period’s actual gross revenue or volume, as applicable, to our forecasted annual gross revenue or volume, as applicable. Based on our review of the forecasts at each interim period, any changes in estimates and the related allocation of sales incentives are recognized beginning in the interim period that they are identified. In addition, we apply a similar allocation methodology for interim reporting purposes for certain advertising and other marketing activities. Our annual consolidated financial statements are not impacted by this interim allocation methodology.Advertising and other marketing activities, reported as selling, general and administrative expenses, totaled $4.6 billion in 2020, $4.7 billion in 2019 and $4.2 billion in 2018, including advertising expenses of $3.0 billion in both 2020 and 2019, and $2.6 billion in 2018. Deferred advertising costs are not expensed until the year first used and consist of:•media and personal service prepayments;•promotional materials in inventory; and•production costs of future media advertising.Deferred advertising costs of $48 million and $55 million as of December 26, 2020 and December 28, 2019, respectively, are classified as prepaid expenses and other current assets on our balance sheet.Distribution CostsDistribution costs, including the costs of shipping and handling activities, which include certain merchandising activities, are reported as selling, general and administrative expenses. Shipping and handling expenses were $11.9 billion in 2020, $10.9 billion in 2019 and $10.5 billion in 2018.Software CostsWe capitalize certain computer software and software development costs incurred in connection with developing or obtaining computer software for internal use when both the preliminary project stage is completed and it is probable that the software will be used as intended. Capitalized software costs include (1) external direct costs of materials and services utilized in developing or obtaining computer software, (2) compensation and related benefits for employees who are directly associated with the software projects and (3) interest costs incurred while developing internal-use computer software. Capitalized software costs are included in property, plant and equipment on our balance sheet and amortized on a straight-line basis when placed into service over the estimated useful lives of the software, which approximate five to 10 years. Software amortization totaled $152 million in 2020, $166 million in 2019 and $204 million in 2018. Net capitalized software and development costs were $664 million and $572 million as of December 26, 2020 and December 28, 2019, respectively.Commitments and ContingenciesWe are subject to various claims and contingencies related to lawsuits, certain taxes and environmental matters, as well as commitments under contractual and other commercial obligations. We recognize liabilities for contingencies and commitments when a loss is probable and estimable.70Table of ContentsResearch and DevelopmentWe engage in a variety of research and development activities and continue to invest to accelerate growth and to drive innovation globally. Consumer research is excluded from research and development costs and included in other marketing costs. Research and development costs were $719 million, $711 million and $680 million in 2020, 2019 and 2018, respectively, and are reported within selling, general and administrative expenses. Goodwill and Other Intangible AssetsIndefinite-lived intangible assets and goodwill are not amortized and, as a result, are assessed for impairment at least annually, using either a qualitative or quantitative approach. We perform this annual assessment during our third quarter, or more frequently if circumstances indicate that the carrying value may not be recoverable. Where we use the qualitative assessment, first we determine if, based on qualitative factors, it is more likely than not that an impairment exists. Factors considered include macroeconomic (including those related to the COVID-19 pandemic), industry and competitive conditions, legal and regulatory environment, historical financial performance and significant changes in the brand or reporting unit. If the qualitative assessment indicates that it is more likely than not that an impairment exists, then a quantitative assessment is performed.In the quantitative assessment for indefinite-lived intangible assets and goodwill, an assessment is performed to determine the fair value of the indefinite-lived intangible asset and the reporting unit, respectively. Estimated fair value is determined using discounted cash flows and requires an analysis of several estimates including future cash flows or income consistent with management’s strategic business plans, annual sales growth rates, perpetuity growth assumptions and the selection of assumptions underlying a discount rate (weighted-average cost of capital) based on market data available at the time. Significant management judgment is necessary to estimate the impact of competitive operating, macroeconomic and other factors (including those related to the COVID-19 pandemic) to estimate future levels of sales, operating profit or cash flows. All assumptions used in our impairment evaluations for indefinite-lived intangible assets and goodwill, such as forecasted growth rates (including perpetuity growth assumptions) and weighted-average cost of capital, are based on the best available market information and are consistent with our internal forecasts and operating plans. A deterioration in these assumptions could adversely impact our results. Amortizable intangible assets are only evaluated for impairment upon a significant change in the operating or macroeconomic environment. If an evaluation of the undiscounted future cash flows indicates impairment, the asset is written down to its estimated fair value, which is based on its discounted future cash flows. See Note 4 for further information. Other Significant Accounting PoliciesOur other significant accounting policies are disclosed as follows:•Basis of Presentation – Note 1 includes a description of our policies regarding use of estimates, basis of presentation and consolidation.•Income Taxes – Note 5.•Share-Based Compensation – Note 6.•Pension, Retiree Medical and Savings Plans – Note 7.•Financial Instruments – Note 9.•Cash Equivalents – Cash equivalents are highly liquid investments with original maturities of three months or less.71Table of Contents•Inventories – Note 15. Inventories are valued at the lower of cost or net realizable value. Cost is determined using the average; first-in, first-out (FIFO); or, in limited instances, last-in, first-out (LIFO) methods. •Property, Plant and Equipment – Note 15. Property, plant and equipment is recorded at historical cost. Depreciation is recognized on a straight-line basis over an asset’s estimated useful life. Land is not depreciated and construction in progress is not depreciated until ready for service. •Translation of Financial Statements of Foreign Subsidiaries – Financial statements of foreign subsidiaries are translated into U.S. dollars using period-end exchange rates for assets and liabilities and weighted-average exchange rates for revenues and expenses. Adjustments resulting from translating net assets are reported as a separate component of accumulated other comprehensive loss within common shareholders’ equity as currency translation adjustment.Recently Issued Accounting Pronouncements - Adopted In 2016, the Financial Accounting Standards Board (FASB) issued guidance that changes the impairment model used to measure credit losses for most financial assets. Under the new model we are required to estimate expected credit losses over the life of our trade receivables, certain other receivables and certain other financial instruments. The new model replaced the existing incurred credit loss model and generally results in earlier recognition of allowances for credit losses. We adopted this guidance in the first quarter of 2020 and the adoption did not have a material impact on our consolidated financial statements or disclosures. On initial recognition, we recorded an after-tax cumulative effect decrease to retained earnings of $34 million ($44 million pre-tax) as of the beginning of 2020.Recently Issued Accounting Pronouncements - Not Yet Adopted In 2019, the FASB issued guidance to simplify the accounting for income taxes. The guidance primarily addresses how to (1) recognize a deferred tax liability after we transition to or from the equity method of accounting, (2) evaluate if a step-up in the tax basis of goodwill is related to a business combination or is a separate transaction, (3) recognize all of the effects of a change in tax law in the period of enactment, including adjusting the estimated annual tax rate, and (4) include the amount of tax based on income in the income tax provision and any incremental amount as a tax not based on income for hybrid tax regimes. The guidance is effective in the first quarter of 2021 with early adoption permitted. We will adopt the guidance when it becomes effective in the first quarter of 2021. The guidance is not expected to have a material impact on our consolidated financial statements or related disclosures.Note 3 — Restructuring and Impairment ChargesA summary of our restructuring and impairment charges and other productivity initiatives is as follows:2020201920182019 Productivity Plan$289 $370 $138 2014 Productivity Plan— — 170 Total restructuring and impairment charges289 370 308 Other productivity initiatives— 3 8 Total restructuring and impairment charges and other productivity initiatives$289 $373 $316 72Table of Contents2019 Multi-Year Productivity PlanThe 2019 Productivity Plan, publicly announced on February 15, 2019, will leverage new technology and business models to further simplify, harmonize and automate processes; re-engineer our go-to-market and information systems, including deploying the right automation for each market; and simplify our organization and optimize our manufacturing and supply chain footprint. In connection with this plan, we expect to incur pre-tax charges of approximately $2.5 billion, including cash expenditures of approximately $1.6 billion. These pre-tax charges are expected to consist of approximately 65% of severance and other employee-related costs, 15% for asset impairments (all non-cash) resulting from plant closures and related actions and 20% for other costs associated with the implementation of our initiatives. We expect to complete this plan by 2023.The total expected plan pre-tax charges are expected to be incurred by division approximately as follows:FLNAQFNAPBNALatAmEuropeAMESAAPACCorporateExpected pre-tax charges15 %1 %30 %10 %25 %5 %3 %11 %A summary of our 2019 Productivity Plan charges is as follows:202020192018Cost of sales$30 $115 $3 Selling, general and administrative expenses 239 253 100 Other pension and retiree medical benefits expense20 2 35 Total restructuring and impairment charges$289 $370 $138 After-tax amount$231 $303 $109 Net income attributable to PepsiCo per common share$0.17 $0.21 $0.08 202020192018Plan to Datethrough 12/26/2020FLNA $83 $22 $31 $136 QFNA5 2 5 12 PBNA47 51 40 138 LatAm31 62 9 102 Europe48 99 6 153 AMESA14 38 3 55 APAC5 47 2 54 Corporate36 47 7 90 269 368 103 740 Other pension and retiree medical benefits expense20 2 35 57 Total$289 $370 $138 $797 Plan to Datethrough 12/26/2020Severance and other employee costs$444 Asset impairments125 Other costs228 Total$797 73Table of ContentsSeverance and other employee costs primarily include severance and other termination benefits, as well as voluntary separation arrangements. Other costs primarily include costs associated with the implementation of our initiatives, including contract termination costs, consulting and other professional fees.A summary of our 2019 Productivity Plan activity is as follows:Severance and Other Employee CostsAsset ImpairmentsOther CostsTotal2018 restructuring charges$137 $— $1 $138 Non-cash charges and translation(32)— — (32)Liability as of December 29, 2018105 — 1 106 2019 restructuring charges149 92 129 370 Cash payments (a)(138)— (119)(257)Non-cash charges and translation12 (92)10 (70)Liability as of December 28, 2019128 — 21 149 2020 restructuring charges158 33 98 289 Cash payments (a)(138)— (117)(255)Non-cash charges and translation(26)(33)3 (56)Liability as of December 26, 2020$122 $— $5 $127 (a)Excludes cash expenditures of $2 million and $4 million for 2020 and 2019, respectively, reported in the cash flow statement in pension and retiree medical contributions.Substantially all of the restructuring accrual at December 26, 2020 is expected to be paid by the end of 2021.2014 Multi-Year Productivity PlanThe 2014 Productivity Plan, publicly announced on February 13, 2014, included the next generation of productivity initiatives that we believed would strengthen our beverage, food and snack businesses by: accelerating our investment in manufacturing automation; further optimizing our global manufacturing footprint, including closing certain manufacturing facilities; re-engineering our go-to-market systems in developed markets; expanding shared services; and implementing simplified organization structures to drive efficiency. To build on the 2014 Productivity Plan, in the fourth quarter of 2017, we expanded and extended the plan through the end of 2019 to take advantage of additional opportunities within the initiatives described above that further strengthened our beverage, food and snack businesses. The 2014 Productivity Plan was completed in 2019. In 2019, there were no material pre-tax charges related to this plan and all cash payments were paid at year end. The total plan pre-tax charges and cash expenditures approximated the previously disclosed plan estimates of $1.3 billion and $960 million, respectively. These total plan pre-tax charges consisted of 59% of severance and other employee costs, 15% of asset impairments and 26% of other costs, including costs associated with the implementation of our initiatives, including certain consulting and other contract termination costs. These total plan pre-tax charges were incurred by division as follows: FLNA 14%, QFNA 3%, PBNA 29%, LatAm 15%, Europe 23%, AMESA 3%, APAC 3% and Corporate 10%. 74Table of ContentsA summary of our 2014 Productivity Plan charges is as follows:2018Selling, general and administrative expenses $169 Other pension and retiree medical benefits expense1 Total restructuring and impairment charges$170 After-tax amount$143 Net income attributable to PepsiCo per common share$0.10 2018FLNA $8 QFNA2 PBNA51 LatAm30 Europe53 AMESA 15 APAC12 Corporate (a)(1)Total$170 (a)Income amount primarily relates to other pension and retiree medical benefits.A summary of our 2014 Productivity Plan activity is as follows:Severance and Other Employee CostsAsset ImpairmentsOther CostsTotalLiability as of December 30, 2017$212 $— $14 $226 2018 restructuring charges86 28 56 170 Cash payments (a)(203)— (52)(255)Non-cash charges and translation(4)(28)5 (27)Liability as of December 29, 201891 — 23 114 Cash payments(77)— (16)(93)Non-cash charges and translation(14)— (7)(21)Liability as of December 28, 2019$— $— $— $— (a)Excludes cash expenditures of $11 million reported in the cash flow statement in pension and retiree medical plan contributions.Other Productivity InitiativesThere were no material charges related to other productivity and efficiency initiatives outside the scope of the 2019 and 2014 Productivity Plans.We regularly evaluate different productivity initiatives beyond the productivity plans and other initiatives described above. 75Table of ContentsNote 4 — Intangible AssetsA summary of our amortizable intangible assets is as follows: 202020192018AverageUseful Life (Years)GrossAccumulated Amortization Net GrossAccumulated Amortization Net Acquired franchise rights (a)56 – 60$976 $(173)$803 $846 $(158)$688 Customer relationships (b)10 – 24642 (204)438 457 (177)280 Brands20 – 401,348 (1,099)249 1,326 (1,066)260 Other identifiable intangibles10 – 24474 (261)213 459 (254)205 Total$3,440 $(1,737)$1,703 $3,088 $(1,655)$1,433 Amortization expense $90 $81 $69 (a)The change in 2020 primarily reflects our distribution agreement with Vital Pharmaceuticals, Inc., with an expected residual value higher than our carrying value. The distribution agreement’s useful life is three years, in accordance with the three-year termination notice issued, and is not reflected in the average useful life above.(b)The change in 2020 primarily reflects our acquisitions of Pioneer Foods and Be & Cheery. See Note 14 for further information. Amortization is recognized on a straight-line basis over an intangible asset’s estimated useful life. Amortization of intangible assets for each of the next five years, based on existing intangible assets as of December 26, 2020 and using average 2020 foreign exchange rates, is expected to be as follows:20212022202320242025Five-year projected amortization$92 $89 $87 $87 $84 Depreciable and amortizable assets are evaluated for impairment upon a significant change in the operating or macroeconomic environment. In these circumstances, if an evaluation of the undiscounted cash flows indicates impairment, the asset is written down to its estimated fair value, which is based on discounted future cash flows. Useful lives are periodically evaluated to determine whether events or circumstances have occurred which indicate the need for revision.Indefinite-Lived Intangible AssetsWe did not recognize any impairment charges for goodwill in each of the years ended December 26, 2020, December 28, 2019 and December 29, 2018. In 2020, we recognized a pre-tax impairment charge of $41 million related to a coconut water brand in PBNA. We did not recognize any material impairment charges for indefinite-lived intangible assets in each of the years ended December 28, 2019 and December 29, 2018. As of December 26, 2020, the estimated fair values of our indefinite-lived reacquired and acquired franchise rights recorded at PBNA exceeded their carrying values. However, there could be an impairment of the carrying value of PBNA’s reacquired and acquired franchise rights if future revenues and their contribution to the operating results of PBNA’s CSD business do not achieve our expected future cash flows or if macroeconomic conditions result in a future increase in the weighted-average cost of capital used to estimate fair value. We have also analyzed the impact of the macroeconomic conditions in Russia on the estimated fair value of our indefinite-lived intangible assets in Russia and have concluded that there are no impairments for the year ended December 26, 2020. However, there could be an impairment of the carrying value of certain brands in Russia, including juice and dairy brands, if there is a deterioration in these conditions, if future revenues and their contributions to the operating results do not achieve our expected future cash flows (including perpetuity growth assumptions), if there are significant changes in the decisions regarding assets that do not perform consistent with our expectations, or if macroeconomic conditions result in a future increase in the weighted-average cost of capital used to estimate fair value. For further information on our policies for indefinite-lived intangible assets, see Note 2.76Table of ContentsThe change in the book value of indefinite-lived intangible assets is as follows:Balance,Beginning2019AcquisitionsTranslationand OtherBalance,End of2019AcquisitionsTranslationand OtherBalance,End of2020FLNA (a)Goodwill$297 $(3)$5 $299 $164 $2 $465 Brands161 — 1 162 179 (1)340 Total458 (3)6 461 343 1 805 QFNA Goodwill184 6 (1)189 — — 189 Brands25 (14)— 11 — (11)— Total209 (8)(1)200 — (11)189 PBNA (b)Goodwill 9,813 66 19 9,898 2,280 11 12,189 Reacquired franchise rights7,058 — 31 7,089 — 18 7,107 Acquired franchise rights1,510 — 7 1,517 16 3 1,536 Brands353 418 (8)763 2,400 (41)3,122 Total18,734 484 49 19,267 4,696 (9)23,954 LatAmGoodwill509 — (8)501 — (43)458 Brands127 — (2)125 — (17)108 Total636 — (10)626 — (60)566 Europe (c) (d)Goodwill3,361 440 160 3,961 (2)(153)3,806 Reacquired franchise rights497 — 8 505 — (9)496 Acquired franchise rights161 — (4)157 — 15 172 Brands4,188 (139)132 4,181 — (109)4,072 Total8,207 301 296 8,804 (2)(256)8,546 AMESA (e)Goodwill437 11 (2)446 560 90 1,096 Brands— — — — 183 31 214 Total437 11 (2)446 743 121 1,310 APAC (f)Goodwill207 — — 207 306 41 554 Brands101 — (1)100 309 36 445 Total308 — (1)307 615 77 999 Total goodwill14,808 520 173 15,501 3,308 (52)18,757 Total reacquired franchise rights7,555 — 39 7,594 — 9 7,603 Total acquired franchise rights1,671 — 3 1,674 16 18 1,708 Total brands4,955 265 122 5,342 3,071 (112)8,301 Total$28,989 $785 $337 $30,111 $6,395 $(137)$36,369 (a)The change in acquisitions in 2020 primarily reflects our acquisition of BFY Brands.(b)The change in acquisitions in 2020 primarily reflects our acquisition of Rockstar. See Note 14 for further information. The change in acquisitions in 2019 primarily reflects our acquisition of CytoSport Inc.(c)The change in translation and other in 2020 primarily reflects the depreciation of the Russian ruble. The change in translation and other in 2019 primarily reflects the appreciation of the Russian ruble.(d)The change in acquisitions in 2019 primarily reflects our acquisition of SodaStream. See Note 14 for further information.(e)The change in acquisitions in 2020 primarily reflects our acquisition of Pioneer Foods. See Note 14 for further information.(f)The change in acquisitions in 2020 primarily reflects our acquisition of Be & Cheery. See Note 14 for further information. 77Table of ContentsNote 5 — Income TaxesThe components of income before income taxes are as follows:202020192018United States$4,070 $4,123 $3,864 Foreign4,999 5,189 5,325 $9,069 $9,312 $9,189 The provision for/(benefit from) income taxes consisted of the following:202020192018Current:U.S. Federal$715 $652 $437 Foreign932 807 378 State110 196 63 1,757 1,655 878 Deferred:U.S. Federal273 325 140 Foreign(167)(31)(4,379)State31 10 (9)137 304 (4,248)$1,894 $1,959 $(3,370)A reconciliation of the U.S. Federal statutory tax rate to our annual tax rate is as follows:202020192018U.S. Federal statutory tax rate21.0 %21.0 %21.0 %State income tax, net of U.S. Federal tax benefit1.2 1.6 0.5 Lower taxes on foreign results(0.8)(0.9)(2.2)One-time mandatory transition tax - TCJ Act— (0.1)0.1 Remeasurement of deferred taxes - TCJ Act— — (0.4)International reorganizations— — (47.3)Tax settlements— — (7.8)Other, net(0.5)(0.6)(0.6)Annual tax rate20.9 %21.0 %(36.7)%Tax Cuts and Jobs ActDuring the fourth quarter of 2017, the TCJ Act was enacted in the United States. Among its many provisions, the TCJ Act imposed a mandatory one-time transition tax on undistributed international earnings and reduced the U.S. corporate income tax rate from 35% to 21%, effective January 1, 2018. In 2017, the SEC issued guidance related to the TCJ Act which allowed recording of provisional tax expense using a measurement period, not to exceed one year, when information necessary to complete the accounting for the effects of the TCJ Act is not available. We elected to apply the measurement period provisions of this guidance to certain income tax effects of the TCJ Act when it became effective in the fourth quarter of 2017.As a result of the enactment of the TCJ Act, we recognized a provisional net tax expense of $2.5 billion ($1.70 per share) in the fourth quarter of 2017.78Table of ContentsThe provisional measurement period allowed by the SEC ended in the fourth quarter of 2018. As a result, in 2018, we recognized a net tax benefit of $28 million ($0.02 per share) related to the TCJ Act. While our accounting for the recorded impact of the TCJ Act was deemed to be complete, additional guidance issued by the IRS impacted our recorded amounts after December 29, 2018. In 2019, we recognized a net tax benefit totaling $8 million ($0.01 per share) related to the TCJ Act. There were no tax amounts recognized in 2020 related to the TCJ Act.As of December 26, 2020, our mandatory transition tax liability was $3.2 billion, which must be paid through 2026 under the provisions of the TCJ Act. We reduced our liability through cash payments and application of tax overpayments by $78 million in 2020, $663 million in 2019 and $150 million in 2018. We currently expect to pay approximately $309 million of this liability in 2021.The TCJ Act also created a requirement that certain income earned by foreign subsidiaries, known as global intangible low-tax income (GILTI), must be included in the gross income of their U.S. shareholder. The FASB allows an accounting policy election of either recognizing deferred taxes for temporary differences expected to reverse as GILTI in future years or recognizing such taxes as a current-period expense when incurred. During the first quarter of 2018, we elected to treat the tax effect of GILTI as a current-period expense when incurred.Coronavirus Aid, Relief, and Economic Security ActThe CARES Act was enacted on March 27, 2020 in the United States. The CARES Act and related notices include several significant provisions, such as delaying certain payroll tax payments, mandatory transition tax payments under the TCJ Act and estimated income tax payments. The CARES Act did not have a material impact on our financial results in 2020, including on our annual estimated effective tax rate or on our liquidity. We will continue to monitor and assess the impact similar legislation in other countries may have on our business and financial results.Other Tax MattersOn May 19, 2019, a public referendum held in Switzerland passed the TRAF, effective January 1, 2020. The enactment of certain provisions of the TRAF resulted in adjustments to our deferred taxes. During 2020, we recorded a net tax benefit of $72 million related to the adoption of the TRAF in the Swiss Canton of Bern. During 2019, we recorded net tax expense of $24 million related to the impact of the TRAF. While the accounting for the impacts of the TRAF are deemed to be complete, further adjustments to our financial statements and related disclosures could be made in future quarters, including in connection with final tax return filings.In 2018, we reorganized certain of our international operations, including the intercompany transfer of certain intangible assets. As a result, we recognized other net tax benefits of $4.3 billion ($3.05 per share) in 2018. The related deferred tax asset of $4.4 billion is being amortized over a period of 15 years beginning in 2019. Additionally, the reorganization generated significant net operating loss carryforwards and related deferred tax assets that are not expected to be realized, resulting in the recording of a full valuation allowance.79Table of ContentsDeferred tax liabilities and assets are comprised of the following:20202019Deferred tax liabilitiesDebt guarantee of wholly-owned subsidiary$578 $578 Property, plant and equipment1,851 1,583 Recapture of net operating losses504 335 Right-of-use assets371 345 Other159 167 Gross deferred tax liabilities3,463 3,008 Deferred tax assetsNet carryforwards5,008 4,168 Intangible assets other than nondeductible goodwill1,146 793 Share-based compensation90 94 Retiree medical benefits153 154 Other employee-related benefits373 350 Pension benefits80 104 Deductible state tax and interest benefits150 126 Lease liabilities371 345 Other866 741 Gross deferred tax assets8,237 6,875 Valuation allowances(4,686)(3,599)Deferred tax assets, net3,551 3,276 Net deferred tax assets$(88)$(268)A summary of our valuation allowance activity is as follows: 202020192018Balance, beginning of year$3,599 $3,753 $1,163 Provision1,082 (124)2,639 Other additions/(deductions)5 (30)(49)Balance, end of year$4,686 $3,599 $3,753 ReservesA number of years may elapse before a particular matter, for which we have established a reserve, is audited and finally resolved. The number of years with open tax audits varies depending on the tax jurisdiction. Our major taxing jurisdictions and the related open tax audits are as follows:JurisdictionYears Open to AuditYears Currently Under AuditUnited States2014-20192014-2016Mexico2014-20192014-2016United Kingdom2017-2019NoneCanada (Domestic)2016-20192016-2017Canada (International)2010-20192010-2017Russia2017-2019None80Table of ContentsIn 2018, we recognized a non-cash tax benefit of $364 million ($0.26 per share) resulting from the conclusion of certain international tax audits. Additionally, in 2018, we recognized non-cash tax benefits of $353 million ($0.24 per share) as a result of our agreement with the IRS resolving all open matters related to the audits of taxable years 2012 and 2013, including the associated state impact. The conclusion of certain international tax audits and the resolution with the IRS, collectively, resulted in non-cash tax benefits totaling $717 million ($0.50 per share) in 2018.Our annual tax rate is based on our income, statutory tax rates and tax planning strategies and transactions, including transfer pricing arrangements, available to us in the various jurisdictions in which we operate. Significant judgment is required in determining our annual tax rate and in evaluating our tax positions. We establish reserves when, despite our belief that our tax return positions are fully supportable, we believe that certain positions are subject to challenge and that we likely will not succeed. We adjust these reserves, as well as the related interest, in light of changing facts and circumstances, such as the progress of a tax audit, new tax laws, relevant court cases or tax authority settlements. Settlement of any particular issue would usually require the use of cash. Favorable resolution would be recognized as a reduction to our annual tax rate in the year of resolution.As of December 26, 2020, the total gross amount of reserves for income taxes, reported in other liabilities, was $1.6 billion. We accrue interest related to reserves for income taxes in our provision for income taxes and any associated penalties are recorded in selling, general and administrative expenses. The gross amount of interest accrued, reported in other liabilities, was $338 million as of December 26, 2020, of which $93 million of tax expense was recognized in 2020. The gross amount of interest accrued, reported in other liabilities, was $250 million as of December 28, 2019, of which $84 million of tax expense was recognized in 2019.A reconciliation of unrecognized tax benefits is as follows:20202019Balance, beginning of year$1,395 $1,440 Additions for tax positions related to the current year128 179 Additions for tax positions from prior years153 93 Reductions for tax positions from prior years(22)(201)Settlement payments(13)(74)Statutes of limitations expiration(23)(47)Translation and other3 5 Balance, end of year$1,621 $1,395 Carryforwards and AllowancesOperating loss carryforwards totaling $28.3 billion as of December 26, 2020 are being carried forward in a number of foreign and state jurisdictions where we are permitted to use tax operating losses from prior periods to reduce future taxable income. These operating losses will expire as follows: $0.2 billion in 2021, $25.2 billion between 2022 and 2040 and $2.9 billion may be carried forward indefinitely. We establish valuation allowances for our deferred tax assets if, based on the available evidence, it is more likely than not that some portion or all of the deferred tax assets will not be realized.Undistributed International Earnings In 2018, we repatriated $20.4 billion of cash, cash equivalents and short-term investments held in our foreign subsidiaries without such funds being subject to further U.S. federal income tax liability, related to the TCJ Act. As of December 26, 2020, we had approximately $6 billion of undistributed international earnings. We intend to continue to reinvest $6 billion of earnings outside the United States for the 81Table of Contentsforeseeable future and while future distribution of these earnings would not be subject to U.S. federal tax expense, no deferred tax liabilities with respect to items such as certain foreign exchange gains or losses, foreign withholding taxes or state taxes have been recognized. It is not practicable for us to determine the amount of unrecognized tax expense on these reinvested international earnings.Note 6 — Share-Based CompensationOur share-based compensation program is designed to attract and retain employees while also aligning employees’ interests with the interests of our shareholders. PepsiCo has granted stock options, RSUs, PSUs, PEPunits and long-term cash awards to employees under the shareholder-approved PepsiCo, Inc. Long-Term Incentive Plan (LTIP). Executives who are awarded long-term incentives based on their performance may generally elect to receive their grant in the form of stock options or RSUs, or a combination thereof. Executives who elect stock options receive four stock options for every one RSU that would have otherwise been granted. Certain executive officers and other senior executives do not have a choice and are granted 66% PSUs and 34% long-term cash, each of which are subject to pre-established performance targets. The Company may use authorized and unissued shares to meet share requirements resulting from the exercise of stock options and the vesting of RSUs, PSUs and PEPunits. As of December 26, 2020, 52 million shares were available for future share-based compensation grants under the LTIP.The following table summarizes our total share-based compensation expense, which is primarily recorded in selling, general and administrative expenses, and excess tax benefits recognized:202020192018Share-based compensation expense - equity awards$264 $237 $256 Share-based compensation expense - liability awards11 8 20 Restructuring charges(1)(2)(6)Total$274 $243 $270 Income tax benefits recognized in earnings related to share-based compensation$48 $39 $45 Excess tax benefits related to share-based compensation$35 $50 $48 As of December 26, 2020, there was $300 million of total unrecognized compensation cost related to nonvested share-based compensation grants. This unrecognized compensation cost is expected to be recognized over a weighted-average period of two years.Method of Accounting and Our AssumptionsThe fair value of share-based award grants is amortized to expense over the vesting period, primarily three years. Awards to employees eligible for retirement prior to the award becoming fully vested are amortized to expense over the period through the date that the employee first becomes eligible to retire and is no longer required to provide service to earn the award. In addition, we use historical data to estimate forfeiture rates and record share-based compensation expense only for those awards that are expected to vest. We do not backdate, reprice or grant share-based compensation awards retroactively. Repricing of awards would require shareholder approval under the LTIP. 82Table of ContentsStock OptionsA stock option permits the holder to purchase shares of PepsiCo common stock at a specified price. We account for our employee stock options under the fair value method of accounting using a Black-Scholes valuation model to measure stock option expense at the date of grant. All stock option grants have an exercise price equal to the fair market value of our common stock on the date of grant and generally have a 10-year term. Our weighted-average Black-Scholes fair value assumptions are as follows:202020192018Expected life6 years5 years5 yearsRisk-free interest rate0.9 %2.4 %2.6 %Expected volatility14 %14 %12 %Expected dividend yield3.4 %3.1 %2.7 %The expected life is the period over which our employee groups are expected to hold their options. It is based on our historical experience with similar grants. The risk-free interest rate is based on the expected U.S. Treasury rate over the expected life. Volatility reflects movements in our stock price over the most recent historical period equivalent to the expected life. Dividend yield is estimated over the expected life based on our stated dividend policy and forecasts of net income, share repurchases and stock price. A summary of our stock option activity for the year ended December 26, 2020 is as follows:Options(a)Weighted-Average ExercisePriceWeighted-Average ContractualLife Remaining(years)Aggregate IntrinsicValue(a)Outstanding at December 28, 201911,625 $89.03 Granted1,847 $131.79 Exercised(2,440)$73.37 Forfeited/expired(392)$102.69 Outstanding at December 26, 202010,640 $99.54 5.26$484,362 Exercisable at December 26, 20206,545 $85.84 3.31$387,625 Expected to vest as of December 26, 20203,719 $120.67 8.31$90,725 (a)In thousands.Restricted Stock Units and Performance Stock UnitsEach RSU represents our obligation to deliver to the holder one share of PepsiCo common stock when the award vests at the end of the service period. PSUs are awards pursuant to which a number of shares are delivered to the holder upon vesting at the end of the service period based on PepsiCo’s performance against specified financial performance metrics. The number of shares may be increased to the maximum or reduced to the minimum threshold based on the results of these performance metrics in accordance with the terms established at the time of the award. During the vesting period, RSUs and PSUs accrue dividend equivalents that pay out in cash (without interest) if and when the applicable RSU or PSU vests and becomes payable.The fair value of RSUs and PSUs are measured at the market price of the Company’s stock on the date of grant. 83Table of ContentsA summary of our RSU and PSU activity for the year ended December 26, 2020 is as follows:RSUs/PSUs(a)Weighted-AverageGrant-Date Fair ValueWeighted-Average Contractual LifeRemaining (years)AggregateIntrinsicValue(a)Outstanding at December 28, 20196,380 $111.53 Granted (b)2,496 $131.21 Converted (c)(2,315)$109.61 Forfeited(434)$117.51 Outstanding at December 26, 2020 (d)6,127 $119.92 1.27$888,832 Expected to vest as of December 26, 20205,447 $119.72 1.26$790,179 (a)In thousands.(b)Grant activity for all PSUs are disclosed at target.(c)Represents the number of PSUs that vested during the year, net of awards above and below target levels based on the achievement of its performance conditions.(d)The outstanding PSUs for which the vesting period has not ended as of December 26, 2020, at the threshold, target and maximum award levels were zero, 1 million and 2 million, respectively.PEPunitsPEPunits provide an opportunity to earn shares of PepsiCo common stock with a value that adjusts based upon changes in PepsiCo’s absolute stock price as well as PepsiCo’s Total Shareholder Return relative to the S&P 500 over a three-year performance period. The fair value of PEPunits is measured using the Monte-Carlo simulation model, which incorporates into the fair-value determination the possibility that the market condition may not be satisfied until actual performance is determined. PEPunits were last granted in 2015 and all outstanding PEPunits were converted to 278,000 shares in 2018.Long-Term CashCertain executive officers and other senior executives were granted long-term cash awards for which final payout is based on PepsiCo’s Total Shareholder Return relative to a specific set of peer companies and achievement of a specified performance target over a three-year performance period. Long-term cash awards that qualify as liability awards under share-based compensation guidance are valued through the end of the performance period on a mark-to-market basis using the Monte Carlo simulation model. 84Table of ContentsA summary of our long-term cash activity for the year ended December 26, 2020 is as follows:Long-Term Cash Award(a)Balance Sheet Date Fair Value(a)Contractual Life Remaining(years)Outstanding at December 28, 2019$44,224 Granted (b)18,975 Vested (c)(15,686)Forfeited— Outstanding at December 26, 2020 (d)$47,513 $45,669 1.23Expected to vest as of December 26, 2020$42,658 $41,318 1.14(a)In thousands.(b)Grant activity for all long-term cash awards are disclosed at target.(c)Represents the amount of long-term cash awards that vested during the year, net of awards above and below target levels based on the achievement of its market conditions.(d)The outstanding long-term cash awards for which the vesting period has not ended as of December 26, 2020, at the threshold, target and maximum award levels were zero, 48 million and 95 million, respectively.Other Share-Based Compensation DataThe following is a summary of other share-based compensation data:202020192018Stock OptionsTotal number of options granted (a)1,847 1,286 1,429 Weighted-average grant-date fair value of options granted$8.31 $10.89 $9.80 Total intrinsic value of options exercised (a)$155,096 $275,745 $224,663 Total grant-date fair value of options vested (a)$8,652 $9,838 $15,506 RSUs/PSUsTotal number of RSUs/PSUs granted (a)2,496 2,754 2,634 Weighted-average grant-date fair value of RSUs/PSUs granted$131.21 $116.87 $108.75 Total intrinsic value of RSUs/PSUs converted (a)$303,165 $333,951 $260,287 Total grant-date fair value of RSUs/PSUs vested (a)$235,523 $275,234 $232,141 PEPunitsTotal intrinsic value of PEPunits converted (a)$— $— $30,147 Total grant-date fair value of PEPunits vested (a)$— $— $9,430 (a)In thousands.As of December 26, 2020 and December 28, 2019, there were approximately 287,000 and 269,000 outstanding awards, respectively, consisting primarily of phantom stock units that were granted under the PepsiCo Director Deferral Program and will be settled in shares of PepsiCo common stock pursuant to the LTIP at the end of the applicable deferral period, not included in the tables above.85Table of ContentsNote 7 — Pension, Retiree Medical and Savings PlansIn 2020, lump sum distributions exceeded the total of annual service and interest cost and triggered a pre-tax settlement charge in Plan A of $205 million ($158 million after-tax or $0.11 per share).In 2020, we adopted an amendment to the U.S. defined benefit pension plans to freeze benefit accruals for salaried participants, effective December 31, 2025. Since 2011, salaried new hires are not eligible to participate in the defined benefit plan. After the effective date, all salaried participants will receive an employer contribution to the 401(k) savings plan based on age and years of service regardless of employee contribution and will have the opportunity to receive employer contributions to match employee contributions up to defined limits. As a result of this amendment, pension benefits pre-tax expense is expected to decrease by approximately $70 million in 2021, primarily impacting corporate unallocated expenses.In 2020, we approved an amendment to reorganize the U.S. qualified defined benefit pension plans that resulted in the transfer of certain participants from Plan A to Plan I and to a newly created plan, Plan H, effective January 1, 2021. The benefits offered to the plans’ participants were unchanged. The reorganization will facilitate a more targeted investment strategy and provide additional flexibility in evaluating opportunities to reduce risk and volatility. No material impact to pension benefit pre-tax expense is expected from this reorganization. In 2020, we adopted an amendment, effective January 1, 2021, to enhance the pay credit benefits of certain participants in Plan H. As a result of this amendment, pension benefits pre-tax expense is expected to increase approximately $45 million in 2021, primarily impacting service cost expense. In 2019, Plan A purchased a group annuity contract whereby a third-party insurance company assumed the obligation to pay and administer future annuity payments for certain retirees. This transaction triggered a pre-tax settlement charge in 2019 of $220 million ($170 million after-tax or $0.12 per share). Also in 2019, certain former employees who had vested benefits in our U.S. defined benefit pension plans were offered the option of receiving a one-time lump sum payment equal to the present value of the participant’s pension benefit. This transaction triggered a pre-tax settlement charge in 2019 of $53 million ($41 million after-tax or $0.03 per share). Collectively, the group annuity contract and one-time lump sum payments to certain former employees who had vested benefits resulted in settlement charges in 2019 of $273 million ($211 million after-tax or $0.15 per share).Gains and losses resulting from actual experience differing from our assumptions, including the difference between the actual return on plan assets and the expected return on plan assets, as well as changes in our assumptions, are determined at each measurement date. These differences are recognized as a component of net gain or loss in accumulated other comprehensive loss. If this net accumulated gain or loss exceeds 10% of the greater of the market-related value of plan assets or plan obligations, a portion of the net gain or loss is included in other pension and retiree medical benefits (expense)/income for the following year based upon the average remaining service life for participants in Plan A (approximately 10 years) and retiree medical (approximately 8 years), or the remaining life expectancy for participants in Plan I (approximately 23 years). In 2021, we expect the average remaining service life for participants in Plan A to be approximately 9 years, the remaining life expectancy for participants in Plan I to be approximately 27 years and the average remaining service life for participants in Plan H to be approximately 11 years.The cost or benefit of plan changes that increase or decrease benefits for prior employee service (prior service cost/(credit)) is included in other pension and retiree medical benefits (expense)/income on a straight-line basis over the average remaining service life for participants in both Plan A and Plan H, except that prior service cost/(credit) for salaried participants subject to the freeze will be amortized on a 86Table of Contentsstraight-line basis over the period up to the effective date of the freeze, or the remaining life expectancy for participants in Plan I.Selected financial information for our pension and retiree medical plans is as follows: PensionRetiree Medical U.S.International 202020192020201920202019Change in projected benefit obligationObligation at beginning of year$15,230 $13,807 $3,753 $3,098 $988 $996 Service cost434 381 86 73 25 23 Interest cost435 543 85 97 25 36 Plan amendments(221)15 (17)1 (25)— Participant contributions— — 2 2 — — Experience loss2,042 2,091 467 515 81 36 Benefit payments(378)(341)(92)(100)(89)(105)Settlement/curtailment (808)(1,268)(24)(31)— — Special termination benefits19 2 — — — — Other, including foreign currency adjustment— — 170 98 1 2 Obligation at end of year$16,753 $15,230 $4,430 $3,753 $1,006 $988 Change in fair value of plan assetsFair value at beginning of year$14,302 $12,258 $3,732 $3,090 $302 $285 Actual return on plan assets1,908 3,101 401 551 47 78 Employer contributions/funding387 550 120 122 55 44 Participant contributions— — 2 2 — — Benefit payments(378)(341)(92)(100)(89)(105)Settlement(754)(1,266)(29)(31)— — Other, including foreign currency adjustment— — 169 98 — — Fair value at end of year$15,465 $14,302 $4,303 $3,732 $315 $302 Funded status$(1,288)$(928)$(127)$(21)$(691)$(686) Amounts recognizedOther assets$797 $744 $110 $99 $— $— Other current liabilities(53)(52)(1)(1)(51)(58)Other liabilities(2,032)(1,620)(236)(119)(640)(628)Net amount recognized$(1,288)$(928)$(127)$(21)$(691)$(686)Amounts included in accumulated other comprehensive loss (pre-tax)Net loss/(gain)$4,116 $3,516 $1,149 $914 $(212)$(285)Prior service (credit)/cost(119)114 (19)— (45)(32)Total$3,997 $3,630 $1,130 $914 $(257)$(317)Changes recognized in net loss/(gain) included in other comprehensive lossNet loss/(gain) arising in current year$1,009 $(120)$268 $152 $50 $(24)Amortization and settlement recognition(409)(457)(75)(44)23 27 Foreign currency translation loss/(gain)— — 42 26 — (1)Total$600 $(577)$235 $134 $73 $2 Accumulated benefit obligation at end of year$15,949 $14,255 $4,108 $3,441 The net loss/(gain) arising in the current year is primarily attributable to the decrease in discount rate, offset by actual asset returns exceeding expected returns.87Table of ContentsThe amount we report in operating profit as pension and retiree medical cost is service cost, which is the value of benefits earned by employees for working during the year.The amounts we report below operating profit as pension and retiree medical cost consist of the following components:•Interest cost is the accrued interest on the projected benefit obligation due to the passage of time. •Expected return on plan assets is the long-term return we expect to earn on plan investments for our funded plans that will be used to settle future benefit obligations.•Amortization of prior service cost/(credit) represents the recognition in the income statement of benefit changes resulting from plan amendments. •Amortization of net loss/(gain) represents the recognition in the income statement of changes in the amount of plan assets and the projected benefit obligation based on changes in assumptions and actual experience. •Settlement/curtailment loss/(gain) represents the result of actions that effectively eliminate all or a portion of related projected benefit obligations. Settlements are triggered when payouts to settle the projected benefit obligation of a plan due to lump sums or other events exceed the annual service and interest cost. Settlements are recognized when actions are irrevocable and we are relieved of the primary responsibility and risk for projected benefit obligations. Lump sum payouts are generally higher when interest rates are lower. Curtailments are due to events such as plant closures or the sale of a business resulting in a reduction of future service or benefits. Curtailment losses are recognized when an event is probable and estimable, while curtailment gains are recognized when an event has occurred (when the related employees terminate or an amendment is adopted).•Special termination benefits are the additional benefits offered to employees upon departure due to actions such as restructuring.The components of total pension and retiree medical benefit costs are as follows: PensionRetiree Medical U.S.International 202020192018202020192018202020192018Service cost$434 $381 $431 $86 $73 $92 $25 $23 $32 Other pension and retiree medical benefits (income)/expense:Interest cost$435 $543 $482 $85 $97 $93 $25 $36 $34 Expected return on plan assets(929)(892)(943)(202)(188)(197)(16)(18)(19)Amortization of prior service cost/(credits)12 10 3 — — — (12)(19)(20)Amortization of net losses/(gains)196 161 179 61 32 45 (23)(27)(8)Settlement/curtailment losses (a)213 296 8 19 12 6 — — — Special termination benefits19 1 36 — — 2 — — 1 Total other pension and retiree medical benefits (income)/expense$(54)$119 $(235)$(37)$(47)$(51)$(26)$(28)$(12)Total$380 $500 $196 $49 $26 $41 $(1)$(5)$20 (a)In 2020, U.S. includes a settlement charge of $205 million ($158 million after-tax or $0.11 per share) related to lump sum distributions exceeding the total of annual service and interest cost. In 2019, U.S. includes settlement charges related to the purchase of a group annuity contract of $220 million ($170 million after-tax or $0.12 per share) and a pension lump sum settlement charge of $53 million ($41 million after-tax or $0.03 per share). 88Table of ContentsThe following table provides the weighted-average assumptions used to determine net periodic benefit cost and projected benefit obligation for our pension and retiree medical plans: PensionRetiree Medical U.S.International 202020192018202020192018202020192018Net Periodic Benefit CostService cost discount rate 3.4 %4.4 %3.8 %3.2 %4.2 %3.5 %3.2 %4.3 %3.6 %Interest cost discount rate 2.9 %4.1 %3.4 %2.4 %3.2 %2.8 %2.6 %3.8 %3.0 %Expected return on plan assets6.8 %7.1 %7.2 %5.6 %5.8 %6.0 %5.8 %6.6 %6.5 %Rate of salary increases3.1 %3.1 %3.1 %3.3 %3.7 %3.7 %Projected Benefit ObligationDiscount rate2.5 %3.3 %4.4 %2.0 %2.5 %3.4 %2.3 %3.1 %4.2 %Rate of salary increases3.0 %3.1 %3.1 %3.3 %3.3 %3.7 %The following table provides selected information about plans with accumulated benefit obligation and total projected benefit obligation in excess of plan assets: PensionRetiree Medical U.S.International 202020192020201920202019Selected information for plans with accumulated benefit obligation in excess of plan assets(a) Obligation for service to date$(5,537)$(9,194)$(172)$(192)Fair value of plan assets$4,156 $8,497 $123 $151 Selected information for plans with projected benefit obligation in excess of plan assetsBenefit obligation$(9,172)$(10,169)$(2,933)$(632)$(1,006)$(988)Fair value of plan assets$7,088 $8,497 $2,696 $512 $315 $302 (a) The decrease in U.S. pension plans in 2020 primarily reflects the approved reorganization of the U.S. qualified defined benefit plans, resulting in the transfer of obligations and plan assets relating to certain participants from Plan A to Plan I and Plan H.Of the total projected pension benefit obligation as of December 26, 2020, approximately $854 million relates to plans that we do not fund because the funding of such plans does not receive favorable tax treatment.Future Benefit Payments Our estimated future benefit payments are as follows:202120222023202420252026 - 2030Pension$925 $1,080 $915 $960 $990 $5,270 Retiree medical (a)$95 $95 $90 $85 $80 $370 (a)Expected future benefit payments for our retiree medical plans do not reflect any estimated subsidies expected to be received under the 2003 Medicare Act. Subsidies are expected to be approximately $1 million for each of the years from 2021 through 2025 and approximately $4 million in total for 2026 through 2030.These future benefit payments to beneficiaries include payments from both funded and unfunded plans.89Table of ContentsFundingContributions to our pension and retiree medical plans were as follows:PensionRetiree Medical202020192018202020192018Discretionary (a)$339 $417 $1,417 $— $— $37 Non-discretionary168 255 198 55 44 56 Total$507 $672 $1,615 $55 $44 $93 (a)Includes $325 million contribution in 2020, $400 million contribution in 2019 and $1.4 billion contribution in 2018 to fund Plan A in the United States.In November 2020, we received approval from our Board of Directors to make discretionary contributions of $500 million to our U.S. qualified defined benefit plans. We contributed $300 million of the approved amount in January 2021; we expect to contribute the remaining $200 million in the third quarter of 2021. In addition, in 2021, we expect to make non-discretionary contributions of approximately $160 million to our U.S. and international pension benefit plans and approximately $50 million for retiree medical benefits.We continue to monitor the impact of the COVID-19 pandemic and related global economic conditions and uncertainty on the net unfunded status of our pension and retiree medical plans. We regularly evaluate opportunities to reduce risk and volatility associated with our pension and retiree medical plans.Plan Assets Our pension plan investment strategy includes the use of actively managed accounts and is reviewed periodically in conjunction with plan obligations, an evaluation of market conditions, tolerance for risk and cash requirements for benefit payments. This strategy is also applicable to funds held for the retiree medical plans. Our investment objective includes ensuring that funds are available to meet the plans’ benefit obligations when they become due. Assets contributed to our pension plans are no longer controlled by us, but become the property of our individual pension plans. However, we are indirectly impacted by changes in these plan assets as compared to changes in our projected obligations. Our overall investment policy is to prudently invest plan assets in a well-diversified portfolio of equity and high-quality debt securities and real estate to achieve our long-term return expectations. Our investment policy also permits the use of derivative instruments, such as futures and forward contracts, to reduce interest rate and foreign currency risks. Futures contracts represent commitments to purchase or sell securities at a future date and at a specified price. Forward contracts consist of currency forwards.For 2021 and 2020, our expected long-term rate of return on U.S. plan assets is 6.4% and 6.8%, respectively. Our target investment allocations for U.S. plan assets are as follows:20212020Fixed income51 %50 %U.S. equity24 %25 %International equity21 %21 %Real estate4 %4 %Actual investment allocations may vary from our target investment allocations due to prevailing market conditions. We regularly review our actual investment allocations and periodically rebalance our investments.The expected return on plan assets is based on our investment strategy and our expectations for long-term rates of return by asset class, taking into account volatility and correlation among asset classes and our historical experience. We also review current levels of interest rates and inflation to assess the 90Table of Contentsreasonableness of the long-term rates. We evaluate our expected return assumptions annually to ensure that they are reasonable. To calculate the expected return on plan assets, our market-related value of assets for fixed income is the actual fair value. For all other asset categories, such as equity securities, we use a method that recognizes investment gains or losses (the difference between the expected and actual return based on the market-related value of assets) over a five-year period. This has the effect of reducing year-to-year volatility.Plan assets measured at fair value as of year-end 2020 and 2019 are categorized consistently by Level 1 (quoted prices in active markets for identical assets), Level 2 (significant other observable inputs) and Level 3 (significant unobservable inputs) in both years and are as follows: Fair Value Hierarchy Level20202019U.S. plan assets (a)Equity securities, including preferred stock (b)1$7,179 $6,605 Government securities (c)22,177 2,154 Corporate bonds (c)25,437 4,737 Mortgage-backed securities (c)2119 159 Contracts with insurance companies (d)39 9 Cash and cash equivalents (e)1, 2278 275 Sub-total U.S. plan assets15,199 13,939 Real estate commingled funds measured at net asset value (f)517 605 Dividends and interest receivable, net of payables64 60 Total U.S. plan assets$15,780 $14,604 International plan assetsEquity securities (b)1, 2 $2,119 $1,973 Government securities (c)2937 725 Corporate bonds (c)2445 331 Fixed income commingled funds (g)1509 437 Contracts with insurance companies (d)350 42 Cash and cash equivalents133 24 Sub-total international plan assets4,093 3,532 Real estate commingled funds measured at net asset value (f)202 193 Dividends and interest receivable8 7 Total international plan assets$4,303 $3,732 (a)Includes $315 million and $302 million in 2020 and 2019, respectively, of retiree medical plan assets that are restricted for purposes of providing health benefits for U.S. retirees and their beneficiaries.(b)Invested in U.S. and international common stock and commingled funds, and the preferred stock portfolio was invested in domestic and international corporate preferred stock investments. The common stock is based on quoted prices in active markets. The commingled funds are based on the published price of the fund and include one large-cap fund that represents 13% and 16% of total U.S. plan assets for 2020 and 2019, respectively. The preferred stock investments are based on quoted bid prices for comparable securities in the marketplace and broker/dealer quotes in active markets. The international portfolio includes Level 1 assets of $2,119 million and $1,941 million for 2020 and 2019, respectively, and Level 2 assets of $32 million for 2019.(c)These investments are based on quoted bid prices for comparable securities in the marketplace and broker/dealer quotes in active markets. Corporate bonds of U.S.-based companies represent 30% and 28% of total U.S. plan assets for 2020 and 2019, respectively. (d)Based on the fair value of the contracts as determined by the insurance companies using inputs that are not observable. The changes in Level 3 amounts were not significant in the years ended December 26, 2020 and December 28, 2019.(e)Cash and cash equivalents in the U.S. includes Level 1 assets of $178 million and $159 million for 2020 and 2019, respectively, and Level 2 assets of $100 million and $116 million for 2020 and 2019, respectively.(f)The real estate commingled funds include investments in limited partnerships. These funds are based on the net asset value of the appraised value of investments owned by these funds as determined by independent third parties using inputs that are not observable. The majority of the funds are redeemable quarterly subject to availability of cash and have notice periods ranging from 45 to 90 days.(g)Based on the published price of the fund.91Table of ContentsRetiree Medical Cost Trend Rates20212020Average increase assumed6 %6 %Ultimate projected increase 5 %5 %Year of ultimate projected increase 20402039These assumed health care cost trend rates have an impact on the retiree medical plan expense and obligation, however the cap on our share of retiree medical costs limits the impact. Savings PlanCertain U.S. employees are eligible to participate in a 401(k) savings plan, which is a voluntary defined contribution plan. The plan is designed to help employees accumulate savings for retirement and we make Company matching contributions for certain employees on a portion of employee contributions based on years of service.Certain U.S. salaried employees, who are not eligible to participate in a defined benefit pension plan, are also eligible to receive an employer contribution based on age and years of service regardless of employee contribution.In 2020, 2019 and 2018, our total Company contributions were $225 million, $197 million and $180 million, respectively.Note 8 — Debt ObligationsThe following table summarizes our debt obligations:2020(a)2019(a)Short-term debt obligations (b)Current maturities of long-term debt$3,358 $2,848 Commercial paper (0.2%)396 — Other borrowings (1.7% and 6.4%)26 72 $3,780 $2,920 Long-term debt obligations (b)Notes due 2020 (2.7%)— 2,840 Notes due 2021 (2.2% and 2.4%)3,356 3,276 Notes due 2022 (2.5% and 2.7%)3,867 3,831 Notes due 2023 (1.5% and 2.8%)3,017 1,272 Notes due 2024 (2.1% and 3.4%)3,067 1,839 Notes due 2025 (2.7% and 3.1%)3,227 1,691 Notes due 2026-2060 (2.9% and 3.4%)27,165 17,219 Other, due 2020-2026 (1.3% and 1.3%)29 28 43,728 31,996 Less: current maturities of long-term debt obligations(3,358)(2,848)Total$40,370 $29,148 (a)Amounts are shown net of unamortized net discounts of $260 million and $163 million for 2020 and 2019, respectively.(b)The interest rates presented reflect weighted-average effective interest rates at year-end. Certain of our fixed rate indebtedness have been swapped to floating rates through the use of interest rate derivative instruments. See Note 9 for further information regarding our interest rate derivative instruments. 92Table of ContentsAs of December 26, 2020 and December 28, 2019, our international debt of $29 million and $69 million, respectively, was related to borrowings from external parties, including various lines of credit. These lines of credit are subject to normal banking terms and conditions and are fully committed at least to the extent of our borrowings.In 2020, we issued the following senior notes:Interest RateMaturity DateAmount(a)2.250 %March 2025$1,500 2.625 %March 2027$500 2.750 %March 2030$1,500 3.500 %March 2040$750 3.625 %March 2050$1,500 3.875 %March 2060$750 0.750 %May 2023$1,000 1.625 %May 2030$1,000 0.250 %May 2024€1,000 0.500 %May 2028€1,000 0.400 %October 2023$750 1.400 %February 2031$750 0.400 %October 2032€750 1.050 %October 2050€750 (a)Represents gross proceeds from issuances of long-term debt excluding debt issuance costs, discounts and premiums.The net proceeds from the issuances of the above notes will be used for general corporate purposes, including the repayment of commercial paper.In 2020, we entered into a new 364-day unsecured revolving credit agreement (364-Day Credit Agreement) which expires on May 31, 2021. The 364-Day Credit Agreement enables us and our borrowing subsidiaries to borrow up to $3.75 billion in U.S. dollars and/or euros, subject to customary terms and conditions. We may request that commitments under this agreement be increased up to $4.5 billion in U.S dollars and/or euros. We may request renewal of this facility for an additional 364-day period or convert any amounts outstanding into a term loan for a period of up to one year, which term loan would mature no later than the anniversary of the then effective termination date. The 364-Day Credit Agreement replaced our $3.75 billion 364-day credit agreement, dated as of June 3, 2019. The 364-Day Credit Agreement is in addition to the five-year unsecured revolving credit agreement (Five-Year Credit Agreement) we entered into in 2019, and which expires on June 3, 2024. The Five-Year Credit Agreement enables us and our borrowing subsidiaries to borrow up to $3.75 billion in U.S. dollars and/or euros, including a $0.75 billion swing line subfacility for euro-denominated borrowings permitted to be borrowed on a same-day basis, subject to customary terms and conditions. We may request that commitments under this agreement be increased up to $4.5 billion in U.S. dollars and/or euros. Additionally, we may, once a year, request renewal of the agreement for an additional one-year period. Funds borrowed under the 364-Day Credit Agreement and Five-Year Credit Agreement may be used for general corporate purposes. Subject to certain conditions, we may borrow, prepay and reborrow amounts under these agreements. As of December 26, 2020, there were no outstanding borrowings under the 364-Day Credit Agreement or the Five-Year Credit Agreement.In 2020, one of our international consolidated subsidiaries borrowed 21.7 billion South African rand, or approximately $1.3 billion, from our two unsecured bridge loan facilities (Bridge Loan Facilities) to fund 93Table of Contentsour acquisition of Pioneer Foods. These borrowings were fully repaid in April 2020 and no further borrowings under these Bridge Loan Facilities are permitted.In 2020, we paid $1.1 billion to redeem all $1.1 billion outstanding principal amount of our 2.15% senior notes due 2020 and terminated associated interest rate swaps with a notional amount of $0.8 billion.In 2019, we paid $1.0 billion to redeem all $1.0 billion outstanding principal amount of our 4.50% senior notes due 2020.In 2018, we completed a cash tender offer to redeem $1.3 billion of certain notes issued by PepsiCo and predecessors to a PepsiCo subsidiary for $1.6 billion in cash. Also in 2018, we completed an exchange offer for certain notes issued by predecessors to a PepsiCo subsidiary for newly issued PepsiCo notes. These notes were issued in an aggregate principal amount of $732 million, equal to the exchanged notes. As a result of the above transactions, we recorded a pre-tax charge of $253 million ($191 million after-tax or $0.13 per share) to interest expense in 2018, primarily representing the tender price paid over the carrying value of the tendered notes.Note 9 — Financial InstrumentsDerivatives and HedgingWe are exposed to market risks arising from adverse changes in:•commodity prices, affecting the cost of our raw materials and energy;•foreign exchange rates and currency restrictions; and•interest rates.In the normal course of business, we manage commodity price, foreign exchange and interest rate risks through a variety of strategies, including productivity initiatives, global purchasing programs and hedging. Ongoing productivity initiatives involve the identification and effective implementation of meaningful cost-saving opportunities or efficiencies, including the use of derivatives. We do not use derivative instruments for trading or speculative purposes. Our global purchasing programs include fixed-price contracts and purchase orders and pricing agreements. Our hedging strategies include the use of derivatives and, in the case of our net investment hedges, debt instruments. Certain derivatives are designated as either cash flow or fair value hedges and qualify for hedge accounting treatment, while others do not qualify and are marked to market through earnings. The accounting for qualifying hedges allows changes in a hedging instrument’s fair value to offset corresponding changes in the hedged item in the same reporting period that the hedged item impacts earnings. Gains or losses on derivatives designated as cash flow hedges are recorded in accumulated other comprehensive loss and reclassified to our income statement when the hedged transaction affects earnings. If it becomes probable that the hedged transaction will not occur, we immediately recognize the related hedging gains or losses in earnings; such gains or losses reclassified during the year ended December 26, 2020 were not material. Cash flows from derivatives used to manage commodity price, foreign exchange or interest rate risks are classified as operating activities in the cash flow statement. We classify both the earnings and cash flow impact from these derivatives consistent with the underlying hedged item.Credit RiskWe perform assessments of our counterparty credit risk regularly, including reviewing netting agreements, if any, and a review of credit ratings, credit default swap rates and potential nonperformance of the counterparty. Based on our most recent assessment of our counterparty credit risk, we consider this risk to 94Table of Contentsbe low. In addition, we enter into derivative contracts with a variety of financial institutions that we believe are creditworthy in order to reduce our concentration of credit risk.Certain of our agreements with our counterparties require us to post full collateral on derivative instruments in a net liability position if our credit rating is at A2 (Moody’s Investors Service, Inc.) or A (S&P Global Ratings) and we have been placed on credit watch for possible downgrade or if our credit rating falls below these levels. The fair value of all derivative instruments with credit-risk-related contingent features that were in a net liability position as of December 26, 2020 was $283 million. We have posted no collateral under these contracts and no credit-risk-related contingent features were triggered as of December 26, 2020.Commodity PricesWe are subject to commodity price risk because our ability to recover increased costs through higher pricing may be limited in the competitive environment in which we operate. This risk is managed through the use of fixed-price contracts and purchase orders, pricing agreements and derivative instruments, which primarily include swaps and futures. In addition, risk to our supply of certain raw materials is mitigated through purchases from multiple geographies and suppliers. We use derivatives, with terms of no more than three years, to hedge price fluctuations related to a portion of our anticipated commodity purchases, primarily for agricultural products, energy and metals. Derivatives used to hedge commodity price risk that do not qualify for hedge accounting treatment are marked to market each period with the resulting gains and losses recorded in corporate unallocated expenses as either cost of sales or selling, general and administrative expenses, depending on the underlying commodity. These gains and losses are subsequently reflected in division results when the divisions recognize the cost of the underlying commodity in operating profit.Our commodity derivatives had a total notional value of $1.1 billion as of December 26, 2020 and December 28, 2019. Foreign ExchangeWe are exposed to foreign exchange risks in the international markets in which our products are made, manufactured, distributed or sold. Additionally, we are exposed to foreign exchange risk from net investments in foreign subsidiaries, foreign currency purchases and foreign currency assets and liabilities created in the normal course of business. We manage this risk through sourcing purchases from local suppliers, negotiating contracts in local currencies with foreign suppliers and through the use of derivatives, primarily forward contracts with terms of no more than two years. Exchange rate gains or losses related to foreign currency transactions are recognized as transaction gains or losses on our income statement as incurred. We also use net investment hedges to partially offset the effects of foreign currency on our investments in certain of our foreign subsidiaries.Our foreign currency derivatives had a total notional value of $1.9 billion as of December 26, 2020 and December 28, 2019. The total notional amount of our debt instruments designated as net investment hedges was $2.7 billion as of December 26, 2020 and $2.5 billion as of December 28, 2019. For foreign currency derivatives that do not qualify for hedge accounting treatment, gains and losses were offset by changes in the underlying hedged items, resulting in no material net impact on earnings.Interest RatesWe centrally manage our debt and investment portfolios considering investment opportunities and risks, tax consequences and overall financing strategies. We use various interest rate derivative instruments including, but not limited to, interest rate swaps, cross-currency interest rate swaps, Treasury locks and 95Table of Contentsswap locks to manage our overall interest expense and foreign exchange risk. These instruments effectively change the interest rate and currency of specific debt issuances. Certain of our fixed rate indebtedness have been swapped to floating rates. The notional amount, interest payment and maturity date of the interest rate and cross-currency interest rate swaps match the principal, interest payment and maturity date of the related debt. Our cross-currency interest rate swaps have terms of no more than twelve years. Our Treasury locks and swap locks are entered into to protect against unfavorable interest rate changes relating to forecasted debt transactions.Our interest rate derivatives had a total notional value of $3.0 billion as of December 26, 2020 and $5.0 billion as of December 28, 2019. As of December 26, 2020, approximately 3% of total debt, after the impact of the related interest rate derivative instruments, was subject to variable rates, compared to approximately 9% as of December 28, 2019.Held-to-Maturity Debt SecuritiesInvestments in debt securities that we have the positive intent and ability to hold until maturity are classified as held-to-maturity. Highly liquid debt securities with original maturities of three months or less are recorded as cash equivalents. Our held-to-maturity debt securities consist of U.S. Treasury securities and commercial paper. As of December 26, 2020, we had $2.1 billion of investments in U.S. Treasury securities with $2.0 billion recorded in cash and cash equivalents and $0.1 billion in short-term investments. We had no investments in U.S. Treasury securities as of December 28, 2019. As of December 26, 2020, we had $260 million of investments in commercial paper with $75 million recorded in cash and cash equivalents and $185 million in short-term investments. As of December 28, 2019, we had $130 million of investments in commercial paper recorded in cash and cash equivalents. Held-to-maturity debt securities are recorded at amortized cost, which approximates fair value, and realized gains or losses are reported in earnings. Our investments mature in less than one year. As of December 26, 2020 and December 28, 2019, gross unrecognized gains and losses and the allowance for expected credit losses were not material. 96Table of ContentsFair Value MeasurementsThe fair values of our financial assets and liabilities as of December 26, 2020 and December 28, 2019 are categorized as follows: 20202019 Fair Value Hierarchy Levels(a)Assets(a)Liabilities(a)Assets(a)Liabilities(a)Index funds (b)1$231 $— $229 $— Prepaid forward contracts (c)2$18 $— $17 $— Deferred compensation (d)2$— $477 $— $468 Contingent consideration (e)3$— $861 $— $— Derivatives designated as fair value hedging instruments:Interest rate (f)2$2 $— $— $5 Derivatives designated as cash flow hedging instruments:Foreign exchange (g)2$9 $71 $5 $32 Interest rate (g)213 307 — 390 Commodity (h)1— — 2 5 Commodity (i)232 — 2 5 $54 $378 $9 $432 Derivatives not designated as hedging instruments:Foreign exchange (g)2$4 $8 $3 $2 Commodity (h)1— — 23 7 Commodity (i)219 7 6 24 $23 $15 $32 $33 Total derivatives at fair value (j)$79 $393 $41 $470 Total$328 $1,731 $287 $938 (a)Fair value hierarchy levels are defined in Note 7. Unless otherwise noted, financial assets are classified on our balance sheet within prepaid expenses and other current assets and other assets. Financial liabilities are classified on our balance sheet within accounts payable and other current liabilities and other liabilities.(b)Based on the price of index funds. These investments are classified as short-term investments and are used to manage a portion of market risk arising from our deferred compensation liability. (c)Based primarily on the price of our common stock. (d)Based on the fair value of investments corresponding to employees’ investment elections.(e)In connection with our acquisition of Rockstar, we recorded a liability for tax-related contingent consideration payable over up to 15 years, with an option to accelerate all remaining payments, with estimated maximum payments of approximately $1.1 billion, using current tax rates. The fair value of the liability is estimated using probability-weighted, discounted future cash flows at current tax rates. The significant unobservable inputs (Level 3) used to estimate the fair value include the expected future tax benefits associated with the acquisition, the probability that the option to accelerate all remaining payments will be exercised and discount rates. The expected annual future tax benefits range from approximately $40 million to $110 million, with an average of $70 million. The probability, in any given year, that the option to accelerate will be exercised ranges from 3 to 25 percent, with a weighted-average payment period of approximately 4 years. The discount rates range from less than 1 percent to 5 percent, with a weighted average of 3 percent. The contingent consideration measured at fair value using unobservable inputs as of December 26, 2020 is $861 million, comprised of an $882 million liability recognized at the acquisition date of Rockstar and a fair value decrease of $21 million in the year ended December 26, 2020, recorded in selling, general and administrative expenses.(f)Based on London Interbank Offered Rate forward rates. As of December 26, 2020 and December 28, 2019, the carrying amount of hedged fixed-rate debt was $0.2 billion and $2.2 billion, respectively, and classified on our balance sheet within short-term and long-term debt obligations. As of December 26, 2020 and December 28, 2019, the cumulative amount of fair value hedging adjustments to hedged fixed-rate debt was a $2 million gain and $5 million loss, respectively. As of December 26, 2020, the cumulative amount of fair value hedging adjustments on discontinued hedges was a $19 million loss, which is being amortized over the remaining life of the related debt obligations.97Table of Contents(g)Based on recently reported market transactions of spot and forward rates.(h)Based on quoted contract prices on futures exchange markets.(i)Based on recently reported market transactions of swap arrangements.(j)Derivative assets and liabilities are presented on a gross basis on our balance sheet. Amounts subject to enforceable master netting arrangements or similar agreements which are not offset on the balance sheet as of December 26, 2020 and December 28, 2019 were not material. Collateral received or posted against our asset or liability positions was not material. Exchange-traded commodity futures are cash-settled on a daily basis and, therefore, not included in the table as of December 26, 2020.The carrying amounts of our cash and cash equivalents and short-term investments approximate fair value due to their short-term maturity. Our cash equivalents and short-term investments are classified as Level 2 in the fair value hierarchy. The fair value of our debt obligations as of December 26, 2020 and December 28, 2019 was $50 billion and $34 billion, respectively, based upon prices of similar instruments in the marketplace, which are considered Level 2 inputs.Losses/(gains) on our hedging instruments are categorized as follows: Fair Value/Non-designated HedgesCash Flow and Net Investment Hedges Losses/(Gains)Recognized inIncome Statement(a)Losses/(Gains)Recognized inAccumulated OtherComprehensive LossLosses/(Gains)Reclassified fromAccumulated OtherComprehensive Lossinto IncomeStatement(b)202020192020201920202019Foreign exchange $— $(1)$(9)$57 $(43)$3 Interest rate (6)(64)(96)67 (129)7 Commodity 53 (17)(21)7 56 4 Net investment— — 235 (30)— — Total$47 $(82)$109 $101 $(116)$14 (a)Foreign exchange derivative losses/gains are primarily included in selling, general and administrative expenses. Interest rate derivative losses/gains are primarily from fair value hedges and are included in net interest expense and other. These losses/gains are substantially offset by decreases/increases in the value of the underlying debt, which are also included in net interest expense and other. Commodity derivative losses/gains are included in either cost of sales or selling, general and administrative expenses, depending on the underlying commodity.(b)Foreign exchange derivative losses/gains are included in cost of sales. Interest rate derivative losses/gains are included in net interest expense and other. Commodity derivative losses/gains are included in either cost of sales or selling, general and administrative expenses, depending on the underlying commodity. Based on current market conditions, we expect to reclassify net losses of $7 million related to our cash flow hedges from accumulated other comprehensive loss into net income during the next 12 months.98Table of ContentsNote 10 — Net Income Attributable to PepsiCo per Common ShareThe computations of basic and diluted net income attributable to PepsiCo per common share are as follows: 202020192018 IncomeShares(a)IncomeShares(a)IncomeShares(a)Net income attributable to PepsiCo$7,120 $7,314 $12,515 Preferred stock:Redemption premium (b)— — (2)Net income available for PepsiCo common shareholders$7,120 1,385 $7,314 1,399 $12,513 1,415 Basic net income attributable to PepsiCo per common share$5.14 $5.23 $8.84 Net income available for PepsiCo common shareholders$7,120 1,385 $7,314 1,399 $12,513 1,415 Dilutive securities:Stock options, RSUs, PSUs and other (c)— 7 — 8 — 10 Employee stock ownership plan (ESOP) convertible preferred stock— — — — 2 — Diluted$7,120 1,392 $7,314 1,407 $12,515 1,425 Diluted net income attributable to PepsiCo per common share$5.12 $5.20 $8.78 (a)Weighted-average common shares outstanding (in millions).(b)See Note 11 for further information.(c)The dilutive effect of these securities is calculated using the treasury stock method.The weighted-average amount of antidilutive securities excluded from the calculation of diluted earnings per common share was immaterial for the years ended December 26, 2020, December 28, 2019 and December 29, 2018. Note 11 — Preferred StockIn connection with our merger with The Quaker Oats Company (Quaker) in 2001, shares of our convertible preferred stock were authorized and issued to an ESOP fund established by Quaker. Quaker made the final award to its ESOP in June 2001.In 2018, all of the outstanding shares of our convertible preferred stock were converted into an aggregate of 550,102 shares of our common stock. As a result, there are no shares of our convertible preferred stock outstanding as of December 29, 2018 and our convertible preferred stock is retired for accounting purposes.Activities of our preferred stock are included in the equity statement.99Table of ContentsNote 12 — Accumulated Other Comprehensive Loss Attributable to PepsiCoThe changes in the balances of each component of accumulated other comprehensive loss attributable to PepsiCo are as follows:Currency Translation AdjustmentCash Flow HedgesPension and Retiree MedicalOtherAccumulated Other Comprehensive Loss Attributable to PepsiCoBalance as of December 30, 2017 (a)$(10,277)$47 $(2,804)$(23)$(13,057)Other comprehensive (loss)/income before reclassifications (b)(1,664)(61)(813)6 (2,532)Amounts reclassified from accumulated other comprehensive loss44 111 218 — 373 Net other comprehensive (loss)/income(1,620)50 (595)6 (2,159)Tax amounts(21)(10)128 — 97 Balance as of December 29, 2018 (a)(11,918)87 (3,271)(17)(15,119)Other comprehensive (loss)/income before reclassifications (c)636 (131)(89)(2)414 Amounts reclassified from accumulated other comprehensive loss— 14 468 — 482 Net other comprehensive (loss)/income636 (117)379 (2)896 Tax amounts(8)27 (96)— (77)Balance as of December 28, 2019 (a)(11,290)(3)(2,988)(19)(14,300)Other comprehensive (loss)/income before reclassifications (d)(710)126 (1,141)(1)(1,726)Amounts reclassified from accumulated other comprehensive loss— (116)465 — 349 Net other comprehensive (loss)/income(710)10 (676)(1)(1,377)Tax amounts60 (3)144 — 201 Balance as of December 26, 2020 (a)$(11,940)$4 $(3,520)$(20)$(15,476)(a)Pension and retiree medical amounts are net of taxes of $1,338 million as of December 30, 2017, $1,466 million as of December 29, 2018, $1,370 million as of December 28, 2019 and $1,514 million as of December 26, 2020.(b)Currency translation adjustment primarily reflects the depreciation of the Russian ruble, Canadian dollar, Pound sterling and Brazilian real. (c)Currency translation adjustment primarily reflects the appreciation of the Russian ruble, Canadian dollar, Mexican peso and Pound sterling.(d)Currency translation adjustment primarily reflects the depreciation of the Russian ruble and Mexican peso.100Table of ContentsThe following table summarizes the reclassifications from accumulated other comprehensive loss to the income statement:Amount Reclassified from Accumulated Other Comprehensive LossAffected Line Item in the Income Statement202020192018Currency translation:Divestitures$— $— $44 Selling, general and administrative expensesCash flow hedges:Foreign exchange contracts$— $1 $(1)Net revenueForeign exchange contracts(43)2 (7)Cost of salesInterest rate derivatives(129)7 119 Net interest expense and otherCommodity contracts50 3 3 Cost of salesCommodity contracts6 1 (3)Selling, general and administrative expensesNet (gains)/losses before tax(116)14 111 Tax amounts29 (2)(27)Net (gains)/losses after tax$(87)$12 $84 Pension and retiree medical items:Amortization of net prior service credit$— $(9)$(17)Other pension and retiree medical benefits income/(expense)Amortization of net losses238 169 216 Other pension and retiree medical benefits income/(expense)Settlement/curtailment losses227 308 19 Other pension and retiree medical benefits income/(expense)Net losses before tax465 468 218 Tax amounts(101)(102)(45)Net losses after tax$364 $366 $173 Total net losses reclassified for the year, net of tax$277 $378 $301 Note 13 — LeasesLesseeWe determine whether an arrangement is a lease at inception. We have operating leases for plants, warehouses, distribution centers, storage facilities, offices and other facilities, as well as machinery and equipment, including fleet. Our leases generally have remaining lease terms of up to 20 years, some of which include options to extend the lease term for up to five years, and some of which include options to terminate the lease within one year. We consider these options in determining the lease term used to establish our right-of-use assets and lease liabilities. Our lease agreements do not contain any material residual value guarantees or material restrictive covenants.As most of our leases do not provide an implicit rate, we use our incremental borrowing rate based on the information available at commencement date in determining the present value of lease payments.We have lease agreements that contain both lease and non-lease components. For real estate leases, we account for lease components together with non-lease components (e.g., common-area maintenance).101Table of ContentsComponents of lease cost are as follows:20202019Operating lease cost (a)$539 $474 Variable lease cost (b)$111 $101 Short-term lease cost (c)$436 $379 (a)Includes right-of-use asset amortization of $478 million and $412 million in 2020 and 2019, respectively. (b)Primarily related to adjustments for inflation, common-area maintenance and property tax. (c)Not recorded on our balance sheet.Rent expense for the year ended December 29, 2018 was $771 million.In 2020 and 2019, we recognized gains of $7 million and $77 million, respectively, on sale-leaseback transactions with terms under four years.Supplemental cash flow information and non-cash activity related to our operating leases are as follows:20202019Operating cash flow information:Cash paid for amounts included in the measurement of lease liabilities$555 $478 Non-cash activity:Right-of-use assets obtained in exchange for lease obligations$621 $479 Supplemental balance sheet information related to our operating leases is as follows:Balance Sheet Classification20202019Right-of-use assetsOther assets$1,670 $1,548 Current lease liabilitiesAccounts payable and other current liabilities$460 $442 Non-current lease liabilitiesOther liabilities$1,233 $1,118 Weighted-average remaining lease term and discount rate for our operating leases are as follows:20202019Weighted-average remaining lease term6 years6 yearsWeighted-average discount rate4 %4 %Maturities of lease liabilities by year for our operating leases are as follows:2021$486 2022385 2023278 2024194 2025139 2026 and beyond413 Total lease payments1,895 Less: Imputed interest(202)Present value of lease liabilities$1,693 LessorWe have various arrangements for certain foodservice and vending equipment under which we are the lessor. These leases meet the criteria for operating lease classification. Lease income associated with these leases is not material.102Table of ContentsNote 14 — Acquisitions and DivestituresAcquisition of Pioneer Food Group Ltd.On March 23, 2020, we acquired all of the outstanding shares of Pioneer Foods, a food and beverage company in South Africa with exports to countries across the globe, for 110.00 South African rand per share in cash. The total consideration transferred was approximately $1.2 billion and was funded by the Bridge Loan Facilities entered into by one of our international consolidated subsidiaries. See Note 8 for further information.We accounted for the transaction as a business combination. We recognized and measured the identifiable assets acquired and liabilities assumed at their estimated fair values on the date of acquisition, in our AMESA segment. The assets acquired and liabilities assumed in Pioneer Foods as of the acquisition date, which primarily include goodwill and other intangible assets of $0.8 billion and property, plant and equipment of $0.4 billion, are based on preliminary estimates that are subject to revisions and may result in adjustments to preliminary values as valuations are finalized. We expect to finalize these amounts as soon as possible, but no later than the second quarter of 2021. In connection with our acquisition of Pioneer Foods, we have made certain commitments to the South Africa Competition Commission, including a commitment to provide the equivalent of 7.7 billion South African rand, or approximately $0.4 billion as of the acquisition date, in value for the benefit of our employees, agricultural development, education, developing Pioneer Foods’ operations and enterprise development programs in South Africa. Included in this commitment is 2.2 billion South African rand, or approximately $0.1 billion, relating to the implementation of an employee ownership plan and an agricultural, entrepreneurship and educational development fund, which is an irrevocable condition of the acquisition and will primarily be settled within the twelve-month period from the acquisition date. This was recorded in selling, general and administrative expenses in 2020. The remaining commitment of 5.5 billion South African rand, or approximately $0.3 billion as of the acquisition date, relates to capital expenditures and/or business-related costs which will be incurred and recorded over a five-year period from the acquisition date.Acquisition of Rockstar Energy BeveragesOn April 24, 2020, we acquired Rockstar, an energy drink maker with whom we had a distribution agreement prior to the acquisition, for an upfront cash payment of approximately $3.85 billion and contingent consideration related to estimated future tax benefits associated with the acquisition of approximately $0.9 billion. See Note 9 for further information about the contingent consideration.We accounted for the transaction as a business combination. We recognized and measured the identifiable assets acquired and liabilities assumed at their estimated fair values on the date of acquisition, primarily in our PBNA segment. The assets acquired and liabilities assumed in Rockstar as of the acquisition date, which primarily include goodwill and other intangible assets of $4.7 billion, are based on preliminary estimates that are subject to revisions and may result in adjustments to preliminary values as valuations are finalized. We expect to finalize these amounts as soon as possible, but no later than the second quarter of 2021.Acquisition of Hangzhou Haomusi Food Co., Ltd.On June 1, 2020, we acquired all of the outstanding shares of Be & Cheery, one of the largest online snacks companies in China, from Haoxiangni Health Food Co., Ltd. for cash. The total consideration transferred was approximately $0.7 billion. We accounted for the transaction as a business combination. We recognized and measured the identifiable assets acquired and liabilities assumed at their estimated fair values on the date of acquisition, in our 103Table of ContentsAPAC segment. The assets acquired and liabilities assumed in Be & Cheery as of the acquisition date, which primarily include goodwill and other intangible assets of $0.7 billion, are based on preliminary estimates that are subject to revisions and may result in adjustments to preliminary values as valuations are finalized. We expect to finalize these amounts as soon as possible, but no later than the third quarter of 2021.Acquisition of SodaStream International Ltd.On December 5, 2018, we acquired all of the outstanding shares of SodaStream, a manufacturer and distributor of sparkling water makers, for $144.00 per share in cash, in a transaction valued at approximately $3.3 billion. The total consideration transferred was $3.3 billion (or $3.2 billion, net of cash and cash equivalents acquired). The purchase price allocation was finalized in the fourth quarter of 2019. Refranchising in ThailandIn 2018, we refranchised our beverage business in Thailand by selling a controlling interest in our Thailand bottling operations to form a joint venture, where we now have an equity method investment. We recorded a pre-tax gain of $144 million ($126 million after-tax or $0.09 per share) in selling, general and administrative expenses in our APAC segment as a result of this transaction.Refranchising in Czech Republic, Hungary and SlovakiaIn 2018, we refranchised our entire beverage bottling operations and snack distribution operations in Czech Republic, Hungary and Slovakia. We recorded a pre-tax gain of $58 million ($46 million after-tax or $0.03 per share) in selling, general and administrative expenses in our Europe segment as a result of this transaction.Inventory Fair Value Adjustments and Merger and Integration Charges A summary of our inventory fair value adjustments and merger and integration charges is as follows:202020192018Cost of sales$32 $34 $— Selling, general and administrative expenses223 21 75 Total$255 $55 $75 After-tax amount$237 $47 $75 Net income attributable to PepsiCo per common share$0.17 $0.03 $0.05 Inventory fair value adjustments and merger and integration charges include fair value adjustments to the acquired inventory included in the acquisition-date balance sheets (recorded in cost of sales) and closing costs, employee-related costs, contract termination costs, changes in the fair value of contingent consideration and other integration costs (recorded in selling, general and administrative expenses). Merger and integration charges also include liabilities to support socioeconomic programs in South Africa, which are irrevocable conditions of our acquisition of Pioneer Foods (recorded in selling, general and administrative expenses). 104Table of ContentsInventory fair value adjustments and merger and integration charges by division are as follows:202020192018AcquisitionFLNA$29 $— $— BFY BrandsPBNA66 — — RockstarEurope— 46 57 SodaStreamAMESA173 7 — Pioneer FoodsAPAC7 — — Be & CheeryCorporate (a)(20)2 18 Rockstar, SodaStreamTotal$255 $55 $75 (a)In 2020, the income amount primarily relates to the change in the fair value of contingent consideration associated with our acquisition of Rockstar.Note 15 — Supplemental Financial InformationBalance Sheet202020192018Accounts and notes receivableTrade receivables$6,892 $6,447 Other receivables1,713 1,480 Total8,605 7,927 Allowance, beginning of year105 101 $129 Cumulative effect of accounting change44 — — Net amounts charged to expense (a)79 22 16 Deductions (b)(32)(30)(33)Other (c)5 12 (11)Allowance, end of year201 105 $101 Net receivables$8,404 $7,822 Inventories (d)Raw materials and packaging $1,720 $1,395 Work-in-process205 200 Finished goods2,247 1,743 Total$4,172 $3,338 Property, plant and equipment, net (e)AverageUseful Life (Years)Land $1,171 $1,130 Buildings and improvements15 - 4410,214 9,314 Machinery and equipment, including fleet and software5 - 1531,276 29,390 Construction in progress3,679 3,169 46,340 43,003 Accumulated depreciation(24,971)(23,698)Total$21,369 $19,305 Depreciation expense$2,335 $2,257 $2,241 Other assetsNoncurrent notes and accounts receivable$109 $85 Deferred marketplace spending130 147 Pension plans (f)910 846 Right-of-use assets (g)1,670 1,548 Other493 385 Total$3,312 $3,011 105Table of ContentsAccounts payable and other current liabilitiesAccounts payable$8,853 $8,013 Accrued marketplace spending2,935 2,765 Accrued compensation and benefits2,059 1,835 Dividends payable1,430 1,351 Current lease liabilities (g)460 442 Other current liabilities 3,855 3,135 Total$19,592 $17,541 (a)In 2020, includes an allowance for expected credit losses of $56 million related to the COVID-19 pandemic. See Note 1 for further information.(b)Includes accounts written off. (c)Includes adjustments related primarily to currency translation and other adjustments.(d)Approximately 6% and 7% of the inventory cost in 2020 and 2019, respectively, were computed using the LIFO method. The differences between LIFO and FIFO methods of valuing these inventories were not material. See Note 2 for further information.(e)See Note 2 for further information.(f)See Note 7 for further information.(g)See Note 13 for further information.Statement of Cash Flows202020192018Interest paid (a)$1,156 $1,076 $1,388 Income taxes paid, net of refunds (b)$1,770 $2,226 $1,203 (a)In 2018, excludes the premiums paid in accordance with the debt transactions. See Note 8 for further information.(b)In 2020, 2019 and 2018, includes tax payments of $78 million, $423 million and $115 million, respectively, related to the TCJ Act.The following table provides a reconciliation of cash and cash equivalents and restricted cash as reported within the balance sheet to the same items as reported in the cash flow statement.20202019Cash and cash equivalents$8,185 $5,509 Restricted cash included in other assets (a)69 61 Total cash and cash equivalents and restricted cash$8,254 $5,570 (a)Primarily relates to collateral posted against certain of our derivative positions.106Table of ContentsReport of Independent Registered Public Accounting FirmTo the Shareholders and Board of DirectorsPepsiCo, Inc.:Opinions on the Consolidated Financial Statements and Internal Control over Financial ReportingWe have audited the accompanying Consolidated Balance Sheet of PepsiCo, Inc. and Subsidiaries (the Company) as of December 26, 2020 and December 28, 2019, and the related Consolidated Statements of Income, Comprehensive Income, Cash Flows, and Equity for each of the fiscal years in the three-year period ended December 26, 2020 and the related notes (collectively, the consolidated financial statements). We also have audited the Company’s internal control over financial reporting as of December 26, 2020, based on criteria established in Internal Control – Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission.In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of the Company as of December 26, 2020 and December 28, 2019, and the results of its operations and its cash flows for each of the fiscal years in the three-year period ended December 26, 2020, in conformity with U.S. generally accepted accounting principles. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 26, 2020, based on criteria established in Internal Control – Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission.As permitted by SEC guidance, the scope of management's assessment of the effectiveness of internal control over financial reporting as of December 26, 2020 excluded Pioneer Food Group Ltd. and its subsidiaries (Pioneer Foods) and Hangzhou Haomusi Food Co., Ltd. and its subsidiaries (Be & Cheery), both of which the Company acquired in 2020. Pioneer Foods’ total assets and net revenue represented approximately 2.2% and 1.4%, respectively, of the consolidated total assets and net revenue of the Company as of and for the year ended December 26, 2020. Be & Cheery’s total assets and net revenue represented approximately 1.1% and 0.4%, respectively, of the consolidated total assets and net revenue of the Company as of and for the year ended December 26, 2020. Our audit of internal control over financial reporting of the Company also excluded an evaluation of the internal control over financial reporting of Pioneer Foods and Be & Cheery.Basis for OpinionsThe Company’s management is responsible for these consolidated financial statements, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Annual Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the Company’s consolidated financial statements and an opinion on the Company’s internal control over financial reporting based on our audits. We are a public accounting firm registered with the Public Company Accounting Oversight Board (United States) (PCAOB) and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement, whether due to error or fraud, and whether effective internal control over financial reporting was maintained in all material respects.Our audits of the consolidated financial statements included performing procedures to assess the risks of material misstatement of the consolidated financial statements, whether due to error or fraud, and 107Table of Contentsperforming procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the consolidated financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the consolidated financial statements. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.Definition and Limitations of Internal Control over Financial ReportingA company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.Critical Audit MattersThe critical audit matters communicated below are matters arising from the current period audit of the consolidated financial statements that were communicated or required to be communicated to the audit committee and that: (1) relate to accounts or disclosures that are material to the consolidated financial statements and (2) involved our especially challenging, subjective, or complex judgments. The communication of critical audit matters does not alter in any way our opinion on the consolidated financial statements, taken as a whole, and we are not, by communicating the critical audit matters below, providing separate opinions on the critical audit matters or on the accounts or disclosures to which they relate.Sales incentive accrualsAs discussed in Note 2 to the consolidated financial statements, the Company offers sales incentives and discounts through various programs to customers and consumers. A number of the sales incentives are based on annual targets, resulting in the need to accrue for the expected liability. These incentives are accrued for in the “Accounts payable and other current liabilities” line on the balance sheet. These accruals are based on sales incentive agreements, expectations regarding customer and consumer participation and performance levels, and historical experience and trends.We identified the evaluation of certain of the Company’s sales incentive accruals as a critical audit matter. Subjective and complex auditor judgment is required in evaluating these sales incentive accruals as a result of the timing difference between when the product is delivered and when the incentive is settled. This specifically related to (1) forecasted customer and consumer participation 108Table of Contentsand performance level assumptions underlying the accrual, and (2) the impact of historical experience and trends.The following are the primary procedures we performed to address this critical audit matter. We evaluated the design and tested the operating effectiveness of certain internal controls related to the critical audit matter. This included controls related to the Company’s sales incentive process, including (1) the accrual methodology, (2) assumptions around forecasted customer and consumer participation, (3) performance levels, and (4) monitoring of actual sales incentives incurred compared to estimated sales incentives in respect of historical periods. To evaluate the timing and amount of certain accrued sales incentives we (1) analyzed the accrual by sales incentive type as compared to historical trends to identify specific sales incentives that may require additional testing, (2) recalculated expenses and closing accruals on a sample basis, based on volumes sold and terms of the sales incentives, (3) assessed the Company’s ability to accurately estimate its sales incentive accrual by comparing previously established accruals to actual settlements, and (4) tested a sample of settlements or claims that occurred after period end, and compared them to the recorded sales incentive accrual.Carrying value of certain reacquired and acquired franchise rights and certain juice and dairy brands As discussed in Notes 2 and 4 to the consolidated financial statements, the Company performs impairment testing of its indefinite-lived intangible assets on an annual basis during the third quarter of each fiscal year and whenever events and changes in circumstances indicate that there is a greater than 50% likelihood that the asset is impaired. The carrying value of indefinite-lived intangible assets as of December 26, 2020 was $36.4 billion which represents 39% of total assets, and includes PepsiCo Beverages North America’s (PBNA) reacquired and acquired franchise rights which had a carrying value of $8.6 billion as of December 26, 2020. We identified the assessment of the carrying value of PBNA’s reacquired and acquired franchise rights and certain of Europe’s juice and dairy brands in Russia as a critical audit matter. Significant auditor judgment is necessary to assess the impact of competitive operating and macroeconomic factors on future levels of sales, operating profit and cash flows. The impairment analysis of these indefinite-lived intangible assets requires significant auditor judgment to evaluate the Company’s forecasted revenue and profitability levels, including the expected long-term growth rates and the selection of the discount rates to be applied to the projected cash flows. The following are the primary procedures we performed to address this critical audit matter. We evaluated the design and tested the operating effectiveness of certain internal controls related to the critical audit matter. This included controls related to the Company’s indefinite-lived assets impairment process to develop the forecasted revenue, profitability levels, and expected long-term growth rates and select the discount rates to be applied to the projected cash flows. We also evaluated the sensitivity of the Company’s conclusion to changes in assumptions, including the assessment of changes in assumptions from prior periods. To assess the Company’s ability to accurately forecast, we compared the Company’s historical forecasted results to actual results. We compared the cash flow projections used in the impairment tests with available external industry data and other internal information. We involved valuation professionals with specialized skills and knowledge who assisted in evaluating (1) the long-term growth rates used in the impairment tests by comparing against economic data and information specific to the respective assets, including projected long-term nominal Gross Domestic Product growth in the respective local countries, and (2) the discount rates used in the impairment tests by comparing them against discount rates that were independently developed using publicly available market data, including that of comparable companies. 109Table of ContentsUnrecognized tax benefitsAs discussed in Note 5 to the consolidated financial statements, the Company’s global operating model gives rise to income tax obligations in the United States and in certain foreign jurisdictions in which it operates. As of December 26, 2020, the Company recorded reserves for unrecognized tax benefits of $1.6 billion. The Company establishes reserves if it believes that certain positions taken in its tax returns are subject to challenge and the Company likely will not succeed, even though the Company believes the tax return position is supportable under the tax law. The Company adjusts these reserves, as well as the related interest, in light of new information, such as the progress of a tax examination, new tax law, relevant court rulings or tax authority settlements.We identified the evaluation of the Company’s unrecognized tax benefits as a critical audit matter because the application of tax law and interpretation of a tax authority’s settlement history is complex and involves subjective judgment. Such judgments impact both the timing and amount of the reserves that are recognized, including judgments about re-measuring liabilities for positions taken in prior years’ tax returns in light of new information.The following are the primary procedures we performed to address this critical audit matter. We evaluated the design and tested the operating effectiveness of certain internal controls related to the critical audit matter. This included controls related to the Company’s unrecognized tax benefits process, including controls to (1) identify uncertain income tax positions, (2) evaluate the tax law and tax authority’s settlement history used to estimate the unrecognized tax benefits, and (3) monitor for new information that may give rise to changes to the existing unrecognized tax benefits, such as progress of a tax examination, new tax law or tax authority settlements. We involved tax and valuation professionals with specialized skills and knowledge, who assisted in assessing the unrecognized tax benefits by (1) evaluating the Company’s tax structure and transactions, including transfer pricing arrangements, and (2) assessing the Company’s interpretation of existing tax law as well as new and amended tax laws, tax positions taken, associated external counsel opinions, information from tax examinations, relevant court rulings and tax authority settlements./s/ KPMG LLPWe have served as the Company’s auditor since 1990.New York, New YorkFebruary 10, 2021110Table of ContentsGLOSSARYAcquisitions and divestitures: all mergers and acquisitions activity, including the impact of acquisitions, divestitures and changes in ownership or control in consolidated subsidiaries and nonconsolidated equity investees.Bottler Case Sales (BCS): measure of physical beverage volume shipped to retailers and independent distributors from both PepsiCo and our independent bottlers. Bottler funding: financial incentives we give to our independent bottlers to assist in the distribution and promotion of our beverage products.Concentrate Shipments and Equivalents (CSE): measure of our physical beverage volume shipments to independent bottlers.Constant currency: financial results assuming constant foreign currency exchange rates used for translation based on the rates in effect for the comparable prior-year period. In order to compute our constant currency results, we multiply or divide, as appropriate, our current year U.S. dollar results by the current year average foreign exchange rates and then multiply or divide, as appropriate, those amounts by the prior year average foreign exchange rates.Consumers: people who eat and drink our products.CSD: carbonated soft drinks.Customers: authorized independent bottlers, distributors and retailers.Direct-Store-Delivery (DSD): delivery system used by us and our independent bottlers to deliver snacks and beverages directly to retail stores where our products are merchandised.Effective net pricing: reflects the year-over-year impact of discrete pricing actions, sales incentive activities and mix resulting from selling varying products in different package sizes and in different countries.Free cash flow: net cash provided by operating activities less capital spending, plus sales of property, plant and equipment. Independent bottlers: customers to whom we have granted exclusive contracts to sell and manufacture certain beverage products bearing our trademarks within a specific geographical area.Mark-to-market net impact: change in market value for commodity derivative contracts that we purchase to mitigate the volatility in costs of energy and raw materials that we consume. The market value is determined based on prices on national exchanges and recently reported transactions in the marketplace.Organic: a measure that adjusts for impacts of acquisitions, divestitures and other structural changes, and where applicable, foreign exchange translation and the impact of the 53rd reporting week. In excluding the impact of foreign exchange translation, we assume constant foreign exchange rates used for translation based on the rates in effect for the comparable prior-year period. See the definition of “Constant currency” for further information. Total marketplace spending: includes sales incentives and discounts offered through various programs to our customers, consumers or independent bottlers, as well as advertising and other marketing activities.Transaction gains and losses: the impact on our consolidated financial statements of exchange rate changes arising from specific transactions.111Table of ContentsTranslation adjustment: the impact of converting our foreign affiliates’ financial statements into U.S. dollars for the purpose of consolidating our financial statements.112Table of ContentsItem 7A. Quantitative and Qualitative Disclosures About Market Risk.Included in “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations – Our Business Risks.”
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+Item 7. We cannot be sure that any of our current ratings will remain in effect for any given period of time or that a rating will not be lowered or withdrawn entirely by a rating agency if, in its judgment, circumstances in the future so warrant. Any downgrade or withdrawal could adversely affect the market price of Pinnacle West’s and APS’s securities, limit our access to capital and increase our borrowing costs, which would 42Table of Contents adversely impact our financial results. We could be required to pay a higher interest rate for future financings, and our potential pool of investors and funding sources could decrease. In addition, borrowing costs under our existing credit facilities depend on our credit ratings. A downgrade could also require us to provide additional support in the form of letters of credit or cash or other collateral to various counterparties. If our short-term ratings were to be lowered, it could severely limit access to the commercial paper market. We note that the ratings from rating agencies are not recommendations to buy, sell or hold our securities and that each rating should be evaluated independently of any other rating.Investment performance, changing interest rates and other economic, social and political factors could decrease the value of our benefit plan assets, nuclear decommissioning trust funds and other special use funds or increase the valuation of our related obligations, resulting in significant additional funding requirements. We are also subject to risks related to the provision of employee healthcare benefits and healthcare reform legislation. Any inability to fully recover these costs in our utility rates would negatively impact our financial condition.We have significant pension plan and other postretirement benefits plan obligations to our employees and retirees, and legal obligations to fund our pension trust and nuclear decommissioning trusts for Palo Verde. We hold and invest substantial assets in these trusts that are designed to provide funds to pay for certain of these obligations as they arise. Declines in market values of the fixed income and equity securities held in these trusts may increase our funding requirements into the related trusts. Additionally, the valuation of liabilities related to our pension plan and other postretirement benefit plans are impacted by a discount rate, which is the interest rate used to discount future pension and other postretirement benefit obligations. Declining interest rates decrease the discount rate, increase the valuation of the plan liabilities and may result in increases in pension and other postretirement benefit costs, cash contributions, regulatory assets, and charges to OCI. Changes in demographics, including increased number of retirements or changes in life expectancy and changes in other actuarial assumptions, may also result in similar impacts. The minimum contributions required under these plans are impacted by federal legislation and related regulations. Increasing liabilities or otherwise increasing funding requirements under these plans, resulting from adverse changes in legislation or otherwise, could result in significant cash funding obligations that could have a material impact on our financial position, results of operations or cash flows.We recover most of the pension and other postretirement benefit expense and all of the currently estimated nuclear decommissioning costs in our regulated rates. Any inability to fully recover these costs in a timely manner could have a material negative impact on our financial condition, results of operations or cash flows.While most of the Patient Protection and Affordable Care Act provisions have been implemented, changes to or repeal of that Act and pending or future federal or state legislative or regulatory activity or court proceedings could increase costs of providing medical insurance for our employees and retirees. Any potential changes and resulting cost impacts cannot be determined with certainty at this time.Our cash flow depends on the performance of APS and its ability to make distributions.We derive essentially all of our revenues and earnings from our wholly-owned subsidiary, APS. Accordingly, our cash flow and our ability to pay dividends on our common stock is dependent upon the earnings and cash flows of APS and its distributions to us. APS is a separate and distinct legal entity and has no obligation to make distributions to us.APS’s financing agreements may restrict its ability to pay dividends, make distributions or otherwise transfer funds to us. In addition, an ACC financing order requires APS to maintain a common equity ratio of at least 40% and does not allow APS to pay common dividends if the payment would reduce its common equity below that threshold. The common equity ratio, as defined in the ACC order, is total 43Table of Contents shareholder equity divided by the sum of total shareholder equity and long-term debt, including current maturities of long-term debt.Pinnacle West’s ability to meet its debt service obligations could be adversely affected because its debt securities are structurally subordinated to the debt securities and other obligations of its subsidiaries.Because Pinnacle West is structured as a holding company, all existing and future debt and other liabilities of its subsidiaries will be effectively senior in right of payment to its own debt securities. The assets and cash flows of our subsidiaries will be available, in the first instance, to service their own debt and other obligations. Our ability to have the benefit of their cash flows, particularly in the case of any insolvency or financial distress affecting our subsidiaries, would arise only through our equity ownership interests in our subsidiaries and only after their creditors have been satisfied.The use of derivative contracts in the normal course of our business could result in financial losses that negatively impact our results of operations.APS’s operations include managing market risks related to commodity prices. APS is exposed to the impact of market fluctuations in the price and transportation costs of electricity, natural gas and coal to the extent that unhedged positions exist. We have established procedures to manage risks associated with these market fluctuations by utilizing various commodity derivatives, including exchange traded futures and over-the-counter forwards, options, and swaps. As part of our overall risk management program, we enter into derivative transactions to hedge purchases and sales of electricity and natural gas. The changes in market value of such contracts have a high correlation to price changes in the hedged commodity. To the extent that commodity markets are illiquid, we may not be able to execute our risk management strategies, which could result in greater unhedged positions than we would prefer at a given time and financial losses that negatively impact our results of operations.The Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank Act”) contains measures aimed at increasing the transparency and stability of the over-the-counter (“OTC”) derivative markets and preventing excessive speculation. The Dodd-Frank Act could restrict, among other things, trading positions in the energy futures markets, require different collateral or settlement positions, or increase regulatory reporting over derivative positions. Based on the provisions included in the Dodd-Frank Act and the implementation of regulations, these changes could, among other things, impact our ability to hedge commodity price and interest rate risk or increase the costs associated with our hedging programs.We are exposed to losses in the event of nonperformance or nonpayment by counterparties. We use a risk management process to assess and monitor the financial exposure of all counterparties. Despite the fact that the majority of APS’s trading counterparties are rated as investment grade by the rating agencies, there is still a possibility that one or more of these companies could default, which could result in a material adverse impact on our earnings for a given period.GENERAL RISKSProposals to change policy in Arizona or other states made through ballot initiatives or referenda may increase the Company’s cost of operations or impact its business plans.In Arizona and other states, a person or organization may file a ballot initiative or referendum with the Arizona Secretary of State or other applicable state agency and, if a sufficient number of verifiable signatures are presented, the initiative or referendum may be placed on the ballot for the public to vote on the matter. Ballot initiatives and referenda may relate to any matter, including policy and regulation related to the electric industry, and may change statutes or the state constitution in ways that could impact Arizona utility customers, the Arizona economy and the Company. Some ballot initiatives and referenda are drafted in an unclear manner and their potential industry and economic impact can be subject to varied 44Table of Contents and conflicting interpretations. We may oppose certain initiatives or referenda (including those that could result in negative impacts to our customers, the state or the Company) via the electoral process, litigation, traditional legislative mechanisms, agency rulemaking or otherwise, which could result in significant costs to the Company. The passage of certain initiatives or referenda could result in laws and regulations that impact our business plans and have a material adverse impact on our financial condition, results of operations or cash flows.The market price of our common stock may be volatile.The market price of our common stock could be subject to significant fluctuations in response to factors such as the following, some of which are beyond our control:•variations in our quarterly operating results;•operating results that vary from the expectations of management, securities analysts and investors;•changes in expectations as to future financial performance, including financial estimates by securities analysts and investors;•developments generally affecting industries in which we operate;•announcements by us or our competitors of significant contracts, acquisitions, joint marketing relationships, joint ventures or capital commitments;•announcements by third parties of significant claims or proceedings against us;•favorable or adverse regulatory or legislative developments;•our dividend policy;•future sales by the Company of equity or equity-linked securities; and•general domestic and international economic conditions.In addition, the stock market in general has experienced volatility that has often been unrelated to the operating performance of a particular company. These broad market fluctuations may adversely affect the market price of our common stock.Financial market disruptions or new rules or regulations may increase our financing costs or limit our access to various financial markets, which may adversely affect our liquidity and our ability to implement our financial strategy.Pinnacle West and APS rely on access to credit markets as a significant source of liquidity and the capital markets for capital requirements not satisfied by cash flow from our operations. We believe that we will maintain sufficient access to these financial markets. However, certain market disruptions or revisions to rules or regulations may cause our cost of borrowing to increase generally, and/or otherwise adversely affect our ability to access these financial markets.In addition, the credit commitments of our lenders under our bank facilities may not be satisfied or continued beyond current commitment periods for a variety of reasons, including new rules and regulations, periods of financial distress or liquidity issues affecting our lenders or financial markets, which could materially adversely affect the adequacy of our liquidity sources and the cost of maintaining these sources.Changes in economic conditions, monetary policy, fiscal policy, financial regulation, rating agency treatment or other factors could result in higher interest rates, which would increase interest expense on our 45Table of Contents existing variable rate debt and new debt we expect to issue in the future, and thus increase the cost and/or reduce the amount of funds available to us for our current plans.Additionally, an increase in our leverage, whether as a result of these factors or otherwise, could adversely affect us by:•causing a downgrade of our credit ratings;•increasing the cost of future debt financing and refinancing;•increasing our vulnerability to adverse economic and industry conditions; and•requiring us to dedicate an increased portion of our cash flow from operations to payments on our debt, which would reduce funds available to us for operations, future investment in our business or other purposes.Certain provisions of our articles of incorporation and bylaws and of Arizona law make it difficult for shareholders to change the composition of our board and may discourage takeover attempts.These provisions, which could preclude our shareholders from receiving a change of control premium, include the following:•restrictions on our ability to engage in a wide range of “business combination” transactions with an “interested shareholder” (generally, any person who beneficially owns 10% or more of our outstanding voting power, or any of our affiliates or associates who beneficially owned 10% or more of our outstanding voting power at any time during the prior three years) or any affiliate or associate of an interested shareholder, unless specific conditions are met;•anti-greenmail provisions of Arizona law and our bylaws that prohibit us from purchasing shares of our voting stock from beneficial owners of more than 5% of our outstanding shares unless specified conditions are satisfied;•the ability of the Board of Directors to increase the size of and fill vacancies on the Board of Directors, whether resulting from such increase, or from death, resignation, disqualification or otherwise; •the ability of our Board of Directors to issue additional shares of common stock and shares of preferred stock and to determine the price and, with respect to preferred stock, the other terms, including preferences and voting rights, of those shares without shareholder approval; •restrictions that limit the rights of our shareholders to call a special meeting of shareholders; and•restrictions regarding the rights of our shareholders to nominate directors or to submit proposals to be considered at shareholder meetings.While these provisions may have the effect of encouraging persons seeking to acquire control of us to negotiate with our Board of Directors, they could enable the Board of Directors to hinder or frustrate a transaction that some, or a majority, of our shareholders might believe to be in their best interests and, in that case, may prevent or discourage attempts to remove and replace incumbent directors.ITEM 1B. UNRESOLVED STAFF COMMENTS Neither Pinnacle West nor APS has received written comments regarding its periodic or current reports from the SEC staff that were issued 180 days or more preceding the end of its 2020 fiscal year and that remain unresolved.46Table of Contents ITEM 2. PROPERTIESGeneration Facilities APS’s portfolio of owned generating facilities as of December 31, 2020 is provided in the table below: NameNo. ofUnits%Owned (a)PrincipalFuelsUsedPrimaryDispatchTypeOwnedCapacity(MW)Nuclear: Palo Verde (b)329.1 %UraniumBase Load1,146 Total Nuclear 1,146 Steam: Four Corners 4, 5 (c)263 %CoalBase Load970 Cholla 1,3 2 CoalBase Load387 Total Steam 1,357 Combined Cycle: Redhawk (e)2 GasLoad Following1,088 West Phoenix5 GasLoad Following887 Total Combined Cycle 1,975 Combustion Turbine: Ocotillo (d)7 GasPeaking620 Saguaro3 GasPeaking189 Douglas/Fairview1 OilPeaking16 Sundance10 GasPeaking420 West Phoenix2 GasPeaking110 Yucca 1, 2, 33 GasPeaking93 Yucca 41 OilPeaking54 Yucca 5, 62 GasPeaking96 Total Combustion Turbine 1,598 Solar: Cotton Center (f)1 SolarAs Available17 Hyder I (f)1 SolarAs Available16 Paloma (f)1 SolarAs Available17 Chino Valley1 SolarAs Available19 Gila Bend (f)1SolarAs Available32 Hyder II (f)1 SolarAs Available14 Foothills (f)1 SolarAs Available35 Luke AFB1SolarAs Available10 Desert Star (f)1SolarAs Available10 Red Rock1SolarAs Available40 APS Owned Distributed Energy SolarAs Available31 Multiple facilities SolarAs Available4 Total Solar 245 Total Capacity 6,321 47Table of Contents (a)100% unless otherwise noted.(b)Our 29.1% ownership in Palo Verde includes leased interests. See “Business of Arizona Public Service Company — Energy Sources and Resource Planning — Generation Facilities — Nuclear” in Item 1 for details regarding leased interests in Palo Verde. The other participants are Salt River Project (17.49%), SCE (15.8%), El Paso (15.8%), Public Service Company of New Mexico (10.2%), Southern California Public Power Authority (5.91%), and Los Angeles Department of Water & Power (5.7%). The plant is operated by APS.(c)The other participants are Salt River Project (10%), Public Service Company of New Mexico (13%), Tucson Electric Power Company (7%) and NTEC (7%). The plant is operated by APS. (d)Ocotillo Steam Units 1 and 2 were retired on January 10, 2019. Units 3 through 7 all went into service on or prior to May 30, 2019 which increased generation capacity by 510 MW. (e)Redhawk generation capacity increased by 104 MW following the Advanced Gas Path upgrade installed on both units.(f)APS is under contract and currently plans to add battery storage at these AZ Sun sites. (See “Business of Arizona Public Service Company — Energy Sources and Resource Planning — Energy Storage” above for details related to these and other energy storage agreements.)See “Business of Arizona Public Service Company — Environmental Matters” in Item 1 with respect to matters having a possible impact on the operation of certain of APS’s generating facilities. See “Business of Arizona Public Service Company” in Item 1 for a map detailing the location of APS’s major power plants and principal transmission lines.4CA4CA, a wholly-owned subsidiary of Pinnacle West, purchased El Paso’s 7% interest in Units 4 and 5 of Four Corners on July 6, 2016 and subsequently sold the interest to NTEC on July 3, 2018. (See “Business of Arizona Public Service Company — Energy Sources and Resource Planning — Generation Facilities — Coal-Fueled Generating Facilities — Four Corners” in Item 1 and “Four Corners — 4CA Matter” in Note 11 for additional information about 4CA’s interest in Four Corners.) Transmission and Distribution Facilities Current Facilities. APS’s transmission facilities consist of approximately 5,728 pole miles of overhead lines and approximately 74 miles of underground lines, 5,591 miles of which are located in Arizona. APS’s distribution facilities consist of approximately 11,225 miles of overhead lines and approximately 22,453 miles of underground primary cable, all of which are located in Arizona. APS also owns and maintains 80 transmission substations and 443 distribution substations. APS shares ownership of some of its transmission facilities with other companies. 48Table of Contents The following table shows APS’s jointly-owned interests in those transmission facilities recorded on the Consolidated Balance Sheets at December 31, 2020: Percent Owned(Weighted-Average)Morgan — Pinnacle Peak System64.6 %Palo Verde — Rudd 500kV System50.0 %Round Valley System50.0 %ANPP 500kV System33.5 %Navajo Southern System26.0 %Four Corners Switchyards61.8 %Palo Verde — Yuma 500kV System25.3 %Phoenix — Mead System17.1 %Palo Verde — Morgan System88.9 %Hassayampa — North Gila System80.0 %Cholla 500kV Switchyard85.7 %Saguaro 500kV Switchyard60.0 %Kyrene — Knox System50.0 % Expansion. Each year APS prepares and files with the ACC a ten-year transmission plan. In APS’s 2021 plan, APS projects it will develop 26 miles of new transmission lines over the next ten years. One significant project, the Palo Verde to Morgan project recently completed all phases and provides a new 500kV path that spans from the Palo Verde hub around the western and northern edges of the Phoenix metropolitan area and terminates at a bulk substation in the northeast part of Phoenix. The Palo Verde to Morgan project includes Palo Verde-Delaney-Sun Valley-Morgan-Pinnacle Peak. The project consisted of four phases and the fourth phase, Morgan to Sun Valley 500kV, was energized in April of 2018. In total, the project consisted of over 100 miles of new 500kV lines, with many of those miles constructed with the capability to employ a 230kV line as a second circuit. APS continues to work with regulators to identify transmission projects necessary to support renewable energy facilities. Two such projects, which have been completed and were included in previous APS transmission plans, are the Delaney to Palo Verde line and the North Gila to Hassayampa line, both of which support the transmission of renewable energy to Phoenix and California. The North Gila to Hassayampa line went into service in May 2015 and the Delaney to Palo Verde line went into service in May 2016.Plant and Transmission Line Leases and Rights-of-Way on Indian Lands The Navajo Plant and Four Corners are located on land held under leases from the Navajo Nation and also under rights-of-way from the federal government. The Navajo Plant ceased operations in November 2019. The co-owners and the Navajo Nation executed a lease extension on November 29, 2017 that allows for decommissioning activities to begin after the plant ceased operations. APS, on behalf of the Four Corners participants, negotiated amendments to the Four Corners facility lease with the Navajo Nation, which extends the Four Corners leasehold interest from 2016 to 2041. See “Business of Arizona Public Service Company — Energy Sources and Resource Planning — Generating Facilities — Coal-Fueled Generating Facilities — Four Corners” in Item 1 for additional information about the Four Corners right-of-way and lease matters. 49Table of Contents Certain portions of our transmission lines are located on Indian lands pursuant to rights-of-way that are effective for specified periods. Some of these rights-of-way have expired and our renewal applications have not yet been acted upon by the appropriate Indian tribes or federal agencies. Other rights expire at various times in the future and renewal action by the applicable tribe or federal agencies will be required at that time. In recent negotiations, certain of the affected Indian tribes have required payments substantially in excess of amounts that we have paid in the past for such rights-of-way. The ultimate cost of renewal of certain of the rights-of-way for our transmission lines is therefore uncertain.ITEM 3. LEGAL PROCEEDINGS See “Business of Arizona Public Service Company — Environmental Matters” in Item 1 with regard to pending or threatened litigation and other disputes.See Note 4 for ACC and FERC-related matters.See Note 11 for information regarding environmental matters, Superfund–related matters and other disputes. ITEM 4. MINE SAFETY DISCLOSURES Not applicable.50Table of Contents INFORMATION ABOUT OUR EXECUTIVE OFFICERSPinnacle West’s executive officers are elected no less often than annually and may be removed by the Board of Directors, or in certain cases also by the Human Resources Committee, at any time. The executive officers, their ages at February 24, 2021, current positions and principal occupations for the past five years are as follows:NameAgePositionPeriodJeffrey B. Guldner55Chairman of the Board, President and Chief Executive Officer of Pinnacle West; Chairman of the Board and Chief Executive Officer of APS2019-PresentPresident of APS2018-2020Executive Vice President, Public Policy of Pinnacle West2017-2019Executive Vice President, Public Policy of APS2017-2018General Counsel of Pinnacle West and APS2017-2018Senior Vice President, Public Policy of APS2014-2017Elizabeth A. Blankenship49Vice President, Controller and Chief Accounting Officer of Pinnacle West and APS2019-PresentGeneral Manager, Accounting Operations of APS 2019-2019Director, Accounting Operations of APS2014-2019Andrew D. Cooper42Vice President and Treasurer of Pinnacle West and APS2020-PresentDirector, Corporate Finance of Consolidated Edison Company of New York, Inc.2017-2020Director, Power & Utilities Investment Banking of Barclays Capital, Inc.2008-2017Donna M. Easterly56Senior Vice President, Human Resources of APS2020-PresentVice President, Human Resources and Ethics of APS2017-2020Vice President, Chief Procurement Officer of APS2014-2017Daniel T. Froetscher59President and Chief Operating Officer of APS2020-PresentExecutive Vice President, Operations of APS2018-2020Senior Vice President, Transmission, Distribution & Customers of APS2014-2018Theodore N. Geisler42Senior Vice President and Chief Financial Officer of Pinnacle West and APS2020-PresentVice President and Chief Information Officer of APS2018-2020General Manager, Transmission and Distribution Operations and Maintenance of APS2017-2018Director, Investor Relations of Pinnacle West2016-2017Director, Transmission Operations and Maintenance of APS2013-2016James R. Hatfield63Chief Administrative Officer of Pinnacle West and APS2020-PresentExecutive Vice President of Pinnacle West and APS2012-PresentTreasurer of Pinnacle West and APS2020-2020Chief Financial Officer of Pinnacle West and APS2008-2020Maria L. Lacal60Executive Vice President and Chief Nuclear Officer, PVGS, of APS2020-PresentSenior Vice President, Regulatory and Oversight, PVGS, of APS2016-2020Vice President, Regulatory and Oversight, PVGS, of APS2015-2016Vice President, Operations Support, PVGS, of APS2011-2015Barbara D. Lockwood54Senior Vice President, Public Policy of APS2020-PresentVice President, Regulation of APS2015-2020General Manager, Regulatory Policy and Compliance of APS2014-2015Robert E. Smith51Senior Vice President and General Counsel of Pinnacle West and APS2018-PresentSenior Vice President and General Counsel of Columbia Pipeline Group, Inc. 2014-201651Table of Contents PART II ITEM 5. MARKET FOR REGISTRANTS’ COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIESPinnacle West’s common stock is publicly held and is traded on the New York Stock Exchange under stock symbol PNW. At the close of business on February 17, 2021, Pinnacle West’s common stock was held of record by approximately 16,415 shareholders.APS’s common stock is wholly-owned by Pinnacle West and is not listed for trading on any stock exchange. The sole holder of APS’s common stock, Pinnacle West, is entitled to dividends when and as declared out of legally available funds. At December 31, 2020, APS did not have any outstanding preferred stock.Stock Performance ChartThis graph compares the cumulative total shareholder return on Pinnacle West’s common stock during the five years ended December 31, 2020 to the cumulative total returns on the S&P 500 Index and the Edison Electric Index. The comparison assumes that $100 was invested on December 31, 2015 in Pinnacle West's common stock and in each of the indices shown and that all of the dividends were reinvested.Years Ended December 31,Company/Index201520162017201820192020Pinnacle West Common Stock$100$125$141$146$159$147Edison Electric Institute Index$100$117$131$136$171$169S&P 500 Index$100$112$136$130$171$20352Table of ContentsITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSINTRODUCTION The following discussion should be read in conjunction with Pinnacle West’s Consolidated Financial Statements and APS’s Consolidated Financial Statements and the related Notes that appear in Item 8 of this report. This discussion provides a comparison of the 2020 results with 2019 results. A comparison of the 2019 results with 2018 results can be found in the Annual Report on Form 10-K for the fiscal year ended December 31, 2019. For information on factors that may cause our actual future results to differ from those we currently seek or anticipate, see “Forward-Looking Statements” at the front of this report and “Risk Factors” in Item 1A.OVERVIEW Business OverviewPinnacle West is an investor-owned electric utility holding company based in Phoenix, Arizona with consolidated assets of about $20 billion. For over 130 years, Pinnacle West and our affiliates have provided energy and energy-related products to people and businesses throughout Arizona. Pinnacle West derives essentially all of our revenues and earnings from our principal subsidiary, APS. APS is Arizona’s largest and longest-serving electric company that generates safe, affordable and reliable electricity for approximately 1.3 million retail customers in 11 of Arizona’s 15 counties. APS is also the operator and co-owner of Palo Verde — a primary source of electricity for the southwest United States and the largest nuclear power plant in the United States.COVID-19 Pandemic The COVID-19 pandemic continues to be a rapidly evolving situation. It has led to economic disruption and volatility in financial markets worldwide. The Company is operating under long-standing pandemic and business continuity plans that exist to address situations including pandemics like COVID-19. We are focused on ensuring the health and safety of our employees, contractors and the general public by helping limit the spread of this virus and ensuring continued, safe and reliable electric service for APS customers. We have identified business-critical positions in our operations and support organizations, with backup personnel ready to assist if an issue were to arise. Additionally, efforts to ensure the health and safety of our employees have resulted in bifurcated control rooms, thus reducing the number of employees in mission-critical locations. We also established COVID-19 safety protocols, social distancing practices including limiting one employee per vehicle and offering virtual options whenever possible. The Company also took rapid action to implement an all Company COVID-19 hotline, a focused COVID-19 team, and procured on-site COVID-19 testing at key facilities early in the pandemic. Through this testing, case management and contact tracing, the Company has been able to significantly limit COVID-19 transmission in the workplace. As a result of these efforts, we have been able to maintain the continuity of the essential services that we provide to our customers, while also managing the spread of the virus and promoting the health, physical and mental well-being and safety of our employees, customers and communities.53Table of Contents Essential planned work and capital investments are continuing during the pandemic, with some non-essential planned work postponed to the first quarter of 2021. APS has continuous discussions with suppliers on manpower and supply issues pertaining to COVID-19 and has measures in place to continue to monitor resource needs and supply chain adequacy. At this time, APS does not believe it has any material supply chain risks due to COVID-19 that would impact its ability to serve customers’ needs. The Company’s operations and maintenance expenses, exclusive of bad debt expense, increased by approximately $25 million for the year ended December 31, 2020 due to costs for personal protective equipment and other health and safety-related costs related to COVID-19. We expect the Company’s operation and maintenance expenses will continue to be impacted for 2021 by the need for additional personal protective equipment and other health and safety-related costs related to COVID-19.While the total expected impact of COVID-19 on future sales is currently unknown, APS has experienced higher electric residential sales and lower electric commercial and industrial sales since the outset of the pandemic. From March 13, 2020 through December 31, 2020, the cumulative impact in weather-normalized usage was approximately a 1% increase. During that period, APS’s retail electric residential weather-normalized sales increased 5%, and its retail electric commercial and industrial weather-normalized sales decreased 4% in the aggregate. APS expects the reduction in electric demand from commercial and industrial customers and increased demand from residential customers to normalize somewhat during 2021 as business activity continues to recover and more people return to work. Based on past experience, a 1% variation in our annual kWh sales projections under normal business conditions can result in increases or decreases in annual net income of approximately $20 million.On March 31, 2020, a stay at home order became effective for the state of Arizona and remained in effect until May 16, 2020, when it was lifted and Arizona began reopening. In June 2020, Arizona saw an increase in the number of COVID-19 cases, hospitalizations, and deaths. Accordingly, on June 29, 2020, the governor of Arizona closed bars, indoor gyms and fitness clubs or centers, indoor movie theaters, water parks and tubing operations until July 27, 2020 as a partial reversal of the state’s reopening and to mitigate the spread of COVID-19. On July 23, 2020, the governor of Arizona extended these closures and they remained in place until August 27, 2020, when bars, gyms and movie theaters reopened with certain restrictions. We cannot predict the impact of the spread of COVID-19 in Arizona, whether there will be additional reclosures and how any such reclosures will impact our financial position, results of operations or cash flows. We are continuing to monitor the impacts of COVID-19.As a result of the COVID-19 pandemic, in mid-March 2020, the commercial paper markets failed to function normally and we were unable to utilize commercial paper as our primary method of acquiring short-term capital, which resulted in us drawing on our revolving credit facilities during the first quarter of 2020. In mid-April 2020, we were again able to utilize the commercial paper market and we have paid down the entire amount of the revolving credit facilities that were utilized as a result of the commercial paper market failure. The Coronavirus Aid, Relief, and Economic Security (CARES) Act allows employers to defer payments of the employer share of Social Security payroll taxes that would have otherwise been owed from March 27, 2020 through December 31, 2020. We deferred the cash payment of the employer’s portion of Social Security payroll taxes for the period July 1, 2020 through December 31, 2020 that was approximately $18 million. We will pay half of this cash deferral by December 31, 2021 and the remainder by December 31, 2022.54Table of Contents On June 30, 2020, FERC issued an order granting a waiver request related to the existing AFUDC rate calculation beginning March 1, 2020 through February 28, 2021. The order provides a simplified approach that companies may elect to implement in order to minimize the significant distorted effect on the AFUDC formula resulting from increased short-term debt financing during the COVID-19 pandemic. APS has adopted this simplified approach to computing the AFUDC composite rate by using a simple average of the actual historical short-term debt balances for 2019, instead of current period short-term debt balances, and has left all other aspects of the AFUDC formula composite rate calculation unchanged. This change impacts the AFUDC composite rate in 2020, but does not impact prior years. Furthermore, the change in the composite rate calculation does not impact our accounting treatment for these costs. The change did not have a material impact on our financial statements (see Note 1.) Due to the COVID-19 pandemic, APS voluntarily suspended disconnections of customers for nonpayment beginning March 13, 2020. In addition, APS waived all late payment fees during this suspension period. On September 14, 2020, APS extended this suspension of disconnection of customers for nonpayment and waiver of late payment fees until December 31, 2020. The suspension of disconnection of customers for nonpayment ended on January 1, 2021 and customers were automatically placed on eight-month payment arrangements if they had past due balances at the end of the disconnection period of $75 or greater. APS will continue to waive late payment fees until October 15, 2021. APS has experienced and is continuing to experience an increase in bad debt expense associated with the COVID-19 pandemic. The Summer Disconnection Moratorium (see Note 4), the suspension of disconnections during the COVID-19 pandemic and the increased bad debt expense associated with both events resulted in a negative impact to its 2020 operating results of approximately $23 million pre-tax above the impact of disconnections on its operating results for years that did not have the Summer Disconnection Moratorium or COVID-19 pandemic. APS also currently estimates that the Summer Disconnection Moratorium, the suspension of disconnections during the COVID-19 pandemic and the increased bad debt expense associated with this will result in a negative impact to its 2021 operating results of approximately $20 million to $30 million pre-tax above the impact of disconnections on its operating results for years that did not have the Summer Disconnection Moratorium or COVID-19 pandemic. These estimated impact amounts for 2021 depend on certain current assumptions, including, but not limited to, customer behaviors, population and employment growth, and the impacts of COVID-19 on the economy. Additionally, due to COVID-19, APS delayed the reset of the EIS adjustor and suspended the discontinuation of TEAM Phase II to the first billing cycle in May 2020 rather than April 2020 and and also delayed the reset of the PSA to the first billing cycle of April 2021 rather than February 2021 (see Note 4). On April 17, 2020, APS filed an application with the ACC requesting a COVID-19 emergency relief package to provide additional assistance to its customers. On May 5, 2020, the ACC approved APS returning $36 million that had been collected through the DSM Adjustor Charge, but not allocated for current DSM programs, directly to customers through a bill credit in June 2020 (see Note 4). As of December 31, 2020, APS had refunded approximately $43 million to customers. The additional $7 million over the approved amount of $36 million was the result of the kWh credit being based on historic consumption which was different than actual consumption in the refund period. This difference was recorded to the DSM balancing account and will be addressed in subsequent DSM filings.APS has spent more than $15 million to assist customers and local non-profits and community organizations to help with the impact of the COVID-19 pandemic, with $12.4 million of these dollars directly committed to bill assistance programs (the “COVID Customer Support Fund”). The COVID Customer Support Fund was comprised of a series of voluntary commitments of funds that are not recoverable through rates throughout 2020 of approximately $8.8 million. An additional $3.6 million in bill credits for limited income customers was ordered by the ACC in December 2020 of which 50%, up to a 55Table of Contents maximum of $2.5 million, was committed to be funds that are not recoverable through rates with the remaining being deferred for potential future recovery in rates. Included in the COVID Customer Support Fund were programs that assisted customers that had a delinquency of two or more months with a one-time credit of $100, an expanded credit of $300 for limited income customers, programs to assist extra small and small non-residential customers with a one-time credit of $1,000, and other targeted programs allocated to assist with other COVID-19 needs in support of utility bill assistance. The December 2020 ACC order further assisted delinquent limited income customers with an additional bill credit of up to $250 or their delinquent balance, whichever was less. As of December 31, 2020, APS had distributed all funds for all COVID Customer Support Fund programs combined. Beyond the COVID Customer Support Fund, APS has also provided $2.7 million to assist local non-profits and community organizations working to mitigate the impacts of the COVID-19 pandemic.More detailed discussion of the impacts and future uncertainties related to the COVID‑19 pandemic can be found throughout this Management’s Discussion and Analysis of Financial Condition and Results of Operations and the Combined Notes to Pinnacle West’s and APS’s financial statements that appear in Part II, Item 8 of this report and “Risk Factors” in Part I, Item 1A of this report.Strategic Overview Our strategy is to deliver shareholder value by creating a sustainable energy future for Arizona by serving our customers with clean, reliable and affordable energy.Clean Energy CommitmentWe are committed to doing our part to make the future clean and carbon-free. Our vision for APS and Arizona presents an opportunity to engage with customers, communities, employees, policymakers, shareholders and others to achieve a shared, sustainable vision for Arizona. This goal is based on sound science and supports continued growth and economic development while maintaining reliability and affordable prices for APS’s customers.APS’s new clean energy goals consist of three parts: •A 2050 goal to provide 100% clean, carbon-free electricity;•A 2030 target of achieving a resource mix that is 65% clean energy, with 45% of the generation portfolio coming from renewable energy; and•A commitment to end APS’s use of coal-fired generation by 2031.APS’s ability to successfully execute its clean energy commitment is dependent upon a number of important external factors, some of which include a supportive regulatory environment, sales and customer growth, development of clean energy technologies and continued access to capital markets.2050 Goal: 100% Clean, Carbon-Free Electricity. Achieving a fully clean, carbon-free energy mix by 2050 is our aspiration. The 2050 goal will involve new thinking and depends on improved and new technologies.2030 Goal: 65% Clean Energy. APS has an energy mix that is already 50% clean with existing plans to add more renewables and energy storage before 2025. By building on those plans, APS intends to attain an energy mix that is 65% clean by 2030, with 45% of APS’s generation portfolio coming from renewable energy. Clean is measured as percent of energy mix which includes carbon-free resources like nuclear and demand-side management, and renewable is expressed as a percent of retail sales. This target will 56Table of Contents serve as a checkpoint for our resource planning, investment strategy, and customer affordability efforts as APS moves toward 100% clean, carbon-free energy mix by 2050.2031 Goal: End APS’s Use of Coal-Fired Generation. The commitment to end APS’s use of coal-fired generation by 2031 will require APS to cease use of coal-generation at Four Corners. APS has permanently retired more than 1,000 MW of coal-fired electric generating capacity. These closures and other measures taken by APS have resulted in a total reduction of carbon emissions of 26% since 2005. In addition, APS has committed to end the use of coal at its remaining Cholla units by 2025.APS understands that the transition away from coal-fired power plants toward a clean energy future will pose unique economic challenges for the communities around these plants. We worked collaboratively with stakeholders and leaders of the Navajo Nation to consider the impacts of ceasing operation of APS coal-fired power plants on the communities surrounding those facilities to propose a comprehensive Coal Community Transition ("CCT") plan. The proposed framework provides substantial financial and economic development support to build new economic opportunities and addresses a transition strategy for plant employees. We are committed to continuing our long-running partnership with the Navajo Nation in other areas as well, including expanding electrification and developing tribal renewable projects. Our proposed CCT plan supports the Navajo Nation, where the Four Corners Power Plant is located, the communities surrounding the Cholla Power Plant and the Hopi Tribe, which is impacted by closure of the Navajo Plant. The CCT plan is currently pending ACC approval. (See Note 4 for a discussion of the CCT plan.)Renewables. APS intends to strengthen its already diverse energy mix by increasing its investments in carbon-free resources. Its near-term actions include competitive solicitations to procure clean energy resources such as solar, wind, energy storage, demand response and DSM resources, all of which lead to a cleaner grid.APS has a diverse portfolio of existing and planned renewable resources, including solar, wind, geothermal, biomass and biogas. APS’s clean energy strategy includes executing purchased power contracts for new facilities, ongoing development of distributed energy resources and procurement of new facilities to be owned by APS. Agreements for the development and completion of future resources are subject to various conditions, including successful siting, permitting and interconnection of the projects to the electric grid. See “Business of Arizona Public Service Company — Energy Sources and Resource Planning — Current and Future Resources — Renewable Energy Standard — Renewable Energy Portfolio” in Item 1 for details regarding APS’s renewable energy resources.Palo Verde. Palo Verde, the nation’s largest carbon-free, clean energy resource, will continue to be a foundational part of APS’s resource portfolio. The plant currently supplies nearly 70% of our clean energy and provides the foundation for the reliable and affordable service for APS customers. Palo Verde is not just the cornerstone of our current clean energy mix, it also is a significant provider of clean energy to the southwest United States. The plant’s continued operation is important to a carbon-free and clean energy future for Arizona and the region, as a reliable, continuous, affordable resource and as a large contributor to the local economy.AffordableWe believe it is APS’s responsibility to deliver electric services to customers in the most cost-effective manner. Since January 2018 through December 2020, the average residential bill decreased by 7.3%, or $10.95.57Table of Contents Building upon existing cost management efforts, APS launched a customer affordability initiative in 2019. The initiative was implemented company-wide to thoughtfully and deliberately assess our business processes and organizational approaches to completing high-value work and internal efficiencies. Through the initiative and existing cost management practices, APS met its goal of $20 million in cost savings as of December 31, 2020. Participation in the EIM continues to be an effective tool for creating savings for APS's customers from the real-time, voluntary market. APS continues to expect that its participation in EIM will lower its fuel and purchased-power costs, improve visibility and situational awareness for system operations in the Western Interconnection power grid, and improve integration of APS’s renewable resources. APS is in discussions with the EIM operator, CAISO, and other EIM participants about the feasibility of creating a voluntary day-ahead market to achieve more cost savings and use the region’s renewable resources more efficiently.ReliableWhile our energy mix evolves, the obligation to deliver reliable service to our customers remains. Notwithstanding the challenges presented by the COVID-19 pandemic as well as the hottest summer on record, APS continued to provide reliable service to its customers in 2020, setting a new all-time high peak energy demand of 7,660 MW, exceeding the prior peak set in 2017 by nearly 300 MW and achieved strong reliability results.Planned investments will support operating and maintaining the grid, updating technology, accommodating customer growth and enabling more renewable energy resources. Our advanced distribution management system allows operators to locate outages, control line devices remotely and helps them coordinate more closely with field crews to safely maintain an increasingly dynamic grid. The system also integrates a new meter data management system that increases grid visibility and gives customers access to more of their energy usage data. Wildfire safety remains a critical focus for APS and other utilities. We increased investment in fire mitigation efforts to clear defensible space around our infrastructure, build partnerships with government entities and first responders and educate customers and communities. These programs contribute to customer reliability, responsible forest management and safe communities.The new units at our modernized Ocotillo power plant provide cleaner-running and more efficient units. They support reliability by responding quickly to the variability of solar generation and delivering energy in the late afternoon and early evening, when solar production declines as the sun sets and customer demand peaks.Customer-FocusedCustomers are at the core of what APS does every day and its focus remains on its customers and the communities it serves. It is APS’s goal to achieve an industry-leading best-in-class customer experience. In 2020, APS adopted a number of changes to improve customer experience. It transitioned to a 24/7 care center operation to better serve its customers around the clock. APS improved its call center performance, answering nearly 75% of its more than 1.5 million telephone calls in 30 seconds or less. APS 58Table of Contents has also made many improvements to its digital experience through its aps.com site, and its overall digital experience continues to improve for its customers. APS also convened a customer advisory board and stakeholder committee in 2020 to serve as a vehicle for gathering valuable qualitative insights, directly from customers and stakeholders, that intends to keep APS apprised of customer needs, wants, and perspectives. Additionally, the customer advisory board is leveraged to identify and diagnose potential customer pain points and to help shape and co-create customer solutions. APS is also providing assistance to residential and business customers that have been impacted by the COVID-19 pandemic. See “COVID-19 Pandemic” above for more information about customer support during COVID-19.Emerging Technologies Energy Storage APS deploys a number of advanced technologies on its system, including energy storage. Storage can provide capacity, improve power quality, be utilized for system regulation, integrate renewable generation, and, in certain circumstances, be used to defer certain traditional infrastructure investments. Energy storage can also aid in integrating higher levels of renewables by storing excess energy when system demand is low and renewable production is high and then releasing the stored energy during peak demand hours later in the day and after sunset. APS is utilizing grid-scale energy storage projects to benefit customers, to increase renewable utilization, and to further our understanding of how storage works with other advanced technologies and the grid. We are preparing for additional energy storage in the future.In early 2018, APS entered into a 15-year power purchase agreement for a 65 MW solar facility that charges a 50 MW solar-fueled battery. Service under the agreement was scheduled to begin in 2021; however, APS terminated the agreement, effective February 16, 2021, because the facility will not meet the expected in-service date. In 2018, APS issued an RFP for approximately 106 MW of energy storage to be located at up to five of its AZ Sun sites. Based upon its evaluation of the RFP responses, APS decided to expand the initial phase of battery deployment to 141 MW by adding a sixth AZ Sun site. These battery storage facilities are expected to be in service by June 2022. Additionally, in February 2019, APS signed two 20-year PPAs for energy storage totaling 150 MW. In April 2019, a battery module in APS’s McMicken battery energy storage facility experienced an equipment failure, which prompted an internal investigation to determine the cause. APS has now completed its investigation of the McMicken battery incident and is working with all counterparties to ensure that the learnings from the investigation, and the corresponding safety requirements, are incorporated into all battery storage projects going forward, including the projects associated with the two above-referenced PPAs. These PPAs were also subject to ACC approval in order to allow for cost recovery through the PSA. APS received the requested ACC approval on January 12, 2021, and service under both agreements is expected to begin in 2022.We currently plan to install at least 850 MW of energy storage by 2025, including the energy storage projects under PPAs and AZ Sun retrofits described above. The remaining energy storage is expected to be made up of resources solicited through current and future RFPs. Currently, APS has two RFPs in the market that seek energy storage resources: (i) a battery storage RFP for projects to be located at the remaining two AZ Sun sites that were not included in the 2018 RFP referenced in the preceding paragraph; and (ii) an ‘all source’ RFP that solicits both standalone energy storage and renewable energy plus energy storage resources. Such resources would be expected to be in service during 2023 and 2024. 59Table of Contents Electric VehiclesAPS is making electric vehicle charging more accessible for its customers and helping Arizona businesses, schools and governments electrify their fleets. In 2020, APS expanded its Take Charge AZ Pilot Program and installed 84 dual-plug Level 2 charging stations at business customer locations with more stations expected to be added through 2021. The program provides charging equipment, installation, and maintenance to business customers, government agencies, and multifamily housing communities. In addition to the Level 2 charging stations, APS will begin construction of direct current fast charging stations that will be owned and operated by APS at five locations in Arizona. This project is projected to be completed by the end of 2021 with each location including 2-150 kilowatt and 2-350 kilowatt DC fast charging stations. These stations will be accessible through the Electrify America charging network. The ACC ordered the state’s public service corporations, including APS, to develop a long-term, comprehensive Statewide Transportation Electrification Plan (“TE Plan”) for Arizona. The TE Plan is intended to provide a roadmap for Transportation Electrification in Arizona, focused on realizing the associated air quality and economic development benefits for all residents in the state along with understanding the impact of electric vehicle charging on the grid. APS is actively participating in this process, which is scheduled to be completed by March 2021 and submitted to the ACC for review and approval.Hydrogen Production Palo Verde, in partnership with Idaho National Laboratory and two other utilities, has been chosen by the DOE’s Office of Nuclear Energy to participate in a hydrogen production project with the goal to improve the long-term economic competitiveness of the nuclear power industry. The multi-phase project is planned for 2020 through 2023. In the first phase, Idaho National Laboratory will perform a technical and economic assessment of using electricity generated at Palo Verde to produce hydrogen. Experience from Palo Verde’s utility partners’ demonstration projects and from the Palo Verde-specific technical economic assessment is expected to offer insights into methods for flexible transitions between electricity and hydrogen generation in solar-dominated electricity markets.Carbon CaptureCarbon capture technologies can isolate CO2 and either sequester it permanently in geologic formations or convert it for use in products. Currently, almost all existing fossil fuel generators do not control carbon emissions the way they control emissions of other air pollutants such as sulfur dioxide or oxides of nitrogen. Carbon capture technologies are still in the demonstration phase and while they show promise, they are still being tested in real-world conditions. These technologies could offer the potential to keep in operation existing generators that otherwise would need to be retired. APS will continue to monitor this emerging technology.Regulatory OverviewOn October 31, 2019, APS filed an application with the ACC seeking an annual increase in retail base rates of $69 million. This amount includes recovery of the deferral and rate base effects of the Four Corners SCR project that is currently the subject of a separate proceeding (see “SCR Cost Recovery” in Note 4). It also reflects a net credit to base rates of approximately $115 million primarily due to the prospective inclusion of rate refunds currently provided through the TEAM. The proposed total annual 60Table of Contents revenue increase in APS’s application is $184 million. The average annual customer bill impact of APS’s request is an increase of 5.6% (the average annual bill impact for a typical APS residential customer is 5.4%).The principal provisions of APS’s application were:•a test year comprised of twelve months ended June 30, 2019, adjusted as described below;•an original cost rate base of $8.87 billion, which approximates the ACC-jurisdictional portion of the book value of utility assets, net of accumulated depreciation and other credits;•the following proposed capital structure and costs of capital: Capital Structure Cost of Capital Long-term debt 45.3 %4.1%Common stock equity 54.7 %10.15 %Weighted-average cost of capital 7.41 % •a 1% return on the increment of fair value rate base above APS’s original cost rate base, as provided for by Arizona law;•a Base Fuel Rate of $0.030168 per kWh;•authorization to defer until APS’s next general rate case the increase or decrease in its Arizona property taxes attributable to tax rate changes after the date the rate application is adjudicated;•a number of proposed rate and program changes for residential customers, including:▪a super off-peak period during the winter months for APS’s time-of-use with demand rates;▪additional $1.25 million in funding for APS’s limited-income crisis bill program; and▪a flat bill/subscription rate pilot program; •proposed rate design changes for commercial customers, including an experimental program designed to provide access to market pricing for up to 200 MW of medium and large commercial customers;•recovery of the deferral and rate base effects of the construction and operating costs of the Ocotillo modernization project (see Note 4 discussion of the 2017 Settlement Agreement); and•continued recovery of the remaining investment and other costs related to the retirement and closure of the Navajo Plant (see Note 4 for details related to the resulting regulatory asset).APS requested that the increase become effective December 1, 2020. On October 2, 2020, the ACC Staff, the Residential Utility Consumer Office (“RUCO”) and other intervenors filed their initial written testimony with the ACC in this rate case. The ACC Staff recommends, among other things, a (i) $89.7 million revenue increase, (ii) average annual customer bill increase of 2.7%, (iii) return on equity of 9.4%, (iv) a 0.3% or, as an alternative, a 0% return on the increment of fair value rate base greater than original cost, (v) recovery of the deferral and rate base effects of the construction and operating costs of the Four Corners SCR project and (vi) recovery of the rate base effects of the construction and ongoing consideration of the deferral of the Ocotillo modernization project. RUCO recommends, among other things, a (i) $20.8 million revenue decrease, (ii) average annual customer bill decrease of 0.63%, (iii) return on equity of 8.74%, (iv) a 0% return on the increment of fair value rate base, (v) nonrecovery of the deferral and rate base effects of the construction and operating costs of the Four Corners SCR project pending further consideration, and (vi) recovery of the deferral and rate base effects of the construction and operating costs of the Ocotillo modernization project.61Table of Contents The filed ACC Staff and intervenor testimony include additional recommendations, some of which materially differ from APS’s filed application. On November 6, 2020, APS filed its rebuttal testimony and the principal provisions which differ from its initial application include, among other things, a (i) $169 million revenue increase, (ii) average annual bill increase of 5.14%, (iii) return on equity of 10%, (iv) return on the increment of fair value rate base of 0.8%, (v) new cost recovery adjustor mechanism, the Advanced Energy Mechanism (“AEM”), to enable more timely recovery of clean investments as APS pursues its clean energy commitment, (vi) recognition that securitization is a potentially useful financing tool to recover the remaining book value of retiring assets and effectuate a transition to a cleaner energy future that APS intends to pursue, provided legislative hurdles are addressed, and (vii) the CCT plan related to the closure or future closure of coal-fired generation facilities of which $25 million would be funds that are not recoverable through rates with a proposal that the remainder be funded by customers over 10 years. The CCT plan includes the following proposed components: (i) $100 million that will be paid over 10 years to the Navajo Nation for a sustainable transition to a post-coal economy, which would be funded by customers, (ii) $1.25 million that will be paid over five years to the Navajo Nation to fund an economic development organization, which would be funds not recoverable through rates, (iii) $10 million to facilitate electrification projects within the Navajo Nation, which would be funded equally by funds not recoverable through rates and by customers, (iv) $2.5 million per year in transmission revenue sharing to be paid to the Navajo Nation beginning after the closure of the Four Corners Power Plant through 2038, which would be funds not recoverable through rates, (v) $12 million that will be paid over five years to the Navajo County Communities surrounding Cholla Power Plant, which would primarily be funded by customers, and (vi) $3.7 million that will be paid over five years to the Hopi Tribe related to APS’s ownership interests in the Navajo Generating Station, which would primarily be funded by customers.The hearing began January 14, 2021. Unfavorable ACC Staff and intervenor positions and recommendations could have a material impact on APS’s financial statements if ultimately adopted by the ACC. APS cannot predict the outcome of this proceeding. See Note 4 for information regarding additional regulatory matters.Arizona Attorney General MatterAPS received civil investigative demands from the Office of the Arizona Attorney General, Civil Litigation Division, Consumer Protection & Advocacy Section (“Attorney General”) seeking information pertaining to the rate plan comparison tool offered to APS customers and other related issues including implementation of rates from the 2017 Settlement Agreement and its Customer Education and Outreach Plan associated with the 2017 Settlement Agreement. APS fully cooperated with the Attorney General’s Office in this matter. On February 22, 2021 APS entered into a consent agreement with the Attorney General as a way to settle the matter. The settlement results in APS paying $24.75 million, $24 million of which is being returned to customers as restitution. While this matter has been resolved with the Attorney General, APS cannot predict whether additional inquiries or actions may be taken by the ACC. Financial Strength and FlexibilityPinnacle West and APS currently have ample borrowing capacity under their respective credit facilities, and may readily access these facilities ensuring adequate liquidity for each company. Capital 62Table of Contents expenditures will be funded with internally generated cash and external financings, which may include issuances of long-term debt and Pinnacle West common stock.Other SubsidiariesBright Canyon Energy. On July 31, 2014, Pinnacle West announced its creation of a wholly-owned subsidiary, BCE. BCE’s strategy is to develop, own, operate and acquire energy infrastructure in a manner that leverages the Company’s core expertise in the electric energy industry. In 2014, BCE formed a 50/50 joint venture with BHE U.S. Transmission LLC, a subsidiary of Berkshire Hathaway Energy Company. The joint venture, named TransCanyon, is pursuing independent electric transmission opportunities within the 11 states that comprise the Western Electricity Coordinating Council, excluding opportunities related to transmission service that would otherwise be provided under the tariffs of the retail service territories of the venture partners’ utility affiliates.On December 20, 2019, BCE acquired minority ownership positions in two wind farms under development by Tenaska Energy, Inc. and Tenaska Energy Holdings, LLC, the 242 MW Clear Creek wind farm in Missouri (“Clear Creek”) and the 250 MW Nobles 2 wind farm in Minnesota (“Nobles 2”). Clear Creek achieved commercial operation in May 2020 and Nobles 2 achieved commercial operation in December 2020. Both wind farms deliver power under long-term power purchase agreements. BCE indirectly owns 9.9% of Clear Creek and 5.1% of Nobles 2.El Dorado. El Dorado is a wholly-owned subsidiary of Pinnacle West. El Dorado owns debt investments and minority interests in several energy-related investments and Arizona community-based ventures. El Dorado committed to a $25 million investment in the Energy Impact Partners fund, which is an organization that focuses on fostering innovation and supporting the transformation of the utility industry. The investment will be made by El Dorado as investments are selected by the Energy Impact Partners fund.Key Financial Drivers In addition to the continuing impact of the matters described above, many factors influence our financial results and our future financial outlook, including those listed below. We closely monitor these factors to plan for the Company’s current needs, and to adjust our expectations, financial budgets and forecasts appropriately. Electric Operating Revenues. For the years 2018 through 2020, retail electric revenues comprised approximately 95% of our total operating revenues. Our electric operating revenues are affected by customer growth or decline, variations in weather from period to period, customer mix, average usage per customer and the impacts of energy efficiency programs, distributed energy additions, electricity rates and tariffs, the recovery of PSA deferrals and the operation of other recovery mechanisms. These revenue transactions are affected by the availability of excess generation or other energy resources and wholesale market conditions, including competition, demand and prices. Actual and Projected Customer and Sales Growth. Retail customers in APS’s service territory increased 2.3% for the year ended December 31, 2020 compared with the prior-year period. For the three years 2018 through 2020, APS’s customer growth averaged 2.0% per year. We currently project annual customer growth to be 1.5% to 2.5% for 2021 and for 2021 through 2023 based on our assessment of steady population growth in Arizona.63Table of Contents Retail electricity sales in kWh, adjusted to exclude the effects of weather variations, increased 1.4% for the year ended December 31, 2020 compared with the prior-year period. While steady customer growth was offset by energy savings driven by customer conservation, energy efficiency, and distributed renewable generation initiatives, the main drivers of positive sales for this period were continued strong residential sales due to work-from-home policies and a gradual improvement in sales to commercial and industrial customers. Though the total expected impact of COVID-19 on future sales is currently unknown, APS has experienced higher electric residential sales and lower electric commercial and industrial sales since the outset of the pandemic. From March 13, 2020 through December 31, 2020, the cumulative impact on weather-normalized usage was approximately a 1% increase. During that period, APS’s retail electric residential weather-normalized sales increased 5%, and its retail electric commercial and industrial weather-normalized sales decreased 4% in the aggregate. APS expects the reduction in electric demand from commercial and industrial customers and increased demand from residential customers to normalize somewhat into 2021 as business activity continues to recover and more people return to work.For the three years 2018 through 2020, annual retail electricity sales were about flat, adjusted to exclude the effects of weather variations. We currently project that annual retail electricity sales in kWh will increase in the range of 0.5% to 1.5% for 2021 and increase on average in the range of 1.0% to 2.0% during 2021 through 2023, including the effects of customer conservation, energy efficiency and distributed renewable generation initiatives, but excluding the effects of weather variations. This projected sales growth range now includes our estimated contributions of several large data centers, but not all, and we will continue to estimate contributions and evaluate sales guidance as these customers develop more usage history. These estimates could be further impacted by slower than expected growth of the Arizona economy, slower than expected ramp-up of the new data centers, or acceleration of the expected effects of customer conservation, energy efficiency, distributed renewable generation initiatives.Consistent with our focus on continuously looking for improvement in our processes and procedures, we updated our weather normalization methodology in 2020 to better leverage available AMI data (smart meter data). While the prior method only used one to two months of daily usage data to estimate weather impacts, the new method utilizes a rolling four-year period of daily usage data, which improves the accuracy of estimated weather impacts on energy sales since many more data points are used for each calculation. Our 1.4% weather normalized sales growth for the year ended December 31, 2020 reflects this change in methodology. The impact to our 2018-2020 average normalized sales growth from this change in methodology is 0.2%. Actual sales growth, excluding weather-related variations, may differ from our projections as a result of numerous factors, such as economic conditions, customer growth, usage patterns and energy conservation, ramp-up of data centers, impacts of energy efficiency programs and growth in distributed generation, and responses to retail price changes. Based on past experience, a 1% variation in our annual kWh sales projections attributable to such economic factors under normal business conditions can result in increases or decreases in annual net income of approximately $20 million. Weather. In forecasting the retail sales growth numbers provided above, we assume normal weather patterns based on historical data. Historically, extreme weather variations have resulted in annual variations in net income in excess of $25 million. However, our experience indicates that the more typical variations from normal weather can result in increases or decreases in annual net income of up to $15 million. 64Table of Contents Fuel and Purchased Power Costs. Fuel and purchased power costs included on our Consolidated Statements of Income are impacted by our electricity sales volumes, existing contracts for purchased power and generation fuel, our power plant performance, transmission availability or constraints, prevailing market prices, new generating plants being placed in service in our market areas, changes in our generation resource allocation, our hedging program for managing such costs and PSA deferrals and the related amortization.Operations and Maintenance Expenses. Operations and maintenance expenses are impacted by customer and sales growth, power plant operations, maintenance of utility plant (including generation, transmission, and distribution facilities), inflation, unplanned outages, planned outages (typically scheduled in the spring and fall), renewable energy and demand side management related expenses (which are offset by the same amount of operating revenues) and other factors. Depreciation and Amortization Expenses. Depreciation and amortization expenses are impacted by net additions to utility plant and other property (such as new generation, transmission, and distribution facilities), and changes in depreciation and amortization rates. See “Liquidity and Capital Resources” below for information regarding the planned additions to our facilities. Pension and Other Postretirement Non-Service Credits, Net. Pension and other postretirement non-service credits can be impacted by changes in our actuarial assumptions. The most relevant actuarial assumptions are the discount rate used to measure our net periodic costs/credit, the expected long-term rate of return on plan assets used to estimate earnings on invested funds over the long-term, the mortality assumptions and the assumed healthcare cost trend rates. We review these assumptions on an annual basis and adjust them as necessary. Property Taxes. Taxes other than income taxes consist primarily of property taxes, which are affected by the value of property in-service and under construction, assessment ratios, and tax rates. The average property tax rate in Arizona for APS, which owns essentially all of our property, was 10.8% of the assessed value for 2020, 10.9% for 2019 and 11.0% for 2018. We expect property taxes to increase as we add new generating units and continue with improvements and expansions to our existing generating units and transmission and distribution facilities. Income Taxes. Income taxes are affected by the amount of pretax book income, income tax rates, certain deductions and non-taxable items, such as AFUDC. In addition, income taxes may also be affected by the settlement of issues with taxing authorities. On December 22, 2017, the Tax Cuts and Jobs Act (the “Tax Act”) was enacted and was generally effective on January 1, 2018. Changes impacting the Company include a reduction in the corporate tax rate to 21%, revisions to the rules related to tax bonus depreciation, limitations on interest deductibility and an associated exception for certain public utilities, and requirements that certain excess deferred tax amounts of regulated utilities be normalized. (See Note 5 for details of the impacts on the Company as of December 31, 2020.) In APS’s 2017 Rate Case Decision, the ACC approved the TEAM, which is being used to pass through the income tax effects to retail customers of the Tax Act. (See Note 4 for details of the TEAM.) 65Table of Contents Interest Expense. Interest expense is affected by the amount of debt outstanding and the interest rates on that debt (see Note 7). The primary factors affecting borrowing levels are expected to be our capital expenditures, long-term debt maturities, equity issuances and internally generated cash flow. An allowance for borrowed funds used during construction offsets a portion of interest expense while capital projects are under construction. We stop accruing AFUDC on a project when it is placed in commercial operation.RESULTS OF OPERATIONS Pinnacle West’s only reportable business segment is our regulated electricity segment, which consists of traditional regulated retail and wholesale electricity businesses (primarily sales supplied under traditional cost-based rate regulation) and related activities and includes electricity generation, transmission and distribution. Operating Results – 2020 compared with 2019Our consolidated net income attributable to common shareholders for the year ended December 31, 2020 was $551 million, compared with $538 million for the prior year. The results reflect an increase of approximately $13 million for the regulated electricity segment primarily due to higher revenue driven by the effects of weather and lower refunds in the current year related to the Tax Act, higher pension and other postretirement non-service credits and higher revenue from customer growth, partially offset by higher income taxes, including lower amortization of excess deferred taxes, higher depreciation and amortization expense, and higher other expenses. Weather had a significant impact on our result of operations due to the hotter than normal weather in 2020 compared to 2019.The following table presents net income attributable to common shareholders by business segment compared with the prior year: Year EndedDecember 31, 20202019Net change (dollars in millions)Regulated Electricity Segment: Operating revenues less fuel and purchased power expenses$2,589 $2,425 $164 Operations and maintenance(953)(939)(14)Depreciation and amortization(614)(591)(23)Taxes other than income taxes(225)(219)(6)Pension and other postretirement non-service credits — net56 23 33 All other income and expenses, net26 61 (35)Interest charges, net of allowance for borrowed funds used during construction(229)(217)(12)Income taxes (Note 5)(78)16 (94)Less income related to noncontrolling interests (Note 18)(19)(19)— Regulated electricity segment income553 540 13 All other(2)(2)— Net Income Attributable to Common Shareholders$551 $538 $13 66Table of Contents Operating revenues less fuel and purchased power expenses. Regulated electricity segment operating revenues less fuel and purchased power expenses were $164 million higher for the year ended December 31, 2020 compared with the prior year. The following table summarizes the major components of this change: Increase (Decrease) OperatingrevenuesFuel andpurchasedpower expensesNet change(dollars in millions)Effects of weather$165 $40 $125 Lower refunds in the current year related to the Tax Act (Note 4)85 — 85 Changes in net fuel and purchased power costs, including off-system sales margins and related deferrals(78)(85)7 Lost fixed cost recovery7 — 7 Lower renewable energy regulatory surcharges, offset by operations and maintenance costs(9)— (9)Lower retail revenue due to the impacts of energy efficiency, distributed generation and changes in customer usage patterns, partially offset by higher customer growth(4)6 (10)Lower transmission revenues (Note 4)(17)— (17)Arizona Attorney General Matter (Note 11)(24)— (24)Miscellaneous items, net(10)(10)— Total$115 $(49)$164 Operations and maintenance. Operations and maintenance expenses increased $14 million for the year ended December 31, 2020 compared with the prior-year period primarily because of: •An increase of $25 million primarily related to COVID Customer Support Fund, personal protective equipment and other health and safety-related costs for COVID-19 response (see Note 4);•An increase of $22 million related to employee benefits;•An increase of $12 million related to customer bad debt expenses for the Summer Disconnection Moratorium and COVID-19 disconnect suspensions (see Note 4);•An increase of $11 million for costs related to information technology;•A decrease of $21 million in nuclear generation costs primarily related to an increased recovery from contributions of administrative and general costs from Palo Verde owners;•A decrease of $14 million related to consulting costs; •A decrease of $13 million primarily related to costs for renewable energy and similar regulatory programs, which are partially offset in operating revenues and purchased power;•A decrease of $6 million for customer outreach costs; and•A decrease of $2 million for corporate resources and other miscellaneous factors.67Table of Contents Depreciation and amortization. Depreciation and amortization expenses were $23 million higher for the year ended December 31, 2020 compared with the prior-year period primarily due to increased plant in service of $37 million, partially offset by the regulatory deferrals for the Ocotillo modernization project and the Four Corners SCR project of $17 million. Taxes other than income taxes. Taxes other than income taxes were $6 million higher for the year ended December 31, 2020 compared with the prior-year period primarily due to higher property values.Pension and other postretirement non-service credits, net. Pension and other postretirement non-service credits, net were $33 million higher for the year ended December 31, 2020 compared to the prior-year period, primarily due to higher market returns in 2019.All other income and expenses, net. All other income and expenses, net were $35 million lower for the year ended December 31, 2020 compared to the prior-year period primarily due to the current year CCT and APS Foundation contributions.Interest charges, net of allowance for borrowed funds used during construction. Interest charges, net of allowance for borrowed funds used during construction were $12 million higher for the year ended December 31, 2020 compared to the prior-year period primarily due to higher debt balances in the current period.Income taxes. Income taxes were $94 million higher for the year ended December 31, 2020 compared with the prior-year period primarily due to higher pre-tax net income and lower amortization of excess deferred taxes, partially offset by higher tax credits.LIQUIDITY AND CAPITAL RESOURCES Overview Pinnacle West’s primary cash needs are for dividends to our shareholders and principal and interest payments on our indebtedness. The level of our common stock dividends and future dividend growth will be dependent on declaration by our Board of Directors and based on a number of factors, including our financial condition, payout ratio, free cash flow and other factors. Our primary sources of cash are dividends from APS and external debt and equity issuances. An ACC order requires APS to maintain a common equity ratio of at least 40%. As defined in the related ACC order, the common equity ratio is defined as total shareholder equity divided by the sum of total shareholder equity and long-term debt, including current maturities of long-term debt. At December 31, 2020, APS’s common equity ratio, as defined, was 51%. Its total shareholder equity was approximately $6.2 billion, and total capitalization was approximately $12.2 billion. Under this order, APS would be prohibited from paying dividends if such payment would reduce its total shareholder equity below approximately $4.9 billion, assuming APS’s total capitalization remains the same. This restriction does not materially affect Pinnacle West’s ability to meet its ongoing cash needs or ability to pay dividends to shareholders. APS’s capital requirements consist primarily of capital expenditures and maturities of long-term debt. APS funds its capital requirements with cash from operations and, to the extent necessary, external debt financings and equity infusions from Pinnacle West.68Table of Contents Summary of Cash Flows The following tables present net cash provided by (used for) operating, investing and financing activities for the years ended December 31, 2020 and 2019 (dollars in millions):Pinnacle West Consolidated 20202019Net cash flow provided by operating activities$967 $957 Net cash flow used for investing activities(1,278)(1,131)Net cash flow provided by financing activities361 179 Net increase in cash and cash equivalents$50 $5 Arizona Public Service Company 20202019Net cash flow provided by operating activities$929 $1,007 Net cash flow used for investing activities(1,286)(1,136)Net cash flow provided by financing activities404 133 Net increase in cash and cash equivalents$47 $4 Operating Cash Flows 2020 Compared with 2019. Pinnacle West’s consolidated net cash provided by operating activities was $967 million in 2020 compared to $957 million in 2019. The increase of $10 million in net cash provided is primarily due to higher cash receipts from electric revenues, lower payments for operations and maintenance, lower pension contributions, lower customer advances for construction, lower income tax payments and lower other taxes, partially offset by higher fuel and purchased power costs. The difference between APS and Pinnacle West’s net cash provided by operating activities primarily relates to APS’s income tax cash payments to Pinnacle West.Retirement plans and other postretirement benefits. Pinnacle West sponsors a qualified defined benefit pension plan and a non-qualified supplemental excess benefit retirement plan for the employees of Pinnacle West and our subsidiaries. The requirements of the Employee Retirement Income Security Act of 1974 (“ERISA”) require us to contribute a minimum amount to the qualified plan. We contribute at least the minimum amount required under ERISA regulations, but no more than the maximum tax-deductible amount. The minimum required funding takes into consideration the value of plan assets and our pension benefit obligations. Under ERISA, the qualified pension plan was 124% funded as of January 1, 2021 and 117% as of January 1, 2020. Under accounting principles generally accepted in the United States of America ("GAAP"), the qualified pension plan was 104% funded as of January 1, 2021 and 97% funded as of January 1, 2020. (See Note 8 for additional details). The assets in the plan are comprised of fixed-income, equity, real estate, and short-term investments. Future year contribution amounts are dependent on plan asset performance and plan actuarial assumptions. We made contributions to our pension plan totaling $100 million in 2020, $150 million in 2019, and $50 million in 2018. The minimum required contributions for the pension plan are zero for the next three years. We expect to make voluntary contributions up to $100 million in 2021 and zero thereafter. With regard to contributions to our other postretirement benefit plan, we did not make a contribution in 2020 and 2019. We do not expect to make 69Table of Contents any contributions over the next three years to our other postretirement benefit plans. The Company was reimbursed $26 million in 2020, $30 million in 2019, and $72 million in 2018 for prior years retiree medical claims from the other postretirement benefit plan trust assets.The Coronavirus Aid, Relief, and Economic Security (CARES) Act allows employers to defer payments of the employer share of Social Security payroll taxes that would have otherwise been owed from March 27, 2020 through December 31, 2020. We deferred the cash payment of the employer’s portion of Social Security payroll taxes for the period July 1, 2020 through December 31, 2020 that was approximately $18 million. We will pay half of this cash deferral by December 31, 2021 and the remainder by December 31, 2022.Investing Cash Flows2020 Compared with 2019. Pinnacle West’s consolidated net cash used for investing activities was $1,278 million in 2020 compared to $1,131 million in 2019. The increase of $147 million in net cash used primarily related to increased capital expenditures.Capital Expenditures. The following table summarizes the estimated capital expenditures for the next three years: Capital Expenditures(dollars in millions)Estimated for the Year EndedDecember 31, 202120222023APSGeneration:Clean:Nuclear Generation$114 $116 $125 Renewables and Energy Storage Systems (“ESS”) (a)200 276 281 Other Generation (b)203 190 187 Distribution577 556 549 Transmission185 181 179 Other (c)221 181 179 Total APS$1,500 $1,500 $1,500 (a)APS Solar Communities program, energy storage, renewable projects and other clean energy projects(b)Includes generation environmental projects(c)Primarily information systems and facilities projects Generation capital expenditures are comprised of various additions and improvements to APS’s clean resources, including nuclear plants, renewables and ESS. Generation capital expenditures also include improvements to existing fossil plants. Examples of the types of projects included in the forecast of generation capital expenditures are additions of renewables and energy storage, and upgrades and capital replacements of various nuclear and fossil power plant equipment, such as turbines, boilers and 70Table of Contents environmental equipment. We are monitoring the status of environmental matters, which, depending on their final outcome, could require modification to our planned environmental expenditures.Distribution and transmission capital expenditures are comprised of infrastructure additions and upgrades, capital replacements, and new customer construction. Examples of the types of projects included in the forecast include power lines, substations, and line extensions to new residential and commercial developments.Capital expenditures will be funded with internally generated cash and external financings, which may include issuances of long-term debt and Pinnacle West common stock. Financing Cash Flows and Liquidity 2020 Compared with 2019. Pinnacle West’s consolidated net cash provided by financing activities was $361 million in 2020 compared to $179 million of net cash provided in 2019, an increase of $182 million in net cash provided. The increase in net cash provided by financing activities includes $504 million in higher issuances of long-term debt partially offset by higher long-term debt repayments of $315 million, a net increase in short term borrowings of $16 million and higher dividend payments of $21 million.APS’s consolidated net cash provided by financing activities was $404 million in 2020 compared to $133 million of net cash provided in 2019, an increase of $271 million in net cash provided. The increase in net cash provided by financing activities includes lower long-term debt repayments of $135 million and $8 million in higher issuances of long-term debt, higher equity infusion of $150 million and higher dividend payments of $21 million.Significant Financing Activities. On December 16, 2020, the Pinnacle West Board of Directors declared a dividend of $0.83 per share of common stock, payable on March 1, 2021 to shareholders of record on February 1, 2021. During 2020, Pinnacle West increased its indicated annual dividend from $3.13 per share to $3.32 per share. For the year ended December 31, 2020, Pinnacle West’s total dividends paid per share of common stock were $3.18 per share, which resulted in dividend payments of $351 million.On January 15, 2020, APS repaid at maturity the remaining $150 million of the $250 million aggregate principal amount of its 2.2% senior notes. On May 22, 2020, APS issued $600 million of 3.35% unsecured senior notes that mature May 15, 2050. The net proceeds from the sale were used to repay early its $200 million term loan facility and to repay short-term indebtedness, consisting of commercial paper and revolver borrowings, and to replenish cash used to fund capital expenditures.On June 17, 2020, Pinnacle West issued $500 million of 1.3% unsecured senior notes that mature June 15, 2025. The net proceeds from the sale were used to repay early its $150 million term loan facility set to mature on December 21, 2020, to repay short-term indebtedness consisting of commercial paper and replenish cash incurred or used to fund capital expenditures, to redeem prior to maturity our $300 million, 2.25% senior notes due November 30, 2020, and for general corporate purposes. 71Table of Contents On September 11, 2020, APS issued $400 million of 2.65% unsecured senior notes that mature September 15, 2050. The net proceeds from the sale will be used to replenish cash used for previous eligible green expenditures and fund future eligible green expenditures.On November 19, 2020, APS reopened its $300 million, 2.6% unsecured senior notes that mature on August 15, 2029, and issued an additional $105 million of 2.6% unsecured senior notes. The aggregate balance of $405 million will mature on August 15, 2029. The net proceeds from the sale, together with funds made available from other sources, were used to redeem, prior to maturity, no later than 20 days after the date that the new notes were issued, (i) the $49.4 million outstanding principal amount of 4.7% City of Farmington, New Mexico Pollution Control Revenue Refunding Bonds (Arizona Public Service Company Four Corners Project), 1994 Series A, and (ii) the $65.75 million outstanding principal amount of 4.7% City of Farmington, New Mexico Pollution Control Revenue Refunding Bonds (Arizona Public Service Company Four Corners Project), 1994 Series B.On December 23, 2020, Pinnacle West entered into a $150 million term loan facility that matures June 2022. The proceeds were received on January 4, 2021 and used for general corporate purposes. We recognized the term loan facility as long-term debt upon settlement on January 4, 2021. On December 28, 2020, Pinnacle West contributed $150 million into APS in the form of an equityinfusion. APS used this contribution to repay short-term indebtedness.Available Credit Facilities. Pinnacle West and APS maintain committed revolving credit facilities in order to enhance liquidity and provide credit support for their commercial paper. On May 5, 2020, Pinnacle West refinanced its 364-day $50 million term loan agreement that would have matured on May 7, 2020 with a new 364-day $31 million term loan agreement that matures May 4, 2021. Borrowings under the agreement bear interest at Eurodollar Rate plus 1.40% per annum. At December 31, 2020, Pinnacle West had $19 million in outstanding borrowings under the agreement.At December 31, 2020, Pinnacle West had a $200 million revolving credit facility that matures in July 2023. Pinnacle West has the option to increase the amount of the facility up to a maximum of $300 million upon the satisfaction of certain conditions and with the consent of the lenders. Interest rates are based on Pinnacle West’s senior unsecured debt credit ratings. The facility is available to support Pinnacle West’s $200 million commercial paper program, for bank borrowings or for issuances of letters of credits. At December 31, 2020, Pinnacle West had no outstanding borrowings under its credit facility, no letters of credit outstanding and $150 million of commercial paper borrowings.At December 31, 2020, APS had two revolving credit facilities totaling $1 billion, including a $500 million credit facility that matures in June 2022 and a $500 million facility that matures in July 2023. APS may increase the amount of each facility up to a maximum of $700 million, for a total of $1.4 billion, upon the satisfaction of certain conditions and with the consent of the lenders. Interest rates are based on APS’s senior unsecured debt credit ratings. These facilities are available to support APS’s $500 million commercial paper program, for bank borrowings or for issuances of letters of credit. At December 31, 2020, APS had no outstanding borrowings under its revolving credit facilities, no letters of credit outstanding and no commercial paper borrowings. See “Financial Assurances” in Note 11 for a discussion of APS’s other outstanding letters of credit.Other Financing Matters. See Note 16 for information related to the change in our margin and collateral accounts.72Table of Contents Debt Provisions Pinnacle West’s and APS’s debt covenants related to their respective bank financing arrangements include maximum debt to capitalization ratios. Pinnacle West and APS comply with these covenants. For both Pinnacle West and APS, these covenants require that the ratio of consolidated debt to total consolidated capitalization not exceed 65%. At December 31, 2020, the ratio was approximately 54% for Pinnacle West and 49% for APS. Failure to comply with such covenant levels would result in an event of default which, generally speaking, would require the immediate repayment of the debt subject to the covenants and could “cross-default” other debt. See further discussion of “cross-default” provisions below. Neither Pinnacle West’s nor APS’s financing agreements contain “rating triggers” that would result in an acceleration of the required interest and principal payments in the event of a rating downgrade. However, our bank credit agreements contain a pricing grid in which the interest rates we pay for borrowings thereunder are determined by our current credit ratings. All of Pinnacle West’s loan agreements contain “cross-default” provisions that would result in defaults and the potential acceleration of payment under these loan agreements if Pinnacle West or APS were to default under certain other material agreements. All of APS’s bank agreements contain “cross-default” provisions that would result in defaults and the potential acceleration of payment under these bank agreements if APS were to default under certain other material agreements. Pinnacle West and APS do not have a material adverse change restriction for credit facility borrowings.See Note 7 for further discussions of liquidity matters. 73Table of Contents Credit RatingsThe ratings of securities of Pinnacle West and APS as of February 23, 2021 are shown below. We are disclosing these credit ratings to enhance understanding of our cost of short-term and long-term capital and our ability to access the markets for liquidity and long-term debt. The ratings reflect the respective views of the rating agencies, from which an explanation of the significance of their ratings may be obtained. There is no assurance that these ratings will continue for any given period of time. The ratings may be revised or withdrawn entirely by the rating agencies if, in their respective judgments, circumstances so warrant. Any downward revision or withdrawal may adversely affect the market price of Pinnacle West’s or APS’s securities and/or result in an increase in the cost of, or limit access to, capital. Such revisions may also result in substantial additional cash or other collateral requirements related to certain derivative instruments, insurance policies, natural gas transportation, fuel supply, and other energy-related contracts. At this time, we believe we have sufficient available liquidity resources to respond to a downward revision to our credit ratings. Moody’s Standard & Poor’s FitchPinnacle West Corporate credit ratingA3 A- A-Senior unsecuredA3 BBB+ A-Commercial paperP-2 A-2 F2OutlookNegative Stable Negative APS Corporate credit ratingA2 A- A-Senior unsecuredA2 A- ACommercial paperP-1 A-2 F2OutlookNegative Stable NegativeOff-Balance Sheet Arrangements See Note 18 for a discussion of the impacts on our financial statements of consolidating certain VIEs. 74Table of Contents Contractual Obligations The following table summarizes Pinnacle West’s consolidated contractual requirements as of December 31, 2020 (dollars in millions): 20212022-20232024-2025ThereafterTotalLong-term debt payments, including interest: (a) APS$227 $452 $985 $8,796 $10,460 Pinnacle West7 14 510 — 531 Total long-term debt payments, including interest234 466 1,495 8,796 10,991 Short-term debt payments, including interest (b)169 — — — 169 Fuel and purchased power commitments (c)657 1,243 1,134 5,264 8,298 Renewable energy credits (d)35 61 53 105 254 Purchase obligations (e)115 60 22 185 382 Coal reclamation16 35 39 69 159 Nuclear decommissioning funding requirements2 4 4 48 58 Noncontrolling interests (f)23 46 32 127 228 Operating lease payments (g)14 20 11 37 82 Total contractual commitments$1,265 $1,935 $2,790 $14,631 $20,621 (a)The long-term debt matures at various dates through 2050 and bears interest principally at fixed rates. Interest on variable-rate long-term debt is determined by using average rates at December 31, 2020 (see Note 7).(b)See Note 6 for further details. (c)Our fuel and purchased power commitments include purchases of coal, electricity, natural gas, renewable energy, nuclear fuel, and natural gas transportation (see Notes 4 and 11).(d)Contracts to purchase renewable energy credits in compliance with the RES (see Note 4).(e)These contractual obligations include commitments for capital expenditures and other obligations.(f)Payments to the noncontrolling interests relate to the Palo Verde sale leaseback (see Note 18). (g)Commitments relating to purchased power lease contracts are included within the fuel and purchased power commitments line above (see Note 9). This table excludes $46 million in unrecognized tax benefits because the timing of the future cash outflows is uncertain. In January 2021, approximately $391 million of new fuel and purchased power commitments have been executed, primarily relating to periods after 2025 (see Note 9). Estimated minimum required pension contributions are zero for 2021, 2022 and 2023 (see Note 8).CRITICAL ACCOUNTING POLICIES In preparing the financial statements in accordance with GAAP, management must often make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues, expenses and related disclosures at the date of the financial statements and during the reporting period. Some of those 75Table of Contents judgments can be subjective and complex, and actual results could differ from those estimates. We consider the following accounting policies to be our most critical because of the uncertainties, judgments and complexities of the underlying accounting standards and operations involved. Regulatory Accounting Regulatory accounting allows for the actions of regulators, such as the ACC and FERC, to be reflected in our financial statements. Their actions may cause us to capitalize costs that would otherwise be included as an expense in the current period by unregulated companies. Regulatory assets represent incurred costs that have been deferred because they are probable of future recovery in customer rates. Regulatory liabilities generally represent amounts collected in rates to recover costs expected to be incurred in the future or amounts collected in excess of costs incurred and are refundable to customers. Management judgments include continually assessing the likelihood of future recovery of regulatory assets and/or a disallowance of part of the cost of recently completed plant, by considering factors such as applicable regulatory environment changes and recent rate orders to other regulated entities in the same jurisdiction. This determination reflects the current political and regulatory climate in Arizona and is subject to change in the future. If future recovery of costs ceases to be probable, the assets would be written off as a charge in current period earnings, except for pension benefits, which would be charged to OCI and result in lower future earnings. Management judgments also include assessing the impact of potential ACC or FERC Commission-ordered refunds to customers on regulatory liabilities. We had $1,426 million of regulatory assets and $2,679 million of regulatory liabilities on the Consolidated Balance Sheets at December 31, 2020. See Notes 1 and 4 for more information.Pensions and Other Postretirement Benefit Accounting Changes in our actuarial assumptions used in calculating our pension and other postretirement benefit assets, liabilities and expense can have a significant impact on our earnings and financial position. The most relevant actuarial assumptions are the discount rate used to measure our liability and net periodic cost, the expected long-term rate of return on plan assets used to estimate earnings on invested funds over the long-term, the mortality assumptions, and the assumed healthcare cost trend rates. We review these assumptions on an annual basis and adjust them as necessary.The following chart reflects the sensitivities that a change in certain actuarial assumptions would have had on the December 31, 2020 reported pension assets and liability on the Consolidated Balance Sheets and our 2020 reported pension expense, after consideration of amounts capitalized or billed to electric plant participants, on Pinnacle West’s Consolidated Statements of Income (dollars in millions): 76Table of Contents Increase (Decrease)Actuarial Assumption (a)Impact onPensionPlansImpact onPensionExpenseDiscount rate: Increase 1%$(429)$(12)Decrease 1%522 12 Expected long-term rate of return on plan assets:Increase 1%— (23)Decrease 1%— 23 (a)Each fluctuation assumes that the other assumptions of the calculation are held constant while the rates are changed by one percentage point. The following chart reflects the sensitivities that a change in certain actuarial assumptions would have had on the December 31, 2020 other postretirement benefit obligation and our 2020 reported other postretirement benefit expense, after consideration of amounts capitalized or billed to electric plant participants, on Pinnacle West’s Consolidated Statements of Income (dollars in millions): Increase (Decrease)Actuarial Assumption (a)Impact on OtherPostretirement BenefitPlansImpact on OtherPostretirementBenefit ExpenseDiscount rate: Increase 1%$(77)$(1)Decrease 1%98 4 Healthcare cost trend rate (b):Increase 1%86 8 Decrease 1%(70)(4)Expected long-term rate of return on plan assets – pretax:Increase 1%— (5)Decrease 1%— 5 (a)Each fluctuation assumes that the other assumptions of the calculation are held constant while the rates are changed by one percentage point.(b)This assumes a 1% change in the initial and ultimate healthcare cost trend rate. See Note 8 for further details about our pension and other postretirement benefit plans. 77Table of Contents Fair Value Measurements We account for derivative instruments, investments held in our nuclear decommissioning trusts fund, investments held in our other special use funds, certain cash equivalents, and plan assets held in our retirement and other benefit plans at fair value on a recurring basis. Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. We use inputs, or assumptions that market participants would use, to determine fair market value. We utilize valuation techniques that maximize the use of observable inputs and minimize the use of unobservable inputs. The significance of a particular input determines how the instrument is classified in a fair value hierarchy. The determination of fair value sometimes requires subjective and complex judgment. Our assessment of the inputs and the significance of a particular input to fair value measurement may affect the valuation of the instruments and their placement within a fair value hierarchy. Actual results could differ from our estimates of fair value. See Note 1 for a discussion of accounting policies and Note 13 for fair value measurement disclosures.Asset Retirement ObligationsWe recognize an ARO for the future decommissioning or retirement of our tangible long-lived assets for which a legal obligation exists. The ARO liability represents an estimate of the fair value of the current obligation related to decommissioning and the retirement of those assets. ARO measurements inherently involve uncertainty in the amount and timing of settlement of the liability. We use an expected cash flow approach to measure the amount we recognize as an ARO. This approach applies probability weighting to discounted future cash flow scenarios that reflect a range of possible outcomes. The scenarios consider settlement of the ARO at the expiration of the asset’s current license or lease term and expected decommissioning dates. The fair value of an ARO is recognized in the period in which it is incurred. The associated asset retirement costs are capitalized as part of the carrying value of the long-lived asset and are depreciated over the life of the related assets. In addition, we accrete the ARO liability to reflect the passage of time. Changes in these estimates and assumptions could materially affect the amount of the recorded ARO for these assets. In accordance with GAAP accounting, APS accrues removal costs for its regulated utility assets, even if there is no legal obligation for removal. AROs as of December 31, 2020 are described further in Note 12.OTHER ACCOUNTING MATTERSOn January 1, 2020, we adopted ASU 2016-13, and related amendments, pertaining to the measurement of credit losses on financial instruments. In 2020, we also adopted ASU 2018-14, related to defined benefit plan disclosures. (See Note 3 for additional information related to new accounting standards.)MARKET AND CREDIT RISKS Market Risks Our operations include managing market risks related to changes in interest rates, commodity prices and investments held by our nuclear decommissioning trust, other special use funds and benefit plan assets. 78Table of Contents Interest Rate and Equity Risk We have exposure to changing interest rates. Changing interest rates will affect interest paid on variable-rate debt and the market value of fixed income securities held by our nuclear decommissioning trust, other special use funds (see Note 13 and Note 19), and benefit plan assets. The nuclear decommissioning trust, other special use funds and benefit plan assets also have risks associated with the changing market value of their equity and other non-fixed income investments. Nuclear decommissioning and benefit plan costs are recovered in regulated electricity prices.The tables below present contractual balances of our consolidated long-term and short-term debt at the expected maturity dates, as well as the fair value of those instruments on December 31, 2020 and 2019. The interest rates presented in the tables below represent the weighted-average interest rates as of December 31, 2020 and 2019 (dollars in millions): Pinnacle West – Consolidated Short-TermDebtVariable-RateLong-Term DebtFixed-RateLong-Term Debt Interest Interest Interest 2020RatesAmountRatesAmountRatesAmount20210.40 %$169 — $— — $— 2022— — — — — — 2023— — — — — — 2024— — — — 3.35 %250 2025— — — — 1.99 %800 Years thereafter— — 0.18 %36 3.95 %5,280 Total $169 $36 $6,330 Fair value $169 $36 $7,577 Short-TermDebtVariable-RateLong-Term DebtFixed-RateLong-Term Debt Interest Interest Interest 2019RatesAmountRatesAmountRatesAmount20202.06 %$115 2.16 %$350 2.23 %$450 2021— — — — — — 2022— — — — — — 2023— — — — — — 2024— — — — 3.78 %365 Years thereafter— — 1.54 %36 4.12 %4,475 Total $115 $386 $5,290 Fair value $115 $386 $5,808 79Table of Contents The tables below present contractual balances of APS’s long-term and short-term debt at the expected maturity dates, as well as the fair value of those instruments on December 31, 2020 and 2019. The interest rates presented in the tables below represent the weighted-average interest rates as of December 31, 2020 and 2019 (dollars in millions): APS — Consolidated Variable-RateLong-Term DebtFixed-RateLong-Term Debt Interest Interest 2020RatesAmountRatesAmount2021— $— — $— 2022— — — — 2023— — — — 2024— — 3.35 %250 2025— — 3.15 %300 Years thereafter0.18 %36 3.95 %5,280 Total$36 $5,830 Fair value $36 $7,068 Variable-RateLong-Term DebtFixed-RateLong-Term Debt Interest Interest 2019RatesAmountRatesAmount20202.12 %$200 2.20 %$150 2021— — — — 2022— — — — 2023— — — — 2024— — 3.78 %365 Years thereafter1.54 %36 4.12 %4,475 Total$236 $4,990 Fair value $236 $5,508 Commodity Price Risk We are exposed to the impact of market fluctuations in the commodity price and transportation costs of electricity and natural gas. Our risk management committee, consisting of officers and key management personnel, oversees company-wide energy risk management activities to ensure compliance with our stated energy risk management policies. We manage risks associated with these market fluctuations by utilizing various commodity instruments that may qualify as derivatives, including futures, forwards, options and swaps. As part of our risk management program, we use such instruments to hedge purchases and sales of electricity and natural gas. The changes in market value of such contracts have a high correlation to price changes in the hedged commodities.80Table of Contents The following table shows the net pretax changes in mark-to-market of our derivative positions (dollars in millions): December 31, 2020December 31, 2019Mark-to-market of net positions at beginning of year$(71)$(58)Decrease (Increase) in regulatory asset57 (15)Recognized in OCI:Mark-to-market losses realized during the period1 2 Change in valuation techniques— — Mark-to-market of net positions at end of year$(13)$(71)The table below shows the fair value of maturities of our derivative contracts (dollars in millions) at December 31, 2020 by maturities and by the type of valuation that is performed to calculate the fair values, classified in their entirety based on the lowest level of input that is significant to the fair value measurement. (See Note 1, “Derivative Accounting” and “Fair Value Measurements,” for more discussion of our valuation methods.)Source of Fair Value20212022202320242025Total fair valueObservable prices provided by other external sources$(2)$(3)$(5)$(2)$— $(12)Prices based on unobservable inputs(1)— — — — (1)Total by maturity$(3)$(3)$(5)$(2)$— $(13)The table below shows the impact that hypothetical price movements of 10% would have on the market value of our risk management assets and liabilities included on Pinnacle West’s Consolidated Balance Sheets (dollars in millions): December 31, 2020Gain (Loss)December 31, 2019Gain (Loss) Price Up 10%Price Down 10%Price Up 10%Price Down 10%Mark-to-market changes reported in: Regulatory asset (liability) (a) Electricity$4 $(4)$— $— Natural gas49 (49)55 (55)Total$53 $(53)$55 $(55)(a)These contracts are economic hedges of our forecasted purchases of natural gas and electricity. The impact of these hypothetical price movements would substantially offset the impact that these same price movements would have on the physical exposures being hedged. To the extent the amounts are eligible for inclusion in the PSA, the amounts are recorded as either a regulatory asset or liability. 81Table of Contents Credit Risk We are exposed to losses in the event of non-performance or non-payment by counterparties. (See Note 16 for a discussion of our credit valuation adjustment policy.)ITEM 7A. QUANTITATIVE AND QUALITATIVEDISCLOSURES ABOUT MARKET RISK See “Market and Credit Risks” in Item 7 above for a discussion of quantitative and qualitative disclosures about market risks.82Table of Contents
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+ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSIncorporated by reference from Management’s Discussion and Analysis of Financial Condition and Results of Operations in our Annual Report. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK The quantitative and qualitative disclosures about market risk are incorporated by reference from section “IV. Results of Operations – Investments” in our Management’s Discussion and Analysis of Financial Condition and Results of Operations, and the Quantitative Market Risk Disclosures section in our Annual Report.
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+Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations (MD&A),
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+ITEM 7.MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSOverviewWe experienced significant volatility in market conditions during 2020. We ended 2019 and began 2020 in an environment exhibiting strong demand conditions. However, on March 11, 2020, the World Health Organization declared COVID-19 a global pandemic, and the various containment and mitigation measures adopted by governments and institutions globally and in the U.S. began to have a severe economic impact, including causing the U.S. to enter into an economic recession that continues through the date of this report.In response to the COVID-19 pandemic and various state and local orders, we instituted the following actions in March:•Placed restrictions on business travel for our employees;•Closed our sales centers, model homes, and design centers to the general public and shifted to appointment-only interactions with our customers where permitted, following recommended distancing and other health and safety protocols when meeting in person with a customer;•Enhanced our virtual sales tools to give customers the ability to shop for a new home online;•Closed the public gathering spaces of our amenity centers as well as community pools and athletic facilities;•Modified our corporate and division office functions in order to allow all of our employees to work remotely except for essential minimum basic operations which could only be done in an office setting;•Eliminated non-emergency warranty work in our customers’ homes;•Modified much of our customer interactions around the mortgage origination and closing process to be virtual and minimize in-person interactions; and•Modified our construction operations to enforce enhanced safety protocols around social distancing, hygiene, and health screening.The severity of these restrictions and the date we resumed more normal operations have varied by market based on the reduction in restrictions under "shelter in place" orders and improvement in public health conditions. While all of the above-referenced steps were, and some remain, necessary and appropriate in light of the COVID-19 pandemic, they impacted our ability to operate our business in its ordinary and traditional course. However, residential construction and financial services have been designated as essential services in almost all of our markets, which has allowed us to continue operations.As the result of the COVID-19 pandemic, our net new orders declined significantly in late March through April. As the pandemic spread and government and business responses expanded, we focused on protecting our liquidity and closely managing our cash flows, including through the following actions:•Delaying the acquisition of certain land parcels and slowing land development where practical;•Limiting our investment in house construction, including strictly limiting production of new unsold "speculative" homes, and contacting backlog customers to reconfirm status before beginning construction of sold homes;•As a precautionary measure, proactively drawing $700.0 million under the Revolving Credit Facility in March;•Suspending the repurchase of shares under our share repurchase program; and•Reducing headcount and other overhead expenses.However, demand began to stabilize in May and then rebounded sharply in June and has remained strong through the date of this report. This resulted in a 17% increase in net new orders for the full year 2020 over 2019, including a 24% increase in net new orders in the fourth quarter of 2020 over the fourth quarter of 2019. We believe the recovery in demand reflects a number of factors, including historically low mortgage interest rates, a limited supply of new and existing home inventory, an increased appeal for homeownership and single-family living, and a desire among some buyers to exit more densely populated urban centers. In addition to the improved demand, all of our operations are now functioning at effectively full capacity subject to health and safety protocols necessitated by the ongoing pandemic. However, we have experienced periodic disruptions in our supply chain, including the availability of skilled labor as industry demand increases, which have elongated the production cycles in certain markets. We are also facing cost pressures related to labor and materials, especially lumber, although we believe that we will be able to increase pricing to offset the majority of such cost increases.Despite the volatility in 2020, the resurgence of demand resulted in the second highest annual pre-tax income and the highest year-end backlog (as measured in dollars) in our history. These financial results, combined with the favorable outlook, have allowed us to:22•Fully repay the $700.0 million drawn on the Revolving Credit Facility;•Reinstate our share repurchase program, including the repurchase of $75.0 million of shares in the fourth quarter of 2020;•Increase our quarterly dividend by 17% to $0.14 per share in the fourth quarter of 2020;•Announce a tender offer expected to be completed in March 2021 for $300 million of our senior notes scheduled to mature in 2026 and 2027;•Increase our investments in new communities via land acquisition and development expenditures; and•Improve our available liquidity to $3.4 billion, consisting of $2.6 billion of cash and cash equivalents and $750.3 million available under our Revolving Credit Facility as of December 31, 2020.The following tables and related discussion set forth key operating and financial data for our Homebuilding and Financial Services operations as of and for the fiscal years ended December 31, 2020 and 2019. For similar operating and financial data and discussion of our fiscal 2019 results compared to our fiscal 2018 results, refer to Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” under Part II of our annual report on Form 10-K for the fiscal year ended December 31, 2019, which was filed with the SEC on January 30, 2020. The following is a summary of our operating results by line of business ($000's omitted, except per share data): Years Ended December 31, 20202019Income before income taxes:Homebuilding$1,542,057 $1,236,261 Financial Services186,637 103,315 Income before income taxes1,728,694 1,339,576 Income tax expense(321,855)(322,876)Net income$1,406,839 $1,016,700 Per share data - assuming dilution:Net income$5.18 $3.66 •Homebuilding income before income taxes increased 25% in 2020, primarily as the result of higher revenues, improved gross margins, and strong overhead management. Homebuilding results also included a goodwill impairment charge of $20.2 million in 2020 (see Note 1) and net favorable insurance-related adjustments totaling $75.7 million and $26.8 million in 2020 and 2019, respectively (see Note 11).•The increase in Financial Services income in 2020 compared with 2019 was primarily the result of the Homebuilding volume growth, an improved capture rate of homebuyers from our Homebuilding operations, and a low mortgage interest rate environment. Mortgage interest rates continued at or near historically low levels during 2020, which resulted in higher gains from the sale of mortgages in the secondary market. These improvements were partially offset by $26.4 million of mortgage repurchase reserve charges (see Note 11 ).•Our effective tax rate was 18.6% and 24.1% for 2020 and 2019, respectively. The lower effective tax rate in 2020 resulted primarily from the extension of federal energy efficient home credits (see Note 8).23Homebuilding OperationsThe following is a summary of income before income taxes for our Homebuilding operations ($000’s omitted): Years Ended December 31, 2020FY 2020 vs. FY 20192019Home sale revenues$10,579,896 7 %$9,915,705 Land sale and other revenues94,017 50 %62,821 Total Homebuilding revenues10,673,913 7 %9,978,526 Home sale cost of revenues (a)(8,004,823)5 %(7,628,700)Land sale and other cost of revenues (b)(77,626)38 %(56,098)Selling, general, and administrative expenses ("SG&A") (c)(1,011,442)(3)%(1,044,337)Goodwill impairment(20,190)(d)— Other expense, net (e)(17,775)35 %(13,130)Income before income taxes$1,542,057 25 %$1,236,261 Supplemental data:Gross margin from home sales (a)24.3 %120 bps23.1 %SG&A % of home sale revenues (c)9.6 %(90) bps10.5 %Closings (units)24,624 6 %23,232 Average selling price$430 1 %$427 Net new orders:Units29,275 17 %24,977 Dollars$12,837,272 21 %$10,615,363 Cancellation rate14 %14 %Average active communities874 1 %863 Backlog at December 31:Units15,158 44 %10,507 Dollars$6,793,182 50 %$4,535,805 (a)Includes the amortization of capitalized interest; land inventory impairments of $7.0 million and $8.6 million in 2020 and 2019, respectively (see Note 2), and warranty charges of $14.8 million related to a closed-out community in 2019 (see Note 11).(b)Includes net realizable value adjustments on sold or land held for sale of $5.4 million in 2019 (see Note 2).(c)Includes insurance reserve reversals of $93.4 million and $49.4 million in 2020 and 2019, respectively, partially offset by reserves against insurance receivables of $17.8 million and $22.6 million 2020 and 2019, respectively (see Note 11). (d)Percentage not meaningful.(e)See "Other expense, net" for a table summarizing significant items (see Note 1).24Home sale revenuesHome sale revenues for 2020 were higher than 2019 by $664.2 million, or 7%. The increase was attributable to a 6% increase in closings combined with a 1% increase in average selling price. The increase in closings was primarily the result of favorable demand conditions that began in 2019 and continued into the first quarter of 2020, especially among first-time buyers, which provided a large backlog of orders such that production could continue through 2020 despite the disruptions caused by the COVID-19 pandemic. The increased average selling price is reflective of favorable pricing actions related to all customer groups taken starting in the third quarter in response to the significant improvement in demand, partially offset by the increase in the mix of first-time buyer homes, which typically carry a lower sales price. Home sale gross margins Home sale gross margins were 24.3% in 2020, compared with 23.1% in 2019. Our results in 2020 and 2019 include the effect of the aforementioned land inventory impairments totaling $7.0 million and $8.6 million, respectively. Excluding such impairments, gross margins remained strong in both 2020 and 2019 relative to historical levels and reflect a combination of factors, including shifts in community mix and the aforementioned warranty charge of $14.8 million in 2019 related to a closed-out community in the Southeast. The low mortgage interest rate environment combined with limited supply of new and existing housing inventory has contributed to our ability to maintain or increase pricing in the majority of our markets, which has allowed us to effectively manage pressure in house and land costs as well as expand margins. Amortized interest costs in 2020 remained roughly equal in dollar terms with 2019 but declined slightly as a percentage of revenue to 1.7% in 2020 compared with 1.8% in 2019.Land sale and other revenuesWe periodically elect to sell parcels of land to third parties in the event such assets no longer fit into our strategic operating plans or are zoned for commercial or other development. Land sale and other revenues and their related gains or losses vary between periods, depending on the timing of land sales and our strategic operating decisions. Land sales and other revenues contributed income of $16.4 million and $6.7 million in 2020 and 2019, respectively.SG&ASG&A as a percentage of home sale revenues was 9.6% and 10.5% in 2020 and 2019, respectively. The gross dollar amount of our SG&A decreased $32.9 million, or 3%, in 2020 compared with 2019 and reflects net favorable insurance-related adjustments totaling $75.7 million (0.7% of revenues) and $26.8 million (0.3% of revenues) in 2020 and 2019, respectively. These adjustments resulted from favorable insurance reserve adjustments partially offset by reserves against insurance receivables. The lower gross SG&A dollars were partially offset by severance expense of $10.3 million recorded in the second quarter of 2020 related to various overhead actions taken as a result of the COVID-19 pandemic as well as higher incentive compensation expense.Goodwill impairmentAs a result of the significant decline in equity market valuations that occurred during the period between our acquisition of Innovative Construction Group ("ICG") in January 2020 and March 31, 2020, we determined that an event-driven goodwill impairment test was appropriate for the ICG goodwill, which resulted in an impairment totaling $20.2 million in the first quarter of 2020. This impairment was not the result of any unique factors specific to ICG's operations but, rather, reflected the broad-based declines in the market capitalizations of publicly-traded construction companies in the short period of time between the acquisition and the March 31, 2020 valuation date.25Other expense, netOther expense, net includes the following ($000’s omitted):20202019Write-offs of deposits and pre-acquisition costs (Note 2)$(12,390)$(13,116)Loss on debt retirement (Note 5)— (4,927)Amortization of intangible assets (Note 1)(19,685)(14,200)Interest income6,837 16,739 Interest expense(4,248)(584)Equity in earnings (loss) of unconsolidated entities (Note 4)1,880 747 Miscellaneous, net9,831 2,211 Total other expense, net$(17,775)$(13,130)The higher intangible assets amortization in 2020 reflects the ICG acquisition in January 2020. The lower interest income in 2020 resulted from the lower interest rate environment while the higher interest expense reflects the aforementioned short-term borrowing under the Revolving Credit Facility.Net new ordersNet new orders in units increased 17% in 2020 compared with 2019 while net new orders in dollars increased by 21% compared with 2019. The increased new orders resulted from the strong demand for new housing during the year, not withstanding the impact on demand in the second quarter of the COVID-19 pandemic, which we attribute to a variety of factors, including historically low mortgage interest rates, a restricted supply of new and existing home inventory, an increased appeal for homeownership and single-family living, and a desire among some buyers to exit more densely populated urban centers. While the annual cancellation rate (canceled orders for the period divided by gross new orders for the period) was flat in 2020 with 2019 at 14%, the cancellation rate spiked in the period of mid-March through May as the result of the falloff in demand triggered by the onset of the COVID-19 pandemic before stabilizing and then declining, ending the year with a cancellation rate of 12% in the fourth quarter. Due to supply chain challenges resulting from both disruptions caused by the COVID-19 pandemic as well as the surge in demand, we have consciously moderated the pace of sales in certain communities in order to better balance pricing, sales pace, lot availability, and production capacity. This has allowed us to increase pricing in the majority of our communities. Despite this moderation, ending backlog units, which represent orders for homes that have not yet closed, increased 44% as measured in units and 50% as measured in dollars at December 31, 2020 compared with December 31, 2019. This represented the highest year-end backlog (as measured in dollars) in our history. Homes in productionThe following is a summary of our homes in production at December 31, 2020 and 2019:20202019Sold10,421 7,423 UnsoldUnder construction1,694 2,672 Completed255 685 1,949 3,357 Models1,287 1,342 Total13,657 12,122 The number of homes in production at December 31, 2020 was 13% higher compared to December 31, 2019. The increase in homes under production resulted primarily from the higher backlog. Since demand accelerated in June 2020, the new housing supply chain has experienced delays in regard to certain materials and labor as well as with obtaining necessary approvals, permits, and inspections from local municipalities. As a result, our production cycle times have elongated somewhat, which has 26also contributed to the higher number of homes in production. The number of unsold, or "speculative", homes has decreased significantly as we have focused our production on completing sold homes consistent with the moderation of sales pace in certain communities discussed above.Controlled lotsThe following is a summary of our lots under control at December 31, 2020 and 2019:December 31, 2020December 31, 2019OwnedOptionedControlledOwnedOptionedControlledNortheast4,956 4,001 8,957 4,999 4,240 9,239 Southeast15,051 18,248 33,299 16,174 12,802 28,976 Florida20,737 24,396 45,133 20,281 17,802 38,083 Midwest9,728 14,734 24,462 10,016 12,027 22,043 Texas15,923 17,841 33,764 16,256 10,573 26,829 West24,968 9,769 34,737 25,633 7,459 33,092 Total91,363 88,989 180,352 93,359 64,903 158,262 Developed (%)43 %16 %30 %39 %22 %32 %Of our controlled lots, 91,363 and 93,359 were owned and 88,989 and 64,903 were under land option agreements at December 31, 2020 and 2019, respectively. While competition for well-positioned land is robust, we continue to pursue strategic land investments that we believe can achieve appropriate risk-adjusted returns on invested capital. The remaining purchase price under our land option agreements totaled $3.8 billion at December 31, 2020. These land option agreements generally may be canceled at our discretion and in certain cases extend over several years. Our maximum exposure related to these land option agreements is generally limited to our deposits and pre-acquisition costs, which totaled $291.9 million, of which $16.2 million is refundable, at December 31, 2020.Homebuilding Segment OperationsOur homebuilding operations represent our core business. Homebuilding offers a broad product line to meet the needs of homebuyers in our targeted markets. As of December 31, 2020, we conducted our operations in 40 markets located throughout 23 states. For reporting purposes, our Homebuilding operations are aggregated into six reportable segments: Northeast: Connecticut, Maryland, Massachusetts, New Jersey, Pennsylvania, VirginiaSoutheast: Georgia, North Carolina, South Carolina, TennesseeFlorida:FloridaMidwest:Illinois, Indiana, Kentucky, Michigan, Minnesota, OhioTexas:TexasWest: Arizona, California, Nevada, New Mexico, WashingtonWe also have a reportable segment for our financial services operations, which consist principally of mortgage banking and title operations. The Financial Services segment operates generally in the same markets as the Homebuilding segments.27The following table presents selected financial information for our reportable Homebuilding segments: Operating Data by Segment ($000's omitted) Years Ended December 31, 2020FY 2020 vs. FY 20192019Home sale revenues:Northeast$845,853 10 %$771,349 Southeast1,687,139 1 %1,673,670 Florida2,274,113 10 %2,068,422 Midwest1,507,450 1 %1,485,370 Texas1,447,715 5 %1,384,533 West2,817,626 11 %2,532,361 $10,579,896 7 %$9,915,705 Income before income taxes (a):Northeast$136,985 18 %$116,221 Southeast (b)258,794 47 %175,763 Florida362,276 17 %309,596 Midwest213,017 15 %184,438 Texas242,383 24 %195,751 West424,803 10 %386,361 Other homebuilding (c)(96,201)27 %(131,869)$1,542,057 25 %$1,236,261 Closings (units):Northeast1,522 5 %1,443 Southeast4,108 3 %3,982 Florida5,496 9 %5,045 Midwest3,553 (1)%3,583 Texas4,747 5 %4,528 West5,198 12 %4,651 24,624 6 %$23,232 Average selling price:Northeast$556 4 %$535 Southeast411 (2)%420 Florida414 1 %410 Midwest424 2 %415 Texas305 — %306 West542 — %544 $430 1 %$427 (a)Includes land-related charges as summarized in the following land-related charges table (see Note 2).(b)Southeast includes a warranty charge of $14.8 million in 2019 related to a closed-out community (see Note 11). (c)Other homebuilding includes the amortization of intangible assets, amortization of capitalized interest, and other items not allocated to the operating segments. Also includes: reserves against insurance receivables of $17.8 million and $22.6 million associated with the resolution of certain insurance matters in 2020 and 2019, respectively; and insurance reserve reversals of $93.4 million and $49.4 million in 2020 and 2019, respectively (see Note 11).28The following table present additional selected financial information for our reportable Homebuilding segments: Operating Data by Segment ($000's omitted)Years Ended December 31,2020FY 2020 vs. FY 20192019Net new orders - units:Northeast1,886 21 %1,562 Southeast4,583 8 %4,237 Florida6,844 25 %5,462 Midwest4,212 13 %3,721 Texas5,950 22 %4,886 West5,800 14 %5,109 29,275 17 %24,977 Net new orders - dollars:Northeast$1,059,479 23 %$861,234 Southeast1,934,579 10 %1,758,110 Florida2,923,718 30 %2,246,631 Midwest1,846,109 19 %1,548,927 Texas1,837,939 23 %1,489,188 West3,235,448 19 %2,711,273 $12,837,272 21 %$10,615,363 Cancellation rates:Northeast10 %11 %Southeast10 %11 %Florida13 %12 %Midwest11 %12 %Texas18 %17 %West18 %16 %14 %14 %Unit backlog:Northeast953 62 %589 Southeast2,340 25 %1,865 Florida3,654 58 %2,306 Midwest2,199 43 %1,540 Texas3,053 65 %1,850 West2,959 26 %2,357 15,158 44 %10,507 Backlog dollars:Northeast$561,323 61 %$347,696 Southeast1,030,910 32 %783,469 Florida1,627,865 66 %978,261 Midwest990,635 52 %651,977 Texas981,091 66 %590,868 West1,601,358 35 %1,183,534 $6,793,182 50 %$4,535,805 29The following table presents additional selected financial information for our reportable Homebuilding segments:Operating Data by Segment ($000's omitted)Years Ended December 31,20202019Land-related charges*:Northeast$5,301 $1,122 Southeast3,815 15,697 Florida1,395 2,811 Midwest2,390 2,581 Texas4,588 1,151 West1,936 2,568 Other homebuilding880 1,171 $20,305 $27,101 * Land-related charges include land impairments, net realizable value adjustments for land held for sale, and write-offs of deposits and pre-acquisition costs. Other homebuilding consists primarily of write-offs of capitalized interest resulting from land-related charges. See Notes 2 and 3 to the Consolidated Financial Statements for additional discussion of these charges.Northeast:For 2020, Northeast home sale revenues increased 10% compared with 2019 due to a 5% increase in closings combined with a 4% increase in average selling price. The increase in closings was primarily attributable to Mid-Atlantic while the increase in average selling price was primarily attributable to Northeast Corridor. The increased income before income taxes resulted primarily due to the higher revenues across all markets. Net new orders increased 21%, which is attributable primarily to Mid-Atlantic.Southeast:For 2020, Southeast home sale revenues increased 1% compared with 2019 due to a 3% increase in closings partially offset by a 2% decrease in average selling price. The increase in closings occurred in all markets except Georgia and Tennessee while the decrease in average selling price occurred across the majority of markets. Income before income taxes increased 47% primarily due to higher revenues, improved gross margins, and improved overhead management, which occurred across the majority of markets, and charges related to estimated costs to complete repairs in a closed-out community during 2019. Net new orders increased 8%, which is attributable to a majority of our markets.Florida:For 2020, Florida home sale revenues increased 10% compared with 2019 due to a 9% increase in closings combined with a 1% increase in average selling price. The increase in closings and average selling price occurred across the majority of markets. The increased income before income taxes for 2020 resulted primarily from higher revenues and improved gross margin across the majority of markets. Net new orders increased 25%, which is attributable to all of our markets. Midwest:For 2020, Midwest home sale revenues increased 1% compared with the prior year period due to a 2% increase in average selling price partially offset by a 1% decrease in closings. The increase in average selling price occurred across all markets while the decrease in closings primarily occurred in Michigan. Income before income taxes increased 15% primarily due to improved overhead management and gross margins. Net new orders increased 13%,which is attributable to the majority of markets.30Texas:For 2020, Texas home sale revenues increased 5% compared with the prior year period due to an 5% increase in closings partially offset by a slight decrease in the average selling price. The increase in closings occurred in all markets except Dallas while the decrease in average selling price occurred across all markets except Austin. Income before income taxes increased primarily due to increased revenues, improved overhead management and gross margins. Net new orders increased 22%, which is attributable to all of our markets.West:For 2020, West home sale revenues increased 11% compared with the prior year period due to a 12% increase in closings partially offset by a slight decrease in the average selling price. Closings were higher in most markets with Las Vegas benefiting from the American West acquisition that occurred in 2019. However, Northern California experienced significantly lower revenues, primarily due to the prior period completion, or near completion, of several high performing communities and an overall moderation of demand in that market. The decrease in average selling prices was mixed among markets. Income before income taxes increased 10% primarily as the result of higher revenues and improved gross margins across the majority of markets. Net new orders increased by 14%, which is attributable to all markets except Arizona.Financial Services OperationsWe conduct our Financial Services operations, which include mortgage banking, title, and insurance brokerage operations, through Pulte Mortgage and other subsidiaries. In originating mortgage loans, we initially use our own funds, including funds available pursuant to credit agreements with third parties. Substantially all of the loans we originate are sold in the secondary market within a short period of time after origination, generally within 30 days. We also sell the servicing rights for the loans we originate through fixed price servicing sales contracts to reduce the risks and costs inherent in servicing loans. This strategy results in owning the loans and related servicing rights for only a short period of time. Operating as a captive business model primarily targeted to supporting our Homebuilding operations, the business levels of our Financial Services operations are highly correlated to Homebuilding. Our Homebuilding customers continue to account for substantially all loan production. We believe that our capture rate, which represents loan originations from our Homebuilding operations as a percentage of total loan opportunities from our Homebuilding operations, excluding cash closings, is an important metric in evaluating the effectiveness of our captive mortgage business model. The following table presents selected financial information for our Financial Services operations ($000’s omitted): Years Ended December 31, 2020FY 2020 vs. FY 20192019Mortgage revenues$293,099 72 %$169,917 Title services revenues57,023 10 %51,836 Insurance brokerage commissions12,047 (5)%12,678 Total Financial Services revenues362,169 54 %234,431 Expenses(175,481)34 %(130,770)Other income, net(51)(85)%(346)Income before income taxes$186,637 81 %$103,315 Total originations:Loans18,433 17 %15,821 Principal$6,075,132 22 %$4,976,973 31 Years Ended December 31, 20202019Supplemental data:Capture rate86.4 %82.4 %Average FICO score751 751 Funded origination breakdown:Government (FHA, VA, USDA)21 %20 %Other agency71 %71 %Total agency92 %90 %Non-agency8 %10 %Total funded originations100 %100 %RevenuesTotal Financial Services revenues during 2020 increased 54% compared with 2019. The increase occurred primarily as the result of the Homebuilding volume growth combined with the low mortgage interest rate environment. Mortgage interest rates continued at or near historically low levels during 2020, which resulted in higher gains from the sale of mortgages in the secondary market and also contributed to an improved capture rate. Income before income taxesThe increase in income before income taxes for 2020 as compared with 2019 was due primarily to higher volume, higher revenue per loan, and improved expense leverage. These improvements were partially offset by $26.4 million of mortgage repurchase reserve charges (see Note 11).Income TaxesOur effective tax rate was 18.6% and 24.1% for 2020 and 2019, respectively. The lower effective tax rate in 2020 resulted primarily from the extension of federal energy efficient home credits (see Note 8).Liquidity and Capital ResourcesWe finance our land acquisition, development, and construction activities and financial services operations using internally-generated funds supplemented by credit arrangements with third parties and capital market financing. We routinely monitor current and expected operational requirements and financial market conditions to evaluate accessing available financing sources, including revolving bank credit and securities offerings.At December 31, 2020, we had unrestricted cash and equivalents of $2.6 billion, restricted cash balances of $50.0 million, and $750.3 million available under our Revolving Credit Facility. We follow a diversified investment approach for our cash and equivalents by maintaining such funds with a broad portfolio of banks within our group of relationship banks in high quality, highly liquid, short-term deposits and investments.We retired outstanding debt totaling $65.3 million and $310.0 million during 2020 and 2019, respectively. Our ratio of debt-to-total capitalization, excluding our Financial Services debt, was 29.5% at December 31, 2020, which is slightly below our targeted long-term range of 30.0% to 40.0%. Unsecured senior notesDuring 2019, we completed a tender offer to retire $310.0 million of our unsecured senior notes maturing in 2021. At December 31, 2020, we had $2.7 billion of unsecured senior notes outstanding with no repayments due until March 2021 when $426.0 million of notes are scheduled to mature. In January 2021, the Company announced a tender offer expected to be completed in February 2021 for up to $300 million of our senior notes scheduled to mature in 2026 and 2027.32Other notes payableCertain of our local homebuilding operations are party to non-recourse and limited recourse collateralized notes payable with third parties that totaled $40.1 million at December 31, 2020. These notes have maturities ranging up to three years, are secured by the applicable land positions to which they relate, have no recourse to any other assets, and are classified within notes payable. Revolving credit facilityWe maintain a Revolving Credit Facility, maturing in June 2023 that has a maximum borrowing capacity of $1.0 billion and contains an uncommitted accordion feature that could increase the capacity to $1.5 billion, subject to certain conditions and availability of additional bank commitments. The Revolving Credit Facility also provides for the issuance of letters of credit that reduce the available borrowing capacity under the Revolving Credit Facility, with a sublimit of $500.0 million at December 31, 2020. The interest rate on borrowings under the Revolving Credit Facility may be based on either the London Interbank Offered Rate ("LIBOR") or a base rate plus an applicable margin, as defined therein. In the event that LIBOR is no longer widely available, the agreement contemplates transitioning to an alternative widely available market rate agreeable between the parties. As a precautionary measure during the initial phase of the COVID-19 pandemic, we made the decision in March 2020 to draw $700.0 million under the Revolving Credit Facility. In June 2020, we repaid the full outstanding balance of $700.0 million. We had no borrowings outstanding and $249.7 million and $262.8 million of letters of credit issued under the Revolving Credit Facility at December 31, 2020 and 2019, respectively.The Revolving Credit Facility contains financial covenants that require us to maintain a minimum Tangible Net Worth, a minimum Interest Coverage Ratio, and a maximum Debt-to-Capitalization Ratio (as each term is defined in the Revolving Credit Facility). As of December 31, 2020, we were in compliance with all covenants. Outstanding balances under the Revolving Credit Facility are guaranteed by certain of our wholly-owned subsidiaries. Our available and unused borrowings under the Revolving Credit Facility, net of outstanding letters of credit, amounted to $750.3 million and $737.2 million as of December 31, 2020 and 2019, respectively.Financial Services debtPulte Mortgage provides mortgage financing for the majority of our home closings by utilizing its own funds and funds made available pursuant to credit agreements with third parties. Pulte Mortgage uses these resources to finance its lending activities until the loans are sold in the secondary market, which generally occurs within 30 days. Pulte Mortgage maintains a master repurchase agreement with third party lenders (the "Repurchase Agreement") that matures in July 2021. The maximum aggregate commitment was $420.0 million during the seasonally high borrowing period from December 28, 2020 through January 15, 2021. At all other times, the maximum aggregate commitment ranges from $230.0 million to $375.0 million. The purpose of the changes in capacity during the term of the agreement is to lower associated fees during seasonally lower volume periods of mortgage origination activity. Borrowings under the Repurchase Agreement are secured by residential mortgage loans available-for-sale. The Repurchase Agreement contains various affirmative and negative covenants applicable to Pulte Mortgage, including quantitative thresholds related to net worth, net income, and liquidity. Pulte Mortgage had $411.8 million and $326.6 million outstanding under the Repurchase Agreement at December 31, 2020 and 2019, respectively, and was in compliance with its covenants and requirements as of such dates.Share repurchase programWe repurchased 4.5 million and 8.4 million shares in 2020 and 2019, respectively, for a total of $170.7 million and $274.3 million in 2020 and 2019, respectively, under this program. In 2018, our Board of Directors authorized a $500.0 million share repurchase program and approved an increase of $500.0 million in May 2019. The repurchase of shares was suspended in March 2020 as a response to the COVID-19 pandemic and was reinstated in October 2020. At December 31, 2020, we had remaining authorization to repurchase $354.9 million of common shares. DividendsOur declared quarterly cash dividends totaled $135.1 million and $124.4 million in 2020 and 2019, respectively. 33Cash flowsOperating activitiesOur net cash provided by operating activities in 2020 was $1.8 billion, compared with net cash provided by operating activities of $1.1 billion in 2019. Generally, the primary drivers of our cash flow from operations are profitability and changes in inventory levels and residential mortgage loans available-for-sale, each of which experiences seasonal fluctuations. Our positive cash flow from operations for 2020 was primarily due to our net income of $1.4 billion, which included various non-cash items, including land-related charges of $20.3 million and $137.6 million of deferred income tax expense. These factors were partially offset by a $56.7 million increase in residential mortgage loans available-for-sale. Our positive cash flow from operations for 2019 was primarily due to our net income of $1.0 billion, which included non-cash land-related charges of $27.1 million and $105.4 million of deferred income tax expense. These factors were partially offset by a net increase in inventories of $237.7 million and a $48.3 million increase in residential mortgage loans available-for-sale. Investing activitiesNet cash used in investing activities totaled $107.9 million in 2020, compared with $224.7 million in 2019. The 2020 cash outflows primarily reflect our acquisition of ICG in January 2020 for $83.3 million, as well as capital expenditures of $58.4 million related to our ongoing investment in new communities and certain information technology applications. The use of cash in investing activities in 2019 was primarily due to our acquisition of American West in April 2019 for $163.7 million as well as $58.1 million of capital expenditures.Financing activitiesNet cash used in financing activities was $295.6 million in 2020 compared with $733.6 million during 2019. The net cash used in financing activities for 2020 resulted primarily from the repurchase of 4.5 million common shares for $170.7 million under our repurchase authorization, repayments of debt of $65.3 million, and cash dividends of $130.2 million.Net cash used in financing activities for 2019 resulted primarily from the repurchase of 8.4 million common shares for $274.3 million under our repurchase authorization, repayments of debt of $310.0 million, and cash dividends of $122.4 million.InflationWe, and the homebuilding industry in general, may be adversely affected during periods of inflation because of higher land and construction costs. Inflation may also increase our financing costs. In addition, higher mortgage interest rates affect the affordability of our products to prospective homebuyers. While we attempt to pass on to our customers increases in our costs through increased sales prices, market forces may limit our ability to do so. If we are unable to raise sales prices enough to compensate for higher costs, or if mortgage interest rates increase significantly, our revenues, gross margins, and net income could be adversely affected.SeasonalityAlthough significant changes in market conditions have impacted our seasonal patterns in the past and could do so again, we historically experience variability in our quarterly results from operations due to the seasonal nature of the homebuilding industry. We generally experience increases in revenues and cash flow from operations during the fourth quarter based on the timing of home closings. This seasonal activity increases our working capital requirements in our third and fourth quarters to support our home production and loan origination volumes. As a result of the seasonality of our operations, our quarterly results of operations are not necessarily indicative of the results that may be expected for the full year. Additionally, given thedisruption in economic activity caused by the COVID-19 pandemic, our quarterly results in 2020 are not necessarily indicativeof results that may be achieved in the future.34Contractual Obligations and Commercial CommitmentsThe following table summarizes our payments under contractual obligations as of December 31, 2020: Payments Due by Period($000’s omitted) 20212022-20232024-2025After 2025TotalContractual obligations:Notes payable (a)$596,928 $285,766 $271,250 $2,881,229 $4,035,173 Operating lease obligations21,154 42,746 23,335 19,432 106,667 Total contractual obligations (b)$618,082 $328,512 $294,585 $2,900,661 $4,141,840 (a)Represents principal and interest payments related to our senior notes and limited recourse collateralized financing arrangements.(b)We do not have any payments due in connection with capital lease or long-term purchase obligations.We are currently under examination by various taxing jurisdictions and anticipate finalizing the examinations with certain jurisdictions within the next twelve months. The final outcome of these examinations is not yet determinable. The statute of limitations for our major tax jurisdictions remains open for examination for tax years 2016 to 2020. At December 31, 2020, we had $30.9 million of gross unrecognized tax benefits and $2.8 million of related accrued interest and penalties, which are excluded from the above table.We are subject to certain obligations associated with entering into contracts (including land option contracts) for the purchase, development, and sale of real estate in the routine conduct of our business. Option contracts for the purchase of land enable us to defer acquiring portions of properties owned by third parties and unconsolidated entities until we have determined whether to exercise our option, which may serve to reduce our financial risks associated with long-term land holdings. At December 31, 2020, we had $291.9 million of deposits and pre-acquisition costs, of which $16.2 million is refundable, relating to option agreements to acquire 88,989 lots with a remaining purchase price of $3.8 billion. We expect to acquire the majority of such land within the next three years.The following table summarizes our other commercial commitments as of December 31, 2020: Amount of Commitment Expiration by Period($000’s omitted) 20212022-20232024-2025After 2025TotalOther commercial commitments:Revolving Credit Facility (a)$— $1,000,000 $— $— $1,000,000 Repurchase Agreement (b)420,000 — — — 420,000 Total commercial commitments (c)$420,000 $1,000,000 $— $— $1,420,000 (a)The $1.0 billion in 2022-2023 represents the capacity of our Revolving Credit Facility, under which no borrowings were outstanding, and $249.7 million of letters of credit were issued at December 31, 2020.(b)Represents the capacity of the Repurchase Agreement, of which $411.8 million was outstanding at December 31, 2020. The capacity of $420.0 million was effective through January 15, 2021 after which it ranges from $230.0 million to $375.0 million until its expiration in July 2021.(c)The above table excludes an aggregate $1.5 billion of surety bonds, which typically do not have stated expiration dates.Supplemental Guarantor Financial InformationAs of December 31, 2020 PulteGroup, Inc. had outstanding $2.7 billion principal amount of unsecured senior notes due at dates from March 2021 through February 2035 and no amounts outstanding on its Revolving Credit Facility.All of our unsecured senior notes and the Revolving Credit Facility are fully and unconditionally guaranteed, on a joint and several basis, by certain subsidiaries of PulteGroup, Inc. ("Guarantors" or "Guarantor Subsidiaries"). Each of the Guarantor 35Subsidiaries is 100% owned, directly or indirectly, by PulteGroup, Inc. Our subsidiaries associated with our financial services operations and certain other subsidiaries do not guarantee the unsecured senior notes or the Revolving Credit Facility (collectively, "Non-Guarantor Subsidiaries"). The guarantees are senior unsecured obligations of each Guarantor and rank equal with all existing and future senior debt of such Guarantor and senior to all subordinated debt of such Guarantor. The guarantees are effectively subordinated to any secured debt of such Guarantor to the extent of the value of the assets securing such debt. A court could void or subordinate any Guarantor’s guarantee under the fraudulent conveyance laws if existing or future creditors of any such Guarantor were successful in establishing that such Guarantor:(a) incurred the guarantee with the intent of hindering, delaying or defrauding creditors; or(b) received less than reasonably equivalent value or fair consideration in return for incurring the guarantee and, in the case of and any one of the following is also true at the time thereof:•such Guarantor was insolvent or rendered insolvent by reason of the issuance of the incurrence of the guarantee;•the incurrence of the guarantee left such Guarantor with an unreasonably small amount of capital or assets to carry on its business;•such Guarantor intended to, or believed that it would, incur debts beyond its ability to pay as they mature;•such Guarantor was a defendant in an action for money damages, or had a judgment for money damages docketed against it, if the judgment is unsatisfied after final judgment.The measures of insolvency for purposes of determining whether a fraudulent conveyance occurred would vary depending upon the laws of the relevant jurisdiction and upon the valuation assumptions and methodology applied by the court. However, in general, a court would deem a company insolvent if:•the sum of its debts, including contingent and unliquidated liabilities, was greater than the fair saleable value of all of its assets;•the present fair saleable value of its assets was less than the amount that would be required to pay its probable liability on its existing debts, including contingent liabilities, as they become absolute and mature; or•it could not pay its debts as they became due.The guarantees of the senior notes contain a provision to limit each Guarantor’s liability to the maximum amount that it could incur without causing the incurrence of obligations under its guarantee to be a fraudulent transfer. However, under recent case law, this provision may not be effective to protect such guarantee from being voided under fraudulent transfer law or otherwise determined to be unenforceable. If a court were to find that the incurrence of a guarantee was a fraudulent transfer or conveyance, the court could void the payment obligations under that guarantee, could subordinate that guarantee to presently existing and future indebtedness of the Guarantor or could require the holders of the senior notes to repay any amounts received with respect to that guarantee. In the event of a finding that a fraudulent transfer or conveyance occurred, you may not receive any repayment on the senior notes.Finally, as a court of equity, a bankruptcy court may subordinate the claims in respect of the guarantees to other claims against us under the principle of equitable subordination if the court determines that (1) the holder of senior notes engaged in some type of inequitable conduct, (2) the inequitable conduct resulted in injury to our other creditors or conferred an unfair advantage upon the holders of senior notes and (3) equitable subordination is not inconsistent with the provisions of the bankruptcy code.On the basis of historical financial information, operating history and other factors, we believe that each of the Guarantors, after giving effect to the issuance of the guarantees when such guarantees were issued, was not insolvent, did not have unreasonably small capital for the business in which it engaged and did not and has not incurred debts beyond its ability to pay such debts as they mature. We cannot assure you, however, as to what standard a court would apply in making these determinations or that a court would agree with our conclusions in this regard.36The following tables present summarized financial information for PulteGroup, Inc. and the Guarantor Subsidiaries on a combined basis after intercompany transactions and balances have been eliminated among PulteGroup, Inc. and the Guarantor Subsidiaries, as well as their investment in and equity in earnings from the Non-Guarantor Subsidiaries ($000’s omitted):PulteGroup, Inc. and Guarantor SubsidiariesSummarized Balance Sheet DataASSETSDecember 31, 2020Cash, cash equivalents, and restricted cash$2,429,639House and land inventory7,600,542 Total assets11,028,911 LIABILITIESAccounts payable, customer deposits, accrued and other liabilities$2,101,427Notes payable2,752,302 Amount due to Non-Guarantor Subsidiaries12,208 Total liabilities4,948,275 For the year endedSummarized Statement of Operations DataDecember 31, 2020Revenues$10,368,616Cost of revenues7,839,807 Selling, general, and administrative expenses966,662 Income before income taxes1,510,185 Off-Balance Sheet ArrangementsWe use letters of credit and surety bonds to guarantee our performance under various contracts, principally in connection with the development of our homebuilding projects. The expiration dates of the letter of credit contracts coincide with the expected completion date of the related homebuilding projects. If the obligations related to a project are ongoing, annual extensions of the letters of credit are typically granted on a year-to-year basis. At December 31, 2020, we had outstanding letters of credit of $249.7 million. Our surety bonds generally do not have stated expiration dates; rather, we are released from the bonds as the contractual performance is completed. These bonds, which approximated $1.5 billion at December 31, 2020, are typically outstanding over a period of approximately three to five years. Because significant construction and development work has been performed related to the applicable projects but has not yet received final acceptance by the respective counterparties, the aggregate amount of surety bonds outstanding is in excess of the projected cost of the remaining work to be performed.In the ordinary course of business, we enter into land option agreements in order to procure land for the construction of houses in the future. At December 31, 2020, these agreements had an aggregate remaining purchase price of $3.8 billion. Pursuant to these land option agreements, we provide a deposit to the seller as consideration for the right to purchase land at different times in the future, usually at predetermined prices. 37Critical Accounting Policies and EstimatesThe accompanying consolidated financial statements were prepared in conformity with U.S. generally accepted accounting principles. When more than one accounting principle, or the method of its application, is generally accepted, we select the principle or method that is appropriate in our specific circumstances (see Note 1 to our Consolidated Financial Statements). Application of these accounting principles requires us to make estimates about the future resolution of existing uncertainties; as a result, actual results could differ from these estimates. In preparing these consolidated financial statements, we have made our best estimates and judgments of the amounts and disclosures included in the consolidated financial statements, giving due regard to materiality.Revenue recognitionHome sale revenues - Home sale revenues and related profit are generally recognized when title to and possession of the home are transferred to the buyer at the home closing date. Little to no estimation is involved in recognizing such revenues.Land sale and other revenues - We periodically elect to sell parcels of land to third parties in the event such assets no longer fit into our strategic operating plans or are zoned for commercial or other development. Land sales are generally outright sales of specified land parcels with cash consideration due on the closing date, which is generally when performance obligations are satisfied. Revenues related to our construction services operations are generally recognized as materials are delivered and installation services are provided. Financial services revenues - Loan origination fees, commitment fees, and direct loan origination costs are recognized as incurred. Expected gains and losses from the sale of residential mortgage loans and their related servicing rights are included in the measurement of written loan commitments that are accounted for at fair value through Financial Services revenues at the time of commitment. The determination of fair value for certain of these financial instruments requires the use of estimates and management judgment. Subsequent changes in the fair value of these loans are reflected in Financial Services revenues as they occur. Interest income is accrued from the date a mortgage loan is originated until the loan is sold. Mortgage servicing fees represent fees earned for servicing loans for various investors. Servicing fees are based on a contractual percentage of the outstanding principal balance, or a contracted set fee in the case of certain sub-servicing arrangements, and are credited to income when related mortgage payments are received or the sub-servicing fees are earned. Revenues associated with our title operations are recognized as closing services are rendered and title insurance policies are issued, both of which generally occur as each home is closed. Insurance brokerage commissions relate to commissions on home and other insurance policies placed with third party carriers through various agency channels. Our performance obligations for policy renewal commissions are considered satisfied upon issuance of the initial policy, and related contract assets for estimated future renewal commissions are included in other assets and totaled $38.5 million at December 31, 2020. Due to uncertainties in the estimation process and the long duration of renewal policies, which can extend years into the future, actual results could differ from such estimates.Inventory and cost of revenuesInventory is stated at cost unless the carrying value is determined to not be recoverable, in which case the affected inventory is written down to fair value. Cost includes land acquisition, land development, and home construction costs, including interest, real estate taxes, and certain direct and indirect overhead costs related to development and construction. For those communities for which construction and development activities have been idled, applicable interest and real estate taxes are expensed as incurred. Land acquisition and development costs are allocated to individual lots using an average lot cost determined based on the total expected land acquisition and development costs and the total expected home closings for the community. The specific identification method is used to accumulate home construction costs.We capitalize interest cost into homebuilding inventories. Each layer of capitalized interest is amortized over a period that approximates the average life of communities under development. Interest expense is allocated over the period based on the timing of home closings.Cost of revenues includes the construction cost, average lot cost, estimated warranty costs, and closing costs applicable to the home. Sales commissions are classified within selling, general, and administrative expenses. The construction cost of the home includes amounts paid through the closing date of the home, plus an accrual for costs incurred but not yet paid, based on an analysis of budgeted construction costs. This accrual is reviewed for accuracy based on actual payments made after closing compared with the amount accrued, and adjustments are made if needed. Total community land acquisition and development 38costs are based on an analysis of budgeted costs compared with actual costs incurred to date and estimates to complete. The development cycles for our communities range from under one year to in excess of ten years for certain master planned communities. Adjustments to estimated total land acquisition and development costs for the community affect the amounts costed for the community’s remaining lots.We test inventory for impairment when events and circumstances indicate that the undiscounted cash flows estimated to be generated by the community may be less than its carrying amount. Such indicators include gross margins or sales paces significantly below expectations, construction costs or land development costs significantly in excess of budgeted amounts, significant delays or changes in the planned development for the community, and other known qualitative factors. Communities that demonstrate potential impairment indicators are tested for impairment by comparing the expected undiscounted cash flows for the community to its carrying value. For those communities whose carrying values exceed the expected undiscounted cash flows, we determine the fair value of the community and impairment charges are recorded if the fair value of the community’s inventory is less than its carrying value.We generally determine the fair value of each community using a combination of discounted cash flow models and market comparable transactions, where available. These estimated cash flows are significantly impacted by estimates related to expected average selling prices, expected sales paces, expected land development and construction timelines, and anticipated land development, construction, and overhead costs. The assumptions used in the discounted cash flow models are specific to each community. Due to uncertainties in the estimation process, the significant volatility in demand for new housing, the long life cycles of many communities, and potential changes in our strategy related to certain communities, actual results could differ significantly from such estimates.Generally, a community must have projected gross margin percentages in the mid-single digits or lower to potentially fail the undiscounted cash flow step and proceed to the fair value step. Our overall gross margin realized during 2020 and our average gross margin in backlog at December 31, 2020 both exceeded 20%, and we have only a small minority of communities with gross margins below 10%. However, in the event of an extended economic slowdown that leads to moderate or significant decreases in the price of new homes in certain geographic or buyer submarkets, we could have a larger number of communities that begin to approach these levels such that more detailed impairment analyses would be necessary, and the resulting impairments could be material. Additionally, we have $291.9 million of deposits and pre-acquisition costs at December 31, 2020 related to option agreements to acquire additional land. In the event of an extended economic slowdown, we could elect to cancel a large portion of such land option agreements, which would generally result in the write-off of the related deposits and pre-acquisition costs.Residential mortgage loans available-for-saleIn accordance with Accounting Standards Codification ("ASC") 825, “Financial Instruments” (“ASC 825”), we use the fair value option for our residential mortgage loans available-for-sale. Election of the fair value option for residential mortgage loans available-for-sale allows a better offset of the changes in fair values of the loans and the derivative instruments used to economically hedge them without having to apply complex hedge accounting provisions. Changes in the fair value of these loans are reflected in revenues as they occur.Allowance for warrantiesHome purchasers are provided with a limited warranty against certain building defects, including a one-year comprehensive limited warranty and coverage for certain other aspects of the home’s construction and operating systems for periods of up to (and in limited instances exceeding) 10 years. We estimate the costs to be incurred under these warranties and record a liability in the amount of such costs at the time revenue is recognized. Factors that affect our warranty liability include the number of homes sold, historical and anticipated rates of warranty claims, and the projected cost of claims. We periodically assess the adequacy of our recorded warranty liability for each geographic market in which we operate and adjust the amounts as necessary. Actual warranty costs in the future could differ from our estimates.Income taxesWe evaluate our deferred tax assets each period to determine if a valuation allowance is required based on whether it is "more likely than not" that some portion of the deferred tax assets would not be realized. The ultimate realization of these deferred tax assets is dependent upon the generation of sufficient taxable income during future periods. We conduct our evaluation by considering all available positive and negative evidence. This evaluation considers, among other factors, historical operating results, forecasts of future profitability, the duration of statutory carryforward periods, and the outlooks for the U.S. housing 39industry and broader economy. The accounting for deferred taxes is based upon estimates of future results. Differences between estimated and actual results could result in changes in the valuation of our deferred tax assets that could have a material impact on our consolidated results of operations or financial position. Changes in existing tax laws could also affect actual tax results and the realization of deferred tax assets over time. Unrecognized tax benefits represent the difference between tax positions taken or expected to be taken in a tax return and the benefits recognized for financial statement purposes. We follow the provisions of ASC 740, “Income Taxes” (“ASC 740”), which prescribes a minimum recognition threshold a tax position is required to meet before being recognized in the financial statements. Significant judgment is required to evaluate uncertain tax positions. Our evaluations of tax positions consider a variety of factors, including relevant facts and circumstances, applicable tax law, correspondence with taxing authorities, and effective settlements of audit issues. Changes in the recognition or measurement of uncertain tax positions could result in material increases or decreases in income tax expense (benefit) in the period in which the change is made. Interest and penalties related to income taxes and unrecognized tax benefits are recognized as a component of income tax expense (benefit).Self-insured risksAt any point in time, we are managing over 1,000 individual claims related to general liability, property, errors and omission, workers compensation, and other business insurance coverage. We reserve for costs associated with such claims (including expected claims management expenses) on an undiscounted basis at the time product revenue is recognized for each home closing and periodically evaluate the recorded liabilities based on actuarial analyses of our historical claims. The actuarial analyses calculate estimates of the ultimate cost of all unpaid losses, including estimates for incurred but not reported losses ("IBNR"). IBNR represents losses related to claims incurred but not yet reported plus development on reported claims.Our recorded reserves for all such claims totaled $641.8 million and $709.8 million at December 31, 2020 and 2019, respectively, the vast majority of which relate to general liability claims. The recorded reserves include loss estimates related to both (i) existing claims and related claim expenses and (ii) IBNR and related claim expenses. Liabilities related to IBNR and related claim expenses represented approximately 68% of the total general liability reserves at both December 31, 2020 and 2019. The actuarial analyses that determine the IBNR portion of reserves consider a variety of factors, including the frequency and severity of losses, which are based on our historical claims experience supplemented by industry data. The actuarial analyses of the reserves also consider historical third-party recovery rates and claims management expenses. Because of the inherent uncertainty in estimating future losses related to these claims, actual costs could differ significantly from estimated costs. Based on the actuarial analyses performed, we believe the range of reasonably possible losses related to these claims is $550 million to $750 million. While this range represents our best estimate of our ultimate liability related to these claims, due to a variety of factors, including those factors described above, there can be no assurance that the ultimate costs realized by us will fall within this range.Volatility in both national and local housing market conditions can affect the frequency and cost of construction defect claims. Additionally, IBNR estimates comprise the majority of our liability and are subject to a high degree of uncertainty due to a variety of factors, including changes in claims reporting and resolution patterns, third party recoveries, insurance industry practices, the regulatory environment, and legal precedent. State regulations vary, but construction defect claims are reported and resolved over an extended period often exceeding ten years. Changes in the frequency and timing of reported claims and estimates of specific claim values can impact the underlying inputs and trends utilized in the actuarial analyses, which could have a material impact on the recorded reserves. Additionally, the amount of insurance coverage available for each policy period also impacts our recorded reserves. Because of the inherent uncertainty in estimating future losses and the timing of such losses related to these claims, actual costs could differ significantly from estimated costs. Adjustments to reserves are recorded in the period in which the change in estimate occurs. During 2020 and 2019, we reduced general liability reserves by $93.4 million and $49.4 million, respectively, as a result of changes in estimates resulting from actual claim experience observed being less than anticipated in previous actuarial projections. The changes in actuarial estimates were driven by changes in actual claims experience that, in turn, impacted actuarial estimates for potential future claims. These changes in actuarial estimates did not involve any changes in actuarial methodology but did impact the development of estimates for future periods, which resulted in adjustments to the IBNR portion of our recorded liabilities. There were no material adjustments to individual claims. Rather, the adjustments reflect an overall lower level of losses related to construction defect claims in recent years as compared with our previous experience. We attribute this favorable experience to a variety of factors, including improved construction techniques, rising home values, and increased participation from our subcontractors in resolving claims.40In certain instances, we have the ability to recover a portion of our costs under various insurance policies or from subcontractors or other third parties. Estimates of such amounts are recorded when recovery is considered probable. Our receivables from insurance carriers totaled $69.5 million and $118.4 million at December 31, 2020 and 2019, respectively. The insurance receivables relate to costs incurred or to be incurred to perform corrective repairs, settle claims with customers, and other costs related to the continued progression of both known and anticipated future construction defect claims that we believe to be insured related to previously closed homes. We believe collection of these insurance receivables is probable based on various factors, including the legal merits of our positions after review by legal counsel, favorable legal rulings received to date, the credit quality of our carriers, and our long history of collecting significant amounts of insurance reimbursements under similar insurance policies related to similar claims, including significant amounts funded by the above carriers under different policies. While the outcome of these matters cannot be predicted with certainty, we do not believe that the resolution of such matters will have a material adverse impact on our results of operations, financial position, or cash flows.41ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKWe are subject to market risk on our debt instruments primarily due to fluctuations in interest rates. We utilize both fixed-rate and variable-rate debt. For fixed-rate debt, changes in interest rates generally affect the fair value of the debt instrument but not our earnings or cash flows. Conversely, for variable-rate debt, changes in interest rates generally do not affect the fair value of the debt instrument but could affect our earnings and cash flows. Except in very limited circumstances, we do not have an obligation to prepay our debt prior to maturity. As a result, interest rate risk and changes in fair value should not have a significant impact on our fixed-rate debt until we are required or elect to refinance or repurchase such debt.The following table sets forth the principal cash flows by scheduled maturity, weighted-average interest rates, and estimated fair value of our debt obligations as of December 31, 2020 and 2019 ($000’s omitted). As of December 31, 2020 for theYears ending December 31, 20212022202320242025ThereafterTotalFairValueRate-sensitive liabilities:Fixed rate debt$451,596 $14,456 $— $— $— $2,300,000 $2,766,052 $3,415,662 Average interest rate4.10 %0.28 %— %— %— %5.90 %5.57 %Variable rate debt (a)$411,821 $— $— $— $— $— $411,821 $411,821 Average interest rate2.55 %— %— %— %— %— %2.55 % As of December 31, 2019 for theYears ending December 31, 20202021202220232024ThereafterTotalFairValueRate-sensitive liabilities:Fixed rate debt$21,327 $447,712 $10,295 $— $— $2,300,000 $2,779,334 $3,152,046 Average interest rate2.09 %4.17 %0.39 %— %— %5.90 %5.57 %Variable rate debt (a)$326,573 $— $— $— $— $— $326,573 $326,573 Average interest rate3.59 %— %— %— %— %— %3.59 %(a) Includes the Pulte Mortgage Repurchase Agreement. There were no borrowings outstanding under our Revolving Credit Facility at either December 31, 2020 or 2019.Derivative instruments and hedging activitiesPulte Mortgage is exposed to market risks from commitments to lend, movements in interest rates, and canceled or modified commitments to lend. A commitment to lend at a specific interest rate (an interest rate lock commitment) is a derivative financial instrument (interest rate is locked to the borrower). The interest rate risk continues through the loan closing and until the loan is sold to an investor. We are generally not exposed to variability in cash flows of derivative instruments for more than approximately 60 days. In periods of rising interest rates, the length of exposure will generally increase due to customers locking in an interest rate sooner as opposed to letting the interest rate float. In periods of low or decreasing interest rates, the length of exposure will also generally increase as customers desire to lock before the possibility of rising rates. In order to reduce these risks, we use other derivative financial instruments, principally cash forward placement contracts on mortgage-backed securities and whole loan investor commitments, to economically hedge the interest rate lock commitment. We generally enter into one of the aforementioned derivative financial instruments upon accepting interest rate lock commitments. Changes in the fair value of interest rate lock commitments and the other derivative financial instruments are recognized in Financial Services revenues. We do not use any derivative financial instruments for trading purposes. At December 31, 2020 and 2019, residential mortgage loans available-for-sale had an aggregate fair value of $565.0 million and $509.0 million, respectively. At December 31, 2020 and 2019, we had aggregate interest rate lock commitments of $367.2 million and $255.3 million, respectively, which were originated at interest rates prevailing at the date of commitment. Unexpired forward contracts totaled $686.4 million and $518.2 million at December 31, 2020 and 2019, respectively, and whole loan investor commitments totaled $169.6 million and $200.7 million, respectively, at such dates. Hypothetical changes in the fair values of our financial instruments arising from immediate parallel shifts in long-term mortgage rates would not be material to our financial results due to the offsetting nature in the movements in fair value of our financial instruments.42SPECIAL NOTES CONCERNING FORWARD-LOOKING STATEMENTSAs a cautionary note, except for the historical information contained herein, certain matters discussed in Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operations, and Item 7A, Quantitative and Qualitative Disclosures About Market Risk, are “forward-looking” statements within the meaning of the Private Securities Litigation Reform Act of 1995. Such forward-looking statements are subject to a number of risks, uncertainties and other factors that could cause our actual results, performance, prospects or opportunities, as well as those of the markets we serve or intend to serve, to differ materially from those expressed in, or implied by, these statements. You can identify these statements by the fact that they do not relate to matters of a strictly factual or historical nature and generally discuss or relate to forecasts, estimates or other expectations regarding future events. Generally, the words “believe,” “expect,” “intend,” “estimate,” “anticipate,” “plan,” “project,” “may,” “can,” “could,” “might,” "should", “will” and similar expressions identify forward-looking statements, including statements related to any potential impairment charges and the impacts or effects thereof, expected operating and performing results, planned transactions, planned objectives of management, future developments or conditions in the industries in which we participate and other trends, developments and uncertainties that may affect our business in the future. Such risks, uncertainties and other factors include, among other things: interest rate changes and the availability of mortgage financing; competition within the industries in which we operate; the availability and cost of land and other raw materials used by us in our homebuilding operations; the impact of any changes to our strategy in responding to the cyclical nature of the industry, including any changes regarding our land positions and the levels of our land spend; the availability and cost of insurance covering risks associated with our businesses; shortages and the cost of labor; weather related slowdowns; slow growth initiatives and/or local building moratoria; governmental regulation directed at or affecting the housing market, the homebuilding industry or construction activities; uncertainty in the mortgage lending industry, including revisions to underwriting standards and repurchase requirements associated with the sale of mortgage loans; the interpretation of or changes to tax, labor and environmental laws which could have a greater impact on our effective tax rate or the value of our deferred tax assets than we anticipate; economic changes nationally or in our local markets, including inflation, deflation, changes in consumer confidence and preferences and the state of the market for homes in general; legal or regulatory proceedings or claims; our ability to generate sufficient cash flow in order to successfully implement our capital allocation priorities; required accounting changes; terrorist acts and other acts of war; the negative impact of the COVID-19 pandemic on our financial position and ability to continue our Homebuilding or Financial Services activities at normal levels or at all in impacted areas; the duration, effect and severity of the COVID-19 pandemic; the measures that governmental authorities take to address the COVID-19 pandemic which may precipitate or exacerbate one or more of the above-mentioned and/or other risks and significantly disrupt or prevent us from operating our business in the ordinary course for an extended period of time; and other factors of national, regional and global scale, including those of a political, economic, business and competitive nature. See Item 1A – Risk Factors for a further discussion of these and other risks and uncertainties applicable to our businesses. We undertake no duty to update any forward-looking statement, whether as a result of new information, future events or changes in our expectations. 43
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+Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations – Impact of Foreign Currency Exchange Rates and Liquidity and Capital Resources” and “Item 7A. Quantitative and Qualitative Disclosures About Market Risk” for additional information on our financial risks. If one or more of our counterparty financial institutions default on their financial or performance obligations to us or fail, we may incur significant losses.We have significant amounts of cash, cash equivalents, receivables outstanding, and other investments on deposit or in accounts with banks or other financial institutions in the U.S. and international jurisdictions. As part of our currency hedging activities, we enter into transactions involving derivative financial instruments with various financial institutions. Certain banks and financial institutions are also lenders under our credit facilities. We regularly monitor our exposure to counterparty credit risk, and actively manage this exposure to mitigate the associated risk. Despite these efforts, we may be exposed to the risk of default by, or deteriorating operating results or financial condition or failure of, these counterparty financial institutions. If one of our counterparties were to become insolvent or file for bankruptcy, our ability to recover losses incurred as a result of default or to access or recover our assets that are deposited, held in accounts with, or otherwise due from, such counterparty may be limited by the counterparty’s liquidity or the applicable laws governing the insolvency or bankruptcy proceedings. In the event of default or failure of one or more of our counterparties, we could incur significant losses, which could negatively impact our results of operations and financial condition.There are risks associated with our indebtedness.We have incurred indebtedness, and we may incur additional indebtedness in the future. Our ability to pay interest and repay the principal for our indebtedness is dependent upon our ability to manage our business operations and generate sufficient cash flows to service such debt. Our outstanding indebtedness and any additional indebtedness we incur may have significant consequences, including, without limitation: requiring us to use a significant portion of our cash flow from operations and other available cash to service our indebtedness, thereby reducing the funds available for other purposes, including capital expenditures, acquisitions, and strategic investments; reducing our flexibility in planning for or reacting to changes in our business, competition pressures and market conditions; and limiting our ability to obtain additional financing for working capital, capital expenditures, acquisitions, share repurchases, or other general corporate and other purposes.Our revolving credit facilities and the indenture for our senior unsecured notes pursuant to which certain of our outstanding debt securities were issued contain financial and other covenants that restrict or could restrict, among other things, our business and operations. If we fail to pay amounts due under a debt instrument or breach any of its covenants, the lenders would typically have the right to demand immediate repayment of all borrowings thereunder (subject in certain cases to a grace or cure period). Moreover, any such acceleration and required repayment of, or default in respect of, our indebtedness could, in turn, constitute an event of default under other debt instruments, thereby resulting in the acceleration and required repayment of our indebtedness. Any of these events could materially adversely affect our liquidity and financial condition.25Table of ContentsChanges by any rating agency to our outlook or credit rating could negatively affect the value of both our debt and equity securities and increase our borrowing costs. If our credit ratings are downgraded or other negative action is taken, the interest rates payable by us under our indebtedness may increase, and our ability to obtain additional financing in the future on favorable terms or at all could be adversely affected.Changes in tax laws, exposure to unanticipated additional tax liabilities, or implementation of record-keeping obligations could have a material adverse effect on our business.An increasing number of U.S. states, the U.S. federal government, and foreign jurisdictions, as well as international organizations, such as the Organization for Economic Co-operation and Development and the EU Commission, are focused on tax reform and other legislative or regulatory action to increase tax revenue. Various countries have proposed or enacted digital services taxes. These actions may materially affect our effective tax rate.The determination of our worldwide provision for income taxes and other tax liabilities requires estimation and significant judgment, and there are many transactions and calculations where the ultimate tax determination is uncertain. We are currently undergoing a number of investigations, audits, and reviews by tax authorities in multiple U.S. and foreign tax jurisdictions. Any adverse outcome of any such audit or review could result in unforeseen tax-related liabilities that differ from the amounts recorded in our financial statements, which may, individually or in the aggregate, materially affect our financial results in the periods for which such determination is made. While we have established reserves based on assumptions and estimates that we believe are reasonable to cover such eventualities, these reserves may prove to be insufficient.In addition, our future income taxes could be adversely affected by the incurrence of losses or earnings being lower than anticipated in jurisdictions that have lower statutory tax rates, and earnings being higher than anticipated in jurisdictions that have higher statutory tax rates; by changes in the valuation of our deferred tax assets and liabilities, including as a result of gains on our foreign currency exchange risk management program; by changes in tax laws, regulations, or accounting principles; or by certain discrete items.A number of U.S. states, the U.S. federal government, and foreign jurisdictions have implemented and may impose reporting or record-keeping obligations on companies that engage in or facilitate e-commerce to improve tax compliance. A number of jurisdictions are also reviewing whether payment service providers and other intermediaries could be deemed to be the legal agent of merchants for certain tax purposes. We have modified our systems to meet applicable requirements and expect that further modifications will be required to comply with future requirements, which may negatively impact our customer experience and increase operational costs. Any failure by us to comply with these and similar reporting and record-keeping obligations could result in substantial monetary penalties and other sanctions, adversely impact our ability to do business in certain jurisdictions, and harm our business. If the distribution of our common stock in connection with our separation from eBay, together with certain related transactions, does not qualify as a transaction that is generally tax-free for U.S. federal income tax purposes, we and certain of our stockholders could be subject to significant tax liabilities.On July 17, 2015, we became an independent publicly traded company through the pro rata distribution by eBay Inc. of 100% of our outstanding common stock to eBay’s stockholders (which we refer to as the “separation” or the “distribution”). eBay received an opinion from its outside legal counsel regarding the qualification of the distribution, together with certain related transactions, as a transaction that is generally tax-free for U.S. federal income tax purposes under Sections 368(a)(1)(D) and 355 of the Internal Revenue Code. Notwithstanding the opinion of counsel, the Internal Revenue Service (the “IRS”) could determine that the distribution, together with certain related transactions, should be treated as a taxable transaction if the IRS determines that any of these representations, assumptions, or undertakings upon which such opinion was based are incorrect or have been violated or if the IRS disagrees with the conclusions in the opinion of counsel. If the distribution, together with certain related transactions, failed to qualify as a transaction that is generally tax-free, eBay stockholders who received PayPal common stock in the distribution may be subject to tax as if they had received a taxable distribution equal to the fair market value of such shares, and we could incur significant liabilities.26Table of ContentsThere are risks associated with our relationship with eBay.In connection with our separation from eBay, we entered into a separation and distribution agreement with eBay and various other agreements, including an operating agreement and agreements covering tax, employee, and intellectual property matters, data sharing, and product development. These agreements determined the allocation of assets and liabilities between the companies following the separation for those respective areas and associated indemnification obligations and established certain commercial relationships between eBay and us. If either we or eBay are unable to satisfy our performance, payment, or indemnification obligations under these agreements or other commercial agreements between the parties, we could incur operational difficulties or losses or be required to make substantial indemnification or other payments to eBay.We expect the portion of our revenue and operating income attributable to eBay will continue to decline due to various factors, including the speed and extent to which eBay intermediates payments on its platform and migrates eBay merchants to eBay’s managed payments platform, limits the availability of PayPal as a payment option, offers or promotes alternative payment options, directs transactions on its platforms to different providers of payment services, or eliminates or modifies its risk management or customer protection programs on its platforms, which could result in customer dissatisfaction, reduction in eBay volume, and other consequences adverse to our business. If we are unable to generate sufficient business from our non-eBay customers to offset the expected reduction in the portion of our business attributable to eBay, the growth of our business and our ability to meet our long-term financial targets could be negatively impacted.We may be unable to attract, retain, and develop the highly skilled employees we need to support our business. Competition for key and other highly skilled personnel is intense, especially for executive talent, software engineers, and other technology talent. We may be limited in our ability to recruit or hire internationally, including due to restrictive laws or policies on immigration, travel, or availability of visas for skilled workers. The loss of the services of any of our key personnel, or our inability to attract, hire, train, and retain highly qualified personnel effectively, could harm our business and growth prospects.We are subject to risks associated with information disseminated through our products and services.We may be subject to claims relating to information disseminated through our online services, including claims alleging defamation, libel, harassment, hate speech, breach of contract, invasion of privacy, negligence, copyright or trademark infringement, or other theories based on the nature and content of the materials disseminated through the services, among other things. If the laws or regulations that provide protections for online dissemination of information are invalidated or are modified to reduce protections available to us and we become liable for information provided by our customers and carried on our products and services, we could be directly harmed and we may be forced to implement new measures to reduce our exposure, including expending substantial resources or discontinuing certain product or service offerings, which could harm our business.ITEM 1B. UNRESOLVED STAFF COMMENTSNone. ITEM 2. PROPERTIESWe own and lease various properties in the U.S. and other countries around the world. We use the properties for executive and administrative offices, data centers, product development offices, and customer services and operations centers. As of December 31, 2020, our owned and leased properties provided us with aggregate square footage as follows:United StatesOther CountriesTotal (In millions)Owned facilities1.0 0.2 1.2 Leased facilities1.4 2.0 3.4 Total facilities2.4 2.2 4.6 We own a total of approximately 106 acres of land, with approximately 85 acres in the U.S. Our corporate headquarters are located in San Jose, California and occupy approximately 0.7 million of owned square feet. 27Table of ContentsITEM 3. LEGAL PROCEEDINGSThe information set forth under “Note 13—Commitments and Contingencies—Litigation and Regulatory Matters” to the consolidated financial statements included in Part IV, Item 15 of this Form 10-K is incorporated herein by reference.ITEM 4. MINE SAFETY DISCLOSURESNot applicable.28Table of ContentsPART II ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIESCOMMON STOCKPayPal common stock is quoted on the NASDAQ Global Select Market under the ticker symbol “PYPL.” As of January 29, 2021, there were 3,926 holders of record of our common stock. The actual number of stockholders is significantly greater than this number of record holders, and includes stockholders who are beneficial owners but whose shares are held in street name by brokers and other nominees. DIVIDEND POLICY We have never paid any cash dividends and we currently do not anticipate paying any cash dividends in the foreseeable future.STOCK REPURCHASE ACTIVITYIn July 2018, our Board of Directors authorized a stock repurchase program that provides for the repurchase of up to $10 billion of our common stock, with no expiration from the date of authorization. Our stock repurchase program is intended to offset the impact of dilution from our equity compensation programs and, subject to market conditions and other factors, may also be used to make opportunistic repurchases of our common stock to reduce outstanding share count. Any share repurchases under our stock repurchase program may be made through open market transactions, block trades, privately negotiated transactions including accelerated share repurchase agreements or other means at times and in such amounts as management deems appropriate, and will be funded from our working capital or other financing alternatives. Moreover, any stock repurchases are subject to market conditions and other uncertainties and we cannot predict if or when any stock repurchases will be made. We may terminate our stock repurchase program at any time without prior notice. The stock repurchase activity under our stock repurchase program during the three months ended December 31, 2020 is summarized as follows:Total number of shares purchasedAverage price paid per share(1)Total number of shares purchased as part of publicly announced plans or programsApproximate dollar value of shares that may yet be purchased under the plans or programs(In millions, except per share amounts)Balance as of September 30, 2020$8,698 October 1, 2020 through October 31, 20200.6 $198.39 0.6 8,586 November 1, 2020 through November 30, 20200.5 $188.64 0.5 8,488 December 1, 2020 through December 31, 20200.2 $224.55 0.2 8,433 Balance as of December 31, 20201.3 1.3 $8,433 (1) Average price paid per share for open market purchases includes broker commissions.29Table of ContentsITEM 6. SELECTED FINANCIAL DATAThe following selected financial data reflect the consolidated operations of PayPal. PayPal derived the selected consolidated income statement data for the years ended December 31, 2020, 2019, and 2018 and the selected consolidated balance sheet data as of December 31, 2020 and 2019 as set forth below, from its audited consolidated financial statements, which are included in “Item 15. Exhibits, Financial Statement Schedules” of this Annual Report on Form 10-K (“Form 10-K”). PayPal derived the selected consolidated income statement data for the years ended December 31, 2017 and 2016 and selected consolidated balance sheet data as of December 31, 2018, 2017, and 2016 from audited consolidated financial statements not included in this Form 10-K. The historical results do not necessarily indicate the results expected for any future period. You should read the selected consolidated financial data presented below in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the consolidated financial statements and accompanying notes included in this report. Year Ended December 31, 20202019201820172016 (In millions, except per share amounts)Consolidated Statement of Income Data:Net revenues$21,454 $17,772 $15,451 $13,094 $10,842 Operating income3,289 2,719 2,194 2,127 1,586 Net income4,202 2,459 2,057 1,795 1,401 Net income per share:Basic$3.58 $2.09 $1.74 $1.49 $1.16 Diluted$3.54 $2.07 $1.71 $1.47 $1.15 Weighted average shares:Basic1,173 1,174 1,184 1,203 1,210 Diluted1,187 1,188 1,203 1,221 1,218 Consolidated Balance Sheet Data:Total assets$70,379 $51,333 $43,332 $40,774 $33,103 Total long-term liabilities11,869 7,485 2,042 1,917 1,513 30Table of ContentsITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSThis Form 10-K contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, including statements that involve expectations, plans, or intentions (such as those relating to future business, future results of operations or financial condition, new or planned features or services, mergers or acquisitions, or management strategies). Additionally, our forward-looking statements include expectations related to anticipated impacts of the outbreak of the novel coronavirus. These forward-looking statements can be identified by words such as “may,” “will,” “would,” “should,” “could,” “expect,” “anticipate,” “believe,” “estimate,” “intend,” “strategy,” “future,” “opportunity,” “plan,” “project,” “forecast,” and other similar expressions. These forward-looking statements involve risks and uncertainties that could cause our actual results and financial condition to differ materially from those expressed or implied in our forward-looking statements. Such risks and uncertainties include, among others, those discussed in “Item 1A. Risk Factors” of this Form 10-K, as well as in our consolidated financial statements, related notes, and the other information appearing in this report and our other filings with the Securities and Exchange Commission (“SEC”). We do not intend, and undertake no obligation except as required by law, to update any of our forward-looking statements after the date of this report to reflect actual results or future events or circumstances. Given these risks and uncertainties, readers are cautioned not to place undue reliance on such forward-looking statements. You should read the following “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in conjunction with the audited consolidated financial statements and the related notes that appear in this report. Unless otherwise expressly stated or the context otherwise requires, references to “we,” “our,” “us,” “the Company,” and “PayPal” refer to PayPal Holdings, Inc. and its consolidated subsidiaries.This Management’s Discussion and Analysis of Financial Condition and Results of Operations focuses on discussion of 2020 results as compared to 2019 results. For discussion of 2019 results as compared to 2018 results, see “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations” within our Form 10-K for the year ended December 31, 2019 filed with the SEC on February 6, 2020.BUSINESS ENVIRONMENTTHE COMPANYWe are a leading technology platform and digital payments company that enables digital and mobile payments on behalf of merchants and consumers worldwide. PayPal is committed to democratizing financial services to improve the financial health of individuals and to increase economic opportunity for entrepreneurs and businesses of all sizes around the world. Our goal is to enable our merchants and consumers to manage and move their money anywhere in the world, anytime, on any platform, and using any device when sending payments or getting paid. We also facilitate person-to-person (“P2P”) payments through our PayPal, Venmo, and Xoom products and services and simplify and personalize shopping experiences for our consumers through our Honey Platform. Our combined payment solutions, including our core PayPal, PayPal Credit, Braintree, Venmo, Xoom, iZettle, and Hyperwallet products and services, comprise our proprietary Payments Platform.Regulatory EnvironmentWe operate globally and in a rapidly evolving regulatory environment characterized by a heightened focus by regulators globally on all aspects of the payments industry, including countering terrorist financing, anti-money laundering, privacy, cybersecurity, and consumer protection. The laws and regulations applicable to us, including those enacted prior to the advent of digital and mobile payments, are continuing to evolve through legislative and regulatory action and judicial interpretation. New or changing laws and regulations, including the changes to their interpretation and implementation, as well as increased penalties and enforcement actions related to non-compliance, could have a material adverse impact on our business, results of operations, and financial condition. We monitor these areas closely and are focused on designing compliant solutions for our customers.31Table of ContentsInformation SecurityInformation security risks for global payments and technology companies like us have increased significantly in recent years. Although we have developed systems and processes designed to protect the data we manage, prevent data loss and other security incidents, and effectively respond to known and potential risks, and expect to continue to expend significant resources to bolster these protections, we remain subject to these risks and there can be no assurance that our security measures will provide sufficient security or prevent breaches or attacks. For additional information regarding our information security risks, see “Item 1A. Risk Factors—Cyberattacks and security vulnerabilities could result in serious harm to our reputation, business, and financial condition.”COVID-19 In March 2020, the World Health Organization declared the outbreak of the novel coronavirus (“COVID-19”) as a pandemic. The outbreak has resulted in government authorities and businesses throughout the world implementing numerous measures intended to contain and limit the spread of COVID-19, including travel restrictions, border closures, quarantines, shelter-in-place and lock-down orders, mask and social distancing requirements, and business limitations and shutdowns. These measures have negatively impacted consumer and business spending and payments activity generally, and have significantly contributed to deteriorating macroeconomic conditions and higher unemployment in some countries, including those in which we have significant operations. The spread of COVID-19 has caused us to make significant modifications to our business practices, including enabling most of our workforce to work from home, establishing strict health and safety protocols for our offices, restricting physical participation in meetings, events, and conferences, and imposing restrictions on employee travel. We will continue to actively monitor the situation and may take further actions that may alter our business practices as may be required by federal, state, or local authorities or that we determine are in the best interests of our employees, customers, or business partners. While the current macroeconomic environment as a result of the COVID-19 pandemic has adversely impacted general consumer and merchant spending with a more pronounced impact on travel and events verticals, the spread of COVID-19 has also accelerated the shift from in-store shopping and traditional in-store payment methods (e.g. cash) towards e-commerce and digital payments and resulted in increased customer demand for safer payment and delivery solutions (e.g. contactless payment methods, buy online and pick up in store) and a significant increase in online spending in certain verticals that have historically had a strong in-store presence. On balance, our business has benefited from these behavioral shifts, including a significant increase in net new active accounts and payments volume. To the extent that consumer preferences revert to pre-COVID-19 behaviors as mitigation measures to limit the spread of COVID-19 are lifted or relaxed, our business, financial condition, and results of operations could be adversely impacted. The rapidly changing global market and economic conditions as a result of COVID-19 have impacted, and are expected to continue to impact, our operations and business. The broader implications of the COVID-19 pandemic on our business, financial condition, and results of operations remain uncertain. For additional information on how COVID-19 has impacted and could continue to negatively impact our business, see below for specific discussion in the respective areas, and also refer to “Part I, Item 1A, Risk Factors” in this Form 10-K.BREXITThe United Kingdom (“U.K.”) formally exited the European Union (“EU”) and the European Economic Area (“EEA”) on January 31, 2020 (commonly referred to as “Brexit”) with the expiration of a transition period on December 31, 2020. PayPal (Europe) S.à.r.l. et Cie, SCA (“PayPal (Europe)”) operates in the U.K. within the scope of its passport permissions (as they stood at the end of the transition period) under the Temporary Permissions Regime pending the grant of new U.K. authorizations by the U.K. financial regulators. We are currently unable to determine the longer-term impact that Brexit will have on our business, which will depend, in part, on the implications of new tariff, trade and regulatory frameworks that now govern the provision of cross-border goods and services between the U.K. and the EEA, as well as the financial and operational consequences of the requirement for PayPal (Europe) to obtain new U.K. authorizations to operate its business longer-term within the U.K. market. For additional information on how Brexit could affect our business, see “Item 1A. Risk Factors—Brexit: The United Kingdom’s departure from the EU could harm our business, financial condition, and results of operations.” 32Table of ContentsBrexit may contribute to instability in financial, stock, and foreign currency exchange markets, including volatility in the value of the British Pound and Euro. We have foreign currency exchange exposure management programs designed to help reduce the impact from foreign currency exchange rate movements. In 2020, 2019, and 2018, net revenues generated from our U.K. operations constituted 11% of total net revenues. In 2020, 2019, and 2018, net revenues generated from the EU (excluding the U.K.) constituted less than 20% of total net revenues. Approximately 50% and 37% of our gross loans and interest receivables as of December 31, 2020 and 2019, respectively, were due from customers in the U.K. Approximately 14% and 6% of our gross loans and interest receivables as of December 31, 2020 and 2019, respectively, were due from customers in the EU (excluding the U.K.). The increase in the percentage of gross loans and interest receivable outstanding in the U.K. and EU as of December 31, 2020 as compared to 2019 was driven by an increase in the balances in those regions as we continue to originate consumer loans in our international markets, combined with a decline in our gross total loans and interest receivable outstanding due to minimal originations in our merchant credit portfolio as compared to 2019.OVERVIEW OF RESULTS OF OPERATIONSThe following table provides a summary of our consolidated financial results for the years ended December 31, 2020, 2019, and 2018: Year Ended December 31,Percent Increase/(Decrease) 20202019201820202019 (In millions, except percentages and per share amounts)Net revenues$21,454 $17,772 $15,451 21 %15 %Operating expenses18,165 15,053 13,257 21 %14 %Operating income3,289 2,719 2,194 21 %24 %Operating margin15 %15 %14 %****Other income (expense), net1,776 279 182 537 %53 %Income tax expense863 539 319 60 %69 %Effective tax rate17 %18 %13 %****Net income$4,202 $2,459 $2,057 71 %20 %Net income per diluted share$3.54 $2.07 $1.71 71 %21 %Net cash provided by operating activities(1)$5,854 $4,071 $5,480 44 %(26)%All amounts in tables are rounded to the nearest million, except as otherwise noted. As a result, certain amounts may not recalculate using the rounded amounts provided.** Not Meaningful(1) Prior period amounts have been revised to conform to the current period presentation. Refer to “Note 1—Overview and Summary of Significant Accounting Policies” to our consolidated financial statements included in this Form 10-K for additional information.Net revenues increased $3.7 billion, or 21%, in 2020 as compared to 2019 driven primarily by growth in total payment volume (“TPV”, as defined below under “Net Revenues”) of 31%. Our acquisition of Honey Science Corporation (“Honey”) contributed approximately one percentage point to the growth rate in 2020. Total operating expenses increased $3.1 billion, or 21%, in 2020 as compared to 2019 due primarily to an increase in transaction expense, and to a lesser extent, increases in technology and development expenses, sales and marketing expenses, transaction and credit losses, and general and administrative expenses. Our acquisitions of Honey and a 70% equity interest in Guofubao Information Technology Co. (GoPay), Ltd. (“GoPay”) collectively contributed approximately five percentage points to the growth rate in total operating expenses in 2020.Operating income increased $570 million, or 21%, in 2020 as compared to 2019 due to growth in net revenues, partially offset by an increase in operating expenses. Our operating margin was 15% in both 2020 and 2019. Our acquisitions of Honey and GoPay collectively had a negative impact of approximately three percentage points to our operating margin, which was offset by operating efficiencies.Net income increased by $1.7 billion, or 71%, in 2020 as compared to 2019 due to the previously discussed increase in operating income of $570 million and an increase in other income (expense), net of $1.5 billion, driven primarily by net gains on strategic investments, partially offset by an increase in income tax expense of $324 million, driven primarily by tax expense related to gains on strategic investments.33Table of ContentsIMPACT OF FOREIGN CURRENCY EXCHANGE RATESWe have significant international operations that are denominated in foreign currencies, primarily the British Pound, Euro, Australian Dollar, and Canadian Dollar, subjecting us to foreign currency exchange risk which may adversely impact our financial results. The strengthening or weakening of the U.S. dollar versus the British Pound, Euro, Australian Dollar, and Canadian Dollar, as well as other currencies in which we conduct our international operations, impacts the translation of our net revenues and expenses generated in these foreign currencies into the U.S. dollar. In 2020, 2019, and 2018, we generated approximately 49%, 47%, and 46% of our net revenues from customers domiciled outside of the United States, respectively. Because we generate substantial net revenues internationally, we are subject to the risks of doing business outside of the U.S., including those discussed under “Item 1A. Risk Factors.” We calculate the year-over-year impact of foreign currency exchange movements on our business using prior period foreign currency exchange rates applied to current period transactional currency amounts. While changes in foreign currency exchange rates affect our reported results, we have a foreign currency exchange exposure management program in which we designate certain foreign currency exchange contracts as cash flow hedges intended to reduce the impact on earnings from foreign currency exchange rate movements. Gains and losses from these foreign currency exchange contracts are recognized as a component of transaction revenues in the same period the forecasted transactions impact earnings.In the years ended December 31, 2020 and 2019, the year-over-year foreign currency movements relative to the U.S. dollar had the following impact on our reported results:Year Ended December 31,20202019(In millions)Favorable (unfavorable) impact to net revenues (exclusive of hedging impact)$66 $(316)Hedging impact20 238 Favorable (unfavorable) impact to net revenues 86 (78)Favorable impact to operating expense4 158 Net favorable impact to operating income$90 $80 While we enter into foreign currency exchange contracts to help reduce the impact on earnings from foreign currency exchange rate movements, it is impossible to predict or eliminate the total effects of this exposure.We also used a foreign currency exchange contract, designated as a net investment hedge, to reduce the foreign currency exchange risk related to our investment in a foreign subsidiary. Gains and losses associated with this instrument will remain in accumulated other comprehensive income until the foreign subsidiary is sold or substantially liquidated. Additionally, in connection with our services that are paid for in multiple currencies, we generally set our foreign currency exchange rates daily and may face financial exposure if we incorrectly set our foreign currency exchange rates or as a result of fluctuations in foreign currency exchange rates between the times that we set our foreign currency exchange rates. Given that we also have foreign currency exchange risk on our assets and liabilities denominated in currencies other than the functional currency of our subsidiaries, we have an additional foreign currency exchange exposure management program in which we use foreign currency exchange contracts to offset the impact of foreign currency exchange rate movements on our assets and liabilities. The foreign currency exchange gains and losses on our assets and liabilities are recorded in other income (expense), net, and are offset by the gains and losses on the foreign currency exchange contracts. These foreign currency exchange contracts reduce, but do not entirely eliminate, the impact of foreign currency exchange rate movements on our assets and liabilities. 34Table of ContentsFINANCIAL RESULTSNET REVENUESOur revenues are classified into the following two categories:•Transaction revenues: Net fees charged to merchants and consumers on a transaction basis primarily based on the TPV completed on our Payments Platform. Growth in TPV is directly impacted by the number of payment transactions that we enable on our Payments Platform. We earn additional fees on transactions where we perform currency conversion, when we enable cross-border transactions (i.e., transactions where the merchant and consumer are in different countries), to facilitate the instant transfer of funds for our customers from their PayPal or Venmo account to their debit card or bank account, and other miscellaneous fees.•Revenues from other value added services: Net revenues derived primarily from revenue earned through partnerships, referral fees, subscription fees, gateway fees, and other services we provide to our merchants and consumers. We also earn revenues from interest and fees earned primarily on our portfolio of loans receivable, and interest earned on certain assets underlying customer balances.Our revenues can be significantly impacted by the following: •The mix of merchants, products, and services;•The mix between domestic and cross-border transactions;•The geographic region or country in which a transaction occurs; and•The amount of our loans receivable outstanding with merchants and consumers.Active accounts, number of payment transactions, number of payment transactions per active account, and TPV are key non-financial performance metrics (“key metrics”) that management uses to measure the performance of our business, and are defined as follows:•An active account is an account registered directly with PayPal or a platform access partner that has completed a transaction on our Payments Platform or through our Honey Platform, not including gateway-exclusive transactions, within the past 12 months. A platform access partner is a third party whose customers are provided access to PayPal’s Payments Platform through such third party’s login credentials. The number of active accounts provides management with additional perspective on the growth of accounts across our Payments and Honey Platforms as well as the overall scale of our platforms.•Number of payment transactions are the total number of payments, net of payment reversals, successfully completed on our Payments Platform or enabled by PayPal via a partner payment solution, not including gateway-exclusive transactions. •Number of payment transactions per active account reflects the total number of payment transactions within the previous 12-month period, divided by active accounts at the end of the period. The number of payment transactions per active account provides management with insight into the number of times a customer is engaged in payments activity on our Payments Platform in a given period. •TPV is the value of payments, net of payment reversals, successfully completed on our Payments Platform, or enabled by PayPal via a partner payment solution, not including gateway-exclusive transactions. As our transaction revenue is typically correlated with TPV growth and the number of payment transactions completed on our Payments Platform, management uses these metrics to gain insights into the scale and strength of our Payments Platform, the engagement level of our customers, and underlying activity and trends which are indicators of current and future performance. We present these key metrics to enhance investors’ evaluation of the performance of our business and operating results.35Table of ContentsNet Revenue AnalysisThe components of our net revenue for the years ended December 31, 2020, 2019 and 2018 were as follows (in millions):Transaction revenuesTransaction revenues increased by $3.8 billion, or 24%, in 2020 compared to 2019 and were mainly attributable to our core PayPal products and services due primarily to strong growth in TPV and the number of payment transactions, both of which resulted primarily from an increase in our active accounts, and to a lesser extent, an increase in revenue from currency conversion fees.The current macroeconomic environment as a result of the COVID-19 pandemic has adversely impacted general consumer and merchant spending with a more pronounced impact on travel and events verticals. However, we have experienced strong growth in online retail, gaming, and food volume, offsetting this decline. The graphs below present the respective key metrics (in millions) for the years ended December 31, 2020, 2019, and 2018:*Reflects active accounts at the end of the applicable period. Active accounts as of December 31, 2020 includes 10.2 million active accounts contributed by Honey on the date of acquisition in January 2020. The following table provides a summary of related metrics: Year Ended December 31,Percent Increase/(Decrease) 20202019201820202019Payment transactions per active account40.9 40.6 36.9 1 %10 %Percent of cross-border TPV17 %18 %19 %** ** ** Not meaningful36Table of ContentsTransaction revenues grew more slowly than TPV, which grew 31%, and the number of payment transactions, which grew 25%, in 2020 compared to 2019 due primarily to a higher proportion of P2P transactions (primarily from our Venmo products) from which we earn lower fees, a decline in hedging gains, and a higher portion of TPV generated by platform partners and large merchants who generally pay lower rates with higher transaction volumes. Changes in prices charged to our customers did not significantly impact transaction revenue growth in 2020.Revenues from other value added servicesRevenues from other value added services decreased by $137 million, or 8%, in 2020 compared to 2019 due primarily to a decline in interest earned on certain assets underlying customer account balances resulting from lower interest rates and a decrease in interest and fee income on our loans and advances receivable due to an increase in the allowance for expected credit losses against interest and fees receivable, a decline in originations, and payment holidays that we provided during the year to our customers as a part of our COVID-19 payment relief initiatives. Additionally, the decline in revenues from other value added services was driven by a decline in revenue earned from transition servicing activities provided to Synchrony Bank (“Synchrony”), which ended in the second quarter of 2019. This decline was partially offset by incremental revenues from our acquisition of Honey, which contributed approximately 15 percentage points to the revenue growth rate for other value added services in 2020, and an increase in our revenue share earned from Synchrony.The total gross consumer and merchant loans receivable balance as of December 31, 2020 and 2019 was $3.6 billion and $4.2 billion, respectively. The year-over-year decrease of 15% in 2020 compared to 2019 was driven by a decline in our merchant receivable portfolio due to reduced originations, partially offset by growth in our consumer receivable portfolio. In response to the COVID-19 pandemic, we have taken both proactive and reactive measures to support our merchants and consumers that have loans and interest receivables due to us under our credit product offerings. These measures were intended to reduce financial difficulties experienced by our customers and included providing payment holidays to grant payment deferrals to certain borrowers for varying periods of time, and amended payment terms through loan modifications in certain cases. These measures have adversely impacted and are expected to continue to adversely impact the recognition of interest and fee income in future periods. Given the uncertainty surrounding the COVID-19 pandemic, including its duration and severity and the ultimate impact it may have on the financial condition of our merchants and consumers, the extent of these types of actions and their prospective impact on our interest and fee income is not determinable. In addition, consumers that have outstanding loans and interest receivable due to Synchrony may experience similar hardships that result in increased losses recognized by Synchrony, which may result in a decrease in our revenue share earned from Synchrony in future periods. In the event the overall return on the PayPal branded credit programs funded by Synchrony does not meet a minimum rate of return (“minimum return threshold”) in a particular quarter, our revenue share for that period would be zero. Further, in the event the overall return on the PayPal branded credit programs managed by Synchrony does not meet the minimum return threshold as measured over four consecutive quarters and in the following quarter, we would be required to make a payment to Synchrony, subject to certain limitations. Through December 31, 2020, the overall return on the PayPal branded credit programs funded by Synchrony exceeded the minimum return threshold.OPERATING EXPENSESThe following table summarizes our operating expenses and related metrics we use to assess the trends in each: Year Ended December 31,Percent Increase/(Decrease) 20202019201820202019 (In millions, except percentages)Transaction expense$7,934 $6,790 $5,581 17 %22 %Transaction and credit losses1,741 1,380 1,274 26 %8 %Customer support and operations1,778 1,615 1,407 10 %15 %Sales and marketing1,861 1,401 1,314 33 %7 %Technology and development2,642 2,085 1,831 27 %14 %General and administrative2,070 1,711 1,541 21 %11 %Restructuring and other charges139 71 309 96 %(77)%Total operating expenses$18,165 $15,053 $13,257 21 %14 %Transaction expense rate(1)0.85 %0.95 %0.96 %****Transaction and credit loss rate(2)0.19 %0.19 %0.22 %****(1) Transaction expense rate is calculated by dividing transaction expense by TPV. (2) Transaction and credit loss rate is calculated by dividing transaction and credit losses by TPV. ** Not meaningful.37Table of ContentsTransaction expenseTransaction expense is primarily composed of the costs we incur to accept a customer’s funding source of payment. These costs include fees paid to payment processors and other financial institutions to draw funds from a customer’s credit or debit card, bank account, or other funding source they have stored in their digital wallet. Transaction expense also includes fees paid to disbursement partners to enable a transaction. We refer to the allocation of funding sources used by our consumers as our “funding mix.” The cost of funding a transaction with a credit or debit card is generally higher than the cost of funding a transaction from a bank or through internal sources such as a PayPal or Venmo account balance or PayPal Credit. As we expand the availability and presentation of alternative funding sources to our customers, our funding mix may change, which could increase or decrease our transaction expense rate. The cost of funding a transaction is also impacted by the geographic region or country in which a transaction occurs because we generally pay lower rates for transactions funded with credit cards outside the U.S. than in the U.S. Our transaction expense rate is impacted by changes in product mix, merchant mix, regional mix, funding mix, and assessments charged by payment processors and other financial institutions when we draw funds from a customer’s credit or debit card, bank account, or other funding sources. Macroeconomic environment changes may also result in behavioral shifts in consumer spending patterns affecting the type of funding source they use, which also impacts the funding mix. Transaction expense increased by $1.1 billion, or 17%, in 2020 compared to 2019 and was primarily attributable to an increase in TPV of 31%. The decrease in transaction expense rate in 2020 compared to 2019 was due primarily to favorable changes in product mix and funding mix. For the years ended December 31, 2020, 2019, and 2018, approximately 2% of TPV was funded with PayPal Credit. For the years ended December 31, 2020, 2019, and 2018, approximately 40%, 41%, and 43% of TPV, respectively, was generated outside of the U.S. Transaction and credit lossesTransaction losses include the expense associated with our buyer and seller protection programs, fraud, and chargebacks. Credit losses include the losses associated with our merchant and consumer loans receivable portfolio. Beginning in 2020, these losses are based on current expected credit losses. Our transaction and credit losses fluctuate depending on many factors, including TPV, current and projected macroeconomic conditions including unemployment rates, merchant insolvency events, changes to and usage of our customer protection programs, the impact of regulatory changes, and the credit quality of loans receivable arising from transactions funded with our credit products for consumers and loans and advances to merchants. 38Table of ContentsThe components of our transaction and credit losses (in millions) for the years ended December 31, 2020, 2019, and 2018 were as follows:Transaction and credit losses increased by $361 million, or 26%, in 2020 compared to 2019. Transaction loss rate (transaction losses divided by TPV) was 0.12%, 0.15%, and 0.18% for the years ended December 31, 2020, 2019, and 2018, respectively.Transaction losses increased by $43 million, or 4%, in 2020 compared to 2019 due to growth in TPV, partially offset by benefits realized through improvements in risk management capabilities, which also contributed to a decrease in our transaction loss rate over the same period. The duration and severity of the impacts of the COVID-19 pandemic remain unknown. The negative impact on macroeconomic conditions could increase the risk of merchant bankruptcy, insolvency, business failure, or other business interruption, which may adversely impact our transaction losses, particularly for merchants that sell goods or services in advance of the date of their delivery or use.Credit losses increased by $318 million, or 110%, in 2020 compared to 2019 due primarily to an increase in provisions for our loans and interest receivable associated with changes in current and projected macroeconomic conditions, including qualitative adjustments to account for the impact of limitations in our expected credit loss models that have arisen due to the extreme fluctuations in both the actual and projected macroeconomic conditions during the period as well as to incorporate varying degrees of merchant performance in the current environment and expected performance in future periods. Our estimate of the macroeconomic impact on current expected credit losses is most significantly impacted by projected unemployment trends and benchmark credit card charge-off rates, which directly correlate to the forecast of loans and interest receivables that we expect to charge off in the future. Credit losses for the year ended December 31, 2020 include the impact of the increase in actual unemployment rates and credit card charge-off rates during the current period and expectations of a prolonged economic recovery period over which the value of loans and interest receivable that charge-off are projected to exceed historical trends. If the actual unemployment and charge-offs vary from these projections as of December 31, 2020, the credit losses recognized in future periods will be impacted. The consumer loans and interest receivables balance as of December 31, 2020 and 2019 was $2.2 billion and $1.3 billion, respectively. The year-over-year increase of 64% in 2020 compared to 2019 was due to growth of PayPal Credit in international markets and, to a lesser extent, growth of our installment credit products in the U.S. and international markets. Approximately 77% and 94% of our consumer loans receivables outstanding as of December 31, 2020 and 2019, respectively, were due from consumers in the U.K. 39Table of ContentsThe following table provides information regarding the credit quality of our consumer loans and interest receivable balance: December 31,20202019Percent of consumer loans and interest receivables current (1),(2)97.9 %96.7 %Percent of consumer loans and interest receivables > 90 days outstanding (1), (2), (3)0.9 %1.5 %Net charge off rate(4)2.4 %4.1 %(1) Prior period revised to conform to the current period presentation. (2) Includes the impact of payment holidays provided by the Company as a part of our COVID-19 payment relief initiatives.(3) Represents percentage of balances which are 90 days past the billing date to the consumer.(4) Net charge off rate is the annual ratio of net credit losses, excluding fraud losses, on consumer loans receivables as a percentage of the average daily amount of consumer loans and interest receivables balance during the period. The decrease in the net charge off rate for consumer receivables at December 31, 2020 as compared to December 31, 2019 was primarily attributable to the continued expansion and maturity of our international consumer loan receivable portfolio and was in-part favorably impacted in the current year by payment holidays provided by the Company as a part of our COVID-19 payment relief initiatives.We offer access to credit products for certain small and medium-sized merchants, which we refer to as our merchant lending offerings. Total merchant loans, advances, and interest and fees receivable outstanding, net of participation interest sold, as of December 31, 2020 and 2019 were $1.4 billion and $2.8 billion, respectively. The year-over-year decrease of 51% in 2020 compared to 2019 was due primarily to a reduction in originations due to modifications in our acceptable risk parameters as well as a shift towards merchants borrowing through the U.S. Government’s Paycheck Protection Program (“PPP”) administered by the U.S. Small Business Administration (“SBA”) and enacted in March 2020 under the Coronavirus Aid, Relief, and Economic Security Act (“CARES Act”) in response to the COVID-19 pandemic. We do not own the receivables associated with loans originated through the PPP. Approximately 81% and 10% of our merchant receivables outstanding as of December 31, 2020 were due from merchants in the U.S. and U.K., as compared to 83% and 10% as of December 31, 2019, respectively. The following table provides information regarding the credit quality of our merchant loans, advances, and interest and fees receivable balance:December 31,20202019Percent of merchant receivables within original expected or contractual repayment period75.4 %89.6 %Percent of merchant receivables > 90 days outstanding after the end of original expected or contractual repayment period (1)12.5 %4.2 %Net charge off rate (2)18.9 %7.4 %(1) Includes the impact of payment holidays and modification programs provided by the Company as a part of our COVID-19 payment relief initiatives.(2) Net charge off rate is the annual ratio of net credit losses, excluding fraud losses, on merchant loans and advances as a percentage of the average daily amount of merchant loans, advances, and interest and fees balance during the period.The decline in the percent of merchant receivables within the original expected or contractual repayment period, increase in percent of merchant receivables greater than 90 days outstanding, and increase in the net charge off rate for merchant receivables at December 31, 2020 as compared to December 31, 2019 was primarily due to an increase in payment delinquency driven by financial difficulties experienced by our merchants associated with the economic impact of COVID-19 and a significant decline in our outstanding merchant receivables balance due to repayments and reduced originations, which increases net charge offs and delinquency rates presented as a percentage of our outstanding loan balance. Beginning in the third quarter of 2020, we have granted certain merchants loan modifications intended to provide them with financial relief and to help enable us to mitigate losses. The associated loans and interest receivables have been treated as troubled debt restructurings due to significant changes in their structure, including repayment terms and fee/rate structure. For additional information, see “Note 11—Loans and Interest Receivable” in the notes to our consolidated financial statements included in this Form 10-K.40Table of ContentsDuring the year ended December 31, 2020, modifications to the acceptable risk parameters of our credit products in response to the impacts of the COVID-19 pandemic resulted in the implementation of a number of risk mitigation strategies, including reduction of maximum loan size, tightening eligibility terms, and a shift from automated to manual underwriting of loans and advances. These changes in acceptable risk parameters have resulted in a deceleration in the growth of our borrowing base and a decrease in merchant receivables as of December 31, 2020, as compared to 2019. While the impact of COVID-19 on the economic environment remains uncertain, the longer and more severe the pandemic, the more likely it is to have a material adverse impact on our borrowing base, which is primarily comprised of small and medium-sized merchants. For additional information, see “Note 11—Loans and Interest Receivable” in the notes to the consolidated financial statements, and “Item 1A. Risk Factors—Our credit products expose us to additional risks.” included in this Form 10-K. Customer support and operationsCustomer support and operations includes (a) costs incurred in our global customer operations centers, including costs to provide call support to our customers, (b) costs to support our trust and security programs protecting our merchants and consumers, and (c) other costs incurred related to the delivery of our products, including payment devices, card production, and customer onboarding and compliance costs.Customer support and operations costs increased $163 million, or 10%, in 2020 compared to 2019. The increase in 2020 was primarily attributable to an increase in employee-related expenses and contractors and consulting costs mainly in our operations function that support the growth of our active accounts and payment transactions, as well as customer onboarding and compliance costs.Sales and marketingSales and marketing includes costs incurred for customer acquisition, business development, advertising, and marketing programs. Sales and marketing expenses increased $460 million, or 33%, in 2020 compared to 2019 due primarily to higher spend on marketing programs and employee-related expenses. Our acquisitions of Honey and GoPay collectively contributed approximately 20 percentage points to the growth rate of sales and marketing expenses in 2020.41Table of ContentsTechnology and developmentTechnology and development includes (a) costs incurred in connection with the development of our Payments Platform, new products, and the improvement of our existing products, including the amortization of software and website development costs incurred in developing our Payments Platform, which are capitalized, and acquired developed technology, and (b) our site operations and other infrastructure costs incurred to support our Payments Platform.Technology and development expenses increased $557 million, or 27%, in 2020 compared to 2019 due primarily to increases in employee-related expenses, amortization of acquired intangibles, data center and cloud computing services utilized in delivering our products, and costs related to contractors and consultants. Our acquisitions of Honey and GoPay collectively contributed approximately 15 percentage points to the growth rate of technology and development expenses in 2020. General and administrativeGeneral and administrative includes costs incurred to provide support to our business, including legal, human resources, finance, risk, compliance, executive, and other support operations. General and administrative expenses increased $359 million, or 21%, in 2020 compared to 2019 due primarily to increases in employee-related expenses, professional services expenses, including those attributable to acquisition related transaction expenses, and amortization of acquired intangibles and internally developed software used in our general and administrative functions. Our acquisitions of Honey and GoPay collectively contributed approximately 13 percentage points to the growth rate of general and administrative expenses in 2020. 42Table of ContentsRestructuring and other chargesRestructuring and other charges primarily consist of restructuring expenses and, in 2018, cost adjustments related to our loans and receivables, held for sale portfolio. Restructuring and other charges increased by $68 million in 2020 compared to 2019.During the first quarter of 2020, management approved a strategic reduction of the existing global workforce, which resulted in restructuring charges of $109 million. The approved strategic reduction in 2020 is part of a multiphase process to reorganize our workforce concurrently with the redesign of our operating structure, which spanned multiple quarters. We primarily incurred employee severance and benefits costs, as well as other associated consulting costs under the 2020 strategic reduction. We have experienced delays, primarily as a result of COVID-19, in the execution of these restructuring actions, which are now expected to be completed by the end of the first quarter of 2021.Additionally, in 2020, we incurred asset impairment charges of $30 million due to the write-off of certain right-of-use lease assets and related leasehold improvements in conjunction with exiting certain leased properties.In the first quarter of 2019, management approved strategic reductions of the existing global workforce, which resulted in restructuring charges of $78 million. The approved strategic reductions for 2019 were intended to better align our teams to support key business priorities and included the transfer of certain operational functions between geographies, as well as the impact of the transition of servicing activities provided to Synchrony, which ended in the second quarter of 2019. We primarily incurred employee and severance benefits expenses under the 2019 strategic reductions, which were substantially completed by the end of the first quarter of 2020.For information on the associated restructuring liability, see “Note 17—Restructuring and Other Charges” in the notes to the consolidated financial statements included in this Form 10-K.Other income (expense), netOther income (expense), net increased $1.5 billion, or 537%, in 2020 compared to 2019 primarily driven by net gains on strategic investments of $1.7 billion due primarily to favorable changes in fair value related to our marketable equity securities. This increase was partially offset by a decline in interest income driven by lower interest rates as well as incremental interest expense associated with our fixed rate notes issued in the third quarter of 2019 and second quarter of 2020.Income tax expense Our effective tax rate was 17% in 2020 and 18% in 2019. The decrease in our effective tax rate in 2020 was primarily the result of favorable discrete tax adjustments, partially offset by taxes associated with gains on strategic investments. See “Note 16—Income Taxes” to the consolidated financial statements included in this Form 10-K for more information on our effective tax rate.43Table of ContentsLIQUIDITY AND CAPITAL RESOURCESWe require liquidity and access to capital to fund our global operations, including customer protection programs, our credit products, capital expenditures, investments in our business, potential acquisitions and strategic investments, working capital, and other cash needs. The following table summarizes our cash, cash equivalents, and investments as of December 31, 2020 and 2019:Year Ended December 31,20202019(In millions)Cash, cash equivalents, and investments(1)(2)$15,852 $11,722 (1) Excludes assets related to funds receivable and customer accounts of $33.4 billion and $22.5 billion as of December 31, 2020 and 2019, respectively.(2) Excludes total restricted cash of $88 million and $64 million at December 31, 2020 and 2019, respectively, and strategic investments of $3.2 billion and $1.8 billion as of December 31, 2020 and 2019, respectively.Foreign Cash, Cash Equivalents, and InvestmentsCash, cash equivalents, and investments held by our foreign subsidiaries were $7.0 billion at December 31, 2020 and $7.2 billion at December 31, 2019, or 44% and 61% of our total cash, cash equivalents, and investments as of those respective dates. At December 31, 2020, all of our cash, cash equivalents, and investments held by foreign subsidiaries were subject to U.S. taxation under Subpart F, Global Intangible Low Taxed Income (“GILTI”), or the one-time transition tax. Subsequent repatriations to the U.S. will not be taxable from a U.S. federal tax perspective, but may be subject to state or foreign withholding tax. A significant aspect of our global cash management activities involves meeting our customers’ requirements to access their cash while simultaneously meeting our regulatory financial ratio commitments in various jurisdictions. Our global cash balances are required not only to provide operational liquidity to our businesses, but also to support our global regulatory requirements across our regulated subsidiaries. As such, not all of our cash is available for general corporate purposes.Available Credit and DebtIn May 2020 and September 2019, we issued fixed rate notes with varying maturity dates for an aggregate principal amount of $9.0 billion (collectively referred to as the “Notes”). Proceeds from the issuance of these Notes may be used for general corporate purposes, which may include funding the repayment or redemption of outstanding debt, share repurchases, ongoing operations, capital expenditures, and possible acquisitions of businesses, assets, or strategic investments. As of December 31, 2020, we had $9.0 billion in fixed rate debt outstanding with varying maturity dates. In September 2019, we entered into a credit agreement (the “Credit Agreement”) that provides for an unsecured $5.0 billion, five-year revolving credit facility that includes a $150 million letter of credit sub-facility and a $500 million swingline sub-facility, with available borrowings under the revolving credit facility reduced by the amount of any letters of credit and swingline borrowings outstanding from time to time. In March 2020, we drew down $3.0 billion under the Credit Agreement. In May 2020, we repaid the $3.0 billion using proceeds from the May 2020 debt issuance. As of December 31, 2020, no borrowings were outstanding under the Credit Agreement and as such, $5.0 billion of borrowing capacity was available for the purposes permitted by the Credit Agreement, subject to customary conditions to borrowing. Additionally, in September 2019, we entered into a 364-day credit agreement that provided for an unsecured $1.0 billion 364-day revolving credit facility, which terminated in September 2020.We maintain an uncommitted credit facility with a borrowing capacity of approximately $30 million, where we can withdraw and utilize the funds at our discretion for general corporate purposes. As of December 31, 2020, the majority of the borrowing capacity under this credit facility was available, subject to customary conditions to borrowing.For additional information, see “Note 12—Debt” to our consolidated financial statements included in this Form 10-K. We have a cash pooling arrangement with a financial institution for cash management purposes. The arrangement allows for cash withdrawals from the financial institution based upon our aggregate operating cash balances held within the financial institution (“Aggregate Cash Deposits”). The arrangement also allows us to withdraw amounts exceeding the Aggregate Cash Deposits up to an agreed-upon limit. The net balance of the withdrawals and the Aggregate Cash Deposits are used by the financial institution as a basis for calculating our net interest expense or income under the arrangement. As of December 31, 2020, we had a total of $3.9 billion in cash withdrawals offsetting our $3.9 billion in Aggregate Cash Deposits held within the financial institution under the cash pooling arrangement.44Table of ContentsLiquidity for Loans Receivable Growth in our portfolio of loan receivables increases our liquidity needs, and any inability to meet those liquidity needs could adversely affect our business. We continue to evaluate partnerships and third party sources of funding for our loans receivable portfolio. In June 2018, the Luxembourg Commission de Surveillance du Secteur Financier (the “CSSF”) agreed that PayPal’s management may designate up to 35% of European customer balances held in our Luxembourg banking subsidiary to be used for European and U.S. credit activities. As of December 31, 2020, the cumulative amount approved by management to be designated for credit activities aggregated to $2.0 billion and represented approximately 21% of European customer balances potentially available for our corporate use at that date as determined by applying financial regulations maintained by the CSSF. We may periodically seek to designate additional amounts of customer balances, if necessary, based on utilization of the approved funds and anticipated credit funding requirements. Our objective is to expand the availability of our credit products with capital from external sources, although there can be no assurance that we will be successful in achieving that goal. Under certain exceptional circumstances, corporate liquidity could be called upon to meet our obligations related to our European customer balances.In April 2020, PayPal was approved to participate in the PPP administered by the SBA. The program was designed to provide a direct incentive for small businesses to keep their workers on payroll during the COVID-19 pandemic and includes initial loan repayment deferrals and debt forgiveness provisions for eligible borrowers. Loans made under this program are funded by an independent chartered financial institution that we partner with, and the related receivables are not purchased by PayPal. We receive a fee for providing origination services and loan servicing for the loans and retain operational risk related to those activities. Credit RatingsAs of December 31, 2020, we continue to be rated investment grade by Standard and Poor’s Financial Services, LLC, Fitch Ratings, Inc., and Moody’s Investors Services Inc. We expect that these credit rating agencies will continue to monitor our performance, including our capital structure and results of operations. Our goal is to be rated investment grade, but as circumstances change, there are factors that could result in our credit ratings being downgraded or put on a watch list for possible downgrading. If that were to occur, it could increase our borrowing rates, including the interest rate on borrowings under our credit agreement.Risk of LossThe risk of losses from our buyer and seller protection programs are specific to individual customers, merchants, and transactions, and may also be impacted by regional variations in, and changes or modifications to, the programs, including as a result of changes in regulatory requirements. For the periods presented in these consolidated financial statements included in this report, our transaction loss rates ranged between 0.12% and 0.18% of TPV. Historical loss rates may not be indicative of future results. The duration and severity of the impacts of the COVID-19 pandemic remain unknown. Its negative impact on macroeconomic conditions could increase the risk of merchant bankruptcy, insolvency, business failure, or other business interruption, which may result in an adverse impact on our transaction losses, particularly for merchants that sell goods or services in advance of the date of their delivery or use.Stock Repurchases and AcquisitionsDuring the year ended December 31, 2020, we repurchased approximately $1.6 billion of our common stock in the open market under our stock repurchase programs authorized in April 2017 and July 2018. The July 2018 stock repurchase program became effective during the first quarter of 2020 upon completion of the April 2017 stock repurchase program. As of December 31, 2020, a total of approximately $8.4 billion remained available for future repurchases of our common stock under our July 2018 stock repurchase program. For additional information, see “Note 14—Stock Repurchase Programs” to our consolidated financial statements included in this Form 10-K. In January 2020, we completed our acquisition of Honey for approximately $3.6 billion in cash and approximately $400 million in assumed restricted stock, restricted stock units, and options, subject to vesting conditions. We believe our acquisition of Honey will enhance our value proposition by allowing us to further simplify and personalize shopping experiences for consumers while driving conversion and increasing consumer engagement and sales for merchants. For additional information, see “Note 4—Business Combinations” in the notes to the consolidated financial statements included in this Form 10-K.45Table of ContentsOther ConsiderationsIn the second quarter of 2020, we announced our commitment to invest $530 million to support racial equality. The investments will include: charitable contributions, grants to small businesses, internal investments to support and strengthen diversity and inclusion initiatives, and an economic opportunity fund, which will include bolstering our relationships with community banks and credit unions serving underrepresented minority communities, as well as investing directly into black- and minority-led startups and minority-focused investment funds.Our liquidity, access to capital, and borrowing costs could be adversely impacted by declines in our credit rating, our financial performance, and global credit market conditions, as well as a broad range of other factors, including those related to the COVID-19 pandemic discussed in this Form 10-K. In addition, our liquidity, access to capital, and borrowing costs could also be negatively impacted by the outcome of any of the legal or regulatory proceedings to which we are a party. See “Item 1A. Risk Factors” and “Note 13—Commitments and Contingencies” to our consolidated financial statements included in this Form 10-K for additional discussion of these and other risks that our business faces.We believe that our existing cash, cash equivalents, and investments, cash expected to be generated from operations, and our expected access to capital markets, together with potential external funding through third party sources, will be sufficient to fund our operating activities, anticipated capital expenditures, and our credit products for the foreseeable future. Depending on market conditions, we may from time to time issue debt, including in private or public offerings, to fund our operating activities, finance acquisitions, make strategic investments, repurchase shares under our stock repurchase program, or reduce our cost of capital.CASH FLOWSThe following table summarizes our consolidated statements of cash flows: Year Ended December 31, 202020192018 (In millions)Net cash provided by (used in):Operating activities(1)$5,854 $4,071 $5,480 Investing activities(1)(16,218)(5,742)821 Financing activities(1)12,492 4,187 (1,240)Effect of exchange rates on cash, cash equivalents, and restricted cash169 (6)(113)Net increase in cash, cash equivalents, and restricted cash$2,297 $2,510 $4,948 (1) Prior period amounts have been revised to conform to the current period presentation. Refer to “Note 1—Overview and Summary of Significant Accounting Policies” to our consolidated financial statements included in this Form 10-K for additional information.Operating ActivitiesCash flows from operating activities includes net income adjusted for certain non-cash expenses, timing differences between expenses recognized for provision for transaction and credit losses and actual cash transaction losses incurred, and changes in other assets and liabilities. Significant non-cash expenses for the period include depreciation and amortization and stock-based compensation. The cash impact from actual transaction losses incurred during a period is reflected as a negative impact to changes in other assets and liabilities in cash from operating activities. The expenses recognized during the period for provision for credit losses are estimates of current expected credit losses on our merchant and consumer credit products. Actual charge-offs of receivables related to our merchants and consumer credit products have no impact on cash from operating activities.We generated cash from operating activities of $5.9 billion in 2020 due primarily to operating income of $3.3 billion, as well as adjustments for non-cash expenses including: provision for transaction and credit losses of $1.7 billion, stock-based compensation of $1.4 billion, and depreciation and amortization of $1.2 billion. Net income was also adjusted for net gains on our strategic investments of $1.9 billion in 2020, and changes in other assets and liabilities primarily related to actual cash transaction losses incurred during the period of $1.1 billion and an increase in other assets of $498 million, partially offset by an increase in other liabilities of $1.0 billion.46Table of ContentsWe generated cash from operating activities of $4.1 billion in 2019 due primarily to operating income of $2.7 billion. During 2019, adjustments for non-cash expenses included provision for transaction and credit losses of $1.4 billion, stock-based compensation of $1.0 billion, and depreciation and amortization of $912 million, partially offset by adjustments related to deferred income taxes of $269 million and net unrealized gains on our strategic investments of $208 million. The cash generated from operating activities was negatively impacted by changes in other assets and liabilities primarily related to actual cash transaction losses incurred during the period of $1.1 billion, an increase in other assets of $566 million and accounts receivable of $120 million, partially offset by an increase in other liabilities of $722 million. We generated cash from operating activities of $5.5 billion in 2018 due primarily to operating income of $2.2 billion and the positive impact of $1.4 billion of changes in loans and interest receivable, held for sale, net following the sale of our U.S. consumer credit receivables portfolio. During 2018, adjustments for non-cash expenses included provision for transaction and credit losses of $1.3 billion, stock-based compensation of $853 million, depreciation and amortization of $776 million, and cost basis adjustments to loans and interest receivable held for sale of $244 million. The cash generated from operating activities was also impacted by changes in other assets and liabilities, primarily related to actual cash transaction losses incurred during the period of $1.0 billion, partially offset by an increase in other liabilities of $428 million.Cash paid for income taxes, net in 2020, 2019, and 2018 was $565 million, $665 million, and $328 million, respectively.Investing ActivitiesCash flows from investing activities includes purchases, maturities and sales of investments, cash paid for acquisitions and strategic investments, purchases and sales of property and equipment, changes in principal loans receivable, and funds receivable. The net cash used in investing activities of $16.2 billion in 2020 was due primarily to purchases of investments of $41.5 billion, acquisitions (net of cash acquired) of $3.6 billion, changes in funds receivable from customers of $1.6 billion, and purchases of property and equipment of $866 million. These cash outflows were partially offset by maturities and sales of investments of $30.9 billion, changes in principal loans receivable, net of $294 million, and proceeds from the sale of property and equipment of $120 million.The net cash used in investing activities of $5.7 billion in 2019 was due primarily to purchases of investments of $27.9 billion, changes in principal loans receivable, net of $1.6 billion, purchases of property and equipment of $704 million, and changes in funds receivable from customers of $351 million. These cash outflows were partially offset by maturities and sales of investments of $24.9 billion.We generated cash from investing activities of $821 million in 2018 due primarily to maturities and sales of investments of $21.9 billion, changes in principal loans receivable, net of $3.1 billion, and changes in funds receivable from customers of $1.1 billion. These cash inflows were offset by purchases of investments of $22.4 billion, acquisitions of $2.1 billion (net of cash and restricted cash acquired), and purchases of property and equipment of $823 million.Financing ActivitiesCash flows from financing activities includes proceeds from issuance of common stock, purchases of treasury stock, tax withholdings related to net share settlements of equity awards, borrowings and repayments under financing arrangements, and funds payable and amounts due to customers. We generated cash from financing activities of $12.5 billion in 2020 due primarily to changes in funds payable and amounts due to customers of $10.6 billion and $7.0 billion of cash proceeds from the issuance of long-term debt in the form of fixed rate notes, as well as proceeds from borrowings under our Credit Agreement. These cash inflows were partially offset by the repayment of outstanding borrowings under our Credit Agreement of $3.0 billion, the repurchase of $1.6 billion of our common stock under our stock repurchase program, and tax withholdings related to net share settlement of equity awards of $521 million.We generated cash from financing activities of $4.2 billion in 2019 due primarily to $5.5 billion of cash proceeds from the issuance of long-term debt in the form of fixed rate notes as well as borrowings under a previous credit agreement, and changes in funds payable and amounts due to customers of $3.0 billion. These cash inflows were partially offset by repayment of borrowings under a previous credit agreement of $2.5 billion, the repurchase of $1.4 billion of our common stock under our stock repurchase programs, and tax withholdings related to net share settlement of equity awards of $504 million.47Table of ContentsThe net cash used in financing activities of $1.2 billion in 2018 was due primarily to the repurchase of $3.5 billion of our common stock under our stock repurchase programs, repayments of borrowing under financing arrangements of $1.1 billion, and tax withholdings related to net share settlement of equity awards of $419 million, partially offset by cash inflows from borrowings under financing arrangements of $2.1 billion and changes in funds payable and amounts due to customers of $1.6 billion.Effect of Exchange Rates on Cash, Cash Equivalents, and Restricted CashForeign currency exchange rates had a positive impact of $169 million, a negative impact of $6 million, and a negative impact of $113 million on cash, cash equivalents, and restricted cash during 2020, 2019, and 2018, respectively. The positive impact in 2020 was due to the weakening of the U.S. dollar against certain foreign currencies, primarily the Australian dollar. The negative impact in 2018 was due to the strengthening of the U.S. dollar against certain foreign currencies, primarily the Australian dollar and to a lesser extent, the Euro.OFF-BALANCE SHEET ARRANGEMENTSAs of December 31, 2020 and 2019, we had no off-balance sheet arrangements that have, or are reasonably likely to have, a current or future material effect on our consolidated financial condition, results of operations, liquidity, capital expenditures, or capital resources.FUTURE LIQUIDITY AND OBLIGATIONSAs of December 31, 2020, approximately $3.0 billion of unused credit was available to PayPal Credit account holders compared to $3.1 billion of unused credit as of December 31, 2019. Substantially all of the PayPal Credit account holders with unused credit are in the U.K. While this amount represents the total unused credit available, we have not experienced, and do not anticipate, that all our PayPal Credit account holders will access their entire available credit at any given point in time. In addition, the individual lines of credit that make up this unused credit are subject to periodic review and termination based on, among other things, account usage and customer creditworthiness. We have certain fixed contractual obligations and commitments that include future estimated payments for general operating purposes. Changes in our business needs, contractual cancellation provisions, fluctuating interest rates, and other factors may result in actual payments differing from the estimates. We cannot provide certainty regarding the timing and amounts of these payments. The following table summarizes our obligations as of December 31, 2020 that are expected to impact liquidity and cash flow in future periods. We believe we will be able to fund these obligations through our existing cash and investment portfolio and cash expected to be generated from operations. PurchaseObligationsOperatingLeasesTransition TaxLong-term DebtTotalPayments Due During the Year Ending December 31,(In millions)2021$409 $171 $114 $213 $907 2022239 140 114 1,213 1,706 2023129 126 212 1,185 1,652 2024134 116 284 1,428 1,962 202560 100 354 1,140 1,654 Thereafter52 277 — 5,854 6,183 $1,023 $930 $1,078 $11,033 $14,064 The significant assumptions used in our determination of amounts presented in the above table are as follows:•Purchase obligation amounts include minimum purchase commitments for advertising, capital expenditures (computer equipment, software applications, engineering development services, and construction contracts), data center and cloud computing services, and other goods and services entered into in the ordinary course of business.•Operating lease amounts include minimum rental payments under our non-cancelable operating leases (including leases not yet commenced) primarily for office and data center facilities. The amounts presented are consistent with contractual terms and are not expected to differ significantly from actual results under our existing leases, unless a substantial change in our headcount needs requires us to expand our occupied space or exit an office facility early.48Table of Contents•Transition tax represents the one-time mandatory tax on previously deferred foreign earnings under the Tax Cuts and Jobs Act. •Long-term debt amounts represent the future principal and interest payments (based on contractual interest rates) on our fixed-rate debt. For more information, see “Note 12—Debt” to our consolidated financial statements included in this Form 10-K. As we are unable to reasonably predict the timing of settlement of liabilities related to unrecognized tax benefits, net, the table above does not include $1.4 billion of such non-current liabilities included in deferred and other tax liabilities recorded on our consolidated balance sheet as of December 31, 2020.SEASONALITYThe Company does not experience meaningful seasonality with respect to net revenues. No individual quarter in 2020, 2019, or 2018 accounted for more than 30% of annual net revenue.CRITICAL ACCOUNTING POLICES AND ESTIMATESThe application of U.S. GAAP requires us to make estimates and assumptions about certain items and future events that directly affect our reported financial condition. We have established detailed policies and control procedures to provide reasonable assurance that the methods used to make estimates and assumptions are well controlled and are applied consistently from period to period. The accounting estimates and assumptions discussed in this section are those that we consider to be the most critical to our financial statements. An accounting estimate is considered critical if both (a) the nature of the estimate or assumption is material due to the levels of subjectivity and judgment involved, and (b) the impact within a reasonable range of outcomes of the estimate and assumption is material to our financial condition. Senior management has discussed the development, selection, and disclosure of these estimates with the Audit, Risk, and Compliance Committee of our Board of Directors. Our significant accounting policies, including recent accounting pronouncements, are described in “Note 1—Overview and Summary of Significant Accounting Policies” to the consolidated financial statements included in this Form 10-K.A quantitative sensitivity analysis is provided where information is available to reasonably estimate the impact, and provides material information to investors. The amounts used to assess sensitivity are included to allow users of this report to understand a general directional cause and effect of changes in the estimates and do not represent management’s predictions of variability. For all of these estimates, it should be noted that future events rarely develop exactly as forecasted, and estimates require regular review and adjustment.TRANSACTION AND CREDIT LOSSESTransaction and credit losses include the expense associated with our customer protection programs, fraud, chargebacks, and credit losses associated with our loans receivable balances. Our transaction and credit losses fluctuate depending on many factors, including: total TPV, current and projected macroeconomic conditions, including unemployment rates, merchant insolvency events, changes to and usage of our customer protection programs, the impact of regulatory changes, and the credit quality of loans receivable arising from transactions funded with our credit products, which include our PayPal Credit consumer product and merchant loans and advances arising from our PayPal Working Capital (“PPWC”) and PayPal Business Loan (“PPBL”) products.We establish allowances for negative customer balances and estimated transaction losses arising from processing customer transactions, such as chargebacks for unauthorized credit card use and merchant-related chargebacks due to non-delivery or unsatisfactory delivery of purchased items, buyer protection program claims, account takeovers, and Automated Clearing House returns. Additions to the allowance, in the form of provisions, are reflected in transaction and credit losses on our consolidated statements of income. The allowances are based on known facts and circumstances, internal factors including experience with similar cases, historical trends involving collection and write-off patterns, and the mix of transaction and loss types, as well as current and projected macroeconomic factors, as appropriate.49Table of ContentsWe also establish an allowance for loans and interest receivable, which represents our estimate of current expected credit losses inherent in our portfolio of loans and interest receivable. This evaluation process is subject to numerous estimates and judgments. The allowance is primarily based on expectations of credit losses based on historical lifetime loss data as well as macroeconomic forecasts applied to the portfolio, which is segmented by factors such as geographic region, delinquency, and vintage. Loss curves are generated using historical loss data for each loan portfolio and are applied to segments of each portfolio, categorized by factors such as geographic region, first borrowing versus reuse, delinquency, credit rating and vintage, which vary by portfolio. We then apply macroeconomic factors such as forecasted trends in unemployment and benchmark credit card charge-off rates, which are sourced externally, using a single scenario that we believe is most appropriate to the economic conditions applicable to a particular period. We utilize externally sourced macroeconomic scenario data to supplement our historical information due to the limited period in which our credit product offerings have been in existence. Projected loss rates, inclusive of historical loss data and macroeconomic factors, are applied to the principal amount of our consumer and merchant receivables. We also include qualitative adjustments that incorporate incremental information not captured in the quantitative estimates of our current expected credit losses. Our consumer receivables are primarily revolving in nature and do not have a contractual term; however, the reasonable and supportable forecast period we have included in our projected loss rates based on externally sourced data is approximately seven years. Our merchant receivables vary in contractual term; however, the reasonable and supportable forecast period we have considered for projected loss rates is approximately 2.5 to 3.5 years, depending upon the product. The allowance for credit losses on interest and fees receivable is determined primarily by applying loss curves to each portfolio by geography, delinquency, and period of origination, among other factors.Determining appropriate current expected credit loss allowances for loans and interest receivable is an inherently uncertain process and ultimate losses may vary from the current estimates. We regularly update our allowance estimates as new facts become known and events occur that may impact the settlement or recovery of losses. The allowances are maintained at a level we deem appropriate to adequately provide for current expected credit losses at the balance sheet date after incorporating the impact of externally sourced macroeconomic forecasts. These forecasts project scenarios such as future unemployment and benchmark credit card charge-off rates. As of December 31, 2020, we utilized externally published projections of the U.S. and U.K. forecasted unemployment rates and credit card charge-off rates over the reasonable and supportable period, indicating a slight increase in the first half of 2021 followed by a gradual decline and ultimate stabilization of these rates, resulting in an overall principal and interest coverage ratio of approximately 23%. The projected gradual decline in unemployment and credit card charge-off rates is reflective of a prolonged recovery period where we expect to experience elevated charge-off rates. A significant change in the forecasted macroeconomic factors could result in a material change in our allowances. Our allowance as of December 31, 2020 has been adjusted to account for the proactive and reactive measures that we have taken that are intended to reduce financial difficulties experienced by our customers, and other limitations in our expected credit loss models that have arisen due to the extreme fluctuations in both the actual and projected macroeconomic conditions during the period. These qualitative adjustments were also made to incorporate varying degrees of merchant performance both in the current environment as well as expected future performance, and to account for payment holidays granted. Our allowance as of December 31, 2020 has not been adjusted to account for the potential impacts of the CARES Act, which are also intended to help mitigate the negative impact the current pandemic may have on the financial condition of our customers. We are unable to predict the ultimate impact of these actions which may result in adjustments to our allowance for loans and interest receivable in future periods. An increase of 1% in the principal and interest coverage ratio would increase our allowances by approximately $36 million based on the loans and interest receivable balance outstanding as of December 31, 2020.ACCOUNTING FOR INCOME TAXES Our annual tax rate is based on our income, statutory tax rates, and tax planning opportunities available to us in the various jurisdictions in which we operate. Tax laws are complex and subject to different interpretations by the taxpayer and respective government taxing authorities. Significant judgment is required in determining our tax expense and in evaluating our tax positions, including evaluating uncertainties. We review our tax positions quarterly and adjust the balances as new information becomes available. Our income tax rate is significantly affected by the tax rates that apply to our foreign earnings. In addition to local country tax laws and regulations, our income tax rate depends on the extent that our foreign earnings are taxed by the U.S. through provisions such as the GILTI tax and base erosion anti-abuse tax or as a result of our indefinite reinvestment assertion. Indefinite reinvestment is determined by management’s judgment about, and intentions concerning, our future operations. Deferred tax assets represent amounts available to reduce income taxes payable on taxable income in future years. Such assets arise because of temporary differences between the financial reporting and tax bases of assets and liabilities, as well as from net operating loss and tax credit carryforwards. We evaluate the recoverability of these future tax deductions and credits by assessing the adequacy of future expected taxable income from all sources, including reversal of taxable temporary differences, forecasted operating earnings, and available tax planning strategies. These sources of income rely heavily on estimates that are based on a number of factors, including our historical experience and short-range and long-range business forecasts. To the extent deferred tax assets are not expected to be realized, we record a valuation allowance.50Table of ContentsWe recognize and measure uncertain tax positions in accordance with U.S. GAAP, pursuant to which we only recognize the tax benefit from an uncertain tax position if it is more likely than not that the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the position. The tax benefits recognized in the financial statements from such positions are then measured based on the largest benefit that has a greater than 50 percent likelihood of being realized upon ultimate settlement. We report a liability for unrecognized tax benefits resulting from uncertain tax positions taken or expected to be taken in a tax return. U.S. GAAP further requires that a change in judgment related to the expected ultimate resolution of uncertain tax positions be recognized in earnings in the quarter in which such change occurs. We recognize interest and penalties, if any, related to unrecognized tax benefits in income tax expense.We file annual income tax returns in multiple taxing jurisdictions around the world. A number of years may elapse before an uncertain tax position is audited by the relevant tax authorities and finally resolved. While it is often difficult to predict the final outcome or the timing of resolution of any particular uncertain tax position, we believe that our reserves for income taxes are adequate such that we reflect the benefits more likely than not to be sustained in an examination. We adjust these reserves, as well as the related interest and penalties, where appropriate in light of changing facts and circumstances. Settlement of any particular position could require the use of cash.Based on our results for the year ended December 31, 2020, a one-percentage point increase in our effective tax rate would have resulted in an increase in our income tax expense of approximately $51 million.LOSS CONTINGENCIESWe are currently involved in various claims, regulatory and legal proceedings, and investigations of potential operating violations by regulatory oversight authorities. We regularly review the status of each significant matter and assess our potential financial exposure. If the potential loss from any claim, legal proceeding, or potential regulatory violation is considered probable and the amount can be reasonably estimated, we accrue a liability for the estimated loss. Significant judgment is required in both the determination of probability and whether an exposure is reasonably estimable. Our judgments are subjective and are based on the status of the legal or regulatory proceedings, the merits of our defenses, and consultation with in-house and outside legal counsel. Because of uncertainties related to these matters, accruals are based only on the best information available at the time. As additional information becomes available, we reassess the potential liability related to pending claims, litigation, or other violations and may revise our estimates. Due to the inherent uncertainties of the legal and regulatory process in the multiple jurisdictions in which we operate, our judgments may differ materially from the actual outcomes.REVENUE RECOGNITIONApplication of the accounting principles in U.S. GAAP related to the measurement and recognition of revenue requires us to make judgments and estimates. Complex arrangements with nonstandard terms and conditions may require significant contract interpretation to determine the appropriate accounting. Specifically, the determination of whether we are a principal to a transaction (gross revenue) or an agent (net revenue) can require considerable judgment. Further, we provide incentive payments to consumers and merchants, which require judgment to determine whether the payments should be recorded as a reduction to gross revenue. Changes in judgments with respect to these assumptions and estimates could impact the amount of revenue recognized. VALUATION OF GOODWILL AND INTANGIBLESThe valuation of assets acquired in a business combination and asset impairment reviews require the use of significant estimates and assumptions. The acquisition method of accounting for business combinations requires us to estimate the fair value of assets acquired, liabilities assumed, and any noncontrolling interest in an acquired business to properly allocate purchase price consideration between assets that are depreciated or amortized and goodwill. Impairment testing for assets, other than goodwill and indefinite-lived intangible assets, requires the allocation of cash flows to those assets or group of assets and, if required, an estimate of fair value for the assets or group of assets. Our estimates are based upon assumptions that we believe to be reasonable, but which are inherently uncertain and unpredictable. These valuations require the use of management’s assumptions, which do not reflect unanticipated events and circumstances that may occur.51Table of ContentsWe evaluate goodwill and intangible assets for impairment on an annual basis, or sooner if indicators of impairment exist. Under U.S. GAAP, the evaluation of indefinite-lived intangible assets for impairment allows for a qualitative assessment to be performed, which is similar to U.S. GAAP for evaluating goodwill for impairment. In performing these qualitative assessments, we consider relevant events and conditions, including but not limited to: macroeconomic trends, industry and market conditions, overall financial performance, cost factors, company-specific events, legal and regulatory factors, and our market capitalization. If the qualitative assessments indicate that it is more likely than not that the fair value of the reporting unit or indefinite-lived intangible assets are less than their carrying amounts, we must perform a quantitative impairment test.Under the quantitative impairment test, if the carrying amount of the reporting unit goodwill or indefinite-lived intangible asset exceeds the fair value of the respective reporting unit goodwill or indefinite-lived intangible asset, an impairment loss is recorded in the statement of income. Measurement of the fair value of a reporting unit could be based on one or more of the following fair value measures: amounts at which the unit as a whole could be bought or sold in a current transaction between willing parties, present value techniques of estimated future cash flows, valuation techniques based on multiples of earnings or revenue, or a similar performance measure.52Table of ContentsITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKMarket risk is the potential for economic losses to be incurred on market risk sensitive instruments arising from adverse changes in market factors such as interest rates, foreign currency exchange rates, and equity investment risk. Management establishes and oversees the implementation of policies governing our investing, funding, and foreign currency derivative activities in order to mitigate market risks. We monitor risk exposures on an ongoing basis. INTEREST RATE RISKWe are exposed to interest rate risk relating to our investment portfolio and from interest-rate sensitive assets underlying the customer balances we hold on our consolidated balance sheets as customer accounts. As of December 31, 2020 and 2019, approximately 30% and 63%, respectively, of our total cash, cash equivalents, and investment portfolio (excluding restricted cash and strategic investments) was held in cash and cash equivalents. The assets underlying the customer balances which we hold on our consolidated balance sheets as customer accounts are maintained in interest and non-interest bearing bank deposits, time deposits, U.S. and foreign government and agency securities, corporate debt securities, and asset-backed securities. We seek to preserve principal while holding eligible liquid assets, as defined by applicable regulatory requirements and commercial law in certain jurisdictions where we operate, equal to at least 100% of the aggregate amount of all customer balances. We do not pay interest on amounts due to customers.If interest rates increased by 100 basis points, the fair value of our available-for-sale debt securities investment portfolio would decrease by approximately $173 million and $68 million at December 31, 2020 and 2019, respectively.We have $9.0 billion in fixed rate debt with varying maturity dates. Since these notes bear interest at fixed rates, they do not result in any financial statement risk associated with changes in interest rates. However, the fair value of these notes fluctuates when interest rates change. We also have a committed revolving credit facility of $5.0 billion available to us. We are obligated to pay interest on borrowings under this facility as well as other customary fees, including an upfront fee and an unused commitment fee based on our debt rating. Borrowings under this facility, if any, bear interest at floating rates. As a result, we are exposed to the risk related to fluctuations in interest rate to the extent of our borrowings. As of December 31, 2020 and 2019, we had no amounts outstanding under this credit facility. For additional information, see “Note 12—Debt” in the notes to the consolidated financial statements included in this Form 10-K.Interest rates may also adversely impact our customers’ spending levels and ability and willingness to pay outstanding amounts owed to us. Higher interest rates often lead to larger payment obligations by customers of our credit products to us, or to lenders under mortgage, credit card, and other consumer and merchant loans, which may reduce our customers’ ability to remain current on their obligations to us and therefore lead to increased delinquencies, charge-offs, and allowances for loans and interest receivable, which could have an adverse effect on our net income. FOREIGN CURRENCY EXCHANGE RATE RISKWe have significant operations internationally that are denominated in foreign currencies, primarily the British Pound, Euro, Australian Dollar, and Canadian Dollar, subjecting us to foreign currency exchange rate risk, which may adversely impact our financial results. We transact business in various foreign currencies and have significant international revenues and costs. In addition, we charge our international subsidiaries for their use of intellectual property and technology and for certain corporate services. Our cash flows, results of operations, and certain of our intercompany balances that are exposed to foreign currency exchange rate fluctuations may differ materially from expectations, and we may record significant gains or losses due to foreign currency fluctuations and related hedging activities. We are generally a net receiver of foreign currencies and therefore benefit from a weakening of the U.S. dollar, and are adversely affected by a strengthening of the U.S. dollar, relative to foreign currencies.We have a foreign currency exchange exposure management program designed to identify material foreign currency exposures, manage these exposures, and reduce the potential effects of currency fluctuations on our consolidated cash flows and results of operations through the execution of foreign currency exchange contracts. These foreign currency exchange contracts are accounted for as derivative instruments. For additional details related to our foreign currency exchange contracts, please see “Note 10—Derivative Instruments” to the consolidated financial statements included in this Form 10-K.53Table of ContentsWe use foreign currency exchange forward contracts to protect our forecasted U.S. dollar-equivalent earnings and our investment in a foreign subsidiary from adverse changes in foreign currency exchange rates. These hedging contracts reduce, but do not entirely eliminate, the impact of adverse foreign currency exchange rate movements. We designate these contracts as cash flow and net investment hedges for accounting purposes. The derivative’s gain or loss is initially reported as a component of accumulated other comprehensive income (“AOCI”). Cash flow hedges are subsequently reclassified into the financial statement line item in which the hedged item is recorded in the same period the forecasted transaction affects earnings. The accumulated gains and losses associated with the net investment hedge will remain in AOCI until the foreign subsidiary is sold or substantially liquidated, at which point they will be reclassified into earnings.We considered the historical trends in foreign currency exchange rates and determined that it was reasonably possible that changes in exchange rates of 20% for all currencies could be experienced in the near term. If the U.S. dollar weakened by 20% at December 31, 2020 and 2019, the amount recorded in AOCI related to our foreign currency exchange forward contracts, before taxes, would have been approximately $1.1 billion and $900 million lower, respectively. If the U.S. dollar strengthened by 20% at December 31, 2020 and 2019, the amount recorded in AOCI related to our foreign currency exchange forward contracts, before taxes, would have been approximately $1.1 billion and $900 million higher, respectively.We have an additional foreign currency exchange management program in which we use foreign currency exchange contracts to offset the foreign currency exchange risk on our assets and liabilities denominated in currencies other than the functional currency of our subsidiaries. These contracts are not designated as hedging instruments and reduce, but do not entirely eliminate, the impact of currency exchange rate movements on our assets and liabilities. The foreign currency exchange gains and losses on our assets and liabilities are recorded in other income (expense), net, and are offset by the gains and losses on the foreign currency exchange contracts.Adverse changes in exchange rates of 20% for all currencies would have resulted in an adverse impact on income before income taxes of approximately $353 million and $147 million at December 31, 2020 and 2019, respectively, without considering the offsetting effect of foreign currency exchange contracts. Foreign currency exchange contracts in place as of December 31, 2020 would have positively impacted income before income taxes by approximately $369 million, resulting in a net positive impact of approximately $16 million. Foreign currency exchange contracts in place as of December 31, 2019 would have positively impacted income before income taxes by approximately $153 million, resulting in a net positive impact of approximately $6 million. These reasonably possible adverse changes in exchange rates of 20% were applied to total monetary assets and liabilities denominated in currencies other than the functional currencies of our subsidiaries at the balance sheet dates to compute the adverse impact these changes would have had on our income before income taxes in the near term.EQUITY INVESTMENT RISKOur strategic investments are subject to a variety of market-related risks that could substantially reduce or increase the carrying value of the portfolio. As of December 31, 2020 and 2019, our strategic investments totaled $3.2 billion and $1.8 billion, respectively, which represented approximately 17% and 13% of our total cash, cash equivalents, and investment portfolio at each of those respective dates. Our strategic investments include marketable equity securities, which are publicly traded, and non-marketable equity securities, which are investments in privately held companies that are not publicly traded. We are required to record all adjustments to the value of these strategic investments through our consolidated statements of income. As such, we anticipate volatility to our net income in future periods due to changes in fair value related to our investments in marketable equity securities and changes in observable prices related to our non-marketable equity securities accounted for under the Measurement Alternative. These changes could be material based on market conditions. A hypothetical adverse change of 10% in the carrying value of our strategic investments, which could be experienced in the near term, would have resulted in a decrease of approximately $323 million to the carrying value of the portfolio as of December 31, 2020. We review our non-marketable equity investments accounted for under the Measurement Alternative for impairment when events and circumstances indicate a decline in fair value of such assets below carrying value. Our analysis includes a review of recent operating results and trends, recent purchases and sales of securities, and other publicly available data.
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+Item 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSManagement’s Discussion and Analysis is the company’s analysis of its financial performance and financial condition, and of significant trends that may affect future performance. It should be read in conjunction with the consolidated financial statements and notes thereto included elsewhere in this Annual Report on Form 10-K.The terms “earnings” and “loss” refer to net income (loss) attributable to Phillips 66. The terms “before-tax income” or “before-tax loss” refer to income (loss) before income taxes. EXECUTIVE OVERVIEW AND BUSINESS ENVIRONMENTPhillips 66 is an energy manufacturing and logistics company with midstream, chemicals, refining, and marketing and specialties businesses. At December 31, 2020, we had total assets of $54.7 billion.Executive OverviewThe COVID-19 pandemic continues to disrupt economic activities globally. Actions taken by governments to prevent the spread of the disease, including travel and business restrictions, have resulted in substantial decreases in the demand for many refined petroleum products, particularly gasoline and jet fuel. The lack of demand for petroleum products has resulted in low crude oil prices and refining margins. Accordingly, crude oil producers have shut in high cost production, and refiners have reduced crude oil processing rates. During 2020, we took the following significant steps to enhance our liquidity in this challenged margin environment:•Issued $3.75 billion of senior unsecured notes and borrowed a net $500 million under a term loan facility.•Temporarily suspended our share repurchase program.•Reduced consolidated capital spending in 2020 by more than $700 million compared with our original budget.•Exceeded our $500 million cost reduction target in 2020.In 2020, we reported a loss of $4.0 billion and generated $2.1 billion in cash from operating activities. We used available cash and the debt financing noted above to fund capital expenditures and investments of $2.9 billion, pay dividends of $1.6 billion, and repurchase $0.4 billion of our common stock. We ended 2020 with $2.5 billion of cash and cash equivalents and approximately $5.3 billion of total committed capacity available under our credit facilities.Our results in 2020 reflect the adverse effects of the COVID-19 pandemic, including asset and investment impairments. These adverse effects may continue to be significant in the near term. The depth and duration of the economic consequences of the COVID-19 pandemic remain unknown. We continuously monitor our asset and investment portfolio for impairments, as well as optimization opportunities, in this challenging business environment. As such, additional impairments may be required in the future.36Table of ContentsIndex to Financial StatementsWe continue to focus on the following strategic priorities:•Operating Excellence. Our commitment to operating excellence guides everything we do. We are committed to protecting the health and safety of everyone who has a role in our operations and the communities in which we operate. Continuous improvement in safety, environmental stewardship, reliability and cost efficiency is a fundamental requirement for our company and employees. We employ rigorous training and audit programs to drive ongoing improvement in both personal and process safety as we strive for zero incidents. In 2020, we achieved a 0.11 total recordable incident rate—the lowest since our inception. Since we cannot control commodity prices, controlling operating expenses and overhead costs, within the context of our commitment to safety and environmental stewardship, is a high priority. Senior management actively monitors these costs. We are committed to protecting the environment and strive to reduce our environmental footprint throughout our operations. Optimizing utilization rates at our refineries through reliable and safe operations enables us to capture the value available in the market in terms of prices and margins. During 2020, our worldwide refining crude oil capacity utilization rate was 76%, mainly driven by the decrease in market demand for refined petroleum products due to negative impacts from the COVID-19 pandemic. •Growth. A disciplined capital allocation process ensures we invest in projects that are expected to generate competitive returns. Our strategy primarily focuses on investing in growth opportunities in the Midstream and Chemicals segments. In response to the challenging market conditions caused by the COVID-19 pandemic, we reduced our 2021 capital budget to $1.7 billion. We are prioritizing sustaining capital spending and completion of in-progress growth projects, as well as advancing our investments in renewable fuels. In the third quarter of 2020, we announced Rodeo Renewed, a project to reconfigure our San Francisco Refinery in Rodeo, California, to produce renewable fuels. In 2021, we have budgeted $615 million for Midstream capital expenditures and investments, including $305 million for Phillips 66 Partners. Capital will be used to complete near-term committed and optimization projects and to maintain our integrated logistics infrastructure network. In Chemicals, our share of expected self-funded capital spending by CPChem is $410 million. CPChem plans to use its growth capital to fund expansion of its normal alpha olefins production, optimization and debottleneck opportunities in the olefins and polyolefins chains, as well as continuing development of petrochemical projects on the U.S. Gulf Coast and in Qatar. We recently formed an Emerging Energy organization. This group is charged with establishing a lower-carbon business platform that delivers attractive returns. It will focus on opportunities within our portfolio, such as Rodeo Renewed, as well as commercializing emerging energy technologies for a sustainable future.•Returns. We plan to enhance Refining returns by increasing throughput of advantaged feedstocks, improving yields, portfolio optimization and an ongoing commitment to operating excellence. For 2021, capital in Refining will be directed toward high-return projects to enhance the yield of higher-value products and other high-return, quick-payout projects, as well as investments to competitively position the company for a lower-carbon future. M&S will continue to develop and enhance our retail network and brands in the United States and Europe. •Distributions. We believe shareholder value is enhanced through, among other things, consistent growth of regular dividends, complemented by share repurchases. Regular dividends demonstrate the confidence our Board of Directors and management have in our capital structure and operations’ capability to generate free cash flow throughout the business cycle. In 2020, despite the challenging business environment, we maintained stable quarterly dividend distributions to shareholders and repurchased $443 million of common stock before suspending our share repurchase program in March 2020 to preserve liquidity.•High-Performing Organization. We strive to attract, develop and retain individuals with the knowledge and skills to implement our business strategy and who support our values and culture. Throughout the company, we focus on getting results in the right way, embrace our values as a common bond, and believe success is both what we do and how we do it. We encourage collaboration throughout our company, while valuing differences, respecting diversity, and creating a great place to work. We foster an environment of learning and development through structured programs focused on enhancing functional and technical skills where employees are engaged in our business and committed to their own, as well as the company’s, success.37Table of ContentsIndex to Financial StatementsBusiness EnvironmentThe Midstream segment includes our Transportation and NGL businesses. Our Transportation business contains fee-based operations that are not directly exposed to commodity price risk. Our NGL business contains both fee-based operations and operations that are directly impacted by NGL prices. The Midstream segment also includes our 50% equity investment in DCP Midstream. NGL prices were significantly lower in 2020, compared with 2019, due to negative economic impacts caused by the COVID-19 pandemic. The Chemicals segment consists of our 50% equity investment in CPChem. The chemicals and plastics industry is mainly a commodity-based industry where the margins for key products are based on supply and demand, as well as cost factors. Compared with 2019, the benchmark high-density polyethylene chain margin was lower in the first three quarters of 2020, before rebounding strongly in the fourth quarter of 2020. The lower margin in the first three quarters of 2020 was mainly due to lower polyethylene sales prices. The significant margin increase in the fourth quarter of 2020 was primarily driven by tight supply caused by hurricane impacts in the Gulf Coast region and a strong global market demand.Our Refining segment results are driven by several factors, including refining margins, refinery throughput, feedstock costs, product yields, turnaround activity, and other operating costs. The price of U.S. benchmark crude oil, West Texas Intermediate (WTI) at Cushing, Oklahoma, decreased to an average of $39.31 per barrel during 2020, compared with an average of $57.02 per barrel in 2019, due to a significant decline in global demand driven by the adverse impacts of the COVID-19 pandemic. Market crack spreads are used as indicators of refining margins and measure the difference between market prices for refined petroleum products and crude oil. During 2020, the worldwide market crack spreads were significantly lower compared with 2019, mainly driven by a sharp decline in demand for refined petroleum products resulting from the COVID-19 global pandemic.Results for our M&S segment depend largely on marketing fuel and lubricant margins, and sales volumes of our refined petroleum and other specialty products. While M&S margins are primarily driven by market factors, largely determined by the relationship between supply and demand, marketing fuel margins, in particular, are influenced by the trend in spot prices for refined petroleum products. Generally speaking, a downward trend of spot prices has a favorable impact on marketing fuel margins, while an upward trend of spot prices has an unfavorable impact on marketing fuel margins. The global disruption caused by the COVID-19 pandemic significantly reduced demand for our refined petroleum and specialty products in 2020 compared with 2019.38Table of ContentsIndex to Financial StatementsRESULTS OF OPERATIONSConsolidated ResultsA summary of income (loss) before income taxes by business segment with a reconciliation to net income (loss) attributable to Phillips 66 follows: Millions of DollarsYear Ended December 31 202020192018Midstream$(9)684 1,181 Chemicals635 879 1,025 Refining(6,155)1,986 4,535 Marketing and Specialties1,446 1,433 1,557 Corporate and Other(881)(804)(853)Income (loss) before income taxes(4,964)4,178 7,445 Income tax expense (benefit)(1,250)801 1,572 Net income (loss)(3,714)3,377 5,873 Less: net income attributable to noncontrolling interests261 301 278 Net income (loss) attributable to Phillips 66$(3,975)3,076 5,595 2020 vs. 2019 Our results decreased $7,051 million in 2020, mainly reflecting: •Lower realized refining margins and decreased refinery production.•A goodwill impairment in our Refining segment.•A long-lived asset impairment associated with our plan to reconfigure the San Francisco Refinery into a renewable fuels facility, which impacted our Refining and Midstream segments.•Higher impairments of equity investments in our Midstream segment.These decreases were partially offset by an income tax benefit recognized in 2020, compared with income tax expense recognized in 2019. 2019 vs. 2018 Our earnings decreased $2,519 million in 2019, mainly reflecting: •Lower realized refining and marketing margins.•Impairments associated with our equity investment in DCP Midstream.•Decreased equity in earnings of affiliates in our Refining and Chemicals segments.These decreases were partially offset by:•Lower income tax expense.•Improved results from our NGL and transportation businesses. See the “Segment Results” section for additional information on our segment results.39Table of ContentsIndex to Financial StatementsStatement of Operations Analysis2020 vs. 2019 Sales and other operating revenues and purchased crude oil and products both decreased 40% in 2020. The decreases were mainly due to lower prices and volumes for refined petroleum products and crude oil, reflecting the impact of the COVID-19 pandemic. Equity in earnings of affiliates decreased 44% in 2020. The decrease was primarily due to lower realized refining margins and decreased refinery production at WRB, and lower margins, partially offset by higher sales volumes, at CPChem. See Chemicals segment analysis in the “Segment Results” section for additional information on CPChem. Net gain on dispositions increased $88 million in 2020. The increase was mainly due to a gain of $84 million associated with a co-venturer’s prior-year acquisition of a 35% interest in Phillips 66 Partners’ consolidated holding company that owns an interest in Gray Oak Pipeline, LLC. See Note 27—Phillips 66 Partners LP, in the Notes to Consolidated Financial Statements, for additional information.Operating expenses decreased 10% in 2020, primarily driven by our company-wide cost reduction initiatives in response to the COVID-19 pandemic, lower utility costs, and decreased refinery turnaround activities.Impairments increased $3,391 million in 2020. See Note 9—Impairments, and Note 16—Fair Value Measurements, in the Notes to Consolidated Financial Statements, for additional information associated with impairments.We had an income tax benefit of $1,250 million in 2020, compared with income tax expense of $801 million in 2019, primarily due to a net loss in 2020 versus net income in 2019. See Note 21—Income Taxes, in the Notes to Consolidated Financial Statements, for more information regarding our income taxes.2019 vs. 2018 Sales and other operating revenues and purchased crude oil and products decreased 4% and 2%, respectively, in 2019. The decreases were mainly driven by lower prices for refined petroleum products, crude oil and NGL. Equity in earnings of affiliates decreased 21% in 2019. The decrease was mainly due to lower margins at WRB and CPChem, partially offset by improved results from our Transportation and NGL joint venture assets. Lower equity earnings in 2019 also reflected higher goodwill and other asset impairments at DCP Midstream. See the “Segment Results” section for additional information.Other income increased $58 million in 2019. The increase was mainly driven by trading activities not directly related to our physical business. See Note 15—Derivatives and Financial Instruments, in the Notes to Consolidated Financial Statements, for additional information associated with our commodity derivatives.Impairments increased $853 million in 2019. The increase was driven by an $853 million before-tax impairment associated with our investment in DCP Midstream recognized in the third quarter of 2019. See Note 9—Impairments, and Note 16—Fair Value Measurements, in the Notes to Consolidated Financial Statements, for additional information associated with this impairment.Income tax expense (benefit) decreased 49% in 2019. The decrease in income tax expense was primarily attributable to lower income before income taxes. See Note 21—Income Taxes, in the Notes to Consolidated Financial Statements, for more information regarding our income taxes.40Table of ContentsIndex to Financial StatementsSegment ResultsMidstream Year Ended December 31 202020192018 Millions of DollarsIncome (Loss) Before Income TaxesTransportation$508 946 770 NGL and Other441 522 305 DCP Midstream(958)(784)106 Total Midstream$(9)684 1,181 Thousands of Barrels DailyTransportation VolumesPipelines*3,005 3,396 3,441 Terminals2,971 3,315 3,153 Operating StatisticsNGL fractionated**249 224 216 NGL extracted***399 417 413 * Pipelines represent the sum of volumes transported through each separately tariffed consolidated pipeline segment. ** Excludes DCP Midstream.*** Includes 100% of DCP Midstream’s volumes. Dollars Per GallonWeighted-Average NGL Price*DCP Midstream$0.41 0.51 0.75 * Based on index prices from the Mont Belvieu market hub, which are weighted by NGL component mix.The Midstream segment provides crude oil and refined petroleum product transportation, terminaling and processing services, as well as natural gas and NGL transportation, storage, fractionation, processing and marketing services, mainly in the United States. This segment includes our MLP, Phillips 66 Partners, as well as our 50% equity investment in DCP Midstream, which includes the operations of its MLP, DCP Partners.2020 vs. 2019 Midstream’s results decreased $693 million in 2020, compared with 2019. Results from our Transportation business decreased $438 million in 2020, compared with 2019. The decrease was primarily attributable to before-tax impairments of $300 million, decreased equity earnings, lower pipeline and terminal throughput volumes, and higher operating costs, partially offset by an $84 million before-tax gain recognized in the second quarter of 2020 associated with the Gray Oak Pipeline joint venture.The $300 million before-tax impairments consisted of a $120 million impairment of the pipeline and terminal assets associated with the planned reconfiguration of our San Francisco Refinery into a renewable fuels facility, a $96 million impairment of Phillips 66 Partners’ equity investments in two crude oil logistics joint ventures, and an $84 million impairment of our equity investment in the canceled Red Oak Pipeline project. See Note 9—Impairments, and Note 27—Phillips 66 Partners LP, in the Notes to Consolidated Financial Statements, for additional information regarding the impairments and the $84 million before-tax gain, respectively.41Table of ContentsIndex to Financial StatementsResults from our NGL and Other business decreased $81 million in 2020, compared with 2019. The decrease was mainly due to lower results from our trading activities and decreased margins, partially offset by higher export cargos and increased fractionation volumes from the startup of Frac 2 and Frac 3 in late 2020, as well as the startup of a new isomerization unit at our Lake Charles Refinery in the second half of 2019.Results from our investment in DCP Midstream decreased $174 million in 2020, compared with 2019. The decrease was primarily due to higher impairment charges, partially offset by the recognition of a larger benefit to our equity earnings from the amortization of the basis difference associated with the impairments and DCP Midstream’s cost reduction initiatives in response to the challenging business environment. See Note 6—Investments, Loans and Long-Term Receivables, and Note 9—Impairments, in the Notes to Consolidated Financial Statements, for additional information regarding the impairments and the associated basis difference amortization related to our investment in DCP Midstream.See the “Executive Overview and Business Environment” section for information on market factors impacting 2020 results.2019 vs. 2018 Before-tax income from the Midstream segment decreased $497 million in 2019, compared with 2018, mainly driven by an $853 million before-tax impairment associated with our investment in DCP Midstream and lower equity earnings from DCP Midstream, partially offset by improved results from our Transportation and NGL and Other businesses. Before-tax income from our Transportation business increased $176 million in 2019, compared with 2018. The increase was mainly driven by higher volumes and pipeline tariffs from our portfolio of consolidated and joint venture assets.Before-tax income from our NGL and Other business increased $217 million in 2019, compared with 2018. The increase was mainly due to improved margins and volumes, primarily at the Sweeny Hub, and higher equity earnings from certain pipeline affiliates driven by higher volumes.Before-tax income from our investment in DCP Midstream decreased $890 million in 2019, compared with 2018. The decrease was primarily due to an $853 million before-tax impairment associated with our investment in DCP Midstream and lower equity earnings driven by higher goodwill and other asset impairments at DCP Partners in 2019. See Note 6—Investments, Loans and Long-Term Receivables, Note 9—Impairments, and Note 16—Fair Value Measurements, in the Notes to Consolidated Financial Statements, for additional information regarding our investment in DCP Midstream.42Table of ContentsIndex to Financial StatementsChemicals Year Ended December 31 202020192018 Millions of DollarsIncome Before Income Taxes$635 879 1,025 Millions of PoundsCPChem Externally Marketed Sales Volumes*Olefins and Polyolefins20,993 20,237 18,977 Specialties, Aromatics and Styrenics4,367 4,281 4,931 25,360 24,518 23,908 * Represents 100% of CPChem’s outside sales of produced petrochemical products, as well as commission sales from equity affiliates.Olefins and Polyolefins Capacity Utilization (percent)99 %97 94 The Chemicals segment consists of our 50% interest in CPChem, which we account for under the equity method. CPChem uses NGL and other feedstocks to produce petrochemicals. These products are then marketed and sold or used as feedstocks to produce plastics and other chemicals. We structure our reporting of CPChem’s operations around two primary business lines: Olefins and Polyolefins (O&P) and Specialties, Aromatics and Styrenics (SA&S). The O&P business line produces and markets ethylene and other olefin products. Ethylene produced is primarily consumed within CPChem for the production of polyethylene, normal alpha olefins and polyethylene pipe. The SA&S business line manufactures and markets aromatics and styrenics products, such as benzene, cyclohexane, styrene and polystyrene. SA&S also manufactures and/or markets a variety of specialty chemical products. Unless otherwise noted, amounts referenced below reflect our net 50% interest in CPChem.2020 vs. 2019 Before-tax income from the Chemicals segment decreased $244 million in 2020, compared with 2019. The decrease was mainly due to lower margins and decreased earnings from CPChem’s equity affiliates, partially offset by higher sales volumes and a favorable impact from lower-of-cost-or-market adjustments of inventories valued on the last-in-first-out (LIFO) basis attributable to petrochemical product price recovery in 2020. See the “Executive Overview and Business Environment” section for information on market factors impacting CPChem’s 2020 results.2019 vs. 2018 Before-tax income from the Chemicals segment decreased $146 million in 2019, compared with 2018. The decrease was mainly due to lower polyethylene margins attributable to additional industry capacity and slower demand growth in Asia. In addition, CPChem recorded lower-of-cost-or-market write-downs of LIFO-valued inventories during 2019, and our portion of the write-downs reduced our equity earnings from CPChem by $65 million, before-tax. The decreases were partially offset by higher polyethylene sales volumes and lower turnaround and maintenance activity during 2019.43Table of ContentsIndex to Financial StatementsRefining Year Ended December 31 202020192018Millions of DollarsIncome (Loss) Before Income TaxesAtlantic Basin/Europe$(1,224)608 567 Gulf Coast(2,077)364 1,040 Central Corridor(641)1,338 2,817 West Coast(2,213)(324)111 Worldwide$(6,155)1,986 4,535 Dollars Per BarrelIncome (Loss) Before Income TaxesAtlantic Basin/Europe$(7.18)3.11 3.05 Gulf Coast(9.71)1.24 3.55 Central Corridor(6.96)12.95 26.50 West Coast(20.01)(2.49)0.81 Worldwide(10.48)2.75 6.29 Realized Refining Margins*Atlantic Basin/Europe$2.17 9.33 10.32 Gulf Coast1.85 7.42 9.48 Central Corridor7.17 14.91 22.22 West Coast3.43 9.18 11.20 Worldwide3.51 9.91 12.99 * See the “Non-GAAP Reconciliations” section for a reconciliation of this non-GAAP measure to the most directly comparable measure under generally accepted accounting principles in the United States (GAAP), income (loss) before income taxes per barrel.44Table of ContentsIndex to Financial StatementsThousands of Barrels Daily Year Ended December 31 202020192018Operating StatisticsRefining operations*Atlantic Basin/EuropeCrude oil capacity537 537 537 Crude oil processed434 497 477 Capacity utilization (percent)81 %92 89 Refinery production470 541 514 Gulf CoastCrude oil capacity769 764 752 Crude oil processed533 725 717 Capacity utilization (percent)69 %95 95 Refinery production586 804 808 Central CorridorCrude oil capacity530 515 493 Crude oil processed431 498 507 Capacity utilization (percent)81 %97 103 Refinery production446 518 530 West CoastCrude oil capacity364 364 364 Crude oil processed279 323 343 Capacity utilization (percent)77 %89 94 Refinery production301 354 373 WorldwideCrude oil capacity2,200 2,180 2,146 Crude oil processed1,677 2,043 2,044 Capacity utilization (percent)76 %94 95 Refinery production1,803 2,217 2,225 * Includes our share of equity affiliates.The Refining segment refines crude oil and other feedstocks into petroleum products, such as gasoline, distillates and aviation fuels, at 13 refineries in the United States and Europe. 2020 vs. 2019 Results from the Refining segment decreased $8,141 million in 2020, compared with 2019. The decreased results in 2020 were due to:•Lower realized refining margins and decreased refinery production. A sharp decline in demand for refined petroleum products resulting from global economic disruption caused by the COVID-19 pandemic led to lower market crack spreads and reduced refinery production in 2020. In addition, hurricane impacts contributed to the lower refinery production in the Gulf Coast region in 2020.•A before-tax long-lived asset impairment of $910 million in the third quarter of 2020 associated with our plan to reconfigure the San Francisco Refinery into a renewable fuels facility.•A before-tax goodwill impairment of $1,845 million in the first quarter of 2020.45Table of ContentsIndex to Financial StatementsOur worldwide refining crude oil capacity utilization rate was 76% and 94% in 2020 and 2019, respectively. The lower utilization rate in 2020 was primarily due to reduced refining runs driven by lower demand for refined petroleum products as a result of the COVID-19 pandemic, as well as hurricane impacts in the Gulf Coast region. See the “Executive Overview and Business Environment” section for information on industry crack spreads and other market factors impacting this year’s results.2019 vs. 2018 Before-tax income for the Refining segment decreased $2,549 million in 2019, compared with 2018. The decrease was primarily driven by lower realized refining margins and lower refinery production at certain refineries due to turnaround activities and unplanned downtime. In 2019, the decrease in realized refining margins was primarily due to lower feedstock advantage driven by narrowing heavy crude differentials.Our worldwide refining crude oil capacity utilization rate was 94% and 95% in 2019 and 2018, respectively. 46Table of ContentsIndex to Financial StatementsMarketing and Specialties Year Ended December 31202020192018Millions of DollarsIncome Before Income TaxesMarketing and Other$1,271 1,199 1,306 Specialties175 234 251 Total Marketing and Specialties$1,446 1,433 1,557 Dollars Per BarrelIncome Before Income TaxesU.S.$1.42 1.22 1.21 International4.84 3.58 5.00 Realized Marketing Fuel Margins*U.S.$1.87 1.57 1.62 International6.34 4.90 6.87 * See the “Non-GAAP Reconciliations” section for a reconciliation of this non-GAAP measure to the most directly comparable GAAP measure, income before income taxes per barrel.Dollars Per GallonU.S. Average Wholesale Prices*Gasoline$1.56 2.12 2.20 Distillates1.47 2.12 2.29 * On third-party branded refined petroleum product sales, excluding excise taxes.Thousands of Barrels DailyMarketing Refined Petroleum Product SalesGasoline1,021 1,230 1,195 Distillates895 1,104 975 Other17 18 18 1,933 2,352 2,188 The M&S segment purchases for resale and markets refined petroleum products, such as gasoline, distillates and aviation fuels, mainly in the United States and Europe. In addition, this segment includes the manufacturing and marketing of specialty products, such as base oils and lubricants. 2020 vs. 2019 Before-tax income from the M&S segment increased $13 million in 2020, compared with 2019. The increase was primarily attributable to higher realized marketing fuel margins, partially offset by lower sales volumes for refined petroleum and specialty products driven by decreased demand.See the “Executive Overview and Business Environment” section for information on marketing fuel margins and other market factors impacting 2020 results.2019 vs. 2018 Before-tax income from the M&S segment decreased $124 million in 2019, compared with 2018. The decrease was primarily due to lower realized marketing fuel margins, mainly driven by international marketing, partially offset by higher sales volumes. 47Table of ContentsIndex to Financial StatementsCorporate and Other Millions of DollarsYear Ended December 31 202020192018Loss Before Income TaxesNet interest expense$(485)(415)(459)Corporate overhead and other(396)(389)(394)Total Corporate and Other$(881)(804)(853)Net interest expense consists of interest and financing expense, net of interest income and capitalized interest. Corporate overhead and other includes general and administrative expenses, technology costs, environmental costs associated with sites no longer in operation, foreign currency transaction gains and losses, and other costs not directly associated with an operating segment.2020 vs. 2019 Net interest expense increased $70 million in 2020, compared with 2019, primarily due to higher average debt principal balances, reflecting new debt issuances during 2020, along with decreased interest income driven by lower interest rates in 2020. See Note 12—Debt, in the Notes to Consolidated Financial Statements, for additional information on the debt issuances in 2020. 2019 vs. 2018 Net interest expense decreased $44 million in 2019, compared with 2018, mainly due to higher capitalized interest related to capital projects under development in our Midstream segment, partially offset by higher debt balances in 2019. 48Table of ContentsIndex to Financial StatementsCAPITAL RESOURCES AND LIQUIDITYFinancial IndicatorsMillions of Dollars, Except as Indicated202020192018Cash and cash equivalents$2,514 1,614 3,019 Net cash provided by operating activities2,111 4,808 7,573 Short-term debt987 547 67 Total debt15,893 11,763 11,160 Total equity21,523 27,169 27,153 Percent of total debt to capital*42 %30 29 Percent of floating-rate debt to total debt12 %9 11 * Capital includes total debt and total equity.To meet our short- and long-term liquidity requirements, we use a variety of funding sources but rely primarily on cash generated from operating activities and debt financing. During 2020, we generated $2.1 billion in cash from operations and had net borrowings of $4.1 billion. We used available cash primarily for capital expenditures and investments of $2.9 billion and dividend payments on our common stock of $1.6 billion. During the first quarter of 2020, we repurchased $443 million of common stock before suspending our share repurchase program in March 2020. During 2020, cash and cash equivalents increased $900 million to $2.5 billion.Significant Sources of CapitalOperating ActivitiesDuring 2020, cash generated by operating activities was $2,111 million, a 56% decrease compared with 2019. The decrease was primarily due to lower realized refining margins, driven by the global economic disruption caused by the COVID-19 pandemic, partially offset by lower cash income taxes paid. During 2019, cash generated by operating activities was $4,808 million, a 37% decrease compared with 2018. The decrease was mainly driven by lower realized refining margins and decreased distributions from our equity affiliates, along with unfavorable working capital impacts, partially offset by improved results from our Transportation and NGL and Other businesses. Our short- and long-term operating cash flows are highly dependent upon refining and marketing margins, NGL prices and chemicals margins. Prices and margins in our industry are typically volatile, and are driven by market conditions over which we have little or no control. Absent other mitigating factors, as these prices and margins fluctuate, we would expect a corresponding change in our operating cash flows. The recent decline in demand for refined petroleum products has led to a decrease in refining margins. If the global economic disruption associated with the COVID-19 pandemic sustains, we expect refining margins to remain challenged in the near term, all of which could have an unfavorable impact on our future operating cash flows. The level and quality of output from our refineries also impacts our cash flows. Factors such as operating efficiency, maintenance turnarounds, market conditions, feedstock availability and weather conditions can affect output. We actively manage the operations of our refineries, and any variability in their operations typically has not been as significant to cash flows as that caused by margins and prices. However, the recent decline in demand for refined petroleum products has led to a reduction of our refinery production. If the global economic disruption associated with the COVID-19 pandemic sustains, we expect refinery production, along with marketing, transportation and terminaling volumes, to remain challenged in the near term, which could have an unfavorable impact on our future operating cash flows. Our worldwide refining crude oil capacity utilization was 76%, 94% and 95% in 2020, 2019 and 2018, respectively.49Table of ContentsIndex to Financial StatementsEquity Affiliate Operating DistributionsOur operating cash flows are also impacted by distribution decisions made by our equity affiliates, including CPChem, DCP Midstream and WRB. Over the three years ended December 31, 2020, our operating cash flows included aggregate distributions from our equity affiliates of $6,406 million, including $290 million from DCP Midstream, $2,490 million from CPChem and $1,230 million from WRB. We cannot control the amount or timing of future distributions from equity affiliates; therefore, future distributions are not assured.Tax RefundsAn income tax receivable of $1.5 billion is included in the “Accounts and notes receivable” line item on our consolidated balance sheet as of December 31, 2020, which reflects tax refunds we expect to receive within the next 12 months. Phillips 66 PartnersIn 2013, we formed Phillips 66 Partners, a publicly traded MLP, to own, operate, develop and acquire primarily fee-based midstream assets.Ownership and Restructuring TransactionOn August 1, 2019, Phillips 66 Partners completed a restructuring transaction to eliminate the incentive distribution rights (IDRs) held by us and to convert our 2% economic general partner interest into a noneconomic general partner interest in exchange for 101 million Phillips 66 Partners common units. No distributions were made for the general partner interest after August 1, 2019. At December 31, 2020, we owned 170 million Phillips 66 Partners common units, representing 74% of Phillips 66 Partners’ limited partner units. We consolidate Phillips 66 Partners as a variable interest entity for financial reporting purposes. See Note 27—Phillips 66 Partners LP, in the Notes to Consolidated Financial Statements, for additional information on why we consolidate the partnership. As a result of this consolidation, the public common and preferred unitholders’ interests in Phillips 66 Partners are reflected as noncontrolling interests of $2,219 million in our consolidated balance sheet at December 31, 2020. Debt and Equity FinancingsDuring the three years ended December 31, 2020, Phillips 66 Partners raised net proceeds of approximately $1 billion from the following third-party debt and equity offerings:•In September 2019, Phillips 66 Partners received net proceeds of $892 million from the issuance of $300 million of 2.450% Senior Notes due December 2024 and $600 million of 3.150% Senior Notes due December 2029.•In March 2019, Phillips 66 Partners entered into a senior unsecured term loan facility with a borrowing capacity of $400 million due March 20, 2020. Phillips 66 Partners borrowed an aggregate amount of $400 million under the facility during the first half of 2019, which was repaid in full in September 2019. •Phillips 66 Partners has authorized an aggregate of $750 million under three $250 million continuous offerings of common units, or at-the-market (ATM) programs. Phillips 66 Partners completed the first two programs in June 2018 and December 2019, respectively. For the three years ended December 31, 2020, net proceeds of $303 million have been received under these programs.Phillips 66 Partners primarily used these net proceeds to fund the cash portion of acquisitions of assets from Phillips 66 and for capital spending and investments. See Note 27—Phillips 66 Partners LP, in the Notes to Consolidated Financial Statements, for additional information regarding Phillips 66 Partners.50Table of ContentsIndex to Financial StatementsTransfers of Equity InterestsGray Oak Pipeline, LLC was formed to develop and construct the Gray Oak Pipeline, which transports crude oil from the Permian and Eagle Ford to Texas Gulf Coast destinations that include Corpus Christi, Texas, and the Sweeny area, including our Sweeny Refinery. Phillips 66 Partners has a consolidated holding company that owns 65% of Gray Oak Pipeline, LLC. In December 2018, a third party acquired a 35% interest in the holding company. Because the holding company’s sole asset was its ownership interest in Gray Oak Pipeline, LLC, which was considered a financial asset, and because certain restrictions were placed on the third party’s ability to transfer or sell its interest in the holding company during the construction of the Gray Oak Pipeline, the legal sale of the 35% interest did not qualify as a sale under GAAP at that time. The Gray Oak Pipeline commenced full operations in the second quarter of 2020, and the restrictions placed on the co-venturer were lifted on June 30, 2020, resulting in the recognition of the sale under GAAP. Accordingly, at June 30, 2020, the co-venturer’s 35% interest in the holding company was recharacterized from a long-term obligation to a noncontrolling interest on our consolidated balance sheet, and the premium of $84 million previously paid by the co-venturer in 2019 was recharacterized from a long-term obligation to a gain in our consolidated statement of operations. For the year ended December 31, 2020, the co-venturer contributed an aggregate of $61 million to the holding company to fund its portion of Gray Oak Pipeline, LLC’s cash calls. Phillips 66 Partners’ effective ownership interest in Gray Oak Pipeline, LLC is 42.25% , after considering the co-venturer’s 35% interest in the consolidated holding company. See Note 6—Investments, Loans and Long-Term Receivables, for further discussion regarding Phillips 66 Partners’ investment in Gray Oak Pipeline, LLC.Revolving Credit Facilities and Commercial PaperPhillips 66 has a $5 billion revolving credit facility which may be used for direct bank borrowings, as support for issuances of letters of credit, and as support for our commercial paper program. We have an option to increase the overall capacity to $6 billion, subject to certain conditions. We also have the option to extend the scheduled maturity of the facility for up to two additional one-year terms after its July 30, 2024, maturity date, subject to, among other things, the consent of the lenders holding the majority of the commitments and of each lender extending its commitment. The facility is with a broad syndicate of financial institutions and contains covenants that are usual and customary for an agreement of this type, including a maximum consolidated net debt-to-capitalization ratio of 65% as of the last day of each fiscal quarter. The facility has customary events of default, such as nonpayment of principal when due; nonpayment of interest, fees or other amounts; and violation of covenants. Outstanding borrowings under the facility bear interest, at our option, at either: (a) the Eurodollar rate in effect from time to time plus the applicable margin; or (b) the reference rate (as described in the facility) plus the applicable margin. The facility also provides for customary fees, including commitment fees. The pricing levels for the commitment fees and interest-rate margins are determined based on the ratings in effect for Phillips 66’s senior unsecured long-term debt from time to time. Phillips 66 may at any time prepay outstanding borrowings under the facility, in whole or in part, without premium or penalty. At December 31, 2020 and 2019, no amount had been drawn under the facility. Phillips 66 also has a $5 billion uncommitted commercial paper program for short-term working capital needs that is supported by our revolving credit facility. Commercial paper maturities are contractually limited to 365 days. At December 31, 2020 and 2019, no borrowings were outstanding under the program. 51Table of ContentsIndex to Financial StatementsPhillips 66 Partners has a $750 million revolving credit facility which may be used for direct bank borrowings and as support for issuances of letters of credit. Phillips 66 Partners has an option to increase the overall capacity to $1 billion, subject to certain conditions. Phillips 66 Partners also has the option to extend the facility for two additional one-year terms after its July 30, 2024, maturity date, subject to, among other things, the consent of the lenders holding the majority of the commitments and of each lender extending its commitment. The facility is with a broad syndicate of financial institutions and contains covenants that are usual and customary for an agreement of this type. The facility has customary events of default, such as nonpayment of principal when due; nonpayment of interest, fees or other amounts; and violation of covenants. Outstanding revolving borrowings under the facility bear interest, at Phillips 66 Partners’ option, at either: (a) the Eurodollar rate in effect from time to time plus the applicable margin; or (b) the reference rate (as described in the facility) plus the applicable margin. The facility also provides for customary fees, including commitment fees. The pricing levels for the commitment fees and interest-rate margins are determined based on Phillips 66 Partners’ credit ratings in effect from time to time. Borrowings under this facility may be short-term or long-term in duration, and Phillips 66 Partners may at any time prepay outstanding borrowings under the facility, in whole or in part, without premium or penalty. At December 31, 2020, borrowings of $415 million were outstanding under this facility, compared with no borrowings outstanding at December 31, 2019. At both December 31, 2020 and 2019, $1 million in letters of credit had been issued that were supported by this facility. We had approximately $5.3 billion and $5.7 billion of total committed capacity available under our revolving credit facilities at December 31, 2020 and 2019, respectively. Other Debt Issuances and FinancingsSenior Unsecured NotesOn November 18, 2020, Phillips 66 closed its public offering of $1.75 billion aggregate principal amount of senior unsecured notes consisting of:•$450 million aggregate principal amount of Floating Rate Senior Notes due 2024 (the Floating Rate Notes).•$800 million aggregate principal amount of 0.900% Senior Notes due 2024.•$500 million aggregate principal amount of 1.300% Senior Notes due 2026.The Floating Rate Notes will bear interest at a floating rate, reset quarterly, equal to the three-month London Interbank Offered Rate (LIBOR) plus 0.62% per year, subject to adjustment. Interest on the Senior Notes due 2024 and 2026 is payable semiannually on February 15 and August 15 of each year, commencing on February 15, 2021. Proceeds received from the public offering of senior unsecured notes on November 18, 2020, were $1.74 billion, net of underwriters’ discounts and commissions, as well as debt issuance costs. On November 19, 2020, a portion of these proceeds were used to repay $500 million of outstanding borrowings under the term loan facility that Phillips 66 entered into in March 2020 (see the “Term Loan Facility” section below for a full description of the term loan facility). In addition, a portion of the proceeds will be used to repay the $500 million aggregate principal amount of our outstanding Floating Rate Senior Notes due February 2021. The remainder of the proceeds are being used for general corporate purposes. 52Table of ContentsIndex to Financial StatementsOn June 10, 2020, Phillips 66 closed its public offering of $1 billion aggregate principal amount of senior unsecured notes consisting of:•$150 million aggregate principal amount of 3.850% Senior Notes due 2025.•$850 million aggregate principal amount of 2.150% Senior Notes due 2030.On April 9, 2020, Phillips 66 closed its public offering of $1 billion aggregate principal amount of senior unsecured notes consisting of:•$500 million aggregate principal amount of 3.700% Senior Notes due 2023.•$500 million aggregate principal amount of 3.850% Senior Notes due 2025. Interest on the Senior Notes due 2023 is payable semiannually on April 6 and October 6 of each year, commencing on October 6, 2020. The Senior Notes due 2025 issued on June 10, 2020, constitute a further issuance of the Senior Notes due 2025 originally issued on April 9, 2020. The $650 million in aggregate principal amount of Senior Notes due 2025 is treated as a single class of debt securities. Interest on the Senior Notes due 2025 is payable semiannually on April 9 and October 9 of each year, commencing on October 9, 2020. Interest on the Senior Notes due 2030 is payable semiannually on June 15 and December 15 of each year, commencing on December 15, 2020.Proceeds received from the public offerings of senior unsecured notes on June 10, 2020, and April 9, 2020, were $1,008 million and $993 million, respectively, net of underwriters’ discounts or premiums and commissions, as well as debt issuance costs. These proceeds are being used for general corporate purposes. Term Loan FacilityOn March 19, 2020, Phillips 66 entered into a $1 billion 364-day delayed draw term loan agreement (the Facility) and borrowed $1 billion under the Facility shortly thereafter. On April 6, 2020, Phillips 66 increased the size of the Facility to $2 billion, and in June 2020, the Facility was amended to extend the commitment period to September 19, 2020. We did not draw additional amounts under the Facility before the end of the commitment period or further extend the commitment period. In November 2020, we repaid $500 million of borrowings outstanding under the Facility, and the Facility was amended to extend the maturity date of the remaining $500 million outstanding borrowings from March 18, 2021, to November 20, 2023. Borrowings under the Facility bear interest at a floating rate based on either the Eurodollar rate or the reference rate, plus a margin determined by the credit rating of Phillips 66’s senior unsecured long-term debt. Phillips 66 is using the proceeds for general corporate purposes. Availability of Debt FinancingWe have a BBB+ credit rating, with a negative outlook, from Standard & Poor’s and an A3 credit rating, with a negative outlook, from Moody’s Investors Service. These investment grade ratings have served to lower our borrowing costs and facilitate access to a variety of lenders. We do not have any ratings triggers on any of our corporate debt that would cause an automatic default, and thereby impact our access to liquidity, in the event of a rating downgrade. Failure to maintain strong investment grade ratings could prohibit us from accessing the commercial paper market, although we would expect to be able to access funds under our liquidity facilities mentioned above.53Table of ContentsIndex to Financial StatementsOff-Balance Sheet ArrangementsLease Residual Value GuaranteesIn September 2020, we amended the operating lease agreement for our headquarters facility in Houston, Texas, and extended the lease term from June 2021 to September 2025. Under this agreement, we have the option, at the end of the lease term, to request to renew the lease, purchase the facility or assist the lessor in marketing it for resale. We have a residual value guarantee associated with the operating lease agreement with a maximum potential future exposure of $514 million at December 31, 2020. We also have residual value guarantees associated with railcar and airplane leases with maximum potential future payments totaling $381 million. These operating leases have remaining terms of up to nine years. Dakota Access, LLC (Dakota Access) and Energy Transfer Crude Oil Company, LLC (ETCO)In March 2019, a wholly owned subsidiary of Dakota Access closed an offering of $2.5 billion aggregate principal amount of senior unsecured notes, consisting of:•$650 million aggregate principal amount of 3.625% Senior Notes due 2022. •$1.0 billion aggregate principal amount of 3.900% Senior Notes due 2024. •$850 million aggregate principal amount of 4.625% Senior Notes due 2029.Dakota Access and ETCO have guaranteed repayment of the notes. In addition, Phillips 66 Partners and its coventurers in Dakota Access provided a Contingent Equity Contribution Undertaking (CECU) in conjunction with the notes offering. Under the CECU, the co-venturers may be severally required to make proportionate equity contributions to Dakota Access if there is an unfavorable final judgment in the ongoing litigation related to an easement granted by the U.S. Army Corps of Engineers (USACE) to allow the pipeline to be constructed under Lake Oahe in North Dakota. Contributions may be required if Dakota Access determines that the issues included in any such final judgment cannot be remediated and Dakota Access has or is projected to have insufficient funds to satisfy repayment of the notes. If Dakota Access undertakes remediation to cure issues raised in a final judgment, contributions may be required if any series of the notes become due, whether by acceleration or at maturity, during such time, to the extent Dakota Access has or is projected to have insufficient funds to pay such amounts. At December 31, 2020, Phillips 66 Partners’ share of the maximum potential equity contributions under the CECU was approximately $631 million and the aggregate book value of Phillips 66 Partners’ investments in Dakota Access and ETCO was $577 million.In March 2020, the trial court presiding over this litigation ordered the USACE to prepare an Environmental Impact Statement (EIS) and requested additional information to enable a decision on whether the Dakota Access Pipeline should be shut down while the EIS is being prepared. In July 2020, the trial court ordered the Dakota Access Pipeline to be shut down and emptied of crude oil within 30 days and that the pipeline should remain shut down pending the preparation of the EIS by the USACE, which the USACE has indicated is expected to take approximately 13 months. Dakota Access filed an appeal and a request for a stay of the order, which was granted. In January 2021, the appellate court affirmed the trial court’s order that: (1) vacated Dakota Access’s easement under Lake Oahe, and (2) directed the USACE to prepare an EIS. The appellate court did not affirm the trial court’s order that the Dakota Access Pipeline be shut down and emptied of crude oil. However, the appellate court acknowledged the precise consequences of the vacated easement remain uncertain. Since the pipeline is now an encroachment, the USACE could seek a shutdown of the pipeline during the preparation of the EIS. Alternatively, the trial court could again issue an injunction that the pipeline be shut down, assuming it makes all findings necessary for injunctive relief. A status hearing is scheduled for April 9, 2021, at which time the parties will discuss the appellate court’s decision and how the USACE plans to proceed given the vacating of the easement. If the pipeline is required to cease operations pending the preparation of the EIS, and should Dakota Access and ETCO not have sufficient funds to pay ongoing expenses, Phillips 66 Partners also could be required to support its share of the ongoing expenses, including scheduled interest payments on the notes of approximately $25 million annually, in addition to the potential obligations under the CECU.54Table of ContentsIndex to Financial StatementsGray Oak Pipeline, LLCGray Oak Pipeline, LLC had a third-party term loan facility with a borrowing capacity of $1,379 million, inclusive of accrued interest. Phillips 66 Partners and its co-venturers provided a guarantee through an equity contribution agreement requiring proportionate equity contributions to Gray Oak Pipeline, LLC up to the total outstanding loan amount, plus any additional accrued interest and associated fees, if Gray Oak Pipeline, LLC defaulted on certain of its obligations thereunder. In September 2020, Gray Oak Pipeline, LLC fully repaid the outstanding balance of the term loan facility, and the associated equity contribution agreement was terminated. See Note 13—Guarantees, in the Notes to Consolidated Financial Statements, for additional information on our guarantees.55Table of ContentsIndex to Financial StatementsCapital RequirementsCapital Expenditures and InvestmentsFor information about our capital expenditures and investments, see the “Capital Spending” section below. Debt FinancingOur debt balance at December 31, 2020, was $15.9 billion and our total debt-to-capital ratio was 42%. See Note 12—Debt, in the Notes to Consolidated Financial Statements, for our annual debt maturities over the next five years and more information on debt repayments.Debt Incurred During 2020As noted in “Significant Sources of Capital,” Phillips 66 received approximately $4.7 billion in proceeds from debt issuances during 2020, while repaying approximately $1.0 billion of debt. Phillips 66 Partners had net borrowings of $415 million under its revolving credit facility during 2020. The net increase in debt of $4.1 billion reflects our response to the COVID-19 pandemic’s negative impacts on our operating cash flows. As economic conditions improve and our operating cash flows return to more typical levels, we will continue to prioritize funding sustaining capital expenditures and the company’s dividend. After these cash flow needs, we expect to prioritize repayment of debt, with an objective of maintaining our investment grade credit ratings and reducing our debt to pre-pandemic levels. We intentionally structured the maturities and call options of our debt issued in 2020 to facilitate these objectives. Additionally, restarting our share repurchase program remains a priority once operating cash flows exceed amounts needed to fulfill the other priorities stated above and assuming our shares are trading below intrinsic value.Joint Venture LoansDuring 2020, we and our co-venturer provided member loans to WRB. At December 31, 2020, our share of the loan balance was $277 million. The need for additional loans to WRB in 2021, as well as WRB’s repayment schedule, will depend on market conditions.DividendsOn February 10, 2021, our Board of Directors declared a quarterly cash dividend of $0.90 per common share, payable March 1, 2021, to holders of record at the close of business on February 22, 2021. We expect that our Board of Directors will continue to declare quarterly dividends in 2021. Share RepurchasesSince July 2012, our Board of Directors has authorized an aggregate of $15 billion of repurchases of our outstanding common stock. The authorizations do not have expiration dates. The share repurchases are expected to be funded primarily through available cash. We are not obligated to repurchase any shares of common stock pursuant to these authorizations and may commence, suspend or terminate repurchases at any time. Since the inception of our share repurchase program in 2012, we have repurchased 159 million shares at an aggregate cost of $12.5 billion. Shares of stock repurchased are held as treasury shares. We suspended share repurchases in mid-March 2020 to preserve liquidity in response to the global economic disruption caused by the COVID-19 pandemic.56Table of ContentsIndex to Financial StatementsContractual ObligationsThe following table summarizes our aggregate contractual fixed and variable obligations as of December 31, 2020:Millions of DollarsPayments Due by Period TotalUp to1 YearYears2-3Years4-5After5 YearsDebt obligations (a)$15,716 965 3,000 2,700 9,051 Finance lease obligations264 16 30 32 186 Software obligations19 6 10 3 — Total debt15,999 987 3,040 2,735 9,237 Interest on debt7,434 568 998 866 5,002 Operating lease obligations1,372 406 455 240 271 Purchase obligations (b)76,887 28,946 9,742 8,099 30,100 Other long-term liabilities (c)Asset retirement obligations309 9 40 29 231 Accrued environmental costs427 70 131 65 161 Repatriation income tax liability (d)88 9 27 52 — Total$102,516 30,995 14,433 12,086 45,002 (a)For additional information, see Note 12—Debt, in the Notes to Consolidated Financial Statements.(b)Represents any agreement to purchase goods or services that is enforceable, legally binding and specifies all significant terms. We expect these purchase obligations will be fulfilled with operating cash flows in the applicable maturity period. The majority of the purchase obligations are market-based contracts, including exchanges and futures, for the purchase of products such as crude oil and raw NGL. The products are used to supply our refineries and fractionators and optimize our supply chain. Product purchase commitments with third parties totaled $29,551 million. Related party purchase commitments totaled $31,729 million and included purchases from CPChem, DCP Midstream and other equity affiliates. Purchase obligations of $4,027 million are related to agreements to access and utilize the capacity of third-party equipment and facilities, including pipelines and product terminals, to transport, process, treat, and store products. The remainder is primarily our net share of purchase commitments for materials and services for jointly owned facilities where we are the operator.(c)Excludes pensions and unrecognized income tax benefits. From 2021 through 2025, we expect to contribute an average of $125 million per year to our qualified and nonqualified pension and other postretirement benefit plans in the United States and an average of $30 million per year to our non-U.S. plans. The U.S. five-year average consists of approximately $40 million for 2021 and $145 million per year for the remaining four years. Our minimum funding in 2021 is expected to be $40 million in the United States and $30 million outside the United States. This amount also excludes unrecognized tax benefits of $56 million because the ultimate disposition and timing of any tax payments to be made with regard to such amounts are not reasonably estimable or the amounts relate to potential refunds. This amount also excludes interest of $5 million. Although unrecognized tax benefits are not a contractual obligation, they represent potential demands on our liquidity. (d)We elected to pay the one-time deemed repatriation income tax on foreign-sourced earnings, recognized as a result of the Tax Act enacted in December 2017, in installments over eight years beginning in 2018. The amount represents the remaining income tax liability. 57Table of ContentsIndex to Financial StatementsCapital Spending Our capital expenditures and investments represent consolidated capital spending. Our adjusted capital spending is a non-GAAP financial measure that demonstrates our net share of capital spending, and reflects an adjustment for the portion of our consolidated capital spending funded by certain joint venture partners. Millions of Dollars 2021Budget202020192018Capital Expenditures and InvestmentsMidstream$615 1,747 2,292 1,548 Chemicals— — — — Refining776 816 1,001 826 Marketing and Specialties116 173 374 125 Corporate and Other166 184 206 140 Total Capital Expenditures and Investments1,673 2,920 3,873 2,639 Less: capital spending funded by certain joint venture partners*5 61 423 — Adjusted Capital Spending$1,668 2,859 3,450 2,639 Selected Equity Affiliates**DCP Midstream$55 119 472 484 CPChem410 284 382 339 WRB242 175 175 156 $707 578 1,029 979 * Included in the Midstream segment.** Our share of joint venture’s capital spending.MidstreamCapital spending in our Midstream segment during the three-year period ended December 31, 2020, included:•Continued development of additional Gulf Coast fractionation capacity. During 2020, Phillips 66 commenced operations of two new NGL fractionators (Frac 2 and Frac 3) at the Sweeny Hub in Texas. •Contributions by Phillips 66 Partners to fund the Gray Oak Pipeline project and South Texas Gateway Terminal development activities.•Construction activities on Phillips 66 Partners’ C2G Pipeline that will connect its Clemens Caverns storage facility to petrochemical facilities in Gregory, Texas.•Contributions to joint ventures to develop and construct crude oil pipeline systems, including the Liberty Pipeline system.•Construction activities to increase storage and export capacity at our Beaumont Terminal.•Construction of Phillips 66 Partners’ Sweeny to Pasadena refined petroleum product pipeline. •Construction of Phillips 66 Partners’ new isomerization unit at the Lake Charles Refinery. •Contributions to Bayou Bridge Pipeline, LLC, a Phillips 66 Partners’ 40 percent-owned joint venture, for the construction of a pipeline from Nederland, Texas, to Lake Charles, Louisiana, and a pipeline segment from Lake Charles to St. James, Louisiana. •Spending associated with other return, reliability and maintenance projects in our Transportation and NGL businesses.58Table of ContentsIndex to Financial StatementsIn March 2020, the development and construction of our Red Oak Pipeline system and Sweeny Frac 4, as well as Phillips 66 Partners’ Liberty Pipeline system projects, were deferred as a result of the challenging business environment. In the third quarter of 2020, the Red Oak Pipeline project was canceled. We plan to resume construction of Sweeny Frac 4 in the second half of 2021.During the three-year period ended December 31, 2020, DCP Midstream’s self-funded capital expenditures and investments were $2.1 billion on a 100% basis. Capital spending during this period was primarily for expansion projects and maintenance capital expenditures for existing assets. Expansion projects included construction of the Latham II offload facilities, the Cheyenne Connector, and the Mewbourn 3 and O’Connor 2 plants, as well as investments in the Sand Hills, Southern Hills and Gulf Coast Express pipeline joint ventures.ChemicalsDuring the three-year period ended December 31, 2020, CPChem had a self-funded capital program that totaled $2.0 billion on a 100% basis. The capital spending was primarily for the development of U.S. Gulf Coast petrochemical projects, debottlenecking projects on existing assets, and the development of a petrochemicals complex in Qatar.RefiningCapital spending for the Refining segment during the three-year period ended December 31, 2020, was $2.6 billion, primarily for refinery upgrade projects to enhance the yield of high-value products, renewable diesel projects, improvements to the operating integrity of key processing units, and safety-related projects. Key projects completed during the three-year period included: •Installation of facilities to improve clean product yield at the Bayway and Lake Charles refineries, as well as the jointly owned Borger and Wood River refineries.•Installation of facilities to improve product value at the Bayway and Sweeny refineries.•Installation of facilities to improve processing of advantaged crude at the Lake Charles refinery.•Installation of facilities to comply with the EPA Tier 3 gasoline regulations at the Bayway and Ferndale refineries.Marketing and SpecialtiesCapital spending for the M&S segment during the three-year period ended December 31, 2020, was primarily for an investment in a U.S. West Coast retail marketing joint venture, and the acquisition, development and enhancement of retail sites in Europe. Corporate and OtherCapital spending for Corporate and Other during the three-year period ended December 31, 2020, was primarily for information technology and facilities.59Table of ContentsIndex to Financial Statements2021 BudgetOur 2021 capital budget is $1.7 billion, including $305 million of Phillips 66 Partners’ planned capital spending. Our projected $1.7 billion capital budget excludes our portion of planned capital spending by our major joint ventures DCP Midstream, CPChem and WRB totaling $707 million. Phillips 66 Partners’ planned capital spending of $305 million includes $5 million of capital expected to be funded by a joint venture partner.The Midstream capital budget is $615 million, of which $5 million is expected to be funded by a joint venture partner. The Midstream growth capital budget is directed toward completing near-term committed and optimization projects, including the construction of Sweeny Frac 4 and the completion of the C2G Pipeline. Sustaining capital will be used to enhance asset integrity and reliability. Refining’s capital budget of $776 million includes $521 million of sustaining capital for reliability, safety and environmental projects. The Refining budget includes $255 million for high-return, quick-payout projects to enhance margins by improving clean product yields and reducing feedstock costs, as well as investments to competitively position the company for a lower carbon future. The Refining budget also includes pre-construction engineering and design costs related to the company’s plans to reconfigure the San Francisco Refinery in Rodeo, California, to produce renewable fuels. The M&S capital budget of $116 million primarily reflects the development and improvement of our international retail sites. The Corporate and Other capital budget of $166 million will primarily fund digital transformation projects, including a new enterprise resource planning system.60Table of ContentsIndex to Financial StatementsContingenciesA number of lawsuits involving a variety of claims that arose in the ordinary course of business have been filed against us or are subject to indemnifications provided by us. We also may be required to remove or mitigate the effects on the environment of the placement, storage, disposal or release of certain chemical, mineral and petroleum substances at various active and inactive sites. We regularly assess the need for financial recognition or disclosure of these contingencies. In the case of all known contingencies (other than those related to income taxes), we accrue a liability when the loss is probable and the amount is reasonably estimable. If a range of amounts can be reasonably estimated and no amount within the range is a better estimate than any other amount, then the minimum of the range is accrued. We do not reduce these liabilities for potential insurance or third-party recoveries. If applicable, we accrue receivables for probable insurance or other third-party recoveries. In the case of income tax-related contingencies, we use a cumulative probability-weighted loss accrual in cases where sustaining a tax position is less than certain.Based on currently available information, we believe it is remote that future costs related to known contingent liability exposures will exceed current accruals by an amount that would have a material adverse impact on our consolidated financial statements. As we learn new facts concerning contingencies, we reassess our position both with respect to accrued liabilities and other potential exposures. Estimates particularly sensitive to future changes include contingent liabilities recorded for environmental remediation, tax and legal matters. Estimated future environmental remediation costs are subject to change due to such factors as the uncertain magnitude of cleanup costs, the unknown time and extent of such remedial actions that may be required, and the determination of our liability in proportion to that of other potentially responsible parties. Estimated future costs related to tax and legal matters are subject to change as events evolve and as additional information becomes available during the administrative and litigation processes.Legal and Tax MattersOur legal and tax matters are handled by our legal and tax organizations. These organizations apply their knowledge, experience and professional judgment to the specific characteristics of our cases and uncertain tax positions. We employ a litigation management process to manage and monitor the legal proceedings. Our process facilitates the early evaluation and quantification of potential exposures in individual cases and enables the tracking of those cases that have been scheduled for trial and/or mediation. Based on professional judgment and experience in using these litigation management tools and available information about current developments in all our cases, our legal organization regularly assesses the adequacy of current accruals and determines if adjustment of existing accruals, or establishment of new accruals, is required. In the case of income tax-related contingencies, we monitor tax legislation and court decisions, the status of tax audits and the statute of limitations within which a taxing authority can assert a liability. See Note 21—Income Taxes, in the Notes to Consolidated Financial Statements, for additional information about income tax-related contingencies.EnvironmentalWe are subject to international, federal, state and local environmental laws and regulations. Among the most significant of these international and federal environmental laws and regulations are the: •U.S. Federal Clean Air Act, which governs air emissions.•U.S. Federal Clean Water Act, which governs discharges into water bodies.•European Union Regulation for Registration, Evaluation, Authorization and Restriction of Chemicals (REACH), which governs production, marketing and use of chemicals.•U.S. Federal Comprehensive Environmental Response, Compensation and Liability Act (CERCLA), which imposes liability on generators, transporters and arrangers of hazardous substances at sites where hazardous substance releases have occurred or are threatening to occur.•U.S. Federal Resource Conservation and Recovery Act (RCRA), which governs the treatment, storage and disposal of solid waste.•U.S. Federal Emergency Planning and Community Right-to-Know Act (EPCRA), which requires facilities to report toxic chemical inventories to local emergency planning committees and response departments.61Table of ContentsIndex to Financial Statements•U.S. Federal Oil Pollution Act of 1990 (OPA90), under which owners and operators of onshore facilities and pipelines as well as owners and operators of vessels are liable for removal costs and damages that result from a discharge of oil into navigable waters of the United States.•European Union Trading Directive resulting in the European Union Emissions Trading Scheme (EU ETS), which uses a market-based mechanism to incentivize the reduction of greenhouse gas (GHG) emissions, as well as the United Kingdom Emissions Trading Scheme (UK ETS), which will replace the EU ETS in the United Kingdom beginning April 30, 2021.These laws and their implementing regulations set limits on emissions and, in the case of discharges to water, establish water quality limits. They also, in most cases, require permits in association with new or modified operations. These permits can require an applicant to collect substantial information in connection with the application process, which can be expensive and time consuming. In addition, there can be delays associated with notice and comment periods and the agency’s processing of the application. Many of the delays associated with the permitting process are beyond the control of the applicant.Other foreign countries and many states where we operate also have, or are developing, similar environmental laws and regulations governing these same types of activities. While similar, in some cases these regulations may impose additional, or more stringent, requirements that can add to the cost and difficulty of developing infrastructure and marketing and transporting products across state and international borders. For example, in California the South Coast Air Quality Management District (SCAQMD) approved amendments to the Regional Clean Air Incentives Market (RECLAIM) that became effective in 2016, which require a phased reduction of nitrogen oxide emissions through 2022, affecting refineries in the Los Angeles metropolitan area. In 2017, SCAQMD required additional nitrogen dioxide emissions reductions through 2025 and is now promulgating new regulations to replace the RECLAIM program with a traditional command and control regulatory regime.The ultimate financial impact arising from environmental laws and regulations is neither clearly known nor easily determinable as new standards, such as air emission standards, water quality standards and stricter fuel regulations, continue to evolve. However, environmental laws and regulations, including those that may arise to address concerns about global climate change, are expected to continue to have an increasing impact on our operations in the United States and in other countries in which we operate. Notable areas of potential impacts include air emissions compliance and remediation obligations in the United States.An example of this in the fuels area is the Energy Independence and Security Act of 2007 (EISA). It requires fuel producers and importers to provide additional renewable fuels for transportation motor fuels and stipulates a mix of various types. RINs form the mechanism used by the EPA to record compliance with the Renewable Fuel Standard. If an obligated party has more RINs than it needs to meet its obligation, it may sell or trade the extra RINs, or instead choose to “bank” them for use the following year. We have met the stringent requirements to date while establishing implementation, operating and capital strategies, along with advanced technology development, to address projected future requirements. It is uncertain how various future requirements contained in EISA, and the regulations promulgated thereunder, may be implemented and what their full impact may be on our operations. For the 2020 compliance year, the EPA set volumes of advanced and total renewable fuels required to be blended into transportation fuels at higher levels than in previous years; it is uncertain if these increased obligations will be achievable by fuel producers and shippers without drawing on the RIN bank. Additionally, we may experience a decrease in demand for refined petroleum products due to the regulatory program as currently promulgated. This program continues to be the subject of possible Congressional review and re-promulgation in revised form, and the EPA’s regulations pertaining to the 2019 and 2020 compliance years are subject to legal challenge, further creating uncertainty regarding renewable fuel volume requirements and obligations. Uncertainty also exists surrounding compliance year 2021, as the EPA has not yet promulgated standards for that compliance year, although we expect the EPA to follow its past practice of using its authority to reduce the statutorily required volumes under EISA of advanced and total renewable fuels required to be blended into transportation fuels. Compliance with the regulation has been further complicated as the market for RINs has been the subject of fraudulent third-party activity, and it is possible that some RINs that we have purchased may be determined to be invalid. Should that occur, we could incur costs to replace those fraudulent RINs. Although the cost for replacing any fraudulently marketed RINs is not reasonably estimable at this time, we would not expect such costs to have a material impact on our results of operations or financial condition.62Table of ContentsIndex to Financial StatementsWe also are subject to certain laws and regulations relating to environmental remediation obligations associated with current and past operations. Such laws and regulations include CERCLA and RCRA and their state equivalents. Remediation obligations include cleanup responsibility arising from petroleum releases from underground storage tanks located at numerous previously and currently owned and/or operated petroleum-marketing outlets throughout the United States. Federal and state laws require contamination caused by such underground storage tank releases be assessed and remediated to meet applicable standards. In addition to other cleanup standards, many states have adopted cleanup criteria for methyl tertiary-butyl ether (MTBE) for both soil and groundwater.At RCRA-permitted facilities, we are required to assess environmental conditions. If conditions warrant, we may be required to remediate contamination caused by prior operations. In contrast to CERCLA, which is often referred to as “Superfund,” the cost of corrective action activities under RCRA corrective action programs typically is borne solely by us. We anticipate increased expenditures for RCRA remediation activities may be required, but such annual expenditures for the near term are not expected to vary significantly from the range of such expenditures we have experienced over the past few years. Longer-term expenditures are subject to considerable uncertainty and may fluctuate significantly.We occasionally receive requests for information or notices of potential liability from the EPA and state environmental agencies alleging that we are a potentially responsible party under CERCLA or an equivalent state statute. On occasion, we also have been made a party to cost recovery litigation by those agencies or by private parties. These requests, notices and lawsuits assert potential liability for remediation costs at various sites that typically are not owned by us, but allegedly contain wastes attributable to our past operations. As of December 31, 2019, we reported that we had been notified of potential liability under CERCLA and comparable state laws at 27 sites within the United States. During 2020, we were notified of one previously resolved site that was returned to active status and three sites that were deemed resolved and closed, leaving 25 unresolved sites with potential liability at December 31, 2020. For the majority of Superfund sites, our potential liability will be less than the total site remediation costs because the percentage of waste attributable to us, versus that attributable to all other potentially responsible parties, is relatively low. Although liability of those potentially responsible is generally joint and several for federal sites and frequently so for state sites, other potentially responsible parties at sites where we are a party typically have had the financial strength to meet their obligations, and where they have not, or where potentially responsible parties could not be located, our share of liability has not increased materially. Many of the sites for which we are potentially responsible are still under investigation by the EPA or the state agencies concerned. Prior to actual cleanup, those potentially responsible normally assess site conditions, apportion responsibility and determine the appropriate remediation. In some instances, we may have no liability or attain a settlement of liability. Actual cleanup costs generally occur after the parties obtain the EPA or equivalent state agency approval of a remediation plan. There are relatively few sites where we are a major participant, and given the timing and amounts of anticipated expenditures, neither the cost of remediation at those sites nor such costs at all CERCLA sites, in the aggregate, is expected to have a material adverse effect on our competitive or financial condition.Expensed environmental costs were $610 million in 2020 and are expected to be approximately $720 million per year in 2021 and 2022. Capitalized environmental costs were $131 million in 2020 and are expected to be approximately $105 million and $140 million, in 2021 and 2022, respectively. These amounts do not include capital expenditures made for other purposes that have an indirect benefit on environmental compliance.Accrued liabilities for remediation activities are not reduced for potential recoveries from insurers or other third parties and are not discounted (except those assumed in a business combination, which we record on a discounted basis).Many of these liabilities result from CERCLA, RCRA and similar state laws that require us to undertake certain investigative and remedial activities at sites where we conduct, or once conducted, operations or at sites where our generated waste was disposed. We also have accrued for a number of sites we identified that may require environmental remediation, but which are not currently the subject of CERCLA, RCRA or state enforcement activities. If applicable, we accrue receivables for probable insurance or other third-party recoveries. In the future, we may incur significant costs under both CERCLA and RCRA. Remediation activities vary substantially in duration and cost from site to site, depending on the mix of unique site characteristics, evolving remediation technologies, diverse regulatory agencies and enforcement policies, and the presence or absence of potentially liable third parties. Therefore, it is difficult to develop reasonable estimates of future site remediation costs.63Table of ContentsIndex to Financial StatementsNotwithstanding any of the foregoing, and as with other companies engaged in similar businesses, environmental costs and liabilities are inherent concerns in certain of our operations and products, and there can be no assurance that those costs and liabilities will not be material. However, we currently do not expect any material adverse effect on our results of operations or financial position as a result of compliance with current environmental laws and regulations.Climate ChangeThere has been a broad range of proposed or promulgated state, national and international laws focusing on GHG emissions reduction, including various regulations proposed or issued by the EPA. These proposed or promulgated laws apply or could apply in states and/or countries where we have interests or may have interests in the future. Laws regulating GHG emissions continue to evolve, and while it is not possible to accurately estimate either a timetable for implementation or our future compliance costs relating to implementation, such laws potentially could have a material impact on our results of operations and financial condition as a result of increasing costs of compliance, lengthening project implementation and agency reviews, or reducing demand for certain hydrocarbon products. Examples of legislation or precursors for possible regulation that do or could affect our operations include: •EU ETS, which is part of the European Union’s policy to combat climate change and is a key tool for reducing industrial GHG emissions. EU ETS impacts factories, power stations and other installations across all EU member states. As a result of the United Kingdom’s exit from the European Union (BREXIT), those types of entities in the United Kingdom will be subject to the UK ETS, rather than the EU ETS, beginning April 30, 2021. •California’s Senate Bill No. 32, which requires reduction of California's GHG emissions to 40% below the 1990 emission level by 2030, and Assembly Bill 398, which extends the California GHG emission cap and trade program through 2030. Other GHG emissions programs in the western U.S. states have been enacted or are under consideration or development, including amendments to California's Low Carbon Fuel Standard, Oregon's Low Carbon Fuel Standard, and Washington's carbon reduction programs.•The U.S. Supreme Court decision in Massachusetts v. EPA, 549 U.S. 497, 127 S. Ct. 1438 (2007), confirming that the EPA has the authority to regulate carbon dioxide as an “air pollutant” under the Federal Clean Air Act.•The EPA’s announcement on March 29, 2010 (published as “Interpretation of Regulations that Determine Pollutants Covered by Clean Air Act Permitting Programs,” 75 Fed. Reg. 17004 (April 2, 2010)), and the EPA’s and U.S. Department of Transportation’s joint promulgation of a Final Rule on April 1, 2010, that triggers regulation of GHGs under the Clean Air Act. These collectively may lead to more climate-based claims for damages, and may result in longer agency review time for development projects to determine the extent of potential climate change. •The EPA's 2015 Final Rule regulating GHG emissions from existing fossil fuel-fired electrical generating units under the Federal Clean Air Act, commonly referred to as the Clean Power Plan. The EPA commenced rulemaking in 2017 to rescind the Clean Power Plan and, in August 2018, the EPA proposed the Affordable Clean Energy (ACE) rule as its replacement. On January 19, 2021, the U.S. Court of Appeals for the District of Columbia invalidated the ACE rule and remanded the matter to the EPA, essentially restarting this rulemaking process. •Carbon taxes in certain jurisdictions.•GHG emission cap and trade programs in certain jurisdictions.In the EU, the first phase of the EU ETS completed at the end of 2007. Phase II was undertaken from 2008 through 2012, and Phase III ran from 2013 through to 2020. Phase IV runs from January 1, 2021 through 2030 and sectors covered under the ETS must reduce their GHG emissions by 43% compared to 2005 levels. From April 30, 2021, the United Kingdom will no longer be part of the EU ETS and has launched the UK ETS. Phillips 66 has assets that are subject to the EU ETS and assets that will be subject to the UK ETS.64Table of ContentsIndex to Financial StatementsFrom November 30 to December 12, 2015, more than 190 countries, including the United States, participated in the United Nations Climate Change Conference in Paris, France. The conference culminated in what is known as the “Paris Agreement,” which, upon certain conditions being met, entered into force on November 4, 2016. The Paris Agreement establishes a commitment by signatory parties to pursue domestic GHG emission reductions. In 2017, President Trump announced his intention to withdraw the United States from the Paris Agreement and that withdrawal became effective on November 4, 2020. On January 20, 2021, President Biden signed the “Acceptance on Behalf of the United States of America,” which allows the United States to rejoin the Paris Agreement. The United States officially rejoined the Paris Agreement in February 2021, which could lead to additional GHG emission reduction requirements for sources in the United States.In the United States, some additional form of regulation is likely to be forthcoming in the future at the state or federal levels with respect to GHG emissions. Such regulation could take any of several forms that may result in additional financial burden in the form of taxes, the restriction of output, investments of capital to maintain compliance with laws and regulations, or required acquisition or trading of emission allowances. Compliance with changes in laws and regulations that create a GHG emission trading program, GHG reduction requirements or carbon taxes could significantly increase our costs, reduce demand for fossil energy derived products, impact the cost and availability of capital and increase our exposure to litigation. Such laws and regulations could also increase demand for less carbon intensive energy sources. An example of one such program is California’s cap and trade program, which was promulgated pursuant to the State’s Global Warming Solutions Act. The program had been limited to certain stationary sources, which include our refineries in California, but beginning in January 2015 was expanded to include emissions from transportation fuels distributed in California. Inclusion of transportation fuels in California’s cap and trade program as currently promulgated has increased our cap and trade program compliance costs. The ultimate impact on our financial performance, either positive or negative, from this and similar programs, will depend on a number of factors, including, but not limited to: •Whether and to what extent legislation or regulation is enacted.•The nature of the legislation or regulation, such as a cap and trade system or a tax on emissions.•The GHG reductions required.•The price and availability of offsets.•The demand for, and amount and allocation of allowances.•Technological and scientific developments leading to new products or services.•Any potential significant physical effects of climate change, such as increased severe weather events, changes in sea levels and changes in temperature.•Whether, and the extent to which, increased compliance costs are ultimately reflected in the prices of our products and services.We consider and take into account anticipated future GHG emissions in designing and developing major facilities and projects, and implement energy efficiency initiatives to reduce GHG emissions. Data on our GHG emissions, legal requirements regulating such emissions, and the possible physical effects of climate change on our coastal assets are incorporated into our planning, investment, and risk management decision-making. We are working to continuously improve operational and energy efficiency through resource and energy conservation throughout our operations.65Table of ContentsIndex to Financial StatementsCRITICAL ACCOUNTING ESTIMATESThe preparation of financial statements in conformity with GAAP requires management to select appropriate accounting policies and to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses. See Note 1—Summary of Significant Accounting Policies, in the Notes to Consolidated Financial Statements, for descriptions of our major accounting policies. Some of these accounting policies involve judgments and uncertainties to such an extent that there is a reasonable likelihood that materially different amounts would have been reported under different conditions, or if different assumptions had been used. The following discussion of critical accounting estimates, along with the discussion of contingencies in this report, address all important accounting areas where the nature of accounting estimates or assumptions could be material due to the levels of subjectivity and judgment necessary to account for highly uncertain matters or the susceptibility of such matters to change.Impairment of Long-Lived Assets and Equity Method InvestmentsLong-lived assets used in operations are assessed for impairment whenever changes in facts and circumstances indicate a possible significant deterioration in future expected cash flows. If the sum of the undiscounted expected future before-tax cash flows of an asset group is less than the carrying value, including applicable liabilities, the carrying value is written down to estimated fair value. Individual assets are grouped for impairment purposes based on a judgmental assessment of the lowest level for which there are identifiable cash flows that are largely independent of the cash flows of other assets. Because there usually is a lack of quoted market prices for long-lived assets, the fair value of impaired assets is typically determined using one or more of the following methods: the present value of expected future cash flows using discount rates and other assumptions believed to be consistent with those used by principal market participants; a market multiple for similar assets; historical market transactions including similar assets, adjusted using principal market participant assumptions when necessary; or replacement cost adjusted for physical deterioration and economic obsolescence. The expected future cash flows used for impairment reviews and related fair value calculations are based on judgmental assessments, including future volumes, commodity prices, operating costs, margins, discount rates and capital project decisions, considering all available information at the date of review.Investments in nonconsolidated entities accounted for under the equity method are assessed for impairment when there are indicators of a loss in value, such as a lack of sustained earnings capacity or a current fair value less than the investment’s carrying amount. When it is determined that an indicated impairment is other than temporary, a charge is recognized for the difference between the investment’s carrying value and its estimated fair value. When determining whether a decline in value is other than temporary, management considers factors such as the duration and extent of the decline, the investee’s financial condition and near-term prospects, and our ability and intention to retain our investment for a period that allows for recovery. When quoted market prices are not available, the fair value is usually based on the present value of expected future cash flows using discount rates and other assumptions believed to be consistent with those used by principal market participants and observed market earnings multiples of comparable companies, if appropriate. Different assumptions could affect the timing and the amount of an impairment of an investment in any period.See Note 9—Impairments, in the Notes to Consolidated Financial Statements, for information about significant impairments recorded in 2020 and 2019.Asset Retirement ObligationsUnder various contracts, permits and regulations, we have legal obligations to remove tangible equipment and restore the land at the end of operations at certain operational sites. Our largest asset removal obligations involve asbestos abatement at refineries. Estimating the timing and cost of future asset removals is difficult. Most of these removal obligations are many years, or decades, in the future, and the contracts and regulations often have vague descriptions of what removal practices and criteria must be met when the removal event actually occurs. Asset removal technologies and costs, regulatory and other compliance considerations, expenditure timing, and other inputs into valuation of the obligation, including discount and inflation rates, are also subject to change.66Table of ContentsIndex to Financial StatementsEnvironmental CostsIn addition to asset retirement obligations discussed above, we have certain obligations to complete environmental-related projects. These projects are primarily related to cleanup at domestic refineries, underground storage sites and nonoperated sites. Future environmental remediation costs are difficult to estimate because they are subject to change due to such factors as the uncertain magnitude of cleanup costs, timing and extent of such remedial actions that may be required, and the determination of our liability in proportion to that of other responsible parties.Intangible Assets and GoodwillAt December 31, 2020, we had $725 million of intangible assets that we have determined to have indefinite useful lives, and therefore do not amortize. The judgmental determination that an intangible asset has an indefinite useful life is continuously evaluated. If, due to changes in facts and circumstances, management determines these intangible assets have finite useful lives, amortization will commence at that time on a prospective basis. As long as these intangible assets are determined to have indefinite lives, they will be subject to at least annual impairment tests that require management’s judgment of their estimated fair value.At December 31, 2020, we had $1.4 billion of goodwill recorded in conjunction with past business combinations. Goodwill is not amortized. Instead, goodwill is subject to at least annual tests for impairment at a reporting unit level. A reporting unit is an operating segment or a component that is one level below an operating segment, and it is determined primarily based on the manner in which the business is managed.We perform our annual goodwill impairment test using a qualitative assessment and a quantitative assessment, if one is deemed necessary. As part of our qualitative assessment, we evaluate relevant events and circumstances that could affect the fair value of our reporting units, including macroeconomic conditions, overall industry and market considerations and regulatory changes, as well as company-specific market metrics, performance and events. The evaluation of company-specific events and circumstances includes evaluating changes in our stock price and cost of capital, actual and forecasted financial performance, as well as the effect of significant asset dispositions. If our qualitative assessment indicates it is likely the fair value of a reporting unit has declined below its carrying value (including goodwill), a quantitative assessment is performed.When a quantitative assessment is performed, management applies judgment in determining the estimated fair values of the reporting units because quoted market prices for our reporting units are not available. Management uses available information to make this fair value determination, including estimated future cash flows, cost of capital, observed market earnings multiples of comparable companies, our common stock price and associated total company market capitalization. See Note 9—Impairments, and Note 16—Fair Value Measurements, in the Notes to Consolidated Financial Statements, for additional information regarding the goodwill impairment we recorded in the first quarter of 2020. We completed our annual qualitative assessment of goodwill as of October 1, 2020, and concluded that the fair values of our reporting units exceeded their respective carrying values (including goodwill). A decline in the estimated fair value of one or more of our reporting units in the future could result in an impairment. As such, we continue to monitor for indicators of impairment until our next annual impairment assessment is performed. 67Table of ContentsIndex to Financial StatementsTax Assets and LiabilitiesOur operations are subject to various taxes, including federal, state and foreign income taxes, property taxes, and transactional taxes such as excise, sales and use, value-added and payroll taxes. We record tax liabilities based on our assessment of existing tax laws and regulations. The recording of tax liabilities requires significant judgment and estimates. We recognize the financial statement effects of an income tax position when it is more likely than not that the position will be sustained upon examination by a taxing authority. A contingent liability related to a transactional tax claim is recorded if the loss is both probable and reasonably estimable. Actual incurred tax liabilities can vary from our estimates for a variety of reasons, including different interpretations of tax laws and regulations and different assessments of the amount of tax due.In determining our income tax expense (benefit), we assess the likelihood our deferred tax assets will be recovered through future taxable income. Valuation allowances reduce deferred tax assets to an amount that will, more likely than not, be realized. Judgment is required in estimating the amount of valuation allowance, if any, that should be recorded against our deferred tax assets. Based on our historical taxable income, our expectations for the future, and available tax-planning strategies, we expect our net deferred tax assets will more likely than not be realized as offsets to reversing deferred tax liabilities and as reductions to future taxable income. If our actual results of operations differ from such estimates or our estimates of future taxable income change, the valuation allowance may need to be revised.New tax laws and regulations, as well as changes to existing tax laws and regulations, are continuously being proposed or promulgated. The implementation of future legislative and regulatory tax initiatives could result in increased income tax liabilities that cannot be predicted at this time.Projected Benefit Obligations Calculation of the projected benefit obligations for our defined benefit pension and postretirement plans impacts the obligations on the balance sheet and the amount of benefit expense in the statement of operations. The actuarial calculation of projected benefit obligations and company contribution requirements involves judgment about uncertain future events, including estimated retirement dates, salary levels at retirement, mortality rates, lump-sum election rates, rates of return on plan assets, future interest rates, future health care cost-trend rates, and rates of utilization of health care services by retirees. We engage outside actuarial firms to assist in the calculation of these projected benefit obligations and company contribution requirements due to the specialized nature of these calculations. As financial accounting rules and the pension plan funding regulations promulgated by governmental agencies have different objectives and requirements, the actuarial methods and assumptions for the two purposes differ in certain important respects. Ultimately, we will be required to fund all promised benefits under pension and postretirement benefit plans not funded by plan assets or investment returns, but the judgmental assumptions used in the actuarial calculations significantly affect periodic financial statements and funding patterns over time. Benefit expense is particularly sensitive to the discount rate and return on plan assets assumptions. A one percentage-point decrease in the discount rate assumption used for the plan obligation would increase annual benefit expense by an estimated $70 million, while a one percentage-point decrease in the return on plan assets assumption would increase annual benefit expense by an estimated $40 million. In determining the discount rate, we use yields on high-quality fixed income investments with payments matched to the estimated distributions of benefits from our plans.The expected weighted-average long-term rate of return for worldwide pension plan assets was approximately 6% for both 2020 and 2019, while the actual weighted-average rate of return was 12% in 2020 and 18% in 2019. For the past ten years, our actual weighted-average rate of return for worldwide pension plan assets was 9%.68Table of ContentsIndex to Financial StatementsGUARANTOR FINANCIAL INFORMATIONAt December 31, 2020, Phillips 66 had $11 billion of senior unsecured notes outstanding guaranteed by Phillips 66 Company, a direct, wholly owned operating subsidiary of Phillips 66. Phillips 66 conducts substantially all of its operations through subsidiaries, including Phillips 66 Company, and those subsidiaries generate substantially all of its operating income and cash flow. The guarantees are (1) unsecured obligations of Phillips 66 Company, (2) rank equally with all of Phillips 66 Company’s other unsecured and unsubordinated indebtedness, and (3) are full and unconditional.Summarized financial information of Phillips 66 and Phillips 66 Company (the Obligor Group) is presented on a combined basis. Intercompany transactions among the members of the Obligor Group have been eliminated. The financial information of non-guarantor subsidiaries has been excluded from the summarized financial information. Significant intercompany transactions and receivable/payable balances between the Obligor Group and non-guarantor subsidiaries are presented separately in the summarized financial information. The summarized results of operations for the year ended December 31, 2020, and the summarized financial position at December 31, 2020, for the Obligor Group on a combined basis were:Summarized Combined Statement of OperationsMillions of DollarsSales and other operating revenues$47,950 Revenues and other income—non-guarantor subsidiaries3,211 Purchased crude oil and products—third parties32,187 Purchased crude oil and products—related parties6,433 Purchased crude oil and products—non-guarantor subsidiaries8,690 Impairments2,777 Loss before income taxes(5,111)Net loss(3,882)Summarized Combined Balance SheetMillions of DollarsAccounts and notes receivable—third parties$4,060 Accounts and notes receivable—related parties804 Due from non-guarantor subsidiaries, current288 Total current assets8,965 Investments and long-term receivables 9,229 Net properties, plants and equipment12,815 Goodwill1,047 Due from non-guarantor subsidiaries, noncurrent6,173 Other assets associated with non-guarantor subsidiaries2,870 Total noncurrent assets34,034 Total assets42,999 Due to non-guarantor subsidiaries, current$2,203 Total current liabilities7,938 Long-term debt11,330 Due to non-guarantor subsidiaries, noncurrent 9,316 Total noncurrent liabilities26,044 Total liabilities33,982 Total equity9,017 Total liabilities and equity42,999 69Table of ContentsIndex to Financial StatementsNON-GAAP RECONCILIATIONSRefiningOur realized refining margins measure the difference between (a) sales and other operating revenues derived from the sale of petroleum products manufactured at our refineries and (b) costs of feedstocks, primarily crude oil, used to produce the petroleum products. The realized refining margins are adjusted to include our proportional share of our joint venture refineries’ realized margins, as well as to exclude those items that are not representative of the underlying operating performance of a period, which we call “special items.” The realized refining margins are converted to a per-barrel basis by dividing them by total refinery processed inputs (primarily crude oil) measured on a barrel basis, including our share of inputs processed by our joint venture refineries. Our realized refining margin per barrel is intended to be comparable with industry refining margins, which are known as “crack spreads.” As discussed in “Business Environment,” industry crack spreads measure the difference between market prices for refined petroleum products and crude oil. We believe realized refining margin per barrel calculated on a similar basis as industry crack spreads provides a useful measure of how well we performed relative to benchmark industry refining margins.The GAAP performance measure most directly comparable to realized refining margin per barrel is the Refining segment’s “income (loss) before income taxes per barrel.” Realized refining margin per barrel excludes items that are typically included in a manufacturer’s gross margin, such as depreciation and operating expenses, and other items used to determine income (loss) before income taxes, such as general and administrative expenses. It also includes our proportional share of joint venture refineries’ realized refining margins and excludes special items. Because realized refining margin per barrel is calculated in this manner, and because realized refining margin per barrel may be defined differently by other companies in our industry, it has limitations as an analytical tool. Following are reconciliations of income (loss) before income taxes to realized refining margins:70Table of ContentsIndex to Financial StatementsMillions of Dollars, Except as IndicatedRealized Refining MarginsAtlantic Basin/EuropeGulf CoastCentral CorridorWest CoastWorldwideYear Ended December 31, 2020Loss before income taxes$(1,224)(2,077)(641)(2,213)(6,155)Plus:Taxes other than income taxes61 107 51 89 308 Depreciation, amortization and impairments643 968 571 1,460 3,642 Selling, general and administrative expenses44 39 28 38 149 Operating expenses774 1,354 498 1,000 3,626 Equity in losses of affiliates10 3 363 — 376 Other segment (income) expense, net1 1 (2)5 5 Proportional share of refining gross margins contributed by equity affiliates67 — 298 — 365 Special items:Certain tax impacts(6)— — — (6)Realized refining margins$370 395 1,166 379 2,310 Total processed inputs (thousands of barrels)170,536 213,871 92,050 110,602 587,059 Adjusted total processed inputs (thousands of barrels)*170,536 213,871 162,693 110,602 657,702 Loss before income taxes per barrel (dollars per barrel)**$(7.18)(9.71)(6.96)(20.01)(10.48)Realized refining margins (dollars per barrel)***2.17 1.85 7.17 3.43 3.51 Year Ended December 31, 2019Income (loss) before income taxes$608 364 1,338 (324)1,986 Plus:Taxes other than income taxes52 73 40 85 250 Depreciation, amortization and impairments198 271 135 253 857 Selling, general and administrative expenses39 23 22 31 115 Operating expenses863 1,449 550 1,143 4,005 Equity in (earnings) losses of affiliates11 2 (331)— (318)Other segment (income) expense, net(16)(3)— 5 (14)Proportional share of refining gross margins contributed by equity affiliates69 — 1,073 — 1,142 Special items:Pending claims and settlements— — (21)— (21)Realized refining margins$1,824 2,179 2,806 1,193 8,002 Total processed inputs (thousands of barrels)195,506 293,666 103,294 130,014 722,480 Adjusted total processed inputs (thousands of barrels)*195,506 293,666 188,045 130,014 807,231 Income (loss) before income taxes per barrel (dollars per barrel)**$3.11 1.24 12.95 (2.49)2.75 Realized refining margins (dollars per barrel)***9.33 7.42 14.91 9.18 9.91 * Adjusted total processed inputs include our proportional share of processed inputs of an equity affiliate. ** Income (loss) before income taxes divided by total processed inputs.*** Realized refining margins per barrel, as presented, are calculated using the underlying realized refining margin amounts, in dollars, divided by adjusted total processed inputs, in barrels. As such, recalculated per barrel amounts using the rounded margins and barrels presented may differ from the presented per barrel amounts.71Table of ContentsIndex to Financial StatementsMillions of Dollars, Except as IndicatedRealized Refining MarginsAtlantic Basin/EuropeGulf CoastCentral CorridorWest CoastWorldwideYear Ended December 31, 2018Income before income taxes$567 1,040 2,817 111 4,535 Plus:Taxes other than income taxes56 88 43 100 287 Depreciation, amortization and impairments201 268 135 237 841 Selling, general and administrative expenses63 57 34 50 204 Operating expenses950 1,312 488 1,040 3,790 Equity in (earnings) losses of affiliates10 6 (812)— (796)Other segment (income) expense, net(11)3 (13)(9)(30)Proportional share of refining gross margins contributed by equity affiliates87 — 1,565 — 1,652 Special items:Certain tax impacts(5)— — — (5)Realized refining margins$1,918 2,774 4,257 1,529 10,478 Total processed inputs (thousands of barrels)186,042 292,665 106,299 136,332 721,338 Adjusted total processed inputs (thousands of barrels)*186,042 292,665 191,561 136,332 806,600 Income before income taxes per barrel (dollars per barrel)**$3.05 3.55 26.50 0.81 6.29 Realized refining margins (dollars per barrel)***10.32 9.48 22.22 11.20 12.99 * Adjusted total processed inputs include our proportional share of processed inputs of an equity affiliate. ** Income before income taxes divided by total processed inputs.*** Realized refining margins per barrel, as presented, are calculated using the underlying realized refining margin amounts, in dollars, divided by adjusted total processed inputs, in barrels. As such, recalculated per barrel amounts using the rounded margins and barrels presented may differ from the presented per barrel amounts.72Table of ContentsIndex to Financial StatementsMarketingOur realized marketing fuel margins measure the difference between (a) sales and other operating revenues derived from the sale of fuels in our M&S segment and (b) costs of those fuels. The realized marketing fuel margins are adjusted to exclude those items that are not representative of the underlying operating performance of a period, which we call “special items.” The realized marketing fuel margins are converted to a per-barrel basis by dividing them by sales volumes measured on a barrel basis. We believe realized marketing fuel margin per barrel demonstrates the value uplift our marketing operations provide by optimizing the placement and ultimate sale of our refineries’ fuel production.Within the M&S segment, the GAAP performance measure most directly comparable to realized marketing fuel margin per barrel is the marketing business’ “income before income taxes per barrel.” Realized marketing fuel margin per barrel excludes items that are typically included in gross margin, such as depreciation and operating expenses, and other items used to determine income before income taxes, such as general and administrative expenses. Because realized marketing fuel margin per barrel excludes these items, and because realized marketing fuel margin per barrel may be defined differently by other companies in our industry, it has limitations as an analytical tool. Following are reconciliations of income before income taxes to realized marketing fuel margins: Millions of Dollars, Except as IndicatedU.S.International202020192018202020192018Realized Marketing Fuel MarginsIncome before income taxes$870 916 843 454 380 505 Plus:Taxes other than income taxes1 5 (2)5 6 2 Depreciation, amortization and impairment12 10 13 70 65 71 Selling, general and administrative expenses623 743 763 246 249 280 Equity in earnings of affiliates(31)(27)(8)(108)(99)(91)Other operating revenues*(327)(379)(379)(27)(37)(32)Other segment expense, net— — — 1 1 2 Special items:Certain tax impacts— (90)(100)— — — Marketing margins1,148 1,178 1,130 641 565 737 Less: margin for nonfuel related sales— — — 46 44 44 Realized marketing fuel margins$1,148 1,178 1,130 595 521 693 Total fuel sales volumes (thousands of barrels)613,869 752,064 697,696 93,773 106,263 100,949 Income before income taxes per barrel (dollars per barrel)$1.421.221.214.843.585.00 Realized marketing fuel margins (dollars per barrel)**1.87 1.57 1.62 6.34 4.90 6.87* Includes other nonfuel revenues.** Realized marketing fuel margins per barrel, as presented, are calculated using the underlying realized marketing fuel margin amounts, in dollars, divided by sales volumes, in barrels. As such, recalculated per barrel amounts using the rounded margins and barrels presented may differ from the presented per barrel amounts.73Table of ContentsIndex to Financial StatementsItem 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKFinancial Instrument Market RiskWe and certain of our subsidiaries are exposed to market risks produced by changes in the prices of crude oil, refined petroleum products, natural gas, NGL and electric power, as well as fluctuations in interest rates and foreign currency exchange rates. We and certain of our subsidiaries may hold and use derivative contracts to manage these risks.Commodity Price RiskGenerally, our policy is to remain exposed to the market prices of commodities. Consistent with this policy, we use derivative contracts to convert our exposure from fixed-price sales or purchase contracts, often specified in contracts with refined petroleum product customers, back to floating market prices. We also use futures, forwards, swaps and options in various markets to accomplish the following objectives:•Balance physical systems or meet our refinery requirements and market demand. In addition to cash settlement prior to contract expiration, certain exchange-traded futures may be settled by physical delivery of the underlying commodity.•Enable us to use the market knowledge gained from our physical commodity market activities to capture market opportunities, such as moving physical commodities to more profitable locations, storing commodities to capture seasonal or time premiums, and blending commodities to capture quality upgrades. Derivatives may be utilized to optimize these activities. •Manage the risk to our cash flows from price exposures on specific crude oil, refined petroleum product, natural gas and NGL transactions.These objectives optimize the value of our supply chain and may reduce our exposure to fluctuations in market prices.Our use of derivative instruments is governed by an “Authority Limitations” document approved by our Board of Directors. This document prohibits the use of highly leveraged derivatives or derivative instruments without sufficient market liquidity for comparable valuations, and establishes Value at Risk (VaR) limits. Compliance with these limits is monitored daily by our global risk group. We use a VaR model to estimate the loss in fair value that could potentially result on a single day from the effect of adverse changes in market conditions on the derivative commodity instruments held or issued. Using Monte Carlo simulation, a 95% confidence level and a one-day holding period, the VaR for derivative commodity instruments issued or held at December 31, 2020 and 2019, was immaterial to our cash flows and results of operations.74Table of ContentsIndex to Financial StatementsInterest Rate RiskOur use of fixed- or variable-rate debt directly exposes us to interest rate risk. Fixed-rate debt, such as our senior notes, exposes us to changes in the fair value of our debt due to changes in market interest rates. Fixed-rate debt also exposes us to the risk that we may need to refinance maturing debt with new debt at higher rates, or that we may be obligated to pay rates higher than the current market. Variable-rate debt, such as our floating-rate notes or borrowings under our revolving credit facility, exposes us to short-term changes in market rates that impact our interest expense. The following tables provide information about our debt instruments that are sensitive to changes in U.S. interest rates. These tables present principal cash flows and related weighted-average interest rates by expected maturity dates. Weighted-average variable rates are based on effective rates at each reporting date. The carrying amount of our floating-rate debt approximates its fair value. The fair value of the fixed-rate financial instruments is estimated based on observable market prices.Millions of Dollars, Except as IndicatedExpected Maturity DateFixed Rate MaturityAverage Interest RateFloating Rate MaturityAverage Interest RateYear-End 20202021$— — %$965 1.05 %20222,000 4.30 — — 2023500 3.70 500 1.40 20241,100 1.32 450 0.84 20251,150 3.74 — — Remaining years9,026 4.22 25 0.76 Total$13,776 $1,940 Fair value$15,597 $1,940 Millions of Dollars, Except as IndicatedExpected Maturity DateFixed Rate MaturityAverage Interest RateFloating Rate MaturityAverage Interest RateYear-End 20192020$— — %$525 2.69 %2021— — 550 2.46 20222,000 4.30 — — 2023— — — — 2024300 2.45 — — Remaining years8,176 4.57 25 2.39 Total$10,476 $1,100 Fair value$11,813 $1,100 Our Chief Executive Officer and Chief Financial Officer monitor risks resulting from commodity prices, interest rates and foreign currency exchange rates. For additional information about our use of derivative instruments, see Note 15—Derivatives and Financial Instruments, in the Notes to Consolidated Financial Statements.75Table of ContentsIndex to Financial StatementsCAUTIONARY STATEMENT FOR THE PURPOSES OF THE “SAFE HARBOR” PROVISIONS OF THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995This report includes forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. You can normally identify our forward-looking statements by the words “anticipate,” “estimate,” “believe,” “budget,” “continue,” “could,” “intend,” “may,” “plan,” “potential,” “predict,” “seek,” “should,” “will,” “would,” “expect,” “objective,” “projection,” “forecast,” “goal,” “guidance,” “outlook,” “effort,” “target” and similar expressions, but the absence of such words does not mean a statement is not forward-looking.We based the forward-looking statements on our current expectations, estimates and projections about us, our operations, our joint ventures and entities in which we have equity interests, as well as the industries in which we and they operate in general. We caution you these statements are not guarantees of future performance as they involve assumptions that, while made in good faith, may prove to be incorrect, and involve risks and uncertainties we cannot predict. In addition, we based many of these forward-looking statements on assumptions about future events that may prove to be inaccurate. Accordingly, our actual outcomes and results may differ materially from what we have expressed or forecast in the forward-looking statements. Any differences could result from a variety of factors, including the following:•The continuing effects of the COVID-19 pandemic and its negative impact on commercial activity and demand for refined petroleum products, as well as the extent and duration of recovery of economies and demand for our products after the pandemic subsides. •Fluctuations in NGL, crude oil, refined petroleum product and natural gas prices and refining, marketing and petrochemical margins.•Changes in governmental policies relating to NGL, crude oil, natural gas or refined petroleum products pricing, regulation or taxation, including exports.•Actions taken by the Organization of the Petroleum Exporting Countries (OPEC) and other countries impacting supply and demand and correspondingly, commodity prices.•Unexpected changes in costs or technical requirements for constructing, modifying or operating our facilities or transporting our products.•Unexpected technological or commercial difficulties in manufacturing, refining or transporting our products, including chemical products.•Lack of, or disruptions in, adequate and reliable transportation for our NGL, crude oil, natural gas and refined petroleum products.•The level and success of drilling and quality of production volumes around our Midstream assets.•The inability to timely obtain or maintain permits, including those necessary for capital projects.•The inability to comply with government regulations or make capital expenditures required to maintain compliance.•Changes to worldwide government policies relating to renewable fuels and greenhouse gas emissions that adversely affect programs like the renewable fuel standards program, low carbon fuel standards and tax credits for biofuels.•Failure to complete definitive agreements and feasibility studies for, and to complete construction of, announced and future capital projects on time and within budget.•Potential disruption or interruption of our operations due to accidents, weather events (including as a result of climate change), civil unrest, insurrections, political events, terrorism or cyberattacks.•General domestic and international economic and political developments including armed hostilities, expropriation of assets, and other political, economic or diplomatic developments, including those caused by public health issues, outbreaks of diseases and pandemics.•Failure of new products and services to achieve market acceptance.•International monetary conditions and exchange controls.76Table of ContentsIndex to Financial Statements•Substantial investments required, or reduced demand for products, as a result of existing or future environmental rules and regulations, including reduced consumer demand for refined petroleum products.•Liability resulting from litigation or for remedial actions, including removal and reclamation obligations under environmental regulations.•Changes in tax, environmental and other laws and regulations (including alternative energy mandates) applicable to our business.•Changes in estimates or projections used to assess fair value of intangible assets, goodwill and property and equipment and/or strategic decisions with respect to our asset portfolio that cause impairment charges.•Limited access to capital or significantly higher cost of capital related to changes to our credit profile or illiquidity or uncertainty in the domestic or international financial markets.•The operation, financing and distribution decisions of our joint ventures that we do not control.•The factors generally described in “Item 1A. Risk Factors” in this report. 77Table of ContentsIndex to Financial Statements
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+Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations. Throughout this discussion, we reflect amounts in U.S. dollars, our reporting currency. Included in these amounts are consolidated and unconsolidated investments denominated in foreign currencies, principally the British pound sterling, euro and Japanese yen that are impacted by fluctuations in exchange rates when translated to U.S. dollars. We mitigate our exposure to foreign currency fluctuations by investing outside the U.S. through co-investment ventures, borrowing in the functional currency of our subsidiaries and utilizing derivative financial instruments. OPERATING SEGMENTS Our business comprises two operating segments: Real Estate Operations and Strategic Capital. Below is information summarizing consolidated activity within our segments over the last three years (in millions): (1) NOI from Real Estate Operations is calculated directly from our Consolidated Financial Statements as Rental Revenues and Development Management and Other Revenues less Rental Expenses and Other Expenses. (2) A developed property moves into the operating portfolio when it meets our definition of stabilization, which is the earlier of one year after completion or 90% occupancy. Amounts represent our total expected investment (“TEI”), which includes the estimated cost of development, land, construction and leasing costs. Real Estate Operations Rental. Rental operations comprise the largest component of our operating segments and generally contribute 85% to 90% of our consolidated revenues, earnings and funds from operations (“FFO”). We collect rent from our customers through operating leases, including reimbursements for the majority of our property operating costs. We expect to generate internal growth by increasing rents, maintaining high occupancy rates and controlling expenses. The primary driver of our revenue growth will be rolling in-place leases to current market rents as leases expire. We believe our active portfolio management, combined with the skills of our property, leasing, maintenance, capital, energy, sustainability and risk management teams allow us to maximize NOI across our portfolio. A majority of our consolidated rental revenue, NOI and cash flows are generated in the U.S. Development. Given the scarcity of modern logistics facilities in our target markets, our development business provides us the opportunity to build what our customers need. We develop properties to meet these needs, deepen our market presence and maintain a modern portfolio. We believe we have a competitive advantage due to (i) the strategic locations of our land bank and redevelopment sites; (ii) the development expertise of our local teams; and (iii) the depth of our customer relationships. Successful development and redevelopment efforts provide significant earnings growth as projects are leased, generate income and increase the net asset value of our Real Estate Operations segment. Based on our current estimates, our consolidated land, including options, has the potential to support the development of $11.8 billion of TEI of new logistics space. In addition to our land portfolio, we have also made investments in other properties that have the potential to be redeveloped to increase value. Generally, we develop properties in the U.S. for long-term hold and outside the U.S. for contribution to our unconsolidated co-investment ventures. Strategic Capital Our strategic capital segment allows us to partner with many of the world’s largest institutional investors and capitalize our business through private equity, principally perpetual open-ended or long-term ventures. We also access capital in this segment through two publicly traded vehicles: Nippon Prologis REIT, Inc. in Japan and FIBRA Prologis in Mexico. We align our interests with our partners by holding significant ownership interests in all of our 9 unconsolidated co-investment ventures (ranging from 15% to 50%), which allows us to reduce our exposure to foreign currency movements for investments outside the U.S. 5 This segment produces stable, long-term cash flows and generally contributes 10% to 15% of our recurring consolidated revenues, earnings and FFO. We generate strategic capital revenues from our unconsolidated co-investment ventures, principally through asset and property management services. We earn additional revenues by providing leasing, acquisition, construction, development and disposition services. In certain ventures, we also have the ability to earn revenues through incentive fees (“promotes” or “promote revenues”) periodically during the life of a venture or upon liquidation. We plan to profitably grow this business by increasing our assets under management in existing or new ventures. Most of the strategic capital revenues are generated outside the U.S. NOI in this segment is calculated directly from our Consolidated Financial Statements as Strategic Capital Revenues less Strategic Capital Expenses and excludes property-related NOI. FUTURE GROWTH We believe the quality and scale of our global portfolio, the expertise of our team, the depth of our customer relationships and the strength of our balance sheet give us unique competitive advantages to grow revenues, NOI, earnings, FFO and cash flows. (1) General and Administrative (“G&A”) Expenses is a line item in the Consolidated Financial Statements. Adjusted G&A expenses is calculated from our Consolidated Financial Statements as G&A Expenses and Strategic Capital Expenses, less expenses under the Prologis Promote Plan (“PPP”) and property-level management expenses for the properties owned by the ventures. • Rent Growth. Despite the COVID-19 pandemic and the current economic environment, we expect rents in our markets to increase due to demand for the location and quality of our properties. In addition, due to strong market rent growth over the last several years, our in-place leases have considerable upside potential. We estimate that the rental rates of our leases are 13% below current market on the basis of our weighted average ownership at December 31, 2020. Therefore, even if market rent growth is flat, a lease renewal will likely translate into increased future rental income, on a consolidated basis or through the earnings we recognize from our unconsolidated co-investment ventures based on our ownership. We have experienced positive rent change on rollover (comparing the net effective rent (“NER”) of the new lease to the prior lease for the same space) in every quarter since 2013. We expect this trend to continue for several more years due to our current in-place rents being below market. We also expect future growth in market rents to further contribute to increased rental income. • Value Creation from Development. A successful development and redevelopment program involves maintaining control of well-located and entitled land and redevelopment sites. We believe that the carrying value of our land bank is below its current fair value. Due to the strategic nature of our land bank, development expertise of our teams and strength of our customer relationships, we expect to create value as we build new properties. We measure the estimated value creation of a development project as the margin above our anticipated cost to develop. As properties under development stabilize, we expect to realize the value creation principally through contributions to the unconsolidated co-investment ventures and increases in the NOI of our operating portfolio. • Balance Sheet Strength. Through the acquisitions of Liberty and IPT and execution of several opportunistic debt refinancings at historically low rates, we further enhanced our financial position during 2020 while maintaining low leverage. At December 31, 2020, we had total available liquidity of $4.8 billion. As a result of our low leverage and available liquidity, we have significant capacity to capitalize on value-added investment opportunities that will translate into future earnings growth. • Economies of Scale from Growth. We use adjusted G&A expenses as a percentage of the O&M portfolio to measure and evaluate our overhead costs. We have scalable systems and infrastructure in place to grow both our consolidated and O&M portfolios with limited incremental G&A expense. We believe we can continue to grow NOI and strategic capital revenues organically and through accretive development and acquisition activity while further reducing G&A as a percentage of our investments in real estate. As noted in the graph above, the acquisitions of the Liberty and IPT portfolios are key examples of this effort, where we increased our investments in real estate in the O&M portfolio by over 20% in the first quarter of 2020 and had minimal increases to G&A expenses, which results in lower G&A expenses as a percentage of the investments in real estate. • Staying “Ahead of What’s Next™”. We are working on initiatives to create value beyond the real estate by enhancing our customers’ experience, utilizing our scale to streamline our procurement activities and negotiating better pricing on products and services for us and our customers, as well as delivering improvements to our business through innovation, data analytics and 6 digitization efforts. Underlying our future strategy for growth is our ongoing commitment to, and initiatives in, environmental stewardship, social responsibility and governance (“ESG”). Competition Real estate ownership is highly fragmented, and we therefore face competition from many owners and operators. Competitively priced logistics space could impact our occupancy rates and have an adverse effect on how much rent we can charge, which in turn could affect our operating results. We may face competition regarding our capital deployment activities, including local, regional and national operators or developers. We also face competition from investment managers for institutional capital within our strategic capital business. Despite the competition we may face, our strategic focus over the years has given us distinct competitive advantages, including the following: • a portfolio of properties strategically located in markets characterized by large population densities, growing consumption and high barriers to entry, typically near large labor pools and extensive transportation infrastructure, including our Last Touch® facilities; • an investment in ESG practices that enhances asset values while improving sustainability performance, including the development of logistics facilities with sustainable design features that meet customer needs for high-quality buildings; • established relationships with customers served by our experienced and responsive local and regional teams; • the ability to leverage our organizational scale and structure to provide a single point of contact for our focus customers to address their needs through our in-house global customer solutions team; • proven property management and leasing expertise; • relationships and successful track record with current and prospective investors in our strategic capital business; • a strategically located land bank and redevelopment sites; • local teams with development expertise; and • a strong balance sheet and credit ratings, coupled with significant liquidity and borrowing capacity. Customers Our broad customer base represents a spectrum of international, national, regional and local logistics users. At December 31, 2020, in our Real Estate Operations segment representing our consolidated properties, we had more than 3,400 customers occupying 446 million square feet of logistics operating properties. 7 In order to provide for a customer-centric location strategy, we have invested in properties located within infill and urban areas in our largest global markets with same day and next day access to the consumer population, these are our Last Touch® and city distribution facilities, respectively. To support these distribution facilities, we utilize multi-market facilities located at key transportation hubs on the edge of these major infill and urban areas and gateway distribution facilities that incorporate access to major sea and intermodal ports. Below are the primary categories of goods in our buildings for our consolidated real estate properties at December 31, 2020. (1) NER is calculated using the estimated total cash to be received over the term of the lease divided by the lease term to determine the average amount of cash rent payments received per year. Amounts derived in a currency other than the U.S. dollar have been translated using the average rate from the previous year. The following table details our top 25 customers for our consolidated real estate properties at December 31, 2020 (square feet in millions): Top Customers % of NER Total Occupied Square Feet 1. Amazon 6.1 22 2. Home Depot 1.9 9 3. FedEx 1.9 6 4. UPS 1.2 5 5. XPO Logistics 1.1 5 6. Geodis 1.0 5 7. Wal-Mart 0.9 4 8. U.S. Government 0.9 1 9. DHL 0.7 3 10. PepsiCo 0.6 3 Top 10 Customers 16.3 63 11. DSV Panalpina A/S 0.6 3 12. Office Depot 0.5 3 13. Kellogg Company 0.5 2 14. Staples 0.4 3 15. Ryder System Inc. 0.4 2 16. VF Corporation 0.4 1 17. Berkshire Hathaway Inc. 0.4 1 18. ZOZO, Inc. 0.4 1 19. Westrock Company 0.4 1 20. Kuehne + Nagel 0.3 1 21. Express Messenger 0.3 1 22. Mondelez International 0.3 2 23. Bed Bath & Beyond, Inc. 0.3 2 24. Sysco Guest Supply, LLC 0.3 2 25. NFI 0.3 1 Top 25 Customers 22.1 89 8 In our Strategic Capital segment, we view our partners and investors as our customers. At December 31, 2020, we had approximately 128 investors in our private equity ventures, several of which invest in multiple ventures. Employees We believe our employees are the most important part of our business. When attracting, developing and retaining talent, we seek individuals who hold varied experiences and viewpoints to create an inclusive and diverse culture and workplace that allows each employee to do their best work and drive our collective success. We focus on leadership development at every level of the organization. We align employees’ goals with our overall strategic direction to create a clear link between individual efforts and the long-term success of the company and then provide effective feedback on their performance towards goals to ensure their growth. We believe a commitment to our employees’ learning and development through training, educational opportunities and mentorship is critical to our ability to continue to innovate. Through performance plans, talent recognition and individual development planning, along with reward packages, we advance our talent pool and create a sustainable and long-term enterprise. For additional discussion on the impact of COVID-19 on our employees, see the Summary of 2020 section in Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations. The following table summarizes our total number of employees at December 31, 2020: Geographies U.S. (1) 1,091 Other Americas 146 Europe 458 Asia 250 Total 1,945 (1) This includes employees who were based in the U.S. but also support other geographies. We allocate the personnel costs related to providing property management and leasing functions to our Real Estate Operations and Strategic Capital segments based on the square footage of the respective portfolios. The personnel costs to perform only Strategic Capital functions are allocated directly to that segment. We believe we have good relationships with our employees. Prologis employees are not organized under collective bargaining agreements, other than in Brazil, although some employees in Europe are represented by statutory Works Councils and as such, benefit from applicable labor agreements. CODE OF ETHICS AND BUSINESS CONDUCT We maintain a Code of Ethics and Business Conduct applicable to our board of directors (the “Board”) and all of our officers and employees, including the principal executive officer, the principal financial officer and the principal accounting officer, and other people performing similar functions. A copy of our Code of Ethics and Business Conduct is available on our website, www.prologis.com. In addition to being accessible through our website, copies of our Code of Ethics and Business Conduct can be obtained, free of charge, upon written request to Investor Relations, Pier 1, Bay 1, San Francisco, California 94111. Any amendments to or waivers of our Code of Ethics and Business Conduct that apply to the principal executive officer, the principal financial officer, the principal accounting officer, or other people performing similar functions, and that relate to any matter enumerated in Item 406(b) of Regulation S-K, will be disclosed on our website. ENVIRONMENTAL STEWARDSHIP, SOCIAL RESPONSIBILITY AND GOVERNANCE (“ESG”) Our long-standing dedication to ESG creates value for our company by strengthening our relationships with our customers, investors, employees and the communities in which we do business. The principles of ESG are an important aspect of our business strategy, delivering a strategic business advantage while positively impacting the environment. We develop modern and efficient building designs with state-of-the-art technology to stay ahead of our customers’ needs while advancing structural, transportation, and energy requirements. We invest in sustainable design features and practices, such as the addition of solar panels, cool roofs, light emitting diode (“LED”) lighting, electric vehicle charging stations, waste diversion, recycling and xeriscaping, that result in cost-savings and operational efficiency for our customers and reduce energy and water consumption, as well as decrease greenhouse gas emissions across our portfolio and corporate operations. We have a comprehensive carbon strategy that includes science-based targets to address our global carbon footprint. We are committed to social responsibility and strengthening relationships important to our business through customer partnerships, investor outreach, community involvement, labor solutions, and inclusion and diversity initiatives, as well as a focus on our employees and our customers’ employees through health and wellness programs and building design. Through our community workforce initiative, for example, we are helping build a talent pipeline for our customers with an emphasis on revitalizing career pathways and creating economic opportunities in the communities where we operate. We set an ambitious goal to train 25,000 individuals by 2025 by partnering with leading public sector organizations and leveraging learning technologies to develop innovative training solutions. Our strong governance and oversight creates a culture of uncompromising integrity. Our Board independence and diversity, open communication with our stockholders and a risk management framework that supports our investment and process decisions all serve 9 to mitigate risk and preserve value for our company. The strength of our balance sheet and credit ratings, ability to stay ahead of customer needs, and engagement with our employees through ethics and anti-corruption training, along with stockholder outreach ensures the financial, operational and reputational resilience of our organization for the long-term. Our approach is reinforced by our Code of Ethics and Business Conduct, as described above. ENVIRONMENTAL MATTERS We are exposed to various environmental risks that may result in unanticipated losses and affect our operating results and financial condition. Either the previous owners or we have conducted environmental reviews on a majority of the properties we have acquired, including land. While some of these assessments have led to further investigation and sampling, none of the environmental assessments have revealed an environmental liability that we think would have a material adverse effect beyond amounts recorded as of December 31, 2020. See further discussion in Item 1A. Risk Factors and Note 16 to the Consolidated Financial Statements in Item 8. Financial Statements and Supplementary Data. GOVERNMENTAL MATTERS We are exposed to various regulatory requirements, taxes, tariffs, trade wars and laws within the countries in which we operate and unexpected changes in these items may result in unanticipated losses, adverse tax consequences and affect our operating results and financial condition. In addition, we may be impacted by the ability of our non-U.S. subsidiaries to distribute or otherwise transfer cash among our subsidiaries due to currency exchange control regulations and transfer pricing regulations. The impact of regional or country-specific economic instability, including government shutdowns or other internal trade alliances or agreements could also have a material adverse effect on our business, financial condition or results of operations. See further discussion in Item 1A. Risk Factors. INSURANCE COVERAGE We carry insurance coverage on our properties. We determine the type of coverage and the policy specifications and limits based on what we deem to be the risks associated with our ownership of properties and our business operations in specific markets. Such coverage typically includes property damage and rental loss insurance resulting from such perils as fire, windstorm, flood, earthquake and terrorism; commercial general liability insurance; and environmental insurance. Insurance is maintained through a combination of commercial insurance, self-insurance and a wholly-owned captive insurance entity. The costs to insure our properties are primarily covered through expense reimbursements from our customers. We believe our insurance coverage contains policy specifications and insured limits that are customary for similar properties, business activities and markets and we believe our properties are adequately insured. See further discussion in Item 1A. Risk Factors. ITEM 1A. Risk Factors Our operations and structure involve various risks that could adversely affect our business and financial condition, including but not limited to, our financial position, results of operations, cash flow, ability to make distributions and payments to security holders and the market value of our securities. These risks relate to Prologis as well as our investments in consolidated and unconsolidated entities and include among others, (i) risks related to our global operations (ii) risks related to our business; (iii) risks related to financing and capital; (iv) risks related to income taxes; and (v) general risks. Risks Related to our Global Operations As a global company, we are subject to social, political and economic risks of doing business in many countries. We conduct a significant portion of our business and employ a substantial number of people outside of the U.S. During 2020, we generated approximately $484 million or 10.9% of our consolidated revenues from operations outside the U.S. Circumstances and developments related to international operations that could negatively affect us include, but are not limited to, the following factors: • difficulties and costs of staffing and managing international operations in certain geographies, including differing employment practices and labor issues; • local businesses and cultural factors that differ from our usual standards and practices; • volatility in currencies and currency restrictions, which may prevent the transfer of capital and profits to the U.S.; • challenges in establishing effective controls and procedures to regulate operations in different geographies and to monitor compliance with applicable regulations, such as the Foreign Corrupt Practices Act, the United Kingdom (“U.K.”) Bribery Act and other similar laws; • unexpected changes in regulatory requirements, taxes, tariffs, trade wars and laws within the countries in which we operate; • potentially adverse tax consequences; • the responsibility of complying with multiple and potentially conflicting laws, e.g., with respect to corrupt practices, employment and licensing; 10 • the impact of regional or country-specific business cycles and economic instability, including government shutdowns, uncertainty in the U.K., or further withdrawals from the European Union or other international trade alliances or agreements; • political instability, uncertainty over property rights, civil unrest, drug trafficking, political activism or the continuation or escalation of terrorist or gang activities; • foreign ownership restrictions in operations with the respective countries; and • access to capital may be more restricted, or unavailable on favorable terms or at all in certain locations. In addition, we may be impacted by the ability of our non-U.S. subsidiaries to dividend or otherwise transfer cash among our subsidiaries due to currency exchange control regulations, transfer pricing regulations and potentially adverse tax consequences, among other factors. Compliance or failure to comply with regulatory requirements could result in substantial costs. We are required to comply with many regulations in different countries, including (but not limited to) the Foreign Corrupt Practices Act, the U.K. Bribery Act and similar laws and regulations. Our properties are also subject to various federal, state and local regulatory requirements, such as the Americans with Disabilities Act and state and local fire and life-safety requirements. Noncompliance could result in the imposition of governmental fines or the award of damages to private litigants. While we believe that we are currently in material compliance with these regulatory requirements, the requirements may change or new requirements may be imposed that could require significant unanticipated expenditures by us. Disruptions in the global capital and credit markets may adversely affect our operating results and financial condition. To the extent there is turmoil in the global financial markets, this turmoil has the potential to adversely affect (i) the value of our properties; (ii) the availability or the terms of financing that we have or may anticipate utilizing; (iii) our ability to make principal and interest payments on, or refinance any outstanding debt when due; and (iv) the ability of our customers to enter into new leasing transactions or satisfy rental payments under existing leases. Disruptions in the capital and credit markets may also adversely affect the market price of our securities and our ability to make distributions and payments to our security holders. The depreciation in the value of the foreign currency in countries where we have a significant investment may adversely affect our results of operations and financial position. We hold significant real estate investments in international markets where the U.S. dollar is not the functional currency. At December 31, 2020, approximately $8.6 billion or 15.3% of our total consolidated assets were invested in a currency other than the U.S. dollar, principally the British pound sterling, euro and Japanese yen. For the year ended December 31, 2020, $289 million or 8.9% of our total consolidated segment NOI, as disclosed in Note 17 to the Consolidated Financial Statements in
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+ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSBUSINESS OVERVIEWWe are a global premier systems provider of high technology products and services to the aerospace and defense industries. On April 3, 2020, United Technologies Corporation (UTC) completed the Separation Transactions as defined below, and on April 3, 2020, completed the Raytheon Merger as defined below, to form the new company, Raytheon Technologies Corporation. As a result of these transactions, we now operate in four principal business segments: Collins Aerospace Systems (Collins Aerospace), Pratt & Whitney, Raytheon Intelligence & Space (RIS) and Raytheon Missiles & Defense (RMD).Separation Transactions and Distributions. On April 3, 2020, UTC (since renamed Raytheon Technologies Corporation) completed the separation of its business into three independent, publicly traded companies – UTC, Carrier Global Corporation (Carrier) and Otis Worldwide Corporation (Otis) (such separations, the “Separation Transactions”). UTC distributed all of the outstanding shares of Carrier common stock and all of the outstanding shares of Otis common stock to UTC shareowners who held shares of UTC common stock as of the close of business on March 19, 2020, the record date for the distributions (the Distributions). UTC distributed 866,158,910 and 433,079,455 shares of common stock of Carrier and Otis, respectively in the Distributions, each of which was effective at 12:01 a.m., Eastern Time, on April 3, 2020. The historical results of Carrier and Otis are presented as discontinued operations and, as such, have been excluded from both continuing operations and segment results for all periods presented. Throughout this Annual Report on Form 10-K, unless otherwise indicated, amounts and activity are presented on a continuing operations basis. Raytheon Merger. On April 3, 2020, following the completion of the Separation Transactions and the Distributions, pursuant to an Agreement and Plan of Merger dated June 9, 2019, as amended, UTC and Raytheon Company (Raytheon) completed their all-stock merger of equals transaction (the Raytheon Merger). Upon closing of the Raytheon Merger, Raytheon Company became a wholly owned subsidiary of UTC, which changed its name to “Raytheon Technologies Corporation.”On November 26, 2018, we completed the acquisition of Rockwell Collins (the Rockwell Acquisition), a leader in aviation and high-integrity solutions for commercial and military customers as well as leading-edge avionics, flight controls, aircraft interior and data connectivity solutions. Refer to “Note 2: Business Acquisitions, Dispositions, Goodwill and Intangible Assets” within Item 8 of this Form 10-K for additional discussion on the Rockwell Acquisition.Unless the context otherwise requires, the terms “we,” “our,” “us,” “the Company,” “Raytheon Technologies,” and “RTC” mean United Technologies Corporation and its subsidiaries when referring to periods prior to the Raytheon Merger and to the combined company, Raytheon Technologies Corporation, when referring to periods after the Raytheon Merger. Unless the context otherwise requires, the terms “Raytheon Company,” or “Raytheon” mean Raytheon Company and its subsidiaries prior to the Raytheon Merger. UTC was determined to be the accounting acquirer in the merger, and as a result the financial statements of Raytheon Technologies for year ended December 31, 2020 include Raytheon Company’s financial position and results of operations for the period subsequent to the completion of the Raytheon Merger on April 3, 2020. The historical results of Carrier and Otis are presented as discontinued operations and, as such, have been excluded from both continuing operations and segment results for all periods presented. See “Note 3: Discontinued Operations” within Item 8 of this Form 10-K for additional information.Industry ConsiderationsOur worldwide operations can be affected by industrial, economic and political factors on both a regional and global level. Our operations include original equipment manufacturer (OEM) and extensive related aftermarket parts and services related to our aerospace operations. Our defense business serves both domestic and international customers primarily as a prime contractor or subcontractor on a broad portfolio of defense and related programs for government customers. Our business mix also reflects the combination of shorter cycles in our commercial aerospace spares contracts and certain service contracts in our defense business primarily at RIS, and longer cycles in our aerospace OEM and aftermarket maintenance contracts and on our defense contracts to design, develop, manufacture or modify complex equipment. Our customers are in the public and private sectors, and our businesses reflect an extensive geographic diversification that has evolved with continued globalization. Government legislation, policies and regulations, including regulations related to global warming, carbon footprint and fuel efficiency, can have a negative impact on our worldwide operations. Government and industry-driven safety and performance regulations, restrictions on aircraft engine noise and emissions, government imposed travel restrictions, and government procurement practices can impact our businesses.Collins Aerospace and Pratt & Whitney serve both commercial and government aerospace customers. Revenue passenger miles (RPMs), available seat miles and the general economic health of airline carriers are key barometers for our commercial aerospace operations. Performance in the general aviation sector is closely tied to the overall health of the economy and is 33Table of Contentspositively correlated to corporate profits. Our commercial aftermarket operations continue to evolve as a significant portion of our aerospace operations’ customers are covered under long-term aftermarket service agreements at both Collins Aerospace and Pratt & Whitney. These agreements are comprehensive long-term spare part and service agreements with our customers.RIS, RMD, and the defense operations of Collins Aerospace and Pratt & Whitney are affected by U.S. Department of Defense (DoD) budget and spending levels, changes in demand, changes in policy positions or priorities from a new U.S. Administration and the global political environment. Total sales to the U.S. government, excluding foreign military sales (FMS), were $26.0 billion, $9.1 billion and $6.6 billion in 2020, 2019 and 2018 or 45.9%, 20.1% and 18.9% of total net sales for those years, respectively.Impact of the COVID-19 PandemicIn March 2020, the coronavirus disease 2019 (COVID-19) was declared a pandemic by the World Health Organization and a national emergency by the U.S. government. The pandemic has negatively affected the U.S. and global economy, disrupted global supply chains and financial markets, and resulted in significant travel restrictions, mandated facility closures and shelter-in-place and social distancing orders in numerous jurisdictions around the world. Raytheon Technologies is taking all prudent measures to protect the health and safety of our employees, such as practicing social distancing, performing deep cleaning in all of our facilities, temperature screening, health questionnaires and enabling our employees to work from home where possible. We have also taken appropriate actions to help support our communities in addressing the challenges posed by the pandemic, including the production and donation of personal protective equipment.Our business and operations and the industries in which we operate have been significantly impacted by public and private sector policies and initiatives in the U.S. and worldwide to address the transmission of COVID-19, such as the imposition of travel restrictions and the adoption of remote working. Additionally, public sentiments regarding air travel have also had a significant impact. We began to experience issues related to COVID-19 in the first quarter of 2020, primarily related to a limited number of facility closures, less than full staffing, and disruptions in supplier deliveries, most significantly in our Collins Aerospace and Pratt & Whitney businesses.The continued disruption to air travel and commercial activities and the significant restrictions and limitations on businesses, particularly within the aerospace and commercial airline industries, have negatively impacted global supply, demand and distribution capabilities. These conditions, which began in the second quarter of 2020, continued through the remainder of 2020. In particular, the unprecedented decrease in air travel resulting from the COVID-19 pandemic is adversely affecting our airline and airframer customers, and their demand for the products and services of our Collins Aerospace and Pratt & Whitney businesses. Based on recent public data, revenue passenger miles (RPMs) declined by approximately 65% in the first eleven months of 2020, compared to the prior year, due to the pandemic. As a result, our airline customers have reported significant reductions in fleet utilization, aircraft grounding and unplanned retirements, and have deferred and, in some cases, cancelled new aircraft deliveries. Airlines have shifted to cash conservation behaviors such as deferring engine maintenance due to lower flight hours and aircraft utilization, requesting extended payment terms, deferring delivery of new aircraft and spare engines and requesting discounts on engine maintenance. Some airline customers have filed for bankruptcy due to their inability to meet their financial obligations. Additionally, we are seeing purchase order declines in line with publicly communicated aircraft production volumes as original equipment manufacturer (OEM) customers delay and cancel orders. We continue to monitor these trends and are working closely with our customers. We have been and continue to actively mitigate costs and adjust production schedules to accommodate these declines in demand. We have also been taking actions to preserve capital and protect the long-term needs of our businesses, including cutting discretionary spending, significantly reducing capital expenditures and research and development spend, suspending our share buybacks in 2020, deferring merit increases and implementing temporary pay reductions, freezing non-essential hiring, repositioning employees to defense work, furloughing employees when needed, and personnel reductions. In 2020, we recorded total restructuring charges of $777 million primarily related to personnel reductions at our Collins Aerospace and Pratt & Whitney businesses to preserve capital and at our corporate headquarters due to consolidation from the Raytheon Merger. The former Raytheon Company businesses, although experiencing minor impacts, have not experienced significant facility closures or other significant business disruptions as a result of the COVID-19 pandemic.Given the impacts described above that have resulted from the COVID-19 pandemic, we expect our future operating results, particularly those of our Collins Aerospace and Pratt & Whitney businesses to continue to be significantly negatively impacted. Our expectations regarding the COVID-19 pandemic and its potential financial impact are based on available information and assumptions that we believe are reasonable at this time; however, the actual financial impact is highly uncertain and subject to a wide range of factors and future developments. While we believe that the long-term outlook for the aerospace industry remains positive due to the fundamental drivers of air travel demand, there is significant uncertainty with respect to when commercial air traffic levels will begin to recover, and whether and at what point capacity will return to and/or exceed pre-COVID-19 levels. Our latest estimates are that this recovery may occur in 2023 or 2024. New information may emerge concerning the 34Table of Contentsscope, severity and duration of the COVID-19 pandemic, as well as any worsening of the pandemic, the effect of mutating strains and whether additional outbreaks of the pandemic will continue to occur, actions to contain the pandemic’s spread or treat its impact, timing of the availability of vaccines, and their distribution, acceptance and efficacy, and governmental, business and individual personal actions taken in response to the pandemic (including restrictions and limitations on travel and transportation, and changes in leisure and business travel patterns and work environments) among others. Some of these actions and related impacts may be trends that continue in the future even after the pandemic no longer poses a significant public health risk.We considered the deterioration in general economic and market conditions primarily due to the COVID-19 pandemic to be a triggering event in the first and second quarters of 2020, requiring an impairment evaluation of goodwill, intangible assets and other assets in our commercial aerospace businesses, Collins Aerospace and Pratt & Whitney. Beginning in the second quarter of 2020, we observed several airline customer bankruptcies, delays and cancellations of aircraft purchases by airlines, fleet retirements and repositioning of OEM production schedules and we experienced a significant decline in revenues at our Collins Aerospace and Pratt & Whitney businesses due to a decline in flight hours, aircraft fleet utilization, shop visits and commercial OEM deliveries. These factors contributed to a deterioration of our expectations regarding the timing of a return to pre-COVID-19 commercial flight activity, which further reduced our future sales and cash flows expectations. Based on our updated forecast assumptions in the second quarter of 2020, we concluded that the carrying values of two of our Collins Aerospace reporting units were greater than their respective fair values, and accordingly, recorded a goodwill impairment charge of $3.2 billion. We did not identify any further deterioration to our expectations in the third quarter of 2020 and, therefore, did not have a triggering event.We completed our annual goodwill impairment testing as of October 1, 2020 and determined that no additional adjustments to the carrying value of our goodwill were necessary. Refer to “Note 2: Acquisitions, Dispositions, Goodwill and Intangible Assets” within Item 8 of this Form 10-K for additional information. As described further in “Note 8: Commercial Aerospace Industry Assets and Commitments” within Item 8 of this Form 10-K, we have significant exposure related to our airline and airframer customers, including significant accounts receivable and contract assets balances. Given the uncertainty related to the severity and length of the pandemic, as well as any worsening of the pandemic, mutations to the strains of the virus and the timing and impact of vaccines and whether there will be additional outbreaks of the pandemic and its impact across the aerospace industry, we may be required to record additional charges or impairments in future periods. For a discussion on the 2020 impacts see “Note 1: Basis of Presentation and Summary of Accounting Principles” within Item 8 of this Form 10-K.Although the impact of COVID-19 on our commercial business is significant, we currently believe we have sufficient liquidity to withstand the current estimated impacts.Other MattersGlobal economic and political conditions, changes in raw material and commodity prices, interest rates, foreign currency exchange rates, energy costs, levels of air travel, the financial condition of commercial airlines, and the impact from natural disasters and weather conditions create uncertainties that could impact our businesses in 2021. With regard to political conditions, in July 2019, the U.S. government suspended Turkey’s participation in the F-35 Joint Strike Fighter program because Turkey accepted delivery of the Russian-built S-400 air and missile defense system. The U.S. has imposed, and may impose additional, sanctions on Turkey as a result of this or other political disputes. Turkish companies supply us with components, some of which are sole-sourced, primarily in our aerospace operations for commercial and military engines and aerospace products. Depending upon the scope and timing of U.S. sanctions on Turkey and potential reciprocal actions, if any, such sanctions or actions could impact our sources of supply and could have a material adverse effect on our results of operations, cash flows or financial condition. In addition, in October 2020, the People’s Republic of China (China) announced that it may sanction RTC in connection with a possible Foreign Military Sale to Taiwan of six MS-110 Reconnaissance Pods and related equipment manufactured by Collins Aerospace. Foreign Military Sales are government-to-government transactions that are initiated by, and carried out at the direction of, the U.S. government. To date, the Chinese government has not imposed sanctions on RTC or indicated the nature or timing of any future potential sanctions or other actions. If China were to impose sanctions or take other regulatory action against RTC, our suppliers, teammates or partners, it could potentially disrupt our business operations. The impact of potential sanctions or other actions by China cannot be determined at this time. The recent U.S. presidential and congressional election could result in changes to the U.S. government’s foreign policies that may impact regulatory approval for direct commercial sales contracts for certain of our products and services to certain foreign customers. Likewise, it is uncertain whether approvals previously granted for prior sales could also be paused or revoked if the products and services have not yet been delivered to the customer. If we ultimately do not receive all of the regulatory approvals, or those approvals are revoked, it could have a material effect on our financial results.35Table of ContentsIn particular, we have direct commercial sales contracts for precision guided munitions with a certain Middle East customer, for which we have not yet obtained regulatory approval. Due to the result of the U.S. presidential and congressional election, and the resulting uncertainty surrounding U.S. foreign policy on direct commercial sales for precision guided munitions with this customer, we determined that it is no longer probable that we will be able to obtain required regulatory approvals for these contracts; however, this determination could change as the U.S. government’s foreign policy views are clarified. Therefore, in the fourth quarter of 2020, we reversed $119 million of sales for work performed on these specific contracts subsequent to the date of the Raytheon Merger and through the end of the third quarter of 2020, and the related operating profit. In addition, we recognized an unfavorable profit impact of $516 million, primarily related to inventory reserves, contract asset impairments and recognition of supplier related obligations related to termination liability, which we now do not expect to be utilized or otherwise directed to other customers. In addition, we reversed $755 million of backlog on these contracts. Our contract liabilities include $405 million of advance payments received from the customer on these contracts, which may become refundable to the customer if the contracts are ultimately terminated. See Item 1A. Risk Factors within Part I of this Form 10-K for further discussion of these items.FINANCIAL SUMMARYWe use the following key financial performance measures to manage our business on a consolidated basis and by business segment, and to monitor and assess our results of operations:– Net Sales—a growth metric that measures our revenue for the current year;– Operating Profit—a measure of our profit from continuing operations for the year, before non-operating expenses, net and income taxes; and– Operating Margin—a measure of our operating profit as a percentage of total net sales.(dollars in millions)202020192018Total net sales$56,587 $45,349 $34,701 Operating profit (loss)(1,889)4,914 2,877 Operating margin(3.3)%10.8 %8.3 %Operating cash flow from continuing operations$4,334 $5,821 $2,670 Total backlog150,119 111,665 93,844 Backlog, which is equivalent to our remaining performance obligations for our contracts, represents the dollar value of firm orders for which work has not been performed and excludes unexercised contract options and potential orders under ordering-type contracts (e.g., indefinite-delivery, indefinite-quantity (IDIQ) type contracts). Backlog generally increases with bookings and/or orders and generally converts into sales as we incur costs under the related contractual commitments for our contracts recognized over time or as products are transferred to our customers for point in time contracts. Backlog is affected by changes in foreign exchange rates. In addition, we maintain a strong focus on program execution and the prudent management of capital and investments in order to maximize operating income and cash. We focus on adjusted earnings per share (EPS) and measures to assess our cash generation and the efficiency and effectiveness of our use of capital, such as free cash flow (FCF) and return on invested capital (ROIC), all of which are not defined measurements under U.S. Generally Accepted Accounting Principles (GAAP) and may be calculated differently by other companies.Considered together, we believe these metrics are strong indicators of our overall performance and our ability to create shareowner value. We feel these measures are balanced among long-term and short-term performance, efficiency and growth. We also use these and other performance metrics for executive compensation purposes.A discussion of our results of operations and financial condition follows below in Results of Operations, Segment Review, and Liquidity and Financial Condition.RESULTS OF OPERATIONSAs described in our “Cautionary Note Concerning Factors That May Affect Future Results” in this Form 10-K, our period-to-period comparisons of our results, particularly at a segment level, may not be indicative of our future operating results. The following discussions of comparative results among periods, including the discussion of segment results, should be viewed in this context. As discussed further above in “Business Overview,” the results of RIS and RMD reflect the period subsequent to the completion of the Raytheon Merger on April 3, 2020. In addition, as a result of the Separations Transactions and the 36Table of ContentsDistributions, the historical results of Carrier and Otis are presented as discontinued operations and, as such, have been excluded from both continuing operations and segment results for all periods presented.Net Sales(dollars in millions)202020192018Net sales$56,587 $45,349 $34,701 The factors contributing to the total change year-over-year in total net sales are as follows:(dollars in millions)20202019Organic (1)$(10,438)$2,351 Foreign currency translation14 (73)Acquisitions and divestitures, net21,662 8,370 Other— — Total Change$11,238 $10,648 (1) We provide the organic change in net sales for our consolidated results of operations. We believe that this measure is useful to investors because it provides transparency to the underlying performance of our business, which allows for better year-over-year comparability. The organic change excludes the effect of foreign currency exchange rate fluctuations; acquisitions and divestitures, net; and other significant non-recurring and non-operational items. A reconciliation of this measure to reported U.S. GAAP amounts is provided in the table above.Net sales decreased $10,438 million organically in 2020 compared to 2019. This decrease reflects lower organic sales of $6.6 billion at Collins Aerospace, primarily driven by lower commercial aerospace OEM sales and lower commercial aerospace aftermarket sales, partially offset by higher military sales. The declines in commercial aerospace OEM sales and commercial aerospace aftermarket sales were primarily due to the current economic environment principally driven by the COVID-19 pandemic, which has resulted in lower flight hours, aircraft fleet utilization and commercial OEM deliveries. The decrease in net sales also reflects lower organic sales of $4.1 billion at Pratt & Whitney primarily due to lower commercial aftermarket sales due to a significant reduction in shop visits and related spare part sales, and lower commercial OEM sales, primarily due to a significant reduction in commercial engine deliveries, all principally driven by the current economic and operating environment primarily due to the COVID-19 pandemic. The decrease at Pratt & Whitney was partially offset by higher military sales primarily driven by an increase in F135 engine sales and aftermarket growth on multiple platforms. The $21,662 million sales increase in Acquisitions and divestitures, net in 2020 compared to 2019, is primarily driven by the Raytheon Merger on April 3, 2020. Included in the change in Acquisitions and divestitures, net was the sale of the Collins Aerospace military Global Positioning System (GPS) and space-based precision optics businesses sold in the third quarter of 2020, as further discussed in “Note 2: Acquisitions, Dispositions, Goodwill and Intangible Assets” within Item 8 of this Form 10-K.Net sales increased $2,351 million organically in 2019 compared to 2018. This increase reflects higher organic sales of $1.6 billion at Pratt & Whitney, primarily driven by higher military, commercial OEM, and commercial aftermarket sales. The increase in net sales also reflects higher organic sales of $1.1 billion at Collins Aerospace primarily driven by higher commercial aftermarket and military sales, partially offset by lower commercial aerospace OEM sales. The $8,370 million sales increase in Acquisitions and divestitures, net in 2019 compared to 2018, is primarily driven by the Rockwell Acquisition. The composition of external net sales by products and services sales for 2020 was approximately the following:Collins Aerospace SystemsPratt & WhitneyRaytheon Intelligence & SpaceRaytheon Missiles & DefenseProducts80 %60 %75 %90 %Services20 %40 %25 %10 %% of Total Net Sales(dollars in millions)202020192018202020192018Net SalesProducts$43,319 $32,998 $24,141 77 %73 %70 %Services13,268 12,351 10,560 23 %27 %30 %Total net sales$56,587 $45,349 $34,701 100 %100 %100 %Net products sales grew $10,321 million in 2020 compared to 2019 primarily due to an increase in external product sales of $18.4 billion due to the Raytheon Merger on April 3, 2020, partially offset by decreases in external product sales of $5.3 billion 37Table of Contentsat Collins Aerospace and $2.8 billion at Pratt & Whitney. Net services sales grew $917 million in 2020 compared to 2019 primarily due to an increase in external services sales of $3.4 billion due to the Raytheon Merger on April 3, 2020, partially offset by decreases in external services sales of $1.3 billion at Pratt & Whitney and $1.2 billion at Collins Aerospace.Net products sales grew $8,857 million in 2019 compared to 2018 primarily due to an increase in external product sales of $7.3 billion at Collins Aerospace principally driven by the Rockwell Acquisition and an increase in external product sales of $1.6 billion at Pratt & Whitney. Net services sales grew $1,791 million in 2019 compared to 2018 primarily due to an increase in external services sales of $1.9 billion at Collins Aerospace primarily due to the Rockwell Acquisition.Our sales to major customers were as follows:% of Total Net Sales(dollars in millions)202020192018202020192018Sales to the U.S. government (1)$25,962 $9,094 $6,560 46 %20 %19 %Foreign military sales through the U.S. government4,585 1,571 902 8 %3 %3 %Foreign government direct commercial sales3,974 1,498 1,275 7 %3 %4 %Commercial aerospace and other commercial sales22,066 33,186 25,964 39 %73 %75 %Total net sales$56,587 $45,349 $34,701 100 %100 %100 %(1) Excludes foreign military sales through the U.S. government.Cost of Products and Services Sold (dollars in millions)202020192018Total cost of products and services sold$48,056 $34,598 $27,465 Percentage of net sales85 %76 %79 %The factors contributing to the change year-over-year in total cost of products and services sold are as follows:(dollars in millions)20202019Organic (1)$(4,432)$1,781 Foreign currency translation8 (125)Acquisitions and divestitures, net17,696 5,241 Restructuring220 89 FAS/CAS operating adjustment(965)— Acquisition accounting adjustments939 424 Other(8)(277)Total Change$13,458 $7,133 (1) We provide the organic change in cost of sales for our consolidated results of operations. We believe that this measure is useful to investors because it provides transparency to the underlying performance of our business, which allows for better year-over-year comparability. The organic change excludes the effect of foreign currency exchange rate fluctuations; acquisitions and divestitures, net; restructuring costs; costs related to certain acquisition accounting adjustments and other significant non-recurring and non-operational items. A reconciliation of this measure to reported U.S. GAAP amounts is provided in the table above.The organic decrease in total cost of products and services sold in 2020 compared to 2019 of $4,432 million was primarily driven by the organic sales decreases noted above. The increase in Acquisitions and divestitures, net of $17,696 million in 2020 compared to 2019 is primarily driven by the Raytheon Merger on April 3, 2020. Included in the change in Acquisitions and divestitures, net is the sale of the Collins Aerospace military GPS and space-based precision optics businesses sold in the third quarter of 2020, as further discussed in “Note 2: Acquisitions, Dispositions, Goodwill and Intangible Assets” within Item 8 of this Form 10-K and an unfavorable profit impact of $516 million related to inventory reserves, contract asset impairments and recognition of supplier related obligations for certain international contracts at RMD as further described in “Segment Review” below. Included in the decrease in Other of $8 million in 2020 compared to 2019 was prior year amortization of inventory fair value step-up associated with the Rockwell Collins acquisition of $181 million at Collins Aerospace, partially offset by an $89 million impairment of commercial aircraft program assets at Pratt & Whitney in the current year.The organic increase in total cost of products and services sold in 2019 compared to 2018, of $1,781 million was primarily driven by the organic sales increases noted above. The increase in Acquisitions and divestitures, net of $5,241 million for 2019 compared to 2018 was primarily driven by the Rockwell Acquisition. The decrease in Other of $277 million primarily reflects the absence of a 2018 customer contract settlement at Pratt & Whitney.38Table of ContentsFor further discussion on Restructuring costs see “Restructuring Costs” section below. For further discussion on FAS/CAS operating adjustment see “FAS/CAS operating adjustment” section below. For further discussion on Acquisition accounting adjustments, see “Acquisition accounting adjustments” subsection under the “Segment Review” section below. % of Total Net Sales(dollars in millions)202020192018202020192018Cost of salesProducts$38,137 $26,910 $21,083 67 %59 %61 %Services9,919 7,688 6,382 18 %17 %18 %Total cost of sales$48,056 $34,598 $27,465 85 %76 %79 %Net products cost of sales grew $11,227 million in 2020 compared to 2019 primarily due to an increase in external product cost of sales due to the Raytheon Merger on April 3, 2020, partially offset by decreases in external product cost of sales at Collins Aerospace and Pratt & Whitney. Net services cost of sales grew $2,231 million in 2020 compared to 2019 primarily due to an increase in external services cost of sales due to the Raytheon Merger on April 3, 2020, partially offset by a decrease in external services cost of sales at Collins Aerospace.Net products cost of sales grew $5,827 million in 2019 compared to 2018 primarily due to an increase in external product cost of sales at Collins Aerospace, primarily due to the Rockwell Acquisition, and at Pratt & Whitney. Net services cost of sales grew $1,306 million in 2019 compared to 2018 primarily due to an increase in external services cost of sales at Collins Aerospace primarily due to the Rockwell Acquisition.Research and Development(dollars in millions)202020192018Company-funded$2,582 $2,452 $1,878 Percentage of net sales4.6 %5.4 %5.4 %Customer-funded (1)$4,111 $2,283 $1,517 Percentage of net sales7.3 %5.0 %4.4 %(1) Customer-funded research and development costs are included in cost of sales in our Consolidated Statement of Operations.Research and development spending is subject to the variable nature of program development schedules and, therefore, year-over-year fluctuations in spending levels are expected. The increase in company-funded research and development of $130 million in 2020 compared to 2019, was primarily driven by $0.6 billion related to the Raytheon Merger on April 3, 2020, partially offset by lower expenses of $0.3 billion across various commercial programs at Pratt & Whitney and $0.2 billion across various commercial programs at Collins Aerospace, both principally driven by cost reduction measures in response to the current economic environment primarily due to COVID-19. The increase in company-funded research and development of $574 million in 2019 compared to 2018, was primarily driven by $0.5 billion related to the Rockwell Acquisition. Excluding this impact, Collins Aerospace company-funded research and development increased $0.1 billion driven by higher expenses across various commercial programs.The increase in customer-funded research and development of $1,828 million in 2020 compared to 2019, was primarily driven by $1.7 billion related to the Raytheon Merger on April 3, 2020. The increase in customer-funded research and development of $766 million in 2019 compared to 2018, was primarily driven by $0.8 billion related to the Rockwell Acquisition.Selling, General and Administrative(dollars in millions)202020192018Selling, general and administrative$5,540 $3,711 $2,864 Percentage of net sales9.8 %8.2 %8.3 %Selling, general and administrative expenses increased $1,829 million in 2020 compared to 2019, primarily driven by $1.6 billion related to the Raytheon Merger on April 3, 2020, excluding the impact of merger-related restructuring costs. The increase in Selling, general and administrative expenses also includes higher expenses of $0.4 billion related to increased estimates of expected credit losses primarily due to customer bankruptcies and additional allowances for credit losses at Pratt & Whitney and Collins Aerospace, higher general and administrative restructuring costs of $0.3 billion, and lower expenses due to cost reduction initiatives.Selling, general and administrative expenses increased $847 million in 2019 compared to 2018, primarily driven by $0.6 billion of incremental selling, general and administrative expenses resulting from the Rockwell Acquisition and $0.1 billion of costs 39Table of Contentsassociated with the Raytheon Merger. The increase in Selling, general and administrative expenses also includes higher expenses of $0.2 billion at Collins Aerospace, primarily driven by increased headcount and employee compensation related expenses partially offset by synergy capture related to the Rockwell Acquisition.We are continuously evaluating our cost structure and have implemented restructuring actions in an effort to keep our cost structure competitive. As appropriate, the amounts reflected above include the beneficial impact of previous restructuring actions on Selling, general and administrative expenses. See “Note 14: Restructuring Costs” within Item 8 of this Form 10-K and Restructuring Costs, below, for further discussion.Other Income, Net(dollars in millions)202020192018Other income, net$885 $326 $383 Other income, net includes equity earnings in unconsolidated entities, royalty income, foreign exchange gains and losses, as well as other ongoing and nonrecurring items. The increase in Other income, net of $559 million in 2020 compared to 2019 was primarily due to $595 million of gains on the sales of the Collins Aerospace businesses, as further discussed in “Note 2: Acquisitions, Dispositions, Goodwill and Intangible Assets” within Item 8 of this Form 10-K, and $225 million related to foreign government wage subsidies due to COVID-19 at Pratt & Whitney and Collins Aerospace, partially offset by a net unfavorable year-over-year impact of foreign exchange gains and losses of $138 million.The decrease in Other income, net of $57 million in 2019 compared to 2018, was primarily due to a net unfavorable impact of foreign exchange gains and losses.Operating Profit (Loss)(dollars in millions)202020192018Operating profit (loss)$(1,889)$4,914$2,877Operating profit (loss) margin(3.3)%10.8 %8.3 %The change in Operating profit (loss) of $6,803 million in 2020 compared to 2019 was primarily driven by the operating performance at our segments as described below in “Segment Review” and the $3,183 million goodwill impairment in the second quarter of 2020 related to two Collins Aerospace reporting units. Included in the change in Operating profit (loss) was an increase in acquisition accounting adjustments of $1,057 million related to the Raytheon Merger, an increase in restructuring costs of $527 million primarily related to restructuring actions taken at our Collins Aerospace segment and restructuring actions in connection with the Raytheon Merger on April 3, 2020 and an unfavorable profit impact of $516 million related to inventory reserves, contract asset impairments and recognition of supplier related obligations for certain international contracts at RMD as further described in “Segment Review” below.The increase in Operating profit (loss) of $2,037 million in 2019 compared to 2018 was primarily driven by operating performance at our segments as described below in “Segment Review.” Included in the increase in Operating profit (loss) was an increase in acquisition accounting adjustments of $375 million primarily related to the Rockwell acquisition and increase in restructuring costs of $93 million primarily related to actions taken at our Collins Aerospace and Pratt & Whitney segments.Non-service Pension (Income) Expense(dollars in millions)202020192018Non-service pension (income) expense$(902)$(829)$(659)The change in Non-service pension (income) expense of $73 million in 2020 compared to 2019 was primarily driven by the inclusion of Raytheon Company plans in 2020 as a result of the Raytheon Merger and a decrease in the interest rates at December 31, 2019 and during 2020 compared to December 31, 2018, partially offset by a decrease in the expected return on plan assets (EROA) assumption for the UTC plans in 2020 and a one-time curtailment gain of $98 million in 2019. The one-time curtailment gain was due to the recognition of previously unrecognized prior service credits as a result of an amendment to the UTC domestic defined benefit plans to cease accrual of additional benefits for future service and compensation for non-union participants effective December 31, 2019.The change in Non-service pension (income) expense of $170 million in 2019 compared to 2018 was primarily driven the inclusion of Rockwell Collins plans in 2019 as a result of the Rockwell Collins acquisition and a one-time curtailment gain of $98 million in 2019.40Table of ContentsInterest Expense, Net(dollars in millions)202020192018Interest expense$1,408 $1,711 $1,182 Interest income(42)(120)(150)Interest expense, net$1,366 $1,591 $1,032 Average interest expense rate - average outstanding borrowings during the year:Short-term borrowings2.0 %1.7 %1.3 %Total debt4.0 %3.6 %3.5 %Average interest expense rate - outstanding borrowings as of December 31:Short-term borrowings0.6 %2.3 %1.9 %Total debt4.2 %3.6 %3.5 %Interest expense, net decreased $225 million in 2020 as compared with 2019, primarily due to a decrease in interest expense principally driven by the repayment of long-term debt, partially offset by a decrease in interest income principally driven by interest income of $63 million related to tax settlements in the prior year. The average maturity of our long-term debt at December 31, 2020 was approximately 14 years. Interest expense, net increased $559 million in 2019 as compared with 2018, primarily due to an increase in interest expense driven by debt acquired from the Rockwell Acquisition and the impact of the August 16, 2018 issuance of notes representing $11 billion in aggregate principal amount. The average maturity of our long-term debt at December 31, 2019 was approximately 10 years.Income Taxes202020192018Effective income tax rate(24.4)%10.1 %43.8 %The 2020 negative effective tax rate is a result of having tax expense of $575 million on a loss from continuing operations before income taxes of $2,353 million. The loss from continuing operations before income taxes includes the $3,183 million goodwill impairment as described in “Note 2: Business Acquisitions, Dispositions, Goodwill and Intangible Assets,” within Item 8 of this Form 10-K, most of which is non-deductible for tax purposes. Tax expense includes net deferred tax charges of $367 million resulting from the Separation Transactions and the Raytheon Merger primarily related to the impairment of deferred tax assets, and incremental tax expense of $177 million related to the disposal of businesses, including the sales of the Collins Aerospace and RIS businesses and the entry into a definitive agreement to sell Forcepoint, as described in “Note 2: Business Acquisitions, Dispositions, Goodwill and Intangible Assets” within Item 8 of this Form 10-K. As a result of the Separation Transactions and the restructuring charges recognized in 2020, tax expense also includes $49 million related to revaluation of the tax benefit for certain international tax incentives, as the Company no longer expects to meet the incentive requirements. Also included in the 2020 effective tax rate are tax benefits of $142 million associated with U.S. research and development credits and $83 million associated with Foreign Derived Intangible Income (FDII).The 2019 effective tax rate includes tax benefits of $290 million primarily associated with the conclusion of the audit by the Examination Division of the Internal Revenue Service (IRS) for the Company’s 2014, 2015 and 2016 tax years and the filing by a subsidiary of the Company to participate in an amnesty program offered by the Italian Tax Authority. The 2019 effective tax rate also includes tax benefits of $138 million associated with FDII and $101 million related to U.S. research and development credits.On December 22, 2017, the Tax Cuts and Jobs Act of 2017 (TCJA) was enacted. The 2018 effective tax rate reflects a net charge of $744 million for TCJA related adjustments. The amount primarily relates to non-U.S. taxes that will become due when previously reinvested earnings of certain international subsidiaries are remitted. The 2018 effective tax rate also includes tax benefits of $102 million associated with FDII and $73 million related to U.S. research & development credits.For additional discussion of income taxes and the effective income tax rate, see “Income Taxes” within Critical Accounting Estimates, below, and “Note 13: Income Taxes” within Item 8 of this Form 10-K.41Table of ContentsNet Income (Loss) from Continuing Operations Attributable to Common Shareowners (dollars in millions, except per share amounts)202020192018Net income (loss) from continuing operations attributable to common shareowners $(3,109)$3,510 $1,216 Diluted earnings (loss) per share from continuing operations$(2.29)$4.06 $1.50 Net loss from continuing operations attributable to common shareowners for 2020 includes the following:•acquisition accounting adjustments primarily related to the Raytheon Merger of $1,435 million, net of tax, which had an unfavorable impact on diluted EPS from continuing operations of $1.06;•restructuring charges of $598 million, net of tax, which had an unfavorable impact on diluted EPS from continuing operations of $0.44;•$3,240 million of primarily non-deductible goodwill and intangibles impairment charges related to our Collins Aerospace segment, which had an unfavorable impact on diluted EPS from continuing operations of $2.37;•significant unfavorable contract adjustments at Collins Aerospace and Pratt & Whitney of $667 million, net of tax, which had an unfavorable impact on diluted EPS from continuing operations of $0.49;•$415 million of tax charges in connection with the Separation Transactions, including the impairment of deferred tax assets not expected to be utilized, which had an unfavorable impact on diluted EPS from continuing operations of $0.31;•unfavorable profit impact at RMD of $412 million, net of tax, related to certain direct commercial sales contracts for precision guided munitions with a certain Middle East customer, which had an unfavorable impact on diluted EPS from continuing operations of $0.30;•increased estimates of expected credit losses driven by customer bankruptcies and additional allowances for credit losses of $300 million, net of tax, which had an unfavorable impact on diluted EPS from continuing operations of $0.22; and •gains on the sales of the Collins Aerospace businesses of $240 million, net of tax, which had a favorable impact on diluted EPS from continuing operations of $0.18.Net income from continuing operations attributable to common shareowners for 2019 includes the following:•acquisition accounting adjustments of $704 million, net of tax, which had an unfavorable impact on diluted EPS from continuing operations of $0.81;•restructuring charges of $186 million, net of tax, which had an unfavorable impact on diluted EPS from continuing operations of $0.21;•tax settlements and related interest income on tax settlements of $341 million, which had a favorable impact on diluted EPS from continuing operations of $0.39; and•amortization on the inventory fair value step-up associated with the Rockwell Acquisition of $140 million, net of tax, which had an unfavorable impact on diluted EPS from continuing operations of $0.16.Net income from continuing operations attributable to common shareowners for 2018 includes the following:•acquisition accounting adjustments of $432 million, net of tax, which had an unfavorable impact on diluted EPS from continuing operations of $0.53;•restructuring charges of $114 million, net of tax, which had an unfavorable impact on diluted EPS from continuing operations of $0.14;•an income tax charge related to the estimated impact of the TCJA of $744 million, which had an unfavorable impact on diluted EPS from continuing operations of $0.92; and•the unfavorable impact of customer contract matters at Pratt & Whitney of $220 million, net of tax, which had an unfavorable impact on diluted EPS from continuing operations of $0.27.Net Income (Loss) from Discontinued Operations Attributable to Common Shareowners(dollars in millions, except per share amounts)202020192018Net income (loss) from discontinued operations attributable to common shareowners $(410)$2,027 $4,053 Diluted earnings (loss) per share from discontinued operations$(0.30)$2.35 $5.00 On April 3, 2020, we completed the separation of our commercial businesses, Carrier and Otis. Effective as of such date, the historical results of the Carrier and Otis segments have been reclassified to discontinued operations for all periods presented. See “Note 3: Discontinued Operations” within Item 8 of this Form 10-K for additional information. The change in net income (loss) from discontinued operations attributable to common shareowners of $2,437 million and the related change in diluted earnings (loss) per share from discontinued operations of $2.65 in 2020 compared to 2019 was 42Table of Contentsprimarily due to prior year Carrier and Otis operating activity, as the Separation Transactions occurred on April 3, 2020, partially offset by higher prior year costs associated with the separation of our commercial businesses as discussed below. Net income (loss) from discontinued operations for 2020 and 2019 includes $888 million, net of tax, and $1,284 million, net of tax, respectively, of costs associated with the Company’s separation of its commercial businesses. Separation costs in 2020 primarily related to debt extinguishment costs of $611 million in connection with the early repayment of outstanding principal.The change in net income (loss) from discontinued operations attributable to common shareowners of $2,026 million and the related change in diluted earnings (loss) per share from discontinued operations of $2.65 in 2019 compared to 2018 was primarily due to the increased costs associated with the separation of our commercial businesses in 2019 and the absence of a gain on Carrier’s sale of Taylor Company of $591 million, net of tax in 2018.Net Income (Loss) Attributable to Common Shareowners (dollars in millions, except per share amounts)202020192018Net income (loss) attributable to common shareowners $(3,519)$5,537 $5,269 Diluted earnings (loss) per share from operations$(2.59)$6.41 $6.50 The change in net income (loss) attributable to common shareowners and diluted EPS from operations for 2020 compared to 2019 was driven by the decrease in continuing operations, as discussed above in Net Income (Loss) from Continuing Operations Attributable to Common Shareowners and the decrease from discontinued operations, as discussed above in Net Income (Loss) from Discontinued Operations Attributable to Common Shareowners.The change in net income (loss) attributable to common shareowners and diluted EPS from operations for 2019 compared to 2018 was driven by the increase in continuing operations, as discussed above in Net Income (Loss) from Continuing Operations Attributable to Common Shareowners, partially offset by the decrease from discontinued operations, as discussed above in Net Income (Loss) from Discontinued Operations Attributable to Common Shareowners. RESTRUCTURING COSTS(dollars in millions)202020192018Restructuring costs$777 $245 $158 Restructuring actions are an essential component of our operating margin improvement efforts and relate to existing and recently acquired operations. Charges generally arise from severance related to workforce reductions and facility exit costs associated with the consolidation of field and manufacturing operations and costs to exit legacy programs. We continue to closely monitor the economic environment and may undertake further restructuring actions to keep our cost structure aligned with the demands of the prevailing market conditions.2020 Actions. During 2020, we recorded net pre-tax restructuring charges of $770 million for restructuring efforts initiated in 2020, primarily related to severance and restructuring actions at Pratt & Whitney and Collins Aerospace in response to the impact on our operating results related to the current economic environment primarily caused by the COVID-19 pandemic, the Raytheon Merger, and the ongoing cost reduction efforts. We expect to incur additional restructuring and other charges of $40 million to complete these actions. We are targeting to complete in 2021 the majority of actions initiated in 2020. We expect recurring pre-tax savings in continuing operations related to these actions to reach approximately $1.1 billion annually within one to two years. Approximately 80% of the total pre-tax charge will require cash payments, which we have funded and expect to continue to fund with cash generated from operations. During 2020, we had cash outflows of approximately $400 million related to the 2020 actions. 2019 Actions. During 2020 and 2019, we recorded net pre-tax restructuring charges of $10 million and $162 million, respectively, for actions initiated in 2019. We expect to incur additional restructuring charges of $58 million to complete these actions. We are targeting to complete in 2021 the majority of the remaining workforce and all facility related cost reduction actions initiated in 2019. We expect annual recurring pre-tax savings in continuing operations related to these actions to reach approximately $200 million annually within two years of initiating these actions. Approximately 90% of the total pre-tax charge will require cash payments, which we have funded and expect to continue to fund with cash generated from operations. During 2020, we had cash outflows of approximately $40 million related to the 2019 actions. In addition, during 2020, we reversed $3 million of net pre-tax restructuring costs for restructuring actions initiated in 2018 and prior. In 2019 and 2018, we recorded $83 million and $158 million, respectively, of net pre-tax restructuring costs for restructuring actions initiated in 2018 and prior. For additional discussion of restructuring, see “Note 14: Restructuring Costs” within Item 8 of this Form 10-K.43Table of ContentsSEGMENT REVIEWAs discussed further above in Business Overview, on April 3, 2020, United Technologies Corporation (UTC) completed the Separation Transactions, and on April 3, 2020, completed the Raytheon Merger with United Technologies Corporation being renamed Raytheon Technologies Corporation. As a result of these transactions, we now operate in four principal business segments: Collins Aerospace Systems (Collins Aerospace), Pratt & Whitney, Raytheon Intelligence & Space (RIS) and Raytheon Missiles & Defense (RMD). The results of RIS and RMD reflect the period subsequent to the completion of the Raytheon Merger on April 3, 2020. The historical results of Carrier and Otis are presented as discontinued operations and, as such, have been excluded from both continuing operations and segment results for all periods presented. For a detailed description of our businesses, see “Business” within Item 1 of this Form 10-K.In conjunction with the Raytheon Merger, we revised our measurement of segment performance to reflect how management now reviews and evaluates operating performance. Under the new segment performance measurement, certain acquisition accounting adjustments are now excluded from segments’ results in order to better represent the ongoing operational performance of those segments. In addition, the majority of Corporate expenses are now allocated to the segments, excluding certain items that remain at Corporate because they are not included in management’s review of the segments’ results. Historical results, discussion and presentation of our business segments reflect the impact of these adjustments for all periods presented.Also as a result of the Raytheon Merger, we now present a FAS/CAS operating adjustment outside of segment results, which represents the difference between the service cost component of our pension and postretirement benefit (PRB) expense under the Financial Accounting Standards (FAS) requirements of U.S. GAAP and our pension and PRB expense under U.S. government Cost Accounting Standards (CAS) primarily related to our RIS and RMD segments. While the ultimate liability for pension and PRB costs under FAS and CAS is similar, the pattern of cost recognition is different. Over time we generally expect to recover the related RIS and RMD pension and PRB liabilities through the pricing of our products and services to the U.S. government. Because the Collins Aerospace and Pratt & Whitney segments generally record pension and PRB expense on a FAS basis, historical results were not impacted by this change in segment reporting.Segments are generally based on the management structure of the businesses and the grouping of similar operations, based on capabilities and technologies, where each management organization has general operating autonomy over diversified products and services. Segment total net sales and operating profit include intercompany sales and profit, which are ultimately eliminated within Eliminations and other, which also includes certain smaller non-reportable segments. For our defense contracts, where the primary customer is the U.S. government subject to Federal Acquisition Regulation (FAR) part 12, our intercompany sales and profit is generally recorded at cost-plus a specified fee, which may differ from what the selling entity would be able to obtain on sales to external customers. Segment results exclude certain acquisition accounting adjustments, the FAS/CAS operating adjustment and certain corporate expenses, as further discussed below.We attempt to quantify material factors within our discussion of the results of each segment whenever those factors are determinable. However, in some instances, the factors we cite within our segment discussion are based upon input measures or qualitative information that does not lend itself to quantification when discussed in the context of the financial results measured on an output basis and are not, therefore, quantified in the below discussions.Given the nature of our business, we believe that total net sales and operating profit (and the related operating profit margin percentage), which we disclose and discuss at the segment level, are most relevant to an understanding of management’s view of our segment performance, as described below.Total Net Sales. Total net sales by segment were as follows:(dollars in millions)202020192018Collins Aerospace Systems$19,288 $26,028 $16,634 Pratt & Whitney16,799 20,902 19,402 Raytheon Intelligence & Space10,841 — — Raytheon Missiles & Defense11,660 — — Total segment58,588 46,930 36,036 Eliminations and other(2,001)(1,581)(1,335)Consolidated$56,587 $45,349 $34,701 44Table of ContentsOperating Profit (Loss). Operating profit (loss) by segment was as follows:(dollars in millions)202020192018Collins Aerospace Systems$1,466 $4,508 $2,397 Pratt & Whitney(564)1,801 1,402 Raytheon Intelligence & Space1,014 — — Raytheon Missiles & Defense890 — — Total segment2,806 6,309 3,799 Eliminations and other(111)(140)(69)Corporate expenses and other unallocated items(590)(367)(340)FAS/CAS operating adjustment1,106 — — Acquisition accounting adjustments(1)(5,100)(888)(513)Consolidated$(1,889)$4,914 $2,877 (1) Acquisition accounting adjustments in 2020 includes the $3.2 billion goodwill impairment loss in the second quarter of 2020 related to two Collins Aerospace reporting units. Refer to “Note 2: Acquisitions, Dispositions, Goodwill and Intangible Assets” in Item 8 of this Form 10-K for additional information.Included in segment operating profit are Estimate at Completion (EAC) adjustments, which relate to changes in operating profit and margin due to revisions to total estimated revenues and costs at completion. These changes reflect improved or deteriorated operating performance or award fee rates. For a full description of our EAC process, refer to “Note 1: Basis of Presentation and Summary of Accounting Principles” within Item 8 of this Form 10-K. Given that we have thousands of individual contracts and given the types and complexity of the assumptions and estimates we must make on an on-going basis, we have both favorable and unfavorable EAC adjustments. We had the following aggregate EAC adjustments for the periods presented:(dollars in millions)202020192018Gross favorable$994 $419 $579 Gross unfavorable(1,637)(488)(629)Total net EAC adjustments$(643)$(69)$(50)As a result of the Raytheon Merger, RIS’s and RMD’s long-term contracts that are accounted for on a percentage of completion basis, were reset to zero percent complete as of the merger date since only the unperformed portion of the contract at the merger date represents an obligation of the Company. This has had the impact of reducing gross favorable and unfavorable EAC adjustments for these segments in the short-term, with the exception of EAC adjustments related to loss reserves. The change in net EAC adjustments of $574 million in 2020 compared 2019 was primarily due to an increase in net unfavorable EAC adjustments of $544 million at Pratt & Whitney, principally due to the current economic and operating environment primarily driven by the COVID-19 pandemic. Net EAC adjustments in 2019 were relatively consistent with 2018. Significant EAC adjustments in the years ended December 31, 2020, 2019 and 2018 are discussed in each business segment’s discussion below. Refer to the individual segment results for further information.Defense Backlog and Defense Bookings. We believe defense backlog and defense bookings are relevant to an understanding of management’s view of our defense operations’ performance. Our defense operations consist primarily of our RIS and RMD businesses and operations in the defense businesses within our Collins Aerospace and Pratt & Whitney segments. Defense backlog was approximately $67.3 billion and $22.3 billion as of December 31, 2020 and 2019, respectively, out of total backlog, including commercial, of $150.1 billion and $111.7 billion as of December 31, 2020 and 2019, respectively. Defense bookings were approximately $31.2 billion, $16.9 billion and $14.1 billion for 2020, 2019 and 2018 respectively.Defense backlog, which is equivalent to our remaining performance obligations for our defense contracts, represents the dollar value of firm orders for which work has not been performed and excludes unexercised contract options and potential orders under ordering-type contracts (e.g., IDIQ type contracts). Defense backlog is affected by changes in foreign exchange rates. Defense bookings generally represent the dollar value of new external defense contracts awarded to us during the reporting period and include firm orders for which funding has not been appropriated. We believe defense bookings are an important measure of future performance for our defense operations and are an indicator of potential future changes in these operations’ total net sales, because we cannot record revenues under a new contract without first having a booking in the current or a preceding period.Defense bookings exclude unexercised contract options and potential orders under ordering-type contracts (e.g., IDIQ type contracts), and are reduced for contract cancellations and terminations of bookings recognized in the current period. We reflect contract cancellations and terminations from prior year bookings, as well as the impact of changes in foreign exchange rates, 45Table of Contentsdirectly as an adjustment to backlog in the period in which the cancellation or termination occurs and the impact is determinable. Contract cancellations and terminations also include contract underruns on cost-type programs.Defense bookings are impacted by the timing and amounts of awards in a given period, which are subject to numerous factors, including: (1) the desired capability by the customer and urgency of customer needs, (2) customer budgets and other fiscal constraints, (3) political and economic and other environmental factors, (4) the timing of customer negotiations, (5) the timing of governmental approvals and notifications, and (6) the timing of option exercises or increases in scope. In addition, due to these factors, quarterly bookings tend to fluctuate from period to period, particularly on a segment basis. As a result, we believe comparing bookings on a quarterly basis or for periods less than one year is less meaningful than for longer periods and that shorter term changes in bookings may not necessarily indicate a material trend.Collins Aerospace Systems% Change(dollars in millions)2020201920182020 compared with 20192019 compared with 2018Net Sales$19,288 $26,028 $16,634 (26)%56 %Operating Profit1,466 4,508 2,397 (67)%88 %Operating Profit Margins7.6 %17.3 %14.4 %2020 Compared with 2019 Factors Contributing to Total Change(dollars in millions)Organic(1)FXTranslationAcquisitions /Divestitures, netRestructuringCostsOtherTotal ChangeNet Sales$(6,554)$15 $(201)$— $— $(6,740)Operating Profit(3,598)(1)$(12)(258)827 (3,042)2019 Compared with 2018 Factors Contributing to Total Change(dollars in millions)Organic(1)FXTranslationAcquisitions /Divestitures, netRestructuringCostsOtherTotal ChangeNet Sales$1,068 $(72)$8,398 $— $— $9,394 Operating Profit47 32 2,005 58 (31)2,111 (1) We provide the organic change in net sales and operating profit for our Collins Aerospace and Pratt & Whitney segments. We believe that these measures are useful to investors because they provide transparency to the underlying performance of our business, which allows for better year-over-year comparability. The organic change excludes the effect of foreign currency exchange rate fluctuations; acquisitions and divestitures, net; restructuring costs and other significant non-recurring and non-operational items. A reconciliation of these measures to reported U.S. GAAP amounts is provided in the table above.2020 Compared with 2019The organic sales decrease of $6.6 billion in 2020 compared to 2019 primarily relates to lower commercial aerospace OEM sales of $3.7 billion and lower commercial aerospace aftermarket sales of $3.4 billion, including declines across all aftermarket sales channels. These reductions were primarily due to the current economic environment principally driven by the COVID-19 pandemic, which has resulted in lower flight hours, aircraft fleet utilization and commercial OEM deliveries. This decrease was partially offset by higher military sales of $0.6 billion. Included in the organic sales decrease were lower commercial aerospace OEM and aftermarket sales of approximately $1.0 billion related to the Boeing 737 Max program and fewer upgrades due to certain regulatory mandates that were primarily completed in early 2020. The organic profit decrease of $3.6 billion in 2020 compared to 2019 is primarily due to lower commercial aerospace operating profit of $4.0 billion principally driven by the lower commercial aerospace OEM and aftermarket sales volume discussed above. Included in the lower commercial OEM operating profit were $157 million of significant unfavorable adjustments principally driven by the expected acceleration of fleet retirements of a certain aircraft. The decrease was partially offset by lower Research and development expenses of $0.2 billion, which includes the impact of cost reduction initiatives. Included in the operating profit decrease was $125 million of increased estimates of expected credit losses due to customer bankruptcies and additional allowances for credit losses.Included in organic profit in 2020 was other income of $72 million related to foreign government wage subsidies due to COVID-19 and $12 million related to the favorable impact of a contract related matter in the first quarter of 2020.46Table of ContentsThe decrease in net sales and operating profit due to acquisitions / divestitures, net primarily relates to the sale of our Collins Aerospace military GPS and space-based precision optics businesses in the third quarter of 2020 as further discussed in “Note 2: Acquisitions, Dispositions, Goodwill and Intangible Assets” within Item 8 of this Form 10-K.The increase in Other operating profit of $0.8 billion in 2020 compared to 2019 primarily relates to gains of $595 million on the sales of the Collins Aerospace businesses discussed above, the absence of prior year amortization of inventory fair value step-up associated with the Rockwell Acquisition of $181 million and the absence of a prior year loss on the sale of a business of $25 million.2019 Compared with 2018The organic sales increase of $1.1 billion in 2019 compared to 2018 primarily reflects higher commercial aerospace aftermarket sales of $0.8 billion and higher military sales of $0.4 billion, partially offset by lower commercial aerospace OEM sales of $0.1 billion.Organic profit in 2019 was relatively consistent compared to 2018. Included in the change in organic profit was higher commercial aerospace margin contribution of $0.2 billion driven by the commercial aftermarket sales growth noted above partially offset by lower commercial aerospace OEM margin contribution, and higher military margin contribution of $0.1 billion driven by the sales growth noted above. This increase was partially offset by higher Selling, general and administrative expenses of $0.2 billion and higher Research and development costs of $0.1 billion.The increase in net sales and operating profit due to acquisitions / divestitures, net primarily relates to the acquisition of Rockwell Collins in 2018 as further discussed in “Note 2: Acquisitions, Dispositions, Goodwill and Intangible Assets” within Item 8 of this Form 10-K.Pratt & Whitney% Change(dollars in millions)2020201920182020 compared with 20192019 compared with 2018Net Sales$16,799$20,902$19,402(20)%8 %Operating Profit(564)1,8011,402(131)%28 %Operating Profit Margins(3.4)%8.6 %7.2 %2020 Compared with 2019 Factors Contributing to Total Change(dollars in millions)Organic(1)FXTranslation(2)Acquisitions /Divestitures, netRestructuringCostsOtherTotal ChangeNet Sales$(4,080)$(23)$— $— $— $(4,103)Operating Profit(2,126)(5)— (47)(187)(2,365)2019 Compared with 2018 Factors Contributing to Total Change(dollars in millions)Organic(1)FXTranslation(2)Acquisitions /Divestitures, netRestructuringCostsOtherTotal ChangeNet Sales$1,576 $(48)$(28)$— $— $1,500 Operating Profit228 (7)(7)(140)325 399 (1) We provide the organic change in net sales and operating profit for our Collins Aerospace and Pratt & Whitney segments. We believe that these measures are useful to investors because they provide transparency to the underlying performance of our business, which allows for better year-over-year comparability. The organic change excludes the effect of foreign currency exchange rate fluctuations; acquisitions and divestitures, net; restructuring costs and other significant non-recurring and non-operational items. A reconciliation of these measures to reported U.S. GAAP amounts is provided in the table above.(2) For Pratt & Whitney only, the transactional impact of foreign exchange hedging at Pratt & Whitney Canada (P&WC) has been netted against the translational foreign exchange impact for presentation purposes in the table above. For all other segments these foreign exchange transactional impacts are included within the organic/operational caption in their respective tables. Due to its significance to Pratt & Whitney’s overall operating results, we believe it is useful to segregate the foreign exchange transactional impact in order to clearly identify the underlying financial performance.2020 Compared with 2019 The organic sales decrease of $4.1 billion in 2020 compared to 2019 primarily reflects lower commercial aftermarket sales of $3.8 billion, due to a significant reduction in shop visits and related spare part sales, and lower commercial OEM sales of $1.1 billion, primarily due to a significant reduction in commercial engine deliveries, all principally driven by the current 47Table of Contentseconomic and operating environment primarily due to the COVID-19 pandemic. These declines were partially offset by higher military sales of $0.8 billion primarily driven by an increase in F135 engine sales and aftermarket growth on multiple platforms. Included in the lower commercial aftermarket sales is a $0.4 billion impact to sales from the net unfavorable contract adjustments discussed further below. The organic profit decrease of $2.1 billion in 2020 compared to 2019 was primarily driven by lower commercial aftermarket operating profit of $2.4 billion driven by the sales volume decrease discussed above, unfavorable mix, a $334 million unfavorable EAC adjustment on a commercial engine aftermarket contract due to lower estimated revenues driven by a change in the estimated maintenance coverage period, an unfavorable EAC adjustment of $129 million related to lower estimated revenues due to the restructuring of a customer contract, and $86 million related to an unfavorable EAC adjustment and increased allowances for warranty for legacy fleet related retrofits. The decrease was also driven by higher Selling, general and administrative expenses of $0.2 billion primarily driven by $257 million of increased estimates of expected credit losses due to customer bankruptcies and additional allowances for credit losses. This decrease in organic profit was partially offset by lower Research and development costs of $0.3 billion, which includes the impact of cost reduction initiatives, and other income of $153 million related to foreign government wage subsidies due to COVID-19.Included in organic profit was an increase in net unfavorable EAC adjustments of $544 million, which included the unfavorable EAC adjustments discussed above and significant net unfavorable EAC adjustments of $62 million based on a portfolio review of our commercial aftermarket programs in the second quarter of 2020 in consideration of the estimated lower flight hours, a change in the estimated number of shop visits and the related amount of estimated costs. Also included was an unfavorable EAC adjustment of $44 million in the second quarter of 2020 on a military program primarily driven by a shift in estimated overhead costs due to the lower commercial engine activity discussed above.The decrease in Other operating profit of $187 million in 2020 compared to 2019 was primarily due to an $89 million impairment of commercial aircraft program assets in the current year and $43 million of reserves related to a commercial financing arrangement in the current year.2019 Compared with 2018The organic sales increase of $1.6 billion primarily reflects higher military sales of $0.8 billion, higher commercial OEM sales of $0.5 billion, and higher commercial aftermarket sales of $0.2 billion. The organic profit increase of $0.2 billion was primarily driven by higher military margin contribution of $0.2 billion, driven by the sales increase noted above and higher commercial OEM margin contribution of $0.1 billion primarily driven by continued year-over-year cost reduction and favorable mix on large commercial engine shipments. These increases were partially offset by higher Research and development costs and Selling, general and administrative expenses of $0.1 billion.The $0.3 billion increase in Other operating profit primarily reflects the absence of a 2018 customer contract settlement.Raytheon Intelligence & Space% Change(dollars in millions)2020201920182020 compared with 20192019 compared with 2018Net Sales$10,841— — NMNMOperating Profit1,014— — NMNMOperating Profit Margins9.4 %— — Bookings$10,243— — NMNMNM = Not meaningfulThe increase in net sales of $10,841 million in 2020 compared to 2019 was due to the Raytheon Merger on April 3, 2020.The increase in operating profit of $1,014 million and the related increase in operating profit margins in 2020 compared to 2019 was due to the Raytheon Merger. Included in operating profit in 2020 were $124 million of unfavorable EAC adjustments for loss reserves related to a domestic classified fixed price development program in a net loss position, of which $87 million was recorded in the fourth quarter of 2020.Backlog and Bookings– Backlog was $18,676 million at December 31, 2020 compared to zero at December 31, 2019. The increase in backlog of $18,676 million was due to the Raytheon Merger. In 2020, RIS booked $3,294 million on a number of classified contracts, $236 million to produce and deliver Silent Knight radar systems and spares for the U.S. Special Operations Command, $229 million to perform operations and sustainment for the U.S. Air Force’s Launch and Test Range System (LTRS), $201 million on the Development, Operations and Maintenance (DOMino) cyber program for the Department of 48Table of ContentsHomeland Security (DHS), $193 million on the Global Aircrew Strategic Network Terminal (Global ASNT) program for the U.S. Air Force, and $157 million for the Military GPS User Equipment Increment 2 Miniature Serial Interface Receiver Card (MGUE INC 2 MSI) program for the U.S. Air Force.Raytheon Missiles & Defense% Change(dollars in millions)2020201920182020 compared with 20192019 compared with 2018Net Sales$11,660— — NMNMOperating Profit890— — NMNMOperating Profit Margins7.6 %— — Bookings$10,041— — NMNMNM = Not meaningfulThe increase in net sales of $11,660 million in 2020 compared to 2019 was due to the Raytheon Merger on April 3, 2020.The increase in operating profit of $890 million and the related increase in operating profit margins in 2020 compared to 2019 was due to the Raytheon Merger. Included in operating profit in 2020 was an unfavorable net impact of $516 million related to certain international contracts as further described below, and a $25 million net favorable EAC adjustment due to a revised estimate in costs to complete an industrial cooperation agreement obligation on multiple contracts for an international customer based upon an agreement signed in the fourth quarter of 2020.In the fourth quarter of 2020, RMD reversed $119 million of sales for work performed subsequent to the date of the Raytheon Merger through the end of the third quarter of 2020, and the related operating profit, on our direct commercial sales contracts for precision guided munitions with a certain Middle East customer, for which we have not yet obtained regulatory approval. As discussed in the “Other Matters” subsection of the “Business Overview” section above, due to the recent U.S. presidential and congressional election and the resulting uncertainty surrounding U.S. foreign policy on direct commercial sales for precision guided munitions with this customer, we determined that it is no longer probable that we will be able to obtain regulatory approvals for these contracts. RMD also recognized an unfavorable profit impact of $516 million related to these contracts, primarily related to inventory reserves, contract asset impairments and recognition of supplier related obligations related to termination liability, which we now do not expect to be utilized or otherwise directed to other customers. In addition, we reversed $755 million of backlog on these contracts.Backlog and Bookings– Backlog was $29,593 million at December 31, 2020 compared to zero at December 31, 2019. The increase in backlog of $29,593 million was due to the Raytheon Merger. In 2020, RMD booked $2,426 million on the Army Navy/Transportable Radar Surveillance-Model 2 (AN/TPY-2) radar program for the Kingdom of Saudi Arabia (KSA), $351 million for Standard Missile-3 (SM-3) for the Missile Defense Agency (MDA) and an international customer, $340 million for StormBreaker for the U.S. Air Force, $268 million for the AN/TPY-2 radar sustainment program for the MDA, and $237 million for Tube-launched, Optically-tracked, Wireless-guided (TOW) missiles for the U.S. Army and international customers. RMD also booked $1,503 million on a number of classified contracts, including $354 million on a major contract. In 2020, RMD recorded a backlog adjustment of $755 million on certain international contracts as discussed above.Eliminations and otherEliminations and other reflects the elimination of sales, other income and operating profit transacted between segments, as well as the operating results of certain smaller non-reportable business segments, including Forcepoint, LLC, which was acquired as part of the Raytheon Merger and subsequently disposed of in January 2021, as further discussed in “Note 2: Business Acquisitions, Dispositions, Goodwill and Intangible Assets” within Item 8 of this Form 10-K. Net SalesOperating Profit(dollars in millions)202020192018202020192018Inter-segment eliminations$(2,528)$(1,594)$(1,347)$(83)$(208)$(181)Other non-reportable segments527 13 12 (28)68 112 Eliminations and other$(2,001)$(1,581)$(1,335)$(111)$(140)$(69)The increase in inter-segment eliminations sales in 2020 compared to 2019, was primarily due to the Raytheon Merger on April 3, 2020.49Table of ContentsThe increase in other non-reportable segment sales in 2020 compared to 2019, was primarily related to Forcepoint sales.The decrease in other non-reportable segments operating profit in 2020 compared to 2019, was primarily due to the impact of foreign currency translation, partially offset by operating profit related to Forcepoint.Other non-reportable segment sales in 2019 were relatively consistent with 2018.The decrease in other non-reportable segments operating profit in 2019 compared to 2018, was primarily due to the impact of foreign currency translation.Corporate expenses and other unallocated itemsCorporate expenses and other unallocated items consists of costs and certain other unallowable corporate costs not considered part of management’s evaluation of reportable segment operating performance including restructuring and merger costs related to the Raytheon Merger, net costs associated with corporate research and development, including the Lower Tier Air and Missile Defense Sensor (LTAMDS) program which was acquired as part of the Raytheon Merger, and certain reserves. See Restructuring Costs, above, for a more detailed discussion of our restructuring costs.(dollars in millions)202020192018Corporate expenses and other unallocated items$(590)$(367)$(340)The change in Corporate expenses and other unallocated items of $223 million for 2020 compared to 2019 was primarily driven by increased restructuring costs of $201 million, $130 million of net expenses related to the LTAMDS project acquired as part of the Raytheon Merger and an increase in merger-related costs for the Raytheon Merger of $82 million, partially offset by $40 million of merger-related costs for the Rockwell Acquisition in 2019 and other unallocated items with no individual or common significant driver.Corporate expenses and other unallocated items in 2019 was relatively consistent with 2018. Included in the change were merger-related costs for the Raytheon Merger of $83 million in 2019 and a decrease in merger-related costs for the Rockwell Acquisition of $78 million.FAS/CAS operating adjustmentThe segment results of RIS and RMD only include pension and PRB expense as determined under U.S. government CAS, which we generally recover through the pricing of our products and services to the U.S. government. The difference between our CAS expense and the FAS service cost attributable to these segments under U.S. GAAP is the FAS/CAS operating adjustment. The FAS/CAS operating adjustment results in consolidated pension expense in operating profit equal to the service cost component of FAS expense under U.S. GAAP. The segment results of Collins Aerospace and Pratt & Whitney include FAS service cost. The pension and PRB components of the FAS/CAS operating adjustment were as follows:(dollars in millions)202020192018FAS service cost (expense)$(354)$— $— CAS expense1,460 — — FAS/CAS operating adjustment$1,106 $— $— The change in our FAS/CAS operating adjustment of $1,106 million in 2020 compared to 2019 was due to the Raytheon Merger on April 3, 2020.Acquisition accounting adjustmentsAcquisition accounting adjustments include the amortization of acquired intangible assets related to acquisitions, the amortization of the property, plant and equipment fair value adjustment acquired through acquisitions and the amortization of customer contractual obligations related to loss making or below market contracts acquired. These adjustments are not considered part of management’s evaluation of segment results.50Table of ContentsThe components of Acquisition accounting adjustments were as follows:(dollars in millions)202020192018Goodwill impairment charge$(3,183)$— $— Amortization of acquired intangibles (2,142)(1,211)(689)Amortization of property, plant and equipment fair value adjustment(69)(23)(76)Amortization of customer contractual obligations related to acquired loss-making and below-market contracts294 346 252 Acquisition accounting adjustments$(5,100)$(888)$(513)Acquisition accounting adjustments related to acquisitions in each segment were as follows:(dollars in millions)202020192018Collins Aerospace Systems$(3,926)$(605)$(235)Pratt & Whitney(117)(283)(278)Raytheon Intelligence & Space(394)— — Raytheon Missiles & Defense(607)— — Total segment(5,044)(888)(513)Eliminations and other(56)— — Acquisition accounting adjustments$(5,100)$(888)$(513)The change in the Acquisition accounting adjustments of $4,212 million in 2020 compared to 2019, is primarily driven by the $3.2 billion goodwill impairment in the second quarter of 2020 related to two Collins Aerospace reporting units and an increase of $1.1 billion related to the Raytheon Merger, primarily related to the amortization of acquired intangibles. Refer to “Note 2: Acquisitions, Dispositions, Goodwill and Intangible Assets” within Item 8 of this Form 10-K for additional information on the goodwill impairment.The change in the Acquisition accounting adjustments of $375 million in 2019 compared to 2018, is primarily driven by a change of $370 million at Collins Aerospace primarily related to the Rockwell Acquisition.LIQUIDITY AND FINANCIAL CONDITION(dollars in millions)20202019Cash and cash equivalents$8,802 $4,937 Total debt31,823 43,252 Total equity73,852 44,231 Total capitalization (total debt plus total equity)105,675 87,483 Total debt to total capitalization30 %49 %We assess our liquidity in terms of our ability to generate cash to fund our operating, investing and financing activities. Our principal source of liquidity is cash flows from operating activities. In addition to operating cash flows, other significant factors that affect our overall management of liquidity include: capital expenditures, customer financing requirements, investments in businesses, dividends, common stock repurchases, pension funding, access to the commercial paper markets, adequacy of available bank lines of credit, redemptions of debt and the ability to attract long-term capital at satisfactory terms. We had $6.84 billion available under our various credit facilities at December 31, 2020.As discussed above in Business Overview, in response to the COVID-19, we have taken actions to preserve capital and protect the long-term needs of our business. Although our business has been and will continue to be significantly impacted by COVID-19, we currently believe we have sufficient liquidity to withstand the potential impacts.The Coronavirus Aid, Relief, and Economic Security Act (CARES Act), along with earlier issued IRS guidance, provides for a net deferral of payroll tax payments. We did not realize any cash flows benefit in 2020, and do not expect an impact to future years’ cash flows, from a net deferral of payroll tax payments. In addition, deferrals of required estimated federal, foreign and state income tax payments due to the CARES Act and other similar state and foreign stimulus incentives only impacted the timing of these payments within the year. The CARES Act, among other things, also contains numerous other provisions which may impact us. We continue to refine our understanding of the impact of the CARES Act on our business, and ongoing government guidance related to COVID-19 that may be issued. We may be entitled to recovery for certain costs through the 51Table of Contentspricing of our products and services to the U.S. government; however, we do not believe these costs are probable of recovery at this time, and therefore, have not assumed any recovery within our EACs.At December 31, 2020, we had cash and cash equivalents of $8.8 billion, of which approximately 45% was held by RTC’s foreign subsidiaries. We manage our worldwide cash requirements by reviewing available funds among the many subsidiaries through which we conduct our business and the cost effectiveness with which those funds can be accessed. The Company no longer intends to reinvest certain undistributed earnings of its international subsidiaries that have been previously taxed in the U.S. As such, we recorded the taxes associated with the future remittance of these earnings. For the remainder of the Company’s undistributed international earnings, unless tax effective to repatriate, RTC will continue to permanently reinvest these earnings. We repatriated $2.3 billion and $1.6 billion of cash for the year ended December 31, 2020 and 2019, respectively. On occasion, we are required to maintain cash deposits with certain banks with respect to contractual obligations related to acquisitions or divestitures or other legal obligations. As of December 31, 2020 and 2019, the amount of such restricted cash was $30 million and $24 million respectively. Historically, our strong credit ratings and financial position have enabled us to issue long-term debt at favorable market rates. As of December 31, 2020, our maximum commercial paper borrowing limit was $5.0 billion as the commercial paper is backed by our $5.0 billion revolving credit agreement. We had $160 million of commercial paper borrowings as of December 31, 2020. The maximum amount of short-term commercial paper borrowings outstanding at any point in time during the year ended December 31, 2020 was $1,904 million. We use our commercial paper borrowings for general corporate purposes, including the funding of potential acquisitions, pension contributions, debt refinancing, dividend payments and repurchases of our common stock. The commercial paper notes outstanding have original maturities of not more than 90 days from the date of issuance.In preparation for and in anticipation of the Separation Transactions, the Distributions and the Raytheon Merger, the Company entered into and terminated a number of credit agreements. Refer to “Note 10: Borrowings and Lines of Credit” within Item 8 of this Form 10-K for additional information. On March 16, 2020, we entered into a revolving credit agreement with various banks permitting aggregate borrowings of up to $5.0 billion which became available upon completion of the Raytheon Merger on April 3, 2020. This credit agreement matures on April 3, 2025. On May 6, 2020, we entered into a revolving credit agreement with various banks permitting aggregate borrowings of up to $2.0 billion. This credit agreement matures on May 5, 2021. As of December 31, 2020, we had revolving credit agreements with various banks permitting aggregate borrowings of up to $7.0 billion, and there were no borrowings outstanding under these agreements.We have an existing universal shelf registration statement, which we filed with the Securities and Exchange Commission (SEC) on September 27, 2019, for an indeterminate amount of debt and equity securities for future issuance, subject to our internal limitations on the amount of debt to be issued under this shelf registration statement. The Company has offered a voluntary supply chain finance (SCF) program with a global financial institution for more than 10 years, which enables our suppliers, at their sole discretion, to sell their receivables from the Company to the financial institution at a rate that leverages our credit rating, which might be beneficial to them. Our suppliers’ participation in the SCF program does not impact or change our terms and conditions with those suppliers, and therefore, we have no economic interest in a supplier’s decision to participate in the program. In addition, we provide no guarantees or otherwise pay for any of the costs of the program incurred by those suppliers that choose to participate, and have no direct financial relationship with the financial institution, as it relates to the program. As such, amounts due to suppliers that have elected to participate in the SCF program are included in Accounts payable on our Consolidated Balance Sheet and all payment activity related to amounts due to suppliers that elected to participate in the SCF program are reflected in cash flows from operating activities in our Consolidated Statement of Cash Flow. As of December 31, 2020, and December 31, 2019, the amount due to suppliers participating in the SCF program and included in Accounts payable was approximately $394 million and $460 million, respectively. The decrease from December 31, 2019 to December 31, 2020 is due to decreases in our underlying supply chain purchases. The SCF program does not impact our overall liquidity.We believe our future operating cash flows will be sufficient to meet our future operating cash needs. Further, we continue to have access to the commercial paper markets and our existing credit facilities, and our ability to obtain debt or equity financing, as well as the availability under committed credit lines, provides additional potential sources of liquidity should they be required or appropriate.52Table of ContentsCash Flow—Operating Activities(dollars in millions)202020192018Net cash flows provided by operating activities from continuing operations$4,334 $5,821 $2,670 Net cash flows (used in) provided by operating activities from discontinued operations(728)3,062 3,652 2020 Compared with 2019 - Continuing OperationsCash generated from operating activities in 2020 was $1,487 million lower than 2019. This decrease is primarily due to a decrease in net income after adjustments for depreciation and amortization, the 2020 goodwill impairment charge, the deferred income tax provision, stock compensation costs and net periodic pension and other post retirement (income) expense of $1,950 million primarily driven by a decrease at Pratt & Whitney and Collins Aerospace as a result of the current economic environment primarily driven by COVID-19, partially offset by net income from RIS and RMD following the Raytheon Merger. Included in the decrease in operating cash flows was an increase in pension contributions, as further discussed below, and an unfavorable impact from accounts payable primarily at Collins Aerospace and Pratt & Whitney due to a decline in volume principally driven by the current economic environment primarily driven by COVID-19, which was partially offset by a favorable change in inventory at Collins Aerospace and Pratt & Whitney due to the decline in volume and a favorable change in accounts receivable and contract assets due to the timing of billings and collections in 2020 across our segments. The Company enters into various factoring agreements with third-party financial institutions to sell certain of its receivables. Factoring activity resulted in a decrease of approximately $1.6 billion in cash flows from operating activities during the year ended December 31, 2020, as compared to the prior year. This decrease in factoring activity was driven by a decrease in factoring levels at Collins Aerospace and Pratt & Whitney primarily driven by lower sales volume.2019 Compared with 2018 - Continuing OperationsCash generated from operating activities in 2019 was $3.2 billion higher than 2018. The increase is largely driven by an increase in Net income after adjustments for depreciation and amortization, the deferred income tax provision, stock compensation costs, and the net periodic pension and other postretirement (income) expense of $2.3 billion and an increase in other long term assets and liabilities cash flows of $1.1 billion, partially offset by a decrease in working capital cash flows of $0.7 billion. Factoring activity resulted in a decrease of approximately $200 million in cash generated from operating activities during the year ended December 31, 2019, as compared to the prior year. This decrease in factoring activity was primarily driven by a decrease in factoring levels at Pratt & Whitney, partially offset by an increase at Collins Aerospace.We make both required and discretionary contributions to our pension plans. Required contributions are primarily determined by Employee Retirement Income Security Act of 1974 (ERISA) funding rules, which require us to fully fund our U.S qualified pension plans over a rolling seven-year period as determined annually based on the Pension Protection Act of 2006 (PPA) calculated funded status at the beginning of each year. The funding requirements are primarily based on the year’s expected service cost and amortization of other previously unfunded liabilities, which are dependent upon many factors, including returns on invested assets, the level of market interest rates and actuarial assumptions. We can contribute cash or RTC shares to our plans at our discretion, subject to applicable regulations. As of December 31, 2020, the total investment by the U.S. qualified pension plans in RTC shares was less than 1% of total plan assets.We made the following contributions to our U.S. qualified and international defined benefit and PRB plans’ trusts during the years ended December 31: (dollars in millions)202020192018U.S. qualified defined benefit plans$885 $25 $— International defined benefit plans125 30 79 PRB plans15 — — Total$1,025 $55 $79 The contributions to our U.S. qualified defined benefit plans for the year ended December 31, 2020 include a $750 million discretionary contribution to the Raytheon Company U.S. qualified pension plans’ trust. As a result of this discretionary contribution, we do not expect to make any required contributions to our U.S. qualified plans’ trust until 2022.The contributions to our International defined benefit plans for the year ended December 31, 2020 include a $51 million discretionary contribution. We expect to make total contributions of approximately $50 million to our international defined benefit plans’ trusts in 2021, which are expected to meet or exceed the current funding requirements.53Table of ContentsGlobal pension and PRB cash funding requirements are expected to be $370 million, $850 million and $750 million in 2021, 2022 and 2023, respectively, which includes benefit payments to be paid directly by the company.Operating Activities - Discontinued OperationsThe $3,790 million decrease in cash flows provided by operating activities from discontinued operations in 2020 compared to 2019 primarily relates to a decrease in net income from discontinued operations driven by the absence of operating activity for the majority of the year, as the Separation Transactions occurred on April 3, 2020. The $590 million decrease in cash flows provided by operating activities from discontinued operations in 2019 compared to 2018 primarily relates to a decrease in net income from discontinued operations, partially offset by an increase in working capital cash inflows.Cash Flow—Investing Activities(dollars in millions)202020192018Net cash flows provided by (used in) investing activities from continuing operations$3,343 $(2,676)$(17,259)Net cash flows (used in) provided by investing activities from discontinued operations(241)(416)286 Our investing activities primarily include capital expenditures, cash investments in customer financing assets, investments/dispositions of businesses, payments related to our collaboration intangible assets and contractual rights to provide product on new aircraft platforms, and settlements of derivative contracts not designated as hedging instruments.2020 Compared with 2019 - Continuing OperationsThe $6.0 billion increase in cash flows used in investing activities in 2020 compared to 2019 primarily relates to cash acquired in the Raytheon Merger of $3.2 billion, the sale of our Collins Aerospace military GPS and space-based precision optics businesses for a combined $2.3 billion in gross cash proceeds and a net increase in the source of cash from customer financing assets of $747 million, partially offset by an increase in cash outflows resulting from the Blue Canyon Technologies acquisition of $419 million. Additions to property, plant and equipment were as follows:(dollars in millions)202020192018Additions to property, plant and equipment$(1,795)$(1,868)$(1,467)Capital expenditures decreased by $73 million in 2020 compared to 2019 as reductions at Collins Aerospace of $321 million and Pratt & Whitney of $257 million were largely offset by increased capital expenditures driven by the Raytheon Merger.Dispositions of businesses in 2020 of $2,556 million primarily related to the sale of our Collins Aerospace military GPS and space-based precision optics businesses for a combined $2.3 billion in gross cash proceeds.Increases to customer financing assets is primarily driven by additional Geared Turbofan engines to support customer fleets and was a use of cash of $280 million and $787 million in 2020 and 2019, respectively. The decline within increases to customer financing assets is due to fewer engines added in 2020 compared to 2019. The decrease in customer financing assets which provided a source of cash of $368 million in 2020 compared to $128 million in 2019 is driven by a sale and leaseback transaction for the sale of equipment in 2020. Refer to “Note 12: Leases” within Item 8 of this Form 10-K for additional discussion of the sale lease-back transaction.In 2020, we increased our collaboration intangible assets by approximately $172 million, which primarily relates to payments made under our 2012 agreement to acquire Rolls-Royce’s collaboration interests in International Aero Engines AG (IAE).At December 31, 2020, we had commercial aerospace financing and other contractual commitments, including exclusivity and collaboration payments of approximately $13.4 billion. Refer to “Note 19: Commitments and Contingencies” within Item 8 of this Form 10-K for further details on our commercial aerospace financing and other contractual commitments. As discussed in “Note 15: Financial Instruments” within Item 8 of this Form 10-K, we enter into derivative instruments primarily for risk management purposes, including derivatives designated as hedging instruments under the Derivatives and Hedging Topic of the Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) and those utilized as economic hedges. We operate internationally and in the normal course of business, are exposed to fluctuations in interest rates, foreign exchange rates and commodity prices. These fluctuations can increase the costs of financing, investing and operating the business. We have used derivative instruments, including swaps, forward contracts and options to manage certain foreign currency, interest rate and commodity price exposures. During the years ended December 31, 2020 and 2019, we had net cash receipts of approximately $32 million and $342 million, respectively, from the settlement of these derivative instruments not designated as hedging instruments.54Table of ContentsIn October 2020, we entered into a definitive agreement to sell our Forcepoint business, which we completed in January 2021, for $1.1 billion in cash.In December 2020, we completed the acquisition of Blue Canyon Technologies, a leading provider of small satellites and spacecraft systems components, for $426 million, net of cash received. Blue Canyon Technologies is reported in the Raytheon Intelligence & Space segment. 2019 Compared with 2018 - Continuing OperationsThe $14.6 billion decrease in cash flows used in investing activities in 2019 compared to 2018 primarily relates to the absence of cash paid to acquire Rockwell Collins of $14.9 billion in November 2018.Capital expenditures of $1.9 billion for 2019 increased $401 million from 2018. This increase primarily relates to several projects at Collins Aerospace and investments in production and aftermarket capacity at Pratt & Whitney.Dispositions of businesses in 2019 of $134 million primarily consisted of the businesses sold in connection with the Rockwell Acquisition.Increases to customer financing assets is primarily driven by additional Geared Turbofan engines to support customer fleets and was a use of cash of $787 million and $988 million in 2019 and 2018, respectively. The decrease in the source of cash related to customer financing assets of $128 million in 2019 compared to $604 million in 2018 is driven by lower repayments on customer financing. In 2019, we increased our collaboration intangible assets by approximately $351 million, which primarily relates to payments made under our 2012 agreement to acquire Rolls-Royce’s collaboration interests in IAE. Investing Activities - Discontinued OperationsThe $175 million increase in cash flows used in investing activities from discontinued operations in 2020 compared to 2019 primarily relates to a reduction in capital expenditures at Carrier and Otis of approximately $300 million, partially offset by a reduction in investment cash of approximately $135 million. The $702 million decrease in cash flows provided by investing activities from discontinued operations in 2019 compared to 2018 primarily relates to the absence of $1.0 billion in proceeds from the sale of Taylor Company in June 2018 by Carrier, partially offset by a decrease in business acquisition activity.Cash Flow—Financing Activities(dollars in millions)202020192018Net cash flows (used in) provided by financing activities from continuing operations$(3,860)$(1,913)$12,209 Net cash flows used in financing activities from discontinued operations(1,414)(2,651)(4,244)Our financing activities primarily include the issuance and repayment of short-term and long-term debt, payment of dividends and stock repurchases. 2020 Compared with 2019 - Continuing OperationsFinancing activities were a cash outflow of $3.9 billion in 2020 compared to a cash outflow of $1.9 billion in 2019. This change is driven by increases in long-term debt repayments of $13.4 billion, a $4.4 billion change in net cash transfers to discontinued operations, an increase in short-term borrowing repayments of $2.9 billion, and an increase in dividends paid on common stock of $0.3 billion, partially offset by an increase in long-term debt issuances of $19.2 billion. The 2020 debt issuances reflect debt incurred by Carrier and Otis of approximately $6 billion and $11 billion, respectively. The net proceeds of these issuances and draws were primarily utilized by UTC to extinguish Raytheon Technologies short-term and long-term debt in order to not exceed the maximum applicable net indebtedness required by the Raytheon Merger Agreement.At December 31, 2020, management had remaining authority to repurchase approximately $5.0 billion of our common stock under the December 7, 2020 share repurchase program. Under this program, shares may be purchased on the open market, in privately negotiated transactions, under accelerated share repurchase programs, and under plans complying with Rules 10b5-1 and 10b-18 under the Securities Exchange Act of 1934, as amended. We may also reacquire shares outside of the program from time to time in connection with the surrender of shares to cover taxes on vesting of restricted stock and as required under our employee savings plan. We expect to engage in share repurchase activity in 2021. Our ability to repurchase shares is subject to applicable law.2019 Compared with 2018 - Continuing OperationsFinancing activities was a cash outflow of $1.9 billion in 2019 compared to a cash inflow of $12.2 billion in 2018. This change is driven by the absence of $13.4 billion of long-term debt issuances in the prior year which was primarily utilized to fund the 55Table of ContentsRockwell Acquisition, an increase in dividends paid on common stock of $0.3 billion and an increase in debt repayments of $0.2 billion, partially offset by an increase in short term borrowings of $1.3 billion and a reduction in common stock repurchases of $0.2 billion.Our share repurchases were as follows for the years ended December 31:(dollars in millions; shares in thousands)202020192018$Shares$Shares$SharesShares of Common Stock repurchased$47 330 $151 1,133 $325 2,727 Our Board of Directors authorized the following cash dividends for the years ended December 31:(dollars in millions, except per share amounts)202020192018Dividends per share of Common Stock$2.160 $2.940 $2.840 Total dividends paid$2,732 $2,442 $2,170 On February 6, 2021, the Board of Directors declared a dividend of $0.475 per share payable March 25, 2021 to shareowners of record at the close of business on February 26, 2021.We had the following issuances of long-term debt during 2020 and 2018, which is inclusive of issuances made by Carrier and Otis which were primarily used by the Company to extinguish certain Raytheon Technologies short-term and long-term debt and, therefore, were treated as a distribution from discontinued operations within financing activities from continuing operation on our Consolidated Statement of Cash Flows:Issuance DateDescription of NotesAggregate Principal Balance (in millions)May 18, 20202.250% notes due 2030$1,000 3.125% notes due 2050$1,000 March 27, 2020Term Loan due 2023 (Otis) (1)$1,000 Term Loan due 2023 (Carrier) (1)$1,750 February 27, 20201.923% notes due 2023 (1)$500 LIBOR plus 0.450% floating rate notes due 2023 (1)$500 2.056% notes due 2025 (1)$1,300 2.242% notes due 2025 (1)$2,000 2.293% notes due 2027 (1)$500 2.493% notes due 2027 (1)$1,250 2.565% notes due 2030 (1)$1,500 2.722% notes due 2030 (1)$2,000 3.112% notes due 2040 (1)$750 3.377% notes due 2040 (1)$1,500 3.362% notes due 2050 (1)$750 3.577% notes due 2050 (1)$2,000 August 16, 20183.350% notes due 2021 (2)$1,000 3.650% notes due 2023 (2)$2,250 3.950% notes due 2025 (2)$1,500 4.125% notes due 2028 (2)$3,000 4.450% notes due 2038 (2)$750 4.625% notes due 2048 (3)$1,750 LIBOR plus 0.65% floating rate notes due 2021 (2)$750 May 18, 20181.150% notes due 2024 (4)€750 2.150% notes due 2030 (4)$500 EURIBOR plus 0.20% floating rate notes due 2020 (4)$750 (1) The debt issuances and term loan draws reflect debt incurred by Carrier and Otis. The net proceeds of these issuances were primarily utilized to extinguish Raytheon Technologies short-term and long-term debt in order to not exceed the maximum applicable net indebtedness required by the Raytheon Merger Agreement.56Table of Contents(2) The net proceeds received from these debt issuances were used to partially finance the cash consideration portion of the purchase price for Rockwell Collins and fees, expenses and other amounts related to the Rockwell Acquisition. (3) The net proceeds from these debt issuances were used to fund the repayment of commercial paper and for other general corporate purposes. (4) The net proceeds received from these debt issuances were used for general corporate purposes. We had no issuances of long-term debt during 2019. We made the following repayments of debt during 2020, 2019 and 2018:Repayment DateDescription of NotesAggregate Principal Balance (in millions)October 15, 20203.125% notes due 2020 (1)$1,000 May 19, 20203.650% notes due 2023 (2)(3)$410 May 15, 2020EURIBOR plus 0.20% floating rate notes due 2020 (€750 million principal value)(3)$817 March 29, 20204.500% notes due 2020 (2)(3)$1,250 1.125% notes due 2021 (€950 million principal value) (2)(3)$1,082 1.250% notes due 2023 (€750 million principal value) (2)(3)$836 1.150% notes due 2024 (€750 million principal value) (2)(3)$841 1.875% notes due 2026 (€500 million principal value) (2)(3)$567 March 3, 20201.900% notes due 2020 (2)(3)$1,000 3.350% notes due 2021 (2)(3)$1,000 LIBOR plus 0.650% floating rate notes due 2021 (2)(3)$750 1.950% notes due 2021 (2)(3)$750 2.300% notes due 2022 (2)(3)$500 3.100% notes due 2022 (2)(3)$2,300 2.800% notes due 2024 (2)(3)$800 March 2, 20204.875% notes due 2020 (2)(3)$171 February 28, 20203.650% notes due 2023 (2)(3)$1,669 2.650% notes due 2026 (2)(3)$431 November 15, 20198.875% notes $271 November 13, 2019EURIBOR plus 0.15% floating rate notes €750 November 1, 2019LIBOR plus 0.350% floating rate notes $350 1.500% notes $650 July 15, 20191.950% notes (4)$300 5.250% notes (4)$300 December 14, 2018Variable-rate term loan due 2020 (1 month LIBOR plus 1.25%) (4)$482 May 4, 20181.778% junior subordinated notes$1,100 February 22, 2018EURIBOR plus 0.80% floating rate notes€750 February 1, 20186.80% notes$99 (1) These notes were assumed in connection with the Raytheon Merger and subsequently repaid.(2) In connection with the early repayment of outstanding principal, Raytheon Technologies recorded debt extinguishment costs of $703 million for the year ended December 31, 2020, which are classified as discontinued operations in our Consolidated Statement of Operations as we would not have had to redeem the debt, except for the Separation Transactions. No proceeds of the notes issued May 18, 2020 were used to fund the May 19, 2020 redemption.(3) Extinguishment of Raytheon Technologies short-term and long-term debt in order to not exceed the maximum net indebtedness required by the Raytheon Merger Agreement.(4) These notes were assumed in connection with the Rockwell Collins Acquisition and subsequently repaid. Financing Activities - Discontinued OperationsThe $1.2 billion decrease in cash flows used in financing activities from discontinued operations in 2020 compared to 2019 primarily relates to $703 million of debt extinguishment costs related to the early repayment of debt in 2020 and cash distributions made to Carrier and Otis of $2.8 billion, which were more than offset by a change in net transfer activity of $4.5 billion. The $1.6 billion decrease in cash flows used in financing activities from discontinued operations in 2019 compared to 2018 primarily relates to the change in net transfers to continuing operations.57Table of ContentsCRITICAL ACCOUNTING ESTIMATESPreparation of our financial statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses. Management believes the most complex and sensitive judgments, because of their significance to the Consolidated Financial Statements, result primarily from the need to make estimates about the effects of matters that are inherently uncertain. The most significant areas involving management judgments and estimates are described below. Actual results in these areas could differ from management’s estimates.Long-Term Contract Accounting. We recognize revenue on an over-time basis for substantially all defense contracts and certain long-term aerospace aftermarket contracts. We measure progress toward completion of these contracts on a percentage of completion basis, using costs incurred to date relative to total estimated costs at completion. Incurred costs represent work performed, which correspond with and best depict transfer of control to the customer. Contract costs are incurred over a period of time, which can be several years, and the estimation of these costs requires management’s judgment. We review our Estimate at Completion (EACs) on significant contracts on a periodic basis and for others, no less than annually or when a change in circumstances warrant a modification to a previous estimate. Due to the nature of the work required to be performed on many of the Company’s performance obligations, the estimation of total revenue and cost at completion is complex, subject to many variables and requires significant judgment by management on a contract by contract basis. As part of this process, management reviews information including, but not limited to, any outstanding key contract matters, progress towards completion and the related program schedule, identified risks and opportunities and the related changes in estimates of revenues and costs. The risks and opportunities relate to management’s judgment about the ability and cost to achieve the schedule, consideration of customer-directed delays or reductions in scheduled deliveries, technical requirements, customer activity levels, such as flight hours or aircraft landings, and related variable consideration. Management’s judgment related to these considerations has become increasingly more significant given the current economic environment primarily caused by the COVID-19 pandemic. Management must make assumptions and estimates regarding contract revenue and costs, including estimates of labor productivity and availability, the complexity and scope of the work to be performed, the availability and cost of materials, the length of time to complete the performance obligation, execution by our subcontractors, the availability and timing of funding from our customer, overhead cost rates, and current and past maintenance cost and frequency driven by estimated aircraft and engine utilization and estimated useful lives of components, among others. In particular, fixed-price development programs involve significant management judgment, as development contracts by nature have elements that have not been done before and thus, are highly subject to future unexpected cost growth. Cost estimates may also include the estimated cost of satisfying our industrial cooperation agreements, sometimes in the form of either offset obligations or in-country industrial participation (ICIP) agreements, required under certain contracts primarily within our RIS and RMD segments. These obligations may or may not be distinct depending on their nature. If cash is paid to a customer to satisfy our offset obligations it is recorded as a reduction in the transaction price. Changes in estimates of net sales, cost of sales and the related impact to operating profit are recognized on a cumulative catch-up basis, which recognizes the cumulative effect of the profit changes on current and prior periods based on a performance obligation’s percentage of completion in the current period. A significant change in one or more of these estimates could affect the profitability of one or more of our performance obligations. Our EAC adjustments also include the establishment of loss provisions on our contracts accounted for on a percentage of completion basis. Net EAC adjustments had the following impact on our operating results:(dollars in millions, except per share amounts)202020192018Operating profit (loss)$(643)$(69)$(50)Income (loss) from continuing operations attributable to common shareowners (1)(508)(55)(40)Diluted earnings (loss) per share from continuing operations attributable to common shareowners (1)$(0.37)$(0.06)$(0.05)(1) Amounts reflect a U.S. statutory tax rate of 21%, which approximates our tax rate on our EAC adjustments.As a result of the Raytheon Merger, Raytheon Company’s contracts accounted for on a percentage of completion basis were reset to zero percent complete as of the merger date, since only the unperformed portion of the contract at the merger date represents the obligation of the Company. For additional information related to the Raytheon Merger, see “Note 2: Acquisitions, Dispositions, Goodwill and Intangible Assets” within Item 8 of this Form 10-K.Costs incurred for engineering and development of aerospace products under contracts with customers are capitalized as contract fulfillment costs, to the extent recoverable from the associated contract margin and customer funding, and subsequently amortized as the OEM products are delivered to the customer. The estimation of contract margin requires management’s judgment. We regularly assess capitalized contract fulfillment costs for impairment.58Table of ContentsIncome Taxes. Management believes that our earnings during the periods when the temporary differences become deductible will be sufficient to realize the related future income tax benefits, which may be realized over an extended period of time. For those jurisdictions where the expiration date of tax carryforwards or the projected operating results indicate that realization is not likely, a valuation allowance is provided.In assessing the need for a valuation allowance, we estimate future taxable income, considering the feasibility of ongoing tax planning strategies and the realizability of tax loss carryforwards. Valuation allowances related to deferred tax assets can be affected by changes to tax laws, changes to statutory tax rates and future taxable income levels. In the event we were to determine that we would not be able to realize all or a portion of our deferred tax assets in the future, we would reduce such amounts through an increase to tax expense in the period in which that determination is made or when tax law changes are enacted. Conversely, if we were to determine that we would be able to realize our deferred tax assets in the future in excess of the net carrying amounts, we would decrease the recorded valuation allowance through a decrease to tax expense in the period in which that determination is made.In the ordinary course of business there is inherent uncertainty in quantifying our income tax positions. We assess our income tax positions and record tax benefits for all years subject to examination based upon management’s evaluation of the facts, circumstances and information available at the reporting date. For those tax positions where it is more likely than not that a tax benefit will be sustained, we have recorded the largest amount of tax benefit with a greater than 50% likelihood of being realized upon ultimate settlement with a taxing authority that has full knowledge of all relevant information. For those income tax positions where it is not more likely than not that a tax benefit will be sustained, no tax benefit has been recognized in the financial statements. In addition, we have entered into certain internal legal entity restructuring transactions necessary to effectuate the Separation Transactions. We have accrued tax on these transactions based on our interpretation of the applicable tax laws and our determination of appropriate entity valuations. See “Note 1: Basis of Presentation and Summary of Accounting Principles” and “Note 13: Income Taxes” within Item 8 of this Form 10-K for further discussion.Management has determined that the distributions of Carrier and Otis on April 3, 2020, and certain related internal business separation transactions, qualified as tax-free under applicable law. In making these determinations, we applied the tax law in the relevant jurisdictions to our facts and circumstances and obtained tax rulings from the relevant taxing authorities, tax opinions, and/or other external tax advice related to the concluded tax treatment. If the completed distributions of Carrier or Otis, in each case, or certain internal business separation transactions, were to fail to qualify for tax-free treatment, the Company could be subject to significant liabilities, and there could be material adverse impacts on the Company’s business, financial condition, results of operations and cash flows in future reporting periods.Goodwill and Intangible Assets. The assets and liabilities of acquired businesses are recorded under the acquisition method of accounting at their estimated fair values at the dates of acquisition. Goodwill represents costs in excess of fair values assigned to the underlying identifiable net assets of acquired businesses. Intangible assets acquired in business combinations consist of patents, trademarks/tradenames, developed technology, customer relationships, and other intangible assets. The fair value for acquired customer relationship intangibles is determined as of the acquisition date based on estimates and judgments regarding expectations for the future after-tax cash flows arising from the follow-on revenue from customer relationships that existed on the acquisition date over their estimated lives, including the probability of expected future contract renewals and revenue, less a contributory assets charge, all of which is discounted to present value. The fair value of the trademark and tradename intangible assets are determined utilizing the relief from royalty method which is a form of the income approach. Under this method, a royalty rate based on observed market royalties is applied to projected revenue supporting the tradename and discounted to present value using an appropriate discount rate. See “Note 1: Basis of Presentation and Summary of Accounting Principles” within Item 8 of this Form 10-K for further details.We applied these approaches to the valuation of intangibles for the Raytheon Merger, for which the most significant intangible assets identified were customer relationships and tradenames. Specific to these intangible assets, our estimates of market participant future cash flows included forecasted revenue growth rates, remaining developmental effort, operational performance including company specific synergies, program life cycles, material and labor pricing, and other relevant customer, contractual and market factors. For the customer relationships, where appropriate, the net cash flows were probability-adjusted to reflect the uncertainties associated with the underlying assumptions, including cancellation rates related to backlog, government demand for sole-source and recompete contracts and win rates for recompete contracts, as well as the risk profile of the net cash flows utilized in the valuation. In addition, the net cash flows were discounted using an appropriate discount rate that requires judgment by management. The estimated fair value of identifiable intangible assets acquired in connection with the Raytheon Merger was approximately $19.1 billion.Also included within intangible assets are exclusivity assets, which are payments made to secure certain contractual rights to provide products on new commercial aerospace platforms. Such payments are capitalized when there are distinct rights obtained and there are sufficient incremental cash flows to support the recoverability of the assets established. Otherwise, the applicable 59Table of Contentsportion of the payments are expensed. The gross value of these contractual commitments at December 31, 2020 was approximately $11.6 billion, of which approximately $3.3 billion has been paid to date. We regularly assess the recoverability of these intangibles, which is dependent upon our assumptions around the future success and profitability of the underlying aircraft platforms including the associated aftermarket revenue streams, and the related future cash flows.Goodwill and intangible assets deemed to have indefinite lives are not amortized, but are subject to impairment testing annually, or more frequently if events or changes in circumstances indicate the asset might be impaired. The impairment test compares carrying values of the reporting units to its estimated fair values. If the carrying value exceeds the fair value then the carrying value is reduced to fair value. In developing our estimates for the fair value of our reporting units, significant judgment is required in the determination of the appropriateness of using a qualitative assessment or quantitative assessment. For the quantitative assessments that are performed, fair value is primarily based on income approaches using a discounted cash flow method and relief from royalty method, which have significant assumptions including sales growth rates, projected operating profit, terminal growth rates, discount rates and royalty rates. Such assumptions are subject to variability from year to year and are directly impacted by, among other things, global market conditions.We considered the deterioration in general economic and market conditions primarily due to the COVID-19 pandemic to be a triggering event in the first and second quarters of 2020, requiring an impairment evaluation of goodwill, intangible assets and other assets in our commercial aerospace businesses, Collins Aerospace and Pratt & Whitney. Beginning in the second quarter of 2020, we observed several airline customer bankruptcies, delays and cancellations of aircraft purchases by airlines, fleet retirements and repositioning of OEM production schedules and we experienced a significant decline in revenues at our Collins Aerospace and Pratt & Whitney businesses due to a decline in flight hours, aircraft fleet utilization, shop visits and commercial OEM deliveries. These factors contributed to a deterioration of our expectations regarding the timing of a return to pre-COVID-19 commercial flight activity, which further reduced our future sales and cash flows expectations.In the second quarter of 2020, we evaluated the Collins Aerospace and Pratt & Whitney reporting units for goodwill impairment and determined that the carrying values of two of the six Collins Aerospace reporting units exceeded the sum of discounted future cash flows, resulting in goodwill impairments of $3.2 billion. Collins Aerospace discounted future cash flow estimates were developed for three scenarios: a base case, a downside case, and an upside case. These scenarios included assumptions regarding future airline flight activity, out of warranty hours on original equipment, expected repairs, upgrades and replacements, future OEM manufacturing schedules and related environmental assumptions, including individuals’ desire to return to normal travel, business needs to travel, and potential cures or vaccines to prevent or reduce the effects of COVID-19. These estimates require a significant amount of judgment and are subject to change based upon factors outside our control. We weighted the three scenarios as follows: 50% for the base case, 40% for the downside case, and 10% for the upside case, and used these weightings, as we believed they reflected the risks and opportunities relative to our estimates. Goodwill impairment was not indicated for any of the other reporting units evaluated for impairment in any of these scenarios. We did not identify any further deterioration to our expectations in the third quarter of 2020, and therefore, did not have a triggering event.On October 1, 2020, we changed our annual goodwill impairment testing date from July 1 to October 1 to better align with the timing of our annual long-term planning process. This change was not material to our Consolidated Financial Statements as it did not delay, accelerate, or avoid any potential goodwill impairment charges. We completed our annual impairment testing as of October 1, 2020, where we assessed our Pratt & Whitney, RIS, RMD and one of the Collins Aerospace reporting units using qualitative factors to determine whether it was more likely than not that any individual reporting unit’s fair value is less than its carrying value (step 0) and determined that no further testing was required based on there being no significant changes at RIS and RMD since the acquisition of Raytheon Company and the substantial cushion of fair value over book value at the other reporting units. For the remainder of our Collins Aerospace reporting units, we compared the fair value of the reporting units to their respective carrying values (step 1), and determined that no additional adjustments to the carrying value of goodwill were necessary.Based on our annual impairment analysis as of October 1, 2020, the reporting unit that was closest to impairment was a reporting unit at Collins Aerospace with a fair value in excess of book value, including goodwill, of $1.2 billion or 7%. All other factors equal, if the discount rate used for the annual impairment analysis increased by 25 basis points, the fair value in excess of book value for the Collins Aerospace reporting unit would have been approximately $0.3 billion or 2%. Alternatively, all other factors equal, if the cash flows were decreased by 10%, the fair value for the Collins Aerospace reporting unit would have decreased by approximately $1.8 billion. Material changes in these estimates could occur and result in additional impairments in future periods.The Company continuously monitors for events and circumstances that could negatively impact the key assumptions in determining the fair value of goodwill, including long-term revenue growth projections, profitability, discount rates, recent market valuations from transactions by comparable companies, volatility in the Company’s market capitalization, and general 60Table of Contentsindustry, market and macro-economic conditions. It is possible that future changes in such circumstances, including a more prolonged and/or severe COVID-19 pandemic than originally anticipated, or future changes in the variables associated with the judgments, assumptions and estimates used in assessing the fair value of our reporting units, including the expected long term recovery of airline travel to pre-COVID-19 levels, would require the Company to record a non-cash impairment charge.Contingent Liabilities. Our operating units include businesses which sell products and services and conduct operations throughout the world. As described in “Note 19: Commitments and Contingencies” within Item 8 of this Form 10-K, contractual, regulatory and other matters in the normal course of business may arise that subject us to claims or litigation. Of note, the design, development, production and support of new aerospace technologies is inherently complex and subject to risk. Since the PW1000G Geared Turbofan engine entered into service in 2016, technical issues have been identified and experienced with the engine, which is typical for new engines and new aerospace technologies. Pratt & Whitney has addressed these issues through various improvements and modifications. These issues have resulted in financial impacts, including increased warranty provisions, customer contract settlements, and reductions in contract performance estimates. Additional technical issues, either related to this program or other programs, may also arise in the normal course, which may result in financial impacts that could be material to the Company’s financial position, results of operations and cash flows.Additionally, we have significant contracts with the U.S. government, subject to government oversight and audit, which may require significant adjustment of contract prices. We accrue for liabilities associated with these matters when it is probable that a liability has been incurred and the amount can be reasonably estimated. The most likely cost to be incurred is accrued based on an evaluation of then currently available facts with respect to each matter. When no amount within a range of estimates is more likely, the minimum is accrued. The inherent uncertainty related to the outcome of these matters can result in amounts materially different from any provisions made with respect to their resolution.Employee Benefit Plans. We sponsor domestic and foreign defined benefit pension and PRB plans. Assumptions used to calculate our funded status are determined based on company data and appropriate market indicators. They are evaluated annually at December 31 and when significant events require a mid-year remeasurement. A change in any of these assumptions or actual experience that differs from these assumptions are subject to recognition in pension and postretirement net periodic benefit (income) expense reported in the Consolidated Financial Statements.Assumptions used in the accounting for these employee benefit plans require judgement. Major assumptions include the discount rate and EROA. Other assumptions include mortality rates, demographic assumptions (such as retirement age), rate of increase in employee compensation levels, and health care cost increase projections. The weighted-average discount rates used to measure pension and PRB liabilities are based on yield curves developed using high-quality corporate bonds as well as plan specific cash flows. For our significant plans, we utilize a full yield curve approach in the estimation of the service cost and interest cost components of net periodic benefit expense by applying the specific spot rates along the yield curve used in determination of the benefit obligation to the relevant discounted projected cash flows. The following table shows the sensitivity of our pension and PRB plan liabilities and net periodic benefit income to a 25 basis point change in the discount rates for benefit obligations, interest cost and service cost as of December 31, 2020:(dollars in millions)Increase in Discount Rate of 25 bpsDecrease in Discount Rate of 25 bpsProjected benefit obligation$(2,072)$2,183 Net periodic benefit income(7)8 The discount rate sensitivities assume no change in the shape of the yield curve that will be applied to the projected cash outflows for future benefit payments in order to calculate interest and service cost. A flattening of the yield curve, results in a narrowing of the spread between interest and obligation discount rates and would decrease our net periodic benefit income. Conversely, a steepening of the yield curve would result in an increase in the spread between interest and obligation discount rates and would increase our net periodic benefit income.The EROA is the average rate of earnings expected over the long term on assets invested to fund anticipated future benefit payment obligations. In determining the EROA assumption, we consider the target asset allocation of plan assets, as well as economic and other indicators of future performance. We may consult with and consider the opinions of financial and other professionals in determining the appropriate capital market assumptions. Return projections are validated using a simulation model that incorporates yield curves, credit spreads and risk premiums to project long-term prospective returns. Differences between actual asset returns in a given year and the EROA do not necessarily indicate a change in the assumption is required, as the EROA represents the expected average returns over a long-term horizon.Net periodic benefit income is also sensitive to changes in the EROA. An increase or decrease of 25 basis points in the EROA would have increased or decreased our 2020 net periodic benefit income by approximately $116 million.61Table of ContentsWe must apply both Financial Accounting Standards (FAS) requirements under U.S. GAAP (as described above) and U.S. government Cost Accounting Standards (CAS) requirements to calculate pension and PRB expense. Both FAS and CAS expense use long term assumptions requiring judgement, but the CAS expense calculation is different from the FAS requirements and calculation methodology. While the ultimate liability for pension costs under FAS and CAS is similar, the pattern of cost recognition is different. Our CAS pension expense is comprised primarily of CAS service cost as well as amortization amounts resulting from demographic or economic experience different than expected, changes in assumptions, or changes in plan provisions. CAS requires contractors to compare the liability using a discount rate based on the EROA to a liability using a discount rate based on high-quality corporate bonds, and use the greater of the two liability calculations in developing CAS expense. Additionally, unlike FAS, CAS expense is only recognized for plans that are not fully funded. Consequently, if plans become or cease to be fully funded under CAS due to our asset or liability experience, our CAS expense will change accordingly.ACCOUNTING STANDARDSFor a discussion of recent accounting pronouncements, see the Accounting Pronouncements section in “Note 1: Basis of Presentation and Summary of Accounting Principles” within Item 8 of this Form 10-K.OFF-BALANCE SHEET ARRANGEMENTS AND CONTRACTUAL OBLIGATIONSWe extend a variety of financial guarantees to third parties in support of unconsolidated affiliates and for potential financing requirements of commercial aerospace customers. We also have obligations arising from sales of certain businesses and assets, including indemnities for representations and warranties and environmental, health and safety, tax and employment matters. Circumstances that could cause the contingent obligations and liabilities arising from these arrangements to come to fruition include changes in an underlying transaction (e.g., hazardous waste discoveries, etc.), nonperformance under a contract, customer requests for financing, or deterioration in the financial condition of the guaranteed party.A summary of our consolidated contractual obligations and commitments as of December 31, 2020 is as follows: Payments Due by Period(dollars in millions)Total20212022-20232024-2025ThereafterLong-term debt—principal$31,470 $550 $2,805 $2,844 $25,271 Long-term debt—future interest19,915 1,328 2,532 2,390 13,665 Operating leases2,470 632 803 389 646 Purchase obligations22,111 14,407 6,669 874 161 Other long-term liabilities3,642 587 2,001 261 793 Total contractual obligations$79,608 $17,504 $14,810 $6,758 $40,536 Purchase obligations include amounts committed for the purchase of goods and services under legally enforceable contracts or purchase orders. Where it is not practically feasible to determine the legally enforceable portion of our obligation under certain of our long-term purchase agreements, we include additional expected purchase obligations beyond what is legally enforceable. Approximately 60% of our purchase obligations disclosed above represent purchase orders for products to be delivered under firm contracts with the U.S. government for which we have full recourse under customary contract termination clauses.Other long-term liabilities primarily include those amounts on our December 31, 2020 balance sheet representing performance and operating cost guarantees, estimated environmental remediation costs and expected cash funding requirements under employee benefit programs. Amounts beyond 2023 for cash funding requirements under employee benefits plans are not included. The timing of expected cash flows associated with these obligations is based upon management’s estimates over the terms of these agreements and is largely based upon historical experience.The above table also does not reflect unrecognized tax benefits of $1,225 million, the timing of which is uncertain, except for $36 million that may become payable during 2021. Refer to “Note 13: Income Taxes” within Item 8 of this Form 10-K for additional discussion on unrecognized tax benefits.COMMITMENTS AND CONTINGENCIESRefer to “Note 19: Commitments and Contingencies” within Item 8 of this Form 10-K for discussion on contractual commitments and contingencies.62Table of ContentsENVIRONMENTAL MATTERSOur operations are subject to environmental regulation by federal, state and local authorities in the United States and regulatory authorities with jurisdiction over our foreign operations. As a result, we have established, and continually update, policies relating to environmental standards of performance for our operations worldwide. We believe that expenditures necessary to comply with the present regulations governing environmental protection will not have a material effect upon our competitive position, results of operations, cash flows or financial condition.We have been identified as a potentially responsible party under the Comprehensive Environmental Response Compensation and Liability Act (CERCLA), more commonly known as a Superfund, for a number of sites. The nature and extent of environmental concerns vary from site to site and our share of responsibility varies from sole responsibility to very little responsibility. In estimating our liability for remediation, we consider our likely proportionate share of the anticipated remediation expense and the ability of other potentially responsible parties to fulfill their obligations. We also lease certain government-owned properties and generally are not liable for remediation of preexisting environmental contamination at these sites. As a result, we generally do not provide for these costs in our Consolidated Financing Statements. At December 31, 2020 and 2019, we had $835 million and $725 million reserved for environmental remediation, respectively. Cash outflows for environmental remediation were $53 million in 2020, $44 million in 2019, and $41 million in 2018. We estimate that ongoing environmental remediation expenditures in each of the next two years will not exceed approximately $100 million.GOVERNMENT MATTERSAs described above in “Critical Accounting Estimates—Contingent Liabilities,” our contracts with the U.S. government are subject to audits. Such audits may recommend that certain contract prices should be reduced to comply with various government regulations, or that certain payments be delayed or withheld. We are also the subject of one or more investigations and legal proceedings initiated by the U.S. government with respect to government contract matters. See Item 3. Legal Proceedings, within Part I, and “Note 13: Income Taxes” and “Note 19: Commitments and Contingencies” within Item 8 of this Form 10-K for further discussion of these and other government matters.ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKOur primary market exposures are to fluctuations in foreign currency exchange rates and interest rates as it relates to our market risk sensitive instruments, which are primarily cash, debt and derivative instruments. To quantify our market risk exposure, we perform a sensitivity analysis based on hypothetical changes in foreign currency exchange rates and interest rates. We changed our methodology for quantifying our market risk exposure in the second quarter of 2020 to better align with how we manage our risk exposure. Refer to “Note 1: Basis of Presentation and Summary of Accounting Principles,” “Note 10: Borrowings and Lines of Credit” and “Note 15: Financial Instruments” within Item 8 of this Form 10-K for additional discussion of foreign currency exchange, interest rates and financial instruments.Foreign Currency Exchange Rate Risk. We are subject to foreign currency exchange rate risk relating to receipts from customers and payments to suppliers in foreign currencies and to various internal or external financing arrangements. We use foreign currency forward contracts to hedge the price risk associated with firmly committed and forecasted foreign denominated payments and receipts related to our ongoing business and financing. We actively manage foreign currency exposures that are associated with committed foreign currency purchases and sales, and other assets and liabilities created in the normal course of business at the operating unit level. More than insignificant exposures that cannot be naturally offset within an operating unit are hedged with foreign currency derivatives. Foreign exchange exposures arising from intercompany loan and deposit transactions are also hedged regularly. The aggregate notional amount of our outstanding foreign currency hedges was $11.6 billion and $13.0 billion at December 31, 2020 and 2019, respectively. Foreign currency forward contracts are sensitive to changes in foreign currency exchange rates. A 10% unfavorable exchange rate movement in our portfolio of foreign currency contracts would have resulted in an increase in unrealized losses of $0.8 billion and $1.2 billion at December 31, 2020 and 2019, respectively. Such losses or gains would be offset by corresponding gains or losses in the remeasurement of the underlying transactions being hedged. We believe these foreign currency forward exchange contracts and the offsetting underlying commitments, when taken together, do not create material market riskWithin our aerospace business, our sales are typically denominated in U.S. Dollars. However, for our non-U.S. based entities, such as Pratt & Whitney Canada (P&WC), a substantial portion of their costs are incurred in local currencies. Consequently, there is a foreign currency exchange impact and risk to operational results as U.S. Dollars must be converted to local currencies such as the Canadian Dollar in order to meet local currency cost obligations. Additionally, we transact business in various foreign currencies which exposes our cash flows and earnings to changes in foreign currency exchange rates. In order to minimize the exposure that exists from changes in the exchange rate of the U.S. Dollar against these other currencies, we hedge 63Table of Contentsa certain portion of sales to secure the rates at which U.S. Dollars will be converted. The majority of this hedging activity occurs at P&WC and Collins Aerospace, and hedging activity also occurs to a lesser extent at the remainder of Pratt & Whitney. At P&WC and Collins Aerospace, firm and forecasted sales for both original equipment and spare parts are hedged at varying amounts for up to 49 months on the U.S. Dollar sales exposure as represented by the excess of U.S. Dollar sales over U.S. Dollar denominated purchases. Hedging gains and losses resulting from movements in foreign currency exchange rates are partially offset by the foreign currency translation impacts that are generated on the translation of local currency operating results into U.S. Dollars for reporting purposes. While the objective of the hedging program is to minimize the foreign currency exchange impact on operating results, there are typically variances between the hedging gains or losses and the translational impact due to the length of hedging contracts, changes in the sales profile, volatility in the exchange rates and other such operational considerations.Interest Rate Risk. We have financial instruments that are subject to interest rate risk, principally fixed-rate debt obligations. A 100 basis points unfavorable interest rate movement would have had an approximate $4 billion impact on the fair value of our fixed-rate debt at both December 31, 2020 and 2019. The investors in our fixed-rate debt obligations do not generally have the right to demand we pay off these obligations prior to maturity. Therefore, exposure to interest rate risk is not believed to be material for our fixed-rate debt. From time to time, we may hedge to floating rates using interest rate swaps. Currently, we do not hold any derivative contracts that hedge our interest exposures, but may consider such strategies in the future.64Table of Contents
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+ITEM 7.MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSYou should read the following discussion in conjunction with our audited consolidated financial statements and the notes thereto included in Item 8 of this Form 10-K. This discussion may contain forward-looking statements that anticipate results that are subject to uncertainty. We discuss in more detail various factors that could cause actual results to differ from expectations in Item 1A, Risk Factors in this Form 10-K.For further discussion regarding our results of operations for the year ended December 31, 2019 as compared to the year ended December 31, 2018, refer to Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operations, in our Annual Report on Form 10-K for the fiscal year ended December 31, 2019. Recent DevelopmentsIn March 2020, the World Health Organization declared the outbreak of a new strain of coronavirus (COVID-19) a pandemic. The COVID-19 pandemic has negatively impacted the global economy, disrupted global supply chains and created significant volatility and disruption of financial markets. The full extent of the impact of the COVID-19 pandemic on our operations and financial performance will depend on future developments, including the duration and spread of the pandemic, all of which are uncertain and cannot be predicted at this time. Both national and local government agencies have implemented steps to slow the spread of the virus, including shelter-in-place orders and the mandatory shutdown of certain businesses. During this time, we continued to provide essential services to our customers. In mid-March 2020, certain customers in our small- and large-container businesses began adjusting their service levels, which included a decrease in the frequency of pickups or a temporary pause in service. In addition, we experienced a decline in volumes disposed at certain of our landfills and transfer stations. As service levels decreased, we also experienced a decrease in certain costs of our operations which are variable in nature. This decline in service activity peaked in the first half of April and gradually recovered thereafter as local economies began to gradually reopen and customers began to resume service. Large outbreaks and resurgences of COVID-19 in various regions may result in a reinstitution of certain restrictions and further adjustments in our service levels, which would negatively impact our business.31Table of ContentsThe demand for our environmental solutions business depends on the continued demand for, and production of, oil and natural gas in certain shale basins located in the United States. During the year ended December 31, 2020, the price of crude oil and natural gas reached historic lows, resulting in a decrease in rig counts and drilling activity that led to a year-over-year decrease in revenue from our environmental solutions business. During the three months ended December 31, 2020, we recognized a $42.6 million charge as a loss on business divestitures and impairments, net in our consolidated income statement resulting from management’s decision to exit certain product offerings and geographic basins in our upstream environmental solutions business. As the carrying value of the assets associated with these operations was no longer recoverable, we impaired the entire net book value of certain assets, comprised mainly of equipment, vehicles, and containers. On at least a quarterly basis, we will continue to monitor the effect of the evolving COVID-19 pandemic on our business and review our estimates for recoverability of assets.In April 2020, we launched our Committed to Serve initiative to help our employees, customers and communities across the United States. We committed $20 million to support frontline employees and their families, as well as small business customers in the local communities where we serve. In addition to this initiative, we have experienced an increase in certain costs of doing business as a direct result of the COVID-19 pandemic, including costs for additional safety equipment and hygiene products and increased facility and equipment cleaning. These costs are intended to assist in protecting the safety of our frontline employees as we continue to provide an essential service to our customers. We also incurred incremental costs for guaranteeing certain frontline employees a minimum hourly work week regardless of service decreases. In the fourth quarter, we recognized our frontline employees for their commitment and contributions to their communities during the pandemic with a $500 award that was paid in January 2021. In 2020, we incurred costs of $68.4 million as a direct and incremental result of the COVID-19 pandemic. In addition, we incurred incremental costs associated with expanding certain aspects of our existing healthcare programs. We expect to incur similar costs throughout 2021, and potentially into future years, although we expect the annual amount of such costs to be less than those incurred in 2020. The effects of the COVID-19 pandemic on our business are described in more detail in the Results of Operations discussion in this Management's Discussion and Analysis of Financial Condition and Results of Operations.2021 Financial GuidanceIn 2021, we will focus on driving profitable growth, making disciplined acquisition investments, maintaining an inclusive and engaging culture for our people, and advancing technology to empower our employees, increase connectivity with our customers and drive operational excellence. Our team remains focused on executing our strategy to deliver consistent earnings and free cash flow growth, and improving return on invested capital. We are committed to maintaining an efficient capital structure, preserving our investment grade credit ratings and increasing cash returned to our shareholders.Our guidance is based on current economic conditions and does not assume any significant changes in the overall economy in 2021. Specific guidance follows:RevenueWe expect an increase in average yield of approximately 2.5% and volume growth to be in a range of 1.5% to 2.0%.Adjusted Diluted Earnings per ShareThe following is a summary of anticipated adjusted diluted earnings per share for the year ending December 31, 2021 compared to the actual adjusted diluted earnings per share for the year ended December 31, 2020. Adjusted diluted earnings per share is not a measure determined in accordance with U.S. GAAP:(Anticipated) Year Ending December 31, 2021(Actual) Year Ended December 31, 2020Diluted earnings per share$ 3.61 to 3.68$3.02 Loss on extinguishment of debt and other related costs— 0.23 Withdrawal costs - multiemployer pension funds— 0.08 Restructuring charges0.04 to 0.050.05 Loss on business divestitures and impairments, net— 0.21 Bridgeton insurance recovery— (0.03)Adjusted diluted earnings per share$ 3.65 to 3.73$3.56 We believe that the presentation of adjusted diluted earnings per share, which excludes loss on extinguishment of debt and other related costs, multiemployer pension fund withdrawal costs, restructuring charges, loss on business divestitures and impairments, net, and Bridgeton insurance recoveries provides an understanding of operational activities before the financial 32Table of Contentseffect of certain items. We use this measure, and believe investors will find it helpful, in understanding the ongoing performance of our operations separate from items that have a disproportionate effect on our results for a particular period. We have incurred comparable charges and costs in prior periods, and similar types of adjustments can reasonably be expected to be recorded in future periods. Our definition of adjusted diluted earnings per share may not be comparable to similarly titled measures presented by other companies.OverviewRepublic is one of the largest providers of environmental services in the United States, as measured by revenue. As of December 31, 2020, we operated facilities in 41 states through 345 collection operations, 220 transfer stations, 186 active landfills, 76 recycling processing centers, 6 treatment, recovery and disposal facilities, 9 salt water disposal wells, and 7 deep injection wells. We are engaged in 75 landfill gas-to-energy and renewable energy projects and had post-closure responsibility for 128 closed landfills.Revenue for the year ended December 31, 2020 decreased by (1.4)% to $10,153.6 million compared to $10,299.4 million for the same period in 2019. This change in revenue is due to decreased volumes of (3.1)%, fuel recovery fees of (0.7)%, and environmental solutions of (0.9)%, partially offset by increases in average yield of 2.6%, acquisitions, net of divestitures of 0.4%, recycling processing and commodity sales of 0.3%, and one additional workday as compared to 2019. The following table summarizes our revenue, costs and expenses for the years ended December 31, 2020 and 2019 (in millions of dollars and as a percentage of revenue): 20202019Revenue$10,153.6 100.0 %$10,299.4 100.0 %Expenses:Cost of operations6,100.5 60.1 6,298.4 61.2 Depreciation, amortization and depletion of property and equipment1,015.9 10.0 985.8 9.6 Amortization of other intangible assets21.2 0.2 20.4 0.2 Amortization of other assets38.8 0.4 34.3 0.3 Accretion82.9 0.8 81.9 0.8 Selling, general and administrative1,053.0 10.4 1,091.9 10.6 Withdrawal costs - multiemployer pension funds34.5 0.3 — — Loss (gain) on business divestitures and impairments, net77.7 0.8 (14.7)(0.1)Restructuring charges20.0 0.2 14.2 0.1 Operating income$1,709.1 16.8 %$1,787.2 17.3 %Our pre-tax income was $1,142.7 million for the year ended December 31, 2020, compared to $1,295.8 million in 2019. Our net income attributable to Republic Services, Inc. was $967.2 million, or $3.02 per diluted share for 2020, compared to $1,073.3 million, or $3.33 per diluted share, for 2019.33Table of ContentsDuring 2020 and 2019, we recorded a number of charges, other expenses and benefits that impacted our pre-tax income, net income attributable to Republic Services, Inc. (net income – Republic) and diluted earnings per share as noted in the following table (in millions, except per share data). Additionally, see our Results of Operations section of this Management's Discussion and Analysis of Financial Condition and Results of Operations for a discussion of other items that impacted our earnings during the years ended December 31, 2020 and 2019. For comparative purposes, prior year amounts have been reclassified to conform to current year presentation. Year Ended December 31, 2020Year Ended December 31, 2019 Pre-taxIncomeNetIncome -RepublicDilutedEarningsperSharePre-taxIncomeNetIncome -RepublicDilutedEarningsperShareAs reported$1,142.7 $967.2 $3.02 $1,295.8 $1,073.3 $3.33 Loss on extinguishment of debt and other related costs99.1 73.0 0.23 — — — Restructuring charges20.0 14.8 0.0514.2 10.4 0.04Loss (gain) on business divestitures and impairments, net77.7 65.5 0.21 (14.7)(8.7)(0.03)Withdrawal costs - multiemployer pension funds34.5 25.5 0.08 — — — Fire-damage related costs— — — 7.7 5.7 0.02 Bridgeton insurance recovery(10.8)(8.2)(0.03)(24.0)(18.3)(0.06)Incremental contract startup costs - large municipal contract (1)— — — 0.7 0.5 — Total adjustments220.5 170.6 0.54 (16.1)(10.4)(0.03)As adjusted$1,363.2 $1,137.8 $3.56 $1,279.7 $1,062.9 $3.30 (1) The aggregate impact to adjusted diluted earnings per share totals to less than $0.01 for the year ended December 31, 2019.We believe that presenting adjusted pre-tax income, adjusted net income – Republic, and adjusted diluted earnings per share, which are not measures determined in accordance with U.S. GAAP, provide an understanding of operational activities before the financial impact of certain items. We use these measures, and believe investors will find them helpful, in understanding the ongoing performance of our operations separate from items that have a disproportionate impact on our results for a particular period. We have incurred comparable charges and costs in prior periods, and similar types of adjustments can reasonably be expected to be recorded in future periods. Our definitions of adjusted pre-tax income, adjusted net income – Republic, and adjusted diluted earnings per share may not be comparable to similarly titled measures presented by other companies. Further information on each of these adjustments is included below.Loss on extinguishment of debt and other related costs. During 2020, we incurred a loss on the early extinguishment of debt and other related costs related to the early extinguishment of our $600.0 million 5.250% senior notes due November 2021 (the 2021 Notes) and our $850.0 million 3.550% senior notes due June 2022 (the 2022 Notes), and to redeem $250.0 million of the $550.0 million outstanding 4.750% senior notes due May 2023 (the 2023 Notes). We paid total cash premiums of $99.1 million and incurred non-cash charges related to the proportional share of unamortized discounts and deferred issuance costs of $2.8 million. The unamortized proportional share of certain cash flow hedges reclassified to earnings as non-cash interest expense was $1.8 million, and the proportional share of our fair value hedges (related to the 2023 Notes) that were dedesignated and recognized in earnings as a reduction to non-cash interest expense was $4.7 million. During 2019, we did not incur any losses on the early extinguishment of certain financing arrangements.Restructuring charges. In 2019, we incurred costs related to the redesign of certain back-office software systems, which continued into 2020. In addition, in July 2020, we eliminated certain back-office support positions in response to a decline in the underlying demand for services resulting from the COVID-19 pandemic. During 2020, we incurred restructuring charges of $20.0 million which primarily related to these restructuring efforts. During 2019, we incurred restructuring charges of $14.2 million, which primarily related to the redesign of certain of our back-office software systems. We paid $15.5 million and $10.6 million during 2020 and 2019, respectively, related to these restructuring efforts.In 2021, we expect to incur additional restructuring charges of approximately $15 million to $20 million primarily related to the redesign of certain of our back-office software systems. Substantially all of these restructuring charges will be recorded in our corporate segment.Loss (gain) on business divestitures and impairments, net. During 2020, we recorded a net loss on business divestitures and impairments of $77.7 million which was due to business divestitures and asset impairments in certain markets, including $42.6 million resulting from management’s decision to exit certain product offerings and geographic basins in our upstream environmental solutions business. During 2019, we recorded a net gain on business divestitures and impairments of $(14.7) million.34Table of ContentsWithdrawal costs - multiemployer pension funds. During 2020, we recorded charges to earnings of $34.5 million for withdrawal events at multiemployer pension funds to which we contribute. As we obtain updated information regarding multiemployer pension funds, the factors used in deriving our estimated withdrawal liabilities will be subject to change, which may adversely impact our reserves for withdrawal costs. Fire-damage related costs. During the three months ended December 31, 2019, certain of our owned and operated facilities in our Group 1 segment were impacted by separate fire-related events. Although our business may incur fire-related damage to our leased or owned property, plant and equipment from time to time, we specifically identify in the table above fire-damage related costs of $7.7 million incurred during 2019, due to its magnitude. Bridgeton insurance recovery. During 2020 and 2019, we recognized insurance recoveries of $10.8 million and $24.0 million, respectively, related to our closed Bridgeton Landfill in Missouri, which we recognized as a reduction of remediation expenses in our cost of operations. Incremental contract start-up costs - large municipal contract. Although our business regularly incurs startup costs under municipal contracts, we specifically identify in the table above the startup costs with respect to an individual municipal contract (and do not adjust for other startup costs under other contracts in 2020 or 2019). We do this because of the magnitude of the costs involved with this particular municipal contract and the unusual nature for the time period in which they were incurred. During 2019, we incurred costs of $0.7 million related to the implementation of this large municipal contract. These costs did not meet the capitalization criteria prescribed by Accounting Standards Update 2014-09, Revenue from Contracts with Customers (Topic 606) and Other Assets and Deferred Costs-Contracts with Customers (Subtopic 340-40).Results of OperationsRevenueWe generate revenue by providing environmental services to our customers, including the collection and processing of recyclable materials, collection, transfer and disposal of non-hazardous solid waste, and other environmental solutions. Our residential, small-container and large-container collection operations in some markets are based on long-term contracts with municipalities. Certain of our municipal contracts have annual price escalation clauses that are tied to changes in an underlying base index such as a consumer price index. We generally provide small-container and large-container collection services to customers under contracts with terms up to three years. Our transfer stations and landfills generate revenue from disposal or tipping fees charged to third parties. Our recycling processing centers generate revenue from tipping fees charged to third parties and the sale of recycled commodities. Our revenue from environmental solutions consists mainly of fees we charge for disposal of non-hazardous solid and liquid material and in-plant services, such as transportation and logistics. Environmental solutions waste is generated from the by-product of oil and natural gas exploration and production activity. Additionally, it is generated by the daily operations of industrial, petrochemical and refining facilities, including maintenance, plant turnarounds and capital projects. Other non-core revenue consists primarily of revenue from National Accounts, which represents the portion of revenue generated from nationwide or regional contracts in markets outside our operating areas where the associated material handling is subcontracted to local operators. Consequently, substantially all of this revenue is offset with related subcontract costs, which are recorded in cost of operations.35Table of ContentsThe following table reflects our revenue by service line for the years ended December 31, 2020 and 2019 (in millions of dollars and as a percentage of revenue): 20202019Collection:Residential$2,309.0 22.7 %$2,271.9 22.1 %Small-container3,106.8 30.6 3,170.0 30.8 Large-container2,148.9 21.2 2,249.6 21.8 Other51.5 0.5 46.1 0.4 Total collection7,616.2 75.0 7,737.6 75.1 Transfer1,349.4 1,318.7 Less: intercompany(745.9)(748.1)Transfer, net603.5 5.9 570.6 5.5 Landfill2,298.1 2,324.2 Less: intercompany(1,018.5)(1,024.1)Landfill, net1,279.6 12.6 1,300.1 12.6 Environmental solutions127.7 1.3 191.7 1.9 Other:Recycling processing and commodity sales297.1 2.9 273.3 2.7 Other non-core229.5 2.3 226.1 2.2 Total other526.6 5.2 499.4 4.9 Total revenue$10,153.6 100.0 %$10,299.4 100.0 %The following table reflects changes in components of our revenue, as a percentage of total revenue, for the years ended December 31, 2020 and 2019:20202019Average yield2.6 %2.8 %Fuel recovery fees(0.7)— Total price1.9 2.8 Volume(3.1)(0.4)Recycling processing and commodity sales0.3 (0.3)Environmental solutions(0.9)(0.3)Total internal growth(1.8)1.8 Acquisitions / divestitures, net0.4 0.8 Total(1.4)%2.6 %Core price4.8 %4.7 %Average yield is defined as revenue growth from the change in average price per unit of service, expressed as a percentage. Core price is defined as price increases to our customers and fees, excluding fuel recovery, net of price decreases to retain customers. We also measure changes in average yield and core price as a percentage of related-business revenue, defined as total revenue excluding recycled commodities and fuel recovery fees, to determine the effectiveness of our pricing strategies. Average yield as a percentage of related-business revenue was 2.8% and 2.9% for 2020 and 2019, respectively. Core price as a percentage of related-business revenue was 5.0% for both 2020 and 2019.During 2020, we experienced the following changes in our revenue as compared to 2019:•Average yield increased revenue by 2.6% due to positive pricing changes in all lines of business.•The fuel recovery fee program, which mitigates our exposure to increases in fuel prices, decreased revenue by (0.7)%, primarily due to a decrease in fuel prices compared to the same period in 2019 and a decrease in the total revenue subject to the fuel recovery fees. •Volume decreased revenue by (3.1)% primarily due to a reduction in service levels attributable to the COVID-19 36Table of Contentspandemic. We experienced volume declines in our small- and large-container lines of business as a result of a reduction in the frequency of pickups or a temporary pause in service for certain of our customers. In addition, we experienced declines in special waste volumes disposed at certain of our landfills and a decrease in volumes at our transfer stations. These decreases were partially offset by an increase in construction and demolition volumes in our landfill line of business along with one additional workday as compared to 2019. •Recycling processing and commodity sales increased revenue by 0.3% primarily due to an increase in overall commodity prices as compared to 2019. The average price for recycled commodities, excluding glass and organics for 2020 was $96 per ton compared to $77 per ton for 2019.Changing market demand for recycled commodities causes volatility in commodity prices. At current volumes and mix of materials, we believe a $10 per ton change in the price of recycled commodities will change both annual revenue and operating income by approximately $12 million.•Environmental solutions revenue decreased by (0.9)% primarily due to a decrease in rig counts, drilling activity, and the delay of in-plant project work as a result of lower demand for crude oil.•Acquisitions, net of divestitures, increased revenue by 0.4% due to our continued growth strategy of acquiring privately held environmental services companies that complement our existing business platform. This was partially offset by a decrease in revenue due to the divestiture of certain non-strategic assets during the year.Cost of OperationsCost of operations includes labor and related benefits, which consists of salaries and wages, health and welfare benefits, incentive compensation and payroll taxes. It also includes transfer and disposal costs representing tipping fees paid to third party disposal facilities and transfer stations; maintenance and repairs relating to our vehicles, equipment and containers, including related labor and benefit costs; transportation and subcontractor costs, which include costs for independent haulers that transport our material to disposal facilities and costs for local operators who provide environmental services associated with our National Accounts in markets outside our standard operating areas; fuel, which includes the direct cost of fuel used by our vehicles, net of fuel tax credits; disposal fees and taxes, consisting of landfill taxes, host community fees and royalties; landfill operating costs, which includes financial assurance, leachate disposal, remediation charges and other landfill maintenance costs; risk management costs, which include insurance premiums and claims; cost of goods sold, which includes material costs paid to suppliers; and other, which includes expenses such as facility operating costs, equipment rent and gains or losses on sale of assets used in our operations.The following table summarizes the major components of our cost of operations for the years ended December 31, 2020 and 2019 (in millions of dollars and as a percentage of revenue): 20202019Labor and related benefits$2,153.4 21.2 %$2,202.4 21.4 %Transfer and disposal costs796.9 7.9 841.7 8.2 Maintenance and repairs969.6 9.6 1,006.2 9.8 Transportation and subcontract costs674.1 6.6 674.9 6.5 Fuel271.7 2.7 347.9 3.4 Disposal fees and taxes313.5 3.1 325.7 3.2 Landfill operating costs258.2 2.5 244.7 2.4 Risk management213.9 2.1 230.7 2.2 Other460.0 4.5 440.6 4.2 Subtotal6,111.3 60.2 6,314.8 61.3 Fire-damage related costs (1)— — 7.6 0.1 Bridgeton insurance recovery(10.8)(0.1)(24.0)(0.2)Total cost of operations$6,100.5 60.1 %$6,298.4 61.2 %(1) During the three months and year ended December 31, 2019, we incurred an additional $0.1 million of fire-damage related costs, which are reflected in other selling, general, and administrative expense. These cost categories may change from time to time and may not be comparable to similarly titled categories presented by other companies. As such, you should take care when comparing our cost of operations by component to that of other companies and of ours for prior periods.37Table of ContentsOur cost of operations decreased for the year ended December 31, 2020 compared to the same period in 2019 as a result of the following:•Labor and related benefits decreased due to a decline in service levels attributable to the COVID-19 pandemic, partially offset by higher hourly and salaried wages as a result of annual merit increases, and one additional workday during 2020 as compared to 2019.•Transfer and disposal costs decreased as a result of lower collection volumes, partially offset by an increase in third party disposal rates. During both 2020 and 2019, approximately 68% of the total solid waste volume we collected was disposed at landfill sites that we own or operate (internalization).•Maintenance and repairs expense decreased due to a decrease in service levels attributable to the COVID-19 pandemic.•Transportation and subcontract costs decreased slightly primarily due to a decline in demand for our environmental solutions business as well as a decrease in transfer station volumes, partially offset by increases due to acquisition-related activity along with one additional workday during 2020 as compared to 2019.•Fuel costs decreased due to a decline in fuel prices and service levels attributable to the COVID-19 pandemic. The national average cost per gallon for diesel fuel in 2020 was $2.55 compared to $3.06 for 2019.At current consumption levels, we believe a twenty-cent per gallon change in the price of diesel fuel would change our fuel costs by approximately $25 million per year. Offsetting these changes in fuel expense would be changes in our fuel recovery fee charged to our customers. At current participation rates, we believe a twenty-cent per gallon change in the price of diesel fuel would change our fuel recovery fee by approximately $25 million per year.•Disposal fees and taxes decreased due to a decrease in service levels attributable to the COVID-19 pandemic.•Landfill operating expenses increased due to the recognition of certain favorable remediation adjustments in 2019 that did not recur in 2020.•Risk management expenses decreased primarily due to favorable actuarial development in our auto liability and workers compensation prior year programs, coupled with a decline in exposure in our current year program.•Other costs of operations increased during 2020 as a result of incremental costs incurred related to the COVID-19 pandemic, including costs for additional safety equipment and hygiene products, increased facility and equipment cleaning, and costs associated with our Committed to Serve initiative, partially offset by a decline in necessary facility repairs as well as decreased third party equipment rentals as a result of a decline in service levels attributable to the COVID-19 pandemic. •During 2019, we incurred $7.6 million of fire-related damage costs in our cost of operations that resulted from damage to our leased or owned property, plant and equipment in our Group 1 segment.•During 2020 and 2019, we recognized favorable insurance recoveries of $10.8 million and $24.0 million, respectively, related to our closed Bridgeton Landfill as a reduction of remediation expenses in our consolidated statement of income for the applicable period.Depreciation, Amortization and Depletion of Property and EquipmentThe following table summarizes depreciation, amortization and depletion of property and equipment for the years ended December 31, 2020 and 2019 (in millions of dollars and as a percentage of revenue): 20202019Depreciation and amortization of property and equipment$692.9 6.8 %$652.8 6.4 %Landfill depletion and amortization323.0 3.2 333.0 3.2 Depreciation, amortization and depletion expense$1,015.9 10.0 %$985.8 9.6 %Depreciation and amortization of property and equipment increased primarily due to additional assets acquired with our acquisitions.Landfill depletion and amortization decreased in aggregate dollars due to lower landfill disposal volumes primarily driven by decreased special waste volumes, partially offset by an increase in our overall average depletion rate.Amortization of Other Intangible AssetsExpenses for amortization of other intangible assets were $21.2 million and $20.4 million for the years ended December 31, 2020 and 2019, respectively, or 0.2% of revenue for both 2020 and 2019. Our other intangible assets primarily relate to 38Table of Contentscustomer relationships and, to a lesser extent, non-compete agreements. Amortization expense increased due to additional assets acquired with our acquisitions.Amortization of Other AssetsExpenses for amortization of other assets were $38.8 million, or 0.4% of revenue, for the year ended December 31, 2020, compared to $34.3 million, or 0.3% of revenue, for 2019. Our other assets primarily relate to the prepayment of fees and capitalized implementation costs associated with cloud-based hosting arrangements. Accretion ExpenseAccretion expense was $82.9 million and $81.9 million, or 0.8% of revenue, for the years ended December 31, 2020 and 2019, respectively. Accretion expense has remained relatively unchanged as our asset retirement obligations remained relatively consistent period over period.Selling, General and Administrative ExpensesSelling, general and administrative expenses include salaries, health and welfare benefits, and incentive compensation for corporate and field general management, field support functions, sales force, accounting and finance, legal, management information systems, and clerical and administrative departments. Other expenses include rent and office costs, fees for professional services provided by third parties, legal settlements, marketing, investor and community relations services, directors’ and officers’ insurance, general employee relocation, travel, entertainment and bank charges. Restructuring charges are excluded from selling, general and administrative expenses and are discussed separately.The following table summarizes our selling, general and administrative expenses for the years ended December 31, 2020 and 2019 (in millions of dollars and as a percentage of revenue): 20202019Salaries and related benefits$740.5 7.3 %$751.9 7.3 %Provision for doubtful accounts27.8 0.3 34.0 0.3 Other284.7 2.8 306.0 3.0 Total selling, general and administrative expenses$1,053.0 10.4 %$1,091.9 10.6 %These cost categories may change from time to time and may not be comparable to similarly titled categories used by other companies. As such, you should take care when comparing our selling, general and administrative expenses by cost component to those of other companies and of ours for prior periods.The most significant items affecting our selling, general and administrative expenses during 2020 as compared to 2019 are summarized below:•In 2020, salaries and related benefits decreased in aggregate dollars primarily due to a decrease in compensation expense related to our performance shares and continued efficiencies at our customer resource centers attributable to our investments in enhanced technology platforms. This decrease was partially offset by higher wages, benefits and other payroll related items resulting from annual merit increases.•Provision for doubtful accounts decreased in aggregate dollars during 2020, primarily due to improved collections during the period as demonstrated by the reduction in our days sales outstanding to 38.6, or 26.4 days net of deferred revenue, as of December 31, 2020 compared to 39.8, or 27.9 days net of deferred revenue, as of December 31, 2019.•Other selling, general and administrative expenses decreased during 2020, primarily due to a decrease in travel and advertising costs as a result of the COVID-19 pandemic. These decreases were partially offset by an increase in facility and equipment cleaning expenses attributable to the COVID-19 pandemic, professional fees, certain charitable donations associated with our Committed to Serve initiative, and acquisition deal costs. Withdrawal Costs - Multiemployer Pension FundsDuring 2020, we recorded charges to earnings of $34.5 million for withdrawal events at multiemployer pension funds to which we contribute. We paid $34.4 million during 2020 relative to these withdrawal events. As we obtain updated information regarding multiemployer pension funds, the factors used in deriving our estimated withdrawal liabilities will be subject to change, which may adversely impact our reserves for withdrawal costs. Loss (Gain) on Business Divestitures and Impairments, NetWe strive to have a number one or number two market position in each of the markets we serve, or have a clear path on how we 39Table of Contentswill achieve a leading market position over time. Where we cannot establish a leading market position, or where operations are not generating acceptable returns, we may decide to divest certain assets and reallocate resources to other markets. Business divestitures could result in gains, losses or impairment charges that may be material to our results of operations in a given period.During 2020, we recorded a net loss on business divestitures and impairments of $77.7 million, which was due to business divestitures and asset impairments in certain markets, including $42.6 million resulting from management's decision to exit certain product offerings and geographic basins in our upstream environmental solutions business. During 2019, we recorded a net gain on business divestitures and impairments of $(14.7) million. Restructuring ChargesIn 2019, we incurred costs related to the redesign of certain back-office software systems, which continued into 2020. In addition, in July 2020, we eliminated certain back-office support positions in response to a decline in the underlying demand for services resulting from the COVID-19 pandemic. During 2020, we incurred restructuring charges of $20.0 million which primarily related to these restructuring efforts. During 2019, we incurred restructuring charges of $14.2 million, which primarily related to the redesign of certain of our back-office software systems. We paid $15.5 million and $10.6 million during 2020 and 2019, respectively, related to these restructuring efforts.Interest ExpenseThe following table provides the components of interest expense, including accretion of debt discounts and accretion of discounts primarily associated with environmental and risk insurance liabilities assumed in acquisitions (in millions of dollars):20202019Interest expense on debt$300.1 $350.4 Non-cash interest61.7 48.8 Less: capitalized interest(6.2)(7.2)Total interest expense$355.6 $392.0 Total interest expense for 2020 decreased compared to 2019 primarily due to lower interest rates on our floating and fixed rate debt. The decrease attributable to our fixed rate debt is primarily due to the issuance of $350.0 million of 0.875% senior notes and $750.0 million of 1.750% senior notes in November 2020, $650.0 million of 1.450% senior notes in August 2020, $600.0 million of 2.300% senior notes and $400.0 million of 3.050% senior notes in February 2020, as well as the issuance of $900.0 million of 2.500% senior notes in August 2019, the proceeds of which were used to repay outstanding senior notes with coupons ranging from 3.550% to 5.500%. During 2020 and 2019, cash paid for interest, excluding net swap settlements for our fixed to floating interest rate swaps, was $325.1 million and $346.8 million, respectively. Loss on Extinguishment of DebtDuring 2020, we incurred a $101.9 million loss on the early extinguishment of debt . We paid total cash premiums during the year totaling $99.1 million and incurred non-cash charges related to the proportional share of unamortized discounts and deferred issuance costs of $2.8 million.Income TaxesOur provision for income taxes was $173.1 million and $222.0 million for 2020 and 2019, respectively. Our effective income tax rate was 15.2% and 17.1% for 2020 and 2019, respectively. We made income tax payments (net of refunds) of approximately $124 million and $31 million for 2020 and 2019, respectively. Income taxes paid in 2020 and 2019 reflect benefits from 100% bonus depreciation on qualified assets as well as tax credits from our continuing investments in solar energy.During 2020, we acquired non-controlling interests in limited liability companies established to own solar energy assets that qualified for investment tax credits under Section 48 of the Internal Revenue Code. We account for these investments using the equity method of accounting and recognize our share of income or loss and other reductions in the value of our investments in loss from unconsolidated equity method investments within our consolidated statements of income. For further discussion regarding our equity method accounting, see Note 3, Business Acquisitions, Investments and Restructuring Charges, of the notes to our consolidated financial statements in Item 8 of this Form 10-K. Our 2020 tax provision reflects a benefit of approximately $100 million due to the tax credits related to these investments. In addition, our 2020 tax provision was reduced by $17.2 million for adjustments to our valuation allowance due to the realizability of certain state loss carryforwards. Lastly, our provision was further reduced by $8.2 million due to the realization of additional federal and state benefits as well as 40Table of Contentsadjustments to deferred taxes due to the completion of our 2019 tax returns and $11.6 million from excess tax benefits related to stock compensation.Our 2019 tax provision was reduced by $12.3 million from excess tax benefits related to stock compensation, approximately $84 million related to the tax credits from our non-controlling interests in limited liability companies established to own solar energy assets, and approximately $13 million due to the realization of tax credits and lower state rates due to changes in estimates following the completion of our 2018 tax returns.During the three months ended December 31, 2020, we determined that it is more likely than not that we will realize a portion of our deferred tax assets related to certain state loss carryforwards. Most of these loss carryforwards are attributable to a specific subsidiary for which we have historically provided a partial valuation allowance due to the uncertainty surrounding the future utilization of these carryforwards in the tax jurisdictions where the loss carryforwards exist. The realization of these deferred tax assets depends upon the existence of sufficient taxable income in future periods. As a result of recent changes in U.S. tax law, the current macroeconomic environment and our ongoing efforts to streamline and maximize the efficiency of our tax footprint, we completed our restructuring plan which optimized our tax structure to better align with our overall operational footprint. This resulted in a reduction to our valuation allowance of $17.2 million for the year and three months ended December 31, 2020.We have deferred tax assets related to state net operating loss carryforwards of approximately $99 million available as of December 31, 2020. These state net operating loss carryforwards expire at various times between 2021 and 2040. We believe that it is more likely than not that the benefit from some of our state net operating loss carryforwards will not be realized due to limitations on these loss carryforwards in certain states. In recognition of this risk, as of December 31, 2020, we have provided a valuation allowance of approximately $44 million.Reportable SegmentsIn December 2020, our senior management began evaluating, overseeing and managing the financial performance of our operations through three operating segments. Group 1 primarily consists of geographic areas located in the western United States, and Group 2 primarily consists of geographic areas located in the southeastern and mid-western United States, and the eastern seaboard of the United States. Our environmental solutions operating segment, which provides waste management solutions for daily operations of industrial, petrochemical and refining facilities, is aggregated with Corporate entities and other as it only represents approximately 1% of our consolidated revenue. Each of our reportable segments provides integrated environmental services, including collection, transfer, recycling, and disposal services.Summarized financial information concerning our reportable segments for the years ended December 31, 2020 and 2019 is shown in the following table (in millions of dollars and as a percentage of revenue in the case of operating margin):NetRevenueDepreciation, Amortization, Depletion andAccretion BeforeAdjustments forAsset RetirementObligationsAdjustments to AmortizationExpensefor AssetRetirementObligationsDepreciation,Amortization,Depletion andAccretionLoss (Gain) onBusiness Divestitures and Impairments, NetOperatingIncome(Loss)OperatingMargin2020:Group 1$5,057.5 $522.1 $(20.0)$502.1 $— $1,343.3 26.6 %Group 24,791.9 506.4 (17.5)488.9 — 966.4 20.2 %Corporate entities and other304.2 142.8 25.0 167.8 77.7 (600.6)— Total$10,153.6 $1,171.3 $(12.5)$1,158.8 $77.7 $1,709.1 16.8 %2019:Group 1$5,001.9 $505.9 $(12.2)$493.7 $— $1,231.7 24.6 %Group 24,944.4 496.6 (21.5)475.1 — 926.5 18.7 %Corporate entities and other353.1 130.8 22.8 153.6 (14.7)(371.0)— Total$10,299.4 $1,133.3 $(10.9)$1,122.4 $(14.7)$1,787.2 17.4 %Financial information for the year ended December 31, 2019 reflects the transfer of our environmental solutions operating segment from Group 2 to Corporate entities and other. Corporate entities and other include legal, tax, treasury, information technology, risk management, human resources, closed landfills, environmental solutions, and other administrative functions. National Accounts revenue included in corporate entities represents the portion of revenue generated from nationwide and regional contracts in markets outside our operating areas where the associated material handling is subcontracted to local 41Table of Contentsoperators. Consequently, substantially all of this revenue is offset with related subcontract costs, which are recorded in cost of operations.Significant changes in the revenue and operating margins of our reportable segments for 2020 compared to 2019 are discussed below.Group 1Revenue for 2020 increased 1.1% from 2019 primarily due to an increase in average yield in all lines of business and one additional workday during 2020. This increase was partially offset by volume declines in our small- and large-container collection, transfer station, and landfill lines of business.Operating income for Group 1 increased from $1,231.7 million for 2019, or a 24.6% operating margin, to $1,343.3 million for 2020, or a 26.6% operating margin. The following cost categories impacted our operating income margin:•Cost of operations favorably impacted operating income margin during 2020, primarily due to a decrease in labor and related benefits, maintenance and repairs expenses, disposal fees and taxes, and fuel costs as a result of decreased service levels attributable to the COVID-19 pandemic. Fuel costs further decreased due to CNG tax credits that were enacted in December 2019 and recognized during 2020. •Landfill depletion and amortization favorably impacted operating income margin during 2020, primarily due to lower landfill disposal volumes primarily driven by decreased special waste volumes, and by favorable amortization adjustments to our asset retirement obligations during 2020 compared to the adjustments recognized in 2019. Depreciation unfavorably impacted operating margin, primarily due to additional assets acquired with our acquisitions.Group 2Revenue for 2020 decreased (3.1)% from 2019 due to volume declines in our collection lines of business as well as a decrease in special waste volumes in our landfill line of business. These decreases were partially offset by an increase in average yield in all lines of business, increases in construction and demolition and municipal solid waste volumes in our landfill line of business, and one additional workday during 2020.Operating income for Group 2 increased from $926.5 million for 2019, or an 18.7% operating margin, to $966.4 million for 2020, or a 20.2% operating margin. The following cost categories impacted our operating income margin:•Cost of operations favorably impacted operating income margin during 2020, primarily due to a decrease in labor and related benefits, transfer and disposal costs, maintenance and repairs expenses and fuel costs as a result of decreased service levels attributable to the COVID-19 pandemic. Fuel costs further decreased due to CNG tax credits that were enacted in December 2019 and recognized during 2020.•Landfill depletion and amortization unfavorably impacted operating income margin during 2020, primarily due to an increase in our overall average depletion rate, and by decreased favorable amortization adjustments to our asset retirement obligations during 2020 compared to the adjustments recognized in 2019. Depreciation unfavorably impacted operating income margin, primarily due to additional assets acquired with our acquisitions.Corporate Entities and OtherOperating loss in our Corporate entities and other segment increased from $371.0 million for 2019 to $600.6 million for 2020. During 2020, we recorded a net loss on business divestitures and impairments of $77.7 million which was due to business divestitures and asset impairments in certain markets, including $42.6 million resulting from management’s decision to exit certain product offerings and geographic basins in our upstream environmental solutions business. During 2019, we recorded a net gain on business divestitures and impairments of $(14.7) million. Additionally, we recognized an insurance recovery of $10.8 million related to our closed Bridgeton Landfill during 2020, as compared to an insurance recovery of $24.0 million recognized in the same period in 2019. During 2020, we recognized certain direct and incremental costs attributable to the COVID-19 pandemic, including costs for additional safety equipment and hygiene products, increased facility and equipment cleaning, and costs associated with our Committed to Serve initiative.Landfill and Environmental MattersOur landfill costs include daily operating expenses, costs of capital for cell development, costs for final capping, closure and post-closure, and the legal and administrative costs of ongoing environmental compliance. Daily operating expenses include leachate treatment, transportation and disposal costs, methane gas and groundwater monitoring and system maintenance costs, interim cap maintenance costs, and costs associated with applying daily cover materials. We expense all indirect landfill development costs as they are incurred. We use life cycle accounting and the units-of-consumption method to recognize certain direct landfill costs related to landfill development. In life cycle accounting, certain direct costs are capitalized and charged to 42Table of Contentsdepletion expense based on the consumption of cubic yards of available airspace. These costs include all costs to acquire and construct a site, including excavation, natural and synthetic liners, construction of leachate collection systems, installation of methane gas collection and monitoring systems, installation of groundwater monitoring wells, and other costs associated with acquiring and developing the site. Obligations associated with final capping, closure and post-closure are capitalized and amortized on a units-of-consumption basis as airspace is consumed.Cost and airspace estimates are developed at least annually by engineers. Our operating and accounting personnel use these estimates to adjust the rates we use to expense capitalized costs. Changes in these estimates primarily relate to changes in costs, available airspace, inflation and applicable regulations. Changes in available airspace include changes in engineering estimates, changes in design and changes due to the addition of airspace lying in expansion areas that we believe have a probable likelihood of being permitted. Changes in engineering estimates typically include modifications to the available disposal capacity of a landfill based on a refinement of the capacity calculations resulting from updated information.Available AirspaceAs of December 31, 2020 and 2019, we owned or operated 186 and 189 active solid waste landfills, respectively, with total available disposal capacity estimated to be 5.0 billion in-place cubic yards. For these landfills, the following table reflects changes in capacity and remaining capacity, as measured in cubic yards of airspace:Balance as of December 31, 2019NewExpansionsUndertakenLandfillsAcquired,Net ofDivestituresPermits Granted / New Sites,Net of ClosuresAirspaceConsumedChanges inEngineeringEstimatesBalance as of December 31, 2020Cubic yards (in millions):Permitted airspace4,673.0 — (5.1)205.8 (76.1)(5.1)4,792.5 Probable expansion airspace321.7 32.9 — (158.2)— — 196.4 Total cubic yards (in millions)4,994.7 32.9 (5.1)47.6 (76.1)(5.1)4,988.9 Number of sites:Permitted airspace189 (2)(1)186 Probable expansion airspace12 2 (3)11 Balance as of December 31, 2018NewExpansionsUndertakenLandfillsAcquired,Net ofDivestituresPermits Granted / New Sites,Net of ClosuresAirspaceConsumedChanges inEngineeringEstimatesBalance as of December 31, 2019Cubic yards (in millions):Permitted airspace4,736.8 — — 35.0 (81.5)(17.3)4,673.0 Probable expansion airspace341.2 6.7 — (18.1)— (8.1)321.7 Total cubic yards (in millions)5,078.0 6.7 — 16.9 (81.5)(25.4)4,994.7 Number of sites:Permitted airspace190 — (1)189 Probable expansion airspace12 2 (2)12 Total available disposal capacity represents the sum of estimated permitted airspace plus an estimate of probable expansion airspace. Engineers develop these estimates at least annually using information provided by annual aerial surveys. Before airspace included in an expansion area is determined to be probable expansion airspace and, therefore, included in our calculation of total available disposal capacity, it must meet all of our expansion criteria. See Note 2, Summary of Significant Accounting Policies, and Note 8, Landfill and Environmental Costs, of the notes to our consolidated financial statements in Item 8 of this Form 10-K for further information. Also see our Critical Accounting Judgments and Estimates section of this Management's Discussion and Analysis of Financial Condition and Results of Operations.As of December 31, 2020, 11 of our landfills met all of our criteria for including their probable expansion airspace in their total available disposal capacity. At projected annual volumes, these 11 landfills have an estimated remaining average site life of 123 years, including probable expansion airspace. The average estimated remaining life of all of our landfills is 63 years. We have other expansion opportunities that are not included in our total available airspace because they do not meet all of our criteria for treatment as probable expansion airspace.43Table of ContentsThe following table reflects the estimated operating lives of our active landfill sites based on available and probable disposal capacity using current annual volumes as of December 31, 2020:Numberof SiteswithoutProbableExpansionAirspaceNumberof SiteswithProbableExpansionAirspaceTotalSitesPercentofTotal0 to 5 years15 — 15 8.1 %6 to 10 years15 1 16 8.6 11 to 20 years27 2 29 15.6 21 to 40 years49 3 52 28.0 41+ years69 5 74 39.7 Total175 11 186 100.0 %Final Capping, Closure and Post-Closure CostsAs of December 31, 2020, accrued final capping, closure and post-closure costs were $1,346.4 million, of which $57.5 million were current and $1,288.9 million were long-term as reflected in our consolidated balance sheets in accrued landfill and environmental costs included in Item 8 of this Form 10-K.Remediation and Other Charges for Landfill MattersIt is reasonably possible that we will need to adjust our accrued landfill and environmental liabilities to reflect the effects of new or additional information, to the extent that such information impacts the costs, timing or duration of the required actions. Future changes in our estimates of the costs, timing or duration of the required actions could have a material adverse effect on our consolidated financial position, results of operations and cash flows.During 2020 and 2019, we recognized insurance recoveries of $10.8 million and $24.0 million, respectively, related to our closed Bridgeton Landfill in Missouri. As such, we recorded a reduction of remediation expenses included in our cost of operations during the years ended December 31, 2020 and 2019. For a description of our significant remediation matters, see Note 8, Landfill and Environmental Costs, of the notes to our consolidated financial statements in Item 8 of this Form 10-K.Investment in LandfillsAs of December 31, 2020, we expect to spend an estimated additional $9.5 billion on existing landfills, primarily related to cell construction and environmental structures, over their remaining lives. Our total expected investment, excluding non-depletable land, estimated to be $13.6 billion, or $2.72 per cubic yard, is used in determining our depletion and amortization expense based on airspace consumed using the units-of-consumption method.The following table reflects our future expected investment as of December 31, 2020 (in millions):Balance as of December 31, 2020ExpectedFutureInvestmentTotalExpectedInvestmentNon-depletable landfill land$166.3 $— $166.3 Landfill development costs7,991.7 9,519.9 17,511.6 Construction-in-progress - landfill303.8 — 303.8 Accumulated depletion and amortization(4,249.5)— (4,249.5)Net investment in landfill land and development costs$4,212.3 $9,519.9 $13,732.2 44Table of ContentsThe following table reflects our net investment in our landfills, excluding non-depletable land, and our depletion, amortization and accretion expense for the years ended December 31, 2020 and 2019:20202019Number of landfills owned or operated186 189 Net investment, excluding non-depletable land (in millions)$4,046.0 $3,872.9 Total estimated available disposal capacity (in millions of cubic yards)4,988.9 4,994.7 Net investment per cubic yard$0.81 $0.78 Landfill depletion and amortization expense (in millions)$323.0 $333.0 Accretion expense (in millions)82.9 81.9 405.9 414.9 Airspace consumed (in millions of cubic yards)76.1 81.5 Depletion, amortization and accretion expense per cubic yard of airspace consumed$5.33 $5.09 During 2020 and 2019, our average compaction rate was approximately 2,000 pounds per cubic yard based primarily on a three-year historical moving average. Property and EquipmentThe following tables reflect the activity in our property and equipment accounts for the years ended December 31, 2020 and 2019 (in millions of dollars):Gross Property and EquipmentBalance as of December 31, 2019CapitalAdditionsRetirementsAcquisitions,Net ofDivestituresNon-CashAdditionsfor AssetRetirementObligationsAdjustmentsforAssetRetirementObligationsImpairments,TransfersandOtherAdjustmentsBalance as of December 31, 2020Land$448.3 $9.6 $(1.8)$13.2 $— $— $(2.2)$467.1 Non-depletable landfill land170.5 0.3 (6.3)(2.8)— — 4.6 166.3 Landfill development costs7,474.7 2.6 (15.5)62.3 40.6 (45.5)472.5 7,991.7 Vehicles and equipment7,766.0 654.4 (336.3)3.9 — — 31.0 8,119.0 Buildings and improvements1,342.6 4.4 (6.1)24.0 1.7 — 35.9 1,402.5 Construction-in-progress - landfill366.8 406.9 — (3.6)— — (466.3)303.8 Construction-in-progress - other87.7 164.1 — — — — (144.4)107.4 Total$17,656.6 $1,242.3 $(366.0)$97.0 $42.3 $(45.5)$(68.9)$18,557.8 Accumulated Depreciation, Amortization and DepletionBalance as of December 31, 2019AdditionsChargedtoExpenseRetirementsAcquisitions,Net ofDivestituresAdjustmentsforAssetRetirementObligationsImpairments,TransfersandOtherAdjustmentsBalance as of December 31, 2020Landfill development costs$(3,968.6)$(335.6)$15.5 $26.2 $13.0 $— $(4,249.5)Vehicles and equipment(4,728.2)(628.7)322.7 44.4 — 36.4 (4,953.4)Buildings and improvements(576.3)(65.5)4.7 6.8 — 1.6 (628.7)Total$(9,273.1)$(1,029.8)$342.9 $77.4 $13.0 $38.0 $(9,831.6)45Table of ContentsGross Property and EquipmentBalance as of December 31, 2018CapitalAdditionsRetirementsAcquisitions,Net ofDivestituresNon-CashAdditionsfor AssetRetirementObligationsAdjustmentsforAssetRetirementObligationsImpairments,TransfersandOtherAdjustmentsBalance as of December 31, 2019Land$443.6 $2.6 $(1.9)$3.8 $— $— $0.2 $448.3 Non-depletable landfill land167.5 5.0 (2.1)0.4 — — (0.3)170.5 Landfill development costs7,106.0 2.9 (0.1)8.6 43.5 (4.9)318.7 7,474.7 Vehicles and equipment7,377.3 679.2 (400.2)109.9 — — (0.2)7,766.0 Buildings and improvements1,279.8 15.1 (10.1)1.1 1.3 — 55.4 1,342.6 Construction-in-progress - landfill287.9 399.2 — — — — (320.3)366.8 Construction-in-progress - other89.9 113.6 — — — — (115.8)87.7 Total$16,752.0 $1,217.6 $(414.4)$123.8 $44.8 $(4.9)$(62.3)$17,656.6 Accumulated Depreciation, Amortization and DepletionBalance as of December 31, 2018AdditionsChargedtoExpenseRetirementsAcquisitions,Net ofDivestituresAdjustmentsforAssetRetirementObligationsImpairments,TransfersandOtherAdjustmentsBalance as of December 31, 2019Landfill development costs$(3,635.9)$(343.9)$— $— $11.2 $— $(3,968.6)Vehicles and equipment(4,571.1)(592.9)390.7 18.2 — 26.9 (4,728.2)Buildings and improvements(524.9)(62.3)7.7 3.6 — (0.4)(576.3)Total$(8,731.9)$(999.1)$398.4 $21.8 $11.2 $26.5 $(9,273.1)Liquidity and Capital ResourcesCash and Cash EquivalentsThe following is a summary of our cash and cash equivalents and restricted cash and marketable securities balances as of December 31:20202019Cash and cash equivalents$38.2 $47.1 Restricted cash and marketable securities149.1 179.4 Less: restricted marketable securities(73.1)(49.1)Cash, cash equivalents, restricted cash and restricted cash equivalents$114.2 $177.4 Our restricted cash and marketable securities include, among other things, restricted cash and marketable securities pledged to regulatory agencies and governmental entities as financial guarantees of our performance under certain collection, landfill and transfer station contracts and permits, and relating to our final capping, closure and post-closure obligations at our landfills, restricted cash and marketable securities related to our insurance obligations, and restricted cash related to a payment for a certain maturing tax-exempt financing.The following table summarizes our restricted cash and marketable securities as of December 31:20202019Payment for maturing tax-exempt financing$— $49.4 Capping, closure and post-closure obligations31.5 30.6 Insurance117.6 99.4 Total restricted cash and marketable securities$149.1 $179.4 46Table of ContentsIntended Uses of CashWe intend to use excess cash on hand and cash from operating activities to fund capital expenditures, acquisitions, dividend payments, share repurchases and debt repayments. Debt repayments may include purchases of our outstanding indebtedness in the secondary market or otherwise. We believe that our excess cash, cash from operating activities and our availability to draw on our credit facilities provide us with sufficient financial resources to meet our anticipated capital requirements and maturing obligations as they come due.We may choose to voluntarily retire certain portions of our outstanding debt before their maturity dates using cash from operations or additional borrowings. We may also explore opportunities in the capital markets to fund redemptions should market conditions be favorable. Early extinguishment of debt will result in an impairment charge in the period in which the debt is repaid. The loss on early extinguishment of debt relates to premiums paid to effectuate the repurchase and the relative portion of unamortized note discounts and debt issue costs.Summary of Cash Flow ActivityThe major components of changes in cash flows for 2020 and 2019 are discussed in the following paragraphs. The following table summarizes our cash flow from operating activities, investing activities and financing activities for the years ended December 31, 2020 and 2019 (in millions of dollars):20202019Net cash provided by operating activities$2,471.6 $2,352.1 Net cash used in investing activities$(1,922.8)$(1,719.0)Net cash used in financing activities$(612.0)$(589.0)Cash Flows Provided by Operating ActivitiesThe most significant items affecting the comparison of our operating cash flows for 2020 and 2019 are summarized below.Changes in assets and liabilities, net of effects from business acquisitions and divestitures, decreased our cash flow from operations by $129.9 million in 2020, compared to a decrease of $213.4 million in 2019, primarily as a result of the following:•Our accounts receivable, exclusive of the change in allowance for doubtful accounts and customer credits, decreased $13.8 million during 2020, compared to a $38.3 million increase in 2019. As of December 31, 2020, our days sales outstanding were 38.6, or 26.4 days net of deferred revenue, compared to 39.8, or 27.9 days net of deferred revenue, as of December 31, 2019.•Our prepaid expenses and other assets decreased $6.5 million in 2020 compared to an increase of $109.7 million in 2019, primarily due to the receipt of the Bridgeton landfill settlement in the first quarter of 2020, and an increase in alternative fuel tax credit receipts during 2020 compared to 2019, partially offset by an increase of prepaid taxes due to the timing of our estimated tax payments.•Our accounts payable decreased $46.7 million during 2020 compared to an increase of $6.4 million during 2019, due to the timing of payments.•Cash paid for capping, closure and post-closure obligations was $19.6 million lower during 2020 compared to 2019. The decrease in cash paid for capping, closure and post-closure obligations is primarily due to the timing of capping and post-closure payments at certain of our landfill sites.•Cash paid for remediation obligations was $14.4 million higher during 2020 compared to 2019, primarily due to $25.6 million in payments related to management and monitoring of the remediation area of our closed Bridgeton Landfill in Missouri during 2020 as compared to $16.6 million of payments during 2019.In addition, cash paid for interest was $325.1 million and $346.8 million, excluding net swap settlements for our fixed to floating interest rate swaps, for 2020 and 2019, respectively.We use cash flows from operations to fund capital expenditures, acquisitions, dividend payments, share repurchases and debt repayments. Cash Flows Used in Investing ActivitiesThe most significant items affecting the comparison of our cash flows used in investing activities for 2020 and 2019 are summarized below:•Capital expenditures during 2020 were $1,194.6 million as compared to $1,207.1 million for 2019.47Table of Contents•Proceeds from sales of property and equipment during 2020 were $30.1 million as compared to $21.7 million for 2019.•During 2020 and 2019, we used $769.5 million and $575.1 million, respectively, for acquisitions and investments, net of cash acquired. During 2020 and 2019, we received $32.9 million and $42.8 million for business divestitures, respectively.We intend to finance capital expenditures and acquisitions through cash on hand, restricted cash held for capital expenditures, cash flows from operations, our revolving credit facilities, and tax-exempt bonds and other financings. We expect to primarily use cash and borrowings under our revolving credit facilities to pay for future business acquisitions.Cash Flows Used in Financing ActivitiesThe most significant items affecting the comparison of our cash flows used in financing activities for 2020 and 2019 are summarized below:•During 2020, we issued $2,750.0 million of senior notes for cash proceeds, net of discounts and fees of $2,716.1 million. During 2019, we issued $900.0 million of senior notes for cash proceeds, net of discounts and fees of $891.1 million. Net payments of notes payable and long-term debt were $2,595.9 million during 2020, compared to net payments of $581.4 million in 2019. For a more detailed discussion, see the Financial Condition section of this Management’s Discussion and Analysis of Financial Condition and Results of Operations.•During 2020, we paid $99.1 million in cash premiums on the redemption of senior notes.•During 2020, we repurchased 1.2 million shares of our stock for $98.8 million. During 2019, we repurchased 4.9 million shares of our stock for $399.4 million. •In July 2020, our Board of Directors approved an increase in our quarterly dividend to $0.425 per share. Dividends paid were $522.5 million and $491.2 million for 2020 and 2019, respectively.•During 2020 and 2019, cash paid for purchase price holdback releases and contingent purchase price related to acquisitions was $15.5 million and $17.2 million, respectively.In September 2020, we entered into an agreement to extend the term of one of our landfill finance leases by 43 years, or through the end of the landfill's site life. Accordingly, we recognized an incremental finance lease obligation of $90.4 million.Financial ConditionDebt ObligationsAs of December 31, 2020, we had $168.1 million of principal debt maturing within the next 12 months, which includes certain variable rate tax-exempt financings, finance lease obligations and debentures. All of our tax-exempt financings are remarketed either quarterly or semiannually by remarketing agents to effectively maintain a variable yield. The holders of the bonds can put them back to the remarketing agents at the end of each interest period. If the remarketing agent is unable to remarket our bonds, the remarketing agent can put the bonds to us. In the event of a failed remarketing, we currently have availability under our $2.25 billion unsecured revolving credit facility to fund these bonds until they are remarketed successfully. Accordingly, we have classified these borrowings as long-term in our consolidated balance sheet as of December 31, 2020.An extended period of economic disruption associated with the COVID-19 pandemic could further disrupt the global supply chain, negatively impact demand for our services, and disrupt financial markets. These effects could materially and adversely affect our business and financial condition, including our access to sources of liquidity. We will continue to monitor the evolving COVID-19 pandemic along with the effect on our business and access to capital markets. Refer to Part I, Item 1A - Risk Factors of this Annual Report on Form 10-K for a discussion of certain risk factors related to this pandemic.For further discussion of the components of our overall debt, see Note 9, Debt, of the notes to our consolidated financial statements in Item 8 of this Form 10-K. Credit FacilitiesThe 364-Day Credit FacilityIn August 2020, we entered into a $1.0 billion 364-day unsecured revolving credit facility (the 364-Day Credit Facility), which matures in August 2021. At our option, borrowings under the 364-Day Credit Facility bear interest at a Base Rate, or a Eurodollar Rate, plus an applicable margin based on our Debt Ratings (all as defined in the 364-Day Credit Facility agreement). The 364-Day Credit Facility is subject to facility fees based on applicable rates defined in the 364-Day Credit Facility agreement and the aggregate commitment, regardless of usage. Availability under our 364-Day Credit Facility totaled $1.0 billion as of December 31, 2020. The 364-Day Credit Facility can be used for working capital, capital expenditures, 48Table of Contentsacquisitions, and other general corporate purposes. The 364-Day Credit Facility agreement requires us to comply with financial and other covenants, which are consistent with the financial and other covenants included in our Credit Facility. We may pay dividends and repurchase common stock if we are in compliance with these covenants.As of December 31, 2020, we had no borrowings outstanding under our 364-Day Credit Facility.The Credit FacilityIn 2018, we entered into a $2.25 billion unsecured revolving credit facility (as amended, the Credit Facility) , which matures in June 2023. As permitted by the Credit Facility, we have the right to request two one-year extensions of the maturity date but none of the lenders are committed to participate in such extension. The Credit Facility also includes a feature that allows us to increase availability, at our option, by an aggregate amount of up to $1.0 billion through increased commitments from existing lenders or the addition of new lenders. At our option, borrowings under the Credit Facility bear interest at a Base Rate, or a Eurodollar Rate, plus an applicable margin based on our Debt Ratings (all as defined in the Credit Facility agreement). The Credit Facility is subject to facility fees based on applicable rates defined in the Credit Facility agreement and the aggregate commitment, regardless of usage. Availability under our Credit Facility totaled $1,671.8 million and $1,696.9 million as of December 31, 2020 and 2019, respectively. The Credit Facility can be used for working capital, capital expenditures, acquisitions, letters of credit and other general corporate purposes. The Credit Facility agreement requires us to comply with financial and other covenants. We may pay dividends and repurchase common stock if we are in compliance with these covenants. As of December 31, 2020 and 2019, we had $186.0 million and $184.4 million of borrowings outstanding under our Credit Facility, respectively. We had $376.5 million and $351.4 million of letters of credit outstanding under our Credit Facility as of December 31, 2020 and 2019, respectively.In July 2020, we executed an amendment to the Credit Facility agreement to increase flexibility and reduce restrictions, in particular, for future acquisitions. Effective June 30, 2020, the amendment eliminated the consolidated interest coverage ratio and revised the sole remaining financial covenant, total debt to EBITDA ratio.Uncommitted Credit FacilityWe also have an Uncommitted Credit Facility, which bears interest at a LIBOR Rate or a Cost of Funds rate (both as defined in the Uncommitted Credit Facility Agreement), plus an applicable margin. We can use borrowings under the Uncommitted Credit Facility for working capital and other general corporate purposes. The agreement governing our Uncommitted Credit Facility requires us to comply with certain covenants. The Uncommitted Credit Facility may be terminated by either party at any time. As of December 31, 2020, we had no borrowings outstanding under our Uncommitted Credit Facility. As of December 31, 2019, we had $11.6 million of borrowings outstanding under our Uncommitted Credit Facility.Financial and Other CovenantsThe Credit Facility and 364-Day Credit Facility (collectively, the Credit Facilities) require us to comply with financial and other covenants. To the extent we are not in compliance with these covenants, we cannot pay dividends or repurchase common stock. Compliance with covenants also is a condition for any incremental borrowings under the Credit Facilities, and failure to meet these covenants would enable the lenders to require repayment of any outstanding loans (which would adversely affect our liquidity). In July 2020, we executed an amendment to the Credit Facility agreement to increase flexibility and reduce restrictions, in particular, for future acquisitions. Effective June 30, 2020, the amendment eliminated the consolidated interest coverage ratio and revised the sole remaining financial covenant, total debt to EBITDA ratio. The 364-Day Credit Facility and the Credit Facility, as amended, provide that our total debt to EBITDA ratio may not exceed 3.75 to 1.00 as of the last day of any fiscal quarter. In the case of an "elevated ratio period", which may be elected by us if one or more acquisitions during a fiscal quarter involve aggregate consideration in excess of $200.0 million (the Trigger Quarter), the total debt to EBITDA ratio may not exceed 4.25 to 1.00 during the Trigger Quarter and for the three fiscal quarters thereafter. The 364-Day Credit Facility and the Credit Facility, as amended, also provide that there may not be more than two elevated ratio periods during the respective terms of the Credit Facility and 364-Day Credit Facility agreements. As of December 31, 2020, our total debt to EBITDA ratio was 3.07 compared to the 3.75 maximum allowed by the covenants. As of December 31, 2020, we were in compliance with the covenants under the Credit Facilities, and we expect to be in compliance throughout 2021.EBITDA, which is a non-U.S. GAAP measure, is calculated as defined in our Credit Facility and 364-Day Credit Facility agreements. In this context, EBITDA is used solely to provide information regarding the extent to which we are in compliance with debt covenants and is not comparable to EBITDA used by other companies or used by us for other purposes.Failure to comply with the financial and other covenants under the Credit Facilities, as well as the occurrence of certain material adverse events, would constitute defaults and would allow the lenders under the Credit Facilities to accelerate the maturity of all indebtedness under the Credit Facilities agreements. This could have an adverse effect on the availability of financial assurances. In addition, maturity acceleration on the Credit Facilities constitutes an event of default under our other debt 49Table of Contentsinstruments, including our senior notes, and, therefore, our senior notes would also be subject to acceleration of maturity. If such acceleration were to occur, we would not have sufficient liquidity available to repay the indebtedness. We would likely have to seek an amendment under the Credit Facilities for relief from the financial covenant or repay the debt with proceeds from the issuance of new debt or equity, or asset sales, if necessary. We may be unable to amend the Credit Facilities or raise sufficient capital to repay such obligations in the event the maturity is accelerated.Senior Notes and DebenturesAs of December 31, 2020, we had $7,437.0 million of unsecured senior notes and debentures outstanding with maturities ranging from 2021 to 2050. As of December 31, 2019, we had $7,257.0 million of unsecured senior notes and debentures outstanding with maturities ranging from 2020 to 2041. In November 2020, we issued $350.0 million of 0.875% senior notes due 2025 (the 0.875% Notes) and $750.0 million of 1.750% senior notes due 2032 (the 1.750% Notes). We used the net proceeds from the 0.875% Notes and 1.750% Notes to redeem all $850.0 million of the outstanding 3.550% senior notes due June 2022 and $250.0 million of the $550.0 million outstanding 4.750% senior notes due May 2023.In August 2020, we issued $650.0 million of 1.450% senior notes due 2031 (the 1.450% Notes). We used the net proceeds to redeem all $600.0 million of the outstanding 5.250% senior notes due November 2021 plus a make-whole premium of $34.0 million. The remaining proceeds were used for general corporate purposes. In February 2020, we issued $600.0 million of 2.300% senior notes due 2030 (the 2.300% Notes) and $400.0 million of 3.050% senior notes due 2050 (the 3.050% Notes). We used the net proceeds from the 2.300% Notes and 3.050% Notes to repay $850.0 million of 5.000% senior notes that matured in March 2020. The remaining proceeds were used to repay amounts outstanding under our unsecured credit facilities as well as for general corporate purposes. Our senior notes are general senior unsecured obligations. Interest is payable semi-annually.Derivative Instruments and Hedging RelationshipsOur ability to obtain financing through the capital markets is a key component of our financial strategy. Historically, we have managed risk associated with executing this strategy, particularly as it relates to fluctuations in interest rates, by using a combination of fixed and floating rate debt. From time to time, we also have entered into interest rate swap and lock agreements to manage risk associated with interest rates, either to effectively convert specific fixed rate debt to a floating rate (fair value hedges), or to lock interest rates in anticipation of future debt issuances (cash flow hedges). Additionally, we amended certain interest rate lock agreements, extending the mandatory maturity date and dedesignated them as cash flow hedges (the Extended Interest Rate Locks). In addition, we entered into offsetting interest rate swaps to offset future exposures to fair value fluctuations of the Extended Interest Rate Locks.For a description of our derivative contracts and hedge accounting, see Note 9, Debt, to our audited consolidated financial statements included in Part II, Item 8 of this Annual Report on Form 10-K.Tax-Exempt FinancingsAs of December 31, 2020, we had $1,104.7 million of certain variable rate tax-exempt financings outstanding with maturities ranging from 2021 to 2050. As of December 31, 2019, we had $1,116.2 million of certain variable rate tax-exempt financings outstanding with maturities ranging from 2020 to 2049. During the year ended December 31, 2020, we issued $60.0 million of new tax-exempt financings. During the year ended December 31, 2019, we refinanced $35.0 million and issued $30.0 million of tax-exempt financings.Finance LeasesWe had finance lease liabilities of $206.5 million and $119.3 million as of December 31, 2020 and 2019, respectively, with maturities ranging from 2021 to 2063 and 2020 to 2049, respectively.In September 2020, we entered into an agreement to extend the term of one of our landfill finance leases by 43 years, or through the end of the landfill's site life. Accordingly, we recognized an incremental finance lease obligation of $90.4 million.50Table of ContentsContractual ObligationsThe following table summarizes our estimated contractual obligations as of December 31, 2020 (in millions):Year EndingDecember 31,OperatingLeasesMaturities ofNotes Payable,Finance Leasesand Other Long-Term DebtScheduled Interest Payment ObligationsFinal Capping,Closure andPost-ClosureRemediationUnconditionalPurchaseCommitmentsTotal2021$41.5 $168.1 $267.7 $57.5 $57.0 $163.6 $755.4 202237.9 6.4 265.0 61.1 64.7 97.0 532.1 202335.6 659.4 251.0 76.0 67.8 61.0 1,150.8 202430.9 924.9 224.6 75.6 59.8 53.4 1,369.2 202529.4 854.6 203.5 82.2 41.0 29.4 1,240.1 Thereafter105.8 6,441.2 1,694.7 6,348.8 352.4 252.9 15,195.8 Total$281.1 $9,054.6 $2,906.5 $6,701.2 $642.7 $657.3 $20,243.4 Scheduled interest payment obligations in the above table were calculated using stated coupon rates for fixed rate debt and interest rates applicable as of December 31, 2020 for variable rate debt. The effect of our outstanding interest rate swaps on the interest payments of our 4.750% fixed rate senior notes due in May 2023 is also included based on the floating rates in effect as of December 31, 2020.The estimated remaining final capping, closure and post-closure and remediation expenditures presented above are not inflated or discounted and reflect the estimated future payments for liabilities incurred and recorded as of December 31, 2020 and for liabilities yet to be incurred over the remaining life of our landfills.Unconditional purchase commitments consist primarily of (1) disposal related agreements that include fixed or minimum royalty payments, host agreements and take-or-pay and put-or-pay agreements and (2) other obligations including committed capital expenditures and consulting service agreements.Financial AssuranceWe must provide financial assurance to governmental agencies and a variety of other entities under applicable environmental regulations relating to our landfill operations for capping, closure and post-closure costs, and related to our performance under certain collection, landfill and transfer station contracts. We satisfy these financial assurance requirements by providing surety bonds, letters of credit, or insurance policies (Financial Assurance Instruments), or trust deposits, which are included in restricted cash and marketable securities and other assets in our consolidated balance sheets. The amount of the financial assurance requirements for capping, closure and post-closure costs is determined by applicable state environmental regulations. The financial assurance requirements for capping, closure and post-closure costs may be associated with a portion of the landfill or the entire landfill. Generally, states require a third-party engineering specialist to determine the estimated capping, closure and post-closure costs that are used to determine the required amount of financial assurance for a landfill. The amount of financial assurance required can, and generally will, differ from the obligation determined and recorded under U.S. GAAP. The amount of the financial assurance requirements related to contract performance varies by contract. Additionally, we must provide financial assurance for our insurance program and collateral for certain performance obligations. We do not expect a material increase in financial assurance requirements during 2021, although the mix of Financial Assurance Instruments may change.These Financial Assurance Instruments are issued in the normal course of business and are not classified as indebtedness. Because we currently have no liability for the Financial Assurance Instruments, they are not reflected in our consolidated balance sheets; however, we record capping, closure and post-closure liabilities and insurance liabilities as they are incurred.Off-Balance Sheet ArrangementsWe have no off-balance sheet debt or similar obligations, other than short-term operating leases and financial assurances, which are not classified as debt. We have no transactions or obligations with related parties that are not disclosed, consolidated into or reflected in our reported financial position or results of operations. We have not guaranteed any third-party debt.ContingenciesFor a description of our commitments and contingencies, see Note 8, Landfill and Environmental Costs, Note 11, Income Taxes, and Note 19, Commitments and Contingencies, of the notes to our consolidated financial statements in Item 8 of this Form 10-K.51Table of ContentsCritical Accounting Judgments and EstimatesOur consolidated financial statements have been prepared in accordance with U.S. GAAP and necessarily include certain estimates and judgments made by management. The following is a list of accounting policies that we believe are the most critical in understanding our consolidated financial position, results of operations and cash flows and that may require management to make subjective or complex judgments about matters that are inherently uncertain. Such critical accounting policies, estimates and judgments are applicable to all of our operating segments.We have noted examples of the residual accounting and business risks inherent in the accounting for these areas. Residual accounting and business risks are defined as the inherent risks that we face after the application of our policies and processes that are generally outside of our control or ability to forecast.Landfill AccountingLandfill operating costs are treated as period expenses and are not discussed further in this section.Our landfill assets and liabilities fall into the following two categories, each of which requires accounting judgments and estimates:•Landfill development costs that are capitalized as an asset.•Landfill retirement obligations relating to our capping, closure and post-closure liabilities that result in a corresponding landfill retirement asset.We use life-cycle accounting and the units-of-consumption method to recognize landfill development costs over the life of the site. In life-cycle accounting, all current and future capitalized costs to acquire and construct a site are calculated, and charged to expense based on the consumption of cubic yards of available airspace. Obligations associated with final capping, closure and post-closure are also capitalized, and amortized on a units-of-consumption basis as airspace is consumed. Cost and airspace estimates are developed at least annually by engineers.Landfill Development CostsSite permits. To develop, construct and operate a landfill, we must obtain permits from various regulatory agencies at the local, state and federal levels. The permitting process requires an initial site study to determine whether the location is feasible for landfill operations. The initial studies are reviewed by our environmental management group and then submitted to the regulatory agencies for approval. During the development stage we capitalize certain costs that we incur after site selection but before the receipt of all required permits if we believe that it is probable that the site will be permitted.Residual risks:•Changes in legislative or regulatory requirements may cause changes to the landfill site permitting process. These changes could make it more difficult and costly to obtain and maintain a landfill permit.•Studies performed could be inaccurate, which could result in the denial or revocation of a permit and changes to accounting assumptions. Conditions could exist that were not identified in the study, which may make the location not feasible for a landfill and could result in the denial of a permit. Denial or revocation of a permit could impair the recorded value of the landfill asset.•Actions by neighboring parties, private citizen groups or others to oppose our efforts to obtain, maintain or expand permits could result in denial, revocation or suspension of a permit, which could adversely impact the economic viability of the landfill and could impair the recorded value of the landfill. As a result of opposition to our obtaining a permit, improved technical information as a project progresses, or changes in the anticipated economics associated with a project, we may decide to reduce the scope of, or abandon, a project, which could result in an asset impairment.Technical landfill design. Upon receipt of initial regulatory approval, technical landfill designs are prepared. The technical designs, which include the detailed specifications to develop and construct all components of the landfill including the types and quantities of materials that will be required, are reviewed by our environmental management group. The technical designs are submitted to the regulatory agencies for approval. Upon approval of the technical designs, the regulatory agencies issue permits to develop and operate the landfill.Residual risks:•Changes in legislative or regulatory requirements may require changes in the landfill technical designs. These changes could make it more difficult and costly to meet new design standards.•Technical design requirements, as approved, may need modifications at some future point in time.52Table of Contents•Technical designs could be inaccurate and could result in increased construction costs, difficulty in obtaining a permit or the use of rates to recognize the amortization of landfill development costs and asset retirement obligations that are not appropriate.Permitted and probable landfill disposal capacity. Included in the technical designs are factors that determine the ultimate disposal capacity of the landfill. These factors include the area over which the landfill will be developed, such as the depth of excavation, the height of the landfill elevation and the angle of the side-slope construction. The disposal capacity of the landfill is calculated in cubic yards. This measurement of volume is then converted to a disposal capacity expressed in tons based on a site-specific expected density to be achieved over the remaining operating life of the landfill.Residual risks:•Estimates of future disposal capacity may change as a result of changes in legislative or regulatory design requirements.•The density of waste may vary due to variations in operating conditions, including waste compaction practices, site design, climate and the nature of the waste.•Capacity is defined in cubic yards but waste received is measured in tons. The number of tons per cubic yard varies by type of waste and our rate of compaction.Development costs. The types of costs that are detailed in the technical design specifications generally include excavation, natural and synthetic liners, construction of leachate collection systems, installation of methane gas collection systems and monitoring probes, installation of groundwater monitoring wells, construction of leachate management facilities and other costs associated with the development of the site. We review the adequacy of our cost estimates on an annual basis by comparing estimated costs with third-party bids or contractual arrangements, reviewing the changes in year-over-year cost estimates for reasonableness, and comparing our resulting development cost per acre with prior period costs. These development costs, together with any costs incurred to acquire, design and permit the landfill, including capitalized interest, are recorded to the landfill asset on the balance sheet as incurred.Residual risk:•Actual future costs of construction materials and third-party labor could differ from the costs we have estimated because of the level of demand and the availability of the required materials and labor. Technical designs could be altered due to unexpected operating conditions, regulatory changes or legislative changes.Landfill development asset amortization. To match the expense related to the landfill asset with the revenue generated by the landfill operations, we amortize the landfill development asset over its operating life on a per-ton basis as waste is accepted at the landfill. The landfill asset is fully amortized at the end of a landfill’s operating life. The per-ton rate is calculated by dividing the sum of the landfill development asset net book value plus estimated future development costs (as described above) for the landfill, by the landfill’s estimated remaining disposal capacity. The expected future development costs are not inflated or discounted, but rather expressed in nominal dollars. This rate is applied to each ton accepted at the landfill to arrive at amortization expense for the period.Amortization rates are influenced by the original cost basis of the landfill, including acquisition costs, which in turn is determined by geographic location and market values. We secure significant landfill assets through business acquisitions and value them at the time of acquisition based on fair value. Amortization rates are also influenced by site-specific engineering and cost factors.Residual risk:•Changes in our future development cost estimates or our disposal capacity will normally result in a change in our amortization rates and will impact amortization expense prospectively. An unexpected significant increase in estimated costs or reduction in disposal capacity could affect the ongoing economic viability of the landfill and result in asset impairment.On at least an annual basis, we update the estimates of future development costs and remaining disposal capacity for each landfill. These costs and disposal capacity estimates are reviewed and approved by senior operations management annually. Changes in cost estimates and disposal capacity are reflected prospectively in the landfill amortization rates that are updated annually. See our Results of Operations section in this Management's Discussion and Analysis of Financial Condition and Results of Operations for discussion on changes to our landfill depletion and amortization. Landfill Asset Retirement ObligationsWe have two types of retirement obligations related to landfills: (1) capping and (2) closure and post-closure.53Table of ContentsObligations associated with final capping activities that occur during the operating life of the landfill are recognized on a units-of-consumption basis as airspace is consumed within each discrete capping event. Obligations related to closure and post-closure activities that occur after the landfill has ceased operations are recognized on a units-of-consumption basis as airspace is consumed throughout the entire life of the landfill. Landfill retirement obligations are capitalized as the related liabilities are recognized and amortized using the units-of-consumption method over the airspace consumed within the capping event or the airspace consumed within the entire landfill, depending on the nature of the obligation. All obligations are initially measured at estimated fair value. Fair value is calculated on a present value basis using an inflation rate and our credit-adjusted, risk-free rate in effect at the time the liabilities were incurred. Future costs for final capping, closure and post-closure are developed at least annually by engineers, and are inflated to future value using estimated future payment dates and inflation rate projections.Landfill capping. As individual areas within each landfill reach capacity, we must cap and close the areas in accordance with the landfill site permit. These requirements are detailed in the technical design of the landfill site process previously described.Closure and post-closure. Closure costs are costs incurred after a landfill stops receiving waste, but prior to being certified as closed. After the entire landfill has reached capacity and is certified closed, we must continue to maintain and monitor the site for a post-closure period, which generally extends for 30 years. Costs associated with closure and post-closure requirements generally include maintenance of the site, the monitoring of methane gas collection systems and groundwater systems, and other activities that occur after the site has ceased accepting waste. Costs associated with post-closure monitoring generally include groundwater sampling, analysis and statistical reports, third-party labor associated with gas system operations and maintenance, transportation and disposal of leachate, and erosion control costs related to the final cap.Landfill retirement obligation liabilities and assets. Estimates of the total future costs required to cap, close and monitor each landfill as specified by the landfill permit are updated annually. The estimates include inflation, the specific timing of future cash outflows, and the anticipated waste flow into the capping events. Our cost estimates are inflated to the period of performance using an estimate of inflation, which is updated annually and is based upon the ten year average consumer price index (1.7% in 2020 and 2019).The present value of the remaining capping costs for specific capping events and the remaining closure and post-closure costs for each landfill are recorded as incurred on a per-ton basis. These liabilities are incurred as disposal capacity is consumed at the landfill.Capping, closure and post-closure liabilities are recorded in layers and discounted using our credit-adjusted risk-free rate in effect at the time the obligation is incurred (3.4% and 4.3% in 2020 and 2019).Retirement obligations are increased each year to reflect the passage of time by accreting the balance at the weighted average credit-adjusted risk-free rate that was used to calculate each layer of the recorded liabilities. This accretion is charged to operating expenses. Actual cash expenditures reduce the asset retirement obligation liabilities as they are made.Corresponding retirement obligation assets are recorded for the same value as the additions to the capping, closure and post-closure liabilities. The retirement obligation assets are amortized to expense on a per-ton basis as disposal capacity is consumed. The per-ton rate is calculated by dividing the sum of each of the recorded retirement obligation asset’s net book value and expected future additions to the retirement obligation asset by the remaining disposal capacity. A per-ton rate is determined for each separate capping event based on the disposal capacity relating to that event. Closure and post-closure per-ton rates are based on the total disposal capacity of the landfill.Residual risks:•Changes in legislative or regulatory requirements, including changes in capping, closure activities or post-closure monitoring activities, types and quantities of materials used, or term of post-closure care, could cause changes in our cost estimates.•Changes in the landfill retirement obligation due to changes in the anticipated waste flow, changes in airspace compaction estimates or changes in the timing of expenditures for closed landfills and fully incurred but unpaid capping events are recorded in results of operations prospectively. This could result in unanticipated increases or decreases in expense.•Actual timing of disposal capacity utilization could differ from projected timing, causing differences in timing of when amortization and accretion expense is recognized for capping, closure and post-closure liabilities.•Changes in inflation rates could impact our actual future costs and our total liabilities.•Changes in our capital structure or market conditions could result in changes to the credit-adjusted risk-free rate used to discount the liabilities, which could cause changes in future recorded liabilities, assets and expense.•Amortization rates could change in the future based on the evaluation of new facts and circumstances relating to landfill capping design, post-closure monitoring requirements, or the inflation or discount rate.54Table of ContentsOn an annual basis, we update our estimates of future capping, closure and post-closure costs and of future disposal capacity for each landfill. Revisions in estimates of our costs or timing of expenditures are recognized immediately as increases or decreases to the capping, closure and post-closure liabilities and the corresponding retirement obligation assets. Changes in the assets result in changes to the amortization rates which are applied prospectively, except for fully incurred capping events and closed landfills, where the changes are recorded immediately in results of operations since the associated disposal capacity has already been consumed. See our Results of Operations section in this Management's Discussion and Analysis of Financial Condition and Results of Operations for discussion on changes to our landfill depletion and amortization. Permitted and probable disposal capacity. Disposal capacity is determined by the specifications detailed in the landfill permit. We classify this disposal capacity as permitted. We also include probable expansion disposal capacity in our remaining disposal capacity estimates, thus including additional disposal capacity being sought through means of a permit expansion. Probable expansion disposal capacity has not yet received final approval from the applicable regulatory agencies, but we have determined that certain critical criteria have been met and that the successful completion of the expansion is probable. We have developed six criteria that must be met before an expansion area is designated as probable expansion airspace. We believe that satisfying all of these criteria demonstrates a high likelihood that expansion airspace that is incorporated in our landfill costing will be permitted. However, because some of these criteria are judgmental, they may exclude expansion airspace that will eventually be permitted or include expansion airspace that will not be permitted. In either of these scenarios, our amortization, depletion and accretion expense could change significantly. Our internal criteria to classify disposal capacity as probable expansion airspace are as follows:•We own the land associated with the expansion airspace or control it pursuant to an option agreement;•We are committed to supporting the expansion project financially and with appropriate resources;•There are no identified fatal flaws or impediments associated with the project, including political impediments;•Progress is being made on the project;•The expansion is attainable within a reasonable time frame; and•We believe it is likely we will receive the expansion permit.After successfully meeting these criteria, the disposal capacity that will result from the planned expansion is included in our remaining disposal capacity estimates. Additionally, for purposes of calculating landfill amortization and capping, closure and post-closure rates, we include the incremental costs to develop, construct, close and monitor the related probable expansion disposal capacity.Residual risk:•We may be unsuccessful in obtaining permits for probable expansion disposal capacity because of the failure to obtain the final local, state or federal permits or due to other unknown reasons. If we are unsuccessful in obtaining permits for probable expansion disposal capacity, or the disposal capacity for which we obtain approvals is less than what was estimated, both our estimated total costs and disposal capacity will be reduced, which generally increases the rates we charge for landfill amortization and capping, closure and post-closure accruals. An unexpected decrease in disposal capacity could also cause an asset impairment.Environmental LiabilitiesWe are subject to an array of laws and regulations relating to the protection of the environment, and we remediate sites in the ordinary course of our business. Under current laws and regulations, we may be responsible for environmental remediation at sites that we either own or operate, including sites that we have acquired, or sites where we have (or a company that we have acquired has) delivered waste. Our environmental remediation liabilities primarily include costs associated with remediating groundwater, surface water and soil contamination, as well as controlling and containing methane gas migration and the related legal costs. To estimate our ultimate liability at these sites, we evaluate several factors, including the nature and extent of contamination at each identified site, the required remediation methods, timing of expenditures, the apportionment of responsibility among the potentially responsible parties and the financial viability of those parties. We accrue for costs associated with environmental remediation obligations when such costs are probable and reasonably estimable in accordance with accounting for loss contingencies. We periodically review the status of all environmental matters and update our estimates of the likelihood of and future expenditures for remediation as necessary. Changes in the liabilities resulting from these reviews are recognized currently in earnings in the period in which the adjustment is known. Adjustments to estimates are reasonably possible in the near term and may result in changes to recorded amounts. With the exception of those obligations assumed in certain business combinations, environmental obligations are recorded on an undiscounted basis. Environmental obligations assumed in certain business combinations are initially estimated on a discounted basis, and accreted to full value over time through charges to interest expense. Adjustments arising from changes in amounts and timing of estimated costs and 55Table of Contentssettlements may result in increases or decreases in these obligations and are calculated on a discounted basis as they were initially estimated on a discounted basis. These adjustments are charged to operating income when they are known. We perform a comprehensive review of our environmental obligations annually and also review changes in facts and circumstances associated with these obligations at least quarterly. See our Results of Operations section in this Management's Discussion and Analysis of Financial Condition and Results of Operations for discussion on our remediation adjustments. We have not reduced the liabilities we have recorded for recoveries from other potentially responsible parties or insurance companies.Residual risks:•We cannot determine with precision the ultimate amounts of our environmental remediation liabilities. Our estimates of these liabilities require assumptions about uncertain future events. Thus, our estimates could change substantially as additional information becomes available regarding the nature or extent of contamination, the required remediation methods, timing of expenditures, the final apportionment of responsibility among the potentially responsible parties identified, the financial viability of those parties, and the actions of governmental agencies or private parties with interests in the matter. The actual environmental costs may exceed our current and future accruals for these costs, and any adjustments could be material.•Actual amounts could differ from the estimated liabilities as a result of changes in estimated future litigation costs to pursue the matter to ultimate resolution.•An unanticipated environmental liability that arises could result in a material charge to our consolidated statements of income.Insurance Reserves and Related CostsOur insurance policies for workers' compensation, commercial general liability, commercial auto liability and environmental liability are high deductible, or retention programs. The deductibles, or retentions, range from $3 million to $10 million. The employee-related health benefits are also subject to a high deductible insurance policy. Accruals for deductibles or retentions are based on claims filed and actuarial estimates of claims development and claims incurred but not reported.Residual risks:•Incident rates, including frequency and severity, and other actuarial assumptions could change causing our current and future actuarially determined obligations to change, which would be reflected in our consolidated statements of income in the period in which such adjustment is known.•Recorded reserves may not be adequate to cover the future payment of claims. Adjustments, if any, to estimates recorded resulting from ultimate claim payments would be reflected in the consolidated statements of income in the periods in which such adjustments are known.•The settlement costs to discharge our obligations, including legal and health care costs, could increase or decrease causing current estimates of our insurance reserves to change.New Accounting StandardsFor a description of new accounting standards that may affect us, see Note 2, Summary of Significant Accounting Policies, of the notes to our consolidated financial statements in Item 8 of this Form 10-K.ITEM 7A.QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKInterest Rate RiskOur major market risk exposure of our financial instruments is changing interest rates in the United States and fluctuations in LIBOR. We intend to manage interest rate risk through the use of a combination of fixed and floating rate debt. The carrying value of our variable rate debt approximates fair value because interest rates are variable and, accordingly, approximates current market rates for instruments with similar risk and maturities. The fair value of our debt is determined as of the balance sheet date and is subject to change.56Table of ContentsThe table below provides information about certain of our market-sensitive financial instruments and constitutes a forward-looking statement. Expected Maturity Date 20212022202320242025ThereafterTotalFair Valueas ofDecember 31, 2020Fixed rate debt:Amount outstanding (in millions)$41.1 $6.4 $329.2 $904.2 $854.6 $5,621.9 $7,757.4 $8,708.4 Variable rate debt:Amount outstanding (in millions)$127.0 $— $330.2 $20.7 $— $819.3 $1,297.2 $1,290.7 The fixed and variable rate debt amounts above exclude the remaining non-cash discounts, premiums and adjustments to fair value totaling $120.4 million. During the second half of 2013, we entered into various interest rate swap agreements relative to our 4.750% fixed rate senior notes due in May 2023. The goal was to reduce overall borrowing costs and rebalance our debt portfolio's ratio of fixed to floating interest rates. These swap agreements, which were designated as fair value hedges, have a total notional value of $300.0 million as of December 31, 2020. Contemporaneously with our $250.0 million redemption of the 4.750% Notes, we dedesignated the proportional share of these swap agreements as fair value hedges. Our interest rate swap contracts have been authorized pursuant to our policies and procedures. We do not use financial instruments for trading purposes and are not a party to any leveraged derivatives.We have historically entered into multiple swap agreements designated as cash flow hedges to manage exposure to fluctuations in interest rates in anticipation of planned future issuances of senior notes. Upon the expected issuance of senior notes, we terminate the interest rate locks and settle with our counterparties. These transactions were accounted for as cash flow hedges. All of our cash flow hedges settled on or before December 31, 2020, thus there is no related asset or liability as of December 31, 2020. As of December 31, 2019 our interest rate lock agreements had an aggregate notional value of $575.0 million with fixed interest rates ranging from 1.330% to 3.000%. As of December 31, 2020, we had $1,297.2 million of floating rate debt and $300.0 million of floating interest rate swap contracts. If interest rates increased or decreased by 100 basis points on our variable rate debt, annualized interest expense and net cash payments for interest would increase or decrease by approximately $16 million. This analysis does not reflect the effect that interest rates would have on other items, such as new borrowings and the impact on the economy. See Note 9, Debt, of the notes to our consolidated financial statements in Item 8 of this Form 10-K for further information regarding how we manage interest rate risk.Fuel Price RiskFuel costs represent a significant operating expense. When economically practical, we may enter into new fuel hedges, renew contracts, or engage in other strategies to mitigate market risk. As of December 31, 2020, we had no fuel hedges in place. While we charge fuel recovery fees to a majority of our customers, we are unable to charge such fees to all customers. At current consumption levels, we believe a twenty-cent per gallon change in the price of diesel fuel would change our fuel costs by approximately $25 million per year. Offsetting these changes in fuel expense would be changes in our fuel recovery fee charged to our customers. At current participation rates, we believe a twenty-cent per gallon change in the price of diesel fuel would change our fuel recovery fee by approximately $25 million per year.Our operations also require the use of certain petrochemical-based products (such as liners at our landfills) whose costs may vary with the price of petrochemicals. An increase in the price of petrochemicals could increase the cost of those products, which would increase our operating and capital costs. We also are susceptible to increases in fuel recovery fees from our vendors.Our fuel costs were $271.7 million in 2020, or 2.7% of revenue, compared to $347.9 million in 2019, or 3.4% of revenue.Commodities Price RiskWe market recovered materials such as old corrugated containers and old newsprint from our recycling processing centers. Changes in market supply and demand for recycled commodities causes volatility in commodity prices. In prior periods, we have entered into derivative instruments such as swaps and costless collars designated as cash flow hedges to manage our 57Table of Contentsexposure to changes in prices of these commodities. As of December 31, 2020, we had no recycling commodity hedges in place. At current volumes and mix of materials, we believe a $10 per ton change in the price of recycled commodities would change both annual revenue and operating income by approximately $12 million.Revenue from recycling processing and commodity sales during the years ended December 31, 2020 and 2019 was $297.1 million and $273.3 million, respectively. 58Table of Contents
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+ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSOverviewRoss Stores, Inc. operates two brands of off-price retail apparel and home fashion stores—Ross Dress for Less® (“Ross”) and dd’s DISCOUNTS®. Ross is the largest off-price apparel and home fashion chain in the United States with 1,585 locations in 40 states, the District of Columbia, and Guam, as of January 30, 2021. Ross offers first-quality, in-season, name brand and designer apparel, accessories, footwear, and home fashions for the entire family at savings of 20% to 60% off department and specialty store regular prices every day. We also operate 274 dd’s DISCOUNTS stores in 21 states as of January 30, 2021 that feature a more moderately-priced assortment of first-quality, in-season, name brand apparel, accessories, footwear, and home fashions for the entire family at savings of 20% to 70% off moderate department and discount store regular prices every day.Our primary objective is to pursue and refine our existing off-price strategies to maintain and improve both profitability and financial returns over the long term. In establishing appropriate growth targets for our business, and considering the pace and magnitude of the economic recovery post the COVID-19 pandemic, we are closely monitoring market share trends for the off-price industry and believe our share gains will continue to be driven mainly by continued focus on value and convenience by consumers. Our merchandise and operational strategies are designed to take advantage of the expanding market share of the off-price industry as well as the ongoing customer demand for name brand fashions for the family and home at compelling discounts every day. We refer to our fiscal years ended January 30, 2021, February 1, 2020, and February 2, 2019 as fiscal 2020, fiscal 2019, and fiscal 2018, respectively. Effects of the COVID-19 Pandemic on Our Business The United States and other countries are experiencing an ongoing, major global health pandemic related to the outbreak of a novel strain of coronavirus, COVID-19, that started at the beginning of 2020. Governmental authorities in affected regions have taken, and continue to take, dramatic actions in an effort to slow down the spread of the disease. Like other retailers across the country, we temporarily closed all our store locations, our distribution centers, and our buying and corporate offices for a significant part of our first and second fiscal quarters. We also instituted “work from home” measures for many of our associates. Our closures took effect March 20, 2020. All our distribution centers were reopened by the end of May 2020. The vast majority of our store locations were open and operating by the end of June 2020, and remained open throughout the remainder of fiscal 2020. While open, many of our stores were operating on shorter hours and under mandated occupancy restrictions for periods of time as compared to the prior year. The COVID-19 pandemic and the related economic disruption had a material adverse impact on our results of operations, financial position, and cash flows for fiscal 2020. The consolidated results presented in this report reflect the significant revenue decline and other impacts from our temporary store closures (for approximately half of the first quarter and 25 percent of the second quarter), mandated occupancy restrictions, and reduced operating hours. Our core business results improved during the second half of fiscal 2020; however, upsurges of COVID-19 in the fourth quarter, especially in California, our largest state, resulted in reduced customer traffic and slowed the pace of recovery. While vaccines have become available and a steadily increasing portion of the U.S. population is being vaccinated, it will take time for those efforts to reach levels that permit a relaxation of the social distancing restrictions. We expect the material adverse effects from the pandemic to continue through fiscal 2021 and potentially beyond. The temporary closure of all our stores during much of the first two fiscal quarters significantly impacted our ability to sell the seasonal inventory then on hand in a timely manner. As we reopened our stores and resumed operations in the middle of the second quarter, a significant portion of the merchandise in our stores was aged and out of season. We took deep markdowns to sell through this inventory. During the initial reopenings, sales were ahead of our conservative plans, as we benefited from pent-up consumer demand and aggressive markdowns. In the weeks after reopening, sales trends were negatively affected by depleted store inventory levels while we were ramping up our buying and distribution capabilities. During the third quarter, sales improved substantially compared to the second quarter. This was driven by several factors, including an improvement in our merchandise assortments, a 25later back-to-school season, stronger performance in our larger markets, and our return to more normal store hours. Our fourth quarter sales remained suppressed due to the negative impact from the upsurge in the virus that resulted in reduced customer traffic and more stringent occupancy and store operating hours restrictions. The ongoing effect of the COVID-19 pandemic on consumer behavior and spending patterns remains highly uncertain. Despite the initial surge in customer demand as our stores first reopened, we expect customer demand to be generally suppressed for an extended period of time. In addition, there have been recent resurgences in the spread of COVID-19 and new virus variants throughout the United States, which may also recur in the future, in one or more regions, and which have and could require our stores and distribution centers to temporarily close again nationally, regionally, or in specific locations. These closures would negatively impact our future revenue and operations.In response to the COVID-19 pandemic, we incurred various costs to reopen our stores and distribution centers, and we incurred additional operating costs for processes and procedures to facilitate social distancing, to enhance cleaning and sanitation activities, and to provide personal protective equipment to our associates. These actions, combined with various other actions taken to reduce costs, resulted in approximately $130 million of additional net costs in fiscal 2020. We expect our operating costs to remain elevated related to our continuing response to the COVID-19 pandemic.To preserve our financial liquidity and enhance our financial flexibility, we borrowed $800 million from our revolving credit facility in March 2020, completed a $2.0 billion senior notes offering in April 2020, and entered into a new $500 million 364-day senior revolving credit facility in May 2020. In the third quarter of fiscal 2020, we refinanced $775 million in aggregate principal amount of higher interest senior notes with the issuance of $1.0 billion in aggregate principal amount of lower interest rate senior notes. This action resulted in a refinancing charge of approximately $240 million in the third quarter, but will significantly reduce our annual interest expense and total cash outlays over the life of the debt. In addition to refinancing the senior notes, we took several other actions during the third quarter, to reduce our ongoing debt costs, including repayment of the $800 million revolving credit facility and termination of the undrawn $500 million 364-day senior revolving credit facility.We suspended our stock repurchase program in March 2020 and temporarily suspended quarterly dividends in May 2020, and we took measures to reduce our expenses, inventory receipts, and capital expenditures. Beginning April 5, 2020, we implemented temporary furloughs for a large portion of our hourly store and distribution center and other associates in our buying and corporate offices who could not work productively while our stores and distribution centers were closed. Employee health benefits for eligible associates continued during the temporary furlough at no cost to the impacted associates. We also reduced payroll expenses through temporary salary reductions for senior executives and other personnel, which remained in effect until May 24, 2020, when more than half of our stores had reopened. In conjunction with these payroll expense reduction measures, effective April 1, 2020, the non-employee members of our Board of Directors suspended the cash elements of their director compensation, which remained in effect until August 2020.In May 2020, in connection with the phased reopening of our store and distribution center locations, we began recalling many of our furloughed associates, as they were able to resume productive work. As of our third quarter, the majority of these associates had returned to work.Also in May 2020, we suspended rent payments associated with the leases for our temporarily closed stores. During fiscal 2020, we negotiated rent deferrals and/or rent abatements for a significant number of our stores. The repayment of the deferrals will be at later dates, primarily in fiscal 2021. We have recorded accruals for rent payment deferrals and have recorded rent abatements as a reduction of variable lease costs.Given the unprecedented impact the COVID-19 pandemic has had on our business, and the continued uncertainty surrounding the COVID-19 pandemic, including its unknown duration and future severity, the potential for resurgences and new virus variants, and the unknown overall impact on consumer demand and store productivity, we expect that impacts from the COVID-19 pandemic and the related cost increases and economic disruption may have a material adverse impact on our consolidated results of operations, financial condition, and cash flows in fiscal 2021 and potentially beyond.26Results of OperationsThe following table summarizes the financial results for fiscal 2020, 2019, and 2018:202020192018SalesSales (millions)$12,532 $16,039 $14,984 Sales (decline) growth(21.9)%7.0%6.0%Comparable store sales growth n/a13%24%2Costs and expenses (as a percent of sales)Cost of goods sold78.5%71.9%71.6%Selling, general and administrative20.0%14.7%14.8%Interest expense (income), net0.7%(0.1)%(0.1)%Earnings before taxes (as a percent of sales)0.8%13.5%13.7%Net earnings (as a percent of sales)0.7%10.4%10.6%1 Given the temporary store closures resulting from the COVID-19 pandemic, the comparable store sales metric for fiscal 2020 is not meaningful.2 Represents stores that have been open for more than 14 complete months.Stores. Total stores open at the end of fiscal 2020, 2019, and 2018 were 1,859, 1,805, and 1,717, respectively. The number of stores at the end of fiscal 2020, 2019, and 2018 increased by 3%, 5%, and 6% from the respective prior years. In response to the impacts from the COVID-19 pandemic, we reduced our pace of new store openings for fiscal 2020. Our longer term strategy is to open additional stores based on market penetration, local demographic characteristics, competition, expected store profitability, and the ability to leverage overhead expenses. We continually evaluate opportunistic real estate acquisitions and opportunities for potential new store locations. We also evaluate our current store locations and determine store closures based on similar criteria.Store Count202020192018Beginning of the period1,805 1,717 1,622 Opened in the period66 198 99 Closed in the period(12)(10)2(4)End of the period1,859 1,805 1,717 Selling square footage at the end of the period (000)38,800 37,900 36,300 1 Includes the reopening of a store previously temporarily closed due to a weather event.2 Includes the temporary closure of a store impacted by a weather event.Sales. Sales for fiscal 2020 decreased $3.5 billion, or 21.9%, compared to the prior year. This was primarily due to the negative impact from store closures during the March 2020 to June 2020 period, the negative impact on customer demand from the COVID-19 pandemic, mandated occupancy restrictions, and reduced store operating hours during the remainder of fiscal 2020. We opened 54 net new stores during 2020. The sales from these new stores partially offset the overall sales decline.Sales for fiscal 2019 increased $1.1 billion, or 7.0%, compared to the prior year due to the opening of 88 net new stores during 2019 and a 3% increase in sales from comparable stores.27Our sales mix is shown below for fiscal 2020, 2019, and 2018:2020120192018Home Accents and Bed and Bath28 %25 %26 %Ladies23 %26 %26 %Men’s14 %14 %14 %Accessories, Lingerie, Fine Jewelry, and Fragrances14 %13 %13 %Shoes12 %13 %13 %Children’s9 %9 %8 %Total100 %100 %100 %We intend to address the competitive climate for off-price apparel and home goods by pursuing and refining our existing strategies and by continuing to strengthen our merchant organization, diversify our merchandise mix, and more fully develop our systems to improve our merchandise offerings. Our historic strategies and store expansion program have contributed to our sales gains in the past. However, given the impacts from the COVID-19 pandemic on our results for fiscal 2020, and the significant ongoing impacts and uncertainties, including the unknown overall impact on consumer demand and shopping behavior, the unknown duration of the pandemic, and potential responses to it (which may require stores and distribution centers to close again nationally, regionally, or in specific locations), we cannot be sure that our strategies and resumption of our store expansion program will result in a continuation of our historical sales growth or in a recovery of, or an increase in, net earnings.Cost of goods sold. Cost of goods sold in fiscal 2020 decreased $1.7 billion compared to the prior year mainly due to the lower sales from the temporary closure of all store locations (starting on March 20, 2020 through a portion of the second quarter of fiscal 2020), and ensuing negative impact on customer demand from the COVID-19 pandemic after our store reopenings, as well as lower costs from the temporary furlough of most hourly associates in our distribution centers and some associates in our buying offices. These decreases were partially offset by higher markdowns used to clear aged and seasonal inventory, higher distribution costs primarily due to increased wages and higher freight costs due to industry-wide supply chain congestion, added expenditures for COVID-19 related measures, and higher occupancy costs from the opening of 54 net new stores during 2020. As we enter 2021, we expect higher supply chain costs from the industry-wide congestion to continue through fiscal 2021, along with higher costs from increases in wages we implemented in the second half of 2020.Cost of goods sold in fiscal 2019 increased $809.9 million compared to the prior year, mainly due to increased sales from the opening of 88 net new stores during the year and a 3% increase in sales from comparable stores.Cost of goods sold as a percentage of sales for fiscal 2019 increased approximately 35 basis points from the prior year, primarily due to a 35 basis point increase in distribution expenses and a 15 basis point increase in freight costs. These increases were partially offset by a 10 basis point improvement in merchandise gross margin and a five basis point reduction in buying costs.Selling, general and administrative expenses. For fiscal 2020, selling, general and administrative expenses (“SG&A”) increased $146.6 million compared to the prior year, primarily due to approximately $240 million in long-term debt refinancing costs, COVID-related expenses (including for supplies, cleaning, and payroll related to additional safety protocols), and payments to associates while our stores were closed (net of employee retention credits under the Coronavirus Aid, Relief, and Economic Security Act (the “CARES Act”)), partially offset by payroll-related cost reduction measures in response to the COVID-19 pandemic (including the temporary furlough of most hourly associates in our stores during closure periods, and some associates in our corporate offices), reductions in non-business critical operating expenses, and lower store operating expenses on lower sales. As we enter 2021, we expect our operating costs to continue to reflect ongoing COVID-related expenses and also higher wages.For fiscal 2019, SG&A increased $140.2 million compared to the prior year, mainly due to increased store operating costs reflecting the opening of 88 net new stores during the year. SG&A as a percentage of sales for fiscal 2019 decreased by approximately 10 basis points compared to the prior year primarily due to leverage on higher sales.28Interest expense (income), net. In fiscal 2020, net interest expense increased by $101.5 million compared to 2019 primarily due to higher interest expense on long-term debt due to the issuance of Senior Notes in April 2020 and October 2020 (net of repurchase of Senior Notes), lower interest income due to lower interest rates, and higher interest expense on short-term debt due to the draw down on our $800 million revolving credit facility in March 2020 (which was subsequently repaid in October 2020), partially offset by higher capitalized interest primarily related to the construction of our Brookshire, Texas distribution center. In fiscal 2019, net interest income improved by $7.9 million compared to 2018 primarily due to lower interest expense on long-term debt due to the repayment of the Series A 6.38% unsecured Senior Notes in December 2018 and higher capitalized interest primarily related to the construction of our Brookshire, Texas distribution center.The table below shows the components of interest expense and income for fiscal 2020, 2019, and 2018:($000)202020192018Interest expense on long-term debt$88,544 $13,139 $17,900 Interest expense on short-term debt7,863 — — Other interest expense3,908 968 1,004 Capitalized interest(12,251)(4,367)(2,497)Interest income(4,651)(27,846)(26,569)Interest expense (income), net$83,413 $(18,106)$(10,162)Taxes on earnings. Our effective tax rates for fiscal 2020, 2019, and 2018 were approximately 20%, 23%, and 23%, respectively. The effective tax rate represents the applicable combined federal and state statutory rates reduced by the federal benefit of state taxes deductible on federal returns. The effective rate is impacted by changes in tax law and accounting guidance, location of new stores, level of earnings, tax effects associated with share-based compensation, and the resolution of tax positions with various tax authorities. In fiscal 2019, we resolved uncertain tax positions with a state tax authority. As a result, we recognized a tax benefit of approximately $10.0 million in the Consolidated Statement of Earnings. In fiscal 2018, we resolved uncertain tax positions related to fiscal 2015 with the Internal Revenue Service. As a result, we recognized a tax benefit of approximately $26.0 million in the Consolidated Statement of Earnings.On March 27, 2020, the CARES Act was signed into law. The CARES Act made several significant changes to business tax provisions including modifications for net operating losses, employee retention credits, and deferral of employer payroll tax payments. On December 27, 2020, the Consolidated Appropriations Act of 2021 (“CAA”) was signed into law. The CAA made several changes to business tax provisions including increasing and extending the employee retention credits through June 30, 2021 and extending certain employment-related tax credits through December 31, 2025.Net earnings. Net earnings as a percentage of sales for fiscal 2020 were lower than in fiscal 2019, primarily due to higher cost of goods sold, higher SG&A expenses, and higher interest expense. Net earnings as a percentage of sales for fiscal 2019 were lower compared to fiscal 2018, primarily due to higher cost of goods sold, partially offset by lower SG&A expenses and higher interest income.Earnings per share. Diluted earnings per share in fiscal 2020 was $0.24, compared to $4.60 in the prior year. The lower diluted earnings per share in fiscal 2020 was primarily attributable to lower sales due to the closing of all our store locations starting on March 20, 2020 through a portion the second quarter of fiscal 2020 and the negative impact on customer demand from the COVID-19 pandemic, higher markdowns to clear aged and seasonal inventory, long-term debt refinancing costs, payments to associates while our stores were closed (net of employee retention credits under the CARES Act), and higher expenditures for COVID-19 related measures. Diluted earnings per share in fiscal 2019 was $4.60, which included a per share benefit of approximately $0.02 primarily related to the favorable resolution of a tax matter, compared to $4.26 in the prior year, which included a per share benefit of approximately $0.07 from the favorable resolution of a tax matter. 29Financial ConditionLiquidity and Capital ResourcesAs previously noted, the United States and other countries are experiencing a major global health pandemic related to the outbreak of a novel strain of coronavirus, COVID-19 that started at the beginning of 2020. Governmental authorities in affected regions have taken, and continue to take, dramatic actions in an effort to slow down the spread of the disease. Similar to other retailers across the country, we temporarily closed all store locations, our distribution centers, and our buying and corporate offices, effective March 20, 2020 through May 14, 2020, when we began a phased process of resuming operations. All our distribution centers were reopened by the end of May 2020. The vast majority of our store locations were open and operating by the end of June 2020, and remained open throughout the remainder of fiscal 2020, though many of our stores were operating on shorter hours and under mandated occupancy restrictions for periods of time, compared to the prior year. To preserve our financial liquidity and enhance our financial flexibility, we borrowed $800 million from our revolving credit facility in March 2020, completed a $2.0 billion senior notes offering in April 2020, and entered into a new $500 million 364-day senior revolving credit facility in May 2020. In the third quarter of fiscal 2020, we refinanced $775 million in aggregate principal amount of higher interest senior notes with the issuance of $1.0 billion in aggregate principal amount of lower interest rate senior notes. This action resulted in a refinancing charge of approximately $240 million in the third quarter, but will significantly reduce our annual interest expense and total cash outlays over the life of the debt. In addition to refinancing the senior notes refinancing, we took several other actions during the third quarter, to reduce our ongoing debt costs, including repayment of the $800 million revolving credit facility and termination of the undrawn $500 million 364-day senior revolving credit facility.We suspended our stock repurchase program in March 2020 and temporarily suspended quarterly dividends in May 2020, and we took measures to reduce our expenses, inventory receipts, and capital expenditures. Beginning April 5, 2020, we implemented temporary furloughs for a large portion of our hourly store and distribution center and other associates in our buying and corporate offices who could not work productively while our stores and distribution centers were closed. Employee health benefits for eligible associates continued during the temporary furlough at no cost to the impacted associates. We also reduced payroll expenses through temporary salary reductions for senior executives and other personnel, which remained in effect until May 24, 2020, when more than half of our stores had reopened. In conjunction with these payroll expense reduction measures, effective April 1, 2020, the non-employee members of our Board of Directors suspended the cash elements of their director compensation, which remained in effect until August 2020. Also in May 2020, we suspended rent payments associated with the leases for our temporarily closed stores. During fiscal 2020, we negotiated rent deferrals and/or rent abatements for a significant number of our stores. The repayment of the deferrals will be at later dates, primarily in fiscal 2021. We recorded accruals for rent payment deferrals and recorded rent abatements as a reduction of variable lease costs. We ended fiscal 2020 with over $5.6 billion in liquidity, which consists of $4.8 billion unrestricted cash balances and the $800 million available under our revolving credit facility.Historically, our primary sources of funds for our business activities have been cash flows from operations and short-term trade credit. Our primary ongoing cash requirements are for merchandise inventory purchases, payroll, operating and variable lease costs, taxes, and for capital expenditures in connection with new and existing stores, and investments in distribution centers, information systems, and buying and corporate offices. We also use cash to pay dividends, to repay debt as it becomes due, and to repurchase stock under active stock repurchase programs. Due to the COVID-19 pandemic and related economic disruptions, and with the possibility that some of our stores, distribution centers, and other facilities may need to temporarily close again, or continue on reduced operating hours and/or capacity restrictions, as a result of government mandates, we anticipate potential interruptions to our cash flows from operations. We anticipate that we will be required to rely more on our cash reserves and we expect to carefully monitor and manage our cash position in light of ongoing conditions and levels of operations.30($ millions)202020192018Cash provided by operating activities$2,245.9 $2,171.5 $2,066.7 Cash used in investing activities(405.4)(555.0)(410.4)Cash provided by (used in) financing activities1,701.9 (1,683.2)(1,531.5)Net increase (decrease) in cash, cash equivalents, and restricted cash and cash equivalents$3,542.4 $(66.7)$124.8 Operating ActivitiesNet cash provided by operating activities was $2.2 billion in fiscal 2020. This was primarily driven by higher accounts payable due to extended payment terms, lower merchandise receipts as we closely managed inventory levels and used packaway inventory to replenish our stores, and net earnings excluding non-cash expenses for depreciation and amortization. This was partially offset by the lower net earnings due to lower sales from the temporary closing of all store locations starting on March 20, 2020 through a portion of the second quarter, and the negative impact on customer demand from the COVID-19 pandemic. Net cash provided by operating activities was $2.2 billion and $2.1 billion in fiscal 2019 and 2018, respectively, and was primarily driven by net earnings excluding non-cash expenses for depreciation and amortization and for deferred taxes. The increase in cash flow from operating activities in fiscal 2020 compared to fiscal 2019 was primarily driven by higher accounts payable leverage. The increase in cash flow from operating activities in fiscal 2019 compared to fiscal 2018 was primarily driven by higher earnings and the timing of merchandise receipts and related payments versus the prior year. Accounts payable leverage (defined as accounts payable divided by merchandise inventory) was 150%, 71%, and 67% as of January 30, 2021, February 1, 2020, and February 2, 2019, respectively. The increase in accounts payable leverage in fiscal 2020 compared to fiscal 2019 was primarily driven by lower packaway and in-store inventory and extended payment terms. The increase in accounts payable leverage in fiscal 2019 compared to fiscal 2018 was primarily driven by timing of merchandise receipts and related payments versus the prior year.As a regular part of our business, packaway inventory levels will vary over time based on availability of compelling merchandise purchase opportunities in the marketplace and our decisions on the timing for release of that inventory. Packaway merchandise is purchased with the intent that it will be stored in our warehouses until a later date. The timing of the release of packaway inventory to our stores is principally driven by the product mix and seasonality of the merchandise, and its relation to our store merchandise assortment plans. As such, the aging of packaway varies by merchandise category and seasonality of purchase, but in normal times and historically, packaway remains in storage less than six months. We expect to continue to take advantage of packaway inventory opportunities to maximize our ability to deliver bargains to our customers.Changes in packaway inventory levels impact our operating cash flow. At the end of fiscal 2020, packaway inventory was 38% of total inventory compared to 46% at the end of both fiscal 2019 and 2018. Investing ActivitiesNet cash used in investing activities was $405.4 million, $555.0 million, and $410.4 million in fiscal 2020, 2019, and 2018, respectively. The decrease in cash used for investing activities in fiscal 2020 compared to fiscal 2019 was primarily due to a reduction in our capital expenditures. The increase in cash used for investing activities in fiscal 2019 compared to fiscal 2018 was primarily due to an increase in our capital expenditures.The decrease in capital expenditures in fiscal 2020 compared to fiscal 2019 was primarily due to our actions to preserve our financial liquidity in response to the COVID-19 pandemic and related economic disruptions. The increase in capital expenditures in fiscal 2019 compared to fiscal 2018 was primarily due to investments in our distribution centers, and information technology infrastructure investments for our stores, buying, corporate offices, and transportation. We opened 66, 98, and 99 new stores in fiscal 2020, 2019, and 2018, respectively. In fiscal 2020, 2019, and 2018, our capital expenditures were $405.4 million, $555.5 million, and $413.9 million, respectively. Our capital expenditures included costs to build, expand, and improve distribution centers (primarily related to the ongoing construction of our Brookshire, Texas distribution center); open new stores and improve 31existing stores; and for various other expenditures related to our information technology systems, buying, and corporate offices. Our capital expenditures over the last three years are set forth in the table below:($ millions)202020192018New stores$81.1 $137.4 $134.5 Existing stores54.8 125.3 130.5 Information systems, corporate, and other38.3 91.8 84.9 Distribution and transportation231.2 201.0 64.0 Total capital expenditures$405.4 $555.5 $413.9 Capital expenditures for fiscal 2021 are projected to be approximately $700 million. Our planned capital expenditures for fiscal 2021 are expected to be used for continued construction of our Brookshire, Texas distribution center, costs for fixtures and leasehold improvements to open planned new Ross and dd’s DISCOUNTS stores, investments in certain information technology systems, and for various other needed expenditures related to our stores, distribution centers, buying, and corporate offices. We expect to fund capital expenditures with available cash. The increase in our planned capital expenditures from fiscal 2020 are primarily driven by the continued construction of our Brookshire, Texas distribution center and the resumption of certain projects that were deferred from fiscal 2020. Financing ActivitiesNet cash provided by financing activities was $1.7 billion in fiscal 2020. Net cash used in financing activities was $1.7 billion and $1.5 billion in fiscal 2019 and 2018, respectively. The increase in cash provided by financing activities for fiscal 2020, compared to fiscal 2019, was primarily due to the completion of our public debt offerings, net of repurchase and refinancing costs, and the suspension of our share repurchases and dividends in the second quarter of 2020.In July 2019, we entered into a new $800 million unsecured revolving credit facility, which replaced our previous $600 million unsecured revolving credit facility. This current credit facility expires in July 2024, and contains a $300 million sublimit for issuance of standby letters of credit. The facility also contains an option allowing us to increase the size of our revolving credit facility by up to an additional $300 million, with the agreement of the lenders. Interest on borrowings under this facility is based on LIBOR (or an alternate benchmark rate, if LIBOR is no longer available) plus an applicable margin and is payable quarterly and upon maturity. The revolving credit facility may be extended, at our option, for up to two additional one-year periods, subject to customary conditions. In March 2020, we borrowed $800 million under our revolving credit facility. Interest on the loan was based on LIBOR plus 0.875% (or 1.76%). In May 2020, we amended the $800 million revolving credit facility (the “Amended Credit Facility”) to temporarily suspend for the second and third quarters of fiscal 2020 the Consolidated Adjusted Debt to EBITDAR ratio financial covenant, and to apply a transitional modification to that ratio effective in the fourth quarter of fiscal 2020. The Amended Credit Facility also established a new temporary minimum liquidity requirement effective for the first quarter of fiscal 2020 and through the end of April 2021. As of January 30, 2021, we were in compliance with these amended covenants.In October 2020, we repaid in full the $800 million we borrowed under the unsecured revolving credit facility. As a result, we currently have no borrowings or standby letters of credit outstanding under this facility, and the $800 million credit facility remains in place and available. In May 2020, we also entered into an additional $500 million 364-day senior revolving credit facility which was scheduled to expire in April 2021. In October 2020, we terminated this senior revolving credit facility. We had no borrowings under that credit facility at any time.32In April 2020, we issued an aggregate of $2.0 billion in unsecured senior notes in four tenors as follows: $700 million of 4.600% Senior Notes due April 2025, $400 million of 4.700% Senior Notes due April 2027, $400 million of 4.800% Senior Notes due April 2030, and $500 million of 5.450% Senior Notes due April 2050.In October 2020, we accepted for purchase approximately $775 million in aggregate principal amount of senior notes pursuant to cash tender offers as follows: $351 million of the 2050 Notes, $266 million of the 2030 Notes, and $158 million of the 2027 Notes. We paid approximately $1.003 billion in aggregate consideration (including transaction costs, and accrued and unpaid interest) and recorded an approximately $240 million loss on the early extinguishment for the accepted notes.In October 2020, we also issued an aggregate of $1.0 billion in unsecured senior notes in two tenors as follows: 0.875% Senior Notes due April 2026 (the “2026 Notes”) with an aggregate principal amount of $500 million and 1.875% Senior Notes due April 2031 (the “2031 Notes”) with an aggregate principal amount of $500 million. Cash proceeds, net of discounts and other issuance costs, were approximately $987.2 million. We used the net proceeds from the offering of the 2026 and 2031 Notes to fund the purchase of the accepted notes from our tender offers.In June 2020, we amended the covenants associated with the $65 million outstanding Series B unsecured senior notes. The amended covenants are consistent with the corresponding covenants in our existing revolving credit facility. As of January 30, 2021, we were in compliance with these covenants.On December 13, 2018, we repaid at maturity the $85 million principal amount of the Series A 6.38% unsecured Senior Notes. In March 2019, our Board of Directors approved a two-year $2.55 billion stock repurchase program through fiscal 2020. Due to the economic uncertainty stemming from the severe impact of the COVID-19 pandemic, we suspended our stock repurchase program in March 2020, at which time we had repurchased $1.407 billion under the $2.55 billion stock repurchase program. We do not plan on making additional purchases until further notice. In February 2017, our Board of Directors approved a two-year $1.75 billion stock repurchase program through fiscal 2018. In March 2018, our Board of Directors approved an increase in the stock repurchase authorization for fiscal 2018 by $200 million to $1.075 billion, up from the previously available $875 million. We repurchased 1.2 million, 12.3 million, and 12.5 million shares of common stock for aggregate purchase prices of approximately $132 million, $1,275 million, and $1,075 million in fiscal 2020, 2019, and 2018, respectively. We also acquired 0.5 million, 0.6 million, and 0.7 million shares in fiscal 2020, 2019, and 2018, respectively, of treasury stock from our employee stock equity compensation programs, for aggregate purchase prices of approximately $45.2 million, $60.7 million, and $54.4 million during fiscal 2020, 2019, and 2018, respectively. On March 2, 2021, our Board of Directors declared a quarterly cash dividend of $0.285 per common share, payable on March 31, 2021, resuming our payment of quarterly dividends. Our most recent prior quarterly dividend was a cash dividend of $0.285 per common share declared by our Board of Directors in March 2020. In May 2020, we temporarily suspended our quarterly dividends, due to the economic uncertainty stemming from the COVID-19 pandemic. Our Board of Directors declared cash dividends of $0.255 per common share in March, May, August, and November 2019, and cash dividends of $0.225 per common share in March, May, August, and November 2018. During fiscal 2020, 2019, and 2018, we paid dividends of $101.4 million, $369.8 million, and $337.2 million, respectively. Short-term trade credit represents a significant source of financing for our merchandise inventory. Trade credit arises from customary payment terms and trade practices with our vendors. We regularly review the adequacy of credit available to us from all sources. Due to the COVID-19 pandemic and related economic disruptions, we face added uncertainty about the levels of trade credit we can maintain and liquidity available from sales of merchandise. During fiscal 2020, our liquidity and capital requirements were provided by available cash and cash flows from operations, and our long-term debt financing. During fiscal 2019 and 2018, our liquidity and capital requirements were provided by available cash and cash flows from operations.33The COVID-19 pandemic and related economic disruptions, including the temporary closure of all of our store locations effective March 20, 2020 through a portion of the second quarter, continue to create significant uncertainty and challenges. We believe that existing cash balances, our bank credit facility, and trade credit are adequate to meet our operating, investing, and financing needs for at least the next 12 months.Contractual Obligations and Off-Balance Sheet ArrangementsThe table below presents our significant contractual obligations as of January 30, 2021:Less than1 year1 - 3years3 - 5yearsAfter 5yearsTotal¹($000)Recorded contractual obligations: Senior notes$65,000 $— $950,000 $1,524,991 $2,539,991 Operating leases628,613 1,220,165 813,939 611,178 3,273,895 New York buying office ground lease²5,883 13,898 14,178 940,438 974,397 Unrecorded contractual obligations: Real estate obligations36,420 32,937 35,388 113,992 188,737 Interest payment obligations84,369 160,631 136,094 299,041 680,135 Purchase obligations43,048,513 13,540 1,593 — 3,063,646 Total contractual obligations$3,838,798 $1,441,171 $1,951,192 $3,489,640 $10,720,801 1 We have a $65.5 million liability for unrecognized tax benefits that is included in Other long-term liabilities on our Consolidated Balance Sheets. This liability is excluded from the schedule above as the timing of payments cannot be reasonably estimated.² Our New York buying office building is subject to a 99-year ground lease.3 Minimum lease payments for operating leases signed that have not yet commenced.4 Purchase obligations primarily consist of merchandise inventory purchase orders, commitments related to construction projects, store fixtures and supplies, and information technology services, transportation, and maintenance contracts.Other than the unrecorded contractual obligations noted above, we do not have any material off-balance sheet arrangements as of January 30, 2021. Standby letters of credit and collateral trust. We use standby letters of credit outside of our revolving credit facility in addition to a funded trust to collateralize some of our insurance obligations. We also use standby letters of credit outside of our revolving credit facility to collateralize some of our trade payable obligations. As of January 30, 2021 and February 1, 2020, we had $15.3 million and $4.2 million, respectively, in standby letters of credit outstanding, and $56.1 million and $56.0 million, respectively, in a collateral trust. The standby letters of credit are collateralized by restricted cash and the collateral trust consists of restricted cash, cash equivalents, and investments.Trade letters of credit. We had $16.3 million and $11.2 million in trade letters of credit outstanding at January 30, 2021 and February 1, 2020, respectively.Effects of inflation or deflation. We do not consider the effects of inflation or deflation to be material to our financial position and results of operations.OtherCritical Accounting PoliciesThe preparation of our consolidated financial statements requires our management to make estimates and assumptions that affect the reported amounts. These estimates and assumptions are evaluated on an ongoing basis and are based on historical experience and on various other factors that management believes to be reasonable. We believe the following critical accounting policies describe the more significant judgments and estimates used in the preparation of our consolidated financial statements and are not intended to be a comprehensive list of all of our accounting policies. 34In many cases, the accounting treatment of a particular transaction is specifically dictated by Generally Accepted Accounting Principles (“GAAP”), with no need for management’s judgment in their application. There are also areas in which management’s judgment in selecting one alternative accounting principle over another would not produce a materially different result. See our audited consolidated financial statements and notes thereto under Item 8 in this Annual Report on Form 10-K, which contain descriptions of our accounting policies and other disclosures required by GAAP.Merchandise inventory. Our merchandise inventory is stated at the lower of cost (determined using a weighted-average basis) or net realizable value. We purchase inventory that can either be shipped to stores or processed as packaway merchandise with the intent that it will be warehoused and released to stores at a later date. The timing of the release of packaway inventory to our stores is principally driven by the product mix and seasonality of the merchandise, and its relation to the Company’s store merchandise assortment plans. As such, the aging of packaway varies by merchandise category and seasonality of purchase, but typically packaway remains in storage less than six months. Packaway inventory accounted for approximately 38%, 46%, and 46% of total inventories as of January 30, 2021, February 1, 2020, and February 2, 2019, respectively. Merchandise inventory includes acquisition, processing, and storage costs related to packaway inventory.Included in the carrying value of our merchandise inventory is a provision for shortage. The shortage reserve is based on historical shortage rates as evaluated through our annual physical merchandise inventory counts and cycle counts. If actual market conditions, markdowns, or shortage are less favorable than those projected by us, or if sales of the merchandise inventory are more difficult than anticipated, additional merchandise inventory write-downs may be required.Lease accounting. As our leases generally do not provide an implicit discount rate; we use the estimated collateralized incremental borrowing rate based on information available at the lease commencement date in determining the present value of lease payments for use in the calculation of the operating lease liabilities and right-of-use assets. This rate is determined using a portfolio approach based on the risk-adjusted rate of interest and requires estimates and assumptions including credit rating, credit spread, and adjustments for the impact of collateral. We believe that this is the rate we would have to pay to borrow an amount equal to the lease payments on a collateralized basis over a similar lease term. Operating lease liabilities and corresponding right-of-use assets include options to extend lease terms that are reasonably certain of being exercised. We do not record a lease liability and corresponding right-of-use asset for leases with terms of 12 months or less, and account for lease and non-lease components as a single lease component. Our lease portfolio is comprised of operating leases with the lease cost recorded on a straight-line basis over the lease term.Prior to our adoption of Accounting Standards Codification (“ASC”) 842 in the beginning of fiscal 2019, when a lease contained “rent holidays” or required fixed escalations of the minimum lease payments, we recorded rental expense on a straight-line basis over the term of the lease and the difference between the average rental amount was charged to expense and the amount payable under the lease was recorded as deferred rent. We began recording rent expense on the lease possession date. Tenant improvement allowances were amortized over the lease term. Changes in deferred rent and tenant improvement allowances were included as a component of operating activities in the Consolidated Statements of Cash Flows. Insurance obligations. We use a combination of insurance and self-insurance for a number of risk management activities, including workers’ compensation, general liability, and employee-related health care benefits. Our self-insurance and deductible liability is determined actuarially, based on claims filed and an estimate of claims incurred but not reported. Should a greater amount of claims occur compared to what is estimated or the costs of medical care increase beyond what was anticipated, our recorded reserves may not be sufficient and additional charges could be required.Recent Accounting Pronouncements See Note A to the Consolidated Financial Statements - Summary of Significant Accounting Policies (Recently issued accounting standards and Recently adopted accounting standards) for a discussion of recent accounting pronouncements and their impact to our Consolidated Financial Statements.35Forward-Looking StatementsOur Annual Report on Form 10-K for fiscal 2020, and information we provide in our Annual Report to Stockholders, press releases, and other investor communications including those on our corporate website, may contain a number of forward-looking statements regarding, without limitation, the rapidly developing challenges and our plans and responses to the COVID-19 pandemic and related economic disruptions, including adjustments to our operations, planned new store growth, new markets, expected sales, projected earnings levels, capital expenditures, and other matters. These forward-looking statements reflect our then current beliefs, plans, and estimates with respect to future events and our projected financial performance, operations, and competitive position. The words “plan,” “expect,” “target,” “anticipate,” “estimate,” “believe,” “forecast,” “projected,” “guidance,” “looking ahead,” and similar expressions identify forward-looking statements.Future impact from the ongoing COVID-19 pandemic, and other economic and industry trends that could potentially impact revenue, profitability, operating conditions, and growth remain difficult to predict. Our forward-looking statements are subject to risks and uncertainties which could cause our actual results to differ materially from those forward-looking statements and our previous expectations, plans, and projections. Refer to Item 1A in this Annual Report on Form 10-K for a more complete discussion of risk factors for Ross and dd’s DISCOUNTS. The factors underlying our forecasts are dynamic and subject to change. As a result, any forecasts or forward-looking statements speak only as of the date they are given and do not necessarily reflect our outlook at any other point in time. We disclaim any obligation to update or revise these forward-looking statements.ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKWe are exposed to market risks, which primarily include changes in interest rates. We do not engage in financial transactions for trading or speculative purposes.We occasionally use forward contracts to hedge against fluctuations in foreign currency prices. We had no outstanding forward contracts as of January 30, 2021.Interest that is payable on our revolving credit facility is based on variable interest rates and is, therefore, affected by changes in market interest rates. As of January 30, 2021, we had no borrowings outstanding under our revolving credit facility.As of January 30, 2021, we have outstanding eight series of unsecured Senior Notes. Interest that is payable on all series of our Senior Notes is based on fixed interest rates, and is therefore unaffected by changes in market interest rates. We receive interest on our short- and long-term investments. Changes in interest rates may impact interest income recognized in the future, or the fair value of our investment portfolio.A hypothetical 100 basis point increase or decrease in prevailing market interest rates would not have a material negative impact on our consolidated financial position, results of operations, cash flows, or the fair values of our short- and long-term investments as of and for the year ended January 30, 2021. We do not consider the potential losses in future earnings and cash flows from reasonably possible, near-term changes in interest rates to be material.36
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+Item 7. Management’s Discussion and Analysis of Financial Condition and Results of OperationsThe following Management's Discussion and Analysis (“MD&A”) provides a narrative of the results of operations and financial condition of S&P Global Inc. (together with its consolidated subsidiaries, the “Company,” “we,” “us” or “our”) for the years ended December 31, 2020 and 2019, respectively. The MD&A should be read in conjunction with the consolidated financial statements and accompanying notes included in this Annual Report on Form 10-K for the year ended December 31, 2020, which have been prepared in accordance with accounting principles generally accepted in the U.S. (“U.S. GAAP”). The MD&A includes the following sections:•Overview•Results of Operations•Liquidity and Capital Resources•Reconciliation of Non-GAAP Financial Information•Critical Accounting Estimates•Recent Accounting StandardsCertain of the statements below are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. In addition, any projections of future results of operations and cash flows are subject to substantial uncertainty. See Forward-Looking Statements on page 4 of this report.OVERVIEWWe are a leading provider of transparent and independent ratings, benchmarks, analytics and data to the capital and commodity markets worldwide. The capital markets include asset managers, investment banks, commercial banks, insurance companies, exchanges, trading firms and issuers; and the commodity markets include producers, traders and intermediaries within energy, petrochemicals, metals and agriculture. Our operations consist of four reportable segments: S&P Global Ratings ("Ratings"), S&P Global Market Intelligence ("Market Intelligence"), S&P Global Platts ("Platts") and S&P Dow Jones Indices ("Indices"). •Ratings is an independent provider of credit ratings, research and analytics, offering investors and other market participants information, ratings and benchmarks.•Market Intelligence is a global provider of multi-asset-class data, research and analytical capabilities, which integrate cross-asset analytics and desktop services. •Platts is the leading independent provider of information and benchmark prices for the commodity and energy markets.•Indices is a global index provider maintaining a wide variety of valuation and index benchmarks for investment advisors, wealth managers and institutional investors.Major Portfolio Changes The following significant changes were made to our portfolio during the three years ended December 31, 2020:•In January of 2020, we completed the acquisition of the ESG Ratings Business from RobecoSAM, which includes the widely followed SAM* Corporate Sustainability Assessment, an annual evaluation of companies' sustainability practices. The acquisition will bolster our position as the premier resource for essential environmental, social, and governance ("ESG") insights and product solutions for our customers. Through this acquisition, we will be able to offer our customers even more transparent, robust and comprehensive ESG solutions. •In April of 2018, we acquired Kensho Technologies Inc. ("Kensho") for approximately $550 million, net of cash acquired, in a mix of cash and stock. Kensho is a leading-edge provider of next-generation analytics, artificial intelligence, machine learning, and data visualization systems to Wall Street's premier global banks and investment institutions, as well as the National Security community. Beginning in the first quarter of 2019, the contract obligations for revenue from Kensho's major customers were transferred to Market Intelligence for fulfillment. As a result of this transfer, from January 1, 2019 revenue from contracts with Kensho’s customers is reflected in Market Intelligence’s results. In 2018, the revenue from contracts with Kensho’s customers was reported in Corporate revenue.33Table of Contents Shareholder ReturnDuring the three years ended December 31, 2020, we have returned approximately $5.8 billion to our shareholders through a combination of share repurchases and our quarterly dividends: we completed share repurchases of approximately $4.1 billion and distributed regular quarterly dividends totaling approximately $1.7 billion. Also, on January 27, 2021 the Board of Directors approved an increase in the quarterly common stock dividend from $0.67 per share to $0.77 per share.Key Results(in millions)Year ended December 31,% Change 1 202020192018’20 vs ’19’19 vs ’18Revenue$7,442 $6,699 $6,258 11%7%Operating profit 2$3,617 $3,226 $2,790 12%16%% Operating margin49 %48 %45 %Diluted earnings per share from net income$9.66 $8.60 $7.73 12%11% 1 % changes in the tables throughout the MD&A are calculated off of the actual number, not the rounded number presented. 2 2020 includes lease impairments of $120 million, employee severance charges of $66 million, IHS Markit merger costs of $24 million, a gain on dispositions $16 million, a technology-related impairment charge of $12 million, lease-related costs of $11 million and Kensho retention related expense of $11 million. 2019 includes a gain on the sale of RigData and SPIAS of $27 million and $22 million, respectively, employee severance charges of $25 million, Kensho retention related expense of $21 million, lease impairments of $11 million and acquisition-related costs of $4 million. 2018 includes legal settlement expenses of $74 million, Kensho retention related expense of $31 million, restructuring charges related to a business disposition and employee severance charges of $25 million and lease impairments of $11 million. 2020 also includes amortization of intangibles from acquisitions of $123 million and 2019 and 2018 includes amortization of intangibles from acquisitions of $122 million.2020Revenue increased 11%, with a favorable benefit of 1 percentage point from the net impact of recent acquisitions and dispositions, driven by increases at all of our reportable segments. Revenue growth at Ratings was mainly driven by higher corporate bond ratings revenue, partially offset by a decrease in bank loan ratings revenue and structured finance transaction revenues. Revenue growth at Market Intelligence was driven by annualized contract value growth in Market Intelligence Desktop products, Credit Risk Solutions and Data Management Solutions. Revenue growth at Indices was due to higher assets under management for exchange traded funds ("ETFs") and mutual funds, an increase in exchange-traded derivatives revenue and higher data subscription revenue. The revenue increase at Platts was primarily due to continued demand for market data, price assessment and analytics products. Foreign exchange rates had a favorable impact of less than 1 percentage point.Operating profit increased 12%, with a favorable impact from foreign exchange rates of 1 percentage point. Excluding the impact of a higher lease impairment charges in 2020 of 3 percentage points, higher employee severance charges in 2020 of 1 percentage point, a higher gain on dispositions in 2019 of 1 percentage point primarily related to the sale of RigData and Standard & Poor's Investment Advisory Services LLC ("SPIAS") and IHS Markit merger costs in 2020 of 1 percentage point, operating profit increased 18%. The increase was primarily due to revenue growth at all of our reportable segments combined with a decrease in travel and entertainment expenses from non-essential travel restrictions in response to COVID-19, partially offset by an increase in incentive costs and higher compensation costs driven by annual merit increases and additional headcount.2019Revenue increased 7%, with an unfavorable impact of 1 percentage point from foreign exchange rates. The increase was driven by revenue growth at all of our reportable segments. Revenue growth at Ratings was driven by an increase in corporate bond ratings revenue and public finance revenue, partially offset by lower bank loan ratings revenue. The increase at Market Intelligence was driven by annualized contract value growth in the Market Intelligence Desktop, Credit Risk Solutions and Data Management Solutions products. The increase at Indices was due to higher levels of assets under management for ETFs and mutual funds. Revenue growth at Indices was also favorably impacted by the buyout of the balance of intellectual property rights in a family of indices from one of our co-marketing and index development partners in the fourth quarter of 2018, retrospective fees for previously unlicensed and unreported index usage and benefits related to recent contract renegotiation. The increase at Platts was primarily due to continued demand for market data and price assessment products. 34Table of Contents Operating profit increased 16%, with a favorable impact from foreign exchange rates of less than 1 percentage point. Excluding the impact of higher legal settlement expenses in 2018 of 3 percentage points, a gain on our dispositions of 2 percentage points and higher Kensho retention related expense in 2018 of 1 percentage point, operating profit increased 10%. The increase was primarily due to revenue growth at all of our reportable segments, lower professional fees and decreased expenses at Corporate Unallocated driven by a $20 million reduction in contributions made to the S&P Global Foundation in 2018. These increases to operating profit were partially offset by higher technology costs, an increase in incentive costs and higher compensation costs driven by annual merit increases and additional headcount.We are closely monitoring the impact of the outbreak of COVID-19 on all aspects of our business. While COVID-19 did not have a material adverse effect on our reported results for the year ended December 31, 2020, we are unable to predict the ultimate impact that it may have on our business, future results of operations, financial position or cash flows.Our StrategyWe are a leading provider of transparent and independent ratings, benchmarks, analytics and data to the capital and commodity markets worldwide. Our purpose is to provide the intelligence that is essential for companies, governments and individuals to make decisions with conviction. We seek to deliver on this purpose in line with our core values of integrity, excellence and relevance.In 2018, we announced the launch of Powering the Markets of the Future to provide a framework for our forward-looking business strategy. Through this framework, we seek to deliver an exceptional, differentiated customer experience by enhancing our foundational capabilities, evolving and growing our core businesses, and pursuing growth via adjacencies. In 2021, we will strive to deliver on our strategic priorities in the following key areas:Finance•Meeting or exceeding revenue growth and EBITA margin targets with particular focus on accelerating growth in the greater Asia Pacific region;•Funding organic opportunities and pursuing disciplined acquisitions, investments and partnerships to support our key growth areas;•Taking a lead role in the market regarding ESG disclosures and achieving our stated environmental sustainability targets; and•Executing against Integration Management Office ("IMO") and regulatory milestones; building trust and team cohesion with INFO colleagues; laying groundwork to set proforma organization up for successful realization of our synergy and strategic goals.Customer•Continuing to deliver our key initiatives to the market and building them through a customer-first lens;•Prioritizing customer preferences, while enhancing and adjusting the delivery of our products across multiple channels such as feeds and APIs; and delivering on S&P Global Platform initiatives;•Incorporating a customer perspective in all divisions and functions, including the reimagining of our customer's work environments and how best to serve them; pursuing partnerships to meet customers where they are; and•Nurturing and protecting the core franchise, while growing brand equity with the appropriate investments.Operations•Improving end-user productivity and experience by providing our employees with the tools and processes to better serve our customers;•Reimagining our work environment by continuing to standardize our technology and encouraging employee participation in the reshaping of where we work, how we work and how we serve;35Table of Contents •Advancing our risk culture by maturing risk management & compliance processes and our cyber security posture; and•Utilizing our innovation teams and latest technology to maintain our commitment to advancing our shared data processes and technical capabilities.People•Continuing to foster a people first environment, while maintaining existing levels of engagement;•Encouraging career mobility through career coaching, while attracting and retaining the best people; and•Improving diverse representation through talent acquisition, advancement and retention, while continuing to raise awareness of racial education.There can be no assurance that we will achieve success in implementing any one or more of these strategies as a variety of factors could unfavorably impact operating results, including prolonged difficulties in the global credit markets and a change in the regulatory environment affecting our businesses. See Item 1A, Risk Factors, in this Annual Report on Form 10-K.Further projections and discussion on our 2021 outlook for our segments can be found within “ – Results of Operations”.RESULTS OF OPERATIONSConsolidated Review (in millions)Year ended December 31,% Change 202020192018’20 vs ’19’19 vs ’18Revenue$7,442 $6,699 $6,258 11%7%Expenses: Operating-related expenses2,092 1,976 1,838 6%7% Selling and general expenses1,543 1,342 1,424 15%(6)% Depreciation and amortization206 204 206 1%(1)% Total expenses3,841 3,522 3,468 9%2% Gain on dispositions(16)(49)— (67)%N/MOperating profit3,617 3,226 2,790 12%16% Other (income) expense, net(31)98 (25)N/MN/M Interest expense, net141 141 134 —%5%Loss on extinguishment of debt 279 57 — N/MN/M Provision for taxes on income694 627 560 11%12%Net income2,534 2,303 2,121 10%9%Less: net income attributable to noncontrolling interests(195)(180)(163)(9)%(10)%Net income attributable to S&P Global Inc.$2,339 $2,123 $1,958 10%8%N/M- not meaningful36Table of Contents Revenue(in millions)Year ended December 31,% Change 202020192018’20 vs ’19’19 vs ’18Subscription revenue$3,036 $2,843 $2,682 7%6%Non-subscription / transaction revenue2,039 1,632 1,401 25%17%Non-transaction revenue1,492 1,401 1,408 6%(1)%Asset-linked fees648 623 542 4%15%Sales usage-based royalties227 200 225 14%(11)%% of total revenue: Subscription revenue41 %43 %43 % Non-subscription / transaction revenue27 %24 %22 % Non-transaction revenue20 %21 %23 % Asset-linked fees9 %9 %9 % Sales usage-based royalties3 %3 %3 %U.S. revenue$4,504 $3,976 $3,750 13%6%International revenue: European region1,769 1,659 1,543 7%8% Asia782 710 647 10%10% Rest of the world387 354 318 9%11%Total international revenue$2,938 $2,723 $2,508 8%9%% of total revenue: U.S. revenue61 %59 %60 % International revenue39 %41 %40 % 37Table of Contents 2020Revenue increased 11% as compared to 2019. Subscription revenue increased primarily from growth in Market Intelligence's average contract values and continued demand for Platts proprietary content. Higher data subscription revenue at Indices also contributed to subscription revenue growth. Non-subscription / transaction revenue increased due to an increase in corporate bond ratings revenue, partially offset by a decrease in bank loan ratings revenue and structured finance transaction revenues at Ratings. Non-transaction revenue increased primarily due to an increase in surveillance revenue, royalty revenue, and higher Ratings Evaluation Service activity. Asset linked fees increased due to the impact of higher average levels of assets under management for ETFs and mutual funds at Indices. The increase in sales-usage based royalties was primarily driven by higher exchange-traded derivative volumes at Indices. See “Segment Review” below for further information. The favorable impact of foreign exchange rates increased revenue by less than 1 percentage point. This impact refers to constant currency comparisons estimated by recalculating current year results of foreign operations using the average exchange rate from the prior year.2019Revenue increased 7% as compared to 2018. Subscription revenue increased primarily from growth in Market Intelligence's average contract values and continued demand for Platt's proprietary content. Higher data subscription revenue at Indices also contributed to subscription revenue growth. Non-subscription / transaction revenue increased driven by an increase in corporate bond ratings revenue and public finance revenue, partially offset by a decline in bank loan ratings revenue at Ratings. Non-transaction revenue decreased 1% primarily due to the unfavorable impact from foreign exchange rates. Non-transaction revenue was unfavorably impacted by a decline in Ratings Evaluation Service activity, a decrease at CRISIL, primarily within the risk and analytics sector, and lower entity credit ratings revenue, and benefited from an increase in surveillance revenue and higher royalty revenue. Asset linked fees increased due to the impact of higher levels of assets under management for ETFs and mutual funds at Indices. Additionally, asset-linked fees was favorably impacted by the buyout of the balance of intellectual property rights in a family of indices from one of our co-marketing and index development partners in the fourth quarter of 2018, retrospective fees for previously unlicensed and unreported index usage and benefits related to recent contract renegotiations. The decline in sales-usage based royalties was primarily driven by lower exchange-traded derivative volumes at Indices in 2019. See “Segment Review” below for further information. The unfavorable impact of foreign exchange rates reduced revenue by 1 percentage point. This impact refers to constant currency comparisons estimated by recalculating current year results of foreign operations using the average exchange rate from the prior year.Total ExpensesIn the first quarter of 2020, we changed our allocation methodology for allocating our centrally managed technology-related expenses to our reportable segments to more accurately reflect each segment's respective usage. Prior-year amounts have been reclassified to conform with current presentation. The following tables provide an analysis by segment of our operating-related expenses and selling and general expenses for the years ended December 31, 2020 and 2019:(in millions)20202019% ChangeOperating-related expensesSelling andgeneral expensesOperating-related expensesSelling andgeneral expensesOperating-related expensesSelling andgeneral expensesRatings 1$948 $395 $897 $392 6%1%Market Intelligence 2903 524 836 480 8%9%Platts 3195 208 197 196 (1)%6%Indices 4149 166 138 139 8%18%Intersegment eliminations 5(137)— (128)— (7)%N/MTotal segments2,058 1,293 1,940 1,207 6%7%Corporate Unallocated expense 634 250 36 135 (6)%86%$2,092 $1,543 $1,976 $1,342 6%15%N/M - not meaningful38Table of Contents 1 In 2020, selling and general expenses include a technology-related impairment charge of $11 million, lease-related costs of $5 million and employee severance charges of $4 million. In 2019, selling and general expenses include employee severance charges of $11 million.2 In 2020, selling and general expenses include employee severance charges of $27 million and lease-related costs of $3 million. In 2019, selling and general expenses include employee severance charges of $6 million and acquisition-related costs of $4 million. 3 In 2020, selling and general expenses include employee severance charges of $11 million and lease-related costs of $2 million. In 2019, selling and general expenses include employee severance charges of $1 million. 4 In 2020, selling and general expenses include employee severance charges of $5 million, a lease impairment charge of $4 million, a technology-related impairment charge of $2 million and lease-related costs of $1 million. 5 Intersegment eliminations primarily relate to a royalty charged to Market Intelligence for the rights to use and distribute content and data developed by Ratings.6 In 2020, selling and general expenses include lease impairments of $116 million, IHS Markit merger costs of $24 million, employee severance charges of $19 million, Kensho retention related expense of $12 million and a gain related to an acquisition of $1 million. In 2019, selling and general expenses include Kensho retention related expense of $21 million, lease impairments of $11 million and employee severance charges of $7 million. Operating-Related ExpensesOperating-related expenses increased as compared to 2019 driven by increases at Market Intelligence and Ratings. The increase at Market Intelligence was primarily due to higher compensation costs driven by investments in growth initiatives and the acquisition of 451 Research, LLC, and higher incentive costs. The increase at Ratings was primarily driven by higher incentive costs. These increases were partially offset by a decrease in travel and entertainment expenses from non-essential travel restrictions in response to COVID-19.Intersegment eliminations primarily relate to a royalty charged to Market Intelligence for the rights to use and distribute content and data developed by Ratings.Selling and General ExpensesSelling and general expenses increased 15%. Excluding the impact of higher lease impairment charges in 2020 of 9 percentage points, higher employee severance charges in 2020 of 3 percentage costs, lease-related costs in 2020 of 1 percentage point, IHS Markit merger costs in 2020 of 1 percentage point and a technology-related impairment charge of 1 percentage point, partially offset by higher Kensho related retention expense in 2019 of 1 percentage point, selling and general expenses increased 1%. This increase was primarily driven by an increase at Market Intelligence due to higher compensation costs driven by investments in growth initiatives and the acquisition of 451 Research, LLC, and higher incentive costs, and an increase at Indices driven by an increase in legal related costs. These increases were partially offset by a decrease in travel and entertainment expenses from non-essential travel restrictions in response to COVID-19 and lower rental expense from a reduction in the Company's real estate footprint. Depreciation and AmortizationDepreciation and amortization increased $2 million, or 1%, compared to 2019 due to an increase in depreciation expense related to assets that began being depreciated in the second half of 2019 and an increase in amortization expense driven by the acquisitions of RobecoSAM, Greenwich Associates LLC and 451 Research, LLC in January 2020, February 2020 and December 2019, respectively.39Table of Contents The following tables provide an analysis by segment of our operating-related expenses and selling and general expenses for the years ended December 31, 2019 and 2018:(in millions)20192018% ChangeOperating-related expensesSelling andgeneral expensesOperating-related expensesSelling andgeneral expensesOperating-related expensesSelling andgeneral expensesRatings 1$897 $392 $844 $453 6%(14)%Market Intelligence 2836 480 754 480 11%—%Platts 3197 196 212 177 (7)%11%Indices138 139 129 130 7%7%Intersegment eliminations 4(128)— (125)— (2)%N/MTotal segments1,940 1,207 1,814 1,240 7%(3)%Corporate Unallocated expense536 135 24 184 53%(27)%$1,976 $1,342 $1,838 $1,424 7%(6)%N/M - not meaningful1 In 2019, selling and general expenses include employee severance charges of $11 million. In 2018, selling and general expenses include legal settlement expenses of $74 million and employee severance charges of $8 million. 2 In 2019, selling and general expenses include employee severance charges of $6 million and acquisition-related costs of $4 million. In 2018, selling and general expenses include restructuring charges related to a business disposition and employee severance charges of $7 million. 3 In 2019, selling and general expenses include employee severance charges of $1 million. 4 Intersegment eliminations primarily relate to a royalty charged to Market Intelligence for the rights to use and distribute content and data developed by Ratings.5 In 2019, selling and general expenses include Kensho retention related expense of $21 million, lease impairments of $11 million and employee severance charges of $7 million. In 2018, selling and general expenses include Kensho retention related expense of $31 million, lease impairments of $11 million and employee severance charges of $10 million. Operating-Related ExpensesOperating-related expenses increased as compared to 2018 driven by the acquisition of Kensho in April of 2018 and increases at Ratings, Market Intelligence and Indices. Ratings increased primarily due to an increase in incentive costs, partially offset by lower professional fees. The increase at Market Intelligence was due to higher technology costs, higher compensation costs and an increase in intersegment royalties tied to annualized contract value growth. The increase at Indices was primarily related to increased royalties due to increased traction of royalty-based products and higher compensation costs. Intersegment eliminations primarily relate to a royalty charged to Market Intelligence for the rights to use and distribute content and data developed by Ratings.Selling and General ExpensesSelling and general expenses decreased 6%. Excluding the impact of legal settlement expenses in 2018 of 5 percentage points and higher Kensho retention related expense in 2018 of 1 percentage point, selling and general expenses remained unchanged. Increases at Platts, Indices and Ratings, were offset by a decrease in expenses at Corporate Unallocated. The increase at Platts was primarily driven by higher technology costs. The increase at Ratings was primarily driven by an increase in incentive costs. Indices increased primarily due to higher legal expenses and compensation costs. These increases were offset by a decrease in expenses at Corporate Unallocated primarily driven by a $20 million contribution made by the Company to the S&P Global Foundation in 2018 and a decrease in expenses at Kensho. Depreciation and AmortizationDepreciation and amortization decreased $2 million, or 1%, compared to 2018 due to decreases at Market Intelligence and Platts related to assets becoming fully depreciated and assets becoming fully amortized at Platts, partially offset by an increase in amortization expense from the acquisition of Kensho in April of 2018.40Table of Contents Gain on DispositionsDuring the year ended December 31, 2020, we completed the following dispositions that resulted in a pre-tax gain of $16 million, which was included in Gain on dispositions in the consolidated statements of income:•In January of 2020, Market Intelligence entered into a strategic alliance to transition S&P Global Market Intelligence's Investor Relations ("IR") webhosting business to Q4 Inc. ("Q4"), a third party provider of investor relations related services. This alliance will integrate Market Intelligence's proprietary data into Q4's portfolio of solutions, enabling further opportunities for commercial collaboration. In connection with transitioning its IR webhosting business to Q4, Market Intelligence made a minority investment in Q4. During the year ended December 31, 2020, we recorded a pre-tax gain of $11 million ($6 million after-tax), respectively, in Gain on dispositions in the consolidated statement of income related to the sale of IR. •In September of 2020, we sold our facility at East Windsor, New Jersey. During the year ended December 31, 2020, we recorded a pre-tax gain of $4 million ($3 million after-tax) in Gain on dispositions in the consolidated statements of income related to the sale of East Windsor. •During the year ended December 31, 2020, we recorded a pre-tax gain of $1 million ($1 million after-tax) in Gain on dispositions in the consolidated statements of income related to the sale of SPIAS, a business within our Market Intelligence segment, in July of 2019. During the year ended December 31, 2019, we completed the following dispositions that resulted in a pre-tax gain of $49 million, which was included in Gain on dispositions in the consolidated statement of income:•In July of 2019, we completed the sale of RigData, a business within our Platts segment, to Drilling Info, Inc. RigData is a provider of daily information on rig activity for the natural gas and oil markets across North America. During the year ended December 31, 2019, we recorded a pre-tax gain of $27 million ($26 million after-tax) in Gain on dispositions in the consolidated statement of income related to the sale of RigData.•In March of 2019, we entered into an agreement to sell SPIAS to Goldman Sachs Asset Management ("GSAM"). SPIAS provides non-discretionary investment advice across institutional sub-advisory and intermediary distribution channels globally. On July 1, 2019, we completed the sale of SPIAS to GSAM. During the year ended December 31, 2019, we recorded a pre-tax gain of $22 million ($12 million after-tax) in Gain on dispositions in the consolidated statement of income related to the sale of SPIAS.Operating ProfitWe consider operating profit to be an important measure for evaluating our operating performance and we evaluate operating profit for each of the reportable business segments in which we operate. We internally manage our operations by reference to operating profit with economic resources allocated primarily based on each segment's contribution to operating profit. Segment operating profit is defined as operating profit before Corporate Unallocated. Segment operating profit is not, however, a measure of financial performance under U.S. GAAP, and may not be defined and calculated by other companies in the same manner.In the first quarter of 2020, we changed our allocation methodology for allocating our centrally managed technology-related expenses to our reportable segments to more accurately reflect each segment's respective usage. Prior-year amounts have been reclassified to conform with current presentation. 41Table of Contents The table below reconciles segment operating profit to total operating profit:(in millions)Year ended December 31,% Change202020192018’20 vs ’19’19 vs ’18Ratings 1$2,223 $1,783 $1,554 25%15%Market Intelligence 2589 566 500 4%13%Platts 3458 457 401 —%14%Indices 4666 632 566 5%12%Total segment operating profit3,936 3,438 3,021 14%14%Corporate Unallocated 5(319)(212)(231)(50)%8%Total operating profit$3,617 $3,226 $2,790 12%16%1 2020 includes a technology-related impairment charge of $11 million, lease-related costs of $5 million and employee severance charges of $4 million. 2019 includes employee severance charges of $11 million. 2018 includes legal settlement expenses of $74 million and employee severance charges of $8 million. 2020 includes amortization of intangibles from acquisitions of $7 million and 2019 and 2018 includes amortization of intangibles from acquisitions of $2 million.2 2020 includes employee severance charges of $27 million, a gain on dispositions of $12 million and lease-related costs of $3 million. 2019 includes a gain on the sale of SPIAS of $22 million, employee severance charges of $6 million and acquisition-related costs of $4 million. 2018 includes restructuring charges related to a business disposition and employee severance charges of $7 million. 2020, 2019 and 2018 includes amortization of intangibles from acquisitions of $76 million, $75 million and $73 million, respectively.3 2020 includes employee severance charges of $11 million and lease-related costs of $2 million. 2019 includes a gain on the sale of RigData of $27 million and employee severance charges of $1 million. 2020, 2019 and 2018 includes amortization of intangibles from acquisitions of $9 million, $12 million, and $18 million. 4 2020 includes employee severance charges of $5 million, a lease impairment charge of $4 million, a technology-related impairment charge of $2 million and lease-related costs of $1 million. 2020, 2019 and 2018 includes amortization of intangibles from acquisitions of $6 million.5 2020 includes lease impairments of $116 million, IHS Markit merger costs of $24 million, employee severance charges of $19 million, Kensho retention related expense of $12 million and a gain related to an acquisition of $1 million. 2019 includes Kensho retention related expense of $21 million, lease impairments of $11 million and employee severance charges of $7 million. 2018 includes Kensho retention related expense of $31 million, lease impairments of $11 million and employee severance charges of $10 million. 2020, 2019 and 2018 includes amortization of intangibles from acquisitions of $26 million, $28 million, and 23 million. 2020Segment Operating Profit — Increased $498 million, or 14% as compared to 2019. Excluding the impact of higher employee severance charges in 2020 of 1 percentage point, a higher gain on dispositions in 2019 of 1 percentage point primarily related to the sale of RigData and SPIAS, a technology-related impairment charge in 2020 of less than 1 percentage point and lease-related costs in 2020 of less than 1 percentage point, operating profit increased 17%. The increase was primarily due to an increase in revenue at all of our reportable segments combined with a decrease in travel and entertainment expenses from non-essential travel restrictions in response to COVID-19, partially offset by an increase in incentive costs and higher compensation costs driven by annual merit increases and additional headcount.Corporate Unallocated Expense — Corporate Unallocated expense includes costs for corporate center functions, select initiatives and unoccupied office space and Kensho, included in selling and general expenses. Corporate Unallocated expense increased by $107 million or 50% as compared to 2019. Excluding the impact of higher lease impairment charges in 2020 of 53 percentage points, IHS Markit merger costs in 2020 of 12 percentage points and higher employee severance charges in 2020 of 6 percentage points, partially offset by lower Kensho retention related expense in 2020 of 6 percentage points and a gain on disposition in 2020 of 2 percentage points, Corporate Unallocated expense decreased 12% primarily driven by lower rental expense from a reduction in the Company's real estate footprint, a decrease in travel and entertainment expenses and lower professional fees, partially offset by contributions to the S&P Global Foundation made in 2020.Foreign exchange rates had a favorable impact on operating profit of 1 percentage point. The foreign exchange rate impact refers to constant currency comparisons and the remeasurement of monetary assets and liabilities. Constant currency impacts are estimated by recalculating current year results of foreign operations using the average exchange rate from the prior year. Remeasurement impacts are based on the variance between current-year and prior-year foreign exchange rate fluctuations on monetary assets and liabilities denominated in currencies other than the individual business' functional currency. 42Table of Contents 2019Segment Operating Profit — Increased $417 million, or 14% as compared to 2018. Excluding the impact of higher legal settlement expenses in 2018 of 3 percentage points and a gain on our dispositions in 2019 of 2 percentage points, segment operating profit increased 9%. This increase was primarily driven by an increase in revenue at all of our reportable segments and lower professional fees, partially offset by higher technology costs, an increase in incentive costs and higher compensation costs driven by annual merit increases and additional headcount. See “ – Segment Review” below for further information. Corporate Unallocated — Corporate Unallocated includes costs for corporate center functions, select initiatives and unoccupied office space and Kensho, included in selling and general expenses, and Kensho revenue in 2018. Corporate Unallocated improved by $19 million or 8% as compared to 2018. Excluding the favorable impact of lower Kensho retention related expense in 2019 of 2 percentage points, partially offset by the unfavorable impact of higher deal-related amortization in 2019 of 1 percentage point, Corporate Unallocated improved 7% primarily driven by a $20 million contribution made by the Company to the S&P Global Foundation in 2018 and a reduction in professional fees.Foreign exchange rates had a favorable impact on operating profit of less than 1 percentage point. The foreign exchange rate impact refers to constant currency comparisons and the remeasurement of monetary assets and liabilities. Constant currency impacts are estimated by recalculating current year results of foreign operations using the average exchange rate from the prior year. Remeasurement impacts are based on the variance between current-year and prior-year foreign exchange rate fluctuations on monetary assets and liabilities denominated in currencies other than the individual business' functional currency. Other (Income) Expense, netOther (income) expense, net primarily includes the net periodic benefit cost for our retirement and post retirement plans. Other income, net for 2020 was $31 million, other expense, net for 2019 was $98 million and other income, net for 2018 was $25 million. During the year ended December 31, 2020, lump sum withdrawals exceeded the combined total anticipated annual service and interest cost of our U.K. pension plan, triggering the recognition of a non-cash pre-tax settlement charge of $3 million. During the year ended December 31, 2019, the Company purchased a group annuity contract under which an insurance company assumed the Company’s obligation to pay pension benefits to approximately 4,600 retirees and beneficiaries. This purchase eliminates all future investment or mortality risk associated with these retirees. The purchase of this group annuity contract was funded with pension plan assets. As a result, the Company’s outstanding pension benefit obligation was reduced by approximately $370 million, representing approximately 24% of the total obligations of the Company’s qualified pension plans. In connection with this transaction, the Company recorded a pre-tax settlement charge of $113 million, reflecting the accelerated recognition of a portion of unamortized actuarial losses in the plan. The Company also recorded pension settlement charges of $5 million in 2018. Excluding these charges, other income, net was $34 million, $14 million and $29 for 2020, 2019 and 2018, respectively. The increase in other income, net in 2020 compared to 2019 and the decrease in other income, net in 2019 compared to 2018 was primarily due to a higher loss on investments in 2019.Interest Expense, netNet interest expense for 2020 remained relatively unchanged compared to 2019, increasing less than 1%.Net interest expense for 2019 increased $7 million or 5% as compared to 2018, driven by the release of reserves for accrued interest related to the resolution of various tax audits in 2018. Loss on Extinguishment of DebtThe year ended December 31, 2020 includes $279 million related to the redemption fee on the early retirement of our 4.4% senior notes due in 2026 and a portion of the 6.55% senior notes due in 2037 and 4.5% senior notes due in 2048 in the third quarter of 2020. The year ended December 31, 2019 includes $57 million of costs associated with the early repayment of our 3.3% Senior Notes and a portion of our 6.55% Senior Notes.Provision for Income TaxesOur effective tax rate was 21.5%, 21.4% and 20.9% for 2020, 2019 and 2018, respectively. The increase in 2020 was primarily due to a decrease in the recognition of excess tax benefits associated with share-based payments in the statement of income. The increase in 2019 was primarily due to an increase in accruals for potential tax liabilities for prior years in various jurisdictions.43Table of Contents Segment ReviewRatings Ratings is an independent provider of credit ratings, research, and analytics to investors, issuers and other market participants. Credit ratings are one of several tools investors can use when making decisions about purchasing bonds and other fixed income investments. They are opinions about credit risk, and our ratings express our opinion about the ability and willingness of an issuer, such as a corporation or state or city government, to meet its financial obligations in full and on time. Our credit ratings can also relate to the credit quality of an individual debt issue, such as a corporate or municipal bond, and the relative likelihood that the issue may default.Ratings disaggregates its revenue between transaction and non-transaction. Transaction revenue primarily includes fees associated with:•ratings related to new issuance of corporate and government debt instruments, as well as structured finance debt instruments;•bank loan ratings; and•corporate credit estimates, which are intended, based on an abbreviated analysis, to provide an indication of our opinion regarding creditworthiness of a company which does not currently have a Ratings credit rating.Non-transaction revenue primarily includes fees for surveillance of a credit rating, annual fees for customer relationship-based pricing programs, fees for entity credit ratings and global research and analytics at CRISIL. Non-transaction revenue also includes an intersegment royalty charged to Market Intelligence for the rights to use and distribute content and data developed by Ratings. Royalty revenue for 2020, 2019 and 2018 was $128 million, $118 million and $109 million, respectively.The following table provides revenue and segment operating profit information for the years ended December 31:(in millions)Year ended December 31,% Change 202020192018’20 vs ’19’19 vs ’18Revenue$3,606 $3,106 $2,883 16 %8 %Transaction revenue $1,977 $1,577 $1,350 25 %17 %Non-transaction revenue $1,629 $1,529 $1,533 7 %— %% of total revenue:Transaction revenue55 %51 %47 %Non-transaction revenue45 %49 %53 %U.S. revenue$2,110 $1,745 $1,619 21 %8 %International revenue$1,496 $1,361 $1,264 10 %8 %% of total revenue: U.S. revenue59 %56 %56 % International revenue41 %44 %44 %Operating profit 1$2,223 $1,783 $1,554 25 %15 %% Operating margin62 %57 %54 %12020 includes a technology-related impairment charge of $11 million, lease-related costs of $5 million and employee severance charges of $4 million. 2019 includes employee severance charges of $11 million. 2018 includes legal settlement expenses of $74 million and employee severance charges of $8 million. 2020 includes amortization of intangibles from acquisitions of $7 million and 2019 and 2018 includes amortization of intangibles from acquisitions of $2 million.2020Revenue increased 16% including a favorable benefit of 1 percentage point from the impact of recent acquisitions. Transaction 44Table of Contents revenue grew due to an increase in corporate bond ratings revenue primarily driven by higher corporate bond issuance in the U.S. mainly resulting from borrowers’ need for increased liquidity in light of the pandemic-related economic downturn, historically low borrowing costs, and central bank lending actions initially announced at the end of the first quarter of 2020, partially offset by a decrease in bank loan ratings revenue and structured finance revenues. Non-transaction revenue increased primarily due to an increase in surveillance revenue, royalty revenue, and higher Ratings Evaluation Service (“RES”) activity driven by increased M&A activity in the fourth quarter of 2020. Transaction and non-transaction revenue also benefited from improved contract terms across product categories. Foreign exchange rates had a favorable impact of less than 1 percentage point. Revenue was favorably impacted by the acquisitions of the ESG Ratings Business from RobecoSAM and Greenwich Associates LLC in January of 2020 and February of 2020, respectively. See Note 2 - Acquisitions and Divestitures to the consolidated financial statements of this Form 10-K for further discussion.Operating profit increased 25%, with a 2 percentage point favorable impact from foreign exchange rates. Excluding the impact of a technology-related impairment charge in 2020 of less than 1 percentage point, lease-related costs in 2020 of less than 1 percentage point and higher amortization of intangible assets in 2020 of less than 1 percentage point, partially offset by higher employee severance charges in 2019 of less than 1 percentage point, operating profit increased 25%. The impact of revenue growth was partially offset by an increase in incentive costs and higher compensation costs due to annual merit increases and additional headcount, partially offset by a decrease in travel and entertainment expenses from non-essential travel restrictions in response to COVID-19.2019Revenue increased 8%, with a 1 percentage point unfavorable impact from foreign exchange rates, due to an increase in transaction revenue. Transaction revenue increased due to an increase in corporate bond ratings revenue primarily driven by higher corporate bond issuance in the U.S. and Europe mainly resulting from historically low borrowing costs, partially offset by lower bank loan ratings revenue driven by reduced U.S. issuance volumes. An increase in public finance revenue due to increased issuance also contributed to transaction revenue growth. Non-transaction revenue decreased less than 1% primarily due to the unfavorable impact from foreign exchange rates. Non-transaction revenue was unfavorably impacted by a decline in RES activity, a decrease at CRISIL, primarily within the risk and analytics sector, and lower entity credit ratings revenue, and benefited from an increase in surveillance revenue and higher royalty revenue. Transaction and non-transaction revenue also benefited from improved contract terms across product categories. Operating profit increased 15%, with a 1 percentage point unfavorable impact from foreign exchange rates. Excluding the impact of higher legal settlement expenses in 2018 of 5 percentage points, operating profit increased 10%. This increase was primarily due to the increase in revenue discussed above combined with a reduction in legal expenses, lower professional fees from increased leverage on the Global Technology Center and internal resources, partially offset by an increase in incentive costs and AWS cloud infrastructure spend.Market Issuance VolumesWe monitor market issuance volumes regularly within Ratings. Market issuance volumes noted within the discussion that follows are based on where an issuer is located or where the assets associated with an issue are located. Structured Finance issuance includes amounts when a transaction closes, not when initially priced and excludes domestically-rated Chinese issuance. The following tables depict changes in issuance levels as compared to the prior year based on data from SDC Platinum for Corporate bond issuance and based on a composite of external data feeds and Ratings' internal estimates for Structured Finance issuance. 2020 Compared to 2019Corporate Bond Issuance *U.S.EuropeGlobalHigh-yield issuance66%10%27%Investment-grade issuance53%14%26%Total issuance56%13%26%* Includes Industrials and Financial Services.•Corporate issuance was up in 2020 driven by increases in both high-yield and investment grade issuance in the U.S. and Europe. U.S high-yield issuance was particularly strong as issuers were taking advantage of historically low borrowing costs. Issuance was also aided by central bank lending actions intended to provide market stabilization. A number of large financing transactions contributed to the increase in investment-grade issuance in the U.S. and Europe in 2020. 45Table of Contents 2020 Compared to 2019Structured FinanceU.S.EuropeGlobalAsset-backed securities (“ABS”)(18)%24%(13)%Structured credit (primarily CLOs)(22)%(38)%(26)%Commercial mortgage-backed securities (“CMBS”)(41)%(60)%(42)%Residential mortgage-backed securities (“RMBS”)(17)%(20)%(15)%Covered bonds**(42)%(35)%Total issuance(22)%(31)%(23)%** Represents no activity in 2020 and 2019.•ABS issuance in the U.S. decreased in 2020 driven by lower market activity due to the impact of COVID-19. ABS issuance in Europe increased in 2020 reflecting low prior year activity as issuers were trying to comply with the new EU framework for STS Securitization (Simple, Transparent, and Standardized). •Issuance was down in the U.S. and European structured credit markets driven by a decline in CLO transactions as demand for leveraged loans decreased as borrowers turned to the high-yield bond market. •CMBS issuance was down in the U.S. and Europe reflecting decreased market volume due to the poor market environment and the impact of COVID-19 limiting third party site inspections and appraisal reports. •RMBS issuance was down in the U.S. and Europe reflecting decreased market volume in Non-Performing Loans (NPL) due to the impact of COVID-19 and the uncertainty on collateral performance. •Covered bond (debt securities backed by mortgages or other high-quality assets that remain on the issuer's balance sheet) issuance in Europe decreased due to inexpensive central bank funding with TLTRO III. Industry Highlights and OutlookRevenue increased in 2020 primarily driven by higher corporate bond issuance in the U.S. and Europe. In 2020, Ratings continued to focus on ESG initiatives and international expansion in China. In 2021, Ratings will continue to focus on accelerating growth in key markets globally and expanding Ratings capabilities in Asia. Additionally, Ratings will continue to focus on developing key product offerings in ESG and developing new product and product features leveraging technology investments.Legal and Regulatory EnvironmentGeneralRatings and many of the securities that it rates are subject to extensive regulation in both the U.S. and in other countries, and therefore existing and proposed laws and regulations can impact the Company’s operations and the markets in which it operates. Additional laws and regulations have been adopted but not yet implemented or have been proposed or are being considered. In addition, in certain countries, governments may provide financial or other support to locally-based rating agencies. For example, governments may from time to time establish official rating agencies or credit ratings criteria or procedures for evaluating local issuers. We have reviewed the new laws, regulations and rules which have been adopted and we have implemented, or are planning to implement, changes as required. We do not believe that such new laws, regulations or rules will have a material adverse effect on our financial condition or results of operations. Other laws, regulations and rules relating to credit rating agencies are being considered by local, national, foreign and multinational bodies and are likely to continue to be considered in the future, including provisions seeking to reduce regulatory and investor reliance on credit ratings, remuneration and rotation of credit rating agencies, and liability standards applicable to credit rating agencies. The impact on us of the adoption of any such laws, regulations or rules remains uncertain, but could increase the costs and legal risks relating to Ratings’ rating activities, or adversely affect our ability to compete and/or our remuneration, or result in changes in the demand for credit ratings.In the normal course of business both in the U.S. and abroad, Ratings (or the legal entities comprising Ratings) are defendants in numerous legal proceedings and are often the subject of government and regulatory proceedings, investigations and inquiries. Many of these proceedings, investigations and inquiries relate to the ratings activity of Ratings and are or have been brought by purchasers of rated securities. In addition, various government and self-regulatory agencies frequently make inquiries and conduct investigations into Ratings’ compliance with applicable laws and regulations. Any of these proceedings, investigations 46Table of Contents or inquiries could ultimately result in adverse judgments, damages, fines, penalties or activity restrictions, which could adversely impact our consolidated financial condition, cash flows, business or competitive position.U.S.The businesses conducted by our Ratings segment are, in certain cases, regulated under the Credit Rating Agency Reform Act of 2006 (the “Reform Act”), the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd Frank Act”), the Securities Exchange Act of 1934 (the “Exchange Act”) and/or the laws of the states or other jurisdictions in which they conduct business. The financial services industry is subject to the potential for increased regulation in the U.S.S&P Global Ratings is a credit rating agency that is registered with the SEC as a Nationally Recognized Statistical Rating Organization (“NRSRO”). The SEC first began informally designating NRSROs in 1975 for use of their credit ratings in the determination of capital charges for registered brokers and dealers under the SEC’s Net Capital Rule. The Reform Act created a new SEC registration system for rating agencies that choose to register as NRSROs. Under the Reform Act, the SEC is given authority and oversight of NRSROs and can censure NRSROs, revoke their registration or limit or suspend their registration in certain cases. The rules implemented by the SEC pursuant to the Reform Act, the Dodd Frank Act and the Exchange Act address, among other things, prevention or misuse of material non-public information, conflicts of interest, documentation and assessment of internal controls, and improving transparency of ratings performance and methodologies. The public portions of the current version of S&P Global Ratings’ Form NRSRO are available on S&P Global Ratings’ website.European UnionIn the European Union ("EU"), the credit rating industry is registered and supervised through a pan-European regulatory framework which is a compilation of three sets of legislative actions. In 2009, the European Parliament passed a regulation (“CRA1”) that established an oversight regime for the credit rating industry in the EU, which became effective in 2010. CRA1 requires the registration, formal regulation and periodic inspection of credit rating agencies operating in the EU. Ratings was granted registration in October of 2011. In January of 2011, the EU established the European Securities and Markets Authority (“ESMA”), which, among other things, has direct supervisory responsibility for the registered credit rating industry throughout the EU.Additional rules augmenting the supervisory framework for credit rating agencies went into effect in 2013. Commonly referred to as CRA3, these rules, among other things:•impose various additional procedural requirements with respect to ratings of sovereign issuers;•require member states to adopt laws imposing liability on credit rating agencies for an intentional or grossly negligent failure to abide by the applicable regulations;•impose mandatory rotation requirements on credit rating agencies hired by issuers of securities for ratings of resecuritizations, which may limit the number of years a credit rating agency can issue ratings for such securities of a particular issuer;•impose restrictions on credit rating agencies or their shareholders if certain ownership thresholds are crossed; and•impose additional procedural and substantive requirements on the pricing of services.The financial services industry is subject to the potential for increased regulation in the EU. Other JurisdictionsOutside of the U.S. and the EU, regulators and government officials have also been implementing formal oversight of credit rating agencies. Ratings is subject to regulations in most of the foreign jurisdictions in which it operates and continues to work closely with regulators globally to promote the global consistency of regulatory requirements. This includes the UK, which has established a credit rating agencies oversight regime similar to that in place in the EU, and where Ratings was granted registration with the Financial Conduct Authority on January 1, 2021. Regulators in additional countries may introduce new regulations in the future. For a further discussion of competitive and other risks inherent in our Ratings business, see Item 1A, Risk Factors, in this Annual Report on Form 10-K. For a further discussion of the legal and regulatory environment in our Ratings business, see Note 13 - Commitments and Contingencies to the consolidated financial statements under Item 8, Consolidated Financial Statements and Supplementary Data, in this Annual Report on Form 10-K. Market Intelligence Market Intelligence's portfolio of capabilities is designed to help investment professionals, government agencies, corporations and universities track performance, generate alpha, identify investment ideas, understand competitive and industry dynamics, perform valuations and assess credit risk.47Table of Contents In January of 2020, Market Intelligence entered into a strategic alliance to transition S&P Global Market Intelligence's IR webhosting business to Q4, a third party provider of investor relations related services. This alliance will integrate Market Intelligence's proprietary data into Q4's portfolio of solutions, enabling further opportunities for commercial collaboration. In connection with transitioning its IR webhosting business to Q4, Market Intelligence made a minority investment in Q4. During the year ended December 31, 2020, we recorded a pre-tax gain of $11 million ($6 million after-tax), respectively, in Gain on dispositions in the consolidated statement of income related to the sale of IR. In March of 2019, we entered into an agreement to sell SPIAS, a business within our Market Intelligence segment, to GSAM. SPIAS provides non-discretionary investment advice across institutional sub-advisory and intermediary distribution channels globally. On July 1, 2019, we completed the sale of SPIAS to GSAM. During 2019, we recorded a pre-tax gain of $22 million ($12 million after-tax) in Gain on dispositions in the consolidated statement of income related to the sale of SPIAS. During the year ended December 31, 2020, we recorded a pre-tax gain of $1 million ($1 million after-tax) in Gain on dispositions in the consolidated statement of income related to the sale of SPIAS in July of 2019.Market Intelligence includes the following business lines:•Desktop — a product suite that provides data, analytics and third-party research for global finance professionals, which includes the Market Intelligence Desktop (which are inclusive of the S&P Capital IQ and SNL Desktop products);•Data Management Solutions — integrated bulk data feeds and application programming interfaces that can be customized, which includes Compustat, GICS, Point In Time Financials and CUSIP; and•Credit Risk Solutions — commercial arm that sells Ratings' credit ratings and related data, analytics and research, which includes subscription-based offerings, RatingsDirect® and RatingsXpress®, and Credit Analytics.Subscription revenue at Market Intelligence is primarily derived from distribution of data, analytics, third-party research, and credit ratings-related information primarily through web-based channels, including Market Intelligence Desktop, RatingsDirect®, RatingsXpress®, and Credit Analytics. Non-subscription revenue at Market Intelligence is primarily related to certain advisory, pricing and analytical services.The following table provides revenue and segment operating profit information for the years ended December 31:(in millions)Year ended December 31,% Change 202020192018’20 vs ’19’19 vs ’18Revenue$2,106 $1,959 $1,833 8 %7 %Subscription revenue $2,050 $1,904 $1,773 8 %7 %Non-subscription revenue $55 $45 $40 21 %12 %Asset-linked fees$1 $10 $20 (92)%(50)%% of total revenue: Subscription revenue97 %97 %97 % Non-subscription revenue3 %2 %2 % Asset-linked fees— %1 %1 %U.S. revenue$1,355 $1,240 $1,180 9 %5 %International revenue$751 $719 $653 5 %10 %% of total revenue: U.S. revenue64 %63 %64 % International revenue 36 %37 %36 %Operating profit 1$589 $566 $500 4 %13 %% Operating margin28 %29 %27 %12020 includes employee severance charges of $27 million, a gain on dispositions of $12 million and lease-related costs of $3 million. 2019 includes a gain on the disposition of SPIAS of $22 million, employee severance charges of $6 million and acquisition-related costs 48Table of Contents of $4 million. 2018 includes restructuring charges related to a business disposition and employee severance charges of $7 million. 2020, 2019 and 2018 includes amortization of intangibles from acquisitions of $76 million, $75 million and $73 million, respectively.2020Revenue increased 8% and was favorably impacted by 1 percentage point from the net effect of the recent acquisition of 451 Research, LLC, offset by the disposition of SPIAS and the IR webhosting business. The increase in revenue was driven by growth in annualized contract values for RatingsXpress®, RatingsDirect®, CUSIP, our data feed products within Data Management Solutions and our Market Intelligence Desktop products. Excluding the impact of the acquisition and dispositions favorably impacting Desktop revenue growth by 3 percentage points, revenue growth at Credit Risk Solutions, Data Management Solutions and Desktop was 9%, 9% and 4%, respectively. Both U.S. revenue and international revenue increased compared to 2019. Foreign exchange rates had a favorable impact of 1 percentage point. Operating profit increased 4%, with a 3 percentage point favorable impact from foreign exchange rates. Excluding the impact of higher employee severance charges in 2020 of 3 percentage points and a higher gain on dispositions in 2019 of 2 percentage points, operating profit increased 9%. The impact of revenue growth was partially offset by higher compensation costs primarily due to annual merit increases, an increase in incentive costs and higher technology costs, partially offset by a decrease in travel and entertainment expenses from non-essential travel restrictions in response to COVID-19.2019Revenue increased 7% and was favorably impacted by less than 1 percentage point from the net impact of recent acquisitions and a disposition. Excluding the impact of the acquisitions and disposition, increased revenue was driven by growth in annualized contract values in the Market Intelligence Desktop products, RatingsXpress®, RatingsDirect®, CUSIP and our data feed products within Data Management Solutions. Excluding the impact of the acquisitions and disposition favorably impacting Desktop revenue growth by 1 percentage point, revenue growth at Data Management Solutions, Credit Risk Solutions and Desktop was 11%, 9% and 4%, respectively. Both domestic and international revenue increased compared to 2018. In 2019, international revenue represented 37% of Market Intelligence's total revenue compared to 36% in 2018. Foreign exchange rates had an unfavorable impact of less than one percentage point. Revenue was favorably impacted by the acquisitions of 451 Research, LLC, Panjiva Inc. ("Panjiva") and the Rate Watch business ("RateWatch") in December of 2019, February of 2018 and June of 2018, respectively, and the transfer of Kensho revenue from Corporate in January of 2019, and unfavorably impacted by the disposition of SPIAS in July of 2019. See Note 1 - Nature of Operations and Basis of Presentation and Note 2 - Acquisitions and Divestitures to the Consolidated Financial Statements and Supplementary Data, in the Annual Report on Form 10-K for further discussion.Operating profit increased 13%, with a 2 percentage point favorable impact from foreign exchange rates. Excluding the favorable impact of the gain on disposition of SPIAS of 6 percentage points, partially offset by the unfavorable impact of acquisition-related costs in 2019 of 1 percentage point, operating profit increased 8%. The increase was primarily due to revenue growth, partially offset by higher technology costs, higher compensation costs primarily driven by additional headcount and an increase in intersegment royalties tied to annualized contract value growth.Industry Highlights and OutlookIn 2020, Market Intelligence continued to focus on leveraging its strong content heritage to expand the core business, streamlining and enriching the customer experience across all delivery platforms, and harnessing new data sources and technology to extend into new geographies and growth areas such as ESG. In 2021, Market Intelligence will continue to focus on developing key product offerings in growth areas such as ESG and growing new products and product features leveraging technology investments.Legal and Regulatory EnvironmentThe market for research services is very competitive. Market Intelligence competes domestically and internationally on the basis of a number of factors, including the quality of its research and advisory services, client service, reputation, price, geographic scope, range of products and services, and technological innovation. For a further discussion of competitive and other risks inherent in our Market Intelligence business, see Item 1A, Risk Factors, in this Annual Report on Form 10-K.European UnionThe EU enacted a package of legislative measures known as MiFID II ("MiFID II"), which revises and updates the existing EU Markets in Financial Instruments Directive framework, and the substantive provisions became applicable in all EU Member 49Table of Contents States as of January 3, 2018. MiFID II includes provisions that, among other things, require the unbundling of investment research and direct how asset managers pay for research either out of a research payment account or from a firm’s profits. Although the MiFID II package is “framework” legislation (meaning that much of the detail of the rules will be set out in subordinate measures, including some technical standards yet to be adopted by the European Commission), the introduction of the MiFID II package may result in changes to the manner in which Market Intelligence licenses its price certain products. MiFID II may impose regulatory burdens on Market Intelligence activities in the EU, although the exact impact and costs are not yet known.PlattsPlatts is the leading independent provider of information and benchmark prices for the commodity and energy markets. Platts provides essential price data, analytics, and industry insight enabling the commodity and energy markets to perform with greater transparency and efficiency. On July 31, 2019, we completed the sale of RigData, a business within our Platts segment, to Drilling Info, Inc. RigData is a provider of daily information on rig activity for the natural gas and oil markets across North America. During the year ended December 31, 2019, we recorded a pre-tax gain of $27 million ($26 million after-tax) in Gain on dispositions in the consolidated statement of income related to the sale of RigData.Platts' revenue is generated primarily through the following sources:•Subscription revenue — primarily from subscriptions to our real-time news, market data and price assessments, along with other information products; •Sales usage-based royalties — primarily from licensing of our proprietary market price data and price assessments to commodity exchanges; and •Non-subscription revenue — conference sponsorship, consulting engagements, and events.The following table provides revenue and segment operating profit information for the years ended December 31:(in millions)Year ended December 31,% Change 202020192018’20 vs ’19’19 vs ’18Revenue$878 $844 $815 4 %4 %Subscription revenue $809 $774 $750 5 %3 %Sales usage-based royalties$62 $60 $54 3 %11 %Non-subscription revenue $7 $10 $11 (39)%(5)%% of total revenue: Subscription revenue92 %92 %92 % Sales usage-based royalties7 %7 %7 % Non-subscription revenue1 %1 %1 %U.S. revenue$283 $281 $283 — %— %International revenue$595 $563 $532 6 %6 %% of total revenue: U.S. revenue32 %33 %35 % International revenue 68 %67 %65 %Operating profit 1$458 $457 $401 — %14 %% Operating margin52 %54 %49 % 12020 includes employee severance charges of $11 million and lease-related costs of $2 million. 2019 includes a gain on the disposition of RigData of $27 million and employee severance charges of $1 million. 2020, 2019, and 2018 includes amortization of intangibles from acquisitions of $9 million, $12 million, and $18 million.50Table of Contents 2020Revenue increased 4% and was unfavorably impacted by less than 1 percentage point from the net effect of recent acquisitions of Enerdata and Live Rice Index and the disposition of RigData. Revenue increased primarily due to continued demand for market data, price assessment and analytics products driven by both expanded product offerings to our existing customers combined with enhanced contract terms. Additionally, an increase in sales usage-based royalties from the licensing of our proprietary market price data and price assessments to commodity exchanges due to increased trading volumes in the first half of 2020 contributed to revenue growth. These increases were partially offset by a decrease in conference revenue as a result of cancellation and postponement of events due to COVID-19. International revenue grew and U.S. revenue remained relatively unchanged compared to 2019 with the U.S revenue growth rate being unfavorably impacted by the disposition of RigData in July of 2019. Petroleum continues to be the most significant revenue driver, followed by power & gas, metals & agriculture and petrochemicals also contributing to revenue growth. Foreign exchange rates had a favorable impact of less than 1 percentage point. Operating profit remained relatively unchanged with a favorable impact from foreign exchange rates of less than 1 percentage point. Excluding the unfavorable impact of the gain on disposition of RigData in 2019 of 6 percentage points and higher employee severance charges in 2020 of 2 percentage points, operating profit increased 8%. The increase was primarily due to revenue growth combined with a reduction in expenses. Expenses decreased primarily due to a decrease in travel and entertainment expenses from non-essential travel restrictions in response to COVID-19, lower costs as a result of cancellation and postponement of events due to COVID-19 and the favorable impact of a benefit resulting from one-time costs related to the discontinuation of a product line at Platts in 2019. These decreases were partially offset by an increase in operating costs to support business initiatives at Platts and higher incentive costs. 2019Revenue increased 4% and was unfavorably impacted by less than 1 percentage point from the net impact of recent acquisitions and a disposition. Excluding the acquisitions and disposition, revenue increased due to continued demand for market data and price assessment products driven by both expanded product offerings to our existing customers combined with enhanced contract terms. Additionally, revenue growth was driven by an increase in sales usage-based royalties from the licensing of our proprietary market price data and price assessments to commodity exchanges mainly due to increased trading volumes in Iron Ore, LNG and Gasoil. Demand for market data and price assessment products was driven by international customers. International revenue increased and domestic revenue, which was unfavorably impacted by the disposition of RigData in July of 2019, remained relatively unchanged compared to 2018. In 2019, international revenue represented 67% of Platts total revenue compared to 65% in 2018. Petroleum continues to be the most significant revenue driver, followed by power & gas, metals and petrochemicals also contributing to revenue growth. Foreign exchange rates had an unfavorable impact of less than 1 percentage point. Revenue was unfavorably impacted by the disposition of RigData in July of 2019 and favorably impacted by the acquisitions of Live Rice Index and Enerdata in August of 2019 and September of 2019, respectively. See Note 2 - Acquisitions and Divestitures to the Consolidated Financial Statements and Supplementary Data, in the Annual Report on Form 10-K for further discussion.Operating profit increased 14% with a 2 percentage point favorable impact from foreign exchange rates. Excluding the favorable impact of the gain on the disposition of RigData of 7 percentage points and lower amortization of intangibles in 2019 of 2 percentage points, operating profit increased 6%. The increase was primarily due to revenue growth, partially offset by an increase in operating costs to support revenue growth and business initiatives at Platts, including Asia expansion initiatives, an increase in compensation costs due to annual merit increases and increased headcount, higher technology costs, an increase in the bad debt provision in the current year and one-time costs related to the discontinuation of a product line at Platts.Industry Highlights and OutlookIn 2020, sustained demand for market data and price assessment products, led by petroleum, continued to drive revenue growth. In 2020, Platts continued to focus on extending the core business through innovation, simplifying its product and platform strategy, and driving commercial transformation. In 2021, Platts will continue to focus on accelerating growth in key markets globally and expanding Platts capabilities in Asia. Additionally, Platts will continue to focus on developing new product and product features leveraging technology investments and developing key product offerings in ESG.Legal and Regulatory Environment51Table of Contents Platts’ commodities price assessment and information business is subject to increasing regulatory scrutiny in the U.S. and abroad. As discussed below under the heading “Indices-Legal and Regulatory Environment”, the financial benchmarks industry is subject to the new benchmark regulation in the EU (the “EU Benchmark Regulation”) as well as potential increased regulation in other jurisdictions. Platts has obtained authorization and is now supervised by the Dutch Authority for the Financial Markets in the Netherlands under the EU Benchmark Regulation, and may need to take similar steps in other jurisdictions including the United Kingdom post-Brexit and jurisdictions outside of Europe if they pass similar legislation. For a further discussion of competitive and other risks inherent in our Platts business, see Item 1A, Risk Factors, in this Annual Report on Form 10-K.European UnionThe EU has enacted MiFID II, which revise and update the existing EU Markets in Financial Instruments Directive and the substantive provisions became applicable in all EU Member States as of January 3, 2018. MiFID II includes provisions that, among other things: (i) impose new conditions and requirements on the licensing of benchmarks and provide for non-discriminatory access to exchanges and clearing houses; (ii) modify the categorization and treatment of certain classes of derivatives; (iii) expand the categories of trading venue that are subject to regulation; (iv) require the unbundling of investment research and direct how asset managers pay for research either out of a research payment account or from a firm’s profits; and (v) provide for the mandatory trading of certain derivatives on exchanges (complementing the mandatory derivative clearing requirements in the E.U. Market Infrastructure Regulation of 2011). Although the MiFID II package is “framework” legislation (meaning that much of the detail of the rules will be set out in subordinate measures, including some technical standards yet to be adopted by the European Commission), the introduction of the MiFID II package may result in changes to the manner in which Platts licenses its price assessments. MiFID II and the Market Abuse Regulation ("MAR") may impose additional regulatory burdens on Platts activities in the EU over time, but they have not yet resulted in increased substantive impact or costs.In October of 2012, IOSCO issued its Principles for Oil Price Reporting Agencies ("PRA Principles"), which are intended to enhance the reliability of oil price assessments referenced in derivative contracts subject to regulation by IOSCO members. Platts has aligned its operations with the PRA Principles and, as recommended by IOSCO in its final report on the PRA Principles, has aligned to the PRA Principles for other commodities for which it publishes benchmarks.IndicesIndices is a global index provider maintaining a wide variety of indices to meet an array of investor needs. Indices’ mission is to provide transparent benchmarks to help with decision making, collaborate with the financial community to create innovative products, and provide investors with tools to monitor world markets. Indices derives revenue from asset-linked fees when investors direct funds into its proprietary designed or owned indexes, sales-usage royalties of its indices, and to a lesser extent data subscription arrangements. Specifically, Indices generates revenue from the following sources:•Investment vehicles — asset-linked fees such as ETFs and mutual funds, that are based on the S&P Dow Jones Indices' benchmarks that generate revenue through fees based on assets and underlying funds;•Exchange traded derivatives — generate sales usage-based royalties based on trading volumes of derivatives contracts listed on various exchanges;•Index-related licensing fees — fixed or variable annual and per-issue asset-linked fees for over-the-counter derivatives and retail-structured products; and•Data and customized index subscription fees — fees from supporting index fund management, portfolio analytics and research.The following table provides revenue and segment operating profit information for the years ended December 31:52Table of Contents (in millions)Year ended December 31,% Change 202020192018’20 vs ’19’19 vs ’18Revenue$989 $918 $837 8%10%Asset-linked fees$647 $613 $522 5%18%Subscription revenue$177 $165 $144 8%14%Sales usage-based royalties$165 $140 $171 18%(18)%% of total revenue: Asset-linked fees65 %67 %62 % Subscription revenue18 %18 %17 % Sales usage-based royalties17 %15 %21 %U.S. revenue$826 $772 $719 7%7%International revenue$163 $146 $118 12%24%% of total revenue: U.S. revenue84 %84 %86 % International revenue16 %16 %14 %Operating profit 1$666 $632 $566 5%12%Less: net income attributable to noncontrolling interests$181 $170 $151 7%12%Net operating profit$485 $462 $415 5%11%% Operating margin67 %69 %68 %% Net operating margin49 %50 %50 %12020 includes employee severance charges of $5 million, a lease impairment charge of $4 million, a technology-related impairment charge of $2 million and lease-related costs of $1 million. 2020, 2019 and 2018 includes amortization of intangibles from acquisitions of $6 million. 2020Revenue increased 8% primarily due to higher average levels of assets under management ("AUM") for ETFs and mutual funds, an increase in exchange-traded derivatives revenue and higher data subscription revenue, partially offset by lower over-the-counter derivative revenue. Average levels of AUM for ETFs increased 12% to $1.681 trillion and ending AUM for ETFs increased 18% to $1.998 trillion compared to 2019. Operating profit grew 5%. Excluding the impact of employee severance charges in 2020 of 1 percentage point and a lease impairment charge in 2020 of 1 percentage point, operating profit increased 7%. The impact of revenue growth was partially offset by an increase in compensation costs due to annual merit increases and additional headcount as well as professional costs, higher incentive costs and an increase in legal related costs, partially offset by a decrease in travel and entertainment expenses from non-essential travel restrictions in response to COVID-19 and lower cost of sales. Foreign exchange rates had a favorable impact of less than 1 percentage point.2019Revenue increased 10% due to higher levels of AUM for ETFs and mutual funds. Additionally, revenue was favorably impacted by the buyout of the balance of intellectual property rights in a family of indices from one of our co-marketing and index development partners in the fourth quarter of 2018, retrospective fees for previously unlicensed and unreported index usage and benefits related to contract renegotiations. These increases were partially offset by a decrease in exchange-traded derivatives revenue primarily driven by lower volumes in 2019. Ending AUM for ETFs increased 30% to $1.696 trillion in 2019 and average AUM for ETFs increased 8% to $1.503 trillion compared to 2018. Foreign exchange rates had an unfavorable impact of less than 1 percentage point.53Table of Contents Operating profit grew 12%. The impact of revenue growth was partially offset by higher operating costs from increased royalties due to increased traction of royalty-based products, higher legal expenses and increased compensation costs primarily driven by additional headcount, partially offset by lower incentive costs. Foreign exchange rates had a favorable impact of 1 percentage point.Industry Highlights and Outlook Indices continues to be the leading index provider for the ETF market space. In 2020, higher average levels of AUM for ETFs contributed to revenue growth. In 2020, Indices continued to focus on growing the core business, expanding innovative offerings with focus on differentiated solutions such as factor, multi-asset-class, and ESG indices, and growing globally through collaborative client relationships. In 2021, Indices will continue to focus on developing key product offerings in ESG, multi-asset-class and factor indices and developing new product and product features leveraging technology investments.Legal and Regulatory EnvironmentOver the past four years the financial benchmarks industry has been subject to specific benchmark regulation in the European Union (the "EU Benchmark Regulation") and Australia (the "Australia Benchmark Regulation"). Other jurisdictions are also considering new regulation for financial benchmarks.The EU Benchmark Regulation was published June 30, 2016 and included provisions applicable to Indices and Platts. Both Indices and Platts have established separate benchmark administrators in connection with their benchmark activities in Europe. The Indices and Platts entities are both based in Amsterdam and are authorized by the Dutch Authority for Financial Markets (AFM). This legislation will likely cause additional operating obligations but they are not expected to be material at this time, although the exact impact remains unclear.The Australian Benchmark Regulation was enacted in June of 2018 and included provisions applicable to Indices, designating the S&P ASX 200 a significant financial benchmark and therefore requiring Indices, as the administrator of the S&P ASX 200, to obtain a license from the Australian Securities and Investment Commission (“ASIC”). Indices has obtained the relevant license. Although narrower in scope, the requirements of the Australian Benchmark Regulation are similar to those of the EU Benchmark Regulation. This legislation will likely cause additional operating obligations but they are not expected to be material at this time, although the exact impact remains unclear. In July of 2013, the IOSCO issued Financial Benchmark Principles (IOSCO Principles), intended to promote the reliability of financial benchmark determinations. The IOSCO Principles address governance, benchmark quality and accountability mechanisms, including with regard to the indices published by Indices. Even though the IOSCO Principles are not binding law, Indices has taken steps to align its governance regime and operations with the IOSCO Principles and engaged an independent auditor to perform an annual reasonable assurance review of such alignment. The markets for index providers are very competitive. Indices competes domestically and internationally on the basis of a number of factors, including the quality of its benchmark indices, client service, reputation, price, range of products and services (including geographic coverage) and technological innovation. Our Indices business is impacted by market volatility, asset levels of investment products tracking indices, and trading volumes of certain exchange traded derivatives. Volatile capital markets, as well as changing investment styles, among other factors, may influence an investor’s decision to invest in and maintain an investment in an index-linked investment product. For a further discussion of competitive and other risks inherent in our Indices business, see Item 1A, Risk Factors, in this Annual Report on Form 10-K.LIQUIDITY AND CAPITAL RESOURCESWe continue to maintain a strong financial position. Our primary source of funds for operations is cash from our businesses and our core businesses have been strong cash generators. In 2021, cash on hand, cash flows from operations and availability under our existing credit facility are expected to be sufficient to meet any additional operating and recurring cash needs into the foreseeable future. We use our cash for a variety of needs, including but not limited to: ongoing investments in our businesses, strategic acquisitions, share repurchases, dividends, repayment of debt, capital expenditures and investment in our infrastructure.Cash Flow OverviewCash, cash equivalents, and restricted cash were $4.1 billion as of December 31, 2020, an increase of $1.2 billion as compared to December 31, 2019.54Table of Contents (in millions)Year ended December 31, 202020192018Net cash provided by (used for):Operating activities$3,567 $2,776 $2,064 Investing activities(240)(131)(513)Financing activities(2,166)(1,751)(2,288)In 2020, free cash flow increased to $3.3 billion compared to $2.5 billion in 2019. Free cash flow is a non-GAAP financial measure and reflects our cash flow provided by operating activities less capital expenditures and distributions to noncontrolling interest holders. Capital expenditures include purchases of property and equipment and additions to technology projects. See “Reconciliation of Non-GAAP Financial Information” below for a reconciliation of cash flow provided by operating activities, the most directly comparable U.S. GAAP financial measure, to free cash flow and free cash flow excluding certain items.Operating activitiesCash provided by operating activities increased to $3.6 billion in 2020 as compared to $2.8 billion in 2019. The increase is mainly due to higher results from operations in 2020 and improved cash collections on accounts receivable in 2020.Cash provided by operating activities increased to $2.8 billion in 2019 as compared to $2.1 billion in 2018. The increase is mainly due to higher results from operations, lower incentive compensation payments and low legal settlement payments in 2019. Investing activitiesOur cash outflows from investing activities are primarily for acquisitions and capital expenditures, while cash inflows are primarily proceeds from dispositions.Cash used for investing activities increased to $0.2 billion for 2020 as compared to $0.1 billion in 2019, primarily due to cash used for the acquisitions of the ESG Ratings Business from RobecoSAM and Greenwich Associates LLC in 2020.Cash used for investing activities decreased to $0.1 billion for 2019 as compared to $0.5 billion in 2018, primarily due to cash used for the acquisition of Kensho and the purchase of intellectual property in 2018.Refer to Note 2 – Acquisitions and Divestitures to the Consolidated Financial Statements and Supplementary Data, in the Annual Report on Form 10-K for further information.Financing activitiesOur cash outflows from financing activities consist primarily of share repurchases, dividends and repayment of short-term and long-term debt, while cash inflows are primarily inflows from long-term and short-term debt borrowings and proceeds from the exercise of stock options.Cash used for financing activities increased to $2.2 billion in 2020 from $1.8 billion in 2019. The increase is primarily attributable to cash used for the redemption and extinguishment of the $900 million outstanding principal amount of our 4.4% senior notes due in 2026 and a portion of the outstanding principal amounts of our 6.55% senior notes due in 2037 and our 4.5% senior notes due in 2048 in 2020, partially offset by proceeds from the issuance of senior notes in 2020. See Note 5 — Debt to the Consolidated Financial Statements and Supplementary Data, in the Annual Report on Form 10-K for further discussion.Cash used for financing activities decreased to $1.8 billion in 2019 from $2.3 billion in 2018. The decrease is primarily attributable to higher cash paid for share repurchases in 2018 and proceeds from the issuance of senior notes in 2019. During 2020, we used cash to repurchase 4.0 million shares for $1,164 million. We entered into two accelerated share repurchase ("ASR") agreements with a financial institution on February 11, 2020 to initiate share repurchases aggregating $500 million each. We repurchased a total of 1.7 million shares under each ASR agreement for an average purchase price of $292.13 per share. During 2019, we received 5.9 million shares, including 0.4 million shares received in January of 2019 related to our October 29, 2018 ASR agreement, resulting in $1,240 million of cash used to repurchase shares. We entered into an ASR agreement with a financial institution on August 5, 2019 to initiate share repurchases aggregating $500 million. We repurchased a total of 55Table of Contents 2.0 million shares under the ASR agreement for an average purchase price of $253.36 per share. We entered into an ASR agreement with a financial institution on February 11, 2019 to initiate share repurchases aggregating $500 million. We repurchased a total of 2.3 million shares under the ASR agreement for an average purchase price of $214.65 per share. During 2018, we used cash to repurchase 8.4 million shares for $1.7 billion. We entered into an ASR agreement with a financial institution on October 29, 2018 to initiate share repurchases aggregating $500 million. We repurchased a total of 2.9 million shares under the ASR agreement for an average purchase price of $173.80 per share. We entered into an ASR agreement with a financial institution on March 6, 2018 to initiate share repurchases aggregating $1 billion. We repurchased a total of 5.1 million shares under that ASR agreement for an average purchase price of $197.49 per share. On January 29, 2020, the Board of Directors approved a share repurchase program authorizing the purchase of 30 million shares (the "2020 Repurchase Program"), which was approximately 12% of the total shares of our outstanding common stock at that time. On December 4, 2013, the Board of Directors approved a share repurchase program authorizing the purchase of 50 million shares (the "2013 Repurchase Program"), which was approximately 18% of the total shares of our outstanding common stock at that time. Our purchased shares may be used for general corporate purposes, including the issuance of shares for stock compensation plans and to offset the dilutive effect of the exercise of employee stock options. As of December 31, 2020, 30 million shares remained available under the 2020 Repurchase Program and 0.8 million shares remained available under the 2013 repurchase program. See Note 9 — Equity to the Consolidated Financial Statements and Supplementary Data, in the Annual Report on Form 10-K for further discussion related to our ASR agreements.Additional FinancingWe have the ability to borrow a total of $1.2 billion through our commercial paper program, which is supported by our revolving $1.2 billion five-year credit agreement (our "credit facility") that we entered into on June 30, 2017. This credit facility will terminate on June 30, 2022. As of December 31, 2020 and 2019, there was no commercial paper issued or outstanding, and we similarly did not draw or have any borrowings outstanding from the credit facility during the year ended December 31, 2020 and 2019.Depending on our corporate credit rating, we pay a commitment fee of 8 to 17.5 basis points for our credit facility, whether or not amounts have been borrowed. We currently pay a commitment fee of 10 basis points. The interest rate on borrowings under our credit facility is, at our option, calculated using rates that are primarily based on either the prevailing London Inter-Bank Offer Rate, the prime rate determined by the administrative agent or the Federal Funds Rate. For certain borrowings under this credit facility, there is also a spread based on our corporate credit rating.Our credit facility contains certain covenants. The only financial covenant requires that our indebtedness to cash flow ratio, as defined in our credit facility, is not greater than 4 to 1, and this covenant level has never been exceeded.56Table of Contents DividendsOn January 27, 2021, the Board of Directors approved an increase in the quarterly common stock dividend from $0.67 per share to $0.77 per share.Supplemental Guarantor Financial InformationThe senior notes described below were issued by S&P Global Inc. and are fully and unconditionally guaranteed by Standard & Poor's Financial Services LLC, a 100% owned subsidiary of the Company. All senior notes have been registered with the SEC in connection with exchange offers.•On August 13, 2020, we issued $600 million of 1.25% senior notes due in 2030 and $700 million of 2.3% senior notes due in 2060. •On November 26, 2019, we issued $500 million of 2.5% senior notes due in 2029 and $600 million of 3.25% senior notes due in 2049.•On May 17, 2018, we issued $500 million of 4.5% senior notes due in 2048.•On September 22, 2016, we issued $500 million of 2.95% senior notes due in 2027. •On May 26, 2015, we issued $700 million of 4.0% senior notes due in 2025. •On November 2, 2007 we issued $400 million of 6.55% Senior Notes due 2037.The notes above are unsecured and unsubordinated and rank equally and ratably with all of our existing and future unsecured and unsubordinated debt. The guarantees are the subsidiary guarantor’s unsecured and unsubordinated debt and rank equally and ratably with all of the subsidiary guarantor’s existing and future unsecured and unsubordinated debt.The guarantees of the subsidiary guarantor may be released and discharged upon (i) a sale or other disposition (including by way of consolidation or merger) of the subsidiary guarantor or the sale or disposition of all or substantially all the assets of the subsidiary guarantor (in each case other than to the Company or a person who, prior to such sale or other disposition, is an affiliate of the Company); (ii) upon defeasance or discharge of any applicable series of the notes, as described above; or (iii) at such time as the subsidiary guarantor ceases to guarantee indebtedness for borrowed money, other than a discharge through payment thereon, under any Credit Facility of the Company, other than any such Credit Facility of the Company the guarantee of which by the subsidiary guarantor will be released concurrently with the release of the subsidiary guarantor’s guarantees of the notes.Other subsidiaries of the Company do not guarantee the registered debt securities of either S&P Global Inc. or Standard & Poor's Financial Services LLC (the "Obligor Group") which are referred to as the “Non-Obligor Group”.The following tables set forth the summarized financial information of the Obligor Group on a combined basis. This summarized financial information excludes the Non-Obligor Group. Intercompany balances and transactions between members of the Obligor Group have been eliminated. This information is not intended to present the financial position or results of operations of the Obligor Group in accordance with U.S. GAAP.57Table of Contents Summarized results of operations year ended December 31 is as follows:(in millions)2020Revenue$3,082 Operating Profit 1,923 Net Income 712 Net income attributable to S&P Global Inc. 712 Summarized balance sheet information as of December 31 is as follows:(in millions)20202019Current assets (excluding intercompany from Non-Obligor Group)$3,093 $1,611 Noncurrent assets1,055 1,225 Current liabilities (excluding intercompany to Non-Obligor Group)1,179 1,052 Noncurrent liabilities 4,936 4,762 Intercompany payables to Non-Obligor Group 3,893 2,785 Contractual ObligationsWe typically have various contractual obligations, which are recorded as liabilities in our consolidated balance sheets, while other items, such as certain purchase commitments and other executory contracts, are not recognized, but are disclosed herein. For example, we are contractually committed to contracts for information-technology outsourcing, certain enterprise-wide information-technology software licensing and maintenance.We believe that the amount of cash and cash equivalents on hand, cash flow expected from operations and availability under our credit facility will be adequate for us to execute our business strategy and meet anticipated requirements for lease obligations, capital expenditures, working capital and debt service for 2021.The following table summarizes our significant contractual obligations and commercial commitments as of December 31, 2020, over the next several years. Additional details regarding these obligations are provided in the notes to our consolidated financial statements, as referenced in the footnotes to the table:(in millions)Less than 1Year1-3 Years3-5 YearsMore than 5YearsTotalDebt: 1Principal payments$— $— $695 $3,415 $4,110 Interest payments$130 $261 $243 $1,867 $2,501 Operating leases 2$120 $188 $128 $302 $738 Purchase obligations and other 3$142 $171 $66 $33 $412 Total contractual cash obligations$392 $620 $1,132 $5,617 $7,761 1Our debt obligations are described in Note 5 – Debt to our consolidated financial statement.2See Note 13 – Commitments and Contingencies to our consolidated financial statements for further discussion on our operating lease obligations. 3Other consists primarily of commitments for unconditional purchase obligations in contracts for information-technology outsourcing and certain enterprise-wide information-technology software licensing and maintenance.As of December 31, 2020, we had $121 million of liabilities for unrecognized tax benefits. We have excluded the liabilities for unrecognized tax benefits from our contractual obligations table because, until formal resolutions are reached, reasonable estimates of the timing of cash settlements with the respective taxing authorities are not practicable.As of December 31, 2020, we have recorded $2,781 million for our redeemable noncontrolling interest in our S&P Dow Jones Indices LLC partnership discussed in Note 9 – Equity to our consolidated financial statements. Specifically, this amount relates to the put option under the terms of the operating agreement of S&P Dow Jones Indices LLC, whereby, after December 31, 2017, CME Group and CME Group Index Services LLC ("CGIS") has the right at any time to sell, and we are obligated to buy, 58Table of Contents at least 20% of their share in S&P Dow Jones Indices LLC. We have excluded this amount from our contractual obligations table because we are uncertain as to the timing and the ultimate amount of the potential payment we may be required to make.We make contributions to our pension and postretirement plans in order to satisfy minimum funding requirements as well as additional contributions that we consider appropriate to improve the funded status of our plans. During 2020, we contributed $12 million to our retirement plans. Expected employer contributions in 2021 are $11 million and $4 million for our retirement and postretirement plans, respectively. In 2021, we may elect to make additional non-required contributions depending on investment performance and the pension plan status. See Note 7 – Employee Benefits to our consolidated financial statements for further discussion.Off-Balance Sheet ArrangementsAs of December 31, 2020 and 2019, we did not have any material relationships with unconsolidated entities, such as entities often referred to as specific purpose or variable interest entities where we are the primary beneficiary, which would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. As such we are not exposed to any financial liquidity, market or credit risk that could arise if we had engaged in such relationships.59Table of Contents RECONCILIATION OF NON-GAAP FINANCIAL INFORMATIONFree cash flow is a non-GAAP financial measure and reflects our cash flow provided by operating activities less capital expenditures and distributions to noncontrolling interest holders. Capital expenditures include purchases of property and equipment and additions to technology projects. Our cash flow provided by operating activities is the most directly comparable U.S. GAAP financial measure to free cash flow. Additionally, we have considered certain items in evaluating free cash flow, which are included in the table below.We believe the presentation of free cash flow and free cash flow excluding certain items allows our investors to evaluate the cash generated from our underlying operations in a manner similar to the method used by management. We use free cash flow to conduct and evaluate our business because we believe it typically presents a more conservative measure of cash flows since capital expenditures and distributions to noncontrolling interest holders are considered a necessary component of ongoing operations. Free cash flow is useful for management and investors because it allows management and investors to evaluate the cash available to us to prepay debt, make strategic acquisitions and investments and repurchase stock.The presentation of free cash flow and free cash flow excluding certain items are not intended to be considered in isolation or as a substitute for the financial information prepared and presented in accordance with U.S. GAAP. Free cash flow, as we calculate it, may not be comparable to similarly titled measures employed by other companies. The following table presents a reconciliation of our cash flow provided by operating activities to free cash flow excluding the impact of the items below:(in millions)Year ended December 31,% Change 202020192018’20 vs ’19’19 vs ’18Cash provided by operating activities$3,567 $2,776 $2,064 28%34%Capital expenditures(76)(115)(113)Distributions to noncontrolling interest holders, net 1(194)(143)(154)Free cash flow$3,297 $2,518 $1,797 31%40%Settlement of prior-year tax audits— 51 73 Tax on gain from sale of SPIAS and RigData— 13 — Payment of legal settlements— 1 180 Tax benefit from legal settlements— — (44)Free cash flow excluding above items$3,297 $2,583 $2,006 28%29%1 Distributions to noncontrolling interest holders is net of amounts owed to the S&P Dow Jones Indices LLC joint venture by the noncontrolling interest holders.(in millions)202020192018’20 vs ’19’19 vs ’18Cash used for investing activities(240)(131)(513)84%(75)%Cash used for financing activities(2,166)(1,751)(2,288)24%(23)%N/M - not meaningfulCRITICAL ACCOUNTING ESTIMATESOur discussion and analysis of our financial condition and results of operations is based upon our consolidated financial statements, which have been prepared in accordance with U.S. GAAP. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses and related disclosure of contingent assets and liabilities. On an ongoing basis, we evaluate our estimates and assumptions, including those related to revenue recognition, allowance for doubtful accounts, valuation of long-lived assets, goodwill and other intangible assets, pension plans, incentive compensation and stock-based compensation, income taxes, contingencies and redeemable noncontrolling interests. We base our estimates on historical experience, current developments and on various other assumptions that we believe to be reasonable under these circumstances, the results of which form the basis for making judgments about carrying values of assets and liabilities that cannot readily be determined from other sources. There can be no assurance that actual results will not differ from those estimates.60Table of Contents Management considers an accounting estimate to be critical if it required assumptions to be made that were uncertain at the time the estimate was made and changes in the estimate or different estimates could have a material effect on our results of operations. Management has discussed the development and selection of our critical accounting estimates with the Audit Committee of our Board of Directors. The Audit Committee has reviewed our disclosure relating to them in this MD&A.We believe the following critical accounting policies require us to make significant judgments and estimates in the preparation of our consolidated financial statements:Revenue recognitionWe adopted Financial Accounting Standards Board Accounting Standards Codification ("ASC") 606 "Revenue from Contracts with Customers" using the modified retrospective transition method applied to our revenue contracts with customers as of January 1, 2018. Results for reporting periods beginning after January 1, 2018 are presented under ASC 606, while prior year amounts are not adjusted and continue to be reported in accordance with our historic accounting under ASC 605 "Revenue Recognition". We recorded a net increase to opening retained earnings of $35 million as of January 1, 2018 due to the cumulative effect of adopting ASC 606, with the impact primarily related to our treatment of costs to obtain a contract and to a lesser extent, changes to the timing of the recognition of our subscription and non-transaction revenues. Under ASC 606, revenue is recognized when a customer obtains control of promised goods or services in an amount that reflects the consideration the entity expects to receive in exchange for those goods or services. Under ASC 605, revenue was recognized as it was earned and when services were rendered. See Note 1 - Accounting Policies to our consolidated financial statements for further information.Allowance for doubtful accountsThe allowance for doubtful accounts reserve methodology is based on historical analysis, a review of outstanding balances and current conditions, and by incorporating data points that provide indicators of future economic conditions including forecasted industry default rates and industry index benchmarks. In determining these reserves, we consider, amongst other factors, the financial condition and risk profile of our customers, areas of specific or concentrated risk as well as applicable industry trends or market indicators. The impact on operating profit for a one percentage point change in the allowance for doubtful accounts is approximately $16 million. During the year ended December 31, 2020, we incorporated the forecasted impact of future economic conditions into our allowance for doubtful accounts measurement process including the expected adverse impact of COVID-19 on the global economy. Based on our current outlook these assumptions are not expected to significantly change in 2021.Accounting for the impairment of long-lived assets (including other intangible assets)We evaluate long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Upon such an occurrence, recoverability of assets to be held and used is measured by comparing the carrying amount of an asset to current forecasts of undiscounted future net cash flows expected to be generated by the asset. If the carrying amount of the asset exceeds its estimated future cash flows, an impairment charge is recognized equal to the amount by which the carrying amount of the asset exceeds the fair value of the asset. For long-lived assets held for sale, assets are written down to fair value, less cost to sell. Fair value is determined based on market evidence, discounted cash flows, appraised values or management’s estimates, depending upon the nature of the assets. Goodwill and indefinite-lived intangible assetsGoodwill represents the excess of purchase price and related costs over the value assigned to the net tangible and identifiable intangible assets of businesses acquired. As of December 31, 2020 and 2019, the carrying value of goodwill and other indefinite-lived intangible assets was $4.6 billion and $4.4 billion, respectively. Goodwill and other intangible assets with indefinite lives are not amortized, but instead are tested for impairment annually during the fourth quarter each year or more frequently if events or changes in circumstances indicate that the asset might be impaired.61Table of Contents GoodwillAs part of our annual impairment test of our four reporting units, we initially perform a qualitative analysis evaluating whether any events and circumstances occurred that provide evidence that it is more likely than not that the fair value of any of our reporting units is less than its carrying amount. Reporting units are generally an operating segment or one level below an operating segment. Our qualitative assessment included, but was not limited to, consideration of macroeconomic conditions, industry and market conditions, cost factors, cash flows, changes in key Company personnel and our share price. If, based on our evaluation of the events and circumstances that occurred during the year we do not believe that it is more likely than not that the fair value of any of our reporting units is less than its carrying amount, no quantitative impairment test is performed. Conversely, if the results of our qualitative assessment determine that it is more likely than not that the fair value of any of our reporting units is less than its respective carrying amount we perform a quantitative impairment test. If the fair value of the reporting unit is less than the carrying value, the difference is recognized as an impairment charge. For 2020, based on our qualitative assessments, we determined that it is more likely than not that our reporting units’ fair values were greater than their respective carrying amounts. Indefinite-Lived Intangible AssetsWe evaluate the recoverability of indefinite-lived intangible assets by first performing a qualitative analysis evaluating whether any events and circumstances occurred that provide evidence that it is more likely than not that the indefinite-lived asset is impaired. If, based on our evaluation of the events and circumstances that occurred during the year we do not believe that it is more likely than not that the indefinite-lived asset is impaired, no quantitative impairment test is performed. Conversely, if the results of our qualitative assessment determine that it is more likely than not that the indefinite-lived asset is impaired, a quantitative impairment test is performed. If necessary, the impairment test is performed by comparing the estimated fair value of the intangible asset to its carrying value. If the indefinite-lived intangible asset carrying value exceeds its fair value, an impairment analysis is performed using the income approach. The fair value of loss is recognized in an amount equal to that excess. Significant judgments inherent in these analyses include estimating the amount and timing of future cash flows and the selection of appropriate discount rates, royalty rates and long-term growth rate assumptions. Changes in these estimates and assumptions could materially affect the determination of fair value for this indefinite-lived intangible asset and could result in an impairment charge, which could be material to our financial position and results of operations.We performed our impairment assessment of goodwill and indefinite-lived intangible assets and concluded that no impairment existed for the years ended December 31, 2020, 2019, and 2018.Retirement plans and postretirement healthcare and other benefitsOur employee pension and other postretirement benefit costs and obligations are dependent on assumptions concerning the outcome of future events and circumstances, including compensation increases, long-term return on pension plan assets, healthcare cost trends, discount rates and other factors. In determining such assumptions, we consult with outside actuaries and other advisors where deemed appropriate. In accordance with relevant accounting standards, if actual results differ from our assumptions, such differences are deferred and amortized over the estimated remaining lifetime of the plan participants. While we believe that the assumptions used in these calculations are reasonable, differences in actual experience or changes in assumptions could affect the expense and liabilities related to our pension and other postretirement benefits.The following is a discussion of some significant assumptions that we make in determining costs and obligations for pension and other postretirement benefits:•Discount rate assumptions are based on current yields on high-grade corporate long-term bonds.•Healthcare cost trend assumptions are based on historical market data, the near-term outlook and an assessment of likely long-term trends.•The expected return on assets assumption is calculated based on the plan’s asset allocation strategy and projected market returns over the long-term.Our discount rate and return on asset assumptions used to determine the net periodic pension and postretirement benefit cost on our U.S. retirement plans are as follows: Retirement PlansPostretirement PlansJanuary 1202120202019202120202019Discount rate 2.75 %3.45 %4.40 %2.20 %3.08 %4.15 %Return on assets5.00 %5.50 %6.00 %Weighted-average healthcare cost rate6.00 %6.50 %6.50 %62Table of Contents Stock-based compensationStock-based compensation expense is measured at the grant date based on the fair value of the award and is recognized over the requisite service period, which typically is the vesting period. Stock-based compensation is classified as both operating-related expense and selling and general expense in our consolidated statements of income.We use a lattice-based option-pricing model to estimate the fair value of options granted. The following assumptions were used in valuing the options granted: Year Ended December 31, 2018Risk-free average interest rate2.6 - 2.7%Dividend yield1.1 %Volatility21.8 - 22.0%Expected life (years)5.67 - 6.07Weighted-average grant-date fair value per option$112.98 Because lattice-based option-pricing models incorporate ranges of assumptions, those ranges are disclosed. These assumptions are based on multiple factors, including historical exercise patterns, post-vesting termination rates, expected future exercise patterns and the expected volatility of our stock price. The risk-free interest rate is the imputed forward rate based on the U.S. Treasury yield at the date of grant. We use the historical volatility of our stock price over the expected term of the options to estimate the expected volatility. The expected term of options granted is derived from the output of the lattice model and represents the period of time that options granted are expected to be outstanding.In 2018, we made a one-time issuance of incentive stock options under the 2002 Plan to replace Kensho employees' stock options that were assumed in connection with our acquisition of Kensho in April of 2018. There were no stock options granted in 2020 and 2019. Income taxesDeferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to be applied to taxable income in the years in which those temporary differences are expected to be recovered or settled. We recognize liabilities for uncertain tax positions taken or expected to be taken in income tax returns. Accrued interest and penalties related to unrecognized tax benefits are recognized in interest expense and operating expense, respectively.Judgment is required in determining our provision for income taxes, deferred tax assets and liabilities and unrecognized tax benefits. In determining the need for a valuation allowance, the historical and projected financial performance of the operation that is recording a net deferred tax asset is considered along with any other pertinent information.We file income tax returns in the U.S. federal jurisdiction, various states, and foreign jurisdictions, and we are routinely under audit by many different tax authorities. We believe that our accrual for tax liabilities is adequate for all open audit years based on our assessment of many factors including past experience and interpretations of tax law. This assessment relies on estimates and assumptions and may involve a series of complex judgments about future events. It is possible that examinations will be settled prior to December 31, 2021. If any of these tax audit settlements do occur within that period we would make any necessary adjustments to the accrual for unrecognized tax benefits. As of December 31, 2020, we have approximately $3.1 billion of undistributed earnings of our foreign subsidiaries, of which $0.8 billion is reinvested indefinitely in our foreign operations. 63Table of Contents ContingenciesWe are subject to a number of lawsuits and claims that arise in the ordinary course of business. We recognize a liability for such contingencies when both (a) information available prior to issuance of the financial statements indicates that it is probable that a liability had been incurred at the date of the financial statements and (b) the amount of loss can reasonably be estimated. We continually assess the likelihood of any adverse judgments or outcomes to our contingencies, as well as potential amounts or ranges of probable losses, and recognize a liability, if any, for these contingencies based on an analysis of each matter with the assistance of outside legal counsel and, if applicable, other experts. Because many of these matters are resolved over long periods of time, our estimate of liabilities may change due to new developments, changes in assumptions or changes in our strategy related to the matter. When we accrue for loss contingencies and the reasonable estimate of the loss is within a range, we record its best estimate within the range. We disclose an estimated possible loss or a range of loss when it is at least reasonably possible that a loss may have been incurred.Redeemable Noncontrolling Interest The fair value component of the redeemable noncontrolling interest in Indices business is based on a combination of an income and market valuation approach. Our income and market valuation approaches may incorporate Level 3 fair value measures for instances when observable inputs are not available. The more significant judgmental assumptions used to estimate the value of the S&P Dow Jones Indices LLC joint venture include an estimated discount rate, a range of assumptions that form the basis of the expected future net cash flows (e.g., the revenue growth rates and operating margins), and a company specific beta. The significant judgmental assumptions used that incorporate market data, including the relative weighting of market observable information and the comparability of that information in our valuation models, are forward-looking and could be affected by future economic and market conditions. RECENT ACCOUNTING STANDARDSSee Note 1 – Accounting Policies to our consolidated financial statements for a detailed description of recent accounting standards. We do not expect these recent accounting standards to have a material impact on our results of operations, financial condition, or liquidity in future periods. Item 7A. Quantitative and Qualitative Disclosures about Market RiskOur exposure to market risk includes changes in foreign exchange rates. We have operations in various foreign countries where the functional currency is primarily the local currency. For international operations that are determined to be extensions of the parent company, the U.S. dollar is the functional currency. We typically have naturally hedged positions in most countries from a local currency perspective with offsetting assets and liabilities. During the years ended December 31, 2020, 2019 and 2018, we entered into foreign exchange forward contracts in order to mitigate the change in fair value of specific assets and liabilities in the consolidated balance sheet. These forward contracts are not designated as hedges and do not qualify for hedge accounting. During the years ended December 31, 2020, 2019 and 2018, we entered into foreign exchange forward contracts to hedge the effect of adverse fluctuations in foreign currency exchange rates. For the years ended December 31, 2020 and 2019, we entered into cross-currency swap contracts to hedge a portion of our net investment in a foreign subsidiary against volatility in foreign exchange rates. We have not entered into any derivative financial instruments for speculative purposes. See Note 6 – Derivative Instruments to the Consolidated Financial Statements and Supplementary Data, in the Annual Report on Form 10-K for further discussion.64Table of Contents
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+ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSThe following discussion contains forward-looking statements, including, without limitation, our expectations and statements regarding our outlook and future revenues, expenses, results of operations, liquidity, plans, strategies and management objectives and any assumptions underlying any of the foregoing. Our actual results may differ significantly from those projected in the forward-looking statements. Our forward-looking statements and factors that might cause future actual results to differ materially from our recent results or those projected in the forward-looking statements include, but are not limited to, those discussed in the section titled “Forward-Looking Information” and “Risk Factors” of this Annual Report on Form 10-K. Except as required by law, we assume no obligation to update the forward-looking statements or our risk factors for any reason.The following section generally discusses fiscal 2021 and 2020 items and year-to-year comparisons between fiscal 2021 and 2020, as well as certain fiscal 2019 items. Discussions of fiscal 2019 items and year-to-year comparisons between fiscal 2020 and 2019 that are not included in this Form 10-K can be found in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Part II, Item 7 of our Annual Report on Form 10-K for the fiscal year ended January 31, 2020.OverviewWe are a global leader in customer relationship management ("CRM") technology that brings companies and customers together. With our Customer 360 platform we deliver a single source of truth, connecting customer data across systems, apps and devices to help companies sell, service, market and conduct commerce, from anywhere. Since our founding in 1999, we have pioneered innovations in cloud, mobile, social, analytics and artificial intelligence (“AI”), enabling companies of every size and industry to transform their businesses in the all-digital, work-from-anywhere era. COVID-19 ImpactIn December 2019, the novel coronavirus and resulting disease (“COVID-19”) was first reported. After ongoing assessment of the rapid spread, number of cases and countries affected, on March 11, 2020, the World Health Organization characterized COVID-19 as a pandemic. The COVID-19 pandemic has created significant global economic uncertainty, adversely impacted the business of our customers and partners, impacted our business and results of operations and could further impact our results of operations and our cash flows in the future.In response to the COVID-19 pandemic, we have been guided by our core values of trust, customer success, innovation and equality. Beginning in the first fiscal quarter and through the remainder of fiscal 2021, we took actions in response to the pandemic that focused on maintaining business continuity, supporting our employees, helping our customers and communities and preparing for the future and the long-term success of our business. As a result of the pandemic, we experienced a slight decline in new business in the first quarter of fiscal 2021 as compared to the same prior-year period; however, new business grew during the remainder of fiscal 2021 at rates consistent with historical trends prior to COVID-19. In addition, as a result of actions taken by us in response to the pandemic, we experienced incremental operating expenses and lower than expected operating cash flows for the full year of fiscal 2021, when compared to historical trends. For example, changes in billing frequency for new business and investments in our go-to-market efforts resulted in a negative impact to our operating cash flows during the year. In fiscal 2021, our income from operations benefited from our global work from home policy and limited business travel by our employees. We continue to evaluate our office space needs, and as a result we recorded approximately $216 million of impairments to assets associated with real estate 37Table of Contentsleases in select locations we have decided to exit, of which approximately $184 million was recorded in the fourth quarter of fiscal 2021. In addition, we have in the past implemented strategic realignments to position our company for future growth and will continue to do so, particularly as we evaluate the impact of COVID-19 on our business. As part of our current strategic realignment, we have redirected and may in the future redirect some resources from areas that no longer align with our business priorities into key growth and strategic areas, as well as to increase investments in our go-to-market and product efforts. As a result of these investments and redirection efforts, which included some position eliminations, we saw an increase in expenses in fiscal 2021. In addition, as we continue to evaluate our office space needs, we may record additional impairments to associated assets. As we adjust and refine our strategy, there may be additional investments and redirection efforts in the future. We do not yet know the impact the pandemic will have on our long-term revenue growth and profitability. Authorities throughout the world have implemented numerous preventative measures to contain or mitigate further spread of the virus, such as travel bans and restrictions, limitations on business activity, quarantines, work-from-home directives and shelter-in-place orders. These measures have caused, and could continue to cause, business slowdowns or shutdowns in affected areas, both regionally and worldwide. These business slowdowns and shutdowns have impacted and may continue to impact our business and results of operations. For example, the extent and duration of these measures could impact our ability to address cybersecurity incidents; have resulted in increased internet demand, which could cause access issues; could affect our ability to develop and support products and services; and could cause issues with access to data centers.The ultimate extent of the impact of the COVID-19 pandemic on our operational and financial performance depends on certain developments, including the duration of the pandemic and any resurgences, the severity of the disease, responsive actions taken by public health officials, the development, distribution and public acceptance of treatments and vaccines, the impacts on our customers and our sales cycles, our ability to generate new business leads, the impacts on our customers, employee and industry events, and the effects on our vendors, all of which are uncertain and currently cannot be predicted with any degree of certainty. As a result, the extent to which the COVID-19 pandemic will continue to impact our financial condition or results of operations is uncertain. Due to our primarily subscription-based business model, the effect of the COVID-19 pandemic may not be fully reflected in our results of operations until future periods. If the COVID-19 pandemic has a substantial impact on our employees’, partners’ or customers’ productivity, our results of operations and overall financial performance may be harmed. In addition, the global macroeconomic effects of the COVID-19 pandemic and related impacts on our customers’ business operations and their demand for our products and services may persist for an indefinite period, even after the COVID-19 pandemic has subsided.See Part I, Item 1A. “Risk Factors” for further discussion of the impact and possible future impacts of the COVID-19 pandemic on our business.Highlights from the Fiscal Year 2021.•Revenue: Total fiscal 2021 revenue was $21.3 billion, an increase of 24 percent year-over-year. •Earnings per Share: Fiscal 2021 diluted earnings per share was $4.38 as compared to earnings per share of $0.15 from a year ago, and was benefited by approximately $2.0 billion from the one-time discrete tax benefit resulting from the recognition of deferred tax assets related to an intra-entity transfer of intangible property and an unrealized gain of $1.7 billion associated with the initial public offerings of two of our strategic investments. •Cash: Cash provided by operations for fiscal 2021 was $4.8 billion, an increase of 11 percent year-over-year. Total cash, cash equivalents and marketable securities ended fiscal 2021 at $12.0 billion. •Remaining Performance Obligation: Remaining performance obligation ended fiscal 2021 at approximately $36.1 billion, an increase of 17 percent year-over-year. Current remaining performance obligation ended fiscal 2021 at approximately $18.0 billion, an increase of 20 percent year-over-year. •Acquisition: During fiscal 2021, we completed the acquisition of Vlocity, Inc. ("Vlocity") for $1.4 billion, consisting primarily of $1.2 billion in cash. Additionally, during fiscal 2021, we announced our pending acquisition of Slack Technologies, Inc. (“Slack”), a leading channel-based messaging platform, which is expected to close in the second quarter of fiscal 2022, subject to satisfaction of customary closing conditions, including regulatory approvals, for an estimated $15.6 billion in cash and 45 million shares of Salesforce common stock, based on Slack Class A and Class B shares outstanding as of January 31, 2021.We continue to invest for future growth and are focused on several key growth levers, including driving multi-cloud adoption, increasing our penetration with enterprise and international customers and our industry-specific reach with more vertical software solutions. These growth drivers often require a more sophisticated go-to-market approach and, as a result, we may incur additional costs upfront to obtain new customers and expand our relationships with existing customers, including additional sales and marketing expenses specific to subscription and support revenue. As a result, we have seen that customers with many of these characteristics have lower attrition rates than our company average. 38Table of ContentsWe plan to continue to reinvest a significant portion of our income from operations in future periods to grow and innovate our business and service offerings and expand our leadership role in the cloud computing industry. We drive innovation organically and, to a lesser extent, through acquisitions. We regularly evaluate acquisitions and investment opportunities in complementary businesses, joint ventures, services, technologies and intellectual property rights in an effort to expand our service offerings and to nurture the overall ecosystem for our offerings. Past acquisitions have enabled us to deliver innovative solutions in new categories, including analytics and integration. We continue to evaluate investment opportunities and expect to continue to make investments and acquisitions in the future, such as our pending acquisition of Slack. Slack has an integrated value proposition across all of our service offerings and, upon close of the transaction and successful product integration, we believe it will further enable companies to grow and succeed in an all-digital, work-from-anywhere era.As a result of our aggressive growth plans and integration of our previously acquired businesses, we have incurred significant expenses for equity awards and amortization of purchased intangibles, which have reduced our operating income.We periodically make changes to our sales organization to position us for long-term growth, which has in the past and could again in the future result in temporary disruptions to our sales productivity. In addition, we have experienced, and may at times in the future experience, more variation from our forecasted expectations of new business activity due to longer and less predictable sales cycles and increasing complexity of our business, which includes an expanded mix of products and various revenue models resulting from acquisitions and increased enterprise solution selling activities. Slower growth in new business in a given period could negatively affect our revenues in future periods, as well as remaining performance obligation in current or future periods, particularly if experienced on a sustained basis.The expanding global scope of our business and the heightened volatility of global markets, including as a result of COVID-19, expose us to the risk of fluctuations in foreign currency markets. Fluctuations in foreign currency exchange rates had a modest favorable impact on our revenue results for fiscal 2021. In addition, fluctuations in foreign currency exchange rates had a modest favorable impact on both our remaining performance obligation and current remaining performance obligation as of January 31, 2021. We expect these fluctuations to continue in the future.Fiscal YearOur fiscal year ends on January 31. References to fiscal 2021, for example, refer to the fiscal year ending January 31, 2021.Operating SegmentsWe operate as one segment. See Note 1 “Summary of Business and Significant Accounting Policies” to the consolidated financial statements for our discussion about segments. Sources of RevenuesWe derive our revenues from two sources: subscription and support revenues and related professional services. Subscription and support revenues accounted for approximately 94 percent of our total revenues for fiscal 2021. Subscription and support revenues are primarily comprised of subscription fees from customers accessing our enterprise cloud computing services (collectively, "Cloud Services"). Cloud Services allow customers to use our multi-tenant software without taking possession of the software. Revenue is generally recognized ratably over the contract term. With the May 2018 acquisition of MuleSoft and the August 2019 acquisition of Tableau, subscription and support revenues also include revenues associated with software licenses. Software license revenues include fees from the sales of term and perpetual licenses. Revenues from software licenses are generally recognized upfront when the software is made available to the customer and revenues from the related support are generally recognized ratably over the contract term. Changes in contract duration for multi-year licenses can impact the amount of revenues recognized upfront. Revenues from software licenses represent less than ten percent of total subscription and support revenue for fiscal 2021.The revenue growth rates of each of our service offerings, as described below in “Results of Operations,” fluctuate from quarter to quarter and over time. Additionally, we manage the total balanced product portfolio to deliver solutions to our customers and, as a result, the revenue result for each offering is not necessarily indicative of the results to be expected for any subsequent quarter. In addition, some of our Cloud Service offerings have similar features and functions. For example, customers may use our Sales, Service or Platform service offering to record account and contact information, which are similar features across these service offerings. Depending on a customer’s actual and projected business requirements, more than one service offering may satisfy the customer’s current and future needs. We record revenue based on the individual products ordered by a customer, not according to the customer’s business requirements and usage.Our growth in revenues is also impacted by attrition. Attrition represents the reduction or loss of the annualized value of our contracts with customers. We calculate our attrition rate at a point in time on a trailing twelve-month basis as of the end of each month. As of January 31, 2021, our attrition rate, excluding our Integration service offering, Salesforce.org and Tableau, 39Table of Contentswas between 9.0% and 9.5%. Prior to fiscal year 2021, our attrition rate excluded our Commerce service offering. In general, we exclude service offerings from acquisitions from our attrition calculation until they are fully integrated into our customer success organization. While our attrition rate is difficult to predict, we expect it to remain consistent or slightly better in the near term due to the diversity of size, industry and geography within the customer base. However, our attrition rate may increase over time, including, for example, as a result of COVID-19. We continue to invest in a variety of customer programs and initiatives which, along with increasing enterprise adoption, have helped keep our attrition rate consistent as compared to the prior year. Consistent attrition rates play a role in our ability to maintain growth in our subscription and support revenues. Seasonal Nature of Unearned Revenue, Accounts Receivable and Operating Cash FlowUnearned revenue primarily consists of billings to customers for our subscription service. Over 90 percent of the value of our billings to customers is for our subscription and support service. We generally invoice our customers in advance, in annual installments, and typical payment terms provide that our customers pay us within 30 days of invoice. Amounts that have been invoiced are recorded in accounts receivable and in unearned revenue or in revenue depending on whether transfer of control to customers has occurred. In general, we collect our billings in advance of the subscription service period. We typically issue renewal invoices in advance of the renewal service period, and depending on timing, the initial invoice for the subscription and services contract and the subsequent renewal invoice may occur in different quarters. There is a disproportionate weighting toward annual billings in the fourth quarter, primarily as a result of large enterprise account buying patterns. Our fourth quarter has historically been our strongest quarter for new business and renewals. The year-on-year compounding effect of this seasonality in both billing patterns and overall new and renewal business causes the value of invoices that we generate in the fourth quarter for both new business and renewals to increase as a proportion of our total annual billings. Accordingly, because of this billing activity, our first quarter is typically our largest collections and operating cash flow quarter. Conversely, our third quarter has historically been our smallest operating cash flow quarter. In response to COVID-19, we offered temporary financial flexibility to some customers in the first quarter of fiscal 2021 and changed billing frequencies for other customers throughout fiscal 2021, which has delayed payments to periods later than expected. We also have accelerated our investments in our go-to-market and product efforts throughout fiscal 2021, which resulted in increased expenses and a negative impact to operating cash flow. These efforts have affected and may continue to affect trends related to the seasonal nature of unearned revenue, accounts receivable and operating cash flow. Unearned revenues, accounts receivable and operating cash flow may also be impacted by acquisitions. For example, operating cash flows may be adversely impacted by acquisitions due to transaction costs, financing costs such as interest expense and lower operating cash flows from the acquired entity. The sequential quarterly changes in accounts receivable and the related unearned revenue and operating cash flow during the first quarter of our fiscal year are not necessarily indicative of the billing activity that occurs for the following quarters as displayed below (in millions).40Table of ContentsRemaining Performance Obligation Our remaining performance obligation represents all future revenue under contract that has not yet been recognized as revenue and includes unearned revenue and unbilled amounts. Our current remaining performance obligation represents future revenue under contract that is expected to be recognized as revenue in the next 12 months. Remaining performance obligation is not necessarily indicative of future revenue growth and is influenced by several factors, including seasonality, the timing of renewals, average contract terms, foreign currency exchange rates and fluctuations in new business growth. Remaining performance obligation is also impacted by acquisitions. Unbilled portions of the remaining performance obligation denominated in foreign currencies are revalued each period based on the period end exchange rates. For multi-year subscription agreements billed annually, the associated unbilled balance and corresponding remaining performance obligation are typically high at the beginning of the contract period, zero just prior to renewal, and increase if the agreement is renewed. Low remaining performance obligation attributable to a particular subscription agreement is often associated with an impending renewal but may not be an indicator of the likelihood of renewal or future revenue from such customer. Changes in contract duration can impact remaining performance obligation and current remaining performance obligation.Remaining performance obligation consisted of the following (in billions):41Table of ContentsCost of Revenues and Operating ExpensesImpact of AcquisitionsThe comparability of our operating results is impacted by our recent acquisitions, including our acquisition of Vlocity in June 2020 and our acquisition of Tableau in August 2019. Expense contributions by expense type from our recent acquisitions generally may not be separately identifiable due to the integration of these businesses into our existing operations, or may be insignificant to our results of operations during the periods presented.Cost of RevenuesCost of subscription and support revenues primarily consists of expenses related to delivering our service and providing support, including the costs of data center capacity, certain fees paid to various third parties for the use of their technology, services and data and employee-related costs such as salaries and benefits. Cost of professional services and other revenues consists primarily of employee-related costs associated with these services, including stock-based expenses, the cost of subcontractors and certain third-party fees. We expect the cost of professional services to be approximately in line with revenues from professional services in future fiscal periods. We believe that this investment in professional services facilitates the adoption of our service offerings.Research and DevelopmentResearch and development expenses consist primarily of salaries and related expenses, including stock-based expenses and allocated overhead. Marketing and Sales Marketing and sales expenses make up the majority of our operating expenses and consist primarily of salaries and related expenses, including stock-based expenses and commissions, for our sales and marketing staff, as well as payments to partners, marketing programs and allocated overhead. Marketing programs consist of advertising, events, corporate communications, brand building and product marketing activities. We capitalize certain costs to obtain customer contracts, such as commissions, and amortize these costs on a straight-line basis. Payments of these commissions are not consistent with the period in which the expense is recognized.General and Administrative General and administrative expenses consist primarily of salaries and related expenses, including stock-based expenses, for finance and accounting, legal, internal audit, human resources and management information systems personnel and professional services fees. 42Table of ContentsCritical Accounting Policies and EstimatesOur consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States. The preparation of these consolidated financial statements requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues, costs and expenses and related disclosures. On an ongoing basis, we evaluate our estimates and assumptions. Our actual results may differ from these estimates under different assumptions or conditions.We believe that of our significant accounting policies, which are described in Note 1 “Summary of Business and Significant Accounting Policies” to our consolidated financial statements, the following accounting policies and specific estimates involve a greater degree of judgment and complexity.Revenue Recognition - Contracts with Multiple Performance Obligations. We enter into contracts with our customers that may include promises to transfer multiple Cloud Services, software licenses, premium support and professional services. A performance obligation is a promise in a contract with a customer to transfer products or services that are distinct. Determining whether products and services are distinct performance obligations that should be accounted for separately or combined as one unit of accounting may require significant judgment.Cloud Services and software licenses are distinct as such offerings are often sold separately. In determining whether professional services are distinct, we consider the following factors for each professional services agreement: availability of the services from other vendors, the nature of the professional services, the timing of when the professional services contract was signed in comparison to the subscription start date and the contractual dependence of the service on the customer’s satisfaction with the professional services work. To date, we have concluded that professional services included in contracts with multiple performance obligations are generally distinct.We allocate the transaction price to each performance obligation on a relative standalone selling price ("SSP") basis. The SSP is the price at which we would sell a promised product or service separately to a customer. Judgment is required to determine the SSP for each distinct performance obligation. We determine SSP by considering our overall pricing objectives and market conditions. Significant pricing practices taken into consideration include our discounting practices, the size and volume of our transactions, the customer demographic, the geographic area where services are sold, price lists, our go-to-market strategy, historical sales and contract prices. In instances where we do not sell or price a product or service separately, we determine relative fair value using information that may include market conditions or other observable inputs. As our go-to-market strategies evolve, we may modify our pricing practices in the future, which could result in changes to SSP.In certain cases, we are able to establish SSP based on observable prices of products or services sold separately in comparable circumstances to similar customers. We use a single amount to estimate SSP when it has observable prices. If SSP is not directly observable, for example when pricing is highly variable, we use a range of SSP. We determine the SSP range using information that may include pricing practices or other observable inputs. We typically have more than one SSP for individual products and services due to the stratification of those products and services by customer size and geography.Costs Capitalized to Obtain Revenue Contracts. Costs capitalized related to new revenue contracts are amortized on a straight-line basis over four years, which, although longer than the typical initial contract period, reflects the average period of benefit, including expected contract renewals. Significant judgment is required in arriving at this average period of benefit. Therefore, we evaluate both qualitative and quantitative factors, including the estimated life cycles of our offerings and our customer attrition. Business Combinations. Accounting for business combinations requires us to make significant estimates and assumptions, especially at the acquisition date with respect to tangible and intangible assets acquired and liabilities assumed and pre-acquisition contingencies. We use our best estimates and assumptions to accurately assign fair value to the tangible and intangible assets acquired and liabilities assumed at the acquisition date as well as the useful lives of those acquired intangible assets.Critical estimates in valuing certain of the intangible assets and goodwill we have acquired are:•future expected cash flows from subscription and support contracts, professional services contracts, other customer contracts and acquired developed technologies and patents;•historical and expected customer attrition rates and anticipated growth in revenue from acquired customers;•assumptions about the period of time the acquired trade name will continue to be used in our offerings;•discount rates;•uncertain tax positions and tax-related valuation allowances assumed; •fair value of assumed equity awards; and•fair value of pre-existing relationships.Unanticipated events and circumstances may occur that may affect the accuracy or validity of such assumptions, estimates or actual results.43Table of ContentsIncome Taxes. Valuation allowances are established when necessary to reduce deferred tax assets to the amounts that are more likely than not expected to be realized based on the weighting of positive and negative evidence. Future realization of deferred tax assets ultimately depends on the existence of sufficient taxable income of the appropriate character, for example, ordinary income or capital gains, within the carryback or carryforward periods available under the applicable tax law. We regularly review the deferred tax assets for recoverability based on historical taxable income, projected future taxable income, the expected timing of the reversals of existing temporary differences and tax planning strategies. Our judgment regarding future profitability may change due to many factors, including future market conditions and the ability to successfully execute our business plans and tax planning strategies. Should there be a change in the ability to recover deferred tax assets, our income tax provision would increase or decrease in the period in which the assessment is changed.Our tax positions are subject to income tax audits by multiple tax jurisdictions throughout the world. We recognize the tax benefit of an uncertain tax position only if it is more likely than not that the position is sustainable upon examination by the taxing authority, based on the technical merits. The tax benefit recognized is measured as the largest amount of benefit which is greater than 50 percent likely to be realized upon settlement with the taxing authority. We recognize interest accrued and penalties related to unrecognized tax benefits in our income tax provision.In fiscal 2021, we changed our international corporate structure, which included the transfer of certain intangible property between foreign affiliates resulting in a net tax benefit of $2.0 billion related to foreign deferred tax assets. The deferred tax assets were recognized as a result of the book and tax basis difference on the intangible property and were based on the intangible property’s current fair value. In determining the estimated fair value of the intangible property, we made significant estimates and assumptions including, but not limited to, projected revenues, operating expenses and geographic earnings mix in the valuation models. We believe that it is more likely than not that the deferred tax assets will be realized, and will regularly evaluate its realizability.Strategic Investments. Accounting for strategic investments in privately held debt and equity securities in which we do not have a controlling interest or significant influence requires us to make significant estimates and assumptions.Valuations of privately held securities are inherently complex and require judgment due to the lack of readily available market data. Privately held debt and equity securities are valued using significant unobservable inputs or data in an inactive market and the valuation requires our judgment due to the absence of market prices and inherent lack of liquidity. The carrying values of our privately held equity securities are adjusted if there are observable price changes in a same or similar security from the same issuer or if there are identified events or changes in circumstances that may indicate impairment, as discussed below. In determining the estimated fair value of our strategic investments in privately held companies, we utilize the most recent data available, as adjusted to reflect the specific rights and preferences of those securities we hold.We assess our privately held debt and equity securities strategic investment portfolio quarterly for impairment. Our impairment analysis encompasses an assessment of both qualitative and quantitative analyses of key factors including the investee’s financial metrics, market acceptance of the product or technology, and the rate at which the investee is using its cash. If the investment is considered to be impaired, we record the investment at fair value by recognizing an impairment through the consolidated statement of operations and establishing a new carrying value for the investment.The particular privately held debt and equity securities we hold, and their rights and preferences relative to those of other securities within the capital structure, may impact the magnitude by which our investment value moves in relation to movement of the total enterprise value of the company. As a result, our investment value in a specific company may move by more or less than any change in the value of that overall company. An immediate decrease of ten percent in enterprise value of our largest privately held equity securities held as of January 31, 2021 could result in a $66 million reduction in the value of our investment portfolio.44Table of ContentsResults of OperationsThe following tables set forth selected data for each of the periods indicated (in millions):4Fiscal Year Ended January 31, 2021% of Total Revenues2020% of Total Revenues2019% of Total RevenuesRevenues:Subscription and support$19,976 94 %$16,043 94 %$12,413 93 %Professional services and other1,276 6 1,055 6 869 7 Total revenues21,252 100 17,098 100 13,282 100 Cost of revenues (1)(2):Subscription and support 4,154 20 3,198 19 2,604 20 Professional services and other 1,284 6 1,037 6 847 6 Total cost of revenues5,438 26 4,235 25 3,451 26 Gross profit15,814 74 12,863 75 9,831 74 Operating expenses (1)(2):Research and development3,598 17 2,766 16 1,886 14 Marketing and sales9,674 45 7,930 46 6,064 46 General and administrative2,087 10 1,704 10 1,346 10 Loss on settlement of Salesforce.org reseller agreement0 0 166 1 0 0 Total operating expenses15,359 72 12,566 73 9,296 70 Income from operations455 2 297 2 535 4 Gains on strategic investments, net (3)2,170 10 427 2 542 4 Other expense(64)0 (18)0 (94)(1)Income before benefit from (provision for) income taxes2,561 12 706 4 983 7 Benefit from (provision for) income taxes (4)1,511 7 (580)(3)127 1 Net income$4,072 19 %$126 1 %$1,110 8 %45Table of Contents(1) Amounts related to amortization of intangible assets acquired through business combinations, as follows (in millions): Fiscal Year Ended January 31, 2021% of Total Revenues2020% of Total Revenues2019% of Total RevenuesCost of revenues$662 3 %$440 3 %$215 2 %Marketing and sales459 2 %352 2 232 2 (2) Amounts related to stock-based expenses, as follows (in millions): Fiscal Year Ended January 31, 2021% of Total Revenues2020% of Total Revenues2019% of Total RevenuesCost of revenues$241 1 %$204 1 %$161 1 %Research and development703 4 510 3 307 2 Marketing and sales941 4 852 5 643 5 General and administrative305 1 219 1 172 1 (3) During fiscal 2021, two of our strategic investments completed their initial public offering, resulting in an unrealized gain of $1.7 billion as of January 31, 2021.(4) Amounts include approximately $2.0 billion of one-time benefit from a discrete tax item related to the recognition of deferred tax assets resulting from an intra-entity transfer of intangible property in fiscal 2021, and a benefit related to the partial release of the valuation allowance of $612 million for fiscal 2019. The following table sets forth selected balance sheet data and other metrics for each of the periods indicated (in millions, except remaining performance obligation, which is presented in billions): As of January 31,20212020Cash, cash equivalents and marketable securities$11,966 $7,947 Unearned revenue12,607 10,662 Remaining performance obligation36.1 30.8 Principal due on our outstanding debt obligations (1)2,690 2,694 (1) Amounts do not include operating or financing lease obligations.Remaining performance obligation represents contracted revenue that has not yet been recognized, which includes unearned revenue and unbilled amounts that will be recognized as revenue in future periods. Impact of AcquisitionsThe comparability of our operating results for the fiscal year ended January 31, 2021 compared to the same period of fiscal 2020 was impacted by our acquisitions in the current and prior year, including the acquisition of Tableau in the prior year, which was our largest acquisition to date. In our discussion of changes in our results of operations for the fiscal year ended January 31, 2021 compared to the same periods of fiscal 2020, we may quantitatively disclose the impact of our acquired products and services for the fiscal year subsequent to the acquisition date on the growth in certain of our revenues where such discussions would be meaningful. Expense contributions from our recent acquisitions for each of the respective period comparisons generally were not separately identifiable due to the integration of these businesses into our existing operations or were insignificant to our results of operations during the periods presented.Fiscal Year Ended January 31, 2021 and 2020Revenues Fiscal Year Ended January 31,Variance(in millions)20212020DollarsPercentSubscription and support$19,976 $16,043 $3,933 25 %Professional services and other1,276 1,055 221 21 Total revenues$21,252 $17,098 $4,154 24 The increase in subscription and support revenues was primarily caused by volume-driven increases from new business, which includes new customers, upgrades, additional subscriptions from existing customers and acquisition activity. Pricing was 46Table of Contentsnot a significant driver of the increase in revenues for the period. Revenues from term and perpetual software licenses, which are recognized at a point in time, represent approximately six percent of total subscription and support revenues for fiscal 2021. Subscription and support revenues accounted for approximately 94 percent of our total revenues for both fiscal 2021 and fiscal 2020.The acquisition of Tableau in August 2019 contributed approximately $1.5 billion and $652 million to total subscription and support revenues in fiscal 2021 and fiscal 2020, respectively, and is included in the above amounts. As a result of our business combination activity, we recorded unearned revenue related to acquired contracts from acquired entities at fair value on the date of acquisition. As a result, we did not recognize certain revenues related to these acquired contracts that the acquired entities would have otherwise recorded as an independent entity. The increase in professional services and other revenues was due primarily to the higher demand for services from an increased number of customers.Subscription and Support Revenue by Service OfferingSubscription and support revenues consisted of the following (in millions): Fiscal Year Ended January 31, 20212020Variance PercentSales $5,191 $4,598 13%Service5,377 4,466 20%Platform and Other6,275 4,473 40%Marketing and Commerce 3,133 2,506 25%Total$19,976 $16,043 Our Industry Offerings revenue is included in either Sales, Service or Platform and Other depending on the primary service offering purchased. Subscription and support revenues from Platform and Other benefited from a full twelve months of revenue from the acquisition of Tableau in fiscal 2021 as compared to six months in fiscal 2020. The revenue growth rates of each of our core service offerings have been and may be impacted by COVID-19 in the future, depending on our customers’ actual and projected business needs. For example, we experienced increased demand for our Marketing and Commerce service offering for fiscal 2021 when compared to prior periods.Revenues by geography were as follows: Fiscal Year Ended January 31,(in millions)2021As a % of Total Revenues2020As a % of Total RevenuesGrowth RateAmericas$14,736 69 %$12,051 71 %22 %Europe4,501 21 3,430 20 31 Asia Pacific2,015 10 1,617 9 25 Total$21,252 100 %$17,098 100 %Revenues by geography are determined based on the region of the Salesforce contracting entity, which may be different than the region of the customer. The increase in Americas revenues was the result of the increasing acceptance of our services and the investment of additional sales resources. The increase in revenues outside of the Americas was the result of the increasing acceptance of our services, our focus on marketing our services internationally and investment in additional international sales resources. Revenues in the Americas and Europe also benefited from our acquisition of Tableau in August 2019. Foreign currency fluctuations had a minimal impact on revenues outside of the Americas for fiscal 2021 and 2020. Cost of Revenues. Fiscal Year Ended January 31,VarianceDollars(in millions)20212020Subscription and support$4,154 $3,198 $956 Professional services and other1,284 1,037 247 Total cost of revenues$5,438 $4,235 $1,203 Percent of total revenues26 %25 %47Table of ContentsFor fiscal 2021, the increase in cost of revenues was primarily due to an increase of $330 million in employee-related costs, an increase of $37 million in stock-based expenses, an increase of $275 million in service delivery costs primarily due to our efforts to increase data center capacity, an increase in amortization of purchased intangible assets of $222 million and an increase in third party fees and allocated overhead. Service delivery costs associated with our perpetual and term software licenses are lower than service delivery costs associated with our cloud service offerings and as a result, our subscription and support gross margin in fiscal 2021 benefited, in part, due to this shift in our business mix.We have increased our headcount associated with our data centers, customer support, and professional services by 18 percent since fiscal 2020 to meet the higher demand for services from our customers, and our recent acquisitions also contributed to this increase. We intend to continue to invest additional resources in our enterprise cloud computing services and data center capacity to allow us to scale with our customers and continuously evolve our security measures. We also plan to add employees in our professional services group to facilitate the adoption of our services. The timing of these expenses will affect our cost of revenues, both in terms of absolute dollars and as a percentage of revenues, in future periods.Operating Expenses. Fiscal Year Ended January 31,VarianceDollars(in millions)20212020Research and development$3,598 $2,766 $832 Marketing and sales9,674 7,930 1,744 General and administrative2,087 1,704 383 Loss on settlement of salesforce.org reseller agreement 0 166 (166)Total operating expenses$15,359 $12,566 $2,793 Percent of total revenues72 %73 % For fiscal 2021, the increase in research and development expenses was primarily due to an increase of approximately $508 million in employee-related costs, an increase of $193 million in stock-based expenses, and increases in our development and test data center costs and allocated overhead. Our research and development headcount increased by 11 percent since fiscal 2020 in order to improve and extend our service offerings, develop new technologies and integrate acquired companies. We expect that research and development expenses will increase in absolute dollars and may increase as a percentage of revenues in future periods as we continue to invest in additional employees and technology to support the development of new, and improve existing, technologies and the integration of acquired technologies. For fiscal 2021, the increase in marketing and sales expenses was primarily due to an increase of $1.4 billion in employee-related costs and amortization of deferred commissions, an increase of $89 million in stock-based expenses, an increase in amortization of purchased intangible assets of $107 million, and allocated overhead partially offset by a reduction in employee travel and expenses. Marketing and sales expenses for fiscal 2021 were also negatively impacted by the one-time partial minimum commission guarantee offered to our direct sales force. Our marketing and sales headcount increased by 14 percent since fiscal 2020, primarily attributable to hiring additional sales personnel to focus on adding new customers and increasing penetration within our existing customer base. We expect that marketing and sales expenses will increase in absolute dollars and may increase as a percentage of revenues in future periods as we continue to hire additional sales personnel. We also expect an increase in marketing and sales expenses due to the gradual increase of travel and related expenses in the second half of fiscal 2022.For fiscal 2021, the increase in general and administrative expenses was primarily due to an increase in employee-related costs as well as being impacted by our charitable donations to members of our ecosystem and community. Our general and administrative headcount increased by 12 percent since fiscal 2020 as we added personnel to support our growth. While not material to date, we may experience increasing credit loss risks from accounts receivable in future periods depending on the duration or degree of economic slowdown caused by the COVID-19 pandemic, and our actual experience in the future may differ from our past experiences or current assessments. As a result of the June 2019 Salesforce.org business combination, we effectively settled all existing agreements between ourselves and Salesforce.org and, as part of business combination accounting, accordingly recorded a one-time, non-cash operating expense charge of approximately $166 million in fiscal 2020 related to the effective settlement of the reseller agreement.48Table of ContentsOther income and expense. Fiscal Year Ended January 31,VarianceDollars(in millions)20212020Gains on strategic investments, net$2,170 $427 $1,743 Other expense(64)(18)(46)Gains on strategic investments, net consists primarily of mark-to-market adjustments related to our publicly held equity securities, observable price adjustments related to our privately held equity securities and other adjustments. Net gains recognized during fiscal 2021 were primarily driven by unrealized gains recognized on publicly traded equity securities of $1.7 billion and realized gains on sales of equity securities of $0.4 billion.Other expense primarily consists of interest expense on our debt as well as our operating and finance leases offset by investment income. Interest expense was $126 million and $131 million for fiscal 2021 and 2020, respectively. Investment income decreased $34 million in fiscal 2021, respectively, compared to the same period a year ago due to lower interest rates across our portfolio, modestly offset by larger cash equivalents and marketable securities balances. Upon closing of our acquisition of Slack, we expect an increase in interest expense due to debt agreements we plan to enter into in connection with the pending acquisition.Benefit from (provision for) income taxes. Fiscal Year Ended January 31,VarianceDollars(in millions)20212020Benefit from (provision for) income taxes$1,511 $(580)$2,091 Effective tax rate(59)%82 %In fiscal 2021, we recognized a tax benefit of $1.5 billion on a pretax income of $2.6 billion. In the second quarter of fiscal 2021, we changed our international corporate structure, which included the transfer of certain intangible property between foreign affiliates resulting in a net tax benefit of $2.0 billion related to foreign deferred tax assets. The deferred tax assets were recognized as a result of the book and tax basis difference on the intangible property and were based on the intangible property’s current fair value. The determination of the estimated fair value of the intangible property is complex and judgmental due to the use of subjective assumptions in the valuation models used by management. The tax amortization related to the intellectual property transferred will be recognized in future periods and any amortization that is unused in a particular year can be carried forward indefinitely under Irish tax laws. The deferred tax asset and the tax benefit were measured based on the currently enacted Irish tax rate. We believe that it is more likely than not the deferred tax assets will be realized in Ireland. In fiscal 2020, we recognized a tax provision of $580 million on a pretax income of $706 million. Our tax provision was primarily driven by incremental tax costs associated with the integration of acquired operations and assets and profitable jurisdictions outside of the United States.Fiscal Year Ended January 31, 2020 and 2019For a discussion of the year ended January 31, 2020 compared to the year ended January 31, 2019, please refer to Part II, Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations" in our Annual Report on Form 10-K for the year ended January 31, 2020.Liquidity and Capital ResourcesAt January 31, 2021, our principal sources of liquidity were cash, cash equivalents and marketable securities totaling $12.0 billion and accounts receivable of $7.8 billion. Our cash equivalents and marketable securities are comprised primarily of corporate notes and obligations, U.S. treasury securities, U.S. agency obligations, asset-backed securities, foreign government obligations, mortgage-backed obligations, covered bonds, time deposits, money market mutual funds and municipal securities. Our Revolving Loan Credit Agreement, which provides the ability to borrow up to $3.0 billion in unsecured financing (“Credit Facility”) as of January 31, 2021, also serves as a source of liquidity. As of January 31, 2021, our remaining performance obligation was $36.1 billion. Our remaining performance obligation represents contracted revenue that has not yet been recognized and includes unearned revenue, which has been invoiced and is recorded on the balance sheet, and unbilled amounts that are not recorded on the balance sheet, that will be recognized as revenue in future periods. 49Table of ContentsCash from operations could continue to be affected by various risks and uncertainties, including, but not limited to, the effects of the COVID-19 pandemic and other risks detailed in Part I, Item 1A titled “Risk Factors.” We believe our existing cash, cash equivalents, marketable securities, cash provided by operating activities, unbilled amounts related to contracted non-cancelable subscription agreements, which is not reflected on the balance sheet, and, if necessary, our borrowing capacity under our Credit Facility will be sufficient to meet our working capital, capital expenditure and debt repayment needs over the next 12 months. In addition, we expect to have a sufficient combination of available cash and borrowing capacity to fund the aggregate cash portion of the pending acquisition of Slack, which is expected to be approximately $15.6 billion. Sources of financing associated with our pending acquisition of Slack are detailed below in “Debt.”In the future, we may enter into arrangements to acquire or invest in complementary businesses, services and technologies, and intellectual property rights. To facilitate these acquisitions or investments, we may seek additional equity or debt financing, which may not be available on terms favorable to us or at all, impacting our ability to complete subsequent acquisitions or investments. Cash FlowsFor fiscal 2021, 2020 and 2019, our cash flows were as follows (in millions):4Fiscal Year Ended January 31, 202120202019Net cash provided by operating activities$4,801 $4,331 $3,398 Net cash used in investing activities(3,971)(2,980)(5,308)Net cash provided by financing activities1,194 164 2,010 Operating ActivitiesThe net cash provided by operating activities during fiscal 2021 was primarily related to net income of $4.1 billion, adjusted for non-cash items including $2.0 billion from a one-time discrete tax item from the recognition of deferred tax assets related to an intra-entity transfer of certain intangible property, $2.8 billion of depreciation and amortization and $2.2 billion of expenses related to employee stock plans, as well as adjusted for $2.2 billion of gains on strategic investments. Cash provided by operating activities during fiscal 2021 further benefited by the change in unearned revenue of $1.9 billion, offset by a change in accounts receivable, net of $1.6 billion. Cash provided by operating activities during fiscal 2021 was negatively impacted by changes in billing frequency for new business due to the COVID-19 pandemic. In addition, our operating cash flows were negatively impacted by investments made in our go-to-market efforts, such as the partial minimum commission guarantee provided in the first quarter of fiscal 2021.The net cash provided by operating activities during fiscal 2020 was primarily related to net income of $126 million, adjusted for non-cash items such as $2.1 billion related to depreciation and amortization, $1.8 billion of expenses related to employee stock plans and discrete one-time non-cash adjustments.Investing ActivitiesThe net cash used in investing activities during fiscal 2021 was primarily related to cash consideration for the acquisition of Vlocity, net of cash acquired, of approximately $1.2 billion as well as purchases of marketable securities of $4.8 billion, partially offset by sales and maturities of marketable securities of $2.9 billion. In addition, we paid approximately $150 million of cash consideration related to the purchase of the property located at 450 Mission Street (“450 Mission”) in San Francisco, CA, which is reflected in capital expenditures. The net cash used in investing activities during fiscal 2020 was primarily related to the purchases of marketable securities of $3.9 billion, offset by sales and maturities of marketable securities of $2.2 billion. In addition, we paid approximately $0.4 billion of cash consideration, net of cash acquired, for business combinations during fiscal 2020.Financing ActivitiesNet cash provided by financing activities during fiscal 2021 consisted primarily of $1.3 billion from proceeds from equity plans. Net cash provided by financing activities during fiscal 2020 consisted primarily of $840 million from proceeds from equity plans offset by repayments of debt of $503 million, including repayment of our senior unsecured term loan facility that would have matured in April 2021, and principal payments on financing obligations of $173 million. 50Table of ContentsDebtAs of January 31, 2021, we had senior unsecured debt outstanding due in 2023 and 2028 with a total carrying value of $2.5 billion. In addition, we had senior secured notes outstanding related to our loan on our purchase of an office building located at 50 Fremont Street in San Francisco (“50 Fremont”), due in 2023 with a total carrying value of $190 million. We were in compliance with all debt covenants as of January 31, 2021. In December 2020, we entered into a credit agreement (the “Revolving Loan Credit Agreement”), which provides for a $3.0 billion unsecured revolving credit facility (the “Credit Facility”) that matures in December 2025, replacing our previous $1.0 billion revolving credit facility. There were no outstanding borrowings under the Credit Facility as of January 31, 2021. We may use the proceeds of future borrowings under the Credit Facility for general corporate purposes, which may include, without limitation, financing the considerations for and fees, costs and expenses related to any acquisition.In addition, in connection with our pending acquisition of Slack, in December 2020, we obtained commitments from certain financial institutions for a 364-day senior unsecured bridge loan facility (the “Bridge Facility”). The original commitments in respect of the Bridge Facility were $10.0 billion, but were reduced to $7.0 billion in December 2020 following our entry into a $3.0 billion three-year senior unsecured loan agreement (“Acquisition Term Loan”), the proceeds of which may be used to finance a portion of the cash consideration for our pending acquisition of Slack, for the repayment of certain debt of Slack to pay fees, costs and expenses related thereto. In February 2021, we elected to further reduce our Bridge Facility commitments to $4.0 billion. The availability and funding of the Bridge Facility and the Acquisition Term Loan are conditioned on the consummation of the acquisition of Slack in accordance with the terms of the merger agreement and are subject to certain exceptions, qualifications and certain other conditions. We may further reduce the commitments in respect of the Bridge Facility prior to the consummation of the acquisition, all or a portion of which may be in connection with the issuance of one or more series of senior secured debt securities or other incurrences of new indebtedness or commitments in respect thereof. We do not have any special purpose entities and we do not engage in off-balance sheet financing arrangements.Contractual ObligationsOur principal commitments consist of obligations under leases for office space, co-location data center facilities and our development and test data center, as well as leases for computer equipment, software, furniture and fixtures. For more information regarding our lease obligations, see Note 6 “Leases and Other Commitments” to the consolidated financial statements in Item 8 of Part II. In addition, we have a substantial level of debt. For more information regarding our debt service obligations, see Note 9 “Debt” to the consolidated financial statements in Item 8 of Part II. As of January 31, 2021, our other contractual commitments associated with agreements that are enforceable and legally binding and that specify all significant terms were payments of $0.6 billion due in the next 12 months and $1.9 billion due thereafter. We expect to fund these obligations with cash flows from operations and cash on our balance sheet.During fiscal 2021 and in future fiscal years, we have made and expect to continue to make additional investments in our infrastructure to scale our operations, increase productivity and enhance our security measures. We plan to upgrade or replace various internal systems to scale with our overall growth. While we continue to make investments in our infrastructure including offices, information technology and data centers to provide capacity for the growth of our business, our strategy may continue to change related to these investments and we may slow the pace of our investments including in response to the known and potential impacts of COVID-19 on our business.Other Future ObligationsIn December 2020, we entered into a definitive agreement to acquire Slack. Under the terms of the agreement, Slack shareholders will receive $26.79 in cash and 0.0776 shares of Salesforce common stock for each outstanding share of Slack Class A and Class B common stock, resulting in an estimated $15.6 billion of cash consideration and 45 million shares to be issued, based on Slack Class A and Class B shares outstanding as of January 31, 2021. The agreement also provides for the assumption of outstanding equity awards held by Slack employees. We expect to fund the cash portion of the consideration with a combination of new debt, as discussed above, and cash on our balance sheet. In February 2021, we acquired all outstanding stock of Acumen Solutions, Inc. (“Acumen”) for approximately $433 million, in cash.In October 2019, we acquired ClickSoftware for approximately $1.4 billion. In the event that we fully integrate the operations and assets of ClickSoftware, as well as other acquired Israeli based entities into our operations, we may be subject to a potential one-time income tax charge based on an assumed Israeli statutory tax rate of 23 percent applied to the value of any transferred intangibles. The timing and amount of the cash payment, if any, is uncertain and would be based upon a number of factors, including our integration plans, valuations related to intercompany transactions, the tax rate in effect at the time, potential negotiations with the taxing authorities and potential litigation. 51Table of ContentsEnvironmental, Social, Governance We believe the business of business is to make the world a better place for all of our stakeholders, including our stockholders, customers, employees, partners, the planet and the communities in which we work and live. We believe that values drive value, and that effectively managing our priority Environmental, Social, and Governance (“ESG”) topics will help create long-term value for our investors. We also believe that transparently disclosing the goals and relevant metrics related to our ESG programs will allow our stakeholders to be informed about our progress.The topics covered in this section are informed by an internal ESG materiality assessment completed in fiscal 2020, which assessed both the impact on our business and the importance to our stakeholders, as well as by relevant topics identified through third-party ESG reporting frameworks, standards and metrics, such as the Sustainability Accounting Standards Board (“SASB”), and the Task Force on Climate-Related Financial Disclosures (“TCFD”). More information on our key ESG programs, goals and commitments, and key metrics can be found on our website in our annual Stakeholder Impact Report.Our ESG highlights as of the fiscal year ended January 31, 2021 include the following:COVID-19 Response. In fiscal 2021 we mobilized to support our employees, our customers and our communities in response to the COVID-19 pandemic in a number of ways. •Protecting our workforce. In an effort to protect the safety and well-being of our employees, we closed our offices around the world and provided an allowance for employees to use for equipment to improve their ability to work from home. We provided regular communication and updates to employees, including through company-wide video calls led by senior management, with participation of Board members and guest experts in psychology and other medical fields throughout fiscal 2021. Additionally, we expanded our leave programs to include accommodations for child or elder care hardships during the pandemic.•Innovation and customer support. To support our customers, we launched Work.com, which includes new solutions designed to help our customers reopen safely. We also launched Work.com for schools to help schools reopen safely and Vaccine Cloud to help governments and healthcare organizations more safely and efficiently manage vaccine programs at scale.•Supporting our communities. In fiscal 2021, we took action to help address the Personal Protective Equipment (“PPE”) shortage facing medical personnel by sourcing millions of units of PPE for doctors, nurses and first responders in the United States and other countries.Data Security. Customers entrust us with their most sensitive data, and they expect us to protect it using security risk management practices and advanced systems that respond to the changing security landscape and emerging threats. We have made and will continue to make substantial investments in our cybersecurity programs. We provide an overview of our program, training, best practices for our customers, and information on system status, security issues, and compliance certificates on our website at www.trust.salesforce.com.Data Privacy. Our customers trust us to help them build meaningful relationships with their own customers. The privacy of the data that we are entrusted to protect is a top priority. Our customer agreements and our privacy policies (which are publicly available on our website) describe how we safeguard data with an effective privacy and security program. We also offer resources to help our customers operate globally in compliance with privacy laws such as General Data Protection Regulation and the California Consumer Privacy Act. Equality. We invest in programs designed to enhance employee success and create a safe, healthy and engaging working environment that fosters our core value of equality for all. Refer to our “Human Capital Management” Section in Item 1 of Part I for details. Racial Equality and Justice Task Force. In fiscal 2021 we launched our Racial Equality and Justice Task Force to help drive systemic change in our workplace and community. To create the task force, we invited employees from across the business, as well as leaders of our Black employee resource group, to help guide our vision, which includes our focus on the four pillars of “People, Purchasing, Philanthropy and Policy.” Our vision and goals have been formalized in a new Racial Equality and Justice V2MOM, which is an internal management tool that incorporates our vision, values, methods, obstacles and measures.Ethical and Humane Use. We recognize the transformative power of technologies and the importance of ensuring their ethical and humane use. Core to this effort is our Office of Ethical and Humane Use of Technology, which works across product, law, policy and ethics to develop and implement strategic frameworks across the company for the responsible design, development and use of Salesforce technologies. We regularly engage with stakeholders and experts in the field to further this effort. We also rely on our Ethical Use Advisory Council, composed of diverse frontline and executive employees, as well as external academics, industry experts and society leaders, to navigate how we mitigate risk and avoid harmful unintended consequences.Civic Engagement. We work with policymakers and elected officials around the globe on issues that matter to our stakeholders, including our employees, our customers, our stockholders, our communities and the environment. Salesforce is nonpartisan in our work, and we support candidates and eligible organizations of any party who share our priorities, align with our core values, represent and engage with significant numbers of our employees and demonstrate leadership. We are 52Table of Contentscommitted to complying with all laws, rules and regulations relevant to our political activity and we publicly disclose all contributions in the U.S. in reports filed with the Federal Election Commission and with various state campaign finance commissions. Our Governance Committee provides independent oversight and annually reviews our political contributions. Management prepares a detailed annual report of our corporate political spending, which is publicly accessible at https://www.salesforce.com/company/public-policy/. Supporting Our Communities. Giving back is foundational to our corporate culture and our core value of equality. In the fiscal year ended January 31, 2021, together with the Salesforce Foundation, a 501(c)(3) non-profit organization, our social value contribution include the following:•Approximately $1.4 billion in donated or discounted products provided to non-profits and higher education institutions via Salesforce.org. We calculate the social value of products sold or donated based on the estimated price we would have received if a comparable product was sold to a for-profit business of similar size and location, less the price that we received, if any, for the same product from a qualified non-profit educational institution or other Non-Government Organization (“NGO”). When a comparable Salesforce product price was not readily available, we used a ratio based on the weighted average of the Salesforce price to a for-profit company compared to the Salesforce price to a non-profit company.•Approximately $100 million in grants and donations to qualified non-profits, educational institutions or other NGOs in fiscal 2021.In addition, our employees volunteered over 800,000 hours in fiscal 2021.Climate Action. Salesforce continues to support science-based climate policies and decarbonization actions intended to limit the global average temperature increase to 1.5°C above pre-industrial levels.•In fiscal 2021 our absolute location-based GHG emissions declined one percent relative to fiscal 2020. Market-based emissions, which include the net carbon reductions associated with our renewable energy procurement, declined by 40 percent over the same period. In fiscal 2021, we procured electricity from renewable energy resources equivalent to approximately 75 percent of what we used globally. We continued to support new efforts to decarbonize regional energy grids through our first international Virtual Power Purchase Agreement (“VPPA”) in Australia. This VPPA supports our ambition to achieve our 100 percent renewable energy goal by 2022.•As part of our 1.5°C Science-Based Target, we made a commitment that suppliers representing 60% of our Scope 3 emissions will set Science-Based Targets of their own. As of January 31, 2021 and January 31, 2020, 49 and 19 of our suppliers had set or committed to Science-Based Targets, respectively. In addition, in fiscal 2021 we delivered all customers a carbon neutral cloud, offset all operational emissions and offset all emissions associated with business travel and employee commuting.•In January 2020, as a founding partner of 1t.org, and in support of its mission, Salesforce announced our goal to support and mobilize the conservation, restoration and growth of 100 million trees by the end of 2030. While we believe all of these goals align with our long-term growth strategy and financial and operational priorities, they are aspirational and may change, and there is no guarantee or promise that they will be met.53Table of ContentsITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKWe are exposed to financial market risks, including changes in foreign currency exchange rates, interest rates and equity investment risks. This exposure has increased due to recent financial market movements and changes to our expectations of near-term possible movements caused by the impact of COVID-19 as discussed in more detail below.Foreign Currency Exchange RiskWe primarily conduct our business in the following locations: the United States, Europe, Canada, Latin America, Asia Pacific and Japan. The expanding global scope of our business exposes us to the risk of fluctuations in foreign currency markets, including emerging markets. This exposure is the result of selling in multiple currencies, growth in our international investments, including data center expansion, costs associated with third-party infrastructure providers, additional headcount in foreign countries, and operating in countries where the functional currency is the local currency. Specifically, our results of operations and cash flows are subject to fluctuations in the following currencies: the Euro, British Pound Sterling, Japanese Yen, Canadian Dollar, Australian Dollar and Brazilian Real against the United States Dollar (“USD”). These exposures may change over time as business practices evolve and economic conditions change, including market impacts associated with COVID-19. Changes in foreign currency exchange rates could have an adverse impact on our financial results and cash flows. In fiscal 2020, we began transitioning away from our UK-centralized European structure to enable some of our local subsidiaries within Europe, including Germany and France, to invoice customers directly. This transition, which may take multiple years, is expected to enable local subsidiaries to recognize revenues, operating expenses and corresponding balance sheet accounts in local currencies. With the change to local invoicing in some markets, we expect better alignment between our revenue and expenses in the local currency.In January 2020, the UK exited the European Union (“EU”) (“Brexit”). In December 2020, a trade agreement was entered into between the UK and the EU and in January 2021, the transition period ended and the UK was no longer subject to EU rules or regulations. Brexit and the new UK-EU trade agreement could adversely affect the UK, regional (including European) and worldwide economic and market conditions and could contribute to instability in global financial and foreign exchange markets, including volatility in the value of the British Pound Sterling and Euro. We have evaluated and started to implement initiatives, such as the commitment to invest resources in Dublin, Ireland that could partially mitigate the impact Brexit could have on our operations. In fiscal 2021 and 2020, revenues generated in Europe were approximately 21 percent and 20 percent of total revenues, respectively, of which most are recorded in our UK, Germany, France, Italy, Spain and Ireland subsidiaries. Revenues in Europe had a minimal favorable impact in fiscal 2021 compared to fiscal 2020 as a result of fluctuations in the Euro and British Pound Sterling against the USD. We recognize that there are still significant uncertainties surrounding the ultimate resolution of Brexit negotiations, and we will continue to monitor any changes that may arise and assess their potential impact on our business.Foreign Currency Transaction RiskOur foreign currency exposures typically arise from selling annual and multi-year subscriptions in multiple currencies, customer accounts receivable, intercompany transfer pricing arrangements and other intercompany transactions. Our foreign currency management objective is to minimize the effect of fluctuations in foreign exchange rates on selected assets or liabilities without exposing us to additional risk associated with transactions that could be regarded as speculative. We pursue our objective by utilizing foreign currency forward contracts to offset foreign exchange risk. Our foreign currency forward contracts are generally short-term in duration. We neither use these foreign currency forward contracts for trading purposes nor do we currently designate these forward contracts as hedging instruments pursuant to Accounting Standards Codification 815, Derivatives and Hedging. Accordingly, we record the fair values of these contracts as of the end of our reporting period to our consolidated balance sheets with changes in fair values recorded to our consolidated statements of operations. Given the short duration of the forward contracts, the amount recorded is not significant. Our ultimate realized gain or loss with respect to foreign currency exposures will generally depend on the size and type of cross-currency transactions that we enter into, the currency exchange rates associated with these exposures and changes in those rates, the net realized gain or loss on our foreign currency forward contracts and other factors. Foreign Currency Translation RiskFluctuations in foreign currencies impact the amount of total assets, liabilities, revenues, operating expenses and cash flows that we report for our foreign subsidiaries upon the translation of these amounts into USD. Although the USD fluctuated against certain international currencies throughout the year, the amounts of revenue that we reported in USD for foreign subsidiaries that transact in international currencies were similar to what we would have reported during fiscal 2020 using a constant currency rate. However, fluctuations in USD against certain international currencies over the past several months modestly benefited our remaining performance obligation as of January 31, 2021 compared to what we would have reported as of January 31, 2020 using constant currency rate. 54Table of ContentsInterest Rate SensitivityWe had cash, cash equivalents and marketable securities totaling $12.0 billion as of January 31, 2021. This amount was invested primarily in money market funds, time deposits, corporate notes and bonds, government securities and other debt securities with credit ratings of at least BBB or better. The cash, cash equivalents and marketable securities are held for general corporate purposes, including acquisitions of, or investments in, complementary businesses, services or technologies, working capital and capital expenditures. Our investments are made for capital preservation purposes. We do not enter into investments for trading or speculative purposes.Our cash equivalents and our portfolio of marketable securities are subject to market risk due to changes in interest rates. Fixed-rate securities may have their market value adversely impacted due to a rise in interest rates, while floating rate securities may produce less income than expected if interest rates fall. Due in part to these factors, our future investment income may fall short of expectations due to changes in interest rates or we may suffer losses in principal if we are forced to sell securities that decline in market value due to changes in interest rates. However, because we classify our debt securities as “available for sale,” no gains or losses are recognized due to changes in interest rates unless such securities are sold prior to maturity or due to expected credit losses. Our fixed-income portfolio is also subject to interest rate risk. An immediate increase or decrease in interest rates of 100 basis points at January 31, 2021 could result in a $63 million market value reduction or increase of the same amount. This estimate is based on a sensitivity model that measures market value changes when changes in interest rates occur. Fluctuations in the value of our investment securities caused by a change in interest rates (gains or losses on the carrying value) are recorded in other comprehensive income, and are realized only if we sell the underlying securities.At January 31, 2020, we had cash, cash equivalents and marketable securities totaling $7.9 billion. Changes in interest rates of 100 basis points would have resulted in market value changes of $38 million.Market Risk and Market Interest RiskWe deposit our cash with multiple financial institutions. In addition, we maintain debt obligations that are subject to market interest risk, as follows (in millions): InstrumentMaturity DatePrincipal Outstanding as of January 31, 2021Interest TermsEffective Interest Rate for Fiscal 2021Bridge FacilityN/A (1)$0 FloatingN/AAcquisition Term LoanN/A (2)0 FloatingN/A2023 Senior NotesApril 20231,000Fixed3.26%2028 Senior NotesApril 20281,500Fixed3.70%Loan assumed on 50 FremontJune 2023190Fixed3.75%Credit FacilityDecember 20250FloatingN/A(1) Maturity date will be 364 days following the closing of the pending Slack acquisition.(2) Maturity date is three years following the closing of the pending Slack acquisition.Any borrowings under the Bridge Facility will bear interest, at our option, at a base rate plus a spread of 0.00% to 0.875% or an adjusted LIBOR rate plus a spread of 0.50% to 1.125%, in each case with such spread being determined based on our credit ratings from time to time and subject to increases of 0.25% on each of the 90th, 180th and 270th day following the initial funding of the Bridge Facility. As of January 31, 2021, there was no outstanding borrowing amounts under the Bridge Facility.Any borrowings under our Acquisition Term Loan bear interest, at our option, at a base rate plus a spread of 0.00% to 0.125% or an adjusted LIBOR rate plus a spread of 0.50% to 1.125%, in each case with such spread being determined based on our credit ratings from time to time. Our Acquisition Term Loan allows for the LIBOR rate to be phased out and replaced with the Secured Overnight Financing Rate and therefore we do not anticipate a material impact by the expected upcoming LIBOR transition. As of January 31, 2021, there was no outstanding borrowing amount under the Acquisition Term Loan.The borrowings under our Credit Facility bear interest, at our option, at a base rate plus a spread of 0.00% to 0.125% or an adjusted LIBOR rate plus a spread of 0.50% to 1.125%, in each case with such spread being determined based on our credit rating. Our Credit Facility allows for the LIBOR rate to be phased out and replaced with the Secured Overnight Financing Rate and therefore we do not anticipate a material impact by the expected upcoming LIBOR transition. We are also obligated to pay an ongoing commitment fee on undrawn amounts. As of January 31, 2021, there was no outstanding borrowing amount under the Credit Facility.The bank counterparties to our derivative contracts potentially expose us to credit-related losses in the event of their nonperformance. To mitigate that risk, we only contract with counterparties who meet the minimum requirements under our 55Table of Contentscounterparty risk assessment process. We monitor ratings, credit spreads and potential downgrades on at least a quarterly basis. Based on our ongoing assessment of counterparty risk, we adjust our exposure to various counterparties. We generally enter into master netting arrangements, which reduce credit risk by permitting net settlement of transactions with the same counterparty. However, we do not have any master netting arrangements in place with collateral features.We have an investment portfolio that includes strategic investments in privately held and publicly traded companies, which range from early-stage companies to more mature companies both domestically and internationally, including in emerging markets. We primarily invest in enterprise cloud companies, technology startups and system integrators to advance and expand our ecosystem. As the enterprise cloud computing ecosystem continues to mature and technologies change, our investment strategy and corresponding investment opportunities have expanded to include investments in companies concurrently with their initial public offerings, as well as larger capital investments in late stage companies. We plan to continue these types of strategic investments, including in companies representing targeted geographies and targeted business and technological initiatives, as opportunities arise that we find attractive. Our strategy includes using proceeds from realized gains recognized on the sales of our existing strategic investments to, in part, fund these new strategic investments. As of January 31, 2021, our portfolio consisted of investments in over 280 companies, with capital investments ranging from less than $0.3 million to approximately $335 million, and 40 investments with carrying values individually equal to or in excess of approximately $10 million. As of January 31, 2021, we held one publicly traded investment with a carrying value that was approximately 35 percent of our total strategic investments, one publicly traded investment with a carrying value that was greater than 15 percent of our total strategic investments, and one privately held investment with a carrying value greater than five percent of our strategic investment portfolio. The following table sets forth additional information regarding active equity investments within our strategic investment portfolio as of January 31, 2021 and excludes exited investments (in millions):Investment Type Capital Invested Unrealized Gains (Cumulative) Unrealized Losses (Cumulative)Carrying Value as of January 31, 2021Publicly held equity securities $418 $1,650 $0 $2,068 Privately held equity securities 1,720 318 (248)1,790 Total equity securities$2,138 $1,968 $(248)$3,858 We anticipate additional volatility to our consolidated statements of operations due to changes in market prices, observable price changes and impairments to our investments. These changes could be material based on market conditions and events. While historically our investment portfolio has had a positive impact on our financial results, that may not be true for future periods, particularly in periods of significant market fluctuations that affect our equity securities within our strategic investments portfolio. Volatility in the global market conditions, including recent and ongoing volatility related to the impacts of COVID-19 and related public health measures, may impact our investment portfolio and our financial results may fluctuate from historical results and expectations.Our investments in privately held securities are in various classes of equity which may have different rights and preferences. The particular securities we hold, and their rights and preferences relative to those of other securities within the capital structure, may impact the magnitude by which our investment value moves in relation to movement of the total enterprise value of the company. As a result, our investment value in a specific company may move by more or less than any change in value of that overall company. An immediate decrease of ten percent in enterprise value of our publicly traded and significant privately held equity securities held as of January 31, 2021, which represents 74 percent of the strategic investment portfolio, could result in a $272 million reduction in the value of our investment portfolio. Fluctuations in the value of our privately held equity investments are only recorded when there is an observable transaction for a same or similar investment of the same issuer or in the event of impairment.We continually evaluate our investments in privately held and publicly traded companies. In certain cases, our ability to sell these investments may be impacted by contractual obligations to hold the securities for a set period of time after a public offering. One of our publicly traded investments, which individually had a carrying value of approximately 35 percent of our total strategic investment portfolio, is subject to lock-up agreements until March 2021, for the investment made prior to their initial public offering (“IPO”) and September 2021 for the investment made concurrent with their IPO. A portion of our holdings was released from the lock-up agreement early as certain criteria were met. In addition, the financial success of our investment in any company is typically dependent on a liquidity event, such as a public offering, acquisition or other favorable market event reflecting appreciation to the cost of our initial investment. All of our investments, particularly those in privately held companies, are therefore subject to a risk of partial or total loss of invested capital. The rapid spread of COVID-19 and its reverberating effects on the global economy have caused disruptions to the industry and to financial markets that are inhibiting and may continue to inhibit the ability of investee companies to complete a liquidity event. In severe cases, our investee companies may no longer be able to operate or could experience reduced profitability, delayed public offerings, reduced ability to raise favorable rounds of financing, or acquisitions at less favorable 56Table of Contentsterms. These outcomes could have a material adverse affect on the Company’s financial position, results of operations and cash flows.57Table of Contents
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+ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion of our financial condition and results of operations should be read in conjunction with the information contained in our consolidated financial statements and the notes thereto. The following discussion includes forward-looking statements that involve certain risks and uncertainties, including, but not limited to, those described in Item 1A. Risk Factors. Our actual results may differ materially from those discussed below. See “Special Note Regarding Forward-Looking Statements” and Item 1A. Risk Factors. 23Table of Contents We are a leading independent owner and operator of wireless communications infrastructure, including tower structures, rooftops and other structures that support antennas used for wireless communications, which we collectively refer to as “towers” or “sites.” Our principal operations are in the United States and its territories. In addition, we own and operate towers in South America, Central America, Canada, and South Africa. Our primary business line is our site leasing business, which contributed 98.4% of our total segment operating profit for the year ended December 31, 2020. In our site leasing business, we (1) lease antenna space to wireless service providers on towers that we own or operate and (2) manage rooftop and tower sites for property owners under various contractual arrangements. As of December 31, 2020, we owned 32,923 towers, a substantial portion of which have been built by us or built by other tower owners or operators who, like us, have built such towers to lease space to multiple wireless service providers. Our other business line is our site development business, through which we assist wireless service providers in developing and maintaining their own wireless service networks.Site LeasingOur primary focus is the leasing of antenna space on our multi-tenant towers to a variety of wireless service providers under long-term lease contracts in the United States, South America, Central America, Canada, and South Africa. As of December 31, 2020, (1) no U.S. state or territory accounted for more than 10% of our total tower portfolio by tower count, and (2) no U.S. state or territory accounted for more than 10% of our total revenues for the year ended December 31, 2020. In addition, as of December 31, 2020, approximately 30% of our total towers are located in Brazil and less than 4% of our total towers are located in any of our other international markets (each country is considered a market). We derive site leasing revenues primarily from wireless service provider tenants, including T-Mobile, AT&T, Verizon Wireless, Oi S.A., Telefonica, Claro, Tigo, and TIM. Wireless service providers enter into tenant leases with us, each of which relates to the lease or use of space at an individual site. In the United States and Canada, our tenant leases are generally for an initial term of five years to 10 years with multiple renewal periods at the option of the tenant. These tenant leases typically contain specific rent escalators, which average 3-4% per year, including the renewal option periods. Tenant leases in South Africa and our Central and South American markets typically have an initial term of 10 years with multiple renewal periods. In Central America, we have similar rent escalators to that of leases in the United States and Canada while our leases in South America and South Africa escalate in accordance with a standard cost of living index. Site leases in South America typically provide for a fixed rental amount and a pass through charge for the underlying rent related to ground leases and other property interests.Cost of site leasing revenue primarily consists of:•Cash and non-cash rental expense on ground leases and other underlying property interests;•Property taxes;•Site maintenance and monitoring costs (exclusive of employee related costs);•Utilities;•Property insurance; and•Lease initial direct cost amortization.In the United States and our international markets, ground leases and other property interests are generally for an initial term of five years to 10 years with multiple renewal periods, at our option, and provide for rent escalators which typically average 2-3% annually, or in our South American markets and South Africa, adjust in accordance with a standard cost of living index. As of December 31, 2020, approximately 71% of our tower structures were located on parcels of land that we own, land subject to perpetual easements, or parcels of land in which we have a leasehold interest that extends beyond 20 years. For any given tower, costs are relatively fixed over a monthly or an annual time period. As such, operating costs for owned towers do not generally increase as a result of adding additional customers to the tower. The amount of property taxes varies from site to site depending on the taxing jurisdiction and the height and age of the tower. The ongoing maintenance requirements are typically minimal and include replacing lighting systems, painting a tower, or upgrading or repairing an access road or fencing.In our Central American markets and Ecuador, significantly all of our revenue, expenses, and capital expenditures arising from our new build activities are denominated in U.S. dollars. Specifically, most of our ground leases and other property interests, tenant leases, and tower-related expenses are paid in U.S. dollars. In our Central American markets, our local currency obligations are principally limited to (1) permitting and other local fees, (2) utilities, and (3) taxes. In Brazil, Canada, Chile, and South Africa significantly all of our revenue, expenses, and capital expenditures, including tenant leases, ground leases and other property interests, and other tower-related expenses are denominated in local currency. In Colombia, Argentina, and Peru, our revenue, expenses, and capital expenditures, including tenant leases, ground leases and other property interests, and other tower-related expenses are denominated in a mix of local currency and U.S. dollars. 24Table of Contents As indicated in the table below, our site leasing business generates substantially all of our total segment operating profit. For information regarding our operating segments, see Note 15 of our Consolidated Financial Statements included in this annual report. For the year ended December 31, Segment operating profit as a percentage of total 2020 2019 2018 Domestic site leasing 81.0% 80.7% 81.2%International site leasing 17.4% 17.0% 16.8%Total site leasing 98.4% 97.7% 98.0% We believe that the site leasing business continues to be attractive due to its long-term contracts, built-in rent escalators, high operating margins, and low customer churn (which refers to when a customer does not renew its lease or cancels its lease prior to the end of its term) other than in connection with customer consolidation or cessation of a particular technology. We believe that over the long-term, site leasing revenues will continue to grow as wireless service providers lease additional antenna space on our towers due to increasing minutes of network use and data transfer, network expansion and network coverage requirements. During 2021, we expect organic site leasing revenue in both our domestic and international segments to increase over 2020 levels due in part to wireless carriers deploying unused spectrum. We believe our site leasing business is characterized by stable and long-term recurring revenues, predictable operating costs and minimal non-discretionary capital expenditures. Due to the relatively young age and mix of our tower portfolio, we expect future expenditures required to maintain these towers to be minimal. Consequently, we expect to grow our cash flows by (1) adding tenants to our towers at minimal incremental costs by using existing tower capacity or requiring wireless service providers to bear all or a portion of the cost of tower modifications and (2) executing monetary amendments as wireless service providers add or upgrade their equipment. Furthermore, because our towers are strategically positioned, we have historically experienced low tenant lease terminations as a percentage of revenue other than in connection with customer consolidation or cessations of a specific technology.Site DevelopmentOur site development business, which is conducted in the United States only, is complementary to our site leasing business and provides us the ability to keep in close contact with the wireless service providers who generate substantially all of our site leasing revenue and to capture ancillary revenues that are generated by our site leasing activities, such as antenna and equipment installation at our tower locations. Site development revenues are earned primarily from providing a full range of end to end services to wireless service providers or companies providing development or project management services to wireless service providers. Our services include: (1) network pre-design; (2) site audits; (3) identification of potential locations for towers and antennas on existing infrastructure; (4) support in leasing of the location; (5) assistance in obtaining zoning approvals and permits; (6) tower and related site construction; (7) antenna installation; and (8) radio equipment installation, commissioning, and maintenance. We provide site development services at our towers and at towers owned by others on a local basis, through regional, market, and project offices. The market offices are responsible for all site development operations. For information regarding our operating segments, see Note 15 of our Consolidated Financial Statements included in this annual report. Capital Allocation StrategyOur capital allocation strategy is aimed at increasing shareholder value through investment in quality assets that meet our return criteria, stock repurchases when we believe our stock price is below its intrinsic value, and by returning cash generated by our operations in the form of cash dividends. While the addition of a cash dividend to our capital allocation strategy in 2019 has provided us with a new tool to return value to our shareholders, we will also continue to make investments focused on increasing Adjusted Funds From Operations per share. To achieve this, we expect to continue to deploy capital to portfolio growth and stock repurchases, subject to compliance with REIT distribution requirements, available funds and market conditions, while maintaining our target leverage levels. Key elements of our capital allocation strategy include:Portfolio Growth. We intend to continue to grow our asset portfolio, domestically and internationally, primarily through tower acquisitions and the construction of new towers that meet our internal return on invested capital criteria.Stock Repurchase Program. We currently utilize stock repurchases as part of our capital allocation policy when we believe our share price is below its intrinsic value. We believe that share repurchases, when purchased at the right price, will facilitate our goal of increasing our Adjusted Funds From Operations per share. 25Table of Contents Dividend. In 2019, we added dividends as an additional component of our strategy of returning value to shareholders. We do not expect our dividend to require any changes in our leverage and, we believe, it will allow us to continue to focus on building and buying quality assets and opportunistically buying back our stock. While the timing and amount of future dividends will be subject to approval by our Board of Directors, we believe that our future cash flow generation will permit us to grow our cash dividend in the future. COVID-19 Update During the year ended December 31, 2020, we experienced minimal impact to our business or results of operations from the coronavirus (COVID-19) pandemic. The extent to which COVID-19 could adversely affect our future business operations will depend on future developments such as the duration of the outbreak, new information on the severity of COVID-19, and methods taken to contain or treat the outbreak of COVID-19. While the full impact of COVID-19 is not yet known, we will continue to monitor this recent outbreak and the potential effects on our business. For more information regarding COVID-19, refer to Item 1A. Risk Factors.Critical Accounting Policies and Estimates We have identified the policies and significant estimation processes below as critical to our business operations and the understanding of our results of operations. The listing is not intended to be a comprehensive list. In many cases, the accounting treatment of a particular transaction is specifically dictated by accounting principles generally accepted in the United States, with no need for management’s judgment in their application. In other cases, management is required to exercise judgment in the application of accounting principles with respect to particular transactions. The impact and any associated risks related to these policies on our business operations is discussed throughout “Management’s Discussion and Analysis of Financial Condition and Results of Operations” where such policies affect reported and expected financial results. For a detailed discussion on the application of these and other accounting policies, see Note 2 of our Consolidated Financial Statements for the year ended December 31, 2020, included herein. Our preparation of our financial statements requires us to make estimates and assumptions that affect the reported amount of assets and liabilities, disclosure of contingent assets and liabilities at the date of our financial statements, and the reported amounts of revenue and expenses during the reporting periods. Management bases its estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances. There can be no assurance that actual results will not differ from those estimates and such differences could be significant. Revenue Recognition and Accounts Receivable Revenue from site leasing is recognized on a straight-line basis over the current term of the related lease agreements, which are generally five years to 10 years. Receivables recorded related to the straight-lining of site leases are reflected in other assets on the Consolidated Balance Sheets. Rental amounts received in advance are recorded as deferred revenue on the Consolidated Balance Sheets. Revenue from site leasing represents 94% of our total revenue for the year ended 2020. Site development projects in which we perform consulting services include contracts on a fixed price basis that are billed at contractual rates. Revenue is recognized over time based on milestones achieved, which are determined based on costs incurred. Amounts billed in advance (collected or uncollected) are recorded as deferred revenue on our Consolidated Balance Sheets.Revenue from construction projects is recognized over time, determined by the percentage of cost incurred to date compared to management’s estimated total cost for each contract. This method is used because management considers total cost to be the best available measure of progress on the contracts. These amounts are based on estimates, and the uncertainty inherent in the estimates initially is reduced as work on the contracts nears completion. Refer to Note 5 in our Consolidated Financial Statements included in this annual report for further detail of costs and estimated earnings in excess of billings on uncompleted contracts. Provisions for estimated losses on uncompleted contracts are made in the period in which such losses are determined to be probable. The site development segment represents approximately 6% of our total revenues. We account for site development revenue in accordance with ASC 606, Revenue from Contracts with Customers, which was adopted on January 1, 2018 by applying the modified retrospective transition method. Payment terms do not result in any significant financing arrangements. Furthermore, these contracts do not typically include variable consideration; therefore, the transaction price that is recognized over time is generally the amount of the total contract. The cumulative effect of initially applying the new revenue standard had no impact on our financial results. The adoption of the new standard had no impact to net income on an ongoing basis.The accounts receivable balance for the years ended December 31, 2020 and 2019 was $74.1 million and $132.1 million, respectively, of which $14.3 and $40.7 million related to the site development segment, respectively. We perform periodic credit evaluations of our customers. In addition, we monitor collections and payments from our customers and maintain a provision for estimated credit losses based upon historical experience, specific customer collection issues identified, and past due balances as 26Table of Contents determined based on contractual terms. Interest is charged on outstanding receivables from customers on a case by case basis in accordance with the terms of the respective contracts or agreements with those customers. Amounts determined to be uncollectible are written off against the allowance for doubtful accounts in the period in which uncollectibility is determined to be probable. Refer to Note 15 in our Consolidated Financial Statements included in this annual report for further detail of the site development segment.Lease AccountingWe adopted ASU No. 2016-02, Leases (“Topic 842”) using the modified retrospective adoption method with an effective date of January 1, 2019. This standard requires all lessees to recognize a right-of-use asset and a lease liability, initially measured at the present value of the lease payments. The adoption of the new lease standard had a significant impact on our Consolidated Balance Sheets but did not have a significant impact on our lease classification or a material impact on our Consolidated Statements of Operations and liquidity. Additionally, the adoption of Topic 842 did not have a material impact on our debt covenant compliance under our current agreements. We have elected to not separate nonlease components from the associated lease component for all underlying classes of assets.In order to calculate our lease liability, we make certain assumptions related to lease term and discount rate. In making the determination of the period for which we are reasonably certain to remain on the site, we will assume optional renewals are reasonably certain of being exercised for the greater of: (1) a period sufficient to cover all tenants under their current committed term where we have provided rights to the tower not to exceed the contractual ground lease terms including renewals and (2) a period sufficient to recover the investment of significant leasehold improvements located on the site. For the discount rate, we use the rate implicit in the lease when available to discount lease payments to present value. However, our ground leases and other property interests generally do not provide a readily determinable implicit rate. Therefore, we estimate the incremental borrowing rate to discount lease payments based on the lease term and lease currency. We use publicly available data for instruments with similar characteristics when calculating our incremental borrowing rates. Refer to Note 2 in our Consolidated Financial Statements included in this annual report for further discussion on lease accounting.RESULTS OF OPERATIONSThis report presents our financial results and other financial metrics after eliminating the impact of changes in foreign currency exchange rates. We believe that providing these financial results and metrics on a constant currency basis, which are non-GAAP measures, gives management and investors the ability to evaluate the performance of our business without the impact of foreign currency exchange rate fluctuations. We eliminate the impact of changes in foreign currency exchange rates by dividing the current period’s financial results by the average monthly exchange rates of the prior year period, as well as by eliminating the impact of realized and unrealized gains and losses on our intercompany loans. Year Ended 2020 Compared to Year Ended 2019Revenues and Segment Operating Profit: For the year ended Constant December 31, Foreign Constant Currency 2020 2019 Currency Impact Currency Change % Change Revenues (in thousands) Domestic site leasing $ 1,558,311 $ 1,487,108 $ — $ 71,203 4.8%International site leasing 396,161 373,750 (71,307) 93,718 25.1%Site development 128,666 153,787 — (25,121) (16.3%)Total $ 2,083,138 $ 2,014,645 $ (71,307) $ 139,800 6.9%Cost of Revenues Domestic site leasing $ 256,673 $ 258,413 $ — $ (1,740) (0.7%)International site leasing 117,105 115,538 (23,306) 24,873 21.5%Site development 102,750 119,080 — (16,330) (13.7%)Total $ 476,528 $ 493,031 $ (23,306) $ 6,803 1.4%Operating Profit Domestic site leasing $ 1,301,638 $ 1,228,695 $ — $ 72,943 5.9%International site leasing 279,056 258,212 (48,001) 68,845 26.7%Site development 25,916 34,707 — (8,791) (25.3%) 27Table of Contents RevenuesDomestic site leasing revenues increased $71.2 million for the year ended December 31, 2020, as compared to the prior year, primarily due to (1) revenues from 283 towers acquired and 38 towers built since January 1, 2019 and (2) organic site leasing growth, primarily from monetary lease amendments for additional equipment added to our towers as well as new leases and contractual rent escalators, partially offset by lease non-renewals.International site leasing revenues increased $22.4 million for the year ended December 31, 2020, as compared to the prior year. On a constant currency basis, international site leasing revenues increased $93.7 million. These changes were primarily due to (1) revenues from 2,393 towers acquired and 694 towers built since January 1, 2019 and (2) organic site leasing growth from new leases, amendments, and contractual escalators. Site leasing revenue in Brazil represented 11.4% of total site leasing revenue for the period. No other individual international market represented more than 4% of our total site leasing revenue.Site development revenues decreased $25.1 million for the year ended December 31, 2020, as compared to prior year, as a result of decreased carrier activity driven primarily by T-Mobile and Sprint.Operating ProfitDomestic site leasing segment operating profit increased $72.9 million for the year ended December 31, 2020, as compared to the prior year, primarily due to additional profit generated by (1) towers acquired and built since January 1, 2019 and organic site leasing growth as noted above, (2) continued control of our site leasing cost of revenue, and (3) the positive impact of our ground lease purchase program.International site leasing segment operating profit increased $20.8 million for the year ended December 31, 2020, as compared to the prior year. On a constant currency basis, international site leasing segment operating profit increased $68.8 million. These changes were primarily due to additional profit generated by (1) towers acquired and built since January 1, 2019 and organic site leasing growth as noted above, (2) continued control of our site leasing cost of revenue, and (3) the positive impact of our ground lease purchase program.Site development segment operating profit decreased $8.8 million for the year ended December 31, 2020, as compared to the prior year, as a result of decreased carrier activity driven primarily by T-Mobile and Sprint.Selling, General, and Administrative Expenses: For the year ended Constant December 31, Foreign Constant Currency 2020 2019 Currency Impact Currency Change % Change (in thousands) Domestic site leasing $ 102,889 $ 99,707 $ — $ 3,182 3.2%International site leasing 34,905 32,411 (4,058) 6,552 20.2%Total site leasing $ 137,794 $ 132,118 $ (4,058) $ 9,734 7.4%Site development 17,663 21,525 — (3,862) (17.9%)Other 38,810 39,074 — (264) (0.7%)Total $ 194,267 $ 192,717 $ (4,058) $ 5,608 2.9%Selling, general, and administrative expenses increased $1.6 million for the year ended December 31, 2020, as compared to the prior year. On a constant currency basis, selling, general, and administrative expenses increased $5.6 million. These changes were primarily as a result of increases in personnel and other support related costs due in part to our continued international expansion and new business initiatives, as well as charitable contributions related to COVID-19 relief, partially offset by decreases in noncash compensation due to the acceleration of unrecognized stock compensation expense in the prior year related to the adoption of the retirement plan and travel related expenses. 28Table of Contents Acquisition and New Business Initiatives Related Adjustments and Expenses: For the year ended Constant December 31, Foreign Constant Currency 2020 2019 Currency Impact Currency Change % Change (in thousands) Domestic site leasing $ 10,331 $ 7,933 $ — $ 2,398 30.2%International site leasing 6,251 7,295 (960) (84) (1.2%)Total $ 16,582 $ 15,228 $ (960) $ 2,314 15.2%Acquisition and new business initiatives related adjustments and expenses increased $1.4 million for the year ended December 31, 2020, as compared to the prior year. On a constant currency basis, acquisition and new business initiatives related adjustments and expenses increased $2.3 million. These changes were primarily as a result of incremental costs incurred in support of new business initiatives.Asset Impairment and Decommission Costs: For the year ended Constant December 31, Foreign Constant Currency 2020 2019 Currency Impact Currency Change % Change (in thousands) Domestic site leasing $ 28,887 $ 24,202 $ — $ 4,685 19.4%International site leasing 11,210 8,899 (1,139) 3,450 38.8%Total site leasing $ 40,097 $ 33,101 $ (1,139) $ 8,135 24.6%Site Development — 2 — (2) —%Total $ 40,097 $ 33,103 $ (1,139) $ 8,133 24.6%Asset impairment and decommission costs increased $7.0 million for the year ended December 31, 2020, as compared to the prior year. On a constant currency basis, asset impairment and decommission costs increased $8.1 million. These changes were primarily as a result of an increase in impairment charges resulting from our regular analysis of whether the future cash flows from certain towers are adequate to recover the carrying value of the investment in those towers, partially offset by decrease in the impairment charge related to sites decommissioned in the year ended December 31, 2020 compared to the prior year period.Depreciation, Accretion, and Amortization Expense: For the year ended Constant December 31, Foreign Constant Currency 2020 2019 Currency Impact Currency Change % Change (in thousands) Domestic site leasing $ 539,399 $ 527,718 $ — $ 11,681 2.2%International site leasing 174,073 161,183 (31,393) 44,283 27.5%Total site leasing $ 713,472 $ 688,901 $ (31,393) $ 55,964 8.1%Site development 2,356 2,341 — 15 0.6%Other 6,142 5,836 — 306 5.2%Total $ 721,970 $ 697,078 $ (31,393) $ 56,285 8.1%Depreciation, accretion, and amortization expense increased $24.9 million for the year ended December 31, 2020, as compared to the prior year. On a constant currency basis, depreciation, accretion, and amortization expense increased $56.3 million. These changes were primarily due to an increase in the number of towers we acquired and built since January 1, 2019, partially offset by the impact of assets that became fully depreciated since the prior year period. 29Table of Contents Operating Income (Expense): For the year ended Constant December 31, Foreign Constant Currency 2020 2019 Currency Impact Currency Change % Change (in thousands) Domestic site leasing $ 620,132 $ 569,135 $ — $ 50,997 9.0%International site leasing 52,617 48,424 (10,451) 14,644 30.2%Total site leasing $ 672,749 $ 617,559 $ (10,451) $ 65,641 10.6%Site development 5,897 10,839 — (4,942) (45.6%)Other (44,952) (44,910) — (42) 0.1%Total $ 633,694 $ 583,488 $ (10,451) $ 60,657 10.4%Domestic site leasing operating income increased $51.0 million for the year ended December 31, 2020, as compared to the prior year, primarily due to higher segment operating profit, partially offset by increases in depreciation, accretion, and amortization expense, asset impairment and decommission costs, selling, general, and administrative expenses, and acquisition and new business initiatives related adjustments and expenses.International site leasing operating income increased $4.2 million for the year ended December 31, 2020, as compared to the prior year. On a constant currency basis, international site leasing operating income increased $14.6 million. These changes were primarily due to higher segment operating profit, partially offset by increases in depreciation, accretion, and amortization expense, selling, general, and administrative expenses, and asset impairment and decommission costs.Site development operating income decreased $4.9 million for the year ended December 31, 2020, as compared to the prior year, primarily due to lower segment operating profit driven by less activity from T-Mobile and Sprint, partially offset by a decrease in selling, general, and administrative expenses.Other Income (Expense): For the year ended Constant December 31, Foreign Constant Currency 2020 2019 Currency Impact Currency Change % Change (in thousands) Interest income $ 2,981 $ 5,500 $ (510) $ (2,009) (36.5%)Interest expense (367,874) (390,036) 73 22,089 (5.7%)Non-cash interest expense (24,870) (3,193) (1) (21,676) 678.9%Amortization of deferred financing fees (20,058) (22,466) — 2,408 (10.7%)Loss from extinguishment of debt, net (19,463) (457) — (19,006) 4,158.9%Other (expense) income, net (222,159) 14,053 (232,207) (4,005) (120.7%)Total $ (651,443) $ (396,599) $ (232,645) $ (22,199) 5.4% Interest income decreased $2.5 million for the year ended December 31, 2020, as compared to the prior year. On a constant currency basis, interest income decreased $2.0 million. These changes were primarily due to a lower rate of interest earned on both domestic and international investments.Interest expense decreased $22.2 million for the year ended December 31, 2020, as compared to the prior year. This change was primarily due to a lower weighted average interest rate due in part to the new interest rate swap entered into during third quarter of 2020, partially offset by a higher average principal amount of cash-interest bearing debt outstanding.Non-cash interest expense increased $21.7 million for the year ended December 31, 2020, as compared to the prior year primarily related to amortization of accumulated losses related to our interest rate swaps de-designated as cash flow hedges.Amortization of deferred financing fees decreased $2.4 million for the year ended December 31, 2020, as compared to the prior year. This change was primarily due to the repayment of the 2015-1C Tower Securities and 2016-1C Tower Securities in July 2020 and the redemption of the 2014 Senior Notes in February 2020, partially offset by the issuance of the 2019-1C Tower Securities in September 2019, 2020 Tower Securities in July 2020, 2020-1 Senior Notes in February 2020, and 2020-2 Senior Notes in May 2020. 30Table of Contents Loss from extinguishment of debt was $19.5 million for the year ended December 31, 2020 due to the payment of a $9.1 million call premium and the write-off of $7.7 million of the original issuance discount and financing fees related to the redemption of the 2014 Senior Notes in February 2020, as well as the write-off of $2.6 million of unamortized financing fees related to the repayment of the 2015-1C and 2016-1C Tower Securities in July 2020. Loss from extinguishment of debt was $0.5 million for the year ended December 31, 2019 due to the write-off of the unamortized financing fees and accrued interest associated with the repayment of the 2014-1C Tower Securities in September 2019.Other (expense) income, net includes a $220.4 million loss on the remeasurement of U.S. dollar denominated intercompany loans with foreign subsidiaries for the year ended December 31, 2020, while the prior year period included a $10.7 million gain.Benefit (Provision) for Income Taxes: For the year ended Constant December 31, Foreign Constant Currency 2020 2019 Currency Impact Currency Change % Change (in thousands) Benefit (provision) for income taxes $ 41,796 $ (39,605) $ 78,846 $ 2,555 (7.0%)Benefit for income taxes increased $81.4 million for the year ended December 31, 2020, as compared to the prior year. On a constant currency basis, benefit for income taxes increased $2.6 million. These changes were primarily due to a decrease in state and foreign income taxes.Net Income: For the year ended Constant December 31, Foreign Constant Currency 2020 2019 Currency Impact Currency Change % Change (in thousands) Net income $ 24,047 $ 147,284 $ (164,250) $ 41,013 28.9% Net income was $24.0 million for the year ended December 31, 2020, as compared to net income of $147.3 million in the prior year period. This change was primarily due to fluctuations in foreign currency exchange rates including changes recorded on the remeasurement of the U.S. dollar denominated intercompany loans with foreign subsidiaries, an increase in non-cash interest expense, and an increase in loss from extinguishment of debt in the current year period, partially offset by increases in operating income and benefit for income taxes and decreases in interest expense and amortization of deferred financing fees. Year Ended 2019 Compared to Year Ended 2018For a discussion of our 2019 Results of Operations, including a discussion of our financial results for the fiscal year ended December 31, 2019 compared to the fiscal year ended December 31, 2018, refer to Part I, Item 7 of our annual report on Form 10-K filed with the SEC on February 24, 2020.NON-GAAP FINANCIAL MEASURESThis report contains information regarding Adjusted EBITDA, a non-GAAP measure. We have provided below a description of Adjusted EBITDA, a reconciliation of Adjusted EBITDA to its most directly comparable GAAP measure and an explanation as to why management utilizes this measure. This report also presents our financial results and other financial metrics after eliminating the impact of changes in foreign currency exchange rates. We believe that providing these financial results and metrics on a constant currency basis, which are non-GAAP measures, gives management and investors the ability to evaluate the performance of our business without the impact of foreign currency exchange rate fluctuations. We eliminate the impact of changes in foreign currency exchange rates by dividing the current period’s financial results by the average monthly exchange rates of the prior year period, as well as by eliminating the impact of the remeasurement of our intercompany loans.Adjusted EBITDA We define Adjusted EBITDA as net income excluding the impact of non-cash straight-line leasing revenue, non-cash straight-line ground lease expense, non-cash compensation, net loss from extinguishment of debt, other income and expenses, acquisition and new business initiatives related adjustments and expenses, asset impairment and decommission costs, interest income, interest expenses, depreciation, accretion, and amortization, and income taxes. 31Table of Contents We believe that Adjusted EBITDA is useful to investors or other interested parties in evaluating our financial performance. Adjusted EBITDA is the primary measure used by management (1) to evaluate the economic productivity of our operations and (2) for purposes of making decisions about allocating resources to, and assessing the performance of, our operations. Management believes that Adjusted EBITDA helps investors or other interested parties to meaningfully evaluate and compare the results of our operations (1) from period to period and (2) to our competitors, by excluding the impact of our capital structure (primarily interest charges from our outstanding debt) and asset base (primarily depreciation, amortization and accretion) from our financial results. Management also believes Adjusted EBITDA is frequently used by investors or other interested parties in the evaluation of REITs. In addition, Adjusted EBITDA is similar to the measure of current financial performance generally used by our lenders to determine compliance with certain covenants under our Senior Credit Agreement and the indentures relating to the 2016 Senior Notes, 2020 Senior Notes, and 2021 Senior Notes. Adjusted EBITDA should be considered only as a supplement to net income computed in accordance with GAAP as a measure of our performance. For the year ended Constant December 31, Foreign Constant Currency 2020 2019 Currency Impact Currency Change % Change (in thousands) Net income $ 24,047 $ 147,284 $ (164,250) $ 41,013 28.9%Non-cash straight-line leasing revenue (3,475) (12,368) (154) 9,047 (73.1%)Non-cash straight-line ground lease expense 13,955 19,944 (48) (5,941) (29.8%)Non-cash compensation 68,890 73,214 (1,152) (3,172) (4.3%)Loss from extinguishment of debt, net 19,463 457 — 19,006 4,158.9%Other expense (income), net 222,159 (14,053) 232,207 4,005 120.7%Acquisition and new business initiatives related adjustments and expenses 16,582 15,228 (960) 2,314 15.2%Asset impairment and decommission costs 40,097 33,103 (1,139) 8,133 24.6%Interest income (2,981) (5,500) 510 2,009 (36.5%)Interest expense (1) 412,802 415,695 (72) (2,821) (0.7%)Depreciation, accretion, and amortization 721,970 697,078 (31,393) 56,285 8.1%(Benefit) provision for income taxes (2) (40,895) 40,548 (78,848) (2,595) (7.0%)Adjusted EBITDA $ 1,492,614 $ 1,410,630 $ (45,299) $ 127,283 9.0% (1)Total interest expense includes interest expense, non-cash interest expense, and amortization of deferred financing fees. (2)(Benefit) provision for taxes includes $901 and $943 of franchise taxes for the year ended 2020 and 2019, respectively, reflected in selling, general, and administrative expenses on the Consolidated Statement of Operations. Adjusted EBITDA increased $82.0 million for the year ended December 31, 2020, as compared to the prior year. On a constant currency basis, Adjusted EBITDA increased $127.3 million. These changes were primarily due to an increase in site leasing segment operating profit, partially offset by a decrease in site development segment operating profit and an increase in cash selling, general, and administrative expenses.LIQUIDITY AND CAPITAL RESOURCES SBAC is a holding company with no business operations of its own. SBAC’s only significant asset is 100% of the outstanding capital stock of SBA Telecommunications, LLC (“Telecommunications”), which is also a holding company that owns equity interests in entities that directly or indirectly own all of our domestic and international towers and assets. We conduct all of our business operations through Telecommunications’ subsidiaries. Accordingly, our only source of cash to pay our obligations, other than financings, is distributions with respect to our ownership interest in our subsidiaries from the net earnings and cash flow generated by these subsidiaries. 32Table of Contents A summary of our cash flows is as follows: For the year ended December 31, 2020 2019 (in thousands)Cash provided by operating activities $ 1,126,033 $ 970,045Cash used in investing activities (446,366) (947,158)Cash used in financing activities (469,017) (62,314)Change in cash, cash equivalents, and restricted cash 210,650 (39,427)Effect of exchange rate changes on cash, cash equiv., and restricted cash (8,962) 2,247Cash, cash equivalents, and restricted cash, beginning of year 141,120 178,300Cash, cash equivalents, and restricted cash, end of year $ 342,808 $ 141,120 Operating Activities Cash provided by operating activities was $1.1 billion for the year ended December 31, 2020 as compared to $970.0 million for the year ended December 31, 2019. The increase was primarily due to an increase in site leasing segment operating profit, cash inflows associated with working capital changes primarily from timing of customer payments, and a decrease in net cash interest paid, partially offset by a decrease in site development segment operating profit, an increase in cash selling, general, and administrative expenses, and the negative impact on cash from changes in foreign currency exchange rates.Investing ActivitiesA detail of our cash capital expenditures is as follows: For the year ended December 31, 2020 2019 (in thousands) Acquisitions of towers and related intangible assets (1) $ (181,473) $ (701,471)Land buyouts and other assets (2) (89,945) (72,486)Construction and related costs on new builds (54,736) (56,979)Augmentation and tower upgrades (38,340) (62,785)Tower maintenance (29,395) (29,048)General corporate (6,095) (5,424)Net purchases of investments (49,499) (13,156)Other investing activities 3,117 (5,809)Net cash used in investing activities $ (446,366) $ (947,158) (1)Excludes $77.1 million of acquisitions completed during the fourth quarter of 2020 which was funded in January 2021. The year ended December 31, 2019 included one specific acquisition of 1,313 towers in Brazil for $460.0 million.(2)Excludes $12.3 million and $15.2 million spent to extend ground lease terms for the years ended December 31, 2020 and 2019, respectively. Includes amounts paid related to the acquisition of data centers for the years ended December 31, 2020 and 2019.Subsequent to December 31, 2020, we acquired 25 towers and related assets for $8.4 million in cash. In addition, on February 16, 2021, we closed on the acquisition of wireless tenant licenses on 697 utility transmission structures related to the previously announced PG&E transaction for $954.0 million of cash consideration. The balance of the PG&E transaction is anticipated to close by the end of the third quarter. Furthermore, we agreed to purchase and anticipate closing on 299 additional communication sites for an aggregate amount of $72.7 million. We anticipate that the majority of these acquisitions will be consummated by the end of the second quarter of 2021.For 2021, we expect to incur non-discretionary cash capital expenditures associated with tower maintenance and general corporate expenditures of $37.0 million to $47.0 million and discretionary cash capital expenditures, based on current or potential acquisition obligations, planned new tower construction, forecasted tower augmentations, and forecasted ground lease purchases, of $1,200.0 million to $1,220.0 million. We expect to fund these cash capital expenditures from cash on hand, cash flow from operations, and borrowings under the Revolving Credit Facility or new financings. The exact amount of our future cash capital expenditures will 33Table of Contents depend on a number of factors, including amounts necessary to support our tower portfolio, our new tower build and acquisition programs, and our ground lease purchase program.Financing ActivitiesA detail of our financing activities is as follows: For the year ended December 31, 2020 2019 (in thousands)Net (repayments) borrowings under Revolving Credit Facility (1) $ (110,000) $ 165,000Repayment of Term Loans (1) (24,000) (24,000)Proceeds from issuance of Senior Notes, net of fees (1) 1,479,484 —Repayment of Senior Notes (1) (759,143) —Proceeds from issuance of Tower Securities, net of fees (1) 1,335,895 1,152,458Repayment of Tower Securities (1) (1,200,000) (920,000)Termination of interest rate swap (176,200) —Repurchase and retirement of common stock (2) (859,335) (466,982)Payment of dividends on common stock (207,689) (83,387)Proceeds from employee stock purchase/stock option plans 54,049 116,202Other financing activities (2,078) (1,605)Net cash used in financing activities $ (469,017) $ (62,314) (1)For additional information regarding our debt instruments and financings, refer to the Debt Instruments and Debt Service Requirements below.(2)For additional information, refer to Item 5. Issuer Purchases of Equity Securities.For a discussion of our Liquidity and Capital Resources for the fiscal year ended December 31, 2019 compared to the fiscal year ended December 31, 2018, refer to Part I, Item 7 of our annual report on Form 10-K filed with the SEC on February 24, 2020.DividendFor the year ended December 31, 2020, we paid the following cash dividends: Payable to Shareholders of Record At the Close Cash Paid Aggregate Amount Date Declared of Business on Per Share Paid Date Paid February 20, 2020 March 10, 2020 $0.465 $52.2 million March 26, 2020May 5, 2020 May 28, 2020 $0.465 $52.0 million June 18, 2020August 3, 2020 August 25, 2020 $0.465 $52.0 million September 21, 2020November 2, 2020 November 19, 2020 $0.465 $51.5 million December 17, 2020Dividends paid in 2020 and 2019 were ordinary dividends.Subsequent to December 31, 2020, we declared the following cash dividends: Payable to Shareholders Cash to of Record At the Close be Paid Date Declared of Business on Per Share Date to be Paid February 19, 2021 March 10, 2021 $0.58 March 26, 2021The amount of future distributions will be determined, from time to time, by our Board of Directors to balance our goal of increasing long-term shareholder value and retaining sufficient cash to implement our current capital allocation policy, which prioritizes investment in quality assets that meet our return criteria, and then stock repurchases when we believe our stock price is 34Table of Contents below its intrinsic value. The actual amount, timing and frequency of future dividends, will be at the sole discretion of our Board of Directors and will be declared based upon various factors, many of which are beyond our control.Registration Statements We have on file with the Commission a shelf registration statement on Form S-4 registering shares of Class A common stock that we may issue in connection with the acquisition of wireless communication towers or antenna sites and related assets or companies who own wireless communication towers, antenna sites, or related assets. During the year ended December 31, 2020, we did not issue any shares of Class A common stock under this registration statement. As of December 31, 2020, we had approximately 1.2 million shares of Class A common stock remaining under this registration statement. We have on file with the Commission an automatic shelf registration statement for well-known seasoned issuers on Form S-3 which enables us to issue shares of our Class A common stock, preferred stock, debt securities, warrants, or depositary shares as well as units that include any of these securities. We will file a prospectus supplement containing the amount and type of securities each time we issue securities under our automatic shelf registration statement on Form S-3. No securities were issued under this registration statement through the date of this filing.Debt Instruments and Debt Service RequirementsSenior Credit AgreementOn April 11, 2018, we amended and restated our Senior Credit Agreement to (1) issue a new $2.4 billion Term Loan, (2) increase the total commitments under the Revolving Credit Facility from $1.0 billion to $1.25 billion, (3) extend the maturity date of the Revolving Credit Facility to April 11, 2023, (4) lower the applicable interest rate margins and commitment fees under the Revolving Credit Facility, and (5) amend certain other terms and conditions under the Senior Credit Agreement. Terms of the Senior Credit AgreementThe Senior Credit Agreement, as amended, requires SBA Senior Finance II to maintain specific financial ratios, including (1) a ratio of Consolidated Net Debt to Annualized Borrower EBITDA not to exceed 6.5 times for any fiscal quarter, (2) a ratio of Consolidated Net Debt (calculated in accordance with the Senior Credit Agreement) to Annualized Borrower EBITDA for the most recently ended fiscal quarter not to exceed 6.5 times for 30 consecutive days and (3) a ratio of Annualized Borrower EBITDA to Annualized Cash Interest Expense (calculated in accordance with the Senior Credit Agreement) of not less than 2.0 times for any fiscal quarter. The Senior Credit Agreement contains customary affirmative and negative covenants that, among other things, limit the ability of SBA Senior Finance II and its subsidiaries to incur indebtedness, grant certain liens, make certain investments, enter into sale leaseback transactions, merge or consolidate, make certain restricted payments, enter into transactions with affiliates, and engage in certain asset dispositions, including a sale of all or substantially all of their property. The Senior Credit Agreement is also subject to customary events of default. Pursuant to the Second Amended and Restated Guarantee and Collateral Agreement, amounts borrowed under the Revolving Credit Facility, the Term Loans and certain hedging transactions that may be entered into by SBA Senior Finance II or the Subsidiary Guarantors (as defined in the Senior Credit Agreement) with lenders or their affiliates are secured by a first lien on the membership interests of SBA Telecommunications, LLC, SBA Senior Finance, LLC and SBA Senior Finance II and on substantially all of the assets (other than leasehold, easement and fee interests in real property) of SBA Senior Finance II and the Subsidiary Guarantors. The Senior Credit Agreement, as amended, permits SBA Senior Finance II, without the consent of the other lenders, to request that one or more lenders provide SBA Senior Finance II with increases in the Revolving Credit Facility or additional term loans provided that after giving effect to the proposed increase in Revolving Credit Facility commitments or incremental term loans the ratio of Consolidated Net Debt to Annualized Borrower EBITDA would not exceed 6.5 times. SBA Senior Finance II’s ability to request such increases in the Revolving Credit Facility or additional term loans is subject to its compliance with customary conditions set forth in the Senior Credit Agreement including compliance, on a pro forma basis, with the financial covenants and ratios set forth therein and, with respect to any additional term loan, an increase in the margin on existing term loans to the extent required by the terms of the Senior Credit Agreement. Upon SBA Senior Finance II’s request, each lender may decide, in its sole discretion, whether to increase all or a portion of its Revolving Credit Facility commitment or whether to provide SBA Senior Finance II with additional term loans and, if so, upon what terms. 35Table of Contents Revolving Credit Facility under the Senior Credit AgreementThe Revolving Credit Facility consists of a revolving loan under which up to $1.25 billion aggregate principal amount may be borrowed, repaid and redrawn, based upon specific financial ratios and subject to the satisfaction of other customary conditions to borrowing. Amounts borrowed under the Revolving Credit Facility accrue interest, at SBA Senior Finance II’s election, at either (1) the Eurodollar Rate plus a margin that ranges from 112.5 basis points to 175.0 basis points or (2) the Base Rate plus a margin that ranges from 12.5 basis points to 75.0 basis points, in each case based on the ratio of Consolidated Net Debt to Annualized Borrower EBITDA, calculated in accordance with the Senior Credit Agreement. In addition, SBA Senior Finance II is required to pay a commitment fee of between 0.20% and 0.25% per annum on the amount of unused commitment. If not earlier terminated by SBA Senior Finance II, the Revolving Credit Facility will terminate on, and SBA Senior Finance II will repay all amounts outstanding on or before, April 11, 2023. The proceeds available under the Revolving Credit Facility may be used for general corporate purposes. SBA Senior Finance II may, from time to time, borrow from and repay the Revolving Credit Facility. Consequently, the amount outstanding under the Revolving Credit Facility at the end of the period may not be reflective of the total amounts outstanding during such period. During the year ended December 31, 2020, we borrowed $895.0 million and repaid $1.0 billion of the outstanding balance under the Revolving Credit Facility. As of December 31, 2020, the balance outstanding under the Revolving Credit Facility was $380.0 million accruing interest at 1.610% per annum. In addition, SBA Senior Finance II was required to pay a commitment fee of 0.20% per annum on the amount of the unused commitment. As of December 31, 2020, SBA Senior Finance II was in compliance with the financial covenants contained in the Senior Credit Agreement.Subsequent to December 31, 2020, we borrowed $680.0 million and repaid $430.0 million of the outstanding balance under the Revolving Credit Facility. As of the date of this filing, $630.0 million was outstanding under the Revolving Credit Facility.Term Loan under the Senior Credit Agreement2018 Term LoanOn April 11, 2018, we, through our wholly owned subsidiary, SBA Senior Finance II LLC, obtained a new term loan (the “2018 Term Loan”) under the amended and restated Senior Credit Agreement. The 2018 Term Loan consists of a senior secured term loan with an initial aggregate principal amount of $2.4 billion that matures on April 11, 2025. The 2018 Term Loan accrues interest, at SBA Senior Finance II’s election at either the Base Rate plus 75 basis points (with a zero Base Rate floor) or the Eurodollar Rate plus 175 basis points (with a zero Eurodollar Rate floor). The 2018 Term Loan was issued at 99.75% of par value. As of December 31, 2020, the 2018 Term Loan was accruing interest at 1.900% per annum. Principal payments on the 2018 Term Loan commenced on September 30, 2018 and are being made in quarterly installments on the last day of each March, June, September, and December in an amount equal to $6.0 million. We incurred financing fees of approximately $16.8 million in relation to this transaction, which are being amortized through the maturity date. The proceeds from the 2018 Term Loan were used (1) to retire the outstanding $1.93 billion in aggregate principal amount of the 2014 Term Loan and 2015 Term Loan, (2) to pay down the existing outstanding balance under the Revolving Credit Facility, and (3) for general corporate purposes.During the year ended December 31, 2020, we repaid an aggregate of $24.0 million of principal on the 2018 Term Loan. As of December 31, 2020, the 2018 Term Loan had a principal balance of $2.3 billion.On August 4, 2020, we, through our wholly owned subsidiary, SBA Senior Finance II, terminated our existing $1.95 billion cash flow hedge on a portion of our 2018 Term Loan in exchange for a payment of $176.2 million. On the same date, we entered into an interest rate swap for $1.95 billion of notional value accruing interest at one month LIBOR plus 175 basis points for a fixed rate of 1.874% per annum through the maturity date of the 2018 Term Loan.Secured Tower Revenue Securities Tower Revenue Securities TermsAs of December 31, 2020, we, through a New York common law trust (the “Trust”), had issued and outstanding an aggregate of $5.1 billion of Secured Tower Revenue Securities (“Tower Securities”). The sole asset of the Trust consists of a non-recourse mortgage loan made in favor of certain of our subsidiaries that are borrowers on the mortgage loan (the “Borrowers”) under which there is a loan tranche for each Tower Security outstanding with the same interest rate and maturity date as the corresponding Tower Security. The mortgage loan will be paid from the operating cash flows from the aggregate 9,989 tower sites owned by the Borrowers. 36Table of Contents The mortgage loan is secured by (1) mortgages, deeds of trust, and deeds to secure debt on a substantial portion of the tower sites, (2) a security interest in the tower sites and substantially all of the Borrowers’ personal property and fixtures, (3) the Borrowers’ rights under certain tenant leases, and (4) all of the proceeds of the foregoing. For each calendar month, SBA Network Management, Inc., an indirect subsidiary (“Network Management”), is entitled to receive a management fee equal to 4.5% of the Borrowers’ operating revenues for the immediately preceding calendar month. The table below sets forth the material terms of our outstanding Tower Securities as of December 31, 2020: Security Issue Date Amount Outstanding Interest Rate Anticipated Repayment Date Final Maturity Date2013-2C Tower Securities Apr. 18, 2013 $575.0 million 3.722% Apr. 11, 2023 Apr. 9, 20482014-2C Tower Securities Oct. 15, 2014 $620.0 million 3.869% Oct. 8, 2024 Oct. 8, 20492017-1C Tower Securities Apr. 17, 2017 $760.0 million 3.168% Apr. 11, 2022 Apr. 9, 20472018-1C Tower Securities Mar. 9, 2018 $640.0 million 3.448% Mar. 9, 2023 Mar. 9, 20482019-1C Tower Securities Sep. 13, 2019 $1.165 billion 2.836% Jan. 12, 2025 Jan. 12, 20502020-1C Tower Securities Jul. 14, 2020 $750.0 million 1.884% Jan. 9, 2026 Jul. 11, 20502020-2C Tower Securities Jul. 14, 2020 $600.0 million 2.328% Jan. 11, 2028 Jul. 9, 2052The Borrowers may prepay any of the mortgage loan components, in whole or in part, with no prepayment consideration, (1) within twelve months (in the case of the component corresponding to the Secured Tower Revenue Securities Series 2017-1C, Series 2018-1C, 2019-1C, and 2020-1C) or eighteen months (in the case of the components corresponding to the Secured Tower Revenue Securities Series 2013-2C, Series 2014-2C, and Series 2020-2C) of the anticipated repayment date of such mortgage loan component, (2) with proceeds received as a result of any condemnation or casualty of any tower owned by the Borrowers or (3) during an amortization period. In all other circumstances, the Borrowers may prepay the mortgage loan, in whole or in part, upon payment of the applicable prepayment consideration. The prepayment consideration is determined based on the class of the Tower Securities to which the prepaid mortgage loan component corresponds and consists of an amount equal to the net present value associated with the portion of the principal balance being prepaid and calculated in accordance with the formula set forth in the mortgage loan agreement. To the extent that the mortgage loan components corresponding to the Tower Securities are not fully repaid by their respective anticipated repayment dates, the interest rate of each such component will increase by the greater of (1) 5% and (2) the amount, if any, by which the sum of (x) the 10 year U.S. treasury rate plus (y) the credit-based spread for such component (as set forth in the mortgage loan agreement) plus (z) 5%, exceeds the original interest rate for such component. Pursuant to the terms of the Tower Securities, all rents and other sums due on any of the towers owned by the Borrowers are directly deposited by the lessees into a controlled deposit account and are held by the indenture trustee. The monies held by the indenture trustee after the release date are classified as short-term restricted cash on the Consolidated Balance Sheets (see Note 4). However, if the Debt Service Coverage Ratio, defined as the net cash flow (as defined in the mortgage loan agreement) divided by the amount of interest on the mortgage loan, servicing fees and trustee fees that the Borrowers are required to pay over the succeeding twelve months, as of the end of any calendar quarter, falls to 1.30x or lower, then all cash flow in excess of amounts required to make debt service payments, to fund required reserves, to pay management fees and budgeted operating expenses and to make other payments required under the loan documents, referred to as “excess cash flow,” will be deposited into a reserve account instead of being released to the Borrowers. The funds in the reserve account will not be released to the Borrowers unless the Debt Service Coverage Ratio exceeds 1.30x for two consecutive calendar quarters. If the Debt Service Coverage Ratio falls below 1.15x as of the end of any calendar quarter, then an “amortization period” will commence and all funds on deposit in the reserve account will be applied to prepay the mortgage loan until such time that the Debt Service Coverage Ratio exceeds 1.15x for a calendar quarter. In addition, if any of the Tower Securities are not fully repaid by their respective anticipated repayment dates, the cash flow from the towers owned by the Borrowers will be trapped by the trustee for the Tower Securities and applied first to repay the interest, at the original interest rates, on the mortgage loan components underlying the Tower Securities, second to fund all reserve accounts and operating expenses associated with those towers, third to pay the management fees due to Network Management, fourth to repay principal of the Tower Securities and fifth to repay the additional interest discussed above. Furthermore, the advance rents reserve requirement states that the Borrowers are required to maintain an advance rents reserve at any time the monthly tenant Debt Service Coverage Ratio is equal to or less than 2:1 and for two calendar months after such coverage ratio again exceeds 2:1. The mortgage loan agreement, as amended, also includes covenants customary for mortgage loans subject to rated securitizations. Among other things, the Borrowers are prohibited from incurring other indebtedness for borrowed money or further encumbering their assets. 37Table of Contents Risk Retention Tower SecuritiesIn addition, to satisfy certain risk retention requirements of Regulation RR promulgated under the Exchange Act, SBA Guarantor, LLC, a wholly owned subsidiary, purchased (1) $40.0 million of Secured Tower Revenue Securities Series 2017-1R (the “2017-1R Tower Securities”) issued by the Trust with a fixed interest rate of 4.459% per annum, payable monthly, and with the same anticipated repayment date and final maturity date as the 2017-1C Tower Securities, (2) $33.7 million of Secured Tower Revenue Securities Series 2018-1R (the “2018-1R Tower Securities”) issued by the Trust with a fixed interest rate of 4.949% per annum, payable monthly, and with the same anticipated repayment date and final maturity date as the 2018-1C Tower Securities, (3) $61.4 million of Secured Tower Revenue Securities Series 2019-1R (the “2019-1R Tower Securities”) issued by the Trust with a fixed interest rate of 4.213% per annum, payable monthly, and with the same anticipated repayment date and final maturity date as the 2019-1C Tower Securities, and (4) $71.1 million of Secured Tower Revenue Securities Series 2020-2R (the “2020-2R Tower Securities”) issued by the Trust with a fixed interest rate of 4.336% per annum, payable monthly, and with the same anticipated repayment date and final maturity date as the 2020-2C Tower Securities. Principal and interest payments made on the 2017-1R Tower Securities, 2018-1R Tower Securities, 2019-1R Tower Securities, and 2020-2R Tower Securities eliminate in consolidation.Debt CovenantsAs of December 31, 2020, the Borrowers met the debt service coverage ratio required by the mortgage loan agreement and were in compliance with all other covenants as set forth in the agreement. Senior NotesThe table below sets forth the material terms of our outstanding senior notes as of the filing date: Senior Notes Issue Date Amount Outstanding Interest Rate Coupon Maturity Date Interest Due Dates Optional Redemption Date2016 Senior Notes Aug. 15, 2016 $1.1 billion 4.875% Sep. 1, 2024 Mar. 1 & Sep. 1 Sep. 1, 20192020 Senior Notes (1) Feb. 4, 2020 $1.5 billion 3.875% Feb. 15, 2027 Feb. 15 & Aug. 15 Feb. 15, 20232021 Senior Notes Jan. 29, 2021 $1.5 billion 3.125% Feb. 1, 2029 Feb. 1 & Aug. 1 Feb. 1, 2024 (1) The 2020 Senior Notes were issued in two tranches, on February 4, 2020 and on May 26, 2020. However, the 2020 Notes are one series of notes issued under the same indenture.Each of our senior notes is subject to redemption, at our option, in whole or in part on or after the date set forth above. During the subsequent three twelve-month periods, the senior notes are redeemable, at our option, at reducing redemption prices based on the applicable interest rate coupon (as set forth in the indenture) plus accrued and unpaid interest. Subsequent to such date, the senior notes become redeemable until maturity at 100% of the principal plus accrued and unpaid interest. In addition, prior to February 15, 2023 (in the case of the 2020 Senior Notes) and February 1, 2024 (in the case of the 2021 Senior Notes), we may, at our option, use the net proceeds of certain equity offerings to redeem up to 35% of the aggregate principal amount of the notes originally issued at a redemption price of 103.875% (in the case of the 2020 Senior Notes) and 103.125% (in the case of the 2021 Senior Notes) plus accrued and unpaid interest.2021 Senior NotesAs reflected above, on January 29, 2021, we issued $1.5 billion of our 2021 Senior Notes. We incurred financing fees of $14.3 million to date in relation to this transaction, which are being amortized through the maturity date. Net proceeds from this offering were used to redeem all of the outstanding principal amount of the 2017 Senior Notes, repay the amounts outstanding under the Revolving Credit Facility, and for general corporate purposes.Indentures Governing Senior NotesThe Indentures governing the Senior Notes contain customary covenants, subject to a number of exceptions and qualifications, including restrictions on the ability of SBAC and Telecommunications to (1) incur additional indebtedness unless the Consolidated Indebtedness to Annualized Consolidated Adjusted EBITDA Ratio (as defined in the Indenture), pro forma for the additional indebtedness does not exceed, with respect to any fiscal quarter, 9.5x for SBAC, (2) merge, consolidate or sell assets, (3) make restricted payments, including dividends or other distributions, (4) enter into transactions with affiliates, and (5) enter into sale 38Table of Contents and leaseback transactions and restrictions on the ability of the Restricted Subsidiaries of SBAC (as defined in the Indentures) to incur liens securing indebtedness.Debt Service As of December 31, 2020, we believe that our cash on hand, capacity available under our Revolving Credit Facility, and cash flows from operations for the next twelve months will be sufficient to service our outstanding debt during the next twelve months. The following table illustrates our estimate of our debt service requirement over the twelve months ended December 31, 2021 based on the amounts outstanding as of December 31, 2020 and the interest rates accruing on those amounts on such date (in thousands): Revolving Credit Facility (1) $ 7,8592018 Term Loan (2) 67,9512013-2C Tower Securities 21,5852014-2C Tower Securities 24,1852017-1C Tower Securities 24,3182018-1C Tower Securities 22,2702019-1C Tower Securities 33,4092020-1C Tower Securities 14,3682020-2C Tower Securities 14,1592016 Senior Notes 53,6252017 Senior Notes (1) 30,0002020 Senior Notes 58,125Total debt service for the next 12 months (1) $ 371,854 (1)Total debt service excludes interest payments on the $1.5 billion 2021 Senior Notes issued January 29, 2021, proceeds from which were used to redeem all of the outstanding principal amount of the 2017 Senior Notes ($750.0 million) and to repay the amounts outstanding under the Revolving Credit Facility.(2)Total debt service on the 2018 Term Loan includes the impact of the interest rate swap entered into on August 4, 2020 which swapped $1.95 billion of notional value accruing interest at one month LIBOR plus 175 basis points for a fixed rate of 1.874% per annum through the maturity date of the 2018 Term Loan. Inflation The impact of inflation on our operations has not been significant to date. However, we cannot assure you that a high rate of inflation in the future will not adversely affect our operating results particularly in light of the fact that our site leasing revenues are governed by long-term contracts with pre-determined pricing that we will not be able to increase in response to increases in inflation other than our contracts in South America and South Africa which have inflationary index based rental escalators.ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK We are exposed to certain market risks that are inherent in our financial instruments. These instruments arise from transactions entered into in the normal course of business. ‎ 39Table of Contents The following table presents the future principal payment obligations, fair values, and interest payments associated with our long-term debt instruments assuming our actual level of long-term indebtedness as of December 31, 2020: 2021 2022 2023 2024 2025 Thereafter Total Fair Value (in thousands)Revolving Credit Facility $ — $ — $ 380,000 $ — $ — $ — $ 380,000 $ 380,000 2018 Term Loan 24,000 24,000 24,000 24,000 2,244,000 — 2,340,000 2,310,750 2013-2C Tower Securities (1) — — 575,000 — — — 575,000 599,662 2014-2C Tower Securities (1) — — — 620,000 — — 620,000 670,003 2017-1C Tower Securities (1) — 760,000 — — — — 760,000 774,410 2018-1C Tower Securities (1) — — 640,000 — — — 640,000 671,341 2019-1C Tower Securities (1) — — — — 1,165,000 — 1,165,000 1,218,613 2020-1C Tower Securities (1) — — — — — 750,000 750,000 752,910 2020-2C Tower Securities (1) — — — — — 600,000 600,000 597,840 2016 Senior Notes — — — 1,100,000 — — 1,100,000 1,127,500 2017 Senior Notes (3) — 750,000 — — — — 750,000 757,500 2020 Senior Notes — — — — — 1,500,000 1,500,000 1,567,500 Total debt obligation (4) $ 24,000 $ 1,534,000 $ 1,619,000 $ 1,744,000 $ 3,409,000 $ 2,850,000 $ 11,180,000 $ 11,428,029 Interest payments (2)(4) $ 347,854 $ 323,192 $ 254,645 $ 218,840 $ 100,096 $ 94,739 $ 1,339,367 (1)For information on the anticipated repayment date and final maturity date for each tower security, refer to Debt Instruments and Debt Service Requirements above.(2)Represents interest payments based on the 2013-2C Tower Securities interest rate of 3.722%, the 2014-2C Tower Securities interest rate of 3.869%, the 2017-1C Tower Securities interest rate of 3.168%, the 2018-1C Tower Securities interest rate of 3.448%, the 2019-1C Tower Securities interest rate of 2.836%, the 2020-1C Tower Securities interest rate of 1.884%, the 2020-2C Tower Securities interest rate of 2.328%, the 2018 Term Loan at an average interest rate of 1.878% (which includes the impact of interest rate swaps) as of December 31, 2020, the Revolving Credit Facility at an average interest rate of 1.610% as of December 31, 2020, the 2016 Senior Notes interest rate of 4.875%, the 2017 Senior Notes interest rate of 4.000%, and the 2020 Senior Notes interest rate of 3.875%.(3)The 2017 Senior Notes were redeemed on February 11, 2021. (4)Excludes obligations on the $1.5 billion 2021 Senior Notes issued January 29, 2021.Our current primary market risk exposure is (1) interest rate risk relating to our ability to refinance our debt at commercially reasonable rates, if at all, and (2) interest rate risk relating to the impact of interest rate movements on the variable portion of our 2018 Term Loan and any borrowings that we may incur under our Revolving Credit Facility, which are at floating rates. We manage the interest rate risk on our outstanding debt through our large percentage of fixed rate debt, including interest rate swaps. On August 4, 2020, we, through our wholly owned subsidiary, SBA Senior Finance II, entered into an interest rate swap for $1.95 billion of notional value accruing interest at one month LIBOR plus 175 basis points for a fixed rate of 1.874% per annum through the maturity date of the 2018 Term Loan. While we cannot predict our ability to refinance existing debt or the impact interest rate movements will have on our existing debt, we continue to evaluate our financial position on an ongoing basis. In addition, there is currently uncertainty about whether LIBOR will continue to exist after 2021. The discontinuation of LIBOR after 2021 and the replacement with an alternative reference rate may adversely impact interest rates and our interest expense could increase.We are exposed to market risk from changes in foreign currency exchange rates in connection with our operations in Brazil, Canada, Chile, Peru, Argentina, Colombia, South Africa, and to a lesser extent, our markets in Central America. In each of these countries, we pay most of our selling, general, and administrative expenses and a portion of our operating expenses, such as taxes and utilities incurred in the country in local currency. In addition, in Brazil, Canada, Chile, and South Africa, we receive significantly all of our revenue and pay significantly all of our operating expenses in local currency. In Colombia, Argentina, and Peru, we receive our revenue and pay our operating expenses in a mix of local currency and U.S. dollars. All transactions denominated in currencies other than the U.S. Dollar are reported in U.S. Dollars at the applicable exchange rate. All assets and liabilities are translated into U.S. Dollars at exchange rates in effect at the end of the applicable fiscal reporting period, and all revenues and expenses are translated at average rates for the period. The cumulative translation effect is included in equity as a component of Accumulated other comprehensive income (loss). For the year ended December 31, 2020, approximately 13.7% of our revenues and approximately 17.5% of our total operating expenses were denominated in foreign currencies.We have performed a sensitivity analysis assuming a hypothetical 10% adverse movement in the Brazilian Real from the quoted foreign currency exchange rates at December 31, 2020. As of December 31, 2020, the analysis indicated that such an adverse 40Table of Contents movement would have caused our revenues and operating income to decline by approximately 1.0% and 0.5%, respectively, for the year ended December 31, 2020.As of December 31, 2020, we had intercompany debt, which is denominated in a currency other than the functional currency of the subsidiary in which it is recorded. As settlement of this debt is anticipated or planned in the foreseeable future, any changes in the foreign currency exchange rates will result in unrealized gains or losses, which will be included in our determination of net income. A change of 10% in the underlying exchange rates of our unsettled intercompany debt at December 31, 2020 would have resulted in approximately $76.6 million of unrealized gains or losses that would have been included in Other income (expense), net in our Consolidated Statements of Operations for the year ended December 31, 2020.Special Note Regarding Forward-Looking Statements This annual report contains “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. These statements concern expectations, beliefs, projections, plans and strategies, anticipated events or trends and similar expressions concerning matters that are not historical facts. Specifically, this annual report contains forward-looking statements regarding: •our expectations on the future growth and financial health of the wireless industry and the industry participants, the drivers of such growth, the demand for our towers, the future capital investments of our customers, future spectrum auctions, the trends developing in our industry, and competitive factors; •our ability to capture and capitalize on industry growth and the impact of such growth on our financial and operational results; •our expectations regarding consolidation of wireless service providers and the impact of such consolidation on our financial and operational results;•our intent to grow our tower portfolio domestically and internationally and expand through acquisitions, new builds and organic lease up on existing towers; •our belief that over the long-term, site leasing revenues will continue to grow as wireless service providers increase their use of our towers due to increasing minutes of network use and data transfer, network expansion and network coverage requirements;•our expectation regarding site leasing revenue growth, on an organic basis, in our domestic and international segments, and the drivers of such growth; •our focus on our site leasing business and belief that our site leasing business is characterized by stable and long-term recurring revenues, reduced exposure to changes in customer spending, predictable operating costs, and minimal non-discretionary capital expenditures; •our expectation that, due to the relatively young age and mix of our tower portfolio, future expenditures required to maintain these towers will be minimal; •our expectation that we will grow our cash flows by adding tenants to our towers at minimal incremental costs and executing monetary amendments;•our expectations regarding churn rates;•our election to be subject to tax as a REIT and our intent to continue to operate as a REIT;•our belief that our business is currently operated in a manner that complies with the REIT rules and our intent to continue to do so;•our plans regarding our distribution policy, and the amount and timing of, and source of funds for, any such distributions;•our expectations regarding the use of NOLs to reduce REIT taxable income;•our expectations regarding our capital allocation strategy, including future allocation decisions among portfolio growth, stock repurchases, and dividends, the impact of our election to be taxed as a REIT on that strategy, and our goal of increasing our Adjusted Funds From Operations per share;•our expectations regarding dividends and our ability to grow our dividend in the future and the drivers of such growth;•our expectations regarding our future cash capital expenditures, both discretionary and non-discretionary, including expenditures required for new builds and to maintain, improve, and modify our towers, ground lease purchases, and general corporate expenditures, and the source of funds for these expenditures;•our expectations regarding our business strategies, including our strategy for securing rights to the land underlying our towers, and the impact of such strategies on our financial and operational results;•our intended use of our liquidity;•our intent to maintain our target leverage levels, including in light of our dividend;•our expectations regarding our debt service in 2021 and our belief that our cash on hand, capacity under our Revolving Credit Facility, and our cash flows from operations for the next twelve months will be sufficient to service our outstanding debt during the next twelve months; and 41Table of Contents •our expectations and estimates regarding certain tax and accounting matters, including the impact on our financial statements.These forward-looking statements reflect our current views about future events and are subject to risks, uncertainties and assumptions. We wish to caution readers that certain important factors may have affected and could in the future affect our actual results and could cause actual results to differ significantly from those expressed in any forward-looking statement. The most important factors that could prevent us from achieving our goals, and cause the assumptions underlying forward-looking statements and the actual results to differ materially from those expressed in or implied by those forward-looking statements include, but are not limited to, the following:•the impact of consolidation among wireless service providers, including the impact of T-Mobile and Sprint;•the ability of Dish Network to become and compete as a nationwide carrier; •our ability to continue to comply with covenants and the terms of our credit instruments and our ability to obtain additional financing to fund our capital expenditures; •our ability to successfully manage the risks associated with international operations, including risks relating to political or economic conditions, inflation, tax laws, currency restrictions and exchange rate fluctuations, legal or judicial systems, and land ownership; •our ability to successfully manage the risks associated with our acquisition initiatives, including our ability to satisfactorily complete due diligence on acquired towers, the amount and quality of due diligence that we are able to complete prior to closing of any acquisition, our ability to accurately anticipate the future performance of the acquired towers, our ability to receive required regulatory approval, the ability and willingness of each party to fulfill their respective closing conditions and their contractual obligations, and, once acquired, our ability to effectively integrate acquired towers into our business and to achieve the financial results projected in our valuation models for the acquired towers; •the health of the South Africa economy and wireless communications market, and the willingness of carriers to invest in their networks in that market;•developments in the wireless communications industry in general, and for wireless communications infrastructure providers in particular, that may slow growth or affect the willingness or ability of the wireless service providers to expend capital to fund network expansion or enhancements; •our ability to secure as many site leasing tenants as anticipated, recognize our expected economies of scale with respect to new tenants on our towers, and retain current leases on towers;•our ability to secure and deliver anticipated services business at contemplated margins;•our ability to build new towers, including our ability to identify and acquire land that would be attractive for our customers and to successfully and timely address zoning, permitting, weather, availability of labor and supplies and other issues that arise in connection with the building of new towers;•competition for the acquisition of towers and other factors that may adversely affect our ability to purchase towers that meet our investment criteria and are available at prices which we believe will be accretive to our shareholders and allow us to maintain our long-term target leverage ratios while achieving our expected portfolio growth levels;•our capital allocation decisions and the impact on our ability to achieve our expected tower portfolio growth levels;•our ability to protect our rights to the land under our towers, and our ability to acquire land underneath our towers on terms that are accretive;•our ability to sufficiently increase our revenues and maintain expenses and cash capital expenditures at appropriate levels to permit us to meet our anticipated uses of liquidity for operations, debt service and estimated portfolio growth;•the impact of rising interest rates on our results of operations and our ability to refinance our existing indebtedness at commercially reasonable rates or at all;•the extent and duration of the impact of the COVID-19 crisis on the global economy, on our business and results of operations, and on foreign currency exchange rates;•our ability to successfully estimate the impact of regulatory and litigation matters;•natural disasters and other unforeseen damage for which our insurance may not provide adequate coverage;•a decrease in demand for our towers;•the introduction of new technologies or changes in a tenant’s business model that may make our tower leasing business less desirable to existing or potential tenants;•our ability to qualify for treatment as a REIT for U.S. federal income tax purposes and to comply with and conduct our business in accordance with such rules;•our ability to utilize available NOLs to reduce REIT taxable income; and•our ability to successfully estimate the impact of certain accounting and tax matters, including the effect on our company of adopting certain accounting pronouncements and the availability of sufficient NOLs to offset future REIT taxable income. 42Table of Contents
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+Item 7. Management’s Discussion and Analysis of Financial Condition and Results of OperationsThe following discussion should be read in conjunction with the consolidated financial statements and notes thereto that are included in this Annual Report on Form 10-K.OverviewSimon Property Group, Inc. is a Delaware corporation that operates as a self-administered and self-managed real estate investment trust, or REIT, under the Internal Revenue Code of 1986, as amended, or the Internal Revenue Code. REITs will generally not be liable for U.S. federal corporate income taxes as long as they distribute not less than 100% of their REIT taxable income. Simon Property Group, L.P. is our majority-owned Delaware partnership subsidiary that owns all of our real estate properties and other assets. In this discussion, unless stated otherwise or the context otherwise requires, references to "Simon" mean Simon Property Group, Inc. and references to the "Operating Partnership" mean Simon Property Group, L.P. References to "we," "us" and "our" mean collectively Simon, the Operating Partnership and those entities/subsidiaries owned or controlled by Simon and/or the Operating Partnership. According to the Operating Partnership's partnership agreement, the Operating Partnership is required to pay all expenses of Simon.We own, develop and manage premier shopping, dining, entertainment and mixed-use destinations, which consist primarily of malls, Premium Outlets®, and The Mills®. As of December 31, 2020, we owned or held an interest in 203 income-producing properties in the United States, which consisted of 99 malls, 69 Premium Outlets, 14 Mills, four lifestyle centers, and 17 other retail properties in 37 states and Puerto Rico. We also own an 80% noncontrolling interest in The Taubman Realty Group, LLC, or TRG, which has an interest in 24 regional, super-regional, and outlet malls in the U.S. and Asia. In addition, we have redevelopment and expansion projects, including the addition of anchors, big box tenants, and restaurants, underway at several properties in the United States, Canada, Europe and Asia. Internationally, as of December 31, 2020, we had ownership in 31 Premium Outlets and Designer Outlet properties primarily located in Asia, Europe, and Canada. We also have four international outlet properties under development. As of December 31, 2020, we also owned a 22.4% equity stake in Klépierre SA, or Klépierre, a publicly traded, Paris-based real estate company, which owns, or has an interest in, shopping centers located in 15 countries in Europe.We generate the majority of our lease income from retail, dining, entertainment, and other tenants including consideration received from:●fixed minimum lease consideration and fixed common area maintenance (CAM) reimbursements, and●variable lease consideration primarily based on tenants’ sales, as well as reimbursements for real estate taxes, utilities, marketing and certain other items.Revenues of our management company, after intercompany eliminations, consist primarily of management fees that are typically based upon the revenues of the property being managed.We invest in real estate properties to maximize total financial return which includes both operating cash flows and capital appreciation. We seek growth in earnings, funds from operations, or FFO, and cash flows by enhancing the profitability and operation of our properties and investments. We seek to accomplish this growth through the following:●attracting and retaining high quality tenants and utilizing economies of scale to reduce operating expenses,●expanding and re-tenanting existing highly productive locations at competitive rental rates,●selectively acquiring or increasing our interests in high quality real estate assets or portfolios of assets,●generating consumer traffic in our retail properties through marketing initiatives and strategic corporate alliances, and●selling selective non-core assets.We also grow by generating supplemental revenues from the following activities:●establishing our malls as leading market resource providers for retailers and other businesses and consumer-focused corporate alliances, including payment systems (such as handling fees relating to the sales of bank-issued prepaid cards), national marketing alliances, static and digital media initiatives, business development, sponsorship, and events,58 Table of Contents●offering property operating services to our tenants and others, including waste handling and facility services, and the provision of energy services,●selling or leasing land adjacent to our properties, commonly referred to as “outlots” or “outparcels,” and●generating interest income on cash deposits and investments in loans, including those made to related entities.We focus on high quality real estate across the retail real estate spectrum. We expand or redevelop properties to enhance profitability and market share of existing assets when we believe the investment of our capital meets our risk-reward criteria. We selectively develop new properties in markets we believe are not adequately served by existing retail outlet properties.We routinely review and evaluate acquisition opportunities based on their ability to enhance our portfolio. Our international strategy includes partnering with established real estate companies and financing international investments with local currency to minimize foreign exchange risk.To support our growth, we employ a three-fold capital strategy:●provide the capital necessary to fund growth,●maintain sufficient flexibility to access capital in many forms, both public and private, and●manage our overall financial structure in a fashion that preserves our investment grade credit ratings.We consider FFO, net operating income, or NOI, and portfolio NOI to be key measures of operating performance that are not specifically defined by accounting principles generally accepted in the United States, or GAAP. We use these measures internally to evaluate the operating performance of our portfolio and provide a basis for comparison with other real estate companies. Reconciliations of these measures to the most comparable GAAP measure are included below in this discussion.COVID-19On March 11, 2020, the World Health Organization declared the novel strain of coronavirus, or COVID-19, a global pandemic and recommended containment and mitigation measures worldwide. The COVID-19 pandemic has already had a significant negative impact on economic and market conditions around the world in 2020, and, notwithstanding the fact that vaccines have started to be administered in the United States and elsewhere, the pandemic continues to adversely impact economic activity in real estate. The impact of the COVID-19 pandemic continues to evolve and governments and other authorities, including where we own or hold interests in properties, have imposed measures intended to control its spread, including restrictions on freedom of movement, group gatherings and business operations such as travel bans, border closings, business closures, quarantines, stay-at-home, shelter-in-place orders, capacity limitations and social distancing measures. Governments and other authorities are in varying stages of lifting or modifying some of these measures, however certain governments and other authorities have already been forced to, and others may in the future, reinstate these measures or impose new, more restrictive measures, if the risks, or the tenants’ and consumers’ perception of the risks, related to the COVID-19 pandemic worsen at any time. Although tenants and consumers have been adapting to the COVID-19 pandemic, with tenants adding services like curbside pickup, and while consumer risk-tolerance is evolving, such adaptations and evolution may take time, and there is no guarantee that retail will return to pre-pandemic levels even once the pandemic subsides. As a result of the COVID-19 pandemic and these measures, the Company may experience material impacts including changes in the ability to recognize revenue due to changes in our assessment of the probability of collection of lease income and asset impairment charges as a result of changing cash flows generated by our properties. Due to certain restrictive governmental orders placed on us, our domestic portfolio lost approximately 13,500 shopping days during the year.As of October 7, 2020, all of our domestic properties and certain of our retailer investments had reopened, but we do not have certainty that additional closures in the future will not be required. As we developed and implemented our response to the impact of the COVID-19 pandemic and restriction intended to prevent its spread on our business, our primary focus has been on the health and safety of our employees, our shoppers and the communities in which we serve. We implemented a series of actions to reduce costs and increase liquidity in light of the economic impacts of the pandemic, including:●significantly reduced all non-essential corporate spending, ●significantly reduced property operating expenses, including discretionary marketing spend, 59 Table of Contents●implemented a temporary furlough of certain corporate and field employees due to the closure of the Company’s U.S. properties as a result of restrictive governmental orders; reduced certain corporate and field personnel and implemented a temporary freeze on company hiring efforts, and●suspended more than $1.0 billion of redevelopment and new development projects. Results OverviewDiluted earnings per share and diluted earnings per unit decreased $3.22 during 2020 to $3.59 as compared to $6.81 in 2019. The decrease in diluted earnings per share and diluted earnings per unit was primarily attributable to:●a lawsuit settled with our former insurance broker in 2019 related to the significant flood damage sustained at Opry Mills in May 2010 of $68.0 million, or $0.19 per diluted share/unit,●a gain in 2019 related to the disposition of our interest in a multi-family residential investment of $16.2 million, or $0.05 per diluted share/unit,●decreased consolidated lease income of $941.4 million, or $2.65 per diluted share/unit, comprised of decreased fixed lease income of $422.0 million and decreased variable lease income of $519.4 million, which was primarily due to COVID-19 disruption,●decreased other income, excluding the two aforementioned 2019 transactions, of $106.1 million, or $0.30 per diluted share/unit, primarily related to decreased Simon Brand Ventures and gift card revenues due to COVID-19 disruption,●a net loss in 2020 of $115.0 million, or $0.32 per diluted share/unit, primarily related to impairment charges in 2020 related to Klépierre, our investment in HBS, one consolidated property, and three joint venture properties, partially offset by gains from disposition activity in 2020, of $14.9 million, or $0.04 per diluted share/unit which was lower than 2019 net gains,●decreased income from unconsolidated entities of $224.5 million, or $0.63 per diluted share/unit, primarily due to unfavorable domestic and international operations and year-over-year operations from retailer investments of $7.5 million, or $0.02 per diluted share/unit, all of which were impacted by COVID-19 disruption, and●an unrealized unfavorable change in fair value of equity instruments of $11.4 million, or $0.03 per diluted share/unit, partially offset by ●decreased consolidated total operating expenses of $211.7 million, or $0.60 per diluted share/unit, which was primarily related to cost reduction efforts as a result of the COVID-19 disruption,●a charge on early extinguishment of debt of $116.3 million, or $0.33 per diluted share/unit, in 2019, and●decreased tax expense of $34.7 million, or $0.10 per diluted share/unit. Portfolio NOI decreased 17.1% in 2020 as compared to 2019. Average base minimum rent for U.S. Malls and Premium Outlets increased 2.2% to $55.80 psf as of December 31, 2020, from $54.59 psf as of December 31, 2019. Leasing spreads in our U.S. Malls and Premium Outlets decreased to an open/close leasing spread (based on total tenant payments — base minimum rent plus common area maintenance) of $4.41 psf ($60.08 openings compared to $64.49 closings) as of December 31, 2020, representing a 6.8% decrease. Ending occupancy for our U.S. Malls and Premium Outlets decreased 3.8% to 91.3% as of December 31, 2020, from 95.1% as of December 31, 2019, primarily due to 2020 tenant bankruptcy activity, partially offset by leasing activity.Our effective overall borrowing rate at December 31, 2020 on our consolidated indebtedness decreased 18 basis points to 2.98% as compared to 3.16% at December 31, 2019. This decrease was primarily due to a decrease in the effective overall borrowing rate on variable rate debt of 130 basis points (1.31% at December 31, 2020 as compared to 2.61% at December 31, 2019) partially offset by an increase in the effective overall borrowing rate on fixed rate debt of four basis points (3.50% at December 31, 2020 as compared to 3.46% at December 31, 2019). The weighted average years to maturity of our consolidated indebtedness was 7.3 years and 7.4 years at December 31, 2020 and 2019, respectively.60 Table of ContentsOur financing activity for the year ended December 31, 2020 included:●amending and replacing in its entirety the Operating Partnership’s existing $4.0 billion unsecured revolving credit facility, or Credit Facility, by entering into an unsecured credit facility comprised of (i) an amendment and extension of the Credit Facility and (ii) a $2.0 billion delayed-draw term loan facility, or Term Facility,●borrowing $3.1 billion under the Credit Facility and subsequently repaying $3.1 billion under the Credit Facility,●borrowing $875.0 million under the Operating Partnership’s $3.5 billion unsecured revolving credit facility, or Supplemental Facility, and together with the Credit Facility and Term Facility, the Facilities, and subsequently repaying $875.0 million,●decreasing our borrowings under the Operating Partnership’s global unsecured commercial paper note program, or the Commercial Paper program, by $704.0 million,●borrowing $2.0 billion under the Term Facility,●issuing 22,137,500 shares of common stock in a public offering for $1.6 billion, net of issue costs,●completing, on July 9, 2020, the issuance by the Operating Partnership of the following senior unsecured notes: $500 million with a fixed interest rate of 3.50%, $750 million with a fixed interest rate 2.65%, and $750 million with a fixed interest rate of 3.80%, with maturity dates of September 2025 (the “2025 Notes”), June 2030, and June 2050, respectively. The 2025 Notes were issued as additional notes under an indenture pursuant to which the Operating Partnership previously issued $600 million principal amount of 3.50% senior notes due September 2025 on August 17, 2015. Proceeds from the unsecured notes offering funded the optional redemption at par of senior unsecured notes in July and August 2020, as discussed below, and repaid a portion of the indebtedness under the Facilities,●completing, on July 22, 2020, the optional redemption at par of the Operating Partnership’s $500 million 2.50% notes due September 1, 2020, and●completing, on August 6, 2020, the optional redemption at par of the Operating Partnership’s €375 million 2.375% notes due October 2, 2020.Subsequent ActivityOn January 21, 2021 the Operating Partnership completed the issuance of the following senior unsecured notes: $800 million with a fixed interest rate of 1.75%, and $700 million with a fixed interest rate of 2.20%, with maturity dates of January 2028 and 2031, respectively.On January 27, 2021 the Operating Partnership completed the planned optional redemption of its $550 million 2.50% notes due on July 15, 2021, including the make-whole amount. Further on February 2, 2021, the Operating Partnership repaid $750 million under the Term Facility. United States Portfolio DataThe portfolio data discussed in this overview includes the following key operating statistics: ending occupancy, and average base minimum rent per square foot. We include acquired properties in this data beginning in the year of acquisition and remove disposed properties in the year of disposition. For comparative information purposes, we separate the information related to The Mills from our other U.S. operations. We also do not include any information for properties located outside the United States or properties included in TRG.61 Table of ContentsThe following table sets forth these key operating statistics for the combined U.S. Malls and Premium Outlets:●properties that are consolidated in our consolidated financial statements,●properties we account for under the equity method of accounting as joint ventures, and●the foregoing two categories of properties on a total portfolio basis.​​​​​​​​​​​​​​​​​​​​%/Basis Point​​​​%/Basis Point​​​ ​ 2020​Change (1)​2019​Change (1)​2018 U.S. Malls and Premium Outlets:​​​​​​​​​​​​​​Ending Occupancy​​​​​​​​​​​​​​Consolidated​​ 91.5% -380bps ​ 95.3% -60 bps ​ 95.9%Unconsolidated​​ 90.9% -360bps​ 94.5% -130 bps ​ 95.8%Total Portfolio​​ 91.3% -380bps​ 95.1% -80 bps ​ 95.9%Average Base Minimum Rent per Square Foot​​​​​​​​​​​​​​Consolidated​$ 53.98​ 1.7% $ 53.06​ 1.0% $ 52.51​Unconsolidated​$ 60.97​ 3.8% $ 58.71​ 0.2% $ 58.59​Total Portfolio​$ 55.80​ 2.2% $ 54.59​ 0.8% $ 54.18​The Mills:​​​​​​​​​​​​​​Ending Occupancy​ 95.3% -170 bps 97.0% -60bps 97.6%Average Base Minimum Rent per Square Foot​$ 33.77​ 2.1% $ 33.09​ 1.4% $ 32.63​(1)Percentages may not recalculate due to rounding. Percentage and basis point changes are representative of the change from the comparable prior period.Ending Occupancy Levels and Average Base Minimum Rent per Square Foot. Ending occupancy is the percentage of gross leasable area, or GLA, which is leased as of the last day of the reporting period. We include all company owned space except for mall anchors, mall majors, mall freestanding and mall outlots in the calculation. Base minimum rent per square foot is the average base minimum rent charge in effect for the reporting period for all tenants that would qualify to be included in ending occupancy.Total Reported Sales per Square Foot. Given the impact of COVID-19 and the governmental restrictions placed on us, we are not presenting reported retail sales per square foot as we do not believe the trends for the period are indicative of future operating trends.Current Leasing ActivitiesDuring 2020, we signed 460 new leases and 1,175 renewal leases (excluding mall anchors and majors, new development, redevelopment and leases with terms of one year or less) with a fixed minimum rent across our U.S. Malls and Premium Outlets portfolio, comprising approximately 6.1 million square feet, of which 4.8 million square feet related to consolidated properties. During 2019, we signed 990 new leases and 1,281 renewal leases with a fixed minimum rent, comprising approximately 7.6 million square feet, of which 5.7 million square feet related to consolidated properties. The average annual initial base minimum rent for new leases was $53.97 per square foot in 2020 and $56.80 per square foot in 2019 with an average tenant allowance on new leases of $51.01 per square foot and $47.57 per square foot, respectively.Japan DataThe following are selected key operating statistics for our Premium Outlets in Japan. The information used to prepare these statistics has been supplied by the managing venture partner.​​​​​​​​​​​​​​​​ December 31, %/basis point December 31, %/basis point December 31, ​​2020​Change​2019​Change​2018 Ending Occupancy​​99.5%​+0 bps​​99.5%​-20 bps​​99.7%​Average Base Minimum Rent per Square Foot​¥ 5,447​3.38%​¥ 5,269​2.19%​¥ 5,156​​62 Table of ContentsCritical Accounting Policies and EstimatesThe preparation of financial statements in conformity with U.S. generally accepted accounting principles, or GAAP, requires management to use judgment in the application of accounting policies, including making estimates and assumptions. We base our estimates on historical experience and on various other assumptions believed to be reasonable under the circumstances. These judgments affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the dates of the financial statements and the reported amounts of revenue and expenses during the reporting periods. If our judgment or interpretation of the facts and circumstances relating to various transactions had been different, it is possible that different accounting policies would have been applied resulting in a different presentation of our financial statements. From time to time, we reevaluate our estimates and assumptions. In the event estimates or assumptions prove to be different from actual results, adjustments are made in subsequent periods to reflect more current information. Below is a discussion of accounting policies that we consider critical in that they may require complex judgment in their application or require estimates about matters that are inherently uncertain. For a summary of our significant accounting policies, see Note 3 of the notes to the consolidated financial statements.●We, as a lessor, retain substantially all of the risks and benefits of ownership of the investment properties and account for our leases as operating leases. We accrue fixed lease income on a straight-line basis over the terms of the leases, when we believe substantially all lease income, including the related straight-line rent receivable, is probable of collection. Our assessment of collectability incorporates available operational performance measures such as sales and the aging of billed amounts as well as other publicly available information with respect to our tenant’s financial condition, liquidity and capital resources, including declines in such conditions due to, or amplified by, the COVID-19 pandemic. When a tenant seeks to reorganize its operations through bankruptcy proceedings, we assess the collectability of receivable balances including, among other things, the timing of a tenant’s bankruptcy filing and our expectations of the assumption by the tenant in bankruptcy proceeding of leases at the Company’s properties on substantially similar terms. In the event that we determine accrued receivables are not probable of collection, lease income will be recorded on a cash basis, with the corresponding tenant receivable and straight-line rent receivable charged as a direct write-off against lease income in the period of the change in our collectability determination. ●We review investment properties for impairment on a property-by-property basis to identify and evaluate events or changes in circumstances which indicate that the carrying value of investment properties may not be recoverable. These circumstances include, but are not limited to, changes in a property’s operational performance such as declining cash flows, occupancy or total sales per square foot, the Company’s intent and ability to hold the related asset, and, if applicable, the remaining time to maturity of underlying financing arrangements. We measure any impairment of investment property when the estimated undiscounted operating income before depreciation and amortization during the anticipated holding period plus its residual value is less than the carrying value of the property. To the extent impairment has occurred, we charge to income the excess of carrying value of the property over our estimate of its fair value. We also review our investments, including investments in unconsolidated entities, to identify and evaluate whether events or changes in circumstances indicate that the carrying amount of our investments may not be recoverable. We will record an impairment charge if we determine the fair value of the investments are less than their carrying value and such impairment is other-than-temporary. Our evaluation of changes in economic or operating conditions and whether an impairment is other-than-temporary may include developing estimates of fair value, forecasted cash flows or operating income before depreciation and amortization. We estimate undiscounted cash flows and fair value using observable and unobservable data such as operating income, hold periods, estimated capitalization and discount rates, or relevant market multiples, leasing prospects and local market information and whether certain impairments are other-than-temporary. Changes in economic and operating conditions, including changes in the financial condition of our tenants, and changes to our intent and ability to hold the related asset, that occur subsequent to our review of recoverability of investment property and other investments could impact the assumptions used in that assessment and could result in future charges to earnings if assumptions regarding those investments differ from actual results.●To maintain Simon’s status as a REIT, we must distribute at least 90% of REIT taxable income in any given year and meet certain asset and income tests. We monitor our business and transactions that may potentially impact Simon’s REIT status. In the unlikely event that we fail to maintain Simon’s REIT status, and available relief provisions do not apply, we would be required to pay U.S. federal income taxes at regular corporate income tax rates during the period Simon did not qualify as a REIT. If Simon lost its REIT status, it could not elect to be taxed as a REIT for four taxable years following the year during which qualification was lost unless its failure was due 63 Table of Contentsto reasonable cause and certain other conditions were met. As a result, failing to maintain REIT status would result in a significant increase in the income tax expense recorded and paid during those periods.●In the period of a significant acquisition of real estate, we make estimates as part of our valuation of the purchase price of asset acquisitions (including the components of excess investment in joint ventures) to the various components of the acquisition based upon the relative fair value of each component. The most significant components of our real estate valuations are typically the determination of relative fair value to the buildings as-if-vacant, land and market value of in-place leases. In the case of the fair value of buildings and fair value of land and other intangibles, our estimates of the values of these components will affect the amount of depreciation or amortization we record over the estimated useful life of the property acquired or the remaining lease term. In the case of the market value of in-place leases, we make our best estimates of the tenants’ ability to pay rents based upon the tenants’ operating performance at the property, including the competitive position of the property in its market as well as sales psf, rents psf, and overall occupancy cost for the tenants in place at the acquisition date. Our assumptions affect the amount of future revenue that we will recognize over the remaining lease term for the acquired in-place leases. Results of OperationsIn addition to the activity discussed above in the “Results Overview” section, the following acquisitions, dispositions, and openings of consolidated properties affected our consolidated results in the comparative periods:●During the fourth quarter of 2020, we disposed of one consolidated retail property.●On September 19, 2019, we acquired the remaining 50% interest in a hotel adjacent to one of our properties from our joint venture partner.●During the third quarter of 2019, we disposed of two retail properties.●On September 27, 2018, we opened Denver Premium Outlets, a 330,000 square foot center in Thornton (Denver), Colorado. We own a 100% interest in this center.●On September 25, 2018, we acquired the remaining 50% interest in the previously unconsolidated The Outlets at Orange in Los Angeles, California from our joint venture partner.●During 2018, we disposed of two retail properties.In addition to the activities discussed above and in “Results Overview”, the following acquisitions, dispositions, and openings of noncontrolling interests in joint venture properties affected our income from unconsolidated entities in the comparative periods:●On December 29, 2020, we completed the acquisition of an 80% ownership interest in TRG, which is engaged in the ownership of 24 regional, super-regional, and outlet malls in the U.S. and Asia. ●On December 7, 2020, we and a group of co-investors acquired certain assets and liabilities of J.C. Penney, a department store retailer, out of bankruptcy. Our interest in the venture is 41.67%.●On June 23, 2020, we opened Siam Premium Outlets, a 264,000 square foot center in Bangkok, Thailand. We own a 50% interest in this center.●On February 19, 2020 we and a group of co-investors acquired certain assets and liabilities of Forever 21, a retailer of apparel and accessories, out of bankruptcy. The interests were acquired through two separate joint ventures, a licensing venture and an operating venture. Our interest in each of the retail operations venture and in the licensing venture is 37.5%.●On February 13, 2020 through our European investee, we opened Malaga Designer Outlets, a 191,000 square foot center in Malaga, Spain. We own a 46% interest in this center.●In January 2020, we acquired additional interests of 5.05% and 1.37% in SPARC Group, formerly known as Aeropostale and Authentic Brands Groups, LLC, or ABG, respectively.●On October 16, 2019 we acquired a 45% interest in Rue Gilt Groupe, or RGG, to create a new multi-platform venture dedicated to digital value shopping.64 Table of Contents●On May 22, 2019, we and our partner opened Premium Outlets Querétaro, a 274,800 square foot center in Santiago de Querétaro, Mexico. We own a 50% interest in this center.●During the fourth quarter of 2018, our interest in the 41 German department store properties owned through our investment in HBS Global Properties, or HBS, was sold, as further discussed in Note 6 of the notes to the consolidated financial statements.●During 2018, we contributed our interest in the licensing venture of Aéropostale for additional interests in Authentic Brands Group LLC, or ABG. Our original interest in ABG was 5.4% and is currently 6.8%.●On May 2, 2018, we and our partner opened Premium Outlet Collection Edmonton International Airport, a 424,000 square foot shopping center in Edmonton (Alberta), Canada. We have a 50% noncontrolling interest in this new center.For the purposes of the following comparisons between the years ended December 31, 2020 and 2019 and the years ended December 31, 2019 and 2018, the above transactions are referred to as the property transactions. In the following discussions of our results of operations, “comparable” refers to properties we owned and operated in both years in the year to year comparisons.Year Ended December 31, 2020 vs. Year Ended December 31, 2019Lease income decreased $941.4 million, of which the property transactions accounted for $3.9 million of the decrease. Comparable lease income decreased $937.5 million, or 17.9%. Total lease income decreased primarily due to decreases in fixed minimum lease and CAM consideration recorded on a straight-line basis of $422.0 million and reduced variable lease income of $519.4 million, primarily related to lower consideration based on tenant sales and negative variable lease income due to abatements as a result of the COVID-19 pandemic. Total other income decreased $190.2 million, primarily due to a $75.7 million decrease related to Simon Brand Venture and gift card revenues, a $68.0 million decrease related to a gain on settlement with our former insurance broker in 2019, a $16.2 million gain on the 2019 sale of our interest in a multi-family residential property, a $10.9 million decrease in distributions from investments, a $9.1 million decrease in interest income and lower business interruption insurance proceeds received in connection with our two Puerto Rico properties as a result of hurricane damages of $5.2 million, partially offset by a $6.2 million gain on a partial sale and mark-to-market adjustment of our retained interest in a non-retail investment and a $4.1 million gain related to the sale of outparcels.Property operating expenses decreased $104.0 million primarily due to the closure of properties as a result of the COVID-19 pandemic and governmental restrictions intended to prevent its spread and cost reduction efforts, as previously discussed.Repairs and maintenance expenses decreased $19.6 million primarily due to the closure of properties as a result of the COVID-19 pandemic and governmental restrictions intended to prevent its spread and cost reduction efforts, as previously discussed.Advertising and promotion decreased $51.7 million primarily due to the closure of properties as a result of the COVID-19 pandemic and governmental restrictions intended to prevent its spread and cost reduction efforts, as previously discussed.General and administrative expense decreased $12.3 million due to lower executive compensation.Other expense increased $27.8 million primarily related to an increase in legal fees and expenses.During 2019, we recorded a loss on extinguishment of debt of $116.3 million as a result of the early redemption of senior unsecured notes.Income and other tax expense changed by $34.7 million primarily as a result of a higher tax benefit due to larger losses on our share of operating results in the retail operations venture of SPARC Group as compared to 2019, and reduced withholding and income taxes related to certain of our international investments, partially offset by tax expense from a bargain purchase gain recorded as a result of the acquisition of our interest in Forever 21.Income from unconsolidated entities decreased $224.5 million primarily due to unfavorable year-over-year domestic and international property operations, as well as results of operations from our retailer investments, both of which were impacted by COVID-19 disruption, partially offset by a $35.0 million pre-tax non-cash bargain purchase gain recorded as a result of the acquisition of our interest in Forever 21 and a gain from the sale of a non-retail asset, of which our share 65 Table of Contentswas $17.8 million. During 2020, we recorded $125.6 million of impairment charges related to one consolidated property, an other-than-temporary impairment on our equity investment in three joint venture properties, an other-than-temporary impairment to reduce our investment in HBS to its estimated fair value, and a $4.3 million loss, net, related to the impairment and disposition of certain assets by Klépierre, partially offset by a $12.3 million gain on the disposal of our interest in one consolidated property, a $1.9 million excess gain on insurance proceeds related to our two properties in Puerto Rico and a $1.0 million gain related to the disposition of a shopping center by one of our joint venture investments. During 2019, we recorded net gains of $62.1 million primarily related to Klépierre’s disposition of certain shopping centers, offset by a $47.2 million impairment charge related to our investment in HBS. Simon’s net income attributable to noncontrolling interests decreased $156.8 million due to a decrease in the net income of the Operating Partnership. Year Ended December 31, 2019 vs. Year Ended December 31, 2018Lease income increased $85.4 million during 2019, of which the property transactions accounted for $33.2 million of the increase. Comparable lease income increased $52.2 million, or 1.0%, due to increases in fixed minimum lease and CAM consideration recorded on a straight-line basis, as a result of the adoption of ASC 842. Total other income increased $27.9 million, primarily due to a $68.0 million increase related to a lawsuit settled with our former insurance broker in 2019 related to the significant flood damage sustained at Opry Mills in May 2010, a $16.2 million gain on the sale of our interest in a multi-family residential property, a $12.4 million increase in interest income, an $11.2 million increase in Simon Brand Venture and gift card revenues, an increase of $10.4 million in land sales including gains as a result of land contributions for densification projects at two of our properties, and the impact of consolidated franchise and hotel revenues, partially offset by a $35.6 million non-cash gain recorded in 2018 associated with our contribution of our interest in the Aéropostale licensing venture for additional interests in ABG, a $26.7 million decrease in lease settlement income, a $23.9 million decrease in income related to distributions from an international investment received in 2018 and a $9.5 million decrease related to business interruption insurance proceeds received in connection with our two Puerto Rico properties as a result of hurricane damages.Depreciation and amortization expense increased $58.0 million, of which the property transactions accounted for $11.0 million. The comparable properties increased $47.0 million primarily as a result of an increase in tenant allowance write-offs in 2019 and the acceleration of depreciation on a property upon initiation of a major redevelopment.Home and regional office costs increased $53.4 million, primarily due to the suspension of leasing cost capitalization in 2019 as a result of the adoption of a new accounting pronouncement.General and administrative expense decreased $11.7 million due to lower executive compensation.Other expense increased $15.8 million primarily related to a $4.9 million unfavorable non-cash mark-to-market on certain of our non-real estate equity instruments, and the impact of consolidated franchise and hotel operational expenses.During 2019, we recorded a loss on extinguishment of debt of $116.3 million as a result of the early redemption of senior unsecured notes.Income from unconsolidated entities decreased $30.9 million as a result of the sale of German assets within our HBS joint venture in 2018, and the impact from the consolidation of a property that was previously unconsolidated in the third quarter of 2018, partially offset by favorable results of operations from our international joint venture investments.During 2019, we recorded net gains of $62.1 million primarily related to Klépierre’s disposition of certain shopping centers, offset by a $47.2 million impairment charge related to our investment in HBS. During 2018, we recorded net gains of $12.5 million related to property insurance recoveries of previously depreciated assets and $276.3 million primarily related to our disposition of two retail properties, as well as the disposal of our interest in the German department stores owned through our investment in HBS, as further discussed in Note 6 of the notes to the consolidated financial statements.Simon’s net income attributable to noncontrolling interests decreased $60.7 million due to a decrease in the net income of the Operating Partnership. 66 Table of ContentsLiquidity and Capital ResourcesBecause we own long-lived income-producing assets, our financing strategy relies primarily on long-term fixed rate debt. Floating rate debt comprised only 12.1% of our total consolidated debt at December 31, 2020. We also enter into interest rate protection agreements from time to time to manage our interest rate risk. We derive most of our liquidity from positive net cash flow from operations and distributions of capital from unconsolidated entities that totaled $2.6 billion in the aggregate during 2020. The Facilities and the Commercial Paper program provide alternative sources of liquidity as our cash needs vary from time to time. Borrowing capacity under these sources may be increased as discussed further below.Our balance of cash and cash equivalents increased $342.2 million during 2020 to $1.0 billion as of December 31, 2020 as further discussed below.On December 31, 2020, we had an aggregate available borrowing capacity of approximately $6.7 billion under the Facilities, net of outstanding borrowings of $2.1 billion, amounts outstanding under the Commercial Paper program of $623.0 million and letters of credit of $12.3 million. For the year ended December 31, 2020, the maximum aggregate outstanding balance under the Facilities was $3.9 billion and the weighted average outstanding balance was $1.8 billion. The weighted average interest rate was 1.04% for the year ended December 31, 2020. Simon has historically had access to public equity markets and the Operating Partnership has historically had access to private and public, short and long-term unsecured debt markets and access to secured debt and private equity from institutional investors at the property level.Our business model and Simon’s status as a REIT require us to regularly access the debt markets to raise funds for acquisition, development and redevelopment activity, and to refinance maturing debt. Simon may also, from time to time, access the equity capital markets to accomplish our business objectives. We believe we have sufficient cash on hand and availability under the Credit Facility and the Supplemental Facility, or together the Credit Facilities, and the Commercial Paper program to address our debt maturities and capital needs through 2021.Cash FlowsOur net cash flow from operating activities and distributions of capital from unconsolidated entities totaled $2.6 billion during 2020. In addition, we had net proceeds from our debt financing and repayment activities of $2.3 billion in 2020. These activities are further discussed below under “Financing and Debt.” During 2020, we also:●funded the acquisition of the ventures which purchased certain assets of Forever 21, acquired additional interests in SPARC Group and ABG, funded the acquisition of the ventures which purchased certain assets of J.C. Penney, and funded the acquisition of an 80% ownership interest in TRG, the aggregate cash portion of which was $3.6 billion,●issued 22,137,500 shares of common stock in a public offering for $1.6 billion, net of issue costs,●paid stockholder dividends and unitholder distributions totaling approximately $1.7 billion and preferred unit distributions totaling $5.3 million,●funded consolidated capital expenditures of $484.1 million (including development and other costs of $26.3 million, redevelopment and expansion costs of $399.3 million, and tenant costs and other operational capital expenditures of $58.5 million),●funded investments in unconsolidated entities of $191.4 million,●funded investments in equity instruments of $33.0 million,●received proceeds on the sale of equity instruments of $30.0 million,●received insurance proceeds from third-party carriers for property restoration related to hurricane damages of $31.2 million, ●funded the repurchase of $152.6 million of Simon’s common stock and redeemed units of the Operating Partnership for $16.1 million.In general, we anticipate that cash generated from operations will be sufficient to meet operating expenses, monthly debt service, recurring capital expenditures, and dividends to stockholders and/or distributions to partners necessary to 67 Table of Contentsmaintain Simon’s REIT qualification on a long-term basis. At this time, we do not expect the impact of COVID-19 to impact our ability to fund these needs for the foreseeable future; however its ultimate impact is difficult to predict. In addition, we expect to be able to generate or obtain capital for nonrecurring capital expenditures, such as acquisitions, major building redevelopments and expansions, as well as for scheduled principal maturities on outstanding indebtedness, from the following, however a severe and prolonged disruption and instability in the global financial markets, including the debt and equity capital markets, may affect our ability to access necessary capital:●excess cash generated from operating performance and working capital reserves,●borrowings on the Credit Facilities and Commercial Paper program,●additional secured or unsecured debt financing, or●additional equity raised in the public or private markets.We expect to generate positive cash flow from operations in 2021, and we consider these projected cash flows in our sources and uses of cash. These cash flows are principally derived from rents paid by our tenants. A significant deterioration in projected cash flows from operations, including one due to the impact of the COVID-19 pandemic and restrictions intended to restrict its spread, could cause us to increase our reliance on available funds from the Credit Facilities and Commercial Paper program, further curtail planned capital expenditures, or seek other additional sources of financing.Financing and DebtUnsecured DebtAt December 31, 2020, our unsecured debt consisted of $17.1 billion of senior unsecured notes of the Operating Partnership, $125.0 million outstanding under the Credit Facility, $2.0 billion outstanding under the Term Facility, and $623.0 million outstanding under Commercial Paper program. On March 16, 2020, the Operating Partnership replaced in its entirety its existing $4.0 billion unsecured revolving credit facility by entering into an unsecured credit facility comprised of (i) an amendment and extension of the Credit Facility and (ii) the Term Facility. The Credit Facility and the Term Facility can be increased in the form of either additional commitments under the Credit Facility or incremental term loans under the Term Facility in an aggregate amount for all such increases not to exceed $1.0 billion, for a total aggregate size of $7.0 billion, in each case, subject to obtaining additional lender commitments and satisfying certain customary conditions precedent. Borrowings may be denominated in U.S. dollars, Euro, Yen, Sterling, Canadian dollars and Australian dollars. Borrowings in currencies other than the U.S. dollar are limited to 95% of the maximum revolving credit amount, as defined. The initial maturity date of the Term Facility and Credit Facility are June 30, 2022 and June 30, 2024, respectively. Each of the Term Facility and Credit Facility can be extended for two additional six-month periods to June 30, 2023 and June 30, 2025, respectively, at our sole option, subject to satisfying certain customary conditions precedent. The Term Facility was available via a single draw during the nine-month period following March 16, 2020, which the Operating Partnership drew on December 15, 2020.Borrowings under the Credit Facility bear interest, at the Operating Partnership’s election, at either (i) LIBOR plus a margin determined by the Operating Partnership’s corporate credit rating of between 0.65% and 1.40% or (ii) the base rate (which rate is equal to the greatest of the prime rate, the federal funds effective rate plus 0.50% or LIBOR plus 1.00%) (the “Base Rate”), plus a margin determined by the Operating Partnership’s corporate credit rating of between 0.00% and 0.40%. The Credit Facility includes a facility fee determined by the Operating Partnership’s corporate credit rating of between 0.10% and 0.30% on the aggregate revolving commitments under the Credit Facility. The Credit Facility contains a money market competitive bid option program that allows the Operating Partnership to hold auctions to achieve lower pricing for short-term borrowings. Borrowings under the Term Facility bear interest, at the Operating Partnership’s election, at either (i) LIBOR plus a margin determined based on the Operating Partnership’s corporate credit rating of between 0.725% and 1.60% or (ii) the base rate (equal to the greatest of the prime rate, the federal funds effective rate plus 0.50% or LIBOR plus 1.00%) plus a margin determined by the Operating Partnership’s corporate credit rating of between 0.00% and 0.60%. The Term Facility includes a ticking fee equal to 0.10% of the unused term loan commitment under the Term Facility, which ticking fee commenced accruing on the date that is forty-five days after the closing of the Term Facility.The Supplemental Facility’s initial borrowing capacity of $3.5 billion may be increased to $4.5 billion during its term and provides for borrowings denominated in U.S. dollars, Euro, Yen, Sterling, Canadian dollars and Australian dollars. The initial maturity date of the Supplemental Facility was extended to June 30, 2022 and can be extended for an additional year 68 Table of Contentsto June 30, 2023 at our sole option, subject to our continued compliance with the terms thereof. The base interest rate on the Supplemental Facility is LIBOR plus 77.5 basis points, with an additional facility fee of 10 basis points. On December 31, 2020, we had an aggregate available borrowing capacity of $6.7 billion under the Facilities. The maximum aggregate outstanding balance under the Facilities during the year ended December 31, 2020 was $3.9 billion and the weighted average outstanding balance was $1.8 billion. Letters of credit of $12.3 million were outstanding under the Facilities as of December 31, 2020.The Operating Partnership also has available a Commercial Paper program of $2.0 billion, or the non-U.S. dollar equivalent thereof. The Operating Partnership may issue unsecured commercial paper notes, denominated in U.S. dollars, Euro and other currencies. Notes issued in non-U.S. currencies may be issued by one or more subsidiaries of the Operating Partnership and are guaranteed by the Operating Partnership. Notes will be sold under customary terms in the U.S. and Euro commercial paper note markets and rank (either by themselves or as a result of the guarantee described above) pari passu with the Operating Partnership's other unsecured senior indebtedness. The Commercial Paper program is supported by the Credit Facilities and if necessary or appropriate, we may make one or more draws under either of the Credit Facilities to pay amounts outstanding from time to time on the Commercial Paper program. On December 31, 2020, we had $623.0 million outstanding under the Commercial Paper program, fully comprised of U.S. dollar denominated notes with a weighted average interest rate of 0.29%. These borrowings have a weighted average maturity date of February 19, 2021 and reduce amounts otherwise available under the Credit Facilities.On July 9, 2020, the Operating Partnership completed the issuance of the following senior unsecured notes: $500.0 million with a fixed interest rate of 3.50%, $750 million with a fixed interest rate of 2.65%, and $750 million with a fixed interest rate of 3.80%, with maturity dates of September 2025 (the “2025” Notes”), June 2030, and June 2050, respectively. The 2025 Notes were issued as additional notes under an indenture pursuant to which the Operating Partnership previously issued $600 million principal amount of 3.50% senior notes due September 2025 on August 17, 2015. Proceeds from the unsecured notes offering funded the optional redemption at par of senior unsecured notes in July and August 2020, as discussed below, and repaid a portion of the indebtedness under the Facilities.On July 10, 2020 the Operating Partnership repaid $1.75 billion under the Credit Facility and $750.0 million under the Supplemental Facility.On July 22, 2020, the Operating Partnership completed the optional redemption at par of its $500 million 2.50% notes due September 1, 2020. On August 6, 2020 the Operating Partnership completed the optional redemption at par of its €375 million 2.375% notes due October 2, 2020.On January 21, 2021 the Operating Partnership completed the issuance of the following senior unsecured notes: $800 million with a fixed interest rate of 1.75%, and $700 million with a fixed interest rate of 2.20%, with maturity dates of January 2028 and 2031, respectively.On January 27, 2021 the Operating Partnership completed the planned optional redemption of its $550 million 2.50% notes due on July 15, 2021, including the make-whole amount. Further, on February 2, 2021, the Operating Partnership repaid $750 million under the Term Facility.On October 7, 2019 the Operating Partnership completed the early redemption of its $900 million 4.375% notes due March 1, 2021, $700 million 4.125% notes due December 1, 2021, $600 million 3.375% notes due March 15, 2022 and €375 million of the €750 million 2.375% notes due October 2, 2020. We recorded a $116.3 million loss on extinguishment of debt in the fourth quarter of 2019 as a result of the early redemption.Mortgage DebtTotal consolidated mortgage indebtedness, which is typically secured by the underlying assets and non-recourse to the Operating Partnership, was $7.0 billion and $6.9 billion at December 31, 2020 and 2019, respectively.CovenantsOur unsecured debt agreements contain financial covenants and other non-financial covenants. If we were to fail to comply with these covenants, after the expiration of the applicable cure periods, the debt maturity could be accelerated or other remedies could be sought by the lender, including adjustments to the applicable interest rate. As of December 31, 2020, we were in compliance with all covenants of our unsecured debt.69 Table of ContentsAt December 31, 2020, our consolidated subsidiaries were the borrowers under 46 non-recourse mortgage notes secured by mortgages on 49 properties and other assets, including two separate pools of cross-defaulted and cross-collateralized mortgages encumbering a total of five properties. Under these cross-default provisions, a default under any mortgage included in the cross-defaulted pool may constitute a default under all mortgages within that pool and may lead to acceleration of the indebtedness due on each property within the pool. Certain of our secured debt instruments contain financial and other non-financial covenants which are specific to the properties that serve as collateral for that debt. If the applicable borrower under these non-recourse mortgage notes were to fail to comply with these covenants, the lender could accelerate the debt and enforce its rights against their collateral. At December 31, 2020, the applicable borrowers under these non-recourse mortgage notes were in compliance with all covenants where non-compliance could individually or in the aggregate, giving effect to applicable cross-default provisions, have a material adverse effect on our financial condition, liquidity or results of operations.Summary of FinancingOur consolidated debt, adjusted to reflect outstanding derivative instruments, and the effective weighted average interest rates as of December 31, 2020 and 2019, consisted of the following (dollars in thousands):​​​​​​​​​​​​​ ​​ Effective ​​ Effective ​​Adjusted Balance​Weighted​Adjusted ​Weighted ​​as of​Average​Balance as of​Average Debt Subject to​December 31, 2020 Interest Rate(1)​December 31, 2019 Interest Rate(1)​Fixed Rate​$ 23,477,498 3.50%​$ 23,298,167 3.46%​Variable Rate​ 3,245,863 1.31%​ 865,063 2.61%​​​$ 26,723,361 2.98%​$ 24,163,230 3.16%​(1)Effective weighted average interest rate excludes the impact of net discounts and debt issuance costs.Contractual Obligations and Off-balance Sheet ArrangementsIn regards to long-term debt arrangements, the following table summarizes the material aspects of these future obligations on our consolidated indebtedness as of December 31, 2020, and subsequent years thereafter (dollars in thousands) assuming the obligations remain outstanding through initial maturities:​​​​​​​​​​​​​​​​​​ 2021 2022-2023 2024-2025 After 2025 Total Long Term Debt (1) (2) (5)​$ 2,322,729​$ 6,664,864​$ 6,034,695​$ 11,768,557​$ 26,790,845​Interest Payments (3)​ 787,627​ 1,367,869​ 1,065,883​ 3,888,169​ 7,109,548​Consolidated Capital Expenditure Commitments (3)​ 183,447​ —​ —​ —​ 183,447​Lease Commitments (4)​ 32,787​ 65,765​ 66,185​ 886,336​ 1,051,073​(1)Represents principal maturities only and, therefore, excludes net discounts and debt issuance costs.(2)Variable rate interest payments are estimated based on the LIBOR or other applicable rate at December 31, 2020.(3)Represents contractual commitments for capital projects and services at December 31, 2020. Our share of estimated 2020 development, redevelopment and expansion activity is further discussed below under “Development Activity”.(4)Represents only the minimum non-cancellable lease period, excluding applicable lease extension and renewal options, unless reasonably certain of exercise.(5)The amount due in 2021 includes $623.0 million in Global Commercial Paper.Our off-balance sheet arrangements consist primarily of our investments in joint ventures which are common in the real estate industry and are described in Note 6 of the notes to the consolidated financial statements. Our joint ventures typically fund their cash needs through secured non-recourse debt financings obtained by and in the name of the joint venture entity. The joint venture debt is secured by a first mortgage, is without recourse to the joint venture partners, and does not represent a liability of the partners, except to the extent the partners or their affiliates expressly guarantee the joint venture debt. As of December 31, 2020, the Operating Partnership guaranteed joint venture-related mortgage 70 Table of Contentsindebtedness of $219.2 million. Mortgages guaranteed by the Operating Partnership are secured by the property of the joint venture which could be sold in order to satisfy the outstanding obligation and which has an estimated fair value in excess of the guaranteed amount. We may elect to fund cash needs of a joint venture through equity contributions (generally on a basis proportionate to our ownership interests), advances or partner loans, although such fundings are not required contractually or otherwise.Hurricane ImpactsAs discussed further in Note 10 of the notes to the consolidated financial statements, during the third quarter of 2017, two of our wholly-owned properties located in Puerto Rico sustained significant property damage and business interruption as a result of Hurricane Maria. Since the date of the loss, we have received $81.1 million of insurance proceeds from third-party carriers related to the two properties located in Puerto Rico, of which $47.5 million was used for property restoration and remediation and to reduce the insurance recovery receivable. During the years ended December 31, 2020 and 2019, we recorded $5.2 million and $10.5 million, respectively, as business interruption income, which was recorded in other income in the accompanying consolidated statements of operations and comprehensive income. During the third quarter of 2020, one of our properties located in Texas experienced property damage and business interruption as a result of Hurricane Hanna. We wrote-off assets of approximately $9.6 million, and recorded an insurance recovery receivable, and have received $14.3 million of insurance proceeds from third-party carriers. The proceeds were used for property restoration and remediation and reduced the insurance recovery receivable.During the third quarter of 2020, one of our properties located in Louisiana experienced property damage and business interruption as a result of Hurricane Laura. We wrote-off assets of approximately $11.1 million and recorded an insurance recovery receivable, and have received $20.6 million of insurance proceeds from third-party carriers. The proceeds were used for property restoration and remediation and reduced the insurance recovery receivable. Acquisitions and DispositionsBuy-sell, marketing rights, and other exit mechanisms are common in real estate partnership agreements. Most of our partners are institutional investors who have a history of direct investment in retail real estate. We and our partners in our joint venture properties may initiate these provisions (subject to any applicable lock up or similar restrictions). If we determine it is in our best interests for us to purchase the joint venture interest and we believe we have adequate liquidity to execute the purchase without hindering our cash flows, then we may initiate these provisions or elect to buy our partner’s interest. If we decide to sell any of our joint venture interests, we expect to use the net proceeds to reduce outstanding indebtedness or to reinvest in development, redevelopment, or expansion opportunities.Acquisitions. In January 2020, we acquired additional interests of 5.05% and 1.37% in SPARC Group and ABG, respectively, for $6.7 million and $33.5 million, respectively. During the third quarter of 2020, SPARC acquired certain assets and operations of Brooks Brothers and Lucky Brands out of bankruptcy. At September 30, 2020, our noncontrolling equity method interests in the operations venture of SPARC Group and in ABG were 50.0% and 6.8%, respectively.On September 19, 2019, we acquired the remaining 50% interest in a hotel adjacent to one of our properties from our joint venture partner for cash consideration of $12.8 million. As of closing, the property was subject to a $21.5 million, 4.02% variable rate mortgage. On September 25, 2018, we acquired the remaining 50% interest in The Outlets at Orange from our joint venture partner. The Operating Partnership issued 475,183 units, or approximately $84.1 million, as consideration for the acquisition. The property is subject to a $215.0 million 4.22% fixed rate mortgage loan. Dispositions. We may continue to pursue the disposition of properties that no longer meet our strategic criteria or that are not a primary retail venue within their trade area.During 2020, we disposed of our interest in one consolidated retail property. A portion of the gross proceeds on this transaction of $33.4 million was used to partially repay a cross-collateralized mortgage. Our share of the $12.3 million gain is included in (loss) gain on sale or disposal of, or recovery on, assets and interests in unconsolidated entities and impairment, net in the accompanying consolidated statement of operations and comprehensive income. During 2019, we disposed of our interests in one multi-family residential investment. Our share of the gross proceeds on this transaction was $17.9 million. Our share of the gain of $16.2 million is included in other income in the accompanying consolidated statement of operations and comprehensive income. We also recorded net gains of $62.1 million, primarily 71 Table of Contentsrelated to Klépierre’s disposition of its interests in certain shopping centers, of which our share was $58.6 million, as discussed in Note 6 to the consolidated financial statements.During 2018, we recorded net gains of $288.8 million primarily related to disposition activity which included the foreclosure of two consolidated retail properties in satisfaction of their $200.0 million and $80.0 million non-recourse mortgage loans and, as discussed in Note 6 of the notes to the consolidated financial statements, our interest in the German department store properties owned through our investment in HBS was sold during the fourth quarter of 2018. Also, as discussed further in Note 6 of the notes to the consolidated financial statements, Klépierre disposed of its interests in certain shopping centers resulting in a gain of which our share was $20.2 million.Joint Venture Formation ActivityOn December 29, 2020, we completed the acquisition of an 80% ownership interest in TRG, which has an ownership interest in 24 regional, super-regional, and outlet malls in the U.S. and Asia. Under the terms of the transaction, we, through the Operating Partnership, acquired all of Taubman Centers, Inc. common stock for $43.00 per share in cash. Total consideration for the acquisition, including the redemption of Taubman’s $192.5 million 6.5% Series J Cumulative Preferred Shares and its $170.0 million 6.25% Series K Cumulative Preferred Shares, and the issuance of 955,705 Operating Partnership units, was approximately $3.5 billion. Our investment includes the 6.38% Series A Cumulative Redeemable Preferred Units for $362.5 million issued to us.On December 7, 2020, we and a group of co-investors acquired certain assets and liabilities of J.C. Penney, a department store retailer, out of bankruptcy. Our noncontrolling interest in the venture is 41.67% and was acquired for cash consideration of $125.0 million.On February 19, 2020, we and a group of co-investors acquired certain assets and liabilities of Forever 21, a retailer of apparel and accessories, out of bankruptcy. The interests were acquired through two separate joint ventures, a licensing venture and an operating venture. Our noncontrolling interest in each of the retail operations venture and in the licensing venture is 37.5%. Our aggregate investment in the ventures was $67.6 million. In connection with the acquisition of our interest, the Forever 21 joint venture recorded a non-cash bargain purchase gain of which our share of $35.0 million pre-tax is included in income from unconsolidated entities in the consolidated statement of operations and comprehensive income.On October 16, 2019, we contributed approximately $276.8 million consisting of cash and the Shop Premium Outlets, or SPO, assets for a 45% noncontrolling interest in Rue Gilt Groupe, or RGG, to create a new multi-platform venture dedicated to digital value shopping, as further discussed in Note 6 to the consolidated financial statements. Development ActivityWe routinely incur costs related to construction for significant redevelopment and expansion projects at our properties. Redevelopment and expansion projects, including the addition of anchors, big box tenants, and restaurants are underway at several properties in the United States, Canada, Europe, and Asia.In response to the COVID-19 pandemic, the Company has suspended more than $1.0 billion of capital in development projects. The Company will re-evaluate all suspended projects over time. Construction continues on certain redevelopment and new development projects in the U.S. and internationally that are nearing completion. Our share of the costs of all new development, redevelopment and expansion projects currently under construction is approximately $829 million. Simon’s share of remaining net cash funding required to complete the new development and redevelopment projects currently under construction is approximately $89 million. We expect to fund these capital projects with cash flows from operations. We seek a stabilized return on invested capital in the range of 8-10% for all of our new development, expansion and redevelopment projects.72 Table of ContentsSummary of Capital Expenditures. The following table summarizes total capital expenditures on consolidated properties on a cash basis (in millions):​​​​​​​​​​​​ 2020 2019 2018 New Developments​$ 27​$ 73​$ 87​Redevelopments and Expansions​ 399​ 498​ 419​Tenant Allowances​ 53​ 162​ 144​Operational Capital Expenditures​ 5​ 143​ 132​Total​$ 484​$ 876​$ 782​​​73 Table of ContentsInternational Development Activity We typically reinvest net cash flow from our international joint ventures to fund future international development activity. We believe this strategy mitigates some of the risk of our initial investment and our exposure to changes in foreign currencies. We have also funded most of our foreign investments with local currency-denominated borrowings that act as a natural hedge against fluctuations in exchange rates. Our consolidated net income exposure to changes in the volatility of the Euro, Yen, Peso, Won, and other foreign currencies is not material. We expect our share of estimated committed capital for international development projects to be completed with projected delivery in 2021 or 2022 is $36 million, primarily funded through reinvested joint venture cash flow and construction loans.The following table describes recently completed and new development and expansion projects as well as our share of the estimated total cost as of December 31, 2020 (in millions):​​​​​​​​​​​​​​​​​​​Gross​Our​Our Share of​Our Share of​Projected​​​​Leasable​Ownership​Projected Net Cost​Projected Net Cost​OpeningProperty Location Area (sqft) Percentage (in Local Currency) (in USD) (1) DateNew Development Projects:​​​​​​​​​​​​​​Málaga Designer Outlet​Málaga, Spain​ 191,000​46%​EUR 50.3​$ 61.7​Opened Feb. - 2020Siam Premium Outlets Bangkok​Bangkok, Thailand​ 264,000​50%​THB 1,654​$ 55.2​Opened Jun. - 2020West Midlands Designer Outlet​Cannock (West Midlands), England​ 197,000​23%​GBP 31.2​$ 42.6​Mar. 2021Expansions:​​​​​​​​​​​​​​Gotemba Premium Outlets Phase 4​Gotemba, Japan​ 178,000​40%​JPY 7,476​$ 72.5​Opened Jun. - 2020Rinku Premium Outlets Phase 5​Izumisano (Osaka), Japan​ 110,000​40%​JPY 3,219​$ 31.2​Opened Aug. - 2020La Reggia Designer Outlet Phase 3​Marcianise (Naples), Italy​ 58,000​92%​EUR 30.9​$ 37.9​Nov. 2021(1)USD equivalent based upon December 31, 2020 foreign currency exchange rates.Dividends, Distributions and Stock Repurchase ProgramSimon paid a common stock dividend of $1.30 per share in the fourth quarter of 2020 and $4.70 per share for the year ended December 31, 2020. The Operating Partnership paid distributions per unit for the same amounts. In 2019, Simon paid dividends of $2.10 and $8.30 per share for the three and twelve month periods ended December 31, 2019, respectively. The Operating Partnership paid distributions per unit for the same amounts. On December 15, 2020, Simon’s Board of Directors declared a quarterly cash dividend for the fourth quarter of 2020 of $1.30 per share, payable on January 22, 2021 to shareholders of record on December 24, 2020. The distribution rate on units is equal to the dividend rate on common stock. In order to maintain its status as a REIT, Simon must pay a minimum amount of dividends. Simon’s future dividends and the Operating Partnership’s future distributions will be determined by Simon’s Board of Directors, in its sole discretion, based on actual and projected financial condition, liquidity and results of operations, cash available for dividends and limited partner distributions, cash reserves as deemed necessary for capital and operating expenditures, financing covenants, if any, and the amount required to maintain Simon’s status as a REIT.On February 13, 2017, Simon’s Board of Directors authorized a two-year extension of the previously authorized $2.0 billion common stock repurchase plan through March 31, 2019. On February 11, 2019, Simon's Board of Directors authorized a new common stock repurchase plan. Under the plan, Simon could repurchase up to $2.0 billion of its common stock during the two-year period ending February 11, 2021 in the open market or in privately negotiated transactions as market conditions warrant. During the year ended December 31, 2020, Simon purchased 1,245,654 shares at an average price of $122.50 per share. During the year ended December 31, 2019, Simon purchased 2,247,074 shares at an average price of $160.11 per share, of which 46,377 shares at an average price of $164.49 were purchased as part of the previous program. At December 31, 2020, we had remaining authority to repurchase approximately $1.5 billion of common stock, which has subsequently expired. As Simon repurchases shares under these programs, the Operating Partnership repurchases an equal number of units from Simon. Forward-Looking StatementsCertain statements made in this section or elsewhere in this Annual Report on Form 10-K may be deemed "forward–looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995. Although we believe the expectations reflected in any forward–looking statements are based on reasonable assumptions, we can give no assurance that its expectations will be attained, and it is possible that our actual results may differ materially from those indicated by 74 Table of Contentsthese forward–looking statements due to a variety of risks, uncertainties and other factors. Such factors include, but are not limited to: uncertainties regarding the impact of the COVID-19 pandemic and governmental restrictions intended to prevent its spread on our business, financial condition, results of operations, cash flow and liquidity and our ability to access the capital markets, satisfy our debt service obligations and make distributions to our stockholders; changes in economic and market conditions that may adversely affect the general retail environment; the potential loss of anchor stores or major tenants; the inability to collect rent due to the bankruptcy or insolvency of tenants or otherwise; the intensely competitive market environment in the retail industry, including e-commerce; an increase in vacant space at our properties; the inability to lease newly developed properties and renew leases and relet space at existing properties on favorable terms; our international activities subjecting us to risks that are different from or greater than those associated with our domestic operations, including changes in foreign exchange rates; risks associated with the acquisition, development, redevelopment, expansion, leasing and management of properties; general risks related to real estate investments, including the illiquidity of real estate investments; the impact of our substantial indebtedness on our future operations, including covenants in the governing agreements that impose restrictions on us that may affect our ability to operate freely; any disruption in the financial markets that may adversely affect our ability to access capital for growth and satisfy our ongoing debt service requirements; any change in our credit rating; changes in market rates of interest; the transition of LIBOR to an alternative reference rate; our continued ability to maintain our status as a REIT; changes in tax laws or regulations that result in adverse tax consequences; risks relating to our joint venture properties, including guarantees of certain joint venture indebtedness; environmental liabilities; natural disasters; the availability of comprehensive insurance coverage; the potential for terrorist activities; security breaches that could compromise our information technology or infrastructure; and the loss of key management personnel; and. We discussed these and other risks and uncertainties under the heading "Risk Factors" in Part 1, Item 1A of this Annual Report on Form 10-K. We may update that discussion in subsequent other periodic reports, but except as required by law, we undertake no duty or obligation to update or revise these forward-looking statements, whether as a result of new information, future developments, or otherwise. Non-GAAP Financial MeasuresIndustry practice is to evaluate real estate properties in part based on performance measures such as FFO, diluted FFO per share, NOI, and portfolio NOI. We believe that these non-GAAP measures are helpful to investors because they are widely recognized measures of the performance of REITs and provide a relevant basis for comparison among REITs. We also use these measures internally to measure the operating performance of our portfolio.We determine FFO based upon the definition set forth by the National Association of Real Estate Investment Trusts (“NAREIT”) Funds From Operations White Paper – 2018 Restatement. Our main business includes acquiring, owning, operating, developing, and redeveloping real estate in conjunction with the rental of real estate. Gains and losses of assets incidental to our main business are included in FFO. We determine FFO to be our share of consolidated net income computed in accordance with GAAP:●excluding real estate related depreciation and amortization,●excluding gains and losses from extraordinary items,●excluding gains and losses from the sale, disposal or property insurance recoveries of, or any impairment related to, depreciable retail operating properties,●plus the allocable portion of FFO of unconsolidated joint ventures based upon economic ownership interest, and●all determined on a consistent basis in accordance with GAAP.You should understand that our computations of these non-GAAP measures might not be comparable to similar measures reported by other REITs and that these non-GAAP measures:●do not represent cash flow from operations as defined by GAAP,●should not be considered as an alternative to net income determined in accordance with GAAP as a measure of operating performance, and●are not an alternative to cash flows as a measure of liquidity.75 Table of ContentsThe following schedule reconciles total FFO to consolidated net income and, for Simon, diluted net income per share to diluted FFO per share.​​​​​​​​​​​​​​​​​​​​​​​ ​​​​​​​​​​​​​​2020​2019​2018​​​​(in thousands)​ Funds from Operations (A)​$3,236,963​$4,272,271​$ 4,324,601​​Change in FFO from prior period​ (24.2)% (1.2)% 7.6%​Consolidated Net Income​$1,277,324​$2,423,188​$ 2,822,343​​Adjustments to Arrive at FFO:​​​​​​​​​​​Depreciation and amortization from consolidated properties​ 1,308,419​ 1,329,843​ 1,270,888​​Our share of depreciation and amortization from unconsolidated entities, including Klépierre and other corporate investments​ 536,133​ 551,596​ 533,595​​Loss (gain) on sale or disposal of, or recovery on, assets and interests in unconsolidated entities and impairment, net ​ 114,960​ (14,883)​ (288,827)​​Unrealized losses (gains) in fair value of equity instruments​​ 19,632​​ 8,212​​ 15,212​​Net loss (gain) attributable to noncontrolling interest holders in properties​ 4,378​ (991)​ (11,327)​​Noncontrolling interests portion of depreciation and amortization and loss (gain) on disposal of properties​ (18,631)​ (19,442)​ (12,031)​​Preferred distributions and dividends​ (5,252)​ (5,252)​ (5,252)​​FFO of the Operating Partnership (A)​$3,236,963​$4,272,271​$ 4,324,601​​FFO allocable to limited partners​ 424,063​ 563,342​ 568,817​​Dilutive FFO allocable to common stockholders (A)​$2,812,900​$3,708,929​$ 3,755,784​​Diluted net income per share to diluted FFO per share reconciliation:​​​​​​​​​​​Diluted net income per share​$ 3.59​$ 6.81​$ 7.87​​Depreciation and amortization from consolidated properties and our share of depreciation and amortization from unconsolidated entities, including Klépierre and other corporate investments, net of noncontrolling interests portion of depreciation and amortization​ 5.14​ 5.25​ 5.01​​Loss (gain) on sale or disposal of, or recovery on, assets and interests in unconsolidated entities and impairment, net​ 0.32​ (0.04)​ (0.79)​​Unrealized losses (gains) in fair value of equity instruments​​ 0.06​​ 0.02​​ 0.04​​Diluted FFO per share (A)​$ 9.11​$ 12.04​$ 12.13​​Basic and Diluted weighted average shares outstanding​ 308,738​ 307,950​ 309,627​​Weighted average limited partnership units outstanding​ 46,544​ 46,774​ 46,893​​Basic and Diluted weighted average shares and units outstanding​ 355,282​ 354,724​ 356,520​​(A)Includes FFO of the Operating Partnership related to a loss on extinguishment of debt of $116.3 million for the year ended December 31, 2019. Includes Diluted FFO per share/unit related to a loss on extinguishment of debt of $0.33 for the year ended December 31, 2019. Includes Diluted FFO allocable to common stockholders related to a loss on extinguishment of debt of $100.9 million for the year ended December 31, 2019.76 Table of ContentsThe following schedule reconciles consolidated net income to NOI.​​​​​​​​​​For the Year ​​Ended December 31, ​ 2020 2019 ​​(in thousands) Reconciliation of NOI of consolidated entities:​​ ​​​Consolidated Net Income​$1,277,324​$2,423,188​Income and other tax expense (benefit)​ (4,637)​ 30,054​Interest expense​ 784,400​ 789,353​Income from unconsolidated entities​ (219,870)​ (444,349)​Loss on extinguishment of debt​​ --​​ 116,256​Unrealized losses (gains) in fair value of equity instruments​ 19,632​ 8,212​Loss (gain) on sale or disposal of, or recovery on, assets and interests in unconsolidated entities and impairment, net​ 114,960​ (14,883)​Operating Income Before Other Items​ 1,971,809​ 2,907,831​Depreciation and amortization​ 1,318,008​ 1,340,503​Home and regional office costs​​ 171,668​​ 190,109​General and administrative​​ 22,572​​ 34,860​NOI of consolidated entities​$3,484,057​$4,473,303​Reconciliation of NOI of unconsolidated entities:​​​​​​​Net Income​$ 453,816​$ 892,506​Interest expense​ 616,332​ 636,988​Gain on sale or disposal of, or recovery on, assets and interests in unconsolidated entities, net​ —​ (24,609)​Operating Income Before Other Items​ 1,070,148​ 1,504,885​Depreciation and amortization​ 692,424​ 681,764​NOI of unconsolidated entities​$1,762,572​$2,186,649​Add: Our share of NOI from Klépierre, and other corporate investments​​ 253,093​​ 293,979​Combined NOI​$5,499,722​$6,953,931​Less: Corporate and Other NOI Sources (1)​ 228,874​ 548,117​Less: Our share of NOI from Retailer Investments ​​ 21,507​​ 40,149​Less: Our share of NOI from Investments (2)​​ 194,174​​ 269,598​Portfolio NOI​$5,055,167​$6,096,067​Portfolio NOI Change​​ (17.1)% ​​​(1)Includes income components excluded from portfolio NOI (domestic lease termination income, interest income, land sale gains, straight line lease income, above/below market lease adjustments), unrealized and realized gains/losses on non-real estate related equity instruments, Northgate, Simon management company revenues, and other assets. (2)Includes our share of NOI of Klépierre (at constant currency) and other corporate investments.Item 7A. Qualitative and Quantitative Disclosures About Market RiskOur exposure to market risk due to changes in interest rates primarily relates to our long-term debt obligations. We manage exposure to interest rate market risk through our risk management strategy by a combination of interest rate protection agreements to effectively fix or cap a portion of variable rate debt. We are also exposed to foreign currency risk on financings of certain foreign operations. Our intent is to offset gains and losses that occur on the underlying exposures, with gains and losses on the derivative contracts hedging these exposures. We do not enter into either interest rate protection or foreign currency rate protection agreements for speculative purposes.77 Table of ContentsWe may enter into treasury lock agreements as part of anticipated issuances of senior notes. Upon completion of the debt issuance, the cost of these instruments is recorded as part of accumulated other comprehensive income (loss) and is amortized to interest expense over the life of the debt agreement.Our future earnings, cash flows and fair values relating to financial instruments are dependent upon prevalent market rates of interest, primarily LIBOR. Based upon consolidated indebtedness and interest rates at December 31, 2020, a 50 basis point increase in the market rates of interest would decrease future earnings and cash flows by approximately $16.3 million, and would decrease the fair value of debt by approximately $747.2 million.​78 Table of ContentsItem 8. Financial Statements and Supplementary DataReport of Independent Registered Public Accounting FirmThe Stockholders and the Board of Directors of Simon Property Group, Inc.:Opinion on Internal Control over Financial ReportingWe have audited Simon Property Group, Inc.’s internal control over financial reporting as of December 31, 2020, based on criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 Framework) (the COSO criteria). In our opinion, Simon Property Group, Inc. (the Company) maintained, in all material respects, effective internal control over financial reporting as of December 31, 2020, based on the COSO criteria. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (PCAOB), the consolidated balance sheets of the Company as of December 31, 2020 and 2019, the related consolidated statements of operations and comprehensive income, equity and cash flows for each of the three years in the period ended December 31, 2020, and the related notes and financial statement schedule listed in the Index at Item 15(a) and our report dated February 25, 2021, expressed an unqualified opinion thereon.Basis for OpinionThe Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Management’s Report on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.We conducted our audit in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.Definition and Limitations of Internal Control Over Financial ReportingA company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.​/s/ Ernst & Young LLP​​Indianapolis, IndianaFebruary 25, 2021​​79 Table of ContentsReport of Independent Registered Public Accounting FirmThe Stockholders and the Board of Directors of Simon Property Group, Inc.:Opinion on the Financial StatementsWe have audited the accompanying consolidated balance sheets of Simon Property Group, Inc. (the Company) as of December 31, 2020 and 2019, the related consolidated statements of operations and comprehensive income, equity and cash flows for each of the three years in the period ended December 31, 2020, and the related notes and financial statement schedule listed in the Index at Item 15(a) (collectively referred to as the “consolidated financial statements”). In our opinion, the consolidated financial statements present fairly, in all material respects, the financial position of the Company at December 31, 2020 and 2019, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2020, in conformity with U.S. generally accepted accounting principles.We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (PCAOB), the Company’s internal control over financial reporting as of December 31, 2020, based on criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 Framework) and our report dated February 25, 2021, expressed an unqualified opinion thereon.Basis for OpinionThese financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on the Company’s financial statements based on our audits. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether due to error or fraud. Our audits included performing procedures to assess the risks of material misstatement of the financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements. We believe that our audits provide a reasonable basis for our opinion.Critical Audit Matters The critical audit matters communicated below are matters arising from the current period audit of the financial statements that were communicated or required to be communicated to the audit committee and that: (1) relate to accounts or disclosures that are material to the financial statements and (2) involved our especially challenging, subjective or complex judgments. The communication of critical audit matters does not alter in any way our opinion on the consolidated financial statements, taken as a whole, and we are not, by communicating the critical audit matters below, providing separate opinions on the critical audit matters or on the accounts or disclosures to which they relate.​​​​Evaluation of Investment Properties for Impairment​Description of the Matter​At December 31, 2020, the Company’s consolidated net investment properties totaled $23.2 billion. In addition, a significant number of the Company’s investments in unconsolidated entities and its investment in Klépierre hold investment properties. As discussed in Note 3 to the consolidated financial statements, the Company reviews investment properties for impairment on a property-by-property basis to identify and evaluate events or changes in circumstances that indicate the carrying value of an investment property may not be recoverable. The Company estimates undiscounted cash flows of an investment property using observable and unobservable inputs such as historical and forecasted cash flows, operating income before depreciation and amortization, estimated capitalization rates, leasing prospects and local market information. ​Auditing management’s evaluation of investment properties for impairment was complex due to the estimation uncertainty in determining the undiscounted cash flows of an investment property. In particular, the impairment evaluation for investment properties was sensitive to significant assumptions such as forecasted cash flows and operating income before depreciation and amortization, and capitalization rates, all of which can be affected by expectations about future market ​80 Table of Contents​​​or economic conditions, demand, and competition.​​How We Addressed the Matter in Our Audit​We obtained an understanding, evaluated the design, and tested the operating effectiveness of controls over the Company’s process for evaluating investment properties for impairment, including controls over management’s review of the significant assumptions described above. ​To test the Company’s evaluation of investment properties for impairment, we performed audit procedures that included, among others, assessing the methodologies applied, evaluating the significant assumptions discussed above and testing the completeness and accuracy of the underlying data used by management in its analysis. We compared the significant assumptions used by management to current industry and economic trends, relevant market information, and other applicable sources. We also involved a valuation specialist to assist in evaluating certain assumptions. In addition, we compared the forecasted cash flows and operating income before depreciation and amortization to historical actual results and evaluated significant variances, including consideration of the current economic environment. As part of our evaluation, we assessed the historical accuracy of management’s estimates and performed sensitivity analyses of significant assumptions to evaluate the changes in the undiscounted cash flows of the related investment property that would result from changes in the assumptions.​​​Evaluation of Investments in Unconsolidated Entities for ImpairmentDescription of the Matter​At December 31, 2020, the carrying value of the Company’s investments in unconsolidated entities and its investment in Klépierre totaled $4.3 billion. As explained in Note 3 to the consolidated financial statements, the Company reviews investments in unconsolidated entities for impairment if events or changes in circumstances indicate that the carrying value of an investment in an unconsolidated entity may not be recoverable. To identify and evaluate whether an other-than-temporary decline in the fair value of an investment below its carrying value has occurred, the Company assesses economic and operating conditions that may affect the fair value of the investment. The evaluation of operating conditions may include developing estimates of forecasted cash flows or operating income before depreciation and amortization to support the recoverability of the carrying amount of the investment. When required, the Company estimates the fair value of an investment and assesses whether any impairment is other-than-temporary using observable and unobservable inputs such as historical and forecasted cash flows or operating income, estimated capitalization and discount rates, or relevant market multiples, leasing prospects and local market information. ​Auditing management’s evaluation of investments in unconsolidated entities for impairment was complex due to the estimation uncertainty in determining the forecasted cash flows, operating income before depreciation and amortization, estimated fair value of each investment and whether any decline in fair value below the related investment’s carrying amount is other-than-temporary. In particular, the impairment evaluation for these investments was sensitive to significant assumptions such as forecasted cash flows, operating income before depreciation and amortization, relevant market multiples, and capitalization and discount rates, all of which can be affected by expectations about future market or economic conditions, demand, and competition.​​81 Table of ContentsHow We Addressed the Matter in Our Audit​We obtained an understanding, evaluated the design, and tested the operating effectiveness of controls over the Company’s process for evaluating investments in unconsolidated entities for impairment, including controls over management’s review of the significant assumptions described above.​To test the Company’s evaluation of investments in unconsolidated entities for impairment, we performed audit procedures that included, among others, assessing the methodologies applied, evaluating the significant assumptions discussed above and testing the completeness and accuracy of data used by management in its analysis. We compared the significant assumptions used by management to current industry and economic trends, relevant market information, and other applicable sources. We also involved a valuation specialist to assist in evaluating certain assumptions. In addition, we compared the forecasted cash flows and operating income before depreciation and amortization to historical actual results and evaluated significant variances, including consideration of the current economic environment. As part of our evaluation, we assessed the historical accuracy of management’s estimates and performed sensitivity analyses of significant assumptions to evaluate the changes in the cash flows and the fair value of the related investment that would result from changes in the assumptions, and we evaluated whether a decline in fair value below the related investment’s carrying value was other-than-temporary. ​​​Evaluation of Collectability of Tenant Receivables and Accrued Revenue​Description of the Matter​At December 31, 2020, the Company’s tenant receivables and accrued revenue totaled $1.2 billion. As discussed in Notes 3 and 9 to the consolidated financial statements, the Company accrues fixed lease income on a straight-line basis over the term of the lease when the Company believes substantially all lease income, including the related straight-line receivable, is probable of collection. The Company’s assessment of collectability incorporates available tenant operational and liquidity information and includes expectations and estimates made by the Company with respect to each lease. ​Auditing management’s evaluation of collectability of tenant receivables and accrued revenue was challenging due to the significant judgment that was necessary when assessing whether it is probable that the tenant will pay outstanding receivables and whether it is probable that substantially all future lease payments will be collected in accordance with the lease terms. In particular, the assessment of collectability incorporates information regarding a tenant’s financial condition that is obtained from available financial data, the expected outcome of contractual disputes and management’s communications and negotiations with the tenant.​How We Addressed the Matter in Our Audit​We obtained an understanding, evaluated the design, and tested the operating effectiveness of controls over the Company’s process for evaluating collectability of tenant receivables and accrued revenues, including controls over management’s review of the information and judgments described above. ​To test the Company’s evaluation of collectability of tenant receivables and accrued revenue, we performed audit procedures that included, among others, assessing the methodologies applied and evaluating the information used by management in its analysis. As part of our assessment, we reviewed executed lease agreements and amendments, evaluated publicly available information on the tenant’s financial condition and operational performance and considered recent collections activity. Further, we evaluated the status of contractual disputes with certain tenants, including review of the related lease agreements, considered recent resolutions of similar matters and obtained representations from internal legal counsel. We also evaluated the impact of activity subsequent to the balance sheet date on the Company’s estimates.​​​​/s/ Ernst & Young LLP​​We have served as the Company’s auditor since 2002.​​​Indianapolis, IndianaFebruary 25, 2021​​​82 Table of ContentsReport of Independent Registered Public Accounting FirmThe Partners of Simon Property Group, L.P. and the Board of Directors of Simon Property Group, Inc.:Opinion on Internal Control over Financial ReportingWe have audited Simon Property Group, L.P.’s internal control over financial reporting as of December 31, 2020, based on criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 Framework) (the COSO criteria). In our opinion, Simon Property Group, L.P. (the Partnership) maintained, in all material respects, effective internal control over financial reporting as of December 31, 2020, based on the COSO criteria.We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (PCAOB), the consolidated balance sheets of the Partnership as of December 31, 2020 and 2019, the related consolidated statements of operations and comprehensive income, equity and cash flows for each of the three years in the period ended December 31, 2020, and the related notes and financial statement schedule listed in the Index at Item 15(a) and our report dated February 25, 2021, expressed an unqualified opinion thereon. Basis for OpinionThe Partnership’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Management’s Report on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on the Partnership’s internal control over financial reporting based on our audit. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Partnership in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.We conducted our audit in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.Definition and Limitations of Internal Control Over Financial ReportingA company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.​​/s/ Ernst & Young LLP​​Indianapolis, IndianaFebruary 25, 2021​​83 Table of ContentsReport of Independent Registered Public Accounting FirmThe Partners of Simon Property Group, L.P. and the Board of Directors of Simon Property Group, Inc.:Opinion on the Financial StatementsWe have audited the accompanying consolidated balance sheets of Simon Property Group, L.P. (the Partnership) as of December 31, 2020 and 2019, the related consolidated statements of operations and comprehensive income, equity and cash flows for each of the three years in the period ended December 31, 2020 and the related notes and financial statement schedule listed in the Index at Item 15(a) (collectively referred to as the “consolidated financial statements”). In our opinion, the consolidated financial statements present fairly, in all material respects, the financial position of the Partnership at December 31, 2020 and 2019, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2020, in conformity with U.S. generally accepted accounting principles. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (PCAOB), the Partnership’s internal control over financial reporting as of December 31, 2020, based on criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 Framework) and our report dated February 25, 2021, expressed an unqualified opinion thereon.Basis for OpinionThese financial statements are the responsibility of the Partnership’s management. Our responsibility is to express an opinion on the Partnership’s financial statements based on our audits. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Partnership in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether due to error or fraud. Our audits included performing procedures to assess the risks of material misstatement of the financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements. We believe that our audits provide a reasonable basis for our opinion.Critical Audit Matters The critical audit matters communicated below are matters arising from the current period audit of the financial statements that were communicated or required to be communicated to the audit committee and that: (1) relate to accounts or disclosures that are material to the financial statements and (2) involved our especially challenging, subjective or complex judgments. The communication of critical audit matters does not alter in any way our opinion on the consolidated financial statements, taken as a whole, and we are not, by communicating the critical audit matters below, providing separate opinions on the critical audit matters or on the accounts or disclosures to which they relate.​​​​​​​Evaluation of Investment Properties for Impairment​Description of the Matter​At December 31, 2020, the Partnership’s consolidated net investment properties totaled $23.2 billion. In addition, a significant number of the Partnership’s investments in unconsolidated entities and its investment in Klépierre hold investment properties. As discussed in Note 3 to the consolidated financial statements, the Partnership reviews investment properties for impairment on a property-by-property basis to identify and evaluate events or changes in circumstances that indicate the carrying value of an investment property may not be recoverable. The Partnership estimates undiscounted cash flows of an investment property using observable and unobservable inputs such as historical and forecasted cash flows, operating income before depreciation and amortization, estimated capitalization rates, leasing prospects and local market information. ​Auditing management’s evaluation of investment properties for impairment was complex due to the estimation uncertainty in determining the undiscounted cash flows of an investment property. In particular, the impairment evaluation for investment properties was sensitive to significant 84 Table of Contentsassumptions such as forecasted cash flows and operating income before depreciation and amortization, and capitalization rates, all of which can be affected by expectations about future market or economic conditions, demand, and competition.​How We Addressed the Matter in Our Audit​We obtained an understanding, evaluated the design, and tested the operating effectiveness of controls over the Partnership’s process for evaluating investment properties for impairment, including controls over management’s review of the significant assumptions described above. ​To test the Partnership’s evaluation of investment properties for impairment, we performed audit procedures that included, among others, assessing the methodologies applied, evaluating the significant assumptions discussed above and testing the completeness and accuracy of the underlying data used by management in its analysis. We compared the significant assumptions used by management to current industry and economic trends, relevant market information, and other applicable sources. We also involved a valuation specialist to assist in evaluating certain assumptions. In addition, we compared the forecasted cash flows and operating income before depreciation and amortization to historical actual results and evaluated significant variances, including consideration of the current economic environment. As part of our evaluation, we assessed the historical accuracy of management’s estimates and performed sensitivity analyses of significant assumptions to evaluate the changes in the undiscounted cash flows of the related investment property that would result from changes in the assumptions.​​​Evaluation of Investments in Unconsolidated Entities for ImpairmentDescription of the Matter​At December 31, 2020, the carrying value of the Partnership’s investments in unconsolidated entities and its investment in Klépierre totaled $4.3 billion. As explained in Note 3 to the consolidated financial statements, the Partnership reviews investments in unconsolidated entities for impairment if events or changes in circumstances indicate that the carrying value of an investment in an unconsolidated entity may not be recoverable. To identify and evaluate whether an other-than-temporary decline in the fair value of an investment below its carrying value has occurred, the Partnership assesses economic and operating conditions that may affect the fair value of the investment. The evaluation of operating conditions may include developing estimates of forecasted cash flows or operating income before depreciation and amortization to support the recoverability of the carrying amount of the investment. When required, the Partnership estimates the fair value of an investment and assesses whether any impairment is other than temporary using observable and unobservable inputs such as historical and forecasted cash flows or operating income, estimated capitalization and discount rates, or relevant market multiples, leasing prospects and local market information. ​Auditing management’s evaluation of investments in unconsolidated entities for impairment was complex due to the estimation uncertainty in determining the forecasted cash flows, operating income before depreciation and amortization, estimated fair value of each investment and whether any decline in fair value below the related investment’s carrying amount is other-than-temporary. In particular, the impairment evaluation for these investments was sensitive to significant assumptions such as forecasted cash flows, operating income before depreciation and amortization, relevant market multiples, and capitalization and discount rates, all of which can be affected by expectations about future market or economic conditions, demand, and competition.​How We Addressed the Matter in Our Audit​We obtained an understanding, evaluated the design, and tested the operating effectiveness of controls over the Partnership’s process for evaluating investments in unconsolidated entities for impairment, including controls over management’s review of the significant assumptions described above.​To test the Partnership’s evaluation of investments in unconsolidated entities for impairment, we performed audit procedures that included, among others, assessing the methodologies applied, evaluating the significant assumptions discussed above and testing the completeness and accuracy of data used by management in its analysis. We compared the significant assumptions used by management to current industry and economic trends, relevant market information, and other applicable sources. We also involved a valuation specialist to assist in evaluating certain 85 Table of Contentsassumptions. In addition, we compared the forecasted cash flows and operating income before depreciation and amortization to historical actual results and evaluated significant variances, including consideration of the current economic environment. As part of our evaluation, we assessed the historical accuracy of management’s estimates and performed sensitivity analyses of significant assumptions to evaluate the changes in the cash flows and the fair value of the related investment that would result from changes in the assumptions, and we evaluated whether a decline in fair value below the related investment’s carrying value was other-than-temporary. ​​​​​​​Evaluation of Collectability of Tenant Receivables and Accrued Revenue​Description of the Matter​At December 31, 2020, the Partnership’s tenant receivables and accrued revenue totaled $1.2 billion. As discussed in Notes 3 and 9 to the consolidated financial statements, the Partnership accrues fixed lease income on a straight-line basis over the term of the lease when the Partnership believes substantially all lease income, including the related straight-line receivable, is probable of collection. The Partnership’s assessment of collectability incorporates available tenant operational and liquidity information and includes expectations and estimates made by the Partnership with respect to each lease. ​Auditing management’s evaluation of collectability of tenant receivables and accrued revenue was challenging due to the significant judgment that was necessary when assessing whether it is probable that the tenant will pay outstanding receivables and whether it is probable that substantially all future lease payments will be collected in accordance with the lease terms. In particular, the assessment of collectability incorporates information regarding a tenant’s financial condition that is obtained from available financial data, the expected outcome of contractual disputes and management’s communications and negotiations with the tenant.​How We Addressed the Matter in Our Audit​We obtained an understanding, evaluated the design, and tested the operating effectiveness of controls over the Partnership’s process for evaluating collectability of tenant receivables and accrued revenues, including controls over management’s review of the information and judgments described above. ​To test the Partnership’s evaluation of collectability of tenant receivables and accrued revenue, we performed audit procedures that included, among others, assessing the methodologies applied and evaluating the information used by management in its analysis. As part of our assessment, we reviewed executed lease agreements and amendments, evaluated publicly available information on the tenant’s financial condition and operational performance and considered recent collections activity. Further, we evaluated the status of contractual disputes with certain tenants, including review of the related lease agreements, considered recent resolutions of similar matters and obtained representations from internal legal counsel. We also evaluated the impact of activity subsequent to the balance sheet date on the Partnership’s estimates.​​​​/s/ Ernst & Young LLP​​We have served as the Partnership’s auditor since 2002.Indianapolis, IndianaFebruary 25, 2021​​​​86 Table of ContentsSimon Property Group, Inc.Consolidated Balance Sheets(Dollars in thousands, except share amounts)​​​​​​​​​ December 31, December 31, ​​2020​2019 ASSETS:​​​​​​​Investment properties, at cost​$ 38,050,196​$ 37,804,495​Less - accumulated depreciation​ 14,891,937​ 13,905,776​​​ 23,158,259​ 23,898,719​Cash and cash equivalents​ 1,011,613​ 669,373​Tenant receivables and accrued revenue, net​ 1,236,734​ 832,151​Investment in unconsolidated entities, at equity​ 2,603,571​ 2,371,053​Investment in Klépierre, at equity​ 1,729,690​ 1,731,649​Investment in TRG, at equity​​ 3,451,897​​ —​Right-of-use assets, net​​ 512,914​​ 514,660​Deferred costs and other assets​ 1,082,168​ 1,214,025​Total assets​$ 34,786,846​$ 31,231,630​LIABILITIES:​​​​​​​Mortgages and unsecured indebtedness​$ 26,723,361​$ 24,163,230​Accounts payable, accrued expenses, intangibles, and deferred revenues​ 1,311,925​ 1,390,682​Cash distributions and losses in unconsolidated entities, at equity​ 1,577,393​ 1,566,294​Dividend payable​​ 486,922​​ —​Lease liabilities​​ 515,492​​ 516,809​Other liabilities​ 513,515​ 464,304​Total liabilities​ 31,128,608​ 28,101,319​Commitments and contingencies​​​​​​​Limited partners’ preferred interest in the Operating Partnership and noncontrolling redeemable interests in properties​ 185,892​ 219,061​EQUITY:​​​​​​​Stockholders’ Equity​​​​​​​Capital stock (850,000,000 total shares authorized, $0.0001 par value, 238,000,000 shares of excess common stock, 100,000,000 authorized shares of preferred stock):​​​​​​​Series J 83/8% cumulative redeemable preferred stock, 1,000,000 shares authorized, 796,948 issued and outstanding with a liquidation value of $39,847​ 42,091​ 42,420​Common stock, $0.0001 par value, 511,990,000 shares authorized, 342,849,037 and 320,435,256 issued and outstanding, respectively​ 34​ 32​Class B common stock, $0.0001 par value, 10,000 shares authorized, 8,000 issued and outstanding​ —​ —​Capital in excess of par value​ 11,179,688​ 9,756,073​Accumulated deficit​ (6,102,314)​ (5,379,952)​Accumulated other comprehensive loss​ (188,675)​ (118,604)​Common stock held in treasury, at cost, 14,355,621 and 13,574,296 shares, respectively​ (1,891,352)​ (1,773,571)​Total stockholders’ equity​ 3,039,472​ 2,526,398​Noncontrolling interests​ 432,874​ 384,852​Total equity​ 3,472,346​ 2,911,250​Total liabilities and equity​$ 34,786,846​$ 31,231,630​The accompanying notes are an integral part of these statements.​​87 Table of ContentsSimon Property Group, Inc.Consolidated Statements of Operations and Comprehensive Income(Dollars in thousands, except per share amounts)​​​​​​​​​​​​​For the Year ​​Ended December 31, ​ 2020 2019 2018 REVENUE:​​​​​​​​​​Lease income​$ 4,302,367​$ 5,243,771​$ 5,158,420​Management fees and other revenues​ 96,882​ 112,942​ 116,286​Other income​ 208,254​ 398,476​ 370,582​Total revenue​ 4,607,503​ 5,755,189​ 5,645,288​EXPENSES:​​​​​​​​​​Property operating​ 349,154​ 453,145​ 450,636​Depreciation and amortization​ 1,318,008​ 1,340,503​ 1,282,454​Real estate taxes​ 457,142​ 468,004​ 457,740​Repairs and maintenance​ 80,858​ 100,495​ 99,588​Advertising and promotion​ 98,613​ 150,344​ 151,241​Home and regional office costs​ 171,668​ 190,109​ 136,677​General and administrative​ 22,572​ 34,860​ 46,543​Other​ 137,679​ 109,898​ 94,110​Total operating expenses​ 2,635,694​ 2,847,358​ 2,718,989​OPERATING INCOME BEFORE OTHER ITEMS​ 1,971,809​ 2,907,831​ 2,926,299​Interest expense​ (784,400)​ (789,353)​ (815,923)​Loss on extinguishment of debt​​ —​​ (116,256)​​ —​Income and other tax benefit (expense) ​ 4,637​ (30,054)​ (36,898)​Income from unconsolidated entities​ 219,870​ 444,349​ 475,250​Unrealized losses in fair value of equity instruments​​ (19,632)​​ (8,212)​​ (15,212)​(Loss) gain on sale or disposal of, or recovery on, assets and interests in unconsolidated entities and impairment, net​ (114,960)​ 14,883​ 288,827​CONSOLIDATED NET INCOME​​ 1,277,324​​ 2,423,188​​ 2,822,343​Net income attributable to noncontrolling interests​ 164,760​ 321,604​ 382,285​Preferred dividends​ 3,337​ 3,337​ 3,337​NET INCOME ATTRIBUTABLE TO COMMON STOCKHOLDERS​$ 1,109,227​$ 2,098,247​$ 2,436,721​BASIC AND DILUTED EARNINGS PER COMMON SHARE:​​​​​​​​​​Net income attributable to common stockholders​$ 3.59​$ 6.81​$ 7.87​​​​​​​​​​​​Consolidated Net Income​$ 1,277,324​$ 2,423,188​$ 2,822,343​Unrealized (loss) gain on derivative hedge agreements​ (106,548)​ (4,066)​ 21,633​Net (gain) loss reclassified from accumulated other comprehensive loss into earnings​ (106)​ 13,634​ 7,020​Currency translation adjustments​ 27,288​ (1,850)​ (47,038)​Changes in available-for-sale securities and other​ 180​ 718​ 373​Comprehensive income​ 1,198,138​ 2,431,624​ 2,804,331​Comprehensive income attributable to noncontrolling interests​ 155,646​ 322,627​ 379,837​Comprehensive income attributable to common stockholders​$ 1,042,492​$ 2,108,997​$ 2,424,494​​The accompanying notes are an integral part of these statements.​​88 Table of ContentsSimon Property Group, Inc.Consolidated Statements of Cash Flows(Dollars in thousands)​​​​​​​​​​​​​For the Year​​​Ended December 31, ​​​2020​2019​2018​CASH FLOWS FROM OPERATING ACTIVITIES:​​​​​​​​​​Consolidated Net Income​$ 1,277,324​$ 2,423,188​$ 2,822,343​Adjustments to reconcile consolidated net income to net cash provided by operating activities​​​​​​​​​​Depreciation and amortization​ 1,354,991​ 1,394,172​ 1,349,776​Loss on debt extinguishment​​ —​​ 116,256​​ —​Loss (gain) on sale or disposal of, or recovery on, assets and interests in unconsolidated entities and impairment, net​ 114,960​ (14,883)​ (288,827)​Unrealized losses in fair value of equity instruments​​ 19,632​​ 8,212​​ 15,212​Gain on interest in unconsolidated entity (Note 6)​​ —​​ —​​ (35,621)​Straight-line lease loss (income)​ 19,950​ (67,139)​ (18,325)​Equity in income of unconsolidated entities​ (219,870)​ (444,349)​ (475,250)​Distributions of income from unconsolidated entities​ 184,733​ 428,769​ 390,137​Changes in assets and liabilities​​​​​​​​​​Tenant receivables and accrued revenue, net​ (415,911)​ (157)​ (17,518)​Deferred costs and other assets​ (28,191)​ (49,338)​ (75,438)​Accounts payable, accrued expenses, intangibles, deferred revenues and other liabilities​ 19,080​ 13,100​ 84,307​Net cash provided by operating activities​ 2,326,698​ 3,807,831​ 3,750,796​CASH FLOWS FROM INVESTING ACTIVITIES:​​​​​​​​​​Acquisitions​ (3,606,694)​ (12,800)​ (51,060)​Funding of loans to related parties​ (8,236)​ —​ (4,641)​Proceeds on loans to related parties​ —​ 7,641​ —​Capital expenditures, net​ (484,119)​ (876,011)​ (781,909)​Cash impact from the consolidation of properties​ —​ 1,045​ 11,276​Net proceeds from sale of assets​ 33,418​ 6,776​ 183,241​Investments in unconsolidated entities​ (191,368)​ (63,789)​ (63,397)​Purchase of equity instruments​ (32,955)​ (374,231)​ (21,563)​Proceeds from sales of equity instruments​ 30,000​ —​ 25,000​Insurance proceeds for property restoration​​ 31,198​​ 5,662​​ 19,083​Distributions of capital from unconsolidated entities and other ​ 250,358​ 229,000​ 447,464​Net cash used in investing activities​ (3,978,398)​ (1,076,707)​ (236,506)​CASH FLOWS FROM FINANCING ACTIVITIES:​​​​​​​​​​Proceeds from sales of common stock and other, net of transaction costs​ 1,556,148​ (328)​ (329)​Purchase of shares related to stock grant recipients' tax withholdings​​ (854)​​ (2,955)​​ (2,911)​Redemption of limited partner units​ (16,106)​ (6,846)​ (81,506)​Purchase of treasury stock​​ (152,589)​​ (359,773)​​ (354,108)​Distributions to noncontrolling interest holders in properties​ (8,271)​ (41,549)​ (76,963)​Contributions from noncontrolling interest holders in properties​ 220​ 139​ 161​Preferred distributions of the Operating Partnership​ (1,915)​ (1,915)​ (1,915)​Distributions to stockholders and preferred dividends​ (1,443,183)​ (2,558,944)​ (2,449,071)​Distributions to limited partners​ (219,095)​ (388,542)​ (370,656)​Cash paid to extinguish debt​​ —​​ (99,975)​​ —​Proceeds from issuance of debt, net of transaction costs​ 15,234,860​ 13,312,301​ 7,973,719​Repayments of debt​ (12,955,275)​ (12,427,699)​ (9,118,685)​Net cash provided by (used in) provided by financing activities​ 1,993,940​ (2,576,086)​ (4,482,264)​INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS​ 342,240​ 155,038​ (967,974)​CASH AND CASH EQUIVALENTS, beginning of period​​ 669,373​ 514,335​ 1,482,309​CASH AND CASH EQUIVALENTS, end of period​$ 1,011,613​$ 669,373​$ 514,335​The accompanying notes are an integral part of these statements.​​89 Table of ContentsSimon Property Group, Inc.Consolidated Statements of Equity(Dollars in thousands)​​​​​​​​​​​​​​​​​​​​​​​​​​​ ​​ ​​ Accumulated Other ​​ ​​ ​​ ​​ ​​ ​​​​​​​​Comprehensive​Capital in​​​​Common Stock​​​​​​ ​​Preferred​Common​Income​Excess of Par​Accumulated​Held in​Noncontrolling​Total ​​Stock​Stock​(Loss)​Value​Deficit​Treasury​Interests​Equity ​​​​​​​​​​​​​​​​​​​​​​​​​​Balance at December 31, 2017​$ 43,077​$ 32​$ (110,453)​$ 9,614,748​$ (4,782,173)​$ (1,079,063)​$ 552,596​$ 4,238,764​Exchange of limited partner units (92,732 common shares, Note 8)​​​​​​​​​​​ 1,004​​​​​​​​ (1,004)​ —​Issuance of limited partner units (475,183 units)​​​​​​​​​​​​​​​​​​​​ 84,103​​ 84,103​Series J preferred stock premium amortization​​ (329)​​​​​​​​​​​​​​​​​​​​ (329)​Stock incentive program (51,756 common shares, net)​​​​​​​​​​​ (8,651)​​​​​ 8,651​​​​ —​Redemption of limited partner units (454,704 units)​​​​​​​​​​​ (76,555)​​​​​​​​ (4,951)​ (81,506)​Amortization of stock incentive​​​​​​​​​​​ 12,029​​​​​​​​​​​ 12,029​Treasury stock purchase (2,275,194 shares)​​​​​​​​​​​​​​​​​ (354,108)​​​​​ (354,108)​Long-term incentive performance units​​​​​​​​​​​​​​​​​​​​ 26,172​​ 26,172​Cumulative effect of accounting change​​​​​​​​​​​​​​ 7,264​​​​​​​​ 7,264​Issuance of unit equivalents and other (18,680 common shares repurchased)​​​​​​​​​​​ 1,602​​ (109,147)​​ (2,911)​​ (2,510)​​ (112,966)​Unrealized loss on hedging activities​​​​​​​​ 18,781​​​​​​​​​​​ 2,852​​ 21,633​Currency translation adjustments​​​​​​​​ (40,766)​​​​​​​​​​​ (6,271)​​ (47,037)​Changes in available-for-sale securities and other​​​​​​​​ 324​​​​​​​​​​​ 49​​ 373​Net gain reclassified from accumulated other comprehensive loss into earnings​​​​​​​​ 6,097​​​​​​​​​​​ 923​​ 7,020​Other comprehensive income​​​​​​​​ (15,564)​​​​​​​​​​​ (2,447)​ (18,011)​Adjustment to limited partners' interest from change in ownership in the Operating Partnership​​​​​​​​​​​ 156,241​​​​​​​​ (156,241)​ —​Distributions to common stockholders and limited partners, excluding Operating Partnership preferred interests​​​​​​​​​​​​​​ (2,449,071)​​​​​ (370,656)​ (2,819,727)​Distribution to other noncontrolling interest partners​​​​​​​​​​​​​​​​​​​​ (1,741)​ (1,741)​Net income, excluding $1,915 attributable to preferred interests in the Operating Partnership and $3,416 attributable to noncontrolling redeemable interests in properties​​​​​​​​​​​​​​ 2,440,058​​​​​ 376,954​ 2,817,012​Balance at December 31, 2018​$ 42,748​$ 32​$ (126,017)​$ 9,700,418​$ (4,893,069)​$ (1,427,431)​$ 500,275​$ 3,796,956​Exchange of limited partner units (24,000 common shares, Note 8)​​​​​​​​​​​ 253​​​​​​​​ (253)​​ —​Series J preferred stock premium amortization​​ (328)​​​​​​​​​​​​​​​​​​​​ (328)​Stock incentive program (90,902 common shares, net)​​​​​​​​​​​ (16,589)​​​​​ 16,589​​​​​ —​Redemption of limited partner units (43,255 units)​​​​​​​​​​​ (6,453)​​​​​​​​ (393)​​ (6,846)​Amortization of stock incentive​​​​​​​​​​​ 12,604​​​​​​​​​​​ 12,604​Treasury stock purchase (2,247,074 shares)​​​​​​​​​​​​​​​​​ (359,773)​​​​​ (359,773)​Long-term incentive performance units​​​​​​​​​​​​​​​​​​​​ 20,749​​ 20,749​Issuance of unit equivalents and other (16,336 common shares repurchased)​​​​​​​​​​​ 19​​ (29,523)​​ (2,956)​​ 139​​ (32,321)​Unrealized gain on hedging activities​​​​​​​​ (3,553)​​​​​​​​​​​ (513)​​ (4,066)​Currency translation adjustments​​​​​​​​ (1,489)​​​​​​​​​​​ (361)​​ (1,850)​Changes in available-for-sale securities and other​​​​​​​​ 623​​​​​​​​​​​ 95​​ 718​Net loss reclassified from accumulated other comprehensive loss into earnings​​​​​​​​ 11,832​​​​​​​​​​​ 1,802​​ 13,634​Other comprehensive income​​​​​​​​ 7,413​​​​​​​​​​​ 1,023​​ 8,436​Adjustment to limited partners' interest from change in ownership in the Operating Partnership​​​​​​​​​​​ 65,821​​​​​​​​ (65,821)​​ —​Distributions to common stockholders and limited partners, excluding Operating Partnership preferred interests​​​​​​​​​​​​​​ (2,558,944)​​​​​ (388,541)​​ (2,947,485)​Distribution to other noncontrolling interest partners​​​​​​​​​​​​​​​​​​​​ (2,446)​​ (2,446)​Net income, excluding $1,915 attributable to preferred interests in the Operating Partnership and a $431 loss attributable to noncontrolling redeemable interests in properties​​​​​​​​​​​​​​ 2,101,584​​​​​ 320,120​​ 2,421,704​Balance at December 31, 2019​$ 42,420​$ 32​$ (118,604)​$ 9,756,073​$ (5,379,952)​$ (1,773,571)​$ 384,852​$ 2,911,250​90 Table of Contents​​​​​​​​​​​​​​​​​​​​​​​​​​​ ​​ ​​ Accumulated Other ​​ ​​ ​​ ​​ ​​ ​​​​​​​​Comprehensive​Capital in​​​​Common Stock​​​​​​ ​​Preferred​Common​Income​Excess of Par​Accumulated​Held in​Noncontrolling​Total ​​Stock​Stock​(Loss)​Value​Deficit​Treasury​Interests​Equity ​​​​​​​​​​​​​​​​​​​​​​​​​​Exchange of limited partner units (293,204 common shares, Note 8)​​​​​​​​​​​ 2,028​​​​​​​​ (2,028)​​ —​Issuance of limited partner units (955,705 units)​​​​​​​​​​​​​​​​​​​​ 79,601​​ 79,601​Public offering of common stock (22,137,500 common shares)​​​​​ 2​​​​​ 1,556,477​​​​​​​​ —​​ 1,556,479​Series J preferred stock premium amortization​​ (329)​​​​​​​​​​​​​​​​​​​​ (329)​Stock incentive program (462,967 common shares, net)​​​​​​​​​​​ (35,662)​​​​​ 35,662​​​​​ —​Redemption of limited partner units (116,658 units)​​​​​​​​​​​ (15,163)​​​​​​​​ (943)​​ (16,106)​Amortization of stock incentive​​​​​​​​​​​ 11,660​​​​​​​​​​​ 11,660​Treasury stock purchase (1,245,654 shares)​​​​​​​​​​​​​​​​​ (152,590)​​​​​ (152,590)​Long-term incentive performance units​​​​​​​​​​​​​​​​​​​​ 2,331​​ 2,331​Issuance of unit equivalents and other (15,561 common shares repurchased)​​​​​​​​​​​ 30​​ 34,894​​ (853)​​ (3,582)​​ 30,489​Unrealized loss on hedging activities​​​​​​​​ (92,834)​​​​​​​​​​​ (13,714)​​ (106,548)​Currency translation adjustments​​​​​​​​ 22,694​​​​​​​​​​​ 4,594​​ 27,288​Changes in available-for-sale securities and other​​​​​​​​ 162​​​​​​​​​​​ 18​​ 180​Net gain reclassified from accumulated other comprehensive loss into earnings​​​​​​​​ (93)​​​​​​​​​​​ (13)​​ (106)​Other comprehensive income​​​​​​​​ (70,071)​​​​​​​​​​​ (9,115)​​ (79,186)​Adjustment to limited partners' interest from change in ownership in the Operating Partnership​​​​​​​​​​​ (95,755)​​​​​​​​ 95,755​​ —​Distributions to common stockholders and limited partners, excluding Operating Partnership preferred interests​​​​​​​​​​​​​​ (1,869,820)​​​​​ (279,379)​​ (2,149,199)​Distribution to other noncontrolling interest partners​​​​​​​​​​​​​​​​​​​​ (3,507)​​ (3,507)​Net income, excluding $1,915 attributable to preferred interests in the Operating Partnership and a $6,044 loss attributable to noncontrolling redeemable interests in properties​​​​​​​​​​​​​​ 1,112,564​​​​​ 168,889​​ 1,281,453​Balance at December 31, 2020​$ 42,091​$ 34​$ (188,675)​$ 11,179,688​$ (6,102,314)​$ (1,891,352)​$ 432,874​$ 3,472,346​The accompanying notes are an integral part of these statements.​​91 Table of ContentsSimon Property Group, L.P.Consolidated Balance Sheets(Dollars in thousands, except unit amounts)​​​​​​​​​ December 31, December 31, ​​2020​2019 ASSETS:​​​​​​​Investment properties, at cost​$ 38,050,196​$ 37,804,495​Less — accumulated depreciation​ 14,891,937​ 13,905,776​​​ 23,158,259​ 23,898,719​Cash and cash equivalents​ 1,011,613​ 669,373​Tenant receivables and accrued revenue, net​ 1,236,734​ 832,151​Investment in unconsolidated entities, at equity​ 2,603,571​ 2,371,053​Investment in Klépierre, at equity​ 1,729,690​ 1,731,649​Investment in TRG, at equity​​ 3,451,897​​ —​Right-of-use assets, net​​ 512,914​​ 514,660​Deferred costs and other assets​ 1,082,168​ 1,214,025​Total assets​$ 34,786,846​$ 31,231,630​LIABILITIES:​​​​​​​Mortgages and unsecured indebtedness​$ 26,723,361​$ 24,163,230​Accounts payable, accrued expenses, intangibles, and deferred revenues​ 1,311,925​ 1,390,682​Cash distributions and losses in unconsolidated entities, at equity​ 1,577,393​ 1,566,294​Distribution payable​​ 486,922​​ —​Lease liabilities​​ 515,492​​ 516,809​Other liabilities​ 513,515​ 464,304​Total liabilities​ 31,128,608​ 28,101,319​Commitments and contingencies​​​​​​​Preferred units, various series, at liquidation value, and noncontrolling redeemable interests in properties​ 185,892​ 219,061​EQUITY:​​​​​​​Partners’ Equity​​​​​​​Preferred units, 796,948 units outstanding. Liquidation value of $39,847​ 42,091​ 42,420​General Partner, 328,501,416 and 306,868,960 units outstanding, respectively​ 2,997,381​ 2,483,978​Limited Partners, 47,322,212 and 46,740,117 units outstanding, respectively​ 431,784​ 378,339​Total partners’ equity​ 3,471,256​ 2,904,737​Nonredeemable noncontrolling interests in properties, net​ 1,090​ 6,513​Total equity​ 3,472,346​ 2,911,250​Total liabilities and equity​$ 34,786,846​$ 31,231,630​The accompanying notes are an integral part of these statements.​92 Table of ContentsSimon Property Group, L.P.Consolidated Statements of Operations and Comprehensive Income(Dollars in thousands, except per unit amounts)​​​​​​​​​​​​ For the Year ​ Ended December 31, ​ 2020​2019​2018 REVENUE: ​​ ​​ ​​ Lease income​$ 4,302,367​$ 5,243,771​$ 5,158,420​Management fees and other revenues​ 96,882​ 112,942​ 116,286​Other income​ 208,254​ 398,476​ 370,582​Total revenue​ 4,607,503​ 5,755,189​ 5,645,288​EXPENSES:​​​​​​​​​​Property operating​ 349,154​ 453,145​ 450,636​Depreciation and amortization​ 1,318,008​ 1,340,503​ 1,282,454​Real estate taxes​ 457,142​ 468,004​ 457,740​Repairs and maintenance​ 80,858​ 100,495​ 99,588​Advertising and promotion​ 98,613​ 150,344​ 151,241​Home and regional office costs​ 171,668​ 190,109​ 136,677​General and administrative​ 22,572​ 34,860​ 46,543​Other​ 137,679​ 109,898​ 94,110​Total operating expenses​ 2,635,694​ 2,847,358​ 2,718,989​OPERATING INCOME BEFORE OTHER ITEMS​ 1,971,809​ 2,907,831​ 2,926,299​Interest expense​ (784,400)​ (789,353)​ (815,923)​Loss on extinguishment of debt​​ —​​ (116,256)​​ —​Income and other tax benefit (expense)​ 4,637​ (30,054)​ (36,898)​Income from unconsolidated entities​ 219,870​ 444,349​ 475,250​Unrealized losses in fair value of equity instruments​​ (19,632)​​ (8,212)​​ (15,212)​(Loss) gain on sale or disposal of, or recovery on, assets and interests in unconsolidated entities and impairment, net​ (114,960)​ 14,883​ 288,827​CONSOLIDATED NET INCOME​ 1,277,324​ 2,423,188​ 2,822,343​Net (loss) income attributable to noncontrolling interests ​ (4,378)​ 991​ 11,327​Preferred unit requirements​ 5,252​ 5,252​ 5,252​NET INCOME ATTRIBUTABLE TO UNITHOLDERS​$ 1,276,450​$ 2,416,945​$ 2,805,764​NET INCOME ATTRIBUTABLE TO UNITHOLDERS ATTRIBUTABLE TO:​​​​​​​​​​General Partner​$ 1,109,227​$ 2,098,247​$ 2,436,721​Limited Partners​ 167,223​ 318,698​ 369,043​Net income attributable to unitholders​$ 1,276,450​$ 2,416,945​$ 2,805,764​BASIC AND DILUTED EARNINGS PER UNIT:​​​​​​​​​​Net income attributable to unitholders​$ 3.59​$ 6.81​$ 7.87​​​​​​​​​​​​Consolidated Net Income​$ 1,277,324​$ 2,423,188​$ 2,822,343​Unrealized (loss) gain on derivative hedge agreements​ (106,548)​ (4,066)​ 21,633​Net (gain) loss reclassified from accumulated other comprehensive loss into earnings​ (106)​ 13,634​ 7,020​Currency translation adjustments​ 27,288​ (1,850)​ (47,038)​Changes in available-for-sale securities and other​ 180​ 718​ 373​Comprehensive income​ 1,198,138​ 2,431,624​ 2,804,331​Comprehensive income attributable to noncontrolling interests​ 1,666​ 1,422​ 7,911​Comprehensive income attributable to unitholders​$ 1,196,472​$ 2,430,202​$ 2,796,420​The accompanying notes are an integral part of these statements.​​93 Table of ContentsSimon Property Group, L.P.Consolidated Statements of Cash Flows(Dollars in thousands)​​​​​​​​​​​​​For the Year ​​Ended December 31, ​ 2020 2019 ​2018 CASH FLOWS FROM OPERATING ACTIVITIES: ​​ ​​​​​ Consolidated Net Income​$ 1,277,324​$ 2,423,188​$ 2,822,343​Adjustments to reconcile consolidated net income to net cash provided by operating activities​​​​​​​​​​Depreciation and amortization​ 1,354,991​ 1,394,172​ 1,349,776​Loss on debt extinguishment​​ —​​ 116,256​​ —​Loss (gain) on sale or disposal of, or recovery on, assets and interests in unconsolidated entities and impairment, net​ 114,960​ (14,883)​ (288,827)​Unrealized losses in fair value of equity instruments​​ 19,632​​ 8,212​​ 15,212​Gain on interest in unconsolidated entity (Note 6)​​ —​​ —​​ (35,621)​Straight-line lease loss (income)​ 19,950​ (67,139)​ (18,325)​Equity in income of unconsolidated entities​ (219,870)​ (444,349)​ (475,250)​Distributions of income from unconsolidated entities​ 184,733​ 428,769​ 390,137​Changes in assets and liabilities​​​​​​​​​​Tenant receivables and accrued revenue, net​ (415,911)​ (157)​ (17,518)​Deferred costs and other assets​ (28,191)​ (49,338)​ (75,438)​Accounts payable, accrued expenses, intangibles, deferred revenues and other liabilities​ 19,080​ 13,100​ 84,307​Net cash provided by operating activities​ 2,326,698​ 3,807,831​ 3,750,796​CASH FLOWS FROM INVESTING ACTIVITIES:​​​​​​​​​​Acquisitions​ (3,606,694)​ (12,800)​ (51,060)​Funding of loans to related parties​​ (8,236)​​ —​​ (4,641)​Proceeds on loans to related parties​ —​ 7,641​ —​Capital expenditures, net​ (484,119)​ (876,011)​ (781,909)​Cash impact from the consolidation of properties​ —​ 1,045​ 11,276​Net proceeds from sale of assets​​ 33,418​​ 6,776​​ 183,241​Investments in unconsolidated entities​ (191,368)​ (63,789)​ (63,397)​Purchase of equity instruments​ (32,955)​ (374,231)​ (21,563)​Proceeds from sales of equity instruments​​ 30,000​​ —​​ 25,000​Insurance proceeds for property restoration​​ 31,198​​ 5,662​​ 19,083​Distributions of capital from unconsolidated entities and other​ 250,358​ 229,000​ 447,464​Net cash used in investing activities​ (3,978,398)​ (1,076,707)​ (236,506)​CASH FLOWS FROM FINANCING ACTIVITIES:​​​​​​​​​​Issuance of units and other​ 1,556,148​ (328)​ (329)​Purchase of units related to stock grant recipients' tax withholdings​ (854)​ (2,955)​ (2,911)​Redemption of limited partner units​​ (16,106)​​ (6,846)​​ (81,506)​Purchase of general partner units​​ (152,589)​​ (359,773)​​ (354,108)​Distributions to noncontrolling interest holders in properties​ (8,271)​ (41,549)​ (76,963)​Contributions from noncontrolling interest holders in properties​ 220​ 139​ 161​Partnership distributions​ (1,664,193)​ (2,949,401)​ (2,821,642)​Cash paid to extinguish debt​​ —​​ (99,975)​​ —​Mortgage and unsecured indebtedness proceeds, net of transaction costs​ 15,234,860​ 13,312,301​ 7,973,719​Mortgage and unsecured indebtedness principal payments​ (12,955,275)​ (12,427,699)​ (9,118,685)​Net cash provided by (used in) provided by financing activities​ 1,993,940​ (2,576,086)​ (4,482,264)​INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS​ 342,240​ 155,038​ (967,974)​CASH AND CASH EQUIVALENTS, beginning of period​ 669,373​ 514,335​ 1,482,309​CASH AND CASH EQUIVALENTS, end of period​$ 1,011,613​$ 669,373​$ 514,335​The accompanying notes are an integral part of these statements.​​94 Table of ContentsSimon Property Group, L.P.Consolidated Statements of Equity(Dollars in thousands)​​​​​​​​​​​​​​​​​​​Preferred​Simon (Managing​Limited​Noncontrolling​Total ​ Units General Partner) Partners Interests Equity ​​​​​​​​​​​​​​​​​Balance at December 31, 2017​$ 43,077​$ 3,643,091​$ 548,858​$ 3,738​$ 4,238,764​Issuance of limited partner units (475,183 units)​​​​​​​​ 84,103​​​​​ 84,103​Series J preferred stock premium and amortization​​ (329)​​​​​​​​​​​ (329)​Limited partner units exchanged to common units (92,732 units)​​​​​ 1,004​​ (1,004)​​​​​ —​Stock incentive program (51,756 common units, net)​​​​​ —​​​​​​​​ —​Amortization of stock incentive​​​​​ 12,029​​​​​​​​ 12,029​Redemption of limited partner units (454,704 units)​​​​​ (76,555)​​ (4,951)​​​​​ (81,506)​Treasury unit purchase (2,275,194 units)​​​​​ (354,108)​​​​​​​​ (354,108)​Long-term incentive performance units​​​​​​​​ 26,172​​​​​ 26,172​Cumulative effect of accounting change​​​​​ 7,264​​​​​​​​ 7,264​Issuance of unit equivalents and other (18,680 common units)​​​​​ (110,456)​​​​​ (2,510)​​ (112,966)​Unrealized gain on hedging activities​​​​​ 18,781​​ 2,852​​​​​ 21,633​Currency translation adjustments​​​​​ (40,766)​​ (6,271)​​​​​ (47,037)​Changes in available-for-sale securities and other​​​​​ 324​​ 49​​​​​ 373​Net loss reclassified from accumulated other comprehensive loss into earnings​​​​​ 6,097​​ 923​​​​​ 7,020​Other comprehensive income​​​​​ (15,564)​​ (2,447)​​​​​ (18,011)​Adjustment to limited partners' interest from change in ownership in the Operating Partnership​​​​​ 156,241​​ (156,241)​​​​​ —​Distributions, excluding distributions on preferred interests classified as temporary equity​​ (3,337)​​ (2,445,734)​​ (370,656)​​ (1,741)​​ (2,821,468)​Net income, excluding preferred distributions on temporary equity preferred units of $1,915 and $3,416 attributable to noncontrolling redeemable interests in properties​​ 3,337​​ 2,436,721​​ 369,043​​ 7,911​​ 2,817,012​Balance at December 31, 2018​$ 42,748​$ 3,253,933​$ 492,877​$ 7,398​$ 3,796,956​Series J preferred stock premium and amortization​​ (328)​​​​​​​​​​​ (328)​Limited partner units exchanged to common units (24,000 units)​​​​​ 253​​ (253)​​​​​ —​Stock incentive program (90,902 common units, net)​​​​​ —​​​​​​​​ —​Amortization of stock incentive​​​​​ 12,604​​​​​​​​ 12,604​Redemption of limited partner units (43,255 units)​​​​​ (6,453)​​ (393)​​​​​ (6,846)​Treasury unit purchase (2,247,074 units)​​​​​ (359,773)​​​​​​​​ (359,773)​Long-term incentive performance units​​​​​​​​ 20,749​​​​​ 20,749​Issuance of unit equivalents and other (16,336 common units)​​​​​ (32,460)​​​​​ 139​​ (32,321)​Unrealized loss on hedging activities​​​​​ (3,553)​​ (513)​​​​​ (4,066)​Currency translation adjustments​​​​​ (1,489)​​ (361)​​​​​ (1,850)​Changes in available-for-sale securities and other​​​​​ 623​​ 95​​​​​ 718​Net loss reclassified from accumulated other comprehensive loss into earnings​​​​​ 11,832​​ 1,802​​​​​ 13,634​Other comprehensive income​​​​​ 7,413​​ 1,023​​​​​ 8,436​Adjustment to limited partners' interest from change in ownership in the Operating Partnership​​​​​ 65,821​​ (65,821)​​​​​ —​Distributions, excluding distributions on preferred interests classified as temporary equity​​ (3,337)​​ (2,555,607)​​ (388,541)​​ (2,446)​​ (2,949,931)​Net income, excluding preferred distributions on temporary equity preferred units of $1,915 and a $431 loss attributable to noncontrolling redeemable interests in properties​​ 3,337​​ 2,098,247​​ 318,698​​ 1,422​​ 2,421,704​Balance at December 31, 2019​$ 42,420​$ 2,483,978​$ 378,339​$ 6,513​$ 2,911,250​95 Table of Contents​​​​​​​​​​​​​​​​​​​Preferred​Simon (Managing​Limited​Noncontrolling​Total ​ Units General Partner) Partners Interests Equity ​​​​​​​​​​​​​​​​​Issuance of limited partner units (955,705 units)​​​​​​​​ 79,601​​​​​ 79,601​Series J preferred stock premium and amortization​​ (329)​​​​​​​​​​​ (329)​Limited partner units exchanged to common units (293,204 units)​​​​​ 2,028​​ (2,028)​​​​​ —​Issuance of units related to Simon's public offering of its common stock (22,137,500 units)​​​​​ 1,556,479​​​​​​​​ 1,556,479​Stock incentive program (462,967 common units, net)​​​​​ —​​​​​​​​ —​Amortization of stock incentive​​​​​ 11,660​​​​​​​​ 11,660​Redemption of limited partner units (116,658 units)​​​​​ (15,163)​​ (943)​​​​​ (16,106)​Treasury unit purchase (1,245,654 units)​​​​​ (152,590)​​​​​​​​ (152,590)​Long-term incentive performance units​​​​​​​​ 2,331​​​​​ 2,331​Issuance of unit equivalents and other (36,252 units and 15,561 common units)​​​​​ 34,071​​​​​ (3,582)​​ 30,489​Unrealized loss on hedging activities​​​​​ (92,834)​​ (13,714)​​​​​ (106,548)​Currency translation adjustments​​​​​ 22,694​​ 4,594​​​​​ 27,288​Changes in available-for-sale securities and other​​​​​ 162​​ 18​​​​​ 180​Net gain reclassified from accumulated other comprehensive loss into earnings​​​​​ (93)​​ (13)​​​​​ (106)​Other comprehensive income​​​​​ (70,071)​​ (9,115)​​​​​ (79,186)​Adjustment to limited partners' interest from change in ownership in the Operating Partnership​​​​​ (95,755)​​ 95,755​​​​​ —​Distributions, excluding distributions on preferred interests classified as temporary equity​​ (3,337)​​ (1,866,483)​​ (279,379)​​ (3,507)​​ (2,152,706)​Net income, excluding preferred distributions on temporary equity preferred units of $1,915 and a $6,044 loss attributable to noncontrolling redeemable interests in properties​​ 3,337​​ 1,109,227​​ 167,223​​ 1,666​​ 1,281,453​Balance at December 31, 2020​$ 42,091​$ 2,997,381​$ 431,784​$ 1,090​$ 3,472,346​The accompanying notes are an integral part of these statements.​​96 Table of ContentsSimon Property Group, Inc.Simon Property Group, L.P.Notes to Consolidated Financial Statements(Dollars in thousands, except share, per share, unit and per unit amountsand where indicated as in millions or billions)1. OrganizationSimon Property Group, Inc. is a Delaware corporation that operates as a self-administered and self-managed real estate investment trust, or REIT, under the Internal Revenue Code of 1986, as amended, or the Internal Revenue Code. REITs will generally not be liable for U.S. federal corporate income taxes as long as they distribute not less than 100% of their REIT taxable income. Simon Property Group, L.P. is our majority-owned Delaware partnership subsidiary that owns all of our real estate properties and other assets. Unless stated otherwise or the context otherwise requires, references to "Simon" mean Simon Property Group, Inc. and references to the "Operating Partnership" mean Simon Property Group, L.P. References to "we," "us" and "our" mean collectively Simon, the Operating Partnership and those entities/subsidiaries owned or controlled by Simon and/or the Operating Partnership. Unless otherwise indicated, these notes to consolidated financial statements apply to both Simon and the Operating Partnership. According to the Operating Partnership's partnership agreement, the Operating Partnership is required to pay all expenses of Simon.We own, develop and manage premier shopping, dining, entertainment and mixed-use destinations, which consist primarily of malls, Premium Outlets®, and The Mills®. As of December 31, 2020, we owned or held an interest in 203 income-producing properties in the United States, which consisted of 99 malls, 69 Premium Outlets, 14 Mills, four lifestyle centers, and 17 other retail properties in 37 states and Puerto Rico. We also own an 80% noncontrolling interest in the Taubman Realty Group, LLC, or TRG, which has an interest in 24 regional, super-regional, and outlet malls in the U.S. and Asia. Internationally, as of December 31, 2020, we had ownership interests in 31 Premium Outlets and Designer Outlet properties primarily located in Asia, Europe, and Canada. As of December 31, 2020, we also owned a 22.4% equity stake in Klépierre SA, or Klépierre, a publicly traded, Paris-based real estate company which owns, or has an interest in, shopping centers located in 15 countries in Europe.We generate the majority of our lease income from retail, dining, entertainment and other tenants including consideration received from:●Fixed minimum lease consideration and fixed common area maintenance (CAM) reimbursements and,●Variable lease consideration primarily based on tenants’ sales, as well as reimbursements for real estate taxes, utilities, marketing, and certain other items.Revenues of our management company, after intercompany eliminations, consist primarily of management fees that are typically based upon the revenues of the property being managed.We also grow by generating supplemental revenues from the following activities:●establishing our properties as leading market resource providers for retailers and other businesses and consumer-focused corporate alliances, including payment systems (such as handling fees relating to the sales of bank-issued prepaid cards), national marketing alliances, static and digital media initiatives, business development, sponsorship, and events,●offering property operating services to our tenants and others, including waste handling and facility services, and the provision of energy services,●selling or leasing land adjacent to our properties, commonly referred to as “outlots” or “outparcels,” and●generating interest income on cash deposits and investments in loans, including those made to related entities.​97 Table of ContentsSimon Property Group, Inc.Simon Property Group, L.P.Notes to Consolidated Financial Statements(Dollars in thousands, except share, per share, unit and per unit amountsand where indicated as in millions or billions)2. Basis of Presentation and ConsolidationThe accompanying consolidated financial statements include the accounts of all controlled subsidiaries, and all significant intercompany amounts have been eliminated.We consolidate properties that are wholly-owned or properties where we own less than 100% but we control. Control of a property is demonstrated by, among other factors, our ability to refinance debt and sell the property without the consent of any other partner or owner and the inability of any other partner or owner to replace us.We also consolidate a variable interest entity, or VIE, when we are determined to be the primary beneficiary. Determination of the primary beneficiary of a VIE is based on whether an entity has (1) the power to direct activities that most significantly impact the economic performance of the VIE and (2) the obligation to absorb losses or the right to receive benefits of the VIE that could potentially be significant to the VIE. Our determination of the primary beneficiary of a VIE considers all relationships between us and the VIE, including management agreements and other contractual arrangements. There have been no changes during 2020 in previous conclusions about whether an entity qualifies as a VIE or whether we are the primary beneficiary of any previously identified VIE. During the periods presented, we did not provide financial or other support to any identified VIE that we were not contractually obligated to provide.Investments in partnerships and joint ventures represent our noncontrolling ownership interests. We account for these unconsolidated entities using the equity method of accounting. We initially record these investments at cost and we subsequently adjust for net equity in income or loss, which we allocate in accordance with the provisions of the applicable partnership or joint venture agreement, cash contributions and distributions, and foreign currency fluctuations, if applicable. The allocation provisions in the partnership or joint venture agreements are not always consistent with the legal ownership interests held by each general or limited partner or joint venture investee primarily due to partner preferences. We separately report investments in partnerships and joint ventures for which accumulated distributions have exceeded investments in and our share of net income of the partnerships and joint ventures within cash distributions and losses in partnerships and joint ventures, at equity in the consolidated balance sheets. The net equity of certain partnerships and joint ventures is less than zero because of financing or operating distributions that are usually greater than net income, as net income includes non-cash charges for depreciation and amortization.As of December 31, 2020, we consolidated 133 wholly-owned properties and 17 additional properties that are less than wholly-owned, but which we control or for which we are the primary beneficiary. We account for the remaining 84 properties, or the joint venture properties, as well as our investments in Klépierre, HBS Global Properties, or HBS, and TRG, and our retailer investments in Authentic Brands Group LLC, or ABG, Forever 21, J.C. Penney, Rue Gilt Groupe, or RGG, and SPARC Group, formerly known as Aéropostale, using the equity method of accounting, as we have determined we have significant influence over their operations. We manage the day-to-day operations of 57 of the 84 joint venture properties, but have determined that our partner or partners have substantive participating rights with respect to the assets and operations of these joint venture properties. Our investments in joint ventures in Japan, South Korea, Mexico, Malaysia, Germany, Canada, Spain, Thailand, and the United Kingdom comprise 23 of the remaining 27 properties. These international properties and TRG are managed by joint ventures in which we share control.Preferred distributions of the Operating Partnership are accrued at declaration and represent distributions on outstanding preferred units of partnership interests, or preferred units, and are included in net income attributable to noncontrolling interests. We allocate net operating results of the Operating Partnership after preferred distributions to limited partners and to us based on the partners’ respective weighted average ownership interests in the Operating Partnership. Net operating results of the Operating Partnership attributable to limited partners are reflected in net income attributable to noncontrolling interests. 98 Table of ContentsSimon Property Group, Inc.Simon Property Group, L.P.Notes to Consolidated Financial Statements(Dollars in thousands, except share, per share, unit and per unit amountsand where indicated as in millions or billions)Our weighted average ownership interest in the Operating Partnership was as follows:​​​​​​​​​​​For the Year Ended ​​December 31, ​ 2020 2019 2018​Weighted average ownership interest 86.9% 86.8% 86.8% ​As of December 31, 2020 and 2019, our ownership interest in the Operating Partnership was 87.4% and 86.8%, respectively. We adjust the noncontrolling limited partners’ interest at the end of each period to reflect their interest in the net assets of the Operating Partnership.Preferred unit requirements in the Operating Partnership’s accompanying consolidated statements of operations and comprehensive income represent distributions on outstanding preferred units and are recorded when declared. 3. Summary of Significant Accounting PoliciesInvestment PropertiesInvestment properties consist of the following as of December 31:​​​​​​​​​​ 2020 2019 Land​$ 3,700,023​$ 3,692,056​Buildings and improvements​ 33,908,615​ 33,664,683​Total land, buildings and improvements​ 37,608,638​ 37,356,739​Furniture, fixtures and equipment​ 441,558​ 447,756​Investment properties at cost​ 38,050,196​ 37,804,495​Less — accumulated depreciation​ 14,891,937​ 13,905,776​Investment properties at cost, net​$ 23,158,259​$ 23,898,719​Construction in progress included above​$ 773,061​$ 812,982​​We record investment properties at cost. Investment properties include costs of acquisitions; development, predevelopment, and construction (including allocable salaries and related benefits); tenant allowances and improvements; and interest and real estate taxes incurred during construction. We capitalize improvements and replacements from repair and maintenance when the repair and maintenance extends the useful life, increases capacity, or improves the efficiency of the asset. All other repair and maintenance items are expensed as incurred. We capitalize interest on projects during periods of construction until the projects are ready for their intended purpose based on interest rates in place during the construction period. The amount of interest capitalized during each year is as follows:​​​​​​​​​​​​​​For the Year Ended ​​December 31, ​ ​2020 ​2019 ​2018​Capitalized interest​$ 22,917​$ 33,342​$ 19,871​​We record depreciation on buildings and improvements utilizing the straight-line method over an estimated original useful life, which is generally 10 to 35 years. We review depreciable lives of investment properties periodically and we make adjustments when necessary to reflect a shorter economic life. We amortize tenant allowances and tenant improvements utilizing the straight-line method over the term of the related lease or occupancy term of the tenant, if shorter. We record depreciation on equipment and fixtures utilizing the straight-line method over seven to ten years.We review investment properties for impairment on a property-by-property basis to identify and evaluate events or changes in circumstances which indicate that the carrying value of investment properties may not be recoverable. These 99 Table of ContentsSimon Property Group, Inc.Simon Property Group, L.P.Notes to Consolidated Financial Statements(Dollars in thousands, except share, per share, unit and per unit amountsand where indicated as in millions or billions)circumstances include, but are not limited to, declines in a property’s operational performance, such as declining cash flows, occupancy or total sales per square foot, the Company’s intent and ability to hold the related asset, and, if applicable, the remaining time to maturity of underlying financing arrangements. We measure any impairment of investment property when the estimated undiscounted operating income before depreciation and amortization during the anticipated holding period plus its residual value, and, if applicable, on a probability weighted basis, is less than the carrying value of the property. To the extent impairment has occurred, we charge to income the excess of carrying value of the property over our estimate of fair value. We also review our investments, including investments in unconsolidated entities, to identify and evaluate whether events or changes in circumstances indicate that the carrying amount of our investments may not be recoverable. We will record an impairment charge if we determine the fair value of the investment is less than its carrying value and such impairment is other-than-temporary. Our evaluation of changes in economic or operating conditions and whether an impairment is other-than-temporary may include developing estimates of fair value, forecasted cash flows or operating income before depreciation and amortization. We estimate undiscounted cash flows and fair value using observable and unobservable data such as operating income before depreciation and amortization, hold periods, estimated capitalization and discount rates, or relevant market multiples, leasing prospects and local market information, expected probabilities of outcomes, if applicable, and whether an impairment is other-than-temporary. Changes in economic and operating conditions including, changes in the financial condition of our tenants and changes to our intent and ability to hold the related asset, that occur subsequent to our review of recoverability of investment property and other investments could impact the assumptions used in that assessment and could result in future charges to earnings if assumptions regarding those investments differ from actual results. During the fourth quarter of 2020, we recorded an impairment charge of $34.4 million related to one consolidated property, which is included in (loss) gain on sale or disposal of, or recovery on, assets and interests in unconsolidated entities and impairment, net, in the accompanying consolidated statement of operations and comprehensive income. During the third quarter of 2020, we recorded an other-than-temporary impairment charge of $55.2 million, representing our equity method investment balance in three joint venture properties, which is included in (loss) gain on sale or disposal of, or recovery on, assets and interests in unconsolidated entities and impairment, net, in the accompanying consolidated statement of operations and comprehensive income. Purchase AccountingWe allocate the purchase price of asset acquisitions and any excess investment in unconsolidated entities to the various components of the acquisition based upon the relative fair value of each component which may be derived from various observable or unobservable inputs and assumptions. Also, we may utilize third party valuation specialists. These components typically include buildings, land and intangibles related to in-place leases and we estimate:●the relative fair value of land and related improvements and buildings on an as-if-vacant basis,●the market value of in-place leases based upon our best estimate of current market rents and amortize the resulting market rent adjustment into lease income,●the value of costs to obtain tenants, including tenant allowances and improvements and leasing commissions, and●the value of lease income and recovery of costs foregone during a reasonable lease-up period, as if the space was vacant.The relative fair value of buildings is depreciated over the estimated remaining life of the acquired building or related improvements. We amortize tenant improvements, in-place lease assets and other lease-related intangibles over the remaining life of the underlying leases. We also estimate the value of other acquired intangible assets, if any, which are amortized over the remaining life of the underlying related intangibles.100 Table of ContentsSimon Property Group, Inc.Simon Property Group, L.P.Notes to Consolidated Financial Statements(Dollars in thousands, except share, per share, unit and per unit amountsand where indicated as in millions or billions)Cash and Cash EquivalentsWe consider all highly liquid investments purchased with an original maturity of 90 days or less to be cash and cash equivalents. Cash equivalents are carried at cost, which approximates fair value. Cash equivalents generally consist of commercial paper, bankers’ acceptances, Eurodollars, repurchase agreements, and money market deposits or securities. Financial instruments that potentially subject us to concentrations of credit risk include our cash and cash equivalents and our trade accounts receivable. We place our cash and cash equivalents with institutions of high credit quality. However, at certain times, such cash and cash equivalents are in excess of Federal Deposit Insurance Corporation and Securities Investor Protection Corporation insurance limits. See Notes 4 and 8 for disclosures about non-cash investing and financing transactions.Equity Instruments and Debt SecuritiesEquity instruments and debt securities consist primarily of equity instruments, our deferred compensation plan investments, the debt securities of our captive insurance subsidiary, and certain investments held to fund the debt service requirements of debt previously secured by investment properties. At December 31, 2020 and 2019, we had equity instruments with readily determinable fair values of $41.9 million and $68.2 million, respectively. Changes in the fair value of these equity instruments are recorded in earnings. Non-cash mark-to-market adjustments related to an investment we hold in units of a publicly traded real estate investment trust are included in unrealized losses in fair value of equity instruments in our consolidated statements of operations and comprehensive income. Non-cash mark-to-market adjustments related to other non-real estate securities with readily determinable fair values for the years ended December 31, 2020, 2019, and 2018 were nil, $5.0 million, and nil, respectively, and these losses were recorded in other expense in our consolidated statements of operations and comprehensive income. At December 31, 2020 and 2019, we had equity instruments without readily determinable fair values of $309.3 million and $295.4 million, respectively, for which we have elected the measurement alternative. We regularly evaluate these investments for any impairment in their estimated fair value, as well as any observable price changes for an identical or similar equity instrument of the same issuer, and determined that no material adjustment in the carrying value was required for the years ended December 31, 2020 and 2019.Our deferred compensation plan equity instruments are valued based upon quoted market prices. The investments have a matching liability as the amounts are fully payable to the employees that earned the compensation. Changes in value of these securities and changes to the matching liability to employees are both recognized in earnings and, as a result, there is no impact to consolidated net income.At December 31, 2020 and 2019, we held debt securities of $40.5 million and $52.8 million, respectively, in our captive insurance subsidiary. The types of securities included in the investment portfolio of our captive insurance subsidiary are typically U.S. Treasury or other U.S. government securities as well as corporate debt securities with maturities ranging from less than one year to ten years. These securities are classified as available-for-sale and are valued based upon quoted market prices or other observable inputs when quoted market prices are not available. The amortized cost of debt securities, which approximates fair value, held by our captive insurance subsidiary is adjusted for amortization of premiums and accretion of discounts to maturity. Changes in the values of these securities are recognized in accumulated other comprehensive income (loss) until the gain or loss is realized or until any unrealized loss is deemed to be other-than-temporary. We review any declines in value of these securities for other-than-temporary impairment and consider the severity and duration of any decline in value. To the extent an other-than-temporary impairment is deemed to have occurred, an impairment is recorded and a new cost basis is established.Our captive insurance subsidiary is required to maintain statutory minimum capital and surplus as well as maintain a minimum liquidity ratio. Therefore, our access to these securities may be limited. Fair Value MeasurementsLevel 1 fair value inputs are quoted prices for identical items in active, liquid and visible markets such as stock exchanges. Level 2 fair value inputs are observable information for similar items in active or inactive markets, and 101 Table of ContentsSimon Property Group, Inc.Simon Property Group, L.P.Notes to Consolidated Financial Statements(Dollars in thousands, except share, per share, unit and per unit amountsand where indicated as in millions or billions)appropriately consider counterparty creditworthiness in the valuations. Level 3 fair value inputs reflect our best estimate of inputs and assumptions market participants would use in pricing an asset or liability at the measurement date. The inputs are unobservable in the market and significant to the valuation estimate. We have no investments for which fair value is measured on a recurring basis using Level 3 inputs.The equity instruments with readily determinable fair values we held at December 31, 2020 and 2019 were primarily classified as having Level 1 and Level 2 fair value inputs. In addition, we had derivative instruments which were classified as having Level 2 inputs, which consist primarily of foreign currency forward contracts and interest rate swap agreements with an insignificant gross asset balance at December 31, 2020 and $17.5 million at December 31, 2019, and a gross liability balance of $44.6 million and $3.8 million at December 31, 2020 and 2019, respectively. Note 7 includes a discussion of the fair value of debt measured using Level 2 inputs. Notes 3 and 4 include discussions of the fair values recorded in purchase accounting using Level 2 and Level 3 inputs. Level 3 inputs to our purchase accounting and impairment analyses include our estimations of fair value, net operating results of the property, capitalization rates and discount rates. Gains or losses on Issuances of Stock by Equity Method Investees When one of our equity method investees issues additional shares to third parties, our percentage ownership interest in the investee may decrease. In the event the issuance price per share is higher or lower than our average carrying amount per share, we recognize a noncash gain or loss on the issuance, when appropriate. This noncash gain or loss is recognized in our net income in the period the change of ownership interest occurs.Use of EstimatesWe prepared the accompanying consolidated financial statements in accordance with accounting principles generally accepted in the United States, or GAAP. GAAP requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements, and revenues and expenses during the reported period. Our actual results could differ from these estimates.Segment and Geographic LocationsOur primary business is the ownership, development, and management of premier shopping, dining, entertainment and mixed use real estate. We have aggregated our retail operations, including malls, Premium Outlets, The Mills, and our international investments into one reportable segment because they have similar economic characteristics and we provide similar products and services to similar types of, and in many cases, the same, tenants. As of December 31, 2020, approximately 6.9% of our consolidated long-lived assets and 2.4% of our consolidated total revenues were derived from assets located outside the United States. As of December 31, 2019, approximately 6.2% of our consolidated long-lived assets and 2.9% of our consolidated total revenues were derived from assets located outside the United States.102 Table of ContentsSimon Property Group, Inc.Simon Property Group, L.P.Notes to Consolidated Financial Statements(Dollars in thousands, except share, per share, unit and per unit amountsand where indicated as in millions or billions)Deferred Costs and Other AssetsDeferred costs and other assets include the following as of December 31:​​​​​​​​​​ 2020 2019 Deferred lease costs, net​$ 169,651​$ 209,277​In-place lease intangibles, net​ 3,905​ 31,417​Acquired above market lease intangibles, net​ 31,053​ 44,337​Marketable securities of our captive insurance companies​ 40,496​ 52,760​Goodwill​ 20,098​ 20,098​Other marketable and non-marketable securities​ 351,176​ 363,554​Prepaids, notes receivable and other assets, net​ 465,789​ 492,582​​​$ 1,082,168​$ 1,214,025​​Deferred Lease CostsOur deferred leasing costs consist primarily of initial direct costs and, prior to the adoption of ASC 842, capitalized salaries and related benefits, in connection with lease originations. We record amortization of deferred leasing costs on a straight-line basis over the terms of the related leases. Details of these deferred costs as of December 31 are as follows:​​​​​​​​​​ 2020 2019 Deferred lease costs​$ 407,288​$ 443,313​Accumulated amortization​ (237,637)​ (234,036)​Deferred lease costs, net​$ 169,651​$ 209,277​​Amortization of deferred leasing costs is a component of depreciation and amortization expense. The accompanying consolidated statements of operations and comprehensive income include amortization of deferred leasing costs as follows:​​​​​​​​​​​​​​For the Year Ended December 31, ​ 2020 2019 2018 Amortization of deferred leasing costs​$ 51,349​$ 57,201​$ 56,646​​IntangiblesThe average remaining life of in-place lease intangibles is approximately 2.2 years and is being amortized on a straight-line basis and is included with depreciation and amortization in the consolidated statements of operations and comprehensive income. The fair market value of above and below market leases is amortized into lease income over the remaining lease life as a component of reported lease income. The weighted average remaining life of these intangibles is approximately 2.8 years. The unamortized amount of below market leases is included in accounts payable, accrued expenses, intangibles and deferred revenues in the consolidated balance sheets and was $28.7 million and $44.8 million as of December 31, 2020 and 2019, respectively. The amount of amortization of above and below market leases, net, which increased lease income for the years ended December 31, 2020, 2019, and 2018, was $1.3 million, $1.9 million and $1.0 million, respectively. If a lease is terminated prior to the original lease termination, any remaining unamortized intangible is written off to earnings.103 Table of ContentsSimon Property Group, Inc.Simon Property Group, L.P.Notes to Consolidated Financial Statements(Dollars in thousands, except share, per share, unit and per unit amountsand where indicated as in millions or billions)Details of intangible assets as of December 31 are as follows:​​​​​​​​​​​2020​2019​In-place lease intangibles​$173,094 ​$196,007 ​Accumulated amortization​​(169,189)​​(164,590)​In-place lease intangibles, net​$3,905 ​$31,417 ​​​​​​​​​​​2020​2019​Acquired above market lease intangibles​$186,620 ​$252,934 ​Accumulated amortization​​(155,567)​​(208,597)​Acquired above market lease intangibles, net​$31,053 ​$44,337 ​​Estimated future amortization and the increasing (decreasing) effect on lease income for our above and below market leases as of December 31, 2020 are as follows:​​​​​​​​​​​​​​Below​Above​Impact to​​​Market​Market​Lease​​​Leases​Leases​Income, Net​2021​$ 8,193​$ (11,001)​$ (2,808) 2022 ​ 5,565 ​ (8,012) ​ (2,447)​2023 ​ 4,224 ​ (5,858) ​ (1,634)​2024 ​ 3,265 ​ (3,981) ​ (716)​2025 ​ 2,322 ​ (1,677) ​ 645​Thereafter ​ 5,122 ​ (524) ​ 4,598​​​$ 28,691​$ (31,053)​$ (2,362)​​Derivative Financial InstrumentsWe record all derivatives on our consolidated balance sheets at fair value. The accounting for changes in the fair value of derivatives depends on the intended use of the derivative, whether we have designated a derivative as a hedge and whether the hedging relationship has satisfied the criteria necessary to apply hedge accounting. We may use a variety of derivative financial instruments in the normal course of business to selectively manage or hedge a portion of the risks associated with our indebtedness and interest payments. Our objectives in using interest rate derivatives are to add stability to interest expense and to manage our exposure to interest rate movements. To accomplish this objective, we primarily use interest rate swaps and caps. We require that hedging derivative instruments be highly effective in reducing the risk exposure that they are designated to hedge. We formally designate any instrument that meets these hedging criteria as a hedge at the inception of the derivative contract. We have no credit-risk-related hedging or derivative activities.As of December 31, 2020 and 2019, we had no outstanding interest rate derivatives. We generally do not apply hedge accounting to interest rate caps, which had an insignificant value as of December 31, 2020 and 2019, respectively. Our exposure to market risk due to changes in interest rates primarily relates to our long-term debt obligations. We manage exposure to interest rate market risk through our risk management strategy by a combination of interest rate protection agreements to effectively fix or cap a portion of variable rate debt. We may enter into treasury lock agreements as part of an anticipated debt issuance. Upon completion of the debt issuance, the fair value of these instruments is recorded as part of accumulated other comprehensive income (loss) and is amortized to interest expense over the life of the debt agreement.104 Table of ContentsSimon Property Group, Inc.Simon Property Group, L.P.Notes to Consolidated Financial Statements(Dollars in thousands, except share, per share, unit and per unit amountsand where indicated as in millions or billions)The unamortized gain on our treasury locks and terminated hedges recorded in accumulated other comprehensive income was $8.7 million and $10.6 million as of December 31, 2020 and 2019, respectively. Within the next year, we expect to reclassify to earnings approximately $1.0 million of gains related to terminated interest rate swaps from the current balance held in accumulated other comprehensive income (loss).We are also exposed to foreign currency risk on financings of certain foreign operations. Our intent is to offset gains and losses that occur on the underlying exposers, with gains and losses on the derivative contracts hedging these exposers. We do not enter into either interest rate protection or foreign currency rate protection agreements for speculative purposes.We are also exposed to fluctuations in foreign exchange rates on financial instruments which are denominated in foreign currencies, primarily in Yen and Euro. We use currency forward contracts, cross currency swap contracts, and foreign currency denominated debt to manage our exposure to changes in foreign exchange rates on certain Yen and Euro-denominated receivables and net investments. Currency forward contracts involve fixing the Yen:USD or Euro:USD exchange rate for delivery of a specified amount of foreign currency on a specified date. The currency forward contracts are typically cash settled in U.S. dollars for their fair value at or close to their settlement date. 105 Table of ContentsSimon Property Group, Inc.Simon Property Group, L.P.Notes to Consolidated Financial Statements(Dollars in thousands, except share, per share, unit and per unit amountsand where indicated as in millions or billions)We had the following Euro:USD forward contracts designated as net investment hedges at December 31, 2020 and 2019 (in millions):​​​​​​​​​​​​ ​ Asset (Liability) Value as of​​​​December 31, December 31, Notional Value​Maturity Date​2020​2019€ 50.0​March 20, 2020​​ —​ (0.5)€ 50.0​March 20, 2020​​ —​ (0.5)€ 50.0​March 20, 2020​​ —​ (0.5)€ 50.0​May 15, 2020​​ —​ 1.5€ 100.0​June 18, 2020​​ —​ (0.6)€ 90.0​June 18, 2020​​ —​ (0.5)€ 100.0​December 18, 2020​​ —​​ (0.6)€ 100.0​December 18, 2020​​ —​​ (0.6)€ 100.0​March 24, 2021​​ (3.9)​​ —€ 100.0​March 24, 2021​​ (3.8)​​ —€ 50.0​March 24, 2021​​ (2.3)​​ —€ 50.0​March 24, 2021​​ (2.2)​​ —€ 50.0​May 14, 2021​​ (2.2)​​ —€ 50.0​May 14, 2021​​ (2.2)​​ —€ 41.0​May 14, 2021​​ (1.9)​​ —€ 20.0​May 14, 2021​​ (1.7)​​ —€ 50.0​May 14, 2021​​ (2.1)​​ 1.3€ 50.0​May 14, 2021​​ (6.4)​​ —€ 30.0​May 14, 2021​​ (2.6)​ —€ 60.0​December 20, 2021​​ (4.2)​ —€ 60.0​December 20, 2021​​ (4.1)​ —€ 30.0​December 20, 2021​​ (2.2)​ —€ 50.0​July 15, 2021​​ (0.1)​ —€ 50.0​July 15, 2021​​ (0.1)​ —€ 50.0​July 15, 2021​​ (0.1)​ —€ 50.0​July 15, 2021​​ —​​ —€ 50.0​July 15, 2021​​ —​​ —€ 61.0​September 17, 2021​​ (1.3)​ —€ 61.0​September 17, 2021​​ (1.2)​ —​Asset balances in the above table are included in deferred costs and other assets. Liability balances in the above table are included in other liabilities.We used a Euro-denominated cross-currency swap agreement to manage our exposure to changes in foreign exchange rates by swapping $150.0 million of 4.38% fixed rate U.S. dollar-denominated debt to 1.37% fixed rate Euro-denominated debt of €121.6 million. The cross-currency swap matured on December 1, 2020. The fair value of our cross-currency swap agreement on the settlement date was $4.1 million and at December 31, 2019 was $14.7 million, and is included in deferred costs and other assets. 106 Table of ContentsSimon Property Group, Inc.Simon Property Group, L.P.Notes to Consolidated Financial Statements(Dollars in thousands, except share, per share, unit and per unit amountsand where indicated as in millions or billions)We have designated the currency forward contracts and cross-currency swaps as net investment hedges. Accordingly, we report the changes in fair value in other comprehensive income (loss). Changes in the value of these forward contracts are offset by changes in the underlying hedged Euro or Yen-denominated joint venture investment.The total accumulated other comprehensive income (loss) related to Simon’s derivative activities, including our share of other comprehensive income (loss) from unconsolidated entities, was ($53.2) million and $41.2 million as of December 31, 2020 and 2019, respectively. The total accumulated other comprehensive income (loss) related to the Operating Partnership’s derivative activities, including our share of the other comprehensive income from unconsolidated entities, was ($60.9) million and $47.5 million as of December 31, 2020 and 2019, respectively. Noncontrolling InterestsSimonDetails of the carrying amount of our noncontrolling interests are as follows as of December 31:​$(​​​​​​​​ ​​ ​​ ​​​​​​​​​ 2020 2019​Limited partners’ interests in the Operating Partnership​$ 431,784​$ 378,339​Nonredeemable noncontrolling interests in properties, net​ 1,090​ 6,513​Total noncontrolling interests reflected in equity​$ 432,874​$ 384,852​​Net income attributable to noncontrolling interests (which includes nonredeemable and redeemable noncontrolling interests in consolidated properties, limited partners’ interests in the Operating Partnership, and preferred distributions payable by the Operating Partnership on its outstanding preferred units) is a component of consolidated net income. In addition, the individual components of other comprehensive income (loss) are presented in the aggregate for both controlling and noncontrolling interests, with the portion attributable to noncontrolling interests deducted from comprehensive income attributable to common stockholders.The Operating PartnershipOur evaluation of the appropriateness of classifying the Operating Partnership’s common units of partnership interest, or units, held by Simon and the Operating Partnership's limited partners within permanent equity considered several significant factors. First, as a limited partnership, all decisions relating to the Operating Partnership’s operations and distributions are made by Simon, acting as the Operating Partnership’s sole general partner. The decisions of the general partner are made by Simon's Board of Directors or management. The Operating Partnership has no other governance structure. Secondly, the sole asset of Simon is its interest in the Operating Partnership. As a result, a share of common stock of Simon, or common stock, if owned by the Operating Partnership, is best characterized as being similar to a treasury share and thus not an asset of the Operating Partnership.Limited partners of the Operating Partnership have the right under the Operating Partnership’s partnership agreement to exchange their units for shares of common stock or cash, as selected by Simon as the sole general partner. Accordingly, we classify units held by limited partners in permanent equity because Simon may elect to issue shares of common stock to limited partners exercising their exchange rights rather than using cash. Under the Operating Partnership’s partnership agreement, the Operating Partnership is required to redeem units held by Simon only when Simon has repurchased shares of common stock. We classify units held by Simon in permanent equity because the decision to redeem those units would be made by Simon.Net income attributable to noncontrolling interests (which includes nonredeemable and redeemable noncontrolling interests in consolidated properties) is a component of consolidated net income.107 Table of ContentsSimon Property Group, Inc.Simon Property Group, L.P.Notes to Consolidated Financial Statements(Dollars in thousands, except share, per share, unit and per unit amountsand where indicated as in millions or billions)Accumulated Other Comprehensive Income (Loss)SimonThe total accumulated other comprehensive income (loss) related to Simon’s currency translation adjustment was ($136.2) million, ($160.4) million and ($158.9) million as of December 31, 2020, 2019 and 2018, respectively.The reclassifications out of accumulated other comprehensive income (loss) consisted of the following as of December 31:​​​​​​​​​​​​​​​​2020​2019​2018​Affected line item where net income is presented​Currency translation adjustments​$ (1,739)​$ —​$ —​Other income​​​​ 219​​ —​​ —​Net income attributable to noncontrolling interests​​​$ (1,520)​$ —​​ —​​​​​​​​​​​​​​​​Accumulated derivative gains (losses), net​$ 1,845 $ (2,782) $ (7,020) Interest expense​​​​ —​​ (10,852)​​ —​Loss on extinguishment of debt​​​ (232) 1,802 923 Net income attributable to noncontrolling interests​​​$ 1,613​$ (11,832)​$ (6,097)​​​​The Operating PartnershipThe total accumulated other comprehensive income (loss) related to the Operating Partnership’s currency translation adjustment was ($155.8) million, ($184.8) million and ($183.0) million as of December 31, 2020, 2019 and 2018, respectively.The reclassifications out of accumulated other comprehensive income (loss) consisted of the following as of December 31:​​​​​​​​​​​​​​​​2020​2019​2018​Affected line item where net income is presented​Currency translation adjustments​$ (1,739) $ — $ —​Other income​​​​​​​​​​​​​​Accumulated derivative gains (losses), net​$ 1,845 $ (2,782) $ (7,020)​Interest expense​​​​ —​​ (10,852)​​ —​Loss on extinguishment of debt​​​$ 1,845​$ (13,634)​$ (7,020)​​​​​​​​​​​​​​​​​Revenue RecognitionWe, as a lessor, retain substantially all of the risks and benefits of ownership of the investment properties and account for our leases as operating leases. We accrue fixed lease income on a straight-line basis over the terms of the leases when we believe substantially all lease income, including the related straight-line rent receivable, is probable of collection. Substantially all of our retail tenants are also required to pay overage rents based on sales over a stated base amount during the lease year. We recognize this variable lease consideration only when each tenant’s sales exceed the applicable sales threshold. We amortize any tenant inducements as a reduction of lease income utilizing the straight-line method over the term of the related lease or occupancy term of the tenant, if shorter. 108 Table of ContentsSimon Property Group, Inc.Simon Property Group, L.P.Notes to Consolidated Financial Statements(Dollars in thousands, except share, per share, unit and per unit amountsand where indicated as in millions or billions)We structure our leases to allow us to recover a significant portion of our property operating, real estate taxes, repairs and maintenance, and advertising and promotion expenses from our tenants. A substantial portion of our leases, other than those for anchor stores, require the tenant to reimburse us for a substantial portion of our operating expenses, including common area maintenance, or CAM, real estate taxes and insurance. Such property operating expenses typically include utility, insurance, security, janitorial, landscaping, food court and other administrative expenses. This significantly reduces our exposure to increases in costs and operating expenses resulting from inflation or otherwise. For substantially all of our leases in the U.S. mall portfolio, we receive a fixed payment from the tenant for the CAM component which is recognized as lease income on a straight-line basis over the term of the lease beginning with the adoption of ASC 842. When not reimbursed by the fixed CAM component, CAM expense reimbursements are based on the tenant’s proportionate share of the allocable operating expenses and CAM capital expenditures for the property. We accrue all variable reimbursements from tenants for recoverable portions of all of these expenses as variable lease consideration in the period the applicable expenditures are incurred. We recognize differences between estimated recoveries and the final billed amounts in the subsequent year. These differences were not material in any period presented. Our advertising and promotional costs are expensed as incurred. Provisions for credit losses that are not probable of collection are recognized as a reduction of lease income. In April 2020, the FASB staff released guidance focused on treatment of concessions related to the effects of COVID-19 on the application of lease modification guidance in Accounting Standards Codification (ASC) 842, “Leases.” The guidance provides a practical expedient to forgo the associated reassessments required by ASC 842 when changes to a lease result in similar or lower future consideration. We have elected to generally account for rent abatements as negative variable lease consideration in the period granted, or in the period we determine we expect to grant an abatement. Further abatements granted in the future will reduce lease income in the period we grant, or determine we expect to grant, an abatement.We have agreed to deferral or abatement arrangements with a number of our tenants as a result of the COVID-19 pandemic. Discussions with our tenants are ongoing and may result in further rent deferrals, lease amendments, abatements and/or lease terminations, as we deem appropriate on a case-by-case basis based on each tenant's unique financial and operating situation. In addition, uncollected rent due from certain of our tenants is subject to ongoing litigation, the outcome of which may affect our ability to collect in full the associated outstanding receivable balances. In connection with rent deferrals or other accruals of unpaid rent payments, if we determine that rent payments are probable of collection, we will continue to recognize lease income on a straight-line basis over the lease term along with associated tenant receivables. However, if we determine that such deferred rent payments or other accrued but unpaid rent payments are not probable of collection, lease income will be recorded on the cash basis, with the corresponding tenant receivable and deferred rent receivable balances charged as a direct write-off against lease income in the period of the change in our collectability determination. Additionally, our assessment of collectability incorporates information regarding a tenant’s financial condition that is obtained from available financial data, the expected outcome of contractual disputes and other matters, and our communications and negotiations with the tenant.When a tenant seeks to reorganize its operations through bankruptcy proceedings, we assess the collectability of receivable balances. Our ongoing assessment incorporates, among other things, the timing of a tenant’s bankruptcy filing and our expectations of the assumptions by the tenant in bankruptcy proceedings of leases at the Company’s properties on substantially similar terms. Refer to note 9 for further disclosure of lease income. Management Fees and Other RevenuesManagement fees and other revenues are generally received from our unconsolidated joint venture properties as well as third parties. Management fee revenue is earned based on a contractual percentage of joint venture property revenue. Development fee revenue is earned on a contractual percentage of hard costs to develop a property. Leasing fee revenue is earned on a contractual per square foot charge based on the square footage of current year leasing activity. We recognize revenue for these services provided when earned based on the performance criteria.109 Table of ContentsSimon Property Group, Inc.Simon Property Group, L.P.Notes to Consolidated Financial Statements(Dollars in thousands, except share, per share, unit and per unit amountsand where indicated as in millions or billions)Revenues from insurance premiums charged to unconsolidated properties are recognized on a pro-rata basis over the terms of the policies. Insurance losses on these policies and our self-insurance for our consolidated properties are reflected in property operating expenses in the accompanying consolidated statements of operations and comprehensive income and include estimates for losses incurred but not reported as well as losses pending settlement. Estimates for losses are based on evaluations by third-party actuaries and management’s estimates. Total insurance reserves for our insurance subsidiaries and other self-insurance programs as of December 31, 2020 and 2019 approximated $71.6 million and $74.5 million, respectively, and are included in other liabilities in the consolidated balance sheets. Information related to the securities included in the investment portfolio of our captive insurance subsidiary is included within the “Equity Instruments and Debt Securities” section above.Income TaxesSimon and certain subsidiaries of the Operating Partnership have elected to be taxed as REITs under Sections 856 through 860 of the Internal Revenue Code and applicable Treasury regulations relating to REIT qualification. In order to maintain this REIT status, the regulations require the entity to distribute at least 90% of REIT taxable income to its owners and meet certain other asset and income tests as well as other requirements. We intend to continue to adhere to these requirements and maintain Simon’s REIT status and that of the REIT subsidiaries. As REITs, these entities will generally not be liable for U.S. federal corporate income taxes as long as they distribute not less than 100% of their REIT taxable income. Thus, we made no provision for U.S. federal income taxes for these entities in the accompanying consolidated financial statements. If Simon or any of the REIT subsidiaries fail to qualify as a REIT, and if available relief provisions do not apply, Simon or that entity will be subject to tax at regular corporate rates for the years in which it failed to qualify. If Simon or any of the REIT subsidiaries loses its REIT status it could not elect to be taxed as a REIT for four taxable years following the year during which qualification was lost unless the failure to qualify was due to reasonable cause and certain other conditions were satisfied.We have also elected taxable REIT subsidiary, or TRS, status for some of our subsidiaries. This enables us to provide services that would otherwise be considered impermissible for REITs and participate in activities that do not qualify as “rents from real property”. For these entities, deferred tax assets and liabilities are established for temporary differences between the financial reporting basis and the tax basis of assets and liabilities at the enacted tax rates expected to be in effect when the temporary differences reverse. A valuation allowance for deferred tax assets is provided if we believe all or some portion of the deferred tax asset may not be realized. An increase or decrease in the valuation allowance that results from the change in circumstances that causes a change in our judgment about the realizability of the related deferred tax asset is included in income.As a partnership, the allocated share of the Operating Partnership’s income or loss for each year is included in the income tax returns of the partners; accordingly, no accounting for income taxes is required in the accompanying consolidated financial statements other than as discussed above for our TRSs. As of December 31, 2020 and 2019, we had net deferred tax liabilities of $251.1 million and $257.7 million, respectively, which primarily relate to the temporary differences between the carrying value of balance sheet assets and liabilities and their tax bases. These differences were primarily created through the consolidation of various European assets in 2016. Additionally, we have deferred tax liabilities related to our TRSs, consisting of operating losses and other carryforwards for U.S. federal income tax purposes as well as the timing of the deductibility of losses or reserves from insurance subsidiaries, though these amounts are not material to the financial statements. The net deferred tax liability is included in other liabilities in the accompanying consolidated balance sheets. We are also subject to certain other taxes, including state and local taxes, franchise taxes, as well as income-based and withholding taxes on dividends from certain of our international investments, which are included in income and other taxes in the consolidated statements of operations and comprehensive income. ​Corporate ExpensesHome and regional office costs primarily include compensation and personnel related costs, travel, building and 110 Table of ContentsSimon Property Group, Inc.Simon Property Group, L.P.Notes to Consolidated Financial Statements(Dollars in thousands, except share, per share, unit and per unit amountsand where indicated as in millions or billions)office costs, and other expenses for our corporate home office and regional offices. General and administrative expense primarily includes executive compensation, benefits and travel expenses as well as costs of being a public company, including certain legal costs, audit fees, regulatory fees, and certain other professional fees.New Accounting PronouncementsIn June 2016, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2016-13, "Financial Instruments - Credit Losses," which introduced new guidance for an approach based on expected losses to estimate credit losses on certain types of financial instruments. It also modifies the impairment model for available-for-sale debt securities and provides for a simplified accounting model for purchased financial assets with credit deterioration since their origination. Instruments in scope include loans, held-to-maturity debt securities, and net investments in leases as well as reinsurance and trade receivables. In November 2018, the FASB issued ASU 2018-19, which clarifies that operating lease receivables are outside the scope of the new standard. This standard was effective for us as of January 1, 2020. There was no impact on our consolidated financial statements at adoption.In March 2020, the FASB issued ASU 2020-04, “Reference Rate Reform,” which provides temporary optional expedients and exceptions to the US GAAP guidance on contract modifications and hedge accounting to ease the financial reporting burdens of the expected market transition from LIBOR and other interbank offered rates to alternative reference rates. The guidance is effective upon issuance and generally can be applied to any contract modifications or existing and new hedging relationships through December 31, 2022. We are currently evaluating the impact that the expected market transition from LIBOR to alternative references rates will have on our financial statements as well as the applicability of the aforementioned expedients and exceptions provided in ASU 2020-04. ​4. Real Estate Acquisitions and DispositionsWe acquire interests in properties to generate both current income and long-term appreciation in value. We acquire interests in individual properties or portfolios of real estate companies that meet our investment criteria and sell properties which no longer meet our strategic criteria. Unless otherwise noted below, gains and losses on these transactions are included in gain on sale or disposal of, or recovery on, assets and interests in unconsolidated entities and impairment, net in the accompanying consolidated statements of operations and comprehensive income. We capitalize asset acquisition costs and expense costs related to business combinations, as well as disposition related costs as they are incurred. We incurred a minimal amount of transaction expenses during 2020, 2019, and 2018.Our acquisition and disposition activity for the periods presented are as follows:2019 AcquisitionsOn September 19, 2019, we acquired the remaining 50% interest in a hotel adjacent to one of our properties for cash consideration of $12.8 million. As of closing, the property was subject to a $21.5 million, 4.02% variable rate mortgage. We accounted for this transaction as an asset acquisition and substantially all our investment relates to investment property.2018 AcquisitionsOn September 25, 2018, we acquired the remaining 50% interest in The Outlets at Orange from our joint venture partner. The Operating Partnership issued 475,183 units, or approximately $84.1 million, as consideration for the acquisition. The property is subject to a $215.0 million 4.22% fixed rate mortgage loan. We accounted for this transaction as an asset acquisition and substantially all of our investment has been determined to relate to investment property.2020 DispositionsOn October 1, 2020, we disposed of our interest in one consolidated retail property. A portion of the gross proceeds on this transaction of $33.4 million was used to partially repay a cross-collateralized mortgage. Our share of the $12.3 111 Table of ContentsSimon Property Group, Inc.Simon Property Group, L.P.Notes to Consolidated Financial Statements(Dollars in thousands, except share, per share, unit and per unit amountsand where indicated as in millions or billions)million gain is included in (loss) gain on sale or disposed of, or recovery on, assets and interests in unconsolidated entities and impairment, net in the accompanying consolidated statement of operation and comprehensive income.2019 DispositionsDuring 2019, we disposed of our interests in one multi-family residential investment. Our share of the gross proceeds on this transaction was $17.9 million. Our share of the gain of $16.2 million is included in other income in the accompanying consolidated statement of operation and comprehensive income. We also recorded net gains of $62.1 million, primarily related to Klépierre’s disposition of its interests in certain shopping centers, as discussed in Note 6 to the consolidated financial statements.2018 DispositionsDuring 2018, we recorded net gains of $288.8 million primarily related to disposition activity which included the foreclosure of two consolidated retail properties in satisfaction of their $200.0 million and $80.0 million non-recourse mortgage loans and, as discussed in Note 6, our interest in the German department store properties owned through our investment in HBS was sold during the fourth quarter of 2018. Also, as discussed further in Note 6, Klépierre disposed of its interests in certain shopping centers during 2018, resulting in a gain of which our share was $20.2 million.5. Per Share and Per Unit DataWe determine basic earnings per share and basic earnings per unit based on the weighted average number of shares of common stock or units, as applicable, outstanding during the period and we consider any participating securities for purposes of applying the two-class method. We determine diluted earnings per share and diluted earnings per unit based on the weighted average number of shares of common stock or units, as applicable, outstanding combined with the incremental weighted average number of shares or units, as applicable, that would have been outstanding assuming all potentially dilutive securities were converted into shares of common stock or units, as applicable, at the earliest date possible. The following tables set forth the computation of basic and diluted earnings per share and basic and diluted earnings per unit.Simon​​​​​​​​​​​​​​For the Year Ended December 31, ​ 2020​2019​2018 Net Income attributable to Common Stockholders — Basic and Diluted $ 1,109,227 $ 2,098,247 $ 2,436,721​Weighted Average Shares Outstanding — Basic and Diluted ​ 308,737,625​ 307,950,112​ 309,627,178​​For the year ended December 31, 2020, potentially dilutive securities include units that are exchangeable for common stock and long-term incentive performance units, or LTIP units, granted under our long-term incentive performance programs that are convertible into units and exchangeable for common stock. No securities had a material dilutive effect for the years ended December 31, 2020, 2019, and 2018. We have not adjusted net income attributable to common stockholders and weighted average shares outstanding for income allocable to limited partners or units, respectively, as doing so would have no dilutive impact. We accrue dividends when they are declared. On December 15, 2020, Simon’s Board of Directors declared a quarterly cash dividend for the fourth quarter of 2020 of $1.30 per share, payable on January 22, 2021 to shareholders of record on December 24, 2020. At December 31, 2020, we accrued the fourth quarter dividend of $486.9 million, recorded in dividends payable in the accompanying consolidated balance sheet, which was paid in cash on January 22, 2021. 112 Table of ContentsSimon Property Group, Inc.Simon Property Group, L.P.Notes to Consolidated Financial Statements(Dollars in thousands, except share, per share, unit and per unit amountsand where indicated as in millions or billions)The Operating Partnership​​​​​​​​​​​​​​For the Year Ended December 31, ​​ 2020​2019​2018​Net Income attributable to Unitholders — Basic and Diluted $ 1,276,450 $ 2,416,945 $ 2,805,764​Weighted Average Units Outstanding — Basic and Diluted​ 355,281,882​ 354,724,019​ 356,520,452​​For the year ended December 31, 2020, potentially dilutive securities include LTIP units. No securities had a material dilutive effect for the years ended December 31, 2020, 2019, and 2018. We accrue distributions when they are declared. On December 15, 2020, Simon’s Board of Directors declared a quarterly cash distribution for the fourth quarter of 2020 of $1.30 per unit, payable on January 22, 2021 to unitholders of record on December 24, 2020. At December 31, 2020, we accrued the fourth quarter distribution of $486.9 million, recorded in distributions payable in the accompanying consolidated balance sheet, which was paid in cash on January 22, 2021.The taxable nature of the dividends declared and Operating Partnership distributions declared for each of the years ended as indicated is summarized as follows:​​​​​​​​​​​​​​For the Year Ended December 31, ​ 2020 2019 2018 Total dividends/distributions paid per common share/unit $ 6.00 $ 8.30 $ 7.90​Percent taxable as ordinary income​ 97.40 % 100.00 % 96.20 %Percent taxable as long-term capital gains​ 2.60 % 0.00 % 3.80 %​​ 100.00% 100.00% 100.00%​6. Investments in Unconsolidated Entities and International InvestmentsReal Estate Joint Ventures and InvestmentsJoint ventures are common in the real estate industry. We use joint ventures to finance properties, develop new properties and diversify our risk in a particular property or portfolio of properties. As discussed in Note 2, we held joint venture interests in 84 properties as of December 31, 2020 and 82 properties as of December 31, 2019. Certain of our joint venture properties are subject to various rights of first refusal, buy-sell provisions, put and call rights, or other sale or marketing rights for partners which are customary in real estate joint venture agreements and the industry. We and our partners in these joint ventures may initiate these provisions (subject to any applicable lock up or similar restrictions), which may result in either the sale of our interest or the use of available cash or borrowings, or the use of limited partnership interests in the Operating Partnership, to acquire the joint venture interest from our partner.We may provide financing to joint ventures primarily in the form of interest bearing construction loans. As of December 31, 2020 and 2019, we had construction loans and other advances to these related parties totaling $88.4 million and $78.4 million, respectively, which are included in deferred costs and other assets in the accompanying consolidated balance sheets.Unconsolidated Entity TransactionsOn December 29, 2020, we completed the acquisition of an 80% noncontrolling ownership interest in TRG, which has an interest in 24 regional, super-regional, and outlet malls in the U.S. and Asia. Under the terms of the transaction, we, through the Operating Partnership, acquired all of Taubman Centers, Inc., or Taubman, common stock for $43.00 per share 113 Table of ContentsSimon Property Group, Inc.Simon Property Group, L.P.Notes to Consolidated Financial Statements(Dollars in thousands, except share, per share, unit and per unit amountsand where indicated as in millions or billions)in cash. Total consideration for the acquisition, including the redemption of Taubman’s $192.5 million 6.5% Series J Cumulative Preferred Shares and its $170.0 million 6.25% Series K Cumulative Preferred Shares, and the issuance of 955,705 Operating Partnership units, was approximately $3.5 billion. Our investment includes the 6.38% Series A Cumulative Redeemable Preferred Units for $362.5 million issued to us. The purchase price allocations are preliminary and subject to revision within the measurement period, not to exceed one year from the date of acquisition. Substantially all of our investment has preliminarily been determined to relate to investment property based on estimated fair values at the acquisition date.On December 7, 2020, we and a group of co-investors acquired certain assets and liabilities of J.C. Penney, a department store retailer, out of bankruptcy. Our non-controlling interest in the venture is 41.67% and was acquired for cash consideration of $125.0 million. The purchase price allocations are preliminary and subject to revision within the measurement period, not to exceed one year from the date of acquisition.In the third quarter of 2020, we recorded an other-than-temporary impairment charge of $55.2 million, representing our equity method investment balance in three joint venture properties, which is included in (loss) gain on sale or disposal of, or recovery on, assets and interests in unconsolidated entities and impairment, net, in the accompanying consolidated statement of operations and comprehensive income.On February 19, 2020, we and a group of co-investors acquired certain assets and liabilities of Forever 21, a retailer of apparel and accessories, out of bankruptcy. The interest was acquired through two separate joint ventures, a licensing venture and an operating venture. Our noncontrolling interest in each of the retail operations venture and in the licensing venture is 37.5%. Our aggregate investment in the ventures was $67.6 million. In connection with the acquisition of our interest, the Forever 21 joint venture recorded a non-cash bargain purchase gain in the second quarter of which our share of $35.0 million pre-tax is included in income from unconsolidated entities in the consolidated statement of operations and comprehensive income.On October 16, 2019, we contributed approximately $276.8 million consisting of cash and the Shop Premium Outlets, or SPO, assets for a 45% noncontrolling interest in RGG to create a new multi-platform venture dedicated to digital value shopping. We attributed substantially all of our investment to goodwill and certain amortizing and non-amortizing intangibles.On September 19, 2019, as discussed in note 4, we acquired the remaining 50% interest in a hotel adjacent to one of our properties from our joint venture partner. As a result of this acquisition, we now own 100% of this property.During the first quarter of 2019, we disposed of our interests in a multi-family residential investment. Our share of the gross proceeds was $17.9 million. The gain of $16.2 million is included in other income in the accompanying consolidated statement of operations and comprehensive income.On September 25, 2018, as discussed in Note 4, we acquired the remaining 50% interest in The Outlets at Orange from our joint venture partner. The Operating Partnership issued 475,183 units at a price of $176.99 to acquire this remaining interest. As a result of this acquisition, we now own 100% of this property.As of December 31, 2020 and 2019, we had an 11.7%legal noncontrolling equity interest in HBS, a joint venture we formed with Hudson’s Bay Company. In the third quarter of 2020, we recorded an other-than-temporary impairment charge of $36.1 million, which is included in (loss) gain on sale or disposal of, or recovery on, assets and interests in unconsolidated entities and impairment, net, in the accompanying consolidated statement of operations and comprehensive income, to reduce our investment in HBS to its estimated fair value. In the fourth quarter of 2019, we recorded an impairment charge of $47.2 million to reduce our investment in HBS to its estimated fair value. During the fourth quarter of 2018, our interest in the German department store properties was sold to Hudson’s Bay Company and SIGNA Retail Holdings resulting in a gain of $91.1 million. These amounts are included in (loss) gain on sale or disposal of, or recovery on, assets and interests in unconsolidated entities and impairment, net in the consolidated statements of operations and comprehensive income. On June 7, 2018, Aventura Mall, a property in which we own a noncontrolling 33.3% interest, refinanced its $1.2 billion mortgage loan and its $200.8 million construction loan with a $1.75 billion mortgage loan at a fixed interest rate of 4.12% that matures on July 1, 2028. An early repayment charge of $30.9 million was incurred at the property, which along with the write-off of deferred debt issuance costs of $6.5 million, is included in interest expense in the accompanying 114 Table of ContentsSimon Property Group, Inc.Simon Property Group, L.P.Notes to Consolidated Financial Statements(Dollars in thousands, except share, per share, unit and per unit amountsand where indicated as in millions or billions)combined joint venture statements of operations. Our $12.5 million share of the charge associated with the repayment is included in income from unconsolidated entities in the accompanying consolidated statements of operations and comprehensive income. Excess proceeds from the financing were distributed to the venture partners.In May 2017, Colorado Mills, a property in which we have a noncontrolling 37.5% interest, sustained significant hail damage. During the second quarter of 2017, the property recorded an impairment charge of approximately $32.5 million based on the net carrying value of the assets damaged, which was fully offset by anticipated insurance recoveries. For the year ended December 31, 2020, the property had received business interruption insurance proceeds and also property damage proceeds of $1.1 million. For the year ended December 31, 2019, the property had received business interruption proceeds and also property damage proceeds of $67.9 million, which resulted in the property recording a $3.0 million gain in 2019. For the year ended December 31, 2018, the property had received business interruption proceeds and also property damage proceeds of $65.9 million, which resulted in the property recording a $33.4 million gain in 2018. For the periods ended December 31, 2019 and 2018, respectively, our $1.1 million and $12.5 million share of the gain is reflected within the (loss) gain on sale or disposal of, or recovery on, assets and interests in unconsolidated entities and impairment, net in the accompanying consolidated statements of operations and comprehensive income.In 2016, we and a group of co-investors acquired certain assets and liabilities of Aéropostale, a retailer of apparel and accessories, out of bankruptcy and subsequently renamed SPARC Group. The interests were acquired through two separate joint ventures, a licensing venture and an operating venture. In April 2018, we contributed our entire interest in the licensing venture in exchange for additional interests in ABG, a brand development, marketing, and entertainment company. As a result, we recognized a $35.6 million non-cash gain representing the increase in value of our previously held interest in the licensing venture, which is included in other income in the accompanying consolidated statements of operations and comprehensive income. In January 2020, we acquired additional interests of 5.05% and 1.37% in SPARC Group and ABG, respectively, for $6.7 million and $33.5 million, respectively. During the third quarter of 2020, SPARC acquired certain assets and operations of Brooks Brothers and Lucky Brands out of bankruptcy. At December 31, 2020, our noncontrolling equity method interests in the operations venture of SPARC Group and in ABG were 50.0% and 6.8%, respectively.International InvestmentsWe conduct our international operations primarily through joint venture arrangements and account for the majority of these international joint venture investments using the equity method of accounting.European Investments At December 31, 2020, we owned 63,924,148 shares, or approximately 22.4%, of Klépierre, which had a quoted market price of $22.55 per share, which is below our carrying value. We have evaluated this investment and believe that the impairment is not other-than-temporary. Our share of net income, net of amortization of our excess investment, was $26.5 million, $145.2 million and $98.8 million for the years ended December 31, 2020, 2019 and 2018, respectively. Based on applicable Euro:USD exchange rates and after our conversion of Klépierre’s results to GAAP, Klépierre’s total assets, total liabilities, and noncontrolling interests were $20.9 billion, $14.4 billion, and $1.4 billion, respectively, as of December 31, 2020 and $19.6 billion, $12.9 billion, and $1.3 billion, respectively, as of December 31, 2019. Klépierre’s total revenues, operating income before other items and consolidated net income were approximately $1.3 billion, $327.3 million and $211.2 million, respectively, for the year ended December 31, 2020, $1.5 billion, $626.3 million and $655.5 million, respectively, for the year ended December 31, 2019, and $1.6 billion, $670.4 million and $693.0 million, respectively, for the year ended December 31, 2018. During the year ended December 31, 2020, we recorded a $4.3 million net loss related to the impairment and disposition of certain assets of Klépierre. During the years ended December 31, 2019 and 2018, Klépierre completed the disposal of its interests in certain shopping centers and we recorded gains of $58.6 million and $20.2 million, respectively. These transactions are included in (loss) gain on sale or disposal of, or recovery on, assets and interests in unconsolidated entities and impairment, net in the accompanying consolidated statements of operations and comprehensive income.115 Table of ContentsSimon Property Group, Inc.Simon Property Group, L.P.Notes to Consolidated Financial Statements(Dollars in thousands, except share, per share, unit and per unit amountsand where indicated as in millions or billions)We have an interest in a European investee that had interests in ten Designer Outlet properties as of December 31, 2020 and nine Designer Outlet properties as of December 31, 2019 and 2018, respectively, in each case, six of which are consolidated by us. As of December 31, 2020, our legal percentage ownership interests in these properties ranged from 45% to 94%. Due to certain redemption rights held by our venture partner, which will require us to purchase their interests under certain circumstances, the noncontrolling interest is presented (i) in the accompanying Simon consolidated balance sheets outside of equity in limited partners’ preferred interest in the Operating Partnership and noncontrolling redeemable interests in properties and (ii) in the accompanying Operating Partnership consolidated balance sheets within preferred units, various series, at liquidation value, and noncontrolling redeemable interests in properties.In addition, we have a 50.0% noncontrolling interest in a European property management and development company that provides services to the Designer Outlet properties.We also have minority interests in Value Retail PLC and affiliated entities, which own or have interests in and operate nine luxury outlets located throughout Europe and we also have a direct minority ownership in three of those outlets. At December 31, 2020 and 2019, the carrying value of these equity instruments without readily determinable fair values was $140.8 million and is included in deferred costs and other assets.Asian Joint Ventures We conduct our international Premium Outlet operations in Japan through a joint venture with Mitsubishi Estate Co., Ltd. We have a 40%noncontrolling ownership interest in this joint venture. The carrying amount of our investment in this joint venture was $216.8 million and $212.1 million as of December 31, 2020 and 2019, respectively, including all related components of accumulated other comprehensive income (loss). We conduct our international Premium Outlet operations in South Korea through a joint venture with Shinsegae International Co. We have a 50% noncontrolling ownership interest in this joint venture. The carrying amount of our investment in this joint venture was $184.7 million and $173.9 million as of December 31, 2020 and 2019, respectively, including all related components of accumulated other comprehensive income (loss). Summary Financial InformationA summary of the combined balance sheets and statements of operations of our equity method investments and share of income from such investments, excluding our investments in HBS, Klépierre, and TRG as well as our retailer investments in ABG, Forever 21, J.C. Penney, RGG and SPARC Group, follows. 116 Table of ContentsSimon Property Group, Inc.Simon Property Group, L.P.Notes to Consolidated Financial Statements(Dollars in thousands, except share, per share, unit and per unit amountsand where indicated as in millions or billions)COMBINED BALANCE SHEETS​​​​​​​​​​ December 31, December 31, ​​2020​2019 Assets:​​​​​​​Investment properties, at cost​$ 20,079,476​$ 19,525,665​Less - accumulated depreciation​ 8,003,863​ 7,407,627​​​ 12,075,613​ 12,118,038​Cash and cash equivalents​ 1,169,422​ 1,015,864​Tenant receivables and accrued revenue, net​ 749,231​ 510,157​Right-of-use assets, net​​185,598​​ 185,302​Deferred costs and other assets​ 380,087​ 384,663​Total assets​$ 14,559,951​$ 14,214,024​Liabilities and Partners’ Deficit:​​​​​​​Mortgages​$15,569,485​$ 15,391,781​Accounts payable, accrued expenses, intangibles, and deferred revenue​ 969,242​ 977,112​Lease liabilities​​188,863​​186,594​Other liabilities​ 426,321​ 338,412​Total liabilities​ 17,153,911​ 16,893,899​Preferred units​ 67,450​ 67,450​Partners’ deficit​ (2,661,410)​ (2,747,325)​Total liabilities and partners’ deficit​$ 14,559,951​$ 14,214,024​Our Share of:​​​​​​​Partners’ deficit​$ (1,130,713)​$ (1,196,926)​Add: Excess Investment​ 1,399,757​ 1,525,903​Our net Investment in unconsolidated entities, at equity​$ 269,044​$ 328,977​​“Excess Investment” represents the unamortized difference of our investment over our share of the equity in the underlying net assets of the joint ventures or other investments acquired and has been determined to relate to the fair value of the investment properties, intangible assets, including goodwill, and debt premiums and discounts. We amortize excess investment over the life of the related depreciable components of assets acquired, typically no greater than 40 years, the terms of the applicable leases, the estimated useful lives of the finite lived intangibles, and the applicable debt maturity, respectively. The amortization is included in the reported amount of income from unconsolidated entities.​117 Table of ContentsSimon Property Group, Inc.Simon Property Group, L.P.Notes to Consolidated Financial Statements(Dollars in thousands, except share, per share, unit and per unit amountsand where indicated as in millions or billions)As of December 31, 2020, scheduled principal repayments on these joint venture properties’ mortgage indebtedness, assuming the obligations remain outstanding through the initial maturities, are as follows:​​​​​​2021​$ 2,435,875​2022​ 2,039,830​2023​ 1,393,115​2024​ 2,407,930​2025​ 1,771,762​Thereafter​ 5,551,458​Total principal maturities​ 15,599,970​Debt issuance costs​​ (30,485)​Total mortgages​$ 15,569,485​​This debt becomes due in installments over various terms extending through 2035 with interest rates ranging from 0.16% to 9.98% and a weighted average interest rate of 3.79% at December 31, 2020.118 Table of ContentsSimon Property Group, Inc.Simon Property Group, L.P.Notes to Consolidated Financial Statements(Dollars in thousands, except share, per share, unit and per unit amountsand where indicated as in millions or billions)COMBINED STATEMENTS OF OPERATIONS​​​​​​​​​​​​​​​ ​​December 31, ​​ 2020 2019 2018 REVENUE:​​ ​ ​ ​Lease income​$2,544,134​$3,088,594​$3,045,668​Other income​ 300,634​ 322,398​ 326,575​Total revenue​ 2,844,768​ 3,410,992​ 3,372,243​OPERATING EXPENSES:​​​​​​​​​​Property operating​ 519,979​ 587,062​ 590,921​Depreciation and amortization​ 692,424​ 681,764​ 652,968​Real estate taxes​ 262,351​ 266,013​ 259,567​Repairs and maintenance​ 68,722​ 85,430​ 87,408​Advertising and promotion​ 67,434​ 89,660​ 87,349​Other​ 163,710​ 196,178​ 187,292​Total operating expenses​ 1,774,620​ 1,906,107​ 1,865,505​Operating Income Before Other Items​ 1,070,148​ 1,504,885​ 1,506,738​Interest expense​ (616,332)​ (636,988)​ (663,693)​Gain on sale or disposal of assets and interests in unconsolidated entities, net​​ —​​24,609​​ 33,367​Net Income​$ 453,816​$ 892,506​$ 876,412​Third-Party Investors’ Share of Net Income​$226,364​$460,696​$436,767​Our Share of Net Income​$227,452​$431,810​$439,645​Amortization of Excess Investment​ (82,097)​ (83,556)​ (85,252)​Our Share of Gain on Sale or Disposal of Assets and Interests in Other Income in the Consolidated Financial Statements​​ —​​ (9,156)​​ —​Our Share of Gain on Sale or Disposal of, or Recovery on, Assets and Interests in Unconsolidated Entities, net​ —​ (1,133)​ (12,513)​Income from Unconsolidated Entities​$ 145,355​$ 337,965​$ 341,880​​Our share of income from unconsolidated entities in the above table, aggregated with our share of results from our investments in HBS, Klépierre, and TRG as well as our retailer investments in ABG, Forever 21, J.C. Penney, RGG, and SPARC Group, is presented in income from unconsolidated entities in the accompanying consolidated statements of operations and comprehensive income. Unless otherwise noted, our share of the gain (loss) on sale or disposal of, or recovery on, assets and interests in unconsolidated entities, net is reflected within gain on sale or disposal of, or recovery on, assets and interests in unconsolidated entities and impairment, net in the accompanying consolidated statements of operations and comprehensive income.119 Table of ContentsSimon Property Group, Inc.Simon Property Group, L.P.Notes to Consolidated Financial Statements(Dollars in thousands, except share, per share, unit and per unit amountsand where indicated as in millions or billions)7. IndebtednessOur mortgages and unsecured indebtedness, excluding the impact of derivative instruments, consist of the following as of December 31:​​​​​​​​​​ 2020 2019 Fixed-Rate Debt:​​​​​​​Mortgage notes, including $3,348 and $6,775 of net premiums and $15,237 and $15,195 of debt issuance costs, respectively. Weighted average interest and maturity of 3.84% and 4.1 years at December 31, 2020.​$ 5,803,718​$ 6,156,595​Unsecured notes, including $22,470 and $54,976 of net discounts and $74,622 and $70,297 of debt issuance costs, respectively. Weighted average interest and maturity of 2.98% and 7.3 years at December 31, 2020.​ 16,985,990​ 15,747,267​Commercial Paper (see below)​​ 623,020​​ 1,327,050​Total Fixed-Rate Debt​ 23,412,728​ 23,230,912​Variable-Rate Debt:​​​​​​​Mortgages notes, including $7,102 and $4,721 of debt issuance costs, respectively. Weighted average interest and maturity of 2.19% and 2.3 years at December 31, 2020.​ 1,137,034​ 751,130​Credit Facilities (see below), including $16,171 and $11,067 of debt issuance costs, respectively, at December 31, 2020.​ 2,108,829​ 113,933​Total Variable-Rate Debt​ 3,245,863​ 865,063​Other Debt Obligations​ 64,770​ 67,255​Total Mortgages and Unsecured Indebtedness​$ 26,723,361​$ 24,163,230​​General. Our unsecured debt agreements contain financial covenants and other non-financial covenants. If we were to fail to comply with these covenants, after the expiration of the applicable cure periods, the debt maturity could be accelerated or other remedies could be sought by the lender, including adjustments to the applicable interest rate. As of December 31, 2020, we were in compliance with all covenants of our unsecured debt.At December 31, 2020, our consolidated subsidiaries were the borrowers under 46 non-recourse mortgage notes secured by mortgages on 49 properties and other assets, including two separate pools of cross-defaulted and cross-collateralized mortgages encumbering a total of five properties. Under these cross-default provisions, a default under any mortgage included in the cross-defaulted pool may constitute a default under all mortgages within that pool and may lead to acceleration of the indebtedness due on each property within the pool. Certain of our secured debt instruments contain financial and other non-financial covenants which are specific to the properties that serve as collateral for that debt. If the applicable borrower under these non-recourse mortgage notes were to fail to comply with these covenants, the lender could accelerate the debt and enforce its rights against their collateral. At December 31, 2020, the applicable borrowers under these non-recourse mortgage notes were in compliance with all covenants where non-compliance could individually or in the aggregate, giving effect to applicable cross-default provisions, have a material adverse effect on our financial condition, liquidity or results of operations.Unsecured DebtAt December 31, 2020, our unsecured debt consisted of $17.1 billion of senior unsecured notes of the Operating Partnership, $125.0 million outstanding under the Operating Partnership’s $4.0 billion unsecured revolving credit facility, or Credit Facility, $2.0 billion outstanding under the $2.0 billion delayed-draw term loan facility, or Term Facility, and $623.0 million outstanding under the Operating Partnership’s global unsecured commercial paper program, or Commercial Paper program. 120 Table of ContentsSimon Property Group, Inc.Simon Property Group, L.P.Notes to Consolidated Financial Statements(Dollars in thousands, except share, per share, unit and per unit amountsand where indicated as in millions or billions)On March 16, 2020, the Operating Partnership replaced in its entirety its existing $4.0 billion unsecured revolving credit facility by entering into an unsecured credit facility comprised of (i) an amendment and extension of the Credit Facility and (ii) the Term Facility, or together with the Credit Facility and the Operating Partnership’s $3.5 billion unsecured revolving credit facility, or Supplemental Facility, the Facilities. The Credit Facility and the Term Facility can be increased in the form of either additional commitments under the Credit Facility or incremental term loans under the Term Facility in an aggregate amount for all such increases not to exceed $1.0 billion, for a total aggregate size of $7.0 billion, in each case, subject to obtaining additional lender commitments and satisfying certain customary conditions precedent. Borrowings may be denominated in U.S. dollars, Euro, Yen, Sterling, Canadian dollars and Australian dollars. Borrowings in currencies other than the U.S. dollar are limited to 95% of the maximum revolving credit amount, as defined. The initial maturity date of the Term Facility and Credit Facility are June 30, 2022 and June 30, 2024, respectively. Each of the Term Facility and Credit Facility can be extended for two additional six-month periods to June 30, 2023 and June 30, 2025, respectively, at our sole option, subject to satisfying certain customary conditions precedent. The Term Facility was available via a single draw during the nine-month period following March 16, 2020, which the Operating Partnership drew on December 15, 2020.Borrowings under the Credit Facility bear interest, at the Operating Partnership’s election, at either (i) LIBOR plus a margin determined by the Operating Partnership’s corporate credit rating of between 0.65% and 1.40% or (ii) the base rate (which rate is equal to the greatest of the prime rate, the federal funds effective rate plus 0.50% or LIBOR plus 1.00%) (the “Base Rate”), plus a margin determined by the Operating Partnership’s corporate credit rating of between 0.000% and 0.40%. The Credit Facility includes a facility fee determined by the Operating Partnership’s corporate credit rating of between 0.10% and 0.30% on the aggregate revolving commitments under the Credit Facility. The Credit Facility contains a money market competitive bid option program that allows the Operating Partnership to hold auctions to achieve lower pricing for short-term borrowings. Borrowings under the Term Facility bear interest, at the Operating Partnership’s election, at either (i) LIBOR plus a margin determined based on the Operating Partnership’s corporate credit rating of between 0.725% and 1.60% or (ii) the base rate (equal to the greatest of the prime rate, the federal funds effective rate plus 0.50% or LIBOR plus 1.00%) plus a margin determined by the Operating Partnership’s corporate credit rating of between 0.00% and 0.60%. The Term Facility includes a ticking fee equal to 0.10% of the unused term loan commitment under the Term Facility, which ticking fee shall commence accruing on the date that is forty-five days after the closing of the Term Facility.The Supplemental Facility’s initial borrowing capacity of $3.5 billion may be increased to $4.5 billion during its term and provides for borrowings denominated in U.S. dollars, Euro, Yen, Sterling, Canadian dollars and Australian dollars. The initial maturity date of the Supplemental Facility was extended to June 30, 2022 and can be extended for an additional year to June 30, 2023 at our sole option, subject to our continued compliance with the terms thereof. The base interest rate on the Supplemental Facility is LIBOR plus 77.5 basis points, with an additional facility fee of 10 basis points. On December 31, 2020, we had an aggregate available borrowing capacity of $6.7 billion under the Facilities. The maximum aggregate outstanding balance under the Facilities during the year ended December 31, 2020 was $3.9 billion and the weighted average outstanding balance was $1.8 billion. Letters of credit of $12.3 million were outstanding under the Facilities as of December 31, 2020.The Operating Partnership also has available a Commercial Paper program of $2.0 billion, or the non-U.S. dollar equivalent thereof. The Operating Partnership may issue unsecured commercial paper notes, denominated in U.S. dollars, Euro and other currencies. Notes issued in non-U.S. currencies may be issued by one or more subsidiaries of the Operating Partnership and are guaranteed by the Operating Partnership. Notes will be sold under customary terms in the U.S. and Euro commercial paper note markets and rank (either by themselves or as a result of the guarantee described above) pari passu with the Operating Partnership's other unsecured senior indebtedness. The Commercial Paper program is supported by the Credit Facility and the Supplemental Facility, or together the Credit Facilities, and if necessary or appropriate, we may make one or more draws under either of the Credit Facilities to pay amounts outstanding from time to time on the Commercial Paper program. On December 31, 2020, we had $623.0 million outstanding under the Commercial Paper program, fully comprised of U.S. dollar denominated notes with a weighted average interest rate of 0.29%. These borrowings have a weighted average maturity date of February 19, 2021 and reduce amounts otherwise available under the Credit Facilities.121 Table of ContentsSimon Property Group, Inc.Simon Property Group, L.P.Notes to Consolidated Financial Statements(Dollars in thousands, except share, per share, unit and per unit amountsand where indicated as in millions or billions)On July 9, 2020, the Operating Partnership completed the issuance of the following senior unsecured notes: $500.0 million with a fixed interest rate of 3.50%, $750 million with a fixed interest rate of 2.650%, and $750 million with a fixed interest rate of 3.80%, with maturity dates of September 2025 (the “2025” Notes”), June 2030, and June 2050, respectively. The 2025 Notes were issued as additional notes under an indenture pursuant to which the Operating Partnership previously issued $600 million principal amount of 3.50% senior notes due September 2025 on August 17, 2015. Proceeds from the unsecured notes offering funded the optional redemption at par of senior unsecured notes in July and August 2020, as discussed below, and repaid a portion of the indebtedness under the Facilities.On July 10, 2020 the Operating Partnership repaid $1.75 billion under the Credit Facility and $750.0 million under the Supplemental Facility.On July 22, 2020, the Operating Partnership completed the optional redemption at par of its $500 million 2.50% notes due September 1, 2020. On August 6, 2020 the Operating Partnership completed the optional redemption at par of its €375 million 2.375% notes due October 2, 2020.On January 21, 2021 the Operating Partnership completed the issuance of the following senior unsecured notes: $800 million with a fixed interest rate of 1.750%, and $700 million with a fixed interest rate of 2.20%, with maturity dates of January 2028 and 2031, respectively.On January 27, 2021 the Operating Partnership completed the planned optional redemption of its $550 million 2.50% notes due on July 15, 2021, including the make-whole amount. Further, on February 2, 2021 the Operating Partnership repaid $750 million under the Term Facility.On October 7, 2019 the Operating Partnership completed the early redemption of its $900 million 4.375% notes due March 1, 2021, $700 million 4.125% notes due December 1, 2021, $600 million 3.375% notes due March 15, 2022 and €375 million of the €750 million 2.375% notes due October 2, 2020. We recorded a $116.3 million loss on extinguishment of debt in the fourth quarter of 2019 as a result of the early redemption.Mortgage DebtTotal mortgage indebtedness was $7.0 billion and $6.9 billion at December 31, 2020 and 2019, respectively.122 Table of ContentsSimon Property Group, Inc.Simon Property Group, L.P.Notes to Consolidated Financial Statements(Dollars in thousands, except share, per share, unit and per unit amountsand where indicated as in millions or billions)Debt Maturity and OtherOur scheduled principal repayments on indebtedness as of December 31, 2020, assuming the obligations remain outstanding through the initial maturities, are as follows:​​​​​2021​$ 2,322,729(1)2022​ 2,837,586​2023​ 3,827,278​2024​ 2,929,639​2025​ 3,105,056​Thereafter​ 11,768,557​Total principal maturities​ 26,790,845​Net unamortized debt premium​ 35,077​Net unamortized debt discount​​ (54,199)​Debt issuance costs, net​ (113,132)​Other Debt Obligations​​ 64,770​Total mortgages and unsecured indebtedness​$ 26,723,361​​(1)Includes $623.0 million in Global Commercial Paper.Our cash paid for interest in each period, net of any amounts capitalized, was as follows:​​​​​​​​​​​​​​For the Year Ended December 31, ​ 2020 2019 2018 Cash paid for interest​$ 754,306​$ 803,728​$ 811,971​​Debt Issuance CostsOur debt issuance costs consist primarily of financing fees we incurred in order to obtain long-term financing. We record amortization of debt issuance costs on a straight-line basis over the terms of the respective loans or agreements. Details of those debt issuance costs as of December 31 are as follows:​​​​​​​​​ 2020 2019Debt issuance costs​$ 202,859​$ 187,514Accumulated amortization​​ (89,727)​​ (86,234)Debt issuance costs, net​$ 113,132​$ 101,280​We report amortization of debt issuance costs, amortization of premiums, and accretion of discounts as part of interest expense. We amortize debt premiums and discounts, which are included in mortgages and unsecured indebtedness, over the remaining terms of the related debt instruments. These debt premiums or discounts arise either at the time of the debt issuance or as part of purchase accounting for the fair value of debt assumed in acquisitions. The accompanying consolidated statements of operations and comprehensive income include amortization as follows:​​​​​​​​​​​​​​For the Year Ended December 31,​ 2020 2019 2018Amortization of debt issuance costs​$ 23,076​$ 21,499​$ 21,445Amortization of debt discounts/(premiums)​​ 174​​ 1,571​​ 1,618​123 Table of ContentsSimon Property Group, Inc.Simon Property Group, L.P.Notes to Consolidated Financial Statements(Dollars in thousands, except share, per share, unit and per unit amountsand where indicated as in millions or billions)Fair Value of DebtThe carrying value of our variable-rate mortgages and other loans approximates their fair values. We estimate the fair values of consolidated fixed-rate mortgages using cash flows discounted at current borrowing rates and other indebtedness using cash flows discounted at current market rates. We estimate the fair values of consolidated fixed-rate unsecured notes using quoted market prices, or, if no quoted market prices are available, we use quoted market prices for securities with similar terms and maturities. The book value of our consolidated fixed-rate mortgages and unsecured indebtedness including commercial paper was $23.4 billion and $23.2 billion as of December 31, 2020 and 2019, respectively. The fair values of these financial instruments and the related discount rate assumptions as of December 31 are summarized as follows:​​​​​​​​​​​​December 31, ​December 31, ​​​ 2020 2019 Fair value of consolidated fixed rate mortgages and unsecured indebtedness (in millions) $ 25,327​$ 23,231 Weighted average discount rates assumed in calculation of fair value for fixed rate mortgages​ 2.41% 3.75%​Weighted average discount rates assumed in calculation of fair value for unsecured indebtedness​​ 2.63%​ 3.67%​​​8. EquitySimon’s Board of Directors is authorized to reclassify excess common stock into one or more additional classes and series of capital stock, to establish the number of shares in each class or series and to fix the preferences, conversion and other rights, voting powers, restrictions, limitations as to dividends, and qualifications and terms and conditions of redemption of such class or series, without any further vote or action by the stockholders. The issuance of additional classes or series of capital stock may have the effect of delaying, deferring or preventing a change in control of us without further action of the stockholders. The ability to issue additional classes or series of capital stock, while providing flexibility in connection with possible acquisitions and other corporate purposes, could have the effect of making it more difficult for a third party to acquire, or of discouraging a third party from acquiring, a majority of Simon’s outstanding voting stock.Holders of common stock are entitled to one vote for each share held of record on all matters submitted to a vote of stockholders, other than for the election of directors. The holders of Simon’s Class B common stock have the right to elect up to four members of Simon’s Board of Directors. All 8,000 outstanding shares of the Class B common stock are subject to two voting trusts as to which Herbert Simon and David Simon are the trustees. Shares of Class B common stock convert automatically into an equal number of shares of common stock upon the occurrence of certain events and can be converted into shares of common stock at the option of the holders.Common Stock and Unit Issuances and RepurchasesIn 2020, Simon issued 293,204 shares of common stock to 20 limited partners of the Operating Partnership in exchange for an equal number of units pursuant to the partnership agreement of the Operating Partnership. During the year ended December 31, 2020, the Operating Partnership redeemed 116,658 units from four limited partners for $16.1 million in cash. In 2019, Simon issued 24,000 shares of common stock to a limited partner of the Operating Partnership in exchange for an equal number of units pursuant to the partnership agreement of the Operating Partnership. During the year ended December 31, 2019, the Operating Partnership redeemed 43,255 units from nine limited partners for $6.8 million in cash. These transactions increased Simon’s ownership interest in the Operating Partnership.On December 29, 2020, the Operating Partnership issued 955,705 units in connection with the acquisition of an 80% ownership interest in TRG, as discussed in Note 6.124 Table of ContentsSimon Property Group, Inc.Simon Property Group, L.P.Notes to Consolidated Financial Statements(Dollars in thousands, except share, per share, unit and per unit amountsand where indicated as in millions or billions)On November 18, 2020, we issued 22,137,500 shares of common stock in a public offering at a price of $72.50 per share, before underwriting discounts and commissions. A portion of the $1.6 billion proceeds from the offering, net of issue costs, were used to fund the Operating Partnership’s acquisition of an 80% ownership interest in TRG.On September 25, 2018, the Operating Partnership issued 475,183 units in connection with the acquisition of the remaining 50% interest in The Outlets at Orange, as discussed in Note 4.On February 13, 2017, Simon’s Board of Directors authorized a two-year extension of the previously authorized $2.0 billion common stock repurchase plan through March 31, 2019. On February 11, 2019, Simon's Board of Directors authorized a new common stock repurchase plan. Under the program, the Company could purchase up to $2.0 billion of its common stock during the two-year period ending February 11, 2021. Simon may repurchase the shares in the open market or in privately negotiated transactions as market conditions warrant. During the year ended December 31, 2020, Simon purchased 1,245,654 shares at an average price of $122.50 per share. During the year ended December 31, 2019, Simon purchased 2,247,074 shares at an average price of $160.11 per share, of which 46,377 shares at an average price of $164.49 were purchased as part of the previous program. As Simon repurchases shares under this program, the Operating Partnership repurchases an equal number of units from Simon.Temporary EquitySimonSimon classifies as temporary equity those securities for which there is the possibility that Simon could be required to redeem the security for cash irrespective of the probability of such a possibility. As a result, Simon classifies one series of preferred units in the Operating Partnership and noncontrolling redeemable interests in properties in temporary equity. Each of these securities is discussed further below.Limited Partners’ Preferred Interest in the Operating Partnership and Noncontrolling Redeemable Interests in Properties. The redemption features of the preferred units in the Operating Partnership contain provisions which could require the Operating Partnership to settle the redemption in cash. As a result, this series of preferred units in the Operating Partnership remains classified outside permanent equity. The remaining noncontrolling interests in a property or portfolio of properties which are redeemable at the option of the holder or in circumstances that may be outside Simon’s control, are accounted for as temporary equity. The carrying amount of the noncontrolling interest is adjusted to the redemption amount assuming the instrument is redeemable at the balance sheet date. Changes in the redemption value of the underlying noncontrolling interest are recorded and presented within accumulated deficit in the consolidated statements of equity in the line issuance of unit equivalents and other. There were no noncontrolling interests redeemable at amounts in excess of fair value as of December 31, 2020 and 2019. The following table summarizes the preferred units in the Operating Partnership and the amount of the noncontrolling redeemable interests in properties as of December 31.​​​​​​​​​​ 2020 2019 7.50% Cumulative Redeemable Preferred Units, 260,000 units authorized, 255,373 issued and outstanding​$ 25,537​$ 25,537​Other noncontrolling redeemable interests in properties​ 160,355​ 193,524​Limited partners’ preferred interest in the Operating Partnership and noncontrolling redeemable interests in properties​$ 185,892​$ 219,061​​7.50% Cumulative Redeemable Preferred Units. This series of preferred units accrues cumulative quarterly distributions at a rate of $7.50 annually. The preferred units are redeemable by the Operating Partnership upon the death of the survivor of the original holders, or the transfer of any preferred units to any person or entity other than the persons or entities entitled to the benefits of the original holder. The redemption price is the liquidation value ($100.00 per preferred unit) plus accrued and unpaid distributions, payable either in cash or fully registered shares of common stock at our election. 125 Table of ContentsSimon Property Group, Inc.Simon Property Group, L.P.Notes to Consolidated Financial Statements(Dollars in thousands, except share, per share, unit and per unit amountsand where indicated as in millions or billions)In the event of the death of a holder of the preferred units, the occurrence of certain tax triggering events applicable to the holder, or on or after November 10, 2006, the holder may require the Operating Partnership to redeem the preferred units at the same redemption price payable at the option of the Operating Partnership in either cash or shares of common stock. These preferred units have a carrying value of $25.5 million and are included in limited partners’ preferred interest in the Operating Partnership in the consolidated balance sheets at December 31, 2020 and 2019.The Operating PartnershipThe Operating Partnership classifies as temporary equity those securities for which there is the possibility that the Operating Partnership could be required to redeem the security for cash, irrespective of the probability of such a possibility. As a result, the Operating Partnership classifies one series of preferred units and noncontrolling redeemable interests in properties in temporary equity. Each of these securities is discussed further below.Noncontrolling Redeemable Interests in Properties Redeemable instruments, which typically represent the remaining noncontrolling interests in a property or portfolio of properties, and which are redeemable at the option of the holder or in circumstances that may be outside our control, are accounted for as temporary equity. The carrying amount of the noncontrolling interest is adjusted to the redemption amount assuming the instrument is redeemable at the balance sheet date. Changes in the redemption value of the underlying noncontrolling interest are recorded within equity and are presented in the consolidated statements of equity in the line issuance of unit equivalents and other. There are no noncontrolling interests redeemable at amounts in excess of fair value as of December 31, 2020 and 2019. The following table summarizes the preferred units and the amount of the noncontrolling redeemable interests in properties as of December 31. ​​​​​​​​​​ 2020 2019 7.50% Cumulative Redeemable Preferred Units, 260,000 units authorized, 255,373 issued and outstanding​$ 25,537​$ 25,537​Other noncontrolling redeemable interests in properties​ 160,355​ 193,524​Total preferred units, at liquidation value, and noncontrolling redeemable interests in properties​$ 185,892​$ 219,061​​7.50% Cumulative Redeemable Preferred Units The 7.50% preferred units accrue cumulative quarterly distributions at a rate of $7.50 annually. We may redeem the preferred units upon the death of the survivor of the original holders, or the transfer of any preferred units to any person or entity other than the persons or entities entitled to the benefits of the original holder. The redemption price is the liquidation value ($100.00 per preferred unit) plus accrued and unpaid distributions, payable either in cash or fully registered shares of common stock of Simon at our election. In the event of the death of a holder of the 7.5% preferred units, the occurrence of certain tax triggering events applicable to the holder, or on or after November 10, 2006, the holder may require the Operating Partnership to redeem the preferred units at the same redemption price payable at the Operating Partnership’s option in either cash or fully registered shares of common stock of Simon. These preferred units have a carrying value of $25.5 million and are included in preferred units, at liquidation value in the consolidated balance sheets at December 31, 2020 and 2019. Permanent EquitySimonPreferred Stock. Dividends on all series of preferred stock are calculated based upon the preferred stock’s preferred return multiplied by the preferred stock’s corresponding liquidation value. The Operating Partnership pays preferred distributions to Simon equal to the dividends Simon pays on the preferred stock issued.Series J 83/8% Cumulative Redeemable Preferred Stock. Dividends accrue quarterly at an annual rate of 83/8% per share. Simon can redeem this series, in whole or in part, on or after October 15, 2027 at a redemption price of $50.00 per share, plus accumulated and unpaid dividends. This preferred stock was issued at a premium of $7.5 million. The 126 Table of ContentsSimon Property Group, Inc.Simon Property Group, L.P.Notes to Consolidated Financial Statements(Dollars in thousands, except share, per share, unit and per unit amountsand where indicated as in millions or billions)unamortized premium included in the carrying value of the preferred stock at December 31, 2020 and 2019 was $2.2 million and $2.6 million, respectively.The Operating PartnershipSeries J 83/8% Cumulative Redeemable Preferred Units. Distributions accrue quarterly at an annual rate of 83/8% per unit on the Series J 83/8% preferred units, or Series J preferred units. Simon owns all of the Series J preferred units which have the same economic rights and preferences of an outstanding series of Simon preferred stock. The Operating Partnership can redeem this series, in whole or in part, when Simon can redeem the related preferred stock, on and after October 15, 2027 at a redemption price of $50.00 per unit, plus accumulated and unpaid distributions. The Series J preferred units were issued at a premium of $7.5 million. The unamortized premium included in the carrying value of the preferred units at December 31, 2020 and 2019 was $2.2 million and $2.6 million, respectively. There are 1,000,000 Series J preferred units authorized and 796,948 Series J preferred units issued and outstanding.Other Equity ActivityThe Simon Property Group 1998 Stock Incentive Plan, as amended. This plan, or the 1998 plan, provides for the grant of equity-based awards with respect to the equity of Simon in the form of options to purchase shares, stock appreciation rights, restricted stock grants and performance-based unit awards. No options have been granted to executives or other employees since 2001, however options may be granted which are qualified as “incentive stock options” within the meaning of Section 422 of the Internal Revenue Code and options which are not so qualified. An aggregate of 16,300,000 shares of common stock have been reserved for issuance under the 1998 plan. The 1998 plan is administered by the Compensation Committee of Simon’s Board of Directors, or the Compensation Committee. The Compensation Committee determines which eligible individuals may participate and the type, extent and terms of the awards to be granted to them. In addition, the Compensation Committee interprets the 1998 plan and makes all other determinations deemed advisable for its administration. Options granted to employees become exercisable over the period determined by the Compensation Committee. The exercise price of an employee option may not be less than the fair market value of the shares on the date of grant. Employee options generally vest over a three-year period and expire ten years from the date of grant.Directors who are not also our employees or employees of our affiliates are eligible to receive awards under the 1998 plan. Each independent director receives an annual cash retainer of $110,000, and an annual restricted stock award with a grant date value of $175,000. Committee chairs receive annual retainers for the Company’s Audit, Compensation, and Governance and Nominating Committees of $35,000, $35,000 and $25,000, respectively. Directors receive fixed annual retainers for service on the Audit, Compensation and Governance and Nominating Committees, of $15,000, $15,000, and $10,000, respectively. The Lead Director receives an annual retainer of $50,000. These retainers are paid 50% in cash and 50% in restricted stock.Restricted stock awards vest in full after one year. Once vested, the delivery of the shares of restricted stock (including reinvested dividends) is deferred under our Director Deferred Compensation Plan until the director retires, dies or becomes disabled or otherwise no longer serves as a director. The directors may vote and are entitled to receive dividends on the underlying shares; however, any dividends on the shares of restricted stock must be reinvested in shares of common stock and held in the Director Deferred Compensation Plan until the shares of restricted stock are delivered to the former director.In accordance with its terms, the 1998 Plan expired on December 31, 2018. The shares of common stock that were available for grant under the 1998 Plan at the time of its expiration are not available for grant under the 2019 Plan.The Simon Property Group, L.P. 2019 Stock Incentive Plan. This plan, or the 2019 Plan, provides for the grant of equity-based awards with respect to the equity of Simon in the form of incentive and nonqualified stock options to purchase shares, stock appreciation rights, restricted stock grants and performance-based awards. Options may be granted which are qualified as “incentive stock options” within the meaning of Section 422 of the Internal Revenue Code 127 Table of ContentsSimon Property Group, Inc.Simon Property Group, L.P.Notes to Consolidated Financial Statements(Dollars in thousands, except share, per share, unit and per unit amountsand where indicated as in millions or billions)and options which are not so qualified. An aggregate of 8,000,000 shares of common stock have been reserved under the 2019 plan.The 2019 Plan is administered by the Compensation Committee. The Compensation Committee determines which eligible individuals may participate and the type, extent and terms of the awards to be granted to them. In addition, the Compensation Committee interprets the 2019 Plan and makes all other determinations deemed advisable for its administration. Options granted to employees become exercisable over the period determined by the Compensation Committee. The exercise price of an employee option may not be less than the fair market value of the shares on the date of grant. Employee options generally vest over a three-year period and expire ten years from the date of grant.Directors who are not also our employees or employees of our affiliates are eligible to receive awards under the 2019 plan. Each independent director receives an annual cash retainer of $110,000, and an annual restricted stock award with a grant date value of $175,000. Committee chairs receive annual retainers for the Company’s Audit, Compensation, and Governance and Nominating Committees of $35,000, $35,000 and $25,000, respectively. Directors receive fixed annual retainers for service on the Audit, Compensation and Governance and Nominating Committees, of $15,000, $15,000, and $10,000, respectively. The Lead Director receives an annual retainer of $50,000. These retainers are paid 50% in cash and 50% in restricted stock.Restricted stock awards vest in full after one year. Once vested, the delivery of the shares of restricted stock (including reinvested dividends) is deferred under our Director Deferred Compensation Plan until the director retires, dies or becomes disabled or otherwise no longer serves as a director. The directors may vote and are entitled to receive dividends on the underlying shares; however, any dividends on the shares of restricted stock must be reinvested in shares of common stock and held in the Director Deferred Compensation Plan until the shares of restricted stock are delivered to the former director.Stock Based CompensationAwards under our stock based compensation plans primarily take the form of LTIP units and restricted stock grants. Restricted stock and awards under the LTIP programs are either market or performance-based and are based on various individual, corporate and business unit performance measures as further described below. The expense related to these programs, net of amounts capitalized, is included within home and regional office costs and general and administrative costs in the accompanying statements of operations and comprehensive income.LTIP Programs. The Compensation Committee has approved long-term, performance based incentive compensation programs, or the LTIP programs, for certain senior employees. Awards under the LTIP programs take the form of LTIP units, a form of limited partnership interest issued by the Operating Partnership, which are subject to the participant maintaining employment with us through certain dates and other conditions as described in the applicable award agreements. Awarded LTIP units not earned in accordance with the conditions set forth in the applicable award agreements are forfeited. Earned and fully vested LTIP units are equivalent to units of the Operating Partnership. During the performance period, participants are entitled to receive distributions on the LTIP units awarded to them equal to 10% of the regular quarterly distributions paid on a unit of the Operating Partnership. As a result, we account for these LTIP units as participating securities under the two-class method of computing earnings per share.In 2018, the Compensation Committee established and granted awards under a redesigned LTIP program, or the 2018 LTIP program. Awards under the 2018 LTIP program were granted in two tranches, Tranche A LTIP units and Tranche B LTIP units. Each of the Tranche A LTIP units and the Tranche B LTIP units will be considered earned if, and only to the extent to which, the respective goals based on Funds From Operations, or FFO, per share or Relative TSR Goal performance criteria, as defined in the applicable award agreements, are achieved during the applicable two-year and three-year performance periods of the Tranche A LTIP units and Tranche B LTIP units, respectively. One half of the earned Tranche A LTIP units will vest on January 1, 2021 with the other one-half vesting on January 1, 2022. All of the earned Tranche B LTIP units will vest on January 1, 2022.128 Table of ContentsSimon Property Group, Inc.Simon Property Group, L.P.Notes to Consolidated Financial Statements(Dollars in thousands, except share, per share, unit and per unit amountsand where indicated as in millions or billions)The grant date fair value of the portion of the LTIP units based on achieving the target FFO performance criteria is $6.1 million for the Tranche A LTIP units and the Tranche B LTIP units, for a total of $12.1 million. The 2018 LTIP program provides that the value of the FFO-based award may be adjusted up or down based on the Company’s performance compared to the target FFO performance criteria and has a maximum potential fair value of $18.2 million. In 2019, the Compensation Committee established and granted awards under a redesigned LTIP program, or the 2019 LTIP program. Awards under the 2019 LTIP program will be considered earned if, and only to the extent to which, the respective performance conditions (based on Funds From Operations, or FFO, per share, and Objective Criteria Goals) and market conditions (based on Relative TSR performance), as defined in the applicable award agreements, are achieved during the applicable three-year measurement period, subject to the recipient’s continued employment through the vesting date. All of the earned LTIP units under the 2019 LTIP program will vest on January 1, 2023. The 2019 LTIP program provides that the amount earned of the performance-based portion of the awards is dependent on Simon’s performance compared to certain criteria and has a maximum potential fair value at issuance of $22.1 million. The grant date fair values of any LTIP units for market-based awards are estimated using a Monte Carlo model, and the resulting fixed expense is recorded regardless of whether the market condition criteria are achieved if the required service is delivered. The grant date fair values of the market-based awards are being amortized into expense over the period from the grant date to the date at which the awards, if earned, would become vested. The expense of the performance-based award is recorded over the period from the grant date to the date at which the awards, if earned, would become vested, based on our assessment as to whether it is probable that the performance criteria will be achieved during the applicable performance periods. The Compensation Committee approved LTIP unit grants as shown in the table below. The extent to which LTIP units were earned, and the aggregate grant date fair value, are as follows:​​​​​​​​LTIP Program LTIP Units Earned Grant Date Fair Value of TSR Award Grant Date Target Value of Performance-Based Awards2018 LTIP program - Tranche A 38,148 $6.1 million $6.1 million2018 LTIP program - Tranche B To be determined in 2021 $6.1 million $6.1 million2019 LTIP program ​To be determined in 2022 $9.5 million $14.7 million​We recorded compensation expense, net of capitalization and forfeitures, related to LTIP programs of approximately $1.9 million, $15.8 million, and $12.0 million for the years ended December 31, 2020, 2019 and 2018, respectively.Restricted Stock and Restricted Stock Units. The 1998 and 2019 plans also provide for shares of restricted stock to be granted to certain employees at no cost to those employees, subject to achievement of individual performance and certain financial and return-based performance measures established by the Compensation Committee related to the most recent year’s performance. Once granted, the shares of restricted stock then vest annually over a three-year or a four-year period (as defined in the award). The cost of restricted stock grants, which is based upon the stock’s fair market value on the grant date, is recognized as expense ratably over the vesting period. Through December 31, 2020 a total of 5,858,453 shares of restricted stock, net of forfeitures, have been awarded under the 1998 plan, and 481,837 shares of restricted stock and restricted stock units have been awarded under the 2019 plan. During 2020, the Compensation Committee established a one-time grant of 312,263 time-based restricted stock units under the 2019 Plan at a weighted average fair market value of $84.37 per share. These awards will vest, subject to the grantee's continued service on each applicable vesting date, in one-third increments on January 1, 2022, January 1, 129 Table of ContentsSimon Property Group, Inc.Simon Property Group, L.P.Notes to Consolidated Financial Statements(Dollars in thousands, except share, per share, unit and per unit amountsand where indicated as in millions or billions)2023, and January 1, 2024. The grant date fair value of the awards of $26.3 million is being recognized as expense over the three-year vesting service period.Information regarding restricted stock awards is summarized in the following table for each of the years presented:​​​​​​​​​​​​​​For the Year Ended ​​December 31, ​​2020​2019​2018 Shares of restricted stock awarded during the year, net of forfeitures ​ 462,966 ​ 90,902 ​ 51,756​Weighted average fair value of shares granted during the year​$ 73.28​$ 181.94​$ 153.24​Annual amortization​$ 11,660​$ 12,604​$ 12,029​​We recorded compensation expense, net of capitalization, related to restricted stock for employees and non-employee directors of approximately $10.3 million, $11.0 million, and $7.8 million for the years ended December 31, 2020, 2019 and 2018, respectively.Other Compensation Arrangements. On July 6, 2011, in connection with the execution of an employment agreement, the Compensation Committee granted David Simon, Simon’s Chairman, Chief Executive Officer and President, a retention award in the form of 1,000,000 LTIP units, or the Award, for his continued service through July 5, 2019. Effective December 31, 2013, the Award was modified, or the Current Award, and as a result the LTIP units would become earned and eligible to vest based on the attainment of Company-based performance goals, in addition to the service-based vesting requirement included in the original Award. The Current Award does not contain an opportunity for Mr. Simon to receive additional LTIP units above and beyond the original Award should our performance exceed the higher end of the performance criteria. The performance criteria of the Current Award are based on the attainment of specific FFO per share goals. Because the performance criteria has been met, a maximum of 360,000 LTIP units, or the A units, 360,000 LTIP units, or the B units, and 280,000 LTIP units, or the C units, became earned on December 31, 2015, December 31, 2016 and December 31, 2017, respectively. If the relevant performance criteria had not been achieved, all or a portion of the Current Award would have been forfeited. The earned A units vested on January 1, 2018, earned B units vested on January 1, 2019 and earned C units vested on June 30, 2019. The grant date fair value of the retention award of $120.3 million was recognized as expense over the eight-year term of his employment agreement on a straight-line basis based on the applicable vesting periods of the A units, B units and C units. We also maintain a tax-qualified retirement 401(k) savings plan and offer no other post-retirement or post-employment benefits to our employees.Exchange RightsSimonLimited partners in the Operating Partnership have the right to exchange all or any portion of their units for shares of common stock on a one-for-one basis or cash, as determined by Simon’s Board of Directors. The amount of cash to be paid if the exchange right is exercised and the cash option is selected will be based on the trading price of Simon’s common stock at that time. At December 31, 2020, Simon had reserved 54,751,265 shares of common stock for possible issuance upon the exchange of units, stock options and Class B common stock.The Operating PartnershipLimited partners have the right under the partnership agreement to exchange all or any portion of their units for shares of Simon common stock on a one-for-one basis or cash, as determined by Simon in its sole discretion. If Simon selects cash, Simon cannot cause the Operating Partnership to redeem the exchanged units for cash without contributing cash to the Operating Partnership as partners’ equity sufficient to effect the redemption. If sufficient cash is not contributed, 130 Table of ContentsSimon Property Group, Inc.Simon Property Group, L.P.Notes to Consolidated Financial Statements(Dollars in thousands, except share, per share, unit and per unit amountsand where indicated as in millions or billions)Simon will be deemed to have elected to exchange the units for shares of Simon common stock. The amount of cash to be paid if the exchange right is exercised and the cash option is selected will be based on the trading price of Simon’s common stock at that time. The number of shares of Simon’s common stock issued pursuant to the exercise of the exchange right will be the same as the number of units exchanged.9. Lease IncomeAs discussed in Note 3, fixed lease income under our operating leases includes fixed minimum lease consideration and fixed CAM reimbursements recorded on a straight-line basis. Variable lease income includes consideration based on sales, as well as reimbursements for real estate taxes, utilities, marketing, and certain other items including negative variable lease income as discussed in Note 3.​​​​​​​​​​​​​For the Year Ended ​​December 31, ​ 2020 2019​2018Fixed lease income​$ 3,871,395​$ 4,293,401​$ 4,185,174Variable lease income​​ 430,972​​ 950,370​​ 973,246Total lease income​$ 4,302,367​$ 5,243,771​$ 5,158,420​Tenant receivables and accrued revenue in the accompanying consolidated balance sheets includes straight-line receivables of $597.6 million and $618.4 million at December 31, 2020 and 2019, respectively.Minimum fixed lease consideration under non-cancelable tenant operating leases for each of the next five years and thereafter, excluding variable lease consideration and amounts deferred in relation to the COVID-19 pandemic, which with respect to deferrals are expected to be collected primarily in 2021, as of December 31, 2020, is as follows:​​​​2021 $ 3,224,6242022​ 2,806,9162023​ 2,374,5652024​ 1,939,9672025​ 1,540,214Thereafter​ 3,943,703​​$ 15,829,989​10. Commitments and ContingenciesLitigationWe are involved from time-to-time in various legal and regulatory proceedings that arise in the ordinary course of our business, including, but not limited to, commercial disputes, environmental matters, and litigation in connection with transactions such as acquisitions and divestitures. We believe that current proceedings will not have a material adverse effect on our financial condition, liquidity, or results of operations. We record a liability when a loss is considered probable and the amount can be reasonably estimated.During the first quarter of 2019, we settled a lawsuit with our former insurance broker, Aon Risk Services Central Inc., related to the significant flood damage sustained at Opry Mills in May 2010. In accordance with a previous agreement with the prior co-investor in Opry Mills, a portion of the settlement was remitted to the co-investor. Our share of the settlement was approximately $68.0 million, which was recorded as other income in the accompanying consolidated statement of operations and comprehensive income. 131 Table of ContentsSimon Property Group, Inc.Simon Property Group, L.P.Notes to Consolidated Financial Statements(Dollars in thousands, except share, per share, unit and per unit amountsand where indicated as in millions or billions)Lease CommitmentsAs of December 31, 2020, a total of 23 of the consolidated properties are subject to ground leases. The termination dates of these ground leases range from 2021 to 2090, including periods for which exercising an extension option is reasonably assured. These ground leases generally require us to make fixed annual rental payments, or a fixed annual rental payment plus a percentage rent component based upon the revenues or total sales of the property. In addition, we have several regional office locations that are subject to leases with termination dates ranging from 2021 to 2028. These office leases generally require us to make fixed annual rental payments plus pay our share of common area, real estate, and utility expenses. Some of our ground and office leases include escalation clauses. All of our lease arrangements are classified as operating leases. We incurred ground lease expense and office lease expense, which are included in other expense and home office and regional expense, respectively, as follows: ​​​​​​​​​​For the Year Ended ​​December 31, ​ 2020​2019Operating Lease Cost​​​​​​Fixed lease cost​$ 31,404​$ 31,000Variable lease cost​​ 13,270​​ 16,833Sublease income​ (746)​ (694)Total operating lease cost​$ 43,928​$ 47,139​For the year ended December 31, 2018, we incurred $47,320 of lease expense.​​​​​​​​​​For the Year Ended ​​December 31, ​​2020​2019Other Information​​​​​​Cash paid for amounts included in the measurement of lease liabilities​​​​​​Operating cash flows from operating leases​$ 44,570​$ 48,519​​​​​​​Weighted-average remaining lease term - operating leases​​34.4​​35.6Weighted-average discount rate - operating leases​​4.86%​​4.87%​Future minimum lease payments due under these leases for years ending December 31, excluding applicable extension options and renewal options unless reasonably certain of exercise and any sublease income, are as follows:​​​​​2021 $ 32,7872022​ 32,8122023​ 32,9532024​ 33,0872025​ 33,098Thereafter​ 886,336​​$ 1,051,073Impact of discounting​​ (535,581)Operating lease liabilities​$ 515,492​132 Table of ContentsSimon Property Group, Inc.Simon Property Group, L.P.Notes to Consolidated Financial Statements(Dollars in thousands, except share, per share, unit and per unit amountsand where indicated as in millions or billions)InsuranceWe maintain insurance coverage with third-party carriers who provide a portion of the coverage for specific layers of potential losses, including commercial general liability, fire, flood, extended coverage and rental loss insurance on all of our properties in the United States. The initial portion of coverage not provided by third-party carriers may be insured through our wholly-owned captive insurance company, Bridgewood Insurance Company, Ltd., or other financial arrangements controlled by us. If required, a third-party carrier has, in turn, agreed to provide evidence of coverage for this layer of losses under the terms and conditions of the carrier’s insurance policy with us. A similar insurance policy written either through our captive insurance company or other financial arrangements controlled by us also provides initial coverage for property insurance and certain windstorm risks.We currently maintain insurance coverage against acts of terrorism on all of our properties in the United States on an “all risk” basis in the amount of up to $1 billion. Despite the existence of this insurance coverage, any threatened or actual terrorist attacks where we operate could adversely affect our property values, revenues, consumer traffic and tenant sales.Hurricane ImpactsDuring the third quarter of 2017, two of our wholly-owned properties located in Puerto Rico sustained significant property damage and business interruption as a result of Hurricane Maria. Since the date of the loss, we have received $81.1 million of insurance proceeds from third-party carriers related to the two properties located in Puerto Rico, of which $47.5 million was used for property restoration and remediation and to reduce the insurance recovery receivable. During the years ended December 31, 2020 and 2019, we recorded $5.2 million and $10.5 million, respectively, as business interruption income, which was recorded in other income in the accompanying consolidated statements of operations and comprehensive income. During the third quarter of 2020, one of our properties located in Texas experienced property damage and business interruption as a result of Hurricane Hanna. We wrote-off assets of approximately $9.6 million, and recorded an insurance recovery receivable, and have received $14.3 million of insurance proceeds from third-party carriers. The proceeds were used for property restoration and remediation and reduced the insurance recovery receivable.During the third quarter of 2020, one of our properties located in Louisiana experienced property damage and business interruption as a result of Hurricane Laura. We wrote-off assets of approximately $11.1 million and recorded an insurance recovery receivable, and have received $20.6 million of insurance proceeds from third-party carriers. The proceeds were used for property restoration and remediation and reduced the insurance recovery receivable.Guarantees of IndebtednessJoint venture debt is the liability of the joint venture and is typically secured by the joint venture property, which is non-recourse to us. As of December 31,2020 and 2019, the Operating Partnership guaranteed joint venture related mortgage indebtedness of $219.2 million and $214.8 million, respectively. Mortgages guaranteed by the Operating Partnership are secured by the property of the joint venture which could be sold in order to satisfy the outstanding obligation and which have estimated fair values in excess of the guaranteed amount.Concentration of Credit RiskOur U.S. Malls, Premium Outlets, and The Mills rely upon anchor tenants to attract customers; however, anchors do not contribute materially to our financial results as many anchors own their spaces. All material operations are within the United States and no customer or tenant accounts for 5% or more of our consolidated revenues.​133 Table of ContentsSimon Property Group, Inc.Simon Property Group, L.P.Notes to Consolidated Financial Statements(Dollars in thousands, except share, per share, unit and per unit amountsand where indicated as in millions or billions)COVID-19On March 11, 2020, the World Health Organization declared the novel strain of coronavirus, or COVID-19, a global pandemic and recommended containment and mitigation measures worldwide. The COVID-19 pandemic has already had a significant negative impact on economic and market conditions around the world in 2020, and, notwithstanding the fact that vaccines have started to be administered in the United States and elsewhere, the pandemic continues to adversely impact economic activity in real estate. The impact of the COVID-19 pandemic continues to evolve and governments and other authorities, including where we own or hold interests in properties, have imposed measures intended to control its spread, including restrictions on freedom of movement, group gatherings and business operations such as travel bans, border closings, business closures, quarantines, stay-at-home, shelter-in-place orders, density limitations and social distancing measures. Governments and other authorities are in varying stages of lifting or modifying some of these measures, however certain governments and other authorities have already been forced to, and others may in the future, reinstate these measures or impose new, more restrictive measures, if the risks, or the tenants’ and consumers’ perception of the risks, related to the COVID-19 pandemic worsen at any time. Although tenants and consumers have been adapting to the COVID-19 pandemic, with tenants adding services like curbside pickup, and while consumer risk-tolerance is evolving, such adaptations and evolution may take time, and there is no guarantee that retail will return to pre-pandemic levels even once the pandemic subsides. As a result of the COVID-19 pandemic and these measures, the Company may experience material impacts including changes in the ability to recognize revenue due to changes in our assessment of the probability of collection of lease income and asset impairment charges as a result of changing cash flows generated by our properties. As of October 7, 2020, all of our domestic properties and certain of our retailer investments had reopened. 11. Related Party TransactionsTransactions with AffiliatesOur management company provides office space and legal, human resource administration, property specific financing and other support services to Melvin Simon & Associates, Inc., or MSA, a related party, for which we received a fee of $0.6 million in each of 2020, 2019 and 2018. In addition, pursuant to management agreements that provide for our receipt of a management fee and reimbursement of our direct and indirect costs, we have managed since 1993 two shopping centers owned by entities in which David Simon and Herbert Simon have ownership interests, for which we received a fee of $3.3 million, $3.9 million, and $4.2 million in 2020, 2019, and 2018, respectively. Transactions with Unconsolidated Joint VenturesAs described in Note 2, our management company provides management, insurance, and other services to certain unconsolidated joint ventures. Amounts received for such services were $92.7 million, $108.2 million, and $111.5 million in 2020, 2019, and 2018, respectively. During 2020, 2019, and 2018, we recorded development, royalty, and other fee income, net of elimination, related to our unconsolidated international joint ventures of $13.1 million, $14.8 million, and $16.0 million, respectively. The fees related to our international investments are included in other income in the accompanying consolidated statements of operations and comprehensive income. Neither MSA, David Simon, or Herb Simon have an ownership interest in any of our unconsolidated joint ventures, except through their ownership interests in the Company or the Operating Partnership. We have investments in retailers including Forever 21, J.C. Penney, and SPARC Group, and these retailers are lessees at certain of our operating properties. Lease income from the date of our investments in our consolidated statements of operations and comprehensive income related to these retailers was $54.1 million, $20.9 million, and $20.0 million for the years ended December 31, 2020, 2019, and 2018, respectively, net of elimination. ​134 Table of ContentsSimon Property Group, Inc.Simon Property Group, L.P.Notes to Consolidated Financial Statements(Dollars in thousands, except share, per share, unit and per unit amountsand where indicated as in millions or billions)12. Quarterly Financial Data (Unaudited)Quarterly 2020 and 2019 data is summarized in the table below. Quarterly amounts may not sum to annual amounts due to rounding.​​​​​​​​​​​​​​​​ First Second Third Fourth ​​Quarter​Quarter​Quarter​Quarter 2020​​​​​​​​​​​​​Total revenue​$ 1,353,360​$ 1,062,041​$ 1,060,674​$ 1,131,429​Operating income before other items​ 654,869​ 450,868​ 404,024​ 462,047​Consolidated net income​ 505,404​ 290,548​ 168,646​ 312,726​Simon Property Group, Inc.​​​​​​​​​​​​​Net income attributable to common stockholders​$ 437,605​$ 254,213​$ 145,926​$ 271,483​Net income per share — Basic and Diluted​$ 1.43​$ 0.83​$ 0.48​$ 0.86​Weighted average shares outstanding — Basic and Diluted​ 306,504,084​ 305,882,326​ 305,913,431​ 316,595,345​Simon Property Group, L.P.​​​​​​​​​​​​​Net income attributable to unitholders​$ 504,263​$ 292,863​$ 168,086​$ 311,238​Net income per unit — Basic and Diluted​$ 1.43​$ 0.83​$ 0.48​$ 0.86​Weighted average units outstanding — Basic and Diluted​​ 353,191,960​​ 352,410,392​​ 352,420,845​​ 363,050,401​2019​​​​​​​​​​​​​Total revenue​$ 1,452,834​$ 1,397,186​$ 1,416,554​$ 1,488,615​Operating income before other items​ 745,021​ 680,631​ 705,302​ 776,876​Consolidated net income​ 631,947​ 572,102​ 628,724​ 590,416​Simon Property Group, Inc.​​​​​​​​​​​​​Net income attributable to common stockholders​$ 548,475​$ 495,324​$ 544,254​$ 510,194​Net income per share — Basic and Diluted​$ 1.78​$ 1.60​$ 1.77​$ 1.66​Weighted average shares outstanding — Basic and Diluted​ 308,978,053​ 308,708,798​ 307,275,230​ 306,868,960​Simon Property Group, L.P.​​​​​​​​​​​​​Net income attributable to unitholders​$ 631,551​$ 570,389​$ 627,074​$ 587,931​Net income per unit — Basic and Diluted​$ 1.78​$ 1.60​$ 1.77​$ 1.66​Weighted average units outstanding — Basic and Diluted​​ 355,778,250​​ 355,491,396​​ 354,038,110​​ 353,619,579​​​​​135 Table of ContentsItem 9. Changes in and Disagreements with Accountants on Accounting and Financial DisclosureNone.Item 9A. Controls and ProceduresSimonManagement's Evaluation of Disclosure Controls and ProceduresSimon maintains disclosure controls and procedures (as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934, as amended (the "Exchange Act")) that are designed to provide reasonable assurance that information required to be disclosed in the reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC's rules and forms, and that such information is accumulated and communicated to Simon’s management, including its Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosures. Because of inherent limitations, disclosure controls and procedures, no matter how well designed and operated, can provide only reasonable, and not absolute, assurance that the objectives of disclosure controls and procedures are met.Our management, with the participation of Simon’s Chief Executive Officer and Chief Financial Officer, evaluated the effectiveness of the design and operation of Simon’s disclosure controls and procedures as of December 31, 2020. Based on that evaluation, Simon’s Chief Executive Officer and Chief Financial Officer concluded that, as of December 31, 2020, Simon’s disclosure controls and procedures were effective at a reasonable assurance level.Management's Report on Internal Control Over Financial ReportingSimon is responsible for establishing and maintaining adequate internal control over financial reporting. Internal control over financial reporting is defined in Rule 13a-15(f) under the Exchange Act as a process designed by, or under the supervision of, Simon’s principal executive and principal financial officers and effected by Simon’s Board of Directors, management and other personnel, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with U.S. generally accepted accounting principles and includes those policies and procedures that:●Pertain to the maintenance of records that in reasonable detail accurately and fairly reflect our transactions and disposition of assets; ●Provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with U.S. generally accepted accounting principles, and that our receipts and expenditures are being made only in accordance with authorizations of our management and directors; and ●Provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of our assets that could have a material effect on the financial statements.Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.We assessed the effectiveness of Simon’s internal control over financial reporting as of December 31, 2020. In making this assessment, we used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control-Integrated Framework (2013). Based on that assessment and criteria, we believe that, as of December 31, 2020, Simon’s internal control over financial reporting was effective.Attestation Report of the Registered Public Accounting FirmThe audit report of Ernst & Young LLP on their assessment of Simon's internal control over financial reporting as of December 31, 2020 is set forth within Item 8 of this Form 10-K.Changes in Internal Control Over Financial ReportingThere have not been any changes in Simon's internal control over financial reporting (as defined in Rule 13a-15(f) under the Exchange Act) that occurred during the year ended December 31, 2020 that have materially affected, or are reasonably likely to materially affect, Simon's internal control over financial reporting. 136 Table of ContentsThe Operating PartnershipManagement's Evaluation of Disclosure Controls and ProceduresThe Operating Partnership maintains disclosure controls and procedures (as defined in Rule 13a-15(e) under the Exchange Act) that are designed to provide reasonable assurance that information required to be disclosed in the reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC's rules and forms, and that such information is accumulated and communicated to our management, including Simon’s Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosures. Because of inherent limitations, disclosure controls and procedures, no matter how well designed and operated, can provide only reasonable, and not absolute, assurance that the objectives of disclosure controls and procedures are met.Our management, with the participation of Simon’s Chief Executive Officer and Chief Financial Officer, evaluated the effectiveness of the design and operation of the Operating Partnership’s disclosure controls and procedures as of December 31, 2020. Based on that evaluation, Simon’s Chief Executive Officer and Chief Financial Officer concluded that, as of December 31, 2020, the Operating Partnership’s disclosure controls and procedures were effective at a reasonable assurance level.Management's Report on Internal Control Over Financial ReportingThe Operating Partnership is responsible for establishing and maintaining adequate internal control over financial reporting. Internal control over financial reporting is defined in Rule 13a-15(f) under the Exchange Act as a process designed by, or under the supervision of, Simon’s principal executive and principal financial officers and effected by Simon’s Board of Directors, management and other personnel, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with U.S. generally accepted accounting principles and includes those policies and procedures that:●Pertain to the maintenance of records that in reasonable detail accurately and fairly reflect our transactions and disposition of assets; ●Provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with U.S. generally accepted accounting principles, and that our receipts and expenditures are being made only in accordance with authorizations of our management and directors; and ●Provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of our assets that could have a material effect on the financial statements.Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.We assessed the effectiveness of the Operating Partnership’s internal control over financial reporting as of December 31, 2020. In making this assessment, we used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control-Integrated Framework (2013). Based on that assessment and criteria, we believe that, as of December 31, 2020, the Operating Partnership’s internal control over financial reporting was effective.Attestation Report of the Registered Public Accounting FirmThe audit report of Ernst & Young LLP on their assessment of the Operating Partnership’s internal control over financial reporting as of December 31, 2020 is set forth within Item 8 of this Form 10-K.Changes in Internal Control Over Financial ReportingThere have not been any changes in the Operating Partnership’s internal control over financial reporting (as defined in Rule 13a-15(f) under the Exchange Act) that occurred during the year ended December 31, 2020 that have materially affected, or are reasonably likely to materially affect, the Operating Partnership’s internal control over financial reporting.137 Table of ContentsItem 9B. Other InformationDuring the fourth quarter of the year covered by this Annual Report on Form 10-K, the Audit Committee of Simon’s Board of Directors approved certain audit, audit-related and non-audit tax compliance and tax consulting services to be provided by Ernst & Young LLP, our independent registered public accounting firm. This disclosure is made pursuant to Section 10A(i)(2) of the Exchange Act as added by Section 202 of the Sarbanes-Oxley Act of 2002.Part IIIItem 10. Directors, Executive Officers and Corporate GovernanceThe information required by this item is incorporated herein by reference to the definitive proxy statement for Simon’s 2021 annual meeting of stockholders to be filed with the SEC pursuant to Regulation 14A and the information included under the caption "Information about our Executive Officers" in Part I hereof.Item 11. Executive CompensationThe information required by this item is incorporated herein by reference to the definitive proxy statement for Simon’s 2021 annual meeting of stockholders to be filed with the SEC pursuant to Regulation 14A.Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder MattersThe information required by this item is incorporated herein by reference to the definitive proxy statement for Simon’s 2021 annual meeting of stockholders to be filed with the SEC pursuant to Regulation 14A.Item 13. Certain Relationships and Related Transactions and Director IndependenceThe information required by this item is incorporated herein by reference to the definitive proxy statement for Simon’s 2021 annual meeting of stockholders to be filed with the SEC pursuant to Regulation 14A.Item 14. Principal Accountant Fees and ServicesThe information required by this item is incorporated herein by reference to the definitive proxy statement for Simon’s 2020 annual meeting of stockholders to be filed with the SEC pursuant to Regulation 14A.The Audit Committee of Simon's Board of Directors pre-approves all audit and permissible non-audit services to be provided by Ernst & Young LLP, or Ernst & Young, Simon’s and the Operating Partnership’s independent registered public accounting firm, prior to commencement of services. The Audit Committee has delegated to the Chairman of the Audit Committee the authority to pre-approve specific services up to specified individual and aggregate fee amounts. These pre-approval decisions are presented to the full Audit Committee at the next scheduled meeting after such approvals are made. We have incurred fees as shown below for services from Ernst & Young as Simon’s and the Operating Partnership’s independent registered public accounting firm and for services provided to our managed consolidated and joint venture properties and our consolidated non-managed properties. Ernst & Young has advised us that it has billed or will bill these indicated amounts for the following categories of services for the years ended December 31, 2020 and 2019, respectively:​​​​​​​​​​2020 ​2019Audit Fees (1)​$ 4,707,000​$ 4,230,000Audit Related Fees (2)​ 5,068,000​ 4,835,000Tax Fees (3)​ 359,000​ 266,000All Other Fees​ —​ —(1)Audit Fees include fees for the audits of the financial statements and the effectiveness of internal control over financial reporting and quarterly reviews for Simon and the Operating Partnership and services associated with the related SEC registration statements, periodic reports, and other documents issued in connection with securities offerings.138 Table of Contents(2)Audit-Related Fees include audits of individual or portfolios of properties and schedules to comply with lender, joint venture partner or contract requirements and due diligence services for our managed consolidated and joint venture entities and our consolidated non-managed entities. Our share of these Audit-Related Fees was approximately 60% and 59% for the years ended 2020 and 2019, respectively.(3)Tax Fees include fees for international and other tax consulting services, tax due dilligence and tax return compliance services associated with the tax returns for certain managed joint ventures as well as other miscellaneous tax compliance services. Our share of these Tax Fees was approximately 81% and 65% for 2020 and 2019, respectively.​139 Table of ContentsPart IVItem 15. Exhibits and Financial Statement Schedules​​​Page No.(a)(1)Financial Statements​​​The following consolidated financial statements of Simon Property Group, Inc. and Simon Property Group, L.P. are set forth in Part II,
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+Item 7. You should also review the notes to consolidated financial statements under headings in Note 1. Use of Estimates and in Note 9. Commitments and Contingencies.Any forward-looking statements which we make in this report, or in any of the documents that are incorporated by reference herein or herefrom, speak only as of the date of such statement, and we undertake no ongoing obligation to update such statements. Comparisons of results between current and any prior periods are not intended to express any future trends or indications of future performance, unless expressed as such, and should only be viewed as historical data.​2 Table of Contents ITEM 1. BUSINESSSteel Dynamics, Inc. is one of the largest domestic steel producers and metal recyclers in the United States, based on estimated steelmaking and coating capacity of approximately 13 million tons and actual metals recycling volumes as of December 31, 2020, with one of the most diversified product and end-market portfolios in the domestic steel industry. The company’s primary sources of revenue are from the manufacture and sale of steel products, the processing and sale of recycled ferrous and nonferrous metals, and the fabrication and sale of steel joists and deck products.We refer to our founding principles as our six core strategic pillars. They bring us together with a common focus, and they provide the foundation upon which we operate and grow. Our unique entrepreneurial culture and business model benefit us operationally, financially, and through the responsible use of our resources in diverse economic environments. Innovation in all forms is essential to our success, and our teams focus on how to do things “smarter” within our current operations as well as how we continue to grow. This means creating solutions for our teammates, customers, suppliers, and other stakeholders. It also includes finding ways to “do business” with fewer resources and less environmental impact. Our six pillars and the team’s execution of them each day has driven our success and sustainability.​●Safety – Creating and maintaining a safe work environment is the foundation of our decision making. Safety is always at the forefront and is a constant topic of conversation across the company. Our goal is zero injuries—no accidents. ●Culture – Our entrepreneurial culture fosters a team of energetic, positive, driven, innovative and diverse individuals by utilizing open communication and meaningful performance-based compensation aligned to our strategic focus.●Customer Commitment – We focus on being a preferred partner of our customers by providing quality products and unique supply-chain solutions to meet their current and future needs. ●Growth – We focus on intentional margin expansion and consistency through-the-cycle. ●Innovation – Through individual creativity and ingenuity, our teams drive innovation to improve safety, quality, productivity, and resource sustainability. We strive to provide unique, superior products, customer supply chain solutions, and next-generation technologies and processes.●Financial Strength – Through our adaptable value-added product diversification, vertically connected businesses model, coupled with our highly variable operating cost structure and performance-based incentive compensation, along with our continued operating innovations and efficiency, we achieve higher utilization and lower costs, which provide strong cash flow generation through both strong and weak market cycles. Differentiated Model - Uniquely Steel DynamicsCompetitively advantaged differentiation is core to our long-term value creation strategy. We aim to set ourselves apart in every aspect of our business with a spirit of excellence, with the following core values driving our differentiation strategy. Unique Entrepreneurial CultureOur entrepreneurial culture is at the core of our success and is driven by our extensive performance-based incentive compensation philosophy for those on the plant floor to senior leadership. Over 60% of a plant floor colleague’s total potential compensation is “at risk” to both quality production and cost-effectiveness. Over 85% of our senior leadership team’s total potential compensation is “at risk” to company-wide financial performance metrics that encourage long-term value creation, including return on equity, growth, cash generation, and return on invested capital metrics. Our common goal of consistently achieving excellence in all we do is reflected in the esprit de corps that permeates our team. We believe diversity within our teams enhances broad-based thinking, innovation, and value creation. ​Diversified, Value-Added Product Offerings / Supply-Chain Solutions We have one of the most diversified, high-margin product offerings of any domestic steel producer. We have a track record of profitable growth, driving diversification in both end markets and product offerings to sustain higher volume and profitability through all market environments. This includes developing premium, value-added steel products, with over 70% of our steel and fabrication sales being considered value-added. ​3 Table of ContentsA key competitive advantage is our numerous supply-chain solutions which provide significant advantages to our customers, creating long-lasting relationships and higher through-cycle sales. The majority of our steelmaking operations are in locations near sustainable sources of scrap metals and near our customer base, allowing us to realize freight savings for inbound scrap as well as for outbound steel products destined for our customers. This also allows us to provide consistent on-time delivery to our customer base with relatively short lead times, further solidifying our customer relationships. ​This diversified portfolio of products enables us to access a broad range of markets, serve a large customer base, and helps mitigate our market exposure to any one product or sector, resulting in increased through-cycle steel mill utilization. In addition, our value-added steel product offerings help to balance our exposure to commodity grade products supplied by other steel manufacturers. We will continue to seek additional opportunities and to collaborate with our customers to anticipate their future needs by further expanding our range of products and offerings. Our new Southwest-Sinton Flat Roll Division growth investment is a prime example of our internal growth and differentiated business model. This $1.9 billion electric arc furnace (EAF) flat roll steel mill will have an estimated 3.0 million tons of annual steel production capacity, including value-added coating lines comprised of a galvanizing line with planned annual coating capacity of 550,000 tons with galvalume capability and a paint line with annual coating capacity of 250,000 tons. As with all our growth initiatives, we seek to competitively differentiate ourselves through service, product capability and quality, and supply chain solutions. This investment encompasses each of these elements.By leveraging our construction and operating expertise, we are building a "next-generation” EAF flat roll steel mill with production capabilities designed to have product size and quality capabilities beyond that of existing domestic EAF flat roll steel producers, competing even more effectively with the integrated steel model and foreign competition. Our new steel mill will have the capability to provide higher-strength, tougher grades of flat roll steel for the energy and automotive markets. These ultra-high-strength steel products are not currently readily available from other domestic steel producers. We will also be producing value-added steel products at the commencement of operations, providing high-margin product and end-market diversification.Out new steel mill is being strategically located in Sinton, Texas, which has significant competitive advantages—including geographic market positioning, power accessibility, competitive freight for the intended customers, proximity to a deep-water port and site constructability. By locating our new steel mill in Sinton, Texas we are strategically targeting underserved markets that are largely reliant on imports with long lead times and lower product quality capabilities, providing customers throughout the Southwest United States and Mexico significant freight benefits and shorter lead times allowing them to realize working capital advantages. Additionally, our new steel mill site has sufficient acreage to allow for some customers to locate on-site, providing them with logistics savings and our steel mill with volume base-loading opportunities. Three customers have committed to locate onsite, representing over 1.0 million tons of annual processing and consumption capacity, and we expect to secure similar commitments from additional customers. Our new EAF steel mill is adhering to the same sustainability model as our other steelmaking facilities, utilizing state-of-the-art environmental controls and processes to produce high quality sustainable steel. Our existing EAF steel mills have a fraction of the greenhouse gas emissions (GHG) and energy intensity of average traditional integrated steelmaking technology, resulting in a much more environmentally friendly steel production alternative. Operations are planned to begin mid-year 2021.Vertically Connected Businesses and Pull-Through Volume AdvantageOur vertically connected businesses contribute to our higher through-cycle steel production and overall profitability. Steel demand that is generated from our internal manufacturing businesses is a significant competitive advantage supporting higher and more stable through-cycle earnings and cash flow generation. Our steel fabrication operations and downstream processing locations use a significant amount of steel in their operations. During weaker demand environments, we source more of their needs internally, and during strong demand environments, we source more of their needs externally at a preferred cost. Ultimately, we optimize our company-wide profitability in all steel demand environments. In 2020, our own steel consuming businesses purchased 1.5 million tons of steel from our steel mills representing 14% of our total 2020 steel shipments.A strategic synergistic relationship also exists between our steel mills and metals recycling operations, which is the largest supplier of recycled ferrous scrap to our steel operations. This allows us to reduce company-wide working capital, as we retain less scrap inventory at the steel mills, and we are able to source higher-quality scrap for our steel mills, optimizing cost and quality. Additionally, as a consistent consumer of recycled ferrous scrap, our steel operations help maintain steady sales for the metals recycling platform.​4 Table of Contents​Technically Advanced, Low-Cost, Highly-Efficient OperationsWe operate some of the most technically advanced and environmentally friendly steel operations when compared to global steelmaking operations. We are focused on maintaining one of the lowest operating cost structures in the North American steel industry. Our value-added product diversification, vertically connected businesses, and performance-based incentive compensation programs drive our efficient, environmentally friendly, and competitively advantaged footprint.Our low operating costs are primarily a result of our efficient plant designs and operations, our high productivity rate, low ongoing maintenance cost requirements and strategic locations near sources of our primary raw material, ferrous scrap, and near our customers. We will continue to develop innovative ways to use our equipment, enhance our productivity and explore new technologies to further improve our unit costs of production at each of our facilities. As one of the lowest cost producers in each of our three primary operating segments, we are able to better manage through all market cycles, and to consistently maximize our profitability. Additionally, we continuously seek to maximize the variability of our cost structure and to reduce per unit and fixed costs. Sustainability Sustainability is a part of our long-term value creation. We are dedicated to our people, our communities and our environment. We are committed to operating our business with the highest integrity and have been since our founding. We only produce steel using EAF technology, which uses recycled ferrous scrap as the primary raw material. EAF steelmaking technology generates a mere fraction of the carbon emissions produced and energy intensity required by traditional blast furnace steelmaking technology. We believe EAF production is currently the steelmaking technology that provides the least environmental impact, is the most cost effective, and provides the most flexibility, and as such, has been a focus of our growth strategy.Our intentional growth strategy has focused on increasing through-cycle cash generation and providing growth opportunities for our people, partners, communities, and shareholders, all while keeping sustainability of resources and climate-impact at the fore. We intentionally developed a vertically connected operating model, further strengthening our company by creating a “closed loop” manufacturing life cycle. Our metals recycling platform collects and processes scrap from manufacturing and from end-of-life items, such as automobiles, appliances, and machinery. This processed scrap is then sold to end-users for reuse, including our EAF steel mills, which produce new steel from the scrapped material. Our steel is then sold to consumers that both further process and manufacture end products. We sell a meaningful amount of steel to our own manufacturing businesses that in turn sell finished products to consumers. Ultimately, when these products reach the end of their life cycle, they can be collected as scrap and used again in our steelmaking operations, creating our “vertically connected sustainable product life cycle.” We recognize that minimizing the impact of GHG is important to our stakeholders, including local communities and team members. We endeavor for continuous improvement in minimizing carbon dioxide emissions, while maintaining compliance with regulation emission limits. We evaluate our GHG emissions by regularly reviewing furnace performance and efficiency. We analyze the latest available technologies to also determine whether emissions can be minimized. Our carbon mitigation strategy is integral to our overarching sustainability program to address climate-related considerations. Our Board of Directors provides oversight concerning the company’s sustainability strategy, disclosures, and climate-related impact. Our senior leadership, including our President and Chief Executive Officer, Executive Vice President, Chief Financial Officer, and Corporate Secretary, and other operating platform senior executives, establish our near- and long-term strategies related to our climate-related assessments, goals, and programs.Experienced Leadership Team / Fosters an Entrepreneurial CultureOur senior leadership team is highly experienced and has a proven track record in the steel, metals recycling, and steel fabrication industries. Our leadership objectives are closely aligned with our stakeholders through meaningful stock ownership positions and performance-based incentive compensation programs that are correlated to the company’s profitability and operational performance in relationship to our steel manufacturing peers. We emphasize decentralized operational decision making and responsibility, while continuing to maintain appropriate corporate governance and risk oversight. We reward teamwork, innovation, and operating efficiency, and focus on maintaining the effectiveness of our performance-driven incentive bonus plans that are designed to maximize overall productivity and align the interests of our leadership and teams with our stakeholders.5 Table of Contents​​​​​Name​Age​PositionMark D. Millett​61​President and Chief Executive OfficerTheresa E. Wagler​50​Executive Vice President, Chief Financial Officer, and Corporate SecretaryRuss B. Rinn​63​Executive Vice President, Metals RecyclingMiguel Alvarez ​53​Senior Vice President, Southwest United States and MexicoChris A. Graham​56​Senior Vice President, Long Products Steel GroupGlenn A. Pushis​55​Senior Vice President, Special ProjectsBarry T. Schneider​52​Senior Vice President, Flat Roll Steel GroupJames S. Anderson​60​Vice President, Steel Fabrication​Mark D. Millett, a co-founder of our company and director since inception, has been our President and Chief Executive Officer since January 2012. Prior to that, Mr. Millett has held various positions within the company, including President and Chief Operating Officer, Executive Vice President of Metals Recycling and Ferrous Resources, President and Chief Operating Officer of OmniSource, LLC, and Executive Vice President and Chief Operating Officer for Flat Rolled Steels and Ferrous Resources. Mr. Millett was responsible for the design, construction, and start-up operation of all of our steel mills, including our Butler, Indiana flat roll, melting, and casting operations. Prior to co-founding Steel Dynamics, Mr. Millett served in various leadership roles for the Nucor Corporation. His roles included being charged with developing the world’s first commercially viable thin slab casting process as the manager of the project at Nucor’s Hazelett facility and being given the responsibility by Nucor for the design, construction, staffing, and operation of the melting and casting facility at the world’s first thin slab casting facility at Nucor’s Crawfordsville, Indiana facility. Theresa E. Wagler has been our Executive Vice President, Chief Financial Officer and Corporate Secretary since May 2007. Ms. Wagler joined the Steel Dynamics corporate finance team in 1998, and has held various finance and accounting positions, including Chief Accounting Officer and Vice President and Corporate Controller, and was appointed to her current position in May 2007. She is responsible for and oversees accounting and taxation, treasury, risk management, legal, information technology and cyber security, health and safety, human resources, sustainability efforts, and strategic business development functions, as well as investor relations, and corporate communications. Ms. Wagler also has various operational responsibilities directly overseeing two operating joint ventures. Prior to joining Steel Dynamics, Ms. Wagler was as a certified public accountant with Ernst & Young LLP.Russell B. Rinn has been our Executive Vice President for Metals Recycling since July 2011. Mr. Rinn is responsible for OmniSource’s ferrous and nonferrous metals recycling operations including marketing, trading, and logistics activities. OmniSource procures metal scrap, processes it, and markets these recycled metals to external customers and supplies ferrous scrap to the company’s steel mills. Prior to joining Steel Dynamics, Mr. Rinn was an Executive Vice President of Commercial Metals Company, a Texas based mini-mill steel company.Miguel Alvarez has been our Senior Vice President, Southwest United States and Mexico since February 2019. Mr. Alvarez is responsible for the comprehensive business development and partnerships in the regions, encompassing both steel and recycled metals. Prior to joining Steel Dynamics, Mr. Alvarez served in leadership positions at BlueScope, including leading BlueScope’s North American metal buildings business with manufacturing facilities in the United States and Mexico and being responsible for BlueScope’s only North American electric arc furnace flat roll steel mill as President of North Star BlueScope Steel.Chris A. Graham has been our Senior Vice President, Long Products Steel Group since February 2019. In this role, Mr. Graham is responsible for the company’s four long product steel mills. Prior to that, Mr. Graham has served as Senior Vice President, Downstream Manufacturing and President of New Millennium Building Systems, responsible for the company’s steel fabrication and downstream manufacturing operations and other operational and leadership roles. Mr. Graham was also a part of the team that constructed the company’s first steel mill in Butler, Indiana, in 1994.Glenn A. Pushis has been our Senior Vice President, Special Projects since February 2019. Mr. Pushis is responsible for the successful design and construction of the company’s new Southwest-Sinton Flat Roll Division developed to serve the Southwestern United States and Mexico. He has extensive experience in this capacity and has been instrumental in numerous construction projects for Steel Dynamics since its founding. Prior to that, Mr. Pushis served as Senior Vice President, Long Products Steel Group, responsible for the company’s four long product steel mills. Mr. Pushis has been with Steel Dynamics since 1994, holding various operational and leadership roles, including roles within the Engineered Bar Products Division and the Butler Flat Roll Division. He was also part of the team that constructed the company’s first steel mill in Butler, Indiana, in 1994.​Barry T. Schneider has been our Senior Vice President, Flat Roll Steel Group, since March 2016. Mr. Schneider is responsible for the company’s entire flat roll steel operations, including the company’s two flat roll steel mills and numerous flat roll coating operations. Before that, Mr. Schneider served in various operational and leadership roles within the company’s steel operations, 6 Table of Contentsincluding Engineered Bar Products Division and Butler Flat Roll Division. He was also part of the team that constructed the company’s first steel mill in Butler, Indiana, in 1994.James S. Anderson is our Vice President, Steel Fabrication, and President of New Millennium Building Systems, since February 2019. In this role, Mr. Anderson is responsible for the company's steel fabrication operations. Prior to that, Mr. Anderson served as the Chief Operating Officer of New Millennium Building Systems, and was the general manager of The Techs three flat roll galvanizing lines.Human Capital / Valuing PeopleWe value the dedicated people whose passion, innovation, and dedication to excellence have helped successfully grow our company and serve our customers. We have a culture of trust, fostered through individual empowerment and accountability that drives decision-making throughout our businesses. Our performance-based incentive compensation programs align our people with the interests of our strategic long-term growth and our stakeholders, including our customers, communities, and shareholders. We know that our teams will do what is right and that trust comes from effective communication and transparency. The Steel Dynamics team consisted of approximately 9,625 full time team members at December 31, 2020.​Health and SafetyValuing people includes providing a safe and healthy work environment and creating a culture of safety that extends beyond the workplace, into our homes and communities. Safety is and always will be our primary focus and core value. Our goal is for each individual to arrive at the workplace and return home safely each day — without accident or injury. This is achievable when we all work together. It requires commitment from leadership and team members at every level to take ownership and responsibility for their safety and the safety of others. Under no circumstance does the desire to maximize production or earnings override the priority of individual safety. ​Safety is our first core strategic pillar — it is the foundation of our decision making. Safety is always at the forefront and is a constant topic of conversation across the company, whether led by a team member from the plant floor, a supervisor, or a manager. Leadership is engaged and continuously evaluates where we can improve. We believe having every individual engaged in safety will lead to zero injuries. We are committed to achieve world-class safety performance throughout our businesses to ensure everyone goes home safely. The commitment to safety has led to each of our platforms performing better compared to industry benchmarks. Specifically, for 2020, our total recordable injury rate compared to industry benchmarks, and lost time injury and severity rates are as follows:​7 Table of Contents​​1 Total Recordable Injury Rate is defined as OSHA recordable incidents x 200,000 / hours worked. Lost Time Injury Rate is defined as OSHA days away from work cases x 200,000 / hours worked. Severity Rate is defined as OSHA days away from work x 200,000 / hours worked. 2 Source: 2019 U.S. DOL Bureau of Labor Statistics​Coronavirus (COVID-19)Our leadership teams, safety professionals, and nursing team have been instrumental in our responsible handling of the COVID-19 pandemic. Steelmaking and its ancillary support businesses are considered a “critical infrastructure industry” by the U.S. Department of Homeland Security and have been deemed an essential business in all of the states in which we operate. As such, our businesses have remained operational throughout the COVID-19 outbreak. Our teams are our most valued priority and we took decisive, conservative actions and implemented numerous additional health-related protocols and policies very early in 2020, when it became apparent there was a risk to our teams. We believe these steps were and remain critical in protecting our teams, their families, and our communities. During 2020, none of our operations has been closed or idled due to the COVID-19 pandemic.​​​​​8 Table of ContentsTalent Development and Educational OpportunitiesOur people represent the foundation of our six strategic pillars. Their continued education and talent development is paramount to our success. Our education assistance and development programs encourage personal growth so individuals can remain current in their areas of responsibility, as well as develop new skills for advancement. Our senior leadership plays a key role in our development programs, linking our culture to critical, proven leadership concepts. As we continue to grow, building talent and creating opportunities within our teams is one of our most important tasks and is critical to our long-term success. We have numerous programs and development initiatives designed to develop our employees. Compensation StructureWe believe in empowering our teams and rewarding them for their achievements through a four-tiered, performance-based compensation framework. The various components of our compensation programs promote a balance of high-return growth, effective capital investment, low-cost operations, and risk mitigation. By rewarding our teams based on their performance as an individual, as a team, as a company, and based on shareholder concerns, we believe we have the ultimate alignment with our stakeholders. This is achieved through the following methods:​●Individual performance awards consist of an individual’s base compensation, which is determined by their individual performance, responsibilities, and skills. ●Team performance awards are based on departmental results, rewarding cost effectiveness and quality production. Our performance-based incentive programs reward team members for reducing waste and increasing efficiency, while also producing quality products for our customers. These awards can be well over 100% of base wages, based on strong performance and on the teams doing things that are within their control. ●Company-wide performance awards unite everyone through our profit-sharing program, which is based on consolidated pretax profitability, and our 401(k) match, which is based on consolidated return on assets.●Alignment with our shareholders and the pursuit of long-term value creation is fostered through the issuance of restricted stock units. Each full-time, non-union, United States-based team member receives annual equity awards. These awards generally have a two-year vesting period, supporting retention and company-wide strategy alignment.​ Our compensation framework helps ensure that we remain strong with best-in-class performance and retain top talent even in economic downturns. We all share in the company’s success, as well as the challenges.​Workplace PhilosophyOur people are the foundation of our success and are our most important resource. Our culture safeguards all people and requires each person to be treated fairly and with dignity. We have equal employment opportunity, no tolerance for harassment of any kind, respect for human rights, diversity, and inclusion – all of which focus on our expectations of treating every person with the utmost respect. Our leadership is reminded of these expectations and receives recurring training on these critical topics. ​We work together as a unified team and respect each other as individuals. Our team-based compensation structure reinforces this philosophy. We strive to create an open and inclusive environment, ensuring the best ideas are recognized regardless of the position or the individual. We believe these ideals will continue to drive our success.​Given the value our team members provide, retention is a key metric to our company. In 2020, our overall employee retention was approximately 86%, with steel operations retention of 94%.​SegmentsWe have three reporting segments: steel operations, metals recycling operations, and steel fabrication operations. Refer to Notes 1 and 13 in the notes to consolidated financial statements in Part II, Item 8 of this Form 10-K for more thorough segment information.​​​Steel Operations Segment​Steel operations consist of our six EAF steel mills, producing steel from ferrous scrap and scrap substitutes, utilizing continuous casting, automated rolling mills and numerous steel coating and processing lines. Our steel operations sell directly to end-users, steel fabricators, and service centers. These products are used in numerous industry sectors, including the construction, automotive, manufacturing, transportation, heavy and agriculture equipment, and pipe and tube (including OCTG) markets. Our steel operations 9 Table of Contentsaccounted for 74%, 76%, and 75% of our consolidated net sales during 2020, 2019 and 2018, respectively. We currently are predominantly a domestic steel company, with exported sales representing 4% of our steel segment net sales during 2020 and 2019, and 5% in 2018.Our steel operations consist primarily of steelmaking and numerous coating operations. We have approximately 8.4 million tons of flat roll steel annual shipping capacity, comprised of 6.4 million tons of flat roll steel capacity at our Butler and Columbus Flat Roll Divisions. We have additional 2.0 million tons of flat roll steel shipping capacity through The Techs and our Heartland Flat Roll Division – acquired June 29, 2018, as well as distribution of metallic coated and pre-paint products through United Steel Supply (USS) – acquired 75% equity interest March 1, 2019. We have annual flat roll galvanizing capability of 3.9 million tons and painting capability of 1.2 million tons. We also have approximately 4.4 million tons of long product steel capacity at our long products divisions. Once completed, our new Southwest-Sinton Flat Roll Division will increase our total annual steel capacity by over 25%.Capacities represent manufacturing capabilities based on steel mill configuration and related employee support. These capacities do not represent expected volumes in a given year. In addition, estimates of steel mill capacity are highly dependent on the specific product mix manufactured. Each of our steel mills can and do roll many different types and sizes of products; therefore, our capacity estimates assume a typical product mix.​10 Table of ContentsThe following chart summarizes our steel operations primary products and the estimated percentage of tons sold by end market: ​11 Table of Contents​SHEET STEEL PRODUCTSOur sheet steel products, consisting of hot roll, cold roll and coated steel products are currently produced by our Butler and Columbus Flat Roll Divisions, and our numerous downstream coating lines, including The Techs, Heartland Flat Roll Division and USS. Our sheet steel operations represented 69% of steel operations net sales in 2020, and 70% in 2019 and 2018. We produced 7.6 million, 7.8 million, and 7.5 million tons of sheet steel at these facilities in 2020, 2019, and 2018, respectively.We shipped the following sheet steel products volumes at each of these facilities (tons):​​​​​​​​​​​​​​​​​​​​2020​2019​2018​​​Butler Flat Roll Division2,971,548​3,034,254​3,093,419​​​Columbus Flat Roll Division 2,918,187​3,106,293​3,113,600​​​The Techs822,101​847,815​806,345​​​Heartland Flat Roll Division525,542​507,319​167,921​​​United Steel Supply351,785​230,523​ -​​​​The following chart summarizes the types of sheet steel products sold by sales dollars, during the respective years, with cold roll and coated products representing value-added products:Customers. Steel processors and service centers typically act as intermediaries between primary sheet steel producers and the many end-user manufacturers that require further processing of hot roll coils. The additional processing performed by the intermediate steel processors and service centers include pickling, galvanizing, cutting to length, slitting to size, leveling, blanking, shape correcting, edge rolling, shearing and stamping. We believe that our intermediate steel processor and service center customers will remain an integral part of our customer base. The Columbus Flat Roll Division allows us to capitalize on the industrial markets in the Southern United States and Mexico, as well as further expand our customer base in painted, and line and other pipe products. Galvanized flat roll products produced by our Butler and Columbus Flat Roll Divisions are similar and are sold to a similar customer base. The Techs and Heartland Flat Roll Division specialize in the galvanizing of specific types of flat roll steels in primarily non-automotive applications, servicing a variety of customers in the heating, ventilation and air conditioning (HVAC), construction, agriculture and consumer goods markets. USS adds a complementary distribution channel for metallic coated and pre-paint flat roll steel coils to the niche regional roll-former market, serving the roofing and siding industry. This connected us to a rapidly growing industry segment with customers that do not traditionally purchase steel directly from a steel producer. USS provides continued growth to one of our highest-margin flat roll steel products. Our sheet steel operations also provide a substantial portion of the sheet steel utilized in our steel fabrication operations.12 Table of ContentsThe following chart summarizes the types of end-customers who purchased our sheet steel products, by sales dollars, during the respective years:LONG PRODUCTSOur long steel products, consists of a wide array of differentiating products produced by our four mills and Vulcan Threaded Products, Inc. (Vulcan), a downstream finishing operation. Structural and Rail Division produces a variety of parallel flange beams and channel sections, as well as flat bars and large unequal leg angles, and reinforcing bar including custom cut-to-length, smooth bar, and coiled. We also produce standard strength carbon, intermediate alloy hardness, and premium grade rails in 40 to 320 feet length for the railroad industry. Our state-of-the art heat treating system allows us to produce high quality premium rail, which has been certified by all Class I railroads. In addition, our rail-welding facility has the ability to weld (Continuous Welded Rail) in lengths up to 1,600 feet, which offers substantial savings to the railroads both in terms of initial capital cost and through reduced maintenance. We also utilize Structural and Rail Division’s excess capacity to supply our Engineered Bar Products Division with pull-through volume of billets to utilize its excess rolling capacity.Engineered Bar Products Division produces a broad range of engineered special-bar-quality (SBQ), merchant-bar-quality (MBQ) and other engineered round steel bars. We also have a bar finishing facility, which provides various downstream finishing operations for SBQ steel bars, including turning, polishing, straightening, chamfering, precision saw-cutting, and heat-treating capabilities. Vulcan produces threaded rod product, and cold drawn and heat treated bar, creating strategic pull-through demand of our special-bar-quality products.Roanoke Bar Division produces merchant products, including channels, angles, flats, merchant rounds, and reinforcing steel bar. Excess steel billet production is sold to mills without sufficient melting capacities, including our Steel of West Virginia facility. Our steel fabrication operations also purchase angles from Roanoke Bar Division.Steel of West Virginia produces a wide array of specialty merchant bar products and frequently performs fabrication and finishing operations on those products, such as cutting to length, additional straightening, hole punching, shot blasting, welding, galvanizing, and coating. Through this array of products and additional finishing, we create custom finished products that are generally placed directly into our customers’ assembly operations.​13 Table of ContentsWe shipped the following long products volumes at each of these facilities (tons):​​​​​​​​​​​​​​​​​​​​​2020​2019​2018​​​Structural and Rail Division1,663,915​1,469,356​1,630,235​​​ Rail production (included above)283,141​302,821​295,706​​​Engineered Bar Products Division555,620​650,408​827,049​​​Roanoke Bar Division 505,387​529,479​559,801​​​Steel of West Virginia328,998​358,827​315,603​​​Customers. The principal customers for our structural steel products are steel service centers, steel fabricators and various manufacturers. Service centers, though not the ultimate end-user, provide valuable mill distribution channels to the fabricators and manufacturers, including small quantity sales, repackaging, cutting, preliminary processing and warehousing. The steel rail marketplace in the United States, Canada and Mexico is specialized and defined, with eight Class I railroads and a large distribution network.SBQ products are principally consumed by cold finishers, forgers, intermediate processors, OEM manufacturers, steel service centers, and distributors, as well as pull-through volume to Vulcan. Our MBQ products are sold primarily to steel service centers, as well as reinforcing bar distributors, joist producers, and OEMs. Some of the excess steel billet production at the Roanoke Bar Division is sold to mills without sufficient melting capacities, including our Steel of West Virginia facility. Our steel fabrication operations also purchase angles from Roanoke Bar Division. Steel of West Virginia’s customers are primarily OEMs producing truck trailers, industrial lift trucks, merchant products, guardrail posts, manufactured housing, mining, and off-highway construction equipment. Steel of West Virginia’s flexible manufacturing capabilities enable us to meet demand for a variety of custom-ordered and designed products. Many of these products are produced in small quantities for low volume end-uses resulting in a wide variety of customers, the largest of which are in the truck trailer and industrial lift truck industries.Steel Competition. The markets in which we conduct business are highly competitive with an abundance of competition in the carbon steel industry from North American and foreign integrated and mini-mill steelmaking and processing operations. We compete in numerous industry sections, most significantly tied to the construction, automotive, and other manufacturing sectors. In many applications within these industry sections, steel competes with other materials, such as aluminum, cement, composites, plastics, carbon fiber, glass and wood. Some of our products are commodities, subject to their own cyclical fluctuations in supply and demand. However, we are focused on providing a broad range of diversified value-added products that de-emphasize commodity steel. The primary competitive influences on products we sell are price, quality and value-added services.Metals Recycling Operations Segment​The metals recycling operations include both ferrous and nonferrous scrap metal processing, transportation, marketing, and brokerage and scrap management services, strategically located primarily in close proximity to our steel mills and other end-user scrap consumers, throughout the United States, and Central and Northern Mexico. In August 2020, we completed the acquisition of Zimmer, S.A. de C.V. (Zimmer), a Mexican metal recycling company, which is an important part of our raw material procurement strategy for our new steel mill in Sinton, Texas. Our metals recycling operations accounted for 11% of our consolidated net sales during 2020 and 2019, and 13% in 2018. Export sales represented 10%, 9% and 8% of metals recycling segment net sales during 2020, 2019 and 2018, respectively.We shipped the following from our metals recycling operations:​​​​​​​​​​​​​​​​​​​​​2020​2019​2018​​​Ferrous metal total (gross tons)4,591,881​4,627,214​5,123,553​​​ Shipments to our steel mills3,184,451​3,061,257​3,346,135​​​ Percent of total to our steel mills69%​66%​65%​​​​​​​​​​​​Nonferrous metals (thousands of pounds)977,882​1,068,208​1,131,412​​​​14 Table of ContentsWe sell various grades of processed ferrous scrap primarily to steel mills and foundries. Ferrous scrap metal is the primary raw material for EAF’s, such as our steel mills. In addition, we sell various grades of nonferrous metals such as copper, brass, aluminum, and stainless steel, to aluminum, steel and ingot manufacturers, brass and bronze ingot makers, copper refineries and mills, smelters, specialty mills, alloy manufacturers, and other consumers.We purchase processed and unprocessed ferrous and nonferrous scrap metals, in a variety of forms for our metals recycling facilities.Ferrous scrap comes from two primary sources:●Manufacturers and industrial plants, metal fabrication plants, machine shops and factories, which generate ferrous scrap referred to as prompt or industrial scrap, and●Scrap dealers, retail individuals, auto wreckers, demolition firms and others who provide steel and iron scrap, referred to as obsolete scrap. Obsolete scrap includes scrap recycled from end-of-life items, such as automobiles, appliances, and machinery. Nonferrous scrap comes from three primary sources:●Manufacturers and other nonferrous scrap sources, which generate or sell scrap aluminum, copper, stainless steel, and other nonferrous metals,●Producers of items such as electric wire, telecommunication service providers, aerospace, defense and recycling companies that generate nonferrous scrap consisting primarily of copper wire, aluminum beverage cans, and various other metals and alloys, and●Retail individuals who sell material directly to our facilities, which they collect from a variety of sources.We do not purchase a significant amount of scrap metal from a single source or from a limited number of major sources. Market demand and the composition, quality, size, weight, and location of the materials are the primary factors that determine prices.Products. Our metals recycling operations primarily involve the purchase, processing, and resale of ferrous and nonferrous scrap metals into reusable forms and grades. We process an array of ferrous products through a variety of methods, including sorting, shredding, shearing, cutting, and breaking. Our major ferrous products include heavy melting steel, busheling, bundled scrap, shredded scrap and other scrap metal products, such as steel turnings and cast iron. These products vary in properties or attributes related to cleanness, size of individual pieces, and residual alloys. The necessary characteristics of the ferrous products are determined by the specific needs and requirements of the consumer and affect the individual product’s relative value. We process numerous grades of nonferrous products, including aluminum, brass, copper, stainless steel, and other nonferrous metals. Additionally, we provide transportation logistics (truck, rail, and river barge), marketing, brokerage, and scrap management services, providing competitive price and cost advantages to our suppliers and customers. We design, install, and manage customized scrap management programs for industrial manufacturing companies.Customers. We sell various grades of processed ferrous scrap to end-users, such as EAF steel mills, integrated steelmakers, foundries, secondary smelters, and metal brokers, who aggregate materials for other large users. Ferrous scrap metal is the primary raw material for electric arc furnaces, such as our steel mills. Most of our ferrous scrap customers purchase processed scrap through negotiated spot sales contracts which establish a quantity purchase for the month. The price we charge for ferrous scrap depends upon market demand and pricing, transportation costs, as well as the quality and grade of the scrap. Competition. Scrap is a global commodity influenced by conditions in a number of industrialized and emerging markets throughout Asia, Europe and North America. The markets for scrap metals are highly competitive, both in the purchase of raw or unprocessed scrap, and the sale of processed scrap. With regard to the purchase of unprocessed scrap, we compete with numerous independent recyclers, as well as smaller scrap companies engaged only in collecting obsolete scrap. In many cases, we also purchase unprocessed scrap metal from smaller scrap dealers and other processors. Successful procurement of materials is determined primarily by the price offered by the purchaser for the raw scrap and the proximity of our processing facility to the source of the raw scrap. Both ferrous and nonferrous scrap sells as a commodity in both domestic and international markets, which are affected, sometimes significantly, by relative economic conditions, currency fluctuations, and the availability and cost of transportation. Competition for sales of processed scrap is based primarily on the price, quality, and location of the scrap metals, as well as the level of service provided in terms of reliability and timing of delivery.15 Table of ContentsWe also face potential competition for sales of processed scrap from other producers of steel products, such as EAF and integrated steel mills, some of which like us are also vertically integrated in the scrap metals recycling business. In addition, other steel mills may compete with us in attempting to secure scrap supply through direct purchasing from our scrap suppliers. Scrap metal processors also face competition from substitutes for prepared ferrous scrap, such as pig iron, pelletized iron, hot briquetted iron (HBI), direct reduced iron (DRI), and other forms of processed iron. The availability and relative prices of substitutes for ferrous scrap could result in a decreased demand for processed ferrous scrap and could result in lower prices and/or lower demand for our scrap products.The industry is highly fragmented with many smaller, regional, national and global companies, which have multiple locations in areas in which OmniSource also operates. No single scrap metals recycler has a significant market share in the domestic market.​Steel Fabrication Operations Segment​Our steel fabrication operations include seven New Millennium Building Systems plants that primarily serve the non-residential construction industry throughout the United States. We have a national operating footprint that allows us to serve the entire domestic construction market, as well as national accounts, such as large retail chains.Steel fabrication operations accounted for 9% of our consolidated net sales during 2020 and 2019, and 8% in 2018. We sold 666,000, 644,000, and 642,000 tons of joist and deck products during 2020, 2019, and 2018, respectively. Products. Our steel fabrication operations produce steel building components, including steel joists, girders, and trusses, and steel deck. Our joist products include bowstring, arched, scissor, double-pitched and single-pitched joists. Our deck products include a full range of steel decking: roof, form, composite floor, specialty architectural, floor systems, and bridge deck.Customers and Markets. Our primary steel fabrication operations customers are non-residential steel fabricators, such as metal building companies, general construction contractors, developers, brokers and governmental entities. Our customers are located throughout the United States, including national accounts. Our steel fabrication operations maintain approximately one-third of the total domestic steel joist and deck market of approximately 2.3 million tons in 2020, and 2.1 million tons in 2019 and 2018. We believe we are well positioned with our national footprint as the non-residential construction market remains strong, and we have available capacity that can be deployed as needed.Competition. We compete with other North American joist and steel deck producers primarily on the basis of price, quality, customer service, and proximity to the customer. Our national footprint allows us to service the entire domestic non-residential construction market, as well as national accounts such as large retail chains, including their related omni-channel distribution centers, and certain specialty deck customers.​16 Table of ContentsOther Information​Sources, Availability, and Cost of Steel and Other Operations’ Raw MaterialsScrap Metals. The principal raw material of our steel operations is scrap metal derived from, among other sources "home scrap”, generated internally at steel mills themselves; industrial scrap, generated as a by-product of manufacturing; and obsolete scrap recycled from end-of-life automobiles, appliances, and machinery, and demolition scrap from obsolete structures, containers and machines.Ferrous scrap typically comprises more than 80% of the metallic melt mix in EAF steelmaking, in contrast to integrated mill steelmaking, where the proportion of scrap has traditionally been approximately 25% to 35%. Depending upon the scrap substitute material that may be available from time to time, and the relative cost of such material, the percentage of scrap used in our steelmaking operations could be increased or reduced in our metallic melt mix.Many variables can impact ferrous scrap prices, all of which reflect the pushes and pulls of the supply demand equation. These factors include the level of domestic steel production (high quality low-residual scrap is a by-product of steel manufacturing activity), the level of exports of scrap from the United States, and the amount of obsolete scrap production. In addition, domestic ferrous scrap prices generally have a strong correlation and spread to global pig iron pricing. Generally, as domestic steel demand increases, so does scrap demand and resulting scrap prices. The reverse is also normally, but not always, true with scrap prices following steel prices downward when supply exceeds demand. When scrap prices greatly accelerate, this can challenge one of the principal elements of an EAF based steel mill’s traditional lower cost structure—the cost of its metallic raw material. ​Iron Units. In addition to scrap, pig iron, DRI, HBI, and internally sourced liquid pig iron are used in our EAF steel mill production. During 2020, 2019, and 2018, we consumed 10.4 million, 10.6 million and 10.9 million tons, respectively, of metallic materials in our steelmaking furnaces, of which, iron units other than scrap, represented approximately 13% of the tons in 2020 and 2019, and 14% in 2018. Energy ResourcesElectricity. Electricity is a significant input required in the EAFs in our steelmaking operations, representing between 4% and 5% of steel production costs of goods sold in 2020, 2019 and 2018. We have entered into fixed price electricity contracts for the Butler Flat Roll Division, Columbus Flat Roll Division, Roanoke Bar Division and Steel of West Virginia, while our Engineered Bar Products Division has a combination of fixed pricing and market pricing for the various components of the electrical services (demand charge, energy charge, riders, etc.). Our Structural and Rail Division purchases electricity at current market prices and through fixed price forward contracts.Research and DevelopmentOur research and development activities have consisted of efforts to expand, develop and improve our steel products and operating processes, such as our planned Southwest-Sinton Flat Roll Division, and our efforts to develop and improve alternative ironmaking technologies. Most of these research and development efforts have been conducted in-house by our employees. Environmental MattersOur operations are subject to substantial and evolving local, state, and federal environmental, health and safety laws and regulations concerning, among other things, emissions to the air, discharges to surface and ground water and to sewer systems, and the generation, handling, storage, transportation, treatment and disposal of solid and hazardous wastes and secondary materials. Our operations are dependent upon permits regulating discharges into the environment or the use and handling of by-products in order to operate our facilities. We dedicate considerable resources aimed at achieving compliance with federal, state and local laws concerning the environment. While we do not currently believe that our future compliance efforts with such provisions will have a material adverse effect on our results of operations, cash flows or financial condition, this is subject to change in the ever-evolving regulatory environment in which we operate.Since the interpretation and enforcement of environmental laws and regulations that may be enacted from time to time are subject to changing social or political pressures, our environmental capital expenditures and costs for environmental compliance may increase in the future. In addition, due to the possibility of unanticipated regulatory or other developments, the amount and timing of future environmental expenditures may vary substantially from those currently anticipated. The cost of current and future environmental 17 Table of Contentscompliance may also place United States steel producers at a competitive disadvantage with respect to foreign steel producers, which may not be required to undertake equivalent costs in their operations.Pursuant to the Resource Conservation and Recovery Act (RCRA), which governs the treatment, handling and disposal of solid and hazardous wastes, the United States Environmental Protection Agency, or United States EPA, and authorized state or local environmental agencies may conduct inspections to identify alleged violations or areas where there may have been releases of solid or hazardous constituents into the environment and require the facilities to take corrective action to address any such releases. RCRA also allows citizens to bring certain suits against regulated facilities for potential damages and cleanup. Our steelmaking and certain other facilities generate wastes subject to RCRA. Our operations produce various by-products, some of which, for example EAF dust, are often categorized as hazardous waste, requiring special handling for disposal or for the recovery of metallics. We collect such by-products in pollution control equipment, such as baghouses, and then recycle what’s possible, and appropriately dispose of the remaining unusable by-products. While we cannot predict the future actions of the regulators or other interested parties, the potential exists for required corrective action at these facilities, the costs of which could be substantial.​Under the Comprehensive Environmental Response, Compensation and Liability Act, known as (CERCLA) or (Superfund), the United States EPA, state agencies and, in some instances, private parties have the authority to impose joint and several liability for the remediation of contaminated properties upon generators of waste, current and former site owners and operators, transporters and other potentially responsible parties, regardless of fault or the legality of the original disposal activity. Many states have statutes and regulatory authorities similar to CERCLA that can also apply. We have a number of material handling agreements with various contractors to properly dispose of or recycle our EAF dust and certain other by-products of our operations. However, we cannot assure that, even if there has been no fault by us, we may not still be cited as a waste generator by reason of an environmental cleanup at a site to which our by-products were transported.The Clean Water Act and similar state and local laws apply to aspects of our operations and impose regulatory restrictions related to the discharge of wastewater, storm water and dredged or fill material. The United States EPA, state agencies and, in certain instances, private parties have the ability to bring suit alleging violations and seeking penalties and damages. The Clean Water Act’s provisions can require new or expanded water treatment investments to be made and can limit or even prohibit certain current or planned activities at our operations.The Clean Air Act and analogous state and local laws require many of our facilities to obtain and maintain air permits in order to operate. Air permits can impose new or expanded obligations to limit or prevent current or future emissions and to add costly pollution control equipment. Enforcement for alleged violations can be brought by the United States EPA, state agencies, and in certain instances private parties, and can result in substantial penalties and injunctive relief.In addition, there are a number of other environmental, health and safety laws and regulations that apply to our facilities and may affect our operations. By way of example and not of limitation, certain portions of the federal Toxic Substances Control Act, Oil Pollution Act, Safe Drinking Water Act and Emergency Planning and Community Right-to-Know Act, as well as state and local laws and regulations implemented by the regulatory agencies, apply to aspects of our facilities’ operations. In some instances, we may also be subject to foreign governments’ regulations and international treaties and laws. Many of these laws allow both the governments and citizens to bring certain suits against regulated facilities for alleged environmental violations. Finally, our operations could be subject to certain toxic tort suits brought by citizens or other third parties alleging causes of action such as nuisance, negligence, trespass, infliction of emotional distress, or other claims alleging personal injury or property damage.Available InformationOur internet website address is www.steeldynamics.com. We make available on our internet website, under "Investors,” free of charge, as soon as reasonably practicable after such materials are electronically filed with, or furnished to, the Securities and Exchange Commission, our Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and amendments to those reports, as well as press releases, ownership reports pursuant to Section 16(a) of the Securities Act of 1933, our Code of Ethics for Principal Executive Officers and Senior Financial Officers, our Code of Business Conduct and Ethics, and any amendments thereto or waivers thereof, as well as our Audit, Compensation, and Corporate Governance and Nominating Committee Charters. The contents of our or any other website are not incorporated into this report. ​18 Table of ContentsITEM 1A. RISK FACTORSMany factors may have an effect on our business, results of operations, financial condition and cash flows. We are subject to various risks resulting from changing economic, environmental, political, industry, business and financial conditions. The factors, as may be exacerbated by the impact of the COVID-19 pandemic, described below represent our principal risks. Global and National Risks Related to our BusinessOur industry, as well as the industries of many of our customers and suppliers upon whom we are dependent, is affected by domestic and global economic factors including periods of slower than anticipated economic growth and the risk of a recession.Our financial results are substantially dependent not only upon overall economic conditions in the United States and globally, including North America, Europe and in Asia, but also as they may affect one or more of the industries upon which we depend for the sale of our products. Global or domestic actions or conditions, including political actions, trade policies or restrictions, such as the United States-Mexico-Canada Agreement (USMCA), changes in tax laws, terrorism, natural disasters, or pandemics, epidemics, widespread illness or other health issues, such as COVID-19, could result in changing economic conditions in the United States and globally, disruptions to or slowdowns in our business or our global or domestic industry, or those of our customers or suppliers upon whom we are dependent. Additionally, periods of slower than anticipated economic growth could reduce customer confidence and adversely affect demand for our products and further adversely affect our business, results of operations, financial condition and cash flows. Metals industries have historically been vulnerable to significant declines in consumption and product pricing during periods of economic downturn or continued uncertainty, including the pace of domestic non-residential construction activity.Our business is also dependent upon certain industries, such as construction, automotive, manufacturing, transportation, heavy and agriculture equipment, and pipe and tube (including OCTG) markets, and these industries are also cyclical in nature. Therefore, these industries may experience their own fluctuations in demand for our products based on such things as economic conditions, raw material and energy costs, consumer demand and infrastructure funding decisions by governments. Many of these factors are beyond our control. As a result of volatility in our industry or in the industries we serve, we may have difficulty increasing or maintaining our level of sales or profitability. A downturn in our industry or the industries we serve may adversely affect our business, results of operations, financial condition and cash flows.A prospective decline in consumer and business confidence and spending, which is often coupled with reductions in the availability of credit or increased cost of credit, as well as volatility in the capital and credit markets, may adversely affect the business and economic environment in which we operate and the profitability of our business. We are also exposed to risks associated with the creditworthiness of our customers and suppliers. If the availability of credit to fund or support the continuation and expansion of our customers’ business operations is curtailed or if the cost of that credit is increased, the resulting inability of our customers or of their customers to either access credit or absorb the increased cost of that credit may adversely affect our business by reducing our sales or by increasing our exposure to losses from uncollectible customer accounts. A disruption of the credit markets could also result in financial instability of some of our customers and suppliers. The consequences of such adverse effects could include the interruption of production at the facilities of our customers, the reduction, delay or cancellation of customer orders, delays or interruptions of the supply of raw materials we purchase, and bankruptcy of customers, suppliers or other creditors. Any of these events may adversely affect our business, results of operations, financial condition and cash flows.Global steelmaking overcapacity and imports of steel into the United States have adversely affected, and may continue to adversely affect, United States steel prices, which, together with increased scrap prices, may adversely affect our business, results of operations, financial condition and cash flows.Global steelmaking capacity currently exceeds global consumption of steel products, which adversely affects United States and global steel prices. Such excess capacity sometimes results in steel manufacturers in certain countries exporting steel and steel products, including pre-fabricated long product steel, at prices that are lower than prevailing domestic prices, and sometimes at or below their cost of production. Excessive imports of steel and steel products, including pre-fabricated steel, into the United States, have exerted, and may continue to exert, downward pressure on United States steel and steel products prices, which adversely affects our business, results of operations, financial condition and cash flows. Fluctuations in the value of the dollar can also affect imports, as strong United States dollar makes imported products less expensive, potentially resulting in more imports of steel products into the United States by our foreign competitors. Furthermore, anticipated additional domestic steel capacity could increase this global overcapacity. This, in turn, may also increase domestic demand for ferrous scrap. Our results of operations, financial condition and cash flows are driven primarily from the metal spread achieved from the price we sell steel and steel products compared to the price of our metallic raw materials, including scrap. During prolonged periods of steel and steel products overcapacity, leading to lower selling prices, combined with high demand for scrap and raw materials, leading to higher buying prices, our metal spreads could be compressed, which may adversely affect our business, results of operations, financial condition and cash flows.19 Table of ContentsUnited States steel producers compete with many foreign producers, including those in China, Vietnam and other Asian and European countries. Competition from foreign producers is typically strong and is periodically exacerbated by weakening of the economies of certain foreign steelmaking countries, at times due to imports of steel involving dumping and subsidy abuses by foreign steel producers. Some foreign steel producers are owned, controlled or subsidized by foreign governments. As a result, decisions by these producers with respect to their production, sales and pricing are sometimes influenced to a greater degree by political and economic policy considerations than by prevailing market conditions, realities of the marketplace or consideration of profit or loss. Additionally, low iron ore prices, resulting in disruption of the scrap price correlation to iron ore, leads to reduced global costs to produce steel, further depressing steel import prices. A higher volume of steel imports into the United States tends to occur at depressed prices when foreign steelmaking countries experience periods of economic difficulty, decreased demand for steel products or excess capacity. The global steelmaking overcapacity is exacerbated by Chinese steel production capacity that far exceeds that country’s demand and has made China a major global exporter of steel, resulting in weakened global steel pricing than otherwise would be expected. While tariffs pursuant to Section 232 of the Trade Expansion Act of 1962, as amended (Section 232), other measures to curb unfair trade such as duties or quotas, and the renegotiation of trade agreements with other countries, including the USMCA, have decreased the volume of steel and steel products imports, domestic steel and steel products prices remain negatively impacted by excessive imports of steel and steel products. Should the Section 232 tariffs, duties or quotas expire or be relaxed, repealed or circumvented by importers of steel and steel products, or should trade agreements be renegotiated, downward pressure may be exerted on United States steel and steel products prices, which may adversely affect our business, results of operations, financial condition and cash flows.Pandemics, epidemics, widespread illness or other health issues, such as the COVID-19 pandemic may adversely affect our business, results of operations, financial condition, cash flows, liquidity, and stock price.The COVID-19 pandemic has and may continue to adversely affect our business, results of operations, financial condition, cash flows, liquidity and stock price. Other pandemics, epidemics, widespread illness or other health issues may also adversely affect us. The COVID-19 pandemic has resulted in various government actions globally, including United States federal and state governmental actions designed to slow the spread of the virus and its impacts. These actions have included quarantines, “shelter in place,” “stay at home” and “social distancing” orders, business shutdowns and restrictions, travel restrictions and other mitigation efforts, which, among other things, have impacted and may further impact demand for our products, as well as our supply chain. These measures, along with further voluntary measures by businesses and individuals, have impacted and may further impact our working conditions, productivity and operations, as well as those of our customers and suppliers. These mitigation measures have also adversely affected and may continue to adversely affect the United States and global economies, resulting in increased unemployment in the United States and the communities in which we operate. However, due to our variable compensation system that rewards productivity, as well as our low fixed cost structure, we have not and do not expect in the future to significantly reduce our workforce due to the COVID-19 pandemic.We have been identified by the U.S. Department of Homeland Security as a critical infrastructure industry and have been deemed an essential business in all of the states in which we operate. This has permitted us to continue to advance our commitment to our customers and meet their demand by operating our business consistent with federal guidelines and state and local orders, including social distancing guidelines. Our teams are our most valued priority, and we have implemented numerous process and procedural initiatives to ensure the health and safety of our people, their families and our communities. We have adjusted schedules to support social distancing, provided additional and more frequent sanitizing applications, provided additional protective measures, among many other actions. These health and safety initiatives have not and are not expected to have a material effect on our operations, but further required limitations and restrictions may adversely affect our results of operations. Additionally, while we have not currently curtailed our operations, a prolonged COVID-19 pandemic, resurgence or further spread of the virus could further materially reduce demand for our products and thus, reduce the productivity of our operations and adversely affect our business, results of operations, financial condition and cash flows. Certain of our customers and suppliers, such as those in the automotive, energy and related industries, have experienced and in the future may experience temporary shutdowns or significant demand reductions, adversely affecting our operations. Further reduced demand for our products or raw material supply availability due to shutdowns or slowdowns in businesses may further adversely affect our volumes and margins, results of operations, financial condition and cash flows. In the event equipment or supplier personnel from foreign countries are delayed due to COVID-19 related constraints, our ability to complete construction and commissioning of our new Southwest-Sinton Flat Roll Division could be delayed beyond the expected commencement of operations in mid-year 2021. The COVID-19 pandemic has also caused volatility in the financial and capital markets and led to new and expanded governmental programs and initiatives, which affected and may further affect our stock price. There is considerable uncertainty regarding the economic and industry impacts, including duration, from the COVID-19 pandemic and the measures introduced to curtail its spread and its impacts. In the event vaccinations for COVID-19 have unanticipated side-effects, are not widely administered or have more limited than expected benefits, the effects of COVID-19 on the economy and our business could worsen. Although these highly uncertain future impacts cannot be reasonably estimated at this time, 20 Table of Contentsgeneral economic conditions, business closures, slow payments from customers, increased bankruptcies, and labor restrictions may adversely affect our business, results of operations, financial condition, cash flows, liquidity and stock price. Industry Risks Related to our BusinessOur level of production and our sales and earnings are subject to significant fluctuations as a result of the cyclical nature of the steel industry and some of the industries we serve.The steel manufacturing business is cyclical in nature, and the selling price of the steel we make may fluctuate significantly due to many factors beyond our control. Furthermore, a number of our products are commodities, subject to their own cyclical fluctuations in supply and demand in both metal consuming and metal generating industries, including the construction and manufacturing industries. The timing, magnitude and duration of these cycles and the resulting price fluctuations are difficult to predict. The sale of our manufactured steel products is directly affected by demand for our products in other cyclical industries, such as construction, automotive, manufacturing, transportation, heavy and agriculture equipment, and pipe and tube (including OCTG) markets. Economic difficulties, stagnant or slow global economies, supply/demand imbalances and currency fluctuations in the United States or globally may decrease the demand for our products or increase the amount of imports of steel into the United States, which may decrease our sales, margins and profitability.Volatility and major fluctuations in prices and availability of scrap metal, scrap substitutes, supplies, and our potential inability to pass higher costs on to our customers, may constrain operating levels and reduce profit margins.Steel producers require large amounts of raw materials, including scrap metal and scrap substitute products such as pig iron, pelletized iron and other supplies such as zinc, graphite electrodes and ferroalloys. Our principal raw material is scrap metal derived primarily from industrial scrap and end-of-life automobiles, appliances and machinery, and demolition scrap from obsolete structures, containers, and machinery. The prices for scrap are subject to market forces largely beyond our control, including demand by United States and foreign steel producers, freight costs and speculation. The scrap metal recycling industry has historically been, and is expected to remain, highly cyclical and the prices for scrap have varied significantly in the past, may vary significantly in the future and do not necessarily fluctuate in tandem with the price of steel. Moreover, some of our integrated steel producer competitors are not as dependent as we are on scrap as a part of their raw material melt mix, which, during periods of high scrap costs relative to the cost of blast furnace iron used by the integrated producers, give them a raw material cost advantage over EAF mills. While our vertical integration into the metals recycling business and our liquid pig-iron operations are expected to enable us to continue being a cost-effective supplier to our own steelmaking operations, for some of our metallics requirements, we still rely on other metallics and raw material suppliers, as well as upon general industry supply conditions for the balance of our needs.The availability and prices of raw materials, and supplies may also be negatively affected by new, existing, or changing laws and regulations, including those that may impose output limitations or higher costs associated with climate change or GHG allocation by suppliers, interruptions in production, accidents or natural disasters, changes in exchange rates, global price fluctuations, the availability and cost of transportation, and competing uses. As a major producer of galvanized steel products, we purchase and consume a large amount of zinc, which if purchased at high prices, may adversely affect our profit margins. Any inability to secure a consistent, cost-effective and timely supply of our raw materials and supplies may adversely affect our business, financial condition, results of operations and cash flows.Additionally, our inability to pass on all or any substantial part of any cost increases or to provide for our customers’ needs because of the potential unavailability of raw materials or supplies, may result in production slowdowns or curtailments or may otherwise adversely affect our business, financial condition, results of operations and cash flows.The cost and availability of electricity, natural gas, oil and other energy resources are subject to volatile market conditions.Steel producers like us consume large amounts of energy to melt ferrous scrap in EAFs and reheat steel for rolling into finished products. We rely on third parties for the supply of energy resources we consume in our steelmaking activities. The prices for and availability of electricity, natural gas, oil and other energy resources are subject to volatile market conditions, often affected by weather conditions as well as political, environmental and economic factors beyond our control. As consumers of electricity and natural gas, we must have dependable delivery in order to operate. Accordingly, we are at risk in the event of an energy disruption, including power outages or power unavailability. Prolonged blackouts or brownouts or disruptions caused by natural disasters or by political or environmental considerations would substantially disrupt our production. Since a significant portion of our finished steel products are delivered by truck, unforeseen fluctuations in the price of fuel would also adversely affect our costs or the costs of many of our customers.21 Table of ContentsCompliance with and changes in environmental and remediation requirements may result in substantially increased capital requirements and operating costs.Existing laws or regulations, as currently interpreted or as may be interpreted in the future, as well as future laws or regulations, may adversely affect our results of operations and financial condition.We are subject to numerous local, state, federal and international statutory and regulatory environmental requirements relating to, among other things:●the generation, storage, treatment, handling and disposal of solid and hazardous waste and secondary materials;●the discharge of materials into the air, including periodic changes to the National Ambient Air Quality Standards and to emission standards;●the management, treatment and discharge of wastewater and storm water;●the use and treatment of groundwater;●the remediation of soil and groundwater contamination;●climate change legislation or regulation;●the need for and the ability to timely obtain air, water or other environmental permits;●the timely reporting of certain chemical usage, content, storage and releases;●the remediation and reclamation of land used in our operations;●natural resource protections; and●the protection of our employees’ health and safety.Compliance with environmental laws and regulations, which affect our steelmaking, metals recycling, liquid pig-iron, and copper and aluminum production operations, is a significant factor in our business. We are required to obtain and comply with environmental permits and licenses, and failure to obtain or renew or the violation of any permit or license may result in substantial fines and penalties, capital expenditures, operational changes, suspension of operations and/or the closure of a subject facility. Similarly, delays, increased costs and/or the imposition of onerous conditions to the securing or renewal of permits may adversely affect these operations.Uncertainty regarding adequate pollution control levels, testing and sampling procedures, and new pollution control technology are factors that may increase our future compliance expenditures. We are unable to predict the ultimate cost of future compliance with environmental requirements or their effect on our operations. Although we strive to be in substantial compliance with all applicable laws and regulations, legal requirements frequently change and are subject to interpretation such that regulatory agencies may bring enforcement actions for alleged noncompliance. Private parties might also bring claims against us under citizen suit provisions and/or for property damage or personal injury allegedly resulting from our operations. New laws, regulations and changing interpretations by regulatory authorities, together with uncertainty regarding the application of existing requirements are among the factors that may increase our future expenditures to comply with environmental requirements. The cost of complying with existing laws or regulations as currently interpreted or reinterpreted in the future, or with future laws or regulations, may adversely affect our results of operations and financial condition.Our operations produce significant amounts of by-products, some of which are handled as solid or hazardous waste or as hazardous secondary materials. For example, our steel mills generate EAF dust, which the United States Environmental Protection Agency (United States EPA) and other regulatory authorities classify as hazardous waste and regulate accordingly unless recycled in an exempt manner.In addition, the primary feed materials for the shredders operated by our metals recycling operations are automobile bodies. A portion of the feed materials consist of unrecyclable material known as shredder residue. If laws or regulations or the interpretation of the laws or regulations change with regard to EAF dust or shredder residue or other by-products created by our operations, we may incur significant additional expenditures.Federal and state environmental laws enable the United States EPA, state agencies and certain private parties to recover from owners, operators, generators and transporters the cost of investigation and cleanup of sites at which wastes or hazardous substances were disposed. In connection with these laws, we may be required to clean up contamination discovered at our sites including 22 Table of Contentscontamination that may have been caused by former owners or operators of the sites, to conduct additional cleanup at sites that have already had some cleanup performed, and/or to perform cleanup with regard to sites formerly used in connection with our operations.In addition, we may be required to pay for, or to pay a portion of, the costs of cleanup at sites to which we sent materials for disposal or recycling, notwithstanding that the original disposal or recycling activity may have complied with all regulatory requirements then in effect. Under certain laws, a party can be held jointly and severally liable for all of the cleanup costs associated with a disposal site. In practice, a liable party often splits the costs of cleanup with other potentially responsible parties. We have received notices from the United States EPA, state agencies and third parties that we have been identified as potentially responsible for the costs of investigating and cleaning up a number of disposal sites. In most cases, many other parties are also named as potentially responsible parties and also contribute to payment of those costs.Because cleanup liability can in some cases be imposed retroactively on activities that occurred many years ago, and because the United States EPA and state agencies are still discovering sites that pose a threat to public health or the environment, we can provide no assurance that we will not become liable for significant costs associated with investigation and remediation of cleanup sites.Increased regulation associated with the environment, climate change, GHG emissions and sustainability could impose significant costs on both our steelmaking and metals recycling operations.The United States government, various other governmental agencies, regulators, investors or other groups may introduce, request or require environmental monitoring, disclosures or regulations in response to the potential impacts of climate change. International treaties or agreements may also result in increasing regulation of GHG emissions, including the introduction of carbon emissions limitations or trading mechanisms. Any such regulation or disclosure requirement could impose significant costs on our operations and on the operations of our customers and suppliers, including increased energy, capital equipment, emissions controls, environmental monitoring and reporting and other costs in order to comply with current or future laws, regulations or demands concerning the environment, climate change, GHG emissions and sustainability. Any adopted future regulations could negatively impact our ability, and that of our customers and suppliers, to compete with companies situated in areas not subject to or not complying with such limitations. We may see an increase in costs relating to our assets that emit GHGs as a result of these initiatives, which may impact our operations directly or through our customers and suppliers. Until the timing, scope and extent of any future regulation becomes known, we cannot predict the effect on our financial condition, operating performance and ability to compete.Operational and Commercial Risks Related to our BusinessWe may face significant price and other forms of competition from other steel producers, scrap processors and alternative materials, which may adversely affect our business, financial condition, results of operations and cash flows.The global markets in which steel companies and scrap processors conduct business are highly competitive and became even more so due to consolidations in the steel and scrap industries. Additionally, in many applications, steel competes with other materials, such as aluminum, cement, composites, plastics, carbon fiber, glass and wood. Increased use of alternative materials for any reason, including as a response to regulations, could decrease demand for steel or force other steel producers into new products or markets that compete more directly with us, and combined with increased competition could cause us to lose market share, increase expenditures or reduce pricing, any one of which may adversely affect our business, financial condition, results of operations and cash flows.Availability of an adequate source of supply is required for our metals recycling operations.We procure our scrap inventory from numerous sources. These suppliers generally are not bound by long-term contracts and generally have no obligation to sell recyclable metal to us. In periods of low industry scrap prices, scrap suppliers may elect to hold recyclable metal to wait for higher prices or intentionally slow their metal collection activities. If a substantial number of scrap suppliers cease selling recyclable metal to us, we may be unable to recycle metal at desired levels which may adversely affect our results of operations and financial condition. In addition, a slowdown of industrial production in the United States reduces the supply of industrial grades of metal to the metal recycling industry, resulting in our having less recyclable metal available to process and sell.We are subject to cybersecurity threats and may face risks to the security of our sensitive data and information technology, which may adversely affect our business, results of operations, financial condition and cash flows.Increased global cybersecurity and information technology security requirements, vulnerabilities and threats and a rise in sophisticated and targeted cybercrime pose a risk to the security and functionality of our systems and information networks, and to the confidentiality, availability and integrity of sensitive data, including intellectual property, proprietary information, financial information, customer and supplier information, and personally identifiable information. Additionally, such cybersecurity 23 Table of Contentsvulnerabilities or attacks could result in an interruption of the functionality of our automated and electronically controlled manufacturing operating systems, which, if compromised, could cease, threaten, delay or slow down our ability to melt, roll or otherwise process steel or any of our other products for the duration of such interruption. Our customers and suppliers may also store certain of our sensitive information on their information technology systems, which if breached or attacked, could likewise expose our sensitive information. Any of these cybersecurity and information technology breaches or disruptions may result in reputational harm and may adversely affect our business, results of operations, financial condition and cash flows.Although we believe we have adopted procedures and controls to adequately protect our sensitive data, networks and information and operating technology and systems, there can be no assurance that a system or network failure, or cybersecurity breach or attack, will be prevented, whether due to attacks by cyber criminals or due to employee, contractor or other error or malfeasance. This could lead to system interruption, production delays or downtimes and operational disruptions, and the disclosure, modification or destruction of sensitive data, which may adversely affect our reputation, customer and supplier relationships, financial results and results of operations, and could result in litigation or regulatory investigations, actions, fines or penalties, as well as increased cybersecurity monitoring and protection costs, including the cost of insurance. Additionally, as cybersecurity threats continue to evolve and become more sophisticated, we may need to invest additional time, resources and finances to protect the security of our sensitive data, systems and information networks. We maintain an information security risk insurance policy to mitigate the impact of cybersecurity threats and we did not incur any net expenses from information security breach penalties and settlements during 2020, 2019, or 2018.We may face risks associated with the implementation of our growth strategy.Our growth strategy subjects us to various risks. As part of our growth strategy, we may expand existing facilities, enter into new product or process initiatives, acquire or build additional plants, acquire other businesses and assets, enter into joint ventures, or form strategic alliances that we believe will complement our existing business. These expansions and transactions may involve some or all of the following risks:●the risk of entering product or domestic or foreign geographic markets in which we have little experience;●the risk of a newly constructed steel mill being completed over budget or not on time;●the risk of not being able to adequately obtain sufficient labor to efficiently build or staff a new steel mill;●the risk of expected markets, products, customers and demand for products produced by a new steel mill being lower than expected;●the difficulty of competing for acquisitions and other growth opportunities with companies having materially greater financial resources than us;●the inability to realize anticipated synergies or other expected benefits;●the difficulty of integrating new or acquired operations and personnel into our existing operations;●the potential disruption of ongoing operations;●the diversion of financial resources or management attention to new operations or acquired businesses;●the loss of key employees, customers or suppliers of acquired businesses;●the potential exposure to unknown liabilities;●the inability of management to maintain uniform standards, controls, procedures and policies;●the difficulty of managing the growth of a larger company;●the risk of becoming involved in labor, commercial, or regulatory disputes or litigation related to the new operations or acquired businesses;●the risk of becoming more highly leveraged;●the risk of contractual or operational liability to other venture participants or to third parties as a result of our participation;●the inability to work efficiently with joint venture or strategic alliance partners; and●the difficulties of terminating joint ventures or strategic alliances.Our new Southwest-Sinton Flat Roll Division is under construction in Sinton, Texas, and is planned to commence operations in mid-year 2021, with a total expected capital investment of approximately $1.9 billion. The project is subject to the above risks, as well 24 Table of Contentsas unfavorable weather conditions, natural disasters, delayed equipment deliveries and installations, or other conditions outside our control which could increase the capital investment or delay the commencement of operations of our new EAF steel mill. As we begin operations, we could face additional risks related to human capital attraction, development and retention, as well as start-up inefficiencies. Additionally, customer, product, or geographic markets we expect to serve may not be as profitable as currently expected, which may adversely affect our prospects, business, financial condition, results of operations and cash flows.These expansions or transactions might be required for us to remain competitive, but we may not be able to complete any such expansions or transactions on favorable terms or obtain financing, if necessary. Future expansions and transactions may not improve our competitive position and business prospects as anticipated, and if they do not, our business, financial condition, results of operations and cash flows may be adversely affected.We are subject to litigation and legal compliance risks which may adversely affect our financial condition, results of operations and liquidity.We are involved from time to time in various routine litigation matters, including administrative proceedings, regulatory proceedings, governmental investigations, environmental matters, and commercial and construction contract disputes, none of which at the present time are expected to have a material impact on our financial conditions, results of operations or liquidity. For additional information regarding legal proceedings please refer to Item 3. Legal Proceedings.In addition to risks associated with our environmental and other regulatory compliance, our international operations are subject to complex foreign and United States laws and regulations, including the Foreign Corrupt Practices Act and other anti-bribery laws, regulations related to import-export controls, the Office of Foreign Assets Control, and other laws and regulations, each of which may increase our cost of doing business and expose us to increased risk.Unexpected equipment downtime or shutdowns may adversely affect our business, financial condition, results of operations and cash flows.Interruptions in our production capabilities may adversely affect our production costs, products available for sale and earnings during the affected period. In addition to equipment failures, our facilities are also subject to the risk of catastrophic loss due to unanticipated events such as fires, explosions or violent weather conditions. Our manufacturing processes are dependent upon critical pieces of steelmaking equipment, such as our EAFs, continuous casters and rolling equipment, some of which are controlled by our information technology systems, as well as electrical equipment, such as transformers. This equipment may, on occasion, be out of service as a result of unanticipated failures or other events, including cybersecurity breaches or attacks or system failures. We have experienced plant shutdowns or periods of reduced production as a result of such equipment failures and may in the future experience plant shutdowns or periods of reduced production as a result of such equipment failures, or other events. These disruptions may adversely affect our business, financial condition, results of operations and cash flows.Governmental agencies may refuse to grant or renew some of our licenses and permits.We must receive licenses and air, water and other permits and approvals from state and local governments to conduct certain of our operations or to build, expand or acquire new facilities, such as our new EAF flat roll steel mill in Sinton, Texas, currently under construction in Sinton, Texas. Governmental agencies, non-governmental organizations, and members of the public sometimes resist the establishment of certain types of facilities in their communities. There can be no assurance that future approvals, licenses and permits will be granted or that we will be able to maintain and renew the approvals, licenses and permits we currently hold. Failure to do so may adversely affect our business, financial condition, results of operations and cash flows.Our senior unsecured credit facility contains, and any future financing agreements may contain, restrictive covenants that may limit our flexibility.Restrictions and covenants in our existing debt agreements, including our senior unsecured credit facility, and any future financing agreements, may impair our ability to finance future operations or capital needs or to engage in other business activities. A breach of any of the restrictions or covenants could cause a default under our senior unsecured credit facility, our senior notes, or our other debt. A significant portion of our indebtedness may then become immediately due and payable.Under our senior unsecured credit facility, we are required to maintain certain financial covenants tied to our leverage and profitability. Our ability to meet such covenants or other restrictions can be affected by events beyond our control. If a default were to occur, the lenders could elect to declare all amounts then outstanding to be immediately due and payable and terminate all commitments to extend further credit.25 Table of ContentsImpairment charges may adversely affect our results of operations.Occasionally, assumptions that we have made regarding products or businesses we have acquired or sought to develop, about the sustainability of markets we sought to exploit, or about industry conditions that underlie our decision making when we elected to capitalize a venture turn out differently than anticipated. In such instances, the fair value of such assets may fall below their carrying value recorded on our balance sheet.Accordingly, we periodically test goodwill, long-lived tangible and intangible assets and right of use assets to determine whether their estimated fair value is in fact less than their value recorded on our balance sheet. If we determine that the fair value of any of these assets, from whatever cause, is less than the value recorded on our balance sheet, we are required to incur non-cash asset impairment charges that adversely affect our results of operations. There can be no assurances that continued market dynamics or other factors may not result in future impairment charges.ITEM 1B. UNRESOLVED STAFF COMMENTSNone.​26 Table of ContentsITEM 2. PROPERTIESThe following table describes our significant properties as of December 31, 2020. These properties are owned by us, and not subject to any significant encumbrances, or are leased by us. We believe these properties are suitable and adequate for our current operations and are appropriately utilized. For additional information regarding our significant facilities please refer to Item 1. Business.​​​​​​​​​​​​​​​Site​Site​​​​​​Acreage ​AcreageOperations​Location​Description​Owned​LeasedSteel Operations Segment *​​​​​​​​Butler Flat Roll Division:​​​​​​​​ Butler Operations ​Butler, IN​Flat Roll Steel Mill and Coating Facility​997​— Jeffersonville Operations ​Jeffersonville, IN​Flat Roll Steel Coating Facility​27​10 Iron Dynamics​Butler, IN​Liquid Ironmaking Facility​25​—Columbus Flat Roll Division ​Columbus, MS​Flat Roll Steel Mill and Coating Facility​1,387​—Southwest-Sinton Flat Roll Division ​Sinton, TX​Flat Roll Steel Mill and Coating Facility **​2,487​—The Techs ​Pittsburgh, PA​Flat Roll Steel Coating Facilities​16​2Heartland Flat Roll Division​Terre Haute, IN​Flat Roll Steel Cold-Rolling and Coating Facility​193​—United Steel Supply​IN, MS, OR, and TX​Distributor of Painted Galvalume® Flat Roll Steel​12​3Structural and Rail Division ​Columbia City, IN​Structural and Rail Steel Mill​692​—Engineered Bar Division ​Pittsboro, IN​Engineered Bar Steel Mill and Finishing Facility​312​—Vulcan Threaded Products ​Pelham, AL​Bar Steel Processing Facility​29​—Roanoke Bar Division ​Roanoke, VA​Merchant Bar Steel Mill​290​—Steel of West Virginia​WV, KY, and TN​Specialty Shapes Steel Mill and Finishing ​139​6​​​​and Coating Facilities​​​​​​​​​​​​​Metals Recycling Operations Segment ​​​​​​​​OmniSource:​​​​​​​​Alabama​Birmingham, AL​Ferrous Scrap Processing​—​5Indiana ​Multiple Cities​Ferrous and Nonferrous Scrap Processing​380​26Michigan ​Multiple Cities​Ferrous and Nonferrous Scrap Processing​186​—Mississippi​Multiple Cities​Ferrous and Nonferrous Scrap Processing​54​13North Carolina ​Multiple Cities​Ferrous and Nonferrous Scrap Processing​346​—Ohio ​Multiple Cities​Ferrous and Nonferrous Scrap Processing​212​21Oklahoma ​Sand Springs, OK​Ferrous Scrap Processing​—​5Tennessee ​Multiple Cities​Ferrous and Nonferrous Scrap Processing​65​—Virginia ​Multiple Cities​Ferrous and Nonferrous Scrap Processing​121​—Mexico​Multiple Cities​Ferrous and Nonferrous Scrap Processing​—​37​​​​​​​​​Steel Fabrication Operations Segment ​​​​​​​​New Millennium Building Systems:​​​​​​​​Joist and Deck Operations ​Butler, IN​Steel Joist and Deck Fabrication Facility​156​—Joist Operations ​Fallon, NV​Steel Joist Fabrication Facility​53​—Joist and Deck Operations ​Hope, AR​Steel Joist and Deck Fabrication Facility​245​4Joist Operations ​Juarez, MX​Steel Joist Fabrication Facility​17​—Joist and Deck Operations ​Lake City, FL​Steel Joist and Deck Fabrication Facility​75​—Deck Operations ​Memphis, TN​Deck Fabrication Facility​19​—Joist and Deck Operations ​Salem, VA​Steel Joist and Deck Fabrication Facility​63​—​​​​​​​​​​The company’s corporate headquarters is in Fort Wayne, Indiana on 20 owned acres. Our copper rod and wire facility, a controlled subsidiary, is in New Haven, Indiana on 35 owned acres.* Our 2020 steel mill production utilization was 86% of our estimated annual steelmaking capability.** Southwest-Sinton Flat Roll Division is under construction, with planned commencement of operations mid-year 2021.​​27 Table of ContentsITEM 3. LEGAL PROCEEDINGSWe are involved in various litigation matters, including administrative proceedings, regulatory proceedings, governmental investigations, environmental matters, and commercial and construction contract disputes, none of which are currently expected to have a material impact on our financial condition, results of operations, or liquidity.We may also be involved from time to time in various governmental investigations, regulatory proceedings or judicial actions seeking penalties, injunctive relief, and/or remediation under federal, state and local environmental laws and regulations. The United States EPA has conducted such investigations and proceedings involving us, in some instances along with state environmental regulators, under various environmental laws, including RCRA, CERCLA, the Clean Water Act and the Clean Air Act. Some of these matters have resulted in fines or penalties, exclusive of interest and costs, which did not exceed $1 million in aggregate, as of December 31, 2020.ITEM 4. MINE SAFETY DISCLOSURESInformation required to be furnished pursuant to Item 4 concerning mine safety disclosure matters by Section 1503(a) of the Dodd-Frank Wall Street Reform and Consumer Protection Act and Item 104 of Regulation S-K (17 CFR 229.104), is included in Exhibit 95 to this annual report.​28 Table of ContentsPART IIITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIESThe information required by Item 5 with respect to securities authorized for issuance under equity compensation plans is set forth in Part III, Item 12 of this Form 10-K. Our common stock trades on The NASDAQ Global Select Stock Market under the symbol STLD.As of February 19, 2021, we had 211,005,100 shares of common stock outstanding and held beneficially by approximately 24,100 stockholders based on our security position listing. Because many of the shares were held by depositories, brokers and other nominees, the number of registered holders (approximately 1,420) is not representative of the number of beneficial holders.Issuer Purchases of Equity SecuritiesDuring the quarter ended December 31, 2020, we did not purchase any of our equity securities that are registered under Section 12(b) of the Exchange Act. At December 31, 2020, we had $444.0 million remaining available to purchase our equity securities under our share repurchase program.​29 Table of ContentsTotal Return Graph​​​30 Table of ContentsITEM 6. SELECTED FINANCIAL DATAThe following table sets forth the selected consolidated financial and operating data of Steel Dynamics, Inc. The selected consolidated operating, other financial and balance sheet data, as of and for each of the years in the five-year period ended December 31, 2020, were derived from our audited consolidated financial statements. You should read the following data in conjunction with Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations and our consolidated financial statements and notes appearing elsewhere in this Form 10-K.You should also read the following information in conjunction with the data in the table on the following page:●Construction of the Southwest-Sinton Flat Roll Division (Sinton) began in 2019, with operations planned to begin mid-year 2021. Capital expenditures for Sinton were $927.7 million in 2020 and $205.1 million in 2019.●On August 3, 2020, we completed the acquisition of Zimmer for a total cash purchase price of $60.0 million. Zimmer operations, including its approximately 1,000 employees, are reflected in our metals recycling operations from the date of acquisition.●On March 1, 2019, we completed the acquisition of 75% of the equity interest of United Steel Supply, LLC, for a total cash purchase price of $97.1 million. USS operations are reflected in our steel operations from the date of acquisition.●On June 29, 2018, we completed the acquisition of Heartland Steel Processing, LLC (formerly known as Companhia Siderurgica Nacional, LLC) (Heartland), for a total cash purchase price of $434.0 million. Heartland operations are reflected in our steel operations from the date of acquisition.●In the fourth quarter of 2017, we recorded a tax benefit related primarily to the impact of the revaluation of the company’s deferred tax assets and liabilities as of December 31, 2017, using the lower federal tax rate enacted in the Tax Cuts and Jobs Act of 2017, which increased net income and net income attributable to Steel Dynamics, Inc. by $180.6 million, and basic and diluted earnings per share by $0.75.●In the fourth quarter of 2016, we recorded a non-cash asset impairment charge associated with the company’s Minnesota ironmaking operations and certain OmniSource assets, which reduced 2016 operating and pretax income by $132.8 million, net income by $89.5 million, net income attributable to Steel Dynamics, Inc. by $76.4 million, and basic and diluted earnings per share by $0.31.​31 Table of Contents​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​Years Ended December 31,​2020​2019​2018​2017​2016​​​​​​​​​​​​​​​​(dollars and shares in thousands, except per share data)Operating data:​​​​​​​​​​​​​​Net sales $ 9,601,482​$ 10,464,991​$ 11,821,839​$ 9,538,797​$ 7,777,109Gross profit ​ 1,434,728​​ 1,530,984​​ 2,322,814​​ 1,582,014​​ 1,334,864Operating income​ 847,142​​ 986,880​​ 1,722,409​​ 1,066,881​​ 727,966Asset impairment charges reflected in operating income​ (19,409)​​ -​​ -​​ -​​ (132,839)Net income​ 570,828​​ 677,900​​ 1,255,805​​ 805,796​​ 360,006Net income attributable to Steel Dynamics, Inc. ​ 550,822​​ 671,103​​ 1,258,379​​ 812,741​​ 382,115​​​​​​​​​​​​​​​Basic earnings per share $ 2.61​$ 3.06​$ 5.38​$ 3.38​$ 1.57Weighted average common shares outstanding ​ 211,140​​ 219,639​​ 233,923​​ 240,132​​ 243,576​​​​​​​​​​​​​​​Diluted earnings per share $ 2.59​$ 3.04​$ 5.35​$ 3.36​$ 1.56Weighted average common shares and share ​​​​​​​​​​​​​​ equivalents outstanding​ 212,345​​ 220,748​​ 235,193​​ 241,781​​ 245,298​​​​​​​​​​​​​​​Dividends declared per share $ 1.00​$ 0.96​$ 0.75​$ 0.62​$ 0.56​​​​​​​​​​​​​​​Capital expenditures $ 1,198,055​$ 451,945​$ 239,390​$ 164,935​$ 198,160​​​​​​​​​​​​​​​Other data (unaudited):​​​​​​​​​​​​​​Shipments:​​​​​​​​​​​​​​Steel operations segment (net tons) ​ 10,718,333​​ 10,816,641​​ 10,609,763​​ 9,726,977​​ 9,245,946​​​​​​​​​​​​​​​Metals recycling operations segment ​​​​​​​​​​​​​​Ferrous metals (gross tons) ​ 4,591,881​​ 4,627,214​​ 5,123,553​​ 4,952,973​​ 5,070,380Nonferrous metals (thousands of pounds) ​ 977,882​​ 1,068,208​​ 1,131,412​​ 1,086,799​​ 1,103,505​​​​​​​​​​​​​​​Steel fabrication operations segment (net tons) ​ 665,679​​ 644,411​​ 641,698​​ 627,274​​ 562,725​​​​​​​​​​​​​​​Steel mill production (net tons) ​ 9,620,207​​ 9,466,955​​ 9,836,979​​ 9,119,207​​ 8,693,800​​​​​​​​​​​​​​​Number of employees ​ 9,625​​ 8,385​​ 8,200​​ 7,635​​ 7,695​​​​​​​​​​​​​​​Balance sheet data:​​​​​​​​​​​​​​Cash and equivalents and short-term investments$ 1,368,618​$ 1,643,634​$ 1,057,003​$ 1,028,649​$ 841,483Property, plant and equipment, net​ 4,105,569​​ 3,135,886​​ 2,945,767​​ 2,675,904​​ 2,787,215Total assets ​ 9,265,562​​ 8,275,765​​ 7,703,563​​ 6,855,732​​ 6,423,732Long-term debt (including current maturities) ​ 3,102,676​​ 2,734,344​​ 2,376,723​​ 2,381,940​​ 2,356,826Equity ​ 4,189,612​​ 3,921,241​​ 3,775,989​​ 3,195,068​​ 2,777,459​​​​​​​​​​​​​​​Shares outstanding​ 210,914​​ 214,503​​ 225,272​​ 237,397​​ 243,785​​32 Table of ContentsITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSForward-Looking StatementsThis report contains some predictive statements about future events, including statements related to conditions in domestic or global economies, conditions in steel and recycled metals market places, Steel Dynamics' revenues, costs of purchased materials, future profitability and earnings, and the operation of new, existing or planned facilities. These statements, which we generally precede or accompany by such typical conditional words as "anticipate", "intend", "believe", "estimate", "plan", "seek", "project", or "expect", or by the words "may", "will", or "should", are intended to be made as "forward-looking", subject to many risks and uncertainties, within the safe harbor protections of the Private Securities Litigation Reform Act of 1995. These statements speak only as of this date and are based upon information and assumptions, which we consider reasonable as of this date, concerning our businesses and the environments in which they operate. Such predictive statements are not guarantees of future performance, and we undertake no duty to update or revise any such statements. Some factors that could cause such forward-looking statements to turn out differently than anticipated include: (1) domestic and global economic factors; (2) global steelmaking overcapacity and steel imports, together with increased scrap prices; (3) pandemics, epidemics, widespread illness or other health issues, such as the COVID-19 pandemic; (4) the cyclical nature of the steel industry and the industries we serve; (5) volatility and major fluctuations in prices and availability of scrap metal, scrap substitutes, and our potential inability to pass higher costs on to our customers; (6) cost and availability of electricity, natural gas, oil, or other resources are subject to volatile market conditions; (7) compliance with and changes in environmental and remediation requirements; (8) increased regulation associated with the environment, climate change, greenhouse gas emissions and sustainability; (9) significant price and other forms of competition from other steel producers, scrap processors and alternative materials; (10) availability of an adequate source of supply for our metals recycling operations; (11) cybersecurity threats and risks to the security of our sensitive data and information technology; (12) the implementation of our growth strategy; (13) litigation and legal compliance, (14) unexpected equipment downtime or shutdowns; (15) governmental agencies may refuse to grant or renew some of our licenses and permits; (16) our senior unsecured credit facility contains, and any future financing agreements may contain, restrictive covenants that may limit our flexibility; and (17) the impacts of impairment.More specifically, we refer you to our more detailed explanation of these and other factors and risks that may cause such predictive statements to turn out differently, as set forth in the sections titled Special Note Regarding Forward-Looking Statements at the beginning of Part I of this Report and Item 1A. Risk Factors, as well as in other subsequent reports we file with the Securities and Exchange Commission. These reports are available publicly on the Securities and Exchange Commission website, www.sec.gov, and on our website, www.steeldynamics.com under “Investors – SEC Filings.”Operating Statement ClassificationsNet Sales. Net sales from our operations are a factor of volumes shipped, product mix and related pricing. We charge premium prices for certain grades of steel, product dimensions, certain smaller volumes, and for value-added processing or coating of our steel products. Except for the steel fabrication operations, we recognize revenues from sales and the allowance for estimated returns and claims from these sales at the point in time control of the product transfers to the customer, upon shipment or delivery. Our steel fabrication operations recognize revenues over time based on completed fabricated tons to date as a percentage of total tons required for each contract.Costs of Goods Sold. Our costs of goods sold represent all direct and indirect costs associated with the manufacture of our products. The principal elements of these costs are scrap and scrap substitutes (which represent the most significant single component of our consolidated costs of goods sold), steel substrate, direct and indirect labor and related benefits, alloys, zinc, transportation and freight, repairs and maintenance, utilities such as electricity and natural gas, and depreciation.Selling, General and Administrative Expenses. Selling, general and administrative expenses consist of all costs associated with our sales, finance and accounting, and administrative departments. These costs include, among other items, labor and related benefits, professional services, insurance premiums, and property taxes. Company-wide profit sharing and amortization of intangible assets are each separately presented in the statement of income.Interest Expense, net of Capitalized Interest. Interest expense consists of interest associated with our senior credit facilities and other debt net of interest costs that are required to be capitalized during the construction period of certain capital investment projects.Other (Income) Expense, net. Other income consists of interest income earned on our temporary cash deposits and short-term investments; any other non-operating income activity, including income from non-consolidated investments accounted for under the equity method. Other expense consists of any non-operating costs, such as certain acquisition and financing expenses.​33 Table of Contents2020 OverviewImpact of COVID-19 on Our BusinessIn March 2020, the World Health Organization categorized COVID-19 as a pandemic, and since that time, efforts to slow the contagion have impacted domestic and global economies. Countries, including the United States, issued “shelter in place” orders, temporarily closing non-essential businesses and restricting social interactions in an effort to slow the spread of COVID-19. States began to reopen during the second quarter 2020, and domestic manufacturing started to improve.Steelmaking and its ancillary support businesses are considered a “critical infrastructure industry” by the U.S. Department of Homeland Security and we have been deemed an essential busines in all of the states in which we operate. As a result, all of our locations continued to operate during all of 2020 and continue to operate. Our teams are our most valued priority, and we have implemented numerous additional process and procedural initiatives to ensure the health and safety of our people, their families, and our communities. We adjusted schedules to support social distancing, provided additional and more frequent sanitizing applications, provided additional protective measures, among many other actions. Results OverviewWhile our consolidated results for 2020 represented our fourth best year based on net income, we were negatively impacted in the second quarter by the continuing effects of COVID-19 due to the related temporary closures of numerous domestic steel consuming businesses. This largely reversed during the third quarter, as most manufacturing activity resumed throughout the remainder of the year. Domestic steel demand rebounded meaningfully during the third and fourth quarters of 2020, driving higher steel shipments, as well as significantly higher scrap flows and profitability for our steel and metals recycling operations. The non-residential construction market remained strong, with construction activity largely intact, resulting in record 2020 shipments and operating income for our steel fabrication operations.Consolidated operating income for 2020 decreased $139.7 million, or 14%, to $847.1 million, compared to $986.9 million in 2019. Net income attributable to Steel Dynamics, Inc. for 2020 decreased $120.3 million, or 18%, to $550.8 million, compared to 2019. Diluted earnings per share attributable to Steel Dynamics, Inc. was $2.59 for 2020, compared to $3.04 for 2019.Refer to Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations in Part II of our Annual Report on Form 10-K for the year ended December 31, 2019, for additional information regarding results of operations for the year ended December 31, 2019, as compared to the year ended December 31, 2018, and segment operating results for 2019 as compared to 2018.34 Table of ContentsSegment Operating Results (dollars in thousands)​​​​​​​​​​​​​​​​​​​ Years Ended December 31,​​2020​% Change​2019​​​​​​​​​​Net sales​​​​​​​​Steel Operations $ 7,455,637​(9)%​$ 8,234,179​Metals Recycling Operations ​ 2,403,140​(4)%​​ 2,494,014​Steel Fabrication Operations ​ 906,364​(6)%​​ 963,259​Other​ 501,187​25% ​​ 400,747​​​ 11,266,328​​​​ 12,092,199​Intra-company​ (1,664,846)​​​​ (1,627,208)​​$ 9,601,482​(8)%​$ 10,464,991​​​​​​​​​​Operating income (loss)​​​​​​​​Steel Operations $ 889,480​(14)%​$ 1,030,554​Metals Recycling Operations​ 32,991​102% ​​ 16,308​Steel Fabrication Operations ​ 120,575​1% ​​ 119,099​Other ​ (188,525)​(1)%​​ (186,159)​​​ 854,521​​​​ 979,802​Intra-company​ (7,379)​​​​ 7,078​​$ 847,142​(14)%​$ 986,880​​Steel Operations Segment​Steel operations consist of our six EAF steel mills, producing steel from ferrous scrap and scrap substitutes, utilizing continuous casting, automated rolling mills with numerous value-added downstream steel coating and processing operations. Our steel operations sell directly to end-users, steel fabricators, and service centers. These products are used in numerous industry sectors, including the construction, automotive, manufacturing, transportation, heavy and agriculture equipment, and pipe and tube (including OCTG) markets (see Item 1. Business). Steel operations accounted for 74% and 76% of our consolidated net sales during 2020 and 2019, respectively.Steel Operations Shipments (tons):​​​​​​​​​​​​​​​ Years Ended December 31, ​​2020​% Change​2019​Total shipments 10,718,333​(1)%​ 10,816,641​Intra-segment shipments (1,001,396)​​​ (975,372)​Steel Operations Segment shipments 9,716,937​(1)%​ 9,841,269​​​​​​​​External shipments 9,257,334​(2)%​ 9,402,608​35 Table of Contents​​Segment Results 2020 vs. 2019COVID-19 negatively impacted our steel operations during 2020, most notably in the second quarter. Domestic steel demand and raw material supply were robust early in the year, but demand from many steel consuming industries and scrap generation significantly reduced during the second quarter 2020, as the automotive sector and its supply chain temporarily closed. As a result, a significant amount of higher-cost domestic steel production was idled. As travel restrictions and stay at home orders were lifted, and the broader manufacturing base restarted mid-year, steel demand quickly recovered, resulting in steel operations segment shipments decreasing only 1% in 2020, as compared to 2019, reflecting the overall strong steel demand environment. As demand improved in the second half of 2020, some domestic steel production remained idled. When coupled with extremely low steel inventory levels throughout the supply chain, flat roll steel index prices increased over $500 per ton from August through the end of the year. However, overall steel segment operations average selling prices decreased 8%, or $69 per ton, in 2020 compared to 2019. Net sales for the steel operations segment decreased 9% in 2020 when compared to 2019, due to the 8% decrease in average steel selling prices and minimal decline in shipments.​Metallic raw materials used in our EAFs represent our single most significant steel manufacturing cost, generally comprising approximately 50 to 60% of our steel mill operations’ manufacturing costs. Our metallic raw material cost per net ton consumed in our steel mills decreased $25, or 9%, in 2020 compared to 2019.​As a result of average selling prices decreasing more than scrap costs, metal spread (which we define as the difference between average steel selling prices and the cost of ferrous scrap consumed in our steel mills) decreased 8% in 2020 compared to 2019. Due to this metal spread contraction, coupled with the slight decrease in shipments, operating income for the steel operations decreased 14%, to $889.5 million, in 2020 compared to 2019.​​​​​​​​​​​36 Table of ContentsMetals Recycling Operations Segment​Metals recycling operations includes both ferrous and nonferrous scrap metal processing, transportation, marketing, brokerage, and scrap management services. In August 2020, we completed the acquisition of Zimmer, whose post-acquisition operations are included in 2020 results. Our steel mills utilize a large portion (approximately 69% in 2020 and 66% in 2019) of the ferrous scrap sold by our metals recycling operations as raw material in our steelmaking operations, and the remainder is sold to other consumers, such as other steel manufacturers and foundries. Metals recycling operations accounted for 11% of our consolidated net sales during 2020 and 2019.Metals Recycling Operations Shipments:​​​​​​​​​​​​​​​​​​Years Ended December 31,​​​2020​% Change​2019​Ferrous metal (gross tons)​​​​​​​Total​ 4,591,881​(1)%​ 4,627,214​Inter-company​ (3,184,451)​4% ​ (3,061,257)​External shipments​ 1,407,430​(10)%​ 1,565,957​​​​​​​​​Nonferrous metals (thousands of pounds)​​​​​​​Total​ 977,882​(8)%​ 1,068,208​Inter-company​ (146,753)​​​ (144,229)​External shipments​ 831,129​(10)%​ 923,979​​Segment Results 2020 vs. 2019As stated previously, our metals recycling operations benefitted from a rebound in manufacturing in steel consuming industries during the second half of 2020. Scrap flows increased as temporary closures of domestic automotive and other steel consuming manufacturers and their related supply chain were lifted. In addition, domestic steel mill utilization rates rose from the trough experienced in the second quarter 2020, resulting in increased ferrous scrap demand and significantly higher selling prices. However, net sales for our metals recycling operations decreased 4% in 2020 as compared to 2019, as total annual shipments decreased, most notably in the second quarter. Ferrous scrap average selling prices increased 10% during 2020 compared to 2019, while nonferrous pricing was flat year over year. Ferrous metal spread (which we define as the difference between average selling prices and the cost of purchased scrap) increased 27%, while nonferrous metal spread decreased 4% in 2020 compared to 2019. Metals recycling operations operating income in 2020 of $33.0 million increased 102% from 2019 operating income of $16.3 million, due to ferrous metal spread expansion and positive operating results from our Zimmer acquisition, which more than offset decreases in ferrous and nonferrous shipments.​Steel Fabrication Operations Segment​Steel fabrication operations include seven New Millennium Building Systems joist and deck plants located throughout the United States and in Northern Mexico. Revenues from these plants are generated from the fabrication of steel joists, trusses, girders and steel deck used within the non-residential construction industry. Steel fabrication operations accounted for 9% of our consolidated net sales during 2020 and 2019.​​37 Table of Contents​Segment Results 2020 vs. 2019Net sales for the steel fabrication operations decreased $56.9 million, or 6%, during 2020 compared to 2019, as shipments increased 3% to a record 666,000 tons, while average selling prices decreased $133 per ton, or 9%. As our steel fabrication operations continue to leverage our national operating footprint, market demand, orders and backlog continued to be strong in 2020, indicating resilience of the non-residential construction market during COVID-19.The purchase of various steel products is the largest single cost of production for our steel fabrication operations, generally representing approximately two-thirds of the total cost of manufacturing. The average cost of steel consumed decreased by 14% in 2020, as compared to 2019, consistent with decreased steel selling prices in our steel operations. Average selling prices decreased 9%, with resulting metal spread (which we define as the difference between average selling prices and the cost of purchased steel) decreasing 2%, as the decrease in selling prices per ton outpaced the decrease in the cost of purchased steel. Operating income increased $1.5 million to a record $120.6 million in 2020 compared to 2019, as increased shipments more than offset decreased metal spread.​Other Operations​Consolidated Results 2020 vs. 2019Selling, General and Administrative Expenses. Selling, general and administrative expenses increased 9%, or $41.0 million, to $477.5 million during 2020 compared to 2019, representing 5.0% and 4.2% of net sales, respectively. This increase relates primarily to non-capitalized expenses incurred during construction of our new Southwest-Sinton Flat Roll Division. Profit sharing expense was $61.7 million in 2020, a decrease of $16.3 million from the $78.0 million earned during 2019. The company-wide profit sharing plan represents 8% of pretax earnings; therefore, our lower 2020 earnings resulted in lower profit sharing.Interest Expense, net of Capitalized Interest. During 2020, interest expense of $94.9 million decreased $32.2 million from the $127.1 million incurred during 2019 due to decreased interest rates from our December 2019, June 2020, and October 2020 refinancing of $1.95 billion of high yield senior notes with lower interest senior notes, and increased capitalized interest in 2020 in conjunction with construction of our new Southwest-Sinton Flat Roll Division.38 Table of ContentsOther (Income) Expense, net. Net other expense of $46.8 million in 2020 included $33.1 million of costs of premiums, write off of unamortized debt issuance costs, and other expenses related to the call and redemption of our 5 1/4% senior notes due 2023, 5.500% senior notes due 2024, and 4.125% senior notes due 2025. Net other income of $15.6 million in 2019 included interest income of $28.0 million associated with our invested cash and short-term investments, compared to only $9.0 million in 2020, due to lower interest rates on decreasing invested cash and short-term investment balances in 2020.Income Tax Expense. During 2020, income tax expense of $134.7 million, representing an effective income tax rate of 19.1%, was down 32% from $197.4 million, representing an effective income tax rate of 22.6%, during 2019, consistent with decreased income before income taxes. The decrease in effective tax rate in 2020 relates primarily to the release of deferred tax asset valuation allowance and increased federal tax credits. Refer to Note 4. Income Taxes to the consolidated financial statements elsewhere in this report for additional information.Included in the balance of unrecognized tax benefits at December 31, 2020, are potential benefits of $9.0 million that, if recognized, would affect the effective tax rate. We recognize interest and penalties related to our tax contingencies on a net-of-tax basis in income tax expense. During the year ended December 31, 2020, we recognized benefits from the decrease of interest expense and penalties of $450,000, net of tax. In addition to the unrecognized tax benefits noted above, we had $828,000 accrued for the payment of interest and penalties at December 31, 2020.We file income tax returns in the United States federal jurisdiction as well as income tax returns in various state jurisdictions. The tax years 2017 through 2019 remain open to examination by the Internal Revenue Service and various state and local jurisdictions. At this time, we do not believe there will be any significant examination adjustments that would result in a material change to our financial position, results of operations or cash flows. It is reasonably possible that the amount of unrecognized tax benefits could change in the next twelve months in an amount ranging from zero to $3.3 million, as a result of the expiration of the statute of limitations and other federal and state income tax audits.Liquidity and Capital ResourcesCapital Resources and Long-term Debt. Our business is capital intensive and requires substantial expenditures for, among other things, the purchase and maintenance of equipment used in our steel, metals recycling, and steel fabrication operations, and to remain in compliance with environmental laws. Our short-term and long-term liquidity needs arise primarily from working capital requirements, capital expenditures, currently including those related to our new Southwest-Sinton Flat Roll Division, principal and interest payments related to our outstanding indebtedness (no significant principal payments until 2024), dividends to our shareholders, potential stock repurchases, and acquisitions. We have met these liquidity requirements primarily with cash provided by operations and long-term borrowings, and we also have availability under our unsecured Revolver. Our liquidity at December 31, 2020, is as follows (in thousands):​​​​​​​​​​​​​​​​​​​​​​​Cash and equivalents​$ 1,368,618​​​​​​Unsecured revolver availability​​ 1,188,096​​​​​​Total liquidity​$ 2,556,714​​​​Our total outstanding debt increased $368.3 million during 2020, due to our October 2020 issuance of the 2027 Notes and 2050 Notes as described below. Our total long-term debt to capitalization ratio (representing our long-term debt, including current maturities, divided by the sum of our long-term debt, redeemable noncontrolling interests, and our total stockholders’ equity) was 41.6% and 40.2% at December 31, 2020, and December 31, 2019, respectively.Our unsecured credit agreement has a senior unsecured revolving credit facility (Facility), which provides a $1.2 billion unsecured Revolver, and matures in December 2024. Subject to certain conditions, we have the opportunity to increase the Facility size by $500.0 million. The unsecured Revolver is available to fund working capital, capital expenditures, and other general corporate purposes. The Facility contains financial covenants and other covenants pertaining to our ability to incur indebtedness and permit liens on property. Our ability to borrow funds within the terms of the unsecured Revolver is dependent upon our continued compliance with the financial and other covenants. At December 31, 2020, we had $1.2 billion of availability on the Revolver, $11.9 million of outstanding letters of credit and other obligations which reduce availability, and there were no borrowings outstanding.The financial covenants under our Facility state that we must maintain an interest coverage ratio of not less than 2.50:1.00. Our interest coverage ratio is calculated by dividing our last-twelve-months (LTM) consolidated Adjusted EBITDA (earnings before interest, taxes, depreciation, amortization, and certain other non-cash transactions as allowed in the Facility) by our LTM gross interest expense, less amortization of financing fees. In addition, a debt to capitalization ratio of not more than 0.60:1.00 must be maintained. At December 31, 2020, our interest coverage ratio and debt to capitalization ratio were 10.71:1.00 and 0.42:1.00, 39 Table of Contentsrespectively. We were, therefore, in compliance with these covenants at December 31, 2020, and we anticipate we will continue to be in compliance during the next twelve months.In October 2020, we issued $350.0 million of 1.650% notes due 2027 and $400.0 million of 3.250% notes due 2050. The net proceeds from these notes were used to fund the November 2020 call and redemption of the $350.0 million outstanding principal amount of our 4.125% senior notes due 2025 at a redemption price of 102.063%, plus accrued and unpaid interest to, but not including, the date of redemption, and for general corporate purposes. We recorded expenses related to premiums and write off of unamortized debt issuance costs of approximately $10.3 million, which are reflected in other expenses in the consolidated statement of income for the year ended December 31, 2020.In June 2020, we issued $400.0 million of 2.400% notes due 2025 and $500.0 million of 3.250% notes due 2031. The net proceeds from these notes were used to fund the June 2020 call and redemption of the $400.0 million outstanding principal amount of our 5 1/4% senior notes due 2023 at a redemption price of 100.875%, and the $500.0 million outstanding principal amount of our 5.500% senior notes due 2024 at a redemption price of 102.750%, plus accrued and unpaid interest to, but not including, the date of redemption. We recorded expenses related to premiums, write off of unamortized debt issuance costs, and other expenses of approximately $22.8 million, which are reflected in other expenses in the consolidated statement of income for the year ended December 31, 2020.Working Capital. We generated cash flow from operations of $987.0 million in 2020. Operational working capital (representing amounts invested in trade receivables and inventories, less current liabilities other than income taxes payable and debt) increased $50.6 million (3%) to $1.7 billion at December 31, 2020, consistent with increased sales during the fourth quarter of 2020, as compared to the fourth quarter of 2019.Capital Investments. During 2020, we invested $1.2 billion in property, plant and equipment, primarily within our steel operations segment, compared with $451.9 million invested during 2019. The increase in 2020 versus 2019 primarily relates to our new Southwest-Sinton Flat Roll Division, which represented $927.7 million in 2020. We enter 2021 with sufficient liquidity of $2.6 billion to provide for our planned 2021 capital requirements, including those necessary to finish construction of our new steel mill in Sinton, Texas.Cash Dividends. As a reflection of continued confidence in our current and future cash flow generation ability and financial position, we increased our quarterly cash dividend by 4% to $0.25 per share in the first quarter 2020 (from $0.24 per share in 2019), resulting in declared cash dividends of $210.5 million during 2020, compared to $209.5 million during 2019. We paid cash dividends of $209.2 million and $200.3 million during 2020 and 2019, respectively. Our board of directors, along with executive management, approves the payment of dividends on a quarterly basis. The determination to pay cash dividends in the future is at the discretion of our board of directors, after taking into account various factors, including our financial condition, results of operations, outstanding indebtedness, current and anticipated cash needs and growth plans.Other. In February 2020 our board of directors authorized a share repurchase program of up to $500 million of our common stock, subsequent to the completion of a 2018 board authorized share repurchase program of up to $750 million of our common stock during the first quarter of 2020. Under the share repurchase programs, purchases take place as and when we determine in open market or private transactions made based upon the market price of our common stock, the nature of other investment opportunities or growth projects, our cash flows from operations, and general economic conditions. The 2020 share repurchase program does not require us to acquire any specific number of shares, and may be modified, suspended, extended or terminated by us at any time. The 2020 share repurchase program does not have an expiration date. We repurchased 4.4 million shares of our common stock for $106.5 million during 2020, all within the first quarter, fully expending the remaining purchases available under the 2018 program, leaving $444.0 million remaining available to purchase under the 2020 program. See Part II, Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities for additional information.Our ability to meet our debt service obligations and reduce our total debt will depend upon our future performance which, in turn, will depend upon general economic, financial, business and ongoing COVID-19 conditions, along with competition, legislation and regulatory factors that are largely beyond our control. In addition, we cannot assure that our operating results, cash flows, access to credit markets and capital resources will be sufficient for repayment of our indebtedness in the future. We believe that based upon current levels of operations and anticipated growth, cash flows from operations, together with other available sources of funds, including borrowings under our Revolver, if necessary, will be adequate for the next twelve months for making required payments of principal and interest on our indebtedness, funding working capital requirements, and anticipated capital expenditures noted above.​40 Table of ContentsContractual Obligations and Other Long-Term LiabilitiesWe have the following minimum commitments under contractual obligations, including purchase obligations, as defined by the Securities and Exchange Commission. A “purchase obligation” is defined as an agreement to purchase goods or services that is enforceable and legally binding and that specifies all significant terms, including fixed or minimum quantities to be purchased; fixed, minimum or variable price provisions; and the approximate timing of the transaction. Other long-term liabilities are defined as long-term liabilities that are reflected on our balance sheet under generally accepted accounting principles. Based on this definition, the following table includes only those contracts which include fixed or minimum obligations. It does not include normal purchases, which are made in the ordinary course of business. The following table provides aggregated information about outstanding contractual obligations and other long-term liabilities as of December 31, 2020 (in thousands):​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​Payments Due By Period​Total​2021​2022 & 2023​2024 & 2025​2026 & AfterLong-term debt (1) $ 3,158,658​$ 86,894​$ 8,154​$ 806,926​$ 2,256,684Estimated interest payments on debt (2) ​ 1,004,214​​ 101,694​​ 199,984​​ 179,611​​ 522,925Purchase obligations (3) ​ 624,809​​ 265,736​​ 168,035​​ 51,739​​ 139,299Construction commitments (4) ​ 561,064​​ 561,064​​ -​​ -​​ -Lease commitments ​ 106,421​​ 20,734​​ 31,222​​ 20,306​​ 34,159Other commitments (5) ​ 1,390​​ 225​​ 400​​ 325​​ 440Total (6) $ 5,456,556​$ 1,036,347​$ 407,795​$ 1,058,907​$ 2,953,507(1)The long-term debt payment information presented above assumes that our senior notes remain outstanding until maturity. Refer to Note 3. Long-term Debt to the consolidated financial statements elsewhere in this report for additional information regarding these transactions, and our long-term debt.(2)The estimated interest payments shown above assume interest rates of 2.800% on our $400.0 million senior unsecured notes due December 2024; 2.400% on our $400.0 million senior unsecured notes due June 2025; 5.00% on our $400.0 million senior unsecured notes due December 2026; 1.650% on our $350.0 million senior unsecured notes due October 2027; 3.450% on our $600.0 million senior unsecured notes due April 2030; 3.250% on our $500.0 million senior unsecured notes due January 2031; 3.250% on our $400.0 million senior unsecured notes due October 2050; 0.200% commitment fee on our available Revolver; and an average of 2.5% on our other debt of $108.7 million.(3)Purchase obligations include commitments we have for the purchase of such commodities as electricity, water, natural gas and its transportation services, fuel, air products, zinc, and electrodes. These arrangements have “take or pay” or other similar commitment provisions. We have utilized such “take or pay” requirements during the past three years under these contracts, except for certain air products at our idle Minnesota ironmaking operations. Refer to Note 9. Commitments and Contingencies to the consolidated financial statements elsewhere in this report for additional information.(4)Construction commitments relate to firm contracts we have with various vendors for the completion of certain construction projects at our various divisions at December 31, 2020. Construction commitments related to our new Southwest-Sinton Flat Roll Division mill comprise $515.2 million of this total. Refer to Note 9. Commitments and Contingencies to the consolidated financial statements elsewhere in this report for additional information.(5)Other commitments principally relate to deferred compensation plan obligations.(6)We expect to make cash outlays in the future related to our unrecognized tax benefits; however, due to the uncertainty of the timing, we are unable to make reasonably reliable estimates regarding the period of cash settlement with the respective taxing authorities. Accordingly, unrecognized tax benefits and related interest and penalties of $13.7 million as of December 31, 2020, have been excluded from the contractual obligations table above. Refer to Note 4. Income Taxes to the consolidated financial statements elsewhere in this report for additional information.​​41 Table of ContentsOther MattersInflationWe believe that inflation has not had a material effect on our results of operations.Environmental and Other ContingenciesWe have incurred, and in the future will continue to incur, capital expenditures and operating expenses for matters relating to environmental control, remediation, monitoring and compliance. During 2020, we incurred costs related to the monitoring and compliance of environmental matters in the amount of approximately $34.0 million and capital expenditures related to environmental compliance of approximately $87.3 million, of which approximately $83.7 million is related to the construction of our new Southwest-Sinton Flat Roll Division. Of the costs incurred during 2020 for monitoring and compliance, approximately 70% were related to the normal transportation of certain types of waste produced in our steelmaking processes and other facilities, in accordance with legal requirements. We incurred combined environmental remediation costs of approximately $2.4 million at all of our facilities during 2020. We have an accrual of $6.0 million recorded for environmental remediation related to our metals recycling operations, and $2.6 million related to our idled Minnesota ironmaking operations. We believe, apart from our dependence on environmental construction and operating permits for our existing and any future manufacturing facilities, that compliance with current environmental laws and regulations is not likely to have a materially adverse effect on our financial condition, results of operations or liquidity. However, environmental laws and regulations evolve and change, and we may become subject to more stringent environmental laws and regulations in the future, such as the impact of United States government or various governmental agencies introducing regulatory changes in response to the potential of climate change.Critical Accounting Policies and EstimatesManagement’s Discussion and Analysis of Our Financial Condition and Results of Operations is based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. We review the accounting policies we use in reporting our financial results on a regular basis. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses and related disclosure of contingent liabilities. We evaluate the appropriateness of these estimations and judgments on an ongoing basis. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Results may differ from these estimates due to actual outcomes being different from those on which we based our assumptions. We believe the following critical accounting policies affect our more significant judgments and estimates used in the preparation of our consolidated financial statements.Revenue Recognition and Credit Losses. Except for our steel fabrication operations, we recognize revenues at the point in time the performance obligation is satisfied, and control of the product is transferred to the customer upon shipment or delivery, at the amount of consideration the company expects to receive, including any variable consideration. The variable consideration included in the company’s steel operations segment contracts, which is not constrained, include estimated product returns and customer claims based on historical experience, and may include volume rebates which are recorded on an expected value basis. Our steel fabrication operations segment recognizes revenue over time at the amount of consideration the company expects to receive. Revenue is measured on an output method representing completed fabricated tons to date as a percentage of total tons required for each contract. The company does not exercise significant judgements in determining the timing of satisfaction of performance obligations or the transaction price. Provision is made for estimated product returns and customer claims based on historical experience. If the historical data used in our estimates does not reflect future returns and claims trends, additional provision may be necessary. The allowance for credit losses for accounts receivable is based on our reasonable estimate of known credit risks and historical experience, adjusted for current and anticipated economic and other pertinent factors affecting our customers, that may differ from historical experience.We are exposed to credit risk in the event of nonpayment by our customers, which in steel operations are principally intermediate steel processors and service centers that sell our products to numerous industry sectors, including the construction, automotive, manufacturing, transportation, heavy and agriculture equipment, and pipe and tube (including OCTG) markets. Our metals recycling operations sell ferrous scrap to steel mills and foundries, and nonferrous scrap, such as copper, brass, aluminum and stainless steel to, among others, ingot manufacturers, copper refineries and mills, smelters, and specialty mills. Our steel fabrication operations sell fabricated steel joists and deck primarily to the non-residential construction market. We mitigate our exposure to credit risk, which we generally extend initially on an unsecured basis, by performing ongoing credit evaluations and taking further action when necessary, such as requiring letters of credit or other security interests to support the customer receivable. If the financial condition of our customers were to deteriorate for any reason, including the impact of COVID-19 on operations, resulting in the impairment of their ability to make payments, additional allowance may be required.42 Table of ContentsInventories. We record inventories at lower of cost or net realizable value. Cost is determined using a weighted average cost method for raw materials and supplies, and on a first-in, first-out, basis for other inventory. We record amounts required, if any, to reduce the carrying value of inventory to its net realizable value as a charge to cost of goods sold. If product selling prices were to decline in future periods, further write-down of inventory could result, specifically raw material inventory such as scrap purchased during periods of peak market pricing.Impairments of Long-Lived Tangible and Definite-Lived Intangible Assets. We review long-lived assets for impairment whenever events or changes in circumstances indicate the carrying amount of such assets may not be fully recoverable. Impairment losses are recorded on long-lived assets used in operations when indicators of impairment are present and the undiscounted cash flows estimated to be generated by those assets are less than the assets’ carrying amounts. The impairment loss is measured by comparing the fair value of the asset to its carrying amount. We consider various factors and determine whether an impairment test is necessary, including by way of examples, a significant and prolonged deterioration in operating results and/or projected cash flows, significant changes in the extent or manner in which an asset is used, technological advances with respect to assets which would potentially render them obsolete, our strategy and capital planning, and the economic climate in markets to be served. When determining future cash flows and if necessary, fair value, we must make judgments as to the expected utilization of assets and estimated future cash flows related to those assets. We consider historical and anticipated future results, general economic and market conditions, the impact of planned business and operational strategies and all other available information at the time the estimates are made. Those estimates and judgments may or may not ultimately prove accurate.A long-lived asset is classified as held for sale upon meeting specified criteria related to ability and intent to sell. An asset classified as held for sale is measured at the lower of its carrying amount or fair value less cost to sell. As of December 31, 2020, and 2019, the company reported $7.2 million and $8.0 million, respectively, of assets held for sale within other current assets in our consolidated balance sheet. An impairment loss is recognized for any initial or subsequent write-down of the asset held for sale to its fair value less cost to sell. For assets determined to be classified as held for sale in the year ended December 31, 2020 and 2019, the asset carrying amounts approximated their fair value less cost to sell. The company determined fair value using Level 3 fair value inputs as provided for under ASC 820, consisting of information provided by brokers and other external sources along with management’s own assumptions.Events occurred during the fourth quarter of 2020, that represented impairment indicators related to the company’s noncore oil and gas joint ventures. Therefore, the company undertook a fourth quarter 2020 assessment of the recoverability of the carrying amounts of these joint ventures’ property, plant and equipment. Based on the joint ventures’ outlook at the time of this 2020 assessment, the company concluded that the carrying amounts of its property, plant and equipment were fully impaired. This assessment resulted in a total non-cash asset impairment charge of $19.4 million, which include amounts attributable to noncontrolling interests of $2.4, that in total served to reduce net income attributable to Steel Dynamics, Inc. by $12.0 million for the year ended December 31, 2020. Goodwill.Our goodwill, relating to various business combinations, consisted of the following at December 31 (in thousands):​​​​​​​​​​​​​ 2020​ 2019​​​​​​​​​​​Steel Operations Segment​$ 272,133​$ 272,133​​Metals Recycling Operations Segment​​ 183,168​​ 178,857​​Steel Fabrication Operations Segment ​​ 1,925​​ 1,925​​​​$ 457,226​$ 452,915​​At least once annually (as of October 1), or when indicators of impairment exist, the company performs an impairment test for goodwill. Goodwill is allocated to various reporting units, which are generally one level below the company’s operating segments. The fair value of the reporting unit is determined by using an estimate of future cash flows utilizing a risk-adjusted discount rate to calculate the net present value of future cash flows (income approach), and by using a market approach based upon an analysis of valuation metrics of comparable peer companies, using Level 3 fair value inputs as provided for under ASC 820. If the fair value exceeds the carrying value of the reporting unit, there is no impairment. If the carrying amount exceeds the fair value, we recognize an impairment loss in the amount by which the carrying value of the net assets assigned to the reporting unit exceeds the fair value of the reporting unit, with the impairment loss not to exceed the amount of goodwill allocated to the reporting unit.​43 Table of ContentsKey assumptions used to determine the estimated fair value of each reporting unit under the discounted cash flows method (income approach) include: (a) expected cash flows for the five-year period following the testing date (including market share, sales volumes and prices, costs to produce and estimated capital needs); (b) an estimated terminal value using a terminal year growth rate determined based on the growth prospects of the reporting unit; and (c) a risk-adjusted discount rate based on management’s best estimate of market participants’ after-tax weighted average cost of capital and market risk premiums. Key assumptions used to determine the estimated fair value of each reporting unit under the market approach include the expected revenues and cash flows in the next year. We consider historical and anticipated future results, general economic and market conditions, the impact of planned business and operational strategies and all available information at the time the fair values of its reporting units are estimated. Those estimates and judgments may or may not ultimately prove accurate.Goodwill acquired in past transactions are naturally more susceptible to impairment, primarily due to the fact that they are recorded at fair value based on operating plans and economic conditions at the time of acquisition. Consequently, if operating results and/or economic conditions deteriorate after an acquisition, it could result in the impairment of the acquired assets. A deterioration of economic conditions may not only negatively impact the estimated operating cash flows used in our cash flow models but may also negatively impact other assumptions used in our analyses, including, but not limited to, the estimated cost of capital and/or discount rates. Additionally, we are required to ensure that assumptions used to determine fair value in our analyses are consistent with the assumptions a hypothetical marketplace participant would use. As a result, the cost of capital and/or discount rates used in our analyses may increase or decrease based on market conditions and trends, regardless of whether our actual cost of capital has changed. Therefore, we may recognize an impairment in spite of realizing actual cash flows that are approximately equal to or greater than our previously forecasted amounts.Our fourth quarter 2020, 2019, and 2018 annual goodwill impairment analyses did not result in any impairment charges. Management does not believe that it is reasonably likely that our reporting units will fail the goodwill impairment test in the near term, as the determined fair value of the reporting units with goodwill exceeded their carrying value by more than an insignificant amount. We will continue to monitor operating results within all reporting units throughout the upcoming year to determine if events and circumstances warrant interim impairment testing. Otherwise, all reporting units will again be subject to the required annual impairment test during the fourth quarter of 2021. Changes in judgments and estimates underlying our analysis of goodwill for possible impairment, including expected future operating cash flows and discount rate, could decrease the estimated fair value of our reporting units in the future and could result in an impairment of goodwill.Income Taxes. We are required to estimate our income taxes as a part of the process of preparing our consolidated financial statements. This requires us to estimate our actual current tax exposure together with assessing temporary differences resulting from differing treatments of items for tax and accounting purposes. These differences result in deferred tax assets and liabilities, which are included within our consolidated balance sheet. We must then assess the likelihood that our deferred tax assets will be recovered from future taxable income and, to the extent we believe that recovery is not likely, we must establish a valuation allowance. We also establish reserves to reduce some or all of the tax benefit of any of our tax positions at the time we determine that the positions become uncertain. We adjust these reserves, including any impact on the related interest and penalties, in light of changing facts and circumstances, such as the progress of a tax audit. A number of years may elapse before a particular matter for which we have established a reserve is audited by a taxing authority and finally resolved. The number of years with open tax audits varies depending on the tax jurisdiction. The tax benefit that has been previously reserved because of a failure to meet the "more likely than not" recognition threshold would be recognized in our income tax expense in the first interim period when the uncertainty disappears. Settlement of any particular issue would usually require the use of cash.ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKMarket RiskIn the normal course of business, we are exposed to interest rate changes. Our objectives in managing fluctuations in interest rates are to limit the impact of these rate changes on earnings and cash flows and to lower overall borrowing costs. To achieve these objectives, we may use interest rate swaps to manage net exposure to interest rate changes related to our portfolio of borrowings; however, we have not done so during 2020, 2019, or 2018.​44 Table of ContentsThe following table represents the principal cash repayments and related weighted-average interest rates by maturity date for our long-term debt, as of December 31, 2020 (in thousands):​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​Interest Rate Risk​​​​Fixed Rate​Variable Rate​​​​​​Average​​​Average​​​​Principal​Rate​Principal​Rate​​Expected maturity date:​​​​​​​​​​​​​​2021​$ 4,570​​5.5%​$ 82,324​​1.7%​​2022​​ 3,981​​5.1​​ 374​​5.1​​2023​​ 3,799​​4.9​​ -​​​​​2024​​ 403,438​​2.8​​ -​​​​​2025​​ 403,488​​2.4​​ -​​​​​Thereafter ​​ 2,256,684​​3.4​​ -​​​​​Total debt outstanding ​$ 3,075,960​​3.2%​$ 82,698​​1.7%​​Fair value ​$ 3,329,914​​​​$ 82,698​​​​​Commodity RiskIn the normal course of business, we are exposed to the market risk and price fluctuations related to the sale of our products and to the purchase of raw materials used in our operations, such as metallic raw materials, electricity, natural gas and its transportation services, fuel, air products, zinc, and electrodes. Our risk strategy associated with product sales has generally been to obtain competitive prices for our products and to allow operating results to reflect market price movements dictated by supply and demand.Our risk strategy associated with the purchase of raw materials utilized within our operations has generally been to make some commitments with suppliers relating to future expected requirements for some commodities such as electricity, water, natural gas and its transportation services, fuel, air products, zinc, and electrodes. Certain of these commitments contain provisions which require us to “take or pay” for specified quantities without regard to actual usage for periods of generally up to 5 years for physical commodity requirements and commodity transportation requirements, with some extending beyond, and for up to 12 years for air products. Our commitments for these arrangements with “take or pay” or other similar commitment provisions for the years ending December 31 are as follows (in thousands):​​​​​​​​2021​$ 265,736​​2022​​ 124,961​​2023​​ 43,074​​2024​​ 35,248​​2025​​ 16,491​​Thereafter​​ 139,299​​​​$ 624,809​​We utilized such “take or pay” requirements during the past three years under these contracts, except for certain air products at our idle Minnesota ironmaking operations. We believe that production requirements will be such that consumption of the products or services purchased under these commitments will occur in the normal production process, other than certain air products related to our idled Minnesota ironmaking operations.In our metals recycling and steel operations, we have certain fixed price contracts with various customers and suppliers for future delivery of nonferrous and ferrous metals. Our risk strategy has been to enter into base metal financial contracts with the goal to protect the profit margin, within certain parameters, that was contemplated when we entered into the transaction with the customer or vendor. At December 31, 2020, we had a cumulative unrealized loss associated with these financial contracts of $645,000, substantially all of which have settlement dates in 2021. We believe the customer contracts associated with the financial contracts will be fully consummated.​​45 Table of Contents
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+Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSYou should read the following discussion and analysis in conjunction with the information set forth under “Selected Financial Data” and our consolidated financial statements and the notes thereto included elsewhere in this Annual Report on Form 10-K. The statements in this discussion regarding our expectations of our future performance, liquidity, and capital resources; our plans, estimates, beliefs, and expectations that involve risks and uncertainties; and other non-historical statements in this discussion are forward-looking statements. These forward-looking statements are subject to numerous risks and uncertainties, including, but not limited to, the risks and uncertainties described under “Risk Factors” and elsewhere in this Annual Report on Form 10-K. Our actual results may differ materially from those contained in or implied by any forward-looking statements.OverviewWe started Square in February 2009 to enable businesses (sellers) to accept card payments, an important capability that was previously inaccessible to many businesses. However, sellers need many innovative solutions to thrive, and we have expanded to provide them additional products and services and to give them access to a cohesive ecosystem of tools to help them manage and grow their businesses. Similarly, with Cash App, we have built a parallel ecosystem of financial services to help individuals manage their money.Our Seller ecosystem is a cohesive commerce ecosystem that helps sellers start, run and grow their businesses, and consists of over 30 distinct software, hardware, and financial services products. We monetize these products through a combination of transaction, subscription, and service fees. Our suite of cloud-based software solutions are integrated to create a seamless experience and enable a holistic view of sales, customers, employees, and locations. With our offering, a seller can accept payments in person via swipe, dip, or tap of a card or online via Square Invoices, Square Virtual Terminal, or the seller’s website. We also provide hardware to facilitate commerce for sellers, which includes magstripe readers, contactless and chip readers, Square Stand, Square Register, Square Terminal, and third-party peripherals. Square Card is a business prepaid card that enables sellers to spend the balance they have stored with Square. Sellers can also deposit funds into their Square stored balance so they can manage all of their business expenses in one place. Sellers also gain access to business loans through Square Capital based on the seller's payment processing history. We recognize revenue upon the sale of the loans to third-party investors or over time as the sellers pay down the outstanding amounts for the loans that we hold as available for sale. We have grown rapidly to serve millions of sellers that represent a diverse set of industries (including services, food-related business, and retail businesses) and sizes, ranging from a single vendor at a farmers’ market to multi-location businesses. Square sellers also span geographies, including the United States, Canada, Japan, Australia, and the United Kingdom.Our Cash App ecosystem provides financial tools for individuals to store, send, receive, spend and invest money. With Cash App, customers can fund their account with a bank account or debit card, send and receive P2P (peer-to-peer) payments, and receive direct deposit payments. Customers can make purchases with their Cash Card, a Visa prepaid card that is linked to the balance stored in Cash App. With Cash Boost, customers receive instant discounts when they make Cash Card purchases at designated merchants. Customers can also use their stored funds to buy and sell bitcoin and equity investments within Cash App. In the fourth quarter of 2020, we acquired Credit Karma Tax, which adds a tax filing product for individuals to Cash App's ecosystem which provides a seamless, mobile-first solution for individuals to file their taxes for free.Effective June 30, 2020, we changed from one reportable segment to two reportable segments to reflect the way management and our chief operating decision maker (“CODM”) review and assess performance of the business. Our two reportable segments are Seller and Cash App. Seller includes managed payment services, software solutions, hardware and financial services products offered to sellers, while Cash App includes financial tools available to individuals such as P2P (peer-to-peer) payments, Cash Card transactions, bitcoin and stock investing.In April 2020, we were licensed to participate in the Paycheck Protection Program (“PPP”) administered by the Small Business Administration (“SBA”) that was enacted in March 2020 under the Coronavirus Aid, Relief, and Economic Security Act ("CARES Act") in response to the COVID-19 pandemic. The PPP is intended to provide relief to eligible businesses impacted by COVID-19, and to incentivize businesses to keep their workers on the payroll. For the year ended 56December 31, 2020, we facilitated the issuance of $857 million of PPP loans, excluding cancelled loans, through an external bank partner, of which we sold $399.0 million to an investor. These loans are guaranteed by the U.S. government. Additionally, the loans are eligible for forgiveness if the borrowers meet certain criteria. As of December 31, 2020, approximately $46.4 million in PPP loans held for sale on our consolidated balance sheet have been forgiven by the SBA. In February 2021, we began participating in the second round of the PPP program by accepting applications from certain existing Square customers who received a loan in the spring of 2020. Similar to the loans issued in the first round of PPP, the loans are guaranteed by the U.S. government and will be eligible for forgiveness if the borrowers meet certain criteria.On June 2, 2020, we entered into the Paycheck Protection Program Liquidity Facility agreement with the Federal Reserve Bank of San Francisco (“First PPPLF Agreement”) to secure additional credit in an aggregate principal amount of up to $500.0 million. The program was established by the Federal Reserve to supplement the SBA's PPP to support the economy in response to the COVID-19 crisis. The facility is intended to bolster the effectiveness of the PPP and provide liquidity to credit markets, helping to stabilize financial institutions supporting COVID-19 relief efforts. Borrowings under the facility accrue interest at a rate of 0.35% and advances must be collateralized with loans originated under the PPP. The maturity date of any PPPLF advance will be the maturity date of the PPP loan pledged to secure the advance, and will be accelerated upon the occurrence of certain events of default. The advances under this facility are also repayable if the associated PPP loans are forgiven, repaid by the customer, or settled by the government guarantee. As of December 31, 2020, $464.1 million of PPPLF advances were outstanding and collateralized by the same value of the PPP loans held for sale on our consolidated balance sheet. On January 29, 2021, we entered into a second PPPLF agreement with the Federal Reserve Bank of San Francisco (“Second PPPLF Agreement” and together with the First PPPLF Agreement, “PPPLF Agreements”) to secure additional credit, collateralized by loans from the second round of the PPP program, in an aggregate principal amount of up to $1.0 billion under both PPPLF Agreements. On March 5, 2020, we issued $1.0 billion in aggregate principal amount of convertible senior notes that mature on March 1, 2025 (2025 Notes), unless earlier converted or repurchased pursuant to their terms, and bear interest at a rate of 0.1250% payable semi-annually on March 1 and September 1 of each year. On November 13, 2020, we issued an aggregate principal amount of $1.150 billion of convertible senior notes comprised of $575 million of convertible senior notes that mature on May 1, 2026 (2026 Notes) with a 0.0% coupon interest rate, and $575 million of convertible senior notes that mature on November 1, 2027 (2027 Notes) with a 0.25% coupon interest rate. The 2026 Notes and 2027 Notes will mature on each of its respective dates, unless earlier converted or repurchased. The 2027 Notes will bear interest at a rate of 0.25% payable semi-annually on May 1 and November 1 of each year beginning on May 1, 2021. We intend to use the net proceeds from our 2025, 2026 and 2027 Notes offerings for general corporate purposes, which may include capital expenditures, investments, working capital, and potential acquisitions and strategic transactions.Impact of COVID-19 on Current Trends and OutlookBy March 2020, the World Health Organization declared the COVID-19 pandemic a global pandemic following which, many local governments issued various mandates and public health guidelines requiring the closure of non-essential businesses and the curtailing of all unnecessary travel. These orders also required individuals to comply with various shelter-in-place and social distancing orders. As a result, the vast majority of our customers in those affected areas experienced a significant decline in sales in the first half of 2020. In the second half of 2020, as some shelter-in-place orders were relaxed, we saw modest improvements in certain areas including positive growth from higher priced card-not-present transactions as sellers adapted their businesses to contactless commerce, new sellers that joined Square, and the positive impact of various government assistance programs that led to an increase in consumer spending. However, Seller GPV trends have continued to vary by region and depended on regional shelter-in-place restrictions and COVID-19 guidelines. We also experienced an increase in Cash App engagement as a result of customer adoption of multiple products and the deposit of government stimulus funds and unemployment benefits into Cash App customer accounts.In response to the COVID-19 pandemic, we took measures to assist our customers that we believed were in the best interests of our sellers in the long term, including refunding software subscription fees during the months of March and April 2020 as well as introducing options for sellers to temporarily pause and resume their subscriptions. While we continue to actively monitor the worldwide spread of COVID-19, the extent to which COVID-19 will ultimately impact our business remains difficult to predict. Growth trends continued to vary by region, product, and vertical, depending primarily on differences in the timing and phases of reopenings, which we expect will have a significant impact on overall GPV trends. Our priority remains the safety of our employees, customers and the communities in which we live and operate. We continue to remain in close and regular contact with our employees, customers, business partners and communities to help navigate these challenging times. 57Areas in which we continuously evaluate the potential impact of the COVID-19 pandemic on our financial statements, include, and are not limited to, accrued transaction losses and fair value of loans, and to a lesser extent, the impairment of goodwill and intangible assets, impairment of long-lived assets including operating lease right-of-use assets, and property and equipment. We have concluded that our goodwill and other long lived assets are not impaired as of December 31, 2020. We continue to revise our estimates and assumptions to reflect any changes in transaction and loan losses in our financial statements. Where applicable, we have incorporated judgments and estimates of the expected impact of COVID-19 in the preparation of the financial statements based on information currently available. These judgments and estimates are subject to change, as new developments occur and additional information is obtained and are recognized in the consolidated financial statements as they become known.Components of Results of Operations Revenue Transaction-based revenue. We charge our sellers a transaction fee that is generally calculated based on a percentage of the total transaction amount processed. We also selectively offer custom pricing for certain larger sellers. Transaction-based revenue also includes amounts we charge our Cash App customers for peer-to-peer transactions to business accounts and payments sent from a credit card.Subscription and services-based revenue. Revenue from Cash App, Square Capital, and Instant Transfers for sellers currently comprise the majority of our subscription and services-based revenue. Cash App subscription and services-based revenue is primarily comprised of transaction fees from both Cash App Instant Deposit and Cash Card. Our other subscription and services-based products include website hosting and domain name registration services, Gift Cards, Square Appointments, Customer Engagement, Employee Management, Payroll, Square Card, and other product offerings. Prior to 2020, subscriptions and services-based revenue also included revenue generated from Caviar, a food ordering and delivery platform that we sold in the fourth quarter of 2019. Instant Deposit is a functionality within the Cash App and our managed payment solutions that enables customers to instantly deposit funds into their bank accounts, while Cash Card offers Cash App customers the ability use their stored funds via a Visa prepaid card that is linked to the balance the customer stores in Cash App. We charge a per transaction fee which we recognize as revenue when customers instantly deposit funds to their bank account, use their Cash Card to make a purchase, or withdraw funds. Square Capital facilitates loans to sellers that are offered through a partnership bank and are generally repaid through withholding a percentage of the collections of the seller's receivables processed by us. We also facilitate loans to the customers of certain sellers as well as to the sellers of its partners who do not process payments with us. The loans are generally originated by a bank partner, from whom we purchase the loans obtaining all rights, title, and interest. Our intention is to sell the rights, title, and interest in certain loans to third-party investors for an upfront fee when the loans are sold. We are retained by the third-party investors to service the loans and earn a servicing fee for facilitating the repayment of these receivables through our payments solutions. In April 2020, Square Capital was licensed to participate in the Paycheck Protection Program (“PPP”) administered by the Small Business Administration. These loans are guaranteed by the U.S. government and are eligible for forgiveness if the borrowers meet certain criteria. Hardware revenue. Hardware revenue includes revenue from sales of contactless and chip readers, Square Stand, Square Register, Square Terminal, and third-party peripherals. Third-party peripherals include cash drawers, receipt printers, and barcode scanners, all of which can be integrated with Square Stand, Square Register, or Square Terminal to provide a comprehensive point-of-sale solution. Bitcoin revenue. Our Cash App customers have the ability to purchase bitcoin, a cryptocurrency. We recognize revenue when customers purchase bitcoin and it is transferred to the customer's account. We purchase bitcoin from private broker dealers or from Cash App customers and apply a small margin before selling it to our customers. The sale amounts received from our customers are recorded as revenue on a gross basis and the associated bitcoin cost as cost of revenues, as we are the principal in the bitcoin sale transaction. We have determined we are the principal because we control the bitcoin before delivery to the customer, we are primarily responsible for the delivery of the bitcoin to the customer, we are exposed 58to risks arising from fluctuations of the market price of bitcoin before delivery to the customer, and we have discretion in setting prices charged to the customer. Bitcoin revenue may fluctuate as a result of changes in customer demand or the market price of bitcoin. Cost of Revenue and Gross MarginTransaction-based costs. Transaction-based costs consist primarily of interchange and assessment fees, processing fees, and bank settlement fees paid to third-party payment processors and financial institutions.Subscription and services-based costs. Subscription and services-based costs consist primarily of costs related to Cash App including Instant Deposit and Cash Card as well as Instant Transfer for sellers. Caviar costs were also a significant component of the subscription and services-based costs, prior to the sale of Caviar on October 31, 2019. Hardware costs. Hardware costs consist primarily of product costs associated with contactless and chip readers, Square Terminal, Square Stand, Square Register, and third-party peripherals. Product costs include manufacturing-related overhead and personnel costs, certain royalties, packaging, and fulfillment costs. Hardware is sold primarily as a means to grow our transaction-based revenue and, as a result, generating positive gross margins from hardware sales is not the primary goal of the hardware business.Bitcoin costs. Bitcoin cost of revenue is comprised of the amounts we pay to purchase bitcoin, which will fluctuate in line with the price of bitcoin in the market. We purchase bitcoin to facilitate customers’ access to bitcoin.Amortization of acquired technology. These costs consist of amortization related to technologies acquired through acquisitions. These amounts were not material to our financial statements.Operating ExpensesOperating expenses consist of product development, sales and marketing, general and administrative expenses, transaction and loan losses, and amortization of acquired customer assets. For product development and general and administrative expenses, the largest single component is personnel-related expenses, including salaries, commissions and bonuses, employee benefit costs, and share-based compensation. In the case of sales and marketing expenses, a significant portion is related to the Cash App peer-to-peer transactions and Cash Card issuance costs, in addition to paid advertising and personnel-related expenses. Operating expenses also include allocated overhead costs for facilities, human resources, and IT.Product development. Product development expenses currently represent the largest component of our operating expenses and consist primarily of expenses related to our engineering, data science, and design personnel; fees and supply costs related to maintenance at third-party data center facilities; hardware related development and tooling costs; and fees for software licenses, consulting, legal, and other services that are directly related to growing and maintaining our portfolio of products and services. Additionally, product development expenses include the depreciation of product-related infrastructure and tools, including data center equipment, internally developed software, and computer equipment. We continue to focus our product development efforts on adding new features and apps, and on enhancing the functionality and ease of use of our offerings. Our ability to realize returns on these investments is substantially dependent upon our ability to successfully address current and emerging requirements of sellers, buyers, and customers through the development and introduction of these new products and services. Sales and marketing. Sales and marketing expenses are aggregated into two main components. The first component consists of traditional advertising costs incurred such as direct sales expense, account management, local and product marketing, retail and e-commerce, partnerships, and communications personnel. The second component of sales and marketing expense consists of costs incurred for services, incentives and other costs that are not directly related to revenue generating transactions that we consider to be marketing costs to encourage the usage of Cash App. These expenses include, but are not limited to, Cash App peer-to-peer processing costs and transaction losses, card issuance costs, customer referral bonuses, and promotional giveaways that are expensed as incurred.General and administrative. General and administrative expenses consist primarily of expenses related to our customer support, finance, legal, risk operations, human resources, and administrative personnel. General and administrative expenses also include costs related to fees paid for professional services, including legal, tax, and accounting services. 59Transaction and loan losses. We are exposed to transaction losses due to chargebacks as a result of fraud or uncollectibility. We incur loan losses whenever the amortized cost of loans that have been retained exceeds their fair value. Transaction losses include chargebacks for unauthorized credit card use and inability to collect on disputes between buyers and sellers over the delivery of goods or services, as well as losses on Cash App activity related to peer-to-peer payments sent from a credit card, Cash for Business, and Cash Card. We base our reserve estimates on prior chargeback history and current period data points indicative of transaction loss. We reflect additions to the reserve in current operating results, while realized losses are offset against the reserve. The establishment of appropriate reserves for transaction losses is an inherently uncertain process, and ultimate losses may vary from the current estimates. We regularly update our reserve estimates as new facts become known and events occur that may affect the settlement or recovery of losses.Loan losses are recorded at the lower of amortized cost or fair value determined on an individual loan basis. To determine the fair value the Company utilizes industry-standard valuation modeling, such as discounted cash flow models, taking into account the estimated timing and amounts of periodic repayments. The Company recognizes a charge whenever the amortized cost of a loan exceeds its fair value, with such charges being reversed for subsequent increases in fair value, but only to the extent that such reversals do not result in the amortized cost of a loan exceeding its fair value. Amortization of acquired customer assets. Amortization of acquired customer assets includes customer relationships, restaurant relationships, courier relationships, subscriber relationships, and partner relationships. These amounts were not material to our financial statements.Gain on sale of asset groupGain on sale of asset group in 2019 represents the excess of the consideration received from the disposal of the Caviar business less the carrying values of the net assets sold.Interest and Other Income and Expense, netInterest and other income and expense, net consists primarily of gains or losses arising from marking to market of equity investments, interest expense related to our long-term debt, interest income on our investment in marketable debt securities, and foreign currency-related gains and losses.Provision for Income TaxesThe provision for income taxes consists primarily of federal, state, local, and foreign tax. Our effective tax rate fluctuates from period to period due to changes in the mix of income and losses in jurisdictions with a wide range of tax rates, the effect of acquisitions, changes resulting from the amount of recorded valuation allowance, permanent differences between U.S. generally accepted accounting principles and local tax laws, certain one-time items, and changes in tax contingencies. 60Results of Operations Revenue (in thousands, except for percentages)Year Ended December 31,20202019$ Change% ChangeTransaction-based revenue$3,294,978 $3,081,074 $213,904 7 %Subscription and services-based revenue1,539,403 1,031,456 507,947 49 %Hardware revenue91,654 84,505 7,149 8 %Bitcoin revenue4,571,543 516,465 4,055,078 785 %Total net revenue$9,497,578 $4,713,500 $4,784,078 101 % Total net revenue for the year ended December 31, 2020, increased by $4.8 billion, or 101%, compared to the year ended December 31, 2019. Bitcoin revenue increased by $4.1 billion, and represented 85% of the increase in total net revenue. Excluding bitcoin revenue, total net revenue increased by $729.0 million, or 17%, in the year ended December 31, 2020, compared to the year ended December 31, 2019. Transaction-based revenue for the year ended December 31, 2020 increased by $213.9 million or 7%, compared to the year ended December 31, 2019. This increase was in line with the increase in GPV of 6% for the year ended December 31, 2020, compared to the year ended December 31, 2019. The increase was primarily attributable to and affected by the following events and factors:•In January and February of 2020, we benefited from the growth in payment volume processed by existing sellers, in addition to meaningful contributions from new sellers, compared to the same period in the prior year, which included a benefit from the impact of the leap year;•In the second half of March through mid-April, 2020, as a result of the COVID-19 pandemic and subsequent shelter-in-place restrictions, we experienced a significant decline in transaction-based revenue, with GPV generated by our Seller business decreasing compared to the prior year;•Beginning in mid-April 2020, we started to experience improving trends in GPV generated by our Seller business, as some states started to relax shelter-in-place measures, sellers adapted their businesses to contactless commerce, new sellers joined Square and various government assistance programs led to an increase in consumer spending;•In the third and fourth quarters of 2020, we have experienced positive growth of GPV and revenue compared to the third and fourth quarters of 2019, primarily driven by higher priced card-not-present transactions as sellers continued to shift their businesses to adapt to the COVID-19 pandemic.Despite the decrease in transaction-based revenue as a result of the COVID-19 pandemic, the overall increase in transaction-based revenue for the year ended December 31, 2020 compared to the same period in 2019 was primarily driven by growth in higher-priced card-not-present transactions as sellers shifted their businesses to adapt to the COVID-19 pandemic, and the impact from our November 2019 card-present price change, as well as Cash App GPV which includes Cash for Business and peer-to-peer payments sent from a credit card. Cash for Business activity includes peer-to-peer transactions to business accounts using Cash App. The factors and events above had varying impacts on the GPV growth and may continue to impact our revenues in the future. In particular, card-present growth varies by region and product, depending primarily on differences in the timing and phases of reopenings, which we expect will have a significant impact on overall GPV trends.Subscription and services-based revenue for the year ended December 31, 2020 increased by $507.9 million or 49%, compared to the year ended December 31, 2019. On October 31, 2019, we completed the sale of the Caviar business, and, accordingly, Caviar no longer contributes to subscription and services-based revenue. Excluding Caviar, subscription and services-based revenue grew by $653.9 million, or 74%, in the year ended year ended December 31, 2020, compared to the year ended December 31, 2019 driven predominantly by Cash App, and to a lesser extent Square Card and Instant Transfers for sellers, partially offset by a decrease in Square Capital loan volumes. Cash App subscription and services-based revenue is primarily comprised of transaction fees from both Cash App Instant Deposit and Cash Card, with a small portion generated from interest earned on customer funds. In an effort to support our sellers, we temporarily suspended charging customers 61software subscription fees and refunded fees collected in March and April 2020. We resumed charging such fees in May 2020. Square Capital, which has historically been a significant component of the subscriptions and services revenue, suspended facilitating loans to sellers, other than PPP loans, in March 2020 but resumed facilitating such loans at the end of July 2020. Loan volumes remain lower than in 2019, and there is substantial uncertainty about when loan volumes will return to pre-COVID-19 levels. Hardware revenue for the year ended December 31, 2020 increased by $7.1 million or 8%, compared to the year ended December 31, 2019. The increase was primarily a result of an increase in sales of hardware in our international markets, as well as sales of contactless hardware as a result of certain promotions offered in the second and third quarter of 2020.Bitcoin revenue for the year ended December 31, 2020 increased by $4.1 billion or 785% compared to the year ended December 31, 2019. The increase was due to the market price of bitcoin, growth in the number of active bitcoin customers, as well as volume per customer. The amount of bitcoin revenue recognized will fluctuate depending on customer demand as well as changes in the market price of bitcoin. During the year ended December 31, 2020, we saw a significant growth in bitcoin revenue as compared to the year ended December 31, 2019. While bitcoin contributed 48% of the total revenue in 2020, and 85% of the increase in revenues in 2020, gross margin generated from bitcoin was only 3.5% of the total gross margin. Cost of Revenue (in thousands, except for percentages)Year Ended December 31,20202019$ Change% ChangeTransaction-based costs$1,911,848 $1,937,971 $(26,123)(1)%Subscription and services-based costs222,712 234,270 (11,558)(5)%Hardware costs143,901 136,385 7,516 6 %Bitcoin costs4,474,534 508,239 3,966,295 780 %Amortization of acquired technology11,174 6,950 4,224 61 %Total cost of revenue$6,764,169 $2,823,815 $3,940,354 140 %Total cost of revenue for the year ended December 31, 2020, increased by $3.9 billion, or 140%, compared to the year ended December 31, 2019. Bitcoin costs of revenue increased by $4.0 billion, and represented 101% of the increase in the total cost of revenue. Excluding bitcoin costs of revenue, total cost of revenue decreased by approximately $25.9 million, or 1%, in the year ended December 31, 2020, compared to the year ended December 31, 2019. Despite an increase in GPV of 6% for the year ended December 31, 2020, compared to the year ended December 31, 2019, transaction-based costs decreased by $26.1 million or 1% for the year ended December 31, 2020, compared to the year ended December 31, 2019. The decrease in transaction-based costs in the year ended December 31, 2020 was primarily attributable to growth in debit card transactions and increase in average transaction sizes, which lowered the average cost per transaction, partially offset by the increase in GPV. We recognize that the recent shifts in the percentage of debit card transactions, proportion of card-not-present volumes, and average value per transaction size relative to historical periods are in part, a result of changes to consumer behaviors related to COVID-19, which may not continue in future quarters.Subscription and services-based costs for the year ended December 31, 2020 decreased by $11.6 million or 5% compared to the year ended December 31, 2019, primarily as a result of the sale of the Caviar business on October 31, 2019. Caviar contributed approximately 45% total subscription and services-based costs in year ended December 31, 2019. Excluding Caviar, subscription and services-based costs increased by $92.7 million or 71%, in the year ended December 31, 2020, compared to the year ended December 31, 2019, driven mainly by growth in costs associated with Cash Card and Instant Deposit.Hardware costs for the year ended December 31, 2020 increased by $7.5 million or 6%, compared to the year ended December 31, 2019. The increase was primarily due to the same drivers for the increase in hardware revenue discussed above.Bitcoin costs for the year ended December 31, 2020 increased by $4.0 billion or 780%, compared to the year ended December 31, 2019. Bitcoin costs of revenue comprises of the total amounts we pay to purchase bitcoin, which will fluctuate in line with bitcoin revenue. 62Product Development (in thousands, except for percentages)Year Ended December 31,20202019$ Change% ChangeProduct development$881,826 $670,606 $211,220 31 %Percentage of total net revenue9 %14 %Product development expenses for the year ended December 31, 2020, increased by $211.2 million, or 31%, compared to the year ended December 31, 2019, due primarily to the following: •an increase of $155.4 million in personnel costs for the year ended December 31, 2020, related to an increase in headcount among our engineering, data science, and design teams, as we continue to improve and diversify our products. The increase in personnel related costs includes an increase in share-based compensation expense of $78.7 million for the year ended December 31, 2020;•an increase of $23.5 million in software and data center operating costs as a result of increased capacity needs and expansion of our cloud-based services.Sales and Marketing (in thousands, except for percentages)Year Ended December 31,20202019$ Change% ChangeSales and marketing$1,109,670 $624,832 $484,838 78 %Percentage of total net revenue12 %13 %Sales and marketing expenses for the year ended December 31, 2020, increased by $484.8 million, or 78%, compared to the year ended December 31, 2019, primarily due to the following:•an increase in Cash App marketing costs for the year ended December 31, 2020. The increase in Cash App marketing relates to a $355.6 million increase in processing costs and related transaction losses associated with the increased volume of activity with our Cash App peer-to-peer service, increased card issuance costs and increased incentives to customers that are not directly related to revenue generating transactions. We offer services such as stock investing, and certain Cash Card and peer-to-peer services to our Cash App customers for free, and various incentives to customers that we consider to be marketing tools to encourage the usage of Cash App. Additionally, Cash App advertising costs increased by $52.5 million;•an increase of $29.6 million in advertising costs for our Seller Ecosystem services for the year ended December 31, 2020, primarily from increased online and television marketing campaigns;•an increase of $28.3 million in Seller and Cash App sales and marketing personnel costs for the year ended December 31, 2020, to enable growth initiatives. The increase in personnel related costs includes an increase in share-based compensation expense of $9.9 million.General and Administrative (in thousands, except for percentages)Year Ended December 31,20202019$ Change% ChangeGeneral and administrative$579,203 $436,250 $142,953 33 %Percentage of total net revenue6 %9 %General and administrative expenses for the year ended December 31, 2020, increased by $143.0 million, or 33%, compared to the year ended December 31, 2019, primarily due to the following:63•an increase of $58.7 million in general and administrative personnel costs for the year ended December 31, 2020, mainly as a result of additions to our customer support, finance, and legal personnel as we continued to add resources and skills to support our long-term growth as our business continues to scale. The increase in personnel related costs includes an increase in share-based compensation expense of $10.8 million for the year ended December 31, 2020; and•the remaining increase was primarily due to the commencement of new leases, software and subscription costs, local business-related taxes, third-party legal and other professional fees and other administrative expenses, as well as impact of our statutory reserves. Transaction and Loan Losses (in thousands, except for percentages)Year Ended December 31,20202019$ Change% ChangeTransaction and loan losses$177,670 $126,959 $50,711 40 %Transaction and loan losses for the year ended December 31, 2020, increased by $50.7 million, or 40%, compared to the year ended December 31, 2019, primarily due to the following: •transaction losses increased by $44.8 million for the year ended December 31, 2020 due to growth in our Cash App business, as well as increased provisions for transaction losses for our Seller business due to the expected impact of the COVID-19 pandemic that resulted in a significant slowdown in business for many sellers.•an increase of $6.0 million in loan losses for the year ended December 31, 2020 due to incremental provisions for loan losses associated with the COVID-19 pandemic, and to a lesser extent the aging of our Square Capital loan portfolio. The increases in loan losses were offset by decreases in loan volumes as we suspended offers for new loans, other than PPP loans, in March 2020 and resumed offering such loans at the end of July 2020 at lower volumes. Gain on Sale of Asset Group, Interest Expense, Net, and Other Expense (Income), Net (in thousands, except for percentages)Year Ended December 31,20202019$ Change% ChangeGain on sale of asset group$— $(373,445)$373,445 NMInterest expense, net56,943 21,516 35,427 165 %Other expense (income), net(291,725)273 (291,998)NMGain on sale of asset group represents the excess of the consideration received from the sale of the Caviar business in October, 2019, of $410 million less the carrying value of the net assets sold and selling expenses, as analyzed in Note 8, Sale of Asset Group, of the Notes to the Consolidated Financial Statements.Interest expense, net, for the year ended December 31, 2020 increased by $35.4 million compared to the year ended December 31, 2019. The increases were primarily due to higher interest expense related to our convertible notes as a result of the issuance of the 2025 Notes in March 2020, as well as the 2026 Notes and 2027 Notes in November 2020, in addition to a decrease in interest income earned on our investments in marketable debt securities due to lower interest rates prevailing in the market.Other expense (income), net was primarily driven by the amounts of gains or losses arising from the revaluation of our equity investments. In November 2020, upon DoorDash's initial public offering, the preferred shares held by the Company converted into common shares of DoorDash. As of December 31, 2020, the Company revalued this investment and recorded a gain of $276.3 million in the year ended December 31, 2020. Additionally, in the fourth quarter of 2020, we recorded a gain on investment in a privately held entity of $19.0 million based on observable prices for similar equity instruments issued by 64the same entity. In the year ended December 31, 2019, we recorded a loss of $12.3 million on the revaluation of our equity investment Eventbrite, Inc. ("Eventbrite"), offset by the amortization of and realized gains on the sale of investments in marketable securities of $9.7 million, foreign exchange gains of $1.7 million, and other sources of income. In December 2019, the Company sold its entire equity investment in Eventbrite and as a result this investment will not impact the results in future periods. Segment ResultsSeller ResultsThe following tables provide a summary of the revenue and gross profit for our Seller segment for the year ended December 31, 2020 and 2019 (in thousands):Year Ended December 31,20202019$ Change% ChangeNet revenue$3,529,192 $3,461,988 $67,204 2 %Cost of revenue2,021,361 2,071,561 (50,200)(2)%Gross profit$1,507,831 $1,390,427 $117,404 8 %RevenueRevenue for the Seller segment for the year ended December 31, 2020 increased by $67.2 million compared to the year ended December 31, 2019. The COVID-19 pandemic and the subsequent shelter-in-place orders resulted in a material decline in Seller revenues in the latter half of March 2020 through mid-April 2020 due to lower GPV processed. Additionally, Square Capital suspended facilitating loans to sellers from mid-March 2020 through the end of July 2020, other than PPP loans, further negatively impacting Seller revenues. Excluding the impact of Square Capital, other Seller subscription and services-based revenue increased due to growth in software subscriptions, Instant Transfers, and Square Card. This was offset by the recovery and improvements in GPV processed from mid-April through the fourth quarter of 2020 as states started relaxing the shelter-in-place orders and businesses started to adapt to the COVID-19 pandemic. Additionally, we saw a higher percentage of card-not-present transactions from the second quarter through to the fourth quarter of 2020, which have a higher transaction price, as well as the impact of our November 2019 card-present price change. Recent increases in the percentage of debit, proportion of card-not-present volumes, and average transaction size relative to historical periods are in part a result of changes to consumer behaviors related to COVID-19, which may not continue in future quarters.Cost of revenueCost of revenue for the Seller segment for the year ended December 31, 2020 decreased by $50.2 million compared to the year ended December 31, 2019. Seller costs benefited from a higher percentage of debit card transactions and increase in average value per transaction which have lower costs.Cash App ResultsThe following tables provide a summary of the revenue and gross profit for our Cash App segment for the year ended December 31, 2020 and 2019 (in thousands):Year Ended December 31,20202019$ Change% ChangeNet revenue$5,968,386 $1,105,599 $4,862,787 440 %Cost of revenue4,742,808 647,931 4,094,877 632 %Gross profit$1,225,578 $457,668 $767,910 168 %65RevenueRevenue for the Cash App segment for the year ended December 31, 2020 increased by $4.9 billion compared to the year ended December 31, 2019. The primary drivers were growth in bitcoin revenue, and to a lesser extent, Cash App Instant Deposit, Cash Card, and Cash for Business. Bitcoin revenue increased primarily due to an increase in the number of active bitcoin customers, as well as growth in customer demand and bitcoin prices. Additionally, Cash App revenue benefited from increased numbers of transacting active Cash App customers and from disbursements of the CARES Act stimulus programs and unemployment benefits, including a portion of customers who direct deposited these payments into their Cash App accounts. Cash App revenue growth may not be sustained at the same levels in future quarters and may be impacted by the enactment of further stimulus relief and benefit programs, as well as the demand and market prices for bitcoin, amongst other factors.Cost of revenueCost of revenue for the Cash App segment for the year ended December 31, 2020 increased by $4.1 billion compared to the year ended December 31, 2019. The primary drivers for the increase were growth in bitcoin revenue, and to a lesser extent, Cash App Instant Deposit, Cash Card, and Cash for Business. Comparison of Years Ended December 31, 2019 and 2018For a discussion of the 2019 Results of Operations, including a discussion of the financial results for the fiscal year ended December 31, 2019 compared to the fiscal year ended December 31, 2018, refer to Part I, Item 7 of our Form 10-K filed with the SEC on February 26, 2020.66Quarterly Results of Operations The following tables set forth selected unaudited quarterly statements of operations data for the last eight quarters. The information for each of these quarters has been prepared on the same basis as the audited annual financial statements included elsewhere in this Annual Report on Form 10-K and, in the opinion of management, includes all adjustments, which consist only of normal recurring adjustments, necessary for the fair presentation of the results of operations for these periods. This data should be read in conjunction with our audited consolidated financial statements and related notes included elsewhere in this Annual Report on Form 10-K. These quarterly operating results are not necessarily indicative of the results we may achieve in future periods. Three Months Ended,Dec. 31,2020Sep. 30, 2020Jun. 30, 2020Mar. 31, 2020Dec. 31,2019Sep. 30, 2019Jun. 30, 2019Mar. 31, 2019(in thousands, except per share data)(unaudited)Revenue:Transaction-based revenue$929,011 $925,294 $682,572 $758,101 $832,180 $816,622 $775,510 $656,762 Subscription and services-based revenue449,371 447,522 346,275 296,235 281,415 279,801 251,383 218,857 Hardware revenue24,363 27,294 19,322 20,675 22,267 21,766 22,260 18,212 Bitcoin revenue1,756,225 1,633,764 875,456 306,098 177,567 148,285 125,085 65,528 Total net revenue3,158,970 3,033,874 1,923,625 1,381,109 1,313,429 1,266,474 1,174,238 959,359 Cost of revenue:Transaction-based costs535,283 522,680 388,106 465,779 519,241 519,312 490,349 409,069 Subscription and services-based costs65,046 66,786 50,169 40,711 50,276 63,352 60,119 60,523 Hardware costs35,994 45,220 28,315 34,372 40,504 35,672 33,268 26,941 Bitcoin costs1,715,452 1,601,615 858,041 299,426 174,438 146,167 122,938 64,696 Amortization of acquired technology3,505 3,118 2,231 2,320 1,921 1,934 1,719 1,376 Total cost of revenue2,355,280 2,239,419 1,326,862 842,608 786,380 766,437 708,393 562,605 Gross profit803,690 794,455 596,763 538,501 527,049 500,037 465,845 396,754 Operating expenses:Product development253,448 226,567 206,825 194,986 173,284 168,771 174,201 154,350 Sales and marketing328,576 348,463 238,096 194,535 185,231 149,467 156,421 133,713 General and administrative159,420 153,902 136,386 129,495 118,164 115,980 100,508 101,598 Transaction and loan losses15,986 15,198 37,603 108,883 32,132 32,722 34,264 27,841 Amortization of acquired customer assets1,077 983 905 890 890 1,003 1,294 1,294 Total operating expenses758,507 745,113 619,815 628,789 509,701 467,943 466,688 418,796 Operating income (loss)45,183 49,342 (23,052)(90,288)17,348 32,094 (843)(22,042)Gain on sale of asset group— — — — (373,445)— — — Interest expense, net17,988 14,980 14,769 9,206 6,060 5,632 5,143 4,681 Other expense (income), net(271,212)(784)(25,591)5,862 (6,715)(5,541)1,230 11,299 Income (loss) before income tax298,407 35,146 (12,230)(105,356)391,448 32,003 (7,216)(38,022)Provision (benefit) for income taxes4,448 (1,369)(752)535 508 2,606 (476)129 Net income (loss)$293,959 $36,515 $(11,478)$(105,891)$390,940 $29,397 $(6,740)$(38,151)Net income (loss) per share:Basic$0.65 $0.08 $(0.03)$(0.24)$0.91 $0.07 $(0.02)$(0.09)Diluted$0.59 $0.07 $(0.03)$(0.24)$0.83 $0.06 $(0.02)$(0.09)Weighted-average shares used to compute net income (loss) per share:Basic452,869 444,458 440,117 434,940 430,136 427,124 423,305 419,289 Diluted502,237 488,069 440,117 434,940 485,394 466,099 423,305 419,289 67Costs and expenses include share-based compensation expense as follows:Three Months Ended,Dec. 31,2020Sep. 30, 2020Jun. 30, 2020Mar. 31, 2020Dec. 31,2019Sep. 30, 2019Jun. 30, 2019Mar. 31, 2019(in thousands)Share-Based Compensation(unaudited)Cost of revenue$97 $100 $95 $76 $67 $38 $29 $21 Product development83,906 78,682 69,565 57,400 55,726 56,321 56,144 42,649 Sales and marketing9,273 12,063 8,884 6,407 6,416 6,269 7,833 6,202 General and administrative20,352 19,544 17,636 13,420 17,674 14,798 15,460 12,216 Total share-based compensation$113,628 $110,389 $96,180 $77,303 $79,883 $77,426 $79,466 $61,088 The following table sets forth the key operating metrics and non-GAAP financial measures we use to evaluate our business for each of the periods indicated:Three Months Ended,Dec. 31,2020Sep. 30, 2020Jun. 30, 2020Mar. 31, 2020Dec. 31,2019Sep. 30, 2019Jun. 30, 2019Mar. 31, 2019(in thousands, except for GPV and per share data)Key Operating Metrics and non-GAAP Financial Measures(unaudited)Gross Payment Volume (GPV) (in millions)$32,022 $31,729 $22,801 $25,743 $28,639 $28,228 $26,785 $22,587 Adjusted EBITDA$185,489 $181,320 $97,931 $9,331 $118,529 $131,323 $105,304 $61,697 Adjusted Net Income (Loss) Per Share:Basic$0.37 $0.39 $0.20 $(0.02)$0.25 $0.28 $0.23 $0.13 Diluted$0.32 $0.34 $0.18 $(0.02)$0.23 $0.25 $0.21 $0.11 The following table presents a reconciliation of net loss to Adjusted EBITDA for each of the periods indicated:Three Months Ended,Dec. 31,2020Sep. 30, 2020Jun. 30, 2020Mar. 31, 2020Dec. 31,2019Sep. 30, 2019Jun. 30, 2019Mar. 31, 2019(in thousands)Adjusted EBITDA Reconciliation(unaudited)Net income (loss)$293,959 $36,515 $(11,478)$(105,891)$390,940 $29,397 $(6,740)$(38,151)Share-based compensation expense113,628 110,389 96,180 77,303 79,883 77,426 79,466 61,088 Depreciation and amortization22,471 20,624 21,056 20,061 18,719 19,125 18,783 18,971 Interest expense, net17,988 14,980 14,769 9,206 6,060 5,632 5,143 4,681 Other expense (income), net(271,212)(784)(25,591)5,862 (6,715)(5,541)1,230 11,299 Provision (benefit) for income taxes4,448 (1,369)(752)535 508 2,606 (476)129 Loss on disposal of property and equipment475 396 1,481 218 580 128 281 19 Gain on sale of asset group— — — — (373,445)— — — Acquisition related and other costs3,543 359 2,056 1,524 1,260 1,564 6,133 782 Acquired deferred revenue adjustment257 281 302 657 928 1,224 1,849 3,456 Acquired deferred costs adjustment(68)(71)(92)(144)(189)(238)(365)(577)Adjusted EBITDA$185,489 $181,320 $97,931 $9,331 $118,529 $131,323 $105,304 $61,697 68The following table presents a reconciliation of net loss to Adjusted Net Income (Loss) Per Share for each of the periods indicated:Three Months Ended,Dec. 31,2020Sep. 30, 2020Jun. 30, 2020Mar. 31, 2020Dec. 31,2019Sep. 30, 2019Jun. 30, 2019Mar. 31, 2019(in thousands, except per share data)Adjusted Net Income Per Share:(unaudited)Net income (loss)$293,959 $36,515 $(11,478)$(105,891)$390,940 $29,397 $(6,740)$(38,151)Share-based compensation expense113,628 110,389 96,180 77,303 79,883 77,426 79,466 61,088 Amortization of intangible assets5,717 5,236 4,134 4,152 3,714 3,841 3,958 3,487 Amortization of debt discount and issuance costs20,355 17,516 17,580 12,528 9,963 9,843 9,725 9,608 Loss (gain) on revaluation of equity investments(274,299)— (20,998)— (4,141)(2,462)4,842 14,087 Loss on extinguishment of long-term debt4,258 1,403 — 990 — — — — Loss (gain) on disposal of property and equipment475 396 1,481 218 580 128 281 19 Gain on sale of asset group— — — — (373,445)— — — Acquisition related and other costs3,543 359 2,056 1,524 1,260 1,564 6,133 782 Acquired deferred revenue adjustment257 281 302 657 928 1,224 1,849 3,456 Acquired deferred cost adjustment(68)(71)(92)(144)(189)(238)(365)(577)Adjusted Net Income (Loss) - basic$167,825 $172,024 $89,165 $(8,663)$109,493 $120,723 $99,149 $53,799 Cash interest expense on convertible senior notes1,596 1,544 1,565 — 1,277 1,277 1,277 1,277 Adjusted Net Income (Loss) - diluted$169,421 $173,568 $90,730 $(8,663)$110,770 $122,000 $100,426 $55,076 Adjusted Net Income (Loss) Per Share:Basic$0.37 $0.39 $0.20 $(0.02)$0.25 $0.28 $0.23 $0.13 Diluted$0.32 $0.34 $0.18 $(0.02)$0.23 $0.25 $0.21 $0.11 Weighted-average shares used to compute Adjusted Net Income (Loss) Per Share:Basic452,869 444,458 440,117 434,940 430,136 427,124 423,305 419,289 Diluted523,586 514,806 500,201 434,940 485,394 486,404 486,532 487,056 Quarterly TrendsTransaction-based revenue is highly correlated with the level of GPV generated by sellers using our managed payments services. The increase in transaction-based revenue in 2020 was primarily attributable to and affected by the COVID-19 pandemic and subsequent shelter in place orders as discussed in more detail under results of operations. Subscription and services-based revenue generally demonstrates less seasonality than transaction-based revenue. The sequential increases were primarily driven by continued growth of Cash App which has benefited from increased engagement by customers as well as an increase from government stimulus funds deposited into customer accounts. On October 31, 2019, we completed the sale of the Caviar business, and accordingly we will no longer recognize any revenue from Caviar.Bitcoin revenue comprises the total sale amount we receive from bitcoin sales to customers and is recorded upon transfer of bitcoin to the customer's account. The sale amount generally includes a small margin added to the price we pay to purchase bitcoin and accordingly, the amount of bitcoin revenue will fluctuate depending on the volatility of market bitcoin prices and customer demand. We saw unprecedented growth in bitcoin revenues in the second and third quarter of 2020. Various factors impact customer demand and as such, the recent periods' performance may not be indicative of future quarters.Changes in product development expenses primarily reflect the timing of additions of engineering, product, and design personnel. To a lesser extent, they also reflect the timing of fees and supply costs related to maintenance and capacity 69expansion at third-party data center facilities, development and tooling costs related to the design, testing, and shipping of our hardware products, and fees for software licenses, consulting, legal, and other services that are directly related to growing and maintaining our products and services.Changes in sales and marketing expenses reflect the variable nature of the timing and magnitude of paid marketing and customer acquisition initiatives across our advertising channels. Changes in sales and marketing expenses are also affected by the timing of additions of direct sales, account management, local, product and paid marketing, retail and e-commerce, partnerships, and communications personnel. Additionally, sales and marketing expenses are affected by the timing and magnitude of processing costs and transaction losses related to our Cash App peer-to-peer transfer service and Cash Card issuance costs. We offer the Cash Card and certain peer-to-peer services to our Cash App customers for free and we consider these to be marketing tools intended to encourage the usage of Cash App. We saw a substantial increase in sales and marketing expenses in the second and third quarter of 2020 associated with the increased volume of activity with our Cash App peer-to-peer service. Changes in general and administrative expenses primarily reflect the timing of additions of finance, legal, risk operations, human resources, and administrative personnel, as well as the timing of non income tax payments and reserves. They also reflect the timing of costs related to support personnel and systems, as well as fees paid for professional services, including legal and financial services. We recorded incremental provisions for transaction and loan losses in the first quarter of 2020 for our Seller business due to the expected impact of the COVID-19 pandemic and the related subsequent shelter-in-place orders that resulted in a significant slowdown in the business of many sellers. During the second quarter of 2020, we revised and lowered our estimate of transaction loss reserves recorded in the first quarter of 2020 due to better than expected realized transaction losses. Provision for transaction losses declined during the third quarter as a result of better than expected performance, and as we released previously established risk loss provisions for the first and second quarter of 2020. During the fourth quarter of 2020, we revised and lowered our estimate of transaction loss reserves recorded in the second and third quarter of 2020 due to better than expected realized transaction losses. For loan losses, during the second quarter of 2020, we noted improvements in our sellers as some states started reopening and relaxing the shelter-in place measures and have accordingly adjusted the provisions for loan losses. Additionally, other than PPP loans, we suspended offers for new loans in the second quarter of 2020 which contributed to the decrease in loan losses. During the third and fourth quarters of 2020, we continued to experience loan losses in line with the second quarter provisions for loan losses. Provisions for transaction losses increased approximately 106% in the fourth quarter of 2020, compared to the fourth quarter of 2019.Gain on sale of asset group represents the net gain we made on the sale of the Caviar business in the fourth quarter of 2019. Changes in interest expense (income), net are driven by interest expense related to our convertible notes and interest income earned on our investment in marketable debt securities. Changes in other expense (income), net was primarily due to gains or losses arising from revaluation of our publicly traded and privately held equity investments. In the fourth quarter of 2020, we recorded a gain from the revaluation of our DoorDash investment as a result of its initial public offering in December 2020, as well as a gain in the fourth quarter of 2020 due to the revaluation of our investment in a privately held entity. In 2019, we recorded losses in the mark to market revaluation of our Eventbrite investment. In December 2019, the Company sold the investment in Eventbrite and as a result will not be impacted by mark to market revaluations related to this investment in future periods. To a lesser extent this balance is also impacted by foreign exchange gains or losses.70Liquidity and Capital ResourcesThe uncertainty caused by the COVID-19 pandemic continues both in the United States and globally, with the duration and severity of the pandemic and the overall impact on consumer demand and overall economy still unknown. We are unable to forecast the full impact on our business; however, this represents a known area of uncertainty and we continue to expect the COVID-19 pandemic and its related economic disruption may have a material impact on our business, results of operations, financial condition and cash flows. We continue to evaluate our investment plans and discretionary expenditures and will make adjustments accordingly.As of December 31, 2020, we had approximately $4.9 billion in available funds, including undrawn amounts available under our revolving credit facility, as described in Note 13, Indebtedness, of Notes to the Consolidated Financial Statements. We intend to continue focusing on our long-term business initiatives and believe that our available funds are sufficient to meet our liquidity needs for the foreseeable future. We are carefully monitoring and managing our cash position in light of ongoing conditions and levels of operations.The following table summarizes our cash, cash equivalents, restricted cash, and investments in marketable debt securities (in thousands):Liquidity SourcesYear Ended December 31,20202019Cash and cash equivalents$3,158,058 $1,047,118 Short-term restricted cash30,279 38,873 Long-term restricted cash13,526 12,715 Cash, cash equivalents, and restricted cash3,201,863 1,098,706 Investments in short-term debt securities695,112 492,456 Investments in long-term debt securities463,950 537,303 Cash, cash equivalents, restricted cash and investments in marketable debt securities$4,360,925 $2,128,465 Our principal sources of liquidity are our cash and cash equivalents, and investments in marketable debt securities. As of December 31, 2020, we had $4.4 billion of cash and cash equivalents, restricted cash and investments in marketable debt securities, which were held primarily in cash deposits, money market funds, U.S. government and agency securities, commercial paper, and corporate bonds. We consider all highly liquid investments with an original maturity of three months or less when purchased to be cash equivalents. Our investments in marketable debt securities are classified as available-for-sale. From time to time, we have raised capital by issuing equity, equity-linked, or debt securities such as our convertible senior notes. As of December 31, 2020, we held $3.0 billion in aggregate principal amount of convertible senior notes, comprised of $8.5 million in aggregate principal amount of outstanding convertible senior notes that mature on March 1, 2022 (2022 Notes), $862.5 million in aggregate principal amount of convertible senior notes that mature on May 15, 2023 (2023 Notes), $1.0 billion in aggregate amount of convertible senior notes that mature on March 1, 2025 (2025 Notes), and $575.0 million and $575.0 million in aggregate amount of convertible senior notes that mature on May 1, 2026, and November 1, 2027, respectively (2026 and 2027 Notes). The 2022 Notes bear interest at a rate of 0.375% payable semi-annually on March 1 and September 1 of each year, while the 2023 Notes bear interest at a rate of 0.50% payable semi-annually on May 15 and November 15 of each year, and the 2025 Notes bear interest at a rate of 0.125% payable semi-annually on March 1 and September 1 of each year. The 2026 Notes bear no interest, whereas, the 2027 notes bear interest at a rate of 0.25% payable semi-annually on May 1 and November 1 of each year. These notes can be converted or repurchased prior to maturity if certain conditions are met. We purchased $50 million in bitcoin in October 2020 and another $170 million in February 2021, as we believe cryptocurrency is an instrument of economic empowerment that aligns with our corporate purpose. We expect to hold these investments for the long term but will continue to reassess our investment in bitcoin relative to our balance sheet. As bitcoin is considered an indefinite lived intangible asset, under the accounting policy for such assets we will be required to recognize 71any decreases in market prices below cost as an impairment charge, with any mark up in value prohibited if the market price of bitcoin subsequently increases.In September 2020, we announced our intent to invest $100 million in supporting underserved communities, particularly, racial and ethnic minority groups who have been disproportionately affected by COVID-19. This initiative further deepens our commitment toward economic empowerment to help broaden such communities' access to financial services. In June 2020, we entered into the Paycheck Protection Program Liquidity Facility agreement with the Federal Reserve Bank of San Francisco ("First PPPLF Agreement") to secure additional credit collateralized by PPP loans. As of December 31, 2020, $464.1 million of PPPLF advances were outstanding and collateralized by the same value of PPP loans. The advances under this facility are repayable if the associated PPP loans are forgiven, repaid by a customer or settled by the government guarantee. As of February 23, 2021, approximately $376.3 million of PPPLF advances were outstanding and collateralized by the same value of the PPP loans. On January 29, 2021, we entered into a Second PPPLF Agreement with the Federal Reserve Bank of San Francisco to secure additional credit, collateralized by loans from the second round of the PPP program, in an aggregate principal amount of up to $1.0 billion under both PPPLF Agreements. In May 2020, we entered into a new revolving credit agreement with certain lenders, which provides a $500 million senior unsecured revolving credit facility (the "2020 Credit Facility") maturing in May 2023. Loans under the 2020 Credit Facility bear interest at our option of (i) a base rate based on the highest of the prime rate, the federal funds rate plus 0.50%, and the adjusted LIBOR rate plus 1.00%, in each case, plus a margin ranging from 0.25% to 0.75% or (ii) an adjusted LIBOR rate plus a margin ranging from 1.25% to 1.75%. The margin is determined based on our total net leverage ratio, as defined in the agreement. We are obligated to pay other customary fees for a credit facility of this size and type including an unused commitment fee of 0.15%. To date, no funds have been drawn and no letters of credit have been issued under the 2020 Credit Facility.See Note 13, Indebtedness, of the Notes to the Consolidated Financial Statements for more details on these transactions.We believe that our existing cash and cash equivalents, investment in marketable debt securities, and availability under our line of credit will be sufficient to meet our working capital needs, including any expenditures related to strategic transactions and investment commitments that we may from time to time enter into, and planned capital expenditures for at least the next 12 months. From time to time, we may seek to raise additional capital through equity, equity-linked, and debt financing arrangements. We cannot provide assurance that any additional financing will be available to us on acceptable terms or at all.Short-term restricted cash of $30.3 million as of December 31, 2020 reflects pledged cash deposited into savings accounts at the financial institutions that process our sellers' payments transactions and as collateral pursuant to an agreement with the originating bank for the Company's Square Capital loan product. We use the restricted cash to secure letters of credit with these financial institutions to provide collateral for liabilities arising from cash flow timing differences in the processing of these payments. We have recorded this amount as a current asset on our consolidated balance sheets given the short-term nature of these cash flow timing differences and that there is no minimum time frame during which the cash must remain restricted. Additionally, this balance includes certain amounts held as collateral pursuant to multi-year lease agreements, discussed in the paragraph below, which we expect to become unrestricted within the next year.Long-term restricted cash of $13.5 million as of December 31, 2020 is primarily related to cash deposited into money market funds that is used as collateral pursuant to multi-year lease agreements. The Company has recorded this amount as a non-current asset on the consolidated balance sheets as the lease terms extend beyond one year. We experience significant day-to-day fluctuations in our cash and cash equivalents, due to fluctuations in settlements receivable, and customers payable, and hence working capital. These fluctuations are primarily due to:•Timing of period end. For periods that end on a weekend or a bank holiday, our cash and cash equivalents, settlements receivable, and customers payable balances typically will be higher than for periods ending on a weekday, as we settle to our sellers for payment processing activity on business days; and72•Fluctuations in daily GPV. When daily GPV increases, our cash and cash equivalents, settlements receivable, and customers payable amounts increase. Typically our settlements receivable, and customers payable balances at period end represent one to four days of receivables and disbursements to be made in the subsequent period. Customers payable, excluding amounts attributable to Cash App stored funds, and settlements receivable balances typically move in tandem, as pay-out and pay-in largely occur on the same business day. However, customers payable balances will be greater in amount than settlements receivable balances due to the fact that a subset of funds are held due to unlinked bank accounts, risk holds, and chargebacks. Also, customer funds obligations, which are included in customers payable, may cause customers payable to trend differently than settlements receivable. Holidays and day-of-week may also cause significant volatility in daily GPV amounts.Cash Flow ActivitiesThe following table summarizes our cash flow activities (in thousands):Year Ended December 31,20202019Net cash provided by operating activities$381,603 $465,699 Net cash provided by (used in) investing activities:(606,636)95,193 Net cash provided by (used in) financing activities2,315,195 (98,874)Effect of foreign exchange rate on cash and cash equivalents12,995 3,841 Net increase in cash, cash equivalents and restricted cash$2,103,157 $465,859 Cash Flows from Operating ActivitiesCash provided by operating activities consisted of net loss adjusted for certain non-cash items including gain or loss on revaluation of equity investments, depreciation and amortization, non-cash interest and other expense, share-based compensation expense, transaction and loan losses, deferred income taxes, non-cash lease expense, gain on sale of asset group, as well as the effect of changes in operating assets and liabilities, including working capital.For the year ended December 31, 2020, cash provided by operating activities was $381.6 million, primarily due to a net income of $213.1 million, offset by PPP loans facilitated, less loans sold, of $420.8 million, adjusted for the add back of non-cash expenses of $509.4 million consisting primarily of share-based compensation, transaction and loan losses, depreciation and amortization, and non-cash interest and other expenses. Whereas the increase in transaction and loan losses was largely caused by estimated losses attributable to the COVID-19 pandemic, the increase in other non-cash expenses was primarily due to the growth and expansion of our business activities. Additionally, the cash generated from operating activities increased due to a net inflow from changes in other assets and liabilities of $79.9 million due to timing.For the year ended December 31, 2019, cash provided by operating activities was $465.7 million primarily due to a net income of $375.4 million, adjusted for the add back of non-cash expenses of $574.5 million consisting primarily of share-based compensation, transaction and loan losses, depreciation and amortization, and non-cash interest and other expenses largely driven by growth and expansion of our business activities, offset in part by the gain on sale of Caviar of $373.4 million in the fourth quarter. The cash generated from operating activities was negatively affected by a net outflow from changes in other assets and liabilities of $110.8 million.Cash Flows from Investing Activities Cash flows used in investing activities primarily relate to capital expenditures to support our growth, investments in marketable debt securities, investment in privately held entity, and business acquisitions.For the year ended December 31, 2020, cash used in investing activities was $606.6 million, primarily due to the net investments of marketable securities including investments from customer funds of $337.7 million. Additional uses of cash were as a result of the purchase of property and equipment of $138.4 million, business acquisitions, net of cash acquired of 73$79.2 million and purchases of other investments of $51.3 million.For the year ended December 31, 2019, cash provided by investing activities was $95.2 million, primarily as a result of the net cash proceeds from sale of asset group of $309.3 million related to the sale of the Caviar business and proceeds from sale of equity investment in Eventbrite of $33.0 million, offset in part by the net investments of marketable securities including investments from customer funds of $149.0 million. Additional uses of cash in investing activities were a result of purchases of property and equipment of $62.5 million, business combinations, net of cash acquired of $20.4 million, and other investments of $15.3 million.Cash Flows from Financing ActivitiesFor the year ended December 31, 2020, cash provided by financing activities was $2.3 billion, primarily as a result of $1.08 billion in net proceeds from the 2026 and 2027 Note offering, $936.5 million in net proceeds from the 2025 Note offering, proceeds from the First PPPLF Agreement advances of $464.1 million, proceeds from issuances of common stock from the exercise of options and purchases under our employee share purchase plan of $162.0 million, offset by payments for employee tax withholding related to vesting of restricted stock units of $314.0 million. For the year ended December 31, 2019, cash used in financing activities was $98.9 million, primarily as a result of payments for employee tax withholding related to vesting of restricted stock units of $212.3 million offset in part by proceeds from issuances of common stock from the exercise of options and purchases under the employee stock purchase plan, net of $118.5 million.Contractual Obligations and Commitments Our principal commitments consist of convertible senior notes, liquidity facility, operating leases, capital leases, and purchase commitments. The following table summarizes our commitments to settle contractual obligations in cash as of December 31, 2020.Payments due by periodTotalLess than 1 year1 - 3 years3 - 5 yearsMore than 5 years(in thousands)Convertible senior notes, including interest$3,044,046 $7,032 $880,733 $1,004,125 $1,152,156 PPP Liquidity Facility464,094 464,094 — — — Operating leases566,328 70,774 151,202 103,525 240,827 Finance leases— — — — — Purchase commitments40,695 40,695 — — — Total$4,115,163 $582,595 $1,031,935 $1,107,650 $1,392,983 Convertible Senior NotesOn November 13, 2020, we issued $1.15 billion in aggregate principal amount of 2026 and 2027 Notes that mature on May 1, 2026 and November 1, 2027, respectively, unless earlier converted or repurchased. The 2026 Notes bear no interest, whereas, the 2027 Notes bear interest at a rate of 0.25% payable semi-annually on May 1 and November 1 of each year. See Note 13, Indebtedness, of the Notes to the Consolidated Financial Statements for more details on this transaction. On March 5, 2020, we issued $1.0 billion in aggregate principal amount of 2025 Notes that mature on March 1, 2025, unless earlier converted or repurchased, and bear interest at a rate of 0.1250% payable semi-annually on March 1 and September 1 of each year. See Note 13, Indebtedness, of the Notes to the Consolidated Financial Statements for more details on this transaction. On May 25, 2018, we issued $862.5 million in aggregate principal amount of 2023 Notes that mature on May 15, 2023, unless earlier converted or repurchased, and bear interest at a rate of 0.50% payable semi-annually on May 15 and 74November 15 of each year. See Note 13, Indebtedness, of the Notes to the Consolidated Financial Statements for more details on this transaction. On March 6, 2017, we issued $440.0 million in aggregate principal amount of Notes that mature on March 1, 2022, unless earlier converted or repurchased, and bear interest at a rate of 0.375% payable semi-annually on March 1 and September 1 of each year. See Note 13, Indebtedness, of the Notes to the Consolidated Financial Statements for more details on this transaction. Paycheck Protection Program Liquidity FacilityOn June 2, 2020, we entered into the First PPPLF Agreement with the Federal Reserve Bank of San Francisco to secure additional credit in an aggregate principal amount of up to $500.0 million. Borrowings under the facility accrue interest at a rate of 0.35% and must be collateralized with loans originated under the PPP. On January 29, 2021, we entered into a second PPPLF agreement with the Federal Reserve Bank of San Francisco (“Second PPPLF Agreement” and together with the First PPPLF Agreement, “PPPLF Agreements”) to secure additional credit, collateralized by loans from the second round of the PPP program, in an aggregate principal amount of up to $1.0 billion under both PPPLF Agreements. The maturity date of any PPPLF advances will be the maturity date of the PPP loan pledged to secure the advance, and will be accelerated upon the occurrence of certain events of default. Although loans originated under the PPP have a stated maturity of between two and five years from origination, some of the loans may be forgiven 24 weeks after disbursement if they meet certain specified criteria. The PPPLF advances are also repayable if the underlying PPP loan is repaid by the customer. As of December 31, 2020, $464.1 million of PPPLF advances were outstanding. As of February 23, 2021, approximately $376.3 million of PPPLF advances were outstanding and collateralized by the same value of the PPP loans. See Note 13, Indebtedness, of the Notes to the Consolidated Financial Statements for more details on this transaction. Lease CommitmentsWe have entered into various non-cancelable operating leases for certain offices with contractual lease periods expiring between 2021 and 2034. We recognized total rental expenses under operating leases of $75.2 million, $32.5 million, and $23.3 million during the years ended December 31, 2020, 2019, and 2018, respectively.Purchase commitments We had non-cancelable purchase obligations to hardware suppliers for $40.7 million for the year ended December 31, 2020.Off-Balance Sheet ArrangementsWe do not have any off-balance sheet arrangements during the periods presented.Critical Accounting Policies and Estimates Our discussion and analysis of our financial condition and results of operations are based upon our financial statements, which have been prepared in accordance with GAAP. GAAP requires us to make certain estimates and judgments that affect the amounts reported in our financial statements. We base our estimates on historical experience, anticipated future trends, and other assumptions we believe to be reasonable under the circumstances. Because these accounting policies require significant judgment, our actual results may differ materially from our estimates.We believe accounting policies and the assumptions and estimates associated with transaction and loan losses, especially due to uncertainties associated with the COVID-19 pandemic, and revenue recognition have the greatest potential effect on our consolidated financial statements. Therefore, we consider these to be our critical accounting policies and estimates. Transaction LossesWe are exposed to transaction losses due to chargebacks as a result of fraud or uncollectibility of transaction payments. We estimate accrued transaction losses based on available data as of the reporting date, including expectations of future chargebacks, and historical trends related to loss rates that is continuously adjusted for new information and incorporates, where applicable, reasonable and supportable forecasts about future expectations. During the first and second 75quarters of 2020, the Company revised its estimates to reflect expected increased chargebacks from non-delivery of goods and services as well as increased failure rates of its sellers due to the COVID-19 pandemic. During the third and fourth quarters of 2020, the Company continued to further revise its estimates for transaction losses and as a result of better than expected performance, the Company released previously established risk loss provisions for the first three quarters of 2020 amounting to $82.4 million.Convertible NotesWe account for the convertible notes as separate debt and equity components. The carrying amount of the debt component is calculated by measuring the fair value of a similar debt that does not have an associated convertible feature. The carrying amount of the equity component representing the conversion option is calculated by deducting the fair value of the debt component from the principal amount of the convertible notes as a whole. We estimated the fair value of the debt and equity components using a convertible bond model, which includes subjective assumptions such as the expected term and expected volatility. These assumptions involve inherent uncertainties and management judgement.Recent Accounting PronouncementsSee “Recent Accounting Pronouncements” described in Note 1 of the Notes to our consolidated financial statements.ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKWe have operations both within the United States and globally, and we are exposed to market risks in the ordinary course of our business, including the effects of interest rate changes and foreign currency fluctuations. Information relating to quantitative and qualitative disclosures about these market risks is described below.Equity Price RiskMarketable Equity InvestmentsOur marketable equity investments are investments held in publicly traded companies and are measured using quoted prices in active markets which could result in material volatility in our net income in future periods. As of December 31, 2020, we had $376.3 million in marketable equity investments and recorded a gain of $276.3 million in the year ended December 31, 2020. A hypothetical 10% increase or decrease in the market price of our marketable investments as of December 31, 2020 would have resulted in approximately $37.6 million increase or decrease in the value of the investment. Adjustments are recorded in other expense (income), net on the consolidated statements of operations. Non-marketable Equity InvestmentsOur non-marketable equity investments are investments in privately-held companies that we hold for purposes other than trading. These investments are inherently risky because the markets for the technologies or products these companies are developing are typically in the early stages and we could lose our entire investment in these companies. Adjustments are recorded in other expense (income), net on the consolidated statements of operations and establish a new carrying value for the investment. As of December 31, 2020, the aggregate carrying value of our non-marketable equity investments included in other non-current assets was $32.5 million. A hypothetical 10% increase or decrease in the carrying value of our non-marketable equity investments would not have a material effect on our financial results.Interest Rate SensitivityOur cash and cash equivalents, and marketable debt securities as of December 31, 2020, were held primarily in cash deposits, money market funds, U.S. government and agency securities, commercial paper, and corporate bonds. The fair value of our cash, cash equivalents, and marketable debt securities would not be significantly affected by either an increase or decrease in interest rates due mainly to the short-term nature of a majority of these instruments. Additionally, we have the ability to hold these instruments until maturity if necessary to reduce our risk. Any future borrowings incurred under our credit facility would accrue interest at a floating rate based on a formula tied to certain market rates at the time of incurrence 76(as described above). A hypothetical 100 basis point increase or decrease in interest rates would not have a material effect on our financial results.Foreign Currency RiskMost of our revenue is earned in U.S. dollars, and therefore our revenue is not currently subject to significant foreign currency risk. Our foreign operations are denominated in the currencies of the countries in which our operations are located, and may be subject to fluctuations due to changes in foreign currency exchange rates, particularly changes in the Japanese Yen, Canadian Dollar, Australian Dollar, Euro, and British Pound. Fluctuations in foreign currency exchange rates may cause us to recognize transaction gains and losses in our statement of operations. A 10% increase or decrease in current exchange rates would not have a material impact on our financial results.77
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+Item 7. Management's Discussion and Analysis of Results of Operations and Financial Condition.Recent DevelopmentsOn January 4, 2021, we announced together with FLIR Systems, Inc. (“FLIR”) that the companies have entered into a definitive merger agreement under which we will acquire FLIR in a cash and stock transaction valued at approximately $8.0 billion. Under the terms of the merger agreement, FLIR stockholders will receive $28.00 per share in cash and 0.0718 shares of our common stock for each FLIR share, which implies a total purchase price of approximately $56.00 per FLIR share based on the 5-day volume weighted average price of our stock as of December 31, 2020.The transaction is expected to close in the middle of 2021 subject to the receipt of required regulatory approvals, including expiration or termination of the applicable waiting period under the Hart-Scott-Rodino Antitrust Improvements Act (the “HSR Act”) approvals of our stockholders and FLIR stockholders and other customary closing conditions.Our Business SegmentsOur businesses are aligned in four segments: Instrumentation, Digital Imaging, Aerospace and Defense Electronics and Engineered Systems. Financial information about our business segments can be found in Note 12 of the Notes to Consolidated Financial Statements in this Annual Report on Form 10-K for the fiscal year ended January 3, 2021 (this “Form 10-K”).Instrumentation SegmentOur Instrumentation segment provides monitoring and control instruments for marine, environmental, industrial and other applications, and electronic test and measurement equipment. We also provide power and communications connectivity devices for distributed instrumentation systems and sensor networks deployed in mission critical, harsh environments.Our Instrumentation segment represented approximately 35% of our sales for 2020. Below is a description of the product lines that comprise the Instrumentation segment.Marine InstrumentationWe offer a variety of products designed for use in harsh underwater environments, instruments that measure currents and other physical properties in the water column, systems that create acoustic images of objects beneath the water’s surface, including the bottom of a body of water, and sensors that determine the geologic structure below the bottom. We also design and manufacture vehicles that utilize and transport these sensors over and beneath the water’s surface.We provide a broad range of end-to-end undersea interconnect solutions to the offshore oil and gas, naval defense, oceanographic and telecom markets. We manufacture subsea, wet-mateable electrical and fiber-optic interconnect systems and subsea pressure vessel penetrators and connector systems with glass-to-metal seals. Our waterproof and splash-proof neoprene and glass reinforced epoxy connectors and cable assemblies are used in underwater equipment, submerged monitoring systems and other industrial applications. Other marine products used by the U.S. Navy and commercial customers include acoustic modems for networked underwater communication and optical underwater cameras and LED lighting sources.We manufacture complete autonomous-operated underwater vehicles systems. Glider applications range from oceanographic research to persistent surveillance systems for the U.S. Navy. We also design and manufacture remotely operated underwater vehicles used in maritime security, military, search and rescue, aquaculture, and scientific research applications.1Table of ContentsEnvironmental InstrumentationWe offer a wide range of products used for environmental monitoring. Our instrumentation monitors trace levels of gases such as sulfur dioxide, carbon monoxide, oxides of nitrogen and ozone, as well as particulate pollution, in order to measure the quality of the air we breathe. We also supply monitoring systems for the detection, measurement and automated reporting of air pollutants from industrial stack emissions, ozone generators and other process gas monitoring instruments. Our instrumentation is used to detect a variety of water quality parameters and in applications found in petrochemical and refinery facilities.We also manufacture and provide complementary laboratory instrumentation including through laboratory automation and sample introduction systems which automates the preparation and concentration of organic samples. Our advanced elemental analysis products are used by environmental and quality control laboratories to detect trace levels of inorganic contaminants in water, foods, soils and other environmental and geological samples. We manufacture high-precision pumps utilized in a wide variety of analytical, research clinical, preparative and fluid-metering applications. In addition, we manufacture liquid chromatography instruments and accessories for the purification of organic compounds, which include highly sensitive evaporative light scanning detectors, primarily for pharmaceutical laboratories involved in drug discovery and development. Finally, we manufacture instruments that are used by pharmaceutical scientists to evaluate the release rate characteristics and physical properties of various dosage forms to ensure the safety and efficacy of medicines worldwide.Test and Measurement InstrumentationWe believe our test and measurement products provide unique, world-class capabilities that enable the designers of complex electronic systems in many industry sectors to bring their products to market reliably and quickly. Our customers use our equipment in the design, development, manufacture, installation, deployment and operation of electronics equipment in broad range of industry end markets, including aerospace and defense, internet infrastructure, automotive, industrial, computer and semiconductor, consumer electronics and power electronics.We develop, manufacture, sell and license high-performance oscilloscopes, high-speed protocol analyzers, and relatedtest and measurement solutions for a wide range of industries. Our oscilloscopes are used by designers and engineers to measure and analyze complex electronic signals to develop high-performance systems, validate electronic designs, and improve time to market. We also make high-speed, high-resolution modular analog-to-digital conversion systems for applications including test and measurement, medical imaging, Light Detection and Ranging, and software defined radio.Design and test engineers use our protocol analysis solutions to monitor accurately and reliably high data-rate communication interfaces and diagnose operational problems in a wide range of systems and devices to ensure that they comply with industry standards, including the area of cloud computing and networks. Our product lines, along with our leadership in USB technology, provide a unique base to service the mobile, internet of things, automotive and consumer electronics test market. Our most recent acquisition of OakGate Technology, Inc. (“OakGate”) during 2020 provides protocol validation and test tools for disk drives, both spinning and solid state, and servers used for cloud-based storage.We also manufacture torque sensors and automatic data acquisition systems that are used to test critical control valves in nuclear power and industrial plants. Our torque sensors are also used in other markets, including automotive and power tools.Digital Imaging SegmentOur Digital Imaging segment includes high-performance sensors, cameras and systems, within the visible, infrared, ultraviolet and X-ray spectra for use in industrial, scientific, government, defense and security and medical applications, among others. We also produce and provide manufacturing services for micro electromechanical systems (“MEMS”) and high-performance, high-reliability semiconductors including analog-to-digital and digital-to-analog converters. This segment also includes our sponsored and centralized research laboratories. Our Digital Imaging segment represented approximately 32% of our sales for 2020.Through this segment, we design, develop and manufacture image sensors and digital cameras for use in industrial, scientific, academic research and medical applications and hardware and software for image processing and automatic data collection in industrial, academic research and medical applications. We also develop high-resolution, low-dose X-Ray sensors for medical, dental and industrial applications.We provide research and engineering capabilities primarily in the areas of electronics, materials, optical systems, and information science to military, aerospace and industrial customers, as well as to various businesses throughout Teledyne. We receive funding from the Defense Advanced Research Products Agency and various other U.S. Department of Defense funding agencies, and we collaborate with researchers at universities and national laboratories to stay at the forefront of emerging technologies. Through our 2019 acquisition of the scientific imaging businesses of Roper Technologies, Inc., we manufacture state-of-the-art cameras, spectrographs and optics for advanced research in physical sciences, life sciences research and spectroscopy imaging for applications and markets that include materials analysis, quantum technology and cell biology imaging using fluorescence and chemiluminescence. 2Table of ContentsAerospace and Defense Electronics SegmentOur Aerospace and Defense Electronics segment provides sophisticated electronic components and subsystems, data acquisition and communications components and equipment, harsh environment interconnects, general aviation batteries and other components for a variety of commercial and defense applications that require high performance and high reliability. Such applications include aircraft, radar, electronic warfare, weapon systems, space, wireless and satellite communications and terminals and test equipment. Our Aerospace and Defense Electronics segment represented approximately 19% of our sales for 2020.We provide onboard avionics systems and ground-based applications that allow civil and military aircraft software operators to access, manage and utilize their data more efficiently. Our products include aircraft data and connectivity solutions, hardware systems, and software applications used by commercial airlines and the U.S. military, and we provide services related to our products. Engineered Systems SegmentOur Engineered Systems segment provides innovative systems engineering, integration and advanced technology development, and complex manufacturing solutions for defense, space, environmental and energy applications. This segment also designs and manufactures electrochemical energy systems and manufactures specialty electronics for demanding military applications.Our Engineered Systems segment represented approximately 14% of our sales for 2020.Our core business base, includes NASA, the U.S. Department of Defense, the U.S. Department of Energy, foreign militaries and commercial customers.CustomersWe have a large number of customers in the various industries we serve. No commercial customer in 2020 or 2019 accounted for more than 3.0% of total net sales or more than 10% of any segments net sales.Sales to international customers accounted for approximately 45% of total sales in 2020 compared with 44% in 2019. In both 2020 and 2019, we sold products to customers in over 100 foreign countries. Approximately 90% of our sales to international customers during 2020 were made to customers in 22 foreign countries. In 2020, the top five countries for sales to international customers, ranked by sales, volume were China, the United Kingdom, Germany, Japan and France and represented approximately 20% of our total net sales.Approximately 26% and 24% of our total net sales for 2020 and 2019, respectively, were derived from contracts with agencies of, and prime contractors to, the U.S. Government. Information on our sales to the U.S. Government, including direct sales as a prime contractor and indirect sales as a subcontractor, is as follows (in millions):U.S. Government sales by segment: 202020192018Instrumentation $80.6 $80.4 $68.3 Digital Imaging 120.9 107.4 90.5 Aerospace and Defense Electronics 229.9 225.3 177.2 Engineered Systems 386.8 346.7 319.3 Total U.S. Government sales $818.2 $759.8 $655.3 Our principal U.S. Government customer is the U.S. Department of Defense, which totaled approximately $578.4 million and $545.5 million of our total net sales for 2020 and 2019, respectively. In 2020 and 2019, our largest program with the U.S. Government was the Mission Operations and Integration contract with the NASA Marshall Space Flight Center, which represented 1.5% and 1.4% of our total net sales, respectively. As described in greater detail under Item 1A. Risk Factors of this Form 10-K, there are risks associated with doing business with the U.S. Government. In 2020, approximately 67% of our U.S. Government prime contracts and subcontracts were fixed-price type contracts, compared to 64% in 2019. Under these types of contracts, we bear the inherent risk that actual performance cost may exceed the fixed contract price. Such contracts are typically not subject to renegotiation of profits if we fail to anticipate technical problems, estimate costs accurately or control costs during performance. Additionally, U.S. Government contracts are subject to termination by the U.S. Government at its convenience, without identification of any default. When contracts are terminated for convenience, we recover costs incurred or committed, settlement expenses and profit on work completed prior to termination. We had no U.S. Government contracts terminated for convenience in 2020, compared with three in 2019.Many of our government contracts are awarded after a competitive bidding process in which we seek to emphasize our ability to provide superior products and technical solutions in addition to competitive pricing.Our total backlog of confirmed and funded orders was approximately $1,700.2 million at January 3, 2021, compared with $1,699.3 million at December 29, 2019. We expect to fulfill more than 77% of such backlog of confirmed orders during 2021. 3Table of ContentsRaw Materials and SuppliersGenerally, our businesses have experienced minimal fluctuations in the supply of raw materials, but not without some price volatility. While some of our businesses provide services, for those businesses that sell hardware and product, a portion of the value that we provide is labor-oriented, such as design, engineering, assembly and test activities. In manufacturing our products, we use our own production capabilities and third-party suppliers and subcontractors, including international sources. Some of the items we use for the manufacture of our products, including certain components for particular marine navigation applications, certain magnets and helix wire for our traveling wave tubes, certain infrared detectors substrates and certain ceramics and molding compounds used in our sonar systems, as well as certain scintillator materials used in the production of our X-Ray detectors, are purchased from limited or single sources, including international sources, due to technical capability, price and other factors. At times we have experienced difficulty in procuring raw materials, components, sub-assemblies and other supplies required in our manufacturing processes due to shortages and supplier-imposed allocation of components. We did not experience significant difficulty in obtaining raw materials and/or other supplies during 2020.MarketingOur sales and marketing approach varies by segment and by products within our segments. A shared fundamental tenet is the commitment to work closely with our customers to understand their needs, with an aim to secure preferred supplier and longer-term relationships. Given the technical nature of our products, we conduct our domestic and international marketingactivities through a direct internal sales force, as well as third-party sales representatives and distributors, both in the UnitedStates and in other countries.CompetitionBecause of the diversity of products sold and the number of markets we serve, we encounter a wide variety ofcompetitors, none of which we believe offer the same product and service lines or serve all of the same markets as we do. Although we have certain advantages that we believe help us compete effectively in our markets, each of our markets is highly competitive. With regard to our defense businesses, it is common in the defense industry for work on programs to be shared among several companies, including competitors. Our businesses vigorously compete on quality, product performance and reliability, technical expertise, price and service. Many of our competitors have, and potential competitors could have, greater name recognition, a larger installed base of products, more extensive engineering, manufacturing, marketing and distribution capabilities and greater financial, technological and personnel resources than we do.Intellectual PropertyWe own and control various intellectual property rights, including patents, trade secrets, confidential information, trademarks, trade names, and copyrights. We are licensed to use certain patents, technology and other intellectual property rights owned and controlled by others. Similarly, other companies are licensed to use certain patents, technology and other intellectual property rights owned and controlled by us. We do not consider any single patent or trademark, or any groupof them, essential either to Teledyne’s business as a whole or to any one of our reportable segments. The annual royaltiesreceived or paid under license agreements are not significant to any of our reportable segments or to Teledyne’s overalloperations.Patents, patent applications and license agreements will expire or terminate over time by operation of law, in accordance with their terms or otherwise. We do not expect the expiration or termination of these patents, patent applications and license agreements to have a material adverse effect on our business, results of operations or financial condition.Environment and Other Government RegulationsInformation with respect to environmental matters is set forth under “Other Matters – Environmental” of “Item 7. Management’s Discussion and Analysis of Results of Operation and Financial Condition” and Note 14 of the Notes to Consolidated Financial Statements in this Form 10-K. No material capital expenditures relating to environmental or other government regulatory compliance are presently anticipated.SustainabilityTeledyne continues to focus on developing solutions to address sustainability and climate challenges facing humanity today. Many of our products directly support sustainability and climate challenges. We provide a broad range of precision measurement technologies for environmental monitoring and climate research. Our sensors and instruments are deployed everywhere, from pole to pole, in space, on aircraft and drones, on land, on the sea surface, in the water column, and on the seafloor. They operate around the clock, measuring greenhouse gases from space, precisely monitoring air and water quality throughout the world, and continuously profiling all of Earth’s oceans. Applications of our instruments provide scientists information that spans time from the origin of the universe to providing real-time data regarding air pollution and dangerous storms, such as time-critical warning of hurricanes and tsunamis.4Table of ContentsBoard OversightPursuant to the mandate in their respective charters, the Audit Committee of our Board of Directors (the “Board”) regularly reviews matters related to compliance with environmental laws and the health and safety of employees, and the Nominating and Governance Committee of our Board reviews and evaluates our policies and practices and monitors our efforts in areas of legal and social responsibility, diversity and sustainability.Human CapitalWe consider our relations with our employees to be good. At January 3, 2021, our total workforce consisted of approximately 10,670 employees in more than 25 countries. Workforce demographics for various regions are provided below: GenderPercent to Total EmployeesAverage AgeAverage Years of ServiceMaleFemaleNot SpecifiedAmericas72%49.111.459%34%7%Europe, the Middle East and Africa26%44.911.356%22%22%Asia-Pacific Region2%42.47.642%20%38%Employees are vital to the success of our innovation-driven growth strategy. We are focused on effective attraction, development, and retention of employees through competitive compensation and benefits, workforce and management development, diversity and inclusion initiatives, succession planning, corporate culture and leadership quality. We have a stable and long-tenured workforce. In 2020, our average voluntary employee turnover (excluding reductions in force) was approximately 9%. As of January 3, 2021, the average years of service of our employees was approximately 11 years.We are committed to identifying and developing the talents of our next generation of leaders. On an annual basis, we conduct an organization and leadership review with our Executive Chairman and President and Chief Executive Officer for all segment, business unit, and function leaders, focusing on our high performing and high potential talent, diversity and succession for our most critical roles. From this review, individualized development and retention programs are implemented or revised as needed. With the oversight of our Senior Vice President, General Counsel, Chief Compliance Officer, and Secretary and our Vice President of Human Resources, our Equality, Diversity and Inclusion Committee has piloted an anonymized resume review process to evaluate the potential for name bias when reviewing potential candidates, expanded recruitment sources, and enhanced diversity training and awareness. Available InformationTeledyne’s website is www.teledyne.com. We make available on our website, free of charge, annualreports on Form 10-K, quarterly reports on Form 10-Q, and current reports on Form 8-K pursuant to Section 13(a) or Section 15(d) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”) as soon as reasonably practicable after we electronically file or furnish such material to the U.S. Securities and Exchange Commission (the “SEC”) at www.sec.gov. We will provide, free of charge, a paper copy of any report we file with the SEC (without exhibits) upon written request to Melanie S. Cibik, Senior Vice President, General Counsel, Chief Compliance Officer and Secretary, at Teledyne Technologies Incorporated, 1049 Camino Dos Rios, Thousand Oaks, California 91360-2362. Item 1A.Risk FactorsRisk Factors; Cautionary Statement as to Forward-Looking StatementsThe following discussion sets forth the material risk factors that could affect Teledyne’s financial condition andoperations. You should not consider any descriptions of these factors to be a complete set of all potential risks that could affectTeledyne. Any of the risk factors discussed below could by itself, or combined with other factors, materially and adversely affect our business, results of operations, financial condition, competitive position or reputation, including materially increasing expenses or decreasing revenues, which could result in material losses or a decrease in earnings.Risks related to the pending acquisition of FLIROn January 4, 2021, we announced our proposed acquisition of FLIR in a cash and stock transaction valued at approximately $8.0 billion (including net debt), which would make the acquisition our largest to date. FLIR designs, develops, manufactures, markets, and distributes technologies that enhance perception and awareness. FLIR provides innovative sensing solutions through thermal imaging, visible-light imaging, video analytics, measurement and diagnostic, and advanced threat detection systems. FLIR offers a diversified portfolio that serves a number of applications in government and defense, industrial, and commercial markets. FLIR, headquartered in Wilsonville, Oregon, will be part of the Digital Imaging segment.5Table of ContentsWhile many of the products made and markets served by FLIR are complementary to Teledyne, the acquisition of FLIR would expand the size of our Digital Imaging segment relative to our other segments. Continued innovation and research and development efforts will be required to maintain FLIR’s leadership position in imaging products. There are numerous risk and uncertainties associated with the acquisition, including:•Completion of the acquisition is subject to a number of conditions, some of which are outside of our control, and if any of these conditions are not satisfied or waived, the acquisition will not be completed. Among these conditions are the approval by FLIR’s stockholders of the acquisition, the approval by our stockholders of the issuance of Teledyne stock in the acquisition and the receipt of certain regulatory approvals, including the expiration or termination of any applicable waiting period (and any extension thereof) under the HSR Act and under the antitrust laws of certain non-U.S. jurisdictions.•Teledyne’s and FLIR’s existing business relationships with third parties may be disrupted due to uncertainty associated with the acquisition, which could have an adverse effect on the results of operations, cash flows and financial position of the combined company.•Failure to complete the acquisition could negatively impact our stock price and our future business and financial results.•The merger agreement between Teledyne and FLIR subjects us to restrictions on our activities, such as certain equity issuances during the period while the acquisition is pending.•After the acquisition, as a result of the issuance of Teledyne stock in the acquisition to the holders of FLIR stock, Teledyne stockholders will have lower ownership and voting interests in Teledyne than they currently have and will exercise less influence over management.•Litigation challenging the acquisition may increase costs and prevent the acquisition from being completed within the expected timeframe, or from being completed at all. •Both we and FLIR will incur significant transaction costs in connection with the acquisition.•Unplanned future events and conditions could reduce or delay the accretion to earnings that is currently projected by us in connection with the acquisition.•Pursuant to the merger agreement we may be required, under certain circumstances related to the termination of the merger agreement, to pay a termination fee to FLIR of $250.0 million, which, if paid, may materially and adversely affect our financial results.•We intend to pay the cash portion of the consideration for the acquisition, refinance certain existing indebtedness of us and FLIR, and pay other fees and expenses required to be paid in connection with the acquisition from cash on hand and borrowings. There can be no assurance that we will be able to secure the funds necessary to pay the cash portion of the merger consideration in connection with the acquisition and refinance certain existing indebtedness on acceptable terms, in a timely manner or at all. •The COVID-19 pandemic may delay or prevent the completion of the acquisition.•After completion of the acquisition, we may fail to realize the anticipated benefits and cost savings of the transaction, which could adversely affect the value of our common stock.•The future results of the combined company may be adversely impacted if we do not effectively manage our expanded operations following completion of the acquisition.•Both Teledyne and FLIR may have difficulty retaining, motivating, and attracting executives and other employees in light of the pending acquisition, including those experienced with post-acquisition integration, and failure to do so could seriously harm the combined company.•The effects of the COVID-19 pandemic could adversely affect the business, results of operations and financial condition of Teledyne, FLIR and the combined company following the completion of the acquisition.•The market price of our common stock may decline as a result of the acquisition if, among other things, the combined company does not achieve the perceived benefits of the acquisition as rapidly or to the extent anticipated by financial or industry analysts, or if the effect of the acquisition on the combined company’s financial results is not consistent with the expectations of financial or industry analysts.Risks related to the indebtedness expected to be incurred in connection with the FLIR acquisitionThe incurrence by us of substantial indebtedness in connection with the financing of the acquisition, along with the planned assumption of FLIR’s existing senior notes may have an adverse impact on our liquidity, limit our flexibility in responding to other business opportunities and increase our vulnerability to adverse economic and industry conditions.Teledyne expects to incur a significant amount of indebtedness in connection with the financing of the FLIR acquisition, which we expect will be funded using borrowings along with cash on hand. We may also incur additional indebtedness through the planned assumption of FLIR’s existing senior notes. The use of indebtedness to finance the acquisition will reduce our liquidity and could cause us to place more reliance on cash generated from operations to pay principal and interest on our debt, thereby reducing the availability of our cash flow for working capital and capital expenditure 6Table of Contentsneeds or to pursue other potential strategic plans. We expect that the agreements we will enter into with respect to the indebtedness we will incur to finance the acquisition or in connection with the planned assumption of FLIR’s existing senior notes will contain negative covenants, that, subject to certain exceptions, will include limitations on indebtedness, liens, dispositions, investments and mergers and other fundamental changes. Our ability to comply with these negative covenants can be affected by events beyond our control. The indebtedness and these negative covenants will also have the effect, among other things, of limiting our ability to obtain additional financing, if needed, limiting our flexibility in the conduct of our business and making us more vulnerable to economic downturns and adverse competitive and industry conditions. In addition, a breach of the negative covenants could result in an event of default with respect to the indebtedness, which, if not cured or waived, could result in the indebtedness becoming immediately due and payable and could have a material adverse effect on our business, financial condition or operating results.Following completion of the acquisition, the credit rating of the combined company could be downgraded and/or the combined company may fail to obtain an investment grade rating, which may increase borrowing costs or could trigger an obligation to make an offer to purchase FLIR’s $500 million senior notes.By reason of the debt incurred to finance the cash portion of the consideration for the acquisition, the combined company will have a considerably higher level of indebtedness than we and FLIR currently have in the aggregate, and there can be no assurance that the credit ratings of the existing FLIR debt will not be subject to a downgrade below investment grade. If a ratings downgrade were to occur or if the combined company fails to obtain an investment grade rating, the combined company could experience higher borrowing costs in the future and more restrictive debt covenants, which would reduce profitability and diminish operational flexibility. Specifically, in the event that FLIR’s existing senior notes are downgraded below investment grade as a result of the acquisition, the terms of these notes will require the combined company to commence a change of control offer after the closing of the acquisition. Because of higher debt levels, we may not be able to service our debt obligations in accordance with the terms contained in the agreements.Our ability to meet our expense and debt service obligations contained in the agreements we expect to enter into with respect to the indebtedness we will incur to finance the acquisition will depend on our available cash and its future performance, which will be affected by financial, business, economic and other factors, including potential changes in laws or regulations, industry conditions, industry supply and demand balance, customer preferences, the success of our products and pressure from competitors. If we are unable to meet our debt service obligations after the acquisition or should we fail to comply with our financial and other negative covenants contained in the agreements governing our indebtedness, we may be required to refinance all or part of our debt, sell important strategic assets at unfavorable prices, incur additional indebtedness or issue common stock or other equity securities. We may not be able to, at any given time, refinance our debt, sell assets, incur additional indebtedness or issue equity securities on terms acceptable to us, in amounts sufficient to meet our needs. If we are able to raise additional funds through the issuance of equity securities, such issuance would also result in dilution to our stockholders. Our inability to service our obligations or refinance our debt could have a material and adverse effect on our business, financial condition or operating results after the acquisition. In addition, our debt obligations may limit our ability to make required investments in capacity, technology or other areas of our business, which could have a material adverse effect on our business, financial condition or operating results.Risks Related to Our Business and IndustryAcquisitions involve inherent risks that may adversely affect our operating results and financial condition.Our growth strategy includes acquisitions. In 2020 and 2019, we expended $29.0 million and $484.0 million in cash, respectively, relating to acquisitions and other investments. Acquisitions involve various inherent risks, such as:•our ability to assess accurately the value, strengths, weaknesses, internal controls, contingent and other liabilities and potential profitability of acquisition candidates;•difficulties in integrating acquired businesses, including the potential loss of key personnel from an acquired business, our potential inability to achieve identified financial, operating and other synergies anticipated to result from an acquisition, and integration issues associated with internal controls of acquired businesses;•the diversion of management’s attention from our existing businesses;•the potential impairment of assets;•potential unknown liabilities associated with a business that we acquire or in which we invest, including environmental liabilities; and•production delays associated with consolidating acquired facilities and manufacturing operations.While we conduct financial and other due diligence in connection with our acquisitions and generally seek some form of protection, such as indemnification from the seller, insurance coverage, and sometimes placing a portion of the purchase price in escrow to cover potential liabilities, such acquired companies may have weaknesses or liabilities that are not accurately assessed or brought to our attention at the time of the acquisition. Further, indemnities, insurance or escrow arrangements may not fully cover such matters.7Table of ContentsIn connection with our acquisitions, including those acquisitions that we do not complete, we may incur significant transaction costs. We are required to expense, as incurred, such transaction costs, which may have a material adverse impact on our financial results.Our indebtedness, and any failure to comply with our covenants that apply to our indebtedness, could materially and adversely affect our business.As of January 3, 2021, we had $778.5 million total outstanding indebtedness, including $195.0 million in senior unsecured fixed rate notes, $305.3 million in Euro denominated fixed rate notes, $150.0 million in term loans and $125.0 million outstanding under our $750.0 million floating rate credit facility. Our indebtedness or a failure to comply with our covenants that apply to our indebtedness could harm our business by, among other things, reducing the funds available to make acquisitions, capital expenditures, or reducing our flexibility in planning for or reacting to changes in our business or market conditions. Our indebtedness exposes us to interest rate risk since a portion of our debt obligations are at variable rates. Our indebtedness or a failure to comply with our covenants that apply to our indebtedness could also have a material adverse effect on our business by increasing our vulnerability to general adverse economic and industry conditions or a downturn in our business. General adverse economic and industry conditions or a downturn in our business could result in our inability to repay this indebtedness in a timely manner.Further, the Financial Conduct Authority (the authority that regulates the London Interbank Offered Rate, or LIBOR) has announced that it intends to stop compelling banks to submit rates for the calculation of LIBOR after 2021. The Alternative Reference Rates Committee (“ARRC”) has proposed that the Secured Overnight Financing Rate (“SOFR”) is the rate that represents best practice as the alternative to USD-LIBOR for use in debt instruments, derivatives and other financial contracts that are currently indexed to USD-LIBOR. ARRC has proposed a paced market transition plan to SOFR from USD-LIBOR and organizations are currently working on industry wide and company specific transition plans as it relates to derivatives, debt and cash markets exposed to USD-LIBOR. It is unclear as to what the new method of calculating LIBOR that may evolve and this new method could adversely affect the Company’s interest rates on the Company’s indebtedness. The Company is monitoring the ARRC transition plan and is evaluating potential related risks. As of January 3, 2021, approximately 35.3% of the Company’s long-term debt is variable and can be indexed to USD-LIBOR. Our $750.0 million credit facility includes a procedure to switch to LIBOR alternative replacement rates in the future. Escalating global trade tensions and the adoption or expansion of tariffs and trade restrictions could negatively impact us. The Company has operations in China, which represented one of the top five countries for our international sales in 2020 and 2019. Any tariffs or other trade restrictions affecting the import of products from China or any retaliatory trade measures taken by China in response to existing or future tariffs could have a material adverse effect on our results of operations.Starting in 2018, the U.S. Government imposed tariffs on a wide range of goods imported from China and China has retaliated by placing tariffs on various U.S. origin goods. While both countries signed a preliminary trade agreement in January 2020 halting further tariffs and increasing sales of U.S. goods to China, the agreement leaves in place most tariffs on Chinese goods. The final outcome of the negotiations and agreements is not possible to predict. Further escalation of the “trade war” between the U.S. and China, or the countries’ inability to reach further trade agreements, could result in continued or increased tariffs. High tariffs generally increase the cost of materials for our products, which could result in our products becoming less competitive or generating lower margins. With high tariffs imposed on our products, we may also need to find new suppliers and components for our products, which could result in production delays. To the extent our products are the subject of retaliatory tariffs, customers in some countries or regions, such as China, may begin to seek domestic or non-U.S. sources for products that we sell, or be pressured or incentivized by foreign governments not to purchase U.S.-origin goods, which could harm our future sales in these markets. Additionally, if China bolsters laws or regulations requiring the use of local China suppliers, it could have a negative impact on Teledyne’s revenues.Additionally, a number of well-established customers and suppliers have become listed on Government restricted party lists without much warning. In particular, U.S. export enforcement agencies have placed several Chinese and Russian companies and many of their international subsidiaries on such lists, prohibiting the export of most commercial and dual-use items subject to the Export Administration Regulations. Multiple Teledyne companies had large pending orders with some of those companies that had to be either cancelled or for which Teledyne has submitted export license applications that have a low probability of approval. For example, Huawei Technologies, Co., Ltd. (“Huawei”), and its non-U.S. affiliates have been added to the U.S. Department of Commerce Bureau of Industry and Security Entity list. Huawei was a customer of our test and measurement business, and pending export license applications have not yet been approved. The U.S. Government has also made efforts to increase restrictions on some of the listed entities, including proposals to expand U.S. export jurisdiction over foreign made products containing certain U.S.-origin materials. In 2020, the U.S. Government applied restrictions to products sold to Huawei where there was no U.S. content in the products, but certain equipment used to manufacture the products had U.S. origins. Additionally, we face the risk that Airbus, a customer to our commercial aerospace business, will demonstrate a preference for non-U.S. sources due to the complications and uncertainties of trade compliance. While we will continue to work to mitigate the impact of tariffs and trade restrictions, they could result in revenue reduction, price increases on material 8Table of Contentsused in our products or production delays, which could adversely affect our business, financial condition, operational results and cash flows.A material amount of our total revenues is derived from companies in the oil and gas industry, especially the offshore oil and gas industry, a historically cyclical industry with levels of activity that are significantly affected by the levels and volatility of oil and gas prices.A material amount of our total revenues is derived from companies in or connected to oil and gas exploration, development and production, especially the offshore oil and gas industry. The oil and gas industry has historically been cyclical and characterized by significant changes in the levels of exploration and development activities. Oil and gas prices, and market expectations of potential changes in those prices, significantly affect the levels of those activities. Any prolonged reduction in the overall level of offshore oil and gas exploration and development activities, whether resulting from changes in oil and gas prices or otherwise, could materially and adversely affect our financial condition and the results of our businesses within our Instrumentation segment.Some factors that have affected and are likely to continue affecting oil and gas prices and the level of demand for our products and services include the following:•worldwide demand for oil and gas;•general economic and business conditions and industry trends;•the ability of the Organization of Petroleum Exporting Countries (“OPEC”), to set and maintain production levels;•the level of production by non-OPEC countries;•the ability of oil and gas companies to generate or raise funds for capital expenditures;•domestic and foreign tax policy;•laws and governmental regulations that restrict exploration and development of oil and gas in various offshore jurisdictions;•laws and governmental regulation that restrict the use of hydraulic fracturing;•technological changes;•the political environment of oil-producing regions;•the price and availability of alternative fuels; and•climate change regulations that provide incentives to conserve energy or use alternative energy sources.Teledyne manufactures seismic energy sources, interconnects and data acquisition products that are used in offshore energy exploration. When crude oil and natural gas prices are low, the level of marine seismic exploration activity typically decreases, potentially resulting in reduced demand for our products used in offshore energy exploration. In addition, a decline in the level of capital spending by oil and natural gas companies may result in a reduced rate of development of new energy reserves, which could adversely affect demand for our products related to energy production, and, in certain instances, result in the cancellation, modification or rescheduling of existing orders and a reduction in customer-funded research and development related to next generation products. Recession, financial and credit market disruptions, or an economic downturn in China, may adversely affect us.If another global recession emerges, if economic uncertainty in Europe continues or worsens, or if economic growth in China slows, we may experience declines in revenues, profitability and cash flows from reduced orders, payment delays, collection difficulties, increased price pressures for our products, increased risk of excess and obsolete inventories or other factors caused by the economic problems of our customers. Our sales to China-based customers represented approximately 6.0% and 6.6% of total revenues in 2020 and 2019, respectively. Economic growth in China had slowed due to the COVID-19 pandemic. Continued growth in many of our businesses, including those in our Environmental Instrumentation group, could be negatively impacted if another economic downturn occurs in China. The COVID-19 pandemic has increased volatility and pricing in the capital markets. If negative conditions in the global credit markets prevent our customers from having access to credit or render them insolvent, orders for our products may decrease, which would result in lower revenue. Likewise, if our suppliers face challenges in obtaining credit, in selling their products, or otherwise in operating their businesses or remaining solvent, they may become unable to offer the materials we use to manufacture our products. An economic or credit crisis could also impact our ability to raise capital when needed. These events could adversely impact our ability to manufacture affected products and could also result in reductions in our revenue, increased price competition, and increased operating costs, which could adversely affect our business, financial condition, operational results, and cash flows.We develop and manufacture products for customers in the energy exploration and production markets, domestic and international commercial aerospace markets, the semiconductor industry, and the consumer electronics, telecommunications and automotive industries; each of which has been cyclical, exhibited rapid changes and suffered from fluctuating market demands. A cyclical downturn in these markets may materially affect future operating results. Due to declines in air travel, we face risk that our addressable market for retrofit products will shrink further as airlines retire significant number of aircraft.In addition, we sell products and services to customers in industries that are sensitive to the level of general economic activity and consumer spending habits and to customers in more mature industries that are sensitive to capacity constraints. Adverse economic conditions affecting these industries may reduce demand for our products and services, which may reduce our revenues, profits or production levels. Some of our businesses serve industries such as power generation and petrochemical 9Table of Contentsrefining, which may be negatively impacted in the event of future reductions in global capital expenditures and manufacturing capacity.We are subject to the risks associated with international sales and international operations, which could harm our business or results of operations.During 2020, sales to international customers accounted for approximately 45% of our total revenues, compared with 44% in 2019. In 2020, we sold products to customers in over 100 countries. In 2020, the top five countries for international sales were China, Germany, the United Kingdom, Japan and France, constituting approximately 20% of our total sales. We anticipate that future sales to international customers will continue to account for a significant and increasing percentage of our revenues, particularly since business and growth plans for many Teledyne businesses focus on sales outside of the United States to emerging markets such as China, India, Brazil and West Africa. Risks associated with international sales and operations include, but are not limited to:•political and economic instability;•international terrorism;•export controls, including U.S. export controls related to China, sanctions related to Russia, and increased scrutiny of exports of marine instruments, digital imaging and other products;•failure to comply with anti-bribery legislation, including the U.S. Foreign Corrupt Practices Act;•changes in legal and regulatory requirements;•U.S. and foreign government policy changes affecting the markets for our products;•changes in tax laws and tariffs;•changes in U.S. - China and U.S. - Russia relations;•difficulties in protection and enforcement of intellectual property rights;•failure to comply with the foreign data protection laws, including the EU General Data Protection Regulation (“GDPR”) in the European Union;•inadvertent transfers of export-controlled information due to increased cross-border technology transfers and the use of offshore computer servers;•transportation, including piracy in international waters; •currency exchange rate fluctuations; and•challenges relating to managing a global workforce with diverse cultures and backgrounds.Any of these factors could have a material adverse effect on our business, results of operations and financial condition. Exchange rate fluctuations may increase the cost of our products to international customers and therefore reduce our competitive position.In June 2016, the United Kingdom (“U.K.”) held a referendum in which voters approved an exit from the European Union (“E.U.”), commonly referred to as “Brexit.” The U.K. formally left the E.U. on January 31, 2020 and entered a transition period until December 31, 2020 during which the U.K. remained in both the E.U. customs union and single market. That transition period has now ended and the E.U. and U.K. have entered into a Trade and Cooperation Agreement (“TCA”). The TCA ensures tariff-free and quota-free trade in goods between the E.U and the U.K. but also introduces certain non-tariff barriers to trade. In the medium- to long-term, the withdrawal of the U.K. from the E.U. may create further global economic uncertainty, which may adversely impact the economies of the U.K., the E.U. countries and other nations, may cause our current and future customers to reduce their spending on our products and services, and may cause certain E.U.-based customers to source products from businesses based outside of the U.K. For example, Brexit-related uncertainty could lead to a reconsideration by Airbus as to future investment and spending in the U.K., which could reduce sales for our U.K.-based businesses that supply Airbus. Potential Brexit-related risks for our U.K.-based businesses also include increased import duties, loss of customers in the E.U., delays in the movement of goods between the U.K. and the E.U. and loss of access to the E.U. labor pool. Given our several U.K.-based businesses, volatility in the value of the British pound relative to the U.S. dollar, or other foreign currencies, could increase the cost of raw materials and components for our U.K.-based businesses and could otherwise adversely affect the business, operations and the financial condition of our U.K.-based businesses.Higher tax rates may harm our results of operations and cash flow.As Teledyne expands globally, increases in the United States of the taxation of foreign income and expenses may harm our results of operations and cash flow. The relative amount of income we earn in other jurisdictions could reduce our net income and increase our cash payments. Additionally, the new U.S. Presidential administration proposed a higher corporate tax rate of 28% compared to 21%. Such increased tax rate in the U.S. or in other jurisdictions could also reduce our net income and increase our cash payments.10Table of ContentsChanges in future business conditions could cause business investments, goodwill and other long-lived assets to become impaired, resulting in significant losses and write-downs that would reduce our operating income.On January 3, 2021, Teledyne’s goodwill was $2,150.0 million and net acquired intangible assets were $409.7 million. Under current accounting guidance, we are required to test annually both acquired goodwill and other indefinite-lived intangible assets for impairment based upon a fair value approach, rather than amortizing the value over time. We have chosen to perform our annual impairment reviews of goodwill and other indefinite-lived intangible assets during the fourth quarter of each fiscal year. We are also required to test goodwill for impairment between annual tests if events occur or circumstances change that would more likely than not reduce our enterprise fair value below its book value. These events or circumstances could include a significant change in the business climate, including a significant sustained decline in an entity’s market value, legal factors, operating performance indicators, competition, sale or disposition of a significant portion of the business, or other factors. If the fair market value is less than the carrying value, including goodwill, we could be required to record an impairment charge. The valuation of reporting units requires judgment in estimating future cash flows, discount rates and estimated product life cycles. In making these judgments, we evaluate the financial health of the business, including such factors as industry performance, changes in technology and operating cash flows. As we have grown through acquisitions, the amount of goodwill and net acquired intangible assets is a significant portion of our total assets. As a result, the amount of any annual or interim impairment could be significant and could have a material adverse effect on our reported financial results for the period in which the charge is taken. We also may be required to record an earnings charge or incur unanticipated expenses if, as a result of a change in strategy or other reason, we were to determine the value of other assets had been impaired.For additional discussion of business investments, goodwill and other long-lived assets, see the discussion under “Item 7. Management’s Discussion and Analysis of Operations and Financial Condition” and Note 3 of the Notes to Consolidated Financial Statements.Our revenue from U.S. Government contracts depends on the continued availability of funding from the U.S. Government, and, accordingly, we have the risk that funding for our existing contracts may be canceled or diverted to other uses or delayed or that funding for new programs will not be available.We perform work on a number of contracts with the U.S. Department of Defense and other agencies and departments of the U.S. Government including subcontracts with government prime contractors. Sales under contracts with the U.S. Government, including sales under contracts with the U.S. Department of Defense, as prime contractor or subcontractor, represented approximately 26% of our total revenue in 2020, compared with 24% in 2019. Performance under government contracts has inherent risks that could have a material effect on our business, results of operations, and financial condition.Government contracts are conditioned upon the continuing availability of Congressional appropriations and the failure of Congress to appropriate funds for programs in which we participate could negatively affect our results of operations. U.S. Government shutdowns have resulted in delays in anticipated contract awards and delayed payments of invoices for several of our businesses and any new shutdown could have similar or worse effects. The failure by Congress to approve future budgets on a timely basis could delay procurement of our products and services and cause us to lose future revenues. Any renewed emphasis on Federal deficit and debt reduction could lead to a further decrease in overall defense spending. Budgetary concerns could result in future contracts being awarded more on price than on other competitive factors, and smaller defense budgets could result in government in-sourcing of programs and more intense competition on programs that are not in-sourced, which could result in lower revenues and profits.Also, defense spending does not necessarily correlate to continued business for us, because not all of the programs in which we participate or have current capabilities may be provided with continued funding. Changes in policy and budget priorities by the new U.S. Presidential Administration for various defense and National Aeronautics and Space Administration (“NASA”) programs could impact our Engineered Systems, Aerospace and Defense Electronics and Digital Imaging segments. Our Aerospace and Defense Electronics segment may be impacted by volume or price reductions in connection with the F-35 Joint Strike Fighter program, to the extent they are imposed. The timing of program cycles can affect our results of operations for a quarter or year, and cancellations of significant programs such as the Space Launch System (“SLS”), Launch Vehicle Stage Adapter (“LVSA”), International Space Station (“ISS”), Mission Operations and Integration (“MO&I”), or the Shallow Water Combat Submersible (“SWCS”) would affect our results. In 2020 and 2019, our largest contract with the U.S. Government was the MO&I contract, which represented 1.5% and 1.4% of our total net sales, respectively. In June 2020, Teledyne Brown Engineering, Inc. was notified that NASA had awarded to another contractor the Marshall Operations, Systems, Services, and Integration (“MOSSI”) contract, which represented a combination of the Huntsville Operations Support Center contract and the MO&I contract. Subsequently, Teledyne Brown Engineering, Inc. filed a protest challenging such award, which protest was sustained and which sustainment triggered the cancelation of the MOSSI request for proposal and requiring a new acquisition, free of involvement of individuals with a conflict of interest, to begin. While the MO&I contract continues through September 2021, and NASA has several options to further extend it through March 2023, there is no guarantee it will be further extended. NASA anticipates release of the new acquisition, the Marshall Operations, Systems, Services, and Integration II, draft solicitation in April 2021 with the award expected in late 2022. There is no guarantee that Teledyne Brown Engineering will be awarded this new contract.11Table of ContentsIt is also not uncommon for the U.S. Department of Defense to delay the timing of awards or change orders for major programs for six to twelve months. Reductions and delays in research and development funding by the U.S. Government could impact our revenues. Uncertainty over budgets or priorities with the new U.S. Presidential Administration could result in delays in funding and the timing of awards, and changes in funded programs that could have a material impact on our revenues. A significant shift in U.S. Government priorities related to programs and acquisition strategies could have a material impact to our financial results.Further, most of our U.S. Government contracts are subject to termination by the U.S. Government either at its convenience or upon the default of the contractor. Termination for convenience provisions provides only for the recovery of costs incurred or committed, settlement expenses, and profit on work completed prior to termination. Termination for default clauses imposes liability on the contractor for excess costs incurred by the U.S. Government in re-procuring undelivered items from another source. We had no U.S. Government contracts terminated for convenience in 2020, compared with three in 2019. No contracts were terminated for default during such two-year period.Our U.S. Government contracting business is subject to government contracting regulations, including increasingly complex regulations on cybersecurity, and our failure to comply with such laws and regulations could harm our operating results and prospects.Our U.S. Government contracting businesses, like other government contractors, are subject to various audits, reviews and investigations (including private party “whistleblower” lawsuits) relating to our compliance with applicable federal and state laws and regulations. More routinely, the U.S. Government may audit the costs we incur on our U.S. Government contracts, including allocated indirect costs. Such audits could result in adjustments to our contract costs. Any costs found to be improperly allocated to a specific contract will not be reimbursed, and such costs already reimbursed would need to be refunded. We have recorded contract revenues based upon costs we expect to realize after final audit. In a worst case scenario, should a business or division be charged with wrongdoing, or should the U.S. Government determine that the business or division is not a “presently responsible contractor,” that business or division, and conceivably our Company as a whole, could be temporarily suspended or, in the event of a conviction, could be debarred for up to three years from receiving new government contracts or government-approved subcontracts. In addition, we could expend substantial amounts defending against such charges and in damages, fines and penalties if such charges were proven or were to result in negotiated settlements. Routine audits by U.S. Government agencies of Teledyne’s various procurement and accounting systems have the potential to result in disapproval of the audited systems by the administrative contracting officer. Disapproval could significantly impact cash flow, as up to 10% may be withheld from payments.The Department of Defense as well as other U.S. Government contracting agencies have adopted rules and regulations requiring contractors to implement a set of cyber security measures to attain the safeguarding of contractor systems that process, store, or transmit certain information. Implementation and compliance with these cyber security requirements is complex and costly, and could result in unforeseen expenses, lower profitability and, in the case of non-compliance, penalties and damages, all of which could have an adverse effect on our business. The cyber security requirements also impact our supply base which could impact cost, schedule and performance on programs if suppliers do not meet the requirements and therefore, do not qualify to support the programs. We may not have sufficient resources to fund all future research and development and capital expenditures or possible acquisitions.In order to remain competitive, we must make substantial investments in research and development of new or enhanced products and continuously upgrade our process technology and manufacturing capabilities. Our research and development efforts primarily involve engineering and design related to improving existing products and developing new products and technologies in the same or similar fields. Our Teledyne Scientific Company subsidiary, which serves as our primary research center, has been actively promoting and funding joint research and development projects with other Teledyne businesses, including Teledyne Oil & Gas, Teledyne Defense Electronics, Teledyne Digital Imaging and our Test and Measurement businesses. The business of Teledyne e2v, for which the design and development of specialized technology for high performance systems and equipment is integral, also requires substantial investments in research and development. Additionally, some of our businesses have sought or are actively pursuing governmental support and funding for some of their research and development initiatives, including funding in 2019 for DALSA’s semiconductor foundry in Bromont, Quebec. Nonetheless, we may be unable to fund all of our research and development and capital investment needs or possible strategic acquisitions of businesses or product lines. Our ability to raise additional capital will depend on a variety of factors, some of which will not be within our control, including the existence of bank and capital markets, investor perceptions of us, our businesses and the industries in which we operate, and general economic conditions. Failure to successfully raise needed capital or generate cash flow on a timely or cost-effective basis could have a material adverse effect on our business, results of operations and financial condition. In addition, if we fail to accurately predict future customer needs and preferences or fail to produce viable technologies, we may invest heavily in research and development of products that do not lead to significant revenue, which would adversely affect our profitability.Limitations in customer funding for applied research and development and limitations in government support for research and development expenditures may reduce our ability to apply our ongoing investments in some market areas.12Table of ContentsWe may be unable to successfully introduce new and enhanced products in a timely and cost-effective manner or increase our participation in new markets, which could harm our profitability and prospects.Our operating results depend in part on our ability to introduce new and enhanced products on a timely basis. We have major development activities at some of our businesses, for which a failure to execute in a timely manner could negatively impact those businesses. In order to improve our product development capabilities, we purchased the research center that is now Teledyne Scientific Company in 2006 and in 2011 we purchased DALSA to gain access to a well-equipped MEMS research and development center. In 2013, we opened a 52,000-square-foot technology development center in Daytona Beach, Florida primarily to serve the offshore oil and gas production and exploration industries. We are currently upgrading infrastructure at Teledyne e2v’s facility in Chelmsford, U.K. and have expanded Teledyne DALSA’s MEMS foundry in Bromont, Quebec, as well as acquired a second MEMS foundry in Edmonton, Alberta as part of the Micralyne acquisition. Successful product development and introduction depend on numerous factors, including our ability to anticipate customer and market requirements, changes in technology and industry standards, our ability to differentiate our product offerings from the product offerings of our competitors, and market acceptance. We may not be able to develop and introduce new or enhanced products in a timely and cost-effective manner or to develop and introduce products that satisfy customer requirements.We also have the risk that our defense businesses may not be able to replace revenue related to legacy platforms with products for new platform applications. We face the risk that changes in systems architectures will obviate the need for our products. For example, electronically steered radar arrays do not need certain high voltage interconnects like mechanically steered radar arrays do and unmanned aircraft will not need ejection seat sequencers. Our new products also may not achieve market acceptance or correctly address new industry standards and technological changes. We may also lose any technological advantage to competitors if we fail to develop new products in a timely manner.Additionally, new products may trigger increased warranty costs as information on such products is augmented by actual usage. Accelerated entry of new products to meet heightened market demand and competitive pressures may cause additional warranty costs as development and testing time periods might be accelerated or condensed.We intend to both adapt our existing technologies and develop new products to expand into new market segments. We may be unsuccessful in accessing these and other new markets if our products do not meet our customers’ requirements, as a result of changes in either technology and industry standards or because of actions taken by our competitors.We may not be able to reduce the costs of our products to satisfy customers’ cost reduction mandates, which could harm our sales or margins.Cost conscious customers may seek price reductions of our products. While we continually work to reduce our manufacturing and other costs of our products, without affecting product quality and reliability, there is no assurance that we will be able to do so or to do so in a timely manner to satisfy the pricing pressures of our customers. Prices of raw materials and other components used in our products may be beyond our control depending on market conditions. As a result, customers may seek lower cost products from China or other developing countries where manufacturing costs are lower.The airline industry is heavily regulated, and if we fail to comply with applicable requirements, our results of operations could suffer.The Federal Aviation Administration (“FAA”) and equivalent regulatory agencies have increasingly focused on the need to assure that airline industry products are designed with sufficient cybersecurity controls to protect against unauthorized access or other unwanted compromise. A failure to meet these evolving expectations could negatively impact sales into the industry and expose us to legal or contractual liability.Governmental agencies throughout the world, including the FAA, prescribe standards and qualification requirements for aircraft components, including virtually all commercial airline and general aviation products. Specific regulations vary from country to country, although compliance with FAA requirements generally satisfies regulatory requirements in other countries. If any material authorization or approval qualifying us to supply our products is revoked or suspended, then sale of the product would be prohibited by law, which would have an adverse effect on our business, financial condition and results of operations.From time to time, the FAA or equivalent regulatory agencies in other countries propose new regulations or changes to existing regulations, which often are more stringent than existing regulations. If such proposals are adopted and enacted, we may incur significant additional costs to achieve compliance, which could have a material adverse effect on our business, financial condition and results of operations. Recent trends by China’s aviation authority to relax restrictions on airspace may be reversed, and anticipated new regulations loosening airspace restrictions may not materialize, which could impact sales prospects in China for our commercial aerospace businesses.The FAA and the U.S. Department of Justice’s Fraud Section, among other agencies and countries, have been investigating two Boeing 737 Max 8 aircraft crashes that occurred in October 2018 and March 2019, which resulted in the groundings of such aircraft across the world. Subsequently, Boeing announced in December 2019 that it was temporarily suspending production of the 737 Max starting in January 2020. While Boeing has started to resume minimal production in May 2020 and governmental groundings have been lifted, production is not expected to reach historic levels for the immediate future. While resumption of some production of the 737 Max has been factored into our business plans, there is a risk that airlines and air travelers may respond negatively to the 737 Max aircraft due to historic and continuing perceived safety concerns. These factors may further negatively impact our Teledyne Controls’ business. 13Table of ContentsIncreasing competition could reduce the demand for our products and services.Each of our markets is highly competitive. Many of our competitors have, and potential competitors could have, greater name recognition, a larger installed base of products, more extensive engineering, manufacturing, marketing and distribution capabilities and greater financial, technological and personnel resources. New or existing competitors may also develop new technologies that could adversely affect the demand for our products and services. We have been experiencing increased competition for some of our key products. Furthermore, some of our patents have or are expiring, which could open up further competition. For example, our U.S. patent related to our Wireless GroundLink product expired in 2018, allowing several competitors to enter the market. Additionally, some of our customers have been developing competing products or electing to vertically integrate and replace our products with their own. For example, Airbus is providing a wireless product, FOMAX, which now competes directly with Teledyne Controls hardware and services. Furthermore, Boeing has announced a vertical integration program, which includes avionics. Specifically, Boeing has expressed its intention to replace certain Teledyne wireless products on both the 737 Max and 787 aircraft with its own wireless products. Lastly, some of our products face increasing competition from alternative technologies. For example, the lead acid batteries that Teledyne Battery Products sells face competition from lithium ion batteries, among other competing technologies. The hydrogen generation systems that Teledyne Energy Systems sells also face increasing competition from new entrants to the on-site electrolysis of water market.Industry acquisition and consolidation trends, particularly among aerospace and defense contractors, have adversely impacted demand for our aerospace and defense related engineering services as large prime contractors elect to in-source major acquisition programs and expand small business participation to meet Government contracting goals. Such consolidations can also cause delays in business as the newly consolidated organization undergoes integration.Low-cost competition from China and other developing countries could also result in decreased demand for our products. Increasing competition could reduce the volume of our sales or the prices we may charge, which would negatively impact our revenues. Smaller defense budgets both in the United States and Europe could result in additional competition for new and existing defense programs.Product liability claims, product recalls and field service actions could have a material adverse effect on our reputation, business, results of operations and financial condition and we may have difficulty obtaining product liability and other insurance coverage.As a manufacturer and distributor of a wide variety of products, including monitoring instruments, products used in offshore oil and gas production, products used in transportation and commercial aviation and products used in medical devices (including X-Ray detectors), our results of operations are susceptible to adverse publicity regarding the quality or safety of our products. In part, product liability claims challenging the safety of our products may result in a decline in sales for a product, which could adversely affect our results of operations. This could be the case even if the claims themselves are proven to be untrue or settled for immaterial amounts.While we have general liability and other insurance policies concerning product liabilities and errors and omissions, we have self-insured retentions or deductibles under such policies with respect to a portion of these liabilities. Awarded damages could be more than our accruals. We could incur losses above the aggregate annual policy limit as well. We cannot ensure that, for 2021 and in future years, insurance carriers will be willing to renew coverage or provide new coverage for product liability.Product recalls can be expensive and tarnish our reputation and have a material adverse effect on the sales of our products. We cannot assure that we will not have additional product liability claims or that we will not recall any products.We have been joined, among a number of defendants (often over 100), in lawsuits alleging injury or death as a result of exposure to asbestos. In addition, because of the prominent “Teledyne” name, we may continue to be mistakenly joined in lawsuits involving a company or business that was not assumed by us as part of our 1999 spin-off. To date, we have not incurred material liabilities in connection with these lawsuits. However, our historic insurance coverage, including that of our predecessors, may not fully cover such claims and the defense of such matters. Coverage typically depends on the year of purported exposure and other factors. Nonetheless, we intend to vigorously defend our position against these claims.Teledyne Brown Engineering, Inc. and other Teledyne companies manufacture components for customers in the nuclear power market, including utilities and certain governmental entities. Certain liabilities associated with such products are covered by the Price-Anderson Nuclear Industries Indemnity Act and other statutory and common law defenses, and we have received indemnities from some of our customers. However, there is no assurance we will not face product liability claims related to such products or that our exposure will not exceed the amounts for which we have liability coverage or protection.14Table of ContentsOur business and financial results could be adversely affected by conditions and other factors associated with our suppliers, and subcontractors.Some items we purchase for the manufacture of our products are purchased from limited or single sources of supply due to technical capability, price and other factors. For example, Teledyne Digital Imaging has an internal single source of supply for CCD semiconductor wafers used to assemble image sensors and an external single source of supply for CMOS semiconductor wafers used to assemble X-ray panel products. Furthermore, sole source supply is more common among our businesses that are heavily involved in research and development because there can be few suppliers in the world capable of producing the products or providing the services with the right highly specialized technology. Teledyne LeCroy continues to outsource a portion of its research and development activities to third-party engineering firms in Malaysia and India where it may be more difficult for us to enforce our intellectual property rights. We have also outsourced from time to time the manufacturing of certain parts, components, subsystems and even finished products to single or limited sources, including international sources. Disruption of these sources or supplier-imposed rationing of scarce components could cause delays or reductions in shipments of our products or increases in our costs, which could have an adverse effect on our financial condition or operations. We could experience global supply chain disruptions if the COVID-19 pandemic health crisis continues and new strains of the virus emerge. International sources possess additional risks, some of which are similar to those described above regarding international sales. With any continuing disruption in the global economy and financial markets, some of our suppliers may also continue to face issues gaining access to sufficient credit and materials to maintain their businesses, which could reduce the availability of some components and, to the extent such suppliers are single source suppliers, could adversely affect our ability to continue to manufacture and sell our products. Some companies engage subcontractors to perform a portion of the services we provide to our customers. To provide these services, the subcontractor must be financially viable, company with applicable laws, regulations and contract terms. Non-performance by a subcontractor could result in misalignment between subcontractor performance and our contractual obligations to our customers. Lastly, our Teledyne Hi-Rel business screens, tests, packages, performs various services and resells products of a third party, and faces the risk that such third party may end its relationship due to economic conditions and other factors. We face risks related to sales through distributors and other third parties which could harm our business.We sell a portion of our products through third parties such as distributors, value-added resellers and OEMs (collectively, “distributors”). Using third parties for distribution exposes Teledyne to many risks, including concentration, credit risk and legal risk because under certain circumstances we may be held responsible for the actions of those third-party sales channels. We may rely on one or more key distributors for a product, and the loss of these distributors could reduce our revenue. Distributors may face financial difficulties, including bankruptcy, which could harm our collection of accounts receivables and financial results. Violations of the Foreign Corrupt Practices Act (“FCPA”) or similar anti-bribery laws by distributors or other third-party intermediaries could have a material impact on our business. Competitors could also block our access to key distributors. Failing to manage risks related to our use of distributors may reduce sales, increase expenses, and weaken our competitive position, and could result in sanctions against us.Compliance with increasing environmental and climate change regulations, as well as the effects of potential environmental liabilities, could have a material adverse financial effect on us.We, like other industry participants, are subject to various federal, state, local and international environmental laws and regulations. We may be subject to increasingly stringent environmental standards in the future, particularly as greenhouse gas emissions and climate change regulations and initiatives increase. Future developments, administrative actions or liabilities relating to environmental and climate change matters could have a material adverse effect on our business, results of operations or financial condition. Environmental regulations on hydraulic fracturing and the use of seismic energy sources for offshore energy exploration could adversely affect some product lines of our Instrumentation segment.Our manufacturing operations, including former operations, could expose us to material environmental liabilities. Additionally, companies that we acquire may have environmental liabilities that might not be accurately assessed or brought to our attention at the time of the acquisition.The U.S. Environmental Protection Agency (“EPA”) has focused on greenhouse gases (“GHGs”), maintaining GHGs threaten the public health and welfare of the American people. The EPA also maintains that GHG emissions from on-road vehicles contribute to that threat. The EPA’s endangerment finding covers emissions of six greenhouse gases. The EPA’s continuing efforts to limit GHG emissions could adversely affect our U.S. manufacturing operations, increase prices for energy, fuel and transportation, require us to accommodate changes in parameters, such as the way parts are manufactured, and may, in some cases, require us to redesign certain of our products. This, or other federal or state regulations, could lead to increased costs, which we may not be able to recover from customers, delays in product shipments and loss of market share to competitors. For example, Teledyne Battery Products unit makes lead acid batteries in California and is subject to a variety of environmental regulations and inspections, which have increased over time. Also, some of our sites conduct electroplating, metal finishing and other operations that utilize hazardous materials that are subject to similar regulations. Regulatory changes or failure to meet applicable requirements could disrupt that business or force a closure or relocation of the business.Our products are subject to various regulations that prohibit or restrict the use of certain hazardous substances. For example, our products placed on the European market are subject to the Registration, Evaluation, Authorization and Restriction of Chemicals (“REACH”) and the restriction of the use of certain hazardous substances in electrical and electronic equipment 15Table of Contents(“ROHS”) Directives. Future hazardous substance restrictions or prohibitions may limit our ability to market some products in certain countries.For additional discussion of environmental matters, see the discussion under the caption “Other Matters – Environmental” of “Item 7. Management’s Discussion and Analysis of Results of Operation and Financial Condition” and Note 14 of the Notes to Consolidated Financial Statements. For a discussion of our products that contribute to the environment, sustainability and climate science, see “Item 1. Business – Environment and Sustainability.”Our inability to attract and retain key personnel could have a material adverse effect on our future success.Our future success depends to a significant extent upon the continued service of our executive officers and other key management and technical personnel and on our ability to continue to attract, retain and motivate qualified personnel. We also have a maturing workforce. Some of our businesses, including our businesses in traveling wave tube and integrated microwave module design and development, draw from a pool of specialized engineering talent that is small and currently shrinking. Some of our businesses have a need for employees with a certain level of security clearance, and competition for such employees has increased. While we have engaged in succession planning, the loss of the services of one or more of our key employees or our failure to attract, retain and motivate qualified personnel could have a material adverse effect on our business, financial condition and results of operations. We may not be able to sell or reconfigure businesses, facilities or product lines that we determine no longer meet with our growth strategy or that should be consolidated.Consistent with our strategy to emphasize growth in our core markets, we continually evaluate our businesses to ensure that they are aligned with our strategy and objectives. Over the years we have also consolidated some of our business units and facilities, in some cases to respond to downturns in the defense or oil and gas industries, among other reasons. During 2020, we relocated our Teledyne Paradise Datacom operation in State College, Pennsylvania to our Teledyne Microwave Solutions facility in Rancho Cordova, California. We may not be able to realize efficiencies and cost savings from our consolidation activities. There is no assurance that our efforts will be successful. If we do not successfully manage our current consolidation activities, or any other similar activities that we may undertake in the future, expected efficiencies and benefits might be delayed or not realized, and our operations and business could be disrupted. Our ability to dispose of, exit or reconfigure businesses that may no longer be aligned with our growth strategy will depend on many factors, including the terms and conditions of any asset purchase and sale agreement or lease agreement, as well as industry, business and economic conditions. We cannot provide any assurance that we will be able to sell non-strategic businesses on terms that are acceptable to us, or at all. In addition, if the sale of any non-strategic business cannot be consummated or is not practical, alternative courses of action, including relocation of product lines or closure, may not be available to us or may be more costly than anticipated.Natural and man-made disasters could adversely affect our business, results of operations and financial condition.Several of our facilities, as a result of their locations, could be subject to a catastrophic loss caused by earthquakes, hurricanes, tornados, floods, ice storms or other natural disasters. Many of our production facilities and our headquarters are located in California and thus are in areas with above average seismic activity and may also be at risk of damage due to wildfire. In November 2018, wildfires impacted areas near our headquarters and principal research and development center in Thousand Oaks, California, resulting in temporary disruptions and evacuations of employees who lived nearby. Local utilities may impose blackouts during high fire risk weather conditions, which could result in disruptions to our businesses located in California, including our headquarters. In the event of a major earthquake, tornado, hurricane or catastrophic event such as fire, power loss, telecommunications failure, vandalism, cyber-attack, war, terrorist attack or health epidemic (including COVID-19), we may be unable to continue our operations and may endure system interruptions, reputational harm, delays in our application development, lengthy interruptions in our products, breaches of data security and loss of critical data, all of which could harm our business, results of operations and financial condition. Teledyne DALSA’s semiconductor facilities in Quebec, Canada have been impacted by loss of electrical power caused by severe ice storms. In addition, we have manufacturing facilities in the southeastern United States and Texas that have been threatened or struck by major hurricanes. In 2017, our businesses located in Houston, Texas were impacted by Hurricane Harvey and our business in Florida was threatened by Hurricanes Irma and Matthew. Our facilities in Alabama, Florida, Nebraska, Tennessee and Virginia have also been threatened by tornados. If any of our California facilities, including our California headquarters, were to experience a catastrophic earthquake or wildfire loss or if any of our Alabama, Florida, Nebraska, Tennessee or Texas facilities were to experience a catastrophic hurricane, storm, tornado or other natural disaster, or if DALSA’s facilities in Quebec experience long-term loss of electrical power, such event could disrupt our operations, delay production, shipments and revenue, and result in large expenses to repair or replace the facility or facilities. In addition, the insurance we maintain may be insufficient to cover our losses resulting from disasters, cyber-attacks or other business interruptions, and any incidents may result in loss of, or increased costs of, such insurance. In addition, our existing disaster recovery and business continuity plans (including those relating to our information technology systems) may not be fully responsive to, or minimize losses associated with, catastrophic events.Disasters also have an indirect adverse impact on our business. For example, in 2018, a fire at a Netherlands-based facility of a key supplier of printed circuit boards resulted in delivery disruptions to the electronics industry, including to businesses in our Digital Imaging segment.16Table of ContentsTeledyne Brown Engineering, Inc. has developed, built, and launched a multiuser system for earth sensing that is affixed to the International Space Station (“ISS”). For the program to continue to be financially successful, the 21-year-old ISS must continue to fly in a safe and human tended condition. While certain spaceflight risks, such as a high-velocity debris impact to the station causing significant structural damage or necessitating the evacuation of the ISS, have been regarded as small, if such event were to occur, the ISS program continuation could be threatened, jeopardizing our investment and potential revenue generation from ISS-based Earth imaging.We may not be able to enforce or protect our intellectual property rights, or third parties may claim we infringe their intellectual rights, each which may harm our ability to compete and thus harm our business.Our ability to enforce and protect our patents, copyrights, software licenses, trade secrets, know-how, and other intellectual property rights is subject to general litigation risks, as well as uncertainty as to the enforceability of our intellectual property rights in various countries. When we seek to enforce our rights, we have found that various claims may be asserted against us, including claims that our intellectual property right is invalid, is otherwise not enforceable or is licensed to the party against whom we are asserting a claim. In addition, we may be the target of aggressive and opportunistic enforcement of patents by third parties. If we are not ultimately successful in defending ourselves against these claims in litigation, we may not be able to sell a product or family of products due to an injunction, or we may have to pay damages that could, in turn, harm our results of operations. Our inability to enforce our intellectual property rights under these circumstances may harm our competitive position and our business.Our business and operations could suffer in the event of cyber security breaches.Attempts by others to gain unauthorized access to our information technology systems have become more sophisticated and are sometimes successful. These attempts, which might be related to industrial or foreign government espionage, crime, activism, or other motivations, include covertly introducing malware into our computers and computer networks, performing reconnaissance, impersonating authorized users, extortion, and stealing, corrupting or restricting our access to data, among other activities. We continue to train our personnel and update our infrastructure, security tools and processes to protect against security incidents, including both external and internal threats, and to prevent their recurrence. Company personnel and third parties have been tasked to detect, respond to, and investigate such incidents, but it is possible that we might not prevent or be aware of or be able to react to an incident or its magnitude and effects. The theft, corruption, unauthorized use or publication of our intellectual property or confidential business information could harm our competitive position, reduce the value of our investment in research and development and other strategic initiatives or otherwise adversely affect our business. We are subject to U.S. Department of Defense regulations applicable to certain types of data residing on or transiting through our information systems, and these regulations have been and will continue to be incorporated into certain U.S. Department of Defense contracts that we hold. To the extent that any security breach results in inappropriate disclosure of confidential or controlled information of employees, third parties or the U.S. Government, or any of the deployed security controls are deemed insufficient, we may incur liability or the loss of contracts or security clearances. As a result, we expect to continue to devote additional resources to the security of our information technology systems. More resources may be required in the defense arena to the extent the U.S. Government increases its cyber security mandates. Unauthorized access to or control of our products, devices or systems could impact the safety of our customers and other third parties which could result in legal claims against us. Security breaches also could result in a violation of applicable U.S. and international privacy and other laws, including GDPR, Health Insurance Portability and Accountability Act, Payment Card Industry Data Security Standard, and California Consumer Privacy Act and subject us to private consumer or securities litigation and governmental investigations and proceedings, any of which could result in our exposure to material civil or criminal liability. Lastly, we are not immune from cyber security and privacy breaches of our customers and suppliers.Provisions of our governing documents, applicable law, and our Change in Control Severance Agreements could make an acquisition of Teledyne more difficult.Our Restated Certificate of Incorporation, our Amended and Restated Bylaws and the General Corporation Law of the State of Delaware contain several provisions, such as our classified Board, that could make the acquisition of control of Teledyne, in a transaction not approved by our Board, more difficult. We have also entered into Change in Control Severance Agreements with ten members of our current management, which could have an anti-takeover effect. These provisions may prevent or discourage attempts to acquire our Company.Our Amended and Restated Bylaws (“Bylaws”) designate the Court of Chancery of the State of Delaware as the sole and exclusive forum for certain lawsuits between us and our stockholders, which could limit our stockholders’ ability to obtain a judicial forum that it finds favorable for such lawsuits and make it more costly for our stockholders to bring such lawsuits, which may have the effect of discouraging such lawsuits.Our Bylaws provide that, unless we consent in writing to the selection of an alternative forum, the Court of Chancery of the State of Delaware will be, to the fullest extent permitted by law, the sole and exclusive forum for any (i) derivative action or proceeding brought on our behalf, (ii) action asserting a claim of breach of a fiduciary duty owed by any of our directors, officers, employees or agents to us or our stockholders, (iii) action asserting a claim arising pursuant to any provision of the General Corporation Law of the State of Delaware, Restated Certificate of Incorporation or Bylaws, (iv) any action to interpret, apply, enforce or determine the validity of the Restated Certificate of Incorporation or Bylaws or (v) action asserting a claim 17Table of Contentsgoverned by the internal affairs doctrine. Our Bylaws also provide that any person or entity purchasing or otherwise acquiring or holding any interest in shares of our capital stock will be deemed to have notice of and consented to this forum selection provision.However, this forum selection provision is not intended to apply to any actions brought under the Securities Act of 1933 (the "Securities Act"), as amended, or the Exchange Act. Section 27 of the Exchange Act creates exclusive federal jurisdiction over all suits brought to enforce any duty or liability created by the Exchange Act or the rules and regulations thereunder and Section 22 of the Securities Act creates concurrent jurisdiction for federal and state courts over all suits brought to enforce any duty or liability created by the Securities Act or the rules and regulations thereunder. Accordingly, the forum selection provision in our Bylaws will not relieve us of our duties to comply with the federal securities laws and the rules and regulations thereunder, and our stockholders will not be deemed to have waived our compliance with these laws, rules and regulations.Nevertheless, this forum selection provision in our Bylaws may limit a stockholder’s ability to bring a claim in a judicial forum that it finds favorable for disputes with us or any of our directors, officers and other employees, which may discourage lawsuits with respect to such claims, although our stockholders will not be deemed to have waived our compliance with federal securities laws and the rules and regulations thereunder. In addition, stockholders who do bring a claim in the Court of Chancery in the State of Delaware could face additional litigation costs in pursuing any such claim, particularly if they do not reside in or near Delaware. While we believe the risk of a court declining to enforce the forum selection provision contained in our Bylaws is low, if a court were to find the provision inapplicable to, or unenforceable in respect of, one or more of the specified types of actions or proceedings, we may incur additional costs associated with resolving such action in other jurisdictions, which could harm our business, operating results and financial condition.Risks Related to Our SecuritiesAn investment in Teledyne’s Common Stock and other securities involve risks, many of which are beyond our control.Stock markets in general, including the New York Stock Exchange on which our Common Stock is listed, have experienced a high degree of price and volume fluctuations that are not necessarily related to operating performance of the listed companies. In addition to general economic, political and market conditions, such volatility may be related to: (i) changes from analysts’ expectations in revenues, earnings and other financial results; (ii) strategic actions by other competitors; (iii) changes to budgets or policies of the U.S. and other governments; and (iv) other risks described in this report. We cannot provide assurances as to our Common Stock price, which during fiscal 2020 has ranged from a low of $195.34 to a high of $398.99. Item 1B. Unresolved Staff CommentsNone.Item 2.PropertiesThe Company has 68 principal operating facilities in 17 states and six foreign countries. The Company’s executive offices are located in Thousand Oaks, California. Our principal research and development center is also located in Thousand Oaks, California. The Instrumentation segment has principal operations in the United States, the United Kingdom and Denmark, the Digital Imaging segment has principal operations in the United States, Canada, France, the Netherlands and the United Kingdom, the Aerospace and Defense Electronics segment with principal operations in the United States and the United Kingdom and the Engineered Systems segment has principal operations in the United States. We maintain our facilities in good operating condition, and we believe they are suitable and adequate for the purposes for which they are intended and overall have sufficient capacity to conduct business as currently conducted.Item 3.Legal ProceedingsFrom time to time, we become involved in various lawsuits, claims and proceedings arising out of, or incident to, our ordinary course of business including lawsuits, claims or proceedings pertaining to product liability, patent infringement, commercial contracts, employment and employee benefits. While we cannot predict the outcome of any lawsuit, claim or proceeding, our management does not believe that the disposition of any pending matters is likely to have a material adverse effect on our business, financial condition or liquidity. Item 4.Mine Safety DisclosuresNo information is required in response to this item.18Table of ContentsPART II Item 5.Market for Registrant’s Common Equity, Related Stockholder Matters, and Issuer Purchases of Equity SecuritiesOur Common Stock is listed on the New York Stock Exchange and traded under the symbol “TDY”. As of February 22, 2021, there were 2,646 holders of record of the Common Stock. Because many of our shares of common stock are held by brokers and institutions on behalf of stockholders, we are unable to estimate the total number of beneficial owners of our stock represented by these stockholders of record. We intend to use future earnings to fund the development and growth of our businesses, including through potential acquisitions. Therefore, we do not anticipate paying any cash dividends in the foreseeable future.We have stock repurchase programs authorized by our Board of Directors to repurchase up to approximately three million shares. No repurchases were made since 2015. Although we have no current plans to repurchase stock, up to approximately three million shares may be repurchased under the stock repurchase program. See Note 8 of the Notes to Consolidated Financial Statements for additional information about our stock repurchase program.Item 6.Selected Financial DataThe following table presents our summary consolidated financial data. We derived the following historical selected financial data from our audited consolidated financial statements. Our fiscal year is determined based on a 52- or 53-week convention ending on the Sunday nearest to December 31. Each fiscal year presented below contained 52 weeks. The five-year summary of selected financial data should be read in conjunction with the discussion under “Item 7-Management’s Discussion and Analysis of Financial Condition and Results of Operation” and the Notes to Consolidated Financial Statements. Five-Year Summary of Selected Financial Data 2020 2019 2018 20172016 (In millions, except per-share amounts)Net sales $3,086.2 $3,163.6 $2,901.8 $2,603.8 $2,149.9 Net income $401.9 $402.3 $333.8 $227.2 $190.9 Basic earnings per common share $10.95 $11.08 $9.32 $6.45 $5.52 Diluted earnings per common share $10.62 $10.73 $9.01 $6.26 $5.37 Weighted average diluted common shares outstanding37.9 37.5 37.0 36.3 35.5 Total assets $5,084.8 $4,579.8 $3,809.3 $3,846.4 $2,774.4 Long-term debt, less current portion $680.9 $750.0 $610.1 $1,063.9 $509.7 Total stockholders’ equity $3,228.6 $2,714.7 $2,229.7 $1,947.3 $1,554.4 Each fiscal year includes the impact of the acquisitions. See Note 3 to our Consolidated Financial Statements for additional information about recent acquisitions.19Table of ContentsItem 7.Management’s Discussion and Analysis of Financial Condition and Results of OperationsTeledyne Technologies Incorporated provides enabling technologies for industrial growth markets that require advanced technology and high reliability. These markets include aerospace and defense, factory automation, air and water quality environmental monitoring, electronics design and development, oceanographic research, deepwater oil and gas exploration and production, medical imaging and pharmaceutical research. We differentiate ourselves from many of our direct competitors by having a customer and Company-sponsored applied research center that augments our product development expertise. We believe that technological capabilities and innovation and the ability to invest in the development of new and enhanced products are critical to obtaining and maintaining leadership in our markets and the industries in which we compete.Strategy/OverviewOur strategy continues to emphasize growth in our core markets of instrumentation, digital imaging, aerospace and defense electronics and engineered systems. Our core markets are characterized by high barriers to entry and include specialized products and services not likely to be commoditized. We intend to strengthen and expand our core businesses with targeted acquisitions and through product development. We continue to focus on balanced and disciplined capital deployment among capital expenditures, acquisitions and product development. We aggressively pursue operational excellence to continually improve our margins and earnings by emphasizing cost containment and cost reductions in all aspects of our business. At Teledyne, operational excellence includes the rapid integration of the businesses we acquire. Using complementary technology across our businesses and internal research and development, we seek to create new products to grow our company and expand our addressable markets. We continue to evaluate our businesses to ensure that they are aligned with our strategy.Consistent with this strategy, we made one acquisition in 2020 and three acquisitions in 2019. See the Recent and Pending Acquisitions section for additional information. COVID-19 and Other MattersWe concluded 2020 with the best operating margin and cash flow in the Company’s history. With regard to the COVID-19 pandemic, our first priority remains the health and safety of our employees and their families. Our manufacturing sites are deemed essential businesses and remain operational, and we are practicing social distancing, enhanced cleaning protocols, usage of personal protective equipment and other preventative measures.While no company is immune to global economic challenges, Teledyne's business portfolio is well-balanced across end markets and geographies, and includes a high degree of businesses serving critical infrastructure sectors such as the defense industrial base, water and wastewater, and healthcare and public health. However, given the continuing dynamic nature of this situation, the Company may not fully estimate the impacts of COVID-19 on its financial condition, results of operations or cash flows.As part of a continuing effort to reduce costs and improve operating performance, as well as to respond to the impact of COVID-19, in 2020 the Company took actions to reduce headcount by 9.8% across various businesses, reducing our exposure to weak end markets, such as commercial aerospace. At January 3, 2021, $2.1 million remains to be paid related to these actions.20Table of ContentsThe following pre-tax charges were incurred related to severance and facility consolidations (in millions):202020192018Instrumentation$5.9 $1.5 $5.6 Digital Imaging2.9 1.1 0.7 Aerospace and Defense Electronics11.1 0.5 1.3 Engineered Systems0.5 0.1 0.2 Corporate0.4 — — Total$20.8 $3.2 $7.8 202020192018Severance$16.0 $3.5 $5.6 Facility consolidations (a)4.8 (0.3)2.2 Total$20.8 $3.2 $7.8 (a) 2019 includes the reversal of certain amounts recorded in 2018 no longer needed.202020192018Cost of sales$10.3 $0.8 $4.9 Selling, general and administrative expenses10.5 2.4 2.9 Total$20.8 $3.2 $7.8 Recent and Pending AcquisitionsThe Company spent $29.0 million, $484.0 million and $3.1 million on acquisitions and other investments, net of cash acquired in 2020, 2019 and 2018, respectively. Pending 2021 AcquisitionOn January 4, 2021, the first day of our 2021 fiscal year, Teledyne and FLIR Systems, Inc. (“FLIR”) entered into a definitive agreement under which Teledyne will acquire FLIR in a cash and stock transaction valued at approximately $8.0 billion. Under the terms of the agreement, FLIR stockholders will receive $28.00 per share in cash and 0.0718 shares of Teledyne common stock for each FLIR share, which implies a total purchase price of $56.00 per FLIR share based on Teledyne’s 5-day volume weighted average price as of December 31, 2020. The transaction is expected to close in the middle of 2021 subject to the receipt of required regulatory approvals, including expiration or termination of the applicable waiting period under the Hart-Scott-Rodino Antitrust Improvements Act, approvals of Teledyne and FLIR stockholders and other customary closing conditions. FLIR designs, develops, manufactures, markets, and distributes technologies that enhance perception and awareness. FLIR provides innovative sensing solutions through thermal imaging, visible-light imaging, video analytics, measurement and diagnostic, and advanced threat detection systems. FLIR offers a diversified portfolio that serves a number of applications in government and defense, industrial, and commercial markets. FLIR, headquartered in Wilsonville, Oregon, will be part of the Digital Imaging segment.2020 AcquisitionOn January 5, 2020, we acquired OakGate Technology, Inc. (“OakGate”) for $28.5 million in cash, net of cash acquired. Based in Loomis, California, OakGate provides software and hardware designed to test electronic data storage devices from development through manufacturing and end-use applications. The acquired business is part of the Test and Measurement product line within the Instrumentation segment.2019 AcquisitionsOn February 5, 2019, we acquired the scientific imaging businesses of Roper Technologies, Inc. for $224.8 million in cash. The acquired businesses include Princeton Instruments, Photometrics and Lumenera. The acquired businesses provide a range of imaging solutions, primarily for life sciences, academic research and customized OEM industrial imaging solutions. Princeton Instruments and Photometrics manufacture state-of-the-art cameras, spectrographs and optics for advanced research in physical sciences, life sciences research and spectroscopy imaging. Applications and markets include materials analysis, quantum technology and cell biology imaging using fluorescence and chemiluminescence. Lumenera primarily provides rugged USB-based customized cameras for markets such as traffic management, as well as life sciences applications. Principally located in the United States and Canada, the acquired businesses are part of the Digital Imaging segment. 21Table of ContentsOn August 1, 2019, we acquired the gas and flame detection businesses of 3M Company for $233.5 million in cash. The gas and flame detection businesses includes Oldham, Simtronics, Gas Measurement Instruments, Detcon and select Scott Safety products. The gas and flame detection businesses provides a portfolio of fixed and portable industrial gas and flame detection instruments used in a variety of industries including petrochemical, power generation, oil and gas, food and beverage, mining and waste water treatment. Principally located in France, the United Kingdom and the United States, the acquired businesses are part of the Environmental Instrumentation product line of the Instrumentation segment. On August 30, 2019, we acquired Micralyne Inc. (“Micralyne”) for $25.7 million in cash. Micralyne provides micro electromechanical systems (“MEMS”) devices. In particular, Micralyne possesses unique microfluidic technology for biotech applications, as well as capabilities in non-silicon-based MEMS (e.g. gold, polymers) often required for human body compatibility. Based in Edmonton, Alberta, Canada, the acquired business is part of the Digital Imaging segment. See Note 3 of the Notes to Consolidated Financial Statements for additional information about our recent acquisitions and Note 15 of the Notes to Consolidated Financial Statements for additional information about a pending acquisition. Consolidated Operating ResultsOur fiscal year is determined based on a 52- or 53-week convention ending on the Sunday nearest to December 31. Fiscal year 2020 contained 53 weeks while fiscal years 2019 and 2018 each contained 52 weeks. The following are selected financial highlights for 2020, 2019 and 2018 (in millions, except per-share amounts): 2020 2019 2018Net sales $3,086.2 $3,163.6 $2,901.8 Costs and expenses Cost of sales 1,905.3 1,920.3 1,791.0 Selling, general and administrative expenses 700.8 751.6 694.2 Total costs and expenses 2,606.1 2,671.9 2,485.2 Operating income 480.1 491.7 416.6 Interest and debt expense, net (15.3)(21.0)(25.5)Non-service retirement benefit income12.1 8.0 13.5 Other expense, net (7.2) (5.0)(10.7)Income before income taxes 469.7 473.7 393.9 Provision for income taxes 67.8 71.4 60.1 Net income $401.9 $402.3 $333.8 Basic earnings per common share $10.95 $11.08 $9.32 Diluted earnings per common share $10.62 $10.73 $9.01 Our businesses are aligned in four business segments: Instrumentation, Digital Imaging, Aerospace and Defense Electronics and Engineered Systems. Our four business segments and their respective percentage contributions to our total sales in 2020, 2019 and 2018 are summarized in the following table: Percentage of Total Net SalesSegment contribution to total net sales:202020192018Instrumentation35 %35 %35 %Digital Imaging32 %31 %30 %Aerospace and Defense Electronics19 %22 %22 %Engineered Systems14 %12 %13 % 100 %100 %100 %22Table of ContentsResults of Operations2020 compared with 2019 Net sales (dollars in millions)2020 2019 % Change Instrumentation$1,094.5 $1,105.1 (1.0)%Digital Imaging 986.0 992.9 (0.7)%Aerospace and Defense Electronics 589.4 690.1 (14.6)%Engineered Systems 416.3 375.5 10.9 %Total net sales$3,086.2 $3,163.6 (2.4)% Results of operations (dollars in millions)2020 2019 % Change Instrumentation$213.2 $200.4 6.4 %Digital Imaging 192.8 176.5 9.2 %Aerospace and Defense Electronics 80.8 143.4 (43.7)%Engineered Systems 50.1 36.5 37.3 %Corporate expense (56.8)(65.1)(12.7)%Operating income480.1 491.7 (2.4)%Interest and debt expense, net (15.3)(21.0)(27.1)%Non-service retirement benefit income12.1 8.0 51.3 %Other expense, net (7.2)(5.0)44.0 %Income before income taxes 469.7 473.7 (0.8)%Provision for income taxes 67.8 71.4 (5.0)%Net income$401.9 $402.3 (0.1)% Sales and cost of sales by segment and total company (dollars in millions):20202019ChangeInstrumentationNet sales$1,094.5 $1,105.1 $(10.6)Cost of sales$603.4 $612.8 $(9.4)Cost of sales % of net sales55.1 %55.5 %Digital ImagingNet sales$986.0 $992.9 $(6.9)Cost of sales$569.2 $580.6 $(11.4)Cost of sales % of net sales57.7 %58.5 %Aerospace and Defense ElectronicsNet sales$589.4 $690.1 $(100.7)Cost of sales$395.1 $414.7 $(19.6)Cost of sales % of net sales67.0 %60.1 %Engineered SystemsNet sales$416.3 $375.5 $40.8 Cost of sales$337.6 $312.2 $25.4 Cost of sales % of net sales81.1 %83.1 %Total CompanyNet sales$3,086.2 $3,163.6 $(77.4)Cost of sales$1,905.3 $1,920.3 $(15.0)Cost of sales % of net sales61.7 %60.7 %23Table of ContentsWe reported net sales of $3,086.2 million in 2020, compared with net sales of $3,163.6 million for 2019, a decrease of 2.4%. Net income was $401.9 million ($10.62 per diluted share) in 2020, compared with net income of $402.3 million ($10.73 per diluted share) in 2019, a decrease of 0.1%. Total year 2020 and 2019 reflected pretax charges totaling $33.3 million and $8.8 million, respectively, primarily in severance, facility consolidation, acquisition and certain changes in contract cost estimates. Net income for 2020 and 2019 also included net discrete tax benefits of $34.6 million and $26.1 million, respectively. Net salesThe decrease in net sales in 2020, compared with 2019, reflected lower net sales in each segment except the Engineered Systems segment. Net sales in 2020 included $68.9 million in incremental net sales from recent acquisitions. Sales under contracts with the U.S. Government were approximately 26% of net sales in 2020 and 24% of net sales in 2019. Sales to international customers represented approximately 45% of net sales in 2020 and 44% of net sales in 2019. Cost of SalesCost of sales decreased by $15.0 million in 2020, compared with 2019, which primarily reflected the impact of lower net sales, partially offset by higher severance and facility consolidation expense. Cost of sales as a percentage of net sales for 2020 was 61.7%, compared with 60.7% for 2019. Selling, general and administrative expensesSelling, general and administrative expenses, including research and development expense, were lower in 2020, compared with 2019. The decrease primarily reflected the impact of lower net sales. Corporate administrative expense in 2020 was $56.8 million, compared with $65.1 million in 2019. The lower 2020 amount primarily reflected lower compensation expense. For 2020, we recorded a total of $24.7 million in stock option expense, of which $7.2 million was recorded within corporate expense and $17.5 million was recorded in the operating segment results. For 2019, we recorded a total of $26.1 million in stock option expense, of which $9.7 million was recorded within corporate expense and $16.4 million was recorded in the operating segment results. Selling, general and administrative expenses as a percentage of sales was 22.7% for 2020, compared with 23.8% for 2019. Pension Service ExpensePension service expense is included in both cost of sales and selling, general and administrative expense. Pension service expense in 2020 was $10.4 million compared with $9.4 million in 2019. Operating IncomeOperating income for 2020 was $480.1 million, compared with $491.7 million for 2019, a decrease of 2.4%. The decrease in operating income primarily reflected lower operating income in the Aerospace and Defense Electronics segment, partially offset by higher operating income in our other three segments. Operating income in 2020 and 2019 included charges of $33.3 million and $8.8 million, respectively, primarily related to severance, facility consolidation and acquisition expense and certain changes in contract cost estimates. Of these amounts, severance and facility consolidation expense totaled $20.8 million in 2020 and $3.2 million in 2019. The incremental operating income included in the results for 2020 from recent acquisitions was $4.1 million. Interest Expense, Interest Income, Non-Service Retirement Benefit Income and Other ExpenseInterest expense, including credit facility fees and other bank charges, was $15.8 million in 2020 compared with $22.0 million in 2019 and reflected the impact of lower average debt levels in 2020. Interest income was $0.5 million in 2020 and $1.0 million in 2019. Non-service retirement benefit income was $12.1 million in 2020, compared with $8.0 million in 2019. Other expense was $7.2 million for 2020, compared with expense of $5.0 million in 2019 and reflected higher foreign currency expense. Income TaxesThe Company’s effective tax rate for 2020 was 14.4%, compared with 15.1% for 2019. For 2020 net discrete income tax benefits were $34.6 million, which included a $20.9 million income tax benefit related to share-based accounting, $9.8 million primarily related to U.S. export sales, U.S. research credits and other items. For 2019 net discrete income tax benefits were $26.1 million, which included a $15.4 million income tax benefit related to share-based accounting, $13.1 million in income tax benefit as a result of the remeasurement of uncertain tax positions due to expiration of statute of limitations, a favorable tax settlement and a tax benefit related to U.S. export sales. Excluding the net discrete income tax benefits in both years, the effective tax rates would have been 21.8% for 2020 and 20.6% for 2019. 24Table of Contents2019 compared with 2018 Sales (dollars in millions)20192018% ChangeInstrumentation$1,105.1 $1,021.2 8.2 %Digital Imaging 992.9 875.3 13.4 %Aerospace and Defense Electronics 690.1 640.2 7.8 %Engineered Systems 375.5 365.1 2.8 %Total sales$3,163.6 $2,901.8 9.0 % Results of operations (dollars in millions)20192018% ChangeInstrumentation$200.4 $147.4 36.0 %Digital Imaging 176.5 155.5 13.5 %Aerospace and Defense Electronics 143.4 131.8 8.8 %Engineered Systems 36.5 37.9 (3.7)%Corporate expense (65.1)(56.0)16.3 %Operating income491.7 416.6 18.0 %Interest and debt expense, net (21.0)(25.5)(17.6)%Non-service retirement benefit income8.0 13.5 (40.7)%Other expense, net (5.0)(10.7)(53.3)%Income before income taxes 473.7 393.9 20.3 %Provision for income taxes 71.4 60.1 18.8 %Net income$402.3 $333.8 20.5 %Sales and cost of sales by segment and total company (dollars in millions):20192018ChangeInstrumentationNet sales$1,105.1 $1,021.2 $83.9 Cost of sales$612.8 $575.2 $37.6 Cost of sales % of net sales55.5 %56.3 %Digital ImagingNet sales$992.9 $875.3 $117.6 Cost of sales$580.6 $529.4 $51.2 Cost of sales % of net sales58.5 %60.5 %Aerospace and Defense ElectronicsNet sales$690.1 $640.2 $49.9 Cost of sales$414.7 $385.9 $28.8 Cost of sales % of net sales60.1 %60.3 %Engineered SystemsNet sales$375.5 $365.1 $10.4 Cost of sales$312.2 $300.5 $11.7 Cost of sales % of net sales83.1 %82.3 %Total CompanyNet sales$3,163.6 $2,901.8 $261.8 Cost of sales$1,920.3 $1,791.0 $129.3 Cost of sales % of net sales60.7 %61.7 %25Table of ContentsWe reported net sales of $3,163.6 million in 2019, compared with net sales of $2,901.8 million for 2018, an increase of9.0%. Net income was $402.3 million ($10.73 per diluted share) in 2019, compared with net income of $333.8 million ($9.01per diluted share) in 2018, an increase of 20.5%.Total year 2019 and 2018 reflected pretax charges totaling $3.2 million and $7.8 million, respectively, for severance andfacility consolidation charges. Net income for 2019 and 2018 also included net discrete tax benefits of $26.1 million and $23.8million, respectively. Net salesThe increase in net sales in 2019, compared with 2018, reflected higher net sales in each segment. Net sales in 2019included revenue growth of $128.7 million plus $133.1 million in incremental net sales from recent acquisitions.Sales under contracts with the U.S. Government were approximately 24% of net sales in 2019 and 23% of net sales in2018. Sales to international customers represented approximately 44% of net sales in 2019 and 47% of net sales in 2018. Cost of SalesCost of sales increased by $129.3 million in 2019, compared with 2018, which primarily reflected the impact of higher net sales. Cost of sales as a percentage of sales for 2019 was 60.7%, compared with 61.7% for 2018.Selling, general and administrative expensesSelling, general and administrative expenses, including research and development expense, werehigher in 2019, compared with 2018. The increase primarily reflected the impact of higher sales and higher research anddevelopment expense. Corporate administrative expense in 2019 was $65.1 million, compared with $56.0million in 2018. The higher 2019 amount reflected higher compensation expense including higher stock option expense. For2019, we recorded a total of $26.1 million in stock option expense, of which $9.7 million was recorded within corporateexpense and $16.4 million was recorded in the operating segment results. For 2018, we recorded a total of $19.8 million instock option expense, of which $6.3 million was recorded within corporate expense and $13.5 million was recorded in theoperating segment results. Selling, general and administrative expenses as a percentage of sales was 23.8% for 2019, comparedwith 23.9% for 2018.Pension Service ExpensePension service expense is included in both cost of sales and selling, general and administrative expense. Pension service expense in 2019 was $9.4 million compared with pension service expense of $10.7 million in 2018. Operating IncomeOperating income for 2019 was $491.7 million, compared with $416.6 million for 2018, an increase of 18.0%. Theincrease in operating income primarily reflected higher operating income in each segment, except the Engineered Systemssegment. Operating income in 2019 and 2018 reflected $3.2 million and $7.8 million in severance and facility consolidationcosts, respectively. The incremental operating income included in the results for 2019 from recent acquisitions was $16.2million. Interest Expense, Interest Income, Non-Service Retirement Benefit Income and Other ExpenseInterest expense, including credit facility fees and other bank charges, was $22.0 million in 2019 compared with$29.2 million in 2018 and reflected the impact of lower average debt levels in 2019. Interest income was $1.0 million in 2019and $3.7 million in 2018. Non-service retirement benefit income was $8.0 million in 2019, compared with $13.5 million in2018. Other expense was $5.0 million for 2019, compared with expense of $10.7 million in 2018 and reflected lower foreign currency expense in 2019.Income TaxesThe Company’s effective tax rate for 2019 was 15.1%, compared with 15.3% for 2018. For 2019 net discrete income taxbenefits were $26.1 million, which included a $15.4 million income tax benefit related to share-based accounting, $13.1 millionin income tax benefit as a result of the remeasurement of uncertain tax positions due to expiration of statute of limitations, afavorable tax settlement and a tax benefit related to U.S. export sales. For 2018 net discrete income tax benefits were $23.8million, which included a $12.9 million income tax benefit related to share-based accounting, $5.1 million in income tax benefitas a result of the remeasurement of uncertain tax positions due to expiration of statute of limitations and a $4.8 million incometax benefit related to the release of a valuation allowance for which the deferred tax assets are now determined more-likely-than-not to be realizable. Excluding the net discrete income tax benefits in both years, the effective tax rates would have been20.6% for 2019 and 21.3% for 2018.26Table of ContentsSegmentsThe following discussion of our four segments should be read in conjunction with Note 12 of the Notes to Consolidated Financial Statements.Instrumentation(Dollars in millions)202020192018Net sales$1,094.5 $1,105.1 $1,021.2 Cost of sales$603.4 $612.8 $575.2 Selling, general and administrative expenses$277.9 $291.9 $298.6 Operating income$213.2 $200.4 $147.4 Cost of sales % of net sales55.1 %55.5 %56.3 %Selling, general and administrative expenses % of net sales25.4 %26.4 %29.3 %Operating income % of net sales19.5 %18.1 %14.4 %International sales % of net sales57.0 %54.8 %51.0 %U.S. Government sales % of net sales7.4 %7.3 %6.7 %Our Instrumentation segment provides monitoring and control instruments for marine, environmental, industrial and other applications, as well as electronic test and measurement equipment. We also provide power and communications connectivity devices for distributed instrumentation systems and sensor networks deployed in mission critical, harsh environments.2020 compared with 2019 Our Instrumentation segment net sales for 2020 decreased 1.0%, compared with 2019. Operating income for 2020 increased 6.4%, compared with 2019. The 2020 net sales decrease primarily resulted from lower sales of marine instrumentation and test and measurement instrumentation, partially offset by higher sales of environmental instrumentation. Sales of environmental instrumentation increased $19.9 million and included $51.8 million in incremental sales from the gas and flame detection business acquisition. Sales of marine instrumentation decreased by $23.9 million. Sales of test and measurement instrumentation decreased $6.6 million and included $14.8 million in incremental sales from the acquisition of OakGate. The increase in operating income reflected the impact of improved product line margins and lower severance, facility consolidation and acquisition expense. The incremental operating income included in the results for 2020 from recent acquisitions was $4.1 million, including $3.4 million in incremental intangible asset amortization expense. Operating income in 2020 included $7.6 million in severance, facility consolidation and acquisition expense compared with $2.9 million in similar costs for 2019.Cost of sales decreased by $9.4 million in 2020, compared with 2019, and primarily reflected the impact of lower net sales. The cost of sales percentage decreased slightly to 55.1% in 2020 from 55.5% in 2019. Selling, general and administrative expenses, including research and development expense, in 2020, decreased by $14.0 million, compared with 2019, and reflected the impact of lower sales, $3.0 million in lower research and development expense, partially offset by higher severance, facility consolidation and acquisition expense. Selling, general and administrative expenses for 2020, as a percentage of sales, decreased to 25.4%, compared with 26.4% for 2019, and reflected the impact of $3.0 million in lower research and development expense, partially offset by the impact of higher severance and facility consolidation and acquisition expense.2019 compared with 2018 Our Instrumentation segment net sales for 2019 increased 8.2%, compared with 2018. Operating income increased 36.0%, compared with 2018. The 2019 net sales increase primarily resulted from higher sales of environmental instrumentation, marine instrumentationand test and measurement instrumentation, as well as the contribution from the gas and flame detection business acquisition.Sales of environmental instrumentation increased $51.8 million and included $45.3 million in incremental sales from the gasand flame detection business acquisition. Sales of marine instrumentation increased by $17.2 million. Sales of test andmeasurement instrumentation increased $14.9 million. The increase in operating income reflected the impact of higher salesand higher margins across most product lines. The incremental operating income included in the results for 2019 from the gasand flame detection business acquisition was $4.1 million. Operating income in 2019 included $1.5 million in severance andfacility consolidation costs compared with $5.6 million in severance and facility consolidation costs for 2018.27Table of ContentsCost of sales increased by $37.6 million in 2019, compared with 2018, and primarily reflected the impact of higher net sales. The cost of sales percentage decreased slightly to 55.5% in 2019 from 56.3% in 2018. Selling, general and administrative expenses, including research and development expense, in 2019, decreased by $6.7 million, compared with 2018, and reflected the impact of cost control efforts, lower severance and facility consolidation costs and lower research and development expense of $3.2 million. Selling, general and administrative expenses for 2019, as a percentage of sales, decreased to 26.4%, compared with 29.3% for 2018, and reflected the impact of cost control efforts, lower severance and facility consolidation costs and lower research and development expense.Digital Imaging(Dollars in millions)202020192018Net sales$986.0 $992.9 $875.3 Cost of sales$569.2 $580.6 $529.4 Selling, general and administrative expenses$224.0 $235.8 $190.4 Operating income$192.8 $176.5 $155.5 Cost of sales % of net sales57.7 %58.5 %60.5 %Selling, general and administrative expenses % of net sales22.7 %23.7 %21.7 %Operating income % of net sales 19.6 %17.8 %17.8 %International sales % of net sales 60.8 %59.7 %66.0 %U.S. Government sales % of net sales 12.3 %10.8 %10.3 %Our Digital Imaging segment includes high-performance sensors, cameras and systems, within the visible, infrared and X-ray spectra for use in industrial, government and medical applications, as well as MEMS and high-performance, high-reliability semiconductors including analog-to-digital and digital-to-analog converters. It also includes our sponsored and centralized research laboratories which benefit government programs and commercial businesses. 2020 compared with 2019 Our Digital Imaging segment net sales for 2020 decreased 0.7%, compared with 2019. Operating income for 2020 increased 9.2%, compared with 2019. Total year 2020 net sales primarily reflected lower sales of X-ray products for dental and medical applications, due in part to deferred patient treatments, partially offset by greater sales of infrared detectors for defense and space applications, MEMS products, and $2.3 million in incremental sales from recent acquisitions. The increase in operating income for 2020 reflected the impact of favorable product mix. Cost of sales for 2020 decreased by $11.4 million, compared with 2019, and reflected the impact of lower net sales. The cost of sales percentage in 2020 decreased to 57.7% compared with 58.5% in 2019. Selling, general and administrative expenses for 2020 decreased to $224.0 million, compared with $235.8 million in 2019 and reflected the impact of lower net sales and lower research and development expense. The selling, general and administrative expense percentage decreased to 22.7% in 2020 from 23.7% in 2019 and reflected the impact of lower selling and research and development expense.2019 compared with 2018 Our Digital Imaging segment net sales for 2019 increased 13.4%, compared with 2018. Operating income for 2019 increased 13.5%, compared with 2018.Total year 2019 net sales primarily reflected higher sales of X-ray detectors for life sciences applications and aerospace, defense and MEMS products, as well as $87.8 million in sales from recent acquisitions, partially offset by lower sales of industrial machine vision products. The increase in operating income for 2019 reflected the impact of higher sales and incremental operating profit from recent acquisitions. The incremental operating income reflected in the results for 2019 from recent acquisitions was $12.1 million which included $4.7 million in additional intangible asset amortization expense. Cost of sales for 2019 increased by $51.2 million, compared with 2018, and reflected the impact of higher net sales. The cost of sales percentage in 2019 decreased to 58.5% compared with 60.5% in 2018 and reflected product mix differences. Selling, general and administrative expenses for 2019 increased to $235.8 million, compared with $190.4 million in 2018 and reflected the impact of higher net sales, higher research and development expense and intangible amortization expense from recent acquisitions. The selling, general and administrative expense percentage increased to 23.7% in 2019 from 21.7% in 2018 and reflected the impact of higher research and development expense and intangible amortization expense from recent acquisitions. 28Table of ContentsAerospace and Defense Electronics(Dollars in millions)202020192018Net sales$589.4 $690.1 $640.2 Cost of sales$395.1 $414.7 $385.9 Selling, general and administrative expenses$113.5 $132.0 $122.5 Operating income$80.8 $143.4 $131.8 Cost of sales % of net sales67.0 %60.1 %60.3 %Selling, general and administrative expenses % of net sales19.3 %19.1 %19.1 %Operating income % of net sales 13.7 %20.8 %20.6 %International sales % of net sales 27.1 %27.4 %34.1 %U.S. Government sales % of net sales 39.0 %32.6 %27.7 %Our Aerospace and Defense Electronics segment provides sophisticated electronic components and subsystems and communications products, including defense electronics, harsh environment interconnects, data acquisition and communications equipment for aircraft, and components and subsystems for wireless and satellite communications, as well as general aviation batteries. 2020 compared with 2019 Our Aerospace and Defense Electronics segment net sales for 2020 decreased 14.6%, compared with 2019. Operating income for 2020 decreased 43.7%, compared with 2019.The 2020 net sales decrease reflected $94.8 million of lower sales of aerospace electronics and lower sales of $5.9 million of defense electronics. The continued weakness in the commercial aerospace industry, due to COVID-19, has negatively affected sales of aerospace electronics. The decrease in operating income in 2020 primarily reflected the impact of lower sales and $18.3 million of higher severance, facility consolidation expense and certain unfavorable changes in contract cost estimates. Cost of sales for 2020 decreased by $19.6 million, compared with 2019, and reflected the impact of lower net sales. Cost of sales as a percentage of net sales for 2020 increased to 67.0% from 60.1% in 2019 and reflected the impact of higher severance, facility consolidation expense and certain unfavorable changes in contract cost estimates. Selling, general and administrative expenses, including research and development expense, decreased to $113.5 million in 2020, from $132.0 million in 2019 and reflected the impact of lower net sales, partially offset by higher severance and facility consolidation expense. The selling, general and administrative expense percentage was 19.3% in 2020 compared to 19.1% in 2019.2019 compared with 2018 Our Aerospace and Defense Electronics segment net sales for 2019 increased 7.8%, compared with 2018. Operating income for 2019 increased 8.8%, compared with 2018.The 2019 net sales increase reflected $57.9 million of higher sales of defense electronics, partially offset by $8.0 millionof lower sales of aerospace electronics. The higher sales of defense electronics reflected greater sales in most productcategories. Operating income in 2019 reflected the impact of higher net sales.Cost of sales for 2019 increased by $28.8 million, compared with 2018, and reflected the impact of higher net sales. Costof sales as a percentage of net sales for 2019 decreased slightly to 60.1% from 60.3% in 2018. Selling, general and administrative expenses, including research and development expense, increased to $132.0 million in 2019, from $122.5 million in 2018 and reflected higher research and development expense of $10.5 million. The selling, general and administrative expense percentage was 19.1% for both 2019 and 2018.29Table of ContentsEngineered Systems(Dollars in millions)202020192018Net sales$416.3 $375.5 $365.1 Cost of sales$337.6 $312.2 $300.5 Selling, general and administrative expenses$28.6 $26.8 $26.7 Operating income$50.1 $36.5 $37.9 Cost of sales % of net sales81.1 %83.1 %82.3 %Selling, general and administrative expenses % of net sales6.9 %7.2 %7.3 %Operating income % of net sales 12.0 %9.7 %10.4 %International sales % of net sales 0.7 %1.1 %2.9 %U.S. Government sales % of net sales 92.9 %92.3 %87.5 %Our Engineered Systems segment provides innovative systems engineering and integration, advanced technology development, and manufacturing solutions for defense, space, environmental and energy applications. This segment also designs and manufactures electrochemical energy systems and small turbine engines.2020 compared with 2019 Our Engineered Systems segment net sales for 2020 increased 10.9%, compared with 2019. Operating income for 2020 increased 37.3%, compared with 2019.The 2020 sales increase reflected higher sales of $35.2 million of engineered products and services and $8.4 million of turbine engines, partially offset by lower sales of $2.8 million of energy systems products. The higher sales of engineered products and services primarily reflected increased sales from marine, space, nuclear and other manufacturing programs, as well as electronic manufacturing services products, partially offset by lower sales related to missile defense. The higher sales of turbine engines reflected increased sales for the Harpoon missile program. Operating income in 2020 reflected the impact of higher sales and a greater mix of higher margin fixed-price manufacturing programs. Cost of sales for 2020 increased by $25.4 million, compared with 2019, and primarily reflected the impact of higher net sales. Cost of sales as a percentage of net sales for 2020 decreased to 81.1%, compared with 83.1% in 2019. Selling, general and administrative expenses, including research and development and bid and proposal expense, increased to $28.6 million in 2020, compared with $26.8 million in 2019. The selling, general and administrative expense percentage decreased slightly to 6.9% for 2020, compared with 7.2% in 2019.2019 compared with 2018 Our Engineered Systems segment net sales for 2019 increased 2.8%, compared with 2018. Operating income for 2019 decreased 3.7%, compared with 2018.The 2019 sales increase of $10.4 million reflected higher sales of $14.3 million of engineered products and services, partially offset by lower sales of $2.6 million of energy systems products and $1.3 million of turbine engines. The higher sales of engineered products and services primarily reflected increased sales for nuclear manufacturing and space programs. Operating income in 2019 decreased due to product mix differences.Cost of sales for 2019 increased by $11.7 million, compared with 2018, and primarily reflected the impact of higher net sales. Cost of sales as a percentage of net sales for 2019 increased slightly 83.1%, compared with 82.3% in 2018. Selling, general and administrative expenses, including research and development and bid and proposal expense, increased slightly to $26.8 million in 2019, compared with $26.7 million in 2018. The selling, general and administrative expense percentage decreased slightly to 7.2% for 2019, compared with 7.3% in 2018. 30Table of ContentsFinancial Condition, Liquidity and Capital ResourcesPrincipal Cash and Capital RequirementsOur principal cash and capital requirements are to fund working capital needs, capital expenditures, income tax payments and debt service requirements, as well as acquisitions. It is anticipated that operating cash flow, together with available borrowings under the credit facility and the debt financing arrangement described below will be sufficient to meet these requirements and to fund the FLIR acquisition. To support acquisitions, we may need to raise additional capital. Our liquidity is not dependent upon the use of off-balance sheet financial arrangements. We have no off-balance sheet financing arrangements that incorporate the use of special purpose or unconsolidated entities.As part of the pending acquisition of FLIR, Teledyne has arranged a $4.5 billion 364-day credit commitment to support funding of the transaction. Teledyne expects to fund the acquisition with a combination of equity, cash on hand and permanent debt financing, including a combination of senior notes and bank term loans.Credit Facility, Senior Notes and Term LoanLong-term debt (dollars in millions):January 3, 2021December 29, 2019$750.0 million credit facility, due March 2024, weighted average rate of 1.05% at January 3, 2021 and 2.80% at December 29, 2019$125.0 $125.0 Term loan due October 2024, variable rate of 1.15% at January 3, 2021 and 2.702% at December 29, 2019, swapped to a Euro fixed rate of 0.612%150.0 150.0 5.30% Fixed Rate Senior Notes repaid September 2020— 75.0 2.81% Fixed Rate Senior Notes repaid November 2020— 25.0 3.09% Fixed Rate Senior Notes due December 202195.0 95.0 3.28% Fixed Rate Senior Notes due November 2022100.0 100.0 0.70% €50 Million Fixed Rate Senior Notes due April 202261.1 56.0 0.92% €100 Million Fixed Rate Senior Notes due April 2023122.1 111.9 1.09% €100 Million Fixed Rate Senior Notes due April 2024122.1 111.9 Other debt4.0 2.0 Debt issuance costs(0.8)(1.2)Total long-term debt778.5 850.6 Current portion of long-term debt(97.6)(100.6)Total long-term debt, net of current portion$680.9 $750.0 At January 3, 2021, we had $27.7 million in outstanding letters of credit.Our credit facility, senior notes and term loan agreement require the Company to comply with various financial and operating covenants, including maintaining certain consolidated leverage and interest coverage ratios, as well as minimum net worth levels and limits on acquired debt. At January 3, 2021, the Company was in compliance with these covenants and we had a significant amount of margin between required financial covenant ratios and our actual ratios. Currently, we do not believe our ability to undertake additional debt financing, if needed, is reasonably likely to be materially impacted by debt restrictions under our credit agreements subject to our complying with required financial covenants listed in the table below. Financial covenant ratios and the actual ratios at January 3, 2021: $750.0 million Credit Facility expires March 2024 and $150.0 million term loan due October 2024 (issued October 2019)Financial CovenantRequirementActual MeasureConsolidated Leverage Ratio (Net Debt/EBITDA) (a)No more than 3.25 to 11.338 to 1Consolidated Interest Coverage Ratio (EBITDA/Interest) (b)No less than 3.0 to 140.1 to 1$500.3 million Private Placement Senior Notes due from 2021 to 2024Financial CovenantRequirementActual MeasureConsolidated Leverage Ratio (Net Debt/EBITDA) (a)No more than 3.25 to 11.338 to 1Consolidated Interest Coverage Ratio (EBITDA/Interest) (b)No less than 3.0 to 140.1 to 1(a) The Consolidated Leverage Ratio is equal to Net Debt/EBITDA as defined in our private placement note purchase agreement and our $750.0 million credit agreement.(b) The Consolidated Interest Coverage Ratio is equal to EBITDA/Interest as defined in our private placement note purchase agreement and our $750.0 million credit agreement.31Table of ContentsIn the event of an acquisition, our credit agreements permit us, at our option, to exceed the Consolidated Leverage Ratio of 3.25 to 1 for up to four quarters following the fiscal quarter in which the acquisition event occurs, provided that the Consolidated Leverage Ratio does not exceed 3.5 to 1. Available borrowing capacity under the $750.0 million credit facility, which is reduced by borrowings and outstanding letters of credit, was $615.5 million at January 3, 2021. See Note 9, Long-Term Debt to these Consolidated Financial Statements for additional information regarding our credit facility and term loan. Contractual Obligations The following table summarizes our expected cash outflows resulting from financial contracts and commitments at January 3, 2021:Contractual obligations (in millions):20212022202320242025After 2025 TotalDebt obligations$97.1 $161.1 $122.1 $397.1 $0.8 $1.1 $779.3 Interest expense(a)12.9 9.2 5.6 2.2 — — 29.9 Operating lease obligations (b)23.8 22.4 19.2 17.0 15.5 66.0 163.9 Purchase obligations (c)203.7 11.8 1.9 2.7 1.0 0.7 221.8 Total$337.5 $204.5 $148.8 $419.0 $17.3 $67.8 $1,194.9 (a) Interest expense related to the credit facility, including facility fees, is assumed to accrue at the rates in effect at year-end 2020 and is assumed to be paid at the end of each quarter with the final payment in March 2024 when the credit facility expires.(b) Includes imputed interest and the short-term portion of lease obligations.(c) Purchase obligations generally include contractual obligations for the purchase of goods and services and capital commitments that are enforceable and legally binding on us and that specifies all significant terms, including: fixed or minimum quantities to be purchased; fixed, minimum, or variable price provisions; and the approximate timing of the transaction.Unrecognized tax benefits of $32.3 million are not included in the table above because $14.7 million is offset by deferred tax assets, and the remainder cannot be reasonably estimated to be settled in cash due to a lack of prior settlement history and offsetting credits.At January 3, 2021, we were not required, and accordingly are not planning, to make any cash contributions to the domestic qualified pension plans for 2021. Our minimum funding requirements after 2020 as set forth by ERISA, are dependent on several factors as discussed under “Accounting for Pension Plans” in the Critical Accounting Policies section of this Management’s Discussion and Analysis of Financial Condition and Results of Operation. Estimates beyond 2021 have not been provided due to the significant uncertainty of these amounts, which are subject to change until the Company’s pension assumptions can be updated at the appropriate times. In addition, certain pension contributions are eligible for future recovery through the pricing of products and services to the U.S. government under certain government contracts, therefore, future cash contributions are not necessarily indicative of the impact these contributions may have on our liquidity. We also have payments due under our other postretirement benefit plans. These plans are not required to be funded in advance, but are pay as you go. See further discussion in Note 11 of the Notes to Consolidated Financial Statements. Teledyne intends to continue to monitor and manage its defined benefit pension plans obligation and may take additional actions to manage risk in the future.Operating ActivitiesIn 2020, net cash provided by operating activities was $618.9 million, compared with $482.1 million in 2019 and $446.9 million in 2018. The higher cash provided by operating activities in 2020, compared with 2019, was driven by timing of accounts receivable collections, cash flow from recent acquisitions and $35.6 million of lower income tax payments. The higher cash provided by operating activities in 2019, compared with 2018, was driven by higher operating income, partially offset by $45.4 million of higher income tax payments. Free cash flow (cash provided by operating activities less capital expenditures) was $547.5 million in 2020, compared with $393.7 million in 2019 and $360.1 million in 2018. Free Cash Flow(a)(in millions, brackets indicate use of funds)202020192018Cash provided by operating activities$618.9 $482.1 $446.9 Capital expenditures for property, plant and equipment(71.4)(88.4)(86.8)Free cash flow$547.5 $393.7 $360.1 a) We define free cash flow as cash provided by operating activities (a measure prescribed by generally accepted accounting principles) less capital expenditures for property, plant and equipment. We believe that this supplemental non-GAAP information is useful to assist management and the investment community in analyzing our ability to generate cash flow.32Table of ContentsInvesting ActivitiesNet cash used in investing activities was $99.4 million, $571.9 million and $88.6 million for 2020, 2019 and 2018, respectively. Cash flows relating to investing activities consists primarily of cash used for acquisitions and other investments and capital expenditures.Capital expenditures (in millions):202020192018Instrumentation$18.0 $18.9 $14.8 Digital Imaging33.4 45.2 35.8 Aerospace and Defense Electronics10.4 19.0 18.7 Engineered Systems7.5 3.6 13.6 Corporate2.1 1.7 3.9 $71.4 $88.4 $86.8 During 2021, we plan to invest approximately $80.0 million in capital expenditures, principally to upgrade facilities and manufacturing equipment.AcquisitionsInvesting activities used cash for acquisitions and other investments of $29.0 million, $484.0 million and $3.1 million, in 2020, 2019 and 2018, respectively (see “Recent Acquisitions”). Teledyne funded the acquisitions primarily from borrowings under its credit facilities, issuance of senior notes and term loans and cash on hand. On January 5, 2020, we acquired OakGate Technology, Inc. for $28.5 million in cash. For all acquisitions, the results of operations and cash flows are included in our consolidated financial statements from the date of each respective acquisition. The following table shows the purchase price (net of cash acquired), goodwill acquired and intangible assets acquired for the acquisitions and other investments made in 2020 and 2019 (in millions):2020AcquisitionAcquisition dateCash Paid (a)Goodwill AcquiredAcquired Intangible AssetsOakGate Technology, Inc.January 5, 2020$28.5 $16.9 $7.0 Purchase price adjustment - Micralyne Inc.0.5 — — Total$29.0 $16.9 $7.0 (a) Net of cash acquired .Goodwill resulting from the OakGate acquisition will not be deductible for tax purposes. 2019AcquisitionAcquisition dateCash Paid (a)Goodwill AcquiredAcquired Intangible AssetsScientific imaging businessFebruary 5, 2019$224.8 $149.9 $52.4 Gas and flame detection businessAugust 1, 2019233.5 147.7 69.0 Micralyne Inc.August 30, 201925.7 7.3 0.9 Total$484.0 $304.9 $122.3 (a) Net of any cash acquired and any purchase price adjustments.The majority of the goodwill resulting from the acquisition of the scientific imaging businesses will be deductible for tax purposes. Goodwill resulting from the acquisition of the gas and flame detection business and Micralyne will not be deductible for tax purposes. See Note 15, Subsequent Events, to these Consolidated Financial Statements for information about the pending acquisition of FLIR. 33Table of ContentsFinancing ActivitiesFinancing activities for 2020 reflected net payments on debt of $98.1 million, compared with net proceeds from debt of $108.8 million in 2019 and net payments on debt of $306.5 million for 2018. Fiscal years 2020, 2019 and 2018 reflect proceeds from the exercise of stock options of $36.3 million, $34.6 million and $37.2 million, respectively. Other MattersPension PlansEffective January 1, 2020, Teledyne restructured its domestic qualified defined benefit pension plan. The restructuring involved dividing our domestic qualified defined pension plan into two separate plans, one comprised primarily of inactive participants (the “inactive plan”) and the other comprised primarily of active participants (the “active plan”). The reorganization was made to facilitate a targeted investment strategy over time and to provide additional flexibility in evaluating opportunities to reduce risk and volatility. Actuarial gains and losses associated with the active plan will continue to be amortized over the average remaining service period of the active participants, which is approximately nine years, while the actuarial gains and losses associated with the inactive plan will be amortized over the average remaining life expectancy of the inactive participants, which is approximately 17 years. These plans cover substantially all U.S. employees hired before January 1, 2004, or approximately 10% of Teledyne’s active employees as of January 3, 2021. As of January 1, 2004, new U.S. hires participate in a domestic defined contribution plan. In 2020, 2019 and 2018, Teledyne was not required, and did not make any cash contributions to the domestic pension plans. For the Company’s qualified defined benefit pension plans, the discount rate for 2021 will decrease to an average of 2.64% from 3.41% in 2020. The Company also has several small non-qualified domestic and foreign-based defined benefit pension plans. Income TaxesOur income tax expense, deferred tax assets and liabilities, and reserves for unrecognized tax benefits reflect management’s best assessment of estimated current and future taxes to be paid. We are subject to income taxes in both the United States and numerous foreign jurisdictions. Significant judgments and estimates are required in determining the consolidated income tax expense.We intend to reinvest indefinitely the earnings of our material foreign subsidiaries in our operations outside of the United States. The cash that the Company’s foreign subsidiaries hold for indefinite reinvestment is generally used to finance foreign operations and investments, including foreign acquisitions. We estimate that future domestic cash generation will be sufficient to meet future domestic cash requirements. Due to the Tax Act, U.S. federal and applicable state income taxes have been accrued for the deemed repatriation. At January 3, 2021, the amount of undistributed foreign earnings was $326.8 million, for which we have not recorded a deferred tax liability of approximately $1.4 million for corporate income taxes which would be due if reinvested foreign earnings were repatriated. Should we decide to repatriate the foreign earnings, we would need to adjust our income tax provision in the period we determined that we would no longer indefinitely reinvest the earnings outside the United States.Deferred income taxes arise from temporary differences between the tax basis of assets and liabilities and their reported amount in the financial statements, which will result in taxable or deductible amounts in the future. In evaluating our ability to recover our deferred tax assets within the jurisdiction from which they arise, we consider all available positive and negative evidence, including scheduled reversals of deferred tax liabilities, projected future taxable income, tax-planning strategies, and results of recent operations. In projecting future taxable income, we begin with historical results adjusted for the results of discontinued operations and incorporate assumptions about the amount of future state, federal and foreign pretax operating income adjusted for items that do not have tax consequences. The assumptions about future taxable income require significant judgment and are consistent with the plans and estimates we are using to manage the underlying businesses. In evaluating the objective evidence that historical results provide, we consider three years of cumulative operating income. Based on the Company’s history of operating earnings, expectations of future operating earnings and potential tax planning strategies, management believes that it is possible that some portion of deferred taxes will not be realized as a future tax benefit and therefore has recorded a valuation allowance. We file income tax returns in the United States federal jurisdiction and in various states and foreign jurisdictions. The Company has substantially concluded on all U.S. federal income tax matters for all years through 2016, United Kingdom income tax matters for all years through 2019, France income tax matters for all years through 2016 and Canadian income tax matters for all years through 2012. Costs and PricingInflationary trends in recent years have been moderate. Current inventory costs, the increasing costs of equipment and other costs are considered in establishing sales pricing policies. The Company emphasizes cost containment and cost reductions in all aspects of its business. 34Table of ContentsHedging Activities and Market Risk DisclosuresTeledyne transacts business in various foreign currencies and has international sales and expenses denominated in foreign currencies, subjecting the Company to foreign currency risk. The Company’s primary objective is to protect the United States dollar value of future cash flows and minimize the volatility of reported earnings. The Company utilizes foreign currency forward contracts to reduce the volatility of cash flows primarily related to forecasted revenue and expenses denominated in Canadian dollars for our Canadian companies, and in British pounds for our U.K. companies. These contracts are designated and qualify as cash flow hedges. The Company has converted U.S. dollar denominated, variable rate and fixed rate debt obligations of a European subsidiary, into euro fixed rate obligations using a receive float, pay fixed cross currency swap, and a received fixed pay, fixed cross currency swap. These cross currency swaps are designated as cash flow hedges. In addition, the Company has converted domestic U.S. variable rate debt to fixed rate debt using a receive variable, pay fixed interest rate swap. The interest rate swap is also designated as a cash flow hedge. The effectiveness of the cash flow hedge forward contracts, the cross currency swap hedges, and the interest rate swap cash flow hedge is assessed prospectively and retrospectively on a monthly basis using regression analysis, as well as using other timing and probability criteria. To receive hedge accounting treatment, all hedging relationships are formally documented at the inception of the hedges and must be highly effective in offsetting changes to future cash flows on hedged transactions. The effective portion of the cash flow hedge forward contracts’ gains or losses resulting from changes in the fair value of these hedges is initially reported, net of tax, as a component of accumulated other comprehensive income/(loss) (“AOCI”) in stockholders’ equity until the underlying hedged item is reflected in our consolidated statements of income, at which time the effective amount in AOCI is reclassified to revenue in our consolidated statements of income. For the cross currency swap and interest rate cash flow hedges, effective amounts are recorded in AOCI, and reclassified into interest expense in the consolidated statements of income. In addition, for the cross currency swaps an amount is reclassified from AOCI to other income and expense each reporting period, to offset the earnings impact of the remeasurement of the hedged liabilities. Net deferred gains recorded in AOCI, net of tax, for forward contracts that will mature in the next 12 months total $5.4 million. These gains are expected to be offset by anticipated losses in the value of the forecasted underlying hedged item. Amounts related to the cross currency swaps and interest rate swap expected to be reclassified from AOCI into income in the coming 12 months total $1.2 million. In the event that the underlying forecasted transactions do not occur, or it becomes remote that they will occur, within the defined hedge period, the gains or losses on the related cash flow hedges will be reclassified from AOCI to other income and expense. During the current reporting period, all forecasted transactions occurred and, therefore, there were no such gains or losses reclassified to other income and expense, due to missed forecasts. As of January 3, 2021, Teledyne had foreign currency forward contracts designated as cash flow hedges to buy Canadian dollars and to sell U.S. dollars totaling $127.5 million. These foreign currency forward contracts have maturities ranging from March 2020 to February 2021. The cross currency swaps have notional amounts of €113.0 million and $125.0 million, and €135.0 million and $150.0 million, and mature in March 2023 and October 2024, respectively. The interest rate swap has a notional amount of $125.0 million and matures in March 2023.In addition, the Company utilizes foreign currency forward contracts to mitigate foreign exchange rate risk associated with foreign currency denominated monetary assets and liabilities, including intercompany receivables and payables. As of January 3, 2021, Teledyne primarily had foreign currency contracts of this type in the following currency pairs (in millions):Contracts to BuyContracts to SellCurrencyAmountCurrencyAmountCanadian Dollars$78.0 U.S. DollarsUS$59.7 Euros€36.2 U.S. DollarsUS$43.3 Great Britain Pounds£88.9 U.S. DollarsUS$119.1 Canadian Dollars$22.3 Euros€14.4 Danish KroneKr.302.3 U.S. DollarsUS$49.0 These contracts had a positive fair value of $5.6 million at January 3, 2021. The gains and losses on these derivatives which are not designated as hedging instruments, are intended to, at a minimum, partially offset the transaction gains and losses recognized in earnings. All derivatives are recorded on the balance sheet at fair value. As discussed below, the accounting for gains and losses resulting from changes in fair value depends on the use of the derivative and whether it is designated and qualifies for hedge accounting. Teledyne does not use foreign currency forward contracts for speculative or trading purposes.Notwithstanding our efforts to mitigate portions of our foreign currency exchange rate risks, there can be no assurance that our hedging activities will adequately protect us against the risks associated with foreign currency fluctuations. A hypothetical 10 percent price change of the U.S. dollar from its value at January 3, 2021, would result in a decrease or increase 35Table of Contentsin the fair value of our foreign currency forward contracts designated as cash flow hedges to buy Canadian dollars and to sell U.S. dollars by approximately $12.7 million. A hypothetical 10 percent price change in the U.S. dollar from its value at January 3, 2021 would result in a decrease or increase in the fair value of our Euro/U.S. Dollar cross currency swaps designated as cash flow hedges by approximately $31.3 million. A hypothetical 100 basis point increase in U.S. interest rates at January 3, 2021 would result in an increase in the fair value of our U.S. Dollar interest rate swap designated as a cash flow hedge by approximately $2.6 million, while a 100 basis point decrease would result in a decrease in its fair value of $0.5 million. Borrowings under our credit facility are at fixed rates that vary with the term and timing of each loan under the facility. Loans under the facility typically have terms of one, two, three or six months and the interest rate for each such loan is subject to change if the loan is continued or converted following the applicable maturity date. Interest rates are also subject to change based on our debt to earnings before interest, taxes, depreciation and amortization ratio. As of January 3, 2021, we had $125.0 million outstanding under our $750.0 million credit facility. Any borrowings under the Company’s credit facility are based on a fluctuating market interest rate and, consequently, the fair value of any outstanding debt should not be affected materially by changes in market interest rates. Our primary exposure to market risk relates to changes in interest rates and foreign currency exchange rates. We periodically evaluate these risks and have taken measures to mitigate these risks. We own assets and operate facilities in countries that have been politically stable.EnvironmentalWe are subject to various federal, state, local and international environmental laws and regulations which require that we investigate and remediate the effects of the release or disposal of materials at sites associated with past and present operations. These include sites at which Teledyne has been identified as a potentially responsible party under the Comprehensive Environmental Response, Compensation and Liability Act, commonly known as Superfund, and comparable state laws. We are currently involved in the investigation and remediation of a number of sites. Reserves for environmental investigation and remediation totaled $6.5 million and $6.0 million as of January 3, 2021 and December 29, 2019, respectively. As investigation and remediation of these sites proceed and new information is received, the Company will adjust accruals to reflect new information. Based on current information, we do not believe that future environmental costs, in excess of those already accrued, will materially and adversely affect our financial condition or liquidity. See also our environmental risk factor disclosure beginning on page 15 and Notes 2 and 14 of the Notes to Consolidated Financial Statements.Government ContractsWe perform work on a number of contracts with the U.S. Department of Defense and other agencies and departments of the U.S. Government including sub-contracts with government prime contractors. Sales under these contracts with the U.S. Government, which included contracts with the U.S. Department of Defense, were approximately 26% of total net sales in 2020, 24% of total net sales in 2019 and 23% of total sales in 2018. For a summary of sales to the U.S. Government by segment, see Note 12 of the Notes to Consolidated Financial Statements. Sales to the U.S. Department of Defense represented approximately 19%, 17% and 17% of total net sales for 2020, 2019 and 2018, respectively. Performance under government contracts has certain inherent risks that could have a material adverse effect on the Company’s business, results of operations and financial condition. Government contracts are conditioned upon the continuing availability of Congressional appropriations, which usually occurs on a fiscal year basis even though contract performance may take more than one year. See also our government contracts risks factor disclosure beginning on page 11.For information on accounts receivable from the U.S. Government, see Note 5 of the Notes to Consolidated Financial Statements.Estimates and ReservesOur discussion and analysis of financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent liabilities. On an ongoing basis, we evaluate our estimates, including those related to product returns and replacements, allowance for doubtful accounts, inventories, intangible assets, income taxes, warranty obligations, pension and other postretirement benefits, long-term contracts, environmental, workers’ compensation and general liability, employee benefits and other contingencies and litigation. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances at the time, the results of which form the basis for making our judgments. Actual results may differ materially from these estimates under different assumptions or conditions. In some cases, such differences may be material. See also Critical Accounting Policies.36Table of ContentsThe following table reflects significant reserves and valuation accounts, which are estimates and based on judgments as described above, at January 3, 2021, and December 29, 2019:Reserves and Valuation Accounts (in millions): (a)20202019Allowance for doubtful accounts$12.3 $10.2 Reduction to LIFO cost basis$6.7 $7.8 Workers’ compensation and general liability reserves (b)$6.2 $6.5 Environmental reserves (b)$6.5 $6.0 Other accrued liability reserves (b)$12.9 $16.0 (a) This table should be read in conjunction with the Notes to Consolidated Financial Statements.(b) Includes both long-term and short-term reserves.Some of the Company’s products are subject to standard warranties and the Company provides for the estimated cost of product warranties. We regularly assess the adequacy of our pre-existing warranty liabilities and adjust amounts as necessary based on a review of historic warranty experience with respect to the applicable business or products, as well as the length and actual terms of the warranties, which are typically one year. The product warranty reserve is included in current accrued liabilities and other long-term liabilities on the balance sheet. Warranty Reserve (in millions):202020192018Balance at beginning of year$24.8 $21.0 $21.1 Product warranty expense 3.3 13.1 10.0 Deductions (8.2)(14.2)(10.1)Acquisitions 2.5 4.9 — Balance at year-end$22.4 $24.8 $21.0 Critical Accounting PoliciesThe preparation of our consolidated financial statements in conformity with United States generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the financial statements and the notes to the financial statements. Some of those judgments can be subjective and complex, and therefore, actual results could differ materially from those estimates under different assumptions or conditions. Our critical accounting policies are those that are reflective of significant judgment, complexity and uncertainty, and may potentially result in materially different results under different assumptions and conditions. We have identified the following as critical accounting policies: revenue recognition; accounting for pension plans; accounting for business combinations, goodwill and acquired intangible assets; and accounting for income taxes. For additional discussion of the application of these and other accounting policies, see Note 2 of the Notes to Consolidated Financial Statements.Revenue RecognitionApproximately 40% of our revenue is recognized over time with the remaining 60% of our revenue recognized at a point in time. Revenue recognized over time relates primarily to contracts to design, develop and/or manufacture highly engineered products used in both defense and commercial applications. The transaction price in these arrangements may include estimated amounts of variable consideration, including award fees, incentive fees, contract amounts not yet funded, or other provisions that can either increase or decrease the transaction price. We estimate variable consideration at the amount to which we expect to be entitled, and we include estimated amounts in the transaction price to the extent it is probable that a significant reversal of cumulative revenue recognized will not occur when the estimation uncertainty is resolved. The estimation of this variable consideration and determination of whether to include estimated amounts in the transaction price are based largely on an assessment of our anticipated performance and all information (historical, current and forecasted) that is reasonably available to us. As control transfers continuously over time on these contracts, revenue is recognized based on the extent of progress towards completion of the performance obligation. The selection of the method to measure progress towards completion requires judgment and is based on the nature of the products or services to be provided. We generally use the cost-to-cost measure of progress as this measure best depicts the transfer of control to the customer which occurs as we incur costs on our contracts. Under the cost-to-cost method, the extent of progress towards completion is measured based on the ratio of costs incurred to date to the total estimated costs at completion of the performance obligation.37Table of ContentsFor over time contracts using cost-to-cost, we have an Estimate at Completion (“EAC”) process in which management reviews the progress and execution of our performance obligations. This EAC process requires management judgment relative to assessing risks, estimating contract revenue, determining reasonably dependable cost estimates, and making assumptions for schedule and technical issues. Since certain contracts extend over a longer period of time, the impact of revisions in cost and revenue estimates during the progress of work may adjust the current period earnings through a cumulative catch-up basis. This method recognizes, in the current period, the cumulative effect of the changes on current and prior quarters. Additionally, if the current contract estimate indicates a loss, a provision is made for the total anticipated loss in the period that it becomes evident. Contract cost and revenue estimates for significant contracts are generally reviewed and reassessed quarterly. We do not believe that any discrete event or adjustment to an individual contract within the aggregate changes in contract estimates for 2020, 2019 or 2018 was material to the consolidated statements of income for such annual periods.Revenue recognized at a point in time relates primarily to the sale of standard or minimally customized products, with control transferring to the customer generally upon the transfer of title. See Note 2 of the Notes to Consolidated Financial Statements for additional revenue recognition disclosures.Pension PlansThe Company’s accounting for its defined benefit pension plans requires that amounts recognized in financial statements be determined on an actuarial basis, rather than as contributions are made to the plan. In consultation with our actuaries, we determine the appropriate assumptions for use in determining the liability for future pension benefits. Net actuarial gains or losses are amortized to expense on a plan-by-plan basis when they exceed the accounting corridor. The accounting corridor is a defined range within which amortization of net gains and losses is not required and is equal to 10 percent of the greater of the market related value of assets or benefit obligations. Gains or losses outside of the corridor are subject to amortization. For our plan which covers mostly inactive participants, gains and losses subject to amortization are amortized over the average participants future life expectancy which is approximately 17 years. This plan represents the majority of the pension obligations. For our other plan, gains and losses subject to amortization are amortized over the average employee future service period which is approximately nine years. Significant assumptions used in determining the Company’s pension income or expense is the expected long-term rate of return on plan assets, participant mortality estimates, expected rates of increase in future compensation levels, employee turnover, as well as the assumed discount rate on pension obligations. Differences in the discount rate and expected long-term rate of return on assets within the indicated range would have had the following impact on 2020 pension expense (in millions): 0.25 Percentage Point Increase0.25 Percentage Point DecreaseIncrease (decrease) to pension expense resulting from: Change in discount rate$(0.3)$0.3 Change in long-term rate of return on plan assets$(2.1)$2.1 See Note 11 of the Notes to Consolidated Financial Statements for additional pension disclosures.Business Combinations, Goodwill and Acquired Intangible AssetsThe results for all acquisitions are included in the Company’s consolidated financial statements from the date of each respective acquisition. Business acquisitions are accounted for under the acquisition method by assigning the purchase price to tangible and intangible assets acquired and liabilities assumed. Assets acquired and liabilities assumed are recorded at their fair values and the excess of the purchase price over the amounts assigned is recorded as goodwill. We determine the fair value of such assets and liabilities, often in consultation with third-party valuation advisors. Acquired intangible assets with finite lives are amortized over their estimated useful lives. Adjustments to fair value assessments are recorded to goodwill over the purchase price allocation period.Goodwill and acquired intangible assets with indefinite lives are not amortized. We review goodwill and acquired indefinite-lived intangible assets for impairment whenever events or changes in circumstances indicate that the carrying amount of these assets may not be recoverable. The Company also performs an annual impairment test in the fourth quarter of each year. We test goodwill and acquired indefinite-lived intangible assets for impairment between annual tests if events occur or circumstances change that would more likely than not reduce our enterprise fair value below its book value. These events or circumstances could include a significant change in the business climate, including a significant sustained decline in an entity’s market value, legal factors, operating performance indicators, competition, sale or disposition of a significant portion of the business, or other factors. We may use either a qualitative or quantitative approach when testing a reporting unit’s goodwill for impairment. For selected reporting units where we use the qualitative approach, we perform a qualitative evaluation of events and circumstances impacting the reporting unit to determine the likelihood of goodwill impairment. Based on that qualitative evaluation, if we determine it is more likely than not that the fair value of a reporting unit exceeds its carrying amount, no further evaluation is 38Table of Contentsnecessary. Otherwise we perform a quantitative impairment test. We perform a quantitative test for each reporting unit at least once every three years. For goodwill impairment testing using the quantitative approach, the Company estimates the fair value of the selected reporting units primarily through the use of a discounted cash flow model based on our best estimate of amounts and timing of future revenues and cash flows and our most recent business and strategic plans, and compares the estimated fair value to the carrying value of the reporting unit, including goodwill. The discounted cash flow model requires judgmental assumptions about projected revenue growth, future operating margins, discount rates and terminal values over a multi-year period. There are inherent uncertainties related to these assumptions and management’s judgment in applying them to the analysis of goodwill impairment. While the Company believes it has made reasonable estimates and assumptions to calculate the fair value of its reporting units, it is possible a material change could occur. If actual results are not consistent with management’s estimates and assumptions, goodwill may be overstated and a charge would need to be taken against net earnings.Changes in our projections used in the discounted cash flow model could affect the estimated fair value of certain of the Company’s reporting units and could result in a goodwill impairment charge in a future period. In order to evaluate the sensitivity of the fair value calculations used in the quantitative goodwill impairment test, the Company applied a hypothetical 10% decrease to the fair values of each reporting unit subject to a quantitative impairment test and compared those values to the reporting unit carrying values. Based on this sensitivity analysis, the Company did not identify any goodwill impairment. Due to the many variables inherent in the estimation of a reporting unit’s fair value and the relative size of our recorded goodwill, differences in assumptions may have a material effect on the results of our impairment analysis.As of January 3, 2021, the Company had nine reporting units for goodwill impairment testing. The carrying value of goodwill included in the Company’s individual reporting units ranged from $20.4 million to $885.0 million on the quantitative test date. The Company’s analysis in 2020 indicated that in all instances, the fair value of the Company’s reporting units exceeded their carrying values and consequently did not result in an impairment charge. The excess of the estimated fair value over the carrying value (expressed as a percentage of carrying value of the respective reporting unit) for the Company’s reporting units subject to a quantitative test as of the fourth quarter of 2020, the annual testing date, exceeded at least 116%.Income TaxesIncome tax expense and deferred tax assets and liabilities reflect management’s assessment of actual future taxes to be paid on items reflected in the financial statements. Significant judgment is required in evaluating our tax positions and determining our provision for income taxes. Uncertainty exists regarding tax positions taken in previously filed tax returns still under examination and positions expected to be taken in the current year and future returns. Deferred tax assets and liabilities arise due to differences between the consolidated financial statement carrying amounts of existing assets and liabilities and their respective tax bases and tax carryforwards. Although we believe our income tax expense and deferred tax assets and liabilities are reasonable, no assurance can be given that the final tax outcome will not be different from that which is reflected in our historical income tax provisions and accruals. To the extent that the final tax outcome is different than the amounts recorded, such differences will impact the provision for income taxes in the period in which such determination is made. The provision for income taxes includes the impact of uncertain tax benefits that are considered appropriate, as well as the related net interest.Significant judgment is required in determining any valuation allowance recorded against deferred tax assets. In assessing the need for a valuation allowance, we consider all available evidence including past operating results, estimates of future taxable income and the feasibility of tax planning strategies. In the event that we change our determination as to the amount of deferred tax assets that can be realized, we will adjust our valuation allowance with a corresponding impact to the provision for income taxes in the period in which such determination is made.An increase of 100 basis points in our nominal tax rate would have resulted in additional income tax provision for the fiscal year ended January 3, 2021, of $4.7 million. For a description of the Company’s tax accounting policies, refer to Note 2 and Note 10 of the Notes to Consolidated Financial Statements. Recent Accounting StandardsFor a discussion of recent accounting standards see Note 2 of the Notes to Consolidated Financial Statements. Safe Harbor Cautionary Statement Regarding Forward-Looking InformationThis Management’s Discussion and Analysis of Financial Condition and Results of Operation contains forward-looking statements, as defined in the Private Securities Litigation Reform Act of 1995, directly and indirectly relating to earnings, growth opportunities, acquisitions and divestitures, product sales, capital expenditures, pension matters, stock option compensation expense, the credit facility, interest expense, severance and relocation costs, environmental remediation cost, stock repurchases, taxes, exchange rate fluctuations and strategic plans. Forward-looking statements involve risks and uncertainties, are based on the current expectations of the management of Teledyne and are subject to uncertainty and changes in circumstances. The forward-looking statements contained herein may include statements about the expected effects on Teledyne of the proposed acquisition of FLIR, the anticipated timing and scope of the proposed transaction, anticipated 39Table of Contentsearnings enhancements, estimated cost savings and other synergies related to the proposed transaction, costs to be incurred in achieving synergies, anticipated capital expenditures and product developments, and other strategic options. All statements made in this Management’s Discussion and Analysis of Financial Condition and Results of Operation that are not historical in nature should be considered forward-looking. Actual results could differ materially from these forward-looking statements. Many factors could change the anticipated results, including: ongoing challenges and uncertainties posed by the COVID-19 pandemic for businesses and governments around the world; the occurrence of any event, change or other circumstances that could give rise to the right of Teledyne or FLIR or both to terminate the merger agreement; the outcome of any legal proceedings that may be instituted against Teledyne or FLIR in connection with the merger agreement; the failure to obtain necessary regulatory approvals (and the risk that such approvals may result in the imposition of conditions that could adversely affect the combined company or the expected benefits of the transaction) or stockholder approvals or to satisfy any of the other conditions to the proposed transaction on a timely basis or at all; the failure to obtain the debt portion of the financing for the proposed transaction; the inability to complete the acquisition and integration of FLIR successfully, to retain customers and key employees and to achieve operating synergies, including the possibility that the anticipated benefits of the proposed transaction are not realized when expected or at all, including as a result of the impact of, or problems arising from, the integration of the two companies or as a result of the strength of the economy and competitive factors in the areas where Teledyne and FLIR do business; the possibility that the proposed transaction may be more expensive to complete than anticipated, including as a result of unexpected factors or events; the parties’ ability to meet expectations regarding the timing, completion and accounting and tax treatments of the proposed transaction; changes in relevant tax and other laws; the inability to develop and market new competitive products; inherent uncertainties involved in the estimates and judgments used in the preparation of financial statements and the providing of estimates of financial measures, in accordance with U.S. GAAP and related standards; operating results of FLIR being lower than anticipated; disruptions in the global economy; the spread of the COVID-19 virus resulting in production, supply, contractual and other disruptions, including facility closures and furloughs and travel restrictions; customer and supplier bankruptcies; changes in demand for products sold to the defense electronics, instrumentation, digital imaging, energy exploration and production, commercial aviation, semiconductor and communications markets; funding, continuation and award of government programs; cuts to defense spending resulting from existing and future deficit reduction measures or changes to U.S. and foreign government spending and budget priorities triggered by the COVID-19 pandemic; impacts from the United Kingdom’s exit from the European Union; uncertainties related to the policies of the new U.S. Presidential Administration; the imposition and expansion of, and responses to, trade sanctions and tariffs; escalating economic and diplomatic tension between China and the United States; and threats to the security of our confidential and proprietary information, including cyber security threats. Lower oil and natural gas prices, as well as instability in the Middle East or other oil producing regions, and new regulations or restrictions relating to energy production, including with respect to hydraulic fracturing, could further negatively affect our businesses that supply the oil and gas industry. Disruptions from the production delay of Boeing’s 737 Max aircraft and continued weakness in the commercial aerospace industry will negatively affect the markets of our commercial aviation businesses. In addition, financial market fluctuations affect the value of the Company's pension assets.Changes in the policies of U.S. and foreign governments, including economic sanctions, could result, over time, in reductions or realignment in defense or other government spending and further changes in programs in which the Company participates. While Teledyne’s growth strategy includes possible acquisitions, we cannot provide any assurance as to when, if or on what terms any acquisitions will be made. Acquisitions involve various inherent risks, such as, among others, our ability to integrate acquired businesses, retain customers and achieve identified financial and operating synergies. There are additional risks associated with acquiring, owning and operating businesses outside of the United States, including those arising from U.S. and foreign government policy changes or actions and exchange rate fluctuations.We continue to take action to assure compliance with the internal controls, disclosure controls and other requirements of the Sarbanes-Oxley Act of 2002. While we believe our control systems are effective, there are inherent limitations in all control systems, and misstatements due to error or fraud may occur and may not be detected.Additional information concerning factors that could cause actual results to differ materially from those projected in the forward-looking statements is contained beginning on page 5 of this Form 10-K under the caption “Risk Factors; Cautionary Statement as to Forward-Looking Statements.” Forward-looking statements are generally accompanied by words such as “estimate”, “project”, “predict”, “believes” or “expect”, that convey the uncertainty of future events or outcomes. We assume no obligation to publicly update or revise any forward-looking statements, whether as a result of new information or otherwise.Additional Information and Where to Find It In connection with the proposed transaction between Teledyne and FLIR, Teledyne will file with the SEC a Registration Statement on Form S-4 that will include a joint proxy statement of Teledyne and FLIR and a prospectus of Teledyne, as well as other relevant documents concerning the proposed transaction. The proposed transaction involving Teledyne and FLIR will be submitted to Teledyne’s stockholders and FLIR’s stockholders for their consideration. Stockholders of Teledyne and stockholders of FLIR are urged to read the registration statement and the joint proxy statement/prospectus regarding the 40Table of Contentstransaction when they become available and any other relevant documents filed with the SEC, as well as any amendments or supplements to those documents, because they will contain important information.Stockholders will be able to obtain a free copy of the definitive joint proxy statement/prospectus, as well as other filings containing information about Teledyne and FLIR, without charge, at the SEC’s website (http://www.sec.gov). Copies of the joint proxy statement/prospectus and the filings with the SEC that will be incorporated by reference in the joint proxy statement/prospectus can also be obtained, without charge, by directing a request to Teledyne, Attn: Investor Relations, 1049 Camino Dos Rios, Thousand Oaks, California 91360, or to FLIR, Attn: Corporate Secretary, 1201 S Joyce St, Arlington, Virginia 22202.Participants in the Solicitation Teledyne, FLIR and certain of their respective directors, executive officers and employees may be deemed to be participants in the solicitation of proxies in connection with the proposed transaction. Information regarding Teledyne’s directors and executive officers will be available in its definitive proxy statement for its 2021 Annual Meeting, which is expected to be filed with the SEC on or about March 8, 2021, and this Annual Report on Form 10-K. Information regarding FLIR’s directors and executive officers is available in its Annual Report on Form 10-K for the year ended December 31, 2020, which was filed on February 25, 2021. Other information regarding the participants in the proxy solicitation and a description of their direct and indirect interests, by security holdings or otherwise, will be contained in the joint proxy statement/prospectus and other relevant materials filed with the SEC. Free copies of this document may be obtained as described in the preceding paragraph.No Offer or Solicitation This communication shall not constitute an offer to sell or the solicitation of an offer to sell or an offer to buy any securities, nor shall there be any sale of securities in any jurisdiction in which such offer, solicitation or sale would be unlawful prior to registration or qualification under the securities laws of any such jurisdiction. No offer of securities shall be made except by means of a prospectus meeting the requirements of Section 10 of the Securities Act of 1933.Item 7A. Quantitative and Qualitative Disclosures About Market RiskThe information required by this item is included in this Report on page 34 under the caption “Other Matters - Hedging Activities; Market Risk Disclosures” of “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operation.”
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+ITEM 7. Management’s Discussion and Analysis of Financial Condition and Results of OperationsTJX provides projections and other forward-looking statements in the following discussions particularly relating to our future financial performance. These forward-looking statements are estimates based on information currently available to us, are made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995, and subject to the cautionary statements set forth on page 2 of this Form 10-K. Our results are subject to risks and uncertainties including, but not limited to, those described in Part I, Item 1A, Risk Factors, and those identified from time to time in our other filings with the Securities and Exchange Commission. TJX undertakes no obligation to publicly update any forward-looking statements, whether as a result of new information, future developments or otherwise.The discussion that follows relates to our 52-week fiscal years ended January 30, 2021 (fiscal 2021) and February 1, 2020 (fiscal 2020). Our 52-week fiscal year ended February 2, 2019 is referred to as fiscal 2019 and our 52-week fiscal year ended January 29, 2022 is referred to as fiscal 2022.The following is a discussion of our consolidated operating results, followed by a discussion of our segment operating results. Discussions of fiscal 2019 items and year-to-year comparisons between fiscal 2020 and fiscal 2019 that are not included in this Form 10-K can be found in "Management's Discussion and Analysis of Financial Condition and Results of Operations" in Part II, Item 7 of our annual report on Form 10-K for the fiscal year ended February 1, 2020.OVERVIEWWe are the leading off-price apparel and home fashions retailer in the U.S. and worldwide. Our mission is to deliver great value to our customers every day. We do this by selling a rapidly changing assortment of apparel, home fashions and other merchandise at prices generally 20% to 60% below full-price retailers’ (including department, specialty, and major online retailers) regular prices on comparable merchandise, every day. We operate over 4,500 stores through our four main segments: in the U.S., Marmaxx (which operates T.J. Maxx, Marshalls, tjmaxx.com and marshalls.com) and HomeGoods (which operates HomeGoods and Homesense); TJX Canada (which operates Winners, HomeSense and Marshalls in Canada); and TJX International (which operates T.K. Maxx, Homesense and tkmaxx.com in Europe, and T.K. Maxx in Australia). In addition to our four main segments, Sierra operates sierra.com and retail stores in the U.S. The results of Sierra are included in the Marmaxx segment.Impact of the COVID-19 PandemicAfter a novel coronavirus disease (“COVID-19”) emerged and spread worldwide, the World Health Organization declared COVID-19 a pandemic in March 2020, and national, state and local governments and private entities began issuing various restrictions, including travel restrictions, restrictions on public gatherings, stay at home orders and advisories and quarantine or isolation protocols. We temporarily closed all of our stores, online businesses, distribution centers and offices in March 2020, with Associates working remotely where possible. During April 2020, we temporarily furloughed the majority of hourly store and distribution center Associates in the U.S. and Canada, with employee benefits coverage for eligible Associates continuing during the temporary furlough at no cost to impacted Associates. We also took comparable actions with respect to portions of our European and Australian workforces.When we began to reopen stores and distribution centers in May 2020, we implemented new health and safety practices, including practices related to personal protective equipment, enhanced cleaning and social distancing protocols. Early in the fourth quarter of fiscal 2021, in response to increasing cases of COVID-19, hundreds of our stores had additional temporary closures, the vast majority being in Europe and Canada, and additional stores may close temporarily in the future. We continue to monitor developments, including government requirements and recommendations at the national, state, and local level that could result in possible additional impacts to our operations.Our results for fiscal 2021 were negatively impacted by the temporary closure of our stores for approximately 24% of fiscal 2021 in the aggregate. This represents total store days closed due to the COVID-19 pandemic as a percentage of potential total store days open. See additional details below by segment.Fiscal 2021Marmaxx20 %HomeGoods20 TJX Canada29 TJX International 36 Total24 %25As of March 30, 2021, we had approximately 580 stores, primarily in Europe, that were temporarily closed due to government mandates in response to the COVID-19 global pandemic. We expect closures in Europe and Canada to impact our first quarter fiscal 2022 results as stores are expected to be closed for approximately 71% and 12% of the quarter, respectively. Although the majority of our Germany and Netherlands stores were reopened by the end of March, additional operating restrictions have been imposed, including appointment requirements, limited business hours and capacity constraints. In total, based on current restrictions, we expect stores to be closed for approximately 12% of the first quarter of fiscal 2022. All of our e-commerce businesses remain open, including tkmaxx.com in the U.K.In addition to the temporary closures and reopenings of our stores and other facilities, the ongoing COVID-19 pandemic has led to modifications to our operations, including the implementation of health and safety protocols, and has impacted consumer behavior. The continued scope and impact of the pandemic is unpredictable and has in the past caused, currently causes, and may continue to cause additional intermittent or prolonged periods of temporary store closures, and may result in additional changes in consumer demand and behavior or require further modifications to our operations. These potential impacts may lead to increased asset recovery and valuation risks, such as impairment of our stores and other assets and an inability to realize deferred tax assets due to sustaining losses in certain jurisdictions. The uncertainties in the global economy may also impact the financial viability or business operations of some of our suppliers and service providers (including transportation and logistics providers), which may interrupt our supply chain, and require other changes to our operations. These and other factors have had and may continue to have a material impact on our business, results of operations, financial position and cash flows.Store and Associate ActionsWe have taken numerous steps designed to protect the health and well-being of our Associates and customers to operate more safely in light of the COVID-19 pandemic. We established several global task force teams focused on a broad range of strategies to navigate the Company through this global health crisis. Globally, we have put in place practices including social distancing protocols (which include occupancy limits and reducing in-store inventory levels), access to personal protective equipment and enhanced cleaning efforts. For example, upon reopening our stores, we installed protective shields at registers, encouraged social distancing through regular in-store announcements, signage, and markers in our queue lines, implemented new processes for handling merchandise returns, and instituted new cleaning regimens, including enhanced cleaning of high-touch surfaces, such as shopping carts, throughout the day. Further, in many locations, including where mandated, we have required that shoppers wear a face covering in stores.Financial ActionsBalance Sheet, Cash Flow and Liquidity The temporary closure of our stores had a material impact on our results of operations, financial position and liquidity. As further detailed below in Results of Operations, this impact included a 23% decrease in net sales for fiscal 2021 compared to the same period last year, resulting in a significant decline in net profit for the full fiscal year.During fiscal 2021, we generated $4.6 billion of operating cash flows and ended the year with $10.5 billion of cash. In addition, we increased our borrowing capacity by entering into a $500 million 364 Day Revolving Credit Facility, making a total of $1.5 billion available to us under revolving credit facilities. In the first quarter of fiscal 2021, TJX issued $4 billion aggregate principal amount of notes. During the fourth quarter of fiscal 2021, we issued $1 billion in aggregate principal amount of notes and accepted $1.1 billion in combined aggregate principal amount of certain of its notes issued in the first quarter of fiscal 2021 pursuant to cash tender offers. We paid $1.4 billion aggregate consideration (including transaction costs) and recorded a $0.3 billion pre-tax loss on the early extinguishment for the accepted notes. For additional information on the new credit facility and debt transactions, see Note K—Long-Term Debt and Credit Lines of Notes to Consolidated Financial Statements. We intend to continue to be prudent with our expenses for fiscal 2022. Capital spending for fiscal 2022 is expected to be back in line with normal spending, and is expected to be in the range of $1.2 billion to $1.4 billion with incremental investments in our infrastructure and our distribution centers, both existing and new facilities. We are planning approximately 120 net store openings for fiscal 2022. We have currently suspended our share repurchase program. While our Board of Directors did not declare a dividend in the first nine months of fiscal 2021, we declared a dividend of $0.26 per share in the fourth quarter of fiscal 2021, paid in March 2021. We also declared a similar dividend of $0.26 per share in the first quarter of fiscal 2022. During fiscal 2021, we negotiated rent deferrals (primarily for second quarter lease payments) for a significant number of our stores, with repayment at later dates, primarily in fiscal 2022. We elected to treat the COVID-19 pandemic-related rent deferrals as a resolution of a contingency by remeasuring the lease liability, with a corresponding offset to the right-of-use asset, using the remeasured consideration. In addition to negotiating deferral of lease payments, we had temporarily extended payment terms on merchandise orders, which increased our accounts payable as of the end of the fiscal year, benefiting our operating cash flows. As payment terms are reduced and we make deferred payments, we expect our operating cash flows to be negatively impacted.26We evaluated the value of our inventory in light of the temporary store closures in the first and fourth quarters of fiscal 2021 due to the COVID-19 pandemic. Permanent markdowns, which had been or will be taken upon reopening of the stores, on transitional or out of season merchandise and merchandise that was already in markdown status, combined with the write-off of perishable goods, resulted in a reduction of approximately $0.4 billion in inventory for fiscal 2021. Additional markdowns recorded throughout the year were taken in the ordinary course of business operations.Given the substantial reduction in our sales and the reduced cash flow projections as a result of the temporary store closures during fiscal 2021 due to the COVID-19 pandemic, we determined that triggering events had occurred and that impairment assessments were warranted for certain stores. This resulted in impairment charges of $72 million for fiscal 2021, related to operating lease right of use assets and store fixed assets. Operating ExpensesWe incurred additional payroll costs associated with monitoring occupancy limits to comply with social distancing protocols and implementing enhanced cleaning regimens in our stores, distribution centers, and offices. In addition, we provided discretionary appreciation bonuses during fiscal 2021 to store and distribution center Associates and incurred incremental costs for personal protective equipment and additional cleaning supplies. We expect that many of these costs will continue in fiscal 2022. We have implemented, and plan to continue to implement, cost saving initiatives to reduce some ongoing variable and discretionary spending.In response to the COVID-19 pandemic, governments in the U.S., U.K., Canada and various other jurisdictions have implemented programs to encourage companies to retain and pay employees who are unable to work or are limited in the work that they can perform in light of closures or a significant decline in sales. Throughout fiscal 2021 we continued to qualify for certain of these provisions, which partially offset related expenses. During fiscal 2021, these programs reduced our expenses by approximately $0.5 billion on our Consolidated Statements of Income. RESULTS OF OPERATIONSMatters Affecting ComparabilityAs a result of the COVID-19 pandemic, our stores were closed in the aggregate for approximately 24% of fiscal 2021. In addition to lost revenues, we continued to pay wages and provide benefits to many of our Associates during the closures, and incurred incremental operating expenses upon reopening for new health and safety practices. This significantly impacted the operating results of all of our divisions and our expense ratios as compared to the prior year.Highlights of our financial performance for fiscal 2021 include the following:–Net sales decreased 23% to $32.1 billion for fiscal 2021, versus fiscal 2020 sales of $41.7 billion. As of January 30, 2021, the number of stores in operation (including stores that had been temporarily closed due to COVID-19) increased 1% and selling square footage increased 1% compared to the end of fiscal 2020.–Diluted earnings per share for fiscal 2021 were $0.07 versus $2.67 per share in fiscal 2020.–Pre-tax margin (the ratio of pre-tax income to net sales) for fiscal 2021 was 0.3%, a 10.3 percentage point decrease compared with 10.6% in fiscal 2020. –The debt extinguishment charge of $0.3 billion reduced fiscal 2021 pre-tax margin by 1.0 percentage point and reduced earnings per share by $0.19 per share.–Our cost of sales, including buying and occupancy costs, ratio for fiscal 2021 was 76.3%, a 4.8 percentage point increase compared with 71.5% in fiscal 2020. –Our selling, general and administrative (“SG&A”) expense ratio for fiscal 2021 was 21.8%, a 3.9 percentage point increase compared with 17.9% in fiscal 2020. –Our consolidated average per store inventories, including inventory on hand at our distribution centers (which excludes inventory in transit) and excluding our e-commerce sites and Sierra stores, were down 21% on a reported basis and down 22% on a constant currency basis at the end of fiscal 2021 as compared to a 4% increase in average per store inventories on both a reported and constant currency basis at the end of fiscal 2020.–There were no dividends declared during the first nine months of fiscal 2021 and share repurchases were suspended in the first quarter of fiscal 2021. A dividend of $0.26 per share was declared in the fourth quarter of fiscal 2021 and paid in March of 2021. See the Impact of the COVID-19 Pandemic section above for the actions taken regarding our share repurchase programs.27Recent Events and TrendsCOVID-19See discussion above in the Impact of the COVID-19 Pandemic section.Impact of BrexitOn December 24, 2020 the U.K. and EU agreed upon the terms of their future trading relationship. As expected the movement of goods between the U.K. and EU is subject to additional regulatory and compliance requirements, which is expected to have a negative impact on our ability to efficiently move merchandise in the region. We have realigned our European division's supply chain to reduce the volume of merchandise flowing between the U.K. and the EU and have established resources and systems to support this plan. The new trade deal provides for zero customs duties and zero quotas on trade between the U.K. and the EU in goods that are produced in each of the U.K. and the EU. However, a proportion of the merchandise we source in the U.K. and the EU is produced somewhere else in the world, and therefore will be subject to additional customs duty costs under the new trade deal. These additional customs duties and the related operational costs are likely to impact the profitability of our European division, at least in the short term. New immigration requirements between the U.K. and EU countries may also have a negative impact on our ability to recruit and retain current and future talent in the region. We continue to communicate with our Associates about the new immigration requirements. In addition to these operational impacts, factors including changes in legislation, consumer confidence and behavior, economic conditions, interest rates and foreign currency exchange rates could result in a significant financial impact to our European operations, particularly in the short term.Net SalesNet sales for fiscal 2021 totaled $32.1 billion, a 23% decrease over fiscal 2020. The decrease in net sales was driven by temporary store closures as a result of the COVID-19 pandemic and lower customer traffic, with stores closed in the aggregate for approximately 24% of fiscal 2021. Net sales from our e-commerce businesses combined amounted to approximately 3% of total sales.As a result of the extended store closures due to the COVID-19 pandemic and our policy relating to the treatment of extended store closures when calculating comp store sales under our historical definition, we had no stores classified as comp stores at the end of fiscal 2021. In order to provide a performance indicator for our stores as they reopened, since the second quarter of fiscal 2021, we have been temporarily reporting a new sales measure, open-only comp store sales. Open-only comp store sales includes stores initially classified as comp stores at the beginning of fiscal 2021 that have had to temporarily close due to the COVID-19 pandemic. This measure reports the sales increase or decrease of these stores for the days the stores were open in the current period against sales for the same days in the prior year. Open-only comp sales of our foreign segments are calculated by translating the current year using the prior year’s exchange rates. Our historical definition of comp store sales is presented below for reference.Open-only comp store sales were down 4% for fiscal 2021 as compared to last year. These results reflect a decrease in customer traffic, partially offset by an increased average basket across all divisions. Our stores were closed in the aggregate for approximately 24% of fiscal 2021. Home fashion across all major segments outperformed apparel for fiscal 2021.We define customer traffic to be the number of transactions in stores and average ticket to be the average retail price of the units sold. We define average transaction or average basket to be the average dollar value of transactions. Historical Definition of Comp Store SalesWe are temporarily reporting a new sales measure, open-only comp store sales, as described above. The following reflects the way that we have historically classified and reported comp sales results.Historically, we defined comparable store sales, or comp sales, to be sales of stores that have been in operation for all or a portion of two consecutive fiscal years, or in other words, stores that are starting their third fiscal year of operation. We calculated comp sales on a 52-week basis by comparing the current and prior year weekly periods that are most closely aligned. Relocated stores and stores that have changed in size are generally classified in the same way as the original store, and we believe that the impact of these stores on the consolidated comp percentage is immaterial.28Sales excluded from comp sales (“non-comp sales”) consist of sales from:–New stores - stores that have not yet met the comp sales criteria, which represents a substantial majority of non-comp sales–Stores that are closed permanently or for an extended period of time–Sales from our e-commerce sites, meaning sierra.com, tjmaxx.com, marshalls.com and tkmaxx.comWe determine which stores are included in the comp sales calculation at the beginning of a fiscal year and the classification remains constant throughout that year unless a store is closed permanently or for an extended period during that fiscal year. Beginning in fiscal 2020, Sierra stores that otherwise fit the comp store definition are included in comp stores in our Marmaxx segment.Comp sales of our foreign segments are calculated by translating the current year’s comp sales using the prior year’s exchange rates. This removes the effect of changes in currency exchange rates, which we believe is a more accurate measure of segment operating performance.Comp sales may be referred to as “same store” sales by other retail companies. The method for calculating comp sales varies across the retail industry, therefore our measure of comp sales may not be comparable to that of other retail companies.Operating Results as a Percentage of Net SalesThe following table sets forth our consolidated operating results as a percentage of net sales. Percentage of Net Sales Fiscal 2021Fiscal 2020Net sales100.0 %100.0 %Cost of sales, including buying and occupancy costs76.3 71.5 Selling, general and administrative expenses21.8 17.9 Loss on early extinguishment of debt1.0 — Interest expense, net0.6 — Income before income taxes*0.3 %10.6 %*Figures may not foot due to rounding.Revenues by GeographyThe percentages of our consolidated revenues by geography for the last two fiscal years are as follows:Fiscal 2021Fiscal 2020United States:Northeast23 %23 %Midwest13 13 South (including Puerto Rico)27 25 West16 15 Total United States79 %76 %Canada9 10 Europe11 13 Australia1 1 Total100 %100 %Impact of foreign currency exchange ratesOur operating results are affected by foreign currency exchange rates as a result of changes in the value of the U.S. dollar or a division’s local currency in relation to other currencies. We specifically refer to “foreign currency” as the impact of translational foreign currency exchange and mark-to-market of inventory derivatives, as described in detail below. This does not include the impact foreign currency exchange rates can have on various transactions that are denominated in a currency other than an operating division’s local currency referred to as “transactional foreign exchange”, also described below.29Translation Foreign ExchangeIn our consolidated financial statements, we translate the operations of TJX Canada and TJX International from local currencies into U.S. dollars using currency rates in effect at different points in time. Significant changes in foreign exchange rates between comparable prior periods can result in meaningful variations in net sales, net income and earnings per share growth as well as the net sales and operating results of these segments. Currency translation generally does not affect operating margins, or affects them only slightly, as sales and expenses of the foreign operations are translated at approximately the same rates within a given period.Mark-to-Market Inventory DerivativesWe routinely enter into inventory-related hedging instruments to mitigate the impact on earnings of changes in foreign currency exchange rates on merchandise purchases denominated in currencies other than the local currencies of our divisions, principally TJX Canada and TJX International. As we have not elected “hedge accounting” for these instruments as defined by U.S. generally accepted accounting principles (“GAAP”), we record a mark-to-market gain or loss on the derivative instruments in our results of operations at the end of each reporting period. In subsequent periods, the mark-to-market gain or loss is effectively offset when the inventory being hedged is received and paid for. While these effects occur every reporting period, they are of much greater magnitude when there are sudden and significant changes in currency exchange rates during a short period of time. The mark-to-market gain or loss on these derivatives does not affect net sales, but it does affect the cost of sales, operating margins and net income.Transactional Foreign ExchangeWhen discussing the impact on our results of the effect of foreign currency exchange rates on certain transactions, we refer to it as “transactional foreign exchange”. This primarily includes the impact that foreign currency exchange rates may have on the year-over-year comparison of merchandise margin as well as “foreign currency gains and losses” on transactions that are denominated in a currency other than the operating division's local currency. These two items can impact segment margin comparison of our foreign divisions and we have highlighted them when they are meaningful to understanding operating trends.Cost of Sales, Including Buying and Occupancy CostsCost of sales, including buying and occupancy costs, was $24.5 billion, or 76.3% of net sales for fiscal 2021 compared to $29.8 billion, or 71.5% of net sales for fiscal 2020. The main reason for the decrease in the total cost of sales, including buying and occupancy costs, was the reduction in cost of merchandise sold due to a reduction in net sales as compared to the prior year, primarily due to our stores being temporarily closed in the aggregate for approximately 24% of fiscal 2021.The increase in the expense ratio of 4.8% for fiscal 2021 was primarily driven by the impact of lower sales primarily as a result of temporary store closures. A significant portion of our occupancy costs are fixed and although we negotiated rent deferrals to help with our liquidity, our occupancy costs were comparable to last year but increased the expense ratio by approximately 2.1 percentage points due to the lower sales volume. Our distribution costs increased the expense ratio by approximately 1.6 percentage points due to processing more units while our merchandise mix had a lower average ticket. In addition, distribution costs reflect wage increases, discretionary appreciation bonuses, and incremental costs to implement and maintain health and safety protocols, despite a reduction in payroll costs due to Associate furloughs in the first half of fiscal 2021 and $78 million in benefits received from government programs available in the U.S., Canada, the U.K. and various other jurisdictions. Merchandise margin was negatively impacted by increased markdowns as a percentage of net sales, as well as increased freight costs partially offset by strong mark-on. The increased markdowns include those taken to revalue inventories due to our temporary store closures.Selling, General and Administrative ExpensesSG&A expenses were $7 billion, or 21.8% of net sales for fiscal 2021, compared to $7.5 billion, or 17.9% of net sales for fiscal 2020.The increase in SG&A expenses as a percentage of net sales for fiscal 2021 was primarily driven by store payroll and store supply costs which negatively impacted the expense ratio by 2.7 percentage points. These costs were primarily COVID-related, including incremental store payroll investments to allow for enhanced cleaning and monitoring capacity, discretionary appreciation bonuses, and personal protective equipment for our Associates. These incremental costs were partially offset by expense savings, including lower advertising and travel spend, as well as other variable store costs such as credit processing fees, which were lower as a result of the temporary store closures due to the COVID-19 pandemic. We also paid certain Associates during the temporary store closures, which was partially offset by $434 million from government programs available in the U.S., Canada, the U.K. and various other jurisdictions. 30Loss On Early Extinguishment of DebtOn November 30, 2020 we issued $500 million aggregate principal amount of 1.150% notes due 2028 and $500 million aggregate principal amount of 1.600% notes due 2031. We used the proceeds to partially fund the purchase, on December 4, 2020, of $365 million of our 4.500% notes due 2050 and $754 million of our 3.875% notes due 2030 that were tendered and accepted in our cash tender offer. We recorded a pre-tax loss on the early extinguishment of debt of $312 million. For additional information on the debt transactions, see Note K—Long-Term Debt and Credit Lines of Notes to Consolidated Financial Statements.Interest Expense, netThe components of interest expense, net for the last two fiscal years are summarized below: Fiscal Year EndedIn millionsJanuary 30,2021February 1,2020Interest expense$199 $61 Capitalized interest(5)(2)Interest (income)(13)(49)Interest expense, net$181 $10 Net interest expense increased for fiscal 2021 compared to fiscal 2020, primarily driven by the issuance of additional debt in fiscal 2021 due to the COVID-19 pandemic and lower interest income. In addition, fiscal 2021 included interest expense on the $1 billion of borrowings on the revolving credit facilities, which were paid off in the second quarter of fiscal 2021.Provision for Income TaxesThe effective income tax rate was (1.4)% for fiscal 2021 compared to 25.7% for fiscal 2020. The decrease in the fiscal 2021 effective income tax rate is primarily driven by the negative impact of the COVID-19 pandemic to our results and the change in the jurisdictional mix of income and losses.Net Income and Diluted Earnings Per ShareNet income was $0.1 billion in fiscal 2021 compared to $3.3 billion in fiscal 2020. Diluted earnings per share were $0.07 in fiscal 2021 and $2.67 in fiscal 2020. The loss on early extinguishment of debt reduced net income by $229 million, or $0.19 per share, for the twelve months ended January 30, 2021. Our stock repurchase programs, which reduce our weighted average diluted shares outstanding, had no impact on our earnings per share in fiscal 2021 as we suspended the program in March 2020 as a result of the COVID-19 pandemic. Our stock repurchase programs benefited our earnings per share growth by approximately 3% in fiscal 2020.Segment InformationWe operate four main business segments. Our Marmaxx segment (T.J. Maxx, Marshalls, tjmaxx.com and marshalls.com) and the HomeGoods segment (HomeGoods and Homesense) both operate in the United States. Our TJX Canada segment operates Winners, HomeSense and Marshalls in Canada, and our TJX International segment operates T.K. Maxx, Homesense and tkmaxx.com in Europe and T.K. Maxx in Australia. In addition to our four main segments, Sierra operates sierra.com and retail stores in the U.S. The results of Sierra are included in the Marmaxx segment.We evaluate the performance of our segments based on “segment profit or loss,” which we define as pre-tax income or loss before general corporate expense and interest expense, net, and certain separately disclosed unusual or infrequent items. “Segment profit or loss,” as we define the term, may not be comparable to similarly titled measures used by other entities. The terms “segment margin” or “segment profit margin” are used to describe segment profit or loss as a percentage of net sales. These measures of performance should not be considered an alternative to net income or cash flows from operating activities as an indicator of our performance or as a measure of liquidity.Due to the temporary closing of all of our stores as a result of the COVID-19 pandemic, our historical definition of comp store sales is not applicable for the reported periods. In order to provide a performance indicator for our stores as they reopen, since the second quarter of fiscal 2021 we have been temporarily reporting a new sales measure, open-only comp store sales. Open-only comp store sales includes stores initially classified as comp stores at the beginning of fiscal 2021 that have had to temporarily close due to the COVID-19 pandemic. This measure reports the sales increase or decrease of these stores for the days the stores were open in the current period against sales for the same days in the prior year. Presented below is selected financial information related to our business segments.31U.S. SEGMENTSMarmaxx Fiscal Year EndedU.S. dollars in millionsJanuary 30,2021February 1,2020Net sales$19,363 $25,665 Segment profit$891 $3,470 Segment margin4.6 %13.5 %Stores in operation at end of period:T.J. Maxx1,271 1,273 Marshalls1,131 1,130 Sierra48 46 Total2,450 2,449 Selling square footage at end of period (in thousands):T.J. Maxx27,707 27,781 Marshalls25,915 25,909 Sierra796 766 Total54,418 54,456 Net SalesNet sales for Marmaxx decreased 25% for fiscal 2021 as compared to last year. The decrease in net sales was primarily due to the temporary closures of all stores as a result of the COVID-19 pandemic. The stores were closed for approximately 20% of fiscal 2021. In addition, the decrease in net sales was due to lower customer traffic, partially offset by an increase in the average basket. Open-only comp store sales were down 7% for fiscal 2021. Home fashions outperformed apparel for fiscal 2021.Segment Profit Segment profit was $0.9 billion for fiscal 2021, a decrease of $2.6 billion, compared to a segment profit of $3.5 billion for fiscal 2020. The decrease was primarily driven by a reduction in sales from the temporary store closures. This decrease reflects increased markdowns on merchandise primarily taken in the first half of fiscal 2021 due to the COVID-19 pandemic as well as increased freight costs, partially offset by stronger mark-on. In addition, segment profit declined as a result of our reduced buying activity and lower inventory levels resulting in higher buying and distribution costs in fiscal 2021 as compared to last year, and as a result of incremental COVID-19 costs. The decline in segment profit was partially offset by lower advertising and travel spend, a reduction in store payroll while the stores were closed and other variable store expense savings. The reduction in payroll reflects approximately $171 million for fiscal 2021 from government programs as described in the Impacts of the COVID-19 Pandemic section above. In addition, a significant portion of our occupancy costs are fixed. As a result, while our occupancy costs were comparable to last year, they negatively impacted segment margin by approximately 2.2 percentage points, primarily due to the lower sales volume.During the third quarter of fiscal 2020, Marmaxx made online shopping available at www.marshalls.com, along with www.tjmaxx.com, which was launched previously. Our U.S. e-commerce businesses, which represented approximately 3% of Marmaxx’s net sales for both fiscal 2021 and fiscal 2020, did not have a significant impact on year-over-year segment margin comparisons. Along with our stores, we temporarily closed our online businesses for a portion of fiscal 2021 as a result of the COVID-19 pandemic.32HomeGoods Fiscal Year EndedU.S. dollars in millionsJanuary 30,2021February 1,2020Net sales$6,096 $6,356 Segment profit$510 $681 Segment margin8.4 %10.7 %Stores in operation at end of period:HomeGoods821 809 Homesense34 32 Total855 841 Selling square footage at end of period (in thousands):HomeGoods15,034 14,831 Homesense733 685 Total15,767 15,516 Net SalesNet sales for HomeGoods decreased 4% for fiscal 2021 as compared to last year. The decrease in net sales was primarily due to the temporary closures of all stores as a result of the COVID-19 pandemic. The stores were closed for approximately 20% of fiscal 2021. In addition, the decrease in net sales was due to lower customer traffic, partially offset by an increase in the average basket. Open-only comp store sales were up 13% for fiscal 2021.Segment Profit Segment profit was $510 million for fiscal 2021, a decrease of $171 million, compared to a segment profit of $681 million for fiscal 2020. The decrease was primarily driven by a reduction in sales due to temporary store closures and increased store and distribution payroll costs, including incremental COVID-19 costs. The decline in segment profit was partially offset by improved merchandise margin, lower advertising and travel spend and other variable store expense savings. Merchandise margin reflects strong mark-on and favorable markdowns net of increased freight costs. The increase in payroll includes a reduction of approximately $46 million for fiscal 2021 from government programs as described in the Impacts of the COVID-19 Pandemic section above. During the fourth quarter of fiscal 2021, we announced our plan to make online shopping available on www.homegoods.com in late fiscal 2022.33FOREIGN SEGMENTS TJX Canada Fiscal Year EndedU.S. dollars in millionsJanuary 30,2021February 1,2020Net sales$2,836 $4,031 Segment profit$124 $516 Segment margin4.4 %12.8 %Stores in operation at end of period:Winners280 279 HomeSense143 137 Marshalls102 97 Total525 513 Selling square footage at end of period (in thousands):Winners6,015 5,986 HomeSense2,644 2,511 Marshalls2,141 2,043 Total10,800 10,540 Net SalesNet sales for TJX Canada decreased 30% for fiscal 2021 compared to last year. The decrease in net sales was primarily due to temporary store closures, closed for approximately 29% of fiscal 2021, as a result of the COVID-19 pandemic. In addition, net sales decreased due to lower customer traffic, partially offset by an increase in the average basket. Open-only comp store sales were down 8% for fiscal 2021. Segment Profit Segment profit was $124 million for fiscal 2021, a decrease of $392 million, compared to a segment profit of $516 million for fiscal 2020. The decrease was primarily driven by a reduction in sales due to the temporary store closures, including incremental COVID-19 costs. The decline in segment profit was partially offset by improved merchandise margin, a reduction in store payroll while the stores were closed, lower advertising and travel spend and other variable store expense savings. Merchandise margin reflects strong mark-on net of increased markdowns and freight. The reduction in payroll reflects approximately $148 million for fiscal 2021 from government programs as described in the Impacts of the COVID-19 Pandemic section above. In addition, a significant portion of our occupancy costs are fixed. As a result, while our occupancy costs were comparable to last year, they negatively impacted segment margin by approximately 3.8 percentage points, primarily due to the lower sales volume.34TJX International Fiscal Year EndedU.S. dollars in millionsJanuary 30,2021February 1,2020Net sales$3,842 $5,665 Segment (loss) profit$(504)$307 Segment margin(13.1)%5.4 %Stores in operation at end of period:T.K. Maxx602 594 Homesense78 78 T.K. Maxx Australia62 54 Total742 726 Selling square footage at end of period (in thousands):T.K. Maxx12,131 11,997 Homesense1,142 1,149 T.K. Maxx Australia1,109 990 Total14,382 14,136 Net SalesNet sales for TJX International decreased 32% for fiscal 2021 compared to last year. The decrease in net sales was primarily due to the temporary store closures, closed for approximately 36% of fiscal 2021, as a result of the COVID-19 pandemic. In addition, net sales decreased due to lower customer traffic, partially offset by an increase in the average basket. Open-only comp store sales were down 2% for fiscal 2021. E-commerce sales were approximately 5% of TJX International’s net sales for fiscal 2021 and 3% for fiscal 2020. Along with our stores, we temporarily closed our online business for a portion of fiscal 2021, due to the COVID-19 pandemic. Once reopened during the second quarter of fiscal 2021, the online business remained open through fiscal 2021.Segment (Loss) / ProfitSegment loss was $(504) million for fiscal 2021, a decrease of $811 million, compared to a segment profit of $307 million for fiscal 2020. The decrease was primarily driven by a reduction in sales due to the temporary store closures. In addition, the decrease reflects increased markdowns on merchandise due to the COVID-19 pandemic and incremental COVID-19 costs. The decline in segment profit was partially offset by reduced store payroll, a reduction in occupancy costs and lower advertising and travel spend. The reduction in payroll reflects approximately $140 million for fiscal 2021 from government programs as described in the Impacts of the COVID-19 Pandemic section above. In addition, a significant portion of our occupancy costs are fixed. As a result, while our occupancy costs were comparable to last year, they negatively impacted segment margin by approximately 3.1 percentage points, primarily due to the lower sales volume.GENERAL CORPORATE EXPENSE Fiscal Year EndedIn millionsJanuary 30,2021February 1,2020General corporate expense$439 $557 General corporate expense for segment reporting purposes represents those costs not specifically related to the operations of our business segments. General corporate expenses are primarily included in SG&A expenses. The mark-to-market adjustment of our fuel hedges is included in cost of sales, including buying and occupancy costs. The decrease in general corporate expense for fiscal 2021 was primarily driven by lower share-based and incentive compensation costs.35ANALYSIS OF FINANCIAL CONDITIONLiquidity and Capital ResourcesOur liquidity requirements have traditionally been funded through cash generated from operations, supplemented, as needed, by short-term bank borrowings and the issuance of commercial paper. As of January 30, 2021, there were no short-term bank borrowings or commercial paper outstanding. As part of the actions we have taken, and are continuing to take, relating to the COVID-19 pandemic, as described in Impact of the COVID-19 Pandemic above and in Note B—Impact of the COVID-19 Pandemic of Notes to Consolidated Financial Statements, in the first quarter of fiscal 2021, TJX issued $4 billion aggregate principal amount of notes. In the fourth quarter of fiscal 2021, we refinanced $1.1 billion in aggregate principal amount of our higher interest notes with the issuance and sale of $1 billion in aggregate principal amount of lower interest rate senior notes. For additional information on these transactions, see Note K—Long-Term Debt and Credit Lines of Notes to Consolidated Financial Statements.In March 2020, we drew down $1 billion on our revolving credit facilities, subsequently repaying these borrowings in July 2020. On August 10, 2020, we increased our borrowing capacity by entering into a $500 million 364-day facility, making a total of $1.5 billion available to us under revolving credit facilities. See Note K—Long-Term Debt and Credit Lines of Notes to Consolidated Financial Statements for additional details of these transactions. No dividend was declared in the first nine months of fiscal 2021. In the fourth quarter of fiscal 2021, our Board of Directors declared a quarterly dividend of $0.26 per share, paid in March 2021. We declared a similar dividend of $0.26 per share in the first quarter of Fiscal 2022. We have currently suspended our share repurchase program. We qualified for certain government programs in the U.S., the U.K., Canada and other jurisdictions to support payroll and other operating costs. We also reduced spending more broadly across the Company, reducing capital spending, evaluating operating expenses and taking actions to reduce ongoing variable and discretionary spending. We negotiated rent deferrals for fiscal 2021 for a significant amount of our stores, primarily for second quarter lease payments, with repayment at later dates, primarily in fiscal 2022. In addition to negotiating deferral of lease payments, we also temporarily extended payment terms on merchandise orders which increased our accounts payable as of the end of the fiscal year, benefiting our operating cash flows. As payment terms are reduced and we make deferred payments, we expect our operating cash flows to be negatively impacted. The challenges posed by the COVID-19 pandemic on our business continue to evolve. Consequently, we will continue to evaluate our financial position in light of future developments, particularly those relating to the COVID-19 pandemic.We believe our existing cash and cash equivalents, internally generated funds and our credit facilities, described in Note K—Long-Term Debt and Credit Lines of Notes to Consolidated Financial Statements, are adequate to meet our operating needs over the next fiscal year. We may use operating cash flow and cash on hand to repay portions of our indebtedness, depending on prevailing market conditions, liquidity requirements, existing economic conditions, contractual restrictions and other factors. As such, we may, from time to time, seek to retire, redeem, prepay or purchase our outstanding debt through redemptions, cash purchases, prepayments, refinancings and/or exchanges, in open market purchases, privately negotiated transactions, by tender offer or otherwise. If we use our operating cash flow and/or cash on hand to repay our debt, it will reduce the amount of cash available for additional capital expenditures.As of January 30, 2021, TJX held $10.5 billion in cash. Approximately $1.2 billion of our cash was held by our foreign subsidiaries with $0.8 billion held in countries where we intend to indefinitely reinvest any undistributed earnings. TJX has provided for all applicable state and foreign withholding taxes on all undistributed earnings of its foreign subsidiaries in Canada, Puerto Rico, Italy, India, Hong Kong and Vietnam through January 30, 2021. If we repatriate cash from such subsidiaries, we should not incur additional tax expense and our cash would be reduced by the amount of withholding taxes paid.Operating ActivitiesNet cash provided by operating activities was $4.6 billion in fiscal 2021 and $4.1 billion in fiscal 2020. Our operating cash flows increased by $0.5 billion compared to fiscal 2020. The COVID-19 pandemic had a material impact on our operating cash flows. The loss of sales as a result of temporarily closing our stores and e-commerce businesses resulted in net income of $0.1 billion for the twelve month period ended January 30, 2021 compared with net income of $3.3 billion in the twelve month period ended February 1, 2020. This decrease in cash flows was more than offset by the combination of a $2.1 billion favorable impact from the increase in accounts payable, a $0.9 billion favorable impact due to the decrease in merchandise inventories, as well as a $0.6 billion favorable impact due to the increases in accrued expenses, income taxes payable and lease liabilities. The favorable impact of the change in merchandise inventories, net of accounts payable was driven by the timing of payments for merchandise sold and lower inventories.36Investing ActivitiesNet cash used in investing activities resulted in net cash outflows of $0.6 billion in fiscal 2021 and $1.5 billion in fiscal 2020. The cash outflows for both periods were primarily driven by capital expenditures and, in fiscal 2020, we invested $0.2 billion in Familia, an established off-price apparel and home fashion retail chain in Russia. Net cash used in investing activities include capital expenditures for the last two fiscal years as set forth in the table below. Fiscal Year EndedIn millionsJanuary 30,2021February 1,2020New stores$61 $189 Store renovations and improvements124 363 Office and distribution centers383 671 Total capital expenditures$568 $1,223 We expect our capital expenditures in fiscal 2022 will be in the range of approximately $1.2 billion to $1.4 billion, including approximately $0.7 billion to $0.8 billion for our offices and distribution centers (including buying and merchandising systems and other information systems) to support growth, approximately $0.4 billion to $0.5 billion for store renovations and approximately $0.1 billion for new stores. We plan to fund these expenditures with our existing cash balances and through internally generated funds.Financing ActivitiesNet cash used in financing activities resulted in net cash inflows of $3.2 billion in fiscal 2021 and net cash outflows of $2.4 billion in fiscal 2020. In fiscal 2021, these cash inflows were primarily driven by debt transactions. In fiscal 2020, the cash outflows were primarily driven by equity repurchases and dividend payments, partially offset by issuances of common stock.DebtThe cash inflows in fiscal 2021 were a result of completing the issuance and sale in the first quarter of fiscal 2021 of (a) $1.25 billion aggregate principal amount of 3.500% notes due 2025, (b) $0.75 billion aggregate principal amount of 3.750% notes due 2027, (c) $1.25 billion aggregate principal amount of 3.875% notes due 2030 and (d) $0.75 billion aggregate principal amount of 4.500% notes due 2050. In addition, in the first quarter of fiscal 2021, we drew down $1 billion on our previously undrawn revolving credit facilities, which were paid off in full during the second quarter of fiscal 2021. During the fourth quarter, we issued $1 billion in aggregate principal amount of notes and accepted $1.1 billion in combined aggregate principal amount of certain of our notes issued in the first quarter of fiscal 2021 pursuant to cash tender offers. We paid $1.4 billion aggregate consideration in connection with the tender offers, including transaction costs and recorded a $312 million pre-tax loss on the early extinguishment for the accepted notes. See Note K—Long-Term Debt and Credit Lines of Notes to Consolidated Financial Statements for additional information.EquityUnder our stock repurchase programs, during the first quarter of fiscal 2021, TJX paid $0.2 billion to repurchase and subsequently retired 3.4 million shares of our stock on a settlement basis. These outflows were offset by proceeds from the exercise of employee stock options, net of shares withheld for taxes in fiscal 2021. Under our stock repurchase programs, TJX spent $1.6 billion to repurchase 28.2 million shares of our stock in fiscal 2020. For further information regarding equity repurchases, see Note E—Capital Stock and Earnings Per Share of Notes to Consolidated Financial Statements.In February 2020, TJX announced that its Board of Directors had approved a new stock repurchase program that authorizes the repurchase of up to an additional $1.5 billion of TJX common stock from time to time. In March 2020, in connection with the actions taken related to the COVID-19 pandemic as described in Impact of the COVID-19 Pandemic above and in Note B—Impact of the COVID-19 Pandemic of Notes to Consolidated Financial Statements, we suspended our share repurchase program.DividendsIn March 2020, we paid our quarterly dividend declared in the fourth quarter of fiscal 2020, which totaled $0.3 billion. As a result of the uncertainty surrounding the COVID-19 pandemic, no dividends were declared in the first nine months of fiscal 2021. The Board of Directors declared a quarterly dividend of $0.26 per share in the fourth quarter of fiscal 2021, paid in March 2021. We also declared a similar dividend of $0.26 per share in the first quarter of fiscal 2022. TJX declared quarterly dividends on our common stock which totaled $0.92 per share in fiscal 2020. Cash payments for dividends on our common stock totaled $0.3 billion in fiscal 2021 and $1.1 billion in fiscal 2020. We also received proceeds from the exercise of employee stock options of $0.2 billion in both fiscal 2021 and fiscal 2020. 37Contractual Obligations As of January 30, 2021, we had known contractual obligations under long-term debt arrangements (including current installments), other long-term obligations, operating leases for property and equipment and purchase obligations as follows:Payments Due by PeriodIn millionsTotalLess Than 1 Year1-3 Years3-5 YearsMore Than 5 YearsLong-term debt and other long-term obligations(a)$7,510 $918 $808 $1,518 $4,266 Operating lease liabilities, including imputed interest(b)10,277 2,050 3,300 2,419 2,508 Purchase obligations(c)5,019 4,785 232 2 — Total obligations$22,806 $7,753 $4,340 $3,939 $6,774 (a)Includes estimated interest costs.(b)Operating lease liabilities exclude legally binding minimum lease payments for leases signed but not yet commenced and include options to extend lease terms that are now deemed reasonably certain of being exercised according to our Lease Accounting Policy. The balances do not include variable costs for insurance, real estate taxes, other operating expenses and, in some cases, rentals based on a percentage of sales; these items totaled approximately one-third of the total minimum rent for fiscal 2021. (c)Includes estimated obligations under purchase orders for merchandise and under agreements for capital items, products and services used in our business, including executive employment and other agreements. Excludes agreements that can be canceled without penalty.We also have long-term liabilities for which it is not reasonably possible for us to predict when they may be paid which include $680 million for employee compensation and benefits and $264 million for uncertain tax positions.CRITICAL ACCOUNTING POLICIES We prepare our consolidated financial statements in accordance with GAAP which requires us to make certain estimates and judgments that impact our reported results. These judgments and estimates are based on historical experience and other factors which we continually review and believe are reasonable. We consider our most critical accounting policies, involving management estimates and judgments, to be those relating to the areas described below.Inventory ValuationWe use the retail method for valuing inventory for all our businesses except T.K. Maxx in Australia. The businesses that utilize the retail method have some inventory that is initially valued at cost before the retail method is applied as it has not been fully processed for sale (i.e. inventory in transit and unprocessed inventory in our distribution centers). Under the retail method, the cost value of inventory and gross margins are determined by calculating a cost-to-retail ratio and applying it to the retail value of inventory. It involves management estimates with regard to markdowns and inventory shrinkage. Under the retail method, permanent markdowns are reflected in inventory valuation when the price of an item is reduced. Typically, a significant area of judgment in the retail method is the amount and timing of permanent markdowns. However, as a normal business practice, we have a specific policy as to when and how markdowns are to be taken, greatly reducing management’s discretion and the need for management estimates as to markdowns. Inventory shrinkage requires estimating a shrinkage rate for interim periods, however we take a full physical inventory near the fiscal year end to determine shrinkage at year end. We do not generally enter into arrangements with vendors that provide for rebates and allowances that could ultimately affect the value of inventory.Impairment of Long-lived AssetsWe evaluate our long-lived assets, inclusive of operating lease right of use assets, for impairment whenever events or changes in circumstances indicate that their carrying amounts may not be recoverable. Significant judgment is involved in projecting the cash flows of individual stores, which involve a number of factors including historical trends, recent performance and general economic assumptions. If we determine that an impairment has occurred, we record an impairment charge equal to the excess of the carrying value of those assets over the estimated fair value of the assets. We estimate fair value by obtaining market appraisals or using other valuation techniques.38Lease AccountingOperating leases are included in “Operating lease right of use assets”, “Current portion of operating lease liabilities”, and “Long-term operating lease liabilities” on our Consolidated Balance Sheets. Right of use (“ROU”) assets represent our right to use an underlying asset for the lease term and lease liabilities represent our obligation to make lease payments arising from the lease. At the inception of the arrangement, we determine if an arrangement is a lease based on assessment of the terms and conditions of the contract. Operating lease ROU assets and lease liabilities are recognized at possession date based on the present value of lease payments over the lease term. The majority of our leases are retail store locations and the possession date is typically 30 to 60 days prior to the opening of the store and generally occurs before the commencement of the lease term, as specified in the lease. Our lessors do not provide an implicit rate, nor is one readily available, therefore we use our incremental borrowing rate based on the information available at possession date in determining the present value of future lease payments. The incremental borrowing rate is calculated based on the US Consumer Discretionary yield curve and adjusted for collateralization and foreign currency impact for TJX International and TJX Canada leases. The operating lease ROU asset also includes any acquisition costs offset by lease incentives. Our lease terms include options to extend the lease when it is reasonably certain that we will exercise that option. Lease expense for lease payments is recognized on a straight-line basis over the lease term within “Cost of sales, including buying and occupancy costs”. Reserves for Uncertain Tax PositionsSimilar to many large corporations, our income and other tax returns and reports are regularly audited by federal, state and local tax authorities in the United States and in foreign jurisdictions where we operate and such authorities may challenge positions we take. We are engaged in various administrative and judicial proceedings in multiple jurisdictions with respect to assessments, claims, deficiencies and refunds and other tax matters, which proceedings are in various stages of negotiation, assessment, examination, litigation and settlement. The outcomes of these proceedings are uncertain. In accordance with GAAP, we evaluate our uncertain tax positions based on our understanding of the facts, circumstances and information available at the reporting date, and we accrue for exposure when we believe that it is more likely than not, based on the technical merits, that the positions we have taken will not be sustained. However, in the next twelve months and in future periods, the amounts we accrue for uncertain tax positions from time to time or ultimately pay, as the result of the final resolutions of examinations, judicial or administrative proceedings, changes in facts, law, or legal interpretations, expiration of applicable statute of limitations or other resolutions of, or changes in, tax positions may differ either positively or negatively from the amounts we have accrued, and may result in reductions to or additions to accruals, refund claims or payments for periods not currently under examination or for which no claims have been made. Final resolutions of our tax positions or changes in accruals for uncertain tax positions could result in additional tax expense or benefit and could have a material impact on our results of operations of the period in which an examination or proceeding is resolved or in the period in which a changed outcome becomes probable and reasonably estimable.Loss ContingenciesCertain conditions may exist as of the date the financial statements are issued that may result in a loss to us but will not be resolved until one or more future events occur or fail to occur. Our management, with the assistance of our legal counsel, assesses such contingent liabilities. Such assessments inherently involve the exercise of judgment. In assessing loss contingencies related to legal proceedings that are pending against us or claims that may result in such proceedings, our legal counsel assists us in evaluating the perceived merits of any legal proceedings or claims as well as the perceived merits of the relief sought or expected to be sought therein.If the assessment of a contingency indicates that it is probable that a material loss has been incurred and the amount of the liability can be reasonably estimated, we will accrue for the estimated liability in the financial statements. If the assessment indicates that a potentially material loss contingency is not probable, but is reasonably possible, or is probable but cannot be reasonably estimated, we will disclose the nature of the contingent liability, together with an estimate of the range of the possible loss or a statement that such loss is not reasonably estimable.RECENT ACCOUNTING PRONOUNCEMENTSFor a discussion of new accounting pronouncements related to income taxes, see Note A—Basis of Presentation and Summary of Accounting Policies of Notes to Consolidated Financial Statements included in this annual report on Form 10-K, including the dates of adoption and estimated effects on our results of operations, financial position or cash flows. We do not expect any other recently issued accounting pronouncements will have a material effect on our financial statements.39ITEM 7A. Quantitative and Qualitative Disclosure about Market RiskTJX is exposed to market risks in the ordinary course of business. Some potential market risks are discussed below:FOREIGN CURRENCY EXCHANGE RISKWe are exposed to foreign currency exchange rate risk on the translation of our foreign operations into the U.S. dollar and on purchases of goods in currencies that are not the local currencies of stores where the goods are sold and on intercompany debt and interest payable between and among our domestic and international operations. Our currency risk primarily relates to our activity in the Canadian dollar, British pound and Euro. As more fully described in Note F—Financial Instruments of Notes to Consolidated Financial Statements, we use derivative financial instruments to hedge a portion of certain merchandise purchase commitments, primarily at our international operations, and a portion of our intercompany transactions with and within our international operations. We enter into derivative contracts only for the purpose of hedging the underlying economic exposure. We utilize currency forward and swap contracts, designed to offset the gains or losses on the underlying exposures. The contracts are executed with banks we believe are creditworthy and are denominated in currencies of major industrial countries. Our foreign exchange risk management policy prohibits us from using derivative financial instruments for trading or other speculative purposes and we do not use any leveraged derivative financial instruments. We have performed a sensitivity analysis assuming a hypothetical 10% movement in foreign currency exchange rates applied to the hedging contracts and the underlying exposures described above as well as the translation of our foreign operations into our reporting currency. The analysis indicated a potential impact of approximately $38 million on our pre-tax income in fiscal 2021 and approximately $82 million in fiscal 2020.EQUITY PRICE AND OTHER MARKET RISKThe assets of our funded qualified pension plan, a portion of which are equity securities, are subject to the risks and uncertainties of the financial markets. We invest the pension assets (described further in Note J—Pension Plans and Other Retirement Benefits of Notes to Consolidated Financial Statements) in a manner that attempts to manage our exposure to market uncertainties. Investments, in general, are exposed to various risks, such as interest rate, credit, and overall market volatility risks. A significant decline in the financial markets could adversely affect the value of our pension plan assets and the funded status of our pension plan, resulting in increased required contributions to the plan or other plan-related liabilities. Our pension plan investment policy prohibits the use of derivatives for speculative purposes.
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+Item 7.MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSForward-Looking StatementsThis Report contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. Such forward-looking statements include, without limitation, statements concerning property acquisitions and dispositions, development activity and capital expenditures, capital raising activities, rent growth, occupancy, rental expense growth and expected or potential impacts of the novel coronavirus disease (“COVID-19”) pandemic. Words such as “expects,” “anticipates,” “intends,” “plans,” “likely,” “will,” “believes,” “seeks,” “estimates,” and variations of such words and similar expressions are intended to identify such forward-looking statements. Such statements involve known and unknown risks, uncertainties and other factors which may cause our actual results, performance or achievements to be materially different from the results of operations or plans expressed or implied by such forward-looking statements. Such factors include, among other things, the impact of the COVID-19 pandemic and measures intended to prevent its spread or address its effect, unfavorable changes in the apartment market, changing economic conditions, the impact of inflation/deflation on rental rates and property operating expenses, expectations concerning the availability of capital and the stability of the capital markets, the impact of competition and competitive pricing, acquisitions, developments and redevelopments not achieving anticipated results, delays in completing developments and redevelopments, delays in completing lease-ups on schedule or at expected rent and occupancy levels, expectations on job growth, home affordability and demand/supply ratio for multifamily housing, expectations concerning development and redevelopment activities, expectations on occupancy levels and rental rates, expectations concerning joint ventures and partnerships with third parties, expectations that automation will help grow net operating income, and expectations on annualized net operating income.The following factors, among others, could cause our future results to differ materially from those expressed in the forward-looking statements:●the impact of the COVID-19 pandemic and measures intended to prevent its spread or address its effects;●general economic conditions;●unfavorable changes in apartment market and economic conditions that could adversely affect occupancy levels and rental rates, including as a result of COVID-19;●the failure of acquisitions to achieve anticipated results;●possible difficulty in selling apartment communities;●competitive factors that may limit our ability to lease apartment homes or increase or maintain rents;●insufficient cash flow that could affect our debt financing and create refinancing risk;●failure to generate sufficient revenue, which could impair our debt service payments and distributions to stockholders;●development and construction risks that may impact our profitability;●potential damage from natural disasters, including hurricanes and other weather-related events, which could result in substantial costs to us;●risks from climate change that impacts our properties or operations;●risks from extraordinary losses for which we may not have insurance or adequate reserves;●risks from cybersecurity breaches of our information technology systems and the information technology systems of our third party vendors and other third parties;●uninsured losses due to insurance deductibles, self-insurance retention, uninsured claims or casualties, or losses in excess of applicable coverage;37 Table of Contents●delays in completing developments and lease-ups on schedule;●our failure to succeed in new markets;●risks that third parties who have an interest in or are otherwise involved in projects in which we have an interest, including mezzanine borrowers, joint venture partners or other investors, do not perform as expected;●changing interest rates, which could increase interest costs and affect the market price of our securities;●potential liability for environmental contamination, which could result in substantial costs to us;●the imposition of federal taxes if we fail to qualify as a REIT under the Code in any taxable year;●our internal control over financial reporting may not be considered effective which could result in a loss of investor confidence in our financial reports, and in turn have an adverse effect on our stock price; and●changes in real estate laws, tax laws, rent control or stabilization laws or other laws affecting our business.A discussion of these and other factors affecting our business and prospects is set forth in Part I, Item 1A. Risk Factors. We encourage investors to review these risk factors.Although we believe that the assumptions underlying the forward-looking statements contained herein are reasonable, any of the assumptions could be inaccurate, and therefore such statements included in this Report may not prove to be accurate. In light of the significant uncertainties inherent in the forward-looking statements included herein, the inclusion of such information should not be regarded as a representation by us or any other person that the results or conditions described in such statements or our objectives and plans will be achieved.Forward-looking statements and such risks, uncertainties and other factors speak only as of the date of this Report, and we expressly disclaim any obligation or undertaking to update or revise any forward-looking statement contained herein, to reflect any change in our expectations with regard thereto, or any other change in events, conditions or circumstances on which any such statement is based, except to the extent otherwise required by law.COVID-19 Update See Part I, Item 1. “Business – COVID-19 Update” above for more information on the impact of COVID-19 on the Company.​The following discussion should be read in conjunction with the consolidated financial statements appearing elsewhere herein and is based primarily on the consolidated financial statements for the years ended December 31, 2020, and 2019 of each UDR, Inc. and United Domination Realty, L.P.This section of this Form 10-K generally discusses 2020 and 2019 items and year-to-year comparisons between 2020 and 2019 of UDR, Inc. and United Domination Realty, L.P. Discussions of 2018 items and year-to-year comparisons between 2019 and 2018 that are not included in this Form 10-K can be found in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Part II, Item 7 of the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2019.​UDR, Inc.:Business OverviewWe are a self-administered real estate investment trust, or REIT, that owns, operates, acquires, renovates, develops, redevelops, disposes of, and manages multifamily apartment communities. We were formed in 1972 as a Virginia corporation. In June 2003, we changed our state of incorporation from Virginia to Maryland. Our subsidiaries include the Operating Partnership and the DownREIT Partnership. Unless the context otherwise requires, all references in this Report to “we,” “us,” “our,” “the Company,” or “UDR” refer collectively to UDR, Inc., its subsidiaries and its consolidated joint ventures.38 Table of ContentsAt December 31, 2020, our consolidated real estate portfolio included of 149 communities in 13 states plus the District of Columbia totaling of 48,283 apartment homes. In addition, we have an ownership interest in 5,295 completed or to-be-completed apartment homes through unconsolidated joint ventures or partnerships, including 2,165 apartment homes owned by entities in which we hold preferred equity investments. The Same-Store Community apartment home population for the year ended December 31, 2020, was 37,607.Critical Accounting Policies and EstimatesThe preparation of financial statements in conformity with United States generally accepted accounting principles (“GAAP”) requires management to use judgment in the application of accounting policies, including making estimates and assumptions. A critical accounting policy is one that is both important to our financial condition and results of operations as well as involves some degree of uncertainty. Estimates are prepared based on management’s assessment after considering all evidence available. Changes in estimates could affect our financial position or results of operations. Below is a discussion of the accounting policies that we consider critical to understanding our financial condition or results of operations where there is uncertainty or where significant judgment is required. A discussion of our significant accounting policies, including further discussion of the accounting policies described below, can be found in Note 2, Significant Accounting Policies, to the Notes to the UDR, Inc. Consolidated Financial Statements included in this Report.Cost CapitalizationIn conformity with GAAP, we capitalize those expenditures that materially enhance the value of an existing asset or substantially extend the useful life of an existing asset. Expenditures necessary to maintain an existing property in ordinary operating condition are expensed as incurred.In addition to construction costs, we capitalize costs directly related to the predevelopment, development, and redevelopment of a capital project, which include, but are not limited to, interest, real estate taxes, insurance, and allocated development and redevelopment overhead related to support costs for personnel working on the capital projects. We use our professional judgment in determining whether such costs meet the criteria for capitalization or must be expensed as incurred. These costs are capitalized only during the period in which activities necessary to ready an asset for its intended use are in progress and such costs are incremental and identifiable to a specific activity to get the asset ready for its intended use. As each home in a capital project is completed and becomes available for lease-up, the Company ceases capitalization on the related portion. The costs capitalized are reported on the Consolidated Balance Sheets as Total real estate owned, net of accumulated depreciation. Amounts capitalized during the years ended December 31, 2020, 2019, and 2018 were $19.0 million, $13.5 million, and $18.1 million, respectively.Investment in Unconsolidated EntitiesWe may enter into various joint venture agreements and/or partnerships with unrelated third parties to hold or develop real estate assets. We must determine for each of these ventures whether to consolidate the entity or account for our investment under the equity method of accounting. We determine whether to consolidate a joint venture or partnership based on our rights and obligations under the venture agreement, applying the applicable accounting guidance. The application of the rules in evaluating the accounting treatment for each joint venture or partnership is complex and requires substantial management judgment. We evaluate our accounting for investments on a regular basis including when a significant change in the design of an entity occurs. Throughout our financial statements, and in this Management’s Discussion and Analysis of Financial Condition and Results of Operations, we use the term “joint venture” or “partnership” when referring to investments in entities in which we do not have a 100% ownership interest.We continually evaluate our investments in unconsolidated joint ventures when events or changes in circumstances indicate that there may be an other-than-temporary decline in value. We consider various factors to determine if a decrease in the value of the investment is other-than-temporary. These factors include, but are not limited to, age of the venture, our intent and ability to retain our investment in the entity, the financial condition and long-term prospects of the entity, and the relationships with the other joint venture partners and its lenders. The amount of loss recognized is the excess of the investment’s carrying amount over its estimated fair value. If we believe that the decline in fair value is temporary, no impairment is recorded. The aforementioned factors are taken as a whole by management in determining the valuation of our investment property. Should the actual results differ from management’s judgment, the valuation could be negatively affected and may result in a negative impact to our Consolidated Financial Statements.39 Table of ContentsImpairment of Long-Lived AssetsQuarterly or when changes in circumstances warrant, we will assess our real estate properties for indicatorsof impairment. The judgments regarding the existence of impairment indicators are based on certain factors. Such factors include, among other things, operational performance, market conditions, the Company’s intent and ability to hold the related asset, as well as any significant cost overruns on development properties.​If a real estate property has indicators of impairment, we assess whether the long-lived asset’s carrying value exceeds the community’s undiscounted future cash flows, which is representative of projected net operating income (“NOI”) plus the residual value of the community. Our future cash flow estimates are based upon historical results adjusted to reflect our best estimate of future market and operating conditions and our estimated holding periods. If such indicators of impairment are present and the carrying value exceeds the undiscounted cash flows of the community, an impairment loss is recognized equal to the excess of the carrying amount of the asset over its estimated fair value. Our estimates of fair value represent our best estimate based primarily upon unobservable inputs related to rental rates, operating costs, growth rates, discount rates, capitalization rates, industry trends and reference to market rates and transactions.For long-lived assets to be disposed of, impairment losses are recognized when the fair value of the asset less estimated cost to sell is less than the carrying value of the asset. Properties classified as real estate held for disposition generally represent properties that are actively marketed or contracted for sale with the closing expected to occur within the next twelve months. Real estate held for disposition is carried at the lower of cost, net of accumulated depreciation, or fair value, less the cost to sell, determined on an asset-by-asset basis. Expenditures for ordinary repair and maintenance costs on held for disposition properties are charged to expense as incurred. Expenditures for improvements, renovations, and replacements related to held for disposition properties are capitalized at cost. Depreciation is not recorded on real estate held for disposition.Real Estate Investment PropertiesWe purchase real estate investment properties from time to time and record the fair value to various components, such as land, buildings, and intangibles related to in-place leases, based on the fair value of each component. In making estimates of fair values for purposes of allocating purchase price, we utilize various sources, including independent appraisals, our own analysis of recently acquired and existing comparable properties in our portfolio and other market data. The fair value of buildings is determined as if the buildings were vacant upon acquisition and subsequently leased at market rental rates. As such, the determination of fair value considers the present value of all cash flows expected to be generated from the property including an initial lease-up period. We determine the fair value of in-place leases by assessing the net effective rent and remaining term of the lease relative to market terms for similar leases at acquisition. In addition, we consider the cost of acquiring similar leases, the foregone rents associated with the lease-up period, and the carrying costs associated with the lease-up period. The fair value of in-place leases is recorded and amortized as amortization expense over the remaining average contractual lease period.REIT StatusWe are a Maryland corporation that has elected to be treated for federal income tax purposes as a REIT. A REIT is a legal entity that holds interests in real estate and is required by the Code to meet a number of organizational and operational requirements, including a requirement that a REIT must distribute at least 90% of our REIT taxable income (other than our net capital gain) to our stockholders. If we were to fail to qualify as a REIT in any taxable year, we will be subject to federal and state income taxes at the regular corporate rates and may not be able to qualify as a REIT for four years. Based on the net earnings reported for the year ended December 31, 2020 in our Consolidated Statements of Operations, we would have incurred federal and state GAAP income taxes if we had failed to qualify as a REIT.40 Table of ContentsSummary of Real Estate Portfolio by Geographic MarketThe following table summarizes our market information by major geographic markets as of and for the year ended December 31, 2020:​​​​​​​​​​​​​​​​​​​​​​December 31, 2020​Year Ended December 31, 2020​ ​ ​ Percentage Total ​ Monthly Net​​Number of​Number of​of Total ​Carrying​Average​Income per ​Operating​​Apartment​Apartment​Carrying​Value (in​Physical​Occupied​IncomeSame-Store Communities​Communities​Homes​Value​thousands)​Occupancy​Home (a)​(in thousands)West Region ​ ​ ​ Orange County, CA 10 4,434 8.8% $ 1,145,371 96.5% $ 2,328​$ 91,704San Francisco, CA 11 2,751 6.8% ​ 885,036 91.5% ​ 3,501​​ 76,760Seattle, WA 13 2,570 6.8% 889,749 96.7% 2,471​ 53,010Monterey Peninsula, CA 7 1,565 1.4% 185,224 96.6% 1,940​ 27,587Los Angeles, CA 4 1,225 3.5% 463,167 95.5% 2,765​ 27,585Other Southern California 2 654 0.9% 111,656 97.7% 2,038​ 11,796Portland, OR 2 476 0.4% 52,126 97.1% 1,637​ 6,623Mid-Atlantic Region ​​ ​ ​ Metropolitan D.C. 20 7,496 14.9% 1,944,746 96.8% 2,077​ 125,654Baltimore, MD 3 720 1.2% 156,797 97.9% 1,720​ 9,603Richmond, VA 4 1,358 1.2% 153,906 97.8% 1,422​ 16,874Northeast Region ​​ ​ ​ Boston, MA 4 1,388 3.6% 470,541 95.1% 2,783​ 32,372New York, NY 3 1,452 7.9% 1,037,337 92.6% 4,135​ 33,181Southeast Region ​​ ​ ​ Tampa, FL 7 2,287 2.1% 274,126 97.1% 1,484​ 25,949Orlando, FL 9 2,500 1.8% 240,100 96.8% 1,413​ 28,541Nashville, TN 8 2,260 1.7% 223,827 97.8% 1,378​ 25,943Other Florida 1 636 0.7% 89,630 97.2% 1,656​ 8,085Southwest Region ​​ ​ ​ Dallas, TX 7 2,345 2.3% 298,205 97.3% 1,382​ 24,124Austin, TX 4 1,272 1.3% 171,483 97.6% 1,548​ 13,607Denver, CO​ 1​ 218​ 1.1%​ 144,959​ 93.1%​ 3,012​​ 5,200Total/Average Same-Store Communities 120 37,607 68.4% 8,937,986 96.3%$ 2,126​ 644,198Non-Mature, Commercial Properties & Other 28 10,088 28.8% 3,768,954 ​ ​ 196,868Total Real Estate Held for Investment 148 47,695 97.2% 12,706,940 ​ ​ 841,066Real Estate Under Development (b) — 202 1.9% 247,877 ​ ​ 215Real Estate Held for Disposition (c) 1 386 0.9% 116,655 ​ ​ 12,421Total Real Estate Owned 149 48,283 100.0% 13,071,472 ​ ​$ 853,702Total Accumulated Depreciation ​ (4,605,366) ​ ​ Total Real Estate Owned, Net of Accumulated Depreciation ​$ 8,466,106 ​ ​ (a)Monthly Income per Occupied Home represents total monthly revenues divided by the average physical number of occupied apartment homes in our Same-Store portfolio.(b)As of December 31, 2020, the Company was developing five wholly owned communities with a total of 1,378 apartment homes, 202 of which have been completed.(c)The Company had one community located in Orange County, California that met the criteria to be classified as held for disposition at December 31, 2020.We report in two segments: Same-Store Communities and Non-Mature Communities/Other.Our Same-Store Communities segment represents those communities acquired, developed, and stabilized prior to January 1, 2019 and held as of December 31, 2020. These communities were owned and had stabilized occupancy and operating expenses as of the beginning of the prior year, there is no plan to conduct substantial redevelopment activities, and the communities are not classified as held for disposition at year end. A community is considered to have stabilized occupancy once it achieves 90% occupancy for at least three consecutive months.41 Table of ContentsOur Non-Mature Communities/Other segment represents those communities that do not meet the criteria to be included in Same-Store Communities, including, but not limited to, recently acquired, developed and redeveloped communities, and the non-apartment components of mixed use properties.Liquidity and Capital ResourcesLiquidity is the ability to meet present and future financial obligations either through operating cash flows, sales of properties, borrowings under our credit agreements, and/or the issuance of debt and/or equity securities. Our primary source of liquidity is our cash flow from operations, as determined by rental rates, occupancy levels, and operating expenses related to our portfolio of apartment homes, and borrowings under our credit agreements. We routinely use our working capital credit facility, our unsecured revolving credit facility and issuances of commercial paper to temporarily fund certain investing and financing activities prior to arranging for longer-term financing or the issuance of equity or debt securities. During the past several years, proceeds from the sale of real estate have been used for both investing and financing activities as we continue to execute on maintaining a diversified portfolio.We expect to meet our short-term liquidity requirements generally through net cash provided by property operations and borrowings under our credit agreements and our unsecured commercial paper program. We expect to meet certain long-term liquidity requirements such as scheduled debt maturities, the repayment of financing on development activities, and potential property acquisitions, through net cash provided by property operations, secured and unsecured borrowings, the issuance of debt or equity securities, and/or the disposition of properties. We believe that our net cash provided by property operations and borrowings under our credit agreements and our unsecured commercial paper program will continue to be adequate to meet both operating requirements and the payment of dividends by the Company in accordance with REIT requirements. Likewise, the budgeted expenditures for improvements and renovations of certain properties are expected to be funded from property operations, borrowings under credit agreements, the issuance of debt or equity securities, and/or dispositions of properties.We have a shelf registration statement filed with the Securities and Exchange Commission, or “SEC,” which provides for the issuance of common stock, preferred stock, depositary shares, debt securities, guarantees of debt securities, warrants, subscription rights, purchase contracts and units to facilitate future financing activities in the public capital markets. Access to capital markets is dependent on market conditions at the time of issuance.In July 2017, the Company entered into an ATM sales agreement under which the Company may offer and sell up to 20.0 million shares of its common stock, from time to time, to or through its sales agents and may enter into separate forward sales agreements to or through its forward purchasers. Upon entering into the ATM sales agreement, the Company simultaneously terminated the sales agreement for its prior at-the-market equity offering program, which was entered into in April 2017, which replaced the prior at-the-market equity offering program entered into in April 2012. During the year ended December 31, 2020, the Company did not sell any shares of common stock through its ATM program, other than the forward sales described below. As of December 31, 2020, we had 9.6 million shares of common stock available for future issuance under the ATM program.In February 2020, the Company issued $200.0 million of 3.20% senior unsecured medium-term notes due 2030 (the “2030 Notes”). Interest is payable semi-annually in arrears on January 15 and July 15 of each year, beginning on July 15, 2020. The notes were priced at 105.660% of the principal amount at issuance. This was a further issuance of the 2030 Notes, and forms a single series with, the $300.0 million aggregate principal amount of the Company’s 2030 Notes that were issued in July 2019 and the $100.0 million aggregate principal amount of the Company’s 2030 Notes that were issued in October 2019. As of the completion of the offering, the aggregate principal amount of outstanding 2030 notes was $600.0 million. In July 2020, the Company refinanced a 4.35% fixed rate mortgage note payable due in November 2020 with a balance of $79.3 million with a $160.9 million, 2.62% fixed rate mortgage note payable due in 2031. The Company incurred net extinguishment costs of $0.5 million in connection with the refinancing. The incremental proceeds were used to reduce the Company’s borrowings under its unsecured commercial paper program.​In July 2020, the Company announced that it commenced a cash tender offer for any and all of its outstanding 3.75% unsecured medium-term notes due July 2024 (the “2024 Notes”). Pursuant to the tender offer, on July 21, 2020, the Company completed the purchase of $116.9 million aggregate principal amount of the 2024 Notes, or 39.0% of the $300.0 million aggregate principal amount of the 2024 Notes. The tender offer consideration was $1,101.92 for each $1,000 principal amount of the 2024 Notes, plus accrued and unpaid interest to, but not including, July 21, 2020. 42 Table of ContentsIn July 2020, the Company issued $400.0 million of 2.10% senior unsecured medium-term notes due August 1, 2032. Interest is payable semi-annually in arrears on February 1 and August 1. The notes were priced at 99.894% of the principal amount at issuance. The Company used a portion of the net proceeds to fund the purchase of the 2024 Notes accepted pursuant to the tender offer described above and to prepay $245.8 million of 4.64% secured debt due in 2023. The combined prepayment and make-whole amounts for the purchase of the 2024 Notes and the prepayment of the secured debt due in 2023, inclusive of the acceleration of fair market value adjustments originally recorded on secured debt assumed in property acquisitions, totaled approximately $24.0 million.​In December 2020, the Company issued $350.0 million of 1.90% senior unsecured medium-term notes due March 15, 2033 (the “2033 Notes”). Interest is payable semi-annually in arrears on March 15 and September 15. The notes were priced at 99.578% of the principal amount at issuance. The Company used the net proceeds for the repayment of debt, including the redemption of the remaining $183.1 million aggregate principal amount (plus the make-whole amount of approximately $21.1 million) of its 2024 Notes, $67.5 million of secured debt maturing in 2023, and outstanding indebtedness under our commercial paper program and working capital credit facility. The 2033 Notes were issued as “green” bonds and, as a result, the Company will allocate an amount equal to the net proceeds from the sale of the 2033 Notes to fund eligible green projects.​During the year ended December 31, 2020, the Company repurchased 0.6 million shares of its common stock at an average price of $33.11 per share for total consideration of approximately $19.8 million under its share repurchase program.​During the year ended December 31, 2020, the Company entered into forward sales agreements under its ATM program for a total of 2.1 million shares of common stock at a weighted average initial forward price per share of $49.56. The initial forward price per share received by the Company upon settlement was determined on theapplicable settlement date based on adjustments made to the initial forward price to reflect the then-current federal funds rate and the amount of dividends paid to holders of UDR common stock over the term of the forward sales agreement. ​In December 2020, the Company settled all 2.1 million shares sold under the forward sales agreement at a weighted average forward price per share of $48.23, which is inclusive of adjustments made to reflect the then-current federal funds rate, the amount of dividends paid to holders of UDR common stock and commissions paid to sales agents of approximately $3.9 million, for net proceeds of $102.3 million. Aggregate net proceeds from such sales, after deducting related expenses, was $102.2 million.​Future Capital NeedsFuture development and redevelopment expenditures may be funded through unsecured or secured credit facilities, unsecured commercial paper, proceeds from the issuance of equity or debt securities, sales of properties, joint ventures, and, to a lesser extent, from cash flows provided by property operations. Acquisition activity in strategic markets may be funded through joint ventures, by the reinvestment of proceeds from the sale of properties, through the issuance of equity or debt securities, the issuance of operating partnership units and the assumption or placement of secured and/or unsecured debt.During 2021, we have approximately $1.1 million of secured debt maturing, comprised solely of principal amortization, and $190.0 million of unsecured debt maturing, comprised solely of the unsecured commercial paper. Additionally, the Company has no secured or unsecured debt maturing in 2022, other than the unsecured working capital credit facility. We anticipate repaying the debt due in 2021 and 2022 with cash flow from our operations, proceeds from debt or equity offerings, proceeds from dispositions of properties, or from borrowings under our credit agreements and our unsecured commercial paper program.In January 2021, the entire $190.0 million of outstanding unsecured commercial paper as of December 31, 2020 was repaid at maturity with additional proceeds of unsecured commercial paper with maturity dates in February 2021 and proceeds under the Working Capital Credit Facility. As of February 16, 2021, we had no borrowings outstanding under the Revolving Credit Facility, leaving $1.1 billion of unused capacity (excluding $1.9 million of letters of credit), and we had $0.2 million outstanding under the Working Capital Credit Facility, leaving $74.8 million of unused capacity.On February 11, 2021, the Company priced an offering of $300.0 million of 2.10% senior unsecured medium-term notes due 2033. The notes were priced at 99.592% of the principal amount of the notes. The Company intends to 43 Table of Contentsuse the net proceeds to repay indebtedness, including the redemption of its $300.0 million 4.00% senior unsecured medium-term notes due October 2025 (plus the make-whole amount and accrued and unpaid interest), to fund potential acquisitions, or for other general corporate purposes. The settlement of the offering is expected to occur on February 26, 2021, subject to the satisfaction of customary closing conditions.Statements of Cash FlowsThe following discussion explains the changes in Net cash provided by/(used in) operating activities, Net cash provided by/(used in) investing activities, and Net cash provided by/(used in) financing activities that are presented in our Consolidated Statements of Cash Flows for the years ended December 31, 2020 and 2019.Operating ActivitiesFor the year ended December 31, 2020, our Net cash provided by/(used in) operating activities was $604.3 million compared to $630.7 million for 2019. The decrease in cash flow from operating activities was primarily due to changes in operating assets and liabilities, partially offset by an increase in return on investments in unconsolidated joint ventures and improved net operating income, primarily driven by net operating income from communities acquired in 2020 and 2019.Investing ActivitiesFor the year ended December 31, 2020, Net cash provided by/(used in) investing activities was $(460.8) million compared to $(1.7) billion for 2019. The decrease in cash used in investing activities was primarily due to the decrease in acquisitions made during the current year and an increase in proceeds from sales of real estate investments, partially offset by an increase in spend for development of real estate assets and a decrease in distributions received from unconsolidated joint ventures.AcquisitionsIn January 2020, the Company acquired a 294 apartment home operating community located in Tampa, Florida for approximately $85.2 million. The Company increased its real estate assets owned by approximately $83.1 million and recorded approximately $2.1 million of in-place lease intangibles.In January 2020, the Company increased its ownership interest from 49% to 100% in a 276 apartment home operating community located in Hillsboro, Oregon, for a cash purchase price of approximately $21.6 million. In connection with the acquisition, the Company repaid approximately $35.6 million of joint venture construction financing. As a result, the Company consolidated the operating community. The Company had previously accounted for its 49% ownership interest as a preferred equity investment in an unconsolidated joint venture (see Note 5, Joint Ventures and Partnerships). The Company accounted for the consolidation as an asset acquisition resulting in no gain or loss upon consolidation and increased its real estate assets owned by approximately $67.8 million and recorded approximately $1.7 million of in-place lease intangibles.​In August 2020, the Company acquired a to-be-developed parcel of land located in King of Prussia, Pennsylvania for approximately $16.2 million. ​In November 2020, the Company acquired a 672 apartment home operating community located in Tampa, Florida for approximately $122.5 million. The Company increased its real estate assets owned by approximately $119.4 million and recorded approximately $3.1 million of in-place lease intangibles.​In December 2020, the Company acquired a 400 apartment home operating community located in Herndon, Virginia for approximately $128.6 million. The Company increased its real estate assets owned by approximately $125.9 million and recorded approximately $2.7 million of in-place lease intangibles.​In January 2019, the Company increased its ownership interest from 49% to 100% in a 386 apartment home operating community located in Anaheim, California, for a cash purchase price of approximately $33.5 million. In connection with the acquisition, the Company repaid approximately $59.8 million of joint venture construction financing. As a result, the Company consolidated the operating community. The Company had previously accounted for its 49% ownership interest as a preferred equity investment in an unconsolidated joint venture. The Company accounted 44 Table of Contentsfor the consolidation as an asset acquisition resulting in no gain upon consolidation and increased its real estate assets owned by approximately $115.7 million and recorded approximately $2.4 million of in-place lease intangibles.In January 2019, the Company increased its ownership interest from 49% to 100% in a 155 apartment home operating community located in Seattle, Washington, for a cash purchase price of approximately $20.0 million. In connection with the acquisition, the Company repaid approximately $26.0 million of joint venture construction financing. As a result, the Company consolidated the operating community. The Company had previously accounted for its 49% ownership interest as a preferred equity investment in an unconsolidated joint venture. The Company accounted for the consolidation as an asset acquisition resulting in no gain upon consolidation and increased its real estate assets owned by approximately $58.1 million and recorded approximately $2.4 million of real estate intangibles and approximately $0.6 million of in-place lease intangibles.In January 2019, the Company acquired a to-be-developed parcel of land located in Washington, D.C. for approximately $27.1 million.In February 2019, the Company acquired a to-be-developed parcel of land located in Denver, Colorado for approximately $13.7 million.In February 2019, the Company acquired a 188 apartment home operating community located in Brooklyn, New York for approximately $132.1 million. The Company increased its real estate assets owned by approximately $97.5 million and recorded approximately $33.6 million of real estate intangibles and approximately $1.0 million of in-place lease intangibles.In February 2019, the Company acquired a 381 apartment home operating community located in St. Petersburg, Florida for approximately $98.3 million. The Company increased its real estate assets owned by approximately $96.0 million and recorded approximately $2.3 million of in-place lease intangibles. ​In April 2019, the Company acquired a 498 apartment home operating community located in Towson, Maryland for approximately $86.4 million. The Company increased its real estate assets owned by approximately $82.5 million and recorded approximately $3.9 million of in-place lease intangibles. ​In May 2019, the Company acquired a 313 apartment home operating community located in King of Prussia, Pennsylvania for approximately $107.3 million. The Company increased its real estate assets owned by approximately $106.4 million and recorded approximately $0.9 million of in-place lease intangibles.​In May 2019, the Company acquired a 240 apartment home operating community located in St. Petersburg, Florida for approximately $49.4 million. The Company increased its real estate assets owned by approximately $48.2 million and recorded approximately $1.2 million of in-place lease intangibles.​In June 2019, the Company acquired a 200 apartment home operating community located in Waltham, Massachusetts for approximately $84.6 million. The Company increased its real estate assets owned by approximately $82.6 million and recorded approximately $2.0 million of in-place lease intangibles.​In August 2019, the Company acquired a 914 apartment home operating community located in Norwood, Massachusetts for approximately $270.2 million. The Company increased its real estate assets owned by approximately $260.1 million and recorded approximately $10.1 million of in-place lease intangibles.​In August 2019, the Company acquired a 185 apartment home operating community located in Englewood, New Jersey for approximately $83.6 million. The Company increased its real estate assets owned by approximately $77.5 million and recorded approximately $4.6 million of real estate intangibles and approximately $1.5 million of in-place lease intangibles.​In August 2019, the Company purchased a 292 apartment home operating community in Washington, D.C., directly from the UDR/KFH joint venture, thereby increasing its ownership interest from 30% to 100%, for a purchase price at 100% of approximately $184.0 million, before $2.8 million of closing costs incurred by UDR at acquisition. The Company accounted for the consolidation as an asset acquisition, resulting in no gain upon consolidation, and increased its real estate assets owned by approximately $156.0 million and recorded approximately $5.9 million of in-place lease intangibles.​45 Table of ContentsIn November 2019, the Company acquired the approximately 50% ownership interest not previously owned in 10 UDR/MetLife operating communities, one development community and four land parcels valued at $1.1 billion, or $564.2 million at UDR’s share, and sold its approximately 50% ownership interest in five UDR/MetLife operating communities valued at $645.8 million, or $322.9 million at UDR’s share, to MetLife. The Company paid $109.2 million directly to MetLife to complete the transaction. As a result, the Company consolidated the 10 operating communities, one development community and four land parcels, and they are no longer accounted for as equity method investments in an unconsolidated joint venture (see Note 5, Joint Ventures and Partnerships). The Company accounted for the consolidation as an asset acquisition resulting in no gain upon consolidation and increased its real estate assets owned by approximately $977.8 million and recorded approximately $30.0 million of in-place lease intangibles. In connection with the acquisition, the Company assumed six secured fixed rate mortgage notes payable and one credit facility secured by four communities with a combined outstanding balance of $518.4 million and estimated fair value of $551.8 million. The Company recorded the debt at its fair value in Secured debt, net on the Consolidated Balance Sheets.​The following table is a summary of the 10 communities, one development community and four land parcels acquired from the UDR/MetLife joint venture:​​​​PropertyTypeNumber of HomesLocationStrataOperating Community163San Diego, CACrescent Falls ChurchOperating Community214Washington, D.C.Charles River LandingOperating Community350Boston, MALodge at Ames PondOperating Community364Boston, MALenox FarmsOperating Community338Boston, MATowson PromenadeOperating Community379Baltimore, MDSavoyeOperating Community394Addison, TXSavoye2Operating Community351Addison, TXFiori on Vitruvian Park ®Operating Community391Addison, TXVitruvian WestOperating Community383Addison, TXVitruvian West Phase 2 (a)Development Community366Addison, TXVitruvian Park ®4 Land ParcelsN/AAddison, TX(a)The number of apartment homes for the community under development presented in the table above is based on the projected number of total homes upon completion of development. As of December 31, 2019, no apartment homes had been completed.DispositionsIn May 2020, the Company sold an operating community located in Bellevue, Washington with a total of 71 apartment homes for gross proceeds of $49.7 million, resulting in a gain of approximately $29.6 million. The sale was partially financed by the Company through the issuance of a promissory note totaling $4.0 million which was repaid in January 2021. (See Note 2, Significant Accounting Policies for further discussion.) The proceeds were designated for a tax-deferred Section 1031 exchange that were used to pay a portion of the purchase price for the above mentioned acquisition of an operating community in Tampa, Florida, in January 2020.In May 2020, the Company sold an operating community located in Kirkland, Washington with a total of 196 apartment homes for gross proceeds of $92.9 million, resulting in a gain of approximately $31.7 million. ​In October 2020, the Company sold an operating community located in Alexandria, Virginia with a total of 332 apartment homes for gross proceeds of $145.0 million, resulting in a gain of approximately $58.0 million. The proceeds were designated for a tax-deferred Section 1031 exchange and were used to pay a portion of the purchase price for acquisitions in November and December 2020.​In June 2019, the Company sold a parcel of land located in Los Angeles, California for $38.0 million, resulting in a gain of approximately $5.3 million. Prior to the sale, the parcel of land was subject to a ground lease, under which UDR was the lessor, scheduled to expire in 2065. The ground lease included a purchase option for the lessee to acquire the land during specific periods of the ground lease term. During the second quarter of 2019, the lessee exercised the purchase option resulting in the sale by the Company and the ground lease being terminated.We plan to continue to pursue our strategy of exiting markets where long-term growth prospects are limited and redeploying capital to primary locations in markets we believe will provide the best investment returns.46 Table of ContentsCapital ExpendituresWe capitalize those expenditures that materially enhance the value of an existing asset or substantially extend the useful life of an existing asset. Expenditures necessary to maintain an existing property in ordinary operating condition are expensed as incurred.For the year ended December 31, 2020, total capital expenditures of $165.8 million or $3,494 per stabilized home, which in aggregate include recurring capital expenditures and major renovations, were spent across our portfolio, excluding development, as compared to $158.0 million or $3,710 per stabilized home for the prior year.The increase in total capital expenditures was primarily due to:●an increase of 35.8%, or $12.7 million, in major renovations, which include major structural changes and/or architectural revisions to existing buildings; and●an increase of 11.1%, or $5.7 million, in recurring capital expenditures, which include asset preservation and turnover related expenditures; and●an increase of 11.6%, or $5.1 million, in NOI enhancing improvements, such as kitchen and bath remodels and upgrades to common areas.This was partially offset by:​●a decrease of 56.8%, or $15.6 million, in spend as compared to 2019 for our operations platform, which includes smart home installations at certain of our properties.The following table outlines capital expenditures and repair and maintenance costs for all of our communities, excluding real estate under development, for the years ended December 31, 2020 and 2019 (dollars in thousands except Per Home amounts):​​​​​​​​​​​​​​​​​​​​​​​​​​​​Per Home ​​Year Ended December 31, ​Year Ended December 31, ​ 2020 2019 % Change 2020 2019 % Change Turnover capital expenditures​$ 12,978​$ 11,192 16.0% $ 273​$ 263 3.8%Asset preservation expenditures​ 43,946​ 40,054 9.7% 926​ 941 (1.6)%Total recurring capital expenditures​ 56,924​ 51,246 11.1% 1,199​ 1,204 (0.4)%NOI enhancing improvements (a)​ 48,752​ 43,689 11.6% 1,027​ 1,026 0.1%Major renovations (b)​ 48,317​ 35,569 35.8% 1,018​ 835 21.9%Operations platform​​ 11,853​​ 27,445​ (56.8)% ​ 250​​ 645​ (61.3)%Total capital expenditures (c)​$ 165,846​$ 157,949 5.0% $ 3,494​$ 3,710 (5.8)%Repair and maintenance expense​$ 56,794​$ 43,525 30.5% $ 1,196​$ 1,022 17.0%Average home count (d)​ 47,475​ 42,579 11.5% ​​​​​​​​(a)NOI enhancing improvements are expenditures that result in increased income generation or decreased expense growth.(b)Major renovations include major structural changes and/or architectural revisions to existing buildings.(c)Total capital expenditures includes amounts capitalized during the year. Cash paid for capital expenditures is impacted by the net change in related accruals.(d)Average number of homes is calculated based on the number of homes outstanding at the end of each month.​We intend to continue to selectively add NOI enhancing improvements, which we believe will provide a return on investment in excess of our cost of capital. Our objective in redeveloping a community is twofold: we aim to meaningfully grow rental rates while also achieving cap rate compression through asset quality improvement.Consolidated Real Estate Under Development and RedevelopmentAt December 31, 2020, our development pipeline consisted of five wholly-owned communities located in Denver, Colorado, Dublin, California, Addison, Texas, King of Prussia, Pennsylvania and Washington D.C., totaling 1,378 homes, 202 of which have been completed, with a budget of $491.5 million, in which we have an investment of 47 Table of Contents$247.9 million. The communities are estimated to be completed between the first quarter of 2021 and the second quarter of 2023. During 2020, we incurred $121.2 million for development costs, an increase of $95.8 million as compared to costs incurred in 2019 of $25.4 million.At December 31, 2020, the Company was not redeveloping any communities.Unconsolidated Joint Ventures and PartnershipsThe Company recognizes income or losses from our investments in unconsolidated joint ventures and partnerships consisting of our proportionate share of the net income or losses of the joint ventures and partnerships. In addition, we may earn fees for providing management services to the communities held by the unconsolidated joint ventures and partnerships.The Company’s Investment in and advances to unconsolidated joint ventures and partnerships, net, are accounted for under the equity method of accounting. For the year ended December 31, 2020:●we made investments totaling $76.1 million in our unconsolidated joint ventures, including contributions of $66.3 million to four unconsolidated investments under our Developer Capital Program, which earn preferred returns ranging from 8.5% to 13.0%;●our proportionate share of the net income/(loss) of the joint ventures and partnerships was $18.8 million; and●we received distributions of $70.0 million, of which $20.7 million were operating cash flows and $49.3 million were investing cash flows.We evaluate our investments in unconsolidated joint ventures and partnerships when events or changes in circumstances indicate that there may be an other-than-temporary decline in value. We consider various factors to determine if a decrease in the value of the investment is other-than-temporary. The Company did not recognize any other-than-temporary impairments in the value of its investments in unconsolidated joint ventures or partnerships during the years ended December 31, 2020 and 2019.Notes Receivable, net Notes receivable relate to financing arrangements that are typically secured by real estate, real estate related projects or other assets. ​The following significant activities occurred during the year ended December 31, 2020:​●in August 2020, the Company exercised the purchase option associated with the $115.0 million secured note receivable. The purchase is expected to close in 2021. When the note was funded, the Company also entered into a purchase option agreement and paid a deposit of $10.0 million, which gave the Company the option to acquire the community at a fixed price of $170.0 million. The deposit is generally nonrefundable other than due to a failure of closing conditions pursuant to the terms of the agreement. If the Company fails to close the purchase other than due to seller’s failure or other breaches in the purchase option agreement, per the terms of the agreement, the note will be modified to extend the maturity date to 10 years following the date the temporary certificate of occupancy was issued, which was July 2020. Upon modification, the loan would be interest only for the first three years and after such date payments will be based on a 30-year amortization schedule. Financing ActivitiesFor the years ended December 31, 2020 and 2019, Net cash provided by/(used in) financing activities was $(152.6) million and $880.4 million, respectively.The following significant financing activities occurred during the year ended December 31, 2020:●repayments of secured debt of $425.8 million, which was partially offset by proceeds from the issuance of secured debt of $160.9 million;48 Table of Contents●issuance of $200.0 million of 3.20% senior unsecured medium-term notes due January 15, 2030, for net proceeds of approximately $211.3 million;●issuance of $400.0 million of 2.10% senior unsecured medium-term notes due August 1, 2032, for net proceeds of approximately $399.6 million;●issuance of $350.0 million of 1.90% senior unsecured medium-term notes due March 15, 2023, for net proceeds of approximately $348.5 million;●repayment of $300.0 million senior unsecured medium-term notes due July 2024, $116.9 million of which was pursuant to our tender offer;●net repayment of $110.0 million on our unsecured commercial paper program;●sale of 2.1 million shares of common stock under our forward sales agreement for aggregate net proceeds of $102.2 million at a price per share of $48.23;●repurchase of 0.6 million common shares for approximately $19.8 million;●distributions of $419.4 million to our common stockholders; and●payment of debt extinguishment costs of $62.6 million from the early prepayment of debt.The following significant financing activities occurred during the year ended December 31, 2019:●issuance of $300 million of 3.20% senior unsecured medium-term notes due 2030 (3.42% effective rate after the effect of a cash flow hedge), for net proceeds of approximately $296.6 million;●issuance of $400 million of 3.00% senior unsecured medium-term notes due 2031 (3.01% effective rate after the effect of a cash flow hedge), for net proceeds of approximately $395.7 million, $300.0 million of which was used to repay 3.70% medium-term notes due in October 2020;●issuance of $100 million of 3.20% senior unsecured medium-term notes due 2030 (3.24% effective rate after the effect of a cash flow hedge), and issuance of $300 million of 3.10% senior unsecured medium-term notes due 2034 (3.13% effective rate after the effect of a cash flow hedge), for net proceeds of approximately $398.6 million, which was used to repay $400.0 million of 4.63% medium-term notes due in January 2022;●net proceeds of $198.9 million from the Company’s unsecured commercial paper program;●net proceeds of $16.6 million from the Company’s unsecured revolving credit facilities;●repayments of $162.3 million of secured debt, which was offset by net proceeds of $162.5 million from the issuance of secured debt;●sale of 7.5 million shares of common stock in an underwritten public offering for net proceeds of approximately $349.8 million at a price per share of $46.65;●sale of 7.0 million shares of common stock under our ATM program for proceeds of $312.3 million at an weighted average price per share of $45.29;●sale of 1.3 million shares of common stock under our forward sales agreement for net proceeds of $63.5 million at a price per share of $47.41; and●distributions of $383.1 million to our common stockholders.Credit Facilities and Commercial Paper ProgramDuring the year ended December 31, 2020, the Company prepaid the $201.9 million outstanding balance under its secured credit facility with New York Life with proceeds from the issuance of senior unsecured medium-term notes. The Company incurred net extinguishment costs of $9.0 million during the year ended December 31, 2020, which was included in Interest expense on the Consolidated Statements of Operations.​The Company has a $1.1 billion unsecured revolving credit facility and a $350.0 million unsecured term loan. The Credit Agreement for these facilities allows the total commitments under the Revolving Credit Facility and the total 49 Table of Contentsborrowings under the Term Loan to be increased to an aggregate maximum amount of up to $2.0 billion, subject to certain conditions, including obtaining commitments from one or more lenders. The Revolving Credit Facility has a scheduled maturity date of January 31, 2023, with two six-month extension options, subject to certain conditions. The Term Loan has a scheduled maturity date of September 30, 2023. Based on the Company’s current credit rating, the Revolving Credit Facility has an interest rate equal to LIBOR plus a margin of 82.5 basis points and a facility fee of 15 basis points, and the Term Loan has an interest rate equal to LIBOR plus a margin of 90 basis points. Depending on the Company’s credit rating, the margin under the Revolving Credit Facility ranges from 75 to 145 basis points, the facility fee ranges from 10 to 30 basis points, and the margin under the Term Loan ranges from 80 to 165 basis points.As of December 31, 2020, we had no outstanding borrowings under the Revolving Credit Facility, leaving $1.1 billion of unused capacity (excluding $2.8 million of letters of credit at December 31, 2020), and $350.0 million of outstanding borrowings under the Term Loan.We have a working capital credit facility, which provides for a $75 million unsecured revolving credit facility (the “Working Capital Credit Facility”) with a scheduled maturity date of January 14, 2022. Based on the Company’s current credit rating, the Working Capital Credit Facility has an interest rate equal to LIBOR plus a margin of 82.5 basis points. Depending on the Company’s credit rating, the margin ranges from 75 to 145 basis points. As of December 31, 2020, we had $28.0 million of outstanding borrowings under the Working Capital Credit Facility, leaving $47.0 million of unused capacity.The bank revolving credit facilities and the term loan are subject to customary financial covenants and limitations, all of which we were in compliance with at December 31, 2020.We have an unsecured commercial paper program. Under the terms of the program, we may issue unsecured commercial paper up to a maximum aggregate amount outstanding of $500 million. The notes are sold under customary terms in the United States commercial paper market and rank pari passu with all of our other unsecured indebtedness. The notes are fully and unconditionally guaranteed by the Operating Partnership. As of December 31, 2020, we had issued $190.0 million of commercial paper, for one month terms, at a weighted average annualized rate of 0.27%, leaving $310.0 million of unused capacity. In January 2021, the entire $190.0 million of outstanding unsecured commercial paper as of December 31, 2020 was repaid at maturity with additional proceeds of unsecured commercial paper with maturity dates in February 2021 and proceeds under the Working Capital Credit Facility.Interest Rate RiskWe are exposed to interest rate risk associated with variable rate notes payable and maturing debt that has to be refinanced. We do not hold financial instruments for trading or other speculative purposes, but rather issue these financial instruments to finance our portfolio of real estate assets and operations. Interest rate sensitivity is the relationship between changes in market interest rates and the fair value of market rate sensitive assets and liabilities. Our earnings are affected as changes in short-term interest rates impact our cost of variable rate debt and maturing fixed rate debt. We had $280.0 million in variable rate debt that is not subject to interest rate swap contracts as of December 31, 2020. If market interest rates for variable rate debt increased by 100 basis points, our interest expense would increase by $3.8 million based on the average balance outstanding during the year.These amounts are determined by considering the impact of hypothetical interest rates on our borrowing cost. This analysis does not consider the effects of the adjusted level of overall economic activity that could exist in such an environment. Further, in the event of a change of such magnitude, management would likely take actions to further mitigate our exposure to the change. However, due to the uncertainty of the specific actions that would be taken and their possible effects, the sensitivity analysis assumes no change in our financial structure.The Company also utilizes derivative financial instruments to manage interest rate risk and generally designates these financial instruments as cash flow hedges. See Note 14, Derivatives and Hedging Activities, in the Notes to the UDR Consolidated Financial Statements included in this Report for additional discussion of derivative instruments.50 Table of ContentsA presentation of cash flow metrics based on GAAP is as follows (dollars in thousands):​​​​​​​​​Year Ended December 31, ​​2020 2019Net cash provided by/(used in) operating activities $ 604,316 $ 630,704Net cash provided by/(used in) investing activities​ (460,842) (1,686,687)Net cash provided by/(used in) financing activities​ (152,594) 880,383​​Results of OperationsThe following discussion explains the changes in results of operations that are presented in our Consolidated Statements of Operations for the years ended December 31, 2020 and 2019.Net Income/(Loss) Attributable to Common StockholdersNet income/(loss) attributable to common stockholders was $60.0 million ($0.20 per diluted share) for the year ended December 31, 2020, as compared to $180.9 million ($0.63 per diluted share) for the comparable period in the prior year. The decrease resulted primarily from the following items, all of which are discussed in further detail elsewhere within this Report:●an increase in real estate depreciation expense of $107.4 million primarily due to communities acquired in 2020 and 2019, partially offset by a decrease from sold communities and fully depreciated assets;●an increase in interest expense of $31.8 million primarily due to higher average debt balances and the early pay off of debt during 2020 and 2019, resulting in prepayment costs of $49.2 million and $29.6 million, respectively;●a decrease in income/(loss) from unconsolidated entities of $119.0 million, primarily attributable to a $114.9 million gain from the disposition of five operating communities from our UDR/MetLife II joint venture, a $10.6 million gain recognized on the sale of two operating properties from our UDR/KFH joint venture, a $4.6 million unrealized gain recorded on an unconsolidated technology investment, and an increase in preferred interest earned due to increased Developer Capital Program investments in 2019; and●a decrease in interest income and other income/(expense), net of $9.1 million, primarily attributable to an $8.5 million promoted interest on the prepayment of a note to a multifamily technology company in 2019.This was partially offset by:​●gains of $119.3 million from the sale of three operating communities located in Kirkland, Washington, Bellevue, Washington and Alexandria, Virginia, during the year ended December 31, 2020, as compared to a gain of $5.3 million on the sale of a parcel of land in Los Angeles, California during the year ended December 31, 2019; and ●an increase in total property NOI of $45.4 million primarily due to NOI from additional operating communities, including those acquired in 2020 and 2019, partially offset by an increase of $11.2 million in property operating expenses.Apartment Community OperationsOur net income results are primarily from NOI generated from the operation of our apartment communities. The Company defines NOI, which is a non-GAAP financial measure, as rental income less direct property rental expenses. Rental income represents gross market rent less adjustments for concessions, vacancy loss and bad debt. Rental expenses include real estate taxes, insurance, personnel, utilities, repairs and maintenance, administrative and marketing. Excluded from NOI is property management expense which is calculated as 2.875% of property revenue, and land rent. Property management expense covers costs directly related to consolidated property operations, inclusive of corporate management, regional supervision, accounting and other costs.51 Table of ContentsManagement considers NOI a useful metric for investors as it is a more meaningful representation of a community’s continuing operating performance than net income as it is prior to corporate-level expense allocations, general and administrative costs, capital structure and depreciation and amortization.Although the Company considers NOI a useful measure of operating performance, NOI should not be considered an alternative to net income or net cash flow from operating activities as determined in accordance with GAAP. NOI excludes several income and expense categories as detailed in the reconciliation of NOI to Net income/(loss) attributable to UDR, Inc. below.The following table summarizes the operating performance of our total property NOI for each of the periods presented (dollars in thousands):​​​​​​​​​​​​​​​​​​​​Year Ended ​​​Year Ended ​​​​​December 31, (a)​​​December 31, (b)​​​​ 2020 2019 % Change 2019 2018 % Change​Same-Store Communities:​​​ ​​ ​ ​​ ​​​​​Same-Store rental income​$ 924,138 $ 953,121 (3.0)% $ 962,269 $ 928,849​ 3.6%Same-Store operating expense (c)​ (279,940) (268,718) 4.2% (271,826) (265,087)​ 2.5%Same-Store NOI​ 644,198 684,403 (5.9)% 690,443 663,762​ 4.0%​​​​​​​​​​​​​​​​​​Non-Mature Communities/Other NOI:​​​ ​​ ​ ​​ ​​​​​Stabilized, non-mature communities NOI (d)​​ 161,258 98,193​ 64.2% ​ 79,007​​ 11,968​ 560.2%Acquired communities NOI​ 7,919 762 939.2% 5,830 —​ —%Redevelopment communities NOI​​ —​​ —​ —% ​ 18,571​​ 21,875​ (15.1)%Development communities NOI​ 214 (8) NM* (8) 4,374​NM*Non-residential/other NOI (e)​​ 27,694 12,954​ 113.8% ​ 13,174​​ 18,609​ (29.2)%Sold and held for disposition communities NOI​​ 12,419 11,999​ 3.5% ​ 1,286​​ 11,527​ (88.8)%Total Non-Mature Communities/Other NOI​ 209,504 123,900 69.1% 117,860 68,353​ 72.4%Total property NOI​$ 853,702 $ 808,303 5.6%$ 808,303 $ 732,115​ 10.4%*Not meaningful (a)Same-Store consists of 37,607 apartment homes.(b)Same-Store consists of 37,959 apartment homes.(c)Excludes depreciation, amortization, and property management expenses.(d)Represents non-mature communities that have achieved 90% occupancy for three consecutive months but do not meet the criteria to be included in Same-Store Communities.(e)Primarily non-residential revenue and expense and straight-line adjustment for concessions.​52 Table of ContentsThe following table is our reconciliation of Net income/(loss) attributable to UDR, Inc. to total property NOI for each of the periods presented (dollars in thousands):​​​​​​​​​​​​Year Ended December 31, ​ 2020 2019 2018Net income/(loss) attributable to UDR, Inc.​$ 64,266​$ 184,965​$ 203,106Joint venture management and other fees​ (5,069)​ (14,055)​ (11,754)Property management​ 35,538​ 32,721​ 28,465Other operating expenses​ 22,762​ 13,932​ 12,100Real estate depreciation and amortization​ 608,616​ 501,257​ 429,006General and administrative​ 49,885​ 51,533​ 46,983Casualty-related charges/(recoveries), net​ 2,131​ 474​ 2,121Other depreciation and amortization​ 10,013​ 6,666​ 6,673(Gain)/loss on sale of real estate owned​ (119,277)​ (5,282)​ (136,197)(Income)/loss from unconsolidated entities​ (18,844)​ (137,873)​ 5,055Interest expense​ 202,706​ 170,917​ 134,168Interest income and other (income)/expense, net​​ (6,274)​​ (15,404)​​ (6,735)Tax provision/(benefit), net​ 2,545​ 3,838​ 688Net income/(loss) attributable to redeemable noncontrolling interests in the Operating Partnership and DownREIT Partnership​ 4,543​ 14,426​ 18,215Net income/(loss) attributable to noncontrolling interests​ 161​ 188​ 221Total property NOI​$ 853,702​$ 808,303​$ 732,115​Same-Store CommunitiesOur Same-Store Community properties (those acquired, developed, and stabilized prior to January 1, 2019 and held on December 31, 2020) consisted of 37,607 apartment homes and provided 75.5% of our total NOI for the year ended December 31, 2020.NOI for our Same-Store Community properties decreased 5.9%, or $40.2 million, for the year ended December 31, 2020 compared to the same period in 2019. The decrease in property NOI was attributable to a 3.0%, or $29.0 million, decrease in property rental income and a 4.2%, or $11.2 million, increase in operating expenses. The decrease in property rental income was primarily driven by an $11.7 million increase in our reserve on multifamily tenant lease receivables, an increase of $15.1 million in rent concessions and an increase of $10.0 million in economic occupancy loss, partially offset by a 0.7%, or $6.0 million, increase in rental rates and a 1.7%, or $1.8 million, increase in reimbursement and ancillary and fee income. Physical occupancy decreased by 0.5% to 96.3% and total monthly income per occupied home decreased 2.6% to $2,126.The increase in operating expenses was primarily driven by a 12.5%, or $4.8 million, increase in repair and maintenance expense due to the increased use of third party vendors, partially offset by a 2.7%, or $1.7 million, decrease in personnel expense as a result of fewer employees, and a 6.9%, or $7.7 million, increase in real estate taxes, which was primarily due to higher assessed valuations.The operating margin (property net operating income divided by property rental income) was 69.7% and 71.8% for the years ended December 31, 2020 and 2019, respectively.Non-Mature Communities/OtherUDR’s Non-Mature Communities/Other represent those communities that do not meet the criteria to be included in Same-Store Communities, which include communities recently developed or acquired, redevelopment properties, sold or held for disposition properties, and non-apartment components of mixed use properties.The remaining 24.5%, or $209.5 million, of our total NOI during the year ended December 31, 2020 was generated from our Non-Mature Communities/Other. NOI from Non-Mature Communities/Other increased by 69.1%, or $85.6 million, for the year ended December 31, 2020 as compared to the same period in 2019. The increase was primarily attributable to a $63.1 million increase in NOI from stabilized, non-mature communities, primarily due to communities acquired in 2020 and 2019, a $14.7 million increase in non-residential/other primarily due to changes in straight-line rent as a result of increased tenant rent concessions during the period, and a $7.2 million increase in acquired communities.53 Table of ContentsReal estate depreciation and amortizationFor the years ended December 31, 2020 and 2019, the Company recognized real estate depreciation and amortization of $608.6 million and $501.3 million, respectively. The increase in 2020 as compared to 2019 was primarily attributable to communities acquired in 2020 and 2019, partially offset by a decrease from sold communities and fully depreciated assets.Gain/(Loss) on Sale of Real Estate OwnedDuring the year ended December 31, 2020, the Company recognized gains of $119.3 million from the sale of three operating communities located in Kirkland, Washington, Bellevue, Washington and Alexandria, Virginia. During the year ended December 31, 2019, the Company recognized a gain of $5.3 million on the sale of a parcel of land in Los Angeles, California.Income/(Loss) from Unconsolidated EntitiesFor the years ended December 31, 2020 and 2019, we recognized income/(loss) from unconsolidated entities of $18.8 million and $137.9 million, respectively. The decrease of $119.1 million was primarily due to:●no dispositions from the Company’s unconsolidated entities during the year ended December 31, 2020.As compared to:●gains of $114.9 million from the disposition of five operating communities from our UDR/MetLife II joint venture, a $10.6 million gain from the sale of two operating communities in our UDR/KFH joint venture, and a $4.6 million unrealized gain recorded on an unconsolidated technology investment and an increase in Developer Capital Program investments during the year ended December 31, 2019.Interest expenseFor the years ended December 31, 2020 and 2019, the Company recognized interest expense of $202.7 million and $170.9 million, respectively. The increase in 2020 as compared to 2019 was primarily attributable to higher average debt balances, and the early pay off of debt during 2020 and 2019, resulting in prepayment costs of $49.2 million and $29.6 million, respectively.Interest income and other income/(expense), netFor the years ended December 31, 2020 and 2019, the Company recognized interest income and other income/(expense), net of $6.3 million and $15.4 million, respectively. The decrease in 2020 as compared to 2019 was primarily attributable to an $8.5 million promoted interest on the prepayment of a note to a multifamily technology company in 2019.InflationWe believe that the direct effects of inflation on our operations have been immaterial. While the impact of inflation primarily impacts our results of operations as a result of wage pressures and increases in utilities and material costs, the majority of our apartment leases have initial terms of 12 months or less, which generally enables us to compensate for any inflationary effects by increasing rental rates on our apartment homes. Although an extreme escalation in costs could have a negative impact on our residents and their ability to absorb rent increases, we do not believe this has had a material impact on our results for the year ended December 31, 2020.Off-Balance Sheet ArrangementsWe do not have any off-balance sheet arrangements that have, or are reasonably likely to have, a current or future effect on our financial condition, changes in financial condition, revenue or expenses, results of operations, liquidity, capital expenditures or capital resources that are material.54 Table of ContentsContractual ObligationsThe following table summarizes our contractual obligations as of December 31, 2020 (dollars in thousands):​​​​​​​​​​​​​​​​​​Payments Due by PeriodContractual Obligations 2021 2022-2023 2024-2025 Thereafter TotalLong-term debt obligations​$ 191,097​$ 380,347​$ 584,113​$ 3,829,660​$ 4,985,217Interest on debt obligations (a)​ 149,982​ 297,275​ 271,162​ 479,084​ 1,197,503Letters of credit​ 2,839​ —​ —​ —​ 2,839Operating lease obligations:​ ​ ​ ​ ​ Ground leases (b)​ 12,442​ 24,884​ 24,884​ 442,778​ 504,988​​$ 356,360​$ 702,506​$ 880,159​$ 4,751,522​$ 6,690,547(a)Interest payments on variable rate debt instruments are based on each debt instrument’s respective year-end interest rate at December 31, 2020.(b)For purposes of our ground lease contracts, the Company uses the minimum lease payment, if stated in the agreement. For ground lease agreements where there is a rent reset provision based on fair market value or changes in the consumer price index but does not include a specified minimum lease payment, the Company uses the current rent over the remainder of the lease term. During 2020, we incurred gross interest costs of $209.7 million, of which $7.0 million was capitalized.​Funds from Operations, Funds from Operations as Adjusted, and Adjusted Funds from OperationsFunds from OperationsFunds from operations (“FFO”) attributable to common stockholders and unitholders is defined as Net income/(loss) attributable to common stockholders (computed in accordance with GAAP), excluding impairment write-downs of depreciable real estate related to the main business of the Company or of investments in non-consolidated investees that are directly attributable to decreases in the fair value of depreciable real estate held by the investee, gains and losses from sales of depreciable real estate related to the main business of the Company and income taxes directly associated with those gains and losses, plus real estate depreciation and amortization, and after adjustments for noncontrolling interests, and the Company’s share of unconsolidated partnerships and joint ventures. This definition conforms with the National Association of Real Estate Investment Trust’s (“Nareit”) definition issued in April 2002 and restated in November 2018. Historical cost accounting for real estate assets in accordance with GAAP implicitly assumes that the value of real estate assets diminishes predictably over time. Since real estate values instead have historically risen or fallen with market conditions, many industry investors and analysts have considered the presentation of operating results for real estate companies that use historical cost accounting to be insufficient by themselves. Thus, Nareit created FFO as a supplemental measure of a REIT’s operating performance. In the computation of diluted FFO, if OP Units, DownREIT Units, unvested restricted stock, unvested LTIP Units, stock options, and the shares of Series E Cumulative Convertible Preferred Stock are dilutive, they are included in the diluted share count.Management considers FFO a useful metric for investors as the Company uses FFO in evaluating property acquisitions and its operating performance, and believes that FFO should be considered along with, but not as an alternative to, net income and cash flow as a measure of the Company’s activities in accordance with GAAP. FFO does not represent cash generated from operating activities in accordance with GAAP and is not necessarily indicative of funds available to fund our cash needs.Funds from Operations as AdjustedFFO as Adjusted (“FFOA”) attributable to common stockholders and unitholders is defined as FFO excluding the impact of non-comparable items including, but not limited to, acquisition related costs, prepayment costs/benefits associated with early debt retirement, impairment write downs or gains and losses on sales of real estate or other assets incidental to the main business of the Company and income taxes directly associated with those gains and losses, casualty-related expenses and recoveries, severance costs and legal and other costs. Management believes that FFOA is useful supplemental information regarding our operating performance as it provides a consistent comparison of our operating performance across time periods and allows investors to more easily 55 Table of Contentscompare our operating results with other REITs. FFOA is not intended to represent cash flow or liquidity for the period, and is only intended to provide an additional measure of our operating performance. We believe that Net income/(loss) attributable to common stockholders is the most directly comparable GAAP financial measure to FFOA. However, other REITs may use different methodologies for calculating FFOA or similar FFO measures and, accordingly, our FFOA may not always be comparable to FFOA or similar FFO measures calculated by other REITs. FFOA should not be considered as an alternative to net income (determined in accordance with GAAP) as an indication of financial performance, or as an alternative to cash flows from operating activities (determined in accordance with GAAP) as a measure of our liquidity.Adjusted Funds from OperationsAdjusted FFO (“AFFO”) attributable to common stockholders and unitholders is defined as FFOA less recurring capital expenditures on consolidated communities that are necessary to help preserve the value of and maintain functionality at our communities. Therefore, management considers AFFO a useful supplemental performance metric for investors as it is more indicative of the Company’s operational performance than FFO or FFOA.AFFO is not intended to represent cash flow or liquidity for the period, and is only intended to provide an additional measure of our operating performance. We believe that Net income/(loss) attributable to common stockholders is the most directly comparable GAAP financial measure to AFFO. Management believes that AFFO is a widely recognized measure of the operations of REITs, and presenting AFFO will enable investors to assess our performance in comparison to other REITs. However, other REITs may use different methodologies for calculating AFFO and, accordingly, our AFFO may not always be comparable to AFFO calculated by other REITs. AFFO should not be considered as an alternative to net income/(loss) (determined in accordance with GAAP) as an indication of financial performance, or as an alternative to cash flows from operating activities (determined in accordance with GAAP) as a measure of our liquidity, nor is it indicative of funds available to fund our cash needs, including our ability to make distributions.56 Table of ContentsThe following table outlines our reconciliation of Net income/(loss) attributable to common stockholders to FFO, FFOA, and AFFO for the years ended December 31, 2020, 2019, and 2018 (dollars in thousands):​​​​​​​​​​​​Year Ended December 31, ​ 2020 2019 2018Net income/(loss) attributable to common stockholders​$ 60,036​$ 180,861​$ 199,238Real estate depreciation and amortization​ 608,616​ 501,257​ 429,006Noncontrolling interests​ 4,704​ 14,614​ 18,436Real estate depreciation and amortization on unconsolidated joint ventures​ 35,023​ 57,954​ 61,871Net gain on the sale of unconsolidated depreciable property​ —​ (125,407)​ —Net gain on the sale of depreciable real estate owned, net of tax​ (118,852)​ —​ (136,197)FFO attributable to common stockholders and unitholders, basic​$ 589,527​$ 629,279​$ 570,254Distributions to preferred stockholders — Series E (Convertible)​ 4,230​ 4,104​ 3,868FFO attributable to common stockholders and unitholders, diluted​$ 593,757​$ 633,383​$ 574,122Income/(loss) per weighted average common share, diluted​$ 0.20​$ 0.63​$ 0.74FFO per weighted average common share and unit, basic​$ 1.86​$ 2.04​$ 1.95FFO per weighted average common share and unit, diluted​$ 1.85​$ 2.03​$ 1.93Weighted average number of common shares and OP/DownREIT Units outstanding — basic​ 316,855​ 308,020​ 292,727Weighted average number of common shares, OP/DownREIT Units, and common stock equivalents outstanding — diluted​ 320,187​ 311,799​ 297,042​​​​​​​​​​Impact of adjustments to FFO:​ —​ ​ Costs associated with debt extinguishment and other​$ 49,190​$ 29,594​$ 3,476Promoted interest on settlement of note receivable, net of tax​​ —​​ (6,482)​​ —Legal and other costs​ 8,973​ 3,660​ 1,622Net gain on the sale of non-depreciable real estate owned​ —​ (5,282)​ —Realized/unrealized (gain)/loss on unconsolidated technology investments, net of tax​​ (3,582)​​ (3,300)​​ —Joint venture development success fee​ —​ (3,750)​ —Severance costs and other restructuring expense​ 1,948​ 390​ 114Casualty-related charges/(recoveries), net​ 2,545​ 636​ 2,364Casualty-related charges/(recoveries) on unconsolidated joint ventures, net​ 31​ (374)​ —​​$ 59,105​$ 15,092​$ 7,576FFOA attributable to common stockholders and unitholders, diluted​$ 652,862​$ 648,475​$ 581,698​​​​​​​​​​FFOA per weighted average common share and unit, diluted​$ 2.04​$ 2.08​$ 1.96​​​​​​​​​​Recurring capital expenditures​ (56,924)​ (51,246)​ (46,915)AFFO attributable to common stockholders and unitholders, diluted​$ 595,938​$ 597,229​$ 534,783​​​​​​​​​​AFFO per weighted average common share and unit, diluted​$ 1.86​$ 1.92​$ 1.80​57 Table of ContentsThe following table is our reconciliation of FFO share information to weighted average common shares outstanding, basic and diluted, reflected on the UDR Consolidated Statements of Operations for the years ended December 31, 2020, 2019, and 2018 (shares in thousands):​​​​​​​​​​​​Year Ended December 31, ​ 2020 2019 2018Weighted average number of common shares and OP/DownREIT Units outstanding — basic 316,855 308,020 292,727Weighted average number of OP/DownREIT Units outstanding (22,310) (22,773) (24,548)Weighted average number of common shares outstanding — basic per the Consolidated Statements of Operations 294,545 285,247 268,179​​​​​​​Weighted average number of common shares, OP/DownREIT Units, and common stock equivalents outstanding — diluted 320,187 311,799 297,042Weighted average number of OP/DownREIT Units outstanding (22,310) (22,773) (24,548)Weighted average number of Series E Cumulative Convertible Preferred shares outstanding (2,950) (3,011) (3,011)Weighted average number of common shares outstanding — diluted per the Consolidated Statements of Operations 294,927 286,015 269,483​​United Dominion Realty, L.P.:Business OverviewUnited Dominion Realty, L.P. (the “Operating Partnership” or “UDR, L.P.”) is a Delaware limited partnership formed in February 2004 and organized pursuant to the provisions of the Delaware Revised Uniform Limited Partnership Act. The Operating Partnership is the successor-in-interest to United Dominion Realty, L.P., a limited partnership formed under the laws of Virginia, which commenced operations on November 4, 1995. Our sole general partner is UDR, Inc., a Maryland corporation (“UDR” or the “General Partner”), which conducts a substantial amount of its business and holds a substantial amount of its assets through the Operating Partnership. At December 31, 2020, the Operating Partnership’s real estate portfolio included 53 communities located in nine states and the District of Columbia with a total of 17,174 apartment homes.As of December 31, 2020, UDR owned 0.1 million units of our general partnership interests and 176.1 million units of our limited partnership interests (the “OP Units”), or approximately 95.3% of our outstanding OP Units. By virtue of its ownership of our OP Units and being our sole general partner, UDR has the ability to control all of the day-to-day operations of the Operating Partnership. Unless otherwise indicated or unless the context requires otherwise, all references in this section of this Report to the Operating Partnership or “we,” “us” or “our” refer to UDR, L.P. together with its consolidated subsidiaries, and all references in this section to “UDR” or the “General Partner” refer solely to UDR, Inc.UDR is a self-administered real estate investment trust, or REIT, that owns, acquires, renovates, develops, and manages apartment communities. The General Partner was formed in 1972 as a Virginia corporation and changed its state of incorporation from Virginia to Maryland in June 2003. At December 31, 2020, the General Partner’s consolidated real estate portfolio included 149 communities located in 13 states and the District of Columbia with a total of 48,283 apartment homes. In addition, the General Partner had an ownership interest in 5,295 completed or to-be-completed apartment homes through unconsolidated joint ventures or partnerships, including 2,165 apartment homes owned by entities in which we hold preferred equity investments.Critical Accounting Policies and EstimatesThe preparation of financial statements in conformity with United States generally accepted accounting principles (“GAAP”) requires management to use judgment in the application of accounting policies, including making estimates and assumptions. A critical accounting policy is one that is both important to our financial condition and results of operations as well as involves some degree of uncertainty. Estimates are prepared based on management’s assessment after considering all evidence available. Changes in estimates could affect our financial position or results of operations. Below is a discussion of the accounting policies that we consider critical to understanding our financial condition or results of operations where there is uncertainty or where significant judgment is required. A discussion of 58 Table of Contentsour significant accounting policies, including further discussion of the accounting policies described below, can be found in Note 2, Significant Accounting Policies, to the Notes to the Operating Partnership’s Consolidated Financial Statements included in this Report.Cost CapitalizationIn conformity with GAAP, we capitalize those expenditures that materially enhance the value of an existing asset or substantially extend the useful life of an existing asset. Expenditures necessary to maintain an existing property in ordinary operating condition are expensed as incurred.In addition to construction costs, we capitalize costs directly related to the predevelopment, development, and redevelopment of a capital project, which include, but are not limited to, interest, real estate taxes, insurance, and allocated development and redevelopment overhead related to support costs for personnel working on the capital projects. We use our professional judgment in determining whether such costs meet the criteria for capitalization or must be expensed as incurred. These costs are capitalized only during the period in which activities necessary to ready an asset for its intended use are in progress and such costs are incremental and identifiable to a specific activity to get the asset ready for its intended use. As each home in a capital project is completed and becomes available for lease-up, the Operating Partnership ceases capitalization on the related portion. The costs capitalized are reported on the Consolidated Balance Sheets as Total real estate owned, net of accumulated depreciation. Amounts capitalized during the years ended December 31, 2020, 2019, and 2018 were $1.0 million, $1.0 million, and less than $0.1 million, respectively.Investment in Unconsolidated EntitiesWe may enter into various joint venture agreements and/or partnerships with unrelated third parties to hold or develop real estate assets. We must determine for each of these ventures whether to consolidate the entity or account for our investment under the equity method of accounting. We determine whether to consolidate a joint venture or partnership based on our rights and obligations under the venture agreement, applying the applicable accounting guidance. The application of the rules in evaluating the accounting treatment for each joint venture or partnership is complex and requires substantial management judgment. We evaluate our accounting for investments on a regular basis including when a significant change in the design of an entity occurs. Throughout our financial statements, and in this Management’s Discussion and Analysis of Financial Condition and Results of Operations, we use the term “joint venture” or “partnership” when referring to investments in entities in which we do not have a 100% ownership interest.We continually evaluate our investments in unconsolidated joint ventures when events or changes in circumstances indicate that there may be an other-than-temporary decline in value. We consider various factors to determine if a decrease in the value of the investment is other-than-temporary. These factors include, but are not limited to, age of the venture, our intent and ability to retain our investment in the entity, the financial condition and long-term prospects of the entity, and the relationships with the other joint venture partners and its lenders. The amount of loss recognized is the excess of the investment’s carrying amount over its estimated fair value. If we believe that the decline in fair value is temporary, no impairment is recorded. The aforementioned factors are taken as a whole by management in determining the valuation of our investment property. Should the actual results differ from management’s judgment, the valuation could be negatively affected and may result in a negative impact to our Consolidated Financial Statements.Impairment of Long-Lived AssetsQuarterly or when changes in circumstances warrant, we will assess our real estate properties for indicators of impairment. The judgments regarding the existence of impairment indicators are based on certain factors. Such factors include, among other things, operational performance, market conditions, the Operating Partnership’s intent and ability to hold the related asset, as well as any significant cost overruns on development properties.​If a real estate property has indicators of impairment, we assess whether the long-lived asset’s carrying value exceeds the community’s undiscounted future cash flows, which is representative of projected net operating income (“NOI”) plus the residual value of the community. Our future cash flow estimates are based upon historical results adjusted to reflect our best estimate of future market and operating conditions and our estimated holding periods. If such indicators of impairment are present and the carrying value exceeds the undiscounted cash flows of the community, an impairment loss is recognized equal to the excess of the carrying amount of the asset over its estimated fair value. Our estimates of fair value represent our best estimate based primarily upon unobservable inputs related to rental rates, operating costs, growth rates, discount rates and capitalization rates, industry trends and reference to market rates and transactions.59 Table of ContentsFor long-lived assets to be disposed of, impairment losses are recognized when the fair value of the asset less estimated cost to sell is less than the carrying value of the asset. Properties classified as real estate held for disposition generally represent properties that are actively marketed or contracted for sale with the closing expected to occur within the next twelve months. Real estate held for disposition is carried at the lower of cost, net of accumulated depreciation, or fair value, less the cost to sell, determined on an asset-by-asset basis. Expenditures for ordinary repair and maintenance costs on held for disposition properties are charged to expense as incurred. Expenditures for improvements, renovations, and replacements related to held for disposition properties are capitalized at cost. Depreciation is not recorded on real estate held for disposition.Real Estate Investment PropertiesWe purchase real estate investment properties from time to time and record the fair value to various components, such as land, buildings, and intangibles related to in-place leases, based on the fair value of each component. In making estimates of fair values for purposes of allocating purchase price, we utilize various sources, including independent appraisals, our own analysis of recently acquired and existing comparable properties in our portfolio and other market data. The fair value of buildings is determined as if the buildings were vacant upon acquisition and subsequently leased at market rental rates. As such, the determination of fair value considers the present value of all cash flows expected to be generated from the property including an initial lease-up period. We determine the fair value of in-place leases by assessing the net effective rent and remaining term of the lease relative to market terms for similar leases at acquisition. In addition, we consider the cost of acquiring similar leases, the foregone rents associated with the lease-up period, and the carrying costs associated with the lease-up period. The fair value of in-place leases is recorded and amortized as amortization expense over the remaining average contractual lease period.60 Table of ContentsSummary of Real Estate Portfolio by Geographic MarketThe following table summarizes our market information by major geographic markets as of and for the year ended December 31, 2020:​​​​​​​​​​​​​​​​​​​​​​December 31, 2020​Year Ended December 31, 2020​ ​ ​ Percentage Total ​ Monthly Net​​Number of​Number of​of Total ​Carrying​Average​Income per ​Operating​​Apartment​Apartment​Carrying​Value (in​Physical​Occupied​IncomeSame-Store Communities​Communities​Homes​Value​thousands)​Occupancy​Home (a)​(in thousands)West Region​​ ​ ​ ​​​​ ​​​ Orange County, CA​ 5 3,119 18.6% $ 753,801​ 96.6% $ 2,277​$ 62,791San Francisco, CA 9 2,185 15.3% ​ 617,293​ 92.6% ​ 3,198​ 57,812Seattle, WA 5 932 5.8% ​ 233,525​ 97.0% ​ 2,086​ 15,840Monterey Peninsula, CA 7 1,565 4.6% ​ 185,224​ 96.6% ​ 1,940​ 27,587Los Angeles, CA 2 344 2.9% ​ 118,281​ 96.4% ​ 2,728​ 7,740Other Southern California 1 414 1.9% ​ 76,883​ 97.6% ​ 2,155​ 7,897Portland, OR 2 476 1.3% ​ 52,126​ 97.1% ​ 1,637​ 6,623Mid-Atlantic Region​ ​​ ​​​​​ ​​​​ ​Metropolitan D.C. 5 1,736 10.9% ​ 442,224​ 96.3% ​ 2,106​ 29,262Baltimore, MD 2 540 2.7% ​ 108,779​ 97.8% ​ 1,563​ 6,781Northeast Region​ ​​ ​​​​​ ​​​​ ​Boston, MA 1 387 1.9% ​ 76,059​ 95.5% ​ 2,086​ 6,656New York, NY 1 503 8.3% ​ 334,347​ 90.9% ​ 3,449​ 10,684Southeast Region​ ​​ ​​​​​ ​​​​ ​Tampa, FL 2 942 2.8% ​ 114,452​ 97.7% ​ 1,556​ 11,333Nashville, TN​ 6 1,612​ 3.9% ​ 157,415​ 97.6% ​ 1,352​​ 18,159Other Florida 1 636 2.2% ​ 89,630​ 97.2% ​ 1,656​ 8,085Southwest Region​​​​​​​​​​​​​​​​​Denver, CO​ 1​ 218​ 3.6% ​ 144,959​ 93.1% ​ 3,012​​ 5,199Total/Average Same-Store Communities 50 15,609​ 86.7% ​ 3,504,998​ 96.0% $ 2,173​$ 282,449Non-Mature, Commercial Properties & Other 3 1,565 13.3% ​ 538,727​ ​​​ 20,838Total Real Estate Owned 53 17,174 100.0% ​ 4,043,725​ ​​​$ 303,287Total Accumulated Depreciation​​ ​ ​ (1,892,011)​ ​​​ ​Total Real Estate Owned, Net of Accumulated Depreciation​​ ​ $ 2,151,714​ ​​​ ​(a)Monthly Income per Occupied Home represents total monthly revenues divided by the average physical number of occupied apartment homes in our Same-Store portfolio.We report in two segments: Same-Store Communities and Non-Mature Communities/Other.Our Same-Store Communities segment represents those communities acquired, developed, and stabilized prior to January 1, 2019 and held as of December 31, 2020. These communities were owned and had stabilized occupancy and operating expenses as of the beginning of the prior year, there is no plan to conduct substantial redevelopment activities, and the communities are not classified as held for disposition at year end. A community is considered to have stabilized occupancy once it achieves 90% occupancy for at least three consecutive months.Our Non-Mature Communities/Other segment represents those communities that do not meet the criteria to be included in Same-Store Communities, including, but not limited to, recently acquired, developed and redeveloped communities, and the non-apartment components of mixed use properties.Liquidity and Capital ResourcesLiquidity is the ability to meet present and future financial obligations either through operating cash flows, the sale of properties, and the issuance of debt. Both the coordination of asset and liability maturities and effective capital management are important to the maintenance of liquidity. The Operating Partnership’s primary source of liquidity is cash flow from operations, as determined by rental rates, occupancy levels, and operating expenses related to our portfolio of apartment homes, and borrowings owed by us under the General Partner’s credit agreements. The General 61 Table of ContentsPartner will routinely use its working capital credit facility, its unsecured revolving credit facility and issuances of commercial paper to temporarily fund certain investing and financing activities prior to arranging for longer-term financing or the issuance of equity or debt securities. During the past several years, proceeds from the sale of real estate have been used for both investing and financing activities as we continue to execute on maintaining a diversified portfolio.We expect to meet our short-term liquidity requirements generally through net cash provided by property operations and borrowings owed by us under the General Partner’s credit agreements. We expect to meet certain long-term liquidity requirements such as scheduled debt maturities and potential property acquisitions through net cash provided by property operations, borrowings and the disposition of properties. We believe that our net cash provided by property operations and borrowings will continue to be adequate to meet both operating requirements and the payment of distributions. Likewise, the budgeted expenditures for improvements and renovations of certain properties are expected to be funded from property operations, borrowings owed by us under the General Partner’s credit agreements, and the disposition of properties.Future Capital NeedsFuture capital expenditures are expected to be funded with proceeds from the issuance of secured debt or unsecured debt, sales of properties, borrowings owed by us under our General Partner’s credit agreements, and to a lesser extent, from cash flows provided by operating activities.As of December 31, 2020, the Operating Partnership does not have any debt maturing in 2021.Statements of Cash FlowsThe following discussion explains the changes in Net cash provided by/(used in) operating activities, Net cash provided by/(used in) investing activities, and Net cash provided by/(used in) financing activities that are presented in our Consolidated Statements of Cash Flows for the years ended December 31, 2020 and 2019.Operating ActivitiesFor the year ended December 31, 2020, Net cash provided by/(used in) operating activities was $217.7 million compared to $255.1 million for 2019. The decrease in cash flow from operating activities was primarily due to a decrease in net operating income and changes in operating assets and liabilities.Investing ActivitiesFor the year ended December 31, 2020, Net cash provided by/(used in) investing activities was $(140.0) million compared to $(43.9) million for 2019. The increase in cash used in investing activities was primarily due to the acquisition of two operating communities in 2020, partially offset by proceeds from the sale of an operating community 2020 and a decrease in capital expenditures and other major improvements in 2020, as compared to 2019. AcquisitionsIn November 2020, the Operating Partnership acquired a 672 apartment home operating community located in Tampa, Florida for approximately $122.5 million. The Operating Partnership increased its real estate assets owned by approximately $119.4 million and recorded approximately $3.1 million of in-place lease intangibles.​In December 2020, the Operating Partnership acquired a 400 apartment home operating community located in Herndon, Virginia for approximately $128.6 million. The Operating Partnership increased its real estate assets owned by approximately $125.9 million and recorded approximately $2.7 million of in-place lease intangibles.​During the year ended December 31, 2019, the Operating Partnership did not have any acquisitions of real estate.DispositionsIn October 2020, the Operating Partnership sold an operating community located in Alexandria, Virginia with a total of 332 apartment homes for gross proceeds of $145.0 million, resulting in a gain of approximately $58.0 million. 62 Table of ContentsThe proceeds were designated for a tax-deferred Section 1031 exchange and were used to pay a portion of the purchase price for acquisitions in November and December 2020.​During the year ended December 31, 2019, the Operating Partnership did not have any dispositions of real estate.Financing ActivitiesFor the year ended December 31, 2020, Net cash provided by/(used in) financing activities was $(76.6) million compared to $(210.9) million for 2019. The decrease in cash used in financing activities was primarily due to a decrease in repayments of notes payable to the General Partner, partially offset by proceeds from the issuance of secured debt in 2019.Guarantor on Unsecured DebtThe Operating Partnership is the guarantor on the General Partner’s unsecured revolving credit facility with an aggregate borrowing capacity of $1.1 billion, an unsecured commercial paper program with an aggregate borrowing capacity of $500 million, a $350 million term loan due September 2023, $300 million of medium-term notes due October 2025, $300 million of medium-term notes due September 2026, $300 million of medium-term notes due July 2027, $300 million of medium-term notes due January 2028, $300 million of medium-term notes due January 2029, $600 million of medium-term notes due January 2030, $400 million of medium-term notes due August 2031, $400 million of medium-term notes due August 2032, $350 million of medium-term notes due March 2033 and $300 million of medium-term notes due November 2034. As of December 31, 2020 and 2019, the General Partner did not have an outstanding balance under the unsecured revolving credit facility and had $190.0 million and $300.0 million, respectively, outstanding under its unsecured commercial paper program.The credit facilities are subject to customary financial covenants and limitations.Interest Rate RiskWe are exposed to interest rate risk associated with variable rate notes payable and maturing debt that has to be refinanced. We do not hold financial instruments for trading or other speculative purposes, but rather issue these financial instruments to finance our portfolio of real estate assets. Interest rate sensitivity is the relationship between changes in market interest rates and the fair value of market rate sensitive assets and liabilities. Our earnings are affected as changes in short-term interest rates impact our cost of variable rate debt and maturing fixed rate debt. We had $27.0 million in variable rate debt that is not subject to interest rate swap contracts as of December 31, 2020. If market interest rates for variable rate debt increased by 100 basis points, our interest expense would increase by $0.3 million based on the average balance at December 31, 2020.These amounts are determined by considering the impact of hypothetical interest rates on our borrowing cost. These analyses do not consider the effects of the adjusted level of overall economic activity that could exist in such an environment. Further, in the event of a change of such amount, management would likely take actions to further mitigate our exposure to the change. However, due to the uncertainty of the specific actions that would be taken and their possible effects, the sensitivity analysis assumes no change in our financial structure.The General Partner also utilizes derivative financial instruments owed by the Operating Partnership to manage interest rate risk and generally designates these financial instruments as cash flow hedges. See Note 9, Derivatives and Hedging Activities, in the Notes to the Operating Partnership’s Consolidated Financial Statements for additional discussion of derivative instruments.A presentation of cash flow metrics based on GAAP is as follows (dollars in thousands):​​​​​​​​​Year Ended December 31, ​ 2020 2019Net cash provided by/(used in) operating activities​$ 217,683​$ 255,093Net cash provided by/(used in) investing activities​ (140,039)​ (43,906)Net cash provided by/(used in) financing activities​ (76,578)​ (210,853)​​63 Table of ContentsResults of OperationsThe following discussion explains the changes in results of operations that are presented in our Consolidated Statements of Operations for the years ended December 31, 2020 and 2019.Net Income/(Loss) Attributable to OP UnitholdersNet income/(loss) attributable to OP unitholders was $134.2 million ($0.73 per diluted OP Unit) for the year ended December 31, 2020 as compared to net income of $102.2 million ($0.56 per diluted OP Unit) for the prior year. The increase in net income attributable to OP unitholders resulted primarily from the following items, which are discussed in further detail elsewhere within this Report:●gain of $58.0 million on the sale of an operating community in Alexandria, Virginia during the year ended December 31, 2020, as compared to no gains on the sale of real estate in 2019.This was partially offset by:●a decrease in total property NOI of $19.7 million primarily due to an approximately $5.5 million reserve recorded on our multifamily tenant lease receivables, an increase in real estate taxes due to higher assessed valuations, and an increase in repair and maintenance expenses due to increased use of third party vendors, partially offset by a decrease in personnel expense as result of fewer employees; and●an increase in other operating expenses of $6.7 million primarily due to higher ground lease expense.Apartment Community OperationsOur net income results primarily from NOI generated from the operation of our apartment communities. The Operating Partnership defines NOI, which is a non-GAAP financial measure, as rental income less direct property rental expenses. Rental income represents gross market rent less adjustments for concessions, vacancy loss and bad debt. Rental expenses include real estate taxes, insurance, personnel, utilities, repairs and maintenance, administrative and marketing. Excluded from NOI are property management costs, which are the Operating Partnership’s allocable share of costs incurred by the General Partner for shared services of corporate level property management employees and related support functions and costs.Management considers NOI a useful metric for investors as it is a more meaningful representation of a community’s continuing operating performance than net income as it is prior to corporate-level expense allocations, general and administrative costs, capital structure and depreciation and amortization.Although we consider NOI a useful measure of operating performance, NOI should not be considered an alternative to net income or net cash flow from operating activities as determined in accordance with GAAP. NOI excludes several income and expense categories as detailed in the reconciliation of NOI to Net income/(loss) attributable to OP unitholders below.64 Table of ContentsThe following table summarizes the operating performance of our total property NOI for each of the periods presented (dollars in thousands):​​​​​​​​​​​​​​​​​​​​Year Ended ​​​Year Ended ​​​​​December 31, (a)​%​December 31, (b)​%​​ 2020 2019 Change 2019 2018​Change Same-Store Communities:​ ​​ ​​​​ ​​ ​​​​Same-Store rental income​$ 390,848​$ 403,551 (3.1)% $ 404,442​$ 390,647​ 3.5%Same-Store operating expense (b)​ (108,399)​ (103,355) 4.9% (104,284)​ (100,815)​ 3.4%Same-Store NOI​ 282,449​ 300,196 (5.9)% 300,158​ 289,832​ 3.6%​​​​​​​​​​​​​​​​​​Non-Mature Communities/Other NOI:​ ​ ​​ ​ ​​​Stabilized, non-mature communities NOI (d)​​ 8,498​​ 12,773​ (33.5)% ​ 5,621​​ 5,125​ 9.7%Acquired communities NOI​ 1,176​ — —% —​ —​ —​Redevelopment communities NOI​ —​ — —% 12,773​ 14,878​ (14.1)%Non-residential/other NOI (c)​​ 6,959​​ 4,504​ 54.5% ​ 4,454​​ 6,634​ (32.9)%Sold and held for disposition communities NOI​​ 4,205​​ 5,533​ (24.0)% ​ —​​ 911​ (100.0)%Total Non-Mature Communities/Other NOI​ 20,838​ 22,810 (8.6)% 22,848​ 27,548​ (17.1)%Total property NOI​$ 303,287​$ 323,006 (6.1)% $ 323,006​$ 317,380​ 1.8%(a)Same-Store consists of 15,609 apartment homes.(b)Same-Store consists of 15,723 apartment homes.(c)Excludes depreciation, amortization, and property management expenses.(d)Represents non-mature communities that have achieved 90% occupancy for three consecutive months but do not meet the criteria to be included in Same-Store Communities.​The following table is our reconciliation of Net income/(loss) attributable to OP unitholders to total property NOI for the years ended December 31, 2020, 2019 and 2018 (dollars in thousands):​​​​​​​​​​​​Year Ended December 31, ​ 2020 2019 2018Net income/(loss) attributable to OP unitholders​$ 134,229​$ 102,163​$ 229,763Property management​ 12,326​ 12,701​ 11,878Other operating expenses​ 16,138​ 9,488​ 8,864Real estate depreciation and amortization​ 143,005​ 139,975​ 143,481General and administrative​ 17,987​ 18,014​ 16,889Casualty-related charges/(recoveries), net​ 793​ 853​ 951(Gain)/loss on sale of real estate owned​ (57,960)​ —​ (75,507)(Income)/loss from unconsolidated entities​ 5,543​ 8,313​ (43,496)Interest expense​ 29,357​ 29,667​ 22,835Net income/(loss) attributable to noncontrolling interests​ 1,869​ 1,832​ 1,722Total property NOI​$ 303,287​$ 323,006​$ 317,380​Same-Store CommunitiesOur Same-Store Community properties (those acquired, developed, and stabilized prior to January 1, 2019 and held as of December 31, 2020) consisted of 15,609 apartment homes and provided 93.1% of our total NOI for the year ended December 31, 2020.NOI for our Same-Store Community properties decreased 5.9%, or $17.7 million, for the year ended December 31, 2020 compared to 2019. The decrease in property NOI was primarily attributable to a 3.1%, or $12.7 million, decrease in property rental income and a 4.9%, or $5.0 million, increase in operating expenses. The decrease in property rental income was primarily driven by a $6.1 million increase in our reserve on multifamily tenant lease receivables, a $5.9 million increase in rent concessions and a $4.7 million increase in economic occupancy loss, partially offset by a 0.8%, or $3.1 million, increase in rental rates and a 2.0%, or $0.9 million, increase in reimbursement and ancillary and fee income. Physical occupancy decreased 0.8% to 96.0% and total monthly income per occupied home decreased 2.4% to $2,173.65 Table of ContentsThe increase in operating expenses was primarily driven by a 15.9%, or $2.6 million, increase in repair and maintenance expense due to the increased use of third party vendors, partially offset by a 9.0%, or $2.0 million, decrease in personnel expense as a result of fewer employees, and a 7.8%, or $3.0 million, increase in real estate taxes, which was primarily due to higher assessed valuations.The operating margin (property net operating income divided by property rental income) was 72.3% and 74.4% for the years ended December 31, 2020 and 2019, respectively.Non-Mature Communities/OtherThe Operating Partnership’s Non-Mature Communities/Other represent those communities that do not meet the criteria to be included in Same-Store Communities, which include communities recently developed or acquired, redevelopment properties, sold or held for disposition properties and the non-apartment components of mixed use properties.The remaining 6.9%, or $20.8 million, of our total NOI during the year ended December 31, 2020 was generated from our Non-Mature Communities/Other. NOI from Non-Mature Communities/Other decreased 8.6%, or $2.0 million, for the year ended December 31, 2020 as compared to 2019. The decrease was primarily driven by a decrease in NOI of $4.3 million from stabilized, non-mature communities, and a decrease of $1.3 million from sold and held for disposition communities, partially offset by an increase of $2.5 million from non-residential/other primarily due to changes in straight-line rent as a result of increased tenant rent concessions during 2020, and an increase of $1.2 million from acquired communities. Other Operating ExpenseFor the year ended December 31, 2020, other operating expense increased by 70.1%, or $6.7 million, as compared to 2019, which was primarily due to higher ground lease expense in 2020 as a result of a rent reset provision on one of our ground leases.Gain/(Loss) on Sale of Real Estate OwnedDuring the year ended December 31, 2020, the Operating Partnership recognized a gain of $58.0 million on the sale of an operating community in Alexandria, Virginia with a total of 332 apartment homes. During the year ended December 31, 2019, the Operating Partnership did not recognize any gains on the sale of real estate. InflationWe believe that the direct effects of inflation on our operations have been immaterial. While the impact of inflation primarily impacts our results of operations as a result of wage pressures and increases in utilities and material costs, the majority of our apartment leases have initial terms of 12 months or less, which generally enables us to compensate for any inflationary effects by increasing rental rates on our apartment homes. Although an extreme escalation in costs could have a negative impact on our residents and their ability to absorb rent increases, we do not believe this has had a material impact on our results for the year ended December 31, 2020.Off-Balance Sheet ArrangementsWe do not have any off-balance sheet arrangements that have, or are reasonably likely to have, a current or future effect on our financial condition, changes in financial condition, revenue or expenses, results of operations, liquidity, capital expenditures or capital resources that are material.66 Table of ContentsContractual ObligationsThe following table summarizes our contractual obligations as of December 31, 2020 (dollars in thousands):​​​​​​​​​​​​​​​​​​Payments Due by PeriodContractual Obligations 2021 2022-2023 2024-2025 Thereafter TotalLong-term debt obligations​$ — $ — $ — $ 99,500​$ 99,500Interest on debt obligations (a)​ 2,475 ​ 4,950 ​ 4,950 ​ 10,593​ 22,968Operating lease obligations — ground leases (b)​ 12,442 ​ 24,884 ​ 24,884 ​ 442,778​ 504,988Operating lease obligations — equipment leases​​ 179​​ 370​​ 386​​ 813​​ 1,748​​$ 15,096​$ 30,204​$ 30,220​$ 553,684​$ 629,204(a)Interest payments on variable rate debt instruments are based on each debt instrument’s respective year-end interest rate at December 31, 2020.(b)For purposes of our ground lease contracts, the Operating Partnership uses the minimum lease payment, if stated in the agreement. For ground lease agreements where there is a rent reset provision based on fair market value or changes in the consumer price index but does not include a specified minimum lease payment, the Operating Partnership uses the current rent over the remainder of the lease term. Item 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKInformation required by this item is included in and incorporated by reference from Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations of this Report.
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+Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations (dollars in millions, except per share data and unless otherwise indicated) COVID-19As discussed in note 1 to our consolidated financial statements, the COVID-19 pandemic has significantly disrupted supply chains and businesses around the world. The extent and duration of the COVID-19 impact, on the operations and financial position of United Rentals, and on the global economy, is uncertain. See "Item 1. Business- Industry Overview and Economic Outlook" above for a discussion of market performance in 2020.Prior to mid-March 2020, our performance was largely in line with expectations. In early-March, we initiated contingency planning ahead of the impact of COVID-19 on our end-markets. This planning has focused on five key work-streams that are the basis for our crisis response plan:1.Ensuring the safety and well-being of our employees and customers: Above all else, we are committed to ensuring the health, safety and well-being of our employees and customers. We have implemented a variety of COVID-19 safety measures, including ensuring that branches have sufficient and adequate personal protection equipment. We have also implemented appropriate social distancing practices, and increased disinfecting of equipment and facilities.2.Leveraging our competitive advantages to support the needs of customers: We have made modifications to enhance safety measures in our operating processes and protocols that support the needs of our customers. Additionally, our digital capabilities allow customers to perform fully contactless transactions.3.Disciplined capital expenditures: We have a substantial degree of flexibility in managing our capital expenditures and fleet capacity. Net rental capital expenditures (purchases of rental equipment less the proceeds from sales of rental equipment) for 2020 decreased $1.198 billion, or 92 percent, year-over-year. 4.Controlling core operating expenses: A significant portion of our cash operating costs are variable in nature. Since March 2020, we have significantly reduced overtime and temporary labor primarily in response to the impact of COVID-19. Furthermore, we continue to leverage our current capacity to reduce the need for third-party delivery and repair services, and minimize other discretionary expenses across general and administrative areas.5.Proactively managing the balance sheet with a focus on liquidity: We are focused on ensuring that we maintain ample liquidity to meet our business needs as the impact of COVID-19 evolves. As a result, our current $500 share repurchase program was paused in mid-March 2020. At December 31, 2020, our total liquidity was $3.073 billion, comprised of cash and cash equivalents, and availability under the ABL and accounts receivable securitization facilities. We have no note maturities until 2026.The impact of COVID-19 on our business is discussed throughout this “Management’s Discussion and Analysis of Financial Condition and Results of Operations.” As discussed below, the response plan above helped mitigate the impact of COVID-19 on our results.Executive OverviewWe are the largest equipment rental company in the world, with an integrated network of 1,165 rental locations in the U.S., Canada and Europe. In July 2018, we completed the acquisition of BakerCorp, which allowed for our entry into select European markets. Although the equipment rental industry is highly fragmented and diverse, we believe that we are well positioned to take advantage of this environment because, as a larger company, we have more extensive resources and certain competitive advantages. These include a fleet of rental equipment with a total original equipment cost (“OEC”) of $13.8 billion, and a North American branch network that operates in 49 U.S. states and every Canadian province, and serves 99 of the 100 largest metropolitan areas in the U.S. The BakerCorp acquisition discussed above added 11 European locations in France, Germany, the United Kingdom and the Netherlands to our branch network. Our size also gives us greater purchasing power, the ability to provide customers with a broader range of equipment and services, the ability to provide customers with equipment that is more consistently well-maintained and therefore more productive and reliable, and the ability to enhance the earning potential of our assets by transferring equipment among branches to satisfy customer needs.We offer approximately 4,000 classes of equipment for rent to a diverse customer base that includes construction and industrial companies, manufacturers, utilities, municipalities, homeowners and government entities. Our revenues are derived from the following sources: equipment rentals, sales of rental equipment, sales of new equipment, contractor supplies sales and service and other revenues. In 2020, equipment rental revenues represented 84 percent of our total revenues. For the past several years, we have executed a strategy focused on improving the profitability of our core equipment rental business through revenue growth, margin expansion and operational efficiencies. In particular, we have focused on customer segmentation, customer service differentiation, rate management, fleet management and operational efficiency. 26Table of ContentsWe are currently managing the impact of COVID-19, as discussed above. Our general strategy focuses on profitability and return on invested capital, and, in particular, calls for:•A consistently superior standard of service to customers, often provided through a single lead contact who can coordinate the cross-selling of the various services we offer throughout our network. We utilize a proprietary software application, Total Control®, which provides our key customers with a single in-house software application that enables them to monitor and manage all their equipment needs. Total Control® is a unique customer offering that enables us to develop strong, long-term relationships with our larger customers. Our digital capabilities, including our Total Control® platform, allow our sales teams to provide contactless end-to-end customer service;•The further optimization of our customer mix and fleet mix, with a dual objective: to enhance our performance in serving our current customer base, and to focus on the accounts and customer types that are best suited to our strategy for profitable growth. We believe these efforts will lead to even better service of our target accounts, primarily large construction and industrial customers, as well as select local contractors. Our fleet team's analyses are aligned with these objectives to identify trends in equipment categories and define action plans that can generate improved returns;•A continued focus on “Lean” management techniques, including kaizen processes focused on continuous improvement. We continue to implement Lean kaizen processes across our branch network, with the objectives of: reducing the cycle time associated with renting our equipment to customers; improving invoice accuracy and service quality; reducing the elapsed time for equipment pickup and delivery; and improving the effectiveness and efficiency of our repair and maintenance operations; •The continued expansion of our trench, power and fluid solutions footprint, as well as our tools and onsite services offerings, and the cross-selling of these services throughout our network. We believe that the expansion of our trench, power and fluid solutions business, as well as our tools and onsite services offerings, will further position United Rentals as a single source provider of total jobsite solutions through our extensive product and service resources and technology offerings; and•The pursuit of strategic acquisitions to continue to expand our core equipment rental business. Strategic acquisitions allow us to invest our capital to expand our business, further driving our ability to accomplish our strategic goals. In 2021, based on our analyses of industry forecasts and macroeconomic indicators, we expect modest market recovery following the declines experienced in 2020, which included the pronounced impact of COVID-19. See "Item 1. Business- Industry Overview and Economic Outlook" above for a discussion of market performance in 2020. Specifically, we expect that North American industry equipment rental revenue will increase approximately 2 percent, with higher growth expected in Canada than the U.S.As discussed below, fleet productivity is a comprehensive metric that reflects the combined impact of changes in rental rates, time utilization, and mix that contribute to the variance in owned equipment rental revenue. For the full year 2020: •Equipment rentals decreased 10.3 percent year-over-year, including the impact of COVID-19 on volumes;•Average OEC decreased 2.2 percent year-over-year;•Fleet productivity decreased 6.9 percent, primarily due to the impact of COVID-19 since March, when rental volume declined in response to shelter-in-place orders and other market restrictions; and•74 percent of equipment rental revenue was derived from key accounts, as compared to 72 percent in 2019. Key accounts are each managed by a single point of contact to enhance customer service.Financial Overview Prior to taking actions pertaining to our financial flexibility and liquidity, we considered the impact of COVID-19 on liquidity, and assessed our available sources and anticipated uses of cash, including, with respect to sources, cash generated from operations and from the sale of rental equipment. In 2020, we took the following actions to improve our financial flexibility and liquidity, and to position us to invest the necessary capital in our business:•Issued $750 principal amount of 4 percent Senior Notes due 2030;•Issued $1.1 billion principal amount of 3 7/8 percent Senior Notes due 2031;•Redeemed all $800 principal amount of our 5 1/2 percent Senior Notes due 2025;•Redeemed all $1.1 billion principal amount of our 6 1/2 percent Senior Notes due 2026; •Redeemed all $750 principal amount of our 4 5/8 percent Senior Notes due 2025; and27Table of Contents•Amended and extended our accounts receivable securitization facility, including a reduction in the size of the facility from $975 to $800.We have also used cash generated from operations to reduce borrowings under the ABL facility, and total debt has decreased $1.746 billion, or 15.3 percent, since December 31, 2019. As discussed above, disciplined management of capital expenditures and fleet capacity is a component of our COVID-19 response plan, and, in 2020, capital expenditures decreased significantly year-over-year. The decreased capital expenditures contributed to our ability to use proceeds from operations to reduce borrowings under the ABL facility. As of December 31, 2020, we had available liquidity of $3.073 billion, comprised of cash and cash equivalents, and availability under the ABL and accounts receivable securitization facilities.Net income. Net income and diluted earnings per share for each of the three years in the period ended December 31, 2020 are presented below.Year Ended December 31, 202020192018Net income$890 $1,174 $1,096 Diluted earnings per share$12.20 $15.11 $13.12 Net income and diluted earnings per share for each of the three years in the period ended December 31, 2020 include the after-tax impacts of the items below. The tax rates applied to the items below reflect the statutory rates in the applicable entity.Year Ended December 31, 202020192018Tax rate applied to items below25.2 %25.3 %25.5 %Contribution to net income (after-tax)Impact on diluted earnings per shareContribution to net income (after-tax)Impact on diluted earnings per shareContribution to net income (after-tax)Impact on diluted earnings per shareMerger related costs (1)$— $— $(1)$(0.01)$(27)$(0.32)Merger related intangible asset amortization (2)(163)(2.22)(194)(2.48)(147)(1.76)Impact on depreciation related to acquired fleet and property and equipment (3)(6)(0.08)(30)(0.39)(16)(0.19)Impact of the fair value mark-up of acquired fleet (4)(37)(0.51)(56)(0.72)(49)(0.59)Restructuring charge (5)(13)(0.18)(14)(0.18)(23)(0.28)Asset impairment charge (6)(27)(0.37)(4)(0.05)— — Loss on extinguishment of debt securities and amendment of ABL facility (7)(137)(1.88)(45)(0.58)— — (1)This reflects transaction costs associated with the NES and Neff acquisitions that were completed in 2017, and the BakerCorp and BlueLine acquisitions that were completed in 2018. Merger related costs only include costs associated with major acquisitions that significantly impact our operations. For additional information, see "Results of Operations-Other costs/(income)-merger related costs" below.(2)This reflects the amortization of the intangible assets acquired in the RSC, National Pump, NES, Neff, BakerCorp and BlueLine acquisitions.(3)This reflects the impact of extending the useful lives of equipment acquired in the RSC, NES, Neff, BakerCorp and BlueLine acquisitions, net of the impact of additional depreciation associated with the fair value mark-up of such equipment.(4)This reflects additional costs recorded in cost of rental equipment sales associated with the fair value mark-up of rental equipment acquired in the RSC, NES, Neff and BlueLine acquisitions that was subsequently sold.(5)As discussed in note 5 to our consolidated financial statements, this primarily reflects severance costs and branch closure charges associated with our restructuring programs. (6)This reflects write-offs of leasehold improvements and other fixed assets. As discussed in note 5 to our consolidated financial statements, the 2020 charges primarily reflect the discontinuation of certain equipment programs, and were not related to COVID-19.(7)This primarily reflects the difference between the net carrying amount and the total purchase price of the redeemed notes. For additional information, see "Results of Operations-Other costs/(income)-Interest expense, net" below.28Table of ContentsEBITDA GAAP Reconciliations. EBITDA represents the sum of net income, provision for income taxes, interest expense, net, depreciation of rental equipment and non-rental depreciation and amortization. Adjusted EBITDA represents EBITDA plus the sum of the merger related costs, restructuring charge, stock compensation expense, net, and the impact of the fair value mark-up of acquired fleet. These items are excluded from adjusted EBITDA internally when evaluating our operating performance and for strategic planning and forecasting purposes, and allow investors to make a more meaningful comparison between our core business operating results over different periods of time, as well as with those of other similar companies. The net income and adjusted EBITDA margins represent net income or adjusted EBITDA divided by total revenue. Management believes that EBITDA and adjusted EBITDA, when viewed with the Company’s results under U.S. generally accepted accounting principles (“GAAP”) and the accompanying reconciliations, provide useful information about operating performance and period-over-period growth, and provide additional information that is useful for evaluating the operating performance of our core business without regard to potential distortions. Additionally, management believes that EBITDA and adjusted EBITDA help investors gain an understanding of the factors and trends affecting our ongoing cash earnings, from which capital investments are made and debt is serviced. However, EBITDA and adjusted EBITDA are not measures of financial performance or liquidity under GAAP and, accordingly, should not be considered as alternatives to net income or cash flow from operating activities as indicators of operating performance or liquidity. The table below provides a reconciliation between net income and EBITDA and adjusted EBITDA:Year Ended December 31, 202020192018Net income$890 $1,174 $1,096 Provision for income taxes249 340 380 Interest expense, net669 648 481 Depreciation of rental equipment1,601 1,631 1,363 Non-rental depreciation and amortization387 407 308 EBITDA3,796 4,200 3,628 Merger related costs (1)— 1 36 Restructuring charge (2)17 18 31 Stock compensation expense, net (3)70 61 102 Impact of the fair value mark-up of acquired fleet (4)49 75 66 Adjusted EBITDA$3,932 $4,355 $3,863 Net income margin10.4 %12.6 %13.6 %Adjusted EBITDA margin46.1 %46.6 %48.0 %The table below provides a reconciliation between net cash provided by operating activities and EBITDA and adjusted EBITDA:29Table of ContentsYear Ended December 31, 202020192018Net cash provided by operating activities$2,658 $3,024 $2,853 Adjustments for items included in net cash provided by operating activities but excluded from the calculation of EBITDA:Amortization of deferred financing costs and original issue discounts(14)(15)(12)Gain on sales of rental equipment332 313 278 Gain on sales of non-rental equipment8 6 6 Insurance proceeds from damaged equipment40 24 22 Merger related costs (1)— (1)(36)Restructuring charge (2)(17)(18)(31)Stock compensation expense, net (3)(70)(61)(102)Loss on extinguishment of debt securities and amendment of ABL facility (5)(183)(61)— Changes in assets and liabilities241 170 124 Cash paid for interest483 581 455 Cash paid for income taxes, net318 238 71 EBITDA3,796 4,200 3,628 Add back:Merger related costs (1)— 1 36 Restructuring charge (2)17 18 31 Stock compensation expense, net (3)70 61 102 Impact of the fair value mark-up of acquired fleet (4)49 75 66 Adjusted EBITDA$3,932 $4,355 $3,863 _________________(1)This reflects transaction costs associated with the NES and Neff acquisitions that were completed in 2017, and the BakerCorp and BlueLine acquisitions that were completed in 2018. Merger related costs only include costs associated with major acquisitions that significantly impact our operations. For additional information, see "Results of Operations-Other costs/(income)-merger related costs" below.(2)As discussed in note 5 to our consolidated financial statements, this primarily reflects severance costs and branch closure charges associated with our restructuring programs.(3)Represents non-cash, share-based payments associated with the granting of equity instruments.(4)This reflects additional costs recorded in cost of rental equipment sales associated with the fair value mark-up of rental equipment acquired in the RSC, NES, Neff and BlueLine acquisitions that was subsequently sold.(5)This primarily reflects the difference between the net carrying amount and the total purchase price of the redeemed notes. For additional information, see "Results of Operations-Other costs/(income)-Interest expense, net" below.For the year ended December 31, 2020, net income decreased $284, or 24.2 percent, and net income margin decreased 220 basis points to 10.4 percent. For the year ended December 31, 2020, adjusted EBITDA decreased $423, or 9.7 percent, and adjusted EBITDA margin decreased 50 basis points to 46.1 percent.The year-over-year decrease in net income margin primarily reflected 1) decreased gross margin from equipment rentals and 2) increased interest expense, partially offset by lower year-over-year 3) income tax expense and 4) selling, general and administrative ("SG&A") expense as a percentage of revenue. Equipment rentals gross margin decreased 220 basis points year-over-year, with 190 basis points of the margin decline due to an increase in depreciation expense as a percentage of revenue. Depreciation expense included a $30 asset impairment charge, which was not related to COVID-19, associated with the discontinuation of certain equipment programs. Excluding the impact of the asset impairment charge, depreciation expense decreased slightly from 2019, but increased as a percentage of revenue, primarily due to COVID-19. As noted above, COVID-19 began to impact our operations in March 2020, and, since then, equipment rentals have remained down year-over-year in response to shelter-in-place orders and other market restrictions. The remaining 30 basis point decline in equipment rentals gross margin was primarily due to the impact of COVID-19, partially offset by actions we have taken to manage operating costs, such as the reduction of overtime and temporary labor, and the leveraging of our current capacity to reduce the need for third-party delivery and repair services. See "Results of Operations-Gross Margin" below for further discussion of 30Table of Contentsequipment rentals gross margin. Interest expense, net increased $21 year-over-year. Interest expense, net for the years ended December 31, 2020 and 2019 included debt redemption losses of $183 and $61, respectively. Excluding the impact of these losses, interest expense, net for the year ended December 31, 2020 decreased primarily due to decreases in average debt and the average cost of debt. Year-over-year, the effective income tax rate was largely flat, but income tax expense decreased as a percentage of revenue. SG&A expense as a percentage of revenue decreased primarily due to significant reductions in professional fees and travel and entertainment expenses, which were implemented in response to COVID-19, partially offset by increases in salaries and stock compensation as a percentage of revenue. Total salary and stock compensation expense was largely flat year-over-year, generally reflecting normal variability, but increased as a percentage of revenue due in part to the COVID-19 impact on revenue.The decrease in the adjusted EBITDA margin primarily reflects 1) lower margins from equipment rentals (excluding depreciation), sales of rental equipment (excluding the adjustment reflected in the table above for the impact of the fair value mark-up of acquired fleet) and service and other revenues and 2) changes in revenue mix, in particular an increase in the proportion of revenue from sales of rental equipment, partially offset by 3) the impact of decreased SG&A expense (excluding stock compensation). Equipment rentals margin (excluding depreciation) decreased 30 basis points primarily due to the impact of COVID-19, partially offset by actions we have taken to manage operating costs, such as the reduction of overtime and temporary labor, and the leveraging of our current capacity to reduce the need for third-party delivery and repair services. See "Results of Operations-Gross Margin" below for further discussion of equipment rentals gross margin. Gross margin from sales of rental equipment (excluding the adjustment reflected in the table above for the impact of the fair value mark-up of acquired fleet) decreased primarily due to changes in pricing and the mix of equipment sold. The decreased gross margin from service and other revenues reflected the impact of COVID-19, which resulted in reduced training revenue without a proportionate reduction in costs. SG&A expense (excluding stock compensation) as a percentage of revenue decreased primarily due to significant reductions in professional fees and travel and entertainment expenses, which were implemented in response to COVID-19, partially offset by an increase in salaries as a percentage of revenue. Salary expense was largely flat year-over-year, generally reflecting normal variability, but increased as a percentage of revenue due in part to the COVID-19 impact on revenue.For the year ended December 31, 2019, net income increased $78, or 7.1 percent, and net income margin decreased 100 basis points to 12.6 percent. For the year ended December 31, 2019, adjusted EBITDA increased $492, or 12.7 percent, and adjusted EBITDA margin decreased 140 basis points to 46.6 percent.The year-over-year decrease in net income margin primarily reflected 1) decreased gross margin from equipment rentals and 2) increased interest expense, partially offset by lower year-over-year 3) income tax expense and 4) SG&A expense as a percentage of revenue. Equipment rentals gross margin decreased 240 basis points year-over-year, due primarily to the impact of the BlueLine and BakerCorp acquisitions and increased operating costs. The BlueLine and BakerCorp acquisitions were significant drivers of the 19.7 percent depreciation increase, which exceeded the equipment rentals increase of 14.8 percent. Operating costs were impacted by repair and repositioning initiatives that resulted in increased repairs and maintenance expense, which increased 22.4 percent (such increase includes the impact of both 1) the BlueLine and BakerCorp acquisitions and 2) the repair and repositioning initiatives). Net interest expense increased $167 year-over-year primarily due to the debt issued to fund the BakerCorp and BlueLine acquisitions and a $61 debt redemption loss. Our effective tax rate decreased 320 basis points year-over-year primarily due to federal tax credits and favorable changes in the state jurisdictional mix of income. The decrease in SG&A expense as a percentage of revenue primarily reflects a reduction in stock compensation as a percentage of revenue, and decreased bad debt expense. The reduced bad debt expense primarily reflects our adoption in 2019 of an updated lease accounting standard (see note 13 to the consolidated financial statements for further detail). This standard requires that we recognize doubtful accounts associated with lease revenues as a reduction to equipment rentals revenue (such amounts were recognized as SG&A expense prior to 2019).As discussed above, we completed the acquisitions of BakerCorp and BlueLine in July 2018 and October 2018, respectively, and the adjusted EBITDA increase for 2019 includes the impact of these acquisitions. The decrease in the adjusted EBITDA margin primarily reflects the impact of the BakerCorp and BlueLine acquisitions.Revenues. Revenues for each of the three years in the period ended December 31, 2020 were as follows: 31Table of ContentsYear Ended December 31,Change 20202019201820202019Equipment rentals*$7,140 $7,964 $6,940 (10.3)%14.8%Sales of rental equipment858 831 664 3.2%25.2%Sales of new equipment247 268 208 (7.8)%28.8%Contractor supplies sales98 104 91 (5.8)%14.3%Service and other revenues187 184 144 1.6%27.8%Total revenues$8,530 $9,351 $8,047 (8.8)%16.2%*Equipment rentals variance components:Year-over-year change in average OEC(2.2)%17.7%Assumed year-over-year inflation impact (1)(1.5)%(1.5)%Fleet productivity (2) (6.9)%(2.2)%Contribution from ancillary and re-rent revenue (3)0.3%0.8%Total change in equipment rentals(10.3)%14.8%*Pro forma equipment rentals variance components (4):Year-over-year change in average OEC 4.9%Assumed year-over-year inflation impact (1) (1.5)%Fleet productivity (2) 0.6%Contribution from ancillary and re-rent revenue (3) 0.1%Total change in equipment rentals 4.1%_________________(1)Reflects the estimated impact of inflation on the revenue productivity of fleet based on OEC, which is recorded at cost.(2)Reflects the combined impact of changes in rental rates, time utilization, and mix that contribute to the variance in owned equipment rental revenue. See note 3 to the consolidated financial statements for a discussion of the different types of equipment rentals revenue. Rental rate changes are calculated based on the year-over-year variance in average contract rates, weighted by the prior period revenue mix. Time utilization is calculated by dividing the amount of time an asset is on rent by the amount of time the asset has been owned during the year. Mix includes the impact of changes in customer, fleet, geographic and segment mix.(3)Reflects the combined impact of changes in the other types of equipment rentals revenue (see note 3 for further detail), excluding owned equipment rental revenue.(4)We completed the acquisitions of BakerCorp and BlueLine in July 2018 and October 2018, respectively. The pro forma information includes the standalone, pre-acquisition results of BakerCorp and BlueLine. The pro forma components are not reflected above for 2020 versus 2019 because BakerCorp and BlueLine are fully reflected in our results for these periods. Equipment rentals include our revenues from renting equipment, as well as revenue related to the fees we charge customers: for equipment delivery and pick-up; to protect the customer against liability for damage to our equipment while on rent; for fuel; and for environmental costs. Collectively, these "ancillary fees" represented approximately 13 percent of equipment rental revenue in 2020. Delivery and pick-up revenue, which represented approximately seven percent of equipment rental revenue in 2020, is the most significant ancillary revenue component. Sales of rental equipment represent our revenues from the sale of used rental equipment. Sales of new equipment represent our revenues from the sale of new equipment. Contractor supplies sales represent our sales of supplies utilized by contractors, which include construction consumables, tools, small equipment and safety supplies. Services and other revenues primarily represent our revenues earned from providing repair and maintenance services on our customers’ fleet (including parts sales). See note 3 to our consolidated financial statements for further discussion of our revenue recognition accounting.2020 total revenues of $8.5 billion decreased 8.8 percent compared with 2019. Equipment rentals and sales of rental equipment are our largest revenue types (together, they accounted for 94 percent of total revenue for the year ended December 31, 2020). Equipment rentals decreased 10.3 percent. COVID-19 began to impact our operations in March 2020. Through February 2020, equipment rentals were up slightly year-over-year. Since March, equipment rentals have decreased year-over-year, primarily due to the impact of COVID-19. Fleet productivity decreased 6.9 percent, primarily due to the impact of COVID-19 since March, when rental volume declined in response to shelter-in-place orders and other market restrictions. 32Table of ContentsThrough February, fleet productivity was flat year-over-year and in line with expectations. Sales of rental equipment did not change materially year-over-year.2019 total revenues of $9.4 billion increased 16.2 percent compared with 2018. Equipment rentals and sales of rental equipment are our largest revenue types (together, they accounted for 94 percent of total revenue for the year ended December 31, 2019). Equipment rentals increased 14.8 percent, primarily due to a 17.7 percent increase in average OEC, which includes the impact of the BakerCorp and BlueLine acquisitions. On a pro forma basis including the standalone, pre-acquisition results of BakerCorp and BlueLine, equipment rentals increased 4.1 percent, primarily due to a 4.9 percent increase in average OEC and a fleet productivity increase of 0.6 percent, partially offset by the impact of fleet inflation. Sales of rental equipment increased 25.2 percent primarily due to increased volume, which included the impact of the BlueLine acquisition, driven by a larger fleet size in a strong used equipment market. Critical Accounting Policies We prepare our consolidated financial statements in accordance with GAAP. A summary of our significant accounting policies is contained in note 2 to our consolidated financial statements. In applying many accounting principles, we make assumptions, estimates and/or judgments. These assumptions, estimates and/or judgments are often subjective and may change based on changing circumstances or changes in our analysis. Material changes in these assumptions, estimates and/or judgments have the potential to materially alter our results of operations. We have identified below our accounting policies that we believe could potentially produce materially different results if we were to change underlying assumptions, estimates and/or judgments. Although actual results may differ from those estimates, we believe the estimates are reasonable and appropriate. Allowance for Doubtful Accounts. We maintain allowances for doubtful accounts. These allowances reflect our estimate of the amount of our receivables that we will be unable to collect based on historical write-off experience and, as applicable, current conditions and reasonable and supportable forecasts that affect collectibility. Our allowance for doubtful accounts as of December 31, 2020 included an adjustment for the estimated impact of COVID-19 on future collectibility that was not material to our financial statements. Our estimate could require change based on changing circumstances, including changes in the economy or in the particular circumstances of individual customers. Accordingly, we may be required to increase or decrease our allowances. Trade receivables that have contractual maturities of one year or less are written-off when they are determined to be uncollectible based on the criteria necessary to qualify as a deduction for federal tax purposes. Write-offs of such receivables require management approval based on specified dollar thresholds. See note 3 to our consolidated financial statements for further detail.Useful Lives and Salvage Values of Rental Equipment and Property and Equipment. We depreciate rental equipment and property and equipment over their estimated useful lives, after giving effect to an estimated salvage value which ranges from zero percent to 10 percent of cost. Rental equipment is depreciated whether or not it is out on rent. The useful life of an asset is determined based on our estimate of the period over which the asset will generate revenues; such periods are periodically reviewed for reasonableness. In addition, the salvage value, which is also reviewed periodically for reasonableness, is determined based on our estimate of the minimum value we will realize from the asset after such period. We may be required to change these estimates based on changes in our industry or other changing circumstances. If these estimates change in the future, we may be required to recognize increased or decreased depreciation expense for these assets. To the extent that the useful lives of all of our rental equipment were to increase or decrease by one year, we estimate that our annual depreciation expense would decrease or increase by approximately $174 or $226, respectively. If the estimated salvage values of all of our rental equipment were to increase or decrease by one percentage point, we estimate that our annual depreciation expense would change by approximately $18. Any change in depreciation expense as a result of a hypothetical change in either useful lives or salvage values would generally result in a proportional increase or decrease in the gross profit we would recognize upon the ultimate sale of the asset. To the extent that the useful lives of all of our depreciable property and equipment were to increase or decrease by one year, we estimate that our annual non-rental depreciation expense would decrease or increase by approximately $35 or $54, respectively.Acquisition Accounting. We have made a number of acquisitions in the past and may continue to make acquisitions in the future. The assets acquired and liabilities assumed are recorded based on their respective fair values at the date of acquisition. Long-lived assets (principally rental equipment), goodwill and other intangible assets generally represent the largest components of our acquisitions. Rental equipment is valued utilizing either a cost, market or income approach, or a combination of certain of these methods, depending on the asset being valued and the availability of market or income data. The intangible assets that we have acquired are non-compete agreements, customer relationships and trade names and associated trademarks. The estimated fair values of these intangible assets reflect various assumptions about discount rates, revenue growth rates, operating margins, terminal values, useful lives and other prospective financial information. Goodwill is calculated as the excess of the cost of the acquired entity over the net of the fair value of the assets acquired and the liabilities 33Table of Contentsassumed. Non-compete agreements, customer relationships and trade names and associated trademarks are valued based on an excess earnings or income approach based on projected cash flows.Determining the fair value of the assets and liabilities acquired is judgmental in nature and can involve the use of significant estimates and assumptions. The significant judgments include estimation of future cash flows, which is dependent on forecasts; estimation of the long-term rate of growth; estimation of the useful life over which cash flows will occur; and determination of a risk-adjusted weighted average cost of capital. When appropriate, our estimates of the fair values of assets and liabilities acquired include assistance from independent third-party appraisal firms. The judgments made in determining the estimated fair value assigned to the assets acquired, as well as the estimated life of the assets, can materially impact net income in periods subsequent to the acquisition through depreciation and amortization, and in certain instances through impairment charges, if the asset becomes impaired in the future. As discussed below, we regularly review for impairments.When we make an acquisition, we also acquire other assets and assume liabilities. These other assets and liabilities typically include, but are not limited to, parts inventory, accounts receivable, accounts payable and other working capital items. Because of their short-term nature, the fair values of these other assets and liabilities generally approximate the book values on the acquired entities' balance sheets. Evaluation of Goodwill Impairment. Goodwill is tested for impairment annually or more frequently if an event or circumstance indicates that an impairment loss may have been incurred. Application of the goodwill impairment test requires judgment, including: the identification of reporting units; assignment of assets and liabilities to reporting units; assignment of goodwill to reporting units; determination of the fair value of each reporting unit; and an assumption as to the form of the transaction in which the reporting unit would be acquired by a market participant (either a taxable or nontaxable transaction). We estimate the fair value of our reporting units (which are our regions) using a combination of an income approach based on the present value of estimated future cash flows and a market approach based on market price data of shares of our Company and other corporations engaged in similar businesses as well as acquisition multiples paid in recent transactions. We believe this approach, which utilizes multiple valuation techniques, yields the most appropriate evidence of fair value. As discussed in note 2 to our consolidated financial statements, in 2020, we adopted accounting guidance that eliminated the second step from the goodwill impairment test (this guidance did not have a significant impact on our financial statements). Prior guidance required utilizing a two-step process to review goodwill for impairment. A second step was required if there was an indication that an impairment may exist, and the second step required calculating the potential impairment by comparing the implied fair value of the reporting unit's goodwill (as if purchase accounting were performed on the testing date) with the carrying amount of the goodwill. We did not perform this second step for the goodwill impairment test conducted as of October 1, 2020 or 2019 (for 2020, because the adopted accounting guidance eliminated the second step, and, for 2019, because there was no indication that an impairment may have existed). The first step of the impairment test requires comparing the fair value of a reporting unit with its carrying amount. Financial Accounting Standards Board ("FASB") guidance permits entities to first assess qualitative factors to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount.Inherent in our preparation of cash flow projections are assumptions and estimates derived from a review of our operating results, business plans, expected growth rates, cost of capital and tax rates. We also make certain forecasts about future economic conditions, interest rates and other market data. Many of the factors used in assessing fair value are outside the control of management, and these assumptions and estimates may change in future periods. Changes in assumptions or estimates could materially affect the estimate of the fair value of a reporting unit, and therefore could affect the likelihood and amount of potential impairment. The following assumptions are significant to our income approach: Business Projections- We make assumptions about the level of equipment rental activity in the marketplace and cost levels. These assumptions drive our planning assumptions for pricing and utilization and also represent key inputs for developing our cash flow projections. These projections are developed using our internal business plans over a ten-year planning period that are updated at least annually; Long-term Growth Rates- Beyond the planning period, we also utilize an assumed long-term growth rate representing the expected rate at which a reporting unit's cash flow stream is projected to grow. These rates are used to calculate the terminal value of our reporting units, and are added to the cash flows projected during our ten-year planning period; and Discount Rates- Each reporting unit's estimated future cash flows are discounted at a rate that is consistent with a weighted-average cost of capital that is likely to be expected by market participants. The weighted-average cost of capital is an estimate of the overall after-tax rate of return required by equity and debt holders of a business enterprise. 34Table of ContentsThe market approach is one of the other methods used for estimating the fair value of our reporting units' business enterprise. This approach takes two forms: The first is based on the market value (market capitalization plus interest-bearing liabilities) and operating metrics (e.g., revenue and EBITDA) of companies engaged in the same or similar line of business. The second form is based on multiples paid in recent acquisitions of companies. In connection with our goodwill impairment test that was conducted as of October 1, 2020, we bypassed the qualitative assessment for each reporting unit and quantitatively compared the fair values of our reporting units with their carrying amounts. We considered the impact of COVID-19 when performing the test, and it did not have a material impact on the test results. Our goodwill impairment testing as of this date indicated that all of our reporting units, excluding our Fluid Solutions Europe reporting unit, had estimated fair values which exceeded their respective carrying amounts by at least 42 percent. As discussed above, in July 2018, we completed the acquisition of BakerCorp. All of the assets in the Fluid Solutions Europe reporting unit were acquired in the BakerCorp acquisition. The estimated fair value of our Fluid Solutions Europe reporting unit exceeded its carrying amount by 22 percent. As all of the assets in the Fluid Solutions Europe reporting unit were recorded at fair value as of the July 2018 acquisition date, we expected the percentage by which the Fluid Solutions Europe reporting unit’s fair value exceeded its carrying value to be significantly less than the equivalent percentages determined for our other reporting units.In connection with our goodwill impairment test that was conducted as of October 1, 2019, we bypassed the qualitative assessment for each reporting unit and proceeded directly to the first step of the goodwill impairment test. Our goodwill impairment testing as of this date indicated that all of our reporting units, excluding our Fluid Solutions Europe reporting unit, had estimated fair values which exceeded their respective carrying amounts by at least 32 percent. As discussed above, in July 2018, we completed the acquisition of BakerCorp. All of the assets in the Fluid Solutions Europe reporting unit were acquired in the BakerCorp acquisition. The estimated fair value of our Fluid Solutions Europe reporting unit exceeded its carrying amount by 12 percent. As all of the assets in the Fluid Solutions Europe reporting unit were recorded at fair value as of the July 2018 acquisition date, we expected the percentage by which the Fluid Solutions Europe reporting unit’s fair value exceeded its carrying value to be significantly less than the equivalent percentages determined for our other reporting units.Impairment of Long-lived Assets (Excluding Goodwill). We review the recoverability of our rental equipment and property and equipment when events or changes in circumstances occur that indicate that the carrying value of the assets may not be recoverable. If there are such indications, we assess our ability to recover the carrying value of the assets from their expected future pre-tax cash flows (undiscounted and without interest charges). If the expected cash flows are less than the carrying value of the assets, an impairment loss is recognized for the difference between the estimated fair value and carrying value. We also conduct impairment reviews in connection with branch consolidations and other changes in our business. As discussed in note 5 to our consolidated financial statements, during the year ended December 31, 2020, we recorded asset impairment charges of $36, which principally relate to the discontinuation of certain equipment programs, and were not related to COVID-19. We recognized immaterial asset impairment charges during the years ended December 31, 2019 and 2018.In support of our review for indicators of impairment, we perform a review of all assets at the district level relative to district performance and conclude whether indicators of impairment exist associated with our long-lived assets, including rental equipment. We also specifically review the financial performance of our rental equipment. Such review includes an estimate of the future rental revenues from our rental assets based on current and expected utilization levels, the age of the assets and their remaining useful lives. Additionally, we estimate when the assets are expected to be removed or retired from our rental fleet as well as the expected proceeds to be realized upon disposition. Based on our most recently completed quarterly reviews, there were no indications of impairment associated with our rental equipment or property and equipment.Income Taxes. We recognize deferred tax assets and liabilities for certain future deductible or taxable temporary differences expected to be reported in our income tax returns. These deferred tax assets and liabilities are computed using the tax rates that are expected to apply in the periods when the related future deductible or taxable temporary difference is expected to be settled or realized. In the case of deferred tax assets, the future realization of the deferred tax benefits and carryforwards are determined with consideration to historical profitability, projected future taxable income, the expected timing of the reversals of existing temporary differences, and tax planning strategies. After consideration of all these factors, we recognize deferred tax assets when we believe that it is more likely than not that we will realize them. The most significant positive evidence that we consider in the recognition of deferred tax assets is the expected reversal of cumulative deferred tax liabilities resulting from book versus tax depreciation of our rental equipment fleet that is well in excess of the deferred tax assets. We use a two-step approach for recognizing and measuring tax benefits taken or expected to be taken in a tax return regarding uncertainties in income tax positions. The first step is recognition: we determine whether it is more likely than not that a tax position will be sustained upon examination, including resolution of any related appeals or litigation processes, based on the technical merits of the position. In evaluating whether a tax position has met the more-likely-than-not recognition threshold, we presume that the position will be examined by the appropriate taxing authority with full knowledge of all relevant 35Table of Contentsinformation. The second step is measurement: a tax position that meets the more-likely-than-not recognition threshold is measured to determine the amount of benefit to recognize in the financial statements. The tax position is measured at the largest amount of benefit that is greater than 50 percent likely of being realized upon ultimate settlement. We are subject to ongoing tax examinations and assessments in various jurisdictions. Accordingly, accruals for tax contingencies are established based on the probable outcomes of such matters. Our ongoing assessments of the probable outcomes of the examinations and related tax accruals require judgment and could increase or decrease our effective tax rate as well as impact our operating results. We have historically considered the undistributed earnings of our foreign subsidiaries to be indefinitely reinvested, and, accordingly, no taxes were provided on such earnings prior to the fourth quarter of 2020. In the fourth quarter of 2020, we identified $135 of cash in our foreign operations in excess of near-term working capital needs, and determined that this amount could no longer be considered indefinitely reinvested. As a result, our prior assertion that all undistributed earnings of our foreign subsidiaries should be considered indefinitely reinvested has changed, and, in the fourth quarter of 2020, we recorded the immaterial taxes on a distribution of the $135 of cash. We continue to expect that the remaining balance of our undistributed foreign earnings will be indefinitely reinvested. If we determine that all or a portion of such foreign earnings are no longer indefinitely reinvested, we may be subject to additional foreign withholding taxes and U.S. state income taxes. The Tax Act discussed above required a one-time transition tax for deemed repatriation of accumulated undistributed earnings of certain foreign investments, which we primarily recognized upon adoption of the Tax Act in 2017. As discussed in note 14 to the consolidated financial statements, we completed our accounting for the tax effects of enactment of the Tax Act in 2018.Reserves for Claims. We are exposed to various claims relating to our business, including those for which we retain portions of the losses through the application of deductibles and self-insured retentions, which we sometimes refer to as “self-insurance.” These claims include (i) workers' compensation claims and (ii) claims by third parties for injury or property damage involving our equipment, vehicles or personnel. These types of claims may take a substantial amount of time to resolve and, accordingly, the ultimate liability associated with a particular claim may not be known for an extended period of time. Our methodology for developing self-insurance reserves is based on management estimates, which incorporate periodic actuarial valuations. Our estimation process considers, among other matters, the cost of known claims over time, cost inflation and incurred but not reported claims. These estimates may change based on, among other things, changes in our claims history or receipt of additional information relevant to assessing the claims. Further, these estimates may prove to be inaccurate due to factors such as adverse judicial determinations or settlements at higher than estimated amounts. Accordingly, we may be required to increase or decrease our reserve levels. Results of Operations As discussed in note 4 to our consolidated financial statements, our reportable segments are general rentals and trench, power and fluid solutions. The general rentals segment includes the rental of construction, aerial, industrial and homeowner equipment and related services and activities. The general rentals segment’s customers include construction and industrial companies, manufacturers, utilities, municipalities, homeowners and government entities. This segment operates throughout the United States and Canada. The trench, power and fluid solutions segment is comprised of: (i) the Trench Safety region, which rents trench safety equipment such as trench shields, aluminum hydraulic shoring systems, slide rails, crossing plates, construction lasers and line testing equipment for underground work, (ii) the Power and HVAC region, which rents power and HVAC equipment such as portable diesel generators, electrical distribution equipment, and temperature control equipment including heating and cooling equipment, and (iii) the Fluid Solutions and (iv) Fluid Solutions Europe regions, both of which rent equipment primarily used for fluid containment, transfer and treatment. The trench, power and fluid solutions segment’s customers include construction companies involved in infrastructure projects, municipalities and industrial companies. This segment operates throughout the United States and in Canada and Europe.As discussed in note 4 to our consolidated financial statements, we aggregate our eleven geographic regions—Carolinas, Gulf South, Industrial (which serves the geographic Gulf region and has a strong industrial presence), Mid-Atlantic, Mid Central, Midwest, Northeast, Pacific West, South, Southeast and Western Canada—into our general rentals reporting segment. Historically, there have been variances in the levels of equipment rentals gross margins achieved by these regions. For the five year period ended December 31, 2020, three of our general rentals' regions had an equipment rentals gross margin that varied by between 10 percent and 25 percent from the equipment rentals gross margins of the aggregated general rentals' regions over the same period. For the five year period ended December 31, 2020, the general rentals' region with the lowest equipment rentals gross margin was Western Canada. The Western Canada region's equipment rentals gross margin of 30.9 percent for the five year period ended December 31, 2020 was 25 percent less than the equipment rentals gross margins of the aggregated general rentals' regions over the same period. The Western Canada region's equipment rentals gross margin was less than the 36Table of Contentsother general rentals' regions during this period primarily due to declines in the oil and gas business in the region. The rental industry is cyclical, and there historically have been regions with equipment rentals gross margins that varied by greater than 10 percent from the equipment rentals gross margins of the aggregated general rentals' regions, though the specific regions with margin variances of over 10 percent have fluctuated. We expect margin convergence going forward given the cyclical nature of the rental industry, and monitor the margin variances and confirm the expectation of future convergence on a quarterly basis. When monitoring for margin convergence, we include projected future results.We similarly monitor the margin variances for the regions in the trench, power and fluid solutions segment. The trench, power and fluid solutions segment includes the locations acquired in the July 2018 BakerCorp acquisition. As such, there is not a long history of the acquired locations' rental margins included in the trench, power and fluid solutions segment. When monitoring for margin convergence, we include projected future results. We monitor the trench, power and fluid solutions segment margin variances and confirm the expectation of future convergence on a quarterly basis. The historic, pre-acquisition margins for the acquired BakerCorp locations are lower than the margins achieved at the other locations in the segment. We expect that the margins at the acquired locations will increase as we realize synergies following the acquisition, as a result of which, we expect future margin convergence.We believe that the regions that are aggregated into our segments have similar economic characteristics, as each region is capital intensive, offers similar products to similar customers, uses similar methods to distribute its products, and is subject to similar competitive risks. The aggregation of our regions also reflects the management structure that we use for making operating decisions and assessing performance. Although we believe aggregating these regions into our reporting segments for segment reporting purposes is appropriate, to the extent that there are significant margin variances that do not converge, we may be required to disaggregate the regions into separate reporting segments. Any such disaggregation would have no impact on our consolidated results of operations.These segments align our external segment reporting with how management evaluates business performance and allocates resources. We evaluate segment performance primarily based on segment equipment rentals gross profit. Our revenues, operating results, and financial condition fluctuate from quarter to quarter reflecting the seasonal rental patterns of our customers, with rental activity tending to be lower in the winter. Revenues by segment were as follows: General rentalsTrench, power and fluid solutions TotalYear Ended December 31, 2020Equipment rentals$5,472 $1,668 $7,140 Sales of rental equipment785 73 858 Sales of new equipment214 33 247 Contractor supplies sales64 34 98 Service and other revenues164 23 187 Total revenue$6,699 $1,831 $8,530 Year Ended December 31, 2019Equipment rentals$6,202 $1,762 $7,964 Sales of rental equipment768 63 831 Sales of new equipment238 30 268 Contractor supplies sales71 33 104 Service and other revenues157 27 184 Total revenue$7,436 $1,915 $9,351 Year Ended December 31, 2018Equipment rentals$5,550 $1,390 $6,940 Sales of rental equipment619 45 664 Sales of new equipment186 22 208 Contractor supplies sales68 23 91 Service and other revenues127 17 144 Total revenue$6,550 $1,497 $8,047 37Table of ContentsEquipment rentals. 2020 equipment rentals of $7.1 billion decreased 10.3 percent. COVID-19 began to impact our operations in March 2020. Through February 2020, equipment rentals were up slightly year-over-year. Since March, equipment rentals have decreased year-over-year, primarily due to the impact of COVID-19. Fleet productivity decreased 6.9 percent, primarily due to the impact of COVID-19 since March, when rental volume declined in response to shelter-in-place orders and other market restrictions. Through February, fleet productivity was flat year-over-year and in line with expectations. Equipment rentals represented 84 percent of total revenues in 2020. On a segment basis, equipment rentals represented 82 percent and 91 percent of total revenues for general rentals and trench, power and fluid solutions, respectively. General rentals equipment rentals decreased 11.8 percent as compared to 2019, primarily due to COVID-19. As noted above, COVID-19 began to impact our operations in March 2020, when rental volume declined in response to shelter-in-place orders and other market restrictions. Trench, power and fluid solutions equipment rentals decreased 5.3 percent as compared to 2019, primarily due to COVID-19, partially offset by a slight increase in average OEC. 2019 equipment rentals of $8.0 billion increased 14.8 percent, primarily due to a 17.7 percent increase in average OEC, which includes the impact of the BakerCorp and BlueLine acquisitions. On a pro forma basis including the standalone, pre-acquisition results of BakerCorp and BlueLine, equipment rentals increased 4.1 percent, primarily due to a 4.9 percent increase in average OEC and a fleet productivity increase of 0.6 percent, partially offset by the impact of inflation. Equipment rentals represented 85 percent of total revenues in 2019. On a segment basis, equipment rentals represented 83 percent and 92 percent of total revenues for general rentals and trench, power and fluid solutions, respectively. General rentals equipment rentals increased 11.7 percent as compared to 2018, primarily reflecting a 15.4 percent increase in average OEC, which includes the impact of the BlueLine acquisition. On a pro forma basis including the standalone, pre-acquisition results of BlueLine, equipment rental revenue increased 1.8 percent year-over-year, primarily due to a 3.8 percent increase in average OEC, partially offset by the impact of fleet inflation. Trench, power and fluid solutions equipment rentals increased 26.8 percent as compared to 2018, primarily reflecting the impact of acquisitions, including BakerCorp, and cold starts. On a pro forma basis including the standalone, pre-acquisition results of BakerCorp, equipment rental revenue increased 12.8 percent year-over-year, primarily due to a 14.1 percent increase in average OEC, partially offset by the impact of fleet inflation. The pro forma increase in average OEC includes the impact of cold starts and acquisitions other than BakerCorp.Sales of rental equipment. For the three years in the period ended December 31, 2020, sales of rental equipment represented approximately 9 percent of our total revenues. Our general rentals segment accounted for most of these sales. 2020 sales of rental equipment did not change materially from 2019. 2019 sales of rental equipment of $831 increased 25.2 percent from 2018 primarily reflecting increased volume, which included the impact of the BlueLine acquisition, driven by a larger fleet size in a strong used equipment market. Average OEC for the year ended December 31, 2019 increased 17.7 percent year-over-year.Sales of new equipment. For the three years in the period ended December 31, 2020, sales of new equipment represented approximately 3 percent of our total revenues. Our general rentals segment accounted for most of these sales. 2020 sales of new equipment of $247 decreased 7.8 percent from 2019 primarily due to the impact of COVID-19. 2019 sales of new equipment of $268 increased 28.8 percent from 2018 primarily reflecting increased volume driven by broad-based demand. Sales of contractor supplies. For the three years in the period ended December 31, 2020, sales of contractor supplies represented approximately 1 percent of our total revenues. Our general rentals segment accounted for most of these sales. 2020 sales of contractor supplies did not change materially from 2019, and 2019 sales of contractor supplies did not change materially from 2018. Service and other revenues. For the three years in the period ended December 31, 2020, service and other revenues represented approximately 2 percent of our total revenues. Our general rentals segment accounted for most of these sales. 2020 service and other revenues did not change materially from 2019. 2019 service and other revenues of $184 increased 27.8 percent from 2018 primarily reflecting an increased emphasis on this line of business and the impact of the BlueLine acquisition. Fourth Quarter 2020 Items. As discussed in note 12 to our consolidated financial statements, in the fourth quarter of 2020, we redeemed all of our 4 5/8 percent Senior Notes due 2025, using borrowings available under our ABL facility. Upon redemption, we recognized a loss of $24 in interest expense, net, reflecting the difference between the net carrying amount and the total purchase price of the redeemed notes. Fourth Quarter 2019 Items. In the fourth quarter of 2019, we issued $750 aggregate principal amount of 3 7/8 percent Senior Secured Notes due 2027 and redeemed all of our 4 5/8 percent Senior Secured Notes. Upon redemption, we recognized a 38Table of Contentsloss of $29 in interest expense, net. The loss represented the difference between the net carrying amount and the total purchase price of the redeemed notes. In the fourth quarter of 2019, we also completed the $1.25 billion share repurchase program that commenced in July 2018. Segment Equipment Rentals Gross ProfitSegment equipment rentals gross profit and gross margin for each of the three years in the period ended December 31, 2020 were as follows: General rentalsTrench, power and fluid solutions Total2020Equipment Rentals Gross Profit$1,954 $765 $2,719 Equipment Rentals Gross Margin35.7 %45.9 %38.1 %2019Equipment Rentals Gross Profit$2,407 $800 $3,207 Equipment Rentals Gross Margin38.8 %45.4 %40.3 %2018Equipment Rentals Gross Profit$2,293 $670 $2,963 Equipment Rentals Gross Margin41.3 %48.2 %42.7 %General rentals. For the three years in the period ended December 31, 2020, general rentals accounted for 75 percent of our total equipment rentals gross profit. This contribution percentage is consistent with general rentals’ equipment rental revenue contribution over the same period. For the year ended December 31, 2020, general rentals’ equipment rentals gross profit decreased by $453, and equipment rentals gross margin decreased by 310 basis points, from 2019, with 240 basis points of the margin decline due to an increase in depreciation expense as a percentage of revenue. The increase in depreciation expense includes a $26 asset impairment charge, which was not related to COVID-19, associated with the discontinuation of certain equipment programs. Excluding the impact of the asset impairment charge, depreciation expense decreased slightly from 2019, but increased as a percentage of revenue, primarily due to COVID-19. As noted above, COVID-19 began to impact our operations in March 2020, and, since then, equipment rentals have remained down year-over-year in response to shelter-in-place orders and other market restrictions. The remaining 70 basis point decline in equipment rentals gross margin was primarily due to the impact of COVID-19, partially offset by the impact of actions we have taken to manage operating costs, such as the reduction of overtime and temporary labor, and the leveraging of our current capacity to reduce the need for third-party delivery and repair services.General rentals’ equipment rentals gross profit in 2019 increased by $114, primarily due to increased equipment rentals, including the impact of the BlueLine acquisition. As discussed above, equipment rentals increased 11.7 percent as compared to 2018, primarily reflecting a 15.4 percent increase in average OEC. Equipment rentals gross margin decreased 250 basis points from 2018, due primarily to the impact of the BlueLine acquisition and increased operating costs. The BlueLine acquisition was a significant driver of the 17.7 percent depreciation increase, which exceeded the equipment rentals increase of 11.7 percent. Operating costs were impacted by repair and repositioning initiatives that resulted in increased repairs and maintenance expense, which increased 19.8 percent (such increase includes the impact of both the BlueLine acquisition and the repair and repositioning initiatives).Trench, power and fluid solutions. For the year ended December 31, 2020, equipment rentals gross profit decreased by $35, and equipment rentals gross margin increased by 50 basis points from 2019. The increased gross margin primarily reflected decreases in certain operating costs, including delivery, repairs and labor, partially offset by increases in depreciation expense and certain fixed expenses, such as facility costs, as a percentage of revenue. As noted above, we have reduced overtime and temporary labor primarily in response to the impact of COVID-19, and have leveraged our current capacity to reduce the need for third-party delivery and repair services. Depreciation expense was largely flat year-over-year, but increased as a percentage of revenue, primarily due to COVID-19. For the year ended December 31, 2019, equipment rentals gross profit increased by $130 and equipment rentals gross margin decreased 280 basis points from 2018. The increase in equipment rentals gross profit primarily reflects increased equipment rentals revenue on a larger fleet. Year-over-year, trench, power and fluid solutions equipment rentals increased 26.8 percent and average OEC increased 36.0 percent primarily due to the impact of acquisitions, including BakerCorp, and cold starts. On a pro forma basis including the standalone, pre-acquisition results of BakerCorp, equipment rental revenue increased 39Table of Contents12.8 percent year-over-year, primarily due to a 14.1 percent increase in average OEC. The decrease in the equipment rentals gross margin was primarily due to the impact of acquisitions.Gross Margin. Gross margins by revenue classification were as follows: Year Ended December 31, Change20202019201820202019Total gross margin37.3%39.2%41.8%(190) bps(260) bpsEquipment rentals38.1%40.3%42.7%(220) bps(240) bpsSales of rental equipment38.7%37.7%41.9%100 bps(420) bpsSales of new equipment13.4%13.8%13.9%(40) bps(10) bpsContractor supplies sales29.6%29.8%34.1%(20) bps(430) bpsService and other revenues37.4%44.6%43.8%(720) bps80 bps2020 gross margin of 37.3 percent decreased 190 basis points from 2019. Equipment rentals gross margin decreased 220 basis points year-over-year, with 190 basis points of the margin decline due to an increase in depreciation expense as a percentage of revenue. Depreciation expense included a $30 asset impairment charge, which was not related to COVID-19, associated with the discontinuation of certain equipment programs. Excluding the impact of the asset impairment charge, depreciation expense decreased slightly from 2019, but increased as a percentage of revenue, primarily due to COVID-19. As noted above, COVID-19 began to impact our operations in March 2020, and, since then, equipment rentals have remained down year-over-year in response to shelter-in-place orders and other market restrictions. The remaining 30 basis point decline in equipment rentals gross margin was primarily due to the impact of COVID-19, partially offset by the impact of actions we have taken to manage operating costs, such as the reduction of overtime and temporary labor, and the leveraging of our current capacity to reduce the need for third-party delivery and repair services. Gross margin from sales of rental equipment increased 100 basis points from 2019 primarily due to lower margin sales of fleet acquired in the BlueLine acquisition in 2019. The gross margin fluctuations from sales of new equipment, contractor supplies sales and service and other revenues generally reflect normal variability and, to varying degrees, the impact of COVID-19, and such revenue types did not account for a significant portion of total gross profit (gross profit for these revenue types represented 4 percent of total gross profit for the year ended December 31, 2020). Gross margin from service and other revenues was particularly impacted by COVID-19, which resulted in reduced training revenue without a proportionate reduction in costs. 2019 gross margin of 39.2 percent decreased 260 basis points from 2018. Equipment rentals gross margin decreased 240 basis points year-over-year, due primarily to the impact of the BlueLine and BakerCorp acquisitions and increased operating costs. The BlueLine and BakerCorp acquisitions were significant drivers of the 19.7 percent depreciation increase, which exceeded the equipment rentals increase of 14.8 percent. Operating costs were impacted by repair and repositioning initiatives that resulted in increased repairs and maintenance expense, which increased 22.4 percent (such increase includes the impact of both 1) the BlueLine and BakerCorp acquisitions and 2) the repair and repositioning initiatives). On a pro forma basis including the standalone, pre-acquisition results of BakerCorp and BlueLine, equipment rentals increased 4.1 percent, primarily due to a 4.9 percent increase in average OEC and a fleet productivity increase of 0.6 percent, partially offset by the impact of inflation. Gross margin from sales of rental equipment decreased 420 basis points from 2018 primarily due to lower margin sales of fleet acquired in the BlueLine acquisition and changes in the mix of equipment sold and channel mix. The gross margin fluctuations from sales of new equipment, contractor supplies sales and service and other revenues generally reflect normal variability, and such margins did not have a significant impact on total gross margin (gross profit for these revenue types represented 4 percent of total gross profit for the year ended December 31, 2019).Other costs/(income)The table below includes the other costs/(income) in our consolidated statements of income, as well as key associated metrics, for the three years in the period ended December 31, 2020: 40Table of ContentsYear Ended December 31,Change 20202019201820202019Selling, general and administrative ("SG&A") expense$979 $1,092 $1,038 (10.3)%5.2%SG&A expense as a percentage of revenue11.5 %11.7 %12.9 %(20) bps(120) bpsMerger related costs— 1 36 (100.0)%(97.2)%Restructuring charge17 18 31 (5.6)%(41.9)%Non-rental depreciation and amortization387 407 308 (4.9)%32.1%Interest expense, net669 648 481 3.2%34.7%Other income, net(8)(10)(6)(20.0)%66.7%Provision (benefit) for income taxes249 340 380 (26.8)%(10.5)%Effective tax rate21.9 %22.5 %25.7 %(60) bps(320) bpsSG&A expense primarily includes sales force compensation, information technology costs, third party professional fees, management salaries, bad debt expense and clerical and administrative overhead. The decrease in SG&A expense as a percentage of revenue for the year ended December 31, 2020 primarily reflects significant reductions in professional fees and travel and entertainment expenses, which were implemented in response to COVID-19, partially offset by increases in salaries and stock compensation as a percentage of revenue. Total salary and stock compensation expense was largely flat year-over-year, generally reflecting normal variability, but increased as a percentage of revenue due in part to the COVID-19 impact on revenue. The decrease in SG&A expense as a percentage of revenue for the year ended December 31, 2019 primarily reflects a reduction in stock compensation as a percentage of revenue, and decreased bad debt expense. The reduced bad debt expense primarily reflects our adoption in 2019 of an updated lease accounting standard (see note 13 to the consolidated financial statements for further detail). This standard requires that we recognize doubtful accounts associated with lease revenues as a reduction to equipment rentals revenue (such amounts were recognized as SG&A expense prior to 2019).The merger related costs reflect transaction costs associated with the NES and Neff acquisitions that were completed in 2017, and the BakerCorp and BlueLine acquisitions that were completed in 2018. We have made a number of acquisitions in the past and may continue to make acquisitions in the future. Merger related costs only include costs associated with major acquisitions that significantly impact our operations. The historic acquisitions that have included merger related costs are RSC, which had annual revenues of approximately $1.5 billion prior to the acquisition, National Pump, which had annual revenues of over $200 prior to the acquisition, NES, which had annual revenues of approximately $369 prior to the acquisition, Neff, which had annual revenues of approximately $413 prior to the acquisition, BakerCorp, which had annual revenues of approximately $295 prior to the acquisition, and BlueLine, which had annual revenues of approximately $786 prior to the acquisition. The restructuring charges for the years ended December 31, 2020, 2019 and 2018 primarily reflect severance costs and branch closure charges associated with our restructuring programs. See note 5 to our consolidated financial statements for additional information.Non-rental depreciation and amortization includes (i) the amortization of other intangible assets and (ii) depreciation expense associated with equipment that is not offered for rent (such as computers and office equipment) and amortization expense associated with leasehold improvements. Our other intangible assets consist of customer relationships, non-compete agreements and trade names and associated trademarks. The year-over-year increase in non-rental depreciation and amortization for the year ended December 31, 2019 primarily reflects the impact of the BakerCorp and BlueLine acquisitions discussed above.Interest expense, net for the years ended December 31, 2020 and 2019 included aggregate debt redemption losses of $183 and $61, respectively. The debt redemption losses primarily reflect the difference between the net carrying amount and the total purchase price of the redeemed notes. Excluding the impact of these losses, interest expense, net for the year ended December 31, 2020 decreased by 17.2 percent year-over-year primarily due to decreases in average debt and the average cost of debt. Excluding the impact of the 2019 losses, interest expense, net for the year ended December 31, 2019 increased year-over-year primarily due to the impact of higher average debt. The year-over-year increase in average debt includes the impact of the debt used to finance the BakerCorp and BlueLine acquisitions discussed above. A detailed reconciliation of the effective tax rates to the U.S. federal statutory income tax rate is included in note 14 to our consolidated financial statements.In March 2020, the Coronavirus Aid, Relief and Economic Security Act ("CARES Act”) was enacted. The CARES Act, among other things, includes provisions relating to net operating loss carryback periods, alternative minimum tax credit 41Table of Contentsrefunds, modifications to the net interest deduction limitations, technical corrections to tax depreciation methods for qualified improvement property and deferral of employer payroll taxes. The CARES Act did not materially impact our effective tax rate for the year ended December 31, 2020, although it will impact the timing of future cash payments for taxes. As of December 31, 2020, we have deferred employer payroll taxes of $54 under the CARES Act, with approximately half of the deferral due in each of 2021 and 2022.Balance sheet. Accounts receivable, net decreased by $215, or 14.1 percent, from December 31, 2019 to December 31, 2020 primarily due to decreased revenue, which included the impact of COVID-19. Prepaid expenses and other assets increased by $235, or 167.9 percent, from December 31, 2019 to December 31, 2020, primarily due to deposits placed on rental equipment as of December 31, 2020, as discussed further in note 6 to our consolidated financial statements.Liquidity and Capital Resources. We manage our liquidity using internal cash management practices, which are subject to (i) the policies and cooperation of the financial institutions we utilize to maintain and provide cash management services, (ii) the terms and other requirements of the agreements to which we are a party and (iii) the statutes, regulations and practices of each of the local jurisdictions in which we operate. See "Financial Overview" above for a summary of the 2020 capital structure actions taken to improve our financial flexibility and liquidity. Since 2012, we have repurchased a total of $3.7 billion of Holdings' common stock under five completed share repurchase programs. On January 28, 2020, our Board of Directors authorized a new $500 share repurchase program, which commenced in the first quarter of 2020 and was intended to run for 12 months. Through March 18, 2020, when the program was paused due to the COVID-19 pandemic, we repurchased $257 of common stock under the program. We are currently unable to estimate when, or if, the program will be restarted, and we expect to provide an update at a future date.Our principal existing sources of cash are cash generated from operations and from the sale of rental equipment, and borrowings available under our ABL and accounts receivable securitization facilities. As of December 31, 2020, we had cash and cash equivalents of $202. Cash equivalents at December 31, 2020 consist of direct obligations of financial institutions rated A or better. We believe that our existing sources of cash will be sufficient to support our existing operations over the next 12 months. The table below presents financial information associated with our principal sources of cash as of and for the year December 31, 2020:ABL facility:Borrowing capacity, net of letters of credit$2,705 Outstanding debt, net of debt issuance costs (1)977 Interest rate at December 31, 20201.4 %Average month-end principal amount of debt outstanding (1) 794 Weighted-average interest rate on average debt outstanding1.9 %Maximum month-end principal amount of debt outstanding (1)1,494 Accounts receivable securitization facility:Borrowing capacity166 Outstanding debt, net of debt issuance costs634 Interest rate at December 31, 20201.5 %Average month-end principal amount of debt outstanding667 Weighted-average interest rate on average debt outstanding1.8 %Maximum month-end principal amount of debt outstanding811 ___________________(1)The outstanding amount of debt under the ABL facility and the average outstanding amount are less than the maximum outstanding amount primarily due to the use of proceeds (i) from the issuance of 4 percent Senior Notes discussed in note 12 to the consolidated financial statements and (ii) from operations to reduce borrowings under the facility. At the time of the 4 percent Senior Notes offering, we indicated our expectation that we would re-borrow an amount equal to the net proceeds from the offering, along with additional borrowings under the ABL facility, to redeem the $800 principal amount of our 5 1/2 percent Senior Notes due 2025 on or after July 15, 2020. Prior to redeeming the 5 1/2 percent Senior Notes due 2025, we considered the impact of COVID-19 on liquidity, and assessed our available sources and anticipated uses of cash, including, with respect to sources, cash generated from operations and from the sale of rental equipment. In August 2020, we redeemed the 5 1/2 percent Senior Notes due 2025. As discussed above, disciplined management of capital expenditures and fleet capacity is a component of our COVID-19 response plan, and, in 2020, capital expenditures 42Table of Contentsdecreased significantly year-over-year. The decreased capital expenditures contributed to our ability to use proceeds from operations to reduce borrowings under the ABL facility.We expect that our principal needs for cash relating to our operations over the next 12 months will be to fund (i) operating activities and working capital, (ii) the purchase of rental equipment and inventory items offered for sale, (iii) payments due under operating leases, (iv) debt service, (v) share repurchases and (vi) acquisitions. We plan to fund such cash requirements from our existing sources of cash. In addition, we may seek additional financing through the securitization of some of our real estate, the use of additional operating leases or other financing sources as market conditions permit. For information on the scheduled principal and interest payments coming due on our outstanding debt and on the payments coming due under our existing operating leases, see “Certain Information Concerning Contractual Obligations.” To access the capital markets, we rely on credit rating agencies to assign ratings to our securities as an indicator of credit quality. Lower credit ratings generally result in higher borrowing costs and reduced access to debt capital markets. Credit ratings also affect the costs of derivative transactions, including interest rate and foreign currency derivative transactions. As a result, negative changes in our credit ratings could adversely impact our costs of funding. Our credit ratings as of January 25, 2021 were as follows: Corporate RatingOutlook Moody’sBa2PositiveStandard & Poor’sBBStableA security rating is not a recommendation to buy, sell or hold securities. There is no assurance that any rating will remain in effect for a given period of time or that any rating will not be revised or withdrawn by a rating agency in the future. The amount of our future capital expenditures will depend on a number of factors, including general economic conditions and growth prospects. We expect that we will fund such expenditures from cash generated from operations, proceeds from the sale of rental and non-rental equipment and, if required, borrowings available under the ABL facility and accounts receivable securitization facility. Net rental capital expenditures (defined as purchases of rental equipment less the proceeds from sales of rental equipment) were $103 and $1.301 billion in 2020 and 2019, respectively. As discussed above, disciplined management of capital expenditures and fleet capacity is a component of our COVID-19 response plan, which contributed to the year-over-year decrease in net rental capital expenditures.Loan Covenants and Compliance. As of December 31, 2020, we were in compliance with the covenants and other provisions of the ABL, accounts receivable securitization and term loan facilities and the senior notes. Any failure to be in compliance with any material provision or covenant of these agreements could have a material adverse effect on our liquidity and operations. The only financial covenant that currently exists under the ABL facility is the fixed charge coverage ratio. Subject to certain limited exceptions specified in the ABL facility, the fixed charge coverage ratio covenant under the ABL facility will only apply in the future if specified availability under the ABL facility falls below 10 percent of the maximum revolver amount under the ABL facility. When certain conditions are met, cash and cash equivalents and borrowing base collateral in excess of the ABL facility size may be included when calculating specified availability under the ABL facility. As of December 31, 2020, specified availability under the ABL facility exceeded the required threshold and, as a result, this financial covenant was inapplicable. Under our accounts receivable securitization facility, we are required, among other things, to maintain certain financial tests relating to: (i) the default ratio, (ii) the delinquency ratio, (iii) the dilution ratio and (iv) days sales outstanding. The accounts receivable securitization facility also requires us to comply with the fixed charge coverage ratio under the ABL facility, to the extent the ratio is applicable under the ABL facility.URNA’s payment capacity is restricted under the covenants in the ABL and term loan facilities and the indentures governing its outstanding indebtedness. Although this restricted capacity limits our ability to move operating cash flows to Holdings, because of certain intercompany arrangements, we do not expect any material adverse impact on Holdings’ ability to meet its cash obligations. Sources and Uses of Cash. During 2020, we (i) generated cash from operating activities of $2.658 billion, which included $300 of cash outflow for refundable deposits on expected rental equipment purchases, as discussed further in note 6 to the consolidated financial statements, and (ii) generated cash from the sale of rental and non-rental equipment of $900. We used cash during this period principally to (i) purchase rental and non-rental equipment of $1.158 billion, (ii) make debt payments, net of proceeds, of $1.985 billion and (iii) purchase shares of our common stock for $286. During 2019, we (i) generated cash from operating activities of $3.024 billion and (ii) generated cash from the sale of rental and non-rental equipment of $868. We used cash during this period principally to (i) purchase rental and non-rental equipment of $2.350 billion, (ii) purchase other companies for $249, (iii) make debt payments, net of proceeds, of $418 and (iv) purchase shares of our common stock for $870. 43Table of ContentsFree Cash Flow GAAP Reconciliation We define “free cash flow” as net cash provided by operating activities less purchases of, and plus proceeds from, equipment. The equipment purchases and proceeds are included in cash flows from investing activities. Management believes that free cash flow provides useful additional information concerning cash flow available to meet future debt service obligations and working capital requirements. However, free cash flow is not a measure of financial performance or liquidity under GAAP. Accordingly, free cash flow should not be considered an alternative to net income or cash flow from operating activities as an indicator of operating performance or liquidity. The table below provides a reconciliation between net cash provided by operating activities and free cash flow. Year Ended December 31, 202020192018Net cash provided by operating activities$2,658 $3,024 $2,853 Purchases of rental equipment(961)(2,132)(2,106)Purchases of non-rental equipment(197)(218)(185)Proceeds from sales of rental equipment858 831 664 Proceeds from sales of non-rental equipment42 37 23 Insurance proceeds from damaged equipment40 24 22 Free cash flow$2,440 $1,566 $1,271 Free cash flow for the year ended December 31, 2020 was $2.440 billion, an increase of $874 as compared to $1.566 billion for the year ended December 31, 2019. Free cash flow increased primarily due to decreased net rental capital expenditures (purchases of rental equipment less the proceeds from sales of rental equipment), partially offset by reduced net cash provided by operating activities, which included the impact of a $300 cash outflow in 2020 for refundable deposits on expected rental equipment purchases, as discussed further in note 6 to the consolidated financial statements. Net rental capital expenditures decreased $1.198 billion, or 92 percent, year-over-year. As discussed above, disciplined management of capital expenditures and fleet capacity is a component of our COVID-19 response plan, which contributed to the year-over-year decrease in net rental capital expenditures. Free cash flow for the year ended December 31, 2019 was $1.566 billion, an increase of $295 as compared to $1.271 billion for the year ended December 31, 2018. Free cash flow increased primarily due to increased cash provided by operating activities and increased proceeds from sales of rental equipment. Net rental capital expenditures decreased $141, or 10 percent, year-over-year. Certain Information Concerning Contractual Obligations. The table below provides certain information concerning the payments coming due under certain categories of our existing contractual obligations as of December 31, 2020:20212022202320242025ThereafterTotal Debt and finance leases (1)$704 $47 $36 $1,004 $939 $7,025 $9,755 Interest due on debt (2)376 371 370 357 351 853 2,678 Operating leases (1)205 176 144 112 76 113 826 Service agreements (3)16 15 16 — — — 47 Purchase obligations (4)1,569 — — — — — 1,569 Transition tax on unremitted foreign earnings and profits (5)— — — — — 5 5 Total (6)$2,870 $609 $566 $1,473 $1,366 $7,996 $14,880 _________________(1) The payments due with respect to a period represent (i) in the case of debt and finance leases, the scheduled principal payments due in such period, and (ii) in the case of operating leases, the payments due in such period for non-cancelable operating leases with initial or remaining terms of one year or more. See note 12 to the consolidated financial statements for further debt information, and note 13 for further finance lease and operating lease information.(2) Estimated interest payments have been calculated based on the principal amount of debt and the applicable interest rates as of December 31, 2020. (3) These primarily represent service agreements with third parties to provide wireless and network services. (4) As of December 31, 2020, we had outstanding advance purchase orders, which were negotiated in the ordinary course of business, with our equipment and inventory suppliers. These purchase orders can generally be cancelled by us without cancellation penalties. The equipment and inventory receipts from the suppliers pursuant to these purchase orders and the related payments to the suppliers are expected to be completed throughout 2021. The total above includes $300 for 44Table of Contentsrefundable deposits on expected rental equipment purchases, as discussed further in note 6 to the consolidated financial statements. In 2020, due primarily to COVID-19, we canceled a significant portion of our purchase orders. In the fourth quarter of 2020, we entered into a significant amount of purchase commitments, which increased the obligations to levels that are consistent with historic obligations. The obligations above reflect our continuing assessment of the impact of COVID-19, which will also inform our future purchases.(5) The Tax Cuts and Jobs Act, which was enacted in December 2017, included a transition tax on unremitted foreign earnings and profits. We have elected to pay the transition tax amount payable of $55 over an eight-year period. The amount that we expect to pay as reflected in the table above represents the total we owe, net of an overpayment of federal taxes, which we are required to apply to the transition tax(6) This information excludes $10 of unrecognized tax benefits. It is not possible to estimate the time period during which these unrecognized tax benefits may be paid to tax authorities. Additionally, we are exposed to various claims relating to our business, including those for which we retain portions of the losses through the application of deductibles and self-insured retentions, which we sometimes refer to as “self-insurance.” Our self-insurance reserves totaled $127 at December 31, 2020. Self-insurance liabilities are based on estimates and actuarial assumptions and can fluctuate in both amount and in timing of cash settlement because historical trends are not necessarily predictive of the future, and, accordingly, are not included in the table above.Relationship between Holdings and URNA. Holdings is principally a holding company and primarily conducts its operations through its wholly owned subsidiary, URNA, and subsidiaries of URNA. Holdings licenses its tradename and other intangibles and provides certain services to URNA in connection with its operations. These services principally include: (i) senior management services; (ii) finance and tax-related services and support; (iii) information technology systems and support; (iv) acquisition-related services; (v) legal services; and (vi) human resource support. In addition, Holdings leases certain equipment and real property that are made available for use by URNA and its subsidiaries. Information Regarding Guarantors of URNA IndebtednessURNA is 100 percent owned by Holdings and has certain outstanding indebtedness that is guaranteed by both Holdings and, with the exception of its U.S. special purpose vehicle which holds receivable assets relating to the Company’s accounts receivable securitization facility (the “SPV”), all of URNA’s U.S. subsidiaries (the “guarantor subsidiaries”). Other than the guarantee by our Canadian subsidiary of URNA's indebtedness under the ABL facility, none of URNA’s indebtedness is guaranteed by URNA's foreign subsidiaries or the SPV (together, the “non-guarantor subsidiaries”). The receivable assets owned by the SPV have been sold or contributed by URNA to the SPV and are not available to satisfy the obligations of URNA or Holdings’ other subsidiaries. Holdings consolidates each of URNA and the guarantor subsidiaries in its consolidated financial statements. URNA and the guarantor subsidiaries are all 100 percent-owned and controlled by Holdings. Holdings’ guarantees of URNA’s indebtedness are full and unconditional, except that the guarantees may be automatically released and relieved upon satisfaction of the requirements for legal defeasance or covenant defeasance under the applicable indenture being met. The Holdings guarantees are also subject to subordination provisions (to the same extent that the obligations of the issuer under the relevant notes are subordinated to other debt of the issuer) and to a standard limitation which provides that the maximum amount guaranteed by Holdings will not exceed the maximum amount that can be guaranteed without making the guarantee void under fraudulent conveyance laws.The guarantees of Holdings and the guarantor subsidiaries are made on a joint and several basis. The guarantees of the guarantor subsidiaries are not full and unconditional because a guarantor subsidiary can be automatically released and relieved of its obligations under certain circumstances, including sale of the guarantor subsidiary, the sale of all or substantially all of the guarantor subsidiary's assets, the requirements for legal defeasance or covenant defeasance under the applicable indenture being met, designating the guarantor subsidiary as an unrestricted subsidiary for purposes of the applicable covenants or the notes being rated investment grade by both Standard & Poor’s Ratings Services and Moody’s Investors Service, Inc., or, in certain circumstances, another rating agency selected by URNA. Like the Holdings guarantees, the guarantees of the guarantors subsidiaries are subject to subordination provisions (to the same extent that the obligations of the issuer under the relevant notes are subordinated to other debt of the issuer) and to a standard limitation which provides that the maximum amount guaranteed by each guarantor will not exceed the maximum amount that can be guaranteed without making the guarantee void under fraudulent conveyance laws. All of the existing guarantees by Holdings and the guarantor subsidiaries rank equally in right of payment with all of the guarantors' existing and future senior indebtedness. The secured indebtedness of Holdings and the guarantor subsidiaries (including guarantees of URNA’s existing and future secured indebtedness) will rank effectively senior to guarantees of any unsecured indebtedness to the extent of the value of the assets securing such indebtedness. Future guarantees of subordinated indebtedness will rank junior to any existing and future senior indebtedness of the guarantors. The guarantees of URNA’s indebtedness are effectively junior to any indebtedness of our subsidiaries that are not guarantors, including our foreign subsidiaries. As of December 31, 2020, indebtedness of our non-guarantors included (i) $634 of outstanding borrowings by the 45Table of ContentsSPV in connection with the Company’s accounts receivable securitization facility, (ii) $5 of outstanding borrowings under the ABL facility by non-guarantor subsidiaries and (iii) $11 of finance leases of our non-guarantor subsidiaries.Covenants in the ABL facility, accounts receivable securitization and term loan facilities, and the other agreements governing our debt, impose operating and financial restrictions on URNA, Holdings and the guarantor subsidiaries, including limitations on the ability to make share repurchases and dividend payments. As of December 31, 2020, the amount available for distribution under the most restrictive of these covenants was $1.060 billion. The Company’s total available capacity for making share repurchases and dividend payments includes the intercompany receivable balance of Holdings. As of December 31, 2020, our total available capacity for making share repurchases and dividend payments, which includes URNA’s capacity to make restricted payments and the intercompany receivable balance of Holdings, was $4.064 billion.Based on our understanding of Rule 3-10 of Regulation S-X ("Rule 3-10"), we believe that Holdings’ guarantees of URNA indebtedness comply with the conditions set forth in Rule 3-10, which enable us to present summarized financial information for Holdings, URNA and the consolidated guarantor subsidiaries in accordance with Rule 13-01 of Regulation S-X. The summarized financial information excludes information regarding the non-guarantor subsidiaries. In accordance with Rule 3-10, separate financial statements of the guarantor subsidiaries have not been presented. The summarized financial information of Holdings, URNA and the guarantor subsidiaries on a combined basis is as follows:December 31, 2020Current assets$496Long-term assets16,461Total assets16,957Current liabilities1,151Long-term liabilities11,261Total liabilities12,412Year Ended December 31, 2020Total revenues$7,796Gross profit2,910Net income890Item 7A. Quantitative and Qualitative Disclosures About Market Risk Our exposure to market risk primarily consists of (i) interest rate risk associated with our variable and fixed rate debt and (ii) foreign currency exchange rate risk associated with our foreign operations. Interest Rate Risk. As of December 31, 2020, we had an aggregate of $2.6 billion of indebtedness that bears interest at variable rates, comprised of borrowings under the ABL, accounts receivable securitization and term loan facilities. See note 12 to our consolidated financial statements for the amounts outstanding, and the interest rates thereon, as of December 31, 2020 under these facilities. As of December 31, 2020, based upon the amount of our variable rate debt outstanding, our annual after-tax earnings would decrease by approximately $20 for each one percentage point increase in the interest rates applicable to our variable rate debt.The amount of variable rate indebtedness outstanding may fluctuate significantly. For additional information concerning the terms of our variable rate debt, see note 12 to our consolidated financial statements.At December 31, 2020, we had an aggregate of $7.1 billion of indebtedness that bears interest at fixed rates. A one percentage point decrease in market interest rates as of December 31, 2020 would increase the fair value of our fixed rate indebtedness by approximately seven percent. For additional information concerning the fair value and terms of our fixed rate debt, see note 11 (see “Fair Value of Financial Instruments”) and note 12 to our consolidated financial statements. Currency Exchange Risk. We operate in the U.S., Canada and Europe. In July 2018, we completed the acquisition of BakerCorp, which allowed for our entry into select European markets. Our presence in Europe is limited, and most of our foreign revenue and income is from Canada. During the year ended December 31, 2020, our foreign subsidiaries accounted for $733, or 9 percent, of our total revenue of $8.530 billion, and $83, or 7 percent, of our total pretax income of $1.139 billion. 46Table of ContentsBased on the size of our foreign operations relative to the Company as a whole, we do not believe that a 10 percent change in exchange rates would have a material impact on our earnings. We do not engage in purchasing forward exchange contracts for speculative purposes. 47Table of Contents
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+ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSThe following discussion should be read together with the accompanying Consolidated Financial Statements and Notes to the Consolidated Financial Statements thereto included in Part II Item 8, “Financial Statements.” Readers are cautioned the statements, estimates, projections or outlook contained in this report, including discussions regarding financial prospects, economic conditions, trends and uncertainties contained in this Item 7, may constitute forward-looking statements within the meaning of the PSLRA. These forward-looking statements involve risks and uncertainties which may cause our actual results to differ materially from the expectations expressed or implied in the forward-looking statements. A description of some of the risks and uncertainties can be found further below in this Item 7 and in Part I, Item 1A, “Risk Factors.” Discussions of year-over-year comparisons between 2019 and 2018 are not included in this Form 10-K and can be found in Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” of the Company’s Form 10-K for the fiscal year ended December 31, 2019.EXECUTIVE OVERVIEW GeneralUnitedHealth Group is a diversified health care company with a mission to help people live healthier lives and help make the health system work better for everyone. Our two complementary businesses — Optum and UnitedHealthcare — are driven by this unified mission and vision to improve health care access, affordability, experiences and outcomes for the individuals and organizations we are privileged to serve.We have four reportable segments across our two business platforms, Optum and UnitedHealthcare:•OptumHealth;•OptumInsight;•OptumRx; and•UnitedHealthcare, which includes UnitedHealthcare Employer & Individual, UnitedHealthcare Medicare & Retirement, UnitedHealthcare Community & State and UnitedHealthcare Global.Further information on our business and reportable segments is presented in Part I, Item 1, “Business” and in Note 14 of the Notes to the Consolidated Financial Statements included in Part II, Item 8, “Financial Statements.”COVID-19 Trends and UncertaintiesThe COVID-19 pandemic continues to evolve and the ultimate impact on our business, results of operations, financial condition and cash flows remains uncertain. During the second quarter, the global health system experienced unprecedented levels of care deferral, which impacted all of our businesses. As the pandemic advanced, access to and demand for care was most constrained from mid-March through April, began to recover in May and June and restored to near normal seasonal levels in the third quarter. Care patterns continued to normalize in the fourth quarter, returning to, and even exceeding, seasonal baselines, including COVID-19 treatment and testing costs, towards the end of the quarter. The temporary deferral of care experienced in 2020 may cause care patterns to moderately exceed normal baselines in future periods as utilization of health system capacity continues to increase. From time to time, health system capacity may be subject to possible increased volatility due to the pandemic. Specific trends and uncertainties related to our two business platforms are as follows:Optum. The temporary deferral of care impacted the Optum businesses for the year ended December 31, 2020. For example, our fee-for-service care delivery business, such as traditional procedure work at our ambulatory surgery centers, was negatively impacted, while our risk-based care delivery business performance reflected lower demand for care. Our OptumInsight and OptumRx volume-based businesses were negatively impacted by the lower level of care encounters which took place, as well as by broader economic factors, contributing to lower managed services and prescription volume. As the health system returned to normal seasonally adjusted levels of care, we have seen business activity approach normal levels. COVID-19 will also continue to influence customer and consumer behavior, both during and after the pandemic, which could impact how care is delivered and the manner in which consumers wish to receive their prescription drugs or infusion services. The impact of COVID-19 on our care provider and payer clients could impact the volume and types of services Optum provides, as well as the pacing of potential new business opportunities. As a result of the dynamic situation and broad-reaching impact to the health system, the ultimate impact of COVID-19 on our Optum businesses is uncertain.25Table of ContentsUnitedHealthcare. During 2020, we expanded benefit coverage in areas such as COVID-19 care and testing, telemedicine, and pharmacy benefits; provided customers assistance in the form of co-pay waivers and premium forgiveness; offered additional enrollment opportunities to those who previously declined employer-sponsored offerings; extended certain premium payment terms for customers experiencing financial hardship; simplified administrative practices; and accelerated payments to care providers, all with the aim of assisting our customers, care providers, members and communities in addressing the COVID-19 crisis. Temporary care deferrals significantly impacted UnitedHealthcare’s results of operations for the year ended December 31, 2020. The impact of temporary care deferrals was offset by COVID-19 related care and testing, the significant financial assistance we provided our customers, rebate requirements and broader economic impacts. Enrollment in our commercial products declined primarily due to employer actions in response to the pandemic. Increased consumer demand for care, potentially even higher acuity care, along with continued COVID-19 care and testing costs are expected to result in increased future medical costs. Disrupted care patterns, as a result of the pandemic, may temporarily affect the ability to obtain complete member health status information, impacting future revenue in businesses utilizing risk adjustment methodologies. The ultimate overall impact is uncertain and dependent on the future pacing and intensity of the pandemic, the duration of policies and initiatives to address COVID-19, and general economic uncertainty.Business TrendsOur businesses participate in the United States, South America and certain other international health markets. In the United States, health care spending has grown consistently for many years and comprises 18% of gross domestic product (GDP). We expect overall spending on health care to continue to grow in the future, due to inflation, medical technology and pharmaceutical advancement, regulatory requirements, demographic trends in the population and national interest in health and well-being. The rate of market growth may be affected by a variety of factors, including macro-economic conditions, such as the economic impact of COVID-19, and regulatory changes, which could impact our results of operations, including our continued efforts to control health care costs.Pricing Trends. To price our health care benefit products, we start with our view of expected future costs, including any potential impacts from COVID-19. We frequently evaluate and adjust our approach in each of the local markets we serve, considering relevant factors, such as product positioning, price competitiveness and environmental, competitive, legislative and regulatory considerations, including minimum MLR thresholds. We will continue seeking to balance growth and profitability across all of these dimensions. The commercial risk market remains highly competitive in both the small group and large group segments. We expect broad-based competition to continue as the industry adapts to individual and employer needs. The ACA had an annual, nondeductible insurance industry tax (Health Insurance Industry Tax) to be levied proportionally across the insurance industry for risk-based health insurance products. Pricing for contracts covering some portion of calendar year 2021 reflected the permanent repeal of the Health Insurance Industry Tax.Medicare Advantage funding continues to be pressured, as discussed below in “Regulatory Trends and Uncertainties.” We expect Medicaid revenue growth due to anticipated changes in mix and increases in the number of people we serve; we also believe the payment rate environment creates the risk of continued downward pressure on Medicaid margin percentages. We continue to take a prudent, market-sustainable posture for both new business and maintenance of existing relationships. We continue to advocate for actuarially sound rates commensurate with our medical cost trends and we remain dedicated to partnering with those states who are committed to the long-term viability of their programs.Medical Cost Trends. Our medical cost trends primarily relate to changes in unit costs, health system utilization and prescription drug costs. COVID-19 care and testing costs and certain of our customer assistance initiatives have also impacted medical cost trends in the current year and may continue in future years. We endeavor to mitigate those increases by engaging physicians and consumers with information and helping them make clinically sound choices, with the objective of helping them achieve high-quality, affordable care. The uncertain impact of COVID-19 may impact our ability to estimate medical costs payable, which could result in increased variability to medical cost reserve development in future periods.Delivery System and Payment Modernization. The health care market continues to change based on demographic shifts, new regulations, political forces and both payer and patient expectations. Health plans and care providers are being called upon to work together to close gaps in care and improve overall care quality, improve the health of populations and reduce costs. We continue to see a greater number of people enrolled in plans with underlying performance-based care provider payment models rewarding high-quality, affordable care and foster collaboration. We work together with clinicians to leverage our data and analytics to provide the necessary information to close gaps in care and improve overall health outcomes for patients.We are increasingly rewarding care providers for delivering improvements in quality and cost-efficiency. As of December 31, 2020, we served nearly 18 million people through some form of aligned contractual arrangement, including full-risk, shared-risk and bundled episode-of-care and performance incentive payment approaches. 26Table of ContentsThis trend is creating needs for health management services which can coordinate care around the primary care physician, including new primary care channels, and for investments in new clinical and administrative information and management systems, which we believe provide growth opportunities for our Optum business platform. Regulatory Trends and UncertaintiesFollowing is a summary of management’s view of the trends and uncertainties related to some of the key provisions of the ACA and other regulatory matters. For additional information regarding the ACA and regulatory trends and uncertainties, see Part I, Item 1 “Business - Government Regulation” and Item 1A, “Risk Factors.”Medicare Advantage Rates. Final 2021 Medicare Advantage rates resulted in an increase in industry base rates of approximately 1.7%, short of the industry forward medical cost trend, creating continued pressure in the Medicare Advantage program. The ongoing Medicare Advantage funding pressure places continued importance on effective medical management and ongoing improvements in administrative efficiency. There are a number of adjustments we have made to partially offset these rate pressures and reductions. In some years, these adjustments impact the majority of the seniors we serve through Medicare Advantage. For example, we seek to intensify our medical and operating cost management, make changes to the size and composition of our care provider networks, adjust members' benefits and implement or increase the member premiums supplementing the monthly payments we receive from the government. Additionally, we decide annually on a county-by-county basis where we will offer Medicare Advantage plans.Our Medicare Advantage rates are currently enhanced by CMS quality bonuses in certain counties based on our local plans’ Star ratings. The level of Star ratings from CMS, based upon specified clinical and operational performance standards, will impact future quality bonuses. ACA Tax. After a moratorium in 2019, the industry-wide amount of the Health Insurance Industry Tax for 2020, which was primarily borne by customers, was $15.5 billion, with our portion being approximately $3.0 billion. The return of the tax impacted year-over-year comparability of our financial statements, including revenues, operating costs, medical care ratio (MCR), operating cost ratio, effective tax rate and cash flows from operations. The Health Insurance Industry Tax was permanently repealed by Congress, effective January 1, 2021.SELECTED OPERATING PERFORMANCE ITEMSThe following represents a summary of select 2020 year-over-year operating comparisons to 2019.•Consolidated revenues increased by 6%, UnitedHealthcare revenues increased 4% and Optum revenues grew 21%. •UnitedHealthcare served 420,000 fewer people domestically primarily due to increased unemployment and attrition in commercial group benefits, partially offset by growth in government programs.•Earnings from operations increased by 14%, including increases of 20% at UnitedHealthcare and 7% at Optum.•Diluted earnings per common share increased 12% to $16.03. •Cash flows from operations were $22.2 billion, an increase of 20%.•Return on equity was 24.9%.27Table of ContentsRESULTS SUMMARYThe following table summarizes our consolidated results of operations and other financial information:(in millions, except percentages and per share data)For the Years Ended December 31,Change2020201920182020 vs. 2019Revenues:Premiums$201,478 $189,699 $178,087 $11,779 6 %Products34,145 31,597 29,601 2,548 8 Services20,016 18,973 17,183 1,043 5 Investment and other income1,502 1,886 1,376 (384)(20)Total revenues257,141 242,155 226,247 14,986 6 Operating costs:Medical costs159,396 156,440 145,403 2,956 2 Operating costs41,704 35,193 34,074 6,511 19 Cost of products sold30,745 28,117 26,998 2,628 9 Depreciation and amortization2,891 2,720 2,428 171 6 Total operating costs234,736 222,470 208,903 12,266 6 Earnings from operations22,405 19,685 17,344 2,720 14 Interest expense(1,663)(1,704)(1,400)41 (2)Earnings before income taxes20,742 17,981 15,944 2,761 15 Provision for income taxes(4,973)(3,742)(3,562)(1,231)33 Net earnings15,769 14,239 12,382 1,530 11 Earnings attributable to noncontrolling interests(366)(400)(396)34 (9)Net earnings attributable to UnitedHealth Group common shareholders$15,403 $13,839 $11,986 $1,564 11 %Diluted earnings per share attributable to UnitedHealth Group common shareholders$16.03 $14.33 $12.19 $1.70 12 %Medical care ratio (a)79.1 %82.5 %81.6 %(3.4)%Operating cost ratio16.2 14.5 15.1 1.7 Operating margin8.7 8.1 7.7 0.6 Tax rate24.0 20.8 22.3 3.2 Net earnings margin (b)6.0 5.7 5.3 0.3 Return on equity (c)24.9 %25.7 %24.4 %(0.8)%________ (a)Medical care ratio is calculated as medical costs divided by premium revenue.(b)Net earnings margin attributable to UnitedHealth Group shareholders.(c)Return on equity is calculated as net earnings attributable to UnitedHealth Group common shareholders divided by average shareholders’ equity. Average shareholders’ equity is calculated using the shareholders’ equity balance at the end of the preceding year and the shareholders’ equity balances at the end of each of the four quarters of the year presented.2020 RESULTS OF OPERATIONS COMPARED TO 2019 RESULTSConsolidated Financial ResultsRevenueThe increases in revenue were primarily driven by the increase in the number of individuals served through Medicare Advantage and Medicaid; pricing trends; and organic and acquisition growth across the Optum business, primarily due to expansion in pharmacy care services and care delivery. The increases were partially offset by decreased individuals served through our commercial and Global benefits businesses, certain voluntary customer assistance programs and rebate requirements. Revenues were also negatively impacted by decreases in our fee-for-service care delivery and other volume-based businesses, primarily as a result of the care deferral and economic impacts of COVID-19.Medical Costs and MCRMedical costs increased as a result of growth in people served through Medicare Advantage and Medicaid, medical cost trends and COVID-19 care and testing costs, partially offset by decreased people served in commercial and Global, modestly lower care patterns and increased prior year favorable development. The MCR decreased primarily due to the temporary deferral of care and the revenue effects of the return of the Health Insurance Industry Tax, partially offset by COVID-19 care and testing costs, rebate requirements and voluntary customer assistance measures. 28Table of ContentsOperating Cost RatioThe operating cost ratio increased primarily due to the impact of the return of the Health Insurance Industry Tax, COVID-19 response efforts and business mix, partially offset by operating efficiency gains.Income Tax RateOur effective tax rate increased primarily due to the impact of the return of the nondeductible Health Insurance Industry Tax.Reportable SegmentsSee Note 14 of Notes to the Consolidated Financial Statements included in Part II, Item 8, “Financial Statements” for more information on our segments. We utilize various metrics to evaluate and manage our reportable segments, including individuals served by UnitedHealthcare by major market segment and funding arrangement, people served by OptumHealth and adjusted scripts for OptumRx. These metrics are the main drivers of revenue, earnings and cash flows at each business. The metrics also allow management and investors to evaluate and understand business mix, customer penetration and pricing trends when comparing the metrics to revenue by segment.The following table presents a summary of the reportable segment financial information: For the Years Ended December 31,Change(in millions, except percentages)2020201920182020 vs. 2019RevenuesUnitedHealthcare$200,875 $193,842 $183,476 $7,033 4 %OptumHealth39,808 30,317 24,145 9,491 31 OptumInsight10,802 10,006 9,008 796 8 OptumRx87,498 74,288 69,536 13,210 18 Optum eliminations(1,800)(1,661)(1,409)(139)8 Optum136,308 112,950 101,280 23,358 21 Eliminations(80,042)(64,637)(58,509)(15,405)24 Consolidated revenues$257,141 $242,155 $226,247 $14,986 6 %Earnings from operationsUnitedHealthcare$12,359 $10,326 $9,113 $2,033 20 %OptumHealth3,434 2,963 2,430 471 16 OptumInsight2,725 2,494 2,243 231 9 OptumRx3,887 3,902 3,558 (15)— Optum10,046 9,359 8,231 687 7 Consolidated earnings from operations$22,405 $19,685 $17,344 $2,720 14 %Operating marginUnitedHealthcare6.2 %5.3 %5.0 %0.9 %OptumHealth8.6 9.8 10.1 (1.2)OptumInsight25.2 24.9 24.9 0.3 OptumRx4.4 5.3 5.1 (0.9)Optum7.4 8.3 8.1 (0.9)Consolidated operating margin8.7 %8.1 %7.7 %0.6 %UnitedHealthcareThe following table summarizes UnitedHealthcare revenues by business: For the Years Ended December 31,Change(in millions, except percentages)2020201920182020 vs. 2019UnitedHealthcare Employer & Individual$55,872 $56,945 $54,761 $(1,073)(2)%UnitedHealthcare Medicare & Retirement90,764 83,252 75,473 7,512 9 UnitedHealthcare Community & State46,487 43,790 43,426 2,697 6 UnitedHealthcare Global7,752 9,855 9,816 (2,103)(21)Total UnitedHealthcare revenues$200,875 $193,842 $183,476 $7,033 4 %29Table of ContentsThe following table summarizes the number of individuals served by our UnitedHealthcare businesses, by major market segment and funding arrangement: December 31,Change(in thousands, except percentages)2020201920182020 vs. 2019Commercial:Risk-based7,910 8,575 8,495 (665)(8)%Fee-based18,310 19,185 18,420 (875)(5)Total commercial26,220 27,760 26,915 (1,540)(6)Medicare Advantage5,710 5,270 4,945 440 8 Medicaid6,620 5,900 6,450 720 12 Medicare Supplement (Standardized)4,460 4,500 4,545 (40)(1)Total public and senior16,790 15,670 15,940 1,120 7 Total UnitedHealthcare - domestic medical43,010 43,430 42,855 (420)(1)Global5,425 5,720 6,220 (295)(5)Total UnitedHealthcare - medical48,435 49,150 49,075 (715)(1)%Supplemental Data:Medicare Part D stand-alone4,045 4,405 4,710 (360)(8)%Fee-based and risk-based commercial business decreased primarily due to increased unemployment and related attrition. Medicare Advantage increased due to growth in people served through individual Medicare Advantage plans. The increase in people served through Medicaid was primarily driven by states easing redetermination requirements due to COVID-19 and growth in people served via Dual Special Needs Plans. The decrease in people served by UnitedHealthcare Global is a result of increased unemployment and underwriting discipline.UnitedHealthcare’s revenue increased due to growth in the number of individuals served through Medicare Advantage and Medicaid, a greater mix of people with higher acuity needs and the return of the Health Insurance Industry Tax, partially offset by a decrease in the number of individuals served through the commercial and Global businesses and foreign currency impacts. In 2020, earnings from operations increased due to the deferral of care caused by COVID-19 on the health system and the factors impacting revenue, partially offset by the return of the Health Insurance Industry Tax, COVID-19 care and testing costs, customer assistance programs and broader economic effects. OptumTotal revenues increased as each segment reported revenue growth. Earnings from operations increased due to growth at OptumHealth and OptumInsight.The results by segment were as follows:OptumHealthRevenue and earnings at OptumHealth increased primarily due to organic growth and acquisitions in risk-based care delivery. Reduced care volumes in fee-for-service arrangements as a result of COVID-19 partially offset the increases in revenues and earnings. OptumHealth served approximately 98 million people as of December 31, 2020 compared to 96 million people as of December 31, 2019.OptumInsightRevenue and earnings from operations at OptumInsight increased primarily due to growth in technology and managed services, partially offset by decreased activity levels in volume-based services due to the impact of COVID-19 on payer and care provider clients. OptumRxRevenue at OptumRx and the corresponding eliminations increased due to the inclusion of retail pharmacy co-payments. See Note 2 of the Notes to the Consolidated Financial Statements included in Part II, Item 8, "Financial Statements" for further detail. Revenue at OptumRx also increased due to organic and acquisition growth in pharmacy care services, including specialty pharmacy, and new client wins, partially offset by an expected large client transition and lower script volumes driven by COVID-19 related care deferral and fewer people served due to economic-driven employment attrition. Earnings from operations remained relatively flat as COVID-19 impacts were partially offset by the factors impacting revenue and improved 30Table of Contentssupply chain management. OptumRx fulfilled 1.3 billion adjusted scripts in both 2020 and 2019 with growth offset by the large client transition. LIQUIDITY, FINANCIAL CONDITION AND CAPITAL RESOURCESLiquidityIntroductionWe manage our liquidity and financial position in the context of our overall business strategy. We continually forecast and manage our cash, investments, working capital balances and capital structure to meet the short-term and long-term obligations of our businesses while seeking to maintain liquidity and financial flexibility. Cash flows generated from operating activities are principally from earnings before noncash expenses. Our regulated subsidiaries generate significant cash flows from operations and are subject to, among other things, minimal levels of statutory capital, as defined by their respective jurisdiction, and restrictions on the timing and amount of dividends paid to their parent companies.Our U.S. regulated subsidiaries paid their parent companies dividends of $8.3 billion and $5.6 billion in 2020 and 2019, respectively. See Note 10 of the Notes to the Consolidated Financial Statements included in Part II, Item 8, “Financial Statements” for further detail concerning our regulated subsidiary dividends.Our nonregulated businesses also generate significant cash flows from operations available for general corporate use. Cash flows generated by these entities, combined with dividends from our regulated entities and financing through the issuance of long-term debt as well as issuance of commercial paper or the ability to draw under our committed credit facilities, further strengthen our operating and financial flexibility. We use these cash flows to expand our businesses through acquisitions, reinvest in our businesses through capital expenditures, repay debt and return capital to our shareholders through dividends and repurchases of our common stock.Summary of our Major Sources and Uses of Cash and Cash Equivalents For the Years Ended December 31,Change(in millions)2020201920182020 vs. 2019Sources of cash:Cash provided by operating activities$22,174 $18,463 $15,713 $3,711 Issuances of long-term debt and short-term borrowings, net of repayments2,586 3,994 4,134 (1,408)Proceeds from common share issuances1,440 1,037 838 403 Customer funds administered1,677 13 — 1,664 Other— 219 — (219)Total sources of cash27,877 23,726 20,685 Uses of cash:Cash paid for acquisitions, net of cash assumed(7,139)(8,343)(5,997)1,204 Cash dividends paid(4,584)(3,932)(3,320)(652)Common share repurchases(4,250)(5,500)(4,500)1,250 Purchases of property, equipment and capitalized software(2,051)(2,071)(2,063)20 Purchases of investments, net of sales and maturities (2,836)(2,504)(4,099)(332)Other(965)(1,237)(1,743)272 Total uses of cash(21,825)(23,587)(21,722)Effect of exchange rate changes on cash and cash equivalents(116)(20)(78)(96)Net increase (decrease) in cash and cash equivalents$5,936 $119 $(1,115)$5,817 2020 Cash Flows Compared to 2019 Cash FlowsIncreased cash flows provided by operating activities were primarily driven by higher net earnings as well as changes in working capital accounts. Other significant changes in sources or uses of cash year-over-year included an increase in customer funds administered and net purchases of investments, and decreases in net issuances of long-term debt and short-term borrowings, cash paid for acquisitions and share repurchases.31Table of ContentsFinancial ConditionAs of December 31, 2020, our cash, cash equivalent, available-for-sale debt securities and equity securities balances of $59.0 billion included $16.9 billion of cash and cash equivalents (of which $1.3 billion was available for general corporate use), $39.8 billion of debt securities and $2.3 billion of equity securities. Given the significant portion of our portfolio held in cash equivalents, we do not anticipate fluctuations in the aggregate fair value of our financial assets to have a material impact on our liquidity or capital position. Other sources of liquidity, primarily from operating cash flows and our commercial paper program, which is fully supported by our bank credit facilities, reduce the need to sell investments during adverse market conditions. See Note 4 of the Notes to the Consolidated Financial Statements included in Part II, Item 8, “Financial Statements” for further detail concerning our fair value measurements.Our available-for-sale debt portfolio had a weighted-average duration of 3.7 years and a weighted-average credit rating of “Double A” as of December 31, 2020. When multiple credit ratings are available for an individual security, the average of the available ratings is used to determine the weighted-average credit rating.Capital Resources and Uses of LiquidityCash Requirements. The Company’s cash requirements within the next twelve months include medical costs payable, accounts payable and accrued liabilities, commercial paper and current maturities of long-term debt, other current liabilities, and purchase commitments and other obligations. We expect the cash required to meet these obligations to be primarily generated through cash flows from current operations; cash available for general corporate use; and the realization of current assets, such as accounts receivable. Our long-term cash requirements under our various contractual obligations and commitments include:•Debt Obligations. See Note 8 of the Notes to the Consolidated Financial Statements included in Part II, Item 8, “Financial Statements” for further detail of our commercial paper and long-term debt and the timing of expected future payments. Interest coupon payments are typically paid semi-annually.•Operating leases. See Note 12 of the Notes to the Consolidated Financial Statements included in Part II, Item 8, “Financial Statements” for further detail of our obligations and the timing of expected future payments.•Purchase and other obligations. These include $5.3 billion, $2.0 billion of which is expected to be paid within the next twelve months, of fixed or minimum commitments under existing purchase obligations for goods and services, including agreements cancelable with the payment of an early termination penalty, and remaining capital commitments for venture capital funds and other funding commitments. These amounts exclude agreements cancelable without penalty and liabilities to the extent recorded in our Consolidated Balance Sheets as of December 31, 2020.•Other Liabilities. These include other long-term liabilities reflected in our Consolidated Balance Sheets as of December 31, 2020, including obligations associated with certain employee benefit programs, unrecognized tax benefits and various long-term liabilities, which have some inherent uncertainty in the timing of these payments.•Redeemable noncontrolling interests. See Note 2 of the Notes to the Consolidated Financial Statements included in Part II, Item 8, “Financial Statements” for further detail. We do not have any material required redemptions in the next twelve months.We expect the cash required to meet our long-term obligations to be primarily generated through future cash flows from operations. However, we also have the ability to generate cash to satisfy both our current and long-term requirements through the issuance of commercial paper, issuance of long-term debt, or drawing under our committed credit facilities or the ability to sell investments. We believe our capital resources are sufficient to meet future, short-term and long-term, liquidity needs.Short-Term Borrowings. Our revolving bank credit facilities provide liquidity support for our commercial paper borrowing program, which facilitates the private placement of senior unsecured debt through independent broker-dealers, and are available for general corporate purposes. For more information on our commercial paper and bank credit facilities, see Note 8 of the Notes to the Consolidated Financial Statements included in Part II, Item 8, “Financial Statements.”Our revolving bank credit facilities contain various covenants, including covenants requiring us to maintain a defined debt to debt-plus-shareholders’ equity ratio of not more than 60%, subject to increase in certain circumstances set forth in the applicable credit agreement. As of December 31, 2020, our debt to debt-plus-shareholders’ equity ratio, as defined and calculated under the credit facilities, was 38%.Long-Term Debt. Periodically, we access capital markets to issue long-term debt for general corporate purposes, such as, to meet our working capital requirements, to refinance debt, to finance acquisitions or for share repurchases. For more information on our debt, see Note 8 of the Notes to the Consolidated Financial Statements included in Part II, Item 8 “Financial Statements.”32Table of ContentsCredit Ratings. Our credit ratings as of December 31, 2020 were as follows: Moody’sS&P GlobalFitchA.M. Best RatingsOutlookRatingsOutlookRatingsOutlookRatingsOutlookSenior unsecured debtA3StableA+StableAStableA-PositiveCommercial paperP-2n/aA-1n/aF1n/aAMB-1n/aThe availability of financing in the form of debt or equity is influenced by many factors, including our profitability, operating cash flows, debt levels, credit ratings, debt covenants and other contractual restrictions, regulatory requirements and economic and market conditions. A significant downgrade in our credit ratings or adverse conditions in the capital markets may increase the cost of borrowing for us or limit our access to capital.Share Repurchase Program. As of December 31, 2020, we had Board authorization to purchase up to 58 million shares of our common stock. For more information on our share repurchase program, see Note 10 of the Notes to the Consolidated Financial Statements included in Part II, Item 8, “Financial Statements.”Dividends. In June 2020, the Company’s Board of Directors increased the Company’s quarterly cash dividend to shareholders to an annual rate of $5.00 compared to $4.32 per share, which the Company had paid since June 2019. For more information on our dividend, see Note 10 of the Notes to the Consolidated Financial Statements included in Part II, Item 8, “Financial Statements.”Pending Acquisitions. In the fourth quarter of 2020, we entered into agreements to acquire multiple companies in the health care sector, which are expected to close in the first half of 2021, subject to regulatory approval and other customary closing conditions. Additionally, in January 2021, we entered into agreements to purchase multiple companies in the health care sector, most notably, Change Healthcare (NASDAQ: CHNG). This acquisition is expected to close in the second half of 2021, subject to Change Healthcare shareholders’ approval, regulatory approvals and other customary closing conditions. The total anticipated capital required for these acquisitions, excluding the payoff of acquired indebtedness, is approximately $13 billion.We do not have other significant contractual obligations or commitments requiring cash resources. However, we continually evaluate opportunities to expand our operations, which include internal development of new products, programs and technology applications and may include acquisitions.RECENTLY ISSUED ACCOUNTING STANDARDS See Note 2 of the Notes to the Consolidated Financial Statements in Part II, Item 8 “Financial Statements” for a discussion of new accounting pronouncements which affect us.CRITICAL ACCOUNTING ESTIMATESCritical accounting estimates are those estimates requiring management to make challenging, subjective or complex judgments, often because they must estimate the effects of matters inherently uncertain and may change in subsequent periods. Critical accounting estimates involve judgments and uncertainties which are sufficiently sensitive and may result in materially different results under different assumptions and conditions. Medical Costs PayableMedical costs and medical costs payable include estimates of our obligations for medical care services rendered on behalf of insured consumers, but for which claims have either not yet been received or processed. Depending on the health care professional and type of service, the typical billing lag for services can be up to 90 days from the date of service. Approximately 90% of claims related to medical care services are known and settled within 90 days from the date of service and substantially all within twelve months. As of December 31, 2020, our days outstanding in medical payables was 48 days, calculated as total medical payables divided by total medical costs times the number of days in the period. In each reporting period, our operating results include the effects of more completely developed medical costs payable estimates associated with previously reported periods. If the revised estimate of prior period medical costs is less than the previous estimate, we will decrease reported medical costs in the current period (favorable development). If the revised estimate of prior period medical costs is more than the previous estimate, we will increase reported medical costs in the current period (unfavorable development). Medical costs in 2020, 2019 and 2018 included favorable medical cost development related to prior years of $880 million, $580 million and $320 million, respectively.In developing our medical costs payable estimates, we apply different estimation methods depending on the month for which incurred claims are being estimated. For example, for the most recent two months, we estimate claim costs incurred by applying 33Table of Contentsobserved medical cost trend factors to the average per member per month (PMPM) medical costs incurred in prior months for which more complete claim data is available, supplemented by a review of near-term completion factors.Completion Factors. A completion factor is an actuarial estimate, based upon historical experience and analysis of current trends, of the percentage of incurred claims during a given period adjudicated by us at the date of estimation. Completion factors are the most significant factors we use in developing our medical costs payable estimates for periods prior to the most recent two months. Completion factors include judgments in relation to claim submissions such as the time from date of service to claim receipt, claim levels and processing cycles, as well as other factors. Our judgments also consider the impacts of COVID-19 on these factors. If actual claims submission rates from providers (which can be influenced by a number of factors, including provider mix and electronic versus manual submissions) or our claim processing patterns are different than estimated, our reserve estimates may be significantly impacted.The following table illustrates the sensitivity of these factors and the estimated potential impact on our medical costs payable estimates for those periods as of December 31, 2020: Completion Factors(Decrease) Increase in FactorsIncrease (Decrease)In Medical Costs Payable(in millions)(0.75)%$600 (0.50)399 (0.25)199 0.25(198)0.50(395)0.75(591)Medical Cost Per Member Per Month Trend Factors. Medical cost PMPM trend factors are significant factors we use in developing our medical costs payable estimates for the most recent two months. Medical cost trend factors are developed through a comprehensive analysis of claims incurred in prior months, provider contracting and expected unit costs, benefit design and a review of a broad set of health care utilization indicators, which included consideration of COVID-19 in 2020. These factors include but are not limited to pharmacy utilization trends, inpatient hospital authorization data and influenza incidence data from the National Centers for Disease Control. We also consider macroeconomic variables such as GDP growth, employment and disposable income. A large number of factors can cause the medical cost trend to vary from our estimates, including: our ability and practices to manage medical and pharmaceutical costs, changes in level and mix of services utilized, mix of benefits offered, including the impact of co-pays and deductibles, changes in medical practices, catastrophes, epidemics and pandemics, such as COVID-19. The following table illustrates the sensitivity of these factors and the estimated potential impact on our medical costs payable estimates for the most recent two months as of December 31, 2020: Medical Cost PMPM Quarterly TrendIncrease (Decrease) in FactorsIncrease (Decrease)In Medical Costs Payable(in millions)3%$793 2529 1264 (1)(264)(2)(529)(3)(793)The completion factors and medical costs PMPM trend factors analyses above include outcomes considered reasonably likely based on our historical experience estimating liabilities for incurred but not reported benefit claims. Management believes the amount of medical costs payable is reasonable and adequate to cover our liability for unpaid claims as of December 31, 2020; however, actual claim payments may differ from established estimates as discussed above. Assuming a hypothetical 1% difference between our December 31, 2020 estimates of medical costs payable and actual medical costs payable, excluding AARP Medicare Supplement Insurance and any potential offsetting impact from premium rebates, 2020 net earnings would have increased or decreased by approximately $157 million. For more detail related to our medical cost estimates, see Note 2 of the Notes to the Consolidated Financial Statements included in Part II, Item 8, “Financial Statements.” 34Table of ContentsGoodwillWe evaluate goodwill for impairment annually or more frequently when an event occurs or circumstances change indicating the carrying value may not be recoverable. When testing goodwill for impairment, we may first assess qualitative factors to determine if it is more likely than not the carrying value of a reporting unit exceeds its estimated fair value. During a qualitative analysis, we consider the impact of changes, if any, to the following factors: macroeconomic, industry and market factors, cost factors, changes in overall financial performance, and any other relevant events and uncertainties impacting a reporting unit. If our qualitative assessment indicates a goodwill impairment is more likely than not, we perform additional quantitative analyses. We may also elect to skip the qualitative testing and proceed directly to the quantitative testing. For reporting units where a quantitative analysis is performed, we perform a test measuring the fair values of the reporting units and comparing them to their aggregate carrying values, including goodwill. If the fair value is less than the carrying value of the reporting unit, an impairment is recognized for the difference, up to the carrying amount of goodwill.We estimate the fair values of our reporting units using a discounted cash flow method or a weighted combination of discounted cash flows and a market-based method. The discounted cash flow method includes assumptions about a wide variety of internal and external factors. Significant assumptions used in the discounted cash flow method include financial projections of free cash flow, including revenue trends, medical costs trends, operating productivity, income taxes and capital levels; long-term growth rates for determining terminal value beyond the discretely forecasted periods; and discount rates. Financial projections and long-term growth rates used for our reporting units are consistent with, and use inputs from, our internal long-term business plan and strategies. Discount rates are determined for each reporting unit and include consideration of the implied risk inherent in their forecasts. Our most significant estimate in the discount rate determinations involves our adjustments to the peer company weighted average costs of capital reflecting reporting unit-specific factors. We have not made any adjustments to decrease a discount rate below the calculated peer company weighted average cost of capital for any reporting unit. Company-specific adjustments to discount rates are subjective and thus are difficult to measure with certainty. The passage of time and the availability of additional information regarding areas of uncertainty with respect to the reporting units’ operations could cause these assumptions to change in the future. Additionally, as part of our quantitative impairment testing, we perform various sensitivity analyses on certain key assumptions, such as discount rates, cash flow projections and peer company multiples to analyze the potential for a material impact. The market-based method requires determination of appropriate peer group whose securities are traded on an active market. The peer group is used to derive market multiples to estimate fair value. As of October 1, 2020, we completed our annual impairment tests for goodwill with all of our reporting units having fair values substantially in excess of their carrying values. LEGAL MATTERSA description of our legal proceedings is presented in Note 12 of Notes to the Consolidated Financial Statements included in Part II, Item 8, “Financial Statements.” CONCENTRATIONS OF CREDIT RISKInvestments in financial instruments such as marketable securities and accounts receivable may subject us to concentrations of credit risk. Our investments in marketable securities are managed under an investment policy authorized by our Board of Directors. This policy limits the amounts which may be invested in any one issuer and generally limits our investments to U.S. government and agency securities, state and municipal securities and corporate debt obligations of investment grade. Concentrations of credit risk with respect to accounts receivable are limited due to the large number of employer groups and other customers constituting our client base. As of December 31, 2020, there were no significant concentrations of credit risk.ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKOur primary market risks are exposures to changes in interest rates impacting our investment income and interest expense and the fair value of certain of our fixed-rate investments and debt, as well as foreign currency exchange rate risk of the U.S. dollar primarily to the Brazilian real and Chilean peso.As of December 31, 2020, we had $20 billion of financial assets on which the interest rates received vary with market interest rates, which may significantly impact our investment income. Also as of December 31, 2020, $8 billion of our financial liabilities, which include commercial paper, debt and deposit liabilities, were at interest rates which vary with market rates, either directly or through the use of related interest rate swap contracts.The fair value of our fixed-rate investments and debt also varies with market interest rates. As of December 31, 2020, $37 billion of our investments were fixed-rate debt securities and $45 billion of our debt was non-swapped fixed-rate term debt. An increase in market interest rates decreases the market value of fixed-rate investments and fixed-rate debt. Conversely, a decrease in market interest rates increases the market value of fixed-rate investments and fixed-rate debt.35Table of ContentsWe manage exposure to market interest rates by diversifying investments across different fixed-income market sectors and debt across maturities, as well as by matching a portion of our floating-rate assets and liabilities, either directly or through the use of interest rate swap contracts. Unrealized gains and losses on investments in available-for-sale debt securities are reported in comprehensive income.The following tables summarize the impact of hypothetical changes in market interest rates across the entire yield curve by 1% point or 2% points as of December 31, 2020 and 2019 on our investment income and interest expense per annum and the fair value of our investments and debt (in millions, except percentages):December 31, 2020Increase (Decrease) in Market Interest RateInvestmentIncome PerAnnumInterestExpense PerAnnumFair Value ofFinancial AssetsFair Value ofFinancial Liabilities 2%$401 $163 $(3,020)$(8,700)1201 82 (1,499)(4,744)(1)(75)(12)820 5,266 (2)(75)(12)886 8,101 December 31, 2019Increase (Decrease) in Market Interest RateInvestmentIncome PerAnnumInterestExpense PerAnnumFair Value ofFinancial AssetsFair Value ofFinancial Liabilities 2%$282 $185 $(2,668)$(6,813)1141 93 (1,331)(3,704)(1)(141)(93)1,246 4,433 (2)(282)(185)2,071 9,613 Note: Given the low absolute level of short-term market rates on our floating-rate assets and liabilities as of December 31, 2020, the assumed hypothetical change in interest rates does not reflect the full 100 and 200 basis point reduction in interest income or interest expense, as the rates are assumed not to fall below zero. As of December 31, 2020 and 2019, some of our investments had interest rates below 2% so the assumed hypothetical change in the fair value of investments does not reflect the full 200 basis point reduction.We have an exposure to changes in the value of foreign currencies, primarily the Brazilian real and the Chilean peso, to the U.S. dollar in translation of UnitedHealthcare Global’s operating results at the average exchange rate over the accounting period, and UnitedHealthcare Global’s assets and liabilities at the exchange rate at the end of the accounting period. The gains or losses resulting from translating foreign assets and liabilities into U.S. dollars are included in equity and comprehensive income. An appreciation of the U.S. dollar against the Brazilian real or Chilean peso reduces the carrying value of the net assets denominated in those currencies. For example, as of December 31, 2020, a hypothetical 10% and 25% increase in the value of the U.S. dollar against those currencies would have caused a reduction in net assets of approximately $535 million and $1.2 billion, respectively. We manage exposure to foreign currency earnings risk primarily by conducting our international business operations in their functional currencies.As of December 31, 2020, we had $2.3 billion of investments in equity securities, primarily consisting of investments in employee savings plan related investments and non-U.S. dollar fixed-income funds. Valuations in non-U.S. dollar funds are subject to foreign exchange rates. 36Table of Contents
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+Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations, Sources of Revenue-Medicare, for additional disclosure. Beginning in 2024 and continuing through 2027, the Medicaid disproportionate share hospital (“DSH”) allotment to the states from federal funds will be reduced. Such reductions have been delayed several times, most recently under the CAA, which further delays the DSH through 2024. During the reduction period, state Medicaid DSH allotments from federal funds will be reduced by $8 billion annually. Reductions are imposed on states based on percentage of uninsured individuals, Medicaid utilization and uncompensated care. We are subject to uncertainties regarding health care reform. On March 23, 2010, President Obama signed into law the Patient Protection and Affordable Care Act (the “Legislation”). Two primary goals of the Legislation are to provide for increased access to coverage for healthcare and to reduce healthcare-related expenses. Although it was expected that as a result of the Legislation there would be a reduction in uninsured patients, which would reduce our expense from uncollectible accounts receivable, the Legislation makes a number of other changes to Medicare and Medicaid which we believe may have an adverse impact on us. It has been projected that the Legislation will result in a net reduction in Medicare and Medicaid payments to hospitals totaling $155 billion over 10 years. The Legislation revises reimbursement under the Medicare and Medicaid programs to emphasize the efficient delivery of high quality care and contains a number of incentives and penalties under these programs to achieve these goals. The Legislation implements a value-based purchasing program, which will reward the delivery of efficient care. Conversely, certain facilities will receive reduced reimbursement for failing to meet quality parameters; such hospitals will include those with excessive readmission or hospital-acquired condition rates. It remains unclear what portions of that legislation may remain, or what any replacement or alternative programs may be created by future legislation. A 2012 U.S. Supreme Court ruling limited the federal government’s ability to expand health insurance coverage by holding unconstitutional sections of the Legislation that sought to withdraw federal funding for state noncompliance with certain Medicaid coverage requirements. Pursuant to that decision, the federal government may not penalize states that choose not to participate in the Medicaid expansion program by reducing their existing Medicaid funding. Therefore, states can choose to accept or not to participate without risking the loss of federal Medicaid funding. As a result, many states, including Texas, have not expanded their Medicaid programs without the threat of loss of federal funding. CMS has granted section 1115 demonstration waivers providing for work and community engagement requirements for certain Medicaid eligible individuals. CMS has also released guidance to states interested in receiving their Medicaid funding through a block grant mechanism. It is anticipated this will lead to reductions in coverage, and likely increases in uncompensated care, in states where these demonstration waivers are granted. The various provisions in the Legislation that directly or indirectly affect Medicare and Medicaid reimbursement are scheduled to take effect over a number of years. The impact of the Legislation on healthcare providers will be subject to implementing regulations, interpretive guidance and possible future legislation or legal challenges. Certain Legislation provisions, such as that creating the Medicare Shared Savings Program, create uncertainty in how healthcare may be reimbursed by federal programs in the 18 future. Thus, we cannot predict the impact of the Legislation on our future reimbursement at this time and we can provide no assurance that the Legislation will not have a material adverse effect on our future results of operations. The Legislation also contained provisions aimed at reducing fraud and abuse in healthcare. The Legislation amends several existing laws, including the federal Anti-Kickback Statute and the False Claims Act, making it easier for government agencies and private plaintiffs to prevail in lawsuits brought against healthcare providers. While Congress had previously revised the intent requirement of the Anti-Kickback Statute to provide that a person is not required to “have actual knowledge or specific intent to commit a violation of” the Anti-Kickback Statute in order to be found in violation of such law, the Legislation also provides that any claims for items or services that violate the Anti-Kickback Statute are also considered false claims for purposes of the federal civil False Claims Act. The Legislation provides that a healthcare provider that retains an overpayment in excess of 60 days is subject to the federal civil False Claims Act, although certain final regulations implementing this statutory requirement remain pending. The Legislation also expands the Recovery Audit Contractor program to Medicaid. These amendments also make it easier for severe fines and penalties to be imposed on healthcare providers that violate applicable laws and regulations. We have partnered with local physicians in the ownership of certain of our facilities. These investments have been permitted under an exception to the physician self-referral law. The Legislation permits existing physician investments in a hospital to continue under a “grandfather” clause if the arrangement satisfies certain requirements and restrictions, but physicians are prohibited from increasing the aggregate percentage of their ownership in the hospital. The Legislation also imposes certain compliance and disclosure requirements upon existing physician-owned hospitals and restricts the ability of physician-owned hospitals to expand the capacity of their facilities. As discussed below, should the Legislation be repealed in its entirety, this aspect of the Legislation would also be repealed restoring physician ownership of hospitals and expansion right to its position and practice as it existed prior to the Legislation. The impact of the Legislation on each of our hospitals may vary. Because Legislation provisions are effective at various times over the next several years, we anticipate that many of the provisions in the Legislation may be subject to further revision. Initiatives to repeal the Legislation, in whole or in part, to delay elements of implementation or funding, and to offer amendments or supplements to modify its provisions have been persistent. The ultimate outcomes of legislative attempts to repeal or amend the Legislation and legal challenges to the Legislation are unknown. Legislation has already been enacted that has eliminated the penalty for failing to maintain health coverage that was part of the original Legislation. In addition, Congress has considered legislation that would, if enacted, in material part: (i) eliminate the large employer mandate to obtain or provide health insurance coverage, respectively; (ii) permit insurers to impose a surcharge up to 30 percent on individuals who go uninsured for more than two months and then purchase coverage; (iii) provide tax credits towards the purchase of health insurance, with a phase-out of tax credits accordingly to income level; (iv) expand health savings accounts; (v) impose a per capita cap on federal funding of state Medicaid programs, or, if elected by a state, transition federal funding to block grants, and; (vi) permit states to seek a waiver of certain federal requirements that would allow such state to define essential health benefits differently from federal standards and that would allow certain commercial health plans to take health status, including pre-existing conditions, into account in setting premiums. In addition to legislative changes, the Legislation can be significantly impacted by executive branch actions. President Biden is expected to undertake executive actions that will strengthen the Legislation and may reverse the policies of the prior administration. The Trump Administration had directed the issuance of final rules (i) enabling the formation of association health plans that would be exempt from certain Legislation requirements such as the provision of essential health benefits; (ii) expanding the availability of short-term, limited duration health insurance, (iii) eliminating cost-sharing reduction payments to insurers that would otherwise offset deductibles and other out-of-pocket expenses for health plan enrollees at or below 250 percent of the federal poverty level; (iv) relaxing requirements for state innovation waivers that could reduce enrollment in the individual and small group markets and lead to additional enrollment in short-term, limited duration insurance and association health plans; and (v) incentivizing the use of health reimbursement accounts by employers to permit employees to purchase health insurance in the individual market. The uncertainty resulting from these Executive Branch policies has led to reduced Exchange enrollment in 2018, 2019 and 2020 is expected to further worsen the individual and small group market risk pools in future years. It is also anticipated that these policies may create additional cost and reimbursement pressures on hospitals. It remains unclear what portions of the Legislation may remain, or whether any replacement or alternative programs may be created by any future legislation. Any such future repeal or replacement may have significant impact on the reimbursement for healthcare services generally, and may create reimbursement for services competing with the services offered by our hospitals. Accordingly, there can be no assurance that the adoption of any future federal or state healthcare reform legislation will not have a negative financial impact on our hospitals, including their ability to compete with alternative healthcare services funded by such potential legislation, or for our hospitals to receive payment for services. While attempts to repeal the entirety of the Legislation have not been successful to date, a key provision of the Legislation was repealed as part of the Tax Cuts and Jobs Act and on December 14, 2018, a Texas Federal District Court Judge declared the Legislation unconstitutional, reasoning that the individual mandate tax penalty was essential to and not severable from the remainder of the Legislation. The case was appealed to the U.S. Court of Appeals for the Fifth Circuit and on December 18, 2019, a three-judge 19 panel declared the Legislation’s individual mandate unconstitutional and remanded the case back to the Texas Federal District Court to determine which of the Legislation’s provisions should be stricken with the mandate or whether the entire law is unconstitutional without the individual mandate. On March 2, 2020, the Supreme Court agreed to hear two consolidated cases, filed by the State of California and the United States House of Representatives, asking the Supreme Court to review the ruling by the U.S. Court of Appeals for the Fifth Circuit decision and to review whether, if the mandate is unconstitutional, it can be separated from the rest of the Legislation. Oral argument was heard on November 10, 2020, and a ruling is expected in 2021. The Legislation will remain law while the case proceeds through the appeals process; however, the case creates additional uncertainty as to whether any or all of the Legislation could be struck down, which creates operational risk for the health care industry. We cannot predict the effect of the elimination of the individual mandate tax penalty, the final result and effect of the California v. Texas case. While the results of the 2020 elections potentially reduce the risk of the Legislation being eliminated in whole or in part, the continued uncertainties regarding implementation of the Legislation create unpredictability for the strategic and business planning efforts of health care providers, which in itself constitutes a risk. Under the Legislation, hospitals are required to make public a list of their standard charges, and effective January 1, 2019, CMS has required that this disclosure be in machine-readable format and include charges for all hospital items and services and average charges for diagnosis-related groups. On November 27, 2019, CMS published a final rule on “Price Transparency Requirements for Hospitals to Make Standard Charges Public.” This rule took effect on January 1, 2021 and requires all hospitals to also make public their payor-specific negotiated rates, minimum negotiated rates, maximum negotiated rates and cash for all items and services, including individual items and services and service packages, that could be provided by a hospital to a patient. Failure to comply with these requirements may result in daily monetary penalties. As part of the CAA, Congress passed legislation aimed at preventing or limiting patient balance billing in certain circumstances. The CAA addresses surprise medical bills stemming from emergency services, out-of-network ancillary providers at in-network facilities, and air ambulance carriers. The legislation prohibits surprise billing when out-of-network emergency services or out-of-network services at an in-network facility are provided, unless informed consent is received. In these circumstances providers are prohibited from billing the patient for any amounts that exceed in-network cost-sharing requirements. The legislation requires implementing regulations within a year of enactment. We are required to treat patients with emergency medical conditions regardless of ability to pay. In accordance with our internal policies and procedures, as well as the Emergency Medical Treatment and Active Labor Act, or EMTALA, we provide a medical screening examination to any individual who comes to one of our hospitals while in active labor and/or seeking medical treatment (whether or not such individual is eligible for insurance benefits and regardless of ability to pay) to determine if such individual has an emergency medical condition. If it is determined that such person has an emergency medical condition, we provide such further medical examination and treatment as is required to stabilize the patient’s medical condition, within the facility’s capability, or arrange for transfer of such individual to another medical facility in accordance with applicable law and the treating hospital’s written procedures. Our obligations under EMTALA may increase substantially going forward; CMS has sought stakeholder comments concerning the potential applicability of EMTALA to hospital inpatients and the responsibilities of hospitals with specialized capabilities, respectively, but has yet to issue further guidance in response to that request. If the number of indigent and charity care patients with emergency medical conditions we treat increases significantly, or if regulations expanding our obligations to inpatients under EMTALA is proposed and adopted, our results of operations will be harmed. If we fail to continue to meet the promoting interoperability criteria related to electronic health record systems (“EHR”), our operations could be harmed. Pursuant to Health Information Technology for Economic and Clinical Health (“HITECH”) regulations, hospitals that did not qualify as a meaningful user of EHR by 2015 were subject to a reduced market basket update to the inpatient prospective payment system (“IPPS”) standardized amount in 2015 and each subsequent fiscal year. In the 2019 IPPS final rule, CMS re-named the meaningful use program to “promoting interoperability”. We believe that all of our acute care hospitals have met the applicable promoting interoperability criteria and therefore are not subject to a reduced market basked update to the IPPS standardized amount. However, under the HITECH Act, hospitals must continue to meet the applicable criteria in each fiscal year or they will be subject to a market basket update reduction in a subsequent fiscal year. Failure of our acute care hospitals to continue to meet the applicable meaningful use criteria would have an adverse effect on our future net revenues and results of operations. Our performance depends on our ability to attract and retain qualified nurses and medical support staff and we face competition for staffing that may increase our labor costs and harm our results of operations. We depend on the efforts, abilities, and experience of our medical support personnel, including our nurses, pharmacists and lab technicians and other healthcare professionals. We compete with other healthcare providers in recruiting and retaining qualified hospital management, nurses and other medical personnel. The nationwide shortage of nurses and other medical support personnel has been a significant operating issue facing us and other healthcare providers. This shortage may require us to enhance wages and benefits to recruit and retain nurses and other medical support personnel or require us to hire expensive temporary personnel. In addition, in some markets like California, there are 20 requirements to maintain specified nurse-staffing levels. To the extent we cannot meet those levels, we may be required to limit the healthcare services provided in these markets, which would have a corresponding adverse effect on our net operating revenues. We cannot predict the degree to which we will be affected by the future availability or cost of attracting and retaining talented medical support staff. If our general labor and related expenses increase, we may not be able to raise our rates correspondingly. Our failure to either recruit and retain qualified hospital management, nurses and other medical support personnel or control our labor costs could harm our results of operations. Increased labor union activity is another factor that could adversely affect our labor costs. Union organizing activities and certain potential changes in federal labor laws and regulations could increase the likelihood of employee unionization If we fail to comply with extensive laws and government regulations, we could suffer civil or criminal penalties or be required to make significant changes to our operations that could reduce our revenue and profitability. The healthcare industry is required to comply with extensive and complex laws and regulations at the federal, state and local government levels relating to, among other things: hospital billing practices and prices for services; relationships with physicians and other referral sources; adequacy of medical care and quality of medical equipment and services; ownership of facilities; qualifications of medical and support personnel; confidentiality, maintenance, privacy and security issues associated with health-related information and patient medical records; the screening, stabilization and transfer of patients who have emergency medical conditions; certification, licensure and accreditation of our facilities; operating policies and procedures, and; construction or expansion of facilities and services. Among these laws are the federal False Claims Act, the Health Insurance Portability and Accountability Act of 1996, (“HIPAA”), the federal anti-kickback statute and the provision of the Social Security Act commonly known as the “Stark Law.” These laws, and particularly the anti-kickback statute and the Stark Law, impact the relationships that we may have with physicians and other referral sources. We have a variety of financial relationships with physicians who refer patients to our facilities, including employment contracts, leases and professional service agreements. We also provide financial incentives, including minimum revenue guarantees, to recruit physicians into communities served by our hospitals. The Office of the Inspector General of the Department of Health and Human Services, or OIG, has enacted safe harbor regulations that outline practices that are deemed protected from prosecution under the anti-kickback statute. A number of our current arrangements, including financial relationships with physicians and other referral sources, may not qualify for safe harbor protection under the anti-kickback statute. Failure to meet a safe harbor does not mean that the arrangement necessarily violates the anti-kickback statute, but may subject the arrangement to greater scrutiny. We cannot assure that practices that are outside of a safe harbor will not be found to violate the anti-kickback statute. CMS published a Medicare self-referral disclosure protocol, which is intended to allow providers to self-disclose actual or potential violations of the Stark law. Because there are only a few judicial decisions interpreting the Stark law, there can be no assurance that our hospitals will not be found in violation of the Stark Law or that self-disclosure of a potential violation would result in reduced penalties. Federal regulations issued under HIPAA contain provisions that require us to implement and, in the future, may require us to implement additional costly electronic media security systems and to adopt new business practices designed to protect the privacy and security of each of our patient’s health and related financial information. Such privacy and security regulations impose extensive administrative, physical and technical requirements on us, restrict our use and disclosure of certain patient health and financial information, provide patients with rights with respect to their health information and require us to enter into contracts extending many of the privacy and security regulatory requirements to third parties that perform duties on our behalf. Additionally, recent changes to HIPAA regulations may result in greater compliance requirements, including obligations to report breaches of unsecured patient data, as well as create new liabilities for the actions of parties acting as business associates on our behalf. These laws and regulations are extremely complex, and, in many cases, we do not have the benefit of regulatory or judicial interpretation. In the future, it is possible that different interpretations or enforcement of these laws and regulations could subject our current or past practices to allegations of impropriety or illegality or could require us to make changes in our facilities, equipment, personnel, services, capital expenditure programs and operating expenses. A determination that we have violated one or more of these laws (see Note 8 to the Consolidated Financial Statements - Commitments and Contingencies, as included this Form 10-K), or the public announcement that we are being investigated for possible violations of one or more of these laws, could have a material adverse effect on our business, financial condition or results of operations and our business reputation could suffer significantly. In addition, we cannot predict whether other legislation or regulations at the federal or state level will be adopted, what form such legislation or regulations may take or what their impact on us may be. See Item 1 Business—Self-Referral and Anti-Kickback Legislation. If we are deemed to have failed to comply with the anti-kickback statute, the Stark Law or other applicable laws and regulations, we could be subjected to liabilities, including criminal penalties, civil penalties (including the loss of our licenses to operate one or more facilities), and exclusion of one or more facilities from participation in the Medicare, Medicaid and other federal and state healthcare programs. The imposition of such penalties could have a material adverse effect on our business, financial condition or results of operations. 21 We also operate health care facilities in the United Kingdom and have operations and commercial relationships with companies in other foreign jurisdictions and, as a result, are subject to certain U.S. and foreign laws applicable to businesses generally, including anti-corruption laws. The Foreign Corrupt Practices Act regulates U.S. companies in their dealings with foreign officials, prohibiting bribes and similar practices, and requires that they maintain records that fairly and accurately reflect transactions and appropriate internal accounting controls. In addition, the United Kingdom Bribery Act has wide jurisdiction over certain activities that affect the United Kingdom. Our operations in the United Kingdom are also subject to a high level of regulation relating to registration and licensing requirements employee regulation, clinical standards, environmental rules as well as other areas. We are also subject to a highly regulated business environment, and failure to comply with the various laws and regulations, applicable to us could lead to substantial penalties, and other adverse effects on our business. We are subject to occupational health, safety and other similar regulations and failure to comply with such regulations could harm our business and results of operations. We are subject to a wide variety of federal, state and local occupational health and safety laws and regulations. Regulatory requirements affecting us include, but are not limited to, those covering: (i) air and water quality control; (ii) occupational health and safety (e.g., standards regarding blood-borne pathogens and ergonomics, etc.); (iii) waste management; (iv) the handling of asbestos, polychlorinated biphenyls and radioactive substances; and (v) other hazardous materials. If we fail to comply with those standards, we may be subject to sanctions and penalties that could harm our business and results of operations. We are subject to pending legal actions, purported stockholder class actions, governmental investigations and regulatory actions. We, our subsidiaries, PSI, and its subsidiaries, are subject to pending legal actions, governmental investigations and regulatory actions (see Note 8 to the Consolidated Financial Statements - Commitments and Contingencies, as included this Form 10-K). We may become subject to additional medical malpractice lawsuits, product liability lawsuits, class action lawsuits and other legal actions in the ordinary course of business. Defending ourselves against the allegations in the lawsuits and governmental investigations, or similar matters and any related publicity, could potentially entail significant costs and could require significant attention from our management and our reputation could suffer significantly. We are unable to predict the outcome of these matters or to reasonably estimate the amount or range of any such loss; however, these lawsuits and the related publicity and news articles that have been published concerning these matters could have a material adverse effect on our business, financial condition, results of operations and/or cash flows which in turn could cause a decline in our stock price. In an effort to resolve one or more of these matters, we may choose to negotiate a settlement. Amounts we pay to settle any of these matters may be material. All professional and general liability insurance we purchase is subject to policy limitations. We believe that, based on our past experience and actuarial estimates, our insurance coverage is adequate considering the claims arising from the operations of our hospitals. While we continuously monitor our coverage, our ultimate liability for professional and general liability claims could change materially from our current estimates. If such policy limitations should be partially or fully exhausted in the future, or payments of claims exceed our estimates or are not covered by our insurance, it could have a material adverse effect on our operations. We are and may become subject to other loss contingencies, both known and unknown, which may relate to past, present and future facts, events, circumstances and occurrences. Should an unfavorable outcome occur in some or all of our legal proceedings or other loss contingencies, or if successful claims and other actions are brought against us in the future, there could be a material adverse impact on our financial position, results of operations and liquidity. In particular, government investigations, as well as qui tam and stockholder lawsuits, may lead to material fines, penalties, damages payments or other sanctions, including exclusion from government healthcare programs. The federal False Claims Act permits private parties to bring qui tam, or whistleblower, lawsuits on behalf of the government against companies alleging that the defendant has defrauded the federal government. These private parties are entitled to share in any amounts recovered by the government, and, as a result, the number of whistleblower lawsuits that have been filed against providers has increased significantly in recent years. Because qui tam lawsuits are filed under seal, we could be named in one or more such lawsuits of which we are not aware. Settlements of lawsuits involving Medicare and Medicaid issues routinely require both monetary payments and corporate integrity agreements, each of which could have a material adverse effect on our business, financial condition, results of operations and/or cash flows. The failure of certain employers, or the closure of certain facilities, could have a disproportionate impact on our hospitals. The economies in the communities in which our hospitals operate are often dependent on a small number of large employers. Those employers often provide income and health insurance for a disproportionately large number of community residents who may depend on our hospitals and other health care facilities for their care. The failure of one or more large employer or the closure or substantial reduction in the number of individuals employed at facilities located in or near the communities where our hospitals operate, could cause affected employees to move elsewhere to seek employment or lose insurance coverage that was otherwise available to them. The occurrence of these events could adversely affect our revenue and results of operations, thereby harming our business. 22 If any of our existing health care facilities lose their accreditation or any of our new facilities fail to receive accreditation, such facilities could become ineligible to receive reimbursement under Medicare or Medicaid. The construction and operation of healthcare facilities are subject to extensive federal, state and local regulation relating to, among other things, the adequacy of medical care, equipment, personnel, operating policies and procedures, fire prevention, rate-setting and compliance with building codes and environmental protection. Additionally, such facilities are subject to periodic inspection by government authorities to assure their continued compliance with these various standards. All of our hospitals are deemed certified, meaning that they are accredited, properly licensed under the relevant state laws and regulations and certified under the Medicare program. The effect of maintaining certified facilities is to allow such facilities to participate in the Medicare and Medicaid programs. We believe that all of our healthcare facilities are in material compliance with applicable federal, state, local and other relevant regulations and standards. However, should any of our healthcare facilities lose their deemed certified status and thereby lose certification under the Medicare or Medicaid programs, such facilities would be unable to receive reimbursement from either of those programs and our business could be materially adversely effected. State efforts to regulate the construction or expansion of health care facilities could impair our ability to expand. Many of the states in which we operate hospitals have enacted Certificates of Need, or (“CON”), laws as a condition prior to hospital capital expenditures, construction, expansion, modernization or initiation of major new services. Our failure to obtain necessary state approval could result in our inability to complete a particular hospital acquisition, expansion or replacement, make a facility ineligible to receive reimbursement under the Medicare or Medicaid programs, result in the revocation of a facility’s license or impose civil or criminal penalties on us, any of which could harm our business. In addition, significant CON reforms have been proposed in a number of states that would increase the capital spending thresholds and provide exemptions of various services from review requirements. In the past, we have not experienced any material adverse effects from those requirements, but we cannot predict the impact of these changes upon our operations. Risks Related to Information Technology A cyber security incident could cause a violation of HIPAA, breach of member privacy, or other negative impacts. In September, 2020, we experienced an information technology security incident which led us to suspend user access to our information technology applications related to operations located in the United States. While our information technology applications were offline, patient care was delivered safely and effectively at our facilities across the country utilizing established back-up processes, including offline documentation methods. We have investigated the nature and potential impact of the security incident and engaged third-party information technology and forensic vendors to assist. No evidence of unauthorized access, copying or misuse of any patient or employee data has been identified to date. Promptly after the incident, our information technology applications were restored at our acute care and behavioral health hospitals, as well as at the corporate level, thereby re-establishing connections to all major systems and applications, including electronic medical records, laboratory and pharmacy systems and our hospitals resumed normal operations. We rely extensively on our information technology (“IT”) systems to manage clinical and financial data, communicate with our patients, payers, vendors and other third parties and summarize and analyze operating results. In addition, we have made significant investments in technology to adopt and utilize electronic health records and to become meaningful users of health information technology pursuant to the American Recovery and Reinvestment Act of 2009. Our IT systems are subject to damage or interruption from power outages, facility damage, computer and telecommunications failures, computer viruses, security breaches including credit card or personally identifiable information breaches, vandalism, theft, natural disasters, catastrophic events, human error and potential cyber threats, including malicious codes, worms, phishing attacks, denial of service attacks, ransomware and other sophisticated cyber-attacks, and our disaster recovery planning cannot account for all eventualities. As cyber criminals continue to become more sophisticated through evolution of their tactics, techniques and procedures, we have taken, and will continue to take, additional preventive measures to strengthen the cyber defenses of our networks and data. However, if any of our systems are damaged, fail to function properly or otherwise become unavailable, we may incur substantial costs to repair or replace them, and may experience loss or corruption of critical data such as protected health information or other data subject to privacy laws and proprietary business information and interruptions or disruptions and delays in our ability to perform critical functions, which could materially and adversely affect our businesses and results of operations and could result in significant penalties or fines, litigation, loss of customers, significant damage to our reputation and business, and other losses. In addition, our future results of operations, as well as our reputation, could be adversely impacted by theft, destruction, loss, or misappropriation of public health information, other confidential data or proprietary business information. Risks Related to the Market Conditions and Liquidity Our revenues and volume trends may be adversely affected by certain factors over which we have no control. Our revenues and volume trends are dependent on many factors, including physicians’ clinical decisions and availability, payer programs shifting to a more outpatient-based environment, whether or not certain services are offered, seasonal and severe weather conditions, including the effects of extreme low temperatures, hurricanes and tornados, earthquakes, climate change, current local 23 economic and demographic changes. In addition, technological developments and pharmaceutical improvements may reduce the demand for healthcare services or the profitability of the services we offer. Further, the Medicare program’s three-year phase out and eventual elimination of the Inpatient Only List, a list of surgeries and procedures that are only covered by Medicare when provided in an inpatient setting, may reduce inpatient volumes. A worsening of economic and employment conditions in the United States could materially affect our business and future results of operations. Our patient volumes, revenues and financial results depend significantly on the universe of patients with health insurance, which to a large extent is dependent on the employment status of individuals in our markets. Worsening of economic conditions may result in a higher unemployment rate which may increase the number of individuals without health insurance. As a result, our facilities may experience a decrease in patient volumes, particularly in less intense, more elective service lines, or an increase in services provided to uninsured patients. These factors could have a material unfavorable impact on our future patient volumes, revenues and operating results. In addition, as of December 31, 2020, we had approximately $3.9 billion of goodwill recorded on our consolidated balance sheet. Should the revenues and financial results of our acute care and/or behavioral health care facilities be materially, unfavorably impacted due to, among other things, a worsening of the economic and employment conditions in the United States that could negatively impact our patient volumes and reimbursement rates, a continued rise in the unemployment rate and continued increases in the number of uninsured patients treated at our facilities, we may incur future charges to recognize impairment in the carrying value of our goodwill and other intangible assets, which could have a material adverse effect on our financial results. Legal uncertainty or a worsening of the economic conditions in the United Kingdom could materially affect our business and future results of operations. On June 23, 2016, the United Kingdom affirmatively voted in a non-binding referendum in favor of the exit of the United Kingdom from the European Union (“Brexit”) and it was approved by vote of the British legislature. On March 29, 2017, the United Kingdom triggered Article 50 of the Lisbon Treaty, formally starting negotiations regarding its exit from the European Union. On January 31, 2020, the United Kingdom formally exited the European Union. On December 24, 2020, the United Kingdom and the European Union reached a post-Brexit trade and cooperation agreement that created new business and security requirements and preserved the United Kingdom’s tariff- and quota-free access to the European Union member states. Changes to the trading relationship between the United Kingdom and the European Union may result in increased cost of goods imported into the United Kingdom. Additional currency volatility could result in a weaker British pound, which may decrease the profitability of our operations in the United Kingdom. A weaker British pound versus the U.S. Dollar also causes local currency results of our United Kingdom operations to be translated into fewer U.S. Dollars during a reporting period. While we may elect to enter into hedging arrangements to protect our business against certain currency fluctuations, these hedging arrangements do not provide comprehensive protection, and our results of operations could be adversely affected by foreign exchange fluctuations. Brexit could lead to legal and regulatory uncertainty as the United Kingdom determines which European Union laws to replace or replicate. Brexit could also lead to increased legal and regulatory complexity as national laws and regulations in the United Kingdom start to diverge from European Union laws and regulations. For instance, rules for data transfers outside of the United Kingdom and European Economic Area have changed significantly with Brexit and a recent Court of European Justice decision, and are subject to further revision and updated regulatory guidance, making necessary compliance measures challenging to ascertain and implement with respect to our United Kingdom operations. The exit of the United Kingdom from the European Union could also create future economic uncertainty, both in the United Kingdom and globally, and could cause disruptions to and create uncertainty surrounding our business. Any of these effects of Brexit, and others we cannot anticipate, could harm our business, financial condition or results of operations. We continue to see rising costs in construction materials and labor. Such increased costs could have an adverse effect on the cash flow return on investment relating to our capital projects. The cost of construction materials and labor has significantly increased. As we continue to invest in modern technologies, emergency rooms and operating room expansions, the construction of medical office buildings for physician expansion and reconfiguring the flow of patient care, we spend large amounts of money generated from our operating cash flow or borrowed funds. Although we evaluate the financial feasibility of such projects by determining whether the projected cash flow return on investment exceeds our cost of capital, such returns may not be achieved if the cost of construction continues to rise significantly or the expected patient volumes are not attained. The deterioration of credit and capital markets may adversely affect our access to sources of funding and we cannot be certain of the availability and terms of capital to fund the growth of our business when needed. We require substantial capital resources to fund our acquisition growth strategy and our ongoing capital expenditure programs for renovation, expansion, construction and addition of medical equipment and technology. We believe that our capital expenditure program is adequate to expand, improve and equip our existing hospitals. We cannot predict, however, whether financing for our 24 growth plans and capital expenditure programs will be available to us on satisfactory terms when needed, which could harm our business. To fund all or a portion of our future financing needs, we rely on borrowings from various sources including fixed rate, long-term debt as well as borrowings pursuant to our revolving credit facility and accounts receivable securitization program. If any of the lenders were unable to fulfill their future commitments, our liquidity could be impacted, which could have a material unfavorable impact our results of operations and financial condition. The LIBOR calculation method may change and LIBOR is expected to be phased out after 2021. Our Credit Agreement permits interest on borrowings to be calculated based on LIBOR, and in the past, we have had interest rate swaps that were based on LIBOR. On July 27, 2017, the United Kingdom Financial Conduct Authority (the “FCA”) announced that it will no longer require banks to submit rates for the calculation of LIBOR after 2021. The phase-out of LIBOR may result in the establishment of one or more alternative benchmark rates, but at this time it is uncertain what alternative benchmark rates would replace LIBOR. In the meantime, actions by the FCA, other regulators, or law enforcement agencies may result in changes to the method by which LIBOR is calculated. At this time, it is not possible to predict the effect of any such changes or any other reforms to LIBOR that may be enacted in the United Kingdom or elsewhere. Risks Related to Our Common Stock The number of outstanding shares of our Class B Common Stock is subject to potential increases or decreases. At December 31, 2020, 22.1 million shares of Class B Common Stock were reserved for issuance upon conversion of shares of Class A, C and D Common Stock outstanding, for issuance upon exercise of options to purchase Class B Common Stock and for issuance of stock under other incentive plans. Class A, C and D Common Stock are convertible on a share for share basis into Class B Common Stock. To the extent that these shares were converted into or exercised for shares of Class B Common Stock, the number of shares of Class B Common Stock available for trading in the public market place would increase substantially and the current holders of Class B Common Stock would own a smaller percentage of that class. In addition, from time-to-time our Board of Directors approve stock repurchase programs authorizing us to purchase shares of our Class B Common Stock on the open market at prevailing market prices or in negotiated transactions off the market. Such repurchases decrease the number of outstanding shares of our Class B Common Stock. Conversely, as a potential means of generating additional funds to operate and expand our business, we may from time-to-time issue equity through the sale of stock which would increase the number of outstanding shares of our Class B Common Stock. Based upon factors such as, but not limited to, the market price of our stock, interest rate on borrowings and uses or potential uses for cash, repurchase or issuance of our stock could have a dilutive effect on our future basic and diluted earnings per share. The right to elect the majority of our Board of Directors and the majority of the general shareholder voting power resides with the holders of Class A and C Common Stock, the majority of which is owned by Alan B. Miller, Executive Chairman of our Board of Directors. Our Restated Certificate of Incorporation provides that, with respect to the election of directors, holders of Class A Common Stock vote as a class with the holders of Class C Common Stock, and holders of Class B Common Stock vote as a class with holders of Class D Common Stock, with holders of all classes of our Common Stock entitled to one vote per share. As of March 24, 2020, the shares of Class A and Class C Common Stock constituted 8.5% of the aggregate outstanding shares of our Common Stock, had the right to elect five members of the Board of Directors and constituted 87.9% of our general voting power as of that date. As of March 24, 2020, the shares of Class B and Class D Common Stock (excluding shares issuable upon exercise of options) constituted 91.5% of the outstanding shares of our Common Stock, had the right to elect two members of the Board of Directors and constituted 12.1% of our general voting power as of that date. As to matters other than the election of directors, our Restated Certificate of Incorporation provides that holders of Class A, Class B, Class C and Class D Common Stock all vote together as a single class, except as otherwise provided by law. Each share of Class A Common Stock entitles the holder thereof to one vote; each share of Class B Common Stock entitles the holder thereof to one-tenth of a vote; each share of Class C Common Stock entitles the holder thereof to 100 votes (provided the holder of Class C Common Stock holds a number of shares of Class A Common Stock equal to ten times the number of shares of Class C Common Stock that holder holds); and each share of Class D Common Stock entitles the holder thereof to ten votes (provided the holder of Class D Common Stock holds a number of shares of Class B Common Stock equal to ten times the number of shares of Class D Common Stock that holder holds). In the event a holder of Class C or Class D Common Stock holds a number of shares of Class A or Class B Common Stock, respectively, less than ten times the number of shares of Class C or Class D Common Stock that holder holds, then that holder will be entitled to only one vote for every share of Class C Common Stock, or one-tenth of a vote for every share of Class D Common Stock, which that holder holds in excess of one-tenth the number of shares of Class A or Class B Common Stock, respectively, held by that 25 holder. The Board of Directors, in its discretion, may require beneficial owners to provide satisfactory evidence that such owner holds ten times as many shares of Class A or Class B Common Stock as Class C or Class D Common Stock, respectively, if such facts are not apparent from our stock records. Since a substantial majority of the Class A shares and Class C shares are controlled by Mr. Alan B. Miller and members of his family, one of whom is Marc D. Miller, our Chief Executive Officer, President and a director, and they can elect a majority of our company’s directors and effect or reject most actions requiring approval by stockholders without the vote of any other stockholders, there are potential conflicts of interest in overseeing the management of our company. In addition, because this concentrated control could discourage others from initiating any potential merger, takeover or other change of control transaction that may otherwise be beneficial to our businesses, our business and prospects and the trading price of our securities could be adversely affected. ITEM 1B. Unresolved Staff Comments None. ITEM 2. Properties Executive and Administrative Offices and Commercial Health Insurer We own various office buildings in King of Prussia and Wayne, Pennsylvania, Brentwood, Tennessee, Denton, Texas and Reno, Nevada. Facilities The following tables set forth the name, location, type of facility and, for acute care hospitals and behavioral health care facilities, the number of licensed beds: Acute Care Hospitals Name of Facility Location Number ofBeds RealPropertyOwnershipInterest Aiken Regional Medical Centers Aiken, South Carolina 211 Owned Aurora Pavilion Aiken, South Carolina 62 Owned Centennial Hills Hospital Medical Center Las Vegas, Nevada 336 Owned Corona Regional Medical Center Corona, California 238 Owned Desert Springs Hospital Las Vegas, Nevada 293 Owned Desert View Hospital Pahrump, Nevada 25 Owned Doctors’ Hospital of Laredo (7) Laredo, Texas 183 Owned Doctor’s Hospital Emergency Room Laredo Laredo, Texas — Leased Doctor’s Hospital Emergency Room Saunders Laredo, Texas — Owned Fort Duncan Regional Medical Center Eagle Pass, Texas 101 Owned The George Washington University Hospital (1) Washington, D.C. 395 Leased Henderson Hospital Henderson, Nevada 170 Owned ER at Green Valley Ranch Henderson, Nevada — Owned Lakewood Ranch Medical Center Bradenton, Florida 120 Owned ER at Fruitville Sarasota, Florida — Owned Manatee Memorial Hospital Bradenton, Florida 295 Owned Northern Nevada Medical Center Sparks, Nevada 124 Owned ER at McCarren NW Reno, Nevada — Owned Northwest Texas Healthcare System Amarillo, Texas 405 Owned The Pavilion at Northwest Texas Healthcare System Amarillo, Texas 90 Owned Northwest Emergency at Town Square Amarillo, Texas — Owned Northwest Emergency on Georgia Amarillo, Texas — Owned Palmdale Regional Medical Center Palmdale, California 184 Owned South Texas Health System (3) 26 Name of Facility Location Number ofBeds RealPropertyOwnershipInterest Edinburg Regional Medical Center/Children’s Hospital (3) Edinburg, Texas 235 Owned McAllen Medical Center (2) (3) McAllen, Texas 441 Leased McAllen Heart Hospital (3) McAllen, Texas 60 Owned South Texas Behavioral Health Center (3) McAllen, Texas 134 Owned South Texas Health System ER Alamo (3) Alamo, Texas — Owned South Texas Health System ER McColl (3) Edinburg, Texas — Owned South Texas Health System ER Mission (2) (3) Mission, Texas — Leased South Texas Health System ER Monte Cristo (3) Edinburg, Texas — Owned South Texas Health System ER Ware Road (3) McAllen, Texas — Owned South Texas Health System ER Weslaco (2) (3) Weslaco, Texas — Leased Southwest Healthcare System Inland Valley Campus (2) Wildomar, California 120 Leased Rancho Springs Campus Murrieta, California 120 Owned Spring Valley Hospital Medical Center Las Vegas, Nevada 364 Owned ER at Blue Diamond Las Vegas, Nevada — Owned St. Mary’s Regional Medical Center Enid, Oklahoma 229 Owned Summerlin Hospital Medical Center Las Vegas, Nevada 485 Owned Temecula Valley Hospital Temecula, California 140 Owned Texoma Medical Center Denison, Texas 354 Owned TMC Behavioral Health Center Denison, Texas 60 Owned ER at Anna Anna, Texas — Owned ER at Sherman Sherman, Texas — Owned Valley Hospital Medical Center Las Vegas, Nevada 306 Owned Wellington Regional Medical Center (2) West Palm Beach, Florida 235 Leased ER at Westlake West Palm Beach, Florida — Leased Inpatient Behavioral Health Care Facilities United States: Name of Facility Location Number ofBeds RealPropertyOwnershipInterest Alabama Clinical Schools Birmingham, Alabama 80 Owned Alhambra Hospital Rosemead, California 115 Owned Alliance Health Center Meridian, Mississippi 214 Owned The Arbour Hospital Boston, Massachusetts 136 Owned Arbour-Fuller Hospital South Attleboro, Massachusetts 102 Owned Arbour-HRI Hospital Brookline, Massachusetts 62 Owned Arrowhead Behavioral Health Maumee, Ohio 48 Owned Austin Lakes Hospital Austin, Texas 58 Leased Austin Oaks Hospitals Austin, Texas 80 Owned Behavioral Hospital of Bellaire Houston, Texas 124 Leased Belmont Pines Hospital Youngstown, Ohio 121 Owned Benchmark Behavioral Health System Woods Cross, Utah 94 Owned Black Bear Treatment Center Sautee, Georgia 115 Owned Bloomington Meadows Hospital Bloomington, Indiana 78 Owned Boulder Creek Academy Bonners Ferry, Idaho 105 Owned Brentwood Behavioral Health of Mississippi Flowood, Mississippi 121 Owned Brentwood Hospital Shreveport, Louisiana 260 Owned The Bridgeway North Little Rock, Arkansas 127 Owned Brook Hospital—Dupont Louisville, Kentucky 88 Owned Brook Hospital—KMI Louisville, Kentucky 110 Owned Brooke Glen Behavioral Hospital Fort Washington, Pennsylvania 146 Owned 27 United States: Name of Facility Location Number ofBeds RealPropertyOwnershipInterest Brynn Marr Hospital Jacksonville, North Carolina 102 Owned Calvary Addiction Recovery Center Phoenix, Arizona 68 Owned Canyon Behavioral Health Temple, Texas 102 Owned Canyon Ridge Hospital Chino, California 157 Owned The Carolina Center for Behavioral Health Greer, South Carolina 156 Owned Cedar Creek St. Johns, Michigan 54 Owned Cedar Grove Residential Treatment Center Murfreesboro, Tennessee 40 Owned Cedar Hills Hospital (8) Beaverton, Oregon 98 Owned Cedar Ridge Oklahoma City, Oklahoma 60 Owned Cedar Ridge Residential Treatment Center Oklahoma City, Oklahoma 56 Owned Cedar Ridge Bethany Bethany, Oklahoma 56 Owned Cedar Springs Behavioral Health Colorado Springs, Colorado 110 Owned Centennial Peaks Louisville, Colorado 104 Owned Center for Change Orem, Utah 58 Owned Central Florida Behavioral Hospital Orlando, Florida 174 Owned Chris Kyle Patriots Hospital Anchorage, Alaska 36 Owned Clarion Psychiatric Center Clarion, Pennsylvania 112 Owned Clive Behavioral Health (12) Clive, Iowa 100 Leased Coastal Behavioral Health Savannah, Georgia 50 Owned Coastal Harbor Treatment Center Savannah, Georgia 141 Owned Columbus Behavioral Center for Children and Adolescents Columbus, Indiana 57 Owned Compass Intervention Center Memphis, Tennessee 108 Owned Copper Hills Youth Center West Jordan, Utah 197 Owned Coral Shores Stuart, Florida 80 Owned Cumberland Hall Hopkinsville, Kentucky 97 Owned Cumberland Hospital New Kent, Virginia 110 Owned Cypress Creek Hospital Houston, Texas 128 Owned Del Amo Hospital Torrance, California 166 Owned Diamond Grove Center Louisville, Mississippi 55 Owned Dover Behavioral Health Dover, Delaware 104 Owned El Paso Behavioral Health System El Paso, Texas 166 Owned Emerald Coast Behavioral Hospital Panama City, Florida 86 Owned Fairmount Behavioral Health System Philadelphia, Pennsylvania 239 Owned Fairfax Fairfax Hospital Kirkland, Washington 157 Owned Fairfax Hospital—Everett Everett, Washington 30 Leased Fairfax Hospital—Monroe Monroe, Washington 34 Leased Forest View Hospital Grand Rapids, Michigan 108 Owned Fort Lauderdale Hospital Fort Lauderdale, Florida 182 Owned Foundations Behavioral Health Doylestown, Pennsylvania 108 Leased Foundations for Living Mansfield, Ohio 84 Owned Fox Run Hospital St. Clairsville, Ohio 100 Owned Fremont Hospital Fremont, California 148 Owned Friends Hospital Philadelphia, Pennsylvania 219 Owned Garfield Park Hospital Chicago, Illinois 88 Owned Garland Behavioral Health Garland, Texas 72 Leased Glen Oaks Hospital Greenville, Texas 54 Owned Gulf Coast Youth Services Fort Walton Beach, Florida 28 Owned Gulfport Behavioral Health System Gulfport, Mississippi 109 Owned Hampton Behavioral Health Center Westhampton, New Jersey 120 Owned Harbour Point (Pines) Portsmouth, Virginia 186 Owned Hartgrove Hospital Chicago, Illinois 160 Owned 28 United States: Name of Facility Location Number ofBeds RealPropertyOwnershipInterest Havenwyck Hospital Auburn Hills, Michigan 243 Owned Heartland Behavioral Health Services Nevada, Missouri 151 Owned Hermitage Hall Nashville, Tennessee 111 Owned Heritage Oaks Hospital Sacramento, California 125 Owned Hickory Trail Hospital DeSoto, Texas 86 Owned Highlands Behavioral Health System Highlands Ranch, Colorado 86 Owned Hill Crest Behavioral Health Services Birmingham, Alabama 219 Owned Holly Hill Hospital Raleigh, North Carolina 296 Owned The Horsham Clinic Ambler, Pennsylvania 206 Owned Hughes Center Danville, Virginia 64 Owned Inland Northwest Behavioral Health (10) Spokane, Washington 100 Owned Intermountain Hospital Boise, Idaho 155 Owned Kempsville Center of Behavioral Health Norfolk, Virginia 82 Owned KeyStone Center Wallingford, Pennsylvania 153 Owned Kingwood Pines Hospital Kingwood, Texas 116 Owned La Amistad Behavioral Health Services Maitland, Florida 85 Owned Lakeside Behavioral Health System Memphis, Tennessee 373 Owned Lancaster Behavioral Health Hospital (9) Lancaster, Pennsylvania 126 Owned Laurel Heights Hospital Atlanta, Georgia 124 Owned Laurel Oaks Behavioral Health Center Dothan, Alabama 124 Owned Laurel Ridge Treatment Center San Antonio, Texas 330 Owned Liberty Point Behavioral Health Stauton, Virginia 56 Owned Lighthouse Care Center of Augusta Augusta, Georgia 82 Owned Lighthouse Care Center of Conway Conway, South Carolina 105 Owned Lincoln Prairie Behavioral Health Center Springfield, Illinois 97 Owned Lincoln Trail Behavioral Health System Radcliff, Kentucky 140 Owned Mayhill Hospital Denton, Texas 59 Leased McDowell Center for Children Dyersburg, Tennessee 32 Owned The Meadows Psychiatric Center Centre Hall, Pennsylvania 119 Owned Meridell Achievement Center Austin, Texas 134 Owned Mesilla Valley Hospital Las Cruces, New Mexico 119 Owned Michael’s House Palm Springs, California 90 Owned Michiana Behavioral Health Center Plymouth, Indiana 83 Owned Midwest Center for Youth and Families Kouts, Indiana 74 Owned Millwood Hospital Arlington, Texas 134 Leased Mountain Youth Academy Mountain City, Tennessee 90 Owned Natchez Trace Youth Academy Waverly, Tennessee 115 Owned Newport News Behavioral Health Center Newport News, Virginia 132 Owned North Spring Behavioral Healthcare Leesburg, Virginia 127 Leased North Star Hospital Anchorage, Alaska 74 Owned North Star Bragaw Anchorage, Alaska 30 Owned North Star DeBarr Residential Treatment Center Anchorage, Alaska 30 Owned North Star Palmer Residential Treatment Center Palmer, Alaska 30 Owned Oak Plains Academy Ashland City, Tennessee 98 Owned Okaloosa Youth Academy Crestview, Florida 75 Leased Old Vineyard Behavioral Health Winston-Salem, North Carolina 164 Owned Palmetto Lowcountry Behavioral Health North Charleston, South Carolina 108 Owned Palmetto Summerville Summerville, South Carolina 64 Leased Palm Point Behavioral Titusville, FL 74 Owned Palm Shores Behavioral Health Center Bradenton, Florida 64 Owned Palo Verde Behavioral Health Tucson, Arizona 84 Leased Parkwood Behavioral Health System Olive Branch, Mississippi 148 Owned 29 United States: Name of Facility Location Number ofBeds RealPropertyOwnershipInterest The Pavilion Champaign, Illinois 106 Owned Peachford Behavioral Health System of Atlanta Atlanta, Georgia 246 Owned Pembroke Hospital Pembroke, Massachusetts 120 Owned Pinnacle Pointe Hospital Little Rock, Arkansas 127 Owned Poplar Springs Hospital Petersburg, Virginia 208 Owned Prairie St John’s Fargo, North Dakota 158 Owned Pride Institute Eden Prairie, Minnesota 42 Owned Provo Canyon School Provo, Utah 274 Owned Provo Canyon Behavioral Hospital Orem, Utah 80 Owned Psychiatric Institute of Washington Washington, D.C. 130 Owned Quail Run Behavioral Health Phoenix, Arizona 102 Owned The Recovery Center Wichita Falls, Texas 34 Leased The Ridge Behavioral Health System Lexington, Kentucky 110 Owned Rivendell Behavioral Health Services of Arkansas Benton, Arkansas 80 Owned Rivendell Behavioral Health Services of Kentucky Bowling Green, Kentucky 125 Owned River Crest Hospital San Angelo, Texas 80 Owned Riveredge Hospital Forest Park, Illinois 210 Owned River Oaks Hospital New Orleans, Louisiana 126 Owned River Park Hospital Huntington, West Virginia 187 Owned River Point Behavioral Health Jacksonville, Florida 84 Owned Rockford Center Newark, Delaware 138 Owned Rolling Hills Hospital Franklin, Tennessee 130 Owned Roxbury Shippensburg, Pennsylvania 112 Owned Salt Lake Behavioral Health Salt Lake City, Utah 118 Leased San Marcos Treatment Center San Marcos, Texas 265 Owned Sandy Pines Hospital Tequesta, Florida 149 Owned Schick Shadel Hospital Burien, Washington 60 Owned Sierra Vista Hospital Sacramento, California 171 Owned Southern Crescent Behavioral Health Anchor Hospital Atlanta, Georgia 122 Owned St. Simons by the Sea St. Simons, Georgia 101 Owned Skywood Recovery Augusta, Michigan 100 Owned Spring Mountain Sahara Las Vegas, Nevada 30 Owned Spring Mountain Treatment Center Las Vegas, Nevada 110 Owned Springwoods Fayetteville, Arkansas 80 Owned Stonington Institute North Stonington, Connecticut 64 Owned Streamwood Behavioral Health Streamwood, Illinois 178 Owned Summit Oaks Hospital Summit, New Jersey 126 Owned SummitRidge Lawrenceville, Georgia 96 Owned Suncoast Behavioral Health Center Bradenton, Florida 60 Owned Texas NeuroRehab Center Austin, Texas 123 Owned Three Rivers Behavioral Health West Columbia, South Carolina 122 Owned Three Rivers Residential Treatment-Midlands Campus West Columbia, South Carolina 64 Owned Turning Point Hospital Moultrie, Georgia 79 Owned University Behavioral Center Orlando, Florida 112 Owned University Behavioral Health of Denton Denton, Texas 104 Owned Valle Vista Hospital Greenwood, Indiana 132 Owned Valley Hospital Phoenix, Arizona 122 Owned The Vines Hospital Ocala, Florida 98 Owned Virginia Beach Psychiatric Center Virginia Beach, Virginia 100 Owned Wekiva Springs Jacksonville, Florida 120 Owned Wellstone Regional Hospital Jeffersonville, Indiana 100 Owned 30 United States: Name of Facility Location Number ofBeds RealPropertyOwnershipInterest West Hills Hospital Reno, Nevada 95 Owned West Oaks Hospital Houston, Texas 176 Owned Willow Springs Center Reno, Nevada 116 Owned Windmoor Healthcare Clearwater, Florida 144 Owned Windsor—Laurelwood Center Willoughby, Ohio 160 Leased Wyoming Behavioral Institute Casper, Wyoming 129 Owned United Kingdom: Name of Facility Location Number ofBeds RealPropertyOwnershipInterest Acer Clinic Chestherfield, UK 14 Owned Acer Clinic 2 Chestherfield, UK 14 Owned Albert Ward Darlington, UK 25 Owned Amberwood Lodge Dorset, UK 9 Owned Ashbrook Birmingham, UK 16 Owned Ashfield House Huddersfield, UK 6 Owned Aspen House South Yorkshire, UK 20 Owned Aspen Lodge Rotherham, UK 16 Owned Beacon Lower Bradford, UK 8 Owned Beacon Upper Bradford, UK 8 Owned Beckly House Halifax, UK 12 Owned Bostall House London, UK 6 Owned Bury Hospital Bury, UK 167 Owned Broughton House Lincolnshire, UK 34 Owned Broughton Lodge Cheshire, UK 20 Owned Cambian Alders Gloucester, UK 20 Owned Cambian Ansel Clinic Nottingham, UK 25 Owned Cambian Appletree Durham, UK 26 Owned Cambian Beeches Nottinghamshire, UK 12 Owned Cambian Birches Notts, UK 6 Owned Cambian Cedars Birmingham, UK 24 Owned Cambian Churchill London, UK 57 Owned Cambian Conifers Derby, UK 7 Owned Cambian Elms Birmingham, UK 10 Owned Cambian Grange Nottinghamshire, UK 8 Owned Cambian Heathers West Bromwich, UK 20 Owned Cambian Lodge Nottinghamshire, UK 8 Owned Cambian Manor Central Drive, UK 20 Owned Cambian Nightingale Dorset, UK 10 Owned Cambian Oaks Barnsley, UK 36 Owned Cambian Pines Woodhouse, UK 7 Owned Cambian Views Matlock, UK 10 Owned Cambian Woodside Bradford, UK 9 Owned CAS Brunel Henbury, UK 32 Owned Cedar Vale Nottinghamshire, UK 14 Owned Chaseways Sawbridgeworth, UK 6 Owned Cherry Tree House Nottinghamshire, UK 6 Owned Chesterholme Northumberland, UK 16 Owned Coventry Coventry, UK 56 Owned Cygnet Hospital—Beckton Beckton, UK 62 Owned 31 United Kingdom: Name of Facility Location Number ofBeds RealPropertyOwnershipInterest Cygnet Hospital—Bierley Bierley, UK 63 Owned Cygnet Wing—Blackheath Blackheath, UK 32 Leased Cygnet Lodge—Brighouse Brighouse, UK 25 Owned Cygnet Hospital—Derby Derby, UK 50 Owned Cygnet Hospital—Ealing Ealing, UK 26 Owned Cygnet Hospital—Godden Green Godden Green, UK 39 Owned Cygnet Hospital—Harrogate Harrogate, UK 36 Owned Cygnet Hospital—Harrow Harrow, UK 61 Owned Cygnet Hospital—Kewstoke Kewstoke, UK 72 Owned Cygnet Lodge—Lewisham Lewisham, UK 17 Owned Cygnet Lodge – Salford Manchester, UK 24 Owned Cygnet Hospital—Stevenage Stevenage, UK 88 Owned Cygnet Hospital—Taunton Taunton, UK 55 Owned Cygnet Lodge – Kenton Westlands, UK 15 Owned Cygnet Hospital—Wyke Wyke, UK 49 Owned Cygnet Lodge – Woking Knaphill, UK 31 Owned Delfryn House Flintshire, UK 28 Owned Delfryn Lodge Flintshire, UK 24 Owned Dene Brook Dalton Parva, UK 13 Owned Devon Lodge Southampton, UK 12 Owned Dove Valley Wombwell, UK 10 Owned Ducks Halt Essex, UK 5 Owned Eleni House Essex, UK 8 Owned Ellen Mhor Dundee, UK 12 Owned Elston House Nottinghamshire, UK 8 Owned Fairways Suffolk, UK 8 Owned Farm Lodge Rainham, UK 5 Owned The Fields Sheffield, UK 54 Owned Highwoods Colchester, UK 20 Owned The Fountains Blackburn, UK 32 Owned The Gables Essex, UK 7 Owned Gledcliffe Road Huddersfield, UK 6 Owned Gledholt Huddersfield, UK 9 Owned Gledholt Mews Huddersfield, UK 21 Owned Glyn House Stoke on Trent, UK 5 Owned Hawkstone Utley, UK 10 Owned Hollyhurst County Durham, UK 19 Owned Hope House County Durham, UK 11 Owned Kirkside House Leeds, UK 7 Owned Kirkside Lodge Leeds, UK 8 Owned Langdale House Huddersfield, UK 8 Owned Langdale Coach House Huddersfield, UK 3 Owned Larch Court Essex, UK 4 Owned Limes Houses Nottinghamshire, UK 6 Owned Lindsay House Dundee, UK 2 Owned Longfield House Bradford, UK 9 Owned Lowry House Hyde, UK 12 Owned Maidstone Maidstone, UK 65 Owned Marion House Derby, UK 5 Owned Meadows Mews Tipton, UK 10 Owned Morgan House Stoke on Trent, UK 5 Owned Newbus Grange County Durham, UK 17 Owned 32 United Kingdom: Name of Facility Location Number ofBeds RealPropertyOwnershipInterest Newham House Middlesbrough, UK 20 Owned Nield House Crewe, UK 30 Owned Norcott House Liversedge, UK 11 Owned Norcott Lodge Liversedge, UK 9 Owned North West Supported Living Macclesfield, UK 5 Owned Oak Court Essex, UK 12 Owned Oakhurst Lodge Hampshire, UK 8 Owned Oaklands Northumberland, UK 19 Owned Old Leigh House Essex, UK 7 Leased The Orchards Essex, UK 5 Owned The Outwood Leeds, UK 10 Owned Oxley Lodge Huddersfield, UK 4 Owned Oxley Woodhouse Huddersfield, UK 13 Owned Pindar House Barnsley, UK 22 Owned Portland Road 45 Edgbaston, UK 4 Leased Raglan House West Midlands, UK 25 Owned Ramsey Colchester, UK 21 Owned Ranaich House Stirling, UK 14 Owned Redlands County Durham, UK 5 Owned Rhyd Alyn Flintshire, UK 6 Owned Rufford Lodge Mansfield, UK 2 Owned Sedgley House Wolverhampton, UK 20 Owned Sedgley Lodge Wolverhampton, UK 14 Owned Shear Meadow Hemel Hempstead, UK 4 Owned Sheffield Hospital Sheffield, UK 57 Owned Sherwood House Mansfield, UK 30 Owned Sherwood Lodge Mansfield, UK 17 Owned Sherwood Lodge Step Down Mansfield, UK 9 Owned The Squirrels Hampshire, UK 9 Owned St. Augustine's Stoke on Trent, UK 32 Owned St. Teilo House Gwent, UK 23 Owned St. Williams Darlington, UK 12 Owned Storthfields Derby, UK 22 Owned The Sycamores Derbyshire, UK 6 Owned The Sycamores No 4 & 5 Derbyshire, UK 4 Owned Tabley Nursing Home—Tabley Tabley, UK 51 Leased Thistle Care Home Dundee, UK 10 Owned Thornfield Grange County Durham, UK 9 Owned Thornfield House Bradford, UK 7 Owned Thors Park Essex, UK 14 Owned Toller Road Leicestershire, UK 8 Owned Trinity House Galloway, UK 13 Owned Tupwood Gate Nursing Home Caterham, UK 33 Owned River View County Durham, UK 6 Owned Vincent Court Lancashire, UK 5 Owned Walkern Lodge Stevenage, UK 4 Owned Wallace Hospital Dundee, UK 10 Owned Wast Hills West Midlands, UK 26 Owned Whorlton Hall County Durham, UK 17 Owned Willow House West Midlands, UK 8 Owned Woking Hospital Woking, UK 60 Owned Woodcross Street Wolverhampton, UK 8 Owned 33 United Kingdom: Name of Facility Location Number ofBeds RealPropertyOwnershipInterest Woodrow House Stockport, UK 9 Owned Yew Trees Essex, UK 10 Owned Puerto Rico: Name of Facility Location Number ofBeds RealPropertyOwnershipInterest First Hospital Panamericano—Cidra Cidra, Puerto Rico 165 Owned First Hospital Panamericano—San Juan San Juan, Puerto Rico 45 Owned First Hospital Panamericano—Ponce Ponce, Puerto Rico 30 Owned Outpatient Behavioral Health Care Facilities United States: Name of Facility Location RealPropertyOwnershipInterest Arbour Counseling Services Rockland, Massachusetts Owned Arbour Senior Care Rockland, Massachusetts Owned Behavioral Educational Services Riverdale, Florida Leased The Canyon at Santa Monica Santa Monica, California Leased First Home Care (VA) Portsmouth, Virginia Leased Foundations Atlanta Atlanta, Georgia Leased Foundations Detroit Bingham Farms, Michigan Leased Foundations San Francisco San Francisco, California Leased Michael’s House Outpatient Palm Springs, California Leased The Pointe Little Rock, Arkansas Leased St. Louis Behavioral Medicine Institute St. Louis, Missouri Owned Talbott Recovery Atlanta, Georgia Owned United Kingdom: Name of Facility Location RealPropertyOwnershipInterest Long Eaton Day Services Nottingham, UK Owned Oakwood Gardens (SL) Wolverhampton, UK Leased Sheffield Day Services Sheffield, UK Owned Outpatient Centers and Surgical Hospital Name of Facility Location RealPropertyOwnershipInterest Aiken Surgery Center Aiken, South Carolina Owned Cancer Care Institute of Carolina Aiken, South Carolina Owned Cornerstone Regional Hospital (4) Edinburg, Texas Leased Manatee Diagnostic Center Bradenton, Florida Leased Palms Westside Clinic ASC (6) Royal Palm Beach, Florida Leased Quail Surgical and Pain Management Center (11) Reno, Nevada Leased 34 Outpatient Centers and Surgical Hospital Name of Facility Location RealPropertyOwnershipInterest Temecula Valley Day Surgery and Pain Therapy Center (5) Murrieta, California Leased (1) We hold an 80% ownership interest in this facility through a general partnership interest in a limited partnership. The remaining 20% ownership interest is held by an unaffiliated third party which leases the property to the partnership for nominal rent. The term of the partnership is scheduled to expire in July, 2047, and we have five, five-year extension options. The term of the lease is coterminous with the partnership term with a fair market value rental of the property during the extension term. (2) Real property leased from Universal Health Realty Income Trust. (3) These entities are consolidated under one license operating as the South Texas Health System. (4) We manage and own a noncontrolling interest of approximately 50% in the entity that operates this facility. (5) We manage and own a majority interest in an LLC that owns and operates this center. (6) We own a noncontrolling ownership interest of approximately 50% in the entity that operates this facility that is managed by a third-party. (7) We hold an 89% ownership interest in this facility through both general and limited partnership interests. The remaining 11% ownership interest is held by unaffiliated third parties. (8) Land of this facility is leased. (9) We manage and own a noncontrolling interest of 50% in this facility. The remaining 50% ownership interest is held by an unaffiliated third party. Land of this facility is leased from the unaffiliated third party member. (10) We manage and hold an 80% ownership interest in this facility. The remaining 20% ownership interest is held by an unaffiliated third party. (11) We hold a 51% ownership interest in this facility. The remaining 49% ownership interest is held by unaffiliated third parties. (12) We manage and hold a 52% ownership interest in this facility. The remaining 48% ownership interest is held by an unaffiliated third party. The real property is leased from Universal Health Realty Income Trust. We own or lease medical office buildings adjoining some of our hospitals. We believe that the leases on the facilities, medical office buildings and other real estate leased or owned by us do not impose any material limitation on our operations. The aggregate lease payments on facilities leased by us were $82 million in both 2020 and 2019 and $81 million in 2018. ITEM 3. Legal Proceedings The information regarding our legal proceedings is contained in Note 8 to the Consolidated Financial Statements - Commitments and Contingencies, as included this Form 10-K, is incorporated herein by reference. ITEM 4. Mine Safety Disclosures Not applicable. 35 PART II ITEM 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities Our Class B Common Stock is traded on the New York Stock Exchange under the symbol UHS. Shares of our Class A, Class C and Class D Common Stock are not traded in any public market, but are each convertible into shares of our Class B Common Stock on a share-for-share basis. The number of stockholders of record as of January 31, 2021, were as follows: Class A Common 17 Class B Common 895 Class C Common 1 Class D Common 92 Stock Repurchase Programs In July, 2019, our Board of Directors authorized a $1.0 billion increase to our stock repurchase program, which increased the aggregate authorization to $2.7 billion from the previous $1.7 billion authorization approved in various increments since 2014. Pursuant to this program, which had an aggregate available repurchase authorization of $559.6 million as of December 31, 2020, shares of our Class B Common Stock may be repurchased, from time to time as conditions allow, on the open market or in negotiated private transactions. There is no expiration date for our stock repurchase programs. In April, 2020, as part of various COVID-19 initiatives, we suspended our stock repurchase program. We are planning to resume stock repurchases, subject to approval by our Board of Directors, during the second quarter of 2021. As reflected below, during the three-month period ended December 31, 2020, no shares were repurchased pursuant to the terms of our stock repurchase program, since as mentioned above, we have suspended our stock repurchase program as part of our various COVID-19 initiatives. During the three –month period ended December 31, 2020, 49,525 shares were repurchased in connection with income tax withholding obligations resulting from the exercise of stock options and the vesting of restricted stock grants. During the period of October 1, 2020 through December 31, 2020, we repurchased the following shares: Additional Dollars Authorized For Repurchase (in thousands) Total number of shares purchased Total number of shares cancelled Average price paid per share for forfeited restricted shares Total Number of shares purchased as part of publicly announced programs Average price paid per share for shares purchased as part of publicly announced program Aggregate purchase price paid (in thousands) Maximum number of dollars that may yet be purchased under the program (in thousands) October, 2020 — — 1,100 $ 0.01 — $ — $ — $ 559,563 November, 2020 — 10,346 573 $ 0.01 — $ — $ — $ 559,563 December, 2020 — 39,179 1,384 $ 0.01 — $ — $ — $ 559,563 Total October through December $ - 49,525 3,057 $ 0.01 — N/A $ — Dividends We have a history of paying quarterly cash dividends to our shareholders. In April, 2020, as part of various COVID-19 initiatives, we suspended declaration and payment of quarterly dividends. Our Board of Directors have recently approved resumption of quarterly dividend payments, of $0.20 per share, beginning in the first quarter of 2021. Our Credit Agreement contains covenants that include limitations on, among other things, dividends and stock repurchases (see below in Capital Resources-Credit Facilities and Outstanding Debt Securities). Equity Compensation Refer to Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters, of this report for information regarding securities authorized for issuance under our equity compensation plans. 36 Stock Price Performance Graph The following graph compares the cumulative total stockholder return on our common stock with the cumulative total return on the stock included in the Standard & Poor’s 500 Index and a Peer Group Index during the five year period ended December 31, 2020. The graph assumes an investment of $100 made in our common stock and each Index as of January 1, 2016 and has been weighted based on market capitalization. Note that our common stock price performance shown below should not be viewed as being indicative of future performance. Companies in the peer group, which consist of companies in the S&P 500 Index or S&P MidCap 400 Index are as follows: Acadia Healthcare Company, Inc., Community Health Systems, Inc., HCA Healthcare, Inc., LifePoint Health, Inc. (included until November, 2018, when it was acquired by Apollo Management) and Tenet Healthcare Corporation. Company Name / Index 2015 Base 2016 2017 2018 2019 2020 Universal Health Services, Inc. $ 100.00 $ 89.32 $ 95.51 $ 98.53 $ 121.80 $ 116.92 S&P 500 Index $ 100.00 $ 111.96 $ 136.40 $ 130.42 $ 171.49 $ 203.04 Peer Group $ 100.00 $ 90.10 $ 102.29 $ 138.74 $ 172.52 $ 197.03 37 ITEM 6. Selected Financial Data The following table contains our selected financial data for, or as of the end of, each of the five years ended December 31, 2020. You should read this table in conjunction with the consolidated financial statements and related notes included elsewhere in this report and in Part II, Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations. Year Ended December 31, 2020 2019 2018 2017 2016 Summary of Operations (in thousands) Net revenues $ 11,558,897 $ 11,378,259 $ 10,772,278 $ 10,409,865 $ 9,766,210 Income before income taxes $ 1,252,083 $ 1,066,337 $ 1,034,525 $ 1,135,009 $ 1,156,358 Net income attributable to UHS $ 943,953 $ 814,854 $ 779,705 $ 752,303 $ 702,409 Net margin 8.2 % 7.2 % 7.2 % 7.2 % 7.2 % Return on average equity 16.1 % 15.0 % 14.6 % 15.5 % 16.0 % Financial Data (in thousands) Cash provided by operating activities $ 2,360,169 $ 1,438,469 $ 1,274,742 $ 1,247,585 $ 1,254,509 Capital expenditures, net (1) $ 731,307 $ 634,095 $ 664,962 $ 557,506 $ 519,939 Total assets $ 13,476,879 $ 11,668,250 $ 11,265,480 $ 10,761,828 $ 10,317,802 Current maturities of long-term debt $ 331,998 $ 87,550 $ 63,446 $ 545,619 $ 105,895 Long-term debt $ 3,524,253 $ 3,896,577 $ 3,935,187 $ 3,494,390 $ 4,030,230 UHS’s common stockholders’ equity $ 6,317,146 $ 5,504,105 $ 5,389,262 $ 4,989,514 $ 4,533,220 Percentage of total debt to total capitalization 38 % 42 % 43 % 45 % 48 % Operating Data—Acute Care Hospitals (2) Average licensed beds 6,457 6,379 6,232 6,127 5,934 Average available beds 6,285 6,205 6,056 5,954 5,759 Inpatient admissions 286,535 317,983 303,985 297,390 274,074 Average length of patient stay 5.1 4.6 4.5 4.4 4.6 Patient days 1,458,321 1,451,847 1,376,988 1,312,265 1,251,511 Occupancy rate for licensed beds 62 % 62 % 61 % 59 % 58 % Occupancy rate for available beds 63 % 64 % 62 % 60 % 59 % Operating Data—Behavioral Health Facilities (2) Average licensed beds 23,661 23,812 23,509 23,151 21,829 Average available beds 23,559 23,711 23,425 23,068 21,744 Inpatient admissions 448,870 488,367 482,658 467,822 456,052 Average length of patient stay 13.7 13.3 13.3 13.6 13.2 Patient days 6,142,823 6,487,707 6,418,334 6,381,756 6,004,066 Occupancy rate for licensed beds 71 % 75 % 75 % 76 % 75 % Occupancy rate for available beds 71 % 75 % 75 % 76 % 75 % Per Share Data Net income attributable to UHS—basic $ 11.06 $ 9.16 $ 8.35 $ 7.86 $ 7.22 Net income attributable to UHS—diluted $ 10.99 $ 9.13 $ 8.31 $ 7.81 $ 7.14 Dividends declared $ 0.20 $ 0.60 $ 0.40 $ 0.40 $ 0.40 Other Information (in thousands) Weighted average number of shares outstanding—basic 85,061 88,762 93,276 95,652 97,208 Weighted average number of shares and share equivalents outstanding—diluted 85,587 89,040 93,750 96,325 98,380 (1) Amounts exclude non-cash capital lease obligations, if any. (2) Excludes statistical information related to divested facilities. 38 ITEM 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations Overview Our principal business is owning and operating, through our subsidiaries, acute care hospitals and outpatient facilities and behavioral health care facilities. As of February 25, 2021, we owned and/or operated 360 inpatient facilities and 39 outpatient and other facilities including the following located in 38 states, Washington, D.C., the United Kingdom and Puerto Rico: Acute care facilities located in the U.S.: • 26 inpatient acute care hospitals; • 17 free-standing emergency departments, and; • 6 outpatient centers & 1 surgical hospital. Behavioral health care facilities (334 inpatient facilities and 15 outpatient facilities): Located in the U.S.: • 185 inpatient behavioral health care facilities, and; • 12 outpatient behavioral health care facilities. Located in the U.K.: • 146 inpatient behavioral health care facilities, and; • 3 outpatient behavioral health care facilities. Located in Puerto Rico: • 3 inpatient behavioral health care facilities. As a percentage of our consolidated net revenues, net revenues from our acute care hospitals, outpatient facilities and commercial health insurer accounted for 55% during 2020, 54% during 2019 and 53% during 2018. Net revenues from our behavioral health care facilities and commercial health insurer accounted for 45% of our consolidated net revenues during 2020, 46% during 2019 and 47% during 2018. Our behavioral health care facilities located in the U.K. generated net revenues of approximately $584 million in 2020, $554 million in 2019 and $505 million in 2018. Total assets at our U.K. behavioral health care facilities were approximately $1.334 billion as of December 31, 2020, $1.270 billion as of December 31, 2019 and $1.224 billion as of December 31, 2018. Services provided by our hospitals include general and specialty surgery, internal medicine, obstetrics, emergency room care, radiology, oncology, diagnostic care, coronary care, pediatric services, pharmacy services and/or behavioral health services. We provide capital resources as well as a variety of management services to our facilities, including central purchasing, information services, finance and control systems, facilities planning, physician recruitment services, administrative personnel management, marketing and public relations. Forward-Looking Statements and Risk Factors You should carefully review the information contained in this Annual Report, and should particularly consider any risk factors that we set forth in this Annual Report and in other reports or documents that we file from time to time with the Securities and Exchange Commission (the “SEC”). In this Annual Report, we state our beliefs of future events and of our future financial performance. This Annual Report contains “forward-looking statements” that reflect our current estimates, expectations and projections about our future results, performance, prospects and opportunities. Forward-looking statements include, among other things, the information concerning our possible future results of operations, business and growth strategies, financing plans, expectations that regulatory developments or other matters will not have a material adverse effect on our business or financial condition, our competitive position and the effects of competition, the projected growth of the industry in which we operate, and the benefits and synergies to be obtained from our completed and any future acquisitions, and statements of our goals and objectives, and other similar expressions concerning matters that are not historical facts. Words such as “may,” “will,” “should,” “could,” “would,” “predicts,” “potential,” “continue,” “expects,” “anticipates,” “future,” “intends,” “plans,” “believes,” “estimates,” “appears,” “projects” and similar expressions, as well as statements in future tense, identify forward-looking statements. In evaluating those statements, you should specifically consider various factors, including the risks related to healthcare industry trends and those set forth herein in Item 1A. Risk Factors. Those factors may cause our actual results to differ materially from any of our forward-looking statements. 39 Forward-looking statements should not be read as a guarantee of future performance or results, and will not necessarily be accurate indications of the times at, or by which, such performance or results will be achieved. Forward-looking information is based on information available at the time and/or our good faith belief with respect to future events, and is subject to risks and uncertainties that could cause actual performance or results to differ materially from those expressed in the statements. Such factors include, among other things, the following: • we are subject to risks associated with public health threats and epidemics, including the health concerns relating to the COVID-19 pandemic. In January 2020, the Centers for Disease Control and Prevention (“CDC”) confirmed the spread of the disease to the United States. In March 2020, the World Health Organization declared the COVID-19 outbreak a pandemic. The federal government has declared COVID-19 a national emergency, as many federal and state authorities have implemented aggressive measures to “flatten the curve” of confirmed individuals diagnosed with COVID-19 in an attempt to curtail the spread of the virus and to avoid overwhelming the health care system; • the COVID-19 pandemic has adversely impacted and is likely to further adversely impact us, our employees, our patients, our vendors and supply chain partners, and financial institutions, which could continue to have a material adverse effect on our business, results of operations and financial condition. In an effort to slow the spread of the disease, since March, 2020, at various times, most state and local governments mandated general “shelter-in-place” orders or other similar restrictions that require or strongly encourage social distancing and, face coverings, and that have closed or limited non-essential business activities. Some of these restrictions remain in place. Additionally, evidence suggests that individuals may be deciding to forego medical care delivered in traditional venues. These dynamics have manifested themselves in our hospitals in, among other ways, reduced emergency room visits, elective/scheduled procedures and acute and behavioral health patient days. While such measures are expected to assist in responding to the recent outbreak, self-quarantines, shelter-in-place orders, and suspension of voluntary procedures and surgeries have had, and will likely continue to have, an adverse impact on the operations and financial position of health care provider systems due to increased costs (including labor costs which have been pressured during the COVID-19 pandemic due to a shortage of clinicians and increased wage rates resulting from increased demand for those services), actual reduction and potential reduction in overall patient volume, and shifts in payor mix. Despite these measures, there have been waves of escalated COVID-19 cases at various times, including the fourth quarter of 2020 and into the first quarter of 2021, in many states in the U.S., including many states in which we operate hospitals. Recently, COVID-19 vaccinations have begun to be administered and while we expect the administration of vaccines will assist in easing the number of COVID-19 patients, the pace at which this is likely to occur is difficult to predict. The extent to which the COVID-19 pandemic and measures taken in response thereto impact our business, results of operations and financial condition will depend on numerous factors and future developments, most of which are beyond our control or ability to predict. The ultimate impact of the COVID-19 pandemic is highly uncertain and subject to change. We are not able to fully quantify the impact that these factors will have on our future financial results, but expect developments related to the COVID-19 pandemic to materially affect our financial performance in 2021. Even after the COVID-19 pandemic has subsided, we may continue to experience materially adverse impacts on our financial condition and our results of operations as a result of its macroeconomic impact, including any recession that has occurred or may occur in the future, and many of our known risks described in the Risk Factors section herein; • the Coronavirus Aid, Relief, and Economic Security Act (the “CARES Act”), a stimulus package signed into law on March 27, 2020, authorizes $100 billion in grant funding to hospitals and other healthcare providers to be distributed through the Public Health and Social Services Emergency Fund (the “PHSSEF”). These funds are not required to be repaid provided the recipients attest to and comply with certain terms and conditions, including limitations on balance billing and not using PHSSEF funds to reimburse expenses or losses that other sources are obligated to reimburse. However, since the expenses and losses will be ultimately measured over the life of the COVID-19 pandemic, potential retrospective unfavorable adjustments in future periods, of funds recorded as revenues in prior periods, could occur. The U.S. Department of Health and Human Services (“HHS”) initially distributed $30 billion of this funding based on each provider’s share of total Medicare fee-for-service reimbursement in 2019. Subsequently, HHS distributed $50 billion in CARES Act funding (including the $30 billion already distributed) would be allocated proportional to providers’ share of 2018 net patient revenue. We have received payments from these initial distributions of the PHSSEF as disclosed herein. HHS has indicated that distributions of the remaining $50 billion will be targeted primarily to hospitals in COVID-19 high impact areas, to rural providers, safety net hospitals and certain Medicaid providers and to reimburse providers for COVID-19-related treatment of uninsured patients. We have received payments from these targeted distributions of the PHSSEF, as disclosed herein. The CARES Act also makes other forms of financial assistance available to healthcare providers, including through Medicare and Medicaid payment adjustments and an expansion of the Medicare Accelerated and Advance Payment Program, which makes available accelerated payments of Medicare funds in order to increase cash flow to providers. On April 26, 2020, CMS announced it was reevaluating and temporarily suspending the Accelerated and Advance Payment Program in light of the availability of the PHSSEF and the significant funds available through other programs. We have received accelerated payments under this program as disclosed herein. The Paycheck Protection Program and Health Care Enhancement Act (the “PPPHCE Act”), a stimulus package signed into law on April 24, 2020, 40 includes additional emergency appropriations for COVID-19 response, including $75 billion to be distributed to eligible providers through the PHSSEF. A third phase of PHSSEF allocations was recently announced, under which $24.5 billion was made available for providers who previously received, rejected or accepted PHSSEF payments. Applicants that have not yet received PHSSEF payments of 2 percent of patient revenue will receive a payment that, when combined with prior payments (if any), equals 2 percent of patient care revenue. Providers that have already received payments of approximately 2 percent of annual revenue from patient care can submit more information and may be eligible for an additional payment. On December 27, 2020, the Consolidated Appropriations Act, 2021 (“CAA”) was signed into law. The CAA appropriated an additional $3 billion to the PHSSEF, codified flexibility for providers to calculate lost revenues, and permitted parent organizations to allocate PHSSEF targeted distributions to subsidiary organizations. The CAA also provides that not less than 85 percent of the unobligated PHSSEF amounts and any future funds recovered from health care providers should be used for additional distributions that consider financial losses and changes in operating expenses in the third or fourth quarters of 2020 and the first quarter of 2021 that are attributable to the coronavirus. The CAA provided additional funding for testing, contact tracing and vaccine administration. Providers receiving payments were required to sign terms and conditions regarding utilization of the payments. Any provider receiving funds in excess of $10,000 in the aggregate will be required to report data elements to HHS detailing utilization of the payments. Providers will report healthcare related expenses attributable to COVID-19 that have not been reimbursed by another source, which may include general and administrative or healthcare related operating expenses. Funds may also be applied to lost revenues, represented as a negative change in year-over-year net patient care operating income. All Provider Relief Fund payments must be expended by June 30, 2021. Recipients will not be required to repay the government for funds received, provided they comply with HHS-defined terms and conditions. There is a high degree of uncertainty surrounding the implementation of the CARES Act and the PPPHCE Act, and the federal government may consider additional stimulus and relief efforts, but we are unable to predict whether additional stimulus measures will be enacted or their impact. There can be no assurance as to the total amount of financial and other types of assistance we will receive under the CARES Act and the PPPHCE Act, and it is difficult to predict the impact of such legislation on our operations or how they will affect operations of our competitors. Moreover, we are unable to assess the extent to which anticipated negative impacts on us arising from the COVID-19 pandemic will be offset by amounts or benefits received or to be received under the CARES Act and the PPPHCE Act; • our ability to comply with the existing laws and government regulations, and/or changes in laws and government regulations; • an increasing number of legislative initiatives have been passed into law that may result in major changes in the health care delivery system on a national or state level. Legislation has already been enacted that has eliminated the penalty for failing to maintain health coverage that was part of the original Patient Protection and Affordable Care Act (the “Legislation”). President Biden is expected to undertake executive actions that will strengthen the Legislation and may reverse the policies of the prior administration. The Trump Administration had directed the issuance of final rules (i) enabling the formation of association health plans that would be exempt from certain Legislation requirements such as the provision of essential health benefits; (iii) expanding the of short-term, limited duration health insurance, (iii) eliminating cost-sharing reduction payments to insurers that would otherwise offset deductibles and other out-of-pocket expenses for health plan enrollees at or below 250 percent of the federal poverty level; (iv) relaxing requirements for state innovation waivers that could reduce enrollment in the individual and small group markets and lead to additional enrollment in short-term, limited duration insurance and association health plans, and; (v) incentivizing the use of health reimbursement arrangements by employers to permit employees to purchase health insurance in the individual market. The uncertainty resulting from these Executive Branch policies has led to reduced Exchange enrollment in 2018, 2019 and 2020 and is expected to further worsen the individual and small group market risk pools in future years. It is also anticipated that these policies, to the extent that they remain as implements, may create additional cost and reimbursement pressures on hospitals, including ours. In addition, while attempts to repeal the entirety of the Legislation have not been successful to date, a key provision of the Legislation was repealed as part of the Tax Cuts and Jobs Act and on December 14, 2018, a federal U.S. District Court Judge in Texas ruled the entire Legislation is unconstitutional. That ruling was appealed and on December 18, 2019, the Fifth Circuit Court of Appeals voted 2-1 to strike down the Legislation individual mandate as unconstitutional and sent the case back to the U.S. District Court in Texas to determine which Legislation provisions should be stricken with the mandate or whether the entire law is unconstitutional without the individual mandate. On March 2, 2020, the U.S. Supreme Court agreed to hear, during the 2020-2021 term, two consolidated cases, filed by the State of California and the United States House of Representatives, asking the Supreme Court to review the ruling by the Fifth Circuit Court of Appeals. Oral argument was heard on November 10, 2020, and a ruling is expected in 2021. The Legislation will remain law while the case proceeds through the appeals process; however, the case creates additional uncertainty as to whether any or all of the Legislation could be struck down, which creates operational risk for the health care industry. We are unable to predict the final outcome of this matter which has caused greater uncertainty regarding the future status of the Legislation. If all or any parts of the Legislation are ultimately found to be unconstitutional, it could have a material adverse effect on our business, financial condition and results of operations. See below in Sources of Revenue and Health Care Reform for additional disclosure; 41 • under the Legislation, hospitals are required to make public a list of their standard charges, and effective January 1, 2019, CMS has required that this disclosure be in machine-readable format and include charges for all hospital items and services and average charges for diagnosis-related groups. On November 27, 2019, CMS published a final rule on “Price Transparency Requirements for Hospitals to Make Standard Charges Public.” This rule took effect on January 1, 2021 and requires all hospitals to also make public their payor-specific negotiated rates, minimum negotiated rates, maximum negotiated rates, and cash for all items and services, including individual items and services and service packages, that could be provided by a hospital to a patient. Failure to comply with these requirements may result in daily monetary penalties; • as part of the CAA, Congress passed legislation aimed at preventing or limiting patient balance billing in certain circumstances. The CAA addresses surprise medical bills stemming from emergency services, out-of-network ancillary providers at in-network facilities, and air ambulance carriers. The legislation prohibits surprise billing when out-of-network emergency services or out-of-network services at an in-network facility are provided, unless informed consent is received. In these circumstances providers are prohibited from billing the patient for any amounts that exceed in-network cost-sharing requirements. The legislation requires HHS, as well as the Department of the Treasury, and Department of Labor to issue implementing regulations within a year of enactment; • possible unfavorable changes in the levels and terms of reimbursement for our charges by third party payers or government based payers, including Medicare or Medicaid in the United States, and government based payers in the United Kingdom; • our ability to enter into managed care provider agreements on acceptable terms and the ability of our competitors to do the same, including contracts with United/Sierra Healthcare in Las Vegas, Nevada. Effective January, 2020, United/Sierra Healthcare in Las Vegas, entered into an agreement with a competitor health system that was previously excluded from their contractual network in the area. As a result, we believe that our 6 acute care hospitals in the Las Vegas, Nevada market, will likely experience a decline in patient volumes. However, we have entered into an amended agreement with United/Sierra Healthcare related to our hospitals in the Las Vegas market that provide for various rate increases beginning in January, 2020. Although we estimate that the unfavorable impact of the projected declines in patient volumes should be largely offset by the favorable impact of the increased rates, we can provide no assurance that these developments, as well as the effect of COVID-19 on the Las Vegas market, will not have a material adverse impact on our future results of operations; • the outcome of known and unknown litigation, government investigations, false claims act allegations, and liabilities and other claims asserted against us and other matters as disclosed in Note 8 to the Consolidated Financial Statements - Commitments and Contingencies and the effects of adverse publicity relating to such matters; • the unfavorable impact on our business of the deterioration in national, regional and local economic and business conditions, including a worsening of unfavorable credit market conditions; • competition from other healthcare providers (including physician owned facilities) in certain markets; • technological and pharmaceutical improvements that increase the cost of providing, or reduce the demand for healthcare; • our ability to attract and retain qualified personnel, nurses, physicians and other healthcare professionals and the impact on our labor expenses resulting from a shortage of nurses and other healthcare professionals; • demographic changes; • we experienced a cyberattack in September, 2020 that had an adverse effect on our operating results during the fourth quarter of 2020. Although we can provide no assurance or estimation related to the amount of the ultimate insurance proceeds that we may receive in connection with this incident, we believe we are entitled to recovery of the majority of the unfavorable economic impact of the cyberattack pursuant to a commercial insurance policy. However, there is a heightened risk of future cybersecurity threats, including ransomware attacks targeting healthcare providers. If successful, future cyberattacks could have a material adverse effect on our business. Any costs that we incur as a result of a data security incident or breach, including costs to update our security protocols to mitigate such an incident or breach could be significant. Any breach or failure in our operational security systems can result in loss of data or an unauthorized disclosure of or access to sensitive or confidential member or protected personal or health information and could result in significant penalties or fines, litigation, loss of customers, significant damage to our reputation and business, and other losses; • the availability of suitable acquisition and divestiture opportunities and our ability to successfully integrate and improve our acquisitions since failure to achieve expected acquisition benefits from certain of our prior or future acquisitions could result in impairment charges for goodwill and purchased intangibles; • the impact of severe weather conditions, including the effects of hurricanes and climate change; 42 • as discussed below in Sources of Revenue, we receive revenues from various state and county based programs, including Medicaid in all the states in which we operate (we receive Medicaid revenues in excess of $100 million annually from each of California, Texas, Nevada, Washington, D.C., Pennsylvania, Illinois and Massachusetts); CMS-approved Medicaid supplemental programs in certain states including Texas, Mississippi, Illinois, Oklahoma, Nevada, Arkansas, California and Indiana, and; state Medicaid disproportionate share hospital payments in certain states including Texas and South Carolina. We are therefore particularly sensitive to potential reductions in Medicaid and other state based revenue programs as well as regulatory, economic, environmental and competitive changes in those states. We can provide no assurance that reductions to revenues earned pursuant to these programs, and the effect of the COVID-19 pandemic on state budgets, particularly in the above-mentioned states, will not have a material adverse effect on our future results of operations; • our ability to continue to obtain capital on acceptable terms, including borrowed funds, to fund the future growth of our business; • our inpatient acute care and behavioral health care facilities may experience decreasing admission and length of stay trends; • our financial statements reflect large amounts due from various commercial and private payers and there can be no assurance that failure of the payers to remit amounts due to us will not have a material adverse effect on our future results of operations; • in August, 2011, the Budget Control Act of 2011 (the “2011 Act”) was enacted into law. The 2011 Act imposed annual spending limits for most federal agencies and programs aimed at reducing budget deficits by $917 billion between 2012 and 2021, according to a report released by the Congressional Budget Office. Among its other provisions, the law established a bipartisan Congressional committee, known as the Joint Select Committee on Deficit Reduction (the “Joint Committee”), which was tasked with making recommendations aimed at reducing future federal budget deficits by an additional $1.5 trillion over 10 years. The Joint Committee was unable to reach an agreement by the November 23, 2011 deadline and, as a result, across-the-board cuts to discretionary, national defense and Medicare spending were implemented on March 1, 2013 resulting in Medicare payment reductions of up to 2% per fiscal year with a uniform percentage reduction across all Medicare programs. The Bipartisan Budget Act of 2015, enacted on November 2, 2015, continued the 2% reductions to Medicare reimbursement imposed under the 2011 Act. The CARES Act suspended payment reductions between May 1 and December 31, 2020, in exchange for extended cuts through 2030. The CAA extended the suspension of payment reductions until March 31, 2021. We cannot predict whether Congress will restructure the implemented Medicare payment reductions or what other federal budget deficit reduction initiatives may be proposed by Congress going forward; • uninsured and self-pay patients treated at our acute care facilities unfavorably impact our ability to satisfactorily and timely collect our self-pay patient accounts; • changes in our business strategies or development plans; • in June, 2016, the United Kingdom affirmatively voted in a non-binding referendum in favor of the exit of the United Kingdom (“U.K.”) from the European Union (the “Brexit”) and it was approved by vote of the British legislature. On March 29, 2017, the United Kingdom triggered Article 50 of the Lisbon Treaty, formally starting negotiations regarding its exit from the European Union. On January 31, 2020, the U.K. formally exited the European Union. On December 24, 2020, the United Kingdom and the European Union reached a post-Brexit trade and cooperation agreement that created new business and security requirements and preserved the United Kingdom’s tariff- and quota-free access to the European Union member states. We do not know to what extent Brexit will ultimately impact the business and regulatory environment in the U.K., the European Union, or other countries. Any of these effects of Brexit, and others we cannot anticipate, could harm our business, financial condition and results of operations; • fluctuations in the value of our common stock, and; • other factors referenced herein or in our other filings with the Securities and Exchange Commission. Given these uncertainties, risks and assumptions, as outlined above, you are cautioned not to place undue reliance on such forward-looking statements. Our actual results and financial condition could differ materially from those expressed in, or implied by, the forward-looking statements. Forward-looking statements speak only as of the date the statements are made. We assume no obligation to publicly update any forward-looking statements to reflect actual results, changes in assumptions or changes in other factors affecting forward-looking information, except as may be required by law. All forward-looking statements attributable to us or persons acting on our behalf are expressly qualified in their entirety by this cautionary statement. 43 Critical Accounting Policies and Estimates The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires us to make estimates and assumptions that affect the amounts reported in our consolidated financial statements and accompanying notes. A summary of our significant accounting policies is outlined in Note 1 to the financial statements. We consider our critical accounting policies to be those that require us to make significant judgments and estimates when we prepare our financial statements, including the following: Revenue Recognition: On January 1, 2018, we adopted, using the modified retrospective approach, ASU 2014-09 and ASU 2016-08, “Revenue from Contracts with Customers (Topic 606)” and “Revenue from Contracts with Customers: Principal versus Agent Considerations (Reporting Revenue Gross versus Net)”, respectively, which provides guidance for revenue recognition. The standard’s core principle is that a company will recognize revenue when it transfers promised goods or services to customers in an amount that reflects the consideration to which the company expects to be entitled in exchange for those goods or services. The most significant change from the adoption of the new standard relates to our estimation for the allowance for doubtful accounts. Under the previous standards, our estimate for amounts not expected to be collected based upon our historical experience, were reflected as provision for doubtful accounts, included within net revenue. Under the new standard, our estimate for amounts not expected to be collected based on historical experience will continue to be recognized as a reduction to net revenue, however, not reflected separately as provision for doubtful accounts. Under the new standard, subsequent changes in estimate of collectability due to a change in the financial status of a payer, for example a bankruptcy, will be recognized as bad debt expense in operating charges. The adoption of this ASU in 2018, and amounts recognized as bad debt expense and included in other operating expenses, did not have a material impact on our consolidated financial statements. See Note 10 to the Consolidated Financial Statements-Revenue Recognition, for additional disclosure related to our revenues including a disaggregation of our consolidated net revenues by major source for each of the periods presented herein. We report net patient service revenue at the estimated net realizable amounts from patients and third-party payers and others for services rendered. We have agreements with third-party payers that provide for payments to us at amounts different from our established rates. Payment arrangements include rates per discharge, reimbursed costs, discounted charges and per diem payments. Estimates of contractual allowances, which represent explicit price concessions under ASC 606, under managed care plans are based upon the payment terms specified in the related contractual agreements. We closely monitor our historical collection rates, as well as changes in applicable laws, rules and regulations and contract terms, to assure that provisions are made using the most accurate information available. However, due to the complexities involved in these estimations, actual payments from payers may be different from the amounts we estimate and record. We estimate our Medicare and Medicaid revenues using the latest available financial information, patient utilization data, government provided data and in accordance with applicable Medicare and Medicaid payment rules and regulations. The laws and regulations governing the Medicare and Medicaid programs are extremely complex and subject to interpretation and as a result, there is at least a reasonable possibility that recorded estimates will change by material amounts in the near term. Certain types of payments by the Medicare program and state Medicaid programs (e.g. Medicare Disproportionate Share Hospital, Medicare Allowable Bad Debts and Inpatient Psychiatric Services) are subject to retroactive adjustment in future periods as a result of administrative review and audit and our estimates may vary from the final settlements. Such amounts are included in accounts receivable, net, on our Consolidated Balance Sheets. The funding of both federal Medicare and state Medicaid programs are subject to legislative and regulatory changes. As such, we cannot provide any assurance that future legislation and regulations, if enacted, will not have a material impact on our future Medicare and Medicaid reimbursements. Adjustments related to the final settlement of these retrospectively determined amounts did not materially impact our results in 2020, 2019 or 2018. If it were to occur, each 1% adjustment to our estimated net Medicare revenues that are subject to retrospective review and settlement as of December 31, 2020, would change our after-tax net income by approximately $1 million. Charity Care, Uninsured Discounts and Other Adjustments to Revenue: Collection of receivables from third-party payers and patients is our primary source of cash and is critical to our operating performance. Our primary collection risks relate to uninsured patients and the portion of the bill which is the patient’s responsibility, primarily co-payments and deductibles. We estimate our revenue adjustments for implicit price concessions based on general factors such as payer mix, the aging of the receivables and historical collection experience. We routinely review accounts receivable balances in conjunction with these factors and other economic conditions which might ultimately affect the collectability of the patient accounts and make adjustments to our allowances as warranted. At our acute care hospitals, third party liability accounts are pursued until all payment and adjustments are posted to the patient account. For those accounts with a patient balance after third party liability is finalized or accounts for uninsured patients, the patient receives statements and collection letters. Historically, a significant portion of the patients treated throughout our portfolio of acute care hospitals are uninsured patients which, in part, has resulted from patients who are employed but do not have health insurance or who have policies with relatively high deductibles. Patients treated at our hospitals for non-elective services, who have gross income of various amounts, dependent upon the state, ranging from 200% to 400% of the federal poverty guidelines, are deemed eligible for charity care. The federal poverty 44 guidelines are established by the federal government and are based on income and family size. Because we do not pursue collection of amounts that qualify as charity care, the transaction price is fully adjusted and there is no impact in our net revenues or in our accounts receivable, net. A portion of the accounts receivable at our acute care facilities are comprised of Medicaid accounts that are pending approval from third-party payers but we also have smaller amounts due from other miscellaneous payers such as county indigent programs in certain states. Our patient registration process includes an interview of the patient or the patient’s responsible party at the time of registration. At that time, an insurance eligibility determination is made and an insurance plan code is assigned. There are various pre-established insurance profiles in our patient accounting system which determine the expected insurance reimbursement for each patient based on the insurance plan code assigned and the services rendered. Certain patients may be classified as Medicaid pending at registration based upon a screening evaluation if we are unable to definitively determine if they are currently Medicaid eligible. When a patient is registered as Medicaid eligible or Medicaid pending, our patient accounting system records net revenues for services provided to that patient based upon the established Medicaid reimbursement rates, subject to the ultimate disposition of the patient’s Medicaid eligibility. When the patient’s ultimate eligibility is determined, reclassifications may occur which impacts net revenues in future periods. Although the patient’s ultimate eligibility determination may result in adjustments to net revenues, these adjustments did not have a material impact on our results of operations in 2020, 2019 or 2018 since our facilities make estimates at each financial reporting period to adjust revenue based on historical collections. Under ASC 605, these estimates were reported in the provision for doubtful accounts. We also provide discounts to uninsured patients (included in “uninsured discounts” amounts below) who do not qualify for Medicaid or charity care. Because we do not pursue collection of amounts classified as uninsured discounts, the transaction price is fully adjusted and there is no impact in our net revenues or in our net accounts receivable. In implementing the discount policy, we first attempt to qualify uninsured patients for governmental programs, charity care or any other discount program. If an uninsured patient does not qualify for these programs, the uninsured discount is applied. Uncompensated care (charity care and uninsured discounts): The following table shows the amounts recorded at our acute care hospitals for charity care and uninsured discounts, based on charges at established rates, for the years ended December 31, 2020, 2019 and 2018: (dollar amounts in thousands) 2020 2019 2018 Amount % Amount % Amount % Charity care $ 622,668 28 % $ 672,326 31 % $ 761,783 40 % Uninsured discounts 1,578,470 72 % 1,511,738 69 % 1,132,811 60 % Total uncompensated care $ 2,201,138 100 % $ 2,184,064 100 % $ 1,894,594 100 % The estimated cost of providing uncompensated care: The estimated cost of providing uncompensated care, as reflected below, were based on a calculation which multiplied the percentage of operating expenses for our acute care hospitals to gross charges for those hospitals by the above-mentioned total uncompensated care amounts. The percentage of cost to gross charges is calculated based on the total operating expenses for our acute care facilities divided by gross patient service revenue for those facilities. An increase in the level of uninsured patients to our facilities and the resulting adverse trends in the adjustments to net revenues and uncompensated care provided could have a material unfavorable impact on our future operating results. (amounts in thousands) 2020 2019 2018 Estimated cost of providing charity care $ 73,690 $ 77,886 $ 94,088 Estimated cost of providing uninsured discounts related care 186,804 175,128 139,913 Estimated cost of providing uncompensated care $ 260,494 $ 253,014 $ 234,001 Self-Insured/Other Insurance Risks: We provide for self-insured risks including general and professional liability claims, workers’ compensation claims and healthcare and dental claims. Our estimated liability for self-insured professional and general liability claims is based on a number of factors including, among other things, the number of asserted claims and reported incidents, estimates of losses for these claims based on recent and historical settlement amounts, estimate of incurred but not reported claims based on historical experience, and estimates of amounts recoverable under our commercial insurance policies. All relevant information, including our own historical experience is used in estimating the expected amount of claims. While we continuously monitor these factors, our ultimate liability for professional and general liability claims could change materially from our current estimates due to inherent uncertainties involved in making this estimate. Our estimated self-insured reserves are reviewed and changed, if necessary, at each reporting date and changes are recognized currently as additional expense or as a reduction of expense. In addition, we also: (i) own commercial health insurers headquartered in Reno, Nevada, and Puerto Rico and; (ii) maintain self- 45 insured employee benefits programs for employee healthcare and dental claims. The ultimate costs related to these programs/operations include expenses for claims incurred and paid in addition to an accrual for the estimated expenses incurred in connection with claims incurred but not yet reported. Given our significant insurance-related exposure, there can be no assurance that a sharp increase in the number and/or severity of claims asserted against us will not have a material adverse effect on our future results of operations. See Note 8 to the Consolidated Financial Statements-Commitments and Contingencies, for additional disclosure related to our professional and general liability, workers’ compensation liability and property insurance. Long-Lived Assets: We review our long-lived assets for impairment whenever events or circumstances indicate that the carrying value of these assets may not be recoverable. The assessment of possible impairment is based on our ability to recover the carrying value of our asset based on our estimate of its undiscounted future cash flow. If the analysis indicates that the carrying value is not recoverable from future cash flows, the asset is written down to its estimated fair value and an impairment loss is recognized. Fair values are determined based on estimated future cash flows using appropriate discount rates. Goodwill and Intangible Assets: Goodwill and indefinite-lived intangible assets are reviewed for impairment at the reporting unit level on an annual basis or sooner if the indicators of impairment arise. Our judgments regarding the existence of impairment indicators are based on market conditions and operational performance of each reporting unit. We have designated October 1st as our annual impairment assessment date for our goodwill and indefinite-lived intangible assets. We performed an impairment assessment as of October 1, 2020 which indicated no impairment of goodwill. There were also no goodwill impairments during 2019 or 2018. Our 2019 and 2018 financial results included aggregate pre-tax provisions for asset impairments of $98 million and $49 million, respectively, recorded in connection with Foundations Recovery Network, L.L.C. (“Foundations”), which was acquired by us in 2015. These pre-tax provisions for asset impairments include: (i) a $124 million impairment provision to write-off the carrying value of the Foundations’ tradename intangible asset ($75 million recorded during 2019 and $49 million recorded during 2018), and; (ii) a $23 million impairment provision recorded during 2019 to reduce the carrying value of real property assets of certain Foundations’ facilities. Please see below in Provision for Asset Impairment-Foundations Recovery Network for additional information. Future changes in the estimates used to conduct the impairment review, including profitability and market value projections, could indicate impairment in future periods potentially resulting in a write-off of a portion or all of our goodwill or indefinite-lived intangible assets. Income Taxes: Deferred tax assets and liabilities are recognized for the amount of taxes payable or deductible in future years as a result of differences between the tax basis of assets and liabilities and their reported amounts in the financial statements. We believe that future income will enable us to realize our deferred tax assets net of recorded valuation allowances relating to state and foreign net operating loss carry-forwards, foreign tax credits, and interest deduction limitations. On December 22, 2017, the President of the United States signed into law comprehensive tax legislation commonly referred to as the Tax Cuts and Jobs Act of 2017 (the “TCJA-17”). The TCJA-17 made broad and complex changes to the U.S. tax code, including, but not limited to, (1) reducing the U.S. federal corporate tax rate from 35 percent to 21 percent; (2) requiring companies to pay a one-time transition tax on certain unrepatriated earnings of foreign subsidiaries; (3) generally eliminating U.S. federal income taxes on dividends from foreign subsidiaries; (4) requiring current inclusion in U.S. federal taxable income of certain earnings of controlled foreign corporations through the implementation of a territorial tax system; (5) creating a new limitation on deductible interest expense, and; (6) limiting certain other deductions. We provided a provisional estimate of the effects of the TCJA-17 in the fourth quarter of 2017 financial statements. In the fourth quarter of 2018, we completed our analysis to determine the effects of the TCJA-17 in accordance with Staff Accounting Bulletin No. 118 as follows: Reduction of U.S. federal corporate tax rate: The TCJA-17 reduces the corporate tax rate to 21 percent, effective January 1, 2018. Deferred income taxes are based on the estimated future tax effects of differences between the financial statement carrying amounts and the tax basis of assets and liabilities under the provisions of the enacted laws. For certain of our deferred tax assets and deferred tax liabilities, we recorded a provisional decrease of $97 million and $127 million, respectively, with a corresponding net adjustment to deferred tax benefit of $30 million for the year ended December 31, 2017. Upon completion of our 2017 U.S. Corporate Income Tax Return, an increase of $1 million attributable to certain deferred tax assets and a decrease of $5 million attributable to certain deferred tax liabilities was recorded resulting in an additional net deferred tax benefit of $6 million. Deemed Repatriation Transition Tax: The Deemed Repatriation Transition Tax (“Transition Tax”) is a tax on previously untaxed accumulated and current earnings and profits (“E&P”) of certain of our foreign subsidiaries. The one-time Transition Tax is based upon the amount of post-1986 E&P of the relevant subsidiaries, the amount of non-U.S. income tax paid on such earnings, as well as other factors. We originally estimated and recorded a provisional Transition Tax obligation of $11.3 million. Upon 46 completion of our 2017 U.S. Corporate Income Tax Return, the final Transition Tax increased by $100,000 for a total of $11.4 million. We operate in multiple jurisdictions with varying tax laws. We are subject to audits by any of these taxing authorities. Our tax returns have been examined by the Internal Revenue Service through the year ended December 31, 2006. We believe that adequate accruals have been provided for federal, foreign and state taxes. See Provision for Income Taxes and Effective Tax Rates below for discussion of our effective tax rates during each of the last three years. Recent Accounting Pronouncements: For a summary of recent accounting pronouncements, please see Note 1 to the Consolidated Financial Statements-Accounting Standards as included in this Report on Form 10-K for the year ended December 31, 2020. CARES Act and Other Governmental Grants and Medicare Accelerated Payments: As of December 31, 2020, we have received an aggregate of $1.112 billion as follows: • Approximately $417 million of funds received from various governmental stimulus programs, most notably the PHSSEF, as provided for by the CARES Act. o Included in our net income attributable to UHS for the year ended December 31, 2020, was the favorable impact of approximately $309 million resulting from the recording of approximately $413 million of CARES Act and other grant income revenues. Approximately $316 million of the grant income revenues were attributable to our acute care services and approximately $97 million were attributable to our behavioral health care services. o As of December 31, 2020, approximately $4 million of these funds remain in the Medicare accelerated payments and deferred CARES Act and other grants liability account in our consolidated balance sheet. o Approximately $695 million of Medicare accelerated payments received pursuant to the Medicare Accelerated and Advance Payment Program (“MAAPP”). Pursuant to legislation enacted on October 1, 2020, these funds are required to be repaid to the government beginning in the second quarter of 2021 through the third quarter of 2022 through withholding of future Medicare revenues earned during those periods. There was no impact on our earnings during 2020 in connection with receipt of these funds. ▪ We are planning for the early repayment of the $695 million of Medicare accelerated payments previously received pursuant to the MAAPP. We have commenced the repayment process and anticipate that the $695 million of funds will be repaid to the government in March or April of 2021. Additional CARES Act grants amounting to $187 million were received in January, 2021. There was no impact on our results of operations for the year ended December 31, 2020 in connection with receipt of these funds. Please see Sources of Revenue- 2019 Novel Coronavirus Disease Medicare and Medicaid Payment Related Legislation below for additional disclosure. Information Technology Incident: As previously disclosed on September 29, 2020, we experienced an information technology security incident in the early morning hours of September 27, 2020. As a result of this cyberattack, we suspended user access to our information technology applications related to operations located in the United States. While our information technology applications were offline, patient care was delivered safely and effectively at our facilities across the country utilizing established back-up processes, including offline documentation methods. Our information technology applications were substantially restored at our acute care and behavioral health hospitals at various times in October, 2020, on a rolling/staggered basis, and our facilities generally resumed standard operating procedures at that time. Immediately after the incident, we worked diligently with our information technology security partners to restore our information technology infrastructure and business operations as quickly as possible. In parallel, we began investigating the nature and potential impact of the security incident and engaged third-party information technology and forensic vendors to assist. No evidence of unauthorized access, copying or misuse of any patient or employee data has been identified to date. 47 Given the disruption to the standard operating procedures at our facilities during the period of September 27, 2020 into October, 2020, certain patient activity, including ambulance traffic and elective/scheduled procedures at our acute care hospitals, were diverted to competitor facilities. We also incurred significant incremental labor expense, both internal and external, to restore information technology operations as expeditiously as possible. Additionally, certain administrative functions such as coding and billing were delayed into December, 2020, which had a negative impact on our operating cash flows during the fourth quarter of 2020. As a result of these factors, we estimate that this incident had an aggregate unfavorable pre-tax impact of approximately $67 million during the year ended December 31, 2020. The substantial majority of the unfavorable impact was attributable to our acute care services and consisted primarily of lost operating income resulting from the related decrease in patient activity as well as increased revenue reserves recorded in connection with the associated billing delays. Also included were certain labor expenses, professional fees and other operating expenses incurred as a direct result of this incident and the related disruption to our operations. Although we can provide no assurance or estimation related to the receipt timing, or amount, of the proceeds that we may receive pursuant to commercial insurance coverage we have in connection with this incident, we believe we are entitled to recovery of the majority of the ultimate financial impact resulting from the cyberattack. Results of Operations The following table summarizes our results of operations, and is used in the discussion below, for the years ended December 31, 2020, 2019 and 2018 (dollar amounts in thousands): Year Ended December 31, 2020 2019 2018 % of Net % of Net % of Net Amount Revenues Amount Revenues Amount Revenues Net revenues $ 11,558,897 100.0 % $ 11,378,259 100.0 % $ 10,772,278 100.0 % Operating charges: Salaries, wages and benefits 5,613,097 48.6 % 5,588,893 49.1 % 5,254,536 48.8 % Other operating expenses 2,672,762 23.1 % 2,723,911 23.9 % 2,614,687 24.3 % Supplies expense 1,288,132 11.1 % 1,251,346 11.0 % 1,168,654 10.8 % Depreciation and amortization 510,493 4.4 % 490,392 4.3 % 453,045 4.2 % Lease and rental expense 116,059 1.0 % 107,809 0.9 % 106,094 1.0 % Subtotal-operating expenses 10,200,543 88.2 % 10,162,351 89.3 % 9,597,016 89.1 % Income from operations 1,358,354 11.8 % 1,215,908 10.7 % 1,175,262 10.9 % Interest expense, net 106,285 0.9 % 162,733 1.4 % 154,956 1.4 % Other (income) expense, net (14 ) 0.0 % (13,162 ) -0.1 % (14,219 ) -0.1 % Income before income taxes 1,252,083 10.8 % 1,066,337 9.4 % 1,034,525 9.6 % Provision for income taxes 299,293 2.6 % 238,794 2.1 % 236,642 2.2 % Net income 952,790 8.2 % 827,543 7.3 % 797,883 7.4 % Less: Net income attributable to noncontrolling interests 8,837 0.1 % 12,689 0.1 % 18,178 0.2 % Net income attributable to UHS $ 943,953 8.2 % $ 814,854 7.2 % $ 779,705 7.2 % Year Ended December 31, 2020 as compared to the Year Ended December 31, 2019: Net revenues increased 1.6%, or $181 million, to $11.56 billion during 2020 as compared to $11.38 billion during 2019. As discussed above, included in our net revenues during 2020 was approximately $413 million of net revenues recorded in connection with various governmental stimulus programs, most notably the CARES Act. The increase in net revenues was primarily attributable to: • a $216 million or 1.9% increase in net revenues generated from our acute care and behavioral health care operations owned during both periods (which we refer to as “same facility”), and; • $35 million of other combined net decreases including a $13 million reduction in revenues related to provider tax programs which had no impact on net income attributable to UHS as reflected above since the amounts were offset between net revenues and other operating expenses. Income before income taxes increased $186 million to $1.25 billion during 2020 as compared to $1.07 billion during 2019. The net increase in our income before income taxes during 2020, as compared to 2019, was due to the following: • a decrease of $20 million at our acute care facilities, as discussed below in Acute Care Hospital Services, including the favorable impact of approximately $306 million (net of amounts attributable noncontrolling interests) resulting from the 48 $316 million of net revenues recorded during 2020 in connection with various governmental stimulus programs, most notably the CARES Act; • an increase of $24 million at our behavioral health care facilities, as discussed below in Behavioral Health Services, including the favorable impact of approximately $97 million resulting from the net revenues recorded during 2020 in connection with various governmental stimulus programs, most notably the CARES Act, and excluding the impact of a $98 million provision for asset impairment recorded 2019; • an increase of $98 million due to a provision for asset impairment recorded during 2019 in connection with Foundations Recovery Network, L.L.C. (see Other Operating Results-Provision for Asset Impairment-Foundations Recovery Network below for additional disclosure); • an increase of $56 million due to a decrease in interest expense due primarily to lower average outstanding borrowings and a decrease in the average cost of borrowings, as discussed below in Other Operating Results-Interest Expense; • an increase of $11 million due to an increase recorded during 2019 to the reserve previously established in connection with the settlement finalized in July, 2020 with the Department of Justice, Civil Division, and; • $17 million of other combined net increases. Net income attributable to UHS increased $129 million to $944 million during 2020 as compared to $815 million during 2019. This increase was attributable to: • a $186 million increase in income before income taxes, as discussed above; • an increase of $4 million due to a decrease in income attributable to noncontrolling interests, and; • a decrease of $60 million resulting from an increase in the provision for income taxes due primarily to: (i) the income tax provision recorded in connection with the $186 million increase in pre-tax income; (ii) a $20 million increase in the provision for income taxes recorded in connection with our adoption of ASU 2016-09 which increased our provision for income taxes by approximately $7 million during 2020, as compared to a decrease of approximately $12 million during 2019; partially offset by; (iii) a $6 million decrease in the provision for income taxes due to the 2019 recording of the non-deductible portion of the net federal and state income taxes due on the settlement finalized in July, 2020 with the Department of Justice, Civil Division. Please see additional disclosure below in Other Operating Results-Provision for Income Taxes and Effective Tax Rates. Increase to self-insured professional and general liability reserves: Our estimated liability for self-insured professional and general liability claims is based on a number of factors including, among other things, the number of asserted claims and reported incidents, estimates of losses for these claims based on recent and historical settlement amounts, estimates of incurred but not reported claims based on historical experience, and estimates of amounts recoverable under our commercial insurance policies. As a result of unfavorable trends experienced during 2020, we recorded an increase of $25 million to our reserves for self-insured professional and general liability claims. Approximately $19 million of the increase to our reserves for self-insured professional and general liability claims is included in our same facility basis acute care hospitals services’ results, as reflected below, and approximately $6 million is included in our behavioral health services’ results. Year Ended December 31, 2019 as compared to the Year Ended December 31, 2018: Net revenues increased 5.6%, or $606 million, to $11.38 billion during 2019 as compared to $10.77 billion during 2018. The increase was primarily attributable to: • a $583 million or 5.5% increase in net revenues generated from our acute care and behavioral health care operations on a same facility basis, and; • $23 million of other combined net revenue increases due primarily to the revenues generated at 25 behavioral health facilities located in the U.K. acquired during the third quarter of 2018 in connection with our acquisition of The Danshell Group. Income before income taxes increased $32 million to $1.07 billion during 2019 as compared to $1.03 billion during 2018. The net increase in our income before income taxes during 2019, as compared to 2018, was due to the following: • an increase of $5 million as discussed below in Acute Care Hospital Services; • an increase of $34 million as discussed below in Behavioral Health Services, excluding the asset impairment charges recorded during 2019 and 2018 related to Foundations Recovery Network, LLC, as discussed below; 49 • a net increase of $91 million due to a favorable change in the pre-tax increases recorded during 2019 and 2018 to the reserve established in connection with the civil aspects of the government’s investigation of certain of our behavioral health care facilities ($11 million pre-tax reserve increase recorded during 2019 as compared to a $102 million pre-tax increase recorded during 2018); • a net decrease of $49 million from an increase in the asset impairment charges recorded during 2019 ($98 million) and 2018 ($49 million) in connection with Foundations Recovery Network, LLC which was acquired by us during 2015 (see Other Operating Results-Provision for Asset Impairment-Foundations Recovery Network below for additional disclosure); • a decrease of $8 million resulting from an increase in interest expense, as discussed below in Other Operating Results-Interest Expense, and; • $41 million of other combined net decreases. Net income attributable to UHS increased $35 million to $815 million during 2019 as compared to $780 million during 2018. The increase consisted of: • an increase of $32 million in income before income taxes, as discussed above; • an increase of $5 million due to a decrease in the income attributable to noncontrolling interests, and; • a decrease of $2 million resulting from a net increase in the provision for income taxes resulting primarily from: (i) an increase in the provision for income taxes due to the $32 million increase in pre-tax income; (ii) a $6 million increase in the provision for income taxes recorded during 2019 resulting from the net estimated federal and state income taxes due on the portion of the reserve established in connection with the civil aspects of the government’s investigation of certain of our behavioral health care facilities that is estimated to be non-deductible for income tax purposes, partially offset by; (iii) a decrease in the provision for income taxes of $11 million resulting from our adoption of ASU 2016-09 which decreased our provision for income taxes by approximately $12 million during 2019, as compared to a decrease of approximately $1 million during 2018. Please see additional disclosure below in Other Operating Results-Provision for Income Taxes and Effective Tax Rates. Acute Care Hospital Services Year Ended December 31, 2020 as compared to the Year Ended December 31, 2019: Acute Care Hospital Services-Same Facility Basis We believe that providing our results on a “Same Facility” basis (which is a non-GAAP measure), which includes the operating results for facilities and businesses operated in both the current year and prior year periods, is helpful to our investors as a measure of our operating performance. Our Same Facility results also neutralize (if applicable) the effect of items that are non-operational in nature including items such as, but not limited to, gains/losses on sales of assets and businesses, impacts of settlements, legal judgments and lawsuits, impairments of long-lived and intangible assets and other amounts that may be reflected in the current or prior year financial statements that relate to prior periods. Our Same Facility basis results reflected on the tables below also exclude from net revenues and other operating expenses, provider tax assessments incurred in each period as discussed below Sources of Revenue-Various State Medicaid Supplemental Payment Programs. However, these provider tax assessments are included in net revenues and other operating expenses as reflected in the table below under All Acute Care Hospital Services. The provider tax assessments had no impact on the income before income taxes as reflected on the tables below since the amounts offset between net revenues and other operating expenses. To obtain a complete understanding of our financial performance, the Same Facility results should be examined in connection with our net income as determined in accordance with GAAP and as presented in the condensed consolidated financial statements and notes thereto as contained in this Annual Report on Form 10-K. 50 The following table summarizes the results of operations for our acute care hospital services on a same facility basis and is used in the discussions below for the years ended December 31, 2020 and 2019 (dollar amounts in thousands): Year Ended Year Ended December 31, 2020 December 31, 2019 % of Net % of Net Amount Revenues Amount Revenues Net revenues $ 6,238,236 100.0 % $ 6,054,901 100.0 % Operating charges: Salaries, wages and benefits 2,611,143 41.9 % 2,559,682 42.3 % Other operating expenses 1,462,627 23.4 % 1,365,015 22.5 % Supplies expense 1,081,154 17.3 % 1,049,747 17.3 % Depreciation and amortization 318,077 5.1 % 305,264 5.0 % Lease and rental expense 69,638 1.1 % 60,485 1.0 % Subtotal-operating expenses 5,542,639 88.8 % 5,340,193 88.2 % Income from operations 695,597 11.2 % 714,708 11.8 % Interest expense, net 1,567 0.0 % 1,330 0.0 % Other (income) expense, net 0 0.0 % (32 ) 0.0 % Income before income taxes $ 694,030 11.1 % $ 713,410 11.8 % On a same facility basis during 2020, as compared to 2019, net revenues from our acute care hospital services increased $183 million or 3.0%. Income before income taxes (and before income attributable to noncontrolling interests) decreased $19 million, or 3%, to $694 million or 11.1% of net revenues during 2020 as compared to $713 million or 11.8% of net revenues during 2019. As mentioned above, included in our acute care hospital services’ revenues during 2020 was approximately $316 million of revenues recorded in connection with funds received from various governmental stimulus programs, most notably the CARES Act. Excluding these governmental stimulus program revenues from 2020, net revenues from our acute care hospital services, on a same facility basis, decreased $132 million or 2.2% during 2020, as compared to 2019, and income before income taxes decreased $335 million or 47% during 2020, as compared to 2019. During 2020, excluding the impact of the $316 million of governmental stimulus program revenues recorded during 2020, net revenue per adjusted admission increased 14.1% while net revenue per adjusted patient day increased 2.4%, as compared to 2019. During 2020, as compared to 2019, inpatient admissions to our acute care hospitals decreased 9.9% and adjusted admissions decreased 15.2%. Patient days at these facilities increased 0.4% and adjusted patient days decreased 5.5% during 2020 as compared to 2019. The average length of inpatient stay at these facilities increased to 5.1 days during 2020, as compared to 4.6 days during 2019. The occupancy rate, based on the average available beds at these facilities, was 63% and 64% during 2020 and 2019, respectively. As mentioned above, we estimate that the information technology security incident that occurred on September 27, 2020, had an aggregate unfavorable pre-tax impact of approximately $67 million on our consolidated results of operations during the year ended December 31, 2020. The substantial majority of the unfavorable impact was attributable to our acute care services and consisted primarily of lost operating income resulting from the related decrease in patient activity as well as increased revenue reserves recorded in connection with the associated billing delays. Please see Information Technology Incident as included above for additional disclosure regarding this incident, including potential related commercial insurance recoveries. All Acute Care Hospital Services The following table summarizes the results of operations for all our acute care operations during 2020 and 2019. These amounts include: (i) our acute care results on a same facility basis, as indicated above; (ii) the impact of provider tax assessments which increased net revenues and other operating expenses but had no impact on income before income taxes, and; (iii) certain other amounts including, if applicable, the results of recently acquired/opened ancillary businesses. Dollar amounts below are reflected in thousands. 51 Year Ended Year Ended December 31, 2020 December 31, 2019 % of Net % of Net Amount Revenues Amount Revenues Net revenues $ 6,337,304 100.0 % $ 6,164,560 100.0 % Operating charges: Salaries, wages and benefits 2,611,514 41.2 % 2,559,682 41.5 % Other operating expenses 1,561,875 24.6 % 1,474,674 23.9 % Supplies expense 1,081,159 17.1 % 1,049,747 17.0 % Depreciation and amortization 318,124 5.0 % 305,264 5.0 % Lease and rental expense 69,638 1.1 % 60,485 1.0 % Subtotal-operating expenses 5,642,310 89.0 % 5,449,852 88.4 % Income from operations 694,994 11.0 % 714,708 11.6 % Interest expense, net 1,567 0.0 % 1,330 0.0 % Other (income) expense, net 0 0.0 % (32 ) 0.0 % Income before income taxes $ 693,427 10.9 % $ 713,410 11.6 % During 2020, as compared to 2019, net revenues from our acute care hospital services increased $173 million or 2.8% to $6.34 billion as compared to $6.16 billion during 2019 due to: (i) the $183 million, or 3.0%, increase in same facility revenues, as discussed above, and; (ii) an $10 million reduction in provider tax assessments which had no impact on net income attributable to UHS since the amounts were offset between net revenues and other operating expenses. Income before income taxes decreased $20 million, or 3%, to $693 million or 10.9% of net revenues during 2020 as compared to $713 million or 11.6% of net revenues during 2019. The $20 million decrease in income before income taxes from our acute care hospital services resulted from the decrease in income before income taxes at our hospitals, on a same facility basis, as discussed above. Excluding the above-mentioned $316 million of revenues recorded during 2020 in connection with various governmental stimulus programs, net revenues from our acute care hospital services decreased $143 million or 2.3% during 2020, as compared to 2019, and income before income taxes decreased $336 million or 47% during 2020, as compared to 2019. Year Ended December 31, 2019 as compared to the Year Ended December 31, 2018: Acute Care Hospital Services-Same Facility Basis The following table summarizes the results of operations for our acute care hospital services on a same facility basis and is used in the discussions below for the years ended December 31, 2019 and 2018 (dollar amounts in thousands): Year Ended Year Ended December 31, 2019 December 31, 2018 % of Net % of Net Amount Revenues Amount Revenues Net revenues $ 6,053,228 100.0 % $ 5,621,338 100.0 % Operating charges: Salaries, wages and benefits 2,556,383 42.2 % 2,366,985 42.1 % Other operating expenses 1,364,735 22.5 % 1,242,521 22.1 % Supplies expense 1,048,639 17.3 % 968,067 17.2 % Depreciation and amortization 304,206 5.0 % 278,661 5.0 % Lease and rental expense 60,324 1.0 % 57,235 1.0 % Subtotal-operating expenses 5,334,287 88.1 % 4,913,469 87.4 % Income from operations 718,941 11.9 % 707,869 12.6 % Interest expense, net 1,330 0.0 % 1,658 0.0 % Other (income) expense, net (32 ) 0.0 % (2,498 ) 0.0 % Income before income taxes $ 717,643 11.9 % $ 708,709 12.6 % On a same facility basis during 2019, as compared to 2018, net revenues from our acute care services increased $432 million or 7.7%. Income before income taxes increased $9 million or 1% to $718 million or 11.9% of net revenues during 2019 as compared to $709 million or 12.6% of net revenues during 2018. 52 Inpatient admissions to our acute care hospitals owned during both years increased 4.6% during 2019, as compared to 2018, while patient days increased 5.4%. Adjusted admissions (adjusted for outpatient activity) increased 4.8% and adjusted patient days increased 5.7% during 2019, as compared to 2018. The average length of inpatient stay at these facilities was 4.6 days during 2019 and 4.5 days during 2018. The occupancy rate, based on the average available beds at these facilities, was 64% during 2019 and 62% during 2018. On a same facility basis, net revenue per adjusted admission at these facilities increased 2.5% during 2019, as compared to 2018, and net revenue per adjusted patient day increased 1.7% during 2019, as compared to 2018. All Acute Care Hospital Services The following table summarizes the results of operations for all our acute care operations during 2019 and 2018. These amounts include: (i) our acute care results on a same facility basis, as indicated above; (ii) the impact of provider tax assessments which increased net revenues and other operating expenses but had no impact on income before income taxes, and; (iii) certain other amounts including, if applicable, the results of recently acquired/opened ancillary businesses. Dollar amounts below are reflected in thousands. Year Ended Year Ended December 31, 2019 December 31, 2018 % of Net % of Net Amount Revenues Amount Revenues Net revenues $ 6,164,560 100.0 % $ 5,719,905 100.0 % Operating charges: Salaries, wages and benefits 2,559,682 41.5 % 2,367,014 41.4 % Other operating expenses 1,474,674 23.9 % 1,341,088 23.4 % Supplies expense 1,049,747 17.0 % 968,067 16.9 % Depreciation and amortization 305,264 5.0 % 278,661 4.9 % Lease and rental expense 60,485 1.0 % 57,235 1.0 % Subtotal-operating expenses 5,449,852 88.4 % 5,012,065 87.6 % Income from operations 714,708 11.6 % 707,840 12.4 % Interest expense, net 1,330 0.0 % 1,658 0.0 % Other (income) expense, net (32 ) 0.0 % (2,498 ) 0.0 % Income before income taxes $ 713,410 11.6 % $ 708,680 12.4 % During 2019, as compared to 2018, net revenues generated from our acute care hospital services increased $445 million or 7.8% to $6.16 billion due primarily to: (i) a $432 million, or 7.7%, increase same facility revenues, as discussed above, and; (ii) other combined net increase of $13 million due primarily to increased provider tax assessments incurred during 2019 as compared to 2018. Income before income taxes increased $5 million to $713 million or 11.6% of net revenues during 2019 as compared to $709 million or 12.4% of net revenues during 2018. The increase resulted from the $9 million increase in income before income taxes from our acute care hospital services, on a same facility basis, as discussed above, partially offset by $4 million of other combined net unfavorable changes. Behavioral Health Care Services Year Ended December 31, 20120 as compared to the Year Ended December 31, 2019 Behavioral Health Care Services-Same Facility Basis Our Same Facility basis results (which is a non-GAAP measure), which include the operating results for facilities and businesses operated in both the current year and prior year period, neutralize (if applicable) the effect of items that are non-operational in nature including items such as, but not limited to, gains/losses on sales of assets and businesses, impact of the reserve established in connection with the civil aspects of the government’s investigation of certain of our behavioral health care facilities, impacts of settlements, legal judgments and lawsuits, impairments of long-lived and intangible assets and other amounts that may be reflected in the current or prior year financial statements that relate to prior periods. Our Same Facility basis results reflected on the table below also excludes from net revenues and other operating expenses, provider tax assessments incurred in each period as discussed below Sources of Revenue-Various State Medicaid Supplemental Payment Programs. However, these provider tax assessments are included in net revenues and other operating expenses as reflected in the table below under All Behavioral Health Care Services. The provider tax assessments had no impact on the income before income taxes as reflected on the tables below since the amounts offset between net revenues and other operating expenses. To obtain a complete understanding of our financial performance, the Same Facility results should be examined in connection with our net income as determined in accordance with GAAP and as presented in the condensed consolidated financial statements and notes thereto as contained in this Annual Report on Form 10-K. 53 The following table summarizes the results of operations for our behavioral health care services, on a same facility basis, and is used in the discussions below for the years ended December 31, 2020 and 2019 (dollar amounts in thousands): Year Ended Year Ended December 31, 2020 December 31, 2019 % of Net % of Net Amount Revenues Amount Revenues Net revenues $ 5,124,358 100.0 % $ 5,092,071 100.0 % Operating charges: Salaries, wages and benefits 2,722,041 53.1 % 2,711,813 53.3 % Other operating expenses 931,850 18.2 % 952,714 18.7 % Supplies expense 204,658 4.0 % 199,726 3.9 % Depreciation and amortization 176,652 3.4 % 167,340 3.3 % Lease and rental expense 42,532 0.8 % 42,956 0.8 % Subtotal-operating expenses 4,077,733 79.6 % 4,074,549 80.0 % Income from operations 1,046,625 20.4 % 1,017,522 20.0 % Interest expense, net 1,447 0.0 % 1,460 0.0 % Other (income) expense, net 1,060 0.0 % 404 0.0 % Income before income taxes $ 1,044,118 20.4 % $ 1,015,658 19.9 % On a same facility basis during 2020, net revenues generated from our behavioral health services increased $32 million, or 0.6%, to $5.12 billion, from $5.09 billion generated during 2019. Income before income taxes increased $28 million, or 3%, to $1.04 billion or 20.4% of net revenues during 2020, as compared to $1.02 billion or 19.9% of net revenues during 2019. As mentioned above, included in our behavioral health services’ revenues during 2020 was approximately $97 million of revenues recorded in connection with funds received from various governmental stimulus programs, most notably the CARES Act. Excluding these governmental stimulus program revenues from 2020, net revenues from our behavioral health services, on a same facility basis, decreased $65 million or 1.3% during 2020, as compared to 2019, and income before income taxes decreased $69 million or 7% during 2020, as compared to 2019. During 2020, excluding the impact of the $97 million of governmental stimulus program revenues, net revenue per adjusted admission increased 7.3% and net revenue per adjusted patient day increased 4.3%, as compared to 2019. On a same facility basis, inpatient admissions and adjusted admissions to our behavioral health facilities decreased 7.5% and 8.0%, respectively, during 2020 as compared to 2019. Patient days and adjusted patient days at these facilities decreased 4.8% and 5.3% during 2020, respectively, as compared to 2019. The average length of inpatient stay at these facilities was 13.7 days and 13.3 days during 2020 and 2019, respectively. The occupancy rate, based on the average available beds at these facilities, was 71% and 76% during 2020 and 2019, respectively. All Behavioral Health Care Services The following table summarizes the results of operations for all our behavioral health care services during 2020 and 2019. These amounts include: (i) our behavioral health care results on a same facility basis, as indicated above; (ii) the impact of provider tax assessments which increased net revenues and other operating expenses but had no impact on income before income taxes; (iii) provision for asset impairments recorded during 2019 in connection with Foundations Recovery Network, L.L.C., and; (iv) certain other amounts including the results of facilities acquired or opened during the past year as well as the results of certain facilities that were closed or restructured during the past year. Dollar amounts below are reflected in thousands. 54 Year Ended Year Ended December 31, 2020 December 31, 2019 % of Net % of Net Amount Revenues Amount Revenues Net revenues $ 5,208,722 100.0 % $ 5,210,063 100.0 % Operating charges: Salaries, wages and benefits 2,727,129 52.4 % 2,739,871 52.6 % Other operating expenses 1,023,733 19.7 % 1,152,733 22.1 % Supplies expense 204,711 3.9 % 201,114 3.9 % Depreciation and amortization 182,012 3.5 % 172,697 3.3 % Lease and rental expense 45,505 0.9 % 46,799 0.9 % Subtotal-operating expenses 4,183,090 80.3 % 4,313,214 82.8 % Income from operations 1,025,632 19.7 % 896,849 17.2 % Interest expense, net 1,599 0.0 % 1,460 0.0 % Other (income) expense, net 776 0.0 % (5,576 ) -0.1 % Income before income taxes $ 1,023,257 19.6 % $ 900,965 17.3 % During 2020, as compared to 2019, net revenues generated from our behavioral health services decreased $1 million due to: (i) the above-mentioned $32 million or 0.6% increase in net revenues on a same facility basis, and; (ii) $33 million other combined net decreases. Income before income taxes increased $122 million, or 14%, to $1.02 billion or 19.6% of net revenues during 2020, as compared to $901 million or 17.3% of net revenues during 2019. The increase in income before income taxes at our behavioral health facilities was due primarily to: (i) the above-mentioned $28 million increase on a same facility basis, and; (ii) the $98 million provision for asset impairment recorded during 2019 in connection with Foundations Recovery Network, L.L.C. (see Other Operating Results-Provision for Asset Impairment-Foundations Recovery Network below for additional disclosure). Excluding the above-mentioned $97 million of revenues recorded during 2020 in connection with various governmental stimulus programs, net revenues from our behavioral health services decreased $98 million or 1.9% during 2020, as compared to 2019, and income before income taxes increased $25 million or 3% during 2020, as compared to 2019. Year Ended December 31, 2019 as compared to the Year Ended December 31, 2018 Behavioral Health Care Services-Same Facility Basis The following table summarizes the results of operations for our behavioral health care services, on a same facility basis, and is used in the discussions below for the years ended December 31, 2019 and 2018 (dollar amounts in thousands): Year Ended Year Ended December 31, 2019 December 31, 2018 % of Net % of Net Amount Revenues Amount Revenues Net revenues $ 5,058,199 100.0 % $ 4,907,002 100.0 % Operating charges: Salaries, wages and benefits 2,687,677 53.1 % 2,577,411 52.5 % Other operating expenses 947,073 18.7 % 939,220 19.1 % Supplies expense 199,578 3.9 % 197,243 4.0 % Depreciation and amortization 163,963 3.2 % 155,652 3.2 % Lease and rental expense 44,123 0.9 % 45,673 0.9 % Subtotal-operating expenses 4,042,414 79.9 % 3,915,199 79.8 % Income from operations 1,015,785 20.1 % 991,803 20.2 % Interest expense, net 1,460 0.0 % 1,597 0.0 % Other (income) expense, net (380 ) 0.0 % 2,530 0.1 % Income before income taxes $ 1,014,705 20.1 % $ 987,676 20.1 % On a same facility basis during 2019, as compared to 2018, net revenues generated from our behavioral health care services increased $151 million or 3.1% to $5.06 billion during 2019 as compared to $4.91 billion during 2018. Income before income taxes 55 increased $27 million or 3% to $1.01 billion or 20.1% of net revenues during 2019 as compared to $988 million or 20.1% of net revenues during 2018. Inpatient admissions to our behavioral health care facilities owned during both years increased 1.1% during 2019, as compared to 2018, while patient days increased 0.5%. Adjusted admissions increased 1.2% and adjusted patient days increased 0.6% during 2019, as compared to 2018. The average length of inpatient stay at these facilities were 13.1 days and 13.2 days during 2019 and 2018, respectively. The occupancy rate, based on the average available beds at these facilities, were 76% during each of 2019 and 2018. On a same facility basis, net revenue per adjusted admission at these facilities increased 2.2% during 2019, as compared to 2018, and net revenue per adjusted patient day increased 2.7% during 2019, as compared to 2018. During 2019, as compared to longer term historical trends, admission growth slowed, in part, due to labor shortages in selected geographies which reduced our ability to fully meet the demand of patients eligible for admission. All Behavioral Health Care Services The following table summarizes the results of operations for all our behavioral health care services during 2019 and 2018. These amounts include: (i) our behavioral health care results on a same facility basis, as indicated above; (ii) the impact of provider tax assessments which increased net revenues and other operating expenses but had no impact on income before income taxes; (iii) provision for asset impairments recorded during 2019 and 2018 in connection with Foundations Recovery Network, L.L.C., and; (iv) certain other amounts including the results of facilities acquired or opened during the past year as well as the results of certain facilities that were closed or restructured during the past year. Dollar amounts below are reflected in thousands. Year Ended Year Ended December 31, 2019 December 31, 2018 % of Net % of Net Amount Revenues Amount Revenues Net revenues $ 5,210,063 100.0 % $ 5,038,874 100.0 % Operating charges: Salaries, wages and benefits 2,739,871 52.6 % 2,617,337 51.9 % Other operating expenses 1,152,733 22.1 % 1,091,102 21.7 % Supplies expense 201,114 3.9 % 200,008 4.0 % Depreciation and amortization 172,697 3.3 % 163,155 3.2 % Lease and rental expense 46,799 0.9 % 48,316 1.0 % Subtotal-operating expenses 4,313,214 82.8 % 4,119,918 81.8 % Income from operations 896,849 17.2 % 918,956 18.2 % Interest expense, net 1,460 0.0 % 1,597 0.0 % Other (income) expense, net (5,576 ) -0.1 % 1,842 0.0 % Income before income taxes $ 900,965 17.3 % $ 915,517 18.2 % During 2019, as compared to 2018, net revenues generated from our behavioral health care services increased $171 million, or 3.4%, to $5.21 billion during 2019 as compared to $5.04 billion during 2018. The increase in net revenues was attributable to: (i) $151 million or 3.1% increase in same facility revenues, as discussed above, and; (ii) a $20 million other combined net increase consisting primarily of the revenues generated at the 25 behavioral health facilities acquired in the U.K. acquired during the third quarter of 2018 in connection with our acquisition of The Danshell Group. Income before income taxes decreased $15 million or 2% to $901 million or 17.3% of net revenues during 2019 as compared to $916 billion or 18.2% of net revenues during 2018. The decrease in income before income taxes at our behavioral health facilities was attributable to: • a $27 million increase at our behavioral health facilities on a same facility basis, as discussed above; • a net decrease of $49 million from the asset impairment charges recorded during 2019 ($98 million) and 2018 ($49 million) in connection with Foundations Recovery Network, LLC which was acquired by us during 2015 (see Other Operating Results-Provision for Asset Impairment-Foundations Recovery Network below for additional disclosure), and; • other combined net increase of $7 million including a $6 million gain on asset disposal recording during 2019. Sources of Revenue Overview: We receive payments for services rendered from private insurers, including managed care plans, the federal government under the Medicare program, state governments under their respective Medicaid programs and directly from patients. 56 Hospital revenues depend upon inpatient occupancy levels, the medical and ancillary services and therapy programs ordered by physicians and provided to patients, the volume of outpatient procedures and the charges or negotiated payment rates for such services. Charges and reimbursement rates for inpatient routine services vary depending on the type of services provided (e.g., medical/surgical, intensive care or behavioral health) and the geographic location of the hospital. Inpatient occupancy levels fluctuate for various reasons, many of which are beyond our control. The percentage of patient service revenue attributable to outpatient services has generally increased in recent years, primarily as a result of advances in medical technology that allow more services to be provided on an outpatient basis, as well as increased pressure from Medicare, Medicaid and private insurers to reduce hospital stays and provide services, where possible, on a less expensive outpatient basis. We believe that our experience with respect to our increased outpatient levels mirrors the general trend occurring in the health care industry and we are unable to predict the rate of growth and resulting impact on our future revenues. Patients are generally not responsible for any difference between customary hospital charges and amounts reimbursed for such services under Medicare, Medicaid, some private insurance plans, and managed care plans, but are responsible for services not covered by such plans, exclusions, deductibles or co-insurance features of their coverage. The amount of such exclusions, deductibles and co-insurance has generally been increasing each year. Indications from recent federal and state legislation are that this trend will continue. Collection of amounts due from individuals is typically more difficult than from governmental or business payers which unfavorably impacts the collectability of our patient accounts. As described below in the section titled 2019 Novel Coronavirus Disease Medicare and Medicaid Payment Related Legislation, the federal government has enacted multiple pieces of legislation to assist healthcare providers during the COVID-19 world-wide pandemic and U.S. National Emergency declaration. We have outlined those legislative changes related to Medicare and Medicaid payment and their estimated impact on our financial results, where estimates are possible. Sources of Revenues and Health Care Reform: Given increasing budget deficits, the federal government and many states are currently considering additional ways to limit increases in levels of Medicare and Medicaid funding, which could also adversely affect future payments received by our hospitals. In addition, the uncertainty and fiscal pressures placed upon the federal government as a result of, among other things, impacts on state revenue and expenses resulting from the COVID-19 pandemic, economic recovery stimulus packages, responses to natural disasters, and the federal and state budget deficits in general may affect the availability of government funds to provide additional relief in the future. We are unable to predict the effect of future policy changes on our operations. On March 23, 2010, President Obama signed into law the Patient Protection and Affordable Care Act (the “Legislation”). Two primary goals of the Legislation are to provide for increased access to coverage for healthcare and to reduce healthcare-related expenses. The Legislation revises reimbursement under the Medicare and Medicaid programs to emphasize the efficient delivery of high quality care and contains a number of incentives and penalties under these programs to achieve these goals. The Legislation provides for decreases in the annual market basket update for federal fiscal years 2010 through 2019, a productivity offset to the market basket update beginning October 1, 2011 for Medicare Part B reimbursable items and services and beginning October 1, 2012 for Medicare inpatient hospital services. The Legislation and subsequent revisions provide for reductions to both Medicare DSH and Medicaid DSH payments. The Medicare DSH reductions began in October, 2013 while the Medicaid DSH reductions are scheduled to begin in 2024. The Legislation implemented a value-based purchasing program, which will reward the delivery of efficient care. Conversely, certain facilities will receive reduced reimbursement for failing to meet quality parameters; such hospitals will include those with excessive readmission or hospital-acquired condition rates. A 2012 U.S. Supreme Court ruling limited the federal government’s ability to expand health insurance coverage by holding unconstitutional sections of the Legislation that sought to withdraw federal funding for state noncompliance with certain Medicaid coverage requirements. Pursuant to that decision, the federal government may not penalize states that choose not to participate in the Medicaid expansion by reducing their existing Medicaid funding. Therefore, states can choose to expand or not to expand their Medicaid program without risking the loss of federal Medicaid funding. As a result, many states, including Texas, have not expanded their Medicaid programs without the threat of loss of federal funding. CMS has granted, and is expected to grant additional, section 1115 demonstration waivers providing for work and community engagement requirements for certain Medicaid eligible individuals. CMS has also released guidance to states interested in receiving their Medicaid funding through a block grant mechanism. It is anticipated this will lead to reductions in coverage, and likely increases in uncompensated care, in states where these demonstration waivers are granted. On December 14, 2018, a Texas Federal District Court deemed the Legislation to be unconstitutional in its entirety. The Court concluded that the Individual Mandate is no longer permissible under Congress’s taxing power as a result of the Tax Cut and Jobs Act of 2017 (“TCJA”) reducing the individual mandate’s tax to $0 (i.e., it no longer produces revenue, which is an essential feature of a tax), rendering the Legislation unconstitutional. The court also held that because the individual mandate is “essential” to 57 the Legislation and is inseverable from the rest of the law, the entire Legislation is unconstitutional. Because the court issued a declaratory judgment and did not enjoin the law, the Legislation remains in place pending its appeal. The District Court for the Northern District of Texas ruling was appealed to the U.S. Court of Appeals for the Fifth Circuit. On December 18, 2019, the Fifth Circuit Court of Appeals’ three-judge panel voted 2-1 to strike down the Legislation individual mandate as unconstitutional. The Fifth Circuit Court also sent the case back to the Texas district court to determine which Legislation provisions should be stricken with the mandate or whether the entire Legislation is unconstitutional. On March 2, 2020, the U.S. Supreme Court agreed to hear, during the 2020-2021 term, two consolidated cases, filed by the State of California and the United States House of Representatives, asking the Supreme Court to review the ruling by the Fifth Circuit Court of Appeals. Oral argument was heard on November 10, 2020, and a ruling is expected in 2021. On February 10, 2021, the Department of Justice announced that it has withdrawn support for the challenge before the Supreme Court. The Legislation will remain law while the case proceeds through the appeals process; however, the case creates additional uncertainty as to whether any or all of the Legislation could be struck down, which creates operational risk for the health care industry. We are unable to predict the final outcome of this legal challenge and its financial impact on our future results of operation. The various provisions in the Legislation that directly or indirectly affect Medicare and Medicaid reimbursement are scheduled to take effect over a number of years. The impact of the Legislation on healthcare providers will be subject to implementing regulations, interpretive guidance and possible future legislation or legal challenges. Certain Legislation provisions, such as that creating the Medicare Shared Savings Program creates uncertainty in how healthcare may be reimbursed by federal programs in the future. Thus, we cannot predict the impact of the Legislation on our future reimbursement at this time and we can provide no assurance that the Legislation will not have a material adverse effect on our future results of operations. The Legislation also contained provisions aimed at reducing fraud and abuse in healthcare. The Legislation amends several existing laws, including the federal Anti-Kickback Statute and the False Claims Act, making it easier for government agencies and private plaintiffs to prevail in lawsuits brought against healthcare providers. While Congress had previously revised the intent requirement of the Anti-Kickback Statute to provide that a person is not required to “have actual knowledge or specific intent to commit a violation of” the Anti-Kickback Statute in order to be found in violation of such law, the Legislation also provides that any claims for items or services that violate the Anti-Kickback Statute are also considered false claims for purposes of the federal civil False Claims Act. The Legislation provides that a healthcare provider that retains an overpayment in excess of 60 days is subject to the federal civil False Claims Act. The Legislation also expands the Recovery Audit Contractor program to Medicaid. These amendments also make it easier for severe fines and penalties to be imposed on healthcare providers that violate applicable laws and regulations. We have partnered with local physicians in the ownership of certain of our facilities. These investments have been permitted under an exception to the physician self-referral law. The Legislation permits existing physician investments in a hospital to continue under a “grandfather” clause if the arrangement satisfies certain requirements and restrictions, but physicians are prohibited from increasing the aggregate percentage of their ownership in the hospital. The Legislation also imposes certain compliance and disclosure requirements upon existing physician-owned hospitals and restricts the ability of physician-owned hospitals to expand the capacity of their facilities. As discussed below, should the Legislation be repealed in its entirety, this aspect of the Legislation would also be repealed restoring physician ownership of hospitals and expansion right to its position and practice as it existed prior to the Legislation. The impact of the Legislation on each of our hospitals may vary. Because Legislation provisions are effective at various times over the next several years, we anticipate that many of the provisions in the Legislation may be subject to further revision. Initiatives to repeal the Legislation, in whole or in part, to delay elements of implementation or funding, and to offer amendments or supplements to modify its provisions have been persistent. The ultimate outcomes of legislative attempts to repeal or amend the Legislation and legal challenges to the Legislation are unknown. Legislation has already been enacted that eliminated the individual mandate penalty, effective January 1, 2019, related to the obligation to obtain health insurance that was part of the original Legislation. In addition, Congress previously considered legislation that would, in material part: (i) eliminate the large employer mandate to offer health insurance coverage to full-time employees; (ii) permit insurers to impose a surcharge up to 30 percent on individuals who go uninsured for more than two months and then purchase coverage; (iii) provide tax credits towards the purchase of health insurance, with a phase-out of tax credits accordingly to income level; (iv) expand health savings accounts; (v) impose a per capita cap on federal funding of state Medicaid programs, or, if elected by a state, transition federal funding to block grants, and; (vi) permit states to seek a waiver of certain federal requirements that would allow such state to define essential health benefits differently from federal standards and that would allow certain commercial health plans to take health status, including pre-existing conditions, into account in setting premiums. In addition to legislative changes, the Legislation can be significantly impacted by executive branch actions. President Biden is expected to undertake executive actions that will strengthen the Legislation and may reverse the policies of the prior administration. The Trump Administration had directed the issuance of final rules (i) enabling the formation of health plans that would be exempt from certain Legislation essential health benefits requirements; (ii) expanding the availability of short-term, limited duration health insurance; (iii) eliminating cost-sharing reduction payments to insurers that would otherwise offset deductibles and other out-of- 58 pocket expenses for health plan enrollees at or below 250 percent of the federal poverty level; (iv) relaxing requirements for state innovation waivers that could reduce enrollment in the individual and small group markets and lead to additional enrollment in short-term, limited duration insurance and association health plans; (vi) incentivizing the use of health reimbursement arrangements by employers to permit employees to purchase health insurance in the individual market, and; (vii) increasing transparency of healthcare price and quality information. The uncertainty resulting from these Executive Branch policies led to reduced Exchange enrollment in 2018, 2019 and 2020 and is expected to further worsen the individual and small group market risk pools in future years. The recent and on-going COVID-19 pandemic and related U.S. National Emergency declaration may significantly increase the number of uninsured patients treated at our facilities extending beyond the most recent CBO published estimates due to increased unemployment and loss of group health plan health insurance coverage. It is also anticipated that these spolicies may create additional cost and reimbursement pressures on hospitals. It remains unclear what portions of the Legislation may remain, or whether any replacement or alternative programs may be created by any future legislation. Any such future repeal or replacement may have significant impact on the reimbursement for healthcare services generally, and may create reimbursement for services competing with the services offered by our hospitals. Accordingly, there can be no assurance that the adoption of any future federal or state healthcare reform legislation will not have a negative financial impact on our hospitals, including their ability to compete with alternative healthcare services funded by such potential legislation, or for our hospitals to receive payment for services. For additional disclosure related to our revenues including a disaggregation of our consolidated net revenues by major source for each of the periods presented herein, please see Note 12 to the Consolidated Financial Statements-Revenue. Medicare: Medicare is a federal program that provides certain hospital and medical insurance benefits to persons aged 65 and over, some disabled persons and persons with end-stage renal disease. All of our acute care hospitals and many of our behavioral health centers are certified as providers of Medicare services by the appropriate governmental authorities. Amounts received under the Medicare program are generally significantly less than a hospital’s customary charges for services provided. Since a substantial portion of our revenues will come from patients under the Medicare program, our ability to operate our business successfully in the future will depend in large measure on our ability to adapt to changes in this program. Under the Medicare program, for inpatient services, our general acute care hospitals receive reimbursement under the inpatient prospective payment system (“IPPS”). Under the IPPS, hospitals are paid a predetermined fixed payment amount for each hospital discharge. The fixed payment amount is based upon each patient’s Medicare severity diagnosis related group (“MS-DRG”). Every MS-DRG is assigned a payment rate based upon the estimated intensity of hospital resources necessary to treat the average patient with that particular diagnosis. The MS-DRG payment rates are based upon historical national average costs and do not consider the actual costs incurred by a hospital in providing care. This MS-DRG assignment also affects the predetermined capital rate paid with each MS-DRG. The MS-DRG and capital payment rates are adjusted annually by the predetermined geographic adjustment factor for the geographic region in which a particular hospital is located and are weighted based upon a statistically normal distribution of severity. While we generally will not receive payment from Medicare for inpatient services, other than the MS-DRG payment, a hospital may qualify for an “outlier” payment if a particular patient’s treatment costs are extraordinarily high and exceed a specified threshold. MS-DRG rates are adjusted by an update factor each federal fiscal year, which begins on October 1. The index used to adjust the MS-DRG rates, known as the “hospital market basket index,” gives consideration to the inflation experienced by hospitals in purchasing goods and services. Generally, however, the percentage increases in the MS-DRG payments have been lower than the projected increase in the cost of goods and services purchased by hospitals. In September, 2020, CMS published its IPPS 2021 final payment rule which provides for a 2.4% market basket increase to the base Medicare MS-DRG blended rate. When statutorily mandated budget neutrality factors, annual geographic wage index updates, documenting and coding adjustments, and adjustments mandated by the Legislation are considered, without consideration for the required Medicare DSH payments changes and increase to the Medicare Outlier threshold, the overall increase in IPPS payments is approximately 1.8%. Including DSH payments and certain other adjustments, we estimate our overall increase from the final IPPS 2021 rule (covering the period of October 1, 2020 through September 30, 2021) will approximate 2.3%. This projected impact from the IPPS 2021 final rule includes an increase of approximately 0.5% to partially restore cuts made as a result of the American Taxpayer Relief Act of 2012 (“ATRA”), as required by the 21st Century Cures Act but excludes the impact of the sequestration reductions related to the 2011 Act, Bipartisan Budget Act of 2015, and Bipartisan Budget Act of 2018, as discussed below. In the final rule, CMS will require: o Hospitals to report certain market-based payment rate information for Medicare Advantage (“MA”) organizations on their Medicare cost report for cost reporting periods ending on or after January 1, 2021, to be used in a potential change to the methodology for calculating the IPPS MS-DRG relative weights to reflect relative market-based pricing, beginning in FY 2024. o Hospitals to report on the Medicare cost report of its median payer-specific negotiated charges with all of its MA organizations, by MS-DRG. 59 In August, 2019, CMS published its IPPS 2020 final payment rule which provides for a 3.0% market basket increase to the base Medicare MS-DRG blended rate. When statutorily mandated budget neutrality factors, annual geographic wage index updates, documenting and coding adjustments, and adjustments mandated by the Legislation are considered, without consideration for the required Medicare DSH payments changes and increase to the Medicare Outlier threshold, the overall increase in IPPS payments is approximately 2.8%. Including DSH payments and certain other adjustments, we estimate our overall increase from the final IPPS 2020 rule (covering the period of October 1, 2019 through September 30, 2020) will approximate 2.1%. This projected impact from the IPPS 2020 final rule includes an increase of approximately 0.5% to partially restore cuts made as a result ATRA, as required by the 21st Century Cures Act but excludes the impact of the sequestration reductions related to the 2011 Act, Bipartisan Budget Act of 2015, and Bipartisan Budget Act of 2018, as discussed below. CMS completed its full phase-in to use uncompensated care data from the 2015 Worksheet S-10 hospital cost reports to allocate approximately $8.5 billion in the DSH Uncompensated Care Pool. In June, 2019, the Supreme Court of the United States issued a decision favorable to hospitals impacting prior year Medicare DSH payments (Azar v. Allina Health Services, No. 17-1484 (U.S. Jun. 3, 2019)). In Allina, the hospitals challenged the Medicare DSH adjustments for federal fiscal year 2012, specifically challenging CMS’s decision to include inpatient hospital days attributable to Medicare Part C enrollee patients in the numerator and denominator of the Medicare/SSI fraction used to calculate a hospital’s DSH payments. This ruling addresses CMS’s attempts to impose the policy espoused in its vacated 2004 rulemaking to a fiscal year in the 2004–2013 time period without using notice-and-comment rulemaking. This decision should require CMS to recalculate hospitals’ DSH Medicare/SSI fractions, with Medicare Part C days excluded, for at least federal fiscal year 2012, but likely federal fiscal years 2005 through 2013. In August, 2020, CMS issued a rule that proposes to retroactively negate the effects of the aforementioned Supreme Court decision. Although we can provide no assurance that we will ultimately receive additional funds, we estimate that the favorable impact of this court ruling on certain prior year hospital Medicare DSH payments could range between $18 million to $28 million in the aggregate. In August, 2018, CMS published its IPPS 2019 final payment rule which provides for a 2.9% market basket increase to the base Medicare MS-DRG blended rate. When statutorily mandated budget neutrality factors, annual geographic wage index updates, documenting and coding adjustments ACA-mandated adjustments are considered, without consideration for the decreases related to the required Medicare DSH payment changes and decrease to the Medicare Outlier threshold, the overall increase in IPPS payments is approximately 0.5%. Including the estimated increase to our DSH payments (approximating 2.1%) and certain other adjustments, we estimate our overall increase from the final IPPS 2019 rule (covering the period of October 1, 2018 through September 30, 2019) will approximate 2.7%. This projected impact from the IPPS 2019 final rule includes an increase of approximately 0.5% to partially restore cuts made as a result of the ATRA, as required by the 21st Century Cures Act but excludes the impact of the sequestration reductions related to the 2011 Act, Bipartisan Budget Act of 2015, and Bipartisan Budget Act of 2018, as discussed below. CMS continued to phase-in the use of uncompensated care data from both the 2014 and 2015 Worksheet S-10 hospital cost reports, two-third weighting as part of the proxy methodology to allocate approximately $8 billion in the DSH Uncompensated Care Pool. The 2011 Act included the imposition of annual spending limits for most federal agencies and programs aimed at reducing budget deficits by $917 billion between 2012 and 2021, according to a report released by the Congressional Budget Office. Among its other provisions, the law established a bipartisan Congressional committee, known as the Joint Committee, which was responsible for developing recommendations aimed at reducing future federal budget deficits by an additional $1.5 trillion over 10 years. The Joint Committee was unable to reach an agreement by the November 23, 2011 deadline and, as a result, across-the-board cuts to discretionary, national defense and Medicare spending were implemented on March 1, 2013 resulting in Medicare payment reductions of up to 2% per fiscal year. The Bipartisan Budget Act of 2015, enacted on November 2, 2015, and the Bipartisan Budget Act of 2019, enacted on August 2, 2019, continued the 2% reductions to Medicare reimbursement imposed under the 2011 Act through 2029. The CARES Act suspended payment reductions between May 1 and December 31, 2020, in exchange for extended cuts through 2030. The Consolidated Appropriations Act, 2021 extended the suspension of payment reductions until March 31, 2021. Inpatient services furnished by psychiatric hospitals under the Medicare program are paid under a Psychiatric Prospective Payment System (“Psych PPS”). Medicare payments to psychiatric hospitals are based on a prospective per diem rate with adjustments to account for certain facility and patient characteristics. The Psych PPS also contains provisions for outlier payments and an adjustment to a psychiatric hospital’s base payment if it maintains a full-service emergency department. In July, 2020, CMS published its Psych PPS final rule for the federal fiscal year 2021. Under this final rule, payments to our psychiatric hospitals and units are estimated to increase by 2.2% compared to federal fiscal year 2020. This amount includes the effect of the 2.2% market basket update. In July, 2019, CMS published its Psych PPS final rule for the federal fiscal year 2020. Under this final rule, payments to our psychiatric hospitals and units are estimated to increase by 1.7% compared to federal fiscal year 2019. This amount includes the effect of the 2.9% market basket update less a 0.75% adjustment as required by the ACA and a 0.4% productivity adjustment. 60 In August, 2018, CMS published its Psych PPS final rule for the federal fiscal year 2019. Under this final rule, payments to our psychiatric hospitals and units are estimated to increase by 1.35% compared to federal fiscal year 2018. This amount includes the effect of the 2.90% market basket update less a 0.75% adjustment as required by the ACA and a 0.8% productivity adjustment. CMS’s calendar year 2018 final OPPS rule, issued on November 13, 2017, substantially reduced Medicare Part B reimbursement for 340B Program drugs paid to hospitals. Beginning January 1, 2018, CMS reimbursement for certain separately payable drugs or biologicals that are acquired through the 340B Program by a hospital paid under the OPPS (and not excepted from the payment adjustment policy) is the average sales price of the drug or biological minus 22.5 percent, an effective reduction of 26.89% in payments for 340B program drugs. In December, 2018, the U.S. District Court for the District of Columbia ruled that HHS did not have statutory authority to implement the 2018 Medicare OPPS rate reduction related to hospitals that qualify for drug discounts under the federal 340B Program and granted a permanent injunction against the payment reduction. On July 31, 2020, the U.S. Court of Appeals for the D.C. Circuit reversed the District Court and held that HHS’s decision to lower drug reimbursement rates for 340B hospitals rests on a reasonable interpretation of the Medicare statute. No further legal challenges are available to the plaintiffs and, as a result, we recognized $8 million of revenues during 2020 that were previously reserved in a prior year. In December, 2020, CMS published its OPPS final rule for 2021. The hospital market basket increase is 2.4% and there is no productivity adjustment reduction to the 2021 OPPS market basket. When other statutorily required adjustments and hospital patient service mix are considered, we estimate that our overall Medicare OPPS update for 2021 will aggregate to a net increase of 3.3% which includes a 9.2% increase to behavioral health division partial hospitalization rates. In November, 2019, CMS published its OPPS final rule for 2020. The hospital market basket increase is 3.0%. The Medicare statute requires a productivity adjustment reduction of 0.4% to the 2020 OPPS market basket resulting in a 2020 update to OPPS payment rates by 2.6%. When other statutorily required adjustments and hospital patient service mix are considered, we estimate that our overall Medicare OPPS update for 2020 will aggregate to a net increase of 2.7% which includes a 7.7% increase to behavioral health division partial hospitalization rates. When the behavioral health division’s partial hospitalization rate impact is excluded, we estimate that our Medicare 2020 OPPS payments will result in a 1.9% increase in payment levels for our acute care division, as compared to 2019. For CY 2020, CMS will use the FY 2020 hospital IPPS post-reclassified wage index for urban and rural areas as the wage index for the OPPS to determine the wage adjustments for both the OPPS payment rate and the copayment standardized amount. On November 15, 2019, CMS finalized its Hospital Price Transparency rule that implements certain requirements under the June 24, 2019 Presidential Executive Order related to Improving Price and Quality Transparency in American Healthcare to Put Patients First. Under this final rule, effective January 1, 2021, CMS will require: (1) hospitals make public their standard changes (both gross charges and payer-specific negotiated charges) for all items and services online in a machine-readable format, and; (2) hospitals to make public standard charge data for a limited set of “shoppable services” the hospital provides in a form and manner that is more consumer friendly. A lawsuit was filed by several hospital associations, health systems, and hospitals in the U.S. District court for the District of Columbia challenging the legal authority of HHS to implement the final rule. In June, 2020, the U.S. District Court issued a decision in favor of the federal government. The Plaintiffs in the case filed a notice of appeal to the Court of Appeals for the D.C. Circuit and oral argument was heard on October 15, 2020. On December 29, 2020, the Appeals Court ruled against the Plaintiffs challenge. As a result, the price transparency rule became effective January 1, 2021. We are unable to determine the impact, if any, this final rule will have on our future results of operations. In November, 2018, CMS published its OPPS final rule for 2019. The hospital market basket increase is 2.9%. The Medicare statute requires a productivity adjustment reduction of 0.8% and 0.75% reduction to the 2019 OPPS market basket resulting in a 2019 update to OPPS payment rates by 1.35%. When other statutorily required adjustments and hospital patient service mix are considered, we estimate that our overall Medicare OPPS update for 2019 will aggregate to a net increase of 1.1% which includes a 5.7% increase to behavioral health division partial hospitalization rates. When the behavioral health division’s partial hospitalization rate impact is excluded, we estimate that our Medicare 2019 OPPS payments will result in a 0.4% increase in payment levels for our acute care hospitals, as compared to 2018. Medicaid: Medicaid is a joint federal-state funded health care benefit program that is administered by the states to provide benefits to qualifying individuals. Most state Medicaid payments are made under a PPS-like system, or under programs that negotiate payment levels with individual hospitals. Amounts received under the Medicaid program are generally significantly less than a hospital’s customary charges for services provided. In addition to revenues received pursuant to the Medicare program, we receive a large portion of our revenues either directly from Medicaid programs or from managed care companies managing Medicaid. All of our acute care hospitals and most of our behavioral health centers are certified as providers of Medicaid services by the appropriate governmental authorities. We receive revenues from various state and county based programs, including Medicaid in all the states in which we operate (we receive Medicaid revenues in excess of $100 million annually from each of California, Texas, Nevada, Washington, D.C., 61 Pennsylvania, Illinois, Florida and Massachusetts); CMS-approved Medicaid supplemental programs in certain states including Texas, Mississippi, Illinois, Oklahoma, Nevada, Arkansas, California and Indiana, and; state Medicaid disproportionate share hospital payments in certain states including Texas and South Carolina. We are therefore particularly sensitive to potential reductions in Medicaid and other state based revenue programs as well as regulatory, economic, environmental and competitive changes in those states. We can provide no assurance that reductions to revenues earned pursuant to these programs, particularly in the above-mentioned states, will not have a material adverse effect on our future results of operations. The Legislation substantially increases the federally and state-funded Medicaid insurance program, and authorizes states to establish federally subsidized non-Medicaid health plans for low-income residents not eligible for Medicaid starting in 2014. However, the Supreme Court has struck down portions of the Legislation requiring states to expand their Medicaid programs in exchange for increased federal funding. Accordingly, many states in which we operate have not expanded Medicaid coverage to individuals at 133% of the federal poverty level. Facilities in states not opting to expand Medicaid coverage under the Legislation may be additionally penalized by corresponding reductions to Medicaid disproportionate share hospital payments beginning in 2020, as discussed below. We can provide no assurance that further reductions to Medicaid revenues, particularly in the above-mentioned states, will not have a material adverse effect on our future results of operations. On November 12, 2019, CMS issued the proposed Medicaid Fiscal Accountability Rule (“MFAR”) which CMS believed would strengthen the fiscal integrity of the Medicaid program and help ensure that state supplemental payments and financing arrangements are transparent and value-driven. On January 14, 2021, CMS issued a formal notice of withdrawal of this proposed rule. In January, 2020, CMS announced a new opportunity to support states with greater flexibility to improve the health of their Medicaid populations. The new 1115 Waiver Block Grant Type Demonstration program, titled Healthy Adult Opportunity (“HAO”), emphasizes the concept of value-based care while granting states extensive flexibility to administer and design their programs within a defined budget. CMS believes this state opportunity will enhance the Medicaid program’s integrity through its focus on accountability for results and quality improvement, making the Medicaid program stronger for states and beneficiaries. The HAO program will include: • Beneficiary Protections. • Flexibility in the Administration of Benefits. • Transparency. • Financing and Program Integrity o States participating in HAO demonstrations will need to agree to operate their program within a defined budget target, set on either a total expenses or per-enrollee basis, in a manner similar to that used in other section 1115 demonstrations. o To the extent states achieve savings and demonstrate no declines in access or quality, CMS will share back a portion of the federal savings for reinvestment into Medicaid. • Limited Medicaid Population o The population includes adults under age 65 who are not eligible for Medicaid on the basis of disability or on their need for long term care services and supports, and who are not eligible under a state plan. • Benefit Design and Drug Coverage o States have the opportunity to design a benefit package that aligns with private coverage. o Provide states with greater negotiating power to lower drug spending and promote value in the program. • Managed Care and Delivery Systems o States will be able to use any combination of fee-for-service and managed care delivery systems and will have flexibility to alter these arrangements over the course of the demonstration • Streamlined Application Process Transitioning 1115 Demonstrations • Quality Strategy and Performance Assessment o States will be held to a high standard of accountability for producing positive health outcomes and will be subject to regular and thorough monitoring and evaluation. We are unable to predict whether any states will opt to apply for participation in the HAO demonstration or the impact on our future results of operations. Various State Medicaid Supplemental Payment Programs: We incur health-care related taxes (“Provider Taxes”) imposed by states in the form of a licensing fee, assessment or other mandatory payment which are related to: (i) healthcare items or services; (ii) the provision of, or the authority to provide, the health care items or services, or; (iii) the payment for the health care items or services. Such Provider Taxes are subject to various federal regulations that limit the scope and amount of the taxes that can be levied by states in order to secure federal matching funds as part of 62 their respective state Medicaid programs. As outlined below, we derive a related Medicaid reimbursement benefit from assessed Provider Taxes in the form of Medicaid claims based payment increases and/or lump sum Medicaid supplemental payments. Included in these Provider Tax programs are reimbursements received in connection with the Texas Uncompensated Care/Upper Payment Limit program (“UC/UPL”) and Texas Delivery System Reform Incentive Payments program (“DSRIP”). Additional disclosure related to the Texas UC/UPL and DSRIP programs is provided below. Texas Uncompensated Care/Upper Payment Limit Payments: Certain of our acute care hospitals located in various counties of Texas (Grayson, Hidalgo, Maverick, Potter and Webb) participate in Medicaid supplemental payment Section 1115 Waiver indigent care programs. Section 1115 Waiver Uncompensated Care (“UC”) payments replace the former Upper Payment Limit (“UPL”) payments. These hospitals also have affiliation agreements with third-party hospitals to provide free hospital and physician care to qualifying indigent residents of these counties. Our hospitals receive both supplemental payments from the Medicaid program and indigent care payments from third-party, affiliated hospitals. The supplemental payments are contingent on the county or hospital district making an Inter-Governmental Transfer (“IGT”) to the state Medicaid program while the indigent care payment is contingent on a transfer of funds from the applicable affiliated hospitals. However, the county or hospital district is prohibited from entering into an agreement to condition any IGT on the amount of any private hospital’s indigent care obligation. On December 21, 2017, CMS approved the 1115 Waiver for the period January 1, 2018 to September 30, 2022. The Waiver continued to include UC and DSRIP payment pools with modifications and new state specific reporting deadlines that if not met by THHSC will result in material decreases in the size of the UC and DSRIP pools. For UC during the initial two years of this renewal, the UC program will remain relatively the same in size and allocation methodology. For year three of this waiver renewal, FFY 2020, and through FFY 2022, the size and distribution of the UC pool will be determined based on charity care costs reported to HHSC in accordance with Medicare cost report Worksheet S-10 principles. In September 2019, CMS approved the annual UC pool size in the amount of $3.9 billion for demonstration years (“DYs”) 9, 10 and 11 (October 1, 2019 to September 30, 2022). On January 15, 2021, CMS approved the 1115 Waiver renewal through September 30, 2030. The terms of the Waiver renewal require HHSC to resize the UC pool in (1) FFY 2022 (DY 11) using 2019 cost report year data and (2) in FFY 2027 (DY 16) using 2025 cost report data. Our impact of the UC pool resizing is not known. Effective April 1, 2018, certain of our acute care hospitals located in Texas began to receive Medicaid managed care rate enhancements under the Uniform Hospital Rate Increase Program (“UHRIP”). The non-federal share component of these UHRIP rate enhancements are financed by Provider Taxes. The Texas 1115 Waiver rules require UHRIP rate enhancements be considered in the Texas UC payment methodology which results in a reduction to our UC payments. The UC amounts reported in the State Medicaid Supplemental Payment Program Table below reflect the impact of this new UHRIP program. In July 2020, THHSC announced CMS approval of an increase to UHRIP pool for the state’s 2021 fiscal year to $2.7 billion from its current funding level of $1.6 billion. We estimate that this UHRIP pool increase will not have a material impact on the Company financial results due to CMS approved pool allocation methodology for the SFY 2021 program. On January 4, 2021, HHSC published a proposed rule that will apply to program periods on or after September 1, 2021, and UHRIP will be re-named the Comprehensive Hospital Increase Reimbursement Program (“CHIRP”). CHIRP will be comprised of a UHRIP component and an Average Commercial Incentive Award (“ACIA”) component. HHSC has proposed a pool size of $5.0 billion subject to CMS approval. The Company is not able to estimate the financial impact of the program change. On January 11, 2021, HHSC announced that CMS approved the pre-print modification that HHSC submitted for UHRIP period March 1, 2021 through August 31, 2021. CMS approved rate changes that will now increase rates for private Institutions of Mental Disease (“IMD”) for services provided to patients under age 21 or patients 65 years of age or older. We estimate that this payment policy change will increase our UHRIP reimbursement by $10 million in FY 2021 and this amount is included the aggregated FY 2021 Medicaid Supplemental Payment projection total below. On November 16, 2018, THHSC published a final rule effective in federal fiscal years 2018 and 2019 that changes the definition of a rural hospital for the purposes of determining Texas UC payments and the applicable UC payment reduction. The application of UC payment reduction allows the THHSC to comply with the overall statewide UC payment cap required under the special terms and condition of the approved 1115 Waiver. Two of our acute care hospitals, which have been designated as a Rural Referral Center by CMS and which are located in an urban Metropolitan Statistical Area, recorded: (i) increased UC payments/revenue for the federal fiscal year ending September 30, 2018, and; (ii) decreased UC payments/revenue for the federal fiscal year beginning October 1, 2018. The net impact of these changes had a favorable impact on our 2018 results of operations and are included in the amounts reflected below in the State Medicaid Supplemental Payment Program table. 63 Texas Delivery System Reform Incentive Payments: In addition, the Texas Medicaid Section 1115 Waiver includes a DSRIP pool to incentivize hospitals and other providers to transform their service delivery practices to improve quality, health status, patient experience, coordination, and cost-effectiveness. DSRIP pool payments are incentive payments to hospitals and other providers that develop programs or strategies to enhance access to health care, increase the quality of care, the cost-effectiveness of care provided and the health of the patients and families served. In May, 2014, CMS formally approved specific DSRIP projects for certain of our hospitals for demonstration years 3 to 5 (our facilities did not materially participate in the DSRIP pool during demonstration years 1 or 2). DSRIP payments are contingent on the hospital meeting certain pre-determined milestones, metrics and clinical outcomes. Additionally, DSRIP payments are contingent on a governmental entity providing an IGT for the non-federal share component of the DSRIP payment. THHSC generally approves DSRIP reported metrics, milestones and clinical outcomes on a semi-annual basis in June and December. Under the CMS approval noted above, the Waiver renewal requires the transition of the DSRIP program to one focused on "health system performance measurement and improvement." THHSC must submit a transition plan describing "how it will further develop its delivery system reforms without DSRIP funding and/or phase out DSRIP funded activities and meet mutually agreeable milestones to demonstrate its ongoing progress." The size of the DSRIP pool will remain unchanged for the initial two years of the waiver renewal with unspecified decreases in years three and four of the renewal, FFY 2020 and 2021, respectively. In FFY 2022, DSRIP funding under the waiver is eliminated. For FFY 2020 and 2021, we estimate these changes will result in a $3 million and $4 million decrease in DSRIP payments, respectively. For FFY 2022, we will no longer receive DSRIP funds due to the elimination of this funding source by CMS in the Waiver renewals. In March, 2020, HHSC submitted a DSRIP Transition Plan to CMS as required by the 1115 Waiver Special Terms and Conditions #37 that outlines a transition from the current DSRIP program to a Value-Based Purchasing (“VBP”) type payment model. As noted above, HHSC proposed a rule to make changes to existing UHRIP program. These proposed amendments are HHSC’s efforts to comply with federal regulations that require directed-payment programs to advance goals included in the state’s Medicaid managed care quality strategy and to align with the ongoing efforts to transition from the Delivery System Reform Incentive Payment program. The effective date of a new VBP payment model (if proposed by HHSC and approved by CMS) is not yet known. Similarly, details of any VBP model are still under HHSC consideration and possible development. As a result, we are unable to estimate the financial impact of this payment change. Summary of Amounts Related To The Above-Mentioned Various State Medicaid Supplemental Payment Programs: The following table summarizes the revenues, Provider Taxes and net benefit related to each of the above-mentioned Medicaid supplemental programs for the years ended December 31, 2020, 2019 and 2018. The Provider Taxes are recorded in other operating expenses on the Condensed Consolidated Statements of Income as included herein. (amounts in millions) 2020 2019 2018 Texas UC/UPL: Revenues $ 119 $ 123 $ 135 Provider Taxes (37 ) (47 ) (51 ) Net benefit $ 82 $ 76 $ 84 Texas DSRIP: Revenues $ 33 $ 35 $ 29 Provider Taxes (10 ) (12 ) (9 ) Net benefit $ 23 $ 23 $ 20 Various other state programs: Revenues $ 336 $ 261 $ 223 Provider Taxes (138 ) (135 ) (119 ) Net benefit $ 198 $ 126 $ 104 Total all Provider Tax programs: Revenues $ 488 $ 419 $ 387 Provider Taxes (185 ) (194 ) (179 ) Net benefit $ 303 $ 225 $ 208 We estimate that our aggregate net benefit from the Texas and various other state Medicaid supplemental payment programs will approximate $262 million (net of Provider Taxes of $216 million) during the year ending December 31, 2021. This estimate is based upon various terms and conditions that are out of our control including, but not limited to, the states’/CMS’s continued approval of the programs and the applicable hospital district or county making IGTs consistent with 2020 levels. Future changes to these terms and conditions could materially reduce our net benefit derived from the programs which could have a material adverse impact on our future consolidated results of operations. In addition, Provider Taxes are governed by both federal and state laws and are subject to 64 future legislative changes that, if reduced from current rates in several states, could have a material adverse impact on our future consolidated results of operations. As described below in 2019 Novel Coronavirus Disease Medicare and Medicaid Payment Related Legislation, a 6.2% increase to the Medicaid Federal Matching Assistance Percentage (“FMAP”) is included in the Families First Coronavirus Response Act. The impact of the enhanced FMAP Medicaid supplemental and DSH payments are reflected in our results for year ended December 31, 2020. We are unable to estimate the prospective financial impact of this provision at this time as our financial impact is contingent on unknown state action during future eligible federal fiscal quarters. Texas and South Carolina Medicaid Disproportionate Share Hospital Payments: Hospitals that have an unusually large number of low-income patients (i.e., those with a Medicaid utilization rate of at least one standard deviation above the mean Medicaid utilization, or having a low income patient utilization rate exceeding 25%) are eligible to receive a DSH adjustment. Congress established a national limit on DSH adjustments. Although this legislation and the resulting state broad-based provider taxes have affected the payments we receive under the Medicaid program, to date the net impact has not been materially adverse. Upon meeting certain conditions and serving a disproportionately high share of Texas’ and South Carolina’s low income patients, five of our facilities located in Texas and one facility located in South Carolina received additional reimbursement from each state’s DSH fund. The South Carolina and Texas DSH programs were renewed for each state’s 2021 DSH fiscal year (covering the period of October 1, 2020 through September 30, 2021). In connection with these DSH programs, included in our financial results was an aggregate of approximately $48 million during 2020, $50 million during 2019 and $38 million during 2018. We expect the aggregate reimbursements to our hospitals pursuant to the Texas and South Carolina 2021 fiscal year programs to be approximately $45 million. The Legislation and subsequent federal legislation provides for a significant reduction in Medicaid disproportionate share payments beginning in federal fiscal year 2024 (see above in Sources of Revenues and Health Care Reform-Medicaid Revisions for additional disclosure related to the delay of these DSH reductions). HHS is to determine the amount of Medicaid DSH payment cuts imposed on each state based on a defined methodology. As Medicaid DSH payments to states will be cut, consequently, payments to Medicaid-participating providers, including our hospitals in Texas and South Carolina, will be reduced in the coming years. Based on the CMS final rule published in September, 2019, beginning in fiscal year 2024 (as amended by the CARES Act and the CAA), annual Medicaid DSH payments in South Carolina and Texas could be reduced by approximately 74% and 44%, respectively, from 2020 DSH payment levels. Our behavioral health care facilities in Texas have been receiving Medicaid DSH payments since FFY 2016. As with all Medicaid DSH payments, hospitals are subject to state audits that typically occur up to three years after their receipt. DSH payments are subject to a federal Hospital Specific Limit (“HSL”) and are not fully known until the DSH audit results are concluded. In general, freestanding psychiatric hospitals tend to provide significantly less charity care than acute care hospitals and therefore are at more risk for retroactive recoupment of prior year DSH payments in excess of their respective HSL. In light of the retroactive HSL audit risk for freestanding psychiatric hospitals, we have established DSH reserves for our facilities that have been receiving funds since FFY 2016. These DSH reserves are also impacted by the resolution of federal DSH litigation related to Children’s Hospital Association of Texas v. Azar (“CHAT”), No. 17-cv-844 (D.D.C. March 2, 2018), appeal docketed, No. 18-5135 (D.C. Cir. May 9, 2018) where the calculation of HSL was being challenged. In August, 2019, DC Circuit Court of Appeals issued a unanimous decision in CHAT and reversed the judgment of the district court in favor of CMS and ordered that CMS’s “2017 Rule” (regarding Medicaid DSH Payments—Treatment of Third Party Payers in Calculating Uncompensated Care Costs) be reinstated. CMS has not issued any additional guidance post the ruling. In April 2020, the plaintiffs in the case have petitioned the Supreme Court of the United States to hear their case. Additionally, there have been separate legal challenges on this same issue in the Fifth and Eight Circuits. On November 4, 2019, the United States Court of Appeals for the Eighth Circuit issued an opinion upholding the 2017 Rule. Missouri Hosp. Ass’n v. Azar, No. 18-1778 (8th Cir. Nov. 4, 2019) (i.e. reversing a district court order enjoining the 2017 rule). On April 20, 2020, the United States Court of Appeals of the Fifth Circuit issued a decision also upholding the 2017 Rule. Baptist Memorial Hospital v. Azar, No. 18-60592 (5th Cir. April 20, 2020). In light of these court decisions, we continue to maintain reserves in the financial statements for cumulative Medicaid DSH and UC reimbursements related to our behavioral health hospitals located in Texas that amounted to $35 million and $34 million as of December 31, 2020 and 2019, respectively. Nevada SPA: In Nevada, CMS approved a state plan amendment (“SPA”) in August, 2014 that implemented a hospital supplemental payment program retroactive to January 1, 2014. This SPA has been approved for additional state fiscal years including the 2021 fiscal year covering the period of July 1, 2020 through June 30, 2021. In connection with this program, included in our financial results was approximately $25 million during 2020, $28 million during 2019 and $26 million during 2018. We estimate that our reimbursements pursuant to this program will approximate $20 million during the year ended December 31, 2021. 65 California SPA: In California, CMS issued formal approval of the 2017-19 Hospital Fee Program in December, 2017 retroactive to January 1, 2017 through September 30, 2019. In September, 2019, the state submitted a request to renew the Hospital Fee Program for the period July 1, 2019 to December 31, 2021. On February 25, 2020, CMS approved this renewed program. These approvals include the Medicaid inpatient and outpatient fee-for-service supplemental payments and the overall provider tax structure but did not yet include the approval of the managed care rate setting payment component for certain rate periods (see table below). The managed care payment component consists of two categories of payments, “pass-through” payments and “directed” payments. The pass-through payments are similar in nature to the prior Hospital Fee Program payment method whereas the directed payment method will be based on actual concurrent hospital Medicaid managed care in-network patient volume. California Hospital Fee Program CMS Approval Status: Hospital Fee Program Component CMS Methodology Approval Status CMS Rate Setting Approval Status Fee For Service Payment Approved through December 31, 2021 Approved through December 31, 2021 Managed Care-Pass-Through Payment Approved through December 31, 2020 Approved through September 30, 2017; Paid in advance of approval through September 30, 2019 Managed Care-Directed Payment Approved through December 31, 2020 Approved through September 30, 2019; Paid through December 31, 2018 In connection with the existing program, included in our financial results was approximately $63 million during 2020, $29 million during 2019 and $25 million during 2018. Our financial results for the year ended December 31, 2020 include a $28 million favorable adjustment, as discussed below, of which $11 million relates to 2020 and $17 million relates to prior years. We estimate that our reimbursements pursuant to this program will approximate $43 million during the year ended December 31, 2021. The aggregate impact of the California supplemental payment program, as outlined above, is included in the above State Medicaid Supplemental Payment Program table. In April, 2020, the California Department of Health Care Services (“DHCS”) notified hospital providers that participate in the Medicaid managed care directed payment program that DHCS would recalculate directed payments for the period of July 1, 2017 through September 30, 2018 (“SFY 2018”) to remedy an identified data error. In August, 2020, as a follow-up to that notification, DHCS issued its corrected directed payment calculations. The updated calculation resulted in a favorable adjustment to the above program year and also resulted in increased expected supplemental payment amount for program years subsequent to the recalculated SFY 2018 rate period. The California Hospital Fee amounts noted above include our portion of the state corrected data. Kentucky Hospital Rate Increase Program (“HRIP”): In January, 2021, CMS approved the Medicaid Managed Care Hospital Rate Increase Program (“HRIP”) for state fiscal year 2021 (covering the period of July 1, 2020 to June 30, 2021). The CMS approval could increase the program statewide net benefit to eligible Kentucky hospitals to approximately $1.1 billion from the original HRIP CMS-approved pool size of $86 million. The increased HRIP payments are contingent on various actions occurring including the enactment of legislative authority to permit the payment of the increased HRIP pool size as well as certification of the new HRIP rates by the state actuaries and related CMS approval of the rates. Although we are unable to estimate the amount of the program change, given the material increase in the overall pool size, the program change could have a favorable impact on our operating results and would be retroactive to July 1, 2020. Risk Factors Related To State Supplemental Medicaid Payments: As outlined above, we receive substantial reimbursement from multiple states in connection with various supplemental Medicaid payment programs. The states include, but are not limited to, Texas, Mississippi, Illinois, Nevada, Arkansas, California and Indiana. Failure to renew these programs beyond their scheduled termination dates, failure of the public hospitals to provide the necessary IGTs for the states’ share of the DSH programs, failure of our hospitals that currently receive supplemental Medicaid revenues to qualify for future funds under these programs, or reductions in reimbursements, could have a material adverse effect on our future results of operations. In April, 2016, CMS published its final Medicaid Managed Care Rule which explicitly permits but phases out the use of pass-through payments (including supplemental payments) by Medicaid Managed Care Organizations (“MCO”) to hospitals over ten years but allows for a transition of the pass-through payments into value-based payment structures, delivery system reform initiatives or payments tied to services under a MCO contract. Since we are unable to determine the financial impact of this aspect of the final rule, 66 we can provide no assurance that the final rule will not have a material adverse effect on our future results of operations. In November, 2018, CMS issued a proposed rule that would permit pass-through supplemental provider payments during a time-limited period when states transition populations or services from fee-for-service Medicaid to managed care. HITECH Act: In July 2010, the Department of Health and Human Services (“HHS”) published final regulations implementing the health information technology (“HIT”) provisions of the American Recovery and Reinvestment Act (referred to as the “HITECH Act”). The final regulation defines the “meaningful use” of Electronic Health Records (“EHR”) and establishes the requirements for the Medicare and Medicaid EHR payment incentive programs. The final rule established an initial set of standards and certification criteria. The implementation period for these Medicare and Medicaid incentive payments started in federal fiscal year 2011 and can end as late as 2016 for Medicare and 2021 for the state Medicaid programs. State Medicaid program participation in this federally funded incentive program is voluntary but all of the states in which our eligible hospitals operate have chosen to participate. Our acute care hospitals qualified for these EHR incentive payments upon implementation of the EHR application assuming they meet the “meaningful use” criteria. The government’s ultimate goal is to promote more effective (quality) and efficient healthcare delivery through the use of technology to reduce the total cost of healthcare for all Americans and utilizing the cost savings to expand access to the healthcare system. All of our acute care hospitals have met the applicable meaningful use criteria. However, under the HITECH Act, hospitals must continue to meet the applicable meaningful use criteria in each fiscal year or they will be subject to a market basket update reduction in a subsequent fiscal year. Failure of our acute care hospitals to continue to meet the applicable meaningful use criteria would have an adverse effect on our future net revenues and results of operations. In the 2019 IPPS final rule, CMS overhauled the Medicare and Medicaid EHR Incentive Program to focus on interoperability, improve flexibility, relieve burden and place emphasis on measures that require the electronic exchange of health information between providers and patients. We can provide no assurance that the changes will not have a material adverse effect on our future results of operations. Managed Care: A significant portion of our net patient revenues are generated from managed care companies, which include health maintenance organizations, preferred provider organizations and managed Medicare (referred to as Medicare Part C or Medicare Advantage) and Medicaid programs. In general, we expect the percentage of our business from managed care programs to continue to grow. The consequent growth in managed care networks and the resulting impact of these networks on the operating results of our facilities vary among the markets in which we operate. Typically, we receive lower payments per patient from managed care payers than we do from traditional indemnity insurers, however, during the past few years we have secured price increases from many of our commercial payers including managed care companies. Commercial Insurance: Our hospitals also provide services to individuals covered by private health care insurance. Private insurance carriers typically make direct payments to hospitals or, in some cases, reimburse their policy holders, based upon the particular hospital’s established charges and the particular coverage provided in the insurance policy. Private insurance reimbursement varies among payers and states and is generally based on contracts negotiated between the hospital and the payer. Commercial insurers are continuing efforts to limit the payments for hospital services by adopting discounted payment mechanisms, including predetermined payment or DRG-based payment systems, for more inpatient and outpatient services. To the extent that such efforts are successful and reduce the insurers’ reimbursement to hospitals and the costs of providing services to their beneficiaries, such reduced levels of reimbursement may have a negative impact on the operating results of our hospitals. Other Sources: Our hospitals provide services to individuals that do not have any form of health care coverage. Such patients are evaluated, at the time of service or shortly thereafter, for their ability to pay based upon federal and state poverty guidelines, qualifications for Medicaid or other state assistance programs, as well as our local hospitals’ indigent and charity care policy. Patients without health care coverage who do not qualify for Medicaid or indigent care write-offs are offered substantial discounts in an effort to settle their outstanding account balances. Health Care Reform: Listed below are the Medicare, Medicaid and other health care industry changes which have been, or are scheduled to be, implemented as a result of the Legislation. Implemented Medicare Reductions and Reforms: • The Legislation reduced the market basket update for inpatient and outpatient hospitals and inpatient behavioral health facilities by 0.25% in each of 2010 and 2011, by 0.10% in each of 2012 and 2013, 0.30% in 2014, 0.20% in each of 2015 and 2016 and 0.75% in each of 2017, 2018 and 2019. • The Legislation implemented certain reforms to Medicare Advantage payments, effective in 2011. 67 • A Medicare shared savings program, effective in 2012. • A hospital readmissions reduction program, effective in 2012. • A value-based purchasing program for hospitals, effective in 2012. • A national pilot program on payment bundling, effective in 2013. • Reduction to Medicare DSH payments, effective in 2014, as discussed above. Medicaid Revisions: • Expanded Medicaid eligibility and related special federal payments, effective in 2014. • The Legislation (as amended by subsequent federal legislation) requires annual aggregate reductions in federal DSH funding from federal fiscal year (“FFY”) 2024 through FFY 2027. The aggregate annual reduction amounts are $8.0 billion for FFY 2024 through FFY 2027. In December, 2019, federal legislation was enacted which delays the reduction in the Medicaid DSH allotment through May 22, 2020 and then subsequent federal legislation in March, 2020 delayed the reduction through November 30, 2020. H.R. 8319 Continuing Resolution further delayed these Medicaid DSH reductions through December 11, 2020. The Consolidated Appropriation Act, 2021 (H.R. 133) and other intervening legislation further delayed the Medicaid DSH reductions through FFY 2023. Health Insurance Revisions: • Large employer insurance reforms, effective in 2015. • Individual insurance mandate and related federal subsidies, effective in 2014. As noted above in Health Care Reform, the Tax Cuts and Jobs Act enacted into law in December, 2017 eliminated the individual insurance federal mandate penalty beginning January 1, 2019. • Federally mandated insurance coverage reforms, effective in 2010 and forward. The Legislation seeks to increase competition among private health insurers by providing for transparent federal and state insurance exchanges. The Legislation also prohibits private insurers from adjusting insurance premiums based on health status, gender, or other specified factors. We cannot provide assurance that these provisions will not adversely affect the ability of private insurers to pay for services provided to insured patients, or that these changes will not have a negative material impact on our results of operations going forward. Value-Based Purchasing: There is a trend in the healthcare industry toward value-based purchasing of healthcare services. These value-based purchasing programs include both public reporting of quality data and preventable adverse events tied to the quality and efficiency of care provided by facilities. Governmental programs including Medicare and Medicaid currently require hospitals to report certain quality data to receive full reimbursement updates. In addition, Medicare does not reimburse for care related to certain preventable adverse events. Many large commercial payers currently require hospitals to report quality data, and several commercial payers do not reimburse hospitals for certain preventable adverse events. The Legislation required HHS to implement a value-based purchasing program for inpatient hospital services which became effective on October 1, 2012. The Legislation requires HHS to reduce inpatient hospital payments for all discharges by a percentage beginning at 1% in FFY 2013 and increasing by 0.25% each fiscal year up to 2% in FFY 2017 and subsequent years. HHS will pool the amount collected from these reductions to fund payments to reward hospitals that meet or exceed certain quality performance standards established by HHS. HHS will determine the amount each hospital that meets or exceeds the quality performance standards will receive from the pool of dollars created by these payment reductions. In its fiscal year 2016 IPPS final rule, CMS funded the value-based purchasing program by reducing base operating DRG payment amounts to participating hospitals by 1.75%. For FFY 2017 and subsequent years, this reduction was increased to its maximum of 2%. Hospital Acquired Conditions: The Legislation prohibits the use of federal funds under the Medicaid program to reimburse providers for medical assistance provided to treat hospital acquired conditions (“HAC”). Beginning in FFY 2015, hospitals that fall into the top 25% of national risk-adjusted HAC rates for all hospitals in the previous year will receive a 1% reduction in their total Medicare payments. Readmission Reduction Program: 68 In the Legislation, Congress also mandated implementation of the hospital readmission reduction program (“HRRP”). Hospitals with excessive readmissions for conditions designated by HHS will receive reduced payments for all inpatient discharges, not just discharges relating to the conditions subject to the excessive readmission standard. The HRRP currently assesses penalties on hospitals having excess readmission rates for heart failure, myocardial infarction, pneumonia, acute exacerbation of chronic obstructive pulmonary disease (COPD) and elective total hip arthroplasty (THA) and/or total knee arthroplasty (TKA), excluding planned readmissions, when compared to expected rates. In the fiscal year 2015 IPPS final rule, CMS added readmissions for coronary artery bypass graft (CABG) surgical procedures beginning in fiscal year 2017. To account for excess readmissions, an applicable hospital's base operating DRG payment amount is adjusted for each discharge occurring during the fiscal year. Readmissions payment adjustment factors can be no more than a 3 percent reduction. Accountable Care Organizations: The Legislation requires HHS to establish a Medicare Shared Savings Program that promotes accountability and coordination of care through the creation of accountable care organizations (“ACOs”). The ACO program allows providers (including hospitals), physicians and other designated professionals and suppliers to voluntarily work together to invest in infrastructure and redesign delivery processes to achieve high quality and efficient delivery of services. The program is intended to produce savings as a result of improved quality and operational efficiency. ACOs that achieve quality performance standards established by HHS will be eligible to share in a portion of the amounts saved by the Medicare program. CMS is also developing and implementing more advanced ACO payment models, such as the Next Generation ACO Model, which require ACOs to assume greater risk for attributed beneficiaries. On December 21, 2018, CMS published a final rule that, in general, requires ACO participants to take on additional risk associated with participation in the program. On April 30, 2020, CMS issued an interim final rule with comment in response to the COVID-19 national emergency permitting ACOs with current agreement periods expiring on December 31, 2020 the option to extend their existing agreement period by one year, and permitting certain ACOs to retain their participation level through 2021. It remains unclear to what extent providers will pursue federal ACO status or whether the required investment would be warranted by increased payment. Bundled Payments for Care Improvement Advanced: The Center for Medicare & Medicaid Innovation (“CMMI”) implemented a new, second generation voluntary episode payment model, Bundled Payments for Care Improvement Advanced (“BPCI-Advanced” or the “Program”), with the first performance period beginning October 1, 2018. BPCI-Advanced is designed to test a new iteration of bundled payments with an aim to align incentives among participating health care providers to reduce expenditures and improve quality of care for traditional Medicare beneficiaries. During the fourth quarter of 2020, CMS restructured the FY2021 to FY2023 program and required participants to select from eight Clinical Episode Service Line Groups instead of individual clinical episodes. CMS also announced that the now voluntary program would become mandatory in 2024. For our hospitals that participated in the program, the CMS BPCI-A reconciliation for the period October 1, 2018 through June 30, 2020 did not have a material impact on our financial results. The ultimate success and financial impact of the BPCI-Advanced program is contingent on multiple variables so we are unable to estimate the future impact. However, given the breadth and scope of participation of our acute care hospitals in BPCI-Advanced, the impact could be significant (either favorably or unfavorably) depending on actual program results. 2019 Novel Coronavirus Disease Medicare and Medicaid Payment Related Legislation In response to the growing threat of the 2019 Novel Coronavirus Disease (“COVID-19”), on March 13, 2020 President Trump declared a national emergency. The declaration empowered the HHS Secretary to waive certain Medicare, Medicaid and Children’s Health Insurance Program (“CHIP”) program requirements and Medicare conditions of participation under Section 1135 of the Social Security Act. Having been granted this authority by HHS, CMS issued a broad range of blanket waivers, which eased certain requirements for impacted providers, including: • Waivers and Flexibilities for Hospitals and other Healthcare Facilities including those for physical environment requirements and certain Emergency Medical Treatment & Labor Act provisions • Provider Enrollment Flexibilities • Flexibility and Relief for State Medicaid Programs including those under section 1135 Waivers • Suspension of Certain Enforcement Activities In addition to the national emergency declaration, Congress passed and President Trump signed legislation intended to support state and local authority responses to COVID-19 as well as provide fiscal support to businesses, individuals, financial markets, hospitals and other healthcare providers. This enacted legislation includes: • Public Law No: 116-123 - Coronavirus Preparedness and Response Supplemental Appropriations Act, 2020 (3/06/2020) 69 o The legislation provided $8.3 billion in emergency funding for federal agencies to respond to the coronavirus outbreak. • Public Law No: 116-127 Families First Coronavirus Response Act (3/18/2020) o The legislation provides paid sick leave, tax credits, and free COVID-19 testing; expands nutrition assistance and unemployment benefits; and increases Medicaid funding. • This legislation increases the Medicaid FMAP by 6.2% retroactive to the federal fiscal quarter beginning January 1, 2020 and each subsequent federal fiscal quarter for all states and U.S. territories during the declared public health emergency, in accordance with specified conditions. For example, in order to receive the increased FMAP, a state Medicaid program may not require standards for eligibility that are more restrictive than the standards that were in effect on January 1, 2020. • The HHS Secretary renewed the public health emergency (“PHE”) effective January 21, 2021 for ninety (90) days. As a result, states would be eligible for the enhanced FMAP through the third quarter of federal fiscal year 2021 should the PHE not be rescinded by the Secretary before the end of the ninety day period. • In response to this legislation, certain state Medicaid supplemental and DSH payment programs such as those in Texas and Mississippi have increased the level of provider payments or reduced the related Provider Tax amount used to fund the non-federal share of these supplemental payments. The favorable impact from these state Medicaid responses are included in the above State Medicaid Supplemental Payment and State Medicaid DSH Program noted amounts. • H.R. 748, the Coronavirus Aid, Relief, and Economic Security Act, (“CARES Act”)(03/27/2020) o The CARES Act includes sweeping measures that provides $2.2 trillion in emergency assistance to individuals, families, and businesses affected by the COVID-19 pandemic. Legislative provisions granting immediate funding relief are: o The creation of a $175 billion Public Health and Social Services Emergency Fund (“PHSSEF”) for grants available to hospitals and other healthcare providers (as amended by H.R. 266 on April 24, 2010 which added $75 billion to the fund). o This new program will provide grants intended to cover unreimbursed health care related expenses or lost revenues attributable to the public health emergency resulting from the coronavirus. o The new program will also reimburse hospitals at Medicare rates for uncompensated COVID-19 care for the uninsured (we have received approximately $22 million as of December 31, 2020 in connection with this program). o Grants to eligible recipients will be made in multiple tranches by HHS. • As of December 31, 2020, we have received approximately $417 million of funds from various governmental stimulus programs, most notably the PHSSEF as provided by the CARES Act. Our operating results for the year ended December 31, 2020 include the recognition of $413 million in PHSSEF grant income pursuant to meeting the applicable the terms and conditions of the various distribution programs as of December 31, 2020. The Consolidated Appropriations Act, 2021 (H.R. 133) enacted on December 27, 2020 includes language that provides specific instructions on: (1) the redistribution of PHSSEF grant payments by a parent company among its subsidiaries, and; (2) the calculation of lost revenue in a PHSSEF grant entitlement determination. The HHS terms and conditions for all grant recipients and specific fund distributions are located at https://www.hhs.gov/coronavirus/cares-act-provider-relief-fund/for-providers/index.html Additional CARES Act grants amounting to $187 million were received in January, 2021. There was no impact on results of operations for the year ended December 31, 2020 in connection with receipt of these funds. • HHS expects providers will only use Provider Relief Fund (i.e., “PHSSEF”) payments for as long as they have healthcare related expenses or lost revenue attributable to COVID-19, they are not reimbursed from other sources and other sources were not obligated to reimburse them. All Provider Relief Fund payments must be expended by no later than June 30, 2021. If providers have leftover Provider Relief Fund money that they cannot expend on permissible expenses or losses, then they will return this money to HHS. We are unable to predict if any funds received will ultimately need to be returned to HHS. • HHS Distributions from the PHSSEF include General Distributions to eligible healthcare providers and Targeted Distributions that focus on providers in areas particularly impacted by the COVID-19 outbreak, rural providers, providers of services with lower shares of Medicare reimbursement or who predominantly serve the Medicaid population, and providers requesting reimbursement for the treatment of uninsured Americans. 70 • Increase of provider funding through immediate Medicare sequester relief. • Suspension of the 2% Medicare sequestration offset for Medicare services provided from May 1, 2020 through December 31, 2020 and extended to March 31, 2021 by subsequent legislation (see H.R. 133 below). • We estimate that this provision had a favorable impact of $30 million during 2020. • Medicare add-on for inpatient hospital COVID-19 patients. • Increases the payment that would otherwise be made to a hospital for treating a Medicare patient admitted with COVID-19 by twenty percent (20%) for the duration of the COVID-19 public health emergency. • As of December 31, 2020, we estimate that additional payments under this provision were approximately $16 million. These payments offset the increased expenses associated with the treatment of Medicare COVID-19 patients. • Expansion of the Medicare Accelerated and Advance Payment Program (“MAAPP”). • As of December 31, 2020, we have received approximately $695 million under MAAPP. As a result of H.R. 8319 Continuing Resolution enacted into law on October 1, 2020, hospitals that receive funds under this program are subject to the following repayment terms. • No repayment until one year after first receiving the loan. • Medicare will withhold 25% per claim for the first 11 months of repayment. • Medicare will withhold 50% per claim for the next 6 months of repayment. • After 29 months, the HHS Secretary can require the outstanding balance be paid in full and determine the percent Medicare will withhold per claim. • An interest rate of 4% will be assessed on loan balances outstanding after 29 months. • Coronavirus Relief Fund. • Establishes a $150 billion Coronavirus Relief Fund. The Secretary of Treasury is authorized to make payments for COVID-19 response efforts to states, tribal governments and local governments with populations of 500,000 or more. We are unable to predict whether any portion of this this state and local funding will ultimately be paid to our hospitals impacted by COVID-19. Please see COVID-19 State and Local Grant Programs below for additional disclosure. • H.R 266 – The Paycheck Protection Program and Health Care Enhancement Act (4/24/2020) • Includes an additional $75 billion for the PHSSEF to reimburse hospitals and health care providers for COVID-19 related expenses and lost revenue. The legislation also includes $25 billion for necessary expenses to research, develop, validate, manufacture, purchase, administer and expand capacity for COVID-19 tests. • Consolidated Appropriations Act, 2021 (H.R. 133) (12/27/2020) The legislation includes the following highlighted provisions: • $22.4 billion for testing, contract tracing, and other activities necessary to effectively monitor and suppress COVID-19. • $3 billion in additional grants for hospital and health care providers to be reimbursed for health care related expenses or lost revenue directly attributable to the public health emergency resulting from coronavirus, along with direction to allocate not less than 85% of unobligated funding in the Provider Relief Fund through an application-based portal to reimburse health care providers based on “financial losses and changes in operating expenses” occurring in the third and fourth quarters of calendar year 2020, or the first quarter of calendar year 2021. • Provides for a one-time, one-year increase in the Medicare physician fee schedule of 3.75%. • Further suspends the 2% sequestration cuts for an additional three months (through March 31, 2021). • Eliminates Medicaid Disproportionate Share Hospital (“DSH”) payment reduction for FYs 2021, 2022 and 2023, adding DSH reductions for FYs 2026 and 2027. • Redefines the hospital-specific Medicaid DSH limit to generally exclude dual eligible patients from the hospital-specific DSH limit calculation beginning with FY 2022. COVID-19 State and Local Grant Programs We have pursued available COVID-19 related state and local grant funding opportunities where available. State and local grants received as of December 31, 2020 include an aggregate of approximately $13 million received in connection with certain of 71 our hospitals located in Washington, D.C., Massachusetts and California. We are unable to predict the aggregate amount of state and local grant opportunities that we will ultimately secure. In addition to statutory and regulatory changes to the Medicare program and each of the state Medicaid programs, our operations and reimbursement may be affected by administrative rulings, new or novel interpretations and determinations of existing laws and regulations, post-payment audits, requirements for utilization review and new governmental funding restrictions, all of which may materially increase or decrease program payments as well as affect the cost of providing services and the timing of payments to our facilities. The final determination of amounts we receive under the Medicare and Medicaid programs often takes many years, because of audits by the program representatives, providers’ rights of appeal and the application of numerous technical reimbursement provisions. We believe that we have made adequate provisions for such potential adjustments. Nevertheless, until final adjustments are made, certain issues remain unresolved and previously determined allowances could become either inadequate or more than ultimately required. Finally, we expect continued third-party efforts to aggressively manage reimbursement levels and cost controls. Reductions in reimbursement amounts received from third-party payers could have a material adverse effect on our financial position and our results. Other Operating Results Interest Expense Reflected below are the components of our interest expense which amounted to $106 million during 2020, $163 million during 2019 and $155 million during 2018 (amounts in thousands): 2020 2019 2018 Revolving credit & demand notes (a.) $ 2,248 $ 3,066 $ 12,240 $300 million, 3.75% Senior Notes due 2019 (b.) — — 10,156 $700 million, 4.75% Senior Notes due 2022 (c.) 23,932 32,280 32,280 $400 million, 5.00% Senior Notes due 2026 (d.) 20,000 20,000 20,000 $800 million, 2.65% Senior Notes due 2030 (e.) 5,849 — — Term loan facility A (a.) 38,467 73,005 63,021 Term loan facility B (a.) 11,892 20,274 3,511 Accounts receivable securitization program (f.) 3,752 12,471 11,785 Subtotal-revolving credit, demand notes, Senior Notes, term loan facility and accounts receivable securitization program 106,140 161,096 152,993 Interest rate swap (income)/expense, net — (3,400 ) (6,726 ) Amortization of financing fees 4,938 5,118 9,143 Other combined interest expense 2,268 3,754 3,343 Capitalized interest on major projects (4,257 ) (3,366 ) (2,266 ) Interest income (2,804 ) (469 ) (1,531 ) Interest expense, net $ 106,285 $ 162,733 $ 154,956 (a.) In October, 2018, we entered into a sixth amendment to our credit agreement dated November 15, 2010 to, among other things: (i) increase the aggregate amount of the revolving commitments by $200 million to $1 billion; (ii) increase the aggregate amount of the term loan facility A by approximately $290 million to $2 billion, and; (iii) extend the maturity date of the credit agreement from August 7, 2019 to October 23, 2023. On October 31, 2018, we added a seven-year, Tranche B term loan facility in the aggregate amount of $500 million pursuant to our credit agreement. The Trance B term loan matures on October 31, 2025. The credit agreement, as amended in October, 2018, consists of: (i) an $1 billion revolving credit facility with no outstanding borrowings as of December 31, 2020; (ii) a term loan A facility with $1.9 billion of outstanding borrowings as of December 31, 2020, and; (iii) a term loan B facility with $490 million of outstanding borrowings as of December 31, 2020. (b.) On November 26, 2018 we redeemed the $300 million aggregate principal, 3.75% Senior Notes due 2019. The 2019 Notes were redeemed for an aggregate price equal to 100.485% of the principal amount (premium of approximately $1 million) plus accrued interest to the redemption date. (c.) In September, 2020, we redeemed the entire $700 million aggregate principal amount of our previously outstanding 4.75% Senior Secured Notes that were scheduled to mature in 2022 (“2022 Notes”) at a cash redemption price equal to the sum of: 72 (i) 100% of the aggregate principal amount of the 2022 Notes redeemed, and; (ii) accrued and unpaid interest on the 2022 Notes to the redemption date. (d.) In June, 2016, we completed the offering of $400 million aggregate principal amount of 5.00% Senior Notes due in 2026. (e.) In September, 2020, we completed the offering of $800 million aggregate principal amount of 2.65% Senior Notes due in 2030. The net proceeds of this offering were primarily used to redeem all of the $700 million, 2022 Notes as discussed above. (f.) In April, 2018, we amended our accounts receivable securitization program, which was scheduled to expire in December, 2018. Pursuant to the amendment, the term has been extended through April 26, 2021, and the borrowing limit has been increased to $450 million from $440 million. As of December 31, 2020, we had $225 million of borrowings outstanding pursuant to this program. Interest expense decreased $56 million during 2020 to $106 million as compared to $163 million during 2019. The decrease was due primarily to a net $55 million decrease in aggregate interest expense on our revolving credit, demand notes, senior notes, term loan A and B facilities and accounts receivable securitization program resulting from a decrease in our aggregate average cost of borrowings pursuant to these facilities (2.8% during 2020 and 4.0% during 2019), as well as a decrease in the aggregate average outstanding borrowings ($3.70 billion during 2020 and $3.99 billion during 2019). Interest expense increased $8 million during 2019 to $163 million as compared to $155 million during 2018. The increase was due primarily to an increase in our aggregate average cost of borrowings pursuant to our revolving credit, demand notes, senior notes, term loan A and B facilities and accounts receivable securitization program facilities. The average cost of borrowings on these facilities increased to 4.0% during 2019, as compared to 3.8% during 2018, on average outstanding borrowings of approximately $4.0 billion during each year. The average effective interest rate, including amortization of deferred financing costs, original issue discount and designated interest rate swap expense/income, on borrowings outstanding under our revolving credit, demand notes, senior notes, term loan A and B facilities and accounts receivable securitization program, which amounted to approximately $3.7 billion during 2020 and $4.0 billion during each of 2019 and 2018, were 3.0% during 2020, 4.0% during 2019 and 3.8% during 2018. Costs Related to Early Extinguishment of Debt In connection with financing transactions completed during 2020 and 2018, our results of operations for each year include pre-tax charges of $1 million in 2020 and $4 million in 2018, incurred for the costs related to the extinguishment of debt. These charges, which were included in other operating expenses, consisted of the following: (ii) during 2020, write-off of deferred charges ($3 million), partially offset by the recording of the unamortized bond premium ($2 million), related to the above-mentioned redemption, in September, 2020, of the $700 million aggregate principal amount of our previously outstanding 4.75% senior secured notes that were scheduled to mature in 2022, and; (ii) during 2018, write-off of deferred charges ($3 million) as well as the make-whole premium paid ($1 million) on the early redemption of the $300 million, 3.75% senior notes which were scheduled to mature in 2019. Provision for Asset Impairment-Foundations Recovery Network: Our financial results for the years ended December 31, 2019 and 2018 include pre-tax provisions for asset impairments of approximately $98 million and $49 million, respectively, recorded in connection with Foundations Recovery Network, L.L.C. (“Foundations”), which was acquired by us in 2015. The pre-tax provision for asset impairment recording during 2019 includes: (i) a $75 million impairment provision to write-off the carrying value of the Foundations’ tradename intangible asset, and; (ii) a $23 million impairment provision to reduce the carrying value of real property assets of certain Foundations’ facilities. The $49 million pre-tax provision for asset impairment recorded during 2018 reduced the carrying value of a tradename intangible asset to approximately $75 million from its original value of approximately $124 million. The provision for asset impairment recorded during 2019, which is included in other operating expenses in our consolidated statements of income, was recorded after evaluation of the estimated fair value of the Foundations’ tradename as well as certain related real property assets. The provision for asset impairment was impacted by the following: (i) decisions made by management during 2019 to cancel the opening of future planned de novo facilities; (ii) reductions in projected future patient volumes, revenues and cash flows resulting from continued operating trends and financial results experienced by existing facilities that significantly lagged expectations, and; (iii) competitive pressures experienced in certain markets that were deemed to be permanent. The provision for asset impairment recorded during 2018, which is also included in other operating expenses, was recorded after an evaluation, at that time, of the estimated fair value of the Foundations’ tradename for its existing facilities, consisting of 4 inpatient and 12 outpatient facilities as of December 31, 2018, as well as estimated planned de novos. The 2018 asset impairment charge was 73 impacted by the following: (i) the lost future revenue and cash flows resulting from the permanent closure of a Foundations’ inpatient facility located in Malibu, California that was severely damaged in the California wildfires during the fourth quarter of 2018; (ii) reduction in growth rates of projected future patient volumes, revenues and operating cash flows based upon pressures on reimbursement rates experienced from certain payers and competitive pressures experienced in certain markets, and; (iii) revisions made to the number and timing of planned de novo facilities. Provision for Income Taxes and Effective Tax Rates The effective tax rates, as calculated by dividing the provision for income taxes by income before income taxes, were as follows for each of the years ended December 31, 2020, 2019 and 2018 (dollar amounts in thousands): 2020 2019 2018 Provision for income taxes $ 299,293 $ 238,794 $ 236,642 Income before income taxes 1,252,083 1,066,337 1,034,525 Effective tax rate 23.9 % 22.4 % 22.9 % The provision for income taxes increased $60 million and the effective tax rate increased 1.5% during 2020, as compared to 2019, due primarily to: (i) the income tax provision recorded in connection with the $186 million increase in pre-tax income, as discussed above in Results of Operations; (ii) a $20 million increase in the provision for income taxes recorded in connection with our adoption of ASU 2016-09 which increased our provision for income taxes by approximately $7 million during 2020, as compared to a decrease of approximately $12 million during 2019; partially offset by; (iii) a $6 million decrease in the provision for income taxes due the 2019 recording of the non-deductible portion of the net federal and state income taxes due on the settlement finalized in July, 2020 with the Department of Justice, Civil Division. The provision for income taxes increased $2 million and the effective tax rate decreased 0.5% during 2019, as compared 2018, due primarily to: (i) an increase resulting from the provision for income taxes recorded on the $32 million increase in pre-tax income, as discussed above in Results of Operations; (ii) a decrease of $11 million resulting from our adoption of ASU 2016-09 which decreased our provision for income taxes by approximately $12 million during 2019, as compared to a decrease of approximately $1 million during 2018; (iii) a $4 million decrease resulting from a favorable adjustment recorded during 2019 related to a change in state tax law, partially offset by; (iv) a $6 million increase recorded during 2019 resulting from the above-mentioned net estimated federal and state income taxes due on the portion of the DOJ Reserve that is estimated to be non-deductible for income tax purposes. Effects of Inflation and Seasonality Seasonality —Our acute care services business is typically seasonal, with higher patient volumes and net patient service revenue in the first and fourth quarters of the year. This seasonality occurs because, generally, more people become ill during the winter months, which results in significant increases in the number of patients treated in our hospitals during those months. Inflation —Inflation has not had a material impact on our results of operations over the last three years. However, since the healthcare industry is very labor intensive and salaries and benefits are subject to inflationary pressures, as are supply and other costs, we cannot predict the impact that future economic conditions may have on our ability to contain future expense increases. Our ability to pass on increased costs associated with providing healthcare to Medicare and Medicaid patients is limited due to various federal, state and local laws which have been enacted that, in certain cases, limit our ability to increase prices. We believe, however, that through adherence to cost containment policies, labor management and reasonable price increases, the effects of inflation on future operating margins should be manageable. 74 Liquidity Year ended December 31, 2020 as compared to December 31, 2019: Net cash provided by operating activities Net cash provided by operating activities was $2.360 billion during 2020 as compared to $1.438 billion during 2019. The net increase of $922 million was primarily attributable to the following: • a favorable change of $699 million resulting primarily from the $695 million of Medicare accelerated payments received during 2020; • a favorable change of $176 million due to the 2020 payment deferral of the employer’s share of Social Security taxes, as provided for by the CARES Act; • an unfavorable change of $104 million in accounts receivable due, in part, to the coding and billing delays experienced during the fourth quarter of 2020 resulting from the information technology incident discussed herein; • a favorable change of $55 million resulting from an increase in net income plus/minus depreciation and amortization expense, stock-based compensation, provision for asset impairment, net gains/losses on sales of assets and businesses and costs related to extinguishment of debt; • a favorable change of $38 million in accrued insurance expense, net of commercial premiums paid; • a favorable change of $35 million in accrued and deferred income taxes, and; • $23 million of other combined net favorable changes. Days sales outstanding (“DSO”): Our DSO are calculated by dividing our net revenue by the number of days in the year. The result is divided into the accounts receivable balance at the end of the year. Our DSO were 55 days at December 31, 2020, 50 days at December 31, 2019 and 51 days at December 31, 2018. Net cash used in investing activities Net cash used in investing activities was $803 million during 2020 and $688 million during 2019. 2020: The $803 million of net cash used in investing activities during 2020 consisted of: • $731 million spent on capital expenditures including capital expenditures for equipment, renovations and new projects at various existing facilities; • $52 million spent to acquire businesses and property, consisting primarily of the real estate assets of an acute care hospital located in Las Vegas, Nevada; • $22 million spent in connection with net cash outflows from forward exchange contracts that hedge our investment in the U.K. against movements in exchange rates; • $8 million of proceeds received from sales of assets and businesses; • $3 million spent on the purchase and implementation of information technology applications, and; • $3 million spent to fund investments in various joint-ventures; 2019: The $688 million of net cash used in investing activities during 2019 consisted of: • $634 million spent on capital expenditures including capital expenditures for equipment, renovations and new projects at various existing facilities; • $21 million spent on the purchase and implementation of information technology applications; • $20 million spent in connection with net cash outflows from forward exchange contracts that hedge our investment in the U.K. against movements in exchange rates; 75 • $15 million spent to fund investments in various joint-ventures; • $9 million of proceeds received from sales of assets and businesses, and; • $8 million spent to acquire businesses and property. Net cash used in financing activities Net cash used in financing activities was $385 million during 2020 and $845 million during 2019. 2020: The $385 million of net cash used in financing activities during 2020 consisted of the following: • spent $963 million on net repayment of debt as follows: (i) $700 million to redeem our previously outstanding 4.75% senior secured notes which were scheduled to mature in 2022; (ii) $175 million related to our accounts receivable securitization program; (iii) $50 million related to our term loan A facility; (iv) $31 million related to our short-term, on-demand credit facility; (v) $5 million related to our term loan B facility, and; (vi) $2 million related to other debt facilities; • generated $802 million of proceeds related to new borrowings as follows: (i) $798 million of proceeds (net of discount) received in connection with the issuance in September, 2020, of the $800 million, 2.65% senior secured notes which are scheduled to mature in 2030, and; (ii) $4 million related to other debt facilities. • spent $207 million to repurchase shares of our Class B Common Stock in connection with: (i) open market purchases pursuant to our $2.7 billion stock repurchase program, which was suspended in April, 2020 for the remainder of 2020 as a result of the COVID-19 pandemic ($197 million), and; (ii) income tax withholding obligations related to stock-based compensation programs ($10 million); • spent $20 million to pay profit distributions related to noncontrolling interests in majority owned businesses; • received $18 million in capital contributions from minority members in majority owned businesses; • spent $17 million to pay a cash dividend of $.20 per share during the first quarter of 2020 (quarterly dividends were suspended during the remainder of 2020 as a result of the COVID-19 pandemic); • generated $12 million from the issuance of shares of our Class B Common Stock pursuant to the terms of employee stock purchase plans, and; • spent $10 million to pay financing costs incurred in connection with the $800 million, 2.65% senior secured notes which were issued during the third quarter of 2020. 2019: The $845 million of net cash used in financing activities during 2019 consisted of the following: • spent $57 million on net repayment of debt as follows: (i) $50 million related to our term loan A facility; (ii) $5 million related to our term loan B facility, and; (iii) $2 million related to other debt facilities; • generated $39 million of proceeds related to new borrowings as follows: (i) $25 million pursuant to a short-term, on-demand credit facility; (ii) $10 million pursuant to our accounts receivable securitization program, and; (iii) $4 million related to other debt facilities. • spent $771 million to repurchase shares of our Class B Common Stock in connection with: (i) open market purchases pursuant to our $2.7 billion stock repurchase program ($723 million), and; (ii) income tax withholding obligations related to stock-based compensation programs ($48 million); • spent $53 million to pay quarterly cash dividends of $.20 per share in each of September and December of 2019 and $.10 per share in each of March and June of 2019; • spent $16 million to pay profit distributions related to noncontrolling interests in majority owned businesses; • generated $11 million from the issuance of shares of our Class B Common Stock pursuant to the terms of employee stock purchase plans, and; • received $1 million in capital contributions from minority members in majority owned businesses. 76 Year ended December 31, 2019 as compared to December 31, 2018: Net cash provided by operating activities Net cash provided by operating activities was $1.438 billion during 2019 as compared to $1.275 billion during 2018. The net increase of $164 million was primarily attributable to the following: • a favorable change of $110 million resulting from an increase in net income plus/minus depreciation and amortization expense, stock-based compensation, provision for asset impairment, net gains on sales of assets and costs related to extinguishment of debt; • a favorable change of $29 million in accrued and deferred income taxes, and; • $25 million of other combined net favorable changes. Net cash used in investing activities Net cash used in investing activities was $688 million during 2019 and $747 million during 2018. The factors contributing to the $688 million of net cash used in investing activities during 2019 are detailed above. 2018: The $747 million of net cash used in investing activities during 2018 consisted of: • $665 million spent on capital expenditures including capital expenditures for equipment, renovations and new projects at various existing facilities; • $110 million spent to acquire businesses and property consisting primarily of the acquisition of: (i) The Danshell Group, consisting of 25 behavioral health facilities located in the U.K. (acquired during the third quarter of 2018), and; (ii) a 109-bed behavioral health care facility located in Gulfport, Mississippi (acquired during the first quarter of 2018); • $66 million received in connection with net cash inflows from forward exchange contracts that hedge our investment in the U.K. against movements in exchange rates; • $36 million spent on the purchase and implementation of information technology applications; • $15 million spent to fund construction costs of a new behavioral health care facility, that is jointly owned by us and a third-party, that was completed and opened during the third quarter of 2018, and; • $13 million received in connection with the sale of a business and property including The Limes, an 18-bed facility located in the U.K. Net cash used in financing activities Net cash used in financing activities was $845 million during 2019 and $492 million during 2018. The factors contributing to the $845 million of net cash used in financing activities during 2019 are detailed above. 2018: The $492 million of net cash used in financing activities during 2018 consisted of the following: • spent $830 million on net repayment of debt as follows: (i) $67 million related to our term loan A facility; (ii) $403 million related to our revolving credit facility; (iii) $300 million related to the early redemption of our 3.75% bonds that were scheduled to mature in 2019; (iv) $29 million related to our accounts receivable securitization program; (v) $29 million related to our short-term, on-demand credit facility, and; (vi) $2 million related to other debt facilities; • generated $791 million of proceeds related to new borrowings pursuant to our term loan A facility ($291 million) and our term loan B facility ($500 million); • spent $397 million to repurchase shares of our Class B Common Stock in connection with: (i) open market purchases pursuant to our stock repurchase program ($384 million), and; (ii) income tax withholding obligations related to stock-based compensation programs ($13 million); • spent $37 million to pay quarterly cash dividends of $.10 per share; • spent $14 million in financing costs; • spent $15 million to pay profit distributions related to noncontrolling interests in majority owned businesses, and; 77 • generated $10 million from the issuance of shares of our Class B Common Stock pursuant to the terms of employee stock purchase plans. 2021 Expected Capital Expenditures: During 2021, we expect to spend approximately $850 million to $1.0 billion on capital expenditures which includes expenditures for capital equipment, construction of new facilities, and renovations and expansions at existing hospitals. We believe that our capital expenditure program is adequate to expand, improve and equip our existing hospitals. We expect to finance all capital expenditures and acquisitions with internally generated funds and/or additional funds, as discussed below. Capital Resources: Cash and Cash Equivalents As of December 31, 2020, we had approximately $1.22 billion of cash and cash equivalents consisting primarily of short-term cash accounts on which interest is being earned at various annual rates ranging from 0.20% to 0.25%. Credit Facilities and Outstanding Debt Securities On October 23, 2018, we entered into a Sixth Amendment (the “Sixth Amendment”) to our credit agreement dated as of November 15, 2010, as amended on March 15, 2011, September 21, 2012, May 16, 2013, August 7, 2014 and June 7, 2016, among UHS, as borrower, the several banks and other financial institutions from time to time parties thereto, as lenders, JPMorgan Chase Bank, N.A., as administrative agent, and the other agents party thereto (the “Senior Credit Agreement”). The Sixth Amendment to the Senior Credit Agreement, among other things: (i) increased the aggregate amount of the revolving credit facility to $1 billion (increase of $200 million over the $800 million previous commitment); (ii) increased the aggregate amount of the tranche A term loan commitments to $2 billion (increase of approximately $290 million over the $1.71 billion of outstanding borrowings prior to the amendment), and; (iii) extended the maturity date of the revolving credit and tranche A term loan facilities to October 23, 2023 from August 7, 2019. On October 31, 2018, we added a seven-year tranche B term loan facility in the aggregate principal amount of $500 million pursuant to the Senior Credit Agreement. The tranche B term loan matures on October 31, 2025. We used the proceeds to repay borrowings under the revolving credit facility, the Securitization (as defined below), to redeem our $300 million, 3.75% Senior Notes that were scheduled to mature in 2019 and for general corporate purposes. As of December 31, 2020, we had no borrowings outstanding pursuant to our $1 billion revolving credit facility and we had $997 million of available borrowing capacity net of $3 million of outstanding letters of credit. Pursuant to the terms of the Sixth Amendment, the tranche A term loan, which had $1.900 billion of borrowings outstanding as of December 31, 2020, provided for eight installment payments of $12.5 million per quarter which commenced in March of 2019 and continued through December of 2020. Payments of $25 million per quarter are scheduled, commencing in March of 2021 until maturity in October of 2023, when all outstanding amounts will be due. The tranche B term loan, which had $490 million of borrowings outstanding as of December 31, 2020, provides for installment payments of $1.25 million per quarter, which commenced on March 31, 2019 and are scheduled to continue until maturity in October of 2025, when all outstanding amounts will be due. Borrowings under the Senior Credit Agreement bear interest at our election at either (1) the ABR rate which is defined as the rate per annum equal to the greatest of (a) the lender’s prime rate, (b) the weighted average of the federal funds rate, plus 0.5% and (c) one month LIBOR rate plus 1%, in each case, plus an applicable margin based upon our consolidated leverage ratio at the end of each quarter ranging from 0.375% to 0.625% for revolving credit and term loan A borrowings and 0.75% for tranche B borrowings, or (2) the one, two, three or six month LIBOR rate (at our election), plus an applicable margin based upon our consolidated leverage ratio at the end of each quarter ranging from 1.375% to 1.625% for revolving credit and term loan A borrowings and 1.75% for the tranche B term loan. As of December 31, 2020, the applicable margins were 0.375% for ABR-based loans and 1.375% for LIBOR-based loans under the revolving credit and term loan A facilities. The revolving credit facility includes a $125 million sub-limit for letters of credit. The Senior Credit Agreement is secured by certain assets of the Company and our material subsidiaries (which generally excludes asset classes such as substantially all of the patient-related accounts receivable of our acute care hospitals, and certain real estate assets and assets held in joint-ventures with third parties) and is guaranteed by our material subsidiaries. The Senior Credit Agreement includes a material adverse change clause that must be represented at each draw. The Senior Credit Agreement contains covenants that include a limitation on sales of assets, mergers, change of ownership, liens and indebtedness, transactions with affiliates, dividends and stock repurchases; and requires compliance with financial covenants including maximum leverage. We are in compliance with all required covenants as of December 31, 2020 and December 31, 2019. 78 In April, 2018, we entered into the sixth amendment to our accounts receivable securitization program (“Securitization”) dated as of October 27, 2010 with a group of conduit lenders, liquidity banks, and PNC Bank, National Association, as administrative agent, which provides for borrowings outstanding from time to time by certain of our subsidiaries in exchange for undivided security interests in their respective accounts receivable. The sixth amendment, among other things, extended the term of the Securitization program through April 26, 2021 and increased the borrowing capacity to $450 million (from $440 million previously). In July, 2020, we entered into the seventh amendment to the Securitization which temporarily waived the minimum borrowing requirement through September 30, 2020. Pursuant to the terms of our Securitization program, substantially all of the patient-related accounts receivable of our acute care hospitals (“Receivables”) serve as collateral for the outstanding borrowings. We have accounted for this Securitization as borrowings. We maintain effective control over the Receivables since, pursuant to the terms of the Securitization, the Receivables are sold from certain of our subsidiaries to special purpose entities that are wholly-owned by us. The Receivables, however, are owned by the special purpose entities, can be used only to satisfy the debts of the wholly-owned special purpose entities, and thus are not available to us except through our ownership interest in the special purpose entities. The wholly-owned special purpose entities use the Receivables to collateralize the loans obtained from the group of third-party conduit lenders and liquidity banks. The group of third-party conduit lenders and liquidity banks do not have recourse to us beyond the assets of the wholly-owned special purpose entities that securitize the loans. At December 31, 2020, we had $225 million of outstanding borrowings pursuant to the terms of the Securitization (which are included in current maturities of long-term debt at December 31, 2020) and $225 million of available borrowing capacity. As of December 31, 2020, we had combined aggregate principal of $1.2 billion from the following senior secured notes: • $800 million aggregate principal amount of 2.65% senior secured notes due in October, 2030 (“2030 Notes”) which were issued on September 21, 2020. • $400 million aggregate principal amount of 5.00% senior secured notes due in June, 2026 (“2026 Notes”) which were issued on June 3, 2016. Interest on the 2026 Notes is payable on June 1 and December 1 until the maturity date of June 1, 2026. Interest on the 2030 Notes payable on April 15 and October 15, commencing April 15, 2021, until the maturity date of October 15, 2030. The 2026 Notes and 2030 Notes were offered only to qualified institutional buyers under Rule 144A and to non-U.S. persons outside the United States in reliance on Regulation S under the Securities Act of 1933, as amended (the “Securities Act”). The 2026 Notes and 2030 Notes have not been registered under the Securities Act and may not be offered or sold in the United States absent registration or an applicable exemption from registration requirements. The 2030 Notes are guaranteed (the “Guarantees”) on a senior secured basis by all of our existing and future direct and indirect subsidiaries (the “Subsidiary Guarantors”) that guarantee our Senior Credit Agreement, dated as of November 15, 2010, as amended, restated or supplemented from time to time, or other first lien obligations or any junior lien obligations. The 2030 Notes and the Guarantees are secured by first-priority liens, subject to permitted liens, on certain of the Company’s and the Subsidiary Guarantors’ assets now owned or acquired in the future by the Company or the Subsidiary Guarantors (other than real property, accounts receivable sold pursuant to the Company’s Existing Receivables Facility (as defined in the Indenture pursuant to which the 2030 Notes were issued (the “Indenture”)), and certain other excluded assets). The Company’s obligations with respect to the 2030 Notes, the obligations of the Subsidiary Guarantors under the Guarantees, and the performance of all of the Company’s and the Subsidiary Guarantors’ other obligations under the Indenture are secured equally and ratably with the Company’s and the Subsidiary Guarantors’ obligations under the Senior Credit Agreement and the Company’s 2026 Notes by a perfected first-priority security interest, subject to permitted liens, in the collateral owned by the Company and its Subsidiary Guarantors, whether now owned or hereafter acquired. However, the liens on the collateral securing the 2030 Notes and the Guarantees will be released if: (i) the 2030 Notes have investment grade ratings; (ii) no default has occurred and is continuing, and; (iii) the liens on the collateral securing all first lien obligations (including the Senior Credit Agreement and the 2026 Notes) and any junior lien obligations are released or the collateral under the Senior Credit Agreement, any other first lien obligations and any junior lien obligations is released or no longer required to be pledged. The liens on any collateral securing the 2030 Notes and the Guarantees will also be released if the liens on that collateral securing the Senior Credit Agreement, other first lien obligations and any junior lien obligations are released. In connection with the issuance of the 2030 Notes, the Company, the Subsidiary Guarantors and the representatives of the several initial purchasers, entered into a Registration Rights Agreement (the “Registration Rights Agreement”), whereby the Company and the Subsidiary Guarantors have agreed, at their expense, to use commercially reasonable best efforts to: (i) cause to be filed a registration statement enabling the holders to exchange the 2030 Notes and the Guarantees for registered senior secured notes issued by the Company and guaranteed by the then Subsidiary Guarantors under the Indenture (the “Exchange Securities”), containing terms identical to those of the 2030 Notes (except that the Exchange Securities will not be subject to restrictions on transfer or to any increase in annual interest rate for failure to comply with the Registration Rights Agreement); (ii) cause the registration statement to become effective; (iii) complete the exchange offer not later than 60 days after such effective date and in any event on or prior to a target registration date of March 21, 2023, and; (iv) file a shelf registration statement for the resale of the 2030 Notes if the exchange offer cannot be effected within the time periods listed above. The interest rate on the 2030 Notes will increase and additional interest thereon will be payable if the Company does not comply with its obligations under the Registration Rights Agreement. 79 On September 28, 2020, we redeemed the entire $700 million aggregate principal amount of our previously outstanding 4.75% Senior Secured Notes due 2022 (the “2022 Notes”), at a cash redemption price equal to the sum of: (i) 100% of the aggregate principal amount of the 2022 Notes redeemed, and; (ii) accrued and unpaid interest on the 2022 Notes to the redemption date. Included in our financial results for the three and nine-month periods ended September 30, 2020, was a loss on extinguishment of debt of approximately $1 million recorded in connection with the redemption of the 2022 Notes. At December 31, 2020, the carrying value and fair value of our debt were each approximately $3.9 billion. At December 31, 2019, the carrying value and fair value of our debt were each approximately $4.0 billion. The fair value of our debt was computed based upon quotes received from financial institutions. We consider these to be “level 2” in the fair value hierarchy as outlined in the authoritative guidance for disclosures in connection with debt instruments. Our total debt as a percentage of total capitalization was approximately 38% at December 31, 2020 and 42% at December 31, 2019. We expect to finance all capital expenditures and acquisitions and pay dividends and potentially repurchase shares of our common stock utilizing internally generated and additional funds. Additional funds may be obtained through: (i) borrowings under our existing revolving credit facility, which has $997 million of availably borrowing capacity as of December 31, 2020, or through refinancing the existing Senior Credit Agreement; (ii) the issuance of other long-term debt, and/or; (iii) the issuance of equity. We believe that our operating cash flows, cash and cash equivalents, as well as access to the capital markets, provide us with sufficient capital resources to fund our operating, investing and financing requirements for the next twelve months, including the repayment or refinancing of our above-mentioned Securitization which is scheduled to mature in April, 2021. However, in the event we need to access the capital markets or other sources of financing, there can be no assurance that we will be able to obtain financing on acceptable terms or within an acceptable time. Our inability to obtain financing on terms acceptable to us could have a material unfavorable impact on our results of operations, financial condition and liquidity. Contractual Obligations and Off-Balance Sheet Arrangements As of December 31, 2020 we were party to certain off balance sheet arrangements consisting of standby letters of credit and surety bonds which totaled $158 million consisting of: (i) $149 million related to our self-insurance programs, and; (ii) $9 million of other debt and public utility guarantees. Obligations under operating leases for real property, real property master leases and equipment amount to $442 million as of December 31, 2020. The real property master leases are leases for buildings on or near hospital property for which we guarantee a certain level of rental income. We sublease space in these buildings and any amounts received from these subleases are offset against the expense. In addition, we lease four hospital facilities from Universal Health Realty Trust (the “Trust”) with two hospital terms expiring in 2021, one in 2026, and one (which commenced in December, 2020) in 2040. These leases contain various 5-year renewal options. We also lease two free-standing emergency departments and space in certain medical office buildings which are owned by the Trust. In addition, we lease the real property of certain other facilities from non-related parties as indicated in Item 2. Properties, as included herein. The following represents the scheduled maturities of our contractual obligations as of December 31, 2020: Payments Due by Period (dollars in thousands) Less than 2-3 4-5 After Total 1 year years years 5 years Long-term debt obligations (a) $ 3,856,251 $ 331,998 $ 1,812,666 $ 476,926 $ 1,234,661 Estimated future interest payments on debt outstanding as of December 31, 2020 (b) 517,912 94,142 162,442 107,847 153,481 Construction commitments (c) 94,525 66,439 28,086 0 0 Purchase and other obligations (d) 348,907 55,002 120,386 55,714 117,805 Operating leases (e) 442,368 72,722 118,581 87,963 163,102 Estimated future payments for defined benefit pension plan, and other retirement plan (f) 180,517 17,577 16,045 18,567 128,328 Health and dental unpaid claims (g) 90,639 90,639 0 0 0 Total contractual cash obligations $ 5,531,119 $ 728,519 $ 2,258,206 $ 747,017 $ 1,797,377 (a) Reflects borrowings outstanding, after unamortized financing costs, as of December 31, 2020 as discussed in Note 4 to the Consolidated Financial Statements. 80 (b) Assumes that all debt outstanding as of December 31, 2020, including borrowings under our Credit Agreement and accounts receivable securitization program, remain outstanding until the final maturity of the debt agreements at the same interest rates (some of which are floating) which were in effect as of December 31, 2020. We have the right to repay borrowings upon short notice and without penalty, pursuant to the terms of the Credit Agreement and accounts receivable securitization program. (c) Our share of the remaining estimated construction cost of five behavioral health care facilities that are under construction and scheduled to be completed at various times in 2021, 2022 and 2023. We are required to build these facilities pursuant to joint-venture agreements with third parties. In addition, we had various other projects under construction as of December 31, 2020. Because we can terminate substantially all of the construction contracts related to the various other projects at any time without paying a termination fee, these costs are excluded from the table above. (d) Consists of: (i) $27 million related to long-term contracts with third-parties consisting primarily of certain revenue cycle data processing services for our acute care facilities; (ii) $218 million related to the future expected costs to be paid to a third-party vendor in connection with the ongoing operation of an electronic health records application and purchase and implementation of a revenue cycle and other applications for our acute care facilities; (iii) and $29 million for other software applications, and; (iv) $75 million in healthcare infrastructure in Washington D.C. in connection with various agreements with the District of Columbia, as discussed below. (e) Reflects our future minimum operating lease payment obligations related to our operating lease agreements outstanding as of December 31, 2020 as discussed in Note 7 to the Consolidated Financial Statements. Some of the lease agreements provide us with the option to renew the lease and our future lease obligations would change if we exercised these renewal options. In connection with these operating lease commitments, our consolidated balance sheet as of December 31, 2020 includes right of use assets amounting to $337 million and aggregate operating lease liabilities of $338 million ($60 million included in current liabilities and $278 million included in noncurrent liabilities). (f) Consists of $159 million of estimated future payments related to our non-contributory, defined benefit pension plan (estimated through 2078), as disclosed in Note 8 to the Consolidated Financial Statements, and $22 million of estimated future payments related to other retirement plan liabilities ($18 million of liabilities recorded in other non-current liabilities as of December 31, 2020 in connection with these retirement plans). (g) Consists of accrued and unpaid estimated claims expense incurred in connection with our commercial health insurers and self-insured employee benefit plans. As of December 31, 2020, the total accrual for our professional and general liability claims was $264 million, of which $74 million is included in other current liabilities and $190 million is included in other non-current liabilities. We exclude the $264 million for professional and general liability claims from the contractual obligations table because there are no significant contractual obligations associated with these liabilities and because of the uncertainty of the dollar amounts to be ultimately paid as well as the timing of such payments. Please see Self-Insured/Other Insurance Risks above for additional disclosure related to our professional and general liability claims and reserves. During 2020, we entered into a various agreements with the District of Columbia (the “District”) related to the development, leasing and operation of an acute care hospital and certain other facilities/structures on land owned by the District (“District Facilities”). The agreements contemplate that we will serve as manager for development and construction of the District Facilities on behalf of the District, with a projected aggregate cost of approximately $375 million which will be entirely funded by the District. Construction of the District Facilities is expected to be completed by 2024. Upon completion of the District Facilities, we will lease the District Facilities for a nominal rental amount for a period of 75 years and are obligated to operate the District Facilities during the lease term. We have certain lease termination rights in connection with the District Facilities beginning on the tenth anniversary of the lease commencement date for various and decreasing amounts as provided for in the agreements. Additionally, any time after the 10th anniversary of the lease term, we have a right to purchase the District Facilities for a price equal to the greater of fair market value of the District Facilities or the amount necessary to defease the bonds issued by the District to fund the construction of the District Facilities. The lease agreement also entitles the District to participation rent should certain specified earnings before interest, taxes, depreciation and amortization thresholds be achieved by the acute care hospital. Additionally, we have committed to expend no less than $75 million, over a projected 13-year period, in healthcare infrastructure including expenditures related to the District Facilities as well as other healthcare related expenditures in certain specified areas of Washington, D.C. This financial commitment is included in “Purchase and other obligations” as reflected on the contractual obligations table above. Pursuant to the agreements, the District is entitled to certain termination fees and other amounts as specified in the agreements in the event we, within certain specified periods of time, cease to operate the acute care hospital or there is a transfer of control of us or our subsidiary operating the hospital. ITEM 7A. Quantitative and Qualitative Disclosures About Market Risk We manage our ratio of fixed and floating rate debt with the objective of achieving a mix that management believes is appropriate. To manage this risk in a cost-effective manner, we, from time to time, enter into interest rate swap agreements in which we agree to exchange various combinations of fixed and/or variable interest rates based on agreed upon notional amounts. We account for our derivative and hedging activities using the Financial Accounting Standard Board’s guidance which requires all derivative 81 instruments, including certain derivative instruments embedded in other contracts, to be carried at fair value on the balance sheet. For derivative transactions designated as hedges, we formally document all relationships between the hedging instrument and the related hedged item, as well as its risk-management objective and strategy for undertaking each hedge transaction. Derivative instruments designated in a hedge relationship to mitigate exposure to variability in expected future cash flows, or other types of forecasted transactions, are considered cash flow hedges. Cash flow hedges are accounted for by recording the fair value of the derivative instrument on the balance sheet as either an asset or liability, with a corresponding amount recorded in accumulated other comprehensive income (“AOCI”) within shareholders’ equity. Amounts are reclassified from AOCI to the income statement in the period or periods the hedged transaction affects earnings. From time to time, we use interest rate derivatives in our cash flow hedge transactions. Such derivatives are designed to be highly effective in offsetting changes in the cash flows related to the hedged liability. For hedge transactions that do not qualify for the short-cut method, at the hedge’s inception and on a regular basis thereafter, a formal assessment is performed to determine whether changes in the fair values or cash flows of the derivative instruments have been highly effective in offsetting changes in cash flows of the hedged items and whether they are expected to be highly effective in the future. The fair value of interest rate swap agreements approximates the amount at which they could be settled, based on estimates obtained from the counterparties. When applicable, we assess the effectiveness of our hedge instruments on a quarterly basis. Although we do not anticipate nonperformance by our counterparties to interest rate swap agreements, the counterparties expose us to credit risk in the event of nonperformance. We do not hold or issue derivative financial instruments for trading purposes. During 2015, we entered into nine forward starting interest rate swaps whereby we paid a fixed rate on a total notional amount of $1.0 billion and received one-month LIBOR. The average fixed rate payable on these swaps, all of which matured on April 15, 2019, was 1.31%. When applicable, we measure our interest rate swaps at fair value on a recurring basis. The fair value of our interest rate swaps is based on quotes from our counterparties. We consider those inputs to be “level 2” in the fair value hierarchy as outlined in the authoritative guidance for disclosures in connection with derivative instruments and hedging activities. The table below presents information about our long-term financial instruments that are sensitive to changes in interest rates as of December 31, 2020. For debt obligations, the table presents principal cash flows and related weighted-average interest rates by contractual maturity dates. Maturity Date, Fiscal Year Ending December 31 (dollar amounts in thousands) 2021 2022 2023 2024 2025 Thereafter Total Long-term debt: Fixed rate: Debt $ 2,081 $ 2,587 $ 2,918 $ 3,284 $ 2,371 $ 1,234,661 $ 1,247,902 Average interest rates 3.7 % 3.6 % 3.6 % 3.6 % 3.6 % 3.2 % 3.6 % Variable rate: Debt $ 329,917 $ 105,000 1,702,161 5,000 466,271 0 $ 2,608,349 Average interest rates 1.6 % 1.6 % 1.6 % 1.9 % 1.9 % 0.0 % 1.7 % As calculated based upon our variable rate debt outstanding as of December 31, 2020 that is subject to interest rate fluctuations, each 1% change in interest rates would impact our pre-tax income by approximately $26 million.
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+ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSThe following discussion and analysis of our financial condition and results of operations should be read in conjunction with the consolidated financial statements and related notes included in Part II, Item 8, “Financial Statements and Supplementary Data,” of this Annual Report on Form 10-K.In addition to our historical consolidated financial information, the following discussion contains forward-looking statements that reflect our plans, estimates, and beliefs. Our actual results could differ materially from those discussed in the forward-looking statements. You should review the sections titled “Special Note Regarding Forward-Looking Statements” for a discussion of forward-looking statements and in Part I, Item 1A, “Risk Factors”, for a discussion of factors that could cause actual results to differ materially from the results described in or implied by the forward-looking statements contained in the following discussion and analysis and elsewhere in this Annual Report on Form 10-K.OverviewWe are a technology platform that uses a massive network, leading technology, operational excellence and product expertise to power movement from point A to point B. We develop and operate proprietary technology applications supporting a variety of offerings on our platform. We connect consumers with providers of ride services, merchants and food delivery services as well as public transportation networks. We use this same network, technology, operational excellence and product expertise to connect shippers with carriers in the freight industry. We are also developing technologies that provide new solutions to solve everyday problems.COVID-19In March 2020, the World Health Organization declared the outbreak of the coronavirus disease (“COVID-19”) a pandemic. The COVID-19 pandemic has rapidly changed market and economic conditions globally, impacting Drivers, Delivery People, Merchants, consumers and business partners, as well as our business, results of operations, financial position and cash flows. Various governmental restrictions, including the declaration of a federal National Emergency, multiple cities’ and states’ declarations of states of emergency, school and business closings, quarantines, “shelter at home” orders, restrictions on travel, limitations on social or public gatherings, and other social distancing measures have had, and may continue to have, an adverse impact on our business and operations, including, for example, by reducing the global demand for Mobility rides. The significant adverse changes in the economic and market conditions resulting from COVID-19 triggered the recognition of pre-tax impairment charges of $1.7 billion in the first quarter of 2020, principally relating to our investment in Didi. For additional information on impairment charges, refer to Note 3 - Investments and Fair Value Measurement and Note 7 – Goodwill and Intangible Assets in the notes to the consolidated financial statements included in Part II, Item 8, “Financial Statements and Supplementary Data,” of this Annual Report on Form 10-K.COVID-19 Response InitiativesWe continue to prioritize the health and safety of our consumers, Drivers and Merchants and the communities we serve. As one of the world’s largest platforms for work, we continue to believe that we will play an important role in the economic recovery of cities around the globe. We are focused on navigating the challenges presented by COVID-19 through preserving our liquidity and managing our cash flow by taking preemptive action to enhance our ability to meet our short-term liquidity needs. The pandemic has reduced the demand for our Mobility offering globally. We have responded to the COVID-19 pandemic by launching new, or expanding existing, services or features on an expedited basis, particularly those related to delivery of food and other goods.To comply with social distancing guidelines of national, state and local governments, we have temporarily suspended UberPOOL, our shared Mobility offering, globally and implemented “leave at door” delivery options for Delivery offerings. Additionally, we have asked that all employees who are able to do so work remotely.In addition, to support those whose earning opportunities have been depressed as a result of the COVID-19 pandemic, as well as communities hit hard during this unprecedented period, we announced and implemented several initiatives during the first quarter of 2020, including a financial assistance program, for Drivers who are impacted by the pandemic, as well as personal protective equipment disbursement.While we continue to assess the impact from the COVID-19 outbreak, we are unable to accurately predict the full impact of COVID-19 on our business, results of operations, financial position and cash flows due to numerous uncertainties, including the severity of the disease, the duration of the outbreak, any future waves or resurgences of the virus, variants of the virus, the timing of widespread adoption of vaccines against the virus, additional actions that may be taken by governmental authorities, the further impact on the business of Drivers, Merchants, consumers, and business partners, and other factors identified in Part I, Item 1A. “Risk Factors” of this Annual Report on Form 10-K.Driver Classification DevelopmentsThe classification of Drivers is currently being challenged in courts, by legislators and by government agencies in the United States and abroad. We are involved in numerous legal proceedings globally, including putative class and collective class action lawsuits, demands for arbitration, charges and claims before administrative agencies, and investigations or audits by labor, social 52security, and tax authorities that claim that Drivers should be treated as our employees (or as workers or quasi-employees where those statuses exist), rather than as independent contractors. Of particular note are proceedings in California, where on May 5, 2020, the California Attorney General, in conjunction with the city attorneys for San Francisco, Los Angeles and San Diego, filed a complaint in San Francisco Superior Court (the “Court”) against Uber and Lyft, alleging that drivers are misclassified, and sought an injunction and monetary damages related to the alleged competitive advantage caused by the alleged misclassification of drivers.On August 10, 2020, the Court issued a preliminary injunction order prohibiting us from classifying Drivers as independent contractors and from violating various wage and hour laws. Following a stay of the injunction and our unsuccessful appeal of the injunction to a Court of Appeal, we were ordered to comply with the preliminary injunction. In November 2020, California voters approved Proposition 22, a state ballot initiative that provides a framework for drivers that use platforms like ours for independent work. Proposition 22 went into effect in December 2020 and we expect that Drivers will be able to maintain their status as independent contractors under California law and that we and our competitors will be required to comply with the provisions of Proposition 22. Although we do not expect that the California Attorney General’s preliminary injunction will go into effect, litigation asserting that Assembly Bill 5 requires Drivers in California to be classified as employees, including the California Attorney General’s suit, remains pending, and we may face liability relating to periods before the effective date of Proposition 22.To comply with Proposition 22, we have incurred and expect to incur additional expenses, including expenses associated with a guaranteed minimum earnings floor for Drivers, insurance for injury protection and subsidies for health care. We do not expect these changes will have a material impact on our business, results of operations, financial position, or cash flows.Also of note, on October 28, 2015, a claim by 25 Drivers, including Mr. Y. Aslam and Mr. J. Farrar, was brought in the UK Employment Tribunal against us asserting that they should be classified as “workers” (a separate category between independent contractors and employees) in the UK rather than independent contractors. The tribunal ruled on October 28, 2016 that the Drivers were workers whenever our app was switched on and they were ready and able to take trips, based on an assessment of the app in July 2016. The Court of Appeal rejected our appeal in a majority decision on December 19, 2018. We appealed to the Supreme Court and a hearing at the Supreme Court took place in July 2020.On February 19, 2021, the Supreme Court of the UK upheld the tribunal ruling. Damages may include back pay including holiday pay and minimum wage. Additional claimants have also filed and each claimant will be required to bring their own separate action to an employment tribunal to determine whether they met the “worker” classification and if so, how much each claimant will be awarded. In addition, we expect to be subject to related pension contributions, which will require separate engagement with the UK pension regulator, but the ultimate resolution of this matter, including the amount of any exposure is uncertain.If, as a result of legislation or judicial decisions, we are required to classify Drivers as employees, workers or quasi-employees where those statuses exist, we would incur significant additional expenses for compensating Drivers, including expenses associated with the application of wage and hour laws (including minimum wage, overtime, and meal and rest period requirements), employee benefits, social security contributions, taxes (direct and indirect), and potential penalties. Additionally, we may not have adequate Driver supply as Drivers may opt out of our platform given the loss of flexibility under an employment model, and we may not be able to hire a majority of the Drivers currently using our platform. Any of these events could negatively impact our business, result of operations, financial position, and cash flows.For a discussion of risk factors related to how misclassification challenges may impact our business, result of operations, financial position and operating condition and cash flows, see the risk factor titled “-Our business would be adversely affected if Drivers were classified as employees, workers or quasi-employees” included in Part I, Item 1A, “Risk Factors”, and Note 15 - Commitments and Contingencies to our consolidated financial statements included in Part II, Item 8, “Financial Statements and Supplementary Data,” of this Annual Report on Form 10-K.In addition, if we are required to classify Drivers as employees, this may impact our current financial statement presentation including revenue, cost of revenue, incentives and promotions as further described in our significant and critical accounting policies in Note 1 - Description of Business and Summary of Significant Accounting Policies in the notes to the consolidated financial statements included in Part II, Item 8, “Financial Statements and Supplementary Data,” and the section titled “Critical Accounting Policies and Estimates” in Part II, Item 7, of this Annual Report on Form 10-K.53Financial and Operational HighlightsYear Ended December 31,(In millions, except percentages)2018201920202018 to 2019 % Change2019 to 2020 % Change2019 to 2020 % Change (Constant Currency (1))Monthly Active Platform Consumers (“MAPCs”) (2), (3)911119322 %(16)%Trips (2)5,2206,9045,02532 %(27)%Gross Bookings (2)$49,799 $65,001 $57,897 31 %(11)%(9)%Revenue (4)$10,433 $13,000 $11,139 25 %(14)%(13)%Net income (loss) attributable to Uber Technologies, Inc. (5)$997 $(8,506)$(6,768)**20 %Mobility Adjusted EBITDA$1,541 $2,071 $1,169 34 %(44)%Delivery Adjusted EBITDA$(601)$(1,372)$(873)(128)%36 %Adjusted EBITDA (1), (2)$(1,847)$(2,725)$(2,528)(48)%7 %(1) See the section titled “Reconciliations of Non-GAAP Financial Measures” for more information and reconciliations to the most directly comparable GAAP financial measure.(2) See the section titled “Certain Key Metrics and Non-GAAP Financial Measures” below for more information.(3) MAPCs presented for annual periods are MAPCs for the fourth quarter of the year. The 2018 MAPCs exclude the impact of our 2018 Divested Operations, defined as operations in (i) Southeast Asia prior to the sale of those operations to Grab and (ii) Russia/CIS prior to the formation of our Yandex.Taxi joint venture.(4) Our previously reported revenue in 2018 and 2019 has been retrospectively adjusted to reflect the implementation of the new accounting presentation policy. Refer to Note 1 - Description of Business and Summary of Significant Accounting Policies to our consolidated financial statements included in Part II, Item 8, “Financial Statements and Supplementary Data,” of this Annual Report on Form 10-K for further information on the change in accounting policy.(5) Net income (loss) attributable to Uber Technologies, Inc. includes stock-based compensation expense of $172 million, $4.6 billion and $827 million during the years ended December 31, 2018, 2019 and 2020, respectively.** Percentage not meaningful.Highlights for 2020Overall Gross Bookings declined by $7.1 billion in 2020, down 11%, or 9% on a constant currency basis, compared to 2019. Mobility Gross Bookings declined 44%, on a constant currency basis, year-over-year from 2019, and ended the fourth quarter down 47%, on a constant currency basis, showing continued recovery from the second quarter year-over-year decline of 73% year-over-year, on a constant currency basis.Delivery Gross Bookings grew 110% from 2019, on a constant currency basis, outpacing Delivery Trip growth driven by a 32% increase in basket sizes globally driven by stay-at-home order demand related to COVID-19.Revenue was $11.1 billion, or down 14% year-over-year, reflecting the impact of COVID-19 on our Mobility business, partially offset by overall growth in our Delivery business. Revenue improved every quarter from the second quarter of 2020, with a Take Rate of 19.2% in 2020.Net loss attributable to Uber Technologies, Inc. was $6.8 billion, a 20% improvement year-over-year, reflecting reductions in our fixed cost structure, as well as increased variable cost efficiencies, and included $827 million of stock-based compensation expense.Adjusted EBITDA loss was $2.5 billion, improving $197 million from 2019 with Mobility Adjusted EBITDA profit of $1.2 billion, despite Mobility Gross Bookings decline of 44%, on a constant currency basis. Additionally, Delivery Adjusted EBITDA loss of $873 million, improved $499 million and Delivery Adjusted EBITDA margin as a percentage of Delivery Revenue improved to (22.4)% from (97.9)%, compared to 2019.We ended the year with $6.8 billion in cash, cash equivalents and short-term investments.542020 Significant DevelopmentsAcquisitionsCareemOn January 2, 2020, we completed the acquisition of substantially all of the assets of Careem Inc. (“Careem”). Dubai-based Careem was founded in 2012, and provides primarily ridesharing and, to a lesser extent, meal delivery, and payments services to millions of users in cities across the Middle East, North Africa, and Pakistan.CornershopOn July 6, 2020, we completed our purchase of a controlling interest in Cornershop Cayman (“Cornershop”) in all jurisdictions where we received regulatory approval or did not require regulatory approval. In January 2021, we obtained regulatory approval in Mexico. Cornershop operates an online grocery delivery platform primarily in Chile and Mexico.RoutematchOn July 14, 2020, we acquired 100% of the equity of Routematch, a software company offering specialized software and solutions to transit agencies, serving customers in the United States and Australia. The acquisition is expected to accelerate our development in the transit space.PostmatesOn December 1, 2020, we completed the acquisition of Postmates, Inc. (“Postmates”), an on-demand delivery platform in the United States. The acquisition brings together our global Mobility and Delivery platform with Postmates’ distinctive delivery business in the United States.For additional information on acquisitions, see Note 18 – Business Combinations included in Part II, Item 8, “Financial Statements and Supplementary Data,” of this Annual Report on Form 10-K.DivestituresUber Eats India to ZomatoOn January 21, 2020, we entered into a definitive agreement and completed the divestiture of Uber’s food delivery operations in India (“Uber Eats India”) to Zomato Media Private Limited (“Zomato”) in exchange for (i) compulsorily convertible cumulative preference shares of Zomato representing, when converted, 9.99% of the total voting capital of Zomato and (ii) a non-interest bearing note receivable to be repaid over the course of four years for reimbursement by Zomato of goods and services tax.JUMP and Investment in LimeOn May 7, 2020, we entered into a series of transactions and agreements with Neutron Holdings, Inc. dba Lime (“Lime”) including the divestiture of certain assets of our dockless e-bikes and e-scooters business and operations operated as JUMP, which was included in our New Mobility offering.For additional information, see Note 19 - Divestitures included in Part II, Item 8, “Financial Statements and Supplementary Data,” of this Annual Report on Form 10-K.Note Issuances and RedemptionIssuance of 2025 Senior NotesIn May 2020, we issued five-year notes with an aggregate principal amount of $1.0 billion due on May 15, 2025 (the “2025 Senior Notes”) in a private placement to qualified institutional buyers pursuant to Rule 144A under the Securities Act of 1933, as amended (the “Securities Act”).Issuance of 2028 Senior NotesIn September 2020, we issued eight-year notes with an aggregate principal amount of $500 million due on January 15, 2028 (the “2028 Senior Notes”) in a private placement to qualified institutional buyers pursuant to Rule 144A under the Securities Act.Redemption of 2023 Senior NotesOn October 2020, the net proceeds from the 2028 Senior Notes, along with cash on hand, were used to redeem all of our outstanding 2023 Senior Notes. Issuance of 2025 Convertible NotesIn December 2020, we issued $1.15 billion aggregate principal amount of 0% convertible senior notes due in 2025 (the “2025 Convertible Notes”) in a private placement to qualified institutional buyers pursuant to Rule144A under the Securities Act.55For additional information, see Note 8 - Long-Term Debt and Revolving Credit Arrangements included in Part II, Item 8, “Financial Statements and Supplementary Data,” of this Annual Report on Form 10-KGreenbriar Equity Group, L.P. Investment in FreightOn October 1, 2020, we entered into a preferred stock purchase agreement with affiliates of Greenbriar Equity Group, L.P. (“Greenbriar”). Pursuant to the preferred stock purchase agreement, Greenbriar agreed to invest an aggregate of $500 million in Uber Freight Holding Corporation (“Freight Holding”), the holding company for our Uber Freight business, in exchange for Series A convertible preferred stock of Freight Holding. For additional information, see Note 17 - Non-Controlling Interests included in Part II, Item 8, “Financial Statements and Supplementary Data,” of this Annual Report on Form 10-K.Recent DevelopmentsPending Joint Venture Agreement with SK TelecomIn October 2020, we entered into a joint venture agreement with SK Telecom Co., LTD. (“SK Telecom”). Pursuant to this agreement, we and SK Telecom’s mobility business (“Mobility Company”), which will be spun out of SK Telecom prior to the closing of the joint venture, will form a joint venture (the “JV Business”) in South Korea, focused on the business of e-hailing of passenger transportation (including taxis and limousines). Uber has agreed to invest an aggregate of approximately $100 million in the JV Business. At the date of the close of the transaction, we will own a majority stake in the JV Business. The transaction is subject to regulatory approval and other customary closing conditions, including the approval by SK Telecom’s stockholders of the spin-off of Mobility Company, and is expected to close in the first half of 2021.Sale of ATG BusinessOn December 7, 2020, we announced the sale of Apparate USA LLC (“ATG Business” or “Apparate”), our subsidiary focused on the development and commercialization of autonomous vehicle technologies, to Aurora Innovation, Inc. (“Aurora”). Our ATG Business is included within our ATG and Other Technology Programs segment. For additional information, see Note 9 – Assets and Liabilities Held for Sale included in Part II, Item 8, “Financial Statements and Supplementary Data,” of this Annual Report on Form 10-K.On January 19, 2021, we completed the sale of our ATG Business to Aurora. Also on January 19, 2021, we made a $400 million cash investment in Aurora and entered into a collaboration agreement with Aurora pursuant to which the parties will collaborate with respect to the launch and commercialization of self-driving vehicles on our ridesharing network.Pending Acquisition of DrizlyOn February 2, 2021, we entered into a definitive agreement to acquire 100% ownership interest in The Drizly Group, Inc. (“Drizly”), which operates an on-demand alcohol marketplace in North America. The aggregate consideration to be paid by us is estimated to be approximately $1.1 billion, subject to certain adjustments set forth in the definitive agreement payable in a combination of cash and shares of our stock based on a fixed price of approximately $53.16 per share. The transaction is subject to regulatory approval and other customary closing conditions, and is expected to close in the first half of 2021.Equity and Term Loan Investment in MooveOn February 12, 2021, we entered into and completed a series of agreements with Garment Investments S.L. dba Moove (“Moove”) including (i) an equity investment in which Uber acquired a 30% minority interest in Moove from its current shareholders for approximately $5 million at closing and up to $185 million contingent on future performance of Moove and certain other conditions through the eighth anniversary of the agreement, (ii) a term loan of up to approximately $230 million to Moove, and (iii) a commercial partnership agreement. Moove is a vehicle fleet operator in Spain.2016 and 2018 Senior Secured Term Loan RefinancingOn February 25, 2021, we entered into a refinancing transaction under which we borrowed $2.6 billion pursuant to an amendment to the 2016 Senior Secured Term Loan agreement, the proceeds of which were used to repay in full all previously outstanding loans under the 2016 Senior Secured Term Loan agreement and the 2018 Senior Secured Term Loan agreement. The $2.6 billion is comprised of (i) a $1.1 billion tranche with a maturity date of February 25, 2027, and (ii) a $1.5 billion tranche with a maturity date of April 4, 2025 (together the “Refinanced 2016 Senior Secured Term Loans”). The interest rate for the Refinanced 2016 Senior Secured Term Loans is LIBOR plus 3.50% per annum, subject to a floor of 0.00%.Components of Results of OperationsChange in Accounting PolicyDuring the fourth quarter of 2020, we changed our accounting policy related to the presentation of cumulative payments to Drivers in excess of cumulative revenue from Drivers. Our policy for the presentation of these excess cumulative payments has changed from presenting them within cost of revenue, exclusive of depreciation and amortization, to presenting them as a reduction of revenue in our consolidated statements of operations. As a result, prior period information presented has been retrospectively adjusted to reflect the implementation of the new accounting policy. Refer to Note 1 - Description of Business and Summary of Significant 56Accounting Policies to our consolidated financial statements included in Part II, Item 8, “Financial Statements and Supplementary Data,” of this Annual Report on Form 10-K for further information on change in accounting policy.RevenueWe generate substantially all of our revenue from fees paid by Drivers and Merchants for use of our platform. We have concluded that we are an agent in these arrangements as we arrange for other parties to provide the service to the end-user. Under this model, revenue is net of Driver and Merchant earnings and Driver incentives. We act as an agent in these transactions by connecting consumers to Drivers and Merchants to facilitate a Trip, meal or grocery delivery service.During the first quarter of 2020, we began charging end-users a fee for Mobility and Delivery services in certain markets. While our contracts and our previously disclosed accounting policy for Mobility Drivers and restaurants remains unchanged, in these markets we subcontract with Delivery People to provide delivery services to end-users. Revenue from restaurants, Mobility Drivers, and end-users is recognized separately, while costs associated with payments to Delivery People are recorded as cost of revenue.For additional discussion related to our revenue, see the section titled “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Critical Accounting Policies and Estimates - Revenue Recognition,” “Note 1 - Description of Business and Summary of Significant Accounting Policies - Revenue Recognition,” and “Note 2 - Revenue” to our consolidated financial statements included in Part II, Item 8, “Financial Statements and Supplementary Data,” of this Annual Report on Form 10-K.Cost of Revenue, Exclusive of Depreciation and AmortizationCost of revenue, exclusive of depreciation and amortization, primarily consists of certain insurance costs related to our Mobility and Delivery offerings, credit card processing fees, bank fees, data center and networking expenses, mobile device and service costs, costs incurred for certain Delivery transactions where we are primarily responsible for delivery services and pay Delivery People for services provided, costs incurred with carriers for Uber Freight transportation services, amounts related to fare chargebacks and other credit card losses.We expect that cost of revenue, exclusive of depreciation and amortization, will fluctuate on an absolute dollar basis for the foreseeable future in line with Trip volume changes on the platform. As Trips increase or decrease, we expect related changes for insurance costs, credit card processing fees, hosting and co-located data center expenses, maps license fees, and other cost of revenue, exclusive of depreciation and amortization.Operations and SupportOperations and support expenses primarily consist of compensation expenses, including stock-based compensation, for employees that support operations in cities, including the general managers, Driver operations, platform user support representatives and community managers. Also included is the cost of customer support, Driver background checks and the allocation of certain corporate costs.As our business recovers from the impacts of COVID-19 and Trip volume increases, we would expect operations and support expenses to increase on an absolute dollar basis for the foreseeable future, but decrease as a percentage of revenue as we become more efficient in supporting platform users.Sales and MarketingSales and marketing expenses primarily consist of compensation costs, including stock-based compensation to sales and marketing employees, advertising costs, product marketing costs and discounts, loyalty programs, promotions, refunds, and credits provided to end-users who are not customers, and the allocation of certain corporate costs. We expense advertising and other promotional expenditures as incurred.As our business recovers from the impacts of COVID-19, we would anticipate sales and marketing expenses to increase on an absolute dollar basis for the foreseeable future but vary from period to period as a percentage of revenue due to timing of marketing campaigns.Research and DevelopmentResearch and development expenses primarily consist of compensation costs, including stock-based compensation, for employees in engineering, design and product development. Expenses includes ATG and Other Technology Programs development expenses, as well as expenses associated with ongoing improvements to, and maintenance of, existing products and services, and allocation of certain corporate costs. We expense substantially all research and development expenses as incurred.We expect research and development expenses to increase and vary from period to period as a percentage of revenue as we continue to invest in research and development activities relating to ongoing improvements to and maintenance of our platform offerings and other research and development programs, offset by a decrease in investments in our ATG and Other Technology Programs subsequent to the divestiture of ATG.57General and AdministrativeGeneral and administrative expenses primarily consist of compensation costs, including stock-based compensation, for executive management and administrative employees, including finance and accounting, human resources, policy and communications, legal, and certain impairment charges, as well as allocation of certain corporate costs, occupancy, and general corporate insurance costs. General and administrative expenses also include certain legal settlements.As our business recovers from the impacts of COVID-19 and Trip volume increases, we expect that general and administrative expenses will increase on an absolute dollar basis for the foreseeable future, but decrease as a percentage of revenue as we find efficiencies in our internal support functions.Depreciation and AmortizationDepreciation and amortization expenses primarily consist of depreciation on buildings, site improvements, computer and network equipment, software, leasehold improvements, leased vehicles, furniture and fixtures, and amortization of intangible assets. Depreciation includes expenses associated with buildings, site improvements, computer and network equipment, leased vehicles, and furniture, fixtures, as well as leasehold improvements. Amortization includes expenses associated with our capitalized internal-use software and acquired intangible assets.As our business recovers from the impacts of COVID-19, we would anticipate depreciation and amortization expenses to increase as we continue to build out our network infrastructure and building locations.Interest ExpenseInterest expense primarily consists of interest expense associated with our outstanding debt, including accretion of debt discount and debt issuance costs. For additional detail related to our debt obligations, see “Note 8 - Long-Term Debt and Revolving Credit Arrangements” to our consolidated financial statements included in Part II, Item 8, “Financial Statements and Supplementary Data,” of this Annual Report on Form 10-K.Other Income (Expense), NetOther income (expense), net primarily includes the following items:•Interest income, which primarily consists of interest earned on our cash and cash equivalents and restricted cash and cash equivalents.•Foreign currency exchange gains (losses), net, which primarily consist of remeasurement of transactions and monetary assets and liabilities denominated in currencies other than the functional currency at the end of the period. •Gain (loss) on business divestitures, net.•Unrealized gain (loss) on debt and equity securities, net, which primarily consists of gains (losses) from fair value adjustments relating to our non-marketable securities.•Change in fair value of embedded derivatives, which primarily consists of gains and losses on embedded derivatives related to our 2021 and 2022 Convertible Notes until their extinguishment in connection with our IPO.•Gain on extinguishment of convertible notes and settlement of derivatives.•Other, net, which primarily consists of changes in the fair value of warrants and income from forfeitures of warrants.Provision for (Benefit from) Income TaxesWe are subject to income taxes in the United States and foreign jurisdictions in which we do business. These foreign jurisdictions have different statutory tax rates than those in the United States. Additionally, certain of our foreign earnings may also be taxable in the United States. Accordingly, our effective tax rate will vary depending on the relative proportion of foreign to domestic income, use of foreign tax credits, changes in the valuation of our deferred tax assets, and liabilities and changes in tax laws.Equity Method InvestmentsEquity method investments primarily includes the results of our share of income or loss from our Yandex.Taxi joint venture.58Results of OperationsThe following table summarizes our consolidated statements of operations for each of the periods presented (in millions):Year Ended December 31,2018 (1)2019 (1)2020Revenue$10,433 $13,000 $11,139 Costs and expensesCost of revenue, exclusive of depreciation and amortization shown separately below 4,786 6,061 5,154 Operations and support1,516 2,302 1,819 Sales and marketing3,151 4,626 3,583 Research and development1,505 4,836 2,205 General and administrative2,082 3,299 2,666 Depreciation and amortization426 472 575 Total costs and expenses13,466 21,596 16,002 Loss from operations(3,033)(8,596)(4,863)Interest expense(648)(559)(458)Other income (expense), net4,993 722 (1,625)Income (loss) before income taxes and loss from equity method investments1,312 (8,433)(6,946)Provision for (benefit from) income taxes283 45 (192)Loss from equity method investments(42)(34)(34)Net income (loss) including non-controlling interests987 (8,512)(6,788)Less: net loss attributable to non-controlling interests, net of tax(10)(6)(20)Net income (loss) attributable to Uber Technologies, Inc. $997 $(8,506)$(6,768)(1) Our revenue and cost of revenue, exclusive of depreciation and amortization for 2018 and 2019 have been retrospectively adjusted to reflect the implementation of our new accounting policy adopted in the fourth quarter of 2020. There was no net impact to loss from operations or net income (loss) attributable to Uber Technologies, Inc. for any periods presented. Refer to Note 1 - Description of Business and Summary of Significant Accounting Policies to our consolidated financial statements included in Part II, Item 8, “Financial Statements and Supplementary Data,” of this Annual Report on Form 10-K for further information on the change in accounting policy.59The following table sets forth the components of our consolidated statements of operations for each of the periods presented as a percentage of revenue (1):Year Ended December 31,201820192020Revenue100 %100 %100 %Costs and expensesCost of revenue, exclusive of depreciation and amortization shown separately below46 %47 %46 %Operations and support15 %18 %16 %Sales and marketing30 %36 %32 %Research and development14 %37 %20 %General and administrative20 %25 %24 %Depreciation and amortization4 %4 %5 %Total costs and expenses129 %166 %144 %Loss from operations(29)%(66)%(44)%Interest expense(6)%(4)%(4)%Other income (expense), net48 %6 %(15)%Income (loss) before income taxes and loss from equity method investments13 %(65)%(62)%Provision for (benefit from) income taxes3 %— %(2)%Loss from equity method investments— %— %— %Net income (loss) including non-controlling interests9 %(65)%(61)%Less: net loss attributable to non-controlling interests, net of tax— %— %— %Net income (loss) attributable to Uber Technologies, Inc.10 %(65)%(61)%(1) Totals of percentage of revenues may not foot due to rounding.Comparison of the Years Ended December 31, 2018, 2019 and 2020RevenueYear Ended December 31,2018 to 2019 % Change2019 to 2020 % Change(In millions, except percentages)201820192020Revenue$10,433 $13,000 $11,139 25 %(14)%2020 Compared to 2019Revenue decreased $1.9 billion, or 14%, primarily attributable to a decline in Gross Bookings of 11%, or 9% on a constant currency basis. The decrease in Gross Bookings was primarily driven by a decline in Mobility Gross Bookings of 46%, or 44% on a constant currency basis, due to adverse impacts from COVID-19. The decrease was partially offset by Delivery Gross Bookings growth of 109%, or 110% on a constant currency basis, due to an increase in food delivery orders and higher basket sizes as a result of stay-at-home order demand related to COVID-19. Additionally, we had a one-time Driver appreciation award of $299 million recorded in the 2019, that was not incurred in 2020.2019 Compared to 2018Revenue increased $2.6 billion, or 25%, primarily attributable to an increase in Gross Bookings of 31%, or 34%, on a constant currency basis. The overall increase in Gross Bookings was driven by a 22% increase in MAPCs primarily due to global expansion of our Delivery product offerings combined with wider market adoption of our Mobility product, and overall growth in our other offerings.Cost of Revenue, Exclusive of Depreciation and AmortizationYear Ended December 31,2018 to 2019% Change2019 to 2020% Change(In millions, except percentages)201820192020Cost of revenue, exclusive of depreciation and amortization$4,786 $6,061 $5,154 27 %(15)%Percentage of revenue46 %47 %46 %602020 Compared to 2019Cost of revenue, exclusive of depreciation and amortization, decreased $907 million, or 15%, mainly due to a $2.0 billion decrease in Mobility driven by COVID-19 related volume declines primarily resulting in lower insurance costs. This decrease was partially offset by a $984 million increase in Delivery primarily related to a $513 million increase in Delivery People payments and incentives in certain markets, combined with a $233 million increase in Freight carrier payments.2019 Compared to 2018Cost of revenue, exclusive of depreciation and amortization, increased $1.3 billion, or 27%, primarily attributable to a $543 million increase in insurance costs and credit card processing fees largely due to overall growth in Trips in our Mobility and Delivery businesses, as well as a $374 million increase in Freight carrier payments.Operations and SupportYear Ended December 31,2018 to 2019% Change2019 to 2020% Change(In millions, except percentages)201820192020Operations and support$1,516 $2,302 $1,819 52 %(21)%Percentage of revenue15 %18 %16 %2020 Compared to 2019Operations and support expenses decreased $483 million, or 21%, primarily attributable to a $382 million decrease in stock-based compensation mainly related to RSUs with a performance condition satisfied upon our IPO in 2019, a $175 million decrease in employee headcount costs and a $79 million decrease in external contractor expenses, partially offset by a $172 million increase in restructuring and related charges.2019 Compared to 2018Operations and support expenses increased $786 million, or 52%, primarily attributable to a $439 million increase in stock-based compensation mainly related to RSUs with a performance condition satisfied upon our IPO in 2019, a $282 million increase in employee headcount costs.Sales and MarketingYear Ended December 31,2018 to 2019% Change2019 to 2020% Change(In millions, except percentages)201820192020Sales and marketing$3,151 $4,626 $3,583 47 %(23)%Percentage of revenue30 %36 %32 %2020 Compared to 2019Sales and marketing expenses decreased $1.0 billion, or 23%, primarily attributable to a decrease in discounts, loyalty expenses, promotions, credits and refunds of $446 million to $2.0 billion compared to $2.5 billion in 2019, a decrease of $298 million in consumer advertising and other marketing programs, as well as a $194 million decrease in stock-based compensation related to RSUs with a performance condition satisfied upon our IPO in 2019. 2019 Compared to 2018Sales and marketing expenses increased $1.5 billion, or 47%, primarily attributable to an increase in discounts, loyalty expenses, promotions, credits and refunds of $1.1 billion to $2.5 billion compared to $1.4 billion in 2018, a $233 million increase in stock-based compensation related to RSUs with a performance condition satisfied upon our IPO in 2019 and a $174 million increase in employee headcount costs. Research and DevelopmentYear Ended December 31,2018 to 2019% Change2019 to 2020% Change(In millions, except percentages)201820192020Research and development$1,505 $4,836 $2,205 221 %(54)%Percentage of revenue14 %37 %20 %612020 Compared to 2019Research and development expenses decreased $2.6 billion, or 54%, primarily attributable to a $2.5 billion decrease in stock-based compensation related to RSUs with a performance condition satisfied upon our IPO in 2019, partially offset by an $85 million increase in restructuring and related charges. 2019 Compared to 2018Research and development expenses increased by $3.3 billion, or 221%. This increase was primarily due to a $2.9 billion increase in stock-based compensation related to RSUs with a performance condition satisfied upon our IPO in 2019 and a $467 million increase in employee headcount costs.General and AdministrativeYear Ended December 31,2018 to 2019% Change2019 to 2020% Change(In millions, except percentages)201820192020General and Administrative$2,082 $3,299 $2,666 58 %(19)%Percentage of revenue20 %25 %24 %2020 Compared to 2019General and administrative expenses decreased $633 million, or 19%, primarily attributable to a $712 million decrease in stock-based compensation expense and a net $388 million decrease in legal, tax, and regulatory reserve changes and settlements, partially offset by $193 million in impairment charges related to our New Mobility reporting unit recorded during the first quarter of 2020 primarily related to COVID-19 impacts on certain markets, an $84 million increase in restructuring and related charges, $102 million attributable to accelerated lease expense in 2020 and $52 million in asset impairments.2019 Compared to 2018General and administrative expenses increased $1.2 billion, or 58%, primarily attributable to an $859 million increase in stock-based compensation related to RSUs with a performance condition satisfied upon our IPO in 2019 and a $309 million increase in employee headcount costs.Depreciation and AmortizationYear Ended December 31,2018 to 2019% Change2019 to 2020% Change(In millions, except percentages)201820192020Depreciation and amortization$426 $472 $575 11 %22 %Percentage of revenue4 %4 %5 %2020 Compared to 2019Depreciation and amortization expenses increased $103 million, or 22%, primarily attributable to additional amortization expenses related to newly acquired intangible assets, primarily held by Careem and Postmates, and an increase in leased server depreciation, partially offset by a decrease in depreciation of data center assets.2019 Compared to 2018Depreciation and amortization expenses increased $46 million, or 11%, primarily attributable to data center servers depreciation.Interest ExpenseYear Ended December 31,2018 to 2019% Change2019 to 2020% Change(In millions, except percentages)201820192020Interest expense$(648)$(559)$(458)(14)%(18)%Percentage of revenue(6)%(4)%(4)%2020 Compared to 2019Interest expense decreased by $101 million, or 18%, primarily due to the conversion of our 2021 and 2022 Convertible Notes upon our IPO in May 2019 and favorable LIBOR rates on our term loans, partially offset by additional interest expense resulting from the issuance of our $1.0 billion 2025 Senior Notes in May 2020, as well as additional bonds issued during 2020.622019 Compared to 2018Interest expense decreased by $89 million, or 14%, primarily due to the conversion of all our outstanding Convertible Notes into common stock upon our IPO in May 2019, partially offset by additional interest expense resulting from the issuance of our 2023 Senior Notes and our 2026 Senior Notes in October 2018.Other Income (Expense), NetYear Ended December 31,2018 to 2019% Change2019 to 2020% Change(In millions, except percentages)201820192020Interest income$104 $234 $55 125 %(76)%Foreign currency exchange gains (losses), net(45)(40)(128)11 %(220)%Gain on business divestitures, net3,214 — 204 (100)%**Unrealized gain (loss) on debt and equity securities, net1,996 2 (125)(100)%**Impairment of debt and equity securities— — (1,690)****Change in fair value of embedded derivatives(501)58 — 112 %(100)%Gain on extinguishment of convertible notes and settlement of derivatives— 444 — **(100)%Other, net225 24 59 (89)%146 %Other income (expense), net$4,993 $722 $(1,625)(86)%**Percentage of revenue48 %6 %(15)%** Percentage not meaningful.2020 Compared to 2019Interest income decreased by $179 million or 76% primarily due to declining balances and yields in our money market fund investments, bank deposits, and available-for-sale securities.Foreign currency exchange gains (losses), net increased by $88 million due to unrealized impacts on foreign exchange resulting from remeasurement of our foreign currency monetary assets and liabilities denominated in currencies other than the functional currency of an entity.Gain on business divestitures, net increased by $204 million due to a $154 million gain on the sale of our Uber Eats India operations to Zomato during the first quarter of 2020 and a $77 million gain on the sale of our European Freight Business to sennder GmbH (“Sennder”) recognized in the fourth quarter of 2020, partially offset by a $27 million loss on the sale of our JUMP operations to Lime recognized during the second quarter of 2020.Unrealized gain (loss) on debt and equity securities, net decreased by $127 million primarily due to loss from fair value adjustments of our non-marketable securities recorded under the fair value option.Impairment of debt and equity securities primarily relates to a $1.7 billion impairment of our investment in Didi. For additional information, refer to Note 3 - Investments and Fair Value Measurement included in Part II, Item 8, “Financial Statements and Supplementary Data,” of this Annual Report on Form 10-K.Change in fair value of embedded derivatives decreased by $58 million as a result of settlement of convertible debts in the second quarter of 2019.Gain on extinguishment of convertible notes and settlement of derivatives decreased by $444 million due to the conversion of our 2021 and 2022 Convertible Notes and settlement of the related derivatives in connection with our IPO during the second quarter of 2019.2019 Compared to 2018Interest income increased by $130 million or 125% primarily due to interest income earned on higher average cash balances from the proceeds of our IPO and additional investment from our ATG Investors.Foreign currency exchange gains (losses), net decreased by $5 million due to unrealized impacts on foreign exchange resulting from remeasurement of our foreign currency monetary assets and liabilities denominated in currencies other than the functional currency of an entity.Gain on business divestitures, net decreased by $3.2 billion due to the non-recurrence in 2019 of gains on the divestitures of our Southeast Asia and Russia/CIS operations in 2018.63Unrealized gain (loss) on debt and equity securities, net decreased by $2.0 billion primarily due to the non-recurrence in 2019 of a gain from a fair value adjustment of our Didi investment in 2018.Change in fair value of embedded derivatives increased by $559 million as a result of their revaluation, primarily due to changes in discount yield and time to liquidity.Gain on extinguishment of convertible notes and settlement of derivatives increased by $444 million due to the conversion of our 2021 and 2022 Convertible Notes and settlement of the related derivatives in connection with our IPO during the second quarter of 2019.Other, net decreased by $201 million primarily due to non-recurrence in 2019 of income from forfeitures of warrants during the year ended December 31, 2018.Provision for (Benefit from) Income TaxesYear Ended December 31,2018 to 2019% Change2019 to 2020% Change(In millions, except percentages)201820192020Provision for (benefit from) income taxes$283 $45 $(192)(84)%**Effective tax rate21.6 %(0.5)%2.8 %** Percentage not meaningful.2020 Compared to 2019Provision for income taxes decreased by $237 million primarily due to a tax impact from the impairment charge of our investment in Didi. 2019 Compared to 2018Provision for income taxes decreased by $238 million, primarily driven by the deferred U.S. tax expense related to our investment in Didi and Grab and deferred China tax related to our investment in Didi incurred during the first quarter of 2018.In March 2019, we initiated a series of transactions resulting in changes to our international legal structure, including a redomiciliation of a subsidiary to the Netherlands and a transfer of certain intellectual property rights among our wholly-owned subsidiaries, primarily to align our structure to our evolving operations. The redomiciliation resulted in a step-up in the tax basis of intellectual property rights and a correlated increase in foreign deferred tax assets in an amount of $6.4 billion, net of a reserve for uncertain tax positions of $1.4 billion. Based on available objective evidence, we believed it was not more-likely-than-not that these additional foreign deferred tax assets would be realizable as of December 31, 2019 and, therefore, they were offset by a full valuation allowance to the extent not offset by reserves from uncertain tax positions.Loss from Equity Method InvestmentsYear Ended December 31,2018 to 2019% Change2019 to 2020% Change(In millions, except percentages)201820192020Loss from equity method investments$(42)$(34)$(34)19 %— %Percentage of revenue— %— %— %** Percentage not meaningful.2019 Compared to 2018Loss from equity method investments decreased by $8 million due to a decrease in our portion of the net loss from our Yandex.Taxi joint venture and amortization expense on intangible assets resulting from the basis difference in this investment.Supplemental Disclosure Related to Restructuring and Related ChargesDuring the second quarter of 2020, we initiated and completed certain restructuring activities in order to reduce our overall cost structure in response to the economic challenges and uncertainty resulting from the COVID-19 pandemic and its impact on our business. We also exited the JUMP business and incurred costs related to site closures, asset impairments and write-offs. As a result, during the year ended December 31, 2020, we recognized $362 million in total restructuring and related charges in the consolidated statement of operations. Total restructuring and related charges included $248 million of cash settled charges, primarily for severance and other termination benefits. The remaining costs related to these restructuring activities are expected to be immaterial. Restructuring activities during the years ended December 31, 2018 and 2019 were not material.These activities were designed to generate an aggregate cost savings of at least $1.0 billion annually when compared to our original fourth quarter 2020 planned cost structure, with the largest component of savings resulting from reductions in workforce. We do not believe these cost-saving measures will impair our ability to conduct any of our key business functions. There is no guarantee 64that we will achieve the cost savings that we expect. Refer to Note 20 – Restructuring and Related Charges in the notes to the consolidated financial statements included in Part II, Item 8, “Financial Statements and Supplementary Data,” of this Annual Report on Form 10-K.Segment Results of OperationsWe operate our business as four operating and reportable segments: Mobility, Delivery, Freight, and ATG and Other Technology Programs. For additional information about our segments, see Note 14 - Segment Information and Geographic Information in the notes to the consolidated financial statements included in Part II, Item 8, “Financial Statements and Supplementary Data,” of this Annual Report on Form 10-K.RevenueYear Ended December 31,2018 to 2019 % Change2019 to 2020 % Change(In millions, except percentages)2018 (1)2019 (1)2020Mobility (2)$9,288 $10,707 $6,089 15 %(43)%Delivery772 1,401 3,904 81 %179 %Freight356 731 1,011 105 %38 %ATG and Other Technology Programs (3)— 42 100 **138 %All Other17 119 35 **(71)%Total revenue$10,433 $13,000 $11,139 25 %(14)%(1) Our previously reported revenue in 2018 and 2019 has been retrospectively adjusted to reflect the implementation of the new accounting policy. Refer to Note 1 - Description of Business and Summary of Significant Accounting Policies to our consolidated financial statements included in Part II, Item 8, “Financial Statements and Supplementary Data,” of this Annual Report on Form 10-K for further information on the change in accounting policy.(2) Mobility revenue includes revenue recognized as an operating lease as defined under ASC 840 for 2018 and ASC 842 for 2019 and 2020. Total revenue recognized under ASC 840 and ASC 842 for the years ended December 31, 2018, 2019 and 2020 was $151 million, $88 million, and $21 million, respectively. For additional information, see Note 2 - Revenue to our consolidated financial statements included in Part II, Item 8, “Financial Statements and Supplementary Data,” of this Annual Report on Form 10-K.(3) Consists of $42 million and $100 million, respectively, in collaboration revenue from Toyota recognized for the years ended December 31, 2019 and 2020. For additional information, see Note 17 - Non-Controlling Interests to our consolidated financial statements included in Part II, Item 8, “Financial Statements and Supplementary Data,” of this Annual Report on Form 10-K.** Percentage not meaningful.Segment Adjusted EBITDASegment Adjusted EBITDA is defined as revenue less the following expenses: cost of revenue, exclusive of depreciation and amortization, operations and support, sales and marketing, and general and administrative and research and development expenses associated with our segments. Segment adjusted EBITDA also excludes non-cash items, certain transactions that are not indicative of ongoing segment operating performance and / or items that management does not believe are reflective of our ongoing core operations. For additional information, see Note 14 - Segment Information and Geographic Information to our consolidated financial statements included in Part II, Item 8, “Financial Statements and Supplementary Data,” of this Annual Report on Form 10-K.Year Ended December 31,2018 vs. 2019 % Change2019 vs. 2020% Change(In millions, except percentages)201820192020Mobility$1,541 $2,071 $1,169 34 %(44)%Delivery(601)(1,372)(873)(128)%36 %Freight(102)(217)(227)(113)%(5)%ATG and Other Technology Programs(537)(499)(375)7 %25 %All Other(50)(251)(86)**66 %Corporate G&A and Platform R&D (1), (2)(1,971)(2,457)(2,136)(25)%13 %Impact of 2018 Divested Operations (1)(127)— — ****Adjusted EBITDA (3)$(1,847)$(2,725)$(2,528)(48)%7 %(1) Excluding stock-based compensation expense.(2) Includes costs that are not directly attributable to our reportable segments. Corporate G&A also includes certain shared costs such as finance, accounting, tax, human resources, information technology and legal costs. Platform R&D also includes mapping 65and payment technologies and support and development of the internal technology infrastructure. Our allocation methodology is periodically evaluated and may change.(3) See the section titled “Reconciliations of Non-GAAP Financial Measures” for more information and reconciliations to the most directly comparable GAAP financial measure.** Percentage not meaningful.Mobility SegmentFor the year ended December 31, 2020 compared to the same period in 2019, Mobility revenue decreased $4.6 billion, or 43% and Mobility adjusted EBITDA profit decreased $902 million, or 44%.Mobility revenue decreased primarily attributable to a decrease in Mobility Gross Bookings due to adverse impacts from the COVID-19 pandemic, partially offset by rationalization in incentive spend. Mobility Take Rate improved to 22.9% from 21.5% compared to 2019 mainly driven by an overall decrease in incentive spend as well as a one-time Driver appreciation award recorded in the second quarter of 2019.Mobility adjusted EBITDA profit decreased primarily attributable to a decrease in Mobility revenue, partially offset by a $1.4 billion decrease in insurance expense as a result of a decrease in miles driven, a $961 million decrease in consumer promotions, and a $516 million decrease in credit card processing costs. Additionally, Mobility adjusted EBITDA margin as a percentage of Mobility revenue declined to 19.2% from 19.3% compared to 2019.For the year ended December 31, 2019 compared to the same period in 2018, Mobility revenue increased $1.4 billion, or 15% and Mobility adjusted EBITDA profit increased $530 million, or 34%.Mobility revenue increased primarily attributable to U.S. pricing changes effective in the second and third quarter of 2019 and deeper penetration into international markets, partially offset by a Driver appreciation award. Mobility Take Rate decreased to 21.5% from 22.4% compared to the same period in 2018 driven by an increase in incentive spend in Latin America.Mobility adjusted EBITDA profit increased primarily attributable to an increase in Mobility revenue partially offset by an increase in consumer promotions and variable costs attributable to the overall growth of the business.Delivery SegmentFor the year ended December 31, 2020 compared to the same period in 2019, Delivery revenue increased 2.5 billion, or 179% and Delivery adjusted EBITDA loss decreased $499 million, or 36%.Delivery revenue increased primarily attributable to an increase in Delivery Gross Bookings of 110%, on a constant currency basis, driven by an increase in food delivery orders and higher basket sizes as a result of stay-at-home demand related to COVID-19. Delivery Take Rate improved to 12.9% from 9.7% compared to the same period in 2019 driven by a decrease in incentive spend combined with an overall improvement in basket sizes. Additionally, the increase in Delivery revenue and Delivery Take Rate resulted from an increase in certain Delivery People payments and incentives that are recorded in cost of revenue, where we are primarily responsible for delivery services and pay Delivery People for services provided. Delivery adjusted EBITDA loss decreased primarily attributable to an increase in Delivery revenue, partially offset by a $965 million increase in cost of revenue as well as a $550 million increase in consumer promotions.For the year ended December 31, 2019 compared to the same period in 2018, Delivery revenue increased $629 million, or 81% and Delivery adjusted EBITDA loss increased $771 million, or 128%.Delivery revenue increased primarily attributable to an increase in Delivery Gross Bookings of 87%, on a constant currency basis mainly due to changes to our service fees in U.S. and Canada and continued expansion into international markets. These increases were partially offset by a one-time Driver appreciation award as well as higher Delivery People incentive spend, primarily in our international markets. Delivery adjusted EBITDA loss increased primarily attributable to an increase in consumer promotions, brand marketing, and employee headcount costs.Freight SegmentFor the year ended December 31, 2020 compared to the same period in 2019, Freight revenue increased $280 million, or 38% and Freight adjusted EBITDA loss increased $10 million, or 5%.Freight revenue increased primarily attributable to growth in the number of shippers and carriers on the network combined with an increase in volumes with our top shippers. Freight adjusted EBITDA loss increased attributable to an increase in investment spend in our technology and services as we continue to grow the business. 66For the year ended December 31, 2019 compared to the same period in 2018, Freight revenue increased $375 million, or 105% and Freight adjusted EBITDA loss increased $115 million, or 113%.Freight revenue increased primarily attributable to an increase in load volume over 100% domestically as the business expanded the number of shippers and carriers on the network despite industry-wide conditions that have led to a decline in revenue per load.Freight adjusted EBITDA loss increased attributable to an increase in investment spend in our technology and services as we continue to grow the business.ATG and Other Technology Programs SegmentFor the year ended December 31, 2020 compared to the same period in 2019, ATG and Other Technology Programs revenue increased $58 million, or 138% and ATG and Other Technology Programs adjusted EBITDA loss decreased $124 million, or 25%.ATG and Other Technology Programs revenue increased attributable to collaboration revenue related to our three-year joint collaboration agreement with Toyota and DENSO entered into in July 2019.ATG and Other Technology Programs adjusted EBITDA loss decreased due to an increase in revenue, as noted above, partially offset by an increase in operational expenses.For the year ended December 31, 2019 compared to the same period in 2018, ATG and Other Technology Programs revenue increased $42 million, and ATG and Other Technology Programs adjusted EBITDA loss decreased $38 million, or 7%.ATG and Other Technology Programs revenue increased attributable to collaboration revenue related to our three-year joint collaboration agreement with Toyota and DENSO entered into in July 2019.ATG and Other Technology Programs adjusted EBITDA loss decreased due to an increase in revenue, as noted above, partially offset by an increase in operational expenses.All Other For the year ended December 31, 2020 compared to the same period in 2019, All Other revenue decreased $84 million, or 71% and All Other adjusted EBITDA loss decreased $165 million, or 66%.All Other revenue and All Other adjusted EBITDA loss decreased primarily due to the JUMP Divestiture in the second quarter of 2020.For the year ended December 31, 2019 compared to the same period in 2018, All Other revenue increased $102 million, and All Other adjusted EBITDA loss increased $201 million.All Other revenue increased as we continue to expand the reach of our New Mobility offerings.All Other adjusted EBITDA loss increased attributable to an increase in investment spend in our New Mobility offerings as we continue to launch in new cities.67Certain Key Metrics and Non-GAAP Financial MeasuresAdjusted EBITDA and Adjusted EBITDA margin as a percentage of revenue, as well as revenue growth rates in constant currency, are non-GAAP financial measures. For more information about how we use these non-GAAP financial measures in our business, the limitations of these measures, and reconciliations of these measures to the most directly comparable GAAP financial measures, see the section titled “Reconciliations of Non-GAAP Financial Measures.”Monthly Active Platform Consumers. MAPCs is the number of unique consumers who completed a Mobility or New Mobility ride or received a Delivery meal or grocery order on our platform at least once in a given month, averaged over each month in the quarter. While a unique consumer can use multiple product offerings on our platform in a given month, that unique consumer is counted as only one MAPC. We use MAPCs to assess the adoption of our platform and frequency of transactions, which are key factors in our penetration of the countries in which we operate.Trips. We define Trips as the number of completed consumer Mobility or New Mobility rides and Delivery meal or grocery deliveries in a given period. For example, an UberPOOL ride with three paying consumers represents three unique Trips, whereas an UberX ride with three passengers represents one Trip. We believe that Trips are a useful metric to measure the scale and usage of our platform.68Gross Bookings. We define Gross Bookings as the total dollar value, including any applicable taxes, tolls, and fees, of Mobility and New Mobility rides, Delivery meal or grocery deliveries, and amounts paid by Freight shippers, in each case without any adjustment for consumer discounts and refunds, Driver and Merchant earnings, and Driver incentives. Gross Bookings do not include tips earned by Drivers. Gross Bookings are an indication of the scale of our current platform, which ultimately impacts revenue. (In millions) Q12019Q2 2019Q3 2019Q4 2019Q12020Q2 2020Q3 2020Q4 2020Mobility$11,446 $12,188 $12,554 $13,512 $10,874 $3,046 $5,905 $6,789 Delivery3,071 3,386 3,658 4,374 4,683 6,961 8,550 10,050 Freight128 167 223 219 198 212 290 313 All Other4 15 30 26 21 5 — — Take Rate is defined as revenue as a percentage of Gross Bookings.Adjusted EBITDA. See the section titled “Reconciliations of Non-GAAP Financial Measures” for our definition and a reconciliation of net income (loss) attributable to Uber Technologies, Inc. to Adjusted EBITDA.Year Ended December 31,2018 to 2019% Change2019 to 2020% Change(In millions, except percentages)201820192020Adjusted EBITDA$(1,847)$(2,725)$(2,528)(48)%7 %2020 Compared to 2019Adjusted EBITDA loss decreased $197 million, or 7%, primarily attributable to a $499 million improvement in Delivery Adjusted EBITDA, a $321 million decrease in Corporate G&A and Platform R&D costs as well as the favorable impact of $165 million related to the JUMP Divestiture that occurred in the second quarter of 2020. These impacts were partially offset by a $902 million decrease in Mobility Adjusted EBITDA.Reconciliations of Non-GAAP Financial MeasuresWe collect and analyze operating and financial data to evaluate the health of our business and assess our performance. In addition to revenue, net income (loss), loss from operations, and other results under GAAP, we use Adjusted EBITDA and Adjusted EBITDA margin as a percentage of revenue as well as revenue growth rates in constant currency, which are described below, to evaluate our business. We have included these non-GAAP financial measures because they are key measures used by our management to evaluate our operating performance. Accordingly, we believe that these non-GAAP financial measures provide useful information to investors and others in understanding and evaluating our operating results in the same manner as our management team and board of directors. Our calculation of these non-GAAP financial measures may differ from similarly-titled non-GAAP measures, if any, reported by our peer companies. These non-GAAP financial measures should not be considered in isolation from, or as substitutes for, financial information prepared in accordance with GAAP.Adjusted EBITDAWe define Adjusted EBITDA as net income (loss), excluding (i) income (loss) from discontinued operations, net of income taxes, (ii) net income (loss) attributable to non-controlling interests, net of tax, (iii) provision for (benefit from) income taxes, (iv) income (loss) from equity method investments, (v) interest expense, (vi) other income (expense), net, (vii) depreciation and amortization, (viii) 69stock-based compensation expense, (ix) certain legal, tax, and regulatory reserve changes and settlements, (x) goodwill and asset impairments/loss on sale of assets, (xi) acquisition and financing related expenses, (xii) restructuring and related charges and (xiii) other items not indicative of our ongoing operating performance, including COVID-19 response initiatives related payments for financial assistance to Drivers personally impacted by COVID-19, the cost of personal protective equipment distributed to Drivers, Driver reimbursement for their cost of purchasing personal protective equipment, the costs related to free rides and food deliveries to healthcare workers, seniors, and others in need as well as charitable donations.We have included Adjusted EBITDA in this Annual Report on Form 10-K because it is a key measure used by our management team to evaluate our operating performance, generate future operating plans, and make strategic decisions, including those relating to operating expenses. Accordingly, we believe that Adjusted EBITDA provides useful information to investors and others in understanding and evaluating our operating results in the same manner as our management team and board of directors. In addition, it provides a useful measure for period-to-period comparisons of our business, as it removes the effect of certain non-cash expenses and certain variable charges. To help our board, management and investors assess the impact of COVID-19 pandemic on our results of operations, we are excluding the impacts of COVID-19 response initiatives related payments for financial assistance to Drivers personally impacted by COVID-19, the cost of personal protective equipment distributed to Drivers, Driver reimbursement for their cost of purchasing personal protective equipment, the costs related to free rides and food deliveries to healthcare workers, seniors, and others in need as well as charitable donations from Adjusted EBITDA. Our board and management find the exclusion of the impact of these COVID-19 response initiatives from Adjusted EBITDA to be useful because it allows us and our investors to assess the impact of these response initiatives on our results of operations.COVID-19 Response InitiativesTo support those whose earning opportunities have been depressed as a result of COVID-19, as well as communities hit hard by the pandemic, we have announced and implemented several initiatives, including, in particular, payments for financial assistance to Drivers personally impacted by COVID-19, the cost of personal protective equipment distributed to Drivers, Driver reimbursement for their cost of purchasing personal protective equipment, the costs related to free rides and food deliveries to healthcare workers, seniors, and others in need as well as charitable donations. The payments for financial assistance to Drivers personally impacted by COVID-19 and Driver reimbursement for their cost of purchasing personal protective equipment are recorded as a reduction to revenue. The cost of personal protective equipment distributed to Drivers, the costs related to free rides and food deliveries to healthcare workers, seniors, and others in need as well as charitable donations are recorded as an expense in our costs and expenses.Limitations of Non-GAAP Financial Measures and Adjusted EBITDA ReconciliationAdjusted EBITDA has limitations as a financial measure, should be considered as supplemental in nature, and is not meant as a substitute for the related financial information prepared in accordance with GAAP. These limitations include the following:•Adjusted EBITDA excludes certain recurring, non-cash charges, such as depreciation of property and equipment and amortization of intangible assets, and although these are non-cash charges, the assets being depreciated and amortized may have to be replaced in the future, and Adjusted EBITDA does not reflect all cash capital expenditure requirements for such replacements or for new capital expenditure requirements;•Adjusted EBITDA excludes certain restructuring and related charges, part of which may be settled in cash;•Adjusted EBITDA excludes stock-based compensation expense, which has been, and will continue to be for the foreseeable future, a significant recurring expense in our business and an important part of our compensation strategy;•Adjusted EBITDA excludes other items not indicative of our ongoing operating performance, including COVID-19 response initiatives related payments for financial assistance to Drivers personally impacted by COVID-19, the cost of personal protective equipment distributed to Drivers, Driver reimbursement for their cost of purchasing personal protective equipment, the costs related to free rides and food deliveries to healthcare workers, seniors, and others in need as well as charitable donations;•Adjusted EBITDA does not reflect period to period changes in taxes, income tax expense or the cash necessary to pay income taxes;•Adjusted EBITDA does not reflect the components of other income (expense), net, which primarily includes: interest income; foreign currency exchange gains (losses), net; gain (loss) on business divestitures, net; and unrealized gain (loss) on debt and equity securities, net;, and impairment of debt and equity securities; and•Adjusted EBITDA excludes certain legal, tax, and regulatory reserve changes and settlements that may reduce cash available to us.70 The following table presents a reconciliation of net income (loss) attributable to Uber Technologies, Inc., the most directly comparable GAAP financial measure, to Adjusted EBITDA for each of the periods indicated:Year Ended December 31,(In millions)201820192020Adjusted EBITDA reconciliation:Net income (loss) attributable to Uber Technologies, Inc.$997 $(8,506)$(6,768)Add (deduct):Net income (loss) attributable to non-controlling interests, net of tax(10)(6)(20)Provision for (benefit from) income taxes283 45 (192)Loss from equity method investments42 34 34 Interest expense648 559 458 Other (income) expense, net(4,993)(722)1,625 Depreciation and amortization426 472 575 Stock-based compensation expense172 4,596 827 Legal, tax, and regulatory reserve changes and settlements340 353 (35)Driver appreciation award— 299 — Payroll tax on IPO stock-based compensation— 86 — Goodwill and asset impairments/loss on sale of assets237 8 317 Acquisition, financing and divestitures related expenses15 — 86 Accelerated lease costs related to cease-use of ROU assets— — 102 COVID-19 response initiatives— — 106 Gain on lease arrangement, net(4)— (5)Restructuring and related charges, net— 57 362 Adjusted EBITDA$(1,847)$(2,725)$(2,528)The comparability of the results for the periods presented above was impacted by our 2018 Divested Operations. During the year ended December 31, 2018, the 2018 Divested Operations unfavorably impacted net income (loss) attributable to Uber Technologies, Inc. by $127 million.Adjusted EBITDA Margin as a Percentage of RevenueWe define Adjusted EBITDA margin as a percentage of revenue as Adjusted EBITDA divided by revenue.Constant CurrencyWe compare the percent change in our current period results from the corresponding prior period using constant currency disclosure. We present constant currency growth rate information to provide a framework for assessing how our underlying revenue performed excluding the effect of foreign currency rate fluctuations. We calculate constant currency by translating our current period financial results using the corresponding prior period’s monthly exchange rates for our transacted currencies other than the U.S. dollar. Selected Quarterly Financial Data The following tables set forth our unaudited selected quarterly financial data for each of the quarters indicated. This unaudited selected quarterly financial data has been prepared on the same basis as our audited consolidated financial statements included elsewhere in this Annual Report on Form 10-K. In the opinion of management, the financial data set forth in the tables below reflect all normal recurring adjustments necessary for the fair statement of results of operations for these periods. Our historical results are not necessarily indicative of the results that may be expected in the future and the results of a particular quarter or other interim period are not necessarily indicative of the results for a full year. This financial data should be read in conjunction with the section titled “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our consolidated financial statements and related notes included elsewhere in this Annual Report on Form 10-K.71Quarterly Consolidated Statements of Operations Three Months Ended March 31, 2019June 30, 2019Sept. 30, 2019Dec. 31, 2019March 31, 2020June 30, 2020Sept. 30, 2020Dec. 31, 2020 (In millions, except per share amounts)Revenue (1)$2,796 $2,903 $3,554 $3,747 $3,248 $1,913 $2,813 $3,165 Costs and expensesCost of revenue, exclusive of depreciation and amortization shown separately below (1)1,378 1,477 1,601 1,605 1,491 924 1,298 1,441 Operations and support (2)434 864 498 506 503 582 365 369 Sales and marketing (2)1,040 1,222 1,113 1,251 885 736 924 1,038 Research and development (2)409 3,064 755 608 645 584 493 483 General and administrative (2)423 1,638 591 647 859 565 711 531 Depreciation and amortization146 123 102 101 128 129 138 180 Total costs and expenses3,830 8,388 4,660 4,718 4,511 3,520 3,929 4,042 Loss from operations(1,034)(5,485)(1,106)(971)(1,263)(1,607)(1,116)(877)Interest expense(217)(151)(90)(101)(118)(110)(112)(118)Other income (expense), net (3)260 398 49 15 (1,795)(44)151 63 Loss before income taxes and loss from equity method investments(991)(5,238)(1,147)(1,057)(3,176)(1,761)(1,077)(932)Provision for (benefit from) income taxes19 (2)3 25 (242)4 23 23 Loss from equity method investments, net of tax(6)(10)(9)(9)(12)(7)(8)(7)Net loss including non-controlling interests(1,016)(5,246)(1,159)(1,091)(2,946)(1,772)(1,108)(962)Less: net income (loss) attributable to non-controlling interests, net of tax(4)(10)3 5 (10)3 (19)6 Net loss attributable to Uber Technologies, Inc.$(1,012)$(5,236)$(1,162)$(1,096)$(2,936)$(1,775)$(1,089)$(968)Net loss per share attributable to Uber Technologies, Inc. common stockholders:Basic$(2.23)$(4.72)$(0.68)$(0.64)$(1.70)$(1.02)$(0.62)$(0.54)Diluted$(2.26)$(4.72)$(0.68)$(0.64)$(1.70)$(1.02)$(0.62)$(0.54)(1) During the fourth quarter of 2020, we changed our accounting policy related to the presentation of cumulative payments to Drivers in excess of cumulative revenue from Drivers. Our policy for the presentation of these excess cumulative payments has changed from presenting them within cost of revenue, exclusive of depreciation and amortization, to presenting them as a reduction of revenue in our consolidated statements of operations. Refer to Note 1 - Description of Business and Summary of Significant Accounting Policies for further information on change in accounting policy. As a result, our revenue and cost of revenue for the first three quarters of 2020 and all quarters of 2019 have been retrospectively adjusted. The effect of the change by quarter is as follows:72 Three Months Ended March 31, 2019June 30, 2019Sept. 30, 2019Dec. 31, 2019March 31, 2020June 30, 2020Sept. 30, 2020Dec. 31, 2020 (In millions)Revenue:As previously reported*$3,099 $3,166 $3,813 $4,069 $3,543 $2,241 $3,129 $3,509 Effect of change(303)(263)(259)(322)(295)(328)(316)(344)As Adjusted$2,796 $2,903 $3,554 $3,747 $3,248 $1,913 $2,813 $3,165 Cost of revenue, exclusive of depreciation and amortization:As previously reported*$1,681 $1,740 $1,860 $1,927 $1,786 $1,252 $1,614 $1,785 Effect of change(303)(263)(259)(322)(295)(328)(316)(344)As Adjusted$1,378 $1,477 $1,601 $1,605 $1,491 $924 $1,298 $1,441 *As previously reported through September 30, 2020 and as would have been reported under our pre-existing accounting presentation policy in the quarter ended December 31, 2020.(2) The three months ended June 30, 2019 includes $3.6 billion of stock-based compensation expense for awards with a performance-based vesting condition satisfied upon our IPO. For additional information on our IPO, see Note 11 - Stockholders' Equity in the notes to the consolidated financial statements included in Part II, Item 8, “Financial Statements and Supplementary Data,” of this Annual Report on Form 10-K. The three months ended June 30, 2020, includes a $111 million reversal, included in and offsetting stock-based compensation expense, related to forfeitures of awards for employees that were part of the second quarter 2020 restructuring. The following table sets forth the stock-based compensation expense for each of the quarters indicated: Three Months Ended March 31, 2019June 30, 2019Sept. 30, 2019Dec. 31, 2019March 31, 2020June 30, 2020Sept. 30, 2020Dec. 31, 2020 (In millions)Operations and support$1 $404 $26 $23 $25 $11 $16 $20 Sales and marketing1 212 16 13 14 10 11 13 Research and development3 2,557 262 136 167 72 102 136 General and administrative6 768 97 71 71 38 54 67 Total$11 $3,941 $401 $243 $277 $131 $183 $236 (3) The three months ended March 31, 2020 includes an impairment charge of $1.7 billion, primarily related to our investment in Didi. For additional information, see Note 3 - Investments and Fair Value Measurement to our consolidated financial statements included in Part II, Item 8, “Financial Statements and Supplementary Data,” of this Annual Report on Form 10-K.73Quarterly Consolidated Statements of Operations, as a Percentage of Revenue (1) Three Months EndedMarch 31, 2019June 30, 2019Sept. 30, 2019Dec. 31, 2019March 31, 2020June 30, 2020Sept. 30, 2020Dec. 31, 2020Revenue100 %100 %100 %100 %100 %100 %100 %100 %Costs and expensesCost of revenue, exclusive of depreciation and amortization shown separately below49 %51 %45 %43 %46 %48 %46 %46 %Operations and support16 %30 %14 %14 %15 %30 %13 %12 %Sales and marketing37 %42 %31 %33 %27 %38 %33 %33 %Research and development15 %106 %21 %16 %20 %31 %18 %15 %General and administrative15 %56 %17 %17 %26 %30 %25 %17 %Depreciation and amortization5 %4 %3 %3 %4 %7 %5 %6 %Total costs and expenses137 %289 %131 %126 %139 %184 %140 %128 %Loss from operations(37)%(189)%(31)%(26)%(39)%(84)%(40)%(28)%Interest expense(8)%(5)%(3)%(3)%(4)%(6)%(4)%(4)%Other income (expense), net9 %14 %1 %— %(55)%(2)%5 %2 %Loss before income taxes and loss from equity method investments(35)%(180)%(32)%(28)%(98)%(92)%(38)%(29)%Provision for (benefit from) income taxes1 %— %— %1 %(7)%— %1 %1 %Loss from equity method investments, net of tax— %— %— %— %— %— %— %— %Net loss including non-controlling interests(36)%(181)%(33)%(29)%(91)%(93)%(39)%(30)%Less: net income (loss) attributable to non-controlling interests, net of tax— %— %— %— %— %— %(1)%— %Net loss attributable to Uber Technologies, Inc.(36)%(180)%(33)%(29)%(90)%(93)%(39)%(31)%(1) Totals of percentage of revenues may not foot due to rounding.Liquidity and Capital ResourcesYear Ended December 31,(In millions)201820192020Net cash used in operating activities$(1,541)$(4,321)$(2,745)Net cash used in investing activities(695)(790)(2,869)Net cash provided by financing activities4,640 8,939 1,379 Operating ActivitiesNet cash used in operating activities was $2.7 billion for the year ended December 31, 2020, primarily consisting of $6.8 billion of net loss, adjusted for certain non-cash items, which primarily included $1.7 billion in impairment of non-marketable equity securities, $827 million of stock-based compensation expense, depreciation and amortization expense of $575 million, $404 million in impairment of goodwill, long-lived assets and other assets, as well as a $393 million decrease in cash consumed by working capital. The decrease in cash consumed by working capital and other operating activities was primarily driven by a decrease in our operating lease right-of-use assets, prepaid expenses and other assets and increase in accrued expenses and other liabilities, partially offset by lower accounts payable and operating lease liabilities. Net cash used in operating activities was $4.3 billion for the year ended December 31, 2019 , primarily consisting of $8.5 billion of net loss, adjusted for certain non-cash items, which primarily included $4.6 billion of stock-based compensation expense, $444 million of gain on extinguishment of convertible notes, $58 million of revaluation gain of our derivative liabilities, depreciation and amortization expense of $472 million, $82 million in accretion of discount on our long-term debt, as well as $1.2 billion withdrawal of collateral from restricted cash from James River and a $699 million decrease in cash consumed by working capital. The decrease in cash consumed by working capital was primarily driven by an increase in our insurance reserve, accrued expenses and other liabilities, partially offset by higher accounts receivable and prepaid expenses. 74Net cash used in operating activities was $1.5 billion for the year ended December 31, 2018, primarily consisting of $1.0 billion of net income, adjusted for certain non-cash items, which primarily included a $3.2 billion gain on business divestitures related to our 2018 Divested Operations, unrealized gain on investment of $2.0 billion related to our investment in Didi, $501 million of revaluation expense of our derivative liabilities, depreciation and amortization expense of $426 million, $318 million in accretion of discount on our long-term debt, impairment of long-lived assets held for sale of $197 million, and $170 million of stock-based compensation expense, as well as an $890 million decrease in cash consumed by working capital primarily driven by an increase in our insurance reserves and accrued expenses, partially offset by higher accounts receivable and prepaid expenses.Investing ActivitiesNet cash used in investing activities was $2.9 billion for the year ended December 31, 2020, primarily consisting of $2.1 billion in purchases of marketable securities, $1.5 billion in acquisition of businesses, net of cash acquired and $616 million in purchases of property and equipment, partially offset by proceeds from maturities and sales of marketable securities of $1.4 billion.Net cash used in investing activities was $790 million for the year ended December 31, 2019, primarily consisting of $588 million in purchases of property and equipment and $441 million in purchases of marketable securities, partially offset by $293 million in proceeds from business disposal, net of cash divested.Net cash used in investing activities was $695 million for the year ended December 31, 2018, primarily consisting of $412 million contributed to equity method investees and $558 million in purchases of property and equipment, partially offset by $369 million of proceeds from sales and disposals of property and equipment.Financing ActivitiesNet cash provided by financing activities was $1.4 billion for the year ended December 31, 2020, primarily consisting of $2.6 billion of proceeds from issuance of notes, net of issuance costs and $247 million of proceeds from issuance of subsidiary preferred stock units, partially offset by $891 million of principal repayment on Careem Notes and $527 million of principal repayment on term loan and notes.Net cash provided by financing activities was $8.9 billion for the year ended December 31, 2019, primarily consisting of $8.0 billion of proceeds from issuance of common stock upon our IPO, net of offering costs, $1.2 billion of proceeds from issuance of term loan and senior notes, net of issuance costs, and $500 million of proceeds from issuance of common stock in private placement, partially offset by $1.6 billion taxes paid related to net share settlement of equity awards to satisfy tax withholding requirements and $138 million of principal payments on capital and finance leases.Net cash provided by financing activities was $4.6 billion for the year ended December 31, 2018, primarily consisting of $3.5 billion from issuance of term loan and senior notes, net of issuance costs, $1.8 billion in proceeds from the issuance of redeemable convertible preferred stock, net of issuance costs, partially offset by $491 million of principal repayment on revolving lines of credit.Other InformationAs of December 31, 2020, $1.8 billion of our $5.6 billion in cash and cash equivalents was held by our foreign subsidiaries. Cash held outside the United States may be repatriated, subject to certain limitations, and would be available to be used to fund our domestic operations. However, repatriation of funds may result in immaterial tax liabilities. We believe that our existing cash balance in the United States is sufficient to fund our working capital needs in the United States. We are in compliance with our debt and line of credit covenants as of December 31, 2020, including by meeting our reporting obligations. We also believe that our sources of funding and our available line of credit will be sufficient to satisfy our currently anticipated cash requirements including capital expenditures, working capital requirements, potential acquisitions, potential prepayments of contested indirect tax assessments (“pay-to-play”), and other liquidity requirements through at least the next 12 months. We intend to continue to evaluate and may, in certain circumstances, take preemptive action to preserve liquidity during the COVID-19 pandemic. As the circumstances around the COVID-19 pandemic remain uncertain, we continue to actively monitor the pandemic's impact to us worldwide including our financial position, liquidity, results of operations and cash flows.Off-Balance Sheet ArrangementsAs of December 31, 2020, we did not have any off-balance sheet arrangements that have or are reasonably likely to have a current or future effect on our financial condition, changes in our financial condition, revenue, or expenses, results of operations, liquidity, capital expenditures, or capital resources that are material to investors.75Contractual ObligationsThe following table summarizes our contractual obligations as of December 31, 2020:Payments Due by Period(In millions)TotalLess than 1 Year1-3 Years3-5 YearsMore than 5 yearsLong-term debt (1)$7,914 $27 $1,120 $3,567 $3,200 Financing obligation (2)851 6 12 13 820 Operating lease commitments (2)3,832 223 634 514 2,461 Finance lease commitments (2)315 189 126 — — Non-cancelable purchase obligations (3)516 187 291 38 — Total contractual obligations$13,428 $632 $2,183 $4,132 $6,481 (1) Refer to Note 8 - Long-Term Debt and Revolving Credit Arrangements of Part II, Item 8, “Financial Statements and Supplementary Data,” of this Annual Report on Form 10-K for further details regarding our long-term debt obligations.(2) Refer to Note 6 - Leases of Part II, Item 8, “Financial Statements and Supplementary Data,” of this Annual Report on Form 10-K for further details regarding our operating and finance leases.(3) Consists primarily of non-cancelable commitments for network, data and cloud services, background checks, and other items in the ordinary course of business with varying expiration terms through 2024.The contractual commitment obligations in the table above are associated with agreements that are enforceable and legally binding. As of December 31, 2020, we had recorded liabilities of $95 million related to uncertain tax positions. Due to uncertainties in the timing of potential tax audits, the timing of the resolution of these positions is uncertain and we are unable to make a reasonable estimate of the timing of payments in individual years particularly beyond 12 months. As a result, this amount is not included in the table above. The table above also excludes approximately $771 million of non-interest bearing unsecured convertible notes related to the acquisition of Careem. For additional discussion on the acquisition of Careem, see Note 18 – Business Combinations to our consolidated financial statements included in Part II, Item 8, “Financial Statements and Supplementary Data,” of this Annual Report on Form 10-K.Critical Accounting Policies and EstimatesWe believe that the following accounting policies involve a high degree of judgment and complexity and are critical to understanding and evaluating our consolidated financial condition and results of our operations. An accounting policy is considered to be critical if it requires judgment on a significant accounting estimate to be made based on assumptions about matters that are uncertain at the time the estimate is made, and if different estimates that reasonably could have been used, or changes in the accounting estimates that are reasonably likely to occur periodically, could materially impact the reported amounts of assets, liabilities, revenue and expenses, and related disclosures in our audited consolidated financial statements. We have based our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Although we believe that the estimates we use are reasonable, due to the inherent uncertainty involved in making those estimates, actual results reported in future periods could differ from those estimates.We believe that the following critical accounting policies reflect the more significant judgments, estimates and assumptions used in the preparation of our consolidated financial statements. For additional information, see the disclosure included in Note 1 - Description of Business and Summary of Significant Accounting Policies in the notes to the consolidated financial statements included in Part II, Item 8, “Financial Statements and Supplementary Data,” of this Annual Report on Form 10-K.Revenue RecognitionWe derive our revenue principally from service fees paid by Drivers and Merchants for the use of our platform in connection with our Mobility products and Delivery offering provided by Drivers and Merchants to end-users. Our sole performance obligation in the transaction is to connect Drivers and Merchants with end-users to facilitate the completion of a successful ridesharing trip or Delivery meal delivery. Because end-users access our platform for free, except in certain markets, and we have no performance obligation to end-users, end-users are not our customers.Further, judgment is required in evaluating the presentation of revenue on a gross versus net basis based on whether we control the service provided to the end-user and are the principal in the transaction (gross), or we arrange for other parties to provide the service to the end-user and are the agent in the transaction (net). We have concluded that we are the agent in most markets as we arrange for Drivers and Merchants to provide the service to the end user in Mobility and Delivery transactions. The assessment of 76whether we are considered the principal or the agent in a transaction could impact the accounting for certain payments and incentives provided to Drivers and end-users and change the timing and amount of revenue recognized.In certain markets, consumers have the option to pay Drivers cash for trips, and we generally collect our service fee from Drivers for these trips by offsetting against any other amounts due to Drivers, including Driver incentives. Because we have limited means to collect our service fee for cash trips, and because we cannot control whether Drivers will generate future earnings that we can offset to collect our service fee, we have concluded collectability of such amounts is not probable until collected. As such, uncollected service fees for cash trips are not recognized in our consolidated financial statements until collected.Driver IncentivesIncentives provided to customers are recorded as a reduction of revenue if we do not receive a distinct service in exchange or cannot reasonably estimate the fair value of the service received. Driver incentives that are not for a distinct service are evaluated as variable consideration, in the most likely amount to be earned by the Drivers at the time or as they are earned by the Drivers, depending on the type of Driver incentive.During the fourth quarter of 2020, we changed our accounting policy related to the presentation of cumulative payments to Drivers in excess of cumulative revenue from Drivers. Our policy for the presentation of these excess cumulative payments has changed from presenting them within cost of revenue, exclusive of depreciation and amortization, to presenting them as a reduction of revenue in our consolidated statements of operations. For additional information, see Note 1 - Description of Business and Summary of Significant Accounting Policies in the notes to the consolidated financial statements included in Part II, Item 8, “Financial Statements and Supplementary Data,” of this Annual Report on Form 10-K.Referral incentives offered by us and earned by Drivers for performing marketing services of referring other Drivers to drive on our platform are recorded as sales and marketing expense, as we receive a distinct service. The amount recorded is the lesser of the amount of the Driver incentive paid or the established fair market value of the distinct service received. Fair market value of the distinct service is estimated using amounts paid to vendors for similar services.End-User Discounts and PromotionsWe offer discounts and promotions to end-users (that are not customers) to encourage use of our platform. These are offered in various forms and include:•Targeted end-user discounts and promotions: These discounts and promotions are offered to specific end-users in a market to acquire, re-engage, or generally increase end-users’ use of our platform. An example is an offer providing a discount on a limited number of rides or meal deliveries during a limited time period, and are akin to coupons. We record the cost of these discounts and promotions as sales and marketing expense at the time they are redeemed by the end-user.•End-user referrals: These referrals are earned when an existing end-user (the referring end-user) refers a new end-user (the referred end-user) to the platform and the new end-user takes his or her first ride on the platform. These referrals are typically paid in the form of a credit given to the referring end-user when earned. These referrals are offered to attract new end-users to our platform. We record the liability for these referrals and corresponding expense as sales and marketing expense at the time the referral is earned by the referring end-user.•Market-wide promotions: These promotions are pricing actions in the form of discounts that reduce the end-user fare charged by Drivers and Merchants to end-users for all or substantially all Mobility or meal deliveries in a specific market. Accordingly, we record the cost of these promotions as a reduction of revenue at the time the trip is completed.Business CombinationsWe allocate the fair value of purchase consideration to the tangible assets acquired, liabilities assumed, and intangible assets acquired based on their estimated fair values. The excess of the fair value of purchase consideration over the fair values of these identifiable assets and liabilities is recorded as goodwill. Such valuations require management to make significant estimates and assumptions, especially with respect to intangible assets. Significant estimates in valuing certain intangible assets include, but are not limited to, future expected cash flows from acquired driver, fleet, merchant, and end-user contracts, acquired technology, and trade names, based on expected future growth rates and margins, attrition rates, future changes in technology and royalty for similar brand licenses, useful lives, and discount rates.Management's estimates of fair value are based upon assumptions believed to be reasonable, but which are inherently uncertain and unpredictable and, as a result, actual results may differ from estimates. Allocation of purchase consideration to identifiable assets and liabilities affects our amortization expense, as acquired finite-lived intangible assets are amortized over the useful life, whereas any indefinite lived intangible assets, including goodwill, are not amortized. During the measurement period, which is not to exceed one year from the acquisition date, we may record adjustments to the assets acquired and liabilities assumed, with the corresponding offset to goodwill. Upon the conclusion of the measurement period, any subsequent adjustments are recorded to earnings.77Embedded DerivativesDuring 2015, we had issued convertible notes that contain embedded features subject to derivative accounting. These embedded features are composed of conversion options that have the economic characteristics of a contingent early redemption feature settled in shares of our stock rather than cash, because the total number of shares of our common stock delivered to settle these embedded features will have a fixed value. These conversion options are bifurcated from the underlying instrument and accounted for and valued separately from the host instrument. Embedded derivatives are recognized as derivative liabilities on our consolidated balance sheet. We measure these instruments at their estimated fair value and recognize changes in their estimated fair value in other income (expense), net in our consolidated statement of operations and comprehensive loss during the period of change.We value these embedded derivatives as the difference between the estimated value of these convertible notes with and without the Qualified Initial Public Offering (“QIPO”) conversion option (“QIPO Conversion Option”). The fair value of these convertible notes with and without the QIPO Conversion Option is estimated utilizing a discounted cash flow model to discount the expected payoffs at various potential QIPO dates to the valuation date. The key inputs to the valuation model include the probability of a QIPO occurring at various points in time and the discount yield, which was derived by imputing the fair value as equal to the face value on the issuance date of these convertible notes. The discount rate is updated during each period to reflect the yield of a comparable instrument issued as of the valuation date. Upon closing of the IPO in May 2019, holders of these convertible notes elected to convert all outstanding notes into shares of common stock. For additional information, refer to Note 11 - Stockholders' Equity included in Part II, Item 8, “Financial Statements and Supplementary Data,” of this Annual Report on Form 10-K.Investments—Non-Marketable Equity and Debt SecuritiesWe hold investments in privately held companies in the form of equity securities and debt securities without readily determinable fair values and in which we do not have a controlling interest or significant influence. Investments in equity securities without readily determinable fair values are initially recorded at cost and are subsequently adjusted to fair value for impairments and price changes from observable transactions in the same or a similar security from the same issuer. Investments in material available-for-sale debt securities are recorded initially at fair value and subsequently remeasured to fair value at each reporting date with the changes in fair value recognized in other comprehensive income (loss), net of tax. We may elect the fair value option for financial instruments and account for investments in debt and equity securities at fair value with changes reported in net income (loss) from continuing operations.Privately held equity and debt securities are valued using significant unobservable inputs or data in inactive markets. This valuation requires judgment due to the absence of market prices and inherent lack of liquidity and are classified as Level 3 in the fair value hierarchy. In determining the estimated fair value of our investments in privately held companies, we utilize the most recent data available including observed transactions such as equity financing transactions of the investees and sales of the existing shares of the investees’ securities. In addition, the determination of whether an observed transaction is similar to the equity and debt securities held by us requires significant management judgment based on the rights and preferences of the securities.We assess our investment portfolio of privately held equity and debt securities quarterly for impairment. The impairment analysis for investments in equity securities includes a qualitative analysis of factors including the investee’s financial performance, industry and market conditions, and other relevant factors. If an equity investment is considered to be impaired we will establish a new carrying value for the investment and recognize an impairment loss through our consolidated statement of operations. Investments in debt securities are evaluated for impairment quarterly based on whether its fair value has declined below its amortized cost. In circumstances where we intend to sell, or are more likely than not required to sell the security before it recovers its amortized cost basis, the difference between the fair value and amortized cost is recognized as a loss in the consolidated financial statement of operations, with a corresponding write-down of the security’s amortized cost. In circumstances where neither condition exists, we then evaluate whether a decline is due to credit-related factors. The factors considered in determining whether a credit loss exists can include the extent to which fair value is less than the amortized cost basis, changes in the credit quality of the underlying loan obligors, credit ratings actions, as well as other factors. To determine the portion of a decline in fair value that is credit-related, we compare the present value of the expected cash flows of the security discounted at the security’s effective interest rate to the amortized cost basis of the security. A credit-related impairment is limited to the difference between fair value and amortized cost, and recognized as an allowance for credit loss on the consolidated balance sheet with a corresponding adjustment to net income (loss). Any remaining decline in fair value that is non-credit related is recognized in other comprehensive income (loss), net of tax. Improvements in expected cash flows due to improvements in credit are recognized through reversal of the credit loss and corresponding reduction in the allowance for credit loss.Equity Method InvestmentsWe account for investments in the common stock or in-substance common stock of entities in which we have the ability to exercise significant influence, but do not own a controlling financial interest, using the equity method. Investments accounted for under the equity method are initially recorded at cost. Subsequently, we recognize through our consolidated statement of operations, and as an adjustment to the investment balance, our proportionate share of the entities’ net income or loss and reflect the amortization 78of basis differences. In accounting for these investments, we record our share of the entities’ net income or loss one quarter in arrears. Equity method investments for which the fair value option is elected are measured at fair value on a recurring basis with changes in fair value reflected in earnings.We review our equity method investments for impairment whenever events or changes in business circumstances indicate that the carrying value of the investment may not be fully recoverable. Qualitative and quantitative factors considered as indicators of a potential impairment include financial results and operating trends of the investees, implied values in transactions of the investee’s securities, severity and length of decline in value, and our intention for holding the investment, among other factors. If an impairment is determined to be other-than-temporary, the fair value of the impaired investment would have to be determined and an impairment charge recorded for the difference between the fair value and the carrying value of the investment. The fair value determination, particularly for investments in privately held companies, requires significant judgment to determine appropriate estimates and assumptions. Changes in these estimates and assumptions could affect the calculation of the fair value of the investments and the determination of the impairment charges.Loss ContingenciesWe are involved in legal proceedings, claims, and regulatory, non-income tax, or government inquiries and investigations that arise in the ordinary course of business. Certain of these matters include claims for substantial or indeterminate amounts of damages. We record a liability when we believe that it is both probable that a loss has been incurred and the amount can be reasonably estimated. If we determine that a loss is reasonably possible and the loss or range of loss can be reasonably estimated, we disclose the possible loss in the accompanying notes to the consolidated financial statements.We review the developments in our contingencies that could affect the amount of the provisions that have been previously recorded, and the matters and related reasonably possible losses disclosed. We make adjustments to our provisions and changes to our disclosures accordingly to reflect the impact of negotiations, settlements, rulings, advice of legal counsel, and updated information. Significant judgment is required to determine both the probability and the estimated amount of loss. These estimates have been based on our assessment of the facts and circumstances at each balance sheet date and are subject to change based on new information and future events.The outcomes of litigation and other disputes are inherently uncertain. Therefore, if one or more of these matters were resolved against us for amounts in excess of management’s expectations, our results of operations and financial condition, including in a particular reporting period in which any such outcome becomes probable and estimable, could be materially adversely affected.Income TaxesWe are subject to income taxes in the United States and foreign jurisdictions. We account for income taxes using the asset and liability method. The establishment of deferred tax assets from intra-entity transfers of intangible assets requires management to make significant estimates and assumptions to determine the fair value of such intangible assets. Significant estimates in valuing intangible assets may include, but are not necessarily limited to, internal revenue and expense forecasts, the estimated life of the intangible assets, comparable transaction values, and / or discount rates. The discount rates used to discount expected future cash flows to present value are derived from a weighted-average cost of capital analysis and are adjusted to reflect the inherent risks related to the cash flow. Although we believe the assumptions and estimates we have made are reasonable and appropriate, they are based, in part, on historical experience, internal and external comparable data and are inherently uncertain. Unanticipated events and circumstances may occur that could affect either the accuracy or validity of such assumptions, estimates or actual results.We account for uncertainty in tax positions by recognizing a tax benefit from uncertain tax positions when it is more-likely-than-not that the position will be sustained upon examination. Evaluating our uncertain tax positions, determining our provision for income taxes, and evaluating the ongoing impact of the Tax Act, are inherently uncertain and require making judgments, assumptions, and estimates. While we believe we have adequately reserved for our uncertain tax positions, no assurance can be given that the final tax outcome of these matters will not be different. We adjust these reserves in light of changing facts and circumstances, such as the closing of a tax audit. To the extent that the final tax outcome of these matters is different than the amounts recorded, such differences will impact the provision for income taxes and the effective tax rate in the period in which such determination is made.The provision for income taxes includes the impact of reserve provisions and changes to reserves as well as the related net interest and penalties. In addition, we are subject to the continuous examination of our income tax returns by the IRS and other tax authorities which may assert assessments against us. We regularly assess the likelihood of adverse outcomes resulting from these examinations and assessments to determine the adequacy of our provision for income taxes.Insurance ReservesWe use a combination of third-party insurance and self-insurance mechanisms, including a wholly-owned captive insurance subsidiary, to provide for the potential liabilities for certain risks, including auto liability, uninsured and underinsured motorist, auto physical damage, general liability, and workers’ compensation. The insurance reserves is an estimate of our potential liability for unpaid losses and loss adjustment expenses, which represents the estimate of the ultimate unpaid obligation for risks retained by us and includes an amount for case reserves related to reported claims and an amount for losses incurred but not reported as of the 79balance sheet date. The estimate of the ultimate unpaid obligation utilizes generally accepted actuarial methods applied to historical claim and loss experience. In addition, we use assumptions based on actuarial judgment related to claim and loss development patterns and expected loss costs, which consider frequency trends, severity trends, and relevant industry data. These reserves are continually reviewed and adjusted as experience develops and new information becomes known. Adjustments, if any, relating to accidents that occurred in prior years are reflected in the current year results of operations.All estimates of ultimate losses and allocated loss adjustment expenses, and of resulting reserves, are subject to inherent variability caused by the nature of the insurance claim settlement process. Such variability is increased for us due to limited historical experience and the nature of the coverage provided. Actual results depend upon the outcome of future contingent events and can be affected by many factors, such as claim settlement processes and changes in the economic, legal, and social environments. As a result, the net amounts that will ultimately be paid to settle the liability, and when these amounts will be paid, may vary in the near term from the estimated amounts.While management believes that the insurance reserve amount is adequate, the ultimate liability may be in excess of, or less than, the amount provided.Stock-Based CompensationWe have granted stock-based awards consisting primarily of stock options, restricted common stock, RSUs, warrants, and SARs to employees, members of our board of directors, and non-employee advisors. The substantial majority of our stock-based awards have been made to employees. The majority of our outstanding RSUs, as well as certain options, SARs, and shares of restricted common stock, contain both a service-based vesting condition and a liquidity-event based vesting condition. The service-based vesting condition for the majority of these awards is satisfied over four years. The liquidity event-based vesting condition is satisfied upon the occurrence of a qualifying event, which is generally defined as a change in control transaction or the effective date of an initial public offering (“IPO”). Prior to our IPO in May 2019, no qualifying event had occurred, and we did not recognized any stock-based compensation expense for the RSUs and other awards with both a service-based vesting condition and a liquidity event-based vesting condition.We account for stock-based employee compensation under the fair value recognition and measurement provisions, in accordance with applicable accounting standards, which requires compensation expense for the grant-date fair value of stock-based awards to be recognized over the requisite service period. We account for forfeitures when they occur.We have elected to use the Black-Scholes option-pricing model to determine the fair value of stock options, warrants, and SARs on the grant date. The Black-Scholes option-pricing model requires certain subjective inputs and assumptions, including the fair value of our common stock, the expected term, risk-free interest rates, expected stock price volatility, and expected dividend yield of our common stock.These assumptions used in the Black-Scholes option-pricing model, other than the fair value of our common stock (see the section titled “-Common Stock Valuations” below), are estimated as follows:•Expected term. We estimate the expected term based on the simplified method for employees and on the contractual term for non-employees.•Risk-free interest rate. The risk-free interest rate is based on the U.S. Treasury yield curve in effect at the time of grant.•Expected volatility. We estimate the volatility of our common stock on the date of grant based on the weighted-average historical stock price volatility of comparable publicly-traded companies in our industry group.•Expected dividend yield. Expected dividend yield is zero percent, as we have not paid and do not anticipate paying dividends on our common stock.We continue to use judgment in evaluating the expected volatility and expected term utilized in our stock-based compensation expense calculation on a prospective basis. As we continue to accumulate additional data related to our common stock, we may refine our estimates of expected volatility and expected term, which could materially impact our future stock-based compensation expense.Recent Accounting Pronouncements See Note 1 - Description of Business and Summary of Significant Accounting Policies, to the consolidated financial statements included in Part II, Item 8, “Financial Statements and Supplementary Data,” of this Annual Report on Form 10-K.ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKWe are exposed to market risks in the ordinary course of our business. These risks primarily include interest rate risk, investment risk, and foreign currency risk as follows:Interest Rate RiskOur exposures to market risk for changes in interest rates relate primarily to our 2016 Term Loan Facility and our 2018 Term Loan Facility. The 2016 Term Loan Facility and 2018 Term Loan Facility are floating rate notes and are carried at amortized cost. Therefore, fluctuations in interest rates will impact our consolidated financial statements. A rising interest rate environment will 80increase the amount of interest paid on these loans. A hypothetical 100 basis point increase or decrease in interest rates would not have a material effect on the results of our operations.The fair value of our fixed rate notes and 2025 Convertible Notes outstanding will generally fluctuate with movements in interest rates and the market price of our stock. A hypothetical 100 basis point increase in interest rates would have decreased the fair value of our notes by $271 million as of December 31, 2020.Investment Risk Our investment policy objective aims to preserve capital and meet liquidity requirements without significantly increasing risk. We had cash and cash equivalents including restricted cash and cash equivalents totaling $12.1 billion and $7.4 billion as of December 31, 2019 and 2020, respectively. Marketable debt securities classified as short-term investments totaled $1.2 billion as of December 31, 2020. Our cash, cash equivalents, and marketable debt securities primarily consist of money market funds, cash deposits, U.S. government securities, U.S. government agency securities, and investment-grade corporate debt securities. We do not enter into investments for trading or speculative purposes. Our investments in fixed rate securities carry a degree of interest rate risk. Changes in rates would primarily impact interest income due to the relatively short-term nature of our investments. A hypothetical 100 basis point change in interest rates would have increased or decreased our interest income by $22 million and $97 million for the three and twelve months ended December 31, 2020, respectively. A hypothetical 100 basis point change in interest rates would not have a material impact on the fair value of our marketable debt securities portfolio.We have significant risk related to the carrying amounts of investments in other companies, including our minority-owned affiliates, as all of our investments are currently in illiquid private company stock which are inherently difficult to value given the lack of publicly available information. As of December 31, 2020, the carrying value of our investments was $10.1 billion, including equity method investments.Foreign Currency RiskWe transact business globally in multiple currencies. Our international revenue, as well as costs and expenses denominated in foreign currencies, expose us to the risk of fluctuations in foreign currency exchange rates against the U.S. dollar. We are exposed to foreign currency risks related to our revenue and operating expenses denominated in currencies other than the U.S. dollar. Accordingly, changes in exchange rates may negatively affect our future revenue and other operating results as expressed in U.S. dollars. Our foreign currency risk is partially mitigated as our revenue recognized in currencies other than the U.S. dollar is diversified across geographic regions and we incur expenses in the same currencies in such regions.We have experienced and will continue to experience fluctuations in our net income/(loss) as a result of transaction gains or (losses) related to remeasurement of our asset and liability balances that are denominated in currencies other than the functional currency of the entities in which they are recorded. Foreign currency rates may also impact the value of our equity method investment in our Yandex.Taxi joint venture. At this time, we do not, but we may in the future, enter into derivatives or other financial instruments in an attempt to hedge our foreign currency exchange risk.81
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+Item 7. Management’s Discussion and Analysis of Financial Condition and Results of OperationsThe following discussion and analysis of our financial condition and results of operations should be read in conjunction with our financial statements and related notes included elsewhere in this Annual Report on Form 10-K.OverviewWe were founded in 1990 as a beauty retailer at a time when prestige, mass, and salon products were sold through distinct channels – department stores for prestige products; drug stores and mass merchandisers for mass products; and salons and authorized retail outlets for professional hair care products. We developed a unique specialty retail concept that offers a broad range of brands and price points, a compelling value proposition, and a convenient and welcoming shopping environment. We define our target consumer as a beauty enthusiast, a consumer who is passionate about the beauty category and has high expectations for the shopping experience. We estimate that beauty enthusiasts represent approximately 57% of shoppers and 77% of spend in the U.S. beauty category. We believe our strategy provides us with the competitive advantages that have contributed to our financial performance.We are the largest beauty retailer in the United States and the premier beauty destination for cosmetics, fragrance, skin care products, hair care products, and salon services. We provide unmatched product breadth, value, and convenience in a distinctive specialty retail environment. Key aspects of our business include: our ability to offer our guests a unique combination of more than 25,000 beauty products from across the categories of prestige and mass cosmetics, fragrance, haircare, prestige and mass skincare, bath and body products, and salon styling tools, as well as a full-service salon in every store featuring hair, skin, and brow services; our focus on delivering a compelling value proposition to our guests across all of our product categories; and convenience, as our stores are predominantly located in convenient, high-traffic locations such as power centers.The continued growth of our business and any future increases in net sales, net income, and cash flows is dependent on our ability to execute our strategic priorities: 1) build omnichannel operations that more deeply connects guests across channels, 2) reimagine how guests experience and discover beauty, 3) drive market share growth through the deployment of winning category strategies, 4) deepen Ulta Beauty love and loyalty, 5) drive holistic cost optimization, and 6) develop our talent and strengthen our culture. We believe that the expanding U.S. beauty products and salon services 30 Table of Contentsindustry, the shift in distribution channel of prestige beauty products from department stores to specialty retail stores, coupled with Ulta Beauty’s competitive strengths, position us to capture additional market share in the industry.Comparable sales is a key metric that is monitored closely within the retail industry. Our comparable sales have fluctuated in the past, and we expect them to continue to fluctuate in the future. A variety of factors affect our comparable sales, including general U.S. economic conditions, changes in merchandise strategy or mix, and timing and effectiveness of our marketing activities, among others.Over the long term, our growth strategy is to increase total net sales through increases in our comparable sales, opening new stores, and increasing omnichannel capabilities. Long-term operating profit is expected to increase as a result of our ability to expand merchandise margin and leverage our fixed store costs with comparable sales increases and operating efficiencies offset by incremental investments in people, systems, and supply chain required to support a 1,500 to 1,700 store chain in the U.S. with successful e-commerce and competitive omnichannel capabilities.COVID-19 responseWe have been and continue to closely monitor the impact of the COVID-19 outbreak on all facets of our business. We have taken decisive actions to protect the safety of our associates and guests and to manage the business throughout the fluid and challenging environment resulting from the COVID-19 pandemic.In late 2019, COVID-19 was detected in Wuhan, China and other jurisdictions, prompting the Chinese government to quarantine certain affected regions and impose both internal and external travel restrictions within the country. The virus has since spread to every other part of the world, including the U.S., and in March 2020, the World Health Organization declared COVID-19 a global pandemic. Federal, state, and local governments have since implemented various restrictions, including travel restrictions, border closings, restrictions on public gatherings, quarantining of people who may have been exposed to the virus, shelter-in-place restrictions and limitations on business operations.In response to government recommendations and for the health and safety of our associates and guests, on March 19, 2020 we temporarily closed all stores across the U.S., while continuing to support our essential e-commerce operations. Effective April 19, 2020, we temporarily furloughed many of our store and salon associates. In April 2020, we introduced curbside pickup, and in May 2020, we began reopening stores. Throughout the second quarter, stores were reopened on a phased timeline, by taking a thoughtful, measured approach based on a variety of criteria, including state and local guidelines and the adoption of our new Shop Safe Standards. As of July 20, 2020, we completed our phased reopening process. By October 31, 2020, salon and brow services had resumed in almost all stores. Due to COVID-19 restrictions, we have not resumed skin and makeup services but we have plans to resume skin and makeup services as soon as it is safe to do so. Our results of operations for the fiscal year ended January 30, 2021 were significantly impacted by the effects of the COVID-19 pandemic. Comparable sales decreased 17.9% for the fiscal year ended January 30, 2021 as a result of the COVID-19 pandemic, but the multi-year, strategic investments we have made to enhance our omnichannel and supply chain capabilities, combined with the ongoing commitment of our distribution associates, have enabled us to support increased e-commerce demand and strong guest engagement. In addition to decreases in net revenue, our overall profitability also decreased as compared to the prior year. These developments have further required us to recognize certain long-lived asset impairment charges and restructuring charges. Further, in connection with the Coronavirus Aid, 31 Table of ContentsRelief, and Economic Security (CARES) Act, we recognized payroll subsidies as a reduction of selling, general and administrative expenses in the consolidated statement of operations.As we navigated these unprecedented circumstances, we continued to focus on our financial flexibility, including drawing down $800.0 million under our $1.0 billion revolving credit facility on March 18, 2020, which was repaid in full on September 2, 2020. In addition, we took the following steps to preserve financial liquidity:●limited new hires and delayed merit increases for all corporate, store, and salon associates;●reduced marketing, travel and controllable expenses;●aligned inventory receipts with current sales trends;●prioritized payment obligations;●reduced new store openings, relocations and remodel projects; and●suspended the stock repurchase program, which resumed in the fourth quarter of fiscal 2020.To help support our associates through this crisis, we expanded the criteria for our Associate Relief Program to include those who need assistance due to a personal hardship as a result of the COVID-19 pandemic. The Ulta Beauty executive team and Board of Directors have each made personal donations to the program.​Sales are expected to be challenged as events continue to change, and we are unable to accurately predict the future impact that the COVID-19 pandemic will have on our results of operations due to uncertainties including, but not limited to, the potential temporary reclosing of certain of our stores, the potential temporary restrictions on certain store operating hours and/or in-store capacity, the duration of potential future quarantines, shelter-in-place and other travel restrictions within the U.S. and other affected countries, the duration of the pandemic and any more dangerous variants of the virus, the duration, timing and severity of the impact on consumer spending, the timing and effectiveness of vaccine distribution, and how quickly and to what extent normal economic and operating conditions can resume. ​Industry trends​Our research indicates that Ulta Beauty has captured meaningful market share across all categories over the last several years. However, our research also suggests that the cosmetics category in the overall U.S. market experienced mid-single digit declines through fiscal 2019 and 2020. Beauty cycles are impacted by demographics and innovation. While demographic trends continue to be favorable, we believe a lack of incremental innovation has resulted in a challenging cycle for the cosmetics category, as innovation brought to the market has not resulted in incremental product purchases. In addition, the COVID-19 pandemic and its various impacts have changed consumer behavior and consumption of beauty products due to the closures of offices, retail stores and other businesses and the significant decline in social gatherings. We expect the beauty category will return to growth as consumers recover from the impacts of COVID-19, and we remain confident that our differentiated and diverse business model, our commitment to strategic investments, and our highly engaged associates will continue to drive market share gains over the long term. ​Basis of presentation​The Company has one reportable segment, which includes retail stores, salon services, and e-commerce. We recognize merchandise revenue at the point of sale in our retail stores. E-commerce sales are recognized upon shipment or guest pickup of the merchandise based on meeting the transfer of control criteria. Retail store and e-commerce sales are recorded net of estimated returns. Shipping and handling are treated as costs to fulfill the contract and not a separate performance obligation. Accordingly, we recognize revenue for our single performance obligation related to online sales at the time control of the merchandise passes to the customer, which is at the time of shipment or guest pickup. We provide refunds for merchandise returns within 60 days from the original purchase date; however, due to store closures during the first half of fiscal 2020, we extended our return policy to 180 days through November 16, 2020. State sales taxes are presented on a net basis as we consider our self a pass-through conduit for collecting and remitting state sales tax. Salon service revenue is recognized at the time the service is provided to the guest. Gift card sales revenue is deferred until the guest redeems the gift card. Company coupons and other incentives are recorded as a 32 Table of Contentsreduction of net sales. Other revenue sources include the private label and co-branded credit card programs, as well as deferred revenue related to the loyalty program and gift card breakage.​Comparable sales reflect sales for stores beginning on the first day of the 14th month of operation. Therefore, a store is included in our comparable store base on the first day of the period after one year of operations plus the initial one-month grand opening period. Non-comparable store sales include sales from new stores that have not yet completed their 13th month of operation and stores that were closed for part or all of the period in either year. Remodeled stores are included in comparable sales unless the store was closed for a portion of the current or prior period. Comparable sales include retail sales and salon services (including stores temporarily closed due to COVID-19), and e-commerce. There may be variations in the way in which some of our competitors and other retailers calculate comparable or same store sales.Measuring comparable sales allows us to evaluate the performance of our store base as well as several other aspects of our overall strategy. Several factors could positively or negatively impact our comparable sales results:●the general national, regional, and local economic conditions and corresponding impact on customer spending levels;●the introduction of new products or brands;●the location of new stores in existing store markets;●competition;●our ability to respond on a timely basis to changes in consumer preferences;●the effectiveness of our various merchandising and marketing activities; and●the number of new stores opened and the impact on the average age of all of our comparable stores.Cost of sales includes:●the cost of merchandise sold, including substantially all vendor allowances, which are treated as a reduction of merchandise costs;●distribution costs including labor and related benefits, freight, rent, depreciation and amortization, real estate taxes, utilities, and insurance;●shipping and handling costs;●retail stores occupancy costs including rent, depreciation and amortization, real estate taxes, utilities, repairs and maintenance, insurance, and licenses;●salon services payroll and benefits; and●shrink and inventory valuation reserves.Our cost of sales may be negatively impacted as we open new stores. Changes in our merchandise mix may also have an impact on cost of sales. This presentation of items included in cost of sales may not be comparable to the way in which our competitors or other retailers compute their cost of sales.Selling, general and administrative expenses include:●payroll, bonus, and benefit costs for retail store and corporate employees;●advertising and marketing costs;●occupancy costs related to our corporate office facilities;●stock-based compensation expense;●depreciation and amortization for all assets, except those related to our retail stores and distribution operations, which are included in cost of sales; and●legal, finance, information systems, and other corporate overhead costs.This presentation of items in selling, general and administrative expenses may not be comparable to the way in which our competitors or other retailers compute their selling, general and administrative expenses.33 Table of ContentsImpairment, restructuring and other costs include long-lived asset impairment charges, restructuring costs associated with store closings, costs associated with the suspension of our Canadian expansion, and employee related severance costs. Pre-opening expenses include non-capital expenditures during the period prior to store opening for new, remodeled, and relocated stores including rent during the construction period for new and relocated stores, store set-up labor, management and employee training, and grand opening advertising.Interest expense (income), net includes both interest income and expense. Interest expense includes interest costs and facility fees associated with our credit facility, which is structured as an asset-based lending instrument. Our credit facility interest is based on a variable interest rate structure which can result in increased cost in periods of rising interest rates. Interest income represents interest from cash equivalents and short-term investments with maturities of twelve months or less from the date of purchase.Income tax expense reflects the federal statutory tax rate and the weighted average state statutory tax rate for the states in which we operate stores.Results of operationsOur fiscal years are the 52- or 53-week periods ending on the Saturday closest to January 31. The Company’s fiscal years ended January 30, 2021 (fiscal 2020), February 1, 2020 (fiscal 2019), and February 2, 2019 (fiscal 2018) were all 52-week years.As of January 30, 2021, we operated 1,264 stores across 50 states. The following tables present the components of our consolidated results of operations for the periods indicated:​​​​​​​​​​​​Fiscal year ended​​January 30,​February 1,​February 2,(Dollars in thousands)​2021 2020 2019Net sales ​$ 6,151,953​$ 7,398,068​$ 6,716,615Cost of sales​​ 4,202,794​​ 4,717,004​​ 4,307,304Gross profit​​ 1,949,159​​ 2,681,064​​ 2,409,311​​​​​​​​​​Selling, general and administrative expenses​​ 1,583,017​​ 1,760,716​​ 1,535,464Impairment, restructuring and other costs​​ 114,322​​ —​​ —Pre-opening expenses​​ 15,000​​ 19,254​​ 19,767Operating income ​​ 236,820​​ 901,094​​ 854,080Interest expense (income), net​​ 5,735​​ (5,056)​​ (5,061)Income before income taxes​​ 231,085​​ 906,150​​ 859,141Income tax expense​​ 55,250​​ 200,205​​ 200,582Net income​$ 175,835​$ 705,945​$ 658,559​​​​​​​​​​Other operating data:​​​​​​​​​Number of stores end of year​​1,264​​1,254​​1174Comparable sales​​(17.9)%​​5.0%​​8.1%​​​​​​​​​34 Table of Contents​​​​​​​​​​​​Fiscal year ended​​January 30,​February 1,​February 2,(Percentage of net sales)​2021 2020 2019Net sales ​​100.0%​​100.0%​​100.0%Cost of sales​​68.3%​​63.8%​​64.1%Gross profit​​31.7%​​36.2%​​35.9%​​​​​​​​​​Selling, general and administrative expenses​​25.7%​​23.8%​​22.9%Impairment, restructuring and other costs​​1.9%​​0.0%​​0.0%Pre-opening expenses​​0.2%​​0.3%​​0.3%Operating income​​3.9%​​12.1%​​12.7%Interest expense (income), net​​0.1%​​(0.1)%​​(0.1)%Income before income taxes​​3.8%​​12.2%​​12.8%Income tax expense​​0.9%​​2.7%​​3.0%Net income​​2.9%​​9.5%​​9.8%​Fiscal year 2020 versus fiscal year 2019Net salesNet sales decreased $1.2 billion, or 16.8%, to $6.2 billion in fiscal 2020 compared to $7.4 billion in fiscal 2019. The net sales decrease was driven by the negative impacts of the COVID-19 pandemic, including the temporary closing of our brick-and-mortar retail stores, social distancing and quarantines, reduction of operating hours, and limitations on in-store capacity, and a decrease of $6.6 million in other revenue. Total comparable sales in fiscal 2020 decreased 17.9% compared to an increase of 5.0% in fiscal 2019. During fiscal 2020, transactions declined 24.5% and average ticket increased 8.8%. ​Gross profitGross profit decreased $0.7 billion, or 27.3%, to $1.9 billion in fiscal 2020, compared to $2.7 billion in fiscal 2019. Gross profit as a percentage of net sales decreased 450 basis points to 31.7% in fiscal 2020 compared to 36.2% in fiscal 2019. The decrease in gross profit margin was primarily due to:●220 basis points of deleverage due to channel mix shifts; ●220 basis points deleverage of fixed costs and 90 basis points of deleverage in salon services, both attributed to the impact of lower sales; partially offset by●80 basis points of leverage driven by lower promotional activity and cost optimization efforts. ​Selling, general and administrative expensesSelling, general and administrative (SG&A) expenses decreased $0.2 billion, or 10.1%, to $1.6 billion in fiscal 2020 compared to $1.8 billion in fiscal 2019. As a percentage of net sales, SG&A expenses increased 190 basis points to 25.7% in fiscal 2020 compared to 23.8% in fiscal 2019. The deleverage in SG&A expenses was primarily due to:●170 basis points of deleverage primarily due to higher corporate overhead; ●80 basis points of deleverage of store payroll and benefits and variable store expenses due to the impact of lower sales and personal protective equipment and COVID-related expenses; and●30 basis points of deleverage of marketing expenses attributed to the impact of lower sales volume; partially offset by●90 basis points of leverage related to the employee retention credits made available under the CARES Act. ​​35 Table of ContentsImpairment, restructuring and other costs Impairment, restructuring and other costs were $114.3 million for fiscal 2020, which consisted of $41.9 million due to the impairment of tangible long-lived assets and operating lease assets associated with certain retail stores, $29.1 million related to the suspension of the planned expansion to Canada, $27.5 million related to the permanent closure of 19 stores, and $15.8 million of severance charges. All restructuring expenses were recognized in fiscal 2020. There was no impairment, restructuring and other costs in fiscal 2019.​Pre-opening expensesPre-opening expenses decreased $4.3 million, or 22.1%, to $15.0 million in fiscal 2020 compared to $19.3 million in fiscal 2019 due to current year real estate activity and stores expected to open in the first quarter of fiscal 2021. During fiscal 2020, we opened 30 new stores and relocated five stores. During fiscal 2019, we opened 86 new stores, remodeled 12 stores, and relocated eight stores.Interest expense (income), netInterest expense, net was $5.7 million in fiscal 2020 compared to $5.1 million of interest income, net in fiscal 2019. Interest expense represents interest on borrowings and fees related to the credit facility. Interest income results from cash equivalents and short-term investments with maturities of twelve months or less from the date of purchase. We did not have any outstanding borrowings on our credit facility as of January 30, 2021 and February 1, 2020. Income tax expenseIncome tax expense of $55.3 million in fiscal 2020 represents an effective tax rate of 23.9%, compared to fiscal 2019 income tax expense of $200.2 million and an effective tax rate of 22.1%. The higher effective tax rate is primarily due to less investment tax credits received and tax expense from the income tax accounting for stock-based compensation compared to a benefit in fiscal 2019.​Net incomeNet income decreased $530.1 million, or 75.1%, to $175.8 million in fiscal 2020 compared to $705.9 million in fiscal 2019. The decrease in net income was primarily due to a $731.9 million decrease in gross profit and a $114.3 million increase in impairment, restructuring and other costs, partially offset by a $177.6 million decrease in SG&A expenses and $145.0 million decrease in income taxes. Fiscal year 2019 versus fiscal year 2018Net salesNet sales increased $0.7 billion, or 10.1%, to $7.4 billion in fiscal 2019 compared to $6.7 billion in fiscal 2018. The net sales increases are due to the opening of 80 net new stores in 2019, a 5.0% increase in comparable sales, and an increase of $23.4 million in other revenue. The 5.0% comparable sales increase included a 3.3% increase in transactions and a 1.7% increase in average ticket. We attribute the increase in comparable sales to our successful marketing and merchandising strategies. ​​​36 Table of ContentsGross profitGross profit increased $0.3 billion, or 11.3%, to $2.7 billion in fiscal 2019, compared to $2.4 billion in fiscal 2018. Gross profit as a percentage of net sales increased 30 basis points to 36.2% in fiscal 2019 compared to 35.9% in fiscal 2018. The increase in gross profit margin was primarily due to:●50 basis points improvement in merchandise margins driven by our marketing and merchandising strategies and benefits from our Efficiencies for Growth (EFG) initiatives;●20 basis points of leverage in fixed store costs attributed to the impact of higher sales volume, partially offset by;●40 basis points of deleverage due to investments in our salon services and supply chain operation.​Selling, general and administrative expensesSG&A expenses increased $0.2 billion, or 14.7%, to $1.8 billion in fiscal 2019 compared to $1.5 billion in fiscal 2018. As a percentage of net sales, SG&A expenses increased 90 basis points to 23.8% in fiscal 2019 compared to 22.9% in fiscal 2018. The deleverage in SG&A expenses was primarily due to:●80 basis points of deleverage primarily due to strategic investments in future growth opportunities and infrastructure to support our EFG initiatives;●50 basis points of deleverage related to higher payroll and benefit-related expenses, partially offset by;●30 basis points of leverage in lower variable compensation expense; and●10 basis points of leverage in marketing expense attributed to strong sales growth.​Pre-opening expensesPre-opening expenses decreased $0.5 million, or 2.6%, to $19.3 million in fiscal 2019 compared to $19.8 million in fiscal 2018. During fiscal 2019, we opened 86 new stores, remodeled 12 stores, and relocated eight stores. During fiscal 2018, we opened 107 new stores, remodeled 13 stores, and relocated two stores.Interest income, netInterest income, net was $5.1 million in fiscal 2019 and fiscal 2018. Interest income results from cash equivalents and short-term investments with maturities of twelve months or less from the date of purchase. Interest expense represents interest on borrowings and fees related to the credit facility. We did not have any outstanding borrowings on our credit facility as of February 1, 2020 and February 2, 2019. Income tax expenseIncome tax expense of $200.2 million in fiscal 2019 represents an effective tax rate of 22.1%, compared to fiscal 2018 income tax expense of $200.6 million and an effective tax rate of 23.3%. The lower tax rate is primarily due to income tax accounting for stock-based compensation and federal income tax credits.Net incomeNet income increased $47.4 million, or 7.2%, to $705.9 million in fiscal 2019 compared to $658.6 million in fiscal 2018. The increase in net income was primarily due to a $271.8 million increase in gross profit partially offset by a $225.3 million increase in SG&A expenses.37 Table of ContentsLiquidity and capital resourcesOur primary cash needs are for rent, capital expenditures for new, remodeled, and relocated stores, increased merchandise inventories related to store expansion and new brand additions, supply chain improvements, share repurchases, and continued improvement in our information technology systems.Our primary sources of liquidity are cash and cash equivalents, short-term investments, cash flows from operations, including changes in working capital, and borrowings under our credit facility. The most significant components of our working capital are merchandise inventories and cash and cash equivalents reduced by related accounts payable and accrued expenses.Our working capital needs are greatest from August through November each year as a result of our inventory build-up during this period for the approaching holiday season. Based on past performance and current expectations, we believe that cash and cash equivalents, short-term investments, cash generated from operations, and borrowings under the credit facility will satisfy the Company’s working capital needs, capital expenditure needs, commitments, and other liquidity requirements through at least the next twelve months.The following table presents a summary of our cash flows for fiscal years 2020, 2019 and 2018:​​​​​​​​​​​​Fiscal year ended​​January 30,​February 1,​February 2,(In thousands) 2021 2020 2019Net cash provided by operating activities​$ 810,355​$ 1,101,293​$ 956,127Net cash used in investing activities​​ (48,751)​​ (471,480)​​ (215,107)Net cash used in financing activities​​ (107,934)​​ (646,739)​​ (609,214)Effect of exchange rate changes on cash and cash equivalents​​ 56​​ —​​ —Net increase (decrease) in cash and cash equivalents​$ 653,726​$ (16,926)​$ 131,806Operating activitiesOperating activities consist of net income adjusted for certain non-cash items, including depreciation and amortization, non-cash lease expense, long-lived asset impairment charge, deferred income taxes, stock-based compensation expense, realized gains or losses on disposal of property and equipment, and the effect of working capital changes. The fiscal 2020 decrease over fiscal 2019 is mainly due to the decrease in net income, merchandise inventories, and the timing of accounts payable. The decrease in net income was primarily due to a decrease in gross profit resulting from lower sales as a result of the COVID-19 pandemic and an increase in impairment, restructuring and other costs, partially offset by a decrease in SG&A expenses and income taxes. Merchandise inventories, net were $1.2 billion at January 30, 2021, compared to $1.3 billion at February 1, 2020, representing a decrease of $125.5 million or 9.7%. The decrease in total inventory was primarily driven by reduced store inventory due to a decline in store traffic trends, partially offset by an increase due to 10 net new stores opened since February 1, 2020 and the opening of our Jacksonville fast fulfillment center.Investing activitiesWe have historically used cash primarily for new, remodeled, relocated, and refreshed stores, supply chain investments, short-term investments, and investments in information technology systems. Investment activities for capital expenditures were $151.9 million in fiscal 2020 compared to $298.5 million and $319.4 million in fiscal 2019 and 2018, respectively. Capital expenditures decreased in fiscal 2020 compared to fiscal 2019 due to actions we took to preserve liquidity as we navigated through the COVID-19 pandemic. Proceeds of short-term investments were $110.0 million during fiscal 2020 and consist of certificates of deposit with maturities of three to twelve months from the date of purchase. During fiscal 2020, we contributed $5.7 million to equity method investments. 38 Table of ContentsThe following table presents a summary of our store activities in fiscal years 2020, 2019, and 2018: ​​​​​​​​ Fiscal year ended​​January 30, February 1, February 2,​​2021​2020​2019Stores opened​ 30​ 86​ 107Stores remodeled​ –​ 12​ 13Stores relocated​ 5​ 8​ 2Stores refreshed​ –​ 240​ 109​During fiscal 2020, the average investment required to open a new Ulta Beauty store was approximately $1.4 million, which includes capital investment net of landlord contributions, pre-opening expenses, and initial inventory net of payables. Capital expenditures for fiscal 2020, 2019 and 2018 by major category are as follows:​​​​​​​​​​​​​​​Budget​​​​​​​​​​​Fiscal ​Fiscal​Fiscal​Fiscal(In millions) 2021 2020 2019 2018New, Remodeled, and Relocated Stores​$ 79​$ 56​$ 141​$ 154Merchandising and Refreshed Stores​​ 36​​ 14​​ 29​​ 63Information Technology Systems​​ 47​​ 36​​ 54​​ 51Supply Chain​​ 30​​ 13​​ 17​​ 22Store Maintenance and Other​​ 33​​ 33​​ 58​​ 29Total​$225​$152​$ 299​$319​Our future investments will depend primarily on the number of new, remodeled, and relocated stores, information technology systems, and supply chain investments that we undertake and the timing of these expenditures. Based on past performance and current expectations, we believe our sources of liquidity will be sufficient to fund future capital expenditures. Financing activitiesFinancing activities in fiscal 2020, 2019 and 2018 consist principally of borrowing and repayment of our revolving credit facility, share repurchases, and capital stock transactions. Purchases of treasury shares represent the fair value of common shares repurchased from plan participants in connection with shares withheld to satisfy minimum statutory tax obligations upon the vesting of restricted stock.We had no borrowings outstanding under our credit facility at the end of fiscal 2020, 2019 and 2018. At the beginning of the COVID-19 pandemic, we drew down $800.0 million of our $1.0 billion revolving credit facility and suspended our share repurchase program. We repaid the $800.0 million of borrowings on September 2, 2020 and resumed share repurchases in the fourth quarter. The zero outstanding borrowings position continues to be due to a combination of factors including an improvement in sales trends in the second half of the year, overall performance of management initiatives including expense control as well as inventory and other working capital reductions. We may require borrowings under the facility from time to time in future periods for unexpected business disruptions, to support our new store program, share repurchases, and seasonal inventory needs. Share repurchase planOn March 15, 2018, we announced that the Board of Directors authorized a share repurchase program (the 2018 Share Repurchase Program) pursuant to which the Company could repurchase up to $625.0 million of the Company’s common stock. The 2018 Share Repurchase Program authorization revoked the previously authorized but unused amount of $41.3 million from the earlier share repurchase program. The 2018 Share Repurchase Program did not have an expiration date but provided for suspension or discontinuation at any time.39 Table of ContentsOn March 14, 2019, we announced that the Board of Directors authorized a new share repurchase program (the 2019 Share Repurchase Program) pursuant to which the Company could repurchase up to $875.0 million of the Company’s common stock. The 2019 Share Repurchase Program authorization revoked the previously authorized but unused amount of $25.4 million from the 2018 Share Repurchase Program. The 2019 Share Repurchase Program did not have an expiration date but provided for suspension or discontinuation at any time.On March 12, 2020, we announced that the Board of Directors authorized a new share repurchase program (the 2020 Share Repurchase Program) pursuant to which the Company may repurchase up to $1.6 billion of the Company’s common stock. The 2020 Share Repurchase Program authorization revoked the previously authorized but unused amounts of $177.8 million from the 2019 Share Repurchase Program. The 2020 Share Repurchase Program does not have an expiration date and may be suspended or discontinued at any time. On April 2, 2020, we announced that the share repurchase program had been suspended in order to strengthen liquidity and preserve cash while navigating the COVID-19 pandemic. The program resumed during the fourth quarter of fiscal 2020.A summary of the Company’s common stock repurchase activity is presented in the following table:​​​​​​​​​​​​Fiscal year ended​​January 30,​February 1,​February 2,(Dollars in millions) 2021​2020​2019Shares repurchased​​ 474,794​​ 2,320,896​​ 2,463,555Total cost of shares repurchased​$ 114.9​$ 681.0​$ 616.2​​Credit facilityOn March 11, 2020, we entered into Amendment No. 1 to the Second Amended and Restated Loan Agreement (as so amended, the Loan Agreement) with Wells Fargo Bank, National Association, as Administrative Agent, Collateral Agent and a Lender thereunder; Wells Fargo Bank, National Association and JPMorgan Chase Bank, N.A., as Lead Arrangers and Bookrunners; JPMorgan Chase Bank, N.A., as Syndication Agent and a Lender; PNC Bank, National Association, as Documentation Agent and a Lender; and the other lenders party thereto. The Loan Agreement matures on March 11, 2025, provides maximum revolving loans equal to the lesser of $1.0 billion or a percentage of eligible owned inventory and eligible owned receivables (which borrowing base may, at the election of the Company and satisfaction of certain conditions, include a percentage of qualified cash), contains a $50.0 million subfacility for letters of credit and allows the Company to increase the revolving facility by an additional $100.0 million, subject to the consent by each lender and other conditions. The Loan Agreement contains a requirement to maintain a fixed charge coverage ratio of not less than 1.0 to 1.0 during such periods when availability under the Loan Agreement falls below a specified threshold. Substantially all of the Company’s assets are pledged as collateral for outstanding borrowings under the Loan Agreement. Outstanding borrowings bear interest, at the Company’s election, at either a base rate plus a margin of 0% to 0.125% or the London Interbank Offered Rate plus a margin of 1.125% to 1.250%, with such margins based on the Company’s borrowing availability, and the unused line fee is 0.20% per annum.As of January 30, 2021 and February 1, 2020, we had no borrowings outstanding under the credit facility and we were in compliance with all terms and covenants of the Loan Agreement.SeasonalityOur business is subject to seasonal fluctuation. Significant portions of our net sales and profits are realized during the fourth quarter of the fiscal year due to the holiday selling season. To a lesser extent, our business is also affected by Mother’s Day and Valentine’s Day. Any decrease in sales during these higher sales volume periods could have an adverse effect on our business, financial condition, or operating results for the entire fiscal year. Our quarterly results of operations have varied in the past and are likely to do so again in the future. As such, we believe that period-to-period comparisons of our results of operations should not be relied upon as an indication of our future performance.40 Table of ContentsImpact of inflation and changing pricesAlthough we do not believe that inflation has had a material impact on our financial position or results of operations to date, a high rate of inflation in the future may have an adverse effect on our ability to maintain current levels of gross margin and SG&A expenses as a percentage of net sales if the selling prices of our products do not increase with these increased costs. In addition, inflation could materially increase the interest rates on any future debt.Off-balance sheet arrangementsAs of January 30, 2021, we have not entered into any “off-balance sheet” arrangements, as that term is described by the SEC. We do, however, have off-balance sheet purchase obligations incurred in the ordinary course of business as indicated within the contractual obligations table below.Contractual obligationsThe following table summarizes our contractual arrangements and the timing and effect that such commitments are expected to have on our liquidity and cash flows in future periods. The table below includes obligations for executed agreements for which we do not yet have the right to control the use of the property as of January 30, 2021:​​​​​​​​​​​​​​​​​​​​​Less Than ​1 to 3​3 to 5​More than 5(In thousands) Total 1 Year Years Years YearsOperating lease obligations (1)​$ 2,227,650​$ 321,708​$ 683,114​$ 552,688​$ 670,140Purchase obligations ​​ 1,020​​ 1,020​​ —​​ —​​ —Total (2)​$ 2,228,670​$ 322,728​$ 683,114​$ 552,688​$ 670,140(1)These amounts are for our undiscounted lease obligations recorded in our consolidated balance sheets, as operating lease liabilities. Also included are legally binding minimum lease payments for leases signed but not yet commenced of $75,782, which are excluded from operating lease liabilities shown on our consolidated balance sheets. (2)The unrecognized tax benefit of $2.8 million as of January 30, 2021 is excluded due to uncertainty regarding the realization and timing of the related future cash flows, if any.Purchase obligations reflect legally binding agreements entered into by the Company to purchase goods or services. Excluded from our purchase obligations are normal purchases and contracts entered into in the ordinary course of business. The amount of purchase obligations relates to commitments made to third-parties for products and services and other goods and service contracts entered into as of January 30, 2021.Critical accounting policies and estimatesManagement’s discussion and analysis of financial condition and results of operations is based upon our consolidated financial statements, which have been prepared in accordance with U.S. generally accepted accounting principles. The preparation of these financial statements required the use of estimates and judgments that affect the reported amounts of our assets, liabilities, revenues, and expenses. Management bases estimates on historical experience and other assumptions it believes to be reasonable under the circumstances and evaluates these estimates on an on-going basis. Actual results may differ from these estimates. A discussion of our more significant estimates follows. Management has discussed the development, selection, and disclosure of these estimates and assumptions with the Audit Committee of the Board of Directors.Inventory valuationMerchandise inventories are carried at the lower of cost or market (net realizable value). Cost is determined using the moving average cost method and includes costs incurred to purchase and distribute goods as well as related vendor allowances including co-op advertising, markdowns, and volume discounts. We record valuation adjustments to our inventories if the cost of a specific product on hand exceeds the amount we expect to realize from the ultimate sale or 41 Table of Contentsdisposal of the inventory. These estimates are based on management’s judgment regarding future demand, age of inventory, and analysis of historical experience. If actual demand or market conditions are different than those projected by management, future merchandise margin rates may be unfavorably or favorably affected by adjustments to these estimates.Inventories are adjusted for the results of periodic physical inventory counts at each of our locations. We record a shrink reserve representing management’s estimate of inventory losses by location that have occurred since the date of the last physical count. This estimate is based on management’s analysis of historical results and operating trends.We do not believe that there is a reasonable likelihood that there will be a material change in the future estimates or assumptions we use to calculate our inventory reserves. Adjustments to earnings resulting from revisions to management’s estimates of the inventory reserves have been insignificant during fiscal 2020, 2019 and 2018. An increase or decrease in the lower of cost or market (net realizable value) reserve of 10% would not have a material impact on our operating income for fiscal 2020. An increase or decrease in the shrink rate included in the shrink reserve calculation of 10% would not have a material impact on our operating income for fiscal 2020.Vendor allowancesThe majority of cash consideration received from a vendor is considered to be a reduction of the cost of the related products and is reflected in cost of sales in our consolidated statements of operations as the related products are sold unless it is in exchange for an asset or service or a reimbursement of a specific, incremental, identifiable cost incurred by the Company in selling the vendors’ products. We estimate the amount recorded as a reduction of inventory at the end of each period based on a detailed analysis of inventory turns and management’s analysis of the facts and circumstances of the various contractual agreements with vendors. We record cash consideration expected to be received from vendors in receivables. We do not believe there is a reasonable likelihood there will be a material change in the future estimates or assumptions we use to calculate our reduction of inventory. An increase or decrease in inventory turns of five basis points would not have a material impact on our operating income for fiscal 2020.Impairment of long-lived tangible assetsWe review long-lived tangible assets whenever events or circumstances indicate these assets might not be recoverable. Assets are primarily reviewed at the store level, which is the lowest level for which cash flows can be identified. Significant estimates are used in determining future operating results of each store over its remaining lease term. An impairment loss would be recorded if the carrying amount of the long-lived asset exceeds its fair value. We do not believe that there is a reasonable likelihood that there will be a material change in the future estimates or assumptions we use to calculate our impairment charges. During fiscal 2020, we recognized $72.5 million of impairment of long-lived tangible and right-of-use assets which consisted of $41.9 million due to impairment analysis which indicated that the carrying values of certain long-lived assets exceeded their respective fair values, $19.6 million related to the suspension of the planned expansion to Canada, and $11.0 million related to the permanent closure of 19 stores. No significant impairment charges were recognized in fiscal 2019 or fiscal 2018.Loyalty programWe maintain a customer loyalty program, Ultamate Rewards, which allows members to earn points based on purchases of merchandise or services. Points earned are valid for at least one year. The loyalty program represents a material right to the customer and points may be redeemed on future products and services. Revenue from the loyalty program is recognized when the members redeem points or points expire. We defer revenue related to points earned that have not yet been redeemed. The amount of deferred revenue includes estimates for the standalone selling price of points earned by members and the percentage of points expected to be redeemed. The expected redemption percentage is based on historical redemption patterns and considers current information or trends. The estimated redemption rate is evaluated each reporting period. We do not believe that there is a reasonable likelihood there will be a material change in the future estimates or assumptions used to calculate the estimated redemption rate. 42 Table of ContentsAdjustments to earnings resulting from revisions to management’s estimates of the redemption rates have been insignificant during fiscal 2020, 2019 and 2018. An increase or decrease in the estimated redemption rate of 5% would not have a material impact on our operating income in fiscal 2020. ​Income taxes​We are subject to income taxes in the United States. Judgment is required in determining our provision for income taxes and income tax assets and liabilities, including evaluating uncertainties in the application of accounting principles and complex tax laws.​We recognize deferred income taxes for the estimated future tax consequences attributable to temporary differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which temporary differences are anticipated to be recovered or settled. The effect on deferred taxes of a change in income tax rates is recognized in the consolidated statements of operations in the period of enactment. A valuation allowance is recorded to reduce the carrying amounts of deferred tax assets to the amount expected to be realized unless it is more-likely-than-not that such assets will be realized in full. The estimated tax benefit of an uncertain tax position is recorded in our consolidated financial statements only after determining a more-likely-than-not probability that the uncertain tax position will withstand challenge, if any, from applicable taxing authorities. ​Judgment is required in assessing the future tax consequences of events that have been recognized on our consolidated financial statements or tax returns. Variations in the actual outcome of these future tax consequences could materially impact our consolidated financial statements. ​Recent accounting pronouncements not yet adoptedSee Note 2 to our consolidated financial statements, “Summary of significant accounting policies – Recent accounting pronouncements not yet adopted.”Recently adopted accounting pronouncementsSee Note 2 to our consolidated financial statements, “Summary of significant accounting policies – Recently adopted accounting pronouncements.”Item 7A. Quantitative and Qualitative Disclosures about Market RiskMarket risk represents the risk of loss that may impact our financial position due to adverse changes in financial market prices and rates. Our market risk exposure is primarily the result of fluctuations in interest rates and foreign currency exchange rates. We do not hold or issue financial instruments for trading purposes.Interest rate riskWe are exposed to interest rate risks primarily through borrowings under our credit facility. Interest on our borrowings is based upon variable rates. We did not have any outstanding borrowings on our credit facility as of January 30, 2021, February 1, 2020, or February 2, 2019. A hypothetical 1% increase in interest rates on variable rate debt would have increased interest expense for fiscal 2020 by approximately $3.7 million.Foreign currency exchange rate riskWe are exposed to risks from foreign currency exchange rate fluctuations on the translation of our foreign operations into U.S. dollars and on the purchase of goods by these foreign operations that are not denominated in their local currencies. Our exposure to foreign currency rate fluctuations is not material to our financial condition or results of operations.43 Table of Contents
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+Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations. We disclaim any intent or obligation to update or revise any of the forward-looking statements, whether in response to new information, unforeseen events, changed circumstances or otherwise, except as required by applicable law. PART IITEM 1. BUSINESS.OverviewUnited Airlines Holdings, Inc. (together with its consolidated subsidiaries, "UAL" or the "Company") is a holding company and its principal, wholly-owned subsidiary is United Airlines, Inc. (together with its consolidated subsidiaries, "United"). As UAL consolidates United for financial statement purposes, disclosures that relate to activities of United also apply to UAL, unless otherwise noted. United's operating revenues and operating expenses comprise nearly 100% of UAL's revenues and operating expenses. In addition, United comprises approximately the entire balance of UAL's assets, liabilities and operating cash flows. When appropriate, UAL and United are named specifically for their individual contractual obligations and related disclosures and any significant differences between the operations and results of UAL and United are separately disclosed and explained. We sometimes use the words "we," "our," "us," and the "Company" in this report for disclosures that relate to all of UAL and United.The Company's principal executive office is located at 233 South Wacker Drive, Chicago, Illinois 60606 (telephone number (872) 825-4000). The Company's website is located at www.united.com and its investor relations website is located at ir.united.com. The information contained on or connected to the Company's websites is not incorporated by reference into this Annual Report on Form 10-K and should not be considered part of this or any other report filed with the U.S. Securities and Exchange Commission ("SEC"). The Company's filings with the SEC, including annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and all amendments to those reports, as well as UAL's proxy statement for its annual meeting of stockholders, are accessible without charge on the Company's investor relations website, as soon as reasonably practicable, after such material is electronically filed with, or furnished to, the SEC. Such filings are also available on the SEC's website at www.sec.gov. OperationsThe Company transports people and cargo throughout North America and to destinations in Asia, Europe, Africa, the Pacific, the Middle East and Latin America. UAL, through United and its regional carriers, operates across six continents, with hubs at Newark Liberty International Airport ("Newark"), Chicago O'Hare International Airport ("Chicago O'Hare"), Denver International Airport ("Denver"), George Bush Intercontinental Airport ("Houston Bush"), Los Angeles International Airport ("LAX"), A.B. Won Pat International Airport ("Guam"), San Francisco International Airport ("SFO") and Washington Dulles International Airport ("Washington Dulles"). All of the Company's domestic hubs are located in large business and population centers, contributing to a large amount of "origin and destination" traffic. The hub and spoke system allows us to transport passengers between a large number of destinations with substantially more frequent service than if each route were served directly. The hub system also allows us to add service to a new destination from a large number of cities using only one or a limited number of aircraft. As discussed under Alliances below, United is a member of Star Alliance, the world's largest alliance network.The Company began experiencing a significant decline in passenger demand related to the novel coronavirus (COVID-19) during the first quarter of 2020. The full extent of the ongoing impact of COVID-19 on the Company's longer-term operational and financial performance will depend on future developments, including those outside our control related to the efficacy and speed of vaccination programs in curbing the spread of the virus, the introduction and spread of new variants of the virus which may be resistant to currently approved vaccines, passenger testing requirements, mask mandates or other restrictions on travel, all of which are highly uncertain and cannot be predicted with certainty. In response to decreased demand, the Company cut, relative to 2019 capacity, approximately 57% of its scheduled capacity for 2020. In the first quarter of 2021, the Company expects scheduled capacity to be down at least 51% versus the first quarter of 2019. The Company plans to continue to proactively evaluate and cancel flights on a rolling 60-day basis until it sees signs of a recovery in demand and expects demand to remain suppressed, relative to 2019 levels, until vaccines for COVID-19 are widely distributed and are effective in curbing 3Table of Contentsthe spread of the virus. In addition, the Company does not currently expect the recovery from COVID-19 to follow a linear path. As such, the Company's actual flown capacity may differ materially from its currently scheduled capacity.Regional. The Company has contractual relationships with various regional carriers to provide regional aircraft service branded as United Express. This regional service complements our operations by carrying traffic that connects to our hubs and allows flights to smaller cities that cannot be provided economically with mainline aircraft. Champlain Enterprises, LLC d/b/a CommutAir ("CommutAir"), Republic Airline Inc. ("Republic"), GoJet Airlines LLC ("GoJet"), Mesa Airlines, Inc. ("Mesa"), SkyWest Airlines, Inc. ("SkyWest"), and Air Wisconsin Airlines LLC ("Air Wisconsin") are all regional carriers that operate with capacity contracted to United under capacity purchase agreements ("CPAs"). Under these CPAs, the Company pays the regional carriers contractually agreed fees (carrier costs) for operating these flights plus a variable rate adjustment based on agreed performance metrics, subject to annual adjustments. The fees are based on specific rates multiplied by specific operating statistics (e.g., block hours, departures), as well as fixed monthly amounts. Under these CPAs, the Company is also responsible for all fuel costs incurred, as well as landing fees and other costs, which are either passed through by the regional carrier to the Company without any markup or directly incurred by the Company. In some cases, the Company owns some or all of the aircraft subject to the CPA and leases such aircraft to the regional carrier. In return, the regional carriers operate the capacity of the aircraft included within the scope of such CPA exclusively for United, on schedules determined by the Company. The Company also determines pricing and revenue management, assumes the inventory and distribution risk for the available seats and permits mileage accrual and redemption for regional flights through its MileagePlus loyalty program. The significant decline in demand for air travel services resulting from the COVID-19 pandemic has also materially impacted demand for regional carrier services and, as a result, the Company's utilization of its regional network is significantly reduced and is expected to remain so for the foreseeable future. As a result, we may face claims that we failed to perform certain obligations under our agreements with our regional carriers and may incur damages. Additionally, in July 2020, the Company announced its plans to consolidate its Embraer 145 ("E145") operations into a single regional partner, CommutAir. As a result, the Company terminated its CPA with ExpressJet Airlines, LLC, a domestic regional airline ("ExpressJet"). ExpressJet flew its last commercial flight, on behalf of United, on September 30, 2020. Additionally, United transferred all of its E145 operations over to CommutAir as United's sole regional partner for this aircraft type. We expect the disruption to services resulting from the COVID-19 pandemic to continue to adversely affect our regional carriers, some of which may declare bankruptcy or otherwise cease to operate.Alliances. United is a member of Star Alliance, a global integrated airline network and the largest and most comprehensive airline alliance in the world. Despite the global challenges posed by the COVID-19 pandemic, Star Alliance carriers continued to serve nearly 1,000 airports in 154 countries with close to 10,000 daily departures as of January 1, 2021. Star Alliance members, in addition to United, are Aegean Airlines, Air Canada, Air China, Air India, Air New Zealand, All Nippon Airways ("ANA"), Asiana Airlines, Austrian Airlines, Aerovías del Continente Americano S.A. ("Avianca"), Brussels Airlines, Copa Airlines ("Copa"), Croatia Airlines, EGYPTAIR, Ethiopian Airlines, EVA Air, LOT Polish Airlines, Lufthansa, SAS Scandinavian Airlines, Shenzhen Airlines, Singapore Airlines, South African Airways, SWISS, TAP Air Portugal, THAI Airways International and Turkish Airlines. In addition to its members, Star Alliance includes Shanghai-based Juneyao Airlines and Thailand-based Thai Smile Airways, a subsidiary of THAI Airways International, as connecting partners.United has a variety of bilateral commercial alliance agreements and obligations with Star Alliance members, addressing, among other things, reciprocal earning and redemption of frequent flyer miles, access to airport lounges and, with certain Star Alliance members, codesharing of flight operations (whereby one carrier's selected flights can be marketed under the brand name of another carrier). In addition to the alliance agreements with Star Alliance members, United currently maintains independent marketing alliance agreements with other air carriers, including Aeromar, Aer Lingus, Air Dolomiti, Azul Linhas Aéreas Brasileiras S.A. ("Azul"), Boutique Air, Cape Air, Edelweiss, Eurowings, Hawaiian Airlines, Olympic Air, Silver Airways and Vistara. United also participates in four passenger joint business arrangements ("JBAs"): one with Air Canada and the Lufthansa Group (which includes Lufthansa and its affiliates Austrian Airlines, Brussels Airlines, Eurowings and SWISS) covering transatlantic routes, one with ANA covering certain transpacific routes, one with Air New Zealand covering certain routes between the United States and New Zealand and one with Avianca and Copa, which, upon regulatory approval, will cover routes between the United States and Central and South America, excluding Brazil. These passenger JBAs enable the participating carriers to integrate the services they provide in the respective regions, capturing revenue synergies and delivering enhanced customer benefits, such as highly competitive flight schedules, fares and services. Separate from the passenger JBAs, United also participates in cargo JBAs with ANA for transpacific cargo services and with Lufthansa for transatlantic cargo services. These cargo JBAs offer expanded and more seamless access to cargo space across the carriers' respective combined networks.Loyalty Program. United's MileagePlus loyalty program builds customer loyalty by offering awards, benefits and services to program participants. Members in this program earn miles for flights on United, United Express, Star Alliance members and certain other airlines that participate in the program. Members can also earn miles by purchasing goods and services from our 4Table of Contentsnetwork of non-airline partners, such as domestic and international credit card issuers, retail merchants, hotels and car rental companies. Members can redeem miles for free (other than taxes and government-imposed fees), discounted or upgraded travel and non-travel awards.United has an agreement with JPMorgan Chase Bank, N.A. ("Chase"), pursuant to which members of United's MileagePlus loyalty program who are residents of the United States can earn miles for making purchases using a MileagePlus credit card issued by Chase (the "Co-Brand Agreement"). The Co-Brand Agreement also provides for joint marketing and other support for the MileagePlus credit card and provides Chase with other benefits such as permission to market to the Company's customer database.In 2020, approximately 1.9 million MileagePlus flight awards were used on United and United Express. These awards represented 6.2% of United's total revenue passenger miles. Total miles redeemed for flights on United and United Express, including class-of-service upgrades, represented approximately 80% of the total miles redeemed. In addition, excluding miles redeemed for flights on United and United Express, MileagePlus members redeemed miles for approximately 0.8 million other awards. These awards include United Club memberships, car and hotel awards, merchandise and flights on other air carriers. Redemptions in 2020 were adversely impacted by the COVID-19 pandemic. In response to the impact of COVID-19, the Company made changes to its MileagePlus® Premier® program that will make it easier to earn status in 2021 for the 2022 program year. United will again have reduced Premier Qualifying Points ("PQP") and Premier Qualifying Flights ("PQF") thresholds in 2021 and will have innovative promotions that help members earn status more quickly. Early in 2021, United deposited 25% of the PQP-only requirements in Premier members' accounts based on their 2021 Premier status level. Premier members will earn double the PQP on each of the first three PQP-eligible trips completed January 1 through March 31, 2021 (up to 1,500 PQP per trip), helping their flights go further toward reaching status.Aircraft Fuel. The table below summarizes the fuel consumption and expense of UAL's aircraft (including the operations of our regional partners operating under CPAs) during the last three years. YearGallons Consumed(in millions)Fuel Expense(in millions)Average Price Per GallonPercentage of Total Operating Expense20202,004 $3,153 $1.57 15 %20194,292 $8,953 $2.09 23 %20184,137 $9,307 $2.25 24 %Our operational and financial results can be significantly impacted by changes in the price and availability of aircraft fuel. To provide adequate supplies of fuel, the Company routinely enters into purchase contracts that are customarily indexed to market prices for aircraft fuel, and the Company generally has some ability to cover short-term fuel supply and infrastructure disruptions at certain major demand locations. The price of aircraft fuel has fluctuated substantially in the past several years. The Company's current strategy is to not enter into transactions to hedge its fuel consumption, although the Company regularly reviews its strategy based on market conditions and other factors.Third-Party Business. United generates third-party business revenue that includes maintenance services, catering, frequent flyer award non-travel redemptions and ground handling. Third-party business revenue is recorded in Other operating revenue. Expenses associated with third-party business, except non-travel redemptions, are recorded in Other operating expenses. Non-travel redemptions expenses are recorded to Other operating revenue. Air Cargo. United provides freight and mail services (air cargo). The majority of cargo services are provided to commercial businesses, freight forwarder firms and the United States Postal Service. Through our global network, our cargo operations are able to connect the world's major freight gateways. We generate cargo revenues in domestic and international markets through the use of cargo space on regularly scheduled passenger aircraft, and starting in 2020, cargo-only flights. Distribution Channels. The Company's airline seat inventory and fares are distributed through the Company's direct channels, traditional travel agencies and on-line travel agencies. The use of the Company's direct sales website, www.united.com, the Company's mobile applications and alternative distribution systems provides the Company with an opportunity to de-commoditize its services, better present its content, make more targeted offerings, better retain its customers, enhance its brand and lower its ticket distribution costs. Agency sales are primarily sold using global distribution systems ("GDS"). United has developed and expects to continue to develop capabilities to sell certain ancillary products through the GDS channel to provide an enhanced buying experience for customers who purchase in that channel. 5Table of ContentsIndustry ConditionsCOVID-19. The COVID-19 pandemic, together with the measures implemented or recommended by governmental authorities and private organizations in response to the pandemic, has had an adverse impact that has been material to the airline industry. Measures such as "shelter in place" or quarantine requirements, international and domestic travel restrictions or advisories, limitations on public gatherings, social distancing recommendations, remote work arrangements and closures of tourist destinations and attractions, as well as consumer perceptions of the safety, ease and predictability of air travel, have contributed to a precipitous decline in passenger demand and bookings for both business and leisure travel. The full extent of the ongoing impact of COVID-19 on the Company's longer-term operational and financial performance will depend on future developments, including those outside our control related to the efficacy and speed of vaccination programs in curbing the spread of the virus, the introduction and spread of new variants of the virus which may be resistant to currently approved vaccines, passenger testing requirements, mask mandates or other restrictions on travel, all of which are highly uncertain and cannot be predicted with certainty. Effective August 30, 2020, United permanently eliminated change fees on all standard Economy and Premium cabin tickets for travel within the 50 U.S. states, Washington, D.C., Puerto Rico and the U.S. Virgin Islands. Also, in December 2020, the Company eliminated change fees on flights from the U.S. to all international destinations and fees on Basic Economy and all other international travel tickets issued by March 31, 2021. In addition, effective January 1, 2021, United began allowing passengers to standby for free on a flight departing the day of their travel regardless of the type of ticket or class of service, while MileagePlus Premier members can confirm a seat on a different flight on the same day with the same departure and arrival cities as their original ticket if a seat in the same ticket fare class is available.Domestic Competition. The domestic airline industry is highly competitive and dynamic. The Company's competitors consist primarily of other airlines and, to a certain extent, other forms of transportation. Currently, any U.S. carrier deemed fit by the U.S. Department of Transportation (the "DOT") is largely free to operate scheduled passenger service between any two points within the United States. Competition can be direct, in the form of another carrier flying the exact non-stop route, or indirect, where a carrier serves the same two cities non-stop from an alternative airport in that city or via an itinerary requiring a connection at another airport. Air carriers' cost structures are not uniform and are influenced by numerous factors. Carriers with lower costs may offer lower fares to passengers, which could have a potential negative impact on the Company's revenues. Domestic pricing decisions are impacted by intense competitive pressure exerted on the Company by other U.S. airlines. In order to remain competitive and maintain passenger traffic levels, we often find it necessary to match competitors' discounted fares. Since we compete in a dynamic marketplace, attempts to generate additional revenue through increased fares often fail.International Competition. Internationally, the Company competes not only with U.S. airlines, but also with foreign carriers. International competition has increased and may continue to increase in the future as a result of airline mergers and acquisitions, JBAs, alliances, restructurings, liberalization of aviation bilateral agreements and new or increased service by competitors, including government-subsidized competitors from certain Middle East countries. Competition on international routes is subject to varying degrees of governmental regulation. The Company's ability to compete successfully with non-U.S. carriers on international routes depends in part on its ability to generate traffic to and from the entire United States via its integrated domestic route network and its ability to overcome business and operational challenges across its network worldwide. Foreign carriers currently are prohibited by U.S. law from carrying local passengers between two points in the United States and the Company generally experiences comparable restrictions in foreign countries. Separately, "fifth freedom rights" allow the Company to operate between points in two different foreign countries and foreign carriers may also have fifth freedom rights between the U.S. and another foreign country. In the absence of fifth freedom rights, or some other extra-bilateral right to conduct operations between two foreign countries, U.S. carriers are constrained from carrying passengers to points beyond designated international gateway cities. To compensate partially for these structural limitations, U.S. and foreign carriers have entered into alliances, immunized JBAs and marketing arrangements that enable these carriers to exchange traffic between each other's flights and route networks. Through these arrangements, the Company strives to provide consumers with a growing number of seamless, cost-effective and convenient travel options. See Alliances, above, for additional information.Seasonality. The air travel business is subject to seasonal fluctuations. Historically, demand for air travel is higher in the second and third quarters, driving higher revenues, than in the first and fourth quarters, which are periods of lower travel demand.Industry RegulationAirlines are subject to extensive domestic and international regulatory oversight. The following discussion summarizes the principal elements of the regulatory framework applicable to our business. Regulatory requirements, including but not limited to those discussed below, affect our operations and increase our operating costs, and future regulatory developments may continue to do the same in the future. In addition, should any of our governmental authorizations or certificates be modified, suspended or revoked, our business and competitive position could be materially adversely affected. See Part I, Item 1A. Risk 6Table of ContentsFactors—"The airline industry is subject to extensive government regulation, which imposes significant costs and may adversely impact our business, operating results and financial condition" for additional information on the material effects of compliance with government regulations. Domestic Regulation. All carriers engaged in air transportation in the United States are subject to regulation by the DOT. Absent an exemption, no air carrier may provide air transportation of passengers or property without first being issued a DOT certificate of public convenience and necessity. The DOT also grants international route authority, approves international codeshare arrangements and regulates methods of competition. The DOT regulates consumer protection and maintains jurisdiction over advertising, denied boarding compensation, tarmac delays, baggage liability and other areas and may add additional expensive regulatory burdens in the future. The DOT has launched investigations or claimed rulemaking authority to regulate commercial agreements among carriers or between carriers and third parties in a wide variety of contexts. Airlines are also regulated by the Federal Aviation Administration (the "FAA"), an agency within the DOT, primarily in the areas of flight safety, air carrier operations and aircraft maintenance and airworthiness. The FAA issues air carrier operating certificates and aircraft airworthiness certificates, prescribes maintenance procedures, oversees airport operations, and regulates pilot and other employee training. From time to time, the FAA issues directives that require air carriers to inspect, modify or ground aircraft and other equipment, potentially causing the Company to incur substantial, unplanned expenses. The airline industry is also subject to numerous other federal laws and regulations. The U.S. Department of Homeland Security ("DHS") has jurisdiction over virtually every aspect of civil aviation security. The Antitrust Division of the U.S. Department of Justice ("DOJ") has jurisdiction over certain airline competition matters. The U.S. Postal Service has authority over certain aspects of the transportation of mail by airlines. Labor relations in the airline industry are generally governed by the Railway Labor Act ("RLA"), a federal statute. The Company is also subject to investigation inquiries by the DOT, FAA, DOJ, DHS, the U.S. Food and Drug Administration ("FDA"), the U.S. Department of Agriculture ("USDA"), Centers for Disease Control and Prevention ("CDC"), U.S. Occupational Safety and Health Administration ("OSHA"), and other U.S. and international regulatory bodies.Airport Access. Access to landing and take-off rights, or "slots," at several major U.S. airports served by the Company are subject to government regulation. Federally-mandated domestic slot restrictions that limit operations and regulate capacity currently apply at three airports: Reagan National Airport in Washington, D.C. ("Reagan National"), and John F. Kennedy International Airport and LaGuardia Airport ("LaGuardia") in the New York City metropolitan region. Additional restrictions on takeoff and landing slots at these and other airports may be implemented in the future and could affect the Company's rights of ownership and transfer as well as its operations.Legislation. The airline industry is subject to legislative actions (or inactions) that may have an impact on operations and costs. In 2018, the U.S. Congress approved a five-year reauthorization for the FAA, which encompasses significant aviation tax and policy-related issues. The law includes a range of policy changes related to airline customer service and aviation safety. Implementation of some items continues into the new Administration and, depending on how they are implemented, could impact our operations and costs. U.S. Congressional action in response to the COVID-19 pandemic has provided funding for U.S. airlines, in both grants and loans. The U.S. Congress has imposed limited conditions on airlines accepting funding, including workforce retention and minimum service requirements. With the change in control of the U.S. Congress and a new presidential administration, any future funding or other pandemic relief could include additional requirements that could impact our operations and costs. Additionally, the U.S. Congress may consider legislation related to environmental issues or increases to the U.S. federal corporate income tax rate, which could impact the Company and the airline industry. Catering Operations. The Company owns and operates catering kitchens at airports in Denver, Cleveland, Newark, Houston, and Honolulu, which prepare ready-to-eat food for United flights. Some of the Company's kitchens also prepare ready-to-eat food for other domestic and international airlines. The Company's onboard food service operations are subject to FDA regulation through its interstate conveyance sanitation regulations, and the Company's catering operations are subject to regulation by the FDA and the USDA, as well as other federal, state, and local regulatory agencies. In particular, the FDA enforces the Federal Food Safety Modernization Act which requires all food manufacturers, including ready-to-eat catering operations, to implement stringent risk-based preventive controls. As a result, the Company's catering and food service operations are periodically subject to inspections and enforcement by regulatory agencies.International Regulation. International air transportation is subject to extensive government regulation. In connection with the Company's international services, the Company is regulated by both the U.S. government and the governments of the foreign countries the Company serves. In addition, the availability of international routes to U.S. carriers is regulated by aviation agreements between the U.S. and foreign governments, and in some cases, fares and schedules require the approval of the DOT and/or the relevant foreign governments.Legislation. Foreign countries are increasingly enacting passenger protection laws, rules and regulations that meet or exceed U.S. requirements. In cases where this activity exceeds U.S. requirements, additional burden and liability may be placed on the 7Table of ContentsCompany. Certain countries have regulations requiring passenger compensation and/or enforcement penalties from the Company in addition to changes in operating procedures due to canceled and delayed flights.Airport Access. Historically, access to foreign markets has been tightly controlled through bilateral agreements between the U.S. and each foreign country involved. These agreements regulate the markets served, the number of carriers allowed to serve each market and the frequency of carriers' flights. Since the early 1990s, the U.S. has pursued a policy of "Open Skies" (meaning all U.S.-flag carriers have access to the destination), under which the U.S. government has negotiated a number of bilateral agreements allowing unrestricted access between U.S. and foreign markets. Currently, there are more than 100 Open Skies agreements in effect. However, even with Open Skies, many of the airports that the Company serves in Europe, Asia and Latin America maintain slot controls. A large number of these slot controls exist due to congestion, environmental and noise protection and reduced capacity due to runway and air traffic control ("ATC") construction work, among other reasons. London Heathrow International Airport, Frankfurt Rhein-Main Airport, Shanghai Pudong International Airport, Beijing Capital International Airport, Sao Paulo Guarulhos International Airport and Tokyo Haneda International Airport are among the most restrictive foreign airports due to slot and capacity limitations.The Company's ability to serve some foreign markets and expand into certain others is limited by the absence of aviation agreements between the U.S. government and the relevant foreign governments. Shifts in U.S. or foreign government aviation policies may lead to the alteration or termination of air service agreements. Depending on the nature of any such change, the value of the Company's international route authorities and slot rights may be materially enhanced or diminished. Similarly, foreign governments control their airspace and can restrict our ability to overfly their territory, enhancing or diminishing the value of the Company's existing international route authorities and slot rights.The COVID-19 pandemic has caused most governments to restrict entry to foreign nationals (with some exceptions) and to impose multiple health management rules which can include COVID-19 testing, quarantine upon arrival, health declarations, and temperature screens, among others. Such requirements may result in reduced demand for travel and cause the Company to suspend service to some foreign markets. Certain foreign governments have granted waivers for limited periods that allow the Company to maintain existing slot rights and route authorizations while not operating at a particular foreign point. The airline industry is advocating for the continuation of such waivers until the operating and demand environment return to normal, but future waivers are not guaranteed. Environmental Regulation. The airline industry is subject to increasingly stringent federal, state, local and international environmental requirements, including those regulating emissions to air, water discharges, safe drinking water and the use and management of hazardous substances and wastes.Climate Change. There is an increasing global regulatory focus on greenhouse gas ("GHG") emissions and their potential impacts relating to climate change. An initiative to regulate GHG emissions from aviation known as the European Union ("EU") Emission Trading System ("ETS") was adopted in 2009, but applicability to flights arriving at or departing from airports outside the EU has been postponed several times. In December 2017, the European Parliament voted to extend exemptions for extra-EU flights until December 2023 in order to align the extension date with the completion of the pilot phase of the International Civil Aviation Organization's ("ICAO") Carbon Offsetting and Reduction Scheme for International Aviation ("CORSIA"). CORSIA, which was adopted in October 2016, is intended to create a single global market-based measure to achieve carbon-neutral growth for international aviation, which can be achieved through airline purchases of eligible carbon offset credits and the use of eligible sustainable fuels. The unprecedented nature of the COVID-19 pandemic prompted ICAO to include only 2019 emissions (as opposed to the originally planned average of 2019-20 emissions) as the baseline upon which offsetting obligations would be calculated for the pilot phase (2021-23) of the scheme; the applicable baseline for the subsequent phases of the scheme, however, is still uncertain. The European Parliament is expected to assess CORSIA implementation and re-assess the applicability of EU ETS to international aviation in 2024, at which point the EU could require all extra- and intra-EU flights to participate in EU ETS. Certain CORSIA program aspects could potentially be affected by the results of the pilot phase of the program, and thus the impact of CORSIA cannot be fully predicted. However, CORSIA is expected to increase operating costs for the Company, depending on a number of factors, including the number of its flights that are subject to CORSIA, the fuel efficiency of the Company's fleet, the Company's purchase and use of CORSIA-eligible sustainable fuels, aviation sector growth, the price of CORSIA-eligible offsets and the applicable baseline year(s) applied to future phases of the program. In 2017, ICAO also adopted a carbon dioxide ("CO2") emission standard for aircraft. In December 2020, the U.S. Environmental Protection Agency ("EPA") adopted its own aircraft and aircraft engine GHG emissions standards, which are aligned with the 2017 ICAO airplane CO2 emission standards. While United endeavors to comply with all applicable environmental regulations, United's Eco-Skies commitment to becoming a more environmentally sustainable company extends beyond seeking to comply with regulatory requirements. 8Table of ContentsWe have made a series of tangible commitments and actions to help reduce our carbon emission footprint, including the following:•In 2015, we invested $30 million in Fulcrum BioEnergy, a sustainable aviation fuel ("SAF") producer that converts trash to low-carbon jet fuel.•In 2016, we became the first airline globally to use SAF in regular operations on a continuous basis and, as of December 31, 2020, based on publicly announced commitments, have purchased more SAF than any other U.S. commercial airline.•In 2018, we became the first U.S. airline to establish a climate goal of reducing our emissions 50% by 2050 versus our 2005 baseline.• In 2020:◦We pledged to become 100% green by reducing our GHG emissions by 100% by 2050—without relying on voluntary carbon offsets.◦We became the first airline to announce a commitment to invest in Direct Air Capture technology through 1PointFive, a joint venture between Oxy Low Carbon Ventures and Rusheen Capital.◦The Carbon Disclosure Project ("CDP") named United as the only airline globally to its climate 'A List' for the Company's actions to cut emissions, mitigate climate risks and develop the low-carbon economy, marking the seventh consecutive year that United had the highest CDP score among U.S. airlines.•In the first quarter of 2021, United entered into an agreement to work with, and to invest in, air mobility company Archer Aviation Inc. on the development of electric vertical takeoff and landing (eVTOL) aircraft that have the potential for future use as an 'air taxi' in urban markets. Additional information regarding United's Eco-Skies program and our pledge to become 100% green by reducing GHG emissions by 100% by 2050, can be found on our website at united.com/100green. The information contained on or connected to the Company's website is not incorporated by reference into this Annual Report on Form 10-K and should not be considered part of this or any other report filed with the SEC. Other Regulations. Our operations are subject to a variety of other environmental laws and regulations both in the United States and internationally. These include noise-related restrictions on aircraft types and operating times and state and local air quality initiatives which have resulted, or could in the future result in curtailments in services, increased operating costs, limits on expansion, or further emission reduction requirements. Certain airports and/or governments, both domestically and internationally, either have established or are seeking to establish environmental fees and other requirements applicable to carbon emissions, local air quality pollutants and/or noise. The implementation of these requirements is expected to result in restrictions on mobile sources of air pollutants such as cars, trucks and airport ground support equipment in corresponding locations. Various states have passed legislation restricting the use of Class B fire-fighting foam agents that contain intentionally added per- and polyfluoroalkyl substances ("PFAS"), which are expected to require the Company to incur costs to convert existing fixed foam fire suppression systems to accommodate PFAS-free firefighting foam agents. Finally, environmental cleanup laws could require the Company to undertake or subject the Company to liability for investigation and remediation costs at certain owned or leased locations or third-party disposal locations.Until the applicability of new regulations to our specific operations is better defined and/or until pending regulations are finalized, future costs to comply with such regulations will remain uncertain but are likely to increase our operating costs over time. While we continue to monitor these developments, the precise nature of future requirements and their applicability to the Company are difficult to predict, but the financial impact to the Company and the aviation industry could be significant. Human CapitalAs of December 31, 2020, UAL, including its subsidiaries, had approximately 74,400 employees, not including furloughed employees who were recalled in connection with the Payroll Support Program extension under Subtitle A of Title IV of Division N of the Consolidated Appropriations Act, 2021 (the "PSP Extension Law"). Approximately 84% of the Company's employees were represented by various U.S. labor organizations. The Company believes engaged and empowered employees are important for the success of its mission. The Company's focus areas for employee engagement and retention include, but are not limited to: Workplace Safety. At United, safety is first in everything we do and is our first core4 service standard (Safe, Caring, Dependable and Efficient). We have implemented policies and training programs, as well as performed self-audits designed to ensure our employees are safe every day. United has onsite clinic locations in certain of its hubs that provide services to active employees including, but not limited to, occupational injury, Company-directed exams, acute care for personal illness, pre-9Table of Contentsemployment exams, travel immunizations and OSHA audiometric testing. For all other locations, United has partnered with third-party clinics to provide such services. United has a Drug Abatement organization that has implemented programs aimed at supporting United's goal of maintaining a drug- and alcohol-free workplace. Additionally, since the start of the COVID-19 pandemic, the Company has actively implemented additional safety measures in compliance with CDC guidelines and we actively follow their recommendations.Talent and Pay. At United, we take great pride in the unique opportunity that we have to create and support the kind of careers that are increasingly hard to find in the 21st century American economy. There are thousands of jobs at United that do not require a four-year college degree and also provide significant schedule flexibility. For example our flight attendants and ramp agents have significant flexibility in their work schedules and, as they gain seniority, have the opportunity to earn up to six-figures in total annual compensation and benefits. There are thousands of additional specialized roles at United, like technicians and pilots, with even higher wage scales. Each of these jobs comes with a full suite of employment benefits including a retirement plan, life insurance, health insurance, free travel and more. These employees also enjoy valuable protections negotiated by U.S. labor organizations.Culture. Having an engaged and proud work force is important to the success of our business. We undertake a confidential employee survey that provides us with point-in-time insights multiple times a year. We use the employee feedback to better understand the employee experience and assess progress made on achieving our goal of making United the best place to work.Diversity, Equity and Inclusion. United is committed to creating a workplace where all employees feel included and empowered to make a measurable difference in our success. United offers policies, programs, benefits and recognition designed to reward and support the success of our diverse workforce. To help advance United's goals for diversity, equity and inclusion, the airline supports seven employee-run business resource groups with over 8,000 participants. Each group — LGBTQ+, Multi-cultural, People with Disabilities, Veterans, Women, Black/African American and Next Generation — helps increase awareness and understanding of cultural issues and opportunities for employees, while nurturing United's diverse talent, enriching the airline's organizational culture and contributing to Company performance. In 2020 and for the fifth consecutive year, United was recognized as a top-scoring company and best place to work for disability inclusion with a perfect score of 100 on the 2020 Disability Equality Index (DEI). In February, 2021, United received a perfect score of 100%, for the tenth consecutive year, on the Human Rights Campaign Foundation's 2021 Corporate Equality Index (CEI). The scorecard is a benchmarking report on corporate policies and practices related to LGBTQ workplace equality. The perfect score places United on the prestigious 2021 list of "Best Places to Work for LGBTQ Equality."Additionally, we announced in January that we have achieved near perfect gender and pay equity for our U.S.-based population and, to promote greater transparency, have shared our gender and racial/ethnic representation for our workforce with our employees. We remain committed to continuing to share this information as we continue our journey towards great diversity, equity and inclusion throughout our organization.Health Benefits: COVID-19 Impacts. United offers a variety of medical plans and options, including vision, dental, long-term disability and life insurance. At United, physical, emotional and financial wellness are top priorities. In 2020, United implemented new benefits and enhanced preexisting benefits to assist employees during the COVID-19 pandemic. These included enhanced telemedicine offerings to all employees, contact tracing, modified absence management practices and additional mental health programs and resources. Collective Bargaining Agreements. Collective bargaining agreements between the Company and its represented employee groups are negotiated under the RLA. Such agreements typically do not contain an expiration date and instead specify an amendable date, upon which the agreement is considered "open for amendment." 10Table of ContentsThe following table reflects the Company's represented employee groups, the number of employees per represented group, union representation for each employee group, and the amendable date for each employee group's collective bargaining agreement as of December 31, 2020: Employee GroupNumber of EmployeesUnionAgreement Open for AmendmentFlight Attendants 16,507 Association of Flight Attendants (the "AFA")August 2021Pilots11,840 ALPAJanuary 2019Fleet Service11,383 International Association of Machinists and Aerospace Workers (the "IAM")December 2021Passenger Service9,272 IAMDecember 2021Technicians6,630 IBTDecember 2022Passenger Service - United Ground Express, Inc. 3,427 IAMMarch 2025Catering1,941 UNITE HEREN/AStorekeepers653 IAMDecember 2021Dispatchers 249 Professional Airline Flight Control AssociationDecember 2021Fleet Tech Instructors112 IAMDecember 2021Load Planners41 IAMDecember 2021Security Officers45 IAMDecember 2021Maintenance Instructors36 IAMDecember 2021Information about Our Executive OfficersKate Gebo. Age 52. Ms. Gebo has served as Executive Vice President Human Resources and Labor Relations of UAL and United since December 2017. From November 2016 to November 2017, Ms. Gebo served as Senior Vice President, Global Customer Service Delivery and Chief Customer Officer of United. From October 2015 to November 2016, Ms. Gebo served as Vice President of the Office of the Chief Executive Officer. From November 2009 to October 2015, Ms. Gebo served as Vice President of Corporate Real Estate of United.Brett J. Hart. Age 51. Mr. Hart has served as President of UAL and United since May 2020. From March 2019 to May 2020, he served as Executive Vice President and Chief Administrative Officer of UAL and United. From May 2017 to March 2019, he served as Executive Vice President, Chief Administrative Officer and General Counsel of UAL and United. From February 2012 to May 2017, he served as Executive Vice President and General Counsel of UAL and United. Mr. Hart served as acting Chief Executive Officer and principal executive officer of the Company, on an interim basis, from October 2015 to March 2016. From December 2010 to February 2012, he served as Senior Vice President, General Counsel and Secretary of UAL, United and Continental Airlines, Inc. ("Continental"). From June 2009 to December 2010, Mr. Hart served as Executive Vice President, General Counsel and Corporate Secretary at Sara Lee Corporation, a consumer food and beverage company. From March 2005 to May 2009, Mr. Hart served as Deputy General Counsel and Chief Global Compliance Officer of Sara Lee Corporation.Linda P. Jojo. Age 55. Ms. Jojo has served as Executive Vice President Technology and Chief Digital Officer of UAL and United since May 2017. From November 2014 to May 2017, Ms. Jojo served as Executive Vice President and Chief Information Officer of UAL and United. From July 2011 to October 2014, Ms. Jojo served as Executive Vice President and Chief Information Officer of Rogers Communications, Inc., a Canadian communications and media company. From October 2008 to June 2011, Ms. Jojo served as Chief Information Officer of Energy Future Holdings, a Dallas-based privately held energy company and electrical utility provider. Chris Kenny. Age 56. Mr. Kenny has served as Vice President and Controller of UAL and United since October 2010. From September 2003 to September 2010, Mr. Kenny served as Vice President and Controller of Continental. Mr. Kenny joined Continental in 1997.J. Scott Kirby. Age 53. Mr. Kirby has served as Chief Executive Officer of UAL and United since May 2020. Mr. Kirby served as President of UAL and United from August 2016 to May 2020. Prior to joining the Company, from December 2013 to August 2016, Mr. Kirby served as President of American Airlines Group and American Airlines, Inc. Mr. Kirby also previously served as President of US Airways from October 2006 to December 2013. Mr. Kirby held significant other leadership roles at US Airways and at America West prior to the 2005 merger of those carriers, including Executive Vice President—Sales and Marketing (2001 to 2006); Senior Vice President, e-business (2000 to 2001); Vice President, Revenue Management (1998 to 11Table of Contents2000); Vice President, Planning (1997 to 1998); and Senior Director, Scheduling and Planning (1995 to 1998). Prior to joining America West, Mr. Kirby worked for American Airlines Decision Technologies and at the Pentagon.Gerald Laderman. Age 63. Mr. Laderman has served as Executive Vice President and Chief Financial Officer since August 2018. Mr. Laderman served as Senior Vice President Finance, Procurement and Treasurer for UAL and United from 2013 to August 2015, and again from August 2016 to May 2018. Mr. Laderman additionally was acting Chief Financial Officer from August 2015 to August 2016 and from May 2018 to August 2018. Mr. Laderman served as Senior Vice President Finance and Treasurer for the Company from 2010 to 2013. From 2001 to 2010, Mr. Laderman served as Senior Vice President of Finance and Treasurer for Continental. Mr. Laderman joined Continental in 1988 as senior director legal affairs, finance and aircraft programs.Oscar Munoz. Age 62. Mr. Munoz has served as Executive Chairman of the Board of Directors of UAL since May 2020. Mr. Munoz served as Chief Executive Officer of UAL and United from September 2015 to May 2020, and also as President of UAL and United from September 2015 until August 2016. From February 2015 to September 2015, Mr. Munoz served as President and Chief Operating Officer of CSX Corporation ("CSX"), a railroad and intermodal transportation services company, overseeing operations, sales and marketing, human resources, service design and information technology. Prior to his appointment as President and Chief Operating Officer of CSX, Mr. Munoz served as Executive Vice President and Chief Operating Officer of CSX from January 2012 to February 2015 and as Executive Vice President and Chief Financial Officer of CSX from 2003 to 2012. Mr. Munoz has been a member of the UAL Board of Directors since 2010.Andrew Nocella. Age 51. Mr. Nocella has served as Executive Vice President and Chief Commercial Officer of UAL and United since September 2017. From February 2017 to September 2017, he served as Executive Vice President and Chief Revenue Officer of UAL and United. Prior to joining the Company, from August 2016 to February 2017, Mr. Nocella served as Senior Vice President, Alliances and Sales of American Airlines, Inc. From December 2013 to August 2016, he served as Senior Vice President and Chief Marketing Officer of American Airlines, Inc. From August 2007 to December 2013, he served as Senior Vice President, Marketing and Planning of US Airways.Jonathan Roitman. Age 55. Mr. Roitman has served as Executive Vice President and Chief Operations Officer of UAL and United since September 2020. Mr. Roitman served as Senior Vice President and Chief Operations Officer of the Company from June 2020 to September 2020. Mr. Roitman served as Senior Vice President Airport and Network Operations of United from November 2019 to May 2020. From August 2018 to November 2019, Mr. Roitman served as Senior Vice President Airport and Catering Operations, and from January 2015 to August 2018, he served as Senior Vice President Airport Operations of United. From December 1997 through January 2015, Mr. Roitman held positions of increasing responsibility at United and at Continental prior to its merger with the Company, including as Senior Vice President Operations and Cargo, Vice President, Newark Hub, and Vice President, Cleveland Hub. Prior to joining Continental in December 1997, Mr. Roitman was the manager of business development for BWAB Incorporated, a real estate development and oil and gas production firm, and served in the U.S. Army.12Table of ContentsITEM 1A. RISK FACTORS. The following risk factors should be read carefully when evaluating the Company's business and the forward-looking statements contained in this report and other statements the Company or its representatives make from time to time. Any of the following risks could materially and adversely affect the Company's business, operating results, financial condition and the actual outcome of matters as to which forward-looking statements are made in this report. Risks not currently known to the Company or that the Company currently deems to be immaterial may also materially and adversely affect the Company's business, operating results, financial condition and the actual outcome of matters as to which forward-looking statements are made in this report.Risk Factor SummaryThe following is a summary of the principal risks that could adversely affect, or have adversely affected, the Company's business, operating results and financial condition:•The adverse impacts of the ongoing COVID-19 global pandemic, and possible outbreaks of another disease or similar public health threat in the future, on our business, operating results, financial condition, liquidity and near-term and long-term strategic operating plan, including possible additional adverse impacts resulting from the duration and spread of the pandemic;•Unfavorable economic and political conditions in the United States and globally;•The highly competitive nature of the global airline industry and susceptibility of the industry to price discounting and changes in capacity;•High and/or volatile fuel prices or significant disruptions in the supply of aircraft fuel;•Our reliance on technology and automated systems to operate our business and the impact of any significant failure or disruption of, or failure to effectively integrate and implement, the technology or systems;•Our reliance on third-party service providers and the impact of any failure of these parties to perform as expected, or interruptions in our relationships with these providers or their provision of services;•Adverse publicity, harm to our brand, reduced travel demand and potential tort liability as a result of an accident, catastrophe or incident involving us, our regional carriers, our codeshare partners, or another airline;•Terrorist attacks, international hostilities or other security events, or the fear of terrorist attacks or hostilities, even if not made directly on the airline industry;•Increasing privacy and data security obligations or a significant data breach;•Disruptions to our regional network and United Express flights provided by third-party regional carriers;•The failure of our significant investments in other airlines, including AVH and its affiliates, and the commercial relationships that we have with those carriers, to produce the returns or results we expect;•Further changes to the airline industry with respect to alliances and JBAs or due to consolidations;•Changes in our network strategy or other factors outside our control resulting in less economic aircraft orders, costs related to modification or termination of aircraft orders or entry into less favorable aircraft orders;•Our reliance on single suppliers to source a majority of our aircraft and certain parts, and the impact of any failure to obtain timely deliveries, additional equipment or support from any of these suppliers;•The impacts of union disputes, employee strikes or slowdowns, and other labor-related disruptions on our operations;•Extended interruptions or disruptions in service at major airports where we operate;•The impacts of the United Kingdom's withdrawal from the EU on our operations in the United Kingdom and elsewhere;•The impacts of seasonality and other factors associated with the airline industry;•Our failure to realize the full value of our intangible assets or our long-lived assets, causing us to record impairments;•Any damage to our reputation or brand image;•The limitation of our ability to use our net operating loss carryforwards and certain other tax attributes to offset future taxable income for U.S. federal income tax purposes;•The costs of compliance with extensive government regulation of the airline industry;•Costs, liabilities and risks associated with environmental regulation and climate change;•Continued restrictions on the use of our Boeing 737 MAX aircraft and our inability to accept or integrate new aircraft into our fleet as planned;•The impacts of our significant amount of financial leverage from fixed obligations, the possibility we may seek material amounts of additional financial liquidity in the short-term and insufficient liquidity on our financial condition and business;13Table of Contents•Failure to comply with the covenants in the MileagePlus Financing agreements, resulting in the possible acceleration of the MileagePlus indebtedness, foreclosure upon the collateral securing the MileagePlus indebtedness or the exercise of other remedies;•Failure to comply with financial and other covenants governing our other debt;•Changes in, or failure to retain, our senior management team or other key employees;•Current or future litigation and regulatory actions, or failure to comply with the terms of any settlement, order or arrangement relating to these actions; and•Increases in insurance costs or inadequate insurance coverage.For a more complete discussion of the material risks facing the Company's business, see below.Risks Relating to COVID-19The global pandemic resulting from a novel strain of coronavirus has had an adverse impact that has been material to the Company's business, operating results, financial condition and liquidity, and the duration and spread of the pandemic could result in additional adverse impacts. The outbreak of another disease or similar public health threat in the future could also have an adverse effect on the Company's business, operating results, financial condition and liquidity.The novel coronavirus (COVID-19) pandemic, together with the measures implemented or recommended by governmental authorities and private organizations in response to the pandemic, has had an adverse impact that has been material to the Company's business, operating results, financial condition and liquidity. Measures such as "shelter in place" or quarantine requirements, international and domestic travel restrictions or advisories, limitations on public gatherings, social distancing recommendations, remote work arrangements and closures of tourist destinations and attractions, as well as consumer perceptions of the safety, ease and predictability of air travel, have contributed to a precipitous decline in passenger demand and bookings for both business and leisure travel.The Company began experiencing a significant decline in international and domestic demand related to COVID-19 during the first quarter of 2020. The decline in demand caused a material deterioration in our revenues in 2020, resulting in a net loss of $7.1 billion. The full extent of the ongoing impact of COVID-19 on the Company's longer-term operational and financial performance will depend on future developments, including those outside our control related to the efficacy and speed of vaccination programs in curbing the spread of the virus, the introduction and spread of new variants of the virus which may be resistant to currently approved vaccines, passenger testing requirements, mask mandates or other restrictions on travel, all of which are highly uncertain and cannot be predicted with certainty. In response to decreased demand, the Company cut, relative to 2019 capacity, approximately 57% of its scheduled capacity for 2020. In the first quarter of 2021, the Company expects scheduled capacity to be down at least 51% versus the first quarter of 2019. The Company plans to continue to proactively evaluate and cancel flights on a rolling 60-day basis until it sees signs of a recovery in demand and expects demand to remain suppressed, relative to 2019 levels, until vaccines for COVID-19 are widely distributed and are effective in curbing the spread of the virus. In addition, the Company does not currently expect the recovery from COVID-19 to follow a linear path. As such, the Company's actual flown capacity may differ materially from its currently scheduled capacity.The Company has taken a number of actions in response to the decreased demand for air travel. In addition to the schedule reductions discussed above, the Company reduced its planned capital expenditures and reduced operating expenditures for 2020, terminated its share repurchase program, issued or entered into approximately $13.4 billion in secured notes, secured facilities and new aircraft financings, raised approximately $2.1 billion in cash proceeds from the issuance and sale of UAL common stock, borrowed $1.0 billion under the $2.0 billion revolving credit facility, entered into an agreement to finance certain aircraft currently subject to purchase agreements through sale and leaseback transactions, deferred $199 million in payroll taxes incurred through December 31, 2020, as provided by the CARES Act, until December 2021, at which time 50% is due, with the remaining amount due December 2022, temporarily grounded certain of its mainline fleet, implemented strategic workforce reductions and took a number of other actions to reduce employee-related costs. In addition, in connection with the Payroll Support Program under the CARES Act, United entered into Payroll Support Program agreements with the U.S. Treasury Department ("Treasury") that provided the Company with total funding of approximately $7.7 billion to pay the salaries and benefits of employees through March 31, 2021. The Company also entered into a term loan facility of up to approximately $7.5 billion (the "Term Loan Facility") pursuant to the loan program established under Section 4003(b) of the CARES Act (the "Loan Program"), and on September 28, 2020, United borrowed $520 million under the Term Loan Facility. The grants and loans under the CARES Act subject the Company and its business to certain restrictions, including, but not limited to, restrictions on the payment of dividends and the ability to repurchase UAL's equity securities, requirements to maintain certain levels of scheduled service, requirements to recall certain furloughed employees and maintain U.S. employment levels through March 31, 2021 and certain limitations on executive compensation. These restrictions and requirements have materially affected and will continue to materially affect the Company's operations, and the Company may not be successful in managing these impacts for the duration of the restrictions. In particular, limitations on executive 14Table of Contentscompensation, which, depending on the form of aid, could extend up to six years, may impact the Company's ability to attract and retain senior management or attract other key employees during this critical time.The full extent of the ongoing impact of COVID-19 on the Company's longer-term operational and financial performance and liquidity position will depend on future developments, including the effectiveness of the mitigation strategies discussed above in offsetting decreased demand, the duration and spread of COVID-19 and related travel advisories and restrictions, the impact of COVID-19 on overall long-term domestic and international demand for air travel, including the impact on overall demand for business travel as a result of increased usage of teleconferencing and other technologies, the impact of COVID-19 on the financial health and operations of the Company's business partners and future governmental actions, including whether applicable governmental authorities will continue to grant waivers of usage requirements for certain of the Company's slots, routes and gates or will require passenger testing for domestic U.S. travel. All of these future developments are highly uncertain and cannot be predicted with certainty. The COVID-19 pandemic has had a material impact on the Company, and the continuation of reduced demand could have a material adverse effect on the Company's business, operating results, financial condition and liquidity.In addition, an outbreak of another disease or similar public health threat, or fear of such an event, that affects travel demand, travel behavior or travel restrictions could have a material adverse impact on the Company's business, financial condition and operating results. Outbreaks of other diseases could also result in increased government restrictions and regulation, such as those actions described above or otherwise, which could adversely affect our operations.COVID-19 has materially disrupted our strategic operating plans in the near-term, and there are risks to our business, operating results and financial condition associated with executing our strategic operating plans in the long-term.COVID-19 has materially disrupted our strategic operating plans in the near-term, and there are risks to our business, operating results and financial condition associated with executing our strategic operating plans in the long-term. In recent years, we have announced several strategic operating plans, including several revenue-generating initiatives and plans to optimize our revenue, such as our plans to add capacity, including international expansion and new or increased service to mid-size airports, initiatives and plans to optimize and control our costs and opportunities to enhance our segmentation and improve the customer experience at all points in air travel. In developing our strategic operating plans, we make certain assumptions, including, but not limited to, those related to customer demand, competition, market consolidation, the availability of aircraft and the global economy. Actual economic, market and other conditions have been and may continue to be different from our assumptions. Most significantly in 2020, the precipitous decline in demand for air travel required us to cut, rather than grow, capacity and materially and adversely impacted our ability to execute our strategic operating plans. If we do not successfully execute or adjust our strategic operating plans in the long-term, or if actual results continue to vary significantly from our prior assumptions or vary significantly from our future assumptions, our business, operating results and financial condition could be materially and adversely impacted.Risks Relating to Our Business and Industry Unfavorable economic and political conditions, in the United States and globally, may have a material adverse effect on our business, operating results and financial condition.The Company's business and operating results are significantly impacted by U.S. and global economic and political conditions. The airline industry is highly cyclical, and the level of demand for air travel is correlated to the strength of the U.S. and global economies. Robust demand for the Company's air transportation services depends largely on favorable economic conditions, including the strength of the domestic and foreign economies, low unemployment levels, strong consumer confidence levels and the availability of consumer and business credit. Air transportation is often a discretionary purchase that leisure travelers may limit or eliminate during difficult economic times. Short-haul travelers, in particular, have the option to replace air travel with surface travel. In addition, during periods of unfavorable economic conditions, business travelers historically have reduced the volume of their travel, either due to cost-saving initiatives, the replacement of travel with alternatives such as videoconferencing, or as a result of decreased business activity requiring travel. During such periods, the Company's business and operating results may be adversely affected due to significant declines in industry passenger demand, particularly with respect to the Company's business and premium cabin travelers, and a reduction in fare levels.As a global business with operations outside of the United States from which it derives significant operating revenues, volatile conditions in certain international regions may have a negative impact on the Company's operating results and its ability to achieve its business objectives. The Company's international operations are a vital part of its worldwide airline network. Political disruptions and instability in certain regions can negatively impact the demand and network availability for air travel. Additionally, any deterioration in global trade relations, such as increased tariffs or other trade barriers, could result in a decrease in the demand for international air travel.15Table of ContentsStagnant or weakening global economic conditions either in the United States or in other geographic regions may have a material adverse effect on the Company's revenues, operating results and liquidity. The global airline industry is highly competitive and susceptible to price discounting and changes in capacity, which could have a material adverse effect on our business, operating results and financial condition. The airline industry is highly competitive, marked by significant competition with respect to routes, fares, schedules (both timing and frequency), services, products, customer service and frequent flyer programs. Consolidation in the airline industry, the rise of well-funded government sponsored international carriers, changes in international alliances and the creation of immunized JBAs have altered and are expected to continue to alter the competitive landscape in the industry, resulting in the formation of airlines and alliances with increased financial resources, more extensive global networks and services and competitive cost structures.Airlines also compete by increasing or decreasing their capacity, including route systems and the number of destinations served. Several of the Company's domestic and international competitors have increased their international capacity by including service to some destinations that the Company currently serves, causing overlap in destinations served, and therefore, increasing competition for those destinations. This increased competition in both domestic and international markets may have a material adverse effect on the Company's business, operating results and financial condition.The Company's U.S. operations are subject to competition from traditional network carriers, national point-to-point carriers, and discount carriers, including low-cost carriers and ultra-low-cost carriers. Such carriers may have lower costs and provide service at lower fares to destinations also served by the Company. The significant presence of low-cost carriers and ultra-low-cost carriers, which engage in substantial price discounting, may diminish our ability to achieve sustained profitability on domestic and international routes. This level of discounted pricing has also caused us to reduce fares for certain routes, resulting in lower yields on many domestic markets. Our ability to compete in the domestic market effectively depends, in part, on our ability to maintain a competitive cost structure. If we cannot maintain our costs at a competitive level, then our business, operating results and financial condition could continue to be materially and adversely affected. In addition, our competitors have established new routes and destinations, including some at our hub airports, in light of the expansion opportunities presented by the COVID-19 pandemic, which may compete with our existing routes and destinations and expansion plans. Our international operations are subject to competition from both foreign and domestic carriers. Competition is significant from government subsidized competitors from certain Middle East countries. These carriers have large numbers of international widebody aircraft on order and are increasing service to the U.S. from their hubs in the Middle East. The government support provided to these carriers has allowed them to grow quickly, reinvest in their product, invest in other airlines and expand their global presence. We also face competition from foreign carriers operating under "fifth freedom" rights permitted under international treaties that allow certain carriers to provide service to and from stopover points between their home country and ultimate destination, including points in the United States, in competition with service provided by us.Through alliance and other marketing and codesharing agreements with foreign carriers, U.S. carriers have increased their ability to sell international transportation, such as services to and beyond traditional global gateway cities. Similarly, foreign carriers have obtained increased access to interior U.S. passenger traffic beyond traditional U.S. gateway cities through these relationships. In addition, several JBAs among U.S. and foreign carriers have received grants of antitrust immunity allowing the participating carriers to coordinate schedules, pricing, sales and inventory. If we are not able to continue participating in these types of alliance and other marketing and codesharing agreements in the future, our business, operating results and financial condition could be materially and adversely affected.Our MileagePlus frequent flyer program benefits from the attractiveness and competitiveness of United Airlines as a material purchaser of award miles, and the majority recipient for mileage redemption. If we are not able to maintain a competitive and attractive airline business, our ability to acquire, engage and retain customers in the loyalty program may be adversely affected, which could adversely affect the loyalty program's operating results and financial condition.Further our MileagePlus frequent flyer program also faces significant and increasing direct competition from the frequent flyer programs offered by other airlines, as well as from similar loyalty programs offered by banks and other financial services companies. Competition among loyalty programs is intense regarding customer acquisition incentives, the value and utility of program currency, rewards range and value, fees, required usage, and other terms and conditions of these programs. If we are not able to maintain a competitive frequent flyer program, our ability to attract and retain customers to MileagePlus and United alike may be adversely affected, which could adversely affect our enterprise operating results and financial condition.16Table of ContentsHigh and/or volatile fuel prices or significant disruptions in the supply of aircraft fuel could have a material adverse impact on the Company's strategic plans, operating results, financial condition and liquidity.Aircraft fuel is critical to the Company's operations and is one of our largest operating expenses. During the year ended December 31, 2020, the Company's fuel expense was approximately $3.2 billion. The timely and adequate supply of fuel to meet operational demand depends on the continued availability of reliable fuel supply sources, as well as related service and delivery infrastructure. Although the Company has some ability to cover short-term fuel supply and infrastructure disruptions at some major demand locations, it depends significantly on the continued performance of its vendors and service providers to maintain supply integrity. Consequently, the Company can neither predict nor guarantee the continued timely availability of aircraft fuel throughout the Company's system. Aircraft fuel has historically been the Company's most volatile operating expense due to the highly unpredictable nature of market prices for fuel. The Company generally sources fuel at prevailing market prices. Market prices for aircraft fuel have historically fluctuated substantially in short periods of time and continue to be highly volatile due to a dependence on a multitude of unpredictable factors beyond the Company's control. These factors include changes in global crude oil prices, the balance between aircraft fuel supply and demand, natural disasters, prevailing inventory levels and fuel production and transportation infrastructure. Prices of fuel are also impacted by indirect factors, such as geopolitical events, economic growth indicators, fiscal/monetary policies, fuel tax policies, changes in regulations, environmental concerns and financial investments in energy markets. Both actual changes in these factors, as well as changes in related market expectations, can potentially drive rapid changes in fuel prices in short periods of time.Given the highly competitive nature of the airline industry, the Company may not be able to increase its fares and fees sufficiently to offset the full impact of increases in fuel prices, especially if these increases are significant, rapid and sustained. Further, any such fare or fee increase may not be sustainable, may reduce the general demand for air travel and may also eventually impact the Company's strategic growth and investment plans for the future. In addition, decreases in fuel prices for an extended period of time may result in increased industry capacity, increased competitive actions for market share and lower fares or surcharges. If fuel prices were to then subsequently rise quickly, there may be a lag between the rise in fuel prices and any improvement of the revenue environment.To protect against increases in the market prices of fuel, the Company may hedge a portion of its future fuel requirements. The Company does not currently hedge its future fuel requirements. However, to the extent the Company decides to start a hedging program, such hedging program may not be successful in mitigating higher fuel costs, and any price protection provided may be limited due to the choice of hedging instruments and market conditions, including breakdown of correlation between hedging instrument and market price of aircraft fuel and failure of hedge counterparties. To the extent that the Company decides to hedge a portion of its future fuel requirements and uses hedge contracts that have the potential to create an obligation to pay upon settlement if fuel prices decline significantly, such hedge contracts may limit the Company's ability to benefit fully from lower fuel prices in the future. If fuel prices decline significantly from the levels existing at the time the Company enters into a hedge contract, the Company may be required to post collateral (margin) beyond certain thresholds. There can be no assurance that the Company's hedging arrangements, if any, will provide any particular level of protection against rises in fuel prices or that its counterparties will be able to perform under the Company's hedging arrangements. Additionally, deterioration in the Company's financial condition could negatively affect its ability to enter into new hedge contracts in the future.The Company relies heavily on technology and automated systems to operate its business and any significant failure or disruption of, or failure to effectively integrate and implement, the technology or these systems could materially harm its business.The Company depends on automated systems and technology to operate its business, including, but not limited to, computerized airline reservation systems, electronic tickets, electronic airport kiosks, demand prediction software, flight operations systems, in-flight wireless internet, cloud-based technologies, revenue management systems, accounting systems, technical and business operations systems, telecommunication systems and commercial websites and applications, including www.united.com and the United Airlines app. United's website and other automated systems must be able to accommodate a high volume of traffic, maintain secure information and deliver important flight and schedule information, as well as process critical financial transactions. These systems could suffer substantial or repeated disruptions due to various events, some of which are beyond the Company's control, including natural disasters, power failures, terrorist attacks, equipment or software failures or cyber security attacks. We have initiatives in place to prevent disruptions and disaster recovery plans, and we continue to invest in improvements to these initiatives and plans; however, these measures may not be adequate to prevent or mitigate disruptions. Substantial or repeated systems failures or disruptions, including failures or disruptions related to the Company's complex integration of systems, could reduce the attractiveness of the Company's services versus those of its competitors, materially impair its ability to market its services and operate its flights, result in the unauthorized release of 17Table of Contentsconfidential or otherwise protected information, result in increased costs, lost revenue and the loss or compromise of important data, and may adversely affect the Company's business, operating results and financial condition. The Company may also face challenges in integrating, implementing and modifying the automated systems and technology required to operate its business. As a result of the complexity of such automated systems and technology, the integration, implementation and modification process may require significant expenditures, human resources, the development of effective internal controls and the transformation of business and financial processes. If the Company is unable to timely or effectively integrate, implement or modify its systems and technology, the Company's operations could be adversely affected.The Company's business relies extensively on third-party service providers, including certain technology providers. Failure of these parties to perform as expected, or interruptions in the Company's relationships with these providers or their provision of services to the Company, could have a material adverse effect on the Company's business, operating results and financial condition.The Company has engaged third-party service providers to perform a large number of functions that are integral to its business, including regional operations, operation of customer service call centers, distribution and sale of airline seat inventory, provision of information technology infrastructure and services, transmitting or uploading of data, provision of aircraft maintenance and repairs, provision of various utilities and performance of airport ground services, aircraft fueling operations and catering services, among other vital functions and services. The Company does not directly control these third-party service providers, although generally it does enter into agreements that define expected service performance and compliance requirements, such as compliance with legal requirements, including anti-corruption laws; however, there can be no assurance that our third-party service providers will adhere to these requirements. Any of these third-party service providers, however, may materially fail to meet its service performance commitments to the Company or may suffer disruptions to its systems that could impact its services. For example, failures in certain third-party technology or communications systems may cause flight delays or cancellations. The failure of any of the Company's third-party service providers to perform its service obligations adequately, or other interruptions of services, may reduce the Company's revenues and increase its expenses, prevent the Company from operating its flights and providing other services to its customers or result in adverse publicity or harm to our brand. We may also be subject to consequences from any illegal conduct of our third-party service providers, including for their failure to comply with anti-corruption laws, such as the U.S. Foreign Corrupt Practices Act. In addition, the Company's business and financial performance could be materially harmed if its customers believe that its services are unreliable or unsatisfactory. The Company may also have disagreements with such providers or such contracts may be terminated or may not be extended or renewed. For example, the number of flight reservations booked through third-party GDSs or online travel agents ("OTAs") may be adversely affected by disruptions in the business relationships between the Company and these suppliers. Such disruptions, including a failure to agree upon acceptable contract terms when contracts expire or otherwise become subject to renegotiation, may cause the Company's flight information to be limited or unavailable for display by the affected GDS or OTA operator, significantly increase fees for both the Company and GDS/OTA users and impair the Company's relationships with its customers and travel agencies. Any such disruptions or contract terminations may adversely impact our operations and financial results. If we are not able to negotiate or renew agreements with third-party service providers, or if we renew existing agreements on less favorable terms, our operations and financial results may be adversely affected.The Company could experience adverse publicity, harm to its brand, reduced travel demand, potential tort liability and voluntary or mandatory operational restrictions as a result of an accident, catastrophe or incident involving its aircraft or its operations, the aircraft or operations of its regional carriers, the aircraft or operations of its codeshare partners, or the aircraft or operations of another airline, which may result in a material adverse effect on the Company's business, operating results and financial condition.An accident, catastrophe or incident involving an aircraft that the Company operates, or an aircraft that is operated by a codeshare partner, one of the Company's regional carriers or another airline, or an incident involving the Company's operations, or the operations of a codeshare partner, one of the Company's regional carriers or of another airline, could have a material adverse effect on the Company if such accident, catastrophe or incident created a public perception that the Company's operations, or the operations of its codeshare partners or regional carriers, are not safe or reliable, or are less safe or reliable than other airlines. Additionally, any accident, catastrophe or incident involving an aircraft type that is operated by the Company, its codeshare partners or regional carriers could have a material adverse effect on the Company if such accident, catastrophe or incident creates a public perception that such aircraft type was not safe or reliable. Further, any such accident, catastrophe or incident involving the Company, its regional carriers or its codeshare partners could expose the Company to 18Table of Contentssignificant tort liability. Although the Company currently maintains liability insurance in amounts and of the type the Company believes to be consistent with industry practice to cover damages arising from any such accident, catastrophe or incident, and the Company's codeshare partners and regional carriers carry similar insurance and generally indemnify the Company for their operations, if the Company's liability exceeds the applicable policy limits or the ability of another carrier to indemnify it, the Company could incur substantial losses from an accident, catastrophe or incident which may result in a material adverse effect on the Company's operating results and financial condition. In addition, any such accident, catastrophe or incident involving the Company, its regional carriers or its codeshare partners could result in operational restrictions on the Company, including voluntary or mandatory groundings of aircraft. For example, the Company decided to voluntarily ground its Boeing 777 aircraft following certain mechanical failures, and the resulting public perceptions of the safety of our operations and the reliability of Boeing 777 aircraft could adversely affect our business. A prolonged period of time operating a reduced fleet in these circumstances could result in a material adverse effect on the Company's operating results and financial condition.In addition, the outbreak and spread of the COVID-19 pandemic have adversely impacted customer perceptions of the health and safety of travel and these negative perceptions could continue even after the pandemic subsides. Actual or perceived risk of infection on our flights, at airports and during other travel-related activities has had, and may continue to have, a material adverse effect on the public's perception of us, which has harmed, and may continue to harm, our reputation and business. We have incurred, and expect that we will continue to incur, COVID-19- related costs as we sanitize aircraft, implement additional hygiene-related protocols and take other actions to limit the threat of infection among our employees and passengers and combat negative customer perceptions of the health and safety of travel on our aircraft and at our terminals. Negative public perceptions could, in turn, result in adverse publicity for the Company, cause harm to the Company's brand and reduce travel demand on the Company's flights, or the flights of its codeshare partners or regional carriers. Terrorist attacks, international hostilities or other security events, or the fear of terrorist attacks or hostilities, even if not made directly on the airline industry, could negatively affect the Company and the airline industry.Terrorist attacks or international hostilities, even if not made on or targeted directly at the airline industry, or the fear of or the precautions taken in anticipation of such attacks (including elevated national threat warnings, travel restrictions, selective cancellation or redirection of flights and new security regulations) could materially and adversely affect the Company and the airline industry. Security events pose a significant risk to our passenger and cargo operations. These events could include acts of violence in public areas that we cannot control. The Company's financial resources may not be sufficient to absorb the adverse effects of any future terrorist attacks, international hostilities or other security events. Any such events could have a material adverse impact on the Company's financial condition, liquidity and operating results. In addition, due to threats against the aviation industry, the Company has incurred, and may continue to incur, significant expenditures to comply with security-related requirements to mitigate the threats and ensure the safety of our employees and customers. With the need to implement proper security measures, and the need to ensure the efficacy and efficiency of security inspection throughput to support the pace of our operations, it is unlikely that we will be able to capture all security-related costs through increased fares, which could adversely affect our operating results. Increasing privacy and data security obligations or a significant data breach may adversely affect the Company's business. In our regular business operations, we collect, process, store and transmit to commercial partners sensitive data, including personal information of our customers and employees such as payment processing information and information of our business partners. The Company depends on the ability to use information we collect to provide our services and operate our business.The Company must manage increasing legislative, regulatory and consumer focus on privacy issues and data security in a variety of jurisdictions across the globe. For example, the EU's General Data Protection Regulation imposes significant privacy and data security requirements, as well as potential for substantial penalties for non-compliance that have resulted in substantial adverse financial consequences to non-compliant companies. Also, some of the Company's commercial partners, such as credit card companies, have imposed data security standards that the Company must meet. These standards continue to evolve. The Company will continue its efforts to meet its privacy and data security obligations; however, it is possible that certain new obligations or customer expectations may be difficult to meet and could require changes in the Company's operating processes and increase the Company's costs. Additionally, the Company must manage evolving cybersecurity risks. Our network, systems and storage applications, and those systems and applications maintained by our third-party commercial partners (such as credit card companies and international airline partners), may be subject to attempts to gain unauthorized access, breach, malfeasance or other system disruptions. In some cases, it is difficult to anticipate or to detect immediately such incidents and the damage caused thereby. In addition, as attacks by cybercriminals become more sophisticated, frequent and intense, the costs of proactive defense measures may increase. Furthermore, the Company's remote work arrangements make it more vulnerable to targeted activity from 19Table of Contentscybercriminals and significantly increase the risk of cyber-attacks or other security breaches. While we continually work to safeguard our internal network, systems and applications, including through risk assessments, system monitoring, cybersecurity and data protection security policies, processes and technologies and employee awareness and training, and require third-party security standards, there is no assurance that such actions will be sufficient to prevent cyber-attacks or data breaches. The loss, disclosure, misappropriation of or access to sensitive Company information, customers', employees' or business partners' information or the Company's failure to meet its obligations could result in legal claims or proceedings, penalties and remediation costs. A significant data breach or the Company's failure to meet its obligations may adversely affect the Company's operations, reputation, relationships with our business partners, business, operating results and financial condition.Disruptions to our regional network and United Express flights provided by third-party regional carriers could adversely affect our business, operating results and financial condition.The Company has contractual relationships with various regional carriers to provide regional aircraft service branded as United Express. These regional operations are an extension of the Company's mainline network and complement the Company's operations by carrying traffic that connects to mainline service and allows flights to smaller cities that cannot be provided economically with mainline aircraft. The Company's business and operations are dependent on its regional flight network, with regional capacity accounting for approximately 14.6% of the Company's total capacity for the year ended December 31, 2020.Although the Company has agreements with its regional carriers that include contractually agreed performance metrics, each regional carrier is a separately certificated commercial air carrier, and the Company does not control the operations of these carriers. A number of factors may impact the Company's regional network, including weather-related effects and seasonality. The significant decline in demand for air travel services resulting from the COVID-19 pandemic has also materially impacted demand for regional carrier services and, as a result, the Company's utilization of its regional network is significantly reduced and is expected to remain so for the foreseeable future. As a result, we may face claims that we failed to perform certain obligations under our agreements with our regional carriers and may incur damages. We expect the disruption to services resulting from the COVID-19 pandemic to continue to adversely affect our regional carriers, some of which may declare bankruptcy or otherwise cease to operate.In addition, the decrease in qualified pilots driven by changes to federal regulations has adversely impacted and could continue to affect the Company's regional flying. For example, the FAA's expansion of minimum pilot qualification standards, including a requirement that a pilot have at least 1,500 total flight hours, as well as the FAA's revised pilot flight and duty time requirements under Part 117 of the Federal Aviation Regulations, have contributed to a smaller supply of pilots available to regional carriers. The decrease in qualified pilots resulting from the regulations as well as factors including a decreased student pilot population and a shrinking U.S. military from which to hire qualified pilots, could adversely impact the Company's operations and financial condition, and could also require the Company to reduce regional carrier flying.If, as a result of the COVID-19 pandemic, the pilot shortage or another significant disruption to our regional network, one or more of the regional carriers with which the Company has relationships is unable to perform its obligations over an extended period of time, there could be a material adverse effect on the Company's business, operating results and financial condition. In addition, although our need for regional carrier services is materially lower than in prior years, we may be obligated to make minimum payments under one or more of our contracts with our regional providers that are in excess of the cost of the services we currently require from them.Our significant investments in other airlines, including in other parts of the world, and the commercial relationships that we have with those carriers may not produce the returns or results we expect.An important part of our strategy to expand our global network has included making significant investments in airlines both domestically and in other parts of the world and expanding our commercial relationships with these carriers. For example, in January 2019, we completed the acquisition of a 49.9% interest in ManaAir LLC ("ManaAir"), which, as of immediately following the closing of that investment, owns 100% of the equity interests in ExpressJet. We also have minority equity interests in CommutAir and Republic Airways Holdings Inc. See Note 9 to the financial statements included in Part II, Item 8 of this report for additional information regarding our investments in regional airlines. We also have significant investments in Latin American airlines, including significant investments in Avianca Holdings, S.A. ("AVH") and BRW Aviation LLC ("BRW"), an affiliate of Synergy Aerospace Corporation and the majority shareholder of AVH, and an equity investment in Azul Linhas Aéreas Brasileiras S.A. ("Azul"). In the future, our regional and global business strategy could include entering into JBAs, commercial agreements and strategic alliances with other carriers, and possibly making loan transactions with, and non-controlling investments in, such carriers.20Table of ContentsThese transactions and relationships involve significant challenges and risks, and we face competition in forming and maintaining these relationships, since there are a limited number of potential arrangements and other airlines are looking to enter into similar relationships. We are dependent on these other carriers for significant aspects of our network in the regions in which they operate. While we work closely with these carriers, each is a separately certificated commercial air carrier, and we do not have control over their operations, strategy, management or business methods. And not only are these airlines subject to a number of the same risks as our business, which are described elsewhere in this Part I, Item 1A. Risk Factors, including the impact of the COVID-19 pandemic, competitive pressures on pricing, demand and capacity, changes in aircraft fuel pricing, and the impact of global and local political and economic conditions on operations and customer travel patterns, among others, they are also subject to their own distinct financial and operational risks.As a result of these and other factors, we may not realize satisfactory returns on our investments, and we may not receive repayment of any invested or loaned funds. Further, these investments may not generate the revenue or operational synergies we expect, and they may distract management focus from our operations or other strategic options. Finally, our reliance on these other carriers in the regions in which they operate may negatively impact our regional and global operations and results if those carriers continue to be impacted by the COVID-19 pandemic and other general business risks discussed above or perform below our expectations or needs and are not able to effectively mitigate these impacts or restore performance levels. Any one or more of these events could have a material adverse effect on our operating results or financial condition.We exercised our right to withdraw all aircraft from our capacity purchase agreement with ExpressJet, and, as of October 1, 2020 ExpressJet no longer provides regional capacity services to United. See Notes 9 and 11 to the financial statements included in Part II, Item 8 of this report for additional information regarding our investments in AVH and Azul and our capacity purchase arrangements with ExpressJet, respectively. See also the additional risks with respect to our investment in AVH, which are described elsewhere in this Part I, Item 1A. Risk Factors.We may also be subject to consequences from any illegal conduct of JBA partners, including for failure to comply with anti-corruption laws such as the U.S. Foreign Corrupt Practices Act. Furthermore, our relationships with these carriers may be subject to the laws and regulations of non-U.S. jurisdictions in which these carriers are located or conduct business. In addition, any political or regulatory change in these jurisdictions that negatively impacts or prohibits our arrangements with these carriers could have an adverse effect on our operating results or financial condition. To the extent that the operations of any of these carriers are disrupted over an extended period of time (including as a result of the COVID-19 pandemic) or their actions subject us to the consequences of failure to comply with laws and regulations, our operating results may be adversely affected.Our significant investments in AVH and its affiliates, and the commercial relationships that we have with Avianca may not produce the returns or results we expect.In November 2018, as part of our global network strategy, United entered into a revenue-sharing JBA with Avianca, a subsidiary of AVH, Copa and several of their respective affiliates, subject to regulatory approval. Concurrently with this transaction, United, as lender, entered into a Term Loan Agreement (the "BRW Term Loan Agreement") with, among others, BRW Aviation Holding LLC ("BRW Holding") and BRW, as guarantor and borrower, respectively. Pursuant to the BRW Term Loan Agreement, United provided to BRW a $456 million term loan (the "BRW Term Loan"), secured by a pledge of BRW's equity, as well as BRW's 516 million common shares of AVH, which can be converted and exchanged into 64.5 million American Depositary Receipts ("ADRs") of AVH (such shares and equity, collectively, the "BRW Loan Collateral"). In connection with funding the BRW Term Loan Agreement, the Company entered into an agreement with Kingsland Holdings Limited, AVH's largest minority shareholder ("Kingsland"), pursuant to which United granted to Kingsland a right to put its AVH common shares to United at market price on the fifth anniversary of the BRW Term Loan Agreement or upon certain sales of AVH common shares owned by BRW, including upon a foreclosure of United's security interest or any completed liquidation or dissolution of AVH, and also guaranteed BRW's obligation to pay Kingsland the excess, if any, of $12 per ADR on the NYSE and such market price of AVH common shares on the fifth anniversary, or upon any such sale, as applicable (the "Cooperation Payment"), for an aggregate maximum possible combined put payment and guarantee amount of $217 million. See Notes 8 and 13 to the financial statements included in Part II, Item 8 of this report for additional information regarding our obligations to Kingsland and their interrelationship with the BRW Term Loan Agreement. BRW is currently in default under the BRW Term Loan Agreement, and since May 2019 United has been exercising certain remedies under the terms of the BRW Term Loan Agreement and related documents. In September 2019, a New York state court granted summary judgment authorizing the foreclosure on the BRW Loan Collateral, and enjoined BRW Holding from interfering with the ability of Kingsland (as United's agent) to exercise voting and other rights in certain equity interests in BRW. These rulings are intermediate steps in the judicial foreclosure process in New York and are being appealed. The timing and outcome of the judicial foreclosure process is subject to significant uncertainty given the filing by AVH and certain of its affiliates of voluntary reorganization proceedings under Chapter 11 of the United States Bankruptcy Code in the U.S. 21Table of ContentsBankruptcy Court for the Southern District of New York (the "Bankruptcy Court") on May 10, 2020 (as described in more detail below, the "AVH Reorganization Proceedings"). In light of the AVH Reorganization Proceedings, the New York state court judge presiding over the foreclosure proceedings agreed to stay those proceedings until March 2021. Based on United's assessment of AVH's financial uncertainty and the fact that Avianca had ceased operations as a consequence of the COVID-19 pandemic, during the first quarter of 2020, the Company recorded a $697 million expected credit loss allowance for the BRW Term Loan and the Cooperation Payment.In 2019, United entered into a senior secured convertible term loan agreement (the "AVH Convertible Loan Agreement") with, among others, AVH, as borrower, and pursuant thereto provided a convertible term loan to AVH in the aggregate amount of $150 million (the "AVH Convertible Loan").See Notes 8 and 13 to the financial statements included in Part II, Item 8 of this report for additional information regarding our investments in AVH and its affiliates and our guarantee of the Cooperation Payment, respectively.In October 2020, AVH consummated a $2 billion debtor-in-possession financing (the "AVH DIP Financing"). The AVH Convertible Loan was refinanced, or "rolled up," into the AVH DIP Financing without any investment of new funds by United, and as a result United is a Tranche B DIP lender in the AVH DIP Financing to the extent of the principal and interest owed on the AVH Convertible Loan (or less, under certain circumstances). United's Tranche B loan accrues interest at a rate of 14.5% per annum and can be converted, at AVH's option in certain circumstances, into equity upon AVH's exit from bankruptcy. As part of the AVH DIP Financing, the Bankruptcy Court also approved certain amendments to the alliance agreement and certain related agreements among United, Avianca and some of Avianca's subsidiaries and additional arrangements among those parties applicable to whether AVH accepts or rejects the JBA at or prior to the end of the bankruptcy case. There is no guarantee that United's participation in the AVH DIP Financing will produce the results expected or result in the ultimate repayment to United of the amounts initially loaned under the AVH Convertible Loan. While United's position as an AVH DIP Financing lender provides it with priority secured claims and liens that have been approved by the Bankruptcy Court, the duration of the AVH Reorganization Proceedings is difficult to predict, and United's recovery on its claims, including possibly repayment or conversion of its Tranche B DIP Loans, may be adversely affected by, among other things, delays while a plan of reorganization is being negotiated and approved by creditors entitled to vote on it and whether such plan or reorganization is confirmed by the Bankruptcy Court and subsequently becomes effective.These transactions and relationships involve significant challenges and risks, particularly given the AVH Reorganization Proceedings, the impact of the COVID-19 pandemic and the judicial foreclosure process to which the repayment of the BRW Term Loan is subject. Furthermore, while we have worked closely with Avianca in connection with the JBA, and have supported AVH by providing capital in the form of the AVH Convertible Loan and then the AVH DIP Financing, Avianca is a separately certificated commercial air carrier, and we do not have control over its or AVH's operations, strategy, management or business methods. Avianca is also subject to a number of the same risks as our business, which are described elsewhere in this Part I, Item 1A. Risk Factors, as updated by this report, including the impact of the COVID-19 pandemic, competitive pressures on pricing, demand and capacity, changes in aircraft fuel pricing, and the impact of global and local political and economic conditions on operations and customer travel patterns, among others, as well as to its own distinct financial and operational risks.As a result of these and other factors, including the AVH Reorganization Proceedings and delays in foreclosure proceedings, we may not receive full (or any) repayment of our BRW Term Loan (including any payment we make in respect of the Cooperation Payment), our AVH Convertible Loan or our participation in the AVH DIP Financing, and we may be unable to realize the full (or any) value of the BRW Loan Collateral or the collateral securing the AVH Convertible Loan or the AVH DIP Financing, as applicable. As a consequence, we may not realize a satisfactory (or any) return on our invested or loaned funds with respect to BRW, AVH and its affiliates.Further, these investments may not generate the revenue or operational synergies we expect, and they may distract management focus from our operations or other strategic options. Finally, our reliance on Avianca in the region in which it operates may negatively impact our global operations and results if AVH does not successfully emerge from the AVH Reorganization Proceedings or the COVID-19 pandemic, if the JBA is rejected in connection with the AVH Reorganization Proceedings or if AVH is otherwise impacted by general business risks or performs below our expectations or needs. Any one or more of these events could have a material adverse effect on our operating results or financial condition.The airline industry may undergo further change with respect to alliances and JBAs or due to consolidations, any of which could have a material adverse effect on the Company.The Company faces, and may continue to face, strong competition from other carriers due to the modification of alliances and formation of new JBAs. Carriers may improve their competitive positions through airline alliances, slot swaps and/or JBAs. Certain types of airline JBAs further competition by allowing multiple airlines to coordinate routes, pool revenues 22Table of Contentsand costs, and enjoy other mutual benefits, achieving many of the benefits of consolidation. Open Skies agreements, including the longstanding agreements between the United States and each of the EU, Canada, Japan, Korea, New Zealand, Australia, Colombia and Panama, as well as the more recent agreements between the United States and each of Mexico and Brazil, may also give rise to better integration opportunities among international carriers. Movement of airlines between current global airline alliances could reduce joint network coverage for members of such alliances while also creating opportunities for JBAs and bilateral alliances that did not exist before such realignment. Further airline and airline alliance consolidations or reorganizations could occur in the future. The Company routinely engages in analyses and discussions regarding its own strategic position, including current and potential alliances, asset acquisitions and divestitures and may have future discussions with other airlines regarding strategic activities. If other airlines participate in such activities, those airlines may significantly improve their cost structures or revenue generation capabilities, thereby potentially making them stronger competitors of the Company and potentially impairing the Company's ability to realize expected benefits from its own strategic relationships.Orders for new aircraft typically must be placed years in advance of scheduled deliveries, and changes in the Company's network strategy over time or other factors outside of the Company's control may make aircraft on order less economic for the Company, result in costs related to modification or termination of aircraft orders or cause the Company to enter into orders for new aircraft on less favorable terms.The Company's orders for new aircraft are typically made years in advance of actual delivery of such aircraft, and the financial commitment required for purchases of new aircraft is substantial. As of February 2021, the Company had firm commitments to purchase 298 new aircraft from The Boeing Company ("Boeing"), Airbus S.A.S ("Airbus") and Embraer S.A. ("Embraer"), as well as related agreements with engine manufacturers, maintenance providers and others. As of February 2021, the Company's commitments relating to the acquisition of aircraft and related spare engines, aircraft improvements and other related obligations aggregated to a total of approximately $24.3 billion.Subsequent to the Company placing an order for new aircraft, the Company's network strategy may change. As a result, the Company's preference for a particular aircraft that it has ordered, often years in advance, may be decreased or eliminated. If the Company were to modify or terminate any of its existing aircraft order commitments, it may be responsible for material liabilities to its counterparties arising from any such modification. Additionally, the Company may have a need for additional aircraft that are not available under its existing orders. In such cases, the Company may seek to acquire aircraft from other sources, such as through lease arrangements, which may result in higher costs or less favorable terms, or through the purchase or lease of used aircraft. The Company may not be able to acquire such aircraft when needed on favorable terms or at all.The imposition of new tariffs, or any increase in existing tariffs, on the importation of commercial aircraft that the Company orders may result in higher costs. For example, in October 2019, the United States imposed tariffs on certain imports from the EU, including a customs duty at an ad valorem rate of 10% on new commercial aircraft, which rate, in February 2020, was increased to 15%. These tariffs apply to certain new Airbus aircraft that we have on order. Additionally, in December 2020, the United States imposed tariffs on certain aircraft components from France and Germany. While the scope and rate of these tariffs are subject to change, if and to the extent these tariffs are imposed on us, they could increase the effective cost of, among other things, new Airbus aircraft and aircraft components.A majority of the Company's aircraft and certain parts are sourced from single suppliers; therefore, the Company would be materially and adversely affected if it were unable to obtain timely deliveries, additional equipment or support from any of these suppliers.The Company currently sources the majority of its aircraft and many related aircraft parts from Boeing. In addition, our aircraft suppliers are dependent on other suppliers for certain other aircraft parts. Therefore, if the Company is unable to acquire additional aircraft from Boeing, or if Boeing fails to make timely deliveries of aircraft or to provide adequate support for its products, the Company's operations could be materially and adversely affected. The Company is also dependent on a limited number of suppliers for aircraft engines and certain other aircraft parts and could, therefore, also be materially and adversely affected in the event of the unavailability of these engines and other parts. Union disputes, employee strikes or slowdowns, and other labor-related disruptions could adversely affect the Company's operations and could result in increased costs that impair its financial performance.United is a highly unionized company. As of December 31, 2020, the Company and its subsidiaries had approximately 74,400 employees, of whom approximately 84% were represented by various U.S. labor organizations. See Part I, Item 1. Business—Human Capital, of this report for additional information on our represented employee groups and collective bargaining agreements.23Table of ContentsThere is a risk that unions or individual employees might pursue judicial or arbitral claims arising out of changes implemented as a result of the Company entering into collective bargaining agreements with its represented employee groups. There is also a possibility that employees or unions could engage in job actions such as slowdowns, work-to-rule campaigns, sick-outs or other actions designed to disrupt the Company's normal operations, in an attempt to pressure the Company in collective bargaining negotiations. Although the RLA makes such actions unlawful until the parties have been lawfully released to self-help, and the Company can seek injunctive relief against premature self-help, such actions can cause significant harm even if ultimately enjoined. Similarly, if the operations of our third-party regional carriers, ground handlers or other vendors are impacted by labor-related disruptions, our operations could be adversely affected. In addition, collective bargaining agreements with the Company's represented employee groups increase the Company's labor costs, which increase could be material.Extended interruptions or disruptions in service at major airports where we operate could have a material adverse impact on our operations.The airline industry is heavily dependent on business models that concentrate operations in major airports in the United States and throughout the world. An extended interruption or disruption at an airport where we have significant operations could have a material impact on our business, financial condition and results of operation.We operate principally through our domestic hubs in Newark, Chicago O'Hare, Denver, Houston Bush, LAX, Guam, SFO and Washington Dulles. Substantially all of our flights either originate in or fly into one of these locations. A significant interruption or disruption in service at one of our hubs or other airports where we have a significant presence resulting from ATC delays, weather conditions, natural disasters, growth constraints, relations with third-party service providers, failure of computer systems, disruptions to government agencies or personnel (including as a result of government shutdowns), disruptions at airport facilities or other key facilities used by us to manage our operations, labor relations, power supplies, fuel supplies, terrorist activities, international hostilities or otherwise could result in the cancellation or delay of a significant portion of our flights and, as a result, could have a material impact on our business, operating results and financial condition. We have minimal control over the operation, quality or maintenance of these services or whether vendors will improve or continue to provide services that are essential to our business.The United Kingdom's withdrawal from the EU may adversely impact our operations in the United Kingdom and elsewhere.On January 31, 2020, the United Kingdom ("UK") withdrew from the EU, and started a transition period that ran through December 31, 2020. During that time, the EU and UK negotiated a comprehensive trade agreement that provisionally went into effect on January 1, 2021. The agreement includes an aviation chapter that preserves EU-UK air connectivity. In connection with the UK's exit from the EU, we could face new challenges in our operations, such as instability in global financial and foreign exchange markets. This instability could result in market volatility, including in the value of the British pound and European euro, additional travel restrictions on passengers traveling between the UK and EU countries, changes to the legal status of EU-resident employees, legal uncertainty and divergent national laws and regulations. At this time, we cannot predict the precise impact that the UK's exit from the EU will have on our business generally and our UK and European operations more specifically, and no assurance can be given that our operating results, financial condition and prospects would not be adversely impacted by the result.The Company's operating results fluctuate due to seasonality and other factors associated with the airline industry, many of which are beyond the Company's control.Due to greater demand for air travel during the spring and summer months, revenues in the airline industry in the second and third quarters of the year are generally stronger than revenues in the first and fourth quarters of the year, which are periods of lower travel demand. The Company's operating results generally reflect this seasonality, but have also been impacted by numerous other factors that are not necessarily seasonal, including, among others, extreme or severe weather, outbreaks of disease or pandemics, ATC congestion, geological events, political instability, terrorism, natural disasters, changes in the competitive environment due to industry consolidation, tax obligations, general economic conditions and other factors. As a result, the Company's quarterly operating results are not necessarily indicative of operating results for an entire year and historical operating results in a quarterly or annual period are not necessarily indicative of future operating results.The Company may never realize the full value of its intangible assets or its long-lived assets causing it to record impairments that may negatively affect its financial condition and operating results. In accordance with applicable accounting standards, the Company is required to test its indefinite-lived intangible assets for impairment on an annual basis, or more frequently where there is an indication of impairment. In addition, the Company is required to test certain of its other assets for impairment where there is any indication that an asset may be impaired.24Table of ContentsThe Company may be required to recognize losses in the future due to, among other factors, extreme fuel price volatility, tight credit markets, government regulatory changes, decline in the fair values of certain tangible or intangible assets, such as aircraft, route authorities, airport slots and frequent flyer database, unfavorable trends in historical or forecasted results of operations and cash flows and an uncertain economic environment, as well as other uncertainties. For example, in 2020, the Company recorded impairment charges of $130 million for its China routes, primarily as a result of the COVID-19 pandemic and the Company's subsequent suspension of flights to China, $38 million for its right-of-use asset associated with an embedded aircraft lease under a CPA, primarily as a result of reduced cash flows from the COVID-19 pandemic, and $94 million related to certain of the Company's fleet of Boeing 757 aircraft, and $56 million with respect to various cancelled facility, aircraft induction and information technology capital projects as a result of the COVID-19 pandemic's impact on our operations. In addition, in 2019, the Company recorded impairment charges of $90 million associated with its Hong Kong routes, resulting in the full impairment of these assets. The Company can provide no assurance that a material impairment loss of tangible or intangible assets will not occur in a future period. The value of the Company's aircraft could be impacted in future periods by changes in supply and demand for these aircraft. Such changes in supply and demand for certain aircraft types could result from the grounding of aircraft. An impairment loss could have a material adverse effect on the Company's financial condition and operating results.Any damage to our reputation or brand image could adversely affect our business or financial results.We operate in a public-facing industry and maintaining a good reputation is critical to our business. The Company's reputation or brand image could be adversely impacted by any failure to maintain satisfactory practices for all of our operations and activities, any failure to achieve and/or make progress toward our environmental and sustainability, and diversity, equity and inclusion, goals, public pressure from investors or policy groups to change our policies, customer perceptions of our advertising campaigns, sponsorship arrangements or marketing programs, customer perceptions of our use of social media, or customer perceptions of statements made by us, our employees and executives, agents or other third parties. Damage to our reputation or brand image or loss of customer confidence in our services could adversely affect our business and financial results, as well as require additional resources to rebuild our reputation.The Company's ability to use its net operating loss carryforwards and certain other tax attributes to offset future taxable income for U.S. federal income tax purposes may be significantly limited due to various circumstances, including certain possible future transactions involving the sale or issuance of UAL common stock, or if taxable income does not reach sufficient levels.As of December 31, 2020, UAL reported consolidated U.S. federal net operating loss ("NOL") carryforwards of approximately $11.0 billion.The Company's ability to use its NOL carryforwards and certain other tax attributes will depend on the amount of taxable income it generates in future periods. As a result, certain of the Company's NOL carryforwards and other tax attributes may expire before it can generate sufficient taxable income to use them in full.In addition, the Company's ability to use its NOL carryforwards and certain other tax attributes to offset future taxable income may be limited if it experiences an "ownership change" as defined in Section 382 of the Internal Revenue Code of 1986, as amended ("Section 382"). An ownership change generally occurs if certain stockholders increase their aggregate percentage ownership of a corporation's stock by more than 50 percentage points over their lowest percentage ownership at any time during the testing period, which is generally the three-year period preceding any potential ownership change.In general, a corporation that experiences an ownership change will be subject to an annual limitation on its pre-ownership change NOLs and certain other tax attribute carryforwards equal to the value of the corporation's stock immediately before the ownership change, multiplied by the applicable long-term, tax-exempt rate posted by the IRS. Any unused annual limitation may, subject to certain limits, be carried over to later years, and the limitation may, under certain circumstances, be increased by built-in gains in the assets held by such corporation at the time of the ownership change. This limitation could cause the Company's U.S. federal income taxes to be greater, or to be paid earlier, than they otherwise would be, and could cause a portion of the Company's NOLs and certain other tax attributes to expire unused. Similar rules and limitations may apply for state income tax purposes. For purposes of determining whether there has been an "ownership change," the change in ownership as a result of purchases by "5-percent shareholders" will be aggregated with certain changes in ownership that occurred over the three-year period ending on the date of such purchases. Potential future transactions involving the sale or issuance of UAL common stock may increase the possibility that the Company will experience a future ownership change under Section 382. Such transactions may include the exercise of warrants issued in connection with the CARES Act programs, the issuance of UAL common stock upon the conversion of any convertible debt that UAL may issue in the future, the repurchase of any debt with UAL common stock, any issuance of UAL common stock for cash, and the acquisition or disposition of any stock by a stockholder owning 5% 25Table of Contentsor more of the outstanding shares of UAL common stock, or a combination of the foregoing. If we were to experience an "ownership change," it is possible that the Company's NOLs and certain other tax attribute carryforwards could expire before we would be able to use them to offset future income tax obligations. On December 4, 2020, the board of directors of the Company adopted a tax benefits preservation plan (the "Plan") in order to preserve the Company's ability to use its NOLs and certain other tax attributes to reduce potential future income tax obligations. The Plan is designed to reduce the likelihood that the Company experiences an "ownership change" by deterring certain acquisitions of Company securities. There is no assurance, however, that the deterrent mechanism will be effective, and such acquisitions may still occur. In addition, the Plan may adversely affect the marketability of UAL common stock by discouraging existing or potential investors from acquiring UAL common stock or additional shares of UAL common stock because any non-exempt third party that acquires 4.9% or more of the then-outstanding shares of UAL common stock would suffer substantial dilution of its ownership interest in the Company.Risks Relating to Legal and Regulatory Compliance The airline industry is subject to extensive government regulation, which imposes significant costs and may adversely impact our business, operating results and financial condition.Airlines are subject to extensive regulatory and legal oversight. Compliance with U.S. and international regulations imposes significant costs and may have adverse effects on the Company. Laws, regulations, taxes and airport rates and charges, both domestically and internationally, have been proposed from time to time that could significantly increase the cost of airline operations or reduce airline revenue. The airline industry is heavily taxed and additional taxation could negatively impact our business.United provides air transportation under certificates of public convenience and necessity issued by the DOT. If the DOT altered, amended, modified, suspended or revoked these certificates, it could have a material adverse effect on the Company's business. The DOT also regulates consumer protection and, through its investigations or rulemaking authority, could impose restrictions that materially impact the Company's business. The FAA regulates the safety of United's operations. United operates pursuant to an air carrier operating certificate issued by the FAA. The FAA's regulations include stringent pilot flight and duty time requirements under Part 117 of the Federal Aviation Regulations, as well as minimum qualifications for air carrier first officers. From time to time, the FAA also issues orders, airworthiness directives and other regulations relating to the maintenance and operation of aircraft that require material expenditures or operational restrictions by the Company. These FAA orders and directives have resulted in the temporary grounding of an entire aircraft type if the FAA identifies design, manufacturing, maintenance or other issues requiring immediate corrective action (including the FAA Order grounding Boeing 737 MAX aircraft). These FAA directives or requirements could have a material adverse effect on the Company.In 2018, the U.S. Congress approved a five-year reauthorization for the FAA, which encompasses significant aviation tax and policy-related issues. The law includes a range of policy changes related to airline customer service and aviation safety. Implementation of some items continues into the new Administration and, depending on how they are implemented, could impact our operations and costs. U.S. Congressional action in response to the COVID-19 pandemic has provided funding for U.S. airlines, in both grants and loans. The U.S. Congress has imposed limited conditions on airlines accepting funding, including workforce retention and minimum service requirements. With the change in control of the U.S. Congress and a new presidential administration, any future funding or other pandemic relief could include additional requirements that could impact our operations and costs. Additionally, the U.S. Congress may consider legislation related to environmental issues or increases to the U.S. federal corporate income tax rate, which could impact the Company and the airline industry. The Company's operations may also be adversely impacted due to the existing antiquated ATC system utilized by the U.S. government and regulated by the FAA. During peak travel periods in certain markets, the current ATC system's inability to handle demand has led to short-term capacity constraints imposed by government agencies and resulted in delays and disruptions of air traffic. In addition, the current system will not be able to effectively handle projected future air traffic growth. The outdated technologies also cause the ATC to be less resilient in the event of a failure, causing flight cancellations and delays. Imposition of these ATC constraints on a long-term basis may have a material adverse effect on the Company's operations. Failure to update the ATC system in a timely manner and the substantial funding requirements of a modernized ATC system that may be imposed on air carriers may have an adverse impact on the Company's financial condition or operating results.Access to landing and take-off rights, or "slots," at several major U.S. airports and many foreign airports served by the Company are, or recently have been, subject to government regulation. Certain of the Company's major hubs are among the most congested airports in the United States and have been or could be the subject of regulatory action that might limit the number of flights and/or increase costs of operations at certain times or throughout the day. The DOT (including FAA) may limit the Company's airport access by limiting the number of departure and arrival slots at high density traffic airports, which 26Table of Contentscould affect the Company's ownership and transfer rights, and local airport authorities may have the ability to control access to certain facilities or the cost of access to their facilities, which could have an adverse effect on the Company's business. The DOT historically has taken actions with respect to airlines' slot holdings that airlines have challenged; if the DOT were to take actions that adversely affect the Company's slot holdings, the Company could incur substantial costs to preserve its slots or may lose slots. If slots are eliminated at an airport, or if the number of hours of operation governed by slots is reduced at an airport, the lack of controls on take-offs and landings could result in greater congestion both at the affected airport or in the regional airspace (e.g., the New York City metropolitan region airspace) and could significantly impact the Company's operations. In addition, as airports around the world become more congested, space, facility, and infrastructure constraints may prevent the Company from maintaining existing service and/or implementing new service in a commercially viable manner. Further, the Company's operating costs at airports, including the Company's major hubs, may increase significantly because of capital improvements at such airports that the Company may be required to fund, directly or indirectly. Such costs could be imposed by the relevant airport authority without the Company's approval and may have a material adverse effect on the Company's financial condition. Because of airport infrastructure updates and other factors, the Company has experienced increased space rental rates at various airports in its network. Further, the Company cannot control decisions by other airlines to reduce their capacity. When this occurs, certain fixed airport costs are allocated among fewer total flights, which can result in increased landing fees and other costs for the Company. In light of constraints on existing facilities, there is presently a significant amount of capital spending underway at major airports in the United States, including large projects underway at a number of airports where we have significant operations, such as Chicago O'Hare International Airport (ORD), Los Angeles International Airport (LAX), LaGuardia Airport (LGA) and Ronald Reagan Washington National Airport (DCA). This spending is expected to result in increased costs to airlines and the traveling public that use those facilities as the airports seek to recover their investments through increased rental, landing and other facility costs. In some circumstances, such costs could be imposed by the relevant airport authority without our approval. Accordingly, our operating costs are expected to increase significantly at many airports at which we operate, including a number of our hubs and gateways, as a result of capital spending projects currently underway and additional projects that we expect to commence over the next several years.The ability of carriers to operate flights on international routes between the United States and other countries is highly regulated. Applicable arrangements between the United States and foreign governments may be amended from time to time, government policies with respect to airport operations may be revised, and the availability of appropriate slots or facilities may change. The Company currently operates a number of flights on international routes under government arrangements, regulations or policies that designate the number of carriers permitted to operate on such routes, the capacity of the carriers providing services on such routes, the airports at which carriers may operate international flights, or the number of carriers allowed access to particular airports. In addition, the pandemic has resulted in, and created the potential for, increased regulatory burdens in the U.S. and around the globe. These include but are not limited to closure of international borders to flights and/or passengers from specific countries, passenger and crew quarantine requirements, and other regulations promulgated to protect public health but that have a negative impact on travel and airline operations. Any limitations, additions or modifications to such arrangements, regulations or policies could have a material adverse effect on the Company's financial condition and operating results. Additionally, a change in law, regulation or policy for any of the Company's international routes, such as Open Skies, could have a material adverse impact on the Company's financial condition and operating results and could result in the impairment of material amounts of related tangible and intangible assets. In addition, competition from revenue-sharing JBAs and other alliance arrangements by and among other airlines could impair the value of the Company's business and assets on the Open Skies routes. The Company's plans to enter into or expand U.S. antitrust immunized alliances and JBAs on various international routes are subject to receipt of approvals from applicable U.S. federal authorities and obtaining other applicable foreign government clearances or satisfying the necessary applicable regulatory requirements. There can be no assurance that such approvals and clearances will be granted or will continue in effect upon further regulatory review or that changes in regulatory requirements or standards can be satisfied.See Part I, Item 1. Business—Industry Regulation, of this report for additional information on government regulation impacting the Company.We are subject to many forms of environmental regulation and liability and risks associated with climate change, and may incur substantial costs as a result.Many aspects of the Company's operations are subject to increasingly stringent federal, state, local and international laws protecting the environment, including those relating to emissions to the air, water discharges, safe drinking water, the use and management of hazardous materials and wastes, and noise emissions. Compliance with existing and future environmental laws and regulations can require significant expenditures and violations can lead to significant fines and penalties. In addition, from time to time we are identified as a responsible party for environmental investigation and remediation costs under applicable environmental laws due to the disposal of hazardous substances generated by our operations. We could also be subject to environmental liability claims from various parties, including airport authorities, related to our operations at our owned or leased premises or the off-site disposal of waste generated at our facilities.27Table of ContentsWe may incur substantial costs as a result of changes in weather patterns due to climate change. Increases in the frequency, severity or duration of severe weather events such as thunderstorms, hurricanes, flooding, typhoons, tornados and other severe weather events could result in increases in delays and cancellations, turbulence-related injuries and fuel consumption to avoid such weather, any of which could result in significant loss of revenue and higher costs. In addition, we could incur significant costs to improve the climate resiliency of our infrastructure and supply chain and otherwise prepare for, respond to, and mitigate the effects of climate change. We are not able to predict accurately the materiality of any potential losses or costs associated with the effects of climate change.To mitigate climate change risks, CORSIA has been developed by ICAO, a UN specialized agency. CORSIA is intended to create a single global market-based measure to achieve carbon-neutral growth for international aviation after 2020 through airline purchases of carbon offset credits. The voluntary pilot and first phases of the program are expected to run from 2021 through 2023, and 2024 through 2026, respectively, with airlines having until January 2025 to cancel eligible emissions units to comply with their total offsetting requirements for the pilot phase. Certain CORSIA program aspects could potentially be affected by the results of the pilot phase of the program, and thus the impact of CORSIA cannot be fully predicted. However, CORSIA is expected to result in increased operating costs for airlines that operate internationally, including the Company.In addition to CORSIA, in December 2020 the EPA adopted its own aircraft and aircraft engine GHG emissions standards, which are aligned with the 2017 ICAO airplane carbon dioxide emission standards. Other jurisdictions in which United operates have adopted or are considering GHG emissions reduction initiatives, which could impact various aspects of the Company's business. While the Company has voluntarily pledged to reduce 100% of our GHG emissions by 2050, the precise nature of future requirements and their applicability to the Company are difficult to predict, and the financial impact to the Company and the aviation industry would likely be adverse and could be significant if they vary significantly from the Company's own plans and strategy with respect to reducing GHG emissions.See Part I, Item 1. Business—Industry Regulation—Environmental Regulation, of this report for additional information on environmental regulation impacting the Company.Continued restrictions on the use of the Boeing 737 MAX aircraft, and the inability to accept or integrate new aircraft into our fleet as planned, may have a material adverse effect on our business, operating results and financial condition.On March 13, 2019, the FAA issued an emergency order prohibiting the operation of Boeing 737 MAX series aircraft by U.S. certificated operators (the "FAA Order"). As a result, the Company grounded all 14 Boeing 737 MAX 9 aircraft in its fleet, and Boeing also suspended deliveries of new Boeing 737 MAX series aircraft. On November 18, 2020, the FAA announced that it had rescinded the FAA Order and cleared the 737 MAX aircraft to fly again after a 20-month review and certification process. While several countries, following the FAA's lead, have lifted the grounding of the Boeing 737 MAX aircraft, other countries have delayed their expected approval of the aircraft until later in 2021. There are also many countries, such as China, that have no current plans to lift the aircraft's grounding and may not do so in the foreseeable future.In 2019, the grounding affected the delivery of 16 Boeing 737 MAX aircraft that were scheduled for delivery in 2019 and were not delivered, and it also affected the timing of future Boeing 737 MAX aircraft deliveries, including the Boeing 737 MAX aircraft of which the Company planned to take delivery in 2020. The extent of the delay of future deliveries is expected to be impacted by Boeing's production rate and the pace at which Boeing can deliver aircraft, among other factors, and these factors have been and could continue to be significantly impacted by the COVID-19 pandemic. If, for any reason, we are unable to accept deliveries of new aircraft or integrate such new aircraft into our fleet as planned, we may face higher financing and operating costs than planned, or be required to seek extensions of the terms for certain leased aircraft or otherwise delay the exit of other aircraft from our fleet. Such unanticipated extensions or delays may require us to operate existing aircraft beyond the point at which it is economically optimal to retire them, resulting in increased maintenance costs, or reductions to our schedule, thereby reducing revenues.In response to the grounding of the Boeing 737 MAX aircraft, the Company made adjustments to its flight schedule and operations, including substituting replacement aircraft on routes originally intended to be flown by Boeing 737 MAX aircraft. In 2019 and early 2020, the grounding impacted the Company's ability to implement its strategic growth strategy, reducing the Company's scheduled capacity from its planned capacity, and resulted in increased costs as well as lower operating revenue. Continued restrictions on the use of Boeing 737 MAX aircraft in other countries could impact the aircraft's optimal use in our network. Furthermore, in 2021, like 2020, demand has been, and is expected to continue to be, significantly impacted by COVID-19, which, in addition to the previous grounding of the Boeing 737 MAX aircraft, has materially disrupted the timely execution of our plans to add capacity in 2021. The Company had discussions with Boeing regarding compensation from Boeing for the Company's financial damages related to the grounding of the airline's Boeing 737 MAX aircraft, and in March 2020, the Company entered into a confidential settlement with Boeing with respect to compensation for financial damages incurred in 2019. The settlement agreement was amended and restated in June 2020 to provide for the settlement of additional 28Table of Contentsitems related to aircraft delivery and to update the scheduled delivery for substantially all undelivered Boeing 737 MAX aircraft.Risks Relating to Our IndebtednessThe Company has a significant amount of financial leverage from fixed obligations and may seek material amounts of additional financial liquidity in the short-term, and insufficient liquidity may have a material adverse effect on the Company's financial condition and business.The Company has a significant amount of financial leverage from fixed obligations, including aircraft lease and debt financings, leases of airport property, secured loan facilities and other facilities, and other material cash obligations. In addition, the Company has substantial noncancelable commitments for capital expenditures, including for the acquisition of new and used aircraft and related spare engines.In addition, in response to the travel restrictions and advisories, decreased demand and other effects the COVID-19 pandemic has had and is expected to have on the Company's business, the Company may continue to seek material amounts of additional financial liquidity in the short-term, which may include additional drawings of loans under the Loan Program of the CARES Act, the issuance of additional unsecured or secured debt securities, equity securities and equity-linked securities, the sale of assets as well as additional bilateral and syndicated secured and/or unsecured credit facilities, among other items.There can be no assurance as to the timing of any such incurrence or issuance, which may be in the near term, or that any such additional financing will be completed on favorable terms, or at all. As of December 31, 2020, we had total long-term debt of $26.7 billion, approximately $7.0 billion available for borrowing under the Loan Program under the CARES Act and $1.0 billion available for borrowing under our revolving credit facility. The Company's substantial level of indebtedness, the Company's non-investment grade credit ratings and the availability of Company assets as collateral for loans or other indebtedness, which available collateral has been reduced as a result of CARES Act Loan Program borrowings, may make it difficult for the Company to raise additional capital if needed to meet its liquidity needs on acceptable terms, or at all.Although the Company's cash flows from operations and its available capital, including the proceeds from financing transactions, have been sufficient to meet its obligations and commitments to date, the Company's liquidity has been, and may in the future be, negatively affected by the risk factors discussed elsewhere in this Part I, Item 1A. Risk Factors, including risks related to future results arising from the COVID-19 pandemic. If the Company's liquidity is materially diminished, the Company's cash flow available for general corporate purposes may be materially and adversely affected. In particular, with respect to the $6.8 billion of senior secured notes and a secured term loan facility (the "MileagePlus Financing") secured by substantially all of the assets of Mileage Plus Holdings, LLC, a direct wholly-owned subsidiary of United ("MPH"), and Mileage Plus Intellectual Property Assets, Ltd., an indirect wholly-owned subsidiary of MPH ("MIPA"), the cash flows generated by the MileagePlus business are required to first satisfy interest and principal due thereunder. Therefore, the cash generated by the MileagePlus program is not fully available for our operations or to satisfy our other indebtedness obligations for the seven-year term of the MileagePlus Financing debt. This limitation on our cash flows could have a material adverse effect on our operations and flexibility.A material reduction in the Company's liquidity could also result in the Company not being able to timely pay its leases and debts or comply with material provisions of its contractual obligations, including covenants under its financing and credit card processing agreements. Moreover, as a result of the Company's financing activities in response to the COVID-19 pandemic, the number of financings with respect to which such covenants and provisions apply has increased, thereby subjecting the Company to more substantial risk of default, cross-default and cross-acceleration in the event of breach, and additional covenants and provisions could become binding on the Company as it continues to seek additional liquidity. In addition, several of the Company's debt agreements contain covenants that, among other things, restrict the ability of the Company and its subsidiaries to incur additional indebtedness. The Company has agreements with financial institutions that process customer credit card transactions for the sale of air travel and other services. Under certain of the Company's credit card processing agreements, the financial institutions in certain circumstances have the right to require that the Company maintain a reserve equal to a portion (or potentially all) of advance ticket sales that have been processed by that financial institution, but for which the Company has not yet provided the air transportation. Such financial institutions may require cash or other collateral reserves to be established or withholding of payments related to receivables to be collected, including if the Company does not maintain certain minimum levels of unrestricted cash, cash equivalents and short-term investments. In light of the effect COVID-19 is having on demand and, in turn, capacity, the Company has seen an increase in demand from consumers for refunds on their tickets, and we anticipate some level of increased demand for refunds on tickets will continue to be the case for the near future. Refunds lower our liquidity and put us at risk of triggering liquidity covenants in these processing agreements and, in doing so, could force us to post cash collateral with the credit card companies for advance ticket sales. The Company 29Table of Contentsalso maintains certain insurance- and surety-related agreements under which counterparties have required, and may require, additional collateral.In addition to the foregoing, the degree to which we are leveraged could have important consequences to holders of our securities, including the following:•we must dedicate a substantial portion of cash flow from operations to the payment of principal and interest on applicable indebtedness, which, in turn, reduces funds available for operations and capital expenditures;•our flexibility in planning for, or reacting to, changes in the markets in which we compete may be limited;•we may be at a competitive disadvantage relative to our competitors with less indebtedness;•we are rendered more vulnerable to general adverse economic and industry conditions;•we are exposed to increased interest rate risk given that a portion of our indebtedness obligations are at variable interest rates; and•our credit ratings may be reduced and our debt and equity securities may significantly decrease in value.Finally, as of December 31, 2020, the Company had $9.5 billion in variable rate indebtedness, all or a portion of which uses London interbank offered rates ("LIBOR") as a benchmark for establishing applicable rates. As most recently announced in November 30, 2020, LIBOR is expected to be phased out starting on January 1, 2022 for the one-week and two-month USD LIBOR settings and starting on July 1, 2023 for the remaining USD LIBOR settings. Although many of our LIBOR-based obligations provide for alternative methods of calculating the interest rate payable if LIBOR is not reported, the extent and manner of any future changes with respect to methods of calculating LIBOR or replacing LIBOR with another benchmark are unknown and impossible to predict at this time and, as such, may result in interest rates that are materially higher than current interest rates. If interest rates applicable to the Company's variable interest indebtedness increase, the Company's interest expense will also increase, which could make it difficult for the Company to make interest payments and fund other fixed costs and, in turn, adversely impact our cash flow available for general corporate purposes.See Part II, Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations, of this report for additional information regarding the Company's liquidity as of December 31, 2020.If we are not able to comply with the covenants in the MileagePlus Financing agreements, our lenders could accelerate the MileagePlus indebtedness, foreclose upon the collateral securing the MileagePlus indebtedness or exercise other remedies, which would have a material adverse effect on our business, results of operations and financial condition.The covenants in the agreements governing the MileagePlus Financing contain a number of provisions that limit our ability to modify aspects of the MileagePlus program if such modifications would be reasonably expected to have a material adverse effect on the MileagePlus program or on our ability to pay the obligations under the MileagePlus Financing agreements. Moreover, the terms of such agreements also place certain restrictions on our establishing or owning another mileage or loyalty program and our ability to make material modifications to our agreements with certain MileagePlus partners. Furthermore, the MileagePlus Financing may also negatively affect certain material business relationships, and if any such relationship were to be materially impaired and/or terminated, we could experience a material adverse effect on our business, results of operations and financial condition.The agreements governing the MileagePlus Financing restrict our ability to terminate or modify the intercompany agreements governing the relationship between United and the MileagePlus program, including the agreement governing the rate that United must pay MPH for the purchase of miles and United's obligation to make certain seat inventory available to MPH for redemption. Such restrictions are in addition to restrictions on the ability of the obligors under the MileagePlus indebtedness to make restricted payments, incur additional indebtedness, dispose of, create or incur certain liens on, or transfer or convey, the collateral securing the MileagePlus indebtedness, enter into certain transactions with affiliates, merge, consolidate, or sell assets, or designate certain subsidiaries as unrestricted. Complying with these covenants may restrict our ability to make material changes to the operation of the MPH business and may limit our ability to take advantage of business opportunities that may be in our long-term interest. We may also take actions, or omit to take actions, to comply with such covenants that could have a material adverse effect on our business and operations.Our failure to comply with any of these covenants or restrictions could result in a default under the agreements governing the MileagePlus Financing, which could lead to an acceleration of the debt under such instruments and, in some cases, the acceleration of debt under other instruments that contain cross-default or cross-acceleration provisions, each of which could have a material adverse effect on us. In the case of an event of default under the agreements governing the MileagePlus Financing agreements, or a cross-default or cross-acceleration under our other indebtedness, we may not have sufficient funds available to make the required payments. If we are unable to repay amounts owed under the agreements governing the 30Table of ContentsMileagePlus Financing, the lenders or noteholders thereunder may choose to exercise their remedies in respect of the collateral securing such indebtedness, including foreclosing upon the MileagePlus collateral, in which case we would lose the right to operate the MileagePlus program thereafter. The exercise of such remedies, especially the loss of the MileagePlus program, would have a material adverse effect on our business, results of operations and financial condition.In connection with the MileagePlus Financing, we were required to contribute certain assets, including certain MileagePlus intellectual property, including brands and member data, to Mileage Plus Intellectual Property Assets, Ltd., an indirect wholly-owned subsidiary of MPH structured to be bankruptcy remote that serves as a co-issuer of the MileagePlus Financing indebtedness, the assets of which subsidiary are collateral for such indebtedness. United and MPH will have the right to use the contributed intellectual property pursuant to a license agreement with MIPA. Such license agreement will be terminated, and our right to use such intellectual property will cease, upon specified termination events, including, but not limited to, our failure to assume the license agreement and various related intercompany agreements in a restructuring process. The termination of the license agreement would be an event of default under the agreements governing the MileagePlus Financing and in certain circumstances would trigger a liquidated damages payment in an amount that is several multiples of the principal amount of the MileagePlus Financing debt. Thus, the terms of the MileagePlus Financing limit our flexibility to manage our capital structure going forward, and as a result, in the future we may take actions to ensure that the MileagePlus Financing debt is satisfied or that the lenders' remedies under such debt are not exercised, potentially to the detriment of our other creditors.Agreements governing our other debt include financial and other covenants. Failure to comply with these covenants could result in events of default.In addition to the covenants in the MileagePlus Financing agreements discussed above, our other financing agreements include various financial and other covenants. Certain of these covenants require UAL or United, as applicable, to maintain minimum liquidity and/or minimum collateral coverage ratios. UAL's or United's ability to comply with these covenants may be affected by events beyond its control, including the overall industry revenue environment, the level of fuel costs and the appraised value of the collateral. In addition, our financing agreements contain other negative covenants customary for such financings. These covenants are subject to important exceptions and qualifications. If we fail to comply with these covenants and are unable to remedy or obtain a waiver or amendment, an event of default would result.If an event of default were to occur, the lenders could, among other things, declare outstanding amounts immediately due and payable. In addition, an event of default or declaration of acceleration under one financing agreement could also result in an event of default under other of our financing agreements due to cross-default and cross-acceleration provisions. The acceleration of significant amounts of debt could require us to renegotiate, repay or refinance the obligations under our financing arrangements.General Risk FactorsIf we experience changes in, or are unable to retain, our senior management team or other key employees, our operating results could be adversely affected.Much of our future success depends on the continued availability of skilled personnel with industry experience and knowledge, including our senior management team and other key employees. If we are unable to attract and retain talented, highly qualified senior management and other key employees, or if we are unable to effectively provide for the succession of senior management, our business may be adversely affected.Current or future litigation and regulatory actions, or failure to comply with the terms of any settlement, order or arrangement relating to these actions, could have a material adverse impact on the Company. From time to time, we are subject to litigation and other legal and regulatory proceedings relating to our business or investigations or other actions by governmental agencies, including as described in Part I, Item 3, Legal Proceedings, of this report. No assurances can be given that the results of these or new matters will be favorable to us. An adverse resolution of lawsuits, arbitrations, investigations or other proceedings or actions could have a material adverse effect on our financial condition and operating results, including as a result of non-monetary remedies, and could also result in adverse publicity. Defending ourselves in these matters may be time-consuming, expensive and disruptive to normal business operations and may result in significant expense and a diversion of management's time and attention from the operation of our business, which could impede our ability to achieve our business objectives. Additionally, any amount that we may be required to pay to satisfy a judgment, settlement, fine or penalty may not be covered by insurance. If we fail to comply with the terms contained in any settlement, order or agreement with a governmental authority relating to these matters, we could be subject to criminal or civil penalties, which could have a material adverse impact on the Company. Under our charter and certain indemnification agreements that we have entered into (and may in the future enter into) with our officers, directors and certain third parties, we 31Table of Contentscould be required to indemnify and advance expenses to them in connection with their involvement in certain actions, suits, investigations and other proceedings. There can be no assurance that any of these payments will not be material.Increases in insurance costs or inadequate insurance coverage may materially and adversely impact our business, operating results and financial condition.The Company could be exposed to significant liability or loss if its property or operations were to be affected by a natural catastrophe or other event, including aircraft accidents. The Company maintains insurance policies, including, but not limited to, terrorism, aviation hull and liability, workers' compensation and property and business interruption insurance, but we are not fully insured against all potential hazards and risks incident to our business. If the Company is unable to obtain sufficient insurance with acceptable terms, the costs of such insurance increase materially, or if the coverage obtained is unable to pay or is insufficient relative to actual liability or losses that the Company experiences, whether due to insurance market conditions, policy limitations and exclusions or otherwise, our operations, operating results and financial condition could be materially and adversely affected.ITEM 1B. UNRESOLVED STAFF COMMENTS.None.ITEM 2. PROPERTIES. Fleet. As of December 31, 2020, United's mainline and regional fleets consisted of the following:Aircraft TypeTotalOwnedLeasedSeats in Standard Configuration Average Age(In Years)Mainline: 777-300ER22 22 — 350 3.0 777-200ER55 52 3 267-27620.8 777-20019 19 — 364 23.5 787-1013 13 — 318 1.6 787-935 28 7 252 3.6 787-812 12 — 219 7.5 767-400ER16 14 2 240 19.3 767-300ER38 30 8 167-21424.9 757-30021 9 12 234 18.3 757-20040 35 5 142-17623.9 737 MAX 922 14 8 179 1.5 737-900ER136 136 — 179 8.0 737-90012 8 4 179 19.3 737-800141 97 44 166 16.8 737-70049 37 12 126 20.7 A320-20096 78 18 150 22.3 A319-10085 56 29 126-12818.9 Total mainline812 660 152 16.0 In addition to the aircraft presented in the table above, United owned or leased, as of December 31, 2020, eleven Boeing 757-200s, three Airbus A319s, three Airbus A320s and one Boeing 767-200 that are not used in its operations.32Table of ContentsAircraft TypeTotalOwnedOwned or Leased by Regional Carrier Regional Carrier Operator and Number of AircraftSeats in Standard ConfigurationRegional: Embraer E175/E175LL190 91 99 SkyWest:Mesa:Republic:90722870 (a)Embraer 17038 — 38 Republic:38 70 CRJ70027 — 27 Mesa:SkyWest:81970 CRJ55038 — 38 GoJet:38 50 CRJ200133 — 133 SkyWest:Air Wisconsin:706350 Embraer ERJ 145 (XR/LR)49 49 — CommutAir:49 50 Total regional475 140 335 (a) In 2020, the Company temporarily modified all 76-seat aircraft to have a 70-seat configuration as agreed upon in the Pandemic Recovery Agreement between the Company and its pilots.In addition to the aircraft presented in the table above, United owned or leased the following regional aircraft as of December 31, 2020:•Four Embraer E175LLs, which were delivered but not yet in service;•119 Embraer ERJ 145s currently in storage with several aircraft scheduled to be inducted into CommutAir's fleet throughout 2021 and 2022; and•12 CRJ700s that are being transitioned between CPAs and for which United continues to make monthly payments.Firm Order and Option Aircraft. As of December 31, 2020 (adjusted to include the effects of the February 26, 2021 agreement with Boeing discussed below), United had firm commitments and options to purchase new aircraft from Boeing, Airbus and Embraer as presented in the table below:Scheduled Aircraft DeliveriesAircraft TypeNumber of Firm Commitments (a)20212022After 2022Airbus A321XLR50 — — 50 Airbus A35045 — — 45 Boeing 737 MAX188 21 40 127 Boeing 78711 11 — — Embraer E1754 4 — — (a) United also has options and purchase rights for additional aircraft.On February 26, 2021, the Company entered into an agreement with The Boeing Company ("Boeing") for a firm order of 25 Boeing 737 MAX aircraft for delivery in 2023, and to reschedule the delivery of 40 previously ordered Boeing 737 MAX aircraft to 2022 and 5 Boeing 737 MAX aircraft into 2023.The aircraft listed in the table above are scheduled for delivery through 2030. To the extent the Company and the aircraft manufacturers with which the Company has existing orders for new aircraft agree to modify the contracts governing those orders, the amount and timing of the Company's future capital commitments could change. United also has an agreement to purchase 11 used Boeing 737-700 aircraft with expected delivery dates in 2021. In addition, United has an agreement to purchase 17 used Airbus A319 aircraft, which it intends to sell, with expected delivery dates in 2021 and 2022.See Notes 10 and 13 to the financial statements included in Part II, Item 8 of this report for additional information.Facilities. United leases gates, hangar sites, terminal buildings and other airport facilities in the municipalities it serves. United has major terminal facility leases at SFO, Washington Dulles, Chicago O'Hare, LAX, Denver, Newark, Houston Bush and Guam with expiration dates ranging from 2021 through 2053. Substantially all of these facilities are leased on a net-rental basis, resulting in the Company's responsibility for maintenance, insurance and other facility-related expenses and services.United also maintains administrative, catering, cargo, training, maintenance and other facilities to support its operations in the cities it serves. In addition, United has multiple leases, which expire from 2030 through 2033, for its principal executive office and operations center in downtown Chicago and administrative offices in downtown Houston.33Table of ContentsITEM 3. LEGAL PROCEEDINGS.On June 30, 2015, UAL received a Civil Investigative Demand ("CID") from the Antitrust Division of the DOJ seeking documents and information from the Company in connection with a DOJ investigation related to statements and decisions about airline capacity. The Company has completed its response to the CID. The Company is not able to predict what action, if any, might be taken in the future by the DOJ or other governmental authorities as a result of the investigation. Beginning on July 1, 2015, subsequent to the announcement of the CID, UAL and United were named as defendants in multiple class action lawsuits that asserted claims under the Sherman Antitrust Act, which have been consolidated in the United States District Court for the District of Columbia. The complaints generally allege collusion among U.S. airlines on capacity impacting airfares and seek treble damages. The Company intends to vigorously defend against the class action lawsuits.On October 13, 2015, United received a CID from the Civil Division of the DOJ. The CID requested documents and oral testimony from United in connection with an industry-wide DOJ investigation related to delivery scan and other data purportedly required for payment for the carriage of mail under United's International Commercial Air Contracts with the U.S. Postal Service. The Company has been responding to the DOJ's request and cooperating in the investigation since that time. On November 8, 2016, the DOJ Criminal Division met with representatives from the Company and advised they are conducting an industry-wide investigation into the same matter. In February 2021, United entered into a settlement with the Civil and Criminal Divisions of the DOJ, pursuant to which the Company agreed to pay $49.5 million. In conjunction with these settlements, United entered into a non-prosecution agreement with the Criminal Division of the DOJ.Other Legal Proceedings. The Company is involved in various other claims and legal actions involving passengers, customers, suppliers, employees and government agencies arising in the ordinary course of business. Additionally, from time to time, the Company becomes aware of potential non-compliance with applicable environmental regulations, which have either been identified by the Company (through internal compliance programs such as its environmental compliance audits) or through notice from a governmental entity. In some instances, these matters could potentially become the subject of an administrative or judicial proceeding and could potentially involve monetary sanctions. After considering a number of factors, including (but not limited to) the views of legal counsel, the nature of contingencies to which the Company is subject and prior experience, management believes that the ultimate disposition of these other claims and legal actions will not materially affect its consolidated financial position or results of operations. However, the ultimate resolutions of these matters are inherently unpredictable. As such, the Company's financial condition and results of operations could be adversely affected in any particular period by the unfavorable resolution of one or more of these matters.ITEM 4. MINE SAFETY DISCLOSURES.Not applicable.PART II ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES.UAL's common stock is listed on the Nasdaq Global Select Market ("Nasdaq") under the symbol "UAL." As of February 24, 2021, there were 5,989 holders of record of UAL common stock.The following graph shows the cumulative total stockholder return for UAL's common stock during the period from December 31, 2015 to December 31, 2020. The graph also shows the cumulative returns of the Standard and Poor's 500 Index ("SPX") and the NYSE Arca Airline Index ("XAL") of 15 investor-owned airlines over the same five-year period. The comparison assumes $100 was invested on December 31, 2015 in each of UAL common stock, the SPX and the XAL.34Table of ContentsNote: The stock price performance shown in the graph above should not be considered indicative of potential future stock price performance. The foregoing performance graph is being furnished as part of this report solely in accordance with the requirement under Rule 14a-3(b)(9) to furnish our stockholders with such information, and therefore, shall not be deemed to be filed or incorporated by reference into any filings by the Company under the Securities Act or the Exchange Act.The following table presents repurchases of UAL common stock made in the fourth quarter of fiscal year 2020:PeriodTotal number ofshares purchasedAverage price paidper shareTotal number of shares purchased as part of publicly announced plans or programs (a)Maximum number of shares (or approximate dollar value) of shares that may yet be purchased under the plans or programsOctober 2020— $— — $— November 2020— — — — December 2020— — — — Total— — (a) On April 24, 2020, UAL's Board of Directors terminated its share repurchase program. Under the Payroll Support Program agreements and Loan Program, the Company and its business are subject to certain restrictions, including, but not limited to, restrictions on the ability to repurchase UAL's equity securities through September 26, 2026 (or such earlier date that is one year after repayment in full of the Term Loan Facility).ITEM 6. SELECTED FINANCIAL DATA. UAL's consolidated financial statements and statistical data are provided in the tables below:Year Ended December 31,20202019201820172016Income Statement Data (in millions, except per share amounts):Operating revenue$15,355 $43,259 $41,303 $37,784 $36,558 Operating expense21,714 38,958 38,074 34,166 32,214 Operating income (loss)(6,359)4,301 3,229 3,618 4,344 Net income (loss)(7,069)3,009 2,122 2,143 2,234 Basic earnings (loss) per share(25.30)11.63 7.70 7.08 6.77 Diluted earnings (loss) per share(25.30)11.58 7.67 7.06 6.76 Balance Sheet Data at December 31 (in millions):Unrestricted cash, cash equivalents and short-term investments$11,683 $4,944 $3,950 $3,798 $4,428 Total assets59,548 52,611 49,024 47,469 40,208 Debt and finance lease obligations 27,153 14,818 13,792 13,576 11,705 35Table of Contents Year Ended December 31,20202019201820172016Select operating statistics (a)Passengers (thousands) (b)57,761162,443158,330148,067143,177Revenue passenger miles ("RPMs") (millions) (c)73,883239,360230,155216,261210,309Available seat miles ("ASMs") (millions) (d)122,804284,999275,262262,386253,590Cargo revenue ton miles (millions) (e)2,7113,3293,4253,3162,805Passenger load factor (f)60.2%84.0%83.6%82.4%82.9%Passenger revenue per available seat mile ("PRASM") (cents)9.6113.9013.7013.1313.18Total revenue per available seat mile ("TRASM") (cents)12.5015.1815.0014.4014.42Average yield per revenue passenger mile ("Yield") (cents) (g)15.9816.5516.3815.9315.90Cost per available seat mile ("CASM") (cents)17.6813.6713.8313.0212.70Average price per gallon of fuel, including fuel taxes$1.57$2.09$2.25$1.74$1.49Fuel gallons consumed (millions)2,0044,2924,1373,9783,904Average stage length (miles) (h)1,3071,4601,4461,4601,473Employee headcount, as of December 31 (thousands)74.495.991.789.887.8(a) Includes data from our regional carriers operating under CPAs unless otherwise noted.(b) The number of revenue passengers measured by each flight segment flown.(c) The number of scheduled miles flown by revenue passengers.(d) The number of seats available for passengers multiplied by the number of scheduled miles those seats are flown.(e) The number of cargo revenue tons transported multiplied by the number of miles flown.(f) RPM divided by ASM.(g) The average passenger revenue received for each revenue passenger mile flown.(h) Average stage length equals the average distance a flight travels weighted for size of aircraft. 36Table of ContentsITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.OverviewUnited Airlines Holdings, Inc. (together with its consolidated subsidiaries, "UAL" or the "Company") is a holding company and its principal, wholly-owned subsidiary is United Airlines, Inc. (together with its consolidated subsidiaries, "United"). As UAL consolidates United for financial statement purposes, disclosures that relate to activities of United also apply to UAL, unless otherwise noted. United's operating revenues and operating expenses comprise nearly 100% of UAL's revenues and operating expenses. In addition, United comprises approximately the entire balance of UAL's assets, liabilities and operating cash flows. When appropriate, UAL and United are named specifically for their individual contractual obligations and related disclosures and any significant differences between the operations and results of UAL and United are separately disclosed and explained. We sometimes use the words "we," "our," "us," and the "Company" in this report for disclosures that relate to all of UAL and United.Impact of COVID-19 and OutlookThe novel coronavirus (COVID-19) pandemic, together with the measures implemented or recommended by governmental authorities and private organizations in response to the pandemic, has had an adverse impact that has been material to the Company's business, operating results, financial condition and liquidity. The Company began experiencing a significant decline in international and domestic demand related to COVID-19 during the first quarter of 2020. The decline in demand caused a material deterioration in our revenues in 2020, resulting in a net loss of $7.1 billion. The full extent of the ongoing impact of COVID-19 on the Company's longer-term operational and financial performance will depend on future developments, including those outside our control related to the efficacy and speed of vaccination programs in curbing the spread of the virus, the introduction and spread of new variants of the virus which may be resistant to currently approved vaccines, passenger testing requirements, mask mandates or other restrictions on travel, all of which are highly uncertain and cannot be predicted with certainty.In response to decreased demand, the Company cut, relative to 2019 capacity, approximately 57% of its scheduled capacity for 2020. In the first quarter of 2021, the Company expects scheduled capacity to be down at least 51% versus the first quarter of 2019. The Company plans to continue to proactively evaluate and cancel flights on a rolling 60-day basis until it sees signs of a recovery in demand and expects demand to remain suppressed, relative to 2019 levels, until vaccines for COVID-19 are widely distributed and are effective in curbing the spread of the virus. In addition, the Company does not currently expect the recovery from COVID-19 to follow a linear path. As such, the Company's actual flown capacity may differ materially from its currently scheduled capacity.The Company has taken a number of actions in response to the decreased demand for air travel. In addition to the schedule reductions discussed above, the Company has:•reduced its planned capital expenditures and reduced operating expenditures in 2020 (including by postponing projects deemed non-critical to the Company's operations); •terminated its share repurchase program; •issued or entered into approximately $13.4 billion in new secured notes, secured term loan facilities and new aircraft financings in 2020, including short term borrowings that were paid in 2020;•borrowed $1.0 billion under the $2.0 billion revolving credit facility established under the Amended and Restated Credit and Guaranty Agreement (the "Credit Agreement"); •availed itself of financial assistance and/or financing made available by the U.S. Treasury Department ("Treasury"), as further described below;•raised approximately $2.1 billion in cash proceeds from the issuance and sale of UAL common stock in 2020;•entered into agreements to finance certain aircraft currently subject to purchase agreements through sale and leaseback transactions;•elected to defer the payment of $199 million in payroll taxes incurred through December 31, 2020, as provided by the Coronavirus Aid, Relief, and Economic Security Act (the "CARES Act"), until December 2021, at which time 50% is due, with the remaining amount due December 2022; and•taken a number of actions to reduce employee-related costs, including, among other items, the Company's Chief Executive Officer and President waived 100% of their respective base salaries through the end of 2020, other officers temporarily waived a portion of their base salaries, the Company's non-employee directors waived 100% of their cash 37Table of Contentscompensation for the second and third quarters of 2020, the Company suspended merit salary increases for 2020 and implemented a temporary four-day work week for management and administrative employees and the Company offered voluntary unpaid leaves of absence. The Company also entered into an agreement with its pilots to distribute fewer flight hours to a larger number of pilots, while also reaching agreements to provide a path to early retirement and reduce expense through voluntary leave of absence programs. In addition, and as announced in July 2020, the Company started the involuntary furlough process by issuing Worker Adjustment and Retraining Notification ("WARN") Act notices to 36,000 of its employees. Since then, the Company worked to reduce the total number of furloughs to approximately 13,000 employees by working closely with its union partners, introducing new voluntary options selected by approximately 9,000 employees and proposing creative solutions that would save jobs. As a result of the Company's entry into the PSP2 Agreement, as described below, the Company issued recall notices to these furloughed employees and others impacted by furlough mitigation programs. See the discussion below for more detail about the PSP2 Agreement and the recall process.The Company continues to focus on reducing expenses and managing its liquidity. We expect to continue to modify our cost management structure and capacity as the timing of demand recovery becomes more certain.On March 27, 2020, the President of the United States signed the CARES Act into law. The CARES Act is intended to respond to the COVID-19 pandemic and its impact on the economy, public health, state and local governments, individuals, and businesses. The CARES Act also provides supplemental appropriations for federal agencies to respond to the COVID-19 pandemic.On April 20, 2020, United entered into a Payroll Support Program Agreement (the "PSP Agreement") with Treasury providing the Company with total funding of approximately $5.1 billion pursuant to the Payroll Support Program established under the CARES Act. These funds were used to pay for the wages, salaries and benefits of United employees. Approximately $3.6 billion of the $5.1 billion was provided as a direct grant, and approximately $1.5 billion consists of indebtedness evidenced by a 10-year senior unsecured promissory note issued by UAL to Treasury (the "PSP Note"). See Note 2 to the financial statements included in Part II, Item 8 of this report for additional information related to warrants issued in connection with the PSP Note and Note 10 to the financial statements included in Part II, Item 8 of this report for a discussion of the PSP Note.During 2020, UAL and United entered into a loan and guarantee agreement with Treasury. The agreement provides for a term loan facility of up to approximately $7.5 billion (the "CARES Act Term Loan Facility") pursuant to the loan program established under Section 4003(b)(1) of the CARES Act (the "Loan Program"). The loans (the "CARES Act Term Loans") may be disbursed in up to three disbursements on or before May 28, 2021. On September 28, 2020, United borrowed, and recorded as Long-term debt on the Company's consolidated balance sheet, $520 million under the CARES Act Term Loan Facility, the proceeds of which were used to pay certain transaction fees and expenses and for working capital and other general corporate purposes of the Company. See Note 2 to the financial statements included in Part II, Item 8 of this report for a discussion on warrants issued in connection with the CARES Act Term Loans and Note 10 to the financial statements included in Part II, Item 8 of this report for a discussion of the CARES Act Term Loans.Under the PSP Agreement and the Loan Program, the Company and its business are subject to certain restrictions, including, but not limited to, restrictions on the payment of dividends and the ability to repurchase UAL's equity securities, requirements to maintain certain levels of scheduled service and certain limitations on executive compensation.On January 15, 2021, United entered into a Payroll Support Agreement (the "PSP2 Agreement") with Treasury providing the Company with total funding of approximately $2.6 billion, pursuant to the Payroll Support Program established under Subtitle A of Title IV of Division N of the Consolidated Appropriations Act, 2021 (the "PSP Extension Law"). These funds were used to pay for the wages, salaries and benefits of United employees, including the payment of lost wages, salaries and benefits to returning employees. Approximately $1.9 billion was provided as a direct grant and approximately $753 million consists of indebtedness evidenced by a 10-year senior unsecured promissory note issued by UAL to Treasury (the "PSP2 Note"). As of February 25, 2021, we have received a total of $1.3 billion. See Note 2 to the financial statements included in Part II, Item 8 of this report for additional information on warrants issued in connection with the PSP2 Note and Note 10 to the financial statements included in Part II, Item 8 of this report for a discussion of the PSP2 Note.Pursuant to the PSP2 Agreement, the Company is required to comply with certain provisions of the PSP Extension Law, including, among others, the requirement that all funds provided under the Payroll Support Program will be used by United exclusively for the continuation of payment of its U.S. employee wages, salaries and benefits, including the payment of lost wages, salaries and benefits to returning U.S. employees; requirements to maintain U.S. employment levels from the date of the PSP2 Agreement through March 31, 2021; requirements to recall (as such term is defined in the PSP2 Agreement), any U.S. employees subject to involuntary termination or furlough between October 1, 2020 and the date of the PSP2 Agreement, 38Table of Contentscompensate such returning employees for certain lost salary, wages and benefits between December 1, 2020 and the date of the PSP2 Agreement and restore certain rights and protections for such returning employees; provisions prohibiting certain reductions in U.S. employee wages, salaries and benefits; provisions prohibiting the payment of dividends and the repurchase of certain equity until March 31, 2022; and provisions restricting the payment of certain executive compensation until October 1, 2022.As a result of the PSP2 Agreement, the Company offered employment, through March 2021, to employees who were impacted by involuntary furloughs. Because the Company cannot predict with certainty whether it will receive further payroll support from the federal government or when demand for air travel will increase in the short term, the Company is preparing for the possibility that these recalled employees might again be furloughed as soon as the end of the first quarter of 2021. The Company may record additional costs associated with these actions in the first quarter of 2021. Also, in order to reduce the number of such furloughs, during the first quarter of 2021, the Company offered voluntary leave and other programs to certain of its frontline employees, the cost of which cannot be estimated at this time.Results of OperationsThe following discussion provides an analysis of our results of operations and reasons for material changes therein for 2020 as compared to 2019. See "Results of Operations" in Part II, Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations in the Company's 2019 Annual Report on Form 10-K, filed with the SEC on February 25, 2020 (the "2019 Annual Report"), for analysis of the 2019 results as compared to 2018.Operating Revenue. The table below illustrates the year-over-year percentage change in the Company's operating revenues for the years ended December 31 (in millions, except percentage changes): 20202019Increase (Decrease)% ChangePassenger revenue$11,805 $39,625 $(27,820)(70.2)Cargo1,648 1,179 469 39.8 Other operating revenue1,902 2,455 (553)(22.5)Total operating revenue$15,355 $43,259 $(27,904)(64.5)The table below presents passenger revenue and select operating data of the Company, broken out by geographic region, expressed as year-over-year changes:Increase (decrease) from 2019:DomesticAtlanticPacificLatin TotalPassenger revenue (in millions)$(16,717)$(5,326)$(3,546)$(2,231)$(27,820)Passenger revenue(67.4)%(77.9)%(79.4)%(63.4)%(70.2)%Average fare per passenger(11.7)%0.1 %3.6 %(7.8)%(16.2)%Yield(7.0)%(9.0)%11.5 %(1.9)%(3.4)%PRASM(31.0)%(44.8)%(27.0)%(24.1)%(30.9)%Passengers(63.1)%(77.9)%(80.1)%(60.3)%(64.4)%RPMs (traffic)(64.9)%(75.7)%(81.5)%(62.7)%(69.1)%ASMs (capacity)(52.8)%(59.9)%(71.8)%(51.8)%(56.9)%Passenger load factor (points)(22.0)(32.5)(27.9)(19.2)(23.8)Note: See Part II, Item 6. Selected Financial Data, of this report for the definition of these statistics.Passenger revenue decreased $27.8 billion, or 70.2%, in 2020 as compared to 2019, primarily due to the decrease in demand for air travel as a result of the worldwide spread of COVID-19 and the associated shelter-in-place directives and travel restrictions. Earlier in 2020, the Company suspended change fees and effective August 30, 2020, the Company eliminated change fees on all standard Economy and Premium cabin tickets for travel within the 50 U.S. states, Puerto Rico and the U.S. Virgin Islands. Also, in December 2020, the Company eliminated change fees on flights from the U.S. to all international destinations and fees on Basic Economy and all other international travel tickets issued by March 31, 2021. The elimination of change fees and waivers associated with the COVID-19 pandemic resulted in change fee revenue declining $542 million in 2020 as compared to 2019.Cargo revenue increased $469 million, or 39.8%, in 2020 as compared to 2019, primarily due to an increase in cargo-only charter flights with higher yields as a result of increased demand for critical goods during the COVID-19 pandemic.39Table of ContentsOther operating revenue decreased $553 million, or 22.5%, in 2020 as compared to 2019, primarily due to a decline in mileage revenue from non-airline partners, including the co-branded credit card partner, Chase, and lower revenue from airport lounges due to United Club closures and fewer overall customers utilizing these lounges.Operating Expense. The table below includes data related to the Company's operating expense for the years ended December 31 (in millions, except percentage changes): 20202019Increase (Decrease)% ChangeSalaries and related costs$9,522 $12,071 $(2,549)(21.1)Aircraft fuel3,153 8,953 (5,800)(64.8)Depreciation and amortization2,488 2,288 200 8.7 Landing fees and other rent2,127 2,543 (416)(16.4)Regional capacity purchase2,039 2,849 (810)(28.4)Aircraft maintenance materials and outside repairs858 1,794 (936)(52.2)Distribution expenses459 1,651 (1,192)(72.2)Aircraft rent198 288 (90)(31.3)Special charges (credit)(2,616)246 (2,862)NMOther operating expenses3,486 6,275 (2,789)(44.4)Total operating expenses$21,714 $38,958 $(17,244)(44.3)Salaries and related costs decreased $2.5 billion, or 21.1%, in 2020 as compared to 2019, primarily due to a 22.4% reduction in employees resulting from voluntary separation programs and furloughs caused by COVID-19, $623 million lower profit sharing and other employee incentives due to the impact of COVID-19 on 2020 results and $180 million in tax credits provided by the Employee Retention Credit under the CARES Act in 2020.Aircraft fuel expense decreased $5.8 billion, or 64.8%, in 2020 as compared to 2019. The table below presents the significant changes in aircraft fuel cost per gallon for the years ended December 31 (in millions, except percentage changes and per gallon data): 20202019%ChangeFuel expense$3,153 $8,953 (64.8)Total fuel consumption (gallons)2,004 4,292 (53.3)Average price per gallon$1.57 $2.09 (24.9)Depreciation and amortization increased $200 million, or 8.7%, in 2020 as compared to 2019, primarily due to additions of aircraft, upgrades to aircraft interiors and completion of technology projects.Landing fees and other rent decreased $416 million, or 16.4%, in 2020 as compared to 2019, primarily due to reduced flying. A portion of other rents, especially at airport facilities, is fixed in nature and is not impacted by the reduction in flights.Regional capacity purchase costs decreased $810 million, or 28.4%, in 2020 as compared to 2019, primarily due to reduced regional flying as a result of COVID-19 and reduced rates under certain capacity purchase agreements.Aircraft maintenance materials and outside repairs decreased $936 million, or 52.2%, in 2020 as compared to 2019, primarily due to a reduction in airframe checks, engine overhauls, expenses associated with power-by-the-hour engine maintenance contracts and line maintenance due to reduced flying.Distribution expenses decreased $1.2 billion, or 72.2%, in 2020 as compared to 2019, as a result of the overall decrease in passenger revenue due to the COVID-19 pandemic.Aircraft rent decreased $90 million, or 31.3%, in 2020 as compared to 2019, primarily due to the purchase of leased aircraft.The table below presents special charges (credit) recorded by the Company during the years ended December 31 (in millions):40Table of Contents20202019CARES Act grant$(3,536)$— Severance and benefit costs575 16 Impairment of assets318 171 (Gains) losses on sale of assets and other special charges27 59 Total special charges$(2,616)$246 See Note 14 to the financial statements included in Part II, Item 8 of this report for additional information.Other operating expenses decreased $2.8 billion, or 44.4%, in 2020 as compared to 2019, primarily due to the impacts of COVID-19 on our catering, airport ground handling, navigation fees, technology projects, advertising and crew-related expenses.Nonoperating Income (Expense). The following table illustrates the year-over-year dollar and percentage changes in the Company's nonoperating income (expense) for the years ended December 31 (in millions, except percentage changes):20202019Increase (Decrease)% ChangeInterest expense$(1,063)$(731)$332 45.4 Interest capitalized71 85 (14)(16.5)Interest income50 133 (83)(62.4)Unrealized gains (losses) on investments, net(194)153 (347)NMMiscellaneous, net (1,327)(27)1,300 NMTotal nonoperating expense, net$(2,463)$(387)$2,076 NMInterest expense increased $332 million, or 45.4%, in 2020 as compared to 2019, primarily due to the issuance of new debt in 2020 to provide additional liquidity to the Company during the COVID-19 pandemic.Interest income decreased $83 million, or 62.4%, in 2020 as compared to 2019, primarily due to a decrease in interest rates.Unrealized gains (losses) on investments, net decreased $347 million in 2020 as compared to 2019, due to $194 million in losses in 2020 as compared to $153 million in gains in the year-ago period, primarily as a result of a decrease in the market value of the Company's equity investment in Azul and a decrease in the fair value of the Avianca Holdings S.A. ("AVH") share call options, AVH share appreciation rights and AVH share-based upside sharing agreement. See Notes 9 and 14 to the financial statements included in Part II, Item 8 of this report for additional information.Miscellaneous, net increased $1.3 billion in 2020 as compared to 2019, primarily due to credit loss allowances associated with the Company's Term Loan Agreement, with, among others, BRW Aviation Holding LLC and BRW Aviation LLC, and related guarantee and settlement losses and special termination benefits related to furloughs and voluntary separation programs under the Company's non-pilot U.S. defined benefit pension plan and postretirement medical programs. See Notes 7, 8, 13 and 14 to the financial statements included in Part II, Item 8 of this report for additional information.Income Taxes. See Note 6 to the financial statements included in Part II, Item 8 of this report for information related to income taxes.41Liquidity and Capital Resources As of December 31, 2020, the Company had $11.7 billion in unrestricted cash, cash equivalents and short-term investments, an increase of approximately $6.7 billion from December 31, 2019. The Company also had approximately $7.0 billion available for borrowing by United under the Loan Program at any time until May 28, 2021 and $1.0 billion available for borrowing by United under the revolving credit facility of the Credit Agreement at any time until April 1, 2022.The Company has taken a number of actions in response to the significant decline in international and domestic demand for air travel related to COVID-19, as discussed under "Impact of COVID-19 and Outlook" above.The Company continues to focus on reducing expenses and managing its liquidity. We expect to continue to modify our cost management structure and capacity as the timing of demand recovery becomes more certain.On April 20, 2020, United entered into the PSP Agreement with Treasury providing the Company with total funding of approximately $5.1 billion pursuant to the Payroll Support Program established under the CARES Act. These funds were used to pay for the wages, salaries and benefits of United employees.During 2020, UAL and United entered into a loan and guarantee agreement with Treasury. The agreement provides for a CARES Act Term Loan Facility of up to approximately $7.5 billion pursuant to the Loan Program. The CARES Act Term Loans may be disbursed in up to three disbursements on or before May 28, 2021. On September 28, 2020, United borrowed $520 million under the CARES Act Term Loan Facility, the proceeds of which were used to pay certain transaction fees and expenses and for working capital and other general corporate purposes of the Company.On January 15, 2021, United entered into the PSP2 Agreement with Treasury, providing the Company with total funding of approximately $2.6 billion, approximately $1.9 billion as a direct grant and approximately $753 million from the PSP2 Note. See Note 10 to the financial statements included in Part II, Item 8 of this report for a discussion of the PSP2 Note.Several of the Company's debt agreements contain covenants that, among other things, restrict the ability of the Company and its subsidiaries to incur additional indebtedness and pay dividends on or repurchase stock. As of December 31, 2020, UAL and United were in compliance with their respective debt covenants. In addition, in connection with the PSP Agreement, the PSP2 Agreement and the Loan Program, the Company and its business will be subject to certain restrictions.We have a significant amount of fixed obligations, including debt and leases of aircraft, airport and other facilities, and pension funding obligations. As of December 31, 2020, the Company had approximately $33.9 billion of debt, finance lease, operating lease and sale-leaseback obligations, including $2.7 billion that will become due in the next 12 months. In addition, we have substantial noncancelable commitments for capital expenditures, including the acquisition of certain new aircraft and related spare engines. For 2021, including the impact of the recent Boeing agreement, the Company expects approximately $4.4 billion of gross capital expenditures. See Note 13 to the financial statements included in Part II, Item 8 of this report for additional information on commitments.Our 2021 liquidity needs will be met through our existing liquidity levels plus additional debt or equity issuances. We must return to profitability and/or access the capital markets to meet our significant long-term debt and finance lease obligations and future commitments for capital expenditures, including the acquisition of aircraft and related spare engines. Financing may be necessary to satisfy the Company's capital commitments for its firm order aircraft and other related capital expenditures. The Company has backstop financing commitments available from certain of its aircraft manufacturers for a limited number of its future aircraft deliveries, subject to certain customary conditions.See Note 10 to the financial statements included in Part II, Item 8 of this report for additional information on aircraft financing and other debt instruments.As of December 31, 2020, a substantial portion of the Company's assets, principally aircraft and certain related assets, its loyalty program, certain route authorities and airport slots, was pledged under various loan and other agreements. As of December 31, 2020, the Company had unencumbered assets, including aircraft, engines and other physical assets, routes, slots and gates, among other items, available to be pledged as collateral for future financings, if needed.The following is a discussion of the Company's sources and uses of cash for 2020 as compared to 2019. See "Liquidity and Capital Resources" in Part II, Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations in the 2019 Annual Report for a discussion of the Company's sources and uses of cash in 2019 as compared to 2018.Operating Activities. Cash flows used by operations for the year ended December 31, 2020 was $4.1 billion compared to $6.9 billion provided by operations in the same period in 2019. The change is primarily attributable to a $10.7 billion decrease in operating income for 2020 as compared to 2019 caused by the COVID-19 pandemic.42At December 31, 2020, $4.8 billion of current liabilities related to tickets sold to passengers for travel which includes $3.1 billion of credits issued to customers on electronic travel certificates ("ETCs") and future flight credits ("FFCs"), primarily for ticket cancellations, which can be applied towards a purchase of a new ticket. In April 2020, due to the COVID-19 pandemic, the Company extended the expiration dates of ETCs from 12 months from the date of issuance to 24 months from the date of issuance and extended the expiration of FFCs, for tickets issued between May 1, 2019 and March 31, 2020 to 24 months from the original issue date. On February 24, 2021, the Company extended the expiration dates for all tickets issued between May 1, 2019 and March 31, 2021 to March 31, 2022. While we expect many of those passengers to utilize these ETCs and FFCs during 2021, a delay in the recovery from the COVID-19 pandemic could result in a further extension of their expiration dates.Investing Activities. The Company's capital expenditures, net of flight equipment purchase deposit returns, were $1.7 billion and $4.5 billion in 2020 and 2019, respectively. The Company's capital expenditures for both years were primarily attributable to the purchase of aircraft, aircraft improvements, facility and fleet-related costs and the purchase of information technology assets.Maturities and sales of short-term investments provided $2.3 billion of liquidity in 2020.In December 2019, United issued the AVH Convertible Loan. For additional information regarding the AVH Convertible Loan, see Note 8 to the financial statements included in Part II, Item 8 of this report.Financing Activities. Significant financing events in 2020 were as follows:Debt Issuances. During 2020, United received and recorded $16.8 billion from various credit agreements, including the MileagePlus financing, the PSP Note, the CARES Act Term Loan Facility and enhanced equipment trust certificate ("EETC") pass-through trusts established in September 2019 and October 2020. As of December 31, 2020, United had recorded approximately $159 million of debt to finance the construction of an aircraft maintenance and ground service equipment complex at Los Angeles International Airport.Debt and Finance Lease Principal Payments. During the year ended December 31, 2020, the Company made debt and finance lease principal payments of $4.4 billion. Share Issuance. During the year ended December 31, 2020, the Company raised approximately $2.1 billion in cash proceeds from the issuance and sale of UAL common stock, par value $0.01 per share, including through "at the market offerings" under an equity distribution agreement (the "Distribution Agreement"), dated June 15, 2020, among the Company, Citigroup Global Markets Inc., BofA Securities, Inc. and J.P. Morgan Securities LLC. (the "ATM Offering"). During the quarter ended December 31, 2020, approximately 20.8 million shares were sold in the ATM Offering at an average price of $46.85 per share, with net proceeds to the Company totaling approximately $968 million. During the year ended December 31, 2020, approximately 21.4 million shares were sold in the ATM Offering at an average price of $46.70 per share, with net proceeds to the Company totaling approximately $989 million. As of February 23, 2021, the Company had sold all of the 28 million shares authorized under the ATM Offering, at an average price of $45.82 per share, with net proceeds to the Company of approximately $1.3 billion. The Board of Directors has authorized the Company to establish a new program providing for the issuance and sale from time to time of up to 37 million additional shares of UAL common stock in "at the market offerings". See Note 2 to the financial statements included in Part II, Item 8 of this report for more information about these issuances.Share Repurchases. In 2020, UAL's Board of Directors terminated the share repurchase program. In 2020, prior to the termination of the program, UAL repurchased approximately 4 million shares of UAL common stock in open market transactions for $0.3 billion. See Part II, Item 5, Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities of this report for additional information.Significant financing events in 2019 were as follows:Debt Issuances. During 2019, United received and recorded $1.8 billion of proceeds as debt related to EETC offerings created in 2019 to finance the purchase of aircraft. Also, United received and recorded $350 million of proceeds from the 4.875% Senior Notes due January 15, 2025 and borrowed approximately $105 million aggregate principal amount from various financial institutions to finance the purchase of several aircraft delivered in 2019. As of December 31, 2019, United had recorded approximately $39 million of debt to finance the construction of an aircraft maintenance and ground service equipment complex at Los Angeles International Airport.Debt and Finance Lease Principal Payments. During the year ended December 31, 2019, the Company made debt and finance lease principal payments of $1.4 billion.43Share Repurchases. The Company used $1.6 billion of cash to purchase approximately 19.2 million shares of its common stock during 2019.For additional information regarding these Liquidity and Capital Resource matters, see Notes 2, 10, 11 and 13 to the financial statements included in Part II, Item 8 of this report. For information regarding non-cash investing and financing activities, see the Company's statements of consolidated cash flows. Credit Ratings. As of the filing date of this report, UAL and United had the following corporate credit ratings: S&PMoody'sFitchUALB+Ba2BB-UnitedB+*BB-*The credit agency does not issue corporate credit ratings for subsidiary entities. These credit ratings are below investment grade levels; however, the Company has been able to secure financing with investment grade credit ratings for certain EETCs, term loans and secured bond financings. Downgrades from these rating levels, among other things, could restrict the availability, or increase the cost, of future financing for the Company. Other Liquidity MattersBelow is a summary of additional liquidity matters. See the indicated notes to our consolidated financial statements included in Part II, Item 8 of this report for additional details related to these and other matters affecting our liquidity and commitments.Pension and other postretirement plansNote 7Long-term debt and debt covenantsNote 10Leases and capacity purchase agreementsNote 11Commitments and contingenciesNote 13Contractual Obligations. The Company's business is capital intensive, requiring significant amounts of capital to fund the acquisition of assets, particularly aircraft. In the past, the Company has funded the acquisition of aircraft with cash, by using EETC financing, by entering into finance or operating leases, or through other financings. The Company also often enters into long-term lease commitments with airports to ensure access to terminal, cargo, maintenance and other required facilities.The table below provides a summary of the Company's material contractual obligations as of December 31, 2020 (in billions):20212022202320242025After 2025TotalLong-term debt (a)$1.9 $3.9 $2.7 $5.1 $3.7 $10.0 $27.3 Finance lease obligations—principal portion0.2 0.1 — — — 0.1 0.4 Total debt and finance lease obligations2.1 4.0 2.7 5.1 3.7 10.1 27.7 Interest on debt and finance lease obligations (b)1.1 1.0 0.9 0.7 0.5 1.0 5.2 Operating lease obligations0.8 0.7 0.7 0.7 0.6 4.0 7.5 Sale-leasebacks financial obligations0.1 0.1 0.1 0.1 0.1 1.5 2.0 Regional CPAs (c)1.8 1.8 1.7 1.5 1.2 3.1 11.1 Postretirement obligations (d)0.1 0.1 0.1 0.1 0.1 0.3 0.8 Pension obligations (e)— — 0.2 0.2 0.3 1.5 2.2 Purchase obligations (f)4.9 2.9 2.8 1.6 2.0 10.1 24.3 Total contractual obligations$10.9 $10.6 $9.2 $10.0 $8.5 $31.6 $80.8 (a)Long-term debt presented in the Company's financial statements is net of $554 million of debt discount, premiums and debt issuance costs which are being amortized over the debt terms. Contractual payments do not include the debt discount, premiums and debt issuance costs.(b)Includes interest portion of finance lease obligations of $16 million in 2021, $10 million in 2022, $8 million in 2023, $6 million in 2024, $3 million in 2025 and $5 million thereafter. Interest payments on variable interest rate debt were calculated using London interbank offered rates ("LIBOR") applicable at December 31, 2020.(c)Represents our estimates of future minimum noncancelable commitments under our CPAs and does not include the portion of the underlying obligations for aircraft and facility rent that is disclosed as part of operating lease obligations. Amounts also exclude a portion of United's finance lease obligation recorded for certain of its CPAs. See Note 11 to the financial statements included in Part II, Item 8 of this report for the significant assumptions used to estimate the payments.(d)Amounts represent postretirement benefit payments through 2030. Benefit payments approximate plan contributions as plans are substantially unfunded. 44(e)Represents an estimate of the minimum funding requirements as determined by government regulations for United's U.S. pension plans. Amounts are subject to change based on numerous assumptions, including the performance of assets in the plans and bond rates.(f)Represents contractual commitments for firm order aircraft (including the order entered into on February 26, 2021 with Boeing), spare engines and other capital purchase commitments. See Note 13 to the financial statements included in Part II, Item 8 of this report for a discussion of our purchase commitments.Off-Balance Sheet Arrangements. An off-balance sheet arrangement is any transaction, agreement or other contractual arrangement involving an unconsolidated entity under which a company has (1) made guarantees, (2) a retained or a contingent interest in transferred assets, (3) an obligation under derivative instruments classified as equity, or (4) any obligation arising out of a material variable interest in an unconsolidated entity that provides financing, liquidity, market risk or credit risk support, or that engages in leasing, hedging or research and development arrangements. The Company's primary off-balance sheet arrangements include guarantees that are discussed below and variable-rate operating leases. See Note 11 to the financial statements included in Part II, Item 8 of this report for more information related to variable-rate operating leases.Letters of Credit and Surety Bonds. As of December 31, 2020, United had approximately $658 million of letters of credit and surety bonds securing various obligations with expiration dates through 2030. Certain of these amounts are cash collateralized and reported within Restricted cash on our statement of financial position. See Note 13 to the financial statements included in Part II, Item 8 of this report for more information related to these letters of credit and surety bonds.Guarantee of Debt of Others. As of December 31, 2020, United is the guarantor of $119 million of aircraft mortgage debt issued by one of United's regional carriers. The aircraft mortgage debt is subject to increased cost provisions and the Company would potentially be responsible for those costs under the guarantees. The increased cost provisions in the $119 million of aircraft mortgage debt are similar to those in certain of the Company's debt agreements. See discussion under Increased Cost Provisions, below, for additional information on increased cost provisions related to the Company's debt.EETCs. As of December 31, 2020, United had $12.1 billion principal amount of equipment notes outstanding issued under EETC financings. Generally, the structure of these EETC financings consists of pass-through trusts created by United to issue pass-through certificates, which represent fractional undivided interests in the respective pass-through trusts and are not obligations of United. The proceeds of the issuance of the pass-through certificates are used to purchase equipment notes which are issued by United and secured by aircraft and, in certain structures, spare engines and spare parts. United is responsible for the payment obligations under the equipment notes. In certain EETC structures, proceeds received from the sale of pass-through certificates are initially held by a depositary in escrow for the benefit of the certificate holders until United issues equipment notes to the trust, which purchases such notes with a portion of the escrowed funds. These escrowed funds are not guaranteed by United and are not reported as debt on United's consolidated balance sheet because the proceeds held by the depositary are not United's assets. There were no EETC funds held in escrow as of December 31, 2020. See Note 10 to the financial statements included in Part II, Item 8 of this report for additional information.Fuel Consortia. United participates in numerous fuel consortia with other air carriers at major airports to reduce the costs of fuel distribution and storage. Interline agreements govern the rights and responsibilities of the consortia members and provide for the allocation of the overall costs to operate the consortia based on usage. The consortia (and in limited cases, the participating carriers) have entered into long-term agreements to lease certain airport fuel storage and distribution facilities that are typically financed through tax-exempt bonds, either special facilities lease revenue bonds or general airport revenue bonds, issued by various local municipalities. In general, each consortium lease agreement requires the consortium to make lease payments in amounts sufficient to pay the maturing principal and interest payments on the bonds. As of December 31, 2020, approximately $2.3 billion principal amount of such bonds were secured by significant fuel facility leases in which United participates, as to which United and each of the signatory airlines has provided indirect guarantees of the debt. As of December 31, 2020, the Company's contingent exposure was approximately $293 million principal amount of such bonds based on its recent consortia participation. The Company's contingent exposure could increase if the participation of other air carriers decreases. The guarantees will expire when the tax-exempt bonds are paid in full, which ranges from 2022 to 2051. The Company did not record a liability at the time these indirect guarantees were made.Increased Cost Provisions. In United's financing transactions that include loans in which United is the borrower, United typically agrees to reimburse lenders for any reduced returns with respect to the loans due to any change in capital requirements and, in the case of loans with respect to which the interest rate is based on LIBOR, for certain other increased costs that the lenders incur in carrying these loans as a result of any change in law, subject, in most cases, to obligations of the lenders to take certain limited steps to mitigate the requirement for, or the amount of, such increased costs. At December 31, 2020, the Company had $9.8 billion of floating rate debt with remaining terms of up to 12 years that are subject to these increased cost provisions. In several financing transactions involving loans or leases from non-U.S. entities, with remaining terms of up to 12 years and an aggregate balance of $8.3 billion, the Company bears the risk of any change in tax laws that would subject loan or lease payments thereunder to non-U.S. entities to withholding taxes, subject to customary exclusions.45Table of ContentsCritical Accounting PoliciesCritical accounting policies are defined as those that are affected by significant judgments and uncertainties which potentially could result in materially different accounting under different assumptions and conditions. The Company has prepared the financial statements in conformity with accounting principles generally accepted in the United States of America ("GAAP"), which requires management to make estimates and assumptions that affect the reported amounts in the financial statements. Actual results could differ from those estimates under different assumptions or conditions. The Company has identified the following critical accounting policies that impact the preparation of the financial statements.Revenue Recognition. Passenger revenue is recognized when transportation is provided. Passenger tickets and related ancillary services sold by the Company for flights are purchased primarily via credit card transactions, with payments collected by the Company in advance of the performance of related services. The Company initially records ticket sales in its Advance ticket sales liability, deferring revenue recognition until the travel occurs. For travel that has more than one flight segment, the Company deems each segment as a separate performance obligation and recognizes revenue for each segment as travel occurs. Tickets sold by other airlines where the Company provides the transportation are recognized as passenger revenue at the estimated value to be billed to the other airline when travel is provided. Differences between amounts billed and the actual amounts may be rejected and rebilled or written off if the amount recorded was different from the original estimate. When necessary, the Company records a reserve against its billings and payables with other airlines based on historical experience. The Company sells certain tickets with connecting flights with one or more segments operated by its other airline partners. For segments operated by its other airline partners, the Company has determined that it is acting as an agent on behalf of the other airlines as they are responsible for their portion of the contract (i.e. transportation of the passenger). The Company, as the agent, recognizes revenue within Other operating revenue at the time of the travel for the net amount representing commission to be retained by the Company for any segments flown by other airlines.Advance ticket sales represent the Company's liability to provide air transportation in the future. All tickets sold at any given point of time have travel dates extending up to 12 months. The Company defers amounts related to future travel in its Advance ticket sales liability account. The Company's Advance ticket sales liability also includes credits issued to customers on ETCs and FFCs, primarily for ticket cancellations, which can be applied towards a purchase of a new ticket. In April 2020, due to the COVID-19 pandemic, the Company extended the expiration dates of ETCs from 12 months from the date of issuance to 24 months from the date of issuance and extended the expiration of FFCs for tickets issued between May 1, 2019 and March 31, 2020 to 24 months from the original issue date. On February 24, 2021, the Company extended the expiration dates for all tickets issued between May 1, 2019 and March 31, 2021 to March 31, 2022. As of December 31, 2020, the Company's Advance ticket sales liability included $3.1 billion related to these credits.The Company records breakage revenue on the travel date for its estimate of tickets that will expire unused. To determine breakage, the Company uses its historical experience with refundable and nonrefundable expired tickets and other facts, such as recent aging trends, program changes and modifications that could affect the ultimate expiration patterns of tickets. The Company continues to use its historical experience and most recent trends and program changes to estimate its breakage. The Company will update its breakage estimates as future information is received. Given the uncertainty of travel demand caused by COVID-19, a significant portion of the $3.1 billion related to the ETCs and FFCs may expire unused in future periods and get recognized as breakage. Also, the Company is unable to estimate the amount of the ETCs and FFCs that will be used within the next 12 months and has classified the entire amount of the Advanced ticket liability in current liabilities even though some of the ETCs and FFCs could be used after the next 12 months.Frequent Flyer Accounting. United's MileagePlus loyalty program builds customer loyalty by offering awards, benefits and services to program participants. Members in this program earn miles for travel on United, United Express, Star Alliance members and certain other airlines that participate in the program. Members can also earn miles by purchasing goods and services from our network of non-airline partners. We have contracts to sell miles to these partners with the terms extending from one to nine years. These partners include domestic and international credit card issuers, retail merchants, hotels, car rental companies and our participating airline partners. Miles can be redeemed for free (other than taxes and government-imposed fees), discounted or upgraded air travel and non-travel awards.Co-Brand Agreement. During 2020, the Company entered into a Third Amended and Restated Co-Branded Card Marketing Services Agreement (as amended from time to time, the "Co-Brand Agreement") with its co-branded credit card partner Chase. The Co-Brand Agreement extended the term of the agreement into 2029 and modified certain other terms, resulting in a different allocation among the separately identifiable performance obligations. Chase awards miles to MileagePlus members based on their credit card activity. United identified the following significant separately identifiable performance obligations in the Co-Brand Agreement:46Table of Contents•MileagePlus miles awarded – United has a performance obligation to provide MileagePlus cardholders with miles to be used for air travel and non-travel award redemptions. The Company records Passenger revenue related to the travel awards when the transportation is provided and records Other revenue related to the non-travel awards when the goods or services are delivered. The Company records the cost associated with non-travel awards in Other operating revenue, as an agent.•Marketing – United has a performance obligation to provide Chase access to United's customer list and the use of United's brand. Marketing revenue is recorded to Other operating revenue as miles are delivered to Chase. •Advertising – United has a performance obligation to provide advertising in support of the MileagePlus card in various customer contact points such as United's website, email promotions, direct mail campaigns, airport advertising and in-flight advertising. Advertising revenue is recorded to Other operating revenue as miles are delivered to Chase. •Other travel-related benefits – United's performance obligations are comprised of various items such as waived bag fees, seat upgrades and lounge passes. Lounge passes are recorded to Other operating revenue as customers use the lounge passes. Bag fees and seat upgrades are recorded to Passenger revenue at the time of the associated travel. We account for all the payments received (including monthly and one-time payments) under the Co-Brand Agreement by allocating them to the separately identifiable performance obligations. The fair value of the separately identifiable performance obligations is determined using management's estimated selling price of each component. The objective of using the estimated selling price based methodology is to determine the price at which we would transact a sale if the product or service were sold on a stand-alone basis. Accordingly, we determine our best estimate of selling price by considering multiple inputs and methods including, but not limited to, discounted cash flows, brand value, volume discounts, published selling prices, number of miles awarded and number of miles redeemed. The Company estimated the selling prices and volumes over the term of the Co-Brand Agreement in order to determine the allocation of proceeds to each of the components to be delivered. We also evaluate volumes on an annual basis, which may result in a change in the allocation of the estimated consideration from the Co-Brand Agreement on a prospective basis. Indefinite-lived intangible assets. The Company has indefinite-lived intangible assets, including goodwill. Goodwill and indefinite-lived intangible assets are not amortized but are reviewed for impairment on an annual basis as of October 1, or on an interim basis whenever a triggering event occurs. An impairment occurs when the fair value of an intangible asset is less than its carrying value. The Company determines the fair value using a variation of the income approach known as the excess earnings method, which discounts an asset's projected future net cash flows to determine the current fair value. Assumptions used in the discounted cash flow methodology include a discount rate, which is based upon the Company's current weighted average cost of capital plus an asset-specific risk factor, and a projection of sales, expenses, gross margin, tax rates and contributory asset charges for several future years and a terminal growth rate. The assumptions used for future projections are determined based upon the Company's asset-specific forecasts along with the Company's strategic plan. These assumptions are inherently uncertain as they relate to future events and circumstances. Actual results will be influenced by the competitive environment, fuel costs and other expenses, and potentially other unforeseen events or circumstances that could have a material impact on future results. In light of the ongoing impact of the COVID-19 pandemic on both the U.S. and global economies, the significant, sustained impact on the demand for travel and government policies that restrict air travel, the exact timing of the recovery from the COVID-19 pandemic, and the speed at which such recovery could occur, continues to remain uncertain and could result in additional impairment charges in the future. We expect to continue to modify our cost management structure and capacity as the timing of demand recovery becomes more certain.As a result of the impairment assessments, the Company recorded impairment charges of $130 million during 2020 for its China routes which was primarily caused by the COVID-19 pandemic, the Company's subsequent suspension of flights to China and a further delay in the expected return of full capacity to the China markets. Based on our assessment at year-end, a 10% decline in the fair value of our China routes would not have resulted in an incremental impairment.See Note 1 and 14 to the financial statements included in Part II, Item 8 of this report for additional information.Tax valuation allowance. A tax valuation allowance is recognized if it is more likely than not that some portion or all of the deferred tax assets will not be realized. The Company's management assesses available positive and negative evidence regarding the Company's ability to realize its deferred tax assets and records a valuation allowance when it is more likely than not that deferred tax assets will not be realized. In order to form a conclusion, management considers positive evidence in the form of taxable income in prior carryback years, reversing temporary differences, tax planning strategies and projections of future taxable income during the periods in which those temporary differences become deductible, as well as negative evidence such as historical losses. Although the Company was in a cumulative loss position at the end of 2020, management determined that the 2020 results were not indicative of future results due to the impact of the COVID-19 pandemic on its operations. The Company concluded that the positive evidence outweighs the negative evidence, primarily driven by the approval and distribution of COVID-19 vaccines as well as increased confidence with the timing of the recovery. The Company has $6.6 47Table of Contentsbillion of deferred tax assets, of which $2.3 billion are attributable to federal net operating losses ("NOLs") at December 31, 2020. The majority of the NOLs do not expire and the Company expects to recognize the NOLs through the reversal of existing deferred tax liabilities of $6.5 billion and projected future taxable income. Therefore, we have not recorded a valuation allowance on our deferred tax assets other than the capital loss carryforwards and state attributes that have short expiration periods. While the Company expects to generate sufficient future profits to fully utilize these NOLs, the Company may have to record a valuation allowance against its NOLs if it is unable to generate sufficient taxable income in future periods. Recording a valuation allowance against our NOLs would not impact our ability to use them. However, our ability to use NOLs may be significantly limited due to various circumstances, as discussed in more detail in Part I, Item 1A. Risk Factors—"The Company's ability to use its net operating loss carryforwards and certain other tax attributes to offset future taxable income for U.S. federal income tax purposes may be significantly limited due to various circumstances, including certain possible future transactions involving the sale or issuance of UAL common stock, or if taxable income does not reach sufficient levels." Assumptions about our future taxable income are consistent with the plans and estimates used to manage our business. Management will continue to evaluate future financial performance to determine whether such performance is both sustained and significant enough to provide sufficient evidence to support not recording a valuation allowance on these NOLs. Any reduction in estimated future taxable income may require additional valuation allowance against the deferred tax assets, which could be material.As of December 31, 2020, the Company has recorded $185 million of valuation allowance against its capital loss deferred tax assets. Capital losses have a limited carryforward period of five years, and they can be utilized only to the extent of capital gains. The Company does not anticipate generating sufficient capital gains to utilize the losses before they expire, therefore, a valuation allowance is necessary as of December 31, 2020. Additionally, the Company recorded a valuation allowance of $62 million on the state NOL and state tax credit deferred tax assets primarily due to utilization limitations resulting from a prior ownership change.Forward-Looking InformationCertain statements throughout Part II, Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations, and elsewhere in this report are forward-looking and thus reflect the Company's current expectations and beliefs with respect to certain current and future events and anticipated financial and operating performance. Such forward-looking statements are and will be subject to many risks and uncertainties relating to the Company's operations and business environment that may cause actual results to differ materially from any future results expressed or implied in such forward-looking statements. Words such as "expects," "will," "plans," "anticipates," "indicates," "remains," "believes," "estimates," "forecast," "guidance," "outlook," "goals", "targets" and similar expressions are intended to identify forward-looking statements.Additionally, forward-looking statements include statements that do not relate solely to historical facts, such as statements which identify uncertainties or trends, discuss the possible future effects of current known trends or uncertainties, or which indicate that the future effects of known trends or uncertainties cannot be predicted, guaranteed or assured. All forward-looking statements in this report are based upon information available to us on the date of this report. We undertake no obligation to publicly update or revise any forward-looking statement, whether as a result of new information, future events, changed circumstances or otherwise, except as required by applicable law.Our actual results could differ materially from these forward-looking statements due to numerous factors including, without limitation, the following: the duration and spread of the ongoing global COVID-19 pandemic and the outbreak of any other disease or similar public health threat and the impact on our business, results of operations and financial condition; the lenders' ability to accelerate the MileagePlus indebtedness, foreclose upon the collateral securing the MileagePlus indebtedness or exercise other remedies if we are not able to comply with the covenants in the MileagePlus financing agreements; the effects of borrowing pursuant to the Loan Program under the CARES Act and the effects of the grant and promissory note through the Payroll Support Program under the CARES Act; the costs and availability of financing; our significant amount of financial leverage from fixed obligations and ability to seek additional liquidity and maintain adequate liquidity; our ability to comply with the terms of our various financing arrangements; our ability to utilize our net operating losses to offset future taxable income; the material disruption of our strategic operating plan as a result of the COVID-19 pandemic and our ability to execute our strategic operating plans in the long term; general economic conditions (including interest rates, foreign currency exchange rates, investment or credit market conditions, crude oil prices, costs of aircraft fuel and energy refining capacity in relevant markets); risks of doing business globally, including instability and political developments that may impact our operations in certain countries; demand for travel and the impact that global economic and political conditions have on customer travel patterns; our capacity decisions and the capacity decisions of our competitors; competitive pressures on pricing and on demand; changes in aircraft fuel prices; disruptions in our supply of aircraft fuel; our ability to cost-effectively hedge against increases in the price of aircraft fuel, if we decide to do so; the effects of any technology failures or cybersecurity or significant data breaches; disruptions to services provided by third-party service providers; potential reputational or other impact from adverse events involving our aircraft or operations, the aircraft or operations of our regional carriers or our code share partners or the 48Table of Contentsaircraft or operations of another airline; our ability to attract and retain customers; the effects of any terrorist attacks, international hostilities or other security events, or the fear of such events; the mandatory grounding of aircraft in our fleet; disruptions to our regional network as a result of the COVID-19 pandemic or otherwise; the impact of regulatory, investigative and legal proceedings and legal compliance risks; the success of our investments in other airlines, including in other parts of the world, which involve significant challenges and risks, particularly given the impact of the COVID-19 pandemic; industry consolidation or changes in airline alliances; the ability of other air carriers with whom we have alliances or partnerships to provide the services contemplated by the respective arrangements with such carriers; costs associated with any modification or termination of our aircraft orders; disruptions in the availability of aircraft, parts or support from our suppliers; our ability to maintain satisfactory labor relations and the results of any collective bargaining agreement process with our union groups; any disruptions to operations due to any potential actions by our labor groups; labor costs; the impact of any management changes; extended interruptions or disruptions in service at major airports where we operate; U.S. or foreign governmental legislation, regulation and other actions (including Open Skies agreements, environmental regulations and the United Kingdom's withdrawal from the European Union); the seasonality of the airline industry; weather conditions; the costs and availability of aviation and other insurance; our ability to realize the full value of our intangible assets and long-lived assets; any impact to our reputation or brand image and other risks and uncertainties set forth under Part I, Item 1A. Risk Factors, of this report, as well as other risks and uncertainties set forth from time to time in the reports we file with the SEC.49Table of ContentsITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.Interest Rates. Our net income is affected by fluctuations in interest rates (e.g. interest expense on variable rate debt and interest income earned on short-term investments). The Company's policy is to manage interest rate risk through a combination of fixed and variable rate debt. The following table summarizes information related to the Company's interest rate market risk at December 31 (in millions):20202019Variable rate debtCarrying value of variable rate debt at December 31$9,533 $3,408 Impact of 100 basis point increase on projected interest expense for the following year81 33 Fixed rate debtCarrying value of fixed rate debt at December 3117,214 11,144 Fair value of fixed rate debt at December 3119,273 11,736 Impact of 100 basis point increase in market rates on fair value(709)(458)As most recently announced on November 30, 2020, LIBOR is expected to be phased out starting on January 1, 2022 for the one-week and two-month USD LIBOR settings and starting on July 1, 2023 for the remaining USD LIBOR settings. Uncertainty as to the nature of alternative reference rates and as to potential changes or other reforms to LIBOR may adversely impact our interest rates and related interest expense. As of December 31, 2020, the Company had $9.5 billion in variable rate indebtedness. See Part II, Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations—Other Liquidity Matters, of this report for more information on interest expense.A change in market interest rates would also impact interest income earned on our cash, cash equivalents and short-term investments. Assuming our cash, cash equivalents and short-term investments remain at their average 2020 levels, a 100 basis point increase in interest rates would result in a corresponding increase in the Company's interest income of approximately $95 million during 2021.Commodity Price Risk (Aircraft Fuel). The price of aircraft fuel can significantly affect the Company's operations, results of operations, financial position and liquidity.Our operational and financial results can be significantly impacted by changes in the price and availability of aircraft fuel. To provide adequate supplies of fuel, the Company routinely enters into purchase contracts that are customarily indexed to market prices for aircraft fuel, and the Company generally has some ability to cover short-term fuel supply and infrastructure disruptions at some major demand locations. The Company's current strategy is to not enter into transactions to hedge fuel price volatility, although the Company regularly reviews its policy based on market conditions and other factors. The Company's 2021 forecasted fuel consumption is presently approximately 2.1 billion gallons, and based on this forecast, a one-dollar change in the price of a barrel of crude oil would change the Company's annual fuel expense by approximately $49 million.Foreign Currency. The Company generates revenues and incurs expenses in numerous foreign currencies. Changes in foreign currency exchange rates impact the Company's results of operations through changes in the dollar value of foreign currency-denominated operating revenues and expenses. Some of the Company's more significant foreign currency exposures include the Canadian dollar, Chinese renminbi, European euro, British pound and Japanese yen. The Company's current strategy is to not enter into transactions to hedge its foreign currency sales, although the Company regularly reviews its policy based on market conditions and other factors.The result of a uniform 1% strengthening in the value of the U.S. dollar from December 31, 2020 levels relative to each of the currencies in which the Company has foreign currency exposure would result in a decrease in pre-tax income of approximately $10 million for the year ending December 31, 2021. This sensitivity analysis was prepared based upon projected 2021 foreign currency-denominated revenues and expenses as of December 31, 2020.50Table of Contents
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+ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSThe following review of our results of operations and financial condition should be read in conjunction with Item 1A, “RISK FACTORS,” and Item 8, “FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA,” included in this report.This discussion and analysis includes the years ended December 31, 2020 and 2019 and comparisons between such years. The discussions for the year ended December 31, 2018 and comparisons between the years ended December 31, 2019 and 2018 have been omitted from this Annual Report on Form 10-K for the year ended December 31, 2020, as such information can be found in “MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS” in Part II, Item 7 in our Annual Report on Form 10-K for the year ended December 31, 2019, which was filed on February 26, 2020.CAUTIONARY STATEMENT FOR THE PURPOSE OF SAFE HARBOR PROVISIONS OF THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995This report, including without limitation our disclosures below under the heading “OVERVIEW AND OUTLOOK,” includes forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. You can identify our forward-looking statements by the words “anticipate,” “believe,” “expect,” “plan,” “intend,” “scheduled,” “estimate,” “project,” “projection,” “predict,” “budget,” “forecast,” “goal,” “guidance,” “target,” “could,” “would,” “should,” “will,” “may,” “strive,” “seek,” “potential,” “opportunity,” “aimed,” “considering,” “continue,” and similar expressions.These forward-looking statements include, among other things, statements regarding:•the effect, impact, potential duration, or other implications of the COVID-19 pandemic and global crude oil production levels, and any expectations we may have with respect thereto, including with respect to our operations and the production levels of our assets;•future refining segment margins, including gasoline and distillate margins;•future renewable diesel segment margins;•future ethanol segment margins;•expectations regarding feedstock costs, including crude oil differentials, and operating expenses;•anticipated levels of crude oil and refined petroleum product inventories and storage capacity;•our anticipated level of capital investments, including deferred turnaround and catalyst cost expenditures, capital expenditures for environmental and other purposes, and joint venture investments, the expected timing applicable to such capital investments and any related projects, and the effect of those capital investments on our results of operations;•our anticipated level of cash distributions or contributions, such as our dividend payment rate and contributions to our qualified pension plans and other postretirement benefit plans;•anticipated trends in the supply of and demand for crude oil and other feedstocks and refined petroleum products, renewable diesel, and ethanol and corn related co-products in the regions where we operate, as well as globally;•expectations regarding environmental, tax, and other regulatory initiatives; and•the effect of general economic and other conditions on refining, renewable diesel, and ethanol industry fundamentals.30Table of ContentsWe based our forward-looking statements on our current expectations, estimates, and projections about ourselves, our industry, and the global economy and financial markets generally. We caution that these statements are not guarantees of future performance or results and involve risks, uncertainties, and assumptions that we cannot predict. In addition, we based many of these forward-looking statements on assumptions about future events that may prove to be inaccurate. Accordingly, actual results may differ materially from the future performance or results that we have expressed or forecast in the forward-looking statements. Differences between actual results and any future performance or results suggested in these forward-looking statements could result from a variety of factors, including the following:•demand for, and supplies of, refined petroleum products (such as gasoline, diesel, jet fuel, and petrochemicals), renewable diesel, and ethanol and corn related co-products;•demand for, and supplies of, crude oil and other feedstocks;•the effects of public health threats, pandemics, and epidemics, such as the COVID-19 pandemic, and the adverse impacts thereof on our business, financial condition, results of operations, and liquidity, including, but not limited to, our growth, operating costs, supply chain, labor availability, logistical capabilities, customer demand for our products, and industry demand generally, margins, production and throughput capacity, utilization, inventory value, cash position, taxes, the price of our securities and trading markets with respect thereto, our ability to access capital markets, and the global economy and financial markets generally;•acts of terrorism aimed at either our refineries and plants or third-party facilities that could impair our ability to produce or transport refined petroleum products, renewable diesel, ethanol, or corn related co-products, or to receive feedstocks;•political and economic conditions in nations that produce crude oil or other feedstocks or consume refined petroleum products, renewable diesel, ethanol or corn related co-products;•the ability of the members of OPEC to agree on and to maintain crude oil price and production controls;•the level of consumer demand, including seasonal fluctuations;•refinery, renewable diesel plant or ethanol plant overcapacity or undercapacity;•our ability to successfully integrate any acquired businesses into our operations;•the actions taken by competitors, including both pricing and adjustments to refining capacity or renewable fuels production in response to market conditions;•the level of competitors’ imports into markets that we supply;•accidents, unscheduled shutdowns, weather events, civil unrest, political events, terrorism, cyberattacks, or other catastrophes or disruptions affecting our operations, production facilities, machinery, pipelines and other logistics assets, equipment, or information systems, or any of the foregoing of our suppliers, customers, or third-party service providers;•changes in the cost or availability of transportation or storage capacity for feedstocks and our products;•the price, availability, and acceptance of alternative fuels and alternative-fuel vehicles, as well as sentiment and perceptions with respect to GHG emissions more generally;•the levels of government subsidies for, and mandates or other policies with respect to, alternative fuels, alternative-fuel vehicles, and other low-carbon technologies;•the volatility in the market price of biofuel credits (primarily RINs needed to comply with the RFS) and GHG emission credits needed to comply with the requirements of various GHG emission programs;•delay of, cancellation of, or failure to implement planned capital projects and realize the various assumptions and benefits projected for such projects or cost overruns in constructing such planned capital projects;31Table of Contents•earthquakes, hurricanes, tornadoes, and irregular weather, which can unforeseeably affect the price or availability of natural gas, crude oil, rendered and recycled materials, corn, and other feedstocks, refined petroleum products, renewable diesel, and ethanol;•rulings, judgments, or settlements in litigation or other legal or regulatory matters, including unexpected environmental remediation costs, in excess of any reserves or insurance coverage;•legislative or regulatory action, including the introduction or enactment of legislation or rulemakings by governmental authorities, including tariffs and tax and environmental regulations, such as those implemented under the California cap-and-trade system and similar programs, and the U.S. EPA’s or other governmental regulation of GHGs, which may adversely affect our business or operations;•changes in the credit ratings assigned to our debt securities and trade credit;•changes in currency exchange rates, including the value of the Canadian dollar, the pound sterling, the euro, the Mexican peso, and the Peruvian sol relative to the U.S. dollar;•the adequacy of capital resources and liquidity, including availability, timing, and amounts of cash flow or our ability to borrow;•overall economic conditions, including the stability and liquidity of financial markets; and•other factors generally described in the “RISK FACTORS” section included in Item 1A, “RISK FACTORS” in this report.Any one of these factors, or a combination of these factors, could materially affect our future results of operations and whether any forward-looking statements ultimately prove to be accurate. Our forward-looking statements are not guarantees of future performance, and actual results and future performance may differ materially from those suggested in any forward-looking statements. We do not intend to update these statements unless we are required by the securities laws to do so.All subsequent written and oral forward-looking statements attributable to us or persons acting on our behalf are expressly qualified in their entirety by the foregoing. We undertake no obligation to publicly release any revisions to any such forward-looking statements that may be made to reflect events or circumstances after the date of this report or to reflect the occurrence of unanticipated events.NON-GAAP FINANCIAL MEASURESThe discussions in “OVERVIEW AND OUTLOOK,” “RESULTS OF OPERATIONS,” and “LIQUIDITY AND CAPITAL RESOURCES” below include references to financial measures that are not defined under U.S. generally accepted accounting principles (GAAP). These non-GAAP financial measures include adjusted operating income (loss) (including adjusted operating income (loss) for each of our reportable segments, as applicable); refining, renewable diesel, and ethanol segment margin; and capital investments attributable to Valero. We have included these non-GAAP financial measures to help facilitate the comparison of operating results between years and to help assess our cash flows. See the tables in note (f) beginning on page 46 for reconciliations of adjusted operating income (loss) (including adjusted operating income (loss) for each of our reportable segments, as applicable) and refining, renewable diesel, and ethanol segment margin to their most directly comparable U.S. GAAP financial measures. Also in note (f), we disclose the reasons why we believe our use of such non-GAAP financial measures provides useful information. See the table on page 53 for a reconciliation of capital investments attributable to Valero to its most directly comparable U.S. GAAP financial measure. Beginning on page 52, we disclose the reasons why we believe our use of this non-GAAP financial measure provides useful information.32Table of ContentsOVERVIEW AND OUTLOOKOverviewBusiness Operations UpdateThe outbreak of COVID-19 and its development into a pandemic in March 2020 has resulted in significant economic disruption globally, including in North America, Europe, and Latin America, the primary geographic areas where we operate. In March, governmental authorities around the world took actions, such as stay-at-home orders and other social distancing measures, to slow the spread of COVID-19 that restricted travel, public gatherings, and the overall level of individual movement and in-person interaction across the globe. These actions significantly reduced global economic activity and negatively impacted many businesses, including our business. Airlines have dramatically reduced flights and motor vehicle usage has significantly declined, in each case relative to typical pre-pandemic levels. As a result, in the first half of 2020, there was a decline in the demand for, and thus also the market prices of, most of the transportation fuels that we produce and sell. There was also a decline in the global demand for crude oil, the primary feedstock for our refined products, resulting in a decline in crude oil prices and production levels. While the production levels of all types of crude oils have declined, sour crude oil production has declined significantly and by more than production levels for sweet crude oils. This has reduced the price advantage of sour crude oils relative to sweet crude oils, which has exacerbated the negative impact of lower product prices on our refining margin.6,7Beginning in the latter part of the second quarter, certain governmental authorities in the U.S. and other countries across the world, particularly those in our U.S. Gulf Coast and U.S. Mid-Continent regions, began lifting many of the restrictions put in place to slow the spread of COVID-19, while governmental authorities in our U.S. West Coast and North Atlantic regions began lifting restrictions on a more moderate basis during the third quarter. This resulted in an increase in the level of individual movement and travel and, in turn, an increase in the demand and market prices for most of our products relative to what we experienced during the early months of the pandemic. However, in the second half of 2020, many locations where restrictions were lifted, and others where the restrictions were only more moderately lifted (such as California in our U.S. West Coast region, and New York, Canada, and the U.K. in our North Atlantic region), experienced a resurgence in the spread of COVID-19, which prompted many governmental authorities to reimpose certain restrictions. In December 2020, the U.S. FDA and Canadian and U.K. regulators each granted emergency-use authorization for multiple COVID-19 vaccines to be used as immunization against the COVID-19 virus. Although these vaccines may be seen as a key factor in helping to restore public confidence, and thus stimulate and increase economic activity, potentially to pre-pandemic levels, they may not be distributed widely on a timely basis and they may not be effective against new variants of the virus. Based on these and other circumstances that cannot be predicted, the broader implications of the pandemic on our results of operations and financial position remain uncertain.As previously noted, the decrease in the demand for transportation fuels has resulted in a significant decrease in the price of refined petroleum products manufactured by our refining segment. For example, the price of gasoline8 in the U.S. Gulf Coast region where eight of our 15 refineries are located was $68.82 per barrel at the beginning of 2020, fell to $17.65 per barrel at the end of March (a 74 percent decline), and partially recovered to $57.63 per barrel by the end of December (a 16 percent decline over 6 See page 46 for our definition of refining margin and why we believe it is an important financial and operating measure.7 Sour crude oils typically sell at a discount to the price of benchmark sweet crude oils, which set the price of most refined products. Therefore, lower prices for sour crude oils that we process have a favorable impact on our refining margin.8 Gasoline prices quoted represent the price of U.S. Gulf Coast conventional blendstock of oxygenate blending gasoline.33Table of Contentsthe twelve-month period). Another example is the price of diesel9 in the U.S. Gulf Coast region, which was $81.71 per barrel at the beginning of 2020, fell to $39.18 per barrel at the end of March (a 52 percent decline), and partially recovered to $60.20 per barrel by the end of December (a 26 percent decline over the twelve-month period). On February 22, 2021, the prices of gasoline and diesel were $76.62 per barrel and $76.84 per barrel, respectively.Demand for renewable diesel has not declined due to continued demand for this low-carbon transportation fuel despite the current economic environment; therefore, our renewable diesel segment has not been impacted as were our refining and ethanol segments.The price of ethanol manufactured by our ethanol segment has also decreased due to a decline in demand. Because ethanol is primarily blended into gasoline, ethanol demand declined along with the decline in the demand for gasoline.Prices for the products we sell and the feedstocks we purchase impact our revenues, cost of sales, operating income, and liquidity. In addition, a decline in the market prices of products and feedstocks below their carrying values in our inventory results in a writedown in the value of our inventories, and a subsequent recovery in market prices results in a write-up in the value of our inventories, not to exceed their previous carrying values. These inventory valuation adjustments are referred to as LCM inventory valuation adjustments and are described in Note 5 of Notes to Consolidated Financial Statements. We wrote down the value of our inventories by $2.5 billion in the first quarter of 2020 due to the significant decline in market prices at that time, but as market prices improved, the writedown was fully reversed by the end of the third quarter.For the year ended December 31, 2020, we generated an operating loss of $1.6 billion. Our operating results for the year ended December 31, 2020, including operating results by segment, are described in the summary below, and detailed descriptions can be found under “RESULTS OF OPERATIONS” on pages 37 through 49.Our cash and cash equivalents increased by $730 million during 2020, from $2.6 billion as of December 31, 2019 to $3.3 billion as of December 31, 2020. We invested $2.4 billion in our business and returned $1.8 billion to our stockholders primarily through dividend payments. These uses of cash were offset by proceeds from two public debt offerings totaling $4.0 billion before deducting the underwriting discounts and debt issuance costs as described in Note 10 of Notes to Consolidated Financial Statements. In addition, our operations generated net cash of $948 million, which was driven by a decrease in inventory on hand. We had $9.0 billion of liquidity10 as of December 31, 2020. A summary of our cash flows is presented on page 50, and a description of our cash flows and other matters impacting our liquidity and capital resources, including measures we have taken to address the impacts of the COVID-19 pandemic on our liquidity, can be found under “LIQUIDITY AND CAPITAL RESOURCES” on pages 49 through 55.We have responded in multiple ways to the impacts from the COVID-19 pandemic on our business, and we will strive to continue to respond to these impacts. During the early months of the pandemic, we reduced the amount of crude oil processed at most of our refineries in response to the decreased demand for our products, we temporarily idled various gasoline-making units at certain of our refineries to further limit gasoline production, and we took measures to reduce jet fuel production. We also temporarily idled 9 Diesel prices quoted represent the price of U.S. Gulf Coast ultra-low sulfur diesel.10 See the components of our liquidity as of December 31, 2020 in the table on page 50 under “LIQUIDITY AND CAPITAL RESOURCES—Our Liquidity.”34Table of Contentseight of our ethanol plants and reduced production at our other ethanol plants, in each case in order to address the decreased demand for ethanol. We have since increased the production of most of our products to align with increasing demand, and we restarted the gasoline-making units and most of the ethanol plants that had been temporarily idled. Demand for our products taken as a whole, however, has not returned to pre-pandemic levels, and as of December 31, 2020, our refineries and plants are operating to meet current product demand. In addition to these measures and the issuances of an aggregate of $4.0 billion of debt previously noted, we have addressed our liquidity as outlined below:•We deferred projects representing approximately $500 million of capital investments that we had expected to make in 2020 related to our refining and ethanol segments.•We deferred income and indirect (e.g., VAT and motor fuel taxes) tax payments of approximately $440 million due in the first and second quarters of 2020. These deferrals were provided to taxpayers under new legislation, such as the Coronavirus Aid, Relief, and Economic Security (CARES) Act in the U.S., and by various taxing authorities under existing legislation. As of December 31, 2020, we had approximately $250 million of deferred tax payments. Of the $250 million, approximately 70 percent will be paid in 2021 and 30 percent in 2022.•We have not purchased any shares of our common stock under our stock purchase program since mid-March 2020, and we will evaluate the timing of repurchases when appropriate. We have no obligation to make purchases under our stock purchase program.•We entered into a 364-day Revolving Credit Facility on April 13, 2020 with an aggregate principal amount of up to $875 million as described in Note 10 of Notes to Consolidated Financial Statements. As of December 31, 2020 and February 22, 2021, we had no outstanding borrowings under this facility.•We extended the maturity date of our accounts receivable sales facility to July 2021 and decreased the facility amount from $1.3 billion to $1.0 billion as described in Note 10 of Notes to Consolidated Financial Statements. As of December 31, 2020 and February 22, 2021, we had no outstanding borrowings under this facility.Many uncertainties remain with respect to the COVID-19 pandemic, including its resulting economic effects, and we are unable to predict the ultimate economic impacts from the pandemic on our business and how quickly national economies can recover once the pandemic subsides, the timing or effectiveness of vaccine distributions, or whether any recovery will ultimately experience a reversal or other setbacks. However, the adverse impacts of the economic effects on our company have been and will likely continue to be significant. We believe we have proactively addressed many of the known impacts of the pandemic to the extent possible and we will strive to continue to do so, but there can be no assurance that these or other measures will be fully effective.Results for the Year Ended December 31, 2020For 2020, we reported a net loss attributable to Valero stockholders of $1.4 billion compared to net income attributable to Valero stockholders of $2.4 billion for 2019, which represents a decrease of $3.8 billion. The decrease was primarily due to lower operating income of $5.4 billion, partially offset by a $1.6 billion decrease in income taxes. The decrease in operating income included a $224 million charge for the impact of a liquidation of LIFO inventory layers, which is described in Note 5 of Notes to Consolidated Financial Statements and in note (a) on page 44.35Table of ContentsWhile our operating income decreased by $5.4 billion in 2020 compared to 2019, adjusted operating income decreased by $5.0 billion. Adjusted operating income excludes the LIFO liquidation adjustment and other adjustments to operating income reflected in the table in note (f) on page 49.The $5.0 billion decrease in adjusted operating income was primarily due to the following:•Refining segment. Refining segment adjusted operating income decreased by $5.1 billion primarily due to decreases in gasoline and distillate margins, lower throughput volumes, and the higher cost of biofuel credits, partially offset by higher margins on other products and lower operating expenses (excluding depreciation and amortization expense). This is more fully described on pages 41 and 42.•Renewable diesel segment. Renewable diesel segment adjusted operating income increased by $62 million primarily due to a favorable impact from commodity derivative instruments associated with our price risk management activities. This is more fully described on page 43.•Ethanol segment. Ethanol segment adjusted operating income decreased by $40 million primarily due to lower ethanol prices and production volumes, partially offset by higher prices on corn related co-products, lower corn prices, and lower operating expenses (excluding depreciation and amortization expense). This is more fully described on pages 43 and 44.OutlookAs previously discussed, many uncertainties remain with respect to the COVID-19 pandemic, and while it is difficult to predict the ultimate economic impacts that the pandemic will have on us and how quickly we can recover once the pandemic subsides, we have noted several factors below that have impacted or may impact our results of operations during the first quarter of 2021.•Gasoline, jet fuel, and diesel prices are expected to improve as industry-wide excess inventory levels continue to draw toward historical levels and product demand recovers.•Sour crude oil discounts are not expected to improve until OPEC production is increased in response to any growth in global oil demand.•Renewable diesel margins are expected to remain consistent with current levels.•Ethanol margins are expected to decline.As a result of Brexit in June 2016, the U.K. withdrew from the EU on January 31, 2020 consistent with the terms of the EU-UK Withdrawal Agreement. In late December 2020, the European Commission reached a trade agreement with the U.K. on the terms of its future cooperation with the EU. The trade agreement offers U.K. and EU companies preferential access to each other’s markets, ensuring imported goods will be free of tariffs and quotas (subject to rules of origin requirements). Although the ultimate impact of this trade agreement is currently unknown, we do not anticipate any material adverse effect on our operations in the U.K.In mid-February 2021, the U.S. Gulf Coast and U.S. Mid-Continent regions experienced a severe winter storm that disrupted the operation of industrial facilities like refineries, plants, and logistical assets, including ours located in those regions. Most facilities experienced curtailments or outages of various utilities and other services necessary for such facilities to remain operational. All of our facilities in those 36Table of Contentsregions were impacted to some extent by the severe cold and/or supply and utility disruptions. We are in the process of returning to normal operations and we are currently unable to estimate the impact this event will have on our results of operations.RESULTS OF OPERATIONSThe following tables, including the reconciliations of non-GAAP financial measures to their most directly comparable U.S. GAAP financial measures in note (f) beginning on page 46, highlight our results of operations, our operating performance, and market reference prices that directly impact our operations.Financial Highlights by Segment and Total Company(millions of dollars)Year Ended December 31, 2020RefiningRenewableDieselEthanolCorporateandEliminationsTotalRevenues:Revenues from external customers$60,840 $1,055 $3,017 $— $64,912 Intersegment revenues8 212 226 (446)— Total revenues60,848 1,267 3,243 (446)64,912 Cost of sales:Cost of materials and other (a) (b)56,093 500 2,784 (444)58,933 LCM inventory valuation adjustment (c)(19)— — — (19)Operating expenses (excluding depreciation and amortization expense reflected below)3,944 85 406 — 4,435 Depreciation and amortization expense (d)2,138 44 121 — 2,303 Total cost of sales62,156 629 3,311 (444)65,652 Other operating expenses34 — 1 — 35 General and administrative expenses (excluding depreciation and amortization expense reflected below)— — — 756 756 Depreciation and amortization expense— — — 48 48 Operating income (loss) by segment$(1,342)$638 $(69)$(806)(1,579)Other income, net132 Interest and debt expense, net of capitalized interest(563)Loss before income tax benefit(2,010)Income tax benefit(903)Net loss(1,107)Less: Net income attributable to noncontrolling interests (b)314 Net loss attributable to Valero Energy Corporation stockholders$(1,421)________________________See note references on pages 44 through 49.37Table of ContentsFinancial Highlights by Segment and Total Company (continued)(millions of dollars)Year Ended December 31, 2019RefiningRenewableDieselEthanolCorporateandEliminationsTotalRevenues:Revenues from external customers$103,746 $970 $3,606 $2 $108,324 Intersegment revenues18 247 231 (496)— Total revenues103,764 1,217 3,837 (494)108,324 Cost of sales:Cost of materials and other (b)93,371 360 3,239 (494)96,476 Operating expenses (excluding depreciation and amortization expense reflected below)4,289 75 504 — 4,868 Depreciation and amortization expense2,062 50 90 — 2,202 Total cost of sales99,722 485 3,833 (494)103,546 Other operating expenses20 — 1 — 21 General and administrative expenses (excluding depreciation and amortization expense reflected below)— — — 868 868 Depreciation and amortization expense— — — 53 53 Operating income by segment$4,022 $732 $3 $(921)3,836 Other income, net (e)104 Interest and debt expense, net of capitalized interest(454)Income before income tax expense3,486 Income tax expense702 Net income2,784 Less: Net income attributable to noncontrolling interests (b)362 Net income attributable toValero Energy Corporation stockholders$2,422 ________________________See note references on pages 44 through 49.38Table of ContentsAverage Market Reference Prices and DifferentialsYear Ended December 31,20202019RefiningFeedstocks (dollars per barrel)Brent crude oil$43.15 $64.18 Brent less West Texas Intermediate (WTI) crude oil3.84 7.15 Brent less Alaska North Slope (ANS) crude oil0.82 (0.86)Brent less LLS crude oil1.91 1.47 Brent less Argus Sour Crude Index (ASCI) crude oil3.26 3.56 Brent less Maya crude oil6.89 6.57 LLS crude oil41.24 62.71 LLS less ASCI crude oil1.35 2.09 LLS less Maya crude oil4.98 5.10 WTI crude oil39.31 57.03 Natural gas (dollars per million British Thermal Units (MMBtu))2.00 2.47 Products (dollars per barrel)U.S. Gulf Coast:Conventional Blendstock of Oxygenate Blending (CBOB)gasoline less Brent2.97 4.37 Ultra-low-sulfur (ULS) diesel less Brent7.11 14.90 Propylene less Brent(12.12)(22.31)CBOB gasoline less LLS4.88 5.84 ULS diesel less LLS9.02 16.37 Propylene less LLS(10.22)(20.84)U.S. Mid-Continent:CBOB gasoline less WTI6.96 13.62 ULS diesel less WTI12.11 22.77 North Atlantic:CBOB gasoline less Brent5.50 7.20 ULS diesel less Brent9.17 17.22 U.S. West Coast:CARBOB 87 gasoline less ANS10.33 16.28 CARB diesel less ANS12.42 19.30 CARBOB 87 gasoline less WTI13.36 24.29 CARB diesel less WTI15.44 27.31 39Table of ContentsAverage Market Reference Prices and Differentials, (continued)Year Ended December 31,20202019Renewable dieselNew York Mercantile Exchange ULS diesel (dollars per gallon)$1.25 $1.94 Biodiesel RIN (dollars per RIN)0.64 0.48 California Low-Carbon Fuel Standard (dollars per metric ton)200.12 196.82 Chicago Board of Trade (CBOT) soybean oil (dollars per pound)0.32 0.29 EthanolCBOT corn (dollars per bushel)3.64 3.84 New York Harbor (NYH) ethanol (dollars per gallon)1.36 1.53 2020 Compared to 2019Total Company, Corporate, and OtherThe following table includes selected financial data for the total company, corporate, and other for 2020 and 2019. The selected financial data is derived from the Financial Highlights by Segment and Total Company tables on pages 37 and 38, unless otherwise noted.Year Ended December 31,20202019ChangeRevenues$64,912 $108,324 $(43,412)Cost of sales (see notes (a) through (c) beginning on page 44)65,652 103,546 (37,894)General and administrative expenses (excluding depreciationand amortization expense)756 868 (112)Operating income (loss)(1,579)3,836 (5,415)Adjusted operating income (loss) (see note (f) on page 49)(1,309)3,699 (5,008)Interest and debt expense, net of capitalized interest(563)(454)(109)Income tax expense (benefit)(903)702 (1,605)Net income attributable to noncontrolling interests (see note (b) on page 44)314 362 (48)Revenues decreased by $43.4 billion in 2020 compared to 2019 primarily due to decreases in refined petroleum product prices associated with sales made by our refining segment. The decrease in revenues was partially offset by a decrease in cost of sales of $37.9 billion and a decrease in general and administrative expenses (excluding depreciation and amortization expense) of $112 million, which resulted in a $5.4 billion decrease in operating income, from $3.8 billion of operating income in 2019 to an operating loss of $1.6 billion in 2020. The decrease in cost of sales was primarily due to decreases in crude oil and other feedstock costs, partially offset by the $224 million LIFO liquidation adjustment, which is described in note (a) on page 44.Adjusted operating income decreased by $5.0 billion, from $3.7 billion of adjusted operating income in 2019 to an adjusted operating loss of $1.3 billion in 2020. The $5.0 billion decrease includes a $112 million decrease in general and administrative expenses (excluding depreciation and amortization 40Table of Contentsexpense) associated with our corporate activities, and this decrease is discussed below. The remaining components of the decrease in adjusted operating income are discussed by segment in the segment analysis that follows.General and administrative expenses (excluding depreciation and amortization expense) decreased by $112 million in 2020 compared to 2019 primarily due to a decrease in employee incentive compensation expenses of $37 million, a decrease in charitable contributions of $20 million, lower advertising expenses of $18 million, and lower taxes other than income taxes of $16 million, as well as the effect from transaction costs of $7 million associated with the Merger Transaction with VLP in 2019.“Interest and debt expense, net of capitalized interest” increased by $109 million in 2020 compared to 2019 primarily due to interest expense associated with public debt offerings in 2020 and finance leases that commenced in the latter part of 2019 and the first nine months of 2020. See Notes 6 and 10 in Notes to Consolidated Financial Statements for additional details. Income tax expense decreased by $1.6 billion in 2020 compared to 2019 primarily as a result of lower income before income tax expense. Our effective tax rate was 45 percent in 2020 compared to 20 percent in 2019. The effective tax rate for 2020 was impacted by a U.S. federal tax net operating loss (NOL) carried back to 2015 when the U.S. federal statutory rate was 35 percent, as described in Note 16 of Notes to Consolidated Financial Statements. Net income attributable to noncontrolling interests decreased by $48 million in 2020 compared to 2019 primarily due to lower earnings associated with DGD. The decrease in DGD’s earnings is primarily due to the effect of a $156 million benefit for the 2018 blender’s tax credit recognized in 2019, of which 50 percent is attributable to the holder of the noncontrolling interest, as described in note (b) on page 44.Refining Segment ResultsThe following table includes selected financial and operating data of our refining segment for 2020 and 2019. The selected financial data is derived from the Financial Highlights by Segment and Total Company tables on pages 37 and 38, respectively, unless otherwise noted.Year Ended December 31,20202019ChangeOperating income (loss)$(1,342)$4,022 $(5,364)Adjusted operating income (loss) (see note (f) on page 48)(1,105)4,040 (5,145)Refining margin (see note (f) on page 46)$4,977 $10,391 $(5,414)Operating expenses (excluding depreciation and amortization expense reflected below)3,944 4,289 (345)Depreciation and amortization expense2,138 2,062 76 Throughput volumes (thousand BPD) (see note (g) on page 49)2,555 2,952 (397)Refining segment operating income decreased by $5.4 billion in 2020; however, refining segment adjusted operating income, which excludes the adjustments in the table in note (f) on page 48, decreased 41Table of Contentsby $5.1 billion in 2020 compared to 2019. The components of this decrease, along with the reasons for the changes in those components, are outlined below.•Refining segment margin decreased by $5.4 billion in 2020 compared to 2019. Refining segment margin is primarily affected by the prices of the refined petroleum products that we sell and the cost of crude oil and other feedstocks that we process. The table on page 39 reflects market reference prices and differentials that we believe had a material impact on the change in our refining segment margin in 2020 compared to 2019. The decrease in refining segment margin was primarily due to the following:◦A decrease in distillate (primarily diesel) margins had an unfavorable impact of approximately $3.4 billion. ◦A decrease in gasoline margins had an unfavorable impact of approximately $1.7 billion.◦A decrease in throughput volumes of 397,000 BPD had an unfavorable impact of $773 million. As noted in “OVERVIEW AND OUTLOOK—Overview—Business Operations Update” on pages 33 through 35, as a result of the economic disruption from the COVID-19 pandemic, we reduced the amount of crude oil processed at our refineries and limited the production of gasoline and jet fuel at certain of our refineries during the early months of the pandemic. While we have since increased the production of most of our products and restarted the gasoline-making units that we had temporarily idled at certain of our refineries in order to align with increasing demand for most of our products, we expect to continue to operate most of our refineries at reduced rates.◦An increase in the cost of biofuel credits (primarily RINs in the U.S.) had an unfavorable impact of $330 million. See Note 21 of Notes to Consolidated Financial Statements for additional information on our government and regulatory compliance programs.◦Higher margins on other products had a favorable impact of approximately $1.1 billion.•Refining segment operating expenses (excluding depreciation and amortization expense) decreased by $345 million primarily due to lower natural gas and electricity costs of $161 million, lower chemical and catalyst costs of $78 million, lower maintenance expenses of $40 million, and lower employee incentive compensation costs of $28 million. The decrease in operating expenses was primarily due to lower production.•Refining segment depreciation and amortization expense associated with our cost of sales increased by $76 million primarily due to an increase in depreciation expense of $118 million associated with capital projects that were completed and finance leases that commenced in the latter part of 2019 and the first nine months of 2020, partially offset by lower refinery turnaround and catalyst amortization expense of $33 million.42Table of ContentsRenewable Diesel Segment ResultsThe following table includes selected financial and operating data of our renewable diesel segment for 2020 and 2019. The selected financial data is derived from the Financial Highlights by Segment and Total Company tables on pages 37 and 38, respectively, unless otherwise noted.Year Ended December 31,20202019ChangeOperating income$638 $732 $(94)Adjusted operating income (see note (f) on page 48)638 576 62 Renewable diesel margin (see note (f) on page 47)$767 $701 $66 Operating expenses (excluding depreciation andamortization expense reflected below)85 75 10 Depreciation and amortization expense44 50 (6)Sales volumes (thousand gallons per day)(see note (g) on page 49)787 760 27 Renewable diesel segment operating income decreased by $94 million in 2020; however, renewable diesel segment adjusted operating income, which excludes the adjustment in the table in note (f) on page 48, increased by $62 million in 2020 compared to 2019. The increase was primarily due to higher renewable diesel segment margin.Renewable diesel segment margin increased by $66 million in 2020 compared to 2019. The increase was primarily due to a favorable impact from commodity derivative instruments associated with our price risk management activities. We recognized a hedge gain of $34 million in 2020 compared to a hedge loss of $24 million in 2019, resulting in a favorable change of $58 million between the years.Ethanol Segment ResultsThe following table includes selected financial and operating data of our ethanol segment for 2020 and 2019. The selected financial data is derived from the Financial Highlights by Segment and Total Company tables on pages 37 and 38, respectively, unless otherwise noted.Year Ended December 31,20202019ChangeOperating income (loss)$(69)$3 $(72)Adjusted operating income (loss) (see note (f) on page 48)(36)4 (40)Ethanol margin (see note (f) on page 47)$461 $598 $(137)Operating expenses (excluding depreciation and amortization expense reflected below)406 504 (98)Depreciation and amortization expense (see note (d) onpage 45)121 90 31 Production volumes (thousand gallons per day) (see note (g) on page 49)3,588 4,269 (681)43Table of ContentsEthanol segment operating income decreased by $72 million in 2020; however, ethanol segment adjusted operating income, which excludes the adjustments in the table in note (f) on page 48, decreased by $40 million in 2020 compared to 2019. The components of this decrease, along with the reasons for the changes in these components, are outlined below.•Ethanol segment margin decreased by $137 million in 2020 compared to 2019.Ethanol segment margin is primarily affected by prices of the ethanol and corn related co-products that we sell and the cost of corn that we process. The table on page 40 reflects market reference prices that we believe had a material impact on the change in our ethanol segment margin in 2020 compared to 2019. The decrease in ethanol segment margin was primarily due to the following:◦Lower ethanol prices had an unfavorable impact of approximately $166 million.◦A decrease in production volumes of 681,000 gallons per day had an unfavorable impact of approximately $92 million. As noted in “OVERVIEW AND OUTLOOK—Overview—Business Operations Update” on pages 33 through 35, as a result of the economic disruption from the COVID-19 pandemic, eight of our ethanol plants were temporarily idled and production was reduced at our remaining ethanol plants during the early months of the pandemic. However, demand for ethanol began to recover during the latter part of 2020, and as a result, most of our ethanol plants have recently increased production to meet current product demand.◦Higher prices on the co-products that we produce, primarily DDGs, had a favorable impact of approximately $79 million.◦Lower corn prices had a favorable impact of approximately $45 million.•Ethanol segment operating expenses (excluding depreciation and amortization expense) decreased by $98 million primarily due to lower natural gas and electricity costs of $43 million, lower chemical and catalyst costs of $23 million, and lower maintenance expenses of $15 million. The decrease in operating expenses was primarily due to lower production.________________________The following notes relate to references on pages 32 through 44.(a)Cost of materials and other for the year ended December 31, 2020 includes a charge of $224 million related to the liquidation of LIFO inventory layers attributable to our refining and ethanol segments. Our inventory levels decreased throughout 2020 due to lower production resulting from lower demand for our products caused by the negative economic impacts of COVID-19 on our business. As a result, our inventory levels at December 31, 2020 were below their December 31, 2019 levels. Of the $224 million charge recognized for the year ended December 31, 2020, $222 million and $2 million is attributable to our refining and ethanol segments, respectively.(b)Cost of materials and other for the years ended December 31, 2020 and 2019 includes a benefit related to the blender’s tax credit. The legislation authorizing the credit through December 31, 2022 was passed and signed into law in December 2019. As a result, for the year ended December 31, 2020, we recognized a benefit of $297 million related to the blender’s tax credit attributable to renewable diesel volumes blended during 2020. The legislation also reinstated the credit retroactively to volumes blended during 2019 and 2018, and 44Table of Contentsconsequently, we recognized a benefit of $449 million in December 2019 for the blender’s tax credit attributable to volumes blended during those two years. The entire amount was recognized by us in December 2019 because the law was enacted in that month. The above-mentioned pre-tax benefits are attributable to our reportable segments and stockholders as follows:Year Ended December 31,20202019Blender’s tax credit by reportable segmentRefining:Amount related to reporting period$9 $16 Amount related to prior periods but recognized in reportingperiod— 2 Total9 18 Renewable diesel:Amount related to reporting period288 275 Amount related to prior periods but recognized in reportingperiod— 156 Total288 431 Total recognized in reporting period$297 $449 Interests to which blender’s tax credit is attributableValero Energy Corporation stockholders:Amount related to reporting period$153 $154 Amount related to prior periods but recognized in reportingperiod— 80 Total153 234 Noncontrolling interest:Amount related to reporting period144 137 Amount related to prior periods but recognized in reportingperiod— 78 Total144 215 Total recognized in reporting period$297 $449 (c)The market value of our inventories accounted for under the LIFO method fell below their historical cost on an aggregate basis as of March 31, 2020. As a result, we recorded an LCM inventory valuation adjustment of $2.5 billion in March 2020. The market value of our LIFO inventories improved due to the subsequent recovery in market prices, which resulted in a full reversal of the reserve by September 30, 2020. The LCM inventory valuation adjustment for the year ended December 31, 2020 reflects a net benefit of $19 million due solely to the foreign currency translation effect of the portion of the LCM inventory valuation adjustments attributable to our international operations.(d)Depreciation and amortization expense for the year ended December 31, 2020 includes $30 million in accelerated depreciation related to a change in the estimated useful life of one of our ethanol plants. (e)“Other income, net” for the year ended December 31, 2019 includes a $22 million charge from the early redemption of $850 million of our 6.125 percent senior notes due February 1, 2020.45Table of Contents(f)We use certain financial measures (as noted below) that are not defined under U.S. GAAP and are considered to be non-GAAP financial measures.We have defined these non-GAAP measures and believe they are useful to the external users of our financial statements, including industry analysts, investors, lenders, and rating agencies. We believe these measures are useful to assess our ongoing financial performance because, when reconciled to their most comparable U.S. GAAP measures, they provide improved comparability between periods through the exclusion of certain items that we believe are not indicative of our core operating performance and that may obscure our underlying business results and trends. These non-GAAP measures should not be considered as alternatives to their most comparable U.S. GAAP measures nor should they be considered in isolation or as a substitute for an analysis of our results of operations as reported under U.S. GAAP. In addition, these non-GAAP measures may not be comparable to similarly titled measures used by other companies because we may define them differently, which diminishes their utility.Non-GAAP financial measures are as follows:◦Refining margin is defined as refining operating income (loss) excluding the blender’s tax credit not attributable to volumes blended during the applicable period, the LIFO liquidation adjustment, the LCM inventory valuation adjustment, operating expenses (excluding depreciation and amortization expense), depreciation and amortization expense, and other operating expenses, as reflected in the table below.Year Ended December 31,20202019Reconciliation of refining operating income (loss)to refining marginRefining operating income (loss)$(1,342)$4,022 Adjustments:Blender’s tax credit (see note (b))— (2)LIFO liquidation adjustment (see note (a))222 — LCM inventory valuation adjustment (see note (c))(19)— Operating expenses (excluding depreciation and amortization expense)3,944 4,289 Depreciation and amortization expense2,138 2,062 Other operating expenses34 20 Refining margin$4,977 $10,391 46Table of Contents◦Renewable diesel margin is defined as renewable diesel operating income excluding the blender’s tax credit not attributable to volumes blended during the applicable period, operating expenses (excluding depreciation and amortization expense), and depreciation and amortization expense, as reflected in the table below.Year Ended December 31,20202019Reconciliation of renewable diesel operating incometo renewable diesel marginRenewable diesel operating income$638 $732 Adjustments:Blender’s tax credit (see note (b))— (156)Operating expenses (excluding depreciation and amortization expense)85 75 Depreciation and amortization expense44 50 Renewable diesel margin$767 $701 ◦Ethanol margin is defined as ethanol operating income (loss) excluding the LIFO liquidation adjustment, operating expenses (excluding depreciation and amortization expense), depreciation and amortization expense, and other operating expenses, as reflected in the table below.Year Ended December 31,20202019Reconciliation of ethanol operating income (loss) to ethanol marginEthanol operating income (loss)$(69)$3 Adjustments:LIFO liquidation adjustment (see note (a))2 — Operating expenses (excluding depreciation and amortization expense)406 504 Depreciation and amortization expense (see note (d))121 90 Other operating expenses1 1 Ethanol margin$461 $598 47Table of Contents◦Adjusted refining operating income (loss) is defined as refining segment operating income (loss) excluding the blender’s tax credit not attributable to volumes blended during the applicable period, the LIFO liquidation adjustment, the LCM inventory valuation adjustment, and other operating expenses, as reflected in the table below.Year Ended December 31,20202019Reconciliation of refining operating income (loss)to adjusted refining operating incomeRefining operating income (loss)$(1,342)$4,022 Adjustments:Blender’s tax credit (see note (b))— (2)LIFO liquidation adjustment (see note (a))222 — LCM inventory valuation adjustment (see note (c))(19)— Other operating expenses34 20 Adjusted refining operating income (loss)$(1,105)$4,040 ◦Adjusted renewable diesel operating income is defined as renewable diesel segment operating income excluding the blender’s tax credit not attributable to volumes blended during the applicable period, as reflected in the table below.Year Ended December 31,20202019Reconciliation of renewable diesel operating incometo adjusted renewable diesel operating incomeRenewable diesel operating income$638 $732 Adjustments:Blender’s tax credit (see note (b))— (156)Adjusted renewable diesel operating income$638 $576 ◦Adjusted ethanol operating income (loss) is defined as ethanol segment operating income (loss) excluding the LIFO liquidation adjustment, the change in estimated useful life, and other operating expenses, as reflected in the table below.Year Ended December 31,20202019Reconciliation of ethanol operating income (loss)to adjusted ethanol operating income (loss)Ethanol operating income (loss)$(69)$3 Adjustments:LIFO liquidation adjustment (see note (a))2 — Change in estimated useful life (see note (d))30 — Other operating expenses1 1 Adjusted ethanol operating income (loss)$(36)$4 48Table of Contents◦Adjusted operating income (loss) is defined as total company operating income (loss) excluding the blender’s tax credit not attributable to volumes blended during the applicable period, the LIFO liquidation adjustment, the LCM inventory valuation adjustment, the change in estimated useful life, and other operating expenses, as reflected in the table below.Year Ended December 31,20202019Reconciliation of total company operating income (loss)to adjusted operating income (loss)Total company operating income (loss)$(1,579)$3,836 Adjustments:Blender’s tax credit (see note (b))— (158)LIFO liquidation adjustment (see note (a))224 — LCM inventory valuation adjustment (see note (c))(19)— Change in estimated useful life (see note (d))30 — Other operating expenses35 21 Adjusted operating income (loss)$(1,309)$3,699 (g)We use throughput volumes, sales volumes, and production volumes for the refining segment, renewable diesel segment, and ethanol segment, respectively, due to their general use by others who operate facilities similar to those included in our segments.LIQUIDITY AND CAPITAL RESOURCESOverviewDuring the first half of 2020, our liquidity was negatively impacted by the significant economic effects resulting from the COVID-19 pandemic as described in “OVERVIEW AND OUTLOOK—Overview—Business Operations Update.” However, we took a number of actions to address the economic environment and its impact on our liquidity, most notably two public debt offerings totaling $4.0 billion before deducting the underwriting discounts and debt issuance costs, which are described in Note 10 of Notes to Consolidated Financial Statements. We took other actions to address our liquidity and those actions are described in “OVERVIEW AND OUTLOOK—Overview—Business Operations Update” on pages 33 through 35 and in the discussion of matters impacting our liquidity and capital resources below. As a result of the actions taken during 2020, our liquidity position has improved as of December 31, 2020 compared to the end of the first quarter of 2020, which was when the pandemic began to have a negative impact on our business.49Table of ContentsOur LiquidityOur liquidity consisted of the following as of December 31, 2020 (in millions):Available borrowing capacity from committed facilities:Valero Revolver$3,966 364-day Revolving Credit Facility875 Canadian Revolver(a)114 Accounts receivable sales facility885 Letter of credit facility50 Total available borrowing capacity5,890 Cash and cash equivalents(b)3,152 Total liquidity$9,042 ________________________(a)The amount for our Canadian Revolver is shown in U.S. dollars. As set forth in the summary of our credit facilities in Note 10 of Notes to Consolidated Financial Statements, the availability under our Canadian Revolver as of December 31, 2020 in Canadian dollars was C$145 million.(b)Excludes $161 million of cash and cash equivalents related to our variable interest entities (VIEs) that is available for use only by our VIEs.Information about our outstanding borrowings, letters of credit issued, and availability under our credit facilities is reflected in Note 10 of Notes to Consolidated Financial Statements. We believe that cash provided by operations, along with cash from our public debt offerings in April and September of 2020 and available borrowings under our credit facilities, is sufficient to fund our ongoing operating requirements and other commitments. We expect that, to the extent necessary, we can raise additional cash through equity or debt financings in the public and private capital markets or the arrangement of additional credit facilities. However, there can be no assurances regarding the availability of any future financings or additional credit facilities or whether such financings or additional credit facilities can be made available on terms that are acceptable to us.Cash FlowsComponents of our cash flows are set forth below (in millions):Year Ended December 31,20202019Cash flows provided by (used in):Operating activities$948 $5,531 Investing activities(2,425)(3,001)Financing activities:Borrowings4,570 2,131 Other financing activities(2,493)(5,128)Financing activities2,077 (2,997)Effect of foreign exchange rate changes on cash130 68 Net increase (decrease) in cash and cash equivalents$730 $(399)50Table of ContentsCash Flows for the Year Ended December 31, 2020During the year ended December 31, 2020, we used $948 million of cash generated by our operations and $4.6 billion in borrowings to make $2.4 billion of investments in our business, fund $2.5 billion of other financing activities, and increase our available cash on hand by $730 million. The borrowings are described in Note 10 of Notes to Consolidated Financial Statements.As previously noted, our operations generated $948 million of cash in 2020, which was negatively impacted by an unfavorable change in working capital of $345 million. The change in working capital was affected primarily by a $740 million use of cash11 resulting from the rapid decline in market prices of refined petroleum products and crude oil as a result of the negative economic effects of the COVID-19 pandemic that impacted our receivables and accounts payable. This use of cash, along with other uses of cash, were partially offset by a $1.0 billion source of cash driven by a reduction in inventory levels on hand. Details regarding the components of the change in working capital, along with the reasons for the changes in those components, are described in Note 19 of Notes to Consolidated Financial Statements. In addition, see “RESULTS OF OPERATIONS” for an analysis of our net loss.Our investing activities of $2.4 billion consisted of $2.5 billion in capital investments, as defined below, of which $548 million related to self-funded capital investments by DGD, and $251 million was related to capital expenditures of VIEs other than DGD.Other financing activities of $2.5 billion consisted primarily of $1.6 billion in dividend payments, $490 million of payments of debt and finance lease obligations, $208 million to pay distributions to noncontrolling interests, and $156 million for the purchase of common stock for treasury.Cash Flows for the Year Ended December 31, 2019During the year ended December 31, 2019, we used $5.5 billion of cash generated by our operations, $2.1 billion in borrowings, and $399 million of cash on hand to make $3.0 billion of investments in our business and fund $5.1 billion of other financing activities. The borrowings are described in Note 10 of Notes to Consolidated Financial Statements.As previously noted, our operations generated $5.5 billion of cash in 2019, driven primarily by net income of $2.8 billion, noncash charges to income of $2.5 billion, and a positive change in working capital of $294 million. Details regarding the components of the change in working capital, along with the reasons for the changes in those components, are described in Note 19 of Notes to Consolidated Financial Statements. In addition, see “RESULTS OF OPERATIONS” for an analysis of our net income.Our investing activities of $3.0 billion consisted primarily of $2.9 billion in capital investments, as defined below, of which $160 million is related to self-funded capital investments by DGD, and $225 million was related to capital expenditures of VIEs other than DGD.Other financing activities of $5.1 billion consisted primarily of $1.8 billion of payments of debt and finance lease obligations, $1.5 billion in dividend payments, $950 million to acquire all of the outstanding publicly held common units of VLP, and $777 million for the purchase of common stock for treasury.11 Represents the net cash flow change in “receivables, net” of $3.3 billion and accounts payable of $4.1 billion during the year ended December 31, 2020, as described in Note 19 of Notes to Consolidated Financial Statements.51Table of ContentsCapital InvestmentsOur operations are highly capital intensive. Each of our refineries and plants comprises a large base of property assets, consisting of a series of interconnected, highly integrated and interdependent crude oil and other feedstock processing facilities and supporting logistical infrastructure (Units), and these Units are improved continuously. The cost of improvements, which consist of the addition of new Units and betterments of existing Units, can be significant. We plan for these improvements by developing a multi-year capital program that is updated and revised based on changing internal and external factors.We have historically acquired our refineries at amounts significantly below their replacement costs, whereas our improvements are made at full replacement value. As such, the costs for improving our refinery assets increase over time and are significant in relation to the amounts we paid to acquire our refineries. We make improvements to our refineries in order to maintain and enhance their operating reliability, to meet environmental obligations with respect to reducing emissions and removing prohibited elements from the products we produce, or to enhance their profitability. Reliability and environmental improvements generally do not increase the throughput capacities of our refineries. Improvements that enhance refinery profitability may increase throughput capacity, but many of these improvements allow our refineries to process different types of crude oil and to refine crude oil into products with higher market values. Therefore, many of our improvements do not increase throughput capacity significantly.Our capital investments include capital expenditures, deferred turnaround and catalyst cost expenditures, and investments in unconsolidated joint ventures. Capital investments attributable to Valero, which is a non-GAAP financial measure, reflects our net share of capital investments and is defined as all capital expenditures, deferred turnaround and catalyst cost expenditures, and investments in unconsolidated joint ventures presented in our consolidated statements of cash flows, excluding the portion of DGD’s capital investments attributable to our joint venture partner and all of the capital expenditures of other VIEs.We are a 50/50 joint venture partner in DGD and consolidate DGD’s financial statements; as a result, all of DGD’s net cash provided by operating activities (or operating cash flow) is included in our consolidated net cash provided by operating activities. DGD’s partners use DGD’s operating cash flow (excluding changes in its current assets and current liabilities) to fund its capital investments rather than distribute all of that cash to themselves. Because DGD’s operating cash flow is effectively attributable to each partner, only 50 percent of DGD’s capital investments should be attributed to our net share of capital investments. We also exclude the capital expenditures of our other consolidated VIEs because we do not operate those VIEs. We believe capital investments attributable to Valero is an important measure because it more accurately reflects our capital investments.52Table of ContentsCapital investments attributable to Valero should not be considered as an alternative to capital investments, its most comparable U.S. GAAP measure, nor should it be considered in isolation or as a substitute for an analysis of our cash flows as reported under U.S. GAAP. In addition, this non-GAAP measure may not be comparable to similarly titled measures used by other companies because we may define it differently, which may diminish its utility.Year Ended December 31,20202019Reconciliation of capital investmentsto capital investments attributable to ValeroCapital expenditures (excluding VIEs)$1,014 $1,627 Capital expenditures of VIEs:DGD523 142 Other VIEs251 225 Deferred turnaround and catalyst cost expenditures(excluding VIEs)623 762 Deferred turnaround and catalyst cost expendituresof DGD25 18 Investments in unconsolidated joint ventures54 164 Capital investments2,490 2,938 Adjustments:DGD’s capital investments attributable to our jointventure partner(274)(80)Capital expenditures of other VIEs(251)(225)Capital investments attributable to Valero$1,965 $2,633 We expect to incur capital investments and capital investments attributable to Valero in 2021 as follows by reportable segment (in millions):Refining$1,600 Renewable diesel720 Ethanol40 Corporate25 Capital investments2,385 Adjustments:DGD’s capital investments attributable to our joint venture partner(360)Capital expenditures of other VIEs(25)Capital investments attributable to Valero$2,000 Approximately 60 percent of the capital investments attributable to Valero are for sustaining the business and 40 percent are for growth strategies, almost half of which is allocated to expanding the renewable diesel business. However, we continuously evaluate our capital budget and make changes as conditions warrant. This capital investment estimate excludes strategic acquisitions, if any.53Table of ContentsOther Matters Impacting Liquidity and Capital ResourcesStock Purchase ProgramOn January 23, 2018, our board of directors authorized the 2018 Program for the purchase of our outstanding common stock. As of December 31, 2020, we had $1.4 billion available for purchase under the 2018 Program, which has no expiration date. We have not purchased any shares of our common stock under the 2018 Program since mid-March 2020, and we will evaluate the timing of repurchases when appropriate. We have no obligation to make purchases under this program.Pension Plan FundingWe plan to contribute $128 million to our pension plans and $22 million to our other postretirement benefit plans during 2021. See Note 14 of Notes to Consolidated Financial Statements for a discussion of our employee benefit plans.Environmental MattersOur operations are subject to extensive environmental regulations by governmental authorities relating to the discharge of materials into the environment, waste management, pollution prevention measures, GHG emissions, and characteristics and composition of gasolines and distillates. Because environmental laws and regulations are becoming more complex and stringent and new environmental laws and regulations are continuously being enacted or proposed, the level of future expenditures required for environmental matters could increase in the future. In addition, any major upgrades in any of our refineries or plants could require material additional expenditures to comply with environmental laws and regulations. See Note 9 of Notes to Consolidated Financial Statements for disclosure of our environmental liabilities.Tax MattersUnder deferrals provided by recently passed legislation, such as the CARES Act in the U.S., and by various taxing authorities under other existing legislation, we deferred approximately $440 million of income and indirect (e.g., VAT and motor fuel taxes) tax payments due in the first and second quarters of 2020. As of December 31, 2020, we had approximately $250 million of deferred tax payments. Of the $250 million, approximately 70 percent will be paid in 2021 and 30 percent in 2022.We take tax positions in our tax returns from time to time that may not be ultimately allowed by the relevant taxing authority. When we take such positions, we evaluate the likelihood of sustaining those positions and determine the amount of tax benefit arising from such positions, if any, that should be recognized in our financial statements. Tax benefits not recognized by us are recorded as a liability for unrecognized tax benefits, which represents our potential future obligation to various taxing authorities if the tax positions are not sustained.As of December 31, 2020, our liability for unrecognized tax benefits, excluding related interest and penalties, was $821 million. Of this amount, $525 million is associated with refund claims associated with taxes paid on incentive payments received from the U.S. federal government for blending biofuels into refined petroleum products. We recorded a tax refund receivable of $525 million in connection with our refund claims, but we also recorded a liability for unrecognized tax benefits of $525 million due to the complexity of this matter and uncertainties with respect to sustaining these refund claims. Therefore, our financial position, results of operations, and liquidity will not be negatively impacted if we are unsuccessful in sustaining these refund claims. The remaining liability for unrecognized tax benefits, excluding related interest and penalties, of $296 million represents our potential future obligations to various taxing authorities if the tax positions associated with that liability are not sustained.54Table of ContentsDetails about our liability for unrecognized tax benefits, along with other information about our unrecognized tax benefits, are included in Note 16 of Notes to Consolidated Financial Statements.Cash Held by Our International SubsidiariesAs of December 31, 2020, $2.5 billion of our cash and cash equivalents was held by our international subsidiaries. Cash held by our international subsidiaries can be repatriated to us without any U.S. federal income tax consequences, but certain other taxes may apply, including, but not limited to, withholding taxes imposed by certain international jurisdictions and U.S. state income taxes. Therefore, there is a cost to repatriate cash held by certain of our international subsidiaries to us, but we believe that such amount is not material to our financial position or liquidity.Concentration of CustomersOur operations have a concentration of customers in the refining industry and customers who are refined petroleum product wholesalers and retailers. These concentrations of customers may impact our overall exposure to credit risk, either positively or negatively, in that these customers may be similarly affected by changes in economic or other conditions including the uncertainties concerning the COVID-19 pandemic and volatility in the global oil markets. However, we believe that our portfolio of accounts receivable is sufficiently diversified to the extent necessary to minimize potential credit risk. Historically, we have not had any significant problems collecting our accounts receivable. See also Item 1A, “RISK FACTORS”—Risks Related to Our Business, Industry, and Operations—Developments with respect to low-carbon fuel policies and the market for alternative fuels may affect demand for our renewable fuels and could adversely affect our financial performance.OFF-BALANCE SHEET ARRANGEMENTSWe have not entered into any transactions, agreements, or other contractual arrangements that would result in off-balance sheet liabilities.CONTRACTUAL OBLIGATIONSOur contractual obligations as of December 31, 2020 are summarized below (in millions).Payments Due by Year20212022202320242025ThereafterTotalDebt and financelease obligations (a)$790 $188 $1,632 $1,103 $1,828 $9,972 $15,513 Debt obligations – interestpayments550 544 524 501 469 3,544 6,132 Operating lease liabilities (b)324 231 194 155 107 435 1,446 Purchase obligations14,641 1,871 1,268 1,246 1,124 2,445 22,595 Other long-term liabilities (c)— 129 225 235 259 1,887 2,735 Total$16,305 $2,963 $3,843 $3,240 $3,787 $18,283 $48,421 ________________________(a)Debt obligations exclude amounts related to unamortized discounts and debt issuance costs. Finance lease obligations include related interest expense. Debt obligations due in 2021 include $598 million associated with borrowings under the IEnova Revolver (as defined and described in Note 10 of Notes to Consolidated Financial Statements) for the construction of terminals in Mexico by Central Mexico Terminals (as defined and described 55Table of Contentsin Note 13 of Notes to Consolidated Financial Statements). The IEnova Revolver is only available to the operations of Central Mexico Terminals, and its creditors do not have recourse against us.(b)Operating lease liabilities include related interest expense.(c)Other long-term liabilities exclude amounts related to the long-term portion of operating lease liabilities that are separately presented above.Debt and Finance Lease ObligationsOur debt and finance lease obligations are described in Notes 10 and 6, respectively, of Notes to Consolidated Financial Statements.Our debt and financing agreements do not have rating agency triggers that would automatically require us to post additional collateral. However, in the event of certain downgrades of our senior unsecured debt by the ratings agencies, the cost of borrowings under some of our bank credit facilities and other arrangements may increase. As of December 31, 2020, all of our ratings on our senior unsecured debt, including debt guaranteed by us, are at or above investment grade level as follows:Rating AgencyRatingMoody’s Investors ServiceBaa2 (negative outlook)Standard & Poor’s Ratings ServicesBBB (negative outlook)Fitch RatingsBBB (negative outlook)We cannot provide assurance that these ratings will remain in effect for any given period of time or that one or more of these ratings will not be lowered or withdrawn entirely by a rating agency. We note that these credit ratings are not recommendations to buy, sell, or hold our securities. Each rating should be evaluated independently of any other rating. Any future reduction below investment grade or withdrawal of one or more of our credit ratings could have a material adverse impact on our ability to obtain short- and long-term financing and the cost of such financings.Debt Obligations – Interest PaymentsInterest payments for our debt obligations as described in Note 10 of Notes to Consolidated Financial Statements are the expected payments based on information available as of December 31, 2020.Operating Lease LiabilitiesOur operating lease liabilities arise from leasing arrangements for the right to use various classes of underlying assets as described in Note 6 of Notes to Consolidated Financial Statements. Operating lease liabilities are recognized for leasing arrangements with terms greater than one year and are not reduced by minimum lease payments to be received by us under subleases.Purchase ObligationsA purchase obligation is an enforceable and legally binding agreement to purchase goods or services that specifies significant terms, including (i) fixed or minimum quantities to be purchased, (ii) fixed, minimum, or variable price provisions, and (iii) the approximate timing of the transaction. We have various purchase obligations under certain crude oil and other feedstock supply arrangements, industrial gas supply arrangements (such as hydrogen supply arrangements), natural gas supply arrangements, and various throughput, transportation and terminaling agreements. We enter into these contracts to ensure an adequate supply of feedstock and utilities and adequate storage capacity to operate our refineries and plants. Substantially all of our purchase obligations are based on market prices or adjustments based on market indices. Certain of these purchase obligations include fixed or minimum volume requirements, while others are based on our usage requirements. The purchase obligation amounts shown in the 56Table of Contentspreceding table include both short- and long-term obligations and are based on (i) fixed or minimum quantities to be purchased and (ii) fixed or estimated prices to be paid based on current market conditions.Other Long-Term LiabilitiesOur other long-term liabilities are described in Note 9 of Notes to Consolidated Financial Statements. For purposes of reflecting amounts for other long-term liabilities in the preceding table, we made our best estimate of expected payments for each type of liability based on information available as of December 31, 2020.NEW ACCOUNTING PRONOUNCEMENTSAs discussed in Note 1 of Notes to Consolidated Financial Statements, certain new financial accounting pronouncements became effective in 2020 and January 2021. The effect on our financial statements upon adoption of these pronouncements is discussed in the above-referenced note.CRITICAL ACCOUNTING ESTIMATESThe preparation of financial statements in accordance with U.S. GAAP requires us to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates. The following summary provides further information about our critical accounting policies that involve critical accounting estimates, and should be read in conjunction with Note 1 of Notes to Consolidated Financial Statements, which summarizes our significant accounting policies. The following accounting policies involve estimates that are considered critical due to the level of subjectivity and judgment involved, as well as the impact on our financial position and results of operations. We believe that all of our estimates are reasonable. Unless otherwise noted, estimates of the sensitivity to earnings that would result from changes in the assumptions used in determining our estimates is not practicable due to the number of assumptions and contingencies involved, and the wide range of possible outcomes.Unrecognized Tax BenefitsWe take tax positions in our tax returns from time to time that may not be ultimately allowed by the relevant taxing authority. When we take such positions, we evaluate the likelihood of sustaining those positions and determine the amount of tax benefit arising from such positions, if any, that should be recognized in our financial statements. Tax benefits not recognized by us are recorded as a liability for unrecognized tax benefits, which represents our potential future obligation to various taxing authorities if the tax positions are not sustained.The evaluation of tax positions and the determination of the benefit arising from such positions that are recognized in our financial statements requires us to make significant judgments and estimates based on an analysis of complex tax laws and regulations and related interpretations. These judgments and estimates are subject to change due to many factors, including the progress of ongoing tax audits, case law, and changes in legislation.Details of our liability for unrecognized tax benefits, along with other information about our unrecognized tax benefits, are included in Note 16 of Notes to Consolidated Financial Statements.Impairment of Long-Lived Assets and GoodwillLong-lived assets (primarily property, plant, and equipment) are tested for recoverability whenever events or changes in circumstances indicate that the carrying amount of the asset may not be recoverable. A 57Table of Contentslong-lived asset is not recoverable if its carrying amount exceeds the sum of the undiscounted cash flows expected to result from its use and eventual disposition. If a long-lived asset is not recoverable, an impairment loss is recognized for the amount by which the carrying amount of the long-lived asset exceeds its fair value, with fair value determined based on discounted estimated net cash flows or other appropriate methods.In order to test for recoverability, we must make estimates of projected cash flows related to the asset being evaluated; such estimates include, but are not limited to, assumptions about future sales volumes, commodity prices, operating costs, margins, the use or disposition of the asset, the asset’s estimated remaining useful life, and future expenditures necessary to maintain the asset’s existing service potential. Due to the significant subjectivity of the assumptions used to test for recoverability, changes in market conditions could result in significant impairment charges in the future, thus affecting our earnings.Goodwill is tested for impairment annually or more frequently if events or changes in circumstances indicate the asset might be impaired. We first evaluate qualitative factors to determine if it is more likely than not (i.e., a likelihood of more than 50%) that the fair value of a reporting unit is less than its carrying amount, including goodwill, by taking into consideration relevant events and circumstances. If, after assessing the totality of events or circumstances, we determine that it is not more likely than not that the fair value of a reporting unit is less than its carrying amount, no further testing is necessary. However, if we determine that it is more likely than not that the fair value of a reporting unit is less than its carrying amount, then we perform the quantitative goodwill impairment test. An impairment loss is recognized if the carrying amount of the reporting unit, including goodwill, exceeds its fair value. During 2020, we performed qualitative assessments of the reporting unit to which our goodwill is related to determine if the quantitative impairment test was necessary. We considered company-specific information, such as current and future financial performance, as well as external factors, that could affect the fair value of the reporting unit. We evaluated (i) the impact that the COVID-19 pandemic had on the demand for our products and utilization of our U.S. refineries, (ii) the expected contribution from the reporting unit, which historically has had strong performance, and (iii) the estimated margin between the carrying amount and the implied enterprise value of our reporting unit. Due to the significant subjectivity of the assumptions used to test for impairment, changes in market conditions could result in significant impairment charges in the future, thus affecting our earnings.As of December 31, 2020, we determined there was no impairment of our long-lived assets or goodwill as discussed in Note 2 of Notes to Consolidated Financial Statements.ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKCOMMODITY PRICE RISKWe are exposed to market risks related to the volatility in the price of feedstocks (primarily crude oil and corn), the products we produce (primarily refined petroleum products), and natural gas used in our operations. To reduce the impact of price volatility on our results of operations and cash flows, we use commodity derivative instruments, including futures and options to manage the volatility of:•inventories and firm commitments to purchase inventories generally for amounts by which our current year inventory levels (determined on a LIFO basis) differ from our previous year-end LIFO inventory levels; and58Table of Contents•forecasted purchases and/or product sales at existing market prices that we deem favorable.Our positions in commodity derivative instruments are monitored and managed on a daily basis by our risk control group to ensure compliance with our stated risk management policy that has been approved by our board of directors.As of December 31, 2020 and 2019, the amount of gain or loss that would have resulted from a 10 percent increase or decrease in the underlying price for all of our commodity derivative instruments entered into for purposes other than trading with which we have market risk was not material. See Note 21 of Notes to Consolidated Financial Statements for notional volumes associated with these derivative contracts as of December 31, 2020.COMPLIANCE PROGRAM PRICE RISKWe are exposed to market risk related to the volatility in the price of credits needed to comply with various governmental and regulatory environmental compliance programs. To manage this risk, we enter into contracts to purchase these credits when prices are deemed favorable. As of December 31, 2020 and 2019, the amount of gain or loss in the fair value of derivative instruments that would have resulted from a 10 percent increase or decrease in the underlying price of the contracts was not material. See Note 21 of Notes to Consolidated Financial Statements for a discussion about these compliance programs.INTEREST RATE RISKThe following table provides information about our debt instruments (dollars in millions), the fair values of which are sensitive to changes in interest rates. Principal cash flows and related weighted-average interest rates by expected maturity dates are presented. See Note 10 of Notes to Consolidated Financial Statements for additional information related to our debt.December 31, 2020Expected Maturity Dates2021 (a)20222023 (b)20242025There-afterTotal (c)FairValueFixed rate$— $— $850$925$1,650$8,474$11,899$13,899 Average interest rate— %— %2.7 %1.2 %3.1 %5.1 %4.4 %Floating rate (d)$603$6 $595$— $— $— $1,204$1,204 Average interest rate3.9 %3.0 %1.4 %— %— %— %2.7 %December 31, 2019Expected Maturity Dates2020 (a)2021202220232024There-afterTotal (c)FairValueFixed rate$— $11 $— $— $— $8,474$8,485$10,099 Average interest rate— %5 %— %— %— %5.2 %5.2 %Floating rate (d)$453$6 $6 $19 $— $— $484$484 Average interest rate5.0 %4.5 %4.5 %4.5 %— %— %5.0 %________________________(a)As of December 31, 2020 and 2019, our floating rate debt due in 2021 and 2020 includes $598 million and $348 million, respectively, associated with borrowings under the IEnova Revolver for the construction of terminals in Mexico by Central Mexico Terminals. The IEnova Revolver is only available to the operations of Central Mexico Terminals, and its creditors do not have recourse against us.59Table of Contents(b)As of December 31, 2020, our floating rate debt also includes $575 million aggregate principal amount of our Floating Rate Notes issued in September 2020, which are due September 15, 2023.(c)Excludes unamortized discounts and debt issuance costs.(d)As of December 31, 2020 and 2019, we had an interest rate swap associated with $31 million and $36 million, respectively, of our floating rate debt resulting in an effective interest rate of 3.85 percent as of each of those reporting dates. The fair value of the swap was immaterial for all periods presented.FOREIGN CURRENCY RISKWe are exposed to exchange rate fluctuations on transactions related to our international operations that are denominated in currencies other than the local (functional) currencies of those operations. To manage our exposure to these exchange rate fluctuations, we use foreign currency contracts. The following table provides information about our foreign currency contracts (dollars in millions), the fair values of which are sensitive to changes in foreign currency exchange rates. Contracts that were outstanding as of December 31, 2020 mature on or before April 15, 2021 and those outstanding as of December 31, 2019 matured in 2020. Currency abbreviations presented below are as follows: U.S. dollars (USD), Canadian dollars (CAD), and pounds sterling (GBP).Receive USD/Pay CADReceive USD/Pay GBPReceive CAD/Pay USDDecember 31, 2020Contract amount$228 $97 $1,600 Weighted-averagecontractual exchange rate0.782051.344540.78492Fair value liability$(1)$(1)$(2)December 31, 2019Contract amount$406 $333 $2,250 Weighted-averagecontractual exchange rate0.759111.312010.76217Fair value asset (liability)$(6)$(4)$27 See Note 21 of Notes to Consolidated Financial Statements for a discussion about our foreign currency risk management activities.60Table of Contents
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+ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSFORWARD-LOOKING STATEMENTS This Form 10-K contains forward-looking statements within the meaning of Section 27A of the Securities Act and Section 21E of the Exchange Act. These forward-looking statements are based on current expectations and assumptions and involve risks and uncertainties, including, among other things, statements regarding our expectations about (i) the impact from the effects of the COVID-19 pandemic, (ii) revenue growth in 2021, (iii) continued growth in registrations in the domain name base in 2021, (iv) cost of revenues, sales and marketing expenses, research and development expenses, general and administrative expenses, interest expense, and non-operating income, net, in 2021, (v) our effective tax rate for 2021, (vi) the sufficiency of our existing cash, cash equivalents and marketable securities, and funds generated from operations, together with our ability to arrange for additional financing, (vii) cash paid for income taxes in 2021, and (viii) our planned property and equipment expenditures for 2021. Forward-looking statements include, among others, those statements including the words “expects,” “anticipates,” “intends,” “believes” and similar language. Our actual results may differ significantly from those projected in the forward-looking statements. Factors that might cause or contribute to such differences include, but are not limited to, those discussed in the section titled “Risk Factors” in Part I, Item 1A of this Form 10-K. You should also carefully review the risks described in other documents we file from time to time with the SEC, including the Quarterly Reports on Form 10-Q or Current Reports on Form 8-K that we file in 2021. You are cautioned not to place undue reliance on the forward-looking statements, which speak only as of the date of this Form 10-K. We undertake no obligation to update publicly or revise such statements, whether as a result of new information, future events, or otherwise, except as required by law.This section of this Form 10-K generally discusses 2020 and 2019 items and year-to-year comparisons between 2020 and 2019. Discussions of 2018 items and year-to-year comparisons between 2019 and 2018 that are not included in this Form 10-K can be found in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Part II, Item 7 of our Annual Report on Form 10-K for the fiscal year ended December 31, 2019.OverviewWe are a global provider of domain name registry services and internet infrastructure, enabling internet navigation for many of the world’s most recognized domain names. We enable the security, stability, and resiliency of key internet infrastructure and services, including providing root zone maintainer services, operating two of the 13 global internet root servers, and providing registration services and authoritative resolution for the .com and .net top-level domains, which support the majority of global e-commerce. As of December 31, 2020, we had approximately 165.2 million .com and .net registrations in the domain name base. The number of domain names registered is largely driven by continued growth in online advertising, e-commerce, and the number of internet users, which is partially driven by greater availability of internet access, as well as marketing activities carried out by us and our registrars. Growth in the number of domain name registrations under our management may be hindered by certain factors, including overall economic conditions, competition from ccTLDs, other gTLDs, services that offer alternatives for an online presence, such as social media, and ongoing changes in the internet practices and behaviors of consumers and businesses. Factors such as the evolving practices and preferences of internet users, and how they navigate the internet, as well as the motivation of domain name registrants and how they will manage their investment in domain names, can negatively impact our business and the demand for new domain name registrations and renewals.2020 Business Highlights and Trends•We recorded revenues of $1,265.1 million in 2020, which represents an increase of 3% compared to 2019.•We recorded operating income of $824.2 million during 2020, which represents an increase of 2% as compared to 2019. •We finished 2020 with 165.2 million .com and .net registrations in the domain name base, which represents a 4% increase from December 31, 2019.•During 2020, we processed 42.4 million new domain name registrations for .com and .net compared to 40.3 million in 2019.•The final .com and .net renewal rate was 73.7% for the third quarter of 2020 and 2019. Renewal rates are not fully measurable until 45 days after the end of the quarter.•We repurchased 3.7 million shares of our common stock for an aggregate cost of $734.9 million in 2020. As of December 31, 2020, there was $335.6 million remaining for future share repurchases under the share repurchase program.23Table of Contents•Effective February 11, 2021, our Board of Directors authorized the repurchase of our common stock in the amount of $747.0 million, in addition to the $253.0 million that remained available for repurchases under the share repurchase program, for a total repurchase authorization of up to $1.0 billion under the program.•We generated cash flows from operating activities of $730.2 million in 2020, which represents a decrease of 3% as compared to 2019.•During 2020, we recognized an income tax benefit of $204.2 million as a result of the remeasurement of certain previously unrecognized income tax benefits and the lapse of statutes of limitations related to other unrecognized income tax benefits.•During 2020, we announced a freeze on the registry prices for all of our TLDs, including .com and .net, through March 31, 2021. Additionally, we announced a waiver of the wholesale restore fee for expired domain names through the end of 2020.•On February 11, 2021, we announced that we will increase the annual registry-level wholesale fee for each new and renewal .com domain name registration from $7.85 to $8.39, effective September 1, 2021.COVID-19 UpdateThe United States and the global community we serve are facing unprecedented challenges posed by the COVID-19 pandemic. In response to the pandemic, we have established a task force to monitor the pandemic and have taken a number of actions to protect our employees, including restricting travel, modifying our sick leave policy to encourage quarantine and isolation when warranted, and directing most of our employees to work from home. We have implemented our readiness plans, which include the ability to maintain critical internet infrastructure with most employees working remotely. We believe that the effects of the pandemic to date have led to a modest increase in the demand for domain names, particularly as businesses and entrepreneurs have been seeking to establish or expand their presence online in response to the pandemic. Our revenues increased during 2020 primarily driven by an increase in the domain name base for the .com TLD; however, the situation remains uncertain and hard to predict. The broader implications of the pandemic on our business and operations and our financial results, including the extent to which the effects of the pandemic will impact future growth in the domain name base, remain uncertain. The duration and severity of the economic disruptions from the pandemic may ultimately result in negative impacts on our business and operations, results of operations, financial condition, cash flows, liquidity and capital and financial resources. Because fees for domain name registrations and renewals are generally due at the time of registration or renewal and revenues from such registrations and renewals are recognized ratably over their terms, the effects of the pandemic may not be fully reflected in our results of operations until future periods. For further discussion, see “Risk Factors – The effects of the COVID-19 pandemic have impacted how we operate our business, and the extent to which the effects of the pandemic will impact our business, operations, financial condition and results of operations remains uncertain” in Part I, Item 1A of this Form 10-K.Critical Accounting Policies and Significant Management Estimates The discussion and analysis of our financial condition and results of operations are based upon our Consolidated Financial Statements, which have been prepared in accordance with U.S. generally accepted accounting principles. The preparation of these financial statements requires management to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosures of contingent assets and liabilities. On an ongoing basis, management evaluates those estimates. Management bases its estimates on historical experience and on various assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily available from other sources. Actual results may differ from these estimates under different assumptions or conditions. An accounting estimate is considered critical if the nature of the estimates or assumptions is material due to the levels of subjectivity and judgment involved, and the impact of changes in the estimates and assumptions would have a material effect on the consolidated financial statements. We believe the following critical accounting estimates and policies have the most significant impact on our consolidated financial statements: Income taxes We operate in multiple tax jurisdictions in the United States and internationally. Tax laws and regulations in these jurisdictions are complex, interrelated, and periodically changing. Significant judgment or interpretation of these laws and regulations is often required in determining our worldwide provision for income taxes, including, for example, the calculations of taxable income in each jurisdiction, deferred taxes, and the availability and amount of deductions and tax credits. The final taxes payable are also dependent upon many factors, including negotiations with taxing authorities in various jurisdictions and resolution of disputes arising from various tax examinations. We only recognize or continue to recognize tax positions and tax benefit amounts that are more likely than not to be sustained upon examination. We adjust these amounts in light 24Table of Contentsof changing facts and circumstances; however, due to the complexity of some of these uncertainties, the ultimate resolution may result in an outcome that is materially different from our current estimate of unrecognized tax benefits. See Note 10, “Income Taxes” of our Notes to Consolidated Financial Statements in Item 8 of this Form 10-K for a discussion of significant changes in unrecognized tax benefits during 2020.Results of OperationsThe following table presents information regarding our results of operations as a percentage of revenues:Year Ended December 31, 202020192018Revenues100.0 %100.0 %100.0 %Costs and expenses:Cost of revenues14.2 14.6 15.8 Sales and marketing2.9 3.8 5.3 Research and development5.9 4.9 4.8 General and administrative11.8 11.2 10.9 Total costs and expenses34.8 34.5 36.8 Operating income65.2 65.5 63.2 Interest expense(7.1)(7.4)(9.5)Non-operating income, net1.2 3.5 6.3 Income before income taxes59.3 61.6 60.0 Income tax benefit (expense)5.1 (11.9)(12.1)Net income64.4 %49.7 %47.9 %RevenuesOur revenues are primarily derived from registrations for domain names in the .com and .net domain name registries. We also derive revenues from operating domain name registries for several other TLDs and from providing back-end registry services to a number of TLD registry operators, all of which are not significant in relation to our consolidated revenues. For domain names registered in the .com and .net registries we receive a fee from registrars per annual registration that is determined pursuant to our agreements with ICANN. Individual customers, called registrants, contract directly with registrars or their resellers, and the registrars in turn register the domain names with Verisign. Changes in revenues are driven largely by changes in the number of new domain name registrations and the renewal rate for existing registrations as well as the impact of new and prior price increases, to the extent permitted by ICANN and the DOC. New registrations and the renewal rate for existing registrations are impacted by continued growth in online advertising, e-commerce, and the number of internet users, as well as marketing activities carried out by us and our registrars. The annual fee for a .com domain name registration has been fixed at $7.85 since 2012. On October 26, 2018, Verisign and the DOC amended the Cooperative Agreement. The amendment, among other items, extends the term of the Cooperative Agreement until November 30, 2024 and permits the price of a .com domain name to be increased, subject to appropriate changes to the .com Registry Agreement, without further DOC approval, by up to 7% in each of the final four years of each six-year period beginning on October 26, 2018. On March 27, 2020, Verisign and ICANN amended the .com Registry Agreement (“Third .com Amendment”) that, among other items, incorporates these changes agreed to with the DOC to the pricing terms. We have the contractual right to increase the fees for .net domain name registrations by up to 10% each year during the term of our agreement with ICANN, through June 30, 2023. As part of our response to the COVID-19 crisis, we announced on March 25, 2020 that we would freeze registry prices for domain name registrations and renewals for all of our TLDs, including .com and .net, through the end of 2020. On July 23, 2020, we announced that we would extend the freeze on registry prices for all of our TLDs, including .com and .net, through March 31, 2021. On February 11, 2021, we announced that we will increase the annual registry-level wholesale fee for each new and renewal .com domain name registration from $7.85 to $8.39, effective September 1, 2021. We offer promotional incentive-based discount programs to registrars based upon market conditions and the business environment in which the registrars operate. All fees paid to us for .com and .net registrations are in U.S. dollars.A comparison of revenues is presented below:25Table of ContentsYear Ended December 31,2020%Change2019%Change2018 (Dollars in thousands)Revenues$1,265,052 3 %$1,231,661 1 %$1,214,969 The following table compares the .com and .net domain name registrations in the domain name base: As of December 31,2020%Change2019%Change2018.com and .net domain name registrations in the domain name base165.2 million4 %158.8 million4 %153.0 millionGrowth in the domain name base has been primarily driven by continued internet growth and marketing activities carried out by us and our registrars. However, competitive pressure from ccTLDs, other gTLDs, services that offer alternatives for an online presence, such as social media, ongoing changes in internet practices and behaviors of consumers and business, as well as the motivation of existing domain name registrants managing their investment in domain names, and historical global economic uncertainty, has limited the rate of growth of the domain name base in recent years and may continue to do so in 2021 and beyond. Revenues increased by $33.4 million in 2020 compared to 2019, primarily due to an increase in revenues from the operation of the registry for the .com TLD, partially offset by the elimination of revenues from our sale of our security services customer contracts. The increase in revenues from the .com TLD was driven by a 4% increase in the domain name base for .com.Geographic revenuesWe generate revenues in the U.S.; Europe, the Middle East and Africa (“EMEA”); China; and certain other countries, including Canada, Australia and Japan. The following table presents a comparison of the Company’s geographic revenues: Year Ended December 31,2020%Change2019%Change2018(Dollars in thousands)U.S$804,647 4 %$772,586 2 %$756,907 EMEA214,204 3 %206,975 (3)%212,699 China113,048 (5)%119,291 12 %106,841 Other133,153 — %132,809 (4)%138,522 Total revenues$1,265,052 3 %$1,231,661 1 %$1,214,969 Revenues in the table above are attributed to the country of domicile and the respective regions in which our registrars are located; however, this may differ from the regions where the registrars operate or where registrants are located. Revenue growth for each region may be impacted by registrars reincorporating, relocating, or from acquisitions or changes in affiliations of resellers. Revenue growth for each region may also be impacted by registrars domiciled in one region, registering domain names in another region. The majority of our revenue growth in 2020 has come from increased sales to registrars based in the U.S. and EMEA. Revenues from registrars based in China declined during 2020 as a result of lower new registrations and renewal rates in the country. We expect revenues to continue to grow in 2021, as a result of the increased volume of domain registrations in 2020, and continued growth in registrations in the domain name base in 2021.Cost of revenuesCost of revenues consist primarily of salaries and employee benefits expenses for our personnel who manage the operational systems, depreciation expenses, operational costs associated with the delivery of our services, fees paid to ICANN, customer support and training, costs of facilities and computer equipment used in these activities, telecommunications expense and allocations of indirect costs such as corporate overhead.26Table of ContentsA comparison of cost of revenues is presented below:Year Ended December 31,2020%Change2019%Change2018 (Dollars in thousands)Cost of revenues$180,177 — %$180,467 (6)%$192,134 Cost of revenues remained consistent in 2020 compared to 2019, as a decrease in salary and employee benefits expenses was offset by an increase in direct cost of revenues. Salary and employee benefits expenses decreased by $2.3 million due to a functional realignment of some headcount to research and development, partially offset by headcount increases throughout the year and an increase in expenses for other employee benefits including expanded paid time off benefits provided to employees in response to the COVID-19 pandemic. Direct cost of revenues increased by $1.8 million as a result of an increase in registry fees primarily related to the .com TLD.We expect cost of revenues as a percentage of revenues to increase slightly in 2021 as compared to 2020.Sales and marketingSales and marketing expenses consist primarily of salaries and other personnel-related expenses, travel and related expenses, trade shows, costs of computer and communications equipment and support services, facilities costs, consulting fees, costs of marketing programs, such as online, television, radio, print and direct mail advertising costs, and allocations of indirect costs such as corporate overhead.A comparison of sales and marketing expenses is presented below:Year Ended December 31,2020%Change2019%Change2018 (Dollars in thousands)Sales and marketing$36,790 (21)%$46,637 (28)%$64,891 Sales and marketing expenses decreased by $9.8 million in 2020 compared to 2019 primarily due to a $6.9 million decrease in advertising and marketing expenses and a combination of other individually insignificant factors. Advertising and marketing expenses declined as a result of decreases in marketing programs in various regions.We expect sales and marketing expenses as a percentage of revenues to remain consistent in 2021 as compared to 2020.Research and developmentResearch and development expenses consist primarily of costs related to research and development personnel, including salaries and other personnel-related expenses, consulting fees, facilities costs, computer and communications equipment, support services used in our service and technology development, and allocations of indirect costs such as corporate overhead.A comparison of research and development expenses is presented below:Year Ended December 31,2020%Change2019%Change2018 (Dollars in thousands)Research and development$74,671 23 %$60,805 5 %$57,884 Research and development expenses increased by $13.9 million in 2020 compared to 2019 primarily due to increases in salary and employee benefits expenses and allocated overhead expenses. Salary and employee benefits expenses increased by $10.2 million as a result of several factors, including a functional realignment of some headcount from cost of revenues, additional headcount increases throughout the year, and an increase in expenses for other employee benefits including expanded paid time off benefits provided to employees in response to the COVID-19 pandemic. Allocated overhead expenses increased by $4.0 million primarily due to an increase in average headcount relative to other cost types.We expect research and development expenses as a percentage of revenues to remain consistent in 2021 as compared to 2020.27Table of ContentsGeneral and administrativeGeneral and administrative expenses consist primarily of salaries and other personnel-related expenses for our executive, administrative, legal, finance, information technology and human resources personnel, costs of facilities, computer and communications equipment, management information systems, support services, professional services fees, and certain tax and license fees, offset by allocations of indirect costs such as facilities and shared services expenses to other cost types.A comparison of general and administrative expenses is presented below:Year Ended December 31,2020%Change2019%Change2018 (Dollars in thousands)General and administrative$149,213 8 %$137,625 4 %$132,668 General and administrative expenses increased by $11.6 million in 2020 compared to 2019 primarily due to increases in salary and employee benefits expenses, software license expenses, charitable contributions, and contract and professional services expenses, partially offset by a decrease in stock-based compensation expenses and an increase in overhead expenses allocated to other cost types. Salary and employee benefits expenses increased by $8.1 million as a result of an increase in average headcount as well as an increase in expenses for other employee benefits including expanded paid time off benefits provided to employees in response to the COVID-19 pandemic. Software license expenses increased by $3.3 million due to expenses related to network security and other software services. Charitable contributions increased by $3.6 million to support the response to the COVID-19 pandemic and to promote equal justice. Contract and professional services expenses increased by $2.0 million due to increases in expenses for network security and other corporate support services. Stock-based compensation expense decreased by $2.4 million as a result of a decrease in the projected achievement levels on certain performance-based RSU grants. Overhead costs allocated to other cost types increased by $3.0 million due to an increase in total allocable expenses.We expect general and administrative expenses as a percentage of revenues to remain consistent in 2021 as compared to 2020.Interest expenseSee Note 4, “Debt and Interest Expense” of our Notes to Consolidated Financial Statements in Item 8 of this Form 10-K. We expect interest expense to remain consistent in 2021 as compared to 2020.Non-operating income, netSee Note 9, “Non-operating Income, Net” of our Notes to Consolidated Financial Statements in Item 8 of this Form 10-K. We expect Non-operating income, net to decrease in 2021 as compared to 2020 due to the transition services income and gain recognized in 2020 in connection with the sale of our security services customer contracts which will not recur in 2021, and lower interest income in 2021 as a result of lower interest rates.Income tax (benefit) expense Year Ended December 31,202020192018 (Dollars in thousands)Income tax (benefit) expense(64,644)$146,477 $147,027 Effective tax rate(9)%19 %20 %The effective tax rate for each of the periods in the table above differed from the statutory federal rate of 21% due to a lower foreign effective tax rate and excess tax benefits related to stock-based compensation, offset by state income taxes and U.S. taxes on foreign earnings, net of foreign tax credits.Additionally, during 2020, we recognized an income tax benefit of $204.2 million as a result of the remeasurement of certain previously unrecognized income tax benefits. The majority of this tax benefit related to the worthless stock deduction taken in 2013. These remeasurements were based on written confirmations from Internal Revenue Service (“IRS”), received in 2020, indicating no examination adjustments would be proposed related to the worthless stock deduction or certain other matters reviewed as part of the audit of our federal income tax returns for 2010 through 2014, and the lapse of statutes of limitations related to other unrecognized income tax benefits. Notwithstanding these written confirmations, our U.S. federal income tax returns for 2010 through 2014 remain under examination by the IRS.28Table of ContentsAs of December 31, 2020, we had deferred tax assets arising from deductible temporary differences, tax losses, and tax credits of $74.4 million, net of valuation allowances, but before the offset of certain deferred tax liabilities. With the exception of deferred tax assets related to certain state and foreign net operating loss carryforwards, we believe it is more likely than not that the tax effects of the deferred tax liabilities, together with future taxable income, will be sufficient to fully recover the remaining deferred tax assets. We qualified for a tax holiday in Switzerland until the end of 2019 which lowered tax rates on certain types of income and required certain thresholds of foreign source income. The tax holiday reduced our foreign income tax expense by $17.3 million ($0.15 per share) in 2019. The benefit from the tax holiday is calculated before consideration of any offsetting tax impact in the United States. Effective January 1, 2020, due to Swiss tax law changes, the tax holiday was eliminated, which was partially offset by a lowered statutory tax rate.We expect the effective tax rate for 2021 to be between 20% and 23%.Liquidity and Capital ResourcesAs of December 31,20202019 (In thousands)Cash and cash equivalents$401,194 $508,196 Marketable securities765,713 709,863 Total$1,166,907 $1,218,059 As of December 31, 2020, our principal source of liquidity was $401.2 million of cash and cash equivalents and $765.7 million of marketable securities. The marketable securities consist primarily of debt securities issued by the U.S. Treasury meeting the criteria of our investment policy, which is focused on the preservation of our capital through investment in investment grade securities. The cash equivalents consist mainly of amounts invested in money market funds and U.S. Treasury bills purchased with original maturities of three months or less. As of December 31, 2020, all of our debt securities have contractual maturities of less than one year. Our cash and cash equivalents are readily accessible. For additional information on our investment portfolio, see Note 2, “Financial Instruments,” of our Notes to Consolidated Financial Statements in Item 8 of this Form 10-K.In 2020, we repurchased 3.7 million shares of our common stock at an average stock price of $200.06 for an aggregate cost of $734.9 million under our share repurchase program. In 2019, we repurchased 3.9 million shares of our common stock at an average stock price of $188.84 for an aggregate cost of $738.5 million. Effective February 11, 2021, our Board of Directors authorized the repurchase of our common stock in the amount of $747.0 million, in addition to the $253.0 million that remained available for repurchases under the share repurchase program, for a total repurchase authorization of up to $1.0 billion under the program.As of December 31, 2020, we had $550.0 million principal amount outstanding of 4.75% senior unsecured notes due 2027, $500.0 million principal amount outstanding of the 5.25% senior unsecured notes due 2025 and $750.0 million principal amount outstanding of the 4.625% senior unsecured notes due 2023. As of December 31, 2020, there were no borrowings outstanding under the $200.0 million unsecured revolving credit facility that will expire in 2024.We believe existing cash, cash equivalents and marketable securities, and funds generated from operations, together with our ability to arrange for additional financing should be sufficient to meet our working capital, capital expenditure requirements, and to service our debt for the next 12 months. We regularly assess our cash management approach and activities in view of our current and potential future needs.In summary, our cash flows for 2020, 2019, and 2018 were as follows:Year Ended December 31, 202020192018 (In thousands)Net cash provided by operating activities$730,183 $753,892 $697,767 Net cash (used in) provided by investing activities(72,258)167,195 1,070,130 Net cash used in financing activities(764,877)(770,303)(1,875,325)Effect of exchange rate changes on cash, cash equivalents and restricted cash(48)64 (958)Net (decrease) increase in cash, cash equivalents and restricted cash$(107,000)$150,848 $(108,386)29Table of ContentsCash flows from operating activities Our largest source of operating cash flows is cash collections from our customers. Our primary uses of cash from operating activities are for personnel related expenditures, and other general operating expenses, as well as payments related to taxes, interest and facilities. Net cash provided by operating activities decreased in 2020 compared to 2019 primarily due to an increase in cash paid for income taxes and decreases in cash received from interest on investments and from transition services, partially offset by an increase in cash received from customers. Cash paid for income taxes increased as we used the majority of our net operating loss carryforwards and tax credit carryforwards by the end of 2019. Cash received from interest on investments decreased due to a decline in interest rates. Cash received from transition services decreased due to the expiration of the transition services agreement related to our sale of our security services customer contracts in February 2020. Cash received from customers increased primarily due to higher domain name registrations and renewals. Cash flows from investing activities The changes in cash flows from investing activities primarily relate to purchases, maturities and sales of marketable securities, purchases of property and equipment and the sale of businesses. We had net cash outflows from investing activities in 2020, compared to net cash inflows during 2019, primarily due to an increase in purchases of marketable securities and investments, net of proceeds from maturities and sales of marketable securities and investments, and an increase in purchases of property and equipment, partially offset by contingent consideration received related to our sale of security services customer contracts.Cash flows from financing activities The changes in cash flows from financing activities primarily relate to share repurchases, repayment of borrowings, and our employee stock purchase plan. Net cash used in financing activities decreased in 2020 compared to 2019 primarily due to a decrease in share repurchases.Impact of Inflation We do not believe that inflation has had a significant impact on our operations in any of the periods presented. Income taxes We expect cash paid for income taxes as a percentage of pre-tax income to be between 20% and 23% in 2021. Property and Equipment Expenditures Our planned property and equipment expenditures for 2021 are anticipated to be between $55.0 million and $65.0 million and will primarily be focused on infrastructure upgrades and enhancements to our product portfolio.Contractual Obligations See Note 11, “Commitments and Contingencies,” Purchase Obligations and Contractual Agreements, of our Notes to Consolidated Financial Statements in Item 8 of this Form 10-K. Off-Balance Sheet Arrangements It is not our business practice to enter into off-balance sheet arrangements. As of December 31, 2020, we did not have any significant off-balance sheet arrangements. See Note 11, “Commitments and Contingencies,” Off-Balance Sheet Arrangements, of our Notes to Consolidated Financial Statements in Item 8 of this Form 10-K for further information regarding off-balance sheet arrangements. 30Table of Contents Dilution from RSUs Grants of stock-based awards are key components of the compensation packages we provide to attract and retain certain of our employees and align their interests with the interests of existing stockholders. We recognize that these stock-based awards dilute existing stockholders and have sought to control the number granted while providing competitive compensation packages. As of December 31, 2020, there are a total of 0.7 million unvested RSUs which represent potential dilution of less than 1.0%. This maximum potential dilution will only result if all outstanding RSUs vest and are settled. In recent years, our stock repurchase program has more than offset the dilutive effect of RSU grants to employees; however, we may reduce the level of our stock repurchases in the future as we may use our available cash for other purposes. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK We are exposed to financial market risks, including changes in interest rates and foreign exchange rates. We have not entered into any market risk sensitive instruments for trading purposes. Interest Rate Sensitivity The fixed income securities in our investment portfolio are subject to interest rate risk. As of December 31, 2020, we had $1.01 billion of fixed income securities, which consisted of U.S. Treasury bills with maturities of less than one year. A hypothetical change in interest rates by 100 basis points would not have a significant impact on the fair value of our investments.Foreign Exchange Risk Management We conduct business in several countries and transact in multiple foreign currencies. The functional currency for all of our international subsidiaries is the U.S. dollar. Our foreign currency risk management program is designed to mitigate foreign exchange risks associated with monetary assets and liabilities of our operations that are denominated in currencies other than the U.S. dollar. The primary objective of this program is to minimize the gains and losses to income resulting from fluctuations in exchange rates. We may choose not to hedge certain foreign exchange exposures due to immateriality, prohibitive economic cost of hedging particular exposures, and limited availability of appropriate hedging instruments. We do not enter into foreign currency transactions for trading or speculative purposes, nor do we hedge foreign currency exposures in a manner that entirely offsets the effects of changes in exchange rates. The program may entail the use of forward or option contracts, which are usually placed and adjusted monthly. These foreign currency forward contracts are derivatives and are recorded at fair market value. We attempt to limit our exposure to credit risk by executing foreign exchange contracts with financial institutions that have investment grade ratings. As of December 31, 2020, we held foreign currency forward contracts in notional amounts totaling $27.5 million to mitigate the impact of exchange rate fluctuations associated with certain foreign currencies. Gains or losses on the foreign currency forward contracts would be largely offset by the remeasurement of our foreign currency denominated assets and liabilities, resulting in an insignificant net impact to income. A hypothetical uniform 10% strengthening or weakening in the value of the U.S. dollar relative to the foreign currencies in which our revenues and expenses are denominated would not result in a significant impact to our financial statements. Market Risk Management The fair market values of our senior notes are subject to interest rate risk. Generally, the fair market value of fixed interest rate debt will increase as interest rates fall and decrease as interest rates rise. As of December 31, 2020, the fair values of the senior notes issued in 2013, 2015 and 2017 were $758.8 million, $569.1 million, and $589.9 million, respectively, based on available market information from public data sources. 31Table of Contents
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+Item 7. under the headings "Management’s Discussion and Analysis of Financial Condition and Results of Operations - Overview" and - "Segment Results of Operations" and in Note 13 to the consolidated financial statements of Verizon Communications Inc. and Subsidiaries.Service and Product OfferingsOur Consumer segment's wireless and wireline products and services are available to our retail customers, as well as resellers that purchase wireless network access from us on a wholesale basis. Our Business segment’s wireless and wireline products and services are organized by the primary customer groups targeted by these offerings: Small and Medium Business, Global Enterprise, Public Sector and Other, and Wholesale.WirelessWe offer wireless services and equipment to customers of both Consumer and Business.Wireless ServicesOur Consumer and Business segments provide a wide variety of wireless services accessible on a broad range of devices. Customers can obtain our wireless services on a postpaid or prepaid basis. Retail (non-wholesale) postpaid accounts primarily represent retail customers that are directly served and managed by Verizon and use Verizon branded services. A single account may include monthly wireless services for a variety of connected devices. Our postpaid service is generally billed one month in advance for a monthly access charge in return for access to and usage of network services. Our prepaid service is offered only to Consumer customers and enables individuals to obtain wireless services without credit verification by paying for all services in advance. Approximately 96% of our Consumer retail connections were postpaid connections as of December 31, 2020. We offer various postpaid and prepaid service plans tailored to the needs of our customers. Depending on those needs at a particular time, our plans may include features related to, among other things: unlimited or metered domestic and/or international voice, data, and texting; the ability to share data allowances and/or use data allowances in different periods; high definition voice and video features; the ability to use a device as a Wi-Fi hotspot; and varying data rates depending on the plan and usage on that plan. Our service offerings vary from time to time 4Table of Contentsbased on customer needs, technology changes and market conditions and may be provided as standard plans or as part of limited time promotional offers.Access to the internet is available on all smartphones and nearly all basic phones. In addition, our customers can access the internet at broadband speeds on notebook computers and tablets that are either wireless-enabled or that are used in conjunction with separate dedicated devices that provide a mobile Wi-Fi connection.We no longer offer Consumer customers new fixed-term, subsidized service plans for devices; however, we continue to offer subsidized plans to our Business customers. We also continue to service existing plans for customers who have not yet purchased and activated devices under the Verizon device payment program. Wireless EquipmentConsumer and Business offer several categories of wireless equipment to customers, including a variety of smartphones and other handsets, wireless-enabled internet devices, such as tablets and other wireless-enabled connected devices, such as smart watches. In certain cases, we permit customers to acquire equipment from us using device payment plans, which permit the customer to pay for the device in installments over time.Verizon Consumer GroupIn addition to the wireless services and equipment discussed above, Consumer sells residential fixed connectivity solutions, including internet, video and voice services, and wireless network access to resellers on a wholesale basis. Residential Fixed Services. We provide residential fixed connectivity solutions to customers over our 100% fiber-optic network through our Verizon Fios product portfolio, and over a traditional copper-based network to customers who are not served by Fios. As of December 31, 2020, we have commercially launched fifth-generation (5G) fixed wireless technology for the home (5G Home) in 12 U.S. markets. In addition, in 2020, we launched our Long-Term Evolution (LTE) Home fixed wireless access internet service in rural parts of 189 markets across 48 U.S. states.We offer residential fixed services tailored to the needs of our customers. Depending on those needs at a particular time, our services may include features related to, among other things: internet access at different speed tiers using fiber-optic, copper or wireless technology; video services that may feature a variety of channel options, video on demand products, cloud-based services and digital video recording capabilities; over-the-top video services; and voice services. Network Access Services. We sell network access to mobile virtual network operators (MVNOs) on a wholesale basis, who in turn resell wireless service under their own brand(s) to consumers. Our largest such arrangement is with TracFone Wireless Inc. (Tracfone), a provider of prepaid and value mobile services in the U.S. In September 2020, we entered into a purchase agreement with América Móvil to acquire Tracfone. The transaction is subject to regulatory approvals and closing conditions and is expected to close in the second half of 2021.Verizon Business Group In addition to the wireless services and equipment discussed above, our Business segment provides wireless and wireline communications services and products, including data, video and conferencing services, corporate networking solutions, security and managed network services, local and long distance voice services and network access to deliver various IoT products and services. Small and Medium BusinessSmall and Medium Business offers wireless services and equipment, conferencing services, tailored voice and networking products, Fios services, Internet Protocol (IP) networking, advanced voice solutions and security and managed information technology (IT) services to our U.S.-based small and medium businesses that do not meet the requirements to be categorized as Global Enterprise, as described below. In 2020, Small and Medium Business revenues were $11.1 billion, representing approximately 36% of Business’s total revenues.In addition to the wireless services and equipment discussed above, Small and Medium Business provides fixed connectivity solutions comparable to the residential fixed services provided by Consumer, as well as business services and connectivity similar to the products and services offered by Global Enterprise, in each case with features and pricing designed to address the needs of small and medium businesses.Global EnterpriseGlobal Enterprise offers services to large businesses, which are identified based on their size and volume of business with Verizon, as well as non-U.S. public sector customers. In 2020, Global Enterprise revenues were $10.4 billion, representing approximately 34% of Business’s total revenues.Global Enterprise offers a broad portfolio of connectivity, security and professional services designed to enable our customers to optimize their business operations, mitigate business risks and capitalize on data. These services include the following:5Table of Contents•Network Services. We offer a portfolio of network connectivity products to help our customers connect with their employees, partners, vendors and customers. These products include private networking services, private cloud connectivity services, virtual and software defined networking services and internet access services. •Advanced Communications Services. We offer a suite of services to our customers to help them communicate with their employees, partners, vendors, constituents and customers. These products include IP-based voice and video services, unified communications and collaboration tools and customer contact center solutions.•Security services. We offer a suite of management and data security services that help our customers protect, detect and respond to security threats to their networks, data, applications and infrastructure.•Core services. We provide a portfolio of domestic and global voice and data solutions utilizing traditional telecommunications technology, including voice calling, messaging services, conferencing, contact center solutions and private line and data access networks. Core services also include the provision of customer premises equipment, and installation, maintenance and site services. •IoT services. We provide the network access required to deliver various IoT products and services. We work with companies that purchase network access from us to connect their devices, bundled together with their own solutions, which they sell to end users. We are building IoT capabilities by leveraging business models that monetize usage on our networks at the connectivity, platform and solution layers.Public Sector and OtherPublic Sector and Other offers wireless products and services as well as wireline connectivity and managed solutions to U.S. federal, state and local governments and educational institutions. These services include business services and connectivity similar to the products and services offered by Global Enterprise, in each case, with features and pricing designed to address the needs of governments and educational institutions. In 2020, Public Sector and Other revenues were $6.4 billion, representing approximately 21% of Business’s total revenues.Public Sector and Other also includes solutions that support fleet tracking management, compliance management, field service management, asset tracking and other types of mobile resource management in the U.S. and around the world. WholesaleWholesale offers wireline communications services including data, voice, local dial tone and broadband services primarily to local, long distance, and wireless carriers that use our facilities to provide services to their customers. In 2020, Wholesale revenues were $3.1 billion, representing approximately 10% of Business’s total revenues. A portion of Wholesale revenues are generated by a few large telecommunications companies, most of which compete directly with us. Wholesale's services include:•Data services. We offer a portfolio of data services to enhance our Wholesale customers’ networks and provide connections to their end-users and subscribers.•Voice services. We provide switched access services that allow carriers to complete their end-user calls that originate or terminate within our territory. In addition, we provide originating and terminating voice services throughout the U.S. and globally utilizing our time-division multiplexing and Voice over Internet Protocol (VoIP) networks.•Local services. We offer an array of local dial tone and broadband services to competitive local exchange carriers, some of which are offered to comply with telecommunications regulations. In addition, we offer services such as colocation, resale and unbundled network elements in compliance with applicable regulations.DistributionWe use a combination of direct, indirect and alternative distribution channels to market and distribute our products and services to Consumer customers. Our direct channel, including our company-operated stores, is a core component of our distribution strategy. Our sales and service centers and business direct sales teams also represent significant distribution channels for our services. In addition, we have a robust digital channel and omni-channel experience for our customers in order to offer choice and convenience.Our indirect channel includes agents that sell our wireless and wireline products and services at retail locations throughout the U.S., as well as through the internet. The majority of these sales are made under exclusive selling arrangements with us. We also have relationships with high-profile national retailers that sell our wireless and wireline products and services, as well as convenience store chains that sell our wireless prepaid products and services. In addition to our direct channel, our Business segment has additional distribution channels that include business solution fulfillment provided by resellers, non-stocked device fulfillment performed by distributors and integrated mobility services provided by system integrators and resellers.6Table of ContentsCompetition and Related TrendsThe telecommunications industry is highly competitive. We expect competition to remain intense as traditional and non-traditional participants seek increased market share. With respect to our wireless connectivity products and services, we compete against other national wireless service providers, including AT&T Inc. and T-Mobile USA, Inc., as well as various regional wireless service providers. We also compete for retail activations with resellers that buy bulk wholesale service from wireless service providers, including Verizon, and resell it to their customers. Resellers include cable companies and others. Competition remains intense as a result of high rates of smartphone penetration in the wireless market, increased network investment by our competitors, the development and deployment of new technologies, such as 5G, the introduction of new products and services, offerings that include additional bundled premium content, new market entrants, the availability of additional licensed and unlicensed spectrum and regulatory changes. Competition may also increase as smaller, stand-alone wireless service providers merge or transfer licenses to larger, better capitalized wireless service providers and as MVNOs resell wireless communication services. In addition, DISH Network has committed to deploy a facilities-based 5G broadband network in each of its license areas capable of serving at least 70 percent of the U.S. population by June 2023, which could result in additional competitive pressures in the U.S. wireless industry. We also face competition from other communications and technology companies seeking to increase their brand recognition and capture customer revenue with respect to the provision of wireless products and services, in addition to non-traditional offerings in mobile data. For example, Microsoft Corporation, Alphabet Inc., Apple Inc. and others are offering alternative means for making wireless voice calls that, in certain cases, can be used in lieu of the wireless provider’s voice service, as well as alternative means of accessing video content. With respect to our wireline connectivity services, we compete against cable companies, wireless service providers, domestic and foreign telecommunications providers, satellite television companies, internet service providers, over-the-top (OTT) providers and other companies that offer network services and managed enterprise solutions. Cable operators have increased the size and capacity of their networks in order to deliver digital products and services. Several major cable operators offer bundles with wireless services through strategic relationships. Customers have an increasing number of choices for obtaining video content from various online services. We expect the market will continue to shift from traditional linear video to OTT offerings. We expect customer migration from traditional voice services to wireless services to continue as a growing number of customers place greater value on mobility and wireless companies position their services as a landline alternative. We also face increasing competition from cable operators and other providers of VoIP services as well as internet portal providers.We believe that the following are the most important competitive factors and trends in the telecommunications industry:•Network reliability, speed and coverage. We consider networks that consistently provide high-quality, fast and reliable service to be a key differentiator in the market and driver of customer satisfaction. Lower prices, improved service quality and new service offerings, which in many cases include video content, have led to increased customer usage of connectivity services. We and other network-based providers must ensure that our networks can meet these increasing capacity usage requirements and offer highly reliable national coverage. •Pricing. With respect to wireless services and equipment, pricing plays an important role in the wireless competitive landscape. As the demand for wireless services continues to grow, wireless service providers are offering a range of service plans at competitive prices. Many wireless service providers also bundle wireless service offerings with other content and offer promotional pricing and incentives, some of which may be targeted specifically to customers of Verizon. We and other wireless service providers, as well as equipment manufacturers, offer device payment options, which provide customers with the ability to pay for their device over a period of time, and some providers offer device leasing arrangements. In addition, aggressive device promotions have become more common in an effort to gain a greater share of subscribers interested in changing carriers. Pricing also plays an important role in the wireline competitive landscape, as traditional service providers compete aggressively in offerings such as IP Networking, Core Voice and other legacy products. In addition, as non-traditional modes of providing wireline communication services emerge, new entrants attempt to capture market share from incumbents using competitive pricing. For example, VoIP and portal-based voice and video calling is often free or nearly free for customers and supported by advertising revenues. •Customer service. We believe that high-quality customer service is a key factor in retaining customers and attracting new customers, including those of other providers. Our customer service, retention and satisfaction programs are based on providing customers with convenient and easy-to-use products and services and focusing on their needs in order to promote long-term relationships and minimize churn.Customer service is highly valued by our Business customers. We provide Global Enterprise and Public Sector and Other customers with ready access to their system and performance information, and we conduct proactive testing of our networks to identify issues before they affect our customers. We service our Small and Medium Business customers through service representatives and online support, as well as through store-based representatives for small business customers. For Wholesale customers, we pursue service improvement through continued system automation initiatives.•Product differentiation. Customer and revenue growth are increasingly dependent on the development of new and enhanced products and services, as the delivery of new and innovative products and services has been accelerating. Customers are shifting their focus from access to applications and are seeking ways to leverage their broadband, video and wireless connections. To compete effectively, providers need to continuously review, improve and refine their product portfolio and develop and rapidly 7Table of Contentsdeploy new products and services tailored to the needs of customers. We continue to pursue the development and rapid deployment of new and innovative products and services, both independently and in collaboration with application providers, content providers and device manufacturers. Features such as wireless and wireline inter-operability are becoming increasingly important, driven by both customer demand and technological advancement. •Sales and distribution. A key to achieving sales success in the consumer and small and medium business sectors of the wireless industry is the reach and quality of sales channels and distribution points. We seek to optimally vary distribution channels among our company-operated stores selling wireless products and services, outside sales teams and telemarketing, web-based sales and fulfillment capabilities, our extensive indirect distribution network of retail outlets and our sale of wireless service to resellers, which resell wireless services to their end-users.In addition to these competitive factors and trends, companies with a global presence are increasingly competing with us in our Business segment. A relatively small number of telecommunications and integrated service providers with global operations serve customers in the global enterprise market and, to a lesser extent, the global wholesale market. We compete with these providers for large contracts to provide integrated solutions to global enterprises and government customers. Many of these companies have strong market presence, brand recognition and existing customer relationships, all of which contribute to intensifying competition that may affect our future revenue growth. In the Small and Medium Business market, customer purchasing behaviors and preferences continue to evolve. Solution speed and simplicity with user interfaces that have a consumer-like "look and feel" are becoming key differentiators for customers who are seeking full life-cycle offers that simplify the process of starting, running and growing their businesses. Several major cable operators also offer bundles with wireless services through strategic relationships. In the Global Enterprise and Public Sector and Other markets, competition levels remain high, primarily as a result of increased industry focus on technology convergence. We compete in this area with system integrators, carriers, and hardware and software providers. In addition, some of the largest information technology services companies are making strategic acquisitions, divesting non-strategic assets and forging new alliances to improve their cost structure. Many new alliances and acquisitions have focused on emerging fields, such as cloud computing, software defined networking, communication applications and other computing tasks via networks, rather than by the use of in-house machines. Our Wholesale business competes with traditional carriers for long-haul, voice and IP services. In addition, mobile video and data needs are driving a greater need for wireless backhaul. Network providers, cable companies and niche players are competitors for this business opportunity.Verizon MediaOur media business, Verizon Media Group (Verizon Media), includes diverse media and technology brands that serve both consumers and businesses. Verizon Media provides consumers with owned and operated and third-party search properties as well as mail, news, finance, sports and entertainment offerings, and provides other businesses and partners access to consumers through digital advertising, content delivery and video streaming platforms. In 2020, Verizon Media's revenues were $7.0 billion.Verizon Media Products and SolutionsAd PlatformOur Verizon Media Ad Platform provides advertisers and publishers with a simplified suite of intelligent advertising solutions across desktop, mobile and television devices. Verizon Media's business is comprised primarily of search advertising, display advertising and Ecommerce.•Search advertising. Our search properties serve as a guide for users to discover information on the internet. Verizon Media serves click-based search advertisements generated by proprietary algorithmic technology, as well as advertisements from partners. Verizon Media provides the underlying search products that facilitate user searches within Verizon Media and third-party partner properties. •Display advertising. Display advertising is made up of both graphical and performance-based advertising and takes the form of impression-based contracts, time-based contracts and performance-based contracts. Verizon Media display ads leverage proprietary data signals to identify and engage users on Verizon Media properties and across the web. Through the Verizon Media Ad Platform, we provide customers the ability to buy advertising inventory and measure campaigns across screens and advertising formats using self-serve technology or our managed services. We also provide publishers with the ability to monetize their ad inventory. •Ecommerce. Our Ecommerce offering includes different types of business models, including facilitating transactions between businesses and consumers, enabling businesses that facilitate transactions for other businesses and facilitating transactions between consumers.Subscription MembershipsOur paid subscription offerings include premium content and services across our mail, news, finance, sports and entertainment properties, privacy and security solutions and computer protection.8Table of ContentsVerizon Media PlatformAs the digital platform reshapes the delivery of media and entertainment content, there is an increasing need for stable, high-quality video delivery platforms. Our Media Platform offers a scalable platform for delivering content, including live broadcasts, video on demand, games, software and websites to our customers on their devices at any time. This platform is targeted at media and entertainment companies and other businesses that deliver their digital products and services through the internet.Global Network and TechnologyOur global network architecture is used by Consumer, Business and Verizon Media. Our network technology platforms include both wireless and wireline technologies. Network Evolution We are evolving the architecture of our networks to a next-generation multi-use platform, providing improved efficiency and virtualization, increased automation and opportunities for edge computing services that will support both our fiber-based and radio access network technologies. We call this the Intelligent Edge Network. We expect that this new architecture will simplify operations by eliminating legacy network elements, speed the deployment of 5G wireless technology and create new opportunities in the business market in a cost efficient manner. 5G Deployment Over the past several years, we have been leading the development of 5G wireless technology industry standards and the ecosystems for fixed and mobile 5G wireless services. We expect that 5G technology will provide higher throughput and lower latency than the current fourth-generation (4G) (LTE) technology and enable our networks to handle more traffic as the number of internet-connected devices grows. As of December 31, 2020, we have launched our 5G Ultra Wideband Network in 61 U.S. markets. We have commercially launched 5G Home in 12 of those markets. We also launched our 5G Nationwide Network in October 2020, which is available in over 2,700 cities across the U.S. covering approximately 230 million people. 5G Nationwide uses low and mid-band spectrum and dynamic spectrum sharing (DSS) technology, which allows 5G service to run simultaneously with 4G LTE on multiple spectrum bands. With DSS, whenever customers move outside Verizon’s high-band Ultra Wideband coverage area, their 5G-enabled devices will remain on 5G technology using the lower spectrum bands where the 5G Nationwide network is available. This allows us to more fully and effectively utilize our current spectrum resources to serve both 4G and 5G customers.4G LTE The wireless network technology platform that carries the majority of our wireless traffic is 4G LTE, which provides higher data throughput performance for data services at a lower cost compared to that offered by 3G technology. As of December 31, 2020, our 4G LTE network is available in over 700 markets covering approximately 327 million people, including those in areas served by our LTE in Rural America partners. Under this program, we have collaborated with wireless carriers in rural areas to build and operate a 4G LTE network using each carrier’s network assets with our core 4G LTE equipment and 700 Megahertz (MHz) C Block and Advanced Wireless Services (AWS) spectrum. In 2020, we launched LTE Home Internet, a home broadband internet service that leverages the Verizon 4G LTE network.Wireless Network Reliability and Build-Out We consider the reliability, coverage and speed of our wireless network to be key factors for our continued success. We believe that steady and consistent network and platform investments provide the foundation for innovative products and services. As we design and deploy our network, we focus on the number of successful data sessions the network enables, delivering on our advertised throughput speeds, and the number of calls that are connected on the first attempt and completed without being dropped. We utilize three strategies to maintain the quality of our network: increasing the density of our network elements, deploying new technologies as they are developed and putting additional wireless spectrum into service.We have been densifying our network by utilizing small cell technology, in-building solutions and distributed antenna systems. Network densification enables us to add capacity to address increasing mobile video consumption and the growing demand for IoT products and services on our 4G LTE and 5G networks. We are also utilizing existing network capabilities to handle increased traffic without interrupting the quality of the customer experience. We continue to deploy advanced technologies to increase both network capacity and data rates. In order to build and upgrade our existing 4G LTE network and deploy our 5G network, we must complete a variety of steps, which can include securing rights to a large number of sites as well as obtaining zoning and other governmental approvals and fiber facilities, for our macro and small cells, in-building systems and antennas and related radio equipment that comprise distributed antenna systems. We have relationships with a wide variety of vendors that supply various products and services that support our wireless network operations. We utilize tower site management firms as lessors or managers of a portion of our existing leased and owned tower sites.Our networks in the U.S. include various elements of redundancy designed to enhance the reliability of the services provided to our customers. To mitigate the impact of power disruptions on our operations, we have battery backup at every switch and every macro cell. We also utilize backup generators at a majority of our macro cells and at every switch location. In addition, we have a fleet of portable backup 9Table of Contentsgenerators that can be deployed, if needed. We further enhance reliability by using a fully redundant Multiprotocol Label Switching backbone network in critical locations.In addition to our own network coverage, we have roaming agreements with a number of wireless service providers to enable our customers to receive wireless service in nearly all other areas in the U.S. where wireless service is available. We also offer a variety of international wireless voice and data services to our customers through roaming arrangements with wireless service providers outside the U.S. Fios Residential broadband service has seen significant growth in bandwidth demand over the past several years, and we believe that demand will continue to grow. We expect the continued emergence of new video services, new data applications and the proliferation of IP devices in the home will continue to drive new network requirements for increased data speeds and throughput. We believe that the Passive Optical Network (PON) technology underpinning Fios positions us well to meet these demands in a cost-effective and efficient manner. While deployed initially as a consumer broadband network, our PON infrastructure is also experiencing more widespread application in the Business segment, especially as businesses increasingly migrate to Ethernet-based access services.Global IP Verizon owns and operates one of the largest global fiber-optic networks in the world, providing connectivity to Business customers in more than 180 countries. Our global IP network includes long-haul, metro and submarine assets that span over 1 million route miles and enable and support international operations.Global business is rapidly evolving to an "everything-as-a-service" model in which Business customers seek cloud-based, converged enterprise solutions delivered securely via managed and professional services. We are continuing to deploy packet optical transport technology in order to create a global network platform to meet this demand.SpectrumThe spectrum licenses we hold can be used for mobile wireless voice, video and data communications services. We are licensed by the Federal Communications Commission (FCC) to provide these wireless services on portions of the 800 MHz band, also known as cellular spectrum, the 1800-1900 MHz band, also known as Personal Communication Services (PCS) spectrum, portions of the 700 MHz upper C band and AWS 1 and 3 spectrum in the 1700 and 2100 MHz bands, in areas that, collectively, cover nearly all of the population of the U.S. We have also deployed 4G technologies in 3.5 Gigahertz (GHz) shared spectrum, using LTE/Citizens Broadband Radio Service, and in 5 GHz unlicensed spectrum, using LTE/Licensed Assisted Access. All of this spectrum is collectively called low and mid-band spectrum. We are using our low and mid-band spectrum to provide 3G, 4G LTE and 5G wireless services. We are increasingly reallocating spectrum previously used for 3G service to provide 4G LTE service. We are also utilizing low and mid-band spectrum, through DSS, for 5G to complement our spectrum licenses in the 28 and 39 GHz band, collectively called millimeter wave spectrum.Millimeter wave and low and mid-band spectrum are being used for our 5G technology deployment. We anticipate that we will need additional spectrum to meet future demand. This increasing demand is driven by growth in customer connections and the increased usage of wireless broadband services that use more bandwidth and require faster rates of speed, as well as the wider deployment of 5G mobile and fixed services. We can meet our future 4G and 5G spectrum needs by acquiring licenses or leasing spectrum from other licensees, or by acquiring new spectrum licenses from the FCC, if and when future FCC spectrum auctions occur. From time to time we have exchanged spectrum licenses with other wireless service providers through secondary market swap transactions. We expect to continue to pursue similar opportunities to trade spectrum licenses in order to meet capacity and expansion needs in the future. In certain cases, we have entered into intra-market spectrum swaps designed to increase the amount of contiguous spectrum within frequency bands in a specific market. Contiguous spectrum improves network performance and efficiency. These swaps, as well as any spectrum purchases, require us to obtain governmental approvals.Information regarding spectrum license transactions is included in Note 3 to the consolidated financial statements of Verizon Communications Inc. and Subsidiaries.Human Capital ResourcesAt Verizon, we know that our people are one of our most valuable assets. In order to realize our core business strategy, we have developed human capital programs and practices that support, develop and care for our employees from the time they join our team through the entirety of their careers with Verizon. These programs are centered on the following principles:•Attract the right talent for our future and maintain a diverse workforce that has a capacity for learning and brings high-value skills and expertise to the Company. •Develop our employees to their full potential through best-in-class educational programs and exceptional development experiences, creating a culture of continuous learning and engagement.10Table of Contents•Inspire individuals to build a career at Verizon by providing meaningful work and upskilling opportunities and establishing an inspiring and inclusive work environment for all.Verizon is committed to being an employer of choice. With approximately 132,200 employees measured on a full-time equivalent basis as of December 31, 2020, we know that we need employees with diverse backgrounds, experiences and perspectives to help us understand and connect more meaningfully to the diverse customers and communities we serve. Our human capital programs and practices are designed to create a workplace where employees are empowered to share their authentic selves and feel seen and heard as vital contributors to Verizon’s corporate purpose. In addition, Verizon has extensive on-the-job training opportunities, tuition reimbursement programs and career development support to enable our employees to maximize their potential and thrive professionally. Guided by our long-standing commitment to diversity and inclusion, our hiring and outreach programs have resulted in a strong representation of women and people of color. As of December 31, 2020, Verizon's global workforce was approximately 66.2% male, 33.7% female and 0.1% unknown or undeclared, and the race/ethnicity of our U.S. workforce was 53.9% White, 19.3% Black, 11.3% Hispanic, 9.4% Asian, 0.4% American Indian/Alaskan Native, 0.3% Native Hawaiian/Pacific Islander, 2.5% two or more races, and 2.9% unknown or undeclared. Women represented 37.9% of U.S. senior leadership (vice president level and above). People of color represented 34.6% of U.S. senior leadership.Verizon respects our employees’ rights to freedom of association and collective bargaining in compliance with applicable law, including the right to join or not join labor unions. We have a long history of working with the Communications Workers of America and the International Brotherhood of Electrical Workers—the two unions that in total represent approximately 22.5% of our employees as of December 31, 2020. In addition, where applicable outside of the U.S., we engage with employee representative bodies such as works council. Verizon meets with U.S. national and local union leaders, as well as works council leaders outside the U.S., to talk about key business topics, including safety, customer service, plans to improve operational processes, our business performance and the impacts that changing technology and competition are having on our customers, employees and business strategy. In 2020, Verizon employees across the Company came together in new ways in response to the health and humanitarian crisis brought on by the novel coronavirus (COVID-19) pandemic. Soon after COVID-19 was first identified, Verizon took many broad-ranging steps to support our employees and their families so that the Company could continue providing our essential services to our customers and communities. Some of these measures included temporarily moving over 115,000 of our employees to remote work arrangements and temporarily closing nearly 70% of our Company-owned retail store locations or moving to appointment-only store access; limiting our customer-focused field operations for a period of time; enhancing safety protocols for employees working outside their homes; launching a COVID-19 leave of absence policy and expanded family care assistance for employees; and providing additional compensation to employees in front line roles that could not be done from home for a period of time. In an effort to foster transparency and provide support during this unprecedented time, Verizon launched a daily live webcast with current information on the Company’s actions to address the impacts of COVID-19 as well as a number of broad ranging resources for employees. In addition, Verizon re-trained over 20,000 frontline employees to temporarily serve in other roles, such as customer service or telesales, which not only promoted the health and safety of our employees, but also provided opportunities for learning and career development. For a discussion of the oversight provided by the Verizon Board of Directors over the Company’s human capital management practices, see the section entitled "Governance — Our Approach to Governance — Our Approach to Strategy and Risk Oversight — Oversight of Human Capital Management" in our definitive Proxy Statement to be filed with the Securities and Exchange Commission and delivered to shareholders in connection with our 2021 Annual Meeting of Shareholders.Patents, Trademarks and LicensesWe own or have licenses to various patents, copyrights, trademarks, domain names and other intellectual property rights necessary to conduct our business. We actively pursue the filing and registration of patents, copyrights, trademarks and domain names to protect our intellectual property rights within the United States and abroad. We also actively grant licenses, in exchange for appropriate fees or other consideration and subject to appropriate safeguards and restrictions, to other companies that enable them to utilize certain of our intellectual property rights and proprietary technology as part of their products and services. Such licenses enable the licensees to take advantage of Verizon's brands and the results of Verizon’s research and development efforts. While these licenses result in valuable consideration for Verizon, we do not believe that the loss of such consideration, or the expiration of any of our intellectual property rights, would have a material effect on our results of operations.We periodically receive offers from third parties to purchase or obtain licenses for patents and other intellectual property rights in exchange for royalties or other payments. We also periodically receive notices alleging that our products or services infringe on third-party patents or other intellectual property rights. These claims, whether against us directly or against third-party suppliers of products or services that we sell to our customers, if successful, could require us to pay damages or royalties, rebrand, or cease offering the relevant products or services.Regulatory and Competitive TrendsRegulatory and Competitive LandscapeVerizon operates in a regulated and highly competitive market, as described above. Some of our competitors are subject to fewer regulatory constraints than Verizon. For many services offered by Verizon, the FCC is our primary regulator. The FCC has jurisdiction over interstate telecommunications services and other matters under the Communications Act of 1934, as amended (Communications Act or Act). Other Verizon services are subject to state and local regulation.11Table of ContentsFederal, State and Local RegulationWireless ServicesThe FCC regulates several aspects of our wireless operations. Generally, the FCC has jurisdiction over the construction, operation, acquisition and transfer of wireless communications systems. All wireless services require use of radio frequency spectrum, the assignment and distribution of which is subject to FCC oversight. Verizon anticipates that it will need additional spectrum to meet future demand. We can meet our needs for licensed spectrum by purchasing licenses or leasing spectrum from others, or by participating in a competitive bidding process to acquire new spectrum from the FCC. Those processes are subject to certain reviews, approvals and potential conditions.Today, Verizon holds FCC spectrum licenses that allow it to provide a wide range of mobile and fixed communications services, including both voice and data services. FCC spectrum licenses typically have a term of 10 years, at which time they are subject to renewal. While the FCC has routinely renewed all of Verizon’s wireless licenses, challenges could be raised in the future. If a wireless license was revoked or not renewed, Verizon would not be permitted to provide services on the spectrum covered by that license. Some of our licenses require us to comply with so-called "open access" FCC regulations, which generally require licensees of particular spectrum to allow customers to use devices and applications of their choice, subject to certain technical limitations. The FCC has also imposed certain specific mandates on wireless carriers, including construction and geographic coverage requirements, technical operating standards, provision of enhanced 911 services, roaming obligations and requirements for wireless tower and antenna facilities.The Act generally preempts regulation by state and local governments of the entry of, or the rates charged by, wireless carriers. The Act does not prohibit states from regulating the other "terms and conditions" of wireless service. For example, some states impose reporting requirements. Several states also have laws or regulations that address safety issues (e.g., use of wireless handsets while driving) and taxation matters. In addition, wireless tower and antenna facilities are often subject to state and local zoning and land use regulation, and securing approvals for new or modified facilities is often a lengthy and expensive process.BroadbandVerizon offers many different broadband services. The FCC recognizes broadband internet access services as "information services" subject to a "light touch" regulatory approach rather than to the traditional, utilities-style regulations. However, a number of states have taken steps to regulate broadband and two of those cases related to regulations in California and Vermont are being litigated in the courts. Regardless of regulation, Verizon remains committed to the open internet, which provides consumers with competitive choices and unblocked access to lawful websites and content. Our commitment to our customers can be found on our website at https://www.verizon.com/about/our-company/verizon-broadband-commitment.Wireline VoiceVerizon offers many different wireline voice services, including traditional telephone service and other services that rely on technologies such as VoIP. For regulatory purposes, legacy telephone services are generally considered to be "common carrier" services. Common carrier services are subject to heightened regulatory oversight with respect to rates, terms and conditions and other aspects of the services. The FCC has not decided the regulatory classification of VoIP but has said VoIP service providers must comply with certain rules, such as 911 capabilities and law enforcement assistance requirements.State public utility commissions regulate Verizon’s telephone operations with respect to certain telecommunications intrastate matters. Verizon operates as an "incumbent local exchange carrier" in nine states and the District of Columbia. These incumbent operations are subject to various levels of pricing flexibility and other state oversight and requirements. Verizon also has other wireline operations that are more lightly regulated.VideoVerizon offers a multichannel video service that is regulated like traditional cable service. The FCC has a body of rules that apply to cable operators, and these rules also generally apply to Verizon. In areas where Verizon offers its facilities-based multichannel video services, Verizon has been required to obtain a cable franchise from local government entities, or in some cases a state-wide franchise, and comply with certain one-time and ongoing obligations as a result.Privacy and Data SecurityWe are subject to local, state, federal, and international laws and regulations relating to privacy and data security that impact all parts of our business, including wireline, wireless, broadband and the development and roll out of new products, such as those in the media and IoT space. At the federal level, our voice business is subject to the FCC's privacy requirements. Oversight of broadband internet access privacy and data security is governed by the Federal Trade Commission (FTC). Europe's General Data Protection Regulation, which went into effect in May 2018, and the California Consumer Privacy Act, which went into effect in January 2020, both include significant penalties for non-compliance. In addition, other new privacy laws took effect in 2020, including in Brazil and Maine. Generally, attention to privacy and data security requirements is increasing at all levels of government globally, and privacy-related legislation has been introduced or is under consideration in many locations. These regulations could have a significant impact on our businesses.Public Safety and CybersecurityThe FCC plays a role in addressing public safety concerns by regulating emergency communications services and mandating widespread availability of both media (broadcast/cable) and wireless emergency alerting services. In response to cyber attacks that have occurred or could 12Table of Contentsoccur in the future, however, the FCC or other regulators may attempt to increase regulation of the cybersecurity practices of providers. The FCC is also addressing the use by American companies of equipment produced by certain companies deemed to cause potential national security risks. Verizon does not currently use equipment in its networks from vendors under such restrictions. In addition, due to recent natural disasters, federal and state agencies may attempt to impose regulations to ensure continuity of service during disasters; for example, the California Public Utilities Commission has imposed regulations on back-up power for communications facilities.Intercarrier Compensation and Network AccessThe FCC regulates some of the rates that carriers pay each other for the exchange of voice traffic (particularly traditional wireline traffic) over different networks and other aspects of interconnection for some voice services. The FCC also regulates some of the rates and terms and conditions for certain wireline "business data services" and other services and network facilities. Verizon is both a seller and a buyer of these services, and both makes and receives interconnection payments. The FCC has focused in recent years on whether changes in the rates, terms and conditions for both the exchange of traffic and for business data services may be appropriate.Regulatory Response to the COVID-19 PandemicSince the time that COVID-19 began to spread throughout the world in 2020, Verizon has been subject to various international, federal, state and local policies, regulations and initiatives aimed at reducing the transmission of the disease and protecting the health and safety of the world’s population. In addition, governments have imposed a wide variety of consumer protection measures that limit how certain businesses, including telecommunications companies, can operate their business and interact with their customers. Because the severity, magnitude and duration of the COVID-19 pandemic and its economic consequences are uncertain and rapidly changing, the impact of the crisis and the governmental responses to the crisis on our business in 2021 and beyond remains uncertain and difficult to predict. Information About Our Executive OfficersSee Part III, Item 10. "Directors, Executive Officers and Corporate Governance" of this Annual Report on Form 10-K for information about our executive officers.Information on Our Internet WebsiteWe make available, free of charge on our website, our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and all amendments to those reports at https://www.verizon.com/about/investors as soon as reasonably practicable after such reports are electronically filed with the Securities and Exchange Commission (SEC). These reports and other information are also available on the SEC's website at https://www.sec.gov. We periodically provide other information for investors on our website, including news and announcements regarding our financial performance, information on corporate governance and details related to our annual meeting of shareholders. We encourage investors, the media, our customers, business partners and other stakeholders to review the information we post on this channel. Website references in this report are provided as a convenience and do not constitute, and should not be viewed as, incorporation by reference of the information contained on, or available through, the websites. Therefore, such information should not be considered part of this report.Cautionary Statement Concerning Forward-Looking StatementsIn this report we have made forward-looking statements. These statements are based on our estimates and assumptions and are subject to risks and uncertainties. Forward-looking statements include the information concerning our possible or assumed future results of operations. Forward-looking statements also include those preceded or followed by the words "anticipates," "believes," "estimates," "expects," "hopes" or similar expressions. For those statements, we claim the protection of the safe harbor for forward-looking statements contained in the Private Securities Litigation Reform Act of 1995. We undertake no obligation to revise or publicly release the results of any revision to these forward-looking statements, except as required by law. Given these risks and uncertainties, readers are cautioned not to place undue reliance on such forward-looking statements. The following important factors, along with those discussed elsewhere in this report and in other filings with the SEC, could affect future results and could cause those results to differ materially from those expressed in the forward-looking statements: •cyber attacks impacting our networks or systems and any resulting financial or reputational impact; •natural disasters, terrorist attacks or acts of war, or significant litigation and any resulting financial or reputational impact; •the impact of the COVID-19 pandemic on our operations, our employees and the ways in which our customers use our networks and other products and services;•disruption of our key suppliers’ or vendors' provisioning of products or services, including as a result of the COVID-19 pandemic; •material adverse changes in labor matters and any resulting financial or operational impact; •the effects of competition in the markets in which we operate; •failure to take advantage of developments in technology and address changes in consumer demand; 13Table of Contents•performance issues or delays in the deployment of our 5G network resulting in significant costs or a reduction in the anticipated benefits of the enhancement to our networks; •the inability to implement our business strategy; •adverse conditions in the U.S. and international economies; •changes in the regulatory environment in which we operate, including any increase in restrictions on our ability to operate our networks or businesses; •our high level of indebtedness; •an adverse change in the ratings afforded our debt securities by nationally accredited ratings organizations or adverse conditions in the credit markets affecting the cost, including interest rates, and/or availability of further financing; •significant increases in benefit plan costs or lower investment returns on plan assets; •changes in tax laws or treaties, or in their interpretation; and •changes in accounting assumptions that regulatory agencies, including the SEC, may require or that result from changes in the accounting rules or their application, which could result in an impact on earnings. Item 1A. Risk FactorsThe following discussion of "Risk Factors" identifies factors that may adversely affect our business, operations, financial condition or future performance. This information should be read in conjunction with "Management’s Discussion and Analysis of Financial Condition and Result of Operations" and the consolidated financial statements and related notes. The following discussion of risks is not all-inclusive but is designed to highlight what we believe are the material factors to consider when evaluating our business and expectations. These factors could cause our future results to differ materially from our historical results and from expectations reflected in forward-looking statements.Operational RisksCyber attacks impacting our networks or systems could have an adverse effect on our business.Cyber attacks, including through the use of malware, computer viruses, dedicated denial of services attacks, credential harvesting, social engineering and other means for obtaining unauthorized access to or disrupting the operation of our networks and systems and those of our suppliers, vendors and other service providers, could have an adverse effect on our business. Cyber attacks may cause equipment failures, loss of information, including sensitive personal information of customers or employees or valuable technical and marketing information, as well as disruptions to our or our customers’ operations. Cyber attacks against companies, including Verizon, have increased in frequency, scope and potential harm in recent years. They may occur alone or in conjunction with physical attacks, especially where disruption of service is an objective of the attacker. The development and maintenance of systems to prevent such attacks is costly and requires ongoing monitoring and updating to address their increasing prevalence and sophistication. While, to date, we have not been subject to cyber attacks that, individually or in the aggregate, have been material to Verizon's operations or financial condition, the preventive actions we take to reduce the risks associated with cyber attacks, including protection of our systems and networks, may be insufficient to repel or mitigate the effects of a major cyber attack in the future.The inability to operate or use our networks and systems or those of our suppliers, vendors and other service providers as a result of cyber attacks, even for a limited period of time, may result in significant expenses to Verizon and/or a loss of market share to other communications providers. The costs associated with a major cyber attack on Verizon could include expensive incentives offered to existing customers and business partners to retain their business, increased expenditures on cybersecurity measures and the use of alternate resources, lost revenues from business interruption and litigation. Further, certain of Verizon’s businesses, such as those offering security solutions and infrastructure and cloud services to business customers, could be negatively affected if our ability to protect our own networks and systems is called into question as a result of a cyber attack. Our presence in the IoT industry, which includes offerings of telematics products and services, could also increase our exposure to potential costs and expenses and reputational harm in the event of cyber attacks impacting these products or services. In addition, a compromise of security or a theft or other compromise of valuable information, such as financial data and sensitive or private personal information, could result in lawsuits and government claims, investigations or proceedings. Any of these occurrences could damage our reputation, adversely impact customer and investor confidence and result in a material adverse effect on Verizon’s results of operation or financial condition.Natural disasters, terrorist acts or acts of war could cause damage to our infrastructure and result in significant disruptions to our operations.Our business operations are subject to interruption by power outages, terrorist attacks, other hostile acts and natural disasters, including an increasing prevalence of wildfires and intensified storm activities. Such events could cause significant damage to our infrastructure upon which our business operations rely, resulting in degradation or disruption of service to our customers, as well as significant recovery time and expenditures to resume operations. Our system redundancy may be ineffective or inadequate to sustain our operations through all such events. 14Table of ContentsWe are implementing, and will continue to implement, measures to protect our infrastructure and operations from the impacts of these events in the future, but these measures and our overall disaster recovery planning may not be sufficient for all eventualities. These events could also damage the infrastructure of the suppliers that provide us with the equipment and services that we need to operate our business and provide products to our customers. These occurrences could result in lost revenues from business interruption, damage to our reputation and reduced profits.Public health crises, including the COVID-19 pandemic, could materially adversely affect our business, financial condition and results of operations.We are subject to risks related to public health crises, such as the COVID-19 pandemic, which had an adverse effect on our operating results in 2020. Our business is based on our ability to provide products and services to customers throughout the United States and around the world and the ability of those customers to use and pay for those products and services for their businesses and in their daily lives. As a result, our business, financial condition and results of operations could be materially adversely affected by a crisis, like the COVID-19 pandemic, that significantly impacts the way customers use and are able to pay for our products and services, the way our employees are able to provide services to our customers, and the ways that our partners and suppliers are able to provide products and services to us. For example, public and private sector policies and initiatives to reduce the transmission of COVID-19 and initiatives Verizon has taken in response to the health crisis to promote the health and safety of our employees and provide critical infrastructure and connectivity to our customers, along with the related global slowdown in economic activity, resulted in decreased revenues, increased costs and lower earnings per share during 2020. In addition, such a crisis could significantly increase the probability or consequences of the risks our business faces in ordinary circumstances, such as risks associated with our supplier and vendor relationships, risks of an economic slowdown, regulatory risks, and the costs and availability of financing. Because the severity, magnitude and duration of the COVID-19 pandemic and its economic consequences are uncertain and rapidly changing, the impact on our business, financial condition and results of operations in 2021 and beyond remains uncertain and difficult to predict. In addition, the ultimate impact of the COVID-19 pandemic on our business, financial condition and results of operations depends on many factors, including those discussed above, that are not within our control.We depend on key suppliers and vendors to provide equipment that we need to operate our business.We depend on various key suppliers and vendors to provide us, directly or through other suppliers, with equipment and services, such as fiber, switch and network equipment, smartphones and other wireless devices that we need in order to operate our business and provide products to our customers. For example, our smartphone and other device suppliers often rely on one vendor for the manufacture and supply of critical components, such as chipsets, used in their devices, and there are a limited number of companies capable of supplying the network infrastructure equipment on which we depend. These suppliers or vendors could fail to provide equipment or service on a timely basis, or fail to meet our performance expectations, for a number of reasons, including, for example, disruption to the global supply chain as a result of the COVID-19 pandemic. If such failures occur, we may be unable to provide products and services as and when requested by our customers, or we may be unable to continue to maintain or upgrade our networks. Because of the cost and time lag that can be associated with transitioning from one supplier to another, our business could be substantially disrupted if we were required to, or chose to, replace the products or services of one or more major suppliers with products or services from another source, especially if the replacement became necessary on short notice. Any such disruption could increase our costs, decrease our operating efficiencies and have a material adverse effect on our business, results of operations and financial condition.The suppliers and vendors on which we rely may also be subject to litigation with respect to technology on which we depend, including litigation involving claims of patent infringement. Such claims are frequently made in the communications industry. We are unable to predict whether our business will be affected by any such litigation. We expect our dependence on key suppliers to continue as we develop and introduce more advanced generations of technology.A significant portion of our workforce is represented by labor unions, and we could incur additional costs or experience work stoppages as a result of the renegotiation of our labor contracts.As of December 31, 2020, approximately 22.5% of our workforce is represented by the Communications Workers of America or the International Brotherhood of Electrical Workers. While we have labor contracts in place with these unions, with subsequent negotiations we could incur additional costs and/or experience work stoppages, which could adversely affect our business operations. In addition, while a small percentage of the workforce of our wireless and other businesses outside of wireline is represented by unions for bargaining, we cannot predict what level of success unions may have in further organizing this workforce or the potentially negative impact it could have on our operations.Economic and Strategic RisksWe face significant competition that may reduce our profits.We face significant competition in our industries. The rapid development of new technologies, services and products has eliminated many of the traditional distinctions among wireless, cable, internet and local and long distance communication services and brought new competitors to our markets, including other telecommunications companies, cable companies, wireless service providers, satellite providers and application and device providers. While these changes have enabled us to offer new types of products and services, they have also allowed other providers to broaden the scope of their own competitive offerings. If we are unable to compete effectively, we could experience lower than expected revenues and earnings. A projected sustained decline in any of our reporting units' revenues and earnings could have a significant impact on its fair value and has caused us in the past, and may cause us in the future, to record goodwill impairment charges. The amount of any impairment charge could be significant and could have a material adverse impact on our results of operations for the period in 15Table of Contentswhich the charge is taken. In addition, wireless service providers are significantly altering the financial relationships with their customers through commercial offers that vary service and device pricing, promotions, incentives and levels of service provided – in some cases specifically targeting our customers. Our ability to compete effectively will depend on, among other things, our network quality, capacity and coverage, the pricing of our products and services, the quality of our customer service, our development of new and enhanced products and services, the reach and quality of our sales and distribution channels, our ability to market our products and services effectively and our capital resources. It will also depend on how successfully we anticipate and respond to various factors affecting our industries, including new technologies and business models, changes in consumer preferences and demand for existing services, demographic trends and economic conditions. If we are not able to respond successfully to these competitive challenges, we could experience reduced profits.If we are not able to take advantage of developments in technology and address changing consumer demand on a timely basis, we may experience a decline in the demand for our services, be unable to implement our business strategy and experience reduced profits.Our industries are rapidly changing as new technologies are developed that offer consumers an array of choices for their communications needs and allow new entrants into the markets we serve. In order to grow and remain competitive, we will need to adapt to future changes in technology, enhance our existing offerings and introduce new offerings to address our customers’ changing demands. If we are unable to meet future challenges from competing technologies on a timely basis or at an acceptable cost, we could lose customers to our competitors. We may not be able to accurately predict technological trends or the success of new services in the market. The deployment of our 5G network is subject to a variety of risks, including those related to equipment and spectrum availability, unexpected costs, and regulatory permitting requirements that could cause deployment delays or network performance issues. These issues could result in significant costs or reduce the anticipated benefits of the enhancements to our networks. If our services fail to gain acceptance in the marketplace, or if costs associated with the implementation and introduction of these services materially increase, our ability to retain and attract customers could be adversely affected. In addition to introducing new offerings and technologies, such as 5G technology, we must phase out outdated and unprofitable technologies and services. If we are unable to do so on a cost-effective basis, we could experience reduced profits. In addition, there could be legal or regulatory restraints on our ability to phase out current services.Adverse conditions in the U.S. and international economies could impact our results of operations.Unfavorable economic conditions, such as a recession or economic slowdown in the U.S. or elsewhere, could negatively affect the affordability of and demand for some of our products and services. In difficult economic conditions, consumers may seek to reduce discretionary spending by forgoing purchases of our products, electing to use fewer higher margin services, dropping down in price plans or obtaining lower-cost products and services offered by other companies. Similarly, under these conditions, the business customers that we serve may delay purchasing decisions, delay full implementation of service offerings or reduce their use of services. In addition, adverse economic conditions may lead to an increased number of our consumer and business customers that are unable to pay for services. If these events were to occur, it could have a material adverse effect on our results of operations.Regulatory and Legal RisksChanges in the regulatory framework under which we operate could adversely affect our business prospects or results of operations.Our domestic operations are subject to regulation by the FCC and other federal, state and local agencies, and our international operations are regulated by various foreign governments and international bodies. These regulatory regimes frequently restrict or impose conditions on our ability to operate in designated areas and provide specified products or services. We are frequently required to maintain licenses for our operations and conduct our operations in accordance with prescribed standards. We are often involved in regulatory and other governmental proceedings or inquiries related to the application of these requirements. It is impossible to predict with any certainty the outcome of pending federal and state regulatory proceedings relating to our operations, or the reviews by federal or state courts of regulatory rulings. Without relief, existing laws and regulations may inhibit our ability to expand our business and introduce new products and services. Similarly, we cannot guarantee that we will be successful in obtaining the licenses needed to carry out our business plan or in maintaining our existing licenses. For example, the FCC grants wireless licenses for terms generally lasting 10 years, subject to renewal. The loss of, or a material limitation on, certain of our licenses could have a material adverse effect on our business, results of operations and financial condition.New laws or regulations or changes to the existing regulatory framework at the federal, state and local, or international level, such as those described below, new laws or regulations enacted to address the potential impacts of climate change, or requirements limiting our ability to discontinue service to customers could restrict the ways in which we manage our wireline and wireless networks and operate our Consumer, Business and Verizon Media businesses, impose additional costs, impair revenue opportunities and potentially impede our ability to provide services in a manner that would be attractive to us and our customers. •Privacy and data protection - we are subject to federal, state and international laws related to privacy and data protection. Europe's General Data Protection Regulation, which went into effect in May 2018, and the California Consumer Privacy Act, which went into effect in January 2020, both include significant penalties for non-compliance. In addition, other new privacy laws took effect in 2020, including in Brazil and Maine. Generally, attention to privacy and data security requirements is increasing at all levels of 16Table of Contentsgovernment globally, and privacy-related legislation has been introduced or is under consideration in many locations. These regulations could have a significant impact on our businesses.•Regulation of broadband internet access services - In its 2015 Title II Order, the FCC nullified its longstanding "light touch" approach to regulating broadband internet access services and "reclassified" these services as telecommunications services subject to utilities-style common carriage regulation. The FCC repealed the 2015 Title II Order in December 2017, and returned to its traditional light-touch approach for these services. The 2017 order has been affirmed in part by the D.C. Circuit but may be revisited by future FCC commissions or by Congress and further appeals and challenges are possible; the outcome and timing of these or any other challenge remains uncertain. Several states have also adopted or are considering adopting laws or executive orders that would impose net neutrality and other requirements on some of our services (in some cases different from the FCC’s 2015 rules). The enforceability and effect of these state rules is uncertain.•"Open Access" - we hold certain wireless licenses that require us to comply with so-called "open access" FCC regulations, which generally require licensees of particular spectrum to allow customers to use devices and applications of their choice. Moreover, certain services could be subject to conflicting regulation by the FCC and/or various state and local authorities, which could significantly increase the cost of implementing and introducing new services. The further regulation of broadband, wireless and our other activities and any related court decisions could restrict our ability to compete in the marketplace and limit the return we can expect to achieve on past and future investments in our networks.We are subject to a significant amount of litigation, which could require us to pay significant damages or settlements.We are subject to a substantial amount of litigation, including, from time to time, shareholder derivative suits, patent infringement lawsuits, antitrust class actions, wage and hour class actions, personal injury claims, property claims, and lawsuits relating to our advertising, sales, billing and collection practices. In addition, our wireless business also faces personal injury and wrongful death lawsuits relating to alleged health effects of wireless phones or radio frequency transmitters. We may incur significant expenses in defending these lawsuits. In addition, we may be required to pay significant awards or settlements.Financial RisksVerizon has significant debt, which could increase further if Verizon incurs additional debt in the future and does not retire existing debt.As of December 31, 2020, Verizon had approximately $118.5 billion of outstanding unsecured indebtedness, $9.4 billion of unused borrowing capacity under our existing revolving credit facility and $10.6 billion of outstanding secured indebtedness. Verizon’s debt level and related debt service obligations could have negative consequences, including:•requiring Verizon to dedicate significant cash flow from operations to the payment of principal, interest and other amounts payable on our debt, which would reduce the funds we have available for other purposes, such as working capital, capital expenditures, dividend payments and acquisitions;•making it more difficult or expensive for Verizon to obtain any necessary future financing for working capital, capital expenditures, debt service requirements, debt refinancing, acquisitions or other purposes;•reducing Verizon’s flexibility in planning for or reacting to changes in our industries and market conditions;•making Verizon more vulnerable in the event of a downturn in our business; and•exposing Verizon to increased interest rate risk to the extent that our debt obligations are subject to variable interest rates.Adverse changes in the credit markets and other factors could increase our borrowing costs and the availability of financing.We require a significant amount of capital to operate and grow our business. We fund our capital needs in part through borrowings in the public and private credit markets. Adverse changes in the credit markets, including increases in interest rates, could increase our cost of borrowing and/or make it more difficult for us to obtain financing for our operations or refinance existing indebtedness. In addition, our ability to obtain funding under asset-backed debt transactions is subject to our ability to continue to originate a sufficient amount of assets eligible to be securitized. Our borrowing costs also can be affected by short- and long-term debt ratings assigned by independent rating agencies, which are based, in significant part, on our performance as measured by customary credit metrics. A decrease in these ratings would likely increase our cost of borrowing and/or make it more difficult for us to obtain financing. A severe disruption in the global financial markets could impact some of the financial institutions with which we do business, and such instability could also affect our access to financing.17Table of ContentsIncreases in costs for pension benefits and active and retiree healthcare benefits may reduce our profitability and increase our funding commitments.With approximately 132,200 employees and approximately 190,000 retirees as of December 31, 2020 eligible to participate in Verizon’s benefit plans, the costs of pension benefits and active and retiree healthcare benefits have a significant impact on our profitability. Our costs of maintaining these plans, and the future funding requirements for these plans, are affected by several factors, including the legislative and regulatory uncertainty regarding the potential modification of the Patient Protection and Affordable Care Act, increases in healthcare costs, decreases in investment returns on funds held by our pension and other benefit plan trusts and changes in the discount rate and mortality assumptions used to calculate pension and other postretirement expenses. If we are unable to limit future increases in the costs of our benefit plans, those costs could reduce our profitability and increase our funding commitments.Item 1B. Unresolved Staff CommentsNone.Item 2. PropertiesOur principal properties do not lend themselves to simple description by character and location. Our total gross investment in property, plant and equipment was approximately $280 billion at December 31, 2020 and $266 billion at December 31, 2019, including the effect of retirements, but before deducting accumulated depreciation. Our gross investment in property, plant and equipment consisted of the following:At December 31,20202019Network equipment77.6 %77.3 %Land, buildings and building equipment12.0 %12.0 %Furniture and other10.4 %10.7 %100.0 %100.0 %Network equipment consists primarily of cable (aerial, buried, underground or undersea) and the related support structures of poles and conduit, wireless plant, switching equipment, network software, transmission equipment and related facilities. Land, buildings and building equipment consists of land and land improvements, central office buildings or any other buildings that house network equipment, and buildings that are used for administrative and other purposes. Substantially all the switching centers are located on land and in buildings we own due to their critical role in the networks and high set-up and relocation costs. We also maintain facilities throughout the U.S. comprised of administrative and sales offices, customer care centers, retail sales locations, garage work centers, switching centers, cell sites and data centers. Furniture and other consists of telephone equipment, furniture, data processing equipment, office equipment, motor vehicles, plant under construction and leasehold improvements.Item 3. Legal ProceedingsVerizon is not subject to any administrative or judicial proceeding arising under any Federal, State or local provisions that have been enacted or adopted regulating the discharge of materials into the environment or primarily for the purpose of protecting the environment that is likely to result in monetary sanctions of $1 million or more.Item 4. Mine Safety DisclosuresNone.18Table of ContentsPART IIItem 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity SecuritiesThe principal market for trading in the common stock of Verizon is the New York Stock Exchange under the symbol "VZ". As of December 31, 2020, there were 510,654 shareholders of record.Stock RepurchasesIn February 2020, the Verizon Board of Directors authorized a share buyback program to repurchase up to 100 million shares of Verizon's common stock. The program will terminate when the aggregate number of shares purchased reaches 100 million, or a new share repurchase plan superseding the current plan is authorized, whichever is sooner. Under the program, shares may be repurchased in privately negotiated transactions, on the open market, or otherwise, including through plans complying with Rule 10b5-1 under the Exchange Act. The timing and number of shares purchased under the program, if any, will depend on market conditions and the Company's capital allocation priorities.During the years ended December 31, 2020 and 2019, Verizon did not repurchase any shares of Verizon’s common stock under our current or previously authorized share buyback programs. At December 31, 2020, the maximum number of shares that could be purchased by or on behalf of Verizon under our share buyback program was 100 million. Stock Performance Graph201520162017201820192020Verizon$100.0 $120.7 $125.6 $139.7 $159.1 $158.9 S&P 500100.0 112.0 136.4 130.4 171.4 203.0 S&P 500 Telecom Services100.0 123.5 121.9 106.7 141.5 174.9 The graph compares the cumulative total returns of Verizon, the S&P 500 Stock Index and the S&P 500 Telecommunications Services Index over a five-year period. It assumes $100 was invested on December 31, 2015 with dividends being reinvested.Item 6. Selected Financial DataNone.Item 7. Management’s Discussion and Analysis of Financial Condition and Results of OperationsOverviewVerizon Communications Inc. (Verizon or the Company) is a holding company that, acting through its subsidiaries, is one of the world’s leading providers of communications, technology, information and entertainment products and services to consumers, businesses and government entities. With a presence around the world, we offer data, video and voice services and solutions on our networks and platforms that are designed to meet customers’ demand for mobility, reliable network connectivity, security and control. 19Table of ContentsTo compete effectively in today’s dynamic marketplace, we are focused on the capabilities of our high-performing networks to drive growth based on delivering what customers want and need in the new digital world. During 2020, we focused on leveraging our network leadership; retaining and growing our high-quality customer base while balancing profitability; enhancing ecosystems in growth businesses; and driving monetization of our networks, platforms and solutions. We are creating business value by earning customers', employees' and shareholders' trust, limiting our environmental impact and continuing our customer base growth while creating social benefit through our products and services. Our strategy requires significant capital investments primarily to acquire wireless spectrum, put the spectrum into service, provide additional capacity for growth in our networks, invest in the fiber that supports our businesses, evolve and maintain our networks and develop and maintain significant advanced information technology systems and data system capabilities. We believe that steady and consistent investments in our networks and platforms will drive innovative products and services and fuel our growth.We are consistently deploying new network architecture and technologies to secure our leadership in both fourth-generation (4G) and fifth-generation (5G) wireless networks. We expect that our next-generation multi-use platform, which we call the Intelligent Edge Network, will simplify operations by eliminating legacy network elements, speed the deployment of 5G wireless technology and create new opportunities in the business market in a cost efficient manner. Our network leadership is the hallmark of our brand and the foundation for the connectivity, platforms and solutions upon which we build our competitive advantage.Highlights of Our 2020 Financial Results(dollars in millions)Impacts of the Novel Coronavirus (COVID-19) PandemicThis disclosure discusses the actions Verizon has taken in response to the COVID-19 pandemic and the impacts it has had on our business, as well as related known or expected trends. The disclosure in the remainder of this Management's Discussion & Analysis of Financial Condition and Results of Operations is qualified by the disclosure in this section on the impacts of the COVID-19 pandemic and, to the extent that the disclosure in the remainder of Management's Discussion & Analysis refers to a financial or performance metric that has been affected by a trend or activity, that reference is in addition to any impact discussed in this section on the impacts of the pandemic.COVID-19 was identified in late 2019 and in 2020 spread throughout the world, including throughout the United States (U.S.). Public and private sector policies and initiatives to reduce the transmission of COVID-19 have varied significantly across the U.S., but at various times during the year ended December 31, 2020 a significant percentage of the U.S. population was subject to meaningful restrictions on activities, which included limitations on the operation of businesses including retail operations, requirements that individuals remain in or close to their homes, school closures, travel restrictions, limitations on large gatherings and other policies to promote or enforce physical distancing. 20Table of ContentsSimilar restrictions have been implemented in many other countries in which we operate. As described below, these restrictions and our responses to them have significantly impacted how our customers use our products and services, how they interact with us, and how our employees work and provide services to our customers. In addition, governments have imposed a wide variety of consumer protection measures that limit how certain businesses, including telecommunications companies, can operate their businesses and interact with their customers. The pandemic and governmental responses to the pandemic have also resulted in a slowdown of global economic activity, which has significantly impacted our customers. As a result, prior trends in our business may not be applicable to our operations during the pendency of the pandemic.The impact of COVID-19 in the future will depend on the duration and severity of the pandemic and the related public policy actions, additional initiatives we may undertake in response to employee, market or regulatory needs or demands, the length and severity of the global economic slowdown, and whether and how our customers change their behaviors over the longer term.OperationsIn response to the pandemic beginning in the first quarter 2020, we began executing our business continuity plans and evolving our operations to protect the safety of our employees and customers and to continue to provide critical infrastructure and connectivity to our customers as they changed their ways of working and living. Some of the initiatives we took include:•Moving over 115,000 of our 132,200 employees to remote work arrangements.•Temporarily closing nearly 70% of our company-owned retail store locations and moving to appointment-only access to our remaining store locations.•Limiting our customer-focused field operations based on the criticality of the services being provided or repaired.•Enhancing our safety protocols for employees working outside their homes.•Providing temporary additional compensation to employees in front line roles that cannot be done from home.•Adjusting other compensation and benefits programs to address circumstances created by the pandemic.•Taking the Federal Communication Commission's (FCC's) "Keep Americans Connected" pledge, through which we pledged to waive late fees for, and not terminate service to, any of our consumer or small business customers who informed us that they had been impacted financially by the COVID-19 pandemic through May 13, which we extended to June 30, 2020. •Providing additional data allocations to permit wireless consumer and small business customers to remain connected during the first several months of the pandemic.•Temporarily waiving activation and upgrade fees through digital distribution channels.•Working with business customers to address payment needs during the crisis.•Maintaining effective governance and internal controls in a remote work environment.As some of the restrictions on physical movement and limitations on business and other activities described above eased to varying degrees in the second half of 2020, we resumed certain of our operations, with the health and safety of our employees and customers as our utmost priority, and modified some of our temporary policies. These initiatives include:•Transitioning to facility access at limited capacity where feasible for those with remote work arrangements.•Optimizing our sales channels to drive more activity through online and telesales to serve customers.•Reopening temporarily closed company-owned retail store locations and introducing social distancing measures for employee and customer safety, such as touch-less retail, appointment scheduling and curbside pickup options. •Continuous monitoring of stores, as well as temporary closures and cleaning of stores that have an identified COVID-19 exposure.•Starting July 1, customers who had notified us that they had been financially impacted by the pandemic and had an unpaid balance were automatically enrolled in our "Stay Connected" repayment program, which allows customers to pay off their service balance over six months and extends any unpaid device payment plan agreements by the number of months unpaid. •Resuming most customer-focused field operations.•Discontinuing certain of our temporary compensation and benefits arrangements.We expect that we will continue to revise our approach to these initiatives as the circumstances surrounding the pandemic evolve in 2021 in order to meet the needs of our employees, customers and the Company and continue to provide our innovative products and services.Liquidity and Capital ResourcesVerizon finished the fourth quarter 2020 in a strong financial position. As of December 31, 2020, our balance sheet included:Cash and cash equivalents$22.2 billionUnsecured debt$118.5 billionAs of December 31, 2020, our Cash and cash equivalents balance was $22.2 billion compared to $2.6 billion as of December 31, 2019. We made the decision at the beginning of the COVID-19 pandemic to maintain a higher cash balance in order to further protect the Company against the economic uncertainties associated with the COVID-19 pandemic and to opportunistically raise cash to finance future obligations at a time when we believed that market conditions were favorable. During the three months ended December 31, 2020, we redeemed $566 million of unsecured notes maturing in 2021. As of December 31, 2020, we have less than $150 million of unsecured notes maturing in 2021. As of December 31, 2020, we had not drawn down on our $9.5 billion revolving credit facility and the unused borrowing capacity was approximately $9.4 billion. The revolving credit facility does not require us to comply with financial covenants or maintain specified credit ratings, and it permits us to borrow even if our business has incurred a material adverse change. During the three months ended December 31, 2020, we issued $12.0 billion aggregate principal amount of U.S dollar-denominated unsecured notes and £1.2 billion aggregate principal 21Table of Contentsamount of Pound Sterling-denominated unsecured notes. In addition, we completed exchange offers with respect to 17 series of unsecured notes issued by Verizon, allowing us to exchange the notes accepted in the exchange offers for new unsecured Verizon notes having a later maturity date and, for certain of the accepted series of notes, cash. We also amended our revolving credit facility to extend the maturity date to 2024. We had no outstanding commercial paper as of December 31, 2020.The COVID-19 pandemic, together with other dynamics in the marketplace, has caused borrowing costs to fluctuate significantly and, in certain cases, restricted the ability of borrowers to access the capital markets and other sources of financing. In order to provide financial flexibility and finance certain investments and projects, we may continue to utilize external financing arrangements that have been or may be affected by these market conditions. However, we believe that our cash on hand, the cash we expect to generate from our operations, and cash from other sources of financing available to us are, and will continue to be, sufficient to meet our ongoing operating, capital expenditure, debt service and investing requirements. We expect to continue to have sufficient cash to fund our operations, although we could experience significant fluctuations in our cash flows from period to period during the pendency of the pandemic. The net cash generated from our operations provides our primary source of cash flows. While we have historically experienced consistently low levels of payment delinquencies among our consumer and business accounts, beginning late in the first quarter 2020, we started to see increases in delinquencies across our retail customer base and our small and medium business accounts. This change in delinquency rate moderated during the second quarter and improved to levels seen before the COVID-19 pandemic during the third and fourth quarters of 2020. Accordingly, our provision for credit losses increased in the first quarter 2020, but decreased in the second quarter of 2020 and remained flat in the third and fourth quarters of 2020. If these levels of delinquencies begin to grow again, they could have a material adverse impact on our cash flows. We could also experience fluctuations in our cash flows resulting from the ongoing impacts of the pandemic on macroeconomic conditions in the U.S. and our customers working to become current on their bills in the first quarter of 2021 and beyond. In addition, we issue asset-backed debt secured by our device payment plan agreement receivables and the collections on such receivables. These transactions require us to comply with various tests, including delinquency and loss-related tests, which, if not met, would cause the asset-backed debt to amortize earlier and faster than otherwise expected. The holders of our asset-backed debt do not have any recourse to Verizon with respect to the payment of principal and interest on the debt. However, if an early amortization of our asset-backed debt occurs, including as a result of increased customer delinquencies or losses relating to the COVID-19 pandemic, all collections on the securitized device payment plan agreement receivables would be used to pay principal and interest on the asset-backed debt, and our financing cash flow requirements would increase for the twelve months immediately following an early amortization event. Impacts on Financial ResultsOur revenues and expenses in 2020 were impacted by the COVID-19 pandemic as a result of the actions we took to care for our employees and to keep our customers connected and as a result of our customers’ changing activities as well as the restrictions on activities and the global economic slowdown, as described below. The impact of the COVID-19 pandemic on our 2020 results was primarily a result of decreases in wireless service revenue, wireless equipment revenue and advertising and search revenue at Verizon Media Group (Verizon Media), and the operational actions we took, as described above.Revenues The year ended December 31, 2020 included lower overage revenues and lower fees from activations and upgrades and fewer fees, as well as lower roaming revenues as our customers significantly reduced travel during the year. As a result of our decision to keep our customers connected during the crisis, we experienced fewer step ups in data plans in the first half of 2020. We saw the rate of step ups increase during the second half of 2020. During the first half of 2020, we also saw a reduction in advertising and search revenue in Verizon Media, as customers scaled back their advertising campaigns. This reduction moderated during the third quarter of 2020 and turned to revenue growth during the fourth quarter of 2020.We have seen considerably less churn in the consumer wireless base and lower equipment volumes and upgrade rates since the beginning of the pandemic. As a result of changing customer behaviors, we experienced significantly lower equipment revenue during the year ended December 31, 2020.ExpensesWhile certain expenses, such as wireless equipment cost, were lower during the year ended December 31, 2020 as a result of the revenue impacts discussed above, these decreases were partially offset by an increase in commission expense. The increase in commission expense was a result of an expansion of our compensation programs for both employees and agents early in the pandemic. This COVID-19 relief program did not qualify for deferral treatment as defined by Accounting Standards Update (ASU) 2014-09, "Revenue from Contracts with Customers;" however the costs were not materially different on a cash basis.As a result of waiving late fees and keeping customers connected during the pandemic pursuant to our pledge, and pursuant to various state orders and laws, we saw increases in delinquencies across our retail customer base and certain of our business accounts. This change in the delinquency rate has since moderated, as discussed above; however, if the levels of delinquencies for our consumer and small and medium business customers begin to grow again, additional provisions to our allowance for credit losses may be required, which could be significant. We continue to monitor customer behavior and our expected loss assumptions and estimates.22Table of ContentsOtherEquity and debt markets experienced significant volatility during 2020 partially as a result of the pandemic, and federal governmental actions to stimulate the economy have significantly impacted interest rates. These circumstances could affect the funding level of our pension plans and our calculated liabilities under our pension and other postemployment benefit plans. Other impacts from the pandemic on our financial results in the first quarter of 2021 and beyond could result from a further slowdown in the global economy, additional regulatory or legislative initiatives that impact our relationships with our customers, and other initiatives we undertake to respond to the needs of our employees and our customers. Business Overview We have two reportable segments that we operate and manage as strategic business units - Verizon Consumer Group (Consumer) and Verizon Business Group (Business). Revenue by Segment ———Note: Excludes eliminations.Verizon Consumer GroupOur Consumer segment provides consumer-focused wireless and wireline communications services and products. Our wireless services are provided across one of the most extensive wireless networks in the U.S. under the Verizon brand and through wholesale and other arrangements. Our wireline services are provided in nine states in the Mid-Atlantic and Northeastern U.S., as well as Washington D.C., over our 100% fiber-optic network through our Verizon Fios product portfolio and over a traditional copper-based network to customers who are not served by Fios. Our Consumer segment's wireless and wireline products and services are available to our retail customers, as well as resellers that purchase wireless network access from us on a wholesale basis.Customers can obtain our wireless services on a postpaid or prepaid basis. Our postpaid service is generally billed one month in advance for a monthly access charge in return for access to and usage of network services. Our prepaid service is offered only to Consumer customers and enables individuals to obtain wireless services without credit verification by paying for all services in advance. The Consumer segment also offers several categories of wireless equipment to customers, including a variety of smartphones and other handsets, wireless-enabled internet devices, such as tablets and other wireless-enabled connected devices, such as smart watches.In addition to the wireless services and equipment discussed above, Consumer sells residential fixed connectivity solutions, including internet, video and voice services, and wireless network access to resellers on a wholesale basis. The Consumer segment's operating revenues for the year ended December 31, 2020 totaled $88.5 billion, a decrease of $2.5 billion, or 2.8%, compared to the year ended December 31, 2019. See "Segment Results of Operations" for additional information regarding our Consumer segment’s operating performance and selected operating statistics.Verizon Business GroupOur Business segment provides wireless and wireline communications services and products, including data, video and conferencing services, corporate networking solutions, security and managed network services, local and long distance voice services and network access to deliver various Internet of Things (IoT) services and products, including solutions that support fleet tracking management, compliance management, field service management, asset tracking and other types of mobile resource management. We provide these products and services to businesses, government customers and wireless and wireline carriers across the U.S. and select products and services to customers around the world. The Business segment's operating revenues for the year ended December 31, 2020 totaled $31.0 billion, a decrease of $481 million, or 1.5%, compared to the year ended December 31, 2019. See "Segment Results of Operations" for additional information regarding our Business segment’s operating performance and selected operating statistics.23Table of ContentsCorporate and OtherCorporate and other includes the results of our media business, Verizon Media, and other businesses, investments in unconsolidated businesses, insurance captives, unallocated corporate expenses, certain pension and other employee benefit related costs and interest and financing expenses. Corporate and other also includes the historical results of divested businesses and other adjustments and gains and losses that are not allocated in assessing segment performance due to their nature. Although such transactions are excluded from the business segment results, they are included in reported consolidated earnings. Gains and losses from transactions that are not individually significant are included in segment results as these items are included in the chief operating decision maker’s assessment of segment performance.Verizon Media includes diverse media and technology brands that serve both consumers and businesses. Verizon Media provides consumers with owned and operated and third-party search properties as well as mail, news, finance, sports and entertainment offerings, and provides other businesses and partners access to consumers through digital advertising, content delivery and video streaming platforms. Verizon Media's total operating revenues were $7.0 billion for the year ended December 31, 2020. This was a decrease of 5.6% from the year ended December 31, 2019. Capital Expenditures and InvestmentsWe continue to invest in our wireless networks, high-speed fiber and other advanced technologies to position ourselves at the center of growth trends for the future. During the year ended December 31, 2020, these investments included $18.2 billion for capital expenditures. See "Cash Flows Used in Investing Activities" and "Operating Environment and Trends" for additional information. We believe that our investments aimed at expanding our portfolio of products and services will provide our customers with an efficient, reliable infrastructure for competing in the information economy.Global Network and TechnologyWe are focusing our capital spending on adding capacity and density to our 4G LTE network, while also building our next generation 5G network. We are densifying our network by utilizing small cell technology, in-building solutions and distributed antenna systems. Network densification enables us to add capacity to address increasing mobile video consumption and the growing demand for IoT products and services on our 4G LTE and 5G networks. Over the past several years, we have been leading the development of 5G wireless technology industry standards and the ecosystems for fixed and mobile 5G wireless services. We expect that 5G technology will provide higher throughput and lower latency than the current 4G LTE technology and enable our networks to handle more traffic as the number of internet-connected devices grows. As of December 31, 2020, we have launched our 5G Ultra Wideband Network in 61 U.S. markets. We have commercially launched 5G Home in 12 of those markets. We also launched our 5G Nationwide Network in October 2020, which is available in over 2,700 cities across the U.S. covering approximately 230 million people. 5G Nationwide uses low and mid-band spectrum and dynamic spectrum sharing (DSS) technology, which allows 5G service to run simultaneously with 4G LTE on multiple spectrum bands. With DSS, whenever customers move outside Verizon’s high-band Ultra Wideband coverage area, their 5G-enabled devices will remain on 5G technology using the lower spectrum bands where the 5G Nationwide network is available. This allows us to more fully and effectively utilize our current spectrum resources to serve both 4G and 5G customers.To compensate for the shrinking market for traditional copper-based products, we continue to build fiber-based networks supporting data, video and advanced business services - areas where demand for reliable high-speed connections is growing. We are evolving the architecture of our networks to a next-generation multi-use platform, providing improved efficiency and virtualization, increased automation and opportunities for edge computing services that will support both our fiber-based and radio access network technologies. We call this the Intelligent Edge Network. We expect that this new architecture will simplify operations by eliminating legacy network elements, speed the deployment of 5G wireless technology and create new opportunities in the business market in a cost efficient manner.Wireless SpectrumIn September 2020, Cellco Partnership (Cellco), a wholly-owned subsidiary of Verizon, filed an application to participate in FCC Auction 107, which relates to mid-band wireless spectrum known as C-Band. The auction commenced on December 8, 2020. On February 24, 2021, the FCC issued a final notice announcing the conclusion and results of the auction. In its final notice, the FCC announced that Cellco was the winning bidder with respect to approximately $45.5 billion of licenses. Down payments, in the amount of 20% of the cost of the spectrum licenses less the amount of the upfront payment made by bidders in October 2020, with respect to the auction are due on March 10, 2021, and final payments in the amount of 80% of the cost of the spectrum licenses are due on March 24, 2021. In accordance with the rules applicable to the auction, licensees also must pay their allocable shares of an estimated $13.1 billion in associated clearing and incentive costs at the times contemplated by the auction rules.Consolidated Results of OperationsIn this section, we discuss our overall results of operations and highlight special items that are not included in our segment results. Our revenues and expenses in 2020 were impacted by the COVID-19 pandemic as a result of the actions we took to care for our employees and keep our customers connected and as a result of our customers’ changing activities, restrictions on activities and the global economic slowdown. See "Overview" for more information. In "Segment Results of Operations," we review the performance of our two reportable segments in more detail. A detailed discussion of 2018 items and year-over-year comparisons between 2019 and 2018 that are not included in this Form 10-K can be found in the "Management's Discussion and Analysis of Financial Condition and Results of Operations" in our Annual Report on Form 10-K for the year ended December 31, 2019.24Table of ContentsConsolidated Revenues(dollars in millions)Increase/(Decrease)Years Ended December 31,202020192020 vs. 2019Consumer$88,533 $91,056 $(2,523)(2.8)%Business30,962 31,443 (481)(1.5)Corporate and other9,334 9,812 (478)(4.9)Eliminations(537)(443)(94)21.2 Consolidated Revenues$128,292 $131,868 $(3,576)(2.7)Consolidated revenues decreased during 2020 compared to 2019, due to decreases in our Consumer segment, Business segment and Corporate and other. Revenues for our segments are discussed separately below under the heading "Segment Results of Operations."Corporate and other revenues decreased during 2020 compared to 2019, primarily due to a decrease of $417 million in revenues within Verizon Media.Consolidated Operating Expenses(dollars in millions)Increase/(Decrease)Years Ended December 31,202020192020 vs. 2019Cost of services$31,401 $31,772 $(371)(1.2)%Cost of wireless equipment19,800 22,954 (3,154)(13.7)Selling, general and administrative expense31,573 29,896 1,677 5.6 Depreciation and amortization expense16,720 16,682 38 0.2 Media goodwill impairment— 186 (186)nmConsolidated Operating Expenses$99,494 $101,490 $(1,996)(2.0)nm - not meaningfulOperating expenses for our segments are discussed separately below under the heading "Segment Results of Operations."Cost of ServicesCost of services includes the following costs directly attributable to a service: salaries and wages, benefits, materials and supplies, content costs, contracted services, network access and transport costs, customer provisioning costs, computer systems support, costs to support our outsourcing contracts and technical facilities and traffic acquisition costs. Aggregate customer service costs, which include billing and service provisioning, are allocated between Cost of services and Selling, general and administrative expense. Cost of services decreased during 2020 compared to 2019, primarily due to decreases in traffic acquisition costs due to the COVID-19 pandemic, as well as decreases in costs related to the device protection offerings to our wireless retail postpaid customers, roaming costs resulting from decreased travel due to the COVID-19 pandemic, regulatory fees and personnel costs. These decreases were partially offset by increases in customer premise equipment, digital content, other direct costs and rent expense as a result of adding capacity to the networks to support demand.Cost of Wireless EquipmentCost of wireless equipment decreased during 2020 compared to 2019, primarily as a result of declines in the number of wireless devices sold as a result of an elongation of the handset upgrade cycle as well as lower gross adds and upgrade volumes partially due to the COVID-19 pandemic. The decreases were partially offset by a shift to higher priced devices in the mix of wireless devices sold.Selling, General and Administrative ExpenseSelling, general and administrative expense includes salaries and wages and benefits not directly attributable to a service or product, the provision for credit losses, taxes other than income taxes, advertising and sales commission costs, call center and information technology costs, regulatory fees, professional service fees and rent and utilities for administrative space. Also included is a portion of the aggregate customer care costs as discussed above in "Cost of Services."Selling, general and administrative expense increased during 2020 compared to 2019, primarily due to a $1.2 billion loss resulting from the Auction 103 spectrum license auction and a net gain from dispositions of assets and businesses during 2019 (see "Special Items"), as well as an increase in sales commission expense. These increases were partially offset by decreases in personnel costs, advertising expenses and the provision for credit losses. The increase in sales commission expense during 2020 compared to 2019 was inclusive of a lower net deferral of 25Table of Contentscommission costs in the current year compared to the prior year, as well as sales compensation while certain of our stores and agent locations were closed due to the COVID-19 pandemic. Depreciation and Amortization ExpenseDepreciation and amortization expense increased during 2020 compared to 2019, primarily due to the change in the mix of net depreciable assets. Media Goodwill ImpairmentThe goodwill impairment charge recorded in 2019 for Verizon Media was a result of the Company's annual impairment test performed in the fourth quarter (see "Critical Accounting Estimates").Other Consolidated ResultsOther Income (Expense), NetAdditional information relating to Other income (expense), net is as follows:(dollars in millions)Increase/(Decrease)Years Ended December 31,202020192020 vs. 2019Interest income$65 $121 $(56)(46.3)%Other components of net periodic benefit (cost) income(425)627 (1,052)nmEarly debt extinguishment costs(129)(3,604)3,475 96.4 Other, net(50)(44)(6)(13.6)Total$(539)$(2,900)$2,361 81.4 nm - not meaningfulOther income (expense), net reflects certain items not directly related to our core operations, including interest income, gains and losses from non-operating asset dispositions, debt extinguishment costs, components of net periodic pension and postretirement benefit costs and foreign exchange gains and losses. The change in Other income (expense), net during 2020 compared to 2019, was primarily driven by early debt redemption costs of $129 million recorded during 2020, compared to $3.6 billion recorded during 2019 (see "Special Items"), partially offset by pension and benefit charges of $1.6 billion recorded during 2020, compared to pension and benefit charges of $126 million recorded during 2019 (see "Special Items"). See Note 11 to the consolidated financial statements for additional information on the other components of net periodic benefit (cost) income.Interest Expense(dollars in millions)Increase/(Decrease)Years Ended December 31,202020192020 vs. 2019Total interest costs on debt balances$4,802 $5,386 $(584)(10.8)%Less capitalized interest costs555 656 (101)(15.4)Total$4,247 $4,730 $(483)(10.2)Average debt outstanding (1) (3)$116,888 $112,901 Effective interest rate (2) (3)4.1 %4.8 %(1)The average debt outstanding is a financial measure and is calculated by applying a simple average of prior thirteen-month end balances of total short-term and long-term debt, net of discounts, premiums and unamortized debt issuance costs.(2)The effective interest rate is the rate of actual interest incurred on debt. It is calculated by dividing the total interest costs on debt balances by the average debt outstanding. (3)We believe that this measure is useful to management, investors and other users of our financial information in evaluating our debt financing cost and trends in our debt leverage management.Total interest expense decreased during 2020 primarily due to lower interest rates as a result of our refinancing activities.Provision for Income Taxes(dollars in millions)Increase/(Decrease)Years Ended December 31,202020192020 vs. 2019Provision for income taxes$5,619 $2,945 $2,674 90.8 %Effective income tax rate23.4 %13.0 %26Table of ContentsThe effective income tax rate is calculated by dividing the provision for income taxes by income before the provision for income taxes. The increase in the effective income tax rate and the provision for income taxes was primarily due to the recognition of a $2.2 billion tax benefit in connection with the disposition of preferred stock representing a minority interest in a foreign affiliate in 2019 that did not reoccur in 2020. See "Cash Flows Provided by Operating Activities" for discussion of the receipt of the cash tax benefit in 2020.A reconciliation of the statutory federal income tax rate to the effective income tax rate for each period is included in Note 12 to the consolidated financial statements.Consolidated Net Income, Consolidated EBITDA and Consolidated Adjusted EBITDAConsolidated earnings before interest, taxes, depreciation and amortization expenses (Consolidated EBITDA) and Consolidated Adjusted EBITDA, which are presented below, are non-generally accepted accounting principles (GAAP) measures that we believe are useful to management, investors and other users of our financial information in evaluating operating profitability on a more variable cost basis as they exclude the depreciation and amortization expense related primarily to capital expenditures and acquisitions that occurred in prior years, as well as in evaluating operating performance in relation to Verizon’s competitors. Consolidated EBITDA is calculated by adding back interest, taxes, and depreciation and amortization expenses to net income.Consolidated Adjusted EBITDA is calculated by excluding from Consolidated EBITDA the effect of the following non-operational items: equity in losses of unconsolidated businesses and other income and expense, net, as well as the effect of special items. We believe that this measure is useful to management, investors and other users of our financial information in evaluating the effectiveness of our operations and underlying business trends in a manner that is consistent with management’s evaluation of business performance. We believe that Consolidated Adjusted EBITDA is widely used by investors to compare a company’s operating performance to its competitors by minimizing impacts caused by differences in capital structure, taxes, and depreciation and amortization policies. Further, the exclusion of non-operational items and special items enables comparability to prior period performance and trend analysis. See "Special Items" for additional information.It is management’s intent to provide non-GAAP financial information to enhance the understanding of Verizon’s GAAP financial information, and it should be considered by the reader in addition to, but not instead of, the financial statements prepared in accordance with GAAP. Each non-GAAP financial measure is presented along with the corresponding GAAP measure so as not to imply that more emphasis should be placed on the non-GAAP measure. We believe that providing these non-GAAP measures in addition to the GAAP measures allows management, investors and other users of our financial information to more fully and accurately assess both consolidated and segment performance. The non-GAAP financial information presented may be determined or calculated differently by other companies and may not be directly comparable to that of other companies.(dollars in millions)Years Ended December 31,20202019Consolidated Net Income$18,348 $19,788 Add:Provision for income taxes5,619 2,945 Interest expense(1)4,247 4,730 Depreciation and amortization expense16,720 16,682 Consolidated EBITDA44,934 44,145 Add (Less):Other expense, net(2)539 2,900 Equity in losses of unconsolidated businesses(3)45 15 Severance charges221 204 Loss on spectrum license transaction1,195 — Impairment charges— 186 Net (gain) loss from dispositions of assets and businesses126 (261)Consolidated Adjusted EBITDA$47,060 $47,189 (1) Includes Early debt redemption costs, where applicable. See "Special Items" for additional information.(2) Includes Pension and benefits mark-to-market adjustments and Early debt redemption costs, where applicable. See "Special Items" for additional information (3) Includes impairment charges, where applicable.The changes in Consolidated Net Income, Consolidated EBITDA and Consolidated Adjusted EBITDA in the table above during 2020 compared to 2019, were primarily a result of the factors described in connection with operating revenues and operating expenses.Segment Results of OperationsWe have three segments that we operate and manage as strategic business units, Consumer, Business and Media, of which Consumer and Business are our reportable segments. We measure and evaluate our segments based on segment operating income. The use of segment operating income is consistent with the chief operating decision maker’s assessment of segment performance.27Table of ContentsTo aid in the understanding of segment performance as it relates to segment operating income, management uses the following operating statistics to evaluate the overall effectiveness of our segments. We believe these operating statistics are useful to investors and other users of our financial information because they provide additional insight into drivers of our segments’ operating results, key trends and performance relative to our peers. These operating statistics may be determined or calculated differently by other companies and may not be directly comparable to those statistics of other companies.Wireless retail connections are retail customer device postpaid and prepaid connections as of the end of the period. Retail connections under an account may include those from smartphones and basic phones (collectively, phones), as well as tablets and other internet devices, including wearables and retail IoT devices. Wireless retail connections are calculated by adding total retail postpaid and prepaid new connections in the period to prior period retail connections, and subtracting total retail postpaid and prepaid disconnects in the period. Wireless retail postpaid connections are retail postpaid customer device connections as of the end of the period. Retail connections under an account may include those from phones, as well as tablets and other internet devices, including wearables and retail IoT devices. Wireless retail postpaid connections are calculated by adding retail postpaid new connections in the period to prior period retail postpaid connections, and subtracting retail postpaid disconnects in the period. Fios internet connections are the total number of connections to the internet using Fios internet services as of the end of the period. Fios internet connections are calculated by adding Fios internet new connections in the period to prior period Fios internet connections, and subtracting Fios internet disconnects in the period.Fios video connections are the total number of connections to traditional linear video programming using Fios video services as of the end of the period. Fios video connections are calculated by adding Fios video net additions in the period to prior period Fios video connections. Fios video net additions are calculated by subtracting the Fios video disconnects from the Fios video new connections.Broadband connections are the total number of connections to the internet using Digital Subscriber Line (DSL) and Fios internet services as of the end of the period. Broadband connections are calculated by adding broadband net additions in the period to prior period broadband connections. Broadband net additions are calculated by subtracting the broadband disconnects from the broadband new connections.Wireless retail connections, net additions are the total number of additional retail customer device postpaid and prepaid connections, less the number of device disconnects in the period. Wireless retail connections, net additions in each period presented are calculated by subtracting the total retail postpaid and prepaid disconnects, net of certain adjustments, from the total retail postpaid and prepaid new connections in the period. Wireless retail postpaid connections, net additions are the total number of additional retail customer device postpaid connections, less the number of device disconnects in the period. Wireless retail postpaid connections, net additions in each period presented are calculated by subtracting the retail postpaid disconnects, net of certain adjustments, from the retail postpaid new connections in the period. Wireless retail postpaid phone connections, net additions are the total number of additional retail customer postpaid phone connections, less the number of phone disconnects in the period. Wireless retail postpaid phone connections, net additions in each period presented are calculated by subtracting the retail postpaid phone disconnects, net of certain adjustments, from the retail postpaid phone new connections in the period. Fios internet, net additions are the total number of additional Fios internet connections, less the number of disconnects in the period. Fios internet, net additions are calculated by subtracting the Fios internet disconnects from the Fios internet new connections in the period.Wireless Churn is the rate at which service to retail, retail postpaid, or retail postpaid phone connections is terminated on average in the period. The churn rate in each period presented is calculated by dividing retail disconnections, retail postpaid disconnections, or retail postpaid phone disconnections by the average retail connections, average retail postpaid connections, or average retail postpaid phone connections, respectively, in the period. Wireless retail postpaid ARPA is the calculated average retail postpaid service revenue per account (ARPA) from retail postpaid accounts in the period. Wireless retail postpaid service revenue does not include recurring device payment plan billings related to the Verizon device payment program, plan billings related to Total Mobile Protection packages or regulatory fees. Wireless retail postpaid ARPA in each period presented is calculated by dividing retail postpaid service revenue by the average retail postpaid accounts in the period. Wireless retail postpaid accounts are wireless retail customers that are directly served and managed under the Verizon brand and use its services as of the end of the period. Accounts include unlimited plans, shared data plans and corporate accounts, as well as legacy single connection plans and family plans. A single account may include monthly wireless services for a variety of connected devices. Wireless retail postpaid accounts are calculated by adding retail postpaid new accounts to the prior period retail postpaid accounts. Wireless retail postpaid connections per account is the calculated average number of retail postpaid connections per retail postpaid account as of the end of the period. Wireless retail postpaid connections per account is calculated by dividing the total number of retail postpaid connections by the number of retail postpaid accounts as of the end of the period.28Table of ContentsWireless retail postpaid gross additions are new retail postpaid connections that have activated service on the wireless network in the period. Wireless retail postpaid gross additions are calculated as the total number of new retail postpaid phone, tablet and other device connections in the period.Segment operating income margin reflects the profitability of the segment as a percentage of revenue. Segment operating income margin is calculated by dividing total segment operating income by total segment operating revenues. Segment earnings before interest, taxes, depreciation and amortization (Segment EBITDA), which is presented below, is a non-GAAP measure and does not purport to be an alternative to operating income (loss) as a measure of operating performance. We believe this measure is useful to management, investors and other users of our financial information in evaluating operating profitability on a more variable cost basis as it excludes the depreciation and amortization expenses related primarily to capital expenditures and acquisitions that occurred in prior years, as well as in evaluating operating performance in relation to our competitors. Segment EBITDA is calculated by adding back depreciation and amortization expense to segment operating income (loss). Segment EBITDA margin is calculated by dividing Segment EBITDA by total segment operating revenues. You can find additional information about our segments in Note 13 to the consolidated financial statements.Verizon Consumer GroupOur Consumer segment provides consumer-focused wireless and wireline communications services and products. Our wireless services are provided across one of the most extensive wireless networks in the U.S. under the Verizon brand and through wholesale and other arrangements. Our wireline services are provided in nine states in the Mid-Atlantic and Northeastern U.S., as well as Washington D.C., over our 100% fiber-optic network through our Verizon Fios product portfolio and over a traditional copper-based network to customers who are not served by Fios. Our revenues and expenses in 2020 were impacted by the COVID-19 pandemic as a result of the actions we took to care for our employees and keep our customers connected and as a result of our customers’ changing activities, restrictions on activities and the global economic slowdown. See "Overview" for more information.29Table of ContentsOperating Revenues and Selected Operating Statistics (dollars in millions, except ARPA)Increase/(Decrease)Years Ended December 31,202020192020 vs. 2019Service$64,884 $65,383 $(499)(0.8)%Wireless equipment15,492 18,048 (2,556)(14.2)Other8,157 7,625 532 7.0 Total Operating Revenues$88,533 $91,056 $(2,523)(2.8)Connections (‘000):(1)Wireless retail connections94,373 94,544 (171)(0.2)Wireless retail postpaid connections90,346 90,481 (135)(0.1)Fios internet connections6,202 5,902 300 5.1 Fios video connections3,854 4,152 (298)(7.2)Broadband connections6,647 6,467 180 2.8 Net Additions in Period (‘000):(2)Wireless retail(5)379 (384)nmWireless retail postpaid40 970 (930)(95.9)Wireless retail postpaid phones95 737 (642)(87.1)Churn Rate:Wireless retail1.03 %1.28 %Wireless retail postpaid0.87 %1.05 %Wireless retail postpaid phones0.67 %0.79 %Account Statistics:Wireless retail postpaid ARPA$118.40 $118.13 $0.27 0.2 Wireless retail postpaid accounts (‘000)(1)33,659 33,875 (216)(0.6)Wireless retail postpaid connections per account(1)2.68 2.67 0.01 0.4 (1)As of end of period(2)Includes certain adjustments nm - not meaningfulConsumer's total operating revenues decreased during 2020 compared to 2019, as a result of decreases in Service and Wireless equipment revenues, partially offset by an increase in Other revenue.Service Revenue Service revenue decreased during 2020 compared to 2019, primarily due to decreases in wireless service and wireline voice and video services. Wireless service revenue decreased $186 million, or 0.3%, during 2020 compared to 2019, primarily due to decreases in roaming and TravelPass revenues due to customers' changing activities during the COVID-19 pandemic and waived fees as part of customer assistance initiatives that we undertook during the COVID-19 pandemic. The decrease was further driven by a decrease in data overage revenues resulting from waived charges as part of customer assistance initiatives we undertook to address the impacts of the COVID-19 pandemic and the shift of customer accounts to unlimited plans. These decreases were partially offset by growth from reseller accounts, increases in access revenues, customers shifting to higher priced plans, and growth in mobile security products included in certain protection packages. The growth from reseller accounts was partially due to customers' changing activities during the COVID-19 pandemic. For the year ended December 31, 2020, Fios service revenue totaled $10.4 billion and decreased $95 million, or 0.9%, compared to 2019. This decrease was due to decreases in Fios video and voice revenues. The decrease in Fios video revenue reflects a one-time credit provided to customers related to regional sport networks during the COVID-19 pandemic and the ongoing shift from traditional linear video to over-the-top offerings. These decreases were partially offset by an increase in Fios internet connections, reflecting increased demand for higher broadband speeds as consumers work and learn from home during the COVID-19 pandemic.Wireless Equipment RevenueWireless equipment revenue decreased during 2020 compared to 2019, as a result of overall declines in wireless device sales partially due to an elongation of the handset upgrade cycle as well as lower gross adds and upgrade volumes primarily due to the impacts of the COVID-19 30Table of Contentspandemic on our customers. These decreases were partially offset by a shift to higher priced units in the mix of wireless devices sold and a decline in promotions.Other RevenueOther revenue includes non-service revenues such as regulatory fees, cost recovery surcharges, revenues associated with our device protection offerings, leasing and interest on equipment financed under a device payment plan agreement when sold to the customer by an authorized agent. Other revenue increased during 2020 compared to 2019, primarily due to pricing and subscriber increases related to our wireless device protection offerings, as well as cost recovery surcharges. These increases were partially offset by decreases in regulatory fees.Operating Expenses(dollars in millions)Increase/(Decrease)Years Ended December 31,202020192020 vs. 2019Cost of services$15,610 $15,884 $(274)(1.7)%Cost of wireless equipment15,736 18,219 (2,483)(13.6)Selling, general and administrative expense16,936 16,639 297 1.8 Depreciation and amortization expense11,395 11,353 42 0.4 Total Operating Expenses$59,677 $62,095 $(2,418)(3.9)Cost of ServicesCost of services decreased during 2020 compared to 2019, primarily due to decreases in costs related to the device protection offerings to our wireless retail postpaid customers, roaming costs, which were primarily driven by a significant decrease in international travel due to the COVID-19 pandemic, and regulatory fees. These decreases were partially offset by increases in digital content costs, other direct costs and rent expense as a result of adding capacity to the networks to support demand.Cost of Wireless EquipmentCost of wireless equipment decreased during 2020 compared to 2019, primarily as a result of declines in the number of wireless devices sold due to an elongation of the handset upgrade cycle as well as lower gross adds and upgrade volumes primarily due to the COVID-19 pandemic, and declines in the number of accessories sold partly due to the COVID-19 pandemic. These decreases were partially offset by a shift to higher priced devices and accessories in the mix of products sold.Selling, General and Administrative ExpenseSelling, general and administrative expense increased during 2020 compared to 2019, primarily due to increases in sales commission and advertising expenses, partially offset by decreases in the provision for credit losses and personnel costs. The increase in sales commission expense during 2020 compared to 2019 was inclusive of a lower net deferral of commission costs in the current year compared to the prior year, as well as sales compensation while certain of our stores and agent locations were closed due to the COVID-19 pandemic.Depreciation and Amortization ExpenseDepreciation and amortization expense increased during 2020 compared to 2019, driven by the change in the mix of total Verizon depreciable assets and Consumer's usage of those assets.Segment Operating Income and EBITDA(dollars in millions)Increase/(Decrease)Years Ended December 31,202020192020 vs. 2019Segment Operating Income$28,856 $28,961 $(105)(0.4)%Add Depreciation and amortization expense11,395 11,353 42 0.4 Segment EBITDA$40,251 $40,314 $(63)(0.2)Segment operating income margin32.6 %31.8 %Segment EBITDA margin45.5 %44.3 %The changes in the table above during the periods presented were primarily a result of the factors described in connection with operating revenues and operating expenses. 31Table of ContentsVerizon Business GroupOur Business segment provides wireless and wireline communications services and products, including data, video and conferencing services, corporate networking solutions, security and managed network services, local and long distance voice services and network access to deliver various IoT services and products. We provide these products and services to businesses, government customers and wireless and wireline carriers across the U.S. and select products and services to customers around the world. The Business segment is organized in four customer groups: Small and Medium Business, Global Enterprise, Public Sector and Other, and Wholesale.Our revenues and expenses in 2020 were impacted by the COVID-19 pandemic as a result of the actions we took to care for our employees and keep our customers connected and as a result of our customers’ changing activities, restrictions on activities and the global economic slowdown. See "Overview" for more information.Operating Revenues and Selected Operating Statistics (dollars in millions)Increase/(Decrease)Years Ended December 31,202020192020 vs. 2019Small and Medium Business$11,132 $11,464 $(332)(2.9)%Global Enterprise10,410 10,818 (408)(3.8)Public Sector and Other6,362 5,922 440 7.4 Wholesale3,058 3,239 (181)(5.6)Total Operating Revenues(1)$30,962 $31,443 $(481)(1.5)Connections (‘000):(2)Wireless retail postpaid connections26,507 25,148 1,359 5.4 Fios internet connections335 326 9 2.8 Fios video connections73 77 (4)(5.2)Broadband connections482 489 (7)(1.4)Net Additions in Period ('000):(3)Wireless retail postpaid1,518 1,413 105 7.4 Wireless retail postpaid phones572 700 (128)(18.3)Churn Rate:Wireless retail postpaid1.20 %1.23 %Wireless retail postpaid phones0.96 %0.99 %(1)Service and other revenues included in our Business segment amounted to approximately $28.1 billion and $27.9 billion for the years ended December 31, 2020 and 2019, respectively. Wireless equipment revenues included in our Business segment amounted to approximately $2.9 billion and $3.5 billion for the years ended December 31, 2020 and 2019, respectively.(2)As of end of period(3)Includes certain adjustments Business's total operating revenues decreased during 2020 compared to 2019, as a result of decreases in Small and Medium Business, Global Enterprise and Wholesale revenues, partially offset by an increase in Public Sector and Other revenue.Small and Medium BusinessSmall and Medium Business offers wireless services and equipment, conferencing services, tailored voice and networking products, Fios services, Internet Protocol (IP) networking, advanced voice solutions and security and managed information technology services to our U.S.-based small and medium businesses that do not meet the requirements to be categorized as Global Enterprise, as described below.Small and Medium Business revenues decreased during 2020 compared to 2019, primarily due to a decrease in wireless equipment revenue, declines related to the loss of voice and DSL service connections and a decrease in IP networking. Wireless equipment revenue decreased as a result of declines in the number of wireless devices sold primarily due to an elongation of the handset upgrade cycle as well as declines in activation volumes due to decreased demand and store closures resulting from the COVID-19 pandemic. The decreases were partially offset by a shift to higher priced units in the mix of wireless devices sold. These revenue decreases were partially offset by an increase in wireless retail postpaid service revenue of 4.4% during 2020 compared to 2019, as a result of increases in the amount of wireless retail postpaid connections, partially offset by lower roaming and usage due to the COVID-19 pandemic. Also contributing to the partial offset was an increase in revenue related to our wireless device protection package as well as an increase in revenue related to Fios services.Fios revenues totaled $926 million, which represents an increase of 1.2% during 2020 compared to 2019. The increase in Fios revenues during 2020 compared to 2019 reflects the increase in total connections, as well as increased demand for higher broadband speeds as a result of the transition to work and learn from home during the COVID-19 pandemic.32Table of ContentsGlobal EnterpriseGlobal Enterprise offers services to large businesses, which are identified based on their size and volume of business with Verizon, as well as non-U.S. public sector customers.Global Enterprise revenues decreased during 2020 compared to 2019, primarily due to declines in traditional data and voice communication services as a result of competitive price pressures, as well as a decrease in wireless equipment revenue. Wireless equipment revenue decreased as a result of declines in the number of wireless devices sold due to an elongation of the handset upgrade cycle as well as declines in activation volumes partially due to the COVID-19 pandemic. In addition, wireless equipment revenue decreased due to a shift to lower priced units in the mix of wireless devices sold. The decreases in revenue were partially offset by an increase in advanced communication services revenue resulting primarily from the COVID-19 pandemic and the Blue Jeans Network, Inc. (BlueJeans) acquisition, and an increase in customer premise equipment revenues. See Note 3 to the consolidated financial statements for additional information on the BlueJeans acquisition.Public Sector and OtherPublic Sector and Other offers wireless products and services as well as wireline connectivity and managed solutions to U.S. federal, state and local governments and educational institutions. These services include business services and connectivity similar to the products and services offered by Global Enterprise, in each case, with features and pricing designed to address the needs of governments and educational institutions.Public Sector and Other revenues increased during 2020 compared to 2019, driven by increases in wireless retail postpaid service revenue as a result of an increase in gross additions partially due to federal, state and educational agencies responding to the COVID-19 pandemic. In addition, the increases were driven by increases in wireless equipment revenue and advanced communication services revenues. Wireless equipment revenue increased as a result of an increase in the number of wireless devices sold primarily due to the COVID-19 pandemic, partially offset by a shift to lower priced units in the mix of wireless devices sold. The increases in revenue were partially offset by decreases in networking revenue and traditional voice communication services.WholesaleWholesale offers wireline communications services including data, voice, local dial tone and broadband services primarily to local, long distance, and wireless carriers that use our facilities to provide services to their customers.Wholesale revenues decreased during 2020 compared to 2019, primarily due to declines in core data resulting from the effect of technology substitution and continuing contraction of market rates due to competition, partially offset by an increase in traditional voice communication services due to the COVID-19 pandemic.Operating Expenses(dollars in millions)Increase/(Decrease)Years Ended December 31,202020192020 vs. 2019Cost of services$10,659 $10,655 $4 — %Cost of wireless equipment4,064 4,733 (669)(14.1)Selling, general and administrative expense8,380 8,188 192 2.3 Depreciation and amortization expense4,086 4,105 (19)(0.5)Total Operating Expenses$27,189 $27,681 $(492)(1.8)Cost of ServicesCost of services were unchanged during 2020 compared to 2019, which was due to an increase in customer premise equipment and other direct costs, which was fully offset by lower roaming costs primarily driven by a significant decrease in international travel due to the COVID-19 pandemic and decreases in costs related to the device protection offerings to our wireless retail postpaid customers and personnel costs.Cost of Wireless EquipmentCost of wireless equipment decreased during 2020 compared to 2019, primarily due to lower overall postpaid sales and a shift to lower priced units in the mix of wireless devices sold, partially offset by an increase in the net number of wireless devices sold to support distance learning programs.Selling, General and Administrative ExpenseSelling, general and administrative expense increased during 2020 compared to 2019, primarily driven by increases in personnel costs and sales commission expense. The increase in sales commission expense during 2020 compared to 2019 inclusive of a lower net deferral of commission costs in the current year compared to the prior year, as well as sales compensation while certain of our stores and agent locations were closed due to the COVID-19 pandemic. These increases were partially offset by a one-time international tax benefit. 33Table of ContentsDepreciation and Amortization ExpenseDepreciation and amortization expense decreased during 2020 compared to 2019, driven by the change in the mix of total Verizon depreciable assets and the Business segment's usage of those assets.Segment Operating Income and EBITDA(dollars in millions)Increase/(Decrease)Years Ended December 31,202020192020 vs. 2019Segment Operating Income$3,773 $3,762 $11 0.3 %Add Depreciation and amortization expense4,086 4,105 (19)(0.5)Segment EBITDA$7,859 $7,867 $(8)(0.1)Segment operating income margin12.2 %12.0 %Segment EBITDA margin25.4 %25.0 %The changes in the table above during the periods presented were primarily a result of the factors described in connection with operating revenues and operating expenses. Special ItemsSpecial items included in Income Before Provision For Income Taxes were as follows: (dollars in millions)Years Ended December 31,20202019Severance, pension and benefits chargesSelling, general and administrative expense$221 $204 Other income (expense), net1,610 126 Loss on spectrum license auctionSelling, general and administrative expense1,195 — Impairment chargesMedia goodwill impairment— 186 Equity in losses of unconsolidated businesses— 50 Early debt redemption costsOther income (expense), net129 3,604 Interest expense(27)— Net (gain) loss from dispositions of assets and businessesSelling, general and administrative expense126 (261)Other income (expense), net(7)— Total$3,247 $3,909 The Consolidated Adjusted EBITDA non-GAAP measure presented in the Consolidated Net Income, Consolidated EBITDA and Consolidated Adjusted EBITDA discussion (see "Consolidated Results of Operations") excludes all of the amounts included above, as described below. The income and expenses related to special items included in our consolidated results of operations were as follows:(dollars in millions)Years Ended December 31,20202019Within Total Operating Expenses$1,542 $129 Within Equity in losses of unconsolidated businesses— 50 Within Other income (expense), net1,732 3,730 Within Interest expense(27)— Total$3,247 $3,909 Severance, Pension and Benefits ChargesDuring 2020, in accordance with our accounting policy to recognize actuarial gains and losses in the period in which they occur, we recorded net pre-tax pension and benefits charges of $1.6 billion in our pension and postretirement benefit plans. The charges were recorded in Other income (expense), net in our consolidated statement of income and were primarily driven by a decrease in our discount rate assumption used to determine the current year liabilities of our pension plans and postretirement benefit plans from a weighted-average of 3.3% at December 34Table of Contents31, 2019 to a weighted-average of 2.6% at December 31, 2020 ($3.2 billion), partially offset by the difference between our estimated return on assets and our actual return on assets ($1.6 billion). During 2020, we also recorded net pre-tax severance charges of $221 million related to a voluntary offer under our existing separation plans in Selling, general and administrative expense in our consolidated statements of income. During 2019, in accordance with our accounting policy to recognize actuarial gains and losses in the period in which they occur, we recorded net pre-tax pension and benefits charges of $126 million in our pension and postretirement benefit plans. The charges were recorded in Other income (expense), net in our consolidated statements of income and were primarily driven by a decrease in our discount rate assumption used to determine the current year liabilities of our pension plans and postretirement benefit plans from a weighted-average of 4.4% at December 31, 2018 to a weighted-average of 3.3% at December 31, 2019 ($4.3 billion), partially offset by the difference between our estimated return on assets and our actual return on assets ($2.3 billion) and other assumption adjustments of $1.9 billion, of which $1.6 billion related to healthcare claims experience. During 2019, we also recorded net pre-tax severance charges of $204 million in Selling, general and administrative expense in our consolidated statements of income. Due to the presentation of the other components of net periodic benefit cost, we recognize a portion of the pension and benefits charges in Other income (expense), net in our consolidated statements of income. See Note 11 to the consolidated financial statements for additional information related to severance, pension and benefits charges.Loss on Spectrum License AuctionDuring 2020, we recorded a pre-tax net loss of $1.2 billion as a result of the conclusion of the FCC incentive auction, Auction 103, for spectrum licenses in the upper 37 Gigahertz (GHz), 39 GHz and 47 GHz bands. See Note 3 to the consolidated financial statements for additional information.Impairment ChargesThe impairment charges consist of write-downs of goodwill and other investments or assets. The goodwill impairment charge of $186 million recorded during 2019 for Verizon Media was a result of the Company's annual impairment test performed in the fourth quarter (see "Critical Accounting Estimates"). In addition, we recorded an impairment charge of $50 million in Equity in losses of unconsolidated businesses related to a media joint venture investment during 2019.Early Debt Redemption CostsDuring 2020 and 2019, we recorded early debt redemption costs of $102 million and $3.6 billion, respectively.See Note 7 to the consolidated financial statements for additional information related to our early debt redemptions.Net (Gain) Loss from Dispositions of Assets and BusinessesDuring 2020, we recorded a pre-tax net loss of $119 million, primarily in connection with the sale of our Huffington Post business. During 2019, we recorded pre-tax net gains from dispositions of assets and businesses of $261 million in connection with the sale of various real estate properties and businesses. See Note 3 to the consolidated financial statements for additional information related to dispositions of assets and businesses.Operating Environment and TrendsThe telecommunications industry is highly competitive. We expect competition to remain intense as traditional and non-traditional participants seek increased market share. Our high-quality customer base and networks differentiate us from our competitors and give us the ability to plan and manage through changing economic and competitive conditions. We remain focused on executing on the fundamentals of the business: maintaining a high-quality customer base, delivering strong financial and operating results and strengthening our balance sheet. We will continue to invest for growth, which we believe is the key to creating value for our shareholders. We continue to lead in 4G LTE performance while building momentum for our 5G network. Our strategy lays the foundation for the future through investments in our Intelligent Edge Network that enable efficiencies throughout our core infrastructure and deliver flexibility to meet customer requirements.The U.S. wireless market has achieved a high penetration of smartphones, which reduces the opportunity for new phone connection growth for the industry. We expect future revenue growth in the industry to be driven by expanding existing customer relationships, increasing the number of ways customers can connect with wireless networks and services and increasing the penetration of other connected devices including wearables, tablets and IoT devices. We expect 5G technology will provide a significant opportunity for growth in the industry in 2021 and beyond. With respect to our wireless connectivity products and services, we compete against other national wireless service providers, including AT&T Inc. and T-Mobile USA, Inc., as well as various regional wireless service providers. We also compete for retail activations with resellers that buy bulk wholesale service from wireless service providers, including Verizon, and resell it to their customers. Resellers include cable companies and others. We face competition from other communications and technology companies seeking to increase their brand recognition and capture customer revenue with respect to the provision of wireless products and services, in addition to non-traditional offerings in mobile data. For example, Microsoft Corporation, Alphabet Inc., Apple Inc. and others are offering alternative 35Table of Contentsmeans for making wireless voice calls that, in certain cases, can be used in lieu of the wireless provider’s voice service, as well as alternative means of accessing video content.With respect to wireless services and equipment, pricing plays an important role in the wireless competitive landscape. We compete in this area by offering our customers services and devices that we believe they will regard as the best available value for the price. As the demand for wireless services continues to grow, wireless service providers are offering a range of service plans at competitive prices. These service offerings will vary from time to time based on customer needs, technology changes and market conditions and may be provided as standard plans or as part of limited time promotional offers.We expect future service revenue growth opportunities to arise from increased access revenue as customers shift to higher access plans, driven in part by attractive bundled content with premium brands, as well as from increased connections per account. Future service revenue growth opportunities will be dependent on expanding the penetration of our services, increasing the number of ways that our customers can connect with our networks and services and the development of new ecosystems. We and other wireless service providers, as well as equipment manufacturers, offer device payment options, which provide customers with the ability to pay for their device over a period of time, and some providers offer device leasing arrangements.Current and potential competitors in the wireline service market include cable companies, wireless service providers, domestic and foreign telecommunications providers, satellite television companies, internet service providers, over-the-top providers and other companies that offer network services and managed enterprise solutions.In addition, companies with a global presence are increasingly competing with us in our wireline services. A relatively small number of telecommunications and integrated service providers with global operations serve customers in the global enterprise market and, to a lesser extent, the global wholesale market. We compete with these providers for large contracts to provide integrated solutions to global enterprises and government customers. Many of these companies have strong market presence, brand recognition and existing customer relationships, all of which contribute to intensifying competition that may affect our future revenue growth.Despite this challenging environment, we expect that we will be able to grow key aspects of our wireline services. We continue to provide network reliability and offer products, which include fiber-optic internet access, several video services, and voice services. Further, we will continue to offer our business and government customers more robust IP products and services, and advance our IoT strategies by leveraging business models that monetize usage on our networks at the connectivity, platform and solution layers.The online advertising market continues to evolve as online users are migrating from traditional desktop to mobile and multiple-device usage. Also, there is a continued shift towards programmatic advertising which presents opportunities to connect online advertisers with the appropriate online users in a rapid environment. Our media business competes with other online search engines, advertising platforms, digital video services and social networks. We are experiencing pressure from search and desktop usage and believe the pressure in these sectors will continue. We are implementing initiatives to realize synergies across all of our media assets and build services around our core content pillars to diversify revenue and return to growth. We will also continue to focus on cost efficiencies to ensure we have the maximum flexibility to adjust to changes in the competitive and economic environments and maximize returns to shareholders.2021 Connection TrendsIn our Consumer segment, we expect to continue to attract new customers and maintain high-quality retail postpaid customers, capitalizing on demand for data services and providing our customers new ways of using wireless services in their daily lives. We expect that future connection growth will be driven by smartphones, tablets and other connected devices such as wearables. We believe the combination of our wireless network performance and Mix & Match unlimited plans provides a superior customer experience, supporting increased penetration of data services and the continued attraction and retention of higher valued retail postpaid connections. We expect to manage churn by providing a consistent, reliable experience on our wireless service and focusing on improving the customer experience through simplified pricing and continued focus in our distribution channels. We expect to continue to grow our Fios internet connections as we seek to increase our penetration rates within our Fios service areas, further supported by the demand for higher speed internet connections. In Fios video, the business continues to face ongoing pressure as observed throughout the linear television market. We expect to manage market pressure by offering customers a choice of video service, including options such as Mix & Match on Fios and other offerings. We have experienced continuing access line and DSL losses as customers have disconnected both primary and secondary lines and switched to alternative technologies such as wireless, Voice over Internet Protocol, and cable for voice and data services. In our Business segment, we offer wireless products and services to business and government customers across the U.S. We continue to grow our retail connections while operating in a competitive environment. We expect to maintain connection growth in part by adding capacity and density to our 4G LTE network, in addition to leading the build-out of our 5G network. We expect this connection growth, combined with our industry-leading network assets, will provide additional opportunities to sell solutions, such as those around security, advanced communications and professional services. We expect to expand our existing services offered to business customers through our Intelligent Edge Network, our multi-use platform. 36Table of Contents2021 Operating Revenue TrendsIn our Consumer segment, we expect to see an acceleration of service revenue growth in 2021 as customers shift to higher access plans with additional services and increase the number of devices they connect with our networks and services. We expect Fios revenue to benefit in 2021 as growth in our broadband customer base offsets the impact of the shift from the triple-play bundle to standalone service. In our Business segment, we expect wireless revenue to expand, driven by an increase in the number of connections. We expect that our Fios products, through increased penetration, will also contribute to revenue growth. Legacy traditional wireline services will continue to face secular pressures. In addition, certain products and services provided by our Public Sector and Global Enterprise groups experienced elevated demand during 2020 as a result of the COVID-19 pandemic. Demand for those products and services may return to more historical levels in 2021.Our media business, Verizon Media, is primarily made up of digital advertising products. We expect Verizon Media revenue to grow in 2021 as the strong advertising trends from 2020 are expected to continue, with the exception of political advertising spend. We will continue the implementation of initiatives to realize synergies across all of our media assets and build services around our core content pillars. We expect positive growth in mobile services and products.2021 Operating Expense and Cash Flow from Operations TrendsWe expect our consolidated operating income margin and adjusted consolidated EBITDA margin to remain strong as we continue to undertake initiatives to reduce our overall cost structure by improving productivity and gaining efficiencies in our operations throughout the business in 2021 and beyond. Business Excellence initiatives include the adoption of the zero-based budgeting methodology, driving capital efficiencies from the architecture of the networks, evolving our Information Technology strategy and the continuing benefit from the Voluntary Separation Program. We believe our additional investments in our Business segment in both product simplification and continued focus on process improvements and new work tools will drive cost savings and create incremental growth opportunities in areas such as 5G and One Fiber. The goal of the Business Excellence initiative is to take $10 billion of cumulative cash outflows out of the business over four years, beginning in 2018. As part of this initiative, we are focusing on both operating expenses and capital expenditures. Our Business Excellence initiatives produced cumulative cash savings of $9.5 billion through the end of 2020 from a mix of capital and operational expenditure activities. The program remains on track to achieve our goal in 2021. We will continue to explore opportunities for additional savings beyond the program.We create value for our shareholders by investing the cash flows generated by our business in opportunities and transactions that support continued profitable growth, thereby increasing customer satisfaction and usage of our products and services. In addition, we have used our cash flows to maintain and grow our dividend payout to shareholders. Verizon’s Board of Directors increased the Company’s quarterly dividend by 2.0% during 2020, making this the fourteenth consecutive year in which we have raised our dividend.Our goal is to use our cash to create long-term value for our shareholders. We will continue to look for investment opportunities that will help us to grow the business, strengthen our balance sheet, acquire spectrum licenses (see "Cash Flows from Investing Activities"), pay dividends to our shareholders and, when appropriate, buy back shares of our outstanding common stock (see "Cash Flows from Financing Activities").Capital ExpendituresOur 2021 capital program includes capital to fund advanced networks and services, including expanding our core networks, adding capacity and density to our 4G LTE network in order to stay ahead of our customers’ increasing data demands and deploying our 5G network, transforming our structure to deploy the Intelligent Edge Network while reducing the cost to deliver services to our customers, and pursuing other opportunities to drive operating efficiencies. We expect that the new network architecture will simplify operations by eliminating legacy network elements, improve our 4G LTE coverage, speed the deployment of 5G technology, and create new enterprise opportunities in the business market. The level and the timing of the Company’s capital expenditures within these broad categories can vary significantly as a result of a variety of factors outside of our control, such as material weather events, equipment availability from vendors and permits from local governments. We believe that we have significant discretion over the amount and timing of our capital expenditures on a Company-wide basis as we are not subject to any agreement that would require significant capital expenditures on a designated schedule or upon the occurrence of designated events.Consolidated Financial Condition(dollars in millions)Years Ended December 31,20202019Cash flows provided by (used in)Operating activities$41,768 $35,746 Investing activities(23,512)(17,581)Financing activities1,325 (18,164)Increase in cash, cash equivalents and restricted cash$19,581 $1 We use the net cash generated from our operations to fund expansion and modernization of our networks, service and repay external financing, pay dividends, invest in new businesses and spectrum and, when appropriate, buy back shares of our outstanding common stock. Our sources of funds, primarily from operations and, to the extent necessary, from external financing arrangements, are sufficient to meet 37Table of Contentsongoing operating and investing requirements. We made the decision at the beginning of the COVID-19 pandemic to maintain a higher cash balance in order to further protect the Company against the economic uncertainties associated with the COVID-19 pandemic and to opportunistically raise cash to finance future obligations at a time when we believed that market conditions were favorable. We expect that our capital spending requirements will continue to be financed primarily through internally generated funds. Debt or equity financing may be needed to fund additional investments or development activities, including, for example, to complete our acquisition of TracFone Wireless, Inc. (Tracfone) or to acquire additional wireless spectrum, or to maintain an appropriate capital structure to ensure our financial flexibility. Our cash and cash equivalents are held both domestically and internationally, and are invested to maintain principal and provide liquidity. See "Market Risk" for additional information regarding our foreign currency risk management strategies.Our available external financing arrangements include an active commercial paper program, credit available under credit facilities and other bank lines of credit, vendor financing arrangements, issuances of registered debt or equity securities, U.S. retail medium-term notes and other capital market securities that are privately-placed or offered overseas. In addition, we monetize our device payment plan agreement receivables through asset-backed debt transactions.Cash Flows Provided By Operating ActivitiesOur primary source of funds continues to be cash generated from operations. Net cash provided by operating activities increased by $6.0 billion during 2020 compared to 2019, primarily due to improvements in working capital, which includes the receipt of the $2.2 billion cash tax benefit related to preferred shares in a foreign affiliate sold during the fourth quarter 2019 and lower wireless volumes, as well as the receipt of $764 million relating to the settlement of interest rate swaps during 2020. In addition, an employee benefits contribution as well as severance payments as a result of the Voluntary Separation Program in 2019 did not repeat in 2020. These comparative increases were partially offset by lower earnings in 2020. We made a $300 million discretionary employee benefits contribution during the first quarter 2019 to our defined benefit pension plan. As a result of the 2019 discretionary pension contribution and higher actual asset returns than expected returns in both 2019 and 2020, we expect that there will be no required pension funding through 2030, subject to changes in market conditions. The 2019 contribution also improved the funded status of our qualified pension plan.Cash Flows Used In Investing ActivitiesCapital ExpendituresCapital expenditures continue to relate primarily to the use of capital resources to increase the operating efficiency and productivity of our networks, maintain our existing infrastructure, facilitate the introduction of new products and services and enhance responsiveness to competitive challenges.Capital expenditures, including capitalized software, were $18.2 billion and $17.9 billion for 2020 and 2019, respectively. Capital expenditures increased approximately $253 million, or 1.4%, during 2020 compared to 2019, primarily due to increased focus on 5G technology deployment.Acquisitions of Wireless LicensesDuring 2020 and 2019, we invested $2.1 billion and $898 million, respectively, in acquisitions of wireless licenses. In March 2020, the FCC completed an incentive auction, Auction 103, for spectrum licenses. Through December 31, 2020, we paid approximately $1.6 billion, including $101 million paid in December 2019. In 2019, the FCC completed two millimeter wave spectrum license auctions, Auction 101 and Auction 102. We paid approximately $521 million for spectrum licenses in connection with these auctions.During 2020 and 2019, we entered into and completed various other wireless license acquisitions for cash consideration of $360 million and an insignificant amount, respectively.Acquisitions of Businesses, Net of Cash AcquiredDuring 2020 and 2019, we invested $520 million and an insignificant amount, respectively, in acquisitions of businesses, net of cash acquired.In April 2020, we entered into a definitive purchase agreement to acquire BlueJeans, an enterprise-grade video conferencing and event platform, whose services are sold to Business customers globally. The transaction closed in May 2020. The aggregate cash consideration paid by Verizon at the closing of the transaction was approximately $397 million, net of cash acquired. During 2020, we completed various other acquisitions for approximately $127 million in cash consideration.See "Acquisitions and Divestitures" for information on our acquisitions.Other, NetIn September 2020, the FCC completed Auction 105 for Priority Access Licenses. Through December 31, 2020, we paid a cash deposit of approximately $1.9 billion for the licenses. See Note 3 to the consolidated financial statements for additional information.38Table of ContentsDuring 2019, we received gross proceeds of approximately $1.0 billion for a sale-leaseback transaction for buildings and real estate. See Note 6 to the consolidated financial statements for additional information.Cash Flows Provided by (Used In) Financing ActivitiesWe seek to maintain a mix of fixed and variable rate debt to lower borrowing costs within reasonable risk parameters and to protect against earnings and cash flow volatility resulting from changes in market conditions. During 2020, net cash provided by financing activities was $1.3 billion. During 2019, net cash used in financing activities was $18.2 billion. 2020During 2020, our net cash provided by financing activities of $1.3 billion was primarily driven by $31.5 billion provided by proceeds from long-term borrowings, which included $5.6 billion of proceeds from our asset-backed debt transactions. These cash flows provided by financing activities were partially offset by $17.2 billion used for repayments, redemptions and repurchases of long-term borrowings and finance lease obligations, which included $7.4 billion used for prepayments and repayments of asset-backed long-term borrowings, $10.2 billion used for dividend payments and $2.7 billion used for other financing activities. Proceeds from and Repayments, Redemptions, and Repurchases of Long-Term BorrowingsAt December 31, 2020, our total debt increased to $129.1 billion as compared to $111.5 billion at December 31, 2019. Our effective interest rate was 4.1% and 4.8% during the years ended December 31, 2020 and 2019, respectively. The substantial majority of our total debt portfolio consists of fixed rate indebtedness, therefore, changes in interest rates do not have a material effect on our interest payments. See also "Market Risk" and Note 7 to the consolidated financial statements for additional information.At December 31, 2020, approximately $29.0 billion, or 22.5%, of the aggregate principal amount of our total debt portfolio consisted of foreign denominated debt, primarily Euro and British Pound Sterling. We have entered into cross currency swaps on substantially all of our foreign denominated debt in order to fix our future interest and principal payments in U.S. dollars and mitigate the impact of foreign currency transaction gains or losses. See "Market Risk" for additional information.Verizon may continue to acquire debt securities issued by Verizon and its affiliates in the future through open market purchases, redemptions, privately negotiated transactions, tender offers, exchange offers, or otherwise, upon such terms and at such prices as Verizon may from time to time determine, for cash or other consideration.Other, NetOther, net financing activities during 2020 includes $827 million in payments related to vendor financing arrangements and $748 million in cash paid on debt exchanges. See Note 15 to the consolidated financial statements for additional information.DividendsThe Verizon Board of Directors assesses the level of our dividend payments on a periodic basis taking into account such factors as long-term growth opportunities, internal cash requirements and the expectations of our shareholders. During the third quarter of 2020, the Board increased our quarterly dividend payment by 2.0% to $0.6275 from $0.6150 per share from the previous quarter. This is the fourteenth consecutive year that Verizon’s Board of Directors has approved a quarterly dividend increase.As in prior periods, dividend payments were a significant use of capital resources. During 2020, we paid $10.2 billion in dividends.2019During 2019, our net cash used in financing activities of $18.2 billion was primarily driven by:•$23.9 billion used for repayments, redemptions and repurchases of long-term borrowings and finance lease obligations, which included $6.3 billion used for prepayments and repayments of asset-backed long-term borrowings;•$10.0 billion used for dividend payments; and•$1.8 billion used for net debt related costs.These uses of cash were partially offset by proceeds from long-term borrowings of $18.7 billion, which included $8.6 billion of proceeds from our asset-backed debt transactions.Proceeds from and Repayments, Redemptions, and Repurchases of Long-Term BorrowingsAt December 31, 2019, our total debt was $111.5 billion, and during the year ended December 31, 2019, our effective interest rate was 4.8%. The substantial majority of our total debt portfolio consisted of fixed rate indebtedness, therefore, changes in interest rates did not have a material effect on our interest payments. See "Market Risk" and Note 7 to the consolidated financial statements for additional information.At December 31, 2019, approximately $23.5 billion, or 21.1%, of the aggregate principal amount of our total debt portfolio consisted of foreign denominated debt, primarily Euro and British Pound Sterling. We have entered into cross currency swaps on substantially all of our foreign denominated debt in order to fix our future interest and principal payments in U.S. dollars and mitigate the impact of foreign currency transaction gains or losses. See "Market Risk" for additional information.39Table of ContentsOther, NetOther, net financing activities during 2019, included early debt redemption costs. See "Special Items" for additional information, as well as cash paid on debt exchanges and derivative-related transactions. See Note 15 to the consolidated financial statements for additional information.DividendsDuring the third quarter of 2019, the Board increased our quarterly dividend payment by 2.1% to $0.6150 per share. As in prior periods, dividend payments were a significant use of capital resources. During 2019, we paid $10.0 billion in dividends.Asset-Backed DebtAs of December 31, 2020, the carrying value of our asset-backed debt was $10.6 billion. Our asset-backed debt includes Asset-Backed Notes (ABS Notes) issued to third-party investors (Investors) and loans (ABS Financing Facilities) received from banks and their conduit facilities (collectively, the Banks). Our consolidated asset-backed debt bankruptcy remote legal entities (each, an ABS Entity or collectively, the ABS Entities) issue the debt or are otherwise party to the transaction documentation in connection with our asset-backed debt transactions. Under the terms of our asset-backed debt, Cellco and certain other affiliates of Verizon (collectively, the Originators) transfer device payment plan agreement receivables to one of the ABS Entities, which in turn transfers such receivables to another ABS Entity that issues the debt. Verizon entities retain the equity interests in the ABS Entities, which represent the rights to all funds not needed to make required payments on the asset-backed debt and other related payments and expenses. Our asset-backed debt is secured by the transferred device payment plan agreement receivables and future collections on such receivables. The device payment plan agreement receivables transferred to the ABS Entities and related assets, consisting primarily of restricted cash, will only be available for payment of asset-backed debt and expenses related thereto, payments to the Originators in respect of additional transfers of device payment plan agreement receivables, and other obligations arising from our asset-backed debt transactions, and will not be available to pay other obligations or claims of Verizon’s creditors until the associated asset-backed debt and other obligations are satisfied. The Investors or Banks, as applicable, which hold our asset-backed debt have legal recourse to the assets securing the debt, but do not have any recourse to Verizon with respect to the payment of principal and interest on the debt. Under a parent support agreement, Verizon has agreed to guarantee certain of the payment obligations of Cellco and the Originators to the ABS Entities. Cash collections on the device payment plan agreement receivables collateralizing our asset-backed debt securities are required at certain specified times to be placed into segregated accounts. Deposits to the segregated accounts are considered restricted cash and are included in Prepaid expenses and other, and Other assets in our consolidated balance sheets. Proceeds from our asset-backed debt transactions are reflected in Cash flows from financing activities in our consolidated statements of cash flows. The asset-backed debt issued and the assets securing this debt are included in our consolidated balance sheets. See Note 7 to the consolidated financial statements for additional information. In May 2020, we amended and restated our outstanding ABS financing facility originally entered into in 2016, and previously amended and restated in 2019, with a number of financial institutions (ABS Financing Facility). One loan agreement is outstanding in connection with the ABS Financing Facility, and such loan agreement was amended and restated in May 2020. Under the loan agreement, we have the right to prepay all or a portion of the advances at any time without penalty, but in certain cases, with breakage costs. During 2020, we borrowed $1.3 billion and prepaid $4.0 billion under the loan agreement.Long-Term Credit FacilitiesAt December 31, 2020(dollars in millions)MaturitiesFacility CapacityUnused CapacityPrincipal Amount Outstanding Verizon revolving credit facility (1)2024$9,500 $9,392 N/AVarious export credit facilities (2)2022-20287,500 1,000 $4,882 Total$17,000 $10,392 $4,882 N/A - not applicable(1) The revolving credit facility does not require us to comply with financial covenants or maintain specified credit ratings, and it permits us to borrow even if our business has incurred a material adverse change. The revolving credit facility provides for the issuance of letters of credit.(2) During 2020 and 2019, we drew down $1.0 billion and $1.5 billion from these facilities, respectively. These credit facilities are used to finance equipment-related purchases. Borrowings under certain of these facilities amortize semi-annually in equal installments up to the applicable maturity dates. Maturities reflect maturity dates of principal amounts outstanding. Any amounts borrowed under these facilities and subsequently repaid cannot be reborrowed.40Table of Contents2021 Credit AgreementDelayed Draw Term Loan Credit AgreementOn February 24, 2021 (the Effective Date), Verizon entered into a $25.0 billion Delayed Draw Term Loan Credit Agreement (the Credit Agreement) with two financial institutions, which includes initial commitments of $12.5 billion from each of these parties. The Credit Agreement provides Verizon with the ability to borrow up to $25.0 billion for general corporate purposes, including any potential acquisition of spectrum. The loans under the Credit Agreement are available during the period (the Availability Period) beginning on the Effective Date and ending on the earlier of (i) May 28, 2021, and (ii) the receipt by the two financial institutions of written notice by Verizon of its election to terminate commitments pursuant to the Credit Agreement. The availability of the loans under the Credit Agreement, which have not yet been funded, is subject to the satisfaction (or waiver) of the conditions that certain representations of Verizon are accurate in all material respects and the absence of certain event of default. The loans under the Credit Agreement are to be made in a single borrowing on the funding date and will mature and be payable in full on the date that is 364 days after the funding date unless extended pursuant to the terms of the Credit Agreement. The two financial institutions may syndicate their commitments under the Credit Agreement, subject to the terms of the Credit Agreement. Interest Rate and FeesThe loans under the Credit Agreement will bear interest at a rate equal to, at the option of Verizon, (i) the base rate (defined as the greater of the rate last quoted by the Wall Street Journal as the "prime rate", the federal funds rate plus 0.500%, and the one-month London Inter-Bank Offered Rate (LIBOR) plus 1.000%, subject to a floor of 1.000%) or (ii) LIBOR, in each case plus a margin to be determined by reference to Verizon’s credit ratings and ranging from 0.000% to 0.125% in the case of base rate loans and 0.625% to 1.125% in the case of LIBOR loans. Additional margin of 0.125% is added to the loan on December 31, 2021.Verizon will pay a commitment fee on the daily actual unused commitment of each lender starting on the date that is 60 days after the Effective Date through the last day of the Availability Period. This fee accrues at a rate determined by reference to Verizon’s credit ratings and ranges from 0.070% to 0.125% per annum.PrepaymentsThe Credit Agreement requires Verizon to reduce unused commitments and prepay the loans with 100% of the net cash proceeds received from issuances or sales of equity and incurrences of borrowed money indebtedness, subject to certain exceptions.Covenants and Events of DefaultThe Credit Agreement contains certain negative covenants, including a negative pledge covenant, a merger or similar transaction covenant and an accounting changes covenant, and affirmative covenants and events of default that are customary for companies maintaining an investment grade credit rating. An event of default may result in the inability to borrow in certain circumstances or the acceleration of any outstanding loan under the Credit Agreement, as applicable. Common StockCommon stock has been used from time to time to satisfy some of the funding requirements of employee and shareholder plans. During the years ended December 31, 2020 and 2019, we issued 2.3 million and 3.8 million common shares from Treasury stock, respectively, which had an insignificant aggregate value.In February 2020, the Verizon Board of Directors authorized a share buyback program to repurchase up to 100 million shares of Verizon's common stock. The program will terminate when the aggregate number of shares purchased reaches 100 million, or a new share repurchase plan superseding the current plan is authorized, whichever is sooner. The program permits Verizon to repurchase shares over time, with the amount and timing of repurchases depending on market conditions and corporate needs. There were no repurchases of common stock during 2020 and 2019 under our current or previously authorized share buyback program.Credit RatingsVerizon’s credit ratings did not change in 2020 or 2019.Securities ratings assigned by rating organizations are expressions of opinion and are not recommendations to buy, sell or hold securities. A securities rating is subject to revision or withdrawal at any time by the assigning rating organization. Each rating should be evaluated independently of any other rating.CovenantsOur credit agreements contain covenants that are typical for large, investment grade companies. These covenants include requirements to pay interest and principal in a timely fashion, pay taxes, maintain insurance with responsible and reputable insurance companies, preserve our corporate existence, keep appropriate books and records of financial transactions, maintain our properties, provide financial and other reports to our lenders, limit pledging and disposition of assets and mergers and consolidations, and other similar covenants.We and our consolidated subsidiaries are in compliance with all of our restrictive covenants in our debt agreements. 41Table of ContentsChange In Cash, Cash Equivalents and Restricted CashOur Cash and cash equivalents at December 31, 2020 totaled $22.2 billion, a $19.6 billion increase compared to December 31, 2019, primarily as a result of the factors discussed above. Restricted cash at December 31, 2020 totaled $1.3 billion, relatively flat compared to restricted cash at December 31, 2019, primarily related to cash collections on the device payment plan agreement receivables that are required at certain specified times to be placed into segregated accounts.Free Cash FlowFree cash flow is a non-GAAP financial measure that reflects an additional way of viewing our liquidity that, we believe, when viewed with our GAAP results, provides management, investors and other users of our financial information with a more complete understanding of factors and trends affecting our cash flows. Free cash flow is calculated by subtracting capital expenditures (including capitalized software) from net cash provided by operating activities. We believe it is a more conservative measure of cash flow since purchases of fixed assets are necessary for ongoing operations. Free cash flow has limitations due to the fact that it does not represent the residual cash flow available for discretionary expenditures. For example, free cash flow does not incorporate payments made on finance lease obligations or cash payments for business acquisitions or wireless licenses. Therefore, we believe it is important to view free cash flow as a complement to our entire consolidated statements of cash flows. The following table reconciles net cash provided by operating activities to free cash flow: (dollars in millions)Years Ended December 31,20202019Net cash provided by operating activities$41,768 $35,746 Less Capital expenditures (including capitalized software)18,192 17,939 Free cash flow$23,576 $17,807 The increase in free cash flow during 2020 is a reflection of the increase in operating cash flows, partially offset by the increase in capital expenditures discussed above.Employee Benefit Plans Funded Status and ContributionsEmployer ContributionsWe operate numerous qualified and nonqualified pension plans and other postretirement benefit plans. These plans primarily relate to our domestic business units. We made no discretionary contribution to our qualified pension plan in 2020. In 2019, we made contributions of $300 million to our qualified pension plans. During 2020 and 2019 we made contributions of $57 million and $71 million to our nonqualified pension plans, respectively. The Company’s overall investment strategy is to achieve a mix of assets that allows us to meet projected benefit payments while taking into consideration risk and return. In an effort to reduce the risk of our portfolio strategy and better align assets with liabilities, we have adopted a liability driven pension strategy that seeks to better match the interest rate sensitivity of the liability hedging assets with the interest rate sensitivity of the liability. We expect that the strategy will reduce the likelihood that assets will decline at a time when liabilities increase (referred to as liability hedging), with the goal to reduce the risk of underfunding to the plan and its participants and beneficiaries; however, we also expect the strategy to result in lower asset returns. Nonqualified pension contributions are estimated to be approximately $70 million in 2021.Contributions to our other postretirement benefit plans generally relate to payments for benefits on an as-incurred basis since these other postretirement benefit plans do not have funding requirements similar to the pension plans. We contributed $709 million and $449 million to our other postretirement benefit plans in 2020 and 2019, respectively. Contributions to our other postretirement benefit plans are estimated to be approximately $800 million in 2021.Leasing ArrangementsSee Note 6 to the consolidated financial statements for a discussion of leasing arrangements.42Table of ContentsContractual ObligationsThe following table provides a summary of our contractual obligations and commercial commitments at December 31, 2020. Additional detail about these items is included in the notes to the consolidated financial statements.(dollars in millions)Payments Due By PeriodContractual ObligationsTotalLess than1 year1 to 3 years3 to 5 yearsMore than5 yearsLong-term debt(1)$128,062 $5,227 $16,156 $12,814 $93,865 Finance lease obligations(2)1,366 373 591 301 101 Total long-term debt, including current maturities129,428 5,600 16,747 13,115 93,966 Interest on long-term debt(1)73,688 4,702 8,941 8,131 51,914 Operating lease obligations(2)24,994 4,327 7,485 5,212 7,970 Purchase obligations(3)24,585 8,179 10,835 4,051 1,520 Other long-term liabilities(4)4,076 798 1,659 1,619 — Finance obligations(5)1,256 286 590 380 — Total contractual obligations$258,027 $23,892 $46,257 $32,508 $155,370 (1)Items included in long-term debt with variable coupon rates exclude unamortized debt issuance costs, and are described in Note 7 to the consolidated financial statements.(2)See Note 6 to the consolidated financial statements for additional information.(3)Items included in purchase obligations are primarily commitments to purchase content and network services, equipment, software and marketing services, which will be used or sold in the ordinary course of business. These amounts do not represent our entire anticipated purchases in the future, but represent only those items that are the subject of contractual obligations. We also purchase products and services as needed with no firm commitment. For this reason, the amounts presented in this table alone do not provide a reliable indicator of our expected future cash outflows or changes in our expected cash position. See Note 16 to the consolidated financial statements for additional information.(4)Other long-term liabilities represent estimated postretirement benefit and qualified pension plan contributions. Estimated qualified pension plan contributions include expected minimum funding contributions, which commence after 2030 based on the plan's current funded status. Estimated postretirement benefit payments include expected future postretirement benefit payments. These estimated amounts: (1) are subject to change based on changes to assumptions and future plan performance, which could impact the timing or amounts of these payments; and (2) exclude expectations beyond 5 years due to uncertainty of the timing and amounts. See Note 11 to the consolidated financial statements for additional information.(5)Represents future minimum payments under the sublease arrangement for our tower transaction. See Note 6 to the consolidated financial statements for additional information.We are not able to make a reasonable estimate of when the unrecognized tax benefits balance of $2.9 billion and related interest and penalties will be settled with the respective taxing authorities until issues or examinations are further developed. See Note 12 to the consolidated financial statements for additional information.GuaranteesWe guarantee the debentures of our operating telephone company subsidiaries as well as the debt obligations of GTE LLC, as successor in interest to GTE Corporation, that were issued and outstanding prior to July 1, 2003. See Note 7 to the consolidated financial statements for additional information.In connection with the execution of agreements for the sale of businesses and investments, Verizon ordinarily provides representations and warranties to the purchasers pertaining to a variety of nonfinancial matters, such as ownership of the securities being sold, as well as financial losses. See Note 16 to the consolidated financial statements for additional information.As of December 31, 2020, letters of credit totaling approximately $677 million, which were executed in the normal course of business and support several financing arrangements and payment obligations to third parties, were outstanding. See Note 16 to the consolidated financial statements for additional information.Other Future ObligationsDuring 2020, Verizon entered into 12 renewable energy purchase agreements (REPAs) with third parties, in addition to one signed in 2019. See Note 16 to the consolidated financial statements for additional information. Under our REPA arrangements, we plan to purchase up to an aggregate of nearly 1.7 gigawatts of capacity across multiple states, including Illinois, Indiana, Maryland, New York, North Carolina, Ohio, Pennsylvania, Texas and West Virginia.43Table of ContentsCritical Accounting Estimates and Recently Issued Accounting StandardsCritical Accounting EstimatesA summary of the critical accounting estimates used in preparing our financial statements is as follows:Wireless Licenses and GoodwillWireless licenses and Goodwill are a significant component of our consolidated assets. Both our wireless licenses and goodwill are treated as indefinite-lived intangible assets and, therefore are not amortized, but rather are tested for impairment annually in the fourth fiscal quarter, unless there are events requiring an earlier assessment or changes in circumstances during an interim period providing impairment indicators are present. We believe our estimates and assumptions are reasonable and represent appropriate marketplace considerations as of the valuation date. Although we use consistent methodologies in developing the assumptions and estimates underlying the fair value calculations used in our impairment tests, these estimates and assumptions are uncertain by nature, may change over time and can vary from actual results. It is possible that in the future there may be changes in our estimates and assumptions, including the timing and amount of future cash flows, margins, growth rates, market participant assumptions, comparable benchmark companies and related multiples and discount rates, which could result in different fair value estimates. Significant and adverse changes to any one or more of the above-noted estimates and assumptions could result in a goodwill impairment for one or more of our reporting units.Wireless LicensesThe carrying value of our wireless licenses was approximately $96.1 billion as of December 31, 2020. We aggregate our wireless licenses into one single unit of accounting, as we utilize our wireless licenses on an integrated basis as part of our nationwide wireless network. Our wireless licenses provide us with the exclusive right to utilize certain radio frequency spectrum to provide wireless communication services. There are currently no legal, regulatory, contractual, competitive, economic or other factors that limit the useful life of our wireless licenses.In the first quarter of 2020, we reclassified substantially all of our 39 GHz wireless licenses, including capitalized interest, with a carrying value of $2.8 billion to assets held for sale in connection with the FCC's incentive auction, Auction 103. As a result, these wireless licenses were adjusted down to their fair value of $1.6 billion resulting in a pre-tax loss of $1.2 billion ($914 million after-tax).During the fourth quarter of 2020 and 2019, we performed a qualitative impairment assessment as our annual impairment test to determine whether it is more likely than not that the fair value of our wireless licenses was less than the carrying amount. As part of our assessment we considered several qualitative factors including the business enterprise value of our combined wireless business, macroeconomic conditions (including changes in interest rates and discount rates), industry and market considerations (including industry revenue and EBITDA margin results, projections and recent merger and acquisition activity), the recent and projected financial performance of our combined wireless business as a whole, as well as other factors. Our annual impairment tests in 2020 and 2019 indicated that it is more likely than not that the fair value of our wireless licenses remained above their carrying value and, therefore, did not result in an impairment. Goodwill To determine if goodwill is potentially impaired, we have the option to perform a qualitative assessment to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying value. If we elect not to conduct the qualitative assessment or if indications of a potential impairment exist, the determination of whether an impairment has occurred requires the determination of the fair value of each the reporting unit being assessed.Under the qualitative assessment, we consider several qualitative factors, including the business enterprise value of the reporting unit from the last quantitative test and the excess of fair value over carrying value from this test, macroeconomic conditions (including changes in interest rates and discount rates), industry and market considerations (including industry revenue and EBITDA margin results, projections and recent merger and acquisition activity), the recent and projected financial performance of the reporting unit, as well as other factors. Under our quantitative assessment, the fair value of the reporting unit is calculated using a market approach and a discounted cash flow method, as a form of the income approach. The market approach includes the use of comparative multiples to corroborate discounted cash flow results. The discounted cash flow method is based on the present value of two components-projected cash flows and a terminal value. The terminal value represents the expected normalized future cash flows of the reporting unit beyond the cash flows from the discrete projection period. The fair value of the reporting unit is calculated based on the sum of the present value of the cash flows from the discrete period and the present value of the terminal value. The discount rate represented our estimate of the weighted-average cost of capital (WACC), or expected return, that a marketplace participant would have required as of the valuation date. The application of our goodwill impairment test required key assumptions underlying our valuation model. The discounted cash flow analysis factored in assumptions on discount rates and terminal growth rates to reflect risk profiles of key strategic revenue and cost initiatives, as well as revenue and EBITDA growth relative to history and market trends and expectations. The market multiples approach incorporated significant judgment involved in the selection comparable public company multiples and benchmarks. The selection of companies was influenced by differences in growth and profitability, and volatility in market prices of peer companies. These valuation inputs are inherently uncertain, and an adverse change in one or a combination of these inputs could trigger a goodwill impairment loss in the future.A projected sustained decline in a reporting unit's revenues and earnings could have a significant negative impact on its fair value and may result in impairment charges. Such a decline could be driven by, among other things: (1) further anticipated decreases in service pricing, sales volumes and long-term growth rate as a result of competitive pressures or other factors; or (2) the inability to achieve or delays in achieving 44Table of Contentsthe goals in strategic initiatives. Also, adverse changes to macroeconomic factors, such as increases to long-term interest rates, would also negatively impact the fair value of the reporting unit. At December 31, 2020, the balance of our goodwill was approximately $24.8 billion, of which $17.2 billion was in our Consumer reporting unit and $7.5 billion was in our Business reporting unit. We performed qualitative impairment assessments for our Consumer and Business reporting units during the fourth quarter of 2020. Our qualitative assessments indicated that it was more likely than not that the fair values for our Consumer and Business reporting units exceeded their respective carrying values and, therefore, did not result in an impairment. In November 2018, we announced a strategic reorganization of our business, which resulted in changes to our segments and reporting units effective April 1, 2019. As a result, we performed impairment assessments of the reporting units impacted by the strategic reorganization, specifically our historical Wireless, historical Wireline and historical Connect reporting units on March 31, 2019, immediately before our strategic reorganization became effective. Our impairment assessments indicated that the fair value for each of our historical Wireless, historical Wireline and historical Connect reporting units exceeded their respective carrying values, and therefore did not result in a goodwill impairment. We then performed quantitative assessments of our Consumer and Business reporting units on April 1, 2019, immediately following our strategic reorganization. Our impairment assessments indicated that the fair value for each of our Consumer and Business reporting units exceeded their respective carrying values and therefore, did not result in a goodwill impairment. Our Media reporting unit was not impacted by the strategic reorganization and there was no indicator of impairment as of the reorganization date.We performed qualitative impairment assessments for our Consumer and Business reporting units during the fourth quarter of 2019. Our qualitative assessments indicated that it was more likely than not that the fair values of our Consumer and Business reporting units exceeded their respective carrying values and, therefore, did not result in an impairment. We performed a quantitative impairment assessment for our Media reporting unit in 2019. In connection with Verizon’s annual budget process during the fourth quarter of 2019, the leadership at both Verizon Media and Verizon completed a comprehensive five-year strategic planning review of Verizon Media's business prospects resulting in unfavorable adjustments to Verizon Media's financial projections. These revised projections were used as a key input into Verizon Media's annual goodwill impairment test performed in the fourth quarter of 2019. During the fourth quarter of 2019, consistent with our accounting policy, we applied a combination of a market approach and a discounted cash flow method reflecting current assumptions and inputs, including our revised projections, discount rate and expected growth rates, which resulted in the determination that the fair value of the Media reporting unit was less than its carrying amount. As a result, we recorded a non-cash goodwill impairment charge of approximately $186 million ($176 million after-tax) in the fourth quarter of 2019 in our consolidated statement of income. The goodwill balance of the Media reporting unit had been fully written off as a result of the impairment charge. At December 31, 2019, the balance of our goodwill was approximately $24.4 billion, of which $17.1 billion was in our Consumer reporting unit and $7.3 billion was in our Business reporting unit. Pension and Other Postretirement Benefit Plans We maintain benefit plans for most of our employees, including, for certain employees, pension and other postretirement benefit plans. At December 31, 2020, in the aggregate, pension plan benefit obligations exceeded the fair value of pension plan assets, which will result in future pension plan expense. Other postretirement benefit plans have larger benefit obligations than plan assets, resulting in expense. Significant benefit plan assumptions, including the discount rate used, the long-term rate of return on plan assets, the determination of the substantive plan and health care trend rates are periodically updated and impact the amount of benefit plan income, expense, assets and obligations. Changes to one or more of these assumptions could significantly impact our accounting for pension and other postretirement benefits. A sensitivity analysis of the impact of changes in these assumptions on the benefit obligations and expense (income) recorded, as well as on the funded status due to an increase or a decrease in the actual versus expected return on plan assets as of December 31, 2020 and for the year then ended pertaining to Verizon’s pension and postretirement benefit plans, is provided in the table below.(dollars in millions)Percentage pointchangeIncrease/(decrease) at December 31, 2020*Pension plans discount rate+0.50$(1,258)-0.501,416 Rate of return on pension plan assets+1.00(182)-1.00182 Postretirement plans discount rate+0.50(920)-0.501,032 Rate of return on postretirement plan assets+1.00(6)-1.006 * In determining its pension and other postretirement obligation, the Company used a weighted-average discount rate of 2.6%. The rate was selected to approximate the composite interest rates available on a selection of high-quality bonds available in the market at December 31, 2020. The bonds selected had maturities that coincided with the time periods during which benefit payments are expected to occur, were non-callable and available in sufficient quantities to ensure marketability (at least $300 million par outstanding). The annual measurement date for both our pension and other postretirement benefits is December 31. We use the full yield curve approach to estimate the interest cost component of net periodic benefit cost for pension and other postretirement benefits. The full yield curve approach 45Table of Contentsrefines our estimate of interest cost by applying the individual spot rates from a yield curve composed of the rates of return on several hundred high-quality fixed income corporate bonds available at the measurement date. These individual spot rates align with the timing of each future cash outflow for benefit payments and therefore provide a more precise estimate of interest cost.Income Taxes Our current and deferred income taxes and associated valuation allowances are impacted by events and transactions arising in the normal course of business as well as in connection with the adoption of new accounting standards, changes in tax laws and rates, acquisitions and dispositions of businesses and non-recurring items. As a global commercial enterprise, our income tax rate and the classification of income taxes can be affected by many factors, including estimates of the timing and realization of deferred income tax assets and the timing and amount of income tax payments. We account for tax benefits taken or expected to be taken in our tax returns in accordance with the accounting standard relating to the uncertainty in income taxes, which requires the use of a two-step approach for recognizing and measuring tax benefits taken or expected to be taken in a tax return. We review and adjust our liability for unrecognized tax benefits based on our best judgment given the facts, circumstances and information available at each reporting date. To the extent that the final outcome of these tax positions is different than the amounts recorded, such differences may impact income tax expense and actual tax payments. We recognize any interest and penalties accrued related to unrecognized tax benefits in income tax expense. Actual tax payments may materially differ from estimated liabilities as a result of changes in tax laws as well as unanticipated transactions impacting related income tax balances. See Note 12 to the consolidated financial statements for additional information.Property, Plant and Equipment Our Property, plant and equipment balance represents a significant component of our consolidated assets. We record Property, plant and equipment at cost. We depreciate Property, plant and equipment on a straight-line basis over the estimated useful life of the assets. We expect that a one year increase in estimated useful lives of our Property, plant and equipment would result in a decrease to our 2020 depreciation expense of $2.7 billion and that a one year decrease would result in an increase of approximately $4.5 billion in our 2020 depreciation expense.Accounts Receivable Prior to January 1, 2020, accounts receivable were recorded at cost less an allowance for doubtful accounts. The gross amount of accounts receivable and corresponding allowance for doubtful accounts were presented separately in the consolidated balance sheets. We maintained allowances for uncollectible accounts receivable, including our direct-channel device payment plan agreement receivables, for estimated losses resulting from the failure or inability of our customers to make required payments. Indirect-channel device payment receivables are considered financial instruments and were initially recorded at fair value net of imputed interest, and credit losses were recorded as incurred. However, receivable balances were assessed quarterly for impairment and an allowance was recorded if the receivable was considered impaired. Subsequent to January 1, 2020, accounts receivable are recorded at amortized cost less an allowance for credit losses that are not expected to be recovered. The gross amount of accounts receivable and corresponding allowance for credit losses are presented separately in the consolidated balance sheets. We maintain allowances for credit losses resulting from the expected failure or inability of our customers to make required payments. We recognize the allowance for credit losses at inception and reassess quarterly based on management’s expectation of the asset’s collectability. The allowance is based on multiple factors including historical experience with bad debts, the credit quality of the customer base, the aging of such receivables and current macroeconomic conditions, such as the COVID-19 pandemic, as well as management’s expectations of conditions in the future, if applicable. Our allowance for credit losses is based on management’s assessment of the collectability of assets pooled together with similar risk characteristics.We record an allowance to reduce the receivables to the amount that is expected to be collectible. For device payment plan agreement receivables, we record bad debt expense based on a default and loss calculation using our proprietary loss model. The expected loss rate is determined based on customer credit scores and other qualitative factors as noted above. The loss rate is assigned individually on a customer by customer basis and the custom credit scores are then aggregated by vintage and used in our proprietary loss model to calculate the weighted-average loss rate used for determining the allowance balance.We monitor the collectability of our wireless service receivables as one overall pool. Wireline service receivables are disaggregated and pooled by the following customer groups: consumer, small and medium business, global enterprise, public sector and wholesale. For wireless service receivables and wireline consumer and small and medium business receivables, the allowance is calculated based on a 12 month rolling average write-off balance multiplied by the average life-cycle of an account from billing to write-off. The risk of loss is assessed over the contractual life of the receivables and we adjust the historical loss amounts for current and future conditions based on management’s qualitative considerations. For global enterprise, public sector and wholesale wireline receivables, the allowance for credit losses is based on historical write-off experience and individual customer credit risk, if applicable. We consider multiple factors in determining the allowance as discussed above.If there is a deterioration of our customers’ financial condition or if future actual default rates on receivables in general differ from those currently anticipated, we may have to adjust our allowance for credit losses, which would affect earnings in the period the adjustments are made.46Table of ContentsAcquisitions and DivestituresBlue Jeans Network, Inc.In April 2020, we entered into a definitive purchase agreement to acquire BlueJeans, an enterprise-grade video conferencing and event platform, whose services are sold to Business customers globally. The transaction closed in May 2020. The aggregate cash consideration paid by Verizon at the closing of the transaction was approximately $397 million, net of cash acquired. See Note 3 to the consolidated financial statements for additional information.TracFone Wireless, Inc.In September 2020, we entered into a purchase agreement (Tracfone Purchase Agreement) with América Móvil to acquire Tracfone, a provider of prepaid and value mobile services in the U.S. Under the terms of the Tracfone Purchase Agreement, we will acquire all of the stock of Tracfone for approximately $3.1 billion in cash and $3.1 billion in Verizon common stock, subject to customary adjustments, at closing. The number of shares issued will be based on an average trading price determined as of the closing date and is subject to a minimum number of shares issuable of 47,124,445 and a maximum number of shares issuable of 57,596,544. The Tracfone Purchase Agreement also includes up to an additional $650 million in future cash consideration related to the achievement of certain performance measures and other commercial arrangements. The transaction is subject to regulatory approvals and closing conditions and is expected to close in the second half of 2021. Bluegrass CellularIn October 2020, we entered into a definitive agreement to acquire certain assets of Bluegrass Cellular, a rural wireless operator serving central Kentucky. Bluegrass Cellular provides wireless service to 210,000 customers in 34 counties in rural service areas 3, 4, and 5 in Central Kentucky. The transaction is subject to regulatory approvals and closing conditions and is expected to close in the first quarter of 2021.Spectrum License TransactionsFrom time to time, we enter into agreements to buy, sell or exchange spectrum licenses. We believe these spectrum license transactions have allowed us to continue to enhance the reliability of our wireless network while also resulting in a more efficient use of spectrum. See Note 3 to the consolidated financial statements for additional information regarding our spectrum license transactions.OtherFrom time to time, we enter into strategic agreements to acquire various other businesses and investments. See Note 3 to the consolidated financial statements for additional information.In November 2020, Verizon entered into an agreement to sell our Huffington Post business. In connection with this transaction, we recorded a pre-tax loss of $126 million in Selling, general and administrative expense in our consolidated statement of income for the year ended December 31, 2020. The transaction closed in February 2021.Item 7A. Quantitative and Qualitative Disclosures About Market RiskWe are exposed to various types of market risk in the normal course of business, including the impact of interest rate changes, foreign currency exchange rate fluctuations, changes in investment, equity and commodity prices and changes in corporate tax rates. We employ risk management strategies, which may include the use of a variety of derivatives including cross currency swaps, forward starting interest rate swaps, interest rate swaps, interest rate caps, treasury rate locks and foreign exchange forwards. We do not hold derivatives for trading purposes.It is our general policy to enter into interest rate, foreign currency and other derivative transactions only to the extent necessary to achieve our desired objectives in optimizing exposure to various market risks. Our objectives include maintaining a mix of fixed and variable rate debt to lower borrowing costs within reasonable risk parameters and to protect against earnings and cash flow volatility resulting from changes in market conditions. We do not hedge our market risk exposure in a manner that would completely eliminate the effect of changes in interest rates and foreign exchange rates on our earnings. Counterparties to our derivative contracts are major financial institutions with whom we have negotiated derivatives agreements (ISDA master agreements) and credit support annex (CSA) agreements which provide rules for collateral exchange. The CSA agreements contain rating based thresholds such that we or our counterparties may be required to hold or post collateral based upon changes in outstanding positions as compared to established thresholds and changes in credit ratings. We do not offset fair value amounts recognized for derivative instruments and fair value amounts recognized for the right to reclaim cash collateral or the obligation to return cash collateral arising from derivative instruments recognized at fair value. At December 31, 2020, we held $0.2 billion of collateral related to derivative contracts under collateral exchange agreements, which were recorded as Other current liabilities in our consolidated balance sheet. At December 31, 2019, we held an insignificant amount of collateral related to derivative contracts under collateral exchange arrangements, which were recorded as Other current liabilities in our consolidated balance sheet. While we may be exposed to credit losses due to the nonperformance of our counterparties, we consider the risk remote and do not expect that any such nonperformance would result in a significant effect on our results of operations or financial condition due to our diversified pool of counterparties. See Note 9 to the consolidated financial statements for additional information regarding the derivative portfolio.47Table of ContentsInterest Rate RiskWe are exposed to changes in interest rates, primarily on our short-term debt and the portion of long-term debt that carries floating interest rates. As of December 31, 2020, approximately 83% of the aggregate principal amount of our total debt portfolio consisted of fixed rate indebtedness, including the effect of interest rate swap agreements designated as hedges. The impact of a 100-basis-point change in interest rates affecting our floating rate debt would result in a change in annual interest expense, including our interest rate swap agreements that are designated as hedges, of approximately $227 million. The interest rates on our existing long-term debt obligations are unaffected by changes to our credit ratings.Certain of our floating rate debt and our interest rate derivative transactions utilize interest rates that are linked to LIBOR as the benchmark rate. LIBOR is the subject of recent U.S. and international regulatory guidance and proposals for reform. These reforms and other pressures may cause LIBOR to become unavailable or to perform or be reported differently than in the past. The consequences of these developments cannot be entirely predicted but could include an increase in the cost of our floating rate debt or exposure under our interest rate derivative transactions. We do not anticipate a significant impact to our financial position given our current mix of variable and fixed-rate debt, taking into account the impact of our interest rate hedging.The table that follows summarizes the fair values of our long-term debt, including current maturities, and interest rate swap derivatives as of December 31, 2020 and 2019. The table also provides a sensitivity analysis of the estimated fair values of these financial instruments assuming 100-basis-point upward and downward shifts in the yield curve. Our sensitivity analysis does not include the fair values of our commercial paper and bank loans, if any, because they are not significantly affected by changes in market interest rates.(dollars in millions)Long-term debt and related derivativesFair ValueFair Value assuming+ 100 basis point shiftFair Value assuming - 100 basis point shiftAt December 31, 2020$155,695 $142,420 $170,423 At December 31, 2019128,633 119,288 139,980 Interest Rate SwapsWe enter into interest rate swaps to achieve a targeted mix of fixed and variable rate debt. We principally receive fixed rates and pay variable rates that are currently based on LIBOR, resulting in a net increase or decrease to Interest expense. These swaps are designated as fair value hedges and hedge against interest rate risk exposure of designated debt issuances. At December 31, 2020, the fair value of the asset and liability of these contracts were $787 million and $303 million, respectively. At December 31, 2019, the fair value of the asset and liability of these contracts were $568 million and $173 million, respectively. At December 31, 2020 and 2019, the total notional amount of the interest rate swaps was $17.8 billion and $17.0 billion, respectively.Forward Starting Interest Rate SwapsWe have entered into forward starting interest rate swaps designated as cash flow hedges in order to manage our exposure to interest rate changes on future forecasted transactions. At December 31, 2020 and 2019, the fair value of the liability of these contracts was $797 million and $604 million, respectively. At December 31, 2020 and 2019, the total notional amount of the forward starting interest rate swaps was $2.0 billion and $3.0 billion, respectively. Interest Rate CapsWe also have interest rate caps which we use as an economic hedge but for which we have elected not to apply hedge accounting. We enter into interest rate caps to mitigate our interest exposure to interest rate increases on our ABS Financing Facilities and ABS Notes. The fair value of the asset and liability of these contracts was insignificant at both December 31, 2020 and 2019. At December 31, 2020, there was no outstanding total notional amount for these contracts and, at December 31, 2019, the total notional amount of these contracts was $679 million.Treasury Rate LocksWe enter into treasury rate locks to mitigate our interest rate risk. There was no outstanding notional amount for treasury rate locks at December 31, 2020 or 2019.Foreign Currency TranslationThe functional currency for our foreign operations is primarily the local currency. The translation of income statement and balance sheet amounts of our foreign operations into U.S. dollars is recorded as cumulative translation adjustments, which are included in Accumulated other comprehensive income (loss) in our consolidated balance sheets. Gains and losses on foreign currency transactions are recorded in the consolidated statements of income in Other income (expense), net. At December 31, 2020, our primary translation exposure was to the British Pound Sterling, Euro, Australian Dollar, Canadian Dollar and Japanese Yen.48Table of ContentsCross Currency SwapsWe have entered into cross currency swaps designated as cash flow hedges to exchange our British Pound Sterling, Euro, Swiss Franc, Canadian Dollar and Australian Dollar-denominated cash flows into U.S. dollars and to fix our cash payments in U.S. dollars, as well as to mitigate the impact of foreign currency transaction gains or losses. The fair value of the asset of these contracts was $1.4 billion and $211 million at December 31, 2020 and 2019, respectively. At December 31, 2020 and 2019, the fair value of the liability of these contracts was $196 million and $912 million, respectively. At December 31, 2020 and 2019, the total notional amount of the cross currency swaps was $26.3 billion and $23.1 billion, respectively.Foreign Exchange ForwardsWe also have foreign exchange forwards which we use as an economic hedge but for which we have elected not to apply hedge accounting. We enter into British Pound Sterling and Euro foreign exchange forwards to mitigate our foreign exchange rate risk related to non-functional currency denominated monetary assets and liabilities of international subsidiaries, as well as foreign exchange risk related to debt settlements. At both December 31, 2020 and 2019, the fair value of the asset and liability of these contracts was insignificant. At December 31, 2020 and 2019, the total notional amount of the foreign exchange forwards was $1.4 billion and $1.1 billion, respectively.49Table of Contents
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+ITEM 7. Management’s Discussion and Analysis of Financial Condition and Results of OperationsThe following discussion provides information that management believes is relevant to an understanding and assessment of the consolidated financial condition and results of operations of Ventas, Inc. You should read this discussion in conjunction with our Consolidated Financial Statements and the notes thereto included in Part II, Item 8 of this Annual Report and our Risk Factors included in Part I, Item 1A of this Annual Report.Business Summary and Overview of 2020 Ventas, Inc., an S&P 500 company, is a real estate investment trust (“REIT”) operating at the intersection of healthcare and real estate, with a highly diversified portfolio of senior housing; life science, research and innovation; and healthcare properties; which we generally refer to as “healthcare real estate,” located throughout the United States, Canada and the United Kingdom. As of December 31, 2020, we owned or managed through unconsolidated real estate entities approximately 1,200 properties (including properties classified as held for sale), consisting of senior housing communities, medical office buildings (“MOBs”), life science, research and innovation centers, inpatient rehabilitation facilities (“IRFs”) and long-term acute care facilities (“LTACs”), and health systems. Our company was originally founded in 1983 and is headquartered in Chicago, Illinois with an additional office in Louisville, Kentucky. We primarily invest in a diversified portfolio of healthcare real estate assets through wholly owned subsidiaries and other co-investment entities. We operate through three reportable business segments: triple-net leased properties, senior living operations, which we also refer to as SHOP, and office operations. See our Consolidated Financial Statements and the related notes, including “Note 2 – Accounting Policies” and “Note 19 – Segment Information,” included in Part II, Item 8 of this Annual Report. Our senior housing properties are either operated under triple-net leases in our triple-net leased properties segment or through independent third-party managers in our senior living operations segment.39We aim to enhance shareholder value by delivering consistent, superior total returns by (1) generating reliable and growing cash flows, (2) maintaining a balanced, diversified portfolio of high-quality assets and (3) preserving our financial strength, flexibility and liquidity.Our ability to access capital in a timely and cost-effective manner is critical to the success of our business strategy because it affects our ability to satisfy existing obligations, including the repayment of maturing indebtedness, and to make future investments. Factors such as general market conditions, interest rates, credit ratings on our securities, expectations of our potential future earnings and cash distributions, and the trading price of our common stock impact our access to and cost of external capital. For that reason, we generally attempt to match the long-term duration of our investments in real property with long-term financing through the issuance of shares of our common stock or the incurrence of long-term fixed rate debt.COVID-19 UpdateDuring fiscal 2020 and continuing into fiscal 2021, the COVID-19 pandemic has negatively affected our businesses in a number of ways and is expected to continue to do so. Operating Results. Our senior living operations segment, which we also refer to as SHOP, was significantly impacted by the COVID-19 pandemic. Occupancy decreased over the course of 2020, while operating expenses increased as our senior living communities responded to the pandemic, resulting in a significant decline in NOI compared to 2019. Our NNN senior housing tenants’ performance was similarly affected by COVID-19. During the course of 2020, we modified certain NNN senior housing leases to reset rent and provided other modest financial accommodations to certain NNN senior housing tenants who needed it as a result of COVID-19. We also wrote-off previously accrued straight-line rental income related to NNN senior housing tenants due to COVID-19. However, we benefited from our ongoing strategy of diversification, with our office and NNN healthcare businesses demonstrating resilience in the face of the pandemic. The Company’s NNN healthcare tenants benefited from significant government financial support that was deployed early and has partially offset the direct financial impact of the pandemic. Our office operations segment, which primarily serves MOB and research and innovation tenants that were less impacted by the pandemic, delivered steady performance throughout the year. Provider Relief Grants. In the third and fourth quarter of 2020, we applied for grants under Phase 2 and Phase 3 of the Provider Relief Fund administered by the U.S. Department of Health & Human Services (“HHS”) on behalf of the assisted living communities in our senior living operations segment to partially mitigate losses attributable to COVID-19. These grants are intended to reimburse eligible providers for expenses incurred to prevent, prepare for and respond to COVID-19 and lost revenues attributable to COVID-19. Recipients are not required to repay distributions from the Provider Relief Fund, provided that they attest to and comply with certain terms and conditions. See “Government Regulation—Governmental Response to the COVID-19 Pandemic” in Part I, Item 1 of this Annual Report. During the fourth quarter of 2020, we received $34.3 million and $0.8 million in grants in connection with our Phase 2 and Phase 3 applications, respectively, and recognized these grants within property-level operating expenses in our Consolidated Statements of Income. Subsequent to December 31, 2020, we received $13.6 million in grants in connection with our Phase 3 applications, which we expect to recognize in 2021. While we have received all amounts under our Phase 2 applications and have begun to receive amounts under our Phase 3 applications, there can be no assurance that our remaining applications will be approved or that additional funds will ultimately be received. Any grants that are ultimately received and retained by us are not expected to fully offset the losses incurred in our senior living operating portfolio that are attributable to COVID-19. Further, although we continue to monitor and evaluate the terms and conditions associated with the Provider Relief Fund distributions, we cannot assure you that we will be in compliance with all requirements related to the payments received under the Provider Relief Fund. Capital Conservation Actions. In response to the COVID-19 pandemic, we took precautionary steps to increase liquidity and preserve financial flexibility in light of the resulting uncertainty. See “—Liquidity and Capital Resources; Recent Capital Conservation Actions.” As of February 16, 2021, we had approximately $3.0 billion in liquidity, including availability under our revolving credit facility and cash and cash equivalents on hand, with no borrowings outstanding under our commercial paper program and negligible near-term debt maturing.Continuing Impact. The trajectory and future impact of the COVID-19 pandemic remains highly uncertain. The extent of the pandemic’s continuing and ultimate effect on our operational and financial performance will depend on a variety of factors, including the speed at which available vaccines can be successfully deployed; the rate of acceptance of available vaccines, particularly among the residents and staff in our senior housing communities; the impact of new variants of the virus 40and the effectiveness of available vaccines against those variants; ongoing clinical experience, which may differ considerably across regions and fluctuate over time; and on other future developments, including the ultimate duration, spread and intensity of the outbreak, the availability of testing, the extent to which governments impose, roll-back or re-impose preventative restrictions and the availability of ongoing government financial support to our business, tenants and operators. Due to these uncertainties, we are not able at this time to estimate the ultimate impact of the COVID-19 pandemic on our business, results of operations, financial condition and cash flows.See “Note 1 - Description of Business - COVID-19 Update” for a description of charges recognized during the year ended December 31, 2020 as a result of the COVID-19 pandemic.Select 2020 and Early 2021 HighlightsCOVID-19 Response•Since the start of the COVID-19 pandemic, in addition to actions described under “COVID-19 Update” above, we have consistently prioritized the health and safety of employees, residents, tenants and managers, serving as an important resource for information and best practices and leading our industry in testing, including through an early arrangement with Mayo Clinic Laboratories.•We executed on a multi-pronged capital conservation strategy to mitigate the impact of COVID-19, including reducing our planned capital expenditures, reducing capital commitments, establishing a quarterly dividend of $0.45 per share beginning in the second quarter and adjusting the Company’s corporate cost structure.Ventas Investment Management•We established a third party capital platform, Ventas Investment Management (“VIM”), bringing together our third party capital ventures under one umbrella, including the Ventas Life Science and Healthcare Real Estate Fund, L.P. (the “Ventas Fund”) and our research and innovation (“R&I”) development joint venture with GIC (the “R&I Development JV”) described below. As of December 31, 2020, VIM had over $3 billion in assets under management.•In March 2020, we formed the Ventas Fund, a perpetual life investment vehicle focused on investments in research and innovation centers, medical office buildings and senior housing communities in North America. We are the sponsor and general partner of the Ventas Fund. To seed the Ventas Fund, we contributed six stabilized research and innovation and medical office properties and received cash consideration of $620 million and a 21% interest in the Ventas Fund. In October 2020, the Ventas Fund acquired a portfolio of three life science properties in the South San Francisco life science cluster for $1.0 billion.•In October 2020, we formed the R&I Development JV with GIC. To seed the R&I Development JV, we contributed our controlling interest in four in-progress university-based research and innovation development projects whose total expected cost approximates $930 million. Investments and Dispositions•During the year ended December 31, 2020, we acquired 10 properties for an aggregate consideration of $249.5 million.•During the year ended December 31, 2020, we recognized $262.2 million of gains on sale of real estate including 2020, including $225.1 million for the sale of six properties to the Ventas Fund, $13.7 million for the sale of four in-progress development projects to the R&I Development JV and and $23.4 million for the sale of 31 other properties.•During the year ended December 31, 2020, we received aggregate proceeds of $106.1 million for the full repayment of the principal balances of various loans receivable with a weighted average interest rate of 8.3% that were due to mature between 2020 and 2025, resulting in total gains of $1.4 million.41Liquidity and Capital •As of December 31, 2020, we had approximately $3.3 billion in liquidity, including availability under our revolving credit facility and cash and cash equivalents on hand, with no borrowings outstanding under our commercial paper program and negligible near-term debt maturing.•In April 2020, we raised $500.0 million through the issuance of 4.75% senior notes due 2030. •In October 2020,we reduced near-term debt maturities by retiring $236.3 million aggregate principal amount then outstanding of our 3.25% senior notes due 2022 at 104.14% of par value, plus accrued and unpaid interest to the payment date. •During 2020, we sold an aggregate of 1.5 million shares of common stock under our “at-the-market” equity offering program for average gross proceeds of $44.88 per share.•In January 2021, we entered into an amended and restated unsecured credit facility (the “New Credit Facility”) comprised of a $2.75 billion unsecured revolving credit facility initially priced at LIBOR plus 82.5 basis points.•In February 2021, in order to reduce near-term maturities, we issued a make whole redemption for the entirety of the $400 million outstanding aggregate principal amount of 3.10% senior notes due January 2023. The redemption is expected to settle in March 2021, principally using cash on hand.Portfolio•In July 2020, we entered into a revised master lease agreement (the “Brookdale Lease”) and certain other agreements (together with the Brookdale Lease, the “Agreements”) with Brookdale Senior Living.•In April 2020, we completed a transaction with affiliates of Holiday Retirement (with its affiliates, collectively, “Holiday”), including entry into a new, terminable management agreement for our 26 independent living assets that were previously subject to a triple-net lease (the “Holiday Lease”) with Holiday.Environmental, Social and Governance•During 2020, we continued our leadership in ESG, receiving numerous accolades, including the 2020 Nareit Health Care “Leader in the Light” award for a fourth consecutive year, the 2020 Bloomberg Gender-Equality Index for the second consecutive year, the 2020 Dow Jones Sustainability World Index for the second consecutive year and maintaining our industry-leading position in GRESB.Critical Accounting Policies and EstimatesOur Consolidated Financial Statements included in Part II, Item 8 of this Annual Report have been prepared in accordance with U.S. generally accepted accounting principles (“GAAP”) set forth in the Accounting Standards Codification (“ASC”), as published by the Financial Accounting Standards Board (“FASB”). GAAP requires us to make estimates and assumptions regarding future events that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting periods. We base these estimates on our experience and assumptions we believe to be reasonable under the circumstances. However, if our judgment or interpretation of the facts and circumstances relating to various transactions or other matters had been different, we may have applied a different accounting treatment, resulting in a different presentation of our financial statements. We periodically reevaluate our estimates and assumptions, and in the event they prove to be different from actual results, we make adjustments in subsequent periods to reflect more current estimates and assumptions about matters that are inherently uncertain. We believe that the critical accounting policies described below, among others, affect our more significant estimates and judgments used in the preparation of our financial statements. For more information regarding our critical accounting policies, see “Note 2 – Accounting Policies” of the Notes to Consolidated Financial Statements included in Part II, Item 8 of this Annual Report.42Principles of ConsolidationThe Consolidated Financial Statements included in Part II, Item 8 of this Annual Report include our accounts and the accounts of our wholly owned subsidiaries and the joint venture entities over which we exercise control. All intercompany transactions and balances have been eliminated in consolidation, and our net earnings are reduced by the portion of net earnings attributable to noncontrolling interests.GAAP requires us to identify entities for which control is achieved through means other than voting rights and to determine which business enterprise is the primary beneficiary of variable interest entities (“VIEs”). A VIE is broadly defined as an entity with one or more of the following characteristics: (a) the total equity investment at risk is insufficient to finance the entity’s activities without additional subordinated financial support; (b) as a group, the holders of the equity investment at risk lack (i) the ability to make decisions about the entity’s activities through voting or similar rights, (ii) the obligation to absorb the expected losses of the entity, or (iii) the right to receive the expected residual returns of the entity; and (c) the equity investors have voting rights that are not proportional to their economic interests, and substantially all of the entity’s activities either involve, or are conducted on behalf of, an investor that has disproportionately few voting rights. We consolidate our investment in a VIE when we determine that we are its primary beneficiary. We may change our original assessment of a VIE upon subsequent events such as the modification of contractual arrangements that affects the characteristics or adequacy of the entity’s equity investments at risk and the disposition of all or a portion of an interest held by the primary beneficiary.We identify the primary beneficiary of a VIE as the enterprise that has both: (i) the power to direct the activities of the VIE that most significantly impact the entity’s economic performance; and (ii) the obligation to absorb losses or the right to receive benefits of the VIE that could be significant to the entity. We perform this analysis on an ongoing basis. Accounting for Real Estate Acquisitions When we acquire real estate, we first make reasonable judgments about whether the transaction involves an asset or a business. Our real estate acquisitions are generally accounted for as asset acquisitions as substantially all of the fair value of the gross assets acquired is concentrated in a single identifiable asset or group of similar identifiable assets. Regardless of whether an acquisition is considered a business combination or an asset acquisition, we record the cost of the businesses or assets acquired as tangible and intangible assets and liabilities based upon their estimated fair values as of the acquisition date. We estimate the fair value of buildings acquired on an as-if-vacant basis or replacement cost basis and depreciate the building value over the estimated remaining life of the building, generally not to exceed 35 years. We determine the fair value of other fixed assets, such as site improvements and furniture, fixtures and equipment, based upon the replacement cost and depreciate such value over the assets’ estimated remaining useful lives as determined at the applicable acquisition date. We determine the value of land either by considering the sales prices of similar properties in recent transactions or based on internal analyses of recently acquired and existing comparable properties within our portfolio. We generally determine the value of construction in progress based upon the replacement cost. However, for certain acquired properties that are part of a ground-up development, we determine fair value by using the same valuation approach as for all other properties and deducting the estimated cost to complete the development. During the remaining construction period, we capitalize project costs until the development has reached substantial completion. Construction in progress, including capitalized interest, is not depreciated until the development has reached substantial completion. Intangibles primarily include the value of in-place leases and acquired lease contracts. We include all lease-related intangible assets and liabilities within acquired lease intangibles and accounts payable and other liabilities, respectively, on our Consolidated Balance Sheets. The fair value of acquired lease-related intangibles, if any, reflects: (i) the estimated value of any above or below market leases, determined by discounting the difference between the estimated market rent and in-place lease rent; and (ii) the estimated value of in-place leases related to the cost to obtain tenants, including leasing commissions, and an estimated value of the absorption period to reflect the value of the rent and recovery costs foregone during a reasonable lease-up period as if the acquired space was vacant. We amortize any acquired lease-related intangibles to revenue or amortization expense over the remaining life of the associated lease plus any assumed bargain renewal periods. If a lease is terminated prior to its stated expiration or not renewed upon expiration, we recognize all unamortized amounts of lease-related intangibles associated with that lease in operations over the shortened lease term. We estimate the fair value of purchase option intangible assets and liabilities, if any, by discounting the difference between the applicable property’s acquisition date fair value and an estimate of its future option price. We do not amortize the resulting intangible asset or liability over the term of the lease, but rather adjust the recognized value of the asset or liability 43upon sale. In connection with an acquisition, we may assume rights and obligations under certain lease agreements pursuant to which we become the lessee of a given property. We generally assume the lease classification previously determined by the prior lessee absent a modification in the assumed lease agreement. We assess assumed operating leases, including ground leases, to determine whether the lease terms are favorable or unfavorable to us given current market conditions on the acquisition date. To the extent the lease terms are favorable or unfavorable to us relative to market conditions on the acquisition date, we recognize an intangible asset or liability at fair value and amortize that asset or liability to interest or rental expense in our Consolidated Statements of Income over the applicable lease term. Where we are the lessee, we record the acquisition date values of leases, including any above or below market value, within operating lease assets and operating lease liabilities on our Consolidated Balance Sheets. We estimate the fair value of noncontrolling interests assumed consistent with the manner in which we value all of the underlying assets and liabilities. We calculate the fair value of long-term assumed debt by discounting the remaining contractual cash flows on each instrument at the current market rate for those borrowings, which we approximate based on the rate at which we would expect to incur a replacement instrument on the date of acquisition, and recognize any fair value adjustments related to long-term debt as effective yield adjustments over the remaining term of the instrument. Impairment of Long-Lived and Intangible AssetsWe periodically evaluate our long-lived assets, primarily consisting of investments in real estate, for impairment indicators. If indicators of impairment are present, we evaluate the carrying value of the related real estate investments in relation to the future undiscounted cash flows of the underlying operations. In performing this evaluation, we consider market conditions and our current intentions with respect to holding or disposing of the asset. We adjust the net book value of real estate properties and other long-lived assets to fair value if the sum of the expected future undiscounted cash flows, including sales proceeds, is less than book value. We recognize an impairment loss at the time we make any such determination. Estimates of fair value used in our evaluation of investments in real estate are based upon discounted future cash flow projections, if necessary, or other acceptable valuation techniques that are based, in turn, upon all available evidence including level three inputs, such as revenue and expense growth rates, estimates of future cash flows, capitalization rates, discount rates, general economic conditions and trends, or other available market data such as replacement cost or comparable transactions. Our ability to accurately predict future operating results and cash flows and to estimate and determine fair values impacts the timing and recognition of impairments. While we believe our assumptions are reasonable, changes in these assumptions may have a material impact on our financial results. Revenue Recognition We recognize rental revenues under our leases on a straight-line basis over the applicable lease term when collectability of substantially all rents is probable. We assess the probability of collecting substantially all rents under our leases based on several factors, including, among other things, payment history, the financial strength of the tenant and any guarantors, the historical operations and operating trends of the property, the historical payment pattern of the tenant, the type of property, the value of the underlying collateral, if any, expected future performance of the property and current economic conditions. If our evaluation of these factors indicates it is not probable that we will be able to collect substantially all rents under the lease, we record a charge to rental income. If we change our conclusions regarding the probability of collecting rent payments required by a lease, we may recognize adjustments to rental income in the period we make such change in our conclusions. Federal Income TaxWe have elected to be treated as a REIT under the applicable provisions of the Internal Revenue Code of 1986, as amended (the “Code”), for every year beginning with the year ended December 31, 1999. Accordingly, we generally are not subject to federal income tax on net income that we distribute to our stockholders, provided that we continue to qualify as a REIT. However, with respect to certain of our subsidiaries that have elected to be treated as taxable REIT subsidiaries (“TRS” or “TRS entities”), we record income tax expense or benefit, as those entities are subject to federal income tax similar to regular corporations. Certain foreign subsidiaries are subject to foreign income tax, although they did not elect to be treated as TRSs.44We account for deferred income taxes using the asset and liability method and recognize deferred tax assets and liabilities for the expected future tax consequences of events that have been included in our financial statements or tax returns. Under this method, we determine deferred tax assets and liabilities based on the differences between the financial reporting and tax bases of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to reverse. Any increase or decrease in the deferred tax liability that results from a change in circumstances, and that causes us to change our judgment about expected future tax consequences of events, is included in the tax provision when such changes occur. Deferred income taxes also reflect the impact of operating loss and tax credit carryforwards. A valuation allowance is provided if we believe it is more likely than not that all or some portion of the deferred tax asset will not be realized. Any increase or decrease in the valuation allowance that results from a change in circumstances, and that causes us to change our judgment about the realizability of the related deferred tax asset, is included in the tax provision when such changes occur.We recognize the tax benefit from an uncertain tax position claimed or expected to be claimed on a tax return only if it is more likely than not that the tax position will be sustained on examination by taxing authorities, based on the technical merits of the position. The tax benefits recognized in the financial statements from such a position are measured based on the largest benefit that has a greater than fifty percent likelihood of being realized upon ultimate settlement. We recognize interest and penalties, if applicable, related to uncertain tax positions as part of income tax benefit or expense.Recently Issued or Adopted Accounting StandardsWe adopted ASC Topic 842, Leases (“ASC 842”) on January 1, 2019, which introduced a lessee model that brings most leases on the balance sheet and, among other changes, eliminates the requirement in current GAAP for an entity to use bright-line tests in determining lease classification.ASC 842 allows for several practical expedients which permit the following: no reassessment of lease classification or initial direct costs; use of the standard’s effective date as the date of initial application; and no separation of non-lease components from the related lease components and, instead, to account for those components as a single lease component if certain criteria are met. We elected these practical expedients using the effective date as our date of initial application. Therefore, financial information and disclosures under ASC 842 are not provided for periods prior to January 1, 2019. Upon adoption, we recognized both right of use assets and lease liabilities for leases in which we lease land, real property or other equipment. We now also report revenues and expenses within our triple-net leased properties reportable business segment for real estate taxes and insurance that are escrowed and obligations of the tenants in accordance with their respective leases with us. This reporting had no impact on our net income. Resident leases within our senior living operations reportable business segment and office leases also contain service elements. We elected the practical expedient to account for our resident and office leases as a single lease component. Also, we now expense certain leasing costs, other than leasing commissions, as they are incurred. Prior to the adoption of ASC 842, GAAP provided for the deferral and amortization of such costs over the applicable lease term. We are continuing to amortize any unamortized deferred lease costs as of December 31, 2018 over their respective lease terms. As of January 1, 2019 we recognized operating lease assets of $361.7 million on our Consolidated Balance Sheets which includes the present value of minimum lease payments as well as certain existing above and/or below market lease intangible values associated with such leases. Also upon adoption, we recognized operating lease liabilities of $216.9 million on our Consolidated Balance Sheets. The present value of minimum lease payments was calculated on each lease using a discount rate that approximates our incremental borrowing rate primarily adjusted for the length of the individual lease terms. As of the January 1, 2019 adoption date, we utilized discount rates ranging from 6.15% to 7.60% for our ground leases. Upon adoption, we recognized a cumulative effect adjustment to retained earnings of $0.6 million primarily relating to certain costs associated with unexecuted leases that were deferred as of December 31, 2018. 45Results of Operations As of December 31, 2020, we operated through three reportable business segments: triple-net leased properties, senior living operations and office operations. In our triple-net leased properties segment, we invest in and own senior housing and healthcare properties throughout the United States and the United Kingdom and lease those properties to healthcare operating companies under “triple-net” or “absolute-net” leases that obligate the tenants to pay all property-related expenses. In our senior living operations segment, we invest in senior housing communities throughout the United States and Canada and engage independent operators, such as Atria and Sunrise, to manage those communities. In our office operations segment, we primarily acquire, own, develop, lease and manage MOBs and research and innovation centers throughout the United States. Information provided for “all other” includes income from loans and investments and other miscellaneous income and various corporate-level expenses not directly attributable to any of our three reportable business segments. Assets included in “all other” consist primarily of corporate assets, including cash, restricted cash, loans receivable and investments, and miscellaneous accounts receivable. Our chief operating decision makers evaluate performance of the combined properties in each reportable business segment and determine how to allocate resources to those segments, in significant part, based on segment net operating income (“NOI”) and related measures. In addition to the information presented below, see “Note 19 – Segment Information” of the Notes to Consolidated Financial Statements included in Part II, Item 8 of this Annual Report for further information regarding our business segments and a discussion of our definition of segment NOI. See “Non-GAAP Financial Measures” included elsewhere in this Annual Report for additional disclosure and reconciliations of net income attributable to common stockholders, as computed in accordance with GAAP, to NOI.46Years Ended December 31, 2020 and 2019 The table below shows our results of operations for the years ended December 31, 2020 and 2019 and the effect of changes in those results from period to period on our net income attributable to common stockholders. For the Years EndedDecember 31,(Decrease) Increase to Net Income 20202019$% (Dollars in thousands)Segment NOI: Triple-net leased properties$673,105 $754,337 $(81,232)(10.8 %)Senior living operations538,489 630,135 (91,646)(14.5)Office operations549,375 574,157 (24,782)(4.3)All other87,021 92,610 (5,589)(6.0)Total segment NOI1,847,990 2,051,239 (203,249)(9.9)Interest and other income7,609 10,984 (3,375)(30.7)Interest expense(469,541)(451,662)(17,879)(4.0)Depreciation and amortization(1,109,763)(1,045,620)(64,143)(6.1)General, administrative and professional fees(130,158)(158,726)28,568 18.0 Loss on extinguishment of debt, net(10,791)(41,900)31,109 74.2 Merger-related expenses and deal costs(29,812)(15,235)(14,577)(95.7)Allowance on loans receivable and investments(24,238)— (24,238)nmOther(707)10,339 (11,046)nmIncome before unconsolidated entities, real estate dispositions, income taxes, discontinued operations and noncontrolling interests80,589 359,419 (278,830)(77.6)Income (loss) from unconsolidated entities1,844 (2,454)4,298 nmGain on real estate dispositions262,218 26,022 236,196 nmIncome tax benefit 96,534 56,310 40,224 71.4 Income from continuing operations441,185 439,297 1,888 0.4 Discontinued operations— — — nmNet income441,185 439,297 1,888 0.4 Net income attributable to noncontrolling interests2,036 6,281 4,245 67.6 Net income attributable to common stockholders$439,149 $433,016 6,133 1.4 nm—not meaningfulSegment NOI—Triple-Net Leased PropertiesThe following table summarizes results of operations in our triple-net leased properties reportable business segment, including assets sold or classified as held for sale as of December 31, 2020, but excluding assets whose operations were classified as discontinued operations: For the Years EndedDecember 31,(Decrease) Increase to Segment NOI 20202019$% (Dollars in thousands)Segment NOI—Triple-Net Leased Properties: Rental income$695,265 $780,898 $(85,633)(11.0 %)Less: Property-level operating expenses(22,160)(26,561)4,401 16.6 Segment NOI$673,105 $754,337 (81,232)(10.8)nm—not meaningful47In our triple-net leased properties reportable business segment, our revenues generally consist of fixed rental amounts (subject to contractual escalations) received from our tenants in accordance with the applicable lease terms. We report revenues and property-level operating expenses within our triple-net leased properties reportable business segment for real estate tax and insurance expenses that are paid from escrows collected from our tenants. The Triple-net leased properties segment NOI decrease in 2020 over the prior year is attributable primarily to the transition of 26 independent living assets at the start of the second quarter 2020 operated by Holiday from our triple-net portfolio to our senior housing operating portfolio, lower rental income from the Brookdale lease modification at the start of the third quarter of 2020, and the COVID-19 related write-off of previously accrued straight-line rental income during 2020 of $67.6 million (non-Holiday assets), partially offset by the $50.2 million impact of terminating the Holiday Lease. We will continue to try to collect rent on a contractual basis for the tenants where straight-line rent has been written off, but we have determined that collectability is not probable due to COVID-19.Occupancy rates may affect the profitability of our tenants’ operations. The following table sets forth average continuing occupancy rates related to the triple-net leased properties we owned at December 31, 2020 and measured over the trailing 12 months ended September 30, 2020 (which is the most recent information available to us from our tenants) and average continuing occupancy rates related to the triple-net leased properties we owned at December 31, 2019 and measured over the 12 months ended September 30, 2019. The table excludes non-stabilized properties, properties owned through investments in unconsolidated real estate entities, certain properties for which we do not receive occupancy information and properties acquired or properties that transitioned operators for which we do not have a full four quarters of occupancy results.Number of Properties at December 31, 2020Average Occupancy for the Trailing 12 Months Ended September 30, 2020Number of Properties at December 31, 2019Average Occupancy for the Trailing 12 Months Ended September 30, 2019Senior housing communities290 82.1 %326 86.0 %Skilled nursing facilities (“SNFs”)16 82.9 16 87.3 IRFs and LTACs35 55.7 36 53.6 Declines in occupancy are primarily the result of COVID-19 impacts to senior housing and SNF operations. The following table compares results of operations for our 359 same-store triple-net leased properties. See “Non-GAAP Financial Measures—NOI” included elsewhere in this Annual Report on Form 10-K for additional disclosure regarding same-store NOI for each of our reportable business segments. For the Years EndedDecember 31,(Decrease) Increase to Segment NOI 20202019$% (Dollars in thousands)Same-Store Segment NOI—Triple-Net Leased Properties: Rental income$601,195 $669,510 $(68,315)(10.2 %)Less: Property-level operating expenses(19,166)(19,198)32 0.2 Segment NOI$582,029 $650,312 (68,283)(10.5)nm—not meaningfulThe decrease in our same-store triple-net leased properties rental income in 2020 over the prior year is attributable primarily to the COVID-19 related write-off of previously accrued straight-line rental income of $67.6 million during 2020 and lower rental income from the Brookdale lease modification at the start of the third quarter of 2020, partially offset by rent increases due to contractual escalations pursuant to the terms of our leases. We will continue to try to collect rent on a contractual basis for the tenants where straight-line rent has been written off, but we have determined that collectability is not probable due to COVID-19.48Segment NOI—Senior Living OperationsThe following table summarizes results of operations in our senior living operations reportable business segment, including assets sold or classified as held for sale as of December 31, 2020. For the Years EndedDecember 31,Increase (Decrease) to Segment NOI 20202019$% (Dollars in thousands)Segment NOI—Senior Living Operations: Resident fees and services$2,197,160 $2,151,533 $45,627 2.1 %Less: Property-level operating expenses(1,658,671)(1,521,398)(137,273)(9.0)Segment NOI$538,489 $630,135 (91,646)(14.5) Number ofProperties atDecember 31,Average Unit Occupancyfor the Years EndedDecember 31,Average Monthly Revenue Per Occupied Room for the Years EndedDecember 31, 202020192020201920202019Total communities432 401 81.7 %86.6 %$4,766 $5,451 Resident fees and services include all amounts earned from residents at our senior housing communities, such as rental fees related to resident leases, extended healthcare fees and other ancillary service income. Property-level operating expenses related to our senior living operations segment include labor, food, utilities, marketing, management and other costs of operating the properties. The decrease in our senior living operations segment NOI in 2020 over the prior year is primarily attributable to lower occupancy resulting from the COVID-19 pandemic. In addition, NOI has been negatively impacted by increased operating costs as a result of the COVID-19 pandemic, which is partially offset by the receipt of $35.1 million in grants during the fourth quarter 2020 from HHS under the Provider Relief Fund. We also had more properties in this segment because of the transition of 26 independent living assets at the start of the second quarter 2020 operated by Holiday from our triple-net portfolio to our senior housing operating portfolio and the third quarter 2019 acquisition of 34 Canadian senior housing communities via an equity partnership with Le Groupe Maurice, which contributed to NOI.The following table compares results of operations for our 335 same-store senior living operating communities. For the Years EndedDecember 31,(Decrease) Increase to Segment NOI 20202019$% (Dollars in thousands)Same-Store Segment NOI—Senior Living Operations: Resident fees and services$1,796,135 $1,967,402 $(171,267)(8.7 %)Less: Property-level operating expenses(1,385,316)(1,376,587)(8,729)(0.6)Segment NOI$410,819 $590,815 (179,996)(30.5)nm—not meaningful Number ofProperties atDecember 31,Average Unit Occupancyfor the Years EndedDecember 31,Average Monthly Revenue Per Occupied Room for the Years EndedDecember 31, 202020192020201920202019Same-store communities335 335 79.6 %86.9 %$5,765 $5,790 49The decrease in our same-store senior living operations segment NOI is primarily attributable to lower occupancy resulting from the COVID-19 pandemic. In addition, NOI has been negatively impacted by increased operating costs as a result of the COVID-19 pandemic, which is partially offset by the receipt of $31.9 million in grants from HHS under the Provider Relief Fund. Segment NOI—Office OperationsThe following table summarizes results of operations in our office operations reportable business segment, including assets sold or classified as held for sale as of December 31, 2020. For the Years EndedDecember 31,(Decrease) Increase to Segment NOI 20202019$% (Dollars in thousands)Segment NOI—Office Operations: Rental income$799,627 $828,978 $(29,351)(3.5 %)Office building services revenue8,675 7,747 928 12.0 Total revenues808,302 836,725 (28,423)(3.4)Less: Property-level operating expenses(256,612)(260,249)3,637 1.4 Office building services costs(2,315)(2,319)4 0.2 Segment NOI$549,375 $574,157 (24,782)(4.3) Number ofProperties atDecember 31,Occupancy atDecember 31,Annualized Average Rent Per Occupied Square Foot for the Years Ended December 31, 202020192020201920202019Total office buildings374 382 89.7 %90.3 %$34 $34 The decrease in our office operations segment NOI in 2020 over the prior year is attributable to assets sold to the Ventas Fund in the first quarter of 2020, lease termination fees received in 2019, and COVID-19 impacts including the write-off of previously accrued straight-line rental income during 2020 and reduced parking revenues. These reduction in NOI were partially offset by active leasing at recently developed and redeveloped properties, improved tenant retention, contractual rent escalators, acquisitions and business interruption insurance proceeds.The following table compares results of operations for our 355 same-store office buildings. For the Years EndedDecember 31,Increase (Decrease) to Segment NOI 20202019$% (Dollars in thousands)Same-Store Segment NOI—Office Operations: Rental income$743,563 $733,482 $10,081 1.4 %Less: Property-level operating expenses(235,789)(231,946)(3,843)(1.7)Segment NOI$507,774 $501,536 6,238 1.2 Number ofProperties atDecember 31,Occupancy atDecember 31,Annualized Average Rent Per Occupied Square Foot for the Years Ended December 31, 202020192020201920202019Same-store office buildings355 355 91.3 %92.2 %$34 $33 The increase in our same-store office operations segment NOI in 2020 over the prior year is attributable primarily to successful leasing, enhanced tenant retention, continued strong collections through the COVID-19 pandemic and contractual rent escalations.50All OtherInformation provided for all other segment NOI includes income from loans and investments and other miscellaneous income not directly attributable to any of our three reportable business segments. The $5.6 million decrease in all other segment NOI in 2020 over the prior year is primarily due to reduced interest income from our loans receivable investments from lower LIBOR-based interest rates, repayments of loans outstanding net of new issuances, partially offset by increased management fee revenues from investments in unconsolidated real estate entities. See “Note 6 – Loans Receivable and Investments” of the Notes to Consolidated Financial Statements included in Part II, Item 8 of this Annual Report.Interest and Other IncomeThe $3.4 million decrease in interest and other income in 2020 over the prior year is primarily due to 2019 income from the exercise of warrants related to our research and innovation properties, partially offset by a 2020 reduction of a liability related to an acquisition and interest income on short-term investments.Interest ExpenseThe $17.9 million increase in total interest expense in 2020 over the prior year is primarily attributable to an increase of $53.0 million due to higher debt balances, partially offset by a decrease of $35.5 million due to a lower effective interest rate. Our weighted average effective interest rate was 3.5% for 2020, compared to 3.8% for 2019. Capitalized interest for 2020 and 2019 was $9.6 million and $9.0 million, respectively.Depreciation and AmortizationDepreciation and amortization expense increased during 2020 compared to 2019, primarily due to an increase in real estate impairments during 2020 and asset acquisitions, including the 2019 acquisition of senior housing communities operated by LGM. This is partially offset by the impact of dispositions during 2020. See “Note 1 – Description of Business - COVID-19 Update” for information regarding 2020 real estate impairment charges.General, Administrative and Professional FeesThe $28.6 million decrease in general, administrative and professional fees in 2020 over the prior year is primarily a result of the capital conservation actions taken during 2020, including the June 2020 elimination of approximately 25% of corporate positions and a reduction in executives’ salaries for the second half of 2020. See “2020 Capital Conservation Actions” for information regarding these measures.Loss on Extinguishment of Debt, NetThe loss on extinguishment of debt, net in 2020 is due primarily to the notice of redemption of $236.3 million of our 3.25% senior notes due 2022. The loss on extinguishment of debt, net in 2019 was due primarily to the redemption and repayment of $600.0 million aggregate principal amounts then outstanding of our 4.25% senior notes due 2022. See “—Liquidity and Capital Resources”.Merger-Related Expenses and Deal CostsThe $14.6 million increase in merger-related expenses and deal costs in 2020 over the prior year is due primarily to costs incurred as a result of the Brookdale transaction and 2020 expenses related to severance and operator transitions.Allowance on Loans Receivable and InvestmentsThe allowance on loans receivable and investments in 2020 is due to credit losses on certain of our non-mortgage loans receivable and government-sponsored pooled loan investments, less recoveries received during the year. See “Note 1 – Description of Business - COVID-19 Update” for more information regarding these allowances.51OtherThe $11.0 million change in other from income in 2019 to an expense in 2020 is primarily due to insurance recoveries received in 2019 and increased corporate-level insurance costs in 2020, partially offset by the change in fair value of stock warrants received in connection with the Brookdale transaction.Income (Loss) from Unconsolidated EntitiesThe $4.3 million increase in income (loss) from unconsolidated entities for 2020 over 2019 is primarily due to our share of financial results from our unconsolidated entities in 2020, offset by an impairment of our investment in an unconsolidated operating entity in 2020. See “Note 1 – Description of Business - COVID-19 Update” for information regarding 2020 impairment charges.Gain on Real Estate DispositionsThe $236.2 million increase in gain on real estate dispositions for 2020 over 2019 is due primarily to our contribution of six properties to the Ventas Fund in 2020. Income Tax BenefitThe $40.2 million increase in income tax benefit related to continuing operations for 2020 over 2019 is primarily due to a $152.9 million deferred tax benefit related to the internal restructuring of certain U.S. taxable REIT subsidiaries completed within the first quarter of 2020, partially offset by changes in the valuation allowance against deferred tax assets of certain of our TRS entities. The restructuring benefit resulted from the transfer of assets subject to certain deferred tax liabilities from taxable REIT subsidiaries to the entities other than the TRS entities in this tax-free transaction. Years Ended December 31, 2019 and 2018 Our Annual Report for the year ended December 31, 2019, filed with the SEC on February 24, 2020, contains information regarding our results of operations for the years ended December 31, 2019 and 2018 and the effect of changes in those results from period to period on our net income attributable to common stockholders.Non-GAAP Financial MeasuresWe consider certain non-GAAP financial measures to be useful supplemental measures of our operating performance. A non-GAAP financial measure is a measure of historical or future financial performance, financial position or cash flows that excludes or includes amounts that are not so excluded from or included in the most directly comparable measure calculated and presented in accordance with GAAP. Described below are the non-GAAP financial measures used by management to evaluate our operating performance and that we consider most useful to investors, together with reconciliations of these measures to the most directly comparable GAAP measures.The non-GAAP financial measures we present in this Annual Report may not be comparable to those presented by other real estate companies due to the fact that not all real estate companies use the same definitions. You should not consider these measures as alternatives to net income attributable to common stockholders (determined in accordance with GAAP) as indicators of our financial performance or as alternatives to cash flow from operating activities (determined in accordance with GAAP) as measures of our liquidity, nor are these measures necessarily indicative of sufficient cash flow to fund all of our needs. In order to facilitate a clear understanding of our consolidated historical operating results, you should examine these measures in conjunction with net income attributable to common stockholders as presented in our Consolidated Financial Statements and other financial data included elsewhere in this Annual Report.52Funds From Operations and Normalized Funds From Operations Attributable to Common StockholdersHistorical cost accounting for real estate assets implicitly assumes that the value of real estate assets diminishes predictably over time. However, since real estate values historically have risen or fallen with market conditions, many industry investors deem presentations of operating results for real estate companies that use historical cost accounting to be insufficient by themselves. For that reason, we consider Funds From Operations attributable to common stockholders (“FFO”) and normalized FFO to be appropriate supplemental measures of operating performance of an equity REIT. In particular, we believe that normalized FFO is useful because it allows investors, analysts and our management to compare our operating performance to the operating performance of other real estate companies and between periods on a consistent basis without having to account for differences caused by non-recurring items and other non-operational events such as transactions and litigation. In some cases, we provide information about identified non-cash components of FFO and normalized FFO because it allows investors, analysts and our management to assess the impact of those items on our financial results.We use the National Association of Real Estate Investment Trusts (“Nareit”) definition of FFO. Nareit defines FFO as net income attributable to common stockholders (computed in accordance with GAAP), excluding gains or losses from sales of real estate property, including gains or losses on remeasurement of equity method investments, and impairment write-downs of depreciable real estate, plus real estate depreciation and amortization, and after adjustments for unconsolidated partnerships and entities. Adjustments for unconsolidated partnerships and entities will be calculated to reflect FFO on the same basis. We define normalized FFO as FFO excluding the following income and expense items (which may be recurring in nature): (a) merger-related costs and expenses, including amortization of intangibles, transition and integration expenses, and deal costs and expenses, including expenses and recoveries relating to acquisition lawsuits; (b) the impact of any expenses related to asset impairment and valuation allowances, the write-off of unamortized deferred financing fees, or additional costs, expenses, discounts, make-whole payments, penalties or premiums incurred as a result of early retirement or payment of our debt; (c) the non-cash effect of income tax benefits or expenses, the non-cash impact of changes to our executive equity compensation plan, derivative transactions that have non-cash mark to market impacts on our Consolidated Statements of Income and non-cash charges related to leases; (d) the financial impact of contingent consideration, severance-related costs and charitable donations made to the Ventas Charitable Foundation; (e) gains and losses for non-operational foreign currency hedge agreements and changes in the fair value of financial instruments; (f) gains and losses on non-real estate dispositions and other unusual items related to unconsolidated entities; (g) expenses related to the reaudit and re-review in 2014 of our historical financial statements and related matters; (h) net expenses or recoveries related to natural disasters; and (i) any other incremental items set forth in the normalized FFO reconciliation included herein. The following table summarizes our FFO and normalized FFO for each of the five years ended December 31, 2020. The decrease in normalized FFO for the year ended December 31, 2020 over the prior year is due to the impact of COVID-19 on our senior housing business and increases in interest expense from incremental borrowings arising as a consequence of the impact of COVID-19, partially offset by the positive impact of our third quarter 2019 acquisition of an interest in 34 Canadian senior housing communities via an equity partnership with Le Groupe Maurice. 53 For the Years Ended December 31, 20202019201820172016 (In thousands)Net income attributable to common stockholders$439,149 $433,016 $409,467 $1,356,470 $649,231 Adjustments: Real estate depreciation and amortization1,104,114 1,039,550 913,537 881,088 891,985 Real estate depreciation related to noncontrolling interests(16,767)(9,762)(6,926)(7,565)(7,785)Real estate depreciation related to unconsolidated entities4,986 187 1,977 4,231 5,754 Gain on real estate dispositions related to unconsolidated entities— (1,263)(875)(1,057)(439)Gain on re-measurement of equity interest upon acquisition, net— — — (3,027)— Impairment on equity method investment— — 35,708 — — (Loss) gain on real estate dispositions related to noncontrolling interests(9)343 1,508 18 — Gain on real estate dispositions(262,218)(26,022)(46,247)(717,273)(98,203)Discontinued operations: Loss on real estate dispositions— — — — 1 FFO attributable to common stockholders1,269,255 1,436,049 1,308,149 1,512,885 1,440,544 Adjustments: Change in fair value of financial instruments(21,928)(78)(18)(41)62 Non-cash income tax benefit(98,114)(58,918)(18,427)(22,387)(34,227)Effect of the 2017 Tax Act— — (24,618)(36,539)— Loss on extinguishment of debt, net10,791 41,900 63,073 839 2,779 Gain on non-real estate dispositions related to unconsolidated entities(597)(18)(2)(39)(557)Merger-related expenses, deal costs and re-audit costs34,690 18,208 38,145 14,823 28,290 Amortization of other intangibles472 484 759 1,458 1,752 Other items related to unconsolidated entities(614)3,291 5,035 3,188 — Non-cash impact of changes to equity plan(452)7,812 4,830 5,453 — Non-cash charges related to lease terminations— — 21,299 — — Natural disaster expenses (recoveries), net1,247 (25,683)63,830 11,601 — Impact of Holiday lease termination(50,184)— — — — Write-off of straight-line rental income, net of noncontrolling interests70,863 — — — — Allowance on loan investments and impairment of unconsolidated entities, net of noncontrolling interests34,543 — — — — Normalized FFO attributable to common stockholders$1,249,972 $1,423,047 $1,462,055 $1,491,241 $1,438,643 54Adjusted EBITDAWe consider Adjusted EBITDA an important supplemental measure because it provides another manner in which to evaluate our operating performance and serves as another indicator of our credit strength and our ability to service our debt obligations. We define Adjusted EBITDA as consolidated earnings before interest, taxes, depreciation and amortization (including non-cash stock-based compensation expense, asset impairment and valuation allowances), excluding gains or losses on extinguishment of debt, our partners’ share of EBITDA of consolidated entities, merger-related expenses and deal costs, expenses related to the reaudit and re-review in 2014 of our historical financial statements, net gains or losses on real estate activity, gains or losses on remeasurement of equity interest upon acquisition, changes in the fair value of financial instruments, unrealized foreign currency gains or losses, net expenses or recoveries related to natural disasters and non-cash charges related to leases, and including Ventas’ share of EBITDA from unconsolidated entities and adjustments for other immaterial or identified items. The following table sets forth a reconciliation of net income attributable to common stockholders to Adjusted EBITDA: For the Years Ended December 31, 202020192018 (In thousands)Net income attributable to common stockholders$439,149 $433,016 $409,467 Adjustments: Interest 469,541 451,662 442,497 Loss on extinguishment of debt, net 10,791 41,900 58,254 Taxes (including amounts in general, administrative and professional fees)(91,389)(52,677)(37,230)Depreciation and amortization 1,109,763 1,045,620 919,639 Non-cash stock-based compensation expense21,487 33,923 29,963 Merger-related expenses, deal costs and re-audit costs29,811 15,246 33,608 Net income attributable to noncontrolling interests, adjusted for partners’ share of consolidated entity EBITDA(24,381)(16,396)(10,420)Loss from unconsolidated entities, adjusted for Ventas share of EBITDA from unconsolidated entities59,631 32,462 86,278 Gain on real estate dispositions(262,218)(26,022)(46,247)Unrealized foreign currency (gains) losses (439)(1,061)138 Changes in fair value of financial instruments(21,928)(104)(54)Non-cash charges related to lease terminations— — 21,299 Natural disaster expenses (recoveries), net1,203 (25,981)54,684 Write-off of straight-line rental income from Holiday lease termination49,611 — — Write-off of straight-line rental income, net of noncontrolling interests70,863 — — Allowance on loan investments and impairment of unconsolidated entities, net of noncontrolling interests23,879 — — — Adjusted EBITDA$1,885,374 $1,931,588 $1,961,876 NOIWe also consider NOI an important supplemental measure because it allows investors, analysts and our management to assess our unlevered property-level operating results and to compare our operating results with those of other real estate companies and between periods on a consistent basis. We define NOI as total revenues, less interest and other income, 55property-level operating expenses and office building services costs. Cash receipts may differ due to straight-line recognition of certain rental income and the application of other GAAP policies.The following table sets forth a reconciliation of net income attributable to common stockholders to NOI: For the Years Ended December 31, 202020192018 (In thousands)Net income attributable to common stockholders$439,149 $433,016 $409,467 Adjustments: Interest and other income (7,609)(10,984)(24,892)Interest expense469,541 451,662 442,497 Depreciation and amortization 1,109,763 1,045,620 919,639 General, administrative and professional fees 130,158 158,726 145,978 Loss on extinguishment of debt, net10,791 41,900 58,254 Merger-related expenses and deal costs29,812 15,235 30,547 Allowance on loan receivable and investments24,238 — — Discontinued operations— — 10 Other 707 (10,339)72,772 Net income attributable to noncontrolling interests2,036 6,281 6,514 (Income) loss from unconsolidated entities(1,844)2,454 55,034 Income tax benefit(96,534)(56,310)(39,953)Gain on real estate dispositions(262,218)(26,022)(46,247)NOI $1,847,990 $2,051,239 $2,029,620 See “Results of Operations” for discussions regarding both segment NOI and same-store segment NOI. We define same-store as properties owned, consolidated and operational for the full period in both comparison periods and are not otherwise excluded; provided, however, that we may include selected properties that otherwise meet the same-store criteria if they are included in substantially all of, but not a full, period for one or both of the comparison periods, and in our judgment such inclusion provides a more meaningful presentation of our portfolio performance. Newly acquired or recently developed or redeveloped properties in our senior living operations segment will be included in same-store once they are stabilized for the full period in both periods presented. These properties are considered stabilized upon the earlier of (a) the achievement of 80% sustained occupancy or (b) 24 months from the date of acquisition or substantial completion of work. Recently developed or redeveloped properties in our office operations and triple-net leased properties segments will be included in same-store once substantial completion of work has occurred for the full period in both periods presented. Our senior living operations and triple-net leased properties that have undergone operator or business model transitions will be included in same-store once operating under consistent operating structures for the full period in both periods presented. Properties are excluded from same-store if they are: (i) sold, classified as held for sale or properties whose operations were classified as discontinued operations in accordance with GAAP; (ii) impacted by materially disruptive events such as flood or fire; (iii) those properties that are currently undergoing a materially disruptive redevelopment; (iv) for our office operations, those properties for which management has an intention to institute a redevelopment plan because the properties may require major property-level expenditures to maximize value, increase NOI, or maintain a market-competitive position and/or achieve property stabilization; or (v) for the senior living operations and triple-net leased segments, those properties that are scheduled to undergo operator or business model transitions, or have transitioned operators or business models after the start of the prior comparison period. To eliminate the impact of exchange rate movements, all portfolio performance-based disclosures assume constant exchange rates across comparable periods, using the following methodology: the current period’s results are shown in actual reported USD, while prior comparison period’s results are adjusted and converted to USD based on the average exchange rate for the current period.56Asset/Liability ManagementAsset/liability management, a key element of enterprise risk management, is designed to support the achievement of our business strategy, while ensuring that we maintain appropriate and tolerable levels of market risk (primarily interest rate risk and foreign currency exchange risk) and credit risk. Effective management of these risks is a contributing factor to the absolute levels and variability of our FFO and net worth. The following discussion addresses our integrated management of assets and liabilities, including the use of derivative financial instruments.Market RiskWe are exposed to market risk related to changes in interest rates with respect to borrowings under our unsecured revolving credit facility, our secured construction revolver and our unsecured term loans, certain of our mortgage loans that are floating rate obligations, mortgage loans receivable that bear interest at floating rates and available for sale securities. These market risks result primarily from changes in LIBOR rates or prime rates. To manage these risks, we continuously monitor our level of floating rate debt with respect to total debt and other factors, including our assessment of current and future economic conditions. 57The table below sets forth certain information with respect to our debt, excluding premiums and discounts. As of December 31, 202020192018 (Dollars in thousands)Balance: Fixed rate: Senior notes$8,869,036$8,584,056$7,945,598Unsecured term loans200,000200,000400,000Secured revolving construction credit facility—160,492—Mortgage loans and other1,389,2271,325,854698,136Variable rate: Senior notes235,664231,018—Unsecured revolving credit facility39,395120,787765,919Unsecured term loans392,773385,030500,000Commercial paper notes—567,450—Secured revolving construction credit facility154,098—90,488Mortgage loans and other702,878671,115429,561Total$11,983,071$12,245,802$10,829,702Percent of total debt: Fixed rate: Senior notes73.9 %70.1 %73.4 %Unsecured term loans1.7 1.6 3.7 Secured revolving construction credit facility— 1.3 — Mortgage loans and other11.6 10.8 6.4 Variable rate: Senior notes2.0 1.9 — Unsecured revolving credit facility0.3 1.0 7.1 Unsecured term loans3.3 3.1 4.6 Commercial paper notes— 4.7 — Secured revolving construction credit facility1.3 — 0.8 Mortgage loans and other5.9 5.5 4.0 Total100.0 %100.0 %100.0 %Weighted average interest rate at end of period: Fixed rate: Senior notes3.7 %3.7 %3.8 %Unsecured term loans3.6 2.0 2.8 Secured revolving construction credit facility— 4.5 — Mortgage loans and other3.5 3.7 4.4 Variable rate:Senior notes1.0 2.5 — Unsecured revolving credit facility1.0 2.4 3.2 Unsecured term loans1.4 2.9 3.3 Commercial paper notes— 2.0 — Secured revolving construction credit facility1.9 — 4.1 Mortgage loans and other1.9 3.4 3.4 Total3.4 3.5 3.7 The variable rate debt in the table above reflects, in part, the effect of $146.7 million notional amount of interest rate swaps with maturities ranging from March 2022 to May 2022, in each case that effectively convert fixed rate debt to variable 58rate debt. In addition, the fixed rate debt in the table above reflects, in part, the effect of $305.9 million and C$145.7 million notional amount of interest rate swaps with maturities ranging from January 2023 to December 2029, in each case that effectively convert variable rate debt to fixed rate debt. See “Note 10 – Senior Notes Payable and Other Debt” of the Notes to Consolidated Financial Statements included in Part II, Item 8 of this Annual Report. The decrease in our outstanding variable rate debt at December 31, 2020 compared to December 31, 2019 is primarily attributable to reduced borrowings on our revolving credit facility and commercial paper program, partially offset by the change in presentation of the secured revolving construction credit facility to variable rate debt. The secured revolving construction credit facility was previously reflected as fixed rate debt due to an interest rate swap which had effectively converted the associated interest expense from variable to fixed until its expiration in August 2020.Assuming a 100 basis point increase in the weighted average interest rate related to our variable rate debt and assuming no change in our variable rate debt outstanding as of December 31, 2020, interest expense on an annualized basis would increase by approximately $14.7 million, or $0.04 per diluted common share. As of December 31, 2020 and 2019, our joint venture partners’ aggregate share of total debt was $271.6 million and $228.2 million, respectively, with respect to certain properties we owned through consolidated joint ventures. Total debt does not include our portion of debt related to investments in unconsolidated real estate entities, which was $213.0 million and $60.6 million as of December 31, 2020 and 2019, respectively. The fair value of our fixed rate debt is based on current market interest rates at which we could obtain similar borrowings. Increases in market interest rates typically result in a decrease in the fair value of fixed rate debt while decreases in market interest rates typically result in an increase in the fair value of fixed rate date. While changes in market interest rates affect the fair value of our fixed rate debt, these changes do not affect the interest expense associated with our fixed rate debt. Therefore, interest rate risk does not have a significant impact on our fixed rate debt obligations until their maturity or earlier prepayment and refinancing. If interest rates have risen at the time we seek to refinance our fixed rate debt, whether at maturity or otherwise, our future earnings and cash flows could be adversely affected by additional borrowing costs. Conversely, lower interest rates at the time of refinancing may reduce our overall borrowing costs.To highlight the sensitivity of our fixed rate debt to changes in interest rates, the following summary shows the effects of a hypothetical instantaneous change of 100 basis points in interest rates: As of December 31, 20202019 (In thousands)Gross book value$10,458,262 $10,270,402 Fair value11,550,236 10,784,441 Fair value reflecting change in interest rates:-100 basis points12,204,507 11,438,507 +100 basis points10,951,483 10,196,943 The change in fair value of our fixed rate debt from December 31, 2019 to December 31, 2020 was due primarily to 2020 senior note issuances, net of repayments, partially offset by the change in presentation of the secured revolving construction credit facility to variable rate debt. The secured revolving construction credit facility was previously reflected as fixed rate debt due to an interest rate swap which had effectively converted the associated interest expense from variable to fixed until its expiration in August 2020.As of December 31, 2020 and 2019, the fair value of our secured and non-mortgage loans receivable, based on our estimates of currently prevailing rates for comparable loans, was $565.7 million and $710.5 million, respectively. See “Note 6 – Loans Receivable and Investments” and “Note 11 – Fair Values of Financial Instruments” of the Notes to Consolidated Financial Statements included in Part II, Item 8 of this Annual Report.As a result of our Canadian and United Kingdom operations, we are subject to fluctuations in certain foreign currency exchange rates that may, from time to time, affect our financial condition and operating performance. Based solely on our results for the year ended December 31, 2020 (including the impact of existing hedging arrangements), if the value of the U.S. dollar relative to the British pound and Canadian dollar were to increase or decrease by one standard deviation compared to the average exchange rate during the year, our normalized FFO per share for the year ended December 31, 2020 would decrease or 59increase, as applicable, by less than $0.01 per share or 1%. We will continue to mitigate these risks through a layered approach to hedging looking out for the next year and continual assessment of our foreign operational capital structure. Nevertheless, we cannot assure you that any such fluctuations will not have an effect on our earnings.Concentration and Credit RiskWe use concentration ratios to identify, understand and evaluate the potential impact of economic downturns and other adverse events that may affect our asset types, geographic locations, business models, and tenants, operators and managers. We evaluate concentration risk in terms of investment mix and operations mix. Investment mix measures the percentage of our investments that is concentrated in a specific asset type or that is operated or managed by a particular tenant, operator or manager. Operations mix measures the percentage of our operating results that is attributed to a particular tenant, operator or manager, geographic location or business model. The following tables reflect our concentration risk as of the dates and for the periods presented: As ofDecember 31, 20202019Investment mix by asset type(1): Senior housing communities63.5 %62.2 %MOBs19.7 19.3 Research and innovation centers7.1 8.7 Health systems5.2 5.1 IRFs and LTACs1.7 1.6 SNFs0.7 0.7 Secured loans receivable and investments, net2.1 2.4 Investment mix by tenant, operator and manager(1): Atria20.8 %20.4 %Sunrise10.4 10.3 Brookdale Senior Living8.2 7.7 Ardent4.9 4.7 Kindred1.1 1.0 All other54.6 55.9 (1)Ratios are based on the gross book value of consolidated real estate investments (excluding properties classified as held for sale) as of each reporting date.60 For the Years Ended December 31, 202020192018Operations mix by tenant and operator and business model: Revenues(1): Senior living operations58.0 %55.8 %55.3 %Brookdale Senior Living(2)4.4 4.7 4.3 Ardent3.2 3.1 3.1 Kindred3.5 3.3 3.5 All others30.9 33.1 33.8 Adjusted EBITDA: Senior living operations30.8 %32.5 %31.3 %Brookdale Senior Living(2)9.5 8.1 6.7 Ardent7.0 5.4 5.1 Kindred7.5 5.8 5.6 All others45.2 48.2 51.3 NOI: Senior living operations29.4 %31.1 %30.7 %Brookdale Senior Living(2)9.0 8.7 7.6 Ardent6.6 5.8 5.7 Kindred7.1 6.3 6.4 All others47.9 48.1 49.6 Operations mix by geographic location(3): California15.7 %15.9 %15.7 %New York8.1 8.8 8.4 Texas6.1 6.0 6.2 Pennsylvania4.6 4.7 4.6 Illinois4.1 4.0 4.4 All others61.4 60.6 60.7 (1)Total revenues include medical office building and other services revenue, revenue from loans and investments and interest and other income (including amounts related to assets classified as held for sale). (2)Results exclude eight senior housing communities which are included in the senior living operations reportable business segment. 2018 results include the impact of a net non-cash charge of $21.3 million related to April 2018 lease extensions.(3)Ratios are based on total revenues (including amounts related to assets classified as held for sale) for each period presented. See “Non-GAAP Financial Measures” included elsewhere in this Annual Report for additional disclosure and reconciliations of net income attributable to common stockholders, as computed in accordance with GAAP, to Adjusted EBITDA and NOI, respectively.We derive a significant portion of our revenues by leasing assets under long-term triple-net leases in which the rental rate is generally fixed with escalators, subject to certain limitations. Some of our triple-net lease escalators are contingent upon the satisfaction of specified facility revenue parameters or based on increases in the Consumer Price Index (“CPI”), with caps, floors or collars. We also earn revenues directly from individual residents in our senior housing communities that are managed by independent operators, such as Atria and Sunrise, and tenants in our office buildings. For the year ended December 31, 2020, 61.0% of our Adjusted EBITDA was derived from our senior living operations and office operations, for which rental rates may fluctuate more frequently upon lease rollovers and renewals due to shorter-term leases and changing economic or market conditions.The concentration of our triple-net leased properties segment revenues and operating income that are attributed to Brookdale Senior Living, Ardent and Kindred creates credit risk. If any of Brookdale Senior Living, Ardent or Kindred becomes unable or unwilling to satisfy its obligations to us or to renew its leases with us upon expiration of the terms thereof, our financial condition and results of operations could decline, and our ability to service our indebtedness and to make 61distributions to our stockholders could be impaired. See “Risk Factors—Our Business Operations and Strategy Risks—A significant portion of our revenues and operating income is dependent on a limited number of tenants and managers, including Brookdale Senior Living, Ardent, Kindred, Atria and Sunrise.” included in Part I, Item 1A of this Annual Report and “Note 3 – Concentration of Credit Risk” of the Notes to Consolidated Financial Statements included in Part II, Item 8 of this Annual Report.We regularly monitor and assess any changes in the relative credit risk of our significant tenants, and in particular those tenants that have recourse obligations under our triple-net leases. The ratios and metrics we use to evaluate a significant tenant’s liquidity and creditworthiness depend on facts and circumstances specific to that tenant and the industry or industries in which it operates, including without limitation the tenant’s credit history and economic conditions related to the tenant, its operations and the markets in which the tenant operates, that may vary over time. Among other things, we may (i) review and analyze information regarding the real estate, senior housing and healthcare industries generally, publicly available information regarding the significant tenant, and information required to be provided by the tenant under the terms of its lease agreements with us, (ii) examine monthly or quarterly financial statements of the significant tenant to the extent publicly available or otherwise provided under the terms of our lease agreements, and (iii) participate in periodic discussions and in-person meetings with representatives of the significant tenant. Using this information, we calculate multiple financial ratios (which may, but do not necessarily, include leverage, fixed charge coverage and tangible net worth), after making certain adjustments based on our judgment, and assess other metrics we deem relevant to an understanding of the significant tenant’s credit risk.Because Atria and Sunrise manage our properties in exchange for the receipt of a management fee from us, we are not directly exposed to the credit risk of our managers in the same manner or to the same extent as our triple-net tenants. However, we rely on our managers’ personnel, expertise, technical resources and information systems, proprietary information, good faith and judgment to manage our senior living operations efficiently and effectively. We also rely on Atria and Sunrise to set appropriate resident fees, to provide accurate property-level financials results in a timely manner and otherwise operate our senior housing communities in compliance with the terms of our management agreements and all applicable laws and regulations. Although we have various rights as the property owner under our management agreements, including various rights to terminate and exercise remedies under the agreements as provided therein, Atria’s or Sunrise’s failure, inability or unwillingness to satisfy its respective obligations under those agreements, to efficiently and effectively manage our properties or to provide timely and accurate accounting information with respect thereto could have a Material Adverse Effect on us. See “Risk Factors—Our Business Operations and Strategy Risks.” included in Part I, Item 1A of this Annual Report. We hold a 34% ownership interest in Atria, which entitles us to customary minority rights and protections, as well as the right to appoint two of the six members on the Atria Board of Directors. Triple-Net Lease Performance and ExpirationsAny failure, inability or unwillingness by our tenants to satisfy their obligations under our triple-net leases could have a material adverse effect on us. Also, if our tenants are not able or willing to renew our triple-net leases upon expiration, we may be unable to reposition the applicable properties on a timely basis or on the same or better economic terms, if at all. Although our lease expirations are staggered, the non-renewal of some or all of our triple-net leases that expire in any given year could have a material adverse effect on us. During the year ended December 31, 2020, we had no triple-net lease renewals or expirations without renewal that, in the aggregate, had a material impact on our financial condition or results of operations for that period. See “Risk Factors—Our Business Operations and Strategy Risks—If we must replace any of our tenants or managers, we may be unable to do so on as favorable terms, or at all, and we could be subject to delays, limitations and expenses, which could adversely affect our business, financial condition and results of operations.” included in Part I, Item IA of this Annual Report.62The following table summarizes our lease expirations in our triple-net leased properties segment currently scheduled to occur over the next 10 years as of December 31, 2020:Number ofProperties(1)2020 Annualized Base Rent (“ABR”)(2)% of 2020 Total Triple-Net Leased Properties Segment Rental Income (Dollars in thousands)20219 $12,062 1.7 %20228 5,799 0.8 2023(3)6 31,240 4.5 202426 13,970 2.0 2025179 234,549 33.7 202639 53,660 7.7 20274 8,784 1.3 202827 25,196 3.6 202921 22,788 3.3 20306 4,748 0.7 (1)Excludes assets sold or classified as held for sale, unconsolidated entities development properties not yet operational, unconsolidated joint ventures and land parcels.(2)ABR represents the annualized impact of the current period’s cash base rent at 100% share for consolidated entities. ABR does not include common area maintenance charges, the amortization of above/below market lease intangibles or other noncash items. ABR is used only for the purpose of determining lease expirations.(3)Relates to 6 LTACs leased by Kindred. While the lease term expires in 2023, Kindred may extend the term for 5 years by delivering a renewal notice to the Company 12 to 18 months prior to expiration.Liquidity and Capital ResourcesDuring 2020, our principal sources of liquidity were cash flows from operations, proceeds from the issuance of debt and equity securities, borrowings under our unsecured revolving credit facility, and proceeds from asset sales. For the next 12 months, our principal liquidity needs are to: (i) fund operating expenses; (ii) meet our debt service requirements; (iii) repay maturing mortgage and other debt; (iv) fund acquisitions, investments and commitments and any development and redevelopment activities; (v) fund capital expenditures; and (vi) make distributions to our stockholders and unitholders, as required for us to continue to qualify as a REIT. Depending upon the availability of external capital, we believe our liquidity is sufficient to fund these uses of cash. We expect that these liquidity needs generally will be satisfied by a combination of the following: cash flows from operations, cash on hand, debt assumptions and financings (including secured financings), issuances of debt and equity securities, dispositions of assets (in whole or in part through joint venture arrangements with third parties) and borrowings under our revolving credit facilities and commercial paper program. However, an inability to access liquidity through multiple capital sources concurrently could have a material adverse effect on us. While continuing decreased revenue and net operating income as a result of the COVID-19 pandemic could lead to downgrades of our long-term credit rating and therefore adversely impact our cost of borrowing, we currently believe we will continue to have access to one or more debt markets during the duration of the pandemic and could seek to enter into secured debt financings or issue debt and equity securities to satisfy our liquidity needs, although no assurances can be made in this regard. See “COVID-19 Update.” See “Risk Factors—Our Capital Structure Risks—We are highly dependent on access to the capital markets. Limitations on our ability to access capital could have an adverse effect on us, including our ability to make required payments on our debt obligations, make distributions to our stockholders or make future investments necessary to implement our business strategy.” included in Part I, Item 1A of this Annual Report.2020 Capital Conservation ActionsIn 2020, we executed on a multi-pronged capital conservation strategy to mitigate the impact of COVID-19, which included reducing our planned capital expenditures and capital commitments. We also established a quarterly dividend of $0.45 per share beginning in the second quarter, which was a reduction from the first quarter dividend of $0.7925 per share. This action enabled us to conserve approximately $130 million of cash per quarter compared to the prior dividend level. Also, in June 2020, we eliminated roles representing over 25% of our corporate positions, excluding onsite field personnel. For the 63second half of 2020, the base salaries of our CEO and other executive officers were voluntarily reduced by 20% and 10%, respectively. Primarily as a result of these capital conservation actions, our 2020 general and administrative expenses are $29 million lower than 2019.See “Note 10 – Senior Notes Payable and Other Debt” of the Notes to Consolidated Financial Statements included in Part II, Item 8 of this Annual Report for further information regarding our significant financing activities. Credit Facilities, Commercial Paper and Unsecured Term Loans As of December 31, 2020, our unsecured credit facility was comprised of a $3.0 billion unsecured revolving credit facility priced at LIBOR plus 0.875% based on the Company’s debt rating, which was scheduled to mature in 2021. In January 2021, we entered into an amended and restated unsecured credit facility (the “New Credit Facility”) comprised of a $2.75 billion unsecured revolving credit facility initially priced at LIBOR plus 0.825% based on the Company’s debt rating. The New Credit Facility matures in 2025, but may be extended at our option subject to the satisfaction of certain conditions, for two additional periods of six months each. The New Credit Facility also includes an accordion feature that permits us to increase our aggregate borrowing capacity thereunder to up to $3.75 billion.As of December 31, 2020, $39.4 million was outstanding under the unsecured revolving credit facility with an additional $24.9 million restricted to support outstanding letters of credit. In addition, we limit our utilization of the unsecured revolving credit facility, to the extent necessary, to support our commercial paper program when commercial paper notes are outstanding. We had $2.9 billion in available liquidity under the unsecured revolving credit facility as of December 31, 2020. In connection with the New Credit Facility, we paid off all amounts outstanding under the existing unsecured revolving credit facility as of January 29, 2021 by drawing down the same amount on the New Credit Facility. Our wholly owned subsidiary, Ventas Realty, Limited Partnership (“Ventas Realty”), may issue from time to time unsecured commercial paper notes up to a maximum aggregate amount outstanding at any time of $1.0 billion. The notes are sold under customary terms in the United States commercial paper note market and are ranked pari passu with all of Ventas Realty’s other unsecured senior indebtedness. The notes are fully and unconditionally guaranteed by Ventas, Inc. As of December 31, 2020, we had no borrowings outstanding under our commercial paper program.As of December 31, 2020, we had a $200.0 million unsecured term loan priced at LIBOR plus 0.90% that matures in 2023. The term loan also includes an accordion feature that effectively permits us to increase our aggregate borrowings thereunder to up to $800.0 million.As of December 31, 2020, we had a $400.0 million secured revolving construction credit facility with $154.1 million of borrowings outstanding. The secured revolving construction credit facility matures in 2022 and is primarily used to finance the development of research and innovation centers and other construction projects.As of December 31, 2020, we had a C$500 million unsecured term loan facility priced at Canadian Dollar Offered Rate (“CDOR”) plus 0.90% that matures in 2025.Senior NotesIn April 2020, Ventas Realty issued and sold $500.0 million aggregate principal amount of 4.75% senior notes due 2030 at an amount equal to 97.86% of par. In October 2020, we redeemed, pursuant to a cash tender offer, $236.3 million aggregate principal amount then outstanding of our 3.25% senior notes due 2022 at 104.14% of par value, plus accrued and unpaid interest to the payment date. As a result, we recognized a loss on extinguishment of debt of $11.1 million during the year ended December 31, 2020.As of December 31, 2020, we had outstanding $7.7 billion aggregate principal amount of senior notes issued by Ventas Realty ($263.7 million of which was co-issued by Ventas Realty’s wholly owned subsidiary, Ventas Capital Corporation), approximately $75.2 million aggregate principal amount of senior notes issued by Nationwide Health Properties, Inc. (“NHP”) and assumed by our subsidiary, Nationwide Health Properties, LLC (“NHP LLC”), as successor to NHP, in connection with our acquisition of NHP, and C$1.7 billion aggregate principal amount of senior notes issued by our subsidiary, Ventas Canada Finance Limited (“Ventas Canada”). All of the senior notes issued by Ventas Realty and Ventas Canada are unconditionally guaranteed by Ventas, Inc.64In February 2021, in order to reduce near-term maturities, we issued a make-whole redemption for the entirety of the $400 million outstanding aggregate principal amount of 3.10% senior notes due January 2023. The redemption is expected to settle in March 2021 and will be funded primarily with cash on hand.We may, from time to time, seek to retire or purchase our outstanding senior notes for cash or in exchange for equity securities in open market purchases, privately negotiated transactions or otherwise. Such repurchases or exchanges, if any, will depend on prevailing market conditions, our liquidity requirements, contractual restrictions, prospects for capital and other factors. The amounts involved may be material.The indentures governing our outstanding senior notes require us to comply with various financial and other restrictive covenants. We were in compliance with all of these covenants at December 31, 2020.MortgagesAt December 31, 2020 and 2019, our consolidated aggregate principal amount of mortgage debt outstanding was $2.1 billion and $2.0 billion, respectively, of which our share was $1.8 billion for both years.Under certain circumstances, contractual and legal restrictions, including those contained in the instruments governing our subsidiaries’ outstanding mortgage indebtedness, may restrict our ability to obtain cash from our subsidiaries for the purpose of meeting our debt service obligations, including our payment guarantees with respect to Ventas Realty’s and Ventas Canada Finance Limited’s senior notes. Derivatives and HedgingIn the normal course of our business, interest rate fluctuations affect future cash flows under our variable rate debt obligations, loans receivable and marketable debt securities, and foreign currency exchange rate fluctuations affect our operating results. We follow established risk management policies and procedures, including the use of derivative instruments, to mitigate the impact of these risks.DividendsDuring 2020, we declared four dividends totaling $2.1425 per share of our common stock, including a fourth quarter dividend of $0.45 per share. In order to continue to qualify as a REIT, we must make annual distributions to our stockholders of at least 90% of our REIT taxable income (excluding net capital gain). In addition, we will be subject to income tax at the regular corporate rate to the extent we distribute less than 100% of our REIT taxable income, including any net capital gains. We intend to pay dividends greater than 100% of our taxable income, after the use of any net operating loss carryforwards, for 2021. We expect that our cash flows will exceed our REIT taxable income due to depreciation and other non-cash deductions in computing REIT taxable income and that we will be able to satisfy the 90% distribution requirement. However, from time to time, we may not have sufficient cash on hand or other liquid assets to meet this requirement or we may decide to retain cash or distribute such greater amount as may be necessary to avoid income and excise taxation. If we do not have sufficient cash on hand or other liquid assets to enable us to satisfy the 90% distribution requirement, or if we desire to retain cash, we may borrow funds, issue additional equity securities, pay taxable stock dividends, if possible, distribute other property or securities or engage in a transaction intended to enable us to meet the REIT distribution requirements or any combination of the foregoing.Capital ExpendituresThe terms of our triple-net leases generally obligate our tenants to pay all capital expenditures necessary to maintain and improve our triple-net leased properties. However, from time to time, we may fund the capital expenditures for our triple-net leased properties through loans or advances to the tenants, which may increase the amount of rent payable with respect to the properties in certain cases. We may also fund capital expenditures for which we may become responsible upon expiration of our triple-net leases or in the event that our tenants are unable or unwilling to meet their obligations under those leases. We also expect to fund capital expenditures related to our senior living operations and office operations reportable business segments with the cash flows from the properties or through additional borrowings. We expect that these liquidity needs generally will be satisfied by a combination of the following: cash flows from operations, cash on hand, debt assumptions and financings (including secured financings), issuances of debt and equity securities, dispositions of assets (in whole or in part through joint venture arrangements with third parties) and borrowings under our revolving credit facilities.65To the extent that unanticipated capital expenditure needs arise or significant borrowings are required, our liquidity may be affected adversely. Our ability to borrow additional funds may be restricted in certain circumstances by the terms of the instruments governing our outstanding indebtedness.We are party to certain agreements that obligate us to develop senior housing or healthcare properties funded through capital that we and, in certain circumstances, our joint venture partners provide. As of December 31, 2020, we had 13 properties under development pursuant to these agreements, including three properties that are owned by unconsolidated real estate entities. In addition, from time to time, we engage in redevelopment projects with respect to our existing senior housing communities to maximize the value, increase NOI, maintain a market-competitive position, achieve property stabilization or change the primary use of the property. Equity OfferingsFrom time to time, we may sell up to an aggregate of $1.0 billion of our common stock under an “at-the-market” equity offering program (“ATM program”). As of December 31, 2020, we have $755.5 million remaining under our existing ATM program. During the years ended December 31, 2020 and 2019, we sold 1.5 million and 2.7 million shares of our common stock under our ATM program for gross proceeds of $44.88 and $66.75 per share, respectively. During the year ended December 31, 2018, we sold no shares of common stock under our ATM program. In June 2019, we sold 12.7 million shares of our common stock under a registered public offering for gross proceeds of $62.75 per share. We used the majority of the net proceeds to fund our LGM Acquisition. See “Note 4 – Acquisitions of Real Estate Property” of the Notes to Consolidated Financial Statements included in Part II, Item 8 of this Annual Report for additional information regarding the LGM Acquisition.Cash FlowsThe following table sets forth our sources and uses of cash flows for the years ended December 31, 2020 and 2019: For the Years EndedDecember 31,(Decrease) Increaseto Cash 20202019$% (Dollars in thousands)Cash, cash equivalents and restricted cash at beginning of year$146,102 $131,464 $14,638 11.1 %Net cash provided by operating activities1,450,176 1,437,783 12,393 0.9 Net cash provided by (used in) investing activities154,295 (1,585,299)1,739,594 nmNet cash (used in) provided by financing activities(1,300,021)160,674 (1,460,695)nmEffect of foreign currency translation 1,088 1,480 (392)(26.5)Cash, cash equivalents and restricted cash at end of year$451,640 $146,102 305,538 nmnm—not meaningfulCash Flows from Operating ActivitiesCash flows from operating activities increased $12.4 million during the year ended December 31, 2020 over the same period in 2019 primarily due to the up-front consideration received in connection with the Brookdale transaction, partially offset by lower NOI.Cash Flows from Investing ActivitiesCash flows from investing activities increased $1.7 billion during 2020 over 2019 primarily due to decreased acquisition and investment activity together with increased proceeds from real estate dispositions.66Cash Flows from Financing ActivitiesCash flows from financing activities decreased $1.5 billion during 2020 over 2019 primarily due to lower issuances of common stock, decreased debt borrowings during 2020, net of repayments, partially offset by lower dividends paid to common stockholders during 2020.Contractual ObligationsThe following table summarizes the effect that minimum debt (which includes principal and interest payments) and other material noncancelable commitments are expected to have on our cash flow in future periods as of December 31, 2020:TotalLess than 1 year(3)1 - 3 years(4)3 - 5 years(5)More than 5years(6) (In thousands)Long-term debt obligations (1) (2)$15,107,176 $1,002,409 $3,475,813 $3,794,808 $6,834,146 Operating obligations, including ground lease obligations726,410 26,968 43,352 36,413 619,677 Total$15,833,586 $1,029,377 $3,519,165 $3,831,221 $7,453,823 (1)Amounts represent contractual amounts due, including interest.(2)Interest on variable rate debt based on rates as of December 31, 2020.(3)Includes $39.4 million of borrowings outstanding on our unsecured revolving credit facility and $235.7 million outstanding principal amount of our floating rate senior notes, Series F due 2021.(4)Includes $154.1 million of borrowings outstanding on our secured revolving construction credit facility, $263.7 million outstanding principal amount of our 3.25% senior notes due 2022, $196.4 million outstanding principal amount of our 3.30% senior notes, Series C due 2022, $216.0 million outstanding principal amount of our 2.55% senior notes, Series D due 2023, $200.0 million of borrowings outstanding on our unsecured term loan due 2023, $400.0 million outstanding principal amount of our 3.125% senior notes due 2023, and $400.0 million outstanding principal amount of our 3.10% senior notes due 2023.(5)Includes $400.0 million outstanding principal amount of our 3.50% senior notes due 2024, $400.0 million outstanding principal amount of our 3.75% senior notes due 2024, $471.3 million outstanding principal amount of our 2.80% senior notes, Series E due 2024, $196.4 million outstanding principal amount of our 4.125% senior notes, Series B due 2024, $392.8 million of borrowings outstanding on our unsecured term loan due 2025, $450.0 million outstanding principal amount of our 2.65% senior notes due 2025, and $600.0 million outstanding principal amount of our 3.50% senior notes due 2025.(6)Includes $4.8 billion aggregate principal amount outstanding of our senior notes maturing between 2025 and 2049. $52.4 million aggregate principal amount outstanding of our 6.90% senior notes due 2037 are subject to repurchase, at the option of the holders, at par, on October 1, 2027, and $22.8 million aggregate principal amount outstanding of our 6.59% senior notes due 2038 are subject to repurchase, at the option of the holders, at par, on July 7 in each of 2023 and 2028.As of December 31, 2020, we had $6.1 million of unrecognized tax benefits that are excluded from the table above, as we are unable to make a reasonably reliable estimate of the period of cash settlement, if any, with the respective tax authority.Off-Balance Sheet ArrangementsWe own interests in certain unconsolidated entities as described in Note 7 – Investments in Unconsolidated Entities. Except in limited circumstances, our risk of loss is limited to our investment in the joint venture and any outstanding loans receivable. In addition, we have certain properties which serve as collateral for debt that is owed by a previous owner of certain of our facilities, as described under Note 10 – Senior Notes Payable and Other Debt to the Consolidated Financial Statements. Our risk of loss for these certain properties is limited to the outstanding debt balance plus penalties, if any. Further, we use financial derivative instruments to hedge interest rate and foreign currency exchange rate exposure. Finally, at December 31, 2020, we had $24.9 million outstanding letter of credit obligations. We have no other material off-balance sheet arrangements that we expect would materially affect our liquidity and capital resources except those described above under “Contractual Obligations.”67Guarantor and Issuer Financial InformationVentas, Inc. has fully and unconditionally guaranteed the obligation to pay principal and interest with respect to the outstanding senior notes issued by our 100%-owned subsidiary, Ventas Realty, including the senior notes that were jointly issued with Ventas Capital Corporation. Ventas Capital Corporation is a direct, 100%-owned subsidiary of Ventas Realty that has no assets or operations, but was formed in 2002 solely to facilitate offerings of senior notes by a limited partnership. None of our other subsidiaries (excluding Ventas Realty and Ventas Capital Corporation) is obligated with respect to Ventas Realty’s outstanding senior notes. Ventas, Inc. has also fully and unconditionally guaranteed the obligation to pay principal and interest with respect to the outstanding senior notes issued by our 100%-owned subsidiary Ventas Canada Finance Limited (“Ventas Canada”). None of our other subsidiaries is obligated with respect to Ventas Canada’s outstanding senior notes, all of which were issued on a private placement basis in Canada.In connection with the acquisition of Nationwide Health Properties, Inc. (“NHP”), our 100%-owned subsidiary Nationwide Health Properties, LLC (“NHP LLC”), as successor to NHP, assumed the obligation to pay principal and interest with respect to the outstanding senior notes issued by NHP. Neither we nor any of our subsidiaries (other than NHP LLC) is obligated with respect to any of NHP LLC’s outstanding senior notes.Under certain circumstances, contractual and legal restrictions, including those contained in the instruments governing our subsidiaries’ outstanding mortgage indebtedness, may restrict our ability to obtain cash from our subsidiaries for the purpose of meeting our debt service obligations, including our payment guarantees with respect to Ventas Realty’s and Ventas Canada’s senior notes. The following summarizes our guarantor and issuer balance sheet and statement of income information as of December 31, 2020 and December 31, 2019 and for the years ended December 31, 2020, 2019 and 2018.Balance Sheet InformationAs of December 31, 2020GuarantorIssuer (In thousands)Assets Investment in and advances to affiliates$16,576,278 $2,727,931 Total assets16,937,149 2,844,339 Liabilities and equity Intercompany loans10,691,626 (4,532,350)Total liabilities10,918,320 3,577,009 Redeemable OP unitholder and noncontrolling interests89,669 — Total equity (deficit)5,929,161 (732,670)Total liabilities and equity16,937,149 2,844,339 68Balance Sheet InformationAs of December 31, 2019GuarantorIssuer (In thousands)Assets Investment in and advances to affiliates$15,774,897 $2,728,110 Total assets15,875,910 2,838,270 Liabilities and equity Intercompany loans8,789,600 (5,105,070)Total liabilities9,133,733 3,363,067 Redeemable OP unitholder and noncontrolling interests102,657 — Total equity (deficit)6,639,520 (524,797)Total liabilities and equity15,875,910 2,838,270 Statement of Income InformationFor the Year Ended December 31, 2020GuarantorIssuer (In thousands)Equity earnings in affiliates$469,311 $— Total revenues474,392 143,259 Income (loss) before unconsolidated entities, real estate dispositions, income taxes and noncontrolling interests440,210 (215,406)Net income (loss)439,149 (202,845)Net income (loss) attributable to common stockholders439,149 (202,845)Statement of Income InformationFor the Year Ended December 31, 2019GuarantorIssuer (In thousands)Equity earnings in affiliates$362,143 $— Total revenues366,243 142,754 Income (loss) before unconsolidated entities, real estate dispositions, income taxes and noncontrolling interests432,020 (246,929)Net income (loss)433,016 (246,841)Net income (loss) attributable to common stockholders433,016 (246,841)For the Year Ended December 31, 2018GuarantorIssuer (In thousands)Equity earnings in affiliates$308,764 $— Total revenues335,613 139,062 Income (loss) before unconsolidated entities, real estate dispositions, income taxes and noncontrolling interests400,349 (269,557)Net income (loss)409,467 (269,557)Net income (loss) attributable to common stockholders409,467 (269,557)69ITEM 7A. Quantitative and Qualitative Disclosures About Market RiskThe information set forth in Part II, Item 7 of this Annual Report under “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Asset/Liability Management” is incorporated by reference into this Item 7A.70
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+Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations – Key Operational Risks and Challenges).Transactions in ERCOT take place in two key markets: the day-ahead market and the real-time market. The day-ahead market is a voluntary, financial electricity market conducted the day before each operating day in which generators and purchasers of electricity may bid for one or more hours of electricity supply or consumption. The real-time market is a physical market in which electricity is dispatched and priced in five-minute intervals. The day-ahead market provides market participants with visibility into where prices are expected to clear, and the prices are not impacted by subsequent events. Conversely, the real-time market exposes purchasers to the risk of transient operational events and price spikes. These two markets allow market participants to manage their risk profile by adjusting their participation in each market. In addition, ERCOT uses ancillary services to maintain system reliability, including regulation service, responsive reserve service and non-spinning reserve service. Ancillary services are provided by generators to help maintain the stable voltage and frequency requirements of the transmission system. Because ERCOT has one of the highest concentrations of wind capacity generation among U.S. markets, the ERCOT market is more susceptible to fluctuations in wholesale electricity supply due to intermittent wind production, making ERCOT more vulnerable to periods of generation scarcity.East SegmentOur East segment is comprised of 21 power generation facilities in 10 states totaling 12,093 MW of generating capacity in PJM, ISO-NE and NYISO.ISO/RTOTechnologyPrimary FuelNumber of FacilitiesNet Capacity (MW)PJMCCGTNatural Gas86,081 PJMCTNatural Gas41,346 PJMCTFuel Oil293 ISO-NECCGTNatural Gas63,361 NYISOCCGTNatural Gas11,212 Total East Segment2112,093 PJM — PJM is an RTO that manages the flow of electricity from approximately 180,000 MW of installed generation capacity to approximately 65 million customers in all or parts of Delaware, Illinois, Indiana, Kentucky, Maryland, Michigan, New Jersey, North Carolina, Ohio, Pennsylvania, Tennessee, Virginia, West Virginia and the District of Columbia.6Table of ContentsLike ERCOT, PJM administers markets for wholesale electricity and provides transmission planning for the region, utilizing a locational marginal pricing (LMP) methodology which calculates a price for every generator and load point within PJM. PJM operates day-ahead and real-time markets into which generators can bid to provide energy and ancillary services. PJM also administers a forward capacity auction, the Reliability Pricing Model (RPM), which establishes a long-term market for capacity. We have participated in RPM auctions for years up to and including PJM's planning year 2021-2022, which ends May 31, 2022. Due to a change in auction rules, PJM's next RPM auction, for planning year 2022-2023, was delayed until May 2021. We also enter into bilateral capacity transactions. PJM's Capacity Performance (CP) rules were designed to improve system reliability and include penalties for under-performing units and reward for over-performing units during shortage events. Full transition of the capacity market to CP rules occurred in planning year 2020-2021. An independent market monitor continually monitors PJM markets to ensure a robust, competitive market and to identify improper behavior by any entity.ISO-NE — ISO-NE is an ISO that manages the flow of electricity from approximately 31,000 MW of installed generation capacity to approximately 15 million customers in the states of Vermont, New Hampshire, Massachusetts, Connecticut, Rhode Island and Maine. ISO-NE dispatches power plants to meet system energy and reliability needs and settles physical power deliveries at LMPs. Its energy markets allow market participants to buy and sell energy and ancillary services at prices established through real-time and day-ahead auctions. Energy prices vary among the participating states in ISO-NE and are largely influenced by transmission constraints and fuel supply. ISO-NE offers a forward capacity market where capacity prices are determined through auctions. Performance incentive rules have the potential to increase capacity payments for those resources that are providing excess energy or reserves during a shortage event, while penalizing those that produce less than the required level.NYISO — NYISO is an ISO that manages the flow of electricity from approximately 40,000 MW of installed generation capacity to approximately 20 million New York customers.NYISO dispatches power plants to meet system energy and reliability needs and settles physical power deliveries at LMPs. Its energy markets allow market participants to buy and sell energy and ancillary services at prices established through real-time and day-ahead auctions. Energy prices vary among the regional zones in the NYISO and are largely influenced by transmission constraints and fuel supply. NYISO offers a forward capacity market where capacity prices are determined through auctions. Strip auctions occur one to two months prior to the commencement of a six-month seasonal planning period. Subsequent auctions provide an opportunity to sell excess capacity for the balance of the seasonal planning period or the upcoming month. Due to the short-term nature of the NYISO-operated capacity auctions and a relatively liquid bilateral market for NYISO capacity products, our Independence facility sells a significant portion of its capacity through bilateral transactions. The balance is cleared through the seasonal and monthly capacity auctions.West SegmentOur West segment is comprised of two power generation facilities totaling 1,185 MW of generation capacity and one battery ESS totaling 300 MW in CAISO, all of which are located in California. ISO/RTOTechnologyPrimary FuelNumber of FacilitiesNet Capacity (MW)CAISOCCGTNatural Gas11,020 CAISOBatteryRenewable1300 CAISOCTFuel Oil1165 Total West Segment31,485 In addition, we are developing approximately 136 MW of battery energy storage systems at our Moss Landing and Oakland facilities that are expected to enter commercial operations in 2021-2022 (see Note 3 to the Financial Statements).CAISO — CAISO is an ISO that manages the flow of electricity to approximately 32 million customers primarily in California, representing approximately 80% percent of the state's electric load.7Table of ContentsEnergy is priced in CAISO utilizing an LMP methodology. The capacity market is comprised of Generic, Flexible and Local Resource Adequacy (RA) Capacity and is administered by the California Public Utilities Commission. Unlike other centrally cleared capacity markets, the resource adequacy market in California is a bilaterally traded market. In November 2016, CAISO implemented a voluntary capacity auction for annual, monthly, and intra-month procurement to cover for deficiencies in the market. The voluntary Competitive Solicitation Process, which FERC approved in October 2015, is a modification to the Capacity Procurement Mechanism (CPM) and provides another avenue to sell RA capacity.Sunset SegmentOur Sunset segment is comprised of 10 power generation facilities totaling 7,486 MW of generating capacity in MISO, PJM and ERCOT. The Sunset segment represents plants with announced retirement plans between 2022 and 2027 that were previously reported in the ERCOT, PJM and MISO segments No separate segment previously existed to differentiate operating plants with defined retirement plans from operating plants without defined retirement plans. See Note 4 to the Financial Statements for more information related to these planned generation retirements.ISO/RTOTechnologyPrimary FuelNumber of FacilitiesNet Capacity (MW)ERCOTSTCoal1650 MISOSTCoal43,187 MISOCTNatural Gas2221 PJMSTCoal33,428 Total Sunset Segment107,486 See Texas Segment above for a discussion of the ERCOT ISO and East Segment above for a discussion of the PJM RTO.MISO — MISO is an RTO that manages the flow of electricity from approximately 198,000 MW of installed generation capacity to approximately 42 million customers in all or parts of Iowa, Minnesota, North Dakota, Wisconsin, Michigan, Kentucky, Indiana, Illinois, Missouri, Arkansas, Mississippi, Texas, Louisiana, Montana, South Dakota and Manitoba, Canada.MISO dispatches power plants to meet system energy and reliability needs and settles physical power deliveries at LMPs. Its energy markets allow market participants to buy and sell energy and ancillary services at prices established through real-time and day-ahead auctions. Energy prices vary among the regional zones in MISO and are largely influenced by transmission constraints and fuel supply. An independent market monitor is responsible for evaluating the performance of the markets and identifying conduct by market participants or MISO that may compromise the efficiency or distort the outcome of the markets.MISO administers a one-year Planning Resource Auction for the next planning year from June 1st of the current year to May 31st of the following year. We participate in these auctions with open capacity that has not been committed through bilateral or retail transactions. We also participate in the MISO annual and monthly financial transmission rights auctions to manage the cost of our transmission congestion, as measured by the congestion component of the LMP price differential between two points on the transmission grid across the market area.Joppa, which is partially interconnected to MISO and partially within the Electric Energy, Inc. (EEI) control area, is interconnected to the Tennessee Valley Authority and Louisville Gas and Electric Company. Joppa primarily sells its capacity and energy to MISO.8Table of ContentsWholesale OperationsOur wholesale commodity risk management group is responsible for dispatching our generation fleet in response to market needs after implementing portfolio optimization strategies, thus linking and integrating the generation fleet production with our retail customer and wholesale sales opportunities. Market demand, also known as load, faced by electric power systems, such as those we operate in, varies from moment to moment as a result of changes in business and residential demand, which is often driven by weather. Unlike most other commodities, the production and consumption of electricity must remain balanced on an instantaneous basis. There is a certain baseline demand for electricity across an electric power system that occurs throughout the day, which is typically satisfied by baseload generating units with low variable operating costs. Baseload generating units can also increase output to satisfy certain incremental demand and reduce output when demand is unusually low. Intermediate/load-following generating units, which can more efficiently change their output to satisfy increases in demand, typically satisfy a large proportion of changes in intraday load as they respond to daily increases in demand or unexpected changes in supply created by reduced generation from renewable resources or other generator outages. Peak daily loads may be satisfied by peaking units. Peaking units are typically the most expensive to operate, but they can quickly start up and shut down to meet brief peaks in demand. In general, baseload units, intermediate/load following units and peaking units are dispatched into the ISO/RTO grid in order from lowest to highest variable cost. Price formation is typically based on the highest variable cost unit that clears the market to satisfy system demand at a given point in time.Our commodity risk management group also enters into electricity, gas and other commodity derivative contracts to reduce exposure to changes in prices primarily to hedge future revenues and fuel costs for our generation facilities and purchased power costs for our Retail segment.SeasonalityThe demand for and market prices of electricity and natural gas are affected by weather. As a result, our operating results are impacted by extreme or sustained weather conditions and may fluctuate on a seasonal basis. Typically, demand for and the price of electricity is higher in the summer and winter seasons, when the temperatures are more extreme, and the demand for and price of natural gas is also generally higher in the winter. More severe weather conditions such as heat waves or extreme winter weather have made, and may make such fluctuations more pronounced. The pattern of this fluctuation may change depending on, among other things, the retail load served and the terms of contracts to purchase or sell electricity.CompetitionCompetition in the markets in which we operate is impacted by electricity and fuel prices, congestion along the power grid, subsidies provided by state and federal governments for new and existing generation facilities, new market entrants, construction of new generating assets, technological advances in power generation, the actions of environmental and other regulatory authorities, and other factors. We primarily compete with other electricity generators and retailers based on our ability to generate electric supply, market and sell electricity at competitive prices and to efficiently utilize transportation from third-party pipelines and transmission from electric utilities to deliver electricity to end-users. Competitors in the generation and retail power markets in which we participate include numerous regulated utilities, industrial companies, non-utility generators, competitive subsidiaries of regulated utilities, independent power producers, REPs and other energy marketers. See Item 1A. Risk Factors for additional information concerning the risks faced with respect to the markets in which we operate.Brand ValueOur TXU Energy brand, which has been used to sell electricity to customers in the competitive retail electricity market in Texas for approximately 19 years, is registered and protected by trademark law and is the only material intellectual property asset that we own. We have also acquired the trade names for Ambit Energy, Dynegy Energy Services, Homefield Energy, TriEagle Energy, Public Power and U.S. Gas & Electric through the Ambit Transaction, Crius Transaction and the Merger, as the case may be. As of December 31, 2020, we have reflected intangible assets on our balance sheet for our trade names of approximately $1.374 billion (see Note 6 to the Financial Statements).9Table of ContentsHuman Capital Resources As a key component of our core principle that we work as a team, Vistra believes our most valuable asset is our talented, dedicated and diverse group of employees who work together to achieve our objectives, and our top priority is ensuring their safety. One of Vistra's core principles is that we care about our key stakeholders, including our employees. We invest in our people through numerous development and training opportunities, engaging employee programs and generous benefit and wellness offerings.As of December 31, 2020, we had approximately 5,365 full-time employees, including approximately 1,640 employees under collective bargaining agreements.SafetyVistra's mindset around safety is exemplified by our motto: Best Defense. Everyone wins. No one gets hurt. Our safety culture revolves around people and human performance. We place a high importance on continuous improvement, along with a keen focus on numerous learning and error-prevention tools. To facilitate a learning environment, our various operating plants share their investigations and learnings of all safety events with all operations employees on weekly calls. The information is presented by front-line employees and supported by management. The lessons from each event are shared across the fleet to prevent similar incidents at other locations. All personnel at Vistra locations are encouraged to be actively involved in the safety process. Managers are required to participate in safety engagements with staff to enable constant communication and sustained interaction. In 2020, the generation fleet conducted more than 57,000 leadership safety engagements across the fleet continuing our employee driven safety program focused on engagement of all employees.Our focus on reducing the severity of injuries for both our employees and contractors who work with us has shown positive results. In 2020, we did not have any serious injuries or fatalities to our Vistra employees. Although we do not focus on recordable incidents, our Total Recordable Incident rate (TRIR) for the company was 0.61, better than the first quartile as compared to the Edison Electric Institute (EEI) 2019 Total Company Injury data. We encourage near-miss reporting and review of events to promote a learning environment. In 2020, safety learning calls were held every week where near miss and safety events were reviewed by our operating teams to promote learning across the fleet.All Vistra employees are covered by our safety program. Office employees are required to complete periodic training on safety topics through our online learning management system. Power plant employees are required to complete trainings based on job function, which is also tracked through our central learning management system. In addition, the Company engages an independent third-party conformity assessment and certification vendor to manage adherence to our safety standards for all vendors and contractors who work at our plants. In addition, we work closely with our suppliers and contractors to ensure our safety practices are upheld.Our generation fleet has a total of 12 plants that have been awarded the Voluntary Protection Program (VPP) Star designation by the OSHA for superior demonstration of effective safety and health management systems and for maintaining injury and illness rates below the national averages for our industry. Two additional plants submitted applications in 2020 and are awaiting review by the OSHA. VPP Star status is the highest designation of OSHA's Voluntary Protection Programs. The achievement recognizes employers and workers who have implemented effective safety and health management systems and maintain injury and illness rates below national Bureau of Labor Statistics averages for their respective industries. These sites are self-sufficient in their ability to control workplace hazards and are reevaluated every three to five years. Additionally, 23 of our power plants and mine locations have adopted a proactive Behavior Based Safety approach to safety which focuses on identifying and providing feedback on at-risk behaviors observed.In 2020, our Kosse mine site was recognized for the Sentinels of Safety Award by the National Mining Association, the highest distinction for mine safety. This is the second time Kosse has been awarded in the last three years showing the commitment to safety at our mining operations.10Table of ContentsDiversity, Equity and InclusionWe recognize the value of having a diverse and inclusive workforce. Our diversity includes all the ways we differ, such as age, gender, ethnicity and physical appearance, as well as underlying differences such as thoughts, styles, religions, nationality, education and numerous other traits. Creating and maintaining an environment where differences are valued and respected enhances our ability to recruit and retain the best talent in the marketplace. As we continue to promote and maintain an environment that fosters creativity, productivity and mutual respect, Vistra becomes the employer of choice by recognizing and using the value that each individual brings to the workplace.Vistra's diversity is evolving and management is leading by example. Overall, 28% of the Company's workforce is ethnically diverse. Women currently hold 26% of the Company's senior management positions, and ethnically diverse employees represent 23% of senior management. In 2020, the Board of Directors increased diversity as well. Currently three of the ten board members are women, and two of the ten board members are ethnically diverse.During 2020, we launched multiple initiatives to unlock the full potential of our people - and our company - through our diversity, equity, and inclusion efforts. We formalized a Diversity, Equity and Inclusion Advisory Council and expanded our Employee Resource Groups (ERG) to promote the appreciation of and communicate awareness of diverse employee groups and communities and their contribution to the overall success of the organization, both internally and externally. New ERGs will join existing ERGs such as Vistra's Women's Information Network, Opportunities for Professional Enrichment and Networking, Parents at Work, Veterans and Toastmasters. Further initiatives were launched to support the education, recruitment and retention of current and future employees, with particular emphasis being placed on driving equal access to opportunities throughout the organization. We contracted with Basic Diversity, Inc. to conduct an assessment of Vistra's diversity, equity and inclusion training needs, and as part of our commitment to diversity, equity and inclusion, we named our first Chief Diversity Officer in January 2021.Training and DevelopmentWe believe the development of employees at all levels is critical to Vistra's current and future success. We have launched key programs to develop leaders at all levels of the organization, including monthly leader meetings for director-level employees focusing on gaining a deeper understanding of Vistra's strategy, developing cross-functional relationships and interacting with senior leadership of the company. Essentials in Leadership provides first time managers with skills to lead organizations in situational leadership, business acumen, identification of communication styles and inclusive communication practices, and exposes them to best practices from across the company. We also revised multiple leadership programs to continue virtually during the COVID-19 pandemic.Vistra also provides many other training and development programs to help grow and develop employees at every level, including online learning platform courses, learning management system courses, recorded webinars and presentations, self-paced development and employee-specific skill training. Thousands of web-based targeted courses are available to all employees, and the company further supports employees in completing thousands of hours of professional training to support continuing education requirements for their respective professional licenses, including accounting, legal and nuclear. We also support a variety of employee-initiated and -led programs based on demographics, interests and purpose, including Women's Information Network, Opportunities for Professional Enrichment and Networking, Parents at Work, TXU Green Team and Toastmasters.Employee BenefitsMaintaining attractive benefits and pay are important for recruiting and retaining talent. We are committed to maintaining an equitable compensation structure, including performing annual salary reviews by employee category level within significant locations of operations. Eligible full- and part-time employees are provided access to medical, prescription drug, dental, vision, life insurance, accidental death and dismemberment and long-term disability coverage. Regular full-time employees are eligible for short-term disability benefits, and all employees are eligible for the employee assistance program, parental leave, maternity leave and a 401(k) plan through which the Company matches employee contributions up to 6%.11Table of ContentsWellnessWe believe a healthy workforce leads to greater well-being at work and at home. Our healthcare plans are designed to reward employees for getting annual physicals and cancer screenings. Fitness centers in multiple facilities offer cardio equipment, a selection of free weights and exercise mats. Our employee-led wellness team engages our people to get active and support causes that promote healthy living. With support from the company, the wellness team covers the registration costs for employees to participate in more than a dozen running events each year. Additionally, the team hosts quarterly blood drives and recruits participants for our cycling and soccer teams.Environmental Regulations and Related ConsiderationsWe are subject to extensive environmental regulation by governmental authorities, including the EPA and the environmental regulatory bodies of states in which we operate. The EPA has recently finalized or proposed several regulatory actions establishing new requirements for control of certain emissions from sources, including electricity generation facilities. See Item 1A. Risk Factors for additional discussion of risks posed to us regarding regulatory requirements. See Note 13 to the Financial Statements for a discussion of litigation related to EPA reviews.In January 2021, the Biden administration issued a series of Executive Orders, including one titled Protecting Public Health and the Environment and Restoring Science to Tackle the Climate Crisis (the Environment Executive Order) which directed agencies, including the EPA, to review various agency actions promulgated during the prior administration and take action where the previous administration's action conflicts with national objectives. Several of the EPA agency actions discussed below are now subject to this review.Climate ChangeThere is increasing attention and interest domestically and internationally about global climate change and how greenhouse gas (GHG) emissions, such as carbon dioxide (CO2), contribute to global climate change. GHG emissions from the combustion of fossil fuels, primarily by our coal/lignite-fueled-generation plants, represent the substantial majority of our total GHG emissions. CO2, methane and nitrous oxide are emitted in this combustion process, with CO2 representing the largest portion of these GHG emissions. We estimate that our generation facilities produced approximately 103 million short tons of CO2 in 2020.We have already taken or announced significant steps to transition the fuel-mix and reduce the emissions profile of our generation fleet, including:•Solar Development Projects — In 2018, we began commercial operation of our 180 MW Upton 2 solar facility. In September 2020, we announced the planned development of 668 MW of solar generation facilities in Texas that are expected to begin commercial operations during 2021-2022.•Battery Energy Storage Projects — In 2018, our 10 MW battery energy storage system (ESS) at our Upton 2 solar facility in Texas commenced operations. Between 2018 and 2020, we announced the planned development of approximately 436 MW of various ESSs in California that are expected to enter commercial operations in 2021-2022. In September 2020, we announced the planned development of a 260 MW ESS in Texas that is expected to enter commercial operation in 2022.•Acquisition of CCGTs — In 2016 and 2017, we acquired 4,042 MW of CCGTs in Texas. In 2018, we acquired 15,448 MW of CCGTs across various ISOs/RTOs in connection with the Merger.•Retirements of Coal Generation — In 2018, we retired 4,167 MW of lignite/coal-fueled generation facilities in Texas. In 2019, we retired 2,068 MW of coal-fueled generation facilities in Illinois. We expect to retire an additional 7,486 MW of coal-fueled generation facilities in Illinois, Ohio and Texas no later than year-end 2027.See Note 3 to the Financial Statements for discussion of our solar and battery energy storage projects and Note 4 to the Financial Statements for discussion of our retirement of generation facilities.12Table of ContentsGreenhouse Gas EmissionsIn August 2015, the EPA finalized rules to address GHG emissions from electricity generation units, referred to as the Clean Power Plan, including rules for existing facilities that would establish state-specific emissions rate goals to reduce nationwide CO2 emissions. Various parties filed petitions for review in the U.S. Court of Appeals for the District of Columbia Circuit (D.C. Circuit Court). In July 2019, petitioners filed a joint motion to dismiss in light of the EPA's new rule that replaces the Clean Power Plan, the Affordable Clean Energy rule, discussed below. In September 2019, the D.C. Circuit Court granted petitioners' motion to dismiss and dismissed all of the petitions challenging the Clean Power Plan as moot.In July 2019, the EPA finalized a rule to repeal the Clean Power Plan, with new regulations addressing GHG emissions from existing coal-fueled electric generation units, referred to as the Affordable Clean Energy (ACE) rule. The ACE rule develops emission guidelines that states must use when developing plans to regulate GHG emissions from existing coal-fueled electric generating units. The ACE rule set a deadline of July 2022 for states to submit their plans for regulating GHG emissions from existing facilities. States where we operate coal plants (Texas, Illinois and Ohio) have begun the development of their state plans to comply with the rule. Environmental groups and certain states filed petitions for review of the ACE rule and the repeal of the Clean Power Plan in the D.C. Circuit Court, and the D.C. Circuit Court heard argument on those issues in October 2020. In January 2021, the D.C. Circuit Court vacated the ACE rule and remanded the rule to the EPA for further action. In its decision, the D.C. Circuit Court concluded that the EPA's basis for repealing the Clean Power Plan and adopting the ACE rule was not supported by the Clean Air Act. Additionally, in December 2018, the EPA issued proposed revisions to the emission standards for new, modified and reconstructed units. Vistra submitted comments on that proposed rulemaking in March 2019. In January 2021, the EPA, just prior to the transition to the Biden administration, issued a final rule setting forth a significant contribution finding for the purpose of regulating GHG emissions from new, modified, or reconstructed electric utility generating units. The final rule exclude sectors from future regulation where GHG emissions make up less than three percent of U.S. GHG emissions. The final rule did not set any specific emission limits for new, modified, or reconstructed electric utility generating units. The ACE rule and the rule on significant contribution are subject to the Environment Executive Order discussed above.State Regulation of GHGsMany states where we operate generation facilities have, are considering, or are in some stage of implementing, state-only regulatory programs intended to reduce emissions of GHGs from stationary sources as a means of addressing climate change.Regional Greenhouse Gas Initiative (RGGI) — RGGI is a state-driven GHG emission control program that took effect in 2009 and was initially implemented by ten New England and Mid-Atlantic states to reduce CO2 emissions from power plants. The participating RGGI states implemented a cap-and-trade program. Compliance with RGGI can be achieved by reducing emissions, purchasing or trading allowances, or securing offset allowances from an approved offset project. We are required to hold allowances equal to at least 50 percent of emissions in each of the first two years of the three-year control period.In December 2017, the RGGI states released an updated model rule with changes to the CO2 budget trading program, including an additional 30 percent reduction in the CO2 annual cap by the year 2030, relative to 2020 levels.Our generating facilities in Connecticut, Maine, Massachusetts, New Jersey and New York emitted approximately 7 million tons of CO2 during 2020. The spot market price of RGGI allowances required to operate these facilities as of December 31, 2020 was approximately $8.11 per allowance. The spot market price of RGGI allowances required to operate our affected facilities during 2021 was $8.34 per allowance on February 23, 2021. While the cost of allowances required to operate our RGGI-affected facilities is expected to increase in future years, we expect that the cost of compliance would be reflected in the power market, and the actual impact to gross margin would be largely offset by an increase in revenue.Massachusetts — In August 2017, the Massachusetts Department of Environmental Protection (MassDEP) adopted final rules establishing an annual declining limit on aggregate CO2 emissions from 21 in-state fossil-fueled electricity generation units. The rules establish an allowance trading system under which the annual aggregate electricity generation unit sector cap on CO2 emissions declines from 8.96 million metric tons in 2018 to 1.8 million metric tons in 2050. MassDEP allocated emission allowances to affected facilities for 2018. Beginning in 2019, the allocation process transitioned to a competitive auction process whereby allowances are partially distributed through a competitive auction process and partially distributed based on the process and schedule established by the rule. Beginning in 2021, all allowances will be distributed through the auction. Limited banking of unused allowances is allowed.13Table of ContentsVirginia — In May 2019, the Virginia Department of Environmental Quality issued a final rule to adopt a carbon cap-and trade program for fossil-fueled electricity generation units, including our Hopewell facility, beginning in 2020. The program is based on the RGGI proposed 2017 model rule and will link Virginia to RGGI beginning in 2021.New Jersey — In January 2018, the Governor of New Jersey signed an executive order directing the state's environmental agency and public utilities board to begin the process of rejoining RGGI, and New Jersey formally rejoined RGGI in June 2019. In June 2019, New Jersey adopted two rules that govern New Jersey's reentry into the RGGI auction and distribution of the RGGI auction proceeds.California — Our assets in California are subject to the California Global Warming Solutions Act, which required the California Air Resources Board (CARB) to develop a GHG emission control program to reduce emissions of GHGs in the state to 1990 levels by 2020. In April 2015, the Governor of California issued an executive order establishing a new statewide GHG reduction target of 40 percent below 1990 levels by 2030 to ensure California meets its 2050 GHG reduction target of 80 percent below 1990 levels. We have participated in quarterly auctions or in secondary markets, as appropriate, to secure allowances for our affected assets.In July 2017, California enacted legislation extending its GHG cap-and-trade program through 2030 and the CARB adopted amendments to its cap-and-trade regulations that, among other things, established a framework for extending the program beyond 2020 and linking the program to the new cap-and-trade program in Ontario, Canada beginning in January 2018.Air EmissionsThe Clean Air Act (CAA)The CAA and comparable state laws and regulations relating to air emissions impose various responsibilities on owners and operators of sources of air emissions, which include requirements to obtain construction and operating permits, pay permit fees, monitor emissions, submit reports and compliance certifications, and keep records. The CAA requires that fossil-fueled electricity generation plants meet certain pollutant emission standards and have sufficient emission allowances to cover sulfur dioxide (SO2) emissions and in some regions nitrogen oxide (NOX) emissions.In order to ensure continued compliance with the CAA and related rules and regulations, we utilize various emission reduction technologies. These technologies include flue gas desulfurization (FGD) systems, dry sorbent injection (DSI), baghouses and activated carbon injection or mercury oxidation systems on select units and electrostatic precipitators, selective catalytic reduction (SCR) systems, low-NOX burners and/or overfire air systems on all units. Additionally, our MISO coal-fueled facilities mainly use low sulfur coal, which, prior to combustion, goes through a refined coal process to further reduce NOX and mercury emissions. In 2018, we received approval to use refined coal at some of our Texas coal-fueled facilities.Regional Haze — Reasonable Progress and Best Available Retrofit Technology (BART) for TexasThe Regional Haze Program of the CAA establishes "as a national goal the prevention of any future, and the remedying of any existing, impairment of visibility in mandatory class I federal areas which impairment results from man-made pollution." There are two components to the Regional Haze Program. First, states must establish goals for reasonable progress for Class I federal areas within the state and establish long-term strategies to reach those goals and to assist Class I federal areas in neighboring states to achieve reasonable progress set by those states towards a goal of natural visibility by 2064. Second, certain electricity generation units built between 1962 and 1977 are subject to BART standards designed to improve visibility if such units cause or contribute to impairment of visibility in a federal class I area. BART reductions of SO2 and NOX are required either on a unit-by-unit basis or are deemed satisfied by state participation in an EPA-approved regional trading program such as the CSAPR or other approved alternative program.14Table of ContentsIn October 2017, the EPA issued a final rule addressing BART for Texas electricity generation units, with the rule serving as a partial approval of Texas' 2009 State Implementation Plan (SIP) and a partial Federal Implementation Plan (FIP). For SO2, the rule established an intrastate Texas emission allowance trading program as a "BART alternative" that operates in a similar fashion to a CSAPR trading program. The program includes 39 generating units (including our Martin Lake, Big Brown, Monticello, Sandow 4, Coleto Creek, Stryker 2 and Graham 2 plants). The compliance obligations in the program started on January 1, 2019. The retirements of our Monticello, Big Brown and Sandow 4 plants have enhanced our ability to comply with this BART rule for SO2. For NOX, the rule adopted the CSAPR's ozone program as BART and for particulate matter, the rule approved Texas's SIP that determines that no electricity generation units are subject to BART for particulate matter. Various parties filed a petition challenging the rule in the Fifth Circuit Court as well as a petition for reconsideration filed with the EPA. Luminant intervened on behalf of the EPA in the Fifth Circuit Court action. In March 2018, the Fifth Circuit Court abated its proceedings pending conclusion of the EPA's reconsideration process. In August 2020, the EPA issued a final rule affirming the prior BART final rule but also included additional revisions that were proposed in November 2019. In October 2020, environmental groups petitioned for review of this rule in both the D.C. Circuit Court and the Fifth Circuit Court. Briefing is underway on the proper venue for any challenge to the final rule. As finalized, we expect that we will be able to comply with the rule. The BART rule is subject to the Environment Executive Order discussed above.Affirmative Defenses During MalfunctionsIn May 2015, the EPA finalized a rule requiring 36 states, including Texas, Illinois and Ohio, to remove or replace either EPA-approved exemptions or affirmative defense provisions for excess emissions during upset events and unplanned maintenance and startup and shutdown events, referred to as the SIP Call. Various parties (including Luminant, the State of Texas and the State of Ohio) filed petitions for review of the EPA's final rule, and all of those petitions were consolidated in the D.C. Circuit Court. In April 2017, the D.C. Circuit Court ordered the case to be held in abeyance. In April 2019, the EPA Region 6 proposed a rule to withdraw the SIP Call with respect to the Texas affirmative defense provisions. We submitted comments on that proposed rulemaking in June 2019. In February 2020, the EPA issued the final rule withdrawing the Texas SIP Call. In April 2020, a group of environmental petitioners, including the Sierra Club, filed a petition in the D.C. Circuit Court challenging the EPA's action with respect to Texas. Briefing is currently underway in the challenge to the EPA's action with respect to Texas. In October 2020, the EPA issued new guidance on the inclusion of startup, shutdown and malfunction (SSM) provisions in SIPs, which is intended to supersede the policy in the multi-state SIP Call. The guidance provides that the SIPs may contain provisions for SSM events if certain conditions are met. The EPA SSM guidance is subject to the Environment Executive Order discussed above.Illinois Multi-Pollutant Standards (MPS)In August 2019, changes proposed by the Illinois Pollution Control Board to the MPS rule, which places NOX, SO2 and mercury emissions limits on our coal plants located in MISO went into effect. Under the revised MPS rule, our allowable SO2 and NOX emissions from the MISO fleet are 48% and 42% lower, respectively, than prior to the rule changes. The revised MPS rule requires the continuous operation of existing selective catalytic reduction (SCR) control systems during the ozone season, requires SCR-controlled units to meet an ozone season NOX emission rate limit, and set an additional, site-specific annual SO2 limit for our Joppa Power Station. Additionally, in 2019, the Company retired its Havana, Hennepin, Coffeen and Duck Creek plants in order to comply with the MPS rule's requirement to retire at least 2,000 MW of our generation in MISO. See Note 4 to the Financial Statements for information regarding the retirement of these four plants.National Ambient Air Quality Standards (NAAQS)The CAA requires the EPA to regulate emissions of pollutants considered harmful to public health and the environment. The EPA has established NAAQS for six such pollutants, including SO2 and ozone. Each state is responsible for developing a SIP that will attain and maintain the NAAQS. These plans may result in the imposition of emission limits on our facilities.15Table of ContentsSO2 Designations for TexasIn November 2016, the EPA finalized its nonattainment designations for counties surrounding our Big Brown, Monticello and Martin Lake generation plants. The final designations require Texas to develop nonattainment plans for these areas. In February 2017, the State of Texas and Luminant filed challenges to the nonattainment designations in the Fifth Circuit Court. Subsequently, in October 2017, the Fifth Circuit Court granted the EPA's motion to hold the case in abeyance considering the EPA's representation that it intended to revisit the nonattainment rule. In December 2017, the TCEQ submitted a petition for reconsideration to the EPA. In August 2019, the EPA issued a proposed Error Correction Rule for all three areas, which, if finalized, would revise its previous nonattainment designations and each area at issue would be designated unclassifiable. In September 2019, we submitted comments in support of the proposed Error Correction Rule. In April 2020, the Sierra Club filed suit to compel the EPA to issue a Finding of Failure to submit an attainment plan with respect to the three areas in Texas. In August 2020, the EPA issued a Finding of Failure for Texas to submit an attainment plan. In September 2020, the EPA proposed a "Clean Data" determination for the areas surrounding the retired Big Brown and Monticello plants, which, if finalized, would redesignate those areas as attainment based on monitoring data supporting an attainment designation. We expect the TCEQ to develop a SIP for Texas for submittal to the EPA in 2021.Ozone DesignationsThe EPA issued a final rule in October 2015 lowering the ozone NAAQS from 75 to 70 parts per billion. Various parties challenged the 2015 ozone NAAQS; however, in August 2019, the D.C. Circuit Court generally upheld the 2015 ozone NAAQS but remanded the secondary ozone standard to the EPA for reconsideration. In November 2017, the EPA issued an initial round of area designations for the 2015 ozone NAAQS, designating most areas of the U.S. as attainment/unclassifiable. Several states and other groups have filed lawsuits seeking to compel the EPA to complete designations for all areas of the country. In December 2017, the EPA notified states of expected nonattainment area designations for the 2015 ozone NAAQS. Those areas include areas concerning our Dicks Creek, Miami Fort and Zimmer facilities in Ohio, our Calumet facility in Illinois and our Wise, Ennis and Midlothian facilities in Texas. In June 2018, the EPA finalized these designations as marginal nonattainment areas.In November 2017, the EPA denied a petition from nine northeastern states to add several states, including Illinois and Ohio, to the Ozone Transport Region. Eight of the northeastern states filed a petition for judicial review challenging the EPA's action in the D.C. Circuit Court. In April 2019, the D.C. Circuit Court denied the states' petition for review, upholding the EPA's denial. Additionally, in January 2018, New York and Connecticut filed a lawsuit against the EPA in the Southern District of New York seeking to compel the agency to issue a FIP for the 2008 ozone NAAQS that addresses sources in five upwind states, including Illinois. The plaintiffs filed a motion for summary judgment on the matter in April 2018, and the court granted that motion in June 2018. As a result, the EPA was required to propose an action to address the 2008 ozone NAAQS by June 29, 2018, and promulgate a final action by December 6, 2018. In January 2019, the plaintiffs informed the district court that the EPA had satisfied its deadlines in accordance with the court's order. However, in January 2019, New York, Connecticut, four other states, and the City of New York filed a separate petition for review in the D.C. Circuit Court challenging the final action the EPA took in December 2018 consistent with the Southern District of New York's order. In October 2019, the D.C. Circuit Court vacated the final rule, and in February 2020, New Jersey, Connecticut, three other states and the City of New York filed a lawsuit against the EPA in the Southern District of New York to compel the EPA to promulgate a fully-compliant FIP to address the 2008 ozone NAAQS in light of the D.C. Circuit Court's vacatur. In July 2020, the U.S. District Court for the Southern District of New York ordered the EPA to issue a final rulemaking fully addressing the 2008 ozone NAAQS by March 15, 2021. The EPA proposed its action to address the outstanding 2008 ozone NAAQS obligations in October 2020. Vistra subsidiaries filed comments on that rulemaking in December 2020. These actions are subject to the Environment Executive Order discussed above.In November 2016, the State of Maryland petitioned the EPA to impose additional NOX emission control requirements on 36 electricity generation units in five upwind states, including our Zimmer facility, that the State alleges are contributing to nonattainment with the 2008 ozone NAAQS in Maryland. In the fall of 2017, Maryland and several environmental groups filed lawsuits against the EPA seeking to compel the Agency to act on the State's petition. In October 2018, the EPA took final action denying the Maryland petition, and Maryland filed a petition for review of the EPA's denial in the D.C. Circuit Court. In May 2020, the D.C. Circuit Court largely upheld the EPA's denial of Maryland's petition but granted Maryland's petition with respect to the EPA's treatment of sources with non-catalytic controls and remanded the issue to the EPA. Given that the Zimmer facility utilizes SCR technology to control NOX emissions, we do not believe that the EPA's action on remand could cause a material adverse impact on our future financial results.16Table of ContentsIn March 2018, the State of New York petitioned the EPA to find that emissions from hundreds of sources in nine states, including Illinois, Ohio, Virginia and West Virginia are significantly contributing to New York's nonattainment and interfering with New York's maintenance of the 2008 and 2015 ozone NAAQS. On October 18, 2019, the EPA took final action denying New York's petition. On October 29, 2019, New York, New Jersey and the City of New York filed a petition for review of the EPA's denial of the Section 126 petition. In July 2020, the D.C. Circuit Court vacated the EPA's denial and remanded the action to the EPA for further proceedings.Coal Combustion Residuals (CCR)/GroundwaterThe combustion of coal to generate electric power creates large quantities of ash and byproducts that are managed at power generation facilities in dry form in landfills and in wet form in surface impoundments. Each of our coal-fueled plants has at least one CCR surface impoundment. At present, CCR is regulated by the states as solid waste.Coal Combustion ResidualsThe EPA's CCR rule, which took effect in October 2015, establishes minimum federal requirements for the construction, retrofitting, operation and closure of, and corrective action with respect to, existing and new CCR landfills and surface impoundments, as well as inactive CCR surface impoundments. The requirements include location restrictions, structural integrity criteria, groundwater monitoring, operating criteria, liner design criteria, closure and post-closure care, recordkeeping and notification. The rule allows existing CCR surface impoundments to continue to operate for the remainder of their operating life, but generally would require closure (i.e., cessation of placement of CCR material and corrective action necessary to reach the standards provided in the CCR rule and applicable state rules) if groundwater monitoring demonstrates that the CCR surface impoundment is responsible for exceedances of groundwater quality protection standards or the CCR surface impoundment does not meet location restrictions or structural integrity criteria. The deadlines for beginning and completing closure vary depending on several factors. Several petitions for judicial review of the CCR rule were filed. The Water Infrastructure Improvements for the Nation Act (the WIIN Act), which was enacted in December 2016, provides for EPA review and approval of state CCR permit programs.In July 2018, the EPA published a final rule, which became effective in August 2018, that amends certain provisions of the CCR rule that the agency issued in 2015. Among other changes, the 2018 revisions extended closure deadlines to October 31, 2020, related to the aquifer location restriction and groundwater monitoring requirements. Also, in August 2018, the D.C. Circuit Court issued a decision that vacates and remands certain provisions of the 2015 CCR rule, including an applicability exemption for legacy impoundments. In December 2019, the EPA issued a proposed rule containing a revised closure deadline for unlined CCR impoundments and new procedures for seeking extensions of that revised closure deadline. We filed comments on the proposal in January 2020. In August 2020, the EPA issued a rule finalizing the December 2019 proposal, establishing a deadline of April 11, 2021 to cease receipt of waste and initiate closure at unlined CCR impoundments. The final rule allows a generation plant to seek the EPA's approval to extend this deadline if no alternative disposal capacity is available and either a conversion to comply with the CCR rule is underway or retirement will occur by either 2023 or 2028 (depending on the size of the impoundment at issue). Prior to the November 2020 deadline, we submitted applications to the EPA requesting compliance extensions under both conversion and retirement scenarios. In November 2020, environmental groups petitioned for review of this rule in the D.C. Circuit Court, and Vistra subsidiaries filed a motion to intervene in support of the EPA in December 2020. Also, in November 2020, the EPA finalized a rule that would allow an alternative liner demonstration for certain qualifying facilities. In November 2020, we submitted an alternate liner demonstration for one CCR unit at Martin Lake. In October 2020, the EPA published an advanced notice of proposed rulemaking requesting information to inform the EPA in the development of a rule to address legacy impoundments that existed prior to the 2015 CCR regulation as required by the August 2018 D.C. Circuit Court decision. We filed comments on this proposal in February 2021. The rules on revised closure deadlines and alternative liner demonstrations are subject to the Environment Executive Order discussed above.MISO — In 2012, the Illinois Environmental Protection Agency (IEPA) issued violation notices alleging violations of groundwater standards onsite at our Baldwin and Vermilion facilities' CCR surface impoundments. These violation notices remain unresolved; however, in 2016, the IEPA approved our closure and post-closure care plans for the Baldwin old east, east, and west fly ash CCR surface impoundments. We are working towards implementation of those closure plans.17Table of ContentsAt our retired Vermilion facility, which was not subject to the EPA's 2015 CCR rule until the aforementioned D.C. Circuit Court decision in August 2018, we submitted proposed corrective action plans involving closure of two CCR surface impoundments (i.e., the old east and the north impoundments) to the IEPA in 2012, and we submitted revised plans in 2014. In May 2017, in response to a request from the IEPA for additional information regarding the closure of these Vermilion surface impoundments, we agreed to perform additional groundwater sampling and closure options and riverbank stabilizing options. In May 2018, Prairie Rivers Network filed a citizen suit in federal court in Illinois against our subsidiary Dynegy Midwest Generation, LLC (DMG), alleging violations of the Clean Water Act for alleged unauthorized discharges. In August 2018, we filed a motion to dismiss the lawsuit. In November 2018, the district court granted our motion to dismiss and judgment was entered in our favor. Plaintiffs have appealed the judgment to the U.S. Court of Appeals for the Seventh Circuit and argument was heard in November 2020. In April 2019, PRN also filed a complaint against DMG before the Illinois Pollution Control Board (IPCB), alleging that groundwater flows allegedly associated with the ash impoundments at the Vermilion site have resulted in exceedances both of surface water standards and Illinois groundwater standards dating back to 1992. This matter is in the very early stages.In 2012, the IEPA issued violation notices alleging violations of groundwater standards at the Newton and Coffeen facilities' CCR surface impoundments. We are addressing these CCR surface impoundments in accordance with the federal CCR rule. In June 2018, the IEPA issued a violation notice for alleged seep discharges claimed to be coming from the surface impoundments at our retired Vermilion facility and that notice has since been referred to the Illinois Attorney General.In December 2018, the Sierra Club filed a complaint with the IPCB alleging the disposal and storage of coal ash at the Coffeen, Edwards, and Joppa generation facilities are causing exceedances of the applicable groundwater standards.In July 2019, coal ash disposal and storage legislation in Illinois was enacted. The legislation addresses state requirements for the proper closure of coal ash ponds in the state of Illinois. The law tasks the IEPA and the IPCB to set up a series of guidelines, rules and permit requirements for closure of ash ponds. In March 2020, the IEPA issued its proposed rule, and we expect the rulemaking process should be completed by early 2021. Under the proposed rule, coal ash impoundment owners would be required to submit a closure alternative analysis to the IEPA for the selection of the best method for coal ash remediation at a particular site. The proposed rule does not mandate closure by removal at any site. Public hearings for the proposed rule were held in August 2020 and September 2020. We expect that the rule will be finalized by March 2021.For all of the above matters, if certain corrective action measures, including groundwater treatment or removal of ash, are required at any of our coal-fueled facilities, we may incur significant costs that could have a material adverse effect on our financial condition, results of operations, and cash flows. Until the revisions to the Illinois coal ash rulemaking are finalized and we undertake further site-specific evaluations required by each program we will not know the full range of costs of groundwater remediation, if any, that ultimately may be required under those rules. However, the currently anticipated CCR surface impoundment and landfill closure costs, as reflected in our existing ARO balances, reflect the costs of closure methods that our operations and environmental services teams believe are appropriate and protective of the environment for each location.WaterThe EPA and the environmental regulatory bodies of states in which we operate have jurisdiction over the diversion, impoundment and withdrawal of water for cooling and other purposes and the discharge of wastewater (including storm water) from our facilities. We believe our facilities are presently in material compliance with applicable federal and state requirements relating to these activities. We believe we hold all required permits relating to these activities for facilities in operation and have applied for or obtained necessary permits for facilities under construction. We also believe we can satisfy the requirements necessary to obtain any required permits or renewals.Cooling Water Intake Structures — Clean Water Act Section 316(b) regulations pertaining to existing water intake structures at large generation facilities became effective in 2014. This provision generally requires that the location, design, construction and capacity of cooling water intake structures reflect the best technology available for minimizing adverse environmental impacts. Although the rule does not mandate a certain control technology, it does require site-specific assessments of technology feasibility on a case-by-case basis at the state level.18Table of ContentsAt this time, we estimate the cost of our compliance with the cooling water intake structure rule to be minimal at our Illinois plants due to the planned retirements of those plants by 2027. Our estimate could change materially depending upon a variety of factors, including site-specific determinations made by states in implementing the rule, the results of impingement and entrainment studies required by the rule, the results of site-specific engineering studies and the outcome of litigation concerning the rule and potential plant retirements.Effluent Limitation Guidelines (ELGs) — In November 2015, the EPA revised the ELGs for steam electricity generation facilities, which will impose more stringent standards (as individual permits are renewed) for wastewater streams, such as flue gas desulfurization (FGD), fly ash, bottom ash and flue gas mercury control wastewaters. Various parties filed petitions for review of the ELG rule, and the petitions were consolidated in the Fifth Circuit Court. In April 2017, the EPA granted petitions requesting reconsideration of the ELG rule and administratively stayed the rule's compliance date deadlines. In August 2017, the EPA announced that its reconsideration of the ELG rule would be limited to a review of the effluent limitations applicable to FGD and bottom ash wastewaters and the agency subsequently postponed the earliest compliance dates in the ELG rule for the application of effluent limitations for FGD and bottom ash wastewaters from November 1, 2018 to November 1, 2020. Based on these administrative developments, the Fifth Circuit Court agreed to sever and hold in abeyance challenges to effluent limitations. The remainder of the case proceeded, and in April 2019 the Fifth Circuit Court vacated and remanded portions of the EPA's ELG rule pertaining to effluent limitations for legacy wastewater and leachate. In November 2019, the EPA issued a proposal that would extend the compliance deadline for FGD wastewater to no later than December 31, 2025 and maintains the December 31, 2023 compliance date for bottom ash transport water. The proposal also creates new sub-categories of facilities with more flexible FGD compliance options, including a retirement exemption to 2028 and a low utilization boiler exemption. The proposed rule also modified some of the FGD final effluent limitations. We filed comments on the proposal in January 2020. The EPA published the final rule in October 2020. The final rule extends the compliance date for both FGD and bottom ash transport water to no later than December 2025, as negotiated with the state permitting agency. Additionally, the final rule allows for a retirement exemption that exempts facilities certifying that units will retire by December 2028 provided certain effluent limitations are met. Notification to the state agency on the retirement exemption is due by October 2021. In November 2020, environmental groups petitioned for review of the new ELG revisions, and Vistra subsidiaries filed a motion to intervene in support of the EPA in December 2020. The final rule is subject to the Environment Executive Order discussed above.Radioactive WasteThe nuclear industry has developed ways to store used nuclear fuel on site at nuclear generation facilities, primarily using dry cask storage, since there are no facilities for reprocessing or disposal of used nuclear fuel currently in operation in the U.S. Luminant stores its used nuclear fuel on-site in storage pools or dry cask storage facilities and believes its on-site used nuclear fuel storage capability is sufficient for the foreseeable future.19Table of ContentsItem 1A.RISK FACTORSSummary of Risk FactorsThe following summarizes the principal factors that make an investment in our company speculative or risky, all of which are more fully described in the Risk Factors section below. This summary should be read in conjunction with the Risk Factors section and should not be relied upon as an exhaustive summary of the material risks facing our business. The following factors could result in harm to our business, financial condition, results of operations, cash flows, and prospects, among other impacts:Market, Financial and Economic Risks•Our revenues, results of operations and operating cash flows are affected by price fluctuations in the wholesale power market and other market factors beyond our control.•We purchase natural gas, coal, fuel oil, and nuclear fuel for our generation facilities, and higher than expected fuel costs or disruptions in these fuel markets may have an adverse impact on, our costs, revenues, results of operations, financial condition and cash flows.•We have retired, announced planned retirements, and may be forced to retire or idle additional, underperforming generation units which could result in significant costs and have an adverse effect on our operating results.•Our assets or positions cannot be fully hedged against changes in commodity prices and market heat rates, and hedging transactions may not work as planned or hedge counterparties may default on their obligations.•Competition, changes in market structure, and/or state or federal interference in the wholesale and retail power markets, together with subsidized generation, may have a material adverse effect on our financial condition, results of operations and cash flows.•Our results of operations and financial condition could be materially and adversely affected if energy market participants continue to construct new generation facilities or expand or enhance existing generation facilities despite relatively low power prices and such additional generation capacity results in a reduction in wholesale power prices.•The agreements and instruments governing our debt, including the Vistra Operations Credit Facilities and indentures, contain restrictions and limitations that could affect our ability to operate our business, our liquidity, and our results of operations, and any failure to comply with these restrictions could have a material adverse effect on us.•We may not be able to complete future acquisitions on favorable terms or at all, successfully integrate future acquisitions into our business, or effectively identify and invest in value-creating businesses, assets or projects, which could result in unanticipated expenses and losses or otherwise hinder or delay our growth strategy.•Our solar generation, energy storage system, and other renewables development projects are subject to substantial uncertainties.•Tax legislation initiatives or challenges to our tax positions, or potential future legislation or the imposition of new or increased taxes or fees, could have a material adverse affect on our financial condition, results of operations and cash flows.•We are required to pay the holders of TRA Rights for certain tax benefits, which amounts are expected to be substantial.Regulatory and Legislative Risks•Our businesses are subject to ongoing complex governmental regulations and legislation that have adversely impacted, and may in the future adversely impact, our businesses, results of operations, liquidity and financial condition.•Our cost of compliance with existing and new environmental laws could have a material adverse effect on us.20Table of Contents•Pending or proposed laws or regulations, including those proposed or implemented under the Biden administration, could have a material adverse effect on our businesses, results of operations, liquidity and financial condition.•Changes to laws, rules or regulations related to market structures in the markets in which we participate may have a material adverse effect on our businesses, results of operation, liquidity and financial condition.•We could be materially and adversely affected if current regulations are implemented or if new federal or state legislation or regulations are adopted to address global climate change, or if we are subject to lawsuits for alleged damage to persons or property resulting from greenhouse gas emissions.•Litigation, legal proceedings, regulatory investigations or other administrative proceedings could expose us to significant liabilities and reputational damage that could have a material adverse effect on us.Operational Risks•Volatile power supply costs and demand for power have and could in the future adversely affect the financial performance of our retail businesses.•Our retail operations are subject to significant competition from other REPs, which could result in a loss of existing customers and the inability to attract new customers.•The operation of our businesses is subject to cyber-based security and integrity risk. Attacks on our infrastructure that breach cyber/data security measures could expose us to significant liabilities, reputational damage, regulatory action, and disrupt business operations, which could have a material adverse effect on us.•We may suffer material losses, costs and liabilities due to operational risks, regulatory risks, and the risk of nuclear accidents arising from the ownership and operation of the Comanche Peak nuclear generation facility.•The operation and maintenance of power generation facilities and related mining operations are capital intensive and involve significant risks that could adversely affect our results of operations, liquidity and financial condition.•We may be materially and adversely affected by obligations to comply with federal and state regulations, laws, and other legal requirements that govern the operations, assessments, storage, closure, corrective action, disposal and monitoring relating to CCR.•We are subject to, and may be materially and adversely affected by, the effects of extreme weather conditions and seasonality.•The outbreak of COVID-19, or the future outbreak of any other highly infectious or contagious diseases, could have a material and adverse effect on our business, financial condition, results of operations and cash flows.•Changes in technology, increased electricity conservation efforts, or energy sustainability efforts may reduce the value of our generation facilities and may otherwise have a material adverse effect on us.Risks Related to Our Structure and Ownership of our Common Stock•Investor focus on environmental, social, and governance issues, including climate change and sustainability matters, could adversely affect our stock price.21Table of ContentsPlease carefully consider the following discussion of significant factors, events, and uncertainties that make an investment in our securities risky. These factors, in addition to others specifically addressed in Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations (MD&A), provide important information for the understanding of our forward-looking statements in this annual report on Form 10-K. If one or more of the factors, events and uncertainties discussed below or in the MD&A were to materialize, our business, results of operations, liquidity, financial condition, cash flows, reputation or prospects could be materially adversely affected. In addition, if one or more of such factors, events and uncertainties were to materialize, it could cause results or outcomes to differ materially from those contained in or implied by any forward-looking statement in this annual report on Form 10-K. There may be further risks and uncertainties that are not currently known or that are not currently believed to be material that may adversely affect our business, results of operations, liquidity, financial condition and prospects and the market price of our common stock in the future. The realization of any of these factors could cause investors in our securities (including our common stock) to lose all or a substantial portion of their investment.Market, Financial and Economic RisksOur revenues, results of operations and operating cash flows generally are affected by price fluctuations in the wholesale power market and other market factors beyond our control.We are not guaranteed any rate of return on capital investments in our businesses. We conduct integrated power generation and retail electricity activities, focusing on power generation, wholesale electricity sales and purchases, retail sales of electricity and natural gas to end users and commodity risk management. Our wholesale and retail businesses are to some extent countercyclical in nature, particularly for the wholesale power and ancillary services supplied to the retail business. However, we do have a wholesale power position that is subject to wholesale power price moves, which may be significant. As a result, our revenues, results of operations and operating cash flows depend in large part upon wholesale market prices for electricity, natural gas, uranium, lignite, coal, fuel, and transportation in our regional markets and other competitive markets in which we operate and upon prevailing retail electricity rates, which may be impacted by, among other things, actions of regulatory authorities.Market prices for power, capacity, ancillary services, natural gas, coal and fuel oil are unpredictable and may fluctuate substantially over relatively short periods of time. Unlike most other commodities, electric power can only be stored on a very limited basis and generally must be produced concurrently with its use. As a result, power prices are subject to significant volatility due to supply and demand imbalances, especially in the day-ahead and spot markets. Demand for electricity can fluctuate dramatically, creating periods of substantial under- or over-supply. Over-supply can occur as a result of the construction of new power generation sources, as we have observed in recent years. During periods of over-supply, electricity prices might be depressed. For example, the cost of electricity from renewable resources, such as solar, wind and battery storage systems, has dropped substantially in recent years. In many instances, energy from these sources are bid into the relevant spot market at a price of zero or close to zero during certain times of the day, lowering the clearing price for all power wholesalers in such market. Also, at times there is political pressure, or pressure from regulatory authorities with jurisdiction over wholesale and retail energy commodity and transportation rates, to impose price limitations, bidding rules and other mechanisms to address volatility and other issues in these markets.Extreme weather events can also materially impact power prices or otherwise exacerbate conditions or circumstances that result in volatility of power prices. For example, in February 2021, the U.S. experienced winter storm Uri and extreme cold temperatures in the central U.S., including Texas. This severe weather event substantially increased the demand for natural gas used in our electric power generation business, and the cold further limited the availability of renewable generation across the region contributing to extremely high market prices for natural gas and electricity, which resulted in substantial increases in the costs to procure sufficient fuel supply and increased collateral posting requirements. See "We may be materially and adversely affected by the effects of extreme weather conditions and seasonality" and Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations for additional discussion about the expected impacts of extreme weather, including the winter storm.22Table of ContentsThe majority of our facilities operate as "merchant" facilities without long-term power sales agreements. As a result, we largely sell electric energy, capacity and ancillary services into the wholesale energy spot market or into other wholesale and retail power markets on a short-term basis and are not guaranteed any rate of return on our capital investments. Consequently, there can be no assurance that we will be able to sell any or all of the electric energy, capacity or ancillary services from those facilities at commercially attractive rates or that our facilities will be able to operate profitably. We depend, in large part, upon prevailing market prices for power, capacity and fuel. Given the volatility of commodity power prices, to the extent we are unable to hedge or otherwise secure long-term power sales agreements for the output of our power generation facilities, our revenues and profitability will be subject to volatility, and our financial condition, results of operations and cash flows could be materially adversely affected.We purchase natural gas, coal, fuel oil, and nuclear fuel for our generation facilities, and higher than expected fuel costs, volatility, or disruption in these fuel markets may have an adverse impact on our costs, revenues, results of operations, financial condition and cash flows.We rely on natural gas, coal, fuel oil, and nuclear fuel for the majority of our power generation facilities. Delivery of these fuels to the facilities is dependent upon the continuing financial viability of contractual counterparties as well as upon the infrastructure (including mines, rail lines, rail cars, barge facilities, roadways, riverways and natural gas pipelines) available and functioning to serve each generation facility. As a result, we are subject to the risks of disruptions or curtailments in the production of power at our generation facilities if no fuel is available at any price, if a counterparty fails to perform or if there is a disruption in the fuel delivery infrastructure.We have sold forward a substantial portion of our expected power sales in the next one to two years in order to lock in long-term prices. In order to hedge our obligations under these forward power sales contracts, we have entered into long-term and short-term contracts for the purchase and delivery of fuel. Many of the forward power sales contracts do not allow us to pass through changes in fuel costs or discharge the power sale obligations in the case of a disruption in fuel supply due to force majeure events or the default of a fuel supplier or transporter. Fuel costs (including diesel, natural gas, lignite, coal and nuclear fuel) are volatile, and the wholesale price for electricity does not always change at the same rate as changes in fuel costs, and disruptions in our fuel supplies may therefore require us to find alternative fuel sources at costs which may be higher than planned, to find other sources of power to deliver to counterparties at a higher cost, or to pay damages to counterparties for failure to deliver power as contracted. Long-term and short-term contracts are subject to risk of non-delivery or claims of force majeure, which may impact our ability to economically recover the value of the contract. In addition, we purchase and sell natural gas and other energy related commodities, and volatility in these markets may affect costs incurred in meeting our obligations. Further, any changes in the costs of natural gas, coal, fuel oil, nuclear fuel or transportation rates and changes in the relationship between such costs and the market prices of power will affect our financial results. If we are unable to procure fuel for physical delivery at prices we consider favorable, or if we are unable to procure these fuels at all, our financial condition, results of operations and cash flows could be materially adversely affected.We also buy significant quantities of fuel on a short-term or spot market basis. Prices for all of our fuels fluctuate, sometimes rising or falling significantly over a relatively short period of time. The price we can obtain for the sale of energy may not rise at the same rate, or may not rise at all, to match a rise in fuel or delivery costs. This may have a material adverse effect on our financial and operating performance. Volatility in market prices for fuel and electricity results from, among other factors:•demand for energy commodities and general economic conditions;•volatility in commodity prices and the supply of commodities, including but not limited to natural gas, coal and fuel oil;•volatility in market heat rates;•volatility in coal and rail transportation prices;•volatility in nuclear fuel and related enrichment and conversion services;•disruption or other constraints or inefficiencies of electricity, natural gas or coal transmission or transportation;•severe, sustained or unexpected weather conditions, including extreme cold, drought and limitations on access to water;•seasonality;•changes in electricity and fuel usage resulting from conservation efforts, changes in technology or other factors;•illiquidity in the wholesale electricity or other commodity markets;•transmission or transportation disruptions, constraints, inoperability or inefficiencies, or other changes in power transmission infrastructure;•development and availability of new fuels, new technologies and new forms of competition for the production and storage of power, including competitively priced alternative energy sources or storage;23Table of Contents•changes in market structure and liquidity;•changes in the way we operate our facilities, including curtailed operation due to market pricing, environmental regulations and legislation, safety or other factors;•changes in generation capacity or efficiency;•outages or otherwise reduced output from our generation facilities or those of our competitors;•changes in electric capacity, including the addition of new supplies of power as a result of the development of new plants, expansion of existing plants, the continued operation of uneconomic power plants due to federal, state or local subsidies, or additional transmission capacity;•our creditworthiness and liquidity and the willingness of fuel suppliers and transporters to do business with us;•changes in the credit risk, payment practices, or financial condition of market participants;•changes in production and storage levels of natural gas, lignite, coal, uranium, diesel and other refined products;•natural disasters, wars, sabotage, terrorist acts, embargoes and other catastrophic events; and•changes in law, including judicial decisions, federal, state and local energy, environmental and other regulation and legislation.See Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations for additional discussion about the expected impacts of winter storm Uri.We have retired, announced planned retirements, and may be forced to retire or idle additional underperforming generation units which could result in significant costs and have an adverse effect on our operating results.A sustained decrease in the financial results from, or the value of, our generation units has resulted in the retirement or planned retirement of, and ultimately could result in additional retirements or idling of, generation units. In recent years, we have generally operated certain of our lignite- and coal-fueled generation assets only during parts of the year that have higher electricity demand and, therefore, higher related wholesale electricity prices. In connection with the closure and remediation of retired generation units, we have spent, and may in the future spend, a significant amount of money, internal resources and time to complete the required closure and reclamation, which could have a material adverse effect on our financial and operating performance.Our assets or positions cannot be fully hedged against changes in commodity prices and market heat rates, and hedging transactions may not work as planned or hedge counterparties may default on their obligations.Our hedging activities do not fully protect us against the risks associated with changes in commodity prices, most notably electricity and natural gas prices, because of the expected useful life of our generation assets and the size of our position relative to the duration of available markets for various hedging activities. Generally, commodity markets that we participate in to hedge our exposure to electricity prices and heat rates have limited liquidity after two to three years. Further, our ability to hedge our revenues by utilizing cross-commodity hedging strategies with natural gas hedging instruments is generally limited to a duration of four to five years. To the extent we have unhedged positions, fluctuating commodity prices and/or market heat rates can materially impact our results of operations, cash flows, liquidity and financial condition, either favorably or unfavorably.To manage our financial exposure related to commodity price fluctuations, we routinely enter into contracts to hedge portions of purchase and sale commitments, fuel requirements and inventories of natural gas, lignite, coal, diesel fuel, uranium and refined products, and other commodities, within established risk management guidelines. As part of this strategy, we routinely utilize fixed-price forward physical purchase and sale contracts, futures, financial swaps and option contracts traded in over-the-counter markets or on exchanges. Given our exposure to risks of commodity price movements, we devote a considerable amount of time and effort to the establishment of risk management policies and procedures, as well as the ongoing review of the implementation of these policies and procedures. Additionally, we have processes and controls in place that are designed to monitor and accurately report hedging activities and positions. The policies, procedures, processes and controls in place may not always function as planned and cannot eliminate all the risks associated with these activities, including unauthorized hedging activity, or improper reporting thereof, by our employees in violation of our existing risk management policies and procedures. For example, we hedge the expected needs of our wholesale and retail customers, but unexpected changes due to weather, natural disasters, consumer behavior, market constraints or other factors could cause us to purchase electricity to meet unexpected demand in periods of high wholesale market prices or resell excess electricity into the wholesale market in periods of low prices. As a result of these and other factors, the impacts of our commodity hedging activities and risk management decisions may have a material adverse effect on our business, financial condition, results of operations and cash flows.24Table of ContentsBased on economic and other considerations, we may not be able to, or we may decide not to, hedge the entire exposure of our operations to commodity price risk. To the extent we do not hedge against commodity price risk and applicable commodity prices change in ways adverse to us, we could be materially and adversely affected. To the extent we do hedge against commodity price risk, those hedges may ultimately prove to be ineffective. Additionally, there may be changes to existing laws or regulations that could significantly impact our ability to effectively hedge, which may have a material adverse effect on us.With the continued tightening of credit markets that began in 2008 and expansion of regulatory oversight through various financial reforms, there has been a decline in the number of market participants in the wholesale energy commodities markets, resulting in less liquidity. Notably, participation by financial institutions and other intermediaries (including investment banks) in such markets has declined. Extended declines in market liquidity could adversely affect our ability to hedge our financial exposure to desired levels.To the extent we engage in hedging and risk management activities, we are exposed to the credit risk that counterparties that owe us money, energy or other commodities as a result of these activities will not perform their obligations to us. Should the counterparties to these arrangements fail to perform, we could be forced to enter into alternative hedging arrangements or honor the underlying commitment at then-current market prices. Additionally, our counterparties may seek bankruptcy protection under Chapter 11 or liquidation under Chapter 7 of the Bankruptcy Code. Our credit risk may be exacerbated to the extent collateral held by us cannot be realized or is liquidated at prices not sufficient to recover the full amount due to us. There can be no assurance that any such losses or impairments to the carrying value of our financial assets would not materially and adversely affect our financial condition, results of operations and cash flows. In such event, we could incur losses or forgo expected gains in addition to amounts, if any, already paid to the counterparties. Market participants in the ISOs/RTOs in which we operate are also exposed to risks that another market participant may default on its obligations to pay such ISO/RTO for electricity or services taken, in which case such costs, to the extent not offset by posted security and other protections available to such ISO/RTO, may be allocated to various non-defaulting ISO/RTO market participants, including us.We do not apply hedge accounting to our commodity derivative transactions, which may cause increased volatility in our quarterly and annual financial results.We engage in economic hedging activities to manage our exposure related to commodity price fluctuations through the use of financial and physical derivative contracts for commodities. These derivatives are accounted for in accordance with GAAP, which requires that we record all derivatives on the balance sheet at fair value with changes in fair value immediately recognized in earnings as unrealized gains or losses. GAAP permits an entity to designate qualifying derivative contracts as normal purchases and sales. If designated, those contracts are not recorded at fair value. GAAP also permits an entity to designate qualifying derivative contracts in a hedge accounting relationship. If a hedge accounting relationship is used, a significant portion of the changes in fair value is not immediately recognized in earnings. We have elected not to apply hedge accounting to our commodity contracts, and we have designated contracts as normal purchases and sales in only limited cases, such as our retail sales contracts. As a result, our quarterly and annual financial results in accordance with GAAP are subject to significant fluctuations caused by changes in forward commodity prices. Competition, changes in market structure, and/or state or federal interference in the wholesale and retail power markets, together with subsidized generation, may have a material adverse effect on our financial condition, results of operations and cash flows.Our generation and competitive retail businesses rely on a competitive wholesale marketplace. The competitive wholesale marketplace may be undermined by changes in market structure and out-of-market subsidies provided by federal or state entities, including bailouts of uneconomic plants, imports of power from Canada, renewable mandates or subsidies, as well as out-of-market payments to new generators.Our power generation business competes with other non-utility generators, regulated utilities, unregulated subsidiaries of regulated utilities, other energy service companies and financial institutions in the sale of electric energy, capacity and ancillary services, as well as in the procurement of fuel, transmission and transportation services. Moreover, aggregate demand for power may be met by generation capacity based on several competing technologies, as well as power generating facilities fueled by alternative or renewable energy sources, including hydroelectric power, synthetic fuels, solar, wind, wood, geothermal, waste heat and solid waste sources. Regulatory initiatives designed to enhance and/or subsidize renewable generation increases competition from these types of facilities and out-of-market subsidies to existing or new generation can undermine the competitive wholesale marketplace, which can lead to premature retirement of existing facilities, including those owned by us.25Table of ContentsWe also compete against other energy merchants on the basis of our relative operating skills, financial position and access to credit sources. Electric energy customers, wholesale energy suppliers and transporters often seek financial guarantees, credit support such as letters of credit and other assurances that their energy contracts will be satisfied. Companies with which we compete may have greater resources or experience in these areas. Over time, some of our plants may become unable to compete because of subsidized generation, including public utility commission supported power purchase agreements, and the construction of new plants. Such new plants could have a number of advantages including: more efficient equipment, newer technology that could result in fewer emissions or more advantageous locations on the electric transmission system. Additionally, these competitors may be able to respond more quickly to new laws and regulations because of the newer technology utilized in their facilities or the additional resources derived from owning more efficient facilities.Other factors may contribute to increased competition in wholesale power markets. We expect that we will continue to face intense competition from numerous companies, including new entrants or consolidation of existing competitors, in the industry. Certain federal and state entities in jurisdictions in which we operate have either enacted or are considering regulations or legislation to subsidize otherwise uneconomic plants and attempt to incent, including through certain tax benefits, the construction and development of additional renewable resources as well as increases in energy efficiency investments. Subsidies (or increases thereto) to our competitors could have a material adverse effect on our financial condition, results of operations and cash flows.In addition, our retail marketing efforts compete for customers in a competitive environment, which impacts the margins that we can earn on the volumes we are able to serve. Further, with retail competition, it is easier for residential customers where we serve load to switch to and from competitive electricity generation suppliers for their energy needs. The volatility and uncertainty that results from such mobility may have material adverse effects on our financial condition, results of operations and cash flows. For example, if fewer customers switch to another supplier than anticipated, the load we must serve will be greater than anticipated and, if market prices of fuel have increased, our costs will increase more than expected due to the need to go to the market to cover the incremental supply obligation. If more customers switch to another supplier than anticipated, the load we must serve will be lower than anticipated and, if market prices of electricity have decreased, our operating results could suffer.Our results of operations and financial condition could be materially and adversely affected if energy market participants continue to construct new generation facilities or expand or enhance existing generation facilities despite relatively low power prices and such additional generation capacity results in a reduction in wholesale power prices.Given the overall attractiveness of certain of the markets in which we operate and certain tax benefits associated with renewable energy, among other matters, energy market participants have continued to construct new generation facilities or invest in enhancements or expansions of existing generation facilities despite relatively low wholesale power prices. If this market dynamic continues, our results of operations and financial condition could be materially and adversely affected if such additional generation capacity results in an over-supply of electricity that causes a reduction in wholesale power prices.Economic downturns would likely have a material adverse effect on our businesses.Our results of operations may be negatively affected by sustained downturns or sluggishness in the economy, including lower prices for power, generation capacity and natural gas, which can fluctuate substantially. Increased unemployment of residential customers and decreased demand for products and services by commercial and industrial customers resulting from an economic downturn could lead to declines in the demand for energy and an increase in the number of uncollectible customer balances, which would negatively impact our overall sales and cash flows. Additionally, prolonged economic downturns that negatively impact our financial condition, results of operations and cash flows could result in future material impairment charges to write down the carrying value of certain assets to their respective fair values.26Table of ContentsOur liquidity needs could be difficult to satisfy, particularly during times of uncertainty in the financial markets or during times of significant fluctuation in commodity prices, and we may be unable to access capital on favorable terms or at all in the future, which could have a material adverse effect on us. We currently maintain non-investment grade credit ratings that could negatively affect our ability to access capital on favorable terms or result in higher collateral requirements, particularly if our credit ratings were to be downgraded in the future.Our businesses are capital intensive. In general, we rely on access to financial markets and credit facilities as a significant source of liquidity for our capital requirements and other obligations not satisfied by cash-on-hand or operating cash flows. The inability to raise capital or to access credit facilities, particularly on favorable terms, could adversely impact our liquidity and our ability to meet our obligations or sustain and grow our businesses and could increase capital costs and collateral requirements, any of which could have a material adverse effect on us.Our access to capital and the cost and other terms of acquiring capital are dependent upon, and could be adversely impacted by, various factors, including:•general economic and capital markets conditions, including changes in financial markets that reduce available liquidity or the ability to obtain or renew credit facilities on favorable terms or at all;•conditions and economic weakness in the U.S. power markets;•regulatory developments;•changes in interest rates;•a deterioration, or perceived deterioration, of our creditworthiness, enterprise value or financial or operating results;•a downgrade of Vistra's or its applicable subsidiaries' credit ratings, or credit ratings of its issuances;•our level of indebtedness and compliance with covenants in our debt agreements;•a deterioration of the creditworthiness or bankruptcy of one or more lenders or counterparties under our credit facilities that affects the ability of such lender(s) to make loans to us;•credit, security, or collateral requirements, including those relating to volatility in commodity prices;•general credit availability from banks or other lenders for us and our industry peers;•investor and lender confidence in and sentiment of the industry, our business, and the wholesale electricity markets in which we operate;•a material breakdown in or oversight in effectuating our risk management procedures;•the occurrence of changes in our businesses;•disruptions, constraints, or inefficiencies in the continued reliable operation of our generation facilities and energy storage systems; and•changes in or the operation of provisions of tax and regulatory laws.There are also increasing financial risks for companies that own and operate fossil fuel generation as institutional lenders have become more attentive to sustainable lending practices and some of them may elect not to provide funding for companies who produce or utilize fossil fuel energy or that have higher levels of GHG emissions. Additionally, the lending practices of institutional lenders have been the subject of intensive lobbying efforts in recent years, oftentimes public in nature, by environmental activists and others concerned about climate change not to provide funding for companies in the broader energy sector. Limitation on our access to, or increases in our cost of, capital could have a material adverse effect on us.In addition, we currently maintain non-investment grade credit ratings. As a result, we may not be able to access capital on terms (financial or otherwise) as favorable as companies that maintain investment-grade credit ratings or we may be unable to access capital at all at times when the credit markets tighten. In addition, due to our non-investment grade credit ratings, counterparties request collateral support (including cash or letters of credit) in order to enter into certain transactions with us.A downgrade in long-term debt ratings generally causes borrowing costs to increase and the potential pool of investors to shrink and could trigger liquidity demands pursuant to contractual arrangements. Future transactions by Vistra or any of its subsidiaries, including the issuance of additional debt, could result in a temporary or permanent downgrade in our credit ratings.27Table of ContentsOur indebtedness and the proposed phaseout of LIBOR, or the replacement of LIBOR with a different reference rate, could adversely affect our ability in the future to raise additional capital to fund our operations. It could also expose us to the risk of increased interest rates and limit our ability to react to changes in the economy, or our industry, as well as impact our cash available for distribution.As of December 31, 2020, we had approximately $9.6 billion of total indebtedness and approximately $9.2 billion of indebtedness net of cash. Our debt could have negative consequences for our financial condition including:•increasing our vulnerability to general economic and industry conditions;•requiring a significant portion of our cash flows from operations to be dedicated to the payment of principal and interest on our indebtedness, therefore reducing our ability to pay dividends to holders of our common stock or to fund our operations, capital expenditures and future business opportunities;•limiting our ability to enter into long-term power sales or fuel purchases which require credit support;•limiting our ability to fund operations or future acquisitions;•restricting our ability to make distributions or pay dividends with respect to our capital stock and the ability of our subsidiaries to make distributions to us, in light of restricted payment and other financial covenants in our credit facilities and other financing agreements;•inhibiting the growth of our stock price;•exposing us to the risk of increased interest rates because certain of our borrowings, including borrowings under the Vistra Operations Credit Facilities, are at variable rates of interest;•limiting our ability to obtain additional financing for working capital including collateral postings, capital expenditures, debt service requirements, acquisitions and general corporate or other purposes; and•limiting our ability to adjust to changing market conditions and placing us at a competitive disadvantage compared to our competitors who may have less debt.We may not be successful in obtaining additional capital for these or other reasons. Furthermore, we may be unable to refinance or replace our existing indebtedness on favorable terms or at all upon the expiration or termination thereof. Our failure to obtain additional capital or enter into new or replacement financing arrangements when due may constitute a default under such existing indebtedness and may have a material adverse effect on our business, financial condition, results of operations and cash flows.In July 2017, the United Kingdom's Financial Conduct Authority, which regulates LIBOR, announced that it intends to phase out LIBOR by the end of 2021. LIBOR is the interest rate benchmark used as a reference rate on a portion of our variable rate debt, including our revolving credit facility and interest rate swaps. It is unclear if LIBOR will cease to exist at that time or if new methods of calculating LIBOR will be established such that it continues to exist after 2021. In November 2020, ICE Benchmark Administration (IBA), the administrator of LIBOR, with the support of the U.S. Federal Reserve and the United Kingdom's Financial Conduct Authority, announced plans to consult on ceasing publication of USD LIBOR on December 31, 2021 for only the one-week and two-month USD LIBOR tenors, and on June 30, 2023 for all other USD LIBOR tenors. While this announcement extends the transition period to June 2023, the U.S. Federal Reserve concurrently issued a statement advising banks to stop new USD LIBOR issuances by the end of 2021. In light of these recent announcements, the future of LIBOR at this time is uncertain and any changes in the methods by which LIBOR is determined or regulatory activity related to LIBOR's phaseout could cause LIBOR to perform differently than in the past or cease to exist. Although regulators and IBA have made clear that the recent announcements should not be read to say that LIBOR has ceased or will cease, in the event LIBOR does cease to exist, we may need to amend our credit agreements and other agreements with LIBOR as the referenced rate, which may result in interest rates and/or payments that do not correlate over time with the interest rates and/or payments that would have been made on our obligations if LIBOR was available in its current form. The Company will also need to consider new contracts and if they should reference an alternative benchmark rate or include suggested fallback language. Accordingly, we could be exposed to increased costs with respect to our variable rate debt, which could have an adverse impact on extensions of our credit and/or we might not be fully hedged on the variable rate exposure on our swapped indebtedness. Any such increased costs or exposure could increase our cost of capital and have a material adverse effect on us.28Table of ContentsThe agreements and instruments governing our debt, including the Vistra Operations Credit Facilities and indentures, contain restrictions and limitations that could affect our ability to operate our business, or liquidity, and results of operations, and any failure to comply with these restrictions could have a material adverse effect on us.The agreements and instruments governing our debt, including the Vistra Operations Credit Facilities and indentures, contain restrictions that could adversely affect us by limiting our ability to operate our businesses and plan for, or react to, market conditions or to meet our capital needs and could result in an event of default under the Vistra Operations Credit Facilities and/or indentures. The Vistra Operations Credit Facilities and indentures contain events of default customary for financings of this type. If we fail to comply with the covenants in the Vistra Operations Credit Facilities and/or indentures and are unable to obtain a waiver or amendment, or a default exists and is continuing, the lenders under such agreements or notes, as the case may be, could give notice and declare outstanding borrowings thereunder immediately due and payable. The breach of any covenants or obligations in certain agreements and instruments governing our debt, including the Vistra Operations Credit Facilities and indentures, not otherwise waived or amended, could result in a default under the applicable debt obligations and could trigger acceleration of those obligations, which in turn could trigger cross defaults under other agreements governing our debt, and any such acceleration of outstanding borrowings could have a material adverse effect on us.Certain of our obligations are required to be secured by letters of credit or cash, which increase our costs. If we are unable to provide such security, it may restrict our ability to conduct our business, which could have a material adverse effect on us.We undertake certain hedging and commodity activities and enter into certain financing arrangements with various counterparties that require cash collateral or the posting of letters of credit which are at risk of being drawn down in the event we default on our obligations. We currently use margin deposits, prepayments and letters of credit as credit support for commodity procurement and risk management activities. Future cash collateral requirements may increase based on the extent of our involvement in standard contracts and movements in commodity prices, and also based on our credit ratings and the general perception of creditworthiness in the markets in which we operate. In the case of commodity arrangements, the amount of such credit support that must be provided typically is based on the difference between the price of the commodity in a given contract and the market price of the commodity. Significant movements in market prices can result in our being required to provide cash collateral and letters of credit in very large amounts. The effectiveness of our strategy may be dependent on the amount of collateral available to enter into or maintain these contracts, and liquidity requirements may be greater than we anticipate or will be able to meet. Without a sufficient amount of working capital to post as collateral, we may not be able to manage price volatility effectively or to implement our strategy. An increase in the amount of letters of credit or cash collateral required to be provided to our counterparties may have a material adverse effect on us.We may not be able to complete future acquisitions on favorable terms or at all, successfully integrate future acquisitions into our business, or effectively identify and invest in value-creating businesses, assets or projects, which could result in unanticipated expenses and losses or otherwise hinder or delay our growth strategy.As part of our growth strategy, including our desire to grow our retail platform, we may pursue acquisitions of assets or operating entities. This strategy depends on the Company's ability to successfully identify and evaluate acquisition opportunities and consummate acquisitions on favorable terms. Our ability to continue to implement this component of our growth strategy will be limited by our ability to identify appropriate acquisition or joint venture candidates and our financial resources, including available cash and access to capital. In addition, the Company will compete with other companies for these limited acquisition opportunities, which may increase the Company's cost of making acquisitions or limit the Company’s ability to make acquisitions at all. Any expense incurred in completing acquisitions or entering into joint ventures, the time it takes to integrate an acquisition or our failure to integrate acquired businesses successfully could result in unanticipated expenses and losses. Furthermore, we may not be able to fully realize the anticipated benefits from any future acquisitions or joint ventures we may pursue. In addition, the process of integrating acquired operations into our existing operations may involve unknown risks, result in unforeseen operating difficulties and expenses, and may require significant financial resources that would otherwise be available for the execution of our business strategy. If the Company is unable to identify and consummate future acquisitions, it may impede the Company's ability to execute its growth strategy.29Table of ContentsWe have a substantial capital allocation plan intended for investments in renewable assets, including solar development projects and energy storage systems. As part of our business strategy, we plan to continually assess potential strategic acquisitions or investments in renewable assets, emerging technologies and related projects. Notably, the Company's ability to successfully develop our current renewables projects, or in the future acquire additional renewable assets, may be impacted by the demand for and viability of renewable assets generally, which may vary depending on availability of projects and financing, as well as public policy, financial and tax mechanisms implemented at the state and federal levels to support the development of renewable assets. Furthermore, various factors could result in increased costs or result in delays or cancellation of these projects, or the loss of, or declines in the value of, our investments in renewable projects. Risks may include both federal and state regulatory approval processes, new legislation impacting the industry, changes to federal income tax laws, economic events or factors, environmental and community concerns, availability of or requirements for additional funding, and enhanced competition. Should any of these factors occur, our financial position, results of operations, and cash flows could be adversely affected, or our future growth opportunities may not be realized as anticipated.Our solar generation, energy storage system, and other renewables development projects are subject to substantial uncertainties.Certain of our subsidiaries are in various stages of developing and constructing solar generation facilities and energy storage systems. Certain of these projects have signed long-term contracts or made similar arrangements for the sale of electricity. Successful completion of the development of these projects depends upon overcoming substantial risks, including, but not limited to, risks relating to siting, financing, engineering and construction, permitting, governmental approvals, regulatory changes, commissioning delays, or the potential for termination of the power sales contract as a result of a failure to meet certain milestones. Additionally, the increased demand for construction of renewables projects, such as energy storage systems and solar projects, may result in limited availability of qualified specialists, contractors, and necessary services and materials, which could lead to delays in and higher costs for the development and construction of our current and future planned projects.In certain cases, our subsidiaries may enter into obligations in the development process even though the subsidiaries have not yet secured power purchase arrangements or other important elements for a successful project. If the project does not proceed as planned, our subsidiaries may remain obligated for certain liabilities even though the project will not be completed. Development is inherently uncertain and we may forgo certain development opportunities and we may undertake significant development costs before determining that we will not proceed with a particular project. We believe that capitalized costs for projects under development are recoverable; however, there can be no assurance that any individual project will be completed and reach commercial operation. If these development efforts are not successful, we may abandon a project under development and write off the costs incurred in connection with such project and could incur additional losses associated with any related contingent liabilities.Circumstances associated with potential divestitures could adversely affect our results of operations and financial condition.In evaluating our business and the strategic fit of our various assets, we may determine to sell one or more of such assets. Despite a decision to divest an asset, we may encounter difficulty in finding a buyer willing to purchase the asset at an acceptable price and on acceptable terms and in a timely manner. In addition, a prospective buyer may have difficulty obtaining financing. Divestitures could involve additional risks, including:•difficulties in the separation of operations and personnel;•the need to provide significant ongoing post-closing transition support to a buyer;•management's attention may be temporarily diverted;•the retention of certain current or future liabilities in order to induce a buyer to complete a divestiture;•the obligation to indemnify or reimburse a buyer for certain past liabilities of a divested asset;•the disruption of our business; and•potential loss of key employees.We may not be successful in managing these or any other significant risks that we may encounter in divesting any asset, which could adversely affect our results of operations and financial condition.30Table of ContentsIf our goodwill, intangible assets, or long-lived assets become impaired, we may be required to record a significant charge to earnings.We have significant goodwill, intangible assets and long-lived assets recorded on our balance sheet. In accordance with U.S. GAAP, goodwill and non-amortizing intangible assets are required to be tested for impairment at least annually. Additionally, we review goodwill, our intangible assets and long-lived assets for impairment when events or changes in circumstances indicate the carrying value of the asset may not be recoverable. Factors that may be considered include a decline in future cash flows, slower growth rates in the energy industry, and a sustained decrease in the price of our common stock.We performed our annual assessment of goodwill and non-amortizing intangibles in the fourth quarter of 2020 and determined that no impairment was required. However, impairment assessments will be performed in future periods and may result in an impairment loss, which could be material.Issuances or acquisitions of our common stock, or sales or dispositions of our common stock by stockholders, that result in an ownership change as defined in Internal Revenue Code (IRC) §382 could further limit our ability to use our federal net operating losses to offset our future taxable income.If an "ownership change," as defined in Section 382 of the IRC (IRC §382) occurs, the amount of NOLs that could be used in any one year following such ownership change could be substantially limited. In general, an "ownership change" would occur when there is a greater than 50 percentage point increase in ownership of a company's stock by stockholders, each of which owns (or is deemed to own under IRC §382) 5 percent or more of such company's stock. Given IRC §382's broad definition, an ownership change could be the unintended consequence of otherwise normal market trading in our stock that is outside our control. Vistra acquired NOLs from its merger with Dynegy; however, Vistra's use of such attributes is limited under IRC §382 because the merger constituted an "ownership change" with respect to Dynegy. If there is an "ownership change" with respect to Vistra (including by the normal trading activity of greater than 5% stockholders), the utilization of all NOLs existing at that time would be subject to additional annual limitations based upon a formula provided under IRC §382 that is based on the fair market value of the Company and prevailing interest rates at the time of the ownership change.Tax legislation initiatives or challenges to our tax positions, or potential future legislation or the imposition of new or increased taxes or fees, could have a material adverse effect on our financial condition, results of operations and cash flows.We are subject to the tax laws and regulations of the U.S. federal, state and local governments. From time to time, legislative measures may be enacted that could adversely affect our overall tax positions regarding income or other taxes. There can be no assurance that our effective tax rate or tax payments will not be adversely affected by these legislative measures. The Tax Cuts and Jobs Act of 2017 (TCJA), enacted December 22, 2017, introduced significant changes to current U.S. federal tax law. These changes are complex and continue to be the subject of additional guidance issued by the U.S. Treasury and the Internal Revenue Service. In addition, the reaction to the federal tax changes by the individual states continues to evolve. Our interpretations and assumptions around U.S. tax reform may evolve in future periods as further administrative guidance and regulations are issued, which may materially affect our effective tax rate or tax payments. U.S. federal, state and local tax laws and regulations are extremely complex and subject to varying interpretations. There can be no assurance that our tax positions will be sustained if challenged by relevant tax authorities and if not sustained, there could be a material impact on our results of operations and financial condition.Additionally, U.S. federal income tax reform and changes in other tax laws could adversely affect us. For example, President Biden has set forth several tax proposals that would, if enacted into law, make significant changes to U.S. tax laws. Such proposals include, but are not limited to (i) an increase in the U.S. corporate income tax rate and (ii) implementation of a 15% minimum tax on a corporation’s worldwide book income. Congress could consider some or all of these proposals in connection with tax reform to be undertaken by the Biden administration. It is unclear whether these or similar changes will be enacted and, if enacted, how soon any such changes could take effect. Additionally, states in which we operate or own assets may impose new or increased taxes or fees on various aspects of our operations. The passage of any legislation as a result of these proposals and other similar changes in U.S. federal income tax laws or the imposition of new or increased taxes or fees could have a material adverse effect on our financial condition, results of operations and cash flows.31Table of ContentsWe may be responsible for U.S. federal and state income tax liabilities that relate to the PrefCo Preferred Stock Sale and Spin-Off.Pursuant to the Tax Matters Agreement, the parties thereto have agreed to take certain actions and refrain from taking certain actions in order to preserve the intended tax treatment of the Spin-Off and to indemnify the other parties to the extent a breach of such covenant results in additional taxes to the other parties. If we breach such a covenant (or, in certain circumstances, if our stockholders or creditors of our Predecessor take or took certain actions that result in the intended tax treatment of the Spin-Off not to be preserved), we may be required to make substantial indemnification payments to the other parties to the Tax Matters Agreement.The Tax Matters Agreement also allocates the responsibility for taxes for periods prior to the Spin-Off between EFH Corp. and us. For periods prior to the Spin-Off, (i) Vistra is generally required to reimburse EFH Corp. with respect to any taxes paid by EFH Corp. that are attributable to us and (ii) EFH Corp. is generally required to reimburse us with respect to any taxes paid by us that are attributable to EFH Corp.We are also required to indemnify EFH Corp. against certain taxes in the event the IRS or another taxing authority successfully challenges the amount of gain relating to the PrefCo Preferred Stock Sale or the amount or allowance of EFH Corp.'s net operating loss deductions.Our indemnification obligations to EFH Corp. are not limited by any maximum amount. If we are required to indemnify EFH Corp. or such other persons under the circumstances set forth in the Tax Matters Agreement, we may be subject to substantial liabilities.We are required to pay the holders of TRA Rights for certain tax benefits, which amounts could be substantial.On the Effective Date, we entered into the TRA with American Stock Transfer & Trust Company, LLC, as the transfer agent. Pursuant to the TRA, we issued beneficial interests in the rights to receive payments under the TRA (TRA Rights) to the first lien creditors of our Predecessor to be held in escrow for the benefit of the first lien creditors of our Predecessor entitled to receive such TRA Rights under the Plan of Reorganization. Our financial statements reflect a liability of $450 million as of December 31, 2020 related to these future payment obligations (see Note 8 to the Financial Statements). This amount is based on certain assumptions as described more fully in the notes to the financial statements and the actual payments made under the TRA could be materially different than this estimate.The TRA generally provides for the payment by us to the holders of TRA Rights of 85% of the amount of cash savings, if any, in U.S. federal, state and local income tax that we and our subsidiaries actually realize as a result of our use of (a) the tax basis step up attributable to the PrefCo Preferred Stock Sale, (b) the entire tax basis of the assets acquired as a result of the purchase and sale agreement, dated as of November 25, 2015 by and between La Frontera Ventures, LLC and Luminant, and (c) tax benefits related to imputed interest deemed to be paid by us as a result of payments under the TRA, plus interest accruing from the due date of the applicable tax return. The amount and timing of any payments under the TRA will vary depending upon a number of factors, including the amount and timing of the taxable income we generate in the future and the tax rate then applicable, our use of loss carryovers and the portion of our payments under the TRA constituting imputed interest.Although we are not aware of any issue that would cause the IRS to challenge the tax benefits that are the subject of the TRA, recipients of the payments under the TRA will not be required to reimburse us for any payments previously made if such tax benefits are subsequently disallowed. As a result, in such circumstances, Vistra could make payments under the TRA that are greater than its actual cash tax savings. Any amount of excess payment can be used to reduce future TRA payments, but cannot be immediately recouped, which could adversely affect our liquidity.Because Vistra is a holding company with no operations of its own, its ability to make payments under the TRA is dependent on the ability of its subsidiaries to make distributions to it. To the extent that Vistra is unable to make payments under the TRA because of the inability of its subsidiaries to make distributions to us for any reason, such payments will be deferred and will accrue interest until paid, which could adversely affect our results of operations and could also affect our liquidity in periods in which such payments are made.The payments we will be required to make under the TRA could be substantial.32Table of ContentsWe may be required to make an early termination payment to the holders of TRA Rights under the TRA.The TRA provides that, in the event that Vistra breaches any of its material obligations under the TRA, or upon certain mergers, asset sales, or other forms of business combination or certain other changes of control, the transfer agent under the TRA may treat such event as an early termination of the TRA, in which case Vistra would be required to make an immediate payment to the holders of the TRA Rights equal to the present value (at a discount rate equal to LIBOR plus 100 basis points) of the anticipated future tax benefits based on certain valuation assumptions.As a result, upon any such breach or change of control, we could be required to make a lump sum payment under the TRA before we realize any actual cash tax savings and such lump sum payment could be greater than our future actual cash tax savings.The aggregate amount of these accelerated payments could be materially more than our estimated liability for payments made under the TRA set forth in our financial statements, which could have a substantial negative impact on our liquidity.We are potentially liable for U.S. income taxes of the entire EFH Corp. consolidated group for all taxable years in which we were a member of such group.Prior to the Spin-Off, EFH Corporate Services Company, EFH Properties Company and certain other subsidiary corporations were included in the consolidated U.S. federal income tax group of which EFH Corp. was the common parent (EFH Corp. Consolidated Group). In addition, pursuant to the private letter ruling from the IRS that we received in connection with the Spin-Off, Vistra will be considered a member of the EFH Corp. Consolidated Group immediately prior to the Spin-Off. Under U.S. federal income tax laws, any corporation that is a member of a consolidated group at any time during a taxable year is severally liable for the group's entire federal income tax liability for the entire taxable year. In addition, entities that are disregarded for U.S. federal income tax purposes may be liable as successors under common law theories or under certain regulations to the extent corporations transferred assets to such entities or merged or otherwise consolidated into such entities, whether under state law or purely as a matter of federal income tax law. Thus, notwithstanding any contractual rights to be reimbursed or indemnified by EFH Corp. pursuant to the Tax Matters Agreement, to the extent EFH Corp. or other members of the EFH Corp. Consolidated Group fail to make any U.S. federal income tax payments required of them by law in respect of taxable years for which the Company or any subsidiary noted above was a member of the EFH Corp. Consolidated Group, the Company or such subsidiary may be liable for the shortfall. At such time, we may not have sufficient cash on hand to satisfy such payment obligation.Our ability to claim a portion of depreciation deductions may be limited for a period of time.Under the IRC, as amended, a corporation's ability to utilize certain tax attributes, including depreciation, may be limited following an ownership change if the corporation's overall asset tax basis exceeds the overall fair market value of its assets (after making certain adjustments). The Spin-Off resulted in an ownership change for the Company and it is expected that the overall tax basis of our assets may have exceeded the overall fair market value of our assets at such time. As a result, there may be a limitation on our ability to claim a portion of our depreciation deductions for a five-year period. This limitation could have a material impact on our tax liabilities and on our obligations under the TRA Rights. In addition, any future ownership change of Vistra following Emergence could likewise result in additional limitations on our ability to use certain tax attributes existing at the time of any such ownership change and have an impact on our tax liabilities and on our obligations under the TRA.Regulatory and Legislative RisksOur businesses are subject to ongoing complex governmental regulations and legislation that have adversely impacted, and may in the future adversely impact, our businesses, results of operations, liquidity, financial condition and cash flows.Our businesses operate in changing market environments influenced by various state and federal legislative and regulatory initiatives regarding the restructuring of the energy industry, including competition in power generation and sale of electricity and natural gas. Although we attempt to comply with changing legislative and regulatory requirements, there is a risk that we will fail to adapt to any such changes successfully or on a timely basis. Compliance with, or changes to, the requirements under these legal and regulatory regimes, including those proposed or implemented under the Biden administration, may cause the Company may adversely impact our businesses, results of operations, liquidity, financial condition and cash flows.33Table of ContentsOur businesses are subject to numerous state and federal laws (including, but not limited to, PURA, the Federal Power Act, the Atomic Energy Act, the Public Utility Regulatory Policies Act of 1978, the Clean Air Act (CAA), the Clean Water Act (CWA), the Resource Conservation and Recovery Act (RCRA), the Energy Policy Act of 2005, the Dodd-Frank Wall Street Reform and the Consumer Protection Act and the Telephone Consumer Protection Act), changing governmental policy and regulatory actions (including those of the FERC, the NERC, the RCT, the MSHA, the EPA, the NRC, the DOJ, the FTC, the CFTC, state public utility commissions and state environmental regulatory agencies), and the rules, guidelines and protocols of ERCOT, CAISO, ISO-NE, MISO, NYISO and PJM with respect to various matters, including, but not limited to, market structure and design, operation of nuclear generation facilities, construction and operation of other generation facilities, development, operation and reclamation of lignite mines, recovery of costs and investments, decommissioning costs, market behavior rules, present or prospective wholesale and retail competition, administrative pricing mechanisms (and adjustments thereto), rates for wholesale sales of electricity, mandatory reliability standards and environmental matters. We, along with other market participants, are subject to electricity pricing constraints and market behavior and other competition-related rules and regulations under PURA. Additionally, Ambit’s direct selling business (i) could be found by federal, state or foreign regulators not to be in compliance with applicable law or regulations, which may lead to our inability to obtain or maintain a license, permit, or similar certification and (ii) may be required to alter its compensation practices in order to comply with applicable federal or state law or regulations. Changes in, revisions to, or reinterpretations of, existing laws and regulations may have a material adverse effect on our businesses, results of operations, liquidity, financial condition and cash flows.As a result of the recent weather events in Texas there have been several announced efforts by both federal and state government and regulatory agencies to investigate and determine the causes of this event. We have received a civil investigative demand from the Attorney General of Texas as well as a request for information from ERCOT related to this event and may receive additional inquiries. We are cooperating with these entities and are working to respond to these requests. Those efforts may result in changes in regulations that impact our industry and businesses including, but not limited to, additional requirements for winterization of various facets of the electricity supply chain including generation, transmission, and fuel supply; improvements in coordination among the various participants in the electricity supply chain during any future event; potential changes to the types of plans permitted to be marketed to residential customers; potential revisions to the way in which the ERCOT market compensates and incentivizes the continued operation of assets that only run periodically, including during this event or other times of scarcity; and other potential corrective actions that may be taken by the State of Texas, ERCOT, the RCT, or the PUCT to resettle pricing across any portion of the supply chain (i.e., fuel supply and wholesale pricing of generation, or allocating the financial impacts of market-wide load shed ratably across all retail market participants). Recently announced or future legal proceedings, regulatory actions, investigations, or other administrative proceedings involving market participants may result lead to adverse determinations or other findings of violations of laws, rules or regulations, any of which may impact the ability of market participants to satisfy, in whole or in part, their respective obligations. We are continuing to monitor and evaluate the impacts of this developing situation but at this time we cannot estimate the likelihood or impacts of any legislative or regulatory changes or actions (including enforcement actions that may be brought against various market participants) that may occur as a result of the event on our business, financial condition, results of operations, or cash flows,. See Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations for a discussion of the expected impacts of winter storm Uri.Finally, the regulatory environment has undergone significant changes in the last several years due to state and federal policies affecting wholesale and retail competition and the creation of incentives for the addition of large amounts of new renewable generation. For example, changes to, or development of, legislation that requires the use of clean renewable and alternate fuel sources or mandate the implementation of energy conservation programs that require the implementation of new technologies, could increase our capital expenditures and/or impact our financial condition. Additionally, in some retail energy markets, state legislators, government agencies and other interested parties have made proposals to change the use of market-based pricing, re-regulate areas of these markets that have previously been competitive, or permit electricity delivery companies to construct or acquire generating facilities. Other proposals to re-regulate the retail energy industry may be made, and legislative or other actions affecting electricity and natural gas deregulation or restructuring process may be delayed, discontinued or reversed in states in which we currently operate or may in the future operate. If such changes were to be enacted by a regulatory body, we may lose customers, incur higher costs and/or find it more difficult to acquire new customers. These changes are ongoing, and we cannot predict the future design of the wholesale power markets or the ultimate effect that the changing regulatory environment will have on our business.34Table of ContentsWe are required to obtain, and to comply with, government permits and approvals.We are required to obtain, and to comply with, numerous permits and licenses from federal, state and local governmental agencies. The process of obtaining and renewing necessary permits and licenses can be lengthy and complex and can sometimes result in the establishment of conditions that make the project or activity for which the permit or license was sought unprofitable or otherwise unattractive. In addition, such permits or licenses may be subject to denial, revocation or modification under various circumstances. Failure to obtain or comply with the conditions of permits or licenses, or failure to comply with applicable laws or regulations, may result in the delay or temporary suspension of our operations and electricity sales or the curtailment of our delivery of electricity to our customers and may subject us to penalties and other sanctions. Although various regulators routinely renew existing permits and licenses, renewal of our existing permits or licenses could be denied or jeopardized by various factors, including (a) failure to provide adequate financial assurance for closure, (b) failure to comply with environmental, health and safety laws and regulations or permit conditions, (c) local community, political or other opposition and (d) executive, legislative or regulatory action.Our inability to procure and comply with the permits and licenses required for our operations, or the cost to us of such procurement or compliance, could have a material adverse effect on us. In addition, new environmental legislation or regulations, if enacted, or changed interpretations of existing laws, may cause activities at our facilities to need to be changed to avoid violating applicable laws and regulations or elicit claims that historical activities at our facilities violated applicable laws and regulations. In addition to the possible imposition of fines in the case of any such violations, we may be required to undertake significant capital investments and obtain additional operating permits or licenses, which could have a material adverse effect on us.Our cost of compliance with existing and new environmental laws could have a material adverse effect on us.We are subject to extensive environmental regulation by governmental authorities, including federal and state environmental agencies and/or attorneys general. We may incur significant additional costs beyond those currently contemplated to comply with these regulatory requirements. If we fail to comply with these regulatory requirements, we could be subject to administrative, civil or criminal liabilities and fines. Existing environmental regulations could be revised or reinterpreted, new laws and regulations could be adopted or become applicable to us or our facilities, and future changes in environmental laws and regulations could occur, including potential regulatory and enforcement developments related to air emissions, all of which could result in significant additional costs beyond those currently contemplated to comply with existing requirements. Any of the foregoing could have a material adverse effect on us.The EPA has recently finalized or proposed several regulatory actions establishing new requirements for control of certain emissions from sources, including electricity generation facilities. In the future, the EPA may also propose and finalize additional regulatory actions that may adversely affect our existing generation facilities or our ability to cost-effectively develop new generation facilities. There is no assurance that the currently installed emissions control equipment at our lignite, coal and/or natural gas-fueled generation facilities will satisfy the requirements under any future EPA or state environmental regulations. Some of the recent regulatory actions, such as the EPA's proposed Cross-State Air Pollution Rule Update, the ACE rule and any proposed or future actions to replace the ACE rule, and actions under the Regional Haze program, could require us to install significant additional control equipment, resulting in potentially material costs of compliance for our generation units, including capital expenditures, higher operating and fuel costs and potential production curtailments. These costs could have a material adverse effect on us.We may not be able to obtain or maintain all required environmental regulatory approvals. If there is a delay in obtaining any required environmental regulatory approvals, if we fail to obtain, maintain or comply with any such approval or if an approval is retroactively disallowed or adversely modified, the operation of our generation facilities could be stopped, disrupted, curtailed or modified or become subject to additional costs. Any such stoppage, disruption, curtailment, modification or additional costs could have a material adverse effect on us.In addition, we may be responsible for any on-site liabilities associated with the environmental condition of facilities that we have acquired, leased, developed or sold, regardless of when the liabilities arose and whether they are now known or unknown. In connection with certain acquisitions and sales of assets, we may obtain, or be required to provide, indemnification against certain environmental liabilities. Another party could, depending on the circumstances, assert an environmental claim against us or fail to meet its indemnification obligations to us, which could have a material adverse effect on us.35Table of ContentsWe could be materially and adversely affected if new federal or state legislation or regulations are adopted to address global climate change that could require efforts that exceed or are more expensive than our currently planned initiatives or if we are subject to lawsuits for alleged damage to persons or property resulting from greenhouse gas emissions.There is attention and interest nationally and internationally about global climate change and how GHG emissions, such as CO2, contribute to global climate change. Over the last several years, the U.S. Congress has considered and debated several proposals intended to address climate change using different approaches, including a cap on carbon emissions with emitters allowed to trade unused emission allowances (cap-and-trade), a tax on carbon or GHG emissions, incentives for the development of low-carbon technology and federal renewable portfolio standards. In July 2019, the EPA finalized the ACE rule that developed emissions guidelines that states must use when developing plans to regulate GHG emissions from existing coal-fueled electric generating units. In January 2021, the ACE rule was vacated by the D.C. Circuit Court and remanded to the EPA for further consideration in accordance with the court’s ruling. The EPA may develop a more stringent and more encompassing rule to replace the ACE rule in its remand proceeding and has been directed by the Biden Administration to review this rule and others promulgated by the EPA during the Trump Administration. Prior to the vacatur and remand, states where we operate coal plants (Texas, Illinois and Ohio) had begun the development of their state plans to comply with the now-vacated ACE rule. In January 2021, the ACE rule was invalidated by the D.C. Circuit Court. In addition, a number of federal court cases have been filed in recent years asserting damage claims related to GHG emissions, and the results in those proceedings could establish adverse precedent that might apply to companies (including us) that produce GHG emissions. We could be materially and adversely affected if new federal and/or state legislation or regulations are adopted to address global climate change that could require efforts that exceed or are more expensive than our currently planned initiatives or if we are subject to lawsuits for alleged damage to persons or property resulting from GHG emissions.Additionally, in January 2021, President Biden issued written notification to the United Nations of the U.S.'s intention to rejoin the Paris Agreement, effective in February 2021. Although the Paris Agreement does not create any binding obligations for nations to limit their GHG emissions, it does include pledges to voluntarily limit or reduce future emissions, and various corporations, investors and U.S. states and local governments have previously pledged to further the goals of the Paris Agreement. Additionally, the Biden Administration has directed certain agencies to submit a plan to the National Climate Task Force to achieve a carbon-pollution-free electricity sector by 2035. The Company's plan to transition to clean power generation sources and reduce its GHG emissions may not be completed in this timeframe and we may not otherwise achieve our sustainability and emissions reduction targets as expected. Accordingly, we may be required to accelerate or change our targets, incur additional expenses, and/or adjust or cease certain operations as a result of newly implemented federal and/or state regulations to reduce future carbon emissions.The Capacity Performance product in the PJM market and the Pay-for-Performance mechanism in ISO-NE could lead to substantial changes in capacity income and non-performance penalties, which could have a material adverse effect on our results of operations, financial condition and cash flows.Both ISO-NE and PJM operate a pay-for-performance model where capacity payments are modified based on real-time generator performance. Capacity market prices are sensitive to design parameters, as well as additions of new capacity. We may experience substantial changes in capacity income and non-performance penalties, which could have a material adverse effect on our results of operations, financial condition and cash flows.Luminant's mining operations are subject to RCT oversight.We currently own and operate, or are in the process of reclaiming, 12 surface lignite coal mines in Texas to provide fuel for our electricity generation facilities. We also own or lease, and are in the process of reclaiming, two waste-to-energy surface facilities in Pennsylvania. The RCT, which exercises broad authority to regulate reclamation activity, reviews on an ongoing basis whether Luminant is compliant with RCT rules and regulations and whether it has met all the requirements of its mining permits. Any new rules and regulations adopted by the RCT or the Department of Interior Office of Surface Mining, which also regulates mining activity nationwide, or any changes in the interpretation of existing rules and regulations, could result in higher compliance costs or otherwise adversely affect our financial condition or cause a revocation of a mining permit. Any revocation of a mining permit would mean that Luminant would no longer be allowed to mine lignite at the applicable mine to serve its generation facilities.36Table of ContentsLuminant's lignite mining reclamation activity will require significant resources as existing and retired mining operations are reclaimed over the next several years.In conjunction with Luminant's announcements in 2017 to retire several power generation assets and related mining operations, along with the continuous reclamation activity at its continuing mining operations for its mines related to the Oak Grove and Martin Lake generation assets, Luminant is expected to spend a significant amount of money, internal resources and time to complete the required reclamation activities. For the next five years, Vistra is projected to spend approximately $301 million (on a nominal basis) to achieve its reclamation objectives.Litigation, legal proceedings, regulatory investigations or other administrative proceedings could expose us to significant liabilities and reputational damage that could have a material adverse effect on us.We are involved in the ordinary course of business in a number of lawsuits involving, among other matters, employment, commercial, and environmental issues, and other claims for injuries and damages. We evaluate litigation claims and legal proceedings to assess the likelihood of unfavorable outcomes and to estimate, if possible, the amount of potential losses. Based on these evaluations and estimates, when required by applicable accounting rules, we establish reserves and disclose the relevant litigation claims or legal proceedings, as appropriate. These evaluations and estimates are based on the information available to management at the time and involve a significant amount of judgment. Actual outcomes or losses may differ materially from current evaluations and estimates. The settlement or resolution of such claims or proceedings may have a material adverse effect on us. We use appropriate means to contest litigation threatened or filed against us, but the litigation environment poses a significant business risk.We are also involved in the ordinary course of business in regulatory investigations and other administrative proceedings, and we are exposed to the risk that we may become the subject of additional regulatory investigations or administrative proceedings. While we cannot predict the outcome of any regulatory investigation or administrative proceeding, any such regulatory investigation or administrative proceeding could result in us incurring material penalties and/or other costs and have a materially adverse effect on us.Our retail businesses, which each have REP certifications that are subject to review of the public utility commissions in the states in which we operate, are subject to changing state rules and regulations that could have a material impact on the profitability of our business.The competitiveness of our U.S. retail businesses partially depends on state regulatory policies that establish the structure, rules, terms and conditions on which services are offered to retail customers. Specifically, the public utility commissions and/or the attorney generals of the various jurisdictions in which the Retail segment operates may at any time initiate an investigation into whether our retail operations comply with certain commission rules or state laws and whether we have met the requirements for REP certification, including financial requirements. These state policies and investigations, which can include controls on the retail rates our retail businesses can charge, the imposition of additional costs on sales, restrictions on our ability to obtain new customers through various marketing channels and disclosure requirements, investigations into whether our retail operations comply with certain commission rules or state laws and whether we have met the requirements for REP certification, including financial requirements, can affect the competitiveness of our retail businesses. Any removal or revocation of a REP certification would mean that we would no longer be allowed to provide electricity service to retail customers in the applicable jurisdiction, and such decertification could have a material adverse effect on us. Additionally, state or federal imposition of net metering or renewable portfolio standard programs can make it more or less expensive for retail customers to supplement or replace their reliance on grid power. Our retail businesses have limited ability to influence development of these state rules, regulations and policies, and our business model may be more or less effective, depending on changes to the regulatory environment.37Table of ContentsOperational RisksVolatile power supply costs and demand for power have and could in the future adversely affect the financial performance of our retail businesses.Although we are the primary provider of our retail businesses' wholesale electricity supply requirements, our retail businesses purchase a portion of their supply requirements from third parties. As a result, the financial performance of our retail business depends on their ability to obtain adequate supplies of electric generation from third parties at prices below the prices they charge their customers. Consequently, our earnings and cash flows could be adversely affected in any period in which the retail businesses' wholesale electricity supply costs rise at a greater rate than the rates they charge to customers. The price of wholesale electricity supply purchases associated with the retail businesses' energy commitments can be different than that reflected in the rates charged to customers due to, among other factors:•varying supply procurement contracts used and the timing of entering into related contracts;•subsequent changes in the overall price of natural gas;•daily, monthly or seasonal fluctuations in the price of natural gas relative to the 12-month forward prices;•transmission constraints and the Company's ability to move power to our customers;•out-of-market payments, uplifts, or other non-pass through charges, and•changes in market heat rate.The retail businesses' earnings and cash flows could also be adversely affected in any period in which their customers' actual usage of electricity significantly varies from the forecasted usage, which could occur due to, among other factors, weather events, competition and economic conditions. See Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations for a discussion of the expected impacts of winter storm Uri.Our retail operations are subject to significant competition from other REPs, which could result in a loss of existing customers and the inability to attract new customers.We operate in a very competitive retail market and, as a result, our retail operation faces significant competition for customers. We believe our brands are viewed favorably in the retail electricity markets in which we operate, but despite our commitment to providing superior customer service and innovative products, customer sentiment toward our brands, including by comparison to our competitors' brands, depends on certain factors beyond our control. For example, competitor REPs may offer different products, lower electricity prices and other incentives, which, despite our long-standing relationship with many customers, may attract customers away from us. If we are unable to successfully compete with competitors in the retail market it is possible our retail customer counts could decline, which could have a material adverse effect on us.As we try to grow our retail business and operate our business strategy, we compete with various other REPs that may have certain advantages over us. For example, in new markets, our principal competitor for new customers may be the incumbent REP, which has the advantage of long-standing relationships with its customers, including well-known brand recognition. In addition to competition from the incumbent REP, we may face competition from a number of other energy service providers, other energy industry participants, or nationally branded providers of consumer products and services who may develop businesses that will compete with us. Some of these competitors or potential competitors may be larger than we are or have greater resources or access to capital than we have. If there is inadequate potential margin in retail electricity markets with substantial competition to overcome the adverse effect of relatively high customer acquisition costs in such markets, it may not be profitable for us to compete in these markets.38Table of ContentsOur retail operations rely on the infrastructure of local utilities or independent transmission system operators to provide electricity to, and to obtain information about, our customers. Any infrastructure failure could negatively impact customer satisfaction and could have a material adverse effect on us.The substantial majority of our retail operations depend on transmission and distribution facilities owned and operated by unaffiliated utilities to deliver the electricity that we sell to our customers. If transmission capacity is inadequate, our ability to sell and deliver electricity may be hindered and we may have to forgo sales or buy more expensive wholesale electricity than is available in the capacity-constrained area or, with respect to capacity performance in PJM and performance incentives in ISO-NE, we may be subject to significant penalties. For example, during some periods, transmission access is constrained in some areas of the Dallas-Fort Worth metroplex, where we have a significant number of customers. The cost to provide service to these customers may exceed the cost to provide service to other customers, resulting in lower operating margins. In addition, any infrastructure failure that interrupts or impairs delivery of electricity to our customers could negatively impact customer satisfaction with our service. Any of the foregoing could have a material adverse effect on us.The operation of our businesses is subject to cyber-based security and integrity risk. Attacks on our infrastructure that breach cyber/data security measures could expose us to significant liabilities, reputational damage, regulatory action, and disrupt business operations, which could have a material adverse effect on us.Numerous functions affecting the efficient operation of our businesses are dependent on the secure and reliable storage, processing and communication of electronic data and the use of sophisticated computer hardware and software systems and much of our information technology infrastructure is connected (directly or indirectly) to the internet. Our information technology systems and infrastructure, and those of our vendors and suppliers, are susceptible to damage, disruptions, or shutdowns due to power outages, hardware failures, programming errors, defects or other vulnerabilities, cyber-attacks, ransomware attacks, malware attacks, computer viruses, theft, misconduct by employees or other insiders, telecommunications failures, misuse, human errors or other catastrophic events. While we have controls in place designed to protect our infrastructure, such breaches and threats are becoming increasingly sophisticated, complex, change frequently and may be difficult to detect. Any such breach, disruption or similar event that impairs our information technology infrastructure could disrupt normal business operations and affect our ability to control our generation assets, access retail customer information and limit communication with third parties, which could have a material adverse effect on us.As part of the continuing development of new and modified reliability standards, the FERC has approved changes to its Critical Infrastructure Protection reliability standards and has established standards for assets identified as "critical cyber assets." Under the Energy Policy Act of 2005, the FERC can impose penalties (up to $1 million per day, per violation) for failure to comply with mandatory electric reliability standards, including standards to protect the power system against potential disruptions from cyber/data and physical security breaches.Further, our retail business requires us to access, collect, store and transmit sensitive customer data in the ordinary course of business. Concerns about data privacy have led to increased regulation and other actions that could impact our businesses. Examples of sensitive customer data are names, addresses, account information, historical electricity usage, expected patterns of use, payment history, credit bureau data, credit and debit card account numbers, drivers' license numbers, social security numbers and bank account information. Our retail business may need to provide sensitive customer data to vendors and service providers who require access to this information in order to provide services, such as call center operations, to the retail business. Although we take precautions to protect the sensitive customer data that we are required to collect in order to conduct our business, if a significant breach of our information technology systems were to occur, the reputation of our retail business may be adversely affected, customer confidence may be diminished, and our retail business may be subject to substantial legal or regulatory claims, any of which may contribute to the loss of customers and have a material adverse effect on us. Any loss of customer, confidential, or proprietary data through a breach, unauthorized access, disruption, misuse or disclosure could adversely affect our reputation, expose us to material legal or regulatory claims and impair our ability to execute our business strategy, which could have a material adverse effect on us. In addition, we may experience increased capital and operating costs to implement increased security for our information technology infrastructure. We cannot provide any assurance that such events and impacts will not be material in the future, and our efforts to deter, identify and mitigate future breaches may require additional significant capital and may not be successful.39Table of ContentsWe may suffer material losses, costs and liabilities due to operation risks, regulatory risks, and the risk of nuclear accidents arising from the ownership and operation of the Comanche Peak nuclear generation facility.We own and operate a nuclear generation facility in Glen Rose, Texas (Comanche Peak Facility). The ownership and operation of a nuclear generation facility involves certain risks. These risks include:•unscheduled outages or unexpected costs due to equipment, mechanical, structural, cybersecurity or other problems;•inadequacy or lapses in maintenance protocols;•the impairment of reactor operation and safety systems due to human error or force majeure;•the costs of, and liabilities relating to, storage, handling, treatment, transport, release, use and disposal of radioactive materials;•the costs of procuring nuclear fuel;•the costs of storing and maintaining spent nuclear fuel at our on-site dry cask storage facility;•terrorist or cybersecurity attacks and the cost to protect against any such attack;•the impact of a natural disaster;•limitations on the amounts and types of insurance coverage commercially available; and•uncertainties with respect to the technological and financial aspects of modifying or decommissioning nuclear facilities at the end of their useful lives.Any prolonged unavailability of the Comanche Peak Facility could have a material adverse effect on our results of operation, cash flows, financial position and reputation. The following are among the more significant related risks:•Operational Risk — Operations at any generation facility could degrade to the point where the facility would have to be shut down. If such degradations were to occur at the Comanche Peak Facility, the process of identifying and correcting the causes of the operational downgrade to return the facility to operation could require significant time and expense, resulting in both lost revenue and increased fuel and purchased power expense to meet supply commitments. Furthermore, a shut-down or failure at any other nuclear generation facility could cause regulators to require a shut-down or reduced availability at the Comanche Peak Facility.•Regulatory Risk — The NRC may modify, suspend or revoke licenses and impose civil penalties for failure to comply with the Atomic Energy Act, the regulations under it or the terms of the licenses of nuclear generation facilities. Unless extended, as to which no assurance can be given, the NRC operating licenses for the two licensed operating units at the Comanche Peak Facility will expire in 2030 and 2033, respectively. Changes in regulations by the NRC, as well as any extension of our operating licenses, could require a substantial increase in capital expenditures or result in increased operating or decommissioning costs.•Nuclear Accident Risk — Although the safety record of the Comanche Peak Facility and other nuclear generation facilities generally has been very good, accidents and other unforeseen problems have occurred both in the U.S. and elsewhere. The consequences of an accident can be severe and include loss of life, injury, lasting negative health impacts and property damage. Any accident, or perceived accident, could result in significant liabilities and damage our reputation. Any such resulting liability from a nuclear accident could exceed our resources, including insurance coverage, and could ultimately result in the suspension or termination of power generation from the Comanche Peak Facility.40Table of ContentsThe operation and maintenance of power generation facilities and related mining operations are capital intensive and involve significant risks that could adversely affect our results of operations, liquidity and financial condition.The operation and maintenance of power generation facilities and related mining operations involve many risks, including, as applicable, start-up risks, breakdown or failure of facilities, equipment or processes, operator error, lack of sufficient capital to maintain the facilities, the dependence on a specific fuel source, the inability to transport our product to our customers in an efficient manner due to the lack of transmission capacity or the impact of unusual or adverse weather conditions or other natural events, or terrorist attacks, as well as the risk of performance below expected levels of output, efficiency or reliability, the occurrence of any of which could result in substantial lost revenues and/or increased expenses. A significant number of our facilities were constructed many years ago. Older generating equipment, even if maintained or refurbished in accordance with good engineering practices, may require significant capital expenditures to operate at peak efficiency or reliability. The risk of increased maintenance and capital expenditures arises from (a) increased starting and stopping of generation equipment due to the volatility of the competitive generation market and the prospect of continuing low wholesale electricity prices that may not justify sustained or year-round operation of all our generation facilities, (b) any unexpected failure to generate power, including failure caused by equipment breakdown or unplanned outage (whether by order of applicable governmental regulatory authorities, the impact of weather events or natural disasters or otherwise), (c) damage to facilities due to storms, natural disasters, wars, terrorist or cyber/data security acts and other catastrophic events and (d) the passage of time and normal wear and tear. Further, our ability to successfully and timely complete routine maintenance or other capital projects at our existing facilities is contingent upon many variables and subject to substantial risks. Should any such efforts be unsuccessful, we could be subject to additional costs or losses and write downs of our investment in the project.We cannot be certain of the level of capital expenditures that will be required due to changing environmental and safety laws and regulations (including changes in the interpretation or enforcement thereof), needed facility repairs and unexpected events (such as natural disasters or terrorist or cyber/data security attacks). The unexpected requirement of large capital expenditures could have a material adverse effect on us. Moreover, if we significantly modify a unit, we may be required to install the best available control technology or to achieve the lowest achievable emission rates as such terms are defined under the new source review provisions of the CAA, which would likely result in substantial additional capital expenditures.In addition, unplanned outages at any of our generation facilities, whether because of equipment breakdown or otherwise, typically increase our operation and maintenance expenses and may reduce our revenues as a result of selling fewer MWh or non-performance penalties or require us to incur significant costs as a result of running one of our higher cost units or to procure replacement power at spot market prices in order to fulfill contractual commitments. If we do not have adequate liquidity to meet margin and collateral requirements, we may be exposed to significant losses, may miss significant opportunities and may have increased exposure to the volatility of spot markets, which could have a material adverse effect on us. Further, our inability to operate our generation facilities efficiently, manage capital expenditures and costs, and generate earnings and cash flows from our asset-based businesses could have a material adverse effect on our results of operations, financial condition or cash flows. While we maintain insurance, obtain warranties from vendors and obligate contractors to meet certain performance levels, the proceeds of such insurance, warranties or performance guarantees may not be adequate to cover our lost revenues, increased expenses or liquidated damages payments should we experience equipment breakdown or non-performance by contractors or vendors.Operation of power generation facilities involves significant risks and hazards customary to the power industry that could have a material adverse effect on our revenues and results of operations, and we may not have adequate insurance to cover these risks and hazards. Our employees, contractors, customers and the general public may be exposed to a risk of injury due to the nature of our operations.Power generation involves hazardous activities, including acquiring, transporting and unloading fuel, operating large pieces of equipment and delivering electricity to transmission and distribution systems. In addition to natural risks such as extreme weather, earthquake, flood, lightning, hurricane and wind, other human-made hazards, such as nuclear accidents, dam failure, gas or other explosions, mine area collapses, fire, structural collapse, machinery failure and other dangerous incidents are inherent risks in our operations. These and other hazards can cause significant personal injury or loss of life, severe damage to and destruction of property, plant and equipment, contamination of, or damage to, the environment and suspension of operations. Further, our employees and contractors work in, and customers and the general public may be exposed to, potentially dangerous environments at or near our operations. As a result, employees, contractors, customers and the general public are at risk for serious injury, including loss of life.41Table of ContentsThe occurrence of any one of these events may result in us being named as a defendant in lawsuits asserting claims for substantial damages, including for environmental cleanup costs, personal injury and property damage and fines and/or penalties. We maintain an amount of insurance protection that we consider adequate, but we cannot provide any assurance that our insurance will be sufficient or effective under all circumstances and against all hazards or liabilities to which we may be subject and, even if we do have insurance coverage for a particular circumstance, we may be subject to a large deductible and maximum cap. A successful claim for which we are not fully insured could hurt our financial results and materially harm our financial condition. Further, due to rising insurance costs and changes in the insurance markets, including increasing pressure on firms that provide insurance to companies that own and operate fossil fuel generation, we cannot provide any assurance that our insurance coverage will continue to be available at all or at rates or on terms similar to those presently available. Any losses not covered by insurance could have a material adverse effect on our financial condition, results of operations or cash flows.We may be materially and adversely affected by obligations to comply with federal and state regulations, laws, and other legal requirements that govern the operations, assessments, storage, closure, corrective action, disposal and monitoring relating to CCR.As a result of electricity produced for decades at coal-fueled power plants in Illinois, Texas and Ohio, we manage large amounts of CCR material in surface impoundments, all in compliance with applicable regulatory requirements. In addition to the federal requirements under the CCR rule, CCR surface impoundments will continue to be regulated by existing state laws, regulations and permits, as well as additional legal requirements that may be imposed in the future. These federal and state laws, regulations and other legal requirements may require or result in additional expenditures, increased operating and maintenance costs and/or result in closure of certain power generating facilities, which could affect the results of operations, financial position and cash flows of the Company. We have recognized ARO related to these CCR-related requirements. As the closure and CCR management work progresses and final closure plans and corrective action measures are developed and approved at each site, the scope and complexity of work and the amount of CCR material could be greater than current estimates and could, therefore, materially impact earnings through increased compliance expenditures.The EPA is reviewing applications submitted by us to extend closure deadlines for many of our CCR impoundments. The EPA has been directed by the Biden Administration to review a number of environmental rules adopted by the EPA during the Trump Administration, including Coal Combustion Residuals (CCR) rule, the Emissions Limitation Guidelines (ELG) rule, the Affordable Clean Energy (ACE) rule and the PM and Ozone National Ambient Air Quality Standards (NAAQS) rules. All of these rules may significantly and adversely impact our existing coal fleet and may lead to accelerated plant closure timeframes. In addition, the expected revisions to the ACE rule and NAAQS also have the potential to adversely impact our gas-fired units.The EPA is reviewing applications submitted by us to extend closure deadlines for many of our CCR impoundments. The scope and cost of that closure work could increase significantly based on new requirements imposed by the EPA or state agencies. There is no assurance that our current assumptions for closure activities will be accepted by EPA. If ponds must be closed sooner than anticipated, plant closures timeframes may be accelerated.The availability and cost of emission allowances could adversely impact our costs of operations.We are required to maintain, through either allocations or purchases, sufficient emission allowances for SO2, CO2 and NOX to support our operations in the ordinary course of operating our power generation facilities. These allowances are used to meet the obligations imposed on us by various applicable environmental laws. If our operational needs require more than our allocated allowances, we may be forced to purchase such allowances on the open market, which could be costly. If we are unable to maintain sufficient emission allowances to match our operational needs, we may have to curtail our operations so as not to exceed our available emission allowances or install costly new emission controls. As we use the emission allowances that we have purchased on the open market, costs associated with such purchases will be recognized as operating expense. If such allowances are available for purchase, but only at significantly higher prices, the purchase of such allowances could materially increase our costs of operations in the affected markets.42Table of ContentsWe may be materially and adversely affected by the effects of extreme weather conditions and seasonality.We may be materially affected by weather conditions and our businesses may fluctuate substantially on a seasonal basis as the weather changes. In addition, we are subject to the effects of extreme weather conditions, including sustained or extreme cold or hot temperatures, hurricanes, floods, storms, fires, earthquakes or other natural disasters, which could stress our generation facilities and grid reliability, limit our ability to procure adequate fuel supply, or result in outages, damage or destroy our assets and result in casualty losses that are not ultimately offset by insurance proceeds, and could require increased capital expenditures or maintenance costs, including supply chain costs.Moreover, an extreme weather event could cause disruption in service to customers due to downed wires and poles or damage to other operating equipment, which could result in us foregoing sales of electricity and lost revenue. Similarly, certain extreme weather events have previously affected, and may in the future, affect, the availability of generation and transmission capacity, limiting our ability to source or deliver power where it is needed or limit our ability to source fuel for our plants, including due to damage to rail or natural gas pipeline infrastructure. Additionally, extreme weather has resulted, and may in the future result, in (i) unexpected increases in customer load, requiring our retail operation to procure additional electricity supplies at wholesale prices in excess of customer sales prices for electricity, (ii) the failure of equipment at our generation facilities, (iii) a decrease in the availability of, or increases in the cost of, fuel sources, including natural gas, diesel and coal, or (iv) unpredictable curtailment of customer load by the applicable ISO/RTO in order to maintain grid reliability, resulting in the realization of lower wholesale prices or retail customer sales. See Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations for a discussion of the expected impacts of winter storm Uri.Additionally, climate change may produce changes in weather or other environmental conditions, including temperature or precipitation levels, and thus may impact consumer demand for electricity. In addition, the potential physical effects of climate change, such as increased frequency and severity of storms, floods, and other climatic events, could disrupt our operations and cause us to incur significant costs to prepare for or respond to these effects.Weather conditions, which cannot be reliably predicted, could have adverse consequences by requiring us to seek additional sources of electricity when wholesale market prices are high or to sell excess electricity when market prices are low, as well as significantly limiting the supply of, or increasing the cost of our fuel supply, each of which could have a material adverse effect on our business, results of operations, financial condition and liquidity.The outbreak of COVID-19, or the future outbreak of any other highly infectious or contagious diseases, could have a material and adverse effect on our business, financial condition, and results of operations.The outbreak of the COVID-19 pandemic has adversely impacted economic activity and conditions worldwide, and we are responding to the outbreak by taking steps to mitigate the potential risks to us posed by its spread. We continue to examine the impacts of the pandemic on our workforce, liquidity, reliability, cybersecurity, customers, suppliers, along with other macroeconomic conditions and cannot currently predict whether COVID-19 will have a material impact on our results of operations, financial condition, and cash flows.Because we are deemed a critical infrastructure provider that provides a critical service to our customers, we must keep our employees who operate our businesses safe and minimize unnecessary risk of exposure. We have updated and implemented our company-wide pandemic plan to address specific aspects of the COVID-19 pandemic. This plan guides our emergency response, business continuity, and the precautionary measures we are taking on behalf of employees and the public. We will continue to monitor developments affecting both our workforce and our customers, and we will take additional precautions that we determine are necessary in order to mitigate the impacts. In particular, we have taken extra precautions for our employees who work in the field and for employees who continue to work in our facilities including requiring, for both employees and contractors, social distancing where possible and requiring the use of appropriate personal protective equipment in certain circumstances. We have implemented work-from-home policies and other safety measures where appropriate, including, but not limited to, temperature testing at all of our locations for employees, contractors, and other essential visitors and closing our facilities to non-essential visitors. While our systems and operations remain vulnerable to cyber-attacks and other disruptions due in part to the fact that a portion of our workforce continues to work remotely, we have implemented physical and cyber-security measures to ensure that our systems remain functional in order to both serve our operational needs with a remote workforce and keep them running to ensure uninterrupted service to our customers. We will continue to review and modify our plans as conditions change.43Table of ContentsMeasures to control the spread of COVID-19, including restrictions on travel, public gatherings, and certain business operations, have affected the demand for the products and services of many businesses in the areas in which we operate and disrupted supply chains around the world. The full scope and extent of the impacts of COVID-19 on our operations are unknown at this time. However, COVID-19 or another pandemic could have material and adverse effects on our results of operations, financial condition and cash flows due to, among other factors, a protracted slowdown of broad sectors of the economy, changes in demand or supply for commodities, significant changes in legislation or regulatory policy to address the pandemic (including moratoriums or conditions or disconnections and limits or restrictions or late fees), reduced demand for electricity (particularly from commercial and industrial customers), increased late or uncollectible customer payments, negative impacts on the health of our workforce, a deterioration of our ability to ensure business continuity (including increased risk from cybersecurity attacks as a result of a significant portion of our workforce continuing to work from home), and the inability of the Company's contractors, suppliers, and other business partners to fulfill their contractual obligations.Despite our efforts to manage these impacts to the Company, their ultimate impact also depends on factors beyond our knowledge or control, including the duration and severity of this outbreak as well as third-party actions taken to contain its spread and mitigate its public health effects. To the extent COVID-19 adversely affects our business and financial results, it may also have the effect of hastening, heightening, or increasing the negative impacts of, many of the other risks described in this Risk Factors section.Changes in technology, increased electricity conservation efforts, or energy sustainability efforts may reduce the value of our generation facilities and may otherwise have a material adverse effect on us.Technological advances have improved, and are likely to continue to improve, for existing and alternative methods to produce and store power, including gas turbines, wind turbines, fuel cells, hydrogen, micro turbines, photovoltaic (solar) cells, batteries and concentrated solar thermal devices, along with improvements in traditional technologies. Such technological advances may be superior to, or may not be compatible with, some of our existing technologies, investments and infrastructure, and may require us to make significant expenditures to remain competitive, and have resulted, and are expected to continue to reduce the costs of power production or storage, which may result in the obsolescence of certain of our operating assets. Consequently, the value of our more traditional generation assets could be significantly reduced as a result of these competitive advances, which could have a material adverse effect on us and our future success will depend, in part, on our ability to anticipate and successfully adapt to technological changes, to offer services and products that meet customer demands and evolving industry standards. In addition, changes in technology have altered, and are expected to continue to alter, the channels through which retail customers buy electricity (i.e., self-generation or distributed-generation facilities). To the extent self-generation or distributed generation facilities become a more cost-effective option for customers, our financial condition, operating cash flows and results of operations could be materially and adversely affected.Technological advances in demand-side management and increased conservation efforts have resulted, and are expected to continue to result, in a decrease in electricity demand. A significant decrease in electricity demand as a result of such efforts would significantly reduce the value of our generation assets. Certain regulatory and legislative bodies have introduced or are considering requirements and/or incentives to reduce power consumption. Effective power conservation by our customers could result in reduced electricity demand or significantly slow the growth in such demand. Any such reduction in demand could have a material adverse effect on us. Furthermore, we may incur increased capital expenditures if we are required to increase investment in conservation measures. Additionally, increased governmental and consumer focus on energy sustainability efforts, including desire for, or incentives related to, the development, implementation and usage of low-carbon technology, may result in decreased demand for the traditional generation technologies that we currently own and operate.We may potentially be affected by emerging technologies that may over time affect change in capacity markets and the energy industry overall with the inclusion of distributed generation and clean technology.Some of these emerging technologies are shale gas production, distributed renewable energy technologies, energy efficiency, broad consumer adoption of electric vehicles, distributed generation and energy storage devices. Such emerging technologies could affect the price of energy, levels of customer-owned generation, customer expectations and current business models and make portions of our electric system power supply and transmission and/or distribution facilities obsolete prior to the end of their useful lives. These emerging technologies may also affect the financial viability of utility counterparties and could have significant impacts on wholesale market prices, which could ultimately have a material adverse effect on our financial condition, results of operations and cash flows could be materially adversely affected.44Table of ContentsThe loss of the services of our key management and personnel could adversely affect our ability to successfully operate our businesses.Our future success will depend on our ability to continue to attract and retain highly qualified personnel. We compete for such personnel with many other companies, in and outside of our industry, government entities and other organizations. We may not be successful in retaining current personnel or in hiring or retaining qualified personnel in the future. Our failure to attract highly qualified new personnel or retain highly qualified existing personnel could have an adverse effect on our ability to successfully operate our businesses. In addition, effective succession planning is important to our long-term success. Failure to timely and effectively ensure transfer of knowledge and smooth transitions involving senior management and other key personnel could hinder our strategic planning and execution.We could be materially and adversely impacted by strikes or work stoppages by our unionized employees.As of December 31, 2020, we had approximately 1,640 employees covered by collective bargaining agreements. The terms of all current collective bargaining agreements covering represented personnel engaged in lignite mining operations, lignite-, coal- and nuclear-fueled generation operation and some of our natural gas-fueled generation operations expire on various dates between May 2021 and November 2023, but remain effective thereafter unless and until terminated by either party. We are also presently negotiating the terms of first contracts at two of our natural gas-fueled generation facilities. In the event that our union employees strike, participate in a work stoppage or slowdown or engage in other forms of labor strife or disruption, we would be responsible for procuring replacement labor or we could experience reduced power generation or outages. Our ability to procure such labor is uncertain. Strikes, work stoppages or the inability to negotiate current or future collective bargaining agreements on favorable terms or at all could have a material adverse effect on us.Risks Related to Our Structure and Ownership of our Common StockVistra is a holding company and its ability to obtain funds from its subsidiaries is structurally subordinated to existing and future liabilities of its subsidiaries.Vistra is a holding company that does not conduct any business operations of its own. As a result, Vistra's cash flows and ability to meet its obligations are largely dependent upon the operating cash flows of Vistra's subsidiaries and the payment of such operating cash flows to Vistra in the form of dividends, distributions, loans or otherwise. These subsidiaries are separate and distinct legal entities from Vistra and have no obligation (other than any existing contractual obligations) to provide Vistra with funds to satisfy its obligations. Any decision by a subsidiary to provide Vistra with funds to satisfy its obligations, including those under the TRA, whether by dividends, distributions, loans or otherwise, will depend on, among other things, such subsidiary's results of operations, financial condition, cash flows, cash requirements, contractual prohibitions and other restrictions, applicable law and other factors. The deterioration of income from, or other available assets of, any such subsidiary for any reason could limit or impair its ability to pay dividends or make other distributions to Vistra.Investor focus on environmental, social, and governance issues, including climate change and sustainability matters, could adversely affect our stock price.Investor focus on environmental, social, and governance issues, including increasing attention on climate change and sustainability matters, could adversely affect, and increase the potential volatility of, our stock price. Certain financial institutions have announced policies to presently or in the future cease investing or to divest investments in companies that derive any or a specified portion of their income from, or have any or a specified portion of their operations in, fossil fuels. To date these represent small fractions of our overall current or potential equity investors, but that group could grow and thus reduce demand for our common stock or otherwise increase volatility in our stock price. The Company’s plan to transition to clean power generation sources and reduce its carbon footprint may not be completed in the timeframe or achieve the targets as expected. Negative investor sentiment toward us and our industry — including concerns over environmental or sustainability matters and potential changes in federal and state regulatory actions related thereto — could have a negative impact on our stock price.45Table of ContentsWe may not pay any dividends on our common stock in the future.In November 2018, we announced that the Board had adopted a dividend program which we initiated in the first quarter of 2019. Each dividend under the program will be subject to declaration by the Board and, thus, may be subject to numerous factors in existence at the time of any such declaration including, but not limited to, prevailing market conditions, our results of operations, financial condition and liquidity, contractual prohibitions and other restrictions with respect to the payment of dividends. There is no assurance that the Board will declare, or that we will pay, any dividends on our common stock in the future.Item 1B.UNRESOLVED STAFF COMMENTSNone.Item 2.PROPERTIESLuminant's asset fleet consists of power generation and battery ESS units in six ISOs/RTOs, with the location, ISO/RTO, technology, primary fuel type, net capacity and ownership interest for each generation facility shown in the table below:FacilityLocationISO/RTOTechnologyPrimary Fuel (a)Net Capacity (MW) (b)Ownership Interest (c)EnnisEnnis, TXERCOTCCGTNatural Gas366 100%ForneyForney, TXERCOTCCGTNatural Gas1,912 100%HaysSan Marcos, TXERCOTCCGTNatural Gas1,047 100%LamarParis, TXERCOTCCGTNatural Gas1,076 100%MidlothianMidlothian, TXERCOTCCGTNatural Gas1,596 100%OdessaOdessa, TXERCOTCCGTNatural Gas1,054 100%WisePoolville, TXERCOTCCGTNatural Gas787 100%Martin LakeTatum, TXERCOTSTCoal2,250 100%Oak GroveFranklin, TXERCOTSTCoal1,600 100%DeCordovaGranbury, TXERCOTCTNatural Gas260 100%GrahamGraham, TXERCOTSTNatural Gas630 100%Lake HubbardDallas, TXERCOTSTNatural Gas921 100%Morgan CreekColorado City, TXERCOTCTNatural Gas390 100%Permian BasinMonahans, TXERCOTCTNatural Gas325 100%Stryker CreekRusk, TXERCOTSTNatural Gas685 100%TrinidadTrinidad, TXERCOTSTNatural Gas244 100%Comanche PeakGlen Rose, TXERCOTNuclearNuclear2,300 100%Upton 2Upton County, TXERCOTSolar/BatteryRenewable180 100%Total Texas Segment17,623 FayetteMasontown, PAPJMCCGTNatural Gas726 100%Hanging RockIronton, OHPJMCCGTNatural Gas1,430 100%HopewellHopewell, VAPJMCCGTNatural Gas370 100%KendallMinooka, ILPJMCCGTNatural Gas1,288 100%LibertyEddystone, PAPJMCCGTNatural Gas607 100%OntelauneeReading, PAPJMCCGTNatural Gas600 100%SayrevilleSayreville, NJPJMCCGTNatural Gas349 100%WashingtonBeverly, OHPJMCCGTNatural Gas711 100%CalumetChicago, ILPJMCTNatural Gas380 100%Dicks CreekMonroe, OHPJMCTNatural Gas155 100%Miami Fort (CT)North Bend, OHPJMCTFuel Oil77 100%PleasantsSaint Marys, WVPJMCTNatural Gas388 100%RichlandDefiance, OHPJMCTNatural Gas423 100%46Table of ContentsFacilityLocationISO/RTOTechnologyPrimary Fuel (a)Net Capacity (MW) (b)Ownership Interest (c)StrykerStryker, OHPJMCTFuel Oil16 100%BellinghamBellingham, MAISO-NECCGTNatural Gas566 100%BlackstoneBlackstone, MAISO-NECCGTNatural Gas544 100%Casco BayVeazie, MEISO-NECCGTNatural Gas543 100%Lake RoadDayville, CTISO-NECCGTNatural Gas827 100%MasspowerIndian Orchard, MAISO-NECCGTNatural Gas281 100%MilfordMilford, CTISO-NECCGTNatural Gas600 100%IndependenceOswego, NYNYISOCCGTNatural Gas1,212 100%Total East Segment12,093 Moss Landing 1 & 2Moss Landing, CACAISOCCGTNatural Gas1,020 100%Moss LandingMoss Landing, CACAISOBatteryRenewable300 100%OaklandOakland, CACAISOCTFuel Oil165 100%Total West Segment1,485 Coleto CreekGoliad, TXERCOTSTCoal650 100%BaldwinBaldwin, ILMISOSTCoal1,185 100%EdwardsBartonville, ILMISOSTCoal585 100%NewtonNewton, ILMISOSTCoal615 100%Joppa/EEIJoppa, ILMISOSTCoal802 80%Joppa CT 1-3Joppa, ILMISOCTNatural Gas165 100%Joppa CT 4-5Joppa, ILMISOCTNatural Gas56 80%KincaidKincaid, ILPJMSTCoal1,108 100%Miami Fort 7 & 8North Bend, OHPJMSTCoal1,020 100%ZimmerMoscow, OHPJMSTCoal1,300 100%Total Sunset Segment7,486 Total capacity38,687 ___________(a)Renewable represents generation assets fueled by renewable sources including energy storage and solar, which do not have significant fuel costs.(b)Unit capabilities are based on winter capacity and are reflected at our net ownership interest. We have not included units that have been retired or are out of operation.(c)Ownership interest of 100% indicates fee simple ownership of the facility. Ownership of less than 100% indicates the share of ownership in the facility held by the Company.See Note 3 to the Financial Statements for discussion of our solar and battery energy storage projects currently under development.Our wholesale commodity risk management group also procures renewable energy credits from renewable generation in ERCOT to support our electricity sales to wholesale and retail customers to satisfy the increasing demand for renewable resources from such customers. As of December 31, 2020, Vistra had long-term power purchase agreements to procure approximately 1,015 MW of available renewable capacity. These renewable generation sources deliver electricity when conditions make them available, and, when on-line, they generally compete with baseload units. Because they cannot be relied upon to meet demand continuously due to their dependence on weather and time of day, these generation sources are categorized as non-dispatchable and create the need for intermediate/load-following resources to respond to changes in their output.47Table of ContentsFuel SupplyNuclear — We own and operate two nuclear generation units at the Comanche Peak plant site in ERCOT, each of which is designed for a capacity of 1,150 MW. Comanche Peak Unit 1 and Unit 2 went into commercial operation in 1990 and 1993, respectively, and are generally operated at full capacity. Refueling (nuclear fuel assembly replacement) outages for each unit are scheduled to occur every eighteen months during the spring or fall off-peak demand periods. Every three years, the refueling cycle results in the refueling of both units during the same year, which occurred in 2020. While one unit is undergoing a refueling outage, the remaining unit is intended to operate at full capacity. During a refueling outage, other maintenance, modification and testing activities are completed that cannot be accomplished when the unit is in operation. The Comanche Peak facility operated at a capacity factor of 97%, 96% and 101% in 2020, 2019 and 2018, respectively.We have contracts in place for all of our 2021 and the majority of our 2022 nuclear fuel requirements. We do not anticipate any significant difficulties in acquiring uranium and contracting for associated conversion, enrichment and fabrication services in the foreseeable future.Natural Gas — Our natural gas-fueled generation fleet is comprised of 23 CCGT generating facilities totaling 19,512 MW and 13 peaking generation facilities totaling 5,022 MW. We satisfy our fuel requirements at these facilities through a combination of spot market and near-term purchase contracts. Additionally, we have near-term natural gas transportation agreements in place to ensure reliable fuel supply.Coal/Lignite — Our coal/lignite-fueled generation fleet is comprised of 10 generation facilities totaling 11,115 MW of generation capacity. Maintenance outages at these units are scheduled during the spring or fall off-peak demand periods. We meet our fuel requirements at our coal-fueled generation facilities in PJM and MISO with coal purchased from multiple suppliers under contracts of various lengths and transported to the facilities by either railcar or barges. We meet our fuel requirements in ERCOT using lignite that we mine at the Oak Grove generation facility, coal purchased and transported by railcar at the Coleto Creek generation facility and a blend of lignite that we mine and coal purchased and transported by railcar at our Martin Lake generation facility.Item 3.LEGAL PROCEEDINGSSee Note 13 to the Financial Statements for discussion of litigation, including matters related to our generation facilities and EPA reviews.Item 4.MINE SAFETY DISCLOSURESVistra currently owns and operates, or is in the process of reclaiming, 12 surface lignite coal mines in Texas to provide fuel for its electricity generation facilities. Vistra also owns or leases, and is in the process of reclaiming, two waste-to-energy surface facilities in Pennsylvania. These mining operations are regulated by the MSHA under the Federal Mine Safety and Health Act of 1977, as amended (the Mine Act), as well as other federal and state regulatory agencies such as the RCT and Office of Surface Mining. The MSHA inspects U.S. mines, including Vistra's mines, on a regular basis, and if it believes a violation of the Mine Act or any health or safety standard or other regulation has occurred, it may issue a citation or order, generally accompanied by a proposed fine or assessment. Such citations and orders can be contested and appealed, which often results in a reduction of the severity and amount of fines and assessments and sometimes results in dismissal. Disclosure of MSHA citations, orders and proposed assessments are provided in Exhibit 95.1 to this annual report on Form 10-K.48Table of ContentsPART IIItem 5.MARKET FOR REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIESVistra's authorized capital stock consists of 1,800,000,000 shares of common stock with a par value of $0.01 per share.Since May 10, 2017, Vistra's common stock has been listed on the NYSE under the symbol "VST".On April 9, 2018 (Merger Date), pursuant to the Merger Agreement, 94,409,573 shares of Vistra common stock were issued to the former Dynegy stockholders, as well as converting stock options, equity-based awards, tangible equity units and warrants.As of February 23, 2021, there were 483,716,012 shares of common stock issued and outstanding and 698 stockholders of record.In November 2018, we announced that the Board had adopted a dividend program which we initiated in the first quarter of 2019. Our common stockholders are entitled to receive any such dividends or other distributions ratably. In February 2021, our Board declared a quarterly dividend of $0.15 per share that will be paid in March 2021. Each dividend under the program is subject to declaration by the Board and, thus, may be subject to numerous factors in existence at the time of any such declaration including, but not limited to, prevailing market conditions, our results of operations, financial condition and liquidity, Delaware law and contractual limitations. For additional details, see Item 1A. Risk Factors and Note 14 to the Financial StatementsStock Performance GraphThe performance graph below compares Vistra's cumulative total return on common stock for the period from May 10, 2017 (the date we were listed on the NYSE) through December 31, 2020 with the cumulative total returns of the S&P 500 Stock Index (S&P 500) and the S&P Utility Index (S&P Utilities). The graph below compares the return in each period assuming that $100 was invested at May 10, 2017 in Vistra's common stock, the S&P 500 and the S&P Utilities, and that all dividends were reinvested.49Table of ContentsShare Repurchase ProgramThe following table provides information about our repurchase of equity securities that are registered by us pursuant to Section 12 of the Exchange Act, as amended, during the quarter ended December 31, 2020.Total Number of Shares PurchasedAverage Price Paid per ShareTotal Number of Shares Purchased as Part of a Publicly Announced ProgramMaximum Dollar Amount of Shares that may yet be Purchased under the Program (in millions)October 1 - October 31, 2020— $— — $332 November 1 - November 30, 2020— $— — $332 December 1 - December 31, 2020— $— — $332 For the quarter ended December 31, 2020— $— — $332 In September 2020, we announced that the Board had authorized a new share repurchase program (Share Repurchase Program) under which up to $1.5 billion of our outstanding common stock may be repurchased. The Share Repurchase Program became effective January 1, 2021, at which time the Prior Share Repurchase Plan (described below) and all authorized amounts remaining thereunder terminated as of such date.Under the Share Repurchase Program, any purchases of shares of the Company's stock may be repurchased from time to time in open market transactions at prevailing market prices, in privately negotiated transactions, pursuant to plans complying with the Exchange Act or by other means in accordance with federal securities laws. The actual timing, number and value of shares repurchased under the Share Repurchase Program or otherwise will be determined at our discretion and will depend on a number of factors, including our capital allocation priorities, the market price of our stock, general market and economic conditions, applicable legal requirements and compliance with the terms of our debt agreements.In June 2018, we announced that the Board had authorized a share repurchase program under which up to $500 million of our outstanding common stock could be purchased, and in November 2018, we announced that the Board had authorized an incremental share repurchase program under which up to $1.250 billion of our outstanding stock could be purchased, resulting in an aggregate $1.750 billion share repurchase program (Prior Share Repurchase Program). The Prior Share Repurchase Program terminated effective January 1, 2021.See Note 14 to the Financial Statements for more information concerning the Share Repurchase Program and the Prior Share Repurchase Program.Item 6.SELECTED FINANCIAL DATANot applicable.50Table of ContentsItem 7.MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSThe discussion below, as well as other portions of this annual report on Form 10-K, contain forward-looking statements within the meaning of Section 27A of the Securities Act, Section 21E of the Exchange Act and the Private Securities Litigation Reform Act of 1995. In addition, management may make forward-looking statements orally or in other writing, including, but not limited to, in press releases, quarterly earnings calls, executive presentations, in the annual report to stockholders and in other filings with the SEC. Readers can usually identify these forward-looking statements by the use of such words as “may,” “will,” “should,” “likely,” “plans,” “projects,” “expects,” “anticipates,” “believes” or similar words. These statements involve a number of risks and uncertainties. Actual results could materially differ from those anticipated by such forward-looking statements. For more discussion about risk factors that could cause or contribute to such differences, see Part I, Item 1A "Risk Factors" and other risks discussed herein. Forward-looking statements reflect the information only as of the date on which they are made. The Company does not undertake any obligation to update any forward-looking statements to reflect future events, developments, or other information. If Vistra does update one or more forward-looking statements, no inference should be drawn that additional updates will be made regarding that statement or any other forward-looking statements. This discussion is intended to clarify and focus on our results of operations, certain changes in our financial position, liquidity, capital structure and business developments for the periods covered by the consolidated financial statements included under Part II, Item 8 of this annual report on Form 10-K for the year ended December 31, 2020. This discussion should be read in conjunction with those consolidated financial statements and the related notes and is qualified by reference to them.The following discussion and analysis of our financial condition and results of operations for the years ended December 31, 2020, 2019 and 2018 should be read in conjunction with our consolidated financial statements and the notes to those statements. Results are impacted by the effects of the Ambit Transaction, the Crius Transaction and the Merger (see Note 2 to the Financial Statements). The discussion and analysis of our financial condition and results of operations for the year ended December 31, 2018 and for the year ended December 31, 2019 compared to the year ended December 31, 2018 are included in Item 7. Management's Discussion and Analysis of Financial Condition and Results in our 2019 Form 10-K and is incorporated herein by reference except for the operational results from the former ERCOT, PJM, NY/NE and MISO segments that were replaced by the Texas, East, West and Sunset segments in an update of our reportable segments in the third quarter of 2020. Operational results for the Texas, East, West and Sunset segments for the year ended December 31, 2018 and for the year ended December 31, 2019 compared to the year ended December 31, 2018 are included in Results of Operations below to reflect this update of reportable segments.All dollar amounts in the tables in the following discussion and analysis are stated in millions of U.S. dollars unless otherwise indicated.BusinessVistra is a holding company operating an integrated retail and electric power generation business primarily in markets throughout the U.S. Through our subsidiaries, we are engaged in competitive energy market activities including power generation, wholesale energy sales and purchases, commodity risk management and retail sales of electricity and natural gas to end users. Effective July 2, 2020, we changed our name from Vistra Energy Corp. to Vistra Corp. to distinguish from companies that are involved in the exploring for, producing, refining, or transporting fossil fuels (many of which use "energy" in their names) and to better reflect our integrated business model, which combines a retail electricity and natural gas business focused on serving its customers with new and innovative products and services and an electric power generation business powering the communities we serve with safe, reliable power.Operating SegmentsVistra has six reportable segments: (i) Retail, (ii) Texas, (iii) East (iv) West, (v) Sunset and (vi) Asset Closure. In the third quarter of 2020, Vistra updated its reportable segments to reflect changes in how the Company's CODM makes operating decisions, assesses performance and allocates resources. Management believes that the revised reportable segments provide enhanced transparency into the Company's long-term sustainable assets and its commitment to managing the retirement of economically and environmentally challenged plants. See Notes 1 and 20 to the Financial Statements for further information concerning the updates to our reportable business segments.51Table of ContentsSignificant Activities and Events and Items Influencing Future PerformanceWinter Storm UriIn February 2021, the U.S. experienced an unprecedented winter storm Uri, bringing extreme cold temperatures to the central U.S., including Texas. On February 12, 2021, the Governor of Texas declared a state of disaster for all 254 counties in the State in response to the then-forecasted weather conditions. The declaration certified that severe winter weather posed an imminent threat due to prolonged freezing temperatures, heavy snow, and freezing rain statewide. On February 14, 2021, President Biden issued a federal emergency declaration for all 254 Texas counties.As part of its annual winter season preparations, our power plant teams executed a significant winter preparedness strategy, which included installing windbreaks and large radiant heaters to supplement existing freeze protection and insulation and performing preventative maintenance on freeze protection equipment such as the insulation and automatic circuitry designed to keep pipes at the power plants from freezing. In addition, in anticipation of winter storm Uri we took additional steps to prepare, including procuring additional demineralized water supply trailers to ensure sufficient water availability to run for extended periods and verifying that freeze protection circuits were operational.This severe weather resulted in surging demand for power, gas supply shortages, operational challenges for generators, and a significant load shed event (i.e., involuntary outages to customers across the system for varying periods of time) that was ordered by ERCOT beginning on February 15, 2021 and continuing through February 18, 2021. The biggest challenges to our plants throughout the storm were securing adequate natural gas supplies for our gas plants and the handling of frozen fuel at our coal plants. Despite these challenges, we estimate that our fleet generated approximately 25 to 30% of the power on the grid during the height of the outages, as compared to our approximately 18% market share.The overall financial impact from winter storm Uri is still being calculated, but Vistra expects it will have a material adverse impact on its financial results driven by generation output being constrained due to challenges with receiving a steady supply of fuel for some plants as well as challenges with handling fuel already on site given the freezing conditions. As a result of these challenges, Vistra had to procure power in the ERCOT market at prices at or near the price cap to meet its supply obligations. While the financial impacts of winter storm Uri to Vistra are not yet finalized, Vistra management preliminarily estimates the one-time adverse impact on pre-tax net income will be in the range of approximately $900 million to $1.3 billion.This estimated range is preliminary and based on currently available information and management estimates. The final amount of the estimated loss is subject to a variety of factors including, but not limited to, outstanding pricing, load, and settlement data from ERCOT (which is released at various intervals during a period of up to 180 days after the transaction day); the outcome of potential litigation arising from this event (including any litigation that we may pursue or be a party to); or any corrective action taken by the State of Texas, ERCOT, the RCT, or the PUCT to resettle pricing across any portion of the supply chain that is currently being considered or may be considered by any such parties. There have already been several announced efforts by the state and federal governments and regulatory agencies to investigate and determine the causes of this event and its impact on consumers. We have received a civil investigative demand from the Attorney General of Texas as well as a request for information from ERCOT related to this event and may receive additional inquiries. We are cooperating with these entities and are working to respond to these requests. Those efforts may result in changes in regulations that impact our industry including but not limited to additional requirements for winterization of various facets of the electricity supply chain including generation, transmission, and fuel supply; improvements in coordination among the various participants in the electricity supply chain during any future event; potential revisions to the way in which the ERCOT market compensates and incentivizes the continued operation of assets that only run during times of scarcity; and potential changes to the types of plans permitted to be marketed to residential customers. We are continuing to monitor this situation as it develops but at this time cannot estimate any impacts of any legislative or regulatory changes or actions (including enforcement actions that may be brought against various market participants) that may occur as a result of the event on our business, financial condition, results of operations, or cash flows.As of December 31, 2020, Vistra had total available liquidity of approximately $2.4 billion, which was primarily comprised of cash and availability under its revolving credit facility. During this storm event, Vistra was required to post a significant amount of collateral, including to ERCOT, clearinghouses for natural gas and power transactions and other trading counterparties. Despite these posting requirements, Vistra has consistently maintained, and it continues to maintain, sufficient liquidity to conduct its operations in the ordinary course. As of February 25, 2021, Vistra had more than $1.5 billion of cash and availability under its revolving credit facility to meet any of its liquidity needs.52Table of ContentsIn response to the storm, Vistra committed to donate $5 million to assist Texas communities and individuals meet their most pressing needs, including support for food banks and food pantries, critical needs, bill payment assistance, and more. Vistra also assured residential customers across its retail brands that they will not see any near-term impact on their rates due to the winter weather event, though bills may increase due to high usage during the cold weather period in February.Investments in Clean Energy and CO2 ReductionsIn September 2020, we announced the planned development of up to 668 MW of solar photovoltaic power generation facilities and 260 MW of battery ESS in Texas. We will only invest in these growth projects if we are confident in the expected returns. See Note 3 to the Financial Statements for a summary of our solar and battery energy storage projects.In September 2020 and December 2020, we announced our intention to retire (a) all of our remaining coal generation facilities in Illinois and Ohio, (b) one coal generation facility in Texas and (c) one natural gas facility in Illinois, no later than year-end 2027 due to economic challenges, including incremental expenditures that would be required to comply with the CCR rule and ELG rule (see Note 13 to the Financial Statements), and in furtherance of our efforts to significantly reduce our carbon footprint. See Note 4 to the Financial Statements for a summary of these planned generation retirements as well as our generation plant retirements in 2019.COVID-19 PandemicWith the global outbreak of the novel coronavirus (COVID-19) and the declaration of a pandemic by the World Health Organization on March 11, 2020, the U.S. government has deemed electricity generation, transmission and distribution as "critical infrastructure" providing essential services during this global emergency. As a provider of critical infrastructure, Vistra has an obligation to provide critically needed power to homes, businesses, hospitals and other customers. Vistra remains focused on protecting the health and well-being of its employees and the communities in which it operates while assuring the continuity of its business operations.We have updated and implemented our company-wide pandemic plan to address specific aspects of the COVID-19 pandemic to guide our emergency response, business continuity, and the precautionary measures we are taking on behalf of employees and the public. We will continue to monitor developments affecting both our workforce and our customers, and we have taken, and will continue to take, health and safety measures that we determine are necessary in order to mitigate the impacts. To date, as a result of these business continuity measures, the Company has not experienced material disruptions in our operations due to COVID-19.The fundamentals of the Company remain strong. Vistra believes it has sufficient available liquidity to continue business operations during this volatile period. As described under Available Liquidity, the Company has total available liquidity of $2.399 billion as of December 31, 2020, consisting of cash on hand and available capacity under our revolving credit facility (Revolving Credit Facility) of the Vistra Operations Credit Facilities. In addition, the maturities of our long-term debt are relatively modest until 2023. If the Company experienced a significant reduction in revenues or increases in costs or collateral requirements, the Company believes it would have additional alternatives to maintain access to liquidity, including drawing upon available liquidity or reductions to capital expenditures, planned voluntary debt repayments or operating costs. As a result of the Company's ongoing initiatives, the Company believes it is well-positioned to be able to respond to changes in customer demand, regulation or other factors impacting the Company's business related to the COVID-19 pandemic.In response to the economic and employment impacts of the COVID-19 outbreak, various states have instituted moratoriums or other conditions on disconnections for retail electricity customers. For example, in March and April 2020, the PUCT issued multiple orders requiring REPs in the ERCOT market to suspend late fees for residential customers through May 15, 2020, and to offer deferred payment plans to customers upon request. The PUCT also enacted the COVID-19 Electricity Relief Program whereby REPs must forego disconnecting customers certified as experiencing COVID-19-related hardship, and if such customer would otherwise be subject to disconnection and meets other qualifications, such REP would request suppression of the delivery charges from the transmission and distribution utility and request a proxy energy charge reimbursement from the COVID-19 Electricity Relief Program of $0.04/kWh. The PUCT ceased accepting new enrollments under the COVID-19 Electricity Relief Program after August 31, 2020, and the disconnection protections and financial assistance expired after September 30, 2020.See Note 7 to the Financial Statements for a summary of certain anticipated tax-related impacts of the CARES Act to the Company.53Table of ContentsThe COVID-19 pandemic has presented potential new risks to the Company's business. Although there have been logistical and other challenges to date, there has been no material adverse impact on the Company's 2020 results of operations. The situation surrounding COVID-19 remains fluid and the potential for a material impact on the Company's results of operations, financial condition and liquidity increases the longer the virus impacts the level of economic activity in the U.S. and globally. As a result, COVID-19 may have a range of impacts on the Company's operations, the full extent and scope of which are currently unknown. See Part I, Item 1A Risk Factors — The outbreak of COVID-19, or the future outbreak of any other highly infectious or contagious diseases, could have a material and adverse effect on our business, financial condition, and results of operations.Acquisitions and MergerAmbit Transaction — On November 1, 2019 (Ambit Acquisition Date), Volt Asset Company, Inc., an indirect, wholly owned subsidiary of Vistra, completed the acquisition of Ambit (Ambit Transaction). See Note 2 to the Financial Statements for a summary of the Ambit Transaction and business combination accounting.Crius Transaction — On July 15, 2019, Vienna Acquisition B.C. Ltd., an indirect, wholly owned subsidiary of Vistra, completed the acquisition of the equity interests of two wholly owned subsidiaries of Crius that indirectly own the operating business of Crius (Crius Transaction). See Note 2 to the Financial Statements for a summary of the Crius Transaction and business combination accounting.Dynegy Merger Transaction — On the Merger Date, Vistra and Dynegy completed the transactions contemplated by the Merger Agreement. See Note 2 to the Financial Statements for a summary of the Merger transaction and business combination accounting.Dividend ProgramIn November 2018, we announced that the Board had adopted a dividend program which we initiated in the first quarter of 2019. See Note 14 to the Financial Statements for more information about our dividend program.Share Repurchase ProgramIn September 2020, we announced that the Board had authorized a new share repurchase program (Share Repurchase Program) under which up to $1.5 billion of our outstanding common stock may be repurchased. The Share Repurchase Program was effective January 1, 2021, at which time the Prior Share Repurchase Plan terminated. From January 1, 2021 through February 23, 2021, 5,902,720 shares of our common stock had been repurchased under the Share Repurchase Program for $125 million at an average price per share of common stock of $21.15, and at February 23, 2021, $1.375 billion was available for repurchase under the Share Repurchase Program. See Note 14 to the Financial Statements for more information concerning the Share Repurchase Program and the Prior Share Repurchase Program.Debt ActivityWe have stated our objective to reduce our consolidated net leverage. We also intend to continue to simplify and optimize our capital structure, maintain adequate liquidity and pursue opportunities to refinance our long-term debt to extend maturities and/or reduce ongoing interest expense. In 2019 and 2020, we completed several transactions, including the redemption and repayment of all of Parent's previously outstanding senior notes, that we believe, in the aggregate, advanced all of these goals. See Note 11 to the Financial Statements for details of our long-term debt activity and Note 10 to the Financial Statements for details of our accounts receivable financing.54Table of ContentsCapacity MarketsPJM — Reliability Pricing Model (RPM) auction results, for the zones in which our assets are located, are as follows for each planning year:2020-20212021-2022(average price per MW-day)RTO zone (a)$88.32 $140.00 ComEd zone188.12 195.55 MAAC zone86.04 140.00 EMAAC zone187.87 165.73 ATSI zone76.53 171.33 PPL zone86.04 140.00 ____________(a)Planning Year 2020-2021 includes Duke Energy Ohio Kentucky (DEOK) zone, which cleared at $130.00 per MW-day. RTO Zone excluding DEOK Zone was $76.53 per MW-day.Our capacity sales, net of purchases, aggregated by planning year and capacity type through planning year 2022-2023, are as follows:2020-20212021-20222022-2023CP auction capacity sold, net (MW)9,065 9,309 125 Bilateral capacity sold, net (MW)100 250 200 Total segment capacity sold, net (MW)9,165 9,559 325 Average price per MW-day$128.24 $157.30 $165.77 NYISO — The most recent seasonal auction results for NYISO's Rest-of-State zones, in which the capacity for our Independence plant clears, are as follows for each planning period:Summer 2021Winter 2021 - 2022Price per kW-month$2.71 $0.10 Due to the short-term, seasonal nature of the NYISO capacity auctions, we monetize the majority of our capacity through bilateral trades. Our capacity sales, aggregated by season through winter 2022-2023, are as follows:Winter 2020 - 2021Summer 2021Winter 2021 - 2022Summer 2022Winter 2022 - 2023Auction capacity sold (MW)144 — — — — Bilateral capacity sold (MW)747 843 305 210 71 Total capacity sold (MW)891 843 305 210 71 Average price per kW-month$0.72 $2.43 $0.97 $1.13 $1.13 ISO-NE — The most recent Forward Capacity Auction results for ISO-NE Rest-of-Pool, in which most of our assets are located, are as follows for each planning year:2020-20212021-20222022-20232023-2024Price per kW-month$5.30 $4.63 $3.80 $2.00 Performance incentive rules increase capacity payments for those resources that are providing excess energy or reserves during a shortage event, while penalizing those that produce less than the required level. We continue to market and pursue longer term multi-year capacity transactions that extend through planning year 2024-2025.2020-20212021-20222022-20232023-20242024-2025Auction capacity sold (MW)3,085 2,798 2,996 2,496 — Bilateral capacity sold (MW)191 170 95 20 20 Total capacity sold (MW)3,276 2,968 3,091 2,516 20 Average price per kW-month$5.11 $4.57 $3.92 $2.16 $4.93 55Table of ContentsMISO — The capacity auction results for MISO Local Resource Zone 4, in which our assets are located, are as follows for each planning year:2020-2021Price per MW-day$5.00 MISO capacity sales through planning year 2023-2024 are as follows:2020-20212021-20222022-20232023-2024Bilateral capacity sold in MISO (MW)2,672 2,098 573 251 CP auction capacity sold in PJM (MW)— 15 — — Total MISO segment capacity sold (MW)2,672 2,113 573 251 Average price per kW-month$3.04 $3.12 $4.05 $3.69 CAISO — Our capacity sales, aggregated by calendar year for 2021 through 2022 for Moss Landing, are as follows:20212022Bilateral capacity sold (Avg MW)1,020 831 56Table of ContentsKey Operational Risks and ChallengesFollowing is a discussion of certain key operational risks and challenges facing management and the initiatives currently underway to manage such challenges. These matters involve risks that could have a material effect on our business, results of operations, liquidity, financial condition, cash flows, reputation, prospects and the market price for our securities (including our common stock). See also Item 1A. Risk Factors in this annual report on Form 10-K for additional discussion on risks that could have a material effect on our results of operations, liquidity, financial condition, cash flows, reputation, prospects and the market price for our securities (including our common stock).Natural Gas Price and Market Heat Rate Exposure The price of power is typically set by natural gas-fueled generation facilities, with wholesale prices generally tracking increases or decreases in the price of natural gas, with exceptions such as those periods during which ERCOT power prices rise significantly as a result of the scarcity of available generation resources relative to power demand. In recent years, natural gas supply has outpaced demand primarily as a result of development and expansion of hydraulic fracturing in natural gas extraction; this supply/demand environment has resulted in historically low natural gas prices, and such prices have historically been volatile.In contrast to our natural gas-fueled generation facilities, changes in natural gas prices have no significant effect on the cost of generating power at our nuclear-, lignite- and coal-fueled facilities. Consequently, all other factors being equal, these nuclear-, lignite- and coal-fueled generation assets increase or decrease in value as wholesale electricity prices change either as a result of changes in natural gas prices or market heat rates, because of the effect on our operating margins. A persistent decline in the price of natural gas, if not offset by an increase in market heat rates, would likely have a material adverse effect on our results of operations, liquidity and financial condition, predominantly related to the production of power generation volumes in excess of the volumes utilized to service our retail customer load requirements and wholesale hedges.The wholesale market price of electricity divided by the market price of natural gas represents the market heat rate. Market heat rate can be affected by a number of factors, including generation availability, mix of assets and the efficiency of the marginal supplier (generally natural gas-fueled generation facilities) in generating electricity. Our market heat rate exposure is impacted by changes in the availability of generation resources, such as additions and retirements of generation facilities, and mix of generation assets. For example, increasing renewable (wind and solar) generation capacity generally depresses market heat rates, particularly during periods when total demand is relatively low. However, increasing penetration of renewable generation capacity may also contribute to greater volatility of wholesale market prices independent of changes in the price of natural gas, given their intermittent nature. Decreases in market heat rates decrease the value of our generation assets because lower market heat rates result in lower wholesale electricity prices, and vice versa.As a result of our exposure to the variability of natural gas prices and market heat rates, retail sales and hedging activities are critical to our operating results and maintaining consistent cash flow levels.Our integrated power generation and retail electricity business provides us opportunities to hedge our generation position utilizing retail electricity markets as a sales channel. In addition, our approach to managing electricity price risk focuses on the following:•employing disciplined, liquidity-efficient hedging and risk management strategies through physical and financial energy-related contracts intended to partially hedge gross margins;•continuing focus on cost management to better withstand gross margin volatility;•following a retail pricing strategy that appropriately reflects the value of our product offering to customers, the magnitude and costs of commodity price, liquidity risk and retail demand variability; and•improving retail customer service to attract and retain high-value customers.We have engaged in natural gas hedging activities to mitigate the risk of lower wholesale electricity prices that have corresponded to declines in natural gas prices. While current and forward natural gas prices are currently depressed, we continue to seek opportunities to manage our wholesale power price exposure through hedging activities, including forward wholesale and retail electricity sales.57Table of ContentsEstimated hedging levels for generation volumes in our Texas, East, West and Sunset segments at December 31, 2020 were as follows:20212022Nuclear/Renewable/Coal Generation:Texas91 %46 %Sunset98 %57 %Gas Generation:Texas76 %16 %East92 %23 %West99 %9 %The following sensitivity table provides approximate estimates of the potential impact of movements in power prices and spark spreads (the difference between the power revenue and fuel expense of natural gas-fired generation as calculated using an assumed heat rate of 7.2 MMBtu/MWh) on realized pretax earnings (in millions) taking into account the hedge positions noted above for the periods presented. The residual gas position is calculated based on two steps: first, calculating the difference between actual heat rates of our natural gas generation units and the assumed 7.2 heat rate used to calculate the sensitivity to spark spreads; and second, calculating the residual natural gas exposure that is not already included in the gas generation spark spread sensitivity shown in the table below. The estimates related to price sensitivity are based on our expected generation, related hedges and forward prices as of December 31, 2020.20212022Texas:Nuclear/Renewable/Coal Generation: $2.50/MWh increase in power price$12 $63 Nuclear/Renewable/Coal Generation: $2.50/MWh decrease in power price$(9)$(59)Gas Generation: $1.00/MWh increase in spark spread$12 $33 Gas Generation: $1.00/MWh decrease in spark spread$(9)$(30)Residual Natural Gas Position: $0.25/MMBtu increase in natural gas price$(13)$(15)Residual Natural Gas Position: $0.25/MMBtu decrease in natural gas price$1 $3 East:Gas Generation: $1.00/MWh increase in spark spread$5 $38 Gas Generation: $1.00/MWh decrease in spark spread$(3)$(35)Residual Natural Gas Position: $0.25/MMBtu increase in natural gas price$(5)$(4)Residual Natural Gas Position: $0.25/MMBtu decrease in natural gas price$5 $4 West:Gas Generation: $1.00/MWh increase in spark spread$— $4 Gas Generation: $1.00/MWh decrease in spark spread$— $(4)Residual Natural Gas Position: $0.25/MMBtu increase in natural gas price$1 $1 Residual Natural Gas Position: $0.25/MMBtu decrease in natural gas price$(1)$(1)Sunset:Coal Generation: $2.50/MWh increase in power price$5 $40 Coal Generation: $2.50/MWh decrease in power price$(1)$(34)58Table of ContentsCompetitive Retail Markets and Customer RetentionCompetitive retail activity in ERCOT has resulted in retail customer churn as customers switch retail electricity providers for various reasons. Based on numbers of meters, our total retail customer counts increased approximately 1% in 2020 and approximately 2% in both 2019 and 2018. Based upon December 31, 2020 results discussed below in Results of Operations, a 1% decline in retail customers in ERCOT would result in a decline in annual revenues of approximately $57 million. In responding to the competitive landscape in the ERCOT market, we have attempted to reduce overall customer losses by focusing on the following key initiatives:•Maintaining competitive pricing initiatives on residential service plans;•Actively competing for new customers in areas open to competition within ERCOT, while continuing to strive to enhance the experience of our existing customers; we are focused on continuing to implement initiatives that deliver world-class customer service and improve the overall customer experience;•Establishing and leveraging our TXU EnergyTM brand in the sale of electricity to residential and commercial customers, as the most innovative retailer in the ERCOT market by continuing to develop tailored product offerings to meet customer needs; and•Focusing market initiatives largely on programs targeted at retaining the existing highest-value customers and to recapturing customers who have switched REPs, including maintaining and continuously refining a disciplined contracting and pricing approach and economic segmentation of the business market to enhance targeted sales and marketing efforts and to more effectively deploy our direct-sales force; tactical programs we have initiated include improved customer service, aided by an enhanced customer management system, new product price/service offerings and a multichannel approach for the small business market.Exposures Related to Nuclear Asset OutagesOur nuclear assets are comprised of two generation units at the Comanche Peak facility, each with an installed nameplate generation capacity of 1,150 MW. As of December 31, 2020, these units represented approximately 6% of our total generation capacity. The nuclear generation units represent our lowest marginal cost source of electricity. Assuming both nuclear generation units experienced an outage at the same time, the unfavorable impact to pretax earnings is estimated (based upon forward electricity market prices for 2021 at December 31, 2020) to be approximately $1 million per day before consideration of any costs to repair the cause of such outages or receipt of any insurance proceeds. Also see discussion of nuclear facilities insurance in Note 13 to the Financial Statements to understand the importance and limits of our insurance protection.The inherent complexities and related regulations associated with operating nuclear generation facilities result in environmental, regulatory and financial risks. The operation of nuclear generation facilities is subject to continuing review and regulation by the NRC, covering, among other things, operations, maintenance, emergency planning, security, and environmental and safety protection. The NRC may implement changes in regulations that result in increased capital or operating costs and may require extended outages, modify, suspend or revoke operating licenses and impose fines for failure to comply with its existing regulations and the provisions of the Atomic Energy Act. In addition, an unplanned outage at another nuclear generation facility could result in the NRC taking action to shut down our Comanche Peak units as a precautionary measure.We participate in industry groups and with regulators to keep current on the latest developments in nuclear safety, operation and maintenance and on emerging threats and mitigating techniques. These groups include, but are not limited to, the NRC, the Institute of Nuclear Power Operations (INPO) and the Nuclear Energy Institute (NEI). We also apply the knowledge gained through our continuing investment in technology, processes and services to improve our operations and to detect, mitigate and protect our nuclear generation assets. Management continues to focus on the safe, reliable and efficient operations at the facility.Cyber/Data Security and Infrastructure Protection RiskA breach of cyber/data security measures that impairs our information technology infrastructure could disrupt normal business operations and affect our ability to control our generation assets, access retail customer information and limit communication with third parties. Any loss of confidential or proprietary data through a breach could materially affect our reputation, including our TXU EnergyTM, Ambit Energy, Value Based Brands, Dynegy Energy Services, Homefield Energy, TriEagle Energy, Public Power and U.S. Gas & Electric brands, expose the company to legal claims and regulatory scrutiny or impair our ability to execute on business strategies.59Table of ContentsWe participate in industry groups and with regulators to remain current on emerging threats and mitigating techniques. These groups include, but are not limited to, the U.S. Cyber Emergency Response Team, the National Electric Sector Cyber Security Organization, the NRC and NERC.While the Company has not experienced a cyber/data event causing any material operational, reputational or financial impact, we recognize the growing threat within the general market place and our industry, and are proactively making strategic investments in our perimeter and internal defenses, cyber/data security operations center and regulatory compliance activities. We also apply the knowledge gained through industry and government organizations to continuously improve our technology, processes and services to detect, mitigate and protect our cyber and data assets.SeasonalityThe demand for and market prices of electricity and natural gas are affected by weather. As a result, our operating results are impacted by extreme or sustained weather conditions and may fluctuate on a seasonal basis. Typically, demand for and the price of electricity is higher in the summer and winter seasons, when the temperatures are more extreme, and the demand for and price of natural gas is also generally higher in the winter. More severe weather conditions such as heat waves or extreme winter weather have made, and may make such fluctuations more pronounced. The pattern of this fluctuation may change depending on, among other things, the retail load served and the terms of contracts to purchase or sell electricity.Application of Critical Accounting PoliciesOur significant accounting policies are discussed in Note 1 to the Financial Statements. We follow accounting principles generally accepted in the U.S. Application of these accounting policies in the preparation of our consolidated financial statements requires management to make estimates and assumptions about future events that affect the reporting of assets and liabilities at the balance sheet dates and revenues and expenses during the periods covered. The following is a summary of certain critical accounting policies that are impacted by judgments and uncertainties and under which different amounts might be reported using different assumptions or estimation methodologies.Purchase AccountingOn November 1, 2019, an indirect, wholly owned subsidiary of Vistra completed the Ambit Transaction. On July 15, 2019, an indirect, wholly owned subsidiary of Vistra completed the Crius Transaction. Each of the Ambit Transaction and Crius Transaction, respectively, was accounted for in accordance with ASC 805, Business Combinations (ASC 805), with identifiable assets acquired and liabilities assumed recorded at their estimated fair values on the Ambit Acquisition Date and the Crius Acquisition Date, respectively. See Note 2 to the Financial Statements for the purchase price allocations for both the Ambit Transaction and Crius Transaction as well as the related adjustments through the respective measurement periods. Determining fair values of assets acquired and liabilities assumed requires significant estimates and judgments. We determine fair value based on the estimated price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.The acquired assets that involved the most subjectivity in determining fair value consisted of the customer relationship intangible assets. The assignment of fair value to the identifiable intangible assets requires judgment. We apply an income-based valuation methodology in measuring the customer relationships acquired, which include certain assumptions such as forecasted future cash flows, customer attrition rates, and discount rates. Customer relationship intangibles assets are generally amortized using an accelerated method based on historical customer attrition rates and reflecting the expected pattern in which the economic benefits are realized over their estimated useful lives.On the Merger Date, Dynegy merged with and into Vistra, with Vistra continuing as the surviving corporation. The Merger was accounted for in accordance with ASC 805, with identifiable assets acquired and liabilities assumed recorded at their estimated fair values on the Merger Date. Vistra is the acquirer for both federal tax and accounting purposes. The combined results of operations are reported in our consolidated financial statements beginning as of the Merger Date. See Note 2 to the Financial Statements. 60Table of ContentsThe acquired assets and liabilities that involved the most subjectivity in determining fair value consisted of property, plant and equipment and executory contracts, primarily long-term service agreements for maintenance of power plants, a unit-specific power sales agreement and rail transportation contracts. The fair value of each power plant was estimated using a combination of an income approach and a market approach. The income approach is the present value of future cash flows over the life of each power plant that are based on management’s estimates of revenues and operating expenses, and appropriate discount rates. The estimate of long term prices of electricity and natural gas at each plant location that was used in developing forecasted revenues for the income approach was especially subjective, because as of the Merger Date, limited market information about future prices beyond the year 2022 was available. The market valuation method uses prices paid for a reasonably similar asset by other purchasers in the relevant market, with adjustments relating to any differences between the assets and locations. The determination of deferred tax assets was complex as it required assessing income tax rules and regulations and proposed regulations that impose limitations on the future use of acquired net operating losses and other limitations on deductions.Derivative Instruments and Mark-to-Market AccountingWe enter into contracts for the purchase and sale of energy-related commodities, and also enter into other derivative instruments such as options, swaps, futures and forwards primarily to manage commodity price and interest rate risks. Under accounting standards related to derivative instruments and hedging activities, these instruments are subject to mark-to-market accounting, and the determination of market values for these instruments is based on numerous assumptions and estimation techniques.Mark-to-market accounting recognizes changes in the fair value of derivative instruments in the financial statements as market prices change. Such changes in fair value are accounted for as unrealized mark-to-market gains and losses in net income with an offset to derivative assets and liabilities. The availability of quoted market prices in energy markets is dependent on the type of commodity (e.g., natural gas, electricity, etc.), time period specified and delivery point. Where quoted market prices are not available, the fair value is based on unobservable inputs, which require significant judgment. Derivative instruments valued based on unobservable inputs primarily include (i) forward sales and purchases of electricity, natural gas and coal, (ii) electricity, natural gas and coal options, and (iii) financial transmission rights. In computing fair value for derivatives, each forward pricing curve is separated into liquid and illiquid periods. The liquid period varies by delivery point and commodity. Generally, the liquid period is supported by exchange markets, broker quotes and frequent trading activity. For illiquid periods, fair value is estimated based on forward price curves developed using proprietary modeling techniques that take into account available market information and other inputs that might not be readily observable in the market. We estimate fair value as described in Note 15 to the Financial Statements.Accounting standards related to derivative instruments and hedging activities allow for normal purchase or sale elections and hedge accounting designations, which generally eliminate or defer the requirement for mark-to-market recognition in net income and thus reduce the volatility of net income that can result from fluctuations in fair values. Normal purchases and sales are contracts that provide for physical delivery of quantities expected to be used or sold over a reasonable period in the normal course of business and are not subject to mark-to-market accounting if the normal purchase or sale election is made. Accounting standards also permit an entity to designate certain qualifying derivative contracts in a hedge accounting relationship, whereby changes in fair value are not recognized immediately in earnings. Vistra does not have derivative instruments with hedge accounting designations.We report derivative assets and liabilities in the consolidated balance sheets without taking into consideration netting arrangements that we have with counterparties. Margin deposits that contractually offset these assets and liabilities are reported separately in the consolidated balance sheets, with the exception of certain margin amounts related to changes in fair value on CME transactions that are legally characterized as settlement of derivative contracts rather than collateral.See Note 16 to the Financial Statements for further discussion regarding derivative instruments.Accounting for Income TaxesVistra files a U.S. federal income tax return that includes the results of its consolidated subsidiaries. Vistra is the corporate parent of the Vistra consolidated group. Pursuant to applicable U.S. Department of the Treasury regulations and published guidance of the IRS, corporations that are members of a consolidated group have joint and several liability for the taxes of such group.61Table of ContentsOur income tax expense and related consolidated balance sheet amounts involve significant management estimates and judgments. Amounts of deferred income tax assets and liabilities, as well as current and noncurrent accruals, involve estimates and judgments of the timing and probability of recognition of income and deductions by taxing authorities. In assessing the likelihood of realization of deferred tax assets, management considers estimates of the amount and character of future taxable income. Actual income taxes could vary from estimated amounts due to the future impacts of various items, including changes in income tax laws, our forecasted financial condition and results of operations in future periods, as well as final review of filed tax returns by taxing authorities. Income tax returns are regularly subject to examination by applicable tax authorities. In management's opinion, the liability recorded pursuant to income tax accounting guidance related to uncertain tax positions reflects future taxes that may be owed as a result of any examination.See Notes 1 and 7 to the Financial Statements for further discussion of income tax matters.Accounting for Tax Receivable AgreementOn the Effective Date, Vistra entered into a tax receivable agreement (the TRA) with a transfer agent. Pursuant to the TRA, we issued the TRA Rights for the benefit of the first-lien creditors of TCEH entitled to receive such TRA Rights under the Plan of Reorganization. Vistra reflected the obligation associated with TRA Rights at fair value in the amount of $574 million as of the Emergence Date related to these future payment obligations. As of December 31, 2020, the TRA obligation has been adjusted to $450 million. During the year ended December 31, 2020, we recorded a decrease to the carrying value of the TRA obligation totaling $69 million as a result of adjustments to forecasted taxable income, including the impacts of the CARES Act, changes to Section 163(j) percentage limitation amount, the impacts from the issuance of the final Section 163(j) regulations and the anticipated tax benefits from renewable development projects. At December 31, 2020, expected undiscounted federal and state payments under the TRA is estimated to be approximately $1.4 billion. The TRA obligation value is the discounted amount of projected payments to be made each year under the TRA, based on certain assumptions, including but not limited to:•the amount of tax basis related to (i) the Lamar and Forney acquisition and (ii) step-up resulting from the PrefCo Preferred Stock Sale (which is estimated to be approximately $5.5 billion) and the allocation of such tax basis step-up among the assets subject thereto;•the depreciable lives of the assets subject to such tax basis step-up, which generally is expected to be 15 years for most of such assets;•a blended federal/state corporate income tax rate in all future years of 23.3%;•future taxable income by year for future years;•the Company generally expects to generate sufficient taxable income to be able to utilize the deductions arising out of (i) the tax basis step up attributable to the PrefCo Preferred Stock Sale, (ii) the entire tax basis of the assets acquired as a result of the Lamar and Forney Acquisition, and (iii) tax benefits related to imputed interest deemed to be paid by us as a result of payments under the TRA in the tax year in which such deductions arise;•a discount rate of 15%, which represented our view at the Emergence Date of the rate that a market participant would use based on the risk associated with the uncertainty in the amount and timing of the cash flows, at the time of Emergence; and•additional states that Vistra now operates in, the relevant tax rates of those states and how income will be apportioned to those states.We recognize accretion expense over the life of the TRA Rights liability as the present value of the liability is accreted up over the life of the liability. This noncash accretion expense is reported in the consolidated statements of operations as Impacts of Tax Receivable Agreement. Further, there may be significant changes, which may be material, to the estimate of the related liability due to various reasons including changes in federal and state tax laws and regulations, changes in estimates of the amount or timing of future consolidated taxable income, utilization of acquired net operating losses, reversals of temporary book/tax differences and other items. Changes in those estimates are recognized as adjustments to the related TRA Rights liability, with offsetting impacts recorded in the consolidated statements of operations as Impacts of Tax Receivable Agreement. See Note 8 to the Financial Statements.62Table of ContentsAsset Retirement Obligations (ARO)As part of business combination accounting, new fair values were established for all AROs assumed in the Merger. A liability is initially recorded at fair value for an ARO associated with the legal obligation associated with law, regulatory, contractual or constructive retirement requirements of tangible long-lived assets. Changes to the estimate of the ARO requires us to make significant estimates and assumptions. Specifically, the estimates and assumptions required for the mining land reclamation related to lignite mining, such as the costs to fill in mining pits and interpreting the mining permit closure requirements, are complex and require a significant amount of judgment. To develop the estimate associated with the costs to fill in mining pits, we utilize a complex proprietary model to estimate the volume of the pit. A significant portion of the estimate is associated with the Asset Closure Segment, thus related to closed facilities with changes in the estimate recorded to our consolidated statements of operations.During the years ended December 31, 2020 and 2019, we transferred $15 million and $135 million, respectively, in ARO obligations to third parties for remediation. Any remaining unpaid third-party obligation was reclassified to other current liabilities and other noncurrent liabilities and deferred credits in our consolidated balance sheets. At December 31, 2020, the carrying value of our ARO related to our nuclear generation plant decommissioning totaled $1.585 billion and includes an assumption that Vistra receives a license extension of 20 years from the NRC to continue to operate the Comanche Peak facility. The costs to ultimately decommission that facility are recoverable through the regulatory rate making process as part of Oncor's delivery fees and therefore changes in estimates of the ARO do not impact Vistra's earnings. See Note 21 to the Financial Statements for additional discussion of ARO obligations and adjustments made to the ARO obligation estimates during the years ended 2020, 2019 and 2018.Impairment of Goodwill and Other Long-Lived AssetsWe evaluate long-lived assets (including intangible assets with finite lives) for impairment, in accordance with accounting standards related to impairment or disposal of long-lived assets, whenever events or changes in circumstances indicate that their carrying amount may not be recoverable. For our generation assets, possible indications include an expectation of continuing long-term declines in natural gas prices and/or market heat rates or an expectation that "more likely than not" a generation asset will be sold or otherwise disposed of significantly before the end of its estimated useful life. The determination of the existence of these and other indications of impairment involves judgments that are subjective in nature and may require the use of estimates in forecasting future results and cash flows related to an asset or group of assets. Further, the unique nature of our property, plant and equipment, which includes a fleet of generation assets with a diverse fuel mix and individual generation units that have varying production or output rates, requires the use of significant judgments in determining the existence of impairment indications and the grouping of assets for impairment testing. See Note 21 to the Financial Statements for discussion of impairments of long-lived assets recorded in 2020.Recoverability of long-lived assets is determined by a comparison of the carrying amount of the long-lived asset group to the net cash flows expected to be generated by the asset group, through considering specific assumptions for forward natural gas and electricity prices, forward capacity prices, the effects of enacted environmental rules, generation plant performance, forecasted capital expenditures, forecasted fuel prices and forecasted operating costs. The carrying value of such asset groups is determined to be unrecoverable if the projected undiscounted cash flows are less than the carrying value.If an asset group carrying value is determined to be unrecoverable, fair value will be calculated based on a market participant view and a loss will be recorded for the amount the carrying value exceeds the fair value. Fair value is determined primarily by discounted cash flows (income approach) and supported by available market valuations, if applicable. The income approach involves estimates of future performance that reflect assumptions regarding, among other things, forward natural gas and electricity prices, forward capacity prices, market heat rates, the effects of enacted environmental rules, generation plant performance, forecasted capital expenditures and forecasted fuel prices. Another key assumption in the income approach is the discount rate applied to the forecasted cash flows. Any significant change to one or more of these factors can have a material impact on the fair value measurement of our long-lived assets. Additional material impairments related to our generation facilities may occur in the future if forward wholesale electricity prices decline in the markets in which we operate in or if additional environmental regulations increase the cost of producing electricity at our generation facilities.63Table of ContentsGoodwill and intangible assets with indefinite useful lives, such as the intangible asset related to the trade names of TXU EnergyTM, Ambit Energy, 4Change EnergyTM, Homefield, Dynegy Energy Services, TriEagle Energy, Public Power and U.S. Gas & Electric, respectively, are required to be evaluated for impairment at least annually (we have selected October 1 as our annual goodwill test date) or whenever events or changes in circumstances indicate an impairment may exist, such as the indicators used to evaluate impairments to long-lived assets discussed above or declines in values of comparable public companies in our industry. Accounting standards allow a company to qualitatively assess if the carrying value of a reporting unit with goodwill is more likely than not less than the fair value of that reporting unit. If the entity determines the carrying value, including goodwill, is not more likely greater than the fair value, no further testing of goodwill for impairment is required. On the most recent goodwill testing date, we applied qualitative factors and determined that it was more likely than not that the fair value of our Retail and Texas Generation reporting units exceeded their carrying value at October 1, 2020. Significant qualitative factors evaluated included reporting unit financial performance and market multiples, cost factors, customer attrition, interest rates and changes in reporting unit book value.Accounting guidance requires goodwill to be allocated to our reporting units, and at December 31, 2020, $2.461 billion of our goodwill was allocated to our Retail reporting unit and $122 million was allocated to our Texas Generation reporting unit. Goodwill impairment testing is performed at the reporting unit level. Under this goodwill impairment analysis, if at the assessment date, a reporting unit's carrying value exceeds its estimated fair value (enterprise value), the estimated enterprise value of the reporting unit is compared to the estimated fair values of the reporting unit's assets (including identifiable intangible assets) and liabilities at the assessment date, and the resultant implied goodwill amount is then compared to the recorded goodwill amount. Any excess of the recorded goodwill amount over the implied goodwill amount is written off as an impairment charge.The determination of enterprise value of a reporting unit involves a number of assumptions and estimates. We use a combination of fair value measurements to estimate enterprise values of our reporting units including: internal discounted cash flow analyses (income approach), and comparable publicly traded company values (market approach). The income approach involves estimates of future performance that reflect assumptions regarding, among other things, forward natural gas and electricity prices, market heat rates, the effects of environmental rules, generation plant performance, forecasted capital expenditures and retail sales volume trends, as well as determination of a terminal value. Another key variable in the income approach is the discount rate, or weighted average cost of capital, applied to the forecasted cash flows. The determination of the discount rate takes into consideration the capital structure, credit ratings and current debt yields of comparable publicly traded companies as well as an estimate of return on equity that reflects historical market returns and current market volatility for the industry. The market approach involves using trading multiples of EBITDA of those selected publicly traded companies to derive appropriate multiples to apply to the EBITDA of our reporting units. Critical judgments include the selection of publicly traded comparable companies and the weighting of the value metrics in developing the best estimate of enterprise value.64Table of ContentsRESULTS OF OPERATIONSVistra Consolidated Financial Results — Year Ended December 31, 2020 Compared to Year Ended December 31, 2019 and Year Ended December 31, 2019 Compared to Year Ended December 31, 2018Year Ended December 31,2020 vs 2019Favorable (Unfavorable) $ Change2019 vs 2018Favorable (Unfavorable) $ Change202020192018Operating revenues$11,443 $11,809 $9,144 $(366)$2,665 Fuel, purchased power costs and delivery fees(5,174)(5,742)(5,036)568 (706)Operating costs(1,622)(1,530)(1,297)(92)(233)Depreciation and amortization(1,737)(1,640)(1,394)(97)(246)Selling, general and administrative expenses(1,035)(904)(926)(131)22 Impairment of long-lived assets(356)— — (356)— Operating income1,519 1,993 491 (474)1,502 Other income34 56 47 (22)9 Other deductions(42)(15)(5)(27)(10)Interest expense and related charges(630)(797)(572)167 (225)Impacts of Tax Receivable Agreement5 (37)(79)42 42 Equity in earnings of unconsolidated investment4 16 17 (12)(1)Income (loss) before income taxes890 1,216 (101)(326)1,317 Income tax (expense) benefit(266)(290)45 24 (335)Net income (loss)$624 $926 $(56)$(302)$982 Year Ended December 31, 2020RetailTexasEastWestSunsetAsset ClosureEliminations / Corporate and OtherVistra ConsolidatedOperating revenues$8,270 $4,116 $2,415 $282 $1,252 $3 $(4,895)$11,443 Fuel, purchased power costs and delivery fees(6,857)(1,078)(1,262)(168)(704)— 4,895 (5,174)Operating costs(123)(727)(270)(30)(408)(63)(1)(1,622)Depreciation and amortization(303)(475)(721)(19)(133)(22)(64)(1,737)Selling, general and administrative expenses(675)(75)(89)(26)(71)(27)(72)(1,035)Impairment of long-lived assets— — — — (356)— — (356)Operating income (loss)312 1,761 73 39 (420)(109)(137)1,519 Other income6 3 1 1 6 10 7 34 Other deductions1 (12)(30)— 2 (2)(1)(42)Interest expense and related charges(10)8 (7)10 (2)— (629)(630)Impacts of Tax Receivable Agreement— — — — — — 5 5 Equity in earnings of unconsolidated investment— — 4 — — — — 4 Income (loss) before income taxes309 1,760 41 50 (414)(101)(755)890 Income tax expense— — — — — — (266)(266)Net income (loss)$309 $1,760 $41 $50 $(414)$(101)$(1,021)$624 65Table of ContentsYear Ended December 31, 2019RetailTexasEastWestSunsetAsset ClosureEliminations / Corporate and OtherVistra ConsolidatedOperating revenues$6,872 $3,836 $2,790 $338 $1,602 $341 $(3,970)$11,809 Fuel, purchased power costs and delivery fees(5,816)(1,283)(1,393)(187)(767)(267)3,971 (5,742)Operating costs(71)(691)(236)(27)(366)(138)(1)(1,530)Depreciation and amortization(292)(472)(680)(19)(120)— (57)(1,640)Selling, general and administrative expenses(538)(76)(83)(17)(78)(43)(69)(904)Operating income (loss)155 1,314 398 88 271 (107)(126)1,993 Other income— 28 — — 7 3 18 56 Other deductions— (8)(1)— — (5)(1)(15)Interest expense and related charges(21)8 (13)— (4)— (767)(797)Impacts of Tax Receivable Agreement— — — — — — (37)(37)Equity in earnings of unconsolidated investment— — 16 — — — — 16 Income (loss) before income taxes134 1,342 400 88 274 (109)(913)1,216 Income tax expense— — — — — — (290)(290)Net income (loss)$134 $1,342 $400 $88 $274 $(109)$(1,203)$926 Year Ended December 31, 2018RetailTexasEastWestSunsetAsset ClosureEliminations / Corporate and OtherVistra ConsolidatedOperating revenues$5,597 $2,497 $1,895 $208 $1,183 $371 $(2,607)$9,144 Fuel, purchased power costs and delivery fees(4,126)(1,461)(1,131)(134)(505)(286)2,607 (5,036)Operating costs(39)(661)(164)(17)(305)(109)(2)(1,297)Depreciation and amortization(318)(390)(519)(14)(81)— (72)(1,394)Selling, general and administrative expenses(424)(88)(71)(8)(50)(39)(246)(926)Operating income (loss)690 (103)10 35 242 (63)(320)491 Other income29 34 1 — — 2 (19)47 Other deductions— (7)(1)— 1 (1)3 (5)Interest expense and related charges(7)(12)(10)(1)(1)— (541)(572)Impacts of Tax Receivable Agreement— — — — — — (79)(79)Equity in earnings of unconsolidated investment— — 18 — — — (1)17 Income (loss) before income taxes712 (88)18 34 242 (62)(957)(101)Income tax benefit— — — — — — 45 45 Net income (loss)$712 $(88)$18 $34 $242 $(62)$(912)$(56)66Table of ContentsIn 2020, our operating segments delivered strong operating performance with a disciplined focus on cost management, while generating and selling essential electricity in a safe and reliable manner during a period of significant economic disruption. Our performance reflected the stability of our integrated model, including a diversified generation fleet, retail and commercial and hedging activities in support of our integrated business, to produce results that exceeded expectations and generated significant cash from operations of $3.337 billion for the year ended December 31, 2020. The increase of 22% versus 2019 was particularly strong given the general uncertainty in the overall economy and the challenges of dealing with COVID-19.Consolidated results decreased $302 million to net income of $624 million in the year ended December 31, 2020 compared to the year ended December 31, 2019. The change in results was driven by a $465 million pre-tax decrease in unrealized gains on commodity hedging transactions, a $356 million pre-tax impairment of assets related to our Kincaid, Zimmer and Joppa/EEI coal generation facilities and a $29 million pre-tax loss on disposal of our equity method investment in NELP, offset by strong operating results, particularly in the Texas segment, and the addition of Crius and Ambit. See Note 21 to the Financial Statements.Operating costs increased $92 million to $1.622 billion in the year ended December 31, 2020 compared to the year ended December 31, 2019 primarily driven by higher estimated costs for ARO, increased LTSA costs and COVID-related expenses and increased operating costs in Retail driven by the acquisition of Ambit and Crius, partially offset by lower property taxes.SG&A expense increased $131 million to $1.035 billion in the year ended December 31, 2020 compared to the year ended December 31, 2019 primarily due to the increased expense resulting from the acquisition of Crius in July 2019 and Ambit in November 2019.Interest expense and related charges decreased $167 million to $630 million in the year ended December 31, 2020 compared to the year ended December 31, 2019 driven by a $109 million decrease in interest paid/accrued reflecting the reduction in higher interest Vistra senior unsecured notes through the Redemptions and Tender Offers in 2019 and 2020 and a $65 million decrease in unrealized mark-to-market losses on interest rate swaps. Debt extinguishment gains totaled $17 million and $21 million in the years ended December 31, 2020 and 2019, respectively. See Note 21 to the Financial Statements.For the years ended December 31, 2020 and 2019, the impacts of the TRA totaled income of $5 million and expense of $37 million, respectively. See Note 8 to the Financial Statements for discussion of the impacts of the TRA obligation.For the year ended December 31, 2020, income tax expense totaled $266 million and the effective tax rate was 29.9%. For the year ended December 31, 2019, income tax benefit totaled $290 million and the effective tax rate was 23.8%. See Note 7 to the Financial Statements for reconciliation of the effective rates to the U.S. federal statutory rate.For the years ended December 31, 2020 and 2019, consolidated cash flows from operations totaled $3.337 billion and $2.736 billion, respectively.Discussion of Adjusted EBITDANon-GAAP Measures — In analyzing and planning for our business, we supplement our use of GAAP financial measures with non-GAAP financial measures, including EBITDA and Adjusted EBITDA as performance measures. These non-GAAP financial measures reflect an additional way of viewing aspects of our business that, when viewed with our GAAP results and the accompanying reconciliations to corresponding GAAP financial measures included in the tables below, may provide a more complete understanding of factors and trends affecting our business. These non-GAAP financial measures should not be relied upon to the exclusion of GAAP financial measures and are, by definition an incomplete understanding of Vistra and must be considered in conjunction with GAAP measures. In addition, non-GAAP financial measures are not standardized; therefore, it may not be possible to compare these financial measures with other companies' non-GAAP financial measures having the same or similar names. We strongly encourage investors to review our consolidated financial statements and publicly filed reports in their entirety and not rely on any single financial measure.67Table of ContentsEBITDA and Adjusted EBITDA — We believe EBITDA and Adjusted EBITDA provide meaningful representations of our operating performance. We consider EBITDA as another way to measure financial performance on an ongoing basis. Adjusted EBITDA is meant to reflect the operating performance of our segments for the period presented. We define EBITDA as earnings (loss) before interest expense, income tax expense (benefit) and depreciation and amortization expense. We define Adjusted EBITDA as EBITDA adjusted to exclude (i) gains or losses on the sale or retirement of certain assets, (ii) the impacts of mark-to-market changes on derivatives, (iii) the impact of impairment charges, (iv) certain amounts associated with fresh-start reporting, acquisitions, dispositions, transition costs or restructurings, (v) non-cash compensation expense, (vi) impacts from the Tax Receivable Agreement and (vii) other material nonrecurring or unusual items.Because EBITDA and Adjusted EBITDA are financial measures that management uses to allocate resources, determine our ability to fund capital expenditures, assess performance against our peers, and evaluate overall financial performance, we believe they provide useful information for investors.When EBITDA or Adjusted EBITDA is discussed in reference to performance on a consolidated basis, the most directly comparable GAAP financial measure to EBITDA and Adjusted EBITDA is Net income (loss). Adjusted EBITDA — Year Ended December 31, 2020 Compared to Year Ended December 31, 2019 and Year Ended December 31, 2019 Compared to Year Ended December 31, 2018Year Ended December 31,2020 vs 2019Favorable (Unfavorable) $ Change2019 vs 2018Favorable (Unfavorable) $ Change202020192018Net income (loss)$624 $926 $(56)$(302)$982 Income tax expense (benefit)266 290 (45)(24)335 Interest expense and related charges (a)630 797 572 (167)225 Depreciation and amortization (b)1,812 1,713 1,472 99 241 EBITDA3,332 3,726 1,943 (394)1,783 Unrealized net (gain) loss resulting from commodity hedging transactions(231)(696)380 465 (1,076)Generation plant retirement expenses43 54 — (11)54 Fresh start/purchase accounting impacts38 30 41 8 (11)Impacts of Tax Receivable Agreement(5)37 79 (42)(42)Non-cash compensation expenses63 48 73 15 (25)Transition and merger expenses16 115 233 (99)(118)Impairment of long-lived assets356 — — 356 — Loss on disposal of investment in NELP29 — — 29 — COVID-19-related expenses (c)25 — — 25 — Odessa earnout buybacks— — 18 — (18)Other, net19 11 (7)8 18 Adjusted EBITDA$3,685 $3,325 $2,760 $360 $565 ____________(a)Includes unrealized mark-to-market net losses on interest rate swaps of $155 million, $220 million and $5 million for the years ended December 31, 2020, 2019 and 2018, respectively.(b)Includes nuclear fuel amortization in the Texas segment of $75 million, $73 million and $78 million for the years ended December 31, 2020, 2019 and 2018, respectively.(c)Includes material and supplies and other incremental costs related to our COVID-19 response.68Table of ContentsVistra recorded its strongest performance in 2020 with Adjusted EBITDA of $3.685 billion, up nearly 11% versus 2019, despite economic challenges and uncertainties dealing with COVID-19. This performance exceeded our expectations set prior to the onset of the pandemic. Our balanced business was driven by strong performance in our Retail segment, delivering $983 million of Adjusted EBITDA, and our Texas generation segment, which delivered $1.646 billion of Adjusted EBITDA. Our other segments, including East, West, Sunset, Asset Closure and Corp delivered $1.056 billion. The performance of our Retail business on a variety of metrics, including customer satisfaction, customer count and margin are all strong. In Generation, we exceeded our commercial availability and safety targets. Our people drove strong results through our Operations Performance Initiative driving incremental gross margin and cost reduction opportunities, and our Best Defense safety program. Finally, our Commercial team optimized our integrated operations through disciplined risk management and hedging activities to ensure we lock in value for our generation business, while cost effectively supplying our retail business. This strong collaboration among our segments has produced consistent, strong results in each year since Vistra became a public company in 2016.Year Ended December 31, 2020RetailTexasEastWestSunsetAsset ClosureEliminations / Corporate and OtherVistra ConsolidatedNet income (loss)$309 $1,760 $41 $50 $(414)$(101)$(1,021)$624 Income tax expense— — — — — — 266 266 Interest expense and related charges (a)10 (8)7 (10)2 — 629 630 Depreciation and amortization (b) 303 550 721 19 133 22 64 1,812 EBITDA622 2,302 769 59 (279)(79)(62)3,332 Unrealized net (gain) loss resulting from commodity hedging transactions340 (691)15 10 95 — — (231)Generation plant retirement expenses— — — — 43 — — 43 Fresh start/purchase accounting impacts5 (8)22 — 19 — — 38 Impacts of Tax Receivable Agreement— — — — — — (5)(5)Non-cash compensation expenses— — — — — — 63 63 Transition and merger expenses5 2 1 — — (3)11 16 Impairment of long-lived assets— — — — 356 — — 356 Loss on disposal of investment in NELP— — 29 — — — — 29 COVID-19-related expenses (c)— 15 3 — 5 — 2 25 Other, net11 26 10 4 3 1 (36)19 Adjusted EBITDA$983 $1,646 $849 $73 $242 $(81)$(27)$3,685 ____________(a)Includes $155 million of unrealized mark-to-market net losses on interest rate swaps.(b)Includes nuclear fuel amortization of $75 million in the Texas segment.(c)Includes material and supplies and other incremental costs related to our COVID-19 response.69Table of ContentsYear Ended December 31, 2019RetailTexasEastWestSunsetAsset ClosureEliminations / Corporate and OtherVistra ConsolidatedNet income (loss)$134 $1,342 $400 $88 $274 $(109)$(1,203)$926 Income tax expense— — — — — — 290 290 Interest expense and related charges (a)21 (8)13 — 4 — 767 797 Depreciation and amortization (b)292 545 680 19 120 — 57 1,713 EBITDA447 1,879 1,093 107 398 (109)(89)3,726 Unrealized net (gain) loss resulting from commodity hedging transactions278 (591)(196)(41)(146)— — (696)Generation plant retirement expenses— — — — 12 42 — 54 Fresh start/purchase accounting impacts23 (4)4 (4)14 (3)— 30 Impacts of Tax Receivable Agreement— — — — — — 37 37 Non-cash compensation expenses— — — — — — 48 48 Transition and merger expenses49 11 9 1 22 — 23 115 Other, net10 12 15 — 8 2 (36)11 Adjusted EBITDA$807 $1,307 $925 $63 $308 $(68)$(17)$3,325 ____________(a)Includes $220 million of unrealized mark-to-market net losses on interest rate swaps.(b)Includes nuclear fuel amortization of $73 million in the Texas segment.Year Ended December 31, 2018RetailTexasEastWestSunsetAsset ClosureEliminations / Corporate and OtherVistra ConsolidatedNet income (loss)$712 $(88)$18 $34 $242 $(62)$(912)$(56)Income tax benefit— — — — — — (45)(45)Interest expense and related charges (a)7 12 10 (1)1 — 543 572 Depreciation and amortization (b)318 468 519 14 81 — 72 1,472 EBITDA1,037 392 547 47 324 (62)(342)1,943 Unrealized net (gain) loss resulting from commodity hedging transactions(206)498 81 15 (8)— — 380 Fresh start/purchase accounting impacts26 (4)11 — 7 1 — 41 Impacts of Tax Receivable Agreement— — — — — — 79 79 Non-cash compensation expenses— — — — — — 73 73 Transition and merger expenses1 9 16 1 9 2 195 233 Odessa earnout buybacks— 18 — — — — — 18 Other, net(13)(1)25 2 9 (4)(25)(7)Adjusted EBITDA$845 $912 $680 $65 $341 $(63)$(20)$2,760 ____________(a)Includes $5 million of unrealized mark-to-market net losses on interest rate swaps.(b)Includes nuclear fuel amortization of $78 million in the Texas segment.70Table of ContentsRetail Segment — Year Ended December 31, 2020 Compared to Year Ended December 31, 2019Year Ended December 31,Favorable (Unfavorable) Change20202019Operating revenues:Revenues in ERCOT$5,880 $5,061 $819 Revenues in Northeast/Midwest2,406 1,818 588 Amortization expense(5)(15)10 Other revenues(11)8 (19)Total operating revenues$8,270 $6,872 $1,398 Fuel, purchased power costs and delivery fees:Purchases from affiliates(4,566)(3,571)(995)Unrealized net losses on hedging activities with affiliates(329)(305)(24)Unrealized net gains on hedging activities — 19 (19)Delivery fees(1,893)(1,629)(264)Other costs (a)(69)(330)261 Total fuel, purchased power costs and delivery fees$(6,857)$(5,816)$(1,041)Net income$309 $134 $175 Adjusted EBITDA$983 $807 $176 Retail sales volumes (GWh):Retail electricity sales volumes:Sales volumes in ERCOT54,075 47,345 6,730 Sales volumes in Northeast/Midwest36,274 30,255 6,019 Total retail electricity sales volumes90,349 77,600 12,749 Weather (North Texas average) - percent of normal (b):Cooling degree days90.0 %96.0 %Heating degree days91.0 %113.0 %____________(a)For the year ended December 31, 2020 and 2019, includes third-party fuel and power purchases of $69 million and $329 million, respectively.(b)Weather data is obtained from Weatherbank, Inc. For the year ended December 31, 2020, normal is defined as the average over the 10-year period from December 2010 to December 2019. For the year ended December 31, 2019, normal is defined as the average over the 10-year period from December 2009 to December 2018.Net income increased by $175 million to $309 million and Adjusted EBITDA increased by $176 million to $983 million in the year ended December 31, 2020 compared to the year ended December 31, 2019.Year Ended December 31, 2020 Compared to 2019Margin primarily driven by the addition of Crius acquired in July 2019 and Ambit acquired in November 2019$339 Other driven by higher operating costs and SG&A expense (including bad debt expense) primarily due to the addition of Crius and Ambit(162)Change in Adjusted EBITDA$177 Change in depreciation and amortization expenses driven by Crius/Ambit intangibles(11)(Unfavorable) impact of higher unrealized net losses on commodity hedging activities(62)Lower transition and merger and other expenses71 Change in Net income$175 71Table of ContentsGeneration — Year Ended December 31, 2020 Compared to Year Ended December 31, 2019Year Ended December 31,TexasEastWestSunset20202019202020192020201920202019Operating revenues:Electricity sales$896 $1,048 $833 $1,355 $289 $293 $883 $969 Capacity revenue from ISO/RTO— — (52)170 — — 164 197 Sales to affiliates2,543 2,213 1,655 1,074 3 — 365 285 Rolloff of unrealized net gains (losses) representing positions settled in the current period2 371 159 59 (22)(10)(205)(74)Unrealized net gains (losses) on hedging activities217 72 (121)(44)12 51 133 249 Unrealized net gains (losses) on hedging activities with affiliates458 132 (61)180 — — (68)(7)Other revenues— — 2 (4)— 4 (20)(17)Operating revenues4,116 3,836 2,415 2,790 282 338 1,252 1,602 Fuel, purchased power costs and delivery fees:Fuel for generation facilities and purchased power costs(960)(1,117)(1,225)(1,381)(166)(187)(744)(739)Fuel for generation facilities and purchased power costs from affiliates6 — (8)(2)— — 2 2 Unrealized (gains) losses from hedging activities14 16 8 1 — — 45 (22)Ancillary and other costs(138)(182)(37)(11)(2)— (7)(8)Fuel, purchased power costs and delivery fees(1,078)(1,283)(1,262)(1,393)(168)(187)(704)(767)Net income (loss)$1,760 $1,342 $41 $400 $50 $88 $(414)$274 Adjusted EBITDA$1,646 $1,307 $849 $925 $73 $63 $242 $308 Production volumes (GWh):Natural gas facilities35,093 39,433 55,938 55,555 5,284 5,228 Lignite and coal facilities26,013 24,558 29,971 34,424 Nuclear facilities19,480 19,305 Solar/Battery facilities432 439 Capacity factors:CCGT facilities49.2 %55.0 %57.9 %58.4 %59.1 %58.5 %Lignite and coal facilities77.1 %72.8 %47.1 %54.1 %Nuclear facilities96.7 %95.8 %Weather - percent of normal (a):Cooling degree days98 %99 %105 %103 %130 %104 %102 %110 %Heating degree days85 %111 %92 %101 %95 %105 %89 %99 %____________(a)Reflects cooling degree days or heating degree days for the region based on Weather Services International (WSI) data.72Table of ContentsYear Ended December 31,Year Ended December 31,2020201920202019Market pricingAverage Market On-Peak Power Prices ($MWh) (b):Average ERCOT North power price ($/MWh)$21.46 $35.93 PJM West Hub $24.55 $30.87 AEP Dayton Hub$24.49 $31.02 Average NYMEX Henry Hub natural gas price ($/MMBtu)$1.99 $2.51 NYISO Zone C$19.37 $25.90 Massachusetts Hub$26.57 $34.89 Average natural gas price (a):Indiana Hub$26.77 $31.23 TetcoM3 ($/MMBtu)$1.59 $2.39 Northern Illinois Hub$22.47 $28.16 Algonquin Citygates ($/MMBtu)$2.00 $3.17 ____________ (a)Reflects the average of daily quoted prices for the periods presented and does not reflect costs incurred by us.(b)Reflects the average of day-ahead quoted prices for the periods presented and does not necessarily reflect prices we realized.The following table presents changes in net income (loss) and Adjusted EBITDA for the year ended December 31, 2020 compared to the year ended December 31, 2019.Year Ended December 31, 2020 Compared to 2019TexasEastWestSunsetFavorable/(unfavorable) change in revenue net of fuel$390 $(35)$18 $(39)Favorable/(unfavorable) change in other operating costs(20)(15)(3)(4)Favorable/(unfavorable) change in SG&A expenses(7)(7)(6)(22)Other(24)(19)1 (1)Change in Adjusted EBITDA$339 $(76)$10 $(66)Unfavorable change in depreciation and amortization(5)(41)— (13)Change in unrealized net gains/(losses) on commodity hedging activities100 (211)(51)(241)Fresh start/purchase accounting impacts4 (18)(4)(5)Transition and merger expenses9 8 1 22 Impairment of long-lived assets— — — (356)Generation plant retirement expenses— — — (31)Loss on disposal of investment in NELP— (29)— — Other (including interest and COVID-19 related expenses)(29)8 6 2 Change in Net income$418 $(359)$(38)$(688)The change in Texas segment results was driven by higher realized prices through hedging activities and plant optimization efforts and unrealized hedging gains, partially offset by lower insurance reimbursement and COVID-19 related expenses in the current year.The change in East segment results was driven by lower capacity revenue, unrealized hedging losses in current year versus unrealized hedging gains in prior year, loss on disposal of equity method investment in NELP for 100% ownership of NJEA (see Note 21 to the Financial Statements) and COVID-19 related expenses in the current year.The change in West segment results was driven by unrealized hedging losses in current year versus unrealized hedging gains in prior year, partially offset by higher realized prices through hedging activities and plant optimization efforts.The change in Sunset segment results was driven by impairment of assets related to our Kincaid, Zimmer and Joppa/EEI coal generation facilities and related generation plant retirement expenses, unrealized hedging losses in current year versus unrealized hedging gains in prior year, lower capacity revenue, and higher operating costs.73Table of ContentsGeneration — Year Ended December 31, 2019 Compared to Year Ended December 31, 2018Year Ended December 31,TexasEastWestSunset20192018201920182019201820192018Operating revenues:Electricity sales$1,048 $1,162 $1,355 $990 $293 $193 $969 $769 Capacity revenue from ISO/RTO— — 170 375 — 30 197 258 Sales to affiliates2,213 1,819 1,074 614 — — 285 168 Rolloff of unrealized net gains (losses) representing positions settled in the current period371 404 59 3 (10)20 (74)60 Unrealized net gains (losses) on hedging activities72 (689)(44)(43)51 (35)249 (87)Unrealized net gains (losses) on hedging activities with affiliates132 (198)180 (36)— — (7)16 Other revenues— (1)(4)(8)4 — (17)(1)Operating revenues3,836 2,497 2,790 1,895 338 208 1,602 1,183 Fuel, purchased power costs and delivery fees:Fuel for generation facilities and purchased power costs(1,117)(1,307)(1,381)(1,111)(187)(132)(739)(547)Fuel for generation facilities and purchased power costs from affiliates— — (2)(8)— — 2 30 Unrealized (gains) losses from hedging activities16 (15)1 (5)— — (22)19 Ancillary and other costs(182)(139)(11)(7)— (2)(8)(7)Fuel, purchased power costs and delivery fees(1,283)(1,461)(1,393)(1,131)(187)(134)(767)(505)Net income (loss)$1,342 $(88)$400 $18 $88 $34 $274 $242 Adjusted EBITDA$1,307 $912 $925 $680 $63 $65 $308 $341 Production volumes (GWh):Natural gas facilities39,433 35,790 55,555 41,036 5,228 3,664 Lignite and coal facilities24,558 26,243 34,424 29,734 Nuclear facilities19,305 20,416 Solar/Battery facilities439 344 Capacity factors:CCGT facilities55.0 %58.8 %58.4 %59.1 %58.5 %56.1 %Lignite and coal facilities72.8 %77.8 %54.1 %63.4 %Nuclear facilities95.8 %101.3 %Weather - percent of normal (a):Cooling degree days99 %100 %103 %120 %105 %105 %110 %134 %Heating degree days111 %113 %101 %103 %105 %86 %99 %97 %____________(a)Reflects cooling degree days or heating degree days for the region based on Weather Services International (WSI) data.74Table of ContentsYear Ended December 31,Year Ended December 31,2019201820192018Market pricingAverage Market On-Peak Power Prices ($MWh) (b):Average ERCOT North power price ($/MWh)$35.93 $29.96 PJM West Hub $30.87 $41.79 AEP Dayton Hub$31.02 $40.47 Average NYMEX Henry Hub natural gas price ($/MMBtu)$2.51 $3.12 NYISO Zone C$25.90 $37.03 Massachusetts Hub$34.89 $50.11 Average natural gas price (a):Indiana Hub$31.23 $39.01 TetcoM3 ($/MMBtu)$2.39 $3.69 Northern Illinois Hub$28.16 $34.46 Algonquin Citygates ($/MMBtu)$3.17 $4.84 ____________(a)Reflects the average of daily quoted prices for the periods presented and does not reflect costs incurred by us.(b)Reflects the average of day-ahead quoted prices for the periods presented and does not necessarily reflect prices we realized.The following table presents changes in net income and Adjusted EBITDA for the year ended December 31, 2019 compared to the year ended December 31, 2018.Year Ended December 31, 2019 Compared to 2018TexasEastWestSunsetFavorable impact related to operations acquired in the Merger (a)$— $268 $20 $84 Favorable/(unfavorable) change in revenue net of fuel421 10 (11)(159)Favorable/(unfavorable) change in other operating costs(28)(13)(4)41 Favorable/(unfavorable) change in SG&A expenses9 (11)(7)1 Other(7)(9)— — Change in Adjusted EBITDA$395 $245 $(2)$(33)Unfavorable change in depreciation and amortization(77)(161)(5)(39)Change in unrealized net gains on commodity hedging activities1,089 277 56 138 Fresh start/purchase accounting impacts— 7 4 (7)Transition and merger expenses(2)7 — (13)Generation plant retirement expenses— — — (12)Impact of Odessa earnout buybacks18 — — — Other (including interest)7 7 1 (2)Change in Net income$1,430 $382 $54 $32 The change in Texas segment results was driven by higher realized prices through hedging activities and plant optimization efforts, unrealized gains in 2019 versus unrealized losses in 2018, insurance reimbursement received in 2019, and the Odessa earnout buybacks in 2018.The change in East segment results was driven by operations in the first quarter of 2019 acquired in the Merger, partially offset by lower generation in the second through fourth quarters.The change in West segment results was driven by operations in the first quarter of 2019 acquired in the Merger and unrealized hedging gains in 2019 versus unrealized hedging losses in 2018.The change in Sunset segment results was driven by operations in the first quarter of 2019 acquired in the Merger and unrealized hedging gains in 2019, partially offset by decrease in revenue net of fuel reflecting lower realized power prices and capacity revenue.75Table of ContentsAsset Closure Segment — Year Ended December 31, 2020 Compared to Year Ended December 31, 2019Year Ended December 31,Favorable (Unfavorable) Change20202019Operating revenues$3 $341 $(338)Fuel, purchased power costs and delivery fees— (267)267 Operating costs(63)(138)75 Depreciation and amortization(22)— (22)Selling, general and administrative expenses(27)(43)16 Operating loss(109)(107)(2)Other income10 3 7 Other deductions(2)(5)3 Net loss$(101)$(109)$8 Adjusted EBITDA$(81)$(68)$(13)Production volumes (GWh)— 7,484 (7,484)Results for the Asset Closure segment primarily reflect the retirement of the Coffeen, Duck Creek, Havana and Hennepin plants in November and December 2019, respectively, the retirement of the Northeastern waste coal plant in October 2018, retirement of the Stuart and Killen plants in May 2018 (acquired in the Merger), and the retirement of the Monticello, Sandow and Big Brown plants in January and February 2018, respectively (see Note 4 to the Financial Statements). Operating costs for the years ended December 31, 2020 and 2019 included ongoing costs associated with the decommissioning and reclamation of retired plants and mines.Energy-Related Commodity Contracts and Mark-to-Market ActivitiesThe table below summarizes the changes in commodity contract assets and liabilities for the years ended December 31, 2020 and 2019. The net change in these assets and liabilities, excluding "other activity" as described below, reflects $231 million and $696 million in unrealized net gains for the year ended December 31, 2020 and 2019, respectively, arising from mark-to-market accounting for positions in the commodity contract portfolio.Year Ended December 31,20202019Commodity contract net liability at beginning of period$(279)$(850)Settlements/termination of positions (a)(14)358 Changes in fair value of positions in the portfolio (b)245 338 Acquired commodity contracts (c)— (28)Other activity (d)(27)(97)Commodity contract net liability at end of period$(75)$(279)____________(a)Represents reversals of previously recognized unrealized gains and losses upon settlement/termination (offsets realized gains and losses recognized in the settlement period). The years ended December 31, 2020 and 2019 include reversals of $1 million of previously recorded unrealized losses and $3 million of previously recorded unrealized gains related to Vistra beginning balances. respectively. The years ended December 31, 2020 and 2019 also include reversals of $12 million and $124 million, respectively, of previously recorded unrealized losses related to commodity contracts acquired in the Merger, Crius Transaction and Ambit Transaction. Excludes changes in fair value in the month the position settled as well as amounts related to positions entered into, and settled, in the same month.(b)Represents unrealized net gains (losses) recognized, reflecting the effect of changes in fair value. Excludes changes in fair value in the month the position settled as well as amounts related to positions entered into, and settled, in the same month.(c)Includes fair value of commodity contracts acquired on the Ambit Acquisition Date and the Crius Acquisition Date in 2019 (see Note 2 to the Financial Statements).(d)Represents changes in fair value of positions due to receipt or payment of cash not reflected in unrealized gains or losses. Amounts are generally related to premiums related to options purchased or sold as well as certain margin deposits classified as settlement for certain transactions executed on the CME.76Table of ContentsMaturity Table — The following table presents the net commodity contract liability arising from recognition of fair values at December 31, 2020, scheduled by the source of fair value and contractual settlement dates of the underlying positions.Maturity dates of unrealized commodity contract net liability at December 31, 2020Source of fair valueLess than1 year1-3 years4-5 yearsExcess of5 yearsTotalPrices actively quoted$(41)$(80)$(5)$— $(126)Prices provided by other external sources30 (2)1 — 29 Prices based on models107 23 (43)(65)22 Total$96 $(59)$(47)$(65)$(75)FINANCIAL CONDITIONOperating Cash FlowsYear Ended December 31, 2020 Compared to Year Ended December 31, 2019 — Cash provided by operating activities totaled $3.337 billion and $2.736 billion in the years ended December 31, 2020 and 2019, respectively. The favorable change of $601 million reflects the strong operating performance of both the Texas and Retail segments. Additionally, the increase in operating cash flows includes a lower increase in working capital, lower cash interest paid and increased income taxes received, partially offset by an increase in cash margin deposits posted with third-parties.Depreciation and amortization — Depreciation and amortization expense reported as a reconciling adjustment in the consolidated statements of cash flows exceeds the amount reported in the consolidated statements of operations by $311 million, $236 million and $139 million for the year ended December 31, 2020, 2019 and 2018, respectively. The difference represented amortization of nuclear fuel, which is reported as fuel costs in the consolidated statements of operations consistent with industry practice, and amortization of intangible net assets and liabilities that are reported in various other consolidated statements of operations line items including operating revenues and fuel and purchased power costs and delivery fees.Investing Cash FlowsYear Ended December 31, 2020 Compared to Year Ended December 31, 2019 — Cash used in investing activities totaled $1,572 million and $1.717 billion in the years ended December 31, 2020 and 2019, respectively. Capital expenditures totaled $1.259 billion and $713 million in the years ended December 31, 2020 and 2019, respectively. Cash used in investing activities in the year ended December 31, 2020 and 2019 also reflected net purchases of environmental allowances of $339 million and $125 million, respectively. Cash used in investing activities in the year ended December 31, 2019 also reflected $880 million of net cash paid in the Crius and Ambit Transactions. Capital Expenditures — In the years ended December 31, 2020 and 2019, capital expenditures consisted of:Year Ended December 31,20202019Capital expenditures, including LTSA prepayments$770 $520 Nuclear fuel purchases88 89 Growth and development expenditures401 104 Capital expenditures1,259 $713 77Table of ContentsFinancing Cash FlowsYear Ended December 31, 2020 Compared to Year Ended December 31, 2019 — Cash used in financing activities totaled $1.796 billion and $1.237 billion in the years ended December 31, 2020 and 2019, respectively. The change was primarily driven by:•issuance of $5.7 billion principal amount of Vistra Operations senior secured and unsecured notes in 2019;•redemption of $747 million principal amount of outstanding Vistra Unsecured Senior Notes in 2020;•net repayments of $350 million in short-term borrowings under the Revolving Credit Facility in 2020 compared to $350 million in net short-term borrowings under the Revolving Credit Facility in 2019;•net repayments of $150 million under the Receivables Facility in 2020 compared to net borrowings of $111 million in 2019; and•repayment of $100 million of term loans under the Vistra Operations Credit Facilities in 2020,partially offset by:•cash tender offers and early redemptions to purchase approximately $3.0 billion of senior unsecured notes assumed in the Merger in 2019;•repayment of approximately $3.1 billion of term loans under the Vistra Operations Credit Facilities in 2019;•$656 million in cash paid for share repurchases in in 2019; and•$186 million decrease in debt tender offer and other financing fees in 2020 compared to 2019.Debt ActivitySee Note 10 to the Financial statements for details of the Receivables Facility and Repurchase Facility and Note 11 to the Financial Statements for details of the Vistra Operations Credit Facilities and other long-term debt.Available LiquidityThe following table summarizes changes in available liquidity for the year ended December 31, 2020:December 31, 2020December 31, 2019ChangeCash and cash equivalents$406 $300 $106 Vistra Operations Credit Facilities — Revolving Credit Facility1,988 1,426 562 Vistra Operations — Alternate Letter of Credit Facility5 — 5 Total available liquidity (a)$2,399 $1,726 $673 ____________(a)Excludes amounts available to be borrowed under the Receivables Facility and the Repurchase Facility, respectively. See Note 10 to the Financial Statements for detail on our account receivable financing.The $673 million increase in available liquidity for the year ended December 31, 2020 was primarily driven by cash from operations, repayments of cash borrowings under the Revolving Credit Facility and a reduction of letters of credit outstanding under the Revolving Credit Facility reflecting the issuance of $303 million of letters of credit under the Secured LOC Facilities, partially offset by $1.259 billion of capital expenditures (including LTSA prepayments, nuclear fuel and development and growth expenditures), $747 million principal amount of outstanding Vistra Unsecured Senior Notes redeemed in 2020, $266 million in dividends paid to stockholders, the maturity of a $250 million Alternate LOC Facility and $100 million of term loans under the Vistra Operation Credit Facility repaid in March 2020.During the winter storm Uri event, Vistra was required to post a significant amount of collateral, including to ERCOT, clearinghouses for natural gas and power transactions and other trading counterparties. Despite these posting requirements, Vistra has consistently maintained, and it continues to maintain, sufficient liquidity to conduct its operations in the ordinary course. As of February 25, 2021, Vistra had more than $1.5 billion of cash and availability under its revolving credit facility to meet any of its liquidity needs. In February 2021, we borrowed $600 million under the Revolving Credit Facility to fund our general corporate needs, including posting requirements in connection with the expected impacts of winter storm Uri.Based upon our current internal financial forecasts, we believe that we will have sufficient liquidity to fund our anticipated cash requirements, including those related to our capital allocation initiatives, through at least the next 12 months. Our operational cash flows tend to be seasonal and weighted toward the second half of the year.78Table of ContentsCapital ExpendituresEstimated capital expenditures and nuclear fuel purchases for 2021 are expected to total approximately $1.379 billion and include:•$575 million for investments in generation and mining facilities;•$108 million for nuclear fuel purchases;•$9 million for information technology and other corporate investments; and•$687 million for growth and development expenditures.Liquidity Effects of Commodity Hedging and Trading ActivitiesWe have entered into commodity hedging and trading transactions that require us to post collateral if the forward price of the underlying commodity moves such that the hedging or trading instrument we hold has declined in value. We use cash, letters of credit and other forms of credit support to satisfy such collateral posting obligations. See Note 11 to the Financial Statements for discussion of the Vistra Operations Credit Facilities.Exchange cleared transactions typically require initial margin (i.e., the upfront cash and/or letter of credit posted to take into account the size and maturity of the positions and credit quality) in addition to variation margin (i.e., the daily cash margin posted to take into account changes in the value of the underlying commodity). The amount of initial margin required is generally defined by exchange rules. Clearing agents, however, typically have the right to request additional initial margin based on various factors, including market depth, volatility and credit quality, which may be in the form of cash, letters of credit, a guaranty or other forms as negotiated with the clearing agent. Cash collateral received from counterparties is either used for working capital and other business purposes, including reducing borrowings under credit facilities, or is required to be deposited in a separate account and restricted from being used for working capital and other corporate purposes. With respect to over-the-counter transactions, counterparties generally have the right to substitute letters of credit for such cash collateral. In such event, the cash collateral previously posted would be returned to such counterparties, which would reduce liquidity in the event the cash was not restricted.At December 31, 2020, we received or posted cash and letters of credit for commodity hedging and trading activities as follows:•$257 million in cash has been posted with counterparties as compared to $202 million posted at December 31, 2019;•$33 million in cash has been received from counterparties as compared to $8 million received at December 31, 2019;•$878 million in letters of credit have been posted with counterparties as compared to $1.150 billion posted at December 31, 2019; and•$18 million in letters of credit have been received from counterparties as compared to $17 million received at December 31, 2019.Income Tax PaymentsIn the next 12 months, we do not expect to make federal income tax payments due to Vistra's use of NOL carryforwards. We expect to make approximately $56 million in state income tax payments, offset by $9 million in state tax refunds, and $3 million in TRA payments in the next 12 months.For the year ended December 31, 2020, we received refunds of $170 million related to AMT credits. For the year ended December 31, 2020, there were no federal income tax payments, $40 million in state income tax payments, $10 million in state income tax refunds and less than $1 million in TRA payments.CapitalizationOur capitalization ratios consisted of 52% and 56% long-term debt (less amounts due currently) and 48% and 44% stockholders' equity at December 31, 2020 and 2019, respectively. Total long-term debt (including amounts due currently) to capitalization was 53% and 57% at December 31, 2020 and 2019, respectively.79Table of ContentsFinancial CovenantsThe Credit Facilities Agreement includes a covenant, solely with respect to the Revolving Credit Facility and solely during a compliance period (which, in general, is applicable when the aggregate revolving borrowings and issued revolving letters of credit (in excess of $300 million) exceed 30% of the revolving commitments), that requires the consolidated first-lien net leverage ratio not exceed 4.25 to 1.00. Although the period ended December 31, 2020 was not a compliance period, we would have been in compliance with this financial covenant if it was required to be tested at such date.See Note 11 to the Financial Statements for discussion of other covenants related to the Vistra Operations Credit Facilities.Collateral Support ObligationsThe RCT has rules in place to assure that parties can meet their mining reclamation obligations. In September 2016, the RCT agreed to a collateral bond of up to $975 million to support Luminant's reclamation obligations. The collateral bond is effectively a first lien on all of Vistra Operations' assets (which ranks pari passu with the Vistra Operations Credit Facilities) that contractually enables the RCT to be paid (up to $975 million) before the other first-lien lenders in the event of a liquidation of our assets. Collateral support relates to land mined or being mined and not yet reclaimed as well as land for which permits have been obtained but mining activities have not yet begun and land already reclaimed but not released from regulatory obligations by the RCT, and includes cost contingency amounts.The PUCT has rules in place to assure adequate creditworthiness of each REP, including the ability to return customer deposits, if necessary. Under these rules, at December 31, 2020, Vistra has posted letters of credit in the amount of $102 million with the PUCT, which is subject to adjustments.The ISOs/RTOs we operate in have rules in place to assure adequate creditworthiness of parties that participate in the markets operated by those ISOs/RTOs. Under these rules, Vistra has posted collateral support totaling $290 million in the form of letters of credit, $10 million in the form of a surety bond and $1 million of cash at December 31, 2020 (which is subject to daily adjustments based on settlement activity with the ISOs/RTOs).Material Cross-Default/Acceleration ProvisionsCertain of our contractual arrangements contain provisions that could result in an event of default if there was a failure under financing arrangements to meet payment terms or to observe covenants that could result in an acceleration of payments due. Such provisions are referred to as "cross-default" or "cross-acceleration" provisions.A default by Vistra Operations or any of its restricted subsidiaries in respect of certain specified indebtedness in an aggregate amount in excess of $300 million may result in a cross default under the Vistra Operations Credit Facilities. Such a default would allow the lenders to accelerate the maturity of outstanding balances (approximately $2.57 billion at December 31, 2020) under such facilities.Each of Vistra Operations' (or its subsidiaries') commodity hedging agreements and interest rate swap agreements that are secured with a lien on its assets on a pari passu basis with the Vistra Operations Credit Facilities lenders contains a cross-default provision. An event of a default by Vistra Operations or any of its subsidiaries relating to indebtedness equal to or above a threshold defined in the applicable agreement that results in the acceleration of such debt, would give such counterparty under these hedging agreements the right to terminate its hedge or interest rate swap agreement with Vistra Operations (or its applicable subsidiary) and require all outstanding obligations under such agreement to be settled.Under the Vistra Operations Senior Unsecured Indentures and the Vistra Operations Senior Secured Indenture, a default under any document evidencing indebtedness for borrowed money by Vistra Operations or any Guarantor Subsidiary for failure to pay principal when due at final maturity or that results in the acceleration of such indebtedness in an aggregate amount of $300 million or more may result in a cross default under the Vistra Operations Senior Unsecured Notes, the Senior Secured Notes, the Vistra Operations Credit Facilities, the Receivables Facility, the Alternate LOC Facilities, and other current or future documents evidencing any indebtedness for borrowed money by the applicable borrower or issuer, as the case may be, and the applicable Guarantor Subsidiaries party thereto.Additionally, we enter into energy-related physical and financial contracts, the master forms of which contain provisions whereby an event of default or acceleration of settlement would occur if we were to default under an obligation in respect of borrowings in excess of thresholds, which may vary by contract.80Table of ContentsThe Receivables Facility contains a cross-default provision. The cross-default provision applies, among other instances, if TXU Energy, Dynegy Energy Services, Ambit Texas, Value Based Brands and TriEagle, each indirect subsidiaries of Vistra and originators under the Receivables Facility (Originators), fails to make a payment of principal or interest on any indebtedness that is outstanding in a principal amount of at least $300 million, or, in the case of TXU Energy or any of the other Originators, in a principal amount of at least $50 million, after the expiration of any applicable grace period, or if other events occur or circumstances exist under such indebtedness which give rise to a right of the debtholder to accelerate such indebtedness, or if such indebtedness becomes due before its stated maturity. If this cross-default provision is triggered, a termination event under the Receivables Facility would occur and the Receivables Facility may be terminated.The Repurchase Facility contains a cross-default provision. The cross-default provision applies, among other instances, if an event of default (or similar event) occurs under the Receivables Facility or the Vistra Operations Credit Facilities. If this cross-default provision is triggered, a termination event under the Repurchase Facility would occur and the Repurchase Facility may be terminated.Under the Alternate LOC Facilities, a default under any document evidencing indebtedness for borrowed money by Vistra Operations or any Guarantor Subsidiary for failure to pay principal when due at final maturity or that results in the acceleration of such indebtedness in an aggregate amount of $300 million or more, may result in a termination of the Alternate LOC Facilities.Under the Secured LOC Facilities, a default under any document evidencing indebtedness for borrowed money by Vistra Operations or any Guarantor Subsidiary for failure to pay principal when due at final maturity or that results in the acceleration of such indebtedness in an aggregate amount of $300 million or more, may result in a termination of the Secured LOC Facilities.Guarantor Summary Financial InformationDuring the year ended December 31, 2020, we fully redeemed the Vistra Senior Unsecured Notes that were previously guaranteed by substantially all of our wholly owned subsidiaries. The following tables summarize the combined financial information of (i) Vistra Corp. (Parent), which is the ultimate parent company and issuer of the Vistra Senior Unsecured Notes with effect as of the Merger Date, on a stand-alone, unconsolidated basis and (ii) the guarantor subsidiaries of Vistra (Guarantor Subsidiaries). The Guarantor Subsidiaries consist of the wholly owned subsidiaries, which jointly, severally, fully and unconditionally, guaranteed the payment obligations under the Vistra Senior Unsecured Notes. See Note 11 to the Financial Statements for discussion of the Vistra Senior Unsecured Notes and Note 14 to the Financial Statements for discussion of dividend restrictions of Vistra Operations (a guarantor subsidiary of Vistra) and Parent.This financial information should be read in conjunction with the consolidated financial statements and notes thereto of Vistra. Transactions between the Parent and the Guarantor Subsidiaries have been eliminated. The inclusion of Vistra's subsidiaries as Guarantor Subsidiaries in the summary financial information is determined as of the most recent balance sheet date presented.The Parent files a consolidated U.S. federal income tax return. All consolidated income tax expense or benefits and deferred tax assets and liabilities are included in the Guarantor summary financial information presented below, with no allocation made to the non-guarantor subsidiaries. Additionally, all corporate shared service costs are included in the Guarantor summary financial information with no allocation to the non-guarantor subsidiaries.Year Ended December 31, 2020Revenues$10,954 Operating income$1,592 Net income $678 Net income attributable to Vistra$678 December 31, 2020December 31, 2020Current assets$2,404 Current liabilities$1,828 Noncurrent assets21,307 Noncurrent liabilities13,599 Total assets$23,711 Total liabilities$15,427 Noncontrolling interest$— 81Table of ContentsContractual Obligations and CommitmentsSee Note 11 to the Financial Statements for long-term debt maturities, Note 12 to the Financial Statements for maturities of lease liabilities and Note 13 to the Financial Statements for commitments related to long-term service and maintenance contracts, energy-related contracts and other agreements.GuaranteesSee Note 13 to the Financial Statements for discussion of guarantees.COMMITMENTS AND CONTINGENCIESSee Note 13 to the Financial Statements for discussion of commitments and contingencies.CHANGES IN ACCOUNTING STANDARDSSee Note 1 to the Financial Statements for discussion of changes in accounting standards.Item 7A.QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKMarket risk is the risk that in the normal course of business we may experience a loss in value due to changes in market conditions that affect economic factors such as commodity prices, interest rates and counterparty credit. Our exposure to market risk is affected by several factors, including the size, duration and composition of our energy and financial portfolio, as well as the volatility and liquidity of markets.Risk OversightWe manage the commodity price, counterparty credit and commodity-related operational risk related to the competitive energy business within limitations established by senior management and in accordance with overall risk management framework established and overseen by the Company's board of directors (Board) and the sustainability and risk committee of the Board, as applicable. Interest rate risk is managed centrally by our treasury function. Market risks are monitored by risk management groups that operate independently of the wholesale commercial operations, utilizing defined practices and analytical methodologies. These techniques measure the risk of change in value of the portfolio of contracts and the hypothetical effect on this value from changes in market conditions and include, but are not limited to, position reporting and review, Value at Risk (VaR) methodologies and stress test scenarios. Key risk control activities include, but are not limited to, transaction review and approval (including credit review), operational and market risk measurement, transaction authority oversight, validation of transaction capture, market price validation and reporting, and portfolio valuation and reporting.Commodity Price RiskOur business is subject to the inherent risks of market fluctuations in the price of electricity, natural gas and other energy-related products it markets or purchases. We actively manage the portfolio of generation assets, fuel supply and retail sales load to mitigate the near-term impacts of these risks on results of operations. Similar to other participants in the market, we cannot fully manage the long-term value impact of structural declines or increases in natural gas and power prices.In managing energy price risk, we enter into a variety of market transactions including, but not limited to, short- and long-term contracts for physical delivery, exchange-traded and over-the-counter financial contracts and bilateral contracts with customers. Activities include hedging, the structuring of long-term contractual arrangements and proprietary trading. We continuously monitor the valuation of identified risks and adjust positions based on current market conditions.VaR Methodology — A VaR methodology is used to measure the amount of market risk that exists within the portfolio under a variety of market conditions. The resultant VaR produces an estimate of a portfolio's potential for loss given a specified confidence level and considers, among other things, market movements utilizing standard statistical techniques given historical and projected market prices and volatilities.82Table of ContentsParametric processes are used to calculate VaR and are considered by management to be the most effective way to estimate changes in a portfolio's value based on assumed market conditions for liquid markets. The use of this method requires a number of key assumptions, such as use of (i) an assumed confidence level, (ii) an assumed holding period (i.e., the time necessary for management action, such as to liquidate positions) and (iii) historical estimates of volatility and correlation data. The table below details a VaR measure related to various portfolios of contracts.VaR for Underlying Generation Assets and Energy-Related Contracts — This measurement estimates the potential loss in value, due to changes in market conditions, of all underlying generation assets and contracts, based on a 95% confidence level and an assumed holding period of 60 days. The forward period covered by this calculation includes the current and subsequent calendar year at the time of calculation.Year Ended December 31,20202019Month-end average VaR$234 $263 Month-end high VaR$361 $520 Month-end low VaR$164 $103 The VaR risk measures in 2020 were primarily comparable to the prior year. Month-end high VaR was lower in 2020 due to lower prices and a decrease in volatility in ERCOT as compared to the prior year.Interest Rate RiskThe following table provides information concerning our financial instruments at December 31, 2020 and 2019 that are sensitive to changes in interest rates. Debt amounts consist of the Vistra Operations Credit Facilities. See Note 11 to the Financial Statements for further discussion of these financial instruments.Expected Maturity Date2020Total CarryingAmount2020Total FairValue2019Total CarryingAmount2019Total FairValue20212022202320242025There-afterLong-term debt, including current maturities (a):Variable rate debt amount$28 $29 $28 $29 $2,458 $— $2,572 $2,565 $2,700 $2,717 Average interest rate (b)1.90 %1.90 %1.90 %1.90 %1.90 %— %1.90 %3.55 %Debt swapped to fixed (c):Notional amount$— $— $2,300 $— $— $2,300 $4,600 $4,600 Average pay rate3.76 %3.76 %4.18 %4.77 %4.77 %4.77 %Average receive rate1.90 %1.90 %1.97 %2.06 %2.06 %2.06 %___________(a)Unamortized premiums, discounts and debt issuance costs are excluded from the table.(b)The weighted average interest rate presented is based on the rates in effect at December 31, 2020.(c)Interest rate swaps have maturity dates through July 2026. Excludes $2.12 billion of debt swapped to variable that is matched against the terms of $2.12 billion of debt swapped to fixed that effectively fix the out-of-the-money position of such swaps (see Note 11 to the Financial Statements).At December 31, 2020, the potential reduction of annual pretax earnings over the next twelve months due to a one percentage-point (100 basis points) increase in floating interest rates on long-term debt totaled approximately $6 million taking into account the interest rate swaps discussed in Note 11 to Financial Statements.83Table of ContentsCredit RiskCredit risk relates to the risk of loss associated with nonperformance by counterparties. We minimize credit risk by evaluating potential counterparties, monitoring ongoing counterparty risk and assessing overall portfolio risk. This includes review of counterparty financial condition, current and potential credit exposures, credit rating and other quantitative and qualitative credit criteria. We also employ certain risk mitigation practices, including utilization of standardized master agreements that provide for netting and setoff rights, as well as credit enhancements such as margin deposits and customer deposits, letters of credit, parental guarantees and surety bonds. See Note 16 to the Financial Statements for further discussion of this exposure.Bankruptcies — We are party to (i) certain gas transportation agreements with PG&E and (ii) a long-term resource adequacy contract with PG&E in connection with the Moss Landing battery storage project, which was originally approved by the California Public Utilities Commission (CPUC) in November 2018. PG&E filed for Chapter 11 bankruptcy protection in January 2019. In November 2019, the bankruptcy court approved PG&E's motion requesting approval of the assumption of the resource adequacy contract subject to the CPUC approving the terms of an amendment to the resource adequacy contract, and the CPUC approved the terms of the amendment in January 2020. PG&E emerged from bankruptcy protection in July 2020.Credit Exposure — Our gross credit exposure (excluding collateral impacts) associated with retail and wholesale trade accounts receivable and net derivative assets arising from commodity contracts and hedging and trading activities totaled $1.282 billion at December 31, 2020.At December 31, 2020, Retail segment credit exposure totaled $990 million, including $982 million of trade accounts receivable and $8 million related to derivative assets. Cash deposits and letters of credit held as collateral for these receivables totaled $80 million, resulting in a net exposure of $910 million. Allowances for uncollectible accounts receivable are established for the potential loss from nonpayment by these customers based on historical experience, market or operational conditions and changes in the financial condition of large business customers.At December 31, 2020, aggregate Texas, East and Sunset segments credit exposure totaled $292 million including $163 million related to derivative assets and $129 million of trade accounts receivable, after taking into account master netting agreement provisions but excluding collateral impacts.Including collateral posted to us by counterparties, our net Texas, East and Sunset segments exposure was $281 million substantially all of which is with investment grade customers as seen in the following table that presents the distribution of credit exposure at December 31, 2020. Credit collateral includes cash and letters of credit but excludes other credit enhancements such as guarantees or liens on assets.ExposureBefore CreditCollateralCreditCollateralNetExposureInvestment grade$254 $5 $249 Below investment grade or no rating38 6 32 Totals$292 $11 $281 Significant (i.e., 10% or greater) concentration of credit exposure exists with one counterparty, which represented an aggregate $85 million, or 30%, of the total net exposure. We view exposure to this counterparty to be within an acceptable level of risk tolerance due to the counterparty's credit ratings, which is rated as investment grade, the counterparty's market role and deemed creditworthiness and the importance of our business relationship with the counterparty. An event of default by one or more counterparties could subsequently result in termination-related settlement payments that reduce available liquidity if amounts such as margin deposits are owed to the counterparties or delays in receipts of expected settlements owed to us.Contracts classified as "normal" purchase or sale and non-derivative contractual commitments are not marked-to-market in the financial statements and are excluded from the detail above. Such contractual commitments may contain pricing that is favorable considering current market conditions and therefore represent economic risk if the counterparties do not perform. 84Table of ContentsFORWARD-LOOKING STATEMENTSThis report and other presentations made by us contain "forward-looking statements." All statements, other than statements of historical facts, that are included in this report, or made in presentations, in response to questions or otherwise, that address activities, events or developments that may occur in the future, including (without limitation) such matters as activities related to our financial or operational projections, capital allocation, capital expenditures, liquidity, dividend policy, business strategy, competitive strengths, goals, future acquisitions or dispositions, development or operation of power generation assets, market and industry developments and the growth of our businesses and operations (often, but not always, through the use of words or phrases such as "intends," "plans," "will likely," "unlikely," "expected," "anticipated," "estimated," "should," "may," "projection," "target," "goal," "objective" and "outlook"), are forward-looking statements. Although we believe that in making any such forward-looking statement our expectations are based on reasonable assumptions, any such forward-looking statement involves uncertainties and risks and is qualified in its entirety by reference to the discussion under Item 1A. Risk Factors and Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations in this annual report on Form 10-K and the following important factors, among others, that could cause our actual results to differ materially from those projected in or implied by such forward-looking statements:•the actions and decisions of judicial and regulatory authorities;•prohibitions and other restrictions on our operations due to the terms of our agreements;•prevailing federal, state and local governmental policies and regulatory actions, including those of the legislatures and other government actions of states in which we operate, the U.S. Congress, the FERC, the NERC, the TRE, the public utility commissions of states and locales in which we operate, CAISO, ERCOT, ISO-NE, MISO, NYISO, PJM, the RCT, the NRC, the EPA, the environmental regulatory bodies of states in which we operate, the MSHA and the CFTC, with respect to, among other things:▪allowed prices;▪industry, market and rate structure;▪purchased power and recovery of investments;▪operations of nuclear generation facilities;▪operations of fossil-fueled generation facilities;▪operations of mines;▪acquisition and disposal of assets and facilities;▪development, construction and operation of facilities;▪decommissioning costs;▪present or prospective wholesale and retail competition;▪changes in federal, state and local tax laws, rates and policies, including additional regulation, interpretations, amendments, or technical corrections to the TCJA;▪changes in and compliance with environmental and safety laws and policies, including the Coal Combustion Residuals Rule, National Ambient Air Quality Standards, the Cross-State Air Pollution Rule, the Mercury and Air Toxics Standard, regional haze program implementation and GHG and other climate change initiatives; and▪clearing over-the-counter derivatives through exchanges and posting of cash collateral therewith;•expectations regarding, or impacts of, environmental matters, including costs of compliance, availability and adequacy of emission credits, and the impact of ongoing proceedings and potential regulations or changes to current regulations, including those relating to climate change, air emissions, cooling water intake structures, coal combustion byproducts, and other laws and regulations that we are, or could become, subject to, which could increase our costs, result in an impairment of our assets, cause us to limit or terminate the operation of certain of our facilities, or otherwise negatively impact our financial results or stock price;•legal and administrative proceedings and settlements;•general industry trends;•economic conditions, including the impact of any recession or economic downturn;•investor sentiment relating to climate change and utilization of fossil fuels in connection with power generation could reduce demand for, or increase potential volatility in the market price of, our common stock;•the severity, magnitude and duration of pandemics, including the COVID-19 pandemic, and the resulting effects on our results of operations, financial condition and cash flows;•the severity, magnitude and duration of extreme weather events (including winter storm Uri), drought and limitations on access to water, and other weather conditions and natural phenomena, and the resulting effects on our results of operations, financial condition and cash flows;•acts of sabotage, wars or terrorist or cybersecurity threats or activities;•risk of contract performance claims by us or our counterparties, and risks of, or costs associated with, pursuing or defending such claims;•our ability to collect trade receivables from counterparties in the amount or at the time expected, if at all;85Table of Contents•our ability to attract, retain and profitably serve customers;•restrictions on competitive retail pricing or direct-selling businesses;•adverse publicity associated with our retail products or direct selling businesses, including our ability to address the marketplace and regulators regarding our compliance with applicable laws;•changes in wholesale electricity prices or energy commodity prices, including the price of natural gas;•changes in prices of transportation of natural gas, coal, fuel oil and other refined products;•sufficiency of, access to, and costs associated with coal, fuel oil, and natural gas inventories and transportation and storage thereof;•changes in the ability of vendors to provide or deliver commodities as needed;•beliefs and assumptions about the benefits of state- or federal-based subsidies to our market competition, and the corresponding impacts on us, including if such subsidies are disproportionately available to our competitors;•the effects of, or changes to, market design and the power and capacity procurement processes in the markets in which we operate;•changes in market heat rates in the CAISO, ERCOT, ISO-NE, MISO, NYISO and PJM electricity markets;•our ability to effectively hedge against unfavorable commodity prices, including the price of natural gas, market heat rates and interest rates;•population growth or decline, or changes in market supply or demand and demographic patterns, particularly in ERCOT, MISO and PJM;•our ability to mitigate forced outage risk, including managing risk associated with CP in PJM and performance incentives in ISO-NE;•efforts to identify opportunities to reduce congestion and improve busbar power prices;•access to adequate transmission facilities to meet changing demands;•changes in interest rates, commodity prices, rates of inflation or foreign exchange rates;•changes in operating expenses, liquidity needs and capital expenditures;•commercial bank market and capital market conditions and the potential impact of disruptions in U.S. and international credit markets;•access to capital, the attractiveness of the cost and other terms of such capital and the success of financing and refinancing efforts, including availability of funds in capital markets;•our ability to maintain prudent financial leverage and achieve our capital allocation objectives;•our ability to generate sufficient cash flow to make principal and interest payments in respect of, or refinance, our debt obligations;•our expectation that we will continue to pay a comparable cash dividend on a quarterly basis;•our ability to implement and successfully execute upon\ our growth strategy, including the completion and integration of mergers, acquisitions and/or joint venture activity, the identification and completion of sales and divestitures activity, and the completion and commercialization of our other business development and construction projects;•competition for new energy development and other business opportunities;•inability of various counterparties to meet their obligations with respect to our financial instruments;•counterparties' collateral demands and other factors affecting our liquidity position and financial condition;•changes in technology (including large scale electricity storage) used by and services offered by us;•changes in electricity transmission that allow additional power generation to compete with our generation assets;•our ability to attract and retain qualified employees;•significant changes in our relationship with our employees, including the availability of qualified personnel, and the potential adverse effects if labor disputes or grievances were to occur or changes in laws or regulations relating to independent contractor status;•changes in assumptions used to estimate costs of providing employee benefits, including medical and dental benefits, pension and OPEB, and future funding requirements related thereto, including joint and several liability exposure under ERISA;•hazards customary to the industry and the possibility that we may not have adequate insurance to cover losses resulting from such hazards;•the impact of our obligations under the TRA;•our ability to optimize our assets through targeted investment in cost-effective technology enhancements and operations performance initiatives;•our ability to effectively and efficiently plan, prepare for and execute expected asset retirements and reclamation obligations and the impacts thereof;•our ability to successfully complete the integration of businesses acquired by Vistra and our ability to successfully capture the full amount of projected operational and financial synergies relating to such transactions; and•actions by credit rating agencies.86Table of ContentsAny forward-looking statement speaks only at the date on which it is made, and except as may be required by law, we undertake no obligation to update any forward-looking statement to reflect events or circumstances after the date on which it is made or to reflect the occurrence of unanticipated events or circumstances. New factors emerge from time to time, and it is not possible for us to predict them. In addition, we may be unable to assess the impact of any such event or condition or the extent to which any such event or condition, or combination of events or conditions, may cause results to differ materially from those contained in or implied by any forward-looking statement. As such, you should not unduly rely on such forward-looking statements.INDUSTRY AND MARKET INFORMATIONCertain industry and market data and other statistical information used throughout this report are based on independent industry publications, government publications, reports by market research firms or other published independent sources, including certain data published by CAISO, ERCOT, ISO-NE, MISO, NYISO, PJM, the environmental regulatory bodies of states in which we operate and NYMEX. We did not commission any of these publications, reports or other sources. Some data is also based on good faith estimates, which are derived from our review of internal surveys, as well as the independent sources listed above. Industry publications, reports and other sources generally state that they have obtained information from sources believed to be reliable, but do not guarantee the accuracy and completeness of such information. While we believe that each of these studies, publications, reports and other sources is reliable, we have not independently investigated or verified the information contained or referred to therein and make no representation as to the accuracy or completeness of such information. Forecasts are particularly likely to be inaccurate, especially over long periods of time, and we do not know what assumptions were used in preparing such forecasts. Statements regarding industry and market data and other statistical information used throughout this report involve risks and uncertainties and are subject to change based on various factors.87Table of Contents
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+Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations – Results of Operations. For information about our business strategy, see Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations – Corporate Developments. WEC Energy Group, Inc.We were incorporated in the state of Wisconsin in 1981 and became a diversified holding company in 1986. We maintain our principal executive offices in Milwaukee, Wisconsin. On June 29, 2015, we acquired 100% of the outstanding common shares of Integrys and changed our name to WEC Energy Group, Inc. Our wholly owned subsidiaries provide or invest in regulated natural gas and electricity, and renewable energy, as well as nonregulated renewable energy. We have an approximately 60% equity interest in ATC (an electric transmission company operating in Illinois, Michigan, Minnesota, and Wisconsin). At December 31, 2020, we had six reportable segments, which are discussed below. For additional information about our reportable segments, see Note 22, Segment Information.Available InformationOur annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and any amendments to those reports are made available on our website, www.wecenergygroup.com, free of charge, as soon as reasonably practicable after they are filed with or furnished to the SEC. The SEC maintains an Internet site that contains reports, proxy and information statements, and other information regarding issuers that file electronically with the SEC at www.sec.gov.B. UTILITY ENERGY OPERATIONSWisconsin SegmentThe Wisconsin segment includes the electric and natural gas utility operations of WE, WPS, WG, and UMERC.Electric Utility OperationsFor the periods presented in this Annual Report on Form 10-K, our electric utility operations included operations of WE, WPS, and UMERC.•WE generates and distributes electric energy to customers located in southeastern Wisconsin (including the metropolitan Milwaukee area), east central Wisconsin, and northern Wisconsin. WE also served an iron ore mine customer, Tilden, in the Upper Peninsula of Michigan, through March 31, 2019 when Tilden became a customer of UMERC.•WPS generates and distributes electric energy to customers located in northeastern and central Wisconsin.•UMERC generates and distributes electric energy to customers located in the Upper Peninsula of Michigan. UMERC began generating electricity when its new natural gas-fired generation achieved commercial operation on March 31, 2019.2020 Form 10-K3WEC Energy Group, Inc.Table of ContentsOperating RevenuesFor information about our operating revenues disaggregated by customer class for the years ended December 31, 2020, 2019, and 2018, see Note 4, Operating Revenues.Electric SalesOur electric energy deliveries included supply and distribution sales to retail, wholesale, and resale customers, and distribution sales to those customers who switched to an alternative electric supplier in the Upper Peninsula of Michigan. In 2020, retail revenues accounted for 91.9% of total electric operating revenues, wholesale revenues accounted for 4.1% of total electric operating revenues, and resale revenues accounted for 3.1% of total electric operating revenues. See Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations – Results of Operations – Wisconsin Segment Contribution to Net Income Attributed to Common Shareholders for information on MWh sales by customer class.Our electric utilities are authorized to provide retail electric service in designated territories in the state of Wisconsin, as established by indeterminate permits and boundary agreements with other utilities, and in certain territories in the state of Michigan pursuant to franchises granted by municipalities. Our electric utilities buy and sell wholesale electric power by participating in the MISO Energy Markets. The cost of our individual generation offered into the MISO Energy Markets compared to our competitors affects how often our generating units are dispatched and whether we buy or sell power, based on our customers' needs. We provide wholesale electric service to various customers, including electric cooperatives, municipal joint action agencies, other investor-owned utilities, municipal utilities, and energy marketers. For more information, see E. Regulation.The majority of our sales for resale are sold into an energy market operated by MISO at market rates based on the availability of our generation and market demand. Retail fuel costs are reduced by the amount that revenue exceeds the costs of sales derived from these opportunity sales.Steam SalesWE has a steam utility that generates, distributes, and sells steam supplied by the VAPP to customers in metropolitan Milwaukee, Wisconsin. Steam is used by customers for processing, space heating, domestic hot water, and humidification. Annual sales of steam fluctuate from year to year based on system growth and variations in weather conditions. Electric Sales ForecastOur service territory experienced lower weather-normalized retail electric sales in 2020, as compared with 2019, due to the impact of the COVID-19 pandemic. We currently forecast retail electric sales volumes, excluding the Tilden mine located in the Upper Peninsula of Michigan, to grow between 1.0% and 1.3% over the next five years, compared with 2020, assuming normal weather. Electric peak demand is expected to grow between 0.5% and 1.0% over the next five years.CustomersYear Ended December 31(in thousands)202020192018Electric customers – end of year Residential1,459.3 1,449.7 1,441.3 Small commercial and industrial175.8 174.6 173.2 Large commercial and industrial0.8 0.9 0.9 Wholesale and other3.0 2.7 2.7 Total electric customers – end of year 1,638.9 1,627.9 1,618.1 Steam customers – end of year0.4 0.4 0.4 2020 Form 10-K4WEC Energy Group, Inc.Table of ContentsElectric Commercial and Industrial Retail CustomersWe provide electric utility service to a diversified base of customers in industries such as metals and other manufacturing, paper, governmental, health services, real estate, and food products.Electric Generation and Supply MixOur electric supply strategy is to provide our customers with energy from plants using a diverse fuel mix that is expected to balance a stable, reliable, and affordable supply of electricity with environmental stewardship. Through our participation in the MISO Energy Markets, we supply a significant amount of electricity to our customers from power plants that we own. We supplement our internally generated power supply with long-term PPAs, including the Point Beach PPA discussed under the heading "Power Purchase Commitments," and through spot purchases in the MISO Energy Markets. We also sell excess power supply into the MISO Energy Markets when it is economical, which reduces net fuel costs by offsetting costs of purchased power. All options, including owned generation resources and purchased power opportunities, are continually evaluated on a real-time basis to select and dispatch the lowest-cost resources available to meet system load requirements.The table below indicates our sources of electric energy supply as a percentage of sales for the three years ended December 31, as well as estimates for 2021:Estimate (1)Actual2021202020192018Company-owned generation units:Coal33.2 %31.1 %36.3 %44.7 %Natural gas:Combined cycle26.3 %27.8 %26.8 %19.7 %Steam turbine0.7 %1.0 %0.8 %0.6 %Natural gas/oil peaking units2.0 %2.4 %0.9 %1.7 %Renewables (2)5.0 %5.3 %4.4 %4.1 %Total company-owned generation units67.2 %67.6 %69.2 %70.8 %Power purchase contracts:Nuclear19.6 %19.5 %19.8 %18.6 %Natural gas2.4 %1.9 %1.8 %1.5 %Renewables (2)2.4 %1.9 %2.0 %2.4 %Other1.8 %1.7 %1.8 %1.7 %Total power purchase contracts26.2 %25.0 %25.4 %24.2 %Purchased power from MISO6.6 %7.4 %5.4 %5.0 %Total purchased power32.8 %32.4 %30.8 %29.2 %Total electric utility supply100.0 %100.0 %100.0 %100.0 %(1) The values included in the estimate assume a natural gas price based on the December 2020 NYMEX.(2) Includes hydroelectric, biomass, solar, and wind generation.Electric Generation FacilitiesOur generation portfolio is a mix of energy resources having different operating characteristics and fuel sources designed to balance providing energy that is stable, reliable, and affordable with environmental stewardship. We own 7,666 MW of generation capacity, including owned and jointly owned facilities. We Power's generating units are also included in the generation capacity. Our facilities include coal-fired plants, natural gas-fired plants, and renewable generation. Certain of our natural gas fired generation units have the ability to burn oil if natural gas is not available due to delivery constraints. For more information about our facilities, see Item 2. Properties.On November 2, 2020, we added to our electric generation portfolio when WPS's new utility-scale solar plant, Two Creeks, with 150 MW nameplate capacity in Manitowoc County, Wisconsin achieved commercial operation. WPS owns 100 MW of Two Creeks.2020 Form 10-K5WEC Energy Group, Inc.Table of ContentsOn March 31, 2019, we added to our electric generation portfolio when UMERC's new natural gas-fired generation with a 183 MW rated capacity in the Upper Peninsula of Michigan achieved commercial operation.Creating a Sustainable FutureThe ESG Progress Plan includes the retirement of older, fossil-fueled generation, to be replaced with the construction of zero-carbon-emitting renewable generation and natural gas-fired generation. When taken together, the retirements and new investments should better balance our supply with our demand, while maintaining reliable, affordable energy for our customers. The retirements will contribute to meeting our goals to reduce CO2 emissions from our electric generation. In 2019, we met and surpassed our original goal to reduce CO2 emissions by 40% below 2005 levels. In July 2020, we announced new goals to reduce CO2 emissions from our electric generation by 70% below 2005 levels by 2030 and to be net carbon neutral by 2050. We added a near-term goal in November 2020 to reduce CO2 emissions by 55% below 2005 levels by 2025. We already have retired more than 1,800 MW of coal-fired generation since the beginning of 2018, which included the 2019 retirement of the PIPP as well as the 2018 retirements of the Pleasant Prairie power plant, the Pulliam power plant, and the jointly-owned Edgewater Unit 4 generating units. See Note 6, Regulatory Assets and Liabilities, for more information related to these power plant retirements. As part of the ESG Progress Plan, we expect to retire approximately 1,800 MW of additional fossil-fueled generation by 2025. See Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations – Corporate Developments for more information on the ESG Progress Plan.Renewable GenerationOur electric utilities meet a portion of their electric generation supply with various renewable energy resources, including wind, hydroelectric, biomass, and solar. This helps our electric utilities maintain compliance with renewable energy legislation. These renewable energy resources also help us maintain diversity in our generation portfolio, which effectively serves as a price hedge against future fuel costs, and will help mitigate the risk of potential unknown costs associated with any future carbon restrictions for electric generators. In December 2018, WE received approval from the PSCW for the Dedicated Renewable Energy Resource pilot program, a program for customers who wish to access a large-scale renewable project located in Wisconsin that WE would operate. The project will contribute toward meeting WE's peak demand, adding up to 150 MW of renewables to WE's portfolio, and help these larger customers to meet their sustainability and renewable energy goals.WindIn February 2021, WE and WPS filed an application with the PSCW for approval to accelerate up to approximately $154 million in capital investments in BSGF and CCWP, to repower major components. In response to the COVID-19 pandemic, the IRS issued guidance extending the period for work to be completed on facilities in order to be eligible for PTCs if certain requirements are met. If approved, WE and WPS each expect to receive an additional 10 years of PTCs, and BSGF and CCWP would be allowed to continue providing a reliable, cost-effective, zero-fuel-cost, zero-emission capacity and energy resource for customersSolarIn February 2021, WE and WPS, along with an unaffiliated utility, filed an application with the PSCW for approval to acquire and construct the Paris Solar-Battery Park, a utility-scale solar-powered electric generating facility with a battery energy storage system. The project will be located in Kenosha County, Wisconsin and features 200 MW of solar generation and 110 MW of battery storage. The joint applicants propose that WE would acquire a 75% ownership interest, WPS would acquire a 15% ownership interest, and the unaffiliated utility would acquire the remaining 10% ownership interest. If approved, our share of the cost of this project is estimated to be approximately $385 million with construction expected to begin in 2022 and completed by the end of 2023.As part of our commitment to invest in zero-carbon generation, we have received approval from the PSCW to invest in 300 MW of utility-scale solar within our Wisconsin segment. 2020 Form 10-K6WEC Energy Group, Inc.Table of Contents•In August 2019, WE partnered with an unaffiliated utility to construct a solar project, Badger Hollow II, that will be located in Iowa County, Wisconsin and is expected to enter commercial operation in December 2022. Once constructed, WE will own 100 MW of this project. •In April 2019, WPS partnered with an unaffiliated utility to construct two solar projects in Wisconsin: Two Creeks, in service as of November 2020, and Badger Hollow I, construction in progress and targeted for completion in the second quarter of 2021. Badger Hollow I is located in Iowa County, Wisconsin, and Two Creeks is located in Manitowoc County, Wisconsin. WPS owns 100 MW of Two Creeks and will own 100 MW of Badger Hollow I for a total of 200 MW.In December 2018, WE received approval from the PSCW for the Solar Now pilot program, which is expected to add 35 MW of solar generation to WE's portfolio, allowing non-profit and government entities, as well as commercial and industrial customers to site utility owned solar arrays on their property. Under this program, WE has energized 13 Solar Now projects and currently has another five under construction, together totaling more than 15 MW.Electric System ReliabilityThe PSCW requires us to maintain a planning reserve margin above our projected annual peak demand forecast to help ensure reliability of electric service to our customers. These planning reserve requirements are consistent with the MISO calculated planning reserve margin. In 2008, the PSCW established a 14.5% reserve margin requirement for long-term planning (planning years two through ten). For short-term planning (planning year one), the PSCW requires Wisconsin utilities to follow the planning reserve margin established by MISO. MISO has an 18.0% installed capacity reserve margin requirement for the planning year from June 1, 2020, through May 31, 2021, and an 18.3% installed capacity reserve margin requirement for the planning year from June 1, 2021, through May 31, 2022. MISO's short-term reserve margin requirements experience year-to-year fluctuations, primarily due to changes in the generation resource mix and average forced outage rate of generation within the MISO footprint.Michigan legislation requires all electric providers to demonstrate to the MPSC that they have adequate resources to serve the anticipated needs of their customers for a minimum of four consecutive planning years beginning in the upcoming planning year June 1, 2021, through May 31, 2022. The MPSC has established future planning reserve margin requirements based on the same study conducted by MISO that determines the short-term reserve margin requirements.In both our Wisconsin and Michigan jurisdictions, we believe that we have adequate capacity through company-owned generation units and power purchase contracts to meet the MISO calculated planning reserve margin during the current planning year. We also fully anticipate that we will have adequate capacity to meet the planning reserve margin requirements for the upcoming planning year in both jurisdictions. Fuel and Purchased Power CostsOur retail electric rates in Wisconsin are established by the PSCW and include base amounts for fuel and purchased power costs. The electric fuel rules set by the PSCW allow us to defer, for subsequent rate recovery or refund, under- or over-collections of actual fuel and purchased power costs beyond a 2% price variance from the costs included in the rates charged to customers. Prudently incurred fuel and purchased power costs are recovered dollar-for-dollar from our Michigan retail electric customers. For more information about the fuel rules, see E. Regulation.Our average fuel and purchased power costs per MWh by fuel type, including delivery costs, were as follows for the years ended December 31:202020192018Coal$20.16 $22.77 $23.54 Natural gas combined cycle16.24 19.55 21.69 Natural gas/oil peaking units39.37 51.80 49.06 Biomass130.76 102.99 97.33 Purchased power43.50 42.53 42.85 WE and WPS purchase coal under long-term contracts, which helps with price stability. In the past, coal and associated transportation services were exposed to volatility in pricing due to changing domestic and world-wide demand for coal and diesel fuel. WE and WPS have PSCW approval for a hedging program to moderate this volatility exposure. This program allows them to 2020 Form 10-K7WEC Energy Group, Inc.Table of Contentshedge, over a 36-month period, up to 75% of their potential risks related to rail transportation fuel surcharge exposure. The results of this hedging program, when used, are reflected in the average costs of purchased power.We purchase natural gas for our plants on the spot market from natural gas marketers, utilities, and producers, and we arrange for transportation of the natural gas to our plants. We have firm and interruptible transportation, as well as balancing and storage agreements, intended to support our plants' variable usage. WE and WPS also have PSCW approval for a hedging program to moderate volatility related to natural gas price risk. This program allows them to hedge, over a 36-month period, up to 75% of their estimated natural gas use for electric generation. The results of this hedging program are reflected in the average costs of natural gas.Coal SupplyWe diversify the coal supply for our electric generating facilities and jointly-owned plants by purchasing coal from several mines in Wyoming and Pennsylvania, as well as from various other states. For 2021, approximately 88% of our total projected coal requirements of 8.4 million tons are contracted under fixed-price contracts. See Note 24, Commitments and Contingencies, for more information on amounts of coal purchases and coal deliveries under contract.The annual tonnage amounts contracted for 2021 and 2022 are set forth below. We have not entered into any coal contracts for years after 2022.(in thousands)Annual Tonnage20217,380 20222,100 Coal DeliveriesAll of our 2021 and 2022 coal requirements are expected to be shipped by unit trains that we own or lease under existing transportation agreements. The unit trains transport the coal for electric generating facilities from mines in Wyoming and Pennsylvania. Additional small volume agreements may also be used to supplement the normal coal supply for our facilities.Power Purchase CommitmentsWe enter into short- and long-term power purchase commitments to meet a portion of our anticipated electric energy supply needs. Our power purchase commitments with unaffiliated parties are 1,379 MW for 2021 and 1,133 MW per year for 2022 through 2025, which exclude planning capacity purchases. Each of these amounts include 1,033 MW per year related to a long-term PPA for electricity generated by Point Beach. As part of our ESG Progress Plan, we retired some of our older, less efficient coal-fired generation in 2018 and 2019. To procure additional planning capacity, we purchased capacity from the MISO annual auction to ensure that we maintain our compliance with planning reserve requirements as established by the PSCW, MPSC, and MISO. Natural Gas Utility OperationsWE, WPS, and WG are authorized to provide retail natural gas distribution service in designated territories in the state of Wisconsin, as established by indeterminate permits and boundary agreements with other utilities. Our Wisconsin natural gas utilities operate throughout the state of Wisconsin, including the City of Milwaukee and surrounding areas, northeastern Wisconsin, and in large areas of both central and western Wisconsin. In addition, UMERC is authorized to provide retail natural gas distribution service in designated territories in the Upper Peninsula of Michigan.Our Wisconsin segment natural gas utilities provide service to residential, commercial and industrial, and transportation customers. Major industries served include real estate, restaurants, food products, governmental, and paper. See Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations – Results of Operations – Wisconsin Segment Contribution to Net Income Attributed to Common Shareholders for information on natural gas sales volumes by customer class in Wisconsin and the Upper Peninsula of Michigan.2020 Form 10-K8WEC Energy Group, Inc.Table of ContentsOperating RevenuesFor information about our operating revenues disaggregated by customer class for the years ended December 31, 2020, 2019, and 2018, see Note 4, Operating Revenues. Natural Gas Sales ForecastOur combined Wisconsin service territories experienced lower weather-normalized retail natural gas deliveries (excluding natural gas deliveries for electric generation) in 2020 as compared to 2019 due to the impact of the COVID-19 pandemic. We currently forecast retail natural gas delivery volumes to grow at a rate between 1.0% and 1.3% over the next five years, compared to 2020, assuming normal weather.CustomersYear Ended December 31(in thousands)202020192018Customers – end of yearResidential1,349.9 1,339.6 1,329.6 Commercial and industrial132.3 131.5 130.6 Transport3.4 3.2 3.0 Total customers1,485.6 1,474.3 1,463.2 Natural Gas Supply, Pipeline Capacity and StorageWe have been able to meet our contractual obligations with both our suppliers and our customers. For more information on our natural gas utility supply and transportation contracts, see Note 24, Commitments and Contingencies.Pipeline Capacity and StorageThe interstate pipelines serving Wisconsin originate in major natural gas producing areas of North America: the Oklahoma and Texas basins, western Canada, and the Rocky Mountains. We have contracted for long-term firm capacity from a number of these sources. This strategy reflects management's belief that overall supply security is enhanced by geographic diversification of the supply portfolio. Due to variations in natural gas usage in Wisconsin, our Wisconsin natural gas utilities have also contracted for substantial underground storage capacity, primarily in Michigan. WE, WPS, and WG have entered into long-term service agreements for natural gas storage with a wholly owned subsidiary of Bluewater. Bluewater owns natural gas storage facilities in Michigan and provides approximately one-third of the current storage needs for our Wisconsin natural gas utilities. We target storage inventory levels at approximately 40% of forecasted demand for November through March. Diversity of natural gas supply enables us to manage significant changes in demand and to optimize our overall natural gas supply and capacity costs. We generally inject natural gas into storage during the spring and summer months and withdraw it in the winter months.We hold daily transportation and storage capacity entitlements with interstate pipeline companies as well as other service providers under varied-length long-term contracts.Natural gas pipeline capacity and storage and natural gas supplies under contract can be resold in secondary markets. Peak or near-peak demand generally occurs only a few times each year. The secondary markets facilitate utilization of capacity and supply during times when the contracted capacity and supply are in excess of utility demand. The proceeds from these transactions are passed through to customers, subject to our approved GCRMs. For information on the GCRMs, see Note 1(d), Operating Revenues.To ensure a reliable supply of natural gas during peak winter conditions, we have LNG and propane facilities located within our distribution system. These facilities are typically utilized during extreme demand conditions to ensure reliable supply to our customers. In addition to their existing facilities, WE and WG each plan to construct an additional LNG facility. Subject to PSCW approval, each facility would provide approximately one Bcf of natural gas supply to meet anticipated peak demand without requiring the construction of additional interstate pipeline capacity. Commercial operation of the LNG facilities is targeted for the end of 2023.2020 Form 10-K9WEC Energy Group, Inc.Table of ContentsCombined with our storage capability, management believes that the volume of natural gas under contract is sufficient to meet our forecasted firm peak-day and seasonal demand. Our Wisconsin segment natural gas utilities' forecasted design peak-day throughput is 34.8 million therms for the 2020 through 2021 heating season. Our Wisconsin segment natural gas utilities' peak daily send-out during 2020 was 22.8 million therms on February 13, 2020.Natural Gas SupplyWe have contracts with suppliers for natural gas acquired in the Chicago, Illinois market hub and in the producing areas discussed above. The pricing of the term contracts is based upon first of the month indices. We expect to continue to make natural gas purchases in the spot market as price and other circumstances dictate. We have supply relationships with a number of sellers from whom we purchase natural gas in the spot market.Hedging Natural Gas Supply PricesWE, WPS, and WG have PSCW approval to hedge up to 60% of planned winter demand and up to 15% of planned summer demand using a mix of NYMEX-based natural gas options and futures contracts. These approvals allow these companies to pass 100% of the hedging costs (premiums, brokerage fees, and losses) and proceeds (gains) to customers through their respective GCRMs.To the extent that opportunities develop and physical supply operating plans are supportive, WE, WPS, and WG also have PSCW approval to utilize NYMEX-based natural gas derivatives to capture favorable forward-market price differentials. These approvals provide for 100% of the related proceeds to accrue to these companies' respective GCRMs.Illinois SegmentOur Illinois segment includes the natural gas utility operations of PGL and NSG. Our customers are located in Chicago and the northern suburbs of Chicago. PGL and NSG provide service to residential, commercial and industrial, and transportation customers. Major industries served include real estate, non-profits, education, restaurants, and wholesale distributors. See Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations – Results of Operations – Illinois Segment Contribution to Net Income Attributed to Common Shareholders for information on natural gas sales volumes by customer class.Illinois Utilities Operating StatisticsOperating RevenuesFor information about our operating revenues disaggregated by customer class for the years ended December 31, 2020, 2019, and 2018, see Note 4, Operating Revenues. CustomersYear Ended December 31(in thousands)202020192018Customers – end of yearResidential895.9 870.6 863.2 Commercial and industrial71.4 71.8 72.1 Transport74.8 88.7 97.5 Total customers1,042.1 1,031.1 1,032.8 Natural Gas Supply, Pipeline Capacity, and StorageWe manage portfolios of natural gas supply contracts, storage services, and pipeline transportation services designed to meet varying customer use patterns with safe, reliable natural gas supplies at the best value. For more information on our natural gas utility supply and transportation contracts, see Note 24, Commitments and Contingencies. 2020 Form 10-K10WEC Energy Group, Inc.Table of ContentsPipeline Capacity and StorageWe contract with local distribution companies and interstate pipelines to purchase firm transportation services. We believe that having multiple pipelines that serve our natural gas service territory benefits our customers by improving reliability, providing access to a diverse supply of natural gas, and fostering competition among these service providers. These benefits can lead to favorable conditions for our Illinois utilities when negotiating new agreements for transportation and storage services.We own a 38.8 Bcf storage field (Manlove Field in central Illinois) and contract with various other underground storage service providers for additional storage services. Storage allows us to manage significant changes in daily natural gas demand and to purchase steady levels of natural gas on a year-round basis, which provides a hedge against supply cost volatility. We also own a natural gas pipeline system that connects Manlove Field to Chicago and nine major interstate pipelines. These assets are directed primarily to serving rate-regulated retail customers and are included in our regulatory rate base. We also use a portion of these company-owned storage and pipeline assets as a natural gas hub, which consists of providing transportation and storage services in interstate commerce to our wholesale customers. Customers deliver natural gas to us for storage through an injection into the storage reservoir, and we return the natural gas to the customers under an agreed schedule through a withdrawal from the storage reservoir. Title to the natural gas does not transfer to us. We recognize service fees associated with the natural gas hub services provided to wholesale customers. These service fees reduce the cost of natural gas and services charged to retail customers in rates. Natural gas pipeline capacity and storage and natural gas supplies under contract can be resold in secondary markets. Peak or near-peak demand generally occurs only a few times each year. The secondary markets facilitate utilization of capacity and supply during times when the contracted capacity and supply are in excess of utility demand. The proceeds from these transactions are passed through to customers, subject to our approved GCRMs. For information on the GCRMs, see Note 1(d), Operating Revenues.Combined with our storage capability, management believes that the volume of natural gas under contract is sufficient to meet our forecasted firm peak-day and seasonal demand. Our Illinois utilities' forecasted design peak-day throughput is 26.3 million therms for the 2020 through 2021 heating season. Our Illinois utilities' peak daily send-out during 2020 was 15.7 million therms on February 13, 2020.Natural Gas SupplyOur natural gas supply requirements are met through a combination of fixed-price purchases, index-priced purchases, contracted and owned storage, peak-shaving facilities, and natural gas supply call options. We contract for fixed-term firm natural gas supply each year to meet the demand of firm system sales customers. To supplement natural gas supply and manage risk, we purchase additional natural gas supply on the monthly and daily spot markets.Hedging Natural Gas Supply PricesOur Illinois utilities further reduce their supply cost volatility through the use of financial instruments, such as commodity futures, swaps, and options as part of their hedging programs. Their hedging programs are reviewed by the ICC as part of the annual purchased gas adjustment reconciliation. They hedge between 25% and 50% of natural gas purchases, with a target of 37.5%. Natural Gas System Modernization ProgramPGL is continuing work on the SMP, a project to replace approximately 2,000 miles of Chicago's aging natural gas pipeline infrastructure that began in 2011. PGL currently recovers these costs through a surcharge on customer bills pursuant to an ICC approved QIP rider, which is in effect through 2023. For information on regulatory proceedings related to the SMP, see Note 26, Regulatory Environment. Other States SegmentOur other states segment includes the natural gas utility operations of MERC and MGU and the non-utility operations of MERC related to servicing appliances for customers. MERC serves customers in various cities and communities throughout Minnesota, and MGU serves customers in southern and western Michigan. MERC and MGU provide service to residential, commercial and industrial, and transportation customers. Major industries served include education, wholesale distributors, non-profits, metals manufacturing, and real estate. See Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations – Results of 2020 Form 10-K11WEC Energy Group, Inc.Table of ContentsOperations – Other States Segment Contribution to Net Income Attributed to Common Shareholders for information on natural gas sales volumes by customer class for this segment.Other States Utilities Operating StatisticsOperating RevenuesFor information about our operating revenues disaggregated by customer class for the years ended December 31, 2020, 2019, and 2018, see Note 4, Operating Revenues.CustomersYear Ended December 31(in thousands)202020192018Customers – end of yearResidential365.7 360.8 356.5 Commercial and industrial35.1 35.0 34.9 Transport24.4 24.7 24.7 Total customers425.2 420.5 416.1 Natural Gas Supply, Pipeline Capacity and StorageWe manage portfolios of natural gas supply contracts, storage services, and pipeline transportation services designed to meet varying customer use patterns with safe, reliable natural gas supplies at the best value. For more information on our natural gas utility supply and transportation contracts, see Note 24, Commitments and Contingencies.Pipeline Capacity and StorageMGU owns a 2.9 Bcf storage field (Partello in Michigan) and contract with various other underground storage service providers for additional storage services. We contract with local distribution companies and interstate pipelines to purchase firm transportation services. We believe that having diverse capacity and storage benefits our customers.Natural gas pipeline capacity and storage and natural gas supplies under contract can be resold in secondary markets. Peak or near-peak demand generally occurs only a few times each year. The secondary markets facilitate utilization of capacity and supply during times when the contracted capacity and supply are in excess of utility demand. The proceeds from these transactions are passed through to customers, subject to our approved GCRMs. For information on the GCRMs, see Note 1(d), Operating Revenues.Combined with our storage capability, management believes that the volume of gas under contract is sufficient to meet our forecasted firm peak-day and seasonal demand. Forecasted design peak-day throughput for our other states utilities is 9.2 million therms for the 2020 through 2021 heating season. Our other states utilities' peak daily send-out during 2020 was 6.6 million therms on February 13, 2020.Natural Gas SupplyOur natural gas supply requirements are met through a combination of fixed-price purchases, index-priced purchases, contracted and owned storage, and natural gas supply call options. We contract for fixed-term firm natural gas supply each year to meet the demand of firm system sales customers. To supplement natural gas supply and manage risk, we purchase additional natural gas supply on the monthly and daily spot markets.Hedging Natural Gas Supply PricesOur other states utilities further reduce their supply cost volatility through the use of financial instruments, such as commodity futures, swaps, and options as part of their hedging programs. MERC has MPUC approval to hedge up to 30% of planned winter demand using NYMEX financial instruments. MGU has MPSC approval to hedge up to 20% of its planned annual purchases using NYMEX financial instruments.2020 Form 10-K12WEC Energy Group, Inc.Table of ContentsGeneralSeasonalityElectric Utility Operations – Wisconsin SegmentOur electric utility sales are impacted by seasonal factors and varying weather conditions. We sell more electricity during the summer months because of the residential cooling load. We continue to upgrade our electric distribution system, including substations, transformers, and lines, to meet the demand of our customers. In 2020, our generating plants performed as expected during the warmest periods of the summer, and all power purchase commitments under firm contract were received. During this period, our electric utilities did not require public appeals for conservation, and they did not interrupt or curtail service to non-firm customers who participate in load management programs. WPS did have economic interruption events, however service to customers was not curtailed. Economic interruptions are declared during times in which the price of electricity in the regional market exceeds the cost of operating the company's peaking generation. During this time, interruptible customers can choose to continue using electricity at a price based on wholesale market prices or to reduce their load.Natural Gas Utility Operations – Wisconsin, Illinois, and Other States SegmentsSince the majority of our customers use natural gas for heating, customer use is sensitive to weather and is generally higher during the winter months. Accordingly, we are subject to some variations in earnings and working capital throughout the year as a result of changes in weather. The effect on earnings from these changes in weather are reduced by decoupling mechanisms included in the rates of PGL, NSG, and MERC. These mechanisms differ by state and allow the utilities to recover or refund the differences between actual and authorized margins for certain customer classes.Our natural gas utilities' working capital needs are met by cash generated from operations and debt (both long-term and short-term). The seasonality of natural gas revenues causes the timing of cash collections to be concentrated from January through June. A portion of the winter natural gas supply needs is typically purchased and stored from April through November. Also, planned capital spending on our natural gas distribution facilities is concentrated in April through November. Because of these timing differences, the cash flow from customers is typically supplemented with temporary increases in short-term borrowings (from external sources) during the late summer and fall. Short-term debt is typically reduced over the January through June period.CompetitionElectric Utility Operations – Wisconsin SegmentOur electric utilities face competition from various entities and other forms of energy sources available to customers, including self-generation by customers and alternative energy sources. Our electric utilities compete with other utilities for sales to municipalities and cooperatives as well as with other utilities and marketers for wholesale electric business.Natural Gas Utility Operations – Wisconsin, Illinois, and Other States SegmentsOur natural gas utilities also face varying degrees of competition from other entities and other forms of energy available to consumers. Many large commercial and industrial customers have the ability to switch between natural gas and alternative fuels. In addition, the majority of our natural gas customers have the opportunity to choose a natural gas supplier other than us. Our natural gas utilities offer transportation services for customers that elect to purchase natural gas directly from a third-party supplier. We continue to earn distribution revenues from these transportation customers for their use of our distribution systems to transport natural gas to their facilities. As such, the loss of revenue associated with the cost of natural gas that our transportation customers purchase from third-party suppliers has little impact on our net income, as it is offset by an equal reduction to natural gas costs. For more information on competition in each of our service territories, see Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations – Factors Affecting Results, Liquidity, and Capital Resources – Competitive Markets.2020 Form 10-K13WEC Energy Group, Inc.Table of ContentsC. ELECTRIC TRANSMISSION SEGMENTATC is a regional transmission company that owns, maintains, monitors, and operates electric transmission systems in Wisconsin, Michigan, Illinois, and Minnesota. ATC is expected to provide comparable service to all customers, including WE, WPS, and UMERC, and to support effective competition in energy markets without favoring any market participant. ATC is regulated by the FERC for all rate terms and conditions of service and is a transmission-owning member of MISO. MISO maintains operational control of ATC's transmission system, and WE, WPS, and UMERC are non-transmission owning members and customers of MISO. As of December 31, 2020, our ownership interest in ATC was approximately 60%. In addition, we owned approximately 75% of ATC Holdco, a separate entity formed in December 2016 to invest in transmission-related projects outside of ATC's traditional footprint. See Note 21, Investment in Transmission Affiliates, for more information.In May 2020, the FERC issued an order related to the authorized base ROE for all MISO transmission owners, including ATC. See Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations – Factors Affecting Results, Liquidity, and Capital Resources – Other Matters – American Transmission Company Allowed Return on Equity Complaints, for more information.D. NON-UTILITY OPERATIONSNon-Utility Energy Infrastructure SegmentThe non-utility energy infrastructure segment includes We Power, which owns and leases generating facilities to WE; Bluewater, which owns underground natural gas storage facilities in Michigan; and WECI, which holds ownership interests in several wind generating facilities. See Item 2. Properties, for more information on our non-utility energy infrastructure facilities.W.E. Power, LLCWe Power, through wholly owned subsidiaries, designed and built approximately 2,500 MW of generation in Wisconsin. This generation is made up of capacity from the ERGS units, ER 1 and ER 2, which were placed in service in February 2010 and January 2011, respectively, and the PWGS units, PWGS 1 and PWGS 2, which were placed in service in July 2005 and May 2008, respectively. Two unaffiliated entities collectively own approximately 17%, or approximately 211 MW, of ER 1 and ER 2. We Power's share of the ERGS units and both PWGS units are being leased to WE under long-term leases (the ERGS units have 30-year leases and the PWGS units have 25-year leases), and are positioned to continue to provide a significant portion of our generation needs.Because of the significant investment necessary to construct these generating units, we constructed the plants under Wisconsin's Leased Generation Law, which allows a non-utility affiliate to construct an electric generating facility and lease it to the public utility. The law allows a public utility that has entered into a lease approved by the PSCW to recover fully in its retail electric rates that portion of any payments under the lease that the PSCW has allocated to the public utility's Wisconsin retail electric service, and all other costs that are prudently incurred in the public utility's operation and maintenance of the electric generating facility allocated to the utility's Wisconsin retail electric service. In addition, the PSCW may not modify or terminate a lease it has approved under the Leased Generation Law except as specifically provided in the lease or the PSCW's order approving the lease. This law effectively created regulatory certainty in light of the significant investment being made to construct the units. All four units were constructed under leases approved by the PSCW.We are recovering our costs of these units, including subsequent capital additions, through lease payments that are billed from We Power to WE and then recovered in WE's rates as authorized by the PSCW and the FERC. Under the lease terms, our return is calculated using a 12.7% ROE and the equity ratio is assumed to be 55% for the ERGS units and 53% for the PWGS units.Bluewater Natural Gas Holding, LLC Bluewater, located in Michigan, provides natural gas storage and hub services for our Wisconsin natural gas utilities. WE, WPS, and WG have entered into long-term service agreements for natural gas storage with a wholly owned subsidiary of Bluewater.2020 Form 10-K14WEC Energy Group, Inc.Table of ContentsWEC Infrastructure LLC At December 31, 2020, our non-utility energy infrastructure segment included WECI's ownership interests in the wind generating facilities reflected in the table below.NameOwnership InterestUpstream90.0 %Bishop Hill III90.0 %Coyote Ridge80.0 %Blooming Grove90.0 %Tatanka Ridge (1)85.0 %(1) Tatanka Ridge achieved commercial operation on January 5, 2021.Bishop Hill III, Coyote Ridge, Blooming Grove, and Tatanka Ridge have offtake agreements with creditworthy unaffiliated third parties for the sale of all the energy they produce. In addition, Upstream's revenue is substantially fixed over a 10-year period through an agreement with a creditworthy unaffiliated third party. Under the Tax Legislation, all of these investments qualify for PTCs. WECI is entitled to the tax benefits of each facility in proportion to its ownership interest, with the exception of Coyote Ridge and Tatanka Ridge. WECI is entitled to 99% of the tax benefits of Coyote Ridge and Tatanka Ridge for the first 11 years of commercial operation, after which WECI will be entitled to tax benefits equal to its ownership interest. WECI recognizes PTCs as power is generated over 10 years.In August 2019, WECI signed an agreement to acquire an 80% ownership interest in Thunderhead, a 300 MW wind generating facility under construction in Nebraska. In addition, in February 2020, WECI amended this agreement to acquire an additional 10% ownership interest in Thunderhead. The project has an offtake agreement with an unaffiliated third party for all of the energy to be produced by the facility for 12 years. Under the Tax Legislation, WECI's investments in Thunderhead is expected to qualify for PTCs.See Note 2, Acquisitions, for more information on these wind generating facilities.SeasonalityThe electricity produced and revenues generated by our wind power plants depend heavily on wind conditions, which are variable. Operating results for wind power plants vary significantly from period to period depending on the wind conditions during the periods in question. Historically, wind production has been greater in the first and fourth quarters.Corporate and Other SegmentThe corporate and other segment includes the operations of the WEC Energy Group holding company, the Integrys holding company, and the PELLC holding company, as well as the operations of Wispark, WBS, and PDL (prior to the sale of its remaining solar facilities as discussed in more detail in Note 3, Dispositions). This segment also includes Wisvest and WECC, which no longer have significant operations.Wispark develops and invests in real estate, primarily in southeastern Wisconsin. Wispark had $28.8 million in real estate holdings at December 31, 2020.WBS is a wholly owned centralized service company that provides administrative and general support services to our regulated entities. WBS also provides certain administrative and support services to our nonregulated entities.E. REGULATIONWe are a holding company and are subject to the requirements of the PUHCA 2005. We also have various subsidiaries that meet the definition of a holding company under the PUHCA 2005 and are also subject to its requirements.Pursuant to the non-utility asset cap provisions of Wisconsin's public utility holding company law, the sum of certain assets of all non-utility affiliates in a holding company system generally may not exceed 25% of the assets of all public utility affiliates. However, among other items, the law exempts energy-related assets, including the generating plants constructed by We Power and the other assets in our non-utility energy infrastructure segment, from being counted against the asset cap provided that they are employed in 2020 Form 10-K15WEC Energy Group, Inc.Table of Contentsqualifying businesses. We report to the PSCW annually on our compliance with this law and provide supporting documentation to show that our non-utility assets are below the non-utility asset cap.Regulated Utility OperationsIn addition to the specific regulations noted above and below, our utilities are subject to various other regulations, which primarily consist of regulations, where applicable, of the EPA; the WDNR; the IDNR; the IEPA; the Michigan Department of Environment, Great Lakes, and Energy (previously Michigan Department of Environmental Quality); the Michigan Department of Natural Resources; the United States Army Corps of Engineers; the Minnesota Department of Natural Resources; and the Minnesota Pollution Control Agency. RatesOur utilities' rates are subject to the regulations and oversight of various state regulatory commissions and the FERC, as applicable. Decisions by these regulators can significantly impact our liquidity, financial condition, and results of operations. The following table compares our utility operating revenues by regulatory jurisdiction for each of the three years ended December 31:202020192018(in millions)AmountPercentAmountPercentAmountPercentElectric Wisconsin$3,823.7 89.4 %$3,807.4 88.2 %$3,890.4 87.7 %Michigan127.2 3.0 %142.6 3.3 %152.4 3.4 %FERC – Wholesale323.1 7.6 %367.6 8.5 %396.1 8.9 %Total electric4,274.0 100.0 %4,317.6 100.0 %4,438.9 100.0 %Natural GasWisconsin 1,196.2 41.2 %1,325.3 42.6 %1,351.8 42.3 %Illinois 1,321.9 45.5 %1,357.1 43.6 %1,400.0 43.8 %Minnesota 255.9 8.8 %281.5 9.0 %289.8 9.1 %Michigan 131.5 4.5 %148.7 4.8 %152.4 4.8 %Total natural gas2,905.5 100.0 %3,112.6 100.0 %3,194.0 100.0 %Total utility operating revenues$7,179.5 $7,430.2 $7,632.9 Retail RatesThe state regulatory commissions have general supervisory and regulatory powers over public utilities in their respective jurisdictions including, but not limited to, approval of retail utility rates and standards of service, mergers, affiliate transactions, location and construction of electric generating units and natural gas facilities, and certain other additions and extensions to utility facilities. The PSCW, ICC, and MPUC also regulate security issuances at utilities in their respective jurisdictions. Historically, retail rates approved by the state commissions have been designed to provide utilities the opportunity to generate revenues to recover all prudently-incurred costs, along with a return on investment sufficient to pay interest on debt and provide a reasonable ROE. Rates charged to customers vary according to customer class and rate jurisdiction. WE, WPS, and WG are each subject to an earnings sharing mechanism in which a portion of the utility's earnings are required to be refunded to customers if the utility earns above its authorized ROE. See Note 26, Regulatory Environment, for more information on these earnings sharing mechanisms.2020 Form 10-K16WEC Energy Group, Inc.Table of ContentsThe table below reflects the various state commissions that regulated each of our utilities' retail rates during 2020, along with the approved ROE and capital structure for each utility during 2020.Regulated Retail RatesRegulatory CommissionAuthorized ROEAverage Common Equity ComponentWE – electric, natural gas, and steamPSCW10.0%52.5%WPS – electric and natural gasPSCW10.0%52.5%WG – natural gasPSCW10.2%52.5%UMERC – electric (former WE customers)MPSC10.1%55.3%UMERC – electric (former WPS customers)MPSC10.2%52.94%PGL – natural gasICC9.05%50.33%NSG – natural gasICC9.05%50.48%MERC – natural gasMPUC9.7%50.9%MGU – natural gasMPSC9.9%52.0%In addition to amounts collected from customers through approved base rates, our utilities have certain recovery mechanisms in place that allow them to recover or refund prudently incurred costs that differ from those approved in base rates.Embedded within our electric utilities' rates is an amount to recover fuel and purchased power costs. The Wisconsin retail fuel rules require a utility to defer, for subsequent rate recovery or refund, any under-collection or over-collection of fuel and purchased power costs that are outside of the utility's symmetrical fuel cost tolerance, which the PSCW typically sets at plus or minus 2% of the utility's approved fuel and purchased power cost plan. The deferred fuel and purchased power costs are subject to an excess revenues test. If the utility's ROE in a given year exceeds the ROE authorized by the PSCW, the recovery of under-collected fuel and purchased power costs would be reduced by the amount by which the utility's return exceeds the authorized amount. Prudently incurred fuel and purchased power costs are recovered dollar-for-dollar from our Michigan retail electric customers.Our natural gas utilities operate under GCRMs as approved by their respective state regulator. Generally, the GCRMs allow for a dollar-for-dollar recovery of prudently incurred natural gas costs.See Note 1(d), Operating Revenues, for additional information on the significant mechanisms our utilities had in place in 2020 that allowed them to recover or refund changes in prudently incurred costs from rate case-approved amounts.Our utilities file periodic requests with their respective state commission to request changes in retail rates. All of our utilities' rate requests are based on forward looking test years, which reflect additions to infrastructure and changes in costs incurred or expected to be incurred. For information on our regulatory proceedings, see Note 26, Regulatory Environment. Orders from our respective regulators can be viewed at the following websites:Regulatory CommissionWebsitePSCW https://psc.wi.gov/ICChttps://www.icc.illinois.gov/MPSChttp://www.michigan.gov/mpsc/MPUChttp://mn.gov/puc/The material and information contained on these websites are not intended to be a part of, nor are they incorporated by reference into, this Annual Report on Form 10-K.Wholesale RatesThe FERC regulates our wholesale sales of electric energy, capacity, and ancillary services. Our electric utilities have received market-based rate authority from the FERC. Market-based rate authority allows wholesale electric sales to be made in the MISO market and directly to third parties based on the negotiated market value of the transaction. WE and WPS also make wholesale sales pursuant to cost-based formula rates. Cost-based formula rates provide for recovery of the utility's costs and an approved rate of return. The predetermined formula is initially based on the utility's expenses from the previous year, but is eventually trued up to reflect actual, current-year costs.2020 Form 10-K17WEC Energy Group, Inc.Table of ContentsElectric Transmission, Capacity, and Energy MarketsIn connection with its status as a FERC-approved RTO, MISO operates bid-based energy markets. MISO is responsible for monitoring and ensuring equal access to the electric transmission system in its footprint.In MISO, base transmission costs are currently being paid by load-serving entities located in the service territories of each MISO transmission owner. The FERC has previously confirmed the use of the current transmission cost allocation methodology. Certain additional costs for new transmission projects are allocated throughout the MISO footprint.As part of MISO, a market-based platform is used for valuing transmission congestion premised upon an LMP system. The LMP system includes the ability to hedge transmission congestion costs through ARRs and FTRs. ARRs are allocated to market participants by MISO, and FTRs are purchased through auctions. A new allocation and auction were completed for the period of June 1, 2020, through May 31, 2021. The resulting ARR allocation and the secured FTRs are expected to mitigate our transmission congestion risk for that period.MISO has an annual zonal resource adequacy requirement to ensure there is sufficient generation capacity to serve the MISO market. To meet this requirement, capacity resources can be acquired through MISO's annual capacity auction, bilateral contracts for capacity, or provided from generating or demand response resources. All of our capacity requirements during the planning year from June 1, 2020, through May 31, 2021 were met.Other Electric RegulationsOur electric utilities are subject to the Federal Power Act and the corresponding regulations developed by certain federal agencies. The Energy Policy Act amended the Federal Power Act in 2005 to, among other things, make electric utility industry consolidation more feasible, authorize the FERC to review proposed mergers and the acquisition of generation facilities, change the FERC regulatory scheme applicable to qualifying cogeneration facilities, and modify certain other aspects of energy regulations and federal tax policies applicable to us. Additionally, the Energy Policy Act created an Electric Reliability Organization to be overseen by the FERC, which established mandatory electric reliability standards and has the authority to levy monetary sanctions for failure to comply with these standards.WE and WPS are subject to Act 141 in Wisconsin, and UMERC is subject to Public Acts 295 and 342 in Michigan, which contain certain minimum requirements for renewable energy generation.All of our hydroelectric facilities follow FERC guidelines and/or regulations.Other Natural Gas RegulationsAlmost all of the natural gas we distribute is transported to our distribution systems by interstate pipelines. The pipelines' transportation and storage services, including PGL's natural gas hub, are regulated by the FERC under the Natural Gas Act and the Natural Gas Policy Act of 1978. In addition, the Pipeline and Hazardous Materials Safety Administration and the state commissions are responsible for monitoring and enforcing requirements governing our natural gas utilities' safety compliance programs for our pipelines under the United States Department of Transportation regulations. These regulations include 49 CFR Part 191 (Transportation of Natural and Other Gas by Pipeline; Annual Reports, Incident Reports, and Safety-Related Condition Reports), 49 CFR Part 192 (Transportation of Natural and Other Gas by Pipeline: Minimum Federal Safety Standards), and 49 CFR Part 195 (Transportation of Hazardous Liquids by Pipeline).We are required to provide natural gas service and grant credit (with applicable deposit requirements) to customers within our service territories. We are generally not allowed to discontinue natural gas service during winter moratorium months to residential heating customers who do not pay their bills. Federal and certain state governments have programs that provide for a limited amount of funding for assistance to low-income customers of our utilities.Non-Utility Energy Infrastructure OperationsThe generation facilities constructed by wholly owned subsidiaries of We Power are being leased on a long-term basis to WE. Environmental permits necessary for operating the facilities are the responsibility of the operating entity, WE. We Power received 2020 Form 10-K18WEC Energy Group, Inc.Table of Contentsdeterminations from the FERC that upon the transfer of the facilities by lease to WE, We Power's subsidiaries would not be deemed public utilities under the Federal Power Act and thus would not be subject to the FERC's jurisdiction.Bluewater is regulated by the FERC under the Natural Gas Act and the Natural Gas Policy Act of 1978. In addition, the Pipeline and Hazardous Materials Safety Administration is responsible for monitoring and enforcing requirements governing Bluewater's safety compliance programs for its pipelines under the United States Department of Transportation regulations. These regulations include 49 CFR Parts 191, 192, and 195. Given that Bluewater is required to route some of its natural gas through Canada, applicable reporting and licensing with the United States Department of Energy and the Canadian National Energy Board are also required, along with routine reporting related to imports and exports.Bishop Hill III, Blooming Grove, Coyote Ridge, Tatanka Ridge and Upstream are all subject to the FERC’s regulation of wholesale energy under the Federal Power Act.Compliance CostsThe regulations and oversight described above significantly influence our operating environment, and may cause us to incur compliance and other related costs and may affect our ability to recover these costs from our utility customers. Any anticipated capital expenditures for compliance with government regulations for the next three years are included in the estimated capital expenditures described in Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations – Liquidity and Capital Resources – Capital Requirements.F. ENVIRONMENTAL COMPLIANCEOur operations, especially as they relate to our coal-fired generating facilities, are subject to extensive environmental regulation by state and federal environmental agencies governing air and water quality, hazardous and solid waste management, environmental remediation, and management of natural resources. Costs associated with complying with these requirements are significant. Additional future environmental regulations or revisions to existing laws, including for example, additional regulation related to GHG emissions, coal combustion products, air emissions, water use, or wastewater discharges and other climate change issues, could significantly increase these environmental compliance costs.Anticipated expenditures for environmental compliance and certain remediation issues for the next three years are included in the estimated capital expenditures described in Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations – Liquidity and Capital Resources – Capital Requirements. For a discussion of certain environmental matters affecting us, including rules and regulations relating to air quality, water quality, land quality, and climate change, see Note 24, Commitments and Contingencies.G. HUMAN CAPITALWe believe our employees are among our most important resources, so investing in human capital is critical to our success. We strive to foster a diverse workforce and inclusive workplace; attract, retain and develop talented personnel; and keep our employees safe and healthy.Our Board of Directors retains collective responsibility for comprehensive risk oversight, including critical areas that could impact our sustainability, such as human capital. Management regularly reports to the Board of Directors on human capital management topics, including corporate culture, diversity and inclusion, employee development, and safety and health. The Board of Directors delegates specified duties to its committees. In addition to its responsibilities relative to executive compensation, the Compensation Committee has oversight responsibility for reviewing organizational matters that could significantly impact us, including succession planning. The Compensation Committee reviews recruiting and development programs and priorities, receives updates on key talent, and assesses workforce diversity across the organization.2020 Form 10-K19WEC Energy Group, Inc.Table of ContentsWorkforceAs of December 31, 2020, we had the following number of employees, including those represented under union agreements:Total EmployeesUnion EmployeesWE2,460 1,923 WPS1,127 814 (1)WG378 259 PGL 1,492 1,046 NSG160 111 MERC207 43 MGU141 92 WBS1,308 — Total employees7,273 4,288 (1) WPS's contract with Local 420 of International Union of Operating Engineers expires in April 2021. Negotiations are in progress, which we expect will conclude before the expiration of the current agreement.We have a local union presence that spans Wisconsin, Illinois, Minnesota, and Michigan. We believe we have very good overall relations with our workforce. In order to attract and retain talent, we provide competitive wages and benefits to our employees based on their performance, role, location, and market data.Diversity and InclusionWe are committed to fostering a diverse workforce and inclusive workplace. Our commitment is a core strategic competency and an integral part of our culture. As of December 31, 2020, females and minorities represented approximately 25% and 26% of our workforce, respectively. We have a number of initiatives that promote diverse workforce contributions, educate employees about diversity and inclusion, and make our companies attractive employers for persons of diverse backgrounds. These initiatives include eight business resource groups (voluntary, employee-led groups organized around a particular shared background or interest), mentoring programs, and training for leaders on countering unconscious bias, building inclusive teams, and preventing workplace harassment. We also support external leadership and educational programs that support, train, and promote women and minorities in the communities we serve.Safety and HealthOur Executive Safety Committee directs our safety and health strategy, works to ensure consistency across groups, and reinforces our ongoing safety commitment that we refer to as “Target Zero.” Under our Target Zero commitment, we have an ultimate goal of zero incidents, accidents, and injuries. Our corporate safety program provides a forum for addressing employee concerns, training employees and contractors on current safety standards, and recognizing those who demonstrate a safety focus. We monitor and set goals for Occupational Safety and Health Administration (OSHA)-recordable and lost-time incidents, as well as leading indicators, which together raise awareness about employee safety and guide injury-prevention activities.We also provide employees various benefits and resources designed to promote healthy living, both at work and at home. We encourage employees to receive preventive examinations and to proactively care for their health through free health screenings, wellness challenges, and other resources. During 2020, in response to the COVID-19 pandemic, we implemented safety protocols and new procedures to protect our employees and customers. See Factors Affecting Results, Liquidity, and Capital Resources – Coronavirus Disease – 2019, for additional information. 2020 Form 10-K20WEC Energy Group, Inc.Table of ContentsDevelopment and TrainingEmployee training and development of both technical and leadership skills are integral aspects of our human capital strategy. We provide employees with a wide range of development opportunities, including online training, simulations, live classes, and mentoring to assist with their career advancement. These programs include safety and technical job skill training as well as soft-skill programs focused on relevant subjects, including communication and change management. Development of leadership skills remains a top priority and is specialized for all levels of employees. We have specific leadership programs for aspiring leaders and new supervisors, managers, and directors. This development of our employees is an integral part of our succession planning and provides continuity for our senior leadership.2020 Form 10-K21WEC Energy Group, Inc.Table of ContentsITEM 1A. RISK FACTORS We are subject to a variety of risks, many of which are beyond our control, that may adversely affect our business, financial condition, and results of operations. You should carefully consider the following risk factors, as well as the other information included in this report and other documents filed by us with the SEC from time to time, when making an investment decision.Risks Related to Legislation and RegulationOur business is significantly impacted by governmental regulation and oversight.We are subject to significant state, local, and federal governmental regulations, including regulations by the various utility commissions in the states where we serve customers. These regulations significantly influence our operating environment, may affect our ability to recover costs from utility customers, and cause us to incur substantial compliance and other costs. Changes in regulations, interpretations of regulations, or the imposition of new regulations could also significantly impact us, including requiring us to change our business operations. Many aspects of our operations are regulated and impacted by government regulation, including, but not limited to: the rates we charge our retail electric, natural gas, and steam customers; the authorized rates of return of our utilities; construction and operation of electric generating facilities and electric and natural gas distribution systems, including the ability to recover such costs; decommissioning generating facilities, the ability to recover the related costs, and continuing to recover the return on the net book value of these facilities; wholesale power service practices; electric reliability requirements and accounting; participation in the interstate natural gas pipeline capacity market; standards of service; issuance of securities; short-term debt obligations; transactions with affiliates; and billing practices. Failure to comply with any applicable rules or regulations may lead to customer refunds, penalties, and other payments, which could materially and adversely affect our results of operations and financial condition.The rates, including adjustments determined under riders, we are allowed to charge our customers for retail and wholesale services have the most significant impact on our financial condition, results of operations, and liquidity. Rate regulation provides us an opportunity to recover prudently incurred costs and earn a reasonable rate of return on invested capital. However, our ability to obtain rate adjustments in the future is dependent upon regulatory action, and there is no assurance that our regulators will consider all of our costs to have been prudently incurred. In addition, our rate proceedings may not always result in rates that fully recover our costs or provide for a reasonable ROE. We defer certain costs and revenues as regulatory assets and liabilities for future recovery from or refund to customers, as authorized by our regulators. Future recovery of regulatory assets is not assured and is subject to review and approval by our regulators. If recovery of regulatory assets is not approved or is no longer deemed probable, these costs would be recognized in current period expense and could have a material adverse impact on our results of operations, cash flows, and financial condition.We believe we have obtained the necessary permits, approvals, authorizations, certificates, and licenses for our existing operations, have complied in all material respects with all of their associated terms, and that our businesses are conducted in accordance with applicable laws. These permits, approvals, authorizations, certificates, and licenses may be revoked or modified by the agencies that granted them if facts develop that differ significantly from the facts assumed when they were issued. In addition, discharge permits and other approvals and licenses are often granted for a term that is less than the expected life of the associated facility. Licenses and permits may require periodic renewal, which may result in additional requirements being imposed by the granting agency. In addition, existing regulations may be revised or reinterpreted by federal, state, and local agencies, or these agencies may adopt new laws and regulations that apply to us. We cannot predict the impact on our business and operating results of any such actions by these agencies. If we are unable to recover costs of complying with regulations or other associated costs in customer rates in a timely manner, or if we are unable to obtain, renew, or comply with these governmental permits, approvals, authorizations, certificates, or licenses, our results of operations and financial condition could be materially and adversely affected.We face significant costs to comply with existing and future environmental laws and regulations. Our operations are subject to extensive and evolving federal, state, and local environmental laws, regulations, and permit requirements related to, among other things, air emissions (including, but not limited to: CO2, methane, mercury, SO2, and NOx), protection of natural resources, water quality, wastewater discharges, and management of hazardous, toxic, and solid wastes and substances. For example, the EPA adopted and implemented (or is in the process of implementing) regulations governing the emission of NOx, SO2, fine particulate matter, mercury, and other air pollutants under the CAA through the NAAQS, climate change 2020 Form 10-K22WEC Energy Group, Inc.Table of Contentsregulations including the ACE rule, and other air quality regulations. The EPA also finalized regulations under the Clean Water Act that govern cooling water intake structures at our power plants and revised the effluent guidelines for steam electric generating plants. Several of these rules are being challenged, which creates additional uncertainty. For example, the D.C. Court of Appeals vacated the ACE rule in January 2021. In addition, existing environmental laws and regulations may be revised or new laws or regulations may be adopted at the federal, state, or local level. In particular, it is uncertain how the change in the United States presidential administration will impact the final resolution of several environmental standards or the adoption of new environmental laws and regulations. We incur significant capital and operating resources to comply with these environmental laws, regulations, and requirements, including costs associated with the installation of pollution control equipment to further limit GHG emissions from our operations; operating restrictions on our facilities; and environmental monitoring, emissions fees, and permits at our facilities. The operation of emission control equipment and compliance with rules regulating our intake and discharge of water could also increase our operating costs and reduce the generating capacity of our power plants. These regulations may create substantial additional costs in the form of taxes or emission allowances and could affect the availability and/or cost of fossil fuels. Failure to comply with these laws, regulations, and requirements, even if caused by factors beyond our control, may result in the assessment of civil or criminal penalties and fines. We continue to assess the potential cost of complying, and to explore different alternatives in order to comply, with these and other environmental regulations.As a result of these compliance costs and other factors, certain of our coal-fired electric generating facilities have become uneconomical to maintain and operate, which has resulted in these units being retired or converted to an alternative type of fuel. As part of our commitment to a cleaner energy future, we have already retired more than 1,800 MW of coal-fired generation since the beginning of 2018. Under the ESG Progress Plan, we expect to retire approximately 1,800 MW of additional fossil-fueled generation by 2025, to be replaced with the construction of zero-carbon emitting renewable generation and natural gas-fired generation. Our electric and natural gas utilities are also subject to significant liabilities related to the investigation and remediation of environmental impacts at certain of our current and former facilities and at third-party owned sites. We accrue liabilities and defer costs (recorded as regulatory assets) incurred in connection with our former manufactured gas plant sites. These costs include all costs incurred to date that we expect to recover, management's best estimates of future costs for investigation and remediation and related legal expenses, and are net of amounts recovered (or that may be recovered) from insurance or other third parties. Due to the potential for the imposition of stricter standards and greater regulation in the future, the possibility that other potentially responsible parties may not be willing or financially able to contribute to cleanup costs, a change in conditions or the discovery of additional contamination, our remediation costs could increase, and the timing of our capital and/or operating expenditures in the future may accelerate or could vary from the amounts currently accrued.Litigation over environmental issues and claims of various types, including property damage, personal injury, common law nuisance, and citizen enforcement of environmental laws and regulations, has become more frequent throughout the United States. In addition to claims relating to our current facilities, we may also be subject to potential liability in connection with the environmental condition of facilities that we previously owned and operated, regardless of whether the liabilities arose before, during, or after the time we owned or operated these facilities. If we fail to comply with environmental laws and regulations or cause (or caused) harm to the environment or persons, that failure or harm may result in the assessment of civil penalties and damages against us. The incurrence of a material environmental liability or a material judgment in any action for personal injury or property damage related to environmental matters could have a material adverse effect on our results of operations and financial condition.In the event we are not able to recover all of our environmental expenditures and related costs from our customers in the future, our results of operations and financial condition could be adversely affected. Further, increased costs recovered through rates could contribute to reduced demand for electricity and natural gas, which could adversely affect our results of operations, cash flows, and financial condition.Our operations, capital expenditures, and financial results may be affected by the impact of greenhouse gas legislation, regulation, and emission reduction goals. There is continued scientific and political attention to issues concerning the existence and extent of climate change. Management expects this attention to continue, particularly with the change in the United States presidential administration. Although the previously issued ACE rule was vacated in January 2021 adding additional uncertainty, President Biden has indicated that climate change will become one of his primary initiatives, with significant actions expected by his administration during his term in office. As a result, we expect the EPA and states to adopt and implement additional regulations to restrict emissions of GHGs. 2020 Form 10-K23WEC Energy Group, Inc.Table of ContentsCosts associated with such legislation, regulation, and emission reduction goals could be significant. GHG regulations that may be adopted in the future, at either the federal or state level, may cause our environmental compliance spending to differ materially from the amounts currently estimated. These regulations, as well as changes in the fuel markets and advances in technology, could make additional electric generating units uneconomic to maintain or operate, may impact how we operate our existing fossil-fueled power plants and biomass facility, and could affect unit retirement and replacement decisions in the future under the ESG Progress Plan. These regulations could also adversely affect our future results of operations, cash flows, and financial condition. There is no guarantee that we will be allowed to fully recover costs incurred to comply with these and other federal and state regulations or that cost recovery will not be delayed or otherwise conditioned. In addition, our natural gas delivery systems and natural gas storage fields may generate fugitive gas as a result of normal operations and as a result of excavation, construction, and repair. Fugitive gas typically vents to the atmosphere and consists primarily of methane. CO2 is also a byproduct of natural gas consumption. Certain states outside our service territories have passed legislation banning natural gas used in new construction in order to limit these GHG emissions. Future statewide or nationwide actions like these to regulate GHG emissions could increase the price of natural gas, restrict the use of natural gas, cause us to accelerate the replacement and/or updating of our natural gas delivery systems, and adversely affect our ability to operate our natural gas facilities. A significant increase in the price of natural gas may increase rates for our natural gas customers, which could reduce natural gas demand. We also continue to monitor the financial and operational feasibility of taking more aggressive action to further reduce GHG emissions in order to limit future global temperature increases. Our plan to replace older, fossil-fueled generation with zero-carbon emitting renewable generation and natural gas-fired generation will contribute to the achievement of our goals related to reducing CO2 and methane emissions. However, our ability to achieve such goals depends on many external factors, including the development of relevant energy technologies. These efforts could impact how we operate our electric generating units and natural gas facilities and lead to increased competition and regulation, all of which could have a material adverse effect on our operations and financial condition.Changes in tax legislation, IRS audits, or our inability to use certain tax benefits and carryforwards, may adversely affect our financial condition, results of operations, and cash flows, as well as our or our subsidiaries’ credit ratings.Tax legislation and regulations can adversely affect, among other things, our financial condition, results of operations, cash flows, liquidity, and credit ratings. Future changes to corporate tax rates or policies, including under the new United States presidential administration, could require us to take material charges against earnings. Such changes include, among other things, increasing the federal corporate income tax rate, disallowing use of certain tax benefits and carryforwards, limiting interest deductions, and altering the expensing of capital expenditures. Our inability to manage these changes, an adverse determination by one of the applicable taxing jurisdictions, or additional interpretations, implementing regulations, amendments, or technical corrections by the Treasury Department, the IRS, or state income tax authorities, could significantly impact our financial results and cash flows. We have significantly reduced our consolidated federal and state income tax liabilities in the past through tax credits, net operating losses, and charitable contribution deductions. A reduction in or disallowance of these tax benefits could adversely affect our earnings and cash flows. We have not fully used these allowed tax benefits in our previous tax filings and have carried them forward to use against future taxable income. Our inability to generate sufficient taxable income in the future to fully use these tax carryforwards before they expire, could significantly affect our tax obligations and financial results.In addition, we have invested, or plan to invest, in renewable energy generating facilities. These facilities generate PTCs or ITCs that we use to reduce our federal tax obligations. The amount of tax credits we earn depends on the amount of electricity produced, the applicable tax credit rate, or the amount of the investment in qualifying property. A variety of operating and economic factors, including transmission constraints, adverse weather conditions, and breakdown or failure of equipment, could significantly reduce the PTCs generated by the wind parks we have invested in, resulting in a material adverse impact on our financial condition and results of operations. We are also uncertain as to how credit rating agencies, capital markets, the FERC, or state public utility commissions will treat any future changes to federal or state tax legislation. These impacts could subject us or any of our subsidiaries to credit rating downgrades. In addition, certain financial metrics used by credit rating agencies, such as our funds from operations-to-debt percentage, could be negatively impacted by changes in federal or state income tax legislation. 2020 Form 10-K24WEC Energy Group, Inc.Table of ContentsOur electric utilities could be subject to higher costs and penalties as a result of mandatory reliability standards.Our electric utilities are subject to mandatory reliability and critical infrastructure protection standards established by the North American Electric Reliability Corporation and enforced by the FERC. The critical infrastructure protection standards focus on controlling access to critical physical and cyber security assets. Compliance with the mandatory reliability standards could subject our electric utilities to higher operating costs. If our electric utilities are found to be in noncompliance with the mandatory reliability standards, they could be subject to sanctions, including substantial monetary penalties, or damage to our reputation.Provisions of the Wisconsin Utility Holding Company Act limit our ability to invest in non-utility businesses and could deter takeover attempts by a potential purchaser of our common stock that would be willing to pay a premium for our common stock.Under the Holding Company Act, we remain subject to certain restrictions that have the potential of limiting our diversification into non-utility businesses. Under the Holding Company Act, the sum of certain assets of all non-utility affiliates in a holding company system generally may not exceed 25% of the assets of all public utility affiliates in the system, subject to certain exemptions for energy-related assets.In addition, the Holding Company Act precludes the acquisition of 10% or more of the voting shares of a holding company of a Wisconsin public utility unless the PSCW has first determined that the acquisition is in the best interests of utility customers, investors, and the public. This provision and other requirements of the Holding Company Act may delay or reduce the likelihood of a sale or change of control of WEC Energy Group. As a result, shareholders may be deprived of opportunities to sell some or all of their shares of our common stock at prices that represent a premium over market prices.Risks Related to the Operation of Our BusinessThe ongoing COVID-19 pandemic could adversely affect our business functions, financial condition, liquidity, and results of operations.The global outbreak of COVID-19 was declared a pandemic by the WHO and the CDC and has spread globally, including throughout the United States. There is still considerable uncertainty regarding the extent and duration of the COVID-19 pandemic itself, as well as the measures currently in place to try to contain the virus, such as travel bans and restrictions, quarantines, limitations on business operations, and the timing of widespread availability of the vaccines. Although the shelter-in-place orders that were in effect for our service territories have expired, other orders limiting the capacity of various businesses have been adopted in some jurisdictions. In addition, similar or more restrictive orders could be adopted in the future depending on how the virus continues to spread and/or mutate. Although no longer mandated by all of our regulators, our utility subsidiaries are continuing to temporarily suspend disconnections. The effects of the COVID-19 pandemic and related government responses have significantly disrupted economic activity in our service territories. Such effects have included, and may continue to include, extended disruptions to supply chains and capital markets, reduced labor availability and productivity, and a prolonged reduction in economic activity. These effects could continue to have a variety of adverse impacts on us and our subsidiaries, including continued reductions in demand for energy, particularly from commercial and industrial customers; impairment of goodwill or long-lived assets; continued decreases in revenue due to the inability to collect late fees; increased bad debt expense; increases in past due accounts receivable balances, impairment of our and our subsidiaries' ability to develop, construct, and operate facilities; and impaired ability to successfully access funds from credit and capital markets.The COVID-19 pandemic has also caused significant disruption and volatility in the United States capital markets, and any additional or lingering effects on the capital markets may significantly impact us and our subsidiaries. For example, the costs related to our pension and other post-retirement benefit plans are based in part on the value of the plans’ assets. Adverse investment performance for these assets or the failure to maintain sustained growth in pension investments over time could increase our plan costs and funding requirements. Similarly, we rely on access to the capital markets to fund some of our operations and capital requirements. To the extent that access to the capital markets is adversely affected by COVID-19, we may need to consider alternative sources of funding for our operations and for working capital, which may increase our cost of, as well as adversely impact our access to, capital.We have taken precautions with regard to employee hygiene and facility cleanliness, imposed travel limitations on our employees, provided additional employee benefits, and implemented remote work policies where appropriate. Additional protocols have been implemented for our field employees who travel to customer premises in order to protect them, our customers, and the public.2020 Form 10-K25WEC Energy Group, Inc.Table of ContentsAs a reaction to the COVID-19 pandemic, it is possible that federal and state fiscal spending to fund COVID-19 relief measures, coupled with a drop in tax revenue from pandemic-related reductions in economic activity, may add to the pressure to raise more tax revenue from federal and state corporate income, other taxes including payroll or property taxes, to enact new types of taxes on businesses and their customers, or to disallow certain deductions. Despite our efforts to manage the impacts of the COVID-19 pandemic, the extent to which COVID-19 may continue to affect us depends on factors beyond our knowledge or control. Therefore, we are currently unable to determine what additional impact the COVID-19 pandemic may have on our business plans and operations, liquidity, financial condition, and results of operations, but will continue to monitor COVID-19 developments and modify our plans as conditions change.Our operations are subject to risks arising from the reliability of our electric generation, transmission, and distribution facilities, natural gas infrastructure facilities, renewable energy facilities, and other facilities, as well as the reliability of third-party transmission providers.Our financial performance depends on the successful operation of our electric generation, natural gas and electric distribution facilities, and renewable energy facilities. The operation of these facilities involves many risks, including operator error and the breakdown or failure of equipment or processes. Potential breakdown or failure may occur due to severe weather; catastrophic events (i.e., fires, earthquakes, explosions, tornadoes, floods, droughts, pandemic health events, etc.); significant changes in water levels in waterways; fuel supply or transportation disruptions; accidents; employee labor disputes; construction delays or cost overruns; shortages of or delays in obtaining equipment, material, and/or labor; performance below expected levels; operating limitations that may be imposed by environmental or other regulatory requirements; terrorist attacks; or cyber security intrusions. Any of these events could lead to substantial financial losses, including increased maintenance costs, unanticipated capital expenditures, and a reduction of revenues related to our non-utility renewable energy facilities. Because our electric generation and renewable energy facilities are interconnected with third-party transmission facilities, the operation of our facilities could also be adversely affected by events impacting their systems. Unplanned outages at our power plants may reduce our revenues, cause us to incur significant costs if we are required to operate our higher cost electric generators or purchase replacement power to satisfy our obligations, and could result in additional maintenance expenses. Insurance, warranties, performance guarantees, or recovery through the regulatory process may not cover any or all of these lost revenues or increased expenses, which could adversely affect our results of operations and cash flows.Our operations are subject to various conditions that can result in fluctuations in energy sales to customers, including customer growth and general economic conditions in our service areas, varying weather conditions, and energy conservation efforts.Our results of operations and cash flows are affected by the demand for electricity and natural gas, which can vary greatly based upon:•Fluctuations in customer growth and general economic conditions in our service areas. Customer growth and energy use can be negatively impacted by population declines as well as economic factors in our service territories, including workforce reductions, stagnant wage growth, changing levels of support from state and local government for economic development, business closings, and reductions in the level of business investment. Our electric and natural gas utilities are impacted by economic cycles and the competitiveness of the commercial and industrial customers we serve. Any economic downturn, disruption of financial markets, or reduced incentives by state government for economic development could adversely affect the financial condition of our customers and demand for their products or services. These risks could directly influence the demand for electricity and natural gas as well as the need for additional power generation and generating facilities. We could also be exposed to greater risks of accounts receivable write-offs if customers are unable to pay their bills. •Weather conditions. Demand for electricity is greater in the summer and winter months when cooling and heating is necessary. In addition, demand for natural gas peaks in the winter heating season. As a result, our overall results may fluctuate substantially on a seasonal basis. In addition, milder temperatures during the summer cooling season and during the winter heating season, as a result of climate change or otherwise, may result in lower revenues and net income.•Our customers' continued focus on energy conservation. Our customers' use of electricity and natural gas has decreased as a result of continued individual conservation efforts, including the use of more energy efficient technologies. Customers could also voluntarily reduce their consumption of energy in response to decreases in their disposable income and increases in energy prices. Conservation of energy can be influenced by certain federal and state programs that are intended to influence how 2020 Form 10-K26WEC Energy Group, Inc.Table of Contentsconsumers use energy. For example, several states, including Wisconsin and Michigan, have adopted energy efficiency targets to reduce energy consumption. As part of our planning process, we estimate the impacts of changes in customer growth and general economic conditions, weather, and customer energy conservation efforts, but risks still remain. Any of these matters, as well as any regulatory delay in adjusting rates as a result of reduced sales from effective conservation measures or the adoption of new technologies, could adversely impact our results of operations and financial condition.We are actively involved with several significant capital projects, which are subject to a number of risks and uncertainties that could adversely affect project costs and completion of construction projects.Our business requires substantial capital expenditures for investments in, among other things, capital improvements to our electric generating facilities, electric and natural gas distribution infrastructure, natural gas storage, and other projects, including projects for environmental compliance. We also expect to continue constructing and investing in renewable energy generating facilities as part of the ESG Progress Plan, including repowering existing wind generation projects in our generation portfolio, and as part of our non-utility energy infrastructure segment. In addition, WBS continues to invest in technology and the development of software applications to support our utilities. Achieving the intended benefits of any large construction project is subject to many uncertainties, some of which we will have limited or no control over, that could adversely affect project costs and completion time. For example, the timing of Badger Hollow I was impacted by the COVID-19 pandemic. Additional risks include, but are not limited to, the ability to adhere to established budgets and time frames; the availability of labor or materials at estimated costs; the ability of contractors to perform under their contracts; strikes; adverse weather conditions; potential legal challenges; changes in applicable laws or regulations; the impact on global supply chains of pandemic health events; other governmental actions; continued public and policymaker support for such projects; and events in the global economy. In addition, certain of these projects require the approval of our regulators. If construction of commission-approved projects should materially and adversely deviate from the schedules, estimates, and projections on which the approval was based, our regulators may deem the additional capital costs as imprudent and disallow recovery of them through rates, and otherwise available PTCs and ITCs for renewable energy projects could be lost or lose value. To the extent that delays occur, costs become unrecoverable, tax credits are lost or lose value, or we (or third parties with whom we invest and/or partner) otherwise become unable to effectively manage and complete our (or their) capital projects, our results of operations, cash flows, and financial condition may be adversely affected.Our operations are subject to risks beyond our control, including but not limited to, cyber security intrusions, terrorist attacks, acts of war, or unauthorized access to personally identifiable information.We have been subject to attempted cyber attacks from time to time, but these attacks have not had a material impact on our system or business operations. Despite the implementation of security measures, all assets and systems are potentially vulnerable to disability, failures, or unauthorized access due to physical or cyber security intrusions caused by human error, vendor bugs, terrorist attacks, or other malicious acts. These threats could result in a full or partial disruption of our ability to generate, transmit, purchase, or distribute electricity or natural gas or cause environmental repercussions. If our assets or systems were to fail, be physically damaged, or be breached, and were not recovered in a timely manner, we may be unable to perform critical business functions, and data, including sensitive information, could be compromised. We operate in an industry that requires the use of sophisticated information technology systems and network infrastructure, which control an interconnected system of generation, distribution, and transmission systems shared with third parties. A successful physical or cyber security intrusion may occur despite our security measures or those that we require our vendors to take, which include compliance with reliability standards and critical infrastructure protection standards. Successful cyber security intrusions, including those targeting the electronic control systems used at our generating facilities and electric and natural gas transmission, distribution, and storage systems, could disrupt our operations and result in loss of service to customers. These intrusions may cause unplanned outages at our power plants, which may reduce our revenues or cause us to incur significant costs if we are required to operate our higher cost electric generators or purchase replacement power to satisfy our obligations, and could result in additional maintenance expenses. The risk of such intrusions may also increase our capital and operating costs as a result of having to implement increased security measures for protection of our information technology and infrastructure. Our continued efforts to integrate, consolidate, and streamline our operations have also resulted in increased reliance on current and recently completed projects for technology systems, including but not limited to, a customer information and billing system, 2020 Form 10-K27WEC Energy Group, Inc.Table of Contentsautomated meter reading systems, and other similar technological tools and initiatives. We implement procedures to protect our systems, but we cannot guarantee that the procedures we have implemented to protect against unauthorized access to secured data and systems are adequate to safeguard against all security breaches. The failure of any of these or other similarly important technologies, or our inability to support, update, expand, and/or integrate these technologies across our subsidiaries could materially and adversely impact our operations, diminish customer confidence and our reputation, materially increase the costs we incur to protect against these risks, and subject us to possible financial liability or increased regulation or litigation. Our business requires the collection and retention of personally identifiable information of our customers, shareholders, and employees, who expect that we will adequately protect such information. Security breaches may expose us to a risk of loss or misuse of confidential and proprietary information. A significant theft, loss, or fraudulent use of personally identifiable information may lead to potentially large costs to notify and protect the impacted persons, and/or could cause us to become subject to significant litigation, costs, liability, fines, or penalties, any of which could materially and adversely impact our results of operations as well as our reputation with customers, shareholders, and regulators, among others. In addition, we may be required to incur significant costs associated with governmental actions in response to such intrusions or to strengthen our information and electronic control systems. We may also need to obtain additional insurance coverage related to the threat of such intrusions.Any operational disruption or environmental repercussions caused by these on-going threats to our assets and technology systems could result in a significant decrease in our revenues or significant reconstruction or remediation costs, which could materially and adversely affect our results of operations, financial condition, and cash flows. The costs of repairing damage to our facilities, operational disruptions, protecting personally identifiable information, and notifying impacted persons, as well as related legal claims, may also not be recoverable in rates, may exceed the insurance limits on our insurance policies, or, in some cases, may not be covered by insurance. Advances in technology, and legislation or regulations supporting such technology, could make our electric generating facilities less competitive.Advances in new technologies that produce power or reduce power consumption are ongoing and include renewable energy technologies, customer-oriented generation, energy storage devices, and energy efficiency technologies. We generate power at central station power plants and utility-scale renewable generation facilities to achieve economies of scale and produce power at a competitive cost. There are distributed generation technologies that produce power, including fuel cells, microturbines, wind turbines, and solar cells, which have become more cost competitive than they were in the past. It is possible that legislation or regulations could be adopted supporting the use of these technologies. There is also a risk that advances in technology will continue to reduce the costs of these alternative methods of producing power to a level that is competitive with that of central station and utility-scale renewable power production. If these technologies become cost competitive and achieve economies of scale, our market share could be eroded, and the value of our generating facilities could be reduced. Advances in technology could also change the channels through which our electric customers purchase or use power, which could reduce our sales and revenues or increase our expenses.We transport, distribute, and store natural gas, which involves numerous risks that may result in accidents and other operating risks and costs.Inherent in natural gas distribution activities are a variety of hazards and operational risks, such as leaks, accidental explosions, and mechanical problems, which could materially and adversely affect our results of operations, financial condition, and cash flows. In addition, these risks could result in serious injury to employees and non-employees, loss of human life, significant damage to property, environmental pollution, impairment of operations, and substantial losses to us. The location of natural gas pipelines and storage facilities near populated areas, including residential areas, commercial business centers, and industrial sites, could increase the level of damages resulting from these risks. These activities may subject us to litigation and/or administrative proceedings from time to time, which could result in substantial monetary judgments, fines, or penalties against us, or be resolved on unfavorable terms.We face risks related to our non-utility renewable energy facilities that could impact our return on investment or have a negative impact on our financial condition or results of operations.The production of wind energy depends heavily on suitable wind conditions, which are variable. If wind conditions are unfavorable or below our estimates as a result of climate change or otherwise, our electricity production, and therefore our revenues and PTCs earned from our non-utility renewable energy facilities, may be substantially below our expectations. We base our decisions about which sites to acquire and operate in part on the findings of long-term wind and other meteorological data and studies conducted in 2020 Form 10-K28WEC Energy Group, Inc.Table of Contentsthe proposed area, which measure the wind’s speed and prevailing direction and seasonal variations. Actual conditions at these sites, however, may not conform to the measured data in these studies. For example, if there is an increase in frequency and severity of weather conditions, the disruptions to our sites may become more frequent and severe.For the majority of our non-utility renewable energy operations, we have entered into long-term PPAs with a small number of customers to purchase the energy produced by our facilities. Although initial agreements are often ten years or more, in the future we may not be able to replace expiring PPAs related to our non-utility renewable energy facilities with contracts on acceptable terms, including at prices that support operation of the facility on a profitable basis. Decreases in the retail prices of electricity supplied by traditional utilities or other clean energy sources in the areas where our non-utility renewable energy facilities are located could harm our ability to offer competitive pricing and could harm our ability to sign PPAs with customers. If we are unable to replace an expiring PPA with an acceptable new revenue contract, we may be required to sell the power produced by the facility at wholesale prices and be exposed to market fluctuations and risks, or the affected site may temporarily or permanently cease operations. If we are unable to replace an expired distributed generation PPA with an acceptable new contract, we may be required to remove the renewable energy facility from the site or, alternatively, we may have to sell the assets, but the sale price may not be sufficient to replace the revenue previously generated by the renewable energy facility. Our ability to acquire new non-utility renewable energy facilities or generate revenue from existing facilities depends on having interconnection arrangements with transmission providers and a reliable electricity grid. We cannot predict whether transmission facilities will be expanded in specific markets to accommodate or increase competitive access to those markets. In addition, if a transmission network to which one or more of our facilities is connected experiences down time for system emergencies, force majeure, safety, reliability, maintenance or other operational reasons, we may lose revenues and PTCs and be exposed to non-performance penalties and claims from our customers. This risk of curtailment of our non-utility renewable energy facilities may result in a reduced return on our investments, and we may not be compensated for lost energy and ancillary services. We are a holding company and rely on the earnings of our subsidiaries to meet our financial obligations.As a holding company with no operations of our own, our ability to meet our financial obligations including, but not limited to, debt service, taxes, and other expenses, as well as pay dividends on our common stock, is dependent upon the ability of our subsidiaries to pay amounts to us, whether through dividends or other payments. Our subsidiaries are separate legal entities that are not required to pay any of our obligations or to make any funds available for that purpose or for the payment of dividends on our common stock. The ability of our subsidiaries to pay amounts to us depends on their earnings, cash flows, capital requirements, and general financial condition, as well as regulatory limitations. Prior to distributing cash to us, our subsidiaries have financial obligations that must be satisfied, including, among others, debt service and preferred stock dividends. In addition, each subsidiary's ability to pay amounts to us depends on any statutory, regulatory, and/or contractual restrictions and limitations applicable to such subsidiary, which may include requirements to maintain specified levels of debt or equity ratios, working capital, or other assets. Our utility subsidiaries are regulated by various state utility commissions, which generally possess broad powers to ensure that the needs of the utility customers are being met.We may fail to attract and retain an appropriately qualified workforce. We operate in an industry that requires many of our employees to possess unique technical skill sets. Events such as an aging workforce without appropriate replacements, the mismatch of skill sets to future needs, or the unavailability of contract resources may lead to operating challenges or increased costs. These operating challenges include lack of resources, loss of knowledge, and a lengthy time period associated with skill development. In addition, current and prospective employees may determine that they do not wish to work for us. Failure to hire and obtain replacement employees, including the ability to transfer significant internal historical knowledge and expertise to the new employees, may adversely affect our ability to manage and operate our business. If we are unable to successfully attract and retain an appropriately qualified workforce, our results of operations could be adversely affected.Our counterparties may fail to meet their obligations, including obligations under power purchase, natural gas supply, natural gas pipeline capacity, and transportation agreements. We are exposed to the risk that counterparties to various arrangements who owe us money, electricity, natural gas, or other commodities or services will not be able to perform their obligations. Should the counterparties to these arrangements fail to perform or if capacity is inadequate, we may be required to replace the underlying commitment at current market prices or we may be unable to meet all of our customers' electric and natural gas requirements unless or until alternative supply arrangements are put in place. In such event, we may incur losses, and our results of operations, financial position, or liquidity could be adversely affected.2020 Form 10-K29WEC Energy Group, Inc.Table of ContentsWe have entered into several power purchase, natural gas supply, natural gas pipeline capacity, and transportation agreements with non-affiliated companies. Revenues are dependent on the continued performance by the counterparties of their obligations under these agreements. Although we have a comprehensive credit evaluation process and contractual protections, it is possible that one or more counterparties could fail to perform their obligations. If this were to occur, we generally would expect that any operating and other costs that were initially allocated to a defaulting customer's power purchase, natural gas supply, natural gas pipeline capacity, or transportation agreement would be reallocated among our retail customers. To the extent these costs are not allowed to be reallocated by our regulators or there is any regulatory delay in adjusting rates, a counterparty default under these agreements could have a negative impact on our results of operations and cash flows.Risks Related to Economic and Market VolatilityOur business is dependent on our ability to successfully access capital markets.We rely on access to credit and capital markets to support our capital requirements, including expenditures for our utility infrastructure and to comply with future regulatory requirements, to the extent not satisfied by the cash flow generated by our operations. We have historically secured funds from a variety of sources, including the issuance of short-term and long-term debt securities. Successful implementation of our long-term business strategies, including capital investment, is dependent upon our ability to access the capital markets, including the banking and commercial paper markets, on competitive terms and rates. In addition, we rely on committed bank credit agreements as back-up liquidity, which allows us to access the low cost commercial paper markets. Our or our subsidiaries' access to the credit and capital markets could be limited, or our or our subsidiaries' cost of capital significantly increased, due to any of the following risks and uncertainties:•A rating downgrade;•Failure to comply with debt covenants;•An economic downturn or uncertainty;•Prevailing market conditions and rules;•Concerns over foreign economic conditions;•Changes in tax policy;•Changes in investment criteria of institutional investors;•War or the threat of war;•The overall health and view of the utility and financial institution industries; and •Changes in the method of determining LIBOR or the replacement of LIBOR with an alternative reference rate.A portion of our indebtedness provides for interest at variable interest rates, primarily based on LIBOR. LIBOR is the subject of national, international, and other regulatory guidance and proposals for reform, which may cause LIBOR to cease to exist after June 2023 or to perform differently than in the past. While we expect that reasonable alternatives to LIBOR will be implemented prior to the 2023 target date, we cannot predict the consequences and timing of the development of alternative reference rates. The transition to alternative reference rates could include an increase in our interest expense.If any of these risks or uncertainties limit our access to the credit and capital markets or significantly increase our cost of capital, it could limit our ability to implement, or increase the costs of implementing, our business plan, which, in turn, could materially and adversely affect our results of operations, cash flows, and financial condition, and could limit our ability to sustain our current common stock dividend level. A downgrade in our or any of our subsidiaries' credit ratings could negatively affect our or our subsidiaries' ability to access capital at reasonable costs and/or require the posting of collateral.There are a number of factors that impact our and our subsidiaries' credit ratings, including, but not limited to, capital structure, regulatory environment, the ability to cover liquidity requirements, and other requirements for capital. We or any of our subsidiaries could experience a downgrade in ratings if the rating agencies determine that the level of business or financial risk of us, our utilities, or the utility industry has deteriorated. Changes in rating methodologies by the rating agencies could also have a negative impact on credit ratings. 2020 Form 10-K30WEC Energy Group, Inc.Table of ContentsAny downgrade by the rating agencies could: •Increase borrowing costs under certain existing credit facilities;•Require the payment of higher interest rates in future financings and possibly reduce the pool of creditors;•Decrease funding sources by limiting our or our subsidiaries' access to the commercial paper market; •Limit the availability of adequate credit support for our subsidiaries' operations; and•Trigger collateral requirements in various contracts.Fluctuating commodity prices could negatively impact our electric and natural gas utility operations.Our operating and liquidity requirements are impacted by changes in the forward and current market prices of natural gas, coal, electricity, renewable energy credits, and ancillary services. Our electric utilities burn natural gas in several of their electric generation plants and as a supplemental fuel at several coal-fired plants. In many instances the cost of purchased power is tied to the cost of natural gas. The cost of natural gas may increase because of disruptions in the supply of natural gas due to a curtailment in production or distribution, international market conditions, the demand for natural gas, and the availability of shale gas and potential regulations affecting its accessibility. For Wisconsin retail electric customers, our utilities bear the risk for the recovery of fuel and purchased power costs within a symmetrical 2% fuel tolerance band compared to the forecast of fuel and purchased power costs established in their respective rate structures. Prudently incurred fuel and purchased power costs are recovered dollar-for-dollar from our Michigan retail electric customers and our wholesale electric customers. Our natural gas utilities receive dollar-for-dollar recovery of prudently incurred natural gas costs from their natural gas customers. Changes in commodity prices could result in:•Higher working capital requirements, particularly related to natural gas inventory, accounts receivable, and cash collateral postings;•Reduced profitability to the extent that lower revenues, increased bad debt, and higher interest expense are not recovered through rates;•Higher rates charged to our customers, which could impact our competitive position; •Reduced demand for energy, which could impact revenues and operating expenses; and•Shutting down of generation facilities if the cost of generation exceeds the market price for electricity.We may not be able to obtain an adequate supply of coal, which could limit our ability to operate our coal-fired facilities.We own and operate several coal-fired electric generating units. Although we generally carry sufficient coal inventory at our generating facilities to protect against an interruption or decline in supply, there can be no assurance that the inventory levels will be adequate. While we have coal supply and transportation contracts in place, we cannot assure that the counterparties to these agreements will be able to fulfill their obligations to supply coal to us or that we will be able to take delivery of all the coal volume contracted for. If we are unable to obtain our coal requirements under our coal supply and transportation contracts, we may be required to purchase coal at higher prices or we may be forced to reduce generation at our coal-fired units, which could lead to increased fuel costs. The increase in fuel costs could result in either reduced margins on net sales into the MISO Energy Markets, a reduction in the volume of net sales into the MISO Energy Markets, and/or an increase in net power purchases in the MISO Energy Markets. There is no guarantee that we would be able to fully recover any increased costs in rates or that recovery would not otherwise be delayed, either of which could adversely affect our results of operations and cash flows.Our use of derivative contracts could result in financial losses.We use derivative instruments such as swaps, options, futures, and forwards to manage commodity price exposure. We could recognize financial losses as a result of volatility in the market value of these contracts or if a counterparty fails to perform. These risks are managed through risk management policies, which might not work as planned and cannot entirely eliminate the risks associated with these activities. In addition, although the hedging programs of our utilities must be approved by the various state commissions, derivative contracts entered into for hedging purposes might not offset the underlying exposure being hedged as expected, resulting in financial losses. In the absence of actively quoted market prices and pricing information from external sources, the value of these financial instruments can involve management's judgment or use of estimates. Changes in the underlying assumptions or use of alternative valuation methods could affect the reported fair value of these contracts.2020 Form 10-K31WEC Energy Group, Inc.Table of ContentsRestructuring in the regulated energy industry and competition in the retail and wholesale markets could have a negative impact on our business and revenues.The regulated energy industry continues to experience significant structural changes. Deregulation or other changes in law in the states where we serve our customers could allow third-party suppliers to contract directly with customers for their natural gas and electric supply requirements. This increased competition in the retail and wholesale markets could have a material adverse financial impact on us. Certain jurisdictions in which we operate, including Michigan and Illinois, have adopted retail choice. Under Michigan law, our retail customers may choose an alternative electric supplier to provide power supply service. The law limits customer choice to 10% of our Michigan retail load. The iron ore mine located in the Upper Peninsula of Michigan is excluded from this cap. When a customer switches to an alternative electric supplier, we continue to provide distribution and customer service functions for the customer. Although Illinois has adopted retail choice, there is currently little or no impact on the net income of our Illinois utilities as they still earn a distribution charge for transporting the natural gas for these customers. It is uncertain whether retail choice might be implemented in Wisconsin or Minnesota.The FERC continues to support the existing RTOs that affect the structure of the wholesale market within these RTOs. In connection with its status as a FERC-approved RTO, MISO implemented bid-based energy markets that are part of the MISO Energy Markets. All market participants, including us, must submit day-ahead and/or real-time bids and offers for energy at locations across the MISO region. MISO then calculates the most efficient solution for all of the bids and offers made into the market that day and establishes an LMP that reflects the market price for energy. We are required to follow MISO's instructions when dispatching generating units to support MISO's responsibility for maintaining the stability of the transmission system. MISO also implemented an ancillary services market for operating reserves that schedules energy and ancillary services at the same time as part of the energy market, allowing for more efficient use of generation assets in the MISO Energy Markets. These market designs continue to have the potential to increase the costs of transmission, the costs associated with inefficient generation dispatching, the costs of participation in the MISO Energy Markets, and the costs associated with estimated payment settlements.The FERC rules related to transmission are designed to facilitate competition in the wholesale electricity markets among regulated utilities, non-utility generators, wholesale power marketers, and brokers by providing greater flexibility and more choices to wholesale customers, including initiatives designed to encourage the integration of renewable sources of supply. In addition, along with transactions contemplating physical delivery of energy, financial laws and regulations impact hedging and trading based on futures contracts and derivatives that are traded on various commodities exchanges, as well as over-the-counter. Technology changes in the power and fuel industries also have significant impacts on wholesale transactions and related costs. We currently cannot predict the impact of these and other developments or the effect of changes in levels of wholesale supply and demand, which are driven by factors beyond our control.We may experience poor investment performance of benefit plan holdings due to changes in assumptions and market conditions.We have significant obligations related to pension and OPEB plans. If we are unable to successfully manage our benefit plan assets and medical costs, our cash flows, financial condition, or results of operations could be adversely impacted. Our cost of providing these plans is dependent upon a number of factors, including actual plan experience, changes made to the plans, and assumptions concerning the future. Types of assumptions include earnings on plan assets, discount rates, the level of interest rates used to measure the required minimum funding levels of the plans, future government regulation, estimated withdrawals by retirees, and our required or voluntary contributions to the plans. Plan assets are subject to market fluctuations and may yield returns that fall below projected return rates. In addition, medical costs for both active and retired employees may increase at a rate that is significantly higher than we currently anticipate. Our funding requirements could be impacted by a decline in the market value of plan assets, changes in interest rates, changes in demographics (including the number of retirements), or changes in life expectancy assumptions. In addition, we maintain rabbi trusts to fund our deferred compensation plans, which from time to time, hold equity and debt investments that are subject to market fluctuations. Decreases in investment performance of these assets could materially adversely affect our results of operations, cash flows, and financial condition.2020 Form 10-K32WEC Energy Group, Inc.Table of ContentsGeneral RisksWe may fail to maintain effective internal controls in accordance with Section 404 of the Sarbanes-Oxley Act.We are subject to reporting, disclosure control, and other obligations under SOX. SOX contains provisions requiring our management to report on the effectiveness of our internal control over financial reporting and requires our independent registered public accounting firm to attest to the effectiveness of our internal controls. We have undertaken, and will continue to undertake, a variety of initiatives to integrate, standardize, centralize, and streamline our operations with technology, including, but not limited to, the implementation of several different ERP systems. There is a risk that we will not be able to conclude that our internal control over financial reporting is effective because of the discovery of material weaknesses, with either our current controls and processes or with the implementation of new controls and processes around these new technologies. Any failure to maintain effective internal controls or a determination by our independent registered public accounting firm that we have a material weakness in our internal controls could cause investors to lose confidence in the accuracy or completeness of our financial reports, cause a decline in the market price of our common stock, restrict our access to the capital markets, or subject us to investigations by the SEC or other regulatory authorities. We have recorded goodwill that could become impaired.We assess goodwill for impairment on an annual basis or whenever events or circumstances occur that indicate a potential for impairment. If goodwill is deemed to be impaired, we may be required to incur non-cash charges that could materially adversely affect our results of operations. At December 31, 2020, our goodwill was $3,052.8 million.We may be unable to obtain insurance on acceptable terms or at all, and the insurance coverage we do obtain may not provide protection against all significant losses.Our ability to obtain insurance, as well as the cost and coverage of such insurance, could be affected by developments affecting our business; international, national, state, or local events; and the financial condition of insurers and our contractors that are required to acquire and maintain insurance for our benefit. Insurance coverage may not continue to be available at all or at rates or terms similar to those presently available to us. In addition, our insurance may not be sufficient or effective under all circumstances and against all hazards or liabilities to which we may be subject. Any losses for which we are not fully insured or that are not covered by insurance at all could materially adversely affect our results of operations, cash flows, and financial position.ITEM 1B. UNRESOLVED STAFF COMMENTSNone.2020 Form 10-K33WEC Energy Group, Inc.Table of ContentsITEM 2. PROPERTIESWe own our principal properties outright. However, the major portion of our electric utility distribution lines, steam utility distribution mains, and natural gas utility distribution mains and services are located on or under streets and highways, on land owned by others, and are generally subject to granted easements, consents, or permits.A. REGULATEDElectric FacilitiesThe following table summarizes information on our electric generation facilities, including owned and jointly owned facilities, as of December 31, 2020: NameLocationFuelNumber of Generating UnitsCapacity In MW (1)Coal-fired plantsColumbiaPortage, WICoal2 311 (2)ERGSOak Creek, WICoal2 1,059 (3) (4)OCPPOak Creek, WICoal4 1,076 WestonRothschild, WICoal2 719 (2)Total coal-fired plants10 3,165 Natural gas-fired plantsConcordWatertown, WINatural Gas/Oil4 362 De Pere Energy CenterDe Pere, WINatural Gas/Oil1 166 Fox Energy CenterWrightstown, WINatural Gas3 574 GermantownGermantown, WINatural Gas/Oil5 268 F. D. KuesterNegaunee, MINatural Gas7 128 A. J. MihmBaraga, MINatural Gas3 55 ParisUnion Grove, WINatural Gas/Oil4 364 PWGSPort Washington, WINatural Gas2 1,228 (4)PulliamGreen Bay, WINatural Gas/Oil1 81 VAPPMilwaukee, WINatural Gas2 268 West MarinetteMarinette, WINatural Gas/Oil3 149 WestonRothschild, WINatural Gas/Oil3 115 Total natural gas-fired plants38 3,758 RenewablesHydro plants (30 in number)WI and MIHydro81 100 (5) (6)Rothschild Biomass PlantRothschild, WIBiomass1 45 (7)Two CreeksWISolar48 100 (2)Wind sites (5 in number)WI and IAWind350 498 (2)Total renewables480 743 Total system528 7,666 (1) Capacity for our electric generation facilities, other than wind and solar generating facilities, is based on rated capacity, which is the net power output under average operating conditions with equipment in an average state of repair as of a given month in a given year. Values are primarily based on the net dependable expected capacity ratings for summer 2021 established by tests and may change slightly from year to year. The summer period is the most relevant for capacity planning purposes. This is a result of continually reaching demand peaks in the summer months, primarily due to air conditioning demand. Capacity for wind generating facilities is based on nameplate capacity, which is the amount of energy a turbine should produce at optimal wind speeds. Capacity for solar generating facilities is based on nameplate capacity, which is the maximum output that a generator should produce at continuous full power.(2) These facilities are jointly owned by WPS and various other utilities. The capacity indicated for each of these units is equal to WPS's portion of total plant capacity based on its percent of ownership.•Wisconsin Power and Light Company, an unaffiliated utility, operates the Columbia units. WPS holds a 27.5% ownership interest in Columbia. 2020 Form 10-K34WEC Energy Group, Inc.Table of Contents•WPS operates the Weston 4 facility and holds a 70.0% ownership interest in this facility. Dairyland Power Cooperative, an unaffiliated energy cooperative, holds the remaining 30.0% interest.•Two Creeks is jointly owned by WPS and an unaffiliated utility. WPS holds a 66.7% ownership interest in this facility. •WPS, along with two other unaffiliated utilities, owns Forward Wind Energy Center. WPS holds a 44.6% ownership interest in this facility and the unaffiliated utilities own the remaining 55.4%. See Note 2, Acquisitions, for more information on the Forward Wind Energy Center acquisition.(3) This facility is jointly owned by We Power and two other unaffiliated entities. Our share of capacity is equal to We Power's ownership interest of 83.34%.(4) These facilities are part of the Company's non-utility energy infrastructure segment. See B. Non-Utility Energy Infrastructure Segment below.(5) All of our hydroelectric facilities follow FERC guidelines and/or regulations. (6) WRPC owns and operates the Castle Rock and Petenwell units. WPS holds a 50.0% ownership interest in WRPC and is entitled to 50.0% of the total capacity at Castle Rock and Petenwell. WPS's share of capacity for Castle Rock and Petenwell is 7.0 MW and 10.3 MW, respectively.(7) WE has a biomass power plant that uses wood waste and wood shavings to produce electric power as well as steam to support the paper mill's operations. Fuel for the power plant is supplied by both the paper mill and through contracts with biomass suppliers. The plant also has the ability to burn natural gas if wood waste and wood shavings are not available. As of December 31, 2020, we operated approximately 36,100 miles of overhead distribution lines and approximately 34,900 miles of underground distribution cable, as well as approximately 450 electric distribution substations and approximately 507,900 line transformers.Natural Gas FacilitiesAt December 31, 2020, our natural gas properties were located in Illinois, Wisconsin, Minnesota, and Michigan, and consisted of the following:•Approximately 50,300 miles of natural gas distribution mains,•Approximately 1,100 miles of natural gas transmission mains,•Approximately 2.3 million natural gas lateral services,•Approximately 500 natural gas distribution and transmission gate stations,•Approximately 68.2 Bcf of working gas capacities in underground natural gas storage fields:◦Bluewater, 26.5 Bcf of fields located in southeastern Michigan,◦Manlove, a 38.8 Bcf field located in central Illinois,◦Partello, a 2.9 Bcf field located in southern Michigan,•A 2.0 Bcf LNG plant located in central Illinois,•A peak-shaving facility that can store the equivalent of approximately 80 MDth in liquefied petroleum gas located in Illinois,•Peak propane air systems providing approximately 2,960 Dth per day, and•LNG storage plants with a total send-out capability of 73,600 Dth per day.Our natural gas distribution and gas storage systems included distribution mains and transmission mains connected to the pipeline transmission systems of Alliance Pipeline, ANR Pipeline Company, Centra Pipelines, Consumers Energy, Enbridge Gas, Great Lakes Transmission Company, Guardian Pipeline L.L.C., Kinder Morgan Illinois Pipeline, Michigan Consolidated Gas Company, Midwestern Gas Pipeline Company, Natural Gas Pipeline Company of America, Nicor Gas, Northern Border Pipeline Company, Northern Natural Gas Company, Panhandle Gas Transmission, Trunkline Gas Pipeline, Vector Pipeline Company, and Viking Gas Transmission. Our LNG storage plants convert and store, in liquefied form, natural gas received during periods of low consumption.We also own office buildings, natural gas regulating and metering stations, and major service centers, including garage and warehouse facilities, in certain communities we serve. Where distribution lines and services and natural gas distribution mains and services occupy private property, we have in some, but not all instances, obtained consents, permits, or easements for these installations from the apparent owners or those in possession of those properties, generally without an examination of ownership records or title.2020 Form 10-K35WEC Energy Group, Inc.Table of ContentsSteam FacilitiesAs of December 31, 2020, the steam system supplied by the VAPP consisted of approximately 40 miles of both high pressure and low pressure steam piping, approximately four miles of walkable tunnels, and other pressure regulating equipment.GeneralSubstantially all of PGL's and NSG's properties are subject to the lien of the respective company's mortgage indenture for the benefit of bondholders.B. NON-UTILITY ENERGY INFRASTRUCTURE SEGMENTThe non-utility energy infrastructure segment includes We Power, Bluewater, and WECI. We Power and Bluewater are considered non-utility energy infrastructure operations, however, their facilities are shown in the regulated section. We Power owns and leases generating facilities to WE. We Power's share of the ERGS units and both PWGS units are being leased to WE under long-term leases. Bluewater provides natural gas storage and hub services primarily to WE, WPS, and WG, and also provides these same services to several unaffiliated companies. WECI has ownership interests in five wind generating facilities.The following table summarizes information on WECI's wind generating facilities as of December 31, 2020:NameLocationNumber of Generating UnitsNameplate Capacity In MW (1)Wind generating facilitiesUpstreamAntelope County, Nebraska81 202.5 (2)Bishop Hill IIIHenry County, Illinois53 132.1 (3)Coyote RidgeBrookings County, South Dakota39 96.7 (4)Blooming GroveMcLean County, Illinois94 250.0 (5)Tatanka RidgeDeuel County, South Dakota56 155.0 (6)Total wind generating facilities323 836.3 (1) Nameplate capacity is the amount of energy a turbine should produce at optimal wind speeds.(2) In January 2019, WECI completed the acquisition of an 80% ownership interest in Upstream. In February 2020, WECI agreed to acquire an additional 10% ownership interest in this wind park. See Note 2, Acquisitions, for more information.(3) In August 2018, WECI completed the acquisition of an 80% ownership interest in Bishop Hill III. In December 2018, WECI acquired an additional 10% ownership interest in this wind park. See Note 2, Acquisitions, for more information.(4) In December 2018, WECI completed the acquisition of an 80% ownership interest in Coyote Ridge. See Note 2, Acquisitions, for more information.(5) In December 2020, WECI completed the acquisition of a 90% ownership interest in Blooming Grove. See Note 2, Acquisitions, for more information.(6) In December 2020, WECI completed the acquisition of an 85% ownership interest in Tatanka Ridge, which achieved commercial operation on January 5, 2021. See Note 2, Acquisitions, for more information.In August 2019, WECI signed an agreement to acquire an 80% ownership interest in Thunderhead, a 300 MW wind generating facility under construction in Antelope and Wheeler counties in Nebraska. In February 2020, WECI agreed to acquire an additional 10% ownership interest in this wind park. See Note 2, Acquisitions, for more information.ITEM 3. LEGAL PROCEEDINGSThe following should be read in conjunction with Note 24, Commitments and Contingencies, and Note 26, Regulatory Environment, in this report for additional information on material legal proceedings and matters related to us and our subsidiaries. In addition to those legal proceedings discussed in Note 24, Commitments and Contingencies, Note 26, Regulatory Environment, and below, we are currently, and from time to time, subject to claims and suits arising in the ordinary course of business. Although the 2020 Form 10-K36WEC Energy Group, Inc.Table of Contentsresults of these additional legal proceedings cannot be predicted with certainty, management believes, after consultation with legal counsel, that the ultimate resolution of these proceedings will not have a material effect on our financial statements.Environmental MattersManlove Field Matter In September 2017, the IDNR, Office of Oil and Gas Resource Management, issued a VN to PGL related to a leak of natural gas from a well located at the PGL Manlove Gas Storage Field in December 2016. PGL quickly shut down and permanently plugged the well to contain the leak after it was discovered. The leak resulted in the migration of natural gas from the well to the Mahomet Aquifer located in central Illinois and impacted residential freshwater wells. PGL has been working with residents potentially impacted by the natural gas leak, and the Illinois state agencies to investigate and remediate the impacts of the natural gas leak to the Mahomet Aquifer. In October 2017, the Illinois AG filed a complaint against PGL alleging certain violations of the Illinois Environmental Protection Act and the Oil and Gas Act. PGL entered into an Agreed Interim Order with the State of Illinois in October 2017 and a First Amended Agreed Interim Order in September 2019 whereby PGL agreed, among other things, to continue actions it was already undertaking proactively, including the submittal of a GMZ application to the IEPA in August 2019. A supplemental filing was sent to the IEPA in December 2019. Proposed modifications to the GMZ application were submitted to the Illinois AG and the IEPA in May 2020. In September 2020, the IEPA sent PGL a letter conditionally approving the GMZ application.In addition, in December 2017, the IEPA issued a VN to PGL alleging the same violations as the AG. Lastly, in January 2018, the IEPA issued a VN alleging certain violations of Illinois air emission rules arising from the construction and operation of flaring equipment at the leak site. Both of the IEPA VN matters have been referred to the AG for enforcement.In the complaint, as is customary in these types of actions, the AG cited to the statutory penalties allowed by law. Ultimately, the pursuit of any civil penalties is at the AG’s discretion. In the event the AG pursues penalties in connection with a final order, we believe that PGL's high level of cooperation and quick action to remedy the situation and to work with the potentially impacted homeowners would be taken into account. At this time, we believe that civil penalties, if any, will not have a material impact on our financial statements.ITEM 4. MINE SAFETY DISCLOSURESNot applicable.2020 Form 10-K37WEC Energy Group, Inc.Table of ContentsINFORMATION ABOUT OUR EXECUTIVE OFFICERSThe names, ages, and positions of our executive officers are listed below along with their business experience during the past five years. All officers are appointed until they resign, die, or are removed pursuant to our Bylaws. There are no family relationships among these officers, nor is there any agreement or understanding between any officer and any other person pursuant to which the officer was selected.Gale E. Klappa. Age 70.•WEC Energy Group — Executive Chairman since February 2019. Chairman of the Board and Chief Executive Officer from October 2017 to February 2019, and from May 2004 to May 2016. Non-Executive Chairman of the Board from May 2016 to October 2017. President from April 2003 to August 2013. Director since December 2003.•WE — Director since January 2018, and from December 2003 to May 2016. Chairman of the Board from January 2018 to February 2019, and from May 2004 to May 2016. Chief Executive Officer from January 2018 to February 2019, and from August 2003 to May 2016. President from April 2003 to June 2015.J. Kevin Fletcher. Age 62.•WEC Energy Group — Director and Chief Executive Officer since February 2019. President since October 2018.•WE — Chairman of the Board and Chief Executive Officer since February 2019. Director since June 2015. President from May 2016 to November 2018. Executive Vice President - Customer Service and Operations from June 2015 to April 2016.Robert M. Garvin. Age 54.•WEC Energy Group — Executive Vice President - External Affairs since June 2015.•WE — Executive Vice President - External Affairs since June 2015.William J. Guc. Age 51.•WEC Energy Group — Controller since October 2015. Vice President since June 2015.•WE — Vice President and Controller since October 2015.Margaret C. Kelsey. Age 56.•WEC Energy Group — Executive Vice President, Corporate Secretary and General Counsel since January 2018. Executive Vice President from September 2017 to January 2018.•WE — Executive Vice President, Corporate Secretary and General Counsel since January 2018. Director since January 2018.•Modine Manufacturing Company – General Counsel, Corporate Secretary, and Vice President - Legal from April 2008 to August 2017. Vice President - Corporate Communications from April 2014 to August 2017. Modine Manufacturing Company is a manufacturer of thermal management systems and components.Daniel P. Krueger. Age 55.•WEC Energy Group — Executive Vice President - WEC Infrastructure since January 2019. Executive Vice President from November 2018 to January 2019.•WE — Senior Vice President - Wholesale Energy and Fuels from June 2015 to November 2018.Scott J. Lauber. Age 55.•WEC Energy Group — Senior Executive Vice President and Chief Operating Officer since June 2020. Senior Executive Vice President and Chief Financial Officer from October 2019 to June 2020. Senior Executive Vice President, Chief Financial Officer and Treasurer from February 2019 to October 2019. Executive Vice President, Chief Financial Officer and Treasurer from October 2018 to February 2019. Executive Vice President and Chief Financial Officer from April 2016 to October 2018. Vice President and Treasurer from February 2013 to March 2016. •WE — Executive Vice President since June 2020. Executive Vice President and Chief Financial Officer from October 2019 to June 2020, and from April 2016 to October 2018. Executive Vice President, Chief Financial Officer and Treasurer from October 2018 to October 2019. Vice President and Treasurer from February 2013 to March 2016. Director since April 2016.Xia Liu. Age 51.•WEC Energy Group — Executive Vice President and Chief Financial Officer since June 2020.•WE — Executive Vice President and Chief Financial Officer since June 2020. Director since June 2020.2020 Form 10-K38WEC Energy Group, Inc.Table of Contents•CenterPoint Energy, Inc. — Senior Advisor from April 2020 to May 2020. Executive Vice President and Chief Financial Officer from April 2019 to April 2020. CenterPoint Energy, Inc. is a public utility holding company whose operating subsidiaries provide electric and natural gas service to customers in parts of the South and Midwest.•Georgia Power Company — Executive Vice President, Chief Financial Officer and Treasurer from October 2017 to April 2019. Georgia Power Company is a utility subsidiary of The Southern Company that provides electric service to customers throughout Georgia.•Gulf Power Company — Vice President, Chief Financial Officer and Treasurer from July 2015 to October 2017. Gulf Power Company, previously a utility subsidiary of The Southern Company, serves customers in northwest Florida.Charles R. Matthews. Age 64.•PELLC — President since June 2015.•PGL — Director, President, and Chief Executive Officer since June 2015.•NSG — Director, President, and Chief Executive Officer since June 2015.Tom Metcalfe. Age 53.•WE — President since November 2018. Executive Vice President - Generation from April 2016 to November 2018. Senior Vice President - Power Generation from January 2014 to March 2016. Director since January 2018.Anthony L. Reese. Age 39.•WEC Energy Group — Vice President and Treasurer since October 2019.•WE — Vice President and Treasurer since October 2019.•Controller - Illinois from September 2015 to September 2019.Mary Beth Straka. Age 56.•WEC Energy Group — Senior Vice President - Corporate Communications and Investor Relations since June 2015.Certain executive officers also hold officer and/or director positions at WEC Energy Group's other significant subsidiaries.2020 Form 10-K39WEC Energy Group, Inc.Table of ContentsPART IIITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIESNumber of Common ShareholdersAs of January 31, 2021, based upon the number of WEC Energy Group shareholder accounts (including accounts in our stock purchase and dividend reinvestment plan), we had approximately 42,000 registered shareholders.Common Stock Listing and TradingOur common stock is listed on the New York Stock Exchange under the ticker symbol "WEC."Common Stock Dividends of WEC Energy GroupWe review our dividend policy on a regular basis. Subject to any regulatory restrictions or other limitations on the payment of dividends, future dividends will be at the discretion of the Board of Directors and will depend upon, among other factors, earnings, financial condition, and other requirements. For more information on our dividends, including restrictions on the ability of our subsidiaries to pay us dividends, see Note 11, Common Equity. ITEM 6. SELECTED FINANCIAL DATA WEC ENERGY GROUP, INC.COMPARATIVE FINANCIAL DATA AND OTHER STATISTICSAs of or for Year Ended December 31(in millions, except per share information)2020201920182017 (1)2016Operating revenues$7,241.7 $7,523.1 $7,679.5 $7,648.5 $7,472.3 Net income attributed to common shareholders1,199.9 1,134.0 1,059.3 1,203.7 939.0 Total assets37,028.1 34,951.8 33,475.8 31,590.5 30,123.2 Preferred stock of subsidiary30.4 30.4 30.4 30.4 30.4 Long-term debt (excluding current portion)11,728.1 11,211.0 9,994.0 8,746.6 9,158.2 Weighted average common shares outstandingBasic315.4 315.4 315.5 315.6 315.6 Diluted316.5 316.7 316.9 317.2 316.9 Earnings per shareBasic$3.80 $3.60 $3.36 $3.81 $2.98 Diluted$3.79 $3.58 $3.34 $3.79 $2.96 Dividends per share of common stock$2.53 $2.36 $2.21 $2.08 $1.98 (1) Includes a $206.7 million increase in net income attributed to common shareholders related to a re-measurement of our deferred taxes as a result of the Tax Legislation.2020 Form 10-K40WEC Energy Group, Inc.Table of ContentsITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSCORPORATE DEVELOPMENTSIntroductionWe are a diversified holding company with natural gas and electric utility operations (serving customers in Wisconsin, Illinois, Michigan, and Minnesota), an approximately 60% equity ownership interest in American Transmission Company LLC (ATC) (a for-profit electric transmission company regulated by the FERC and certain state regulatory commissions), and non-utility energy infrastructure operations through We Power (which owns generation assets in Wisconsin), Bluewater (which owns underground natural gas storage facilities in Michigan), and WEC Infrastructure LLC (WECI), which holds ownership interests in several wind generating facilities.Corporate StrategyOur goal is to continue to build and sustain long-term value for our shareholders and customers by focusing on the fundamentals of our business: environmental stewardship; reliability; operating efficiency; financial discipline; exceptional customer care; and safety. Our 2021-2025 capital investment plan for efficiency, sustainability and growth, referred to as our ESG Progress Plan, provides a roadmap for us to achieve this goal. It is an aggressive plan to cut emissions, maintain superior reliability, deliver significant savings for customers, and grow our investment in the future of energy.Throughout our strategic planning process, we take into account important developments, risks and opportunities, including new technologies, customer preferences and commodity prices, energy resiliency efforts, and sustainability. We published the results of a priority sustainability issue assessment in 2020, identifying the issues that are most important to our company and its stakeholders over the short and long terms. Our risk and priority assessments have formed our direction as a company.Creating a Sustainable FutureOur ESG Progress Plan includes the retirement of older, fossil-fueled generation, to be replaced with the construction of zero-carbon-emitting renewable generation and clean natural gas-fired generation. When taken together, the retirements and new investments should better balance our supply with our demand, while maintaining reliable, affordable energy for our customers. The retirements will contribute to meeting our goals to reduce carbon dioxide (CO2) emissions from our electric generation.In 2019, we met and surpassed our original goal to reduce CO2 emissions by 40% below 2005 levels. In July 2020, we announced new goals to reduce CO2 emissions from our electric generation by 70% below 2005 levels by 2030 and to be net carbon neutral by 2050. We added a near-term goal in November 2020 to reduce CO2 emissions by 55% below 2005 levels by 2025.We already have retired more than 1,800 megawatts (MW) of coal-fired generation since the beginning of 2018, which included the 2019 retirement of the Presque Isle power plant as well as the 2018 retirements of the Pleasant Prairie power plant, the Pulliam power plant, and the jointly-owned Edgewater Unit 4 generating units. See Note 6, Regulatory Assets and Liabilities, for more information related to these power plant retirements. As part of our ESG Progress Plan, we expect to retire approximately 1,800 MW of additional fossil-fueled generation by 2025.In addition to retiring these older, fossil-fueled plants, we expect to invest approximately $2 billion from 2021-2025 in low-cost renewable energy in Wisconsin. Our plan is to replace a portion of the retired capacity by building and owning a combination of clean, natural gas-fired generation and zero-carbon-emitting renewable generation facilities that are anticipated to include the following new investments:•800 MW of utility-scale solar;•600 MW of battery storage;•100 MW of wind; •100 MW of reciprocating internal combustion engine (RICE) natural gas-fueled generation; and•the planned purchase of 200 MW of capacity in the West Riverside Energy Center – a new, combined-cycle natural gas plant recently completed by Alliant Energy in Wisconsin.These new investments discussed above are in addition to the renewable projects currently underway.2020 Form 10-K41WEC Energy Group, Inc.Table of ContentsWe have received approval to invest in 300 MW of utility-scale solar within our Wisconsin segment. Wisconsin Public Service Corporation (WPS) has partnered with an unaffiliated utility to construct two solar projects in Wisconsin: Two Creeks Solar Park, now in service, and Badger Hollow Solar Park I, targeted for completion in the second quarter of 2021. WPS owns 100 MW of Two Creeks and will own 100 MW of Badger Hollow I for a total of 200 MW. Wisconsin Electric Power Company (WE) has partnered with an unaffiliated utility to construct Badger Hollow Solar Park II that is expected to enter commercial operation in December 2022. Once constructed, WE will own 100 MW of this project.In December 2018, WE received approval from the Public Service Commission of Wisconsin (PSCW) for two renewable energy pilot programs. The Solar Now pilot is expected to add 35 MW of solar generation to WE's portfolio, allowing non-profit and governmental entities, as well as commercial and industrial customers to site utility owned solar arrays on their property. Under this program, WE has energized 13 Solar Now projects and currently has another five under construction, together totaling more than 15 MW. The second program, the Dedicated Renewable Energy Resource pilot, would allow large commercial and industrial customers to access renewable resources that WE would operate, adding up to 150 MW of renewables to WE's portfolio, and helping these larger customers meet their sustainability and renewable energy goals.We also have a goal to decrease the rate of methane emissions from the natural gas distribution lines in our networks by 30% per mile by the year 2030 from a 2011 baseline. We were over halfway toward meeting that goal at the end of 2019.ReliabilityWe have made significant reliability-related investments in recent years, and in accordance with our ESG Progress Plan, expect to continue strengthening and modernizing our generation fleet and distribution networks to further improve reliability. Our investments, coupled with our commitment to operating efficiency and customer care, resulted in We Energies being recognized in 2020 by PA Consulting Group, an independent consulting firm, for superior reliability of its electric delivery network. This was the 10th consecutive year that We Energies has been named the most reliable utility in the Midwest.Below are a few examples of reliability projects that are proposed or currently underway.•WE is constructing approximately 46 miles of natural gas transmission main to increase the quantity and reliability of natural gas service in southeastern Wisconsin. This project, called the Lakeshore Lateral Project, is expected to be completed by the end of 2021.•WE and Wisconsin Gas LLC (WG) each plan to construct their own liquefied natural gas (LNG) facility to meet anticipated peak demand. Subject to PSCW approval, commercial operation of the LNG facilities is targeted for the end of 2023.•The Peoples Gas Light and Coke Company continues to work on its Natural Gas System Modernization Program, which primarily involves replacing old iron pipes and facilities in Chicago’s natural gas delivery system with modern polyethylene pipes to reinforce the long-term safety and reliability of the system.•WPS continues work on its System Modernization and Reliability Project, which involves modernizing parts of its electric distribution system, including burying or upgrading lines. WE, WPS, and WG also continue to upgrade their electric and natural gas distribution systems to enhance reliability.For more details, see Liquidity and Capital Resources – Capital Resources and Requirements – Capital Requirements – Significant Capital Projects.Operating EfficiencyWe continually look for ways to optimize the operating efficiency of our company and will continue to do so under the ESG Progress Plan. For example, we are making progress on our Advanced Metering Infrastructure program, replacing aging meter-reading equipment on both our network and customer property. An integrated system of smart meters, communication networks, and data management programs enables two-way communication between our utilities and our customers. This program reduces the manual effort for disconnects and reconnects and enhances outage management capabilities.2020 Form 10-K42WEC Energy Group, Inc.Table of ContentsWe continue to focus on integrating the resources of all our businesses and finding the best and most efficient processes while meeting all applicable legal and regulatory requirements.Financial DisciplineA strong adherence to financial discipline is essential to meeting our earnings projections and maintaining a strong balance sheet, stable cash flows, a growing dividend, and quality credit ratings.We follow an asset management strategy that focuses on investing in and acquiring assets consistent with our strategic plans, as well as disposing of assets, including property, plants, equipment, and entire business units, that are no longer strategic to operations, are not performing as intended, or have an unacceptable risk profile. See Note 3, Dispositions, for information on the sale of certain WPS Power Development, LLC solar power generation facilities.Our investment focus remains in our regulated utility and non-utility energy infrastructure businesses, as well as our investment in ATC. In our non-utility energy infrastructure segment, we have acquired or agreed to acquire majority interests in six wind parks, capable of providing more than 1,000 MW of carbon-free energy in total. These renewable energy assets represent more than $1.6 billion in committed investments and have long-term agreements to serve customers outside our traditional service areas. Production tax credits from these wind investments reduce our cash tax expense. We also project that these investments will generate higher returns than our regulated business. See Note 2, Acquisitions, for additional information on these transactions.We expect total capital expenditures for our regulated utility and non-utility energy infrastructure businesses to be approximately $15.0 billion from 2021 to 2025. In addition, we currently forecast that our share of ATC's projected capital expenditures over the next five years will be $1.1 billion. Specific projects included in the $16.1 billion ESG Progress Plan are discussed in more detail below under Liquidity and Capital Resources.Exceptional Customer CareOur approach is driven by an intense focus on delivering exceptional customer care every day. We strive to provide the best value for our customers by demonstrating personal responsibility for results, leveraging our capabilities and expertise, and using creative solutions to meet or exceed our customers’ expectations.A multiyear effort is driving a standardized, seamless approach to digital customer service across our companies. We have moved all utilities to a common platform for all customer-facing self-service options. Using common systems and processes reduces costs, provides greater flexibility and enhances the consistent delivery of exceptional service to customers.SafetyAcross the organization, we monitor the integrity of our networks and conduct comprehensive incident response planning to enhance the safety of our operations.Under our "Target Zero" mission, we have an ultimate goal of zero incidents, accidents, and injuries. We also set goals around injury-prevention activities that raise awareness and facilitate conversations about employee safety. Our corporate safety program provides a forum for addressing employee concerns, training employees and contractors on current safety standards, and recognizing those who demonstrate a safety focus.2020 Form 10-K43WEC Energy Group, Inc.RESULTS OF OPERATIONSConsolidated EarningsThe following table compares our consolidated results, including favorable or better, "B", and unfavorable or worse, "W", variances:Year Ended December 312020 vs. 20192019 vs. 2018(in millions, except per share data)202020192018B (W)B (W)Wisconsin$690.4 $649.9 $617.0 $40.5 $32.9 Illinois203.5 170.3 147.1 33.2 23.2 Other states 39.0 43.2 44.1 (4.2)(0.9)Electric transmission112.6 87.4 82.8 25.2 4.6 Non-utility energy infrastructure260.8 246.0 228.4 14.8 17.6 Corporate and other (106.4)(62.8)(60.1)(43.6)(2.7)Net income attributed to common shareholders$1,199.9 $1,134.0 $1,059.3 $65.9 $74.7 Diluted earnings per share $3.79 $3.58 $3.34 $0.21 $0.24 2020 Compared with 2019Earnings increased $65.9 million during 2020, compared with 2019. The significant factors impacting the $65.9 million increase in earnings were:•A $40.5 million increase in net income attributed to common shareholders at the Wisconsin segment. The increase was driven by the impact of the Wisconsin rate orders approved by the PSCW, effective January 1, 2020, lower operation and maintenance expense, and a positive impact from collections of fuel and purchased power costs. Lower electric and natural gas distribution expenses, a decrease in expense related to the earnings sharing mechanisms in place at our Wisconsin utilities, and lower benefit costs all contributed to the lower operation and maintenance expense. These positive impacts were partially offset by higher depreciation and amortization and the impact of lower retail sales volumes. The lower sales volumes were driven by impacts from the COVID-19 pandemic and warmer winter weather during 2020.•A $33.2 million increase in net income attributed to common shareholders at the Illinois segment, driven by lower operation and maintenance expense and PGL's continued capital investment in the SMP project under its QIP rider. Lower natural gas distribution maintenance costs, lower customer service expenses, and lower benefit costs drove the decrease in operation and maintenance expense during 2020. •A $25.2 million increase in net income attributed to common shareholders at our electric transmission segment, driven by higher equity earnings from transmission affiliates. The higher equity earnings were primarily due to the impacts of FERC orders issued in November 2019 and May 2020 addressing complaints related to ATC's ROE. For further discussion of the FERC orders, see Factors Affecting Results, Liquidity, and Capital Resources – Other Matters – American Transmission Company Allowed Return on Equity Complaints. Continued capital investment by ATC also contributed to the higher equity earnings from transmission affiliates. •A $14.8 million increase in net income attributed to common shareholders at the non-utility energy infrastructure segment, primarily due to lower income tax expense in 2020 driven by wind PTCs generated by our Coyote Ridge wind park that achieved commercial operation in December 2019. See Note 2, Acquisitions, and Note 16, Income Taxes, for more information.Partially offsetting these increases in earnings was a $43.6 million increase in the net loss attributed to common shareholders at the corporate and other segment, driven by make-whole premiums related to the early extinguishment of debt during 2020. A higher net operating loss at Wispark, lower net gains from the investments held in the rabbi trust, and a change in unrecognized tax benefits also contributed to the increase in the net loss. These negative impacts were partially offset by lower interest expense. The gains from the investments held in the rabbi trust partially offset benefits costs related to deferred compensation, which are included in our operating segments. See Note 17, Fair Value Measurements, for more information on our investments held in the Integrys rabbi trust.2020 Form 10-K44WEC Energy Group, Inc.Table of Contents2019 Compared with 2018Earnings increased $74.7 million during 2019, compared with 2018. The significant factors impacting the $74.7 million increase in earnings were:•A $32.9 million increase in net income attributed to common shareholders at the Wisconsin segment. The increase was driven by lower operation and maintenance expense related to our power plants, which primarily resulted from lower maintenance and labor costs associated with our 2019 and 2018 plant retirements and increases to certain plant-related regulatory assets resulting from decisions included in the December 2019 Wisconsin rate orders. The positive impact from lower operation and maintenance expense was partially offset by a decrease in electric margins related to lower retail sales volumes, primarily driven by cooler summer weather during 2019 compared with 2018, and higher depreciation and amortization expense, driven by assets being placed into service as we continue to execute on our capital plan.•A $23.2 million increase in net income attributed to common shareholders at the Illinois segment, driven by PGL's continued capital investment in the SMP project under its QIP rider.•A $17.6 million increase in net income attributed to common shareholders at the non-utility energy infrastructure segment, driven by an increase in wind PTCs recognized on the three wind parks acquired in 2018 and 2019. •A $4.6 million increase in net income attributed to common shareholders at our electric transmission segment, driven by lower income tax expense. The decrease in income tax expense was driven by a tax basis adjustment related to the remeasurement of deferred income taxes in 2018 and a change in the tax rates at the segment level resulting from the transfer of ownership in the ATC investment between our subsidiaries. The decrease in income tax expense related to the change in tax rates was offset in the corporate and other segment and, as a result, had no effect on consolidated net income. The positive impact from lower income taxes was partially offset by higher interest expense in 2019, due to debt issuances at ATC Holding in September 2019 and December 2018, and lower equity earnings from our investment in ATC as a result of a FERC order issued in November 2019 that addressed complaints related to ATC's allowed ROE.Partially offsetting these increases in earnings was a $2.7 million increase in the net loss attributed to common shareholders at the corporate and other segment. The increase in the net loss was driven by higher interest expense in 2019, primarily related to continued capital investments across our segments, and higher net operating losses, primarily at WBS, our centralized services company. WBS transferred assets to our regulated utilities in 2018, and as a result of these transfers, the return on these assets is now recognized within our regulated utility operations. These negative impacts were substantially offset by net gains from investments held in the Integrys rabbi trust during 2019, compared with net losses during 2018. Non-GAAP Financial MeasuresThe discussions below address the contribution of each of our segments to net income attributed to common shareholders. The discussions include financial information prepared in accordance with GAAP, as well as electric margins and natural gas margins, which are not measures of financial performance under GAAP. Electric margin (electric revenues less fuel and purchased power costs) and natural gas margin (natural gas revenues less cost of natural gas sold) are non-GAAP financial measures because they exclude other operation and maintenance expense, depreciation and amortization, and property and revenue taxes. We believe that electric and natural gas margins provide a useful basis for evaluating utility operations since the majority of prudently incurred fuel and purchased power costs, as well as prudently incurred natural gas costs, are passed through to customers in current rates. As a result, management uses electric and natural gas margins internally when assessing the operating performance of our segments as these measures exclude the majority of revenue fluctuations caused by changes in these expenses. Similarly, the presentation of electric and natural gas margins herein is intended to provide supplemental information for investors regarding our operating performance.Our electric margins and natural gas margins may not be comparable to similar measures presented by other companies. Furthermore, these measures are not intended to replace operating income as determined in accordance with GAAP as an indicator of operating performance. Each applicable segment discussion below includes a table that provides the calculation of electric margins and natural gas margins, as applicable, along with a reconciliation to the most directly comparable GAAP measure, operating income.2020 Form 10-K45WEC Energy Group, Inc.Table of ContentsWisconsin Segment Contribution to Net Income Attributed to Common ShareholdersThe Wisconsin segment's contribution to net income attributed to common shareholders for the year ended December 31, 2020 was $690.4 million, representing a $40.5 million, or 6.2%, increase over the prior year. The increase was driven by the impact of the Wisconsin rate orders approved by the PSCW, effective January 1, 2020, lower operation and maintenance expense, and a positive impact from collections of fuel and purchased power costs. Lower electric and natural gas distribution expenses, a decrease in expense related to the earnings sharing mechanisms in place at our Wisconsin utilities, and lower benefit costs all contributed to the lower operation and maintenance expense. These increases were partially offset by higher depreciation and amortization and the impact of lower retail sales volumes. The lower sales volumes were driven by impacts from the COVID-19 pandemic and warmer winter weather during 2020.Year Ended December 312020 vs. 20192019 vs. 2018(in millions)202020192018B (W)B (W)Electric revenues$4,274.0 $4,317.6 $4,438.9 $(43.6)$(121.3)Fuel and purchased power1,238.1 1,341.9 1,418.1 103.8 76.2 Total electric margins3,035.9 2,975.7 3,020.8 60.2 (45.1)Natural gas revenues1,199.5 1,329.5 1,355.8 (130.0)(26.3)Cost of natural gas sold595.2 748.0 792.1 152.8 44.1 Total natural gas margins604.3 581.5 563.7 22.8 17.8 Total electric and natural gas margins3,640.2 3,557.2 3,584.5 83.0 (27.3)Other operation and maintenance1,476.7 1,591.3 2,076.1 114.6 484.8 Depreciation and amortization674.5 617.0 546.6 (57.5)(70.4)Property and revenue taxes156.2 159.3 161.6 3.1 2.3 Operating income1,332.8 1,189.6 800.2 143.2 389.4 Other income, net52.8 68.7 65.4 (15.9)3.3 Interest expense561.3 572.0 200.7 10.7 (371.3)Income before income taxes824.3 686.3 664.9 138.0 21.4 Income tax expense132.7 35.2 46.7 (97.5)11.5 Preferred stock dividends of subsidiary1.2 1.2 1.2 — — Net income attributed to common shareholders$690.4 $649.9 $617.0 $40.5 $32.9 The following table shows a breakdown of other operation and maintenance:Year Ended December 312020 vs. 20192019 vs. 2018(in millions)202020192018B (W)B (W)Operation and maintenance not included in line items below$673.5 $670.7 $769.5 $(2.8)$98.8 Transmission (1)518.0 418.1 420.7 (99.9)2.6 Regulatory amortizations and other pass through expenses (2)138.6 160.6 159.1 22.0 (1.5)We Power (3)119.3 140.9 506.9 21.6 366.0 Transmission expense related to the flow through of tax repairs (4)— 67.2 77.8 67.2 10.6 Transmission expense related to Tax Legislation (5)— 65.3 67.7 65.3 2.4 Earnings sharing mechanisms (6)21.6 61.5 67.5 39.9 6.0 Other5.7 7.0 6.9 1.3 (0.1)Total other operation and maintenance$1,476.7 $1,591.3 $2,076.1 $114.6 $484.8 (1) Represents transmission expense that we are authorized to collect in rates, in accordance with the PSCW's approval of escrow accounting for ATC and MISO network transmission expenses for our Wisconsin electric utilities. As a result, WE and WPS defer as a regulatory asset or liability, the difference between actual transmission costs and those included in rates until recovery or refund is authorized in a future rate proceeding. During 2020, 2019, and 2018, $481.8 million, $486.7 million, and $438.2 million, respectively, of costs were billed to our electric utilities by transmission providers. 2020 Form 10-K46WEC Energy Group, Inc.Table of Contents(2) Regulatory amortizations and other pass through expenses are substantially offset in margins and therefore do not have a significant impact on net income.(3) Represents costs associated with the We Power generation units, including operating and maintenance costs recognized by WE. During 2018, the amount also included the lease payments that were billed from We Power to WE and then recovered in WE's rates. We adopted ASU 2016-02, Leases (Topic 842), effective January 1, 2019, which revised the previous guidance regarding the accounting for leases. As a result of this adoption, starting in 2019, lease expense related to the We Power leases with WE was no longer classified within other operation and maintenance, but was instead recorded as depreciation and amortization and interest expense, in accordance with Topic 842. The We Power leases do not impact our financial statements as all amounts associated with the leases are eliminated at the consolidated level.During 2020, 2019, and 2018, $115.1 million, $134.8 million, and $485.3 million, respectively, of costs were billed to or incurred by WE related to the We Power generation units, with the difference in costs billed or incurred and expenses recognized, either deferred or deducted from the regulatory asset. (4) Represents additional transmission expense recorded in 2019 and 2018 associated with WE's flow through of tax benefits of its repair-related deferred tax liabilities starting in 2018 in accordance with a settlement agreement with the PSCW, to maintain certain regulatory asset balances at their December 31, 2017 levels. This decrease in expenses was offset in income taxes. Since WE's transmission regulatory asset was eliminated at December 31, 2019, there were no tax benefits used in 2020.(5) Represents additional transmission expense recorded in 2019 and 2018 associated with the May 2018 PSCW order requiring WE to use 80% of its current 2018 tax benefit, including the amortization associated with the revaluation of deferred taxes, to reduce its transmission regulatory asset balance. Since WE's transmission regulatory asset was eliminated at December 31, 2019, there were no tax benefits used in 2020.(6) See Note 26, Regulatory Environment, for more information about our earnings sharing mechanisms.The following tables provide information on delivered volumes by customer class and weather statistics:Year Ended December 31MWh (in thousands)2020 vs. 20192019 vs. 2018Electric Sales Volumes202020192018B (W)B (W)Customer classResidential11,523.8 10,918.6 11,195.0 605.2 (276.4)Small commercial and industrial (1)12,250.0 12,861.0 13,186.7 (611.0)(325.7)Large commercial and industrial (1)11,661.8 12,601.6 12,946.5 (939.8)(344.9)Other158.7 164.8 169.0 (6.1)(4.2)Total retail (1)35,594.3 36,546.0 37,497.2 (951.7)(951.2)Wholesale3,088.4 3,314.3 3,612.7 (225.9)(298.4)Resale6,189.9 6,006.0 6,019.3 183.9 (13.3)Total sales in MWh (1)44,872.6 45,866.3 47,129.2 (993.7)(1,262.9)(1) Includes distribution sales for customers who have purchased power from an alternative electric supplier in Michigan.Year Ended December 31Therms (in millions)2020 vs. 20192019 vs. 2018Natural Gas Sales Volumes202020192018B (W)B (W)Customer classResidential1,090.8 1,195.6 1,131.1 (104.8)64.5 Commercial and industrial656.7 740.9 733.1 (84.2)7.8 Total retail1,747.5 1,936.5 1,864.2 (189.0)72.3 Transport1,357.7 1,426.1 1,411.5 (68.4)14.6 Total sales in therms3,105.2 3,362.6 3,275.7 (257.4)86.9 2020 Form 10-K47WEC Energy Group, Inc.Table of ContentsYear Ended December 31Degree Days2020 vs. 20192019 vs. 2018Weather202020192018B (W)B (W)WE and WG (1)Heating (6,618 normal)6,092 6,835 6,685 (10.9)%2.2 %Cooling (737 normal)938 727 929 29.0 %(21.7)%WPS (2)Heating (7,450 normal)7,139 7,723 7,554 (7.6)%2.2 %Cooling (515 normal)660 504 678 31.0 %(25.7)%UMERC (3)Heating (8,464 normal)8,189 8,971 8,611 (8.7)%4.2 %Cooling (330 normal)425 284 478 49.6 %(40.6)%(1) Normal degree days are based on a 20-year moving average of monthly temperatures from Mitchell International Airport in Milwaukee, Wisconsin.(2) Normal degree days are based on a 20-year moving average of monthly temperatures from the Green Bay, Wisconsin weather station.(3) Normal degree days are based on a 20-year moving average of monthly temperatures from the Iron Mountain, Michigan weather station. 2020 Compared with 2019Electric Utility MarginsElectric utility margins at the Wisconsin segment increased $60.2 million during 2020, compared with 2019. The significant factors impacting the higher electric utility margins were:•A $101.8 million increase in margins associated with the 2019 negative impact of WE's flow through of tax benefits of its repair-related deferred tax liabilities, in accordance with a settlement agreement with the PSCW to maintain certain regulatory assets at their December 31, 2017 levels. These tax benefits were no longer in effect for 2020. This increase in margins was offset in income taxes. See Note 26, Regulatory Environment, for more information.•An $8.2 million year-over-year positive impact from collections of fuel and purchased power costs compared with costs approved in rates. Under the Wisconsin fuel rules, the margins of our electric utilities are impacted by under- or over-collections of certain fuel and purchased power costs that are within a 2% price variance from the costs included in rates, and the remaining variance beyond the 2% price variance is deferred for future recovery or refund to customers.These increases in margins were partially offset by:•A $26.5 million decrease in margins from other revenues, primarily related to lower revenues from third party use of our assets. •A $9.9 million net decrease in margins related to lower sales volumes, including the impact of weather. We recognized a $24.7 million net reduction in margins related to lower retail sales volumes driven by the COVID-19 pandemic. Sales volumes for our commercial and industrial customers decreased, primarily related to business interruptions and closings, while residential sales volumes increased. These changes in volumes were both driven, in large part, by a shelter-in-place order for the state of Wisconsin, which was in effect from March 25, 2020 through April 24, 2020, as well as the continued impacts of the COVID-19 pandemic. This net decrease in margins was partially offset by a $14.8 million increase in margins related to warmer summer weather. As measured by cooling degree days, 2020 was 29.0% and 31.0% warmer than 2019 in the Milwaukee and Green Bay areas, respectively. •A $5.6 million net decrease in margins related to the impact of the Wisconsin rate orders approved by the PSCW, effective January 1, 2020. This decrease in margins includes a $73.9 million negative impact related to unprotected excess deferred taxes, which we agreed to return to customers and is offset in income taxes. 2020 Form 10-K48WEC Energy Group, Inc.Table of ContentsNatural Gas Utility MarginsNatural gas utility margins at the Wisconsin segment increased $22.8 million during 2020, compared with 2019. The most significant factor impacting the higher natural gas utility margins was a $53.6 million increase related to the impact of the Wisconsin rate orders approved by the PSCW, effective January 1, 2020. This increase in margins includes a $3.1 million negative impact related to unprotected excess deferred taxes, which we agreed to return to customers and is offset in income taxes. This increase in margins was partially offset by a $35.9 million reduction in margins related to lower sales volumes, driven primarily by warmer winter weather during 2020. As measured by heating degree days, 2020 was 10.9% and 7.6% warmer than 2019 in the Milwaukee and Green Bay areas, respectively. In addition to the weather impact, the decrease in sales volumes for our commercial and industrial customers was also driven by business interruptions and closings related to, in large part, the shelter-in-place order issued by the state of Wisconsin, as well as the continued impacts of the COVID-19 pandemic. Other Operating Expenses (includes other operation and maintenance, depreciation and amortization, and property and revenue taxes)Other operating expenses at the Wisconsin segment decreased $60.2 million during 2020, compared with 2019. The significant factors impacting the decrease in operating expenses were:•A $67.2 million decrease in transmission expense related to the flow through of tax repairs during 2019, as discussed in the notes under the other operation and maintenance table above. This decrease in transmission expense was offset in income taxes.•A $65.3 million decrease in transmission expense associated with the May 2018 order from the PSCW related to our required treatment of the tax benefits associated with the Tax Legislation, as discussed in the notes under the other operation and maintenance table above. This decrease in transmission expense was offset by a corresponding decrease in margins.•A $43.2 million decrease in electric and natural gas distribution expenses, driven by lower maintenance and storm restoration expense, as well as our focus on operating efficiency.•A $39.9 million decrease in expense related to the earnings sharing mechanisms in place at our Wisconsin utilities. See Note 26, Regulatory Environment, for more information.•A $25.6 million decrease in benefit costs, primarily due to lower deferred compensation costs, stock-based compensation, and medical costs.•A $22.0 million decrease in regulatory amortizations and other pass through expenses, as discussed in the notes under the other operation and maintenance table above. •A $21.6 million decrease in other operation and maintenance expense related to the We Power leases, as discussed in the notes under the other operation and maintenance table above.These decreases in operating expenses were partially offset by:•A $99.9 million increase in transmission expense as approved in the PSCW's 2019 rate orders, which were effective January 1, 2020. See the notes under the other operation and maintenance table above for more information.•A $57.5 million increase in depreciation and amortization, driven by assets being placed into service as we continue to execute on our capital plan as well as an increase related to the We Power leases.•A $46.0 million net increase in other operation and maintenance expense related to our power plants, driven by changes to certain plant-related regulatory assets resulting from decisions included in the December 2019 Wisconsin rate orders. See Note 26, Regulatory Environment, for more information on the Wisconsin rate orders. These increases were partially offset by a decrease in other operation and maintenance expense at our plants, driven by the retirement of PIPP in March 2019 and reduced operation of the OCPP.•Costs incurred of $12.5 million related to facility damage resulting from a significant rain event in May 2020. See Note 7, Property, Plant, and Equipment, for more information on the significant rain event.2020 Form 10-K49WEC Energy Group, Inc.Table of ContentsOther Income, NetOther income, net at the Wisconsin segment decreased $15.9 million during 2020, compared with 2019. The decrease was primarily driven by the impact from the 2019 deferral of costs that were offset in other income statement line items and had no impact on net income attributed to common shareholders. Partially offsetting this decrease was higher AFUDC–Equity due to continued capital investment.Interest ExpenseInterest expense at the Wisconsin segment decreased $10.7 million during 2020, compared with 2019, primarily due to lower interest rates on short-term debt and lower interest expense on finance lease liabilities. This decrease was partially offset by long-term debt issuances of $750.0 million during the second half of 2019.Income Tax ExpenseIncome tax expense at the Wisconsin segment increased $97.5 million during 2020, compared with 2019. The increase was primarily due to the $169.0 million benefit from the flow through of tax repairs during 2019 in connection with the 2017 Wisconsin rate settlement and an increase in pretax income. Partially offsetting these increases was a $77.0 million positive impact related to the 2020 amortization of the unprotected excess deferred tax benefits from the Tax Legislation in connection with the Wisconsin rate orders approved by the PSCW, effective January 1, 2020. The impacts due to the benefit from the flow through of tax repairs and the amortization of the unprotected excess deferred tax benefits from the Tax Legislation did not impact earnings as they were offset in operating income. See Note 16, Income Taxes, and Note 26, Regulatory Environment, for more information.2019 Compared with 2018Electric Utility MarginsElectric utility margins at the Wisconsin segment decreased $45.1 million during 2019, compared with 2018. The significant factors impacting the lower electric utility margins were:•A $54.1 million decrease related to lower sales volumes, primarily driven by cooler summer weather during 2019 compared with 2018. As measured by cooling degree days, 2019 was 21.7% and 25.7% cooler than 2018 in the Milwaukee and Green Bay areas, respectively.•A $13.7 million decrease in margins associated with WE's flow through of tax benefits of its repair-related deferred tax liabilities starting in 2018 in accordance with a settlement agreement with the PSCW to maintain certain regulatory assets at their December 31, 2017 levels. This decrease in margins was offset in income taxes. See Note 26, Regulatory Environment, for more information.•A $6.8 million decrease in margins related to savings from the Tax Legislation that we are required to return to customers through bill credits or reductions in other regulatory assets. This decrease in margins did not impact net income as it was offset by the net impact of a $22.0 million decrease in income taxes and a $15.2 million increase in depreciation and amortization expense. We received the PSCW order in May 2018, which required WPS to use 40% of its 2018 and 2019 tax benefits associated with the Tax Legislation to reduce certain regulatory assets. See Note 16, Income Taxes, and Note 26, Regulatory Environment, for more information.These decreases in margins were partially offset by:•A $16.3 million increase in margins related to the iron ore mine located in the Upper Peninsula of Michigan. Prior to the transfer of the mine as a full requirements customer of WE to UMERC as of April 1, 2019, the margin from the mine was being deferred for the benefit of Wisconsin retail electric customers, as ordered by the PSCW. On March 31, 2019 when the new natural gas-fired generation in the Upper Peninsula began commercial operation, a new 20 year agreement with Tilden became effective under which Tilden began purchasing electric power from UMERC. Half of the cost of the natural gas-fired generation is being recovered from Tilden under this agreement.2020 Form 10-K50WEC Energy Group, Inc.Table of Contents•A $5.3 million increase in margins related to a net decrease in fuel and purchased power costs driven by the commercial operation of UMERC's new natural gas-fired generation in the Upper Peninsula of Michigan on March 31, 2019. UMERC previously met its market obligations through PPAs.Natural Gas Utility MarginsNatural gas utility margins at the Wisconsin segment increased $17.8 million during 2019, compared with 2018. The most significant factor impacting the higher natural gas utility margins was higher sales volumes, due in part to colder winter weather, customer growth, and higher use per residential customer during 2019, compared with 2018. As measured by heating degree days, 2019 was 2.2% colder than 2018 in the Milwaukee and Green Bay areas.Other Operating Expenses (includes other operation and maintenance, depreciation and amortization, and property and revenue taxes)Other operating expenses at the Wisconsin segment decreased $416.7 million during 2019, compared with 2018. The Wisconsin segment experienced lower overall operating expenses related to efficiencies and effective cost control. The other significant factors impacting the decrease in operating expenses during 2019, compared with 2018, were:•A $363.3 million decrease in other operation and maintenance expense related to the We Power leases, as discussed in the notes under the other operation and maintenance table above.•A $107.6 million decrease in other operation and maintenance expense related to our power plants, driven by lower maintenance and labor costs associated with our 2019 and 2018 plant retirements, and increases to certain plant-related regulatory assets resulting from decisions included in the December 2019 Wisconsin rate orders. Plant retirements included the March 2019 retirement of the PIPP as well as the 2018 retirements of the Pleasant Prairie power plant, Edgewater Unit 4, and Pulliam Units 7 and 8. See Note 7, Property, Plant, and Equipment, for more information on the plant retirements. See Note 26, Regulatory Environment, for more information on the Wisconsin rate orders.•A $10.6 million decrease in transmission expense related to the flow through of tax repairs during 2019, as discussed in the notes under the other operation and maintenance table above. This decrease in transmission expense was offset in income taxes.•A $6.0 million decrease in expense related to the earnings sharing mechanisms in place at our Wisconsin utilities. See Note 26, Regulatory Environment, for more information.These decreases in operating expenses were partially offset by:•A $70.4 million increase in depreciation and amortization, driven by assets being placed into service as we continue to execute on our capital plan as well as an increase related to the We Power leases.•A $16.4 million increase in storm restoration expense during 2019.•A $16.3 million net increase in benefit costs, primarily related to higher deferred compensation costs during 2019.Other Income, NetOther income, net at the Wisconsin segment increased $3.3 million during 2019, compared with 2018, driven by higher net credits from the non-service components of our net periodic pension and OPEB costs. See Note 20, Employee Benefits, for more information on our benefit costs.Interest ExpenseInterest expense at the Wisconsin segment increased $371.3 million during 2019, compared with 2018, primarily due to the adoption of ASU 2016-02, Leases (Topic 842). Effective January 1, 2019, minimum lease payments were no longer classified within cost of sales or other operation and maintenance, but were instead recorded as a component of depreciation and amortization and interest expense in accordance with Topic 842. As a result of the adoption, for the year ended December 31, 2019, $350.9 million of minimum lease payments were recorded as interest expense on finance lease liabilities. The remaining increase was driven by long-term debt issuances of $700.0 million during the fourth quarter of 2018 and $750.0 million during the second half of 2019.2020 Form 10-K51WEC Energy Group, Inc.Table of ContentsIncome Tax ExpenseIncome tax expense at the Wisconsin segment decreased $11.5 million during 2019, compared with 2018. The decrease was driven by a $22.0 million positive impact from the 2018 PSCW order addressing the benefits associated with the Tax Legislation and a $3.1 million increase in the benefit from the flow through of tax repairs in connection with the 2017 Wisconsin rate settlement. These items did not impact earnings as they were offset in operating income. Partially offsetting these decreases to income tax expense was an increase in pretax income.Illinois Segment Contribution to Net Income Attributed to Common ShareholdersThe Illinois segment's contribution to net income attributed to common shareholders for the year ended December 31, 2020 was $203.5 million, representing a $33.2 million, or 19.5%, increase over the prior year. The increase was driven by lower operation and maintenance expense and PGL's continued capital investment in the SMP project under its QIP rider. Lower natural gas distribution maintenance costs, lower customer service expenses, and lower benefit costs drove the decrease in operation and maintenance expense during 2020. Since the majority of PGL and NSG customers use natural gas for heating, net income attributed to common shareholders is sensitive to weather and is generally higher during the winter months.Year Ended December 312020 vs. 20192019 vs. 2018(in millions)202020192018B (W)B (W)Natural gas revenues$1,321.9 $1,357.1 $1,400.0 $(35.2)$(42.9)Cost of natural gas sold330.9 401.4 480.5 70.5 79.1 Total natural gas margins991.0 955.7 919.5 35.3 36.2 Other operation and maintenance435.4 461.1 472.3 25.7 11.2 Depreciation and amortization196.7 181.3 170.3 (15.4)(11.0)Property and revenue taxes28.1 21.4 21.1 (6.7)(0.3)Operating income330.8 291.9 255.8 38.9 36.1 Other income (expense), net2.3 (2.4)(5.7)4.7 3.3 Interest expense63.5 59.0 51.2 (4.5)(7.8)Income before income taxes269.6 230.5 198.9 39.1 31.6 Income tax expense66.1 60.2 51.8 (5.9)(8.4)Net income attributed to common shareholders$203.5 $170.3 $147.1 $33.2 $23.2 The following table shows a breakdown of other operation and maintenance: Year Ended December 312020 vs. 20192019 vs. 2018(in millions)202020192018B (W)B (W)Operation and maintenance not included in the line items below$332.1 $362.2 $372.9 $30.1 $10.7 Riders (1)101.4 97.5 95.3 (3.9)(2.2)Regulatory amortizations (1)(2.6)(1.5)(1.4)1.1 0.1 Other4.5 2.9 5.5 (1.6)2.6 Total other operation and maintenance$435.4 $461.1 $472.3 $25.7 $11.2 (1) These riders and regulatory amortizations are substantially offset in margins and therefore do not have a significant impact on net income.2020 Form 10-K52WEC Energy Group, Inc.Table of ContentsThe following tables provide information on delivered sales volumes by customer class and weather statistics:Year Ended December 31Therms (in millions)2020 vs. 20192019 vs. 2018Natural Gas Sales Volumes202020192018B (W)B (W)Customer ClassResidential832.6 904.8 896.2 (72.2)8.6 Commercial and industrial326.1 368.6 358.3 (42.5)10.3 Total retail1,158.7 1,273.4 1,254.5 (114.7)18.9 Transport785.7 896.6 905.1 (110.9)(8.5)Total sales in therms1,944.4 2,170.0 2,159.6 (225.6)10.4 Year Ended December 31Degree Days2020 vs. 20192019 vs. 2018Weather (1)202020192018B (W)B (W)Heating (6,195 normal)5,597 6,479 6,327 (13.6)%2.4 %(1) Normal heating degree days are based on a 12-year moving average of monthly temperatures from Chicago's O'Hare Airport.2020 Compared with 2019Natural Gas Utility MarginsNatural gas utility margins at the Illinois segment, net of the $3.9 million impact of the riders referenced in the table above, increased $31.4 million during 2020, compared with 2019. The increase in margins was primarily driven by higher revenues at PGL due to continued capital investment in the SMP project. PGL currently recovers the costs related to the SMP through a surcharge on customer bills pursuant to an ICC approved QIP rider, which is in effect through 2023. See Note 26, Regulatory Environment, for more information.Other Operating Expenses (includes other operation and maintenance, depreciation and amortization, and property and revenue taxes)Other operating expenses at the Illinois segment decreased $7.5 million, net of the impact of the riders referenced in the table above, during 2020, compared with 2019. The significant factors impacting the decrease in operating expenses were:•A $13.6 million decrease in natural gas distribution maintenance costs, which reflects the benefit of warmer than normal winter weather in 2020 and the timing of performing certain services.•A $7.1 million decrease in benefit costs, primarily due to lower deferred compensation costs, pension settlement costs, severance costs, and stock-based compensation.•A $6.5 million decrease in customer service expenses, primarily due to lower call volumes and metering costs.These decreases in operating expenses were partially offset by:•A $15.4 million increase in depreciation expense, primarily driven by PGL's continued capital investment in the SMP project.•A $6.7 million increase in property and revenue taxes driven by a $3.0 million increase in property taxes and a $2.9 million increase in the invested capital tax related to higher plant placed in service during 2020, compared to 2019.Other Income (Expense), NetThe Illinois segment had other income, net of $2.3 million during 2020, compared with $2.4 million of other expense, net in 2019. The $4.7 million year-over-year increase in other income was driven by net credits from the non-service components of our net periodic pension and OPEB costs in 2020, compared with net expenses in 2019. See Note 20, Employee Benefits, for more information on our benefit costs.2020 Form 10-K53WEC Energy Group, Inc.Table of ContentsInterest ExpenseInterest expense at the Illinois segment increased $4.5 million during 2020, compared with 2019, primarily due to higher long-term debt balances. This increase in debt balances was primarily related to continued capital investments and was partially offset by lower interest rates on short-term debt. Income Tax ExpenseIncome tax expense at the Illinois segment increased $5.9 million during 2020, compared with 2019, driven by an increase in pretax income, partially offset by a $6.3 million change in unrecognized tax benefits in 2020. See Note 16, Income Taxes, for more information.2019 Compared with 2018Natural Gas Utility MarginsNatural gas utility margins at the Illinois segment, net of the $2.2 million impact of the riders referenced in the table above, increased $34.0 million during 2019, compared with 2018. The increase was primarily driven by higher revenues at PGL due to continued capital investment in the SMP project. PGL currently recovers the costs related to the SMP through a surcharge on customer bills pursuant to an ICC approved QIP rider, which is in effect through 2023. See Note 26, Regulatory Environment, for more information.Other Operating Expenses (includes other operation and maintenance, depreciation and amortization, and property and revenue taxes)Other operating expenses at the Illinois segment decreased $2.1 million, net of the impact of the riders referenced in the table above, during 2019, compared with 2018. The significant factor impacting the decrease in operating expenses was a $23.2 million decrease in natural gas maintenance costs related to our Illinois utilities’ distribution systems.This decrease in other operating expenses was partially offset by:•An $11.0 million increase in depreciation and amortization, primarily driven by PGL's continued capital investment in the SMP project.•An $8.4 million increase in benefit costs, primarily related to higher deferred compensation costs in 2019.Other Expense, NetOther expense, net at the Illinois segment decreased $3.3 million during 2019, compared with 2018, driven by lower costs from the non-service components of our net periodic pension and OPEB costs.Interest ExpenseInterest expense at the Illinois segment increased $7.8 million during 2019, compared with 2018, driven by higher long-term debt balances. This increase in debt balances was primarily related to continued capital investments.Income Tax ExpenseIncome tax expense at the Illinois segment increased $8.4 million during 2019, compared with 2018, driven by an increase in pretax income. 2020 Form 10-K54WEC Energy Group, Inc.Table of ContentsOther States Segment Contribution to Net Income Attributed to Common ShareholdersThe other states segment's contribution to net income attributed to common shareholders for the year ended December 31, 2020 was $39.0 million, representing a $4.2 million, or 9.7%, decrease over the prior year. The decrease was driven by lower natural gas margins due to the negative impact warmer winter weather and COVID-19 had on 2020 sales volumes, as well as an increase in depreciation and amortization. These decreases in net income were partially offset by lower operating expense in 2020 due to effective cost control. Since the majority of MERC and MGU customers use natural gas for heating, net income attributed to common shareholders is sensitive to weather and is generally higher during the winter months.Year Ended December 312020 vs. 20192019 vs. 2018(in millions)202020192018B (W)B (W)Natural gas revenues$384.1 $426.0 $438.2 $(41.9)$(12.2)Cost of natural gas sold184.8 217.5 232.8 32.7 15.3 Total natural gas margins199.3 208.5 205.4 (9.2)3.1 Other operation and maintenance87.0 98.5 101.0 11.5 2.5 Depreciation and amortization33.5 27.5 24.1 (6.0)(3.4)Property and revenue taxes17.2 17.2 11.5 — (5.7)Operating income61.6 65.3 68.8 (3.7)(3.5)Other income (expense), net0.7 — (0.1)0.7 0.1 Interest expense10.2 8.5 8.7 (1.7)0.2 Income before income taxes52.1 56.8 60.0 (4.7)(3.2)Income tax expense13.1 13.6 15.9 0.5 2.3 Net income attributed to common shareholders$39.0 $43.2 $44.1 $(4.2)$(0.9)The following table shows a breakdown of other operation and maintenance: Year Ended December 312020 vs. 20192019 vs. 2018(in millions)202020192018B (W)B (W)Operation and maintenance not included in line items below$67.9 $76.4 $76.1 $8.5 $(0.3)Regulatory amortizations and other pass through expenses (1)18.9 22.0 24.8 3.1 2.8 Other0.2 0.1 0.1 (0.1)— Total other operation and maintenance$87.0 $98.5 $101.0 $11.5 $2.5 (1) Regulatory amortizations and other pass through expenses are substantially offset in margins and therefore do not have a significant impact on net income.The following tables provide information on delivered volumes by customer class and weather statistics:Year Ended December 31Therms (in millions)2020 vs. 20192019 vs. 2018Natural Gas Sales Volumes202020192018B (W)B (W)Customer ClassResidential309.6 345.2 336.1 (35.6)9.1 Commercial and industrial200.5 238.2 218.5 (37.7)19.7 Total retail510.1 583.4 554.6 (73.3)28.8 Transport728.5 777.1 738.7 (48.6)38.4 Total sales in therms1,238.6 1,360.5 1,293.3 (121.9)67.2 2020 Form 10-K55WEC Energy Group, Inc.Table of ContentsYear Ended December 31Degree Days2020 vs. 20192019 vs. 2018Weather (1)202020192018B (W)B (W)MERCHeating (8,030 normal)7,896 8,728 8,490 (9.5)%2.8 %MGUHeating (6,259 normal)5,952 6,347 6,368 (6.2)%(0.3)%(1) Normal heating degree days for MERC and MGU are based on a 20-year moving average and 15-year moving average, respectively, of monthly temperatures from various weather stations throughout their respective territories.2020 Compared with 2019Natural Gas Utility MarginsNatural gas utility margins decreased $9.2 million during 2020, compared with 2019. The decrease was primarily driven by lower sales volumes as a result of warmer than normal winter weather in 2020 and impacts of the COVID-19 pandemic, partially offset by an increase in revenues related to MERC's GUIC rider. The GUIC rider allows MERC to recover previously approved GUIC that were incurred to replace or modify natural gas facilities to the extent the work is required by state, federal, or other government agencies and exceeds the costs included in base rates. MERC began recognizing revenue under the GUIC rider in the second quarter of 2019.Other Operating Expenses (includes other operation and maintenance, depreciation and amortization, and property and revenue taxes)Other operating expenses at the other states segment decreased $5.5 million during 2020, compared with 2019. The decrease in operating expenses was driven by effective cost control, partially offset by an increase in depreciation and amortization.Interest ExpenseInterest expense at the other states segment increased $1.7 million during 2020, compared with 2019, primarily due to MERC and MGU's long-term debt issuances in April 2020 of $50.0 million and $60.0 million, respectively. This increase in debt balances was primarily related to continued capital investments.Income Tax ExpenseIncome tax expense at the other states segment decreased $0.5 million during 2020, compared with 2019, related to a decrease in pretax income.2019 Compared with 2018Natural Gas Utility MarginsNatural gas utility margins increased $3.1 million during 2019, compared with 2018. The increase was primarily driven by higher sales volumes as a result of colder weather and customer growth, capital investment in natural gas utility infrastructure, and MERC recognizing revenue under the GUIC rider. These increases were partially offset by volumetric bill credits MGU is required to provide customers under a MPUC order addressing the effects of the Tax Legislation to return tax savings from the ruling. See Note 16, Income Taxes, and Note 26, Regulatory Environment, for more information.Other Operating Expenses (includes other operation and maintenance, depreciation and amortization, and property and revenue taxes)Other operating expenses at the other states segment increased $6.6 million during 2019, compared with 2018. The increase in operating expenses was partially driven by lower property and revenue taxes in 2018 resulting from a favorable judgment that MERC received related to a property tax matter. Because property taxes were under-recovered from rate payers in prior years, MERC received $4.8 million of the judgment, with the remaining amount being passed back to customers through the property tax tracker. 2020 Form 10-K56WEC Energy Group, Inc.Table of ContentsThe increase was also driven by a $2.1 million positive impact on 2018 depreciation and amortization expense from a depreciation study approved by the MPUC in the second quarter of 2018. These rates were effective retroactively to January 2017.Income Tax ExpenseIncome tax expense at the other states segment decreased $2.3 million during 2019, compared with 2018, related to a decrease in pretax income. Electric Transmission Segment Contribution to Net Income Attributed to Common ShareholdersYear Ended December 312020 vs. 20192019 vs. 2018(in millions)202020192018B (W)B (W)Net income attributed to common shareholders$112.6 $87.4 $82.8 $25.2 $4.6 2020 Compared with 2019Net income attributed to common shareholders at our electric transmission segment increased $25.2 million during 2020, compared with 2019, driven by a $48.2 million increase in equity earnings from transmission affiliates, primarily due to the impacts of FERC orders issued in November 2019 and May 2020 addressing complaints related to ATC's ROE. The FERC order issued in November 2019 reduced the base ROE that ATC was allowed to collect, which resulted in a $19.3 million decrease in ATC's earnings during 2019. The FERC order issued in May 2020 made additional revisions to the methodology used to calculate the base ROE, which resulted in an increase in the base ROE that ATC is allowed to collect, retroactive to November 2013, and increased ATC's earnings by $14.6 million during 2020. For further discussion of the FERC orders, see Factors Affecting Results, Liquidity, and Capital Resources – Other Matters – American Transmission Company Allowed Return on Equity Complaints. Continued capital investment by ATC also contributed to the higher equity earnings. The increase in equity earnings from transmission affiliates was partially offset by:•A $16.6 million increase in income tax expense during 2020, compared with 2019, driven by a $10.9 million negative impact related to an increase in pretax income and changes in amortization of federal excess deferred income taxes.•A $6.3 million increase in interest expense, due to ATC Holding's issuance of $235.0 million of long-term debt in September 2019.2019 Compared with 2018Net income attributed to common shareholders at our electric transmission segment increased $4.6 million during 2019, compared with 2018, driven by a $26.6 million decrease in income tax expense. The decrease in income tax expense was driven by a $12.3 million tax basis adjustment related to the remeasurement of deferred income taxes in 2018 and a $6.1 million favorable impact of lower pretax income in 2019. Also contributing to the decrease was a $7.8 million decrease related to the change in the tax rates at the segment level resulting from the transfer of ownership in the ATC investment between our subsidiaries. The decrease in income tax expense related to the change in tax rates was offset in the corporate and other segment and, as a result, had no effect on consolidated net income attributed to common shareholders.The increase in earnings from lower income tax expense was partially offset by:•A $12.8 million increase in interest expense, due to ATC Holding's issuance of $235.0 million and $240.0 million of long-term debt in September 2019 and December 2018, respectively.•A $9.1 million decrease in equity earnings from transmission affiliates, primarily related to the FERC order issued in November 2019 that addressed complaints related to ATC's allowed ROE, which resulted in a $19.3 million decrease in ATC's earnings. Increased earnings from continued capital investment partially offset the negative impact from the FERC order.Non-Utility Energy Infrastructure Segment Contribution to Net Income Attributed to Common ShareholdersYear Ended December 312020 vs. 20192019 vs. 2018(in millions)202020192018B (W)B (W)Net income attributed to common shareholders$260.8 $246.0 $228.4 $14.8 $17.6 2020 Form 10-K57WEC Energy Group, Inc.Table of Contents2020 Compared with 2019Net income attributed to common shareholders increased $14.8 million during 2020, compared with 2019, primarily related to a $15.2 million decrease in income tax expense during 2020, compared to 2019, driven by wind PTCs generated by our Coyote Ridge wind park that achieved commercial operation in December 2019. See Note 2, Acquisitions, and Note 16, Income Taxes, for more information.2019 Compared with 2018Net income attributed to common shareholders increased $17.6 million, primarily related to a $14.0 million decrease in income tax expense during 2019, compared to 2018, driven by wind PTCs recognized on the three wind parks acquired in 2018 and 2019. Also contributing to the increase in earnings was a $4.8 million increase in operating income at We Power, driven by higher revenues in connection with capital additions to the plants We Power owns and leases to WE. Partially offsetting these increases were $2.4 million of operating losses at the Upstream and Bishop Hill III wind parks. The majority of earnings from our ownership interests in the wind parks come in the form of the wind PTCs discussed previously.Corporate and Other Segment Contribution to Net Income Attributed to Common ShareholdersYear Ended December 312020 vs. 20192019 vs. 2018(in millions)202020192018B (W)B (W)Net loss attributed to common shareholders$(106.4)$(62.8)$(60.1)$(43.6)$(2.7)2020 Compared with 2019The net loss attributed to common shareholders at the corporate and other segment increased $43.6 million during 2020, compared with 2019. The significant factors impacting the higher net loss were:•A $38.4 million loss related to the payment of make-whole premiums during 2020 due to the redemption of $1,030.0 million of long-term debt prior to maturity.•A $9.0 million higher net operating loss at Wispark, driven by reductions in the carrying value of certain real estate-related investments during 2020 as market and other factors indicated the assets may not be fully recoverable.•An $8.5 million decrease in other income, net due to lower net gains from investments held in the Integrys rabbi trust during 2020. These investment gains partially offset benefits costs related to deferred compensation, which are included in other operation and maintenance expense in our operating segments. See Note 17, Fair Value Measurements, for more information on our investments held in the Integrys rabbi trust.•A $5.2 million decrease in interest income from subsidiaries in our operating segments. The decrease was driven by lower interest income from UMERC, as UMERC used the proceeds from its long-term debt issuance in August 2019 to redeem its outstanding long-term debt with WEC Energy Group. These increases in the net loss attributed to common shareholders were partially offset by:•A $16.9 million decrease in interest expense, driven by the issuance of new debt in 2020 with lower interest rates than the debt retired during the year. Also contributing to the decrease was lower interest rates on our short-term and variable-rate long-term debt.•A $1.4 million increase in income tax benefits, driven by an $11.6 million favorable impact from a higher pre-tax loss. This increase in income tax benefits was offset by an $8.2 million change in unrecognized tax benefits during 2020, compared with 2019, and a $3.5 million decrease in excess tax benefits recognized related to stock option exercises during 2020, compared to 2019. See Note 16, Income Taxes, for more information.2020 Form 10-K58WEC Energy Group, Inc.Table of Contents2019 Compared with 2018The net loss attributed to common shareholders at the corporate and other segment increased $2.7 million during 2019, compared with 2018. The significant factors impacting the higher net loss were:•A $15.1 million increase in interest expense, primarily driven by higher long-term debt balances in 2019. The increase in debt balances was primarily related to continued capital investments across our segments.•A $12.2 million increase in the net operating loss, driven by a transfer of assets from WBS to our regulated utilities in 2018. As a result of these transfers, the return on these assets is now recognized within our regulated utility operations. Also contributing to the increase in the net operating loss was a gain recorded in 2018 that related to a previous sale of a legacy business.•A $1.2 million decrease in income tax benefits, driven by a $7.8 million benefit related to the change in the tax rates at the segment level resulting from the transfer of ownership of the ATC investment between our subsidiaries. This decrease was offset in the electric transmission segment and, as a result, had no effect on consolidated net income attributed to common shareholders. Also contributing to the decrease was $2.3 million related to year-over-year changes associated with state net operating losses. These decreases in income tax benefits were substantially offset by a $9.9 million increase in excess tax benefits recognized related to stock option exercises during 2019, compared to 2018.These increases in the net loss attributed to common shareholders were largely offset by a $23.0 million increase in other income, net due to net gains from investments held in the Integrys rabbi trust during 2019, compared with net losses during 2018.LIQUIDITY AND CAPITAL RESOURCESThe following discussion and analysis of our Liquidity and Capital Resources includes comparisons of our cash flows for the year ended December 31, 2020 with the year ended December 31, 2019. For a similar discussion that compares our cash flows for the year ended December 31, 2019 with the year ended December 31, 2018, see Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations – Liquidity and Capital Resources in Part II of our 2019 Annual Report on Form 10-K.Cash FlowsThe following table summarizes our cash flows during the years ended December 31:(in millions)20202019Change in 2020 Over 2019Cash provided by (used in):Operating activities$2,196.0 $2,345.5 $(149.5)Investing activities(2,806.8)(2,494.9)(311.9)Financing activities601.1 85.6 515.5 Operating Activities2020 Compared with 2019 Net cash provided by operating activities decreased $149.5 million during 2020, compared with 2019, driven by:•A $209.3 million decrease in cash related to lower overall collections from customers, primarily due to business interruptions and closings during the COVID-19 pandemic and a moratorium on disconnections causing an increase in past due balances, as well as lower sales volumes driven by warmer winter weather during 2020, compared with 2019. •A $52.8 million net decrease in cash related to $27.9 million of cash paid for income taxes during 2020, compared with $24.9 million of cash received for income taxes during 2019. This decrease in cash was primarily due to alternative minimum tax credits that were refunded to us during 2019.•A $47.3 million decrease in cash related to an increase in contributions and payments related to pension and OPEB plans during 2020, compared with 2019.2020 Form 10-K59WEC Energy Group, Inc.Table of ContentsThese decreases in net cash provided by operating activities were partially offset by:•A $109.0 million increase in cash related to lower payments for fuel used at our plants during 2020, compared with 2019, driven by lower natural gas costs. The average per-unit cost of natural gas decreased 9.7% during during 2020, compared with 2019. Lower fuel costs were also driven by lower sales volumes due to warmer winter weather during 2020 as well as business interruptions and closings during the COVID-19 pandemic.•A $33.5 million increase in cash due to lower collateral requirements, driven by an increase in the fair value of our natural gas derivative assets during 2020, compared with 2019.•A $22.8 million increase in cash due to higher distributions from ATC during 2020, compared with 2019.Investing Activities2020 Compared with 2019 Net cash used in investing activities increased $311.9 million during 2020, compared with 2019, driven by:•The acquisition of a 90% ownership interest in Blooming Grove in December 2020 for $364.6 million, which is net of restricted cash acquired of $24.1 million. See Note 2, Acquisitions, for more information.•The acquisition of an 85% ownership interest in Tatanka Ridge in December 2020 for $239.9 million. See Note 2, Acquisitions, for more information.•A $31.3 million decrease in cash related to lower reimbursements from ATC for construction costs during 2020, compared with 2019. See Note 21, Investment in Transmission Affiliates, for more information. •A $17.3 million decrease in proceeds received from the sale of assets and businesses during 2020, compared with 2019. See Note 3, Dispositions, for more information.These increases in net cash used in investing activities were partially offset by:•The acquisition of an 80% ownership interest in Upstream in January 2019 for $268.2 million, which is net of cash and restricted cash acquired of $9.2 million. See Note 2, Acquisitions, for more information. •A $31.4 million increase in cash related to lower capital contributions to transmission affiliates during 2020, compared with 2019. See Note 21, Investment in Transmission Affiliates, for more information. •A $23.2 million increase in cash related to insurance proceeds received for property damage during 2020. See Note 7, Property, Plant, and Equipment, for more information.•A $22.0 million decrease in cash paid for capital expenditures during 2020, compared with 2019, which is discussed in more detail below. •An $18.2 million net increase in restricted cash during 2020, compared with 2019, due to a $56.0 million increase in the proceeds received from the sale of investments held in the Integrys rabbi trust, partially offset by $37.8 million in purchases of investments held in the rabbi trust in 2020.2020 Form 10-K60WEC Energy Group, Inc.Table of ContentsCapital ExpendituresCapital expenditures by segment for the years ended December 31 were as follows:Reportable Segment(in millions)20202019Change in 2020 Over 2019Wisconsin $1,382.4 $1,378.6 $3.8 Illinois652.7 624.9 27.8 Other states144.3 109.1 35.2 Non-utility energy infrastructure26.3 121.7 (95.4)Corporate and other33.1 26.5 6.6 Total capital expenditures$2,238.8 $2,260.8 $(22.0)2020 Compared with 2019The increase in cash paid for capital expenditures at the Wisconsin segment during 2020, compared with 2019, was primarily driven by an increase in capital expenditures related to Badger Hollow I, Badger Hollow II, the Solar Now program, and upgrades to WE's natural gas distribution system during 2020. These increases in cash paid for capital expenditures were partially offset by decreased capital expenditures related to Two Creeks, the construction of UMERC's natural gas-fired generation facilities in the Upper Peninsula of Michigan, upgrades to WG's natural gas distribution system, upgrades of automated meter reading devices, and various other software projects during 2020, compared with 2019.The increase in cash paid for capital expenditures at the Illinois segment during 2020, compared with 2019, was driven by upgrades of automated meter reading devices, a higher number of meter replacements, and upgrades at the Manlove Gas Storage Field during 2020. These increases in cash paid for capital expenditures were partially offset by decreased capital expenditures on facilities projects in 2020.The increase in cash paid for capital expenditures at the other states segment during 2020, compared with 2019, was primarily driven by MERC and MGU's installation of automated meter reading devices and a higher number of meter replacements during 2020. These increases in cash paid for capital expenditures were partially offset by decreased capital expenditures related to an expansion of MERC's gas distribution system during 2019.The decrease in cash paid for capital expenditures at the non-utility energy infrastructure segment during 2020, compared with 2019, was primarily driven by the construction of Coyote Ridge, most of which occurred in 2019 subsequent to its acquisition, and projects completed at the ERGS during 2019. See Note 2, Acquisitions, for more information. These decreases in cash paid for capital expenditures were partially offset by an increase in capital expenditures related to a compressor project for Bluewater during 2020. See Capital Resources and Requirements – Capital Requirements – Capital Expenditures and Significant Capital Projects below for more information.Financing Activities2020 Compared with 2019 Net cash provided by financing activities increased $515.5 million during 2020, compared with 2019, driven by:•A $1,215.4 million increase in cash due to $606.1 million of net borrowings of commercial paper during 2020, compared with $609.3 million of net repayments of commercial paper during 2019. •A $478.6 million increase in cash due to higher issuances of long-term debt during 2020, compared with 2019. •A $340.0 million increase in cash due to the issuance of a 364-day term loan during 2020, to enhance our liquidity position in response to the COVID-19 pandemic. See Factors Affecting Results, Liquidity, and Capital Resources – Coronavirus Disease – 2019, for additional information.•A $40.9 million increase in cash due to a decrease in the number and cost of shares of our common stock purchased during 2020, compared with 2019, to satisfy requirements of our stock-based compensation plans. 2020 Form 10-K61WEC Energy Group, Inc.Table of ContentsThese increases in net cash provided by financing activities were partially offset by:•A $1,406.9 million decrease in cash related to higher long-term debt repayments during 2020, compared with 2019. •A $53.5 million decrease in cash due to higher dividends paid on our common stock during 2020, compared with 2019. In January 2020, our Board of Directors increased our quarterly dividend by $0.0425 per share (7.2%) effective with the March 2020 dividend payment. •A $43.3 million decrease in cash due to the payment of make-whole premiums related to debt redemptions and higher issuance costs during 2020, compared with 2019.•The acquisition of an additional 10% ownership interest in Upstream in April 2020 for $31.0 million. See Note 2, Acquisitions, for more information. •A $23.2 million decrease in cash from stock options exercised during 2020, compared with 2019.Significant Financing ActivitiesFor more information on our financing activities, see Note 13, Short-Term Debt and Lines of Credit, and Note 14, Long-Term Debt. Capital Resources and RequirementsCapital ResourcesLiquidityWe anticipate meeting our capital requirements for our existing operations through internally generated funds and short-term borrowings, supplemented by the issuance of intermediate or long-term debt securities, depending on market conditions and other factors.We currently have access to the capital markets and have been able to generate funds both internally and externally to meet our capital requirements. Our ability to attract the necessary financial capital at reasonable terms is critical to our overall strategic plan. We currently believe that we have adequate capacity to fund our operations for the foreseeable future through our existing borrowing arrangements, access to capital markets, and internally generated cash. See Factors Affecting Results, Liquidity, and Capital Resources – Coronavirus Disease – 2019, for additional information on the impacts of the COVID-19 pandemic.WEC Energy Group, WE, WPS, WG, and PGL maintain bank back-up credit facilities, which provide liquidity support for each company's obligations with respect to commercial paper and for general corporate purposes. We review our bank back-up credit facility needs on an ongoing basis and expect to be able to maintain adequate credit facilities to support our operations. In March 2020, in order to enhance our liquidity position in response to the COVID-19 pandemic and the ensuing volatility in the commercial paper market, WEC Energy Group entered into a $340 million 364-day term loan, which was used to pay down commercial paper. We expect to have sufficient liquidity to repay the term loan upon its maturity in March 2021. See Note 13, Short-Term Debt and Lines of Credit, for more information about these credit agreements.2020 Form 10-K62WEC Energy Group, Inc.Table of ContentsThe following table shows our capitalization structure as of December 31, 2020 and 2019, as well as an adjusted capitalization structure that we believe is consistent with how a majority of the rating agencies currently view our 2007 Junior Notes:20202019(in millions)ActualAdjustedActualAdjustedCommon shareholders' equity$10,469.7 $10,719.7 $10,113.4 $10,363.4 Preferred stock of subsidiary30.4 30.4 30.4 30.4 Long-term debt (including current portion)12,513.9 12,263.9 11,904.2 11,654.2 Short-term debt1,776.9 1,776.9 830.8 830.8 Total capitalization$24,790.9 $24,790.9 $22,878.8 $22,878.8 Total debt$14,290.8 $14,040.8 $12,735.0 $12,485.0 Ratio of debt to total capitalization57.6 %56.6 %55.7 %54.6 %Included in long-term debt on our balance sheets as of December 31, 2020 and 2019, is $500.0 million principal amount of the 2007 Junior Notes. The adjusted presentation attributes $250.0 million of the 2007 Junior Notes to common shareholders' equity and $250.0 million to long-term debt. The adjusted presentation of our consolidated capitalization structure is included as a complement to our capitalization structure presented in accordance with GAAP. Management evaluates and manages our capitalization structure, including our total debt to total capitalization ratio, using the GAAP calculation as adjusted to reflect the treatment of the 2007 Junior Notes by the majority of rating agencies. Therefore, we believe the non-GAAP adjusted presentation reflecting this treatment is useful and relevant to investors in understanding how management and the rating agencies evaluate our capitalization structure.For a summary of the interest rates, maturity, and amounts of long-term debt outstanding on a consolidated basis, see Note 14, Long-Term Debt.As described in Note 11, Common Equity, certain restrictions exist on the ability of our subsidiaries to transfer funds to us. We do not expect these restrictions to have any material effect on our operations or ability to meet our cash obligations.At December 31, 2020, we were in compliance with all covenants related to outstanding short-term and long-term debt. We expect to be in compliance with all such debt covenants for the foreseeable future. See Note 13, Short-Term Debt and Lines of Credit, and Note 14, Long-Term Debt, for more information.Working CapitalAs of December 31, 2020, our current liabilities exceeded our current assets by $2,065.1 million. We do not expect this to have any impact on our liquidity since we believe we have adequate back-up lines of credit in place for our ongoing operations. We also believe that we can access the capital markets to finance our construction programs and to refinance current maturities of long-term debt, if necessary.Credit Rating Risk We do not have any credit agreements that would require material changes in payment schedules or terminations as a result of a credit rating downgrade. However, we have certain agreements in the form of commodity contracts and employee benefit plans that could require collateral or a termination payment in the event of a credit rating change to below BBB- at S&P Global Ratings, a division of S&P Global Inc., and/or Baa3 at Moody's Investors Service, Inc. We also have other commodity contracts that, in the event of a credit rating downgrade, could result in a reduction of our unsecured credit granted by counterparties.In addition, access to capital markets at a reasonable cost is determined in large part by credit quality. Any credit ratings downgrade could impact our ability to access capital markets.Subject to other factors affecting the credit markets as a whole, we believe our current ratings should provide a significant degree of flexibility in obtaining funds on competitive terms. However, these security ratings reflect the views of the rating agency only. An explanation of the significance of these ratings may be obtained from the rating agency. Such ratings are not a recommendation to buy, sell, or hold securities. Any rating can be revised upward or downward or withdrawn at any time by a rating agency.2020 Form 10-K63WEC Energy Group, Inc.Table of ContentsIf we are unable to successfully take actions to continue to manage any impact from the COVID-19 pandemic, the credit rating agencies could place our or our subsidiaries’ credit ratings on negative outlook or downgrade our or our subsidiaries' credit ratings. Any such actions by credit rating agencies may make it more difficult and costly for us and our subsidiaries to issue future debt securities and certain other types of financing and could increase borrowing costs under our and our subsidiaries’ credit facilities.See Factors Affecting Results, Liquidity, and Capital Resources – Coronavirus Disease – 2019, for additional information.Capital RequirementsContractual ObligationsWe have the following contractual obligations and other commercial commitments as of December 31, 2020:Payments Due by Period (1)(in millions)TotalLess Than 1 Year1-3 Years3-5 YearsMore Than 5 YearsLong-term debt obligations (2)$20,566.7 $1,238.8 $1,731.3 $2,591.2 $15,005.4 Finance lease obligations (3)151.1 10.6 7.0 3.2 130.3 Operating lease obligations (4)46.0 4.5 8.9 8.1 24.5 Energy and transportation purchase obligations (5)10,979.4 1,179.6 2,127.1 1,613.6 6,059.1 Purchase orders (6)849.2 430.6 280.3 67.8 70.5 Pension and OPEB funding obligations (7)43.4 13.7 29.7 — — Total contractual obligations$32,635.8 $2,877.8 $4,184.3 $4,283.9 $21,289.8 (1) The amounts included in the table are calculated using current market prices, forward curves, and other estimates.(2) Principal and interest payments on long-term debt (excluding finance lease obligations). The interest due on our variable rate debt is based on the interest rates that were in effect on December 31, 2020.(3) Finance lease obligations for power purchase commitments and land leases related to solar projects. This amount does not include We Power leases to WE which are eliminated upon consolidation. See Note 15, Leases, for more information.(4) Operating lease obligations for office space, land, and rail car leases. See Note 15, Leases, for more information.(5) Energy and transportation purchase obligations under various contracts for the procurement of fuel, power, gas supply, and associated transportation related to utility and non-utility operations.(6) Purchase obligations related to normal business operations, information technology, and other services. Also includes construction obligations related to Badger Hollow I and Badger Hollow II.(7) Obligations for pension and OPEB plans cannot reasonably be estimated beyond 2023.The table above does not include liabilities related to the accounting treatment for uncertainty in income taxes because we are not able to make a reasonably reliable estimate as to the amount and period of related future payments at this time. For additional information regarding these liabilities, refer to Note 16, Income Taxes.The table above also does not reflect estimated future payments related to the manufactured gas plant remediation liability of $532.9 million at December 31, 2020, as the amount and timing of payments are uncertain. We expect to incur costs annually to remediate these sites. See Note 24, Commitments and Contingencies, for more information about environmental liabilities.AROs in the amount of $513.5 million are not included in the above table. Settlement of these liabilities cannot be determined with certainty, but we believe the majority of these liabilities will be settled in more than five years. See Note 9, Asset Retirement Obligations, for more information.Obligations for utility operations have historically been included as part of the rate-making process and therefore are generally recoverable from customers.2020 Form 10-K64WEC Energy Group, Inc.Table of ContentsSignificant Capital ProjectsWe have several capital projects that will require significant capital expenditures over the next three years and beyond. All projected capital requirements are subject to periodic review and may vary significantly from estimates, depending on a number of factors. These factors include environmental requirements, regulatory restraints and requirements, changes in tax laws and regulations, acquisition and development opportunities, market volatility, economic trends, and the COVID-19 pandemic. Our estimated capital expenditures and acquisitions for the next three years are as follows: (in millions)202120222023Wisconsin$1,763.4 $1,844.6 $2,070.2 Illinois573.9 581.8 660.9 Other states98.4 106.8 92.5 Non-utility energy infrastructure640.0 504.9 434.1 Corporate and other17.1 10.1 3.7 Total$3,092.8 $3,048.2 $3,261.4 WE, WPS, and WG continue to upgrade their electric and natural gas distribution systems to enhance reliability. These upgrades include the AMI program. AMI is an integrated system of smart meters, communication networks, and data management systems that enable two-way communication between utilities and customers. WPS is also continuing work on the System Modernization and Reliability Project. This project includes modernizing parts of its electric distribution system, including burying or upgrading lines. The project focuses on constructing facilities to improve the reliability of electric service WPS provides to its customers. In 2021, WPS expects to invest approximately $50 million on this project at which time it will be substantially complete.We are committed to investing in solar, wind, and battery storage. Below are examples of renewable projects that are proposed or currently underway.•We have received approval to invest in 300 MW of utility-scale solar within our Wisconsin segment. WPS has partnered with an unaffiliated utility to construct two solar projects in Wisconsin. Two Creeks is located in Manitowoc County, Wisconsin, and Badger Hollow I is located in Iowa County, Wisconsin. WPS owns 100 MW of Two Creeks, which achieved commercial operation in November 2020, and will own 100 MW of Badger Hollow I for a total of 200 MW. Commercial operation is targeted for the second quarter of 2021 for Badger Hollow I. WPS's share of the cost of both projects is estimated to be approximately $260 million. WE has partnered with an unaffiliated utility to construct a solar project, Badger Hollow II, that will be located in Iowa County, Wisconsin. Once constructed, WE will own 100 MW of this project. WE's share of the cost of this project is estimated to be $130 million. Commercial operation of Badger Hollow II is targeted for December 2022.•In February 2021, WE and WPS, along with an unaffiliated utility, filed an application with the PSCW for approval to acquire and construct the Paris Solar-Battery Park, a utility-scale solar-powered electric generating facility with a battery energy storage system. The project will be located in Kenosha County, Wisconsin and features 200 MW of solar generation and 110 MW of battery storage. The joint applicants propose that WE would acquire a 75% ownership interest, WPS would acquire a 15% ownership interest, and the unaffiliated utility would acquire the remaining 10% ownership interest. If approved, WE and WPS' combined share of the cost of this project is estimated to be approximately $385 million with construction expected to begin in 2022 and completed by the end of 2023.•In February 2021, WE and WPS filed an application with the PSCW for approval to accelerate up to approximately $154 million in capital investments in BSGF and CCWP, to repower major components. Both projects are expected to be completed by the end of 2022.WE is constructing approximately 46 miles of natural gas transmission main to increase the quantity and reliability of natural gas service in southeastern Wisconsin. This project, which was approved in a written order by the PSCW in June 2020, has been designated as the Lakeshore Lateral Project. The cost of the project is estimated to be between $174 and $180 million. Construction for the project began in December 2020, and the project is expected to be completed by the end of 2021.WE and WG each plans to construct its own LNG facility. Subject to PSCW approval, each facility would provide approximately one Bcf of natural gas supply to meet anticipated peak demand without requiring the construction of additional interstate pipeline capacity. These facilities are expected to reduce the likelihood of constraints on WE's and WG's natural gas systems during the highest demand days of winter. The total cost of both projects is estimated to be approximately $370 million, with approximately half being invested by each utility. Commercial operation of the LNG facilities is targeted for the end of 2023.2020 Form 10-K65WEC Energy Group, Inc.Table of ContentsPGL is continuing work on the SMP, a project under which PGL is replacing approximately 2,000 miles of Chicago's aging natural gas pipeline infrastructure. PGL currently recovers these costs through a surcharge on customer bills pursuant to an ICC approved QIP rider, which is in effect through 2023. PGL's projected average annual investment through 2022 is between $280 million and $300 million. See Note 26, Regulatory Environment, for more information on the SMP.The non-utility energy infrastructure segment line item in the table above includes WECI's planned investment in Thunderhead. See Note 2, Acquisitions, for more information on this wind project.We expect to provide total capital contributions to ATC (not included in the above table) of approximately $45 million from 2021 through 2023. We do not expect to make any contributions to ATC Holdco during that period.See Factors Affecting Results, Liquidity, and Capital Resources – Coronavirus Disease – 2019, for information on the impacts to our capital projects as a result of the COVID-19 pandemic.Common Stock MattersFor information related to our common stock matters, see Note 11, Common Equity.On January 21, 2021, our Board of Directors increased our quarterly dividend to $0.6775 per share effective with the first quarter of 2021 dividend payment, an increase of 7.1%. This equates to an annual dividend of $2.71 per share. In addition, the Board of Directors affirmed our dividend policy that continues to target a dividend payout ratio of 65-70% of earnings.Investments in Outside TrustsWe use outside trusts to fund our pension and certain OPEB obligations. These trusts had investments of approximately $4.2 billion as of December 31, 2020. These trusts hold investments that are subject to the volatility of the stock market and interest rates. We contributed $113.2 million and $65.9 million to our pension and OPEB plans in 2020 and 2019, respectively. Future contributions to the plans will be dependent upon many factors, including the performance of existing plan assets and long-term discount rates. For additional information, see Note 20, Employee Benefits.Off-Balance Sheet ArrangementsWe are a party to various financial instruments with off-balance sheet risk as a part of our normal course of business, including financial guarantees and letters of credit that support construction projects, commodity contracts, and other payment obligations. We believe that these agreements do not have, and are not reasonably likely to have, a current or future material effect on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures, or capital resources. For additional information, see Note 13, Short-Term Debt and Lines of Credit, Note 19, Guarantees, and Note 23, Variable Interest Entities.FACTORS AFFECTING RESULTS, LIQUIDITY, AND CAPITAL RESOURCESCoronavirus Disease – 2019The global outbreak of COVID-19 was declared a pandemic by the WHO and the CDC and has spread globally, including throughout the United States. There is still considerable uncertainty regarding the extent and duration of the COVID-19 pandemic itself, as well as the measures currently in place to try to contain the virus, such as travel bans and restrictions, quarantines, limitations on business operations, and the timing of widespread availability of the vaccines. Although the shelter-in-place orders that were in effect for our service territories have expired, other orders limiting the capacity of various businesses have been adopted in some jurisdictions. In addition, similar or more restrictive orders could be adopted in the future depending on how the virus continues to spread and/or mutate. The effects of the COVID-19 pandemic and related government responses have significantly disrupted economic activity in our service territories. See Item 1A. Risk Factors for more information on our risks related to the COVID-19 pandemic.2020 Form 10-K66WEC Energy Group, Inc.Table of ContentsLiquidity and Financial MarketsVolatility and uncertainty in the financial markets and global economy have impacted us in a number of ways. Upon the initial enactment of certain COVID-19 related shelter-in-place orders in early to mid-March 2020, commercial paper markets became more expensive and related terms became less flexible. In response to these signs of market instability, the Federal Reserve implemented certain measures, including a reduction in its benchmark Federal Funds rate and the establishment of various programs to restore liquidity and stability into the short-term funding markets. These measures have had a mitigating effect on commercial paper rates and availability. In addition, the initial disruption in the long-term debt markets as a result of the COVID-19 pandemic has subsided.In response to the factors discussed above, we have taken several steps to enhance our liquidity position. In March 2020, we entered into a $340 million, 364-day term loan, which was used to pay down commercial paper. Also, while not directly related to COVID-19, we have completed several long-term debt offerings and refinancings in 2020 in order to finance capital investment in accordance with our long-term capital plan and also to take advantage of the low interest rate environment. See Note 14, Long-Term Debt, for more information on recent borrowing activity.Our overall liquidity position remains strong. As of December 31, 2020, we had approximately $1.4 billion available under our credit facilities, providing sufficient backing for our commercial paper program.Pensions and Other BenefitsOur pension and OPEB plans were well funded at December 31, 2020, with total plan assets exceeding total benefit obligations by $273.9 million. There has been significant volatility in global capital markets during the COVID-19 pandemic, although the market losses seen during the early stages of the pandemic in the first quarter of 2020 reversed course throughout the remainder of the year in response to government stimulus and relief efforts and the gradual reopening of businesses. During the year ended December 31, 2020, we recognized a $451.2 million increase in the value of long-term investments held in our pension and OPEB plan trusts as gains recognized during the last three quarters of 2020 more than offset first quarter losses. We could still see earnings volatility associated with certain other benefit plans that we maintain, primarily related to performance units that we grant to certain employees, and our deferred compensation plans. Certain of the liabilities associated with the deferred compensation plans are indexed to mutual funds and our common stock, and the liabilities associated with outstanding performance units are indexed to our common stock. These liabilities are marked to fair value through earnings each period, with earnings increasing as market prices decrease. Earnings volatility associated with our deferred compensation plans is partially mitigated by investments we hold in a rabbi trust.Allowance for Credit LossesWe evaluate the collectability of our accounts receivable and unbilled revenue balances considering a combination of factors. Risks identified that we do not believe are reflected in historical reserve percentages are assessed on a quarterly basis to determine whether further adjustments are required. Economic disruptions caused by the COVID-19 pandemic, including higher unemployment rates and the inability of some businesses to recover from the pandemic, could cause a higher percentage of accounts receivable to become uncollectible. Although impacts on our results of operations related to uncollectible receivable balances are mitigated by regulatory mechanisms and certain COVID-19 specific regulatory orders we have received, the increase in past due receivables we have experienced has resulted in higher working capital requirements. At December 31, 2020, accounts receivables, net of reserves for credit losses, that were greater than 90 days past due, totaled $122.8 million, a $38.6 million increase compared to December 31, 2019.Our exposure to credit losses for certain regulated utility customers is mitigated by regulatory mechanisms we have in place. Specifically, rates related to all of the customers in our Illinois segment, as well as the residential rates of WE, WPS, and WG in our Wisconsin segment include riders or other mechanisms for cost recovery or refund of uncollectible expense based on the difference between the actual provision for credit losses and the amounts recovered in rates. In addition, we have received specific orders related to the deferral of certain costs (including credit losses) and foregone revenues related to the COVID-19 pandemic. The additional protections provided by these COVID-19 specific regulatory orders are still being assessed and will be subject to prudency reviews. See Note 26, Regulatory Environment, for more information on these orders.2020 Form 10-K67WEC Energy Group, Inc.Table of ContentsLoss of BusinessWe have seen a decrease in the consumption of electricity and natural gas by some of our commercial and industrial customers as they continue to experience lower demand for their products and services as a result of the COVID-19 pandemic. Many businesses in our service territories still are not operating at full capacity. The extent to which this decrease in consumption will impact our results of operations and liquidity is dependent upon the duration of the COVID-19 pandemic and the ability of our customers to resume and continue normal operations. Supply Chain and Capital ProjectsWe have not yet experienced a significant disruption in our supply chain as a result of the COVID-19 pandemic. However, if the pandemic significantly impacts our key suppliers’ ability to manufacture or deliver critical equipment and supplies or provide services, we could experience delays in our ability to perform certain maintenance and capital project activities.The timing of Badger Hollow I has been impacted by the COVID-19 pandemic. The parties agreed to delay the expected commercial operation date from December 2020 to the second quarter of 2021 so that initial staffing increases could be minimized in light of state mandated COVID-19 orders. We are not currently aware of any other major delays or changes related to our capital plan as a result of the COVID-19 pandemic, although we are continuing to monitor potential impacts on an ongoing basis.Employee SafetyThe health and safety of our employees during the COVID-19 pandemic is paramount and enables us to continue to provide critical services to our customers.We are following CDC guidelines and have taken precautions with regard to employee hygiene and facility cleanliness, imposed travel limitations on our employees, provided additional employee benefits, and implemented remote work policies where appropriate. We have activated an incident management team and updated our pandemic continuity plan, which includes identifying critical work groups and ensuring safe harbor plans are in place. We have minimized the unnecessary risk of exposure to COVID-19 by implementing self-quarantine measures and have adopted additional precautionary measures for our critical work groups.Additional protocols have been implemented for our field employees who travel to customer premises in order to protect them, our customers, and the public. We have modified our work protocols to ensure compliance with social distancing and face covering recommendations.All of these safety measures have caused us to incur additional costs, and depending upon the duration of the COVID-19 pandemic, could have a material impact on our results of operations and liquidity.Regulatory EnvironmentOur utilities have taken actions to ensure that essential utility services are available to customers in their service territories during the COVID-19 pandemic. In addition, the PSCW, the ICC, the MPUC, and the MPSC have all issued written orders regarding certain measures required in their respective jurisdictions. See Note 26, Regulatory Environment, for more information on these orders and the potential recovery of expenditures incurred as a result of the measures being taken.Market Risks and Other Significant RisksWe are exposed to market and other significant risks as a result of the nature of our businesses and the environments in which those businesses operate. These risks, described in further detail below, include but are not limited to:Regulatory RecoveryOur utilities account for their regulated operations in accordance with accounting guidance under the Regulated Operations Topic of the FASB ASC. Our rates are determined by various regulatory commissions. See Item 1. Business – E. Regulation for more information on these commissions.2020 Form 10-K68WEC Energy Group, Inc.Table of ContentsRegulated entities are allowed to defer certain costs that would otherwise be charged to expense if the regulated entity believes the recovery of those costs is probable. We record regulatory assets pursuant to generic and/or specific orders issued by our regulators. Recovery of the deferred costs in future rates is subject to the review and approval by those regulators. We assume the risks and benefits of ultimate recovery of these items in future rates. If the recovery of the deferred costs, including those referenced below, is not approved by our regulators, the costs would be charged to income in the current period. Regulators can impose liabilities on a prospective basis for amounts previously collected from customers and for amounts that are expected to be refunded to customers. We record these items as regulatory liabilities. As of December 31, 2020, our regulatory assets were $3,544.1 million, and our regulatory liabilities were $3,979.1 million. Due to the Tax Legislation, our regulated utilities remeasured their deferred taxes and recorded a tax benefit of $2,529 million. Our utilities have been returning this tax benefit to ratepayers through refunds, bill credits, riders, and reductions to other regulatory assets, which we expect to continue. See Note 16, Income Taxes, and Note 26, Regulatory Environment, for more information. We expect to request or have requested recovery of the costs related to the following projects discussed in recent or pending rate proceedings, orders, and investigations involving our utilities:•Prior to its acquisition by us, Integrys initiated an information technology project with the goal of improving the customer experience at its subsidiaries. Specifically, the project is expected to provide functional and technological benefits to the billing, call center, and credit collection functions. As of December 31, 2020, we had not received any significant disallowances of the costs incurred for this project. WPS and MERC received approval to recover these costs in their most recent rate orders; however, the costs incurred for this project in our other regulatory jurisdictions are still subject to approval by the applicable regulators.•In January 2014, the ICC approved PGL's use of the QIP rider as a recovery mechanism for costs incurred related to investments in QIP. This rider is subject to an annual reconciliation whereby costs are reviewed for accuracy and prudency. In March 2020, PGL filed its 2019 reconciliation with the ICC, which, along with the 2018, 2017, and 2016 reconciliations, are still pending. As of December 31, 2020, there can be no assurance that all costs incurred under the QIP rider during the open reconciliation years will be deemed recoverable by the ICC.See Note 26, Regulatory Environment, for more information regarding recent and pending rate proceedings, orders, and investigations involving our utilities.Commodity CostsIn the normal course of providing energy, we are subject to market fluctuations in the costs of coal, natural gas, purchased power, and fuel oil used in the delivery of coal. We manage our fuel and natural gas supply costs through a portfolio of short and long-term procurement contracts with various suppliers for the purchase of coal, natural gas, and fuel oil. In addition, we manage the risk of price volatility through natural gas and electric hedging programs.Embedded within our utilities' rates are amounts to recover fuel, natural gas, and purchased power costs. Our utilities have recovery mechanisms in place that allow them to recover or refund all or a portion of the changes in prudently incurred fuel, natural gas, and purchased power costs from rate case-approved amounts. See Item 1. Business – E. Regulation for more information on these mechanisms.Higher commodity costs can increase our working capital requirements, result in higher gross receipts taxes, and lead to increased energy efficiency investments by our customers to reduce utility usage and/or fuel substitution. Higher commodity costs combined with slower economic conditions also expose us to greater risks of accounts receivable write-offs as more customers are unable to pay their bills. See Note 5, Credit Losses, for more information on riders and other mechanisms that allow for cost recovery or refund of uncollectible expense.Due to the cold temperatures, wind, snow and ice throughout the central part of the country during February 2021, the cost of gas purchased for our natural gas utility customers was temporarily driven higher than our normal winter weather expectations. In aggregate, we estimate that the total increase was between $300 million and $350 million as of February 25, 2021. All of our utilities have regulatory mechanisms in place for recovering all prudently incurred gas costs. In addition, we have adequate liquidity and access to capital markets to manage any short-term increase in working capital resulting from the lag in recovery. For information on the GCRMs, see Note 1(d), Operating Revenues.2020 Form 10-K69WEC Energy Group, Inc.Table of ContentsWeatherOur utilities' rates are based upon estimated normal temperatures. Our electric utility margins are unfavorably sensitive to below normal temperatures during the summer cooling season and, to some extent, to above normal temperatures during the winter heating season. Our natural gas utility margins are unfavorably sensitive to above normal temperatures during the winter heating season. PGL, NSG, and MERC have decoupling mechanisms in place that help reduce the impacts of weather. Decoupling mechanisms differ by state and allow utilities to recover or refund certain differences between actual and authorized margins. A summary of actual weather information in our utilities' service territories during 2020 and 2019, as measured by degree days, may be found in Results of Operations. Interest RatesWe are exposed to interest rate risk resulting from our short-term and long-term borrowings and projected near-term debt financing needs. We manage exposure to interest rate risk by limiting the amount of our variable rate obligations and continually monitoring the effects of market changes on interest rates. When it is advantageous to do so, we enter into long-term fixed rate debt. We may also enter into derivative financial instruments, such as swaps, to mitigate interest rate exposure.Based on the variable rate debt outstanding at December 31, 2020 and December 31, 2019, a hypothetical increase in market interest rates of one percentage point would have increased annual interest expense by $20.3 million and $10.8 million in 2020 and 2019, respectively. This sensitivity analysis was performed assuming a constant level of variable rate debt during the period and an immediate increase in interest rates, with no other changes for the remainder of the period.Marketable Securities ReturnWe use various trusts to fund our pension and OPEB obligations. These trusts invest in debt and equity securities. Changes in the market prices of these assets can affect future pension and OPEB expenses. Additionally, future contributions can also be affected by the investment returns on trust fund assets. We believe that the financial risks associated with investment returns would be partially mitigated through future rate actions by our various utility regulators.The fair value of our trust fund assets and expected long-term returns were approximately: (in millions)As of December 31, 2020Expected Return on Assets in 2021Pension trust funds$3,225.0 6.87 %OPEB trust funds$951.4 7.00 %Fiduciary oversight of the pension and OPEB trust fund investments is the responsibility of an Investment Trust Policy Committee. The Committee works with external actuaries and investment consultants on an ongoing basis to establish and monitor investment strategies and target asset allocations. Forecasted cash flows for plan liabilities are regularly updated based on annual valuation results. Target asset allocations are determined utilizing projected benefit payment cash flows and risk analyses of appropriate investments. The targeted asset allocations are intended to reduce risk, provide long-term financial stability for the plans, and maintain funded levels which meet long-term plan obligations while preserving sufficient liquidity for near-term benefit payments. Investment strategies utilize a wide diversification of asset types and qualified external investment managers.We consult with our investment advisors on an annual basis to help us forecast expected long-term returns on plan assets by reviewing actual historical returns and calculating expected total trust returns using the weighted-average of long-term market returns for each of the major target asset categories utilized in the funds.Economic ConditionsWe have electric and natural gas utility operations that serve customers in Wisconsin, Illinois, Minnesota, and Michigan. As such, we are exposed to market risks in the regional Midwest economy. In addition, any economic downturn or disruption of national or international markets could adversely affect the financial condition of our customers and demand for their products, which could affect their demand for our products.2020 Form 10-K70WEC Energy Group, Inc.Table of ContentsInflationWe continue to monitor the impact of inflation, especially with respect to the costs of medical plans, fuel, transmission access, construction costs, and regulatory and environmental compliance in order to minimize its effects in future years through pricing strategies, productivity improvements, and cost reductions. We do not believe the impact of general inflation will have a material impact on our future results of operations.For additional information concerning risk factors, including market risks, see the Cautionary Statement Regarding Forward-Looking Information at the beginning of this report and Item 1A. Risk Factors.Competitive MarketsElectric Utility IndustryThe FERC supports large RTOs, which directly impacts the structure of the wholesale electric market. Due to the FERC's support of RTOs, MISO uses the MISO Energy Markets to carry out its operations, including the use of LMP to value electric transmission congestion and losses. Increased competition in the retail and wholesale markets, which may result from restructuring efforts, could have a significant and adverse financial impact on us. It is uncertain when, if at all, retail choice might be implemented in Wisconsin. However, Michigan has adopted a limited retail choice program.WisconsinElectric utility revenues in Wisconsin are regulated by the PSCW. The PSCW continues to maintain the position that the question of whether to implement electric retail competition in Wisconsin should ultimately be decided by the Wisconsin legislature. No such legislation has been introduced in Wisconsin to date.MichiganUnder Michigan law, our retail customers may choose an alternative electric supplier to provide power supply service. As a result, some of our small retail customers have switched to an alternative electric supplier. At December 31, 2020, Michigan law limited customer choice to 10% of an electric utility's Michigan retail load. Our iron ore mine customer, Tilden, is exempt from this 10% cap based on current law, but Tilden is required under a long-term agreement to purchase electric power from UMERC through March 2039. In addition, certain load increases by facilities already using an alternative electric supplier can still be serviced by their alternative electric supplier, when various conditions exist, even if the cap has already been met. When a customer switches to an alternative electric supplier, we continue to provide distribution and customer service functions for the customer.Natural Gas Utility IndustryWe offer natural gas transportation services to our customers that elect to purchase natural gas directly from a third-party supplier. Since these transportation customers continue to use our distribution systems to transport natural gas to their facilities, we earn distribution revenues from them. As such, the loss of revenue associated with the cost of natural gas that our transportation customers purchase from third-party suppliers has little impact on our net income, as it is substantially offset by an equal reduction to natural gas costs. WisconsinOur Wisconsin utilities offer both natural gas transportation service and interruptible natural gas sales to enable customers to better manage their energy costs. Customers continue to switch between firm system supply, interruptible system supply, and transportation service each year as the economics and service options change. Due to the PSCW's previous proceedings on natural gas industry regulation in a competitive environment, the PSCW currently provides all Wisconsin customer classes with competitive markets the option to choose a third-party natural gas supplier. All of our Wisconsin customer classes have competitive market choices and, therefore, can purchase natural gas directly from either a third-party supplier or their local natural gas utility. Since third-party suppliers can be used in Wisconsin, the PSCW has also adopted standards for transactions between a utility and its natural gas marketing affiliates. We are currently unable to predict the impact, if any, of potential future industry restructuring on our results of operations or financial position.2020 Form 10-K71WEC Energy Group, Inc.Table of ContentsIllinoisAbsent extraordinary circumstances, potential competitors are not allowed to construct competing natural gas distribution systems in the service territories for PGL and NSG. A charter from the state of Illinois gives PGL the right to provide natural gas distribution service in the city of Chicago as a public utility. Further, the "first in the field" and public interest standards limit the ability of potential competitors to operate in an existing utility service territory. In addition, we believe it would be impractical to construct competing duplicate distribution facilities due to the high cost of installation.Since 2002, PGL and NSG have, under ICC-approved tariffs, provided their customers with the option to choose a third-party natural gas supplier. There are no state laws requiring PGL and NSG to make this choice option available to customers, but since this option is currently provided to our Illinois customers under tariff, we would need ICC approval to eliminate it.An interstate pipeline may seek to provide transportation service directly to our Illinois end users, which would bypass our natural gas transportation service. However, PGL and NSG have bypass tariffs approved by the ICC, which allow them to negotiate rates with customers that are potential bypass candidates to help ensure that such customers continue to use their transportation service.MinnesotaNatural gas utilities in the state of Minnesota do not have exclusive franchise service territories and, as a matter of law and policy, natural gas utilities may compete for new customers. However, natural gas utilities have customarily avoided competing for existing customers of other utilities, as there would be duplicative utility facilities and/or increased costs to customers. If this approach were to change, it could lead to a greater level of competition amongst utilities to obtain customers.MERC offers both natural gas transportation service and interruptible natural gas sales to enable customers to better manage their energy costs. Customers continue to switch between firm system supply, interruptible system supply, and transportation service each year as the economics and service options change. MERC has provided its commercial and industrial customers with the option to choose a third-party natural gas supplier since 2006. We are not required by the MPUC or state law to make this choice option available to customers, but since this option is currently provided to our Minnesota commercial and industrial customers, we would need MPUC approval to eliminate it.MichiganThe option to choose a third-party natural gas supplier has been provided to UMERC’s natural gas customers (formerly WPS’s Michigan natural gas customers) since the late 1990s and MGU's customers since 2005. We are not required by the MPSC or state law to make this choice option available to customers, but since this option is currently provided to our Michigan customers, we would need MPSC approval to eliminate it.Environmental MattersSee Note 24, Commitments and Contingencies, for a discussion of certain environmental matters affecting us, including rules and regulations relating to air quality, water quality, land quality, and climate change. Other MattersTax Cuts and Jobs Act of 2017In December 2017, the Tax Legislation was signed into law. During 2018, 2019, and 2020, the PSCW and the MPSC issued written orders regarding how to refund certain tax savings from the Tax Legislation to our ratepayers in Wisconsin and Michigan, respectively. The various remaining impacts of the Tax Legislation on our Wisconsin operations were addressed in the rate orders issued by the PSCW in December 2019. The MPSC also approved a settlement in May 2018 with Tilden that addressed all base rate impacts of the Tax Legislation, and the FERC approved the revised formula rate tariffs for WPS and WE that incorporated the impacts on the Tax Legislation in July 2019 and August 2020, respectively. In addition, the ICC approved the VITA in Illinois during April 2018, and, in Minnesota, the MPUC included the various impacts of the Tax Legislation in MERC's final 2018 rate order. See Note 26, Regulatory Environment, for more information on the state commissions' responses to the Tax Legislation.2020 Form 10-K72WEC Energy Group, Inc.Table of ContentsAmerican Transmission Company Allowed Return on Equity ComplaintsOn November 21, 2019, the FERC issued an order (November 2019 Order) related to the methodology used to calculate the base ROE for all MISO transmission owners, including ATC. Based on this order, the FERC expanded its base ROE methodology to include the capital-asset pricing model in addition to the discounted cash flow model to better reflect how investors make their investment decisions. The FERC's modified methodology reduced the base ROE that ATC is allowed to collect on a going-forward basis, as discussed below. In response to the FERC's decision, requests for the FERC to rehear the November 2019 Order in its entirety were filed by various parties. On May 21, 2020, the FERC issued an order (May 2020 Order) that granted in part and denied in part the requests to rehear the November 2019 Order. In the May 2020 Order, the FERC made additional revisions to its base ROE methodology, including adding the use of the risk premium model. As discussed below, the additional revisions made by the FERC increased ATC's base ROE authorized in the November 2019 Order on a going-forward basis. Various parties filed requests to rehear certain parts of the May 2020 Order with the FERC, but the FERC issued an order in response to the rehearing requests during November 2020 (November 2020 Order) that confirmed the ROE authorized in the May 2020 Order. Petitions for review of the November 2019 Order, relevant parts of the May 2020 Order, and the November 2020 Order have also been filed with the D.C. Circuit Court of Appeals.First Return on Equity ComplaintIn November 2013, a group of MISO industrial customer organizations filed a complaint with the FERC requesting to reduce the base ROE used by MISO transmission owners, including ATC, from 12.2% to 9.15%. In September 2016, the FERC issued an order requiring MISO transmission owners to collect a reduced base ROE of 10.32%, as well as the 0.5% incentive adder approved by the FERC in January 2015 for MISO transmission owners. The FERC then issued the November 2019 Order after directing MISO transmission owners and other stakeholders to provide briefs and comments on a proposed change to the methodology for calculating base ROE. The November 2019 Order further reduced the base ROE for all MISO transmission owners, including ATC, to 9.88%, effective as of September 28, 2016 and prospectively. The November 2019 Order also continued to allow the collection of the 0.5% ROE incentive adder, which only applies to revenues collected after January 6, 2015. In response to the rehearing requests filed related to the November 2019 Order, the FERC issued another order in May 2020. This May 2020 Order increased the base ROE for all MISO transmission owners, including ATC, from the 9.88% authorized in the November 2019 Order to 10.02%, effective as of September 28, 2016 and prospectively. The May 2020 Order also allowed the continued collection of the 0.5% ROE incentive adder.ATC is required to provide refunds, with interest, for the 15-month refund period from November 12, 2013 through February 11, 2015 and for the period from September 28, 2016 through November 19, 2020. As a result, ATC is expected to continue providing WE and WPS with refunds related to the transmission costs they paid during the two refund periods through the end of September 2021. These refunds are being applied to WE's and WPS's PSCW-approved escrow accounting for transmission expense.Second Return on Equity ComplaintIn February 2015, a second complaint was filed with the FERC requesting a reduction in the base ROE used by MISO transmission owners, including ATC, to 8.67%, with a refund effective date retroactive to February 12, 2015. The FERC also addressed this second complaint in the November 2019 Order. Similar to the first complaint, the November 2019 Order stated that the base ROE of 9.88% and the 0.5% incentive adder were reasonable for the period covered by the second complaint, February 12, 2015 through May 10, 2016. However, in the November 2019 Order, the FERC relied on certain provisions of the Federal Power Act to dismiss the second complaint and to determine that refunds were not allowed for this period. In its May 2020 Order, the FERC stated the new base ROE of 10.02% and the 0.5% incentive adder were reasonable for the period covered by the second complaint. However, the FERC relied on the same provisions of the Federal Power Act to again dismiss the complaint and determine that refunds were not allowed for this period. The FERC also denied the requests to rehear both the dismissal of the second complaint and the determination that no refunds are allowed for the second complaint period.Due to the various outstanding petitions related to the November 2019 Order, May 2020 Order, and November 2020 Order, refunds could still be required for the second complaint period. Therefore, our financials continue to reflect a liability of $39.1 million, reducing our equity earnings from ATC. This liability is based on a 10.52% ROE for the second complaint period. If it is ultimately determined that a refund is required for the second complaint period, we would not expect any such refund to have a material impact on our financial statements or results of operations in the future. In addition, WE and WPS would be entitled to receive a portion of the refund from ATC for the benefit of their customers.2020 Form 10-K73WEC Energy Group, Inc.Table of ContentsCritical Accounting Policies and EstimatesPreparation of financial statements and related disclosures in compliance with GAAP requires the application of appropriate technical accounting rules and guidance as well as the use of estimates. The application of these policies necessarily involves judgments regarding future events, including the likelihood of success of particular projects, legal and regulatory challenges, and anticipated recovery of costs. These judgments, in and of themselves, could materially impact the financial statements and disclosures based on varying assumptions. In addition, the financial and operating environment may also have a significant effect, not only on the operation of our business, but on our results reported through the application of accounting measures used in preparing the financial statements and related disclosures, even if the nature of the accounting policies applied have not changed.The following is a list of accounting policies that are most significant to the portrayal of our financial condition and results of operations and that require management's most difficult, subjective, or complex judgments.Regulatory AccountingOur utility operations follow the guidance under the Regulated Operations Topic of the FASB ASC (Topic 980). Our financial statements reflect the effects of the rate-making principles followed by the various jurisdictions regulating us. Certain items that would otherwise be immediately recognized as revenues and expenses are deferred as regulatory assets and regulatory liabilities for future recovery or refund to customers, as authorized by our regulators.Future recovery of regulatory assets, including the timeliness of recovery and our ability to earn a reasonable return, is not assured and is generally subject to review by regulators in rate proceedings for matters such as prudence and reasonableness. Once approved, the regulatory assets and liabilities are amortized into earnings over the rate recovery or refund period. If recovery or refund of costs is not approved or is no longer considered probable, these regulatory assets or liabilities are recognized in current period earnings. Management regularly assesses whether these regulatory assets and liabilities are probable of future recovery or refund by considering factors such as changes in the regulatory environment, earnings from our electric and natural gas utility operations, and the status of any pending or potential deregulation legislation.The application of the Regulated Operations Topic of the FASB ASC would be discontinued if all or a separable portion of our utility operations no longer met the criteria for application. Our regulatory assets and liabilities would be written off to income as an unusual or infrequently occurring item in the period in which discontinuation occurred. As of December 31, 2020, we had $3,544.1 million in regulatory assets and $3,979.1 million in regulatory liabilities. See Note 6, Regulatory Assets and Liabilities, for more information.GoodwillWe completed our annual goodwill impairment tests for all of our reporting units that carried a goodwill balance as of July 1, 2020. No impairments were recorded as a result of these tests. For all of our reporting units, the fair values calculated in step one of the test were greater than their carrying values. The fair values for the reporting units were calculated using a combination of the income approach and the market approach.For the income approach, we used internal forecasts to project cash flows. Any forecast contains a degree of uncertainty, and changes in these cash flows could significantly increase or decrease the calculated fair value of a reporting unit. Since all of our reporting units are regulated, a fair recovery of and return on costs prudently incurred to serve customers is assumed. An unfavorable outcome in a rate case could cause the fair values of our reporting units to decrease.Key assumptions used in the income approach include ROEs, the long-term growth rates used to determine terminal values at the end of the discrete forecast period, and the discount rates. The discount rate is applied to estimated future cash flows and is one of the most significant assumptions used to determine fair value under the income approach. As interest rates rise, the calculated fair values will decrease. The discount rate is based on the weighted-average cost of capital for each reporting unit, taking into account both the after-tax cost of debt and cost of equity. The terminal year ROE for each utility is driven by its current allowed ROE. The terminal growth rate is based primarily on a combination of historical and forecasted statistics for real gross domestic product and personal income for each utility service area. For the market approach, we used an equal weighting of the guideline public company method and the guideline merged and acquired company method. The guideline public company method uses financial metrics from similar publicly traded companies to 2020 Form 10-K74WEC Energy Group, Inc.Table of Contentsdetermine fair value. The guideline merged and acquired company method calculates fair value by analyzing the actual prices paid for recent mergers and acquisitions in the industry. We applied multiples derived from these two methods to the appropriate operating metrics for our reporting units to determine fair value.The underlying assumptions and estimates used in the impairment tests were made as of a point in time. Subsequent changes in these assumptions and estimates could change the results of the tests.For all of our reporting units, the fair value exceeded its carrying value by over 50%. Based on these results, our reporting units are not at risk of failing step one of the goodwill impairment test.Our reporting units had the following goodwill balances at July 1, 2020:(in millions, except percentages)GoodwillPercentage of Total GoodwillWisconsin $2,104.3 68.9 %Illinois758.7 24.9 %Other states183.2 6.0 %Non-utility energy infrastructure6.6 0.2 %Total goodwill$3,052.8 100.0 %See Note 10, Goodwill and Intangibles, for more information.Long-Lived AssetsIn accordance with ASC 980-360, Regulated Operations – Property, Plant, and Equipment, we periodically assess the recoverability of certain long-lived assets when events or changes in circumstances indicate that the carrying amount of those long-lived assets may not be recoverable. Examples of events or changes in circumstances include, but are not limited to, a significant decrease in the market price, a significant change in use, adverse legal factors or a change in business climate, operating or cash flow losses, or an expectation that the asset might be sold. These assessments require significant assumptions and judgments by management. Long-lived assets that would be subject to an impairment assessment would generally include any assets within regulated operations that may not be fully recovered from our customers as a result of regulatory decisions that will be made in the future, and assets within nonregulated operations that are proposed to be sold or are currently generating operating losses.In accordance with ASC 980-360, when it becomes probable that a generating unit will be retired before the end of its useful life, we assess whether the generating unit meets the criteria for abandonment accounting. Generating units that are considered probable of abandonment are expected to cease operations in the near term, significantly before the end of their original estimated useful lives. As a result, the remaining net book value of these assets can be significant. If a generating unit meets applicable criteria to be considered probable of abandonment, and the unit has been abandoned, we assess the likelihood of recovery of the remaining net book value of that generating unit at the end of each reporting period. If it becomes probable that regulators will disallow full recovery or a return on the remaining net book value of a generating unit that is either abandoned or probable of being abandoned, an impairment loss may be required. An impairment loss would be recorded if the remaining net book value of the generating unit is greater than the present value of the amount expected to be recovered from ratepayers.The Pleasant Prairie power plant, Pulliam Units 7 and 8, and the jointly-owned Edgewater 4 generating unit were retired during 2018. PIPP was retired during 2019. Effective with the rate orders issued by the PSCW in December 2019, WE and WPS received approval to collect a return of and on the entire net book value of the retired generating units, excluding the Pleasant Prairie power plant. WE will collect a full return of the net book value of the Pleasant Prairie power plant, and a return on all but $100 million of the net book value. In accordance with its PSCW rate order received in December 2019, WE filed an application with the PSCW on July 20, 2020 requesting a financing order to securitize the remaining $100 million of the Pleasant Prairie power plant's book value related to certain environmental controls, plus the carrying costs accrued on the $100 million during the securitization process and related fees. On November 17, 2020, the PSCW issued a written order approving the application. See Note 6, Regulatory Assets and Liabilities, and Note 26, Regulatory Environment, for more information on our retired generating units, including various approvals we received from the FERC and the PSCW.2020 Form 10-K75WEC Energy Group, Inc.Table of ContentsPension and Other Postretirement Employee BenefitsThe costs of providing non-contributory defined pension benefits and OPEB, described in Note 20, Employee Benefits, are dependent upon numerous factors resulting from actual plan experience and assumptions of future experience.Pension and OPEB costs are impacted by actual employee demographics (including age, compensation levels, and employment periods), the level of contributions made to the plans, and earnings on plan assets. Pension and OPEB costs may also be significantly affected by changes in key actuarial assumptions, including anticipated rates of return on plan assets, mortality and discount rates, and expected health care cost trends. Changes made to the plan provisions may also impact current and future pension and OPEB costs.Pension and OPEB plan assets are primarily made up of equity and fixed income investments. Fluctuations in actual equity and fixed income market returns, as well as changes in general interest rates, may result in increased or decreased benefit costs in future periods. We believe that such changes in costs would be recovered or refunded at our utilities through the rate-making process.The following table shows how a given change in certain actuarial assumptions would impact the projected benefit obligation and the reported net periodic pension cost. Each factor below reflects an evaluation of the change based on a change in that assumption only.Actuarial Assumption(in millions, except percentages)Percentage-Point Change in AssumptionImpact on Projected Benefit ObligationImpact on 2020Pension CostDiscount rate(0.5)$232.2 $21.7 Discount rate0.5(198.7)(17.8)Rate of return on plan assets(0.5)N/A13.7 Rate of return on plan assets0.5N/A(13.7)The following table shows how a given change in certain actuarial assumptions would impact the accumulated OPEB obligation and the reported net periodic OPEB cost. Each factor below reflects an evaluation of the change based on a change in that assumption only.Actuarial Assumption(in millions, except percentages)Percentage-Point Change in AssumptionImpact on PostretirementBenefit ObligationImpact on 2020 PostretirementBenefit CostDiscount rate(0.5)$36.0 $3.9 Discount rate0.5(31.2)(3.3)Health care cost trend rate(0.5)(18.8)(4.1)Health care cost trend rate0.521.6 4.7 Rate of return on plan assets(0.5)N/A4.3 Rate of return on plan assets0.5N/A(4.3)The discount rates are selected based on hypothetical bond portfolios consisting of noncallable, high-quality corporate bonds across the full maturity spectrum. From the hypothetical bond portfolios, a single rate is determined that equates the market value of the bonds purchased to the discounted value of the plans' expected future benefit payments.We establish our expected return on assets based on consideration of historical and projected asset class returns, as well as the target allocations of the benefit trust portfolios. The assumed long-term rate of return on pension plan assets was 6.87% in 2020, and 7.12% in 2019 and 2018. The actual rate of return on pension plan assets, net of fees, was 12.65%, 18.89%, and (4.30)%, in 2020, 2019, and 2018, respectively.In selecting assumed health care cost trend rates, past performance and forecasts of health care costs are considered. For more information on health care cost trend rates and a table showing future payments that we expect to make for our pension and OPEB, see Note 20, Employee Benefits.Unbilled RevenuesWe record utility operating revenues when energy is delivered to our customers. However, the determination of energy sales to individual customers is based upon the reading of their meters, which occurs on a systematic basis throughout the month. At the 2020 Form 10-K76WEC Energy Group, Inc.Table of Contentsend of each month, amounts of energy delivered to customers since the date of their last meter reading are estimated and corresponding unbilled revenues are calculated. This unbilled revenue is estimated each month based upon actual generation and throughput volumes, recorded sales, estimated customer usage by class, weather factors, estimated line losses, and applicable customer rates. Significant fluctuations in energy demand for the unbilled period or changes in the composition of customer classes could impact the accuracy of the unbilled revenue estimate. Total utility operating revenues during 2020 of approximately $7.2 billion included unbilled utility revenues of $499.5 million as of December 31, 2020.Income Tax ExpenseWe are required to estimate income taxes for each of the jurisdictions in which we operate as part of the process of preparing consolidated financial statements. This process involves estimating current income tax liabilities together with assessing temporary differences resulting from differing treatment of items, such as depreciation, for income tax and accounting purposes. These differences result in deferred income tax assets and liabilities, which are included within our balance sheets. We also assess the likelihood that our deferred income tax assets will be recovered through future taxable income. To the extent we believe that realization is not likely, we establish a valuation allowance, which is offset by an adjustment to income tax expense in our income statements.Uncertainty associated with the application of tax statutes and regulations and the outcomes of tax audits and appeals requires that judgments and estimates be made in the accrual process and in the calculation of effective tax rates. Only income tax benefits that meet the "more likely than not" recognition threshold may be recognized or continue to be recognized. Unrecognized tax benefits are re-evaluated quarterly and changes are recorded based on new information, including the issuance of relevant guidance by the courts or tax authorities and developments occurring in the examinations of our tax returns.Significant management judgment is required in determining our provision for income taxes, deferred income tax assets and liabilities, the liability for unrecognized tax benefits, and any valuation allowance recorded against deferred income tax assets. The assumptions involved are supported by historical data, reasonable projections, and interpretations of applicable tax laws and regulations across multiple taxing jurisdictions. Significant changes in these assumptions could have a material impact on our financial condition and results of operations. See Note 1(q), Income Taxes, and Note 16, Income Taxes, for a discussion of accounting for income taxes.We expect our 2021 annual effective tax rate to be between 13% and 14%, which includes an estimated 6% effective tax rate benefit due to the amortization of unprotected excess deferred taxes in connection with the 2019 Wisconsin rate orders. Excluding this estimated effective tax rate benefit, the expected 2021 range would be between 19% and 20%.ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKSee Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations – Factors Affecting Results, Liquidity, and Capital Resources – Market Risks and Other Significant Risks, as well as Note 1(r), Fair Value Measurements, Note 1(s), Derivative Instruments, and Note 19, Guarantees, for information concerning potential market risks to which we are exposed.2020 Form 10-K77WEC Energy Group, Inc.Table of Contents
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+ITEM 7.MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSInformation in response to this Item 7 can be found in the 2020 Annual Report to Shareholders under “Financial Review.” That information is incorporated into this item by reference.ITEM 7A.QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKInformation in response to this Item 7A can be found in the 2020 Annual Report to Shareholders under “Financial Review – Risk Management – Asset/Liability Management.” That information is incorporated into this item by reference.
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+Item 7. Management’s Discussion and Analysis of Financial Condition and Results of OperationsEXECUTIVE SUMMARY Company Overview45Business Strategy46Key Transactions47Key Performance Indicators, Trends and Uncertainties48Corporate Governance49LIQUIDITY AND CAPITAL RESOURCES Sources and Uses of Cash49Off-Balance Sheet Arrangements50Contractual Obligations51Capital Structure51 RESULTS OF OPERATIONS Summary52Seniors Housing Operating53Triple-net55Outpatient Medical57Non-Segment/Corporate59 OTHER Non-GAAP Financial Measures60Critical Accounting Policies65 44Item 7. Management’s Discussion and Analysis of Financial Condition and Results of OperationsThe following discussion and analysis is based primarily on the consolidated financial statements of Welltower Inc. presented in conformity with U.S. generally accepted accounting principles (“U.S. GAAP”) for the periods presented and should be read together with the notes thereto contained in this Annual Report on Form 10-K. Other important factors are identified in “Item 1 — Business” and “Item 1A — Risk Factors” above.Executive SummaryCompany OverviewWelltower Inc. (NYSE:WELL), an S&P 500 company headquartered in Toledo, Ohio, is driving the transformation of health care infrastructure. The company invests with leading seniors housing operators, post-acute providers and health systems to fund the real estate and infrastructure needed to scale innovative care delivery models and improve people’s wellness and overall health care experience. Welltower™, a real estate investment trust (“REIT”), owns interests in properties concentrated in major, high-growth markets in the United States (“U.S.”), Canada and the United Kingdom (“U.K.”), consisting of seniors housing and post-acute communities and outpatient medical properties. The following table summarizes our consolidated portfolio for the year ended December 31, 2020 (dollars in thousands): Percentage ofNumber ofType of PropertyNOI(1)NOIPropertiesSeniors Housing Operating$755,552 37.6 %556Triple-net748,121 37.2 %641Outpatient Medical505,071 25.2 %296Totals$2,008,744 100.0 %1,493 (1) Represents consolidated net operating income ("NOI") and excludes our share of investments in unconsolidated entities. Entities in which we have a joint venture with a minority partner are shown at 100% of the joint venture amount. See Non-GAAP Financial Measures for additional information and reconciliation.The COVID-19 pandemic has had and may continue to have material and adverse effects on our financial condition, results of operations and cash flows in the future. The extent to which the COVID-19 pandemic impacts our operations and those of our operators and tenants will depend on future developments, which are highly uncertain and cannot be predicted with confidence, including the scope, severity and duration of the pandemic, the effectiveness and availability of vaccines and the success of ongoing vaccination deployment efforts in our facilities and the geographic areas in which we operate, the actions taken to contain the pandemic or mitigate its impact and the direct and indirect economic effects of the pandemic and containment measures, among others. Our Seniors Housing Operating revenues are dependent on occupancy. While admission bans were lifted across our portfolio during the second and third quarter, with the ramp up of COVID-19 cases in the general community in the fourth quarter, admissions bans, both government-imposed and voluntary bans adopted by operators, have been reinstated in many locations which have significantly affected occupancy rates. Occupancy has consistently declined since the beginning of the pandemic to 76.2% as of December 31, 2020. Through February 5, 2021, total occupancy declined an additional 180 basis points to 74.4%. Occupancy metrics represents approximate spot occupancy as reported by our operators for properties in operation as of February 29, 2020, including unconsolidated properties but excluding acquisitions, executed dispositions and development conversions since such date.We have incurred increased operational costs as a result of the introduction of public health measures and other regulations affecting our properties, as well as additional health and safety measures adopted by us and our operators related to the COVID-19 pandemic, including increases in labor, personal protective equipment and sanitation. We expect total Seniors Housing Operating expenses to remain elevated during the pandemic and potentially beyond as these additional health and safety measures become standard practice.Our Triple-net operators are experiencing similar occupancy declines and operating costs as described above with respect to our Seniors Housing Operating properties. However, long-term/post-acute care facilities are generally experiencing a higher degree of occupancy declines. These factors may continue to impact the ability of our Triple-net operators to make contractual rent payments to us in the future. Many of our Triple-net operators received funds under the Coronavirus Aid Relief, and Economic Security Act (“CARES Act”) Paycheck Protection Program. In addition, operators of long-term/post-acute care facilities have generally received funds from Phase 1 of the Provider Relief Fund and operators of assisted living facilities have or are expected to receive funds from Phase 2 of the Provider Relief Fund. Accordingly, collection of Triple-net rent due during the COVID-19 pandemic to date (from March to December) has generally been consistent with historical collection rates and no significant rent concessions or deferrals have been made. 45Item 7. Management’s Discussion and Analysis of Financial Condition and Results of OperationsOur Outpatient Medical tenants have experienced temporary medical practice closures or decreases in revenue due to government-imposed restrictions on elective medical procedures, stay at home orders or decisions by patients to delay treatments which may continue to adversely affect their ability to make contractual rent payments. These factors have and may continue to cause operators or tenants to seek modifications of such obligations, resulting in reductions in revenue and increases in uncollectible receivables. We will continue to evaluate each request on a case-by-case basis and determine if a form of rent relief is warranted following an examination of the tenant’s financial health, rent coverage, current operating situation and other factors. Outpatient Medical rent collections through March were generally consistent with pre COVID-19 levels. During the second quarter we executed short term rent deferrals with certain Outpatient Medical tenants which in most cases were required to be repaid by year end. Since then we have collected approximately 99% of Outpatient Medical rent due in the second half of the year, with uncollected amounts primarily attributable to local jurisdictions with COVID-19 related ordinances providing temporary rent relief to tenants. Furthermore, collections of deferred rent due under executed deferrals was over 99%. To the extent that deferred rent is not repaid as expected, or the prolonged impact of the COVID-19 pandemic causes operators or tenants to seek further modifications of their lease agreements, we may recognize reductions in revenue and increases in uncollectible receivables.As a result of uncertainty regarding the length and severity of the COVID-19 pandemic and the impact of the pandemic on our business and related industries, our investments in and acquisitions of seniors housing and health care properties, as well as our ability to transition or sell properties with profitable results in the future, may be limited. In response to the COVID-19 pandemic, acquisitions during the year ended December 31, 2020 declined compared to recent years. Additionally, we undertook certain opportunistic disposals to enhance near-term liquidity. We have a significant development portfolio as of December 31, 2020. To date we have only experienced minor construction and licensing delays with respect to our development portfolio, but may experience more significant delays in the future. Such disruptions to acquisition, disposition and development activity may negatively impact our long-term competitive position. Business StrategyOur primary objectives are to protect stockholder capital and enhance stockholder value. We seek to pay consistent cash dividends to stockholders and create opportunities to increase dividend payments to stockholders as a result of annual increases in NOI and portfolio growth. To meet these objectives, we invest across the full spectrum of seniors housing and health care real estate and diversify our investment portfolio by property type, relationship and geographic location.Substantially all of our revenues are derived from operating lease rentals, resident fees and services and interest earned on outstanding loans receivable. These items represent our primary sources of liquidity to fund distributions and depend upon the continued ability of our obligors to make contractual rent and interest payments to us and the profitability of our operating properties. To the extent that our obligors/partners experience operating difficulties and become unable to generate sufficient cash to make payments or operating distributions to us, there could be a material adverse impact on our consolidated results of operations, liquidity and/or financial condition. To mitigate this risk, we monitor our investments through a variety of methods determined by the type of property. Our asset management process for seniors housing properties generally includes review of monthly financial statements and other operating data for each property, review of obligor/partner creditworthiness, property inspections and review of covenant compliance relating to licensure, real estate taxes, letters of credit and other collateral. Our internal property management division manages and monitors the outpatient medical portfolio with a comprehensive process including review of tenant relations, lease expirations, the mix of health service providers, hospital/health system relationships, property performance, capital improvement needs and market conditions among other things. We evaluate the operating environment in each property’s market to determine the likely trend in operating performance of the facility. When we identify unacceptable trends, we seek to mitigate, eliminate or transfer the risk. Through these efforts, we generally aim to intervene at an early stage to address any negative trends, and in so doing, support both the collectability of revenue and the value of our investment.In addition to our asset management and research efforts, we also aim to structure our relevant investments to mitigate payment risk. Operating leases and loans are normally credit enhanced by guarantees and/or letters of credit. In addition, operating leases are typically structured as master leases and loans are generally cross-defaulted and cross-collateralized with other real estate loans, operating leases or agreements between us and the obligor and its affiliates.For the year ended December 31, 2020, resident fees and services and rental income represented 67% and 31%, respectively, of total revenues. Substantially all of our operating leases are designed with escalating rent structures. Leases with fixed annual rental escalators are generally recognized on a straight-line basis over the initial lease period, subject to a collectability assessment. Rental income related to leases with contingent rental escalators is generally recorded based on the contractual cash rental payments due for the period. Our yield on loans receivable depends upon a number of factors, including the stated interest rate, the average principal amount outstanding during the term of the loan and any interest rate adjustments.Our primary sources of cash include resident fees and services, rent and interest receipts, borrowings under our unsecured revolving credit facility and commercial paper program, public issuances of debt and equity securities, proceeds from investment dispositions and principal payments on loans receivable. Our primary uses of cash include dividend distributions, 46Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operationsdebt service payments (including principal and interest), real property investments (including acquisitions, capital expenditures, construction advances and transaction costs), loan advances, property operating expenses, general and administrative expenses and other expenses. Depending upon the availability and cost of external capital, we believe our liquidity is sufficient to fund these uses of cash.We also continuously evaluate opportunities to finance future investments. New investments are generally funded from temporary borrowings under our unsecured revolving credit facility and commercial paper program, internally generated cash and the proceeds from investment dispositions. Our investments generate cash from NOI and principal payments on loans receivable. Permanent financing for future investments, which replaces funds drawn under our unsecured revolving credit facility and commercial paper program, has historically been provided through a combination of the issuance of public debt and equity securities and the incurrence or assumption of secured debt.Depending upon market conditions, we believe that new investments will be available in the future with spreads over our cost of capital that will generate appropriate returns to our stockholders. It is also likely that investment dispositions may occur in the future. To the extent that investment dispositions exceed new investments, our revenues and cash flows from operations could be adversely affected. We expect to reinvest the proceeds from any investment dispositions in new investments. To the extent that new investment requirements exceed our available cash on-hand, we expect to borrow under our unsecured revolving credit facility and commercial paper program. During 2020, in response to the COVID-19 pandemic, we were strategic and opportunistic in disposing of certain real estate which provided significant near term liquidity. At December 31, 2020, we had $1,545,046,000 of cash and cash equivalents, $475,997,000 of restricted cash and $3,000,000,000 of available borrowing capacity under our unsecured revolving credit facility.Key TransactionsCapital The following summarizes key capital transactions that occurred during the year ended December 31, 2020: •In April 2020, we closed on a $1.0 billion two-year unsecured term loan. The term loan bears interest at a rate of 1-month LIBOR + 1.20%, based on our credit rating. •In June 2020, we completed the issuance of $600,000,000 senior unsecured notes bearing interest at 2.75% with a maturity date of January 2031. Net proceeds were used to fund tender offers for $426,248,000 of our 3.75% senior unsecured notes due 2023 and our 3.95% senior unsecured notes due 2023 which settled on July 1, 2020. The remaining proceeds were used to reduce borrowings under our term loan by $140,000,000.•We sold 2,128,000 shares of common stock under our ATM and DRIP programs, primarily in the first quarter, via both cash settle and forward sale agreements, generating gross proceeds of approximately $175,484,000. The sale of these shares and settlement of previously outstanding forward sales resulted in gross proceeds of approximately $607,177,000 which were used to reduce borrowings under our unsecured revolving credit facility. •We extinguished $632,288,000 of secured debt at a blended average interest rate of 2.21% throughout 2020.Investments The following summarizes property acquisitions and joint venture investments completed during the year ended December 31, 2020 (dollars in thousands): PropertiesInvestment Amount(1)Capitalization Rates(2)Book Amount(3)Seniors Housing Operating26 $574,793 3.5%$610,857 Triple-net11 88,908 6.5%90,731 Outpatient Medical17 246,516 6.1%249,312 Totals54 $910,217 4.5%$950,900 (1) Represents stated pro rata purchase price including cash and any assumed debt but excludes fair value adjustments pursuant to U.S. GAAP.(2) Represents annualized contractual or projected NOI to be received in cash divided by investment amounts.(3) Represents amounts recorded in real property including fair value adjustments pursuant to U.S. GAAP. See Note 3 to our consolidated financial statements for additional information.Dispositions The following summarizes property dispositions completed during the year ended December 31, 2020 (dollars in thousands): PropertiesProceeds(1)Capitalization Rates(2)Book Amount(3)Seniors Housing Operating31 $1,282,439 4.8%$1,289,769 Triple-net8 109,439 7.9%51,666 Outpatient Medical108 2,324,062 5.6%1,755,864 Totals147 $3,715,940 5.4%$3,097,299 (1) Represents pro rata proceeds received upon disposition including any seller financing.(2) Represents annualized contractual income that was being received in cash at date of disposition divided by disposition proceeds.(3) Represents carrying value of net real estate assets at time of disposition. See Note 5 to our consolidated financial statements for additional information.47Item 7. Management’s Discussion and Analysis of Financial Condition and Results of OperationsDividends On February 9, 2021, the Board of Directors declared a cash dividend for the quarter ended December 31, 2020 of $0.61 per share, consistent with the cash dividends for the quarters ended September 30, June 30 and March 31, 2020, representing a 30% decrease from the $0.87 per share dividend for the quarter ended December 31, 2019. The dividend declaration represents the 199th consecutive quarterly dividend payment.Key Performance Indicators, Trends and UncertaintiesWe utilize several key performance indicators to evaluate the various aspects of our business. These indicators are discussed below and relate to operating performance, credit strength and concentration risk. Management uses these key performance indicators to facilitate internal and external comparisons to our historical operating results, in making operating decisions, and for budget planning purposes.Operating Performance We believe that net income and net income attributable to common stockholders (“NICS”) per the Statement of Comprehensive Income are the most appropriate earnings measures. Other useful supplemental measures of our operating performance include funds from operations attributable to common stockholders (“FFO”) and consolidated net operating income (“NOI”); however, these supplemental measures are not defined by U.S. GAAP. Please refer to the section entitled “Non-GAAP Financial Measures” for further discussion and reconciliations. These earnings measures are widely used by investors and analysts in the valuation, comparison and investment recommendations of companies. The following table reflects the recent historical trends of our operating performance measures for the periods presented (in thousands): Year Ended December 31, 202020192018Net income$1,038,852 $1,330,410 $829,750 Net income attributable to common stockholders978,844 1,232,432 758,250 Funds from operations attributable to common stockholders1,102,562 1,577,080 1,392,183 Consolidated net operating income2,008,144 2,431,264 2,267,482 Credit Strength We measure our credit strength both in terms of leverage ratios and coverage ratios. The leverage ratios indicate how much of our balance sheet capitalization is related to long-term debt, net of cash and Internal Revenue Code (“IRC”) Section 1031 deposits. The coverage ratios indicate our ability to service interest and fixed charges (interest, secured debt principal amortization and preferred dividends). We expect to maintain capitalization ratios and coverage ratios sufficient to maintain a capital structure consistent with our current profile. The coverage ratios are based on adjusted earnings before interest, taxes, depreciation and amortization (“Adjusted EBITDA”). Please refer to the section entitled “Non-GAAP Financial Measures” for further discussion and reconciliation of these measures. Leverage ratios and coverage ratios are widely used by investors, analysts and rating agencies in the valuation, comparison, investment recommendations and rating of companies. The following table reflects the recent historical trends for our credit strength measures for the periods presented: Year Ended December 31, 202020192018Net debt to book capitalization ratio40.9%46.5%45.0%Net debt to undepreciated book capitalization ratio33.8%39.4%37.8%Net debt to market capitalization ratio29.7%29.6%31.3%Adjusted interest coverage ratio3.97x4.14x4.11xAdjusted fixed charge coverage ratio3.54x3.78x3.44xConcentration Risk We evaluate our concentration risk in terms of NOI by property mix, relationship mix and geographic mix. Concentration risk is a valuable measure in understanding what portion of our NOI could be at risk if certain sectors were to experience downturns. Property mix measures the portion of our NOI that relates to our various property types. Relationship mix measures the portion of our NOI that relates to our current top five relationships. Geographic mix measures the portion of our NOI that relates to our current top five states (or international equivalents). The following table reflects our recent historical trends of concentration risk by NOI for the years indicated below: 48Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations December 31,(1) 202020192018Property mix: Seniors Housing Operating38%43%43% Triple-net37%38%40% Outpatient Medical25%19%17%Relationship mix: Sunrise Senior Living(2)13%14%15%ProMedica11%9%4% Revera(2)5%6%7% Avery Healthcare4%3%3% Sagora Senior Living3%3%3% Remaining64%65%68%Geographic mix: California14%13%14% United Kingdom10%8%9% Texas9%8%8% Canada6%7%7% Pennsylvania6%6%5% Remaining55%58%57%(1) Excludes our share of investments in unconsolidated entities and non-segment/corporate NOI. Entities in which we have a joint venture with a minority partner are shown at 100% of the joint venture amount.(2) Revera owns a controlling interest in Sunrise Senior Living.We evaluate our key performance indicators in conjunction with current expectations to determine if historical trends are indicative of future results. Our expected results may not be achieved and actual results may differ materially from our expectations. Factors that may cause actual results to differ from expected results are described in more detail in “Item 1 — Business — Cautionary Statement Regarding Forward-Looking Statements” and “Item 1A — Risk Factors” and other sections of this Annual Report on Form 10-K. Management regularly monitors economic and other factors to develop strategic and tactical plans designed to improve performance and maximize our competitive position. Our ability to achieve our financial objectives is dependent upon our ability to effectively execute these plans and to appropriately respond to emerging economic and company-specific trends. Please refer to “Item 1 — Business,” “Item 1A — Risk Factors” in this Annual Report on Form 10-K for further discussion of these risk factors.Corporate GovernanceMaintaining investor confidence and trust is important in today’s business environment. Our Board of Directors and management are strongly committed to policies and procedures that reflect the highest level of ethical business practices. Our corporate governance guidelines provide the framework for our business operations and emphasize our commitment to increase stockholder value while meeting all applicable legal requirements. These guidelines meet the listing standards adopted by the New York Stock Exchange and are available on the Internet at www.welltower.com/investors/governance. The information on our website is not incorporated by reference in this Annual Report on Form 10-K, and our web address is included as an inactive textual reference only.Liquidity and Capital ResourcesSources and Uses of CashOur primary sources of cash include resident fees and services, rent and interest receipts, borrowings under our unsecured revolving credit facility and commercial paper program, public issuances of debt and equity securities, proceeds from investment dispositions and principal payments on loans receivable. Our primary uses of cash include dividend distributions, debt service payments (including principal and interest), real property investments (including acquisitions, capital expenditures, construction advances and transaction costs), loan advances, property operating expenses, general and administrative expenses and other expenses. These sources and uses of cash are reflected in our Consolidated Statements of Cash Flows and are discussed in further detail below. The following is a summary of our sources and uses of cash flows for the periods presented (dollars in thousands):49Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations Year EndedOne Year ChangeYear EndedOne Year ChangeTwo Year Change December 31,December 31, December 31, 20202019$%2018$%$%Cash, cash equivalents and restricted cash at beginning of period$385,766 $316,129 $69,637 22 %$309,303 $6,826 2 %$76,463 25 %Net cash provided from (used in): Operating activities1,364,756 1,535,968 (171,212)-11 %1,583,944 (47,976)-3 %(219,188)-14 %Investing activities2,347,928 (2,048,791)4,396,719 n/a(2,386,471)337,680 -14 %4,734,399 n/aFinancing activities(2,080,858)577,150 (2,658,008)n/a818,368 (241,218)-29 %(2,899,226)n/aEffect of foreign currency translation3,451 5,310 (1,859)-35 %(9,015)14,325 n/a12,466 n/aCash, cash equivalents and restricted cash at end of period$2,021,043 $385,766 $1,635,277 424 %$316,129 $69,637 22 %$1,704,914 539 %Operating Activities The changes in net cash provided from operating activities are primarily attributable to declines in revenue and increases in property operating expenses, as well as the impact of short-term deferrals granted as a result of the COVID-19 pandemic in 2020. Please see “Results of Operations” for discussion of net income fluctuations. For the years ended December 31, 2020, 2019 and 2018, cash flows from operations exceeded cash distributions to stockholders.Investing Activities The changes in net cash used in investing activities are primarily attributable to net changes in real property investments and dispositions, loans receivable and investments in unconsolidated entities which are summarized above in “Key Transactions.” Please refer to Notes 3 and 5 of our consolidated financial statements for additional information. The following is a summary of cash used in non-acquisition capital improvement activities for the periods presented (dollars in thousands): Year EndedOne Year ChangeYear EndedOne Year ChangeTwo Year Change December 31,December 31, December 31, 20202019$%2018$%$%New development$201,336 $323,488 $(122,152)-38 %$160,706 $162,782 101 %$40,630 25 %Recurring capital expenditures, tenant improvements and lease commissions83,146 136,535 (53,389)-39 %90,190 46,345 51 %(7,044)-8 %Renovations, redevelopments and other capital improvements161,843 192,289 (30,446)-16 %175,993 16,296 9 %(14,150)-8 %Total$446,325 $652,312 $(205,987)-32 %$426,889 $225,423 53 %$19,436 5 %The change in new development is primarily due to the number and size of construction projects on-going during the relevant periods. Renovations, redevelopments and other capital improvements include expenditures to maximize property value, increase net operating income, maintain a market-competitive position and/or achieve property stabilization. Financing Activities The changes in net cash provided from/used in financing activities are primarily attributable to changes related to our long-term debt arrangements, the issuances of common stock and dividend payments which are summarized above in “Key Transactions.” Please refer to Notes 10, 11 and 14 of our consolidated financial statements for additional information.On April 1, 2020, in response to uncertain financial market conditions arising from the COVID-19 pandemic, we undertook steps to strengthen our balance sheet and to enhance our liquidity by entering into a $1.0 billion two-year unsecured term loan. Additionally, on June 30, 2020, we completed the issuance of $600,000,000 senior unsecured notes with a maturity date of January 2031. Net proceeds were used to fund tender offers for $426,248,000 of our 3.75% senior unsecured notes due 2023 and our 3.95% senior unsecured notes due 2023, which settled on July 1, 2020. The remaining proceeds were used to reduce borrowings under the term loan by $140,000,000. As of December 31, 2020, we have total near-term available liquidity of approximately $4.5 billion. However, we are unable to accurately predict the full impact that the pandemic will have on our results from operations, financial condition, liquidity and cash flows due to numerous factors discussed in Part I Item 1A. Risk Factors.Off-Balance Sheet ArrangementsAt December 31, 2020, we had investments in unconsolidated entities with our ownership generally ranging from 10% to 65%. We use financial derivative instruments to hedge interest rate and foreign currency exchange rate exposure. At December 31, 2020, we had nine outstanding letter of credit obligations. Please see Notes 8, 12 and 13 to our consolidated financial statements for additional information.50Item 7. Management’s Discussion and Analysis of Financial Condition and Results of OperationsContractual ObligationsThe following table summarizes our payment requirements under contractual obligations as of December 31, 2020 (in thousands): Payments Due by PeriodContractual ObligationsTotal20212022-20232024-2025ThereafterSenior unsecured notes and term credit facilities:(1) U.S. Dollar senior unsecured notes$8,273,752 $— $673,752 $2,600,000 $5,000,000 Canadian Dollar senior unsecured notes(2)235,239 — — — 235,239 Pounds Sterling senior unsecured notes(2)1,434,510 — — — 1,434,510 U.S. Dollar term credit facility1,370,000 — 1,370,000 — — Canadian Dollar term credit facility(2)196,032 — 196,032 — — Secured debt:(1,2) Consolidated2,378,073 451,038 833,433 397,785 695,817 Unconsolidated 1,064,949 54,073 206,924 557,508 246,444 Contractual interest obligations:(3) Senior unsecured notes and term loans(2)3,872,398 423,475 816,492 651,101 1,981,330 Consolidated secured debt(2)309,885 72,990 101,412 58,755 76,728 Unconsolidated secured debt(2)200,426 35,099 65,011 42,031 58,285 Financing lease liabilities(4)197,427 8,777 78,026 2,950 107,674 Operating lease obligations(4)1,002,538 20,316 38,133 33,955 910,134 Purchase obligations(5)784,797 399,771 309,660 65,920 9,446 Total contractual obligations$21,320,026 $1,465,539 $4,688,875 $4,410,005 $10,755,607 (1) Amounts represent principal amounts due and do not reflect unamortized premiums/discounts or other fair value adjustments as reflected on the Consolidated Balance Sheets.(2) Based on foreign currency exchange rates in effect as of balance sheet date.(3) Based on variable interest rates in effect as of December 31, 2020.(4) See Note 6 to our consolidated financial statements for additional information.(5) See Note 13 to our consolidated financial statements for additional information.Capital StructurePlease refer to “Credit Strength” above for a discussion of our leverage and coverage ratio trends. Our debt agreements contain various covenants, restrictions and events of default. Certain agreements require us to maintain financial ratios and minimum net worth and impose certain limits on our ability to incur indebtedness, create liens and make investments or acquisitions. As of December 31, 2020, we were in compliance with all of the covenants under our debt agreements. None of our debt agreements contain provisions for acceleration which could be triggered by our debt ratings. However, under our primary unsecured credit facility, the ratings on our senior unsecured notes are used to determine the fees and interest charged. We plan to manage the company to maintain compliance with our debt covenants and with a capital structure consistent with our current profile. Any downgrades in terms of ratings or outlook by any or all of the rating agencies could have a material adverse impact on our cost and availability of capital, which could have a material adverse impact on our consolidated results of operations, liquidity and/or financial condition.On May 17, 2018, we filed with the Securities and Exchange Commission (1) an open-ended automatic or “universal” shelf registration statement covering an indeterminate amount of future offerings of debt securities, common stock, preferred stock, depositary shares, warrants and units and (2) a registration statement in connection with our enhanced dividend reinvestment plan (“DRIP”) under which we may issue up to 15,000,000 shares of common stock. As of January 29, 2021, 2,541,750 shares of common stock remained available for issuance under the DRIP registration statement. On February 25, 2019, we entered into separate amended and restated equity distribution agreements with each of Barclays Capital Inc., Citigroup Global Markets Inc., Credit Agricole Securities (USA) Inc., Deutsche Bank Securities Inc., Goldman Sachs & Co. LLC, J.P. Morgan Securities LLC, KeyBanc Capital Markets Inc., Merrill Lynch, Pierce, Fenner & Smith Incorporated, Morgan Stanley & Co. LLC, MUFG Securities Americas Inc., RBC Capital Markets, LLC, UBS Securities LLC and Wells Fargo Securities, LLC relating to the offer and sale from time to time of up to $1,500,000,000 aggregate amount of our common stock (“Equity Shelf Program”). The Equity Shelf Program also allows us to enter into forward sale agreements. As of January 29, 2021, we had $499,341,000 of remaining capacity under the Equity Shelf Program and there were no outstanding forward sales agreements. Depending upon market conditions, we anticipate issuing securities under our registration statements to invest in additional properties and to repay borrowings under our unsecured revolving credit facility and commercial paper program.On May 1, 2020, our Board of Directors authorized a share repurchase program whereby we may repurchase up to $1 billion of common stock through December 31, 2021 (the "Repurchase Program"). Under this authorization, we are not required to purchase shares but may choose to do so in the open market or through private transactions at times and amounts based on our 51Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operationsevaluation of market conditions and other factors. We expect to finance any share repurchases under the Repurchase Program using available cash and may use proceeds from borrowings or debt offerings. Results of OperationsSummaryOur primary sources of revenue include resident fees and services, rent and interest income. Our primary expenses include property operating expenses, depreciation and amortization, interest expense, general and administrative expenses, and other expenses. We evaluate our business and make resource allocations on our three business segments: Seniors Housing Operating, Triple-net and Outpatient Medical. The primary performance measures for our properties are NOI and same store NOI ("SSNOI") and other supplemental measures include FFO and Adjusted EBITDA, which are further discussed below. Please see "Non-GAAP Financial Measures" for additional information and reconciliations related to these supplemental measures. This section of this Form 10-K generally discusses 2020 and 2019 items and year-to-year comparisons between 2020 and 2019. Discussions of 2018 items and year-to-year comparisons between 2019 and 2018 that are not included in this Form 10-K can be found in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Part II, Item 7 of the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2019.The following is a summary of our results of operations for the periods presented (dollars in thousands, except per share amounts): Year EndedOne Year ChangeYear EndedOne Year ChangeTwo Year Change December 31,December 31, December 31, 20202019Amount%2018Amount%Amount%Net income$1,038,852 $1,330,410 $(291,558)-22 %$829,750 $500,660 60 %$209,102 25 %NICS978,844 1,232,432 (253,588)-21 %758,250 474,182 63 %220,594 29 %FFO1,102,562 1,577,080 (474,518)-30 %1,392,183 184,897 13 %(289,621)-21 %Adjusted EBITDA2,048,412 2,328,202 (279,790)-12 %2,153,005 175,197 8 %(104,593)-5 %Consolidated NOI2,008,144 2,431,264 (423,120)-17 %2,267,482 163,782 7 %(259,338)-11 %Per share data (fully diluted): Net income attributable to commonstockholders (1)$2.33 $3.05 $(0.72)-24 %$2.02 $1.03 51 %$0.31 15 %Funds from operations attributable to common stockholders$2.64 $3.91 $(1.27)-32 %$3.71 $0.20 5 %$(1.07)-29 %Adjusted interest coverage ratio3.97x4.14x-0.17x-4 %4.11x0.03x1 %-0.14x-3 %Adjusted fixed charge coverage ratio3.54x3.78x-0.24x-6 %3.44x0.34x10 %0.10x3 %(1) Includes adjustment to the numerator for income (loss) attributable to OP unitholders.The following table represents the changes in outstanding common stock for the period from January 1, 2018 to December 31, 2020 (in thousands): Year Ended December 31, 2020December 31, 2019December 31, 2018TotalsBeginning balance410,257 383,675 371,732 371,732 Dividend reinvestment plan issuances264 5,799 6,529 12,592 Preferred stock conversions— 12,712 — 12,712 Option exercises— 11 57 68 Equity Shelf Program issuances6,800 7,856 5,241 19,897 Repurchase of common stock(202)— — (202)Other, net282 204 116 602 Ending balance417,401 410,257 383,675 417,401 Average number of shares outstanding: Basic415,451 401,845 373,620 Diluted417,387 403,808 375,250 During the past three years, inflation has not significantly affected our earnings because of the moderate inflation rate. Additionally, a portion of our earnings are derived primarily from long-term investments with predictable rates of return. These investments are mainly financed with a combination of equity, senior unsecured notes, secured debt and borrowings under our primary unsecured credit facility. During inflationary periods, which generally are accompanied by rising interest rates, our ability to grow may be adversely affected because the yield on new investments may increase at a slower rate than new borrowing costs. Presuming the current inflation rate remains moderate and long-term interest rates do not increase significantly, we believe that inflation will not impact the availability of equity and debt financing for us.52Item 7. Management’s Discussion and Analysis of Financial Condition and Results of OperationsSeniors Housing Operating The following is a summary of our SSNOI at Welltower's Share for the Seniors Housing Operating segment (dollars in thousands): QTD PoolYTD PoolThree Months EndedChangeYear EndedChange December 31, 2020December 31, 2019$%December 31, 2020December 31, 2019$%SSNOI(1)$154,373 $216,166 $(61,793)-28.6 %$591,133 $764,328 $(173,195)-22.7 %(1) Relates to 514 properties for the QTD Pool and 399 properties for the YTD Pool. Please see "Non-GAAP Financial Measures for additional information and reconciliations.The following is a summary of our results of operations for the Seniors Housing Operating segment for the years presented (dollars in thousands): Year EndedOne Year ChangeYear EndedOne Year ChangeTwo Year Change December 31,December 31, December 31, 20202019$%2018$%$%Revenues: Resident fees and services$3,074,022 $3,448,175 $(374,153)-11 %$3,234,852 $213,323 7 %$(160,830)-5 % Interest income618 36 582 n/a578 (542)-94 %40 7 % Other income7,223 8,658 (1,435)-17 %5,024 3,634 72 %2,199 44 % Total revenues3,081,863 3,456,869 (375,006)-11 %3,240,454 216,415 7 %(158,591)-5 %Property operating expenses2,326,311 2,417,349 (91,038)-4 %2,255,432 161,917 7 %70,879 3 % NOI(1)755,552 1,039,520 (283,968)-27 %985,022 54,498 6 %(229,470)-23 %Other expenses: Depreciation and amortization544,462 553,189 (8,727)-2 %529,449 23,740 4 %15,013 3 % Interest expense54,901 67,983 (13,082)-19 %69,060 (1,077)-2 %(14,159)-21 % Loss (gain) on extinguishment of debt, net12,659 1,614 11,045 684 %110 1,504 n/a12,549 n/aProvision for loan losses671 — 671 n/a— — n/a671 n/a Impairment of assets100,741 2,145 98,596 n/a7,599 (5,454)-72 %93,142 1,226 % Other expenses14,265 26,348 (12,083)-46 %6,624 19,724 298 %7,641 115 % 727,699 651,279 76,420 12 %612,842 38,437 6 %114,857 19 %Income (loss) from continuing operations before income taxes and other items 27,853 388,241 (360,388)-93 %372,180 16,061 4 %(344,327)-93 %Income (loss) from unconsolidated entities(33,857)12,388 (46,245)-373 %(28,142)40,530 144 %(5,715)-20 %Gain (loss) on real estate dispositions, net328,249 528,747 (200,498)-38 %(2,245)530,992 n/a330,494 n/aIncome from continuing operations322,245 929,376 (607,131)-65 %341,793 587,583 172 %(19,548)-6 %Net income (loss)322,245 929,376 (607,131)-65 %341,793 587,583 172 %(19,548)-6 %Less: Net income (loss) attributable to noncontrolling interests20,301 56,513 (36,212)-64 %(660)57,173 n/a20,961 n/aNet income (loss) attributable to common stockholders$301,944 $872,863 $(570,919)-65 %$342,453 $530,410 155 %$(40,509)-12 % (1) See Non-GAAP Financial Measures below.Decreases in resident fees and services and property operating expenses are primarily a result of property dispositions and decreases in occupancy across the portfolio due to the COVID-19 pandemic. Occupancy within our Seniors Housing Operating portfolio has declined as follows:Feb.Mar.Apr.MayJun.Jul.Aug.Sep.Oct.Nov.Dec.Spot occupancy (1)85.6 %84.9 %82.6 %80.9 %79.9 %79.3 %78.7 %78.4 %78.0 %77.3 %76.2 %Sequential occupancy change(0.7)%(2.3)%(1.7)%(1.0)%(0.6)%(0.6)%(0.3)%(0.4)%(0.7)%(1.1)%(1) Spot occupancy represents approximate month end occupancy for properties in operation as of February 29, 2020, including unconsolidated properties but excluding acquisitions, dispositions and development conversions since this date.In addition, we have experienced increased operational costs, net of reimbursements, of $78,792,000 during the year ended December 31, 2020, included in property operating expenses relating to our consolidated properties. These expenses were incurred as a result of the introduction of public health measures and other regulations affecting our properties, as well as additional health and safety measures adopted by us and our operators related to the COVID-19 pandemic, including increases in labor and property cleaning expenses and expenditures related to our efforts to procure PPE and supplies, net of reimbursements. We expect total portfolio expenses to be elevated during the pandemic and potentially beyond as these additional health and safety measures become standard practice.53Item 7. Management’s Discussion and Analysis of Financial Condition and Results of OperationsIn 2020 applications were made for amounts under Phase 2 and Phase 3 of the Provider Relief Fund following the announcement from the Department of Health and Human Services that it expanded the eligibility of the CARES Act Provider Relief Fund to include assisted living facilities. During the fourth quarter, we received Provider Relief Funds of approximately $9 million which was recognized as a reduction to property operating expenses. To date in 2021, we have received approximately $34 million of Provider Relief Funds.During the year ended December 31, 2020, we recorded impairment charges of $100,741,000 related to 15 held for sale or sold properties and six held for use properties. During the year ended December 31, 2019, we recorded impairment charges of $2,145,000 related to four held for use properties. Transaction costs related to asset acquisitions are capitalized as a component of the purchase price. Changes in the gain on sale of properties are due to the volume of property sales and sales prices. During the year ended December 31, 2020, we recognized a gain on real estate disposition of $313 million related to an 11 property U.S. portfolio. During the year ended December 31, 2019, we recognized a gain on real estate disposition of $520 million related to the Benchmark Senior Living portfolio. The fluctuation in other expenses is primarily due to the timing of noncapitalizable transaction costs associated with acquisitions and operator transitions.Depreciation and amortization fluctuates as a result of acquisitions, disposition and transitions. To the extent we acquire or dispose of additional properties in the future, our provision for depreciation and amortization will change accordingly.During the year ended December 31, 2020, we completed three Seniors Housing Operating construction projects representing $93,188,000 or $300,606 per unit. The following is a summary of our consolidated Seniors Housing Operating construction projects, excluding expansions, pending as of December 31, 2020 (dollars in thousands):LocationUnits/BedsCommitmentBalanceEst. CompletionPotomac, MD120 $56,720 $48,783 2Q21Beckenham, UK100 64,348 45,722 3Q21Barnet, UK100 70,769 41,215 4Q21Hendon, UK102 75,824 50,817 1Q22Princeton, NJ80 29,780 19,209 3Q22Berea, OH120 14,934 1,538 4Q22Painesville, OH119 14,462 1,508 4Q22Beaver, PA116 14,184 1,152 4Q22857 $341,021 209,944 Toronto, ONProject in planning stage46,856 Brookline, MAProject in planning stage23,679 Washington, DCProject in planning stage22,951 Columbus, OHProject in planning stage11,492 Raleigh, NCProject in planning stage3,107 $318,029 Interest expense represents secured debt interest expense which fluctuates based on the net effect and timing of assumptions, segment transitions, fluctuations in foreign currency rates, extinguishments and principal amortizations. The fluctuations in loss (gain) on extinguishment of debt is primarily attributable to the volume of extinguishments and terms of the related secured debt. The following is a summary of our Seniors Housing Operating segment property secured debt principal activity (dollars in thousands):Year EndedYear EndedYear EndedDecember 31, 2020December 31, 2019December 31, 2018 Weighted Avg. Weighted Avg. Weighted Avg. AmountInterest RateAmountInterest RateAmountInterest RateBeginning balance$2,115,037 3.54%$1,810,587 3.87%$1,988,700 3.66%Debt transferred in— —%— —%35,830 3.84%Debt issued62,055 2.55%343,696 3.11%45,447 3.40%Debt assumed— —%183,061 4.58%121,612 5.55%Debt extinguished(441,208)2.18%(219,864)4.28%(240,095)4.83%Debt transferred out— —%(12,072)3.89%— —%Principal payments(48,498)3.30%(43,997)3.45%(47,886)3.59%Foreign currency18,803 2.93%53,626 3.33%(93,021)3.31%Ending balance$1,706,189 3.05%$2,115,037 3.54%$1,810,587 3.87%Monthly averages$1,875,910 3.19%$1,966,892 3.70%$1,915,663 3.74%54Item 7. Management’s Discussion and Analysis of Financial Condition and Results of OperationsThe majority of our Seniors Housing Operating properties are formed through partnership interests. Losses from unconsolidated entities during the year ended December 31, 2020 are largely attributable to depreciation and amortization of short-lived intangible assets related to certain investments in unconsolidated joint ventures. The gains from unconsolidated entities during the year ended December 31, 2019 are largely due to a gain on the disposition of an unconsolidated entity. Net income attributable to noncontrolling interests represents our partners’ share of net income (loss) related to joint ventures. The increase during the years ended December 31, 2020 and 2019 relates primarily to our partner's share of the gains recognized on the sale of the 11 property U.S. portfolio and the Benchmark Senior Living portfolio, respectively.Triple-net The following is a summary of our SSNOI at Welltower's Share for the Triple-net segment (dollars in thousands): QTD PoolYTD PoolThree Months EndedChangeYear EndedChange December 31, 2020December 31, 2019$%December 31, 2020December 31, 2019$%SSNOI(1)$168,697 $170,052 $(1,355)-0.8 %$628,972 $624,877 $4,095 0.7 %(1) Relates to 632 properties for the QTD Pool and 608 properties for the YTD Pool. Please see Non-GAAP Financial Measures for additional information and reconciliations.The following is a summary of our results of operations for the Triple-net segment for the years presented (dollars in thousands): Year EndedOne Year ChangeYear EndedOne Year ChangeTwo Year Change December 31,December 31, December 31, 20202019$%2018$%$%Revenues: Rental income$733,776 $903,798 $(170,022)-19 %$828,865 $74,933 9 %$(95,089)-11 % Interest income62,625 62,599 26 — %54,926 7,673 14 %7,699 14 % Other income4,903 6,246 (1,343)-22 %17,173 (10,927)-64 %(12,270)-71 % Total revenues801,304 972,643 (171,339)-18 %900,964 71,679 8 %(99,660)-11 %Property operating expenses53,183 53,900 (717)-1 %915 52,985 5,791 52,268 5,712 NOI(1)748,121 918,743 (170,622)-19 %900,049 18,694 2 %(151,928)-17 %Other expenses: Depreciation and amortization232,604 232,626 (22)— %235,480 (2,854)-1 %(2,876)-1 % Interest expense9,477 12,892 (3,415)-26 %14,225 (1,333)-9 %(4,748)-33 % Loss (gain) on derivatives and financial instruments, net11,049 (4,399)15,448 351 %(4,016)(383)-10 %15,065 375 % Loss (gain) on extinguishment of debt, net— — — n/a(32)32 100 %32 100 % Provision for loan losses90,563 18,690 71,873 385 — 18,690 n/a90,563 n/a Impairment of assets34,867 11,926 22,941 192 %107,980 (96,054)-89 %(73,113)-68 % Other expenses22,923 13,771 9,152 66 %90,975 (77,204)-85 %(68,052)-75 % 401,483 285,506 115,977 41 %444,612 (159,106)-36 %(43,129)-10 %Income from continuing operations before income taxes and other items346,638 633,237 (286,599)-45 %455,437 177,800 39 %(108,799)-24 %Income (loss) from unconsolidated entities18,462 22,985 (4,523)-20 %21,938 1,047 5 %(3,476)-16 %Gain (loss) on real estate dispositions, net64,288 218,322 (154,034)-71 %196,589 21,733 11 %(132,301)-67 %Income from continuing operations429,388 874,544 (445,156)-51 %673,964 200,580 30 %(244,576)-36 %Net income429,388 874,544 (445,156)-51 %673,964 200,580 30 %(244,576)-36 %Less: Net income attributable to noncontrolling interests39,985 36,271 3,714 10 %19,306 16,965 88 %20,679 107 %Net income attributable to common stockholders$389,403 $838,273 $(448,870)-54 %$654,658 $183,615 28 %$(265,255)-41 %(1) See Non-GAAP Financial Measures below.The decrease in rental income is primarily attributable to the write-off of straight-line rent receivable balances of $146,508,000 during the year ended December 31, 2020, relating to leases for which collection of substantially all contractual lease payments was no longer deemed probable. Included in such amounts was $91,025,000 relating to Genesis Healthcare whom noted substantial doubt as to their ability to continue as a going concern in August. Certain of our leases contain annual rental escalators that are contingent upon changes in the Consumer Price Index and/or changes in the gross operating revenues of the tenant’s properties. These escalators are not fixed, so no straight-line rent is recorded; however, rental income is recorded based on the contractual cash rental payments due for the period. If gross operating revenues at our facilities and/or the Consumer Price Index do not increase, a portion of our revenues may not continue to increase. For the three months ended 55Item 7. Management’s Discussion and Analysis of Financial Condition and Results of OperationsDecember 31, 2020, we had 18 leases with rental rate increasers ranging from 0.07% to 0.34% in our Triple-net portfolio. Our Triple-net operators are experiencing similar impacts on occupancy and operating costs due to the COVID-19 pandemic as described above with respect to our Seniors Housing Operating properties. However, long-term/post-acute facilities are generally experiencing a higher degree of occupancy declines which may impact the ability of our Triple-net operators to make contractual rent payments to us in the future. Many of our Triple-net operators received funds under the CARES Act Paycheck Protection Program. In addition, operators of long-term/post-acute facilities have generally received funds from Phase 1 of the Provider Relief Fund and operators of assisted living facilities have or are expected to receive funds from Phase 2 of the Provider Relief Fund. Accordingly, collection of rent due during the COVID-19 pandemic to date (March through December) has generally been consistent with historical collection rates and no significant rent concessions or deferrals have been made.Depreciation and amortization fluctuates as a result of acquisitions, disposition and transitions of triple-net properties. To the extent we acquire or dispose of additional properties in the future, our provision for depreciation and amortization will change accordingly.During the year ended December 31, 2020, we recognized a provision for loan losses of $90,563,000, of which $80,873,000 represents additional reserves as a result of the current collateral estimate related to the Genesis Healthcare outstanding loans. During the year ended December 31, 2019, we recognized a provision for loan losses of $18,690,000 to fully reserve for certain real estate loans receivable that were no longer deemed collectible. During the year ended December 31, 2020, we recorded impairment charges of $34,867,000 related to one held for sale and four held for use properties. During the year ended December 31, 2019, we recorded impairment charges of $11,374,000 related to two properties. Changes in the gain on sales of properties are related to the volume and timing of property sales and the sales prices. The fluctuation in other expense is primarily due to noncapitalizable transaction costs from acquisitions and segment transitions.During the year ended December 31, 2020, we completed three Triple-net construction projects representing $75,149,000 or $224,997 per unit. The following is a summary of our consolidated Triple-net construction projects, excluding expansions, pending as of December 31, 2020 (dollars in thousands):LocationUnits/BedsCommitmentBalanceEst. CompletionThousand Oaks, CA82 $25,391 $21,408 1Q21Redhill, UK76 21,723 11,869 2Q21Leicester, UK60 15,301 5,566 1Q22Wombourne, UK66 16,394 5,537 2Q22Raleigh, NC191 154,256 14,339 2Q23Total475 $233,065 $58,719 Loss (gain) on derivatives and financial instruments, net is primarily attributable to the mark-to-market adjustments recorded on our Genesis Healthcare available-for-sale investment. Interest expense represents secured debt interest expense and related fees. The change in secured debt interest expense is due to the net effect and timing of assumptions, segment transitions, fluctuations in foreign currency rates, extinguishments and principal amortizations. The following is a summary of our Triple-net secured debt principal activity for the periods presented (dollars in thousands):Year EndedYear EndedYear EndedDecember 31, 2020December 31, 2019December 31, 2018 Weighted Avg. Weighted Avg. Weighted Avg. AmountInterest RateAmountInterest RateAmountInterest RateBeginning balance$306,038 3.60%$288,386 3.63%$347,474 3.55%Debt transferred in— —%12,072 3.89%— —%Debt extinguished(176,875)2.03%— —%(4,107)4.94%Debt transferred out— —%— —%(35,830)3.84%Principal payments(4,376)5.16%(4,017)5.21%(3,982)5.38%Foreign currency(1,135)2.97%9,597 2.99%(15,169)3.44%Ending balance$123,652 4.91%$306,038 3.60%$288,386 3.63%Monthly averages$215,796 3.85%$294,080 3.63%$321,730 3.51%A portion of our Triple-net properties were formed through partnerships. Income or loss from unconsolidated entities represents our share of net income or losses from partnerships where we are the noncontrolling partner. The decrease in income from unconsolidated entities during the year ended December 31, 2020 is primarily related to the write-off of Genesis Healthcare straight-line rent receivable balances at unconsolidated entities. Net income attributable to noncontrolling interests represents our partners’ share of net income relating to those partnerships where we are the controlling partner. 56Item 7. Management’s Discussion and Analysis of Financial Condition and Results of OperationsOutpatient Medical The following is a summary of our SSNOI at Welltower Share for the Outpatient Medical segment (dollars in thousands): QTD PoolYTD PoolThree Months EndedChangeYear EndedChange December 31, 2020December 31, 2019$%December 31, 2020December 31, 2019$%SSNOI(1)$84,985 $84,144 $841 1.0 %$252,512 $246,789 $5,723 2.3 %(1) Relates to 303 properties for the QTD Pool and 231 properties for the YTD Pool. Please see Non-GAAP Financial Measures for additional information and reconciliations.The following is a summary of our results of operations for the Outpatient Medical segment for the periods presented (dollars in thousands): Year EndedOne Year ChangeYear EndedOne Year ChangeTwo Year Change December 31,December 31, December 31, 20202019$%2018$%$%Revenues: Rental income$709,584 $684,602 $24,982 4 %$551,557 $133,045 24 %$158,027 29 % Interest income5,913 1,195 4,718 395 %310 885 285 %5,603 n/a Other income4,522 2,031 2,491 123 %4,939 (2,908)-59 %(417)-8 % Total revenues720,019 687,828 32,191 5 %556,806 131,022 24 %163,213 29 %Property operating expenses214,948 218,793 (3,845)-2 %176,670 42,123 24 %38,278 22 % NOI(1)505,071 469,035 36,036 8 %380,136 88,899 23 %124,935 33 %Other expenses: Depreciation and amortization261,371 241,258 20,113 8 %185,530 55,728 30 %75,841 41 % Interest expense17,579 13,411 4,168 31 %7,051 6,360 90 %10,528 149 % Loss (gain) on extinguishment of debt, net1,046 — 1,046 n/a11,928 (11,928)-100 %(10,882)-91 % Provision for loan losses.3,202 — 3,202 n/a— — n/a3,202 n/a Impairment of assets— 14,062 (14,062)-100 %— 14,062 n/a— n/a Other expenses8,218 1,788 6,430 360 %7,570 (5,782)-76 %648 9 % 291,416 270,519 20,897 8 %212,079 58,440 28 %79,337 37 %Income from continuing operations before income taxes and other item213,655 198,516 15,139 8 %168,057 30,459 18 %45,598 27 %Income (loss) from unconsolidated entities7,312 7,061 251 4 %5,563 1,498 27 %1,749 31 %Gain (loss) on real estate dispositions, net695,918 972 694,946 n/a221,231 (220,259)-100 %474,687 215 %Income from continuing operations916,885 206,549 710,336 344 %394,851 (188,302)-48 %522,034 132 %Net income (loss)916,885 206,549 710,336 344 %394,851 (188,302)-48 %522,034 132 %Less: Net income (loss) attributable to noncontrolling interests(278)5,194 (5,472)-105 %6,150 (956)-16 %(6,428)-105 %Net income (loss) attributable to common stockholders$917,163 $201,355 $715,808 355 %$388,701 $(187,346)-48 %$528,462 136 %(1) See Non-GAAP Financial Measures below.Increases in rental income are primarily attributable to the acquisitions of new properties and the conversion of newly constructed outpatient medical properties, particularly the $1.25 billion CNL Healthcare Properties portfolio acquisition that closed in May 2019, partially offset by 2020 dispositions. Certain of our leases contain annual rental escalators that are contingent upon changes in the Consumer Price Index. These escalators are not fixed, so no straight-line rent is recorded; however, rental income is recorded based on the contractual cash rental payments due for the period. If the Consumer Price Index does not increase, a portion of our revenues may not continue to increase. Our leases could renew above or below current rental rates, resulting in an increase or decrease in rental income. For the three months ended December 31, 2020, our consolidated outpatient medical portfolio signed 133,859 square feet of new leases and 282,719 square feet of renewals. The weighted-average term of these leases was six years, with a rate of $26.55 per square foot and tenant improvement and lease commission costs of $15.23 per square foot. Substantially all of these leases contain an annual fixed or contingent escalation rent structure ranging from 2.0% to 3.5%. In addition, our Outpatient Medical tenants are experiencing temporary medical practice closures or decreases in revenue due to government imposed restrictions on elective medical procedures or decisions by patients to delay treatments which may adversely affect their ability to make contractual rent payments. Outpatient Medical rent collections through March were generally consistent with pre COVID-19 levels. During the second quarter we executed short term rent deferrals with certain Outpatient Medical tenants which in most cases were required to be repaid by year end. Since then we have collected approximately 99% of Outpatient Medical rent due in the second half of the year, with uncollected amounts primarily attributable to local jurisdictions with COVID-19 related ordinances providing temporary rent relief to tenants. Furthermore, 57Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operationscollections of deferred rent due under executed deferrals was over 99%. To the extent that deferred rent is not repaid as expected, or the prolonged impact of the COVID-19 pandemic causes operators or tenants to seek further modifications of their lease agreements, we may recognize reductions in revenue and increases in uncollectible receivables.The fluctuation in property operating expenses and depreciation and amortization are primarily attributable to acquisitions and construction conversions of outpatient medical facilities, offset by dispositions. To the extent that we acquire or dispose of additional properties in the future, these amounts will change accordingly. During the year ended December 31, 2019, we recognized impairment charges of $14,062,000 related to three held for sale properties as the carrying values exceeded the estimated fair values less costs to sell. Changes in gains/losses on sales of properties are related to volume of property sales and the sales prices. The increase in other expense during the year ended December 31, 2020 is primarily due to noncapitalizable transaction costs from acquisitions no longer expected to be consummated.During the year ended December 31, 2020, we completed three Outpatient Medical construction projects representing $43,493,000 or $306 per square foot. The following is a summary of our consolidated Outpatient Medical construction projects pending as of December 31, 2020 (dollars in thousands):LocationSquare FeetCommitmentBalanceEst. CompletionBrooklyn, NY140,955 $105,306 $104,148 2Q21Kalamazoo, MI40,607 14,267 2,654 3Q21Total181,562 $119,573 $106,802 Total interest expense represents secured debt interest expense. The change in secured debt interest expense is primarily due to the net effect and timing of assumptions, extinguishments and principal amortizations. The following is a summary of our Outpatient Medical secured debt principal activity for the periods presented (dollars in thousands):Year EndedYear EndedYear EndedDecember 31, 2020December 31, 2019December 31, 2018 Weighted Avg. Weighted Avg. Weighted Avg. AmountInterest RateAmountInterest RateAmountInterest RateBeginning balance$572,267 3.97%$386,738 4.20%$279,951 4.72%Debt assumed— —%202,084 4.12%171,275 3.99%Debt extinguished(14,205)5.34%(10,244)5.75%(61,291)7.43%Principal payments(9,833)4.60%(6,311)4.97%(3,197)5.91%Ending balance$548,229 3.55%$572,267 3.97%$386,738 4.20%Monthly averages$562,017 3.72%$397,756 4.15%$238,214 4.25%A portion of our Outpatient Medical properties were formed through partnerships. Income or loss from unconsolidated entities represents our share of net income or losses from partnerships where we are the noncontrolling partner. Net income attributable to noncontrolling interests represents our partners’ share of net income or loss relating to those partnerships where we are the controlling partner.58Item 7. Management’s Discussion and Analysis of Financial Condition and Results of OperationsNon-Segment/CorporateThe following is a summary of our results of operations for the Non-Segment/Corporate activities (dollars in thousands) for the periods presented: Year EndedOne Year ChangeYear EndedOne Year ChangeTwo Year Change December 31,December 31, December 31, 20202019$%2018$%$%Revenues: Other income$2,781 $3,966 $(1,185)-30 %$2,275 $1,691 74 %$506 22 %Total revenues2,781 3,966 (1,185)-30 %2,275 1,691 74 %506 22 %Property operating expenses3,381 — 3,381 n/a— — n/a3,381 n/aNOI(1)(600)3,966 (4,566)-115 %2,275 1,691 74 %(2,875)-126 %Other expenses: Interest expense432,431 461,273 (28,842)-6 %436,256 25,017 6 %(3,825)-1 %General and administrative expenses128,394 126,549 1,845 1 %126,383 166 0 %2,011 2 %Loss (gain) on extinguishments of debt, net33,344 82,541 (49,197)-60 %4,091 78,450 1,918 %29,253 715 %Other expenses24,929 10,705 14,224 133 %7,729 2,976 39 %17,200 223 %Total expenses619,098 681,068 (61,970)-9 %574,459 106,609 19 %44,639 8 %Loss from continuing operations before income taxes and other items(619,698)(677,102)57,404 8 %(572,184)(104,918)-18 %(47,514)-8 %Gain (loss) on real estate dispositions, net— — — n/a— — n/a— n/aIncome tax benefit (expense)(9,968)(2,957)(7,011)-237 %(8,674)5,717 66 %(1,294)-15 %Loss from continuing operations(629,666)(680,059)50,393 7 %(580,858)(99,201)-17 %(48,808)-8 %Preferred stock dividends— — — n/a46,704 (46,704)-100 %(46,704)-100 %Net loss attributable to common stockholders$(629,666)$(680,059)$50,393 7 %$(627,562)$(52,497)-8 %$(2,104)0 %(1) See Non-GAAP Financial Measures below.Property operating expenses represent insurance costs related to our captive insurance company formed as of July 1, 2020, which acts as a direct insurer of property level insurance coverage for our portfolio. The following is a summary of our Non-Segment/Corporate interest expense for the periods presented (dollars in thousands): Year EndedOne Year ChangeYear EndedOne Year ChangeTwo Year Change December 31,December 31, December 31, 20202019$%2018$%$%Senior unsecured notes$400,014 $402,133 $(2,119)-1 %$387,955 $14,178 4 %$12,059 3 %Secured debt— — — n/a115 (115)-100 %(115)-100 %Unsecured credit facility and commercial paper program15,313 43,861 (28,548)-65 %34,626 9,235 27 %(19,313)-56 %Loan expense17,104 15,279 1,825 12 %13,560 1,719 13 %3,544 26 %Totals$432,431 $461,273 $(28,842)-6 %$436,256 $25,017 6 %$(3,825)-1 %The change in interest expense on senior unsecured notes is due to the net effect of issuances and extinguishments, as well as the movement in foreign exchange rates and related hedge activity. Please refer to Note 11 to consolidated financial statements for additional information. The change in interest expense on our unsecured credit facility and commercial paper program is due primarily to the net effect and timing of draws, paydowns and variable interest rate changes. Please refer to Note 10 of our consolidated financial statements for additional information regarding our unsecured revolving credit facility and commercial paper program. Loan expenses represent the amortization of costs incurred in connection with senior unsecured notes issuances. The loss on extinguishment recognized during the year ended December 31, 2020 is due primarily to the early extinguishment of $160,872,000 of our 3.75% senior unsecured notes due March 2023 and $265,376,000 of our 3.95% senior unsecured notes due September 2023. The loss on extinguishment recognized in 2019 is due primarily to the early extinguishment of the $600,000,000 of 4.125% senior unsecured notes due 2019 and the $450,000,000 of 6.125% senior unsecured notes due 2020 in March 2019, the early extinguishment of the $450,000,000 of 4.95% senior unsecured notes due 2021 and the $600,000,000 of 5.25% senior unsecured notes due 2022 in September 2019 and the early redemption of the $300 million Canadian-denominated 3.35% senior unsecured notes due 2020 in December 2019.General and administrative expenses as a percentage of consolidated revenues for the years ended December 31, 2020, 2019 and 2018 were 2.79%, 2.47% and 2.69%, respectively. Other expenses for all years include severance-related costs associated with the departure of certain executive officers and key employees. Income tax expense primarily relates to state taxes, foreign taxes and taxes based on income generated by entities that are structured as TRSs.59Item 7. Management’s Discussion and Analysis of Financial Condition and Results of OperationsOtherNon-GAAP Financial MeasuresWe believe that net income and net income attributable to common stockholders (“NICS”), as defined by U.S. GAAP, are the most appropriate earnings measurements. However, we consider FFO, NOI, SSNOI, EBITDA and Adjusted EBITDA to be useful supplemental measures of our operating performance. Historical cost accounting for real estate assets in accordance with U.S. GAAP implicitly assumes that the value of real estate assets diminishes predictably over time as evidenced by the provision for depreciation. However, since real estate values have historically risen or fallen with market conditions, many industry investors and analysts have considered presentations of operating results for real estate companies that use historical cost accounting to be insufficient. In response, the National Association of Real Estate Investment Trusts (“NAREIT”) created funds from operations attributable to common stockholders (“FFO”) as a supplemental measure of operating performance for REITs that excludes historical cost depreciation from net income. FFO, as defined by NAREIT, means NICS, computed in accordance with U.S. GAAP, excluding gains (or losses) from sales of real estate and impairment of depreciable assets, plus depreciation and amortization, and after adjustments for unconsolidated entities and noncontrolling interests.Consolidated net operating income (“NOI”) is used to evaluate the operating performance of our properties. We define NOI as total revenues, including tenant reimbursements, less property operating expenses. Property operating expenses represent costs associated with managing, maintaining and servicing tenants for our properties. These expenses include, but are not limited to, property-related payroll and benefits, property management fees paid to operators, marketing, housekeeping, food service, maintenance, utilities, property taxes and insurance. General and administrative expenses represent costs unrelated to property operations. These expenses include, but are not limited to, payroll and benefits, professional services, office expenses and depreciation of corporate fixed assets. Same store NOI (“SSNOI”) is used to evaluate the operating performance of our properties using a consistent population which controls for changes in the composition of our portfolio. We believe the drivers of property level NOI for both consolidated properties and unconsolidated properties are generally the same and therefore, we evaluate SSNOI based on our ownership interest in each property ("Welltower Share"). To arrive at Welltower's Share, NOI is adjusted by adding our minority ownership share related to unconsolidated properties and by subtracting the minority partners' noncontrolling ownership interests for consolidated properties. We do not control investments in unconsolidated properties and while we consider disclosures at Welltower Share to be useful, they may not accurately depict the legal and economic implications of our joint venture arrangements and should be used with caution. As used herein, same store is generally defined as those revenue-generating properties in the portfolio for the relevant year-over-year reporting periods. Acquisitions and development conversions are included in SSNOI five full quarters or eight full quarters after acquisition or being placed into service for the QTD Pool and the YTD Pool, respectively. Land parcels, loans and sub-leases, as well as any properties sold or classified as held for sale during the respective periods are excluded from SSNOI. Redeveloped properties (including major refurbishments of a Seniors Housing Operating property where 20% or more of units are simultaneously taken out of commission for 30 days or more or Outpatient Medical properties undergoing a change in intended use) are excluded from SSNOI until five full quarters or eight full quarters post completion of the redevelopment for the QTD Pool and YTD Pool, respectively. Properties undergoing operator transitions and/or segment transitions are also excluded from SSNOI until five full quarters or eight full quarters post completion of the transition for the QTD Pool and YTD Pool, respectively. In addition, properties significantly impacted by force majeure, acts of God, or other extraordinary adverse events are excluded from SSNOI until five full quarters or eight full quarters after the properties are placed back into service for the QTD Pool and YTD Pool, respectively. SSNOI excludes non-cash NOI and includes adjustments to present consistent ownership percentages and to translate Canadian properties and U.K. properties using a consistent exchange rate. We believe NOI and SSNOI provide investors relevant and useful information because they measure the operating performance of our properties at the property level on an unleveraged basis. We use NOI and SSNOI to make decisions about resource allocations and to assess the property level performance of our properties.EBITDA is defined as earnings (net income) before interest, taxes, depreciation and amortization. Adjusted EBITDA is defined as EBITDA excluding unconsolidated entities and including adjustments for stock-based compensation expense, provision for loan losses, gains/losses on extinguishment of debt, gains/loss/impairments on properties, gains/losses on derivatives and financial instruments, other expense, additional other income and other impairment charges. We believe that EBITDA and Adjusted EBITDA, along with net income, are important supplemental measures because they provide additional information to assess and evaluate the performance of our operations. We primarily use these measures to determine our interest coverage ratio, which represents EBITDA and Adjusted EBITDA divided by total interest, and our fixed charge coverage ratio, which represents EBITDA and Adjusted EBITDA divided by fixed charges. Fixed charges include total interest, secured debt principal amortization, and preferred dividends. Covenants in our unsecured senior notes and primary credit facility contain financial ratios based on a definition of EBITDA and Adjusted EBITDA that is specific to those agreements. Our leverage ratios are defined as the proportion of net debt to total capitalization and include book capitalization, undepreciated book capitalization and market capitalization. Book capitalization represents the sum of net debt (defined as total long-term debt, excluding operating lease liabilities, less cash and cash equivalents and any IRC Section 1031 deposits), total equity and redeemable noncontrolling interests. Undepreciated book capitalization represents book capitalization adjusted for accumulated 60Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operationsdepreciation and amortization. Market capitalization represents book capitalization adjusted for the fair market value of our common stock. Our supplemental reporting measures and similarly entitled financial measures are widely used by investors, equity and debt analysts and rating agencies in the valuation, comparison, rating and investment recommendations of companies. Management uses these financial measures to facilitate internal and external comparisons to our historical operating results and in making operating decisions. Additionally, these measures are utilized by the Board of Directors to evaluate management. None of our supplemental measures represent net income or cash flow provided from operating activities as determined in accordance with U.S. GAAP and should not be considered as alternative measures of profitability or liquidity. Finally, the supplemental measures, as defined by us, may not be comparable to similarly entitled items reported by other real estate investment trusts or other companies.The table below reflects the reconciliation of FFO to NICS, the most directly comparable U.S. GAAP measure, for the periods presented. Noncontrolling interest and unconsolidated entity amounts represent adjustments to reflect our share of depreciation and amortization, gains/losses on real estate dispositions and impairments of assets. Amounts are in thousands except for per share data. Year Ended December 31,FFO Reconciliation:202020192018Net income attributable to common stockholders$978,844 $1,232,432 $758,250 Depreciation and amortization1,038,437 1,027,073 950,459 Impairment of assets135,608 28,133 115,579 Loss (gain) on real estate dispositions, net(1,088,455)(748,041)(415,575)Noncontrolling interests(23,968)(20,197)(69,193)Unconsolidated entities62,096 57,680 52,663 Funds from operations attributable to common stockholders$1,102,562 $1,577,080 $1,392,183 Average diluted shares outstanding:417,387 403,808 375,250 Per diluted share data: Net income attributable to common stockholders(1)$2.33 $3.05 $2.02 Funds from operations attributable to common stockholders$2.64 $3.91 $3.71 (1) Includes adjustment to the numerator for income (loss) attributable to OP unitholders.The following tables reflect the reconciliation of NOI to net income, the most directly comparable U.S. GAAP measure, for the years presented. Dollar amounts are in thousands. Year Ended December 31,NOI Reconciliation:202020192018Net income$1,038,852 $1,330,410 $829,750 Loss (gain) on real estate dispositions, net(1,088,455)(748,041)(415,575)Loss (income) from unconsolidated entities8,083 (42,434)641 Income tax expense (benefit)9,968 2,957 8,674 Other expenses70,335 52,612 112,898 Impairment of assets135,608 28,133 115,579 Provision for loan losses94,436 18,690 — Loss (gain) on extinguishment of debt, net47,049 84,155 16,097 Loss (gain) on derivatives and financial instruments, net11,049 (4,399)(4,016)General and administrative expenses128,394 126,549 126,383 Depreciation and amortization1,038,437 1,027,073 950,459 Interest expense514,388 555,559 526,592 Consolidated net operating income (NOI)$2,008,144 $2,431,264 $2,267,482 NOI by segment: Seniors Housing Operating$755,552 $1,039,520 $985,022 Triple-net748,121 918,743 900,049 Outpatient Medical505,071 469,035 380,136 Non-segment/corporate(600)3,966 2,275 Total NOI$2,008,144 $2,431,264 $2,267,482 61Item 7. Management’s Discussion and Analysis of Financial Condition and Results of OperationsQuarterly NOI by Segment:(in thousands)Three Months EndedYear Ended March 31, June 30, September 30, December 31,December 31,2020201920202019202020192020201920202019Seniors Housing Operating:Total revenues$851,128 $872,386 $773,650 $915,529 $742,065 $835,496 $715,020 $833,458 $3,081,863 $3,456,869 Property operating expenses607,871 607,686 595,513 637,317 567,704 581,341 555,223 591,005 2,326,311 2,417,349 NOI$243,257 $264,700 $178,137 $278,212 $174,361 $254,155 $159,797 $242,453 $755,552 $1,039,520 Triple-net:Total revenues$207,729 $248,241 $233,619 $240,758 $120,928 $244,607 $239,028 $239,037 $801,304 $972,643 Property operating expenses13,302 14,955 13,563 12,823 12,567 13,922 13,751 12,200 53,183 53,900 NOI$194,427 $233,286 $220,056 $227,935 $108,361 $230,685 $225,277 $226,837 $748,121 $918,743 Outpatient Medical:Total revenues$199,329 $149,461 $180,831 $163,365 $172,704 $185,189 $167,155 $189,813 $720,019 $687,828 Property operating expenses60,608 48,166 51,688 50,987 52,728 60,325 49,924 59,315 214,948 218,793 NOI$138,721 $101,295 $129,143 $112,378 $119,976 $124,864 $117,231 $130,498 $505,071 $469,035 Corporate:Total revenues$416 $2,157 $375 $454 $1,177 $841 $813 $514 $2,781 $3,966 Property operating expenses—— —— 1,718— 1,663— 3,381 — NOI$416 $2,157 $375 $454 $(541)$841 $(850)$514 $(600)$3,966 The following is a reconciliation of the properties included in our QTD Pool and YTD Pool for SSNOI:QTD PoolYTD PoolSSNOI Property Reconciliations:Seniors Housing OperatingTriple-netOutpatient MedicalTotalSeniors Housing OperatingTriple-netOutpatient MedicalTotalConsolidated properties556 641 296 1,493 556 641 296 1,493 Unconsolidated properties90 39 72 201 90 39 72 201 Total properties646 680 368 1,694 646 680 368 1,694 Recent acquisitions/development conversions(1)(46)(18)(51)(115)(93)(24)(123)(240)Under development(27)(4)(2)(33)(27)(4)(2)(33)Under redevelopment(2)(10)(1)(2)(13)(11)(1)(2)(14)Current held for sale(10)(1)(2)(13)(10)(1)(2)(13)Loans, land parcels and subleases(11)(18)(8)(37)(11)(18)(8)(37)Transitions(3)(27)(6)— (33)(93)(24)— (117)Other(4)(1)— — (1)(2)— — (2)Same store properties514 632 303 1,449 399 608 231 1,238 (1) Acquisitions and development conversions will enter the QTD Pool and YTD Pool five full quarters and eight full quarters after acquisition or certificate of occupancy, respectively. (2) Redevelopment properties will enter the QTD Pool and YTD Pool after five full quarters and eight full quarters of operations post redevelopment completion, respectively.(3) Transitioned properties will enter the QTD Pool and YTD Pool after five full quarters and eight full quarters of operations with the new operator in place or under the new structure, respectively.(4) Includes one closed property in the QTD pool and one closed property and one flooded property in the YTD pool.62Item 7. Management’s Discussion and Analysis of Financial Condition and Results of OperationsThe following is a reconciliation of our consolidated NOI to same store NOI for the periods presented for the respective pools. Dollar amounts are in thousands.QTD PoolYTD PoolThree Months EndedTwelve Months EndedSSNOI Reconciliations:December 31, 2020December 31, 2019December 31, 2020December 31, 2019Seniors Housing Operating: Consolidated NOI$159,797 $242,453 $755,552 $1,039,520 NOI attributable to unconsolidated investments13,182 16,491 53,736 65,387 NOI attributable to noncontrolling interests(9,405)(19,436)(51,334)(81,426)Non-cash NOI attributable to same store properties(349)(842)(3,239)(4,295)NOI attributable to non-same store properties(8,291)(23,254)(166,567)(261,002)Currency and ownership adjustments (1)(561)754 2,985 6,144 SSNOI at Welltower Share154,373 216,166 591,133 764,328 Triple-net:Consolidated NOI225,277 226,837 $748,121 $918,743 NOI attributable to unconsolidated investments4,818 5,133 13,797 20,532 NOI attributable to noncontrolling interests(14,563)(14,751)(58,288)(58,462)Non-cash NOI attributable to same store properties(12,313)(15,224)80,630 (58,846)NOI attributable to non-same store properties(34,236)(32,080)(155,566)(197,487)Currency and ownership adjustments (1)(286)137 278397SSNOI at Welltower Share168,697 170,052 628,972 624,877 Outpatient Medical:Consolidated NOI117,231 130,498 505,071 469,035 NOI attributable to unconsolidated investments3,481 541 9,629 1,930 NOI attributable to noncontrolling interests(4,264)(6,853)(16,565)(27,637)Non-cash NOI attributable to same store properties(1,542)(2,915)(1,094)(2,807)NOI attributable to non-same store properties(24,050)(19,674)(204,525)(129,723)Currency and ownership adjustments (1)(5,871)(17,453)(40,004)(64,009)SSNOI at Welltower Share84,985 84,144 252,512 246,789 SSNOI at Welltower Share:Seniors Housing Operating154,373 216,166 591,133 764,328 Triple-net168,697 170,052 628,972 624,877 Outpatient Medical84,985 84,144 252,512 246,789 Total$408,055 $470,362 $1,472,617 $1,635,994 63Item 7. Management’s Discussion and Analysis of Financial Condition and Results of OperationsThe table below reflects the reconciliation of EBITDA and Adjusted EBITDA to net income, the most directly comparable U.S. GAAP measure, for the periods presented. Dollars are in thousands. Year Ended December 31,Adjusted EBITDA Reconciliation:202020192018Net income (loss)$1,038,852 $1,330,410 $829,750 Interest expense514,388 555,559 526,592 Income tax expense (benefit)9,968 2,957 8,674 Depreciation and amortization1,038,437 1,027,073 950,459 EBITDA2,601,645 2,915,999 2,315,475 Loss (income) from unconsolidated entities8,083 (42,434)641 Stock-based compensation expense(1)28,318 25,047 27,646 Loss (gain) on extinguishment of debt, net47,049 84,155 16,097 Loss (gain) on real estate dispositions, net(1,088,455)(748,041)(415,575)Impairment of assets135,608 28,133 115,579 Provision for loan losses94,436 18,690 — Loss (gain) on derivatives and financial instruments, net11,049 (4,399)(4,016)Other expenses(1)64,171 51,052 111,990 Other impairment146,508 — — Additional other income— — (14,832)Adjusted EBITDA$2,048,412 $2,328,202 $2,153,005 Adjusted Interest Coverage Ratio: Interest expense$514,388 $555,559 $526,592 Capitalized interest17,472 15,272 7,905 Non-cash interest expense(15,751)(8,645)(10,860)Total interest516,109 562,186 523,637 Adjusted EBITDA$2,048,412 $2,328,202 $2,153,005 Adjusted interest coverage ratio3.97x4.14x4.11xAdjusted Fixed Charge Coverage Ratio: Total interest$516,109 $562,186 $523,637 Secured debt principal payments62,707 54,325 56,288 Preferred dividends— — 46,704 Total fixed charges578,816 616,511 626,629 Adjusted EBITDA$2,048,412 $2,328,202 $2,153,005 Adjusted fixed charge coverage ratio3.54x3.78x3.44x(1) Certain severance-related costs are included in stock-based compensation and excluded from other expenses.64Item 7. Management’s Discussion and Analysis of Financial Condition and Results of OperationsOur leverage ratios include book capitalization, undepreciated book capitalization and market capitalization. Book capitalization represents the sum of net debt (defined as total long-term debt less cash and cash equivalents and any IRC Section 1031 deposits), total equity and redeemable noncontrolling interests. Undepreciated book capitalization represents book capitalization adjusted for accumulated depreciation and amortization. Market capitalization represents book capitalization adjusted for the fair market value of our common stock. Our leverage ratios are defined as the proportion of net debt to total capitalization. The table below reflects the reconciliation of our leverage ratios to our balance sheets for the periods presented. Amounts are in thousands, except share price. Year Ended December 31, 202020192018Book capitalization: Unsecured credit facility and commercial paper$— $1,587,597 $1,147,000 Long-term debt obligations(1)13,905,822 13,436,365 12,150,144 Cash and cash equivalents(2)(1,968,765)(284,917)(215,376)Total net debt11,937,057 14,739,045 13,081,768 Total equity and noncontrolling interests(3)17,225,062 16,982,504 16,010,645 Book capitalization$29,162,119 $31,721,549 $29,092,413 Net debt to book capitalization ratio40.9 %46.5 %45.0 %Undepreciated book capitalization:Total net debt$11,937,057 $14,739,045 $13,081,768 Accumulated depreciation and amortization6,104,297 5,715,459 5,499,958 Total equity and noncontrolling interests(3)17,225,062 16,982,504 16,010,645 Undepreciated book capitalization$35,266,416 $37,437,008 $34,592,371 Net debt to undepreciated book capitalization ratio33.8 %39.4 %37.8 %Market capitalization:Common shares outstanding417,401 410,257 383,675 Period end share price$64.62 $81.78 $69.41 Common equity market capitalization$26,972,453 $33,550,817 $26,630,882 Total net debt11,937,057 14,739,045 13,081,768 Noncontrolling interests(3)1,252,343 1,442,060 1,378,311 Preferred stock— — 718,498 Market capitalization:$40,161,853 $49,731,922 $41,809,459 Net debt to market capitalization ratio29.7 %29.6 %31.3 %(1) Amounts include senior unsecured notes, secured debt and lease liabilities related to financing leases, as reflected on our Consolidated Balance Sheets. Operating lease liabilities related to the ASC 842 adoption are excluded.(2) Inclusive of IRC Section 1031 deposits, if any.(3) Includes amounts attributable to both redeemable noncontrolling interests and noncontrolling interests as reflected on our Consolidated Balance Sheets.Critical Accounting PoliciesOur consolidated financial statements are prepared in accordance with U.S. GAAP, which requires us to make estimates and assumptions. Management considers an accounting estimate or assumption critical if:•the nature of the estimates or assumptions is material due to the levels of subjectivity and judgment necessary to account for highly uncertain matters or the susceptibility of such matters to change; and•the impact of the estimates and assumptions on financial condition or operating performance is material.Management has discussed the development and selection of its critical accounting policies with the Audit Committee of the Board of Directors. Management believes the current assumptions and other considerations used to estimate amounts reflected in our consolidated financial statements are appropriate and are not reasonably likely to change in the future. However, since these estimates require assumptions to be made that were uncertain at the time the estimate was made, they bear the risk of change. If actual experience differs from the assumptions and other considerations used in estimating amounts reflected in our consolidated financial statements, the resulting changes could have a material adverse effect on our consolidated results of operations, liquidity and/or financial condition. Please refer to Note 2 to our consolidated financial statements for further information on significant accounting policies that impact us and for the impact of new accounting standards, including accounting pronouncements that were issued but not yet adopted by us.The following table presents information about our critical accounting policies, as well as the material assumptions used to develop each estimate:65Item 7. Management’s Discussion and Analysis of Financial Condition and Results of OperationsNature of CriticalAccounting EstimateAssumptions/ApproachUsedImpairment of Real PropertyAssessing impairment of real property involves subjectivity in determining if indicators of impairment are present and in estimating the future undiscounted cash flows or estimated fair value of an asset. In estimating the undiscounted cash flows or fair value, key assumptions that would be made are the estimation of future rental revenues, operating expenses, capitalization rates and the ability and intent to hold the respective asset, all of which are affected by our expectations of future market or economic conditions. These estimates can have a significant impact on the undiscounted cash flows or estimated fair value of an asset.Quarterly, we evaluate our real estate investments on a property by property basis to determine if there are indicators of impairment. These indicators may include expected operational performance, the tenant's ability to make rent payments, a decision to dispose of an asset before the end of its estimated useful life and changes in the market that may permanently reduce the value of the property. If indicators of impairment exist, an undiscounted cash flow analysis will be prepared and the results of such analysis will be compared to the current net book value to determine if an impairment charge is necessary. This analysis requires us to use judgment in determining whether indicators of impairment exist and to estimate the expected future undiscounted cash flows or estimated fair values of the property. Properties that meet the held for sale criteria are recorded at the lesser of the fair value less costs to sell or carrying value.Real Estate AcquisitionsWe believe that substantially all of our real estate acquisitions are considered asset acquisitions for which we record the related real estate acquired (tangible assets and identifiable intangible assets and liabilities) at cost on a relative fair value basis. Liabilities assumed and any associated noncontrolling interests are reflected at fair value. Tangible assets consist primarily of land, building and improvements. Identifiable intangible assets and liabilities primarily consist of the above or below market component of in-place leases and the value of in-place leases. The total amount of other intangible assets acquired is further allocated to in-place lease values and customer relationship values based on management's evaluation of the specific characteristics of each tenant's lease and our overall relationship with respect to that tenant. The allocation of the purchase price to the related real estate acquired (tangible assets and intangible assets and liabilities) involves subjectivity as such allocations are based on a relative fair value analysis. In determining the fair values that drive such analysis, we estimate the fair value of each component of the real estate acquired which generally includes land, buildings and improvements, the above or below market component of in-place leases and the value of in-place leases. Significant assumptions used to determine such fair values include comparable land sales, capitalization rates, discount rates, market rental rates and property operating data, all of which can be impacted by expectations about future market or economic conditions. Our estimates of the values of these components affect the amount of depreciation and amortization we record over the estimated useful life of the property or the term of the lease.Principles of ConsolidationThe consolidated financial statements include our accounts, the accounts of our wholly-owned subsidiaries, and the accounts of joint venture entities in which we own a majority voting interest with the ability to control operations and where no substantive participating rights or substantive kick out rights have been granted to the noncontrolling interests. In addition, we consolidate those entities deemed to be variable interest entities (“VIEs”) in which we are determined to be the primary beneficiary. All material intercompany transactions and balances have been eliminated in consolidation. We make judgments about which entities are VIEs based on an assessment of whether (i) the equity investors as a group, if any, do not have a controlling financial interest, or (ii) the equity investment at risk is insufficient to finance that entity’s activities without additional subordinated financial support. We make judgments with respect to our level of influence or control of an entity and whether we are (or are not) the primary beneficiary of a VIE. Consideration of various factors includes, but is not limited to, our ability to direct the activities that most significantly impact the entity's economic performance, our form of ownership interest, our representation on the entity's governing body, the size and seniority of our investment, our ability and the rights of other investors to participate in policy making decisions, replace the manager and/or liquidate the entity, if applicable. Our ability to correctly assess our influence or control over an entity at inception of our involvement or on a continuous basis when determining the primary beneficiary of a VIE affects the presentation of these entities in our consolidated financial statements. If we perform a primary beneficiary analysis at a date other than at inception of the VIE, our assumptions may be different and may result in the identification of a different primary beneficiary.66Item 7. Management’s Discussion and Analysis of Financial Condition and Results of OperationsNature of CriticalAccounting EstimateAssumptions/ApproachUsedAllowance for Credit Losses on Loans ReceivableThe allowance for credit losses is maintained at a level believed adequate to absorb potential losses in our loans receivable. The determination of the credit allowance is based on a quarterly evaluation of all outstanding loans, including general economic conditions and estimated collectability of loan payments. The determination of the allowance for credit losses is based on a quarterly evaluation of all outstanding loans, including general economic conditions and estimated collectability of loan payments. We evaluate the collectability of our loans receivable based on a combination of factors, including, but not limited to, payment status, historical loan charge-offs, financial strength of the borrower and guarantors, and nature, extent and value of the underlying collateral. A loan is considered to have deteriorated credit quality when, based on current information and events, it is probable that we will be unable to collect all amounts due as scheduled according to the contractual terms of the loan agreement. For those loans we identified as having deteriorated credit quality, we determine the amount of credit loss on an individual basis. Placement on non-accrual status may be required. Consistent with this definition, all loans on non-accrual are deemed to have deteriorated credit quality. To the extent circumstances improve and the risk of collectability is diminished, we may return these loans to income accrual status. While a loan is on non-accrual status, any cash receipts are applied against the outstanding principal balance. For the remaining loans, we assess credit loss on a collective pool basis and use our historical loss experience for similar loans to determine the reserve for credit losses.67Item 7A. Quantitative and Qualitative Disclosures About Market RiskWe are exposed to various market risks, including the potential loss arising from adverse changes in interest rates and foreign currency exchange rates. We seek to mitigate the underlying foreign currency exposures with gains and losses on derivative contracts hedging these exposures. We seek to mitigate the effects of fluctuations in interest rates by matching the terms of new investments with new long-term fixed rate borrowings to the extent possible. We may or may not elect to use financial derivative instruments to hedge interest rate exposure. These decisions are principally based on our policy to match our variable rate investments with comparable borrowings, but are also based on the general trend in interest rates at the applicable dates and our perception of the future volatility of interest rates. This section is presented to provide a discussion of the risks associated with potential fluctuations in interest rates and foreign currency exchange rates. For more information, see Notes 12 and 17 to our consolidated financial statements.We historically borrow on our unsecured revolving credit facility and commercial paper program to acquire, construct or make loans relating to health care and seniors housing properties. Then, as market conditions dictate, we will issue equity or long-term fixed rate debt to repay the borrowings under our unsecured revolving credit facility and commercial paper program. We are subject to risks associated with debt financing, including the risk that existing indebtedness may not be refinanced or that the terms of refinancing may not be as favorable as the terms of current indebtedness. The majority of our borrowings were completed under indentures or contractual agreements that limit the amount of indebtedness we may incur. Accordingly, in the event that we are unable to raise additional equity or borrow money because of these limitations, our ability to acquire additional properties may be limited.A change in interest rates will not affect the interest expense associated with our fixed rate debt. Interest rate changes, however, will affect the fair value of our fixed rate debt. Changes in the interest rate environment upon maturity of this fixed rate debt could have an effect on our future cash flows and earnings, depending on whether the debt is replaced with other fixed rate debt, variable rate debt or equity or repaid by the sale of assets. To illustrate the impact of changes in the interest rate markets, we performed a sensitivity analysis on our fixed rate debt instruments whereby we modeled the change in net present values arising from a hypothetical 1% increase in interest rates to determine the instruments’ change in fair value. The following table summarizes the analysis performed as of the dates indicated (in thousands): December 31, 2020December 31, 2019 Principal balanceChange in fair valuePrincipal balanceChange in fair valueSenior unsecured notes$9,943,501 $(761,581)$9,724,691 $(751,848)Secured debt1,702,196 (57,756)1,814,229 (69,756)Totals$11,645,697 $(819,337)$11,538,920 $(821,604)Our variable rate debt, including our unsecured revolving credit facility and commercial paper program, is reflected at fair value. At December 31, 2020, we had $2,241,909,000 outstanding related to our variable rate debt. Assuming no changes in outstanding balances, a 1% increase in interest rates would result in increased annual interest expense of $22,420,000. At December 31, 2019, we had $3,470,584,000 outstanding under our variable rate debt. Assuming no changes in outstanding balances, a 1% increase in interest rates would have resulted in increased annual interest expense of $34,706,000.We are subject to currency fluctuations that may, from time to time, affect our financial condition and results of operations. Increases or decreases in the value of the Canadian Dollar or British Pounds Sterling relative to the U.S. Dollar impact the amount of net income we earn from our investments in Canada and the United Kingdom. Based solely on our results for the year ended December 31, 2020, including the impact of existing hedging arrangements, if these exchange rates were to increase or decrease by 10%, our net income from these investments would increase or decrease, as applicable, by less than $3,000,000. We will continue to mitigate these underlying foreign currency exposures with non-U.S. denominated borrowings and gains and losses on derivative contracts. If we increase our international presence through investments in, or acquisitions or development of, seniors housing and health care properties outside the U.S., we may also decide to transact additional business or borrow funds in currencies other than U.S. Dollars, Canadian Dollars or British Pounds Sterling. To illustrate the impact of changes in foreign currency markets, we performed a sensitivity analysis on our derivative portfolio whereby we modeled the change in net present values arising from a hypothetical 1% increase in foreign currency exchange rates to determine the instruments’ change in fair value. The following table summarizes the results of the analysis performed, excluding cross currency hedge activity (dollars in thousands): December 31, 2020December 31, 2019 Carrying valueChange in fair valueCarrying valueChange in fair valueForeign currency exchange contracts$61,851 $12,731 $26,767 $12,136 Debt designated as hedges1,630,542 16,305 1,586,116 15,861 Totals$1,692,393 $29,036 $1,612,883 $27,997 68
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+ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSOVERVIEWThe following discussion is intended to further the reader’s understanding of the consolidated financial condition and results of operations of our Company. It should be read in conjunction with our consolidated financial statements and the accompanying footnotes included in Part II, Item 8 of this Form 10-K. These historical financial statements may not be indicative of our future performance. This Management’s Discussion and Analysis of Financial Condition and Results of Operations contains a number of forward-looking statements, all of which are based on our current expectations and could be affected by the uncertainties and risks discussed in Part I, Item 1A of this Form 10-K.Non-U.S. GAAP Financial MeasuresFor the purpose of aiding the comparison of our year-over-year results, we may refer to net sales and other financial results excluding the effects of changes in foreign currency exchange rates. Organic net sales exclude the impact from acquisitions and/or divestitures and translate the current-period reported sales of subsidiaries whose functional currency is other than USD at the applicable foreign exchange rates in effect during the comparable prior-year period. We may also refer to adjusted consolidated operating profit and adjusted consolidated operating profit margin, which exclude the effects of unallocated items. The unallocated items are not representative of ongoing operations, and generally include restructuring and related charges, certain asset impairments, and other specifically-identified income or expense items. The re-measured results excluding effects from currency translation, the impact from acquisitions and/or divestitures, and excluding the effects of unallocated items are not in conformity with U.S. GAAP and should not be used as a substitute for the comparable U.S. GAAP financial measures. The non-U.S. GAAP financial measures are incorporated in our discussion and analysis as management uses them in evaluating our results of operations and believes that this information provides users with a valuable insight into our overall performance and financial position.Our OperationsWe are a leading global manufacturer in the design and production of technologically advanced, high-quality, integrated containment and delivery systems for injectable drugs and healthcare products. Our products include a variety of primary packaging, containment solutions, reconstitution and transfer systems, and drug delivery systems, as well as contract manufacturing, analytical lab services and integrated solutions. Our customers include the leading biologic, generic, pharmaceutical, diagnostic, and additional medical device companies in the world. Our top priority is delivering quality products that meet the exact product specifications and quality standards customers require and expect. This focus on quality includes a commitment to excellence in manufacturing, scientific and technical expertise and management, which enables us to partner with our customers in order to deliver safe, effective drug products to patients quickly and efficiently. 25Our business operations are organized into two reportable segments, Proprietary Products and Contract-Manufactured Products. Our Proprietary Products reportable segment offers proprietary packaging, containment and drug delivery products, along with analytical lab services and other integrated services and solutions, primarily to biologic, generic and pharmaceutical drug customers. Our Contract-Manufactured Products reportable segment serves as a fully integrated business, focused on the design, manufacture, and automated assembly of complex devices, primarily for pharmaceutical, diagnostic, and medical device customers. We also maintain collaborations to share technologies and market products with affiliates in Japan and Mexico.2020 Financial Performance SummaryThe following tables present a reconciliation from U.S. GAAP to non-U.S. GAAP financial measures: ($ in millions)Operating ProfitIncome tax expenseNet incomeDiluted EPSYear ended December 31, 2020 GAAP$406.9 $72.5 $346.2 $4.57 Unallocated items:Restructuring and severance related charges7.0 1.75.30.07Pension settlement (1)— 0.92.90.04Amortization of acquisition-related intangible assets (2)0.60.13.60.05Cost investment impairment2.5— 2.5 0.03Year ended December 31, 2020 adjusted amounts (non-U.S. GAAP)$417.0 $75.2 $360.5 $4.76 During 2020, we recorded a tax benefit of $20.8 million associated with stock-based compensation. ($ in millions)Operating ProfitIncome tax expenseNet incomeDiluted EPSYear ended December 31, 2019 GAAP$296.6 $59.0 $241.7 $3.21 Unallocated items:Restructuring and related charges 4.9 1.2 3.7 0.04 Gain on restructuring-related sale of assets(1.7)(0.4)(1.3)(0.02)Pension settlement (1)— 0.8 2.7 0.04 Argentina currency devaluation1.0 — 1.0 0.01 Tax Recovery (3)(4.4)(1.5)(2.9)(0.04)Tax law Changes (4)— 0.3 (0.3)— Year ended December 31, 2019 adjusted amounts (non-U.S. GAAP)$296.4 $59.4 $244.6 $3.24 During 2019, we recorded a tax benefit of $10.3 million associated with stock-based compensation. 26($ in millions)Operating ProfitIncome tax expenseNet incomeDiluted EPSYear ended December 31, 2018 GAAP$240.3 $41.4 $206.9 $2.74 Restructuring and related charges 9.11.97.20.09Gain on restructuring-related sale of assets(1.1)(0.2)(0.9)(0.01)Argentina currency devaluation1.1—1.10.02Tax law Changes (4)—2.5(2.5)(0.03)Year ended December 31, 2018 adjusted amounts (non-U.S. GAAP)$249.4 $45.6 $211.8 $2.81 During 2018, we recorded a tax benefit of $14.3 million associated with stock-based compensation. (1) The Company recorded a pension settlement charge within other nonoperating (income) expense, as it determined that normal-course lump-sum payments for each of our U.S. qualified and non-qualified defined benefit pension plan exceeded the threshold for settlement accounting.(2) The Company recorded $0.6 million of amortization expense within operating profit associated with an acquisition of an intangible asset during the second quarter of 2020. Additionally, the company recorded $3.1 million of amortization expense in association with an acquisition of increased ownership interest in Daikyo.(3) The Company recorded a net tax recovery related to previously-paid international excise taxes, following a favorable court ruling.(4) The Company recorded a net tax benefit in December 31, 2019 and December 31, 2018 of $0.3 million and $2.5 million, respectively, due to the impact of federal law changes enacted during the respective years. RESULTS OF OPERATIONSWe evaluate the performance of our segments based upon, among other things, segment net sales and operating profit. Segment operating profit excludes general corporate costs, which include executive and director compensation, stock-based compensation, certain pension and other retirement benefit costs, and other corporate facilities and administrative expenses not allocated to the segments. Also excluded are items that we consider not representative of ongoing operations. Such items are referred to as other unallocated items for which further information can be found above in the reconciliation from U.S. GAAP to non-U.S. GAAP financial measures.Percentages in the following tables and throughout this Results of Operations section may reflect rounding adjustments.27Net SalesThe following table presents net sales, consolidated and by reportable segment:Year Ended December 31,% Change($ in millions)2020201920182020/20192019/2018Proprietary Products$1,648.6 $1,398.6 $1,308.6 17.9 %6.9 %Contract-Manufactured Products498.6 441.5 409.1 12.9 %7.9 %Intersegment sales elimination(0.3)(0.2)(0.3)50.0 %(33.3)%Consolidated net sales$2,146.9 $1,839.9 $1,717.4 16.7 %7.1 %2020 compared to 2019Consolidated net sales increased by $307.0 million, or 16.7%, in 2020, including a favorable foreign currency translation impact of $5.7 million. Excluding foreign currency translation effects, as well as incremental sales of $1.2 million from the acquisition of our distributor in South Korea in 2019, consolidated net sales increased by $300.1 million, or 16.3%.Proprietary Products – Proprietary Products net sales increased by $250.0 million, or 17.9%, in 2020, including a favorable foreign currency translation impact of $2.2 million. Excluding foreign currency translation effects, as well as $1.2 million of incremental sales in 2020 from the acquisition of our distributor in South Korea in 2019, net sales increased by $246.6 million, or 17.6%, primarily due to growth in our high-value product offerings, including our FluroTec-coated components, Westar® components, Daikyo® and NovaPure® components, Daikyo Crystal Zenith® products, and our self-injection delivery platforms, all of which included approximately $99 million in COVID-19 related activity for vaccines, antiviral treatments and treatment of underlying COVID-19 symptoms.Contract-Manufactured Products – Contract-Manufactured Products net sales increased by $57.1 million, or 12.9%, in 2020, including a favorable foreign currency translation impact of $3.5 million. Excluding foreign currency translation effects, net sales increased by $53.5 million, or 12.1%, due to an increase in the sale of healthcare-related injection and diagnostic devices.The intersegment sales elimination, which is required for the presentation of consolidated net sales, represents the elimination of components sold between our segments.2019 compared to 2018Consolidated net sales increased by $122.5 million, or 7.1%, in 2019, including an unfavorable foreign currency translation impact of $52.2 million. Excluding foreign currency translation effects, as well as incremental sales of $3.3 million from the acquisition of our distributor in South Korea in 2019, consolidated net sales increased by $171.4 million or 10.0%. Proprietary Products – Proprietary Products net sales increased by $90.0 million, or 6.9%, in 2019, including an unfavorable foreign currency translation impact of $43.1 million. Excluding foreign currency translation effects, as well as incremental sales of $3.3 million from the acquisition of our distributor in South Korea in 2019, net sales increased by $129.8 million, or 9.9%, primarily due to growth in our high-value product offerings, including our Daikyo components, our ready-to-use seals, stoppers, and plungers, our NovaPure® components and Crystal Zenith products, and our self-injection systems and FluroTec-coated components.Contract-Manufactured Products – Contract-Manufactured Products net sales increased by $32.4 million, or 7.9%, in 2019, including an unfavorable foreign currency translation impact of $9.1 million. Excluding foreign currency translation effects, net sales increased by $41.5 million, or 10.1%, due to an increase in the sale of healthcare-related injection and diagnostic devices. 28The intersegment sales elimination, which is required for the presentation of consolidated net sales, represents the elimination of components sold between our segments.Gross ProfitThe following table presents gross profit and related gross margins, consolidated and by reportable segment:Year Ended December 31,% Change($ in millions)2020201920182020/20192019/2018Proprietary Products: Gross profit$682.2 $540.4 $485.4 26.2 %11.3 %Gross profit margin41.4 %38.6 %37.1 %Contract-Manufactured Products: Gross profit$85.6 $65.5 $60.0 30.7 %9.2 %Gross profit margin17.2 %14.8 %14.7 %Unallocated items$— $(0.2)$— Consolidated gross profit$767.8 $605.7 $545.4 26.8 %11.1 %Consolidated gross profit margin35.8 %32.9 %31.8 %2020 compared to 2019Consolidated gross profit increased by $162.1 million, or 26.8%, in 2020, including a favorable foreign currency translation impact of $1.0 million. Consolidated gross profit margin increased by 2.9 margin points in 2020.Proprietary Products – Proprietary Products gross profit increased by $141.8 million, or 26.2%, in 2020, including a favorable foreign currency translation impact of $0.3 million. Proprietary Products gross profit margin increased by 2.8 margin points in 2020, due to a favorable mix of products sold, production efficiencies, and sales price increases, partially offset by increased overhead costs including compensation costs and COVID-19 related expenses.Contract-Manufactured Products – Contract-Manufactured Products gross profit increased by $20.1 million, or 30.7%, in 2020, including a favorable foreign currency translation impact of $0.7 million. Contract-Manufactured Products gross profit margin increased by 2.4 margin points in 2020, due to a favorable mix of products sold and production efficiencies, partially offset by increased overhead costs including compensation costs.2019 compared to 2018Consolidated gross profit increased by $60.3 million, or 11.1%, in 2019, including an unfavorable foreign currency translation impact of $15.7 million. Consolidated gross profit margin increased by 1.1 margin points in 2019.Proprietary Products – Proprietary Products gross profit increased by $55.0 million, or 11.3%, in 2019, including an unfavorable foreign currency translation impact of $14.3 million. Proprietary Products gross profit margin increased by 1.5 margin points in 2019, due to a favorable mix of products sold, production efficiencies, and sales price increases, partially offset by increased overhead costs. Contract-Manufactured Products – Contract-Manufactured Products gross profit increased by $5.5 million, or 9.2%, in 2019, including an unfavorable foreign currency translation impact of $1.4 million. Contract-Manufactured Products gross profit margin increased by 0.1 margin points in 2019, due to production efficiencies and lower material costs, partially offset by increased overhead costs and an unfavorable mix of products sold. 29Research and Development (“R&D”) CostsThe following table presents consolidated R&D costs:Year Ended December 31,% Change($ in millions)2020201920182020/20192019/2018Consolidated R&D costs$46.9 $38.9 $40.3 20.6 %(3.5)%2020 compared to 2019Consolidated R&D costs increased by $8.0 million, or 20.6%, in 2020, as compared to 2019. Efforts remain focused on the continued investment in self-injection systems development, fluid transfer admixture devices, elastomeric packaging components, and formulation development. 2019 compared to 2018Consolidated R&D costs decreased by $1.4 million, or 3.5%, in 2019, primarily due to an increase in customer-funded R&D projects via customer development agreements.All of the R&D costs incurred during 2020, 2019 and 2018 related to Proprietary Products.Selling, General and Administrative (“SG&A”) CostsThe following table presents SG&A costs, consolidated and by reportable segment and corporate and unallocated items:Year Ended December 31, % Change($ in millions)2020201920182020/20192019/2018Proprietary Products$197.5 $189.9 $185.0 4.0 %2.6 %Contract-Manufactured Products15.5 16.2 16.5 (4.3)%(1.8)%Corporate and unallocated items89.0 66.6 61.4 33.6 %8.5 %Consolidated SG&A costs$302.0 $272.7 $262.9 10.7 %3.7 %SG&A as a % of net sales14.1 %14.8 %15.3 %2020 compared to 2019Consolidated SG&A costs increased by $29.3 million, or 10.7%, in 2020 with no foreign currency translation impact.Proprietary Products – Proprietary Products SG&A costs increased by $7.6 million, or 4.0%, in 2020, primarily due to an increase in compensation costs, partially offset by a reduction in travel expenses and incremental costs incurred in 2019 associated with our voluntary recall. Contract-Manufactured Products – Contract-Manufactured Products SG&A costs decreased by $0.7 million, or 4.3%, in 2020, due to a reduction in travel expenses.Corporate and unallocated items – Corporate SG&A costs increased by $22.4 million, or 33.6%, in 2020, primarily due to increases in stock-based compensation costs, incentive compensation costs and an increase in consulting service costs. 2019 compared to 2018Consolidated SG&A costs increased by $9.8 million, or 3.7%, in 2019, including the impact of foreign currency translation, which decreased SG&A costs by $0.3 million.30Proprietary Products – Proprietary Products SG&A costs increased by $4.9 million, or 2.6%, in 2019, primarily due to an increase in compensation costs, incremental costs associated with our voluntary recall and the acquisition of our distributor in South Korea in 2019, partially offset by ongoing cost control measures. Foreign currency translation decreased Proprietary Products SG&A costs by $0.3 million.Contract-Manufactured Products – Contract-Manufactured Products SG&A costs decreased by $0.3 million, or 1.8%, in 2019, due to ongoing cost control measures. Corporate and unallocated items – Corporate SG&A costs increased by $5.2 million, or 8.5%, in 2019, primarily due to increases in stock-based compensation costs and incentive compensation costs, partially offset by a decrease in U.S. pension costs due to the cessation of our U.S. qualified and non-qualified defined benefit pension plans as of January 1, 2019 (except for interest crediting) and ongoing cost control measures.Other Expense (Income)The following table presents other expense and income items, consolidated and by reportable segment and corporate and unallocated items:Expense (Income)Year Ended December 31,($ in millions) 202020192018Proprietary Products$3.3 $(2.0)$(6.3)Contract-Manufactured Products1.5 0.2 (0.8)Corporate and unallocated items7.2 (0.7)9.0 Consolidated other expense (income)$12.0 $(2.5)$1.9 Other expense and income items, consisting of foreign exchange transaction gains and losses, gains and losses on the sale of fixed assets, development and licensing income, contingent consideration, and miscellaneous income and charges, are generally recorded within segment results.2020 compared to 2019Consolidated other expense (income) changed by $14.5 million in 2020.Proprietary Products – Proprietary Products other expense (income) changed by $5.3 million in 2020, primarily due to an increase in the fixed asset impairments recorded, partially offset by a decrease in the SmartDose contingent consideration charge. Please refer to Note 12, Fair Value Measurements, for further discussion of this item.Contract-Manufactured Products – Contract-Manufactured Products other expense (income) changed by $1.3 million in 2020 as compared to 2019, primarily due to an increase in foreign exchange transaction losses.Corporate and unallocated items – Corporate and unallocated items changed by $7.9 million in 2020. During 2020, we recorded $4.6 million in restructuring and related charges and a $2.5 million impairment charge related to a cost investment. We expect that our 2020 restructuring plan will provide annualized savings in the range of $3.5 million to $4.5 million. In 2019, offsetting the $4.9 million restructuring and related charge and $1.0 million charge as a result of the continued devaluation of Argentina’s currency, the Company recorded a $1.9 million gain on the sale of fixed assets as a result of our 2018 restructuring plan and recognized a tax recovery of $4.7 million related to previously-paid international excise taxes, following a favorable court ruling. 2019 compared to 2018Consolidated other expense (income) changed by $4.4 million in 2019.31Proprietary Products – Proprietary Products other expense (income) decreased by $4.3 million in 2019, primarily due to increased contingent consideration costs. Please refer to Note 12, Fair Value Measurements, for further discussion of this item.Contract-Manufactured Products – Contract-Manufactured Products other expense (income) changed by $1.0 million in 2019, primarily due to a decrease in gains on the sale of fixed assets during 2019.Corporate and unallocated items – Corporate and unallocated items changed by $9.7 million in 2019. During 2019, we recorded $4.9 million in restructuring and related charges, a $1.9 million gain on the sale of fixed assets as a result of our restructuring plan, and a charge of $1.0 million as a result of the continued devaluation of Argentina’s currency. In addition, during 2019, we recognized a tax recovery of $4.7 million related to previously-paid international excise taxes, following a favorable court ruling. Please refer to Note 16, Other Expense (Income), for further discussion of these items.Operating ProfitThe following table presents operating profit and adjusted operating profit, consolidated and by reportable segment, corporate and unallocated items:Year Ended December 31,% Change($ in millions)2020201920182020/20192019/2018Proprietary Products$434.5 $313.6 $266.4 38.6 %17.7 %Contract-Manufactured Products68.6 49.1 44.3 39.7 %10.8 %Corporate(86.1)(66.3)(61.3)29.9 %8.2 %Adjusted consolidated operating profit$417.0 $296.4 $249.4 40.7 %18.8 %Adjusted consolidated operating profit margin19.4 %16.1 %14.5 %Unallocated items(10.1)0.2 (9.1)Consolidated operating profit$406.9 $296.6 $240.3 37.2 %23.4 %Consolidated operating profit margin19.0 %16.1 %14.0 %2020 compared to 2019Consolidated operating profit increased by $110.3 million, or 37.2%, in 2020, including a favorable foreign currency translation impact of $0.8 million.Proprietary Products – Proprietary Products operating profit increased by $120.9 million, or 38.6%, in 2020, including a favorable foreign currency translation impact of $0.2 million, due to the factors described above, most notably the sales increase in our high-value product offerings, inclusive of COVID-19 related activity.Contract-Manufactured Products – Contract-Manufactured Products operating profit increased by $19.5 million, or 39.7%, in 2020, including a favorable foreign currency translation impact of $0.6 million, due to the factors described above, most notably the sales increase in our products with a more favorable gross profit margin.Corporate – Corporate costs increased by $19.8 million, or 29.9%, in 2020, which decreased operating profit, due to the factors described above most notably an increase in stock-based compensation costs and incentive compensation costs.Unallocated items – Please refer to the 2020 Financial Performance Summary section above and Other Expense (Income) section for details.Excluding the unallocated items, our adjusted consolidated operating profit margin increased by 3.3 margin points in 2020.322019 compared to 2018Consolidated operating profit increased by $56.3 million, or 23.4%, in 2019, including a favorable foreign currency translation impact of $0.6 million.Proprietary Products – Proprietary Products operating profit increased by $47.2 million, or 17.7%, in 2019, including a favorable foreign currency translation impact of $0.6 million, due to the factors described above.Contract-Manufactured Products – Contract-Manufactured Products operating profit increased by $4.8 million, or 10.8%, in 2019, due to the factors described above.Corporate – Corporate costs increased by $5.0 million, or 8.2%, in 2019, which decreased operating profit, due to the factors described above.Unallocated items – Please refer to the Other Expense (Income) section for details.Excluding the unallocated items, our adjusted consolidated operating profit margin increased by 1.6 margin points in 2019.Interest Expense, NetThe following table presents interest expense, net, by significant component:Year Ended December 31,% Change($ in millions)2020201920182020/20192019/2018Interest expense$9.6 $9.4 $9.3 2.1 %1.1 %Capitalized interest(1.4)(0.9)(0.9)55.6 %— %Interest income(1.4)(3.8)(2.1)(63.2)%81.0 %Interest expense, net$6.8 $4.7 $6.3 44.7 %(25.4)%2020 compared to 2019Interest expense, net, increased by $2.1 million, or 44.7%, in 2020, due to a decrease in interest income in 2020 resulting from lower interest rates compared to the prior year, partially offset by an increase in capitalized interest due to an increase in capital expenditures in 2020. 2019 compared to 2018Interest expense, net, decreased by $1.6 million, or 25.4%, in 2019, due to an increase in interest income in 2019 resulting from higher interest rates on our deposit accounts and higher average cash and cash equivalents balances.Other Nonoperating (Income) Expense2020 compared to 2019Other nonoperating (income) expense changed by $1.3 million in 2020, primarily due to a decrease in the interest cost component of our net periodic benefit expense, partially offset by an increase in pension settlement charges. A pension settlement charge of $3.7 million was recorded in 2020, as we determined that normal-course lump-sum payments for each of our U.S. qualified and non-qualified defined benefit pension plans exceeded the threshold for settlement accounting under U.S. GAAP for the year. 332019 compared to 2018Other nonoperating (income) expense changed by $6.8 million in 2019, primarily due to a decrease in the expected return on pension plan assets and a pension settlement charge of $3.5 million recorded in 2019, as we determined that normal-course lump-sum payments for each of our U.S. qualified and non-qualified defined benefit pension plans exceeded the threshold for settlement accounting under U.S. GAAP for the year. Effective January 1, 2019, except for interest crediting, benefit accruals under these defined benefit pension plans ceased.Income TaxesThe provision for income taxes was $72.5 million, $59.0 million, and $41.4 million for the years 2020, 2019, and 2018, respectively, and the effective tax rate was 18.1%, 20.2%, and 17.2%, respectively.During 2020, we recorded a tax benefit of $20.8 million associated with stock-based compensation, an increase from the tax benefit of $10.3 million associated with stock-based compensation in 2019, and incurred less tax on international operations versus the prior year, which both contributed to the effective tax rate decline from 20.2% in 2019 to 18.1% in 2020. During 2019, we recorded a net tax benefit of $0.3 million due to the impact of federal law changes enacted during the year, as well as a tax benefit of $10.3 million associated with stock-based compensation.During 2018, we recorded a net tax benefit of $2.5 million for the estimated impact of the 2017 Tax Act and a tax benefit of $14.3 million associated with stock-based compensation. Please refer to Note 17, Income Taxes, for further discussion of the 2017 Tax Act.Please refer to Note 17, Income Taxes, for further discussion of our income taxes.Equity in Net Income of Affiliated CompaniesEquity in net income of affiliated companies represents the contribution to earnings from our 25% ownership interest in Daikyo, which increased to 49% during the fourth quarter of 2019, and our 49% ownership interest in five companies majority-owned by a long-time partner located in Mexico. Please refer to Note 7, Affiliated Companies, for further discussion. Equity in net income of affiliated companies was $17.4 million, $8.9 million, and $7.6 million for the years 2020, 2019, and 2018, respectively. Equity in net income of affiliated companies increased by $8.5 million, or 95.5%, in 2020, primarily due to favorable operating results at Daikyo and the Mexico affiliates and increase in ownership of Daikyo starting in the fourth quarter of 2019. Equity in net income of affiliated companies increased by $1.3 million, or 17.1%, in 2019, primarily due to favorable operating results at Daikyo.FINANCIAL CONDITION, LIQUIDITY AND CAPITAL RESOURCESCash FlowsThe following table presents cash flow data for the years ended December 31:($ in millions)202020192018Net cash provided by operating activities$472.5 $367.2 $288.6 Net cash used in investing activities$(179.5)$(228.0)$(100.8)Net cash used in financing activities$(137.1)$(36.8)$(80.7)34Net Cash Provided by Operating Activities 2020 compared to 2019Net cash provided by operating activities increased by $105.3 million in 2020, primarily due to improved operating results and changes in assets and liabilities.2019 compared to 2018Net cash provided by operating activities increased by $78.6 million in 2019, primarily due to improved operating results and changes in assets and liabilities.Net Cash Used in Investing Activities 2020 compared to 2019Net cash used in investing activities decreased by $48.5 million in 2020, primarily due to 2019 investing activities that did not recur in 2020, such as our increase in Daikyo ownership and the acquisition of our South Korea distributor in 2019. These reductions in investing activities were offset in 2020 by an increase in capital expenditures to support our increased customer demands. 2019 compared to 2018Net cash used in investing activities increased by $127.2 million in 2019, primarily due to the increase in our ownership interest in Daikyo, an increase in capital expenditures, and the acquisition of our distributor in South Korea in 2019.Net Cash Used in Financing Activities 2020 compared to 2019Net cash used in financing activities increased by $100.3 million in 2020, primarily due an increase in purchases under our share repurchases program and given 2019 included new long-term borrowings while no such new borrowings occurred in 2020. 2019 compared to 2018Net cash used in financing activities decreased by $43.9 million in 2019, primarily due to borrowings of $90.0 million under our Term Loan, partially offset by net repayments of our outstanding long-term borrowings under our Credit Facility and increases in purchases under our share repurchases programs and dividend payments.Liquidity and Capital ResourcesThe table below presents selected liquidity and capital measures as of:($ in millions)December 31, 2020December 31, 2019Cash and cash equivalents$615.5 $439.1 Accounts receivable, net$385.3 $319.3 Inventories$321.3 $235.7 Accounts payable$213.1 $156.8 Debt$255.2 $257.3 Equity$1,854.5 $1,573.2 Working Capital$870.3 $717.1 Cash and cash equivalents include all instruments that have maturities of ninety days or less when purchased. Working capital is defined as current assets less current liabilities.35Cash and cash equivalents – Our cash and cash equivalents balance at December 31, 2020 consisted of cash held in depository accounts with banks around the world and cash invested in high-quality, short-term investments. The cash and cash equivalents balance at December 31, 2020 included $293.5 million of cash held by subsidiaries within the U.S. and $322.0 million of cash held by subsidiaries outside of the U.S. In response to the 2017 Tax Act, we reevaluated our position regarding permanent reinvestment of foreign subsidiary earnings and profits through 2017 (with the exception of China and Mexico) and decided that those profits were no longer permanently reinvested. As of January 1, 2018, we reasserted indefinite reinvestment related to all post-2017 unremitted earnings in all of our foreign subsidiaries. In general, it is our practice and intention to permanently reinvest the earnings of our foreign subsidiaries and repatriate earnings only when the tax impact is de minimis, and that position has not changed subsequent to the one-time transition tax under the 2017 Tax Act, except as noted above. Accordingly, no deferred taxes have been provided for withholding taxes or other taxes that would result upon repatriation of approximately $345.6 million of undistributed earnings from foreign subsidiaries to the U.S., as those earnings continue to be permanently reinvested. Further, it is impracticable for us to estimate any future tax costs for any unrecognized deferred tax liabilities associated with our indefinite reinvestment assertion, because the actual tax liability, if any, would be dependent on complex analysis and calculations considering various tax laws, exchange rates, circumstances existing when there is a repatriation, sale or liquidation, or other factors.Working capital - Working capital at December 31, 2020 increased by $153.2 million, or 21.4%, as compared to December 31, 2019, including an increase of $3.2 million due to foreign currency translation. Excluding the impact of currency exchange rates, cash and cash equivalents, accounts receivable, inventories, and total current liabilities increased by $156.0 million, $52.5 million, $73.7 million, and $119.1 million, respectively. The increase in accounts receivable was due to increased sales activity. The increase in inventories that occurred in the period was to ensure we have sufficient inventory on hand to support the needs of our customers. The increase in total current liabilities was primarily due to increases in accounts payable, accrued salaries, wages and benefits, accrued expenses, and income taxes payable.Debt and credit facilities - The $2.1 million decrease in total debt at December 31, 2020, as compared to December 31, 2019, resulted from debt repayments under our Term Loan.Our sources of liquidity include our Credit Facility. At December 31, 2020, we had no outstanding borrowings under the Credit Facility. At December 31, 2020, the borrowing capacity available under the Credit Facility, including outstanding letters of credit of $2.5 million, was $297.5 million. We do not expect any significant limitations on our ability to access this source of funds. Please refer to Note 10, Debt, for further discussion of our Credit Facility.Pursuant to the financial covenants in our debt agreements, we are required to maintain established interest coverage ratios and to not exceed established leverage ratios. In addition, the agreements contain other customary covenants, none of which we consider restrictive to our operations. At December 31, 2020, we were in compliance with all of our debt covenants, and we expect to continue to be in compliance with the terms of these agreements throughout 2021. We believe that cash on hand and cash generated from operations, together with availability under our Credit Facility, will be adequate to address our foreseeable liquidity needs based on our current expectations of our business operations, capital expenditures and scheduled payments of debt obligations.36Commitments and Contractual ObligationsThe following table summarizes our commitments and contractual obligations at December 31, 2020. These obligations are not expected to have a material impact on liquidity.Payments Due By Period($ in millions)TotalLess than 1 year1 - 3 years(through 2023)3 - 5 years(through 2025)More than 5 yearsPurchase obligations (1)$118.4 $41.4 $76.6 $0.4 $— Debt (excluding unamortized debt issuance costs)255.8 2.3 46.5 134.0 73.0 Interest on debt and cross-currency swap (2)30.3 7.0 11.6 7.3 4.4 Operating lease obligations85.2 12.4 19.7 15.6 37.5 Other long-term liabilities (3)7.4 0.7 1.2 2.4 3.1 Total contractual obligations (4)$497.1 $63.8 $155.6 $159.7 $118.0 (1)Our business creates a need to enter into various commitments with suppliers, including for the purchase of raw materials and finished goods. In accordance with U.S. GAAP, these purchase obligations are not reflected in the accompanying consolidated balance sheets. These purchase commitments do not exceed our projected requirements and are in the normal course of business.(2)For fixed-rate long-term debt, interest was based on principal amounts and fixed coupon rates at year-end. Future interest payments on variable-rate debt were calculated using principal amounts and the applicable ending interest rate at year-end. Interest on floating-rate derivative instruments was based on notional amounts and floating interest rates contractually obligated at year-end.(3)Represents acquisition-related contingencies. In connection with certain business acquisitions, we agreed to make payments to the sellers if and when certain operating milestones are achieved, such as sales and operating income targets. (4)This table does not include obligations pertaining to pension and postretirement benefits because the actual amount and timing of future contributions may vary significantly depending upon plan asset performance, benefit payments, and other factors. In 2021, we expect to contribute $3.6 million to pension plans, of which $2.9 million is for international plans. In addition, we expect to contribute $0.7 million for other retirement benefits in 2021. Please refer to Note 15, Benefit Plans, for estimated benefit payments over the next ten years.Reserves for uncertain tax positions - The table above does not include $10.4 million of total gross unrecognized tax benefits as of December 31, 2020. Due to the high degree of uncertainty regarding the timing of potential cash flows, we cannot reasonably estimate the settlement periods for amounts which may be paid.Letters of credit - We have letters of credit totaling $2.5 million supporting the reimbursement of workers’ compensation and other claims paid on our behalf by insurance carriers. Our accrual for insurance obligations was $3.0 million at December 31, 2020, of which $0.9 million is in excess of our deductible and, therefore, is reimbursable by the insurance company.OFF-BALANCE SHEET ARRANGEMENTSAt December 31, 2020, we had no off-balance sheet financing arrangements other than unconditional purchase obligations incurred in the ordinary course of business and outstanding letters of credit related to various insurance programs.37CRITICAL ACCOUNTING POLICIES AND ESTIMATESManagement’s discussion and analysis addresses consolidated financial statements that are prepared in accordance with U.S. GAAP. The application of these principles requires management to make estimates and assumptions, some of which are subjective and complex, that affect the amounts reported in the consolidated financial statements. We believe the following accounting policies and estimates are critical to understanding and evaluating our results of operations and financial position: Revenue Recognition: Our revenue results from the sale of goods or services and reflects the consideration to which we expect to be entitled in exchange for those goods or services. We record revenue based on a five-step model, in accordance with ASC Topic 606 (“ASC 606”). Following the identification of a contract with a customer, we identify the performance obligations (goods or services) in the contract, determine the transaction price, allocate the transaction price to the performance obligations in the contract, and recognize the revenue when (or as) we satisfy the performance obligations by transferring the promised goods or services to our customers. A good or service is transferred when (or as) the customer obtains control of that good or service.We recognize the majority of our revenue, primarily relating to Proprietary Products product sales, at a point in time following the transfer of control of our products to our customers, which typically occurs upon shipment or delivery, depending on the terms of the related agreements.We recognize revenue relating to our Contract-Manufactured Products product sales and certain Proprietary Products product sales over time, as our performance does not create an asset with an alternative use to us and we have an enforceable right to payment for performance completed to date.We recognize revenue relating to our development and tooling agreements over time, as our performance creates or enhances an asset that the customer controls as the asset is created or enhanced.For revenue recognized over time, revenue is recognized by applying a method of measuring progress toward complete satisfaction of the related performance obligation. When selecting the method for measuring progress, we select the method that best depicts the transfer of control of goods or services promised to our customers.Revenue for our Contract-Manufactured Products product sales, certain Proprietary Products product sales, and our development and tooling agreements is recorded under an input method, which recognizes revenue on the basis of our efforts or inputs to the satisfaction of a performance obligation (for example, resources consumed, labor hours expended, costs incurred, time elapsed, or machine hours used) relative to the total expected inputs to the satisfaction of that performance obligation. The input method that we use is based on costs incurred.The majority of the performance obligations within our contracts are satisfied within one year or less. Performance obligations satisfied beyond one year include those relating to a nonrefundable customer payment of $20.0 million received in June 2013 in return for the exclusive use of the SmartDose technology platform within a specific therapeutic area. As of December 31, 2020, there was $4.7 million of unearned income related to this payment, of which $0.9 million was included in other current liabilities and $3.8 million was included in other long-term liabilities. The unearned income is being recognized as income on a straight-line basis over the remaining term of the agreement. The agreement does not include a future minimum purchase commitment from the customer.Our revenue can be generated from contracts with multiple performance obligations. When a sales agreement involves multiple performance obligations, each obligation is separately identified and the transaction price is allocated based on the amount of consideration we expect to be entitled in exchange for transferring the promised good or service to the customer.Some customers receive pricing rebates upon attaining established sales volumes. We record rebate costs when sales occur based on our assessment of the likelihood that the required volumes will be attained. We also maintain an allowance for product returns, as we believe that we are able to reasonably estimate the amount of returns based on our substantial historical experience and specific identification of customer claims.38Contract assets and liabilities result from transactions with revenue recorded primarily over time. If the measure of remaining rights exceeds the measure of the remaining performance obligations, we record a contract asset. Contract assets are recorded on the consolidated balance sheet in accounts receivable, net, and other assets (current and noncurrent portions, respectively). Contract assets included in accounts receivable, net, relate to the unbilled amounts of our product sales for which we have recognized revenue over time. Contract assets included in other assets represent the remaining performance obligations of our development and tooling agreements. Conversely, if the measure of the remaining performance obligations exceeds the measure of the remaining rights, we record a contract liability. Contract liabilities are recorded on the consolidated balance sheet in other liabilities (current and noncurrent portions, respectively) and represent cash payments received in advance of our performance.Impairment of Long-Lived Assets: Long-lived assets, including property, plant and equipment and operating lease right-of-use assets, are tested for impairment whenever circumstances indicate that the carrying value of these assets may not be recoverable. An asset is considered impaired if the carrying value of the asset exceeds the sum of the future expected undiscounted cash flows to be derived from the asset. Once an asset is considered impaired, an impairment loss is recorded within other expense (income) for the difference between the asset’s carrying value and its fair value. For assets held and used in the business, management determines fair value using estimated future cash flows to be derived from the asset, discounted to a net present value using an appropriate discount rate. For assets held for sale or for investment purposes, management determines fair value by estimating the proceeds to be received upon sale of the asset, less disposition costs.Impairment of Goodwill and Other Intangible Assets: Goodwill is tested for impairment at least annually, following the completion of our annual budget and long-range planning process, or whenever circumstances indicate that the carrying value of these assets may not be recoverable. Goodwill is tested for impairment at the reporting unit level, which is the same as, or one level below, our operating segments. A goodwill impairment charge represents the amount by which a reporting unit’s carrying amount exceeds its fair value, not to exceed the total amount of goodwill allocated to that reporting unit. Considerable management judgment is necessary to estimate fair value. Amounts and assumptions used in our goodwill impairment test, such as future sales, future cash flows and long-term growth rates, are consistent with internal projections and operating plans. Amounts and assumptions used in our goodwill impairment test are also largely dependent on the continued sale of drug products delivered by injection and the packaging of drug products, as well as our timeliness and success in new-product innovation or the development and commercialization of proprietary multi-component systems. Changes in the estimate of fair value, including the estimate of future cash flows, could have a material impact on our future results of operations and financial position. Accounting guidance also allows entities to first assess qualitative factors, including macroeconomic conditions, industry and market considerations, cost factors, and overall financial performance, to determine whether it is necessary to perform the quantitative goodwill impairment test. We elected to follow this guidance for our annual impairment test. Based upon our assessment, we determined that it was not more likely than not that the fair value of each of our reporting units was less than its carrying amount and determined that it was not necessary to perform the quantitative goodwill impairment test.Intangible assets with finite lives are amortized using the straight-line method over their estimated useful lives, and reviewed for impairment whenever circumstances indicate that the carrying value of these assets may not be recoverable. 39Employee Benefits: We maintain funded and unfunded defined benefit pension plans in the U.S. and a number of other countries that cover employees who meet eligibility requirements. In addition, we sponsor postretirement benefit plans which provide healthcare benefits for eligible employees who retire or become disabled. Postretirement benefit plans are limited to only those active employees who met the eligibility requirements as of January 1, 2017. The measurement of annual cost and obligations under these defined benefit pension and postretirement plans are subject to a number of assumptions, which are specific for each of our U.S. and foreign plans. The assumptions, which are reviewed at least annually, are relevant to both the plan assets (where applicable) and the obligation for benefits that will ultimately be provided to our employees. Two of the most critical assumptions in determining pension expense are the discount rate and expected long-term rate of return on plan assets. Other assumptions reflect demographic factors such as retirement age, rates of compensation increases, mortality and turnover and are evaluated periodically and updated to reflect our actual experience. For our funded plans, we consider the current and expected asset allocations of our plan assets, as well as historical and expected rates of return, in estimating the long-term rate of return on plan assets. One of the most critical assumptions in determining retiree mental plan expense is the discount rate. Under U.S. GAAP, differences between actual and expected results are generally accumulated in other comprehensive income (loss) as actuarial gains or losses and subsequently amortized into earnings over future periods. Changes in key assumptions could have a material impact on our future results of operations and financial position. We estimate that every 25-basis point reduction in our long-term rate of return assumption would increase pension expense by $0.6 million, and every 25-basis point reduction in our discount rate would decrease pension expense by $0.1 million. A decrease in the discount rate increases the present value of benefit obligations. Our net pension underfunded balance at December 31, 2020 was $40.8 million, compared to $43.8 million at December 31, 2019. Our underfunded balance for other postretirement benefits was $6.1 million at December 31, 2020, compared to $6.6 million at December 31, 2019.Income Taxes: We estimate income taxes payable based upon current domestic and international tax legislation. In addition, deferred income taxes are recognized by applying enacted statutory tax rates to tax loss carryforwards and temporary differences between the tax basis and financial statement carrying values of our assets and liabilities. The enacted statutory tax rate applied is based on the rate expected to be applicable at the time of the forecasted utilization of the loss carryforward or reversal of the temporary difference. Valuation allowances on deferred tax assets are established when it is more likely than not that all or a portion of a deferred tax asset will not be realized. The realizability of deferred tax assets is subject to our estimates of future taxable income, generally at the respective subsidiary company and country level. Changes in tax legislation, business plans and other factors may affect the ultimate recoverability of tax assets or final tax payments, which could result in adjustments to tax expense in the period such change is determined.When accounting for uncertainty in income taxes recognized in our financial statements, we apply a more-likely-than-not threshold for financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return.Please refer to Note 1, Basis of Presentation and Summary of Significant Accounting Policies and Note 2, New Accounting Standards, to our consolidated financial statements for additional information on our significant accounting policies, recently adopted accounting standards, and accounting standards issued but not yet adopted.ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKOur ongoing business operations expose us to various risks, such as fluctuating interest rates, foreign currency exchange rates and increasing commodity prices. These risk factors can impact our results of operations, cash flows and financial position. To manage these market risks, we periodically enter into derivative financial instruments, such as interest rate swaps, options and foreign exchange contracts for periods consistent with, and for notional amounts equal to or less than, the related underlying exposures. We do not purchase or hold any derivative financial instruments for investment or trading purposes. All derivatives are recorded in our consolidated balance sheet at fair value.40Foreign Currency Exchange RiskSales outside of the U.S. accounted for 54.6% of our consolidated net sales in 2020. Virtually all of these sales and related operating costs are denominated in the currency of the local country and translated into USD for consolidated reporting purposes. Although the majority of the assets and liabilities of these subsidiaries are denominated in the functional currency of the subsidiary, they may also hold assets or liabilities denominated in other currencies. These items may give rise to foreign currency transaction gains and losses. As a result, our results of operations and financial position are exposed to changing currency exchange rates. We periodically use forward exchange contracts to hedge certain transactions or to manage month-end balance sheet exposures on cross-currency intercompany loans.We have entered into forward exchange contracts, designated as fair value hedges, to manage our exposure to fluctuating foreign exchange rates on cross-currency intercompany loans. As of December 31, 2020 and December 31, 2019, the total amount of these forward exchange contracts were SGD 601.5 million and $13.4 million.In addition, we have entered into several foreign currency contracts, designated as cash flow hedges, for periods of up to eighteen months, intended to hedge the currency risk associated with a portion of our forecasted transactions denominated in foreign currencies. As of December 31, 2020, we had outstanding foreign currency contracts to purchase and sell certain pairs of currencies, as follows:(in millions)SellCurrencyPurchaseUSDEuroUSD57.0 — 49.2 Yen7,194.1 42.7 22.0 SGD42.9 25.0 5.0 In November and December 2019, in conjunction with the repayment of the outstanding long-term borrowings under our Credit Facility denominated in Euro and Yen, we de-designated these borrowings as hedges of our net investments in certain European subsidiaries and Daikyo. The amounts recorded as a cumulative translation adjustment in accumulated other comprehensive loss related to these borrowings (prior to de-designation) will remain in accumulated other comprehensive loss indefinitely, unless certain future events occur, such as the disposition of the operations for which the net investment hedges relate.In December 2019, in conjunction with the repayment of the outstanding long-term borrowings under our Credit Facility denominated in Yen, we entered into a forward exchange contract, designated as a cash flow hedge, to manage our exposure to fluctuating foreign exchange rates. This forward exchange contract matured on December 30, 2019.In December 2019, we entered into a five-year floating-to-floating forward-starting cross-currency swap (the “cross-currency swap”) for $90 million, which we designated as a hedge of our net investment in Daikyo. The notional amount of the cross-currency swap is ¥9.6 billion ($87.8 million) as of December 31, 2020. Under the cross-currency swap, we receive floating interest rate payments based on three-month USD LIBOR plus a margin, in return for paying floating interest rate payments based on three-month Yen LIBOR plus a margin.Interest Rate Risk As a result of our normal borrowing activities, we have long-term debt with both fixed and variable interest rates. Long-term debt consists of our Term Loan and Series A, B and C notes. 41The following table summarizes our interest rate risk-sensitive instruments (excluding unamortized debt issuance costs): ($ in millions)20212022202320242025ThereafterCarrying ValueFair ValueCurrent Debt:U.S. dollar denominated$2.3$2.3$2.3Average interest rate - variable1.13%Long-Term Debt:U.S. dollar denominated$42.0$53.0$73.0$168.0$180.7Average interest rate - fixed3.67%3.82%4.02%U.S. dollar denominated$2.3$2.2$81.0$85.5$85.5Average interest rate - variable1.13%1.13%1.13%Commodity Price RiskMany of our proprietary products are made from synthetic elastomers, which are derived from the petroleum refining process. We purchase the majority of our elastomers via long-term supply contracts, some of which contain clauses that provide for surcharges related to fluctuations in crude oil prices. In recent years, raw material costs have fluctuated due to crude oil price fluctuations. We expect this volatility to continue and will continue to pursue pricing and hedging strategies, and ongoing cost control initiatives, to offset the effects on gross profit. From November 2017 through December 2020, we purchased several series of call options for a total of 472,477 barrels of crude oil to mitigate our exposure to such oil-based surcharges and protect operating cash flows with regards to a portion of our forecasted elastomer purchases.During 2020, the loss recorded in cost of goods and services sold related to these options was $0.2 million. During 2019, the loss recorded in cost of goods and services sold related to these options was $0.4 million.As of December 31, 2020, we had outstanding contracts to purchase 141,734 barrels of crude oil from January 2021 to June 2022, at a weighted-average strike price of $59.14 per barrel.42
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+ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (MD&A) 39 ECONOMIC AND MARKET CONDITIONS AFFECTING OUR OPERATIONS 39 FINANCIAL PERFORMANCE SUMMARY 40 RESULTS OF OPERATIONS 41 LIQUIDITY AND CAPITAL RESOURCES 46 OFF-BALANCE SHEET ARRANGEMENTS 49 ENVIRONMENTAL MATTERS, LEGAL PROCEEDINGS AND OTHER CONTINGENCIES 49 ACCOUNTING MATTERS 49 PERFORMANCE MEASURES 51 ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK 53
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+Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations. 7Transmission & Gulf of MexicoThis segment includes the Transco interstate natural gas pipeline that extends from the Gulf of Mexico to the eastern seaboard, the Northwest Pipeline interstate natural gas pipeline, as well as natural gas gathering, processing and treating, crude oil production handling, and NGL fractionation assets within the onshore, offshore shelf, and deepwater areas in and around the Gulf Coast states of Texas, Louisiana, Mississippi, and Alabama. This segment also includes various petrochemical and feedstock pipelines in the Gulf Coast region.TranscoTransco is an interstate natural gas transmission company that owns and operates a 9,800-mile natural gas pipeline system, which is regulated by the FERC, extending from Texas, Louisiana, Mississippi, and the Gulf of Mexico through Alabama, Georgia, South Carolina, North Carolina, Virginia, Maryland, Delaware, Pennsylvania, and New Jersey to the New York City metropolitan area. The system serves customers in Texas and 12 southeast and Atlantic seaboard states, including major metropolitan areas in Georgia, North Carolina, Washington, D.C., Maryland, New York, New Jersey, and Pennsylvania.At December 31, 2020, Transco’s system had a system-wide delivery capacity totaling approximately 17.9 MMdth/d. During 2020, Transco completed one fully-contracted expansion and began partial early service on two additional fully-contracted expansions, which added more than 0.5 MMdth of firm transportation capacity per day to our pipeline. Transco’s system includes 57 compressor stations, four underground storage fields, and one LNG storage facility. Compression facilities at sea level-rated capacity total approximately 2.3 million horsepower.Transco has natural gas storage capacity in four underground storage fields located on or near its pipeline system or market areas and operates two of these storage fields. Transco also has storage capacity in an LNG storage facility that it owns and operates. The total usable gas storage capacity available to Transco and its customers in such underground storage fields and LNG storage facility and through storage service contracts is approximately 194 MMdth of natural gas. At December 31, 2020, Transco’s customers had stored in its facilities approximately 148 MMdth of natural gas. Storage capacity permits our customers to inject gas into storage during the summer and off-peak periods for delivery during peak winter demand periods.Northwest PipelineNorthwest Pipeline is an interstate natural gas transmission company that owns and operates a 3,900-mile natural gas pipeline system, which is regulated by the FERC, extending from the San Juan basin in northwestern New Mexico and southwestern Colorado through Colorado, Utah, Wyoming, Idaho, Oregon, and Washington to a point on the Canadian border near Sumas, Washington. Northwest Pipeline provides services for markets in Washington, Oregon, Idaho, Wyoming, Nevada, Utah, Colorado, New Mexico, California, and Arizona, either directly or indirectly through interconnections with other pipelines.At December 31, 2020, Northwest Pipeline’s system had long-term firm transportation and storage redelivery agreements with aggregate capacity reservations of approximately 3.8 MMdth/d. Northwest Pipeline’s system includes 42 transmission compressor stations having a combined sea level-rated capacity of approximately 473,000 horsepower.Northwest Pipeline owns a one-third undivided interest in the Jackson Prairie underground storage facility in Washington and contracts with a third party for natural gas storage services in the Clay basin underground field in Utah. Northwest Pipeline also owns and operates an LNG storage facility in Washington. These storage facilities have an aggregate working natural gas storage capacity of 14.2 MMdth, which is substantially utilized for third-party natural gas. These natural gas storage facilities enable Northwest Pipeline to balance daily receipts and deliveries and provide storage services to customers.8Gas Transportation, Processing, and Treating AssetsThe following tables summarize the significant operated assets of this segment: Offshore Natural Gas PipelinesInletPipelineCapacityOwnershipLocationMiles(Bcf/d)InterestSupply BasinsConsolidated: Canyon Chief, including Blind Faith and Gulfstar extensionsDeepwater Gulf of Mexico1560.5100%Eastern Gulf of MexicoNorphletDeepwater Gulf of Mexico580.3100%Eastern Gulf of MexicoOther Eastern GulfOffshore shelf and other460.2100%Eastern Gulf of MexicoSeahawkDeepwater Gulf of Mexico1150.4100%Western Gulf of MexicoPerdido NorteDeepwater Gulf of Mexico1050.3100%Western Gulf of MexicoOther Western GulfOffshore shelf and other1030.4100%Western Gulf of MexicoNon-consolidated: (1)DiscoveryCentral Gulf of Mexico5940.660%Western Gulf of MexicoNatural Gas Processing FacilitiesNGLInletProductionCapacityCapacityOwnershipLocation(Bcf/d)(Mbbls/d)InterestSupply BasinsConsolidated: MarkhamMarkham, TX0.545100%Western Gulf of MexicoMobile BayCoden, AL0.735100%Eastern Gulf of MexicoNon-consolidated: (1)DiscoveryLarose, LA0.63260%Western Gulf of Mexico_____________(1)Includes 100 percent of the statistics associated with operated equity-method investments.Crude Oil Transportation and Production Handling Assets In addition to our natural gas assets, we own and operate four deepwater crude oil pipelines and own production platforms serving the deepwater in the Gulf of Mexico. Our offshore floating production platforms provide centralized services to deepwater producers such as compression, separation, production handling, water removal, and pipeline landings. The following tables summarize the significant crude oil transportation pipelines and production handling platforms of this segment: Crude Oil Pipelines PipelineCapacityOwnership Miles(Mbbls/d)InterestSupply BasinsConsolidated:Mountaineer, including Blind Faith and Gulfstar extensions155150100%Eastern Gulf of MexicoBANJO5790100%Western Gulf of MexicoAlpine9685100%Western Gulf of MexicoPerdido Norte74150100%Western Gulf of Mexico9 Production Handling PlatformsCrude/NGLGas InletHandling CapacityCapacityOwnership (MMcf/d)(Mbbls/d)InterestSupply BasinsConsolidated:Devils Tower11060100%Eastern Gulf of MexicoGulfstar I FPS (1)1728051%Eastern Gulf of MexicoNon-consolidated: (2)Discovery751060%Western Gulf of Mexico__________(1)Statistics reflect 100 percent of the assets from our 51 percent interest in Gulfstar One.(2)Includes 100 percent of the statistics associated with operated equity-method investments.Transmission & Gulf of Mexico Operating Statistics202020192018Consolidated: Interstate natural gas pipeline throughput (Tbtu/d)15.1 15.3 14.0 Gathering volumes (Bcf/d) 0.25 0.25 0.26 Plant inlet natural gas volumes (Bcf/d) 0.48 0.54 0.50 NGL production (Mbbls/d) (2)29 32 32 NGL equity sales (Mbbls/d) (2)5 7 6 Crude oil transportation (Mbbls/d) (2)121 136 140 Non-consolidated: (1)Interstate natural gas pipeline throughput (Tbtu/d)1.2 1.2 1.3 Gathering volumes (Bcf/d)0.30 0.36 0.26 Plant inlet natural gas volumes (Bcf/d)0.30 0.36 0.27 NGL production (Mbbls/d) (2)21 25 20 NGL equity sales (Mbbls/d) (2)6 6 4 _____________(1)Includes 100 percent of the volumes associated with operated equity-method investments.(2)Annual average Mbbls/d.Certain Equity-Method InvestmentsGulfstreamGulfstream is a 745-mile interstate natural gas pipeline system extending from the Mobile Bay area in Alabama to markets in Florida, which has a capacity to transport 1.3 Bcf/d. We own, through a subsidiary, a 50 percent equity-method investment in Gulfstream. We share operating responsibilities for Gulfstream with the other 50 percent owner. DiscoveryWe own a 60 percent interest in and operate the facilities of Discovery. Discovery’s assets include a 600 MMcf/d cryogenic natural gas processing plant near Larose, Louisiana, a 32 Mbbls/d NGL fractionator plant near Paradis, Louisiana, and a 594-mile offshore natural gas gathering and transportation system in the Gulf of Mexico. 10Discovery’s mainline has a gathering inlet capacity of 600 MMcf/d. Discovery’s assets also include a crude oil production handling platform with capacity of 10 Mbbls/d and gas handling and separation capacity of 75 MMcf/d.Northeast G&P This segment includes our natural gas gathering, compression, processing, and NGL fractionation businesses in the Marcellus and Utica Shale regions in Pennsylvania, West Virginia, New York, and Ohio.The following tables summarize the significant operated assets of this segment: Natural Gas Gathering AssetsInlet PipelineCapacityOwnership LocationMiles(Bcf/d)InterestSupply BasinsConsolidated:Ohio Valley Midstream (1)Ohio, West Virginia, & Pennsylvania2160.865%AppalachianUtica East Ohio Midstream (1) (2)Ohio530.565%AppalachianSusquehanna Supply HubPennsylvania & New York4624.3100%AppalachianCardinal (1)Ohio3780.866%AppalachianFlintOhio950.5100%AppalachianNon-consolidated: (3)Bradford Supply HubPennsylvania7334.066%AppalachianMarcellus SouthPennsylvania & West Virginia3251.068%AppalachianLaurel MountainPennsylvania1,1450.969%AppalachianBlue RacerWest Virginia & Ohio7231.550%Appalachian Natural Gas Processing FacilitiesNGLInletProduction CapacityCapacityOwnership Location(Bcf/d)(Mbbls/d)InterestSupply BasinsConsolidated: (1)Fort BeelerMarshall County, WV0.56265%AppalachianOak GroveMarshall County, WV0.45065%AppalachianKensingtonColumbiana Co., OH0.66865%AppalachianLeesvilleCarroll Co., OH0.21865%AppalachianNon-Consolidated: (3)BerneMonroe Co., OH0.46050%AppalachianNatriumMarshall Co., WV0.812050%Appalachian_____________(1)Statistics reflect 100 percent of the assets from our 65 percent ownership in our Northeast JV and 66 percent ownership of Cardinal gathering system. (2)UEOM inlet capacity consists of 1.3 Bcf/d of a high pressure gathering pipeline that delivers Cardinal gathering volumes to UEOM processing facilities. The listed inlet capacity of 0.5 Bcf/d is incremental capacity to the Cardinal gathering capacity of 0.8 Bcf/d.(3)Includes 100 percent of the statistics associated with operated equity-method investments.Other NGL OperationsWe own and operate a 43 Mbbls/d NGL fractionation facility at Moundsville, West Virginia, de-ethanization and condensate facilities at our Oak Grove processing plant, a condensate stabilization facility near our Moundsville fractionator, and an ethane transportation pipeline. Our Oak Grove de-ethanizer is capable of handling up to approximately 80 Mbbls/d of mixed NGLs to extract up to approximately 40 Mbbls/d of ethane. Our condensate 11stabilizers are capable of handling approximately 17 Mbbls/d of field condensate. We also own and operate 44 Mbbls/d of condensate stabilization capacity, a 135 Mbbls/d NGL fractionation facility, approximately 970,000 barrels of NGL storage capacity, and other ancillary assets, including loading and terminal facilities in Ohio. NGLs are extracted from the natural gas stream in our Oak Grove and Fort Beeler cryogenic processing plants. Ethane produced at our de-ethanizer is transported to markets via our 50-mile ethane pipeline from Oak Grove to Houston, Pennsylvania. The remaining mixed NGL stream from the de-ethanizer is then transported via pipeline and fractionated at either our Moundsville or Harrison County, Ohio, fractionation facility. The resulting products are then transported on truck or rail. Ohio Valley Midstream provides residue natural gas take away options for our customers with interconnections to three interstate transmission pipelines. Northeast G&P Operating Statistics202020192018Consolidated:Gathering volumes (Bcf/d)4.31 4.24 3.63Plant inlet natural gas volumes (Bcf/d)1.32 1.040.52NGL production (Mbbls/d) (1)101 7646NGL equity sales (Mbbls/d) (1)2 34Non-consolidated: (2)Gathering volumes (Bcf/d)4.78 4.293.76__________(1) Annual average Mbbls/d.(2) Includes 100 percent of the volumes associated with operated equity-method investments, including the Laurel Mountain Midstream partnership; and the Bradford Supply Hub and a portion of the Marcellus South Supply Hub within Appalachia Midstream Investments. Beginning November 18, 2020, we operate Blue Racer. Blue Racer gathering volumes of 1.38 Bcf/d, plant inlet natural gas volumes of 0.95 Bcf/d, NGL production of 65 Mbbls/d, and NGL equity sales of 6 Mbbls/d have been excluded.Acquisition of UEOM and formation of Northeast JVAs of December 31, 2018, we owned a 62 percent interest in UEOM which we accounted for as an equity-method investment. On March 18, 2019, we signed and closed the acquisition of the remaining 38 percent interest in UEOM. As a result of acquiring this additional interest, we obtained control of and now consolidate UEOM. (See Note 3 – Acquisitions and Divestitures of Notes to Consolidated Financial Statements).In June 2019, we contributed our consolidated interests in UEOM and our Ohio Valley midstream business to a newly formed partnership, and we retained 65 percent ownership of, as well as operate and consolidate, the Northeast JV business.Certain Equity-Method InvestmentsAppalachia Midstream Investments Through our Appalachia Midstream Investments, we operate 100 percent of and own an approximate average 66 percent interest in the Bradford Supply Hub gathering system and own an approximate average 68 percent interest in the Marcellus South gathering system, together which consist of approximately 1,058 miles of gathering pipeline in the Marcellus Shale region with the capacity to gather 5,031 MMcf/d of natural gas. The majority of our volumes in the region are gathered from northern Pennsylvania, southwestern Pennsylvania, and the northwestern panhandle of West Virginia in core areas of the Marcellus Shale. We operate the assets under long-term, 100 percent fixed-fee gathering agreements that include significant acreage dedications and, in the Bradford Supply Hub, a cost of service mechanism. Additionally, some Marcellus South agreements have MVCs.12Laurel MountainWe own a 69 percent interest in a joint venture, Laurel Mountain, that includes a 1,145-mile gathering system that we operate in western Pennsylvania with the capacity to gather 0.9 Bcf/d of natural gas. Laurel Mountain has a long-term, dedicated, volumetric-based fee agreement, with exposure to natural gas prices, to gather the anchor customer’s production in the western Pennsylvania area of the Marcellus Shale. Blue RacerAs of December 31, 2019, we effectively owned a 29 percent indirect interest in Blue Racer through our 58 percent interest in Caiman II, whose primary asset is a 50 percent interest in Blue Racer. On November 18, 2020, we paid $157 million, net of cash acquired, to acquire an additional 41 percent ownership interest in Caiman II. We now control and consolidate Caiman II, reporting the 50 percent interest in Blue Racer as an equity-method investment.Blue Racer is a joint venture to own, operate, develop, and acquire midstream assets in the Utica Shale and certain adjacent areas in the Marcellus Shale. Blue Racer’s assets include 723 miles of gathering pipelines, and the Natrium complex in Marshall County, West Virginia, with a cryogenic processing capacity of 800 MMcf/d and fractionation capacity of approximately 134 Mbbls/d. Blue Racer also owns the Berne complex in Monroe County, Ohio, with a cryogenic processing capacity of 400 MMcf/d, and NGL and condensate pipelines connecting Natrium to Berne. Blue Racer provides gathering, processing, and marketing service primarily under percentage of liquids and fixed fee agreements. WestGas Gathering, Processing, and Treating AssetsThe following tables summarize the significant operated assets of this segment: Natural Gas Gathering Assets LocationPipeline MilesInlet Capacity (Bcf/d)Ownership InterestSupply Basins/Shale FormationsConsolidated:WamsutterWyoming2,2650.7100%WamsutterSouthwest WyomingWyoming1,6140.5100%Southwest WyomingPiceanceColorado3521.8(1)PiceanceBarnett ShaleTexas8400.5100%Barnett ShaleEagle Ford ShaleTexas1,2800.5100%Eagle Ford ShaleHaynesville ShaleLouisiana6291.8100%Haynesville ShalePermianTexas1030.1100%PermianMid-ContinentOklahoma & Texas2,2480.9100%Miss-Lime, Granite Wash, Colony Wash, ArkomaNon-consolidated: (2)Rocky Mountain MidstreamColorado2000.650%Denver-Julesburg13 Natural Gas Processing FacilitiesNGLInletProduction CapacityCapacityOwnership Location(Bcf/d)(Mbbls/d)InterestSupply BasinsConsolidated:Echo SpringsEcho Springs, WY0.758100%WamsutterOpalOpal, WY1.147100%Southwest WyomingWillow CreekRio Blanco County, CO0.530100%PiceanceParachuteGarfield County, CO1.16100%PiceanceNon-consolidated: (2)Fort LuptonColorado0.35050%Denver-JulesburgKeenesburg IColorado0.24050%Denver-Julesburg_______________(1)Includes our 60 percent ownership of a gathering system in the Ryan Gulch area with 140 miles of pipeline and 0.2 Bcf/d of inlet capacity, and our 67 percent ownership of a gathering system at Allen Point with 8 miles of pipeline and 0.1 Bcf/d of inlet capacity. We operate both systems. We own and operate 100 percent of the balance of the Piceance gathering assets.(2)Includes 100 percent of the statistics associated with operated equity-method investments.Marketing ServicesWe market gas and NGL products to a wide range of users in the energy and petrochemical industries. The NGL marketing business transports and markets our equity NGLs from the production at our processing plants, and also markets NGLs on behalf of third-party NGL producers, including some of our fee-based processing customers, and the NGL volumes owned by Discovery and RMM. The NGL marketing business bears the risk of price changes in these NGL volumes while they are being transported to final sales delivery points. In order to meet sales contract obligations, we may purchase products in the spot market for resale. Other NGL OperationsWe own interests in and/or operate NGL fractionation and storage assets in central Kansas near Conway. These assets include a 50 percent interest in an NGL fractionation facility with capacity of slightly more than 100 Mbbls/d and we own approximately 20 million barrels of NGL storage capacity. We also own a 189-mile NGL pipeline from our fractionator near Conway, Kansas, to an interconnection with a third-party NGL pipeline system in Oklahoma.West Operating Statistics202020192018Consolidated: (1)Gathering volumes (Bcf/d)3.33 3.52 4.27 Plant inlet natural gas volumes (Bcf/d)1.25 1.48 2.01 NGL production (Mbbls/d) (2)49 54 84 NGL equity sales (Mbbls/d) (2)22 22 33 Non-Consolidated: (3)Gathering volumes (Bcf/d)0.25 0.20 0.08 Plant inlet natural gas volumes (Bcf/d)0.25 0.20 0.08 NGL production (Mbbls/d) (2)23 12 3 ________________(1) 2020 and 2019 volumes reflect the absence of Four Corners assets due to the sale in October 2018.(2) Annual average Mbbls/d.(3) Includes 100 percent of the volumes associated with operated equity-method investments, including RMM and Jackalope. Jackalope was a consolidated entity in first- and second-quarter 2018, an equity-method investment during third- and fourth-quarter 2018 as well as first-quarter 2019, and sold effective with second-quarter 2019.14Sale of Four Corners AssetsIn October 2018, we completed the sale of our natural gas gathering and processing assets in the Four Corners area of New Mexico and Colorado. The system was comprised of 3,742 miles of gathering pipeline with 1.8 Bcf/d of gas gathering inlet capacity and two processing facilities with a combined 0.7 Bcf/d of natural gas processing inlet capacity and 41 Mbbls/d of NGL production capacity.Certain Equity-Method InvestmentsOverland Pass PipelineWe also operate and own a 50 percent interest in OPPL. OPPL is capable of transporting 255 Mbbls/d of NGLs and includes approximately 1,035 miles of NGL pipeline extending from Opal, Wyoming, to the Mid-Continent NGL market center near Conway, Kansas, along with extensions into the Piceance and Denver-Julesberg basins in Colorado and the Bakken Shale in the Williston basin in North Dakota. Our equity NGL volumes from our Wyoming plants and our Willow Creek facility in Colorado are dedicated for transport on OPPL under a long-term transportation agreement. NGL volumes from our RMM equity-method investment are also transported on OPPL.Rocky Mountain MidstreamDuring the third quarter of 2018, our joint venture, RMM, purchased a natural gas and crude oil gathering and natural gas processing business in Colorado’s Denver-Julesburg basin. As of December 31, 2020, we operate and own 50 percent of RMM. RMM includes a natural gas gathering pipeline and an approximate 80-mile crude oil transportation pipeline. It also includes crude oil storage assets.Targa Train 7We own a 20 percent interest in Targa Train 7, a Mt. Belvieu fractionation train, which was placed into service in the first quarter of 2020.OtherOther includes certain previously owned operations, minor business activities that are not reportable segments, as well as corporate operations.REGULATORY MATTERS FERCOur gas pipeline interstate transmission and storage activities are subject to FERC regulation under the Natural Gas Act of 1938 (NGA) and under the Natural Gas Policy Act of 1978, and, as such, our rates and charges for the transportation of natural gas in interstate commerce, accounting, and the extension, enlargement, or abandonment of our jurisdictional facilities, among other things, are subject to regulation. Each of our gas pipeline companies holds certificates of public convenience and necessity issued by the FERC authorizing ownership and operation of all pipelines, facilities, and properties for which certificates are required under the NGA. FERC Standards of Conduct govern how our interstate pipelines communicate and do business with gas marketing employees. Among other things, the Standards of Conduct require that interstate gas pipelines not operate their systems to preferentially benefit gas marketing functions.FERC regulation requires all terms and conditions of service, including the rates charged, to be filed with and approved by the FERC before any changes can go into effect. Our interstate gas pipeline companies establish rates through the FERC’s ratemaking process. In addition, our interstate gas pipelines may enter into negotiated rate agreements where cost-based recourse rates are made available. Key determinants in the FERC ratemaking process include:•Costs of providing service, including depreciation expense;15•Allowed rate of return, including the equity component of the capital structure and related income taxes;•Contract and volume throughput assumptions.The allowed rate of return is determined in each rate case. Rate design and the allocation of costs between the reservation and commodity rates also impact profitability. As a result of these proceedings, certain revenues previously collected may be subject to refund.We also own interests in and operate natural gas liquids pipelines that are regulated by various federal and state governmental agencies. Services provided on our interstate natural gas liquids pipelines are subject to regulation under the Interstate Commerce Act by the FERC, which has authority over the terms and conditions of service; rates, including depreciation and amortization policies; and initiation of service. Our intrastate natural gas liquids pipelines providing common carrier service are subject to regulation by various state regulatory agencies. Pipeline SafetyOur gas pipelines are subject to the Natural Gas Pipeline Safety Act of 1968, as amended, the Pipeline Safety Improvement Act of 2002, the Pipeline Safety, Regulatory Certainty, and Jobs Creation Act of 2011 (Pipeline Safety Act), and the Protecting Our Infrastructure of Pipelines and Enhancing Safety Act of 2016, which regulate safety requirements in the design, construction, operation, and maintenance of interstate natural gas transmission facilities. The United States Department of Transportation Pipeline and Hazardous Materials Safety Administration (PHMSA) administers federal pipeline safety laws.Federal pipeline safety laws authorize PHMSA to establish minimum safety standards for pipeline facilities and persons engaged in the transportation of gas or hazardous liquids by pipeline. These safety standards apply to the design, construction, testing, operation, and maintenance of gas and hazardous liquids pipeline facilities affecting interstate or foreign commerce. PHMSA has also established reporting requirements for operators of gas and hazardous liquid pipeline facilities, as well as provisions for establishing the qualification of pipeline personnel and requirements for managing the integrity of gas transmission and distribution lines and certain hazardous liquid pipelines. To ensure compliance with these provisions, PHMSA performs pipeline safety inspections and has the authority to initiate enforcement actions.In 2016, PHMSA published a proposed rulemaking that would impose new or more stringent requirements for certain natural gas pipelines including, expanding certain of PHMSA’s current regulatory safety programs for natural gas lines in high-population areas (also known as moderate consequence areas (MCAs)) that do not qualify as high-consequence areas (HCAs) and requiring maximum allowable operating pressure (MAOP) validation through re-verification of all historical records for pipelines in service, which may require natural gas pipelines installed before 1970 (previously excluded from certain pressure testing obligations) to be pressure tested. However, PHMSA has since decided to split this proposed rule (Mega Rule), into three separate rulemaking proceedings. The first of these three rulemakings, relating to onshore gas transmission pipelines, was published as a final rule on October 1, 2019, and imposes numerous requirements, including MAOP reconfirmation, the periodic assessment of additional pipeline mileage outside of HCAs, the reporting of exceedances of MAOP, and the consideration of seismicity as a risk factor in integrity management. In accordance with the final rule, we have developed new procedures and updated our existing pipeline safety program to facilitate meeting all requirements within the time frames stated. The remaining rulemakings comprising the Mega Rule are expected to be issued in 2021 and will include revised pipeline repair criteria as well as more stringent corrosion control requirements. PHMSA also published new or more stringent rules for onshore hazardous liquids transportation lines in October 2019 requiring integrity assessments on all onshore pipe that accommodate inline inspection tools.We are also expecting additional regulations due to new pipeline safety legislation finalized in December 2020 that reauthorized PHMSA pipeline safety programs. The new legislation includes mandates for PHMSA to publish final rules for advanced leak detection for gas pipelines, additional repair criteria for gas and hazardous liquids pipelines, updated operating and maintenance standards requirements applicable to large-scale liquefied natural gas facilities, certain Coastal Waters and Coastal Beaches to be designated as USA ecological resources for purposes of 16determining whether a hazardous liquid pipeline is in a high consequence area, and the gas gathering portion of the proposed Mega Rule.New regulations adopted by PHMSA may impose more stringent requirements applicable to integrity management programs and other pipeline safety aspects of our operations, which could cause us to incur increased capital and operating costs and operational delays. Pipeline Integrity RegulationsWe have an enterprise-wide Gas Integrity Management Plan that we believe meets the PHMSA final rule that was issued pursuant to the requirements of the Pipeline Safety Improvement Act of 2002. The rule requires gas pipeline operators to develop an integrity management program for gas transmission pipelines that could affect HCAs in the event of pipeline failure. The integrity management program includes a baseline assessment plan along with periodic reassessments to be completed within required time frames. In meeting the integrity regulations, we have identified HCAs and developed baseline assessment plans. Ongoing periodic reassessments and initial assessments of any new HCAs have been completed. We estimate that the cost to be incurred in 2021 associated with this program to be approximately $105 million. Management considers costs associated with compliance with the rule to be prudent costs incurred in the ordinary course of business and, therefore, recoverable through Northwest Pipeline’s and Transco’s rates.We have an enterprise-wide Liquid Integrity Management Plan that we believe meets the PHMSA final rule that was issued pursuant to the requirements of the Pipeline Safety Improvement Act of 2002. The rule requires liquid pipeline operators to develop an integrity management program for liquid transmission pipelines that could affect HCAs in the event of pipeline failure. The integrity management program includes a baseline assessment plan along with periodic reassessments expected to be completed within required time frames. In meeting the integrity regulations, we utilized government defined HCAs and developed baseline assessment plans. We completed assessments within the required time frames. We estimate that the cost to be incurred in 2021 associated with this program will be approximately $3 million. Ongoing periodic reassessments and initial assessments of any new HCAs are expected to be completed within the time frames required by the rule. Management considers the costs associated with compliance with the rule to be prudent costs incurred in the ordinary course of business.State Gathering RegulationsOur onshore midstream gathering operations are subject to laws and regulations in the various states in which we operate. For example, the Texas Railroad Commission has the authority to regulate the terms of service for our intrastate natural gas gathering business in Texas. Although the applicable state regulations vary widely, they generally require that pipeline rates and practices be reasonable and nondiscriminatory, and may include provisions covering marketing, pricing, pollution, environment, and human health and safety. Some states, such as New York, have specific regulations pertaining to the design, construction, and operations of gathering lines within such state. Intrastate Liquids Pipelines in the Gulf CoastOur intrastate liquids pipelines in the Gulf Coast are regulated by the Louisiana Public Service Commission, the Texas Railroad Commission, and various other state and federal agencies. These pipelines are also subject to the liquid pipeline safety and integrity regulations discussed above since both Louisiana and Texas have adopted the integrity management regulations defined in PHMSA.OCSLAOur offshore gas and liquids pipelines located on the outer continental shelf are subject to the Outer Continental Shelf Lands Act, which provides in part that outer continental shelf pipelines “must provide open and nondiscriminatory access to both owner and non-owner shippers.”See Part II,
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+ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion and analysis of our financial condition, results of operations, and liquidity and capital resources for the 52 weeks ended January 31, 2021 (“fiscal 2020”), and the 52 weeks ended February 2, 2020 (“fiscal 2019”) should be read in conjunction with our Consolidated Financial Statements and notes thereto. All explanations of changes in operational results are discussed in order of magnitude. A discussion and analysis of our financial condition, results of operations, and liquidity and capital resources for the 52 weeks ended February 2, 2020 (“fiscal 2019”), compared to the 53 weeks ended February 3, 2019 (“fiscal 2018”), can be found under Item 7 in our Annual Report on Form 10-K for fiscal 2019, filed with the SEC on March 27, 2020, which is available on the SEC’s website at www.sec.gov and under the Financial Reports section of our Investor Relations website. OVERVIEW Williams-Sonoma, Inc. is a specialty retailer of high-quality sustainable products for the home. Our products, representing distinct merchandise strategies — Williams Sonoma, Pottery Barn, Pottery Barn Kids, Pottery Barn Teen, West Elm, Williams Sonoma Home, Rejuvenation, and Mark and Graham — are marketed through e-commerce websites, direct-mail catalogs and retail stores. These brands are also part of The Key Rewards, our free-to-join loyalty program that offers members exclusive benefits across the Williams-Sonoma family of brands. We operate in the U.S., Puerto Rico, Canada, Australia and the United Kingdom, offer international shipping to customers worldwide, and have unaffiliated franchisees that operate stores in the Middle East, the Philippines, Mexico, South Korea and India, as well as e-commerce websites in certain locations. We are also proud to lead the industry with our ESG efforts. COVID-19 On March 11, 2020, the World Health Organization declared COVID-19 to be a global pandemic and recommended containment and mitigation measures worldwide. In March 2020, we announced the temporary closures of all of our retail store operations to protect our employees, customers and the communities in which we operate and to help contain the COVID-19 pandemic. As of January 31, 2021, the majority of our retail stores have reopened for in-person shopping. However, given the continued uncertainty around COVID-19 due to high rates of infections in certain areas, state and local officials in certain geographies have extended closures or restrictions on retail capacity, which may continue to impact our store traffic and retail revenues, and may result in future store impairments. Throughout fiscal 2020, we have continued to operate our e-commerce sites and distribution centers and continued to deliver products to our customers. However, governmental mandates, illness, or the absence of a substantial number of distribution center employees may require in the future that we temporarily close one or more of our distribution centers, or may prohibit or significantly limit us, or our third-party logistics providers from delivering packages to our customers and our stores, which could complicate or prevent us from fulfilling e-commerce orders and supplying merchandise to our stores. Fiscal 2020 Financial Results Net revenues in fiscal 2020 increased by $885,181,000, or 15.0%, compared to fiscal 2019, with comparable brand revenue growth of 17.0% and double-digit comparable brand revenue growth across all our brands. This was primarily driven by an increase of approximately 44% in e-commerce revenues, due to both an increase in demand for our product as well as a larger portion of our net revenues being driven by furniture, which has a higher average selling price, partially offset by a decrease in retail revenues driven by limited capacity in stores and reduced customer store traffic due to COVID-19. During fiscal 2020, we delivered double-digit comparable brand revenue growth across all our brands. The Williams Sonoma brand delivered comparable brand revenue growth of 23.8% as we implemented a content-driven marketing strategy that featured exclusive products and relevant lifestyle stories over promotions. We also 34 Table of Contents grew our exclusive products to 70% of our total business, consistent with one of our key strategic initiatives to increase the mix of product that is only available at Williams Sonoma. In our Pottery Barn Kids and Teen business, we delivered 16.6% comparable brand revenue growth, as we continue to amplify our leadership in design and sustainability in the children’s home furnishings business. In addition to strong core introductions in furniture, we have added a new modern aesthetic that is driving growth and attracting new customers to our brands. The Pottery Barn brand delivered comparable brand revenue growth of 15.2% and our multi-year work to improve our value proposition is paying off. Our value-engineered products are attracting new customers and we believe our multi-step finish, high-quality furniture pieces are the best value in the market. In West Elm, we delivered strong comparable brand revenue growth of 15.2% on top of 14.4% last year. We continue to build this business with original design and by filling white space in underdeveloped categories. And, our emerging brands, Rejuvenation and Mark and Graham, combined delivered another year of double-digit comparable brand revenue growth. We ended the year with a cash balance of $1,200,337,000, compared to $432,162,000 last year, which reflects our strong financial performance as well as operating cash flow, which was more than double last year. In addition to our strong cash balance, we also ended the year with no amount outstanding under our line of credit. This strong liquidity position allowed us to fund the operations of the business, and to provide shareholder returns of approximately $307,645,000 through dividends and share repurchases. In fiscal 2020, diluted earnings per share was $8.61 (which included a $0.26 impact related to store asset impairments, a $0.13 impact from acquisition-related expenses of Outward, Inc., an $0.11 impact related to inventory write-offs, and a $0.06 benefit related to the adjustment of certain deferred tax assets and liabilities) versus $4.49 in fiscal 2019 (which included a $0.30 impact from acquisition-related expenses and the operations of Outward, Inc., an $0.11 impact related to certain employment-related expenses, and an $0.08 benefit related to the adjustment of a deferred tax liability). Throughout fiscal 2020, our three key differentiators were instrumental to our strong financial performance. They are: our in-house design, our digital-first channel strategy, and our values. Our in-house teams design our own products, create original aesthetics, and work with our talented vendors to bring quality, sustainable products to market. The majority of our products cannot be found elsewhere and the design, quality, and value that we offer is strong. Throughout fiscal 2020, we were very deliberate in reducing promotions in all of our brands, resulting in product margin expansion compared to fiscal 2019. Our second differentiator is our digital-first channel strategy. One of the key reasons for our results over the past year was because our e-commerce platform was able to serve our customers at scale. In our digital channels, we have been acquiring a significant number of new customers all year, and our customer retention metrics continue to improve among new customers. We are digital-first but not digital only. Our stores are a competitive advantage that support our online business, for customers who want to experience our products in person, as well as for those who prefer the convenience of our omni-channel fulfillment services, including buy online pick up in store and ship from store. Our third differentiator is our values. We care deeply about sustainability, equity action and supporting our associates and the communities where we work. We believe our commitment to sustainability is one of the main reasons our customers choose us over our competitors and diversity, equity and inclusion is central to who we are as a company. We continued to support our associates and customers throughout fiscal 2020 by continuing to pay our associates during the initial months of COVID-19 while our stores and offices were closed, providing pandemic bonuses and hourly wage increases to our frontline workers, as well as providing personal protective gear and COVID-19 testing to our store and supply chain associates. Looking Ahead to 2021 As we look forward to the year ahead, we will continue to focus on our three key differentiators to drive net revenue and operating margin growth. In our retail stores, we plan to further optimize our store footprint with fewer, better stores that serve as design centers and omni-channel fulfillment hubs. We believe our digital-first channel strategy will continue to accelerate, with our future growth driven predominantly by e-commerce. In our 35 Table of Contents supply chain, we expect to expand our U.S. manufacturing and fulfillment capacity by over 20%-30% next year, including adding close to two million square feet of distribution space to our delivery network. We also plan to deepen our sustainability commitments including our goal to reach 100% responsibly-sourced cotton and 50% responsibly-sourced wood. In fiscal 2021, we believe operating margin expansion will predominantly be driven by overall sales leverage from higher sales levels, a continued shift to our more efficient and profitable e-commerce business, as well as reduced occupancy costs, continued strength in our product margins, and overall strong financial discipline. However, we have experienced and may continue to experience delays in inventory receipts due to COVID-19-related slowdowns, inclement weather, port congestion, and shipping container shortages, and we have incurred and may continue to incur higher shipping charges as we deliver goods to our customers. In addition, given the continued uncertainty around COVID-19 and extended closures or restrictions on retail capacity by state and local officials in certain geographies, we have experienced and may continue to experience reduced store traffic. Overall, the long-term impact of COVID-19 on our business, results of operations and financial condition still remains uncertain. A prolonged pandemic could further interrupt our operations, our vendors’ operations, the economy and overall consumer spending, which could have a material impact on our revenues, results of operations, and cash flows. For more information on risks associated with COVID-19, please see “Risk Factors” in Part I, Item 1A. 36 Table of Contents Results of Operations NET REVENUES Net revenues consist of sales of merchandise to our customers through our e-commerce websites, direct-mail catalogs, and at our retail stores and include shipping fees received from customers for delivery of merchandise to their homes. Our revenues also include sales to our franchisees and wholesale customers, breakage income related to our stored-value cards, and incentives received from credit card issuers in connection with our private label and co-branded credit cards. Net revenues in fiscal 2020 increased by $885,181,000, or 15.0%, compared to fiscal 2019, with comparable brand revenue growth of 17.0% and double-digit comparable brand revenue growth across all our brands. This was primarily driven by an increase of approximately 44% in e-commerce revenues, due to both an increase in demand for our product as well as a larger portion of our net revenues being driven by furniture, which has a higher average selling price, partially offset by a decrease in retail revenues driven by limited capacity in stores and reduced customer store traffic due to COVID-19. The following table summarizes our net revenues by brand for fiscal 2020 and fiscal 2019: In thousands Fiscal 2020 Fiscal 2019 Pottery Barn $ 2,526,241 $ 2,214,397 West Elm 1,682,254 1,466,537 Williams Sonoma 1,242,271 1,032,368 Pottery Barn Kids and Teen 1,042,531 908,561 Other1 289,892 276,145 Total $ 6,783,189 $ 5,898,008 1 Primarily consists of net revenues from our international franchise operations, Rejuvenation and Mark and Graham. Comparable Brand Revenue Comparable brand revenue includes comparable store sales and e-commerce sales, including through our direct-mail catalog, as well as shipping fees, sales returns and other discounts associated with current period sales. Comparable stores are defined as permanent stores where gross square footage did not change by more than 20% in the previous 12 months and which have been open for at least 12 consecutive months without closure for seven or more consecutive days. Comparable stores that were temporarily closed during the year due to COVID-19 were not excluded from the comparable stores calculation. Outlet comparable store net revenues are included in their respective brands. Sales to our international franchisees are excluded from comparable brand revenue as their stores and e-commerce websites are not operated by us. Sales from certain operations are also excluded until such time that we believe those sales are meaningful to evaluating their performance. Additionally, comparable brand revenue growth for newer concepts is not separately disclosed until such time that we believe those sales are meaningful to evaluating the performance of the brand. Comparable brand revenue growth Fiscal 2020 Fiscal 2019 Pottery Barn 15.2 % 4.1 % West Elm 15.2 14.4 Williams Sonoma 23.8 0.4 Pottery Barn Kids and Teen 16.6 4.5 Total1 17.0 % 6.0 % 1 Total comparable brand revenue growth includes the results of Rejuvenation and Mark and Graham. 37 Table of Contents RETAIL STORE DATA Fiscal 2020 1 Fiscal 2019 Store count – beginning of year 614 625 Store openings 10 14 Store closings (43 ) (25 ) Store count – end of year 581 614 Store selling square footage at year-end 3,975,000 4,129,000 Store leased square footage (“LSF”) at year-end 6,301,000 6,558,000 1 Store count at the end of the year for fiscal 2020 includes stores temporarily closed due to COVID-19. Store count data excludes temporary closures and re-openings of our stores due to COVID-19. Fiscal 2020 Fiscal 2019 StoreCount Avg. LSFPer Store StoreCount Avg. LSFPer Store Williams Sonoma 198 6,800 211 6,900 Pottery Barn 195 14,600 201 14,400 West Elm 121 13,100 118 13,100 Pottery Barn Kids 57 7,800 74 7,700 Rejuvenation 10 8,500 10 8,500 Total 581 10,800 614 10,700 COST OF GOODS SOLD In thousands Fiscal 2020 % NetRevenues Fiscal 2019 % NetRevenues Cost of goods sold1 $ 4,146,920 61.1% $ 3,758,916 63.7% 1 Includes occupancy expenses of $696.3 million and $710.5 million fiscal 2020 and fiscal 2019, respectively. Cost of goods sold includes cost of goods, occupancy expenses and shipping costs. Cost of goods consists of cost of merchandise, inbound freight expenses, freight-to-store expenses and other inventory related costs such as replacements, damages, obsolescence and shrinkage. Occupancy expenses consist of rent, depreciation and other occupancy costs, including common area maintenance, property taxes and utilities. Shipping costs consist of third-party delivery services and shipping materials. Our classification of expenses in cost of goods sold may not be comparable to other public companies, as we do not include non-occupancy-related costs associated with our distribution network in cost of goods sold. These costs, which include distribution network employment, third-party warehouse management and other distribution-related administrative expenses, are recorded in selling, general and administrative expenses. Fiscal 2020 vs. Fiscal 2019 Cost of goods sold increased by $388,004,000, or 10.3%, in fiscal 2020 compared to fiscal 2019. Cost of goods sold as a percentage of net revenues decreased to 61.1% in fiscal 2020 from 63.7% in fiscal 2019. This rate decrease was primarily driven by higher merchandise margins from reduced promotional activity in fiscal 2020 and the leverage of occupancy expenses resulting from higher sales and reduced occupancy costs year-over-year due to our efforts to renegotiate rent and close less profitable stores. This decrease was partially offset by higher shipping costs due to a significantly greater portion of our total net revenues being generated from e-commerce and surcharges from our third-party shippers, as well as inventory write-offs of approximately $11,378,000 resulting from the closure of our outlet stores due to COVID-19 in the first quarter of fiscal 2020. 38 Table of Contents SELLING, GENERAL AND ADMINISTRATIVE EXPENSES In thousands Fiscal 2020 % NetRevenues Fiscal 2019 % NetRevenues Selling, general and administrative expenses $ 1,725,572 25.4% $ 1,673,218 28.4% Selling, general and administrative expenses consist of non-occupancy-related costs associated with our retail stores, distribution and manufacturing facilities, customer care centers, supply chain operations (buying, receiving and inspection) and corporate administrative functions. These costs include employment, advertising, third-party credit card processing and other general expenses. Fiscal 2020 vs. Fiscal 2019 Selling, general and administrative expenses increased by $52,354,000, or 3.1%, for fiscal 2020, compared to fiscal 2019. Selling, general and administrative expenses as a percentage of net revenues decreased to 25.4% for fiscal 2020 from 28.4% for fiscal 2019. This rate decrease was primarily driven by lower advertising costs as we further optimized our digital spend on those initiatives that drove higher returns in traffic and conversion, and the leverage of employment costs from higher sales and lower variable store payroll. This decrease was partially offset by store asset impairment charges of approximately $27,069,000 for fiscal 2020 due in part to the impact of COVID-19 on our retail stores. INCOME TAXES The effective income tax rate was 23.9% for fiscal 2020 and 22.1% for fiscal 2019. The increase in the effective tax rate in fiscal 2020 is primarily due to the tax effect of the change in the mix and level of our earnings. LIQUIDITY AND CAPITAL RESOURCES As of January 31, 2021, we held $1,200,337,000 in cash and cash equivalents, the majority of which was held in interest-bearing demand deposit accounts and money market funds, and of which $147,464,000 was held by our international subsidiaries. As is consistent within our industry, our cash balances are seasonal in nature, with the fourth quarter historically representing a significantly higher level of cash than other periods. Throughout the fiscal year, we utilize our cash resources to build our inventory levels in preparation for our fourth quarter holiday sales. In fiscal 2021, we plan to use our cash resources to fund our inventory and inventory-related purchases, advertising and marketing initiatives, stock repurchases and dividend payments, early repayment of our term loan and property and equipment purchases. In addition to our cash balances on hand, we have a credit facility, which provides for a $500,000,000 unsecured revolving line of credit (“revolver”), and a $300,000,000 unsecured term loan facility (“term loan”). The revolver may be used to borrow revolving loans or to request the issuance of letters of credit. We may, upon notice to the administrative agent, request existing or new lenders to increase the revolver by up to $250,000,000, at such lenders’ option, to provide for a total of $750,000,000 of unsecured revolving credit. During fiscal 2020, we had borrowings of $487,823,000 under our revolver, all of which were repaid prior to the end of the fiscal year. No amounts were outstanding as of January 31, 2021. Additionally, as of January 31, 2021, a total of $12,609,000 in issued but undrawn standby letters of credit were outstanding under our revolver. The standby letters of credit were primarily issued to secure the liabilities associated with workers’ compensation and other insurance programs. In May 2020, we entered into an amendment to our credit facility, which, among other changes, extends the maturity date and amends the interest rate of the term loan, modifies covenants under the credit facility, and maintains the maturity date and interest rate of the revolver. As of January 31, 2021, we had $300,000,000 outstanding under our term loan. In February 2021, prior to maturity, we repaid the full outstanding balance on the term loan. 39 Table of Contents In addition to the Credit Facility Amendment, during the second quarter of fiscal 2020 we entered into a new agreement (the “364-Day Credit Agreement”) for an additional $200,000,000 unsecured revolving line of credit. During fiscal 2020, we had no borrowings under the 364-Day Credit Agreement. We do not expect to renew the 364-Day Credit Agreement upon its maturity in May 2021. The Credit Facility Amendment and the 364-Day Credit Agreement contain certain restrictive loan covenants, including, among others, a financial covenant requiring a maximum leverage ratio (funded debt adjusted for lease and rent expense to earnings before interest, income tax, depreciation, amortization and rent expense), and covenants limiting our ability to incur indebtedness, grant liens, make acquisitions, merge or consolidate, and dispose of assets. As of January 31, 2021, we were in compliance with our financial covenants under our credit facilities and, based on our current projections, we expect to remain in compliance throughout the next 12 months. We believe our cash on hand, in addition to our available credit facilities, will provide adequate liquidity for our business operations over the next 12 months. Letter of Credit Facilities We have three unsecured letter of credit reimbursement facilities for a total of $35,000,000, each of which matures on August 22, 2021. The letter of credit facilities contain covenants that are consistent with our credit facility. Interest on unreimbursed amounts under the letter of credit facilities accrues at a base rate as defined in the credit facility, plus an applicable margin based on our leverage ratio. As of January 31, 2021, an aggregate of $3,843,000 was outstanding under the letter of credit facilities, which represents only a future commitment to fund inventory purchases to which we had not taken legal title. The latest expiration date possible for any future letters of credit issued under the facilities is January 19, 2022. Cash Flows from Operating Activities For fiscal 2020, net cash provided by operating activities was $1,274,848,000 compared to $607,294,000 in fiscal 2019. For fiscal 2020, net cash provided by operating activities was primarily attributable to net earnings adjusted for non-cash items, an increase in accrued expenses and other liabilities, a decrease in merchandise inventories and an increase in gift card and other deferred revenue. Net cash provided by operating activities compared to fiscal 2019 increased primarily due to an increase in net earnings, an increase in accrued expenses and other liabilities, an increase in gift card and other deferred revenue and a decrease in merchandise inventories. Cash Flows from Investing Activities For fiscal 2020, net cash used in investing activities was $168,884,000 compared to $185,548,000 in fiscal 2019 and was primarily attributable to purchases of property and equipment. Cash Flows from Financing Activities For fiscal 2020, net cash used in financing activities was $343,019,000 compared to $327,226,000 in fiscal 2019 and was primarily attributable to the payment of dividends and repurchases of common stock. Net cash used in financing activities compared to fiscal 2019 increased primarily due to an increase in the payment of dividends. Dividends In fiscal 2020 and fiscal 2019, total cash dividends declared were approximately $163,316,000, or $2.02 per common share, and $156,103,000, or $1.92 per common share, respectively. In March 2021, our Board of Directors authorized a $0.06, or 11.3%, increase in our quarterly cash dividend, from $0.53 to $0.59 per common share, subject to capital availability. Our quarterly cash dividend may be limited or terminated at any time. Stock Repurchase Program See section titled “Stock Repurchase Program” within Part II, Item 5 of this Annual Report on Form 10-K for further information. 40 Table of Contents Contractual Obligations The following table provides summary information concerning our future contractual obligations as of January 31, 2021: Payments Due by Period1 In thousands Fiscal 2021 Fiscal 2022 to Fiscal 2024 Fiscal 2025 to Fiscal 2026 Thereafter Total Current debt 2 $ 300,000 $ — $ — $ — $ 300,000 Interest 542 — — — 542 Operating leases3 267,760 605,121 263,192 291,356 1,427,429 Purchase obligations4 1,350,121 22,456 — — 1,372,577 Total $ 1,918,423 $ 627,577 $ 263,192 $ 291,356 $ 3,100,548 1 This table excludes $46.9 million of liabilities for unrecognized tax benefits associated with uncertain tax positions as we are not able to reasonably estimate when and if cash payments for these liabilities will occur. This amount, however, has been recorded as a liability in our accompanying Consolidated Balance Sheet as of January 31, 2021. 2 Current debt consists of term loan borrowings under our credit facility, all of which was repaid in full, prior to maturity, in February 2021. See Note C to our Consolidated Financial Statements for discussion of our borrowing arrangements. 3 Projected undiscounted payments include only those amounts that are fixed and determinable as of the reporting date. See Note E to our Consolidated Financial Statements for discussion of our operating leases. 4 Represents estimated commitments at year-end to purchase inventory and other goods and services in the normal course of business to meet operational requirements. Other Contractual Obligations We have other liabilities reflected in our Consolidated Balance Sheet. The payment obligations associated with these liabilities are not reflected in the table above due to the absence of scheduled maturities. The timing of these payments cannot be determined, except for amounts estimated to be payable in fiscal 2021, which are included in our current liabilities as of January 31, 2021. In connection with our acquisition of Outward Inc., we have agreed to pay certain additional amounts to former stockholders of Outward, contingent upon their continued service or the achievement of certain financial performance targets. These contingent obligations are not reflected in the table above. We are party to a variety of contractual agreements under which we may be obligated to indemnify the other party for certain matters. These contracts primarily relate to commercial matters, operating leases, trademarks, intellectual property and financial matters. Under these contracts, we may provide certain routine indemnification relating to representations and warranties or personal injury matters. The terms of these indemnifications range in duration and may not be explicitly defined. Historically, we have not made significant payments for these indemnifications. We believe that if we were to incur a loss in any of these matters, the loss would not have a material effect on our financial condition or results of operations. Commercial Commitments The following table provides summary information concerning our outstanding commercial commitments as of January 31, 2021: Amount of Outstanding Commitment Expiration by Period1 In thousands Fiscal 2021 Fiscal 2022 to Fiscal 2024 Fiscal 2025 to Fiscal 2026 Thereafter Total Standby letters of credit $ 12,609 $ — $ — $ — $ 12,609 Letter of credit facilities 3,843 — — — 3,843 Total $ 16,452 $ — $ — $ — $ 16,452 1 See Note C to our Consolidated Financial Statements for discussion of our borrowing arrangements. 41 Table of Contents IMPACT OF INFLATION The impact of inflation (or deflation) on our results of operations for the past three fiscal years has not been significant. However, we cannot be certain of the effect inflation (or deflation) may have on our results of operations in the future. CRITICAL ACCOUNTING POLICIES AND ESTIMATES Management’s Discussion and Analysis of Financial Condition and Results of Operations is based on our Consolidated Financial Statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these Consolidated Financial Statements requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses and related disclosures of contingent assets and liabilities. These estimates and assumptions are evaluated on an ongoing basis and are based on historical experience and various other factors that we believe to be reasonable under the circumstances. Actual results could differ from these estimates. We believe the following critical accounting policies used in the preparation of our Consolidated Financial Statements include the significant estimates and assumptions that we consider to be the most critical to an understanding of our financial statements because they involve significant judgments and uncertainties. See Note A to our Consolidated Financial Statements for further discussion of each policy. Merchandise Inventories Merchandise inventories, net of an allowance for shrinkage and obsolescence, are stated at the lower of cost (weighted average method) or market. To determine if the value of our inventory should be reduced below cost, we consider current and anticipated demand, customer preferences and age of the merchandise. The significant estimates used in inventory valuation are obsolescence (including excess and slow-moving inventory and lower of cost or market reserves) and estimates of inventory shrinkage. We reserve for obsolescence based on historical trends of inventory sold below cost and specific identification. Reserves for shrinkage are estimated and recorded throughout the year based on historical shrinkage results, cycle count results within our distribution centers, expectations of future shrinkage and current inventory levels. Actual shrinkage is recorded at year-end based on the results of our cycle counts and year end physical inventory counts, and can vary from our estimates due to such factors as changes in operations, the mix of our inventory (which ranges from large furniture to small tabletop items) and execution against loss prevention initiatives in our stores, distribution facilities and off-site storage locations, and with our third-party warehouse and transportation providers. Accordingly, there is no shrinkage reserve at year-end. Historically, actual shrinkage has not differed materially from our estimates. Our obsolescence and shrinkage reserve calculations contain estimates that require management to make assumptions and to apply judgment regarding a number of factors, including market conditions, the selling environment, historical results and current inventory trends. If actual obsolescence or shrinkage estimates change from our original estimate, we will adjust our reserves accordingly throughout the year. We have made no material changes to our assumptions included in the calculations of the obsolescence and shrinkage reserves throughout the year. In addition, we do not believe a 10% change in our inventory reserves would have a material effect on our net earnings. As of January 31, 2021 and February 2, 2020, our inventory obsolescence reserves were $9,827,000 and $13,424,000, respectively. Long-lived Assets Property and equipment is stated at cost. Depreciation is computed using the straight-line method over the estimated useful lives of the assets. We review the carrying value of all long-lived assets for impairment, primarily at an individual store level, whenever events or changes in circumstances indicate that the carrying value of an asset or asset group may not be recoverable. Our impairment analyses determine whether projected cash flows from operations are sufficient 42 Table of Contents to recover the carrying value of these assets. The asset group is comprised of both property and equipment and operating lease right-of-use assets. Impairment may result when the carrying value of the asset or asset group exceeds the estimated undiscounted future cash flows over its remaining useful life. For store asset impairment, our estimate of undiscounted future cash flows over the store lease term is based upon our experience, the historical operations of the stores and estimates of future store profitability and economic conditions. The estimates of future store profitability and economic conditions require estimating such factors as sales growth, gross margin, employment costs, lease escalations, inflation and the overall economics of the retail industry, and are therefore subject to variability and difficult to predict. For right-of-use assets, we determine the fair value of the assets by using estimated market rental rates. These estimates can be affected by factors such as future store results, real estate supply and demand, store closure plans, and economic conditions that can be difficult to predict. Actual future results may differ from those estimates. If a long-lived asset is found to be impaired, the amount recognized for impairment is equal to the excess of the asset or asset group’s net carrying value over its estimated fair value. We measure property and equipment at fair value on a nonrecurring basis using Level 3 inputs as defined in the fair value hierarchy (see Note M to our Consolidated Financial Statements). We measure right-of-use assets at fair value on a nonrecurring basis using Level 2 inputs, primarily market rental rates, that are corroborated by market data. Where Level 2 inputs are not readily available, we use Level 3 inputs. Fair value of these long-lived assets is based on the present value of estimated future cash flows using a discount rate commensurate with the risk. Given the material reductions in our retail store revenues and operating income during fiscal 2020 as a result of the COVID-19 pandemic, we evaluated our estimates and assumptions related to our stores’ future sales and cash flows, and performed a comprehensive review of our stores’ long-lived assets for impairment, including both property and equipment and operating lease right-of-use assets, at an individual store level. Our assumptions account for the estimated impact on future cash flows from the recent temporary store closures and capacity restrictions, including reduced store traffic and longer recovery times in those stores we have re-opened, as well as the reinstatement of closures or restrictions on retail capacity in certain areas. These events and changes in circumstances, including a more prolonged and/or severe COVID-19 pandemic and the reinstatement of closures or restrictions on retail capacity, may lead to increased impairment risk in the future; therefore, we will continue to monitor events and changes in circumstances that may indicate the need to test our long-lived assets, including goodwill, for potential impairment. During fiscal 2020, we recognized asset impairment charges of approximately $19,204,000 related to property and equipment and $7,865,000 related to right-of use assets for our retail stores, which is recognized within selling, general and administrative expenses. During fiscal 2019, we recognized an approximate $3,303,000, net of tax, reduction to the opening balance of retained earnings resulting from the impairment of certain long-lived assets upon adoption of Accounting Standards Update (“ASU”) 2016-02, Leases. Leases We lease store locations, distribution and manufacturing facilities, corporate facilities, customer care centers and certain equipment for our U.S. and foreign operations with initial terms generally ranging from 2 to 22 years. We determine whether an arrangement is or contains a lease at inception by evaluating potential lease agreements, including service and operating agreements, to determine whether an identified asset exists that we control over the term of the arrangement. Lease commencement is determined to be when the lessor provides us access to, and the right to control, the identified asset. Upon lease commencement, we recognize a right-of-use asset and a corresponding lease liability measured at the present value of the fixed future minimum lease payments. We record a right-of-use asset for an amount equal to the lease liability, increased for any prepaid lease costs and initial direct costs and reduced by any lease incentives. We remeasure the lease liability and right-of-use asset when a remeasurement event occurs. Many of our leases contain renewal and early termination options. The option periods are generally not included in the lease term used to measure our lease liabilities and right-of-use assets upon commencement, as we do not believe the exercise of these options to be reasonably certain. We remeasure the lease liability and right-of-use asset when we are reasonably certain to exercise a renewal or an early termination option. 43 Table of Contents Our leases generally do not provide information about the rate implicit in the lease. Therefore, we utilize an incremental borrowing rate to calculate the present value of our future lease obligations. The incremental borrowing rate represents the rate of interest we would have to pay on a collateralized borrowing, for an amount equal to the lease payments, over a similar term and in a similar economic environment. We use judgment in determining our incremental borrowing rate, which is applied to each lease based on the lease term. An increase or decrease in the incremental borrowing rate applied would impact the value of our right-of-use assets and lease liabilities. We use judgment in determining lease classification, including our determination of the economic life and the fair market value of the identified asset. The fair market value of the identified asset is generally estimated based on comparable market data provided by third-party sources. All of our leases are currently classified as operating leases. Income Taxes Income taxes are accounted for using the asset and liability method. Under this method, deferred income taxes arise from temporary differences between the tax basis of assets and liabilities and their reported amounts in our Consolidated Financial Statements. We record reserves for our estimates of the additional income tax liability that is more likely than not to result from the ultimate resolution of foreign and domestic tax examinations. At any one time, many tax years are subject to examination by various taxing jurisdictions. The results of these audits and negotiations with taxing authorities may affect the ultimate settlement of these issues. We review and update the estimates used in the accrual for uncertain tax positions as more definitive information becomes available from taxing authorities, upon completion of tax examination, upon expiration of statutes of limitation, or upon occurrence of other events. In order to compute income tax on an interim basis, we estimate what our effective tax rate will be for the full fiscal year and adjust these estimates throughout the year as necessary. Adjustments to our income tax provision due to changes in our estimated effective tax rate are recorded in the interim period in which the change occurs. The tax expense (or benefit) related to items other than ordinary income is individually computed and recognized when the items occur. Our effective tax rate in a given financial statement period may be materially impacted by changes in the mix and level of our earnings in various taxing jurisdictions or changes in tax law. 44 Table of Contents ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK We are exposed to market risks, which include significant deterioration of the U.S. and foreign markets, changes in U.S. interest rates, foreign currency exchange rate fluctuations and the effects of economic uncertainty which may affect the prices we pay our vendors in the foreign countries in which we do business. We do not engage in financial transactions for trading or speculative purposes. Interest Rate Risk Our revolver, our term loan and our 364-Day Credit Agreement each have a variable interest rate which, when drawn upon, subjects us to risks associated with changes in that interest rate. During the first quarter of fiscal 2020, we had borrowings of $487,823,000 under the revolver, all of which were repaid prior to the end of the fiscal year. Additionally, as of January 31, 2021, we had $300,000,000 outstanding under our term loan, all of which was repaid in full in February 2021 prior to maturity, and no amount outstanding under our 364-Day Credit Agreement, which has not been drawn upon. A hypothetical increase or decrease of one percentage point on our existing variable rate debt instruments would not materially affect our results of operations or cash flows. In addition, we have fixed and variable income investments consisting of short-term investments classified as cash and cash equivalents, which are also affected by changes in market interest rates. As of January 31, 2021, our investments, made primarily in interest bearing demand deposit accounts and money market funds, are stated at cost and approximate their fair values. Foreign Currency Risks We purchase the majority of our inventory from vendors outside of the U.S. in transactions that are primarily denominated in U.S. dollars and, as such, any foreign currency impact related to these international purchase transactions was not significant to us during fiscal 2020 or fiscal 2019. Since we pay for the majority of our international purchases in U.S. dollars, however, a decline in the U.S. dollar relative to other foreign currencies would subject us to risks associated with increased purchasing costs from our vendors in their effort to offset any lost profits associated with any currency devaluation. We cannot predict with certainty the effect these increased costs may have on our financial statements or results of operations. In addition, our businesses in Canada, Australia and the United Kingdom, and our operations throughout Asia and Europe, expose us to market risk associated with foreign currency exchange rate fluctuations. Substantially all of our purchases and sales are denominated in U.S. dollars, which limits our exposure to this risk. However, some of our foreign operations have a functional currency other than the U.S. dollar. While the impact of foreign currency exchange rate fluctuations was not material to us in fiscal 2020, we have continued to see volatility in the exchange rates in the countries in which we do business. As we continue to expand globally, the foreign currency exchange risk related to our foreign operations may increase. To mitigate this risk, we hedge a portion of our foreign currency exposure with foreign currency forward contracts in accordance with our risk management policies (see Note L to our Consolidated Financial Statements). 45 Table of Contents
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+ITEM 7.MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSOverviewThis discussion, which presents our results for the fiscal years ended January 31, 2021 ("fiscal 2021"), January 31, 2020 ("fiscal 2020") and January 31, 2019 ("fiscal 2019"), should be read in conjunction with our Consolidated Financial Statements and the accompanying notes. We intend for this discussion to provide the reader with information that will assist in understanding our financial statements, the changes in certain key items in those financial statements from period to period and the primary factors that accounted for those changes. We also discuss certain performance metrics that management uses to assess the Company's performance. Additionally, the discussion provides information about the financial results of each of the three segments to provide a better understanding of how each of those segments and its results of operations affect the financial position and results of operations of the Company as a whole.Throughout this Item 7, we discuss segment operating income, comparable store and club sales and other measures. Management measures the results of the Company's segments using each segment's operating income, including certain corporate overhead allocations, as well as other measures. From time to time, we revise the measurement of each segment's operating income and other measures as determined by the information regularly reviewed by our chief operating decision maker. Management also measures the results of comparable store and club sales, or comparable sales, a metric that indicates the performance of our existing stores and clubs by measuring the change in sales for such stores and clubs, including eCommerce sales, for a particular period from the corresponding period in the previous year. Walmart's definition of comparable sales includes sales from stores and clubs open for the previous 12 months, including remodels, relocations, expansions and conversions, as well as eCommerce sales. We measure the eCommerce sales impact by including all sales initiated digitally, including omni-channel transactions which are fulfilled through our stores and clubs. Sales at a store that has changed in format are excluded from comparable sales when the conversion of that store is accompanied by a relocation or expansion that results in a change in the store's retail square feet of more than five percent. Sales related to divested businesses are excluded from comparable sales, and sales related to acquisitions are excluded until such acquisitions have been owned for 12 months. Comparable sales are also referred to as "same-store" sales by others within the retail industry. The method of calculating comparable sales varies across the retail industry. As a result, our calculation of comparable sales is not necessarily comparable to similarly titled measures reported by other companies.In discussing our operating results, the term currency exchange rates refers to the currency exchange rates we use to convert the operating results for countries where the functional currency is not the U.S. dollar into U.S. dollars. We calculate the effect of changes in currency exchange rates as the difference between current period activity translated using the current period’s currency exchange rates and the comparable prior year period’s currency exchange rates. Additionally, no currency exchange rate fluctuations are calculated for non-USD acquisitions until owned for 12 months. Throughout our discussion, we refer to the results of this calculation as the impact of currency exchange rate fluctuations. Volatility in currency exchange rates may impact the results, including net sales and operating income, of the Company and the Walmart International segment in the future.Our business is seasonal to a certain extent due to calendar events and national and religious holidays, as well as weather patterns. Generally, our highest sales volume and operating income have occurred in the fiscal quarter ending January 31; however, the COVID-19 pandemic may have an impact on consumer behaviors that could result in temporary changes in the seasonal fluctuations of our business. We have taken certain strategic actions to strengthen our Walmart International portfolio for the long-term, including the following highlights over the last three years:•Acquisition of 81 percent of the outstanding shares, or 77 percent of the diluted shares, of Flipkart Private Limited ("Flipkart") in August 2018. Refer to Note 12 for additional information on the transaction. •Divestiture of 80 percent of Walmart Brazil in August 2018, for which we recorded a pre-tax loss of $4.8 billion in fiscal 2019. Refer to Note 12 for additional information on the transaction.•Divestiture of banking operations in Walmart Chile and Walmart Canada in December 2018 and April 2019, respectively.•In October 2020, we agreed to sell Asda for net consideration of $9.4 billion and recognized an estimated non-cash loss in fiscal 2021 of $5.7 billion, after tax, which includes the loss associated with the expected derecognition of the Asda pension plan. In February 2021, we completed the sale of Asda. Refer to Note 11 and Note 12.•In November 2020, we completed the sale of Walmart Argentina and recorded a non-cash loss of $1.0 billion, after-tax, primarily due to cumulative foreign currency translation losses. Refer to Note 12.33•In November 2020, we agreed to sell a majority stake in Seiyu for net consideration of approximately $1.2 billion and recognized an estimated non-cash loss of $1.9 billion, after-tax, in fiscal 2021. In March 2021, we completed the sale of Seiyu. Refer to Note 12.We operate in the highly competitive omni-channel retail industry in all of the markets we serve. We face strong sales competition from other discount, department, drug, dollar, variety and specialty stores, warehouse clubs and supermarkets, as well as eCommerce businesses. Many of these competitors are national, regional or international chains or have a national or international omni-channel or eCommerce presence. We compete with a number of companies for attracting and retaining quality associates. We, along with other retail companies, are influenced by a number of factors including, but not limited to: catastrophic events, weather, global health epidemics including the ongoing COVID-19 pandemic, competitive pressures, consumer disposable income, consumer debt levels and buying patterns, consumer credit availability, cost of goods, currency exchange rate fluctuations, customer preferences, deflation, inflation, fuel and energy prices, general economic conditions, insurance costs, interest rates, labor costs, tax rates, the imposition of tariffs, cybersecurity attacks and unemployment. Further information on the factors that can affect our operating results and on certain risks to our Company and an investment in its securities can be found herein under "Item 1A. Risk Factors." COVID-19 UpdatesThroughout fiscal 2021, we have operated with a clear set of priorities to guide our decision making through the COVID-19 pandemic. These priorities are:•Supporting our associates on the front lines in terms of their physical safety, financial health and emotional well-being. We are providing extra pay and benefits, including special cash bonuses to associates and the introduction of a COVID-19 Emergency Leave Policy in the U.S. •Serving our customers as safely as possible and keeping our supply chain operating. We reduced our store operating hours at the onset of the COVID-19 pandemic and have expanded store hours slightly toward the end of the year. •Helping others which includes waiving or discounting rent for in-store tenants in April and May 2020 as well as hiring more than 500,000 new associates. •Managing the business well both operationally and financially and driving our long-term strategy. We are maintaining our everyday low-price discipline while investing in our omni-channel offering which continues to resonate with customers around the world who are increasingly seeking convenience.While we incurred incremental costs of $4.0 billion during fiscal 2021 associated with operating during a global health crisis, the COVID-19 pandemic resulted in overall net sales growth during fiscal 2021 with strong comparable sales in the U.S. and the majority of our international markets. Sales trends were positively affected by eCommerce growth acceleration and we also saw customers consolidate shopping trips and purchase larger baskets. For a detailed discussion on results of operations by reportable segment, refer to "Results of Operations" below.We expect continued uncertainty in our business and the global economy due to the duration and intensity of the COVID-19 pandemic; the duration and extent of economic stimulus; timing and effectiveness of global vaccines; and volatility in employment trends and consumer confidence which may impact our results.Company Performance MetricsWe are committed to helping customers save money and live better through everyday low prices, supported by everyday low costs. At times, we adjust our business strategies to maintain and strengthen our competitive positions in the countries in which we operate. We define our financial framework as:•strong, efficient growth;•consistent operating discipline; and•strategic capital allocation.As we execute on this financial framework, we believe our returns on capital will improve over time.34Strong, Efficient GrowthOur objective of prioritizing strong, efficient growth means we will focus on the most productive growth opportunities, increasing comparable store and club sales, accelerating eCommerce sales growth and expanding omni-channel initiatives while slowing the rate of growth of new stores and clubs. At times, we make strategic investments which are focused on the long-term growth of the Company.Comparable sales is a metric that indicates the performance of our existing stores and clubs by measuring the change in sales for such stores and clubs, including eCommerce sales, for a particular period over the corresponding period in the previous year. The retail industry generally reports comparable sales using the retail calendar (also known as the 4-5-4 calendar). To be consistent with the retail industry, we provide comparable sales using the retail calendar in our quarterly earnings releases. However, when we discuss our comparable sales below, we are referring to our calendar comparable sales calculated using our fiscal calendar, which may result in differences when compared to comparable sales using the retail calendar. Calendar comparable sales, including the impact of fuel, for fiscal 2021 and 2020, were as follows: Fiscal Years Ended January 31, 2021202020212020 With FuelFuel ImpactWalmart U.S.8.7%2.9%(0.2)%0.0%Sam's Club8.7%1.6%(3.4)%0.8%Total U.S.8.7%2.7%(0.6)%0.1%Comparable sales in the U.S., including fuel, increased 8.7% and 2.7% in fiscal 2021 and 2020, respectively, when compared to the previous fiscal year. Walmart U.S. comparable sales increased 8.7% and 2.9% in fiscal 2021 and 2020, respectively. For fiscal 2021, comparable sales growth was driven by growth in average ticket primarily resulting from increased demand due to the COVID-19 pandemic, partially offset by a decline in transactions as customers consolidated shopping trips. For fiscal 2020, comparable sales growth was driven by growth in average ticket and transactions. Walmart U.S. eCommerce sales positively contributed approximately 5.4% and 2.1% to comparable sales for fiscal 2021 and 2020, respectively, as we continue to focus on a seamless omni-channel experience for our customers. Sam's Club comparable sales increased 8.7% and 1.6% in fiscal 2021 and 2020, respectively. For fiscal 2021, Sam's Club comparable sales benefited from growth in transactions and average ticket resulting from the COVID-19 pandemic, partially offset by both our decision to remove tobacco from certain club locations and by lower fuel sales. Sam's Club comparable sales for fiscal 2020 benefited from growth in transactions and higher fuel sales, which were partially offset by lower average ticket due to our decision to remove tobacco from certain club locations. Sam's Club eCommerce sales positively contributed approximately 2.2% and 1.8% to comparable sales for fiscal 2021 and 2020, respectively. Consistent Operating DisciplineWe operate with discipline by managing expenses, optimizing the efficiency of how we work and creating an environment in which we have sustainable lowest cost to serve. We invest in technology and process improvements to increase productivity, manage inventory and reduce costs. We measure operating discipline through expense leverage, which we define as net sales growing at a faster rate than operating, selling, general and administrative ("operating") expenses. Fiscal Years Ended January 31,(Amounts in millions, except unit counts)20212020Net sales$555,233 $519,926 Percentage change from comparable period6.8 %1.9 %Operating, selling, general and administrative expenses$116,288 $108,791 Percentage change from comparable period6.9 %1.5 %Operating, selling, general and administrative expenses as a percentage of net sales20.9 %20.9 %For fiscal 2021, operating expenses as a percentage of net sales was flat when compared to the previous fiscal year. Operating expenses as a percentage of net sales benefited from strong growth in comparable sales and lapping the $0.9 billion business restructuring charges from the prior year described below. These benefits were offset by $4.0 billion of incremental costs related to the COVID-19 pandemic and a $0.4 billion business restructuring charge in the Walmart U.S. segment recorded in the second quarter of fiscal 2021.For fiscal 2020, operating expenses as a percentage of net sales decreased 8 basis points compared to the previous fiscal year due to our focus on expense management combined with our growth in comparable store sales. These improvements were partially offset by $0.9 billion in business restructuring charges consisting primarily of non-cash impairment charges for certain trade names, acquired developed technology, and other business restructuring charges due to strategic decisions that resulted in the write down of certain assets in the Walmart U.S. and Walmart International segments.35Strategic Capital AllocationOur strategy includes improving our customer-facing initiatives in stores and clubs and creating a seamless omni-channel experience for our customers. As such, we are allocating more capital to eCommerce, technology, supply chain, and store remodels and less to new store and club openings. Total fiscal 2021 capital expenditures decreased slightly compared to the prior year. The following table provides additional detail:(Amounts in millions)Fiscal Years Ended January 31,Allocation of Capital Expenditures20212020eCommerce, technology, supply chain and other$5,681 $5,643 Remodels2,013 2,184 New stores and clubs, including expansions and relocations134 77 Total U.S.$7,828 $7,904 Walmart International2,436 2,801 Total capital expenditures$10,264 $10,705 ReturnsAs we execute our financial framework, we believe our return on capital will improve over time. We measure return on capital with our return on assets, return on investment and free cash flow metrics. We also provide returns in the form of share repurchases and dividends, which are discussed in the Liquidity and Capital Resources section.Return on Assets and Return on Investment We include Return on Assets ("ROA"), the most directly comparable measure based on our financial statements presented in accordance with generally accepted accounting principles in the U.S. ("GAAP"), and Return on Investment ("ROI") as metrics to assess returns on assets. While ROI is considered a non-GAAP financial measure, management believes ROI is a meaningful metric to share with investors because it helps investors assess how effectively Walmart is deploying its assets. Trends in ROI can fluctuate over time as management balances long-term strategic initiatives with possible short-term impacts. ROA was 5.6% and 6.7% for fiscal 2021 and 2020, respectively. The decrease in ROA was primarily due to the losses on certain international operations held for sale or sold, partially offset by the fair value change in our equity investments as well as the increase in operating income. ROI was 14.0% and 13.4% for fiscal 2021 and 2020, respectively. The increase in ROI was primarily due to the increase in operating income. We define ROI as adjusted operating income (operating income plus interest income, depreciation and amortization, and rent expense) for the trailing twelve months divided by average invested capital during that period. We consider average invested capital to be the average of our beginning and ending total assets, plus average accumulated depreciation and average amortization, less average accounts payable and average accrued liabilities for that period. For fiscal 2020, lease related assets and associated accumulated amortization are included in the denominator at their carrying amount as of that balance sheet date, rather than averaged, because they are not directly comparable to the prior year calculation which included rent for the trailing 12 months multiplied by a factor of 8. A two-point average was used for leased assets beginning in fiscal 2021, after one full year from the date of adoption of ASU 2016-02, Leases (Topic 842) ("ASU 2016-02").Our calculation of ROI is considered a non-GAAP financial measure because we calculate ROI using financial measures that exclude and include amounts that are included and excluded in the most directly comparable GAAP financial measure. For example, we exclude the impact of depreciation and amortization from our reported operating income in calculating the numerator of our calculation of ROI. As mentioned above, we consider ROA to be the financial measure computed in accordance with generally accepted accounting principles most directly comparable to our calculation of ROI. ROI differs from ROA (which is consolidated net income for the period divided by average total assets for the period) because ROI: adjusts operating income to exclude certain expense items and adds interest income; adjusts total assets for the impact of accumulated depreciation and amortization, accounts payable and accrued liabilities to arrive at total invested capital. Because of the adjustments mentioned above, we believe ROI more accurately measures how we are deploying our key assets and is more meaningful to investors than ROA. Although ROI is a standard financial measure, numerous methods exist for calculating a company's ROI. As a result, the method used by management to calculate our ROI may differ from the methods used by other companies to calculate their ROI.36The calculation of ROA and ROI, along with a reconciliation of ROI to the calculation of ROA, the most comparable GAAP financial measure, is as follows: Fiscal Years Ended January 31,(Amounts in millions)20212020CALCULATION OF RETURN ON ASSETSNumeratorConsolidated net income$13,706 $15,201 DenominatorAverage total assets(1)$244,496 $227,895 Return on assets (ROA)5.6 %6.7 %CALCULATION OF RETURN ON INVESTMENTNumeratorOperating income$22,548 $20,568 + Interest income121 189 + Depreciation and amortization11,152 10,987 + Rent2,626 2,670 ROI operating income$36,447 $34,414 DenominatorAverage total assets(1), (2)$244,496 $235,277 + Average accumulated depreciation and amortization(1), (2)94,351 90,351 - Average accounts payable(1)48,057 47,017 - Average accrued liabilities(1)30,131 22,228 Average invested capital$260,659 $256,383 Return on investment (ROI)14.0 %13.4 % As of January 31, 202120202019Certain Balance Sheet Data Total assets$252,496 $236,495 $219,295 Leased assets, netNP21,841 7,078 Total assets without leased assets, netNP214,654 212,217 Accumulated depreciation and amortization94,187 94,514 87,175 Accumulated amortization on leased assetsNP4,694 5,682 Accumulated depreciation and amortization, without leased assetsNP89,820 81,493 Accounts payable49,141 46,973 47,060 Accrued liabilities37,966 22,296 22,159 (1) The average is based on the addition of the account balance at the end of the current period to the account balance at the end of the corresponding prior period and dividing by 2. Average total assets as used in ROA includes the average impact of the adoption of ASU 2016-02. (2) For fiscal 2020, as a result of adopting ASU 2016-02, average total assets is based on the average of total assets without leased assets, net plus leased assets, net as of January 31, 2020. Average accumulated depreciation and amortization is based on the average of accumulated depreciation and amortization, without leased assets plus accumulated amortization on leased assets as of January 31, 2020. NP = Not provided.Free Cash FlowFree cash flow is considered a non-GAAP financial measure. Management believes, however, that free cash flow, which measures our ability to generate additional cash from our business operations, is an important financial measure for use in evaluating the Company’s financial performance. Free cash flow should be considered in addition to, rather than as a substitute for, consolidated net income as a measure of our performance and net cash provided by operating activities as a measure of our liquidity. See "Liquidity and Capital Resources" for discussions of GAAP metrics including net cash provided by operating activities, net cash used in investing activities and net cash used in financing activities.We define free cash flow as net cash provided by operating activities in a period minus payments for property and equipment made in that period. We had net cash provided by operating activities of $36.1 billion, $25.3 billion and $27.8 billion for fiscal 2021, 2020 and 2019, respectively. We generated free cash flow of $25.8 billion, $14.6 billion and $17.4 billion for fiscal 2021, 2020 and 2019, respectively. Net cash provided by operating activities for fiscal 2021 increased when compared to fiscal 2020 primarily due to the impact of the global health crisis which accelerated inventory sell-through, as well as the timing and payment of inventory purchases, incremental COVID-19 related expenses and certain benefit payments. Free cash flow for fiscal 2021 increased when compared to fiscal 2020 due to the same reasons as the increase in net cash provided by operating activities, as well as $0.4 billion in decreased capital expenditures. Net cash provided by operating activities for fiscal 2020 declined when compared to fiscal 2019 was primarily due to the contribution to the Asda pension plan in anticipation of its 37future settlement, the inclusion of a full year of Flipkart operations, and the timing of vendor payments. Free cash flow for fiscal 2020 declined when compared to fiscal 2019 due to the same reasons as the decline in net cash provided by operating activities, as well as $0.4 billion in increased capital expenditures.Walmart's definition of free cash flow is limited in that it does not represent residual cash flows available for discretionary expenditures due to the fact that the measure does not deduct the payments required for debt service and other contractual obligations or payments made for business acquisitions. Therefore, we believe it is important to view free cash flow as a measure that provides supplemental information to our Consolidated Statements of Cash Flows.Although other companies report their free cash flow, numerous methods may exist for calculating a company's free cash flow. As a result, the method used by management to calculate our free cash flow may differ from the methods used by other companies to calculate their free cash flow.The following table sets forth a reconciliation of free cash flow, a non-GAAP financial measure, to net cash provided by operating activities, which we believe to be the GAAP financial measure most directly comparable to free cash flow, as well as information regarding net cash used in investing activities and net cash used in financing activities. Fiscal Years Ended January 31,(Amounts in millions)202120202019Net cash provided by operating activities$36,074 $25,255 $27,753 Payments for property and equipment(10,264)(10,705)(10,344)Free cash flow$25,810 $14,550 $17,409 Net cash used in investing activities(1)$(10,071)$(9,128)$(24,036)Net cash used in financing activities(16,117)(14,299)(2,537)(1) "Net cash used in investing activities" includes payments for property and equipment, which is also included in our computation of free cash flow.Results of OperationsConsolidated Results of OperationsFiscal Years Ended January 31,(Amounts in millions, except unit counts)202120202019Total revenues$559,151 $523,964 $514,405 Percentage change from comparable period6.7 %1.9 %2.8 %Net sales$555,233 $519,926 $510,329 Percentage change from comparable period6.8 %1.9 %2.9 %Total U.S. calendar comparable sales increase8.7 %2.7 %4.0 %Gross profit rate24.3 %24.1 %24.5 %Operating income$22,548 $20,568 $21,957 Operating income as a percentage of net sales4.1 %4.0 %4.3 %Consolidated net income$13,706 $15,201 $7,179 Unit counts at period end(1)11,443 11,501 11,361 Retail square feet at period end(1)1,121 1,129 1,129 (1) Unit counts and associated retail square feet are presented for stores and clubs generally open as of period end, and includes stores associated with operations classified as held for sale as of January 31, 2021. Permanently closed locations are not included. Our total revenues, which includes net sales and membership and other income, increased $35.2 billion or 6.7% and $9.6 billion or 1.9% for fiscal 2021 and 2020, respectively, when compared to the previous fiscal year. These increases in revenues were due to increases in net sales, which increased $35.3 billion or 6.8% and $9.6 billion or 1.9% for fiscal 2021 and 2020, respectively, when compared to the previous fiscal year. For fiscal 2021, the increase was primarily due to strong positive comparable sales for the Walmart U.S. and Sam's Club segments as well as positive comparable sales in the majority of our international markets resulting from increased demand stemming from the COVID-19 pandemic. Overall net sales growth was strong despite certain operating limitations in several international markets in the second quarter of fiscal 2021 due to government regulations and precautionary measures taken as a result of the COVID-19 pandemic. The net sales increase was partially offset by negative fluctuations in currency exchange rates of $5.0 billion. For fiscal 2020, net sales were positively impacted by overall positive comparable sales for Walmart U.S. and Sam's Club segments, along with the addition of net sales from Flipkart, which we acquired in August 2018, and positive comparable sales in the majority of our international markets. These increases were partially offset by $4.1 billion of negative impact from fluctuations in currency exchange rates in fiscal 2020 and our sale of the majority stake in Walmart Brazil in August 2018.Our gross profit rate increased 20 basis points and decreased 40 basis points for fiscal 2021 and 2020, respectively, when compared to the previous fiscal year. For fiscal 2021, the increase was primarily due to strategic sourcing initiatives, strong sales in higher margin categories, and fewer markdowns. This was partially offset in the Walmart U.S. segment by carryover of prior year price investment as well as the temporary closure of our Auto Care Centers and Vision Centers in response to the 38COVID-19 pandemic. For fiscal 2020, the decrease was primarily due to price investment in the Walmart U.S. segment and the addition of Flipkart in the Walmart International segment, partially offset by favorable merchandise mix including strength in private brands and less pressure from transportation costs in the Walmart U.S. segment.For fiscal 2021, operating expenses as a percentage of net sales was flat when compared to the previous fiscal year. Operating expenses as a percentage of net sales benefited from strong growth in comparable sales and lapping the $0.9 billion business restructuring charges from the prior year described below. These benefits were offset by $4.0 billion of incremental costs related to the COVID-19 pandemic and a $0.4 billion business restructuring charge in the Walmart U.S. segment recorded in the second quarter of fiscal 2021.For fiscal 2020, operating expenses as a percentage of net sales decreased 8 basis points, when compared to the previous fiscal year, due to our focus on expense management combined with our growth in comparable store sales. These improvements were partially offset by $0.9 billion in business restructuring charges consisting primarily of non-cash impairment charges for certain trade names, acquired developed technology, and other business restructuring charges due to strategic decisions that resulted in the write down of certain assets in the Walmart U.S. and Walmart International segments. Other gains and losses consisted of net gains of $0.2 billion and $2.0 billion for fiscal 2021 and 2020, respectively. The gain in fiscal 2021 primarily reflects $8.7 billion in net gains associated with the fair value changes of our equity investments, partially offset by the $8.3 billion pre-tax loss related to the divestiture of certain international operations classified as held for sale or sold in fiscal 2021. The gain in fiscal 2020 was primarily the result of a $1.9 billion increase in the market value of our investment in JD.com.Our effective income tax rate was 33.3% for fiscal 2021, 24.4% for fiscal 2020, and 37.4% for fiscal 2019. The increase in our effective tax rate for fiscal 2021 as compared to fiscal 2020 is primarily due to the loss related to the divestiture of certain international operations classified as held for or sold in fiscal 2021, which provided minimal realizable tax benefit. The decrease in our effective tax rate for fiscal 2020 as compared to fiscal 2019 was primarily due to the fiscal 2019 loss on sale of a majority stake in Walmart Brazil, which increased the previous comparative fiscal year's effective tax rate, as it provided minimal realizable tax benefit. Our effective income tax rate may also fluctuate as a result of various factors, including changes in our assessment of certain tax contingencies, valuation allowances, changes in tax law, outcomes of administrative audits, the impact of discrete items and the mix and size of earnings among our U.S. operations and international operations, which are subject to statutory rates that, beginning in fiscal 2019, are generally higher than the U.S. statutory rate. The reconciliation from the U.S. statutory rate to the effective income tax rates for fiscal 2021, 2020 and 2019 is presented in Note 9.As a result of the factors discussed above, we reported $13.7 billion and $15.2 billion of consolidated net income for fiscal 2021 and 2020, respectively, which represents a decrease of $1.5 billion and an increase of $8.0 billion for fiscal 2021 and 2020, respectively, when compared to the previous fiscal year. Diluted net income per common share attributable to Walmart ("EPS") was $4.75, $5.19 and $2.26 for fiscal 2021, 2020 and 2019, respectively. Walmart U.S. Segment Fiscal Years Ended January 31,(Amounts in millions, except unit counts)202120202019Net sales$369,963 $341,004 $331,666 Percentage change from comparable period8.5 %2.8 %4.1 %Calendar comparable sales increase8.7 %2.9 %3.7 %Operating income$19,116 $17,380 $17,386 Operating income as a percentage of net sales5.2 %5.1 %5.2 %Unit counts at period end4,743 4,756 4,769 Retail square feet at period end703 703 705 Net sales for the Walmart U.S. segment increased $29.0 billion or 8.5% and $9.3 billion or 2.8% for fiscal 2021 and 2020, respectively, when compared to the previous fiscal year. The increases in net sales were primarily due to increases in comparable sales of 8.7% and 2.9% for fiscal 2021 and 2020, respectively. Comparable sales in fiscal 2021 were driven by growth in average ticket primarily resulting from meeting the increased demand due to economic conditions related to the COVID-19 pandemic while transactions decreased as customers consolidated shopping trips. Comparable sales in fiscal 2020 were driven by both average ticket and transaction growth for fiscal 2020. Walmart U.S. eCommerce sales positively contributed approximately 5.4% and 2.1% to comparable sales for fiscal 2021 and 2020, respectively, as we continue to focus on a seamless omni-channel experience for our customers. Gross profit rate was flat and decreased 14 basis points for fiscal 2021 and 2020, respectively, when compared to the previous fiscal year. While fiscal 2021 gross profit rate was flat, it benefited from strategic sourcing initiatives and fewer markdowns, offset by a change in merchandise mix, the carryover effect of prior year price investment and the temporary closure of our Auto Care and Vision Centers in response to the COVID-19 pandemic. For fiscal 2020, the decrease was primarily the result of continued price investments which were partially offset by better merchandise mix, including strength in private brands, and less pressure from transportation costs.39Operating expenses as a percentage of segment net sales decreased 15 and 4 basis points for fiscal 2021 and 2020, respectively, when compared to the previous fiscal year. We leveraged operating expenses in fiscal 2021 primarily as a result of strong sales, which were partially offset by $3.2 billion of incremental costs related to the COVID-19 pandemic including special bonuses, expanded sick and emergency leave pay, costs associated with outfitting our stores and associates with masks, gloves and sanitizer, and expanded cleaning practices. Fiscal 2021 operating expenses as a percentage of net sales was also slightly aided by lapping the $0.5 billion business restructuring charges from the prior year described below, offset by a $0.4 billion business restructuring charge recorded in the second quarter of fiscal 2021 resulting from changes to Walmart U.S. support teams to better support its omni-channel strategy. The decrease in fiscal 2020 was primarily due to strong sales and productivity improvements which were mostly offset by business restructuring charges of $0.5 billion consisting primarily of non-cash impairment charges for certain trade names, acquired developed technology and other business restructuring charges due to decisions that resulted in the write down of certain eCommerce assets.As a result of the factors discussed above, segment operating income increased $1.7 billion and decreased $6 million for fiscal 2021 and 2020, respectively, when compared to the previous fiscal year.Walmart International Segment Fiscal Years Ended January 31,(Amounts in millions, except unit counts)202120202019Net sales$121,360 $120,130 $120,824 Percentage change from comparable period1.0 %(0.6)%2.3 %Operating income$3,660 $3,370 $4,883 Operating income as a percentage of net sales3.0 %2.8 %4.0 %Unit counts at period end6,101 6,146 5,993 Retail square feet at period end337 345 344 Net sales for the Walmart International segment increased $1.2 billion or 1.0% and decreased $0.7 billion or 0.6% for fiscal 2021 and 2020, respectively, when compared to the previous fiscal year. For fiscal 2021, the increase was primarily due to positive comparable sales growth in the majority of our markets driven by changes in consumer behavior in response to the COVID-19 pandemic, partially offset by negative fluctuations in currency exchange rates of $5.0 billion. The pandemic led to significant economic pressures and channel and mix shifts due to changes in consumer behavior, including accelerated growth in eCommerce in several markets. While several of our markets experienced extensive store and operational closures in the second quarter as a result of government mandates, most closed stores and warehouses had resumed operations by the third quarter.For fiscal 2020, the decrease was primarily due to negative fluctuations in currency exchange rates of $4.1 billion as well as a reduction in sales due to our sale of the majority stake in Walmart Brazil in August 2018, offset by a full year of net sales from Flipkart and positive comparable sales growth in the majority of our markets. Gross profit rate increased 50 basis points and decreased 136 basis points for fiscal 2021 and 2020, respectively, when compared to the previous fiscal year. For fiscal 2021, the increase was primarily due to Flipkart's improved margin mix and reduced fuel sales in the U.K. For fiscal 2020, the decrease was primarily due to Flipkart, as well as a change in merchandise mix.Operating expenses as a percentage of segment net sales increased 14 basis points and decreased 13 basis points for fiscal 2021 and 2020, respectively, when compared to the previous fiscal year. The increase in operating expenses as a percentage of segment net sales for fiscal 2021 was primarily due to $0.5 billion of incremental costs related to the COVID-19 pandemic, partially offset by positive comparable sales in the majority of our markets and lapping the impairment charges in the prior year discussed below. Fiscal 2020 decreased primarily due to positive comparable sales in the majority of our markets as well as cost discipline across multiple markets, partially offset by $0.4 billion in impairment charges primarily due to the write-off of the carrying value of one of Flipkart's two fashion trade names, Jabong.com, as a result of a strategic decision to focus our efforts on a single fashion platform in order to simplify the business and customer proposition.As a result of the factors discussed above, segment operating income increased $0.3 billion and decreased $1.5 billion for fiscal 2021 and 2020, respectively, when compared to the previous fiscal year.40Sam's Club Segment Fiscal Years Ended January 31,(Amounts in millions, except unit counts)202120202019Including FuelNet sales$63,910 $58,792 $57,839 Percentage change from comparable period8.7 %1.6 %(2.3)%Calendar comparable sales increase8.7 %1.6 %5.4 %Operating income$1,906 $1,642 $1,520 Operating income as a percentage of net sales3.0 %2.8 %2.6 %Unit counts at period end599 599 599 Retail square feet at period end80 80 80 Excluding Fuel (1)Net sales$59,184 $52,792 $52,332 Percentage change from comparable period12.1 %0.9 %(3.9)%Operating income$1,645 $1,486 $1,383 Operating income as a percentage of net sales2.8 %2.8 %2.6 % (1) We believe the "Excluding Fuel" information is useful to investors because it permits investors to understand the effect of the Sam's Club segment's fuel sales on its results of operations, which are impacted by the volatility of fuel prices. Volatility in fuel prices may continue to impact the operating results of the Sam's Club segment in the future. Management uses such information to better measure underlying operating results in the segment. Net sales for the Sam's Club segment increased $5.1 billion or 8.7% and $1.0 billion or 1.6% for fiscal 2021 and 2020, respectively, when compared to the previous fiscal year. Our 8.7% growth in comparable sales for fiscal 2021 benefited from growth in transactions and average ticket resulting from the COVID-19 pandemic, partially offset by both our decision to remove tobacco from certain club locations and by lower fuel sales. Sam's Club eCommerce sales positively contributed approximately 2.2% to comparable sales. For fiscal 2020, the increase was primarily due to comparable sales, including fuel, of 1.6%. Comparable sales benefited from growth in transactions and higher fuel sales, which were partially offset by lower ticket due to our decision to remove tobacco from certain club locations. Sam's Club eCommerce sales positively contributed approximately 1.8% to comparable sales.Gross profit rate increased 65 basis points and decreased 11 basis points for fiscal 2021 and 2020, respectively, when compared to the previous fiscal year. The increase in gross profit rate was due to favorable sales mix, including lower fuel and tobacco sales, and improvement in inventory losses which was partially offset by price investment and higher eCommerce fulfillment costs. For fiscal 2020, gross profit rate decreased due to price investment and higher eCommerce fulfillment costs, partially offset by reduced tobacco sales.Membership and other income increased 6.8% and 4.7% for fiscal 2021 and 2020, respectively, when compared to the previous fiscal year. For fiscal 2021 and 2020, the increases were primarily due to growth in total members, which benefited from higher overall renewal rates, and higher Plus Member penetration. Fiscal 2021 growth was also positively affected by the COVID-19 pandemic. Fiscal 2020 was also benefited by gains on property sales and other income.Operating expenses as a percentage of segment net sales increased 42 and decreased 19 basis points for fiscal 2021 and 2020, respectively, when compared to the previous fiscal year. Despite increased net sales from the strong demand resulting from the COVID-19 pandemic, fiscal 2021 operating expenses as a percentage of net sales increased primarily due to $0.3 billion of incremental costs related to the pandemic, which included additional costs such as special bonuses, expanded cleaning practices and security, expanded sick and emergency leave pay, and outfitting our associates with masks and gloves. Additionally, the increase in operating expense as a percentage of segment net sales was affected by reduced tobacco and fuel sales. For fiscal 2020, the decrease was primarily the result of lower labor-related costs and a charge of approximately $50 million related to lease exit costs in the prior comparable period. These benefits were partially offset by a reduction in sales of tobacco and a higher level of technology investment.As a result of the factors discussed above, segment operating income increased $0.3 billion and $0.1 billion for fiscal 2021 and 2020, respectively, when compared to the previous fiscal year.41Liquidity and Capital ResourcesLiquidityThe strength and stability of our operations have historically supplied us with a significant source of liquidity. Our cash flows provided by operating activities, supplemented with our long-term debt and short-term borrowings, have been sufficient to fund our operations while allowing us to invest in activities that support the long-term growth of our operations. Generally, some or all of the remaining available cash flow has been used to fund dividends on our common stock and share repurchases. We believe our sources of liquidity will continue to be adequate to fund operations, finance our global investment and expansion activities, pay dividends and fund our share repurchases for the foreseeable future.Net Cash Provided by Operating ActivitiesFiscal Years Ended January 31,(Amounts in millions)202120202019Net cash provided by operating activities$36,074 $25,255 $27,753 Net cash provided by operating activities was $36.1 billion, $25.3 billion and $27.8 billion for fiscal 2021, 2020 and 2019, respectively. Net cash provided by operating activities for fiscal 2021 increased when compared to the previous fiscal year primarily due to the impact of the global health crisis which accelerated inventory sell-through, as well as the timing and payment of inventory purchases, incremental COVID-19 related expenses and certain benefit payments. The decrease in net cash provided by operating activities for fiscal 2020, when compared to the previous fiscal year, was primarily due to the contribution to our Asda pension plan in anticipation of its future settlement, the inclusion of a full year of Flipkart operations, and the timing of vendor payments.Cash Equivalents and Working Capital Deficit Cash and cash equivalents were $17.7 billion and $9.5 billion as of January 31, 2021 and 2020, respectively. We maintained more cash at January 31, 2021 compared to January 31, 2020 in order to provide us with enhanced financial flexibility due to the uncertainties related to the COVID-19 pandemic. Our working capital deficit, defined as total current assets less total current liabilities, was $2.6 billion and $16.0 billion as of January 31, 2021 and 2020, respectively. The decrease in working capital deficit as compared to the previous fiscal year is primarily driven by the increase in cash and cash equivalents as well as the increase in current assets and current liabilities due to the classification of the Company's operations in the U.K. and Japan as held for sale. We generally operate with a working capital deficit due to our efficient use of cash in funding operations, consistent access to the capital markets and returns provided to our shareholders in the form of payments of cash dividends and share repurchases. We use intercompany financing arrangements in an effort to ensure cash can be made available in the country in which it is needed with the minimum cost possible. Additionally, from time-to-time, we repatriate earnings and related cash from jurisdictions outside of the U.S. Historically, U.S. taxes were due upon repatriation of foreign earnings. Due to the enactment of U.S. tax reform, repatriations of foreign earnings will generally be free of U.S. federal tax, but may incur other taxes such as withholding or state taxes. While we are awaiting anticipated technical guidance from the Internal Revenue Service ("IRS") and the U.S. Treasury Department, we do not expect current local laws, other existing limitations or potential taxes on anticipated future repatriations of cash amounts held outside the U.S. to have a material effect on our overall liquidity, financial position or results of operations.As of January 31, 2021 and 2020, cash and cash equivalents of $2.8 billion and $2.3 billion, respectively, may not be freely transferable to the U.S. due to local laws or other restrictions. Of the $2.8 billion as of January 31, 2021, approximately $1.0 billion can only be accessed through dividends or intercompany financing arrangements subject to approval of the Flipkart minority shareholders; however, this cash is expected to be utilized to fund the operations of Flipkart.Net Cash Used in Investing Activities Fiscal Years Ended January 31,(Amounts in millions)202120202019Net cash used in investing activities $(10,071)$(9,128)$(24,036)Net cash used in investing activities was $10.1 billion, $9.1 billion and $24.0 billion for fiscal 2021, 2020 and 2019, respectively, and generally consisted of payments for business acquisitions and to expand our eCommerce capabilities, invest in other technologies and supply chain, remodel existing stores and clubs and add new stores and clubs. Net cash used in investing activities increased $0.9 billion for fiscal 2021 when compared to the previous fiscal year primarily as a result of lapping the net proceeds received from the sale of our banking operations in Walmart Canada and the change in other investing activities, partially offset by decreased capital expenditures. Net cash used in investing activities decreased $14.9 billion for fiscal 2020 when compared to the previous fiscal year, primarily as a result of the $13.8 billion payment for the acquisition of Flipkart, net of cash acquired, as well as payments for other, smaller acquisitions in fiscal 2019. 42Additionally, refer to the "Strategic Capital Allocation" section in our Company Performance Metrics for capital expenditure detail for fiscal 2021 and 2020.Growth ActivitiesFor the fiscal year ending January 31, 2022 ("fiscal 2022"), we project capital expenditures will be approximately $14 billion, with a focus on supply chain, automation, customer-facing initiatives and technology. Net Cash Used in Financing Activities Fiscal Years Ended January 31,(Amounts in millions)202120202019Net cash used in financing activities$(16,117)$(14,299)$(2,537)Net cash used in financing activities generally consists of transactions related to our short-term and long-term debt, financing obligations, dividends paid and the repurchase of Company stock. Transactions with noncontrolling interest shareholders are also classified as cash flows from financing activities. Fiscal 2021 net cash used in financing activities increased $1.8 billion when compared to the same period in the previous fiscal year. The increase is primarily due to the timing of issuances and repayments of long-term debt, partially offset by both a reduction in cash used to pay down short-term borrowings as well as share repurchases as we manage our financial position during the current economic environment. Fiscal 2020 net cash used in financing activities increased $11.8 billion for fiscal 2020 when compared to the same period in the previous fiscal year. The increase was primarily due to the $15.9 billion of net proceeds received in fiscal 2019 from the issuance of long-term debt to fund a portion of the purchase price for Flipkart partially offset by $5.5 billion of additional long-term debt in the fiscal 2020 to fund general business operations. Short-term BorrowingsWe generally utilize the liquidity provided by short-term borrowings to provide funding for our operations, dividend payments, share repurchases, capital expenditures and other cash requirements. The following table includes additional information related to the Company's short-term borrowings for fiscal 2021, 2020 and 2019: Fiscal Years Ended January 31,(Amounts in millions)202120202019Maximum amount outstanding at any month-end$4,048 $13,315 $13,389 Average daily short-term borrowings1,577 7,120 10,625 Annual weighted-average interest rate3.1 %2.5 %2.4 %We also have $15.0 billion of various undrawn committed lines of credit in the U.S. as of January 31, 2021 that provide additional liquidity, if needed. Additionally, we maintain access to various credit facilities outside of the U.S. to further support our Walmart International segment operations, as needed. Long-term DebtThe following table provides the changes in our long-term debt for fiscal 2021: (Amounts in millions)Long-term debt due within one yearLong-term debtTotalBalances as of February 1, 2020$5,362 $43,714 $49,076 Repayments of long-term debt(5,382)— (5,382)Reclassifications of long-term debt3,126 (3,126)— Other9 606 615 Balances as of January 31, 2021$3,115 $41,194 $44,309 DividendsOur total dividend payments were $6.1 billion, $6.0 billion and $6.1 billion for fiscal 2021, 2020 and 2019, respectively. The Board of Directors approved, effective February 18, 2021, the fiscal 2022 annual dividend of $2.20 per share, an increase over the fiscal 2021 annual dividend of $2.16 per share. For fiscal 2022, the annual dividend will be paid in four quarterly installments of $0.55 per share, according to the following record and payable dates:Record DatePayable DateMarch 19, 2021April 5, 2021May 7, 2021June 1, 2021August 13, 2021September 7, 2021December 10, 2021January 3, 202243Company Share Repurchase Program From time to time, the Company repurchases shares of its common stock under share repurchase programs authorized by the Company's Board of Directors. All repurchases made during fiscal 2021 were made under the $20 billion share repurchase program approved in October 2017, of which authorization for $3.0 billion of share repurchases remained as of January 31, 2021. On February 18, 2021, the Board of Directors approved a new $20.0 billion share repurchase program which, beginning February 22, 2021, replaced the previous share repurchase program. Any repurchased shares are constructively retired and returned to an unissued status. We regularly review share repurchase activity and consider several factors in determining when to execute share repurchases, including, among other things, current cash needs, capacity for leverage, cost of borrowings, our results of operations and the market price of our common stock. We anticipate that a majority of the ongoing share repurchase program will be funded through the Company's free cash flow. The following table provides, on a settlement date basis, the number of shares repurchased, average price paid per share and total amount paid for share repurchases for fiscal 2021, 2020 and 2019: Fiscal Years Ended January 31,(Amounts in millions, except per share data)202120202019Total number of shares repurchased19.453.979.5Average price paid per share$135.20 $105.98 $93.18 Total amount paid for share repurchases$2,625 $5,717 $7,410 Capital ResourcesWe believe cash flows from operations, our current cash position and access to capital markets will continue to be sufficient to meet our anticipated operating cash needs, which include funding seasonal buildups in merchandise inventories and funding our capital expenditures, acquisitions, dividend payments and share repurchases.We have strong commercial paper and long-term debt ratings that have enabled and should continue to enable us to refinance our debt as it becomes due at favorable rates in capital markets. As of January 31, 2021, the ratings assigned to our commercial paper and rated series of our outstanding long-term debt were as follows:Rating agency Commercial paper Long-term debtStandard & Poor's A-1+ AAMoody's Investors Service P-1 Aa2Fitch Ratings F1+ AACredit rating agencies review their ratings periodically and, therefore, the credit ratings assigned to us by each agency may be subject to revision at any time. Accordingly, we are not able to predict whether our current credit ratings will remain consistent over time. Factors that could affect our credit ratings include changes in our operating performance, the general economic environment, conditions in the retail industry, our financial position, including our total debt and capitalization, and changes in our business strategy. Any downgrade of our credit ratings by a credit rating agency could increase our future borrowing costs or impair our ability to access capital and credit markets on terms commercially acceptable to us. In addition, any downgrade of our current short-term credit ratings could impair our ability to access the commercial paper markets with the same flexibility that we have experienced historically, potentially requiring us to rely more heavily on more expensive types of debt financing. The credit rating agency ratings are not recommendations to buy, sell or hold our commercial paper or debt securities. Each rating may be subject to revision or withdrawal at any time by the assigning rating organization and should be evaluated independently of any other rating. Moreover, each credit rating is specific to the security to which it applies.44Contractual Obligations The following table sets forth certain information concerning our obligations to make contractual future payments, such as debt and lease agreements, and certain contingent commitments as of January 31, 2021: Payments Due During Fiscal Years Ending January 31,(Amounts in millions)Total20222023-20242025-2026ThereafterRecorded contractual obligations:Long-term debt(1)$44,309 $3,115 $7,735 $5,840 $27,619 Short-term borrowings224 224 — — — Operating lease obligations(2)20,949 2,189 3,878 3,224 11,658 Finance lease obligations and other(2)(3)8,835 896 1,461 1,221 5,257 Obligations related to businesses held for sale(4)8,081 564 1,034 899 5,584 Unrecorded contractual obligations:Estimated interest on long-term debt21,124 1,636 3,072 2,678 13,738 Syndicated and other letters of credit2,019 2,019 — — — Purchase obligations15,004 7,017 5,562 1,495 930 Obligations related to businesses held for sale(4)856 621 210 22 3 Total contractual obligations$121,401 $18,281 $22,952 $15,379 $64,789 (1) Includes deferred loan costs, discounts, fair value hedges, foreign-held debt and secured debt. (2) Represents our contractual obligations to make future payments under non-cancelable operating leases and finance lease agreements, both of which are recorded on the balance sheet at their present value. Refer to Note 7 to our Consolidated Financial Statements for additional information regarding operating and finance leases. (3) Finance lease obligations and other includes contractual obligations under other financing obligations of $1.3 billion.(4) Includes obligations related to our operations in Japan and the United Kingdom which are classified as held for sale as of January 31, 2021. Under the terms of the sale of the majority stake of Walmart Brazil, we agreed to indemnify the purchaser for certain pre-closing tax and legal contingencies and other matters for up to R$2.3 billion, adjusted for interest based on the Brazilian interbank deposit rate. As of January 31, 2021, the indemnification liability was $0.6 billion and recorded in deferred income taxes and other in the Company's Consolidated Balance Sheet. Estimated interest payments are based on our principal amounts and expected maturities of all debt outstanding as of January 31, 2021, and assumes interest rates remain at current levels for our variable rate debt. Additionally, we have $15.0 billion of various undrawn committed lines of credit in the U.S. as of January 31, 2021.Purchase obligations include legally binding contracts, such as firm commitments for inventory and utility purchases, as well as commitments to make capital expenditures, software acquisition and license commitments and legally binding service contracts. For the purposes of the above table, contractual obligations for the purchase of goods or services are defined as agreements that are enforceable and legally binding and that specify all significant terms, including: fixed or minimum quantities to be purchased; fixed, minimum or variable price provisions; and the approximate timing of the transaction. Contracts that specify the Company will purchase all or a portion of its requirements of a specific product or service from a supplier, but do not include a fixed or minimum quantity, are excluded from the table above. Accordingly, purchase orders for inventory are not included in the table above as purchase orders represent authorizations to purchase rather than binding agreements. Our purchase orders are based on our current inventory needs and are fulfilled by our suppliers within short time periods. We also enter into contracts for outsourced services; however, the obligations under these contracts are not significant and the contracts generally contain clauses allowing for cancellation without significant penalty.The expected timing for payment discussed above is estimated based on current information. Timing of payments and actual amounts paid may be different depending on the timing of receipt of goods or services or changes to agreed-upon amounts for some obligations.In addition to the amounts shown in the table above, $1.7 billion of net unrecognized tax benefits are considered uncertain tax positions and have been recorded as liabilities. The timing of the payment, if any, associated with these liabilities is uncertain. Refer to Note 9 to our Consolidated Financial Statements for additional discussion of unrecognized tax benefits. Off Balance Sheet ArrangementsAs of January 31, 2021, we had no off-balance sheet arrangements that have, or are reasonably likely to have, a current or future material effect on our consolidated financial position, results of operations, liquidity, capital expenditures or capital resources.45Other MattersWe discuss our "Asda Equal Value Claims" which includes certain existing employment claims against our recently divested United Kingdom subsidiary, Asda Group Limited, including certain risks arising therefrom, under the sub-caption "Legal Proceedings" in Note 10 to our Consolidated Financial Statements. We also discuss the Opioids Litigation including certain risks arising therefrom, in "Item 1A. Risk Factors" under the caption "Legal, Tax, Regulatory, Compliance, Reputational and Other Risks" and under the sub-caption "Legal Proceedings" in Note 10 to our Consolidated Financial Statements. We also discuss various legal proceedings related to the Asda Equal Value Claims and Opioids Litigation in "Item 3. Legal Proceedings" herein under the caption "Supplemental Information." The foregoing matters and other matters described elsewhere in this Annual Report on Form 10-K represent contingencies of the Company that may or may not result in the Company incurring a material liability upon their final resolution.Summary of Critical Accounting EstimatesManagement strives to report our financial results in a clear and understandable manner, although in some cases accounting and disclosure rules are complex and require us to use technical terminology. In preparing the Company's Consolidated Financial Statements, we follow accounting principles generally accepted in the U.S. These principles require us to make certain estimates and apply judgments that affect our financial position and results of operations as reflected in our financial statements. These judgments and estimates are based on past events and expectations of future outcomes. Actual results may differ from our estimates.Management continually reviews our accounting policies, how they are applied and how they are reported and disclosed in our financial statements. Following is a summary of our critical accounting estimates and how they are applied in preparation of the financial statements.InventoriesWe value inventories at the lower of cost or market as determined primarily by the retail inventory method of accounting, using the last-in, first-out ("LIFO") method for Walmart U.S. segment's inventories. The inventory at the Sam's Club segment is valued using the weighted-average cost LIFO method. When necessary, we record a LIFO provision for the estimated annual effect of inflation, and these estimates are adjusted to actual results determined at year-end. Our LIFO provision is calculated based on inventory levels, markup rates and internally generated retail price indices. As a measure of sensitivity, a 1% increase to our retail price indices would not have resulted in a decrease to the carrying value of inventory. As of January 31, 2021 and 2020, our inventories valued at LIFO approximated those inventories as if they were valued at first-in, first-out ("FIFO").Impairment of AssetsWe evaluate long-lived assets for indicators of impairment whenever events or changes in circumstances indicate their carrying amounts may not be recoverable. Management's judgments regarding the existence of impairment indicators are based on market conditions and financial performance. The evaluation of long-lived assets is performed at the lowest level of identifiable cash flows, which is generally at the individual store level. The variability of these factors depends on a number of conditions, including uncertainty about future events and changes in demographics. Thus, our accounting estimates may change from period to period. These factors could cause management to conclude that indicators of impairment exist and require impairment tests be performed, which could result in management determining the value of long-lived assets is impaired, resulting in a write-down of the related long-lived assets. Impairment charges on assets held and used were immaterial in fiscal 2021, 2020 and 2019. As a measure of sensitivity, fiscal 2021 impairment would not change materially with a 10% decrease in the undiscounted cash flows for the stores or clubs with indicators of impairment. In fiscal 2021, the Company's operations in Argentina, Japan and the United Kingdom met the held for sale criteria. As a result, the individual disposal groups were measured at fair value, less costs to sell, which resulted in impairment charges that were included in the total estimated pre-tax loss of $8.3 billion recorded in fiscal 2021. Refer to Note 12. Fiscal 2019 included a pre-tax loss of $4.8 billion related to the sale of the majority stake in Walmart Brazil, which included full impairment of all related assets.Business Combinations, Goodwill, and Acquired Intangible AssetsWe account for business combinations using the acquisition method of accounting, which requires that once control is obtained, all the assets acquired and liabilities assumed, including amounts attributable to noncontrolling interests, are recorded at their respective fair values at the date of acquisition. The determination of fair values of identifiable assets and liabilities requires estimates and the use of valuation techniques when market value is not readily available. For intangible assets acquired in a business combination, we typically use the income method. Significant estimates in valuing certain intangible assets include, but are not limited to, the amount and timing of future cash flows, growth rates, discount rates and useful lives. The excess of the purchase price over fair values of identifiable assets and liabilities is recorded as goodwill.46Goodwill is assigned to the reporting unit which consolidates the acquisition. Components within the same reportable segment are aggregated and deemed a single reporting unit if the components have similar economic characteristics. As of January 31, 2021, our reporting units consisted of Walmart U.S., Walmart International and Sam's Club. Goodwill and other indefinite-lived acquired intangible assets are not amortized, but are evaluated for impairment annually or whenever events or changes in circumstances indicate that the value of a certain asset may be impaired. Generally, this evaluation begins with a qualitative assessment to determine whether a quantitative impairment test is necessary. If we determine, after performing an assessment based on the qualitative factors, that the fair value of the reporting unit is more likely than not less than the carrying amount, or that a fair value of the reporting unit substantially in excess of the carrying amount cannot be assured, then a quantitative impairment test would be performed. The quantitative test for impairment requires management to make judgments relating to future cash flows, growth rates and economic and market conditions. These evaluations are based on determining the fair value of a reporting unit or asset using a valuation method such as discounted cash flow or a relative, market-based approach. Historically, our reporting units have generated sufficient returns to recover the cost of goodwill, as the fair value significantly exceeded the carrying value. Our indefinite-lived acquired intangible assets have also historically generated sufficient returns to recover their cost. Because of the nature of the factors used in these tests, if different conditions occur in future periods, future operating results could be materially impacted. Due to certain strategic restructuring decisions, we recorded approximately $0.7 billion in impairment in fiscal 2020 related to acquired trade names and acquired developed software.ContingenciesWe are involved in a number of legal proceedings. We record a liability when it is probable that a loss has been incurred and the amount is reasonably estimable. We also perform an assessment of the materiality of loss contingencies where a loss is either not probable or it is reasonably possible that a loss could be incurred in excess of amounts accrued. If a loss or an additional loss has at least a reasonable possibility of occurring and the impact on the financial statements would be material, we provide disclosure of the loss contingency in the footnotes to our financial statements. We review all contingencies at least quarterly to determine whether the likelihood of loss has changed and to assess whether a reasonable estimate of the loss or the range of the loss can be made. Although we are not able to predict the outcome or reasonably estimate a range of possible losses in certain matters described in Note 10 to our Consolidated Financial Statements, and have not recorded an associated accrual related to these matters, an adverse judgment or negotiated resolution in any of these matters could have a material adverse effect on our business, financial position, results of operations or cash flows.Income TaxesIncome taxes have a significant effect on our net earnings. We are subject to income taxes in the U.S. and numerous foreign jurisdictions. Accordingly, the determination of our provision for income taxes requires judgment, the use of estimates in certain cases and the interpretation and application of complex tax laws. Our effective income tax rate is affected by many factors, including changes in our assessment of certain tax contingencies, increases and decreases in valuation allowances, changes in tax law, outcomes of administrative audits, the impact of discrete items and the mix of earnings among our U.S. and international operations where the statutory rates are generally higher than the U.S. statutory rate, and may fluctuate as a result.Our tax returns are routinely audited and settlements of issues raised in these audits sometimes affect our tax provisions. The benefits of uncertain tax positions are recorded in our financial statements only after determining a more likely than not probability that the uncertain tax positions will withstand challenge, if any, from taxing authorities. When facts and circumstances change, we reassess these probabilities and record any changes in the financial statements as appropriate. We account for uncertain tax positions by determining the minimum recognition threshold that a tax position is required to meet before being recognized in the financial statements. This determination requires the use of judgment in evaluating our tax positions and assessing the timing and amounts of deductible and taxable items.Deferred tax assets represent amounts available to reduce income taxes payable on taxable income in future years. Such assets arise because of temporary differences between the financial reporting and tax bases of assets and liabilities, as well as from net operating loss and tax credit carryforwards. Deferred tax assets are evaluated for future realization and reduced by a valuation allowance to the extent that a portion is not more likely than not to be realized. Many factors are considered when assessing whether it is more likely than not that the deferred tax assets will be realized, including recent cumulative earnings, expectations of future taxable income, carryforward periods and other relevant quantitative and qualitative factors. The recoverability of the deferred tax assets is evaluated by assessing the adequacy of future expected taxable income from all sources, including reversal of taxable temporary differences, forecasted operating earnings and available tax planning strategies. This evaluation relies on estimates.On December 22, 2017, the Tax Act was enacted and contains significant changes to U.S. income tax law. Effective beginning January 2018, the Tax Act reduced the U.S. statutory tax rate from 35% to 21% and created new taxes on foreign-sourced earnings and related-party payments. As discussed in Note 9 to our Consolidated Financial Statements, we completed our accounting for the tax effects of the Tax Act in fiscal 2019. As further guidance is issued by the U.S. Treasury Department, the IRS, and other standard–setting bodies, any resulting changes to our estimates will be treated in accordance with the relevant accounting guidance. 47ITEM 7A.QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKMarket RiskIn addition to the risks inherent in our operations, we are exposed to certain market risks, including changes in interest rates, currency exchange rates and the fair value of certain equity investments.The analysis presented below for each of our market risk sensitive instruments is based on a hypothetical scenario used to calibrate potential risk and does not represent our view of future market changes. The effect of a change in a particular assumption is calculated without adjusting any other assumption. In reality, however, a change in one factor could cause a change in another, which may magnify or negate other sensitivities.Interest Rate RiskWe are exposed to changes in interest rates as a result of our short-term borrowings and long-term debt. We hedge a portion of our interest rate risk by managing the mix of fixed and variable rate debt and by entering into interest rate swaps. For fiscal 2021, the net fair value of our interest rate swaps increased $69 million primarily due to fluctuations in market interest rates. The table below provides information about our financial instruments that are sensitive to changes in interest rates. For long-term debt, the table represents the principal cash flows and related weighted-average interest rates by expected maturity dates. For interest rate swaps, the table represents the contractual cash flows and weighted-average interest rates by the contractual maturity date, unless otherwise noted. The notional amounts are used to calculate contractual cash flows to be exchanged under the contracts. The weighted-average variable rates are based upon prevailing market rates as of January 31, 2021.Expected Maturity Date(Amounts in millions)Fiscal 2022Fiscal 2023Fiscal 2024Fiscal 2025Fiscal 2026ThereafterTotalLiabilitiesShort-term borrowings:Variable rate$224 $— $— $— $— $— $224 Weighted-average interest rate1.9 %— %— %— %— %— %1.9 %Long-term debt(1):Fixed rate$2,365 $3,014 $4,721 $4,360 $1,480 $27,619 $43,559 Weighted-average interest rate3.8 %1.7 %3.1 %2.7 %3.6 %4.5 %3.9 %Variable rate$750 $— $— $— $— $— $750 Weighted-average interest rate0.5 %— %— %— %— %— %0.5 %Interest rate derivativesInterest rate swaps:Fixed to variable$— $— $1,750 $1,500 $— $— $3,250 Weighted-average pay rate— %— %0.6 %1.3 %— %— %0.9 %Weighted-average receive rate— %— %2.6 %3.3 %— %— %2.9 %(1) Includes deferred loan costs, discounts, fair value hedges, foreign-held debt and secured debt. As of January 31, 2021, our variable rate borrowings, including the effect of our commercial paper and interest rate swaps, represented 9% of our total short-term and long-term debt. Based on January 31, 2021 debt levels, a 100 basis point change in prevailing market rates would cause our annual interest costs to change by approximately $42 million.Foreign Currency RiskWe are exposed to fluctuations in currency exchange rates as a result of our net investments and operations in countries other than the U.S, as well as our foreign-currency-denominated long-term debt. For fiscal 2021, movements in currency exchange rates and the related impact on the translation of the balance sheets resulted in the $0.2 billion net gain in the currency translation and other category of accumulated other comprehensive loss. We hedge a portion of our foreign currency risk by entering into currency swaps. The aggregate fair value of these swaps was in a liability position of $83 million and $241 million as of January 31, 2021 and January 31, 2020, respectively. The change in the fair value of these swaps was due to fluctuations in currency exchange rates, primarily due to the strengthening of certain currencies relative to the U.S. dollar in fiscal 2021. The hypothetical result of a uniform 10% weakening in the value of the U.S. dollar relative to other currencies underlying these swaps would have resulted in a change in the value of the swaps of $524 million. A hypothetical 10% change in interest rates underlying these swaps from the market rates in effect as of January 31, 2021 would have resulted in a change in the value of the swaps of $46 million.48In addition to currency swaps, we also hedge a portion of our foreign currency risk by designating foreign-currency-denominated long-term debt as nonderivative hedges of net investments of certain of our foreign operations. We had outstanding long-term debt of £1.7 billion as of January 31, 2021 and January 31, 2020 that was designated as a hedge of our net investment in the U.K. As of January 31, 2021, a hypothetical 10% increase or decrease in the value of the U.S. dollar relative to the British pound would have resulted in a change in the value of the debt of $210 million. In addition, we had outstanding long-term debt of ¥100 billion as of January 31, 2021 and ¥180 billion as of January 31, 2020 that was designated as a hedge of our net investment in Japan. As of January 31, 2021, a hypothetical 10% change in value of the U.S. dollar relative to the Japanese yen would have resulted in a change in the value of the debt of $87 million. As of January 31, 2021, the Company's operations in the U.K. and Japan are classified as held for sale, and subsequently closed in February 2021 and March 2021, respectively. Refer to Note 12 to our Consolidated Financial Statements. In certain countries, we also enter into immaterial foreign currency forward contracts to hedge the purchase and payment of purchase commitments denominated in non-functional currencies.Investment RiskWe are exposed to changes in the stock price of our equity investments with readily determinable fair values. The change in fair value is recorded within other gains and losses and resulted in a gain of $8.7 billion in fiscal 2021 due to net increases in the stock price of those equity investments. As of January 31, 2021, the fair value of our equity investments with readily determinable fair values was $14.4 billion. As of January 31, 2021, a hypothetical 10% change in the stock price of such investments would have changed the fair value of such investments by approximately $1.4 billion. 49
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+ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion should be read in conjunction with our consolidated financial statements and the notes thereto. This discussion summarizes the significant factors affecting our results of operations and the financial condition of our business. Except as otherwise indicated or unless the context otherwise requires, “Xylem,” “we,” “us,” “our” and “the Company” refer to Xylem Inc. and its subsidiaries. This section of this Form 10-K generally discusses 2020 and 2019 items and year-to-year comparisons between 2020 and 2019. Discussions of 2018 items and year-to-year comparisons between 2019 and 2018 that are not included in this Form 10-K can be found in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Part II, Item 7 of the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2019.OverviewXylem is a leading global water technology company. We design, manufacture and service highly engineered products and solutions ranging across a wide variety of critical applications in utility, industrial, residential and commercial building services settings. Our broad portfolio of solutions addresses customer needs across the water cycle, from the delivery, measurement and use of drinking water to the collection, test, treatment and analysis of wastewater to the return of water to the environment. Our product and service offerings are organized into three reportable segments that are aligned around the critical market applications they provide: Water Infrastructure, Applied Water and Measurement & Control Solutions. •Water Infrastructure serves the water infrastructure sector with pump systems that transport water from aquifers, lakes, rivers and seas; with filtration, ultraviolet and ozone systems that provide treatment, making the water fit to use; and pumping solutions that move the wastewater and storm water to treatment facilities where our mixers, biological treatment, monitoring and control systems provide the primary functions in the treatment process. We also provide sales and rental of specialty dewatering pumps and related equipment and services. Additionally, our offerings use monitoring and control, smart and connected technologies to allow for remote monitoring of performance and enable products to self-optimize pump operations maximizing energy efficiency and minimizing unplanned downtime and maintenance for our customers. In the Water Infrastructure segment, we provide the majority of our sales directly to customers along with strong applications expertise, while the remaining amount is through distribution partners.•Applied Water serves the water usage applications sector with water pressure boosting systems for heating, ventilation and air conditioning, and for fire protection systems to the residential and commercial building services markets. In addition, our pumps, heat exchangers and controls provide cooling to power plants and manufacturing facilities, circulation for food and beverage processing, as well as boosting systems for agricultural irrigation. In the Applied Water segment, we provide the majority of our sales through long-standing relationships with many of the leading independent distributors in the markets we serve, with the remainder going directly to customers.•Measurement & Control Solutions primarily serves the utility infrastructure solutions and services sector by delivering communications, smart metering, measurement and control technologies and critical infrastructure technologies that allow customers to more effectively use their distribution networks for the delivery, monitoring and control of critical resources such as water, electricity and natural gas. We also provide analytical instrumentation used to measure and analyze water quality, flow and level in clean water, wastewater, surface water and coastal environments. Additionally, we offer software and services including cloud-based analytics, remote monitoring and data management, leak detection, condition assessment, asset management and pressure monitoring solutions. In the Measurement & Control Solutions segment, we generate our sales through a combination of long-standing relationships with leading distributors and dedicated channel partners as well as direct sales depending on the regional availability of distribution channels and the type of product.31COVID-19 Pandemic The global spread of COVID-19 has curtailed the movement of people, goods and services worldwide, including in many of the regions where we sell our products and services and conduct operations. This section summarizes the most significant impacts related to the COVID-19 pandemic that we have experienced to date, and we have included additional details as applicable throughout other sections of this Annual Report. Many of these impacts did not begin to be felt broadly across our businesses until the latter part of the first quarter of 2020 and have continued through the remainder of the year. As the COVID-19 pandemic began to unfold in the first quarter of 2020, Xylem deployed a COVID-19 Response Team, responsible for Xylem's Pandemic Plan, which is designed to aid in prevention, preparedness, response and recovery at our sites and across the Company.Depending on the severity, magnitude and duration of the COVID-19 pandemic and its economic consequences, we anticipate that it will become more difficult to distinguish specific aspects of our operational and financial performance that are most directly related to COVID-19 from those that are more broadly influenced by ongoing macroeconomic, market and industry dynamics that are, to varying degrees, related to the COVID-19 pandemic and its consequences.Public health officials have recommended, or governments have mandated, precautions to mitigate the spread of COVID-19, including stay at home or similar measures, such as travel restrictions, for periods of time in many of the areas in which we operate. Operationally, a number of our production facilities across the globe experienced reduced production levels due to such measures to varying degrees during the year, however our current overall operating capacity approximates normal levels globally. In order to maintain a safe work environment, our production facilities continue to spread operations over multiple shifts and implement other protective measures such as testing, temperature screening and social distancing, while maintaining operational capabilities.The COVID-19 pandemic is also adversely affecting, and is expected to continue to adversely affect, our operations, supply chains and businesses. We expect to continue experiencing unpredictable interruptions with our external suppliers into 2021 that could lead to increased logistic costs. We have enhanced our supplier pulsing and redundancy to help mitigate these challenges and do not expect these interruptions to result in a material impact to our business. Additionally, we have in the past and may continue to take measures with respect to buffer stock to minimize freight and logistics delays. If these interruptions are sustained, or additional interruptions occur, they could have a negative impact on our results of operations.To date, the most significant operational impacts we have experienced are volume reductions ranging across all segments and major geographic regions. Although regions such as Europe and China have started to recover and experienced organic revenue growth during the fourth quarter of 2020, recovery in regions such as the U.S., the Middle East and India continues to lag.Future demand for our products and services is uncertain as the COVID-19 pandemic has also had an adverse impact on many of the customers we serve. As such, we have, and may continue to, experience decreased or delayed demand for our products and services. At the end of 2020, total backlog increased 17.9% as compared to December 31, 2019. In many cases, Xylem’s products and services are considered "essential services" under various governmental mandates, and as a result we did not experience significant issues in our ability to distribute products or services, aside from customer-driven project delays, inability to access or travel to customer sites and shipping delays due to stay at home measures. However, because the severity, magnitude and duration of the COVID-19 pandemic and its economic consequences are uncertain, the pandemic’s ongoing and future impacts on our business, financial condition, results of operations, and stock price remain uncertain and difficult to predict, and we expect that our results may continue to be adversely impacted beyond the year ending December 31, 2020. In response to the changes in business and economic conditions arising as a result of the COVID-19 pandemic, management committed to restructuring activities across our businesses and functions globally during the second quarter of 2020. These initiatives are designed to support our long-term financial resilience and simplify our operations, strengthen our competitive positioning and better serve our customers. In light of the uncertainty created by the COVID-19 pandemic, we also proactively took further cost reduction actions in 2020, which included a temporary 20% reduction in the base salary of the Company's Chief Executive Officer ("CEO") and all CEO direct reports, and a temporary 20% reduction in annual cash retainer fees payable to our Board of Directors effective from June 1, 2020 through December 31, 2020. Additionally, in 2020 we committed to reduced capital expenditure and discretionary operating spending. We anticipate that our capital expenditure spending will ramp up to more normal levels throughout 2021 as we see improvements in our markets.Since the pandemic started, Xylem has taken measures to protect the health and safety of our employees, work with our customers to minimize potential disruptions and positively impact our communities. In the first quarter of 322020, we implemented a support pay program for employees impacted by COVID-19, and an essential services premium pay program for the benefit of employees whose roles are classified as an “essential service” and, as such, are required to work either onsite at a Xylem facility or in the field supporting customers during periods of mandated stay at home or similar measures. These programs will remain in place through the first quarter of 2021 and continue to be evaluated for continuation as necessary going forward. Xylem Watermark, our corporate social responsibility program, is also supporting our communities in addressing the challenges posed by this global pandemic through its partnership with Americares and UNICEF, as well as the expansion of the Partner Community Grants program and matching donations program for employees and partners, and other philanthropic commitments. During 2020, Xylem also re-purposed internal manufacturing capabilities and, working with our partners, leveraged our supply chain to donate 300,000 pieces of personal protective equipment ("PPE") to frontline workers.Many of our offices globally have transitioned to a substantially remote work from home status, with no material disruption to operations, financial reporting systems, internal control over financial reporting or disclosure controls and procedures. As public health officials and governments ease recommendations and regulations regarding stay at home measures, our COVID-19 Response Team applies a set of Xylem "Return to Workplace" health and safety guidelines for remote workers to return to our facilities. These guidelines require government officials to first declare an easing of their restrictions, upon which we do a full review of our site to determine its readiness and follow a phased return to work approach, all in service to help ensure the safety of our people. We will continue to work with our customers, employees, suppliers and communities to address the impacts of COVID-19. We also continue to assess the evolving nature of the pandemic and its possible implications to our business, supply chain and customers, and to take actions in an effort to mitigate adverse consequences.Risks related to the impact of COVID-19 are described in further detail under "Item 1A. Risk Factors". Key Performance Indicators and Non-GAAP MeasuresManagement reviews key performance indicators including revenue, gross margins, segment operating income and operating income margins, EBITDA and EBITDA margins, orders growth, working capital and backlog, among others. In addition, we consider certain non-GAAP (or "adjusted") measures to be useful to management and investors evaluating our operating performance for the periods presented, and to provide a tool for evaluating our ongoing operations, liquidity and management of assets. This information can assist investors in assessing our financial performance and measures our ability to generate capital for deployment among competing strategic alternatives and initiatives, including, but not limited to, dividends, acquisitions, share repurchases and debt repayment. Excluding revenue, Xylem provides guidance only on a non-GAAP basis due to the inherent difficulty in forecasting certain amounts that would be included in GAAP earnings, such as discrete tax items, without unreasonable effort. These adjusted metrics are consistent with how management views our business and are used to make financial, operating and planning decisions. These metrics, however, are not measures of financial performance under GAAP and should not be considered a substitute for revenue, operating income, net income, earnings per share (basic and diluted) or net cash from operating activities as determined in accordance with GAAP. We consider the following items represent the non-GAAP measures we consider to be key performance indicators, as well as the related reconciling items to the most directly comparable measure calculated and presented in accordance with GAAP. The non-GAAP measures may not be comparable to similarly-titled measures reported by other companies.•"organic revenue" and "organic orders" defined as revenue and orders, respectively, excluding the impact of fluctuations in foreign currency translation and contributions from acquisitions and divestitures. Divestitures include sales or discontinuance of insignificant portions of our business that did not meet the criteria for classification as a discontinued operation. The period-over-period change resulting from foreign currency translation impacts is determined by translating current period and prior period activity using the same currency conversion rate.•"constant currency" defined as financial results adjusted for foreign currency translation impacts by translating current period and prior period activity using the same currency conversion rate. This approach is used for countries whose functional currency is not the U.S. Dollar.•"adjusted net income" and "adjusted earnings per share" defined as net income and earnings per share, respectively, adjusted to exclude restructuring and realignment costs, special charges, gain or loss from sale of businesses and tax-related special items, as applicable. A reconciliation of adjusted net income and adjusted earnings per share is provided below. 33(in millions, except per share data)20202019Net income & Earnings per share$254 $1.40 $401 $2.21 Restructuring and realignment, net of tax of $17 and $19 60 0.33 63 0.35 Special charges, net of tax of $10 and $6 76 0.42 172 0.95 Tax-related special items(16)(0.09)(88)(0.48)(Gain) loss from sale of business, net of tax benefit of $0 — — (1)(0.01)Adjusted net income & Adjusted earnings per share$374 $2.06 $547 $3.02 ▪"adjusted operating expenses" and "adjusted gross profit" defined as operating expenses and gross profit, respectively, adjusted to exclude restructuring and realignment costs and special charges.▪"adjusted operating income" defined as operating income, adjusted to exclude restructuring and realignment costs and special charges, and "adjusted operating margin" defined as adjusted operating income divided by total revenue.▪“EBITDA” defined as earnings before interest, taxes, depreciation and amortization expense, "EBITDA margin" defined as EBITDA divided by total revenue, "adjusted EBITDA" reflects the adjustment to EBITDA to exclude share-based compensation charges, restructuring and realignment costs, special charges and gain or loss from sale of businesses, and "adjusted EBITDA margin" defined as adjusted EBITDA divided by total revenue. (in millions)20202019Net Income$254 $401Income tax expense31 15Interest expense, net70 62Depreciation117 117Amortization134 140EBITDA$606 $735EBITDA Margin12.4 %14.0 %Share-based compensation 26 29Restructuring and realignment77 82Special charges86 178(Gain) loss from sale of business— (1)Adjusted EBITDA$795 $1,023Adjusted EBITDA Margin16.3 %19.5 %▪“realignment costs” defined as costs not included in restructuring costs that are incurred as part of actions taken to reposition our business, including items such as professional fees, severance, relocation, travel, facility set-up and other costs.▪“special charges" defined as costs incurred by the Company, such as acquisition and integration related costs, non-cash impairment charges and both operating and non-operating adjustments for pension costs.▪"tax-related special items" defined as tax items, such as tax return versus tax provision adjustments, tax exam impacts, tax law change impacts, excess tax benefits/losses and other discrete tax adjustments.▪"free cash flow" defined as net cash from operating activities, as reported in the Statement of Cash Flows, less capital expenditures. Our definition of "free cash flow" does not consider certain non-discretionary cash payments, such as debt. The following table provides a reconciliation of free cash flow. (in millions)20202019Net cash provided by operating activities$824 $839 Capital expenditures(183)(226)Free cash flow$641 $613 Net cash used in investing activities$(169)$(231)Net cash provided (used) by financing activities$473 $(177)34Executive SummaryXylem reported revenue of $4,876 million for 2020, a decrease of $373 million, or 7.1%, from $5,249 million reported in 2019. On a constant currency basis, revenue decreased by $366 million, or 7.0%, driven by an organic decline across all end markets and across all segments during the year. Organic revenue decline during the year was anticipated as our business was negatively impacted by the COVID-19 pandemic.Operating income for 2020 was $367 million, reflecting a decrease of $119 million, or 24.5%, compared to $486 million in 2019. Operating margin was 7.5% for 2020 versus 9.3% for 2019, a decrease of 180 basis points. Operating margin benefited from decreases in special charges of $78 million and decreases in restructuring and realignment costs of $5 million during the year. Excluding the impact of these items, adjusted operating income was $525 million, with an adjusted operating margin of 10.8% in 2020 as compared to adjusted operating income of $727 million with an adjusted operating margin of 13.9% in 2019, a decrease of 310 basis points. The decrease in adjusted operating margin was primarily due to unfavorable volume, impacted significantly by COVID-19; cost inflation; increased quality management costs; unfavorable mix and increased spending on strategic investments. These impacts were partially offset by cost reductions from our productivity, restructuring and other cost saving initiatives.Additional financial highlights for 2020 include the following:•Net income of $254 million, or $1.40 per diluted share ($374 million or $2.06 per diluted share on an adjusted basis, down 31.6% from 2019)•Net cash provided by operating activities of $824 million and free cash flow of $641 million, up 5% from 2019•Orders of $5,033 million, down 5.7% from $5,339 million in 2019 (down 5.3% on an organic basis), impacted by the COVID-19 pandemic; and•Dividends paid to shareholders increased 8% in 2020.2021 Business Outlook We anticipate total revenue growth in the range of 6% to 8% in 2021, with organic revenue growth anticipated to be in the range of 3% to 5%. The following is a summary of our 2020 organic revenue performance and 2021 organic revenue outlook by end market.•Utilities revenue decreased by approximately 6% for 2020 on an organic basis driven by weakness in the U.S., the Middle East and Asia Pacific, partially offset by strength in Europe. For 2021, we expect organic growth in the low-to-mid single-digit range with continued resilience on the wastewater side, as utilities remain focused on mission-critical applications and anticipate modest recovery on a global basis through the year. Additionally, we expect that large clean water utility project deployments will be ramping up beginning in the second quarter and increasing throughout the end of the year. We expect to gain momentum behind key multi-year wins setting up healthy longer term growth, however we believe the end market will continue to be impacted by the COVID-19 pandemic through the year. •Industrial revenue decreased by approximately 10% for 2020 on an organic basis driven by weakness across all major geographic regions. For 2021, we expect organic revenue to be relatively flat to up low-single-digits as short-cycle orders and project activity continues to pick up during the year, however activity is still likely to be limited in the near-term by COVID-19 impacts. We expect that continued softness in the segments served by our dewatering business in North America will stabilize and begin to accelerate through the year.•In the commercial markets, organic revenue decline was approximately 6% for 2020 driven by weakness in the U.S. and the emerging markets, partially offset by strength in western Europe. For 2021, we expect organic revenue to be relatively flat to down low-single-digits. We expect replacement business in the U.S. to be modestly soft during the year, as the COVID-19 pandemic continues to impact market conditions. While we anticipate healthy activity in Europe as the region continues to recover, we expect new construction activity in North America to be slow throughout the first half of the year.•In residential markets, organic revenue decline was approximately 2% in 2020 driven by weakness in the U.S. and western Europe, partially offset by strength in Asia Pacific. This market is primarily driven by replacement revenue serviced through our distribution network. For 2021, we expect organic revenue to be up low-to-mid single digits, driven by healthy demand activity from increased residential users in the U.S. 35and Europe. Additionally, we anticipate strong demand in China for secondary water supply product applications.We will continue to strategically execute restructuring and realignment actions in an effort to optimize our cost structure, improve our operational efficiency and effectiveness, strengthen our competitive positioning and better serve our customers. During 2020, we incurred $54 million and $23 million in restructuring and realignment costs, respectively. We realized approximately $25 million of incremental net savings in 2020 from actions initiated in 2019, and an additional $22 million of net savings from our 2020 actions. As a result of our 2019 and 2020 actions we expect to realize approximately $46 million of incremental net savings in 2021 and beyond. During 2021, we currently expect to incur between $50 million and $60 million in restructuring and realignment costs.We plan to continue to take actions and focus spending in 2021 on actions that allow us to make progress on our top strategic priorities. These priorities include (1) driving customer success by focusing on enhancing the customer experience, accelerating the digital transformation of water and building a leadership position in services and solutions; (2) growing in the Emerging Markets by investing in localizing our capabilities in these regions; (3) strengthening innovation and technology by creating new customer offerings that help solve water challenges in a more powerful way; (4) enhancing operational excellence by building a culture of continuous improvement; and (5) cultivating leadership talent and development that drives shareholder value creation. 36Results of Operations (in millions)202020192020 v. 2019Revenue$4,876 $5,249 (7.1)%Gross profit1,830 2,046 (10.6)%Gross margin37.5 %39.0 %(150)bpRestructuring and realignment costs6 5 20.0 %Adjusted gross profit1,836 2,051 (10.5)%Adjusted gross margin37.7 %39.1 %(140)bpTotal operating expenses1,463 1,560 (6.2)%Expense to revenue ratio30.0 %29.7 %30 bpRestructuring and realignment costs(71)(77)(7.8)%Special charges(81)(159)(49.1)%Adjusted operating expenses1,311 1,324 (1.0)%Adjusted operating expenses to revenue ratio26.9 %25.2 %170 bpOperating income367 486 (24.5)%Operating margin7.5 %9.3 %(180)bpInterest and other non-operating expense, net82 71 15.5 %Gain (loss) from sale of business— 1 NMIncome tax expense31 15 106.7 %Tax rate10.9 %3.7 %720 bpNet income$254 $401 (36.7)%NM Not Meaningful2020 versus 2019 RevenueRevenue generated for 2020 was $4,876 million, a decrease of $373 million, or 7.1%, compared to $5,249 million in 2019. On a constant currency basis, revenue declined 7.0% during 2020. The decrease at constant currency was driven by a decline in organic revenue of $364 million reflecting significantly lower volumes in the U.S., primarily, as well as the Middle East, India and Latin America, largely due to COVID-19, partially offset by growth in Europe and China during the year.The following table illustrates the impact from organic declines, recent acquisitions and divestitures, and foreign currency translation in relation to revenue during 2020:Water InfrastructureApplied WaterMeasurement & Control SolutionsTotal Xylem(in millions)$ Change% Change$ Change% Change$ Change% Change$ Change% Change2019 Revenue$2,177 $1,541 $1,531 $5,249 Organic Impact(89)(4.1)%(108)(7.0)%(167)(10.9)%(364)(6.9)%Acquisitions/(Divestitures)— — %— — %(2)(0.1)%(2)— %Constant Currency(89)(4.1)%(108)(7.0)%(169)(11.0)%(366)(7.0)%Foreign currency translation (a)(9)(0.4)%1 0.1 %1 0.1 %(7)(0.1)%Total change in revenue(98)(4.5)%(107)(6.9)%(168)(11.0)%(373)(7.1)%2020 Revenue$2,079 $1,434 $1,363 $4,876 (a)Foreign currency translation impact for the year primarily due to the weakening in value of various currencies against the U.S. Dollar, the largest being the Russian Ruble, the Norwegian Krone, the Brazilian Real, the South African Rand and the Chilean Peso. These impacts were partially offset by the strengthening of the Euro during the year.37Water InfrastructureWater Infrastructure revenue decreased $98 million, or 4.5%, to $2,079 million in 2020 (4.1% decrease on a constant currency basis) compared to 2019. Revenue was negatively impacted by $9 million of foreign currency translation, with the change at constant currency coming entirely from an organic decline during the year of $89 million. Organic weakness during the year was primarily driven by the industrial end market, particularly in North America and the emerging markets, heavily impacted by the COVID-19 pandemic during the year. Organic revenue decline during the year was also impacted by weakness, to a lesser extent, in the utility end market, particularly in the U.S., partially offset by organic growth in Europe during the year. The COVID-19 pandemic negatively impacted organic growth during the year throughout the entire segment and both end markets.From an application perspective, the organic revenue decline for the year was driven by our transport application, where market conditions continued to soften in the U.S. in the dewatering applications, with construction, mining, oil and gas all down during the year. We also saw organic revenue decline in Asia Pacific within the transport application, primarily in India, where we lapped some large projects executed in the prior year, as well as in Latin America. These declines were partially offset by organic growth in Europe during the year, where demand for essential service work increased during the fourth quarter. Organic revenue declines within the transport application were partially offset by modest organic growth in the treatment application during the year, primarily driven by projects in the emerging markets.Applied WaterApplied Water revenue decreased $107 million, or 6.9%, in 2020 (7.0% decrease on a constant currency basis) compared to 2019. Revenue benefited from $1 million of foreign currency translation, with the change at constant currency coming entirely from an organic decline during the year of $108 million. Organic weakness during the year was driven by declines across all end markets and applications, with industrial water and commercial building services declining the most, followed by a modest decline in building services in the residential market as well. Organic revenue declines in the segment were driven by the COVID-19 pandemic, where restricted activities caused a slow down and general softening in markets served, particularly in the U.S., the emerging markets and western Europe.Measurement & Control SolutionsMeasurement & Control Solutions revenue decreased $168 million, or 11.0%, in 2020 (11.0% decrease on a constant currency basis) compared to 2019. Revenue benefited from $1 million of foreign currency translation during the year, with the change at constant currency driven by an organic decline of $167 million, or 10.9%, and to a lesser extent, $2 million of reduced revenue related to divestiture impacts during the year. Organic weakness during the year was driven by declines in the utility end market, primarily in the U.S., the Middle East and India, marginally offset by organic growth in western Europe during the year. Organic declines were also driven, to a lesser extent, by weakness in the industrial end market, primarily in western Europe, North America, and the Middle East. Organic revenue declines in the segment were significantly impacted by project timing and the COVID-19 pandemic during the year.From an application perspective, the organic revenue decline was primarily driven by the water application, where we lapped large prior year project deployments in the U.S. and Middle East and the COVID-19 pandemic drove project delays, primarily due to site-access restrictions, and overall market softness in the U.S. The energy application also had a decline in organic revenue as compared to the prior year, primarily in the U.S. as we lapped a few large gas project deployments and have been negatively impacted by the COVID-19 pandemic. The test application also experienced organic revenue decline during the year driven by negative impacts from the COVID-19 pandemic across most major geographic regions, and the lapping of a couple large prior year project executions in the Middle East. The software as a service ("SaaS") application had a modest decline in revenue as compared to the prior year, primarily in the U.S.38Orders/BacklogAn order represents a legally enforceable, written document that includes the scope of work or services to be performed or equipment to be supplied to a customer, the corresponding price and the expected delivery date for the applicable products or services to be provided. An order often takes the form of a customer purchase order or a signed quote from a Xylem business. Orders received during 2020 decreased by $306 million, or 5.7%, to $5,033 million (5.4% decrease on a constant currency basis). Order intake during the year was negatively impacted by $18 million of foreign currency translation. The order decline on a constant currency basis primarily consisted of organic order declines of $284 million, or 5.3%, over the prior year. The following table illustrates the impact from organic declines, recent acquisitions and divestitures, and foreign currency translation in relation to orders during 2020:Water InfrastructureApplied WaterMeasurement & Control SolutionsTotal Xylem(in millions)$ Change% Change$ Change% Change$ Change% Change$ Change% Change2019 Orders$2,234 $1,556 $1,549 $5,339 Organic Impact(80)(3.6)%(73)(4.7)%(131)(8.5)%(284)(5.3)%Acquisitions/(Divestitures)— — %— — %(4)(0.3)%(4)(0.1)%Constant Currency(80)(3.6)%(73)(4.7)%(135)(8.7)%(288)(5.4)%Foreign currency translation (a)(20)(0.9)%— — %2 0.1 %(18)(0.3)%Total change in orders(100)(4.5)%(73)(4.7)%(133)(8.6)%(306)(5.7)%2020 Orders$2,134 $1,483 $1,416 $5,033 (a)Foreign currency translation impact for the year primarily due to the weakening in value of various currencies against the U.S. Dollar, the largest being the Russian Ruble, the Norwegian Krone, the Brazilian Real, the South African Rand and the Chilean Peso. These impacts were partially offset by the strengthening of the Euro during the year.Water InfrastructureWater Infrastructure segment orders decreased $100 million, or 4.5%, to $2,134 million (3.6% decrease on a constant currency basis). Order intake during the year was negatively impacted by $20 million of foreign currency translation, with the change at constant currency coming from organic order decline in the transport application, which was partially offset by growth in the treatment application during the year. The transport application experienced an organic order decline during the year, primarily driven by market weakness in construction, mining, and oil and gas impacting the dewatering application in North America, along with the lapping of a large project order in India in the prior year. Organic growth in the treatment application was primarily driven by strong order intake in North America. The COVID-19 pandemic also negatively impacted organic order growth for the segment during the year.Applied WaterApplied Water segment orders decreased $73 million to $1,483 million, or 4.7%, as compared to the prior year and was not significantly impacted by foreign currency translation during the year. The order decrease was primarily driven by organic weakness across all end markets, primarily in the U.S. and, to a lesser extent, in the emerging markets and western Europe. The organic order growth for the segment during the year was negatively impacted by the COVID-19 pandemic.Measurement & Control SolutionsMeasurement & Control Solutions segment orders decreased $133 million, or 8.6%, to $1,416 million (8.7% decrease on a constant currency basis). Order intake during the year benefited from $2 million of foreign currency translation, with the change at constant currency driven by an organic decline of $131 million and, to a lesser extent, a $4 million reduction in orders related to divestiture impacts during the year. Organic weakness during the year was driven by the water application, where we lapped prior year project orders and, to a lesser extent, the energy application, where prior year gas project deployments more than offset strong electric order intake during the year. The SaaS application also contributed to the organic decline during the year, driven by the lapping of large project orders in North America during the prior year. The test application also experienced a reduction in order intake during the year, primarily in the U.K and the U.S. The COVID-19 pandemic significantly impacted the organic order growth during the year. 39BacklogBacklog includes orders on hand as well as contractual customer agreements at the end of the period. Delivery schedules vary from customer to customer based on their requirements. Annual or multi-year contracts are subject to rescheduling and cancellation by customers due to the long-term nature of the contracts. As such, beginning total backlog, plus orders, minus revenues, will not equal ending total backlog due to contract adjustments, foreign currency fluctuations, and other factors. Typically, large projects require longer lead production cycles and deployment schedules and delays can occur from time to time. Total backlog was $2,124 million at December 31, 2020 and $1,801 million at December 31, 2019, an increase of 17.9%. We anticipate that approximately 55% of our total backlog at December 31, 2020 will be recognized as revenue during 2021.Gross MarginGross margin as a percentage of consolidated revenue decreased 150 basis points to 37.5% in 2020 as compared to 39.0% in 2019. The gross margin decrease for the year was primarily driven by cost inflation, increased quality management costs, unfavorable mix, unfavorable volume, impacted by COVID-19, and other lesser impacts, which were partially offset by cost reductions from our global procurement and productivity improvement initiatives and price realization.Operating Expenses(in millions)20202019ChangeSelling, general and administrative expenses ("SG&A")$1,143 $1,158 (1.3)%SG&A as a % of revenue23.4 %22.1 %130 bpResearch and development expenses ("R&D")187 191 (2.1)%R&D as a % of revenue3.8 %3.6 %20 bpRestructuring and asset impairment charges75 63 19.0 %Goodwill impairment charge58 148 (60.8)%Operating expenses$1,463 $1,560 (6.2)%Expense to revenue ratio30.0 %29.7 %30 bpSelling, General and Administrative ("SG&A") ExpensesSG&A expenses decreased by $15 million (decrease of 1.3%) to 23.4% of revenue in 2020, as compared to 22.1% of revenue in 2019. The increase in SG&A as a percent of revenue for the year was primarily driven by the drop in revenue, which was significantly driven by impacts of the COVID-19 pandemic, as well as cost inflation and additional investment in strategic growth initiatives. Cost reductions from our productivity, restructuring and other cost saving initiatives partially offset these items.Research and Development ("R&D") ExpensesR&D expense was $187 million, or 3.8% of revenue, in 2020 as compared to $191 million, or 3.6% of revenue, in 2019. The increase in R&D as a percent of revenue for year was primarily driven by the Company's continued focus on strategic investments during the year, while revenue was negatively impacted by the COVID-19 pandemic.Restructuring and Asset Impairment Charges RestructuringIn response to the changes in business and economic conditions arising as a result of the COVID-19 pandemic, on June 2, 2020 management committed to a restructuring plan that includes actions across our businesses and functions globally. The plan is designed to support our long-term financial resilience and simplify our operations, strengthen our competitive positioning and better serve our customers. As a result of this action, during 2020, we recognized restructuring charges of $20 million, $4 million and $30 million in our Water Infrastructure, Applied Water and Measurement & Control Solutions segments, respectively. These charges included reduction of headcount across all segments and asset impairments within our Measurement & Control Solutions segment. Immaterial restructuring charges incurred during the first quarter are included in the plan information presented below.During 2019, we recognized restructuring costs of $20 million, $5 million and $28 million in our Water Infrastructure, Applied Water and Measurement & Control Solutions, respectively. These charges were incurred primarily as a continuation of our efforts to reposition our European and North American businesses to optimize our cost structure 40and improve our operational efficiency and effectiveness. The charges included the reduction of headcount and consolidation of facilities within our Measurement & Control Solutions and Water Infrastructure segments, as well as headcount reductions within our Applied Water segment.The following is a roll-forward of employee position eliminations associated with restructuring activities for the years ended December 31, 2020 and 2019:20202019Planned reductions - January 1196 69 Additional planned reductions811 674 Actual reductions and reversals(688)(547)Planned reductions - December 31319 196 The following table presents expected restructuring spend in 2020 and thereafter: (in millions)Water InfrastructureApplied WaterMeasurement & Control SolutionsCorporateTotalActions Commenced in 2020:Total expected costs$26 $11 $34 $2 $73 Costs incurred during 202019 4 30 — 53 Total expected costs remaining$7 $7 $4 $2 $20 Actions Commenced in 2019:Total expected costs$19 $5 $27 $— $51 Costs incurred during 201918 5 27 — 50 Costs incurred during 20201 — — — 1 Total expected costs remaining$— $— $— $— $— The Water Infrastructure, Applied Water, and Measurement & Control Solutions actions commenced in 2020 consist primarily of severance charges in each of the segments and asset impairment charges in our Measurement & Control Solutions segment. These actions are expected to continue through 2021. The Water Infrastructure, Applied Water, and Measurement & Control Solutions actions commenced in 2019 consist primarily of severance charges. The actions commenced in 2019 are complete.During the second quarter of 2020 the discontinuance of a product line resulted in $17 million of asset impairments, primarily related to customer relationships, trademarks and fixed assets within our Measurement & Control Solutions segment.These restructuring charges are primarily related to actions taken in response to the changes in business and economic conditions arising as a result of the COVID-19 pandemic. As a result of the actions initiated in 2020, we achieved savings of approximately $22 million in 2020 and estimate annual future net savings beginning in 2021 of approximately $63 million, resulting in $41 million of incremental savings from 2020 actions Asset Impairment During the second and third quarters of 2020, we determined that certain assets within our Measurement & Control Solutions segment, including software, proprietary technology, and internally developed in-process software, were impaired. Accordingly we recognized impairment charges of $21 million during the year. Refer to Note 12, "Goodwill and Other Intangible Assets," for additional information.During the first and third quarters of 2019, we determined that certain assets within our Measurement & Control Solutions segment, including customer relationships, internally developed software, proprietary technology, and plant property & equipment, were impaired. Accordingly we recognized impairment charges of $10 million during the year. Refer to Note 12, "Goodwill and Other Intangible Assets," for additional information.Goodwill Impairment ChargeDuring the third quarter of 2020, the Company recorded a goodwill impairment charge of $58 million related to the AIA goodwill reporting unit within our Measurement & Control Solutions segment. The AIA goodwill reporting unit is 41comprised of our assessment services business (primarily the Pure acquisition) as well as our digital solutions business. The impairment resulted from management's updated forecast of future cash flows for the AIA businesses, which reflects significant negative volume impacts, primarily on our assessment services business, due to travel restrictions and site closures as a result of the COVID-19 pandemic. Our ongoing investment in the AIA businesses also continues to impact near-term profitability. These factors drove a decrease in the fair value, based on a discounted cash flow valuation, of the AIA goodwill reporting unit that is below its carrying value as of the third quarter, requiring an impairment charge. Refer to Note 12, "Goodwill and Other Intangible Assets," for additional information.During the third quarter of 2019, the Company recorded a goodwill impairment charge of $148 million related to the AIA goodwill reporting unit. The impairment resulted from a downward revision of forecasted future cash flows. Factors that contributed to the revised forecast in the third quarter of 2019 included lower-than-expected results as compared to prior forecasts, largely as a result of slower-than-expected conversion of pipeline opportunities to revenue. Additionally, we have continued to invest in the AIA platform ahead of the adoption curve, which has also impacted the near-term profitability of the business. These factors drove a decrease in the fair value, based on a discounted cash flow valuation, of the AIA goodwill reporting unit that was below its carrying value as of July 1, 2019, requiring an impairment charge. Refer to Note 12, "Goodwill and Other Intangible Assets," for additional information.Operating IncomeOperating income was $367 million (operating margin of 7.5%) during 2020, a decrease of $119 million, or 24.5%, when compared to operating income of $486 million (operating margin of 9.3%) during the prior year. Operating margin benefited from decreases in special charges of $78 million and decreases in restructuring and realignment costs of $5 million as compared to the prior year. Excluding these special charges and restructuring and realignment costs, adjusted operating income was $525 million (adjusted operating margin of 10.8%) for 2020 as compared to adjusted operating income of $727 million (adjusted operating margin of 13.9%) during the prior year. The decrease in adjusted operating margin was primarily due to unfavorable volume, impacted significantly by COVID-19; cost inflation; increased quality management costs; unfavorable mix and increased spending on strategic investments. These impacts were partially offset by cost reductions from our productivity, restructuring and other cost saving initiatives.42The table below provides a reconciliation of total and each segment's operating income to adjusted operating income, and a calculation of the corresponding adjusted operating margin:(In millions)20202019ChangeWater InfrastructureOperating income$318 $365 (12.9)%Operating margin15.3 %16.8 %(150)bpRestructuring and realignment costs28 31 (9.7)%Adjusted operating income$346 $396 (12.6)%Adjusted operating margin16.6 %18.2 %(160)bpApplied WaterOperating income$205 $241 (14.9)%Operating margin14.3 %15.6 %(130)bpRestructuring and realignment costs9 13 (30.8)%Adjusted operating income$214 $254 (15.7)%Adjusted operating margin14.9 %16.5 %(160)bpMeasurement & Control SolutionsOperating loss$(106)$(67)58.2 %Operating margin(7.8)%(4.4)%(340)bpRestructuring and realignment costs40 38 5.3 %Special charges79 159 (50.3)%Adjusted operating income$13 $130 (90.0)%Adjusted operating margin1.0 %8.5 %(750)bpCorporate and otherOperating loss$(50)$(53)(5.7)%Special charges2 — NMAdjusted operating loss$(48)$(53)(9.4)%Total XylemOperating income$367 $486 (24.5)%Operating margin7.5 %9.3 %(180)bpRestructuring and realignment costs77 82 (6.1)%Special charges81 159 (49.1)%Adjusted operating income$525 $727 (27.8)%Adjusted operating margin10.8 %13.9 %(310)bpNM Not Meaningful 43Water InfrastructureOperating income for our Water Infrastructure segment decreased $47 million, or 12.9%, during 2020 as compared to the prior year, with operating margin also decreasing from 16.8% to 15.3%. Operating margin benefited from a decrease in restructuring and realignment costs of $3 million in 2020. Excluding these restructuring and realignment costs, adjusted operating income decreased $50 million, or 12.6%, with adjusted operating margin decreasing from 18.2% to 16.6%. The decrease in adjusted operating margin during the year was primarily due to cost inflation; unfavorable volume, impacted significantly by COVID-19; unfavorable mix; increased inventory management costs; increased spending on strategic investments and increased customer related reserves. These impacts were partially offset by cost reductions from our productivity and other cost saving initiatives and price realization.Applied WaterOperating income for our Applied Water segment decreased $36 million, or 14.9%, during 2020 as compared to the prior year, with operating margin also decreasing from 15.6% to 14.3%. Operating margin benefited from a decrease in restructuring and realignment costs of $4 million in 2020. Excluding these restructuring and realignment costs, adjusted operating income decreased $40 million, or 15.7%, with adjusted operating margin decreasing from 16.5% to 14.9%. The decrease in adjusted operating margin during the year was primarily due to cost inflation; unfavorable volume, impacted significantly by COVID-19; increased inventory management costs and other lesser impacts. These impacts were partially offset by cost reductions from our productivity and other cost saving initiatives and price realization.Measurement & Control SolutionsOperating loss for our Measurement & Control Solutions segment increased $39 million, or 58.2%, during 2020 as compared to the prior year, resulting in an operating loss of $106 million, with operating margin decreasing from (4.4)% to (7.8)%. Operating margin benefited from a decrease in special charges of $80 million, which was slightly offset by increased restructuring and realignment costs of $2 million in 2020. Excluding these items, adjusted operating income decreased $117 million, or 90.0%, with adjusted operating margin decreasing from 8.5% to 1.0%. The decrease in adjusted operating margin during the year was driven by unfavorable volume, impacted significantly by COVID-19 related site-access restrictions and customer project delays; cost inflation; unfavorable mix, increased quality management costs, primarily due to warranty charges recorded during the the year; increased spending on strategic investments and other lesser impacts. These impacts were partially offset by cost reductions from our productivity and other cost saving initiatives and price realization.Corporate and otherOperating loss for corporate and other decreased $3 million, or 5.7%, compared to the prior year. The decrease in costs are the result of cost saving actions taken during the year.Interest ExpenseInterest expense was $77 million and $67 million for 2020 and 2019, respectively. The increase in interest expense for both periods is primarily driven by the issuance of our Green Bond (as defined in "Funding and Liquidity Strategy") during the second quarter of 2020. See Note 15, "Credit Facilities and Debt", of our consolidated financial statements for a description of our credit facilities and long-term debt and related interest. Income Tax ExpenseThe income tax provision for 2020 was $31 million at an effective tax rate of 10.9% as compared to $15 million at an effective tax rate of 3.7% in 2019. The 2020 effective tax rate differs from that of 2019 primarily due to the impact of the changes in tax law in Switzerland in 2019 along with the impact of the larger goodwill impairment charge on income before taxes in 2019 as well as a reduction in the amount of unrecognized tax benefits recorded in 2020.44Liquidity and Capital ResourcesThe following table summarizes our sources and uses of cash:Year Ended December 31,(in millions)20202019ChangeOperating activities$824 $839 $(15)Investing activities(169)(231)62 Financing activities473 (177)650 Foreign exchange (a)23 (3)26 Total$1,151 $428 $723 (a)2020 impact is primarily due to the strengthening of the Euro, the Chinese Yuan and various other currencies against the U.S. Dollar. Sources and Uses of LiquidityOperating ActivitiesDuring 2020, net cash provided by operating activities was $824 million, compared to $839 million in 2019. The $15 million year-over-year decrease was primarily driven by a decrease in cash from earnings, partially offset by deferred payments, lower income tax payments, and improved working capital management. Investing ActivitiesCash used in investing activities was $169 million in 2020, compared to $231 million in 2019. This decrease in cash used of $62 million was mainly driven by lower spending on capital expenditures compared to the prior year and a reduction in cash paid for acquisitions.Financing ActivitiesCash generated by financing activities was $473 million in 2020, compared to cash used of $177 million in 2019. The net increase in cash generated by financing activities during the year was primarily driven by the issuance of our Green Bond (as defined in "Funding and Liquidity Strategy") and higher levels of short-term debt during the year, partially offset by the repayment of short-term debt during 2020 and an increase in share repurchase activity of $21 million. Funding and Liquidity StrategyOur ability to fund our capital needs depends on our ongoing ability to generate cash from operations and access to bank financing and the capital markets. As a result of uncertainties caused by the COVID-19 pandemic, we continually evaluated aspects of our spending, including capital expenditures, strategic investments and dividends throughout 2020. Additionally, we committed to reducing our annual capital expenditures during the year. We will continue to evaluate aspects of our spending in 2021 and anticipate our capital expenditures will gradually begin to increase to normal levels during the year as the markets we operate in recover. In 2020, we elected to utilize certain federal, state and foreign tax programs related to timing of tax payments and deductions to further manage our liquidity, and the liabilities associated with these programs are appropriately classified in the applicable "Accrued and other current liabilities" or "Other non-current accrued liabilities" accounts in our Consolidated Balance Sheets. Historically, we have generated operating cash flow sufficient to fund our primary cash needs. As the uncertainty and severity associated with the global spread of the COVID-19 pandemic continued to grow throughout 2020, Xylem issued Senior Notes of $1 billion in aggregate principal ("Green Bond") on June 26, 2020. The primary long-term intention of incurring this debt is to fund green projects across our business segments, as well as manage liquidity risk and increase flexibility, as the duration of the economic effects of the pandemic are uncertain. See Note 15, "Credit Facilities and Debt", of our consolidated financial statements for a description of our credit facilities and long-term debt. Xylem's liquidity position has continued to evolve favorably during 2020, and we will continue to monitor the economic effects of the COVID-19 pandemic and its impact on the Company's future operating cash flows going forward. If our cash flows from operations are less than we expect, we may need to incur debt or issue equity. From time to time, we may need to access the long-term and short-term capital markets to obtain financing. Our access to, and the availability of, financing on acceptable terms and conditions in the future will be impacted by many factors, including: (i) our credit ratings or absence of a credit rating, (ii) the liquidity of the overall capital markets, and (iii) the current state of the economy. There can be no assurance that such financing will be available to us on acceptable terms or that such financing will be available at all. Our securities are rated investment grade. A 45significant change in credit rating could impact our ability to borrow at favorable rates. Refer to Note 15, "Credit Facilities and Debt", of our consolidated financial statements for a description of limitations on obtaining additional funding. We monitor our global funding requirements and seek to meet our liquidity needs on a cost-effective basis. As of December 31, 2020, the COVID-19 pandemic has not materially impacted our borrowing costs or other costs of capital, however the future impact of the COVID-19 pandemic is uncertain and may increase our borrowing costs and other costs of capital and otherwise adversely affect our business, results of operations, financial condition and liquidity.We have considered the impacts of the COVID-19 pandemic on our liquidity and capital resources and do not currently expect it to impact our ability to meet future liquidity needs or continue to comply with debt covenants. To provide for continued access to the full capacity of our credit facilities going forward, Xylem entered into Amendment No. 1 to the 2019 Credit Facility (as defined in Note 15, "Credit Facilities and Debt") on June 22, 2020 which modified the covenant calculation methodology through the quarter ending September 30, 2021 and restricts stock repurchases until March 31, 2021, except for shares of common stock in an amount not to exceed the number of shares issued after the date of the Amendment, subject to customary exceptions. See Note 15, "Credit Facilities and Debt", of our consolidated financial statements for a description of our credit facilities and long-term debt.Based on our current global cash positions, cash flows from operations and access to the capital markets, we believe there is sufficient liquidity to meet our funding requirements and service debt and other obligations in both the U.S. and outside of the U.S. over the next 12 months. In addition, we believe our existing committed credit facilities and access to the public debt markets would provide further liquidity if required. Currently, we have available liquidity of approximately $2.7 billion, consisting of $1.9 billion of cash and $800 million of available credit facilities as disclosed in Note 15, "Credit Facilities and Debt", of our consolidated financial statements. Our debt repayment obligations in 2021 consist of $600 million in Senior Notes which we expect to pay out of cash. Our next long-term debt maturity is March 2023.Risk related to these items are described in our risk factor disclosures referenced under “Item 1A. Risk Factors".Credit Facilities & Long-Term Contractual Commitments See Note 15, "Credit Facilities and Debt" of our consolidated financial statements for a description of our credit facilities and long-term debt. Non-U.S. OperationsFor 2020 and 2019, we generated 53% and 51% of our revenue from non-U.S. operations, respectively. As we continue to grow our operations in the emerging markets and elsewhere outside of the U.S., we expect to continue to generate significant revenue from non-U.S. operations and expect that a substantial portion of our cash will be predominately held by our foreign subsidiaries. We expect to manage our worldwide cash requirements considering available funds among the many subsidiaries through which we conduct business and the cost effectiveness with which those funds can be accessed. We may transfer cash from certain international subsidiaries to the U.S. and other international subsidiaries when we believe it is cost-effective to do so. We continually review our domestic and foreign cash profile, expected future cash generation and investment opportunities and reassess whether there is a need to repatriate funds held internationally to support our U.S. operations. As of December 31, 2020, we have provided a deferred tax liability of $7 million for net foreign withholding taxes and state income taxes on $500 million of earnings expected to be repatriated to the U.S. parent as deemed necessary in the future. 46Contractual ObligationsThe following table summarizes our contractual commitments as of December 31, 2020:(in millions)20212021 - 20222023 - 2024ThereafterTotalDebt obligations (1)$600 $612 $— $1,900 $3,112 Interest payments (1) (2)98 137 110 459 804 Lease obligations (3)69 97 57 79 302 Purchase obligations (4)106 — — — 106 Other long-term obligations reflected on the balance sheet2 32 20 13 67 Total commitments$875 $878 $187 $2,451 $4,391 In addition to the amounts presented in the table above, we have recorded liabilities for net investment hedges of $117 million and employee severance indemnities of $17 million. These amounts have been excluded from the contractual obligations table due to an inability to reasonably estimate the timing or amounts of such payments in individual years. Further, benefit payments which reflect expected future service related to the Company's pension and other post-retirement employee benefit obligations are presented in Note 16, “Post-retirement Benefit Plans” of the consolidated financial statements and deferred income tax liabilities and uncertain tax positions are presented in Note 7, "Income Taxes" of the consolidated financial statements, and as such, these obligations are not included in the above table. Finally, estimated environmental payments and workers' compensation and general liability reserves are excluded from the table above. We estimate, based on historical experience, that we will spend approximately $1 million to $2 million per year on environmental investigation and remediation and approximately $5 million to $6 million per year on workers' compensation and general liability. At December 31, 2020, we had estimated and accrued $3 million and $20 million related to environmental matters, and workers' compensation and general liability, respectively. (1)Refer to Note 15, “Credit Facilities and Debt,” of the consolidated financial statements for discussion of the use and availability of debt and revolving credit agreements. Amounts represent principal payments of short-term and long-term debt including current maturities and exclude unamortized discounts. (2)Amounts represent estimates of future interest payments on short-term and long-term debt outstanding as of December 31, 2020.(3)Refer to Note 11, "Leases" of the consolidated financial statements for further lease discussion.(4)Represents unconditional purchase agreements that are enforceable and legally binding and that specify all significant terms to purchase goods or services, including fixed or minimum quantities to be purchased; fixed, minimum or variable price provisions; and the approximate timing of the transaction. Purchase agreements that are able to cancel without penalty have been excluded.Off-Balance Sheet ArrangementsAs of December 31, 2020, we have issued guarantees for the debt and other obligations of consolidated subsidiaries in the normal course of business. We have determined that none of these arrangements has a material current effect or is reasonably likely to have a material future effect on our consolidated financial statements, financial condition, changes in financial condition, revenues or expenses, liquidity, capital expenditures or capital resources. We obtain certain stand-by letters of credit, bank guarantees and surety bonds from third-party financial institutions in the ordinary course of business when required under contracts or to satisfy insurance related requirements. As of December 31, 2020, the amount of surety bonds, bank guarantees, insurance letters of credit and stand-by letters of credit was $378 million. Critical Accounting Estimates The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue and expenses, and the disclosure of contingent liabilities. Management bases its estimates on historical experience and on various other assumptions that it believes to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources.Significant accounting policies used in the preparation of the consolidated financial statements are discussed in Note 1, “Summary of Significant Accounting Policies,” of the consolidated financial statements. Accounting estimates and assumptions discussed in this section are those that we consider most critical to an understanding of our financial statements because they are inherently uncertain, involve significant judgments, include areas where 47different estimates reasonably could have been used, and changes in the estimates that are reasonably possible could materially impact the financial statements. Management believes that the accounting estimates employed and the resulting balances are reasonable; however, actual results in these areas could differ from management’s estimates under different assumptions or conditions.Revenue Recognition. Xylem recognizes revenue in a manner that depicts the transfer of promised goods and services to customers in an amount that reflects the consideration to which it expects to be entitled for providing those goods and services. For each arrangement with a customer, we identify the contract and the associated performance obligations within the contract, determine the transaction price of that contract, allocate the transaction price to each performance obligation and recognize revenue as each performance obligation is satisfied.The satisfaction of performance obligations in a contract is based upon when the customer obtains control over the asset. Depending on the nature of the performance obligation, control transfers either at a particular point in time, or over time which determines the recognition pattern of revenue.For product sales, other than long-term construction-type contracts, we recognize revenue once control has passed at a point in time, which is generally when products are shipped. In instances where contractual terms include a provision for customer acceptance, revenue is recognized when either (i) we have previously demonstrated that the product meets the specified criteria based on either seller or customer-specified objective criteria or (ii) upon formal acceptance received from the customer where the product has not been previously demonstrated to meet customer-specified objective criteria. We recognize revenue on product sales to channel partners, including resellers, distributors or value-added solution providers, at the point in time when the risks and rewards, possession, and title have transferred to the customer, which usually occurs at the point of delivery.Revenue from performance obligations related to services is primarily recognized over time, as the performance obligations are satisfied. In these instances, the customer consumes the benefit of the service as Xylem performs.Certain businesses also enter into long-term construction-type sales contracts where revenue is recognized over time. In these instances, revenue is recognized using a measure of progress that applies an input method based on costs incurred in relation to total estimated costs. We also recognize revenue for certain of these arrangements using the output method and measure progress based on shipments of product where control has transferred to the customer.For all contracts with customers, we determine the transaction price in the arrangement and allocate the transaction price to each performance obligation identified in the contract. Judgment is required to determine the appropriate unit of account, and we separate out the performance obligations if they are capable of being distinct and are distinct within the context of the contract. The transaction price is adjusted for our estimate of variable consideration, which may include a right of return, discounts, rebates, penalties and retainage. To estimate variable consideration, we apply the expected value or the most likely amount method, based on whichever method most appropriately predicts the amount of consideration we expect to be entitled to. The method applied is typically based on historical experience and known trends. We constrain the amounts of variable consideration that are included in the transaction price, to the extent that it is probable that a significant reversal in the amount of cumulative revenue recognized will not occur or when uncertainties around the variable consideration are resolved.Income Taxes. Deferred tax assets and liabilities are determined based on temporary differences between the financial reporting and tax bases of assets and liabilities, applying enacted tax rates in effect for the year in which we expect the differences will reverse. Based on the evaluation of available evidence, we recognize future tax benefits, such as net operating loss carryforwards, to the extent that we believe it is more likely than not we will realize these benefits. We periodically assess the likelihood that we will be able to recover our deferred tax assets and reflect any changes to our estimate of the amount we are more likely than not to realize in the valuation allowance, with a corresponding adjustment to earnings or other comprehensive income, as appropriate.In assessing the need for a valuation allowance, we look to the future reversal of existing taxable temporary differences, taxable income in carryback years and the feasibility of tax planning strategies and estimated future taxable income. The valuation allowance can be affected by changes to tax laws, changes to statutory tax rates and changes to future taxable income estimates.Due to the U.S. Tax Cuts and Jobs Act ("Tax Act"), we have recorded net foreign withholding taxes and state income taxes on earnings that are expected to be repatriated to the U.S. parent. We have not recorded any deferred taxes on the amounts that the Company currently does not intend to repatriate as the determination of any deferred taxes on this amount is not practicable. The calculation of our tax liabilities involves dealing with uncertainties in the application of complex tax regulations in a multitude of jurisdictions across our global operations. We recognize potential liabilities and record tax liabilities 48for anticipated tax audit issues in the U.S. and other tax jurisdictions based on our estimate of whether, and the extent to which, additional taxes will be due. Furthermore, we recognize the tax benefit from an uncertain tax position only if it is more likely than not that the tax position will be sustained on examination by the taxing authorities or upon completion of the litigation process, based on the technical merits of the position. The tax benefits recognized in the financial statements from such a position are measured based on the largest benefit that has a greater than 50% likelihood of being realized upon ultimate resolution.We adjust our liability for uncertain tax positions in light of changing facts and circumstances; however, due to the complexity of some of these uncertainties, the ultimate resolution may result in a payment that is materially different from our current estimate of the tax liabilities. If our estimate of tax liabilities proves to be less than the ultimate assessment, an additional tax expense would result. If a payment of these amounts ultimately proves to be less than the recorded amounts, the reversal of the liabilities would result in tax benefits being recognized in the period when we determine the liabilities are no longer necessary.Business Combinations. We record acquisitions using the purchase method of accounting. All of the assets acquired, liabilities assumed, contractual contingencies and contingent consideration is recorded at fair value as of the acquisition date. The excess of the purchase price over the estimated fair values of the net tangible and intangible assets acquired is recorded as goodwill. The application of the purchase method of accounting for business combinations requires management to make significant estimates and assumptions in the determination of the fair value of assets acquired and liabilities assumed, in order to properly allocate purchase price consideration between assets that are depreciated and amortized from goodwill. These assumptions and estimates include a market participant’s use of the asset and the appropriate discount rates for a market participant. Our estimates are based on historical experience, information obtained from the management of the acquired companies and, when appropriate, includes assistance from independent third-party appraisal firms. Significant assumptions and estimates include, but are not limited to, the cash flows that an asset is expected to generate in the future, the cost to build/recreate certain technology, the appropriate weighted-average cost of capital, and the cost savings expected to be derived from acquiring an asset. These estimates are inherently uncertain and unpredictable. In addition, unanticipated events and circumstances may occur which may affect the accuracy or validity of such estimates.Goodwill and Intangible Assets. We review goodwill and indefinite-lived intangible assets for impairment annually and whenever events or changes in circumstances indicate the carrying value of an asset may not be recoverable. We also review the carrying value of our finite-lived intangible assets for potential impairment when impairment indicators arise. We conduct our annual impairment test as of the first day of the fourth quarter. For goodwill, the estimated fair value of each reporting unit is compared to the carrying value of the net assets assigned to that reporting unit. If the estimated fair value of the reporting unit exceeds its carrying value, goodwill is not impaired. If the carrying value of the reporting unit exceeds its estimated fair value, then an impairment charge is recognized for that excess up to the amount of recorded goodwill. We estimate the fair value of our reporting units using an income approach. We estimate the fair value of our intangible assets with indefinite lives using either the income approach or the market approach. Under the income approach, we calculate fair value based on the present value of estimated future cash flows. Under the market approach, we calculate fair value based on recent sales and selling prices of similar assets. Determining the fair value of a reporting unit or an indefinite-lived intangible asset is judgmental in nature and involves the use of significant estimates and assumptions, particularly related to future operating results and cash flows. These estimates and assumptions include, but are not limited to, revenue growth rates and operating margins used to calculate projected future cash flows, risk-adjusted discount rates, assumed royalty rates, future economic and market conditions and identification of appropriate market comparable data. In addition, the identification of reporting units and the allocation of assets and liabilities to the reporting units when determining the carrying value of each reporting unit also require judgment. Goodwill is tested for impairment at either the operating segment identified in Note 22, “Segment and Geographic Data,” of the consolidated financial statements, or one level below. The fair value of our reporting units and indefinite-lived intangible assets is based on estimates and assumptions that are believed to be reasonable. Significant changes to these estimates and assumptions could adversely impact our conclusions. Actual future results may differ from those estimates.In the third quarter of 2020, management updated forecasts of future cash flows for the AIA businesses, which reflect significant negative volume impacts from the COVID-19 pandemic, primarily on our assessment services business. Our ongoing investment in the AIA businesses also continues to impact near term profitability. Based on these factors we determined that there were indicators that the AIA reporting unit’s goodwill may be impaired, and accordingly, we performed an interim goodwill impairment test as of July 1, 2020. The results of the impairment test showed that the fair value of the AIA reporting unit was lower than the carrying value, resulting in a $58 million 49goodwill impairment charge. As of December 31, 2020 the remaining goodwill balance in our AIA reporting unit after recording the goodwill impairment charge was $113 million.Also, during the third quarter of 2020, due to the factors discussed above, we assessed whether the carrying amounts of the AIA reporting unit’s long-lived assets may not be recoverable and therefore impaired. Our assessment resulted in an impairment charge of $11 million, primarily related to software and proprietary technology. The charge was calculated using an income approach.The uncertainty of the future impact of the COVID-19 pandemic may also contribute to further deterioration of our future cash flows. If we do not achieve our forecasts it is possible that the goodwill of the AIA reporting unit could be deemed to be impaired again in a future period. The risks and potential impacts of COVID-19 on the fair value of our assets are included in our risk factor disclosures referenced under “Item 1A. Risk Factors".During the fourth quarter of 2020, we performed our annual impairment assessment and determined that the estimated fair values of our goodwill reporting units were substantially in excess of each of their carrying values. However, future goodwill impairment tests could result in a charge to earnings. We will continue to evaluate goodwill on an annual basis as of the beginning of our fourth quarter and whenever events and changes in circumstances require us to do so. We determined that no impairment of the indefinite-lived intangibles existed as of the measurement date in 2020. However, future indefinite-lived intangible impairment tests could result in a charge to earnings. We will continue to evaluate indefinite-lived intangibles on an annual basis as of the beginning of our fourth quarter and whenever events and changes in circumstances indicate there may be a potential impairment. Post-retirement Benefit Plans. Company employees around the world participate in numerous defined benefit plans. The determination of projected benefit obligations and the recognition of expenses related to these plans are dependent on various assumptions. These major assumptions primarily relate to discount rates, expected long-term rates of return on plan assets, rate of future compensation increases, mortality, years of service and other factors (some of which are disclosed in Note 16, “Post-retirement Benefit Plans,” of the consolidated financial statements). Actual results that differ from our assumptions are accumulated and amortized on a straight-line basis only to the extent they exceed 10% of the higher of the market-related value or projected benefit obligation, over the average remaining service period of active plan participants, or for plans with all or substantially all inactive participants, over the average remaining life expectancy.Significant AssumptionsManagement develops each assumption using relevant Company experience, in conjunction with market-related data for each individual country in which such plans exist. All assumptions are reviewed annually with third-party consultants and are adjusted as necessary. The table included below provides the weighted average assumptions used to estimate our defined benefit pension obligations and costs as of and for the years ended 2020 and 2019. 20202019 U.S.Int’lU.S.Int’lBenefit Obligation AssumptionsDiscount rate2.50 %1.06 %3.25 %1.80 %Rate of future compensation increaseNM2.79 %NM2.94 %Net Periodic Benefit Cost AssumptionsDiscount rate3.25 %1.80 %4.50 %2.60 %Expected long-term return on plan assets6.50 %2.82 %7.75 %6.96 %Rate of future compensation increaseNM2.94 %NM2.92 %NM Not meaningful. The pension benefits for future service for all the U.S. pension plans are based on years of service and not impacted by future compensation increases.We determine the expected long-term rate of return on plan assets by evaluating both historical returns and estimates of future returns. Specifically, the Company analyzes the estimated future returns based on independent estimates of asset class returns and evaluates historical broad market returns over long-term timeframes based on the strategic asset allocation, which is detailed in Note 16, “Post-retirement Benefit Plans,” of the consolidated financial statements.50Based on the approach described above, the chart below shows weighted average actual returns versus the weighted average expected long-term rates of return for our pension plans that were utilized in the calculation of the net periodic pension cost for each respective year.20202019Expected long-term rate of return on plan assets3.46 %7.09 %Actual rate of return on plan assets14.06 %12.59 %For the recognition of net periodic pension cost, the calculation of the expected return on plan assets is generally derived by applying the expected long-term rate of return to the market-related value of plan assets. The market-related value of plan assets is based on average asset values at the measurement date over the last five years. The use of fair value, rather than a calculated value, could materially affect net periodic pension cost. The weighted average expected long-term rate of return for all of our plan assets to be used in determining net periodic benefit costs for 2021 is estimated at 3.24%. We estimate that every 25 basis point change in the expected return on plan assets impacts the expense by $1 million.The discount rate reflects our expectation of the present value of expected future cash payments for benefits at the measurement date. A decrease in the discount rate increases the present value of benefit obligations and increases pension expense. We base the discount rate assumption on current investment yields of high-quality fixed income investments during the retirement benefits maturity period. The pension discount rate was determined by considering an interest rate yield curve comprising AAA/AA bonds, with maturities between zero and 30 years, developed by the plan’s actuaries. Annual benefit payments are then discounted to present value using this yield curve to develop a single-point discount rate matching the plan’s characteristics. Our weighted average discount rate for all pension plans effective January 1, 2021, is 1.21%. We estimate that every 25 basis point change in the discount rate impacts the expense by $2 million.The rate of future compensation increase assumption reflects our long-term actual experience and future and near-term outlook. Effective January 1, 2021, our expected rate of future compensation is 2.91% for all pension plans. The estimated impact of a 25 basis point change in the expected rate of future compensation is less than $1 million.The Company has initiated the process for a full buy-out of its largest defined benefit plan in the UK. Upon completion of the buy-out, expected in 2021, we expect a material settlement charge primarily consisting of unrecognized actuarial losses. We currently anticipate making contributions to our pension and post-retirement benefit plans in the range of $19 million to $27 million during 2021. We also anticipate an estimated payment of approximately $15-$17 million for the buy-out of the UK pension plan. Approximately $6 million of contributions are expected to be made in the first quarter.Funded StatusFunded status is derived by subtracting the respective year-end values of the projected benefit obligations from the fair value of plan assets. We estimate that every 25 basis point change in the discount rate impacts the funded status by approximately $42 million.Fair Value of Plan AssetsThe plan assets of our pension plans comprise a broad range of investments, including domestic and foreign equity securities, interests in hedge funds, fixed income investments, insurance contracts, and cash and cash equivalents.A portion of our pension benefit plan assets portfolio comprises investments in hedge funds which are generally measured at net asset value. However, in certain instances, the values reported by the asset managers were not current at the measurement date. Accordingly, we made estimate adjustments to the last reported value where necessary to measure the assets at fair value at the measurement date. These adjustments consider information received from the asset managers, as well as general market information. The adjustment recorded at December 31, 2020 and 2019 for these assets represented less than one percent of total plan assets in each respective year. Asset values for other positions were generally measured using market observable prices. We estimate that a 5% change in asset values will impact funded status by approximately $32 million.New Accounting PronouncementsSee Note 2, “Recently Issued Accounting Pronouncements,” of the consolidated financial statements for a complete discussion of recent accounting pronouncements.51ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKWe are exposed to market risk, primarily related to foreign currency exchange rates and interest rates. These exposures are actively monitored by management. Our exposure to foreign exchange rate risk is due to certain costs, revenue and borrowings being denominated in currencies other than one of our subsidiaries' functional currency. Similarly, we are exposed to market risk as a result of changes in interest rates which may affect the cost of our financing. It is our policy and practice to use derivative financial instruments only to the extent necessary to manage exposures.Foreign Currency Exchange Rate RiskWe conduct approximately 53% of our business in various locations outside the U.S.Our economic foreign currency risk primarily relates to receipts from customers, payments to suppliers and intercompany transactions denominated in foreign currencies. We may use derivative financial instruments to offset risk related to receipts from customers and payments to suppliers, when it is believed that the exposure will not be limited by our normal operating and financing activities. We enter into currency forward contracts periodically in order to manage the exchange rate fluctuation risk on certain intercompany transactions associated with third-party sales and purchases. These risks are also mitigated by natural hedges including the presence of manufacturing facilities outside the U.S., global sourcing and other spending which occurs in foreign countries. Our principal foreign currency transaction exposures primarily relate to the Euro, Swedish Krona, Polish Zloty, Canadian Dollar, British Pound and Australian Dollar. We estimate that a hypothetical 10% movement in foreign currency exchange rates would not have a material economic impact to Xylem’s financial position and results of operations.Additionally, we are subject to foreign exchange translation risk due to changes in the value of foreign currencies in relation to our reporting currency, the U.S. Dollar. The translation risk is primarily concentrated in the exchange rate between the U.S. Dollar and the Euro, Chinese Yuan, British Pound, Canadian Dollar, Australian Dollar and Swedish Krona. As the U.S. Dollar strengthens against other currencies in which we transact business, revenue and income will generally be negatively impacted, and if the U.S. Dollar weakens, revenue and income will generally be positively impacted. We expect to continue to generate significant revenue from non-U.S. operations and we expect our cash will be predominately held by our foreign subsidiaries. We expect to manage our worldwide cash requirements considering available funds among the many subsidiaries through which we conduct business and the cost effectiveness with which those funds can be accessed. We may transfer cash from certain international subsidiaries to the U.S. and other international subsidiaries when it is cost-effective to do so, though we continually review our domestic and foreign cash profile, expected future cash generation and investment opportunities and reassess whether there is a need to repatriate funds held internationally to support our U.S. operations. We also hedge our investment in certain foreign subsidiaries via the use of cross-currency swaps and the designation of our 2.25% Senior Notes of €500 million aggregate principal amount due March 2023 as a net investment hedge. Accordingly, we estimate that a 10% movement of the U.S. Dollar to various foreign currency exchange rates we translate from, in aggregate would not have a material economic impact on our financial position and results of operations.Interest Rate RiskAs of December 31, 2020, our long-term debt portfolio is primarily comprised of five series of fixed-rate senior notes that total approximately $2.5 billion. The senior notes are not exposed to interest rate risk as the bonds are at a fixed rate until maturity. Based on the current interest rate market we do not anticipate material risk associated with our debt refinancing within the target time frame of maturity. Commodity Price ExposuresFor a discussion of risks relating to commodity prices, refer to “Item 1A. Risk Factors.”52
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+ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSManagement's discussion and analysis of financial condition and results of operations is provided as a supplement to, and should be read in conjunction with, our consolidated financial statements and the related notes included elsewhere in this Annual Report on Form 10-K. Components of management's discussion and analysis of financial condition and results of operations include:•Overview •Financial Highlights •Results of Operations •Comparison of 2020 to 2019•Comparable Store Sales and Total Comparable Sales•Non-GAAP Financial Measures•Liquidity and Capital Resources•Revolving Credit Facilities•Contractual Obligations and Commitments•Off-Balance Sheet Arrangements•Critical Accounting Policies and EstimatesOur fiscal year ends on the Sunday closest to January 31 of the following year, typically resulting in a 52-week year, but occasionally giving rise to an additional week, resulting in a 53-week year. Fiscal 2020 and 2019 were each 52-week years. This discussion and analysis contains forward-looking statements based on current expectations that involve risks, uncertainties and assumptions, such as our plans, objectives, expectations, and intentions included in the "Special Note Regarding Forward-Looking Statements." Our actual results and the timing of events may differ materially from those anticipated in these forward-looking statements as a result of various factors, including those described in the "Item 1A. Risk Factors" section and elsewhere in this Annual Report on Form 10-K.We disclose material non-public information through one or more of the following channels: our investor relations website (http://investor.lululemon.com/), the social media channels identified on our investor relations website, press releases, SEC filings, public conference calls, and webcasts.OverviewFiscal 2020 was a year in which we had to adapt our priorities, and evolve our strategies, to navigate the challenges of the COVID-19 pandemic and begin to more impactfully address systemic inequities in our society.We put three foundational principles in place to help guide us through the pandemic. These principles are: 1) protect our people to ensure their health, safety, and well-being, 2) make balanced decisions including investing in our digital and omni capabilities while tightly managing discretionary expenses, and 3) continue to invest in our future. We completed our first acquisition in 2020, with our purchase of MIRROR. MIRROR bolsters our digital sweatlife offerings and brings immersive and personalized at-home sweat and mindfulness solutions to new and existing lululemon guests.In addition, we established IDEA – our commitment to Inclusion, Diversity, Equity, and Action – to help drive lasting change both within our company and the communities in which we operate. In October 2020, we released our Impact Agenda detailing our strategies to become a more sustainable and equitable business, to minimize our environmental impact, and to accelerate positive change both internally and externally. The Power of ThreeDespite the global pandemic, we remain committed to our Power of Three growth plan and the targets contemplated by this plan which include a doubling of our men's business, a doubling of our e-commerce business, and a quadrupling of our international business by 2023 from levels realized in 2018. Due to a shift towards online shopping as a result of COVID-19, we exceeded our e-commerce goal this year.In addition to the growth targets, the three strategic pillars of the plan also remain unchanged and include: product innovation, omni-guest experience, and market expansion.23Table of ContentsProduct InnovationWe continued to leverage our Science of Feel development platform and brought innovations to our guests including a relaunch of our Everlux fabric and an expansion of our Align franchise into tops. We also brought newness into our bra offering and expanded our On the Move assortment. We introduced more inclusive sizing into our core women's styles in 2020 with additional styles to be added in 2021. In men's, our guests responded well to shorts, sweats, hoodies, and joggers as they adapted their wardrobes to working and sweating from home.Omni-Guest ExperienceThe COVID-19 pandemic impacted the way guests interacted with our brand in 2020. Temporary store closures, social distancing requirements, and other actions taken within our stores to keep our guests and employees safe, contributed to a decline in store traffic relative to 2019. Revenue in stores decreased 34%. However, this was offset by significant strength in our e-commerce business. We invested in IT infrastructure, fulfillment capacity, and increased the number of educators assisting guests in our Guest Education Center, including an online digital educator experience to provide a more personalized shopping experience. In addition, we used our social channels to engage with our guests by offering ambassador-led digital sweat sessions, meditation classes, and other recovery and well-being tools. Revenue in our e-commerce channel increased 101% in 2020.In 2020, as it was safe to welcome guests back into our stores, we launched several initiatives to enhance the in-store experience. We adapted our Buy Online Pick-up In-store capability to allow guests to pick-up their purchases at the door of the store or at curbside, we implemented virtual waitlist capabilities so that guests did not have to physically wait in line to enter stores operating under strict capacity constraints, and we offered appointment shopping in-store.Market ExpansionWe continued to expand our presence both in North America and in our international markets. During the year, we opened 30 net new company-operated stores, including 18 stores in Asia Pacific, nine stores in North America, and three stores in Europe. We also expanded our seasonal store strategy in 2020 with over 100 seasonal stores in operation for some period of time during the year. These stores allowed us to better cater to our guests in select markets, while also helping introduce new guests to our brand. In addition, in the fourth quarter, we opened 11 of these stores in close proximity to permanent lululemon stores. Having two stores in select locations, where locally mandated capacity constraints were contributing to long wait times, allowed guests quicker and easier access to our in-store shopping experience. For 2020, our business in North America increased 8%, while total growth in our international markets was 31%.COVID-19 PandemicThe outbreak of the COVID-19 coronavirus was declared a pandemic by the World Health Organization in March 2020 and it has caused governments and public health officials to impose restrictions and to recommend precautions to mitigate the spread of the virus.Throughout the pandemic we have prioritized the safety of our employees and guests. In February and March, we temporarily closed all of our retail locations in Mainland China, North America, Europe, and certain countries in Asia Pacific. Our retail locations in Mainland China reopened during the first quarter of 2020, and our retail locations in other markets began reopening during the second quarter of 2020. Almost all locations were open during the third quarter of 2020, and while most of our retail locations have remained open since then, certain locations have temporarily closed based on government and health authority guidance in those markets. Our distribution centers and most of our open retail locations are operating with restrictive and precautionary measures in place such as reduced operating hours, physical distancing, enhanced cleaning and sanitation, and limited occupancy levels.Prior to the COVID-19 pandemic, guest shopping preferences were shifting towards digital platforms and we had been investing in our websites, mobile apps, and omni-channel capabilities. We believe that the COVID-19 pandemic further shifted guest shopping behaviour and we saw significant increases in traffic to our websites and digital apps. This increased traffic contributed to the significant growth in our direct to consumer net revenue in 2020. While we expect our direct to consumer business to grow, we expect the year over year growth rate in direct to consumer net revenue to moderate in 2021. 24Table of ContentsThe COVID-19 pandemic had a material adverse impact on our results of operations for 2020 and there remains significant uncertainty regarding the extent and duration of the impact that the COVID-19 pandemic will have on our operations. Continued proliferation of the virus, resurgence, or the emergence of new variants may result in further or prolonged closures of our retail locations and distribution centers, reduce operating hours, interrupt our supply chain, cause changes in guest behavior, and reduce discretionary spending. Such factors are beyond our control and could elicit further actions and recommendations from governments and public health authorities.We remain confident in the long-term growth opportunities and our Power of Three growth plan and believe that we have sufficient cash and cash equivalents, and available capacity under our committed revolving credit facility, to meet our liquidity needs. As of January 31, 2021, we had cash and cash equivalents of $1.2 billion and the capacity under our committed revolving credit facility was $397.6 million.Financial HighlightsThe summary below compares 2020 to 2019:•Net revenue increased 11% to $4.4 billion. On a constant dollar basis, net revenue increased 10%.•Company-operated stores net revenue decreased 34% to $1.7 billion.•Direct to consumer net revenue increased 101% to $2.3 billion, or increased 101% on a constant dollar basis.•Gross profit increased 11% to $2.5 billion.•Gross margin increased 10 basis points to 56.0%.•Acquisition-related expenses of $29.8 million were recognized.•Income from operations decreased 8% to $820.0 million. •Operating margin decreased 370 basis points to 18.6%. •Income tax expense decreased 8% to $230.4 million. Our effective tax rate was 28.1% for each of 2020 and 2019.•Diluted earnings per share were $4.50 for 2020 compared to $4.93 in 2019. This includes $26.7 million of after-tax costs related to the MIRROR acquisition, which reduced diluted earnings per share by $0.20 in 2020.Refer to the non-GAAP reconciliation tables contained in the "Non-GAAP Financial Measures" section of this "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations" for reconciliations between constant dollar changes in net revenue and direct to consumer net revenue, and the most directly comparable measures calculated in accordance with GAAP.Results of OperationsThe following table summarizes key components of our results of operations for the periods indicated: 2020201920202019 (In thousands)(Percentage of revenue)Net revenue$4,401,879 $3,979,296 100.0 %100.0 %Cost of goods sold1,937,888 1,755,910 44.0 44.1 Gross profit2,463,991 2,223,386 56.0 55.9 Selling, general and administrative expenses1,609,003 1,334,247 36.6 33.5 Amortization of intangible assets5,160 29 0.1 — Acquisition-related expenses29,842 — 0.7 — Income from operations819,986 889,110 18.6 22.3 Other income (expense), net(636)8,283 — 0.2 Income before income tax expense819,350 897,393 18.6 22.6 Income tax expense230,437 251,797 5.2 6.3 Net income$588,913 $645,596 13.4 %16.2 %25Table of ContentsComparison of 2020 to 2019 Net RevenueNet revenue increased $422.6 million, or 11%, to $4.4 billion in 2020 from $4.0 billion in 2019. On a constant dollar basis, assuming the average exchange rates in 2020 remained constant with the average exchange rates in 2019, net revenue increased $412.7 million, or 10%.The increase in net revenue was primarily due to an increase in direct to consumer net revenue, partially due to a shift in the way guests are shopping due to COVID-19, as well as net revenue from MIRROR. This was partially offset by a decrease in company-operated store net revenue, as well as a decrease in net revenue from our other retail locations driven by temporary closures as a result of COVID-19 as well as reduced operating hours and restricted guest occupancy levels.Net revenue for 2020 and 2019 is summarized below.2020201920202019Year over year change (In thousands)(Percentage of revenue)(In thousands)(Percentage)Company-operated stores$1,658,807 $2,501,067 37.7 %62.9 %$(842,260)(33.7)%Direct to consumer2,284,068 1,137,822 51.9 28.6 1,146,246 100.7 Other459,004 340,407 10.4 8.6 118,597 34.8 Net revenue$4,401,879 $3,979,296 100.0 %100.0 %$422,583 10.6 %Company-Operated Stores. The decrease in net revenue from our company-operated stores segment was primarily due to the impact of COVID-19. All of our stores in North America, Europe, and certain countries in Asia Pacific were temporarily closed for a significant portion of the first two quarters of 2020. Certain stores experienced temporary re-closures during the last two quarters of 2020. COVID-19 restrictions, including reduced operating hours and occupancy limits, reduced net revenue from company-operated stores that have reopened. During 2020, we opened 30 net new company-operated stores, including 18 stores in Asia Pacific, nine stores in North America, and three stores in Europe.Direct to Consumer. Direct to consumer net revenue increased 101%, and increased 101% on a constant dollar basis. The increase in net revenue from our direct to consumer segment was primarily the result of increased traffic, and improved conversion rates, partially offset by a decrease in dollar value per transaction. The increase in traffic was partially due to COVID-19, with more guests shopping online instead of in-stores. During the second quarter of 2020, we held an online warehouse sale in the United States and Canada which generated net revenue of $43.3 million. We did not hold any warehouse sales during 2019. Other. The increase in net revenue from our other operations was primarily the result of net revenue from MIRROR as well as an increased number of temporary locations, including seasonal stores, that were open during 2020 compared to 2019. The increase was partially offset by a decrease in outlet sales primarily due to the impact of COVID-19. Gross Profit20202019Year over year change(In thousands)(In thousands)(Percentage)Gross profit$2,463,991 $2,223,386 $240,605 10.8 %Gross margin56.0 %55.9 %10 basis points26Table of ContentsThe increase in gross margin was primarily the result of:•a decrease in occupancy and depreciation costs as a percentage of net revenue of 60 basis points, driven primarily by the increase in net revenue; •a decrease in costs related to our product departments as a percentage of revenue of 50 basis points, driven by lower incentive compensation and travel costs, as well as the increase in net revenue; and•a favorable impact of foreign exchange rates of 10 basis points.The increase in gross margin was partially offset by an increase in costs as a percentage of net revenue related to our distribution centers of 80 basis points. This was primarily due to an increase in costs related to COVID-19 safety precautions, higher people costs related to the growth in our direct to consumer business, and increased usage of third-party warehouse and logistics providers. There was also a decrease in product margin of 30 basis points, which was primarily due to higher markdowns and air freight costs, partially offset by a favorable mix of higher margin product.Selling, General and Administrative Expenses20202019Year over year change(In thousands)(In thousands)(Percentage)Selling, general and administrative expenses$1,609,003 $1,334,247 $274,756 20.6 %The increase in selling, general and administrative expenses was primarily due to:•an increase in costs related to our operating channels of $253.2 million, comprised of:–an increase in variable costs of $144.1 million primarily due to an increase in distribution costs related to the growth in our direct to consumer net revenue, and an increase in credit card fees as a result of increased net revenue; –an increase in brand and community costs of $116.4 million primarily due to an increase in digital marketing expenses;–an increase in other costs of $14.2 million primarily due to increases in information technology costs; and–a decrease in employee costs of $21.5 million primarily due to lower incentive compensation expenses in our company-operated stores and other channels. This was partially offset by an increase in salaries and wages as a result of increased headcount and labor hours in our direct to consumer and other operations;•an increase in head office costs of $56.5 million, comprised of:–an increase of $63.0 million primarily due to increases in information technology costs, professional fees, depreciation, community giving, and other head office costs; and–a decrease in employee costs of $6.5 million primarily due to lower incentive compensation and travel expenses, partially offset by increased salaries and wages expense as a result of headcount growth, and higher stock-based compensation expense; and•an increase in net foreign exchange and derivative revaluation losses of $1.6 million.The increase in selling, general and administrative expenses was partially offset by $36.5 million of government payroll subsidies. These payroll subsidies partially offset the wages paid to employees while our retail locations were temporarily closed due to the COVID-19 pandemic.Amortization of Intangible Assets20202019Year over year change(In thousands)(In thousands)(Percentage)Amortization of intangible assets$5,160 $29 $5,131 n/aThe increase in the amortization of intangible assets was the result of the intangible assets recognized upon the acquisition of MIRROR during the second quarter of 2020. 27Table of ContentsAcquisition-Related Expenses20202019Year over year change(In thousands)(In thousands)(Percentage)Acquisition-related expenses$29,842 $— $29,842 n/aAs a result of our acquisition of MIRROR in the second quarter of 2020, we recognized acquisition-related compensation of $20.1 million for deferred consideration for certain continuing MIRROR employees. We also recognized transaction and integration related costs of $10.5 million for advisory and professional services, and integration costs subsequent to the acquisition. Acquisition-related expenses were partially offset by a $0.8 million gain recognized on our existing investment. We did not have acquisition-related expenses in 2019. Please refer to Note 6. Acquisition included in Item 8 of Part II of this report for further information.Income from OperationsOn a segment basis, we determine income from operations without taking into account our general corporate expenses. During the first quarter of 2020, we reviewed our segment and general corporate expenses and determined certain costs that are more appropriately classified in different categories. Accordingly, comparative figures have been reclassified to conform to the financial presentation adopted for the current year.Segmented income from operations before general corporate expenses is summarized below. Income from operations2020201920202019Year over year change(In thousands)(Percentage of net revenue of respective operating segment)(In thousands)(Percentage)Segment income from operations:Company-operated stores$212,592 $689,339 12.8 %27.6 %$(476,747)(69.2)%Direct to consumer1,029,102 484,146 45.1 42.6 544,956 112.6 %Other10,502 72,013 2.3 21.2 (61,511)(85.4)%$1,252,196 $1,245,498 $6,698 0.5 %General corporate expenses397,208 356,359 40,849 11.5 %Amortization of intangibles5,160 29 5,131 n/aAcquisition-related expenses29,842 — 29,842 n/aIncome from operations$819,986 $889,110 $(69,124)(7.8)%Operating margin18.6 %22.3 %(370) basis pointsCompany-Operated Stores. The decrease in income from operations from company-operated stores was primarily the result of decreased gross profit of $591.8 million which was primarily due to lower net revenue as well as lower gross margin. The decrease in gross margin was primarily due to deleverage on occupancy and depreciation costs as a result of lower net revenue. The decrease in gross profit was partially offset by a decrease in selling, general and administrative expenses, primarily due to lower people costs and lower operating costs. People costs decreased primarily due to lower incentive compensation. Store operating costs decreased primarily due to lower credit card fees, packaging and supplies, and distribution costs as a result of lower net revenue, as well as lower community, security, and repairs and maintenance costs. The recognition of certain government payroll subsidies also reduced selling, general, and administrative expenses. Income from operations as a percentage of company-operated stores net revenue decreased primarily due to lower gross margin and deleverage on selling, general and administrative expenses.Direct to Consumer. The increase in income from operations from our direct to consumer segment was primarily the result of increased gross profit of $773.7 million which was primarily due to increased net revenue and due to higher gross margin. The increase in gross profit was partially offset by an increase in selling, general and administrative expenses primarily due to higher variable costs including distribution costs, credit card fees, and packaging and supplies costs as a result of higher net revenue, as well as higher digital marketing expenses, employee costs and information technology costs. Income from operations as a percentage of direct to consumer net revenue has increased primarily due to leverage on selling, general and administrative expenses and an increase in gross margin.Other. The decrease in income from operations was primarily the result of increased selling, general and administrative expenses, driven primarily by MIRROR digital marketing expenses, as well as increased distribution costs and credit card fees 28Table of Contentsas a result of revenue generated by MIRROR. The increase in selling, general and administrative expenses was partially offset by an increase in gross profit related to MIRROR, driven by increased net revenue. Income from operations as a percentage of other net revenue decreased primarily due to deleverage on selling, general and administrative expenses.General Corporate Expenses. The increase in general corporate expenses was primarily the result of increases in information technology costs, salaries and wages as a result of headcount growth, professional fees, depreciation, community giving, and an increase in net foreign exchange and derivative losses of $1.6 million. The increase in general corporate expense was partially offset by a decrease in travel and incentive compensation costs, as well as the recognition of certain government payroll subsidies. We expect general corporate expenses to continue to increase in future years as we grow our overall business and require increased efforts at our head office to support our operations.Other Income (Expense), Net20202019Year over year change(In thousands)(In thousands)(Percentage)Other income (expense), net$(636)$8,283 $(8,919)(107.7)%The decrease in other income, net was primarily due to a decrease in net interest income as a result of lower cash balances and lower interest rates during the majority of 2020 compared to 2019. We did not have any borrowings on our revolving credit facilities during 2020 or 2019.Income Tax Expense20202019Year over year change(In thousands)(In thousands)(Percentage)Income tax expense$230,437 $251,797 $(21,360)(8.4)%Effective tax rate28.1 %28.1 %— basis pointsOur effective tax rate for 2020 was consistent with 2019. This included an increase in the effective tax rate due to certain non-deductible expenses related to the MIRROR acquisition which increased the effective tax rate by 60 basis points. This was offset by adjustments upon filing of certain income tax returns and an increase in tax deductions related to stock-based compensation.Net Income20202019Year over year change(In thousands)(In thousands)(Percentage)Net income$588,913 $645,596 $(56,683)(8.8)%The decrease in net income in 2020 was primarily due to an increase in selling, general and administrative expenses of $274.8 million, the recognition of acquisition-related expenses of $29.8 million, an increase in amortization of intangible assets of $5.1 million, and a decrease in other income (expense), net of $8.9 million. This was partially offset by an increase in gross profit of $240.6 million, and a decrease in income tax expense of $21.4 million.Comparable Store Sales and Total Comparable SalesWe use comparable store sales to assess the performance of our existing stores as it allows us to monitor the performance of our business without the impact of recently opened or expanded stores. We use total comparable sales to evaluate the performance of our business from an omni-channel perspective. We therefore believe that investors would similarly find these metrics useful in assessing the performance of our business. However, as the temporary store closures from COVID-19 resulted in a significant number of stores being removed from our comparable store calculations during the first two quarters of 2020, we believe total comparable sales and comparable store sales on a full year basis are not currently representative of the underlying trends of our business. We do not believe these full year metrics are currently useful to investors in understanding performance, therefore we have not included these metrics in our discussion and analysis of results of operations. We did not provide comparable sales metrics that included the first two quarters during 2020, and expect to do the same for 2021.Comparable store sales reflect net revenue from company-operated stores that have been open, or open after being significantly expanded, for at least 12 full fiscal months. Net revenue from a store is included in comparable store sales 29Table of Contentsbeginning with the first fiscal month for which the store has a full fiscal month of sales in the prior year. Comparable store sales exclude sales from new stores that have not been open for at least 12 full fiscal months, from stores which have not been in their significantly expanded space for at least 12 full fiscal months, and from stores which have been temporarily relocated for renovations or temporarily closed. Comparable store sales also exclude sales from direct to consumer and our other operations, as well as sales from company-operated stores that have closed.Total comparable sales combines comparable store sales and direct to consumer sales. In fiscal years with 53 weeks, the 53rd week of net revenue is excluded from the calculation of comparable sales. In the year following a 53 week year, the prior year period is shifted by one week to compare similar calendar weeks. Opening new stores and expanding existing stores is an important part of our growth strategy. Accordingly, total comparable sales is just one way of assessing the success of our growth strategy insofar as comparable sales do not reflect the performance of stores opened, or significantly expanded, within the last 12 full fiscal months. The comparable sales measures we report may not be equivalent to similarly titled measures reported by other companies.Non-GAAP Financial MeasuresConstant dollar changes in net revenue and direct to consumer net revenue are non-GAAP financial measures.A constant dollar basis assumes the average foreign exchange rates for the period remained constant with the average foreign exchange rates for the same period of the prior year. We provide constant dollar changes in our results to help investors understand the underlying growth rate of net revenue excluding the impact of changes in foreign exchange rates.The presentation of this financial information is not intended to be considered in isolation or as a substitute for, or with greater prominence to, the financial information prepared and presented in accordance with GAAP. A reconciliation of the non-GAAP financial measures follows, which includes more detail on the GAAP financial measure that is most directly comparable to each non-GAAP financial measure, and the related reconciliations between these financial measures.The below changes in net revenue show the change compared to the corresponding period in the prior year.2020Net RevenueDirect to Consumer Net Revenue(In thousands)(Percentages)(Percentages)Change$422,583 11 %101 %Adjustments due to foreign exchange rate changes(9,898)(1)— Change in constant dollars$412,685 10 %101 %Liquidity and Capital ResourcesOur primary sources of liquidity are our current balances of cash and cash equivalents, cash flows from operations, and capacity under our committed revolving credit facility. Our primary cash needs are capital expenditures for opening new stores and remodeling or relocating existing stores, investing in information technology and making system enhancements, funding working capital requirements, and making other strategic capital investments both in North America and internationally. We may also use cash to repurchase shares of our common stock. Cash and cash equivalents in excess of our needs are held in interest bearing accounts with financial institutions, as well as in money market funds, treasury bills, and term deposits.We believe that our cash and cash equivalent balances, cash generated from operations, and borrowings available to us under our committed revolving credit facility will be adequate to meet our liquidity needs and capital expenditure requirements for at least the next 12 months. Our cash from operations may be negatively impacted by a decrease in demand for our products as well as the other factors described in "Item 1A. Risk Factors". In addition, we may make discretionary capital improvements with respect to our stores, distribution facilities, headquarters, or systems, or we may repurchase shares under an approved stock repurchase program, which we would expect to fund through the use of cash, issuance of debt or equity securities or other external financing sources to the extent we were unable to fund such capital expenditures out of our cash and cash equivalents and cash generated from operations.Capital expenditures are expected to range between $335.0 million and $345.0 million in fiscal 2021.30Table of ContentsAs of January 31, 2021, our working capital (excluding cash and cash equivalents) was $90.7 million, our cash and cash equivalents were $1.2 billion and our capacity under our committed revolving credit facility was $397.6 million.The following table summarizes our net cash flows provided by and used in operating, investing, and financing activities for the periods indicated: 20202019 (In thousands)Total cash provided by (used in):Operating activities$803,336 $669,316 Investing activities(695,532)(278,408)Financing activities(80,788)(177,173)Effect of exchange rate changes on cash29,996 (1,550)Increase in cash and cash equivalents$57,012 $212,185 Operating ActivitiesNet cash provided by operating activities increased $134.0 million to $803.3 million in 2020 from $669.3 million in 2019, primarily as a result of the following:•an increase from changes in operating assets and liabilities of $146.5 million, primarily due to the following:–$97.5 million related to accounts payable, partially due to a change in payment terms with our non-product vendors;–$76.8 million related to other accrued liabilities, primarily due to increases in accrued duty, freight, and other operating expenses as well as an increase in the sales return allowance as a result of COVID-19 reducing in-period returns;–$38.7 million related to inventories; and–$12.1 million related to other current and non-current liabilities.The increase from changes in operating assets and liabilities was partially offset by the following:–$38.4 million related to prepaid expenses and other current and non-current assets, including increases in cloud computing implementation costs; –$32.0 million related to accrued compensation and related expenses due to lower accrued incentive compensation, partially offset by acquisition-related compensation accruals; and–$8.2 million related to income taxes.•an increase of $44.2 million in adjustments to reconcile net income to net cash provided by operating activities other than changes in operating assets and liabilities, primarily related to an increase in depreciation and amortization, deferred income taxes, the settlement of derivatives not designated in a hedging relationship, and stock-based compensation.The increase in cash provided by operating activities was partially offset by a decrease of $56.7 million in net income.Investing ActivitiesCash used in investing activities increased $417.1 million, to $695.5 million in 2020 from $278.4 million in 2019. The increase was primarily due to the acquisition of MIRROR, net of cash acquired for $452.6 million during 2020. This was partially offset by a decrease in capital expenditures. Capital expenditures for our company-operated stores segment were $134.2 million and $171.5 million in 2020 and 2019, respectively. The capital expenditures for our company-operated stores segment in each period were primarily for the remodeling or relocation of certain stores, for opening new company-operated stores, and ongoing store refurbishment. The decrease in capital expenditures for our company-operated stores segment was primarily due to fewer store renovations during 2020 in comparison with 2019. The capital expenditures for our company-operated stores segment also included $41.0 million to open 40 company-operated stores and $44.3 million to open 57 company-operated stores, in 2020 and 2019 31Table of Contentsrespectively. As a result of the COVID-19 pandemic we delayed certain store renovations and new store openings. We expect to open between 40 and 50 company-operated stores in 2021.Capital expenditures for our direct to consumer segment were $37.2 million and $15.8 million in 2020 and 2019, respectively. We accelerated our investments in our e-commerce websites and mobile apps during 2020 in response to the COVID-19 pandemic and the impact it had on guest shopping behavior. The capital expenditures in 2020 were primarily related to enhancing the functionality and capacity of our websites, and in 2019 were primarily related to our then new distribution center in Toronto, Canada as well as other information technology infrastructure and system initiatives.Capital expenditures related to corporate activities and other were $57.8 million and $95.7 million in 2020 and 2019, respectively. The capital expenditures in each fiscal year were primarily related to investments in information technology and business systems, and for capital expenditures related to opening retail locations other than company-operated stores. The decrease in capital expenditures for our corporate activities and other was partially due to more larger scale projects in the prior year in comparison to the current year as well as a shift to cloud computing. Implementation costs related to cloud service arrangements are capitalized within other non-current assets in the consolidated balance sheets and the associated cash flows are included in operating activities. We anticipate that we will continue to shift towards more cloud-based technology services in the future.Financing ActivitiesCash used in financing activities decreased $96.4 million, to $80.8 million in 2020 from $177.2 million in 2019. The decrease was primarily the result of a decrease in our stock repurchases.During 2020, 0.4 million shares were repurchased at a cost of $63.7 million. During 2019, 1.1 million shares, were repurchased at a cost of $173.4 million. In the first quarter of 2019, we repurchased 1.0 million shares in a private transaction. We did not purchase any shares in private transactions during 2020. The other common stock was repurchased in the open market at prevailing market prices, including under plans complying with the provisions of Rule 10b5-1 and Rule 10b-18 of the Securities Exchange Act of 1934, with the timing and actual number of shares repurchased depending upon market conditions, eligibility to trade, and other factors.Revolving Credit FacilitiesNorth America revolving credit facilityDuring 2016, we obtained a $150.0 million committed and unsecured five-year revolving credit facility with major financial institutions. On June 6, 2018, we amended the credit agreement to provide for (i) an increase in the aggregate commitments under the revolving credit facility to $400.0 million, with an increase of the sub-limits for the issuance of letters of credit and extensions of swing line loans to $50.0 million for each, (ii) an increase in the option, subject to certain conditions, to request increases in commitments from $400.0 million to $600.0 million and (iii) an extension in the maturity of the facility from December 15, 2021 to June 6, 2023. Borrowings under the facility may be made in U.S. Dollars, Euros, Canadian Dollars, and in other currencies, subject to the lenders' approval.As of January 31, 2021, aside from letters of credit of $2.4 million, we had no other borrowings outstanding under this credit facility.Borrowings under the facility bear interest at a rate equal to, at our option, either (a) based on the rates applicable for deposits on the interbank market for U.S. Dollars or the applicable currency in which the borrowings are made ("LIBOR") or (b) an alternate base rate, plus, an applicable margin determined by reference to a pricing grid, based on the ratio of indebtedness to earnings before interest, tax, depreciation, amortization, and rent ("EBITDAR") and ranges between 1.00%-1.50% for LIBOR loans and 0.00%-0.50% for alternate base rate loans. Additionally, a commitment fee of between 0.10%-0.20% is payable on the average unused amounts under the revolving credit facility, and fees of 1.00%-1.50% are payable on unused letters of credit.The credit agreement contains negative covenants that, among other things and subject to certain exceptions, limit the ability of our subsidiaries to incur indebtedness, incur liens, undergo fundamental changes, make dispositions of all or substantially all of their assets, alter their businesses and enter into agreements limiting subsidiary dividends and distributions. We are also required to maintain a consolidated rent-adjusted leverage ratio of not greater than 3.5:1 and to maintain the ratio of consolidated EBITDAR to consolidated interest charges (plus rent) below 2:1. The credit agreement also contains certain customary representations, warranties, affirmative covenants, and events of default (including, among others, an event of default upon the occurrence of a change of control). As of January 31, 2021, we were in compliance with the covenants of the credit facility.32Table of ContentsMainland China revolving credit facilityIn December 2019, we entered into an uncommitted and unsecured 130.0 million Chinese Yuan revolving credit facility with terms that are reviewed on an annual basis. The credit facility was increased to 230.0 million Chinese Yuan during 2020. It comprises of a revolving loan of up to 200.0 million Chinese Yuan and a financial guarantee facility of up to 30.0 million Chinese Yuan, or its equivalent in another currency. Loans are available for a period not to exceed 12 months, at an interest rate equal to the loan prime rate plus a spread of 0.5175%. We are required to follow certain covenants. As of January 31, 2021, we were in compliance with the covenant and there were no borrowings or guarantees outstanding under this credit facility.364-Day revolving credit facilityIn June 2020, we obtained a 364-day $300.0 million committed and unsecured revolving credit facility. In December 2020, we elected to terminate this credit facility.Contractual Obligations and CommitmentsLeases. We lease certain store and other retail locations, distribution centers, offices, and equipment under non-cancellable operating leases. Our leases generally have initial terms of between five and 15 years, and generally can be extended in five-year increments, if at all. The following table details our future minimum lease payments. Minimum lease commitments exclude variable lease expenses including contingent rent payments, common area maintenance, property taxes, and landlord's insurance. Purchase obligations. The amounts listed for purchase obligations in the table below represent agreements (including open purchase orders) to purchase products and for other expenditures in the ordinary course of business that are enforceable and legally binding and that specify all significant terms. In some cases, values are subject to change, such as for product purchases throughout the production process. The reported amounts exclude liabilities included in our consolidated balance sheets as of January 31, 2021.One-time transition tax. As outlined in Note 17. Income Taxes included in Item 8 of Part II of this report, U.S. tax reform imposed a mandatory transition tax on accumulated foreign subsidiary earnings which have not previously been subject to U.S. income tax. The one-time transition tax is payable over eight years beginning in fiscal 2018. The table below outlines the expected payments due by fiscal year.Deferred consideration. The amounts listed for deferred consideration in the table below represent expected future cash payments for certain continuing MIRROR employees, subject to the continued employment of those individuals up to three years from the acquisition date as outlined in Note 6. Acquisition included in Item 8 of Part II of this report.The following table summarizes our contractual arrangements due by fiscal year as of January 31, 2021, and the timing and effect that such commitments are expected to have on our liquidity and cash flows in future periods: Total20212022202320242025Thereafter (In thousands)Operating leases (minimum rent)$874,517 $189,907 $177,819 $151,668 $127,834 $71,670 $155,619 Purchase obligations567,864 522,467 4,696 4,696 15,654 2,348 18,003 One-time transition tax payable48,226 5,076 5,076 9,518 12,691 15,865 — Deferred consideration49,544 25,194 24,341 9 — — — Off-Balance Sheet ArrangementsWe enter into standby letters of credit to secure certain of our obligations, including leases, taxes, and duties. As of January 31, 2021, letters of credit and letters of guarantee totaling $2.8 million had been issued, including $2.4 million under our committed revolving credit facility.We have not entered into any transactions, agreements or other contractual arrangements to which an entity unconsolidated with us is a party and under which we have (i) any obligation under a guarantee, (ii) any retained or contingent interest in assets transferred to an unconsolidated entity that serves as credit, liquidity or market risk support to such entity, (iii) any obligation under derivative instruments that are indexed to our shares and classified as equity in our consolidated balance sheets, or (iv) any obligation arising out of a variable interest in any unconsolidated entity that provides financing, liquidity, market risk or credit support to us or engages in leasing, hedging or research and development services with us.33Table of ContentsCritical Accounting Policies and EstimatesThe preparation of financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions. Predicting future events is inherently an imprecise activity and, as such, requires the use of judgment. Actual results may vary from our estimates in amounts that may be material to the financial statements. An accounting policy is deemed to be critical if it requires an accounting estimate to be made based on assumptions about matters that are highly uncertain at the time the estimate is made, and if different estimates that reasonably could have been used or changes in the accounting estimates that are reasonably likely to occur periodically, could materially impact our consolidated financial statements. Our critical accounting policies, estimates, and judgements are as follows, and see Note 2. Summary of Significant Account Policies included in Item 8 of Part II for additional information:Inventory provisionsInventory is valued at the lower of cost and net realizable value. We periodically review our inventories and make a provision for obsolescence and goods that have quality issues or that are damaged. We record a provision at an amount that is equal to the difference between the inventory cost and its net realizable value. As at January 31, 2021 the net carrying value of our inventories was $647.2 million, which included provisions for obsolete and damaged inventory of $30.0 million. The provision is determined based upon assumptions about product quality, damages, future demand, selling prices, and market conditions. If changes in market conditions result in reductions in the estimated net realizable value of our inventory below our previous estimate, we would increase our reserve in the period in which we made such a determination.Goodwill impairment assessmentGoodwill is tested annually for impairment on the first day of the fourth quarter each fiscal year, or more frequently if there are indicators of impairment. Goodwill is allocated to the reporting unit which is expected to receive the benefit from the synergies of the combination. The Company has allocated $362.5 million of goodwill to the MIRROR reporting unit. As at November 2, 2020, we performed a qualitative assessment and concluded that it was more likely than not that the fair value of the MIRROR reporting unit exceeded its carrying value, and therefore, no further impairment testing was required. In concluding that it was more likely than not that the fair value of the MIRROR reporting unit exceeded its fair value we considered if there had been any negative changes to the key valuation inputs; including future revenue growth rates, future gross and operating margin, discount rates, and terminal value assumptions since the date of acquisition. In future periods a full impairment test may be required depending on changes to market conditions, performance of the MIRROR reporting unit, or changes in the Company's strategy.Deferred taxes on undistributed net investment of foreign subsidiaries. We have not recognized U.S. state income taxes and foreign withholding taxes on the net investment in our subsidiaries which we have determined to be indefinitely reinvested. This determination is based on the cash flow projections and operational and fiscal objectives of each of our foreign subsidiaries. Such estimates are inherently imprecise since many assumptions utilized in the projections are subject to revision in the future. For the portion of our net investment in our Canadian subsidiaries that are not indefinitely reinvested, we have recorded a deferred tax liability for the taxes which would be due upon repatriation. For distributions made by our Canadian subsidiaries, the amount of tax payable is partially dependent on how the repatriation transactions are made. The deferred tax liability has been recorded on the basis that we would choose to make the repatriation transactions in the most tax efficient manner. Specifically, to the extent that the Canadian subsidiaries have sufficient paid-up-capital, any such distributions would be characterized for Canadian tax purposes as a return of capital, rather than as a dividend, and would not be subject to Canadian withholding tax.As of January 31, 2021, the paid-up-capital balance of the Canadian subsidiaries for tax purposes was $2.0 billion. The net investment in our Canadian subsidiaries was $1.8 billion, of which $0.8 billion was determined to be indefinitely reinvested. The Canadian subsidiaries have sufficient paid-up-capital such that we could choose to repatriate the portion of our net investment that is not indefinitely reinvested without paying Canadian withholding tax. Deferred income tax liabilities of $3.0 million have been recognized in relation to the portion of our net investment in our Canadian subsidiaries that is not indefinitely reinvested, principally representing the U.S. state income taxes which would 34Table of Contentsbe due upon repatriation. The unrecognized deferred tax liability on the indefinitely reinvested amount is approximately $2.4 million.In future periods, if the net investment in our Canadian subsidiaries exceeds their paid-up-capital balance, whether due to a change in the amount that is indefinitely reinvested or as a result of accumulation of profits by these subsidiaries, we will record additional deferred tax liabilities for Canadian withholding taxes and our effective tax rate will increase.ContingenciesWe are involved in legal proceedings regarding contractual and employment relationships and a variety of other matters. We record contingent liabilities, when a loss is assessed to be probable and its amount is reasonably estimable. If it is reasonably possible that a material loss could occur through ongoing litigation, we provide disclosure in the footnotes to our financial statements. Assessing probability of loss and estimating the amount of probable losses requires analysis of multiple factors, including in some cases judgments about the potential actions of third-party claimants and courts. Should we experience adverse court judgments or should negotiated outcomes differ to our expectations with respect to such ongoing litigation it could have a material adverse effect on our results of operations, financial position, and cash flows.ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKForeign Currency Exchange Risk. The functional currency of our foreign subsidiaries is generally the applicable local currency. Our consolidated financial statements are presented in U.S. dollars. Therefore, the net revenue, expenses, assets, and liabilities of our foreign subsidiaries are translated from their functional currencies into U.S. dollars. Fluctuations in the value of the U.S. dollar affect the reported amounts of net revenue, expenses, assets, and liabilities. Foreign exchange differences which arise on translation of our foreign subsidiaries' balance sheets into U.S. dollars are recorded as a foreign currency translation adjustment in accumulated other comprehensive income or loss within stockholders' equity.We also have exposure to changes in foreign exchange rates associated with transactions which are undertaken by our subsidiaries in currencies other than their functional currency. Such transactions include intercompany transactions and inventory purchases denominated in currencies other than the functional currency of the purchasing entity. As a result, we have been impacted by changes in exchange rates and may be impacted for the foreseeable future. The potential impact of currency fluctuation increases as our international expansion increases.As of January 31, 2021, we had certain forward currency contracts outstanding in order to hedge a portion of the foreign currency exposure that arises on translation of a Canadian subsidiary into U.S. dollars. We also had certain forward currency contracts outstanding in an effort to reduce our exposure to the foreign exchange revaluation gains and losses that are recognized by our Canadian and Chinese subsidiaries on U.S. dollar denominated monetary assets and liabilities. Please refer to Note 15. Derivative Financial Instruments included in Item 8 of Part II of this report for further information, including details of the notional amounts outstanding.In the future, in an effort to reduce foreign exchange risks, we may enter into further derivative financial instruments including hedging additional currency pairs. We do not, and do not intend to, engage in the practice of trading derivative securities for profit.We currently generate a significant portion of our net revenue and incur a significant portion of our expenses in Canada. We also hold a significant portion of our net assets in Canada. The reporting currency for our consolidated financial statements is the U.S. dollar. A weakening of the U.S. dollar against the Canadian dollar results in:•the following impacts to the consolidated statements of operations:–an increase in our net revenue upon translation of the sales made by our Canadian operations into U.S. dollars for the purposes of consolidation;–an increase in our selling, general and administrative expenses incurred by our Canadian operations upon translation into U.S. dollars for the purposes of consolidation;–foreign exchange revaluation losses by our Canadian subsidiaries on U.S. dollar denominated monetary assets and liabilities; and–derivative valuation gains on forward currency contracts not designated in a hedging relationship;•the following impacts to the consolidated balance sheets:35Table of Contents–an increase in the foreign currency translation adjustment which arises on the translation of our Canadian subsidiaries' balance sheets into U.S. dollars; and–a decrease in the foreign currency translation adjustment from derivative valuation losses on forward currency contracts, entered into as net investment hedges of a Canadian subsidiary.During 2020, the change in the relative value of the U.S. dollar against the Canadian dollar resulted in a $57.0 million reduction in accumulated other comprehensive loss within stockholders' equity. During 2019, the change in the relative value of the U.S. dollar against the Canadian dollar resulted in a $4.6 million increase in accumulated other comprehensive loss within stockholders' equity.A 10% appreciation in the relative value of the U.S. dollar against the Canadian dollar compared to the exchange rates in effect for 2020 would have resulted in lower income from operations of approximately $22.0 million in 2020. This assumes a consistent 10% appreciation in the U.S. dollar against the Canadian dollar throughout the fiscal year. The timing of changes in the relative value of the U.S. dollar combined with the seasonal nature of our business, can affect the magnitude of the impact that fluctuations in foreign exchange rates have on our income from operations.Interest Rate Risk. Our committed revolving credit facility provides us with available borrowings in an amount up to $400.0 million. Because our revolving credit facilities bear interest at a variable rate, we will be exposed to market risks relating to changes in interest rates, if we have a meaningful outstanding balance. As of January 31, 2021, aside from letters of credit of $2.4 million, there were no borrowings outstanding under these credit facilities. We currently do not engage in any interest rate hedging activity and currently have no intention to do so. However, in the future, if we have a meaningful outstanding balance under our revolving facility, in an effort to mitigate losses associated with these risks, we may at times enter into derivative financial instruments, although we have not historically done so. These may take the form of forward contracts, option contracts, or interest rate swaps. We do not, and do not intend to, engage in the practice of trading derivative securities for profit.Our cash and cash equivalent balances are held in the form of cash on hand, bank balances, short-term deposits and treasury bills with original maturities of three months or less, and in money market funds. We do not believe these balances are subject to material interest rate risk.Credit Risk. We have cash on deposit with various large, reputable financial institutions and have invested in U.S. and Canadian Treasury Bills, and in AAA-rated money market funds. The amount of cash and cash equivalents held with certain financial institutions exceeds government-insured limits. We are also exposed to credit-related losses in the event of nonperformance by the financial institutions that are counterparties to our forward currency contracts. The credit risk amount is our unrealized gains on our derivative instruments, based on foreign currency rates at the time of nonperformance. We have not experienced any losses related to these items, and we believe credit risk to be minimal. We seek to minimize our credit risk by entering into transactions with credit worthy and reputable financial institutions and by monitoring the credit standing of the financial institutions with whom we transact. We seek to limit the amount of exposure with any one counterparty.InflationInflationary factors such as increases in the cost of our product and overhead costs may adversely affect our operating results. Although we do not believe that inflation has had a material impact on our financial position or results of operations to date, a high rate of inflation in the future may have an adverse effect on our ability to maintain current levels of gross margin and selling, general and administrative expenses as a percentage of net revenue if the selling prices of our products do not increase with these increased costs.36Table of Contents
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